microsoft word the relationship-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 46 the relationship between income smoothing and income tax and profitability ratios in iran stock market dr. parviz saeidi department of management,aliabad katoul branch islamic azad university, aliabad katoul, iran e-mail: dr.psaeidi@yahoo.com received: december 6, 2011 accepted: january 8, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.790 url: http://dx.doi.org/10.5296/ajfa.v4i1.790 abstract the main goal of this study is to consider the relationship between income smoothing and tax income and profitability ratio, i.e. return on assets (roa) and return on equity (roe).using the financial information of accepted companies in iran stock exchange, the current researcher first made an attempt to distinguish between income smoother companies and non-income smoother companies based on eckel index. after required modifications, a statistical population of 168 companies accepted in iran stock exchange was obtained and their financial information was examined during 2001 to 2oo7. independent variables included tax income and profitability ratio (roa and roe) and dependent variables was income smoothing variable. the findings illustrated the fact that a significant relationship exists between income smoothing and tax income and profitability ratio. keywords: income smoothing, tax income, profitability ratio, return on assets (roa), return on equity (roe) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 47 1. introduction increasingly development of economical activities and their intricacies and also attending to accurate accounting information and financial statements have created modern analytical and managerial approaches in accounting. financial statements are the means by which managers are seeking to see the results of their control over the resources for which they are responsible. the mentioned statements are to convey such information as the financial position, performance and cash flows of a firm. as a firm’s accounting records are not open to stockholders, they mostly rely on such financial statements in their judgments and decisions. for this reason, managers tend to report favorable accounting statistics in their financial statements. manipulating accounting statistics may mislead the users of financial statements in their decisions. bernea, ronen and sadan (1976) consider income smoothing as one of the common approaches of creative accounting in which fluctuations are deliberately manipulated and adjusted about some levels of earnings that is normal for the firm. hepworth (1953) finds smoothing as a reasonable and wise action by which managers smooth their income by using specific means. gordon, horwitz and meyers (1966) started off studies on the association between the accounting method of investment tax credits (income smoothing instrument) and the growth rates of earnings per share and the returns on the stockholders' equity (income smoothing objectives). they concluded that there is noteworthy relationship between them, which shows income smoothing practices are present. archibald (1967) and cushing (1969) worked on depreciation methods and accounting changes respectively. dascher and malcom (1970), barnea, ronen and sadan (1975) by investigating extraordinary items reported income smoothing behavior among selected companies. beidleman (1973) stated that companies use incentive compensation, pension and retirement expenses, research and development costs, sales and advertising expenses to smooth their income. some researchers in their studies on smoothing income claim that those companies with stable growth rate mislead market. these researchers have come up whit this idea based on unusual observations and also estimating risk methods. they believe that a relationship exists between income variance and risk. therefore, if there is evidence of the variance of income, it will affect the stockholder’s interpretation of the firm’s risk. in iran, tax system plays a key role in financial reports of firms and tax regulations is the main factor in selecting the type of accounting policies and methods. firms tend to smooth their income so as to minimize tax effects during the time. since more income leads to pay more tax and indeed results in going out liquidity, iranian firms smooth income in order to minimize going out liquidity particularly in the cases that firms owe considerable tax debts. in this paper, in order to measure profitability ratio, two key financial business ratios to measure a company’s efficiency are return on assets (roa) and return on equity (roe) (saeidi, 2007, p.114). the former shows the after tax earnings of assets and is an indicator of how profitable a company is. return on assets ratio is the key indicator of the profitability of a company. this ratio is calculated by using the following formula: net profit after taxes /total assets. the latter measures the return on the money the investors have put into the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 48 company. return on equity ratio is the key indicator of the management performance. this is calculated by: net income/stockholder's equity 2. literature review income smoothing has been a topic of interest among many researchers for decades especially after 1970. eckel (1981) revisited the previous researches on income smoothing and suggested an alternative conceptual framework to discern income smoothing manner. he criticized most of the researches for using one accounting variable to determine income smoothing. he suggested that firms with a smooth income use the joint effect of accounting variables so as to minimize income variables to the least. he concluded that just three percent of selected sample were carrying out artificial smoothing. although only using sale and income variables in his test, he thought that income arises from the difference between sale and stable and unstable expenses are caused by different variables. ryahi bolouki and pikvar (2002) by dividing the companies into two sections including central and peripheral industries tested the hypothesis to demonstrate that central companies are of less smoothing ratio than peripheral companies. they concluded that peripheral companies report more smoothing behavior than central companies do. moses (1987) demonstrated that accounting changes are considered as income smoothing devices. he indicated that accounting changes can be used to minimize income fluctuation instead of maximizing or minimizing reported income. his research was bases on two tests. the first one examined those companies with a smooth income and the other one investigated the effects of motivational factors toward income smoothing. he found smoothing behavior as subject to management motivations. hunt et al. (2000) claimed that income smoothing enhances synchronic price-earnings relations for each they thought that income smoothing provide better information on earnings. 3. research methodology this research is basically of casual and applied research types and employed the coefficient of variation method developed by eckel (1981) to determine the presence of income smoothing. in this method, the coefficient of variations is used to measure the variability of sales and income. this method has been used by many previous studies in determining the presence of income smoothing like albrecht and richardson (1990). the company is artificial smoothing if 1   scv icv . i nii     1/)( icv 2 i s nss s     1/)( cv 2 i asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 49 i income change s selling change cv coefficient of variation s selling average i income average 4. statistical population in order to analyze income soothing practices in the current study, numbers of accepted companies in tehran stock exchange including168 companies were selected according to the following conditions: 1. the selected companies must have the whole 10-year period and have fiscalyear end of 12/29. 2. companies must be continuously selling their shares in tehran stock exchange. 3. companies must not be of brokerage companies and their financial information is available within the whole 10-year period. 4. companies must be profitable. 5. findings 5.1. the first hypothesis testing: h0: there is no relationship between the income tax of accepted companies in tehran stock exchange and income smoothing. h1: there is relationship between the income tax of accepted companies in tehran stock exchange and income smoothing. for testing the firs hypothesis, logit model developed type of linear regression was used. the results are illustrated in the following table. table 1. the relationship between tax income and income smoothing likelihood ratio tests effect model fitting criteria likelihood ratio tests -2 log likelihood of reduced model chi-square df sig. intercept 5.545a .000 0 . tax 228.733 223.187 162 .001 according to logistic correlation test, the amount of sig obtained is 0/001 with the confidence level of 0/95 that rejected h0. in other words, there is significant relationship asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 50 between income smoothing and tax income of selected companies. the findings obtained from h0 indicated that a positive relationship existed between tax income and income smoothing. considering the table 1, coefficient of sig is 0/001 that rejected h0 and confirmed a significant relationship between tax income and income smoothing. taking this fact into account that an increase in income increases tax and a reduction in liquidity, iranian companies tend to smooth their income so as to decrease a reduction in liquidity particularly when they are suffering from large tax debts. 5.2 the second hypothesis testing h0: there is no reasonable relationship between return on investment (roi) of accepted companies in tehran stock exchange and income smoothing. h1: there is reasonable relationship between return on investment (roi) of accepted companies in tehran stock exchange and income smoothing. table 2. the relationship between roi and income smoothing likelihood ratio tests effect model fitting criteria likelihood ratio tests -2 log likelihood of reduced model chi-square df sig. intercept .000a .000 0 . roi 234.278 234.278 167 .000 according to logistic correlation test, the amount of sig obtained is 0/0 with the confidence level of 0/95 that rejected h0 and accepted h1. in other words, there is a significant relationship between roi and income smoothing. 5.3 the third hypothesis testing h0: there is no reasonable relationship between return on equity (roe) of accepted companies in tehran stock exchange and income smoothing. h1: there is reasonable relationship between return on equity (roe) of accepted companies in tehran stock exchange and income smoothing. table 3. the relationship between roe and income smoothing likelihood ratio tests effect model fitting criteria likelihood ratio tests -2 log likelihood of reduced model chi-square df sig. intercept .000a .000 0 . roe 154.421 154.421 122 .025 according to logistic correlation test, the amount of sig obtained is 0/025 with the confidence level of 0/95 that rejected h0 and accepted h1. in other words, there is a significant relationship between roe and income smoothing. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 51 6. conclusion the hypotheses testing indicated that a significant relationship existed between tax income and income smoothing, and they also demonstrated that the tax income of income-smoothing companies is less than that of non-income smoothing companies. finally a significant relationship existed between profitability ratio and income smoothing. acknowledgment the author wishes to thank mr. ramin rezaei m.a. who assisted in the proof-reading of the manuscript references albecht, w. d., & richardson, f. m. (1990). income smoothing by economy sector. journal of business finance and accounting, 17 (5), 713-730. http://dx.doi.org/10.1111/j.1468-5957.1990.tb00569.x ashari, n., koh, h., tan, s., & wong, w. (1994). factors affecting income smoothing among listed companies in singapore. accounting and business research, 24 (96), 291-301. bamea, a., j., ronen, & s., sadan. (1975). the implementation of accounting objectives-an application to extraordinary items. the accounting review, january, pp.55-68. barnea, a., j. ronen, & s. sadan. (1976). classificatory smoothing of income with extraordinary items. the accounting review, january, 56 (1), 110-112. beidleman, c.r. (1973). income smoothing: the role of management. the accounting review, october, 48 (4), 653-667. carlson, s. j., & bathala, c. t. (1997). ownership differences and firms income smoothing behavior. journal of business finance and accounting, march, vol. 24, pp. 179-182. eckel, n. (1981). the income smoothing hypothesis revisited abacus, 17 (1) 28-40. hepworth, s.r. (1953). smoothing periodic income. accounting review, 28 (1), 32-39. jones, j. (1991). earnings management during import relief investigations. journal of accounting research, 29. pp. 93-228. http://dx.doi.org/10.2307/2491047 kamarudin, k.a., bin, k. w., & kamil, k. (1999). market perception of income smoothing practices: malaysian evidence. university of technology malaysia. moses, a.d. (1987). income smoothing and incentives: empirical tests using accounting changes. the accounting review, april, pp. 358-377. ryahi, b., a., & pikvar, a. (2002). accounting theories. cultural research office publication, tehran, pp. 508-514. saeidi, p. (2007). financial management, vol. 1, tehran, negahe danesh publication. microsoft word 3233-12224-1-rv-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 251 managing financing risks in financial institutions azahari jamaludin (corresponding author) universiti kuala lumpur business school 1016 jalan sultan ismail, 50250 kuala lumpur, malaysia tel: 60-3-2681-7347 e-mail: bjazahari@bis.unikl.edu.my) fais ahmad college of business universiti utara malaysia kedah, malaysia. received: feb. 9, 2013 accepted: april 9, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3233 url: http://dx.doi.org/10.5296/ajfa.v5i1.3233 abstract the rule of thumb for any business decision is, the higher the risk, the higher the return is and vice versa. business risk is defined as risk arises out of uncertainty of future events. if these events are undesirable or unfavorable for business, damages and losses may happen. risk arises because it is impossible to forecast risk in advance whether and to what extent a loss will occur. the importance elements in risk-taking are the hope of success and the fear of failure. that is why it is said that risk is a no-win game. for financial institutions, whether it is conventional bank or islamic bank, making a right decision to finance is often a difficult task to do and crucial as well. a through and strict risk appraisal of the business must be performed and if they are uncomfortable in taking a certain business risk, normally they will then insist on certain terms and conditions with protection in the form of security and guarantees to overcome the risk identified. the objectives of this research is to understand the various types of business risks attached to different businesses as well as to acknowledge that business risk can be mitigated as well through various methods. keywords: business risks, financial institutions, shareholders’ risks, industry risks, funds diversion risk. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 252 1. introduction business risk arises from many different sub-risks and the assessment will also be dependent on the type and structure of lending and the time horizon of the lending. therefore, the level of the financial institutions capital at risk will be reflected through the profit (islamic bank) or interest (conventional bank) spread and/or effective yield of the investing or lending relationship. 2. management and shareholders’ risk character of the management (i.e. integrity and dependability) and capability of the management (i.e. business experience and business connection) are of important in providing the company’s direction and strategic plan. excellent management will be the comfort zone for the banker or investor to even start negotiation on the relationship. the issue of credibility in complying the company law and regulatory requirements, management ability to vision the future, are basic management appraisal/criteria. the management will determine the culture of the organization. understanding of risk associated with management and/or shareholders capability can be further divided into the following sub-risks: history, management capability, organization and ownership. 2.1 history if there is an adverse change in directorship or management team, investor or banker must try to understand the capability and style of the new management team and be ascertained whether they continue to adopt a conservative or aggressive business style. if the risk assessment on the new management and shareholders indicates that the new business plan will not be successfully implemented, then they might want to consider terminating the relationship. this change in management can be an outcome from mergers and/or acquisitions or from business expansion. 2.2 management capability investors/bankers usually take comfort if they lend to people whom they feel can deliver success. judging the “genuine” management requires interpersonal skill and trade checking and this can be done by asking questions on their attitude towards risk (always be careful with management who are in denial mood). assessment on capability should include the experience in handling change or adversity. management skills will affect the achievement of goals on growth, profitability, market share, stock price and dividend. 2.3 organization be clear of the size and layers of the management team. the business can be a part of a larger group of companies. as such, the investor or banker will have to be clear of the organizational role and the way the business decision is made. here, a decision is based on two key influences elements, namely, the corporate culture and the different role of the legal entity or entities. corporate culture referred to the flexibility or bureaucracy of workflow and decision-making asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 253 of the organization is part and parcel of the “culture” of the business. some organization practice the culture of “divide and rule” whilst some organizations practice the teamwork style. both cultures have their good points provided that the management has a strong hold in maintaining the culture. divide and rule encourages the employees to strive by bringing in business and revenue, being motivated by the existence of profit sharing incentives. their incentives correlate positively with the business they bring in. however, this strategy can also back fire due to the possibility of back-stabbing amongst the different business units. on the other hand, the team work culture is also good since all the business unit work towards one common goal, which is the maximization of profit of the whole organization itself. here, since every employee is a team player, each of them will be on the look out to help his other team members in the event of any difficulties or disruptions in operations for the sake of achieving the goal of the organization. however, be on the look out for any danger signals such as incompetence, fraud, strikes, and poor labor relations legal entity/entities, if the business is a part of or a subsidiary or is an associate of a larger group of companies, the investor or banker has to be clear where the management team fits into the larger group of companies. they must be clear of their right under each respective legal entity and study how these entities influence financial decisions of the business. if the management team decision about financing, production, and capital expenditures is made outside the management team which is familiar to the investor or banker, they should further assess the key management team which makes the final decision on these issues. on the other hand, if financial and commercial decisions do not come from the legal entity that borrows, the investor or banker should explore ways where it can control the sources of this decision. this control can be implemented by incorporating a corporate guarantee, letter of comfort, negative covenants of assets or alternatively, affirmative covenant on majority shareholding of the business. the investor/banker can control the business loan by making sure there is no change in shareholding and control. sometimes, decisions to borrow or the parking of the loan itself are made at the holding or investment company level. the loan will then either be on-lend to the operating subsidiary or will be used by the holding company for other investments. therefore, if an investor/banker lends to an investment holding company, they are not in control of the usage of the loan. it is for this reason that they prefer to lend to an operating company which possesses independent capacity to service debt through its own cash flow instead of lending to its parent or its investment holding company. lending direct will also allow them to closely monitor that the funds are being used for the stated purpose. in the event of a crisis where one legal entity/entities shows losses and is incapable of servicing its debt this can result in a cross default amongst the lenders. the investors/lenders must be guided by the companies act 1965. 2.4 ownership be really clear in identifying whether ownership is separate or the same with management. we usually assume that commitment is assured if ownership and management are one and the same. however, there is a possible risk of non-transparency in the business operation. ownership of public or public-listed companies, which are regulated by regulators, is usually asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 254 more transparent and professionally managed compared to private limited company where the investors or bankers faced the risk of lack of information and non-compliance. ownership which is concentrated in a few persons can also be a non-bureaucratic driving force resulting in speedy decision compared to diverse ownership. diverse ownership may result in shareholders squabbles. in a shareholders squabble which usually involves differences in business direction and personality, it is usually out of the investor’s/banker’s control to prevent the risk from deteriorating. therefore, it is advisable to have good security for loans granted against a situation where shareholders are diverse and/or when shareholders are of equal ranking. in case of doubt, insist on assessing the shareholders agreement before further assessing the credit. 3. industry risk (market risk) the industry in which the business competes has to be fully understood by the investor or banker. for example, if they provide long-term financing to the business, the focus will be on the long-term viability of the industry. since each industry has its own market risks and business cycles. market risk is simply defined as the risk when there is a sharp change in the value of the product as a result of price movement on the product in the marketplace. it is the risk of changes in demand and supply on the product as a result of variables beyond the control of the business, thereby resulting in drastic change in demand and price of product. for example, the movement of foreign exchange, commodity prices and stock prices in the bourses are market risk which is beyond the control of the business itself. as for industry, which changes fast in tandem with customer demand, for example information technology, it is important to understand future major trends in the industry that will affect the business. this can be assessed positively or adversely. industry risk or market risk can be further analyzed into three sub-risks: competition, industry demand risk and external factors. 3.1 competition competition can result in a squeeze in market share. assess whether the business’s market share will expand or further diluted. determine the size and strength of major competitors versus the key success variables of the business. assess the nature of competition on the scale from perfect to monopoly stake. the type and quality of products play a big role in the success of a business. assess whether the products and services are unique of uniform, i.e. commodities. in addition, competition can result in a change in market position if the perceived key success variables of the business are not successfully implemented. loss in market share will result in squeeze in profit margin due to high leverage, low sales or high cost. 3.2 industry demand risk each industry has its own variables that create basic demand. for instant, the industry can be financing intensive (leasing and hire-purchase companies), marketing intensive (consumer durable), quality intensive (engineering and electronic products), or service intensive asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 255 (investment banking). the features of the products and services, therefore, need to change in tandem with the change in consumer demand. demand risk can also be a result of benefits or hindrances derived from legal or regulatory support, protection, tariffs, and taxes as well as demographic and social factors. 3.3 external factors the effect of inflation on the industry’s cycle, political instability, war, electricity or power supply/disruption or the failure of transport or communication system are also external factors that will affect the industry’s strength. in analyzing such factors the investor/banker must ascertain whether insurance can be taken to mitigate such external risks on the industry. 4. funds diversion risk this risk can be interpreted as an internal and external source. it is easier to identify this risk when the business is already an existing client of the investor or banker. if they suspect funds are being diverted to various economic entities or out of the country, they should conduct a due diligence meeting with the business. if it is true, and there is no acceptable explanation, they can request that remedial be done (repayment to the investor or banker) within a reasonable time period. if such remedial is not implemented, they can request to terminate the relationship. fund diversion can be done through the following two methods, which are usually considered an acceptable practice by the investor or banker as long as they being notified of such a policy/arrangement: transfer pricing and dividend policy 4.1 transfer pricing transfer pricing can happen through the sales or purchase of the business as a result of inter-company sales or purchases within a bigger group. assuming the flagship of a group of companies is not the borrower itself, the transfer pricing as a result of higher purchase price and/or higher cost of good sold will result in poor profitability for the borrower. whilst the other economic entity which will be the flagship of the group that sells the product to the borrower, will show good profitability. the investor/banker then might decide to use the flagship entity as the borrowing vehicle instead of the loss-making entity. 4.2 dividend policy fund diversion can also be done through generous dividend policy. the banker will have to ascertain whether such generous dividend policy has been consistent. if it is not, investigate on the sudden change in policy because it can be the beginning of a problem at the shareholders’ level and the banker-borrower relationship. if much needed funds of the business are siphoned out through dividends, the banker might want to terminate the relationship for fear that the business financial position will be adversely affected. internally, at the banker’s level – if this is an existing customer’s – the bankers can further verify movement of funds on an inter-company basis and check whether it is consistent with asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 256 the banker’s understanding of the business. at the same time, knowing that the borrower is part of a large group, a complete understanding of inter-company sales purchases, royalties, management fees, loans, investments or dividend policies, will have to be fully understood before money is lent out. 5. regulatory risk whenever required, the investors or bankers must be thorough and satisfied that all regulatory approvals have been complied with or obtained by the business. in malaysia, for example, the movement of funds is controlled by bank negara malaysia through the exchange control malaysia (ecm) notices. if a financing involves the company’s corporate exercises which, in turn, involve equity restructuring and private debt securities, approvals from regulators like securities commission, the kuala lumpur stock exchange and/or the shareholders must be obtained. compliance to the companies act 1965 is a must. government regulations support the profitability of some businesses such as public utilities and entities which rely on tariff walls, taxes, and subsidies. telephone and electricity monopolies are some examples. the investors/bankers must understand the effect of the regulations and judge how likely the policies are to change and how change would affect the business. 6. downside risk some risks can be mitigated and some cannot be mitigated at all are called downside risks. downside risk is defined as possible but unlikely. it means identifying possible real world events which could create a loss to the business or general market. for example, the death of the major shareholder can be a downside risk to the credit by virtue that he provides a pivotal role in the success of the business. alternatively, the crash of the stock exchanges can be the real event for a downside risk to any share margin financing. here, the crash will result in a massive loss to the general investing community or market itself. in assessing a business risk, investors or bankers have got to acknowledge the existence of such downside risks although they cannot be totally mitigated. even with the acknowledgement of the downside risk, they still extend the financing based on the key success variables of the credit or the business itself. all financing activities cannot run away from their respective downside risks. if such a risk cannot be mitigated in totality, the investor or banker usually part mitigates it by taking collateral. 7. other business risk position risk, concentration risk, performance risk and country risk are other business risks that bankers or investors need to carefully examine. 7.1 position risk a position is the extent to which a business is exposed to price movement in something they buy, sell, or own. once you have identified a position and its duration, you can decide how great the potential for adverse market movement over the time in question is. the greater the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 257 risk, the greater the profit margin required to offset the risk. taking position can also be seen as over stocking. once the business position has been identified, two other risks hidden in the business (i.e. concentration risk and performance risk) can be further analyzed. 7.2 concentration risk a business selling a large portion of its output to one purchaser creates a risk. a single plant or facility has greater risk than one with many free standing plants. selling one product as opposed to selling a variety of products, although is a monopoly also creates a risk. purchasing a large portion of raw materials from one supplier creates a risk as well. 7.3 performance risk a buyer might not want to honor its commitment to pay when it finds out that the goods delivered are substandard. analyze the technical competency of the business and decide whether it is able to perform to meet its sales commitment, its contracts in hand and deliver them in time and to confirm that the commitments are legally binding. 7.4 country risk country risk arises from uncertainty in the country’s direction or probably a lack of permanent leadership. if there is a tussle of power and frequent change in leadership of a country, vague and frequent changes in policies can cause disruption in plans and loss of confidence by investors. 8. conclusion risk judgment is the most difficult part of financing assessment because it also involves subjective and qualitative issues. experience, comprehension of financing analysis techniques and depth of business knowledge will result in a more reliable conclusion. understanding the major types of business risks that have an impact on financing risk will result in a better and more informed financing decision, notwithstanding that different financing institutions have different financing bias and risk appetites. therefore, we may find that one banker or investor may reject a financing application from a business whereas 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(2010). financial institutions management: a risk management approach. 7th ed., mcgraw-hill/irwin. retrieved from www.amazon.com/financial-institutions-management-mcgraw-hill-insurance/dp/00735307 51 saunders, a. & cornett, m. (2007). financial institutions management: a risk management approach with s & p card. 6th edition, mcgraw-hill/irwin. retrieved from www.amazon.com/financial-institutions-management-mcgraw-hill-insurance/dp/00735307 51 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 932-3843-1-sm[1]-newwiter2-new-final asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 26 management entrenchment, agency problem and audit fees xinhua wang (corresponding author) international business faculty, beijing normal university, zhuhai campus, china & school of accounting and finance the hong kong polytechnic university, hung hom, kowloon, hong kong sar tel: (852)-2766-7404 e-mail: lgtbb@inet.polyu.edu.hk bibo yang graduate school of business the hong kong polytechnic university, hung hom, kowloon, hong kong sar tel: (852)-2766-5087 e-mail: bibo.yang@inet.polyu.edu.hk received: september 5, 2011 accepted: november 8, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.932 url: http://dx.doi.org/10.5296/ajfa.v3i1.932 abstract this study examines the association between audit fees and management entrenchment, which is proxied by bebchuk et al. (2005) entrenchment index. the results show that audit fees are significantly positively correlated with bebchuk et al. (2005) entrenchment index controlling for other factors. further results show that the positive relation between audit fees and the entrenchment index exists only in firm with low growth opportunity and high free cash flow (i.e. firms with severe jensen agency problem). these results indicate that firms’ agency problems moderate the association between audit fees and management entrenchment. keywords: audit fee, management entrenchment, agency problem jel classification: m42, g34 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 27 1. introduction a number of firms adopt corporate governance provisions to fight against takeover. although these governance provisions provide possible attempts to fend off being targets of merger and acquisitions, it is of great interest to know whether these governance provisions have any negative effects perceived by either capital markets or external auditors. corporate governance provisions have attracted attention from both academics and practitioners. prior studies on governance provisions focus on the effect of these provisions on market valuation (e.g. compers et al. (2003), bebchuk et al. (2005)). this study complements prior studies by investigating whether entrenchment governance provisions result in high level of risk and demand more audit effort by external auditors. it is reasonable to assume that auditors assess entrenchment provisions in auditing planning. the assumption is valid because auditors are sensitive to firm corporate governance and management control in both preplanning and planning judgment (cohen and hanno, 2000). if entrenchment provisions are perceived as higher risk, auditors would charge more audit fees due to more audit effort exercised for high risk clients (other things being equal). if entrenchment provisions are perceived as lower risk, auditors would charge less audit fees since auditors would exercise less audit effort on low risk clients (other things being equal). using audit fee data from u.s. firms, we examine whether auditors charge higher or lower audit fees for firms with higher entrenchment index scores controlling for other factors. we further investigate whether the association between audit fees and management entrenchment is contingent on firms’ agency problems. the contribution of this study is two-fold. first, this study contributes to the corporate governance provisions research by providing empirical evidence that entrenchment provisions results in higher audit fees, suggesting entrenchment provisions lead to higher audit risk. this provides one possible explanation why management entrenchment index has a negative effect on firm value. to this end, this study complements becheck et al. (2005) by providing evidence that entrenchment provisions result in high internal risk, and consequently reduce firm value. second, this study contributes to the auditing literature by providing empirical evidence that auditors charge higher audit fees for firms with more entrenchment governance provisions. this complements the experimental study of cohen (2000) by documenting empirical evidence that auditors are sensitive to the corporate governance ontrol of their clients. the next section develops testable hypotheses. section three presents methodology used in the empirical tests. section four describes the sample and section five provides empirical results and reports sensitivity tests. the final section concludes. 2. hypotheses development 2.1 entrenchment index compers et al. (2003) constructed a board index based on 24 corporate governance provisions and show that the index is negatively associated with firm value. bebchuk et al. (2005) asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 28 construct an entrenchment index using six of 24 corporate governance provisions, and provide empirical evidence that the negative relation between governance index and firm value documented by gompers et al. (2003) is driven by the entrenchment provisions (based on six provisions) rather than the other 18 provisions. among these six provisions, four “constitutional” provisions (staggered board, limits to shareholder bylaw amendments, supermajority requirements for mergers, supermajority requirements for charter amendments) prevent a majority of shareholders from having their way and two “takeover readiness” provisions (poison pills and golden parachutes) defend against a hostile takeover. the entrenchment index ranges from zero to six given equal weight on each of the six provisions. higher entrenchment index score represents more power for management and places strong restriction on shareholder’s ability to exercise their will. 2.2 competing views on governance provisions there are two opposite views regarding these governance provisions. one view is that these governance provisions weaken discipline mechanism to remove management and thus entrench management. manne (1965) argues that the entrenchment governance provisions are harmful to shareholders by weakening the disciplinary threat of removal and consequently increase empire building, shirking and stealing. thus, entrenched management is more likely to be associated with opportunistic and inefficient behavior, which could reduce firm value. the counterargument is that firms adopt entrenchment governance provisions to attract and retain good managers (i.e. these entrenchment provisions are adopted to insulate managers) because managers who are insulated by these entrenching provisions are more likely to invest optimally in long-term projects (stein 1988; bebchuk and stole 1993) and avoid inefficient actions that otherwise be undertaken to reduce the likelihood of a takeover bid (arlen and tally 2003). thus, corporate governance provisions are used to serve the long-term interests of shareholders by insulating management from focusing on short term. companies adopt entrenchment provisions to attract good managers to behavior in the way which benefits the long-run interests of shareholders. these two different views lead to two opposite effects of corporate governance provisions. thus, it is an empirical issue whether the corporate governance provisions entrench management (a negative effect) or insulate management and allow them to pursue long-term projects (a positive effect). to address this issue, this study uses the audit fee model empirically examines whether audit fees are positively or negatively correlated with bebchuk et al. (2005) entrenchment index. 2.3 audit fees and entrenchment provisions as shown by cohen (2000), external auditors are sensitive to firms’ corporate governance and management control in their auditing planning. if entrenchment provisions entrench management and induce non-value maximizing behavior, external auditors will perceive firms with higher level of entrenchment provision as firms with higher risk and thus exercise more audit effort, which leads to higher audit fees. if entrenchment provisions are adopted to attract good managers and induce mangers to pursue long-term projects, external auditors asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 29 will consider firms with higher level of entrenchment provisions as firms with lower risk and thereby exercise less audit effort, which results in lower audit fees. these two competing arguments predict different associations between audit fees and entrenchment provisions. as a result, this study examines the following two competing hypotheses: hypothesis 1a: ceteris paribus, audit fees are positively associated with entrenchment provisions. hypothesis 1b: ceteris paribus, audit fees are negatively associated with entrenchment provisions. 2.4 agency problems a stream of empirical research (e.g. harvey et al. 2004; gul and tsui 1998) which suggests that firm’s agency problem as an important moderator. in firms with severe agency problems, management entrenchment is more likely to result in opportunistic and inefficient behavior. jensen (1986) argues that firms with low growth and high level of free cash flows are more likely to involve in “value destroying activities” and have severe agency problems. the non-value maximizing behavior includes excessive consumption of perquisites, masking of non-optimal expenditures, misappropriation of assets, and salary enhancement (amihu and lev 1981; jensen 1986; christie and zimmerman 1994; rediker and seth 1995). both christie and zimmerman (1994) and gul and tsui (1998) suggest that managers of firms with low growth opportunities and high free cash flows are more likely to mask non-optimal activities by accounting manipulation (gul & tsui 1998, 221) and thus such firms have audit implications in terms of higher inherent audit risks (gul and tsui 2001). consequently, external auditors perceive these firms with high audit risk and exercise more audit effort, which leads to higher audit fees. thus, we further investigate whether agency problems within firms moderate the association between audit fees and management entrenchment. two competing hypotheses are composed in this regard: hypothesis 2a: ceteris paribus, agency problems (i.e. low growth and high level of free cash flows) moderate the association between audit fees and entrenchment provisions. hypothesis 2b: ceteris paribus, agency problems (i.e. low growth and high level of free cash flows) do not moderate the association between audit fees and entrenchment provisions. 3. methodology the ols audit fee regression model is widely used in prior studies (e.g. simunic 1980, francis and simon 1987, chan et al. 1983, gul and tsui (2001), ferguson et al. (2003), francis et al. (2005)). the model uses a set of variables to control for general cross-sectional differences in factors that affect audit fees. prior studies show that the model has good explanatory power (adjusted r2 is 0.70 or higher) and are robust across different samples, time periods, countries and sensitivity analyses for model misspecification. based on prior studies (e.g. ferguson et al. (2003), francis et al. (2005), gul and tsui (2001)), the following audit fee model is used to examine the association between audit fees and asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 30 management entrenchment: laf = α0 + β1size + β2 lseg + β3 current + β4quick + β5de + β6roi + β7foreign + β8qopinion + β9ye + β10loss + β11adjfcf+ β12e_index + fixed effects + ε laf = natural log of total audit fees; size = natural log of total assets in millions of dollars; lseg = natural log of the number of unique business segments; current = ratio of current assets to total assets; quick = ratio of current assets less inventory to current liability; de = ratio of long-term debt divided by total assets; roi = ratio of earnings before interest and tax to total assets; foreign = proportion of total sales from foreign operations; qopinion = indicator variable, 1=qualified audit report; ye = indicator variable, 1=31/12 fiscal year end; loss = indicator variable, 1= loss in current fiscal year; adjfcf = jensen free cash flow; defined as cash flow (revenues less cash expenses including tax and interest payments) less dividends, divided by total assets (gul & tsui 2001; chirinko & schaller 2004); e_index = entrechment index (bebchuk et al. 2005); fixed effects = industry dummy variables for two-digit sic industry classification and year dummy variables; ε = error term. the above model is similar to francis et al. (2005) except for two variables: adjfcf and e_index. adjfcf (jensen free cash flow) is measured in the same way as gul and tsui (1998), gul and tsui (2001) and chirinkoand schaller (2004). e_index is the variable of interest and is the entrenchment index defined by bebchuk et al. (2005) entrenchment index. the positive coefficient on e_index suggests that entrenchment provisions entrench management and induce inefficient or opportunistic behavior. the negative coefficient on e_index suggests that entrenchment provisions are adopted to attract good managers to pursue long-term projects. furthermore, this study investigates whether the relation between audit fees and entrenchment provisions is contingent on firms’ agency problem. we expect that the association between audit fees and entrenchment provisions is stronger for firms with agency problems (i.e. firms with low growth and high level of free cash flows). following chirinko & schaller (2004) and gul & tsui (2001), free cash flows are defined as cash flow less dividends, divided by total assets; cash flow is defined as revenues less cash asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 31 expenses including tax and interest payments. following prior research (chirinko & schaller 2004; harvey et al. 2004; lang et al. 1991), tobin’s q, which measures growth opportunities, is computed as market value of equity plus book value of assets minus book value of equity, and then divided by book value of assets. base on jensen (1986), this study defines firms with agency problems as the firms with low growth and high level of free cash flows. firms with tobin’s q below the full sample median of tobin’s q are classified as firms with low growth opportunities; while firms with free cash flows above the full sample median free cash flows are classified as high level of free cash flows. 4. sample the initial sample consists of all firms with data available on compustat between 2000 and 2004. the sample also meets the following screens: 1) audited by big n accounting firms; 2) required financial statement data available on compustat; 3) not in the financial services sector (sic codes 6000 to 6999); 4) audit fees data available from standard & poor audit fee database; 5) entrenchment provision index available (entrenchment index data are provided by professor bebchuk, please refer to his website). because bebchuk et al. (2005) get corporate provisions data from irrc (investor responsibility research center) and irrc publications are available only for year 2000, 2002 and 2004, that firms’ governance provisions are assumed to be in place during the period immediately following the publication of the volume until the publication of the subsequent irrc volume, which follows bebchuck et al. (2005) and gompers et al. (2003). the final sample meeting the above requirements has 2,510 firm-year observations from 2000 to 2004. table 1. descriptive statistics n=2510 variable mean median std dev q1 q3 minimum maximum auditfee 2071.240 931.450 3702.940 474.000 2132.200 2.684 80593.000 laf 6.947 6.837 1.115 6.161 7.665 0.987 11.297 assets 5613.550 1368.280 13002.970 562.101 4335.000 30.531 174278.000 size 7.418 7.221 1.512 6.332 8.374 3.419 12.068 lseg 0.895 1.099 0.686 0.000 1.386 0.000 2.303 current 0.461 0.443 0.201 0.317 0.606 0.028 0.969 quick 1.917 1.311 2.346 0.891 2.042 0.044 35.795 de 0.213 0.203 0.182 0.064 0.309 0.000 1.555 roi 0.070 0.079 0.132 0.032 0.127 -1.599 0.858 for 0.333 0.325 0.219 0.154 0.481 0.000 1.286 qopinion 0.476 0.000 0.500 0.000 1.000 0.000 1.000 ye 0.653 1.000 0.476 0.000 1.000 0.000 1.000 loss 0.083 0.000 0.276 0.000 0.000 0.000 1.000 adjfcf 0.069 0.078 0.107 0.043 0.113 -1.039 0.453 e_index 2.479 3.000 1.253 2.000 3.000 0.000 6.000 variables are defined as the following: auditfee = total audit fees in thousand dollars asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 32 assets = total assets in million of dollars laf = natural log of total audit fees in thousand dollars size = natural log of total assets in millions of dollars lseg = natural log of the number of unique business segments current = ratio of current assets to total assets quick = ratio of current assets less inventory to current liability de = ratio of long-term debt divided by total assets roi = ratio of earnings before interest and tax to total assets for = proportion of total sales from foreign operations qopinion = indicator variable, 1=qualified audit report ye = indicator variable, 1=31/12 fiscal year end loss = indicator variable, 1= loss in current fiscal year; adjfcf = jensen free cash flow; defined as cash flow (revenues less cash expenses including tax and interest payments) less dividends, divided by total assets e_index = entrechment index (bebchuk et al. 2005) table 1 provides descriptive statistics. as shown in table 1, there is a big difference between the mean and median of audit fee and distribution of audit fees is skewed. in contrast, the difference is much smaller for natural log of audit fees and the distribution of natural log of audit fees is approximately normal. this provides support for natural log-transformation of audit fee and total assets. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 33 5. empirical results table 2. regressions of audit fees on control variables and entrenchment index variable estimate white white t value p value intercept 2.186 16.373 0 size 0.586 48.661 0 lseg 0.163 8.703 0 current 0.581 6.6 0 quick -0.061 -6.324 0 de 0.166 2.094 0.036 roi -0.372 -1.66 0.097 for 0.653 9.576 0 qopinion 0.121 4.054 0 ye 0.157 5.336 0 loss 0.069 1.187 0.235 adjfcf 0.055 0.2 0.841 e_index 0.021 2.556 0.011 y2000 -0.773 -12.914 0 y2001 -0.69 -11.56 0 y2002 -0.382 -6.403 0 y2003 -0.259 -4.279 0 n 2510 r2 0.7382 variables in the regression are defined as the following: laf = natural log of total audit fees in thousand dollars size = natural log of total assets in millions of dollars lseg = natural log of the number of unique business segments current = ratio of current assets to total assets quick = ratio of current assets less inventory to current liability de = ratio of long-term debt divided by total assets roi = ratio of earnings before interest and tax to total assets for = proportion of total sales from foreign operations qopinion = indicator variable, 1=qualified audit report ye = indicator variable, 1=31/12 fiscal year end loss = indicator variable, 1= loss in current fiscal year; adjfcf = jensen free cash flow; defined as cash flow (revenues less cash expenses including tax and interest payments) less dividends, divided by total assets e_index = entrechment index (bebchuk et al. 2005) we control the following 34 two-digit sic industries with more than ten firm year observations: 10, 13, 16, 20, 23, 24, 25, 26, 27, 28, 29, 30, 32, 33, 34, 35, 36, 37, 38, 39, 42, 45, 48, 49, 50, 51, 54, 56, 57, 58, 59, 72, asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 34 73 and 87. for brevity, we do not report coefficients on two-digit sic industry dummy variables. white t value and white p value are t value and p value based on white (1980) corrected for heteroscedasticity. table 2 shows that the coefficient on e_index is 0.021 significant at 0.01 level (white-corrected p value), supporting hypothesis 1a. based on the coefficient, an increase of corporate governance provision by one causes the increase of audit fees by around 1,020 dollars. this suggests that entrenchment provisions entrench management and result in high risk perceived by external auditors. additionally, the results on other control variables are similar with francis et al. (2005 table 4): positive and significant coefficient on size, lseg, current, de, for and qopinion; negative and significant coefficient on quick and roi. the coefficient on ye is positive in this study, but negative in francis et al. (2005) because francis et al. (2005) define ye indicator equals one if non december 31 year end and this study defines ye indicator equals one if december 31 year end. inconsistent with francis et al. (2005 table 4), we do not find significant results on indicator variable loss. after excluding firms with missing data to compute tobin’s q, the sample size drops from 2,510 to 2,444. among the 2,444 firm year observations, 394 observations are classified as observations with low growth and high level of free cash flows. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 35 table 3. effects of entrenchment index on audit fees in two different subsamples panel a: low growth and high free cash flow panel b: the other sample variable estimate white white estimate white white t value p value t value p value intercept 2.458 7.07 0 2.191 14.831 0 size 0.589 22.971 0 0.585 42.943 0 lseg 0.158 3.77 0 0.168 7.666 0 current 0.701 2.947 0.003 0.612 6.242 0 quick -0.183 -4.741 0 -0.065 -6.976 0 de 0.209 0.631 0.528 0.138 1.636 0.102 roi -1.789 -2.659 0.008 -0.153 -0.654 0.513 for 0.488 3.04 0.003 0.653 8.584 0 qopinion 0.181 3.129 0.002 0.117 3.511 0 ye 0.105 1.565 0.119 0.163 4.713 0 loss 0.337 1.709 0.088 0.05 0.863 0.388 adjfcf 1.067 1.149 0.251 -0.27 -0.923 0.356 e_index 0.043 1.921 0.056 0.014 1.455 0.146 y2000 -0.699 -5.133 0 -0.801 -11.828 0 y2001 -0.557 -4.359 0 -0.728 -11.287 0 y2002 -0.291 -2.283 0.023 -0.414 -6.423 0 y2003 -0.205 -1.62 0.106 -0.28 -4.274 0 n 394 2050 r2 0.813 0.7336 variables in the regression are defined as the following: laf = natural log of total audit fees in thousand dollars size = natural log of total assets in millions of dollars lseg = natural log of the number of unique business segments current = ratio of current assets to total assets quick = ratio of current assets less inventory to current liability de = ratio of long-term debt divided by total assets roi = ratio of earnings before interest and tax to total assets for = proportion of total sales from foreign operations qopinion = indicator variable, 1=qualified audit report ye = indicator variable, 1=31/12 fiscal year end loss = indicator variable, 1= loss in current fiscal year; adjfcf = jensen free cash flow; defined as cash flow (revenues less cash expenses including tax and interest payments) less dividends, divided by total assets e_index = entrechment index (bebchuk et al. 2005) we defined firms with low growth and high free cash flow as firms with below full sample median of tobin’s q and above full sample median of free cash flow (adjfcf). the rest are in the others sample. we control the following 34 two-digit sic industries with more than ten firm year observations: 10, 13, 16, asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e2 www.macrothink.org/ajfa 36 20, 23, 24, 25, 26, 27, 28, 29, 30, 32, 33, 34, 35, 36, 37, 38, 39, 42, 45, 48, 49, 50, 51, 54, 56, 57, 58, 59, 72, 73 and 87. for brevity, we do not report coefficient on two-digit sic industry dummy variables. white t value and white p value are t value and p value based on white (1980) corrected for heteroscedasticity. table 3 panel a shows that the coefficient on e_index is 0.043 (p=0.044) significant at 0.05 level (white-correct p value=0.056) for the sample with jensen agency problems (i.e. low growth and high free cash flow). table 3 panel b reports that the coefficient on e_index is 0.014 insignificant (white corrected p=0.146) for other firms. the coefficient on e_index is three times larger in the agency problem firms (low growth and high free cash flow) than in other firms. moreover, r2 is higher for the test sample (r2=0.813) than for the control sample (r2=0.734). sensitivity tests we performance several robustness tests and robustness tests show the tenor of the results is unchanged. first, in order to rule out the results are not driven by outliers. we rerun the regression after winsorizing top 1% and bottom 1% of outliers. the results are qualitatively the same. second, we calculate vif (variance inflation factors) for independent variables and all vifs are less than ten, which shows that multicollinearity is not a concern. third, to ease concern on omitted correlated variables, we rerun the regression after controlling for non-audit fees using two stage least square equation models to control for simultaneous determination for audit fees and non-audit fees. the unreported results are qualitatively unchanged. finally, we also run the regressions with and without controlling for growth (defined by tobin’s q) and results are similar. 5. conclusion this study investigates the association between audit fees and management entrenchment (proxied by bebchuk et al. 2005 entrenchment index). it further investigates whether the association between audit fees and management entrenchment is contingent on firms’ agency problems. the results show that audit fees are positively associated with the entrenchment index (bebchuk et al. 2005). furthermore, results show that the positive relation between audit fees and the entrenchment index only exists for jensen agency problem firms (firms with low growth and high free cash flow). these results provide empirical evidence that the association between audit fees and entrenchment provisions is contingent on firms’ agency problems. acknowledgement we acknowledge insightful comments from professor suresh radhakrishnan from university of texas at dallas. we also acknowledge research support from the hong kong polytechnic university. references bebchuk, l., cohen, a., and ferrell, a. 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(1980). a heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. econometrica 48:817-838. http://dx.doi.org/10.2307/1912934 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 163 www.macrothink.org/ajfa an examination of home advantage (bias) argument in the indian financial markets: domestic financial institutional investors (dfiis) vis-a-vis foreign institutional investors (fiis) sanjay sehgal (corresponding author) professor of finance department of financial studies university of delhi, esc-pau,france email : sanjayfin15@yahoo.co.in neeta tripathi dyal singh college, university of delhi, india abstract in this paper we examine if domestic financial institutional investors (dfiis) have any home advantage (bias) compared to foreign institutional investors (fiis) for both the equity and debt segments of the indian capital market. we find that both the dfiis and fiis follow a positive feedback trading mechanism chasing stock market returns. however, fiis seem to be reacting faster compared to dfiis in the case of the equity market. this may be owing to the fact that the former have international expertise and greater resources and play a dominant role in this segment of capital market as shown by their share in the trading volume. in contrast, the dfiis lead the market returns which in turn attract the fiis thus, supporting home advantage (bias) argument. interestingly, the dfiis unlike in the equity market, play a more important role in debt market trading activities. our results point at greater debt market inefficiency in the indian context which may be a reflection of the relatively underdeveloped nature of this market. key words: home advantage (bias), domestic financial institutional investors, foreign institutional investors, market returns, equity market, debt market. jel classifications: g100, g140 mailto:sanjayfin15@yahoo.co.in asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 164 www.macrothink.org/ajfa 1. introduction since the fortunes of different nations do not always move together, investors can diversify their portfolios by holding assets in different countries. the benefits of international diversification have been recognized for decades. in spite of this, most investors hold nearly all of their wealth in domestic assets. much of the international finance literature emphasize that foreign investors are different from domestic investors. a stylized fact of the international finance literature is the existence of the home bias 1 . with the home bias, investors overweight the domestic market in their portfolios. despite the dramatic increase in cross-border equity and bond transactions over the last 20 years, the home bias has not disappeared. a number of attempts have been made to explain the home bias. one recurring theme in the literature is that foreign investors are less well informed about domestic securities than domestic investors, so that they are at a disadvantage trading and holding these securities 2 . recently, the informational disadvantage of foreign investors has been used as the foundation for models that attempt to explain the contagion nature of financial markets across world. foreign and domestic investors have positions in a national stock market based on their past private information signals, past public signals and the information about the private signals received by others that they are able to glean from the price in noisy rational expectations equilibrium. given these portfolio positions, a public signal leads investors to revise their previous positions. the less well informed (i.e. foreign) investors revise the means of their distributions by more than betterinformed (i.e. local) investors. this implies that if the public signal conveys good news about the payoff on the domestic market portfolio, foreign investors increase their assessment of the expected payoff faster than better informed domestic investors do; as a result price rises to clear the market, and the less well informed foreign investors purchase more of the domestic market portfolio from the better informed domestic investors; the reverse occurs if the news is bad and the price fall (brennan and cao 1997). usually foreign institutional investors have access to both international expertise and talent and have considerable local resources. it is therefore not obvious that foreign institutional investors should be at a disadvantage relative to domestic institutional investors. grinblatt and keloharju (2000) and seasholes (2000) even argue that as a result of their better access to expertise and talent, foreign institutions should be smarter than local institutions. using daily data for the 16 largest finnish stocks, grinblatt and keloharju (2000) find that over a two-year period foreigners and domestic financial corporations buy more stocks that perform well over the next 120 trading days than domestic individual investors, but their sample period is too short for them to conduct a study of holding period returns. seasholes (2000) finds that foreign investors buy (sell) ahead of good (bad) earnings announcements in taiwan while local investors do the opposite. these findings therefore, are consistent with better information and greater sophistication on the part of foreign investors. however, evidence on the performance of foreign investors is mixed. for instance, kang and stulz (1997) using annual data for 18 years find no evidence that foreign investors outperform domestic investors in japan. since 1990/91, the government of india embarked on liberalization and economic reforms with a view to bring about rapid and substantial economic growth and move towards globalization of the economy. these broad based economic reforms were recommended by the report of the high level committee on the balance of payments (govt. of india, 1993). one of the recommendations was to shift the composition of external flows to non debt creating flows. as a result, fiis (foreign institutional investors) were allowed asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 165 www.macrothink.org/ajfa to invest in indian debt and equity markets since september 1992, though fiis investment in shares and debentures began only in january 1993. prior to 1992 only non residents indians (nris) and overseas corporate bodies (ocbs) could undertake portfolio investment in india. there are two categories of fiis registered in india; normal fii (70:30 route) where total investment in equity and equity related instruments cannot be less than 70% of the aggregate of all investment and 100 % debt fii where 100 percent of the investment has to be made in the debt security. the fiis on their own behalf cannot invest more than 10 percent of the total issued capital of an indian company and investment on behalf of each sub account can not exceed 10% of the total issued capital of an indian company. the sub account is generally the underlying fund on whose behalf the fiis invest. for the sub accounts registered under foreign companies / individual categories the investment limit is 5% of the issued capital. the fii flows have to follow the guidelines and the policies of both the sebi (securities and exchange board of india) and the rbi (reserve bank of india) in india. the sebi fii regulations and rbi policies are amended and modified periodically as the domestic and international scenarios change. in this paper, we make an attempt to investigate if domestic financial institutional investors (dfis) have a home advantage (bias) over foreign institutional investors (fiis) using a data set of indian equity market and indian debt market from april 2001 to september 2006. we compare domestic financial institutional investment (dfi is proxied by mutual fund cash flows) and foreign institutional investment (fii). such a comparison is important because in emerging markets, local institutional investors are not as important as they are in developed markets and their actions may at times be affected by political considerations. foreign institutional investors could do well compared to domestic institutions simply because the local institutions are underdeveloped, do not have access to valuable information that some domestic institutions have , or may even be trading to fulfill political objectives. the paper is organized as follows. in section 2 we sketch a brief review of literature and testable hypotheses. section 3 provides data details and their sources. estimation results of home advantage (bias) in equity market are discussed in section 4. section 5 gives empirical findings of home advantage (bias) in debt market. a summary of the findings and major conclusions are described in section 6. 2 review of literature and testable hypotheses the international capm of frankel (1982) provides a utility-maximization model of international asset diversification. the international capm implies that the total portfolio risk can be reduced by holding foreign assets whose returns are negatively correlated with the returns of the home country assets. this suggests that the cross-border equity holdings are (i) negatively related to the degree of correlation between the home and foreign assets (ii) positively related to the returns of the foreign assets. a new school of thought on the home bias puzzle focuses on the information-based explanations. using a simple model of investor preference and behaviour, french and poterba (1991) demonstrate that information asymmetry can generate the same observed portfolio patterns as if the investors expect the domestic equity returns to be several hundred basis points higher than the returns in the foreign markets. gehrig (1993) models the information asymmetry between domestic and foreign assets by using a model where investors observe noisy signals of firms' returns with different degrees of precision. domestic bias arises from better investor information about domestic stocks and the high risk associated with foreign investments. hasan asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 166 www.macrothink.org/ajfa and simaan (2000) derive the premium that an investor is willing to pay to buy the full information of the mean return vector and show that rational investors would prefer home country demonstrated portfolios over diversified portfolios if the variability of estimation errors far exceeds the variability of the mean return vector. on the empirical side, the findings of frankel and schmukler (2000) from country mutual fund data support the hypothesis of asymmetric information, according to which the holders of the underlying assets have more information about local assets than country fund share holders. similarly, using data on foreign stock ownership in japan, kang and stulz (1997) find that foreign investors overweight shares of firms whose information are more readily available. these firms include large firms in the manufacturing industries and firms with good accounting performance etc.. they find that there is no evidence that foreign ownership is related to the expected returns. moreover, portes and rey (1999) show that the gravity model explains the cross-border equity flows remarkably well as distance serves as a good proxy for information cost. however, tesar and werner (1995) suggest that transaction costs are unlikely to be an explanation for home bias. the reason is that a higher transaction cost on foreign investment should lead to lower turnover rates on the foreign components of the asset portfolios, but they find that the portfolio turnover rates are much higher for foreign than domestic assets. their finding is influential but controversial. warnock (2001) suggests that this under-weighted but overtraded puzzle in foreign equities could be due to the intrinsic problems in estimating the cross-border holdings (a stock measure) based on the capital flow data (a flow measure). in the background of the above review we frame the following hypotheses; the indian equity market provides home advantage (bias) to dfis vis-a-vis fiis. the home advantage (bias) argument does work in the indian debt market. 3 data and their sources to study the presence of home advantage (bias) in equity and debt segment of indian capital market, we have used two types of data, one pertaining to equity market and the other to debt market in india. we take data from the websites of sebi (statutory regulator of the indian capital market since 1992, www.sebi.gov.in) and bse (bombay stock exchange, oldest and second largest stock exchange in india which is in existence since 1875, www.bseindia.com). both sources are the most authentic information provider in india. we have analyzed two categories of investors; the first being investment by domestic financial institutional investors (dfis) proxied by mutual fund investment and the second being the investment by foreign institutional investors (fiis) 4 . mutual fund investment is taken as a proxy for domestic financial institutional investment (dfi) because of its growing importance in the indian stock market capturing about 30 percent of total domestic institutional investment in india. further, our analysis includes all the fii (foreign institutional investment) flows rather than one subset of fii flows as the data for each subset of fii is not publicly available in india. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 167 www.macrothink.org/ajfa monthly mutual fund data and monthly fii data in equity and debt are taken from the sebi website. we take two major indices one being bse sensex and the second is i-sec sovereign bond index (i-bex) (from website of industrial credit and investment corporation of india, www.icicisecurities.com). bse sensex is used as equity index and i-bex is used as bond index. bse sensex is an obvious choice as it is considered the pulse of the indian stock market and mfs and fiis do actively trade in shares of the companies that are listed in this index. i-bex is a bond index that act as a metric to measure the performance of the government securities market (in india corporate debt market is still undeveloped). launched in 1994, it has emerged as the preferred benchmark across all classes of market participants. recommended by association of mutual funds in india (amfi), the index is used by fund managers to measure market performance, benchmark the performance of their portfolios, and also as a tool for quantifying risks in the sovereign bond market. it measures the total and principal returns of the respective maturity segments. it has also been extensively used by academia in india as a bond market proxy. the price series have been converted into monthly percentage return series so that they are compatible for further research. returns are defined as follows. rt = ln (pt/pt-1) *100 where, rt = returns (total returns including dividends) at time period t. pt, pt-1 = closing value of the stock price index at time t, t-1, respectively. the implicit yield on the 91 day treasury bills are employed as a measure of short term indian interest rates as per the common practice in investment literature. the data source for t-bills yields is the rbi website (www.rbi.org.in) before 2003, fii flows in debt were negligible. due to the non-availability of fii data in debt time span of the part of the study relating to fii flows in debt market is jan. 2003sept.2006. in order to compare the results of equity market and debt market with respect to home advantage (bias), the total study period of equity market is divided into two sub periods as follows: (a) jan 2001-dec.2002. (b) jan 2003-dec. 2006. 4 evaluating the home advantage (bias) for indian equity market we take two forms of foreign institutional investment viz. fii inflows (gross purchases) and fii outflows (gross sales) and two forms of domestic financial institutional investment proxied by mutual fund investment viz. mf inflows (gross purchases) and mf outflows (gross sales) and examine their relationship with selected variables viz. return on bse sensex (equity market index), i-bex (represent bond market index) and short term interest rates (represented by 91 day tb rates) for equity market and bond market segments of the indian capital market. before testing the relationship between fii flows/ mf flows http://www.icicisecurities.com/ http://www.rbi.org.in/ asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 168 www.macrothink.org/ajfa and selected variables, stationary of all the variables is tested using augmented dickey fuller test. the calculated t-values of all selected variables at different lags exceeds the critical values for 1%, 5% and 10% significance levels. hence, we reject the null hypothesis of a unit root and conclude that all selected variables are stationary. next we conduct granger linear causality test in order to select the ordering of variables. granger causality results are discussed into two categories, in first category results of fii and other variables are shown (table -1, panel-a), in second category results of mf and other variables are reported (table-1, panelb). in table-1, panel a and panel b, we report results only for total period (2001-2006) because we find no significant differences in results for two sub-periods. category-1 fii flows and selected variables return on bse sensex causes fii inflows (gross purchases) but no cause and effect relationship have been found between return on bse sensex and fii outflows. we find that a two-way cause and effect relationship is present between fii inflows and short term interest rates and fii outflows and short term interest rates. further, we find no cause and effect relationship between return on bse sensex and short term interest rates. in sum, bse sensex causes fii inflows, which in turn causes short term interest rates but in case of the latter, this relationship is two way. category-2 mf investment and selected variables return on bse sensex causes both mf inflows and mf outflows. in addition we find two way cause and effect relationship exist between mf inflows and short term interest rates and mf outflows and short term interest rates. the bilateral causality between fii/dfi flows and short term interest rates in case of indian equity market may be owing to the fact that active equity buying by these institutions reduces the demand pressure on money and debt market side. this leads to an erosion in the values of fixed income instruments and causes interest rates to go up. interestingly, fiis tend to follow an aggregate investment strategy in india (i.e. simultaneous buying and selling of securities, see sehga and tripathi 2006-07). hence, it is relevant to keep fii purchases (inflows) and sales (outflows) as a separate variable in the study as net fii flows may be very small on many occasions and lead to misleading results. further, fii inflows cause mf inflows and as two-way causality seem to be present between fii outflows and mf outflows. we find that bse returns determine fii flows and mf flows while the fii flows seem to propel investment by domestic institutional investors (in our case proxied by mf investment). thus, we can infer that there is no visible home advantage to domestic institutional investors. on the contrary, domestic institutional investors seem to be late in reacting to market movements compared to foreign institutional investors. many explanations for home or local bias rely on information asymmetry; investors know more about their home assets and therefore invest more in home assets. our results imply that informational advantage, if any, enjoyed by domestic institutional investors is more than outweighed by the superiors’ security valuation and market timing skills of foreign institutional investors. the increasing flow of fii flows in recent time period also documented our results. the results may also have policy implications. in a asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 169 www.macrothink.org/ajfa country like india, if policy makers wish to raise foreign investor’s activity level and thereby enhance liquidity and development of domestic stock market, they should consider measures to improve transparency, reduce insider trading, and communicate to foreign press information relevant to the financial markets. 5 evaluating home advantage (bias) for indian debt market the mfs have hitherto been the major player in the debt segment of the indian capital market. however, this was changed in the pattern of participation in 2005-06. mfs were also active in the equity market for the greater part of the year. fiis investment in debt segment was negative in all months in 2005-06. the total net investment in this segment in 2005-06 declined by rs.7334 crores mainly due to firming up of the yield rate of g-sec across the entire maturity spectrum. the methodology used in investigating home advantage (bias) in equity market has also been followed in the debt segment. first of all, we employ adf (augmented dickey fuller test) to test the stationary of variables. then, we conduct granger linear causality test. granger causality results are discussed into two categories, first related to fii and second related to mf (table-2, panel a and panel b). category-1 fii flows and selected variables there seems to be no cause and effect relationship between fii flows and i-bex (our bond market index). nor there seem to be any relationship between fii flows and short term interest rates (table -2, panel a). category-2 mf investment and selected variables in contrast to fii flows, mf flows seem to determine bond index returns, while short tern interest rates do not exhibit any relationship with domestic institutional flows. our results indicate that the domestic financial investors seem to have home advantage in debt market compared to foreign institutional investors whose investment behaviour seems to be independent of market returns. in sum, our results are stronger and clearer for the equity market than for the debt market. this may be owing to the fact that the indian debt market is comparatively less developed. equity market trading volume is 80% greater than that of debt market trading volume. development of domestic corporate debt market in india is constrained by a number of factors such as low issuance leading to illiquidity in the secondary market, narrow investor base, inadequate credit assessment skills, and high costs of issuance, lack of transparency in trades, non standardized instruments, comprehensive regulatory framework and underdevelopment of securitization products. the market suffers from deficiencies in products, participants and institutional framework. there is a need to take necessary steps to remove its sluggishness and encourage individual investment including those by fiis. we also get a different picture for the two market settings while the equity market returns seem to attract both fiis and dfis implying a positive feedback mechanism. the former seems to react faster than the later thus, negating the home advantage argument. on the other hand, domestic financial institutions asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 170 www.macrothink.org/ajfa appear to drive bond market returns while the fiis do not seem to be affected by market movements thus, signaling a comparative home advantage for the former. these results probably are explained by the fact that, while fiis play a relatively more important role in the equity market as they account for 68% of the total investment, the dfis dominate the debt market by accounting for about 74% of total investment. the low activity of fiis in the debt market may be due to the reasons cited earlier about the state of development of this component of the capital market. 6. summary and conclusions despite the increase in cross border equity and bond transactions over the last 20 years, the home advantage (bias) argument has not disappeared. a number of attempts has been made to explain the home (bias) advantage. in this paper we examined the presence of home advantage, if any, to domestic financial institutional investors (dfis) vis a vis foreign institutional investors (fiis) both in equity and debt market segments of the indian capital market. bse sensex and i-bex are used as equity market index and debt market index respectively. there is no consensus among the research scholars about the existence of home advantage (bias). some document that foreign investors are at a disadvantage trading and holding foreign securities since they have less information about foreign markets and institutional settings (see frankel and schmukler, (2000), kang and stulz (1997)), while others support the view that foreign institutional investors can never be at a disadvantage trading relative to domestic institutional investors as they have better international expertise and talent and have considerable local resources (see brennan cao (1997), seasholes (2000), grinblatt and keloharju (2000)). however, in the indian context our results are stronger and clearer for the equity market than for the debt market. this may be owing to the fact that indian debt market is comparatively less developed. equity market trading volume is 80% greater than that of debt market trading volume. development of domestic corporate debt market in india is constrained by a number of factors such as low issuance leading to illiquidity in the secondary market, narrow investor base, inadequate credit assessment skills, and high costs of issuance, lack of transparency in trades, non standardized instruments, comprehensive regulatory framework and underdevelopment of securitization products. the market suffers from deficiencies in products, participants and institutional framework. in addition we find different results for these two segments of the indian capital market. both dfis and fiis seem to be attracted by equity market returns, thereby acknowledging positive feedback trading strategy but the latter seems to react faster than the former and thus negating the home advantage argument. these findings can be explained in light of the fact that fiis have access to both international expertise and talent and have considerable local resources. on the other hand, dfis appear to drive bond market returns while the fiis do not seem to be affected by market movements thus signaling a comparative home advantage for the former. these results probably are explained by the fact that, while fiis play a relatively more important role in the equity market as they account for 68% of the total investment, the dfis dominate the debt market by accounting for about 74% of total investment. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 171 www.macrothink.org/ajfa notes 1. see french and poterba (1991), cooper and kaplanis (1998), tesar and werner (1995), and kang and stulz (1997). 2. see brennan and cao (1997) for example. 3. see calvo and mendoza (2000). 4. information about other components of dfis such as venture funds, other corporate bodies is not available on sebi website and hence has been excluded from the study. 5. bse sensex is calculated on a free float market capitalization weighted methodology of 30 components stocks representing large, well established and financially sound companies that account for 48 percent of total market capitalization and about 74 percent of trading activity of bombay stock exchange. it is constructed on the lines of standard&poor’s-500, usa. table 1. results for granger linear causality test for indian equity market (2001-2006) panel a: fiis and other variables null hypotheses f-statistics (2001-06) fii inflows does not granger cause return on bse 0.09 return on bse does not granger cause fii inflows 11.35* fii inflows does not grange cause interest rates 6.23* interest rates does not granger cause fii inflows 6.9* fii outflows does not granger cause return on bse sensex 0.43 return on bse sensex does not granger cause fii outflows 0.7 fii outflows does not granger cause interest rates 3.94* interest rates does not granger cause fii out flows 5.76* return on bse does not granger cause interest rates 0.17 interest rates does not granger cause return on bse 0.07 panel b. mf investment (dfis) and other variables mf inflows does not granger cause return on bse 1.29 return on bse does not granger cause mf inflows 4.67* mf inflows does not grange cause interest rates 13.13* interest rates does not granger cause mf inflows 5.46* asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 172 www.macrothink.org/ajfa mf outflows does not granger cause return on bse sensex 0.22 return on bse sensex does not granger cause mf outflows 11.11* mf outflows does not granger cause interest rates 15.58* interest rates does not granger cause mf out flows 14.41* fii inflows does not granger cause mf inflows 8.75* mf inflows does not granger cause fii inflows 2.84 fii outflows does not granger cause mf outflows 9.59* mf outflows does not granger cause fii outflows 7.52* * significant at 5% level asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 173 www.macrothink.org/ajfa table-2. results for granger linear causality test for indian debt market (2003-2006) panel-a: fiis and other variables null hypotheses f-statistics fii inflows does not grange cause i-bex 1.34 i-bex does not granger cause fii inflows .81 fii inflows does not granger cause interest rates .68 interest rates does not granger cause fii inflows 1.45 fii outflows does not granger cause i-bex 2.06 i-bex does not granger cause fii outflows 0.142 fii outlows does not granger cause interest rates 2.40 interest rates does not granger cause fii out flows 1.24 panelb: mf investment (dfis) and other variables null hypotheses f-statistics mf inflows does not granger cause i-bex 5.35* i-bex does not granger cause mf inflows 0.63 mf inflows does not grange cause interest rates 2.07 interest rates does not granger cause mf inflows 0.001 mf outflows does not granger cause i-bex 4.29* i-bex does not granger cause mf outflows 2.28 mf outflows does not granger cause interest rates 0.68 interest rates does not granger cause mf out flows 0.006 mf inflows does not granger cause fii inflows 2.67* fii inflows does not granger cause mf inflows 0.76 *significant at 5% level asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e8 174 www.macrothink.org/ajfa 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(2006-07), “foreign institutional investment in india: a study of determinants and impact on stock market characteristics” indian journal of finance and research, vol.16, issue (i) and (ii),jan-july 2006-07. tesar, linda and i. werner (1995), "home bias and high turnover". journal of international money and finance, vol.14, pp.467-492. warnock, francis e., (2001), “home bias and high turnover reconsidered, board of governors of the federal reserve system” international finance discussion group papers no. 702. microsoft word 3495-13215-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 320 capital structure choice of bangladeshi firms: an empirical investigation khairul alom school of business studies, southeast university, bangladesh e-mail: khairulalom@yahoo.com received: april 8, 2013 accepted: april 30, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3495 url: http://dx.doi.org/10.5296/ajfa.v5i1.3495 abstract this study endeavors to investigate the impact of firm specific factors on capital structure decision for a sample of 44-firm listed on dhaka stock exchange (dse) during the period of 2004-2011. to achieve the objectives, this study tests a null hypothesis that none of the firm’s specific factors such as, liquidity, market to book, collateral, dividend payment, profitability, size and industry classification has significant impact on leverage using estimate of fixed effect model under ordinary least square (ols) regression. checking multicollinearity and estimating regression analysis through pearson correlation model respectively this study found that profitability, collateral and liquidity have significant and negative impact on leverage. positive and significant impact of market to book value ratio on leverage has been found in this study. on the other hand, dividend payment and size were not found as significant explanatory variables of leverage. results also expose that total debts to total assets ratios are significantly different across bangladeshi industries. keywords: capital structure, leverage, firm’s specific factors, dhaka stock exchange, bangladesh asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 321 1. introduction many corporate finance models rely on rigorous assumptions such as rationality in decision making. however, behavioral finance uses models in which decisions are influenced by psychological and/or cognitive biases. this is an area of research that has developed from the work of kahneman and tversky (1979) and prospect theory. it provides insight into the influence of psychology on the behavior of managers and investors and the subsequent effects on markets of their financial decision making (nofsinger, 2005). identifying the determinants of capital structure can help managers make more informed decisions. academically, it is of interest to understand what determines capital structure given the considerable research since modigliani and miller (1958). however, there is no one universal theory of capital structure and it is only recently that manager confidence has been considered an important variable in capital structure choice. one of the many objectives of financial managers is to maximize the wealth of the firm, more specifically shareholder’s wealth maximization. to maximize firm’s value as well as minimize the cost of fund, a manager should set up an optimal capital structure. the fundamental components in capital structure are debt and equity. a firm should attempt to determine the optimal capital structure that causes the maximization of firm’s value. positive relationship between leverage and value of the firm has been identified in some studies (champion, 1999; ghosh et al, 2000; chowdhury s.& chowdhury a., 2010). capital structure policy is also important in a sense that level of risk and return of a firm is mostly affected by it. using more debt in capital structure to finance firm’s assets results in increase the variability of firm's cash flows stream more specifically and escorts to generate higher risk accordingly. but no strict theory has been developed yet to determine the exact optimal capital structure. so it concerns managers in identifying some factors influencing capital structure decision by which they can benefit to make an optimal mix of debt and equity to maximize firm’s value. moreover these factors vary across countries and firm’s characteristics i.e. liquidity, market to book, collateral, dividend payment, profitability size assets etc. since modigliani and miller (1958), who are the pioneer in this field, executed an instructional research in identifying the determinants of capital structure. thereafter, many researchers have been conducted in the developed country such as rajan and zingales (1995) (the g-7 countries), akhtar (2005) (australia), and akhtar and oliver (2009) (japan). as a developing country bangladesh has become an emerging market with a lot of potential of investment that gets an attention for investors and managers to rethink about the influencing factors of using debt and their extent of influence over firms. although there have been small numbers of research in bangladesh focusing on the primary determinants of capital structure such as chowdhury mu. (2004), lima m. (2009), and sayeed m.a. (2011), there is still disagreement regarding which factors have significant impact in determining a firm's capital structure. nevertheless, an important factors affecting capital structure determination of a firm in developed country may not be equally important to a firm in developing country like bangladesh. furthermore, all possible factors affecting capital asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 322 structure decision have not been considered in a research at a time and that is why some factors are still important to further use in measuring their impact on capital structure determination and there is a need to bridge between current study and capital structure theory. this study extends the existing literature by analyzing the factors affecting capital structure decision on 44 listed companies in the dhaka stock exchange by using the panel data models over the periods 2004-2011. this study is different from others because it considers some firm’s specific factors that have not been used yet in bangladesh. this study attempts to analyze the impact of firm specific factors on capital structure decision in a systemic manner and provides practical and applicable guideline for anyone who wants to have insight of the topic. therefore, this study provides further evidence of the capital structure theories pertaining to a developing country. the rest of this paper proceeds as follows. section 2 summarizes the literature on the capital structure. section 3 describes the determinants of capital structure. section 4 and 5 describes objective and hypothesis of this study. methodology of this study shown is section 6. the analysis and results are presented in section 7. finally, section 8 concludes the paper. 2. theoritical discussion since the work of modigliani and miller (1958) on the irrelevance of capital structure to firm value, theoretical and empirical analyses have been developed to discuss the determinants of corporate financing decisions in practice. this research has generally followed traditional finance theory and comprises the trade-off theory, the pecking-order theory and more recently the market timing theory. however, there is no universal theory of capital structure and no reason to expect one (frank and goyal, 2004). the trade-off theory argues that a firm’s optimal capital structure results from a tradeoff between tax advantages of debt and bankruptcy costs of debts (miller, 1977). according to the pecking-order theory, formalized by myers and majluf (1984) and myers (1984), there is a hierarchy in manager financing choices. external financing transaction costs, especially those associated with adverse selection, result in managers having a preference for internal financing, and then new debt and finally new equity financing. regarding the market timing theory, managers will issue equity when the firm’s market value relative to book value is high and they will issue debt when the debt market conditions are perceived relatively more favorable (see myers, 1984; graham and harvey, 2001; hovakimian, opler and titman, 2001). intensive empirical research has been conducted to test the predictions of these theories (rajan and zingales, 1995; shyam-sunder and myers, 1999; fama and french, 2002; frank and goyal, 2003, 2004). the theories are supported in the empirical research to varying degrees. a nascent literature recognizes that the bias of confidence is a significant determinant of mangers investment and financing decisions. psychological studies document that confidence causes people to underestimate risks, to be more certain about predictions and to exaggerate their ability to control events (see gilovich, griffin and kahneman (2002) for an overview of this area). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 323 heaton (2002) argues that confident managers overestimate the futures cash flows and so the net present value (npv) of new investment projects. hackbarth (2004) develops a theoretical model to study the implications of managerial confidence for financing decisions. the model shows that optimistic and overconfident managers tend to choose higher debt levels and to issue new debt more often compared to otherwise identical less confident managers. recently, malmendier, tate and yan (2005) test these predictions. they find that managerial confidence leads to a preference for internal financing over external finance and conditional on accessing the capital market, debt over equity. the main argument for the manager bias toward debt financing is that confident managers underestimate the probability of financial distress, and therefore take on higher levels of debt than optimal. this may lead to higher probability of bankruptcy and higher costs of capital. hence, in support of this confidence bias we expect a positive relation between manager confidence and leverage. 3. capital structure determinants 3.1 the independent variables the independent variables used in equation (1) are liquidity, market to book ratio (mb), dividend payment (divdum), collateral (colltrl), profit (prf) and the firm size (size). we explain in this sub-section why they are considered determinants of capital structure and how they are measured. 3.2 liquidity as predicted by the pecking order theory, firms with high liquidity will borrow less. the fact that a firm with more current assets is expected to generate more internal inflows, which can be used to finance its operating and investments activities. thus a negative relationship between liquidity and leverage is expected. friend and lang (1988) deesomsak, et al. (2004), sbeiti (2010), and icke and ivgen (2011), found liquidity is negatively and significantly related to leverage. on the other hand, trade-off theory suggests a positive relationship between leverage and liquidity because higher liquidity ratio reflects the greater ability of a firm to meet short-term obligation on time. ozkan (2001) suggests that liquidity has ambiguous effect on the capital structure decisions. in the line with study of ozkan (2001) the proportion of current assets to current liabilities is chosen as a proxy for liquidity. 3.3 market-to-book (mb) the market-to-book ratio has been used by previous research to measure growth opportunities (adam and goyal (2002) present a summary of this literature). when market equity prices are high relative to book prices, the market is signaling higher expected growth. previous empirical studies in the capital structure literature document a negative relation between the market-to-book ratio and leverage ratio. this negative sign is predicted by most capital structure theories. indeed, firms with high market-to-book ratio have higher costs of financial distress (rajan and zingales, 1995) and consequently are expected to have lower debt. this interpretation is consistent with the trade-off theory. under the pecking-order theory, profitable firms have much retained earnings and therefore a smaller need for external finance and thus debt. according to the market timing hypothesis, if the market-to-book ratio asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 324 is high, then issuing equity seems more attractive than issuing debt. given these arguments, we expect a negative relation between leverage and the market-to-book ratio. the market-to-book ratio (mb) is defined as the market value of assets divided by book value of assets. the market value of assets equals the book value of assets minus the book value of common stock plus market value of equity. 3.4 dividend dummy (divdum) predictions about how paying dividend affects leverage are unclear (for more details see fama and bangladeshi, 2002). the pecking order model permits interpretation in two contradictory ways. in one way, dividend paying firms may have high earnings relative to investment opportunities and consequently they can maintain less leveragea negative relation between dividend paying firms and leverage. this prediction is confirmed by fama and bangladeshi (2002). in the other way, as interpreted by shyam-sunder and myers (1999) and reported by frank and goyal (2004), the decision to pay dividend increases firms financing needs, all else equal. if firms are constrained to retain debt financing, the implication of paying dividend is to increase leveragea positive relation between dividend paying firms and leverage. under the trade-off theory, predictions of the relation between leverage and payout decisions can be driven from considering either bankruptcy costs or agency costs of free cash flow. indeed, firms paying dividend have normally more cash flows in comparison to investment opportunities and so they do not have to increase leverage and deadweight costs of debt. in the agency models of jensen and meckling (1976) and easterbrook (1984), the managers do not necessarily act in the interest of shareholders and can waste the free cash flow. dividends and debt, by forcing managers to pay out free cash flow, can control the free cash flow problem. since they are presented as substitutes for controlling the agency problem, we can predict that relation between dividends and leverage will be negative. the empirical study of frank and goyal (2004) has shown that dividend paying firms have lower leverage. the dividend variable (divdum) is measured by a dividend paying dichotomous variable which takes a value of unity if the firm paid dividends in the corresponding year and zero otherwise. 3.5 collateral assets (colltrl) the asymmetric information theory explains that moral hazard and adverse selection problems can appear when banks or creditors have limited information on investment project returns. collateral may be considered as a signal of the solvency capacity of the firm and it can diminish the moral hazard problem. therefore, tangible assets are likely to have an impact on the borrowing decisions of firms. empirical studies (for example rajan and zingales, 1995 and frank and goyal, 2004) show that the relation between collateral and leverage is significant and positive. our proxy for the collateral value of the firm (colltrl) is the sum of inventory plus property, plant and equipment divided by total assets. we predict a positive relation between the level of collateral and leverage. 3.6 firm profitability (prf) from a pecking-order perspective, for firms with large expected investments, it is likely that financing would be from internal sources and low risk debt (myers, 1984). indeed, to manage the risk of foregoing future investments because of a lack of financing resources, profitable asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 325 firms will choose to have less current leverage. frank and goyal (2004) has shown that in the us, more profitable firms have less debt, supporting the pecking order theory. we measure firm profitability (prf) as the operating income before depreciation to total assets. we expect a negative relation between leverage and profitability, supporting the pecking order theory of capital structure. 3.7 firm size (size) the effect of firm size on leverage is ambiguous. rajan and zingales (1995) find that financial leverage increases with size. they justify this finding by the fact that size is an inverse proxy for the probability of bankruptcy. bigger firms can diversify more easily and so the probability of being in financial difficulty is lower. under the trade-off theory, such companies can increase the percentage of debt. in this case, a positive relationship between size and leverage is to be expected. on the other hand, size may proxy for the information available to outsiders. under the pecking order theory, less information asymmetry implies preference for equity relative to debt, thus applying a negative correlation between size and leverage. given those arguments, it is difficult to expect a clear sign of the relation between firm size and leverage. our proxy for firm size (size) is the natural logarithm of total assets. 4. objectives of study this study will attempt to accomplish the following objectives: i. to identify the firm specific factors affecting capital structure decisions of listed firms in dhaka stock exchange. ii. to analyze how the factors affecting capital structure decision are related to leverage. 5. hypotheses of the study taking into account the literature on capital structure debate, the null hypotheses we proposed about the possible determinants of the capital structure decisions of listed firms are as follows: h1: there is no significant impact of liquidity on leverage. h2: there is no significant impact of market to book on leverage. h3: there is no significant impact of collateral on leverage. h4: there is no significant impact of dividend on leverage. h5: there is no significant impact of profitability on leverage. h6: there is no significant impact of size on leverage. 6. methodology of the study 6.1 sample size the sample consists of all bangladeshi firms listed on the dhaka stock exchange (dse) during the year of 2004-2011. financial companies are excluded because they are subjected asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 326 to legal regulations from central bank regarding capital structure. there are 521 firms listed on dhaka stock exchange including 191 non financial firms in 2013. all the accounting and financial statement data are sourced from balance sheet and income statement of specific companies. stock return and market price of stock data are sourced from secondary market (i.e. dse). table 1 illustrates frequency distribution of industry categorization. table 1. frequency distribution of industry classification industry frequency ceramic 3 cement 3 pharmaceuticals 10 textile 9 fuel & power 4 food & allied 8 information technology 2 telecommunication 1 engineering 4 total 44 6.2 data collection procedures this study is based on secondary data. the data used in this analysis can be divided into two groups: the firm specific factors influencing capital structure decision (independent variables) and the capital structure’s variable (dependent variables). it takes ten potential firm specific factors that may have significant impact on capital structure decision namely liquidity, market to book, dividend paid, collateral, profitability and size, and industry classification. in this analysis, the capital structure is the dependant variable and it is measured by the leverage. these data have been collected from the book value based yearly financial data given in the financial statements (balance sheet & profit and loss a/c) of selected companies over 2004 to 2011 which has been gathered from dhaka stock exchange library 6.3 empirical model this study combines cross-sectional with time series to make it a panel data. as noted by schulman et al (1996), panel data allow economists and other social scientists to analyze, in depth, complex economic and related issues which could not be treated with equal rigidity using time-series or cross-sectional data alone. like cross-sectional data, panel data describes each of a number of individuals. like time-series data, it describes changes through time. according to baltagi (1995), by combining time series of cross-section observations, panel data give “more informative data, more variability, less collinearity among variables, and more efficiency.” descriptive and quantitative analysis is used for this research. descriptive analysis presents mean, median, standard deviation, maximum and minimum value for each variable used in the study. in quantitative analysis, pearson’s correlation and pooled regression analysis is used. in regression analysis fixed effects model is used to investigate the relationship and also to prove the hypotheses. the cross section company data and time asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 327 series data are pooled together in a single column letting the intercept may differ across each cross-sectional unit (here the eight industries) and each industry’s intercept does not vary over time. in addition to, it is assumed that the slope coefficients of the regressors do not vary across industry or over time. the estimation method used is seemingly unrelated regression in eviews with a common intercept. this method estimates a feasible gls specification correcting for both cross-section heteroskedasticity and contemporaneous correlation. to ascertain the significance of these determinants for leverage we use a pooled cross sectional time-series model as follows: = + α , + α mb , + divdum , + , + , + , + ε (1) all the independent variables are lagged one year. this allows the information regarding the determinants of capital structure to be available to managers in the year prior to the observed level of leverage. leverage is the total amounts of debt to market value of assets of firm i at a time t, defined as: = (2) market value of assets is obtained as the sum of the market value of equity, long term debt, short term debt, preferred-liquidation value, deferred taxes and investment tax credit. rajan and zingales (1995) and frank and goyal (2004) discuss various definitions of leverage and argue that the most appropriate measure is the total debt to market value of assets 7. analysis and discussion of results this section contains the descriptive statistics, correlation coefficient and the results of regression analysis of 44 sample firms in seven types of industries listed on dse during the five year period from 2004 to 2011. the interpretation of the empirical findings is also presented in this section. finally, important conclusions about the results of the study have been drawn 7.1 descriptive statistics table 2 presents summary statistics of the relevant variables. the average leverage of firms (leverage) in the sample is approximately 61.56%. this value represents an average in both time series and cross section. the average dividend payment is 66.75% across the sample. the minimum of 1% and maximum of 100% indicates most of the sampled firms paid dividend during this period 2004-2011. the average liquidity of bangladeshi firms is 2.15, it indicates current assets are 2.15 times higher than current liabilities and which is quite good in terms of liquidity. the average market-to-book ratio (mb) is 26.75 times. this implies that bangladeshi firms are overvalued value firms over the sample period, trading at premium to their book value. the average proportion of collateral assets to total assets (colltrl) is 45.08%. it indicates most asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 328 of the firm’s assets are backed by collateral to min the default risk. the average profitability of bangladeshi firms (prf) in the sample over the period is 6.77% per annum and max profitability is 37.56% to loss 18.95%. the mean value of size measured in log of sales is 20.44% while the standard deviation is 3.17. the maximum and minimum value of size is 25.36 and 0.022 respectively table 2. explanatory variables – summary statistics this table provides summary information for the dependent and independent variables used in the analyses. it provides the variable’s definition, the source of data for the variable and the key summary statistics. variable variable description (source) n mean median std. dev. min max leverage: lev the sum of current liabilities plus long term debt divided by the market value of assets. 44 61.56 .69 47.45 .17 362.41 dividend paid: divdum 1, if a firm pays more than or equal to 10% dividend and 0 otherwise. 44 0.66 .492 .484 .001 1.00 liquidity: liq current assets divided by current liabilities 44 2.154 1.564 13.33 .046 275.10 market-to–book ratio: mb the market-to-book ratio is defined as the market value of assets divided by book value of assets. the market value of assets equals the book value of assets minus the book value of equity plus market value of equity. 44 26.75 19.85 13.78 1.15 115.25 collateral: colltrl the sum of inventory plus property, plant and equipment divided by total assets. 44 45.08 32.65 23.67 .075 94.23 firm profitability: prf the operating income before depreciation divided by total assets 44 6.77 7.32 8.65 -18.95 37.56 firm size: size natural logarithm of total sales 44 20.44 18.87 3.17 .022 25.36 7.2 collinearity to study the existence of multicolinearity among regressors pearson correlation coefficients is used. in general, independent variables having collinearity at 0.7 or greater would not include in regression analysis due to multicollinearity. as shown in table 3 the highest correlation coefficient is 0.516 between profitability and dividend payment. thus all of the independent variables are free from serious problems of multicollinearity and more competent for regression analysis. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 329 table 3. pearson correlation coefficients variables liq mb divdum colltrl prf size liq 1.00 .316 .015 .478 .324 .132 mb .316 1.00 .439 -.123 .398 .217 divdum .015 .439 1.00 .088 .516 .234 colltrl .478 -.123 .112 1.00 .391 .112 prf .324 .398 .516 .391 1.00 .453 size .132 .217 .234 .112 .453 1.00 *summary of pearson correlation coefficients between variables. 7.3 regression model results of regression analysis table 4 shows the results of pooled regression analysis, in which fixed effect model is applied. in our regression model for leverage has an r-squared (coefficient of determination) of 0.556.it informs that the fraction of variation in the dependent variable that is explained by variation in the independent variables more precisely it shows how well the sample regression line fits the data (goodness of fit). thus, 55.6% of the variation in leverage (total debt/total assets) is accounted for by variation in the independent variables. the value of adjusted r-squared is 0.513. f-statistic, 11.331, shows that overall model is satisfied at the 1% level and the value of durbinwatson, 1.37, signals that the model is fit for regression without estimating any significant autocorrelation. the existence of autocorrelation does not bias the estimated coefficient, but it makes the estimates of the standard errors smaller than the true standard errors. as, these findings are observed from table 4, the first hypothesis of this study is liquidity and beta coefficient is -5.887, rejecting the null hypothesis, it suggests that liquidity has strong negative impact on leverage for dse listed firms. beta coefficient of market to book value ratio is 0.623 and rejects the second hypothesis at 10% significant level. the negative coefficient value of collateral rejects the third hypothesis at 1% significant level. dividend payment the fourth hypothesis of this study is accepted with beta coefficient of -8.65 that mean dividend payment has no significant impact on leverage of bangladeshi firms listed on dse. the coefficient value of profitability is -1.83, which is significant at 1% level. so, fifth null hypothesis has no significant impact on leverage, is rejected. the last or sixth hypothesis of this study is firm size, which beta coefficient is 0.275 and its not significant even at 10% level, thus this hypothesis is accepted. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 330 table 4. regression model results variables beta coefficients standard error t-value sig. constant 87.572 23.674 2.568 .025 liq -5.877 1.053 -4.345* .000 mb .623 .317 1.785*** .012 divdum -8.65 7.138 -1.592 .089 colltrl -.368 .156 -2.785* .014 prf -1.83 .34 -4.271* .23 size .275 1.712 .579 .650 td/ta= total debt/ total assets *significant at 1% level ** significant at 5% level *** significant at 10% level model summary r-squared .675 adjusted r-squared .641 durbin-watson 1.37 f-statistic 27.76 sig. .000 8. summary this study attempts to investigate how firm specific factors are impacting the capital structure decision of a sample of 44 bangladeshi firms listed in dse utilizing ols regression method. data were collected from the financial statements of each firm during the eight-year period from 2004 to 2011. under ols regression, fixed effect model was run and the findings of the study show that profitability, collateral and liquidity have significant and negative impact on leverage. positive and significant impact of market to book value ratio on leverage has been found in this study. on the other hand, dividend payment and size were not found as significant explanatory variables of leverage. results also reveal that leverage ratios are significantly different across bangladeshi industries. overall all the results are almost consistent with previous study and capital structure. however, the limitations of this study can open the door of opportunity for further research work in this area. this study only uses total debt to total assets as a dependent variable, the other definition of leverage can be used in future study to identify which definition of leverage is powerfully explained by given control variables. in conclusion, overall results can be improved by including new explanatory variables and observations and management preference to debt and equity. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 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(2004). la stucture d'endettement des petites et moyennes enterprises francias: uneetude sur donnees de panel, review internationale pme, 17(1), 123-128. microsoft word 3280-12381-1-sm-wirter2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 259 evaluate the profitability in commercial bank comparative study of indian and jordanian banks dr ali mahmoud abdallah alrabei department of accounting, faculty of economic and business jadara university e-mail: alialrabei@yahoo.com received: feb. 19, 2013 accepted: april 19, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3280 url: http://dx.doi.org/10.5296/ajfa.v5i1.3280 abstract banks and financial institutions are the backbone of the economy of the country everywhere, in india, jordan and all over the world. profitability is one of the major criteria for evaluating the performance of a bank; the present study is confined to the state bank of india (sbi) and cairo amman bank (cab), jordan. the period of study is from 2006-07 to 2010-11. it has to be noted that the accounting year of sbi is from april to march while in the case of cab the accounting year starts from 1st jan and ends on 31st dec. there are two sources of date i.e. primary data and secondary data. the primary data is original in nature. the primary data has been collected through personal interviews with the officials of the banks. the secondary data have been collected through published annual reports, magazine and internet. mainly the present study is based on the secondary data. the study finding the state bank of india should try to control the cost of services rendered to increase the gross profit, and the cairo amman bank should try to increase the number of branches at global level also. keywords: evaluate, profitability, commercial banks, jordan, india asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 260 1. introduction profit is the prima facie object of every business. a business can not breathe well without profits. it may be considered as a mirror of the operating performance of a company. in the words of lord keynes, "profit is the engine that drives the business enterprise." a business needs profit not only for its existence but also for the expansion and diversification. "profit is the barometer of the success of the business. it is indeed, a magic eye that mirrors all aspects of entire business operations including the quality of output."(2) profits are the soul of the business without which it is lifeless. in fact, profits are useful intermediate beacon towards which a firm's capital should be directed. (4) m.e. murphy has rightly remarked that “business cannot exist without profits, as an economy cannot exist without sound business. profits must be something for all to be proud of; they should not be suspected.”(6) in accounting, profit is defined as “excess of revenues over related cost applicable to transaction a group of transactions or to the transactions of an operating period.”(5) in the words of r.l.smith “the term ‘profit’ carries a variety of meanings not only in technical sense but in interpretative sense as well.”(10) the company’s financial information is contained in balance sheet and profit and loss account. the figures contained in these statements are absolute and sometimes unconnected with one another. an absolute figure does not convey much meaning. however, it is only in the light of other information that the significance of a figure is realized. for example, mr x weighs 50 kgs. is he fat? we can not give answer unless we know his age and height. similarly a company’s profitability cannot be known unless together with the amount of profit, the capital employed is also seen. the relationship of these two figures expressed mathematically is a ratio. the ratio refers to the numerical or quantitative relationship with the other. the ratio refers to the numerical or quantitative relationship between two variables or items. a ratio is calculated by dividing one item of the relationship with the other. the ratio analysis is one of the most useful and common method of analyzing financial statements. as compared to other tools of financial analysis, the radio analysis provides very useful conclusions about various aspects of the working of the business. the need for ratio arises due to the fact that absolute figures and often misleading. absolute figures are certainly valuable but their value increases manifold if they are studied with another through ratio analysis. ratios enable the mass of data to be summarized and simplified. ratio analysis is an instrument for diagnosis of the financial health of an enterprise. ratios, in fact, are full of meaning and communicate the relative importance of the various items appearing in the balance sheet and profit and loss account. 2. literature review xuezhi qin & dickson pastory.(12) commercial banks profitability position: the case of tanzania. the study examines commercial banks profitability in tanzania for the period of ten years (2000-2009).the study used national microfinance bank (nmb), national bank of commerce (nbc) and crdb as the case study. the study employed the profitability measures of commercial banks, and the evidence of performance in terms of profitability was asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 261 established based on return on average asset, net interest income to average bearing assets and non-interest expenses to average assets. the paper utilized panel secondary data from national bank of commerce, crdb and national microfinance bank in tanzania for the period of ten years, and the hypothesis was tested to know whether there is a significant difference in terms of profitability by using anova test. finally the regression model was run to see the effects of capital adequacy, liquidity and asset quality on the profitability of commercial banks. the findings revealed that there is no significant difference on profitability among the commercial banks, in the context of regression model it has been noted that liquidity and asset quality has positive impact in profitability with exception to the level of nonperforming loans which has a negative influence on profitability. also capital adequacy has shown negative impact on profitability. the study confirmed the profitability of commercial banks to stable and meeting the regulatory requirement of the bank of tanzania (bot). john goddard, phil molyneux and john o. s. wilson. (2004)(3). the profitability of european banks during the 1990s is investigated using cross-sectional, pooled cross-sectional time-series and dynamic panel models. models for the determinants of profitability incorporate size, diversification, risk and ownership type, as well as dynamic effects. despite intensifying competition there is significant persistence of abnormal profit from year to year. the evidence for any consistent or systematic size–profitability relationship is relatively weak. the relationship between the importance of off-balance-sheet business in a bank’s portfolio and profitability is positive for the uk, but either neutral or negative elsewhere. the relationship between the capital–assets ratio and profitability is positive. mohammad khurram manzoor, hassan h. sumra and momina abbas. (2011)(8). under the title,”the impact of e-banking on the profitability of banks: a study of pakistani banks” this research paper aims at examining the impact of electronic banking on the profits of pakistani banks. e banking has increased the competition among the banks and both domestic and foreign banks are offering more and more modern ways of e-banking. the study investigates the services provided by the banks and their impact on their profitability in particular. it is significant due to the proliferation of the service sector and its importance in the economy. it also discusses about the services provided by the banks to its customers and also reveals the major rationales for the banks to use internet and other electronic mediums as the means to providing services to their customers. it is a distinguished one because it reveals the factors which lead to the success of the operations, giving more profits and the ability to manage risks of using electronic means and using the electronic services for the benefit of the bank and how they differentiate through these services in the market and the factors which lead to the increased profitability of banks, be it public or private. mohammad abu sayeed, piyadasa edirisuriya and mohammad hoque. (2012)(7). bank profitability: the case of bangladesh, this study attempts to examine the impact of asset and liability management on the profitability of commercial banks in bangladesh. commercial banks are segmented into high profitable and low profitable and private and public banks. while applying statistical cost accounting (sca) methods study finds high earning banks experience higher returns from their assets and lower returns from their liabilities than the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 262 low earning banks. results are inconclusive with regard to private banks’ and public banks’ returns. this study finds that assets management of large commercial banks is better than those of small banks, but they are not better than small banks in respect of liability management. vasiliou, d. (1996)(11). linking profits to greek production management, investigated portfolio of assets and liabilities between high-profit and low-profit greek banks by employing sca method. his regression results suggest that it is the asset management rather than liability management that play more prominent role in explaining interbank differences in profitability. this study implies that high profit banks earn higher return on their assets than that of low profit banks. at the same time high profit banks enjoy lower expenses for their liabilities. these findings contrast with the findings of kosmidou et al (2004) who find that liability management contributes more in creating the profitability differences among the banks. rasidah mohd said, and mohd hanafi tumin. (2011)(9). performance and financial ratios of commercial banks in malaysia and china. this study aims to investigate the impact of bank-specific factors which include the liquidity, credit, capital, operating expenses and the size of commercial banks on their performance, which is measured by return on average assets (roaa) and return on average equity (roae). the results imply that ratios employed in this study have different effects on the performance of banks in both countries, except credit and capital ratios. operating ratios influence performance of banks in china, but this influence is not true for malaysian banks regardless of the measure of performance. ali alp, ünsal ban, kartal demi̇rgüneş, and saim kilic. (1997)(1). internal determinants of profitability in turkish banking sector. the aim of this study is to identify the internal determinants of profitability of turkish banks in the period of 2002-2009. the importance of the study derives from the fact that finding out the mentioned determinants is a necessity for both the managers of turkish banks who successfully operates -even in times of financial crisis-, and existing (and potential) national and international investors. findings of the study indicate that capital efficiency and size affect profitability positively, while liquidity and operating costs negatively. 3. problem of the study an analysis of the profitability reveals how the profit position stands as a result of total transactions made during a year. such analysis is particularly interesting to suppliers of funds who can evaluate their investment and take decision accordingly. on the other hand, profit ratios are equally beneficial to the management because these ratios reflect the efficiency of the enterprise as whole. and the question that mentions here is how evaluate the profitability effect in commercial banks. 4. significance of the study the word profitability may be defined as the ability of a given investment to earn a return from its use. the state of profitability is a variable thing like temperature and humidity of a day. the definition of profitability by an accountant and or analyst can even be linked to asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 263 temperature reading and study of humidity by meteorologist. the present wealth of a day is recorded so that prospects can be forecasted. profitability has been considered, to a great extent, as one of the main criteria to judge the extent to which management has been successful in maximizing its profits or minimizing it loses, if any. the concept of profit is related to absolute figures. it does not tell about the reason how it takes place or the relationship of this figure with another one. these questions can be answered by a peep into the profitability of an entity. profit, as an absolute term, has no relevance to compare the efficiency of organizations. a very high profit does not always indicate a sound organizational efficiency and a low profitability not always a sign of organizational sickness. in many a situation it so happens that when a concern is implementing expansion plans, it may run into short term losses. therefore, it can be said that profit is not the prime variable on which the operational efficiency and financial efficiency of an organization can be compared. 5. objectives of the study the present research work seeks to examine the effect of profitability on performances of commercial banks. the following are the important objectives of the study: 1) to find evaluate the profitability on the gross profit ratio between sbi and cab. 2) to find evaluate the profitability on the net profit ratio between sbi and cab 3) to find evaluate the profitability on the operating profit ratio between sbi and cab. 4) to find evaluate the profitability on the operating ratio between sbi and cab. 5) to find evaluate the profitability on the return on equity share holder's fund between sbi and cab. 6) to find evaluate the profitability on the return on capital employed ratio between sbi and cab. 7) to find evaluate the profitability on the return on total assets ratio between sbi and cab. 6. research methodology the study is based on the following methodology. 6.1 nature of data the data required for the purpose of the study are the following in nature: 1. information relating to the formation, growth, operational jurisdiction, financial activities and programmes of commercial banks. 2. balance sheet, profit and loss account published in the form of annual reports of commercial banks. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 264 3. statistical summary of all scheduled commercial banks in jordan published in annual reports of commercial banks present and past practices. 4. banking statistics published in the central bank of jordan bulletin. 6.2 sources of data most of the information collected for the study will be secondary in nature. the secondary data will be collected from the following sources: information relating to scheduled commercial bank offices will be obtained from the bank. annual reports of banks. 6.3 period of study the period of study spans over the years between year 2006/2007 to 2010/2011. . it has to be noted that the accounting year of state bank of india (sbi) is from april to march while in the case of cairo amman bank (cab) the accounting year starts from 1st jan and ends on 31st dec. the period of five years has been taken mainly to analyze the impact of profitability of commercial banks. incidentally this is most significant period, in the life of banks because the profits are more or less volatile during the period. thus, the study covers a period of five years from 2006/2007 to 2010/2011. 6.4 scope of the study: in the present study following banks have been covered state bank of india (sbi) cairo amman bank, jordan (cab) 6.5 hypotheses of the study h1 there is no significant difference in gross profit ratio between sbi and cab h2 there is no significant difference in net profit ratio between sbi and cab h3 there is no significant difference in operating profit ratio between sbi and cab h4 there is no significant difference in operating ratio between sbi and cab h5 there is no significant difference in return on equity share holder's fund between sbi and cab h6 there is no significant difference in return on capital employed ratio between sbi and cab h7 there is no significant difference in return on total assets ratio between sbi and cab. 6.5.1 first hypothesis h1: there is no significant difference in gross profit ratio between sbi and cab the gross profit ratio of sbi (india) and cab (jordan) has been presented in the table 1.1 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 265 it can be visualized from the table 1.1 that the gross profit ratio in sbi, india showed a fluctuating trend and varied within the range of 40.39 percent in 2006-07 to 23.26 percent in 2009-10 i.e. the range of total variation was 17.13 percent. on the other hand the gross profit ratio in cab, jordan almost showed a consistent trend during the period of study except in the year 2008-09 and varied within the range of 71.72 percent in 2010-11 to 16.37 percent in 2008-09. the width of range was very high i.e., 55.35 percent which is not favourable for the bank. .the average of gross profit ratio in sbi, india was 32.24 percent while for cab, jordan it was 59.76 percent. from average point of view cab, jordan is better placed and signifies that the cost of services rendered is less in comparison to the cost of services rendered by sbi, india. it denotes an effective management. the variations were high in cab, jordan because the coefficient of variation in cab, jordan was 36.32 percent while in sbi, india it was 16.89 percent. it is suggested that the management of sbi, india should try to reduce and control the cost of services rendered while the management of cab, jordan should try to maintain the same pattern of gross profit ratio but try to control the fluctuations. test of significance (t test for two sample means):to apply the t test, let the hypothesis be that the gross profit ratio of both the banks is same and there is no significant difference computed value of t for two sample means=2.75 table value of t at 5 percent level of significance (for v=5+5-2=8) is 2.306 since the calculated value of t (2.75) is more than the table value (2.306), hence there is no evidence of accepting the hypothesis. therefore, the hypothesis is rejected and it is concluded that the gross profit ratio of both the banks differs significantly or it can be inferred that the gross profit ratio of cab, jordan is better than the gross profit ratio of sbi, india. 6.5.2 second hypothesis h2: there is no significant difference in net profit ratio between sbi and cab inter bank comparison: a comparative study of both the banks with regard to net profit ratio can be made through the table 1.2 it can be observed from the table 1.2 that the net profit ratio in sbi, india showed a consistent trend up to the year 2008-09 and then after a decreasing trend. the net profit ratio varied within the range of 12.89 percent in 2007-08 to 9.84 percent in 2010-11, hence the variations were not high but however, the profitability was low. on the other hand the net profit ratio in cab, jordan showed a decreasing cum increasing trend and varied within the range of 27.73 percent in 2010-11 to 19.66 percent in 2008-09 denoting that the range of variations in the net profit ratio was higher in cab, jordan than sbi, india. it can further be noted that the net profit ratio in sbi was in proportion to gross profit ratio whereas the gross profit ratio in cab was very high and in comparison to gross profit ratio the net profit ratio of cab can not be regarded satisfactory as it implies that the bank had to spend a lot on the indirect cost of operations which should be controlled. net profit ratio of both the banks showed a consistent trend as the coefficient of variation in sbi, india was 8.76 percent and for cab, jordan it was 11.50. however, it is suggested that the management of cab, jordan should try to control the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 266 fluctuations. on the whole it can be said that the net profit ratio of cab, jordan was greater than the net profit ratio of sbi, india. test of significance of net profit ratio (t test for 2 sample means) to apply the t test for net profit ratio of both the banks following hypotheses have been used (i) null hypothesis(ho):there is no significant difference in the net profit ratio of both the banks (ii) alternative hypothesis (ha):the net profit ratio in cab, jordan is better than the net profit ratio of sbi, india. calculated value of t for two sample means= 9.10 degree of freedom (v) = 5+5-2=8 table value of t at 5 percent level of significance (for v=8) = 2.306 decision: as the calculated value of t is more than the table value, hence the null hypothesis is rejected and alternative hypothesis is accepted and it is concluded that the net profit ratio in cab, jordan is better than the net profit ratio of sbi, india. 6.5.3 third hypothesis h3: there is no significant difference in operating profit ratio between sbi and cab inter bank comparison the table 1.3 shows inter firm comparison of the banks for operating profit ratio. it can be noted from the table (1.3) that there was no operating profit in sbi, india accordingly the operating profit ratio was negative throughout the period under study and it fluctuated within the range of -3.33 percent in 2008-09 to -16.19 percent in 2009-10 while the operating profit ratio in cairo amman bank showed an increasing trend except in the year 2009-10. the average of the operating profit ratio in sbi was -8.25 percent, which denotes inefficiency of management and it is suggested that the management should try to control operating expense to increase this ratio. the average of the operating profit ratio in cairo amman bank was 51.93 percent denoting an efficient management and proper control over the operating cost of the business. through the inter bank comparison it can be stated that the performance of cab, jordan was better than sbi, india. test of significance for operating profit ratio (t test for two sample means) hypotheses: (i) null hypothesis(ho):there is no significant difference in the operating profit ratio of both the banks (ii) alternative hypothesis (ha):the operating profit ratio in cab, jordan is better than the operating profit ratio of sbi, india. calculated value of t for the mean values of operating profit =21.43 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 267 degree of freedom (v) = 5+5-2=8 table value of t at 5 percent level of significance for v=8 is 2.306 decision:since the calculated value of t is more than the table value, therefore, the null hypothesis is rejected and alternative hypothesis is accepted and concluded that the difference in the operating profit ratio of sbi and cab is significant. on account of accepting alternative hypothesis it is inferred that the operating profit ratio of cab, jordan is better than sbi, india. 6.5.4 fourth hypothesis h4: there is no significant difference in operating ratio between sbi and cab inter bank comparison the operating ratio of both the banks under study has been shown collectively in the table 1.4 it is evident from the table 1.4 that the operating ratio in sbi is greater than the operating income resulting into operating loss. it denotes that the operating cost in sbi is excessively high not being covered by the operating incomes. the average of the operating ratio in sbi is 108.25 percent. the management of sbi should either reduce the operating cost or increase the operating incomes to convert the operating loss into operating profit. it can be noted from the table that the management failed to control the operating cost as the operating ratio increased during 2009-10 and 2010-11. it shows inefficiency of management. on the other hand, the operating ratio in cab, jordan almost showed a decreasing trend which denotes an effective management and control over unnecessary operating cost. the coefficient of variation was 6.00 percent denoting a consistent trend. the management of cab should try to maintain the same position in future also. 6.5.5 fifth hypothesis h5: there is no significant difference in return on equity share holder's fund between sbi and cab. inter bank comparison a comparative study of return on equity shareholder’s funds as shown in the table 1.5 it can be noted that the return on shareholder’s funds showed a decreasing trend in sbi, india except in the year 2008-09 whereas this ratio showed an increasing trend in cab, jordan. the average of the ratio was 14.78 percent for sbi, india and 14.61 percent for cab, jordan. from average point of view the performance of both the banks is same. however, the rate of return on equity shareholder’s funds can be increased if the operating cost is decreased and operating incomes are increased by the management of the bank. the fluctuations in the ratio of sbi were less as the coefficient of variation was 5.36 percent while the variations in cab were high because the coefficient of variation was 8.18 percent which should be controlled by the management. test of significance for return on equity shareholder’s funds (t test) null hypothesis (ho)-there is no significant difference in the return on equity shareholders’ funds of the banks under study asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 268 alternative hypothesis (ha)-there is significant difference in the return on equity shareholders’ funds and cab, jordan has performed better than sbi, india computed value of t for the difference of the mean values =0.263 table value of t (v=8) at 5% level of significance=2.306 as the computed value of t is less than the table value, hence the null hypothesis is accepted and it is inferred that both the banks have performed equally good as regards the return on equity shareholder’s funds. 6.5.6 sixth hypothesis h6: there is no significant difference in return on capital employed ratio between sbi and cab inter bank comparison a comparative study of the return on capital employed of both the banks has been highlighted in the table 1.6. it can be observed from the table (1.6) that the return on capital employed in sbi, india was very than the return on capital employed of cab, jordan. the average of the ratio in sbi was just 1.48 percent while in cab it was 33.90 percent indicating that the management of cab was very efficient to make an optimum use of the resources. the management of sbi should plan their investment policy to yield an optimum return. the consistency in the return on capital employed was higher in cab than the consistency in sbi, india. test of significance (t test) for return on capital employed hypothesis – a) null hypothesis (ho)there is no significant difference in the return on capital employed ratio of the banks under study b) alternative hypothesis (ha)-the performance of cab is better than sbi as regards the return on capital employed computed value of t for the mean values = 26.68 table value of t at 5 percent level of significance for d.f. 8 is 2.306 decision: the calculated value of t is higher than the table value, hence the null hypothesis is rejected and alternative hypothesis is accepted. accordingly it is concluded that the return on capital employed in cab, jordan is higher than the return on capital employed in sbi, india. 6.5.7 seventh hypothesis h7: there is no significant difference in return on total assets ratio between sbi and cab inter bank comparison the table 1.7 shows a comparative position of both the banks for return on total assets. it can be asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 269 observed from the table (1.7) that the return on total assets in sbi, india was less than the return on total assets in cab, jordan. the average rate of return on total assets in sbi was 1.32 percent while in cab, jordan it was 3.68 percent which means that the total assets were used in cab, jordan effectively in comparison to sbi, india. the variations were high in sbi, india as the coefficient of variation in sbi was 10.30 percent while in cab, jordan it was 4.55 percent. it can be concluded that the return on total assets was better in cab, jordan. test of significance for return on total assets (t test) hypothesis: a) null hypothesis: there is no significant difference in the return on total assets of both the banks under study. b) alternative hypothesis:the return on total assets in cab, jordan is more than the rate of return on total assets in sbi, india. computed value of t =23.90 table value of t at 5 percent level of significance=2.306 decision: since the computed value of t is more than the table value, the null hypothesis is not accepted and it can be concluded that the rate of return on total assets in cab, jordan is more than that of sbi, india. 7. conclusions 1) test of significance has been carried out by applying t test. since the calculated value of t (2.75) is more than the table value (2.306), hence there is no evidence of accepting the hypothesis. therefore, the hypothesis is rejected and it is concluded that the gross profit ratio of both the banks differs significantly or it can be inferred that the gross profit ratio of cab, jordan is better than the gross profit ratio of sbi, india. 2) as the calculated value of t is more than the table value, hence the null hypothesis is rejected and alternative hypothesis is accepted and it is concluded that the net profit ratio in cab, jordan is better than the net profit ratio of sbi, india. 3) since the calculated value of t is more than the table value, therefore, the null hypothesis is rejected and alternative hypothesis is accepted and concluded that the difference in the operating profit ratio of sbi and cab is significant. on account of accepting alternative hypothesis it is inferred that the operating profit ratio of cab, jordan is better than sbi. 4) as the computed value of t (0.263) is less than the table value (2.306) at 5 percent level of significance, hence the null hypothesis is accepted and it is inferred that both the banks have performed equally good as regards the return on equity shareholder’s funds. 5) the calculated value of t is higher than the table value, hence the null hypothesis is rejected and alternative hypothesis is accepted. accordingly it is concluded that the return on capital employed in cab, jordan is higher than the return on capital employed in sbi. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 270 6) since the computed value of t test is more than the table value, the null hypothesis is not accepted and it can be concluded that the rate of return on total assets in cab, jordan is more than that of sbi, india. 8. recommendations 1. state bank of india should try to control the cost of services rendered to increase the gross profit. 2. state bank of india should also try to control and reduce the indirect cost to increase the net profit and maintain consistency in the net profit ratio. 3. state bank of india should follow a strict credit policy to avoid unnecessary losses and try to control operating cost which was more than 100 percent. 4. cairo amman bank should try to maintain the same position in future also because its operating cost was under control and the gross profit as well as the net profit ratio showed a satisfactory trend. 5. the cairo amman bank should try to increase the number of branches at global level also. references ali, a.,ünsal, b., kartal, & demirgüneş, kilic. (1997). internal determinants of profitability in tyrkish banking sector. the ise review, 12, 1301-1642. http://dx.doi.org/10.2139/ssrn.1231064 argenti, john. (1968). corporate planning a practical guide. george allen and unwin ltd., london. john, g., & phil, m., & john, o. s. (2004).the profitability of european banks: a cross-sectional and dynamic panel analysis. the manchester school, london. joseph, f., & bradley. (1964). administrative financial management. kohler, l., & eric. (1984). a dictionary for accountants, prentice hall of india private limited, new delhi. murphy, m. e. (2007). managerial accounting. indian reprint: affiliated east – west press, new delhi. mohammad, abu sayeed., & piyadasa, edirisuriya., &mohammad, hoque. (2012). bank profitability: the case of bangladesh. international review of business research papers, 8(4), 157-176. mohammad, khurram., & manzoor. h h., & momina, abbas. (2011).the impact of e-banking on the profitability of banks: a study of pakistani banks. journal of public administration and governance, 1(1). http://dx.doi.org/10.1080/09669582.2012.709859 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 271 rasidah, m., s., & mohd, h.t. (2011). performance and financial ratios of commercial banks in malaysia and china. international review of business research papers, 7(2), 157-169. http://dx.doi.org/10.1016/j.omega.2010.08.001 smith, r., l. (1992). management accounting, prentice hall, new jersey. vasiliou, d. (1996). linking profits to greek production management. international journal of production economics, 43, 67-73. http://dx.doi.org/10.1080/0960310042000293146 xuezhi, qin., & dickson, pastory. (2012). commercial banks profitability position: the case of tanzania, international journal of business and management, 7(13). http://dx.doi.org/10.5539/ijbm.v7n13p136 table 1. gross profit ratio of the banks under study (from 2006-07 to 2010-11) (ratio in percentage) years sbi cairo amman bank 2006-07 40.39 71.04 2007-08 32.21 69.67 2008-09 33.28 16.37 2009-10 23.26 69.98 2010-11 32.05 71.72 average 32.24 59.76 s.d. 5.44 21.70 c.v.(%) 16.89 36.32 source: annual reports & accounts the banks under study for the period from 2006-07 to 2010-11. table 2. net profit ratio of the banks under study (from 2006-07 to 2010-11) years sbi, india cairo amman bank, jordan 2006-07 12.18 25.52 2007-08 12.89 23.18 2008-09 12.19 19.66 2009-10 12.00 22.64 2010-11 9.84 27.73 average 11.82 23.74 s.d. 1.04 2.73 c.v.(%) 8.76 11.50 source: annual reports & accounts the banks under study for the period from 2006-07 to 2010-11. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 272 table 3. operating profit ratio of the banks under study (from 2006-07 to 2010-11) years sbi cairo amman bank 2006-07 -3.35 46.81 2007-08 -4.59 50.76 2008-09 -3.33 53.78 2009-10 -16.19 53.50 2010-11 -13.81 54.78 average -8.25 51.93 s.d. 5.58 2.88 c.v.(%) -67.62 5.55 source: annual reports & accounts the banks under study for the period from 2006-07 to 2010-11. table 4. operating ratio of the banks under study (from 2006-07 to 2010-11) years sbi cairo amman bank 2006-07 103.35 53.19 2007-08 104.59 49.24 2008-09 103.33 46.22 2009-10 116.19 46.50 2010-11 113.81 45.22 average 108.25 48.07 s.d. 5.58 2.88 c.v.(%) 5.15 6.00 source: annual reports & accounts the banks under study for the period from 2006-07 to 2010-11. table 5. return on equity share’s holder fund ratio of the banks under study (from 2006-07 to 2010-11) years sbi cairo amman bank 2006-07 15.56 13.92 2007-08 15.04 14.42 2008-09 15.43 13.40 2009-10 14.45 14.43 2010-11 13.39 16.87 average 14.78 14.61 s.d. 0.79 1.20 c.v.(%) 5.36 8.18 source: annual reports & accounts the banks under study for the period from 2006-07 to 2010-11. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 273 table 6. return on capital employed ratio of the banks under study (from 2006-07 to 2010-11) years sbi cairo amman bank 2006-07 1.50 34.82 2007-08 1.71 36.85 2008-09 1.60 35.41 2009-10 1.33 33.12 2010-11 1.25 29.27 average 1.48 33.90 s.d. 0.17 2.60 c.v.(%) 11.44 7.67 source: annual reports & accounts the banks under study for the period from 2006-07 to 2010-11. table 7. return on total assets ratio of the banks under study (from 2006-07 to 2010-11) years sbi cairo amman bank 2006-07 1.34 3.55 2007-08 1.50 3.97 2008-09 1.41 3.78 2009-10 1.21 3.58 2010-11 1.12 3.54 average 1.32 3.68 s.d. 0.14 0.17 c.v.(%) 10.30 4.55 source: annual reports & accounts the banks under study for the period from 2006-07 to 2010-11. microsoft word 2629-10240-1-rv-writer2-new m f 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issn 19 2013, vol. www.macrothi needs to ha information ons and ach developme and day in since the p ng to all ne rative-finan he prospe nt of view. em that de anization’s s called sy s that includ transform d means for re n. many em s a success arious titles, mation system zational str rowston & ies, evaluati davis, 1989 formance m environm rk requisites per i ccounting 946-052x 5, no. 1 ink.org/ajfa ave these n system ieving a ent is of massive patient’s eeds and ncial and erity of als with decision ystem or e people, data into eceiving, mpirical index to , such as ms, data ructures, treacy, ion, user , & doll ent help s and the formance impact role of ( goodhu requirem he belie fit wou evaluati criteria 1-featu on syste 2. liter fichbei believed the basi as his su baily & this resu informa rogers his rese five fea compat daivis i two fac percept technol goodhu thirty-fi these st usefuln system goodhu and task and tim 3. mate aim of consiste someho able to c (mis) envir ue believes 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ollection to n statistical questionnair f service. in goodhue in odhue quest sor and an e dity of ques l cronbach or subscales 0.76, 0.73 a uation mod rican scien ation system oodhue th measure info cision maki w how mana task/system follows: ystem fit ccounting 946-052x 5, no. 1 ink.org/ajfa ool is a analysis re asked order to ndex was tionnaire expert of stions in h's alpha s such as and 0.84 del. this ntist that ms in the hompson ormation ing. his agement m fit can in this m task th multidim 4.1 met in order coeffici of class estimate beta we question feature step by 5. resu 5.1 test h0: hos h1: hos table 1 dependen method: l included o variable c ser04 ser05 ser07 ser08 ser09 ser10 r-squared adjusted r f-statistic prob (f-st substitut (ser01+s *ser10 model task hat would mensional e thods of ana r to analyze ients and f sical linear r ed optimal ere estimate ns were en es of the sy step and an ults t the first hy spital inform spital inform . results of nt variable: (se least square observation: 88 d r-square tatistic) ted coefficients ser02+ser03 k / system f be adjust evaluation o alysis e data, infer -statistic fo regression m conditions. ed. the firs ntered into stem policy n appropriat ypothesis mation syste mation syste f task/syste r01+ser02+s coeffici 2.01152 0.197445 -0.10915 0.19796 0.14802 0.12002 0.15701 0.422923 0.380177 9.893773 0.000000 s: )=2.0115+0.19 fit (tsf) ca ted with i of the system rential test l r significan model, ord . in this me t step in ex regression y. after vie te model wa ems (is) bas ems (is) bas em fit ser03) ient 4 5 54 62 29 24 13 3 74*ser04-0.10 25 an be sough individual’s m or system like correlat nt regression dinary least ethod by mi xamining th based on ewing the re as created. sed on task sed on task std.error 0.413231 0.082345 0.059647 0.08496 0.07110 0.08575 0.06231 mea s.d.depen dur 091*ser05+0. asian ht in the cha s abilities. m environme tion was use n was used. squares (ol inimizing th he issue, var task/system esults, regre k/system fit k/system fit 5 7 66 5 5 4 an dependent va ndent var rbin-watson sta .1979*ser07-0 n journal of f aracteristics in fact, ent can be p ed. t-test fo according ls) regress he square e riables in in m fit, indiv ession impr are success are not suc t-statisti 4.86779 2.3977 -1.8299 2.329 2.081 1.3996 2.5197 ar 0 at 0.1480*ser08+ finance & ac issn 19 2013, vol. www.macrothi s of the sys with this possible. or partial re g to the assu sion method error, the al nformation vidual abili rovement w sful. ccessful. tic 92 0 787 994 0 9893 822 606 0 721 3.746212 0.643256 1.987347 +0.1200*ser0 ccounting 946-052x 5, no. 1 ink.org/ajfa tem and model, gression umptions d has the lpha and systems ties and was done prob. 0.0000 0.0188 0.0709 0.0223 0.0405 0.1654 0.0137 09+0.1570 accord prob. (f regressi because approve with 99 of hosp 5.2 test h0: hos h1: hos table 2 dependen method: l included o variable c ser16 ser18 ser19 ser21 ser33 educat r-squared adjusted r s.e. of reg sum squar log likelih f-statistic prob (f-st (ser11+s 0.8962+0. accord validity closer v confide ing to tabl f-statistic) a ion. e the prob. ed through t 9% confiden ital informa t the second spital inform spital inform . results of nt variable: (se least square observation: 81 c d r-square gression red resid hood tatistic) ser12) .0979*ser16-. ing to the re y of the mo value to ze ence level t e (1) the ov and the gre . 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(199 n, g. dunca rk, n.4. 995). under 82-184. & thompson (2), 213-236 95). diffusio an,r., & ho rstanding u n,r. l. (199 6. on of innova olbeck, j. ( 29 ser evaluati 95). tark-te ations. 4th e 1973). inno asian ions of infor echnology f edition, the ovations and n journal of f rmation sys fit and indiv free press, d organizati finance & ac issn 19 2013, vol. www.macrothi stems. mana vidual perfo newyork, n tions. wiley ccounting 946-052x 5, no. 1 ink.org/ajfa agement ormance. ny. y & sons microsoft word 2641-7155-1-sm (1)-writer2-new-final asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 363 total quality management and smps performance effects in nigeria: a review of six sigma methodology kenneth enoch okpala department of financial studies (accounting), redeemer's university mowe, ogun sate. nigeria tel: 805-507-1683 e-mail: kenokpala@aol.com; kenenoch@yahoo.ca received: nov. 8, 2012 accepted: december 10, 2012 published: december 13, 2012 doi:10.5296/ajfa.v4i2.2641 url: http://dx.doi.org/10.5296/ajfa.v4i2.2641 abstract though small and medium practices (smps) which constituted over 70% of auditing firms in nigeria have been in existence from the inception of accountancy profession but have not been given the required attention. this research paper is exploratory on the ground that smps is a new concept. the study investigated the effect of total quality management (tqm) on the performance of the subsector through the use of six sigma methodology (ssm) to improve current business system. the population of the study consists of 884 smps in nigeria. 133 respondents were purposively selected representing a sample fraction of 15%. questionnaire was administered at random and opinions elicited and analyzed. pearson product moment correlation method was used to confirm the hypotheses of the study. finding obtained revealed that leadership style, management of people and consumers focus are the strongest significant predictors of tqm and operational performance but are lacking in most in smps operations. it also discovered that tqm programmes when implemented will influence the quality of auditing services that meets clients’ expectations within the ambit of standards and regulations. the study therefore recommends that smp should embrace ssm to have significant clients’ relationship, improved performance and maximize institutional prosperity. key words: total quality management, smp, performance, six sigma methodology, nigeria asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 364 1. introduction the concept of tqm was originally developed by edwards w. deming, after world war ii for improving the production quality of goods and services. the idea was adopted by japanese in 1950 that employed it to improve their postwar business and dominated world markets by the 1980s (evans & dean, 2003). manufacturers in united states then realized that the existing nineteenth century assembly line factory model in use was obsolete and needed to be changed if americans must compete in modern global markets and be in the forefront among nations of economic consequence (evans & dean, 2003). this move motivated western companies to commence their own quality initiatives which led to a new phase of continuous quality improvement known as tqm between 1980s and 1990s. initially, the idea of quality was based on reducing defects and errors in products and services through the use of measurements and the outcome was the achievement of superior performance and minimized costs of production. organizations realized that achievement of enduring improvement may be impossible without significant attention to the quality of the management practices excised on the day to day basis, caliber of staff in employment and relationship between service provider and the clients (nwabueze, 2001). this made tqm all encompassing (demirbag, et al 2006). schonberger & knod (1997) managers noticed that the approaches they use to listen to customers and develop relationships, craft out strategy, measure performance, analyze data, train employees, deliver products and services and provide leadership in their organizations are the true enablers of quality, satisfaction, and business success. empirical evidence shows that in nigeria, tqm was mainly practiced by multinationals that understood the concept but was notably implemented locally with success by jim ovia ceo of zenith international bank plc. the bank’s management of quality was overhauled; first class graduates were employed, inducted and maintained with a clear cut reproductive management strategy and succession plan. every department understood how to relate quality to their roles to achieve the selected strategies. all staff sees the organization as a single entity for the purpose of providing value to consumers. tqm implementation eliminated long service queue through prompt service, quality service were rendered and bank customers were satisfied. all these led to efficient operations, cost reduction and high profit maximization which elevated the bank to nigeria’s top five, few years after its establishment (zenith economic quarterly, various issues). most smps in nigeria does not pay attention to quality of service renders to clients. the poor quality services ranges from the reckless audited financial report to members of his client company, to tax accounts prepared and presented to the tax authorities without due regards to accounting and auditing standards and other regulatory framework upon which such service provisions are based. the service delivery handicap of smps emanates from inadequate input resources such as finance, professional manpower, specialized skills and modern technology (ifac, 2010). surya., pal-pandi, & jeyathilagar, (2007) noted that inability to implement tqm has brought many problems to smps as follows (i) failure to improve services to satisfy clients (ii) failure to initiate training-on-the job to achieving quality (iii) failure to adopt and institute leadership in all levels of management aimed at the supervision of audit staff and independent review of audit working papers to improve performance and (iv) failure to embrace continuous improvement in all aspects of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 365 services input to gain business growth. the main objective of this study is to investigate tqm and smps performance effects in nigeria. the study will also examine the meaning of quality and application of six sigma methodology to smps service delivery. the research questions on which attempt is made to provide solution includes (i) how does tqm effect the performance of smps in nigeria? and (ii) to what extent has ssm application influenced smps services delivery in nigeria? the research hypotheses include: (i) there is no significant relationship between tqm and smps performance in nigeria and (ii) six sigma methodology has no significant influence on smp services in nigeria. 2. review of related literature quality management has been widely practiced both locally and internationally in different sectors and subsectors of different economies. the concept is linked to several international self-assessment models that evaluate the tqm efforts and in line with the international organization for standardization (iso 9000:2000), which represents a system as a common denominator for what business quality entails internationally. six sigma is a logical and process improvement methodology that helps to achieve tqm (snee, 2004). bilich & neto (2000) stated that quality as a macro function of institutions must be present in the day-to-day administration such as establishment of policies, decision process, selection of personnel, allocation of resources, definition of priorities and service delivery to satisfy customers requirements. quality management is not derived from a single idea or person and this may be the reason for divergence view and definitional problems experienced by managers during the implementation of the strategy. smes are worse off in the matter as they have poor understanding of tqm terminology (oakland, 2000). eriksson & hansson, (2003) stated that tqm brings together the constellation of productivity, ethical leadership and performance into a unique relationship. the question therefore is what is tqm? yong & wilkinson (2001) noted that tqm strategies focus on quality improvement to achieve outcomes such as financial results, customer satisfaction, marketing results, operational results, community results and employee results. hoyer & hoyer (2001) defines quality as two levels concept: level one consist of producing products or delivering services whose measurable characteristics satisfy a fixed set of specifications and level two means products and services that satisfy customer expectations for consumption. evans & dean (2003) stated that quality is much more than conformance to specifications. they identify eight attributes of quality as performance, features, reliability, conformance, durability, serviceability, aesthetics and perceived quality. `rouse, (2005) defined tqm as a comprehensive and structured approach to organizational management that seeks to improve the quality of products and services through ongoing refinements in response to continuous feedback. nwabueze (2001) summaries tqm as having three major requirements outlined as follows: (i) total: participation of all staff in an institution-wide process. tqm requires continuing improvement and getting things right first time. this demands team work and maintenance of good relationships at all cedars (ii) quality: meeting customer requirements at least exactly. tqm requires customer-agreed specifications which allow the supplier to measure performance and customer satisfaction. individuals and teams need to use quality tools and systems to facilitate measurement and problem solution (iii) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 366 management: enabling conditions for total quality. tqm requires leadership and total commitment from senior management to quality goals. 2.1 paradigm shift in quality management over time total quality management has been called various names and this is in response to shift in the model development. it is known as continuous quality improvement (cqu); statistical quality control (sqc); total quality control (tqc), etc. each of these ideas encompasses the underlying scheme of productivity initiatives that increase efficiency and profit by improving the product or services (cua., mckone., & schroeder, 2001). pycraft, singh & phihlela (2000) stated that quality was initially achieved by inspection and screening out defects before customers noticed them. the quality control concept was developed as a more systematic approach not only to detect defects but also to solve quality problems. assurance came with a wider responsibility for quality to include functions other than direct operations of an institution and makes increasing use of more sophisticated statistical quality techniques (dale, 2003). the paradigm shift is illustrated by figure 1 below: figure 1. paradigm shift through time source: adapted from dale (2003) and pycraft, singh & phihlela (2000) pycraft, et al (2000) stated that phase 3 involves meeting the clients’ expectations, improving all parts of the institution, examining all costs relating to quality, developing systems and phase 1: quality of product inspection  error detection quality control  statistical methods  process performance phase 2: quality of i tit ti quality assurance  quality system  quality costing  problem solving total quality management  whole institution involved  quality strategy  team work  staff empowerment tqm phase 3: quality of life error / defect detection asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 367 procedures to support quality improvement and developing a continuous process of improvement 2.2 dimensions of service quality a quality standard is that level of quality which defines the boundary between acceptable and unacceptable (pycraft et al., 2000). service standards should serve as indicators of performance to determine whether the service is meeting the customer’s expectations or not (evans & dean (2003). service standards and feedback mechanism should be established in the entire organization to aid measurement and reporting (hansson, (2003). zeithaml and bitner (1996) noted that understanding the dimensions will help smps both to appreciate clients’ needs and also to provide acceptable standard of service. the five broad dimensions are shown in table 1 below: table 1. five broad dimensions of service quality dimension definitions application to smps service delivery tangibility appearance of physical facilities, equipment, personnel and writing materials this enables smps clients to make inferences about the service quality based on the firm’s tangibles such as office buildings and layout, letterhead paper and staff outlook (jamal & naser, 2002). reliability ability to deliver all service promises dependably and accurately. reliability occurs when smps keeps every promise made to the clients. it should under promise and over perform responsive ness willingness to provide prompt service and help clients. this helps smps to resolve client’s problems as quick as possible and avoid dissatisfaction. assurance employees’ knowledge, courtesy and ability to inspire trust and confidence this enables smps reports to be made without mistakes, behaves pleasantly and politely and makes clients feels like a king. empathy caring, easy access, good communication, understanding and individualized attention to customers. empathy enables clients to deal with the smp more easily (levesque & mcdougall, 1996). communication enables clients’ complaint to be addressed through proper channels. source: zeithaml et al. (1996) recently, quality management emphasizes the concept of zero defects (error-free work) and has become popular as management pursues the climate. all members of staff in the organization are encouraged to dedicate themselves to the idea in service rendition (vroman & luchsinger 1994). mani., putterill., & sluti (1994) considers service to be a process that goes through various stages and in each stage, certain inputs are required from the service provider. if the quality of the service is inferior at any stage, it will result in the end product that will not meeting the clients’ expectations. in audit service cycle, quality testing must be performed at each input point such proper plan, designing good audit program, good record keeping and extensive review of audit working papers as once delivered, the service cannot be recalled as in asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 368 the case of a tangible product. chang., lin., yang., & sheu, (2003).stated that each institution that renders services must have a service strategy which outlines focus point for all staff, departments and management to direct the entire efforts. the management should see quality from organizational point of view and each department/unit within the organization need to adopt the same strategy to serve the clients with excellent quality at lower cost, quicker response time with greater flexibility (schonberger 1990). this will be made easy by adopting the above five broad dimensions of service quality. 2.3 small and medium practice (smp) in nigeria and total quality management there is no clear acceptable definition of smp as at now. the international federation of accountants (ifac) defines such firm as an accounting practice (audit firm) whose clients are mostly smes, which depends on external sources to supplement limited in-house technical resources and hold a limited number of professional staff (ifac 2010). linking smp to smes loaded the definition with difficulties and confusions as what constitutes an sme differs from one country to another. the definition of smes in existing literature varies although the primary concept remained the same. ayagari & demirguc-kunt, (2003) contends that the definition of sme varies according to context, author and countries. in usa, britain and canada sme is defined in terms of annual turnover and the number of paid employees (ekpeyong & nyang, 1992; ariyo, 1999). in nigeria, the central bank of nigeria in its monetary policies circular no. 22 of 1988 described smes as those enterprises which has annual turnover not exceeding 500,000 naira. it means that the classification is subjective and based on different value judgment (wiklund & wiklund, 2002). according to ifac (2010) the fundamental reason for defining smp is to form a basis for the following: (i) to provide a distinction between the second tier and large accountancy organizations (ii) to provide snapshot of key challenges and trends influencing smps globally and smps opportunity to share their insights on key developments facing them and their small business clients (iii) to provide resources through services and products to smp by umbrella international and regional organizations such as ifac, association of accountancy bodies in west africa (atwa) and confederation of asian and pacific accountants (capa) (iv) to enable appropriate members to assess the proportion of resource provided (v) to lobby on behalf of smps to government and regulatory bodies at national and international level and (vi) to provide an important advisory services to smps. ifac board established smp committee to represent the interests of professional accountants operating as smps. the committee investigates ways to respond to the needs of smp as means for sustainable economic development. currently, ican has membership of 32,722 professional (okpala 2012) with 6,500 chartered accountants holding the institute’s practising licences (okwuadigbo, 2012). interestingly, about 72% of this number is made up of sole practitioners. classifications of firms by ican are as follows. (i) small practices: 2-4 partners (ii) medium practices: 5-9 partners and (iii) large practices: 10 above. the total number of audit firms in nigeria as at 27th may, 2011 is 916 firms categorized by number of partners as shown in table 2 below: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 369 table 2. categories of firms by number of partners no. of partners (nop) 1 2 3 4 5 6 13 18 total no. of firms (nof) 1. 655 2. 187 3. 42 4. 17 5. 6 6. 7 7. 1 1 916 % of n of 8. 71.5 9. 20.4 10. 4.6 11. 1.7 12. .6 13. .7 14. .1 .1 100% source: membership affairs record (may, 2011) evident from the table 2 above shows that sole practitioners comprise of the highest number of practising firms in nigeria. the reasons for the dominance of this type of business association include: (a) unwillingness of the sole practitioner to lose control (b) inability to look beyond the immediate environment (c) lack of collaboration among chartered accountants (d) lack of specialization and (e) the desire to work independently and take all the profit. from the practice monitoring exercise survey, most sole practitioners and other small audit firms are faced with many operational challenges and as a result have adopted different survival tactics which impact negatively on the quality of services rendered to their clients (okwuadigbo, 2012). the institute is encouraging firms to merge and pool resources to ensure improved capacity and provides high quality services. managing partners of smp should embrace tqm to ensure that meet clients’ expectation, produce services that conform to meet international standards, have excellent performances, attracts development, eliminate the existing high mortality rate of smps and adopt a comprehensive and structured approach to auditing practice management that improves the quality of services through ongoing refinements in response to continuous feedback from clients. 2.4 six sigma methodology and smp performance according to wyper & harrison (2000) six sigma is a logical and methodical approach to achieving disciplined quality improvements in areas critical to the success of any service-oriented organization. it was originally developed by motorola in 1986 and became well known after jack welch made it a central focus of his business strategy at general electric in 1995. today it is widely used in many sectors locally and internationally. tqm is made up of adding six sigma methodology (ssm) to current business system (cbs). this can be expressed mathematically as: cbs+ ssm = tqm. six sigma implementation assisted motorola to win the 1988 malcolm baldrige national quality award and within the first five years achieved savings of $us2.2 billion (lucey 2002). nave (2002) stated that six sigma methodology includes five steps commonly known as dmaic as follows: define; measure; analyze; improve and control. these steps endeavour to adopt a smarter way of doing things so as to minimize the occurrence of errors. it emphasizes on doing things right the first time, rather than spending effort on correcting errors. according to tennant (2001) smp can apply ssm in the following ways: step 1: definition starts with conducting a baseline study to identify smp market segments and their problems. goals should be accurately defined and must follow the smart principles: s=specific; m= measurable; a = attainable; r= relevant and t= timely. step 2: improvement measurement parameters and extent to be improved should be properly established. actual data should be collected to enable measurement and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 370 calculation of variances between the current and the desired performance. step 3: once the data are analyzed, it will provide insights into the process to be improved. these include identifying the fundamental causes of the defects or errors to enable improvement in the services delivery. step 4: the improve phase is the fourth in ssm. analysis in step 3 will trigger smps management action and the basis for improvements in processes capable of resolving client problems. step 5: control phase: this phase is where improvements implemented are made manifest. it is the most neglected phases in the methodology. one of the main reasons for improvements not showing is because this phase is overlooked. 2.5 virtuous circle of dmaic costin (1994) emphasized that quality is the most significant of all competitive weapons in the business arena and its implementation should be an ongoing process. it should be allowed to become a philosophy and culture of the whole institutions. improving a service should be a continuous process and in audit firms, each employee should accept responsibility for that process (wilkinson., marchington., goodman., & ackers, 1992) dmaic in smp operations should be on cyclical basis. the control phase (step 5) will further provide an avenue for the redefinition stage (step 1). a key philosophy in dealing with clients is that they are responsible for defining what quality is (mohammed. & shamsuddoha, 2012) and for smp to have a successful implementation of ssm, all stakeholders should be treated as business partners with all parties working together to deliver quality services (schroeder, 2006). 2.6 benefit of six sigma methodology chao-ton, & chia-jan, (2008) classified the benefit of ssm into hard saving involving tangible outcome in relation cost and revenue and soft savings involving actual improvements. this is shown in figure 2 below: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 371 sources: chao-ton & chia-jan, (2008). figure 2. benefit of six sigma methodologies 3. methodology the population for the study consisted of 914 smps (firms with between 1 to 6 partners) representing 99.8% of the total firms licensed by the institute of chartered accountants of nigeria to provide auditing services. only principal partners of smps responsible for strategic decision making were selected as respondents due to their involvement in their firms’ management. the sample size of 137 consists of 15% of smps population which forms the basis 137 copies of questionnaire administered at random. 133 valid questionnaires were filled and returned. the questionnaire distribution was independent of sex and age. the instrument consisted of a 9 term survey questionnaire with a 5 likert scale response options. strongly agreed (sa), agreed (a), undecided (u) disagree), and strongly disagreed (sd). pilot survey was adopted for the reliability test and it yielded correlation coefficient of 0.84. the questionnaire was structured in line with the objective, research questions and hypothesis of the study. data was analyzed and pearson product moment correlation method was used to confirm the hypotheses of the study. the formulae are: r = n, by (x) (y) / nx2 (x)2 n2 (y)2 benefit (ssm) hard savings soft savings (improvements) cost reduction revenue enhancement efficiency improvement cash flow improvement cost avoidance quality improvement asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 372 3.1 test of statistical hypothesis hypothesis 1: h0: there is no significant relationship between tqm and smp performance in nigeria h1: there is significant relationship between tqm and smp performance in nigeria table 4. calculation of correlation question 2 of questionnaire administered: adoption of tom will positive influence smps performance in nigeria options point (x) response (y) (xy) (x2) (y2) sa 5 73 65 25 5,329 a 4 32 128 16 1,024 u 3 7 21 9 49 d 2 8 16 4 64 sd 1 13 13 1 169 σ 15 133 543 55 6,635 source: author’s computation, september 2012 r = nσxy – (σx) (σy) / √ n [σx2 – (σx)2] [nσy2 – (σy)2 where: n = 5, σx = 15, σy = 133, σxy = 543, σx2 = 55, σy2 = 6,635 r = 5(543) – (15) (133) / √5 [(15) – (15)2] [5(6,635) – (133)2] = 2,715 – 1,995 / √ (275 – 225) (33,175 – 17,689) = 720/ √ (50) (15,486) = 720 / 880 = 0.818 r = 0.82 (82%) decision: r calculated of 0.82 ≥ 0.5 level of significance. the alternate hypothesis is accepted that says: there is significant relationship between tqm and performance of smps in nigeria therefore the null hypothesis is rejected hypothesis 11: h0: six sigma methodology has no significant influence on smp services delivery in nigeria. h1: six sigma methodology has significant influence on smp services delivery in nigeria asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 373 table 5. calculation of correlation question 5 of questionnaire administered: six sigma methodology has no significant influence on smp services in nigeria. options point (x) response (y) (xy) (x2) (y2) sa 5 50 250 25 2,025 a 4 28 112 16 784 u 3 9 27 9 81 d 2 18 36 4 324 sd 1 28 28 1 784 σ 15 133 453 55 4,473 source: author’s computation, september 2012 r = nσxy – (σx) (σy) / √ n [σx2 – (σx)2] [nσy2 – (σy)2 where: n = 5, σx = 15, σy = 133, σxy = 453, σx2 = 55, σy2 = 4,473 r = 5(453) – (15) (133) / √5 [(15) – (15)2] [5(4,473) – (133)2] = 2,165 – 1,995 / √ (275 – 225) (22,365 – 17,689) = 170/ √ (50) (4,676) = 170 / 484 = 0.351 r = 0.35 (35%) decision: r calculated of 0.35 ≤ 0.5 level of significance. the null hypothesis is accepted that says: there is no significant relationship between tqm and performance of smps in nigeria. therefore the alternative hypothesis is rejected. 4. discussion of result the article investigated relationship between tqm and smps performance on one hand and influence of ssm on smp service rendition the other. the work attempted to fill a gap in tqm research with a survey of smps in nigeria. hypothesis 1 tested in table 4 revealed that there is significant relationship between tqm and smps performance. this issue was addressed by question 2: adoption of tom will positive influence smps performance in nigeria with 55% to rank first. the effect of tqm is seldom seen in smp performance due to lack of resources to implement it. this notion was confirmed by question 1: smp in nigeria does not have enough resources to improve quality of service renders to clients. hypothesis 2 tested in tables 5 revealed that application of six sigma methodology has not influenced smp service rendition in nigeria. this is due to ignorance on the part of smps principal partners. this issue was addressed by question 5 of the questionnaire with 34% to rank 4th. the “r” calculated of 0.82 and 0.35 shows that there is strong positive correlation between tqm and smps performance but inconsequential application has led to no influence in quality services renders hence the benefit ssm is not fully tapped. 5. summary of findings based on the analysis carried out, the following findings were revealed (i) there is a significant but relationship between tqm and organizational performance. (ii) most smps principal asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 374 partners are not conversant with the concept (iii) few smps train employees, provide leadership for continuous improvement in services and meets consumer’s expectations (iii) smps staff embarks on self development with little salary package which affects personnel input in service engagement (iv) quality service can only be provided if continuous improvement is achieved which is lacking in smps operations (v) smps are ignorant of the concept of six sigma methodology hence could not apply it. 6. concluding remarks and recommendations tqm is a management approach which seeks to establish zero defects in any part of service provision in an organization. current business system (cbs) coupled with six sigma methodology (ssm) will result in tqm. however, due to ignorance, the concept is neither employed in part or in whole which makes it impossible for the smp to harvest the benefit of tqm. this might be one of the reasons why smps in nigeria are neither providing excellent services nor developing into full-size accountancy organizations. instead some are winding up. the study recommends that smp should embrace ssm to have significant clients’ relationship, improved performance and maximize institutional prosperity. 7. acknowledgement the authors wish to thank the editor and reviewers of this journal for their helpful comments and suggestions on draft of the article. also dr. umukoro of babcock university for his mentorship and professors enyi patrick enyi my ph.d. supervisor. references ayagari, m. t. b., & demirguc-kunt, a. 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(2010). implementation of total quality management. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 378 appendix 1 table 3. distribution and return of questionnaire no question sample size respons e responden ts percenta ge ranking 1 smp in nigeria does not have enough resources to improve quality of service renders to clients. 133 sa a u d sd 61 23 5 24 20 46% 17% 4% 18% 15% 2nd 2 adoption of tom will positive influence smps performance in nigeria 133 sa a u d sd 73 32 7 8 13 55% 24% 5% 6% 10% 1st 3 management of smps does not embrace quality controls in their operations. 133 sa a u d sd 50 30 6 28 19 38% 23% 5% 21% 14% 3rd 4 six sigma methodology are employed by smps in nigeria to achieve total quality management in their service renditions 133 sa a u d sd 23 14 9 32 55 17% 11% 7% 24% 41% 5th 5 application of six sigma methodology has influence on smp service rendition in nigeria 133 sa a u d sd 45 28 9 18 33 34% 21% 7% 14% 25% 4th source: field survey, september 2012 microsoft word 1783-7010-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 359 do agency costs really matter? a non-linear approach of panel data fitriya fauzi (corresponding author) the university of waikato, waikato management school, new zealand private bag 3105, hamilton 3240, new zealand e-mail: ff21@waikato.ac.nz stuart locke the university of waikato, waikato management school, new zealand private bag 3105, hamilton 3240, new zealand received: may 8, 2012 accepted: may 29, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1783 url: http://dx.doi.org/10.5296/ajfa.v4i1.1783 abstract this paper investigates the relationship between agency cost, ownership structure and corporate governance mechanisms. though previous studies of agency problems, corporate governance mechanisms or ownership variables suffer from endogeneity, with respect to the corporate governance it is unclear as to which variables are endogenous and which are exogenous. this study, using the durbin-wu-hausman test for endogeneity, confirms noendogeneity issues should be addressed. furthermore, addressing the issue of non-linearity, this study confirms that the relationship between agency costs, ownership structures and corporate governance mechanisms are non-linear. using a balanced panel of 79 new zealand-listed firms, this study employs a non-linear panel data method using tobit. apart from block-holders’ ownership, leverage, dividend, non-executive directors and audit committees, managerial ownership, the number of the board size, nomination and remuneration of the committee have significant impact in reducing the agency costs in the context of new zealand-listed firms. overall, it can be concluded that corporate governance mechanisms and ownership structures are vital in mitigating agency costs in the new zealand context. keywords: agency cost, managerial ownership, corporate governance, non-linear panel tobit, new zealand-listed firms jel classification: g34 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 360 1. introduction in publicly held corporations, the management is usually controlled by non-owner managers. these managers act as agents for the owners, who have hired them to make decisions and to manage the firm for the owners’ benefit; that is, to maximise the shareholders’ wealth. however, managers also consider their own interests, and the conflict between the goals of the shareholders and those of managers give rise to agency costs. therefore, corporate governance is necessary to align the interests of shareholders and management. this conflict of interests has been addressed in a legal way through regulations, such as the companies act 1993 in new zealand (nz). the companies act 1993 is aimed at regulating rules of conduct which firms should comply with, for example: the positions of chief executive and chairman should not be held by the same person; the audit committee should be comprised solely of non-executive directors; there should be a nomination committee for board appointments with a majority of independent directors; there should be a remuneration committee to recommend remuneration packages for directors, the members of which are identified in the annual report. if these rules of conduct are well implemented, they reduce the risk of agency problems within the company. in addition, the organisation for economic co-operation and development (2004) states that corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. the organisation for economic co-operation and development (oecd) also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. jensen and meckling (1976) propose two types of agency costs, which are, the agency cost of equity and the agency cost of debt. agency cost of equity occurs when firms sell shares to outside investors in which the investor pays less for the shares because they expect the firms’ performance to change after they buy the shares, and at the end the equity shares issue reduces the market value of corporate assets. to overcome this problem, firms may use debt, as it forces managers to perform effectively, but this also does not come free of charge. using debt can create agency costs of debt because sophisticated debt-holders will create bond agreements which are costly to negotiate and to enforce. to mitigate the agency problems, firms can structure the executive compensation shares packages to align managers’ interest with stakeholders’ interest. compensation shares contracts give managers incentives to act in the shareholders’ best interest, as the shares tie managerial wealth directly to the firm’s share price. this encourages managers to maximise the stock price, as their own wealth will increase along with that of the other shareholders’. lee, lev and yeo (2008), in their study of agency problems, found that higher pay dispersion, including managerial equity compensation shares, can mitigate agency problems and ultimately improve a firm’s performance. the compensation shares method is the most powerful but most expensive method of overcoming agency problems. agency problems also can be reduced by the existence of large investors (block-holders) and dispersed ownership. block-holders play a significant role in controlling the management by using their influence to suppress underperforming management teams. dispersed ownership asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 361 affects the controlling power of the management over the firm; the more widely dispersed the ownership, the less the power of the management team. in addition, dividend payment is considered as one of the solutions to mitigate the agency problems. however, larger firms that generate large quantities of free cash flow tend to have severe agency problems, because managers are likely to spend the free cash flow on investment rather than pay it out to shareholders. in addition, there are some other aspects in determining agency problems, which are firm size, firms’ specific characteristics and industry growth rate. further, the composition of board directors on the board is a central issue, as is whether such representation on the board is a factor of good governance, or does this create possible conflicts that would be bad for the company. similarly there are issues of whether there is a significant impact of both owner and non-owner managers’ presence in the board on agency costs. boyle and ji (2011) report that the average board size in new zealand-listed firms was about 5.9 directors in 2010. compared with the us (ning et al., 2010), the uk (guest, 2009), and australia (kang, cheng &gray., 2007), the board size in new zealand firms is noticeably smaller, but this reflects the smaller size of nz firms. further, boyle and ji report that the representation of independent and non-executive component comprised approximately 2/3 and 4/5 respectively of boards in 2010. however, the independent director representation in nz is lower than elsewhere; for example, independent directors in the us boards were 71.4% in 2003 (chhaochharia & grinstein, 2007), and in australia they are 83% (kang et al., 2007). not all boards are alike. while boards are the main tool of the internal governance mechanism, their efficacy may vary depending on the board characteristics. therefore, it is necessary to examine whether such corporate governance mechanisms are of importance in affecting agency costs. furthermore, new zealand’s unique feature of small and medium enterprises and the agricultural industry’s domination, which is different from other developed countries, may result in different ownership structures, corporate governance conduct and agency costs. thus, it is important to investigate the relationship between ownership structure, corporate governance mechanisms and agency costs in the new zealand context. the results from this study show the importance of agency costs, ownership structures and corporate governance mechanisms for new zealand-listed firms, which new zealand are smaller, compared to other developed countries. so, unquestioning compliance to different codes and principles elsewhere is inappropriate to new zealand firms. they may have to be customised based on specific needs of the new zealand context. furthermore, this study provides recent evidence of which factors contribute in lowering agency costs for new zealand listed firms. 2. literature review there are significant numbers of studies focusing on agency costs across firms and countries which yield mixed results. some of studies provided theoretical frameworks for understanding why agency problems arise, what the consequences are, and how agency problems and their costs can be reduced. furthermore, other studies have examined the role of corporate governance mechanisms and ownership structures in mitigating the agency costs. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 362 the sources of agency problems differ among firms; for example, one firm may have a problem because of their corporate governance structures and another because oftheir ownership structures. for corporate governance structures, there are two conditions must be preserved for an effective governance mechanism; first, the devices used, and second, the mechanismsused to narrow the gap between managers’ and shareholders’ interests (denis, denis &sarin, 1997). furthermore, according to the agency model, jensen and meckling (1976) suggested that higher managerial ownership should reduce agency costs because there is a convergence of interests between shareholders and managers as the managers’ ownership increases. however, stulz (1988) suggested that high levels of insider ownership resulted in management entrenchment, thus reducing the firm’s value. demsetz and villalonga (2001) suggest that the ownership structures differ across firms because of differences in the circumstances facing firms, particularly in regard to scale of economies, regulations and the environment stability in which they operate. holderness, kroszner and sheehan (2002) show that management ownership in the united states has grown over the last 60 years, and equity ownership can be used to align the interests of management with those of shareholders. however, excessive insider ownership can result in entrenchment of management. furthermore, bhabra (2007) found a significant non-linear relationship between ownership structure and firm performance in new zealand’s listed firms, and suggests that the non-linear relationship is robust to differences in governance structures across market. in 2001, the mean proportion of stock held by the top 20 shareholders in nz was 73%, which indicates that nz’s firms are highly concentrated, hence inducing better monitoring and reducing the potential for entrenchment of managers (hossain, prevost &rao, 2001). furthermore, from 2007 to 2011, the average mean proportion of stock held by the top 20 shareholders in nz was 50%, and this indicates that nz’s firms tend to have moderate ownership concentration. the hypothesis regarding managerial ownership and agency costs is: h01: the higher the percentage of managerial ownership, the lower the agency costs. reduction of agency costs can also be achieved through block-holders’ ownership. the role of block-holders is likely to vary over time periods and countries as a function of the legal system and other regulations. block-holders may directly influence dividend policy, and managerial ownership may directly influence capital structure policy. however, more complicated interaction effects are possible and perhaps more likely; for example, when there is a large stakeholder, management usually becomes less accountable to shareholders and more accountable to the large controlling stakeholder who will have considerable control over the firm in excess of the cash flow rights. this may reduce the incentive to expropriate funds but not eliminate it. in 2001, the mean proportion of stock held by the top 20 shareholders in nz was 73%, which indicates that nz’s firms are highly concentrated, which consequently induces better monitoring and reduces the potential for entrenchment of managers (hossain et al., 2001). similarly, healy (2001) found that institutional ownership and external block holding in nz asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 363 counts for 69%, and suggests that higher institutional ownership implies greater monitoring. furthermore, the average mean proportion of stock held by the block-holders in nz, during the period 2007 to 2011, was 50% with maximum value 98.88%, which indicates that the institutional ownership is widely dispersed and hence better monitoring takes place. some studies find that block-holders’ ownership is likely to reduce agency costs. hartzell and starks (2003) report that block-holders’ ownership is positively related to the performance sensitivity of managerial compensation; thus, block-holders’ ownership monitoring tends to be complementary to incentive compensation systems, mitigating agency problems between both shareholders and managers. on the other hand, doukas, kim and pantzalis (2000) argue that block-holders have neither the time nor expertise to act as effective monitors. furthermore, singh and davison (2003) find no evidence that block-holders’ ownership affects agency costs. the hypothesis regarding block-holders’ ownership and agency costs is: h02: the higher the percentage of block-holders’ ownership, the lower the agency costs. agency costs are also the product of corporate governance conduct and policy. capital structure and dividend policy are examples of how conflicts of interest between shareholders, managers and debt-holders arise. firms with higher levels of debt are more closely monitored by debt-holders, and thus can reduce the agency costs (jensen & meckling, 1976). likewise, crutchley and hansen (1989) found a significant impact of leverage in controlling agency costs. apparently, debt appears to have two positive influences on governance. first, debt-holders take on some function of monitoring (see begley & feltham, 1999; jensen, 1986). second, because debt financing reduces the need for sales of shares to raise capital, voting rights remain concentrated in the hands of existing shareholders. as a result, debt makes managers more accountable for consistent performance. however, leverage also brings higher levels of debt-related agency costs and bankruptcy costs. the optimal capital structure should be where the marginal costs of debt equal its marginal benefits. this is the point where the value of the firm is maximised. nevertheless, issuing debt beyond optimal levels will increase its risk and reduce the value of the company. berger, ofek and yermack (1997) found evidence that firms with entrenched ceos tend to have lower levels of debt and boards with few outside directors. excessive debt can be both positive and negative. it can act as a defense against takeovers (begley & feltham, 1999), while excessive debt may lead to larger risk-taking in order to fund debt servicing. recent work by gunasekarage, locke, reddy and scrimgeour (2006) reports that new zealand firms generally have a debt to assets ratio of 48%, which suggests that holders are acting as an external source of management accountability, which should act as a positive influence on firm performance. friend and hasbrouck (1988) suggest that higher inside ownership tends to have less debt, because they prefer to use internal financing to avoid the agency problem with debt holders. the hypothesis regarding the leverage and agency costs is: h03: the use of leverage lowers the agency cost. though the agency costs of dividends imply that dividends are worthless in themselves, dividend is still considered as one appropriate method to alleviate the agency problems asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 364 (rozeff, 1982; easterbrook, 1984). dividends reduce the amount of cash available for management to use for purposes other than maximizing firm performance (jensen, 1986). as a result, dividends can be interpreted as acting as a tool in reducing agency problems. corporate governance policies that seek consistent dividend discipline may be developed to avoid disciplining action by shareholders (myers, 2000). setia-atmaja (2010) found a relationship between board independence, dividends, and countries with strong legal shareholder protection; in particular, setia-atmaja found that a higher proportion of independent directors are likely to influence a firm’s dividend policy and as a result complementary governance mechanisms. easterbrook (1984) suggests that dividends may keep firms in the capital market, where monitoring of managers is available at lower costs, and any dividend policy should be designed to minimise the agency costs. similarly, la porta, lopez-de-silanes, shleifer and vishny (2000) affirm that dividend payments play a basic role in limiting insider expropriation because dividends reduce the free cash flow that might be used for under-investment projects. however, the use of dividends is not costless, in that the dividend payment increases the chance of external equity financing which involve having substantial floatation costs to be paid (crutchley& hansen, 1989).in addition, dividend payments do not carry the same legally binding obligation to make payments as debt, making them a less efficient means of forcing managers to pay out cash-flows. in new zealand, the effect of dividend policy can be directly used as a mechanism to monitor managers’ behaviour (gunasekarageet al, 2006). furthermore, crutchley and hansen find significant impact of dividend in controlling agency costs. the hypothesis regarding the dividend and agency costs is: h04: the dividend payment lowers the agency costs. corporate governance mechanisms, such as the number of directors on the board, the number of non-executives on the board, the presence of audit, nomination, and remuneration committee on the board, play significant roles in mitigating agency costs. according to lipton and lorsch (1992) that the board size, as well as the number of directors, is important because the corporate productivity will decline with a large number of board directors. when board size is large, it is difficult to harmonise the conflicts among directors, which leads to not only principal-principal costs but also principal-agent costs. yermack (1996) and eisendberg, sundgren, and wells (1998) find a negative relationship between board size and firm performance. larger boards are likely to have higher coordination costs, which reduce their ability to effectively monitor management, hence increase agency costs. the hypothesis regarding the board size and agency costs is: h05: the higher board of directors, the lower the agency costs. the positive role of outside directors on company boards with respect to particular discrete tasks has been explored with respect to disciplining poorly performing top management. numerous studies suggest that non-executive directors have a positive effect and find that boards dominated by non-executive directors are more likely to act in shareholders’ best interests, and more independent boards improve performance through better monitoring of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 365 management (borokhovich, parrino, & trapani 1996; hermalin & weisbach, 1988). agrawal and knoeber (1996), klein (1998) and bhagat and black (2002) find a negative relation between board independence and performance. in contrast, hermalin and weisbach (1991) and mehran (1995) find no relation between board independence and performance. the hypothesis regarding the number of non-executive directors on the board and agency costs is: h06: the higher the percentage of non-executive directors on the board, the lower the agency costs. board members are also part of committees; therefore, it is beneficial to examine various aspects of committees. there are at least three committees, such as audit committee, nomination committee and remuneration committee, and mostly, the remuneration committees are comprised only of independent directors in order to increase their neutrality in decision making. findings from this study will improve our understanding of linkage between committees and agency problems. hence, the audit committee and the remuneration committee are of importance to ensure that the financial procedure is carried out well and the directors’ are well compensated, hence mitigating the agency problems. felo, krishnamurthy and soliery (2003) empirically examine the relationship between expertise, independence and size of the audit committees and the quality of financial reporting. they find that expertise and size are positively related to financial reporting quality but are not related to the committee’s independence. they state that given the prior evidence of a negative relationship between financial reporting quality and cost of capital, firms could improve their reporting quality by appropriately structuring their audit committees, thus reducing their cost of capital. the presences of audit committees in public corporate entities have a positive effect on reducing agency cost when measured by cost to revenue (reddy, locke & scrimgeour, 2010). furthermore, an effective nomination committee should ensure the appointment of non-executive directors whose interests are aligned with those of the shareholders and reduce the agency problems. the hypotheses regarding the audit, nomination and remuneration of committees and agency costs are: h07: the presence of the audit committee on the board lowers the agency costs. h08: the presence of the nomination committee lowers the agency costs. h09: the presence of the remuneration committee lowers the agency costs. 3. methodology 3.1 data this study uses data from the annual report of new zealand-listed firms for the period of 2007-2011 collected from the nzx deep archive. those firms with any missing observations for any variable in the model during the research period are dropped, and thus a balanced panel data of 79 new zealand-listed firms were observed from a total of 147. though only 79 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 366 firms were included, the sample may do well in capturing aggregate leverage in the country, because the listed firms tend to represent the whole industry in new zealand. 3.2 variables variables are largely adopted from previous studies, thus this study uses two proxies to measure agency costs, which are assets-to-sales ratio, and the interaction of free cash flow and growth prospects as dependent variables. the assets-to-sales ratio measures the efficiency of the management in how they use the firm’s assets to generate sales. a high ratio shows that assets are generating significant sales and therefore suggests low agency costs. a low ratio suggests that management is implementing poor decisions, such as under-investment decisions, and therefore indicates high agency cost. though these measures have some drawbacks, they provide a useful indicator of agency costs (ang, cole & lin, 2000; singh & davidson, 2003). furthermore, the interaction of free cash flow and growth prospects are an indicator of how managers in high growth prospects utilise their large free cash flow, and this is considered as lowering agency costs. in contrast, firms having low growth prospects and large free cash flow tend to suffer high agency costs (doukas, et al., 2000; jensen, 1986; opler & titman, 1993). the explanatory variables are managerial ownership, block-holders’ ownership, dividend, leverage, firm size, board of directors, non-executive directors, audit committee, nomination committee, and remuneration committee. in addition, the dummy for industries serve as control variables. explanatory variables are defined as follows: managerial ownership is measured as the portion of managers holding the firm’s equity shares; block-holders’ ownership is measured as the portion of large investors (institutional investors) holding the firm’s equity shares; dividend is measured as the proportion of dividend paid to the shareholders; leverage is measured as ratio of total debt over total assets; firm size is measured as the log of total assets; board of directors is measured as the total number of directors serving on the board; non-executive directors is measured as the total of non-executive directors out of the total of board directors; audit committee is a dummy variable that takes the value of 1 if a firm has a formal audit committee and zero if otherwise; nomination committee is a dummy variable that takes a value of 1 if a firm has a formal nomination committee and zero if otherwise; remuneration committee is a dummy variable that takes a value of 1 if a firm has a formal remuneration committee and zero if otherwise; and industry dummy is set as dummy variables. 3.3 method this study uses panel data which allows the unobservable heterogeneity for each observation in the sample to be eliminated and multicollinearity among variables to be alleviated. maddala and lahiri (2008) specify problems that might be present in the regression model, such as heteroskedasticity, multicollinearity and endogeneity problems. those problems cause inconsistency of the ordinary least square (ols) estimates. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 367 as can be seen in the table 2, most cross-correlations for the independent variables are fairly small, thus, giving less cause for concern about the multicollinearity problem. further, the breusch-pagan test for heteroskedasticity results in 7.43 (p-value 0.006), indicating that variances among the explanatory variables are not constant. though previous studies of agency problems, corporate governance mechanisms or ownership variables suffer from endogeneity, with respect to the corporate governance it is unclear as to which variables are endogenous and which are exogenous (whidbee, 1997). this study, using the durbin-wu-hausman test for endogeneity, confirms noendogeneity issues should be addressed. however, most of those previous studies were based in the us, which has different characteristics, different corporate governance practices and different institutional characteristics from new zealand. furthermore, a number of studies have found a non-linear relationship between managerial ownership and performance, which under the agency model, indicates managerial entrenchment (mcconnell & servaes, 1990; morck, shleifer, & vishny, 1986; short & keasey, 1999). addressing the issue of non-linearity, this study confirms that the relationship between agency costs, ownership structures and corporate governance mechanisms are non-linear. results for linear models do not always carry over to non-linear models, and methods used for one type of non-linear model may not be applicable to another type. the general approaches to non-linear panel models are similar to those for linear models, such as pooled, population-averaged (pa), random effects (re) and fixed effects models (fe). unlike the linear case, pooled estimation in non-linear models leads to inconsistent parameter estimates. the re model has a different conditional mean than that for pooled and pa models in which re is multiplicative. furthermore, if the fe model is appropriate compared to re, then an fe estimator must be used, but it only works for long panels (cameron &trivedi, 2010). for short panels, a non-linear model, binary probit and tobit are more appropriate. this study employs non-linear panel data method using re tobit where the dependent variable is a mixture with zero and positive values. cameron and trivedi (2010) suggest that the re panel tobit model specifies that latent variable ∗ to depend on regressors, an idiosyncratic error, and individual-specific error, and individual-specific error, so ∗ (1) where ∼ 0, and ∼ 0, and the regressor vector includes an intercept. for left censoring at l, and observe the variable, where ∗ ∗ ∗ (2) then the regression model is specified as: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 368 where: ac : agency costs iownps : managerial ownership bownps : block-holders’ ownership div : dividend paid lev : leverage utilise fs : firm size bs : board of directors on the board ned : non-executive directors on the board audc : audit committee on the board nomc : nomination committee on the board remc : remuneration committee on the board cv : control variables that are industry dummy 4. findings table 1 presents the descriptive statistics, and the mean value of block-holders’ ownership is 50.04%, suggesting that the ownership concentration is moderately dispersed in new zealand-listed firms. the mean value for managerial ownership is 17.86%, suggesting that the managerial ownership in new zealand is quite high, as other studies classify the managerial ownership 5% to 20% as moderate, while below 5% as low and above 20% as high managerial ownership. the mean value of leverage is 47.78%, suggesting that new zealand-listed firms have considerably moderate debt levels compared to us firms’ debt levels. the mean average of non-executive directors is 69.14% or just over two-thirds, suggesting that the majority directors on boards are non-executive directors. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 369 table 1. descriptive statistics variable obs. mean std. dev. min max agency cost 395 0.1241 0.5985 -0.0033 4.5963 bownps 395 0.5004 0.3254 0.0001 0.9886 iownps 395 0.1786 0.2362 0.0001 0.9777 leverage 395 0.4778 0.2414 0.0100 0.9900 dividend 395 1.6934 20.2460 -100.75 381.11 board size 395 0.7772 0.1187 0.3010 1.1139 ned 395 0.6914 0.1996 0.1667 1.0000 audit_comm 395 0.9114 0.2845 0.0000 1.0000 nom_comm 395 0.5266 0.4999 0.0000 1.0000 rem_comm 395 0.7646 0.4248 0.0000 1.0000 firm size 395 5.5184 1.2742 2.7945 9.7017 ind_primary 395 0.1519 0.3594 0.0000 1.0000 ind_energy 395 0.0759 0.2653 0.0000 1.0000 ind_goods 395 0.1772 0.3823 0.0000 1.0000 ind_property 395 0.0633 0.2438 0.0000 1.0000 ind_service 395 0.4177 0.4938 0.0000 1.0000 ind_investment 395 0.1013 0.3021 0.0000 1.0000 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 370 table 2. correlation matrix agenc y cost bownp s iownp s leverag e dividen d boar d size ned audit_com m nom_com m rem_com m firm size agency cost 1.000 0 bownps -0.139 0 1.0000 iownps -0.011 9 0.1902 1.0000 leverage 0.028 3 0.0751 -0.0805 1.0000 dividend -0.000 1 -0.0081 0.0127 0.0930 1.0000 board size -0.026 4 -0.0006 -0.0256 0.0938 0.0251 1.000 0 ned -0.007 9 -0.1201 -0.1821 0.0654 -0.0198 0.135 5 1.000 0 audit_com m 0.035 7 -0.0162 0.0803 -0.0083 0.0143 0.080 6 -0.014 2 1.0000 nom_com m -0.142 2 0.0799 -0.0559 0.0127 0.0455 0.232 6 0.075 7 0.3288 1.0000 rem_com m -0.026 6 0.0163 -0.0835 0.0569 0.0289 0.198 6 0.056 1 0.5619 0.5853 1.0000 firm size 0.439 3 -0.1379 -0.1308 -0.0282 -0.0109 0.380 1 -0.038 5 0.1338 0.0846 0.0449 1.000 0 table 2 presents the correlation matrix of all variables in the model. the highest correlation is between agency costs and firm size at 0.43, suggesting larger firms tend to have larger agency costs. other variables having the highest correlation are the audit committee and remuneration committee at 0.56, while the nomination committee and remuneration committee are at 0.58, suggesting that firms having an audit committee are also having a remuneration committee, and firms having a nomination committee are also having a remuneration committee. none of the correlations among explanatory variables are above 0.58, indicating a low likelihood of multicollinearity issues arising in the ols regressions. table 3 presents the regression results. the regression results for linear and non-linear method are considerably different. the difference is caused by the nature of the data itself. if the data is non-linear, and is estimated as linear, thus possibly leading to inefficient estimators and biased standard error, and vice versa. this data in this study is characterised as non-linear data, though all the estimated coefficients in the linear method exhibit a significant result, but they present biased estimated. the result for the non-linear method yields less significant estimated coefficients, but they present true values to represent the data in this study. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 371 table 3. regression results variables reg. 1_linear-gls reg. 2_non-linear tobit constant 1.7401*** 0.1846 (0.1822) (0.1497) managerial ownership -0.9780*** -0.1656** (0.1056) (0.0772) block-holders ownership 0.1610*** -0.0622 (0.0531) (0.0400) leverage -0.313*** -0.0099 (0.0660) (0.0578) dividend 0.0005 -0.0001 (0.0023) (0.0005) board size -2.3260*** -0.5501*** (0.2198) (0.1360) non-executive directors -0.4076*** 0.0971 (0.0945) (0.0720) audit committee -0.0931* -0.0426 (0.0560) (0.0620) nomination committee 0.0194 -0.1570*** (0.0400) (0.0363) remuneration committee 0.3122*** 0.2269*** (0.0461) (0.0436) firm size 0.0951*** 0.0627*** (0.0130) (0.0117) groups 79 79 wald-chi2 254.60 86.50 prob.chi2 0.0000 0.0000 standard errors in parentheses are for coefficients. *sig. at 10%level, **sig. at 5% level, and ***sig. at 1% level from non-linear tobit, the coefficient for managerial ownership is a negative and is significant at 5% significance level, suggesting higher managerial ownership can reduce the agency costs. de angelo and de angelo (1985) argue that high levels of managerial ownership will entrench management and create agency problems; however, the result of this study indicates that managerial ownership in new zealand firms lowers the agency costs; this may be due to those managers who are also owners trying to maintain good reputation of their firms by minimising conflicts within the company, hence improving firm performance. this result is similar to what booth, cornett and tehranian (2002) posit, that managerial ownership is of importance in monitoring the divergence between managers and stockholders. the coefficient for board size is a negative and significant at 1% significance level, suggesting higher board size can reduce agency costs. the evidence suggests that the higher asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 372 the number of board members, the broader the diversity of board members, hence reducing agency costs. in addition, larger boards provide greater monitoring and advice (adam & mehran, 2003; anderson, mansi & reeb, 2004; coles, daniel & naveen, 2008). further, boyle and ji (2011) reported that the average board size fell from about 6.6% directors in 1995 to 5.9% in 2010, and that this decline is significant at the 1% level. therefore, increasing the board size is able to deal with the agency problem by alignment of interests of shareholders and directors and improve firm performance. the coefficient for the nomination committee is a negative and significant at 1% significance level, suggesting the presence of a nomination committee as lowering the agency costs. in contrast, the coefficient for the remuneration committee is a positive and significant at 1% significance level, suggesting the presence of a remuneration committee as increasing the agency costs. the positive relationship between remuneration committee and agency costs is reasonable because of two reasons; first, the majority of the remuneration committee are non-executive directors; second, the remuneration committee probably wants to increase the remuneration packages. using a linear model for non-linear data characteristics will yield inefficient and biased estimators. though the linear generalised least square (gls) regression yields a more significant coefficient compared with non-linear tobit, the result for non-linear tobit is efficient and unbiased. as can be seen in table 3, the coefficient for block-holders’ ownership, leverage, dividend, non-executive directors and audit committee are insignificant in affecting agency costs for this study using non-linear tobit. overall, apart from block-holders’ ownership, leverage, dividend, non-executive directors and audit committees; managerial ownership, the number of the board size, the nomination and remuneration committee have significant impact in reducing the agency costs in the context of new zealand-listed firms. hence, it can be concluded that corporate governance mechanisms and ownership structures are vital in mitigating agency costs in new zealand context. 5. conclusions as an internal mechanism, corporate boards are expected to play a more proactive role in discharging their fiduciary role for minimising agency problems and improving firm performance. this study examines the relationship between agency costs, ownership structure and corporate governance mechanisms. using a balanced panel of 79 new zealand-listed firms, this study employs a non-linear panel data method using tobit. though block-holders’ ownership, leverage, dividend, non-executive directors and audit committee have no impact in mitigating agency costs, managerial ownership, the number of the board members, nomination and remuneration committees are significant in reducing the agency costs in new zealand-listed firms’ context. overall, the findings from this study indicate that while corporate governance mechanisms and ownership structures have an important implication for agency costs, one can gain a deeper understanding of such relationships by identifying the contingency conditions in which the relationship between corporate governance mechanisms, ownership structures and agency costs may be dependent on each other. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 373 6. limitations the findings of this study are restricted to the limitation of the data, which was collected through publicly available data sources such as annual reports and other databases. if there are any 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(1996). higher market valuation of companies with a small board of directors. journal of financial economics, 40, 185-211. microsoft word 1990-7832-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 199 futures trading and spot market volatility: evidence from indian commodity markets prof. sanjay sehgal university of delhi e-mail: sanjayfin15@gmail.com dr. namita rajput university of delhi e-mail: namitarajput27@gmail.com mr rajeev kumar dua cmj university e-mail: capt.rkd@gmail.com received: june 25, 2012 accepted: august 20, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1990 url: http://dx.doi.org/10.5296/ajfa.v4i2.1990 abstract in the context of emerging indian commodity futures markets, this paper empirically examines the effect of futures trading activity (trading volume ; proxy of futures liquidity) on spot price volatility for seven agricultural commodities (guar seeds, turmeric, soya bean, black pepper, barley, maize and castor seed).we decompose the futures volume into expected and unexpected components using hodrick–prescott filter (hp filter) .to clearly understand the destabilization effect, the relationship of the unexpected liquidity of futures market is done with unexpected volatility of spot market returns which is estimated by taking the residuals of the garch model. we find that unexpected futures trading volume is granger causing spot price volatility and are significant for five out of seven agricultural commodities (guarseed, turmeric, soybean, maize and castor seed), consistent with bessembinder and seguin (1992).we find reversed effect for one commodity i.e. pepper the effect of spot volatility on futures trading and for barley no causality is revealed either from asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 200 future to spot or vice-versa. besides being of interest to the participants, this study is likely to be useful in addressing the concerns of policy makers in india on alleged destabilizing effect of futures markets on spot prices as for emerging futures markets. commodity exchanges must be strengthen and put under strict and active monitoring for early detection of anomalous trading behaviour. financial autonomy and adequate powers should be given to forward market commission to penalise any insider trading and price manipulations, this will minimize price distortions. the government support shall lead to market growth and overall economic development. keywords: indian commodity futures markets, expected and unexpected futures trading activity, trading volume, open interest, spot volatility jel codes: g10, g14, g15 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 201 1. introduction the global liberalization and integration of financial markets has shaped new investment opportunities, which in turn require the development of new instruments that are more proficient to deal with the increased risks. investors who are actively engaged in industrial and emerging markets need to hedge their risks from these internal as well as cross-border transactions. agents in liberalized market economies who are exposed to volatile stock prices and interest rate changes entail suitable hedging products to pact with them. with the advent of liberalisation and economic expansion in these emerging economies demands that corporations should discover better ways to manage financial and commodity risks. the most wanted instruments that allow market participants to manage risk in the modern securities trading are known as derivatives which are a new advent in developing countries compared to developed countries. the main reason behind the derivatives trading is that derivatives reduce the risk by providing an additional way to invest with lesser trading cost and it facilitates the investors to extend their settlement through the future contracts. it provides extra liquidity in the stock market. they represent contracts whose payoff at expiration is determined by the price of the underlying asset—a currency, an interest rate, a commodity, or a stock. derivatives are traded in organized stock exchanges or over the counter by derivatives dealers. the issue of the impact of derivatives trading on stock market volatility has received considerable attention in recent years in india, particularly after the stock market crash of 2001. derivative products like futures and options on indian stock markets have become important instruments of price discovery, portfolio diversification and risk hedging in recent times. in the last decade, many emerging and transition economies have started introducing derivative contracts. since derivatives markets have been in existence form as long, and by many accounts even longer than that for securities, it has been their growth in the past 30 years that has made them a significant segment of the financial markets.the issue pertaining to the impact of index futures on the volatility of the fundamental spot market has increasingly received the awareness of researchers and policy makers alike. this is primarily due to the destabilizing perception surrounding index futures in the context of several stock market crashes, such as us market crash of 1987, the us flash crash in 2010, and the indian stock market crash in 2008. empirical researchers have tried to find a pattern in stock return movements or factors determining these movements. they believe that speculation is inherently unstable because of the herd tendency, selling at falling prices and buying at rising prices thereby escalating the amplitude of volatility of spot prices. the effect of futures trading on cash price volatility has long been discussed. commodity futures trading in india has been an issue of hot debate amongst policy makers and academics. it has also caught strong media attention in the past few years; owing to fears of price manipulations and the general belief that possible speculative trading in futures market may have destabilised spot prices of underlying commodities. proponents of commodity futures derivative trading assert that these markets help in price discovery of underlying physical commodities and provide risk management platforms for hedgers such as farmers, industrial units, exporters, importers, etc., who have price risk exposures. commodity futures trading have played an important role in economic development because asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 202 of its eco-system linkages and role in employment generation. these trading platforms have also helped in integrating indian markets with the world markets, thus, reducing any price distortions. since india is one of the largest consumer as well as producer of many agri commodities, time is ripe for india to take a price leadership role at international level. however, some concerns have been raised, off and on, about the possible insider-trading and price rigging, especially in futures trading of agri-commodities. they believe that these insider traders might have worked as cartels to unduly influence the prices and make huge profits in the process. thus, it is important to empirically examine the price and trading behaviour of agri-commodities in order to suggest measures for strengthening these markets. we specially focus on seven commodities, i.e., guar seeds, turmeric, soya bean black pepper, barley, maize and castor seeds. the objective of the study is to examine the stabilizing/de-stabilizing effect of derivatives market on spot market for seven agricultural commodities mentioned above. as far as empirical research is concerned, evidence on stabilizing/de-stabilizing effect of derivatives market on spot market is far from conclusive. it is interesting to investigate the issues empirically in emerging markets like indian commodity futures markets. besides being of interest to the participants, it is likely to be useful in addressing the concerns of policy makers in india on alleged destabilizing effect of futures markets on spot prices. emerging futures markets typically have different characteristics. according to bakaert and harvey (1997) and antoniou and ergul (1997), emerging futures market are characterized by low liquidity, thin trading, and consequentially returns exhibit higher sample averages, low correlations with developed market returns, non-normality, better predictability, higher volatility, and offer smaller samples for empirical research. it is usually assumed that the emerging market exhibit higher price variability and poor information processing (tomek, 1980; carter, 1989). poor flow of information and higher volatility may affect the spot prices. in this paper, we empirically investigate the effect of futures trading activity on spot markets. the paper is organized as follows. section 2 presents the data and basic characteristics of spot returns and futures trading activity. in section 3,describes the models used in the study and the results are presented in section 4 and section 5 concludes and references are contained in the last section. 2. review of literature the stabilization issue involves the study of the spot price volatility behaviour. if derivative trading does improve the information transmission efficiency, the volatility clustering behaviour in spot price volatility will be narrowed. the speculative forces attracted by the lower transaction cost feature in derivatives may intense spot price volatility and increase information transmission from derivatives to spot markets. therefore it may be reported that the introduction of derivatives trading significantly affects the volatility of the underlying spot market. this has been a major source of concern for both fund managers and regulators. as a corollary, the impact of derivatives trading on the volatility of the underlying spot market is intensely debated. there are diverse viewpoints relating to stabilisation and destabilisation in spot market prices because of derivative trading. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 203 there are many studies which talk about this that futures trading may de-stabilize the spot market by making them more volatile (cox, 1979; figlewski, 1981; clifton; 1985; grammatikos and saunders, 1986; mccarthy and najand, 1993; chatrath et al., 1996).on the other hand there is a divergent view on this stating that derivatives market stabilizes the spot market (danthine, 1978; kyle's, 1985, and froot and perold, 1991).morgan (1999) concluded that the level of inventories held in the spot market will be determined by the basis and will ensure a more efficient process of private storage, which in turn, ensures a smoother pattern of prices in the spot market hence stabilise the market. the empirical findings significantly shows that comparative advantage of futures market in disseminating information, leading to a significant price discovery and risk management, that can again help to successfully develop the underlying commodity market in india. therefore instead of curbing the commodity futures market, it can always be suggested to strengthen the market structure to achieve the broader target, hence is instrumental in improving market efficiency by capturing the expected demand supply shock in the spot market through hedging in futures market. this process will help in stabilizing spot market volatility. the issue of stabilization /destabilization effect of futures trading on spot market can be grouped into two categories(1) examining the spot volatility before and after the introduction of futures (antoniou et al, 1998; lee & ohk, 1992), (b) probing the connections between futures trading activity (trading volume and open interest) and spot volatility (bessembinder & seguin, 1992; gulen and mayhew, 2000; board et al, 2001). a number of studies in equity, commodity and currency futures markets provide the empirical evidence on de-stabilizing effect of futures trading on spot market. in equity market, many studies (harris, 1989; damodaran, 1990; lockwood and linn, 1990; schwert, 1990; chang, cheng, and pinegar, 1999; kyriacou and sarno, 1999) have found a positive relationship between futures trading activity and spot price volatility in us, uk and other developed markets. on the contrary, some studies (santoni, 1987; bessembinder and seguin, 1992; brown-hruska and kuserk; 1995) found that futures trading activity negatively affects the spot volatility. bessembinder and seguin (1992) there was a division of the trading volume and open interest into two components i.e expected and unexpected component and establish that stock price volatility is positively associated to unexpected trading activity, but negatively associated to expected component of trading activity. chang et al. (2000) decomposed spot volatility estimates into expected and unexpected components and found that hedging activity in futures increases when unexpected volatility increases but speculative activity is not pretentious by the volatility. in currency market, clifton (1985), chatrath (1996), grammatikos and saunders (1986) and mccarthy and najand (1993) positive correlation was found between spot price variability and volume of futures trading. however, adrangi and chatrath (1998) and sarwar (2003) establish stabilizing effect of futures trading on currency market. in commodity futures markets, few studies have addressed this issue. pashigian (1986) and weaver and banerjee (1990) opined that futures trading activity destabilizes the spot volatility of agricultural commodities. in a review paper, kamara (1982) explicate that in the majority of the empirical studies relating to agricultural derivatives market it was found that the introduction of futures trading normally condensed or at least did not increase the spot price asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 204 volatility. in a study done by yang et al. (2005) it was examined that the dynamic relationship between futures trading activity and spot volatility for agricultural commodities found that any increase in unexpected futures trading volume unidirectional causes an increase in the spot price volatility for most of the agricultural commodities. a weak causal relationship between open interest and the spot volatility was found in the study. methodologically, most of the studies pertaining to the empirical test of stabilizing/destabilizing effect of derivatives market on spot market with a focus on the impact of introduction of futures trading compare spot price volatility before and after the introduction of futures trading. studies in this area model time varying volatility as garch process. other approach used in the literature (bessembinder and seguin, 1992) is estimation of contemporaneous relationship between trading activity (trading volume and open interest) and spot volatility. in this approach, spot price volatility is estimated as a garch process. the effect of futures trading activity on spot volatility is investigated through augmented garch model in which trading activity is used as exogenous variable. futures trading volume and open interest are then divided into expected and unexpected components and effect of expected and unexpected part of trading activity on spot volatility is examined. the dynamic relationship between spot volatility and futures trading activity is also examined through vector autoregressive specifications. most of these have been in the context of equity (index futures) and currency markets, and very few studies (pashigian, 1986; weaver and banerjee, 1990, and yang et al., 2005) have investigated this issue empirically in the context of commodity futures market. sen and paul (2010) have clearly suggested that future trading in agricultural goods and especially in food items has neither resulted in price discovery nor less of volatility in food prices. they observed a steep increase in spot prices for major food items along with a granger causal link from future to spot prices for commodities on which futures are traded. in emerging commodity derivatives markets the issue of volatility has not been researched sufficiently owing to features of markets like emaciated in terms of volume and number of derivatives products and in terms of participation also it is very limited. emerging commodity markets in general and india in particular are generally disparaged for speculative activity and destabilizing role of derivatives in spot market through increased price volatility. this is evident from the action of government of india that many a time’s agricultural commodities have been banned for their assumed destabilizing effect on spot market. the commodity derivatives markets in india is also facing increased ruling on futures trading regardless of any reliable empirical evidence in this regard. most of these have been in the context of equity (index futures) and currency markets, and very few studies (pashigian, 1986; weaver and banerjee, 1990, and yang et al., 2005) have investigated this issue empirically in the context of commodity futures market. this study seeks to address these research gaps by investigating the issues of stabilizing/destabilizing effect of futures activity on spot market in indian commodity futures market context. in this study, we analyze few agricultural commodities in detail which will help in understanding the relationships between futures trading activity and spot market volatility for agricultural commodities. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 205 3. data and methodology our data set in the study consists of seven commodities namely guar seeds, turmeric, soybean black pepper, barley, maize and castor seed which are most actively traded on national commodity exchange (ncdex).the selection of agricultural commodities have been done because of the fact that there are serious issues relating to these inflationary pressures and are also in lime light owing to policy debates especially on agricultural commodities. essential commodities like wheat and rice are not a part of the sample as structured time series data relating to these commodities was not available as they were banned because of inflationary tendencies and rest of the sample commodities are highly traded commodities on the exchange hence are a part of our sample. the period of study is from april 2004 to march 2012 however data period varies across commodities owing to their late introduction on trading exchanges and the fact that some agricultural commodities were banned from trading for a certain period to curb speculative impacts which according to policy makers could have triggered high inflation. the data comprises of daily closing spot and futures prices of the sample commodities. natural logarithm of daily prices is taken to minimize the heteroscedasticity in data. the daily spot returns are constructed from the spot price data as log (ps,t/ps,t-1), where ps,t is the spot price at time t. these commodities are applied to examine the aggregate behaviour of commodities with regards to destabilisation effects. the description of data is described in table 1: table 1. description of agricultural commodities taken in sample agri commodities data-periods future market (source) guarseed 13-04-2004 to 10/20/2012 ncdex turmeric, 13-04-2004 to 10/20/2012 ncdex soybean 1-09-2004 to 10/20/2012 ncdex black-pepper 13-04-2004 to 9/19/2012 ncdex barley 13-04-2004 to 9/19/2012 ncdex maize 1-5-2005 to 9/19/2012 ncdex castor seed 21-9-2004 to 9/19/2012 ncdex the table shows the sample commodities used in the study. the period of study is from april 2004-to march 2012 however the data period varies across commodities. the sample consists of five agricultural commodities which are traded on ncdex. given the nature of the problem and the quantum of data, we first study the data properties from an econometric perspective. the time series stationarity of sample price series has been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron (1988) test of stationarity has also been performed for the series. in this work, the issues have been addressed through both contemporaneous as well as dynamic relationship between spot asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 206 price volatility and futures trading activity. following bessembinder & seguin, (1992), we decompose the futures volume into expected and unexpected components using hodrick–prescott filter (hp filter). to clearly understand the destabilization effect, the relationship of the unexpected liquidity of futures market is done with unexpected volatility of spot market returns which is estimated by taking the residuals of the garch model.firstly we test that whether futures trading volume unexpected) affect the conditional spot price volatility contemporaneously .the contemporaneous relationship is tested by garch model. then granger causality test is done to understand the causal relationship of futures and spot i.e. lead lag i.e. to have a clear understanding whether futures trading is leading to rise in spot price volatility or vice-versa. the hodrick–prescott filter (hp filter) the paper uses hp filter to decompose the study series into expected and unexpected components. like any agricultural product, the commodities under our study face seasonal/cyclical fluctuations. the hodrick-prescott filter methodology was used to filter out the transitory components of the fundamental series. this is used to decompose the variables in the prices into trend and stationary components, which are respectively induced by real and nominal shocks. the technique suggests that the real shocks cause permanent changes in prices whereas nominal shocks only cause temporary effects on the real prices. it is thus supposed that if one can observe the values of a series yt through yt and it is possible to decompose the series into a trend (μt) and a stationary component yt μt,one can solve a minimisation problem for the deviation of yt from μt. the hp filter is a tool and provides an estimate of the unobserved variable (trend) as the solution to the following minimization problem (basdevant, 2003):  * * 2 2 * 2 2 2 1 0 1 1 1 : ( ) ( ) t t t t z t min z z z      (12) where z is the observed variable, z* is the unobserved variable being filtered, 2 0 is the variance of the cyclical component * t tz z . 2 1 shows the variance of the growth rate of the trend component. this problem is of course invariant to a homothetic transformation, therefore what matters is the ratio λ= 2 0 2 1   . hodrick and prescott suggest some parameterization of λ depending on the frequency of data. however, the cyclical component is derived by applying hp filter such as: *( ),t tc z z  t = 1, 2…………,t asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 207 unexpected variable which was made by decomposing the trading volume is ready by filtering the data using this test. garch model the garch (1, 1) model we begin with the simplest garch (1,1) specification: ttt xy   ' 2 1 2 1 2   ttt  n which the mean equation given in (a) is written as a function of exogenous variables with an error term. since 2 t is the one-period ahead forecast variance based on past information, it is called the conditional variance. the conditional variance equation specified in (b) is a function of three terms: 1) a constant term ω 2) news about volatility from the previous period, measured as the lag of the squared residual from the mean equation 2 1t (the arch term). 3) last period's forecast variance 2 1t (the garch term). the (1, 1) in garch (1, 1) refers to the presence of a first-order autoregressive garch term (the first term in parentheses) and a first-order moving average arch term (the second term in parentheses). an ordinary arch model is a special case of a garch specification in which there are no lagged forecast variances in the conditional variance equation, a garch (0, 1). there are two equivalent representations of the variance equation that may aid you in interpreting the model: 1) if we recursively substitute for the lagged variance on the right-hand side of equation (b), we can express the conditional variance as a weighted average of all of the lagged squared residuals: 2 1 12 1 jt j j t          we see that the garch (1, 1) variance specification is analogous to the sample variance, but that it down-weights more distant lagged squared errors. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 208 2) the error in the squared returns is given by 222 tttv   . substituting for the variances in the variance equation and rearranging terms we can write our model in terms of the errors: 1 2 1 2 )(   tttt vv  thus, the squared errors follow a heteroscedasitic arma (1, 1) process. the autoregressive root which governs the persistence of volatility shocks is the sum of α and β. in many applied settings, this root is very close to unity so that shocks die out rather slowly. the garch (q, p) model and the garch-m model are other versions of garch model. we take the residuals of garch model to take this as a measure of spot market volatility. garch 11 p q process is checked from (0-4) process and information is optimized for garch 11 model hence our paper model has used this model. granger causality test the unexpected component of trading volume and residuals of garch model are tested for causality i.e. whether liquidity in the futures market is destabilizing the spot market volatility or vice-versa? causality testing a series x may be said to cause y if and only if the expectation of y given that x is different from the unconditional expectation of y. )(),( ktktxt yyexyye   for a theory, x→y, find a z such we derive on a causal sequence x→z→y. if z explains the connection the x-y connection, it follows that controlling z will eliminate all further associations. thus, for 1210 ,  xxy would be zero. testing if 1 =0, then we test the causal theory of y. 4. analysis and interpretations of results the results of stationarity tests are given in table 2. it confirms non stationarity of commodity price and trading volume data; hence we repeat stationarity tests on return series (estimated as first difference of log prices and trading volume) which are also provided in table 2. the table describes the sample price series and trading volume that have been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron (1988) test of stationarity has also been performed for the price series and trading volumes and then both the test are performed on return series panel a,b respectively. the sample return series and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 209 trading volume exhibit stationarity thus conforming that spot and future commodity prices and trading volume are integrated to the first order. table 2. a-priceseries b-inference on return series integration i (i) commodities adf test phillips-perron test adf test phillips-perron test t-statistics t-statistics t-statistics t-statistics guarseed (a)(trading volume) -2.09 -2.10 -36.5 ** -36.51 ** (b)future-price -2.19 -2.17 -36.5 ** -36.51 ** (c)spot-price -1.1 -1.3 -24.9 ** -42.18 ** turmeric -2.37 -2.27 -34.22 ** -32.12 ** (a)(trading volume) (b)future-price -2.67 -2.67 -36.33 ** -36.33 ** (c)spot-price 1.85 3.09 -8.36 ** -36.84 ** soybean (a)trading volume) -0.47 -0.49 -25.62 ** -23.23 ** (a)future-price -0.57 -0.53 -26.75 ** -26.74 ** (b)spot-price -0.42 -0.42 -27.76 ** -27.71 ** black pepper (a)trading volume 0.91 0.72 -33.84 ** -32.34 ** (a)future-price 0.81 0.69 -34.95 ** -34.95 ** (b)spot-price -0.1 -0.16 -36.44 ** -36.45 ** barley (a)trading volume 0.34 0.3 -41.36 ** -41.35 ** (a)future-price 0.36 0.4 -42.47 ** -42.47 ** (b)spot-price -0.35 -0.32 -43.76 ** -43.76 ** maize (a)trading volume 0.33 0.3 -41.36 ** -41.32 ** (a)future-price 0.32 0.3 -33.95 ** -33.74 ** (b)spot-price -0.33 -0.36 -35.44 ** -37.43** castor seed (a)trading volume 0.71 0.57 -39.75 ** -37.95 ** (a)future-price 0.71 0.57 -39.75 ** -37.95 ** (b)spot-price -0.2 -0.75 -36.34 ** -39.45 ** destabilisation effect to understand the destabilization effect which is a relationship of futures liquidity and spot market volatility, the data is filtered using hedrick prescott (hp) filter and unexpected variable (unexpected liquidity) is formulated by subtracting hp trend variable which was generated when data was filtered from trading volume. unexpected volatility of spot market returns was estimated by taking the residuals of bollerslev (1986) generalize autoregressive asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 210 conditional heteroscedasticity (garch) model and then we perform the causality tests between spot volatility and unexpected trading volume, we choose the appropriate lag length using aic (akaike information criterion) lagged length of each variable in this study consistently, to have a clear understanding whether futures trading are leading to rise in spot price volatility or vice-versa. the next step is to conduct diagnostic checking on the selected model. while the volatility model later will be used in a number of different variation, the diagnostic checking will here be conducted on the core garch(1,1) model, to see if it is a reasonable fit for the return data .later in the empirical analysis goodness-of-fit estimates such as lm test and ljung-box q test will be conducted to evaluate the various models ability to fit the data. the diagnostic checking tests are conducted on the estimated standardized residuals, which should have the properties of classical regression models, i.e. they should be white noise. this implies that they should display no autocorrelation, no conditional heteroscedasticity and their distribution should be equivalent to the error distribution used in the model estimation. the model is corrected using the parameters of goodness of fit but are not reported because of space. applying this methodology on seven agricultural commodities the following results were revealed. in case of guarseed, turmeric, soybean, maize and castor seed the study confirms that futures market liquidity (based on trading volume) tends to drive spot market volatility i.e. stating destabilizing effect. this evidence is consistent with bessembinder and seguin (1992). our results indicate that the commodity spot volatility is significantly impacted by the unexpected futures trading volume for five agricultural commodities out of total 7 taken under study, excluding pepper and barley see table iii. this may be because of high transaction costs or the friction associated with the spot market and also in india spot market is slow in assimilating information coming from futures markets thereby confirming the dominant role of futures market. the finding of destabilizing effect of futures trading volume on spot volatility is in line with the large number of empirical studies who also report positive relationship between futures trading volume and spot volatility (pashigian, 1986; weaver and banerjee, 1990; chatrath, ramchander and song (1996) on currency futures and yang et al., 2005), but contradictory to the findings of darrat and rahman (1995) on s&p 500 index futures. the results may be explained by the fact that spot market is not well organized as it is not electronically traded and hence lacks transparency. thus futures trading activity may have inflationary implications on spot prices, which should worry the regulators. the results thus, underline the need for creating organized spot market for agri-commodities. in case of black pepper reversed destabilization effect is observed. spot market volatility tends to affect futures market trading activity, measured by trading volumes liquidity, indicating a strong speculative interest in the market the results may be explained by the fact that spot market is not well-organized and lacks transparency. in case of barley the study confirms that futures market liquidity (based on trading volume) does not affect spot market volatility. it implies that the spot market is well developed for this commodity. no price destabilization effect is observed and there seems to be no relationship between futures market trading activity and spot market volatility. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 211 table 3. destabilizing / stabilizing effects of futures trading on spot price volatility guarseed market f-statistic prob. spot volatility on unexpected futures liquidity 0.65549 0.7305 unexpected-liquidity on spot-volatility 6.91660** 2e-08 turmeric market spot volatility on unexpected futures liquidity 0.09101 0.7632 unexpected-liquidity on spot-volatility 8.42109** 0.0041 soybean market spot volatility on unexpected futures liquidity 1.14057 0.3316 unexpected-liquidity on spot-volatility 2.06633** 0.0271 pepper market spot volatility on unexpected futures liquidity 3.04891** 0.0041 unexpected-liquidity on spot-volatility 0.87045 0.5302 barley market spot volatility on unexpected futures liquidity 0.0708 0.7904 unexpected-liquidity on spot-volatility 1.0869 0.2981 maize market f-statistic prob. spot volatility on unexpected futures liquidity 1.24057 0.4316 unexpected-liquidity on spot-volatility 3.06633** 0.0121 castor seed market f-statistic prob. spot volatility on unexpected futures liquidity 0.08101 0.6632 unexpected-liquidity on spot-volatility 7.32109** 0.0031 ** denotes level of significance at 5% and better. 5. summary conclusion and policy suggestions commodity futures trading in india has been a subject of burning debate amongst policy makers and academia. strong media attention has also been caught in the past few years; due to uncertainties relating to price manipulations and the general belief that possible speculative trading in futures market may have destabilised spot prices of underlying commodities. proponents of commodity futures derivative trading emphasize that these markets help in risk management platforms for hedgers such as farmers, industrial units, exporters, importers, etc., who have price risk exposures and help in price discovery of underlying physical commodities .to understand the destabilization effect which is a relationship of futures liquidity and spot market volatility, the data is filtered using hedrick prescott (hp) filter and unexpected variable (unexpected liquidity) is formulated by subtracting hp trend variable which was generated when data was filtered from trading volume. unexpected volatility of spot market returns was estimated by taking the residuals of bollerslev (1986) generalize asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 212 autoregressive conditional heteroscedasticity (garch) model and then we perform the causality tests between spot volatility and unexpected trading volume, we choose the appropriate lag length using aic (akaike information criterion) lagged length of each variable in this study consistently, to have a clear understanding whether futures trading are leading to rise in spot price volatility or vice-versa. applying this methodology on seven agricultural commodities the following results were revealed.in case of guarseed, turmeric, soybean, maize and castor seed the study confirms that futures market liquidity (based on trading volume) tends to drive spot market volatility i.e. stating destabilizing effect. this evidence is consistent with bessembinder and seguin (1992).as futures and spot markets are interlinked, any information shock should affect both the markets. results of the lead lag relationship between spot price volatility and futures trading activity (unexpected) suggest that in most of the commodities the unexpected futures trading volume causes spot price volatility. the results is confirmed by granger causality test, indicating that the commodity spot volatility is significantly impacted by the unexpected futures trading volume for five agricultural commodities out of total 7 taken under study, excluding pepper and barley. this may be because of low rate of information dissemination coming from futures market, high transaction costs or the friction associated with the spot market. the finding of destabilizing effect of futures trading volume on spot volatility is in line with the large number of empirical studies who also report positive relationship between futures trading volume and spot volatility (pashigian, 1986; weaver and banerjee, 1990; chatrath, ramchander and song (1996) on currency futures and yang et al., 2005), but contradictory to the findings of darrat and rahman (1995) on s&p 500 index futures. the results may be explained by the fact that spot market is not well organized as it is not electronically traded and hence lacks transparency. thus futures trading activity may have inflationary implications on spot prices, which should worry the regulators. the results thus, underline the need for creating organized spot market for agri-commodities. in case of black pepper reversed destabilization effect is observed. spot market volatility tends to affect futures market trading activity, measured by trading volumes liquidity, indicating a strong speculative interest in the market the results may be explained by the fact that spot market is not well-organized and lacks transparency. in case of barley the study confirms that futures market liquidity (based on trading volume) does not affect spot market volatility. it implies that the spot market is well developed for this commodity. no price destabilization effect is observed and there seems to be no relationship between futures market trading activity and spot market volatility. policy suggestions the policy suggestions include those relating to un-notice abrasions in market behaviour and measures that can strengthen the commodity futures trading in india.  the commodity exchanges must strengthen their surveillance system for early detection of anomalous trading behaviour for all commodities. in case there is any anomalous behaviour it must be put under active monitoring on continuous basis.  the government should pass the forward contract regulation amendment (fcra) bill 2010 at the earliest, which shall provide administrative and financial autonomy to forwards asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 213 market commission (fmc) and give it adequate powers to regulate commodity market and penalise any insider trading and price manipulations.  the government must encourage futures trading in these markets as they play an important role in price discovery and price risk management. suspension of trading is a not a solution and may actually harm the process of market development. rather, an efficient surveillance system must be set in place, to minimize probability of price distortions.  given the nascent nature of commodities derivatives market in india, the government must support these trading platforms with by providing fiscal incentives, sound regulatory environment, infrastructure facilities and broad basing the investor list. commodity market has economy wide implications on issues relating to inflation, infrastructure development, wealth creation, employment generation, etc. hence, the government support shall lead to market growth and overall economic development.  well-organized spot markets must be developed, ensuring transparency and trading efficiency. electronically traded spot exchanges must be developed and warehousing, testing labs as well as other eco-system linkages must be established.  institutional investors’ participation must be allowed so that these markets achieve higher trading liquidity. innovative derivative instruments such as commodity options must be introduced to attract higher trading volumes and provide a better risk management alternative.  fmc must come out with a long term investor education strategy. investor education is the best way to empower investors and hence the issue needs special attention. a well-informed investor’s base shall create greater trading liquidity and help in avoiding price manipulations.  we recommend that a detailed analysis 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(2005). futures trading activity and commodity cash price volatility. journal of business finance & accounting, 32, 297-323. http://dx.doi.org/10.1111/j.0306-686x.2005.00595.x asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 76 sustainability reporting by local councils in coastal regions: an australian study nick sciulli associate for the centre for tourism and services research (ctsr) school of accounting victoria university po box 14428 mcmc melbourne, australia tel:(03) 9919-4424 e-mail:nick.sciulli@vu.edu.au abstract the phrase social and environmental accounting research appears to have been superseded by the term sustainability reporting (sr). the global reporting initiative (gri) which is an internationally recognised reporting framework has developed sustainability reporting guidelines for specific industries including for the public sector. the objective of this investigation is to ascertain the type of sustainability reporting practices in six local councils located on the australian coast line. a sustainability reporting disclosure index is developed and is calculated by comparing the disclosures provided by the global reporting initiative with the annual reports of the six coastal councils. the findings suggest that these councils provide high disclosures for the categories of water and biodiversity and low disclosures for the categories of compliance and overall which records total environmental expenditures by type. given that the reporting of sustainability practices by local councils is relatively new, it is expected that disclosures will increase over time. in addition, specialised sustainability reports are starting to be produced by local councils in addition to the statutory obligation of producing an annual report. keywords: sustainability reporting, local councils, annual reports jel classifications: m41, m40 and m49 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 77 1. introduction there is greater awareness and concern regarding an organisations activities and the effect it has on the environment. a substantial body of literature has now been developed under the commonly used term social and environmental accounting. however, it appears that a further expanding phase of research opportunities has emerged. the latest trend appears to favour the term sustainability reporting which implies an emphasis on organisations undertaking activities which continually nourish the adverse effect it may be having on the environment. it must also be recognised though, that there is currently no one universally accepted definition of sustainability and sustainability reporting (moneva et.al. 2006). sustainability practices imply that the service or product can be produced over the long term whilst being sympathetic to the requirement to maintain or improve the environment at the same time. a simplified example would be the requirement of mining companies to account for restoration costs at the completion of their extraction activities. it is becoming apparent that other industries will also be held to account for the impact their activities are having and importantly, report on what these organisations are doing to counter these adverse consequences. accounting for climate change, carbon emissions and water management are just some of the areas that have become significant contemporary issues and will provide a rich pool of research opportunities for academics. hopwood (2009) for example, sets out an array of possibilities for research in accounting and carbon markets. the work of adams (2007), gray (1995), mathews (1997) and deegan et.al (2000) have contributed significantly to this field of research and it is widely acknowledged that there are still many gaps in the literature, and hence, enormous opportunities for researchers to further engage in this important subject matter. of particular concern is the current dearth of research focusing on sustainability issues in the public sector. this has been noted by ball and grubnic (2007) with particular emphasis of the role of local governments in gaining community support for sustainable practices. thus, although much of the focus to date has concentrated on the activities of large corporations, it is also becoming clear that sustainability problems can be worked on, and great advances made, at the individual or community level. local governments appear to be best placed to connect sustainability issues with the community it serves. 2. literature review there have been several ‘calls’ for research into sustainability reporting in the public sector (lewis 2008). as stated earlier, the use of annual reports to assess social and environmental disclosures is not a new phenomenon and has been used by several researchers to identify ‘favourable’ organisations (those with extensive social and environmental disclosures) as opposed to ‘unfavourable’ ones which have limited disclosures (gray et al.,1995; campbell 2000; deegan et al. 2000; moneva and llena 2000; wilmhurst and frost 2000). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 78 there are several theories that can be used as a precursor to sr research. institutional theory espouses that organisations tend to copy each other when practices become widely accepted and distributed amongst key players (bebbington et.al. 2009). legitimacy theory posits that social and environmental disclosures occur because of public pressure. moreover, it is assumed that organisations with poor environmental credentials would provide more extensive positive environmental disclosures in an attempt to annul the offensive activity (cho and patten 2007). the theoretical model adopted for this project is a combination of legitimacy theory and given that the focus of the study is on the public sector, the notion of accountability is also relevant. that is, public sector agencies are accountable for their activities to a range of stakeholders, both internal and external to the organisation. however, it could be argued that this is identical to that of profit oriented firms, but one major difference is that the financial investment in the for profit sector is voluntary whereas in the public sector it is mandatory via the imposition of taxes. hence, it is premised here that the accountability takes on an expanded dimension in the public sector. in the case of legitimacy theory, the idea that organisations seek to be recognised as good corporate citizens by disclosing their activities that have a favourable effect on or seek to minimise damage to the environment is well established. in fact there is a strong case for suggesting that there are some particular limitations of analysing the contents of annual reports. this is because the disclosure of most environmental information is voluntary and therefore, it would be in the best interests of management to produce an annual report that would likely demonstrate skewness towards providing positive information. perhaps more importantly, the promotion of transparency and accountability of an organisation is best achieved through in-depth interviews to assessing managerial motivations (owen 2008). in addition, disclosures in annual reports is ex-post and therefore, certain activities that the community find sensitive may only reach the annual report if a widely reported incident has occurred. farneti and guthrie (2009) undertook in-depth interviews across seven different public sector agencies in australia. the agencies comprised of one federal government department, one state department, three local councils and two state public organisations. twenty-five hours of interviews were undertaken to identify such issues as the reason for sustainability reporting in annual reports, how the agencies communicated sustainability issues, difficulties associated with using the gri and who carried responsibility within the organisation for sustainability reporting. this study focussed on why organisations report on sustainability issues rather than what they report on. the findings suggest that that sustainability reports were mainly directed towards internal stakeholders, however, the annual report was a key communication device for external users. further, a key individual in the organisation gave the impetus and motivation to pursue the path of sustainability reporting. finally, in most cases these agencies had commenced with either triple bottom line (tbl) reporting or the balanced scorecard (bsc) before embarking on the gri framework. the reason being that it had an international reputation which enhanced its legitimacy. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 79 the use of the bsc, the theory of intellectual capital (ic) and the gri is also taken up by yongvanich & guthrie (2006) who incorporate the positive aspects of all three models to develop an extended performance reporting framework (eprf). they argue that: the eprf should enable companies to provide a more complete account of their extended performance. this should empower stakeholders, including shareholders, and help strengthen an organization’s commitment to ‘sustainability’ (yongvanich & guthrie 2006, p.318). whichever model or framework is adopted, it is clear that public sector agencies require guidance on how to best discharge their accountability to their stakeholders on the issue of sustainability activities. it may be the case that local government councils are already reporting on sustainability activities but as yet are not in a format to satisfy the ever growing demand from various interest groups. given the sensitive nature of residing on the coast line this project seeks to investigate the incidence of sustainability reporting across six councils that have had significant population growth that has created concern amongst the community. 3. research method six local councils situated in coastal regions were investigated. they were: 1. bass coast shire council 2. mornington peninsula shire 3. surf coast shire 4. shoalhaven city council 5. wollongong city council and 6. maroochy shire council bass coast, mornington peninsula and surf coast shire are located in victoria, shoalhaven and wollongong in nsw and maroochy in queensland. these six councils were selected because they all reside on the coastline of australia and have experienced large population growth putting pressure on the current infrastructure and the environment. the 2007/2008 annual reports of these six coastal councils were downloaded from the internet and were adopted to gauge the extent of sustainability reporting. it was interesting to note how expansive the annual reports for these councils have become. they ranged in length from ninety-four pages to over two hundred pages. the gri sustainability reporting guidelines (2006) also contain a sector supplement for public agencies which is a separate document but a component of the overall guidelines. this supplement was used as the benchmark against which the local council’s annual reports were analysed. it has been recognised that although useful as a starting point, the gri sustainability guidelines are by their nature, very general in application. hence, sector supplements have also been produced based on various industry clusters such as mining and metals, automotive, food processing , telecommunications to name a few. accordingly, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 80 by providing guidance on how to apply the gri reporting framework in the context of public agencies, the supplement makes a valuable contribution to achieving increased transparency in the public sector. since all public agencies have some core sustainability performance issues in common, the supplement has been designed for general use by public agencies operating in all tiers of government (gri 2005, p.4). although following the gri guidelines is voluntary, it is recognised internationally as the most comprehensive structured reporting framework currently available, and therefore, suitable for this project. under the environmental indicators there are ten major categories as illustrated in table 1. there are also thirty-five (35) elements for which the guidelines provides a brief description of each (en1 to en35). these thirty-five elements are further classified as being either a core (ci) or additional (ai) indicator. both ci and ai were scrutinised for in the annual reports. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 81 table 1 public sector environmental performance indicators category description core indicator (ci) additional indicator (ai) element 1 materials total materials use other than water, by type. ci ci en1,2 2 energy direct and indirect energy use. ci en3,4 ai en17,18,19 3 water water use and recycling ci en5 ai en20,21,22 4 biodiversity location and size ci en6,7 ai en23,24,25,26,27,28,29 5 emissions, effluents and waste type and amount ci en8,9,10,11,12,13 ai en30,31,32 6 suppliers environmental performance of suppliers ai en33 7 products and services environmental impacts ci en14,15 8 compliance incidence of fines ci en16 9 transport environmental impacts ai en34 10 overall environmental expenditures by type ai en35 content analysis was used to identify the incidence of disclosures falling under the ten categories listed in table 1. relatively speaking, content analysis is not a frequently used research technique in the accounting discipline. this may be because it has not been subjected to scrutiny by peer groups rather than from being a tool with insurmountable limitations. some work has been conducted in corporate and social responsibility accounting and sustainability reporting in the public sector (guthrie and mathews 1985; guthrie and farneti asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 82 2008). although this current project was different to the guthrie and farneti (2008) study in that the latter investigated a combination of environmental and social elements, whilst this study focussed on all environmental elements. therefore, a rigid protocol was used to ensure that the coding rules were applied thus providing greater assurance that the analysis can be replicated. to validate the coding rules further, a research assistant was asked to fill in a number of the coding sheets after reviewing the submissions. it was found that there were no significant problems in understanding and filling in the coding sheets and that identical sustainability issues were noted by the assistant. a matrix was developed to note down the incidence of the ten categories across the six councils. 4. results and findings the results are tabulated to develop a sustainability reporting index (sri), whereby the larger the index the greater the incidence of sustainability reporting. table 2. total sustainability reporting disclosures by category. category a= number of core and additional indicators (see table 1) b=total observations from annual reports c=total possible observations (6xa) index:d=srdi (b/c) materials 2 2 12 17% energy 5 4 30 13% water 4 5 24 21% biodiversity 9 12 54 19% emissions, effluents & waste 9 7 54 13% suppliers 1 1 6 17% products & services 2 1 12 8% compliance 1 0 6 0% transport 1 2 6 33% overall 1 0 6 0% total 35 65 210 31% the findings illustrated in table 2 reveal that for these six councils, overall sr disclosures were low. the percentage disclosures ranged from a low of 0% for overall which is an indicator of total environmental expenditures by type to a high of 33% for transport, which measures significant environmental impacts of transportation used for logistical purposes. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 83 the higher srdi are identified under the category water and biodiversity. with australia and in particular victoria experiencing the worst drought period on record, it is becoming apparent that stakeholders are demanding more information on water usage and recycling. for example, the mornington peninsula shire report stated that: the shire helped deliver a shower-head exchange program, completed a water resource management plan………………the shire secured a $300 000 grant to install rainwater tanks and water-efficient appliances at 23 sports pavilions. the project is expected to reduce water consumption at these sites by up to 60 per cent. (mornington peninsula shire annual report 2008, p. 15) biodiversity also has a high srdi. this could be explained by the fact that these six councils reside in environmentally sensitive areas with a rich mix of flora, fauna and marine life. once more, stakeholders would require appropriate reporting on this category. for example, the annual report of bass coast shire stated that: the preparation of the environment sustainability plan is a major step to ensuring that this community can retain their quality of life. this is a priority for council. the plan identifies local priority issues for the natural environment, which are: biodiversity, managing our beaches and bushland reserves, climate change impacts and adaptations…………………. (bass coast shire council annual report 2008 p. 39). a low index is not necessarily an unfavourable outcome. for example, the element en 16 compliance records the incidents of and fines for non-compliance with all applicable international declarations/conventions/treaties, and national, regional and local regulations. thus, if this item had a low srdi, then that suggests that the local council has been compliant with international and local laws. 5. conclusion the objective of this research project was to investigate the incidence of environmental performance indicators in six australian local councils that are located in coastal regions. these areas are characterised by a delicate natural environment and it is critical that adequate reporting is established so that this information can be used to at the very least, minimise environmental damage, but optimistically to sustain and improve what is already available. unsurprisingly, the overall level of disclosures was low. there are three possible explanations for this: the fact that the gri sustainability reporting guidelines and the sector supplements are voluntary and there is no legal or statutory obligation for public sector agencies to adhere to these, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 84 the reporting of various sustainability indicators is a relatively new phenomenon still in its infancy for the public sector and, in relation to the second point, council officers require increased resources and specifically, training and education in order to fulfil the requirements of the gri guidelines. the findings from this study must be treated with caution. a low srdi does not necessarily denote that these councils are not reporting sustainability activities, but may simply suggest that there have not been any significant unfavourable environmental impacts that need to be recorded. this is true for a number of indicators investigated such as en 9 use and emissions of ozone-depleting substances and en 13 significant spills of chemicals, oils and fuels. in addition, some categories such as biodiversity and emissions, effluents and waste had nine indicators each making these srdi low, compared with an element such as suppliers which has only one indicator and if disclosure is noted it would result in a higher percentage srdi because it is coming from a low base figure. one limitation of this study is that the identification of disclosures was limited to only environmental disclosures. social disclosures were not identified because the focus of this study was local councils situated in coastal regions. these regions reside in a delicate web of natural flora, fauna, wetlands and ocean so it was anticipated that there would be greater disclosures on environmental indicators. further research could include a comparative study investigating how for example, urban local councils differ in their sustainability reporting with that of either rural councils or the councils studied for this project, that is, councils that are situated on the coastline. in addition, given the expediency that governments world wide are pressuring government and the private sector for more informed sustainability reporting, a longitudinal study investigating the changes (if any) as to the type and volume of sustainability disclosures would be a welcome addition to the literature. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 85 references adams, c.a. & gonzalez, c.l. (2007). engaging with organisations in pursuit of improved sustainability accounting and performance. accounting, auditing & accountability journal, 20:3, pp. 333-355. ball, a., & grubnic, s. (2007). sustainability accounting and accountability in the public sector. in unerman, j., bebbington, j. & o’dwyer, b. (eds), sustainability accounting and accountability (routledge, london). bebbington, j., higgins, c. & frame, b. (2009). initiating sustainable development reporting: evidence from new zealand. accounting, auditing & accountability journal, 22:4, pp. 588-625. campbell, d. (2000). legitimacy theory or managerial reality construction? corporate social disclosure in marks and spencer plc corporate reports 1969-1997. accounting forum, 24:1, pp. 80-100. cho, c. h., & patten, d.m. (2007). the role of environmental disclosures as tools of legitimacy: a research note. accounting, organizations and society, 32:7-8, pp. 639-647. deegan, c., rankin, m. & vought, p. (2000). firms’ disclosure reactions to major social incidents: australian evidence. accounting forum, 24:1, pp. 101-130. global reporting initiative (gri) (2005). sector supplement for public agencies, amersterdam. global reporting initiative (gri). (2006) . g3 sustainability reporting guidelines. amersterdam. gray, r., kouhy, r. & lavers, s. (1995). corporate social and environmental reporting: a review of the literature and a longitudinal study of uk disclosure. accounting, auditing & accountability journal, 8:2, pp. 47-77. guthrie, j.e & mathews, m.r. (1985). corporate social accounting in australasia, research in corporate social performance and policy, 7, pp. 251-77. guthrie, j & farneti, f. (2008). gri sustainability reporting by australian public sector organizations. public money and management, 28:6, pp. 361-66. hopwood, a.g. (2009). accounting and the environment. accounting, organizations and society, 34:3-4, pp. 433-439. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 86 lewis, t. (2008). debate: public sector sustainability reporting – implications for accountants. public money & management, 28:6, pp. 329-331. mathews, m.r. (1997). twenty-five years of social and environmental accounting education. accounting education, 10:4, pp. 335-52. moneva, j.m & llena, f. (2000). environmental disclosures in the annual reports of large companies in spain. european accounting review, 9:1, pp. 7-29. moneva, j.m., archel, p. & correa, c. (2006). gri and the camouflaging of corporate unsustainability. accounting forum, 30:2, pp. 121-137. owen, d. (2008). chronicles of wasted time? a personal reflection on the current state of, and future prospects for, social and environmental accounting research. accounting, auditing & accountability journal, 21:2, pp. 240-267. wilmhurst, t. & frost, g. (2000). corporate environmental reporting: a test of legitimacy theory. accounting, auditing and accountability journal, 3:1, pp. 10-26. yongvanich, k & guthrie, j. (2006). an extended performance reporting framework for social and environmental accounting. business strategy and the environment, 15:5, pp. 309-321. microsoft word 312-3496-1-pb asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 21 chinese and indian stock market linkages with developed stock markets gurcharan singh pritam singh buckingham business school university of buckingham, united kingdom tel: 44-012-8082-0503 e-mail: gurcharan.singh@buckingham.ac.uk received: 2010-02-01 accepted: 2011-04-28 doi:10.5296/ajfa.v2i2.312 abstract this study examines the linkages of the two leading emerging markets i.e. chinese and indian market with developed markets. using daily data from january 2000 to december 2009, the stock market indices of china, india, united states, united kingdom, japan and hong kong are examined. the linkages are modelled using the correlation test, granger causality and the cointegration test applying error correction model. it was found that chinese and indian markets are both correlated with all four major markets. both markets have at least had a unilateral causality with all four developed markets. this suggests that the benefits of any short-term diversification, or speculative activities, are limited between them. keywords: market linkages, co-integration, china jel classifications: f3, f36, f37 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 22 1. introduction international stock markets have become further integrated in the recent years. factors such as the progressive removal of restrictions and relaxation of controls on capital movements have helped further towards this and have indirectly increased the flow of funds across countries. hence, the national stock exchanges are becoming more integrated and moving towards a single international stock exchange. the point when the correlation between the returns of the equity markets increases, the risk exposure of the portfolio (all else being constant) will start to increase and, at a, certain point international diversification will no longer look beneficial. however this allows investors to spread their portfolio across markets which in return reduce risk when diversified effectively. with the rapid growth in india and china, many investors would certainly consider investing in the two markets rather than in the advanced or developed markets. however, the question of whether both markets are integrated with other stock markets so that investing in india and china will provide the benefit of diversification is a major concern for investors. this lead to investigate whether, despite the growing importance and contribution of the two major emerging markets i.e., india and china to the world economy, their stock markets are interdependent with other stock markets? therefore the aim of this paper is to present the linkages or relationship of indian and chinese with four other major developed markets namely united states, united kingdom, japan and hong kong using various econometric techniques. numerous works studying international linkages of the equity markets have contributed an in-depth understanding of the market behaviour. however, little attention has been given to both the emerging indian and chinese equity markets since their rapid economic growth early this decade. therefore the paper is designed to fill the above gap by applying various robust techniques and the study is organized as follows: section two reviews the empirical studies of this issue. the methodology is discussed in section three, while section four provides a discussion of the data as well as the empirical results. finally, section five offers concluding remarks. 2. literature review numerous studies have been carried out to investigate stock market linkages, integration or interdependence. stock market is said to be integrated when correlation exists between markets. however the results of these studies are mixed, inconsistent and sometimes even contradict with each other (hilliard (1997), aggarwal et. al. (2003), abbas and chancharat (2008)). if evidence of stock market linkage were found, it would imply that there is a common force that brings these markets together (choudhry et. al. (2007)) hence, the benefit of diversification would be limited. apart from analyzing only the interdependencies of stock markets, many researchers have also focused on the impact of major events such as market crisis, market liberalization, etc on the stock market linkages (tan and tse (2002), lim and mcaleer (2004), aggarwal et. al. (2008)). since the early 1990s, most of the research on international stock market linkages has been concentrated on the mature and emerging asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 23 markets. studies by hilliard (1997) and asimakopoulos et. al. (2002) investigated the interrelationship between daily returns generated by major stock exchanges. evidence found that strong interdependence exists between the daily returns generated by united states and other selected major world indices. this was followed by the work of aggarwal et. al. (2003) that examined the time-varying integration of european equity markets over the 1985 to 2002 period using daily data for the main eu countries. using estimates of traditional co-integration, haldane and hall kalman filter technique, and dynamic eigenvalue analysis in their study, the result shows the evidence of integration in european countries only after the establishment of emu and the ecb during 1997-98 periods. the result also indicates that frankfurt is the dominant market for equities in europe. by controlling for the exchange rate, tan and tse (2002) use daily data in local currencies over 1988-2000 to examine the linkages among u.s., japan, and seven asian stock markets including malaysia, philippines, singapore, and thailand. by truncating the data at the end of 1996 and restarting the data in mid-1998 to create a pre-crisis and post-crisis comparison, they found that markets appear to be more integrated after the crisis than before. another interesting result is that malaysia is less affected by the u.s. and japan after the crisis, which can be attributed to the success of its capital and currency controls, but singapore and malaysia still affect each other strongly, which can be attributed to geographic proximity, economic linkages, and structural symmetry. meanwhile golaka et. al. (2003) examined the interdependence of the three major stock markets in south asia. using daily stock market indices of india (nse-nifty), singapore (sti) and taiwan (taiex) from january 1994 to november 2002, employed bivariate and multivariate co-integration test. the result shows that no co-integration was found for the entire period which leads one to conclude that there is no long run equilibrium between india, singapore and taiwan. similarly by working on a list of semi-strong efficient market, lim and mcaleer (2004) conducts a study to examine the dynamic interdependencies of five asean stock markets i.e. indonesia, malaysia, philippines, singapore and thailand with the us stock market over the period of april 1990 to july 1997 using daily total market-return indices for each stock market. the result indicates higher average returns and correlations over the post crisis period. result also indicates an increase in the integration between the asean-5 markets after the financial crisis and us market returns have significant influence on the returns of all asean-5 markets. another study carried out by click and plummer (2005), controlling for local currency examined whether the asean stock markets are integrated or segmented using co-integration technique using daily and weekly stock index quotes in local currency data from july 1998 to december 2002. the empirical result suggests that the asean-5 stock markets are co-integrated. however, only one co-integrating vector is found, leaving four common trends among the five variables. hence, the asean stock markets are integrated, but the integration is still far from complete. later royfaizal et. al. (2007) analyse the stock market interdependencies between the asean and u.s. stock markets before, during and after asian financial crisis by using weekly stock asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 24 indices expressed in local currencies from july1997 to june 1998. employing the granger-causality test based on vecm to test the long run relationship among the stock markets, the study shows that the long-run relationships between asean stock markets occur only for during and post-crisis period. in a similar study on the asian markets choudhry et. al. (2007) observed the changes in the long run relationship between eight far east countries namely thailand, malaysia, indonesia, hong kong, singapore, the philippines, south korea and taiwan around the asian financial crisis of 1997-98. they examined the change in the influence of the u.s. and japanese stock markets in the far east region before, during and after the asian financial crisis using daily stock price indices from january 1, 1998 to january 1, 2003. correlation coefficients, multivariate co-integration, causality test and regression were conducted. results showed significant long-run relationship and linkages between the far east stock markets before, during and after the crisis. it was also found larger u.s. influence in all periods and some evidence of increasing japanese influence to the eight far east countries. meanwhile abbas and chancharat (2008) investigated the existence of co-integration and causality between the stock market price indices of thailand and its major trading partners (australia, hong kong, indonesia, japan, korea, malaysia, the philippines, singapore, taiwan, the uk and the usa), using monthly data spanning the period from december 1987 to december 2005. they used both the engle-granger two-step procedure (by assuming no structural breaks) and the gregory and hansen test (allowing for one structural break). from the result, evidence of potential long run benefits from diversifying the investment portfolios internationally was found. results also notice that the stock returns of thailand and three of its neighbouring countries (malaysia, singapore and taiwan) are interrelated during these periods. although there are continuous researches done on market integration, it has mainly focused on the developed markets. until the late 1980s the asian-pacific stock markets, had grown in some importance, where a considerable amount of work was done to investigate the relationship and linkages among the markets. however, few studies concentrated on the relationship of two major emerging markets namely china and india with other major developed stock markets in the world. in the mid twentieth century, chi et. al. (2006) examined the bilateral relations between three pairs of stock markets, namely india-u.s., india-china and china-u.s. they used weekly stock index of bombay stock exchange national index for india, all shares index from shanghai stock exchange for china, and the s&p 500 index for u.s. market from january 2, 1991 to december 29, 2004. augmented dickey-fuller and phillip-perron unit root test were used to test the stationary of the series and subsequently employ the fractionally integrated vector error correction model (fivecm) to detect the co-movement of the pairs of stock markets. result shows that the three markets are fractionally co-integrated with each other. it was also found that u.s. market leads the indian market in information spill-over and leads the chinese market in return transmission. these results suggest that the two emerging markets appear to be more closely linked to each other relative to the u.s. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 25 similarly chattopadhyay and behera (2006) later examined if the reform in the indian stock market had led to the integration with the developed stock markets in the world. it was found that indian stock market is not co-integrated with the developed market as yet although some short-term impact does exist. more recently, janak raj and sarat dhal (2008) investigated the financial integration of india’s stock market with global and major regional markets. it was found that indian market’s dependence on global markets, such as u.s. and u.k., is substantially higher than on regional markets such as singapore and hong kong while japanese market has weak influence on indian market. one of the recent works by singh et. al. (2009) applied the open and closed price volatility testing the interdependence of fifteen world indices including an indian market index in terms of return and volatility spillover effect. vector autoregressive model (var) was used to estimate the conditional return spillover among these indices in which all fifteen indices are considered together. it is found that there is greater regional influence among asian markets in return and volatility than with european and us. japanese market, which is first to open, is affected by us and european markets only and affects most of the asian markets. us market is influenced by both asian and european markets. in comparison to the work done above this research applied the intra-day readings to observe the linkages between china and india with major developed markets, this study will also focus on analysing whether the two major emerging markets decouple from major developed markets namely u.s., u.k., japan and hong kong. 3. research methodology 3.1 data the data used in this study are from the major stock market indices both the indian and chinese stock market. for the indian market, bombay stock exchange (bse) sensex 30 index and national stock exchange (nse) s&p cnx nifty is used. meanwhile, for chinese market it is shanghai stock exchange composite index and shenzhen composite index. the data for the major four major markets are the dow jones industrial average (djia) for the u.s., ftse-100 for u.k., nikkei-225 stock average for japan and hang seng index for hong kong. refer to figure 1 below on the trading time of these markets. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 26 stock market trading timing 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 tokyo stock market hong kong stock exchange shenzhen stock exchange shanghai stock exchange bombay stock exchange national stock exchange of india london stock exchange new york stock exchange stock exchanges index used time zone opening time closing time tokyo stock exchange (tse) nky jst (utc+9) 09.00 15.00 hong kong stock exchange (hkex) hsi hkt (utc+8) 09:30 16.00 shenzhen stock exchange (szse) szcomp cse (utc+8) 09.30 15.00 shanghai stock exchange (sse) shcomp cse (utc+8) 09.30 15.00 bombay stock exchange (bse) sensex ist (utc+5.5) 09.00 15.30 national stock exchange of india (nse) nifty ist (utc+5.5) 09.00 15.30 london stock exchange (lse) ftse gmt (utc+0, dst) 08.00 16.30 new york stock exchange (nyse) djia et (utc-5, dst) 09.30 16.00 figure 1. stock market trading overlapping hours data consists of the daily intra-day price for each index from january 2000 to december 2009, amounts a total of 1,872 observations with data omitted during market closed. the price of market indices were obtained from bloomberg database. the cut of 31 december 2009 was used due to the preference of observing the volatile market movements even during the major swing in the developed markets due to the us investment banks meltdown. all of the indices are expressed in terms of local currencies to avoid problems associated with transformation due to fluctuations in exchange rates and also to avoid the restrictive assumption the relative purchasing power parity holds. in addition, the preference for local currencies focuses on the domestic causes of stock market interdependence. according to leong and felmingham (2001), by converting these indices to a common currency there is a possibility that the impact of local economic conditions and domestic economic policy maybe distorted. the data is then analysed using e-view 6.1 which provided the data analysis and regression output. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 27 3.2 methodology in order to analyse the linkages of indian and chinese market with other major markets, the study adopts three major methods. 3.2.1 the correlation test the first step involves a simple correlation test to measure the strength and direction of the association between the stock indices. the significance of the correlation for each index provides a preliminary indication of the strength of association between the indices of different stock markets under study. according to leong and bruce felmingham (2001), correlation coefficients are known to be biased upward if the share price indices has heteroskedastic elements, thus it does not provide a sound basis for studies of interdependence. however correlation analysis only measures the degree of linear association between two variables hence provides little insight on the dynamic linkages and causality between stock markets. therefore, the analysis of stock market integration is extended employing granger causality test. 3.2.2 granger causality test granger causality test is conducted to further analyse the significance and direction of causality between chinese and indian market with other major stock markets. according to granger (1969), this test will answer the question of whether x causes y. y is said to be granger-caused by x if x helps in the prediction of y, or equivalently if the coefficient on the lagged x are statistically significant. to show that x granger cause y, first step is to consider an autoregression for y. next, lagged values of x are added as the extra independent variables. granger causality test results are very sensitive to the number of lags used in the analysis. there are four different criteria for specifying the lag length. this study will adopt akaike information criterion (aic) suggested by akaike (1974). the equation for the pairwise granger causality tests are as follow: ttittitt xxyyy    1111110 ........ (1) where, xt and yt = daily stock market index for country x and y respectively µt = error term at time t the f test is used to test the hypotheses of the granger causality as follow: h0: β1 = β2 = 0 (x does not granger cause y) h1: at least one of the β1 ≠ 0 the null hypothesis is rejected if the computed f-value exceeds the critical f value at the chosen level of significance (0.05). this implies that x does granger cause y. the test is performed in pair-form between china and u.s, u.k, japan and hong kong. similarly, the same method is repeated between india and u.s, u.k, japan and hong kong. the causality asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 28 between indian and chinese market is also examined. 3.2.3 unit root test prior to the co-integration analysis, the univariate properties of the data series are examined whether the series are non-stationary or contain a unit root. a series is said to be stationary if the mean and variance of the series do not systematically differ over the time period. regression in which the variables are non-stationary can lead to spurious result where variables may share the same time trend even though they are not really related. unit root test involves examining whether the series are stationary or not at level and subsequently finding the order in which they are integrated if the series is non-stationary. this study employs augmented dickey-fuller (adf) test to determine the unit root property of the stock market indices which requires regressing ∆yi on a constant, a time trend ∆yt-1 and several lags of dependent terms as follows: ttitt yyy     1110 (2) where, ∆ = first difference operator iand  10 , = coefficients to be estimated ty = non-stationary time series t = error term at time t the test statistics known as the tau statistics are checked against the critical values tabulated by dickey and fuller on the basis of monte carlo simulationsi. the null hypothesis of series contain a unit root is rejected if t-statistics is smaller (more negative) than the critical value respectively. the durbin-watson test values are also observed. dw test statistics value of 2 or very close to 2 will indicate that the test result is reliable i.e. indication of no autocorrelation problem. next the presence of co-movement between the stock market indices is tested using co-integration test. 3.2.4 co-integration test co-integration test is among the most widely used method in examining the relationship or integration in financial market. the concept of co-integration was introduced by granger (1981) and further developed by engle and granger (1987) which incorporates the presence of non-stationary, long-term relationship and short-run dynamics in the modelling process. a series is said to be integrated of order one i.e., i (1) if it becomes stationary after the first differencing. if there exists a linear combination of two or more i (1) series that its stationary, then the series are co integrated. co-integration requires that the variables to be integrated of the same order. thus, this study employs augmented dickey fuller (adf) tests to determine the order of integration for every stock return. when both the variables are asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 29 integrated of same order, then the estimate the co-integrating regression is carried out using ordinary least square. ttt xy   10 (3) where y and x are non-stationary series. the residuals, denotes as µt are then tested to ensure that they are i (0) by running the augmented dickey-fuller (adf) test. the time series is said to be co-integrated if the residual is itself stationary, i (0). the residual will still be non-stationary if the time series are not co-integrated. in result the non-stationary i (1) series have cancelled each other out to produce a stationary i (0) residual. next the test statistics against the critical values are checked. if t-statistics is smaller (more negative) than the critical value, null hypothesis of residuals contain unit root is rejected and conclude that the residuals or the error term is stationary. this would imply that the two stock indices are co-integrated. 3.2.5 error correction model (ecm) when the two stock indices are co-integrated, this also implies that there is a long-term equilibrium relationship between them. to test if there may be disequilibrium in the short run, the residual of the co-integrating regression is used to tie its short-run behaviour to its long-run value. according to the granger representation theorem, if two variables are co-integrated, then the relationship between the two can be expressed as an error correction model (ecm). in this model, the error term from the ols regression, lagged once acts as the error correction term. the ecm allows the introduction of past disequilibrium as explanatory variables in the dynamic behaviour of current variable thus enables to capture both the short-run dynamic and long-run relationships between the stock indices. the basic ecm is as follows: tttt xay    121101 (4) where µt-1, is the lagged value of error correction term derived from the co-integration regression and εt is the residual or error term with the usual properties. the model relates to the changes in the dependent variable i.e., stock index y to the change in independent variables i.e., stock index x and the “equilibrating” error in the previous period. in the above regression, xt-1 captures the short-run disturbance in stock index x. the f-tests of the differenced independent stock index xt-1, give a sign of the short-term causal effects. meanwhile, µt-1 captures the adjustment toward the long-run equilibrium. the long-run relationship is indicated through the significance of the t-test of the lagged error correction term µt-1. however, the coefficient of the error correction term α2 is a short-term adjustment coefficient. it will explain the speed of adjustment back to equilibrium if it is statistically significant. in other words, it represents the proportion by which the long-run disequilibrium in stock index y is being corrected in each short period. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 30 4. research results 4.1 descriptive statistics the descriptive statistics for all the eight stock indices under study are given in table 1. these include the distribution of mean, standard deviation, skewness and kurtosis. for the purpose of comparison, the daily closing price index for each stock market is transformed to its return form. table 1. descriptive statistics shcomp szcomp sensex nifty djia ftse nky hsi mean 0.027 0.031 0.057 0.059 0.006 -0.002 -0.033 0.003 median 0.050 0.101 0.139 0.148 0.037 0.023 -0.013 0.037 maximum 9.857 9.684 8.254 8.295 6.348 6.082 14.150 10.721 minimum -8.841 -8.543 -11.139 -12.238 -7.129 -5.481 -11.406 -8.867 std. dev. 1.716 1.819 1.615 1.604 1.095 1.160 1.539 1.540 skewness 0.163 -0.120 -0.414 -0.492 0.014 -0.072 -0.294 -0.047 kurtosis 7.547 6.828 6.337 7.130 6.317 5.702 10.380 8.518 jarque-bera 1879.226 1329.949 1069.148 1629.552 995.011 661.829 4955.139 2753.485 in term of absolute value, the mean of the two indian markets are greater than other indices. meanwhile, in the same observation period, the chinese markets index has been the most volatile while the djia index is the least volatile. table 1 also shows that the indices’ skewness values are negative, and that all the indices have kurtosis values larger than 3, which indicate fat-tails. therefore, the jarque-bera (jb) values of the indices imply that none of the indices is normally distributed which is consistent with prior literature. figure 2. movement of the indices in the observed period figure 2 above presents the movement of all the eight indices in the observed period from asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 31 january 2000 to december 2009. as can be seen in figure 2, hang seng and nikkei record the market capitalizations that are much higher than those of the other observed indices. interesting observation from figure 2 is that sensex’s market capitalization started to increase in the year 2005. all stock indices started to decline or having negative growth in the february 2008 onwards. this is contributed by the credit crisis that took on a full head stem from august 2007 where most world stock markets are falling in tandem with each other. 4.2 analysis of correlations the correlations between the stock indices for the period of january 2000 to december 2009 are computed to measure the strength of the association between the stock indices. table 2 presents the simple correlation coefficients among the 8 stock indices under study. table 2. correlation of stock price indices shcomp szcomp sensex nifty djia ftse nky hsi shcomp 1.000 szcomp 0.985 1.000 sensex 0.749 0.686 1.000 nifty 0.750 0.688 0.999 1.000 djia 0.731 0.683 0.817 0.813 1.000 ftse 0.530 0.529 0.532 0.522 0.814 1.000 nky 0.417 0.397 0.514 0.500 0.762 0.912 1.000 hsi 0.828 0.791 0.918 0.918 0.895 0.733 0.671 1.000 while the numerical values of correlation coefficients may range from 1.0 to -1.0, the majority of the correlation in table 2 exceeds 0.3 and often exceeds 0.5. from the result, we can see that both shanghai and shenzen are highly correlated with hang seng with correlation coefficient of 0.82 and 0.79 respectively. this may be due to the close proximity between the markets resulting in increase money flows as investors can easily switch investments between the two markets. thus stock price indices between china and hong kong tend to correlate. correlation between shanghai and shenzen stock indices with both sensex and nifty are also higher than correlation between them and djia. this suggests that both shanghai and shenzen are more correlated with india as compared to u.s. in the period under study. the increasing economic interdependence between the china and india has contributed to the high correlation or co-movement between the two markets. china has relatively lower correlation with u.k. and japan as the correlation between shanghai and shenzen indices with ftse and nikkei are lower. the result also indicates that the correlations between sensex and nifty with hang seng index are relatively high. this implies that india is highly correlated with hong kong. the correlation between sensex and nifty with djia are also quite high suggesting that there is a positive correlation between india and u.s. nevertheless, there is no negative correlation found between the eight markets asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 32 under study for the period. overall, the results from the correlation coefficients suggest some insight on the short-term relations between china and india with other major markets. 4.3 analysis of granger causality test the granger causality test is conducted to investigate direction of causality between chinese and indian market with other major stock markets. the f-statistics from the granger causality test results is presented in table 3. panel a in the table below show the result of granger causality test between chinese market and other major markets. the test results suggest that there is a bi-directional causality between both shanghai and hang seng. a unidirectional causality exists between shanghai and djia where djia granger causes shanghai. similarly, ftse also granger causes shanghai and hence they have a unidirectional causality. the results also show that shanghai granger causes nikkei which implies that they also have unidirectional causality. similar result with shanghai, shenzen also has bidirectional causality with hang seng and a unidirectional causality with ftse and nikkei. however, an interesting result to note is shenzen has bidirectional causality with djia which is not the case for shanghai. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 33 table 3. results of the granger causality test panel a panel b panel c causality f-statistics p value causality f statistics p-value causality f statistics p value shcomp → djia .3915 0.2045 sensex → djia .3915 0.2045 shcomp → sensex 2.6823* 0.0092 djia → shcomp 13.7304* 0.0000 djia → sensex 13.7304* 0.0000 sensex → shcomp 4.8723* 0.0000 shcomp → ftse 2.2727 0.0264 sensex → ftse 2.2727 0.0264 shcomp → nifty 2.5449* 0.0131 ftse → shcomp 7.7012* 0.0000 ftse → sensex 7.7012* 0.0000 nifty→ shcomp 4.1352* 0.0002 shcomp → nky 4.2241* 0.0001 sensex → nky 4.2241* 0.0001 szcomp → sensex nky → shcomp 0.6580 0.7079 nky → sensex 0.6580 0.7079 sensex → szcomp 3.2893* 0.0018 shcomp → hsi 2.2102* 0.0309 sensex → hsi 2.2102* 0.0309 szcomp → nifty 3.3279* 0.0016 hsi → shcomp 3.4602* 0.0011 hsi → sensex 3.4602* 0.0011 nifty→ szcomp 3.5449* 0.0009 szcomp → djia 2.7042* 0.0086 nifty → djia 1.7164 0.1008 2.7291* 0.0081 djia → szcomp 2.9075* 0.0050 djia → nifty 13.4686* 0.0000 szcomp → ftse 1.2501 0.2717 nifty → ftse 2.3895* 0.0196 ftse → szcomp 3.6839* 0.0006 ftse → nifty 7.5921* 0.0000 szcomp → nky 2.1465* 0.0362 nifty → nky 3.4333* 0.0012 nky → szcomp 1.0607 0.3865 nky → nifty 0.6698 0.6979 szcomp → hsi 7.3174* 0.0000 nifty → hsi 1.9739 0.0551 hsi → szcomp 2.6358* 0.0104 hsi → nifty 4.0323* 0.0002 * indicates significance at the 5% level panel b show the result of granger causality test between indian market and other major markets. the results show that sensex has bidirectional causality with hangseng. this result supports the high correlation found between them in the analysis of correlation earlier. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 34 meanwhile, there is also evidence unidirectional causality from djia to sensex and ftse to sensex. in other words, sensex is granger caused by the djia and also ftse. results also suggest that sensex does granger causes nikkei. a different causality is found in another indian stock index i.e. nifty. the results show that nifty has bidirectional causality with ftse. there is also unidirectional causality from djia to nifty and hang seng to nifty. similar with sensex, nifty also does granger causes nikkei. the direction of causality between the two major emerging markets i.e. china and india are also examined here. the results of granger causality test between the two markets is presented in panel c. it is found that there is bidirectional causality between china and india. this can be seen in the increased amount of bilateral trade between the two countries over the years. to sum up, overall results of granger causality test suggest that the chinese market has bidirectional causality with the hong kong market. this support the evidence of high correlation between the two markets in the analysis of simple correlation conducted earlier. another interesting result is the evidence of bidirectional causality between china and india. 4.4 analysis of unit root test augmented dickey-fuller (adf) test is used to test the stationarity of the stock price indices. the result of adf unit root test in table 4 shows that the null hypothesis of a unit root cannot be rejected, which indicates that all stock indices are non-stationary series. however, since the t-statistics is smaller (more negative) than the critical value in the first difference form, there is no evidence to support that the presence of unit in the series. hence, all the stock price indices are stationary, and integrated of order one, i (1) which is consistent with results in the finance literature. table 4. augmented dickey-fuller test results stock index level (with intercept and trend) first difference (constant) shcomp -0.9696 -45.2038 szcomp -1.1197 -42.5494 sensex -1.6728 -42.7364 nifty -1.7862 -43.8788 djia -2.0061 -45.6734 ftse -2.0221 -33.9525 nky -1.8336 -42.6997 hangseng -1.9343 -45.3721 1% critical value -3.9630 -2.5662 5% critical value -3.4122 -1.9410 10% critical value -3.1280 -1.6166 4.5 analysis of eagle granger test once identifying that all stock indices are integrated of same order, then the co-integrating regression using ols are estimated. the residuals, denotes as µt are tested to ensure that they are stationary by running augmented dickey-fuller (adf) test. the result of the adf test on asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 35 the residuals of the regression is presented in table 5 below. schwarz info criterion is used to determine the appropriate number of lags. the dw test statistics from each regression equations are examined to ensure that there is no autocorrelation problem. since the test statistics are smaller (more negative) than the critical value, null hypothesis of residuals contain unit root is rejected and conclude that the residuals or the error term is stationary. this would imply that the two stock indices are co-integrated. hence the results indicate that shanghai and shenzen composite index are co-integrated with djia, ftse, nikkei, hang seng, sensex and nifty. in other words, china is co-integrated with u.s., u.k., japan, hong kong and india stock market. similarly, the results also indicate that sensex and nifty composite index are co-integrated with djia, ftse, nikkei, hangseng, shanghai and shenzen composite index. in other words, india is also co-integrated with u.s., u.k., japan, hong kong and china stock market. the findings where stock market indices are co-integrated means that there is a linear combination between the indices that forces these indices to have a long-term equilibrium relationship even though the indices may wander away from each other in the short run. table 5. unit root test applied to the residuals of cointegrating regressions indices test statistics for residuals indices test statistics for residuals indices test statistics for residuals indices test statistics for residuals shcomp / djia -45.3205 szcomp / djia -42.5724 sensex / djia -44.3596 nifty / djia -45.4221 shcomp / ftse -45.6862 szcomp / ftse -42.6642 sensex / ftse -45.1657 nifty / ftse -46.2349 shcomp / nky -44.6919 szcomp / nky -41.7810 sensex / nky -45.0863 nifty / nky -45.9832 shcomp / hangseng -44.3255 szcomp / hangseng -40.8034 sensex / hangseng -43.4152 nifty / hangseng -43.8789 shcomp / sensex -45.9762 szcomp / sensex -42.4048 sensex / shcomp -43.4695 nifty / shcomp -44.3998 shcomp / nifty -45.7357 szcomp / nifty -42.0861 sensex / szcomp -42.5959 nifty / szcomp -43.4066 1% critical value -2.5662 5% critical value -1.9410 10% critical value -1.6166 4.6 analysis of error correction model as stated in granger representation theorem, the relationship between two co-integrated variables can be expressed as error correction model (ecm) which is useful to capture both the short-run dynamic and long-run relationships between the stock indices. table 6 below summarise the f-statistics, coefficient of the lagged value of error correction term (ect) and the t-ratio between pairs of stock market indices of china and india with four major markets. this bivariate co-integration, if it exist will reveal the existence of a long-run equilibrium. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 36 the significance of the f-statistics on the lagged value of ect, suggests that short-run causality exists between the two co-integrating indices. on the other hand, the long-run relationship is captured through the significance of the t test of the lagged error correction term. table 6. bivariate ecm for co-integrated indices panel a panel b stock indices α2 t-stat for µt-1 f stock indices α2 t-stat for µt-1 f shcomp / djia -0.047 -2.043* 3.068* sensex / djia -0.026 -1.108 48.293* shcomp / ftse -0.054 -2.334* 12.353* sensex / ftse -0.044 -1.895* 125.877* shcomp / nky -0.036 -1.535 51.614* sensex / nky -0.045 -1.935** 217.661* shcomp/ hangseng -1.024 -1.031 189.966* sensex/ hangseng -0.004 -0.154 611.053* shcomp / sensex -0.062 -2.667* 93.646* sensex/ shcomp -0.006 -0.245 89.781* shcomp / nifty -0.057 -2.440* 105.705* sensex / szcomp 0.015 0.636 59.551* szcomp / djia 0.015 0.664 0.431 nifty / djia -0.049 -2.132* 44.562* szcomp / ftse 0.013 0.571 4.593* nifty / ftse -0.067 -2.909* 118.953* shcomp / nky 0.032 1.374 36.134* nifty / nky -0.065 -2.787* 212.886* shcomp/ hangseng 0.060 2.573* 125.535* nifty / hangseng -0.014 -0.611 628.000* shcomp / sensex 0.019 0.835 59.706* nifty / shcomp -0.027 -1.163 103.151* shcomp / nifty 0.027 1.163 68.056* nifty / szcomp -0.004 -0.181 67.349* * indicates significance at the 5% level ** indicates significance at the 10% level panel a presents the result tested between shanghai and shenzen index with other indices. the significance of the f stat on lagged value of independent stock index xt-1, suggests that short-run causality exist between shanghai and all indices at the 5 per cent level. there is also evidence of short-run causality between shenzen and other indices except djia, which means that there is no causal link from djia to shenzen. however, the significant of t stat on the lagged error correction term µt-1 suggests that there is long-run relationship between shanghai and djia, ftse and both indian stock indices i.e. sensex and nifty at 5 per cent level. however for shenzen, long-run relationship is only found with hang seng. the results of f stat and t ratio for indian market are summarized in panel b. the results saw both sensex and nifty have short-run causality with all the four major markets. however, sensex is found to have a long run relationship only with ftse as evidence by the significance of t stat on lagged error correction term at 5 per cent. result also suggests that sensex has a long run relationship with nikkei at 10 per cent level. therefore, nifty is found to have a long run relationship with djia, ftse and nky. although the ect is only statistically significant in few equations, we cannot assume that all asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 37 other markets are non-causal to both sensex and nifty since the short run channel still active indicated by the significance f stat in all equations of sensex and nifty with other markets. 5. conclusion this study has investigated the linkage of both indian and chinese market with other major developed markets namely united states (u.s.), united kingdom (u.k.), japan and hong kong. extending related empirical studies, the correlation test is used as preliminary phase of examining the linkages between the markets. next the co-integration test is applied to comprehensively investigate the direction of relationship. based on the analysis of correlation, it was found that both china and india are highly correlated with u.s. this is not surprising as u.s is the world’s foremost stock market and has large influence on other stock markets. beside that u.s. is also one of the main trading partners for both china and india. it was also found that china is highly correlated with hong kong. this may be due to the close proximity between the markets resulting in increase money flows as investors can easily switch investments between the two markets. thus stock price indices between china and hong kong tend to correlate. india is also found to have high correlation with hong kong. both chinese and indian markets are found to be highly correlated. the increasing economic interdependence between the china and india has contributed to the high correlation or co-movement between the two markets. overall, the results from the correlation coefficients suggest some insight on the short-term co-movement between china and india with other major markets which suggests that the benefits of any short-term diversification, or speculative activities, are limited between them. several interesting observations emerge from the granger causality analysis. first, the findings show that there is bi-directional causality between china and hong kong. again, this result supports the high correlation found between the two markets. china is also found to have bidirectional causality with u.k. china is also found to have unidirectional causality with japan where china granger causes japan but not vice versa. interestingly, different results are found between shanghai and shenzen with u.s market. it was also found that u.s does granger causes shanghai but not vice versa. however, shenzen found to have bi-directional causality with u.s market. secondly, u.s market is found to granger causes the indian market but not vice versa. whereas, indian market is found to granger cause the japanese market but not vice versa. there is also short run causality between india-u.k and india-hong kong market. this result contradicts with chattopadhyay and behera (2006) where they found that us, uk and hk stock markets granger cause the india stock market but do not vice versa. thirdly, bidirectional causality is found between the chinese and indian markets. this is also further supported by the high correlation found between the two markets earlier. however, this finding slightly differs from chen et. al. (2006) which found that the chinese market asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 38 granger causes the indian market but not vice versa. in terms of co-integration it is seen that there is evidence of co-integration relationship across the markets under study. china is found to be co-integrated with u.s., u.k., japan, hong kong and india stock market. similarly, india is also co-integrated with u.s., u.k., japan, hong kong and china stock market. meanwhile the chinese market is also co-integrated with indian market. subsequently the error correction model (ecm) analysis showed that there is short-run causality between the chinese markets with all the other indices. however, long run relationship is only found between china and u.s, u.k, hong kong and indian market. similarly, the analysis of ecm suggests that the indian market does have short run causality with all the four major developed markets. however, long-run causality is only found between the indian market with u.s., u.k. and japanese market. in conclusion, both chinese and indian market is correlated with all four developed markets under study namely u.s., u.k., japan and hong kong. this result is further confirmed with the analysis of granger causality where the both chinese and indian markets have at least had unilateral causality with all four developed markets. plus there are linkages between the chinese and indian market. the relationship can be seen in the increasing bilateral trades between both countries as india is also one of the largest trading partners of china in south asia. in terms of diversification opportunities this does not mean that the chinese and indian markets are no longer beneficial to investors, as they could switch investments into other different emerging markets that have sufficiently low correlation to developed markets. references abbas v., and surachai c., (2008). dynamic linkages between thai and international stock markets”, journal of economics studies, 35, pp. 425-441. aggarwal r., lucey b. m., muckley c., (2003). dynamics of equity market integration in europe. journal of economic literature, 3, no. 4 asimakopoulos, i., goddard, j. and siriopoulos, c. (2002). interdependence between the us and major european equity markets: evidence from spectral analysis, applied financial economics, 10, 41–7. chattopadhyay and behera. (2006). financial integration for indian stock market working paper, 12th annual conference on money and finance in the indian economy chi, j.; k. li; and m. young. (2006). financial integration in east asian equity markets. pacific economic review 11, 4: 513-526. choudhry t, lu l and peng ke (2007). common stochastic trends among far east stock prices: effects of the asian financial crisis, international review of financial analysis, 16, 242-261. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e2 www.macrothink.org/ajfa 39 click r. w., and plummer m. g., (2005). stock market integration in asean after the asian financial crisis, journal of asian economics, 16, 5-28. golaka, c. nath, (2003). integration of global equity markets – a case for india, nse news, november, pp.11–16. granger, c.w.j. (1969). investigating causal relations by econometric methods and cross-spectral methods, econometrica, 34, 424-438. hilliard, j.e. (1979). relationship between equity indices on world exchanges, journal of finance, 34, pp. 103-104. janak, r., and sarat d. (2008). integration of india’s stock market with global and major regional markets, bis papers, no. 42 leong. s. c. and felmingham. b. (2001). the interdependence of share markets in the developed economies of east asia. pacific-basin finance journal. 11: 219–237. lim, l.k., and mcaleer, m. (2004). convergence and catching up in asean: a comparative analysis, applied economics, 36, 2, pp.137-53. royfaizal, r. c., lee, c and mohamed, azali. (2007). asean-5+3 and us stock markets interdependence before, during and after asian financial crisis, mpra paper 10263, university library of munich, germany tan, k. b., and y.k. tse. (2002). the integration of the east and south-east asian equity markets, international center for the study of east asian development working paper no. 2002-11. copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). i d. a. dickey and w. a. fuller, “distribution of the estimators for autoregressive time series with a unit root,” journal of the american statistical association, vol. 74, 1979, pp. 427-431. asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 68 equity valuation using price multiples: a comparative study for bricks sanjay sehgal (corresponding author) department of financial studies, university of delhi, south campus esc-pau, france email: sanjayfin15@gmail.com asheesh pandey iilm institute for higher education, gurgaon email: asheeshpandey@rediffmail.com received: november 30, 2009 accepted: december 16, 2010 abstract in this paper, we evaluate the efficacy of three value drivers namely, earnings per share, book value and sales for developing stock price forecasts using two performance evaluation criteria: 1) root mean squared error and 2) thail inequality coefficient. we employ data for bricks economies excluding russia from 1993-2007. we conduct our analysis in three phases. in phase one we find that price to book value is the best standalone price multiple for the asian economies (india, china and south korea) while price to earnings does a better job for equity valuation in case of brazil and south africa. in the next phase we show that combination of value drivers do not significantly improve price forecast vis-à-vis standalone multiples. our findings are in contrast with those for developed markets as shown by penman (1996). we also find that in indian context market regression is a better tool for price forecasting compared to sector regression as larger number of observations result in better estimator for our forecast equation. our findings are extremely relevant for equity analysts and portfolio managers who are continuously involved in equity evaluation and developing global asset allocation strategies. keywords: price earnings ratio, price to book value ratio, relative valuation, price multiples, discounted cash flows jel classifications: c51, c52, g11, g15 mailto:sanjayfin15@gmail.com mailto:asheeshpandey@rediffmail.com asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 69 1. introduction capital market activity plays an important role in financial system for most of the world economies. the global capital markets have grown manifold both in terms of size as well as operations over the past three decades. the academicians as well as researchers tend to classify these global markets into mature and emerging blocks. the matured markets provide historically low to medium returns and low risk exposures owing to low growth but stable economies with evolved market microstructure and greater institutional trading resulting in mature investor behavior. emerging markets, on the other hand, are expected to provide high return and risk exposures owing to fast growing but volatile economies involving less evolved market microstructure and greater individual trading leading to less mature investor behavior. bricks are large fast growing emerging economies and have caught attention of global portfolios and fund managers who seek to diversify their international portfolios by holding them across different market blocks to take advantage of low correlations. bric (which is a subset of bricks) comprises of brazil, russia, indian and china. these economies account for a combined gdp of approximately 15.435 trillion dollars and are estimated to become the most dominant economies by 2050 (see goldman sachs, report on dreaming with brics: the path to 2050, (2003)). more recently, the investment banking industry has expanded the emerging markets 1 basket from bric to bricks which now additionally includes south korea and south africa. bricks countries have high potential growth; they cover 30 % of land area of world, 47% of world population, and have a combined gdp of approximately 17.403 trillion dollars, thus attracting investors from all over the world. goldman sachs, have estimated that by 2050 the combined economies of brics can become larger than g7 (us, japan, uk, germany, france, canada and italy) in us dollar terms. bricks countries equity markets have seen a remarkable increase since 2001 in their value: brazil has risen by 369%, russia by 630%, india by 499%, china by 201%, south korea by 460%, and south africa by 70% using the a-share market. these countries have economic asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 70 opportunities, as their aggregate contribution to the world output has been 30% since the year 2000. their economic growth has greatly influenced and in many cases propelled financial markets. however, there has been a worldwide correction in the past one and a half year in the world capital markets (including emerging markets) owing to current global financial crisis. given the potential of these emerging economies it is extremely important to study the valuation dynamics in their capital markets. all assets whether financial or real can be valued, but the complexities and the details of valuation will vary from case to case. the role of valuation is different in different situations. like in portfolio management the role of valuation is determined by the investment philosophy of the investor. valuation plays a limited role in portfolio management for a passive investor, whereas it plays a very important role for an active investor. there are different techniques through which analysts value equities. some analysts use discounted cash flow (dcf) models to value shares, while others use price multiples such as the price earnings and price-book value ratios. technical analysts believe that prices are driven as much by investor psychology as by any underlying financial variables. then there are information traders, who attempt to trade in advance of new information or shortly after it is revealed to financial markets, buying on good news and selling on bad news. efficient marketers believe that the market price at any point in time represents the best estimate of the true value of the firm, and that any effort to exploit perceived market in-efficiencies will cost more than it will make in extra-normal profits. while we tend to focus more on discounted cash flow valuation, while discussing valuation, the reality is that most valuations are relative in nature. the value of most assets, from the house one buys to the stocks that one invests in, are based upon how similar assets are priced in the market place. relative valuation, estimates the value of an asset by looking at the pricing of ‘comparable’ assets relative to a common variable such as earnings, cash flows, book value or sales. there are two components to relative valuation. the first is that to value assets on a relative basis, prices have to be standardized, usually by converting prices into asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 71 multiples of corporate fundamentals. the second is to find similar firms, which is difficult to do since no two firms are identical and firms in the same business can still differ on risk, growth potential and cash flows. it is the most popular technique of valuing an asset because firstly a valuation based upon a multiple for comparable firms can be quickly estimated with far fewer assumptions and in a speedy manner compared to dcf analysis. secondly a relative valuation is simpler to understand and easier to present to clients and customers. finally in situations where market valuations are absent, either because the share capital is privately held, or because the proposed publicly traded entity has not yet been created like in case of spinoffs, relative valuation is the only solution to find value in such cases. valuations under this approach can be standardized relative to earnings firms generate, to the book value or replacement value of the firms themselves, to the revenues that firms generate or to measure a firm’s cash flows. some of the important multiples in relative valuations are earnings multiples which can be estimated using current earnings per share, yielding a current price to earning (p/e), earnings over the last four quarters, resulting in a trailing p/e, or expected earnings per share in the next year providing a forward p/e. book value (p/bv) or replacement value multiple which is the accounting estimate of book value is determined by accounting rules and is heavily influenced by the original price paid for any assets and any accounting adjustments (such as depreciation, inventory valuation etc.) made since. for those who believe that book value is not a good measure of the true value of assets, an alternative is to use the replacement cost of the assets, the ratio of value of firm to replacement cost is called tobin’s q. another important price multiple used in the industry is based on firm revenues which is a ratio of the value of an asset to the revenue it generates. for equity investors this ratio is price to sales ratio (p/s), where the market value per share is divided by the revenues generated per share. some equity researchers emphasize on price to cash flow (p/cf) ratios instead of traditional p/e ratios as the later is impacted by the accounting treatment for certain items, as mentioned for earnings above, in the firm’s financial statements. analysts rely heavily on relative valuations for forecasting purposes because of their importance as mentioned above. in the investment community, be it equity research firms, asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 72 venture capitalists, trading firms, investment banks, and hedge funds etc., relative valuation is the most acceptable technique for valuing stocks apart from dcf valuation. a lot of empirical work has been conducted for matured markets 2 relating to the robustness of value drivers in deriving equity prices. similar work for emerging markets including india, is however limited. the study is organized into 7 sections. section 2 is devoted to review the related literature. section 3 describes data and their sources. equity valuation using historical price multiples is discussed in section 4. in section 5 we analyze equity valuation using combination of historical price multiples and compare it with our findings for standalone multiples. section 6 provides a comparison of sector regressions versus market regressions in forecasting prices for the indian environment. summary and concluding remarks are contained in the last section. 2. review of literature there is a lot of literature in textbooks (e.g. copeland, koller and murrin (1994), damodaran (1996), and palepu, healey, and bernard (2000) discussing price multiples. interestingly there are a few research papers published on the subject. among all the value drivers most of the research work has been done on historical earnings and cash flows. boatsman and baskin (1981) study the valuation accuracy of p/e multiples based on two sets of comparable firms from the same industry. they observe valuation errors were minimized when comparable firms are chosen based on similar historical earnings growth relative to when they are chosen randomly. alford (1992) examine the effect of choosing comparables based on industry, size (risk), and earnings growth on the meticulousness of valuation using p/e multiples. he finds that pricing errors decline when the industry definition used to select comparable firms is narrowed from a broad single digit sic code to classifications based on two and three digits. he also observes that controlling for size and earnings growth over and above industrial controls, does not reduce valuation errors. kaplan and ruback (1995) analyze the valuation properties of dcf approach for highly leveraged transactions. they find that though dcf valuations approximate transacted values reasonably well but simple ebitda asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 73 (earnings before interest, tax, depreciation and amortization) multiples also result in similar valuation accuracy. penman (1996) interprets the p/e ratio & market to book ratio and describe how they articulate. the study also describes the role of book rate of return on equity (the ratio of their denominators) in the determination of ratios and the relation between them. the study proves that the description of p/e ratio reconciles the standard growth interpretation of the p/e with the transitory earnings (molodovsky effect, 1953) interpretation. both are correct only in special cases. penmen (1997) investigate approximate benchmark valuations that combine earnings & book value together. he estimate weights such that a benchmark price = w1*book value + w2* earnings is calculated and he also examines the robustness of these weights over time. the study shows that weights vary in a nonlinear way over the amount of earnings relative to book value, and systematically so over time. it also demonstrates that estimated weights are robust over time and can be used to predict prices when applied out of sample. tasker [1998] compares across-industry patterns in the selection of comparable firms by investment bankers and analysts in acquisition transactions. she finds the systematic use of industry-specific multiples, which is consistent with different multiples being more appropriate in different industries beatty, riffe, and thompson [1999] analyze different linear combinations of value drivers derived from earnings, book value, dividends, and total assets. they derive and document the benefits of using the harmonic mean, and introduce the price-scaled regressions. they find the best performance is achieved by using (1) weights derived from harmonic mean book and earnings multiples and (2) coefficients from price-scaled regressions on earnings and book value. baker and ruback [1999] empirically show that industry multiples estimated using the harmonic mean are close to minimum-variance estimates based on monte carlo simulations. they use the harmonic mean estimator to calculate multiples based on ebitda, ebit, and sales, and find that industry-adjusted ebitda performs better than ebit and sales. instead of focusing only on historical accounting numbers, kim and ritter [1999], in their asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 74 investigation of how initial public offering prices are set using multiples, add forecasted earnings to a conventional list of value drivers, which includes book value, earnings, cash flows, and sales. they find that forward p/e multiples, based on forecasted earnings, dominate all other multiples in valuation accuracy, and that the earning per share (eps) forecast for next year dominates the current year eps forecast. liu, nissim, & thomas (march 2002) examine the valuation performance of a comprehensive list of value drivers to find out which of them best explains the stock prices. they find in terms of relative performance forward earnings measures are followed by historical earnings measures, cash flow measures and book value of equity are tied for third, and sales performs the worst. liu, nissim & thomas (september 2002) extend their previous work for 10 different countries. however, all the companies belong to the matured markets. they find out that multiples based on earnings perform the best, those based on sales perform the worst & dividends and cash flow multiple exhibit intermediate performance. second, using forecasts improve performance over multiples based on reported numbers with greatest (smallest) improvement being earnings (sales). liu, nissim & thomas (2007) try to find out whether valuations based on cash flow multiples are better than earnings multiple. they observe that despite intuitive claims that operating cash flows are better than earnings as a summary measure of value, stock prices are better explained by reported earnings than reported operating cash flows. huang, tsai and chen (2007) re – examine the p/e anomaly by decomposing p/e ratios into a fundamental component and a residual component, which enables them to capture factors that potentially provide better measures of investor overreaction. they find that both firm specific and macroeconomic factors determine p/e multiples. da and schaumburg (2008) document that within industry relative valuations implicit in analyst target prices do provide investors with valuable information although the implied absolute valuations themselves are much less informative. asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 75 small body of literature on price multiples is also available for emerging markets including india. irina, alexander and ivan (2007) prove that using peers from developed markets would overstate the estimation of equity value in emerging market, because companies from emerging markets are subject to various factors such as political and economic risks, low level of corporate governance and high negative skewness etc., and thus require an adequate discount rate by applying an adjustment factor in emerging markets. gill (2003) demonstrates empirically that the stock market valuations are no longer driven solely by traditional investment principles. she find that the low p/e ratio as an indicator does not hold good anymore and there is nothing like a long-term investment strategy. dhankar & kumar (2007) measure the performance of a set of portfolios, which are based on p/e of stocks. the study finds no consistency between the portfolios’ expected return and their corresponding p/e ratios. it observes that the stock market failed to reflect instantaneous response pertaining to earnings information. their findings question the efficient market hypothesis but hold the application of capital asset pricing model in the indian stock market. sehgal and pandey (2009a) examine the behavior of price multiples in india from 1990-07. they observe that price multiple distributions tend to be normal over the study period, thus, making mean and standard deviation of these multiples as relevant parameters for equity analysis in the indian context. they also find that there is a very weak relationship between price multiples and their fundamental determinants and hence the cross-sectional linear models do not seem to be good descriptors of price multiples. the study also proves that price multiples also seem to be sensitive to market conditions and therefore are generally higher in upturns with the exception of infrastructure related sectors. sehgal and pandey (2009b) evaluate alternative price multiples for equity valuation purposes in the indian context. they find that price to earnings provide the best price forecast compared to other three price multiples i.e. price to book value, price to cashflow and price to sales. the study also reveals that historical price to earnings as a standalone multiple does a better job in equity valuation vis a vis all value driver combinations. thus, there seems to be a major research gap on the subject for emerging markets. most of asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 76 the work done in emerging markets relates to p/e ratios while no concrete research has been done on other value drivers like book value, sales & cash flows. in this paper, we attempt to test the efficacy of alternative price multiples for bricks, which are the most important set of countries in emerging market basket. the study has the following objectives: (1) to understand which standalone value driver is best for forecasting prices, (2) to evaluate whether combination of value drivers forecast prices better than standalone value drivers. its corollary would be that if a combination of value drivers gives superior results than standalone value drivers then it means different value drivers provide separate pieces of information for valuing stock, and hence they should be combined to get the fair price and (3) to estimate whether price forecasting is better when one uses sector regressions instead of market regressions. we verify the last objective only for the indian market owing to lack of sectoral information for other brick countries. 3. data we use data for six emerging economies, namely brazil, russia, india, china, south korea and south africa (known as bricks) in our study. the data source is thomson reuters datastream software 5 . the sample financial ratios have been taken from thomson reutors datastream software which provides standardized data for all markets (as per global accounting practices). hence, differences in accounting system across countries do not pose problems for cross country comparisons. the sample period is 1993-2007 (15 years). for each country sample companies are selected based on the following criteria: (1) 250 large cap companies for each country are selected on the basis of year end market capitalization for the last sample year (2007). in case of brazil and south africa, since the data was available only for 195 and 253 companies respectively, hence we use the entire basket without applying the market capitalization rule, (2) the shortlisted companies must have prices available for at least 7 years out of the total sample period, (3) all the companies with prices of less than rs. 20 in a particular year have been omitted out of the sample for that year. this has been done to remove the effect of penny stocks in forecasting the prices as they can make large distortions in forecasted prices and, (4) the value drivers per share should be positive for a company in a asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 77 given year. the details of sample companies for bricks are given in exhibit a. we omit russia from our study owing to negligible number of companies which satisfy our filtering criteria. the data set comprises of three value drivers namely eps, bv and sales for each sample company. we exclude cashflow as a value driver from our work owing to lack of relevant data for all sample companies except india. the definitions for value drivers are given in exhibit b. all information related to stock prices and value drivers (eps, bv and sales) have been taken for the end of march for each sample year. this is required to compare results for india with other bricks countries. it may be noted financial year is april of year t to march of year t+1 for india. in the indian context we additionally compare the price forecasts provided by sector regressions as well as market regressions. for sector regressions we use data for 13 out of 20 major sectors based on sector classification of bombay stock exchange 500 index (bse500) 4 . two sectors namely, diversified and miscellaneous are excluded from our work as they are difficult to benchmark while other five sectors (i.e. media and publishing, tourism, telecom, consumer durable and transport services) have been omitted as they have few listed companies with not so frequent trading record. for each sector 5 12 large cap 5 companies are selected based on the criteria mentioned above. the data details for sample sectors for india are given in exhibit c. exhibit a: details of sample companies for bricks country no. of companies before screening no. of companies after screening brazil 195 195 russia 75 india 500 145 china 1492 200 south korea 931 200 south africa 253 253 asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 78 exhibit b: definitions of price and value drivers definitions price closing price eps (net profit – preference dividend – dividend tax 6 )/number of shares book value net worth / number of shares and net worth= equity + reserves & surplus sales net sales = gross sales – excise duty exhibit c: details of sample sectors for india serial no. sector no. of companies 1 agriculture 12 2 capital goods 12 3 chemical & petrochemical 12 4 finance 12 5 fast moving consumer goods (fmcg) 12 6 healthcare 12 7 housing related 12 8 information technology (it) 12 9 metal, metal products & mining 12 10 oil & gas 12 11 power 6 12 textile 7 13 transport equipment 12 4. equity valuation using historical price multiples in this section we evaluate standalone price multiples to find out which one of them is most efficient in forecasting prices for bricks. we forecast historical prices using three standalone value drives namely, eps, bv, and sales. forecasted price for each year is calculated by using market regression procedure which has been explained below. we then subtract forecasted price from the actual price each year to get the series of pricing errors for the sample period. we next calculate root mean squared error (root mse) and thail asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 79 inequality coefficient for the series of pricing errors obtained for the sample companies. the price multiple for which pricing errors are minimum will be termed as the most efficient one for valuing a share using historical data. in order to compute the forecasted price ols estimation can be done including an intercept term as shown in the following equation:  ititttit p  (1) where, α t is the intercept which captures the average effect of those factors which are not explained by value driver, x it is the value driver for firm i in year t, β t is the multiple on the value driver and e it is the pricing error. many factors besides the value driver under investigation, affect price, and the average effect of such omitted factors is unlikely to be zero. since the intercept in equation (1) captures the average effect of omitted factors, allowing for an intercept should improve the precision of out of sample predictions. through above equation we regress the base year price on the base year’s value driver and use the ols estimates to find out expected price 7 for base year. to improve the estimation efficiency, we divide equation (1) by expected price. (2) we divide equation (1) by expected price and make it a gls estimation equation in order to remove the effect of heteroscedasticity and to obtain a more efficient estimate of value driver. var (ε i) is hetroscadic with respect to square of expected prices in the form of var (ε i) = f (e (pi) 2 ). step 2 is performed only in those cases where there is significant heteroscedasticity as shown by white hetroskedasticity (no cross term term) residual test 8 .   it it it it it t it it pp t pp p   asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 80 estimating equation (2) with no restriction minimizes the square of pricing errors, but the expected value of these errors is non zero. empirically it has been proved by liu, nissim, and thomas (2002) that when we impose the restriction that expected pricing errors (e (ε /p)) be zero it generates lower pricing errors for most firms, relative to an unrestricted estimate, but it generates substantially higher errors in the tail of the distribution. by restricting ourselves to unbiased pricing errors, we are in effect assigning lower weights to extreme pricing errors, relative to unrestricted approach. by doing so we are also maintaining consistency with the tradition in econometrics that strongly prefers unbiasedness over reduced dispersion. therefore, we impose the restriction that pricing errors be unbiased. that is, we seek to estimate the parameters α t and β t that minimize the variance of            it it p  , subject to the restriction that expected value of residual term is zero:                                             it it t it t it itttit it it ppp p p     1 1varvarvarmin , (3a) s.t. 0             it it p  (3b) it can be shown that the estimates for αt and βt that satisfy (3a) and (3b) are as follows:                                                                                                                        it t itit t ititit t it t it itit t ititit t pppppppp p e pppp t   , 1 cov 1 2 1 varvar 1 1 , 1 cov 1 var 22 (4) asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 81                         it it t t t p e p e 1 1    (5) where, the different et[.], var(.), and cov(.) represent the means, variances, and covariances of those expressions for the population, and are estimated using the corresponding sample moments for the comparable group. after putting the above said restriction we compute the forecasted price for next year through gls estimation. we next estimate pricing errors, defined by equation (6), and examine their distributions to determine performance.      it it tt it it it pp p   (6) the pricing error is calculated as a difference between actual and forecasted price. we repeat the same procedure for each country for all the sample years. we compute root mse and thail inequality coefficient on the series of pricing errors over the study period and the price multiple with minimized pricing error is termed as the most efficient one. root mean squared error depends on the scale of dependent variable. it is used as a relative measure to compare forecasts for the same series across different models. according to this criterion the smaller the error in a model, the better is the forecasting ability of that model. it is calculated as follows: asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 82 root mean squared error = h y ht tt t t y           1 2 (7) where, y t = observed value  ty = forecasted value h = number of observations thail inequality coefficient is scale invariant. it always lies in between 0 and 1, where 0 indicates a perfect fit. it is estimated as follow: thail inequality coefficient = h y h h y ht tt t ht tt t ht tt t t y y                  1 2 1 2 1 2 (8) through these two measures we evaluate the market pricing errors to determine the most efficient price multiple based on error minimization criteria. the price multiple whose pricing error, as per both measures, is least among the three multiples viz. p/e, p/bv and p/s will be termed as the most efficient one in forecasting prices. we find that the pricing errors for forecasted prices based on p/bv multiples are lowest for india, china and south korea as compare to other multiples, using both the forecast evaluation measures. as shown in table1 p/bv exhibits minimum pricing error for these three asian economies. p/e is the next efficient price multiple whereas p/s is the worst performer according to both the tests. we also observe that in case of india and china errors given by book value and eps are almost equal, wherein bv has a slight edge over eps. on the other hand for the two non asian economies i.e. brazil and south africa, p/e proves to be the better multiple for forecasting prices as per both the criteria. hence, we can conclude that asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 83 in case of emerging economies price forecasting should be done by p/e or p/bv ratios. 5. equity valuation using combined historical multiples in this section we evaluate combined historical price multiples to verify the following propositions: i. which is the best combination for forecasting prices and ii. how do the combined multiples perform vis-à-vis standalone multiples in equity valuation. we evaluate three combinations of value drivers’ namely: eps-bv, eps-sales, and bv-sales to analyze combined historical multiples. we follow the following estimation process: in step 1 we make stock price as a function of a combination of value drivers as shown in equation (9) below.  ittttttit p  2211 (9) where, α t is the intercept which captures the average effect of those factors which are not explained by value driver, x it is the value driver for firm i in year t,  t1 and  t2 are price multiples for the respective value drivers and e it is the pricing error. through above equation we regress the base year price with the base year’s value drivers to find out expected price for base year. to improve the estimation efficiency, we divide equation (9) by expected price. this step is performed only in those cases where there is significant heteroscedasticity as shown by white hetroskedasticity (no cross term) residual test. (10)   it it it t t it t t it t it it ppppp p     2 2 1 1 asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 84 we estimate equation (10) imposing the restriction for the error term specified in the previous section i.e,            it it p  =0 so that our regression estimates are unbiased. we obtain forecasted prices from equation (10) and then use them to calculate our pricing errors using equation (8). we adopt root mse and thail inequality coefficient as our criteria for checking the quality of price forecast as was done in previous section. the results for combined multiples are given in table 2. while analyzing pricing error distributions for combined multiples we find that for india and china the errors are minimum for the combination of bv-sales value drivers according to both the criteria. eps-sales is the next best value driver while eps-bv performs worst in forecasting prices. however, it is to be noted that pricing errors through eps-sales are almost equal to bv-sales for india and china. in case of other three emerging economies eps-bv is a better measure than other two combinations of value drivers as per both the criteria. we next compare standalone value drivers with value driver combinations. it can be seen from tables 1 and 2, that bv (the best standalone value driver) outperforms bv-sales (the best combination of value drivers) for india as per both the evaluation criteria. the value driver combinations do not consistently do better than standalone value drivers as per our evaluation criteria for china and south korea. on the other hand for brazil and south africa we get inconsistent results as per both the criteria. in case of south africa, eps (the best standalone value driver) performs better than eps-bv (the best combination of value driver) while for brazil eps-bv gets better results than eps as per root mean squared error. while as per thail inequality coefficient criteria eps and eps-bv are the best multiples in forecasting prices for brazil and south africa respectively. we conclude that in general combining value drivers does not improve our price asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 85 forecast and hence, equity valuations can be better done by keeping the process simple by using standalone multiples. our results for emerging markets are in contrast with penman (1997), who finds that combined value drivers do a better job than standalone value drivers in case of matured markets. our findings may be explained by the fact that different price multiples are driven more by investor sentiment in emerging markets where the investors do not perceive each price multiple to be providing different information. see sehgal and pandey (2009). hence, use of multivariate models does not improve our price forecasts. 6. sector regressions versus market regressions: the indian case in this section we analyze indian companies to find out whether sector regressions better explain the stock prices than market regressions. sector regressions are not performed for other sample countries as sector classification information for them is not available with us. in case of sector regressions the price forecasts are obtained using data for sample companies belonging to a particular sector. we calculate pricing errors by taking the difference between actual and forecasted prices. the distributions of pricing errors are then used to estimate our forecast evaluation criteria namely, root mse and thail inequality coefficient. in case of market regressions, the estimation procedure is similar except that price forecasts are obtained by using information for all the sample companies i.e. for the market as a whole. some equity analysts argue that sector regressions are better than market regressions owing to the fact that the former controls for inter – sectoral differences while developing price forecast. others argue in favour of market regressions as all securities compete with each other for each dollar of investment in financial markets, irrespective of their sector classification. the data employed for india is same as is used in section 3. we find that pricing errors are lower for market regressions compared to sector regressions as is shown in table3 both for standalone as well as for pairwise combination of value drivers as per both the evaluation criteria. the reason for this could be that in market regressions the number of sample companies for each sample year is far greater than the number of sample asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 86 companies used for sector regressions. the high degree of freedom in case of market regressions may result in better parameter estimation for price forecast purposes. our results show that contrary to popular belief that price multiples based on sector regressions result in better forecasting of prices, we find that market regressions provide better performance. we therefore, suggest that market regressions should be preferred over sector regressions for equity valuation in the indian context. we could not do similar analysis for other bricks countries owing to lack of sector classification information for them. similar work for these countries shall be greatly useful for equity analysts and global portfolio managers. 7. summary and concluding remarks in this study we evaluate the efficacy of alternative value drivers namely, eps, bv and sales in providing price forecasts. we conduct this analysis for bricks (excluding russia) which is the most important basket amongst the emerging markets. we employ two performance evaluation criteria i.e. root mse and thail inequality coefficient for checking the accuracy of our price forecasts. our work involves three phases. in phase one we evaluate the price forecasts provided by standalone price multiples and find that while bv is the best value driver in case of asian economies (india, china and south korea), eps performs best for brazil and south africa. in the second phase we experiment with binary combinations of value drivers and find that bv-sales is the best combination for india and china, while bv-eps provides best price forecasts for brazil, south korea and south africa. we further observe that combinations of value drivers do not seem to outperform standalone multiples. we recommend that equity valuation process for the sample countries should be kept simple by using relevant standalone price multiples as use of additional multiples do not seem to be providing any significant extra information to investors for developing price forecast. our findings on emerging markets are in contrast with those for matured markets as shown by penman (1997). asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 87 in the final phase we verify if sector regressions result in lower pricing errors compared to market regressions in the indian context. we could not conduct similar analysis for other countries owing to lack of sectoral information. we find that contrary to popular belief sector regressions perform worse than market regressions. while estimating price forecasts our results may be outcome of the fact that market regressions are estimated using large pool of observations (sample companies) resulting in more efficient estimation of the parameters involved in our forecast regressions. we suggest that market regressions should be preferred over sector regressions for equity valuation in the indian environment. similar companies for other bricks countries are desirable and should be covered in further research. our findings are extremely relevant for equity analysts and global portfolio managers who are continuously involved in security evaluation and developing strategic allocation strategies involving distribution of investible funds across world markets including bricks. our study contributes to the equity valuation literature for emerging markets. similar work for other world markets is desirable for inter-country comparisons on the subject. notes 1. emerging markets: for details refer to irina, alexander and evan (2007), gill (2003), dhankar and kumar (2007), and sehgal and pandey (2009). 2. matured markets: for details refer to boatsman and baskin (1981), alford (1992), kaplan and ruback (1995), penman (1996), penman (1997), tasker (1998), baker and ruback (1999), beatty, riffe and thompson (1999), kim and ritter (1999), liu, nissim and thomas (2002), liu, nissim and thomas (2007), huang, tsai and cheng (2007)and da and schaumburg (2008). 3. thomson reuters datastream software: it is a financial and macroeconomic database, covering major instruments, company fundamentals, equities, fixed income securities and economic indicators for 177 countries and 60 markets worldwide. 4. bse 500: bombay stock exchange limited constructed a new index, christened bse-500, consisting of 500 scrips w.e.f. august 9, 1999. bse-500 index represents nearly 93% of the total market capitalization on bse. bse-500 covers all 20 major industries of the economy. in line with other bse indices, effective august 16, 2005 calculation methodology was shifted to the free-float methodology. asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 88 5. large cap: in indian context large cap is a term used by the investment community to refer to companies with a market capitalization value of more than $5 billion. large cap is an abbreviation of the term "large market capitalization". market capitalization is calculated by multiplying the number of a company's shares outstanding by its stock price per share. 6. dividend tax: it is an additional tax to be paid by domestic companies when they declare and distribute dividend among equity shareholders. the tax is levied at prescribed rate (for example in india it is 15% + 7.5% + 3% (dividend tax + surcharge + shec) on the amount which is meant for the payment of dividend). 7. expected price is computed by using the parameters estimated in equation (1) in the form  it itp   where,  it = value driver 8. white hetroskedasticity test: these tests are the extension of white's (1980) test to systems of equations as discussed by kelejian (1982) and doornik (1995). the test regression is run by regressing each cross product of the residuals on the cross products of the regressors and testing the joint significance of the regression. the no cross terms option uses only the levels and squares of the original regressors, while the with cross terms option includes all nonredundant cross-products of the original regressors in the test equation. the test regression always includes a constant term as a regressor. if the chi-square value at the chosen level of significance, or if the p-value of the compute chi square value is reasonably low (say 1% or 5%), we can reject the null hypothesis of hetrocedasticity. references alford, a. (1992).the effect of the set of comparable firms on the accuracy of the price-earnings valuation method. journal of accounting research, 30, 94–108 anthony, e. bopp. (1985). on combining forecasts: some extensions and results. management science, 31, 1492-1498 baker, m., & ruback, r. (1999). estimating industry multiples. working paper: harvard university, cambridge, ma beatty, r.p., riffe, s.m., & thompson, r. (1999).the method of comparables and tax court valuations of private firms: an empirical investigation. accounting horizons, 13, 177–199 boatsman, j., & bakin, e. (1981). asset valuation with incomplete markets. the asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 89 accounting review, 56, 38-53. copeland, t., koller, t., & murrin. j. (1994). valuation . new york: willey da, z., & schaumburg, e. (2011). relative valuation and analyst target price forecasts. journal of financial markets, 14, 161-192 damodaran, a. (1996). damodaran on valuation. new york: willey huang, y., tsai, c.h., & chen, c.r. (2007). expected p/e, residual p/e, and stock return reversal: time – varying fundamentals or investor overreaction?. international journal of business and economics, vol. 6, no.1, 11-28 irina, i., alexander, p., & ivan, k. (2007). adjustments to market multiples – based valuation in emerging markets: empirical study for russia. working paper, corporate finance center, higher school of economics, moscow, russia kaplan, s. n., & ruback, r. s. (1995). the valuation of cash flow forecasts: an empirical analysis. the journal of finance, 50, 1059–1093 kim, m., & ritter,j. (1999). valuing ipos. journal of financial economics, 53, 409–37. koutroumanidis, t., iliadis, l., & sylaois, g.k. (1986).the fisher hypothesis under different monetary regime. the review of economics and statistics, 68, 674-679 liu, j., nssim, d., & thomas, j. (2002a).equity valuation using multiples. journal of accounting research, 40, 135-172 liu, j., nissim, d., & thomas, j. (2002b). international equity valuation using multiples. working paper, anderson graduate school of management, university of california at los angeles. liu, j., nissim, d., & thomas, j. (2007). is cash flow king in valuations. financial analyst journal, volume 63, 56-65. palepu, k., healey, p., & bernard, v. (2000).business analysis and valuation (2nd ed). cincinnati, ohio: south western college publishing penman, s. h. (1996a). the articulation of price-earnings ratios and market –to book ratios and the evolution of growth. journal of accounting research, 34, 253-259 penman, s. h. (1997). combining earnings and book value in equity valuation. working paper, columbia university, department of accounting asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 90 sehgal, s. & pandey, a. (2009). the behavior of price multiples in india (1990-2007). asian academy of management journal of accounting and finance, 5, 31-65 sehgal, s. & pandey, a. (2010). equity valuation using price multiples: evidence from india. asian academy of management journal of accounting and finance, 6, 89-108 tasker, s. c. (1998). industry preferred multiples in acquisition valuation. working paper, cornell university, ithaca, ny thomas,a.barthold., & william.r, dougan. (1986). the fisher hypothesis under different monetary regimes. the review of economics and statistics, 68, 674-679 tables table 1: standalone value drivers panel a: root mean squared error eps bv sales india 245.371 227.190 266.736 china 83.427 82.111 87.087 brazil 740.142 1137.737 1307.666 south korea 18196.243 7635.384 27903.628 south africa 220.254 304.812 303.202 panel b: thail inequality coefficient eps bv sales india 0.392 0.387 0.434 china 0.526 0.527 0.538 brazil 0.287 0.427 0.429 south korea 0.763 0.325 0.656 south africa 0.288 0.348 0.398 asain journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e4 www.macrothink.org/ajfa 91 table 2: pairwise combination of value drivers panel a: root mean squared error eps-bv eps-sales bv-sales india 1672.848 257.125 255.150 china 126.842 83.142 82.239 brazil 325.810 643227.393 1090.400 south korea 4268.134 9748.881 12061.061 south africa 229.338 308.101 684.993 table 3: sector vs market regressions for india root mean squared error thail inequality coefficient sector regression market regression sector regression market regression eps 290.91 245.371 0.418 0.392 bv 322.321 227.190 0.456 0.387 sales 678.838 266.736 0.648 0.434 eps-bv 9166.62 1672.848 0.960 0.825 eps-sales 560.851 257.125 0.576 0.389 bv-sales 332.357 255.150 0.440 0.395 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). panel b: thail inequality coefficient eps-bv eps-sales bv-sales india 0.825 0.389 0.395 china 0.662 0.527 0.526 brazil 0.235 0.998 0.423 south korea 0.339 0.575 0.530 south africa 0.276 0.359 0.569 microsoft word 3417-12838-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 209 the relevance of the application of the neural approaches in the premature detection of the banking difficulties: case of tunisia niazi kammoun & chanez charfi university of sfax (tunisia), higher school of business airport road, 1081, sfax 3018, tunisia received: jan. 30, 2013 accepted: april 8, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3417 url: http://dx.doi.org/10.5296/ajfa.v5i1.3417 abstract: we propose in this study to test the relevance of the use of an early warning system (ews) for banking difficulties in the tunisian case. this model is based on the use of a multilayer neural network with a back-propagation algorithm. from a sample of 18 tunisian banks, we try to establish the different ratios of the financial health of banks, extracted from camel rating system. with a good ranking percentage obtained for the total sample of more than 93%, we conclude that neural networks are found to be robust for the prediction of the fragility of the tunisian banks. keywords: bank performance; bankruptcy prediction models; artificial neural networks. jel classification: g21, g33 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 210 1. introduction one week after the decrease of the rating of the long-term debt by tunisia of two notches to bb, the standards and poor’s rating agency announced, on may 2012, the reduction in the rating of five tunisian banks. this relates to the arab tunisian bank (atb), the bank of housing (bh), the tuniso-kuwaiti bank (btk), the tunisia and emirates bank (bte) as well as the tunisian banking company (stb). the decision is considerable as far as ratings are supposed to measure the probability of failure, be it in an industrial company or a bank. their role is even more fundamental in emerging countries, where the regulatory and institutional environment tends to create incentives for a better risk management (rojas-suarez, 2000; 2001). although the tunisian banking system has played a leading role in the development of the tunisian economy, it has witnessed many difficulties particularly the present-day high level of banking bad debts. in 2010, the part of the bad debts in the total of bank credits remained very high (12.1 %), a value which reveals a big gap if compared with the other emerging countries (chile 2.7 %, malaysia 3.4 %, and turkey 3.2 %). besides, the rate of funding of the bad debts was 59.6%, far from the rate of 70 % set as an objective by the central tunisian bank (ctb) to the horizon of 2012 and below the levels reached by other emerging countries. the quality of the banking debts reveals a structural problem from which the tunisian banking sector suffers. the tunisian banks are characterized by an inadequacy between the nature of the debts and the funding made. fitch ratings, as well as the imf, consider that the tunisian banks were not well funded (international monetary fund [imf], 2006). this situation shows that the tunisian banks became vulnerable because they did not manage to adjust to the new context in which they have to survive. the latter is characterized by important structural changes induced by a process of opening and of financial liberalization. as result, they were less dynamic because they didn’t meet the requirements of the banking economic efficiency. the consolidation of the banking system can be possible by the improvement of the quality of the credit portfolio which includes a relatively high volume of bad debts compared with the international standards, and this is true in spite of the effort made to reduce their part in the commitment total. the public authorities’ strategic choice to free the monetary policy has become a reality through a rather careful approach and this is by establishing standards concerning solvency, division of the risks and liquidity. the adoption of these prudent standards leads banks to grant credits with more rationality and discipline and incites them to strengthen their stockholders' equity and provide the necessary reserves. the overall objective is to prepare an easy passage to basel ii rules. considering the harmful effects that a banking crisis can have_ not only at the level of the economic activity but also at the social level_ the prediction of the bankruptcy of banking institutions has been the subject of several empirical works. they are based on the economic and financial analysis of the failing and the solvent banks so as to determine basic indicators which are indispensable to alert countries to the outbreak of a crisis and allow them to manage their financial sector and their economy better. for example, having noticed that the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 211 non-performance translated in terms of fragility can increase the default risk of a bank, certain authors, such as barr and siems (1994), goyeau and tarazi (1992) and pantalone and platt (1987), tried to establish prediction models of the failure and to determine its explanatory factors. they have asserted that the failure of banks can be accounted for by internal micro-economic factors. this has led to the use of variables from the camel typology which was originally created by the american banking authorities of regulation and supervision at the beginning of 1980s. this rating system allows, from a certain number of financial ratios, to analyze the financial situation of a bank and to give it a grade by combining five domains of performance: the capital adequacy, assets quality, management quality, profitability (earning ability) and liquidity, and a sixth domain of performance came to be added to the previous ones in 1996: sensitivity to market risks. however, other authors like godlewski (2004) assert that besides the internal factors, the elaboration of a model to predict of the failure of a bank needs taking to take consideration the institutional factors. other authors_such us hanschel and monnin (2003) and kibritcioglu (2002) elaborated a clue of financial stress. it is about an aggregated indicator which considers various macroeconomic and microeconomic variables. the necessary approach for the elaboration of such an indicator is complex because it has to integrate a law of probability apart from the choice of a method of aggregation. its major interest is to allow the monetary and supervisory authorities to feign macroeconomic shocks and to quantify their impact on the banking activities (rouabah, 2006). however, it is necessary to notice that the financial stress indicator represents a general clue which gives an evaluation of the vulnerability of the banking sector as a whole and that is the reason why rouabah (2006) has suggested examining the possibility of adopting a clue of stress for each individual bank. significant advances were made then in the study of the banking crises at a microeconomic level, that is at the level of an individual institution. the proposed models try to explain why the banks of a country, undergoing the same macroeconomic shock, do not all go bankrupt? have those which went bankrupt got different characteristics from the others? if so, had some of these characteristics been different long before those banks went bankrupt? in this context, the premature detection of the banking fragility at the individual level should facilitate the implementation of premature corrective measures intended to eliminate any risk of failure and contagion (systematic risk). the recent techniques borrowed from the artificial intelligence, such as the neural networks, have allowed to work out models that help to obtain good predictions by presenting the advantage of not requiring statistical limitations (refait-alexandre, 2004). a neural network is a set of interconnected units which have a big capacity of apprenticeship and data processing. it is in fact a mathematical algorithm which allows to treat knowledge pertaining to the relationship between the input and output so as to classify the situations correctly. this research aims to study the possibility of developing new tools for the detection of the fragility of banking institutions according to a new practical approach seeking to improve the capacity of the authorities to foresee and classify of banks in terms of performance (or asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 212 fragility). more exactly, this research thus aims at determining if it is relevant to use the neural networks in developing a model of premature detection of the banking difficulties and the banking insolvency in tunisia. such a model could enlighten the decisions that are to be made by the authorities in view of preventing the bankruptcies of the tunisian banking institutions. the rest of the paper is organized as follows: in section 2, we will evaluate the stability of the banking system in tunisia. then, section 3 will include a presentation of a prediction model of the banking difficulties in tunisia. in section 4, we will show the results and interpretations. section 5 will be about the conclusion. 2. the evaluation of the stability of the banking system in tunisia 2.1 presentation of the banking system the tunisian banking sector consists of 5 big banks which hold 65 % of market shares. moreover, fitch ratings has found that « tunisia has a significant number of banks for a relatively modest market». however, this market is relatively isolated and is very weakly exposed to foreign capital and the majority of the deposits and credits are local. the banks’ assets in foreign currency represented 8 % of the total of the banking assets at the end of april 2008, and were widely dominated by banks deposits, with a limited exposure to the international capital markets (0.3 % of the total of the banking assets at the end of april 2008). this has proved to be a blessing for banks in tunisia because they were able to stay completely protected from the world financial crisis. indeed, the strict regulatory control on the exchange, namely the limits on the loans from financial institutions and companies, the ban on investment in the foreign capital markets, the limitations on exchange and derivative markets have led to a limited exposure of the local banks to the international financial markets. offshore banks that are subjected to a more flexible regulation and supervision from the central bank of tunisia hold a low part of the total of the banking assets (7 % at the end of april 2008). the participation of foreigners in the capital of the tunisian banks amounted to 37.36% for banks listed on 12 december 2008 against 38.04 % before the emergence of the international financial crisis. this participation is mainly strategic and should remain even more as such owing to the potential offered by the tunisian banking market. it is also part of the strategy of these foreign shareholders in the development of the retail bank (société générale uib, bnp-paribas-ubci, santander-attijariwafa bank-attijari bank company, arab bank plc-atb, cic-bt, etc.). these alliances are seen as the major answer to the fragmentation of the tunisian banking sector and the merger between the tunisian banks remains a solution to several other troubles among which we can note facing the competition from foreign banks which could enter the national market following the liberalization of the services. besides, these alliances will also expand the tunisian banks sizes which will ultimately enable them foreign financial markets. as regards the evolution of the tunisian banking activities, we can note: having recorded a faster growth than that of the nominal gdp in the 1990s, the bank credit for the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 213 non-governmental sector has slowed down since the end of 2000 when banks began to worry about the quality of the credit, and it has increased since 2002 with a pace almost identical to that of the nominal gdp. in 2007, the volume of loans reached 56.8 % of the nominal gdp. this ratio is in the average range of the mena region (58 %) and remains sharply above the average level of certain countries of central europe (around 30%), but obviously lower than the average level of the euro-zone (109.6%). in terms of deposits, the rate of penetration remains relatively low with 50.8 % at the end of 2007 as compared to morocco with 79.1%, kuwait (64.1%) and qatar (68.3%). the public banks continued to play a dominating role in financing the economy assuring more than 8.4 billion tunisian dinars, that is more than 40 % of the global outstanding credits allocated to the economy. indeed, the bna covered about 31 % of the credits granted to the sector of agriculture and the fisheries whereas the stb assured, in 2007, 38 % of the credits granted to the tourism sector. as for the bh, it served more than 22 % of the credits granted on real-estate development. however, the spread of the use of banking services by the population, in spite of its progress, remains still low in tunisia (50 % of the total population in 2007 against 98 % for france, one agency for 9.6 thousand inhabitants against one agency for 7.3 thousand in morocco and one agency for 2.4 thousand inhabitants in france). the tunisian banks are essentially retail banks and the totality of the banking net product results from the network of agencies. 2.2 the reforms and the efforts of consolidation the liberalization of the financial sector was part of a of structural adjustment plan, partially prescribed by the imf in 1987, which aimed at establishing a market economy and a major effort regarding privatization. the restructuring of the banking system aimed at intensifying the interbank competition and at allowing the banks to be more responsible and capable of making their own decisions of credit (moore, 1991). the reforms also aimed at mobilizing the savings and at leading to an effective allocation of the resources. globally, the reforms introduced in tunisia seem to have made a success. jbili and enders (1997) noted a remarkable progress in relation to the financial stability and the adjustment of the real interest rates in positive values _ -4.3 % on average during the pre-reform period (1970-1986), compared with +2 % during the reform period (1987 1995). besides, banks are less subject to governmental pressures as for the sectoral distribution of the credits because the part of the credits allotted for non-governmental sectors has increased from 40.3 % of the gnp during the pre-reform period to 54.1 % of the gnp during the reform period. however, the development of the rules of banking supervision was relatively limited, partially because of the direct control which the tunisian central bank exerted on the distribution of the credits and because of the presence of the government representatives most of the banks’ boards of directors (cook, hababou & robert, 2000). this inefficiency has contributed to the accumulation of bad debts in the balance sheets of several banks. these debts have resulted on the one hand from the financing of public projects of infrastructure asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 214 with industrial and commercial character and on the other hand from a lack of cautions management. in fact, the granting of the banking assistance continues to be widely based on guarantees, to the detriment of a thorough financial analysis intended to estimate the counterparty risk and based in particular on the quality of the project to be financed and its capacity to yield cash flow. besides, the serious difficulties which have affected the tourist sector since 2001 have significantly contributed to heavier stock of bad debts. in spite of a decrease in 2005, the weight of these bad debts still represents about 13.2% of the total of the credits in 2009. the existence of a solid financial system is an essential condition to support the economic growth and job creation. the important reforms introduced have allowed to improve the transparency of the financial transactions. besides, the tunisian banks focused on the improvement of the quality of their asset portfolios. even though the sector managed to achieve the objective of reducing of the rate of bad debts at the levels of 13.2 % in 2009 and 12 % in 2011, these rates remain rather high with regard to an average of 5 % for the other mena countries. regarding provision for bad debts, a significant effort remains to be made to cover the unproductive debts suitably. however, the sector is taking the necessary measures to improve the viability of the granted loans. the ratio of funding for the whole system was 53.2 % at the end of 2007, against 43 % at the end of 2003. given that the value of the real estate guarantees is inevitably subjected to uncertain fluctuations, this relatively low funding makes the system more exposed to external shocks, which increases its vulnerability. to improve its resistance, the authorities fixed an objective of 70 % funding for 2012. indeed, the rate of funding of the bad debts is one of the most important prudent standards considered, but this objective is far from being achieved by most of the tunisian banks, especially those quoted banks. source: maxula bourse (2010) figure 1. quality of the tunisian banks’ assets (in %) these measures have allowed the banks to strengthen their efforts regarding funding and so to improve the bad debts cover rate. in spite of this improvement, the rate of funding remains 20.8 24.2 23.6 20.9 19.3 17.6 15.5 13.243.7 44.1 45.1 46.8 49.0 53.2 56.8 58.3 40 45 50 55 60 12 17 22 27 2002 2003 2004 2005 2006 2007 2008 2009 bad debts rate cover rate asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 215 below the level of the 70 % fixed by the central bank of tunisia. according to the imf, reaching this objective and even going further, would strengthen the banking system capacity of absorbing potential shocks which may affect the economy, considering the progressive opening of the capital account. besides, banks have continued their efforts regarding the strengthening of their capitals through capital increase operations, which has contributed to an of the 11.2 % progress of stockholders' equity in 2009. as a result of this progress, the average ratio of bad debts cover increased from 56.8% in 2008 to 58.3 % in 2009. finally, we have witnessed a considerable improvement on fundamental of good governance among tunisian banks. indeed, the banking net product increased by 13.3 % in 2008 and by 7.2 % in 2009. besides, the net income reached 461.6 million dinars in 2009, a 17 % increase in comparison to that of 2008. this increase had a positive impact of the profitability of stockholders' equity because the roe reached 11.7 % in 2009 against 11.2 % in 2008 and the return on assets (roa) remained at the same level as that of the 2008_1 %. 3. a model of the prediction of the banking difficulties in tunisia performance is a complex and multidimensional notion. it must be tackled with a thorough logic which exceeds the simple appreciation of profitability. it is a question of passing an objective judgment on the result, the functioning and the evolution of the company as a whole through a system of indicators that can be measured quantitatively or qualitatively. 3.1 methodology 3.1.1 description of the sample and the used data our sample consists of 18 tunisian banks (see appendix). the data are taken from the publications of the council of the tunisian financial market and of the tpabfi (tunisia’s professional association of banks and financial institutions). the period of study extends from 2002 to 2009. among the 18 banks in our sample, 11 banks are quoted on the stock exchange of tunis. moreover, on these 18 banks, 3 are public banks and 15 are private ones among which 11 are subsidiaries of foreign banks. indeed, banks having a strong participation of the state are mainly the bna, stb and bh. banks like the bt and amen bank have private tunisian capitals and banks such as the biat, uib, ubci, attijari bank and atb have large foreign capitals. we can note that the total number of commercial banks in tunisia passed from 14 in 2002 to 21 in 2009. the first stage of our empirical study consists in identifying the banking difficulty. to do so, we are interested in the foreseeability of the capitalization ratio deteriorations, under the critical threshold of 8 %. this threshold coincides with the regulatory standards enacted by the 1998 basle agreement. for the tunisian case, we judge that this threshold is too weak and this makes the banks’ managers and the supervisors worry too much. on that account, a bank is considered solvent for a given year if its ratio for the same year is asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 216 higher than 8 %. however, if this ratio is lower than or equal to 8 %, this bank is considered as insolvent. the desired exit is thus formed by binary values: "1" for the solvent banks and "0" for those that are insolvent. this desired exit is going to serve us as a comparison with the calculated exit during the phase of apprenticeship and this is for the error determination. 3.1.2 the selection of variables the financial ratios are variables mostly used in the models of risk forecast. a careful analysis of these ratios allows to estimate the financial health of banks and to find a way of improving it. indeed, the ratios are strongly important tools which help to apply methods which improve profitability, liquidity, financial structure, debts and risk cover. although the ratios often indicate the past performance, they can predict and supply indications on the potential problems (gonzalez-hermosillo, 1999). the 8 financial ratios we have used are classified into three types of ratios: that of liquidity, solvency and profitability. these ratios have been chosen because of their popularity in the literature and in the previous researches on the financial analysis of the situations of banks. they are going to serve as predictive variables of the banking insolvency in our model (see the tables below). table 1. liquidity ratios variables financial ratio definition authors r1 cash ratio current assets total assets godlewski (2003); al-shayea, ghaleb, el-refae and el-itter (2010) abdennour and houhou (2008) r2 current ratio current assetsshort − term deposits al-shayea et al.(2010) r3 loans total assets ratio total loanstotal assets abdennour and houhou (2008); rouabeh (2006) r4 intermediation ratio total loanstotal deposits godlewski (2003) we consider that the increase of the ratio (r3) would be associated with an excessive risk taking by the banks and this could be translated by a severe vulnerability of the whole system. moreover, borio and lowe (2002) as well as eichengreen and arteta (2000) consider that the fast evolution of bank credits constitutes a good indicator of crisis forecast. the quality of the bank management is approximated by the variable (r4). this ratio asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 217 measures the importance of the credits granted by the bank with regard to the main source of funding of its credits. it is a measure of the liquidity of the bank, because it connects the liquidity management with the banking performance. this ratio compares the illiquid assets (the credits) with the main stable source of funding (the deposits). so, the lower this ratio is, the more the bank is considered liquid and converse is true. a low ratio of intermediation (r4) could consequently be interpreted as a sign of a good quality of management because the loans are financed by weakly paid funds, which implies bigger margins of interest. however, when the value of this ratio increases and becomes superior to 1, the probability of a bank to be in trouble becomes important. table 2. solvency ratios variables financial ratio definition authors r5 capitalisation ratio shareholders′ equitytotal assets abdennour and houhou (2008); bongini, claessens and ferri (2000) r6 long-term solvency ratio shareholders′ equitytotal loans al-shayea et al.(2010) the capitalization ratio (r5), called also the capital adequacy ratio, measures the weight of the bank’s own capital with regard to the amount of its total assets. athanasoglou, brissimis, and delis (2005) and berger (1995) assert that in the presence of asymmetry of information, the well capitalized banks can reach funds on better conditions because they are considered as less risky institutions. in our analysis, this ratio constitutes an approximation of cooke ratio since we cannot calculate this ratio ourselves. indeed, we have failed to reach information relative to the incurred risks of banks. so, we consider that a high level of this ratio allows the bank to absorb the possible shocks and to improve its financial solidity contributing to the reduction in its probability to be under-capitalized. the ratio (r6) measures the degree of the long-term financial independence of the bank and translates its financial autonomy. generally, a bank is considered financially autonomous when more than half of its resources come from equity capital. the higher the financial independence is, the healthier the bank is. table 3. the profitability ratios variables financial ratio definition authors asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 218 r7 roa pre − tax returntotal assets al-shayea et al.(2010); abdennour and houhou (2008) r8 roe pre − tax returnshareholders′ equity al-shayea et al.(2010); abdennour and houhou (2008) the profitability of a credit institution represents its ability to make sufficient profits from its exploitation, after deduction of the necessary costs for this exploitation so as pursue its activity. profitability is a bank strategy which has much more importance than the growth of its total assets. one of the variables which assures the solvency is the profitability of banks’ operations. it is thus, a necessary condition for the safety of the whole financial system whether it relates to the return on equity (roe) or return on assets (roa), we notice that the tunisian banks show low rates of profitability. the measure of the profitability of assets (r7) is an indicator which allows to examine the degree of efficiency of the use of the available assets, that is its capacity to generate profits by means of the assets of the bank. an analysis based on the roa can be biased because of the activities off-balance sheet, because these activities significantly generate profits but they are excluded from the denominator of the variable roa. besides, roa places the totality of the assets of the bank on the same level of risk, while the risks relative to the components of the total assets are different (goddard, molyneux & wilson, 2004); (athanasoglou, brissimis & delis, 2008) and (garcia-herrero, gavila & santabarbara, 2009). the use of the second ratio of profitability (r8) to estimate the performance of a bank deserves a particular attention in its interpretation. the roe is often considered as the major tool of banks’ piloting. it constitutes a key indicator on which the managers’ remuneration depends, the analysts’ recommendations and the market requirements depend. it is well known that the least expensive and the safest way to increase the roe is to increase the level of debts with regard to stockholders' equity. indeed, the profitability of shareholders’ equity is equal to the return on assets (roa) multiplied by the total of assets over equity capital. so, for the same economic profitability, the financial profitability is raised all the more as the debt is bigger. this leverage effect is situated in the heart of the activities of a bank, the intermediation is indeed only the use of funds borrowed from customers to be lent to the other customers at a higher rate in order to get a margin. therefore, an analysis based on the roe neglects the effect of the capital leverage and the risks associated to it. so, the debts increase the roe that when the situation is good and lower it when there are difficulties. this law has proved to be true in the recent financial crises. the shareholders who have suffered most are those in banks where the roe and the debts were the highest before the crisis _ as reveals in the study of beltratti and stulz (2009). more exactly, when debts do not create value for the shareholders, they destroy the company. thus, a high level of stockholders' equity of banks does not constitute a brake in their asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 219 competitiveness while a level of high debts, based on a sterile quest of roe, is undoubtedly in the heart of the banking crises. that is why it is hard to judge the quality of the banking governance based on simple consideration of this indicator. 3.2 the neural network adopted structure the neural models allow to plan the banking difficulties and to classify them in two categories: healthy banks and insolvent banks or banks in trouble. in our research, we used a multilayer neural network with a back-propagation algorithm, a sigmoïde function of activation and the mean square error (mse) as function of performance. however, the number of neurons on the hidden layer is fixed after a series of tests. the multi-layer perceptron (mlp) is a feed-forward neural model. the mlp is one of neural networks that are most used for approximation, classification and prediction problems. these models are widely used in the field of finance and successfully in forecasts. the architecture of a mlp is presented in the figure below. figure 2. architecture of a multi-layer perception this model of neural networks is completely inter-connected. it allows signals to circulate always in a single direction: from the source (the input layer) to the destination (the output layer), without feedback. so, the information spreads from the layer to layer without the possibility of moving back. a multi-layer network can include one or several intermediate layers called hidden layer. in our study, we will be using a multi-layer neural network with a single hidden layer. indeed, parizeau (2004) notes that the typical structure of the back-propagation neural network consists of three layers: an input layer, a hidden layer, and an output layer, provided that use a sigmoïde function of activation on the hidden layer. on the input layer, the neural network receives the data. the number of neurons in this layer depends on the number of entries. for our model, the entry layer is composed of seven asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 220 neurons which are going to receive the entering signals represented by the values of the seven ratios selected according to the previously described procedure, and a bias which has 1 for value. we consider a mlp with a single hidden layer. this layer serves to make intermediate calculations and this allows the network to learn, adjust, and generalize from the previously learned facts to the new input. indeed, every neuron in this layer receives the data supplied by the neurons of the previous input layer and makes simply a balanced sum of these entries, adds a threshold to this sum and passes the result by a transfer function to obtain its output. the latter will serve as new input to the neurons of the following layer. for our model, the number of neurons present on this layer is fixed after a series of tests. in our application, the output layer consists of a single neuron emitting output signals which will be compared with the desired values. in fact, desired values are the values determined by the capitalization ratio (r5) previously calculated. the neural network is going to make a series of learning cycles with the aim of finding the desired values by trying to reduce the differences between these values and those calculated. be it known that it is question of ranking and given the fact that the desired values take the values 0 or 1, it is more interesting to use an activation function (or a transfer function) of sigmoïd type (parizeau, 2004). this function is defined by: ( ) = −= n i ii yxe 1 221 (1) with: n : number of examples (bank-year for our study); ix : value desired by the output; iy : value calculated by the output; 4. results and interpretation 4.1 the bank ranking quality the choice of the neuronal models to be adopted is made on the basis of network performance indicators (the percentages of good rankings and the learning and test errors). these models have to meet the following conditions: discriminate between the solvent banks and insolvent banks and predict the insolvency of banks. for the construction of our final neural model, we used the matlab 7.11.0 software. we have first of all proceeded to a ventilation of the initial sample. indeed, the sample established by 144 (18 banks * 8 years) observations is shared in three sub-samples: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 221 • the first sub-sample, called "training data ", is going to serve in the learning phase (or of adaptation of the weights) and represents 70 % of the total sample (100 observations). • the second sub-sample, called "validation data ", represents 15 % of the total sample (22 observations). it is used to measure the capacity of generalization of networks and to stop the procedure of learning when this capacity stops improving. • the third sub-sample which is going to represent the basis of the test contains 15 % of the total sample (22 observations). it has no effect on the procedure of learning, but it supplies an independent measure of the network performance during and after the learning. then, we have proceeded to the apprenticeship of a large number of networks to a single hidden layer to find the optimal architecture by varying the number of neuron on this layer. in fact, we have adopted the procedure of yao, tan and poh (1999). this is an iterative method which consists in gradually increasing the number of hidden neurons of a unit until we find a minimal mse (essid, zribi & boujelbene, 2009). the following table presents the value of the mse calculated at the level of 3 sub-samples for various numbers of hidden neurons. table 4. the value mse for certain architectures mse value number of hidden neurons training data validation data testing data 2 0.0545 0.0301 0.0682 3 0.0615 0.121 0.138 4 0.0992 0.123 0.260 5 0.155 0.185 0.173 6 0.130 0.190 0.136 7 0.142 0.179 0.161 according to the results which appear in the previous table, we notice that a neural network with two neurons presents the minimum of mse and this at the level of three samples (0.0545 for the training data, 0.0301 for the training data and 0.0682 for the testing data). then, the configuration of the adopted network is presented in the following figure. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 222 figure 3. the configuration of the adopted network our network is composed by seven neurons on the entry layer, represented by the values of the seven selected financial ratios, two neurons on the hidden layer and one neuron on the exit layer) which produces the ranking result. the test is a very important stage in the determination of a network performance. so, we have fed our network with the matrix of the testing data (t) to obtain an exit vector, a single column and 144 lines which we have compared with the real values (r5). thus, we have proceeded to the calculation of the rate of good ranking, by bringing the number of well classified observations to the total number of observations. the following table presents the obtained results. table 5. the calculation of the rate of good ranking real situation adjusted situation details according to the state of solvency global results 1 0 samples a v t a v t a v t total 1 64 11 16 0 1 0 64 12 16 92 0 6 0 2 30 10 4 36 10 6 52 total real situation 70 11 18 30 11 4 100 22 22 144 percentage of good ranking 91.43 100 88.89 100 90.91 100 94 95.45 90.91 93.75 percentage of good global ranking 91.91% 97.77% 93.75% a: training data v: validation data t: testing data this table shows that the rate of good global ranking of the solvent banks is 91.91 % and the rate of good ranking) of the insolvent banks is 97.77 %. so, the percentage of good total ranking stemming from the application of the neural networks is 93.75 %. this implies that the considered model manages to learn the patterns corresponding financial fragility of the tunisian banks included in the sample. the mlp neural network constitutes a powerful tool in the ranking of banks according to their degree of performance. likewise, the results show a big capacity of the model in recognizing the level of fragility of certain banks which have not been taken into account during the apprenticeship (belonging to the test sample). indeed, the rate of good ranking at the level of the test sample reached 90.91 %. we note that there is a total recognition of the unsuccessful banks. their rate of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 223 good ranking in the test sample is 100 %. however, it is 88.89 % for the successful banks. the results of the application of the methodology of the mlp artificial neural networks to predict the banking insolvency based on the selected financial ratios have showed a very good disposal of this technique in the construction of a model for the premature detection of the banking difficulties and the supervision of their solvency in tunisia. 4.2 the performances of the tunisian banks to draw finer conclusions, we propose table 6 which presents the descriptive statistics of all the ratios used for each type of bank (solvent and insolvent). table 6. descriptive statistics of all the ratios in % solvent banks (99 observations) ratios mean standard deviation max min r1 91.560 4.791 99.964 75.776 r2 248.783 309.287 1534.826 101.285 r3 79.567 9.029 94.225 37.115 r4 101.774 24.694 209.621 41.128 r5 18.993 13.644 60.401 8.021 r6 59.568 21.744 100.000 8.924 r7 -0.497 8.433 3.865 -75.196 r8 -1.195 46.832 17.624 -429.050 insolvent banks (45 observations) ratios mean standard deviation max min r1 96.119 2.977 99.972 86.843 r2 139.158 207.964 1502.175 95.612 r3 82.703 9.363 95.665 56.476 r4 87.916 9.830 103.335 59.936 r5 5.918 2.201 7.996 -1.098 r6 59.873 40.264 100.000 -148.730 r7 -0.128 2.093 1.436 -10.351 r8 21.508 143.259 942.262 -176.480 this table highlights that there is a disparity between 18 tunisian banks of our sample during the period 2002-2009 regarding banking solvency. it allows to have an idea about the various "banks-years" of each category (solvent and insolvent). we notice that the aggravating factors of risk are more present, on average, in the failing banks. these banks have less capital in the total of their assets (low r5), more loans in their balance sheets (high r3) and fewer liquid assets with regard to the total assets (r1) and with asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 224 regard to the short-term debts (r2). on the other hand, the ratio of capital which covers their long-term credits (r6) is equivalent to that of successful banks, while the ratio of intermediation for healthy banks is more important than that of the failing banks (r4). the obtained results have allowed us to make a ranking of banks considered in our application. this ranking is based on, s, the number of times a bank shows itself solvent, and this over the 8 years of our study period. table 7 shows the category of each bank for every year included in the period of study. by considering all these characteristics, we have been able to establish the ranking of the banks belonging to the sample of study according to a decreasing degree. a first examination of this ranking for the period 2002-2009 shows that the banks which occupy the first rank are the most successful banks. according to the criterion r5, we find at the bottom of the ranking the bft (insolvent bank over the whole study period) and to a lesser extent the abc and attijari. all these banks are small in size and are not quoted on the stock exchange of tunis. they can go bankrupt if the supervision authorities do not take urgent restructuring measures. table 7. the rankings of the tunisian banks (2002-2009) according to the capitalization ratio r5 according to the mlp exit rank banks s rank banks s 1 stb 8 1 stb 8 bt 8 bt 8 bte 8 bte 8 btl 8 btl 8 btk 8 btk 8 ab 8 ab 8 ubci 8 ubci 8 tqb 8 2 tqb 7 2 bts 7 3 bna 6 3 bna 6 4 atb 5 4 atb 5 5 biat 4 5 biat 4 citibank 4 citibank 4 6 uib 3 6 uib 3 bh 3 7 bh 2 7 attijari bank 2 attijari bank 2 abc 2 abc 2 8 bts 0 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 225 8 bft 0 bft 0 for a better characterization of the ranking of banks according to the capitalization ratio r5, we propose the following illustration. banks s 2002 2003 2004 2005 2006 2007 2008 2009 stb 8 bt 8 bte 8 btl 8 btk 8 ab 8 ubci 8 tqb 8 bts 7 bna 6 atb 5 biat 4 citibank 4 uib 3 bh 2 attijari bank 2 abc 2 bft 0 solvent insolvent this illustration shows the predominance of the grey color in the matrix, which implies that the tunisian banking sector is globally solvent. however, the black color_ implying banking fragility_ is relatively important over the periods 2002-2003 and 2007-2009. during these two periods, the majority of banking institutions witnessed a degradation in their results. consequently, they carried out considerable efforts to strengthen their stockholders' equity to restore their financial balance. taken as a whole, these consolidation efforts resulted in slight improvement of the sectoral mean cooke ratio which changed from 12.2 % in 2008 to 12.51 % in 2009, thus respecting the 8 % standard [see table 8]. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 226 table 8. the ratio cooke (in %) 2008 2009 ab 12.6 13.1 atb 11.0 14.3 attijari bank 6.8 9.2 biat 13.7 11.9 bh 10.4 10.2 bna 8.2 11.4 bt 22.1 21.8 stb 9.3 9.0 ubci 10.95 10.51 uib 8.6 9.2 sectoral mean 12.2 12.51 source: maxula bourse (2010) all the banks have to respect this minimum rate to avoid the effect of contagion of the financial instability to the whole system in the case of a possible insolvency of one of them. in the same way, the cover rate of the bad debts by the sector passed from 46 % in 2005 to 58 % in 2009 (maxula bourse, 2010). besides, the stb (one of the biggest public banks in tunisia) is considered _according to our ranking_ among the group of the healthy banks over the whole study period though it is relatively undercapitalized (cooke ratio near 9%) in comparison with the atb and especially to the bt which have a cooke ratio higher than 20 %. the latter show a solidity allowing them a potential credit granting capacity much superior to that of their competitors. contrary to the bt which remains characterized by the lowest rate of bad debts of the sector (8 %) and associated with the highest rate of funding (about 83 %), the stb and the uib still suffer from the weight of the bad debts from the weakness of their cover with regard to the sector average. the stb, for example, had about 20 % of bad debts in 2009 but they were covered only at the level of 49.7 %. the low quality of the assets of the stb dates back, partially, to its merger with the economic development bank of tunisia (edbt) and the national bank of tourism development (nbtd) in 2000. in 2009, the yield on its assets was only 0.3 % while the subsidiary of attijari bank in tunisia reached 1.2 %. besides, it specialized in financing the tourism sector, which has largely weakened due to a bad situation. in spite of the massive transfers of the bad debts to its covering subsidiary, the stb still suffers from its active contribution in financing the tourism sector considered to be having priority by the public authorities. the part of bad debts accumulated from the tourism sector remains the most asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 227 important reaching 49.5 %. besides, the stb still has a low rate of cover (49.7 %), lower than the sectoral average (58.78 %,). the table below summarizes the position of the stb with regard to the other public banks. table 9. the rate of bad debts and the rate of cover of the public banks (2009) rate of bad debts rate of cover bh 8.9% 70% bna 11.9% 68.6% stb 19.8% 49.7% sectoral mean 13.96% 58.78% source: maxula bourse (2010) the results obtained in our rankings (according to the ratio r5 or according to the mlp exit as well) could be explained by the fact that r5 ratio, used as a discriminating variable, is an imperfect approximation of the cooke ratio. indeed, the r5 ratio constitutes a simple measure of the weight of the bank’s capital. it determines the allocation of the bank’s sources of funding into debts and stockholders’ equity. it gives no information about the quality of the assets held by the bank. on the other hand, the cooke ratio is a ratio of risk cover. it is defined as being the ratio of the stockholders' equity of a bank over its assets balanced by the risks. it is an indicator which allows to estimate the extent to which point the banking system is threatened by the credit risks and the quality of the held claims. we indeed notice why the r5 ratio does not establish a good approximation of the cooke ratio. it ensues from this that its use did not allow to characterize the stb vulnerability our ranking. finally, we find in this ranking the bft which occupies the last position. the vulnerability of this bank is explained by the bad practices which created a volume of bad debts 17.5 times as important as its capital. consequently, its indicators of profitability did not stop degrading: its banking net product (bnp) has constantly decreased passing from 11. 4 million tunisian dinars in 2007 to 8.318 million tunisian dinars in 2008 (a 27% reduction), to finish with another decrease of 13 % in 2009. this disastrous situation also represents the main threat for the future of the stb bank which holds 78.18 % of its capital. the bft will probably be the first bank to go bankrupt of a bank in tunisia, but it is very likely that the monetary authorities will come to its rescue taking into account the predictable affects on all the other tunisian banking institutions. 5. conclusion within the framework of this study, we have proposed a model of premature detection of the banking difficulties in tunisia. this model aims at identifying the institutions whose financial asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 228 situation seems worrisome on the one hand, and on the other hand allowing the supervision authorities to take the necessary corrective measures for banks in trouble before their situation worsens and results in bankruptcy. for that purpose, we have tested the validity of the technique of the neural networks of neurons in the construction of a model of premature detection of the banking insolvencies in tunisia. although the artificial neural networks seem well adapted to the problems of forecast of the financial distress and failure, they have certain limitations. indeed, there is no theory allowing to build neural networks. as numerous parameters are involved in construction of networks, we do know how to examine them very well. a judicious choice of the parameters depends on the intuition and the experience which researcher has during the model construction process. the results obtained_ by the application of the methodology of neural networks to predict the banking fragility based on 8 financial ratios for a sample of 18 tunisian banks examined over the period 2002-2009_ showed a very good disposition of the neural networks in the construction of a model of premature detection of the banking difficulties and the supervision of their solvency in tunisia. indeed, the percentage of a good ranking by multilayer neural networks the total sample was superior to 93 %. then the neural networks turn out to be a strong as method for the purpose of prediction. although these results seem to be interesting from in terms of classification of the tunisian banks, they must be considered subject to the reliability of the published financial statements, especially the question of bad debts. besides, it would be interesting to take into account the nature and the quality of the institutional, legal and statutory environment in which the tunisian banks operate and that are crucial for the banks’ risk-taking. so, a system of premature detection alarm of banking difficulties including camel financial variables and institutional, legal and statutory variables could represent a more efficient tool to identify the institutions having financial difficulties, especially in emergent nations. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 229 appendix 18 tunisian banks of the sample ab amen bank abc arab banking corporation atb arab tunisian bank attijari bank attijari bank of tunisia (attijari bank) biat arab international bank of tunisia bft franco-tunisian bank bh bank of housing bna national agricultural bank bt bank of tunisia bte tunisia and emirates bank btk tuniso-kuwaiti bank btl tuniso-libyan bank bts tunisian solidarity bank citibank citibank (onshore branch) stb tunisian banking company tqb tunisian qatari bank ubci banking union for trade and industry uib international banking union references abdennour, f., & houhou, s. 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(1999). neural networks for technical analysis: a study on klci, international journal of theoretical and applied finance, 2(2), http://dx.doi.org/10.1142/s0219024999000145 microsoft word impact-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 1 impact of corporate governance on social and environmental information disclosure of malaysian listed banks: panel data analysis sheila nu nu htay (corresponding author) iium institute of islamic banking and finance international islamic university malaysia 205 a, jalan damansara, damansara heights, 50480 kuala lumpur, malaysia tel: 60-3-2082-2812 e-mail: sheila@iium.edu.my hafiz majdi ab. rashid department of accounting, kulliyah of economics and management sciences international islamic university malaysia p.o. box 10, 50728 kuala lumpur, malaysia tel: 60-3-6196-4699 e-mail: arhafiz@iium.edu.my mohamad akhyar adnan faculty of economics, universitas muhammadiyah yogyakarta jl. lingkar selatan, kasihan bantul diy 55183 e-mail: adnan@umy.ac.id ahamed kameel mydin meera department of finance, kulliyah of economics and sciences international islamic university malaysia p.o. box 10, 50728 kuala lumpur, malaysia tel: 60-36196-4754 e-mail: akameel@iium.edu.my received: july 24, 2011 accepted: november 28, 2011 published: june 1, 2012 doi:10.5296/ajfa.v4i1.810 url: http://dx.doi.org/10.5296/ajfa.v4i1.810 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 2 abstract this study investigates the impact of corporate governance on social and environmental information disclosure of malaysian listed banks by using a panel data analysis. the proxies for good corporate governance are board leadership structure, board composition, board size, director ownership, institutional ownership and block ownership. social and environmental information disclosure index is developed and content analysis is conducted by cross checking between the social and environmental information disclosed in the annual reports and the disclosure index developed by the researcher. the disclosure score used in this study is weighted disclosure score after considering the opinions of accountants and financial analysts who represent preparers and users of the accounting information respectively. the findings show that smaller board size, higher percentage of independent directors (1%) on the board, higher board size (1%), higher percentage of director ownership, lower institutional and lower block ownership (5%) have higher information disclosure. keywords: social and environmental reporting, bank, corporate governance, generalized least square, panel data, agency theory, malaysia asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 3 1. introduction importance of corporate governance has been highlighted over the world nowadays and it has accused as one of the main causes of crisis. agency theory and many corporate guidelines suggest having a good corporate governance system for more transparent disclosing information about the corporation. in addition, corporate governance of banks seems to be more important than other industries because the banking sector plays a crucial financial intermediary role in any economy. poor corporate governance of the banks can drive the market to lose confidence in the ability of a bank to properly manage its assets and liabilities, including deposits, which could in turn trigger a liquidity crisis and then it might lead to economic crisis in a country and pose a systemic risk to the society at large (garcia-marco and robles-fernandez, 2008). therefore, it is interested to examine the importance of corporate governance mechanisms in the banking sector. information disclosure is an important and efficient means of protecting shareholders and is at the heart of corporate governance. it is also integral to corporate governance, i.e. an important element of corporate governance, since higher disclosure could be able to reduce the information asymmetry, to clarify the conflict of interests between the shareholders and the management, and to make corporate insiders accountable. among the different types of information disclosed in the annual reports, disclosure on social and environmental information is focused in this study because corporate governance guidelines extends the responsibilities of the board of directors from the shareholders to wider aspect, i.e. stakeholders. moreover, taking care of society and environment is essential for the long-term sustainability of the firms and corporate social and environmental reporting becomes an important issue nowadays (pramanik et al., 2008). cortez and penacerrada (2010) mention that protecting the society and environment is part of the corporate social responsibility of the corporation and it should be responsible for environmental crisis if it damages the environment. baxi and ray (2009), farid et al. (2009), and uwalomwa and uadiale (2011) also state that corporate social and environmental reporting has received attention in recent years as a part of sustainable development process across the world and it becomes very interesting issue for practice and academic area. they further state that the introducing of global reporting initiative in year 2000 has proposed certain guidelines to social, environmental and financial reporting that many companies can follow as guidelines. however, the social and environmental reporting is still voluntary reporting in most of the developing countries, including malaysia because they do not have strong policy on social and environmental reporting (ionescu, 2010). the boards should also consider the interests of the stakeholders and their responsibility should be extended beyond shareholders (kolk & pinkse, 2010). according to sharifah et al. (2008), in malaysian context, there are limited studies on the association between corporate governance variables and corporate social reporting except haniffa and cooke (2002) and sharifah et al. (2008). these above stated authors did not focus on financial sector and this study fills up the gap by examining the impact of corporate governance on social and environmental reporting in the financial sector. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 4 it could be summed that the governance seems to be a heart of the corporation, especially in the banking sector and to have an influential power on information disclosure of the annual reports. hence, the aim of this paper is to investigate the impact of corporate governance on the social and environmental information disclosure of the banks. 2. theoretical framework and empirical studies according to jensen and meckling (1976), the separation of ownership and control can incur agency cost. one of the best ways to reduce this cost is implementing the good corporate governance (judge et al., 2003) since it promotes goal congruence among principals and agents (conyon and schwalbach, 2000). cheung and chan (2004) also describe that information disclosure is one of the tool to monitor the management and it can be used as tool to reduce the cost of capital. 2.1 agency theory and separate leadership structure based on this theory, a clear separation of the responsibilities of the ceo and the chairman of the board and seems to prefer to have separate leadership structure (jensen and meckling, 1976; fama and jensen, 1983; jensen, 1993). the combined leadership structure promotes ceo entrenchment by reducing board monitoring effectiveness (florackis and ozkan, 2004). board independence attained by separate leadership is necessary to give pressure on the management in disclosing the more material information about the company, which is in line with the interest of the shareholders. hence, it could be assumed that the separate leadership structure will lead to better social and environmental disclosure about the companies. the findings of ho and wong (2001), gul and leung (2004), lakhal (2005), byard, li and weintrop (2006) and huafang and jianguo (2007) are in line with theoretical expectation. this means that there is a positive relationship between separate leadership structure and disclosure. however, norita and shamsul nahar (2004) find that separate leadership structure is not associated with voluntary disclosure. 2.2 agency theory and board composition board composition is very important to monitor the managers effectively and reduce the agency cost (choe and lee, 2003). although the executive directors have specialized skills, expertise and valuable knowledge of the firms’ operating policies and day-to-day activities, there is a need for the independent directors to contribute the fresh ideas, independence, objectivity and expertise gained from their own fields (cho and kim, 2003). hence, the agency theory recommends the involvement of independent non-executive directors to monitor any self-interested actions by managers and to minimize agency costs (florackis and ozkan, 2004; williams et al., 2006). in addition, it can be derived from the agency theory that higher proportion of the independent non-executive directors on the board will be result in higher disclosure of the material aspects of the company in order to increase the transparency since independent boards will be able to encourage the management to disclose more information. the findings of chen and jaggi (2000), gul and leung (2004), byard et al. (2006), and cheng and courtenay (2006) and norita and shamsul nahar (2004.) are in line with theoretical expectation. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 5 2.3 agency theory and board size boards with more than seven or eight members are unlikely to be effective (jensen and ruback, 1983; florackis and ozkan, 2004). they further elaborate that larger boards result in less effective coordination, communication, and decision-making, and are more likely controlled by the ceo. yoshikawa and phan (2003) also highlight that larger boards tend to be less cohesive and more difficult to coordinate because there might be a large number of potential interactions and conflicts among the group members and sometimes, larger boards are purposely created by ceos to disperse the power in the boardroom and reduce the potential for coordinated action by directors, leaving the ceo as the predominant figure. in sum, smaller boards seem to be more conducive to board member participation and thus would result in a positive impact on the monitoring function and the decision-making capability of the board, and independence from the management (huther, 1997). it is expected that smaller board size should be able to monitor the decision of the management related to the information disclosure. this expectation is supported by the findings of byard et al. (2006). they study 1279 firms over the years 2000 to 2002 and find that financial disclosure related to forecast information decreases with board size. however, the findings of lakhal (2005) show that there is an insignificant and weak association between board size and disclosure. 2.4 agency theory and ownership in this study, ownership is looked at from three different perspectives; (a) director ownership, (b) block ownership, and (c) institutional ownership. if directors own shares, the directors as the owners themselves are directly instructing and monitoring the management of the companies (jensen and meckling, 1976). hence, there are likely to be fewer agency problems as compared to the situation where the directors, who are not the owners, supervise the management of the company. it is also supported by seifert et al. (2005) who discuss agency conflicts. however, in the case of information disclosure, the effect of director ownership on disclosure might be different from that of the block holders and institutional investors. directors who have substantial amount of share ownership might not want to disclose the information to the outsiders because they can use their discretionary powers to spend firm resources in ways that serve their own interest at the expense of other shareholders and then they might want to conceal fraud and incompetence, if any. therefore, it could be expected that there is a negative relationship between director ownership and disclosure. theoretical expectation seems to be supported by chau and gray (2002), eng and mak (2003), and leung and horwitz (2004). huafang and jianguo (2007) find that there is no relationship between them. on the contrary, ballesta and garcia-meca (2005) find that higher director ownership provides higher quality of financial reporting. in addition, norita and shamsul nahar (2004) find that executive director ownership has a positive influence to voluntary disclosure level. the reason provided by ballesta and garcia-meca (2005) is that when managers are also the owners, they act in the interest of the firms and thus result in financial statements that are less likely to attract audit qualification. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 6 with regard to block ownership, david and kochhar (1996) and kim and lee (2003) state that if an individual has a substantial amount of interest in a particular company (usually measured at 5%), he or she will be more interested in the company and hence the block holders is an important player to have higher disclosure since they have the voting power that could be used as a tool to monitor the agents. from the agency theory, it could be inferred that block holders have the interests in the firms; most likely they might put the pressure on the management to disclose all the material information. therefore, it could be expected that there is a positive relationship between block holders and disclosure. chau and gray (2002), luo, courtenay and hossain (2006)1, huafang and jianguo (2007) and norita and shamsul nahar (2004) find that extent of outside block ownership is positively associated with voluntary disclosures and hence their finding is in line with theoretical expectation. however, eng and mak (2003) find that block holder ownership is not related to disclosure. the finding of lakhal (2005) seems not to be in line with theoretical expectation. finally, regarding institutional investors, salleh and mallin (2002), le et al. (2006), langnan, steven and weibin (2007) and ramzi (2008) collectively agree on the important role of institutional shareholders in the monitoring of firms because of the voting power, the potential benefits from their activism, the existence of lesser ability to liquidate the shares without affecting the share price, the fiduciary responsibility towards the ultimate owners, and ability to monitor executives since they are professionals. institutional ownership seems to be an important player to have higher disclosure since their voting power can be used as a tool to monitor the agents (david and kochhar, 1996). therefore, it could be expected that there is a positive relationship between institutional investors and disclosure. the findings of eng and mak (2003), and lakhal (2005) are in line with theoretical expectation. whereby, eng and mak (2003) use government ownership as a proxy for institutional shareholder and lakhal (2005) use the foreign institutional investor's ownership as the proxy. however, huafang and jianguo (2007) find that there is state ownership and legal ownership are not related to disclosure and hence they suggest that the chinese regulators should gradually encourage multi-ownership. 3. development of hypotheses and research design 3.1 development of hypotheses disclosing the material information of the firms reduces the information asymmetry between the management and the owners, and it will also reduce the agency conflicts between them. according to patel et al. (2002) and united nation (2003), disclosure is an integral part of the corporate governance because it shows the extent of how good corporate governance is. leong (2005) also mentions that disclosure and transparency are partners of good corporate governance. moreover, beekes and brown (2006) study 250 australian firms rated in the 2002 horwath corporate governance report and find that better-governed firms do make more informative disclosure. hence, the researcher is interested to examine whether corporate governance variables could affect the social and environmental information disclosure and the following hypotheses are developed. 1 the existence of outside block ownership significantly decreases managers’ ability to limit voluntary disclosure. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 7 3.1.1 board leadership structure there should be a control mechanism that could put pressure on the management to disclose the material information. one of the mechanisms, derived from the agency theory is board independence from the management (fama & jensen, 1983). corporate governance literature suggests that board independence could be achieved from separate leadership structure. this suggestion is also supported by empirical findings of prior researchers such as gul and leung (2004), lakhal (2005), byard et al. (2006) and huafang and jianguo (2007) since they find that there is a positive relationship between separate leadership structure and disclosure. therefore, it is expected that separate leadership structure results in higher social and environmental disclosure and the following hypothesis, in an alternative form, is developed. ha1: social and environmental disclosure is positively related to separate leadership structure. 3.1.2 board composition several researchers based on the agency theory highlight the importance of board independence. it has been well recognized by the corporate governance literature that higher proportion of independent non-executive directors makes the board independent from the management (choe & lee, 2003; yatim, kent & clarkson, 2006). furthermore, the findings of prior researchers are in line with the expectation of agency theory, for instance, chen and jaggi (2000), gul and leung (2004), byard et al. (2006), and cheng and courtenay (2006) and norita and shamsul nahar (2004). they find that higher proportion of independent directors has positive impact on disclosure. therefore, the researcher expects that higher proportion of independent non-executive directors will contribute to higher disclosure and the following hypothesis, in an alternative form, is developed. ha2: social and environmental disclosure is positively related to proportion of independent non-executive directors on the board. 3.1.3 board size as explained earlier, agency theory foresees the problems that could arise due to the separation of ownership and management. in order to reduce the problems between them, the board, as a middle person, should be independent from the management so that the board could be able to monitor the management effectively which is in line with the interest of the shareholders. several researchers such as mak and li (2001), yoshikawa and phan (2003), yatim et al. (2006) and khanchel (2007) collectively agree that in order for the board to be free from the management, especially from the ceo, and to effectively control the ceo, board size should be small due to difficulties in organizing and coordinating large group of directors. the finding of byard et al. (2006) is in line with theoretical expectation since their study of 1279 firms over the years 2000 to 2002 shows that analyst forecast accuracy based on the financial disclosure decreases with board size. therefore, it could be expected that smaller board size will result in better disclosure and the following hypothesis, in an alternative form, is developed. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 8 ha3: social and environmental disclosure is negatively related to board size. 3.1.4 ownership corporate governance literature highlights the important role of ownership on the disclosure. if the directors hold the shares, they might not want to disclose all the material information to the outsiders since they would like to channel the benefits of the firms for themselves, not to the outside shareholders and they might conceal some fraud transactions. hence, it could be expected that higher proportion of director ownership results in lower level of disclosure. the above expectation is supported by chau and gray (2002), eng and mak (2003), and leung and horwitz (2004) since they find that there is a negative relationship between director ownership and disclosure. therefore, the following hypothesis, in an alternative form, is developed. ha4: social and environmental disclosure is negatively related to director ownership. on the contrary, in the case of institutional and block ownership, they might put the pressure on the management to disclose all the material information. it is because disclosure is one of the best ways to find out whether the performance of the management meets their expectations, for example, in terms of profitability and risk management. from the agency theory, it also could be derived that since institutional shareholders and block holders have higher proportion of ownership interest, they might be more interested to monitor the firms for better disclosure in order for them to make the economic decisions as well as to discipline poorly performing management (kang & sorensen, 1999; kim & nofsinger, 2004; birt, bilson, smith and whaley, 2006). this theoretical expectation, i.e. higher institutional or block ownership has a positive impact on disclosure, is supported by the findings of eng and mak (2003), and lakhal (2005), whereby eng and mak (2003) use government ownership as a proxy for institutional shareholder and lakhal (2005) uses the foreign institutional investor's ownership as the proxy. in the case of block ownership, chau and gray (2002), luo et al. (2006), huafang and jianguo (2007) and norita and shamsul nahar (2004) find that extent of outside block ownership is positively associated with voluntary disclosures and hence their finding is in line with theoretical expectation. therefore, the following hypotheses, in an alternative form, are developed. they are: ha5: social and environmental disclosure is positively related to block ownership. ha6: social and environmental disclosure is positively related to institutional ownership. 3.2 research design 3.2.1 variables and empirical model dependent variable weighted social and environmental information disclosure score is used as a dependent variable and questionnaire (refer to appendix) is developed to obtain views on the importance of each disclosure item from financial analysts and accountants. before the actual questionnaire is sent, pilot test has been conducted and the findings show that alpha value is asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 9 0.94 and so it has been concluded that the questionnaire is reliable. in addition, pilot test results show that the overall mean score of comprehensiveness of the questionnaire is 4.05, understandability of the questions is 4.10 and understandability of the instruction is 4.62. therefore, it can be concluded that the pilot test questionnaire is good enough to be used as an actual questionnaire. list of social and environmental disclosure items and pilot test results can be referred to table 1 and table 2 respectively. table 1: list of social and environmental information disclosure share option schemes-policy (quantitative) share option schemes-policy (qualitative) profit sharing schemes-policy (quantitative) profit sharing schemes-policy (qualitative) amount spent on training policy on training welfare information recruitment policy charitable donations (quantitative) charitable donations (qualitative) community programs (quantitative) community programs (qualitative) environmental protection policy (quantitative) environmental protection policy (qualitative) effect on environment (quantitative) effect on environment qualitative) table 2. mean score for comprehensiveness and understandability of the questions and the instruction (pilot test) mean no. description accountants financial analysts overall 1 the questionnaire comprehensively covers the important disclosure items of the annual reports. 4.22 3.92 4.05 2 the contents of the questionnaire are easy and simple for the respondents to understand. 4.22 4.00 4.10 3 the instructions to answer the questionnaire are clear. 4.78 4.50 4.62 the annual reports of the sample companies are checked against disclosure index developed by the researcher. the researcher uses dichotomous score, i.e. one is given if the company asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 10 discloses the information, and zero for otherwise. since the annual reports are checked against the disclosure index to provide the disclosure score, during this process, some of the disclosures in the annual reports are not clear for the researcher to decide whether some parts of annual report disclosure represent the items from the disclosure index. hence, for these confusing items, questionnaire is constructed and sent to the ten accountants and six financial analysts in order to seek their opinions on whether these confusing disclosures in the annual reports represent the items in the disclosure check list. it is found out that there is no significant difference between the score provided by the researcher and the answers provided by the selected accountants and financial analysts. finally, the weight for each disclosure item is calculated by the mean score of each disclosure item provided by the accountants and financial analysts. independent variables there are six independent variables, which comprise of three structural measures of corporate governance (i.e. board leadership structure, board composition and board size) and three measures of ownership structure (i.e. director ownership, institutional ownership, and block ownership). finally, the empirical model of the study also includes two control variables related to firm-specific characteristics (i.e. firm size and leverage) because most of the prior researchers such as ho and wong (2005), chau and gray (2002), haniffa and cooke (2002), hyytinen and pajarinen (2005), eng and mak (2003), leung and horwitz (2004), ballesta and garcia-meca (2005), lakhal (2005), luo et al. (2006), huafang and jianguo (2007) and norita and shamsul nahar (2004) have used the above two variables as control variables in examining the relationship between corporate governance variables and disclosures. firm size is controlled because larger and more profitable firms tend to have higher disclosure because they are closely followed by financial intermediaries and need more comprehensive disclosure to minimize the political costs of noncompliance (aksu & kosedag, 2006). for instance, kee and pillay (2003) find that firm size is significantly associated with voluntary disclosure level. in addition, leverage is used as a control variable because in highly leveraged firms, there is a high demand for and supply of information required by the lenders (aksu & kosedag, 2006). according to the corporate governance literature, firm size is commonly measured by total assets and leverage is measured by the ratio of total debt to equity. the complete empirical model is as follow. yit= βo + β1 x1it+β2 x2it − β3 x3it − β4 x4it+β5 x5it + β6 x6it + β7 x7it + β8 x8it + µit where, i = 1,2,3,4,5,6,7,8,9,10,11,12 t=1, 2, 3, 4, 5,6,7,8,9,10 y= weighted social and environmental information disclosure score x1= board leadership structure (bls) x2= proportion of independent non-executive directors on the board (ine_bz) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 11 x3= board size (bz) x4= proportion of director ownership (down) x5= proportion of institutional ownership (iown) x6= proportion of block ownership (bown) x7= log of total assets (ta) x8= leverage (td_te) µ= error term 3.2.2 sample selection and statistical methods samples include the twelve listed companies whose main activity is banking from 1996 until 2005. the total number of observations is 120 observations. however, some of the observations need to be dropped due to unavailability of data and some companies were not classified as banks in all the ten years’ period. it left the final observations to 108 observations. there were significant events incurred during the 10-years span of the sample period. first, the introduction of mccg (2007) promotes better transparency of information disclosure. secondly, the financial crisis incurred towards the end of the 1990s. thirdly, csr framework is introduced by bursa malaysia in 2006 and this framework lays down regulation on disclosure of social and environment information. therefore, the period before 2006 will be better in capturing the nature of purely voluntary environment for social and environmental disclosure. data were collected either from the annual reports of the companies or from bloomberg. the main statistical method used in this study is panel data analysis (generalized least square method). generalized least square method is used because the sample data are not normally distributed and the data have, either, heteroskedasticity problem, autocorrelation problem or both. according to gujarati (2003), using generalized least square method will overcome all these problems. 4. profile of the respondents the background information about the respondents includes gender, educational background, employment category, age and working experience of the respondents (refer to table 3). overall, both male and female respondents seem to be equally distributed since forty nine percent of the respondents are male and fifty one percent of them are female. regarding educational background, the majority of them are bachelor degree holders, and the balances are professional certificate holders. since fifty seven percent of the respondents are from the audit firms and forty three percent of them are from the non-audit firms, the opinion seems not to be too much influenced by one particular group although majority of the respondents are accountants. the age range of the majority is between twenty and twenty-nine, followed by the age range between thirty and thirty-nine. in terms of working experience, majority of the respondents, i.e. forty three percent, are below three years in the current profession and twenty three percent of them have working experience between three to seven years. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 12 table 3. profile of respondents accountants financial analysts overall frequency percentage frequency percentage frequency percentage gender male 52 39.69 37.00 72.55 89.00 48.90 female 79 60.31 14.00 27.45 93.00 51.10 total 131 100.00 51.00 100.00 182.00 100.00 educational background bachelor degree 74 56.92 25.00 50.00 99.00 55.00 master 6 4.62 19.00 38.00 25.00 13.89 ph.d 1.00 2.00 1.00 0.56 professional qualification (acca, cima, cfa, etc) 50 38.46 5.00 10.00 55.00 30.56 total 130 100.00 50.00 100.00 180.00 100.00 employment category audit firm 103 78.63 1.00 1.96 104.00 57.14 non-audit firm 28 21.37 50.00 98.04 78.00 42.86 total 131 100.00 51.00 100.00 182.00 100.00 age range below 20 20 – 29 63 48.09 11.00 21.57 74.00 40.66 30-39 35 26.72 22.00 43.14 57.00 31.32 40-49 27 20.61 14.00 27.45 41.00 22.53 50-59 4 3.05 4.00 7.84 8.00 4.40 60 and above 2 1.53 2.00 1.10 total 131 100.00 51.00 100.00 182.00 100.00 working experience with current profession below 3 years 63.00 48.09 15.00 29.41 78.00 42.86 3 – 7 29.00 22.14 13.00 25.49 42.00 23.08 8 – 12 16.00 12.21 10.00 19.61 26.00 14.29 13 – 17 15.00 11.45 7.00 13.73 22.00 12.09 18 – 22 2.00 1.53 3.00 5.88 5.00 2.75 23 – 27 2.00 1.53 3.00 5.88 5.00 2.75 above 27 4.00 3.05 4.00 2.20 total 131.00 100.00 51.00 100.00 182.00 100.00 additional information masters 1.00 1.96 1.00 0.55 professional qualifications (acca, cima, cfa, etc) 15.00 11.45 7.00 13.73 22.00 12.09 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 13 5. response rate and reliability test results for accountants, total of three hundred and twenty seven questionnaires (i.e. two hundred sixty nine questionnaires to audit firms and fifty eight questionnaires to commercial firms) are distributed to fifty-two audit firms and fourteen commercial firms. the questionnaires are distributed and collected either by hand or mail. out of three hundred and twenty seven questionnaires dispatched one hundred and thirty one accountants response and hence the response rate is forty percent. in the case of financial analysts, eighty-three questionnaires are sent to eighteen equity broker companies. all the questionnaires are sent by hand. only fifty-one financial analysts respond to the questionnaires. hence the response rate is sixty three percent. of the fifty-one respondents, forty-three questionnaires are collected by hand. due to late responses, envelopes are left for the financial analysts to reply through mail. later on, one questionnaire is collected by hand, six questionnaires are received by mail, and one is received through e-mail. the weighted social and environmental information disclosure score used in this study is based on the opinions of one hundred and thirty one accountants and fifty-one financial analysts. there is no non-response bias from the questionnaire received from the accountants and financial analysts based on t statistics and mann-whitney u test (refer to table 4). the reliability test results show that the alpha value is 0.89 and so the weighted social and environmental disclosure score used in this study is reliable. table 4. reliability test results: actual respondents alpha accountants financial analysts overall disclosure on social, environmental and value added information 0.88 0.90 0.89 6. discussion on the results based on the descriptive statistics results (refer to table 5), board leadership structure with mean value (0.81) shows that a majority of the companies have separate leadership structure although the minimum value (zero) shows that there are companies, which have combined leadership structure. similar to the recommendation of the mccg (2001), the sample mean value (0.36) shows that ratio of independent directors is slightly more than one third of the total number of the directors. the mean value (8.23) of board size shows existence of a quite a reasonable board size, e.g. jensen and ruback (1983) suggest that a board size of not more than 7 or 8 members is considered reasonable in ensuring effectiveness. for ownership, the mean values of director ownership and institutional ownership are 0.02 and 0.17 respectively. the ownership of shares by directors can be considered very low where, on average, only 2 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 14 percent of shares owned by the directors. on the other hand, institutional investors, on average, owned 17 percent of shares, which could still be considered low although it is significantly higher than the ownership by the directors. in the case of block ownership, its mean value (0.53) shows that large shareholders own the significant portion of the shares. the mean value of weighted social and environmental disclosure score is 176.23. as for the firm-specific characteristics, the sample companies have the means values of rm45992.19 millions for total assets and 344.73 for the ratio of total debt to total equity. in addition, table 6 shows the correlation among the independent variables. table 5. descriptive statistics: independent, dependent and control variables mean std. dev. min median max skewness kurtosis independent variables cg variables bls 0.81 0.40 0.00 1.00 1.00 -1.57 0.46 ine_bz 0.36 0.18 0.10 0.33 0.83 0.68 -0.49 bz 8.23 2.34 4.00 8.00 14.00 0.33 -0.62 (b) ownership variables down 0.02 0.05 0.00 0.00 0.25 3.26 10.40 iown 0.17 0.18 0.00 0.09 0.64 1.00 -0.53 bown 0.53 0.21 0.00 0.58 1.00 -0.81 0.04 dependent variable weighted social and environmental disclosure score 176.23 61.67 78.93 182.23 297.65 0.12 -0.80 control variables ta 45992.19 40245.92 1120.36 33326.95 191895.30 1.54 2.28 td_te 344.73 331.14 14.03 223.80 1442.26 1.60 1.89 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 15 table 6. correlation between variables bls ine_bz bz down iown bown ta td_te gdp rate dum_ crisis2 bls 1.00 ine_bz 0.12 1.00 bz -0.39 -0.20 1.00 down -0.42 -0.12 0.41 1.00 iown -0.05 -0.26 -0.03 -0.10 1.00 bown -0.08 -0.36 -0.02 0.12 0.34 1.00 ta -0.04 0.11 0.43 -0.08 -0.03 -0.05 1.00 td_te -0.37 -0.26 0.02 -0.02 0.15 0.14 0.32 1.00 gdp rate -0.01 0.12 -0.10 -0.08 -0.01 -0.06 0.04 0.01 1.00 dum_crisis -0.07 -0.18 -0.07 0.14 -0.14 0.17 -0.15 -0.03 -0.24 1.00 note: the figures provided above are the correlation coefficients and none are significant at 5% level. the following table 7 shows the results on disclosure of social and environmental information. ine_bz (at 5% sig. level), down and iown are in line with hypothesis while bls, bz (at 1% sig. level), and bown (at 1% sig. level) are not in line with hypothesis. thus, it can be concluded that higher ine_bz, larger bz, lower bown have higher social and environmental information disclosure. regarding the social and environmental disclosure, the reasons for the rest of the variables not being in line with hypothesis might be (a) the information disclosure on social and environmental information seems to be new compared to the traditional financial information and (b) measuring the level of disclosure quality of social and environmental matters is subjective. 2 dum_crisis refers to economic crisis dummy. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 16 table 7. gls results of social and environmental information disclosure coefficient z_value p value independent variables bls -1.26 -0.72 0.47 ine_bz 4.11 2.1** 0.04 bz 0.70 3.79* 0.00 down -3.94 -0.41 0.68 iown 0.10 0.04 0.97 bown -7.26 -3.99* 0.00 control variables lnta 3.15 6.15* 0.00 td_te 0.00 -2.62* 0.01 cons -24.89 -5.42* 0.00 chi-sq. 1274.26* p value 0.00 heteroskedastic lr chi2 49.12* (lr test) p value 0.00 autocorrelation f statistics 2.32 (wooldridge test) p value 0.16 * significant at 1% ** significant at 5% regarding board size, descriptively, the board size of the sample companies are relatively small compared to the average board size in uk and us. according to allen and gale (2001), in u.s. and u.k., the bz is around 10 to 15 people. furthermore, jensen (1993) in rashidah and fazilah (2006) mentions that the limit of board size is around eight directors as any greater number will interfere with group dynamics and inhibit board performance. coleman et al., (2007) highlight that a range of optimal board size of eight to eleven is feasible for good performance. the descriptive statistics results of this study show that on the average, the board size of the sample companies is around 8. based on the average board size of the sample companies, it could be summed that in general, the companies have the optimal board size and consequently, it becomes difficult to examine the significant and consistent impact of board size on the dependent variables. apart from that, according to the resource dependence theory, larger board size seems to be better since a large number of overall connections with organizations and directors outside the firm provide more sources of information for the director and a level of environmental awareness not readily available to the management (muth and donaldson, 1998). hence, in the malaysian context, the implication of resource dependence theory should be considered since the companies asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 17 involved in the banking sectors might need more directors due to the risky nature of business activities. regarding block ownership, the findings of lakhal (2005) and salim (2007) are similar with this research results. lakhal (2005) finds that there is a negative association between voluntary earnings disclosure and ownership concentration. it might be due to the following facts. first, on the average, 53 percentage of ownership belongs to the block ownership and hence, it seems that block ownership has substantial ownership interest which motivates them to monitor the management. however, since block holders may have the substantial voting power, they might choose family members or trust persons to be the board members in order to know about the financial performance of the banks, not social and environmental performance. hence, they have ensured the performance of the management and they might not be motivated to put pressure to disclose more information about the society and environment. the prior researchers such as ho and wong (2001), chau and gray (2002) and haniffa and cooke (2002) also find that the level of information disclosure is likely to be less in insider or family-controlled companies. secondly, since they have the controlling rights, they may be in a better position to expropriate company assets and exploit the interest of the minority (leng and shazaili, 2005; zulkarnain, 2007). due to that they might discourage the higher disclosure. finally, santema et al. (2005), talha, sallehhuddin and mohammad (2006) and lu et al. (2007) mention the disadvantage of information disclosure. according to santema et al. (2005), general disclosure costs consist of the cost of gathering, processing and auditing and disseminating the information, as well as possible litigation costs and cost that might create competitive disadvantage. talha et al. (2006) who study the segmental reporting practice in malaysia mention that the cost of disclosure includes competitor pressure, political pressure and customer pressure. lu et al. (2007) highlight that information disclosure may reduce shareholder value by revealing valuable information to competitors or by increasing legal costs for the firm even though they recognize the advantages of disclosure such as increase in institutional interest and liquidity of the firms and consequently there will be lower cost of capital and public relation benefits (santema et al., 2005). 7. conclusion, limitation and area for future research the findings of this research show that smaller board size, higher percentage of independent directors (1%) on the board, higher board size (1%), higher percentage of director ownership, lower institutional and lower block ownership (5%) have higher information disclosure. the first limitation of this study is due to small sample size since this study focuses on twelve companies whose main business activity is banking business and they are listed on bursa malaysia. second limitation is the exclusion of foreign banks due to the unavailability of the data. this study focuses on the main corporate governance variables, i.e. board leadership structure, board composition, board size and the ownership variables, i.e. director ownership, institutional ownership and block ownership. hence, future research might be extended by observing other corporate governance variables such as board meeting frequency, which represents board activeness and the independence of audit committee, which represents its effectiveness. this study focuses on the ownership of institutional ownership and block asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 18 ownership but does not distinguish among the different types of institutional ownership such as foreign, local, government and etc. hence, future research might consider it. references aksu, m. & kosedag, a. 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(2003). the performance implications of ownership-driven governance reform, european management journal, vol. 21 no.6, pp. 698-706. http://dx.doi.org/10.1016/j.emj.2003.09.013 zulkarnain, m.s. (2007, february). towards better corporate governance and transparency, paper presented at conference on managing knowledge in the borderless world, selangor, malaysia. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 24 appendix social and environmental disclosure items in the annual reports please give your opinion on how important you think the following items in the annual report are by circling or crossing the appropriate number. the objective is to obtain your opinion on the importance of these items in general, as some of the following items may not be appropriate to your company or organization specifically. no. description 1 employees’ general information qualitative information, e.g. share-option policy quantitative information, e.g. amount spent on training 1 1 2 2 3 3 4 4 5 5 2 community service qualitative information, e.g. community program quantitative information, e.g. charitable donation 1 1 2 2 3 3 4 4 5 5 3 environmental disclosure qualitative information, e.g. environmental protection policy quantitative information, e.g. effect on environment 1 1 2 2 3 3 4 4 5 5 microsoft word 744-3136-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 93 a study on industry superannuation in australia: risk disclosure and pre-global financial crisis diane kraal (phd) lecturer, department of business law and taxation monash university caulfield east, australia 3145 p. w.s. yapa (phd) (corresponding author) associate professor in accounting school of accounting, rmit university melbourne australia 3000 tel: 61-3-9925-1606 e-mail: prem.yapa@rmit.edu.au, received: june 25, 2011 accepted: october 27, 2011 published: june 1, 2012 doi:10.5296/ajfa.v4i1.744 url: http://dx.doi.org/10.5296/ajfa.v4i1.744 we would like to acknowldege participant comments on this paper that was presented as ‘an exploratory study on quantitative and qualitative disclosures by australian superannuation funds with accounting standard aasb 7’, 32nd annual congress of the european accounting association, tampere, finland, 23-25 may2009. we also wish to thank the respondents for their support in providing data for this study. abstract the purpose of this paper is to examine the extent to which the statutory accounts of industry superannuation funds reported risk in 2007, required by the new australian accounting standard aasb 7-financial instruments: disclosures. this study tests our selected methodologies to measure risk disclosure. the sample was randomly selected on the list of industry superannuation funds published by apra. in 2007, there were 74 industry superannuation funds. however, the detailed data published showed only the largest 58 industry super funds. our sample was 44 industry super funds and the response rate was 59 per cent. the findings indicated the trend of low levels of risk disclosure for 2007, the year asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 94 before the onset of the global financial crisis. the study is limited as the data was collected using email requests for published financial data. this paper should also be of interest to the professional community as it investigates primary financial data that is ‘tightly held’ by superannuation funds, that is, data that is not readily available on websites. this research will contribute toward determining if aasb 7 has improved the quality of financial data available to fund members and other interested external parties. keywords: australian industry super-funds, aasb 7, global financial crisis, risk disclosure. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 95 1. introduction in the wake of the global financial crisis (gfc) stakeholders have voiced concerns about the stability of superannuation funds in australia.1 superannuation can be described as monies invested during one’s productive working life to return as a lump sum or an income stream upon retirement. superannuation schemes have been available to select company employees since australia’s federation and later on to public servants. in the 1960s and 70s employer-sponsored superannuation was made available to ‘executive’ employees, a grouping which excluded most women. the enhanced reporting required by the new australian accounting standard aasb 7 financial instruments: disclosures is timely as it addresses the need for more information on risk. the superannuation industry in particular, has had a culture of conservatism in the area of disclosure. although superannuation has been reformed by the passage of the ‘simpler super’ legislation, the way in which billions of funds are invested or managed for millions of australians is still not widely understood.2 hence this paper on super fund risk disclosure should be of interest to external parties, who may have concerns about governance in this sector, and particularly to investors many of whom are attracted to superannuation because of the tax concessions. this paper is an exploratory study and aims to test our selected methodologies to measure risk disclosure. the intent is to examine the extent to which the statutory accounts of a sample of industry superannuation funds in 2007 disclosed data on risk. the data is analysed via a triangulation of methods: a ratings assessment; descriptive statistics where frequencies were determined about qualitative and quantitative risk disclosure; and finally via a content analysis of descriptions of risk mitigation. it was decided that our research would take the form of an exploratory study as a result of difficulties in gaining copies of full financial statements from a number of industry superannuation funds we first approached. the best option was to test our methodological techniques on a small sample of data. with the results of this research we intend to enlarge this sample by re-contacting super funds and once more request data on the basis that we can provide useful information to industry. it is therefore envisaged that the results of this research will be enlarged in the post-exploratory stage to form the first year of comparative information for a longitudinal study in the future. 1 an association of superannuation funds in australia survey notes that ‘a high 65 percent of respondents in total doubt the stability of super tax arrangements, with 36 percent indicating they believe tax arrangements will be quite different when they retire, and 29 percent believing they will be very different’. see: http://www.superannuation.asn.au/mr101108/default.aspx (accessed 23/11/10). a stakeholder may be: a consumer, employee, investor, researcher, a community group, government regulator, or simply an interested individual. 2 tax laws amendment (simplified superannuation) act 2007 and related legislation received royal assent on 15 march 2007. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 96 as a result of the gfc much more focus is being placed on issues such as going concern viability and how organisations will survive the downturn. nervous superannuation investors are also evaluating their investments more carefully. mike lynn, vice president for investor relations at woodside petroleum, says: ‘given the turmoil of recent times, we may see more companies paying greater attention to discussing their risks, their debt/funding situations and the outlook for their sectors...’3 ‘lynn believes the gfc has prompted investors to seek information that relates to the company’s ability to fund its work programs, its debt funding arrangements and its exposure to credit risk.4 although lynn’s words are directed to companies, his unease could equally be addressed to super funds. this paper should also be of interest to the professional community as it investigates primary financial data that is ‘tightly held’ by superannuation funds, that is, data that is not readily available on websites. it took many emails and follow up phone calls to gain copies of full statutory financial accounts for our sample of super funds. our research fills a gap by analysing and reporting this primary data. it is envisaged that our research will contribute toward determining if aasb 7 has improved the quality of financial data available to fund members and other interested external parties. as this study is limited to a sample of large industry super funds one of the outcomes of this research will be to flag the need to review and strengthen the standard of quantitative and qualitative reporting for superannuation funds in australia. the remainder of the paper is organised as follows. in section 2 the research question is explained. the literature review is provided in section 3. section 4 explains the methodology. industry superannuation sector information and an overview of aasb 7 is provided in section 5; the risk standards and processes are presented in section 6; followed by the analysis of super fund data in section 7; and finally a conclusion with comments on future research is provided in section 8. 2. research question our research question is to examine the extent to which the statutory accounts of a sample of industry superannuation funds reported risk in 2007, the year prior to the qualitative and quantitative risk disclosure requirements of the new australian accounting standard aasb 7 financial instruments: disclosures, issued pre-gfc.5 there has been a concern that the new standard aasb 7 will only receive ‘lip service’ to its requirements. a parallel concern arises from a recently published study on narrative reporting. the asb report (2009) set out to study how effectively companies communicate and found while the vast majority of companies are technically compliant with regulations, they still fall short of clearly explaining to stakeholders the what and how of sustainability efforts that fail to fulfil their 3 source: http://www.companydirectors.com.au/media/company+director/2009/august/feature+the+evolving +annual+report.htm accessed 10/2/10 4 ibid. 5 the effects of the gfc were felt from around august 2008. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 97 policy. the report conclusions were based on a random sample of 50 firms from the ‘ftse 350 and smallcap’. the investigators noted: a number of companies resorted to simply providing descriptions of generic risks that could be easily cut-and-pasted into many other ftse annual reports.6 our study is similar to that of the asb report for we set out to study how effectively super funds disclose financial risk. the aasb 7 standard applies to entities that are bound to prepare financial reports to enable stakeholders to evaluate the significance of an entity’s financial instruments; the nature and extent of risks arises from such instruments; and how an entity manages those risks. the standard affects annual reporting periods beginning on or after 1 january 2007. many reporting entities with a 30 june balance date have only been obliged to apply the aasb 7 standard to accounts from the 2008 financial year7. this paper uses 2007 statutory financial statements from a sample of 26 of the 74 industry superannuation funds’ as its primary data. all are market-linked funds (ie. none are defined-benefit funds). in the sample of industry superannuation funds for this paper, all (except one) have not adopted aasb 7 for their 2007 accounts as their balance date is 30 june8. the 2007 data will therefore form the first year of comparative information for use in determining the extent to which the sample funds from the industry superannuation sector comply with the qualitative and quantitative risk disclosure requirements of accounting standard aasb 7. 3. literature review various studies on superannuation industry in australia have examined the effects of financial disclosure (ang et. al., 1999; gallery and gallery, 2003, 2004, 2008; clare, 2007). some studies show the history of recent regulatory changes, guidance for revising accounting standards, and differences across the superannuation industry. for instance one study investigated the value relevance of superannuation disclosures required by aasb 1028 (ang, et al. 1999). here the researchers detailed three important findings: disclosed superannuation information is value relevant in the industry super sector, where these items tend to be material; secondly the market weights on the required disclosures are usually higher than those on recognized assets and liabilities; and thirdly, in contrast to the findings in similar us studies, accrued benefits do not have higher explanatory power relative to vested benefits. the outcomes from this type of disclosure investigation are now less relevant in the current climate of extreme market volatility. the concern by all stakeholders of adequate risk disclosure is the context of this study. more relevant to our current circumstances is the study by gallery and gallery (2006). they have argued that financial reporting of superannuation funds is a key governance mechanism, for it is through these reports that stakeholders are informed of a fund's prior investment 6 accounting standards board (2009) review of narrative reporting by uk listed companies in 2008/2009, 29 october, p.13. 7 the australian 2008 financial year commenced 1 july 2007 and ended 30 june 2008. 8 a second paper using 2008 and 2009 super fund financial data will be completed by the authors by the end of 2011, which is when the standard will have been mandatory for two years. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 98 performance, current financial and investment activities, and financial position at year end. the authors analysed the generally available reports of one large industry superannuation fund and concluded that there were three major accounting barriers to transparency. the specific disclosure failures were that the audited financial report was too highly aggregated; the annual report (located on the fund's website) was selective and too simplistic; and it was difficult to reconcile the audited financial report to the website annual report because the former focused on asset classes and the latter focused on investment pools. it should be noted that the gallery’s study considered the selected fund's 2004 accounts, which was before the issue of the new standard, aasb 7 financial instruments: disclosures. our paper continues to investigate the extent of financial disclosure but to a wider sample of 26 industry super funds. clare (2007) provided a summarised history of recent regulatory changes to the superannuation industry starting with the wallis committee report, the financial system inquiry final report 1997. clare stated the wallis report was framed around a strategic vision for a proposed regulatory regime, which centred on disclosure of information rather than prescriptive regulator intervention. at the time heavy-handed intervention was not popular with some inquiry members. (contrast the thinking in 2001 with the taxpayer bail-out of banks in the united states and europe in 2008.) of interest to our research is where clare cites the roberto rocha et. al (2007) study lists and describes superannuation risks including agency risk (where the interests of administrators of a fund diverge from the interests of fund members); systemic risk (a scenario of financial institution failure that threatens consumer confidence) and investment risk.9 the australian government (via the accounting standards board) is attempting to address investment risk through the issuing of the new accounting standard aasb 7. whilst clare lists and describes a range of risks identified by other researchers and points out how australian authorities have been forced to respond in the aftermath of corporate collapses such as hih insurance and one tel, he does not address the effectiveness of risk mitigation measures. as a first step in measuring the effectiveness of aasb 7 disclosure requirements, our study seeks to analyse risk disclosures in the 2007 statutory financial statements of the sample superannuation funds, the year prior to the standard being mandatory. as far as the authors are aware, no other study has been conducted to examine the disclosure of risk on industry superannuation in australia. the next section will address the methodology for our research. 9 see the ross clare (2007) citation of roberto rocha, richard hinz joaquin gutierrez, ‘improving the regulation and supervision of pension funds: are there lessons from the banking sector?” the world bank, washington d.c, 1999, p.6. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 99 4. methodology for the study the sample for our study was randomly selected by using excel’s ‘random sampler’ on the list of industry superannuation funds published by australian prudential regulation authority (apra).10 in 2007, there were 74 industry superannuation funds. however, the detailed data published showed only the largest 58 industry super funds (apra, 2008). our sample was 44 industry super funds (market-linked) of which 26 industry super funds responded (59% response rate). see table 1 ‘sample frame’. table 1. sample frame sample frame sample unit industry superannuation funds (78 as per apra) respondent chief financial officer (cfo) method of contact mail (or telephone) sample size 44 funds response rate 26 funds responded (response rate is 59%) non-response bias no response bias was detected as no significant differences were found the chosen industry super funds were contacted by telephone to obtain the names of the functional managers in those organisations. subsequently, e-mail messages were sent to them requesting full copies of statutory financial statements for the year ended 30 june 2007. this type of data collection has been criticised mainly for its failure to capture a holistic analysis of the research phenomena and thus seen as less effective for collecting opinions (yin, 2003). however, this aspect is not central to the objectives of this study. for industry funds that did not respond by the due date, second and third reminders were sent. finally a total of 26 responses were received, resulting in a response rate of 59%. some funds only sent partial sets of accounts: operating statement, balance sheet and the note on financial instrument disclosure; however this was enough to complete the analysis. non-response bias tests were undertaken in accordance with those suggested by oppenheim (1966). no response bias was detected as no significant differences were found. our 2007 sample is seen as a preliminary step to the next stage of research for which we will expand the sample number of funds to form comparative data as the aasb 7 financial statement disclosures standard was not mandatory until 2008. the 2007 data and its compliance to aasb 7 is first analysed via a ‘ratings assessment’ devised by the researchers, which is shown at table 2. the construction of the assessment table is based on the qualitative and quantitative criteria required in aasb 7. 10 apra, statistics: superannuation-fund-level-profiles-and-performance, december 2008. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 100 table 2. ratings assessment for aasb 7 disclosure weighting  % 1 qualitative f inanc ial ris k management objec tives,  polic ies  and proces ses 1 2 qualitative c redit r isk  1 3 quantitative c redit r isk  2 4 qualitative l iquidity r isk 6 5 quantitative l iquidity r isk 6 market r isk 6 qualitative ‐     interest rates 14 7 quantitative ‐     interest rates 14 8 qualitative ‐   pric e 14 9 quantitative ‐   pric e 14 10 qualitative ‐    foreign exc hange  rates 14 11 quantitative ‐    foreign exc hange  rates 14 100 our ‘ratings assessment’ methodology is based on the conservative premise that a super fund's narrative on its financial risk management objectives, policies and processes may claim more governance than they deliver, a low weighting was therefore given to this aspect of risk reporting. further, as industry super funds are only allowed very short term, low value borrowing, 'credit risk' is low and thus allocated a low weighting. although some super funds invest heavily in non-liquid property assets, the risk in liquidity is low because funds already have to report liquidity ratios to apra to maintain their australian financial services licence. 'liquidity risk' is therefore given a low weighting. during the gfc period it was found that the investments faltered due to higher interest cost, market price crashes and foreign exchange volatility. these risks are therefore equally weighted (noting that aasb 7 does not rank these risks either). an overall rating of at least 50% would indicate general compliance with risk disclosure. the ‘descriptive statistics’ approach (our second method) for data analysis uses univariate analysis (statistics that describe individual variables) and input our data into the software package spss, version 17. the data for the determination of frequency was first transferred to an excel data file and then uploaded to spss for analysis. our paper shows the frequencies found for each variable in the data set: market, liquidity and credit risk. we look at the range of output values and describe the pattern of response to the variable. the third method applied to our data was ‘content analysis’. since our paper involves examining qualitative risk disclosure in aasb 7, content analysis has been chosen as an appropriate research method. content analysis has been defined by a number of researchers (berelson, 1952; holsti, 1969; krippendorff, 1980; mostyn, 1985; weber, 1990). it is defined by krippendorff (1980) as ‘a research technique for making replicable and valid inferences from data to their context’ (mostyn 1985; krippendorff, 1980; tilt, 2001; kraal, et al, 2008). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 101 5. industry superannuation sector the superannuation industry has had a culture of conservatism in the area of disclosure, as it has grown essentially from a base of privately managed funds to the colossus of more than $1143bill in managed funds it is today. in 1986 under the hawke-keating government in australia, a 3 per cent employer-sponsored superannuation benefit was introduced as part of productivity bargaining for workers under certain wage and salary awards. by after 2002 superannuation guarantee had been introduced to 90% of workers at the level of 9%.11 the profile of the superannuation sector to june 2007 is best summarised by the annual statistics published by apra.12 tables 3 and 4 show distribution and types of super entities in australia and highlight the 2007 statistics of industry superannuation funds that are the focus of this paper. table 3. distribution of entities june 2007 by fund type fund type number of entities number of member accounts (’000) assets ($ billion) corporate 289 676 69.2 industry 74 10,654 197.3 public sector 40 2,925 177.6 retail 172 15,437 369.7 small 365,992 702 286.6 pooled super trusts 101 balance of life office funds 42.8 total 366,668 30394 1143.2 source: australian prudential regulation authority, statistics: annual superannuation bulletin june 2007, p.27. 11  australian prudential regulation authority, statistics: annual superannuation bulletin june 2007 (issued 26  march 2008).  12 ibid. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 102 table 4. superannuation entities june 2007 by regulatory classification fund by regulatory classification number of entities assets ($ billion) average account balance ($’000) apra regulated public offer super funds 225 (industry: 42) 544.7 27 non-public offer super funds 308 (industry: 32) 153.5 54.1 approved deposit funds 155 0.3 30.9 eligible rollover funds 17 5.7 1.1 small apra funds 6,017 3.7 405.1 total 6,722 708 25 -ato regulated self-managed super funds 359,825 282.7 408.5 -other exempt schemes 20 109.7 76.9 pooled superannuation trusts 101 83.7 balance of life office funds 42.8 total 366,668 1,143.2 source: australian prudential regulation authority, statistics: annual superannuation bulletin june 2007, p.27. as can be seen from the preceding tables 3 and 4, the industry superannuation fund sector shows significant figures for 2007 with regard to number of members and value of assets held. industry funds are spread between public offer and non-public offer funds. for the typical member with an account balance of between $27,000 and $54,000 the unforeseen global economic downturn in financial market returns since mid-2008 are of ongoing concern. industry superannuation funds have been selected because they invest and manage the retirement savings for over 10,000,000 australians. as can be seen from table 5 and graph 1, the industry superannuation fund sector has the second largest number of members, with a significant number of members at the age where they are eligible to draw on their benefits. as many australians approach retirement, much is at stake in their superannuation investment. this concern can be evidenced by actions such as industry super fund administrators requesting bernie fraser (exaustralian reserve bank governor) to provide calming words to investors in a televised national broadcast and ongoing advertisements.13 13 bernie fraser spoke about the need for investors not to panic and to view superannuation as a long tern investment. televised national broadcast, 6pm, 14 october 2008. advertisements have been screened on television in 2009. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 103 table 5. age segmentation of member accounts by fund type (‘000s) fund type <35yrs 35-45 yrs 50-59 yrs 60-65 yrs >65 yrs total corporate 249 278 112 24 14 676 industry 5,488 3,357 1,362 342 105 10,654 public sector 740 1,126 657 192 210 2,925 retail 6,284 5,649 2,320 737 447 15,437 total 12,761 10,410 4,451 1,295 776 29,693 source: australian prudential regulation authority, statistics: annual superannuation bulletin june 2007, p.31. graph 1. age segmentation of member accounts by fund type 0 1000 2000 3000 4000 5000 6000 7000 <35yrs 35-45 yrs 50-59 yrs 60-65 yrs >65 yrs age range of member n o . o f m e m b e rs ( '0 0 0 s) corporate industry public sector retail graph 1. 5.1 disclosure requirement of aasb 7 the accounting standard aasb 7 financial instruments: disclosures was introduced to require ‘reporting entities’ to assist their stakeholders in evaluating the significance of financial instruments in relation to an entity’s position and performance.14 the standard is also aimed at assisting stakeholders determine the nature and extent of risks arising from financial instruments. 15 the standard’s disclosure requirements are broad and cover objectives, policies and procedures (incorporating methodologies) for managing financial risk. 14 a ‘reporting entity’ is required to prepare financial reports in accordance with part 2m.3 of the corporations act. 15 aasb7, para 1. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 104 the predecessor to the aasb 7 standard was aasb 132 financial instruments: disclosure and presentation, which required only a statement on the risks of a fund including risk management policies. aasb 7 supersedes the disclosure requirements of aasb 132 but the presentation requirements of the latter remain unchanged. an example of the additional disclosure requirements of aasb 7 is that the accounting polices used in preparing the accounts must be stated. importantly, types of hedge accounting must be described, including fair value hedges, cash flow hedges and hedges of net investments in foreign operations.16 disclosure required can extend to types of investments held within the fund; the role of the investment manager; how compliance for the range of investment risk is monitored by the investment manager; and the range of risks exposed and how they arise. the disclosure is based on information likely to be provided internally to key management personnel including the board. involvement of fund clients may be required to complete some disclosures. generally, in a comparison between aasb 132 and the new aasb 7, the latter is far more prescriptive on disclosure details. this paper will only focus on disclosures prescribed by aasb 7 paragraphs 31 to 42 in the section that is headed ‘nature and extent of risks arising from financial instruments’. the reason for restricting the paper to this aspect is because the global economic downturn has forced many investors to address their lack of understanding of the inherent risks attached to their investment portfolios, and so our study will help determine the assistance provided by aasb 7. 5.2 nature and extent of risks arising from financial instruments with regard to risk generally, superannuation funds are increasingly turning to forensic risk management tools in an effort to capture their absolute exposure in a range of portfolios. according to jp morgan worldwide securities services, the global financial crisis has led to ‘a seismic change in super funds, with funds seeking a better understanding of risk investment exposure in portfolios holding public, private and alternative investments.’ the report stated that ‘driving this seismic change in funds' requirements is the increased need that funds have to build a greater understanding of their risk of investment exposure, as well as exposure to supplier risk associated with using a range of financial services’.17 the aasb 7 standard requires additional information across the categories of ‘qualitative’ and ‘quantitative’ disclosure for range of risks arising from financial instruments. typical types of risk can include, but are not limited to: market, liquidity and credit risks. the sections below detail the risk categories with suggestions about commentary on the more common risks. the key objective of the disclosure is that additional financial information is available to competitors, analysts, investment advisors, potential members under ‘choice of fund’ as required by the afore-mentioned simpler super legislation. 16 aasb7, paras.21-24. 17 comments by jane perry, chief executive, worldwide securities services australia at the ‘conference of major superannuation funds’, as reported by amal awad in super review, 24 march 2009. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 105 5.2.1 qualitative disclosure (a) market risk the reporting entity must provide a narrative on three sub-types of market risk including currency, interest rate and price risk.18 for instance concentrations of currency risk and information on how it is monitored and managed can be detailed. comments could be provided on interest risk and how it is monitored and managed. any number of ‘other price’ risks that affect profit and net assets can be provided, and for many price risk on equities are of concern; however there could be other weak points considered such as commodity price risk, given the 2008 downturn in demand from china. (b) liquidity for liquidity risk, an explanation of exposure to risk and how it arises could be given.19 for instance, many superannuation fund members made investment switches in 2008 (from shares to cash) which impacted the liquidity position of their superannuation fund. (c) credit for credit risk, a description of collateral held as security is required.20 for instance, a description of how credit risk associated with an entity’s service organisations (bankers, custodian or fund managers) is monitored could be detailed, including information on collateral held as security for financial assets. 5.2.2 quantitative disclosure (a). market risk integral to the presentation of market risks is the requirement for a sensitivity analysis for each type of risk (currency, interest rate and price) showing how profits and equity might be affected by fluctuations: for instance rates. methods and assumptions used must be disclosed as well as changes on such from the previous reporting period. if some part of the analysis is unrepresentative, then that fact must be clearly disclosed.21 for the presentation of currency risk data, guidance might be drawn from the aasb 132 example of assets and liabilities values being affected by the risk of different currencies. 18  the types of market risk: currency, interest and price risk are defined in appendix a, aasb7.    19  aasb7, para. 39(b).  20  aasb7, para. 36(b).  21  aasb7, paras. 40‐42.  asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 106 here a fund can prepare a sensitivity analysis of the currency movements against the australian dollar (or other main currency) and its impact on profits and/or members equity. for interest rate risk, a summary of fixed and variable interest could be prepared. the sensitivity analysis might show interest rate movements based on a volatility factor as at the balance sheet date. the sensitivity analysis for ‘other price’ risk might show movements of listed equities in the fund financials. if unlisted equities comprise a significant proportion of the portfolio, further information (for example, market valuations) may be required to derive the movement factor. as an alternative option, an entity utilise its in-house sensitivity analysis. essentially the aim is to quantify the effect on profit and on members’ funds for a reasonable change in that risk variable. (b) liquidity the aasb 7 requirement for liquidity risk is to present a maturity analysis for financial liabilities that shows remaining contractual maturities. 22 for instance any net settled derivatives, which have a negative fair value at the balance sheet date, could be included in the liquidity analysis at contract amounts. when a third-party has a choice of when an amount is paid, the liability is included on the basis of the earliest date on which the fund might be required to repay. (c) credit the aasb 7 standard on quantitative credit disclosure, inter alia, requires details that best represent an entity’s maximum exposure to credit risk at the reporting date (without taking account of any collateral held or other credit enhancements).23 for instance, disclosure could comprise financial assets including debt securities; or cash and other receivables showing balance exposure as at period end, split by asset class. presentation of data could show concentrations of risk. an organisation’s management practices are directed at achieving its aims in an efficient and effective manner, including the identifications of management of those risks that prevent it from achieving their aims. risk management approaches have some common features, such as: identifying objectives related to a project, activity or program, pinpointing the risks to achieving these objectives, and implementing ways of dealing with these risks. 22  aasb7, para. 39.    23  aasb7, para. 36.  asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 107 risk management is now widely accepted as a key element of sound governance practice in large and complex organisations and as a valuable tool for integrating all aspects of management planning and decision making. an executive at a 2009 superannuation conference stated that ‘it will become increasingly essential to have the correct data on superannuation fund members in order to manage risk’.24 at the same conference howard rosario, chief executive, westscheme superannuation fund, stated that it was important to discharge the trustee's fiduciary duty, manage risk and communicate with members. rosario stressed the significance of maintaining proper data in order to manage risk, pointing to the possibility of negatively impacting asset allocations with bad data. ‘it will drain liquidity and strain administrative resources if corrupt data makes changes [for members] more difficult,’ rosario said. apra industry investigations have identified two major tendencies, ‘deliberate indifference and conscious avoidance and problems found included financial losses, critical data errors, incorrectly paid benefits and a failure to follow up data errors systematically.’ recent liquidity updates showed limited trustee ability to extract useful information at short notice. apra’s view is that internal audit focus should be improved and that a greater alignment with risk management was necessary.25 the accounting standard aasb 7 formalises the requirement for reporting entities to disclose information about risks arising from financial instruments. 6. risk standards and processes risk management has become a key focus in the public and private sector since the release of the first australian/new zealand standard for risk management (currently as/nzs4360:2004) and the related standards such as the compliance programs (as 3806:1998). the risk management standard provides a generic framework within which organisations can implement risk management. the objective of the risk management process is to identify all unacceptably high-level risks and put in place processes and structures to deal with them. lower level risks are also considered but priority is given to significant risks. the stages of the process are risk identification, risk analysis & evaluation, monitoring & control and continuous improvement. these stages are outlined by the diagram below followed by some detail on each process stage: 24 comments by ramani venkatramani, general manager, specialised institutions division, apra for the ‘conference of major superannuation funds’ as reported by amal awad in super review ‘data integrity tied to risk management’24 march 2009. 25 ibid. further comments by venkatramani. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 108 risk identification risk analysis & evaluation risk monitoring & control continuous improvement p e r f o r m a n c e s t a n d a r d s 6.1 risk identification and analysis risks (such as market, liquidity and credit) can be expressed as risk scenarios and formally recorded in a document such as a ‘risk scenario management sheet’. the existing risk controls are determined and analysed in terms of consequence and the likelihood in the context of these controls. a reasonable analysis should consider the range of consequences and probability identified in the risk matrix. the levels of risk are compared against pre-established acceptance criteria and ranked into extreme, high, moderate and low risk. for entities subject to aasb 7 for example, it is required that market risk are subject to a sensitivity analysis for each type of risk (currency, interest rate and price). 6.2 risk categories generally risk categories are chosen to reflect the diversity and complexity of an organisation’s operations. however, in the case of the aasb 7 standard, the risk categories of market, liquidity and interest are prescribed. before the global economic downturn many large retail and industry super funds seemed more concerned with including a reasonable level of environmental products in their investment suite. reputational damage to the superannuation sector due to dramatic loss of investment value has caught the industry by surprise. 7. analysis of the sample superannuation funds’ 30 june 2007 data 7.1 ratings analysis results data from the 30 june 2007 statutory accounts of 26 sample industry superannuation funds (those which responded to our emails) have been depicted in graph 2 ‘ratings for aasb 7 disclosure of 26 industry super funds, 30 june 2007 data’ using the ratings methodology described in section 4 (and shown at table 2). three funds gained a rating of more than 50 per cent, which indicates a general level of disclosure to their stakeholders; all other funds in the sample follow the trend of falling below this level. the disclosure benchmark set by this quorum of funds is therefore rather low, which can be explained by the fact that 25 funds did not have to comply with aasb 7 until the 2008 financial year. it is important to note that only one fund (no. 9) was required to comply with aasb 7 in the 2007 financial year (but with a low rating of 39%). interestingly, this fund’s narrative about its price risk on equities declared asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 109 that policies and procedures were in place to mitigate the fund’s exposure to market risk. after the onset of the gfc, all industry superannuation funds experienced four successive quarters of negative returns, except in the 100% cash option.26 0 10 20 30 40 50 60 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 industry super fund r at in g quantitative disclosure on credit risk qualitative disclosure on credit risk quantitative disclosure on liquidity risk qualitative disclosure on liquidity risk quantitative disclosure on price risk qualitative disclosure on price risk quantitative disclosure on interest rate risk qualitative disclosure on interest rate risk quantitative disclosure on currency risk qualitative disclosure on currency risk financial risk management objectives, policies & processes l egend: rating s  methodology for aas b  7 weighting  % 1 qualitative f inancial risk management objectives , policies  and processes 1 2 qualitative c redit r isk  1 3 quantitative c redit r isk  2 4 qualitative l iquidity r isk 6 5 quantitative l iquidity r isk 6 market r isk 6 qualitative ‐   interest rates 14 7 quantitative ‐   interest rates 14 8 qualitative ‐  price 14 9 quantitative ‐  price 14 10 qualitative ‐  foreign exchange rates 14 11 quantitative ‐  foreign exchange rates 14 100 graph 2. ratings for aasb 7 disclosure of 26 industry super funds, 30/6/07 data. 26 see the super ratings media release about industry superannuation fund results, 28 october 2008 http://www.superratings.com.au/media/mediareleases/20081027 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 110 7.2 descriptive statistics results the frequencies of qualitative and quantitative disclosure on (a) market risk (b) liquidity risk and (c) credit risk was analysed using the spss statistical package. table 6 ‘frequencies of qualitative and quantitative risk disclosure of 26 industry super funds using 30 june 2007 data’ shows the spss results at the pre-determined percentage breaks of: 0%, 2%, 3%, 5%, 7%, 8%, 9%, and 100%. graph 3 depicts quantitative data from table 6. it shows liquidity and credit risk with the highest rate of non-disclosure, which is due to the liquidity ratios (post-commercial nominees) already being a mandatory reporting item to apra, whilst credit risk is low because of strict limits on borrowing by industry super funds. the absence of 2007 disclosure on ‘other price risk’ should be of concern because of the subsequent gfc. by contrast almost 50% of the funds had full disclosure on interest and currency risks. graph 4 depicts qualitative data from table 6. it shows between 39%-62% of funds had no narrative explaining any of the risks. in line with the quantitative trend, only 4% of the funds provided a full narrative on interest and currency risks. for both quantitative and qualitative disclosures it should be reiterated that in 2007 there was no mandatory requirement for 25 of the 26 super funds to comply with aasb 7. in this initial paper we will not explore in detail the reasons for the unequal disclosure on each of the variables. it will be more appropriate to address this outcome when we produce the next paper using 2008 and 2009 data. table 6. frequencies of qualitative and qualitative risk disclosure of 26 industry super funds using 30 june 2007 data27 variable disclosure frequency % market risk no disc. 2% disc. 3% disc. 5% disc. 7% disc. 8% disc. 9% disc. full disc. currency risk qual. 10 39� 0 0 0 0 15� 57.7 0 0 0 0 0 0 1 3.8 currency risk quant. 11 42 0 0 0 0 1 3.8 0 0 0 0 0 0 14 54 interest risk qual. 17 65 0 0 0 0 8 30.8 0 0 0 0 0 0 1 3.8 interest risk quant. 3 12 0 0 0 0 0 0 3 11.5 8 31 0 0 12 46 other price risk qual. 14 54 0 0 0 0 12 46.2� 0 0 0 0 0 0 0 0 other price risk quant. 26 100 0 0 0 0 0 0 0 0 0 0 0 0 0 0 liquidity risk qual. 10 39 0 0 0 0 14 53.8 0 0 0 0 0 0 2 7.7 liquidity risk quant. 25 96 0 0 0 0 0 0 0 0 0 0 0 0 1 3.8 credit risk qual. 16 62 0 0 0 0 10 38.5 0 0 0 0 0 0 0 0 credit risk quant. 19 73 0 0 0 0 2 7.7 0 0 1 3.8 0 0 4 15 no. of funds no. of funds % no. of funds % no. of funds % no. of funds % no. of funds %%o. of funds % no. of funds 27 table 6 for example shows for ‘currency risk qualitative disclosure’ 10 funds with no disclosure, which was 39% of the sample (10/26 x 100= 39%). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 111 graph 3. frequencies (%tage) of quantitative risk disclosure by type of risk. funds' 2007 data 0 20 40 60 80 100 120 0% disc. 2% 3% 5% 7% 8% 9% 100% disc. disclosure at pre-determined %tage breaks % t a g e currency risk quant. interest risk quant. other price risk quant. liquidity risk quant. credit risk quant. graph 3. graph 4. frequencies (%tage) of qualitative risk disclosure by type of risk. funds' 2007 data 0 20 40 60 80 0% disc. 2% 3% 5% 7% 8% 9% 100% disc. disclosure at pre-determined %tage breaks % ta g e currency risk qual. interest risk qual. other price risk qual. liquidity risk qual. credit risk qual. graph 4. 7.3 content analysis results the statutory financial statements of 26 sampled super funds were analysed using content analysis. in our analysis of sample financial reports, it was revealed that in general, the length of the descriptions about risk varied from a few short sentences, to a one a4 page containing 20 sentences. the mean number of sentences was 2.36. the standard deviation, an indicator of variability from the mean, was 2.16 sentences. most ‘risk’ information contained a general statement of policy followed by a series of specific aims or objectives. some of the objectives were described extensively. the following quotation from a financial statement of an industry super fund typifies the general statements made regarding compliance with aasb 7: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 112 the fund is exposed to a variety of financial risks as a result of its activities. these risks include market risk (including currency risk, fair value interest rate risk and price risk), credit risk, liquidity risk and cash flow interest rate risk. the fund’s risk management and investment policies, approved by the trustee, seek to minimise the potential adverse effects of these risks on the fund’s financial performance. consistent with regulatory requirements, the trustee has the function of overseeing the establishment and maintenance of risk-based systems and controls for the fund. the trustee has developed, implemented and maintains a risk management strategy (rms) and a risk management plan (rmp). the fund has risk management plan and identified risk categories including investment (market and counter party); financial risk and liquidity; general outsourcing including agency; governance and decision making; compliance and changes in rse licensing law; fraud and theft; specified outstanding risks; and insurance and external.28 table 7 ‘qualitative risk disclosure’ shows the categories of variables investigated using content analysis. the first column indicates the variable used in the sample. the second and third columns respectively show the funds’ disclosure information. the fourth column shows the frequency of each variable’s inclusion in the financial report. the fifth column reports frequency of sentences as a percentage. sixth and seventh columns reflect the mean of sentences dedicated to each variable and the standard deviation of each variable respectively. graph 5 ‘content analysis of risk disclosure’ shows the graphical representation of mean and standard deviation of sentences on qualitative risk disclosures of the sample superannuation funds. 28 the name of the industry super fund has been deleted to preserve anonymity. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 113 table 7. qualitative risk disclosure: content analysis (by pre-determined category and number of words) of 26 industry super funds using 30 june 2007 data pre-determined category of classification of each sentence in financial report number of funds not disclosed number of funds disclosed frequency (n) frequency as a percentage mean sentences standard deviation general policy statement 0 26 40 100 3.17 1.94 stated objectives 34 85 8.37 7.11 stated policies 15 37 1.45 3.00 other sentences 13 32 1.22 3.59 market risk: currency risk 10 16 22 54 0.85 0.98 interest rate risk 14 35 0.79 1.06 other price' risk 3 8 0.15 0.33 liquidity risk 10 16 23 58 3.81 0.47 credit risk 16 10 18 45 1.46 0.97 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 114 graph 5. content analysis of risk disclosure mean and standard deviation graph 5 ‘content analysis of risk disclosure’ show that for 85 per cent of funds in the sample, the greatest proportion of sentences in a financial report are in ‘stated objectives’. this indicates that the sample super funds are disclosing objectives and policies with some clarity in their financial statements. notably, however, narrative on market risk (currency, interest rate and other price risks) appeared in a mere 13 of the financial statements and where it did appear, there were only a few sentences dedicated. for each of currency, interest rate and other price risks, less than one sentence was dedicated. liquidity risk was disclosed by 16 industry super funds and the mean sentences were 3.81 and credit risk was disclosed by 10 funds with a mean number of sentences of 1.46. many studies on financial disclosure tend to measure one or a combination of words, sentences or pages. number of pages as a yardstick of disclosure is often said to be problematic due to differences arising from font size, margins, graphics etc, while the number of words causes difficulties due to styles of writing: those verbose compared to those concise content analysis of risk disclosure 0 1 2 3 4 5 6 7 8 9 g en er al p ol ic y st at em en t s ta te d ob je ct iv es s ta te d po lic ie s o th er se nt en ce s cu rr en cy r is k in te re st r at e ris k o th er pr ic e' r is k li qu id ity r is k c re di t ris k variables mean sentences standard deviation market risk asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 115 (hackston and milne, 1996; tilt, 2001). our analysis used pre-determined categories of information to overcome the issues. the overall trend is that market risk is poorly articulated. 8. conclusions and future research this exploratory paper has examined the extent to which the statutory accounts of a sample of industry superannuation funds reported risk in 2007, the year prior to the qualitative and quantitative risk disclosure requirements of the new australian accounting standard aasb 7 financial instruments: disclosures. this subject has received relatively little attention in the literature as it relates to a new accounting standard. the data from the 2007 statutory financial accounts of the sampled 26 industry superannuation funds will be enlarged in the post-exploratory stage to form the first year of comparative information for a longitudinal study to cover the subsequent years 2008-2009, which will use the same sample of superannuation funds. three methodologies were applied to the sample of published financial data. the first method was a ‘ratings assessment’ showing that 23 of the 26 funds had a rating of less than 50 per cent. the trend of low level of risk disclosure can be explained by the fact that all except one fund did not have to comply with aasb 7 until the 2008 financial year. it is also interesting to note that no superannuation fund provided sensitivity information on ‘price risk’ despite the fact that subtle changes with this risk may affect profit and net assets of superannuation funds. the second interrogation of disclosure data used ‘descriptive statistics’ revealing a trend of low levels of risk disclosure. on the basis of this result, we might infer that super funds are likely to place a higher emphasis on ‘objectives’ and ‘policy’ descriptions rather than discussion on associated risk (particularly market risk). the final analysis was by ‘content analysis’ of descriptions of risk mitigation, which showed that for 85 per cent of funds in the sample, the greatest proportion of sentences in a financial report is in ‘stated objectives’. this indicates that the sample super funds are disclosing objectives and policies with some clarity in their financial statements, whilst the trend for narratives on market risk (currency, interest rate and other price risks) was minimal or low. the findings, however, must be interpreted with caution as it is only an exploratory study to test out our triangulation of methodologies. a second limitation was that the data was collected using email requests for published financial data. consistent with other studies employing this method, it is difficult to capture a comprehensive, holistic and contextual portrayal of the empirical phenomena studied without case study or interview. these approaches are important for a topic of this nature. case studies or interview methods have greater potential to reveal more pragmatic information (yin, 2003). hence, as mentioned in the paper, a questionnaire survey followed by ten interviews will be conducted in future research with selected industry superannuation fund managers. the objective will be to study industry superfund manager’s opinions and suggestions for the improvement of reporting entity disclosure on aasb 7. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 116 the third limitation of the study is its focus only on industry super funds. the disclosure of risk is a requirement of many other industry sectors, but any extrapolation the results reported in this paper to other sectors should be done with caution. lastly, it should be acknowledged that the choice of a risk disclosure is likely to be influenced by a considerable number of factors. these include inter alia fund size, technology and complexity etc. as mentioned below, further research is needed to shed useful light on these issues. this exploratory study has succeeded to some extent determining the appropriate methodology for measuring risk disclosure by industry super funds during 2007. it is envisaged that data from our current and future research will provide a more informed basis for the future refining of risk disclosure by superannuation funds (and other entities) in australia and thus be invaluable for all stakeholders including government policy makers, accounting standard researchers, industry regulators and the wider community. references accounting standards board. 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(2003). case study research: design and methods, third edition, thousand oaks, ca: sage publication. microsoft word 1874-7391-2-rv[1]-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 18 fii and its impact on stock market: a study on lead-lag and volatility spillover dr namita rajput (corresponding author) associate prof in commerce sri aurobindo college (m), university of delhi e-mail: drnamitarajput@ymail.com ms parul chopra research scholar department of management, cmj, shilong e-mail: parulchopra80@gmail.com mr ajay rajput director marketing, patil rail infrastructure pvt ltd e-mail: arajputin@yahoo.co.in received: may 30, 2012 accepted: june 26, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1874 url: http://dx.doi.org/10.5296/ajfa.v4i2.1874 abstract in this paper we examine the information spillover and volatility spill-over relationship for indian stock market. we cover data during 1992-2011. we examine if there has been an increase in volatility persistence in the indian stock market on after the process of financial liberalization initiated in india. further, we examine the shifts in stock price volatility and the nature of events that apparently cause the shifts in volatility. we examine if there has been an increase in volatility persistence in the indian stock market on after the process of financial liberalization initiated in india. this paper explores to develop alternative models from cointegration, vecm, variance de-composition analysis, granger causality, block exogeneity wald test, impulse response analysis and alternative forms of the autoregressive conditional heteroscedasticity (arch) or its generalisation, the generalised arch (garch) family, to estimate volatility in the indian equity market return. bidirectional informational spillover is confirmed. the bidirectional volatility spill-over, persistence and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 19 clustering is also confirmed in the sample series. our findings have implications for policy makers, hedgers and investors. the research contributes to present investment literature for emerging markets such as india. keywords: price discovery, granger causality, vecm, egarch, volatility spill over jel: g13; g14; g 15; g18; c32; f30 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 20 1. introduction there are important implications in economics and finance, as regards estimation of volatility in the equity market. there are adverse effects in the economy because of high volatility in the stock prices and can also change the investment decisions by investors due to high volatility, which may lead to a fall in the long-term capital flows from foreign as well as domestic investors. in the last decade financial crisis have exposed that financial asset price volatility has the potential to undermine financial stability. there is empirical evidence to this context that financial stability is in danger more by abrupt shifts in volatility rather than by a sustained increase in the level of volatility. hence there is an intense need to have the understanding of volatility for risk management in an economy. indian stock market was opened to foreign institutional investors on 14th september 1992. the movements in the stock prices are influenced by the flow of market information are well known to everyone and movement in other stock market can be one source. in contemporary world of today because of trading mechanism and investment patterns there can be information spillover of one market to another. hence return patterns of two different markets might affect each other. economies are becoming increasingly interrelated and integrating themselves to the world economy because of higher degree of openness in the economies (vide john et. al. (1995).all the decisions of portfolio investment are taken embedding the information relating to these price movements and volatility as regards assets traded. this can lead to reducing or gaining out of diversification across border investment in portfolios. the market traders have to formulate hedging, regulatory and portfolio strategies, for this they have to completely understand the behaviour of the market in the global context. this scenario has led to increased capital flows from fiis to emerging economies like india with expanding stock market. there are many factors which have led to the growth of financial integration of indian capital market into world economy like communication technology, computerization of trading system, increased pace of multinational corporations etc. there is a tremendous change in the nature, extent and magnitude of the investment done by theses fiis. there are diverse view of fiis investment in emerging economies in general and india in particular; one view is that fiis are believed to improve market efficiency and helps in lowering the cost of capital the other view holds fiis responsible for increasing the volatility in stock markets. india is considered as a good investment centre after the restrictions are lifted in a liberalised regime. there has been increase in the capital flows into the country which is strong evidence to this context see, figure 1 below. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 21 figure 1. fii equity and debt investment source :www.nseindia.com fii inflows and stock market levels is widely cited, and many studies have concluded that theses fiis cause volatility in the stock market. however, the level of the stock market and the volatility of the stock market are two distinct statistics, and such conclusions are unwarranted. while the stock market level may change over time, volatility refers to the short run fluctuations of the stock market around the trend that captures the level of the stock market .if the market index exhibits wild fluctuations within a short span of time, the research question is: what is the role of fii trading in causing this short term volatility? regulators are concerned about such abnormal short run movements in the stock market and to what extent fiis are responsible for this type of volatility. the existence of volatility also demoralizes the expediency of stock prices as a “signal” about the true intrinsic value of a firm, which is core to the concept of informational efficiency of markets. inference of volatility and its forecasting has become a very important tool of risk management exercise for economies and financial institutions across the globe. in this paper an attempt is made to examine the shifts in stock price volatility and the nature of events that apparently cause the shifts in volatility. this will enable us to identify if a coincidence between the shifts in stock return volatility and financial liberalization exists. we also make an attempt to characterize the evolution of the stock market cycles over time in india and examine if in recent times the stock market cycles have exhibited greater amplitude and volatility. the analysis of bear and bull markets allows us to investigate in greater detail and in an episodic manner, the evolution of stock market instability. an attempt is made in this paper to give financially viable significance to changes in the pattern of stock market volatility in india during 1992-2011.thus it will be interesting to examine the co-movement of indian stock markets and fii investment patterns in the light of lifting the restrictions and foreign ownership see figure ii asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 22 figure 2. comovements of fii inflows and nifty closing prices source: www.nseindia.com there is a vast literature, available on estimating the volatility in the equity markets through the application of the family of arch models. in the context of the indian economy, karmakar (2006) used the application of a tarch (1, 1) model and established the existence of asymmetry in the daily returns in the indian stock market. evidence of contemporaneous transmission effects were also found across volatilities of the stocks and index futures market using a tarch model. in a study done by chen and lian (2005) it was revealed that there was existence of asymmetry in the equity markets of five asean countries, viz. malaysia, singapore, thailand, indonesia and the philippines, and found that the tarch and egarch models performed better in forecasting the equity markets post asian financial countries. sollis (2005) reported that macroeconomic variables are very important carrier of valuable information to forecast stock returns and volatility in the s&p composite index during the 1970's, but not during the 1990's, under the garch framework. understanding the influence of one market on the other and role of each market segment in dominant role is the central question in market microstructure design and it is very important to academia and regulators. in efficient markets, new information is impounded simultaneously into all markets in our case fii investment framework and equity market closing prices (nifty closing).in other words, financial market pricing theory states that market efficiency is a function of how fast and how much information is reflected in prices. the rate at which prices exhibit market information is the rate at which this information is disseminated to market participants. in reality, institutional factors such as liquidity, transaction costs, and other market restrictions may produce an empirical lead-lag asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 23 relationship between price changes in investment scenario or investment behaviour. besides being of academic interest, understanding information flow across markets is also important for hedge funds, portfolio managers and hedgers for hedging and devising cross-market investment strategies. volatility is yet another area of interest both for regulators and for market participants who prefer less volatility to more volatility. a meaningful interpretation of volatility will give us important information and will act as a measure to know as to how far the current prices of an asset deviate from its average past prices. at a fundamental level, volatility specifies the strength or confidence behind a price move. instinctively, we can argue that the measurement issues of volatility can also be useful to comprehend the market assimilation, co-movement and spill over effect. the existence of volatility spillover between the two markets specifies that the volatility of returns in one market has an important effect on the volatility of returns in the other market. considerable amount of research work has been conducted in the field of volatility of stock market and fii investment regime and its spillover, but the results of which are mixed. issues like lead-lag and volatility spillover have been extensively researched for mature markets .emerging markets in general and india in particular, the work is very limited. in this backdrop, an attempt has been made to revisit the debate on lead-lag, causality and volatility spillover in indian stock market. specifically the present study covers empirical analysis both for fairly long study period compared to prior research of the subject and also analysis how the lead-lag, causality and volatility spillover relationships are in indian context. the study addresses the following question 1. to examine if fii investment are useful in impacting stock market and vice-versa, i.e. a lead lag relationship? 2. is there a volatility spill over from fii investment patterns to nifty closing prices and vice-versa? the remainder of the paper proceeds as follows. section one describes the theoretical aspect of indian stock market its importance, relevance, rationale followed by a section (ii) that deals with reviews of the relevant research studies connected with the objectives. section three entails data and methodology describing the nature and sources from which relevant data has been collected and the various statistical tools and techniques employed in the study .section iv exhibits analysis and interpretation of the data through a variety of tables into which relevant details have been compressed and summarized under appropriate heads and presented in the tables. section iv briefs the summary and conclusion of the main findings along with the policy implications that emerged from the findings of the study, along with limitations of the study and directions for future research. section v will list the references cited while undertaking the research. 2. review of literature there are numerous studies that have been explored so far in the ascertainment of whether the fii investment behaviour is reflected in the stock market (closing prices), at various interval of time. many studies done across the globe are done mainly in context of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 24 transmission of volatility across economies and the contagion effects of a financial crisis which include the work done by forbes and rigobon (2002), bekaert, harvey and lumsdaine (2002a,b), edwards (2000) and others. rogobon (2003) focus his study on alternative measures of volatility in the equity and bond markets in the period adjacent the financial crises. bekaert and harvey (2000) analyse equity returns in a group of emerging economies before and after financial reforms in a group of emerging markets and find mixed results. during 1985-95 in a study done by aggarwal, inclan and leal (1999) analyze volatility in emerging stock markets. icss algorithm was used to identify the points of abrupt changes in the variance of returns they examine the nature of events that cause large shifts in stock return volatility in these economies. local events jumps were held responsible for stock market volatility of the emerging markets by a study done by aggarwal et al. they find no systematic effect of liberalisation after studying the behaviour of stock prices after the economy was opened to foreigners or large foreign inflows kim and singal (1997) & de santis and imorohoroglu (1994). the results of this study corroborate bekaert’s findings that volatility in emerging markets is unrelated to his measure of market integration. richards (1996) use two sets of data and three types of methodologies to estimate volatility of emerging markets and find no increase in volatility following the process of liberalisation. levine and zervos (1995) find results contrary to richards (1996) that there may increase volatility after liberalisation. no systematic evidence that foreign trading tends to increase market volatility more than trading by domestic groups was revealed by hamao and mei (2001) who examined the impact of foreign and domestic trading on market volatility for japan. the period of time study mainly relates to the time period during which the foreign portfolio investment in japan was rather small. the study done by folkerts – landau and ito (1995) on volatility of emerging markets in periods that differ in their intensity of portfolio flows generated mixed results with mexican stock prices being least volatile when flows are most volatile and vice versa for hong kong. excess volatility was reported by nilsson (2002) following the process of liberalisation using the markov regime-switching model. he finds evidence of higher expected return, higher volatility and stronger links with international stock markets characteristic of the deregulated period in all nordic stock markets. studies analyzing the behaviour of stock prices over financial cycles have been undertaken in the recent years. it was confirmed in the study that owing to liberalisation the stock markets tend to become more stable. time varying patterns of financial cycles before and after financial liberalization was examined by kaminsky and schumkler (2001, 2002) in 28 countries. the results indicate that more liberalisation cause financial extremes in the short-run and also brings a change in the institutional set up of which will have a supporting and better functioning of financial markets. a temporary rise in volatility was observed in all countries immediately after the liberalisation. in a study done by edwards et al (2003) ,the stock price behaviour in six emerging economies is analyzed .the results they find exhibit that emerging economies like korea are in the process of recuperating their stability where as more stable relatively. 2.1 stock market volatility a study (mt raju et al (2004) find that the volatility is less in mature markets and provide asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 25 very high returns. india and china exhibit high returns where as all other emerging economies exhibit low returns. a study is done on spot price indices of bse sensex and s&p cnx nifty to explain the extent and patterns of stock return volatility. the results exhibits rise in volatility in the period 1990-2000, with a sharp fall in 1992 till 1995, after which there was a sharp rise, however the volatility in the portfolio into india was very small in comparison to other emerging markets, (gordan j and p gupta (2003), harivinder kaur’s (2004).stock market volatility plays an imperative role in the financial development as well as growth. daily volatility is calculated as a standard deviation of the natural log of daily returns on the indices for the respective months. volatility in stock prices in india, by and large has shown a flagging drift except in few certain months. the market may have turned riskier, messy politics could resurface, and oil prices are at a new high (but at present low); but nothing seems to worry local investors, who feel the index can go up further. anand bansal and j.s. pasricha (2009) studied the impact of market opening to fiis on indian stock market behaviour. they empirically analyze the change of market return and volatility after the entry of fiis to indian capital market and found that there is no significant change in the indian stock market average returns; volatility is significantly reduced after india unlocked its stock market to foreign investors. in the next section we are discussing the data sources and methodology of the study understanding volatility is therefore central to risk management in an economy. asymmetry in stock market volatility has its own significance, which implies volatility rises after negative shock than positive shock of similar magnitude. if the stock market is efficient, then the volatility of stock returns should be related to the volatility of the variables that affect asset prices. stock market volatility tends to be persistent; that is, periods of high volatility as well as low volatility tend to last for months. in particular, periods of high volatility tend to occur when stock prices are falling and during recessions. the relationship of stock market volatility with that of economic variables like inflation, industrial production and debt levels in the indian corporate sector also is positively related to volatility in economic variables, such as inflation, industrial production, and debt levels in the corporate sector (schwert 1989). after review the literature, it is quite evident that this issue of volatility of stock returns owing to liberalisation in emerging economies has been studied and examined extensively in the recent years. india is not included in the sample of countries for which liberalization and volatility is analyzed as it was mainly limited to latin america and east asia. as mentioned above, empirical literature on lead-lag and volatility spillover mainly deals with developed markets like us and uk. in india significant and relevant literature in this context is thin this paper examines the case for india i.e., the fii investment patterns effectively serves the price discovery function and impacts the nifty closing prices and vice-versa, and that the introduction of fii equity investment has resulted in volatility in the nifty closing prices and vice-versa .this study is a modest attempt to fill this gap through our analysis. 3. data and methodology period of study :the study spans the period january 1992 to march 2011.this period is very asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 26 important as major changes took place in these years and also , major changes were brought about in the structure as well as functioning of the indian stock markets during this period. major regulatory changes were made in the light of the scam of 1992 and the information, communication, and entertainment (ice) meltdown of 2001 like circuit filters were introduced by the nse, paperless trading was introduced and made compulsory, rolling settlements were introduced in a partial manner, index based futures were introduced ,carry forward of trades was abolished. hence this period for study is quiet significant owing to these changes ,to have a deep understanding of the volatility patterns .the daily stock price data on nifty have been taken from prowess, the online database maintained by the centre for monitoring of indian economy (cmie).cmie maintains this database for calculating its various indices. the database contains all the actively traded stocks at any given time on the nse. daily opening, high, low, and closing prices have been taken for nse indices for the period of study. these prices have been adjusted for bonus and right issues. daily stock prices have been converted to daily returns. the present study uses the logarithmic difference of prices of two successive periods for the calculation of rate of return. the logarithmic difference is symmetric between up and down movements and is expressed in percentage terms for ease of comparability with the straightforward idea of a percentage change. if i t be the closing level of nifty on date t and i t-1 be the same for its previous business day, i.e., omitting intervening weekend or stock exchange holidays, then the one day return on the market portfolio is calculated as: rt = ln (i t /i t-1) x100 where, ln (z) is the natural logarithm of ‘z.’ 3.1 econometric methodology given the nature of the problem and the quantum of data, we first study the data properties from an econometric perspective and find that co-integration and error correction models are required to establish the equilibrium relationship between the markets. further, to quantify and study volatility spill over, we use bivariate egarch framework which is covered in the next section. to test the causality block exogeneity test is performed the results of which are entailed in result section. the regression analysis would yield efficient and time invariant estimates provided that the variables are stationary over time. however, many financial and macroeconomic time series behave like random walk. we first test whether or not the spot and futures price series are co-integrated. the concept of co-integration becomes relevant when the time series being analysed are non stationary. the time series stationarity of sample price series has been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron (1988) test of stationarity has also been performed for the series. 4. analysis and interpretation of results 4.1 lag relationship of fiis and nifty (information spillover and price discovery) 4.1.1 tests of stationarity the results of stationarity tests are given in table 1. it confirms non stationarity of nifty price data & fii equity investment series; hence we repeat stationarity tests on return series asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 27 (estimated as first difference of log prices) which are also provided in table 1. the table describes the sample price series that have been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron (1988) test of stationarity has also been performed for the nifty closing prices and fii equity investment and then both the test are performed on return series also as shown in panel-a (price series) and panel b (return series) are integrated to i (1). the sample return series exhibit stationarity thus conforming that both variables in the sample series are integrated to the first order see table 1 4.1.2 tests of cointegration if two or more series are themselves non-stationary, but a linear combination of them is stationary, then the series is said to be co-integrated. given that sample series are integrated of the same order, co-integration techniques are used to determine the existence of a stable long-run relationship between the series. arrival of new information results in lead-lag, causal relationship for short intervals of time between them due to communication cost. the price linkage between futures market and spot market is examined using cointegration (johansen, 1991) analysis that has several advantages. first, cointegration analysis reveals the extent to which two markets have moved together towards long run equilibrium. secondly, it allows for divergence of respective markets from long-run equilibrium in the short run. the co -integrating vector identify the existence of long run equilibrium while error correction dynamics describes the price discovery process that helps the markets to achieve equilibrium (schreiber and schwartz, 1986). co-integrating methodology fundamentally proceeds with non-stationary nature of level series and minimizes the discrepancy that arises from the deviation of long-run equilibrium. the observed deviations from long-run equilibrium are not only guided by the stochastic process and random shocks in the system but also by other forces like arbitrage process. as a result, the process of arbitrage possesses dominant power in the commodity future market to minimize the very likelihood of the short run disequilibrium. moreover, it is theoretically claimed that if futures and spot price are coinetgrated, then it implies presence of causality at least in one direction. on the other hand, if some level series are integrated of the same order, it does not mean that both level series are coinetgrated. cointegration implies linear combinations of both level series cancelling the stochastic trend, thereby producing a stationary series. johansen’s cointegration test is more sensitive to the lag length employed. besides, inappropriate lag length may give rise to problems of either over parameterization or underparametrisation. the objective of the estimation is to ensure that there is no serial correlation in the residuals. here, akaike information criterion (aic) is used to select the optimal lag length and all related calculations have been done embedding that lag length. the cointegration results are reported in table 2. maximal eigen value and trace test statistics are used to interpret whether null hypothesis of r =0 is rejected at 5% level and not rejected when r =1. rejection of null hypothesis implies that there exists at least one co-integrating vector which confirms a long run equilibrium asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 28 relationship between the two variables, fii equity investment and nifty closing prices in our case. the null hypothesis is rejected which reveals that one cointegration relationship exists between , fii equity investment and nifty closing prices ,thus they share a share common long-run information. despite determining a co integrating vector for each commodity /index, it is customary to produce the diagnostic checking criterions before estimating the ecm model. diagnostic tests are performed only for those series for which there is a long run relationship confirmed by johnson cointegration test. vector auto regression (var) estimated with various lags selected by aic is used to check whether the model satisfies the stability, normality test as well as no serial correlation criterion among the variables in the var adequacy model. testing the var adequacy of the sample series as shown in table 3, it was revealed that all the sample series are satisfying the stability test. in normality test all the sample commodities are found to be normal. in verifying the var residual serial correlation lm tests it was found that in sample series no serial correlation was present. therefore, it leads us to take the position that our model fulfils the adequacy criterion for sample series which exhibit a long run relationship between the sample series as exhibited by johansson cointegration test. the error correction model takes into account the lag terms in the technical equation that invites the short run adjustment towards the long run. this is the advantage of the error correction model in evaluating price discovery. the presence of error correction dynamics in a particular system confirms the price discovery process that enables the market to converge towards equilibrium. in addition, the model shows not only the degree of disequilibrium from one period that is corrected in the next, but also the relative magnitude of adjustment that occurs in both markets in achieving equilibrium. moreover, cointegration analysis delivers the message saying how two markets (such as futures and spot commodity markets) reveal pricing information that are identified through the price difference between the respective markets. the implication of cointegration is that the commodities in two separate markets respond disproportionately to the pricing information in the short run, but they converge to equilibrium in the long run under the condition that both markets are innovative and efficient. in other words, the root cause of disproportionate response to the market information is that a particular market is not dynamic in terms of accessing the new flow of information and adopting better technology. therefore, there is a consensus that price change in one market generates price change in the other market with a view to bring a long run equilibrium relation is: ttt sf   (1) equation (1) can be expressed as in the residual form as: ệ ftst  ệ t (2) in the above equations ft and st are fii and stock prices of a commodity in the respective market at time t. both α and β are intercept and coefficient terms, where as ệt is estimated white noise disturbance term. the main advantage of cointegration is that each series can be asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 29 represented by an error correction model which includes last period’s equilibrium error with adding intercept term as well as lagged values of first difference of each variable. therefore, casual relationship can be gauged by examining the statistical significance and relative magnitude of the error correction coefficient and coefficient on lagged variable. hence, the error correction model is: fttftftfft syfef    11 ^ 1 (3) sttftftsst fyses    11 ^ 1 (4) in the above two equations, the first part et1 ^ is the equilibrium error which measures how the dependent variable in one equation adjusts to the previous period’s deviation that arises from long run equilibrium. the remaining part of the equation is lagged first difference which represents the short run effect of previous period’s change in price on current period’s deviation. the coefficients of the equilibrium error, αf and αs signify the speed of adjustment coefficients in fii equity investment and nifty closing prices that claim significant implication in an error correction model. at least one coefficient must be non zero for the model to be an error correction model (ecm). the coefficient acts as an evidence of direction of casual relation and reveals the speed at which discrepancy from equilibrium is corrected or minimized. if, αf is statistically insignificant, the current period’s change in fii investment pattern does not respond to last period’s deviation from long run equilibrium. if both, αf and βf are statistically insignificant; the closing stock price does not granger cause fiis. the justification of estimating ecm is to know which sample markets play a crucial role in lead-lag relationship and information flow. the vecm results are reported in table iv. it shows that short run dynamics in the price series and price movements in the two markets. the lag length of the series is selected in vector error correction model (vecm) on the basis of akaike’s information criteria. the residual diagnostics tests; indicate existence of heteroscedasticity, in the sample series which exhibit cointegration. thus, t-statistics are adjusted, as well as the wald test statistics which are employed to test for granger causality, by the white (1980) heteroscedasticity correction. after correction, we reestimate vecm and from empirical results and it is noticed that in the vecm model, error correction coefficients are significant in both equations (1) and (2) with correct signs, suggesting a bidirectional error correction in sample series. error correction terms (ects) also known as meanreverting price process, provide some insights into the adjustment process of spot and future prices towards long run equilibrium. for the entire period, coefficients of the ects are statistically significant between one to two lags, in both equations of nifty and fiis as suggested by akaike information criterion (aic). this implies that once the price relationship of fiis and nifty closing prices deviates away from the long-run coinetgrated equilibrium, both markets will make adjustments to re-establish the equilibrium condition. the results reveal that error correction terms of fiis are greater in magnitude than that of nifty closing prices, which means fiis makes greater adjustment in order to re-establish asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 30 the equilibrium. in other words, nifty leads the fiis. in addition, the empirical results of vec granger causality/bloc exogeneity wald test between the sample series have been examined to check the direction of causality. the results of vec granger causality test are also provided in table 4. there are bi-directional granger lead relationships between the two markets which are significant at 5% level. these empirical results are consistent with the co-integrating relationships above. to reconfirm the empirical results of which market whether spot or futures markets have the ability of price discovery and validate the dominant role of the fiis in price discovery, variance decomposition analysis is done. the variance decomposition analysis measures the percentage of the forecast error of a variable that is explained by another variable. it indicates the relative impact that one variable has upon another variable within the vecm system. the variance decomposition enables us to assess the economic significance of these impacts as the percentages of the forecast error for a variable sum to one. this structure of result showing the information share shows that most of the price changes of fiis are because of nifty closing, and more information flows from nifty to fiis. the information share and variance decomposition confirms the dominant role of nifty in information dissemination, the results of which are also shown in table 4. 4.1.3 impulse response analysis the arma impulse response view traces the response of the arma part of the estimated equation to shocks in the innovation. an impulse response function traces the response to a one-time shock in the innovation. the accumulated response is the accumulated sum of the impulse responses. it can be interpreted as the response to step impulse where the same shock occurs in every period from the first. it gives a graphical view as exhibited by variance decomposition analysis. -10 0 10 20 30 40 50 60 70 1 2 3 4 5 6 7 8 9 10 response of encl to encl -10 0 10 20 30 40 50 60 70 1 2 3 4 5 6 7 8 9 10 response of encl to fiieq 0 100 200 300 400 500 600 1 2 3 4 5 6 7 8 9 10 response of fiieq to encl 0 100 200 300 400 500 600 1 2 3 4 5 6 7 8 9 10 response of fiieq to fiieq response to generalized one s.d. innovations ± 2 s.e. it shows a lead role of nifty and fii respond to changes in the movement of nifty, as is shown in the graph of response of fiis to nifty close. the responses correspond with the result of variance decomposition analysis. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 31 4.2 volatility spillover volatility is yet another area of interest both for regulators and for market participants who prefer less volatility to more volatility. a meaningful interpretation of volatility will give us important information and will act as a measure to know as to how far the current prices of an asset deviate from its average past prices. at a fundamental level, volatility specifies the strength or confidence behind a price move. instinctively, we can argue that the measurement issues of volatility can also be useful to comprehend the market assimilation, co-movement and spill over effect. the existence of volatility spillover between the two markets specifies that the volatility of returns in one market has an important effect on the volatility of returns in the other market. first the stationarity of data is analysed using augmented dickey-fuller test (adf) and the results of which are entailed in table v. before estimating the egarch model, it is necessary to check the model adequacy by performing the diagnostic tests that involve serial correlation, normally distributed error and goodness of fit measures. all diagnostic tests are primarily carried on the standardized residuals via ols and it is found that all are significant at 5% level. the diagnostic statistics with respect to egarch model are not reported here to conserve space. the results of volatility spill over relationships between fiis and nifty using bivariate e-garch model are reported in table 6 for entire sample series. the coefficient βsf indicates the volatility spillover from fiis to nifty and βfs means reverse direction. the coefficients βss βff show the volatility clustering, while the coefficients ƴs (stock market) &ƴf (fiis) measure the degree of volatility persistence. the residuals of the model are tested for additional arch effects using arch lm test. the coefficients of β sf and β fs are very important and reveal volatility spill over from the stock market to fiis or fiis to stock. results support the bidirectional volatility spillover process with significant coefficients. volatility persistence is tested for sample series to test the effect of shocks, which is an indicator of market efficiency. it means persistence of volatility that today’s volatility is due to information that arrived today and will affect tomorrow’s volatility and volatility of days to come. γf and γs measure the persistence of volatility in spot and futures market. the smaller the absolute value of the coefficient, the less persistent volatility is after a shock. volatility persistence is significant for both stock market (nifty) and fiis for sample series, as p (value) is coming less than 0.05. volatility estimation is important for several reasons and for different people in the market pricing of securities is supposed to be dependent on volatility of each asset. market prices tend to exhibit periods of high and low volatility. this sort of behaviour is called volatility clustering. volatility clustering is tested for the sample, which means as noted by mandelbrot (1963), “large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes.” a quantitative manifestation of this fact is that, while returns themselves are uncorrelated, absolute returns |rt| or their squares display a positive, significant and slowly decaying autocorrelation function: corr (|rt|,|rt+τ |) > 0 for τ asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 32 ranging from a few minutes to a several weeks. the market-specific volatility clustering coefficients are all positively significant at 5% level in the fiis and stock markets. of course, we can understand the efficiency degree in stock-fiis market from one side according to the magnitude of correlative coefficients. therefore, the bivariate egarch model indicates that past innovations in fiis significantly influence stock market volatility and vice versa. finally arch lagrange multiplier (lm) tests are used to test whether the standardized residuals of bivariate e-garch model exhibit additional arch. the results reveal that egarch (1, 1) capture the entire volatility dynamics see table vii. 5. summary and conclusions foreign institutional investors have gained a significant role in indian stock markets. the dawn of 21st century has shown the real dynamism of stock market and the various benchmarking of nifty index in terms of its highest peaks and sudden falls. the literature relating to information spillover and volatility spillover is not adequately researched in india and is mainly confined to developed economies. empirical studies on the subject will reduces informational asymmetries in the market. the present study evaluates informational spillover and volatility spillover effects in indian stock market to bridge the important gap in the literature. we find that stock market and fiis prices of all sample commodities and indices are non stationary, and in fact integrated to order one and the long run equilibrium relationship is confirmed using johansson cointegration procedure. these cointegration results are supported by var adequacy test. short term dynamics in the series are examined using vecm. the results show that once price relationship of stock and fiis market deviates away from the long run coinetgrated equilibrium, both markets will make adjustments to re-establish the equilibrium with fiis is greater in magnitude than that of stock market which implies that fiis makes greater adjustment in order to re-establish the equilibrium. the results of vec granger causality test show bi-directional granger lead relationships between the sample series. the variance decomposition and impulse responses results reconfirm the dominant role of nifty in information flow for these series. next, we examine the volatility spillover effects for sample series to verify whether any risk transfer mechanism can work between stock market and fiis. e-garch results confirm bivariate volatility spillover. thus efficient hedging as well as speculation strategies can be formed for theses commodities. our results are in conformity to the studies like levine and zervos (1995), ,nilsson (2002), edwards et al (2003), gordan j and p gupta (2003), mt raju et al (2004) harivinder kaur’s (2004) which find that there may increase volatility after liberalisation and in contrary to the studies like de santis and imorohoroglu (1994), richards (1996) .kim and singal (1997), hamao and mei (2001), kaminsky and schumkler (2001, 2002), anand bansal and j.s. pasricha (2009) in which no systematic evidence was found in increasing of volatility in emerging markets i.e. unrelated to the measure of market integration. we conclude that indian stock market is still not perfectly competitive. hence there is an urgent need that the policy makers support these trading platforms with infrastructure development, fiscal incentives, encouraging product innovation, widening investor base and investor education so that they are able to realise their true potential. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 33 references aggarwal, r., c.inclan, & r. leal (1999). volatility in emerging stock markets. journal of financial and quantitative analysis, 34(1), 33-35. http://dx.doi.org/10.2307/2676245 andreou elena, & eric ghysels (2002). detecting multiple breaks in financial market volatility dynamics. discussion paper 2002-02, department of economics, university of cyprus. anand bansal, & j. s. 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(2002). earnings month. prudential financial research table 1. stationarity test for sample series name panel-a panel-b (adf) test phillips-perron test (adf) test phillips-perron test t-statistics t-statistics t-statistics** tsatistics** total fii investment -1.09 -0.51 -41.98 ** -41.98 ** nifty closing price 1.12 -1.38 -41.35 ** -41.32 ** the table describes the sample price series that have been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron (1988) test of stationarity has also been performed for the price series and then both the test are performed on return series also as shown in panel-a (price series) and panel b (return series) are integrated to i(1). all tests are performed using 5%level of significance (**). table 2. johansen’s cointegration test name hypothesis lag length trace critical value** r=0, accept r=1 reject null alternate criterion (sc) max eigen value statistic 5 % sig level fii equity investment & nifty closing price r =0 r ≥1 4 lags* 0.1249 362.5 15.49 reject the table provides the johansen’s co-integration test, maximal eigen value and trace test statistics are used to interpret whether null hypothesis of r=0 is rejected at 5 % level and not rejected where r=1. rejection of null hypothesis implies that there exists at least one co-integrating vector which confirms a long run equilibrium relationship between the two variables asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 37 table 3. adequacy test for var model name of series var adequacy test critical values lags fii equity investment &nifty closing prices 1 stability (modulus values of roots of characteristics polynomials 0.94,.89, 0.24, 0.081 (stable) 4* 2 normality chi-square values 4.81 (jarque-bera) p val (0.0900)( normal) 4* 3 serial correlation lm-test 18.55( p val 0.0806) (no serial correlation) 4* the asterisk (*) shows significance at 1, 2, 3 and 4 lags. diagnostic tests are performed for sample series. vector auto regression (var) estimated with various lags selected by aic is used to check whether the model satisfies the stability, normality test as well as no serial correlation criterion among the variables in the var adequacy model. results reveal that the sample series are satisfying the stability in normality test the sample series are found to be normal. in verifying the var residual serial correlation lm tests it was found that in all sample series no serial correlation was present. therefore, it leads us to take the position that our model fulfils the adequacy criterion table 4. results of vecm, variance decomposition analysis and block exogeneity tests panel (1) vecm indexes fiis nifty close error correction: ∆ft ∆st 7.12** -1.05** cointeq1 (0.48) (0.05) [ 14.62] [-20.17] panel (1 a) : causality test variables nifty close fii s variance decomposition analysis 64.01% 35.9% block exogenity tests dependent variable: dependent variable: var granger causality/block exogeneity wald tests fii nifty close p(0.00) p(0.00) t-statistics values which are indicated in the parenthesis. a (**) is significant at 5%. this table exhibits short run dynamics using vecm model in the price series and price movements in the two markets using akaike’s information criteria. after correction residuals it was noticed that in the vecm model, error correction coefficients are significant in both equations, suggesting a bidirectional error correction and nifty price leads the fiis .the results are reconfirmed by variance decomposition analysis confirming the lead role of nifty. there are bi-directional granger lead relationships between nifty closing and fiis. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 38 table 5. results of unit root statistics name panel-a panel-b (adf) test phillips-perron test (adf) test phillips-perron test t-statistics t-statistics t-statistics** tsatistics** total fii investment -1.09 -0.51 -41.98 ** -41.98 ** nifty closing price 1.12 -1.38 -41.35 ** -41.32 ** nifty turnover 0.78 0.65 -32.96 ** -42.7 ** note: ** statistics significant at 5 % level and are i(1)as regards fii,nifty closing,turnover . table 6. results of volatility relationships name dependent variable: stdstock fiis &nifty coefficient std. err z-stat prob. a.βss (volatility clustering) lagstockest -0.01 0.13 -0.10 0** b.βsf (volitiity spillover) lagstockest 0.0 0.13 0.03 0** c.ʏs (volatility persistence) lagstdstock 0.10 0.02 7.39 0** dependent variable: stdfiis a.βff (volitiity clustering) lagfiiest 0.01 0.13 0.09 0** b.βfs (volitiity spillover) lagfiiest -0.00 0.13 -0.05 0** c.ʏ f (volatility persistence) lagstdfii 0.10 0.02 7.41 0** note: table describes volatility spillover (βsf and βfs ) volatility persistence (ƴf and ƴs) and volatility clustering (βff and βss) from the stock market(nifty) to fiis or fiis to stock respectively. volatility spill over is observed .volatility persistence is significant for both stock market and fiis for sample series , as p (value) is coming less than 0.05. the market-specific volatility clustering coefficients βff and βss are all positively significant at 5% level in the sample series. table 7. arch lm-test commodity coefficient std. error t-statistic prob. 1.comdex dependent variable: std stock(nifty) std_resid^2(-1) 0.04 0.02 2.11e+00 [0.23] dependent variable: stdfiis std_resid^2(-1) 0.05 0.02 2.15 [0.3] microsoft word 1871-7385-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 107 do golden parachutes increase ceo’s desire to be taken over? empirical evidence from australia and united states krishna reddy kr (corresponding author) department of finance, university of waikato, new zealand e-mail: krishna@waikato.ac.nz sazali abidin department of finance, university of waikato, new zealand e-mail: sazali@waikato.ac.nz caillor woon department of finance, university of waikato, new zealand e-mail: ciw2@waikato.ac.nz received: may 29, 2012 accepted: july 25, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1871 url: http://dx.doi.org/10.5296/ajfa.v4i2.1871 abstract this study investigates whether the large payouts that are available to chief executive officers (ceos) from a change in corporate control (takeover) do motivate some ceos to seek acquisition of their firms by making them more attractive to a takeover bid. using australian and the us data, employing ols regression, we report that there is a significant relationship between a ceos change in control payments and their firm’s net cash levels (one of the key factors of takeover attractiveness). our empirical results also indicate that ceos desire their firms to be acquired by decreasing shareholders’ equity, thus supporting the view that change in control payments exist primarily for incumbent managers. our findings provide support to the proposition that managers enjoy having large cash balances to be available to them as it allows them with greater opportunities to derive personal benefit from asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 108 it. therefore, our findings suggest that managers prefer to have large cash balances available to them to ensure their future wellbeing by setting up favourable terms in the control agreements. keywords: change in control payments, takeover attractiveness, equity holding, mergers and acquisitions, agency theory jel classifications: g34, g35 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 109 1. introduction media and popular opinions view managers of publicly listed companies as self-seekers, primarily out for their own gain at the expense of the shareholders (smith, 2009). a prime example of such behaviour is observed in the mergers and acquisitions market. chief executive officers (ceos) that acquire other firms increase their own salaries while ceos whose firms are taken over receive highly lucrative payouts (grinstein and hribar, 2004). lucrative payouts are termed ‘change in control payments’ and have become so large that it is nine times a ceo's annual salary (on an average basis) (hartzell, ofek and yermack, 2004). in some cases, the change in control payment is similar to winning a first prize in a state lottery. the change in control payments is referred as ‘golden parachute’ (hartzell et al, 2004) which is the payment made to the acquired firm’s ceo for terminating employment through no fault of their own. termination of employment often arises when mergers and acquisitions takes place and the change in control payments allow ceos of acquired firms to be financially unharmed, hence the name, golden parachutes. bebchuk, cohen and wang (2010) report that the presence of golden parachute increases the likelihood of takeover bids by 245.4 per cent and increases the likelihood of acquisition by 28.4 per cent. the two key factors that make takeovers attractive are firm’s net cash levels and debt capacity (powell and thomas, 1994). however, a firm’s net cash balance and change in control payments are both depended on the managerial power. jenson (1986) provided a link between managerial power and net cash balance by showing that firms with greater cash levels provide greater opportunities for ceos to gain personally through perks such as company cars and large office space. however, the focus of the extant literature has been on investigating whether golden parachutes reduce risks for ceos (morrison, 1982; maurer, 1984) or remove a ceo's motivation to sabotage an external takeover attempt (morrison, 1982; larcker and lambert, 1985). therefore, little research has been undertaken to date that investigates whether the potential gains from golden parachutes actually motivate some ceos to desire their firm to be taken over. this study is novel as it investigates whether the size of a change in control payments have become so large that it influences ceos to actually desire their firm’s to be taken over. this study contributes to the literature in three distinct areas relating to finance that are, mergers and acquisitions, corporate governance and capital structure. first, most studies relating to mergers and acquisitions argue from the acquiring firm’s viewpoint, that is, whether acquisitions are a wise investment or they simply exist to increase the acquiring ceos power (see holland and hodgkinson, 1994; andrade, mitchell & stafford, 2001). however, the research question that we propose “do golden parachutes increase ceo’s desire for their firms to be taken over?” allows mergers and acquisitions to be viewed from the target firms’ perspective. if golden parachutes do increase ceos desire for their firms to be taken over, it will have important implications for corporate governance issues and the board of directors will be interested to know what impact a ceo's motivation to seek acquisition will have on their firm. moreover, shareholders may desire their firm to be taken asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 110 over for the reasons of the equity premiums as well. therefore, it would be important to know if shareholders’ motivation for the merger and acquisitions is in fact aligned with the ceo’s desire to be taken over. furthermore, the desire to be taken over may actually motivate ceo’s to alter the capital structure of their firm in such a way that it becomes attractive for takeovers (powell and thomas, 1994). finally, studies relating to mergers and acquisition have mainly been based on the uk or the us markets and therefore, little is known about the managerial behaviour relating to golden parachutes outside these countries. for our research, we include data from both australia and the us which adds to our understanding regarding the effect of golden parachutes on ceos motivation on a global basis. our results show a positive association between net cash balances and golden parachutes, which to some extent explain the effects golden parachutes have on ceos desire to be taken over. our findings suggest that ceos with power not only enjoy greater levels of cash but also ensure that their future financial wellbeing is taken care of by locking in large change in control payments. this finding is also supported by jensen (1986), who state that the large change in control payments not only motivates ceos to seek acquisition but also exists as an insurance policy for the incumbent manager against the acquisition market. the rest of this paper is organised as follows. section ii provides reviews of the extant literature on the subject of change in control payments. section iii provides the problem definition and motivation. section iv describes the data sources and research method. section v presents the empirical results and section vi, conclusion. 2. literature review the term ‘golden parachute’ stems from a broader field of corporate governance. for this reason, a majority of scholars have used agency theory paradigm to investigate the effects of golden parachutes on firm performance. many researchers (see grinstein and hribar, 2004 for details) have focused on acquirers; while a few have also studied the effect of golden parachute on the acquired firms as well (hartzell et al., 2004). morrison (1982) argues that ceos whose firms are acquired often lose jobs which motivate them to find ways to reduce the possibility of such acquisitions. there are numerous options available to the ceos and one of the most popular one is to delay and hinder progress of a takeover bid by influencing shareholders. over the last decade or so only 18 per cent of the takeovers were hostile (hartzell, et al., 2004), which indicate that most of the takeovers do require support of the incumbent managers to progress. furthermore, empirical evidence show that acquisitions have largely benefited target companies shareholders (loughran and vijh, 1997; holland and hodgkinson, 1994) and therefore, by resisting takeover attempts, ceos can cost acquiring shareholders significant acquisition premiums. minimizing the cost of the conflict between a ceos desire to keep their job and shareholders’ wealth maximisation is one of the major reason for the existence of golden parachutes. golden parachutes allow managers to objectively review takeover offers without having to be concerned about their own financial security, thus reducing agency costs (morrison, 1982). larcker and lambert (1985) argue that golden parachutes allow firms to realign incentives of the ceos with that of the shareholders. in support, born and trahan (1993) state that golden parachutes have a positive effect on asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 111 firms’ share prices, especially when a firm is previously considered to be ‘out of play’, that is, unlikely to be involved in a takeover. therefore, the likelihood of takeover increases in firms that have golden parachutes (machlin, choe and miles, 1993). furthermore, takeovers provide larger premiums to the target firm’s shareholders that have golden parachutes in place compared to firms without golden parachutes. other benefit of golden parachutes include firms ability to acquire and retain talented executives (morrison, 1982); maurer, 1984). however, knoeber (1986) and narayan and sundaram (1998) state that golden parachutes are required by managers to hedge the risk associated with their employment contracts. firms that have golden parachutes are on an average riskier than firms without golden parachutes (almazan and suarez, 2004; narayan and sundaram, 1998) and therefore, golden parachutes enable firms to have access to managers who otherwise see their position to be too risky ( pfeffer, 1973; provan, 1980). firms without golden parachutes poses greater levels of risk compared to firms that have golden parachutes in place. for example, a firm without golden parachute will find it difficult to attract high achieving executives as they will not be willing to leave their existing firms which have golden parachutes. this is especially of concern for poor performing firms which are more likely to be the target of takeovers due to their relatively low cost. moreover, current executives in firms without golden parachutes may leave in order to find employment in firms that have a greater financial security. for this reason, the likelihood of a manager leaving a firm increases during a takeover offer, thus leaving firm without a leader and making shareholders’ vulnerable (maurer, 1984). to the contrary, whisler (1984), drucker (1974) and lorsch (1989) argue that golden parachutes are forced on boards and shareholders who lack control of the firm. managers that desire greater security for their financial wellbeing force their boards to give them assurances in the form of golden parachutes. larcker and lambert (1985) suggest that golden parachutes allow poor performing managers to shield themselves from the market discipline. wade and o’reilly (1990) reported that ceos appoint more outsiders to the board so that they have a higher incidence of golden parachutes. therefore, findings reported by whisler (1984), drucker (1974), lorsch (1989), larcker and lambert (1985) and wade and o’reilly (1990) provide support to the view that ceos who have more power on their firm have a higher tendency to use this power to ensure their financial future is secured through the use of golden parachutes. furthermore, domhoff (1978) and ratcliff (1980) argue that golden parachutes are a pat on the back from the board of directors to the ceos who are the members of the same social class. such activities are often reported in the popular media and are referred to as corporate back scratching. moreover, singh and harianto (1989) state that firms with golden parachute agreements have a higher tendency to have diffused share ownership structure, thus leading to greater board control. they also report that golden parachutes are related to greater ceo tenure relative to board tenure and having more external directors. according to bowie and fischer (1996), the benefits from golden parachutes are so large that they may encourage ceos to actively solicit takeover regardless of the effect it has on the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 112 shareholders. one of the largest sources of change in control payments for target ceos is the equity premiums. when a firm is the target of a takeover, the acquiring firm is forced to pay equity premium to ensure that they are able to purchase a controlling stake in the firm (loughran and vijh, 1997). ceos that hold large portions of a firm’s equity (due to stock options and the like) often gain substantially from the equity premium involved with a takeover (hartzell et al., 2004). hartzell et al. (2004), reported that on average, a target ceos change in control payments are worth us$12 million, or nine times their annual salary, with one ceo in their sample even earning two hundred times his annual income. around 80 per cent of ceos whose firms are acquired in their sample ceased paid work, either retired or moved into a non-profit sector. based on the findings reported by hartzell et al. (2004), maurer (984) and bowie and fischer (1996), we argue that large gains that are potentially available to ceos under a change in control payments may indeed cause ceos to desire their firms to be taken over. 3. change in control payment, takeover attractiveness and control variables to determine if substantial change in control payments causes ceos to desire their firm to be taken over, we examine whether ceos who stand to gain substantially from acquisitions are also in charge of firms which are more attractive to takeover bids. similar to simons (2002), we also examine whether ceos desire to be taken over by looking at their actions. the view we have taken is that a ceo that has a large golden parachute available to them may get encouraged to desire their firms to be taken over. since we are interested in the effects of golden parachute agreements (or potential payouts), our sample include firms that have been acquired and also firms that have large payouts available to ceos that would motivate them to make their firms more attractive (whether or not a takeover actually eventuates). our focus is on two variables that have potential to determine whether ceos who stand to gain substantially from acquisitions are also in charge of firms that are more attractive to takeover bids, that is, the size of a ceo's change in control payments and the attractiveness of the ceo's firm to takeover bids. 3.1 change in control payments hartzell et al. (2004) report that ceos on an average receive us$8 million to us$11 million as a result of a change in control payments, which is approximately 9 to 16 times their average annual salary. the primary source of the change in control payments are the amount of the equity premium paid by the acquiring firms. since potential acquirers’ pay a premium above a company’s market stock price in order to gain control of the firm, stock price of an acquired firm rises which benefits the acquiring firms’ shareholders. firms often pay their ceos a large portion of their salary as equity to motivate them to improve the value of the firm, so when a firm is acquired and the stock price rises, a target ceo often gains substantially. according to hartzell et al. (2004), equity premiums account for approximately half of a ceo’s gains due to acquisition (or about us$5 million on average). hartzell et al. report that golden parachutes are the second largest source and represent about 20 per cent of a ceos change in control payments, an average of us$1.5 million. about 69 per cent of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 113 ceos in 2004 had golden parachute agreements which required to be paid out should their employment ever be terminated through no fault of their own. the final major source of change in control payments occurs as a result of negotiations involved in the takeover process itself. twenty seven per cent of ceos are able to negotiate an additional takeover bonus worth on an average us$1.2 million, while 12 per cent manage to negotiate an augmentation to their standing golden parachutes agreement, again worth half a million dollars on an average basis. additional negotiated bonuses makes up another 20 per cent of the takeover payments given to acquired ceos. hartzell et al. (2004) show that a ceo’s expected change in control payments, should they be acquired, can be estimated based on their existing equity ownership, change in control payments and an additional bonus worth about one and a half times their annual salary due to the negotiated benefits. therefore, we use a similar method to hartzell et al. (2004) to determine whether a ceo could gain substantially from an acquisition of their firm. 3.2 takeover attractiveness in determining what makes a firm attractive to a takeover bid, many researchers have analysed firms that have been acquired in order to determine common characteristics that make a firm a likely target for a takeover bid. motivated by jensen (1986), many researchers have focused on the view that mergers and acquisitions are a mean of replacing poorly performing managers. managers that exert large agency costs on their firms eventually lower the value of their firms to such a point that the firm will be acquired at a bargain price and the management team will be replaced. martin and mcconnell (1991), palepu (1986) and powell and thomas (1994) found that firms with low stock performance have an increased likelihood of takeover. morck shleifer and vishny (1989) and hasbrouck (1985) have reported similar results using tobin’s q as a measure of firm performance. to the contrary, holland and hodgkinson (1994) found that past performance has no effect on takeover likelihood in the uk. similarly, alcade and espitia (2003) found no support for the view that acquisitions exist to replace incumbent managers in spanish companies. the conflicting empirical evidence relating to firm performance and takeover suggest that debate whether takeovers lead to better performance is far from being over. although poor past performance would reduce a firm’s value and make the firm more attractive for a takeover, reducing firm value would be counterproductive to a ceo looking for their firms to be taken over. since the primary source of change in control payments is the equity premium (hartzell et al 2004), reducing the value of the firm in order to attract a takeover bid would hurt ceos own payout as it would reduce the value of their personal equity. palepu (1986), hasbrouck (1985), ambrose and megginson (1992), berger and ofek (1996) and aaronovich (1981) find that firm size is a key factor that increases takeover likelihood. they argue that smaller firms are cheaper to buy and as such, are more attractive to takeover targets. however, reducing a firm’s size in order to attract a takeover bid would be counterproductive for a ceo who is looking to cash-in on the change in control payments. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 114 any reduction in firm size would not only lower the ceo’s equity value but would also result in reducing their salary as well (hartzell et al 2004, jensen 1986). arguably, a ceo wishing to reap the benefits of change in control payments without reducing the value of their own rewards can be achieved through cash and leverage. palepu (1986), holland and hodgkinson (1994), powell and thomas (1994), lehn and poulsen (1989) all promote the notion that ‘resource rich firms’ are more attractive takeover targets. mergers and acquisitions are often very costly and if firms’ that are acquired have large resources available, it can be used to recoup some of the costs of the acquisition. firms with large cash balances are attractive for takeovers as cash can be used for other projects after acquisition. likewise, firms with low leverage are attractive as well, excess debt capacity can be utilised by raising debt levels to increase cash balances and help make up for the costly acquisition process.1 once the firm is acquired, the extra cash is used to pay back some of the debt while the rest of the debt is now owed by a much larger combined firm, making the debt comparatively smaller. based on the information provided above, we measure a firm’s attractiveness to a takeover bid as the value of their cash balances, leverage and as well as a combined factor incorporating both variables. 3.3 control variables to determine the effect of the level of payout a ceo is entitled to receive after acquisition, the change in control payments is captured by the variable payoutfactor. payoutfactor is an estimate of a ceos change in control payment divided by their annual compensation. the estimate for the change in control payment is the function of a ceos shareholding in the existing golden parachutes and the annual compensation is the ceos annual salary. salaryannual nacquisitioafterpayoutexpected orpayoutfact  miller and modigliani (1963) argue that debt generally has a lower cost than equity and therefore, firms should aim to increase their leverage whenever possible. however, a higher debt level leads to greater risk of bankruptcy or financial distress should they be unable to meet their interest obligations. the tradeoff theory states that firms’ tradeoff the borrowing costs and bankruptcy costs against each other to arrive at an optimal debt and equity ratio for the firms (scott, 1976). a key factor that explains a firm’s debt level is the firm’s financial distress costs. according to john (1993) and devereux and schiantarelli (1989), factors affecting firms’ financial distress costs are the earnings and cash flow volatility. essentially firms that have high volatile cash flows are more unlikely to meet their interest obligations in a specific year due to the uncertainty regarding their income. furthermore, research regarding the reasons for holding high cash balances largely focus on the risk of becoming insolvent. baumol (1952), tobin (1956), meltzer (1963) and miller and orr (1966) state that firms hold 1 an extreme case of such takeovers are leveraged buyouts (lbos) (damodaran, 2005) where the acquiring firm accrues a large amount of debt in order to acquire a target firm with high cash balances and low leverage. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 115 cash to avoid being short on liquid assets when needed. moreover, opler, pinkowitz, stulz and williamson (1999) report that a firm’s desire to hold cash is increased when a firm finds it difficult to raise external funds. therefore, a firm’s desire to hold cash can be partly estimated by their volatility of cash flows. firms with inherently volatile cash flows are more likely to be at risk of insolvency (miller and orr, 1966). we also use risk of cash flows as a proxy for the risk of insolvency. to control for the effects of tradeoff theory on debt and risk of insolvency, we include two proxies, that is, firm’s volatility of cash flows (fcfvar) and earnings (npvar). fcfvar is volatility of firm’s cash flow over the last three years and npvar is the volatility of firm’s net profit over the last three years. similarly, a high financially performing firm will create more value for the ceo than a low performing firm. to capture the effects of performance on change in control payments, we have used tobin’s q as a proxy for performance. tobin’s q is measured as follows: assetstotal debtl/tdebtcurentnetgoutstandinsharesofno.*price qstobin'  to control for the endogeneity effect, we also use an interaction term (interq) which is determined by multiplying factorpayout by tobin’s q.2 because ceos know more about their firm than the outsiders, there is a potential of the existence of information asymmetry when firms apply for outside financing. the pecking order theory postulated by myers and majluf (1984) state that executives prefer to fund projects first with cash, then with debt, and use equity as a last resort due to the higher degree of information asymmetry associated with it. helwege and liang (1996) and graham and harvey (2001) show that more information is known about larger firms and those that pay dividends and therefore, have a lower degree of information asymmetry. based on this view, we also use both firm size and dividend payout ratio as potential explanation for capital structure. we use natural log of total assets (lnta) as a proxy for firm size and the ratio of dividend paid divided by net profit of the firm (divpout) as a proxy for dividend payout. fowley, hartzell titman and twite (2007), state that industry also plays an important part in determining firms’ cash balances and capital structure. a firm’s industry affects the firm’s stability and thus their need to hold cash and financial distress costs. for this reason, we have also included industry dummies in our analysis. we have created seven industry dummy variables where ind is equal to “1” if firm belongs to industrials, otherwise “0”; hc is equal to “1” if firm belongs to health care, otherwise “0”; cs is equal to “1” if firm belongs to consumer services, otherwise “0”; tech is equal to “1” if firm belongs to technology, otherwise “0”; cg is equal to “1” if firm belongs to consumer goods, otherwise “0”; and o&g is equal to “1” if firm belongs to oil & gas, otherwise “0”. the industry the firm belongs to is determined by the datastream industry identifier. 2 we thank the anonymous reviewers who suggested adding performance measure and as well as an interaction term. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 116 table 1 provides a summary of the variables used and its measurement. table 1. variable and measurement variables measurement %equity total equity/total debt net cash net cash divided by the firm’s total assets. net cash is the firms’ total cash balances less any cash debts. attractiveness totakeover netcash + %equity ceo share holdings reported sec value for the chief executives total shares divided by the total number of shares in the firm. ceo existing golden parachutes reported sec value for any payments listed as potential payouts under termination without cause or change of control. the value has been normalised for size by dividing it by the respective firm's total assets. ceo yearly salary reported sec value for the total income of the ceo including expected value of equity payments. the value has been normalised for size by dividing it by the respective firm's total assets. payoutfactor an estimate of a ceos change in control payout divided by their annual compensation. the estimate of change in control payments is a function of ceo share holdings existing golden parachutes lnta natural log of total assets. divpout dividend payout ratio accounting value for the amount of dividends paid in the year divided by the total net profit of the firm. fcfvar cash flow volatility volatility over the last three years of the firms accounting value for total cash flows. npvar earnings volatility volatility over the last three years of the firms accounting value for the total net profit of the firm. tobin’s q (price * no of shares outstanding + net current debt + l/t debt)/total assets interq factorpayout * tobin’s q industry firms are divided into seven key industries: industrials (ind), health care (hc), consumer services (cs), technology (tech), financials (fina), consumer services (cs), and oil & gas (o&g). *accounting variables sourced from datastream database, sec values received from proxy statements from the sec website. 4. data, methodology and research method our sample includes 250 us firms and 100 australian firms for the financial year 2009 from the s&p500 and ax200 indices, respectively. data was collated from three major sources. accounting data, such as data required to measure firm attractiveness and control variables, was collated from the datastream database. in the us, firms are required to submit information on ceo compensation and equity ownership in proxy statements to the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 117 securities and exchange commission and therefore, the change in control payments was collated individually for each firm from the proxy statements. for the australian companies, executive compensation and security ownership information was collected from individual firms’ annual statements. we use ordinary least squares (ols) regression to determine the relationship between change in control payments and attractiveness. three key regression analyses is undertaken: (i) the link between change in control payments and net cash; (ii) the link between change in control payments and debt, and (iii) the link between change in control payments and an attractiveness factor made up of both net cash and debt levels. expected change in control payments are estimated based on ceo shareholdings, existing golden parachute agreements and their existing annual compensation similar to that reported by hartzell et al. (2004). first, the value of the ceos shareholdings is multiplied by an expected equity premium of 22 per cent based on findings reported loughran and vijh (1997) and holland and hodgkinson (1994). second, existing golden parachutes values are then added and are taken at their expected value as found in sec filings for the us companies or annual report for australian firms. hartzell et al. (2004) also find that 27 per cent of ceos manage to negotiate takeover bonuses equal to 1.5 times their annual salary. thus, the expected value of this possibility is also added to the expected change in control payments. finally, hartzell et al. (2004) shows that 8.6 per cent of ceos with golden parachutes and 19.3 per cent of ceos without golden parachutes manage to negotiate an augmentation to their existing golden parachutes agreements. the value of this change in agreements is generally equal to the ceos annual compensation. the expected value of change in agreements is also added to the ceos expected change in control payments. the total expected change in control payment is then normalised by dividing it by the ceos annual salary to make an expected payout factor. the attractiveness factor is created by examining a firm’s relative levels of net cash and debt. firms are ranked first by net cash/total assets and divided into three groups. the top third of firms are given a net cash score of three, the second third a score of two, and so on. this process is repeated for a firm’s debt/total assets. a firm’s total attractiveness score is then given by the combination of these two scores. this method of factor creation is similar to that used by grinstein and hribar (2004) which enable us to examine separately the link between change in control payments, net cash, debt and total attractiveness. our empirical model is formulated a follows: 1..........εindustry npvarfcfvardivpoutassetstotalpayoutacotpaymentscontrolinchange   where, change in control payments = either attractivenesstotakeover, netcash or %equity asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 118 a firm’s attractivenesstotakeover is a combination of netcash and %equity. netcash is net cash/total assets and %equity is total equity/total debt. 5. empirical results table 3 reports the compensation statistics of the sampled firms. our results show that change in control payments on an average are 11.5 times a ceo’s annual salary compared to nine times report by hartzell et al. (2004). the average salary of a ceo in the us is us$10.51 million and the average payout is us$54 million. however, there is a large variation in the actual salary depending on the relative size of the firms. australian results show similar trend to the us, but is of much lower magnitude. this is not surprising as the firms in australian are about 50 per cent the size of the us firms when measured by total assets. the mean (median) values for tobin’s q are 1.53 (1.21) indicate that firms in both countries (australia and the us) have created value for the shareholders which are greater than one. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 119 table 2. compensation statistics sample variable units mean median min max s.e count all total compensation $m 8.8 7.3 0.3 100.1 0.5 332 change in control $m 14.0 10.4 0.0 125.5 1.0 332 total shares m 5.0 1.1 0.0 217.7 1.2 332 estimated payout $m 45.3 24.6 0.7 1620.6 7.1 332 payoutfactor $ 4.7 3.9 0.3 45.7 4.6 332 total assets $m 32.2 7.9 0.1 2322.0 9.9 332 tobin’s q ratio 1.53 1.21 0.50 8.32 0.94 332 aus total compensation $ 4.7 3.9 0.3 45.7 0.3 100 change in control $m 7.3 5.7 0.0 57.3 0.5 100 total shares m 2.8 0.6 0.0 99.3 0.7 100 estimated payout $m 25.1 13.0 0.7 739.3 3.8 100 payoutfactor $ 5.3 1.4 0.3 576.8 2.6 100 total assets $m 17.6 2.3 0.1 617.4 8.0 100 tobin’s q ratio 1.56 1.10 0.50 8.32 1.23 100 us total compensation $m 10.5 8.8 0.6 100.1 0.6 232 change in control $m 16.8 12.5 0.0 126.0 1.1 232 total shares m 5.9 1.4 0.0 218.0 1.4 232 estimated payout $m 54.00 29.6 1.6 1620.6 8.5 232 payoutfactor $ 11.4 3.2 0.60 1264.3 5.5 232 total assets $m 38.5 10.4 0.8 2322.0 10.7 232 tobin’s q ratio 1.52 1.27 0.71 6.12 0.79 232 table 3 reports the correlation coefficient of the independent variables used in this study. a correlation less than 0.8 are generally considered to be appropriate for regression analysis (field, 2008). most of the correlation coefficients reported in table 3 are less than 0.5, apart for the correlation between the fcfvar and npvar which is 0.740. also, our tests for multicollinearity3 show that there are no serial correlation issues in the data. our test for autocorrelation also resulted to be negative as well. we have reported bootstrap standard 3 not provided. however, results can be obtained from the authors if required. to improve robustness, we have also reported bootstrap standard errors as well. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 120 errors which have a tendency to minimise the effect of heteroskedasticity when sample size is small. table 3. partial correlation results for the independent variables payoutfactor (pf) is an estimate of a ceos change in control payment divided by their annual compensation and change in control payment is the function of ceos share holdings in their existing golden parachutes. ta is the natural log of the total assets. npvar is the volatility of the last three years of the firms accounting net profit. fcf var is the volatility of the last three years firms accounting total cash flows. divpout is the dividends paid in the year divided by total net profit for the firm. tobin’s q (q) is the ratio of (price * no. of shares outstanding + net current debt + l/t debt) to total assets. ind indicate firm belonging to the industrial sector, hc indicate healthcare sector, cs indicate consumer services, tech indicate technology, fina indicate financials, cg indicate consumer goods and o&g indicate oil and gas. pf ta np var fcf var div pout q ind hc cs tech fina cg o&g payoutfactor (pf) --- total assets (ta) -0.0144 (0.794) np var -0.004 (0.945) -0.185*** (0.000) fcf var 0.004 (0.946) -0.357*** (0.000) 0.740*** (0.000) divpout -0.021 (0.708) -0.087 (0.116) 0.003 (0.957) -0.031 (0.5790 q 0.064 (0.248) -0.390*** (0.000) 0.271*** (0.000) -0.071 (0.199) industrials (ind) -0.019 (0.719) 0.066 (0.229) -0.026 (0.637) -0.063 (0.250) -0.075 (0.172) -0.034 (0.543) health care (hc) -0.016 (0.773) 0.059 (0.285) -0.019 (0.722) -0.047 (0.392) -0.079 (0.152) 0.237*** (0.000) -0.097† (0.076) consumer services (cs) -0.012 (0.825) 0.042 (0.442) -0.019 (0.733) -0.045 (0.418) -0.080 (0.145) 0.043 (0.438) -0.099† (0.070) -0.079 (0.148) technology (tech) -0.016 (0.770) 0.009 (0.860) -0.021 (0.708) -0.046 (0.401) -0.091† (0.098) 0.118** (0.32) -0.102† (0.064) -0.081 (0.139) -0.083 (0.130) financials (fina) -0.019 (0.718) 0.296*** (0.000) -0.026 (0.639 -0.070 (0.201) 0.041 (0.458) -0.252*** (0.000) -0.122** (0.027) -0.097† (0.077) -0.099† (0.070) -0.102† (0.064) consumer goods (cg) -0.017 (0.753) 0.008 (0.880) -0.021 (0.701) -0.041 (0.447) -0.044 (0.422) -0.017 (0.761) -0.106† (0.054) -0.085 (0.115) -0.087 (0.108) -0.089 (0.108) -0.106† (0.054) oil & gas (o&g) -0.014 (0.8010 0.121** (0.028) -0.017 (0.761) -0.035 (0.523) -0.077 (0.163) 0.076 (0.165 -0.086 (0.118) -0.069 (0.211) -0.070 (0.201) -0.072 (0.192) -0.086 (0.118) -0.075 (0.174) *** denote significance at 1% level, ** denote significance at 5% level and† denote significance at 10% level. in determining whether a ceo has potentially attempted to make their firm more attractive as a takeover target, we regress three exogenous attractiveness variables (netcash or %equity, attractivenesstotakeover) against the potential payout given to a ceo under acquisition. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 121 table 4 report the results of the regression analysis between a firm’s net cash/total assets as the dependent variable. table 4. net cash regression estimate us bootstrapst d. errors aus robust std. errors combined bootstrap std. errors intercept 0.201† (1.85) 0.127 0.499** (2.23) 0.223 0.433*** (3.19) 0.136 payout factor 0.001*** (4.74) 0.000 0.013† (1.76) 0.011 0.001*** (5.83) 0.000 total assets -0.007** (-2.11) 0.007 -0.027** (-2.07) 0.013 -0.028*** (-3.53) 0.007 npvar 0.036** (2.35) 0.101 0.009** (2.96) 0.003 0.008*** (4.35) 0.002 fcfvar -0.253 (-0.93) 0.272 -0.038 (-0.95) 0.039 -0.018 (-0.44) 0.041 divpout -0.005 (-1.20) 0.004 -0.008 (-1.39) 0.005 -0.012** (-2.96) 0.004 q -0.193*** (-6.77) 0.029 -0.199*** (-3.53) 0.056 -0.047*** (-3.63) 0.013 interq 0.043*** (9.22) 0.005 0.042*** (4.25) 0.009 0.001*** (5.79) 0.000 industrials 0.001 (0.02) 0.023 -0.035 (-0.76) 0.046 -0.010 (-0.38) 0.026 health care 0.006 (0.25) 0.025 0.029 (0.35) 0.083 0.044 (1.26) 0.035 consumer services -0.018 (-0.77) 0.023 0.017 (0.24) 0.072 -0.010 -0.34) 0.029 technology 0.124*** (3.91) 0.031 -0.032 (-0.33) 0.096 0.183*** (5.00) 0.036 financials 0.055† (1.87) 0.029 -0.002 (-0.03) 0.048 0.026 (0.89) 0.029 consumer goods 0.043** (1.98) 0.022 -0.079 (-1.08) 0.073 -0.015 (-0.45) 0.034 oil & gas -0.016 (-0.75) 0.021 0.064 (0.65) 0.098 0.054 (1.37) 0.039 r2 (adj. r2) 0.54 (0.51)) 0.53 (0.45) 0.35 (0.32) wald χ2 (14) 250.31*** (0.000) 34.93** (0.001) 127.45*** (0.000) sample size 232 100 332 †, **, *** denote significance at 10%, 5% and 1% respectively asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 122 the regression estimates for the us is provided in column 2, australia in column 3 and combined data in column 4 in table 4. results show that a ceo’s payout (payoutfactor) is statistically significant at 1% level, thus indicate that existence of golden parachutes increases the level of net cash balance in firms. there are a number of plausible reasons for this outcome. first, ceos are attracted to extremely large payouts under a change in control payments and therefore alter their firm’s cash balances in order to entice a potential acquirer. a higher cash balance helps to offset the costs of acquisition, thus increasing the likelihood of a takeover and likelihood of a ceo getting paid out. this explanation is consistent with view provided by jensen (1986) that managers are predominantly self-seekers or it is a reward for social status (domhoff, 1978; ratcliff, 1980). second view is that firms with greater cash balances are more likely to offer large change in control payouts because they have the cash balances to do so. this explanation supports the view that change in control payment may exists to gain access to executive talent (morrison, 1982; maurer, 1984). third view is that firms tend to hold larger cash balances to offset their own internal risks due to volatile cash flows (miller and orr, 1966; karni, 1973). having large change in control agreements in place for executives would most likely worsen the cash flow volatility as the firm would be required to payout significant amount of cash if ceos employment is terminated. this view is supported by our results where the coefficient of the earnings volatility (npvar) is positive and statistically significant at the 5% and 1% level, respectively. this indicates that high earnings volatility leads to higher net cash balances. the firm performance measure tobin’s q has a negative coefficient and is statistically significant at 1 per cent level. this shows that tobin’s q has a negative effect on the net cash balances. firms may have invested more resources to increase value which may have required using cash. however, the coefficient of the interq (interaction between payoutfactor and tobin’s q) is positive and statistically significant at 1 per cent and 10 per cent, respectively. the results for interq indicate that as value of the firm increases, the ceos expected payout also increases. results for the industry dummy variables are interesting to note. result for the us show that technology, financials and consumer goods sectors have positive coefficients and are statistically significant at 1 per cent, 5 per cent and 10 per cent. this suggests that firms in these industries hold more cash compared to other industries. a plausible reason could be that these industries have long lag time between research and payouts which may require them to hold a greater amount of cash than similar sized firms in other industries. in investigating which of the three explanations stated above holds the greatest weight, we examine the firm’s capital structure as the second attractiveness variable, that is, how much of the firm’s assets are owned by firm’s equityholders. a firm with more equity is considered more attractive as a takeover target as the acquiring firm can increase the amount of debt in a firm in order to raise cash after the costly acquisition process. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 123 table 5. equity percentage regression estimate u.s bootstrap std. errors aus bootstrap std. errors combined bootstrap std. errors intercept 1.037*** (7.76) 0.134 1.140*** (5.82) 0.177 1.27*** (10.62) 0.120 payout factor -0.001*** (-2.28) 0.000 -0.006*** (-3.36) 0.014 -0.011*** (-8.01) 0.000 total assets -0.037*** (-4.80* 0.008 -0.035** (-2.62) 0.013 -0.058*** (-8.04) 0.007 npvar -0.219** (-2.05) 0.107 -0.001 (-0.32) 0.002 0.001 (0.47) 0.003 fcfvar -0.599† (-1.89) 0.317 0.000 (0.01) 0.041 -0.024 (-0.49) 0.049 divpout 0.003 (0.69) 0.004 0.017 (1.51) 0.013 0.006 (0.68) 0.009 q -0.289*** (-9.29) 0.031 -0.575*** (-5.80) 0.099 0.017 (0.92) 0.019 interq 0.061*** (12.87) 0.005 0.098*** (6.67) 0.014 -0.003 (-0.09) 0.000 industrials 0.013 (0.58) 0.023 0.035 (0.60) 0.058 0.011 (0.36) 0.032 health care 0.042 (1.18) 0.035 0.115† (1.75) 1.465 0.132** (2.85) 0.046 consumer services 0.042 (1.33) 0.031 0.004 (0.04) 0.104 -0.017 (-0.30) 0.058 technology 0.072** (1.99) 0.036 0.009 (0.10) 0.087 0.176*** (3.64) 0.048 financials -0.066** (-2.40) 0.027 -0.072 (-1.39) 0.052 -0.068** (-2.03) 0.033 consumer goods -0.002 (-0.05) 0.029 -0.007 (-0.09) 0.074 -0.058 (-1.62) 0.037 oil & gas 0.081** (2.51) 0.032 0.105 (1.51) 0.069 0.129** (2.99) 0.043 r2 (adj. r2) 0.69 (0.67) 0.66 (0.61) 0.34 (0.31) wald χ2 (14) 475.03*** (0.000) 177.63*** (0.000) 191.04*** (0.000) sample size 232 100 332 †, **, *** denote significance at 10%, 5% and 1% respectively asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 124 the results reported in table 5 show that payoutfactor has a negative coefficient and is statistically significant at 1 per cent level in all the three cases (columns 2, 3 and 4 in table 5). this indicates that as payoutfactor increases, the total shareholders’ equity decreases, therefore, decreasing shareholders voting power. this supports the view that high golden parachutes do alter firm’s attractiveness via change in the capital structure. according to murphy (1999), incumbent managers prefer a firm with debt as this would allow the firm to hold greater total assets which is a primary determinant of executive compensation (murphy 1999). since our results reported in table 5 examine the effects on capital structure and not net cash, we do not provide any explanation for whether high cash balance increases probability for having managerial talent. however, our results do provide support to the third explanation, that is, managers that have greater influence have greater gain from the change in control agreements as an insurance policy. overall, our results in table 5 for the analysis of the link between capital structure and change in control payments do support the view that managers can alter their firm’s capital structure to attract takeover bids. our results are interesting in relation to the results reported by miller and modigliani (1963) and myers and majluf (1984). miller and modigliani state that firms arrive at a target capital structure through the tradeoff play between the lower cost of debt financing and the potential distress costs of bankruptcy. the distress costs are higher in firms with more variable incomes and cash flows. since our results for both npvar and fcfvar are not significant, it indicates that the distress costs are not relevant for these firms as they hold high cash balances anyway. the pecking order theory states that firms prefer to fund projects with cash, then debt, before finally issuing equity. myers and majluf (1984) suggest that this is due to information asymmetry causing firm’s equity to be undervalued. they also suggest that large firms and those with greater dividend payouts suffer less from information asymmetry, thus indicating that there should be a link between firm size, dividend payout and capital structure. our results show that lnta has a negative coefficient and is statistically significant at 1 per cent level, indicating large firms tend to have high debt financed compared to equity financed. however, the relationship between dividend payouts and capital structure is not statistically significant, thus providing limited support for myers and majluf theory. industry specific results show that industrial, healthcare, technology, consumer services and, oil and gas have statistically significant results. the results show that a firm in each of these industries is likely to have a higher equity to debt ratio and thus, more equity financed. results for the regression analysis between a firm’s attractiveness as a takeover target and the potential payouts available to a ceo under a change in control are reported in table 6. the attractiveness factor is a combination of both a firm’s net cash balance and its capital structure. a firm that is high in both areas will have a higher attractiveness factor. the results reported in table 6 (columns 2, 3 and 4) indicate that payoutfactor has no effect on the firm’s attractiveness. our results reported interq is similar to that reported in table 4. the results indicate that firms with higher firm have higher payout compared to low performing firms. however, the results do indicate that the greatest cause of a firm’s asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 125 attractiveness as a takeover target is the industry in which it operates. this is also supported by schoenberg and reeves (1999) who reported that merger and acquisition activities are concentrated in a few key industries and economic sectors. those industries are industrial, healthcare, technology and the oil and gas industries. table 6. attractiveness factor regression estimate us bootstrap std. errors aus bootstrap std. errors combined bootstrap std. errors intercept 7.019*** (11.21) 0.626 2.228*** (8.56) 0.260 7.57*** (10.97) 0.690 payout factor 0.000 (0.44) 0.000 0.017 (0.69) 0.025 -0.001 (-0.97) 0.000 total assets -0.167*** (-5.16) 0.032 -0.048** (-2.93) 0.016 -0.268*** (-6.67) 0.040 np var -1.498** (-2.04) 0.735 0.000 (0.02) 0.004 0.002 (0.12) 0.012 fcf var 0.437 (0.30) 1.442 -0.036 (-0.56) 0.065 -0.017 (-0.07) 0.236 divpout -0.008 (-0.46) 0.017 0.001 (0.11) 0.007 -0.041 (-1.27) 0.033 q -2.562*** (-10.62) 0.241 -0.666*** (-8.29) 0.080 -0.197** (-2.84) 0.069 interq 0.503*** (14.69) 0.034 0.122*** (8.30) 0.015 0.001† (1.93) 0.000 industrials 0.333*** (3.07) 0.108 -0.058 (-0.76) 0.077 0.207 (0.97) 0.214 health care 0.559*** (3.49) 0.160 0.188 (1.39) 0.135 1.085*** (3.97) 0.273 consumer services 0.483*** (3.89) 0.124 0.109 (1.32) 0.083 0.416† (1.66) 0.250 technology 0.765*** (5.19) 0.147 -0.157 (-1.10) 0.143 1.548*** (6.48) 0.239 financials 0.069 (0.59) 0.116 -0.097 (-1.47) 0.066 -0.047 (-0.24) 0.198 consumer goods 0.484*** (3.13) 0.154 -0.008 (-0.10) 0.086 0.112 (0.46) 0.246 oil & gas 0.589*** (3.79) 0.156 -0.010 (-0.13) 0.084 0.885*** (3.32) 0.266 r2 (adj. r2) 0.88 (0.87) 0.73 (0.69) 0.37 (0.34) wald χ2 (14) 1294.87*** (0.000) 195.10*** (0.000) 263.61*** (0.000) sample size 232 100 332 †, **, *** denote significance at 10%, 5% and 1% respectively asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 126 in summary, results reported in table 4 and 5 provide support to our hypothesis that executives who stand to gain substantially from an acquisition would actively seek to make their firms more attractive to a takeover bid. our results provide support to the results reported by larcker and lambert (1985), wade and o’reilly (1990) and singh and harianto (1989), that managers use their power to secure their financial future with golden parachutes and change in control payments. results reported in table 6 show that the size of an executive’s potential change in control payments is unrelated to the firm’s attractiveness as a takeover target. total assets are negatively related to both equity and cash and npvar is statistically significant in explaining cash balance levels. 6. conclusion using agency theory paradigm, larcker and lambert (1985) and narayan and sundaram (1998) argue that change in control payments exist primarily as an insurance policy for incumbent managers, should their firm ever be acquired. this view is also supported by whisler (1984), drucker (1974) and lorsch (1989) who argue that executives are in complete control of firms and that shareholder and boards of directors are powerless. according to hartzell et al. (2004), since the inception of golden parachutes, change in control payments have become a significant source of executive compensation during a takeover with some ceos receiving up to nine times their annual salary. this study investigates whether change in control payments motivates some ceos to actually desire their firm to be taken over. using the us and australian data, and employing ols regression, we report that the firms with large change in control payments also tend to have large cash balances. this view is also supported by hartzell et al. (2004). our findings reported in table 4 show that an increase in payoutfactor (golden parachute provision) tends to have a positive effect on net cash balance, indicating that firms do hold high cash balances in order to be able to meet their obligation. however, results for total assets indicate that smaller firms hold higher net cash balances compared to larger firms. earnings volatility (npvar) is positive, thus indicating that firms experiencing high volatility tend to hold higher net cash balances. results reported in table 5 indicate that factorpayout has a negative effect on the proportion of equity held by the shareholders. this suggests that managers do change the capital structure of the firm (proportion of debt and equity) in order to gain power of control. our findings reported in tables 6 support the view that managers that have substantial influence over their firms actually use this influence to get their firms to hold more cash and negotiate better change in control contracts. this enables the incumbent manager to use the extra cash for their personal use but also insure that their financial wellbeing is secured should the firm ever be acquired. we conclude that firms with greater cash levels offer change in control agreements as they are more able to afford them and having high golden parachute benefits allow ceos to change the firms’ capital structure for their own benefits. overall, our finding supports the view that change in control agreements are implemented largely due to executives wanting an insurance policy and corporate governance is being relatively powerless to stop them. finally, we wish to caution people from generalising the findings of this study as it is based on a small sample size. it is noted that this study is timely and deals with concerns regarding asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 127 ceo compensation, capital structure and governance issues. the extent to which companies can work to lift governance practices will provide opportunities for research in the future. references andrade, g., mitchell, m., & stafford, e. 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(1984). the rules of the game: inside the corporate board room. homewood, iii: dow-jones irwin. microsoft word 1435-5635-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 173 the impact of accounting information system in planning, controlling and decision-making processes in jodhpur hotels dr. omar a.a. jawabreh tourism and hotels sciences department, al balqa applied university, jordan, aqaba e-mail: www.ojawabreh2000@yahoo.com ali mahmoud abdallah alrabei research scholar, dept of accounting, j.n.v.u e-mail: alialrabei@yahoo.com received: february 23, 2012 accepted: march 25, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1435 url: http://dx.doi.org/10.5296/ajfa.v4i1.1435 abstract the study aims to identify the reality of accounting information systems in four and five-star hotels in terms of planning, controlling and decision making. the descriptive analytical method has been used through data collection by means of a questionnaire distributed to various hotel accountants. after the statistical analysis of the questionnaire, appeared several key findings most important of which are that hotels in jodhpur didn't use the methods of accounting information system in planning, control and decision making processes. the study finding respectively that all grouped items have a mean of (1.77, and 0.00), (1.85 and 0.00), (1.98 and 0.00) level of significance (p-value), which means that these hypothesizes is rejected. because there is no relationship between accounting information system and planning, controlling, and decision-making in four and five star jodhpur hotels. the study recommends increase the rehabilitation of the cadres and develop the information system at jodhpur hotels towards the efficient application of accounting information system methods. keywords: accounting information system, planning, controlling, decision making, hotels. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 174 1. introduction in recent years the firms started changing faster and faster front of globalization technology, part of this changing is an accounting information system, any change depends on data and information, to improve an international accounting information system or to make it more successfully business should be collect high quality of data which will be lead to high quality of information about this enterprise, these information it will be the way to planning, controlling and make right decision. indeed, accounting information system (ais) is vital to all organizations (borthick and clark, 1990; curtis, 1995; rahman et al., 1988; wilkinson, 1993; wilkinson et al., 2000). accounting information can be used to translate these different dimensions into a common financial dimension. accounting information uses formalized categories for collecting and reporting information that creates a common language with which members of the organization can communicate. formalization permits the transmission of information with fewer symbols and this facilitates the coordination between different functions that need to provide input to the decision-making process. however, accounting information is also an imperfect representation of the underlying decision problem, since not all aspects involved can be quantified perfectly in financial numbers (galbraith, 1973). accounting information may help managers to understand their tasks more clearly and reduce uncertainty before making their decisions (chong,1996). we talk about uncertainty as a lack of information compared to what a decision-maker needs to make a decision (galbraith, 1973), and the less managers are able to predict the outcomes from their actions, the more uncertainty there is. the decision to centralize or outsource part or all of the accounting functions involves strategic decisions as well as practical considerations. the reasons for companies considering this are partly to do with cost and reporting processes (chin et al., 1995), but also relate to improving the strategic accounting function, an issue currently of growing importance to hotel groups (collier and gregory, 1995). this raises issues for on-site management concerning the extent of, and responsibility for, the control they undertake. if accounting processes are taken out of the unit, then there may no longer be a need for an on-site financial controller, and hence operational managers may have to take more responsibility for control issues. this raises issues about the perceived skills of managers, and the extent to which the controller is viewed as an advisor to the business, as well as a processor of accounting data. george, h. bodnar., and william, s. hopwood. (2001). they discuss various factors involved in financial control over computer-based accounting information systems. and describe the nature of management decisions, elaborate on the types of decisions that managers make, describe various reports used for management planning and control. indeed, wide variety of people within and outside the organization uses accounting information for decision-making (rahman and halladay, 1988, renau and grabski, 1987). hotels like any sector need to apply the accounting information system by improving the quality of services by planning, controlling and make different decisions by managers, so asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 175 that new technology became plays an important role to cover and record wide range through the impact of accounting information system in planning, controlling and decision making processes in the core of hotels. 2. literature review the study by majed, adel. alsharayri. (2011). under the title. “the e-commerce impact on improving accounting information system in jordanian hotels", this study is aimed to determine the effect of the electronic commerce on accounting information system development in jordan. the data analysis found out that accountants in jordanian hotels have positive attitudes towards information technology, and use internet in accounting works, they agree that hotels depend on ecommerce and customers get orders by using website. eva, heidhues., & chris, patel. (2008). under the title. “the role of accounting information in decision-making processes in a german dairy cooperative", this research has significant implications for the international application of management accounting procedures and practices in decision-making processes. multinational enterprises, governments and researcher would benefit from such insights into the utilization of accounting information in various national contexts. the development of theories on costing, combined with advances in information technology, has improved the theoretical capabilities of such systems. however, two questions remain largely unanswered: a) whether these theories lead to tangible improvements; and b) what are the variables that drive the success of cost accounting systems. our research shows that hotel managers need to be convinced about the use and performance benefits of such systems in the decision making process. burchell et al. (1980) discuss different roles of information in decision-making depending on the level of uncertainty. these roles are defined along two dimensions: uncertainty of objectives and uncertainty of cause and effect. accounting information is one type of information that can be used as a ‘learning machine’. accounting information can help to evaluate how objectives might be achieved by quantifying the financial impact of each alternative available to the decision. we propose that accounting information is particularly useful in operations management when uncertainty over the consequences of action is caused by uncertainty about the weights of the diverse effects of an action. the effects of a decision are various and expressed in different units of measurement, e.g. number of units produced, lead-time of processes, reliability of processes, service towards customers, inventory levels, capacity utilization levels, number of different products. one source of uncertainty is lack of knowledge regarding which effects will occur. rajiv, d. and banker, hsihui. chang. (2002). under the title. “impact of information technology on public accounting firm productivity", this study focuses on five offices of an international public accounting firm that recently made large it investments, primarily in audit software and knowledge-sharing applications. both qualitative and quantitative information from the research site are analyzed to estimate the change in productivity asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 176 following the implementation of it. the results from both regression analysis and data envelopment analysis (dea) indicate significant productivity gains following it implementation, documenting the value impact of it in a public accounting firm. the relationship between it and accounting practices was investigated qualitatively using six case studies and we will measure the impact of it on accountants’ tasks. the findings suggest a tendency for change and the decentralization of accounting tasks. sajady, phd, m. dastgir, phd and h. hashem nejad, m. s. (2008) under the title. “evaluation of the effectiveness of accounting information systems", in this study the effectiveness of accounting information systems of finance managers of listed companies at tehran stock exchange is evaluated. the results indicate that implementation of accounting information systems at these companies caused the improvement of managers’ decision-making process, internal controls, and the quality of the financial reports and facilitated the process of the company’s transactions. the results did not show any indication that performance evaluation process had been improved. 3. problem of the study the purpose of this study is to see relationship between accounting information system and decision making in four and five – star jodhpur hotels, ais is required by the managers at all levels has to planning, controlling and make short term and long term decisions. short term decision-making needs cost data both fixed and variable costs, long-term decisions are made by the top-level executives for the future course of action. the managers at various levels are in need of certain type of ais. and the question that mentions here is how the ais impact in planning, controlling and decision making managers in four and five-star hotels. accounting information is not likely to be useful for every decision problem, because it has specific advantages and disadvantages. managers often consider the management accounting information that is provided as not very useful for decision-making and they would like to have better information (karmarkar et al., 1990; sullivan and smith, 1993). 4. importance of the study the accounting information system has a great role in many decisions. therefore, the recognition by planning, controlling and decision making of these systems in jodhpur tourist hotels and its relationship with technology would contribute to correction of any defect, if any, especially if caused by lack of access to available technology, thus it helps in planning, controlling and making decisions more rational in the light of fierce competition in four and five-star hotels sector in the jodhpur city (jc) on which the indian economy depends increasingly to overcome the encountering problems. 5. objectives of the study the researcher aims to investigate accounting information systems in four and five-star hotels of jodhpur city (jc) in terms of planning, controlling and decision-making. in addition to the following: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 177 1. to find the relationship between accounting information system and controlling in four and five – star jodhpur hotels 2. to identify if there is an impact of accounting information system and planning in four and five – star jodhpur hotels. 3. to find out the difficulties facing jodhpur hotels that is related to the application of accounting information system. 4. to find there is relationship between accounting information system and decision making in four and five – star jodhpur hotels. 6. research methodology 6.1 data collection in this research, two types of data have been used; primary and secondary data. primary data have been collected through the answers received from side the manager in four and five-stare jodhpur hotels. secondary data that have been used in this research are from annual reports and accounts of state hotel of india, books, journals, periodicals and computer database. 6.2 hypotheses of the study h1: there is relationship between accounting information system and planning in four and five – star jodhpur hotels. h2: there is relationship between accounting information system and controlling in four and five – star jodhpur hotels. h3: there is relationship between accounting information system and decision making in four and five – star jodhpur hotels. h$: what are the difficulties facing jodhpur hotels that are related to the application of accounting information system? 6.3 data analyses in this research, the statistical package for the social sciences (spss) was used for data entry as well as for examining the data later. data preparation was the initial step, which aimed to convert raw data into a more structured format that is more appropriate for analysis. tasks in this stage included data editing, data coding and data entry. descriptive statistics were used to summarize respondent’s characteristics, including demographic information, such as age, gender; also questions about the participating company’s profile, such as the numbers of customer were included. furthermore, inferential statistics were used to test hypotheses to determine the relationship between variables. in particular, pearson correlation was used to verify the association of interval level to the construct, whilst chi-square was used to validate the association between nominal variables and the construct. moreover, the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 178 cronbach coefficient alpha was used for reliability tests. lastly, the variable analysis tool, analysis of variance (anova), was used to determine the impact of accounting information system in planning, controlling and decision-making processes in jodhpur hotels 7. description of personal factors and functional respondents table no. (1) shows a description of personal and functional factors of the sample individuals, as follows:  gender: it is shown that 86.0 % of the sample is male, and 14.0 % female.  age range : it is shown that 42.0 % of the sample their age from 21 to 30 years and 34.0 % between 3140 years, 14.0 % between 41 to 50, 6.0 % between 5160 years, 4.0 % of those% less than 20 years .  monthly income: the table shows that 50.0 % of the sample their income less than 1000$, 38.0 % between 1001$ 2000$, 8.0 % between 2001$ 3000$, and 4.0 % their income more than 3000$.  occupation: 82.0 % of the sample individuals are working in private sector, and 18.0 % in public sector.  education: 62.0 % of the sample study has bachelors degree, and 26.0 % of the sample has masters degree, 6.0 % of the sample has post graduate degree, and the same percentage has high school.  experience years: 30.0 % of the samples study their experience from 4 to 6 years and 26.0 % between 79 years, 24.0 % less than 3 years, 20 % equal or more than10 years. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 179 table 1. the frequencies and percentages of the personal levels of the respondents factor frequency percentage % gender male 43 86.0 female 7 14.0 age less than 20 years 2 4.0 2130 years 21 42.0 31 – 40 years 17 34.0 41-50 years 7 14.0 51 -60 years 3 6.0 61 more ------ income less than 1000$ 25 50.0 1001$ 2000$ 19 38.0 2001$ 3000$ 4 8.0 more than 3000$ 2 4.0 occupation private sector 41 82.0 public sector 9 18.0 education high school 3 6.0 bachelors degree 31 62.0 masters degree 13 26.0 post graduate degree 3 6.0 experience years less than 3 years 12 24.0 4 – 6 15 30.0 7 – 9 13 26.0 equal or more than10 years 10 20.0 7.1 stability of the measure the stability of the measure was tested using cronbach's alpha coefficient, it is shown from table (2) that: alpha value related to items of planning equals to 0.71. alpha value related to items of controlling equals to 0.75. alpha value related to items of decision making equals to 0.82. alpha value related to items of difficulties equals to 0.79 alpha value related to all items equals to 0.88. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 180 all these values are greater than 0.60 which means that the measure is stable. table 2. the saturation of the paragraphs and results of cronbach's alpha test item/ dimension saturation cronbach's alpha item/ dimension saturation cronbach's alpha planning 0.71 14 0.37 1 0.41 15 0.44 2 0.56 16 0.50 3 0.77 17 0.79 4 0.48 18 0.64 5 0.50 19 0.51 6 0.35 20 0.60 controlling difficulties 7 0.33 0.75 21 0.47 0.79 8 0.61 22 0.44 9 0.72 23 0.80 10 0.64 24 0.52 11 0.40 25 0.45 decision making 26 0.38 12 0.63 0.82 total 13 0.73 0.88 7.2 validity of instrument the validity of the instrument was verified by using the factorial analysis to check the connection between the sentences and the dimension it’s related to. table 1 shows the results of this analysis, where the saturation of all the items for each dimension were high, and >0.30 which is acceptable, this means that each item is related to the dimension it belongs to. 7.3 first hypothesis there is relationship between accounting information system and planning in four and five – star jodhpur hotels. table 3 shows that all the items have an arithmetic means less than 3.00 which mean that they are not statistically significant, that is, these things do not exist. item (1) which measures how much the hotel depends on revenue cycle in planning for sales & cash collections, received the lowest arithmetic average, this indicates that it is the most decline. item (6) which measures how much the hotels system gets on the information from current payroll system in planning for future payroll system, received the greater arithmetic average, this indicates that it is the least decline . asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 181 test of first hypothesis: the table shows that all grouped items have a mean of 1.77, and 0.00 level of significance (p-value), which means that this hypothesis is rejected. which means there is no relationship between accounting information system and planning in four and five – star jodhpur hotels? table 3. arithmetic mean, standard deviations, t value, and p-value of planning: no item details mean std. deviation t-value p-value 1 the hotel depends on revenue cycle in planning for sales & cash collections. 1.42 0.50 -22.41 0.00 2 the hotel depends on expenditure cycle in planning for purchasing & cash distributions 1.74 0.90 -9.91 0.00 3 ais provide hotels system by information about production cycle in planning for cost management & product pricing. 1.66 0.63 -15.13 0.00 4 ais provide hotels system by information about human resources cycle in planning for recruiting new employees. 1.84 0.68 -12.05 0.00 5 the hotels system gets on the information from development department in planning for technological developments. 1.94 0.51 -14.65 0.00 6 the hotels system gets on the information from current payroll system in planning for future payroll system. 2.02 0.74 -9.34 0.00 all grouped items 1.77 0.38 -22.84 0.00 7.4 second hypothesis there is relationship between accounting information system and controlling in four and five – star jodhpur hotels. table 4 shows that all the items have an arithmetic means less than 3.00 which mean that they are not statistically significant, that is, these things do not exist. item (10) which measures how much ais provide hotels system about control information that should be timeliness, received the lowest arithmetic average, this indicates that it is the most decline. item (8) which measures how much the hotel depends on the control information that should be cost effectiveness., received the greater arithmetic average, this indicates that it is the least decline . test of second hypothesis: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 182 the table (4) shows that all grouped items have a mean of 1.85, and 0.00 level of significance (p-value), which means that this hypothesis is rejected. which means there is no relationship between accounting information system and controlling in four and five – star jodhpur hotels? table 4. arithmetic mean, standard deviations, t value, and p-value of controlling: item no item details mean std. deviation t-value p-value 7 hotel depends on the control information that should be relevant. 1.90 0.30 -25.67 0.00 8 hotel depends on the control information that should be cost effectiveness. 2.10 0.71 -9.00 0.00 9 ais provide hotels system about control information that should be accuracy. 1.74 0.63 -14.08 0.00 10 ais provide hotels system about control information that should be timeliness. 1.68 0.65 -14.30 0.00 11 ais provide hotels system about control information that should be clarity. 1.82 0.52 -15.97 0.00 all grouped items 1.85 0.33 -24.53 0.00 7.5 third hypothesis there is relationship between accounting information system and decision making in four and five – star jodhpur hotels. table 5 shows that all the items have an arithmetic means less than 3.00 which means that they are not statistically significant, that is, these things do not exist. item (16) which measures how ais help hotels management to make financing decision, received the lowest arithmetic average; this indicates that it is the most declines. item (20) which measures how much ais help hotels management to make dividend decisions, received the greater arithmetic average, this indicates that it is the least decline. test of third hypothesis: the table (5) shows that all grouped items have a mean of 1.98, and 0.00 level of significance (p-value), which means that this hypothesis is rejected. which means there is no relationship between accounting information system and decision making in four and five – star asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 183 jodhpur hotels relationship between accounting information system and decision making in four and five – star jodhpur hotels? table 5. arithmetic mean, standard deviations, t value, and p-value of decision making: item no item details mean std. deviation t-value p-value 12 ais help hotels management to make inventory decisions. 2.02 0.71 -9.71 0.00 13 ais help hotels management to make income statement decisions. 2.12 0.77 -8.05 0.00 14 ais help hotels management to make investments decisions. 1.90 0.71 -11.00 0.00 15 ais help hotels management to make cash related decisions. 1.96 0.81 -9.11 0.00 16 ais help hotels management to make financing decision. 1.70 0.58 -15.84 0.00 17 ais help hotels management to make marketing decisions. 1.90 0.54 -14.30 0.00 18 ais help hotels management to make production decisions. 1.94 0.65 -11.50 0.00 19 ais help hotels management to make informed economic decisions. 1.98 0.43 -16.85 0.00 20 ais help hotels management to make dividend decisions. 2.30 0.65 -7.65 0.00 all grouped items 1.98 0.40 -17.97 0.00 7.6 fourth hypothesis the jodhpur hotels facing difficulties that are related to the application of accounting information system. table 6 shows that all the items have an arithmetic means greater than 3.00 and p-value less than 0.05 which means that they are statistically significant, that is, these difficulties facing jodhpur hotels. item (26) which measures which measures the not to develop the information system enough to the optimal application of accounting information system, came in the first rank with an arithmetic average of 4.28. item (25) which measures the lack of competition that urges the application of accounting information system, came in the second rank with an arithmetic average of 4.07. and then came paragraphs no. 22, 24, and 23, respectively. item (21) which measures the lack of qualified of cadres that implement the methods of accounting information system, came in the last rank with an arithmetic average of 3.34. test of fourth hypothesis: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 184 the table (6) shows that all grouped items have a mean of 3.90, and 0.00 p-values, which means that this hypothesis is accepted. which means the jodhpur hotels facing difficulties that are related to the application of accounting information system? table 6. arithmetic mean, standard deviations, t value, and p-value of difficulties: no item details mean std. deviation t-value p-value 21 cadres that implement the methods of accounting information system are not qualified. 3.34 0.48 5.02 0.00 22 costs of the application of accounting information system are relatively high. 4.06 0.42 17.67 0.00 23 senior management is not convinced by the methods of accounting information system. 3.78 0.42 13.18 0.00 24 software required by the application of accounting information system is not available. 3.86 0.57 10.64 0.00 25 there is no competition that urges the application of accounting information system. 4.07 0.55 13.63 0.00 26 the information system is not developed enough to the optimal application of accounting information system 4.28 0.45 19.96 0.00 all grouped items 3.90 0.24 26.93 0.00 8. results 1there is no relationship between accounting information system and planning in four and five – star jodhpur hotels. where the hotels do not depend on revenue cycle in planning for sales & cash collections, nor on expenditure cycle in planning for purchasing & cash distributions, ais does not provide hotels system by information about production cycle in planning for cost management & product pricing, nor provide hotels system by information about human resources cycle in planning for recruiting new employees, the hotels system does not get on the information from development department in planning for technological developments, and nor gets on the information from current payroll system in planning for future payroll system . 2there is no relationship between accounting information system and controlling in four and five – star jodhpur hotels. where hotels do not depend on the control information that should be relevant, nor on the control information that should be cost effectiveness, ais do not provide hotels system about control information that should be accuracy, nor about asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 185 control information that should be timeliness, and nor system about control information that should be clarity. 3there is no relationship between accounting information system and decision making in four and five – star jodhpur hotels relationship between accounting information system and decision making in four and five – star jodhpur hotels. where ais do not help hotels management to make inventory decisions, nor management to make income statement decisions, nor to make investments decisions, nor to make cash related decisions, nor to make financing decision, nor to make marketing decisions, to make production decisions, nor to make informed economic decisions, and nor to make dividend decisions. 4the jodhpur hotels facing difficulties that are related to the application of accounting information system. where cadres that implement the methods of accounting information system are not qualified, costs of the application of accounting information system are relatively high, senior management is not convinced by the methods of accounting information system, software required by the application of accounting information system is not available, there is no competition that urges the application of accounting information system, and the information system is not developed enough to the optimal application of accounting information system . 9. recommendations the jodhpur hotels management should depend on accounting information systems in planning for sales & cash collections in revenue cycle and purchasing & cash distributions for expenditure cycle. the study recommends increase of the development the information systems at jodhpur hotels towards the efficient application of accounting information system methods. the study recommends the jodhpur hotels management should use accounting information systems in control information to get more relevant, cost effectiveness, accuracy, timeliness and clarity. the study recommends the jodhpur hotels management should depend on accounting information systems to make financing decisions. the study recommends increase human resources rehabilitation in jodhpur hotels, especially the head of departments. the jodhpur hotels to get high quality information from the system require software for develop the optimal application of accounting information system. references aizaldain, zirena. 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(2009). cost-based management and decision making in greek luxury hotels. published in: tourismos: an international multidisciplinary journal of tourism, vol. 4, no. 3, pp. 205-225. microsoft word 1764-6924-4-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 1 testing for convergence in the european insurance sector: a non-linear factor approach dr. nicholas apergis* university of piraeus, 185 34, greece e-mail: napergis@unii.gr dr. alexandros gabrielsen sumitomo mitsui banking corporation europe, london, uk e-mail: alexandros_gabrielsen@gb.smbcgroup.com dr. james payne university of south florida, 4202 e. fowler avenue, tampa, fl 33620, usa e-mail: jpayne@poly.usf.edu dr. paolo zagaglia università di bologna, strada maggiore 45 – 40126, italy e-mail: pzagaglia@bologna.it received: may 3, 2012 accepted: may 25, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1764 url: http://dx.doi.org/10.5296/ajfa.v4i2.1764 the views expressed in this paper solely reflect the views of the author and not necessarily those of sumitomo mitsui banking corporation europe limited. abstract this paper investigates the factors behind long-term convergence in the insurance sector by questioning the role of harmonization and regulation across the emu. by investigating convergence through balance-sheet items, the study sheds light on the role played by the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 2 management preferences of insurances across the emu. overall, the convergence tests employed within this study provide evidence of limited convergence within the insurance sector across the emu countries. keywords: financial convergence, phillip and sul convergence method, european insurance sector ________________ * corresponding author asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 3 1. introduction – literature review over the recent period, the financial services industry has experienced significant convergence trends, mainly due to the deregulation of financial markets in europe, the u.s., and asia. prior to the introduction of the european monetary union (emu), the european markets were a fragmented network due to the heterogeneous taxation, regulatory and transaction costs regimes, increasing the complexity of cross-market development. therefore, expectations to find convergence are based on the effects of the harmonization of regulatory and supervisory policies as well as the mechanisms for coordination of macroeconomic policies of the national authorities with the emu. although under the notion of optimum currency, all factors of production should move freely across borders, it is capital flows that cross borders much more easily than labor or goods. hence, financial markets are expected to show a faster rate of convergence compared to the other markets. there are still open questions regarding insurance integration within the emu which are not attributable to labor heterogeneity or persistent residual regulatory differences between member states but also to the effects of the recent credit crisis on the overall european insurance sector. convergence in the market for risk transfer within the property-liability insurance industry has been rather slow, due to certain factors as informational opacity of insurance markets, informational asymmetries between buyers and insurers and between insurers and reinsurers, high transactions costs, and, finally, inhibiting financial innovations that require transparency. nevertheless, convergence in the property-liability insurance market is strong with the most important driver of such trend being the growth in property values in geographical areas prone to catastrophic risk, the capacity of the convergence process itself to moderate the effects of the reinsurance underwriting cycle, the advances of computing and communicating technologies, the development of holistic or enterprise-wide risk management, the presence of certain regulatory, accounting, tax, and rating agency factors enabling insurers to develop a wide range of products to control regulatory and tax costs, and, finally, developments in financial theories that provided a clear understanding to market participants about risk management approaches and financial innovation opportunities (cummins et al., 2004; cummins, 2005; cummins and weiss, 2009). critical questions extend on how to measure the degree of financial integration and ultimately convergence within the insurance sector. growth theory was the main motivator behind economic convergence with the notional idea that the rate of increase of per capita output is inversely related to the initial level of this variable. this is referred to as absolute convergence and the economic interpretation is that if all economies have the same steady state and differ only with respect to initial conditions, then emerging or less developed economies will grow at a faster rate and will eventually catch up with the developed economies. barro and sala-i-martin (1991, 1992) introduce the concepts of βand σ-convergence based on the log-linearized approximation of the solow growth model with a cobb-douglas production function. the β-convergence determines the speed of adjustment of deviations to the long-run equilibrium whereas σ-convergence determines the decline in the variance in the overall cross-section dispersion. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 4 the initial idea of convergence has been extended and applied to a wide range of financial problems, among which is financial market integration. baele et al. (2004) defines financial integration as the market for a given financial instrument when all economic agents with the same relevant characteristics that act in the market face a single set of rules, have equal access and are treated equally. there is a well developed literature that tries to test and find evidence of financial integration. the studies of adam et al. (1998), baele et al. (2004), ozcan et al. (2009), lane, (2008), fabozzi and choudhry, (2004), hristov and rozenov (2009) measure the evolution of capital market integration in the european union (eu) in terms of a set of financial indicators such as: price-based measures that capture the discrepancies in asset prices across different european markets; news-based response measures that analyze the impact of common factors on assets; quantity-based measures that quantify the effects of frictions on the demand for and supply of securities. they find that although integration varies across different product segments and different periods, it has been achieved at a substantial level between standardised fixed income and money markets, i.e. unsecured inter-bank deposits such as eonia and euribor, and interest rate swaps. along with the βand σ-convergence measures, which are based on cross-sectional data, there are a number of studies which employ time series tests of convergence. affinito and farabullini (2006) apply the law of one price to investigate the integration of the eu retail banking. datta (2003) proposes a transitional dynamics and convergence in a time-series framework. sorensen and guiterez (2006) apply cluster analysis techniques to detect possible patterns and trends in the euro area banking sector in terms of the degree of homogeneity of counties. hardouvelis et al (2004, 2007) apply the bekaert and harvey (1995, 1997) time-varying integration model to measure the integration of emu economic and monetary integration. ferreira and gama (2005) apply a volatility decomposition method to study the volatility dynamics at the world, country and local industry levels. fratzscher (2002) measures financial integration based on an uncovered interest rate parity condition. they all find that the integration of the retail banking sector is still progressing, while sorensen and guiterez (2006) identify the presence of clusters within the emu: the contains germany, france, belgium netherland, austria and italy and the second spain, portugal and greece. however, a number of shortcomings have been identified in the application of these tests outside the growth context since βand σ-convergence tests are uninformative on the behavior of the individual economies within the entire cross-sectional panel as well as restrictive in their assumptions regarding the underlying panel structures (islam, 2003; friedman, 1992; quah, 1996; among others). phillips and sul (2007) propose a non-linear time varying factor representation that overcomes the restrictions of unit root and cointegration tests. their formulation allows the estimation of long-run equilibria within a heterogeneous panel, a wide variety of possible transition paths towards convergence relative to the panel cross section average over time and the identification of the presence of club formation. the phillips and sul (2007) formulation is a very robust and attractive informative measure on the behavior of dynamic characteristics of the heterogeneous panel. fritsche and kuzin (2008) apply this method to investigate convergence in european prices, unit labor costs, income and productivity over the period asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 5 1960-2006 and find different transition paths of convergence as well as regional clusters. caporale et al. (2009) apply the phillips and sul (2007) method to test for convergence in stock returns to an extensive dataset including monthly stock prices for five eu countries as well as the us over the period from 1973 to 2008. they are able to document convergence/divergence patterns as well as to detect clusters on a sectoral, industry and global level. they also find that there is a global convergence/divergence process which is not influenced by eu developments, but argue that it may be driven by industry versus country effects. rughoo and sarantis (2009) apply the phillips and sul (2007) framework to investigate the integration process in the eu retail banking sector during the period from 1995 to 2008 by analysing deposit and lending rates to non-financial corporations. these results highlight the limited convergence achieved by european institutions particularly in the banking sector due to persistent regulatory and cross-country heterogeneity, accompanied by the effects of the recent credit crisis on macro fundamentals, i.e. expectations of inflation, growth rates, sovereign credit risk, among others, to liquidity and credit risk in the banking and insurance sectors. following the eu sovereign debt crisis, there have been a number of key developments to reform the functioning of the emu in the event of a crisis. this led to the creation of the european stability facility (efsf), the european financial stability mechanism (efsm) and european treasury. the first two are legal instruments aiming at preserving the financial stability in emu by providing financial assistance to emu states in difficulty. the european treasury is an authority that is responsible for tax policy oversight and government spending coordination of eu member countries. for policy makers financial integration poses a number of challenges that we try to address in this study. therefore, the goal of this study is to investigate the effects of the recent crisis as well as the harmonisation measures put forward on the integration of the eu insurance sector. in this respect we apply the phillips and sul (2007) convergence formulation and clustering algorithm. in particular, the study employs a sample of 16 insurance companies within the emu and it bases the analysis on balance sheet management. not only has this approach not been previously applied, but it is a reflection of the institutions’ long-term strategic management with responses to the exogenous macro conditions. this research effort will provide useful insights into the integration dynamics of the sector under study. the results will allow policy makers to visualise which country’s insurances will converge and, thus, adopt specific measures to promote a higher degree of integration for the other countries’ insurances. the paper is organised as follows: section 2 outlines the methodology employed in this study, while section 3 describes the data set. section 4 presents the empirical results and section 5 concludes. 2. methodology take the simple example of a single factor model: it i t itx     (1) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 6 where i measures the idiosyncratic distance between some common factor t and the systematic part of itx . the model captures the evolution of the individual itx in relation to t by means of its two idiosyncratic elements: the systematic element ( i ) and the error ( it ). phillips and sul (2007) extent (1) to allow the systematic idiosyncratic element to evolve over time; which accommodates heterogeneous agent behaviour and evolution in that behaviour by means of a time varying factor loading coefficient it , such that: it it tx   (2) where both components are now time-varying and it is possible to use a non-parametric formulation to estimate a transition function based on it ; whish is given as: 1 1 it it it it it x h x n n       (3) where ith measures the loading coefficient it in relation to the panel average at time t. in case the factor loading coefficients it converge to  then the relative transition parameters ith converge to unity and the long run cross section variance of ith to zero. measuring convergence entails the estimation of a regression t-test of the null hypothesis of convergence against the alternative of divergence: 0 1 : 0 : 0 i i h and a h and a         (4) the regression of the cross sectional variance ratio 1 / th h is then given as:      1log 2 log log , , 1, , , 0t t h l t a b t u t rt rt t r h                 (5) where asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 7       2 1 1 1 1 , log 1 n it i h h n l t t       (6) additionally, the fitted coefficient of log t (i.e. speed of conversion) is given by 2b a   , where a  is the estimate of  in 0h ; and the regression coefficient b  is then tested under the one-sided null hypothesis 0a  using a hac standard error. under convergence  1log th h diverges to  , either as  2log l t when 0  , or as 2 log t when 0a  . divergence of  1log th h corresponds to 0th as t  . rejection of the null of convergence does not immediately imply that there is no evidence of convergence in the subgroups of the panel. it is possible, when moving away from the strict null hypothesis of full convergence, to observe convergence clusters around separate equilibrium, or even convergence clusters and divergent members in the full panel. it is, therefore, of paramount importance to identify these clusters. phillips and sul (2007) propose a clustering algorithm; which allows the investigation of possible relationships between the empirical clusters and economic characteristics. there are four steps describe the procedure to determine the clustering pattern and to provide a stopping rule for the calculations. the first step, orders the individuals in the panel according to the last observation in the panel; the second step; is to find a core convergence group based on a set of criteria and then proceed to, step three, to evaluate additional individuals for membership of this group. the final step provides the stopping rule for the cluster calculations. 3. data description the study makes use of annual data for a number of financial ratios for 16 insurance institutions (due to data availability) spanning the period 1990-2010 obtained from bloomberg. the names of the insurance institutions are presented in table 1. the dataset includes not only global reinsurance institutions but also regional insurance institutions, a fact that allows the presence of adequate heterogeneity. empirical evidence suggests that financial accounting ratios can predict future stock returns, especially in long horizons (rozeff, 1984; fama and french, 1988; pontiff and schall, 1998; campbell and shiller, 1988, 1989, 2005; cochrane, 1992, 2008; goetzman and jorion, 1993; hodrick, 1992; lewellen, 2004; lettau and ludvigson, 2005; hecht and vuolteenaho, 2006; lettau and nieuwerburgh, 2008; among others). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 8 table 1. list of insurance firms uniqa, vienna insurance, ageas, alm brand as, topdanmark a/s, cnp assurances, axa, scor se, wuerttembergische le, allianz se, generali deutch, hannover rueckversic munchener ruckvewr, nuernberger bet.-ag, sampo oyj, mannheimer ag holdin the accounting rations employed in this study are indicators such as, gross profits to assets, net (operating) income to assets, investment (net investment income before taxes) to assets, equity to assets, provisions of assets (assets which are held to cover obligations to policyholders), growth rates of total assets, total expenses to assets and total reserves to assets, that reflect various aspects of the insurance sector potential future course, such as, profitability, risk exposure, solvency, as well as operational, financial and strategic management. 4. empirical findings the magnitude of the convergence coefficient, b  , delineates the speed of convergence; with a typically a higher value, b  , indicating a faster rate of convergence. the phillips and sul (2007) log t-test results indicates rejection of the null hypothesis of convergence at the 5% significance level; illustrating that the eu insurance sector is heterogeneous in terms of strategic development as well as risk and financial management. furthermore, the value of the convergence coefficient highlights the rate of divergence. in particular, regarding the insurance sector, the highest divergence reported for the insurance sector is detected for the investment to assets ratio  1.564b    , followed by the growth rate of real total assets  1.121�b    , with the lowest being detected for gross profits to assets ratio  0.433�b    . overall, the log t-test provides evidence of limited convergence within the insurance sectors across the emu countries. it is worth mentioning at this point that one of the advantages of the methodological approach is that the number of elements entering each sub-group could be ranged from one to infinity. in other words, even a single element, e.g. firm, is possible to form an entire sub-group without this altering the validity of the results. at the same time, any potential changes that could have occurred over the time span of our sample has been taken explicitly into consideration by the algorithm itself, since it is based on a non-linear function type of estimation. under the assumption that the optimizing behavior of insurances is exogenous and that it does not change through time, our results would be a mere reflection of convergence in both the real economies and across financial markets. however, insurance businesses are characterized by management preferences that tend to change as a function of the state of the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 9 economy, and of the conditions prevailing in financial markets. for instance, when funding conditions tighten in the markets, financial firms may change their asset-liability management plans accordingly. we can think of the short-term response to changes in aggregate macroeconomic and financial conditions as a manifestation of the tactical implementation of actions for the objective of profit maximization. the implementation of these types of actions can lead to a divergence in management practices. financial firms also operate with the purpose of maximizing their company growth and profitability in the long run. in this context, they formulate strategic plans that lay down the general framework for tactical actions. long-term plans are based on assumptions about the macroeconomic and financial environment that firms might see to prevail in the future. to sum up, by investigating convergence through balance-sheet items, our study sheds light on the role played by the management preferences of insurances across the emu. for the insurance section and with regards to gross profits to assets two sub-clubs have been identified each with 14 and 2 insurers, respectively (table 2). the first cluster consist of uniqa, vienna insurance, ageas, alm brand, topdanmark, cnp assurances, axa, scor, wuerttembergische, allianz, generalli deutsch, hannover rueckversic, munchener ruckver and nuernberger ber; and the second cluster of sampo oyj and mannheimer. according to the algorithm of phillips and sul (2007), the methodology first selects uniqa and vienna insurance and determines whether they converge in terms of their gross profits to assets ratio. next, it compares these two as one with the ageas. if the t-statistic recomme3nds convergence it adds the insurance firm in the same group, otherwise it forms a separate group, and so on. moreover, according to the log t-test results the convergence is stronger for the second cluster. table 2. gross profits to assets firms b coefficient t-statistic full sample -0.433 -2.843 1st club uniqa, vienna insurance, ageas, alm brand as, topdanmark a/s, cnp assurances, axa, scor se, wuerttembergische le, allianz se, generali deutsch, hannover rueckversic, munchener ruckver, nuernberger bet.-ag -0.513 -1.495 2nd club sampo oyj, mannheimer ag holdin 0.475 3.172 there exist two sub-clubs within the investment to assets panel (table 3); with 8 and 6 insurers, respectively. the first comprises of uniqa, ageas, topdanmark, scor, hannover rueckversic, munchener ruckver which appears to converge with a stronger convergence speed of  0.358�b   than the second cluster  1.049�b    ; which is made up by the alm asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 10 brand, axa, wuerttembergische, generalli deutsch, mannheimer and nuernberger ber. the non-converging club is made by vienna insurance, sampo oyj and cnp assurances. the club clustering algorithm also identifies three divergent insurers, namely vienna insurance, sampo oyj and cnp assurances. table 3. investment to assets firms b coefficient t-statistic full sample -1.564 -6.523 1st club uniqa,ageas, topdanmark a/s, scor se, allianz se, hannover rueckversic, munchener ruckver 0.358 3.469 2nd club alm brand as, axa, wuerttembergische le, generali deutsch, mannheimer ag holdin, nuernberger bet.-ag -1.049 -1.395 non – converging vienna insurance, sampo oyj, cnp assurances -1.909 -6.532 net income to assets is described by two sub-clubs with 3 and 4 (table 4). the speed of convergence is higher for the second club  1.269�b   , which consists of sampo oyj, generalli deutsch, manheiimer, nuernberger bet; compared with the first club  0.655�b   which is composed by vienna insurance, alm brand and wuerttembergische. finally, the uniqa, ageas, topdanmark, cnp assurances, axa, scor, allianz, hannover rueckversic and munchener ruckver diverge according to the log t-test result. table 4. net income to assets firms b coefficient t-statistic full sample -1.046 -19.134 1st club vienna insurance, alm brand as, wuerttembergische le 0.270 0.655 2nd club sampo oyj, generali deutsch, mannheimer ag holdin, nuernberger bet.-ag 0.610 1.269 non converging uniqa, ageas, topdanmark a/s, cnp assurances, axa, scor se, allianz se, hannover rueckversic, munchener ruckver -0.651 -37.447 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 11 with regards to equity to assets there exist only one sub club that comprises of vienna insurance, alm brand, sampo oyj, wuerttembergische, generalli deutsch, mannheimer and nuernberger bet and all the reaming insurers according to the log t-test diverge (table 5). table 5. equity to assets firms b coefficient t-statistic full sample -0.816 -8.765 1st club vienna insurance, alm brand as, sampo oyj, wuerttembergische le, generali deutsch, mannheimer ag holdin, nuernberger bet.-ag 0.676 3.242 non-convergi ng uniqa, ageas, topdanmark a/s, cnp assurances, axa, scor se, allianz se, hannover rueckversic, munchener ruckver -0.803 -45.190 under provisions to assets there are two sub-groups (table 6). the second club converges at higher speed  1.746�b   than the first club  0.091�b   . the first club is made up by vienna insurance, alm brand, axa, wuerttembergische, mannheimer and nuernberger bet; while the second by sampo oyj and generali deutsh. finally, the club converging algorithm reveals that uniqa, ageas, topdanmark, cnp assurances, scor, allianz, hannover rueckversic and munchener ruckver diverge. table 6. provisions to assets firms b coefficient t-statistic full sample -0.542 -4.672 1st club vienna insurance, alm brand as, axa, wuerttembergische le, mannheimer ag holdin, nuernberger bet.-ag 0.091 0.380 2nd club sampo oyj, generali deutsch 1.746 5.724 non converging uniqa, ageas, topdanmark as, cnp assurances, scor se, allianz se, hannover rueckversic, munchener ruckver -0.583 -43.294 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 12 with regards to growth rate of real total assets three clubs exist with 3, 2 and 2 insurers, respectively (table 7). the first club converges at a higher speed  0.670�b   than the remaining two clubs  0.025�b   and  0.961�b    that weakly converge. the first cluster consists of vienna insurance, alm brand and wuerttembergische; the second cluster of sampo oyj and nuernberger bet; the third cluster of axa and generalli deutsch. finally, the remaining insurers diverge as shown by the log t-statistic. table 7. growth rate of real total assets firms b coefficient t-statistic full sample -1.121 -8.116 1st club vienna insurance, alm brand as, wuerttembergische le 0.670 0.886 2nd club sampo oyj, nuernberger bet.-ag 0.025 0.087 3rd club axa, generali deutsch -0.961 -0.807 non – converging uniqa, ageas, topdanmark a/s, cnp assurances, scor se, allianz se, hannover rueckversic, mannheimer ag holdin, munchener ruckver -0.682 -41.189 in terms of the total expenses to assets ratio, two sub-clubs are highlighted with 4 and 2 insurers, respectively (table 8). the first club consists of vienna insurance, alm brand, wuerttembersgische and generalli deutsch and converges at a higher speed than the second club which is made up by axa and nuerneberget bet. all the other insurers diverge according the log t-statistic, which rejects the null hypothesis of convergence at 1% significant level. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 13 table 8. total expenses to assets firms b coefficient t-statistic full sample -0.878 -284.941 1st club vienna insurance, alm brand as, wuerttembergische le, generali deutsch 0.485 5.589 2nd club axa, nuernberger bet.-ag 0.321 0.154 non converging uniqa, ageas, topdanmark a/s, sampo oyj, cnp assurances, scor se, allianz se, hannover rueckversic, mannheimer ag holdin, munchener ruckver -0.934 -190.823 the final ratio to be examined is the total reserves to assets and the club convergence algorithm reveals two sub-clubs (table 9). the first is comprised by vienna insurance, alm brand and wuerttembergische and second by sampo oyj, generalli deutsch mannheimer and nuerneberger. the convergence coefficient reveals that the second cluster converges at a higher speed  0.610�b   compared with the first cluster  0.270�b   . finally, the remaining insurers diverge. table 9. total reserves to assets firms b coefficient t-stat full sample -1.046 -19.134 1s club vienna insurance, alm brand as, wuerttembergische le 0.270 0.655 2nd club sampo oyj, generali deutsch, mannheimer ag holdin, nuernberger bet.-ag 0.610 1.269 non-converging uniqa, ageas, topdanmark a/s, cnp assurances, axa, scor se, allianz se, hannover rueckversic, munchener ruckver -0.357 -45.994 5. conclusions the results presented in this paper represent only a first step towards understanding the factors behind long-term integration in the insurance sector. first, it calls into question the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 14 role of harmonization and regulation across the emu as a force leading to the creation of common market. these rules are typically amended before their implementation at the national level. in the face of imperfect integration in real and financial markets, it may be argued that this implementation process is adapted to the existing practices and preferences of local insurance businesses, thus providing a further incentive towards divergence in the long run. second, it is not clear whether a mere change in the structure of projective costs is a factor strong enough to change the preferences of insurances in the implementation of their strategic plans of development. in particular, financial firms may have different instruments to neutralize the impact of common regulatory regimes. the results have helpful implications for the insurance industry by helping to identify the need for certain functions undertaken by the insurers in terms of underwriting and risk selection, pricing, and liability management. they could also be useful to identify the way securitization is expected to mitigate any negative effect on liquidity and leverage, to enhance credit quality considerations, to improve any regulatory considerations, to facilitate more efficient risk management, and, thus, to permit the participating insurance firms to continue their growth. our results can be extended along a number of relevant directions. it would be interesting to understand how far the speed of convergence differs between clusters of financial firms, on average. understanding the relation between the convergence rates and observable economic and financial variables, such as money market rates and measures of macroeconomic performance, would provide additional insights on the nature of the different convergence clubs. finally, it would be important to measure the persistence of the deviations from long-term convergence levels across other financial institutions, such as banks. acknowledgement the authors wish to to thank the editor and a referee of this journal for their constructive comments and suggestions on an earlier draft of this paper. needless to say, the usual disclaimer applies. references adam k., jappelli t., menichini a., padula m., & pagano m. 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(2006). euro area banking sector integration – using hierarchical cluster analysis techniques. ecb working paper, no. 627, microsoft word impact of customer-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 118 impact of customer relationship management of hotel (a case study umaid bhwan) dr. tauseef ahmad jai narain vays university department of accounting dr. omar a.a. jawabreh department of tourism and hotels sciences al, balqa applied university, jordan, aqaba e-mail: ojawabreh2000@yahoo.com mahmoud (abdel muhsen)irsheid al afeef research scholar jai narain vays university alaa almomani research scholar university of western sydney received: february 5, 2012 accepted: february 26, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1362 url: http://dx.doi.org/10.5296/ajfa.v4i1.1362 abstract this paper is an attempt to find the variables factors that influence customer relationship management of hotels (a case study umaid bhwan) in india. in this research, the statistical package for the social sciences (spss) was used for data entry, as well as for examining the data later. data preparation was the initial step, which aimed to convert raw data into a more structured format that is more appropriate for analysis. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 119 after analysis of the available data, it has been found there is impact of implementing customer relationship management to increase the customer trust in umaid bahwan with a medium degree where umaid bhwan employees have good skills, and customers feel confident with dealing with umaid bhwan hotel. the information customers get from the hotel is accurate. the hotel always exerts good efforts to fulfill its promises, so the customers could get the hotels services as promised. keywords: umaid bhwan hotel, customer relationship management, hotel, customized services, customer loyalty. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 120 1. introduction today, many businesses such as hotels, insurance companies, and other service providers realize the importance of customer relationship management (crm) and its potential to help them acquire new customers retain existing ones and maximize their lifetime value. at this point, close relationship with customers will require a strong coordination between it and management departments to provide a long-term retention of selected customers. this paper deals with the role of customer relationship management in indian hotel sector and the need for customer relationship management to increase customer value by using some analytical methods in crm applications (light, 2003). crm is a sound business strategy to identify the umaid bhwan most profitable customers and prospects, devotes time and attention to expanding account relationships with those customers through individualized management, reprising, discretionary decision making, and customized service-all delivered through the various sales channels that the hotel uses. customer relationship management (crm) is one of those magnificent concepts that swept the business world in the 1990’s with the promise of forever changing the way businesses small and large interacted with their customer bases. in the short term, however, it proved to be an unwieldy process that was better in theory than in practice for a variety of reasons. first among these was that it was simply so difficult and expensive to track and keep the high volume of records needed accurately and constantly update them. 2. literature of review according to light (2003), customer relationship management is a process of managing customer relations in an organized way. they aim at managing each “moment of truth” that is experienced by the customer. there are various contact points where the hotel comes in direct contact with the customer which are known as ‘touch points’ in the crm language. these touch points are considered important as there is direct interaction with the customer and they provide valuable input to the hotel. the input provided by the customer has to be captured in such a way that it becomes information and can be used by various processes within the hotel. it is based on the argument that “the happier a customer is with a relationship, the greater the likelihood they will stay with an organization". moreover, the comprehension of the potential life-time value of a loyal customer to the company is also closely connected to its development. (chen and popvich, 2003,). it is argued by some researchers that crm can be seen as the organizational implementation of a relationship management philosophy (ryals and knox, 2001, ryals and payne, 2001). through delivering more responsive and customized services to customers, crm increases customer satisfaction and this, in turn, improves customer loyalty. (croteau and li, 2003).the importance of relationship management is increasingly being recognized. kotler (1992) wrote that companies must move from short-term transaction-oriented goals to long-term relationship-building goals. (jackson, 1994). the evolution of relationship management is also closely associated with the realization of the importance of the customer to a company the advancement of technology, the diminishing of product differences and the ever-increasing pressure of competition has led to the acknowledgement that customers are one of a company’s most valuable assets. (chen and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 121 popvich, 2003,). it is argued by some researchers that crm can be seen as the organizational implementation of a relationship management philosophy (ryals and knox, 2001, ryals and payne, 2001). through delivering more responsive and customized services to customers, crm increases customer satisfaction and this, in turn, improves customer loyalty. ndubisi (2003) argued that the only real sustainable business growth strategy is through autoplastic symbiotic relationship with customers, which enables a business to understand their needs more clearly and to create and deliver superior value. keltner (1995) found that german hotels, in contrast to american hotels, managed to maintain a stable market position during the 1980s and early 1990s because of relationship oriented hotel strategies. (johnson, 1999). the term also refers to a customer’s perceptions of how well the whole relationship fulfils expectations, predictions, goals and desires the customer has concerning the whole relationship. henning-thurau et al., 2002). customer service is now more fashionably called customer relationship management. the concept of customer relationship management has a broader focus of not only serving the customer but also creating the customer and retaining him for measurable and substantial returns. also, a review of literature has revealed that studies focusing on relationship management, service and satisfaction already exist. (colgate et al., 2005; martı´n-consuegra et al., 2006).. crm is a vast subject where database marketing supports the concept of one to one marketing. it is also remarkable that there is no research on the relationship between relational benefits and customer satisfaction in retail hotel. (o’malley and tynan, 2000). however, all customers do not want to engage in relationships and, in fact, it has been suggested that close customer relationships in hotel are rare, and that they are being further weakened by the increase in self-service technologies. 3. research objectives the research aims to investigate the impact of customer relationship management on customer’s satisfaction, trust, retention in umaid bhwan in india, in addition to the following: 1. to find the impact of implementing customer relationships management to increase the customers trust to umaid bahwan. 2. to identify if there is an impact of implementing customer relationship management on customer satisfaction in umaid bahwan. 3. to find out if umaid bhwan implement customer relationship management in its management activities. 4. to find the relation between implementing customer relationship management and customer retention in umaid bahwan. 5. to identify the differences of impact of customer relationship management on customers due to their demographic information 4. research methodology 4.1 data collection in this research, two types of data have been used; primary and secondary data. primary data have been collected through the answers received from side the customers of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 122 umaid bhwan in jodhpur. secondary data that have been used in this research are from annual reports and accounts of state hotel of india, books, journals, periodicals and computer database. all customers' department officials in state hotel of india (umaid bahwan) have been deemed as research population. 4.2 hypotheses h0: there is no impact of implementing customer relationship management to increase the customer trust in umaid bahwan. h0: there is no impact of implementing customer relationship management on customer satisfaction in umaid bahwan. h0: umaid bhwan hotel does not implement customer relationship management in its management activities. h0: there are no relations between customer relationship management and customer retention in umaid bahwan. h0: there are no differences in impact of customer relationship management on customers due to their demographic information. 4.3 data analyses in this research, the statistical package for the social sciences (spss) was used for data entry as well as for examining the data later. data preparation was the initial step, which aimed to convert raw data into a more structured format that is more appropriate for analysis. tasks in this stage included data editing, data coding and data entry. descriptive statistics were used to summarize respondent’s characteristics, including demographic information, such as age, gender; also questions about the participating company’s profile, such as the numbers of customer were included. furthermore, inferential statistics were used to test hypotheses to determine the relationship between variables. in particular, pearson correlation was used to verify the association of interval level to the construct, whilst chi-square was used to validate the association between nominal variables and the construct. moreover, the cronbach coefficient alpha was used for reliability tests. lastly, the variable analysis tool, analysis of variance (anova), was used to determine the impact of customer relationship management in state hotel of india on the level of customer’s trust, retention, satisfaction, and management activities. 4.4 description of personal factors: table no. (1) shows a description of personal and functional factors of the sample individuals, as follows:  gender : it is shown that 50.7 % of the sample is male, and 49.3% is female  age range : it is shown that 43.3% of the sample their age from 21 to 30 years and 31.3% between 31-40 years, 12.7 % between 51 to 60, 6.7 % of those less than 20 years, and 6.0 % between 41 to 50. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 123  monthly income: the table shows that 38.0 % of the sample their income less than 1000$, 24.7 % between 1001$ 2000$, 19.3 % between 2001$ 3000$, and 18.0 % their income more than 3000$.  occupation: 62.0 % of the sample individuals is working in private sector, and 38.0 in public sector.  education: 36.7 % of the sample study has post graduate degree, and 32.0% of the sample has bachelors degree, 12.7 % of the sample has master’s degree, and 18.7 % has high school. table 1. the frequencies and percentages of the personal levels of the respondents factor frequency percentage gender male 76 50.7 female 74 49.3 age less than 20 years 10 6.7 2130 years 65 43.3 31 – 40 years 47 31.3 41-50 years 9 6.0 51 -60 years 19 12.7 income less than 1000$ 57 38.0 1001$ 2000$ 37 24.7 2001$ 3000$ 29 19.3 more than 3000$ 27 18.0 occupation private sector 93 62.0 public sector 57 38.0 education high school 19 12.7 bachelors degree 48 32.0 masters degree 28 18.7 post graduate degree 55 36.7 4.5. stability of the measure: the stability of the measure was tested using cronbach's alpha coefficient, it is shown from table (2) that: 1. alpha value related to items of trust dimension equals to 0.88. 2. alpha value related to items of satisfaction dimension equals to 0.86. 3. alpha value related to items of management activities dimension equals to 0.93. 4. alpha value related to items of customer retention dimension equals to 0.94 5. alpha value related to all items equals to 0.96. all these values are greater than 0.60, which means that the measure is stable. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 124 table 2. alpha chronbach values dimension alpha trust 0.88 satisfaction 0.86 management activities 0.93 retention 0.94 all items together 0.96 4.5.1 hypotheses: 4.5.2 first hypothesis h0: there is no impact of implementing customer relationship management to increase the customer trust in umaid bahwan. table 3 shows that all the items have a arithmetic means greater than 3.00 and p-value less than 0.05 which means that they are statistically significant. item (5) which measure the how much the information gotten from the hotel is accurate, came in the first rank with an arithmetic average of 4.12 with a high degree. item (3) which measure how muchumaid bhwan employees have good skills came in the second rank with an arithmetic average of 4.11 with a high degree too. item (4) which measures the how much umaid bhwan employees are trusted came in the third rank with an arithmetic average of 4.05 with a high degree. the other items got medium degrees decently ordered according to the arithmetic mean: 8, 2, 1, 6, and 7. 4.5.2.1 test of first hypothesis the table shows that all grouped items have a mean of 3.97, and 0.00 level of significance (p-value), which means that this hypothesis is rejected. which means there is impact of implementing customer relationship management to increase the customer trust in umaid bhwan with a medium degree? asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 125 table 3. arithmetic mean, standard deviation, t value and significance level (p-value) in terms of trust item no item details arith mean std dev t value pvalue rank degree 1 umaid bhwan employees have good skills 3.92 0.70 16.29 0.00 6 moderate 2 you feel confident with dealing with umaid bhwan 3.93 0.53 21.33 0.00 5 moderate 3 umaid bhwan employees have good skills 4.11 0.55 24.79 0.00 2 high degree 4 umaid bhwan employees are trusted 4.05 0.52 24.54 0.00 3 high degree 5 the information you get from the hotel is accurate 4.12 0.64 21.30 0.00 1 high degree 6 the hotel always exert good efforts to fulfill its promises 3.88 0.65 16.47 0.00 7 moderate 7 the hotel respects it promises as expected 3.81 0.61 16.43 0.00 8 moderate 8 you get the hotels services as promised 3.94 0.77 14.94 0.00 4 moderate all grouped items 3.97 0.47 25.41 0.00 ----moderate 4.5.3 second hypothesis there is no impact of implementing customer relationship management on customer satisfaction in umaid bahwan. table 4 shows that all the items have a arithmetic means greater than 3.00 and p-value less than 0.05 which means that they are statistically significant. item (12) which measures the how much the hotel always provides customers with what he need, came in the first rank with an arithmetic average of 4.05 with a high degree. item (11) which measure how much umaid bahwan hotel comply with its obligations towards customer, came in the second rank with an arithmetic average of 3.95 with a medium degree. item (9) which measures the how much all of customer's transactions are highly protected came in the third rank with an arithmetic average of 3.94 with a medium degree. items number 15, 13,14, 10, 17, 16 got medium degrees. item number 18, which measures the how much customer is happy in dealing with umaid bahwan hotel, came in the last rank with an arithmetic average of 3.48 with a weak degree. 4.5.3.1 test of second hypothesis: the table shows that all grouped items has a mean of 3.78, and 0.00 level of significance (p-value), which means that this hypothesis is rejected. which means there is there is impact of implementing customer relationship management on customer satisfaction in umaid asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 126 bahwan with a medium degree? table 4. arithmetic mean, standard deviation, t value and significance level (p-value) in terms of satisfaction. item no item details arith mean std dev t value pvalue rank degree 9 all of yours transactions are highly protected 3.94 0.62 18.70 0.00 3 moderate 10 the hotel provides quality service consistently 3.76 0.54 17.26 0.00 7 moderate 11 umaid bahwan hotel comply with its obligations towards you 3.95 0.69 16.95 0.00 2 moderate 12 the hotel always provides you with what you need 4.05 0.69 18.61 0.00 1 high degree 13 umaid bahwan provides you with needed information in the specified time 3.78 0.78 12.31 0.00 5 moderate 14 umaid bhwan employees pay you special attention 3.77 0.71 13.25 0.00 6 moderate 15 umaid bhwan employees are willing to provide you with any need 3.81 0.86 11.53 0.00 4 moderate 16 umaid bhwan responsibilities towards the customers are respected 3.54 0.97 6.84 0.00 9 moderate 17 you will not switch to other hotel 3.69 0.57 14.98 0.00 8 moderate 18 you are happy in dealing with umaid bahwan hotel 3.48 0.68 8.61 0.00 10 weak total 3.78 0.49 19.54 0.00 moderate 4.5.4 third hypothesis: umaid bahwan hotel don't implement customer relationship management in its management activities. table 5 shows that all the items have an arithmetic means greater than 3.00 and p-value less than 0.05, which means that they are statistically significant. item (24) which measures the how much customer are informed with any new hostelling product, came in the first rank with an arithmetic average of 4.00 with a high degree. item (28) which measure how much umaid bahwan always tries to build up very close relationship, came in the second rank with an arithmetic average of 3.99 with a medium degree. item (25) which measures the how asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 127 much umaid bhwan employees know how to serve customer, came in the third rank with an arithmetic average of 3.94 with a medium degree. the other items got medium degrees decently ordered according to the arithmetic mean: 21, 22, 27, 23, 26, 220, and 29. 4.5.4.1 test of third hypothesis the table shows that all grouped items has a mean of 3.70, and 0.00 level of significance (p-value), which means that this hypothesis is rejected. this means that umaid bahwan hotel implement customer relationship management in its management activities with a medium degree. table 5. arithmetic mean, standard deviation, t value and significance level (p-value) in terms of management activities item no item details arith mean std dev t value pvalue rank degree 19 umaid bahwan services are updated to meet customers need. actives of management 3.70 0.89 9.65 0.00 11 moderate 20 there is a flexibility in hotels services 3.75 0.63 14.56 0.00 9 moderate 21 umaid bahwan hotel commit itself to your personal needs 3.92 0.54 20.97 0.00 4 moderate 22 information provided by the hotel are trustworthy 3.91 0.43 25.86 0.00 5 moderate 23 the hotel provides you with an access to its services 3.81 0.61 16.43 0.00 7 moderate 24 you are informed with any new hotel product 4.00 0.73 16.72 0.00 1 high degree 25 umaid bhwan employees know how to serve you 3.94 0.70 16.51 0.00 3 moderate 26 umaid bhwan staff know how to solve you problems 3.77 0.78 12.17 0.00 8 moderate 27 problems with the hotel are solved quickly 3.81 0.86 11.53 0.00 6 moderate 28 umaid bahwan always tries to build up very close relationship 3.99 0.58 20.87 0.00 2 moderate 29 umaid bhwan service quality is matching with your needs 3.72 0.86 10.25 0.00 10 moderate total 3.70 0.89 9.65 0.00 ---moderate 4.5.5 fourth hypothesis there are no relation between customer relationship management and customer retention in umaid bahwan. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 128 table 6 shows that all the items have an arithmetic means greater than 3.00 and p-value less than 0.05, which means that they are statistically significant. item (37) which measures the problem with the hotel, it can easily solved friendly – retention, came in the first rank with an arithmetic average of 4.01 with a high degree. item (35) which measure how much hotel policy based on avoiding any potential problems – retention, came in the second rank with an arithmetic average of 3.99 with a medium degree. item (34) which measures the how the umaid bhwan policy respect customer’s own privacy – retention, came in the third rank with an arithmetic average of 3.98 with a medium degree. the other items got medium degrees decently ordered according to the arithmetic mean:39, 41, 36, 30, 32, 38, 40 33, and 31. 4.5.5.1test of fourth hypothesis the table shows that all grouped items has a mean of 3.87, and 0.00 level of significance (p-value), which means that this hypothesis is rejected. which means that there are relation between customer relationship management and customer retention in umaid bahwan with a medium degree? table 6. arithmetic mean, standard deviation, t value and significance level (p-value) in terms of customer retention item no item details arith. mean std dev t value pvalue rank degree 30 hotel tries to keep up with new hotel services 3.87 0.66 16.25 0.00 7 moderate 31 the hotel keeps you updated with new services available 3.64 0.67 11.73 0.00 12 moderate 32 there is a continuous contact from the hotel side 3.86 0.48 22.03 0.00 8 moderate 33 umaid bhwan employees focus on your own needs 3.75 0.54 17.00 0.00 11 moderate 34 the umaid bhwan policy respect your own privacy 3.98 0.67 18.16 0.00 3 moderate 35 your hotel policy based on avoiding any potential problems 3.99 0.58 20.87 0.00 2 moderate 36 the hotel is able to negotiate the problems with you 3.88 0.65 16.47 0.00 6 moderate 37 when you have a problem with the hotel, it can easily solved friendly 4.01 0.80 15.26 0.00 1 high degree 38 in general umaid bhwan services are of high quality 3.83 0.83 12.27 0.00 9 moderate 39 you feel respectful by umaid bhwan employees 3.95 0.69 16.73 0.00 4 moderate 40 you are satisfied in dealing with the hotel 3.82 0.97 10.36 0.00 10 moderate 41 you like to stay with your hotel 3.88 0.73 14.72 0.00 5 moderate total 3.87 0.54 19.92 0.00 moderate asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 129 5. results 1. there is impact of implementing customer relationship management to increase the customer trust in umaid bahwan with a medium degree, where umaid bhwan employees have good skills, customers feel confident with dealing with umaid bhwan hotel, umaid bhwan employees have good skills, umaid bhwan employees are trusted, the information customers get from the hotel is accurate, the hotel always exert good efforts to fulfill its promises, the hotel respects it promises as expected, and customers get the hotels services as promised. 2. there is impact of implementing customer relationship management on customer satisfaction in umaid bahwan with a medium degree, where all of customer's transactions are highly protected, the hotel provides quality service consistently, umaid bahwan hotel comply with its obligations towards customer, the hotel always provides customer with what he need, umaid bahwan provides customer with needed information in the specified time, umaid bhwan employees pay customer special attention, umaid bhwan employees are willing to provide customer with any need, umaid bhwan responsibilities towards the customers are respected, customer will not switch to other hotel, and customers are happy in dealing with umaid bahwan hotel. 3. umaid bahwan hotel implements customer relationship management in its management activities with a medium degree, where umaid bahwan services are updated to meet customers need. actives of management,there is a flexibility in hotels services, umaid bahwan hotel commit itself to customer's personal needs, information provided by the hotel are trustworthy, the hotel provides customer with an access to its services, customers are informed with any new hotel product, umaid bhwan employees know how to serve customer, umaid bhwan staff know how to solve customer problems, problems with the hotel are solved quickly, umaid bahwan always tries to build up very close relationship, umaid bhwan service quality is matching with customer's needs. 4. there are relation between customer relationship management and customer retention in umaid bahwan with a medium degree, where the hotel keeps customer updated with new services available, there is a continuous contact from the hotel side, umaid bhwan employees focus on customer's own needs, the umaid bhwan policy respect customer's own privacy, the hotel policy based on avoiding any potential problems, the hotel is able to negotiate the problems with customer,when customer have a problem with the hotel, it can easily solved friendly, in general umaid bhwan services are of high quality, customer feel respectful by umaid bhwan employees, customers are satisfied in dealing with the hotel, and customer like to stay with their hotel. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 130 5. there are no differences in impact of customer relationship management on customers due to gender, age, income, occupation, education? 6. suggestions based on the results of statistical analysis, which show the impact of customer relations management on the level of client's satisfaction, confidence and the retaining of the clients of the state hotel of india, it is clear that there is no company in the world dropped from defects and imperfect. without doubt, every company should scrutinize and upgrade its plans despite of its success to identify the new strategies, which appropriate to the developed management surroundings, which specified the needs and desires of old, or new consumers. the statistical analysis shows that the customer relationship management has moderate influence on the level of client's satisfaction, confidence and the retaining of the clients of the state hotel of india. to increase the efficiency of the state hotel of india, we recommend the followings: 1. the umaid bhwan manager should focus on the staff's scientific and practical skills and capabilities. to raise their positive psychological level, to live up to the best level of dealing with consumers in line with the concept of customer relationship management, the umaid bhwan manager should provide them training and increase their motivation by rewards. 2. the company must continue in management studies in order to identify the consumers' present and future needs and desires to meet their desires and needs as well as they expected. this will be achieved by qualified and trained staff cope with the development of current and future surroundings to win the consumer's satisfaction. 3. the institution should deal consumers trustworthily and credibly through commitment to the delivery dates of orders without bias to gain consumer's trust of the hotel institution. 4. the institution must take care of the staff's external appearance in order to win the consumer's satisfaction. 5. the institution must allocate places for waiting provided with hospitality services so that the consumer does not feel bored during the waiting period this service increases consumer’s happiness and satisfaction. 6. the directors of the hotel should improve the image of the hotel with regard to the consumer's point of view by good technique and speed in completing the work which increases consumer’s happiness and satisfaction 7. the hotel institution must increase the interest in the periodical awards to consumers, which increases the level of satisfaction and loyalty to the organization. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 131 8. the hotel institution must increase its attention and focus on consumer complaints and suggestions, which increase the level of satisfaction and loyalty to the organization and keep the consumer for the longest possible period. 9. the hotel institution should classify offering services regarding to the consumer groups in line with their culture and demographic factors, which increase the consumer's satisfaction. 10. consumers must be noticed that they have guarantees on their deposits. these guarantees should be activated to increase consumer's confidence in the organization. references chen, i. j., & popvich, k. (2003). understanding customer relationship management (crm): people, process, and technology. business process management journal, 9, 672-688. http://dx.doi.org/10.1108/14637150310496758 colgate, m., buchanan-oliver, m., & elmsly, r. (2006). relationship benefits in an internet environment, managing service quality, vol. 15 no. 5, pp. 426-436. http://dx.doi.org/10.1108/09604520510617284 germany. california management review, vol. 37 no. 4, pp. 45-72. henning-thurau, t., gwinner, k.p., & gremler, d.d. (2002). understanding relationship management outcomes: an integration of relational benefits and relationship quality. journal of service research, vol. 4 no. 3, pp. 230-247. http://dx.doi.org/10.1177/1094670502004003006 jackson, d. j. (1994). relationship selling: the personalization of relationship management. asia-australia management journal, 2, 45-54. http://dx.doi.org/10.1016/s1320-1646(94)70277-x johnson, j.l. (1999). relationship quality in business-to-business service context. journal of management, vol. 24 no. 3, pp. 45-67. keltner, b. (1995). relationship hotel and competitive advantage: evidence from the us and kotler, p. (1992,april,2). it’s time for total management. business week,( 2968) 31-33. light, b. (2003). crm packaged software: a study of organizational experiences. business process management journal, 9, 303-316. http://dx.doi.org/10.1108/14637150310496712 ndubisi, n.o. (2003). service quality: understanding customer perception and reaction, and its impact on business. international journal of business, vol. 5 no. 2, pp. 190-207. o’malley, l., & tynan, c. (2000). relationship management in consumer markets. rhetoric or reality?, european journal of management, vol. 34 no. 7, pp. 797-815. microsoft word board_characteristics-writer2-new-writer3-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 245 board characteristics and financial reporting quality among jordanian listed companies: proposing conceptual framework ebraheem saleem salem alzoubi school of accountancy, college of business, universiti utara malaysia 06010 uum sintok, kedah, malaysia e-mail: he03ma@gmail.com received: february 24, 2012 accepted: march 30, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1442 url: http://dx.doi.org/10.5296/ajfa.v4i1.1442 abstract the east asian financial crises in 1997/1998 as well as the worldwide collapses exposed the considerable need of firms in different countries to progress the corporate governance perform in order to recuperate the investors’ confidence of financial reporting quality (frq). to achieve this, the present research examines the relationship between board characteristics and earning management (em). it is argued that effective board can reduce em and in turn increase frq. keywords: board of directors, corporate governance, earning management, financial reporting quality. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 246 1. introduction several corporate collapses such as bcci and maxwell as well as fluctuating economic climate propelled the development of good corporate governance for disciplining listed companies (barrier, 2002; cadbury report, 1992). the cadbury report (1992) concerned with corporate governance mechanisms being compromised by reduced frq. the east asia financial crisis in 1997/1998 also highlighted weak and poor of both governance along with governance standards that were ultimately blamed for the crisis (hashim, 2009; nam & nam, 2004). this in turn effected in assurance of investors in east asia capital market (abdul rahman & haniffa, 2005; hashim, 2009; leng & chang, 2011). these scenarios have strained the concentration to improve worldwide corporate governance as well as to improve frq for maintaining the assurance of the investors (pergola, 2005). jordan also experienced several financial collapses such as shamayleh gate (jfed, 2003). this has forced jordan to consolidate corporate governance foundations and principles to promote transparency, accountability and the rule of law (jfed, 2003). to assist jordan in this, this paper aims to propose several board characteristics that need to be considered in depth. the remaining of this paper is organized as follows: section 2 introduces the background of the study. section 3 discusses the literature review. section 4 presents the conceptual framework and hypotheses development. lastly section 5 presents the summary and conclusions. 2. background jordan is a small country with partial natural resources, the legal and organizational structures have been amended, and also significant measures took to reorganize, liberalize and raise the national economy openness. its financial market is aiming to the principles of equality, transparency, and effectiveness. it seeks for afford a safe environment for its listed securities at the same time as protecting the rights of the investors. in view of the fact that, jordan is one of the countries where users depend on accounting numbers intended for making decisions, it is of enormous significance to consider the area under discussion of em to protect those users from being mislead. also, by reason of the lack of studies about em in jordan, this study aims at providing evidence concerning em practices (ahmed & ali, 2009). 3. literature review 3.1 financial reporting quality financial reports playing the main medium as the information discrete to the outside user (wild, 1996), in addition, financial accounting standard board (fasb) (2008, p.13) stated that: “the objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. information that is decision useful to capital providers may also be useful to other users of financial reporting who are not capital providers”. as a result, the information that considered as high quality asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 247 can decrease the agency cost problem by means of closing the information asymmetry gap that occurs between shareholders and management (karamanou & vafeas, 2005) 1. on the other hand, there is no consent like to what are comprised of frq. for instance, both blue ribbon commission (brc) (1999) and sarbanes-oxley act (sox) (2002) necessitate auditors to converse the methods and acceptability of frq. furthermore, jonas and blanchet (2000, p. 353) stated that: “in light of these new requirements, auditors, audit committee members, and management are now struggling to define frq”. more willingly than frq identified, prior research literature (barth et al., 2008; nichols & wahlen, 2004) has been paying attention on issues such as em, financial restatements, and fraud that perceptibly restrain high frq attainment and make use of them as an evidence of a breakdown the financial reporting process. frq also is not observed directly (he et al., 2009). arthur levitt (1998) the united states of america (usa) securities and exchange commission (sec) former chairman said that: “high quality accounting standards …improve liquidity and reduce capital costs” and claimed that: “quality information is the lifeblood of strong, vibrant markets. without it, liquidity dries up. fair and efficient markets cease to exist”. as a consequence, in order to find effective frq; there will be decisive need to establish suitable mechanisms of corporate governance. the paper concentrates on board of directors characteristics. 3.2 earning management frq can be investigated from the perspective of em, financial restatements, and fraud (barth et al., 2008; nichols & wahlen, 2004). the focus of this paper is em. this is because it is the most committed fraud in the capital market (ahmed & ali, 2009). em issue has been discussed by many pervious researchers (healy & wahlen, 1999; dechow & skinner, 2000; lo, 2008; schipper, 1989). for example, schipper (1989, p.92) defined em as: “…purposeful intervention in the external financial reporting process, with the intent of obtaining some private gains”. furthermore, healy and wahlen (1999, p.368) stated that em may occur: “…when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers”. arthur levitt former sec chairman (1998) said: “numbers game”, articulated the negative frq as a result of em practice. teets (2002) also stated that frq can be influenced by three decisions: (1) standard setters’ decision; (2) accounting method used as chosen by management; and (3) management judgment and estimates in applying the selected substitutes. additionally, brown (1999, p.61) indicated that: “choices, judgments and estimates are an inevitable consequence of not being able to observe, measure and communicate economic value-added accurately and reliably”. healy and wahlen (1999) mentioned that managers are able to use their judgment in financial reporting 1 pergola (2005, p. 178) defined information asymmetry as: “the fact that the management has inside information about the true economic status of the firm that they may or may not share with stakeholders”. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 248 and in turn more management opportunities to earning manipulation for their profits and that did not replicate the fundamental firms’ economics. in short, em definition is centered on the intent of managers, which is significantly hard to observe (dechow & skinner, 2000; lo, 2008; wiedman, 2002). for that reason, deliberations over the measurement of em issues are continuing through cause of the complexity in the distinguishing between the true belief of the management and the intention of management to earnings manipulation. so, figure 1 presents the distinction between fraud and em as viewed through dechow and skinner (2000, p.239). accounting choices real cash flow choices within gaap overly aggressive recognition of provisions or reserves delaying sales “conservative” accounting overvaluation of acquired in process r&d in purchase acquisitions accelerating r&d or advertising expenditures overstatement of restructuring charges and asset write-offs “neutral” accounting earnings that result from a natural operation of the process “aggressive” accounting understatement of the provision for bad debts postponing r&d or advertising expenditures drawing down provisions or reserves in an overly aggressive manner accelerating sales violate gaap recording sales before they are “realizable” recording fictitious sales “fraudulent” accounting backdating sales invoices overstating inventory by recording fictitious inventory figure 1. the distinction between earning management and fraud source: adapted from dechow & skinner (2000) implicit in figure 1 is that managers are engage in em practices as long as they have inducements to manage earnings. the previous literature (dechow & skinner, 2000; healy & wahlen, 1999; jackson & pitman, 2001) showed three inducements for managers to manipulate earnings which are contractual incentives, market incentives and regulatory incentives. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 249 managers engage in em activities in order to get many incentives such as debt covenants, management compensation agreement, job security and union negotiations. these four incentives are examples of contractual situations. peasnell et al. (2000a) indicated that shareholders exercise earnings for bonus and stock options for manager, this resulted in earnings manipulate for more benefits. also, managers engage in em as they recognize an association among reported earnings and the market value of the company. burgstahler and dichev (1997) confirmed that managers’ manage earnings in order to reduce the forced transactions costs with stockholders. in addition, managers manage earnings to influence the regulators or government officials’ action. jackson and pitman (2001) stated that managers might influence the actions of regulators or government officials through managing the operations results, in that way minimizing political scrutiny and the regulation effects firms. to recapitulate, it could be said that em occur when there are incentives as well as opportunities for it. the question is that: how companies are able to get away with it? this question leads to the significant role played by corporate governance in safeguarding and improve frq. 3.3 corporate governance corporate governance indicates the acting governing firms in order to protect the shareholders’ interests. the ownership and control separation has initiated the assortment of suitable corporate governance mechanisms to make sure a competent interest arrangement for both principals and agents. shleifer and vishny (1997) observed corporate governance from a simple agency viewpoint that dealing with the investors to make sure that they will acquire their investment back from the management. the agency theory apprehensions the problem of principal-agent in ownership and control separation of the firm and attends to the probable for agency problems (fama & jensen, 1983; jensen & meckling, 1976). the signed contracts among shareholders and managers in fact offer managers essential remaining rights control that generates chances to confiscate the funds of shareholders (shleifer & vishny, 1997). corporate governance can be defined as: “… the system by which companies are directed and controlled. boards of directors are responsible for the governance of their companies. the shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structures is in place. the responsibilities of the board include setting the strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. the board’s actions are subject to laws, regulations and the shareholders in general meeting” (cadbury report, 1992, p.15). the above definition highlights the significant role of the boards as an agent to firms’ direct and control in addition to communicate the accurate the fundamental financial information to shareholders (ow-yong & guan, 2000). the board of directors is supposed to do the role of monitoring in aid of shareholders (john & senbet, 1998) and has the major responsibility of firm’ leading and directing in order to attain corporate objectives through intimately monitoring the actions of management and protecting the shareholders’ interest (abdullah, 2004). additionally, the board is considered as the most influential and cost effectual asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 250 mechanism of corporate governance for managers monitoring when pursuing actions that raise the value of firm (abdullah & mohd-nasir, 2004). the effective board presence is to make sure that the effective alignment of managers’ and owners’ interests and to stimulate the wealth and earnings of shareholders (vethanayagam et al., 2006). due to the importance of board of directors as one of the corporate governance mechanisms, this paper intends to propose several characteristics of board of directors. being equipped with this understanding enables jordanian regulatory agencies to reduce em and in turn increase frq. 4. the conceptual framework and hypothesis development the characteristics of board of directors and their linkage with em are integrated in one conceptual framework. figure 2 illustrates the propose framework. in this conceptual framework, board characteristics and em are independent and dependent variables respectively. the present study thus attempts to bridge the gap by providing a basis for discerning the impact of board characteristics on em. although the causal relationships among the constructs illustrated in figure (2) seem to be straightforward, to our knowledge, the present study is the only one that holistically investigates the relationship between board characteristics and em. sections 4.1 till 4.5 will discuss the hypotheses that are developed from the conceptual framework. figure 2. board characteristics and earning management 4.1board independence majority of the prior studies on the association between corporate governance and em documented a negative association between the presence of outside directors and em (bedard et al., 2004; benkel, et al., 2006; klein, 2002a; niu, 2006; osma, 2008; peasnell et al., 2000a; 2000b; 2005; xie et al., 2003). xie et al. (2003) and klein (2002a) investigated the impact of different characteristics of boards on em and found that companies with larger proportion of independent directors will h5 h4 h3 h2 h1 board independence board size board financial expertise board meetings earning management (em) ceo duality asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 251 be less likely engaging in em than the one that have executive directors. this is supported by peasnell et al. (2000a; 2000b; 2005) whereby they found that firms with a higher proportion of outside directors have less income-increasing accruals when earnings fall below the threshold. in other words, outside directors are more concerned with constraining income-increasing accruals. more recently, osma (2008) investigated the independent boards’ effect on constraining research and development (r&d) spending manipulation and uncovered that independent directors are capable of identifying and constraining em represented by r&d cuts. on the other hand, park and shin (2004) they found that independent outside directors per se did not decrease em, while outside directors from financial intermediaries and active institutional shareholders did decrease em. this highlights the importance of appointing outside directors with financial expertise. niu (2006) further supported all these findings by saying that the level of independence of board composition is negatively related to the level of abnormal accruals. benkel, et al. (2006) and osam amd noguer (2007) also observed these phenomena whereby they found that boards and audit committees with higher independence are associated with reduced em levels. jaggi et al. (2009) examined whether independent boards provide effective em monitoring in firms operating in the family ownership environment in hong kong. the results indicated that independent boards provide effective monitoring of em. nevertheless, they found that the monitoring effectiveness of independent boards was moderated in family-controlled firms, which suggests that increasing the proportion of independent directors to strengthen board monitoring is unlikely to be effective in family-controlled firms. lo et al. (2010) investigated whether good governance structures help constrain management's opportunistic behaviors measured through transfer pricing manipulations. they documented that firms with independent boards’ are less likely to engage in transfer pricing manipulations. however, abdul rahman and ali (2006) found that the relationship between board independence and em was insignificant. siregar and utama (2008) also did not found evidence that firms with independent boards engage in informative em. these findings are contrary to other studies. from the aforementioned discussion, it is argued that there is a potential relationship between board independence and em. thus, the following hypothesis is developed: h1: the independence of the board of directors is negatively related to earning management among jordanian listed companies. 4.2 ceo duality the separation roles among chairman and ceo are well recommended to avoid substantial power concentration whereby similar individual executes both roles (cadbury report, 1992; jcgc, 2009). international australian guidelines standards (2003) stipulate that board monitoring role will be jeopardized if board chairperson is also the ceo of the firm (davidson et al., 2005). bowen et al. (1986) stated that the separation of roles between chairman and ceo was significant in preventing em activities. they discovered that earnings smoothing activities asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 252 were higher amongst ceo duality firms. this was consistent with a study conducted in year 2001 in malaysian whereby firms with ceo duality were positively related with em. abdul rahman and haniffa (2005) supported that by saying companies with ceo duality did not perform well and incline to do em. based on the above discussion, it is argued that there is a potential relationship between ceo duality and em. thus the following hypothesis is proposed: h2: ceo duality is positively related to earning management among jordanian listed companies. 4.3 board financial expertise in line with dependency theory, the role of directors as an advice source as well as counsel for the ceo is essential in increasing firms’ valued (daily et al., 2003). it is significant for both inside and outside directors to play an efficient role in improving frq to provide access to the firms’ needed resources such as financial, governance and firm-specific expertise (bedard et al., 2004; jcgc, 2009). barton et al. (2004, p.61) suggested that to do their tasks effectively the boards must have the ability for “asking management tough questions, actively helping to set corporate strategy, monitoring risk management, contributing to ceo successions plan and ensuring that companies set and meet their financial and operating targets”. so far, this can only be achieved if the board has the vital expertise to fully embrace such duties. according to reilly (2003), governance strategic business direction and finance are three areas that every director should master in. xie et al. (2003) uncovered that boards of directors with corporate or investment banking backgrounds are negatively related to the level of em. this suggests that independent directors with corporate and financial backgrounds are critical to deter managed earnings. bedard et al. (2004) observed that the presence of financial expert in the audit committee was negatively related with the probability of aggressive em. karamanou and vafeas (2005) reported that the expertise of audit committee was positively related to the market reaction of earnings forecast. additionally, park and shin (2004) found that the presence of officers from financial intermediaries in the board can limit abnormal accruals as the unmanaged earnings are below the target. they said that experienced outside board members able to understand the firm and its people better and consequently improve their governance competencies. based on the above discussion, it can be said that there is a potential relationship between board financial expertise and em. thus the following hypothesis is proposed: h3: the financial expertise of the board of directors is negatively related to earning management among jordanian listed companies. 4.4 board size monks and minow (2011) and lipton and lorsch (1992) stated that larger boards are able to commit more time and effort, whereas smaller boards are able to commit less time and effort, to overseeing management. klein (2002b) extended this argument by saying that board asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 253 monitoring is positively associated with larger boards because of their ability to distribute the workload to many people. xie et al. (2003) uncovered em is less likely to take place in firms with larger boards. yu (2008) found that small boards seem more prone to failure to detect em. implicit in these findings is that smaller boards incline to be influenced by the management or dominated by block-holders, as larger boards are more capable of monitoring the top management actions. abdul rahman and ali (2006) and kao and chen (2004) found a significant positive association between board size and the empirical indicator of em. however, as xie et al. (2003) found a negative association between em and board size. their different results might be because of different types of em adopted or different markets and corporate governance practice. based on the above discussion, it can be said that there is a potential relationship between board size and em. thus the following hypothesis is proposed: h4: the size of board of directors is negatively related to earning management among jordanian listed companies. 4.5 board meetings directors on boards that meet regularly are more likely to discharge their duties in accordance with interests of shareholders since more time can be devoted to monitoring issues such as em, conflicts of interest and monitoring management. on the other hand, boards that hardly ever meet may have no time to find out about such complex issues and may perhaps have time only to rubber stamp management plans. there are few studies of the impact on board meeting frequency on em. xie et al. (2003) argued that a board that meets rarely may only have time for signing off management plans and listening to presentations; hence, they may not have time to focus on issues such as em. in other words they found that em was significantly negatively related to the number of board meetings. on the other hand, adams et al. (2008) found that directors who primarily monitor management perceives that they participate less in boardroom discussion than other directors and that the ceo often asks them for advice. bearing in mind the above conflicting views, this paper still believes that there is a potential relationship between board meeting and em. thus the following hypothesis is proposed: h5: the number of board of directors meeting negatively related to earning management among jordanian listed companies. 5. summary and conclusions issues relating to em and its effects on the frq are discussed. previous studies provide evidence on the existence of em when managers have both the incentive and opportunity to manage earnings. three main factors (i.e. contractual incentives, market incentives and regulatory incentives) are identified to create motives for em that lead to lower frq. while previous research suggests that em does occur, recent research demonstrates the critical role asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 254 of corporate governance in monitoring em activities and improving frq. this paper, however, discusses one of the elements of corporate governance which is board characteristics. to be more specific this paper intends to investigate the roles of the board of directors on em among jordanian listed companies. the study serves as a wake-up call for reforming the management and boards in jordan. to achieve this five board characteristics are proposed, namely, board independent, ceo duality, board financial expertise, board size and board meeting. in turn five hypotheses are developed to validate the hypothesis survey research will be undertaken. references abdul rahman, r., & ali, f. h. m. 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(2008). analyst coverage and earnings management. journal of financial economics, 88(2), 245-271. http://dx.doi.org/10.1016/j.jfineco.2007.05.008 microsoft word 2022-7936-1-rv-writer3-new a diffe usin receive doi:10.5 abstra in today strategi dynami really d market. to the l feasibil indian s black market. the opti expecte price ha merton of timin a feasi erential ng histo e-mai ed: june 29, 5296/ajfa.v4 ct y’s financia c decisions ic and unce difficult. ma the certain level of mi ity of black stock excha scholes – further the ion price an ed price as c ave any sig model is m ng is more r ibility a l equat orical v stock dr. shyam associate school il: shyamlal , 2012 a 4i2.2022 al world the s can be ma rtain nature any models nity of these inimum dev k scholes anges. the r merton diff e regression nd anova tes omputed by gnificant di more usefull relevenat fo analys tion mo volatili k optio dr. r prof m lal dev e professor of busines dev@gmail accepted: j url: htt ere is a grea ade to 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& ac issn 19 2012, vol. www.macrothi n scenario b prices using mated price d the compo and we arriv m nse web conclusion nal stock e from past stu with 16/8/2 ocks represe tion and vo his model in ssion analy dard deviatio computed by et forces. tween expec n price as we we are starti ations and c urity. macb ccounting 946-052x 4, no. 2 ink.org/ajfa y using black – and onents of ve at the bsite and whether xchange udies on 2011 and enting 5 olume of n indian ysis and on, beta, y b-s-m cted and ell as put ing with conclude beth and mervill (cev) m gonede in the m promine the nob one of t bhattac ideal co applicat radu, t stock type: ∂v constan dividen heston, black-s differen provide elasticit solution arbitrag satisfied lookbac ross. scott m investig evaluate 1 macbe models. 2 blattb statistica 3 bhatta journal 4 turcan p795-79 5 heston mar200 6 mcken model:e journal, le (1980)1 t model, whi es (1974)2 s modern finan ent place sp bel prize for the receipien charya, m. ( onditions, e tions in the turcan(2010 ks option v/∂t + 1/2σ² nt and conti nd are depen , steven l scholes-me ntial equatio e new solut ty of varian ns reflect a ges. we pro d, put-call p ck calls hav mckenzie, gation of th es the prob eth, j. d., an journal of fi berg, r. c., a al models for acharya, m. of financial n. (2010) an 99, n, steven l.; 7, vol. 20 iss nzie, s.; gera vidence from , 1(4), 2007. ested the b ch assumes suggest vola nce theory b pecially afte r economics nt of the pri 1980)3 in h xamined th 21st centur 0)4,in their ns” mentio ²s²∂²v/²s² + inue dividen ndent on tim l.; loewen rton option on (pde). b ions for the nce (cev) asset pricin ovide condi parity might e infinite va dionigi ge he black-sc bability of nd merville, l finance, 35(2) nd gonedes, r stock prices (1980). emp and quantita nals of the u loewenstein sue 2, p359-3 ace, d.; and m the austral lack – scho volatility c atility of the black sch er 1997 whe s. sadly, fis ize (hull & his paper em he "black-s ry economy paper “bl oned that pa rs ∂v/∂s r nds or in ev me. nstein, mar n valuation but this met e cox-inger model, an ng bubbles, itions to rul t not hold, a alue. we cla erace, zaff choles mod an exchang l. j. (1980). ), 285-301. j. (1974). a s. journal of pirical proper ative analysis university of n, mark; wil 390, 32p d subedar, z., lian stock ex 91 oles model changes whe e underlying holes – mert en robert m scher black basu 2010 mpirical prop choles" me y. lack-sch artial differ rv=0 is use valuate opt rk; willard n method i thod can ge rsoll-ross ( nd the hest dominated le out bubb american c arify a long far subedar del: eviden ge traded e tests of the b a comparison f business, 4 rties of the b s, 15(5), 108 f oradea, eco llard, gregor , (2007)an e xchange, aus asian against the en the stock g stock is st ton differen merton and k died in 199 ). perties of th ethod for pr oles mod rential equa ed in evaluat ions in whi d, gregory involves de enerate mul (cir) term ton stochas d investmen bles on und calls have n standing co r, (2007) 6 nce from th european ca black-schole n of the stabl 7(2), 24428 black scholes 81-1105. onomic scien ry a.(2007), mpirical inve stralasian ac n journal of f constant el k prices chan ochastic and ntial equatio myron sch 95, otherwis he black sch icing, its fu del used ation, parab ting equity o ich interest a (2007) eriving and tiple values structure m tic volatilit nts, and (p erlying pric no optimal e onjecture of in their pa he australia all option b es and cox c le and studen 80. s formula un nce series, 2 review of estigation of ccounting bu finance & ac issn 19 2012, vol. www.macrothi lasticity of v anges. blattb nd random. on model (19 holes were a se he too ha holes formu undamentals d to eva bolic blackoptions, tha rate, volati 5 found th d solving a s for an opt model, the ty model. m possibly inf ces. if they exercise pol f cox, ingers aper ‘an em an stock ex being exerc call option va nt distributio nder ideal co 010, vol. 19 f financial st f the black-s usiness and f ccounting 946-052x 4, no. 2 ink.org/ajfa variance berg and 970) has awarded ave been ula under s and its aluate -scholes at paying ility and hat the a partial tion. we constant multiple feasible) y are not licy, and soll, and mpirical xcahnge’ cised on aluation ns as onditions. issue 2, tudies, scholes finance asx20 this pap that the the use of the u model. espen g used th finance neither traders manner differen can be u model t used to scholes saying o chaudh black-s option p two ga options bearing the othe the dire heston for a sp returns volatilit shows t are sub volatilit 7 espen the blac http://ch ack-scho 8 heston valuatio 00 option in per utilises q b & s mod of implied v underlying gaarder hau he black-sc theory and philosophy copying oth r. this stud ntial equatio used to pre to predict st check whe s – merton d of espen ga hury and j scholes mod price is not arch (1,1) are an exc g on the mag er hand, det ection of the and nand ot asset who of the spot ty model a that the outbstantially lo ty for each o n gaarder ha ck-scholes-m hineseactuary oles-merton_ n, sl; 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2012, vol. www.macrothi of non-trade ental parts in nderlying sto oduce most mptions an ed volatility aken in the study perio sis period. feasibility s historical v he dates 1-j has been co annual vola nds paid in ccounting 946-052x 4, no. 2 ink.org/ajfa ed stock ncluding ock. feasible nd these y. study. od. study of volatility jul-2010 omputed atility by the year table 1 data underlyin exercise p considera expiry da historical risk free dividend time(yea d1 n(d1) d2 n(d2) expected actual pri difference % differe source: c table n 7 days. which i free rate in case option p price is case of . difference ng price price ation date ate l volatility rate yield ars) price ice e in value ence computed on t no. 1 shows expected p is based on e of return, t of short per price. the d absent due infy call e between a jp assoc 67.00 70.00 9/22/201 9/29/201 43.56% 8.30% 0.86% 0.02 -0.67230 0.2507 -0.7326 0.2319 0.5871 0.9 0.3129 34.76667 the basis of re difference rice has bee 5 factor viz time to exp riod (7 days difference is to zero valu option i.e. r an expected ciate ril 786 780 11 9/2 11 9/2 23. 8.3 0.7 0.0 07 0.3 0.6 0.2 0.6 14. 18. 4.4 7 23. ealtime data ob between an en computed z. spot pric piry of the op s) there is si s m,aximum ue of n(d1) rs. 1.9780 95 d and actual l 6.35 0.00 22/2011 29/2011 .71% 30% 76% 02 3073922 6207 2746 6082 .4184 .9 4816 .71217 btained from n n expected a d by using u ce of stock, ption, annu gnificant di m in case of h and n(d2), (27.6780-25 asian price of a c sbi 1,937.55 2,300.00 9/22/2011 9/29/2011 31.45% 8.30% 1.08% 0.02 -3.883767 0.0001 -3.9273 0.0000 0.0010 0.75 0.7490 99.86667 nse derivati and actual pr using the bl exercise pr ual volatility ifference be hindalco ca while the co 5.7) 7.15% n journal of f call option e hindalc 139.40 180.00 9/22/2011 9/29/2011 35.50% 8.30% 0.72% 0.02 -5.145161 0.0000 -5.1943 0.0000 0.0000 0.1 0.1000 100 ve segment. rice of a cal lack – scho rice of the o y of the stoc etween expe all option pr omperative only . finance & ac issn 19 2012, vol. www.macrothi expiring in 7 co infy 2,352 2,400 9/22/ 9/29/ 23.34 8.30% 1.85% 0.02 -0.35 0.360 -0.40 0.342 27.67 25.7 1.97 7.146 ll option exp oles – merto option, ann ck. table sh ected and ac rice where e difference i ccounting 946-052x 4, no. 2 ink.org/ajfa 7 days y 2.60 0.00 /2011 /2011 4% % % 56009 09 052 27 780 80 647012 piring in on model nual risk ows that ctual call expected is less in table 2 days data underlyin exercise consider expiry d historica risk free dividend time(ye d1 nd1 d2 nd2 expected actual pr differenc % differ source: table 2 of all se incresed differen highest with .24 sbi cal 2. price diffe ng price price ration date date al volatility e rate d yield ears) d price rice ce in value ence : computed 2 indicates th elected und d because o nce between in case of r 447 as a perc l option pri ference betw jp a 68.3 70.0 9/14 9/29 43.5 8.30 0.86 0.04 -0.1 0.42 -0.2 0.38 1.78 2.05 0.26 13.1 on the basis hat increase erlaying sto f time value n expected ril call opt centage diff ce with 99.7 ween an exp associate 35 00 4/2011 9/2011 56% 0% 6% 4 9134995 241 797 899 807 5 693 3659 s of realtim e in the time ock. due to e of option a price and tion price w ference in in 77%. 96 pected and a ril 825.40 780.00 9/14/2011 9/29/2011 23.71% 8.30% 0.76% 0.04 1.2655302 0.8972 1.2175 0.8883 49.7800 56.15 6.3700 11.34461 me data obta e to expiry b increase in and relative actual pric with rs. 6.37 nfosys call asian actual price sbi 1,826.75 2,300.00 9/14/201 9/29/201 31.45% 8.30% 1.08% 0.04 -3.53491 0.0002 -3.5987 0.0002 0.0058 2.55 2.5442 99.77255 ained from n brings positi n time to exp difference h ce. the diff 7 while low option is low n journal of f of a call op hin 5 145 0 180 11 9/14 11 9/29 35.5 8.30 0.72 0.04 11 -2.9 0.00 -2.9 0.00 0.00 0.25 0.24 5 97.8 nse deriva ive impact o piry call op has been mi ference in t west in hind west with 6 finance & ac issn 19 2012, vol. www.macrothi ption expirin ndalco i .10 2 .00 2 4/2011 9 9/2011 9 50% 2 0% 8 2% 4 0 915668 018 0 9876 014 0 053 4 5 5 447 3 88 6 ative segmen on call optio ption price h inimized in the value h dalco cal .44% and hi ccounting 946-052x 4, no. 2 ink.org/ajfa ng in 15 infy 2,351.65 2,400.00 9/14/2011 9/29/2011 23.34% 8.30% 1.85% 0.04 -0.209978 0.4168 -0.2819 0.3890 49.1178 52.5 3.3822 6.44228 nt. on prices has been terms of has been ll option ighest in table 3 30 days data underlyin exercise consider expiry d historica risk free dividend time (ye d1 nd1 d2 nd2 expected actual pr differenc % differ source: table 4 43 days data underlyin exercise consider expiry d historica risk free dividend time(ye d1 nd1 d2 nd2 expected actual pr differenc % differ . the price s ng price price ration date date al volatility e rate d yield ears) d price rice ce in value ence : computed 4. the price s ng price price ration date date al volatility e rate d yield ears) d price rice ce in value ence difference b jp asso 58.30 70.00 8/29/20 9/29/20 43.56% 8.30% 0.86% 0.08 -1.3274 0.0922 -1.4544 0.0729 0.3018 0.45 0.1482 32.9333 on the basis difference b jp asso 57.15 70.00 8/16/20 9/29/20 43.56% 8.30% 0.86% 0.12 -1.2060 0.1139 -1.3573 0.0873 0.4493 0.7 0.2507 35.8142 between an ociate ri 75 78 11 8/ 11 9/ % 23 8. 0. 0. 45587 -0 0. 4 -0 0. 12 16 3. 33 21 s of realtim between an ociate ri 75 78 11 8/ 11 9/ % 23 8. 0. 0. 0949 -0 0. -0 0. 18 22 3. 29 16 97 expected a il 55.05 80.00 /29/2011 /29/2011 3.71% 30% 76% 08 0.343263 3657 0.4124 3400 2.5778 6 4222 1.38875 me data obta expected a il 59.15 80.00 /16/2011 /29/2011 3.71% 30% 76% 12 0.177559 4295 0.2599 3975 8.8363 2.6 7637 6.65354 asian nd actual pr sbi 1,938.60 2,300.00 8/29/2011 9/29/2011 31.45% 8.30% 1.08% 0.08 -1.752344 0.0399 -1.8440 0.0326 2.7623 6.5 3.7377 57.50308 ained from n nd actual pr sbi 2,196.95 2,300.00 8/16/2011 9/29/2011 31.45% 8.30% 1.08% 0.12 -0.285489 0.3876 -0.3947 0.3465 61.4032 55.05 6.3532 11.54078 n journal of f rice of a cal hindalc 144.10 180.00 8/29/2011 9/29/2011 35.50% 8.30% 0.72% 0.08 -2.036193 0.0209 -2.1397 0.0162 0.1109 0.5 0.3891 77.82 nse deriva rice of a cal hindalc 144.35 180.00 8/16/2011 9/29/2011 35.50% 8.30% 0.72% 0.12 -1.654948 0.0490 -1.7782 0.0377 0.3465 0.7 0.3535 50.5 finance & ac issn 19 2012, vol. www.macrothi ll option exp co inf 2,29 2,40 8/29 9/29 23.3 8.30 1.85 0.08 -0.3 0.37 -0.4 0.33 57.8 47.1 10.7 22.7 ative segmen ll option exp co inf 2,39 2,40 8/16 9/29 23.3 8.30 1.85 0.12 0.12 0.54 -0.0 0.49 126. 81.2 45.0 55.4 ccounting 946-052x 4, no. 2 ink.org/ajfa piring in y 96.25 00.00 9/2011 9/2011 34% 0% 5% 8 22466 735 259 351 8701 15 7201 73616119 nt. piring in y 99.30 00.00 6/2011 9/2011 34% 0% 5% 2 223442 487 009 996 .3427 25 0927 49870769 source: observ in the c achieve associa differen followe expiry o rs.0.14 option w associat table 5 days. data underlyi exercise consider expiry d historica risk fre dividend time(ye d1 nd1 d2 nd2 expected actual p differenc % differ source: : computed vations case of call ed in hinda ates with rs nce in price ed by jaipra of 30 days, 482 and fol with time to tes which is . the price ing price price ration date date al volatility e rate d yield ears) d price price ce in value rence : computed on the basis l option wi alco indust s.0.3129. in e was achi akash asso the least di lowed by h o expiry of 4 s rs.0.2507 difference b jp assoc 67.00 70.00 9/22/201 9/29/201 43.56% 8.30% 0.86% 0.02 -0.67230 0.2507 -0.7326 0.2319 3.4868 3.9 0.4132 10.5948 on the basis s of realtim ith time to tries limited n the case of ieved in hi ociates with fference in hindalco in 43 days, the and follow between an ciate ril 786 780 11 9/2 11 9/2 23.7 8.30 0.7 0.02 07 0.30 0.62 0.27 0.60 6.94 14.4 7.50 7 51.9 s of realtim 98 me data obta expiry of 7 d which is f call option indalco ind h rs.0.2693 price was a ndustries lim e least diffe wed by hind expected an l s 6.35 1 0.00 2 2/2011 9 9/2011 9 71% 3 0% 8 6% 1 2 0 073922 207 0 746 082 0 424 1 45 1 076 4 95571 2 me data obta asian ained from n 7 days, the rs.0.1000 n with time dustries lim . in the cas achieved in mited with erence in pri dalco industr nd actual pri sbi 1,937.55 2,100.00 9/22/2011 9/29/2011 31.45% 8.30% 1.08% 0.02 -1.795032 0.0363 -1.8386 0.0330 160.7120 165 4.2880 2.598788 ained from n n journal of f nse deriva least diffe and follow to expiry o mited which se of call o jaiprakash rs.0.3891. ice was ach ries limited ice of a put o hindalco 139.40 150.00 9/22/2011 9/29/2011 35.50% 8.30% 0.72% 0.02 -1.436585 0.0754 -1.4857 0.0687 10.6079 11.5 0.8921 7.757391 nse deriva finance & ac issn 19 2012, vol. www.macrothi ative segmen erence in pr wed by jai of 15 days, t h is rs.0.24 option with associates w .in the case hieved in jai d with rs.0.3 option expi o infy 2,352.6 2,400.0 9/22/20 9/29/20 23.34% 8.30% 1.85% 0.02 -0.3560 0.3609 -0.4052 0.3427 72.095 78.5 6.4047 8.1588 ative segmen ccounting 946-052x 4, no. 2 ink.org/ajfa nt. rice was iprakash the least 447 and time to which is e of call iprakash 3535 ring in 7 60 00 011 011 % 009 9 2 7 53 7 853503 nt. table 6 15 days data underlying exercise p considerat expiry da historical risk free dividend y time (yea d1 nd1 d2 nd2 expected p actual pric difference % differen source: table 7 30 days data underlying exercise p considerat expiry dat historical risk free r dividend y time (yea d1 nd1 d2 nd2 expected p actual pric difference % differen 6. the price s g price price tion date ate volatility rate yield ars) price ce e in value nce : computed 7. the price s g price price tion date te volatility rate yield ars) price ce e in value nce difference b jp assoc 68.35 70.00 9/14/201 9/29/201 43.56% 8.30% 0.86% 0.04 -0.191349 0.4241 -0.2797 0.3899 3.2165 3.85 0.6335 16.45455 on the basis difference b jp assoc 58.30 70.00 8/29/201 9/29/201 43.56% 8.30% 0.86% 0.08 -1.32745 0.0922 -1.4544 0.0729 11.5526 14.35 2.7974 19.49408 between an iate ril 825 780 1 9/14 1 9/29 23.7 8.30 0.76 0.04 995 1.26 0.89 1.21 0.88 1.98 9.75 7.76 5 79.6 s of realtim between an iate ril 755 780 1 8/29 1 9/29 23.7 8.30 0.76 0.08 587 -0.3 0.36 -0.4 0.34 32.5 38.7 6.2 8 16.0 99 n expected a l s 5.40 1 0.00 2 4/2011 9 9/2011 9 71% 3 0% 8 6% 1 4 0 655302 972 0 175 883 0 818 2 5 2 682 0 67385 0 me data obta n expected a l s 5.05 1 0.00 2 9/2011 8 9/2011 9 71% 3 0% 8 6% 1 8 0 343263 657 0 4124 400 0 5359 1 75 1 141 8 03639 4 asian and actual p sbi 1,826.75 2,100.00 9/14/2011 9/29/2011 31.45% 8.30% 1.08% 0.04 -2.108033 0.0175 -2.1718 0.0149 267.6310 267 0.6310 0.23633 ained from n and actual p sbi 1,938.60 2,100.00 8/29/2011 9/29/2011 31.45% 8.30% 1.08% 0.08 0.759796 0.2237 0.8515 0.1973 170.3353 178.4 8.0647 4.520572 n journal of f rice of a pu hindalco 145.10 150.00 9/14/2011 9/29/2011 35.50% 8.30% 0.72% 0.04 -0.382229 0.3511 -0.4542 0.3248 6.8076 7.85 1.0424 13.27898 nse deriva rice of a pu hindalco 144.10 150.00 8/29/2011 9/29/2011 35.50% 8.30% 0.72% 0.08 -0.273911 0.3921 -0.3774 0.3529 8.8275 11.15 2.3225 20.8296 finance & ac issn 19 2012, vol. www.macrothi ut option exp o infy valu 2,351 2,400 9/14/2 9/29/2 23.34 8.30% 1.85% 0.04 -0.209 0.416 -0.28 0.389 91.08 103.3 113.4 ative segmen ut option exp o infy 2,296 2,400 8/29/2 9/29/2 23.34 8.30% 1.85% 0.08 -0.322 0.373 -0.425 0.335 148.3 140 8.366 5.975 ccounting 946-052x 4, no. 2 ink.org/ajfa piring in y ue .65 0.00 2011 2011 4% % % 9978 68 19 90 26 5 4684341 nt. piring in y 6.25 0.00 2011 2011 4% % % 2466 5 59 1 663 63 928571 source: table 8 43 days data underlyin exercise consider expiry d historica risk free dividend time (ye d1 nd1 d2 nd2 expected actual pr differenc % differ source: observ in the ca in jaipr rs.0.89 was ach with rs price w jaiprak the leas followe cases ja providin it is als and hin than the : computed 8. the price s. ng price price ration date date al volatility e rate d yield ears) d price rice ce in value ence : computed vations ase of put op rakash assoc 921. in the c hieved in st s.0.6335 in was achieve kash associa st differenc ed by hinda aiprakash a ng least diff so observed ndalco indus e historical on the basis difference b jp asso 57.15 70.00 8/16/20 9/29/20 43.56% 8.30% 0.86% 0.12 -1.2060 0.1152 -1.3505 0.0884 12.5859 11.15 0.2439 2.18744 on the basis ption with t ciates which case of put o ate bank of the case of ed in hind ates with rs e in price w alco industr associates an fference from d that jaipra stries limited annual vola s of realtim between an ociate r 75 78 011 8/ 011 9/ % 23 8. 0. 0. 0949 -0 0. 5 -0 0. 9 32 38 5. 44 14 s of realtim ime to expir h is rs.0.41 option with t f india whic put option w alco indust s.2.7974. in was achieve ries limited nd hindalco m the actual akash associ d has got a h atility of oth 100 me data obta n expected a ril 59.15 80.00 /16/2011 /29/2011 3.71% .30% .76% .12 0.177559 .4295 0.2599 .3975 2.6161 8 .3839 4.16816 me data obta ry of 7 days 132 and foll time to exp ch is rs.0.63 with time to tries limite n the case of ed in jaipra with rs.2.8 o industries l price. iates has go historical an her three com asian ained from n and actual p sbi 2,196.95 2,100.00 8/16/2011 9/29/2011 31.45% 8.30% 1.08% 0.12 0.5476283 0.7080 0.4384 0.6695 46.5982 55 8.4018 15.276 ained from n s, the least d lowed by hi iry of 15 da 310 and foll o expiry of d which is f put option akash assoc 8651. so it limited has ot a historic nnual volati mpanies. n journal of f nse deriva rice of a pu hindal 144.35 150.00 8/16/201 9/29/201 35.50% 8.30% 0.72% 0.12 -0.17573 0.4302 -0.2990 0.3825 9.5349 12.4 2.8651 23.10565 nse deriva ifference in indalco indu ays, the least lowed by ja 30 days, the s rs.2.3225 with time to ciates which can be seen occupied th cal annual v ility of 35.5 finance & ac issn 19 2012, vol. www.macrothi ative segmen ut option exp lco in 2,3 2,4 1 8/1 1 9/2 23 8.3 1.8 0.1 8 0.1 0.5 -0. 0.4 10 79 29 5 37 ative segmen n price was a dustries limi t difference aiprakash as e least diffe 5 and follo o expiry of h is rs.0.2 n that most he first two volatility of % which ar ccounting 946-052x 4, no. 2 ink.org/ajfa nt. piring in nfy 399.30 400.00 16/2011 29/2011 .34% 30% 85% 12 1223442 5487 0009 4996 8.4941 .4941 .3343038 nt. achieved ited with e in price ssociates erence in owed by 43 days, 438 and tly in all ranks in f 43.56% re higher it can al all com prices m volatilit and actu market state b limited rs.24,7 it can b jaiprak compan predicti table 9 days to e 7 days 15 days 30 days 43 days observ from th values. decreas black-s days to options average percent black-s analysis lso be seen mpanies in ca mostly when ty, the black ual value of capitalizati bank of ind is rs.2,68 725.59 crore be seen tha kash associa nies. so bl ion for the c 9. table sho expiry ca ave 1.5 2.5 3.6 11. vations he above an in the table sing as the scholes-me expiry incre are mostly e percentag age differen scholes-me s of differen that infosys ase of histo n compared k-scholes-m f call and pu ion of infos dia is rs. 1 8,533.75 cro es and mark at the avera ates is nea lack-schole companies w wing the av all option erage differen 5243 56208 68346 .16276 nalysis it is f e 9, it can b number of rton model eases. it can y lower than e differenc nces compa rton model nce in follow s limited w rical annual to other com merton mod ut options o sys limited ,11,013.7 c ores, marke ket capitaliz age market arly 8.7 tim es-merton m with lower m verage differ nce in price found that t e found that days to ex in computa n also be fou n the avera e is not sim ared to put for a call op wing section 101 which has hi l volatility a mpanies. th del can prov of that stock d is rs. 1,4 crores, mar et capitaliz zation of jai t capitalizat mes lower model seem market capi rence in opt % avg dif 53.21 45.72 42.48 34.00 the expected t the percen xpiry increa ation of call und that the age differen milar in all option pric ption is high n makes ou asian istorical vol and it has s he companie vide least di k. 46,532.7 cro rket capital zation of h iprakash ass tion of hin than the m ms to prov italization. tion prices o put opt ff. average 3.90112 4.4685 5.553 9.2777 d values var ntage averag ses. this sh l option pric e average dif nce in rupee l four cases e. this show her than tha ur inference n journal of f atility of 23 hown the hi es which ha ifference be ores , mark ization of r hindalco ind sociates is r ndalco indu market capi vide least d of five stock tion e difference in 2 6 ry significan ge difference hows that t ces increase fference in r e prices for s as call op ws that the at of the put more valid. finance & ac issn 19 2012, vol. www.macrothi 3.34% is the highest diffe ave higher h etween the e ket capitaliz reliance in dustries lim rs.15586.76 ustries limi italization o difference k options n price % 1 4 1 1 ntly from th e in prices k the accurac es as the nu rupee prices r put option ption shows prediction t option. re . ccounting 946-052x 4, no. 2 ink.org/ajfa e least of erence in historical expected zation of ndustries mited is 6 crores. ited and of other in price % avg diff. 16.21 44.62 13.37 18.41 he actual keeps on y of the umber of s for call ns, while s higher level of gression regress model 1 a predic mod 1 a predic b depen model 1 a depen model 1 a predic model 1 a predic b depen sion analys r .9 ctors: (cons del regressi residua total ctors: (cons ndent varia (constant) days ndent varia (i r .939(a) ctors: (cons regression residual total ctors: (cons ndent varia sis: regress r r 905(a) .8 stant), days sum squa ion 47.0 al 10.3 57.4 stant), days able: ecpri unstanda b -1.151 .248 able: ecpri ii) regressi r square .881 stant), days sum of 15.455 2.079 17.534 stant), days able: eppri ion value o square a 19 . s ano m of ares df 059 1 393 2 452 3 s icedif coeffic ardized coeffi std. err 2.263 .082 icedif on value o adjusted r .822 s ano squares d 2 3 s icedif 102 of differenc adjusted r sq 729 ova(b) mean 47.05 5.196 cients(a) ficients s c ror b . of differenc square ova(b) df 1 2 3 asian ce in call op quare st 2. n square f 9 9. 6 standardized coefficients beta 905 ce in put o std. error of 1.01955 mean squa 15.455 1.039 n journal of f ption prices td. error of the 27955 si 056 .0 t b -.508 3.009 ption price f the estimate are f 14.8 finance & ac issn 19 2012, vol. www.macrothi s e estimate ig. 095(a) sig. std. err .662 .095 es: e si 868 .0 ccounting 946-052x 4, no. 2 ink.org/ajfa ror g. 61(a) model 1 a depen mod 1 a predic model 1 a predic regress depende indepen expiry. option p model. differen similar square to expir to expir greek u b-s-m says tha increase so far a freedom call opt the case (constant) days ndent varia model sum del r .973(a) ctors: (cons model sum r .323(a) ctors: (cons sion analysi ent variable ndent variab on the basi prices have here r valu nce that say relationship value .881 w ry. based on ry is more st under the b model, thou at it is not e in time to anova is con m of denom tion price an es. unstandar b 2.428 .142 able: eppri mmary: re r squa .946 stant), days mmary: re r squa .104 stant), days is is a metho e, in this s ble while ca is of outcom e positive re ue is .905 a ys that if tim p has been o which indic n the regress trong than t b-s-m mode ugh when it necessary t expiry will ncern the tab minator for 5 nd 14.868 fo c rdized coeffic std. error 1.012 .037 icedif gression va are s egression v are adjus -.344 s od to deal w study days all and put o me of regres elationship nd r squar me to expir observed in cate close re sion value w the call opti el. our stud comes to pe that always increase pu ble value fo 5 % level of for put optio 103 oefficients( cients sta co bet .93 alue of % d adjusted r .920 value of % sted r square 4 with the relat to expiry option prices ssion analys as it has b re .819 in ca ry decreases case of put elation ship we can say t on price. th dy based on ercentage d s reduction ut option pric or 1 degree f significanc on price, the asian (a) andardized efficients ta 9 difference square difference e std. 16.7 tionship betw i.e. 7, 15, s are depend sis we can s been one of ase of europ s call prem option beha between the that put opti his relations n regression difference in in time wil ce as the ad of freedom ce is 18.5 a erefore null n journal of f t b 2.399 3.856 in call op std. erro 2.25733 in put opt error of the e 76026 ween indep 30 and 43 dent over th say that tim f the basic p pean call o ium decrea aviour with e put option ion price rel ship is also n analysis pr n the put opt ll reduce pu djusted r sq for numera and compute hypothesis finance & ac issn 19 2012, vol. www.macrothi sig. std. .139 .061 ption prices or of the estim tion prices: estimate pendent vari are consid he change in me to expiry principle of option price ases and vic h r value .93 n premium a lationship w explain by t rove the va tion prices a ut option p quare value ator and 2 d ed value is is accepted ccounting 946-052x 4, no. 2 ink.org/ajfa error 9 1 : mate : able and dered as n time to and call f b-s-m average ce versa. 39 and r and days with time theta (θ) alidity of analaysis rice and is -.344. degree of 9.05 for d in both pair 1 pair 1 pair 1 c pp cpd: c ppd: pu table v indicate accepte hypoth h1: the model accept h2: th actual o corelati h3: bla option p recom  me cpd 43. ppd 23. cpd & pp paire mean cpd pd 20.7 call price av ut price av value at 5% es that b-sed. hesis can be ere is no sig by taking h ed. ere is no im options pric ion between ack schole m price. accep mendation traders nee price of put compared t ean n 8525 4 1525 4 n pd 4 ed differences n std. deviation 15.77646 verage % d erage % di % significanc -m model is concluded gnificant dif historical vo mpact of len ce. rejecte n time to exp merton mod pted ns for the a ed to be cau t option as t to call optio paired std 7.9 14. paired sa correlat .102 paire s std. er mean 7.88823 difference w fference wi ce level for s identical f in the follow fference bet olatrility an ngth of tim d/ not acc piry and pri del gives id application utious while the averge v on. 104 samples s d. deviation 95835 .45960 amples cor tion ed samples rror 95% co differen upper -4.4038 with actual p ith actual p r 3df is 3.1 for both cal wing manne tween the ex nd actual pr me to expiry cepted bec ice. dentical resu of model: e using blac variation in asian tatistics std 3.9 7.2 rrelations s .8 s test onfidence inte nce low 7 45.80 price price 182 while c ll and put op er: xpected opti rice determ y on the diff ause for bo ult for both k-schole-m the prices a n journal of f d. error mean 97917 22980 sig. 898 t rval of the er 0387 2 computed t ption pricin ions price c ined by ma fference betw oth call and call option merton mode are higher in finance & ac issn 19 2012, vol. www.macrothi n t df si (2 std. deviat n 2.624 3 .0 value is 2. ng hencefor computed by arket forces tween expec d put there price as we el for predic n case of pu ccounting 946-052x 4, no. 2 ink.org/ajfa ig. 2-tailed) tio std. erro r mea n 079 624 that rth h3 is y b-s-m s. result cted and is stong ell as put cting the ut option   conclu on the b prices o stock o results volatilit increase black-s options from th options black-s model w is driven investor indian s refern black, efficien black, f politica blattber as sta http://dx burasch markets chen, r empiric http://dx copelan new yo traders sho nearer as th in number o are less wil actual value traders sho seem to pro usion basis of the of stock opti options. the of black-s ty and the m es as the n scholes-me . he research trading scholes-me would lead t n by large n rs. therefor stock option ces f., & scho ncy. journal f., & schol al economy, rg, r. c., & atistical m x.doi.org/10 hi, a., & ja s. review of r., & palm cal eviden x.doi.org/10 nd, t., wes ork: pearson ould avoid u he relative / of days to e ll lead to hig es of call an ould use bla ovide better real time da ions have be e difference choles-mer market capit number of rton model h it is found in nse 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(197 nce and qua d. (1977). t ness, 50(2), r. (1979). http://dx.do r., r, roll. biases” in t x.doi.org/10 , & white, l of finance n, h., & sh al and quan th, j. d., & pricing x.doi.org/10 th, j. d., & on m x.doi.org/10 v., & lee m discontinu x.doi.org/10 a. (1994). t mics, 4(6), 43 seindia.com daram, r. k financial 0.2307/2676 th, h. (1981 , & singleto 0.1111/1468 ng, j., and nance, 53(6 78). the ch antitative an tests of mar 167-197. h the valuati oi.org/10.10 ., & shastri the black-s 0.1111/j.154 a. (1987). 42(2), 281– hanno, d. (1 ntitative ana merville, l g mode 0.1111/j.154 &merville, models. 0.1111/j.154 m. (1990). g uous retu 0.1093/rfs/3 the distribu 31-439. http m k. (1999). o and 6279 1). applied r on, k. j. (20 econome 8-0262.001 whaley, r ), 2059-210 hicago boar nalysis, 13(1 rket efficien ttp://dx.doi. ion of comp 16/0304-40 , k. (1984). scholes mo 40-6261.19 the pricin –300. http:// 987). optio alysis, 22(2) l. j. (1979). el. jour 40-6261.19 l. j. 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(2006) is adopted. the empirical results do not support the assumption of constant conditional correlation and there was clear evidence of time varying correlations between the russian stocks and bond market. both asset markets exhibit positive asymmetries. keywords: dcc-garch, time varying correlations, russia, asymmetric, emerging market jel classification: c32, g15 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 73 1. introduction since the seminal work by markowitz (1952, 1959) clearly addresses the importance of stock–bond correlation in constructing the optimal portfolio, examination of the co-movements between the stock and bond markets has been one of the most fundamental questions to portfolio managers, risk analysts and financial researchers, among others, in recent past. however, the question is still open and there is no general consensus among financial researchers on the dynamics of the stock–bond correlation and how it might perform in the future. for instance, keim and stambaugh (1986), campbell and ammer (1993), and kwan (1996) empirically support the theoretical argument of positive correlation among stocks and bonds. on the other hand gulko (2002), connolly et al. (2005) and baur and lucey (2009) support the phenomenon of “flight to quality” and “flight from quality” which reflects a negative correlation between the two assets, and additionally, alexander et al. (2000) found mixed sign correlations. moreover, prior literature is divided into two distinct opinions regarding the co-movement of two assets; for example, shiller and beltratti (1992) and campbell and ammer (1993) are among those who implicitly assume that stock–bond correlation is time invariant. in contrast, scruggs and glabadanidis (2003) strongly reject models that impose a constant correlation restriction on the covariance matrix between stock and bond returns. furthermore, siegel (1998), gulko (2002), cappiello, engle and sheppard (2006), ilmanen (2003), connolly et al. (2005), jones and wilson (2004) and li (2002) are among those who have shown that the correlation between stock and bond returns exhibits considerable time variation, whereas barsky (1989) is of the view that stock and bond co-movements are state dependent. furthermore, despite its importance, this phenomenon has been severely ignored in the context of emerging markets, regardless of their high returns and favourable diversification opportunities. there is no doubt that futures, options and different kinds of derivative products have acquired an ever increasing importance in today’s modern finance. however, stocks and bonds are still the primary securities traded on stock exchanges and the major component of any optimal portfolio, especially in emerging markets. since the risk–return characteristics of stocks and bonds are very different, stock–bond correlation plays an important role in asset allocation, portfolio management and risk management. it is therefore a natural question to ask whether there is a relationship between the returns on stocks and bonds, considering the main objective of a portfolio manger, i.e., to construct a portfolio that has the largest expected return with a minimum risk. moreover, the above-mentioned contradictory empirics motivate us to explore this issue further and especially in the context of emerging markets. there are several techniques to model the correlations between the returns on the stock and bond markets, but the conventional method relies on a simple regression analysis or takes an unconditional correlation based on a specific sample period, such as rolling window correlation estimation. however, the past two and a half decades have witnessed a high development in time series analysis, especially after the seminal works of engle (1982) and bollerslev (1986). multivariate garch models have been extensively applied to investigate asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 74 the co-movements between different asset markets. however, studies dealing with the interdependence across the stock and bond markets are scarce, particularly within the context of emerging markets. in the early days, bollerslev et al. (1988), among others, proposed a vech model to inspect the correlation between the bond and stock market in the usa. later, the bekk model of engle and kroner (1995) became popular to test the linkage between different markets and it has also been applied to examine the relationship between the stock and bond markets (see, e.g., scruggs and glabadanidis, 2003). similarly, the constant correlation coefficient model of bollerslev (1990) has been applied to investigate the linkage between the stock and bond markets (see, e.g., abid et al., 2003) the most recent addition in the class of multivariate garch models is the dynamic conditional correlation (dcc) model of engle (2002). this model has a clear advantage over previous models as it avoids computational complexities, estimates large conditional variance–covariance matrices and also circumvents the convergence problems. moreover, the dcc model perfectly overcomes the heteroskedasticity problem since the residuals of the returns are standardized by the conditional standard deviation based on the garch (1, 1) process. however, it does not account for the asymmetries in conditional variances, covariances, and correlations, but thanks to cappiello et al. (2006) this oversight was corrected because they recently proposed an asymmetric version of the dynamic conditional correlation (adcc) model to deal with the asymmetries in the conditional variances, covariances, and correlations of two assets. over the past few years the russian equity and fixed income markets have shown a tremendous attraction to both domestic and international investors due to their rapid growth and corrective measures taken by the russian policy makers. although the russian market is considered risky (see, e.g., saleem and vaihekoski, 2008), it is also a fact that today russia is a mainstream market for international investors who are interested to diversify their portfolios geographically. therefore, the russian equity market is worth investigation. in this study the attempt is to model the correlations between the returns on the stock and bond markets of russia. firstly, we question whether the co-movement between the two asset classes is constant over time by utilizing bollerslev’s (1990) constant conditional correlation model. further, to analyze the dynamics of the time varying conditional correlations between the two assets we use the dcc-garch (1, 1) model proposed by engle (2002). finally, to investigate the asymmetries in conditional variances, covariances, and correlations, we adopt an asymmetric version of the dynamic conditional correlation (adcc) model proposed by cappiello et al. (2006). the empirical results do not support the assumption of constant conditional correlation and there was clear evidence of time varying correlations between the russian stocks and bond market. moreover, both asset markets exhibit positive asymmetries. in general, the results offer a better understanding of the dynamics of the correlations between stocks and bonds in an emerging market setting which is obviously very valuable for portfolio managers, international investors, risk analysts and financial researchers as well as for its policy implications. the structure of the paper is as follows. the next section describes the model specifications asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 75 used to study the correlations among russian stock and bond markets. section 3 presents the data in this study. section 4 shows the empirical results, and section 5 provides conclusions. 2. model specification various approaches have been suggested for the modeling of the correlations between two assets. the simplest one is the rolling window correlation. however, due to its fixed window and equal weights given to all the sample points in a data set, it may ignore the structural changes with different degrees of volatility in a time series. bollerslev et al. (1988), among others, proposed a model in the early days to check the conditional covariances between bills, bonds, and stocks; however, the model was not able to assure the positive definiteness of the conditional variance matrix. moreover, this approach does not allow the cross equation conditional variances and covariances to affect each other due to oversimplifying restrictions. many of these problems are circumvented by the constant conditional correlation (ccc) model proposed by bollerslev (1990). however, the assumption of constant correlation is perhaps relatively uncertain and may not hold always. for example, prior research has documented high correlations among financial markets during crisis periods (see, e.g., chesnay and jondeau, 2001). following bollerslev (1990), engle and sheppard (2001) and engle (2002), this empirical specification starts with the assumption that stock market returns from the k series are multivariate and normally distributed with zero mean and conditional variance–covariance matrix ht. hence, this multivariate dcc-garch model can be presented as follows: tttr   (1) with ),0(| 1 ttt hn  where, rt is the (k×1) vector of the returns; εt is a (k×1) vector of zero mean return innovations conditional on the information, 1t , available at time t-1and for the bi-variate case, the conditional variance–covariance matrix (ht) in the dcc model can be expressed as: ,tttt drdh  (2) here d represents a (k×k) diagonal matrix of the conditional volatility of the returns on each asset in the sample and rt is the (k×k) conditional correlation matrix. basically, the dcc-garch model estimates conditional volatilities and correlations in two steps. in the first step the mean equation of each asset in the sample, nested in a univariate garch model of its conditional variance is estimated. hence, we can define dt as follows: ),.......( 2/12/1 kktiitt hhdiagd  (3) where hiit, conditional variance of each asset is assumed to follow a univariate garch(p, q) process given by the following expression: asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 76 , 1 ,, 1 2 1,,1,       qi q ptiqi pi p ptipiiti hh  (4) however, to insure non-negativity and stationarity, some restrictions, such as, pi, > 0, qi, > 0 and   pi p pi 1 , +   qi q qi 1 ,  1 should be imposed. these univariate variance estimates are then used to standardize the zero mean return innovations for each asset. in the second step, the standardized zero mean return innovations are assumed to follow a multivariate garch (m, n) process to illustrate the development of the time varying correlation matrix, r, which can be described as follows: ,)()( 2/12/1  tttt diagqqdiagqr (5) where 111 ')1(   tttt qqq  refers to a (k×k) symmetric positive definite matrix and iititit h/  , q is the (k×k) unconditional variance matrix of it , and α and β are non-negative scalar parameters satisfying α + β < 1. finally, the conditional correlation coefficient ij between two assets i and j is then expressed by the following equation: , )1()1( )1( 2/1 1, 2 1, 2/1 1, 2 1, 1,1,1,      tjjtjjjtiitiii tijtjtiij ij qqqq qq    (6) as per engle and sheppard (2001) and engle (2002) this model can be estimated with the quasi-maximum likelihood method (qmle) given below: ),'loglog2)2log(( 2 1 1 1 tttt t t t rrdnl      (7) since ttttt dh  1/  the log-likelihood function can be rewritten as follows: ),'log2)2log(( 2 1 111 1 ttttt t t ttt drddrdnl      (8) as the dcc model does not allow for asymmetries and asset specific news impact parameter, the modified model of cappiello et al. (2006) for incorporating the asymmetrical effect and asset specific news impact can be written as: asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 77 ,)( 11111 gnngbqbaagngbqbaqaqq tttttt    (9) where a, b and g are diagonal parameter matrixes, nt = i[εt < 0]o εt (with o indicating hadamard product),  tt nnen  . for q and n expectations are infeasible and are replaced with sample analogues,    t t ttt 1 1  and    t t tt nnt 1 1 , respectively. 3. data and descriptive statistics daily total return indices for the russian market calculated by datastream are used as proxy for russian stocks1. the jp morgan embi russia index (proxy for russian bond market) is used to model the key factors influencing movements in the russian bond market. the dataset starts from july 1994 and ends at december 2007, yielding 3522 observations for each series. the beginning of this data set is due to the availability of the total return index for russia, and the use of daily data (over a five-day period) in this study is to get meaningful statistical generalizations and to obtain a better picture of the movements of stock–bond returns. daily returns are constructed as the first difference of logarithmic prices multiplied by 100. table 1 presents a wide range of descriptive statistics for both of the series under investigation. as a first step, stationarity in the time series is checked by applying the augmented dickey fuller (adf) test. the results (see table 1) allow us to reject the null hypothesis that returns have a unit root in favor of the alternate hypothesis of stationarity (even at 1% mackinnon critical value). the development of both asset indices is shown in figure 1. this clearly exhibits non-stationarity in both return indices. 0 1000 2000 3000 4000 5000 6000 7000 8000 jul-94 jul-96 jul-98 jul-00 jul-02 jul-04 jul-06 0 100 200 300 400 500 600 russia-ds jpm embi+ figure 1. development of russian equity market indices (left axis) and the jpm embi russia index (right axis) from 1994 to 2007. 1 note that the total return index series is an index series and not a return series. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 78 the first two moments of the data, i.e., mean and standard deviation, are multiplied by 2402 and the square root of 240 to show them in annual terms. as can be anticipated, stock market indices have higher returns as compared to the bond market, however, the high returns are clearly associated with high risks (standard deviations). both the return series are, without exception, highly leptokurtic and exhibit strong skewness. this suggests the presence of asymmetry in the return series of both stocks and bonds. to check the null hypothesis of normal distribution the jarque-bera test statistic was calculated which rejected the null of the normality in both cases. table 1. summary of descriptive statistics for the russian stock and bond market. mean std. dev. skewness kurtosis jb adf lb(24) lb2 (24) arch lm stock 28.686 40.865 0.358 26.199 <0.001* -57.386* 52.831* 593.04* 118.304* bond 14.331 29.794 -1.582 42.109 0.001* -30.017* 228.490* 3381.6* 226.439* * indicates significance at 5% level. descriptive statistics are provided for russian stock and bond market returns. stocks market returns are proxied by logarithmic returns on datastream daily total return index for russia. bond market returns are proxied by logarithmic returns on jp. morgan embi russia daily index. sample period is from july 1994 to december 2007. mean and standard deviations are annualized by multiplying them by 240 and the square root of 240. jb stands for jarque-bera test on normality of the returns. p-value is reported. adf stands for augmented dickey fuller test to check the stationarity in the time series. lb stands for ljung-box test statistic. since the garch process to model the variance in the asset returns was used, the presence of the arch effect was also tested for. table 1 reports values for the ljung-box test statistic on the squared returns (24 lags) together with the arch lm statistic (five lags) on each returns series. the results show evidence of an autocorrelation pattern in both residuals and their squares, which suggests that garch parameterization might be appropriate for the conditional variance processes. 4. empirical results 4.1 constant conditional correlation estimates following bollerslev (1990), this investigation started with the assumption of constant conditional correlation in a multivariate garch setting where variance–covariance terms are time varying. the ccc model3 seemed to be the best starting point as it avoids computational complexities and assures the positive definiteness of the conditional variance–covariance matrix as well as the conditional correlation matrix. table 2 presents the 2 we chose 5 working days length in a week, so 20 days in one month and 240 working days per year. 3 the estimation is conducted using a modified rats routines originally available at www.estima.com asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 79 results. parameter µ corresponds to the mean equation, whereas ,  and  represent the conditional variance of both the stock and bond returns which are modeled by a separate univariate garch (1, 1) model with no drift parameters. finally  characterizes the correlation between the two assets. all parameters are found highly significant and positive; the significance of mean equation parameter µ shows the dependence of both stock and bond returns on their lag returns, and variance equation parameters  and  support this modeling technique, i.e. the multivariate garch analysis, by revealing the presence of conditional hetroskedasticity in the time series. the estimated constant conditional correlation between the two assets is 0.213. since it is positive it can be argued that both stock and bond markets are exposed to common macroeconomic conditions. the estimated coefficient of ccc reflects the lower co-movements between the two assets which is consistent with prior literature (see, e.g., keim and stambaugh, 1986; campbell and ammer, 1993) and also provides a better opportunity for optimal portfolio selection. since the ccc model assumes that the conditional correlations are constant over time, rolling conditional correlations were estimated with a window size set to six months to check the validity of this assumption. table 2. bond-stock bivariate ccc-garch (1, 1) model      stock 0.156* 0.080* 0.021* 0.978* 0.213* (0.031) (0.000) (0.001) (0.001) bond 0.061* 0.006* 0.080* 0.919* (0.013) (0.007) (0.000) (0.005) (0.005) results are reported from a bivariate constant conditional correlation garch (1, 1) process; conducted by using daily returns on bond and stock market indices for russia from july 1994 to december 2007. in the table,  represents the constant from the mean equation whereas ,  and  are the parameters of bivariate garch processes. the parameter  stands for the correlation between two assets. standard errors are in ( ). * indicates the significance at 5% level. the developments of the stock–bond return correlations in the russian equity market indices and the jpm embi russia index are plotted in figure 2. the gray line represents a six-month rolling window correlation, whereas the brown line stands for conditional correlation produced by the dcc model. several interesting features emerge from this figure. except for the period of 1995–96 the correlations in both indices are positive. from the first quarter of 1996 the correlations were constantly increasing until the collapse of the russian financial market in august 1998. moreover, figure 3 indicates that the stock–bond correlation fluctuated substantially during the period of 1999 and 2003 and then it became rather stable. this may pose challenges for asset allocation and risk management procedures. it is apparent asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 80 that the relation between stock and bond returns has been rather unstable over time, which is clear evidence against the constant correlation hypothesis. -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5 0.6 jan-94 jan-96 jan-98 jan-00 jan-02 jan-04 jan-06 rolling corr. cond. corr figure 2. six-month rolling window correlation and conditional correlation between russian equity market indices and the jpm embi russia index from 1994 to 2007. conditional correlation is calculated on the basis of the estimates in table 3. it may also be noted from figure 2 that the conditional and rolling window stock–bond return correlations exhibit a very similar pattern over time. however, as expected, the rolling window correlation estimates appear to be considerably more unpredictable than the conditional correlations produced by the dcc model. moreover, the dcc estimates should account for the changes in volatility, and thus be free from the possible rising bias during the periods of economic meltdown. 4.2 dynamic conditional correlation estimates acknowledging the reality that the constant correlation coefficient fails to reveal the dynamic market conditions in response to innovation, next the dcc grch (1, 1) model proposed by engle (2002) was applied. basically, the dcc-garch model estimates conditional volatilities and correlations in two steps. in the first step the mean equation of each asset in the sample, nested in a univariate garch model of its conditional variance, is estimated (see figure 3), whereas the second step illustrates the development of the time varying correlation matrix (see figure 2). the results in table 2 confirm that the conditional correlations of bond and stock returns are highly dynamic and time varying. this is evident from figure 3 as well, which presents the plots of conditional variances based on the estimation done in the first step of the dcc estimation procedure. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 81 0 2 4 6 8 10 12 14 16 18 20 jul-94 jul-96 jul-98 jul-00 jul-02 jul-04 jul-06 hbond hstock figure 3. conditional volatilities in russian equity market indices and the jpm embi russia index from 1994 to 2007. the figure above shows that the conditional variances are not constant over time and especially volatile during the periods before and during the russian financial crisis of 1998. moreover it seems that the volatilities of russian stocks and bonds move together, which is consistent with prior research. for instance, schwert (1989) found that volatily in the us stock and bond market tend to move together. from table 3, it is evident that the estimates of the mean equation and variance equation are statistically significant which is consistent with time varying volatility and justifies a clustering phenomenon in the evolution of volatility. moreover, the sum of estimated coefficients (dccs+ dccb) in the variance equation is close to unity, implying that volatility exhibits a highly persistent behavior. table 3. bond-stock bivariate dcc-garch (1, 1) model     dccs dccb stock 0.148* 0.016* 0.022* 0.977* 0.005* 0.993* (0.032) (0.000) (0.001) (0.001) bond 0.061* 0.026* 0.079* 0.920* (0.001) (0.001) (0.006) (0.000) (0.005) (0.005) results are reported from a bivariate dynamic conditional correlation garch (1, 1) process; conducted by using daily returns on bond and stock market indices for russia from july 1994 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 82 to december2007. in the table,  represents the constant from the mean equation whereas ,  and  are the parameters of bivariate garch processes. the parameters, dccs and dccb , are dcc-garch estimates of stock and bond, respectively. standard errors are in ( ). * indicates the significance at 5% level. asymmetric dynamic conditional correlation estimates the dcc model perfectly overcomes the heteroskedasticity problem since the residuals of the returns are standardized by the conditional standard deviation based on the garch (1,1) process. however, it does not account for the asymmetries in conditional variances, covariances, and correlations. hence, an asymmetric version of the dynamic conditional correlation (adcc) model proposed by cappiello et al. (2006) was adopted to deal with the asymmetries in conditional variances, covariances, and correlations of the two assets. table 4 presents the empirics. again the garch (1, 1) parameters are highly significant confirming the time varying variance–covariance process as well as strengthening the use of multivariate garch modeling for the russian stock and bond market data. parameter  measures the asymmetries in conditional variances, covariances, and correlations, and in this regard the results proved to be very interesting. empirics show that the russian bond market and stock market both exhibits positive asymmetries in conditional variances, covariances, and correlations. table 4. bond-stock bivariate adcc-garch(1, 1) model      dccs dccb stock 0.080* -0.025* 0.022* 0.977* 0.001* 0.007* 0.982* (0.009) (0.000) (0.001) (0.001) (0.000) bond 0.062* 0.008* 0.098* 0.901* 0.044** (0.002) (0.002) (0.007) (0.000) (0.007) (0.007) (0.007) results are reported from a bivariate asymmetric dynamic conditional correlation garch (1, 1) model, conducted using daily returns on bond and stock market indices for russia from july 1994 to december 2007. in the table,  represents the constant from the mean equation whereas ,  and  are the parameters of bivariate garch processes.  account for asymmetric behaviour. the last parameters, dccs and dccb , are dcc-garch estimates of stock and bond, respectively. standard errors are in ( ). * (**) indicate the significance at 5% (10%) level. finally, the significance of dcc-garch estimates dccs and dccb once again allow us to conclude that conditional correlations of bond and stock returns are highly dynamic and time varying. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 83 5. summary and conclusions in this study we address one of the most fundamental issues of traditional and modern portfolio management, i.e., the dynamics of stock–bond correlation and how it might perform in the future. stock–bond correlation plays an important role in asset allocation, portfolio management and risk management. despite its importance, this phenomenon has been severely ignored in the context of emerging markets, regardless of their high returns and favorable diversification opportunities. we chose the russian stock and bond market as a test laboratory due to its rapid growth and attraction to both domestic and international investors. the co-movements between the returns on the stock and bond markets of russia were modeled by using multivariate conditional volatility models. the investigation started by applying bollerslev’s (1990) constant conditional correlation model to test whether varying correlations are statistically significant. then the dcc-garch (1, 1) model proposed by engle (2002) was used to analyze the dynamics of conditional correlations between the two assets. finally, to investigate the asymmetries in conditional variances, covariances, and correlations, an asymmetric version of the dynamic conditional correlation (adcc) model proposed by cappiello et al. (2006) was adopted. the empirical results do not support the assumption of constant conditional correlation and there was clear evidence of time varying correlations between the russian stocks and bond market. moreover, both asset markets exhibit positive asymmetries. we believe that our results offer a better understanding of the dynamics of the correlations between the stocks and bonds in an emerging market setting which is obviously very valuable for portfolio managers, international investors, risk analysts and financial researchers as well as for its policy implications. references abid, f., aoua, n., mikhail, a.d. (2003). linkages between, and contagion in, asian stock and foreign exchange markets. finance india 17, 1311-1343. alexander, g., edwards, a., ferri, m. (2000). what does nasdaq’s high-yield bond market reveal about bondholder-stockholder conflicts? financial management 29, 23-39. barsky, r. b. 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(1996). firm-specific information and the correlation between individual stocks and bonds. journal of financial economics, 40, 63-80. http://dx.doi.org/10.1016/0304-405x(95)00836-4 keim, d.b. stambaugh, e.b. (1986). predicting returns in the stock and bond markets. journal of financial economics, 17, 357-390. http://dx.doi.org/10.1016/0304-405x(86)90070-x li, l. (2002). macroeconomic factors and the correlation of stock and bond returns. unpublished working paper. yale international center for finance. markowitz, h. (1952). portfolio selection. journal of finance 7, 77-91. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e5 www.macrothink.org/ajfa 85 markowitz, h. (1959). portfolio selection: efficient diversification of investments. new york: wiley (2nd ed.) cambridge, ma: basil blackwell, 1991. saleem, k., vaihekoski, m. (2008). pricing of global and local sources of risk in russian stock market. emerging markets review 9, 40-56. http://dx.doi.org/10.1016/j.ememar.2007.08.002 schwert, g. w. (1989). why does stock market volatility change over time? journal of finance 44, 1115-53. shiller, r. (beltratti, a., 1992). stock prices and bond yields. journal of monetary economics 30, 25-26. http://dx.doi.org/10.1016/0304-3932(92)90042-z scruggs, j.t., glabdanidis, p. (2003). risk premia and the dynamic covariance between stock and bond return. journal of financial and quantitative analysis 38, 295-316. http://dx.doi.org/10.2307/4126752 siegel, j.j. (1998). stock for the long run: a guide to selecting markets for longterm growth. irwin professional publishing. microsoft word 1752-6880-2-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 330 evaluating company failure in malaysia using financial ratios and logistic regression ben chin fook yap senior lecturer, universiti tun abdul razak e-mail: benyap@unirazak.edu.my dr. shanmugam munuswamy associate professor, universiti tun abdul razak dr. zulkifflee bin mohamed assistant professor, universiti tun abdul razak received: may 2, 2012 accepted: may 14, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1752 url: http://dx.doi.org/10.5296/ajfa.v4i1.1752 abstract this paper investigates the ability of logistic regression in anticipating corporate failures in malaysia over a ten year period covering the economic cycles of boom, the asian financial crisis of 1997 and economic recovery. 64 companies were analyzed with an initial 16 financial ratios. a strong logit model was developed with four ratios found to be significant in its predictive power and classification results showed very high average accuracy rates of 88% and 90% for the analysis and the hold-out samples respectively and for each of the five years preceding the actual failure. this study also showed it does not need many ratios to be able to anticipate potential company failures and that even with more advanced statistical models used recently, logistic regression is still a very effective and reliable statistical tool. keywords: financial ratios, company failures, failure predictions, logistic regression. jel classification codes: g33, c39, m41 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 331 1. introduction an economic downturn like the 1997-98 asian financial crisis resulted in a sharp decline in the value of the malaysian ringgit followed by drastic drops in stock prices that dampened business confidence and increased company bankruptcies. during normal times, however, business failures are more likely to be caused by falling profits or losses for several years in succession, excessive debts, insufficient working capital, managerial errors and misjudgments, though management frauds have surfaced more frequently and involving large multinationals recently. over the years, various analytical techniques such as multiple discriminant analysis, logistic regression, linear probability models and artificial neural network models, have been used to predict potential company failures and these previous studies have found that they are effective and reasonably accurate though some of the claims made may seem not as credible when tested over time and with different samples and populations and in different sectors. however, financial ratios and bankruptcy prediction models are useful and helpful as attested by the continuing interests and continuing usage of them by a wide range of managers, analysts and other professionals in commerce, finance and industry. companies in malaysia do not have as long a history as those in the western countries and their sizes are, for most of the companies, not as large. in addition, their access to funds and capital are not as easily available compared to the more developed countries. the development of the capital market in malaysia is still at its early stages compared to advanced markets in the west. although the government has always been stressing the importance of good corporate governance, malaysia has not been immune to corporate collapses and scandals. therefore, the selection of financial ratios and the predictive models and their statistical techniques used in researches done elsewhere may not be as applicable or as reliable and accurate as when they are applied to the malaysian companies. many investigations and studies on company failure predictions have been carried out in developed countries such as by altman (1968), deakin (1972) and ohlson (1990) in the us, green (1978), wood & piesse (1987) and inman (1991) in the uk, and gepp & kumar (2008) and jones & hensher (2004) in australia. these countries have longer trading and commercial histories with more stringent company law provisions and stronger law enforcements and penalties. studies on company defaults, failure and bankruptcy prediction on malaysian companies only started in 2001 with studies done by (i) mohamed et al. (2001) using the logit method with correct classification of 81% and 74% for the analysis and holdout samples respectively, (ii) zulkarnain et.al. (2001) using mda with correct classification of 91% and 71% for the analysis and holdout samples respective, (iii) low, nor & yatim (2001) using the logit model with correct classification of 82% and 90% for the analysis and holdout samples respectively and (iv) adiana et.al. (2008) using the hazard model with correct classification of 83% and 86% for the analysis and holdout samples respectively. many of the previous studies on bankruptcy prediction do not have the same consensus on the term “failure” or bankruptcy. definitions from different studies vary significantly and arbitrarily. is it loan interest defaults, asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 332 bond interest defaults, inability to pay preference dividends, inability to pay liabilities when due or when a creditor file for liquidation and bankruptcy? in their study, poston et. al. (1994) considered that a company is in financial distress if it has two or more consecutive years of operating losses or a current ratio of less than 1.0 as at the end of any single fiscal year or a negative balance in the retained earnings account as at the end of any single fiscal year. according to them, meeting any one of the above criteria would be considered a distress situation. flagg, giroux & wiggins (1991) identified four potential failure events, namely reductions in dividends, “going concern” qualified audit opinion, troubled debt restructuring and violations of debt covenants. for this study, the failed companies analyzed are either (i) classified by bursa malaysia (formerly the kuala lumpur stock exchange) as falling either under one of the practice notes (pns) namely pn4, pn10 or pn17 or (ii) they have applied to the court under section 176 of the companies act 1965, for a scheme of arrangement. the main reasons for companies being designated as pn companies by bursa malaysia are mainly because of deficits in their shareholders funds where their financial conditions do not justify continued trading and/or listing in the stock exchange. these companies are given certain time to regularize their financial position or take actions that is necessary to release themselves from those criteria that trigger the specific pn classifications stated above. for companies that have applied for section 176 protection, an order is given by the high court to stay any proceedings against the companies whilst the scheme is pending. although many bankruptcy and default prediction models have been developed, it is of utmost importance that we first test for the feasibility of models used for malaysian companies with different company sizes and under the present market and economic conditions. it is also important that we can produce a modified model with different variables, (after reviewing the few studies carried out in malaysia as mentioned above), to identify companies that has a high probability of failure from those that are highly unlikely to fail. this study is based on companies in the manufacturing sector being officially classified as consumer and industrial product companies. companies in the trading, services and property and construction sectors are not included as they have different assets and financing requirements compared to companies involved in manufacturing. for similar reasons, companies in the financial and banking sectors are also excluded. company collapses and bankruptcies affect stakeholders including shareholders, suppliers, creditors, customers, employees and management itself. incidences of company failures, especially large corporate entities that employ large number of people can significantly affect the livelihood of many people and the economy of the locality where the company is located. shareholders and investors can suffer huge economic losses as they are among the last group of interested parties who would be paid off in any liquidations and winding-ups. in cases of negligence or fraud, managers and office bearers can be subject to severe penalties including heavy fines, convictions and jails. if impending company failures are not detected early or the collapse has already happened, it can mean that these companies may not be disclosing truthful and adequate information about their financial health. it can also imply that the accounting asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 333 standards and other regulatory and legal requirements may not be enough to ensure proper and fair disclosures. it is obvious that any additional tools or improved models for detecting signs of companies in distress would be most helpful. finance managers and controllers trained in the analysis and evaluation of the financial health of companies can take corrective and preventive measures to prevent failure in their own companies. institutional investors and fund managers who manage large investment portfolios can improve their performances and generate higher returns for their clients if they can distinguish the weak companies from the healthy ones. the objective of this study is to develop a failure prediction model using logistic regression and a different group of financial/accounting ratios to obtain a much higher correct classification rates for failed and non-failed companies in malaysia under local financial, market and economic conditions for each of the five years preceding the date of the actual company failure. although, more advanced statistical techniques such as artificial neural networks and recursive partitioned decision trees have been used, results obtained from these later methods have outperformed other statistical classification techniques as found by the study by frydma, altman & kao1985). 2. brief review of previous studies according to green (1978), the earliest studies on the financial health of companies were univariate in nature starting with works by fitzpatrick and winakor & smith in the 1930s and mervin in 1942. the most well-known univariate model is probably the 1966 study by beaver, which from then on, has started many other company failure prediction analyses using other statistical techniques. the univariate approach was criticized for various weaknesses. altman (1968) stated that one of the main shortcomings of using the univariate method is that the ratios are not allowed to interact with one another as each ratio is examined separately, in isolation from the other ratios. morris (1998) illustrated with the example that while low profitability may be one signal of financial distress, it may not necessarily be fatal if a business has a strong liquidity position, and likewise, a company that is profitable but which has low reserves of liquid assets is potentially vulnerable if there should be an unexpected setback. thus using a single variable to determine a financial distress situation is risky. from some of the shortcomings of univariate analyses in evaluating ratios individually and independently of each other, it seems obvious that there may be advantages in developing models which simultaneously examine a number of key characteristics, such as profitability, short and long term liquidity, gearing and so on. in attempts to formulate models that take into account the simultaneous interaction between variables, researchers have devised, and come out with newer models mostly based on multiple regression statistical techniques such as multiple discriminant analysis by altman (1968) and koh & killough (1990) and logistic regression by ohlson (1980), gilbert, menon & schwartz (1990) and lin & piesse (2004). another popular modeling technique is artificial neural network which uses a non-linear approach and gives a computer system an amazing capacity to actually learn from input data. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 334 artificial neural networks (anns) have provided solutions to problems normally requiring human observation and thought processes including speech and pattern recognition, credit rating and bankruptcy forecasting. studies on company failure predictions using anns have been carried out by dorsey, edminster & johnson (1995) and pramodh & ravi (2007). some other well-known modeling techniques that have been developed and used for corporate failure predictions include balance sheet decomposition model by lev (1973), cash based models by casey & bartczak (1985) and aziz, emanuel & lawson (1998), the hazard model by shumway (2001) and the survival analysis model by gepp & kumar (2008). however, not all the above methodologies and techniques are popular and some have not been commonly used in distress studies. in almost all bankruptcy studies, financial measures and financial ratios play the dominant role in almost all the variables used as predictors attesting to the fact that ratios do contribute substantially and immeasurably to understanding company financial performance and future financial status. deakin (1972) showed considerable evidence that investors use financial ratios to study and analyze published financial data, implying its usefulness consistent with the accounting and finance literature which asserts that ratio analysis is useful to investors. gardiner (1995) in a review of some of the most important financial ratios stated that ratio analysis is universally recognized as a powerful financial tool and are used by investors when deciding between choices of alternative investments. his study also confirmed that financial ratios are used by banks and other lenders before decisions are made on whether to grant certain loans, by auditors when they conduct analytical reviews of their clients as well as by companies when assessing the creditworthiness of their debtors. 3. methodology 3.1 selection of variables karels & prakash (1987) suggested a careful selection of ratios to be used in the development of a bankruptcy prediction model, as the choice of ratios can affect the prediction accuracy of the model. the choice of ratios used may have to be different for companies in different industries. gombola & ketz (1983) found that ratios in the retail and manufacturing industries are at their extreme in their characteristics and that companies in other industries seems to fall in-between these extreme ends. shivaswamy & holban (1993) identified 19 ratios as important in analyzing retail companies and 14 ratios considered important in analyzing manufacturing companies. in their study, they found that bankers use one set of ratios to evaluate retail firms and another set of ratios when appraising manufacturers. bankers found that liquidity and activity ratio groups were significantly more important for retailers than for manufacturers while the profitability and leverage ratio groups were equally important for both groups. koh & killough (1986) found that it is not necessary to have a large number of ratios to predict business failures and all that is needed is a set of dominant ratios derived from a larger set of related ratios. in this study, 16 ratios (table 1) were selected among the many that had been used in previous studies. these ratios were selected to evaluate profitability, asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 335 efficiency, liquidity, and solvency and leverage. the selection and the choice of ratios were based on two main conditions. the ratios have been frequently used in past studies and that the ratios have been shown to perform well in past studies. table 1 also shows some of the earlier studies that have also used these ratios in their analyses. table 1. the sixteen ratios selected in this study descriptions initials measure used in past studies 1 net income to total assets nita profitability ohlson (1980) flagg (1991) adiana (2008) 2 retained earnings to total assets reta profitability altman (1968) gilbert (1990) flagg (1991) 3 earnings before interest and tax to total assets ebitta profitability altman (1968) gombola (1983) karels (1987) 4 net income to sales nis profitability gombola (1983) mutchler (1985) karels (1987) 5 current asset to current liabilities (current ratio) cacl liquidity beaver (1966) altman (1977) gilbert (1990) zulkarnain (2001) 6 working capital to total assets wcta liquidity beaver (1966) altman (1968) ohlson (1980) mossman (1998) jones (2004) 7 market value equity to total debt metd liquidity altman (1977) mossman (1998) zulkarnain (2001) 8 cash flow to total debts cftd liquidity beaver (1966) casey (1985) gilbert (1990) 9 cash to sales cs liquidity deakin (1972) karels (1987) 10 current assets to total assets cata liquidity deakin (1972) gilbert (1990) 11 working capital to sales wcs liquidity deakin (1972) karels (1987) 12 cash to current liabilities ccl liquidity deakin (1972) zavgren (1985) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 336 adiana (2008) 13 total debts to total assets tdta solvency beaver (1966) ohlson (1980) zulkarnain (2001) 14 funds flow to total liabilities fftl liquidity ohlson (1980) 15 debtors turnover debtor efficiency gombola (1983) zavgren (1985) 16 sales to total assets sta efficiency gilbert (1990) mohamed (2001) 3.2 data collection and sample financial data from the annual reports of the selected failed and non-failed public companies listed in bursa malaysia were extracted. the data collected were for a ten-year period starting 1996 until the end 2005. data of the selected failed and non-failed companies were obtained for five years preceding the actual failure. the “first year preceding failure” is defined as that year included in the most recent financial statement prior to the date that the company failed, i.e., if the company failed in 2006, then the last financial statement data used would be the one prepared for the most recent year before failure. the second year prior to failure would be the financial year preceding the first year. if the first year prior to failure was 31 december 2006, then data for the preceding 4 years ending 31 december 2002 to 31 december 2005 would be used. beaver (1966), altman (1968), lev (1973), letza, kalupa & kowalski (2003) and aziz, emanuel & lawson (1988) has all used matched pair samples of failed and non-failed companies. the paired-sample design is one way of compensating for the effects of industry and asset size differences. companies with the same financial ratios but with different asset sizes may have different probabilities of failure. it is logical that a larger company with a larger asset base will have a lower probability of failure even if the ratios of the two firms are identical. a total of 64 companies are divided equally into half, comprising 32 failed companies and 32 non-failed companies. for each failed company, a non-failed company in the same industry and with the closest asset size is selected. the financial statements of the non-failed companies are obtained for the same fiscal years as those of the failed companies, that is, if the failed company has a financial year ending 31 dec 2006, the non-failed company would be chosen with financial statements ending in the same year. each of the above group will be further divided into half. one half will comprise of 16 failed companies and 16 non-failed companies to be used for the development of the model (the analysis sample) and the other half of 16 failed and 16 non-failed companies will be used as secondary or validation sample (the holdout sample). 3.3 logistic regression logit analysis tries to calculate a probability, based on a probability distribution. like discriminant analysis, it weighs the independent variables and assigns a score in the form of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 337 failure probability to each company in the sample. this statistical procedure does not just group a firm to either fail or healthy based purely on financial factors as there are other external factors to consider in analyzing risks and defaults, such as unexpected random events, macro-economic factors and new governmental rules and regulations. the advantages of logistic regression analysis are that it does not assume multivariate normality and equal covariance matrices. the logit model utilizes the coefficients of the independent variables to predict the probability of failed or non-failed dependent variable. the technique weights the independent variables and creates a score for each company in order to classify it as failed or non-failed. the function considered in logistic regression is called the logistic function. based on ohlson (1980) seminal study, the logistic model is stated as: log , log 1 , i s₁ i s₂ where: x vector of predictors for the i observation = vector of unknown parameters = some probability function, 0 ≤ p ≤ 1 , = the probability of bankruptcy for any given and measures of goodness of fit would be determined through pearson’s and deviance’s chi-square values and the significance of the variables used. if the p-value is > 0.05 then the value is not significant and the model fit is good. a likelihood ratio test is used to see if the variables included in the final model are significant in explaining some of the variability in the data. the chi-square statistic is the difference in –2 log likelihood (-2ll) between the final model and a reduced model. the reduced model is formed by omitting an effect from the final model. the null hypothesis is that all parameters of that effect are 0. this test is comparable to the overall f test for regression analysis. in multiple regressions, r² is an intuitive measure of how well the model predicts the values of the dependent variables. however, in logistic regression, there are no similar measures that are easily interpreted. the psuedo rsquare (cox and snell and nagelkerke) are attempts to quantify the proportion of explained variation in the dependent variable. the cox and snell measures are usually < 1.0 and are difficult to interpret. the nagelkerke’s measure ranges from 0 to 1 and values are normally higher than cox and snell. this measure is the most reported r² for logistic regression (norusis, 2005). the higher the values, the better the model fit. to reduce the large number of financial ratios, numerous logistic runs on the spss are performed using different combination of ratios. for each logit function constructed, the model fit will be assessed on how strong is the function, how well it discriminates and checking the classification matrices for predictive accuracy not just for the failed companies asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 338 but also for the non-failed companies as well. the model accepted has to have a good fit and that the multicollinearity level is acceptable. the companies are classified as failed or non-failed according to their probability estimates. this would be shown in a classification table where the number of failed companies and non-failed companies are accordingly classified. 4. findings and discussion after numerous logistic runs, one logistic regression function was estimated. the logistic function constructed was based on the log transformed values for each ratio and has a 50% probability of group membership, that is, failed and non-failed. four ratios were found to have significant discriminating power in evaluating failure prediction. they are cash flow to total debts (cftd), total debts to total assets (tdta), retained earnings to total assets (reta) and cash to current liabilities (ccl). of these four ratios, two of the ratios measure liquidity, one measure profitability and one measure solvency. hossari & rahman (2005) identified 48 ratios most popularly used in past studies. of the top 10 ratios that are most popular, 4 measures liquidity, another 4 measures profitablilty and the remaining 2 ratios measures solvency. the breakdown of these four ratios identified in this study in terms of what they measure and how they compare to the 10 most popular financial ratios found to be useful in past studies by hossari & rahman (2005) as mentioned earlier are shown in table 2 below. the results showed that those financial ratios that measure liquidity are the most effective in their discriminating power. table 2. comparisons of financial ratios selected and what they measure compared to past studies present study percentage past studies percentage liquidity 50% liquidity 40% profitability 25% profitability 40% solvency 25% solvency 20% the classification results for the analysis sample as shown table 3 below, showed an average correct classification for the failed and non-failed companies of 89% and 88% respectively for the five years preceding actual failure. the results also showed that the highest accuracy rate is for the first year preceding failure at 94% for both the failed and non-failed companies. . it is generally accepted that the discriminating power of any model that is developed will lose its predictive accuracy the further away the time period is from its actual failure. as the results show, even in years 4 and 5 preceding failure, the results are very impressive with an average correct classification of 84% and 88% respectively. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 339 table 3. classification results: analysis sample classification results (%) year 1 year 2 year 3 year 4 year 5 av. 5yrs analysis sample fail 94 88 88 81 94 89 non-fail 94 88 88 88 81 88 average 94 88 88 84 88 88 the results for the holdout sample (table 4) showed even slightly better results compared to the analysis sample giving an average correct classification of 92% and 89% for the failed and non-failed companies respectively for the five years. the highest average correct classification results are 94% for year 2 and year 5 before the actual failure. table 4. classification results: holdout sample classification results (%) year 1 year 2 year 3 year 4 year 5 av. 5yrs holdout sample fail 88 94 88 88 100 92 non-fail 94 94 88 81 88 89 average 91 94 88 84 94 90 for both the analysis and holdout samples, the results are striking in that a consistently high accuracy has been achieved for both the failed and non-failed companies and for each of the five years. it seems that our ‘hit’ rate surpasses some of the past studies, although the sample size is small.” one of the most well known studies using logistic regression was by ohlson and his findings for the three years preceding failure showed average accuracy rates of 88% and 83% for the failed and non-failed companies. the malaysian studies using the logistic regression methods in fact showed a much lower average prediction accuracy rates (mohammed, li & sanda (2001) with 81% and 75% for the analysis and holdout samples respectively and low, nor & yatim (2001) with 82% and 90% for the analysis and holdout samples respectively). the measure of the overall model fit as indicated by the -2 log likelihood value (-2ll), the chi-square goodness-of-fit tests, the pearson and deviance chi-square goodness of fit as well as the pseudo r² measures are as tabulated in table 5 for the analysis sample and table 6 for the holdout sample. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 340 table 5. logistic function model fit results – analysis sample year 1 year 2 year 3 year4 year 5 -2ll final 4.961 12.701 18.839 22.268 21.648 chi-square 39.401 31.661 25.523 22.094 22.714 significance 0.000 0.000 0.000 0.000 0.000 goodness-of-fit pearson chi-square 4.289 14.544 19.373 29.648 40.643 significance 1.000 0.975 0.858 0.330 0.045 deviance chi-square 4.961 12.701 18.839 22.268 21.648 significance 1.000 0.991 0.876 0.724 0.755 pseudo-r² cox & snell 0.708 0.628 0.550 0.499 0.508 nagelkerke 0.944 0.838 0.773 0.665 0.678 for the analysis sample (table 5) and for all the five years, the values of the -2ll are low indicating a well fitting logit model. the relatively high model chi-square values with significant p-values (p-value of <0.05), showed that the independent variables entered in the logit construct significantly impact the dependant variables. the pearson chi-square goodness of fit tests for years 1 to 4 before actual failure showed p-values of >0.05 indicating that they are not significant and the overall model fit is good. for year 5 before actual failure the p-value is 0.045 which is significant but the p-value for the deviance chi-square for the same year is not significant at 0.755. together with the acceptable -2ll and the pseudo-r² results, it may help explain why the correct classification rate for year 5 before actual failure is still very high at 91% and 84% for the failed and non-failed companies respectively. this can be interpreted that the overall measure of fit is still very good. the cox & snell and nagelkerke pseudo-r² results showed values that are reasonably high indicating that an acceptable proportion of variation in the dependent variable is explained by the independent variables. though this measure is similar to the regression analysis’s r², the values calculated for logistic regression are typically smaller than what is seen for linear regression models (norusis 2005). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 341 table 6. logistic function model fit results – holdout sample year 1 year 2 year 3 year4 year 5 -2ll final 21.905 9.083 14.631 26.123 11.583 chi-square 22.457 35.278 29.730 18.238 32.778 significance 0.000 0.000 0.000 0.001 0.000 goodness-of-fit pearson chi-square 39.142 8.966 12.669 25.020 16.881 significance 0.062 1.000 0.991 0.573 0.934 deviance chi-square 21.905 9.083 14.631 26.123 11.583 significance 0.742 1.000 0.974 0.512 0.996 pseudo-r² cox & snell 0.504 0.668 0.605 0.434 0.641 nagelkerke 0.672 0.891 0.807 0.579 0.855 for the holdout sample (table 6), the -2ll, the pearson and deviance chi-square as well as the pseudo-r² measures all indicated that the logit model developed has a good model fit which has also resulted in the high average correct classifications of between 89% and 92% for the failed and non-failed companies as mentioned earlier. the pearson and deviance chi-square p-values are not significant for each of the five years and these values also indicate good model fit. the findings showed that with just four financial ratios (from an original 16) used as independent variables in a logistic regression model, they can predict and anticipate corporate failures with very high correct classifications for each of the five years preceding the actual corporate failure. 5. conclusion the purpose of this study is to examine the ability of logistic regression in anticipating corporate failures in malaysia. over a ten year period covering the economic cycles of boom, bust and recovery, 64 companies were analyzed using 16 financial ratios. a strong logit model was developed with four ratios found to be significant in their discriminating abilities. for the five years preceding the actual failure, the results showed average correct classification rates of between 88% and 90% for the analysis and holdout samples respectively. the results are especially impressive for year 4 and year 5 preceding the actual failure with 84% and 88% for the analysis sample and 84% and 90% for the holdout sample. not many past studies have managed to achieve such high rates of success the further away the time period is from the actual failure. the results also revealed that financial ratios that measure liquidity are the most significant in their discriminating power 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(2001) forecasting corporate failure in malaysian industrial sector firms. asian academy of management journal, 6(1), 15-30. microsoft word 3333-12521-1-rv-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 274 determine the effects of fundamental variables and mass behaviors in changes of stock price (evidence from iran stock exchange) mahmoud samadi largani (corresponding author) department of accounting, tonekabon branch, islamic azad university, tonekabon, iran tel: 98-91-1193-6748 e-mail: m_samadi_largani@yahoo.com mohsen zamani department of accounting, kashan branch, islamic azad university, kashan, iran e-mail: zamanimohsen84@yahoo.com mohsen imeni department of accounting, tonekabon branch, islamic azad university, tonekabon, iran tel: 98-93-5575-8686 e-mail: mohsen.imeni86@yahoo.com meysam kaviani department of accounting, tonekabon branch, islamic azad university, tonekabon, iran tel: 98-93-5148-8917 e-mail: meysamkaviani@gmail.com received: feb. 27, 2012 accepted: april 23, 2012 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3333 url: http://dx.doi.org/10.5296/ajfa.v5i1.3333 abstract previous studies have claimed that new information about market fundamentals provides only a partial explanation of observed price fluctuations. it has been proposed that short-term fluctuations are caused by shifts in market psychology or events that have no direct impact on business prospects or economic conditions. in accordance with the idea that short-term asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 275 variability in asset prices could be explained by causes other than fundamentals. we test the probability of the existence of bubbles and herding behaviors, using panel data from 2005 2010 in tehran exchange securities. the present research deals with two major and three minor hypotheses. price variations are a dependent variable in all these hypotheses. variations of incomes, variations of debts to the shareholders and variations of monthly price fluctuations form independent variables of the minor hypotheses respectively. our results show that there is not significant relation between stock price changes and fundamental hangs. thus existence of bubble is approved. also, other findings about herding behaviors indicate that there is significant relation between stock price changes and changes in herding behavior proxies. keywords: fundamental variables, mass behaviors, stock price asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 276 1. introduction according to the efficient-market theory, the price of securities reflects instantly all related and available information as a whole. the efficient – market hypothesis introduces simply the effectiveness of pricing process in the stock market. therefore, the market value of an asset is theoretically equal to the intrinsic or fundamental value of the same asset (the present value of assets future cash flow). in an efficient market, the price of assets changes in response to new information. as information enters randomly to market, therefore prices should follow the notion of random walk. the theory of random walk is indeed very close to the idea of efficient market. this theory argues that the changes in stock price follow no pattern or trend, thus, the previous trend of prices cannot be used to forecast the future prices. the theory of random walk shall not mean that prices changes irrationally, rather it states that when a huge amount of information is entered into market, all current news are reflected in the ruling price of stocks. the changes in tomorrow’s price only reflect the news of tomorrow. as news is random and unpredictable, therefore, changes of price arising out of the dissemination of information must happen randomly and unpredictably (hirschey, 2003). despite the theory of efficient market and notion of random walk, market prices may not always indicate the fundamental values of company, which are regarded as intrinsic values. some scholars believe that the fluctuation of stock price may be so wide that it cannot be justified by the changes in fundamental values. although they acknowledge that the long-term changes in stock price depend on the changes in market fundamental values, they also argue that short-term fluctuations shall be analyzed based on market psychology using those events, which are not in direct relation with the business perspective or economic conditions (harman, 2000). if price changes cannot reflect the changes in the fundamental value of assets, price fluctuation may be due to the existence of bubbles. bubble is that part of price, which is not related to the fundamental values of an asset. when the price of a share is equal to the present value of future cash flow of the same share, the bubble part of that price is equal to zero. if the price of an asset is fully different from its fundamental value, the bubble part of its price is more than the intrinsic value (gonzales, 2004). the term “speculative bubble” is used to describe the other’s evaluation of market following market drop. these bubbles are emerged when assets are evaluated above their intrinsic value. in this condition, markets are vulnerable and relatively bad news may cause a wave of stock sales. because of such an oversupply, considerable fluctuation may be produced in prices. such a high fluctuation cause that investors lose their confidence, capital costs increase, stock price decreases, investment projects reduces, and at worst, economic growth slows down. in some cases, this crisis may be transferred to other economic sectors and even to other countries (gonzales, 2004). 2. theoretical framework and research literature the results of a research carried out by johnson, lindblom, and platan in 2002 on the bubbles asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 277 of it companies in 1990s showed that the behavior of market members has been to some extent irrational and the combination of investments had a change because of the existence of speculative bubble. the results of this research show that herd behavior has been an important factor in high prices of stocks and reduction of prices (cited in fadainezhad & eshghi, 2006). shiller and pound (1989) have provided evidences consistent with the existence of herd behavior in stock market. they studied institutional investors to identify the factors involved in their decisions made for the purchase of special stock. the results show that the encouragement of others (professionals, fund managers, etc) people are deceived to purchase stocks with risen price. banerjee (1992) has also found that stock market investors ignore their own information, and make their decisions based on the strategies of others. christie and huang (1995) found that dispersion increases significantly during the periods of increase in the absolute value of prices. they concluded that these results are consistent with rational pricing and inconsistent with herd behavior, since rational pricing patterns forecast that more increase in the changes of market return is itself a change in dispersion increase. shiller (1981) has provided a test to determine if prices can reflect fundamental changes. in this test called variance bound test, the changes in stock price are compared with the changes in the fundamental values of assets. it supposes that the current fundamental stock price depends on the future dividends of that stock, which have been adjusted with one discount rate. therefore, ruling price is a predictor (an estimator) of future return. if the market price is consistent with the market fundamental variables, stock price shall be equal to the market fundamental values, and the estimated fluctuation of cash flows (fundamental prices) is less than that of actual cash flows fluctuations (return). shiller extracted prices and dividends of s&p 500 index to show that the fluctuation of stock price is considerably more than the fluctuation of present value of dividends; therefore, dividends cannot be the reasons of changes in stock price. tirole (1985) provided a model, in which the fundamental value of an asset is equal to the present value of the future return of that asset, discounted using a constant rate. therefore, if the price of an asset is more that the market fundamental value, it is said that there is bubbles. this model is a general equilibrium considering an unlimited sequence of overlapping generations with limited horizons of investment. the researcher shows that as long as the rate of economic growth is greater or equal to the expected return rate of assets, the emergence of bubbles is possible. allen and gorton (1988) used a short-term model, in which bubbles were expected to appear. to study the growth of market fundamental variables and stock prices, they tested the time-series reliability of prices and dividends. in case any trend is observed in price or dividends, the series were subtracted. diba and grossman (1988) introduced tests based on the reliability of the characteristics of stock prices and dividends. the general idea of this test, called co-integration text, states that it can be evaluated if the changes in stock price are consistent with the changes in fundamental variables by asking if their growth rates are comparable. if market fundamental variables grow slower than the asset price do, it is said that stock price has bubble part (gonzales, 2000). diba and grossman test (1988) is based on the theoretical conclusion that in case there is a bubble, time series obtained from subtracting must have an unreliable mean. diba and grossman argue that the actual stock asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 278 price and actual dividends co-integrates. they believe that any deviation from fundamental values is the result of the variables having reliable mean. therefore, they did not reject the hypothesis of the consistence of prices with fundamental variables (diba & grossman, 1988). mcqueen and thorley (1994): this method tests rational speculative bubbles, when investors are informed of the existence of bubbles, but they also think that prices may increase further more. mcqueen and thorley assume that if prices have bubbles, the runs of abnormal positive return will have duration dependence, i.e. any increase in the length of run reduces the probability of ending an abnormal positive return runs (the inverse relation between the probability of a run ending and the length of the same run is called duration dependence) (fadainezhad and eshghi, 2006). chirinko and schaller (1996) accept based on the data of 1911 until 1987 that there are bubbles, but the actual decisions for investment are made based on fundamental variables. in most tests mentioned above, the null hypothesis states that there are bubbles, and it is tried to reject the nonexistence of bubbles using alternative hypothesis. in these models, the empirical relation between fundamental variables and dividends is tested. o’connell and zeldes (1998) the difference of their model with tirole’s model is that this model contains asset holders with unlimited planning horizon. anyhow, bubbles grow exponentially with a rate equal to the expected return rate. this is because speculators keep an expensive asset only when they expect that this asset will be priced higher in the future. harman (2000) tested price bubbles and mass behaviors of investors in the stock market of the united states of america, when rational bubbles and collective behaviors of investors were observed notwithstanding positive or negative return in market. konadu et al (2005) have tested the existence of rational bubbles in the stock index of nasdaq for the duration beginning form 1994 to 2003 using interest present value model. for this purpose, they applied a new test based on fractional integration test, and concluded that although co-integration and unit root tests do not reject the existence of bubbles, the fractional integration test carried out on the data excluding monthly data rejects the existence of bubbles in the market (cited in alipour, 2007). nasrollahi (1998) concluded that the fast growth of tehran’s stock exchange index in 1995 and the first season of the year 1996, as well as the reduction of this index in the fall and winter of that year caused some investors and even expert to think of a false increase in prices. in theory, the false increase of price is a price bubble, which should be regarded as the second part of the price of an asset. hazhir kiani and mirshamsi (1999) studied the monthly data of 17 companies accepted in the stock exchange of tehran during the period from 1988 to 1997 using reliability test, the ratio of price to profit, and the co-integration test of price and profit of each share. they provided several reasons proving that the existence of rational bubbles in price cannot be rejected in at least 15 companies from the total seventeen companies studied in their research. ma’delat, kourosh (2002) studied price bubble in an economic research carried out in the stock exchange of tehran using the data of 1991 to 2001. for this, he used state-space method composed of state equations and differential equations. godari (2006) studied rational bubbles in his master dissertation titled “a study of price bubbles in the stock asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 279 exchange of tehran during the recent years (2004 – 2005). godari took a sample consisting of 22 companies in the stock exchange to show that there has been bubble in the price of the shares in the stock exchange of tehran in 2004 and 2005, while most experts believe that bubble is blown up after the drop of prices and break of most companies’ p/e. asadi, hamidizadeh, and soltani (2006) studied the existence of price bubble in the stock exchange of tehran based on the size of seventy companies and industries during the fiscal years beginning from 1991 ending to 2005, and showed that 57 percent of the companies at the confidence coefficient of 95 percent, and 43 percent at the confidence coefficient of 90 percent had price bubble. the analysis of statistical tests show that firstly there is statistically a significant relation between stock price bubbles and size of the company at the confidence coefficient of 95 percent; secondly, there is statistically no significant relation between stock price bubbles and industry type of the company. alipour (2007) studied in his master’s dissertation titled “the study of rational price bubbles in the stock exchange of tehran”, the existence of price bubbles in the stock exchange of tehran during the period from 2000 to the first season of 2007. the main hypothesis of this research states that, “there is rational price bubble in the stock exchange of tehran”. to study this issue, three different tests including unit root test, co-integration test, and fractional integration test were carried out. the results of unit root and co-integration test confirmed the existence of bubble in the stock exchange of tehran. in contrast, the results of fractional integration test show that the data were able to recourse to mean value. eslami bidgoli and shahriari (2007), in this research, the mass behavior of the participants of the stock exchange of tehran during the period from 2001 to 2005 has been studied and tested. the primary evidence indicate that the investors of the stock exchange use rarely quantitative method to determine stock value, and their judgments is mostly based on their mental images, nonscientific information, rumors, and blind obedience to those persons called prominent participants in capital market. therefore, two models have been used to study this behavior in the stock exchange of tehran. for this purpose, the return deviation of the companies’ stocks from market return has been studied in a daily, weekly, and monthly manner and during the increasing or decreasing fluctuation periods. the findings of this research indicate that according to the daily data on return there is no mass behavior during market growth, and in contrast, there are evidence proving the existence of such a mass behavior during market depression. ezzatollah abbasian, vahid mahmoudi, elham farzanegan (2010) carried out a research to identify price bubbles in the common stock of the stock exchange of tehran using present value model, and found that financial markets specially capital market are the most important means of allocating financial resources. considering the strategic financial and economic importance of this market, in case of any big deviation in this market, the allocation of financial resources of the whole country may face a great challenge. one of the factors that may cause problem is price bubble. in general, when the price of a stock is different from the price expected in the future, the issue of bubble in the market is put in limelight. this paper aims to study the credit of present value model with time variable expectation using m-tar momentum threshold co-integration, and it tries to answer if there is any asymmetric adjustment between stock prices and cash return on asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 280 stock in the stock exchange of tehran during the long term from 2000 to november 2008. the results showed that there is no long-term co-integration relation between stock price and cash return to indicate that there is a rational bubble. 3. research hypothesis the hypotheses of this research consist of two main and three auxiliary hypotheses as follows: 3.1 main hypotheses 1change in fundamental variables is effective in the changes of stock price. 2change in the signs of mass behavior is effective in the changes of stock price. 3.2 auxiliary hypotheses 1change in earning is effective in the changes of stock price. 2change in the ratio of debt to shareholder’s equity is effective in the changes of stock price. 3change in price fluctuation is effective in the changes of stock price. 4. research method this research uses an applied method for performance evaluation. the samples are taken using random method, and the results are generalized to the statistical population by induction. for this purpose, inductive – descriptive method has been used. as this method uses the previous operational data, it is an ex-post facto research. 4.1 statistical population and sample the statistical population of this research is composed of the manufacturing companies of the stock exchange of tehran during the period from 2005 to the fiscal year 2010 ending to march 19. in this research, simple random sampling method has been applied. to determine the volume of statistical sample of this research, a pilot random sample of ten companies has been selected. thereafter, s2 (variance) has been calculated in these sampled companies for the dependent variable, and finally 65 companies were selected using an appropriate formula. 4.2 data analysis method to describe the skew and kurtosis of data, mean and median of standard deviation have been used. to analyze the results, the tests of variable distribution normality, linear independence of independent variables, residue distribution normality were applied. variance stability has been also used as the presupposition of a multiple linear regression. to evaluate the relation between variables, fisher, correlation, linearity, and independent tests have been applied. 4.3 research models asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 281 the model of the first and second hypotheses has been defined in general as follows: y = f (x1، x2) y = dependent variable (price changes in comparison to the previous year) x1= first independent variable (changes in earnings in comparison to the previous year) x2= second independent variable (changes in the ratio of debt to shareholder’s equity) the mathematic relation between dependent variable (price change) and independent variables is determined using f: multiple linear regression equation as follows: y = α + β1x1 + β2x2 the model of the third auxiliary hypothesis has been presented in the following form: y = f (x) y = dependent variable (price changes in comparison to the previous year) x= independent variable (changes in price fluctuation in comparison to the previous month) the mathematic relation between dependent variable (changes in price) and independent variable is determined using panel data as follows: y = α + βx α ،β are parameters of panel data regression equation, and are calculated using panel data estimations based on the performance of companies in stock exchange for each month of a six-year period beginning from 2005 ending to 2010. 5. research findings in the following tables, central indices including mean, median, and dispersion indices including standard deviation, kurtosis, and skewness were calculated for different variables. as the mean is greater than the median, it is proved that there are big points in the data. (table 1 & 2) the variable distribution normality test shows that the distribution of variables has not been normal at the level of five percent. therefore, the logarithm of variables has been used to evaluate the relation among the variables. to evaluate the linear independence among independent variables, pearson correlation analysis has been used. as the significance level is 0.214, and greater than 0.05, therefore, the null hypothesis is confirmed. this means that there is a significant relation between two independent variables. the correlation between them is equal to 0.06, which shows a partial and positive correlation. 5.1 first model estimation in the following table, the results of regression analysis have been presented: (table 3) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 282 the probability value of f is equal to 0.353, which is greater than 0.05. therefore, the null hypothesis is not rejected at the confidence level of 95 percent. this means that there is not significant relation at the confidence level of 95 percent. (table 4) the correlation coefficient is equal to 0.047 and the determination coefficient is only equal to 0.002. this means that only about zero percent of the changes of dependent variable is explained by the independent variable. the value of durbin-watson statistic is not very different from 2 and is equal to 2.11. the value that is close to 2 indicates that there is no self-correlation among residues, which is another assumption of regression. the value of t statistic for delta r is equal to 0.93, which is significant and positive at the confidence level of 95 percent. moreover, the t statistic for intercept elevation is – 4.02, which rejects the null hypothesis at the confidence level of 95 percent. this indicates that constant is significant. therefore, the model is in form of a constant line. ∆ = −0.106 5.2 second model in the table 5, the results of regression analysis has been provided: the probability value of f is equal to 0.98, which is considerably greater than 0.05. therefore, the null hypothesis is not rejected at the confidence level of 95 percent. this means that there is not significant relation at the confidence level of 95 percent. (table 6) the correlation coefficient is equal to 0.001 and the determination coefficient is only equal to 0.000. this means that only about zero percent of the changes of dependent variable is explained by the independent variable. the value of durbin-watson statistic is not very different from 2 and is equal to 2.11. (table 7) as the above table shows, the value of t statistic for delta e is equal to 0.025, which is significant and positive at the confidence level of 95 percent. moreover, the t statistic for intercept elevation is – 3.92, which rejects the null hypothesis at the confidence level of 95 percent. this means that the constant is significant. therefore, the model is in form of a constant line. ∆ = −0.106 5.3 third model in the table 8, the result of regression analysis has been provided: the probability value of f is equal to 0.000, which is less than 0.05. therefore, the null hypothesis is rejected at the confidence level of 95 percent. this means that there is a significant relation at the confidence level of 95 percent. (table 9) the correlation coefficient is equal to 0.14 and the determination coefficient is only equal to 0.02. this means that only about 2 percent of the changes of dependent variable are explained by the independent variable. this value is in practice very low, and shows the relation intensity among variables. the value of durbin-watson statistic is not very different from 2 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 283 and is equal to 2.02. the value that is close to 2 indicates that there is no self-correlation among residues, which is another assumption of regression. the value of t statistic for delta p is equal to 9.24, which is significant and positive at the confidence level of 95 percent. moreover, the t statistic for intercept elevation is 12.12, which rejects the null hypothesis at the confidence level of 95 percent. this means that the constant is significant. therefore, the model is in form of the following: ∆iv = 0.749 + 1.44∆p 5.3 the relation of variables considering that the determination coefficient in the linear regression equation has not approached zero, and the hypotheses of this research have been based on the relation among variables, independent test with chi-square criterion has been applied. 5.3.1 the relation between delta p and delta r chi-square is equal to 4.61, which is less that the critical amount i.e. χ , . = 9.49 therefore, the null hypothesis is not rejected. this means that these two variables are independent. 5.3.2 the relation between delta p and delta e chi-square is equal to 1.29, which is less that the critical amount i.e. , . = 9.49 therefore, the null hypothesis is not rejected. this means that these two variables are independent. 5.3.3 the relation between delta iv and delta p chi-square is equal to 488.41, which is greater that the critical amount i.e. , . = 9.49 therefore, the null hypothesis is rejected. this means that there is a relation between these two variables. 6. research in brief, and conclusion in general, the findings of the fundamental model indicate that there is no relation between stock price changes and changes in the fundamental variables. therefore, the first hypothesis of the research stating that there is a significant relation between fundamental variables and changes in stock price is rejected. on the other hand, we know that lack of significant relation between these two variables proves the existence of bubble (since in an efficient market changes in the price of assets must be related to the changes in the fundamental value of assets). the test of the second hypothesis on the existence of the mass behavior of the investors in the stock exchange of tehran shows that the changes in mass behavior affect the changes in stock asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 284 prices. this proves the existence of mass behavior. 6.1 practical recommendations investors are encouraged to transact by analytical study of information and future conditions. any investment notwithstanding the conditions governing transactions leads to loss. short selling may be a factor preventing the emergence of bubble. in short selling, professional investors who decide more rationally than other shareholders can prevent bubbles. by short selling, they increase the supply of assets, and prevent any increase in the price of assets. at present, the best method for predicting price in the stock exchange of tehran for investors and those persons expecting short-term yield, is to pay attention to the previous changes in prices. the correlation among the sequential prices in the stock exchange of tehran indicates that the stock exchange is inefficient. therefore it is suggested to pay more attention to the dissemination of correct and exact information, which is one of the most important factors of efficiency. 6.2 recommendations for the future researches study the relation among fundamental variables (including dividends, amortization, output money used for the purchase of fixed assets) with the changes in stock price study the existence of bubbles in other markets including housing, gold, and foreign currency markets. study the effects of mass behavior on the stock price in short-term periods (weekly) references abbasian, ezatollah; mahmoudi, vahid, & farzanegan, elham. 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(1985). asset bubbles and overlapping generations. econometrical, 53, 499-528. table 1 & 2. descriptive statistics of the variables n mean median std. deviation skewness kurtosis valid missing deltae 390 0 .02849 -.09335 .573305 1.888 5.265 ln(deltap) 390 0 -.1062 -.0980 .52289 -.159 .561 deltar 390 0 .01762 .01026 1.980346 .455 5.395 deltae 390 0 .11300 02569 .569257 1.696 5.345 n mean median std. deviation skewness kurtosis valid missing deltaiv 4443 237 .65397 -.03872 4.063151 9.868 116.775 ln(deltaiv) 4443 237 1.4376 1.3766 .35868 2.365 19.586 deltap 4342 338 -.06578 -.00693 .392737 2.066 29.988 table 3. analysis of variance (anova) test for simple linear regression model sum of squares df mean square f sig. 1 regression .236 1 .236 .864 .353(a) residual 106.121 388 .274 total 106.357 389 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 287 table 4. multiple correlation coefficient, determination coefficient, adjusted determination coefficient, and durbin – watson statistic model r r square adjusted r square std. error of the estimate durbin-watson 1 .047(a) .002 .000 .52298 2.111 a. predictors: (constant), deltar b. dependent variable: ln (deltap) table 5. analysis of variance (anova) test for simple linear regression model sum of squares df mean square f sig. 1 regression .000 1 .000 .001 .980(a) residual 106.357 388 .274 total 106.357 389 a. predictors: (constant), deltae b. dependent variable: ln (deltap) table 6. multiple correlation coefficient, determination coefficient, adjusted determination coefficient, and durbin – watson statistic model r r square adjusted r square std. error of the estimate durbin-watson 1 .001(a) .000 -.003 .52356 2.112 a. predictors: (constant), deltae b. dependent variable: ln (deltap) table 7. estimation and test of the parameters of the model (intercept elevation and gradient of independent variables) sig. t standardized coefficients un standardized coefficients model 1 beta std. error b .000 -3.923 .027 -.106 (constant) .980 -.025 -.001 .047 -.001 deltae a. dependent variable: ln (deltap) table 8. analysis of variance (anova) test for simple linear regression model sum of squares df mean square f sig. 1 regression 1363.756 1 1363.756 85.471 .000(a) residual 68322.328 4282 15.956 total 69686.084 4283 a. predictors: (constant), deltap b. dependent variable: ln(deltaiv) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 288 table 9. multiple correlation coefficient, determination coefficient adjusted determination coefficient, and durbin – watson statistic model r r square adjusted r square std. error of the estimate durbin-watson 1 .140(a) .020 .019 3.994459 2.021 a. predictors: (constant), deltap b. dependent variable: ln (deltaiv) microsoft word 2682-10444-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 60 impact of intellectual capital on performance in audit institutes hossein gazor (corresponding author) department of management & accounting allameh tabataba'ee university, tehran, iran tel: 98-912-435-4291 e-mail: hosseingazor@yahoo.com farhad kohkan department of accounting, university of science and culture, iran e-mail: kohkan_farhad59@yahoo.com amene kiarazm, department of accounting, university of science and culture, iran e-mail: ameneh.kiarazm@yahoo.com hashem rastegari department of management & accounting allameh tabataba'ee university, tehran, iran e-mail: rastegari.hashem@gmail.com received: nov. 13, 2012 accepted: december 26, 2012 published: june 1, 2013 doi:10.5296/ajfa.v5i1.2682 url: http://dx.doi.org/10.5296/ajfa.v5i1.2682 abstract intellectual capital is a momentous asset of today organizations by which they can create competitive advantages. in this paper, we attempt to investigate relationships between dimensions of intellectual capital and organization performance by means of a conceptual model. for testing model, we used path analysis with lisrel. study population was selected asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 61 from accountants of accounting and audit institutes. findings show that human capital plays a vital role in organisation performance. keywords: human capital, structural capital, relational capital, organizational performance asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 62 1. introduction intellectual capital is changing into a momentous issue for a firm's long-term profit and performance within the knowledge-based economy as a lot of corporations determine their core competence as invisible assets instead of visible assets. nonaka and takeuchi (1995) mentioned that future society could be a knowledge-based society during which knowledge storage and application are the premise of economic growth and accumulated capital. because as gazor et al. (2012) mentioned, knowledge is a firm’s most valuable resource because it embodies intangible assets, routines, and creative processes. the concept of intellectual capital arises in varied disciplines. as an example, accountants have an interest in the way to measure it on the balance sheet; info technologists need to codify it in systems; sociologists need to balance power with it; psychologists need to develop minds due to it; human resource managers need to calculate a come on it; and coaching and development officers need to create positive that they will build it (choo and bontis, 2002; vii). this indicates that intellectual capital have many facet in scientific literatures. therefore, it is raised many questions about managing intellectual capital to obtain and maintain competitive advantages. many of these researchers are interested in answering two questions: (1) what causes firms to be worth so much more than their book value, and (2) what specifically is in this intangible asset. stewart (1997) defines intellectual capital as the intellectual material that has been formalized, captured, and leveraged to create wealth by producing a higher valued asset. following the work of bontis (1996a, 1988), roos et al. (1998), stewart (1991,1994,1997), sveiby (1997), edvinsson and malone (1997), saint-onge (1996), sullivan and edvinsson (1996), and edvinsson and sullivan (1996), among others, intellectual capital is defined as encompassing (a) human capital, (b) structural capital, and (c) relational capital. these subphenomena encompass the intelligence found in human beings, organizational routines, and network relationships, respectively. we will explain these in coming sections in more detailed. 2. literature review 2.1. intellectual capital definition intellectual capital, a term initial introduced by economist john kenneth galbraith in 1969, refers to the distinction between an organization's market value and book value. given the growing gap between the market and book values of firms, investigation into how to measure firms’ intellectual capital and whether capital market is efficient with intellectual capital has been drawing broad research interest (chen et al., 2005). several researchers have come back to treat intellectual capital as a firm's primary suggests that of creating competitive advantage. the abstract and dynamic nature of intellectual capital makes it troublesome for students to outline (hsu and fang, 2009). guthrie (2001) considered intellectual capital and intellectual assets or intangible assets as synonyms. some authors indicate that intellectual capital is the product of dynamic business operation processes, and is rigidly linked to knowledge management or organizational learning (stewart, 1997; roos, et al, 1998). also accumulating intellectual capital is vital resources to create and maintain asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 63 competitive advantage (kaplan and norton, 1992; edvinsson and sullivan, 1996; edvinsson and malone, 1997; mcelroy, 2002). 2.2. intellectual capital classification adopting kogut and zander's (1992) perspective on higher order organizing principles, figure 1 proposes a conceptualization of intellectual capital. intellectual capital is a second-order multidimensional construct. its three subdomains include (1) human capital—the tacit knowledge embedded in the people's minds, (2) structural capital—the organizational routines of the business, and (3) relational capital—the knowledge embedded in the relationships established with the outside environment (edvinsson and sullivan 1996). figure 1. conceptualization of intellectual capital (source: bontis, 2002; 629). roos et al. (1998) observe the excellence between intellectual capital and organizational information as follows: “while knowledge may be a part of intellectual capital, intellectual capital is far quite simply knowledge. brands and emblems additionally because the management of relations with external parties (trade distributors, allies, customers, native communities, stakeholders generally and therefore the like) are all dimensions of price creation”, (p. 24). the strategic management of intellectual capital cares not solely with the identification and measurements of stocks of organizational knowledge, however additionally asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 64 with the management and alignment of knowledge flow across organizational levels so as to boost performance. 2.3. human capital human capital is a function of the competence, intellectual agility, and attitudes of the organization's members. human capital represents the human factor in the organization: the combined intelligence, skills, expertise, and knowledge that give the organization its distinctive character. the human in the organization are those that are capable of learning, changing, innovating, value adding, and providing the creative thrust that can ensure the long-run survival of the organization if properly motivated. as per lynn's (1998) overview of human resource accounting, since hermanson's classic study in 1964, the topic of how to and whether to value human assets has been debated by accountants and human resource theorists. indeed, the arguments for and against human resource accounting are especially pertinent to the valuation of intellectual assets in the new economy since they involve essentially the same issues. point a in figure 2 represents the core of human capital. multiple nodes (human capital units) attempt to align themselves in some form of recognizable pattern so that intellectual capital becomes more readily interpretable. this point represents the lowest level of difficulty for development as well as the lowest level of externality from the core of the organization. nelson and winter (1982) analyzed an organization's capabilities. they noted that an individual's skills are composed of subelements that become coordinated in a smooth execution of the overall performance, impressive in its speed and accuracy, with conscious deliberation being confined to matters of overall importance. research by hurwitz et al. (2002) shows that a firm's profit derived primarily from human capital. a firm hiring skilled employees and experienced managers will have higher performance because its manpower can bring skills and capabilities into full play (rhyne et al, 2002). prominent managers with knowledge and vision help organizations fast respond to the market in highly dynamic environment. appreciate to managers, organizations may lead the market, and improve their market value and share. in addition, dakhli and de clercq (2004) show that there is a positive relationship between human capital and innovation. human capital collection determines teamwork performance and the better the employee quality, the higher the innovation performance. based on these findings, following hypothesis is developed: h1: human capital affects organizational performance positively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 65 figure 2. discriminating intellectual capital subdomains (source: bontis, 2002; 631). 2.4. structural capital structural capital refers to the learning and knowledge that is enacted in processes (process capital). from an intellectual capital perspective, knowledge management is about the capture, storage, and retrieval of knowledge located either in the heads of employees, in the heads of outside collaborators, or in documents. capture, storage, and retrieval are brought about through a firm's structural capital, defined by edvinsson (1997) as “the embodiment, empowerment, and supportive infrastructure of human capital.” structural capital is also where the value added by the nonlinearities of the knowledge creation process is assumed to reside. there are important implications for knowledge managing investment in “soft” assets such as brand names, strategic alliances, and personnel skills. such thinking leads, for instance, to human capital accounting and the kind of organizational practices made famous by skandia (e.g., hedberg 2000). point b in figure 2 illustrates the structural ties or links of human capital nodes that are required to transform human capital into structural capital. the arrows within structural capital represent the focus of intellectual capital development from the nodes into the organization's core. structural capital includes two dimensions: process capital and innovation capital. edvinsson and malone (1997) show that process capital supports employees and enhances firm productivity. a learning organization increases knowledge management efficiency and builds asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 66 up a sharing and communicating culture that positively effect on performance (brentani and kleinschmidt, 2004). bontis et al. (2000) empirical study on intellectual capital and firm performance in malaysia indicates that structural capital positively impacts on firm performance in the service industry but not in the non-service industry. pena (2002) also mentioned that structural capital influences new business survival and growth. according to these argues, following hypothesis is developed: h2: structural capital affects organizational performance positively. 2.5. relational capital knowledge that is codified as documents, objects, and intellectual property (intellectual assets); and the reputation and relationships the organization has developed during time with customers and stakeholders (relational capital). knowledge of market channels and of client and provider relationships, also as a sound understanding of governmental or business association impacts, is that the main theme of relational capital. relational capital represents the potential a company has attributable to ex-firm intangibles. these intangibles embrace the data embedded in customers, suppliers, the govt., or connected business associations. point c in figure 2 a pair of illustrates that relational capital is that the toughest of the three subdomains to develop since it's the foremost external to the organization's core. the arrows represent the data that has to flow from sources external to the organization (i.e., its environment) into the organization's core by method of linked nodes. hill and jones (2001) mentioned that organization stakeholders often provide the organization with important resources. customers provide income, suppliers provide materials, and distributors prepare sales channels. firms' strategic partners are advantageous for new product development (kodama, 2005). firms should therefore understand and satisfy stakeholder needs to enhance their performance. many investigations debates that customer collaboration is very important to achieve innovation and economic success. this cooperation improves organizational performance. schulz (2001) further indicates that common values and trust in a network not only eliminate conflicts, but also enhance communication and harmony between members of networks. these attributes are critical for increasing performance. h3: relational capital affects organizational performance positively. 2.6. mutual relationship between three categories of intellectual capital bontis et al. (2000) indicated that human capital significantly affects customer capital in all industries. human capital significantly affects structural capital in non-service industries, while customer capital affects structural capital in both service and non-service industries. employee abilities also affect a firm's process efficiency and innovation processes. higher quality employees will be more pleasant and provide more information to customers and business partners. these employees will attract good customers and business partners as a result. in other words, human capital positively affects relational capital. a firm maintaining a good relationship with its customers and business partners enables the employee to discuss business processes or innovations with customers and business partners. in other words, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 67 relational capital positively affects structural capital (hsu and fang, 2009). according to this, following hypotheses are developed: h4: human capital affects structural capital positively. h5: relational capital affects structural capital positively. h6: human capital affects relational capital positively. 2.7. organizational performance notwithstanding intellectual capital is generally intangible in nature, it is becoming widely accepted as a major corporate strategic asset capable of creating sustainable competitive advantage and exceptional performance (barney, 1991). strategy management is bothered with understanding the causes and forces that designate performance variations between organizations. performance variations between organizations, then, are results of their totally different stocks of knowledge and their differing capabilities in developing and deploying knowledge. information and competence became the first drivers of competitive advantage in advanced nations (choo and bontis, 2002; vii). according to conceptual model shown in figure 3, we developed three hypotheses for indirect paths in model. h7: human capital affects organizational performance through structural capital. h8: relational capital affects organizational performance through structural capital. h9: human capital affects organizational performance through relational capital. figure 3. research conceptual model. 3. methodology 3.1. sample and data collection this study concentrates on accounting and audit institutes of tehran. population of study was selected from accountants working in audit organizations because intellectual capital h1 h2 h3 human capital structural capital relational capital performance h4 h5 h6 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 68 accounting is an issue that includes auditing intangible assets of organization. hence, accountants engage always with this problem to evaluation of this kind of assets. in other hands, for accounting and audit institutes, having skilled and experienced (employees) accountants have been a competitive advantages. therefore, these institutes typically appreciate excellent human capital (a subsection of intellectual capital as mentioned in literature) for attract and maintain new and old customers. statistics obtained from audit organization of tehran indicate that 232 organizations are members of iranian accounting association work in tehran. the questionnaire distributed between accountants working in mentioned-above organizations. from 500 distributed questionnaires came back 406 complete questionnaires that shows 81% response rate. more than 74% of participants were male in which 32% of them have more than 20 years background in auditing. they earn almost 30,000,000 rials monthly. 91% of participants had academic degree in accounting. 3.2. measures for consistency, all responses were measured using a likert-type scale, with 1=“strongly disagree,” 3=“neutral,” and 5=“strongly agree.” the questionnaire comprised three parts. the first part describes individuals' demographic data. the second part contained measurements of intellectual capital (including human capital, structural capital, and relational capital); the third part measured organizational performance. 4. results 4.1. correlation as show in table 1, the high value for correlation between variables belongs to human capital and performance. this shows that intellectual capital could be one of the predictors towards firms’ performance. in a knowledge-based economy, it is expected that the knowledge workers (human capital) will increase organisations power to generate competitive advantages (hazlina and zubaidah, 2008) which can increase profit of a company. relationships between relational capital, human capital, and structure capital have relatively good correlation. but, relational capital and performance don’t have a suitable correlation. this means that knowledge documented in records and links between organization and its stakeholders in external environment. table 1. correlation value between variables. variables structure capital relation capital human capital performance structure capital 1.00 relation capital 0.41 1.00 human capital 0.46 0.43 1.00 performance 0.25 0.13 0.57 1.00 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 69 4.2. path analysis goodness of fit statistics for research model shows that the model is saturated, the fit is perfect. minimum fit function chi-square is 0.0 (p= 1.00) and normal theory weighted least squares chi-square is 0.00 (p = 1.00). for hypothesis 1, relationship between human capital and performance is accepted (t = 4.53). as shown in correlation results, knowledge and experience in people minds can impact on organization outcome and performance dramatically. findings can't support hypothesis 2, therefore, there is no link between structural capital and performance. also, for hypothesis 3 was rejected. findings show that there is a link between human capital structural capital and relational capital (for h4 and h5). for indirect paths, human capital can impact on performance through relational capital but not structural capital; because it was not observed any relation between structural capital and performance. this means that structural capital can't play role of mediator within two variables. finally, structural capital plays a mediator role in impact of relational capital on performance. all results of hypotheses testing were shown in table 2. table 2. path analysis results for all hypotheses. hypothesis (path) variables t-value standard value 1(direct) human capital on performance 4.53 0.23 2(direct) structural capital on performance 0.55 0.03 3(direct) relational capital on performance 1.51 0.08 4(direct) human capital on structural capital 2.88 0.14 5(direct) relational capital on structural capital 4.18 0.21 6(direct) human capital on relational capital 2.56 0.07 7(indirect) human capital on performance through structural capital 1.38 0.02 8(indirect) relational capital on performance through structural capital 3.07 0.05 9(indirect) human capital on performance through relational capital 2.74 0.04 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 70 5. conclusion scholars, enterprises, and governments take into account intellectual capital from in practical applications and further discussion recently. in this study, we attempt to investigate relationship between intellectual capital dimensions and organisation performance. as debated in previous section, no relation was observed between structural capital and performance, and between relational capital and performance. manager should consider processes in which knowledge created and learning taken place. our finding can't confirm bontis et al. (2000) findings that observed there is a positive relationship between structural capital and performance in service industry. structural capital marginally negatively affects performance, indicating. for increase structural capital impact, investments in information technology and innovation help a firm utilize and maximize knowledge creation to improve its organizational performance. relational capital can be explained by the relationship of customers and partners, where sustaining a good relationship is fundamental. hence, managers can maintain continuous linkage with their stakeholders as customers, government's departments, market, and so on. human capital significantly impacts organizational performance, meaning that good quality human resources form a key element in knowledge-intensive industries because knowledgeable workers generate excellent organizational performance. a firm emphasizing human capital gives its employees the chance to contribute increasing organisation performance. references barney, j.b. 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(1997). the new organizational wealth: managing and measuring knowledgebased assets. new york: berrett-koehler microsoft word macro ec ful paper-writer2-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 208 causal relationship between macro-economic indicators and stock market in india dr. naliniprava tripathy associate professor (finance), indian institute of management shillong meghalaya, pin 793 014, india tel: 91-364-230-8037 e-mail: nalini.607@rediffmail.com received: may 16, 2011 accepted: november 13, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.633 url: http://dx.doi.org/10.5296/ajfa.v3i1.633 abstract this paper investigated the market efficiency and causal relationship between selected macroeconomic variables and the indian stock market during the period january 2005 to february 2011 by using ljung-box q test, breusch-godfrey lm test, unit root test, granger causality test.the study confirms the presence of autocorrelation in the indian stock market and macro economic variables which implies that the market fell into form of efficient market hypothesis. further the granger-causality test shows evidence of bidirectional relationship between interest rate and stock market, exchange rate and stock market, international stock market and bse volume, exchange rate and bse volume. so it suggests that any change of exchange rate, interest rate and international market significantly influencing the stock market in the economy and vice versa. the study also reported unidirectional causality running from international stock market to domestic stock market, interest rate, exchange rate and inflation rate indicating sizeable influence in the stock market movement in the considered period. the study points out that the indian stock market is sensitive towards changing behavior of international market, exchange rate and interest rate in the economy and they can be used to predict stock market price fluctuations. keywords: macroeconomic variables, stock market, ljung-box q test, unit root test, granger-causality test jel classification: g1, g7, c32 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 209 1. introduction over the past few decades, the interaction of share returns and the macroeconomic variables has been a subject of interest among academicians and practitioners. kaneko and lee (1995), lee (1992), fama (1981) determined a positive relation between stock returns and real economic activity in us and japanese stock markets but the same relation is not found in european and south asian markets. poon and taylor (1991)’s study for the uk market, martinez and rubio (1989)’s study for the spanish market, and gjerde and saettem (1999)’s study for the norwegian market have not implied a significant relation between stock returns and macroeconomic variables. mookerje and yu (1997)’s study on forecasting share prices for the singapore case obtained a result that money supply and exchange rate have an impact upon forecasting share prices. so the results are mixed. if stock prices accurately reflect the underlying fundamentals, then the stock prices should be employed as leading indicators of future economic activities. therefore, the causal relations among macroeconomic variables and stock prices are important in the formulation of the nation’s macroeconomic policy. presently the performance of indian stock market is analyzed carefully by large number of global players; this motivates us for exploring research in indian stock market and macroeconomic indicators to determine the indian stock market efficiency to give new approach to the foreign investors, policy makers, traders, domestic investors and academic researchers. in this paper, we have raised three research question .first this paper will add to the existing literature by providing robust result. secondly we investigate the causal relationship between macroeconomic variables and indian stock market by using granger causality test for determining whether one time series is useful for forecasting another. thirdly we use unit root test and box-jenkins autoregressive integrated moving average (arima) time-series process to determine whether indian stock market exhibits weak, semi-strong, or strong form of market efficiency with reference to macroeconomic variables is concerned to obtain new insights. therefore, the present work improves the earlier studies and offers a value addition to the existing literature. the paper is organized as follows: section 2 reviews previous literature section 3 describes the data & methodology used in the research. the results are discussed in section 4 and section 5 concludes the observation. 2. literature review the dynamic relationships between macroeconomic variables and share returns have been widely discussed and debated. the informational efficiency of major stock markets has been extensively examined through the study of causal relations between stock price indices and macroeconomic aggregates. kwon and shin (1999) applied engle-granger co integration and the granger-causality tests from the vector error correction model (vecm) and found that the korean stock market is co integrated with a set of macroeconomic variables. however, using the granger-causality test on macroeconomic variables and the korean stock index, the authors found that the korean stock index is not a leading indicator for economic variables. mayasmai and koh (2000) used the johansen co integration test in the vector error correction model (vecm) and found that the singapore stock market is co integrated with asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 210 five macroeconomic variables. muradoglu, metin and argac (2001) examined the long-run relationship between stock returns and three monetary variables (overnight interest rate, money supply and foreign exchange rate) in turkey. they pointed out that the whole sample period (1988-1995) showed no co-integrating relationship between stock prices and any of the monetary variables. this is also true only for the first sub-sample (1988-1989) but all the variables were co integrated with stock prices for the second (1990-1992) and third sub-samples (1993-1995). nevertheless, in general, ibrahim and aziz (2003), booth and booth (1997), wongbanpo and sharma (2002), chen (2003), chen et al. (2005) and mukherjee and naka (1995) reveal that the rate of inflation, money growth, interest rates, industrial production, reserves, and exchange rates are the most popular significant factors in explaining the stock market movement. however, empirical studies by barrows and naka (1994) conclude that inflation has negative effects on the stock market. the ‘exchange rate channel’ by pan et al. (2007) is consistent with the ‘flow oriented’ exchange rate model, introduced by dornbusch and fisher (1980). they affirm that exchange rate movements initially affect the international competitiveness and trade position, followed by the real output of the country, and finally affects the current and future cash flows of companies, which can be inferred from the stock price movements. donatas, p., & vytautas b.,(2009)analyzes the relationships between a group of macroeconomic variables and the lithuanian stock market index and reveals that some macroeconomic variables lead lithuanian stock market returns. 3. time series data and methodology many financial time series contain a unit root, i.e. the series are non-stationary and it is generally acknowledged that stock index and macroeconomic variables might not be exception. so the required time series weekly data have been collected from the www.rbi.com and www.bse.com for a period of six years from january 2005 to february 2011.we have chosen the data period 2005 to 2011 because during this period indian stock markets have undergone substantial policy changes characterised by the revival of private foreign capital flows to emerging market economies, flexible exchange rates, strong economic growth, credit market crisis in the united states and sharp fell in asian market. these changes have affected the movement in index and magnitude of volume trades in the market in different ways. there are many macroeconomic variables which affecting the stock market but the most prominent are interest rate, inflation rate, exchange rate and international market. a fall in interest rates reduces the costs of borrowing and encourages firms for expansion with the expectation of generating future expected returns for the firm. further significant amount of stocks are purchased with borrowed money. so an increase in interest rates will be more costly for stock transactions that lead to reduce demand and affect the share price. hence, changing interest rate has greater influence on stock market variability. so we have chosen 91-days treasury bill as proxy for short term interest rate which is very popular short-term risk free instrument in india. similarly wholesale price index focuses on the price of goods traded between corporations. it also monitors price movements that reflect supply and demand in industry, manufacturing and construction. this helps in analyzing both asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 211 macroeconomic and microeconomic conditions. in india the changes of wpi is used to measure inflation rate. it is believed that change in wpi influences stocks and fixed price markets. so we have chosen wpi as proxy for inflation rate. thirdly, the s&p 500 is considered as the best single gauge of the large cap u.s. equities market. the index includes 500 leading companies in leading industries of the u.s. economy, capturing 75% coverage of u.s. equities. it is also included in the index of leading indicators. further, the "s&p 500"captures the changes in the prices of the index components. it is noticed that many times variability of indian stock market is happening due to international market factors. so s&p 500 is taken as proxy for international market index. fourthly, change in exchange rate affects the overseas operational performances of firm which will affect its share price. so we have taken exchange rate one of the variables to determine its impact on stock market. fifthly, bombay stock exchange is the oldest stock exchange in asia and today, it is the world's 5th most active in terms of number of transactions handled through its electronic trading system. it is also in the top ten of global exchanges in terms of the market capitalization of its listed companies.bse have facilitated the growth of the indian corporate sector by providing with an efficient capital raising platform. the bse index, sensex, is india's first and most popular stock market benchmark index. so we have taken sensex as proxy for indian stock market. lastly trading volume refers to the number of shares traded during a defined time period. when investors or financial analysts see a large increase in volume, it may indicate a significant change in the price of security. significant volume spikes may indicate some kind of important news taking place in the stock market. we have taken trading volume as another variable to determine its impact on stock market as well. the return is calculated as the continuously-compounded return using the closing price: %100)ln( 1  t t t p p r (1) where ln (pt) denotes the natural logarithm of the closing price at time t. the theory behind arma estimation is based on stationary time series. a series is said to be stationary if the mean and auto co variances of the series do not depend on time. any series that is not stationary is said to be non stationary. a common example of a non stationary series is the random walk. serial correlation coefficient test is a widely used procedure that tests the relationship between returns in the current period with those in the previous period. if no significant autocorrelation are found then the series are expected to follow a random walk. the durbin-watson statistics is a test for first-order serial correlation. the durbin-watson is a test of the hypothesis p=0 in the specification: t t pu t u    1 (2) if there is no serial correlation, the dw statistic will be around 2. the dw statistic will fall below 2 if there is positive serial correlation (in the worst case, it will be near zero). if there is asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 212 negative correlation, the statistics will lie somewhere between 2 and 4.however there are limitations of the dw test as a test for serial correlation. so two other tests of serial correlation—the q-statistic and the breusch-godfrey lm test are preferred in most applications. the best alternative is to use a test for autocorrelation in a form of equation, in which relationship between ut and several of its lagged values at the same time could be checked. breusch godfrey test is among the tests widely used for testing autocorrelation of the lags up to r ' th order. t v rt u r p t up t up t up t u          ...... 332211 (3) )2,0( vn t v  random walk hypothesis implies independent residuals and a unit root.the autocorrelations are easy to interpret—each one is the correlation coefficient of the current value of the series with the series lagged a certain number of periods. if the autocorrelation function dies off smoothly at a geometric rate, and the partial autocorrelations were zero after one lag, then a first-order autoregressive model is appropriate. alternatively, if the autocorrelations were zero after one lag and the partial autocorrelations declined geometrically, a first-order moving average process would seem appropriate the auto correlation of a series y at lag k is estimated by 2 1 )( 1 ))((        t t y t y t kt y kt yy t y k (4) where _ y is the sample mean of y. this is the correlation coefficient for values of the series k periods apart. if �1 is non zero, it means that the series is first order serially correlated if �k dies off more or less geometrically with increasing lag k, it is a sign that the series obeys a low order autoregressive (ar) process. if�k drops to zero after a small number of lags; it is a sign that the series obeys a low-order moving-average (ma) process. if the pattern of autocorrelation is one that can be captured by an auto regression of order less than k, then the partial auto correlation at lag k will be close to zero. the partial auto correlation at lag k recursively by asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 213 jkjk k j jkjk k j k k                ,1 1 1 1 ,1 1 1 1 (5) for k = 1 for k > 1 where �k is the estimated auto correlation at lag k and jkkkjkjk    ,1,,1, , q statistics is often issued, as a test of whether the series is white noise. the q statistics at lag k is a test statistics for the null that there is no auto correlation up to order as is computed as jt k j ttqlb j     2 1 )2( (6) where �j is the jth auto correlation and t is the number of observations. if the series is not based upon the results of arima estimation, then under the null hypothesis, q is asymptotically distributed as a χ2 with degrees of freedom equal to the number of autocorrelations. if the series represents the residuals from arima estimation, the appropriate degrees of freedom should be adjusted to represent the number of autocorrelations. if there is no serial correlation in the residuals, the autocorrelations and partial autocorrelations at all lags should be nearly zero, and all q-statistics should be insignificant with large p-values. if q statistics measured found to be significant, it can be said that the market does not follow random walk. knowledge of non-stationarity of the time series is significant in the modelling of economic relationships because standard statistical techniques that assume stationarity may give invalid inferences in the presence of stochastic trends. in case of non-stationarity data, ordinary least squares can produce spurious results. therefore, prior to modelling any relationship, non-stationarity must be tested. the data considered for the study is time series, which is non-stationary. for application of granger causality the initial step in the estimation involves the determination of the times series property of each variable individually by conducting unit root tests. considering a simple ar (1) process: t x t yp t y     ' 1 (7) where xt are optional exogenous regressors which may consist of constant, or a constant and trend, p and δ are parameters to be estimated, and t the are assumed to be white noise. if ,p1, y is a nonstationary series and the variance of increases with time and approaches asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 214 infinity. if ,p< 1.y is a (trend-)stationary series. thus, the hypothesis of (trend-)stationarity can be evaluated by testing whether the absolute value of p is strictly less than one. the null hypothesis ho: p=1 against the one-sided alternativeh1: p<1. in some cases, the null is tested against a point alternative. the most popular unit root rest is the adf test. the standard df test is carried out after subtracting yt-1 from both the sides of the equation: tt x t y t y     ' 1 (8) where α= p-1. the null and alternative hypotheses is written as ho: α=0 h1: α<0 the simply dickey fuller unit root test includes ar (1) process and described valid if the series is correlated at higher order lags, the assumption of white noise disturbances t is violated. the augmented dickey-fuller (adf) test constructs a parametric correction for higher-order correlation by assuming that the y series follows an ar (1 ) process and adding p lagged difference terms of the dependent variable y to the right hand side of the test regression: t v pt y pt y t y t x t y t y           ....... 2211 ' 1 (9) said and dickey (1984) demonstrate that the adf test is asymptotically valid in the presence of a moving average (ma) component, provided that sufficient lagged difference terms are included in the test regression. 4. dickey-fuller test with gls de trending (dfgls) elliott et al. (1996) propose a simple modification of the adf tests in which the data are de trended so that explanatory variables are “taken out” of the data prior to running the test regression. ers (1996) obtain the asymptotic power envelope for unit-root tests by analyzing the sequence of neyman-pearson tests of the null hypothesis h0: p= 1 against the local alternative ha:p=1+c /t, wherec<0. based on asymptotic power calculation, ers show that a modified dickey-fuller test, called the df-gls test, can achieve a substantial gain in power over traditional unit-root tests. the df-gls test that allows for a linear time trend is based on the following regression: t vd t yl p j j d t yd t yl         1 )1( 1 1 )1(  (10) where vt is an error term and d t y is the locally de trended data process under the local asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 215 alternative of tcp /1 is given by  ttt zyy  with β being the least squares regression coefficient of y ̃t ̃ on zt ̃ , for which yt̃ =[y1,(1-p l)y2....(1-p l)yt]’ and zt=[z1,(1-p l)z2,.........(1-p l) z1 ]the df-glst statistic is given by the t-ratio, testing h0:o=0 against ha:0< 0.ers recommend that the parameter of defining the local alternative, c, be set equal to -13.5.for the test without a time trend, denoted by df-gls., it involves the same procedure as the df-glst test, except that d t y is replaced with the locally demeaned series d t y and z =1. in this case, the use of c =-7 is recommended. phillips-perron(pp)test phillips and perron (1988) developed a number of unit root tests that have become popular in the analysis of financial time series. the phillips-perron (pp) unit root tests differ from the adf tests mainly in how they deal with serial correlation and heteroskedasticity in the errors. in particular, where the adf tests use a parametric auto regression to approximate the arma structure of the errors in the test regression, the pp tests ignore any serial correlation in the test regression. the test regression for the pp tests is t u t y t d t y    1 '  (11) where u t is i(0) and may be heteroskedastic. the pp tests correct for any serial correlation and heteroskedasticity in the errors ut of the test regression by directly modifying the test statistics tπ=0 and t ˆπ. these modified statistics, denoted zt and zπ, are given by ) 2ˆ )ˆ( ).( 2ˆ 22ˆ ( 2 1 0.2/1) 2ˆ 2ˆ (       set t t z       (12) )2ˆ2ˆ( 2ˆ )ˆ(.2 2 1 ˆ     set tz (13) the terms ̂ and 2̂ are consistent estimates of the variance parameters      t t t uet xt 1 21 lim 2 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 216      t t t ste xt 1 21 lim 2 where    t t t u t s 1 .the sample variance of the least squares residual t û is a consistent estimate of σ2, and the newey-west long-run variance estimate of ut using t û is a consistent estimate of λ2. under the null hypothesis that π = 0, the pp zt and zπ statistics have the same asymptotic distributions as the adf t-statistic and normalized bias statistics. one advantage of the pp tests over the adf tests is that the pp tests are robust to general forms of heteroskedasticity in the error term ut. another advantage is that the user does not have to specify a lag length for the test regression. 5. kpss (kwiatkowski, phillips, schmidt, and shin) test in the kpss test, stationarity is the null hypothesis and the existence of a unit root is the alternative. kpss tests are used for testing a null hypothesis that an observable time series is stationary around a deterministic trend. the series is expressed as the sum of deterministic trend, random walk, and stationary error, and the test is the lm test of the hypothesis that the random walk has zero variance. kpss type tests are intended to complement unit root tests, such as the adf tests. the kpss statistic is based on the the residuals from the ols regression of y t on the exogenous variables x t   x tty 1 (14) the lm statistics is given by: 2 1 2 / t t t lm ts    (15) where, 2 t is an estimator for the error variance. this latter estimator 2 t may involve corrections for autocorrelation based on the newey-west formula. in the kpss test, if the null of stationarity cannot be rejected, the series might be co integrated. the kpss test is estimated and found to contain a unit root when the test statistics is less than the critical values at the estimated level of significance. 6. ng and perron (np) tests ng and perron (2001) use the gls de trending procedure of ers to create efficient versions of the modified pp tests of perron and ng (1996). these efficient modified pp tests do not exhibit the severe size distortions of the pp tests for errors with large negative ma or ar roots, and they can have substantially higher power than the pp tests. especially, when φ is close to unity. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 217 using the gls de trended data d t y , the efficient modified pp tests are defined as 1 1 1 221 )2)((      t t d t d t ytytmz  (16) 2/1 1 2 1 2 )/(     t t d tytmsb  (17) msbxmzmz t  (18) the statistics mz and tmz are efficient versions of the pp zα and zt tests, that have much smaller size distortions in the presence of negative moving average errors. ng and perron derive the asymptotic distributions of these statistics under the local alternative φ = 1− c/t for dt = 1 and dt = (1, t). in particular, they show that the asymptotic distribution of tmz is the same as the df-gls t-test. 7. granger causality test the dynamic linkage is examined using the concept of granger’s (1969) causality. the granger type causality procedure (granger, 1969, 1988) is applied to determine the direction of causation among the variables. the causality procedure is conducted based on bi-variate system (x, y). formally, a time series xt, granger-causes another time series yt if series yt can be predicted better by using past values of (xt, yt) than by using only the historical values of yt. in other words, xt fails to granger–cause yt if for all m>o the conditional probability distribution of yt+m given (yt, yt-1) is the same as the conditional probability distribution of yt+m given both (yt, yt-1, ….) and (xt, yt-1, ….). that is xt, does not granger cause yt if where pr denotes conditional probability, ψt is the information set at time t on past values yt, and ωt is the information set containing values of both xt and yt up to time point t. testing causal relations between two stationary series xt and yt can be based on the following bivariate auto regression (granger – 1969). (19) asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 218 (20) where p is a suitably chosen positive integer; k’s and βk’s, k = 0, 1, -----, p are constants; ut and vt are usually disturbance terms with zero means and finite variance. the null hypothesis that xt does not granger – cause yt is rejected if the βk’s, k>0 in equation 2 are jointly significantly different from zero using a standard joint test (e.g., an f test). similarly, yt granger – causes if the k’s, k>0 are jointly different from zero. 8. empirical analysis 8.1 descriptive statistics the summary statistics for bse sensex, bse volume change, 91-day t-bill rate, s&p 500, exchange rate, and wpi are given in table-1. all returns are calculated as the first difference of the log of the weekly closing price. the mean of the bse sensex is -0.059856. the volatility of the index is 1.463072. the mean of the 91-day t-bill auction rate is -0. 233921. the s&p 500 returns are -0.120676. the exchange rate is 0.019621; and the mean of wholesale price index is 0.153914.the kurtosis for all the aforementioned factors is more than 3 (excess kurtosis), thus they are leptokurtic, i.e., the frequency distribution assigns a higher probability to returns around zero as well as very high positive and negative returns. the jarque-bera statistic for all the 6 variables is significantly greater than zero (due to the leptokurtic data). thus, jarque-bera statistics shows that all the series are leptokurtic, exhibit non-normality and indicate the presence of heteroscedasticity. table 1. descriptive statistics variable mean std. dev. skewness kurtosis jarque-bera probability bse return -0.059856 1.463072 0.367803 15.64054 2124.299 0.000000 bse volume 0.035957 7.048135 -0.481634 12.00021 1082.181 0.000000 91-day treasury bill rate -0.233921 8.907419 -2.030092 31.28345 10783.80 0.000000 s&p 500 return -0.120676 1.225119 -0.046508 12.66397 1233.671 0.000000 exchange rate 0.019621 0.506510 -0.950935 22.01492 4823.475 0.000000 wpi 0.153914 3.532606 17.54097 310.9098 1268518. 0.000000 table 2. durbin-watson tests variable durbin-watson stat f-statistic prob(f-statistic) bse sensex 1.996156 387.6970 0.000000 bse trading volume 1.987563 134.1877 0.000000 91-day treasury bill 2.021978 93.39633 0.000000 s&p 500 return 1.992787 366.2804 0.000000 exchange rate 1.987834 355.3248 0.000000 wpi 2.000006 315.0488 0.000000 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 219 table-2 reported the durbin-watson statistics for all the variables and they are all within the range of 1.9 and 2.2, which is indicative of the absence of first order serial correlation. hence the result can be relied upon to test unit root. dw test, which is a test for serial correlations, has been used in the past but the explanatory power of the dw can be questioned on the basis that the dw only looks at the serial correlations on one lags as such may not be appropriate test for the daily data. so for market efficiency we have used unit root test of stationarity. autocorrelation is useful for finding repeating patterns in a signal, such as determining the presence of a periodic signal. the auto correlation and partial correlation functions (acf and pacfs) of the series of bse sensex, trading volume, 91-days treasury bill, s&p 500, exchange rate and wpi are presented in the table 3 , fig-1 and fig-2. table 3. auto correlation and partial auto correlation lag ac pac q-stat prob 1 -0.106 -0.106 3.6243 0.057 2 -0.014 -0.026 3.6912 0.158 3 -0.061 -0.066 4.9033 0.179 4 0.084 0.071 7.2028 0.126 5 -0.089 -0.077 9.7881 0.081 6 -0.095 -0.115 12.721 0.048 7 0.036 0.019 13.138 0.069 8 0.059 0.046 14.267 0.075 9 -0.088 -0.079 16.789 0.052 10 -0.086 -0.095 19.225 0.037 11 0.070 0.034 20.828 0.035 12 0.038 0.025 21.299 0.046 13 0.165 0.197 30.388 0.004 14 -0.093 -0.045 33.293 0.003 15 0.097 0.054 36.468 0.002 16 0.087 0.125 39.024 0.001 17 0.034 0.068 39.416 0.002 18 -0.211 -0.163 54.562 0.000 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 220 18161412108642 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 lag a ut oc or re la ti on autocorrelation function for c1 (with 5% significance limits for the autocorrelations) figure 1 18161412108642 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 lag pa rt ia l a ut oc or re la ti on partial autocorrelation function for c1 (with 5% significance limits for the partial autocorrelations) figure 2 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 221 the results of the test presented in table-3 that q-statistics are significant at almost all lags, indicating significant serial correlation in the residuals and the null hypothesis of weak-form market efficiency is rejected. it confirms the presence of autocorrelation in the indian stock market and macro economic variables, which implies that the market does not follow random walk and fell into a form of efficient market hypothesis. however, the theory of stock market behaviour and anomalies presents evidence against the emh. the study here suggests that market rationally process information so that market efficiency holds but significant autocorrelation may arises from market friction. it indicates that market frictions may be due to dependence on weekly returns of macroeconomic variables. table 4. breusch-godfrey serial correlation lm test f-statistic 9.271466 probability 0.000000 obs*r-squared 34.16653 probability 0.000001 breusch-godfrey serial correlation lm test is presented in table 4 and the test rejects the hypothesis of no serial correlation. the q-statistic and the lm test both indicate that the residuals are serially correlated and presence of efficient at the weak-form. table 5. unit root test variable adf test df-gls test pp test kpss test ng-perron test bse sensex -19.69002* -19.68534* -19.97884* 0.157864* 0.05629* bse trading volume -13.14690* -13.12342* -22.94935* 0.048900* 0.03122* 91-day treasury bill -10.86672* -16.99582* -37.41525* 0.322414* 0.05055* s&p 500 return -19.13845* -19.12985* -19.13375* 0.570382* 0.05604* exchange rate -18.85006* -18.87945* -18.82371* 0.082894* 0.05635* wpi -17.74962* -17.75305* -17.74960* 0.184215* 0.05625* asymptotic critical values* 1% level -3.458973 -2.572277 -3.458470 0.739000 0.17400 5% level -2.874029 -1.941827 -2.873809 0.463000 0.23300 10% level -2.573502 -1.616030 -2.573384 0.347000 0.27500 the study here employs the unit root test to examine the time series properties of concerned variables. unit root test describes whether a series is stationary or non-stationary. for the test of unit root the present study employees the augmented dickey fuller test, df-gls test, pp test, kpss test and ng-perron test. these tests are used to measure the stationarity of time series data which in turn tells whether regression can be done on the data or not. it is apparent from table-5 that the results are statistically significant and less than critical values. so the results of all tests are consistent suggesting that these markets are not weak form efficient. it recommends that the return series of all variable does not follow random walk model and the stock returns display predictable behaviour. on observing the outputs it is seen that the test statistic for all 6 variables are less than the critical values at 1%, 5% and 10% confidence level. so, the null hypothesis is rejected and asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 222 the data is found to be stationary. therefore, we can apply granger causality test which requires the data to be stationary in order to avoid getting spurious results. table 6. granger causality test null hypothesis: f-statistic probability bse volume does not granger cause bse sensex bse sensex does not granger cause bse volume 17.1176* 0.42798 8.9e-08 0.65221 91-day treasury bill rate does not granger cause bse sensex bse return does not granger cause 91-day treasury bill rate 2.64972** 4.89076* 0.07227 0.00811 s&p 500 return does not granger cause bse sensex bse sensex does not granger cause s&p 500 return 35.6953* 1.66070 1.1e-14 0.19169 exchange rate does not granger cause bse sensex bse sensex does not granger cause exchange rate 7.52360* 4.23873* 0.00064 0.01527 wpi does not granger cause bse sensex bse sensex does not granger cause wpi 6.78080* 1.43551 0.00131 0.23957 91-day treasury bill rate does not granger cause bse volume bse volume does not granger cause 91-day treasury bill rate 3.41154** 0.97177 0.03423 0.37956 s&p 500 return does not granger cause bse volume bse volume does not granger cause s&p 500 return 4.17823* 3.24498** 0.01620 0.04030 exchange rate does not granger cause bse volume bse volume does not granger cause exchange rate 7.36818* 16.7148* 0.00075 1.3e-07 wpi does not granger cause bse volume bse volume does not granger cause wpi 0.22436 2.10149 0.79916 0.12401 s&p 500 return does not granger cause 91-day treasury bill rate 91-day treasury bill rate does not granger cause s&p 500 return 7.47631* 0.26556 0.00067 0.76695 exchange rate does not granger cause 91-day treasury bill rate 91-day treasury bill rate does not granger cause exchange rate 0.35730 2.17326 0.69985 0.11554 wpi does not granger cause 91-day treasury bill rate 91-day treasury bill rate does not granger cause wpi 0.95018 0.31551 0.38780 0.72965 exchange rate does not granger cause s&p 500 return s&p 500 return does not granger cause exchange rate 1.59432 11.7473* 0.20471 1.2e-05 wpi does not granger cause s&p 500 return s&p 500 return does not granger cause wpi 1.88505 3.99548* 0.15356 0.01935 wpi does not granger cause exchange rate exchange rate does not granger cause wpi 7.00005* 1.01244 0.00106 0.36453 * null hypothesis rejected at 1% significance level **null hypothesis rejected at 5% significance level *** null hypothesis rejected at 10% significance level the granger-causality test is conducted to study the causal relationship between macro economic variables and the indian stock market. table-6 reported pair wise granger causality test results with lags 2 as two lag is an appropriate lag order chooses in terms of the akaike information criteria (aic) for the full sample period. bse trading volume, treasury bill rate, asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e13 www.macrothink.org/ajfa 223 s&p 500, exchange rate, and wpi are found to be the most important variable in determining stock market return. the reported f-values suggests that there is a unidirectional causality between trading volume and stock market, international stock market and domestic stock market, inflation rate and stock market, interest rate and trading volume, international stock market and interest rate, international stock market and exchange rate, international stock market and inflation rate, inflation rate and exchange rate. this implies that international market influence the domestic stock market, exchange rate, inflation rate and interest rate. apart of this, any changes in trading volume and inflation rate also affecting stock market. it is also found from the table-6 that there is bidirectional relationship between interest rate and stock market, exchange rate and stock market, international stock market and bse volume, exchange rate and bse volume. so it suggests that exchange rate and interest rate are influencing the stock market and any variation in stock market also influencing the exchange rate and interest rate in the economy. also it is experimented that variability of international market and exchange rate is affecting trading volume changes in the stock market. again it is observed from the table-6 that there is no apparent causality between inflation rate and trading volume, interest rate and exchange rate, interest rate and inflation rate. 9. concluding observation this study examines the relationship between the stock market and a set of macroeconomic variables during the period of january 2005 to february 2011. the time series data set employed in this study comprises the weekly observations of the bse sensex, wpi, treasury bill rate, exchange rate, s&p 500 and bse trading volume. the study used ljung-box q statistics and breusch-godfrey serial correlation lm test to determine the auto correlation of all variables. the study confirms the presence of autocorrelation in the indian stock market and macro economic variables. the study also used the granger causality test to determine the causal effect relationship between the bse sensex with macro economic variables. statistical inferences are drawn from the data by means of significance tests and bidirectional causality is seen between inflation rate and stock market, exchange rate and stock market, interest rate and stock market, international stock market and bse volume, exchange rate and bse volume. similarly unidirectional causality is found between international stock market and domestic stock market, international stock market and exchange rate, international stock market and inflation rate, international stock market and interest rate. so the study suggests that indian stock market is influenced by inflation rate, exchange rate and interest rate in the economy. so they can be used to predict stock market price fluctuations. the study also found that variability of international market and exchange rate is affecting trading volume change in the stock market in the economy. further the study reveals that indian stock markets are not weak form efficient. so it implies that the sensible investor in india can attain abnormal returns using historical data of stock prices, and macroeconomic indicators. this may enable the traders and investors to work out profitable strategy for trading or to take investment 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(2002). stock market and macroeconomic fundamental dynamic interactions: asean-5 countries. journal of asian economics, 13: 27-51 http://dx.doi.org/10.1016/s1049-0078(01)00111-7   search | asian journal of finance & accounting skip to main content skip to main navigation menu skip to site footer asian journal of finance & accounting current archives for authors submissions author guidelines pay article processing charge ethical guidelines for reviewers editorial team recruitment reviewers publication policies announcements about about the journal privacy statement contact search search register login home / search search search articles for advanced filters published after 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 january february march april may june july august september october november december 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 published before 2009 2010 2011 2012 2013 2014 2015 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copyright © macrothink institute   to make sure that you can receive messages from us, please add the 'macrothink.org' domain to your e-mail 'safe list'. if you do not receive e-mail in your 'inbox', check your 'bulk mail' or 'junk mail' folders. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 1 benchmarking the first year accounting unit: evidence from australia nick sciulli centre for tourism and services research (ctsr) school of accounting, victoria university po box 14428, mcmc 8001, melbourne, australia tel: (03) 9919 4424 e-mail: nick.sciulli@vu.edu.au malcolm smith school of accounting, finance and economics, edith cowan university 270 joondalup drive joondalup wa 6027, perth, australia tel: (08) 6304 5263 e-mail: malcolm.smith@ecu.edu.au phil ross school of accounting, university of western sydney locked bag 1797 penrith south, nsw 1797 tel: (02) 9685-9451 e-mail: p.ross@uws.edu.au abstract this paper compares some key organisational attributes of three accounting schools located at australian universities. in addition, the content, structure and presentation of the first-year accounting unit is examined with a view to identifying best practices. three australian universities – one each from western australia, victoria and new south wales collaborated on this project. the heads of the respective schools supplied relevant data for school comparison purposes and a workshop meeting between the first year accounting unit co-ordinators provided data for a content analysis of their subject guides. the three schools had similar issues to manage. they include an aging staff profile, high use of casual academic staff and large student numbers across different campuses. unsurprisingly, given the need for accreditation from professional accounting bodies, the content of the courses was very similar. however, there were significant differences in delivery and assessment, with potential implications for subject quality and resource use. the size and characteristics of the three universities investigated for this project do not reflect the profile of all accounting schools in australia. the results of this benchmarking comparison has prompted managers to be aware of several critical issues identified to take appropriate action to remedy them. the authors are unaware of any previous benchmarking study comparing accounting schools at australian universities and the findings can lead to better teaching and learning outcomes for first year accounting students. keywords: benchmarking, universities, accounting courses jel classifications: m41, m40 and m49 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 2 1. introduction the benchmarking project which forms the basis of this paper was initiated by the business school deans from the three participating universities – one each from western australia, victoria and new south wales (nsw). the driving force for the initiative was the need to respond to recommendations from the australian universities quality agency (auqa) that universities undertake benchmarking as part of the quality assurance processes in their organisations. the main objective of this project was to compare the content, structure and operations of a large first year unit common to each institution. further, data comparing academic staff and student demographics of the three schools of accounting would also be compared. the analysis was directed specifically towards two outcomes: (a) indicating current best practice to provide the basis for improvement opportunities at each university, and (b) confirming that appropriate standards were being applied by each university. the unit chosen for detailed analysis at each institution was the first year introductory accounting unit that was compulsory for all students undertaking an undergraduate business major. the heads of school of accounting of the three participating universities met in july 2008 and established broad areas for detailed analysis and comparison for the accounting units. the major inputs into the comparative process were conducted via email, with source documents circulated among the interested parties. detailed analysis of the data was undertaken in face to face meetings in september and october 2008, attended by the heads of school and the co-ordinators of the first year accounting units. detailed findings, and recommendations for future action, were reported to the respective business deans in november 2008. the paper details differences across the three universities – designated as case 1, case 2 and case 3. these differences occurred in areas of staff and student demographics, course content, course delivery and course assessment. the paper concludes with recommendations which may be applicable to heads of schools and colleagues in other disciplines as well as to university managers and policy makers. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 3 2. literature review benchmarking is a process for identifying and implementing best practice at a particular point in time. there is currently a considerable volume of research on this management technique as highlighted by the work of dattakumar and jagadeesh (2003) in their review of the benchmarking literature. it is equally applicable to the private sector (see kouzmin et al. 1999; punniyamoorthy & murali 2008) and to the public sector (see for example, vagnoni and maran 2008; wynn-williams 2005). it is a tool that is used to identify best-practice and also, more importantly to gain an understanding of what processes are being utilised to achieve best practice. thus, it is a system where best practices are identified and then, adopted by the organisation seeking to improve its activities. it has been used (most likely, incorrectly), interchangeably with terms such as business process engineering, total quality management and key performance indicators (kpis) (alstete 2008). bowerman et al (2002) makes a distinction between voluntary benchmarking which has an emphasis on continual improvement and defensive benchmarking which may seek to prove to an external authority that the organisation is not the worst performer. alternatively, defensive benchmarking could be used to argue for more resources and/or prove to an audit authority that a recognised management technique is being utilised for improvement purposes. in fact in 2001 the uk government went as far as establishing the public sector benchmarking service (psbs) to encourage public sector agencies to adopt this management tool. andersen, henriksen and spjelkavik (2008) suggest that the principal-agent theoretical framework can be applicable to benchmarking in the public sector context. in particular, benchmarking can be used to expose good or bad performance to the public with the objective of influencing the behaviour of both the agent and the agent‟s constituency, in this case, the students. hence, students can then freely move to „good‟ performing universities based in part, on the results of the benchmarking investigation. a study conducted by magd and curry (2003) suggested that benchmarking is a key tool to use to achieve the goal of „best value‟. best value (bv) is a government initiative which replaced compulsory competitive tendering (cct) in the local government sector. bv encourages local councils to form effective partnerships with the private sector and conferred a legal duty to provide value-for-money to users of their services. investigating five (5) separate public sector case studies, magd and curry (2003) concluded that benchmarking could be used to assist the achievement of bv but that one significant barrier to its use was that benchmarking was viewed as setting up antagonistic competition between public sector providers of similar services. benchmarking is not a new technique to the university sector. in fact, comparisons of university performance based on teaching, research and student satisfaction are well documented and marketed as a tool for ensuring prospective students have access to data that can lead to informed choices regarding the selection of a suitable course of study. pursglove and simpson (2007) benchmarked the performance of english universities by dividing the universities into the russell group (research-oriented universities) and the post-1992 universities. they found that the post-1992 universities were more effective and efficient than the russell group members, contrary to the ranking of these universities published in league tables. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 4 accounting courses in australia are subjected to various external regulatory and internal oversight to ensure that they meet the requirements of various stakeholders. internal mechanisms include that university policies and procedures are adhered to, thus permitting academic boards/councils to approve courses brought to their attention. a powerful external compliance requirement is the need for universities to attain professional accreditation from the two professional accounting bodies in australia, namely, cpa australia and the institute of chartered accountants of australia (icaa). it has been argued that professional body accreditation has led to a reduction in the scope and flexibility for the delivery of accounting courses in australia (mathews 2004). understanding clearly what the issues are regarding the teaching of a first year accounting unit is an important topic for academics, students and prospective employers. jones and sin (2005) found that almost a third of accounting students rated communication skills highly but that more of the non-accounting students placed communication skills first. these authors argue that unit course outlines need to incorporate generic/communication skills into ongoing student assessment. similarly, morgan (1997) found that practioners assigned a high importance to oral communication skills of active listening, constructive participation in meetings and one-to-one communication. one of the project aims for this investigation is to identify what and how students are assessed in their first year accounting unit. in a uk study, lucas (2003) surveyed 250 000 accounting students. she found that the variety of accounting students studying introductory accounting caused problems, because academic staff found it problematic to change their teaching styles to teach masses of students with different entry levels. some of the different characteristics of students included that english was not their first language, age, ethnic group, gender, socio-economic status and students from non-traditional backgrounds (lyons 2006). given this diverse student population, malgwi (2006) surveyed 796 students at one university in the usa to ascertain whether there was merit in providing separate courses to students on the basis of whether they were intending to undertake an accounting major. the findings revealed a significant difference in the interest levels prior to, and after, undertaking the course. that is, the students undertaking a major in accounting showed more interest and confidence in taking their exams than non-accounting major students, suggesting that a separate stream should be considered. this conclusion is supported by the findings of byrne and flood (2008) of a positive association between academic performance and prior academic achievement and prior knowledge of accounting. there remain gaps in the literature regarding specific staffing issues, such as the aging of the academic workforce and the capacity for future student research supervision. in addition, the changing landscape of the measurement of research performance will affect accounting academics. an assessment of the current state of these particular themes would be useful for departmental and university managers in addressing any required changes to policies and/or procedures. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 5 3. method as a consequence of the recommendations of auqa, the business school deans of three australian universities decided to benchmark a large undergraduate unit. this would form the basis of future benchmarking exercises across different schools within the business faculty. to allow for valid comparisons, the three universities chosen were all post-dawkins universities in that they were not established research oriented universities, but rather each had a history as a teaching university. the first year accounting unit was chosen for the first benchmarking exercise because: it was the largest subject offered at each location the unit involved the use of a large number of full-time and casual staff compared with other disciplines, and the students enrolled in the subject comprised a diverse group which included full-time and part-time students, school leavers and mature-age students, local and international students and, students enrolled to gain a major in accounting whilst other students were intending to specialise in other disciplines. the three heads of schools had some freedom in choosing what areas would be benchmarked. after numerous e-mail contacts and telephone conversations it was decided to benchmark the following areas: 1 accounting staff demographics 2 first year student accounting demographics, and 3 first year accounting unit. the rationale for selecting these three areas was that each of the schools had readily accessible data with which to make comparisons and that any changes made to the first year accounting unit could be used as a catalyst for relevant changes to other business units. . data for the accounting staff demographics were more difficult to obtain partly because the source data were scattered across various sections of the school, faculty, and held centrally by the university. moreover, the data were not presented in a form that was tailored for easy comparisons with other accounting schools at other universities. for the staff demographics, source data were obtained from information held within the office of the head of school, as well as information collected from the human resources department. direct contact was made with other academic school staff where clarifications were required and where recently employed staff did not have all of their previous academic history recorded electronically by the respective school. the first year accounting student demographics data were collected from the faculty and cross-referenced with school data for accuracy. the first year accounting unit subject guide was used as the basis for a comparison of this subject across the three universities. moreover, a workshop was scheduled at one of the universities where the first-year accounting unit co-ordinators identified challenges in administering the unit, identified any major differences in unit content and how the assessment tasks differed. the data were then tabulated in a spreadsheet format to allow for easy asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 6 comparison between the three universities. 4. findings and discussion 4.1 accounting staff demographics in terms of staff numbers, case 1‟s accounting discipline has approximately one third the staff of case 3 and case 2 – numbers consistent with the size of their respective student enrolments. both case 1 and case 2 had relatively high numbers of male staff (64% and 76% respectively), whereas case 3 had 53% of its staff as female. the majority of staff are employed at lecturer or associate lecture levels (case 1 55%; case 3 83%; case 2 76%). all three universities had very low numbers of staff at the associate professor and professor level. case 3 did not have any staff at these senior levels. the age profile of accounting academic staff (see table 1) showed case 3 to be the only employer of staff in the 20-29 age group, though this only accounted for 8% of its total staffing. all universities in the study had difficulty in recruiting and retaining younger people for a career in academia. this reflected the requirement that prospective employees should have a higher degree qualifications (ideally a phd) before being considered appointable. it is interesting to note that 46% of staff at case 1 are in the 60+ age bracket and 56% of staff at case 3 are in the 50-59 age bracket. these profiles will need to be monitored carefully across the sector as more staff move into retirement or elect to take an early voluntary retirement package. understanding staffing demographics is important with respect to all accounting subjects, but perhaps even more so to introductory accounting. that is because of the high use of sessional teaching staff in the first year accounting unit and the difficulty of attracting highly competent staff willing to co-ordinate such a large subject across various campus locations. table 1. age of permanent academic staff. case 1 case 2 case 3 number % number % number % age 20-29 0 0 0 0 3 8 30-39 1 9 7 24 2 6 40-49 3 27 11 38 10 28 50-59 2 18 9 31 20 56 60+ 5 46 2 7 1 2 total 11 100 29 100 36 100 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 7 staff demographics have significant implications for the research performance of the three participating universities. each of the three participating university departments has a high proportion of non-researchers in their accounting school: 86% for case 3, 36% for case 1 and 35% for case 2. recent literature such as (smith, whale & noronha, 2008) places all three universities in the bottom half of the rankings for australian schools of accounting. the benchmark data provide evidence to explain such a situation: a paucity of senior staff across all three institutions, with case 3 notable in having no appointments at professorial levels the absence of experienced researchers in senior positions to lead by example, and to mentor colleagues, is clearly apparent. while case 1 and case 2 both benefit from the publication activities of a small number of prolific individuals at a senior level, in their absence, case 3 performs relatively poorly, and since the supervision of higher degree by research candidates, particularly at doctoral level, is normally predominantly undertaken by those at professorial levels, then this impacts on higher degree research (hdr) completions across the three universities, with again, a relatively small number of individuals carrying out this activity. thus, senior positions appear to drive research performance and set the appropriate tone for the development of a research culture, and attract new research appointments. all three universities need to make senior appointments of research-active individuals if their research performance is to improve. the precarious age profile of case 1 also suggests that they need to appoint younger research-active staff. in this regard, table 2 highlights that case 2 is currently the stand-out performer, with a healthy cluster of young academics pursuing doctoral qualifications. however, if case 2, and to a lesser extent case 1 and case 3, are to hold on to their active, qualified researchers, then current perceptions of their being „feeders‟ for more established institutions in their states must change. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 8 table 2. number of active researchers in school of accounting, 2007. case 1 case 2 case 3 number % number % number % active/non researchers active researchers (enrolled in phd) 1 9 12 41 1 3 active researchers (not enrolled in phd) 6 55 7 24 4 11 non researchers 4 36 10 35 31 86 total 11 100 29 100 36 100 none of the three universities made significant use of contract staff, though between 22% and 31% of staff were employed on a sessional (casual) basis. although this percentage of sessional staff does not appear remarkably high, it may convert to a high number of sessional staff concentrated in one place. this proved to be the situation for both case 3 and case 2, with respectively 30 and 40 sessional staff commonly involved each semester in the teaching of their first-year accounting unit. these numbers have serious implications for students who require access to staff members for consultation, as well as for the timeliness of reporting between sessional and permanent staff, and ensuring consistency of presentation to students across the various sessional staff teaching across different campuses. in such situations the management of the unit becomes problematic as there was evidence from case 3 of the unit co-ordinator being forced to prepare and distribute detailed lesson plans to tutorial staff to maintain a semblance of consistency of delivery. disturbingly, some accounting subjects (though not accounting 1) were co-ordinated entirely by sessional staff, with implications for the management approaches necessary to ensure appropriate levels of teaching and learning outcomes. a significant difference existed in the proportions of mature age students, relative to school leavers, in the student cohort of accounting students. in case 1, 80% of students were mature-age compared with 48% for case 3 and 42% for case 2. given the national trend of a declining percentage of school leavers undertaking a higher education qualification, these statistics indicate that more resources may need to be directed towards this mature-age group to meet these challenges. 4.2 first year accounting demographics data from table 3 demonstrate that significant numbers of mature age students may be returning to formal study after an absence from a structured learning environment. the needs of these students may differ markedly from school leavers. careful management of this group would be required to minimise a asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 9 potential large attrition rate. conversely, there are significant potential benefits for students as a whole if the curriculum and teaching style harnesses the work/life experiences of this mature-age cohort. external students are very small in number throughout, but all universities had a significant proportion of mature-age students (relative to school leavers). these demographics in the first year unit indicate the complexity of teaching a first year unit since a significant number of students will not have english as their first language and an even larger proportion may be returning to study after a significant time lag. when combined with the problems referred to above with sessional staffing, notably lack of student access and absence of consistency, then language and confidence problems will likely pose additional pressures on the student cohort, affecting the confidence of the students and retention rates. table 3. number of mature-age students in first year accounting unit case 1 case 2 case 3 number % number % number % mature-age 98 38 577 62 516 44 school leaver 158 62 356 38 656 56 total students 256 100 933 * 100 1,172 100 * includes onshore students only. 4.3 course content: first year accounting unit the objectives and desired outcomes from each of the three courses are similar, with the major focus of each unit being in the areas of preparation and interpretation of basic financial information. all three units have a mix of financial accounting and management accounting with case 2 and case 3 spending three weeks on management accounting topics whilst case 1 spend only two weeks on this area. the remainder of the course focuses on topics related to financial accounting with some minor variations but significantly, none of the three courses focus on the concept of debits and credits. this reflects the fact that all three courses have been developed to cater to the needs of students who are accounting and non-accounting majors. all three universities had recognised the importance of inter-personal skills for business, and were addressing observed deficiencies in written and oral communications among the accounting student cohort. all had either begun, or were contemplating the introduction of „skills based‟ units into the accounting curriculum. at case 3 this was limited to a single unit, teaching students practical skills for library database searches, written communication, literature evaluation, and an appreciation of cultural and ethical issues. in case 2, the corresponding program provided three successive units which developed students‟ business knowledge, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 10 personal attributes and professional skills. the program for case 1 comprised consecutive units in each year of the degree. students were introduced to the concept of business, and were assisted in the acquisition of interpersonal and teamwork skills. thus, while in case 3, the skills course primarily focused on improving students‟ practical skills, those at case 1 and case 2 aimed to assist students to improve their leadership, assessment, decision-making and problem solving skills, in addition to practical business skills. while the course at case 1 was the most wide-ranging, it also had the most serious consequences for the structure of the business degree. because of the limited scope for elective units within the bachelor degree course, there was no longer a common core of introductory-level business subjects applicable to all business students. thus, while both case 2 and case 3 maintained a common-core, it was possible for a non-accounting major to graduate in business without ever having completed an accounting unit. (the same would be true, for example, of a non-marketing major –they need never have completed a marketing unit.) 4.4 delivery all three universities adopted a traditional „lecture + tutorial‟ format, with the lecture used to impart knowledge, and the tutorial having a workshop/seminar structure to follow up, clarify and provide practice exercises. all three universities had three hours of class contact per week over a 12 or 13-week semester to complete their introductory accounting unit. however, while both case 1 and case 2 had a two-hour lecture, with a one-hour tutorial, for case 3 it was the opposite: a one-hour lecture and two hours of tutorial. the latter might be regarded as superior for learning purposes, especially given trends in student attendance (currently around 60% for lectures and 95% for tutorials). however, this structure is much more resource intensive, especially given the large number of tutorials necessary to conduct the case 3 course. a cost-benefit evaluation of this alternative structure might be beneficial. 4.5 assessment the assessment structure for each unit was also similar with case 1 and case 2 having four assessment items while case 3 has five assessment items. the weightings assigned to the assessment items are also similar with the main exception being that case 3 has a final exam weighted at 45%, whereas both case 1 and case 2 have a final exam weighted at 60%. this difference is attributable (partly) to the fact that the final exam at case 3 covers only the second half of the course (i.e., after the mid-semester test) while for case 1 and case 2 all topics covered are examinable in the final exam. while assessment for all three universities comprised a summation of coursework and examinations, there were differences in how this structure was implemented. for case 2 there was no exam threshold; marks across different components were totaled without weighting for whether they were individual time-constrained assessments or team-based assignments. both case 3 and case 1, on the other hand, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 11 implemented examination thresholds – students had to achieve a grade on the final examination to pass the unit (45% for case 3 and 50% for case 1) as well as achieving a 50% overall mark. the use of supplementary examinations provided a further point of difference in the area of assessment. neither case 1 nor case 3 had any form of additional assessment for marginal failures, but case 2 had a non-discretionary supplementary examination for all failing candidates scoring more than 40% overall. the combination of these last two factors undoubtedly contributed to low overall fail grades in the unit at case 2 21% compared to those at case 3 (26%) and case 1(32%). there was also some evidence that the assessment (assignments and examination) in case 1‟s first accounting unit were of a more difficult standard than the equivalents at case 3 and case 2; this may contribute to the higher unit failure rates experienced at case 1. 5. concluding remarks the benchmarking exercise has provided the opportunity to observe and analyse the consistency and diversity of accounting offerings at three australian universities. the three participating universities are far from ideal for a benchmarking analysis due to differences in size, of staffing and student enrolments and departmental discipline focus. thus, the findings are difficult to generalise across the wider population. nonetheless they provide interesting observations which allow the specification of suggestions consistent with the objectives of the exercise. there are several issues where the problems faced by the three universities are common or similar: the age profile is either already precarious, or trending in that direction. urgent attention to succession planning is required; the proportion of senior staff (particularly at professorial level) is consistently small, with significant implications for leadership, mentoring and research performance. additional senior appointments, ideally of research-active staff, are required; the mix of students (i.e., mature-age/school leaver; local/international; major/non-accounting major) in core courses poses particular difficulties, which will impact on student satisfaction; the size of the first-year accounting unit required the use of sessional, rather than permanent staff occasionally to potentially dangerous levels. the implications for the staff co-ordination burden and the student experience should not be underestimated. for such large courses, administrative assistance must be made available to avoid staff stress and burn-out. conversely, there were significant differences in the way the first-year accounting unit was delivered. the content of the units looked similar, but deeper analysis revealed differences in both the depth and mode of delivery, most notably: asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 12 of the three universities only case 1 did not have a common-core of business units. non-accounting majors did not complete the first (compulsory) accounting unit, and correspondingly accounting majors did not necessarily complete first year management or marketing units; there were significant differences in the delivery of the first accounting unit. case 3 operated on a (1 + 2) lecture/tutorial hours split, while both case 1 and case 2 operated on a (2 + 1) split. while the former is more resource intensive, it may provide improved student learning outcomes; there were significant differences in assessment of the first accounting unit. both case 1 and case 3 instituted an exam-performance threshold, so that students with 50% overall only passed the unit if they achieved a specified mark in the exam. no such threshold existed at case 2; if the student accumulated 50% overall they passed the unit, irrespective of how poor their performance in the final examination. comparisons based on the numbers reported for student satisfaction with unit/teacher should be treated with caution, and are not detailed here, since they are based on different survey instruments. a future project might examine the development of a new instrument with common questions, in order to improve comparability. the impact of the introduction of business skills units was already having a significant impact on both course content and resource use at case 2 and case 1, though less so at case 3 where student numbers had caused particular delivery problems. the scope of these skills units suggests that they provide a benchmarking exercise of their own. on an administrative note, given that ranking systems for universities are in place worldwide for various purposes, then, the question of whether some universal ranking system for schools within a faculty would be a worthwhile debate. if this system were implemented then, database and reporting mechanisms across universities would need to be homogenised to allow for accurate and relevant comparisons. 5.1 limitations of this study as stated earlier, generalisations across the whole australian university sector are difficult to make given that this project investigated data from only three universities. in addition, there are many more management practices that are conducted in a department/school of accounting that have not been subjected to benchmarking for this project. for example, a comparison of the incentive schemes for research activity across universities would also be a useful exercise to undertake. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 13 5.1.1 future research this project was essentially a “pilot-test” for further benchmarking exercises across different disciplines within the business faculties. it is expected that with refinements and improvements to the procedures used in this current project, that future assignments will provide further valid comparisons to ultimately improve student and staff outcomes. with the introduction of the excellence for research australia (era) initiative by the rudd government, further opportunities will become available to explore to what extent accounting schools research performance will compare in the australian university sector. it is also important to note the political ramifications of further benchmarking projects. although the current investigation was undertaken in a harmonious fashion, this may not be the case if different universities or different disciplines were benchmarked. collaboration and openness amongst participants are key ingredients for a successful benchmarking exercise. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 14 references alstete, j.w. 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(2003). benchmarking:achieving best value in public-sector organisations. benchmarking: an international journal, 10:3, pp.261-286. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e1 www.macrothink.org/ajfa 15 malgwi, c.a. (2006). discerning accounting and non-accounting students‟ perceptions in the first course in accounting as a proxy for separate course delivery. global perspectives on accounting education, 3:1, pp. 67-91. mathews, m.r. (2004). accounting curricula: does professional accreditation lead to uniformity within australian bachelor‟s degree programmes? accounting education, 13:1, pp. 7189. morgan, g. j. (1997). communication skills required by accounting graduates: practioner and academic perceptions. accounting education, 6:2, pp. 93-107. punniyamoorthy, m. and murali, r. (2008). balanced score for the balanced scorecard: a benchmarking tool. benchmarking: an international journal, 15:4, pp. 420-443. pursglove, j. and simpson, m. (2007). benchmarking the performance of english universities. benchmarking: an international journal, 14:1, pp. 102-122. smith, m., whale, j. & noronha, a. (2008). accounting for journals. charter, may, pp. 20-22. vagnoni, e. and maran, l. (2008). public sector benchmarking: an application to italian health district activity plans. benchmarking: an international journal, 15:3, pp. 193-211. wynn-williams, k.l.h. (2005). performance assessment and benchmarking in the public sector. an example from new zealand. benchmarking: an international journal, 12:5, pp.482-492. microsoft word 469-3514-1-pb asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 55 price and volume effects associated with index additions: evidence from the indian stock market srikanth parthasarathy research scholar, loyola institute of business administration university of madras (chennai) loyola college, nungambakkam, chennai-34, india tel: 91 – 909-413-5843 e-mail: psrikanth2011@gmail.com received: 2010-09-16 accepted: 2011-05-18 doi:10.5296/ajfa.v2i2.469 abstract this study investigates the price and volume effect of index additions to the benchmark nifty index for the recent period 1999-2010 in the indian stock market. this study evidences significant, positive permanent abnormal returns around index announcement and inclusion. the support for permanent abnormal volume around index additions is limited at best. the results in this study do not support either the downward sloping demand curve hypothesis or the price pressure hypothesis as the primary explanation for the index inclusion effect. this study contributes to the growing literature on index inclusion by providing evidence that stock addition to the benchmark nifty index appears to convey information. keywords: indian equity market, nifty index additions, abnormal return and volume, jel classification: g14, g15. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 56 introduction in the past decades, numerous studies have documented the ‘index effects’ associated with stock index changes predominantly in the developed markets. the included stocks experience a significant increase in prices after the announcement and further rise around the actual inclusion. though some of the gain is lost after inclusion, a permanent increase in return is predominantly evidenced over a period of time. trading volumes also increase significantly around announcement and inclusion in the developed markets. the findings are not consistent with market efficiency as index changes are made with apparently made with readily available public information, the slow multiple day price adjustments and volume effects around the stock index changes directly questions the validity of semi-strong efficiency which requires all publicly available information to be reflected in the stock prices quickly. researchers have forwarded various hypotheses to explain the index effects. they are broadly classified into two groups based on their assumption of information content. the first group assumes that the index changes does not convey any information and have attributed the change in price to non-flat demand curve rather than change in fundamental value. in an ideal capital asset pricing model (capm) world, stock prices depend on the return – risk characteristics. in an information free event, the demand curve will be horizontal as the investors can alter their portfolio using near-perfect substitutes to reflect their return-risk profile. if perfect substitutes are not available, then a shock leads to a permanent stock price change as investors expect compensation in order to rebalance their portfolios. an index changes creates excess demand which cannot be satisfied without a shift in the demand curve as stocks are not perfect substitutes (shiefler, 1986). hence the abnormal returns around the inclusions are explained by the changes in the aggregate demand of the stocks due to lack of perfect substitutability and hence downward sloping demand curve. price pressure hypothesis (harris and gurel, 1986) too assumes lack of information in index changes and posits downward sloping demand curve but only in the short term. according to this hypothesis, excess demand due to the indexing and institutional investor activity creates price pressure and reverses once the temporary excess demand is satisfied. the second group of explanations assumes that index changes convey information about the stocks. the index inclusion has an impact on the fundamental value of the stock thereby in the present value of the discounted cash flow. this can work through two ways, namely the expected cash flow or the discount rate. the explanations for increase in cash flow may be the certification hypothesis supported by dhillon and johnson (1991), jain(1987), in which the stocks inclusion to the nifty index may convey positive information regarding the future prospects of the company. denis et al. (2003) and chen et al (2004) support the investor awareness hypothesis which postulates that following index inclusions, investors change the expectation of future cash flow of the stocks as the firms perform better due to enhanced monitoring by analysts and investors. the explanations for decrease in the discount rate are liquidity hypothesis, (amihud and mendelson (1986) and chordia and subrahmanyam (1998)) according to which liquidity and expected returns are negatively related. chen et al (2004) states that greater interest for the asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 57 index stocks causes greater information production. this induces a reduction in the information asymmetry and causes increased liquidity. if some investors know only a subset of stocks and trade only those stocks then those investors will require a premium called the ‘shadow cost’ for the non-systematic risk (merton,1987). there are few studies in the emerging markets like india on index changes. the importance of these studies in the indian stock market can be appreciated based on the fact that the indian equity market stood 13th in the world and 4th in asia in terms of both traded value ($ 1050 bn during 2008) and market capitalisation ($ 645 bn at the year end)1 in 2008. the increasing international portfolio investment and participation provides a perfect platform for gathering information about the market structure, efficiency and evidence of the integration mechanism with the developed markets. the indian stock market differs from the developed markets in the following ways; the indian stock market1 is characterized by less informational efficiency, higher costs, smaller investor base and lower liquidity compared with the stock markets of developed countries. finally, unlike the developed markets, there may be drastic difference in the quality of assets between benchmark index and other index stocks. this is truer for the foreign investors’ as local factors affect pricing significantly. this study attempts to enter the debate by studying index inclusion effect in the nifty index, premier benchmark index in the indian stock market by focusing on the abnormal return, volume and liquidity around two event dates namely ‘announcement date’(ad) and the ’effective date’(ed). the purpose of this study is twofold: whether abnormal returns are permanent and whether nifty index changes convey information. this study expects index addition to cause significant permanent abnormal return for the added stocks and enters the debate by positing that the information explanation might explain the index inclusions better in emerging market like india. this study makes two contributions to the growing index inclusion literature. first, it tests the nifty index additions, premier index of the indian stock market in the current period. also very few papers have focused on the information aspect in the emerging markets. the second section details the theoretical explanations and literature review for the index inclusion effect. the third section details the ‘nifty’ index selection process and methodology. the fourth section gives the findings and analysis and the fifth section concludes. 2. review of literature the literature analyzing the price and volume effects of index changes is ever growing. the existing literature is grouped as per the explanations with the studies supporting information free hypothesis given first. shiefler (1986) studying changes to the s&p 500 index for the period 1976-1983 documented a permanent 2.37% abnormal return and suggested dsdc 1 chakrabarti(2002) and hacibedel(2008) have discussed the differences between developed and emerging markets extensively. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 58 hypothesis as the reason. lynch and mendenhall (1997) studying s&p 500 changes for the period 1990-1995 documents significant abnormal return subsequent to the announcement. they evidenced part reversal consistent with both price pressure and dsdc hypothesis. wurgler and zhuravskaya (2002) based on the difficulty to arbitrage in the absence of perfect substitutes examined the announcement returns relative to a arbitrage measure and found support for dsdc hypothesis. harris and gurel (1986) studying s&p 500 index additions for the period 1976-1983 documented 3.13% abnormal return and found a systematic reversal of initial abnormal return in support of price pressure hypothesis. elliot and warr (2003) also find support for price pressure but only around the inclusion date. mase (2002) studying ftse 100 inclusion effects for the period 1992 – 1999 find support for the price pressure hypothesis. studies have generally supported partial price pressure in the developed markets. there are studies supporting information – free assumption on the index addition induced comovement2 between the return of the included stocks and the index. vijh (1994) evidences significant comovement for s&p 500 additions and supports index fund trading as major cause. barberis, shliefer and wurgler (2005) differentiate between the traditional view of frictionless markets3 and non frictionless markets. in a frictionless market comovement in stocks implies comovement in the fundamentals and the prices may reflect the information more quickly compared to other stocks. in a non frictionless market, comovement between added stocks may be due to category based trading and habitat based trading supporting the information-free assumption. they have suggested that for the friction based comovement, beta of the added stocks would be stronger in the latest data with the increase in institutional investor activity. the evidence in favour of the information explanations are, dhillon and johnson(1991), jain(1987) studying the inclusion effects of s&p 500 found evidence for the certification hypothesis. denis et al. (2003) postulate that following index inclusions, investors change the expectation of future cash flow of the stocks as the firms perform better due to enhanced monitoring by analysts and investors. chen et al (2004) examined the s&p 500 index changes for the period 1976 – 2000. he concludes that investor awareness is the primary reason for the s&p 500 index inclusion effect and greater interest for the index stocks induces a reduction in information asymmetry due to increased information production which results in increased liquidity. bhenish and whaley (1996) studying s&p 500 inclusions for the period 1986-1994 evidence increased trading volume. hradzil (2009) studying s&p 500 stocks find little evidence for the dsdc hypothesis and finds support for the liquidity and information hypothesis. some of the recent researches in the developed markets seem to support investor awareness hypothesis. burcu hadicebel (2008) and chakrabarti (2002) studying the inclusion of stocks from the emerging markets to the global msci index evidence permanent increase in price and volume and that index inclusion convey information. kumar (2005) studying 2 barberis et al(2002) defines comovement as a pattern of positive correlation. in this study comovement of stock return of the included stock and the index return is discussed. 3 ideal trading environment that imposes no costs or restraints on transactions. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 59 nifty index additions in the indian stock market for the period 1998 2003 did not find any significant index effects around announcement date and evidenced 1.47% effective date (ed) abnormal return. li and sadeghi (2009) analysed the chinese index additions have evidenced permanent abnormal returns and increased liquidity post inclusion. they have also found support for information based explanations for the index additions in the chinese stock market. 3. data and back ground information 3.1 the nifty information the s&p cnx nifty (nifty hereafter) is the headline index on the national stock exchange (nse) maintained by the india index services and products ltd.(iisl) since the year 1996. previously the index was managed by crisil. it represents a portfolio of 50 large and most liquid stocks of the nse and captures nearly 65% of the total market capitalization as on december 2009. the main criteria of selection of stocks for the nifty index are market capitalization, float, liquidity and industry representation. the index is normally reviewed every six months and six weeks’ notice is normally given to the market before the change is effected. index removal is normally effected due to corporate actions like restructuring etc. and when market capitalisation of an index stock falls below 50% of the market capitalisation of the top most stock of the replacement pool. 3.2 sample selection: the sample period for this study is 1999 2010 to coincide for the start of index funds in india. the details regarding both announcement date (ad) and effective date (ed) are available only from 1998. the daily data from www.nse-india.com is used to calculate daily return and daily volume of the added stocks and nifty index. appendix 3 displays the frequency of trading days between index addition announcement date (ad) and the index inclusion date (ed) for the stocks included in the nifty index between 19992010. the following stocks are not considered. a) stocks arising out of corporate restructuring are not considered. b) stocks which do not have trading history for at least six months prior to the announcement date. c) stocks which do not have at least 5 clear trading days between announcement and effective date are not considered. the total nifty index additions are 54 for the 1999-2010 period. the total number of stocks available for research after the elimination is 38. appendix 1 lists all the included stocks available for research. even though the sample is small, it comprehensively covers the recent 11 year period in the indian stock market. the sample is separated into two periods namely, 1999 2006 and 2007 – 2010. the latter period is marked by increased institutional activity and participation and represents the current market activity. 3.3 abnormal returns the index inclusion effect is analyzed by studying the abnormal returns around the asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 60 announcement date (ad) and effective date (ed). the daily abnormal returns are calculated as the stocks excess return on day ‘t’ over the index return as in lynch and mendenhall(1998) wherein it is observed that more sophisticated models of abnormal return generation like single factor market model gives very similar results to the simple abnormal return of the stock over the index return. this study uses both cumulative abnormal return (car) and average abnormal return (aar). aar aggregated over the event window gives the car. conversely, the car divided by the number of days in the event window gives the aar. the car of a stock represents the ‘buy and hold’ return over the specific period as buy and hold returns are more relevant to the investors. the car of all the sample stocks are aggregated and averaged over the event window to calculate the overall car for the entire sample. daily return rt is calculated as rt = ln ( pt ) ln (pt-1) (1) where pt is the stock / nifty closing price at time t and pt-1 is the stock / nifty closing price at time t-1. abnormal return (arit) = rit rmt, (2) where rit is the stock return and rmt is the nifty index return on day ‘t’. 3.4 abnormal volume the volume effect is studied in the spirit of harris and gurel(1986) where volume ratio vr = (vit /vmt) ÷ (vi / vm) (3) where vit and vmt are the trading volumes of security i and the total nse respectively, and vi and vm are the average trading volumes of the security i and total nse for the period ad-70 through ad-10. the daily vr is averaged across the various event windows. the volume ratio4 should have a value of ‘one’ under null hypothesis. if in any event window vr is significantly greater than one then volume is said to be abnormal for that event window. 3.5 liquidity ratio amihud(2002) liquidity measure is used. liquidity ratio = volit / │rit │ ÷ voli / │ ri │ (4) where volit is the daily rupee volume and rit is the daily stock return. ‘voli / │ ri │’ is the average liquidity of the security i for the period ad-70 through ad-10. if in any event window the average liquidity ratio is significantly greater than one then liquidity is said to be abnormal for that event window. 4 volume in this study is the number of shares traded. the daily stock volume is standardised using the daily total nse market volume. the calculation of volume ratio takes into account the capitalization changes. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 61 3.6 the event and event windows in this study, the nifty index inclusions between 1999 -2010 are analyzed. the two important event dates are announcement date (ad or day ‘0’) and the effective date of inclusion(ed). the actual ad is the day following the announcement date (ad+1 or day ‘1’) as normally announcements regarding inclusion are made after trading hours and consequently the effects are reflected the next day of the announcement unlike the us market, the number of days between ad and ed varies between 5 to 31 trading days (mean is approximately 25 trading days, median is 27 days). in order to avoid the effect of other events vitiating the study of inclusion effects, the total event window starts 10 days before ad and ends 60 days after inclusion. the event windows are 1. anticipation window runs through ad-10 to ad. 2. ad window5 includes ad+1, ad+2, ad+3. 3. run up window covers the period ad+4 to ed-1. 4. ed is the actual inclusion date. 5. release window which runs from ed+1 to release ending day (lynch and mendenhall, 1997). 6. ed long run window running from ed to ed+60 7. finally, the long term effect window is studied between ed+30 to ed+60. according to lynch and mendenhall (1997), the release ending day is the day when the demand for the stocks reach the normal post change level ( ie. when the index demand ends and price release starts (price pressure ends)). the volume is estimated to have returned to the normal post inclusion level on the earliest day after the change day when the mean abnormal volume is lower than the average mean abnormal volume for all the days from that day through to ed +10. similar to other studies ‘price pressure hypothesis’ is analysed around ed as the index funds rebalance their portfolio around ed to avoid tracking error6. all the other explanations are studied around ad (lynch and mendenhall, 1997). 3.7 regressions firstly, regression with dummy variables7 is used to distinguish between the event days ad+1 abnormal return and ed abnormal return separately with that of other days. yi= β0 + β1 *zi + ε (5) where, zi is ‘1’ if ad+1 or ed and ‘0’ otherwise. β1 measures the difference in the 5 the rationale behind the choice of ad window as ad+1,ad+2,ad+3 is based on the criterion that both mean and median vr is greater than ‘1’. also for the ad window the number of stocks for which car >0 is more than 50%. neither ad nor ad+4 satisfies the above criterion 6 tracking error is the annualized standard deviation between the index fund and its target index 7 the use of this technique deviates from the past research on index additions. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 62 abnormal return between the event days and other days. secondly, the cross sectional regressions in the spirit of shliefer(1986) who regressed the day ‘1’ ad window abnormal return (abret car) and abnormal volume (abvol) to examine the relationship between abnormal return and abnormal volume as a significant slope co-efficient is consistent with downward sloping curves for the added stocks. ad window abret car = α + ψ * ad abvol (6) ad window abret car = α + ψ * ad abvol + µ * usvol (7) where, abret is the abnormal return, abvol is the abnormal volume and usvol is the usual volume( average vr from ad-10 to ad-1). another regression for examining the co-movement of the added stocks rit = α + β * rmt + εit (8) where, rit is stock return, rmt is the nifty index return on day ‘t’ and εit is a random variable with expected value of zero and assumed to be uncorrelated with rmt. the daily pre-event regression is run for the period ad-70 to ad-10. the daily post event regression is run for ed+10 to ed+70. the focus of interest is the difference βc which is calculated for each added stock by subtracting the preevent beta from the post event beta. 4. findings and analysis 4.1 analysis of abnormal return the abnormal return surrounding the event day ad is analysed in this section. table 1 presents the results of the event study during ad window and subsequent to ad window (excluding ad window) to test for reversion in the near term. it is seen that for the complete period 1999-2010, there is a 2.94% ad announcement return which is not only statistically significant at 1% level but also economically significant. the results for nifty inclusions for the period 1999 2010 in this regard are comparable to the developed markets in general and s&p 500 in particular. the ad window abnormal return for the sub-period 1999-2006 is 1.67% and for the sub-period 2007-2010, a statistically and also economically8 highly significant 5.11%. table 1 reports the share price behavior subsequent to the ad window. 8 economic significance in this study refers to risk adjusted return, which net of transaction cost, is significant, profitable in economic terms for a ‘buy and hold’ investor. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 63 table 1 test of permanent abnormal return subsequent to announcement of addition to nifty index for the period 1999-2010. cumulative abnormal return or buy-hold return date relative to ad window n = 38 1999 -2010 1999-2006 2007-2010 ad window or ad+1 to ad+3 car 2.94% 1.67% 5.11% day 1,2,3 t-stat 2.918 1.156 5.324 p-value 0.003*** 0.13 0.001*** ad + 4 to ad + 10 car 1.32% 2.11% -0.02% day 4 to day 10 t-stat 1.326 1.602 -0.019 p-value 0.096* 0.061 0.508 ad +11 to ad +20 car -1.87% -1.98% -1.69% day11 to day 20 t-stat -1.079 -0.790 -0.820 p-value 0.856 0.781 0.786 the sample includes all the nifty additions for the period 1999-2010 in the indian stock market. ‘ad’ is the announcement day. ‘ed’ is the actual date of inclusion. the cumulative abnormal return(car) measures the buy and hold returns for ad window and starting from the day after ad window to the dates mentioned. *, **, *** indicate significance that the observed mean is significantly greater than zero (one tailed t-test) at 10%, 5%, 1% level respectively. for the complete period, the cumulative abnormal return (car) for the periods ad + 3 to ad + 10 and ad+11 to ad+20 is 1.32% and -1.87% respectively. the negative car’s subsequent to ad is not only small but also statistically not significant for the complete period and sub-periods. the results shows that share prices do not fall significantly even after 20 days after ad. interestingly, it is seen that the overall car from ad+1 through ad+10 is 3.78% for the first sub-period and 5.09% for the second sub-period. the lower ad effect in the first period is somewhat compensated in the ad+3 to ad+10 window. however for the second sub-period the highly significant 5.11% abnormal return during ad window is followed by -0.02% in the ad+3 to ad+10 window. it appears that ‘ad effect’ took longer to take effect in the first sub period than in the recent sub-period (2007-2010). in order to analyze the total abnormal return, abnormal return starting from ad and including ad is analysed and displayed in table 2. these results test for the permanence of the ad gain by analysing whether the abnormal return falls substantially after ad in order to offset the ad gains. the results for the complete period 1999 -2010 show that the cumulative abnormal return is a statistically significant 4.70%, 4.63% and 7.01% after 30 days, 60 days and 70 days from ad respectively. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 64 table 2. test of permanent abnormal return subsequent to ad. car measures the buy and hold return from ad+1 or day’0’ to the indicated day. including ad window cumulative abnormal return or buy-hold return period 1999 -2010 1999-2006 2007-2010 ad window or ad+1 to ad+3 car 2.94% 1.67% 5.11% day1,2,3 t-stat 2.918 1.156 5.324 n=38 p-value 0.003*** 0.13 0.001*** ad+1 to ad + 30 car 4.70% 5.13% 4.01% day 1 to day 30 t-stat 2.271 1.681 1.793 p-value 0.015** 0.053* 0.048** ad+1 to ad + 60 car 4.63% 3.77% 6.09% day 1 to day 60 t-stat 1.316 0.786 1.207 p-value 0.098* 0.220 0.123* ad+1 to ad + 70 car 7.01% 6.62% 7.55% day 1 to day 70 t-stat 1.782 1.210 1.486 p-value 0.041** 0.114 0.085* the sample includes all the nifty additions for the period 1999-2010 in the indian stock market. ‘ad’ is the announcement day. ‘ed’ is the actual date of inclusion. *, **, *** indicate significance that the observed mean is significantly greater than zero (one tailed t-test) at 10%, 5%, 1% level respectively. the result is considered permanent in this study if it is permanent for at least 60 trading days (which is roughly three months) from the event date. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 65 figure 1. the mean cumulative abnormal return of the stocks included in the nifty index between 1999-2010.this represents the buy and hold return from day 0 to day t. the x-axis represents the mean car and the y-axis represents the number of days from ad. the results in table 1 and table 2 support the permanent nature of the ad price effects following nifty additions. shiefler (1986) points out that as one moves from ad, the standard error of the cumulative return rises. consequently though the cumulative abnormal return continues to rise and remains economically very significant (see figure-1), it is not statistically significant in a few cases. hence it can be concluded that the abnormal returns are permanent, increasing and statistically significant even after 70 days from ad for nifty inclusions between 1999 and 2010. similar conclusion can be made for the both the sub periods with the recent sub-period displaying increased index addition effect. as the indian stock market becomes broad based, it appears that ad effect becomes more prominent. the above results evidencing permanent abnormal return following ad are similar to many studies in the developed markets and emerging markets. 4.2 event windows the results for the event windows are tabulated in table 3. a significantly positive car for the anticipation window will imply anticipation and leakage of index change announcements. however the anticipation window car is negative (-1.93%) suggesting no evidence of anticipation prior to the announcement for the complete period 1999 – 2010. the results for both the sub-periods are also negative and statistically not significant. the run-up window car for the complete period is 0.2% which is both statistically and economically not significant at any level of significance. however the run-up car for the sub-periods presents a contrasting picture. the car for the 1999-2006 period and asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 66 2007-2010 period is 1.41% and -2.39% respectively and both are not statistically significant. according to lynch and mendenhall(1987), positive and significant run-up car is consistent with the dsdc hypothesis. the results from this study show that the run-up car is not statistically significant. further, for the recent second sub period the run-up car is negative as against the requirement of significantly positive run-up car for dsdc hypothesis. the overall results in general and the recent period results in particular evidence strongly against the dsdc hypothesis. table 3. abnormal return in the event windows around nifty index addition specific event window event days car n = 38 1999-2010 sub-period i 1999-2006 sub-period ii 2007-2010 anticipation window ad-10 to ad -1.93% -2.01% -1.78% t-stat -1.058 -0.772 -0.796 p-value 0.148 0.224 0.220 ad window ad+1,ad+2,ad+3 2.94% 1.67% 5.11% car>0% =68.42% t-stat 2.918 1.156 5.324 p-value 0.003*** 0.13 0.001*** run up window ad+4 to ed-1 0.20% 1.41% -2.39% t-stat 0.026 0.480 -1.000 p-value 0.979 0.635 0.337 effective day ed 1.92% 2.03% 1.73% car>0% =76.32% t-stat 3.459 2.740 2.057 p-value 0.001*** 0.011** 0.060* release window ed+1 to ed + 4 -0.89% -0.89% -0.88% t-stat -1.052 -0.730 -0.893 p-value 0.299 0.479 0.388 ed long run window9 ed to ed+60 4.70% 1.68% 10.35% t-stat 1.275 0.339 2.028 p-value 0.21 0.738 0.065* the sample includes all the nifty additions for the period 1999-2010 in the indian stock market. ‘ad’ is the announcement day. ‘ed’ is the actual date of inclusion. cumulative abnormal returns in smaller event windows -1999 -2010. the first column specifies the event window of interest. the actual start end dates are specified in the second column. the cumulative abnormal return(car) for complete period, first and second period in columns 3,4 and 5 respectively.*, **, *** indicate significance at 1%, 5% and 10% level respectively. in the ed window, it is observed that car for the complete period as well as the sub-periods is statistically and economically significant. it is 1.92% for the complete window, 2.03% for 9 n=37 for this window because for this study only data up to 31-05-2010 was considered. hence the stock kotak bank(sl no 1 in appendix 1) which was included to nifty index on 08-04-2010 was not considered for that window. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 67 the first sub-period and 1.73% for the second sub-period. while the ed window car is significant at 1% level for the complete period, the ed window for the first and second period is significant at 5% level and 10% level respectively. the percentage of stocks with positive car is 76.32%. the inclusion day abnormal return is supposed to be positive due to the action of index funds. this assertion is supported by high percentage of stocks with positive car during ed, even higher than on ad. a control mean including only the stocks with positive car was calculated. it is statistically and economically significant 3.18% for the whole period, 3.26 for the first period and 3.06 for the second period. the release ending day is relevant to the ‘price pressure hypotheses’. the release ending day is ed+4 based on the median values. the abnormal return for the complete period is -0.89%. it is -0.89% and -0.88% for the first and second sub-period respectively. the abnormal returns are not statistically significant. the results for the long run ed window suggests that the post ed returns are increasing and economically significant for the complete period and the second sub period. even for the first sub period, the post ed returns is positive though not statistically significant. the results for the ad window and the ed are similar to the index additions in the developed markets. however the absence of significant ‘release window’ car and the lack of significant run-up car in the nifty index additions are not consistent with the results in the developed markets. the significant negative anticipation window car is very interesting in the light of li and sagedhi(2009) in the emerging chinese stock market. they have evidenced significant negative car during the ‘ad-120 to ad’ period in the chinese market followed by significant car post announcement. they have attributed the results to ‘informed syndicate’ traders sending wrong signal to uninformed investors to sell the shares prior to announcement causing the price to fall. however, the index inclusion announcement signals the uninformed investors to buy the shares enabling the informed syndicate traders to reap a huge profit. in order to test for the above chinese stock market phenomenon in the indian stock market, ‘ad-70 – ad-10’ car for all the 38 nifty additions were studied. the nifty index additions witnessed significant negative car of -4.32% during the ‘ad-70 – ad-10’ period followed by significant post announcement cars in all the tested periods (table 2). on further examination it is seen that the ‘ad-70 – ad-10’ car rises to -1.09%, which is not significant at any level of significance, if one excludes the nifty additions (numbering 4) during the recession year 200810. hence it seems that li and sagedhi (2009) assertion in the chinese markets is not supported in the indian stock market. 4.3 abnormal volume the results in table 4 suggest that even though the mean vr for the various event windows are significant, the median values and the percentage of stocks with vr>1 in each event 10 the entire post addition window cars also increased when the recession year 2008 nifty additions were excluded from the sample. all the other conclusions in this study were similar to the full sample results. for example, ad+1 – ad+70 car for the second period rose from 7.55% to a whopping 14.1%. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 68 window suggests that the outliers in the higher side have skewed the results. in fact except for the ad window and ed, the percentage of stocks with vr>1 is not greater than 50% for any other event window. to overcome this, a control mean is calculated by removing the top 3 outlier on the higher side in each event window. it is seen that the vr is significantly greater than ‘1’ only for the ad window and the ed window for the control mean. table 4. abnormal volume (vr) around ad and ed for 1999-2010 period event window mean control mean % of stocks where vr >1 median ad-10 to ad 1.12 0.97 42.11% 0.83 ad window 1.47*** 1.25** 57.89% 1.14 ad+3 to ad+10 1.14 0.95 47.37% 0.81 ad+11 to ad+20 1.09 0.93 44.74% 0.89 ad+21 to ad+30 1.42* 1.10 50.00% 1.02 ed 2.16*** 1.72*** 78.95% 1.53 ad+31 to ad+40 1.38** 1.16 44.74% 0.94 ad+41 to ad+50 1.54* 1.09 44.74% 0.89 ad+51 to ad+60 1.63* 1.11 47.37% 0.99 ad+61 to ad+70 1.94* 1.14 47.37% 0.97 ad+71 to ad+80 1.56* 1.04 36.84% 0.81 volume ratio vr = (vit /vmt) ÷ (vi / vm) , where vit and vmt are the trading volumes of security i and the total nse respectively, and vi and vm are the average trading volumes of the security i and total nse for the period ad-70 through ad-10. the daily vr is averaged across the various event windows. the volume ratio11 should have a value of ‘one’ under null hypothesis. if in any event window vr is significantly greater than one then volume is said to be abnormal for that event window. control mean is calculated after removing the top 3 outliers on the higher side as number of stocks with 'vr greater than 1' is less than 50 % and the median is consistently less than '1'. ***. **. * denote significance at 1%, 5%, 10% level respectively (one tailed t-test that vr is significantly greater than one.)the pictorial representation of this table is given in appendix 4. the results evidence, unlike the developed markets, only a very small permanent increase in the volume following index announcement and inclusion. the highly significant volume increase on ad and on ed is similar to the volume effect in the developed markets. also a higher volume in ed compared to ad suggest the actions of the index funds around ed. (the results for the sub-periods is not shown for brevity and can be had on request). also the ed 11 volume in this study is the number of shares traded. the daily stock volume is standardised using the daily total nse market volume. the calculation of volume ratio takes into account the capitalization changes. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 69 vr for the 1999-2006 and 2007-2010 period is 1.9 and 2.35 respectively suggesting increased ed effect along with the growth of index funds. the permanent abnormal return without corresponding permanent abnormal volume does not support the dsdc hypothesis. though this result differs from many similar studies, chen et al(2004) also evidence similar results in the s&p 500 additions. 4.4 price pressure hypothesis the effective day or the actual day of inclusion abnormal stock returns are expected to significantly positive due to the action of index funds. hence only the stocks with positive ed abnormal returns are considered for testing the price pressure hypothesis in the indian stock market. this is more appropriate because price pressure hypothesis postulates complete reversion of positive ed abnormal returns once the temporary excess demand of the index funds is satisfied. . the ed abnormal return for the stocks added to nifty index for the period 1999-2010, with positive abnormal return on ed, is 3.18%. the results are displayed in table 5. harris and gurel (1986), compared ed abnormal return with the negative of the corresponding day cumulative return from day ed+1 to day t to explain the price pressure around ed. according to them, if the mean of the cumulative from ed+1 till a reference date ‘t’ (changed in sign) is equal to the ed abnormal return, then it means that all the ed abnormal return is reversed and consequently price pressure is the main reason for ed abnormal return. the ed abnormal return for the stocks added to nifty index for the period 1999-2010, with positive abnormal return on ed, is 3.18%. this ed abnormal return is compared with the negative of the cumulative abnormal return from ed+1 to ed+20 to detect the presence of price pressure and the results are reported in table 5. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 70 table 5. mean cumulative abnormal return from ed+1 to day t for the 29 stocks added to nifty index between 1999-2010 and for which ed abnormal return is greater than zero. day ed+1 to day t mean car from ed+1 to the day indicated t-stat p value % of stocks where car is >0 ed+1 to day t ed to day t ed+1 -0.19% 4.278 0.0001 44.83% 86.21% ed+2 0.16% 3.786 0.0004 48.28% 75.86% ed+3 -0.47% 2.802 0.007 37.93% 68.97% ed+4 -0.49% 2.320 0.025 44.83% 65.52% ed+5 -0.22% 1.909 0.065 51.72% 68.97% ed+6 0.14% 1.882 0.065 37.93% 68.97% ed+7 0.20% 1.764 0.089 51.72% 65.52% ed+8 0.90% 1.890 0.064 48.28% 62.07% ed+9 2.10% 1.858 0.073 51.72% 75.86% ed+10 1.42% 1.843 0.075 51.72% 68.97% ed+15 1.54% 2.058 0.048 58.62% 72.41% ed+20 1.26% 1.840 0.076 51.72% 72.41% t-test for equality of means between ed abnormal return and the negative of the corresponding day ed+1 to day ‘t’ car. satherthwaite's approximation for degrees of freedom is used. n= 29, includes only the stocks which had positive ed abnormal return. two tailed t -test of whether the negative of the mean of the cumulative is equal to the mean of ed abnormal return using cross-sectional data. the results of the t-test show that car from ed+1 through to ed+20 reject the null hypothesis that the mean of the ed abnormal return is equal to the negative of the cars from ed+1 to ed+20 (at least the 10% level of significance). the maximum reversion is only -0.49% and takes place on ed+4. the results provide little evidence of price reversal and hence do not support the price pressure hypothesis in the nifty index additions. even in the complete sample(n=38), the maximum reversion of 1.1% and 0.89% occurs at ed+3, ed+4(release ending day) respectively compared to ed abnormal return of 1.92%. therefore it seems reasonable to conclude that evidence in support of price pressure is limited at best. the result for price pressure is not consistent with some of the results from developed markets who have evidenced significant reversals following ed abnormal return. 4.5 long term effect window– ed+30 to ed+60 according to chen et al(2004), hegde and mcdermott(2003) studying long term liquidity compared (ad-60 to ad-10) period with (ed+10 to ed+60) period. whereas chen et al(2004) used ed+60 as the starting point for steady state studies . in this study ed+30 to ed+60 period is used because not only it is sufficiently distant from the event so as to have reached steady state but also it is not too much farther otherwise other corporate events might vitiate the results. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 71 table 6 long term window12 variable mean control mean % of stocks where variable >1 for ratios and >0 for car median car 3.07% na 53% 2.10% t-stat 1.420* na volume ratio 1.71 1.14 44% 0.925 t-stat 2.006** 1.001 liquidity ratio 1.59 1.24 58% 1.11 t-stat 2.485*** 1.935** long term window represents ed+30 to ed+60 for the stocks added to nifty index between 1999-2010. complete sample,n=38. control mean is calculated after removing the top 3 outliers on the higher side whenever both the % of stocks where vr >1 or car>0 is less than 50% and the median values suggest that few stocks influence the mean. one-tailed t-test to test whether the mean is greater than '0' or the ratios are greater than '1'. ***, **, * denotes significance at 1%,5%,10% level. table 6 reports the results for the long term window. car, volume ratio and liquidity ratio are significant at 10%, 5% and 1% level respectively. but the median value being less than one and the percentage of stocks with vr>1 being only 44% suggests that few outliers are influencing the result as far as the vr is concerned. as explained in section 4.3, a control mean was calculated for vr which was not significant even at 10% level. it is seen that for stocks included in the index the long run window car is statistically and economically significant. the increase in liquidity is even more significant because the buy and hold action of index funds around ed should theoretically reduce liquidity. though liquidity is one of the nifty addition criteria, this study compares post addition liquidity is compared with liquidity just before announcement. this makes the significant increase in liquidity in the long run window all the more interesting. according to chen et al (2004), liquidity can improve without information production if there is a corresponding increase in volume. in this case, though there is clear evidence towards liquidity improvement subsequent to inclusion, corresponding increase in volume is not supported. this result supports the information assertion around index announcements in the nifty additions. the long term improvement in liquidity for added firms is similar to chen et al(2004) in the us stock market. li and sadeghi(2009) and hacibedel(2008) analysing the emerging markets evidence significant long term improvement in liquidity. 12 for the ‘long term window’, instead of kotak bank, data of reliance capital was used. the reliance capital stock data was not used in the other tests in this study as it did not have even two trading days between ad and ed. this adjustment was done as stocks are studied after steady state has been reached for this window. hence n=38 for that window. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 72 4.6 the regression results the earlier results in this study have evidenced the presence of significant ‘ad effect’ and ‘ed effect’. now a hitherto not resorted to technique using ‘dummy’ variables in eq (5) is used to confirm the earlier results. the period ad-10 to ad+20 and ed-5 to ed+30 is considered for the ad effect and ed effect respectively. the results in table 7 show significant slope coefficients for both the effects. the intercept(not shown) representing the mean value of abnormal returns excluding ad+1(ed) for the considered period was marginally negative and not significant at any level. the results were consistent with the earlier results for both the sub periods. according to shiefler (1986), a significant positive slope in the cross sectional regression between abnormal ad return 13 and abnormal ad volume is consistent with dsdc hypothesis. further, shiefler (1986) states that due to standard errors, the slope co-efficient may be biased towards zero and hence suggest introducing ‘usual volume’ (before ad volume) independently in the earlier regression. a significantly positive abnormal volume slope co-efficient and significantly negative usual volume slope co-efficient are consistent with dsdc hypothesis. the regression results are tabulated in the table 7. the results for eq (6) show that even though the slope co-efficient is of proper sign, it is not significant at any reasonable level of significance. similarly the results for eq (7) show that though the sign of the co-efficients are of the expected sign, both the slope co-efficient are not statistically significant even at 10% level. the durbin watson statistic (dw stat) is closer to two which suggests that the regression error terms are not correlated which is one of the assumptions14 of the regression. further, according to lynch and mendenhall (1997), a significantly positive mean car over the run up window(ad+3 to ed-1) is supportive of the dsdc hypothesis. table 3 shows that the run-up window car for the complete period is 0.2%, which is also not significant at any level of significance. 13 the ad window car was regressed with three day ad window abnormal volume which evidenced similar results. however, in deference to researchers who have evidenced that ‘averaging’ leads to spurious autocorrelation, the same was not shown. our stand was vindicated when the dw stat improved from an acceptable 1.5 to a significant 1.84. 14 if this assumption is violated, the usefulness of the estimated regression model is compromised. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 73 table 7. the regression results parameter value t-stat p-value f-stat p-value n dependent variable ad+1 and ed separately –eq(5) dummy variable ad+1, zi=1 0.018 3.324 0.001 11.047 0.001 31 ed, zi=1 0.019 3.998 0.000 15.983 0.000 36 parameter value t-stat p-value d-w stat r-sq n dependent variable – ad+1 careq (6) intercept 0.015 1.799 0.080 1.84 0.002 38 ad ab vol 0.002 0.501 0.620 dependent variable – ad+1 careq (7) intercept 0.009 0.866 0.392 1.85 0.017 38 ad ab vol 0.002 0.436 0.666 ad us vol -0.0004 -0.044 0.965 dependent variable – yearly mean ed car intercept 0.018 2.359 0.046 1.8 0.017 10 yearly beta change 0.0008 0.241 0.815 firstly, regression with dummy variables is used to distinguish between the event days ad+1 abnormal return and ed abnormal return separately with that of other days. yi = β0 + β1zi + εi --(5) where, zi is ‘1’ if ad+1 or ed and ‘0’ otherwise. β1 measures the difference between the event days and other days. for ad and ed effect ad-10 to ad+20 and ed-5 to ed+30 were considered. here ‘n’ represents the number of days studied. the cross sectional regressions in the spirit of shliefer(1986) who regressed the day ‘1’ ad abnormal return (abret car) and abnormal volume (abvol) to examine the relationship between abnormal return and abnormal volume as a significant slope co-efficient is consistent with downward sloping curves for the added stocks. here ‘n’ represents the number of stocks. ad abret car = α + ψ * ad abvol -(6) ad abret car = α + ψ * ad abvol + µ * usvol – (7) where, abret is the abnormal return, abvol is the abnormal volume and usvol is the usual volume( average vr from ad-10 to ad-1). another regression for examining the co-movement of the added stocks rit = α + β * rmt + εit -(8) where, rit is stock return, rmt is the nifty index return on day ‘t’ and εit is a random variable with expected value of zero and assumed to be uncorrelated. the daily pre-event regression is run for the period ad-70 to ad-10. the daily post event regression is run for ed+10 to ed+70. the difference βc calculated for each added stock by subtracting the preevent beta from the post event beta is regressed with yearly ed car. here ‘n’ represents number of years used in the regression. ***. **. * denote significance at 1%, 5%, 10% level respectively. interestingly the recent period result (2007-2010, instead of significantly positive run-up asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 74 window car, evidences a negative car of -2.39%. the above results in table 7 and the result that nifty inclusion is characterized by permanent abnormal return without corresponding permanent abnormal volume do not support dsdc hypothesis as the major explanation for the abnormal permanent return around index announcement in the indian stock market. 4.7 co-movement the beta change βc is calculated as the difference between the slope parameters of pre addition and post addition regressions (eq (8)). the hypothesis that βc is greater than zero is first tested using one-tailed t-test. the mean beta change βc is a statistically significant 0.14 and the number of stocks with positive beta change is 58%. barberis et al (2005) have suggested that the non-informational view of stock inclusion is supported, if the effect(βc) is stronger in the latest data along with the growth of index funds15. the data in appendix 2 shows that βc is not stronger in the latest data. further, in order to verify the information effect, the yearly average beta change from 1999 -2010 is regressed with the yearly average value under mutual funds in india. table 7 shows the slope co-efficient of the regression to be 0.0008 and is not statistically significant at any level of significance. the result evidencing lack of correlation between the mutual fund growth and beta change which should have been the case if the significant positive beta change is due to portfolio rebalancing actions of the mutual funds (index funds) supports the information-view in the indian stock market. the permanent index addition effect, for at least 80 days , may be due to positive information the index addition conveys regarding added stocks. it appears that the informed investors cause the initial price increase around ad and the index funds around ed. the uninformed investors then start investing in the added stocks. the other reason may be that the added stocks give positive signal to the investors in general and foreign institutional investors in particular regarding the quality of the stocks. even the ‘habitat’ view, which according to barberis et al(2005) studying s&p 500 supports the no-information view, may not apply to emerging markets. the reasons may be that, unlike the developed markets, emerging markets like the indian stock market suffer from both lack of information efficiency and cost of information and hence are characterised by quality gaps between various groups of assets. these dissimilarities between the developed markets and the emerging market like india may be driving the evidenced results following nifty index additions. the results are consistent with the findings of other emerging market studies of li and sadeghi(2009) and hacibedel(2008). the results are also consistent with chen et al(2004). the observed results are interesting vis-a-vis the efficient market hypothesis(emh) according to which any information is reflected instantaneously in the stock prices. according to the widely accepted martingale model of the efficient market hypothesis, a market is efficient with respect to any information if no economic profits accrue based on the information. li and 15 as the data for index fund growth in the indian market is not available, the mutual fund data is used as a proxy in this study. see appendix 2. the source is www.amfiindia.com. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 75 sadeghi(2009) state that under emh there should be no price or liquidity effects. this study argues that index additions being information, there will be price and liquidity effects. consequently, only the slow adjustment to market information is not consistent with emh. the results in this study suggest slow adjustment16 to index addition information and economic profits which is not consistent with the efficient market hypothesis and constitutes a significant anomaly. 5. conclusion this study set out to analyse the price and volume effect surrounding nifty index additions over the period 1999-2010. this study focused on two issues, the permanent effect and the information content of index additions. this study evidences that nifty index additions are characterized by permanent abnormal returns subsequent to announcement and inclusion similar to the effects seen in the developed markets. but the evidence for permanent abnormal volume is limited unlike the developed markets. nifty index additions appear to convey information. neither the dsdc hypothesis nor the price pressure hypotheses appears to be the major explanation for the observed permanent abnormal return around nifty index additions. further the permanent abnormal returns and increased liquidity subsequent to index additions is not accompanied by abnormal volume. finally, the significant beta increase subsequent to addition is not the strongest in the latest data and there is no correlation between mutual fund growth and beta change. the evidence for the more recent sub-period sample is particularly important as it reflects the current market environment. the results for the second period (2007-2010) evidence increased price and information effect around index announcement and subsequent to inclusion. the results are consistent with other studies on emerging markets. the increasing participation of foreign investors in the indian stock market may be one of the reasons for the nifty additions to convey information. due to information asymmetry, investors in general and foreign investors in particular might perceive nifty index inclusion as a signaling event regarding the quality of a stock. this appears to produce significant abnormal return directly without much abnormal volume. as the indian stock market is characterized by constantly increasing foreign investments, the stronger ‘ad effect’ in the later period also supports the preceding assertion. further, the cost of information in the markets like india affects the required rate of return and consequently the stock prices. inclusion to benchmark index like nifty might increase the visibility of the stocks for investors and reduce the cost of information. this brings into focus ‘investor awareness hypotheses’. finally, the slow adjustment to nifty index addition information is not consistent with market efficiency in the indian stock market. 16 the mean ad+1 to ad+3 and ad+1 to ad+10 abnormal returns are a statistically significant 2.94% and 4.62% respectively(buy on day ‘1’ and sell on day ‘3’ or day ‘10’). the transaction cost can be taken as 1% for most investors in the indian stock market. the low risk in these strategies can be gauged based on the % of stocks for which car > 0 which is 68% and 74% respectively for the total period. this increases to 93% and 86% for the second period. the annualized risk adjusted return of approximately 200% and 100% respectively clearly suggests economic profits for most investors in the indian stock market. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 76 this study has bought issues which require further research. one such issue may be to delineate between the various ‘information supportive’ explanations in the indian stock market. another issue may be further research into the various co-movement hypotheses in the indian stock market. acknowledgement: i thank dr. victor louis anthuvan, professor of finance, chairperson phd, loyola institute of business administration, chennai-600034, for his guidance and support throughout the study. i also thank the anonymous referees for their constructive suggestions. references amihud, y., mendelson, h. 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(1997). new evidence on stock price effects associated with changes in the s&p 500. journal of business, 70, 351-384. mackinlay, a.c., (1997). event studies in economics and finance. journal of economic literature, 35(1), 13-39. mase, b., (2002). the impact of changes in the ftse 100 index. brunel department of economics and finance, discussion paper, 02-25. merton, r.c., (1987). a simple model of capital market equilibrium with incomplete information. journal of finance, 42, 483-510. shleifer, a., (1986). do demand curve for stocks slope down?. journal of finance, 41, 579-590. vijh, a.m., (1994). s&p 500 trading strategies and stock betas. review of financial studies, 7, 215-251. wurgler, j., zhuravskaya, e.(2002). does arbitrage flatten demand curve for stocks?. journal of business, 75, 583-608. appendix appendix 1. list of stocks included to nifty index between 1999 -2010 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 78 ad stock symbol ed 24-feb-10 kotakbank 08-apr-10 04-sep-09 jp associat 22-oct-09 04-sep-09 idfc 22-oct-09 19-may-09 jindalsteel 17-jun-09 10-feb-09 axisbank 27-mar-09 29-jul-08 reliance power 10-sep-08 31-jan-08 dlf 14-mar-08 26-feb-08 powergrid 14-mar-08 30-oct-07 idea 12-dec-07 30-oct-07 cairn 12-dec-07 11-sep-07 unitech 05-oct-07 10-aug-07 ntpc 24-sep-07 20-feb-07 rpl 04-apr-07 20-feb-07 sterlite 04-apr-07 12-may-06 suzlon 27-jun-06 12-may-06 siemens 27-jun-06 12-jan-05 tcs 25-feb-05 26-mar-04 ongc 12-apr-04 16-jan-04 bharti 01-mar-04 16-jan-04 maruti 01-mar-04 16-jun-03 sail 04-aug-03 13-mar-03 gail 2-may-03 13-mar-03 national alumunium 2-may-03 16-sep-02 bpcl 28-oct-02 16-sep-02 hcltech 28-oct-02 16-sep-02 sci 10-oct-02 15-apr-02 vsnl 31-may-02 14-dec-01 sunpharma 17-jan-02 14-dec-01 wipro 17-jan-02 20-jul-00 digital equipments 01-sep-00 24-apr-00 hcl-insys 24-may-00 24-apr-00 zeetele 24-may-00 26-apr-00 dabur 10-may-00 03-aug-99 britannia 08-sep-99 03-aug-99 satyam computers 08-sep-99 19-apr-99 drreddy 26-may-99 19-apr-99 novartis 26-may-99 19-apr-99 reckitt colman 26-may-99 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 79 appendix 2. yearwise ed abnormal return and beta change is given for the period 1999-2010 in order to verify whether the beta change is stronger in the latest data year ed abnormal return number of additions beta change average assets under mutual funds in rs. crores 1999 3.60% 5 -0.182 97028 2000 2.20% 4 0.249 99326 2001 na 0.249 101822 2002 0.60% 6 0.227 122660 2003 -0.82% 3 -0.183 140093 2004 2.28% 3 -0.098 150537 2005 3.29% 1 0.516 199248 2006 0.51% 2 0.263 323597 2007 4.89% 6 0.237 549936 2008 3.68% 3 -0.184 421117 2009 -0.50% 5 -0.011 794486 the average assets under mutual fund as on december-31 of each year appendix 3. frequency of trading days between ad and ed: nifty index additions (1999 -2010). asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e4 www.macrothink.org/ajfa 80 appendix 4. pictorial representation of vr around ad and ed as in table 4 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word ajfa re--writer2-new-final asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 278 capital structure and firm performance in the financial sector: evidence from australia vedran skopljak school of economics and finance, la trobe university kingsbury drive, bundoora, vic 3086, australia tel: 61-3-9479-1111 e-mail: vedran.skopljak@latrobe.edu.au robin h. luo (corresponding author) department of finance, wuhan university luojia hill, wuhan 430072, china tel: 86-27-6875-2740 e-mail: robin.h.luo@gmail.com received: january 29, 2012 accepted: march 1, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1319 url: http://dx.doi.org/10.5296/ajfa.v4i1.1319 abstract how does capital structure affect firm performance of authorised deposit-taking institutions (adis) using explicitly australian data? this paper investigates the relationship between capital structure and firm performance of australian adis. our findings show a significant and robust quadratic relationship between capital structure and firm performance of australian adis. at relatively low levels of leverage an increase in debt leads to increased profit efficiency hence superior bank performance, at relatively high levels of leverage increased debt leads to decreased profit efficiency as well as bank performance. this can most likely be attributed to financial distress outweighing any gains made from managerial performance improving. keywords: profit efficiency; capital structure; agency cost theory, financial sector asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 279 1. introduction capital structure and its effect on firm performance has long been a topic of discussion, with no shortage of papers on the issue (e.g. modigliani and miller, 1958; myers, 1977; jensen and meckling, 1976; harris and raviv, 1991 and margiratis and pslilaki, 2007). however, these papers are very general in their conclusions and their reach to the financial sector is relatively limited. the reason being that the financial sector has its own unique set of regulations, and is generally highly leveraged; nevertheless, the underlying imperatives still apply to the financial sector just as they do for firms across other disciplines. this paper mainly investigates the relationship between capital structure and firm performance of australian authorised deposit-taking institutions (adis). based on agency cost theory (jensen and meckling, 1976), it suggests that debt is used as a motivating factor for managerial staff. agency theory states that separation of top end management and ownership has a negative effect on firm performance; there is no incentive for management to perform at maximum capacity. debt is enrolled as an instrument to heighten work ethic and performance of management; however an increase in the proportion of debt causes the firm to experience higher financial distress (harris and raviv, 1991). the main hypothesis to be explored in this paper contributes to academic research in this field in two major ways. first, research papers in the field of capital structure have not often concentrated on the effect of capital structure on profit efficiency, especially linking the two in the financial sector. the general method has been to try linking capital structure with firm performance using common financial ratios. one notable research paper by berger and bonaccorsi di patti (2006) stands out as offering a significant and comprehensive empirical contribution to the link of capital structure and profit efficiency in the financial sector. the financial sector is fundamentally different from any other sector of the market in terms of its high leverage and regulation, therefore the results obtained from papers using data across multiple sectors in the market cannot be directly carried over to the financial sector with a high degree of confidence. second, papers on the relationship of capital structure and australian financial sector “firm” performance are very scarce. it is clear that australia has its own set of unique market conditions and regulations, which highlights the importance of extending berger and bonaccorsi di patti’s (2006) paper specifically for australian data. australia intrinsically has a limited financial market with relatively few financial firms in operation therefore it is to be expected that our sample size is relatively small. our final dataset consists of 15 australian adis and their data was collected over years 2005-2007 of operation. part of the reason the relationship between capital structure and firm performance has been known to show contradictory correlation empirically is the fact that a proxy for firm performance has been so difficult to obtain; some form of stock return or a common financial statement ratio has usually been used in the past. although it is an unfortunate fact that these can be manipulated with relative ease, providing a clouded measurement of firm and managerial performance. this paper uses a modified version of berger and mester’s (1997) measure of firm performance-profit efficiency. the measure is a proxy for the productive efficiency of management, linking agency cost with firm performance, which makes it an accurate and practical tool. along with the profit efficiency measure this paper uses a common financial ratio, return on equity (roe), in order to provide robustness to the results. reverse causality has also been identified by previous studies (berger and bonacorrsi di patti 2006) as a possible cause of curious results. it has been argued that it is in fact firm performance which affects capital structure, rather than the other way around. this paper will asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 280 therefore test for reverse causality by performing granger-causality tests on the relationships of capital structure and firm performance. the findings of this paper confirm no significant linear relationship between capital structure and firm performance, however importantly the relationship is significant and robust once a quadratic capital structure term is added. this leads to the conclusion that increased debt improves bank performance at relatively low levels of leverage while at relatively high levels of leverage the effect of financial distress exceeds the beneficial effects of debt on managerial performance and therefore leads to decreased bank performance. several robustness checks are performed and discussed which also yield favourable results. the paper is structured as follows. section 2 reviews major prior literature on the relationship of capital structure and firm performance as well as specific studies of the financial sector. section 3 presents the methodology employed in our study. section 4 addresses the data and explanatory variables in the study. section 5 reports the empirical results including the estimation of profit efficiency and the effect of explanatory variables on profit efficiency. section 6 offers a conclusion of the paper. 2. literature review 2.1 agency cost theory, capital structure and firm performance agency cost theory is a logical concept which states that the separation of goals for management and ownership in a firm may lead to negative consequences in its performance. the fundamental thought process behind the theory is that when ownership and management are separate entities they do not share a common goal. (jensen and meckling, 1976) since it is management who is in control of key decision-making, this separation is detrimental to firm performance. two key assumptions are made in regards to the management and owners of firms for this theory to hold. the human assumption (eisenhardt, 1989) argues that management suffers from human imperfections, which manifest themselves in the form of self-interest. despite managements major role being that of maximizing firm performance, it is driven by a bounded rationality whereby the optimal choices for the firm may be foregone in favour of decisions that lead to personal gain. the organizational assumption (eisenhardt, 1989) states a firm may have many owners whose measure of performance may differ from one another. this leads to partial goal conflict among participants. the key behind optimizing efficiency and minimizing agency cost is the unification of managerial and ownership goals (jensen and meckling, 1976). one way of unifying these goals is to instil responsibility into management through partial ownership (fama and jensen, 1983). shares are issued to management as part of their contractual wage agreement. this is a relatively simple, yet effective way of creating an incentive based wage to management, who are therefore forced to work harder to increase firm performance as well as their wage. more closely related to this paper is the theory behind minimizing agency cost through increasing debt levels. though the idea of debt levels being tiedto agency cost may sound trivial at first, the theory is quite difficult to refute. according to harris and raviv (1991), debt can act as a monitoring and incentive device, since there is a positive correlation between higher debt levels and higher financial distress. a company is more likely to face bankruptcy if it is experiencing high financial distress: this fact drives management to improve firm performance, as it does not want to suffer job loss and/or a bad reputation as a asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 281 consequence of bankruptcy (opler and titman, 1994; grossman and hart, 1982). for the empirical studies, margiratis and psillaki (2007) test for profit efficiency and the role capital structure plays in its determination. they define profit efficiency as the difference between maximum potential output and actual output while keeping input constant. these inefficiencies are considered to be direct outcomes of agency cost. furthermore, reverse causality is tested for by regressing firm performance as measured by profit efficiency against the capital structure of firms. this investigates the validity of the efficiency-risk hypothesis and the franchise value hypothesis. a very similar definition of profit efficiency to that of berger and bonaccorsi di patti (2006) is adopted in margiratis and psillaki’s (2007) paper. a comprehensive 12,240 new zealand firms from the 2004 new zealand annual enterprise survey make up the data-set. these are primarily constituted by small and medium enterprises, and according to the ministry of economic development in new zealand are defined as employing less than 19 workers. their findings match expectations gathered from agency cost theory, pecking order theory, and to a lesser extent, static theory. using the entire range of data they conclude that debt levels have a significant, positive affect on profit efficiency. in other words, the observations show that an increase in proportions of debt level lead to an increase in profit efficiency (which is used as a proxy for firm and managerial performance). furthermore, the data is then tested for reverse causality; this incorporates testing for the efficiency-risk hypothesis, as well as the franchise-value hypothesis. the former hypothesis states that more efficient firms choose higher debt to equity ratios, as higher efficiency reduces the cost of bankruptcy risk and financial distress. the latter states that more efficient firms may choose lower debt to equity ratios in order to protect economic rents derived from higher efficiency from the possibility of liquidation. quantile regression is used to test for reverse causality and therefore the effect of firm efficiency on debt proportions. the findings show validity of both hypotheses, though at different spectrums of the data. at the low to mid range of the leverage distribution, more efficient firms select higher debt level showing evidence for the efficiency-risk hypothesis. at the high end of the leverage distribution range, evidence for the franchise-value hypothesis is shown; higher efficiency firms choose relatively lower debt ratios. opler and titman (1994) specifically study the effects of financial distress among high leveraged firms in relation to relatively low debt firms during industry downturns. the firm performance acts as proxy by operating profit as well as relative market share. it is found that, as predicted in the franchise-value hypothesis, highly leveraged firms do suffer more than their low debt counterparts in an economic downturn. cambello (2003) studies the impact of capital structure on firm performance of product markets in booms and recessions. he found that firms with high debt are affected most (negatively) by recession when there are competitors with relatively lower debt financing in direct contest. no such relationship was witnessed for firms operating in high debt industries. since the financial sector is a highly leveraged industry this paper will go on to further test cambello’s findings. agrawal and knoeber (1996) examine seven control mechanisms which are commonly used to manage agency cost of firms. among them is a control variable for debt, and the paper’s findings contradict that of agency cost theory; increased debt proportions have a significantly negative affect on firm performance when the ordinary least squares regression (ols) was run. these results may be fogged, however, by statistical limitations such as multicollinearity asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 282 etc., such statistical flaws can cause individual variables to take on inaccurate or skewed values. when the two-stage least squares (2sls) model is run using the same data-set, debt is insignificant but shows a positive sign in regard to firm performance. 2.2 capital structure and firm performance in financial sectors as stated earlier, it is important to distinguish the financial sector from the rest of the market when attempting to find a relationship between capital structure and firm performance in the financial sector. banks in general operate under a totally unique and rigorous set of regulations which only apply to that sector, making it impossible to explain the relationship of both the banking market and the rest of the market using only a single model or indeed a single dataset (barth et al., 2004). for example, australian adis do not only have to abide by the general rules enforced by law on all firms, but they also have an additional set of regulations which subject banks to requirements, guidelines and restrictions. barth et al. (2001) undertake an ambitious study in an attempt to compare 107 countries and their banking systems. they test for regulatory power, supervision and other factors which are deemed important in comparing banking systems. australia is almost always on the cautious side of the scale in all disciplines. australia has a high degree of supervision, with 2 major bodies over viewing the banks; the australian prudential regulation authority (apra), whose lone task is to protect depositors through limiting and supervising risk levels taken on by adis, and the australian securities and investment commission (asic), who is responsible for information being made transparent and available to the market as soon as the information is presented to the directors of companies to carry out their acts in honesty, asic also investigates the level of efficiency and fairness in the market. in addition to these australian regulatory bodies, the financial sector is subject to the basel ii accord, first published in 2004, which is an international document outlining the importance of strict risk and capital management requirements, with major emphasis being placed on minimum capital requirements for individual banks. furthermore, banks are fundamentally highly leveraged relative to the rest of the sectors in the economy, making banks a distinctive test subject for the hypotheses this paper intends to answer. studies which empirically test for “real world” accuracy of capital structure theory are not in shortage. empirical research on this topic from an australian viewpoint, especially regarding the financial sector, is quite scarce, however. the focus in this paper will have a particular emphasis on a comprehensive and widely regarded us study conducted by berger and bonaccorsi di patti (2006), and will then be applied to the australian financial sector. studies which came before it often used regular accounting and financial measures as proxies of firm performance (such as roe, returns on stock market, profit etc.), and although these are useful in portraying the performance of a firm, they offer no distinction between management that is excelling and management that is underperforming. berger and bonaccorsi di patti (2006) argue that a more appropriate measure to test firm performance is profit efficiency; it accounts for managerial performance as well as the extent of agency cost suffered by the firm. berger and mester (1997) initially introduce two measures of profit efficiency, the first of which is; asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 283 (1) which is based on the firm profit function: ln( ) ( , , , ) ln lnf w p z v u        (2) where  is the net variable profit of a firm (revenue – expenses including interest earned and paid);  is a constant added to every firm so that the natural log is a positive value; w and p are vectors of prices for inputs outputs respectively; z is the net quantity of fixed output – inputs and v is a variable taking into any other factors affecting profit. the ln u variable represents inefficiencies that reduce overall profit, firms with the highest estimated ln u value are considered to be engaging in the most efficient business practice, and are denoted as maxˆln u . this bank then becomes the benchmark to which berger and bonaccorsi di patti base profit efficiency on. a bank with an speff of .7 earns 70% of its maximum potential profits. the second specification to measure profit efficiency as described by berger and mester (1997); (3) the alternative profit efficiency function is derived from the alternative profit function; ln( ) ( , , , ) ln lnf w y z v u        (4) although the alternative profit efficiency function is calculated in a similar way to the standard one, there is a distinct difference between the two. this difference is the replacement of output price with output quantity as an exogenous variable, hence the price (p) variable is replaced by the output quantity variable (y) in the alternative function. the data was collected of 7,548 banks; a sub-sample, “the ownership sample”, was created, for which detailed information on the insider holdings, block holdings of 5% or more (by insiders or outsiders), and institutional holdings of the bank, or its top-tier holding company, is available. this data was then gathered over the time period of 1990-1995, using a cross sectional model describing the relationship between average efficiency (effi) overtime and average capital ratio over time (ecapi), while keeping averages for most control variables (except some ownership variables). since we are using very similar variables both the exogenous and endogenous variables will be described in detail in the next chapter. the paper uses a two-stage least squares method (2sls) model, it is most frequently used when there is a possibility of reverse causality being present, this is due to the underlying assumption of 2sls being that there is no correlation between the primary model and the model testing for reverse causality. there are arguments for capital structure being affected by firm performance rather than it being the other way around hence for the purpose of checking for reverse causality, the efficiency risk and franchise-value hypothesis are tested by specifying the equity capital ratio as a function of the firm’s profit efficiency. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 284 the findings of the main hypothesis tested by berger and bonaccorsi di patti (2006), that being the agency cost hypothesis, is found to be significant, as an increase of debt proportions of 1% leads to an increase in efficiency of about 16% at the sample mean; showing also that lower equity capital ratios are associated with higher profit efficiency over the whole spectrum of data. in the case of testing for reverse causality, a similar conclusion is found to that of margiratis and psillaki (2007). neither the efficiency-risk nor the franchise-value hypotheses empirically dominate the other over the entire range of data. maudos et al. (2000) undertake a study of both cost and profit efficiencies across countries. the paper tries to identify relationships between cost and profit efficiencies along with testing for the prevalent theories in the field of efficiency based performance. their dataset includes a total of 832 firms across 10 european countries and the regressions are run using several panel data frontier approaches, these are the distribution free approach (dfa), the fixed effect model (fem) as well as the random effects model (rem). the findings show relatively higher inefficiencies in profits rather than costs, this implies that there are inefficiency issues on the revenue side of banking which may need to be analysed. a low positive correlation was found between cost and profit inefficiencies which go against berger and mester’s (1997) findings which show no correlation of cost inefficiencies and profit inefficiencies. further findings of maudos et al. (2000) include that medium sized banks (assets < $10,000,000,000) are most efficient on both the cost and profit side of things, as stated by agency theory banks with a high loans/assets ratio as well as high risk are relatively more efficient. 3. methodology efficiency measures have a considerable place in academic circles, not only in the field of economics and finance but in every imaginable discipline. since finding a way of determining efficiency can be quite challenging, attention has to be paid to the specification of the efficiency for results to be desirable and correct. in light of these factors, this paper attempts to format a simple and easily accessible profit efficiency equation which yields correct and robust profit efficiency figures. berger and mester (1997) developed relatively complex albeit comprehensive efficiency evaluations as mentioned in section 2.3. the problem with employing the same exact specification is that berger and mester (1997) had a dataset of 5949 banks, hence their efficiency evaluation method is appropriate to use in the case where a sample size as large as that is available. in the case of our study which considers australia exclusively, sample size becomes quite an issue. therefore a primary objective was to create a simplified profit efficiency measure based on those of berger and mester (1997) as well as muados et al. (2000). equation 5 shows the specification which was developed in order to maintain consistency with efficiency measures in past papers while being simple enough to be used for a sample of similar size to ours: ln( 1 ) ln( 2 ) ln( 1 ) ln( 2 ) ln( 3 ) ln( 1 1 ) ln( 1 2 ) ln( 1 3 ) ln( 2 1 ) ln( 2 2 ) ln( 2 3 ) ln( ) ln( ) ln( ) i i i i i i i i i i i i i i i i i i i i i peff x x c c c x c x c x c x c x c x c p a p e               (5) where peff is the profit efficiency, ix is the respective output of the respective bank, ic is the respective input of the respective bank, ip is the respective profit, ia is the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 285 respective asset and ie is the respective equity. the alpha term (α) represents a constant term added on to all the figures in order to standardize the inevitable outlying negative values to positive ones (in order for their respective efficiency values to be positive). this is common practice and is exercised both in berger and mester (1997) as well as in muados et al. (2000). naturally adding the alpha term creates some figures of very low profit efficiency and although these figures may seem inaccurate or extreme, the fact is an extremely low profit efficiency figure reflects the banks gross inability to convert inputs into outputs efficiently relatively to the most efficient bank. the ratio of outputs against inputs (xi/ci) measures the ability for each banks potential to convert each input into each output, therefore banks with larger figures for (xi/ci) suggests they are more efficient in converting costs into revenue. the control variables of pi, ai and ei have the responsibility of allowing the model to deflate the models efficiency which is based on purely these factors. having such control variables enables the model to process profit efficiency correctly rather than skewing figures of efficiency for banks based on their outright profits, assets or indeed equity. the profit efficiency measures the relative performance of management to that of the “best performing bank”. an efficiency value of 1 would mean the bank is the “best performing bank” therefore this is the upper limit of possible efficiency values for our dataset. the differences of observed values relative to “the best performing bank” provide us with the percentage amount of inefficiency in the corresponding firm. intuitively values closer to 1 describe banks with relatively low inefficiencies while values closer to 0 show higher inefficiencies. the lower limit of profit efficiency is 0 due to the alpha (α) term. 3.1 the model as described in previous sections, the primary objective of this paper is to test the effect leverage has on profit inefficiency in australian banks. ecap (equity/assets) is used as the proxy of reversed leverage meaning a high ecap illustrates low leverage and hence a low ecap illustrates high leverage. therefore the expectation according to agency theory and past literature (berger and bonaccorsi di patti 2006) is that ecap will have negative relationship with profit efficiency; that is an increase in debt yields higher profit efficiency. the model for the primary hypothesis: ( )i ipeff f ecap x e   (6) where ix denotes the control variables also believed to affect profit efficiency (peff). further findings we are hoping to unearth include determining whether agency theory variables other than leverage have any significant effect on profit efficiency. in our model we have included two such variables to proxy ownership structure, sh5own and shinside have been explained in section 4.2 along with their expected relationships with profit efficiency. along with ownership structure, risk (sdroe), size of the bank (using assets as proxy) and market-share will all be regressed against profit efficiency. as an alternative measure of bank performance a commonly used accounting measure is employed. the return on equity (roe) is regularly used as a measure of firm performance and although it does not capture efficiency as such it does offer us a raw measure of bank performance. it therefore allows us to infer whether the explanatory variables affect firm asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 286 performance in the same way as profit efficiency. the model is specified as: ( )i iroe f ecap x e   (7) where ix denotes the control variables believed to affect the return on equity (roe). berger and bonaccorsi di patti (2006) had a relatively large sample size, this enabled them to use the two-stage least squared method (2sls) when modelling leverage on profit efficiency and vice versa. the (2sls) is the preferred choice for models where reverse causality may possibly be in existence. due to the restriction of our sample size some concessions had to made, one of those being that using the two stage least squares method was not usable. instead a simple least squares method (ls) is utilized. even though the method of regressing the variables differs to that of berger and bonaccorsi di patti (2006), the results of this papers conclusions should not be seen as any less significant, the two stage least squares method simply has slightly more accurate assumptions. 3.2 reverse causality it is not unimaginable that it is actually profit efficiency which drives the capital structure choice of a bank rather than capital structure driving profit efficiency, hence this paper tests for reverse causality using the granger-causality test. the granger-causality test was pioneered by sims (1980) and it is conducted within a vector autoregressive (var) context, the test determines the order of information being processed between two variables. it is therefore important to note that a test finding variable x to granger-cause variable y does not automatically imply that y is the direct result of x occurring, however the implications of information order can be just as important. they allow us to state whether past information of x predicts the value of y or vice versa. it is best to employ as many lags as possible since fundamentally the granger-causality test is based on determining the order of past information and its prediction power on the corresponding variable. given our sample data, the granger-causality test is implemented using the maximum lags available to us (2). the general notation of a granger-causality test which is trying to determine whether the lagged terms of x predict y and whether the lagged terms of y predict x respectively are specified as: 1 0 1 1 2 2 1 1t t t p t p t p t p ty y y y x x                    (8) 0 1 1 2 2 1 1t t t p t p t p t p tx x x x y y u                   (9) where p is the number of lags, t and tu are the error terms. equation 8 tests whether x granger-causes y, if beta (β) does not equal to 0 significantly, we can say that x is useful in forecasting y. equation 9 tests, whether it is y that granger-causes x, if p does not equal to 0 significantly we can say that y granger-causes x. there are two leading theories which suggest that profit efficiency may actually be causing capital structure, therefore it is imperative for us to test whether australian banks do indeed show this to be true. 1 we run two granger causality tests. in the first we denote profit efficiency (peff) as y and capital structure (ecap) is x, in the second granger-causality test we denote peff as y and the quadratic variable of capital structure (1/2ecap^2) as x. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 287 the efficiency-risk hypothesis expresses the idea; relatively efficient firms choose a capital structure which employs a relatively large proportion of debt as the added efficiency makes up for the added financial distress of having lower equity proportions. the franchise-value hypothesis expects highly efficient firms to behave in an opposite manner. it argues, firms with relatively high efficiency are likely to maintain a high proportion of equity as said firm wants to protect its expected returns. 4. data and variables the data originally consisted of a total 23 banks and financial institutions. 22 of those carry out their primary operations in australia while 1 in new zealand, this was 1 of the 7 banks and financial institutions dropped in the process of developing the model. the reasons some banks and financial institutions were dropped ranged from them being incomplete in their data availability to their operations not being active in the year of the sample date. the sample period begins in 2005 and concludes in 2007, this three year period was particularly chosen as it coincides with stable economic and financial market conditions and although it is relatively recent data, the time is distant enough from the recent “global financial crisis“. the most pronounced problem with incorporating the most recent data which coincides with the gfc would have been skewed figures of input costs and profit figures. the implications of this occurrence could have meant that the fair representation of banks characteristics studied was compromised. the firm specific data was extracted from the osiris database, in the case that data was not available in the osiris database the official financial statements were revised and the appropriate data was obtained from there. in regards to the market variable of marketshare which represents the market-share of each bank, it was important that information was gathered from a reliable source hence, the source was the australian prudential regulatory authority (apra). 4.1 the dependent variables the primary variable which we are trying to explain with our model is the profit efficiency measure denoted as (peff). the problem of how to define efficiency in general regardless of its application is always a difficult one. in the case of this paper our concern is profit efficiency. a bank has several inputs that it uses to produce outputs hence in the case of banks, profit efficiency is the measure of outputs produced relative to a given amount of inputs. profit efficiency increases with a relative increase of outputs given any amount of inputs. maudos, pastor, perez, quesada (2000) employ three inputs and three outputs in their quest to derive a profit efficiency measure, our paper uses this methodology as a base. we use very similar identifications of inputs and outputs however we have chosen to reduce the outputs to two rather than three. the reasoning being, there is no evidence to suggest that having three rather than two output definitions yields any gains or would bring about differing results hence using two outputs simplifies the profit efficiency specification slightly. furthermore the format of information available in the osiris database lent its self best to using two outputs. the definitions of the inputs and outputs of our profit efficiency specification can be viewed below (summaries of all variables can be found in table 1): inputs there are three factor costs of production. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 288 c1 = the cost of loaned funds. this is defined as the interest expense divided by the corresponding amount owing. the amount owing is computed by adding up the liabilities of deposits and owing to other banks. c2 = the cost of labour. the cost of labour is defined as the total amount spent on personnel divided by the total number of employees at the bank. c3 = the cost of fixed assets. the cost of fixed assets is defined as the cost on plant and equipment divided by total fixed assets. outputs there are two measures of yields from using the factors of production x1 = revenue from loans. as described in the title, output x1 is the net interest revenue from loans (in absolute values). x2 = revenue from other activities. as the title explains output x2 constitutes the net operating income from activities other than interest revenue. control variables include a profit, asset and equity variable. these are designed for the function to identify actual profit efficiency differences based on relative size of outputs given inputs rather than skewing figures due to differing values of the respective control variable. it is important to draw comparisons of the primary regression which is run using the comprehensive profit efficiency measure to the results of using a more conventional accounting measure of performance. this allows us to test for whether the model is robust and can be extended to draw conclusions on whether the explanatory variables affect general firm performance as measured by the conventional accounting measure (roe) in the same manner as they affect profit efficiency (peff). the return on equity (roe) is chosen to represent this comparative measure due to its popular application in finance and accounting, it provides a general measure of firm performance rather than an efficiency based measure, this gives a good foundation to draw comparisons and conclusions from. the specification for the measure of return on equity (roe) is: roe net income after tax / shareholder’s equity (10) it is quite likely that the explanatory variables will have very similar individual effects on both return on equity (roe) and the profit efficiency measure (peff), however there are sure to be interesting finds in the process of comparing the two. 4.2 the explanatory variables as mentioned in previous sections the common understanding in past papers is that along with the choice of capital structure, the ownership structure is also believed to have a significant impact on agency cost and therefore also profit efficiency (jensen 1986) (ang, cole and lin 2000). the independent variable that captures capital structure which is used in our primary regressions is the ratio of equity divided by capital (ecap). a low ecap describes a bank with relatively high leverage while a high ecap describes a bank with relatively low leverage. as was mentioned in previous sections the agency cost hypothesis suggests that profit efficiency and ecap have an inverse relationship (φecap/φeff)>0, the theory behind asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 289 it suggests that a high ecap or in other words low levels of leverage lead to managers having less incentive to work hard on maximizing potential profit as there is less financial distress on the bank. it is however important to also note that the expected relationship of the ecap and profit efficiency can change if ecap becomes small enough or in other words leverage has become high enough. in this case the financial distress caused by a marginal increase of leverage outweighs the agency cost benefits and therefore can produces a scenario where (φecap/φeff)>0. the most obvious solution to this problem is to run an alternative regression which employs a quadratic variable of ecap to test whether leverage does affect profit efficiency by varying amounts at different levels of debt. therefore in the second regression of our primary objective the term 1/2ecap^2 is added to test whether the relationship of capital structure and profit efficiency is a quadratic one. as a means of testing for robustness of the results from the primary regressions the variable loans/assets (l/a) will be interchanged with ecap, obviously these two variables are highly correlated and will therefore not be included in the same regression output. the variable (l/a) measures the banks loans owing (deposits and amount owing to other banks) divided by the total assets. the interpretation is opposite to that of the ecap, a high l/a shows relatively high leverage while a low l/a shows relatively low leverage. while capital structure may be relatively easy to quantify, the same can not be said about ownership structure. the reason being that ownership structure is a topic which encompasses several subsections that are both quantitative and qualitative. in order to correctly specify a model for ownership structure several variables need to be created to accounting for these many subsections. in order to quantify ownership structure accurately, several variables were used. as was mentioned ownership structure inherently incorporates many quantitative and qualitative variables, therefore allowing for multiple variables in the model to estimate allows a more concise conclusion of the effects ownership structure has on profit efficiency. the variable shinside measures the percentage of ownership directly held by board members (also including family members) as measured by stock. it is generally considered to be a positive signal to the market for board members to have shareholdings in their respective firms; such actions demonstrate an expectation of future growth of the firm. exploring the idea of agency theory also ignites the idea of shinside being positively correlated with profit efficiency. fundamentally agency theory is the conflict of interest between shareholders and decision makers of firms (managers, board members etc.), therefore colluding the two interests by making the decision makers shareholders should drive decision makers to find solutions in the best interest of shareholders. sh5own depicts the proportion of ownership held in blocks greater than 5% by individual share holders. it is expected that banks with relatively large values of sh5own are going to have relatively lower inefficiencies as these are mitigated by having influential shareholders watching over the performance of the decision makers. a variable is introduced to account for dissimilarities in bank performance which are attributed to size differences. total assets are used as a proxy of size as it achieves the most accurate description of size. it is common practice to employ several dummy variables, however considering the small nature of the sample in this paper only 1 dummy variable is used. the data is split into two categories, the larger half of banks according to asset size are given the value of 1 while the smaller half of banks were given a value of 0. risk is another bank characteristic which is generally believed to influence profit efficiency. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 290 it would not be wrong to assume that variables such as (l/a) and (ecap) already form some sort of measurement of risk, these variables measure leverage which in itself is a component of overall risk. therefore the risk these variables account for may not be complete, it is important to have a unique variable which explicitly measures risk. this variable is (sdroe) and it measures the standard deviation of the return on equity. empirically it would be expected that the level of risk is positively correlated with profit efficiency, agency theory suggests higher risk encourages a stronger work ethic, hence profit efficiency is increased. to determine the standard deviation of return on equity (roe), actual observations of (roe) were made over 4 consecutive years for each bank, hence the standard deviation was found employing a general definition of standard deviation. sdroe is defined as:  2 1 1 n i i x n      (11) where (σ) is defined as the standard deviation of roe, (n) is the number of observation, xi is the individual observation and μ defined as the mean of the 4 year observations for each individual bank. a variable to control market share also constitutes part of the model (mktsh), although total assets may give a good indication of market share it is not the preferred measure of previous studies, this is understandable as total assets do not directly equal to a one-to-one relationship with market share, instead a more conventional measure using total deposits of market share is used. the data of individual banks total deposits as well as the total deposits in the market were retrieved from the australian prudential regulation authority (apra). the top 10 banks had a total market share of around 75 percent, the reasonable assumption was that the rest of the banks in the sample had equal share of the remaining 25 percent. the efficiency structure hypothesis states that it is actually efficiency of firms which determines market share; however this paper attempts to find whether there is a relationship that works in the other direction, that is we test if market share has a positive or indeed negative influence on profit efficiency. 5. results 5.1 descriptive statistics here the properties of our profit efficiency findings are discussed. it is essential to our paper to have reliable and robust profit efficiency results of banks in australia. table 1 depicts a very interesting picture and signify the importance of this paper. the results reflect the profit efficiency figures of australian banks as specified by the purposely developed profit efficiency equation (equation 5). it shows profit efficiency in australian banks to be averaging 78.6%; that is, on average banks profit efficiency is 78.6% relative to the performance of the most profit efficient bank. it is important not to forget what the implications of profit efficiency are, profit efficiency measures the actual output produced given any level of inputs required to create said outputs. the percentage of relative profit efficiency is then based on the most efficient bank and its ability to produce outputs given the level of inputs. remembering this, it is then clear that the importance of the figures is not the mean 78.6% profit efficiency but rather the consequential mean profit inefficiency of 21.4%. this figure implies on average, banks can increase profit by 21.4% by simply adjusting behaviour to be in line with that of the best practice bank. it is the duty of management to achieve maximum possible profit efficiency hence any action which a bank is able to take to asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 291 increase incentives for managerial staff to improve performance could yield large increases in profits. table 1. summary table of all variables variable explanation mean std. dev. endogeneous variable peff profit efficiency measure .7861 .2678 roe accounting measure of return on equity .1577 .0513 explanatory variables l/a loans (deposits, owing to other banks)/ total assets .8315 .1256 ecap total financial equity/total assets .0633 .0407 shinside % of direct share ownership by directors and their families .0366 .0497 sh5own % of shares held by shareholders with total holdings of over 5% .2409 .1819 size total assets 128348575 165888162 marketshare % share of depoits held by bank relative to overall market .064957 .065098 sdroe standard deviation of return on equity .0310 .0174 ½ ecap^2 .0028 .0046 determinants of profit efficiency x1 net revenue from loans (interest) 2142224 2988490 x2 net revenue from other than loans 1708502 2018601 c1 cost of funds .0717 .0590 c2 cost of labour 92.335 51.300 c3 cost of fixed assets .3081 .2139 p profit 1813716 2433989 p/a profit/total assets .0130 .0046 e equity 6918591 8677036 a total assets 128348575 165888162 the standard deviation of .2678 or 26.78% shows a relatively profound difference in profit efficiency across banks. once again due to the limitations on sample size availability these standard deviation figures may be slightly distorted due to a few outliers. the effect of these outliers however, must not be overstated as the efficiency results should still be deemed stable and reliable. skewness of -1.96 is in accordance with our intuitive expectation of what it should be for our data. the negative sign shows that most of the observations of profit efficiency lie close to 1 however there are a very few extreme outliers closer to 0, this fits in with how we expect profit efficiency to behave. one would expect profit efficiency of banks to be in the higher end of the spectrum relative to the best practice bank however, due to how efficiency is calculated there is bound to be very few extreme figures close to 0. graphically the expected skewness of profit efficiency can be represented by figure 1. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 292 figure 1. general representation of negative skewness the kurtosis figure of 5.69 is a relatively high value, once again this coincides with the observed descriptive statistics before it. a figure of 5.69 suggests that a large proportion of the standard deviation in profit efficiency is brought on by extreme values. this once again can be explained by the nature of the measure of profit efficiency, a few extreme values are to be expected. 5.2 the effect of explanatory variables on profit efficiency (peff) table 2 displays the significance and the magnitude of the relationship between the explanatory variables and the dependant variables of the differing models. as explained in previous sections all models were regressed using the least squares method. the variables are listed with their coefficients and their corresponding standard errors listed right below the coefficient figures. the two primary regressions are run in order to determine the nature of leverage on profit efficiency, that is to distinguish whether the relationship of leverage on profit efficiency is linear or quadratic. the four following regressions are forms of robustness tests. the first specification tests the whether there is indeed a linear relationship of leverage as measured by equity/assets (ecap) on profit efficiency. though the sign is negative meaning increased leverage leads to increased profit efficiency which is as we would expect given agency theory, the result is statistically insignificant at any significance level. further analysis of this regression reveals the variables shinside (director share ownership) and sdroe (risk) to carry a positive relationship with profit efficiency though once again being statistically insignificant. the signs of both of these variables are as expected, we discussed the expected effect of risk and director share ownership on profit efficiency, both were expected to increase management’s efficiency. the variable for size (sizedummy) shows negative yet statistically insignificant correlation with profit efficiency. sh5own has significant negative sign, this goes against the experiences of previous papers as well as theory. empirically it is believed that large block ownership acts as an unofficial governing body however, our result would suggest the opposite to be true; large block ownership may act as a hindrance. marketshare is significant at the 5% significance level and is positively correlated with profit efficiency, that is increased market share increases profit efficiency. the adjusted r^2 value shows that about 28% of variation in profit efficiency is explained by the explanatory variables. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 293 table 2. regression output the second column consists of the regression which attempts to model a quadratic relationship between capital structure and profit efficiency hence the variable 1/2ecap2 is added. the variable 1/2ecap2 is a quadratic term of capital structure. the model yields an almost surprising increase in overall explanatory power as well as significance of ecap on profit efficiency. the adjusted r2 value has increased by around 12% to a total of 40.1%. more importantly the indication given by the model regarding leverage is that there is a statistically significant relationship of leverage on profit efficiency. as ecap is implicitly the inverse of leverage we must intuitively recognise the relationship of leverage and profit efficiency is as theory would suggest. the regression output shows at low levels of leverage (high levels of ecap) a marginal increase in debt increases the profit efficiency of banks in australia. at relatively high levels of leverage (low levels of ecap) a marginal increase in debt actually decreases the profit efficiency of banks. theory would suggest that this is due to the increased financial distress caused by already high debt levels. ceteris paribus the derivative of: f(peff) = 1/2ecap^2 + ecap + c in the model is f’(peff) = 119.93 – 14.166ecap which illustrates that the behaviour of leverage on profit efficiency is according to that of the major theories presented in this paper. along with leverage now being statistically significant in explaining profit efficiency at any significance level, sh5own and marketshare remain statistically significant at the 5% significance level and 1% significance level respectively while offering the same directional relationship as in the initial regression. shinside, sdroe and sizedummy are all still statistically insignificant as they were in the initial regression. in the process of determining variables to asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 294 use in the model, both shinside and sdroe had shown quadratic relationships with profit efficiency in the paper of berger and bonaccorsi di patti (2006). therefore we tested whether quadratic relationships were in existence for either variable and both yielded unsatisfactory results. they also did not add to the overall explanatory power of the model and in fact reduced it, hence neither variable was included in the regression outputs. 5.3 robustness checks three methods are used to check for robustness of our results. firstly to test whether it remains that the relationship of leverage and profit efficiency in australian banks is a quadratic rather than a linear one, an alternate measure of leverage is used. l/a as used by muados, pastor, perez, quaseda (2000), measures loans/assets (loans are made of deposits and other short term funding as well as other funding). the results of this regression suggest that there is no statistically significant relationship of leverage and profit efficiency whether it be linear or quadratic. the answer to this puzzling outcome may lie in the proxy of leverage l/a as it may not encapsulate the total amount of leverage taken on by a firm. debt may come from other places other than deposits and other loans, hence l/a may just not be a great proxy of leverage. this notion is also strengthened when comparing the overall strength of the model which employs the quadratic form of ecap to that which uses the quadratic form of l/a, you find that the model using l/a as a proxy of leverage has much lower explanatory power. the findings of this robustness test also strengthen the idea that banks should try to increase market share as well as reduce block ownership over 5%, as both of these remain statistically significant. since the first robustness check did not give clarity on the issue of whether the model is robust a second robustness test is initiated. this robustness test as used by berger and bonaccorsi di patti (2006) employs the common accounting measure of firm performance roe (return on equity) as the dependant variable as an alternative to profit efficiency. the findings are of this robustness check is favourable to our primary model, when ecap is used to proxy inverse leverage the findings are robust even when using a common accounting measure of firm performance (roe). the findings of this robustness test are that leverage affects bank performance in a quadratic manner rather than a linear one. ecap is statistically insignificant at any level when testing the linear relationship of ecap and roe (regression not shown here), however when the quadratic relationship of ecap and roe is examined it is statistically significant at any significance level. furthermore this robustness test finds market share to once again be positively correlated with bank performance with statistical significance. sh5own is significant at the 10% significance level when the regression is run with linear ecap on roe however it is insignificant at even the 10% level in the case of the quadratic relationship with roe being specified. all other variables remain statistically insignificant at any level. finally a granger-causality test is employed to test whether profit efficiency (peff) actually causes choice in capital structure (ecap). this is indeed against the underlying assumption of our paper in which we model the impact of capital structure on profit efficiency. both the efficiency-risk hypothesis and the franchise-value hypothesis offer considerable arguments as to why causality may be in the direction of profit efficiency to capital structure. the test is set up so that granger-causality is tested between the linear terms of ecap and peff as well as the quadratic term of ecap (denoted ecapsq) and peff. table 3 shows that when the granger-causality test is conducted with 2 lags between the linear term of ecap and peff we find that granger-causality does not run in either direction. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 295 this does compliment the findings of our primary regression which suggested that there is no relationship between capital structure and profit efficiency. table 3. granger-causality test 2 null hypothesis: obs f-statistic probability ecap does not granger cause peff 15 1.44382 0.28128 peff does not granger cause ecap 0.56267 0.58672 1/2ecap^2 does not granger cause peff 15 3.06392 0.09165* peff does not granger cause 1/2ecap^2 0.44492 0.65297 * denotes significance at the 10% level the second set of output results confirm the findings of our paper that capital structure has a significant quadratic impact on profit efficiency and not the other way around. the output concludes that the quadratic term of capital structure (1/2ecap^2) granger-causes profit efficiency (peff) at the 10% significance level and also importantly profit efficiency (peff) does not granger-cause the quadratic term of capital structure (1/2ecap^2) at any significance level. these results complement our primary findings and conclude that the causality of capital structure and profit efficiency runs in only one direction and that relationship is quadratic. 6. conclusion this paper sets out to contribute to the theory of capital structure in two major ways; the primary objective is to create a specific hypothesis for the effects capital structure has on firm performance in the financial sector, using the data of australian 15 australian adis over the period of 2005-2007. the secondary objective was to create a profit efficiency function that is profound yet simple enough to be employed on a dataset as limited as ours. these objectives have been accomplished successfully, we have shown a clear and robust relationship between capital structure and firm performance s well as created a profit efficiency function that works very well under any condition. the main hypothesis: “how does capital structure affect firm performance of authorised deposit-taking institutions (adis) using explicitly australian data?” is one which is of especially great use for australian banks but its implications could also extend to international data. according to the theory of agency cost, higher levels of debt decrease the agency cost of the separation of ownership and management. this is driven by the increased financial distress caused by the higher debt levels. the added financial distress then forces management to work harder and act in the shareholders best interest. in contrast, at high levels of debt, the financial distress of proportionally increasing debt may outweigh any agency cost benefits received from such debt increases; hence this may have the effect of increasing the overall agency cost inherited by the bank. reverse causality could be argued with both the efficiency-risk and franchise-value hypotheses, offering plausible explanations of firm efficiency affecting capital structure choice; these are tested for. berger and bonaccorsi di patti (2006) find support for the agency cost hypothesis; their findings show higher leverage 2 all granger-causality tests are run using 2 lags as this is the maximum plausible lags available to our dataset. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 296 to be associated with higher profit efficiency. along with the use of the previously described profit efficiency measure, a common accounting performance measure is used to test for robustness as well as draw comparisons from the comparative measures. our findings show a significant and robust quadratic relationship between capital structure and firm performance of australian adis. at relatively low levels of leverage an increase in debt leads to increased profit efficiency hence superior bank performance, at relatively high levels of leverage increased debt leads to decreased profit efficiency as well as bank performance. this can most likely be attributed to financial distress outweighing any gains made from managerial performance improving. the implications of this finding are considerable; we have found that a bank can help optimize the performance of management and general bank performance by simply choosing a capital structure which optimizes managerial incentives while keeping financial distress relatively low. further findings show that increased market share also leads to increased profit efficiency while the variable sh5own which describes ownership held in blocks greater than 5% contradicts results of previous papers. previous papers have shown increased block ownership acts as a governing body and therefore increases profit efficiency, however our results do not complement these findings. our model 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(1980). macroeconomics and reality. econometrica, 48(1), 1–48. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 298 http://dx.doi.org/10.2307/1912017 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word paper6final-writer2-new-final asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 69 triple bottom line reporting in annual reports: a case study of companies listed on the stock exchange of thailand (set) muttanachai suttipun school of business administration, faculty of management sciences prince of songkla university, thailand e-mail: c3080496@uon.edu.au / muttanachai.s@psu.ac.th received: january 11, 2012 accepted: february 1, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1289 url: http://dx.doi.org/10.5296/ajfa.v4i1.1289 abstract this study aims to investigate narrative tbl reporting in the annual reports of the top 50 largest companies listed on the stock exchange of thailand (set), to establish whether there is any relationship between the extent of tbl reporting and a variety of factors used in previous studies conducted in more developed countries. by using a non-probability sampling method, the top 50 listed companies were sampled based on their 2010 annual reports. statistical analysis (descriptive, multiple regression, independent samples t-tests, and anova), was employed to analyse the extent of reporting found and the relationship between tbl disclosure based on a measured score and ten characteristics influencing disclosure identified in previous studies.the findings show that there are statistically significant differences between the tbl reporting scores of high and low profile companies. there are also significant differences in reporting based on industry groups. although the results did not indicate any relationship between tbl disclosure scores and the various factors considered in previous studies, there was a correlation between the age, type of business, and liquidity of companies and their economic information reporting score as well as between the size, risk, and profitability of the company and the environmental information disclosure score. keywords: triple bottom line reporting, annual reports, thailand, the stock exchange of thailand asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 70 1. introduction world economic development faces social and environmental impacts that result in social problems, global warming, natural disasters and pollution. therefore, many corporations take as much responsibility for social and environmental issues as they do for economic issues. one reason for this is that corporations are reflecting growing social expectations and stakeholder concerns. this notion of corporate social and environmental responsibility reflects stakeholder theory. responsibility is reflected in disclosures made by these companies known as corporate social and environmental responsibility reporting. henderson and peirson(2004) explain that social and environmental reporting is an aspect of sustainable development reflecting concerns about environmental protection, intergenerational equality, the earth and its resources. therefore, in today’s world, corporate social responsibility (csr) is placing pressure on traditional corporations to not only provide financial information to their stakeholders but to also include non-financial information about social and environmental issues. some corporations regard csr as a negative drag on their business because it may entail costs in terms of both budget and time. on the other hand, csr can be seen as a positive driving force encouraging corporate top management to look more closely at the operation of their business and make it more successful and sustainable over the long term (luken & stares, 2005). moreover, csr also helps corporations in planning and tracking social and environmental improvements that can bring corporate financial benefits. however, although there are many standards used to disclose non-financial information, such as iso14001, iso26000, sa8000, and aai000, all can measure and report on only a single issue rather than reflecting multiple issues as can triple bottom line (tbl) reporting. slaper (2011) stated that tbl is an accounting framework incorporating three dimensions of corporate performance: financial, social, and environmental. the tbl reporting differs from the traditional reporting frameworks as it includes ecological or environmental and social measures that can be difficult to assign appropriate means of measurement. tbl reporting is one of the most important tools available to support corporate sustainable development goals. the notion of tbl was developed by john elkington (1997) who created a new framework to measure both financial and non-financial performance during the mid-1990s (slaper, 2011). the framework of tbl focuses on the interrelated dimensions of profit, people, and the planet. because tbl reporting is growing across the for-profit, non-profit, and government sectors, many corporations have adopted tbl reporting to measure and evaluate their operational performance. however, although most empirical studies about tbl reporting have focused on the united states of america, canada, australia, new zealand, japan, the united kingdom and other european countries, there are fewer studies about tbl reporting by companies in developing countries where stakeholders still do not have the power to force companies to provide non-financial information. there is no evidence of tbl reporting by thai listed companies. moreover, social and environmental disclosures by thai listed companies are still made only on a voluntary basis so the extent and level of tbl reporting from social and environmental perspectives is unknown. therefore, this study aims to fill that gap by investigating narrative tbl reporting in the annual reports of the top 50 largest thai listed companies, testing whether there is any asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 71 relationship between the extent of tbl reporting and a variety of factors used in previous studies conducted in more developed countries. the study also compares its findings with findings reported in previous studies relating to tbl reporting in developed countries. there are three research questions in this study 1) is there tbl reporting in any of the annual reports of listed companies in the set; 2) what are the factors influencing tbl reporting; and 3) what differences are there in the extent of tbl reporting found in the present study conducted in a developing country and that found in previous studies conducted in developed countries. the remainder of this paper is organized as follows. section 2 reviews the theoretical perspective. section 3 discusses the background of tbl reporting in thailand. sections 4 and 5 review relevant literature and identify the factors potentially influencing tbl reporting. section 6 details the research design and methodology including the methods of data analysis employed. the study findings are presented in section 7, and finally, the conclusions and limitations of the study are set out in section 8. 2. theoretical perspective despite the different theoretical approaches that can be and have been used to explain tbl reporting, the most widely advanced theoretical perspectives in the social and environmental accounting literature are legitimacy and stakeholder theories (branco, eugenio, & ribeiro, 2008; m. islam & c. deegan, 2010; joshi & gao, 2009). these theories reflect the view that corporations with proactive social and environmental programmes gain a competitive advantage over less socially and environmentally active companies by sharing their social and environmental activities with stakeholder groups. however, this study uses only stakeholder theory to investigate tbl reporting by thai listed companies in annual reports because this theory is premised on the notion that stakeholders expect companies to be socially and environmentally responsible so that there is a market premium in improved social and environmental performance. the theory is also concerned with the ways companies manage their stakeholder relationships (gray, collison, & bebbington, 1998; llena, monera, & hernandez, 2007; roberts, 1992). stakeholder theory explains specific corporate actions and activities using a stakeholder-agency approach, and is concerned with how relationships with stakeholders are managed by companies in terms of the acknowledgement of stakeholder accountability (cheng & fan, 2010; freeman, harrison, & wick, 2007). as stakeholder influences become crucial for corporate image and comparative advantage, companies manage their stakeholder relationships by providing information, often in the form of voluntary disclosures in their annual reports or on their websites. the justification is that stakeholders which (collier, 2008) defines as those who have a stake in an organisation, have something at risk as well as the power to influence the organisation, including its actions, decisions, policies or goals. potential stakeholders include shareholders, creditors, suppliers, government, customers, competitors, employees, employees’ families, media, the local community, local charities, and future generations (carrol & bucholtz, 2006; c. deegan, 2001). according to gray et al. (1996), stakeholders are identified by companies to ascertain which groups need to be managed in order to further the interest of the corporation. stakeholder theory suggests that asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 72 companies will manage these relationships based on different factors such as the nature of the task environment, the salience of stakeholder groups and the values of decision makers who determine the shareholder ranking process (donaldson & preston, 1995). as such, management will tend to satisfy the information demands of those stakeholders important to the corporations’ ongoing survival so that corporations would not respond to all stakeholders equally (nasi, nasi, philip, & zylidopoulos, 1997). the power of stakeholders and their expectations can change over time, so that companies have to continually adapt their operating and reporting behaviours (c. deegan, 2001). in summary, stakeholder theory views corporations as part of a social system while focusing on the various stakeholder groups within society (ratanajongkol, davey, & low, 2006). 3. background developing countries and social and environmental degradation are intertwined. the long term economic development of developing countries is threatened by social and environmental catastrophes. in line with the competitive advantage argument, the asian development bank argues that protecting the society and environment is not at odds with pursuing economic growth and development (kazmin and james 2001). the vast asian market could determine the future of the planet. while substantial economic growth in asia has resulted in an overall reduction of poverty, growth has placed considerable strains on the society and environment (kerr, 2008). large economic projects in developing countries bring employment, services and infrastructure that their governments cannot afford to provide, whereas in developed countries such as australia there are alternative sources of public investment and income as well as a safety net of social services. projects are thus welcomed for the benefits they may deliver so that campaigns about social and environmental destruction are most vociferous when projects causing degradation are closing (macintyre 2007). although thailand has changed from an agricultural, self-sufficient economy into an industrialising nation, it is still considered a developing country. its government has promoted thailand as one of the rapidly industrialising nations of asia (kuasirikun, 2005) despite having faced a financial crisis in mid-1997. during that time, many domestic companies had to close their businesses, many workers became unemployed and the thai government did not have enough money to manage the country. since then and until the current global financial crisis (gfc), the thai economy’s growth was about seven percent per year (nesdb, 2003) making it one of fastest growing economies in south and south east asia. post gfc, its growth rate has fallen to about three percent annually. thailand’s economic growth, led by the growth in the manufacturing sector (mukhopadbhyay, 2006), created environmental problems, particularly air, noise, traffic and water pollution, deforestation and land erosion (warr, 2007). thailand’s protest movements have won some victories. authorities have been forced to crack down on illegal logging and large scale infrastructure projects have been resisted by local communities determined to protect their way of life (kazmin and kynge 2001). as a result, in 1999, thai listed companies were asked by the set to promote and build asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 73 certain corporate governance practices into their annual reports (ratanajongkol, et al., 2006). these practices involved including both financial and non-financial information (economic, social and environmental disclosures) in corporate annual reports, but disclosure was voluntary so few listed companies revealed social and environmental information in their annual reports. a revised version of the principle of good corporate governance was published in 2006 (lint, 2009) which suggested that boards of directors should set clear policy on social and environmental issues and that companies should disclose social and environmental policies as well as implementing the conditions of such policies. in addition, voluntary reporting was changed to a “comply or explain” approach. the new principle has been in force for thai listed companies since 2007. however, the extent of tbl reporting by companies in thailand is still unknown. 4. literature review a review of the relevant literature about corporate social and environmental disclosures in addition to financial disclosures revealed studies by researchers and professionals dating back two decades. most studies focused on the reporting of non-financial information by companies in developed countries rather than developing countries such as the united states of america, canada, australia, new zealand, japan, the united kingdom, and other european countries (kolk et al., 2001). for example, ho and taylor (2007) surveyed 50 of the largest us and japanese companies to investigate tbl reporting by using annual reports, stand-alone reports, and website reports. they found that the extent of disclosure was higher for companies of larger size, lower profitability, lower liquidity, and higher profile. moreover, japanese firms undertook more tbl reporting than firms in the us. cheung et al. (2009) examined the impact of changes in csr on market valuation and compared the csr practices of major listed companies from 2001 to 2004 by surveying 495 companies in 25 emerging markets (asian, east european, south african, and latin american markets). their findings indicated that there was a positive and significant relationship between csr and market valuation among asian companies, and csr was positively related to the market valuation of subsequent years. mahadeo et al. (2011) looked at 165 companies listed on the stock exchange of mauritius between 2004 and 2007 to investigate corporate social responsibility reporting (csrr) in annual reports and test whether there was any relationship between the amount of csrr in annual reports and a variety of factors. they found an increase in terms of volume and variety of csrr. additionally, there was a relationship between the size of company and the amount of csrr. uwalomwa and uadiale (2011) also studied csrr in annual reports by listed companies in nigeria. they found that there was a difference in the amount of csrr between industries sampled. however, csrr by nigerian listed companies was still very low and still in an embryonic stage. monteiro and guzman (2010) used content analysis to examine the influence of a new social and environmental accounting standard on the social and environmental disclosures in the annual reports of 109 large companies in portugal during the period 2002-2004. the results indicated that the extent of disclosures had increased, but the amount of disclosure was still asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 74 low. however, the new accounting standard was starting to have an impact on listed companies in portugal. there are only five papers examining social and environmental disclosure by companies in thailand, with all investigating the disclosures made in annual reports. william (1999) analysed 28 corporate annual reports and found that culture and the political and civil system were the determinants of the amount of disclosure. kunsirikun et al. (2004) investigated corporate environmental disclosures in the annual reports of 63 thai firms in 1993 and 84 firms in 1999, finding a slight increase in narrative disclosures from 44% to 45%. using a sample of 120 thai listed companies’ annual reports to test relationships between environmental reporting and market valuation and corporate accounting performance, connelly and limpaphayon (2004) found that there was a significant positive correlation between market valuation and disclosure. there was no significant relationship between environmental reporting and thai corporate accounting performance. ratanajongkol et al. (2006) examined trends in corporate environmental disclosure by utilising content analysis of the disclosure of the 40 largest thai firms in 1997, 1999, and 2001. environmental disclosures decreased over the study period. rahman et al. (2010) studied a sample of 37 thai listed companies in 2006 to examine the relationship between environmental disclosures and financial performance finding that financial performance had no relationship with environmental disclosures however, there has been no study of tbl reporting in thailand, therefore, this study aims to investigate the extent of tbl reporting in the annual reports of the top 50 largest thai listed companies, to test whether there is any relationship between the extent of tbl reporting and a variety of factors, and to compare the findings concerning tbl reporting with prior studies conducted in developed countries to answer the research questions: 1) is there tbl reporting in any of the annual reports of listed companies in the set; 2) what are the factors influencing tbl reporting; and 3) what differences are there in the extent of tbl reporting found in the present study conducted in a in developing country from that found in previous studies conducted in developed countries. 5. characteristics influencing tbl reporting in answering the research questions, the data collection was based on a number of characteristics used in previous studies, thus allowing for comparisons to be made with those studies. not all of those studies recognise the need for reporting companies to be perceived as socially legitimate, even though to be seen as “good corporate citizens” by their stakeholders appears to be important to the disclosing companies (deegan and gordon, 1996). the study examines the influence of the following commonly cited characteristics: company size, industry type, ownership status, country of origin, audit type, age, business type, risk (debt ratio), liquidity, and profitability. each is examined in turn. 5.1 size of company stakeholder theory suggests that larger companies need to make more disclosures because they have more stakeholders than small companies (cowen, ferreri, & parker, 1987). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 75 previous studies (choi, 1999; cormier & gordon, 2001; c. m. deegan & gordon, 1996; ho & taylor, 2007; raar, 2002; stanwick & stanwick, 2006) found a positive association between the amount of non-financial information disclosure (social and environmental disclosure) and the size of companies, although others (davey, 1982; ng, 1985; roberts, 1992) did not find such a relationship and this study investigated whether there is any statistical relationship between the tbl reporting score in annual reports and company size. 5.2 type of industry in many previous studies, companies have been classified according to various criteria. commonly they are separated into high or low profile companies (choi, 1999; hackston & milne, 1996; patten, 1992). high profile companies are those operating in highly environmentally sensitive industries (perry and sheng 1999; stray and ballantain 2000; ho and taylor 2007). high profile companies are postulated to be more exposed politically than companies in industries expected to have little impact on the economy, society, and environment (low profile companies) (newson & deegan, 2002). using the relationship between levels of corporate social and environmental disclosure and the type of industry, many studies such as those by (ahmad & sulaiman, 2004; choi, 1999; ho & taylor, 2007; newson & deegan, 2002; stray & ballantine, 2000), found that high profile companies disclosed more social and environmental information than low profile companies and this study investigated whether there is any statistical relationship between the tbl reporting score in annual reports in thailand and the type of company. 5.3 ownership status this study categorises companies into two types of ownership status based on the percentage of corporate common stock held by either government or private companies. for example, firms where government organizations hold own than 51 percent of the common stock are designated as government companies. on the other hand, if private organizations or individuals hold more than 51 percent of the common stock, then they are classified as private companies. ownership status is not often considered in research into social and environmental reporting, probably because such research is mostly conducted in an anglo-american context where government companies are not common (tagesson, blank, broberg, & collin, 2009). in relation to tbl information, government and private companies may differ in both the quantity and quality of their disclosure. in canada, cormier and gordon (2001) found that government companies provide more social and environmental information than private companies. in sweden, tagesson et al. (2009) found that government companies disclosed more social and environmental information than private companies because state-owned companies are more scrutinized, so that there is pressure from the state as owner, and from the mass media to comply with society’s expectations. contrasting results have been obtained; balal (2000) found that bangladeshi private companies disclose more environmental information than government companies. in italy, secci (2005) found that companies controlled by the italian government disclosed less social and environmental information than other corporations and this study investigated whether there is any statistical relationship between the tbl reporting score in annual reports and the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 76 ownership status of the company. 5.4 country of origin of company similarly to the above categorisation, companies listed are separated into two kinds: international and domestic companies. international companies are those found in developed countries but located in thailand, on another hand, domestic companies are those found and located in thailand. from previous studies, companies from developed countries provided more amount of social and environmental information disclosures than companies in developing countries (adams, hill, & roberts, 1998; kolk, walhain, & wateringen, 2001). possible associations between the country of origin of the company making the disclosures and the amounts of corporate social and environmental disclosure have been found (hackston & milne, 1996; jahamani, 2003; niskala & pretes, 1995; stanwick & stanwick, 2006). however, this characteristic is never tested in thai companies listed, therefore, the study investigated whether there is any statistical relationship between the score of tbl reporting in annual reports and the country of origin of the company. 5.5 audit type big four audit firms that consist of pricewaterhousecoopers, deloitte touche tohmasu, ernst & young, and kpmg are generally held to provide a more independent auditing service and to abide more closely to audit standards than other audit firms (joshi & gao, 2009) because the big four audit firms are likely to suffer more serious damage to their reputations from a poor audit. companies with greater potential gains from external monitoring would tend to employ big four audit firms. evidence about type of audit firms and social and environmental disclosures is mixed (inchausti, 1997; joshi & gao, 2009), therefore, this study will investigate whether there is any statistical relationship between the tbl reporting score in annual reports and audit type. 5.6 business type companies can be separated into two business types: family businesses and non-family businesses. it is quite normal for asian companies to run a business from generation to generation with managers coming from the same family. family businesses do not have a tradition of disclosure since insiders (family members) often control the operating and reporting systems (iu & batten, 2001). choi (1999) speculated that the percentage of ownership held by a family may affect the disclosure of social and environmental information. it is likely that family businesses will make less social and environmental disclosure in their annual reports than non-family businesses. no study has yet explored whether there is a relationship between the amount of disclosure and business type and this study investigated whether there is any statistical relationship between the score of tbl reporting in annual reports and the type of business. 5.7 age stakeholder theory implies that older companies may have to provide more financial and non-financial information because they have amassed more stakeholders than younger asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 77 companies (cowen, et al., 1987). choi (1999) argued that the maturity of a corporation can result in a higher level of reputational risk so that the company engages in more activities related to social and environmental responsibility. whether the age (maturity) of companies influences the levels of tbl reporting in annual reports is untested and this study investigated whether there is any statistical relationship between the tbl reporting score in annual reports and the age of the company. 5.8 risk (debt ratio) companies with high debt ration have to provide more information than other companies because their creditors that are one of corporate stakeholder want to get information as much as the companies can reveal including social and environmental information (schipper 1981). therefore, top management should increase the extent and amount of disclosures in both financial and non-financial information for monitoring purposes (joshi & gao, 2009). however, the empirical evidence on debt-ratio and its relationship to the levels of tbl reporting are mixed (tai, au-yueng, kwok, & lau, 1990; wallace & naser, 1995) and this study will investigate whether there is any statistical relationship between the tbl reporting score in annual reports and risk as evidenced by the debt ratio of the company. 5.9 liquidity ho and taylor (2007) suggested that corporate liquidity is an important determinant of disclosures in both corporate financial and non-financial information. in particular, they indicated that stakeholders are concerned regarding the status of companies as going concerns, so that those with higher liquidity may have stronger incentives to provide more financial and non-financial information in their annual reports than companies with lower liquidity and this study will investigate whether there is any statistical relationship between the tbl reporting score in annual reports and corporate liquidity. 5.10 profitability previous studies have found different results of in regard to the relationship between social and environmental disclosure and financial performance. firstly, some studies have found that social and environmental reporting and financial performance are positively linked (russo and founts, 1997, cohen et al, 1997). cohen et al. (1997) stated that companies that make social and environmental disclosures may be those able to effectively reduce pollution as well as employing more efficient methods of production, and thereby gain competitive advantage. on the other hand, some previous studies found a negative relationship between social and environmental disclosure and financial performance (king and lenox, 2001, mathur and mathur, 2000). their results suggest that social and environmental disclosure entails costs to companies and acts to reduce corporate financial performance. finally, no correlation between social and environmental disclosure and financial performance was found by connelly and limpaphayom (2004) or stanwick and stanwick (2000). therefore, this study will test whether there is any relationship between tbl reporting and financial performance in thai corporate annual reports. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 78 6. research design this study investigated tbl reporting in the annual reports of companies listed on the set. from this population, non-probability sampling was used to select the top 50 listed companies based on their market capitalization as reported in their 2010 annual reports, representing 10 per cent of all listed companies on the set. the number of 50 companies based on size ranking of market capitalization was chosen as this was similar to the number used in previous studies (e.g. guthrie and parker, 1990). this criterion was selected since it has previously been discovered that large companies tend to disclose more environmental information publicly (gray et al, 1995, deegan and gordon, 1996). larger companies tend to have more shareholders who might be concerned about, and demand more social and environmental programmes. besides, larger companies are more likely to have responded to the environmental agenda than small or medium sized companies (brammer and pavelin, 2008). table 1 shows the companies studied classified according to the criteria outlined above, based on five previous studies. high profile companies are those operating in highly environmentally sensitive industries such as raw material extraction, agricultural and food, chemical, wood, paper, and forestry, and are thus more exposed to the political and social environment than low profile companies (newson and deegan 2002). companies classified as low profile included service, healthcare, computers, and electronics. overall therefore, the sample studied consisted of 17 high profile companies and 33 low profile companies. table 1. industry profiles type of industry sample size (n) industry profile this study newson&deegan (2002) choi (1999) hackston&milne (1996) robert (1992) patten (1991) agriculture and food 4 high high high low/high low financial 10 low low industrial 3 high high high high high high property and construction 8 low low low resources 10 high high high high high service 11 low low low low technology 4 low low low low data on a number of relevant variables such as sales, market capitalization, workforce, net profit, total debt and equity, type of auditors, liquidity ratio, ownership status, age, and environmental-related information were collected from the websites of the 50 companies selected (www.set.or.th/set/commomlookup.do). in measuring the tbl reporting in annual reports, the global reporting initiative (gri) reporting guidelines (2002) were utilised in this study. these reporting guidelines include 60 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 79 items to determine the extent of tbl disclosure relatng to economic, social, and environmental perspectives (20 items for each perspective). these items were drawn from an extensive review of the literature and business surveys (ho and taylor, 2007, slaper, 2011). a list of these items is shown in appendix a. the data about tbl reporting in the corporate annual reports was collected twice by the researcher at different times. in scoring the reports, most reporting items were scored on a scale of 0 – 4 based on the unep/sustainability (1996) criteria, but some were scored dichotomously as either 0 or 1. the scale (shown in table 2) was based on the principle that more complete and comprehensive information relating to a given reporting item received a higher score. therefore, a score of 0 means that the company did not report any information relating to that item while a score of 4 means that comprehensive coverage was given on that item. jones and alabaster (1999) suggested a scoring system using a nominal scale, or, at best, an ordinal one. under that scheme, each item is classified into one of five possible and mutually exclusive categories. as jones and alabaster (1999) note, the problem with this scheme is that one cannot legitimately aggregate or average the scores for a given item or section across reports, and it is contrary to how sustainability reports its benchmarking surveys (unep/sustainability, 1996). however, it is sometimes more appropriate, and more useful from an analytical viewpoint, to report disaggregated frequencies. the danger with aggregating scores is that they tend to shift attention away from what is not being reported, and from the quality of the items being reported. aggregate scores derived from annual reports can hide the fact that two reports, while apparently receiving equal mid-level scores, are vastly different in terms of the breadth of coverage versus the quality of the coverage. aware of these issues, this study reports both aggregate scores and disaggregated frequencies. in this study, researcher will consider type of scoring following by the items on each perspective of tbl reporting. for example, environmental awards will be scored dichotomously as 0 or 1 because type of this item can indicate whether there is or is no the environmental in corporate annual reports, on another hand, environmental audit will be scored on the scale of 0 – 4 because the information can classify based on unep/sustainability (1996). the contribution of scoring in this study is that there is a consideration both quantity and quality tbl information reporting in corporate annual reports. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 80 table 2. unep/sustainability reports scoring criteria 0 1 2 3 4 no coverage minimum coverage, little detail detailed and honest, including company shortcomings and commitments commitment to and progress toward sustainable development in core business commitment to and progress towards tbl of sustainable development in core business plus benchmarking against competition and/or best practice in other sectors source: unep/sustainability (1996) there were 10 independent variables. size of company was measured by market capitalization (belkaoui & karpik, 1989; hackston & milne, 1996). as previously mentioned, type of industry was classified (choi, 1999; hackston & milne, 1996; patten, 1992) where 1 = high profile companies and 2 = low profile companies. dummy variables were used for ownership status (where 1 = government companies and 2 = private companies), country of origin (1 = international companies and 2 = domestic companies), auditor (1 = big four and 2 = non-big four), business type (1 = family business and 2 = non-family business). age was measured based on the reported corporate age; liquidity by current assets/current liability, risk by debt/equity ratio and profitability by reported net profit. all the data was hand-collected. the data were analysed using the spss statistical software package, version 17. the study used descriptive statistics to represent the extent of tbl reporting in the annual reports of thai listed companies. to test whether there is any relationship between the extent of tbl reporting and the various factors investigated, the study used a multiple regression model. in addition, independent-sample t-tests and an anova were used to find differences between the effects of the factors studied. 7. findings table 3 illustrates the extent of tbl reporting in the annual reports of companies listed on the set, based on frequency and percentage. tbl reporting is separated into the three perspectives; economic, social, and environmental. under the heading of economic, all of the annual reports of the companies studied provided information about their size and profitability, and listed the name of a contact person who could be approached for additional information. additionally, a breakdown of products and services, and information about dividend distributions, and taxes were also disclosed by most of the companies studied. in terms of social reporting, more companies made statements of corporate commitment to asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 81 stakeholders in society and corporate involvement in community philanthropic activity, and provided information about employee training and education in their annual reports than other categories of disclosure. from the perspective of environmental reporting, companies made fewer environmental disclosures than economic and social disclosures. however, most companies made statements of commitment to environmental protection which was the most common theme from the environmental perspective. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 82 table 3. the extent of tbl reporting in annual reports economic information reporting frequency precentage 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. size and profitability contact person providing additional information product and service breakdown dividend distributions taxes fringe benefit information by countries or regions payroll information by countries or regions size and type of major tangible investment discussion of social capital formation e.g. donations r&d investment 50 50 49 49 37 35 34 33 29 24 100 100 98 98 74 70 68 66 58 48 social information reporting frequency precentage 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. statement of corporate commitment to stakeholders in society corporate involvement in community philanthropy activity employee training and education policy for compliance mechanism for bribery and corruption awards relevant to social performance identification of a contact person providing additional information employee benefits no. employees and their geographic distribution policy for consumer privacy policy or procedure dealing with human right issues 49 48 42 32 26 26 25 25 21 19 98 96 84 64 52 52 50 50 42 38 environmental information reporting frequency precentage 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. statement of commitment to environmental protection incorporation of environmental concerns into business decisions encouragement of renewable energy consumption information concerning materials recycled or reused water usage information identification of contact person providing information discussion on amount of waste and mention of waste management environmental awards environmental audit environmental impacts of principle products and services 44 23 22 22 21 18 18 17 16 15 88 46 44 44 42 36 36 34 32 30 table 4 presents the mean scores for industry groups averaged across both reporting criteria and companies within a group classification adopted by the set which defines eight groups, although only seven are represented in this study. the results show that companies in highly asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 83 environmentally sensitive industries (industrial, resource, and agriculture and food) undertook more tbl reporting in their annual reports than did companies in low profile industries (property and construction, technology, service, and financial). table 4. tbl reporting by industry groups no. group of industry n mean precentage 1. 2. 3. 4. 5. 6. 7. industrial resource agriculture and food property and construction technology service financial 3 13 4 6 4 10 10 30.33 28.77 26.50 25.83 25.50 20.80 19.70 50.55 47.95 44.17 43.05 42.50 34.67 32.83 total 50 24.66 41.10 to test for differences in the tbl reporting scores derived from thai corporate annual reports between each variable, independent samples t-tests were conducted. the findings indicated that there were statistically significant differences between high and low profile companies which were significant at the 1% level (p<0.99), but the study as unable to detect significant differences between government and private companies or between international and domestic companies, family and non-family businesses, and those using big four and non-big four auditors. an anova was used to look for differences among the tbl reporting of industry groups and the study found that there were statistically significant differences between industry groups at the 1% level. to indicate descriptive statistics on the variables used in this study, table 5 is provided. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 84 table 5. descriptive statistics on independent and dependent variables variables mean std. dev. min max skewness kurtosis independent age industry market cap. profit liquidity risk owner country business audit 16.70 1.70 131989.56 9510.86 1.6758 3.1664 1.84 1.88 1.80 1.14 10.181 .678 164469.02 14081.781 1.47398 4.35344 .370 .328 .404 .351 1 1 14910 224 .37 .20 1 1 1 1 36 5 908303 83087 10.26 22.45 2 2 2 2 .398 2.091 2.83 3.469 4.323 2.459 -1.913 -2.412 -1.547 2.140 -.620 10.282 9.906 15.139 23.697 7.132 1.726 3.974 .407 2.684 dependent: tbl reporting economic social environmental 24.66 10.58 8.04 6.04 6.763 2.383 3.220 4.495 11 4 2 0 41 16 16 18 .243 -.202 .027 .664 -.093 .227 -.229 -.176 to examine the relationship of the independent variables to the extent of tbl disclosure, a multiple regression model was used: tbl reporting = a1+ b1market cap. + b2industry + b3 owner + b4 country + b5 audit + b6 business + b7 age + b8 risk + b9 profit + b10 liquidity; where: tbl reporting = the extent of tbl disclosures market cap. = size of company as measured by market capitalization industry = type of industry, dummy variable with 1= high profile, 2= low profile company owner = ownership status, dummy variable with 1= government, 2= private company audit = auditor type, dummy variable with 1= big four, 2= nonbig four auditor business = type of business, dummy variable with 1= family business, 2= non-family business country = country origin of company, dummy variable with 1= international, 2= domestic company asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 85 age = age of corporate operation risk = total debt/total equity liquidity = total current asset/total current liability profit = profitability as measured by net profit table 6 presents the multiple regression results. the findings indicate that there is no single factor which is predictive of the tbl reporting score in the annual reports of companies listed on the set in thailand. however, after separating the tbl reporting into three perspectives (economic, social and environmental), this study found some significant relationships. firstly, from the economic reporting perspective, the findings indicate that age and type of business (family or non-family business) are negatively associated with the economic information reporting score (significant at the p<.90, 10% level). it means that younger companies reported more economic information than older companies. in addition, there is a positive relationship between liquidity and the economic information disclosure score at the 10% level. therefore, companies with higher liquidity provided more economic reporting than companies with lower liquidity. next, from the environmental disclosure perspective, there is negative relationship between the size of company and the risk (debt to equity ratio) with the environmental reporting score (significant at the 10% level). on the other hand, profitability is significantly associated with the score of environmental disclosures at the 5% level (p<.95). this means that companies with higher profit disclosed more environmental information than companies with lower profit. table 6. multiple regression analysis for the determinants of tbl reporting variables tbl reporting economic reporting social reporting environmental reporting age type of industry -1.133(.265) -.898(.375) -1.675(.100*) .741(.463) -.250(.804) -.472(.640) -.485(.631) -1.410(.167) size profit -.820(.418) 1.483(.147) .495(.623) .256(.800) .547(.588) .078(.939) -2.007(.052*) 2.024(.050**) liquidity risk .411(.683) -1.542(.132) 1.708(.096*) -.096(.924) .321(.750) -.416(.680) -.688(.496) -1.923(.062*) ownership country .462(.647) .552(.585) .629(.533) -.257(.799) .986(.331) -.407(.686) -.520(.606) 1.337(.190) family auditor -.215(-1.490) .058(.240) -1.870(.707*) .445(.659) -.940(.353) .133(.895) -.321(.750) -.020(.984) adjusted r2 0.256 0.032 -0.031 0.265 * = p<.90, ** = p<.95, ***= p<.99 it is noteworthy that in comparison to the study of ho and taylor (2007), although the present study used more factors than that study, there were both differences and similarities in the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 86 findings of the two studies in regard to the relationship between the various factors considered and the tbl reporting score. ho and taylor (2007) found that size, liquidity, profit, and country were correlated with the tbl reporting score, relationships which were not detected in the present study. however, this study and ho and taylor (2007) both found a relationship between size and profit and the environmental information disclosure score as well as between liquidity and the economic information reporting score. the difference in the results of the two studies may be because ho and taylor (2007) studied companies in developed countries (the usa and japan) where regulations apply to the reporting of non-financial information (social and environmental disclosure), but non-financial information disclosure in thailand (a developing country) is still based on voluntary reporting. overall, it was difficult for this study to detect the influence of factors on the tbl reporting score in the annual reports of thai listed companies. to compare this findings with thai previous studies, the study indicates that although connelly and limpaphayon (2004), and rahman et al. (2010) found no relationship between environmental disclosures and financial performance, the findings on this study found that there was a relationship between tbl reporting (in terms of environmental disclosures) and financial performance (profit and risk). this study also supports the finding of kuasirikun et al. (2004) about an increasing trend of environmental disclosures because there was 88 precent of companies providing environmental information in their annual reports in 2010. 8. summary and limitations this study investigated the extent of tbl reporting in annual reports by companies listed on the set and tested whether there is a relationship between a variety of factors and the tbl reporting score. the initial findings show that companies listed on the set undertook more economic reporting in their annual reports than social and environmental reporting. companies classified as industrial undertook the greatest extent of tbl reporting, on the other hand, companies in the financial group undertook the lowest extent of reporting of all the groups studied. there were statistically significant differences between the tbl reporting scores of high and low profile companies. there were also significant differences in the reporting practices among industry groups but the results were unable to detect any relationship between the various factors studied and the tbl disclosure score, there was a correlation between age, type of business, and liquidity with the economic information reporting score as well as between size of company, risk, and profitability and the environmental information disclosure score. the implication of these findings is that stakeholders in thailand, (a developing country) exert less pressure on companies to undertake tbl reporting than do stakeholders in developed countries (the usa and japan, see ho and taylor, 2007). therefore, stakeholder theory may not be applicable in developing countries. as far as the researcher is aware, this study is the first to investigate tbl disclosures in the annual reports of companies listed on the set, and to assess the factors influencing tbl reporting in thailand. as such, this study extends the knowledge about tbl reporting by thai listed companies and provides practical benefit. it shows that the development of regulations, even based on a comply-or-explain approach has increased the disclosure of social and environmental information. the study asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 87 also contributes to the tbl reporting, and social and environmental accounting literature, because it provides insights into the tbl reporting, and social environmental disclosure practices of listed companies with respect to their operations within developing countries where there have to date been a limited number of published studies (m. a. islam & c. deegan, 2010). there are some limitations associated with the method adopted in the study. first, the sample consisted of only the top 50 thai companies; intuitively if disclosures are to be made, these are the most likely companies to make them. however, the results may have been different if the composition of the sample was different and sampled both large and smaller companies. second, there may be scope for explaining the extent of tbl reporting by using other variables. further research is needed to compare the tbl disclosure practices of thai listed companies in other media such as websites and/or stand-alone reports; to ascertain why voluntary disclosures are made, and whether disclosures are related to firm performance. references adams, c., hill, w.-y., & roberts, c. 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(1999). voluntary environmental and social accounting disclosure practice in the asia-pacific region: an international empirical test of political economy theory. the international journal of accounting, 34(2), 209-238. http://dx.doi.org/10.1016/s0020-7063(99)00006-0 appendix a: list of items used to evaluate the extent of tbl reporting no. economic perspective social perspective environmental perspective 1 information about size and profitability company’s statement of a corporate commitment to its shareholders and society company’s statement of a corporate commitment to environmental protection 2 identification of a contact person for providing additional information awards received relevant to social performance any mention of environmental regulation 3 products or services breakdown identification of a contact person for providing additional information involvement of environmental experts in business operations 4 market shares by region no. of employees and their geographic distribution environmental audit 5 information on backlog orders turnover of workforce environmental awards 6 information on major suppliers levels of employee education incorporation of environmental concerns into business decisions e.g. green purchasing 7 payroll information by countries or regions employee benefits concerning health care, disability, retirement identification of a contact person providing information 8 fringe benefits information by countries or regions employee job satisfaction energy usage information 9 employee stock options or bonus programs employee health and safety information e.g. number of lost workdays, accidents, or deaths encouragement of renewable energy consumption 10 information on major creditors employee training and education water usage information 11 dividend distributions any mention of policy addressing workplace harassment and discrimination information concerning the materials that are recycled or reused asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 92 12 taxes number of women & minorities any mention of strategy for the use of recycled products 13 discussion of social capital formation e.g. donations policy or procedure dealing with human rights issues information about the source, type and remedy procedures of emissions 14 size and types of major tangible investments any mention of policy for preserving customer health and safety pollution impacts of transportation equipment used for logistical purposes 15 economic performance of major tangible investments company’s involvement in community philanthropic activity environmental impacts of principle products and services 16 r&d investments policy for prioritizing local employment discussion of the amount and type of wastes and mention of waste management 17 investment in information technology policy for compliance mechanism for bribery and corruption any mention of environmental accounting policies 18 other intangible investments e.g. brand value, reputation policy for preventing anti-competitive behavior environmental expenditures 19 earnings or sales forecasts policy for consumer privacy fines, lawsuits, or non-compliance incidents 20 any mention of other forward-looking information provision of business code environmental contingent liabilities microsoft word 1829-7236-1-rv-writer2-new th per receive doi:10.5 abstra the glo financia securiti securiti paper in zealand using n method two-sa in this s perform he glob rforman the uni the uni the uni ed: may 22, 5296/ajfa.v4 ct obal financ al system a ies commi ies act 200 nvestigates d firms’ init new zealan d which app ample mean study. the r mance befor bal fin nce of i f iversity of w private iversity of w private iversity of w private , 2012 a 4i2.1829 cial crisis h and econom ssion and 09, monetar the impact tial public o nd firms’ i lies market -compariso result reveal re, during a nancial ipo: th fir itriya fauzi waikato, w e bag 3105, e-mail: 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(ipos), glob finance & ac issn 19 2012, vol. www.macrothi 2009 period underperfor and ipos’ s interesting bal financia ccounting 946-052x 4, no. 2 ink.org/ajfa ds have a med the hort-run as most al crisis, 1. intro one of instituti compan the first private furtherm improve manage costs of ipos sh (nzx), of ipos an oppo in the p the ne market. limited further nz firm firms’ s conditio the glo in 2006 affect a to min many ch to enco by the n to revie act was this acti the qu enough indicato consum march predicti are barr decemb the curr oduction f the most ional invest nies, they ne t sale of sto firms to ra more, they e their ove erial costs. t f setting up hould be no depending s’ cost. furt ortunity for primary stoc ew zealand the nz i d listed their ipos until h ms started to specific fac ons (such as obal financi 6. the crisis all the us se nimise the i hanges aim ourage confi new zealan ew the secu s to attract a ivity would uestion is w to induce or is the nz mer confiden 2008, whic ions were fo riers that rem ber 2009, th rent state of important e tors, is the t eed to offer ocks by an ise a larger allow a fir erall financ therefore, t an ipo. fo o more than g on each fir ther, not on investors to ck markets, (nz) ipos ipo history r stock on t hallesntein o list their sh ctors, and c s the global al crisis in s began with ectors and o impact of th med at pullin fidence and nd governm urities (dis and retain m d strengthen whether new e investors z roy mor nce rose to ch was the or the new main, which he governm f new zeal events in th transition fr their shares unlisted fir r pool of eq rm to raise ial conditio the benefit o or example, n 6-8% of th rm’s circum nly do ipos o invest in t which prim s conduct ac y can be tra the nzsx i n glassons h hares on the common fa financial cr 2007 and 2 h the defaul other countr he global f ng its regula ease of inv ment to encou closure) am more compa the new ze w zealand’ and busine rgan consu o its highes e first quar zealand ec h prevent b ment set up and's capita 182 he life of a from being a s to the pub rm to the p quity capital many time on. howeve of going pu , in new ze the fund rai mstances. th provide be the share of marily deal w ctivities in aced back t in 1904. ho holding lim e stock mar actors, for e risis which 008 was sta lt of mortga ries, particul financial cri ations and po vestment in urage inves mendment anies to inve ealand econ ’s response esses to en umer confid st level in e rter in whi conomy to e businesses s a capital m al markets, asian a firm, and a private to blic through public throu l than is av es that amou er, an ipo ublic must b ealand the c ised in the n he nzx lis enefit to the f growth of with the issu the nzsx, to the begin owever, afte mited listed rket. the pe example a happened a arted by the age loans in larly those w isis, the ne olicies in lin new zeala stment activ act 2009. est and to d nomy. e to the glo nter and op dence surve early septe ch new z exit recessio eeking to o market dev the internat n journal of f d one of pa o a public c initial publ ugh stock m ailable from unt in one involves f e weighed a costs of rais new zealan ting fees ar e issuers but the firm. a uance of new which is th nning of 19 er the first i their stock rformance o firm’s pres at the beginn e united sta the us, an with tight tr ew zealand ne with inte and. one of vities in its c the purpos do business i obal financi perate in n ey 2009, w ember 2009 ealand ente on in 2010. perate in n velopment t tional conte finance & ac issn 19 2012, vol. www.macrothi articular int company. a lic offering markets. ipo m any other offering an financial co against the sing equity nd stock e re only a sm t also ipos an ipo is co w securities he premier 900, when ipos, there k in 1947; af of ipos dep stige and ec ning of 200 ates subprim nd spread qu rade links to d governmen ernational st f the chang capital mark se of amend in new zea ial crisis h new zealan which indica 9 from the ered the re neverthele new zealand taskforce to ext, future r ccounting 946-052x 4, no. 2 ink.org/ajfa terest to as public g (ipos), os allow r source. nd hence osts and massive through xchange mall part provide onducted s. equities sanford were no fter that, pends on conomic 7). me crisis uickly to o the us. nt made tandards es made kets was ding the aland, as has done nd. one ated that level in ecession. ss, there d. on 16 o review risks and opportu zealand recomm new ze the sh aggarw afterma 1988), signific first-day years (l returns perform regardle sometim though years (l zealand abnorm 0.86% r -0.47% outperfo abnorm losses a at a spe a given defined abnorm the mar the pur new ze quoted represen us ipo 2. liter the int show th markets to be “ sindela ljungqv unities and k d (ministry mendations ealand's eco hort-term pe wal and riv arket returns new zeala cant afterma y returns of lee, taylo of 23% ov mance of ip ess of the m mes weeks) h the new z loughran e d ipos are mal return fo respectively . an abnor formed or u mal return in against mark ecific time, b n period. to d as the sum mal return fo rket perform rpose of th ealand. a s firms are re nt major ac os that typic rature revi ternational hat the init s. this phen “leaving mo ar and ritte vist and wi key changes y of eco will signifi onomic grow erformance voli (1990), s for ipos and (firth, arket returns f over 18% or, & walte ver the pas pos has go method of p immediatel zealand ipo t al., 2006) exhibiting or 2006, 200 y, and the o rmal return underperfor ndicates ca ket perform but it does n o account f m of all ab or new zeal mance. is paper is study of ne elatively yo ctivities of th cally trade o iew evidence on tial underp nomenon is oney on th er (1994), ilhelm (200 s necessary nomic de icantly imp wth and new of ipos h ritter (199 in the us. 1997; loug s. in additio (loughran er, 1996), w st 20 years one through pricing, ipo ly following os have exp , the data re g negative 07, 2008, 20 overall aver can be pos rmed the a apital gain mance. this p not take into for these no bnormal ret land ipos su to investig ew zealand ung and hav he nzsx a on the over-t n short-run pricing is c also known he table”. r loughran 3) all found 183 to deliver t evelopment, prove the co w zealande has become 91), and lo similar to ghran & r on, over the & ritter, 2 while new s (loughran h extensive os tend to y g issue. perienced p eveal that d abnormal r 009 and 201 rage abnorm sitive or ne average ma while a ne provides a c o considera ormal varia turns over uggests that gate the sho d firms is in ve been list and they are the-counter n ipos’ per common for n as short-r ritter (199 and ritter d underprici asian the best pos , 2012). t ontribution ers' well-bein e the focus oughran and the us an ritter, 2006) e last 40 ye 2006) and a w zealand i n, ritter, & observatio yield substa ositive abno during the g return. the 10 is -1.21% mal initial r egative, dep arket perfo egative abno crude measu ation fluctua ations, the c a defined t ipo stock ort-term stoc nteresting b ted for less e listed on th r market. rformance i r both dev run underpr 1), keasey (1995), r ing in the u n journal of f sible financ the taskf that capita ng. s of attenti d ritter (199 nd australia ) is found t ars the us australia for ipos have & rydqvist n and it ha antial return ormal return global finan new zeal %, -0.60%, return durin pending on rmance, an ormal retur ure of the st ations that n cumulative period of t s underperfo ck price beh because a la than twenty he full boar s mixed. t veloped and icing, as th and short ritter and w u.s. market. finance & ac issn 19 2012, vol. www.macrothi cial system force belie al markets m ion. reilly 95) report n a (finn & h to have a n ipos have r 12.1% for experience t, 2006). s as been fou ns in the da rns over the ncial crisis t land ipos -0.20%, -0.7 ng 2006 to n whether th nd thus a rn indicates tock’s perfo naturally oc abnormal r time. the n formed com ehaviour of arge numbe y years. new rd in contra the existing d developin he company t (1992), ib welch (200 . similar to ccounting 946-052x 4, no. 2 ink.org/ajfa for new eves its make to (1977), negative higham, negative enjoyed over 20 d initial hort-run und that ays (and e past 20 the new average 78% and 2010 is he stock positive s capital ormance cur over return is negative mpared to ipos in er of the w issues ast to the g studies ng stock appears bbotson, 02), and the us, lee et market; underpr loughr and vo when o liability zealand new ze in a stu perform period f return o reports public short-ru availabl availabl buy sha investor howeve hence t overval with the market (the imp greater overpric further buy in, underpe internat variatio characte hypothe overval implica returns; in addit accruals reported al. (1996) ; husson an ricing for o an and ritt s (1992) fou only 15% of y. surprisin d ipos exhi ealand ipos udy of a de mance of –1 from 1977 t of –29.13% that the un in the heav un ipo phe le in ipos. le; this lead ares in less rs (rock, 19 er, the afte the abnorm luation by in e "impresar for ipos is presarios) to the initial r cing by inve , underprici in the hope erformance tional evide ons are due eristics of esis predict lued than o ation that th ; this pattern tion, the ipo s in the fis d at the tim and gong nd jacquillat other develo ter (2006) a und that mo f the us ip ngly, this st ibit differen s yield nega eveloped ma 3.73% in th to 1987. li for a samp nderperform vy-volume nomenon. o the numbe ds to a poten s desirable 986). ermarket is mal returns nvestors in rio" hypothe s subject to o create the return at th estors will t ing can cre e that more of ipos in ence is vari e, in part, to companies ts that firm ther ipos ( he high-vo n exists in th os’ underpe scal year of e of the off and sekha t (1989), le oped countr also found th ore than 28% pos were. t tudy reveal nt patterns f ative abnorm arket, agga he first year kewise, rit ple of 1,526 mance is con years. the one explan er of shares ntial “winne ipos’ stoc not immed that ensue the early tr esis, or the f fads and th e appearance e ipos date tend to be a eate a “casc investors w the afterma ied (loughr o the differ s going pu ms going pu (loughran lume perio he us. erformance f the ipos, fering and c 184 ar (2001) r evis (1993), ries, such a he same res % of ipos i this may be ls that duri from other c mal returns. arwal and r r following tter (1991) f 6 ipos over ncentrated a ere are a n nation is the s subscribed er’s curse” f cks’; theref diately effic e to ipos i rading (agg fads hypoth hat ipos ar e of excess e, the greate and the smal cade” effect will follow ( arket has no ran, ritter, rences in r ublic (firth ublic in hig & ritter, 1 ods should e is also pos , because in consequently asian reported un , and kunz as european sult for the in the nz sh e due to the ing the glo countries an rivoli (199 g the initial found a sig r the period among youn number of e rationing d often far for investors fore, the ip cient in val investors a garwal & ri hesis (shille re underpric demand. th er the degre ller subsequ t, whereby ritter, 1998 ot been doc & rydqvi regulations, h, 1997). gh volume p 995; ritter be associat sitively relat nvestors m y overvalue n journal of f nderpricing and aggarw n countries new zeala hare market e effect of d obal financi nd from pre 0) found ne offering for nificant me d 1975 to 19 nger firms a possible ex of a limited exceeds the s, because t po sets a lo luing newly are the resu ivoli, 1990) r, 1990), wh ced by the i his hypothe ee of subseq uent returns initial inves 8; welch, 1 cumented in st, 1994). t contractual the windo periods are r, 1991). th ted with th ted to the si ay misinter e the new is finance & ac issn 19 2012, vol. www.macrothi for the au wal (1994) r . firth (199 and market. t were unde differences ial crisis, t evious time egative afte r 1,435 ipo ean market984. furthe and firms th xplanations d number o e number o the only opt ow price to y issued se ult of a tem ). this is co hich argues investment esis predicts quent corre should be. stors are en 992). howe n all studies these inter al mechanis ow of opp more likel his has the he lowest l ize of discr rpret high e sues (teoh, ccounting 946-052x 4, no. 2 ink.org/ajfa ustralian revealed 97), and cheung erpriced, of legal he new s, as the ermarket os in the adjusted er, ritter hat went for the of shares of shares tion is to o attract ecurities, mporary onsistent s that the bankers s that the ection of nticed to ever, the and the rnational ms, and portunity ly to be testable long-run retionary earnings , welch, & won revalue income perform underpe to inve event st particul movem stock s introduc study, d increase noted th myers ( howeve fama, f that has impact on the s event p revealed should g the nu perform h01 : h02 : h03 : h04 : 3. meth 3.1 da this stu nzx de the nz were on well in represen ng, 1998). t the firm -increasing mance. over erformance estigate the tudy relates lar informat ment. the ex split annou ced by dol doley found ed in 57 of hat studies i (1948), bark er, event stu fisher, jens s been empl of earning stock price, period, and d that the s gain abnorm ull hypothe mance of ipo caar2006 (1 caar2007(1, caar2008(1, caar2009(1, hodology ata udy uses n eep archive zsx market nly 23 ipos capturing a nt the nz ip hen, when h downward accounting rall, the inv or outperfo ipos’ perf s to the inf tion, it will xamples of uncements, ley (1933), d a signific the cases a in the event ker (1956) a udy has bee sen and rol loyed by m announcem using 29 m the abnorm stock price mal return fr esis is that o, and the h 1,t) is not sig t) is not s t) is not s t) is not s new zealand . firms used t is suited t s on the nz aggregate l pos during high pre-iss s. this sce g adjustmen vestors’ sent ormance of t formance, p formation u reflect in t informatio and merg examined cant differen and declined t study field and ashlery en popular s ll (1969). t ost research ments, and f months befo mal return w quickly ad from the spl t the glob hypotheses p gnificantly d ignificantly ignificantly ignificantly d firms’ ip d in this pap to large and zsx. thoug everage in the global f 185 sue earnings enario sug nts and unus ntiments tow the ipos. previous stu uncertainty the firm val on affecting gers and ac the impact nce in the s d in only 26 d have been y (1962). since the sem they introdu hers until no fama et al. ( ore the split was calcula djusted to th it announce bal financia proposed ar different fro y different fr y different fr y different fr pos for the per are thos d establishe gh only 23 the country financial cri asian s are not sus gests that sually poor wards ipos udies emplo in the mark lue, which i stock price cquisitions. of stock sp stock price 6 of the case n conducted minal work uced the m ow. ball an (1969) exam was annou ated using he split ann ement. al crisis ha re as follow om caar200 rom caar2 rom caar2 rom caar2 period of 2 se who listed ed enterpris firms were y because th isis. n journal of f stained, disa issuers hav post-issue e are an imp oy an event ket; when t is indicated e are earnin event stu plit on the movement es. further, since its in of ball and ethodology nd brown (1 mined the im nced to 30 the market nouncement as no imp w: 07(1,t), (t=1… 008(1,t), (t=1 009(1,t), (t=1 010(1,t), (t=1 2006-2010 d their ipo ses. from 2 observed, t he listed fir finance & ac issn 19 2012, vol. www.macrothi appointed in ve unusual earnings an portant facto study analy the market d by the sto ng announc udy analys stock price in which t mackinlay nitial momen d brown (19 y of the eve 1968) exam mpact of sto months afte model. th nt, and no i pact on sh …20 and 1… 1…20 and 1 1…20 and 1 1…20 and 1 collected f only on the 2006 to 201 the sample rms can be ccounting 946-052x 4, no. 2 ink.org/ajfa nvestors lly high nd return or in the ysis. an absorbs ck price cements, sis, first e. in his the price y (1997) ntum by 968) and nt study mined the ock split er as the he result nvestors hort-term …60) 1…60) 1…60) 1…60) from the e nzsx. 10, there may do used to 3.2 met an even market to brow give les willing power binder returns (2004) of the movem market market where r only req market (macki the retu depend abnorm where zero me accord it may a bias, an for a se changes the resu follows are mor arising thod nt study me adjusted re wn and war ss benefit, w ger (1990) su equal to th affirms tha and the ma suggests tha abnormal ments; hence adjusted r return (bro rit and rmt quires the re model is inlay, 1997) urn market on the r2 mal returns, w rit and rmt ean disturba ing to blum affect the e nd the adjus ecurity in w s over time ult of bias; t s a linear tre re accurate. in the mark ethod is emp eturns and m rner (1980), which in fa uggested th he market a at the mean arket and ris at the mark return by e, this increa returns are own & warn are the per eturn marke calculated ). this meth during the regression; which incre are the per ance term. me (1975), th empirical re stment of be which it w as the unce therefore se end, it can b . in addition ket. ployed in th market mode different ab act might w hat the mean and risk ad n adjusted sk adjusted et corrected removing ases the wid calculated ner, 1985). iod t return et. using ord hod controls period esti ; the higher eases the pow 0 riod t return , , he estimate esults. there eta is impor ill be used ertainty aris everal time p be easily sho n, blume’s 186 his paper to el are used bnormal ret worse off th n adjusted r djusted retu returns is returns in d model and the portion der possibili as the retu ns on securit dinary lea s for the risk imated. the r r2, the gr wer to detec 0 ns on secur are the par d beta deriv efore, the e rtant since d to estimat ses in the va periods are own that the method is asian analyse sh to calculate turn benchm he result. fu returns and m urns in esti less power estimating p d the marke n of the r ity of detect urn differen ty i and the ast square k (beta) of t e benefit of reater is the ct the abnor rity i and th rameters of ving from th stimated be it will be u te its marke alue of the used to me e estimated generally a n journal of f ort-term per e abnormal marks used urther, chan market adju imating par rful than th parameters. t model min eturns rela ting the even nce between e market por (ols) reg the stock an f using the e reduction rmal perform he market p the market he historical eta has to b used to forec et risk. fur expected re easure the b beta is unbi appropriate finance & ac issn 19 2012, vol. www.macrothi rformance o returns. ac in the even andra, moria usted return rameters; h he market . likewise, nimise the v ated to the ent effect. n stock ret rtfolio, this gression est nd the move market mo n in the var mance. portfolio, model. l data is bia be adjusted cast the fut rthermore, t eturn, which beta. if the t iased, so th for any co ccounting 946-052x 4, no. 2 ink.org/ajfa of ipos; ccording t studies arty and ns have a however, adjusted castillo variance market turn and (1) method timation ement of odel will iance of (2) (3) is the ased, and to avoid ture beta the beta h can be true beta e results onditions a linea calculat therefor where period 2 the bet on the c the leng ev t0 t0 : lis t0 : 21s the eve necessa by the m and it i because result. f estimati inferenc cumulat under t or varia the var ar regression ted using b re the result is the 2 and i ta in time p correspondi gth of the ev ent window sting day to t trading da figu ent window ary to captur market. the is preferabl e multiple e furthermore ion window ces, and th tive abnorm the null hyp ance) in obs riance of ca n is a comm blume’s m ts are more beta of sec s the error t eriod 2 (21s ing beta in t vent window w t1 20th trading y (after 1st d ure 3.3.1. ab w is the num re both the e length of e to have t events with e, to calcula w, the abnor he aggrega mal return (c pothesis, h0 ervation len ari is: , mon method ethod, to a accurate. t curity i in t term. the fo st trading da the time pe w and the es estimati g day day trading) bnormal ret mber of tradi leakage and the event w the smallest hin an even ate the abno rmal returns ation is cal car) is use , that the ev ngth of the e 187 d used in the acquire unb the linear re time period ormula 1 is ay after listi eriod 1 (seco stimation w ion window ) to 60th trad turn estimat ing days fol d the time n window is a t number o nt window m ormal return s in the sam lculated th ed to accom ,, ∑ vent has no event windo ~ 0, 1 asian e beta estim biased beta egression for d 1, is used to calc ing day to 6 ond part of window used w (post-eve ding day tion using th llowing the needed for t a matter of of days in t may occur n variation o mple firms a hrough time mmodate a m⋯ ,∑ impact on t ow (mackin, n journal of f mation, and t for the fo r beta is: the beta of culate the be 60th trading 20 days). f d in this pap ent) he market m listing day the informa f judgement he event w and affect over the eve are aggrega e and acro multiple peri the behavio nlay, 1998) finance & ac issn 19 2012, vol. www.macrothi the adjusted orecast peri f security i eta in time day), are re figure 3.3.1 per. model that are con ation to be a t for the res window as p the signific ent window ated to draw oss securiti iod event w our of return : ccounting 946-052x 4, no. 2 ink.org/ajfa d beta is iod, and (4) in time period 2. egressed 1 depicts nsidered absorbed searcher, possible, cance of w and the w overall ies. the window. (5) (6) ns (mean (7) (8) the dis the agg the var the dis to sup regress and is u mvrm advanta method equation while b uses ye when t n stock after te and all tribution of gregation is riance of the tribution of pport the t sion model used to me m applying f age of the dology begi ns (binder, binder (198 ear dummy the explanat ks the system esting the m announcem f the car un calculated e cumulativ, f the caar two-sample l (mvrm) easure the e fama et al. mvrm m ins by para 1985): 85) uses du to specify tory variabl m of return mvrm for e ments, and th nder h0 is n, ~ 0 through tim , ⋯∑∑ ve average a under h0 is, ~ 0 mean-com methodolog effect of ne ’s (1969) m method ove ameterising ummy varia which year les in the re equations is each firm, th hen the port 188 no abnorma0, , me and acros , abnormal ret 1 s no abnorm0, , mparison te gy, which ew informa method to m er other ev the abnorm ∑ ables to spe r has signif eturn genera s: ∑ his study ap tfolio return asian l return, the ss securities turns (caa mal return, th est, this st was first in ation on ass measure abn vent study mal returns ecify the an ficant impac ating proces pplies joint h n equation is n journal of f en: s ar) is: hen: tudy emplo ntroduced b set prices. b normal retur methodolo s in the nnouncemen ct on abnor ss are the sa hypothesis s: finance & ac issn 19 2012, vol. www.macrothi oys a mul by gibbons binder (198 rn, and outl ogies. the e individua nt effect, th rmal return ame for eac testing for a ccounting 946-052x 4, no. 2 ink.org/ajfa (9) (10) (11) (12) (13) (14) ltivariate (1982), 85) uses lines the mvrm al return (15) his study of ipo. ch of the (16) all firms 4. find table 1 the aver from -0 firms’ p negativ the diff inflation yield cu long-ter terms o investm model. and hen table 1 caar 2006 2007 2008 2009 2010 table 2 abnorm returns indeed r returns market after th reflecte decline perform howeve hold the market day ob dings presents d rage market 0.0039 to -0 performance e average a ferent calcu n into accou urve; the l rm bond w of risk and ment, which however, t nce provide . descriptiv obs me 60 0.04 60 -0.06 60 -0.03 60 -0.07 60 -0.00 2 and table mal returns across new reflections o and cumul model resp he issuance. ed in the de in the inv mance for n er, the resul e stock for l adjusted re served. ab escriptive s t adjusted re 0.0767. thi e was unde abnormal re lation used unt, wherea longer term was favoured return, an thus resulte the different a better exp ve statistics market a an std.d 447 0.017 698 0.04 360 0.036 767 0.043 039 0.063 3 present th (caar). h w issuance a of ipos per lative abnor pectively are . the avera ecline of ca vestment va new zealan lts only sho longer perio eturns and m bnormal retu statistics for eturns for a is is signific r the marke turns for th for each m as during th m interest r d over shor d because ed in negati t calculation planation th s adjusted retu dev. min 75 -0.012 17 -0.124 68 -0.126 31 -0.141 37 -0.252 he average however, t and so it is rformance. f rmal returns e provided. age abnorm aar. by d alue. the r nd ipos wi ow short-ter ods may ma market mode urns from 189 ∑ r all year ob all years obs cantly diffe et performa he market m method, in w hat period n rates are hi rt-term bon of the inte ive abnorma n methods p han having o urns n max 21 0.0751 45 0.0017 60 0.0318 18 0.0042 22 0.0740 abnormal re there are c of interest furthermor s after listin the abnorm mal return i day 20, the results here ithin a ran rm performa ake substan el, is differe first tradin asian bserved. as served yield erent from z ance. howev model. the r which mark new zealand igher than nd. similarly erest rates, al returns fo provide grea only one me mean 0.0084 -0.0148 0.0177 -0.0017 0.0561 eturns (aar considerable t to examine e, the t-stati ng day usin mal returns in the first caar is e indicate ge of 20 tr ance of ipo ntial profit. o ent from ze ng day to t n journal of f can be seen d negative re zero, sugge ver, only 20 results diffe et adjusted d exhibited short-term y, stocks ar investors f or ipos com ater robustn ethod. market m std.dev. 0.0109 0.0189 0.0219 0.0111 0.0700 r) and the c e variations e whether t istics for the ng market a are shown day to fift 0.0078, sho a continuin rading days os, and prob overall, the ero and insig the twentiet finance & ac issn 19 2012, vol. www.macrothi n, apart fro eturns, with esting that t 007 and 20 er solely be return did d an upward rates. this re more vo favoured lo mpared with ness for the model min -0.0154 -0.0434 -0.0197 -0.0328 -0.0946 cumulative s in the ab these variat e average ab adjusted ret for day 1 to fth day is n owing a sub ng deterior s after listi bably invest e t-statistics gnificant fo eth trading ccounting 946-052x 4, no. 2 ink.org/ajfa (17) m 2006, h a range he ipos 09 yield cause of not take d sloping s means olatile in ong-term h market analysis, max 0.0344 0.0248 0.0602 0.0245 0.1787 average bnormal tions are bnormal turn and o day 20 negative, bstantial ration in ing day. tors who test, for or all the day are negativ due to reduced table 2 e, suggestin some reaso d reputation 2. average a days 1 2 3 4 5 0 6 0 7 8 9 0 10 0 11 0 12 13 0 14 0 15 16 17 18 19 20 *sig. at 10%l ng that inve onable con n of investm abnormal re aar s -0.0047 -0.0006 -0.0018 -0.0002 0.0129 0.0017 -0.0067 -0.0129 0.0102 0.0218 0.0049 -0.0118 0.0021 0.0033 -0.0006 -0.0024 -0.0053 -0.0165 -0.0005 -0.0007 level, **sig. at 5% estors react ditions, for ment bankers eturns after l ma std.dev 0.0214 0.0243 0.0278 0.0226 0.0377 0.0205 0.0162 0.0808 0.0215 0.0930 0.0224 0.0644 0.0608 0.0263 0.0278 0.0177 0.0170 0.0440 0.0259 0.0201 % level, and ***s 190 negatively r example s, and hence listing day arket adjus t-test -0.2187 -0.0231 -0.0657 -0.0075 0.3416 0.0844 -0.4131 -0.1599 0.4769 0.2339 0.2191 -0.1832 0.0349 0.1246 -0.0223 -0.1371 -0.3139 -0.3757 -0.0181 -0.0369 sig. at 1% level asian to the ipo. uncertainty e markets ha sted return caar -0.0047 -0.0052 -0.0071 -0.0072 0.0056 0.0074 0.0007 -0.0122 -0.0020 0.0198 0.0247 0.0129 0.0150 0.0183 0.0177 0.0153 0.0099 -0.0066 -0.0070 -0.0078 n journal of f the negati of the eco ave negative std.dev 0.0214 0.0243 0.0278 0.0226 0.0377 0.0205 0.0162 0.0808 0.0215 0.0930 0.0224 0.0644 0.0608 0.0263 0.0278 0.0177 0.0170 0.0440 0.0259 0.0201 finance & ac issn 19 2012, vol. www.macrothi ive reaction onomic con ve sentiment t-test -0.2187 -0.2156 -0.2546 -0.3198 0.1496 0.3590 0.0430 -0.1513 -0.0920 0.2127 1.1014 0.2005 0.2472 0.6957 0.6365 0.8639 0.5861 -0.1496 -0.2724 -0.3870 ccounting 946-052x 4, no. 2 ink.org/ajfa n may be nditions, ts. table 3 table 4 days aft signific of abno in whic (1,t) is n this stu the yea which contribu . average a days 1 2 3 4 5 0 6 0 7 8 9 0 10 0 11 0 12 13 0 14 0 15 0 16 17 18 19 0 20 0 *sig. at 10% 4 presents t fter the issu cant differen ormal return ch they are c not significa dy. hence, ars compare happened d uting to the abnormal re aar s -0.0044 -0.0030 -0.0057 -0.0012 0.0132 0.0025 -0.0069 -0.0119 0.0118 0.0215 0.0032 -0.0137 0.0037 0.0030 0.0003 -0.0028 -0.0028 -0.0120 0.0023 0.0032 %level, **sig. at 5 the two-sam ance. apart nt between 2 n calculation compared, a antly differe it can be c ed. the diff during 200 difference. eturns after l std.dev 0.0225 0.0273 0.0261 0.0214 0.0374 0.0185 0.0148 0.0710 0.0222 0.0895 0.0198 0.0696 0.0619 0.0184 0.0205 0.0179 0.0173 0.0404 0.0248 0.0189 % level, and *** mple mean-c t from the m 20 trading d n. further, th and thus thi ent from the oncluded th fferent caa 8 and 200 191 listing day market m t-test -0.1965 -0.1094 -0.2164 -0.0563 0.3525 0.1374 -0.4640 -0.1680 0.5337 0.2406 0.1605 -0.1968 0.0591 0.1633 0.0154 -0.1552 -0.1636 -0.2984 0.0946 0.1704 *sig. at 1% level comparison market mod days and 60 he results e is study reje e caar2007 hat there is ar may be 09; howeve asian model caar -0.0044 -0.0074 -0.0131 -0.0143 -0.0011 0.0015 -0.0054 -0.0174 -0.0055 0.0160 0.0192 0.0055 0.0092 0.0122 0.0125 0.0097 0.0069 -0.0052 -0.0028 0.0004 n test for 20 del’s 20 trad trading day xhibit signi ects the null 7(1,t), and fo a significan the result r, other ca n journal of f std.dev 0.0225 0.0273 0.0261 0.0214 0.0374 0.0185 0.0148 0.0710 0.0222 0.0895 0.0198 0.0696 0.0619 0.0184 0.0205 0.0179 0.0173 0.0404 0.0248 0.0189 0 trading d ding days, t ys using two ficant coeff l hypothesis or all compa nt differenc of the glob auses seem finance & ac issn 19 2012, vol. www.macrothi t-test -0.1965 -0.2715 -0.5000 -0.6674 -0.0289 0.0790 -0.3659 -0.2445 -0.2484 0.1790 0.9686 0.0792 0.1481 0.6611 0.6091 0.5436 0.3984 -0.1278 -0.1137 0.0214 days and 60 the results s o different m ficients for a s that the ca ared years t ce of the ca bal financia to be pos ccounting 946-052x 4, no. 2 ink.org/ajfa 0 trading show no methods all years aar2006 tested in aar for al crisis, ssible in table 4 c 2 2 2 2 * finding table 5 only 20 abnorm might b in the m directly perman value d from fin nzsx long-ter changes rate res negativ table 5 4. two-samp caar 2006 & 2007 2007 & 2008 2008 & 2009 2009 & 2010 *sig. at 10%level, g the signifi 5 provides t 008 and 200 mal returns o be also due mid-2006 an y held and nent (in thos declined abo nance comp also lead t rm bond ha s in the inv ulted in the e abnormal 5. ols regr p ple mean-co 7 7. 8 -3 9 4. 0 -4 l, **sig. at 5% lev cant differe the ordinary 09 exhibit ne of ipos sug to the glob nd beginnin via manag se cases wh out $5.5 bil pany failur to negative ad higher int vestor prefe e fall of the returns. ression resu constant 2006 2007 2008 2009 2010 obs. wald chi2 prob.>chi2 *sig. at 10%lev omparison t 20 tradin mar .3821** .6041** .0123** 4.4418** vel, and ***sig. a ent caar f y least squ egative and ggest that th bal financial g of 2007; i ged funds) here a comp llion since es. the dec e sentiment terest rates erence of se e bond value ults 2 vel, **sig. at 5% l 192 test ng days mm 1.8540* 0.9994 1.2621 1.4409 at 1% level for the year uare (ols) significant he market re l crisis that investors in . these lo pany fails). the start of cline in the s toward n compared t ecurities ins e and stock coefficien 0.0010 -0.0009 -0.0020 -0.0026* -0.0027* (omitted) 1380 5.89 0.2074 level, and ***sig asian m ** 19.6 4 -4.7 5.5 9 -7.3 which it co regression coefficient eacts negati started to i ncurred loss sses can p for examp f 2007, and e market in new securit to short-term struments. f k value, and nt s ) (o g. at 1% level n journal of f 60 trading mar 6080** 7130** 583** 3278** ompared wit result. the s. the nega ively toward impact new es on equity persist long ple, in 2007 d was a mu ndices and s ies issuanc m bonds, w further, the d so to for i td.error 0.0011 0.0013 0.0016 0.0014 0.0014 omitted) finance & ac issn 19 2012, vol. www.macrothi g days mm 8.2590** -8.7135** 6.1126** -6.3189** th is necess e results rev ative and sig ds these ipo w zealand e y investmen g-term, or e 7 telecom’s ultiple of th stock prices ce. in addit which resulte e increased ipos which ccounting 946-052x 4, no. 2 ink.org/ajfa * * sary, and veal that gnificant os. this economy nts (both even be s market he losses s on the tion, the ed in the interest h yielded figure adjusted abnorm observa the ben have be prime f and thu compan failures directly (gdp), econom prospec 1 and figur d returns an mal returns f ation. anoth eficiaries fr een astute e fixed intere us contribut nies went in s compound y to the fin the increa mic uncertai ct of new fir -0.15 -0.05 0.05 0.15 -0.12 -0.07 -0.02 0.03 0.08 re 2 depict nd market m for all years her explanat rom the cris enough earl st bonds w ted to the nto receiver ded the con nance comp se of the in inty combi rms (ipos). figure 1. a figure 2. a 5 5 5 5 1 6 1 averag 20 1 6 11 averag 20 the average model respec s fluctuate b tion for thes sis will be fe ly in, or ah which, (with negative ab ship or liqu nditions of panies. in a nflation rat ined to low average abn average abn 11 16 21 ge abnorma 006 2007 16 21 ge abnorm 006 2007 193 e abnormal ctively. as between -0.0 se negative ew in numb head of, the h falling int bnormal re uidation in n f market st addition, th te, the incre wer market normal retur normal retur 26 31 al returns returns) 7 2008 26 31 mal returns 7 2008 asian returns for can be seen 04 and 0.03 fluctuation ber, there wi e crisis to h erest rates) eturns of ip new zealan tability, as he decline ease of une t confidenc rns for 60 tr rns for 60 tr 36 41 4 (market a 2009 36 41 s (market m 2009 n journal of f 60 trading n, apart from 3, suggestin abnormal r ill have bee have sold e will have pos. furthe nd, and thes the capital of growth employmen ce of inves rading days rading days 6 51 56 adjusted 2010 46 51 5 model) 2010 finance & ac issn 19 2012, vol. www.macrothi g days using m 2010, the ng less outli returns is th en some. a equities and increased i ermore, 30 se finance c l market is domestic nt added to stors regard s s 56 ccounting 946-052x 4, no. 2 ink.org/ajfa g market average er in the hat while few will d bought n value, finance company s related product the nz ding the figure using m the caa negativ econom differen caar figur figur 3 and figu market adjus ar for 200 e cumulati mic conditio nt method p were obser -0.3000 -0.2500 -0.2000 -0.1500 -0.1000 -0.0500 0.0000 0.0500 0.1000 1 cu -0.1500 -0.1000 -0.0500 0.0000 0.0500 0.1000 0.1500 0.2000 re 3. cumul re 4. cumul ure 4 exhibi sted returns 06, all coeffi ve average on which im provides dif rved to mov 6 11 umulative a 20 1 6 1 cumulat 20 lative averag lative averag t the cumul and marke icients for t e abnormal mpacted the fferent resu ve upward. 16 21 average ab 006 2007 1 16 21 tive averag 006 2007 194 ge abnorma ge abnorma ulative avera et model res the caar i return, su e ipos per ults, which the differe 26 31 bnormal re returns) 7 2008 26 31 ge abnorm model) 7 2008 asian al returns fo al returns fo age abnorm spectively. f in the years uggesting th rformance a can be seen ent patterns 36 41 eturn (mar 2009 36 41 al returns 2009 n journal of f or 60 trading or 60 trading mal returns f figure 3 sho observed te hat there w after 2006. n in figure of the caa 46 51 rket adjust 2010 46 51 5 (market 2010 finance & ac issn 19 2012, vol. www.macrothi g days g days for 60 tradi ows that ap end to expe was turmoil however, 4 in which ar movem 56 ted 56 ccounting 946-052x 4, no. 2 ink.org/ajfa ing days art from erience a l in the using a h all the ments are due to t the aver 5. conc the ph literatur suppose value. i howeve negativ with tho returns this stu the peri ipos ar average who bo perform trading results s differen coeffici hypothe on. hen compar negativ an imm market consiste of 2006 becomin to the d sentime short-te long-ter ipos. o financia despite future i short ti framew that market rage abnorm clusions henomenon re. based o ed to be the in this case er, this phen e abnormal ose reported for ipos in udy examin iod 2006 to re varied o e abnormal ought ipos mance. the r days and 6 show no sig nt methods ients for all esis that the nce, it can b red. further e and signif mediate imp condition w ent with the 6 and 2007 ng a global difference. ent of the m erm ipos’ rm ipo perf overall, ne al crisis/situ e the current in new zea ime in offi work that wi model coun mal returns, of abnorm on investor fair value o ipos are un nomenon se l returns for d from othe n germany, nes the shor o 2010. the over the 20 returns unt at the close results reve 60 trading gnificant dif of abnorm l years in w e caar2006 be concluded r, the ols ficant coeffi plication of t was unfavo e economic 7 had impa financial c for examp markets; as performanc formance an ew zealand uation. t global glo aland is look ice, that it ill stimulate nting on the hence resul mal initial r rationality of ipos, but nderpriced a eems not to r the first f er countries which is -12 rt-term ipo findings su 0 trading da til the fifth e of trading eal a continu days. in ad fference bet mal return which they 6(1,t) is not s d that there s regression ficients the result is ourable bec condition d cted on oth risis. howe ple, setting s a result t ce alone is nalysis may d ipos out oominess, fin king bright. is willing e confidence 195 e beta being ulting more p return of ip in an effici ut the offer p and exhibit fit new ze few days af s. prior rese 2.1% and -2 os’ performa uggest that ays and 60 trading da g on the firs uing deterio ddition to t tween 20 tr calculation. are compa significantly is a signific n results re s that invest ause of the during 2008 her countrie ever, other c the offerin this impact s unable to y be needed tperformed nancial cris . the new g to implem e and put th asian g estimated, positive retu pos has b ient market price is cons positive ab ealand ipos fter listing d earch report 27.0% for j ance of list returns on 0 trading da ay are negat st day woul oration in sh the market ading days . further, t ared, and th y different f cant differe eveal that ors acted ca e global fin 8 and 2009, es, by spre causes seem ng price too ts on ipos explain th d to support on a short ses and rece governmen ment the ne he country o n journal of f , and the be urns. een well d , the first d sidered to b normal retu , as new ze day. this fi ted that the apanese ipo ed firms on the short-te ays after th tive, sugges d have lost hort-term pe model’s 20 and 60 trad the results hus this stu from the ca nce of the c only 2008 autiously to nancial crisi where the ading all o m to be poss o high may ’ performan he overall p the short-te t-run basis essions do n nt has demo ecessary ch on the road finance & ac issn 19 2012, vol. www.macrothi eta tends to documented day trading be set below urns in the s ealand ipos inding is co negative ab os. n the nzsx erm perform he listing d sting that in against the erformance 0 trading d ding days us exhibit sig udy rejects aar2007(1,t) caar for t and 2009 avoid a los is. the evid us subprim over the wo sible in cont y result in n ance. howe performanc erm perform during the not last forev onstrated, du hanges to s d to recover ccounting 946-052x 4, no. 2 ink.org/ajfa level up d by the price is w the fair short run. s exhibit onsistent bnormal x during mance of day. the nvestors e market over 20 days, the sing two gnificant the null ), and so he years exhibit ss, as the dence is me crisis orld and tributing negative ever, the ce; thus, mance of e global ver. the uring its set up a y. it has proven back to 6. limi the fin through were an would l exchang further any oth referen aggarw manage ball, r. of acco binder, accoun blume, 785-795 brown, financi brown, journal capital retriev http://w rce castillo estudio chandr alternat depende dolley, busines fama, e informa that it can a more nor itations ndings of th h publicly a ny problems limit the v ge from 200 , the conclu her events w nces wal, r., & ement, 19, 4 ., & brown, ounting rese 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(1985) nting resear m. e. (197 5. s. j., & w ial econom s. j., & w l of financi market d ed www.med.go o, a. (2004) os de econo a, r., mori tive return encies in ev j. c. (193 ss review, 3 e. f., fisher ation. intern adapt swiftl rmal environ his study ar available da s relating to alidity of t 06 to 2010, usions are li which affecte rivoli, p. 45-57. , p. (1968). a earch, 6, 15 ). on the use rch, 23(1), 3 75). betas a warner, j. ics, 8, 205-2 warner, j. b ial economi developmen ovt.nz/busin ). the annou mía, 31(2), iarity, s., & generating vent studies 33). charac 316—326. r, l., jensen national eco ly to amend nment. re restricted ata sources o data disclo he findings , which com imited to th ed an ipo’s (1990). fa an empiric 59-178. e of the mul 370-383. and their re b. (1980). 258. b. 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( d equity off 04-405x(98 2010). the atic/nzsx_n act 2009. z/act/public ). new zea -22. http://d ales, learnin 198 utional/econ d. financial nce of initial of ipo activ g/10.1111/1 s. contemp underpriced es and popu 1998). ear fferings. jou 8)00032-4 e new zea _nzdx_lis (2009). ne c/2009/0023 aland ipo u dx.doi.org/1 ng, and casc asian omic-marke l manageme l public offe vity, pricin 540-6261.0 orary finan d? journal ular models rnings man urnal of fin aland stoc sting_rules. ew zealand 3/latest/dlm underpricing 0.5172/ser. cades. journ n journal of f ets-research ent, 6, 28-42 erings. jour g, and allo 00478 nce digest, of financi s. the jour nagement a nancial eco k exhange .pdf. legislation m1827104.h g: the reput 1.1.13 nal of finan finance & ac issn 19 2012, vol. www.macrothi h/consumer2. rnal of fina ocations. jo 2(1), 5-30. ial econom rnal of ec and the po onomics, 50 e. retrieved n. retrieve html tation facto nce, 47, 695 ccounting 946-052x 4, no. 2 ink.org/ajfa -confide ance, 46, urnal of mics, 15, onomics ost-issue 0, 63-99. d from: ed from: or. small 5-732. microsoft word 1813-7155-1-sm _1_-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 131 does islamic interbank rate influence bank characteristics and economic cycle in malaysian monetary transmission? fidlizan muhammad department of economics, faculty of management and economics education university of sultan idris, tanjong malim, perak, malaysia azam sulaiman mohamad department of syariah and economics, academy of islamic studies, university of malaya, kuala lumpur, malaysia mohd yahya mohd hussin department of economics, faculty of management and economics education university of sultan idris, tanjong malim, perak, malaysia azila abdul razak department of economics, faculty of management and economics education university of sultan idris, tanjong malim, perak, malaysia received: may 17, 2012 accepted: july 29, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1813 url: http://dx.doi.org/10.5296/ajfa.v4i2.1813 abstract this study aims to determine the effectiveness of islamic interbank rate as the intermediary target by monetary policymakers in achieving economic goals. via islamic banking institutions as the mediator to channel the policy effect, the relevancy of this tool is identifiable. to attain this objective, a credit channel model was used by adapting macroeconomic variables and also bank specific variables. data from 1997 until 2010 was regressed by using the panel data method with the application of interaction approach. the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 132 analysis finding shows that the iir is capable in influencing the bank specific variables. accordingly, islamic banks are the significant intermediaries in ensuring the effect of policy implementation provides stimulation to the achievement of the desired economic goals. besides, the significant pro cyclical nature through the interaction with the gdp, indicates the effect of this policy tool in influencing bank behavior to offer financing for the economic sectors parallel to the current economy. keywords: islamic banking financing, islamic interbank rate, bank characteristics, economic cycle, panel data asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 133 1. introduction the central bank plays a fundamental role in managing the financial system stability of a country. in operating its function, the central bank has various approaches that can be applied as widely discussed in the financial economic studies. there are two forms of financial policy intermediary target used by the central bank to achieve this objective which are the financial aggregate target and also interest rate target. based on these targets, the debate among the economists especially between the keynesian and monetarists involves the extent of bank role as intermediary in this channel. however, between these two forms of channel, it has been found that the interest rate target channeled through bank intermediary was given priority in much research. thus, this monetary policy transmission is known as the credit channel. a study by bernanke (1983) and bernanke and blinder (1988) regarding the economic crisis in the united state of america known as the great depression was the first preliminary study that discovered the importance of this channel. investigation by using the bank specific variables was then applied in getting a more detailed evidence for the credit channel efficiency. the specific variables studied consisted of bank size (kashyap and stein,1995), bank liquidity (kashyap and stein, 2000) and also bank capital (kishan and opiela,2000). while the current research has also been adopting the credit risk variables for the purpose of demonstrating the actual performance of a bank financial status (altunbas, gambacorta and david, 2010; rajan, 2005; borio and zhu,2008). following the importance of this credit channel in the implementation of financial policy, similar studies have also been conducted in other countries. among them are altunbas, fazylov and molyneux (2002) and pizarro-barcelo (2009) in the european countries, nertherlands (de haan, 2001), greece (brissimis, kamberoglu and simigainnis, 2001), portugal (farinha and carlos, 2001), japan (ogawa,2000), italy (gambacorta and mistrulli,2004) and many more. as many studies were seen as subscribing to this credit channel, hence the same objective must be researched in malaysia. the scenario in malaysia is of the interest to be studied for two reasons. firstly, the bank negara malaysia (bnm) which acts as the responsible institution in managing the country financial target, has changed its financial policy mediating target from the financial aggregate target to the interest rate target in 1990’s (bnm, 1999). this target is still being implemented until today (bnm, 2010). secondly, the dual banking practice that are islamic and conventional banking systems which have been in operation simultaneously since the past three decades. based on the principles of banking operation that need to comply to the shariah requirement, the islamic interbank money market has been established to enable the transaction of fund surplus and deficit between institutions can be carried out. in the meantime, this market is used by the bnm to operate its function in achieving the stability goal in the money market and economic goals. therefore, how far does the managed financial policy tool in this market function to the achievement of basic financial goals will be investigated in this study. the discussion of this study is arranged in such way; section 2 explains on the financial policy and development of islamic banking system in malaysia. data, variables and research asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 134 methodology used in the regression model is elaborated in section 3. in section 4, the discussion proceeds on the outcome of analysis. while the section 5 summarizes the findings of analysis and its implication. 2. development of islamic banking and financial policy in malaysia islamic banking system has rooted in malaysia for almost three decades. in this period, its operation is executed concurrently with the conventional banking system. although the age of the islamic banking in malaysia is still green, from the aspect of growth it is outstanding. this development conforms to the growth of islamic finance at global. the asset of the world islamic financial system currently has surpassed usd 1 trillion and recorded annual growth of 20%. this is in line with the forecast by zaher and m. kabir (2001) who estimated that islamic banking is capable to dominate between 40 to 50 percent from the total of saving or deposit by the world muslim community in 2010. in malaysia, the islamic banking system commenced from the year 1983 with the establishment of the first islamic bank which is the bank islam malaysia berhad (bimb). its years of operation for 10 years without competitors demonstrated a positive level of asset development and financing. this situation implied that this sector has a potential to be developed. after 10 years, the deposit of islamic banking reaches the total of rm1.6 billion, while the total of financing nears to rm1 billion. accordingly, the bnm expanded the islamic banking system by creating the interest free banking system in 1993. through this system, the conventional banking system was allowed to to create its islamic windows operation to to carry out its banking operation based on shariah principles. based on the number of branches and good institution infrastructure, the implementation of this system has given a lot of advantages to the competitiveness of islamic banking in malaysia. as a result, the total of deposit and financing of islamic banking system is increasing year by year. the total of deposit rose from rm 26 billion in 1998 to rm218 billion pada in 2010. similar statistics is also shown in the booming total of financing from rm11.7 billion to rm162 billion during the same period. as a comparison in the growth of financing, islamic banking financing reveals a higher growth rate compared to the conventional banking loans. the islamic banking system recorded a two digit value of growth in 2000 until 2010. in these 5 years period (2005-2010), the average of its financing growth was as much as 17.5% compared to 7% in the conventional banking. entailing to the capability of islamic banking in competing in this market, the bnm increased the dominating figure of islamic banking market by 5% in 2000 to 20% in 2010 and 40% in 2020. due to rapid expanding of the islamic banking in malaysia, the central bank regulation of these institutions is essential to achieve stability in financial markets. this scenario is compatible with the economic dependence on bank loans capital that are steadily increasing. the ratio between bank loans with a total gross domestic product (gdp) in malaysia in 2000 was 127%. it then increased to 158% in 2010. according to alloway (2009), this ratio could trigger a crisis asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 135 if it is not regulated by prudence, as happened in other european countries now. in the islamic banking, this ratio was also increasing by 12% in 2000 to 29% in 2010. accordingly, in attaining the objective of financial stability that will stimulate economic goals, policy makers need to implement the strategic target policy that is able to influence the bank's lending activities. to achieve this purpose, bnm has adapted the policy of targeted strategies from the monetary aggregates target to the interest rate target in the mid 90s. this change is timely because of the economic sectors appear more sensitive to changes in interest rates compared to interest rates of treasury banking. in carrying out its interest rate target for the islamic banking sector, bnm has established the islamic interbank money market (iimm) in 1994. through this market, the surplus and deficit that occurs in institutional funds were traded between institutions based on shariah principles and the agreed funding rate. the applicable rate in the market was known as the interbank rate (islamic interbank rate). this rate was also the target policy tool by the bnm in implementing the financial transmission of islamic banking institutions. dramatic growth in this market was shown which recorded the increased value of transactions by almost 10 times between 1999 to 2010. value of transactions in this market in 2010 was rm2, 552 billion. this significant growth of transactions between the bank shows that the economic capital financing offered is in line with economic growth in malaysia. this relationship shows that the nature of the economic cycle affects banks in providing financing. parallel to the development of islamic banking and monetary policy as practiced in malaysia, its effect on the appropriate financing is duly to be examined. in other sense, the financing of the islamic banking sector, is likely to respond differently to the implemented monetary policy. this is because, the operation of islamic banking is based on asset compared to conventional banking that is based on money alone. this result in the lower risk of islamic banking compared to the conventional banking. however, this practice of dual banking does not exclude the islamic banking to face the risk of interest rates that can influence the institution financial assets status. 3. data and methodology in this study, annual data from 1997 to 2010 was used. a total of seven variables were employed in this credit channel model. it covers five specific variables, namely the number of bank financing (tf), bank size (sz), liquidity (liq), capital (cap) and credit risk (risk) and the two macro variables of the gross domestic product (gdp) and islamic interbank rates (iir). the efficiency of the islamic interbank rate (iir) to function as an instrument of monetary policy transmission mechanism was analyzed by using the model in offering loans that have been used in many previous studies such as kashyap and stein (1995), kishan and opiela (2000) and de haan (2003). in these studies, bank size, liquidity and capital are the variables that can be used in evaluating the efficiency of the transmission of policy on bank lending. meanwhile, a study by ehrmann, gambacorta, jorge, sevestre and worms (2001), keys, mukherjee, seru and vig (2008), aricci, igan and laeven (2008) and altunbas et al. (2010) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 136 have included the credit risk variables in this model. these important variables were included together in the analysis model for the justification of innovation in the financial markets and the availability of facilities to transfer the credit risk is expected to have a tendency to eliminate the actual information on the financial performance of banking institutions (borio and zhu, 2008; instefjord, 2005). in relation to that, the estimation model in this study can be written briefly in the following equation (1): ittti s ti s ttiti yiirxiirxiirytf    ** 51, ' 41, ' 321, (1) with, i = 1, ... n and t = 1, ... t. both of these subscripts refer to the number of institutions and period of time. based on equation (1), tf which represents the amount of financing islamic banks is regressed with real gdp growth as a control variable for controlling the change in loan demand. according to kashyap and stein (1995), better economic situations increase the economic sectors profitable in terms of expected net present value, thereby increasing the demand of credit. the introduction of this variable captures cyclical macroeconomic movements and serves to isolate the monetary policy changes. in this model, four bank specific variables are used to measure bank responses to changes in monetary policy. these variables are bank size (sz), liquidity (liq), capital (cap) and credit risk (risk). three variables (sz, liq and cap) are a standard variable that is often used by researchers to test the credit channel (kashyap and stein, 1995; stein, 1998; kishan and opiela, 2000; van den heuvel, 2002). current research is also included with the risk variables in the model to show a more comprehensive effect. tf variables, gdp and sz in this study are in the form of logs, while liq, cap and risk are as a ratio to total assets. in addition, all bank-specific characteristics refer to 1t in order to avoid endogeneity bias. in testing the efficiency of this channel, the researchers suggested the use of interactive methods. this interaction variable is the variable that shows the effects of monetary policy on bank specific characteristics. coefficient for this variable will show the form of behavior or the banks behavior in providing loans in response to the implemented monetary policy shocks (golodniuk, 2006; hosono, 2006).the bank characteristics were furthermore interacted with the monetary policy indicator to find out if monetary shocks have distributional effects on financing in malaysian islamic banking institutions. the hypothesis is that small size, less liquidity, poorly capitalized and higher credit risks banks will react more strongly to monetary policy indicators changes. meanwhile, to test the nature of economic cycles in the supply of bank financing, the interaction between economic growth and policy tools was adopted. the hypothesis tested is the small banks which show greater response to economic changes. by this hypothesis, monetary policy contraction or increases in the interest rates will have a stronger impact on small banks. therefore, panel data approach was deployed in this study. wooldridge (2002) defines panel data as the data that has both cross-sectional and time-series dimension. in this study, the cross-sectional units are the islamic banking institutions in malaysia. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 137 to perform the analysis of the equation (1) model, selection of appropriate analytical method is important. two main methods are often discussed in the analysis of panel data regression using the method of least squares (ols) or generalized least squares method (gls). to find a suitable method, test specifications performed, including correlation tests, heteroscedasticity (white 'general test) test and autocorrelation (wooldridge test). data that is not normally distributed in the correlation test is an early indication of the choice of gls methods as the appropriate analytical methods. through the heteroscedasticity tests that reject the null hypothesis, it is able to prove that the gls method as the best method (gujarati, 2003). if the null hypothesis in the autocorrelation test is rejected, then the regression model must take into account the terms of the first degree autoregressive (ar1) (wooldridge, 2002). once the results of the regression had been obtained, then the diagnostic test was done. this test is to ensure that the results of econometric estimation is to meet the criteria. heteroscedasticity tests performed using breush pagan test or lagrange (lm), while tests lbi (locally best invariant) was to test the autocorrelation problem. this test was developed by baltagi and wu (1999) to allow testing for serial correlation in the form of unbalanced panel data is done. according to greene (2008), if this diagnostic test reject the null hypothesis, then the estimation model is proposed to be regressed in dynamic form. 4. result of analysis the result of model specification test found that the method of gls with ar1 error term is an appropriate method of analysis to be used to test the efficiency of this transmission channel. it is derived based on the unbalanced data distribution for all variables used. in addition, the null hypothesis in heteroscedasticity test and autocorrelation were also successfully rejected. therefore, the discussion in the analysis is based on the results of analyzes using gls ar (1). before the estimation is carried out on the credit channel model, it is important to test the significant level of islamic interbank rate (iir) as a tool of monetary policy transmission. to find this relationship, the method of response function (impulse response function, irf) in the var model was applied. this reaction is shown in figure 1 below. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 138 figure 1. impulse response based on figure 1, it was found that the impact of shock in the monetary policy through the iir changes gave negative impact on the total supply of bank financing for a period of one year. this effect gradually decreases in further. this is consistent with the expected effects of monetary policy on investment and consumption patterns of economic sectors. in conjunction with these findings, further analysis can be done to evaluate the extend of this rate to affect bank institutions. the analysis shown in table 1. -.2 .0 .2 .4 .6 .8 1 2 3 4 5 6 7 8 9 10 vecm orthogonal impulse response iir to financing_decimal ----95% efron percentile ci(b=1000 h=10) ___ vecm orthogonal impulse response year asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 139 table 1. regression result variable coeficient (s.e) constant -0.1440 (1.6544) controlled variables: gdp 0.0108 (0.0092) policy tool iir -0.04479 (0.0970) bank specific characteristics size -0.0137 (0.1069) cap -2.0270* (0.5917) liq 1.5205*** (0.8123) risk 1.4687* (0.3574) interaction variables isize -0.0437 (0.0335) icap 0.8340* (0.1315) iliq -0.2032*** (0.1226) irisk -0.8410* (0.1322) ikdnk -0.0668** (0.0337) adjusted r2 0.3589 wald test ( 2 ) 92.43* d-watson test 1.7331 baltagi-wu 1.9912 lm test 2.42 vif 3.19 *,**, *** significant at 1%, 5% and 10% based on table 1, the gdp variable and the iir were not significant. this insignificant relationship particularly between iir and tf in this model is interesting to be examined. this finding is consistent with several previous studies such as kohler, hommel and grote (2005), rania and billmeier (2007) and era and floerkemeier (2006). justification for this condition may be associated with the implementation of monetary policy in malaysia itself. it is premised on the conventional interbank rates is better known than this iir. in addition, the reality of practice in policy management for islamic banking is to make conventional interest rate as a benchmark (benchmarking) in forming a competitive islamic interbank rate (iir). in other words, the conventional rate is still a precursor indicators (leading indicators) to the islamic interbank money market in malaysia at present. this is appropriate given that the market share of islamic banking in the financial system in malaysia is still small at only 20%. the insignificance of gdp variable is probably related to the slow growth of malaysian economy due to the asian economic crisis and a few global economic crises occurred asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 140 afterwards. the implementation of open market will incur economic shock and it will also give the same effect to the domestic economy. concurrently, it will also implicate the demand of loans from banking institutions. for bank specific variables, it was found that three variables are significant. two of these specific features demonstrated a positive coefficient value of the variable liq and risk, while the cap variables showed a negative coefficient values. the results from these studies indicate the existence of specific features of the distribution effects on the supply of bank financing. for variables with positive coefficient, it indicated that an increase in liquidity and credit risk reduction can improve the ability of banks to increase the amount of funding. whereas, for negative coefficient variables showed that banks in total liquidity shock, affect the reduction in the total supply of financing. the main empirical evidence for the evidence of islamic financing channel is shown by the positive coefficient on the variable liq (bernanke and blinder, 1988; bernanke and gertler, 1995; farinha and carlos, 2001). this is because a lot of obtained bank liquidity from the deposit will affect the supply of loans to meet capital demand by economic sector for investment or consumption. shocks or changes in monetary policy will affect the resources to this sector. the implication, in short, bank institutions are assumed to have difficulty to source a replacement. this situation in turn will affect the bank's financial capacity and have a direct impact on the supply of bank financing to the economic sector. based on the analysis, it can be concluded that the bank specific characteristics are important to explain the financial structure of a bank institution. therefore, these specific features are suitable to explain the role of the bank to channel the monetary policy transmission impact on the economy. thus, all four of these variables were interacted with the policy tool that is the iir variable to prove the efficiency of this policy transmission. meanwhile, to assess the extent of this iir functions as a signal to economic changes will be derived through iir variable interaction with the gdp. the result of the interaction of these five variables with the policy tool is shown in table 1. based on the analysis, it was found that the effect of monetary policy was channeled into the economy immediately by the banks that have a high level of credit risk and liquidity of the small banks. this scenario can be explained as follows. changes in monetary policy rate will have implications on the debt obligations incurred by economic sector. this resulted in bank institutions to be exposed to risk and in turn affect its ability to supply a larger financing. in addition, it appears that small banks with low liquidity value also showed an immediate response of monetary policy shocks. available financing offerings contracted at 0.20% following the increase in this rate would make massive amounts of deposits of islamic banking to conventional banking profit. this situation will affect the position of the financial portfolio of the institution. this effect further reduces the capacity of institutions of islamic banks to increase the number of financing offer. meanwhile, the capital of the interaction showed a positive effect. this clearly shows that the effect of financial transmission policies through banks with large capital is slower. this finding is consistent with the study by kishan and opiela (2000) who find that banks with large capital asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 141 would show a slow response to shocks policies implemented by policy makers. result of the interaction with the gdp shows that the nature of the financing offer is based on the economy (matsuyama, 2007; stein, 1998). fluctuations in the economy will encourage policy makers to make changes to the policy tool. this rate change is symbolic or a signal to financial institutions related to the occurring economic scenario. result of this analysis indicated that the transmission effects of monetary policy changes on the economy is shown immediately by small banks. based on analysis of discussion on the findings in table 1, it can be concluded that the monetary policy instruments created by bnm through iimm is able to influence a bank for purposes consistent with the implementation of a monetary policy. small banks are immediately available to respond to these policy changes. in addition, it appears that this tool will be the signals to the players in the islamic financial market to the current economic scenario and a significant medium for the transmission of monetary policy implemented by the bnm. 5. conclusion this study discusses the effectiveness of the monetary policy rate instrument executed in the islamic interbank money market to influence the banking institutions to achieve the set economic goals. by using the islamic interbank rate as an instrument of policy objectives, this rate effectively influence the institution of islamic banks, especially banks that have high rates of credit risk and lower liquidity 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(2002). econometric analysis of cross section and panel data, cambridge massachusetts: the mit press. zaher, t. s., and m. kabir hassan (2001). a comparative literature survey of islamic finance and banking. financial markets, institutions & instruments, 4(10), 155-199. http://dx.doi.org/10.1111/1468-0416.00044 microsoft word 456-3504-1-pb asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 1 do institutional investors herd in emerging markets? evidence from the taiwan stock market jonchi shyu (corresponding author) department of business administration, national taiwan university of science and technology no. 43, keelung road, sec. 4, taipei, taiwan, r.o.c. tel: 886 2 2730 1083 e-mail: jonchi.shyu@msa.hinet.net hsin-ming sun sinopac securities 9f, 306 bade road sec.2, taipei, taiwan, r.o.c. tel: 886-2-81618090 e-mail: planes.walker@msa.hinet.net received: august 27, 2010 accepted: december 28, 2010 doi:10.5296/ajfa.v2i2.456 abstract this study employs daily trading data to examine the herding behavior of institutional investors in taiwan’s stock market. our results show evidence of herding for institutional investors; indeed, they would follow both other institutional trades and their own trades. we also find that institutional investors are not driven principally by impulse or instinct and that “herded into” stocks do not exhibit unusual return reversals. moreover, the intensity of herding is negatively related to firm size, which suggests that institutional herding in taiwan’s stock market is driven primarily by information cascades. keywords: institutional investor, herding behavior, information cascade, emerging markets jel classifications: g11, g20, n25 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 2 1.introduction participants in taiwan’s stock market have long been dominated by individual investors, despite the rapidly rising weight of institutional trading in recent years. the taiwanese government opened markets for foreign institutional investors in 1983. thereafter, it gradually removed various restrictions. by 2003, all restrictions on investment positions for foreign institutional investors had been removed. during this period, the government likewise enforced the protection of intellectual property rights and reformed tax regulations to protect and encourage foreign investments. the impact of foreign institutional investors on taiwan’s stock market has grown exponentially since then. by the end of 2004, the market shares of foreign institutional investors have risen significantly to 10.87% from only 2.40% in 1999. the shares further grew to 22.12% in 2008 and stood at 16.32% in 2009. in contrast, the market shareholdings of domestic institutional investors only slightly increased from 9.36% in 1999 to 11.56% in 2004, to 13.97% in 2008 and 11.59% in 2009. as institutional investors, foreign institutional investors have played an increasingly prominent role in taiwan and in other emerging markets. their trading behaviors have had a greater effect on—and have attracted more attention to—the marketplace. in contrast to individual investors, institutional investors have immense resources and professional teams to gather and analyze information and make trading decisions based on specialized knowledge. since institutional investors are equipped with sufficient information and specialized knowledge, they should be able to make independent and rational investment decisions to generate a reasonable profit (grinblatt and keloharju, 2000; goodfellow et al., 2009). however, some empirical studies indicate that institutional investors often follow other institutional investors to engage in herding, that is, in buying or selling the same stocks over a period of time (grinblatt et al., 1995; nofsinger and sias, 1999; wermers, 1999; wylie, 2005; walter and weber, 2006; agudo et al., 2008; andreu et al., 2009). moreover, such a phenomenon is particularly apparent in emerging markets (lobao and serra, 2002; voronkova and bohl, 2005; tan et al., 2008). does institutional herding exist in taiwan’s stock market? would foreign institutional investors who play a decisive role therein but who do not understand the local markets follow the activities of domestic institutional investors? if institutional herding exists, what are the reasons for such behavior? the tendency of institutional investors to herd has important implications for capital markets because herding implies that institutional investors herd in and out of stocks without fundamental justification. due to its high trading volume, this kind of institutional herding is suspected of diluting stock-price information, exacerbating stock-price volatility, and destabilizing capital markets by driving prices away from fundamentals (scharfstein and stein, 1990). this irrational herding behavior may also cause the formation of bubbles (gleason et al., 2004). in addition to investigating herding behavior in different markets or regions, researchers are also interested in knowing whether herding behavior will change from one economic environment to another, such as during extreme market volatility or a financial crisis. the tendency to herd may be the strongest during periods of high market stress, when investors seek the comfort of consensus opinion. obtaining additional reliable information during periods of market stress may also be viewed as a better solution for reducing the costs of limited information. in a study of herding behavior in us equity markets, christie and huang (1995) report that herding does not take place in periods of market stress. gleason et al. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 3 (2004), using sector-based exchange-traded funds (etfs), analyze intraday data to determine whether traders herd during periods of market volatility. the aforementioned authors find that investors do not herd during periods of extreme market movements. in addition, market reaction to news is not symmetrical between up markets and down markets. hwang and salmon (2004) find evidence of herding in the us and south korean stock markets and these herding behaviors exist in both up and down markets. choe et al. (1999) find strong evidence of positive feedback trading and herding by foreign investors before the period of korea’s economic crisis, but no such evidence during the crisis period. kim and wei (2002) examine the behavior of resident and non-resident investors in the south korean market, and find that non-resident investors tend to herd more than resident investors. the above findings substantiate the idea that herding may be related to limited information. because the information structure, trading strategies, investments rules, and sociocultural background of foreign institutional investors are different from those of domestic investors, the herding behavior of the former type of investor may differ from that of the latter. shiller et al. (1996) provide additional evidence that expectations about market returns differ vary significantly between the united states and japan. they find that the japanese were uniformly more optimistic in their short-turn expectations for the stock market than were the americans. this suggests that geographic location or country of origin may play some role in information acquisition and in beliefs about different countries’ returns. dahlquist and robertson (2001) posit that because foreign institutional investors do not understand local stock markets as well as local investors do, the former tend to mirror one another regarding which stocks they trade or hold. similarly, scharfstein and stein (1990) argue that investors may herd if they have access only to limited information resources. hence, the findings of institutional investors’ stronger herding behavior in emerging markets than in mature markets (lobao and serra, 2002; voronkova and bohl, 2005; tan et al., 2008), implies that the soundness of markets may also influence institutional investors’ herding behavior. most of the earlier herding studies have focused only on the existence and the extent of investors’ herding behavior and, to date, have revealed very little empirical evidence regarding the determinants of institutional herding behavior in emerging markets. understanding the determinants of institutional herding behaviors may provide better solutions for reducing market instability that stems from irrational herding behavior, particularly in an emerging market. also, earlier studies of herding relied mainly on monthly or quarterly data to investigate herding behavior among institutional investors. however, taiwan’s stock market turnover ranks among the highest worldwide, and short-term speculation often exists in the market.1 in this case, daily data instead of monthly or quarterly data allow a better observation of short-term herding behavior.2 thus, our current study uses daily data and a large sample of trading information to investigate the herding behavior and the causes of herding for institutional investors in taiwan’s stock market. we first examine whether the three types of institutional investors in taiwan’s stock market herd, and whether there is a significant difference in the level of herding among them. the empirical results show that in taiwan’s stock market, herding is most apparent among domestic mutual–funds investors, is somewhat apparent among foreign institutional investors, 1 according to the statistics published by the taiwan stock exchange, taiwan’s stock market turnover rate was 288% in 1999 and 177% in 2004, ranking number 3 and number 2 around the world, respectively. 2 more recent studies on herding behavior have integrated daily data into empirical investigations; see demirer and kutan (2006), agudo, et al. (2008), zhou and lai (2008), and goodfellow, et al. (2009). asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 4 and is relatively insignificant among domestic securities dealers. interestingly, institutional investors tend to follow both their own previous trades and the trades of other institutions. domestic securities dealers behave in a strikingly different manner in that they lack the propensity to follow either their peers or foreign institutional investors. they exhibit only a relatively weak follower relationship with domestic mutual-funds investors. in examining the impact of extraordinary events on herding behavior, we find that neither the severe acute respiratory syndrome (sars) outbreak nor taiwan’s 2004 presidential-election debacle have significantly affected the herding behavior of institutional investors. the above findings show that market pressure has little influence on institutional herding, and suggest both that the majority of institutional investors would not panic in the face of a market crisis and that their herding behavior is not driven principally by emotion or impulse. we have also found that return reversal does not exist in stocks where institutional investors herd. in addition, momentum trading is not the primary reason for the herding behavior of institutional investors. these preliminary findings have prompted us to further investigate whether institutional herding is driven by informational cascades or investigative herding. when comparing herding in firms of varying size, we find evidence that although herding exists in firms of all sizes, the smaller the firm, the stronger the level of herding. we therefore conclude that informational cascades are the main reason for institutional herding in taiwan’s stock market, in line with research by sias (2004) on the u.s. stock market. 2. data this study sampled trading data over a period of six years (from january 1999december 2004), covering 1,613 trading days. this period encompassed both a bull and a bear market and underwent many significant transformations. for example, in 2003, taiwan’s government removed all the restrictions on the investment position limits for foreign institutional investors. during this transformation period, there was not only a significant increase in the number of listed companies traded by institutional investors, but also a significant tightening of regulator’s requirements governing listed companies’ disclosure of related information. those transformations helped foreign institutional investors boost their market shareholdings from 2.4% in 1999 to 10.9% in 2004. additionally, the inclusion of both up and down markets during the period of 1999-2004 also aviod sample bias problem, since different market situations may cause different herding behavior (gleason et al., 2004). for the current study, we used the taiwan stock exchange (tse) database for calculating herding measures, including data on daily purchases and sales of individual stocks by institutional investors. these data sources constituted 3,606,146 pieces of daily-trading information. the data for individual stock returns, market indexes, bull-or-bear market conditions, and the size of individual stocks derive from the database of the taiwan economic journal (tej). since the current study targets the herding of institutional investors, stocks that institutional investors seldom traded in were not suitable for the sample. thus, in our measure of overall institutional herding, we excluded from our monthly samples any stock that was not bought or sold by an institutional investor during one or more trading days in a month. when measuring the herding behavior for the three types of institutional investors, we excluded from monthly samples any stock that was not bought or sold by a foreign institutional investor, by a domestic mutual-fund investor, or by a domestic securities dealer during one or more trading days in a given month. in addition, we excluded stocks with unusual characteristics (e.g., stocks requiring full delivery and newly listed stocks). asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 5 table 1 shows the average daily trades conducted by institutional investors in the sample. the average daily trades by the three types of institutional investors grew from 1,113 in 1999 to 3,147 in 2004, rising by as much as 183%. average daily trades by foreign institutional investors underwent a nearly threefold jump over the same period, from 522 to 1,921. the number of trades by domestic mutual-funds investors and domestic securities dealers did not rise as significantly as the corresponding number of trades by foreign institutional investors, but showed steady growth, suggesting an increasingly active role by institutional investors in taiwan’s stock market. 3. do institutional investors herd? lakonishok-shleifer-vishny (lsv) herding model is most commonly employed to measure herding, very few empirical studies that concern us markets and that use lsv measurements have found significant herding in the markets (lakonishok et al., 1992; grinblatt et al., 1995; wermers, 1999). the reason for such findings, as explained by sias (2004), is that the lsv herding model measures the propensity of investors to trade in the same direction over a period of time, where part of the propensity is a random or a fortuitous event, and trades occur sequentially because not all trades by different investors take place at the same time. therefore, sias (2004) redesign a measurement that allows for direct observation of the extent to which market investors follow each other in buying or selling the same stock. our study has modified sias’ (2004) model to measure the herding behavior attributable to three types of institutional investors in taiwan’s stock market. because the information structure, trading strategies and sociocultural backgrounds of foreign institutional investors, domestic mutual–funds investors, and domestic securities dealers differ from one group to the other, their herding behavior could vary. for instance, grinblatt and keloharju (2000) suggest that foreign institutional investors have an information advantage over domestic investors insofar as the former type of investor can more accurately assess the intrinsic value of local stocks. alternately, choe et al. (2001) and dahlquist and robertson (2001) posit that because foreign institutional investors do not understand the local stock market as well as local investors, the former tend to trade or hold similar stocks. thus, we have classified institutional investors into foreign institutional investors, domestic mutual-funds investors, and domestic securities dealers to compare the extent of the herding propensity of respective institution types and to explore the situations attributable to different types of institutions that follow each other’s buying or selling patterns. in the following equations, we denote foreign institutional investors, domestic mutual-funds investors, and domestic securities dealers respectively as f, i, and s. the respective number of foreign institutional investors, domestic mutual-funds investors, and domestic securities dealers that trade security k on day t are tkf , , tki , , and tks , ; 1, tkf , 1, tki , and 1, tks are the table 1. daily average of trades by institutional investors 1999 2000 2001 2002 2003 2004 total 1113 1325 1732 2069 2606 3147 foreign institutional investor 522 758 1033 1238 1546 1921 domestic mutual-fund investor 326 324 430 497 558 564 domestic securities dealers 265 243 269 334 502 662 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 6 number of foreign institutional investors, domestic mutual–funds investors, and domestic securities dealers that trade security k on day t−1 respectively. also, * ,tkf , * ,tki , and * ,tks represent the number of foreign institutional investors, domestic mutual-funds investors, and domestic securities dealers that trade stock k on both day t and t−1. taking foreign institutional investors as an example, first, we calculate the raw fraction of foreign institutional investors’ buying as follows: raw f tk , ＝ f tk f tk f tk sb b ,, ,  (1) where f tkb , is the number of foreign institutional investors buying stock k on day t and f tks , is the number of foreign institutional investors selling stock k on day t. if foreign institutional investors herd or if they follow their own lag trades, the fraction of foreign institutional investors buying on the current day will be positively correlated with the fraction of foreign institutional investors buying on the previous day. to allow for aggregation over time and the comparison of coefficients in our regression model, we have to standardize the dependent and independent variables such that both variables have zero mean and unit variance. the standardized fraction of foreign institutional investors buying stock k on day t is defined as follows: f tk , =  f tk f t f tk raw rawraw , ,    (2) where f traw is the cross-sectional average (across k securities) of the raw fraction of foreign institutional investors buying on day t and  f tkraw , is the cross-sectional standard deviation (across k securities) of the raw fraction of foreign institutional investors buying on day t. because standardization is simply a linear rescaling, correlations between the variables and the r2s associated with the regressions are not affected. we continue by estimating, for each day, a cross-sectional regression of the standardized fraction of foreign institutional investors buying of stock k ( f tk , ) on the current day in relation to the standardized fraction of foreign institutional investors buying of stock k ( f tk 1,  ) on the previous day: f tk , ＝ tktk f t ,1,    (3) the coefficient f t is equal to the correlation between f tk , and f tk 1,  , because there is only a single independent variable and because both of the standard deviations of the variables are 1. the fraction of foreign institutional investors buying can be replaced by the sum of a series of dummy variables for each trader (that equals ‘1’ if the trader is a buyer and equals ‘0’ if the trader is a seller) divided by the number of traders. then, f t can be divided into two components: the portion of foreign institutional investors following themselves into and out asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 7 of the same securities over adjacent days, and the portion of foreign institutional investors following other institutions (i.e., herding) over adjacent days.3                                        k k f f tktk ttkf f ttkf tk f tk tk f tk f t tk nf rawdrawd rawrawk 1 1 1,, 11,,,, 1,, 1,, * , 1 1 ,   ＋            1,,1 1 tk f tk rawrawk  ×  k k 1                   tk tkf f tktk ttkm f ttkf n fmm nf rawdrawd, 1, 1 1,, 11,,,, ,1 (4) where 1, tkn is the number of institutional investors trading security k on day t−1, tkfd ,, is a dummy variable that equals 1 (0) when foreign institutional investor f is a buyer (seller) of stock k on day t, and 1,, tkfd is a dummy variable that equals 1 (0) when foreign institutional investor f is a buyer (seller) of stock k on day t−1. the first term on the right side of equation (4) is the portion of the correlation that results from foreign institutional investors’ following their own trades over adjacent days. if foreign institutional investors tend to follow their own trades over adjacent days, the first term will be positive. alternatively, if foreign institutional investors tend to reverse their own trades on adjacent days, the first term will be negative. if the trades of foreign institutional investors on a current day are independent of their own trades on the previous day, the first term will be 0. the second term on the right side of equation (4) is the portion of the correlation that results from foreign institutional investors’ following other institutional investors. similarly, if foreign institutional investors tend to follow others’ trades over adjacent days, the second term will be positive; if the direction of foreign institutional investors’ trades tends to be the reverse of the direction of other’s trades over adjacent days, the second term will be negative; if the trades of foreign institutional investors on a current day are independent of the activities of others on the previous day, the second term will be 0. the portion of the correlation that results from foreign institutional investors’ following other institutional investors can be further decomposed into three components: foreign institutional investors who are following other foreign institutional investors, foreign institutional investors who are following domestic mutual–funds investors, and foreign institutional investors who are following domestic securities dealers—as in equation (5).             1,,1 1 tk f tk rawrawk  ×  k k 1                   tk tkf f tktk ttkm f ttkf n fmm nf rawdrawd, 1, 1 1,, 11,,,, ,1 =                                      k k f f f fmm tktk ttkm f ttkf tk f tk tk tk nf rawdrawd rawrawk 1 1 ,1 1,, 11,,,, 1,, , 1, 1 1  3 the decomposition of the regression coefficient into two parts serves to avoid a situation where a part of the observed herding measurement might have resulted from traders following their own activities on the previous day. as pointed out by kyle (1985) and grossman and miller (1988), to reduce liquidity risks or to keep their own trading activities unknown to other traders, many institutional investors realize their intentions to buy or sell certain stock by strategically placing separate orders over a period of time. such investment behavior, however, does not meet the definition of ‘herding’. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 8 ＋            1,,1 1 tk f tk rawrawk  ×  k k 1                   tk tkf f tktk ttkm f ttkf i imm nf rawdrawd, 1, 1 1,, 11,,,, ,1 ＋            1,,1 1 tk f tk rawrawk  ×  k k 1                   tk tkf f tktk ttkm f ttkf s smm nf rawdrawd, 1, 1 1,, 11,,,, ,1 (5) sias (2004) has proposed that the differences in the number of traders within each classification render the computation of herding measure, it is unfeasible to use the aforementioned measures (correlations across investor types) to directly compare levels of herding across investor types. when the number of institutions making the trade increases, the weight of herding in f t tends to increase, while the weight of following one’s own trades over adjacent periods tends to decrease. in addition, when the trades of many institutions involve a certain stock, the standard deviation of the fraction of buying institutions usually drops, which will affect the standardized regression coefficient of the fraction of buying institutions. given the important influence of the aforementioned factors, we need a measure not subject to the influence of the number of trading institutions so that we can directly compare the levels of herding across investor types. thus, the contribution of herding in f t and the contribution of following one’s own trades over adjacent periods in f t must be averaged as a new measure, if there is to be a rigorous comparison regarding the levels of herding across investor types4. the resulting average contributions are not affected by either the number of institutional traders or the cross-sectional standard deviation of institutions buying. this average contribution can serve as new measures regarding foreign institutional investors who follow their own trades, who follow other foreign institutional investors’ trades, who follow domestic mutual-funds investors’ trades, and who follow domestic securities dealers’ trades. then, this result can compare directly with the measures of domestic mutual-funds investors and domestic securities dealers. table 2 illustrates the resulting time-series average contributions from following one’s own trades and from following other trades for foreign institutional investors, domestic mutual-funds investors and domestic securities dealers, as well as t statistics. 4 for more details, please see sias (2004). institutional herding. the review of financial studies 17, 165-206. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 9 table 2. herding measures of three major institutional investors following one’s own previous-day trades following others’ previous-day trades foreign institutional investors domestic mutual-fund investors domestic securities dealers foreign institutional investors 0.092407 0.009193 0.004722 0.000677 (62.606) *** (24.165) *** (11.045) *** (1.866) domestic mutual fund investors 0.133418 0.003614 0.026915 0.003532 (96.453) *** (8.593) *** (42.325) *** (7.069) *** domestic securities dealers 0.054869 -0.000450 0.002078 0.000467 (37.007) *** (-1.282) (4.015) *** (0.932) note: ** and *** indicate significance at 5% and 1% level, respectively. figures in parentheses are t-statistics. as shown in table 2, the measures attributable to foreign institutional investors who follow their own trades, who follow other foreign institutional investors’ trades or who follow domestic mutual-funds investors’ trades are all statistically significant at the 1% level. only the herding measure attributable to foreign institutional investors who follow domestic securities dealers is not significantly different from 0. for domestic mutual-funds investors, all measures are statistically significant at the 1% level. as for domestic securities dealers, only the measures of following one’s own trades and following domestic mutual–funds investors’ trades over adjacent days are statistically significant, the measures of following other domestic mutual-funds investors’ trades are not. the results in table 2 indicate that in taiwan’s stock market, foreign institutional investors and domestic mutual-funds investors tend to herd, while domestic securities dealers exhibit no marked herding behavior. in addition, except for domestic securities dealers, the average herding measures of foreign institution investors and domestic mutual-funds investors are all greater than the values obtained by sias (2004), who studied the herding behavior of different types of investors in the u.s. stock markets. we surmise that foreign institutional investors and domestic mutual-funds investors in taiwan engage in similar herding behaviors. this similarity might reflect the tendency of both foreign institutional investors and domestic mutual-funds investors to search for similar information or to adopt similar operational strategies. the findings in this study concerning domestic securities dealers coincide with the assertion of li and laih (2005) that the herding behavior of domestic securities dealers is relatively inconspicuous and independent. it might have to do with the characteristics of domestic securities dealers that are starkly different from those of foreign institutional investors and domestic mutual funds, and that bring about dissimilar operating directions and strategies. in taiwan, domestic securities dealers are typically a division of domestic brokerage houses. therefore, some dealing departments need carry out trades to hedge the warrants that issue by brokerage houses which might offset some ordinary trades of the dealing departments. also, domestic securities dealers, unlike domestic mutual-funds investors, are not subject to the pressure of performance comparison, and this difference could be another factor explaining why the herding behavior of domestic asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 10 securities dealers is not as conspicuous as that of domestic mutual-funds investors. regardless of whether it is foreign institutional investors, domestic mutual-funds investors, or domestic securities dealers, the measure of following one’s own trade from the previous day is much greater than the measure of following other investors’ trades from the previous day. the gap between the two measures, following a paired t-test, is significantly different at the 1% level for all three types of institutional investors. this finding suggest that (1) foreign institutional investors’ tendency to follow their own trades from the previous day is greater than the same investors’ tendency to herd, and (2) institutional investors practice a trading strategy of spreading the buy or sell tickets for the same stock over a period of time. 4. what drives herding? since scharfstein and stein (1990) first propose a theoretical interpretation of herding behavior, many scholars have followed suit in an attempt to find reasonable explanations for the same phenomenon. according to the wealth of explanatory models proposed so far, institutional herding can be classified into five types—impulsive or emotional herding (montgomery, 1991; sornette and johansen, 1997; pretcher, 2001), herding related to reputation and salary concerns5 (scharfstein and stein, 1990; lakonishok et al., 1992; wermers, 1999), herding stemming from informational cascades (banerjee, 1992; bikhchandani et al., 1992; welch, 1992), investigative herding (froot et al., 1992; hirshleifer et al., 1994), and characteristic herding (falkenstein, 1996; gompers and metrick, 2001; jegadeesh and titman, 1993). the present study reflects our attempt to identify and to analyze the main reasons for institutional herding in taiwan’s stock market by examining market stress, momentum trading, return reversal, and firm size. in the following section, section 4.1 deals with impulsive or emotional herding, section 4.2 examines the characteristic of herding, section 4.3 investigates herding as related to reputation and salary concerns, and section 4.4 discusses herding from informational cascades or investigative herding. 4.1 market stress and herding sornette and johansen (1997) and pretcher (2001) argue that impulsive or emotional herding is a human biological instinct inherited from ancestors. it is a response similar to the way animals in a herd flee when they see others in the herd starting to stampede, even though they do not sense the presence of a predator or an enemy. montgomery (1991) proposes that when uncertainty or market volatility increases, investors are prone to err under strong pressure, and the impulse to herd becomes particularly strong. at that time, investors are no longer concerned about a reasonable price from discounted future cash flow; they hope only to be relieved of strong pressure. if investors herd out of impulse or emotion, herding behavior would markedly intensify during periods of great market pressure. demirer and kutan (2006) study the impact of the asian financial crisis on herd behavior in the chinese stock market. their results indicate that the crisis did not affect herd formation in the chinese stock market. similar results are also found in a study by hatemi-j and roca (2004). on the other hand, song et al. (2009) find that analysts are more likely to herd to a consensus forecast when there is little uncertainty in earnings. 5 institutional herding out of reputation and salary concern is a consequence of fund managers’ willingness to forgo their private information, and emulate the trading decisions of others in order to avoid the predicament of lagging performance attributable to the fund managers’ trading decisions. as such, even if the trading decisions of others are wrong, there is a sharing-the-blame effect. this phenomenon reflects the presence of an agency problem between the fund managers and the investors. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 11 to further explore the correlation between herding and market pressure, our current study identifies two events, the sars outbreak and the 2004 taiwan presidential-election debacle, as extraordinary events likely to affect the stock market. we examine whether there existed significant herding differences between each of these events and a control period. panel a in table 3 reveals the absence of a significant difference between the herding of institutional investors during the sars outbreak and a control period. panel b in table 3 shows the absence of significant differences between the herding behavior of institutional investors in the week after the 2004 presidential elections and a control period. only foreign institutional investors exhibited markedly enhanced herding behavior following the presidential election. one plausible explanation of this finding could involve the particular sensitivity of foreign institutional investors to country-based risk in taiwan’s stock market, so they tend to liquidate their holdings swiftly in the event of a major and unfamiliar political crisis. in contrast, most local institutional investors conducted business as usual after the 2004 presidential election, possibly because they were accustomed to political pandemonium in taiwan. from panel a and panel b of table 3, it can be seen that except for foreign institutional investors who displayed an enhanced level of herding following the 2004 presidential election, institutional herding in taiwan’s stock market in general did not change significantly under increased market pressure owing to the occurrence of a sudden material event. this finding further supports the assertion that institutional herding in taiwan’s stock market is not primarily driven by impulse or instinct. table 3. changes in institutional herding under market stress panel a: changes in institutional herding during the sars outbreak and a control period period overall foreign institutional investors domestic mutual-fund investors domestic securities dealers sars episode: 2003/1/24 – 2003/4/28 0.212185 0.00704 0.010284 -0.00154 control period: 2002/10/28 – 2003/1/23 2003/4/2 – 2003/7/25 0.223733 0.006423 0.009225 -0.00124 t statistic -0.539 0.515 0.659 -0.224 panel b: changes in institutional herding during the post-“2004 presidential election” period and a control period post-“2004 presidential election”: 2004/3/22 – 2004/3/26 0.152982 0.013223 0.007486 0.001783 control period: 2004/3/15 – 2004/3/19 2004/3/29 – 2004/4/02 0.167873 0.00544 0.0004711 0.001275 t statistic -0.25 2.517 ** 0.449 0.075 note: ** indicates statistical significance at 5% level. 4.2 momentum trading and herding during a certain period or under certain market conditions, institutional investors would have asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 12 a common preference for—or a common aversion to—stocks with certain characteristics. for example, falkenstein (1996) finds that mutual-fund portfolio managers are exhibiting a distinct preference for stocks with high return volatility, high information transparency, low transaction costs, and large capitalization. the work of jegadeesh and titman (1993) suggests that the momentum strategy or contrarian strategy of investors can be regarded as a herding behavior driven by preference for certain stocks. if the majority of institutional investors are momentum traders6, they would follow past winners and distance themselves from past losers, thereby creating the phenomenon of characteristic herding. the contrary also holds true. in order to measure the role that feedback trading plays in herding, this study adds previous-day returns in the regression equation (3) as another independent variable. to allow for direct comparison between variables, the previous-day returns 1, tkr would also undergo standardization. next, the following regression equation is calculated: tk , = tktkttkt r ,1,,21,,1    (6) regression analysis is carried out using standardized current-day fraction of institutions buying as dependent variables, and standardized previous-day returns and standardized previous-day fraction of institutions buying as independent variables. a positive t,2 means that institutional investors adopt the momentum strategy; a negative t,2 means that institutional investors employ a contrarian strategy. if the coefficient of t,2 is insignificant or if the average of t,1 is far greater than t,2 after we take into account the effect of feedback trading, one can reasonably conclude that institutional herding is not being driven principally by momentum trading or contrarian trading. table 4 depicts the time-series average of regression coefficients and associated t-statistics. the regression coefficient of a previous-day returns is statistically significant at the 1% level, indicates that institutional investors in taiwan’s stock market are positive feedback traders (momentum traders), a finding that is consistent with the findings of grinblatt and timan (1993), grinblatt et al. (1995), wermers (1999, 2000), nofsinger and sias (1999) and sias et al. (2002). after factoring in feedback trading, we find that the regression coefficient of the fraction of previous-day institutional buying remained significant at the 1% level. table 4. regression analysis of current-day institutional buying vs. previous-day institutional buying and previous-day returns tk , = tktkttkt r ,1,,21,,1    regression coefficient of previous-day institutional buying ( 1 ) regression coefficient of previous-day returns ( 2 ) 2r 0.3119 0.2107 15.31% （61.746） *** （62.013） *** 6 some of the studies find that institutional investors are momentum traders, see grinblatt and timan, 1993; grinblatt et al., 1995; wermers, 1999, 2000; nofsinger and sias, 1999; cai et al., 2000; sias et al., 2002. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 13 note: *** indicates statistical significance at the 1% level. figures in parentheses are t-statistics. as all the variables are standardized, we can directly compare the coefficients of previous-day institutional buying with previous-day returns and find that the average of the former is 48% greater than that of the latter. the paired t-test result at 1% level rejects the hypothesis that the average of the two being equal, which means current institutional demand, is far more influenced by previous institutional demand than by previous returns. on the basis of the results above, we propose that although institutional investors in taiwan’s stock market are momentum traders, momentum trading is not the primary reason for institutional herding in taiwan’s marketplace given feedback trading’s limited interpretative power over institutional demand. 4.3 return reversal and herding nofsinger and sias (1999) and sias (2004) observe that if impulse, emotion, reputation, salary concern, or stock characteristics drive herding in the stock market, herding’s effect on stock prices is not information-based and the herded stock should exhibit return reversal. alternatively, if institutional herding is driven by informational cascades or is a form of investigative herding, the herded stock should not exhibit return reversal. this study uses the correlation coefficient between the fraction of institutions buying (herding) and stock returns to determine the presence of return reversal. a significantly negative correlation coefficient means that the herded stock would have return reversal. to prevent a situation where a very few institutional investors’ buying or selling has an excessive effect on the fraction of institutions buying and the correlation coefficient, we have screened the sample further so that it includes only stocks with five or more institutions trading each day. this screening has strengthened our calculation of the correlation coefficient between institutions that are buying and stock return. table 5 reports the time-series average of the correlation coefficients between the fraction of institutions buying and the previous-day returns, the same-day returns, the next-day returns, the next-two-day returns, the next-five-day returns, the next-ten-day returns, and associated t-statistics. the correlation coefficients, except for the coefficients of the next-ten-day returns, are all positive and significant at the 1% level. we find a positive correlation coefficient between the institutions that are buying and the previous-day returns, the same-day returns, the next-day returns, the next-two-day returns, and the next-five-day returns, indicating that herded stock will not exhibit conspicuous return reversal; furthermore, this finding is consistent with the findings of grinblatt, et al. (1995), wermers (1999, 2000), nofsinger and sias (1999), sias et al. (2002), and sias (2004). table 5. correlation coefficient between the fraction of institutions buying (herding) and stock return previous-day return same-day return next-day return next-2-day return next-5-day return next-10-day return 0.1570 （47.932） *** 0.1862 （51.933） *** 0.0927 （26.182） *** 0.0315 （9.004） *** 0.025 （5.710） *** 0.007 （0.849） asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 14 note: *** indicates statistical significance at the 1% level. figures in parentheses are t-statistics. nofsinger and sias (1999) and sias (2004) suggest that subsequent return reversal of herded stock indicates impulsive or emotional herding, an agency problem, or characteristic herding. the absence of return reversal, meanwhile, represents information cascades or investigative herding functioning as the primary reasons for institutional herding. the preliminary results in this study pointed to an absence of return reversal in herded stocks; hence, we further tested whether institutional herding in taiwan’s stock market is driven primarily by informational cascades or investigative herding. 4.4 firm size and herding informational cascades usually occur when private information is limited or unreliable, and when it is difficult for information holders to contact each other. so followers assess the information they have by observing the behavior of a given leader, believing that the leader’s information is more valuable than their own, which they consequently abandon. if several leaders make the same moves, it will result in informational dominance that gradually weakens the influence of an individual’s information in the market. consequently, followers are more likely to abandon their private information and mimic the actions of the leaders. such emulative behavior is like a series of descending waterfalls, and leads to the herding phenomenon of informational cascades (welch, 1992). investigative herding arises when investors search for investment decisions and come to similar conclusions because they hold or process similar information and use the same analytical methods or indicators (hirshleifer et al., 1994). although taiwan’s securities and exchange act requires listed companies to fully disclose corporate information, plenty of erroneous information continues to circulate regarding untimely disclosure. with respect to the size of listed stock, small firms do not attract as much attention from investors as large firms and their information is not as transparent. according to wermers (1999) and sias (2004), it is usually easier for investors to obtain substantial and relevant information on larger firms. for this reason, investigative herding is more likely to affect large-cap stocks. in contrast, information on small-cap stocks is not readily accessible, and is less reliable. as it is more difficult to price a stock with unreliable information, investors would rather forsake their own information, and follow the trading activities of others. thus, herding driven by information cascades is more likely to affect small-cap stocks. this study divides all stocks by capitalization into quintiles from smallest to largest with each group having the same number of stocks. next, in each quintile of stocks, we compute the contribution from “following one’s own trades from the previous day” and the contribution from “following others’ trades from the previous day”. there are typically more institutions trading large-cap stocks than small-cap stocks, and the number of institutions trading a stock would affect herding measures. therefore, when examining the relationship between herding and firm size, it is necessary to adjust the method of measurement by averaging the contribution from herding and the contribution from following one’s own trades in equation (4) relative to t for all institutional investors. because the average contributions from following one’s own trades and from herding are unaffected by either the number of institutional trader or the cross-sectional standard deviation of institutions buying, we have calculated the cross-sectional average of those two asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 15 values for all stocks in each quintile to obtain each quintile’s average contribution from following one’s own trades and from herding. using the aforementioned method, we can directly compare the intensity of herding across capitalization quintiles. if the results indicate that the herding relative to small-cap stocks exhibits greater intensity than the herding relative to large-cap stocks, then it is reasonable to conclude that herding is driven primarily by information cascades. otherwise, herding would be driven primarily by institutions both investigating the same information and using similar methodologies (i.e., investigative herding). after dividing all the stocks by capitalization into quintiles from smallest to largest and calculating both the average contribution from following one’s own trades from the previous day and the average contribution from following others’ trades from the previous day, we were able to identify the time-series averages and associated t statistics (computed from time-series standard error), which are presented in table 6. table 6. herding and firm size capitalization quintile average contribution from following one’s own previous-day trades average contribution from following others’ previous-day trades small firms 0.1137 （64.47955） *** 0.0096 （26.44624） *** quintile 2 0.0965 （59.76591） *** 0.0074 （23.67362） *** quintile 3 0.0838 （57.12935） *** 0.0051 （19.20106） *** quintile 4 0.0826 （59.96285） *** 0.0049 （21.39148） *** large firms 0.0719 （57.51551） *** 0.0031 （18.82660） *** f-statistics (p-value) 22.11059 *** 0.000 16.6242 *** 0.000 note: *** indicates statistical significance at the 1% level. figures in parentheses are t-statistics. table 6 shows that both the tendency to follow one’s own trades and the tendency to herd exist, regardless of stock capitalization. measurements pertaining to investors who both follow their own trades and herd show that the trend decreases as firm size increases. the results of an anova also show that measures pertaining to investors who both follow their own trades and herd differ significantly at the 1% level across firms of all sizes, a finding that is consistent with studies on u.s. stock markets (lakonishok et al., 1992; wermers, 1999; sias, 2004). smaller-cap stocks are less liquid, and one or several orders to buy or sell a smaller-cap stock in a short period is more likely to attract the attention of other traders, asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 16 resulting in higher liquidity risk and price effects associated with the trading. thus, institutional investors who trade small-cap stocks exhibit a stronger tendency to accumulate and spread orders over a period of time to reduce transaction costs. the finding of a monotonic inverse relationship between the intensity of herding and firm size indicates that institutional herding in taiwan’s stock market is driven primarily by informational cascades. that is, many institutional investors choose to abandon their own information and judgment, and try to follow in the footsteps of the so-called “smart funds” or institutions with the power to influence the market. 5. conclusion this study use the methodology proposed by sias(2004) to measure the herding behavior of three major institutional investors in taiwan’s stock market, namely foreign institutional investors, domestic mutual–funds investors, and domestic securities dealers. our use of daily data in the study has enabled us to examine herding behavior if it occurs for a very short period of time, and if it is masked by the aggregate nature of the data. in addition, the large number of observations can also enable us to draw inferences of greater precision. aside from discussing the overall phenomenon of institutional herding, we also examine the influence of extraordinary events on herding, and the relationships between herding and momentum trading, between herding and return reversal, and between herding and firm size, all in an attempt to propose the primary reasons for institutional herding in taiwan’s stock market. overall, our finding show that institutional herding exists in taiwan’s stock market. however, institutions tend to follow both their own trades and other institutional trades. by examining each type of institutional investor, we discover that domestic mutual-funds investors exhibit the strongest tendency to herd. the herding behavior of foreign institutional investors is also rather conspicuous. we observe little evidence that domestic securities dealers engage in herding behavior. with regard to the effect of extraordinary events, we did not in general observe significant changes in institutional herding behavior during the sars outbreak or the 2004 presidential election in taiwan. one exception is that more foreign institutional investors dumped their holdings in the week following the 2004 presidential election to avoid the nonrecurring political risk in taiwan’s stock market, a behavior that tended to enhance these investors’ herding activities during that period. the above findings suggest that institutional herding in taiwan’s stock market is not driven principally by emotion or impulse. we find that institutional investors in taiwan’s stock market are momentum traders. but given that the regression coefficient between previous-day institutional investors demand and current-day institutional investors demand is little affected after momentum trading is factored in, and that the regression coefficient of previous-day institutional investors’ demand is significantly larger than that of previous-day returns, we surmise that momentum trading is not the main reason for the herding behavior of institutional investors. furthermore, if institutional herding comes from agency problems or characteristic herding, then the herded stocks should have exhibited return reversal. however, such phenomena are not observed in our preliminary findings. lastly, we divide the sampled stocks into quintiles by capitalization to observe herding in firms of varying size and find that although herding exists in every capitalization quintile, the level of herding increases as firm size decreases. hence, we conclude that institutional herding in taiwan’s stock market is driven primarily by informational cascades. the evidence asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 2: e1 www.macrothink.org/ajfa 17 backing up this assertion suggests that, from the perspective of some institutional investors, the information they have is limited or unreliable, so rather than use their own information in 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(2008). herding and positive feedback trading on property stocks. journal of property investment and finance, 26, 110-131 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 2355-9249-1-rv(2) edited-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 263 ceo succession: choosing between family member or outsider? noor afza amran, phd school of accountancy universiti utara malaysia 06010 sintok kedah malaysia e-mail: afza@uum.edu.my received: sep. 9, 2012 accepted: october 22, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.2355 url: http://dx.doi.org/10.5296/ajfa.v4i2.2355 abstract studies discussing on having a family chief executive officer (ceo) or outsider to manage family companies are widely discussed in overseas but little research that actually taking place in malaysia. thus, this study examines the relationship between the choices of family or outside ceo with company performance. the sample size of this study was 888 family companies listed on bursa malaysia from 2003 to 2007. interestingly, the findings indicate as expected that family ceo enhanced company performance greater than outside ceo. within the family company, ceo-successor enhanced the firm value greater than the ceo-founder. more importantly, family companies prefer to have family ceo to manage the company because of strong family cultures, high sense of family unity and belongings within the companies. keywords: succession, ceo, family member, outsider, malaysia asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 264 1. introduction family companies do play an important role in the business activities. however, research documents that family companies have a low survival rate (ket de vries, 1993; morris, williams & nel, 1996). one of the factors that lead to low survival rate is the issue of family succession. the family succession will affect whether the succession will help enhance firm performance or not. there are many studies that discuss on the choice between insider or outsider to manage the family companies (burkart, panunzi & shleifer, 2002; lee, lim & lim, 2003), but to my knowledge, limited study that explore this issue in malaysia. therefore, this study wants to examine the choice whether better to have family ceo or outsider in enhancing the company performance. experts claim that family-owned and managed companies achieve higher performance than those that are professionally managed (monsen, chiu, & cooley, 1968; daily & dollinger, 1992; ang, cole & lin, 2000). villalonga and amit (2006) found that family ownership only creates value when the founder serves as the ceo or as chairman with a hired ceo. anderson and reeb (2003) result indicate that family companies perform better when the founder is the ceo of the company, but not under the descendant’s management. however, study in india by johl, jackling and joshi (2010) also show the significant result when the ceo is from the descendant’s family rather than from the founder. in contrast, empirical studies elsewhere evidence that firms managed by professionals perform better than the founders (lauterbach & vaninsky, 1999). the non-family employees or professionals play an important role in the family companies (chrisman, chua, & sharma, 1998; gallo, 1995; ibrahim, soufani, & lam, 2001). companies run by a professional manager have a positive impact on the performance (chittoor & das, 2007). professionals possess particular knowledge that is valuable in mentoring of future-generation leaders or in filling the leadership role (lee et al., 2003). in larger companies, non-family executives also participate in strategic decision-making (chua, chrisman & sharma, 2003). a study in taiwan by lin and hu (2007) shows that family companies require high managerial skills and by using a professional ceo it helps to boost the firm performance. in malaysian scenario, it is challenging to get a potential successor who is calibre in managing the family company. some family companies train their sons or grandsons to be the successors. however, failure occurs when the successors are incapable of handling the tasks. therefore, sometimes family companies need to include professional management (non-family managers) based merit rather than on criteria such as blood or regional ties (ping, 2001). this is to ensure the family companies survival. for example, public bank bhd. is controlled by tan sri teh hong piow and it is professionally managed by teh and his managers. although public bank was founded by teh, but none of his children hold significant positions within the group. thus, based on the succession issue discussed above, this study aims to find out the answer whether family ceo or outside-ceo is better-off in enhancing the firm value. in term of the contribution of the study, these findings are likely to provide information on the level of succession planning especially in the emerging countries like malaysia. by carrying out this asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 265 study, the findings may explain the family succession planning and the corporate governance practices witin the family companies. in terms of the organization of this paper, it is structured as follows. in the introduction section, an overview on family ceo and outsider with firm performance are discussed. this is followed by the discussion on the motivation, objective and contribution of the study. the second section elaborates on literature reviews. research methodology is then explained in the next section. next, this paper highlights a section on results and discussion. the last section covers on the conclusion, limitation and future research. 2. literature review 2.1 succession planning in malaysia in malaysia, the majority of family companies evolved from traditional family-owned companies. these firms do not embrace openness in the firms’ practices and continue to be managed as if they are still owned by their founders (ow-yong & cheah, 2000). a survey conducted by shamsir jasani (2002) found that majority of malaysian family companies are small-scale; founders manage the company with the help from children and relatives; and founders do not force the children to join the firms, unless the children themselves are willing to work with families. for example, the genting group is a well-planned succession. the late tan sri lim goh tong has appointed a successor to ensure his huge business empire will continue. lim has passed the baton to his second son, tan sri lim kok thay, in december 2003. the genting group is involved in gaming, power generation, plantations, and oil and gas. better known as kt lim, the 55-year-old tycoon seems to have inherited his father’s ability to seize and exploit fleeting opportunities based on the group’s swift expansion abroad in recent years. assisting kt lim in the global push is his nephew, justin leong 28 who is the head of strategic investments (2007, october 24). other chinese companies tend to have similar stories. for bumiputera companies, some of the notable malay families in today’s market are the melewar group founded by tunku abdullah tuanku abdul rahman and sapura holdings bhd started by tan sri shamsuddin abdul kadir. both families are now in their second-generation (ngui, 2002). for a smaller business, habib jewel bhd. is one of the relatively unknown success stories. this company was founded by habib mohammad in 1953 in penang. in 1988, the father (founder) passed the business to the son, meer sadik, who has been leading it ever since. besides, there are also several successful northern indian textile enterprises operating in malaysia such as kaj chortimall, globe silk store and p lal store. these companies are in their third-generation. unlike the chinese and bumiputera companies, the indian companies have remained basically one-store operations, with little expansion or diversification. the indian entrepreneurs remained conservative and largely cautious of firm expansion due to the highly competitive industry (gomez, 2001). thus, in ensuring the family companies to remain competitive with other non-family companies, strong corporate governance will ensure family companies to last longer. a family company needs to share company vision and must hire professionals to help incorporate the right systems and procedures into the company (say, 2009). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 266 2.2 family ceo or outside-ceo proponents of internal successions (family ceos) stress that the family ceos have greater knowledge of the firm, and their established social networks (chung, lubatkin, rogers & owers, 1987). internal candidates provide a smooth transition and stability because they are well acquainted and have anticipated in developing the existing corporate strategy (carlson, 1961). internal successions also promote loyalty and reputation, thus, the family ceo has a strong incentive to ensure a firm’s profitability (davis, schoorman & donaldson, 1997). experts claim that family-owned and managed firms achieve higher performance than professionally managed (monsen et al., 1968; daily & dollinger, 1992, ang et al., 2000). family members often hold key positions in family companies. owner-managed companies achieve 75% higher profit (roe) than outside-ceo that managed the companies (monsen et al., 1968). a study in the us by anderson and reeb (2003) evidenced that family companies have higher tobin’s q and roa when family members serve as the ceo than outside ceos. villalonga and amit (2006) conducted a study on the performance of family companies and non-family companies in the us. the findings show that family ownership only creates value when the founder serves as the ceo or as chairman with a hired ceo. experts found that family companies that intend to keep the business for future generations perform better than non-family companies. the study found that the family ceo plays an important role in governing family companies, and family members serve as managers (miller & breton-miller, 2006). based on accounting performance measures, anderson and reeb (2003) results indicate that family companies perform better when the founder is the ceo, but not under the descendant’s management. daily and dollinger (1992) reveal that outside-ceo managed companies are larger, older and follow more aggressive strategies. in contrast, family-owned companies are smaller and use less aggressive strategies, but achieve higher performance than outside-ceo who managed the companies. adams, almeida and ferreira (2009) found that the good and bad past accounting performance increases the likelihood that founder-ceos will step out. founder-ceos value control over their succession more than non-founders and founder-ceos want to leave their companies “in good shape”. on the other hand, jayaraman, khorana & nelling (2000) found that there is no main effect on stock return over a three-year holding period, but firm size and firm age moderate the ceo founder status-company performance relationship. a study in india by johl et al. (2010) show that companies led by family ceos do not add value to firm performance. however, when the ceo is from the descendant’s family, the company value is enhanced. this may be because founder ceos are not good managers and or perhaps the founder ceos are managing their income to minimise taxes. in contrast, empirical studies evidence that companies managed by outside-ceos perform better than the founders. lauterbach and vaninsky (1999) distinguish between companies that were managed by a representative of the owners and companies being led by outside-ceo. their analyses demonstrate that companies managed by their owners perform worse than those run by outside-ceo. therefore, family businesses need to professionalise and delegate authority because of growth, lack of management skills within the family, asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 267 preparation for succession, or to change the norms and values of the business (sharma, chrisman & chua, 1997). the outside-ceo possess particular knowledge that is valuable in mentoring of future-generation leaders or in filling the leadership role (lee et al., 2003). a study in taiwan by lin and hu (2007) shows that family companies require high managerial skills and that using an outside-ceo can help increases the firm performance, especially if the family has a low cash-flow rights and weak control. however, when there is a great opportunity for expropriation in a family company, the company’s performance will be better-off if the ceo is a family member and the family has a high cash-flow right. outside-ceos are generally prescribed as a remedy for company difficulties (helmich & brown, 1972). when drastic changes are required, external managers appear to be more promising because he/she is not bound by old policies and implicit contracts of the firm. kosnik (1987) emphasizes that an external succession is the most effective cure for internal inefficiency because a new manager brought from outside is more likely to conceive and implement fresh initiatives. in the same spirit, hambrick and mason (1984) argue that when an organization performs poorly and needs a “change agent”, an external succession becomes more likely. based on the above literatures, there are mixed findings on the importance role of family ceo and outside-ceo. however in malaysian context, this study presumes that family ceos play a significant impact in enhancing companies’ performance than outside-ceos. family ceos have the power, control and better understand about the company. therefore, based on the arguments above, this study hypothesized that: h1: there is a significant relationship between family ceo and company performance. 3. research method 3.1 sample selection this study used data from 2003 to 2007 with 888 family companies as a sample. companies which were classified under finance, unit trusts and reits are excluded from this study because of their differences in compliance and regulatory requirements. the data for this study was hand-collected from the secondary sources, such as company annual reports, thomson financial datastream advance1, business magazines, newspapers, and books. 3.2 research model and measurement the research model is discussed below. perf = b0 + b1ceoit + b2debtit + b3fageit + b4fsizeit + b5cpit +b6ipit + b7tsit + b8propit + b9othersit where: perf = tobin’s q and eps (tests one at a time) 1 the datastream database is available in sultanah bahiyah library, universiti utara malaysia. financial data was downloaded using the thomson financial datastream advance. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 268 ceo = type of ceo debt = business debt fage = firm age fsize = firm size cp = consumer products ip = industrial products ts = trading services prop = properties others = hotels, plantations, infrastructure projects, technologies and constructions this study has tests for the outliers, multicollinearity and heteroscedasticity, and found no serious violations on the data tested. 3.3 control variables 3.3.1 debt in family companies, the first generation companies had the highest use of the equity versus debt financing (sonfield & lussier, 2004). chen, chen & cheng (2008) found that family companies are less likely to acquire external capital from the debt or equity market. debt may reduce agency costs by reducing the cash flows available for expropriation of negative net present value projects (harris & raviv, 1991; jensen, 1986). however, managerial insiders are reluctant to use the optimal amount of debt financing for the organization because of the additional bankruptcy risk associated with the higher level of debt engendered (fosberg, 2004). therefore, managers will not issue the optimal amount of debt without pressure from a disciplining force (jensen, 1986). 3.3.2 firm age firm age is an important determinant of firm growth, the variability of firm growth and the probability of firm dissolution (evans, 1987a). as firm age increases, the managers learn more about their abilities over time (evans, 1987b). studies have shown that young firms, for a given size, grow faster than old firms (dunne & hughes, 1994). smaller firms are vulnerable and firm age is expected to survive “only 5-10 years” (ward & mendoza, 1996). study claims that older firms are more likely than younger firms to achieve a lower performance on average (dunne & hughes, 1994). older firms suffer from ossification of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 269 their routines, non-learning processes, blindness, and conservatism, which cause poor performance and decline (boeker, 1997). 3.3.3 firm size study claims that family companies “only grow at a pace consistent with meeting the advancement needs of organizational members in the family system” (daily & dollinger, 1992). firm size cannot expand if a family management team is reluctant to raise external funds because they fear losing family control (church, 1993). family companies have greater opportunity to train and develop top management and more complex succession plans (helmich, 1972), more training programmes and complex succession plans (trow, 1961), and larger resources to engage external consultants for advice on facilitating the succession planning process. thus, larger family businesses may have more qualified and experienced candidates in place for possible succession (harveston, davis & lyden, 1997). 3.3.4 industry industry do influences the performance outcomes. however, the relationships are significantly mediated by the levels of debt that are sensitive to the sectors (tam & tan, 2007). a study in taiwan found that high-tech firms have significantly higher firm values than other industries no matter what types of large-block ownership they have (chen, 2006). haniffa and hudaib (2006) found that some industries are better than others. plantation/mining sectors under-perform, but the trading sector performs relatively better than their counterparts in the industrial sector). 3.4 model specification the variable ceo is measured using dummy (0, 1). if the ceo is a family member, then it is coded as 1, otherwise 0. there were four control variables in this study. firm age is defined as the number of years since incorporation. firm size is measured as natural log of book value over total assets. debt is the book value of long-term debt by total assets. industry such as consumer products, industrial products, plantation, trading services, construction, infrastructure projects, technology, hotels, and properties were coded as 1, otherwise 0. two dependent variables (tobin’s q and earnings per share) are used in this study and tested one at a time. tobin’s q is the market value of common equity plus book value of preferred shares and debt divided by book value of total assets. eps is the published earnings for ordinary shares divided by average number of shares issued during the period. 4. results and discussion 4.1 descriptive statistics table 1. distribution of family companies (by board) frequency percent main board 650 73.2 second board 238 26.8 total 888 100.0 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 270 table 1 explains that family companies were split into main board and second board. the distribution of family companies on the main board was 650 (73.2%), and 238 companies (26.8%) on the second board companies. table 2. distribution of family succession panel a: level of family succession frequency percent founder (1st generation) 575 64.8 successor (2nd generation) 313 35.2 total 888 100.0 panel b: type of ceo frequency percent family ceo 883 99.4 outside-ceo 5 .6 total 888 100.0 table 2 (panel a) explains that 64.8% (575 family companies) were in the first/founder generation, and these groups contribute significantly to the malaysian economy. meanwhile, second/successor family generations were smaller in number with 35.2% (313 family companies). from the analysis, majority of malaysian family companies were in the 1st generation, and there was a trend of family succession among the malaysian companies. some family companies have passed the power and control to the second generation. this shows that family companies plan for succession in ensuring the family empires remain in the next generation. table 2 (panel b) shows that majority of family businesses in malaysia are still being managed by family ceo. this contributes to 99.4% (883 companies). meanwhile, family companies managed by outside-ceo represent 0.6% (5 companies) only. the reasons why family ceo is preferred are because family directors mostly spend their working lives in the firm they govern, therefore they understand the firms better than outside directors and they are able to make superior decisions. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 271 4.2 correlation matrix table 3. pearson’s correlation (transformed data) q e p s c e o d e b t f s iz e f a g e c p ip t s p r o p o t h e r s q 1 eps .13*** 1 ceo .22*** .08** 1 debt -.07** .04 -.02 1 fsize -.16*** .36*** -.07** .47*** 1 fage -.08** .06 -.05 .11*** .17*** 1 cp -.04 -.03 .10*** -.07** -.21*** -.05 1 ip .08** -.05 .03 -.08** -.17*** .02 -.35*** 1 ts -.13*** -.05 -.07** .06 .01 .05 -.19*** -.26*** 1 prop .06 -.01 -.11*** .12*** .28*** .02 -.20*** -.28*** -.15*** 1 oth .24*** .16*** -.02 .02 .17*** .10*** -.17*** -.24*** -.13*** -.14*** 1 note: q=tobin’s q; eps=earnings per share; ceo=chief executive officer; debt=debt value; fsize=firm size; fage=firm age; cp=consumer products; ip=industrial products; ts=trading services; prop=properties; oth=other industries. * p< .01, ** p< .05, *** p< .001 table 3 explains the correlation signs for family companies. ceo was positively correlated with tobin’s q (significant at 1 percent level) and eps (significant at 5 percent level). this shows that family ceos do influence the company performance. while a negative relationship exists between tobin’s q and firm size, firm age, trading services and others. a positive relationship exists between eps and ceo, firm size and others. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 272 4.4 multivariate analyses table 4. multivariate analyses for ceo and company performance expected sign tobin’s q eps coef. p-value coef. p-value famceo (h1) + .1108854 0.000 .1460748 0.000 debt .0053001 0.919 -.0059658 0.951 fsize + -.0191292 0.000 .0768891 0.000 fage + -.0017053 0.001 -.0049109 0.000 cp + .040372 0.003 .0241345 0.340 ip + .0832931 0.000 .0327309 0.160 ts + .0510101 0.001 .0401071 0.165 prop + .1063905 0.000 -.0600479 0.028 others + .1312887 0.000 .0160802 0.620 _cons .8796963 0.000 -.9946571 0.000 r2: 24.21 18.00 adj. r2 23.00 16.69 note: q=tobin’s q; eps=earnings per share; ceo=chief executive officer; debt=debt value; fsize=firm size; fage=firm age; cp=consumer products; ip=industrial products; ts=trading services; prop=properties; oth=other industries; cons=constant. * p< .01, ** p< .05, *** p< .001 with reference to table 4, family ceo shows a significant relationship with firm performance (when measured using q and eps). family ceos mostly spend their working lives in the family companies, therefore, they understand the companies better than outside ceos. they are able to make superior decisions and usually the ceo has planned to pass the company to the family successor. therefore, this finding supports the previous works (monsen et al., 1968; anderson and reeb, 2003) that family companies’ value is better-off. hence, hypothesis h1 is supported in this study. firm size was positively related with tobin’s q and eps. this explains that larger companies are able to generate more profit than smaller companies. when firm size is large, family businesses have greater opportunity to train and develop top management and more complex succession plans, more training programmes, complex succession plans, and larger resources to engage external consultants’ advice to facilitate the succession planning process (trow, 1961). firm age was found to be negatively related with tobin’s q and eps. these findings indicate that as the family companies are more matured in the market, the firm value decreases. older firms are more likely than younger firms to achieve a lower performance on average (dunne & hughes, 1994). older firms suffer from ossification of their routines, non-learning processes, blindness, and conservatism, which cause poor performance and decline (boeker, 1997). most of the industries were positively related to tobin’s q and eps. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 273 thus, it indicates that majority of the industries do greatly contribute to higher company profits. table 5. sensitivity test between ceo-founder, ceo-successor and company performance tobin’s q eps coef. p-value coef. p-value gen -.0692617 0.000 -.1195755 0.000 debt .2055711 0.043 -.0056453 0.972 fsize -.0335895 0.000 .0476533 0.000 fage -.0029203 0.000 -.0032264 0.009 cp .0319317 0.047 .0267197 0.295 ip (dropped) (dropped) ts .0064968 0.744 .0053184 0.866 prop .0346998 0.081 -.0741367 0.019 others .0603965 0.074 -.0415262 0.438 _cons 1.261349 0.000 -.3956809 0.010 r2: 21.30 16.99 adj. r2 18.89 14.45 note: q=tobin’s q; eps=earnings per share; ceo=chief executive officer; debt=debt value; fsize=firm size; fage=firm age; cp=consumer products; ip=industrial products; ts=trading services; prop=properties; oth=other industries; cons=constant. * p< .01, ** p< .05, *** p< .001 further test examines whether the ceo-founder or ceo-successor that affects the firm value. it was found that ceo-successor influences the company performance for tobin’s q and eps. this explains that ceo-founder makes a small increase for company performance. on the other hand, when the ceo-successor manages the company, the company performance is better-off. it shows that the ceo-successor is able to generate more profits and the vast experience in managing the business was gained from the ceo-founder. moreover, the young ceos are risk takers, aggressive, innovative and energetic in implementing new decisions. 5. conclusion in sum, this study confirms that family ceos enhance company performance greater than outside-ceo. the ceo-successor was evidenced to increase the company performance greater than the ceo-founder. with exposure to business environment, education, experience, and sufficient business capital may give added values to the young ceos to better manage the family companies than the founders. in terms of the limitation, this study only focuses on the family companies. in future, the sample may be expanded to include the non-family companies, so 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(1996). work in the family business. current research occupations and professions, 9, 167-188. microsoft word 3411-12799-1-rv-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 127 beta of viet nam listed computer and electrical company groups during and after the financial crisis 2007-2011 dinh tran ngoc huy banking university, hcmc – gsim, intl. university of japan, japan e-mail: dtnhuy2010@gmail.com received: march 19, 2013 accepted: april 4, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3411 url: http://dx.doi.org/10.5296/ajfa.v5i1.3411 abstract during and after the financial crisis 2007-2011, the viet nam stock market, generally, has unexpected fluctuations and vni-index has decreased. besides, the viet nam computer and electrical industry, specifically, has to re-evaluate the risk level. first, we estimate asset and equity beta of four (4) sub-industrial listed companies in viet nam computer and electrical industries by using a proper traditional model. we found out that the mean value of beta of total 64 firms used in this research is around 0,711, which is quite acceptable. second, through comparison among four (4) different groups, we find out that the values of beta during the period 2007-2011 of listed hardware companies vary less than those of the rest three (3) listed groups: software, electrical and comm./telecommunication firms. finally, this paper provides both internal and external investors, financial institutions, companies and government more evidence in establishing their policies in investments and in governance. keywords: equity beta, financial structure, financial crisis, risk, asset beta, computer and electrical industry jel classification: g010, g100, g390 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 128 1. introduction although measuring beta is a traditional method used in lots of studies by researchers, this paper emphasizes on analyzing it in computer and electrical industry in one of emerging markets: vietnam stock market during the financial crisis 2007-2011. after the previous published article on estimated beta for listed construction company groups, here, we will compare the estimated results of listed viet nam electrical and electronic companies to those in its supply chain activities such as software, hardware and comm../telecommunication companies to make a comparative analysis and risk evaluation after financial crisis impacts. no research, so far, has been done on the same topic. this paper is organized as follow. the research issues and literature review will be covered in next sessions 2 and 3, for a short summary. then, methodology and conceptual theories are introduced in session 4 and 5. session 6 describes the data in empirical analysis. session 7 presents empirical results and findings. then, session 8 gives analysis of risk. lastly, session 9 will conclude with some policy suggestions. this paper also provides readers with references, exhibits and relevant web sources. 2. research issues we mention a couple of issues on the estimating of beta for listed computer and electrical companies in viet nam stock exchange as following: hypothesis/issue 1: among the four (4) companies groups, under the financial crisis impact and high inflation, the beta or risk level of listed companies in electrical and electronic industries will relatively higher than those in the rest three (3) industries. hypothesis/issue 2: because viet nam is an emerging and immature financial/technological market and the stock market still in the recovering stage, there will be a large disperse distribution in beta values estimated in the computer and electrical industries. hypothesis/issue 3: with the above reasons, the mean of equity and asset beta values of these listed computer and electrical companies tend to impose a high risk level, i.e., beta should higher than (>) 1. 3. literature review certainly, beta, as a market risk measure, has certain influence on expected stock returns. as sharpe, lintner (1964), and black. (1972) with capm model identified the expected stock return is linearly proportional to its market beta. fama and french (2004) also indicated in the three factor model that “value” and “size” are significant components which can affect stock returns. they also mentioned that a stock’s return not only depends on a market beta, but also on market capitalization beta. the market beta is used in the three factor model, developed by fama and french, which is the successor to the capm model by sharpe, treynor and lintner. pereiro, luis e (2010) said in merging markets, measuring betas is more difficult and a complicated job because developed markets have abundant historical data. and there might be no comparable local firms and this may cause unreliable capm betas. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 129 and the task of estimating cost of equity in emerging markets is more difficult because of problems such as collecting data in short periods. then, velez-pareja (2011) referred to the lack of inadequate information on the stock market in emerging countries may undermine beta and relevant formulas. frazzini and pedersen (2011) stated risky high-beta assets require lower risk-adjusted returns than low-beta assets. marcin, mariusz, marek and carol (2012) pointed calculated single betas in emerging markets can move counter to the market. they mentioned that the reliability and fitness of calculated betas are relevant to the valuation and investment of investors in merging markets. and xiaowei kang (2012) found that combining weighted or alternative beta strategies can gain significant traction in investment community and reduce risk. next, pablo fernandez (2013) also stated that industry betas are very unstable. finally, a portfolio beta can be calculated by taking market capitalization of each stock in the portfolio and then, average beta of each company security. 4. conceptual theories determinants of equity and asset beta in financial markets, systematic risk relates to the overall risk of the whole market, is affected by some factors such as: interest rate fluctuations or economic crisis, can not be avoided by diversification, and is measured by a financial metric, beta. unlevered beta measures how much systematic risk a firm has, without debt, compared to the benchmark in the stock market. equity beta covers systematic risk of a firm’s equity while asset beta mentions that risk which a firm’s asset has. several factors affecting beta include, but not limit to, the volatility of expected return of a single stock, or the volatility of the expected return of the entire stock market index. therefore, the company performance or its management performance, the investor confidence and the economic expectation might influence beta values. last but not least, for a typical company, its beta can be estimated by using a regression against an overall stock exchange index. 5. methodology we use the input data from the live stock exchange market in viet nam during the four or five years of financial crisis 2007-2011 to estimate results. we do research in this period because viet nam stock market has the declining trend and this is the time highlighting financial crisis impacts. firstly, we use the market stock price of 64 listed companies in the electrical and electronic, software, hardware, and comm./telecommunication industries in viet nam stock exchange market to calculate the variability in monthly stock price in the same period; secondly, we estimate the equity beta for these 4 listed groups of companies and make a comparison. thirdly, from the equity beta values of these listed companies, we perform a comparative analysis between equity and asset beta values of these 4 companies groups in viet nam. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 130 finally, we use the results to suggest policy for both these enterprises, financial institutions and relevant organizations. the below table gives us the number of computer and electrical firms used in the research of estimating beta: market listed electrical and electronic equipments companies (1) listed software companies (2) listed hardware companies (3) listed comm. and telecommunicatio n companies (4) note (4) viet nam 14 5 14 15 estimating by traditional method 4 1 8 3 estimating by comparative method total 18 6 22 18 total firms in group: 64 (note: the above data is at the december 12th, 2012, from viet nam stock exchange) 6. general data analysis in an industrial sample with 64 firms, equity beta is calculated at a value of 0,690 (mean) and that of asset beta is about 0,415 which are good numbers, relating to market risk during the crisis. besides, that sample variance of equity beta is 0,1804 and that of asset beta is 0,1201 is acceptable, even though the range of max and min value of beta is still large. value of equity beta varies in a range from 2,056 (max) to -0,524 (min) and that of asset beta varies in a range from 1,941 (max) to -0,251 (min). this shows us a few companies still has larger risk exposure than most of the others. looking at table 2, we note that there are 17 firms in the computer and electrical industrial sample has beta values higher (>) than 1. next, asset beta max value is 1,941 and min value is -0,251 which show us that though beta of debt is assumed to be zero (0), the company’s financial leverage contributes to a decrease in the market risk level. asset beta’s mean value at 0,415 and sample variance at 0,1201, together are good risk numbers for companies in the industry. lastly, we can see the small difference between equity and asset beta variance values is just 0,0604 and that b.t equity and asset beta mean is about 0,2749; so, there is not big effect from financial leverage on the gap between company’s beta values and industry mean value, although it indicates again that financial leverage can enable computer and electrical firms to reduce market risk. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 131 table 1. estimating beta results for four (4) viet nam listed computer and electrical companies groups (as of dec 2012) statistic results equity beta asset beta (assume debt beta = 0) difference max 2,056 1,941 0,1148 min -0,524 -0,251 -0,2732 mean 0,690 0,415 0,2749 var 0,1804 0,1201 0,0604 note: sample size : 64 source: viet nam stock exchange data table 2. the number of companies in research sample with different beta values and financial leverage beta no. of firms financial leverage (average) ratio <0 2 41,29% 3% 0<beta<1 45 47,67% 70% beta > 1 17 36,88% 27% total 64 44,4% 100% 7. empirical research findings and discussion a-electrical and electronic listed companies group during the crisis 2007-2011, the market for these companies still exists, but has certain difficulties. demand for cable and electrical wire decreases whereas demand for optical cable is still good. some companies have to seek foreign partners and markets. from the table 3 below, from data of 18 electrical/electronic industry companies during 2007-2011 crisis periods, the variance of equity and asset beta of sample group equals to 0,1749 and 0,07 accordingly which lower than the variance of the entire sample equity and asset beta of 0,1804 and 0,1201. the beta mean values are 0,626 and 0,327, lower than (<) 1, which indicates the low risk level for electrical/electronic companies. reasons include the high demand of accommodation, housing and leasing in a developing country, viet nam. we might note that equity and asset beta values of 18 firms in this category are lower than those of firms in the rest three (3) groups. although lending organizations can not reduce borrowing costs immediately, and this threats the cost of capital of these companies, the good market and management can be critical factors to explain this phenomenon. besides, the estimated equity beta mean is 0,626 and sample variance is 0,1749, which is not supporting our 2nd research hypothesis or issue that there would be a large disperse distribution in beta values estimated in this industry as well as our 3rd research hypothesis or issue that the mean of equity and asset beta values of these listed companies tend to impose a high risk level or beta should higher than (>) 1. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 132 table 3. estimating beta results for viet nam listed electrical and electronic equipment companies (as of dec 2012) (source: viet nam stock exchange data) order no. company stock code equity beta asset beta (assume debt beta = 0) note 1 tsb 0,376 0,102 2 bth 0,701 0,465 3 dzm 1,372 0,551 4 dvh 0,136 0,041 tsb as comparable 5 lgc 0,890 0,361 6 cjc 0,587 0,091 7 tya 1,145 0,359 8 pps 0,092 0,007 cmg as comparable 9 glt 0,687 0,482 10 nag 1,220 0,472 11 nhw 0,225 0,087 12 fba 0,543 0,390 bth as comparable 13 sma 0,039 0,005 nhw as comparable 14 tie 0,620 0,489 15 tgp 0,349 0,121 16 vhg 1,206 0,953 17 vbh 0,239 0,206 18 csg 0,851 0,706 note: raw data, not adjusted table 4. statistical results for vietnam listed electrical and electronic equipment companies statistic results equity beta asset beta (assume debt beta = 0) max 1,372 0,953 min 0,039 0,005 mean 0,626 0,327 var 0,1749 0,0700 note: sample size : 18 bsoftware listed companies group in an emerging market such as viet nam, the market for software firms is definitely potential, though it may be affected by impacts from the financial crisis. the table 5 below shows us the equity and asset beta mean of 6 listed software companies equals to 0,725 and 0,445, accordingly. this result, which means the risk is acceptable asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 133 although they are a little bit higher than that of the electrical/electronic firms, maintains the investor confidence of business operation of the whole industry. besides, the distribution of beta value among these 6 firms is normal, from 0,125 to 1,112 and from 0,088 to 1,019, for equity and asset beta, accordingly. please refer to exhibit 2 for more information. table 5. statistical results for vietnam listed software companies statistic results equity beta asset beta (assume debt beta = 0) max 1,112 1,019 min 0,125 0,088 mean 0,725 0,445 var 0,2148 0,1343 note: sample size : 6 chardware listed companies group among 4 groups, this is the group with the biggest number of listed firms and with the highest equity beta value of about 0,75. however, the asset beta mean of about 0,44 is lower than those of software and comm./telecom industries. different from firms in the other industries, 22 listed hardware firms has lower equity and asset beta var values, estimated at 0,108 and 0,089. this presents a more concentrated in level of market risks among firms in this industry. the equity and asset beta mean values are 0,748 and 0,441 are higher than those of 2 previous groups, but they are still good numbers within the estimated max-min range. please refer to exhibit 3 for more information. table 6. statistical results for vietnam listed hardware companies statistic results equity beta asset beta (assume debt beta = 0) max 1,234 1,069 min 0,200 0,054 mean 0,748 0,441 var 0,1085 0,0893 note: sample size : 22 dcomm. & telecommunication listed companies group many firms in this category diversify their operation in different business areas. different from firms in the other three (3) industries, 18 listed comm./telecom firms has wider range of equity and asset beta values. max beta values of 2,056 and 1,941 are the highest and min beta asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 134 values of -0,52 and -0,25 are the lowest among 4 groups. this indicates a less concentrated in level of market risks among firms in this industry. the asset beta mean value is 0,46 (the highest) and equity beta mean value is 0,67 (the 2nd highest in 4 groups) shows the financial leverage has impacts on market risk exposure during the crisis period. please refer to exhibit 4 for more information. table 7. statistical results for vietnam listed comm. and telecommunication companies statistic results equity beta asset beta (assume debt beta = 0) max 2,056 1,941 min -0,524 -0,251 mean 0,671 0,462 var 0,2872 0,2133 note: sample size : 18 comparison among 4 groups of computer and electrical companies in the below chart, we can see the equity and asset beta value mean of listed firms in the electrical and electronic industry is relatively lower than those of listed software, hardware and comm./telecom firms. it rejects our 1st hypothesis or research issue that the beta values in the electrical and electronic industry would be higher than those in the rest three (3) groups. in term of variance difference, the chart shows that the equity beta variance in electrical/electronic and in hardware industries is lower than those in the rest two, which means the bigger gap in market risk exposure in software and comm./telecom industries. but in general, that the range of equity beta var is from 0,11-0,29 and that of asset beta var is from 0,07-0,21 is not big. this also rejects our 2nd hypothesis. and both equity and asset beta mean in 4 groups are lower than (<) 1, which also rejects our 3rd hypothesis. last but not least, the max and min equity and asset beta values of three (3) groups: electrical/electronic, software and hardware industries are close numbers, or have small difference whereas those of comm../telecom groups are much higher. this back-end industry is affected more by market risks. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 135 0,63 0,33 0,17 0,07 0,72 0,44 0,21 0,13 0,75 0,44 0,11 0,09 0,67 0,46 0,29 0,21 0,00 0,10 0,20 0,30 0,40 0,50 0,60 0,70 0,80 equity beta mean asset beta mean equity beta var asset beta var electrical and electronic software hardware comm/telecom chart 1. statistical results of four (4) groups of 64 listed vn computer and electrical firms during/after the crisis period 2007-2011 8. risk analysis generally speaking, during the financial crisis 2007-2011, esp. the period 2007-2009, the computer and electrical has certain negative impacts from unexpected increasing price in the materials, and increasing lending interest rates which are affected by the high inflation of 23% in 2008; so, they could not be decreased in a short time. besides, these firms have to face other kinds of risks: technological changing, or an imperfect corporate governance structure, or operational risk. these risks can affect the operating cash flow of these companies. 9. conclusion and policy suggestion electrical and electronic industry this is the industry which has both the lowest equity/asset beta mean values and the lowest asset beta var (0,63 and 0,33, accordingly). during the crisis, this industry has lower market risk and this market is more stable. after increasing rates period (see exhibit 1), we highly value the efforts of government, central bank and financial institutions having proper policies to support businesses and internal investors, and stabilize inflation. software industry this is one of industries which can be affected much from the global crisis because of the recession of the whole market. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 136 however, in a developing market such as viet nam, the market is potential and market risks are controllable. the using of dfl or degree of financial leverage can be a vital reason for a decrease in asset beta value of 0,44 from equity beta value of 0,72. hardware industry the equity beta variance of this category is the lowest (0,11) among 4 groups although it is the largest group with 22 firms. its equity beta mean is the highest number (0,75) but under financial leverage condition, its asset beta mean is controllable. it might give a good scenario for the management team of these firms to make a proper evaluation of financial conditions and degree of financial leverage on operating. comm./telecommunication industry through our comparative analysis on asset beta values, this is the industry which has the higher market risk exposure than that of the other three (3) industries when we consider impacts of financial leverage. also the equity and asset beta variance (0,29 and 0,21) show a larger dispersion than, esp., hardware and electrical/electronic firms. the reasons might come from market factors and economic crisis. in general, our empirical findings state that they are not in favor of our 1st and 2nd and 3rd hypotheses or research issues. in summary, though viet nam is an emerging market with imperfect financial system, the beta values estimated are at acceptable level with 73% firms in the research sample while just a few companies’ beta values are risky (about 27% firms). additionally, it indicates the higher the using of financial leverage, the lower the beta values. in reality, there are 70% of computer and electrical firms which has 0<beta<1 in this research sample. the financial crisis might cause troubles for these businesses, but if they can continue to borrow sufficient money from financial markets, it can be good for their risk management. furthermore, if we compare these data and values to those of construction and real estate firms in our previous research (see the reference list and exhibit 5), we might see that in here, the beta mean can be a little bit lower. the reason could be the impacts from the crisis on this industrial company groups are less than on the construction and real estate company groups. finally, this paper suggests implications for further research and policy suggestion for the viet nam government and relevant organizations, economists and investors from current market conditions. references adb and viet nam fact sheet. (2010). ang, a., & chen, j. (2007). capm over the long run: 1926-2001. journal of empirical finance. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 137 blitz, david., pang, juan., & vliet, pim v. (2012). the volatility effects on emerging markets. ssrn working paper series. cont, r. (2010). empirical properties of asset returns: stylized facts and statistical issues. quantitative finance. eugene, fama f., & french, kenneth r. (2004). the capital asset pricing model: theory and evidence. journal of economic perspectives. eugene, fama f., & french, kenneth r.. (2006). the value premium and the capm. journal of finance. fernandez, pablo. (2008). levered and unlevered beta. ssrn working paper series. http://www.hsx.vn/hsx/ http://www.ifc.org/ifcext/mekongpsdf.nsf/content/psdp22 http://www.mofa.gov.vn/vi/ huy, dinh t.n. (2012). estimating beta of viet nam listed construction companies groups during the crisis. journal of integration and development. rogers, pablo., securato, and jose roberto. (2007). comparative study of capm, fama and french model and reward beta approach in the brazilian market. ssrn working paper series. exhibit exhibit 1 – interest rates, inflation, gdp growth and macroeconomics factors (source: viet nam commercial banks and economic statistical bureau) year basic rates lending rates deposit rates inflation gdp usd/vnd rate 2011 9% 18%-22% 13%-14% 18% 5,89% 20.670 2010 8%-9% 19%-20% 13%-14% 11,75% (estimated at dec 2010) 6,5% (expected) 19.495 2009 7% 9%-12% 9%-10% 6,88% 5,2% 17.000 2008 8,75%-14% 19%-21% 15%-16,5% 22% 6,23% 17.700 2007 8,25% 12%-15% 9%-11% 12,63% 8,44% 16.132 2006 8,25% 6,6% 8,17% 2005 7,8% 8,4% note approximately (2007: required reserves ratio at sbv is changed from 5% to 10%) (2009: special supporting interest rate is 4%) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 138 exhibit 2 – estimating beta results for viet nam listed software companies (as of dec 2012) (source: viet nam stock exchange data) order no. company stock code equity beta asset beta (assume debt beta = 0) note 1 fpt 0,976 0,364 2 cmg 0,949 0,348 3 srb 1,051 1,019 4 vla 0,125 0,111 sra as comparable 5 hig 1,112 0,740 6 sra 0,137 0,088 exhibit 3 – estimating beta results for viet nam listed hardware companies (as of dec 2012) (source: viet nam stock exchange data) order no. company stock code equity beta asset beta (assume debt beta = 0) note 1 cmt 0,665 0,326 2 svt 0,860 0,651 tlc as comparable 3 vie 0,283 0,054 uni as comparable 4 hpt 0,238 0,063 tst as comparable 5 nis 0,347 0,165 vtc as comparable 6 tst 0,739 0,236 7 st8 0,891 0,682 8 tag 0,632 0,411 9 pot 1,046 0,533 10 ckv 0,604 0,221 11 one 0,551 0,217 uni as comparable 12 pmt 1,234 1,056 13 smt 0,934 0,654 pmt as comparable 14 uni 1,186 0,732 15 tlc 1,066 0,770 16 kst 0,679 0,386 tlc as comparable 17 vat 1,028 0,485 18 vtc 0,635 0,431 19 elc 0,200 0,100 itd as comparable 20 sam 1,191 1,069 21 ltc 1,102 0,329 22 itd 0,351 0,132 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 139 exhibit 4 – estimating beta results for viet nam listed comm. and telecommunication companies (as of dec 2012) (source: viet nam stock exchange data) order no. company stock code equity beta asset beta (assume debt beta = 0) note 1 eci 0,708 0,527 2 inn 0,195 0,104 3 ptp -0,524 -0,251 4 dhi 0,740 0,547 5 ihk 0,514 0,295 tph as comparable 6 htp 1,091 0,846 7 tph 0,801 0,356 8 in4 0,473 0,284 eci as comparable 9 adc 0,425 0,214 dhi as comparable 10 hst -0,042 -0,029 11 sgd 1,089 0,581 12 dae 0,696 0,275 13 hev 0,633 0,434 14 alt 0,759 0,607 15 efi 2,056 1,941 16 eid 1,210 0,874 17 dad 0,625 0,423 18 sed 0,634 0,292 exhibit 5 – statistical results of three (3) groups of 103 listed construction firms during crisis period 0,66 0,439 0,0511 0,1317 0,0697 0,891 0,663 0,0936 0,0506 0,864 0,45 0,1163 0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1 equity beta mean asset beta mean equity beta var asset beta var material construction real estate asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 1 perceived importance of cpa’s generic skills:a japanese study satoshi sugahara (corresponding author) hiroshima shudo university faculty of commerce sciences 1-1-1 ozuka-higashi, asaminami-ku, hiroshima 731-3195, japan telephone: +81-82-830-1150 facsimile: +81-82-848-9450 e-mail: sugahara@shudo-u.ac.jp roanne coman kpmg azsa llc 1 hiroshima office 7f hiroshima kogin building 2-1-22 kamiya-cho, naka-ku, hiroshima 730-0031, japan telephone: +81-82-248-2932 fascimile:+81-82-248-2933 e-mail: roanne.coman@jp.kpmg.com received: june 12 2010 accepted: december 16 2010 abstract the purpose of this study is to compare the differences in japanese accounting faculty and practitioners‟ perceived importance of generic skills for certified public accountants (cpas) in order to assess the cpa law amendment of 2003. 127 effective data were collected from members of the japanese association for international accounting studies (jaias) via a questionnaire-based survey. this study focuses on the differences in the perceived importance of 12 generic skills and four skill types by using the learning skill profile (lsp) instrument, originally developed by boyatzis and kolb (1995). it was found that japanese accounting faculty and practitioners commonly perceived the information skill type as the most important and the behavioral skill type as the second most important, but they tended to regard the interpersonal skill type as less important. several implications are also raised from the findings to improve the quality education of japanese cpas and also to facilitate the international harmonization of accounting education. keywords: generic skills, accounting professional, learning skill profile, certified public accountant (cpa), cpa law jel classifications: m40, m41 and m49 1 this paper presents the authors‟ personal views and does not reflect in any way the official views of kpmg azsa llc. all errors and omissions are the authors‟ sole responsibility. mailto:sugahara@shudo-u.ac.jp mailto:roanne.coman@jp.kpmg.com asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 2 introduction accounting literature has recognised that the radical economic environment of the current generation has changed the role of accounting professionals and created a certain consensus that professional candidates should acquire special skills that are beyond technical and theoretical knowledge (aicpa, 1999; albrecht and sack, 2000; icaa, 2001; henderson, 2001). these skills are widely referred to as generic skills in the literature. de lange et al. (2006), for example, define generic skills as transferable qualities to suit the industry in which one works. technically, they are likely to include, but are not limited to, communication, problem solving, personal and interpersonal skills (gammie, et al, 2002; ballantine and larres, 2004; de lange et al., 2006). from an accounting education perspective, generic skills have been addressed by the international education standard for professional accountants no.3 (ies 3): professional skills. the aim of ies 3 is to ensure professional candidates for membership of a professional body of the international federation of accountants (ifac) are equipped with the skills to function as professional accountants (ifac, 2003). in response, it has been suggested by some literature that the actual contents of an accounting education program should include the development of generic skills (e.g. albrecht and sack, 2000; howieson, 2003). it has also been pointed out that accounting faculty and professional bodies should strive to ensure students understand how important these skills are and should try to encourage them to master these skills (usoff and feldmann, 1998). in japan, the certified public accountant (cpa) law was amended in 2003 to integrate generic skill training into the pre-qualification process for cpas. the purpose of this amendment was to improve the quality of japanese cpas‟ competency by updating the traditional japanese education system and integrating the fundamental notions and concepts of the ies into the system (fsc, 2002). these two items will be looked at in turn below. firstly, the pre 2003 scheme was criticized as being a traditional educational system that mainly emphasized the memorizing of professional knowledge about technical skills and accounting standards (kawahito, 2004). to address this weakness in the previous examination scheme, the amended cpa law requires qualified cpas and cpa candidates to acquire not only comprehensive professional competencies, but also broad generic skills including liberal arts, critical thinking skills, judgment skills, global awareness, foreign language ability and leadership (fsc, 2002). it was reported by the subcommittee on the certified public accountants system that these new skills are required for cpas to keep up with the drastic changes in practice (fsc, 2002). secondly, this reform also considered the implementation of the ies issued by the ifac in order to integrate its fundamental notions and concepts into the domestic accounting education scheme in japan (fsc, 2002). as seen above, the ies contain many suggestions about accounting education across their global members, particularly in terms of generic skills in ies 3 (ifac, 2003). to reflect this standard, the amended cpa law of 2003 has included a requirement of testing applicants‟ competency in terms of not only their professional knowledge, but also thinking skills and judgment skills in practical situations (cpa law, article 8, paragraph 4). asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 3 no study has been undertaken in the prior literature to ascertain the impact of this legal reform in japan. aggestam-pontoppidan (2009) reviewed the cpa examination reform in japan, but the author of the study left room for further study. she suggested in the conclusion that the outcome of the assessment of this reform would depend on how much the expectation gap in training of generic skills has been narrowed across accounting educators, regulators and employers since the law was amended in 2003. albrecht and sack (2000) agreed that such an expectation gap in the perceived importance of the knowledge and skills between academics and practitioners is quite dangerous because the gap implies that the accounting education that faculty provide in tertiary school is not relevant in meeting the expectations of accounting practitioners, who are interested in their students as potential employees. since the existence of such an expectation gap would imply failure of the cpa examination reform, it is crucial to examine the gap among accounting educators and employers in japan. additionally, as stated above, the amended cpa law of 2003 emphasizes the importance of thinking skills and judgment skills in particular (cpa law, article 8 paragraph 4). on the other hand, the ies expect professional candidates to be equipped with a wide variety of generic skills (ifac, 2003). in this light, lin et al. (2005), which replicated albrecht and sack‟s (2000) study to examine the perceived skill gap between faculty and practitioners in a chinese university, implied that the differences in weight given to certain skills were derived from the level of development in economics and technology and social or cultural influence. accordingly, it is also important to identify how much the profiles of perceived importance in generic skills differ between japan and other countries. this finding will contribute to the smooth harmonization of accounting education proposed by the ies. given the above background, this study aims to explore and compare the perceived importance of generic skills for accounting professionals between japanese accounting educators and practitioners. although prior studies have examined such skill gaps in various countries, no such study has been undertaken to examine these gaps among japanese accounting faculty and practitioners. this study also investigates the perceived importance profile of generic skills for japanese educators and employers in order to compare them with their counterparts in other countries. the brief background mentioned in this section will be followed in the next section by a literature review that will form the basis of the research questions. the third section will provide explanations of the research methodology, with the results of the analyses and interpretations presented in the fourth and fifth sections, respectively. the final section will summarize the findings and contributions, together with limitations and further research possibilities. literature review and research questions the shift in educational objectives in the japanese amended cpa law of 2003 has placed greater attention on generic skills among employers in the accounting sector (aggestam-pontoppidan, 2009). however, few studies have been conducted in japan to examine actual perceptions towards generic skills needed for success as a cpa among those who are involved in this sector. in contrast, early works overseas have addressed generic skill issues. these studies initially have attempted to assess the role of perceptions towards generic skills among accounting students (e.g. reed and asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 4 kratchman, 1989; oswick et al., 1994; usoff and feldmann, 1998; hassall et al., 2005). for example, a us study by usoff and feldmann (1998) examined the perceived importance of generic skills to succeed in accounting practice, relative to the technical accounting skills of both undergraduate and postgraduate accounting students. with a questionnaire-based survey, their findings showed that while students tended to be aware of the importance of generic skills in the progress of education and practical experience, they perceived such skills as relatively less important than technical accounting skills. this result was consistent with several later studies, such as gammie et al. (2002) in the uk and mohamed and lashine (2003) in the us. recently, de lange et al. (2006) addressed the perceptions of successful skills in accounting practices from a graduate‟s perspective in australian universities and investigated how much emphasis students thought should be given to generic and specific skills during their undergraduate accounting degree. the result of their factor analysis was that graduates perceived both interpersonal/communication skills and statistical/computing skills as more important than accounting/governance knowledge and technical skills. this conclusion is contrasted to the findings of usoff and feldmann (1998) where students believed the importance of generic skills was much lower than those of technical accounting skills. albrecht and sack (2000) attempted to assess which skills accounting faculty and practitioners in us universities believed as the most important in terms of how much class time should be spent developing each skill. their survey outcomes revealed that the belief profiles of skill importance were substantially similar between faculty and practitioners. both groups regarded that analytical/critical thinking, written communication, oral communication, computing technology, decision making and interpersonal skills were the primary skills to be learned in the education process. in contrast, a us study of baker and mcgregor (2000) tried to identify gaps in the perceptions of generic skills within accounting faculty, business practitioners, accounting professionals and postgraduate students. their results indicated that faculty believed that communication skills were less important for success than the other interest groups, and they tended to view grade point average as the primary factor for success in their students‟ careers. following on from these prior studies, the expectation gap has been discussed actively in other literature in terms of the gaps between accounting educators and employers in the accounting sector (e.g. bui and porter, 2009; kavanagh and drennan, 2008) and between accounting students and employers (e.g. jackling and de lange, 2009; gammie et al., 2002; leveson, 2000). overall it was found by these prior studies that the perceived importance in the profiles of generic skills among faculty was inconsistent with those of employer groups. compared to these previous studies overseas, few investigations have been undertaken in japan to explore the expectation gap in the perceptions of generic skills among those who work in the accounting field. in fact, it does not seem to be clear whether the latest reform of the cpa examination scheme is resolving the expectation gap and the existence of the expectation gap in japan has not been investigated empirically. more recently, aggestam-pontoppidan (2009) reviewed the reform of the cpa examination in japan and suggested that the outcome of the assessment of this reform would depend on how much the gap in the social expectation has been narrowed across educators, regulators and professionals after the law was asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 5 amended in 2003. this prior study did not make an argument with empirical evidence, but encouraged further continual investigation of this gap in order to help achieve successful reform of education programs in japan. in response to the above discussions in the accounting literature, this study developed the following question to address this research interest. rq 1: is there any difference in perceived importance of generic skills needed for success by cpas between accounting faculty and practitioners in japan? as stated earlier, the post 2003 cpa examination scheme in japan advocated placing more emphasis and attention on generic skills training rather than just to test applicants‟ technical knowledge and skills (fsc, 2002). this reform of the cpa examination has brought drastic changes to the cpa pre-qualification structure. aggestam-pontoppidan (2009) depicted this challenge as the integration of some „western‟ teaching methods with the traditional japanese education system. in fact, just after the cpa law amendment of 2003, new professional schools referred to as „accounting schools‟ were established in japan. these new institutions were established partly as a reflection of professional schools in the western world, such as the usa, where the comprehensive accounting curriculum at the tertiary level enables students not only to obtain knowledge and technical skills for sitting the cpa examination, but also to train them with sufficient competencies and generic skills for professional activities (fsc, 2003). the amended cpa law allows graduates from accounting schools exemption from sitting some parts of the cpa examination on the grounds that they completed the degree through the curriculum offered by the accounting schools (cpa law, article 9, paragraph 2). however, a greater difference has been observed in the perceived importance of generic skills between japan and other countries. technically speaking, the cpa law amendment of 2003 emphasized the importance of thinking skills and judgment skills out of the various types of generic skills. the amended cpa law of 2003 specifically mentions the requirement to test applicants‟ competency for thinking skills and judgment skills (cpa law, article 8, paragraph 4). however, no other articles or paragraphs in the amended cpa law of 2003 address other generic skills, such as communication skills or interpersonal skills. in contrast to such a skewed view of skill importance in the japanese legislation, other literature overseas has shown a different perspective in the variety of important skill profiles. some prior studies in various countries show empirical evidence that the perceived importance of generic skills needed for accounting professionals vary broadly. for example, carr et al. (2006) surveyed alumni from one university in new zealand to investigate their views on the most important competencies required for a graduate to excel in the profession. this study identified communication skills and problem solving skills as the primary generic skills, together with technical accounting skills. an australian study by jackling and de lange (2009) examined the perception of students and employers towards technical and generic skills and found that while employers viewed technical skills as the primary skills, they also acknowledged the importance of a board range of generic skills that graduates indicated were not being adequately taught in their accounting degree program these generic skills were team skills, asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 6 leadership, verbal communication and interpersonal skills. a study by hassall et al. (2005) attempted to compare the opinions of the employers of management accountants in spain and the uk to determine vocational skill development priorities. the findings reported that the most important skills for the uk employers were communication skills (oral, written and effective listening), whilst spanish employers rated the commitment to life-long learning and the global vision of the organization as of the most importance. problem solving skills were ranked secondary in the range from fourth to 13th for spanish employees, while this skill category was rated lower in the range from ninth to 15th for uk employees. this result indicates the difference in the ranking of perceived skill importance between nationalities. in a similar vein, lin et al. (2005) asserts that such differences in perceived skill importance have emerged across nationalities and cultures. their study examined the perceptions of accounting students, faculty and professionals regarding the knowledge and skills needed in accounting education from a chinese perspective. they found empirical differences in the perceptions of chinese and us respondents towards the importance of the knowledge and skills required by accounting professionals. this prior study concluded that the emphasis of accounting education in china was upon knowledge training, with greater weight given to some technical accounting knowledge subjects, while the generic skill components received less attention. they also interpreted that such consequences were derived from the level of development in economics and technology and social/cultural influences. compared with these previous studies, no studies have been undertaken to compare the profiles of perceived importance for generic skills between japanese and people from other countries. since accounting education in japan reflects different social/cultural influences from other countries (aggestam-pontoppidan, 2009), it can be assumed that there will be different profiles of perceived importance in generic skills among japanese faculty and practitioners compared with their counterparts in other countries. in particular, it is important to clarify the impact of the latest reform to the cpa examination in japan. as stated above, the cpa law amendment of 2003 emphasizes the importance of thinking skills and judgment skills rather than various types of other generic skills. thus, our research interest in this context is whether this amendment has affected these actual perceptions of generic skills among accounting faculty and practitioners. rq2: are thinking skills and judgment skills regarded as more important than other generic skills among japanese accounting faculty and practitioners? furthermore, compared with previous studies overseas (e.g. jackling and de lange, 2009; carr et al., 2006; hassall et al., 2005), no emphasis has been placed on the cpa law amendment of 2003 in terms of communication and interpersonal skills. to explore this research interest, the following research question is also developed. rq3: are communication and interpersonal skills regarded as less important than other generic skills among japanese accounting faculty and practitioners? asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 7 research methodology data collection data for this study was collected from japanese accounting faculty and practitioners to address the research questions of rq1, rq2 and rq3. for this purpose, the authors posted hard copies of a questionnaire in july 2007 to all members of the japanese association for international accounting studies (jaias). the jaisa members include not only academics in accounting related subjects, especially bookkeeping and financial reporting, but also accounting practitioners, such as certified public accountants and corporate auditors. of the 546 questionnaires initially disseminated, 133 responses were received with 6 responses eliminated due to incompletion of the questionnaire. as a result, the effective response of the data used in this research analysis consists of 127 responses (an effective response rate of 24.3%). this study divided the samples into three groups in relation to the respondents‟ career status: accounting faculty who have researched and taught at tertiary schools (faculty group); accounting faculty who work as faculty members and also have previous or current experience as practitioners (faculty with practical experience group); and accounting practitioners who currently work in business (practitioners group). descriptive information is shown in table 1. the preliminary analysis was initially implemented to examine the influence of demographic factors via chi-square tests. in this analysis, the distribution of respondents‟ ages, gender and specific research areas were analyzed across the groups. specific research areas were examined only for the faculty and faculty with practical experience groups. as a result, a significant unequal distribution was found for age within the three groups, which left open a question of homogeneity among the three participant groups. hence, the impact of age should be taken into consideration by incorporating this attribute into the analysis model. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 8 table 1: descriptive information faculty (81) faculty with practical experience (26) practitioners (20) total (127) chi-square χ2 (sig.) age less than 40 33 (40.7%) 1 (3.8%) 6 (30.0%) 40 (31.5%) 19.626 (.001)*** 40 to 59 33 (40.7%) 15 (57.7%) 4 (20.0%) 52 (40.9%) over 60 15 (18.5%) 10 (38.5%) 10 (50.0%) 35 (27.6%) total 81 (100.0%) 26 (100.0%) 20 (100.0%) 127(100.0%) gender male 63 (77.8%) 23 (88.5%) 18 (90.0%) 104 (81.9%) 2.568 (.277) female 18 (22.2%) 3 (11.5%) 2 (10.0%) 23 (18.1%) total 81 (100.0%) 26 (100.0%) 20 (100.0%) 127(100.0%) research subject bookkeeping 13 (16.3%) 5 (19.2%) 20 (17.0%) 2.336(.801) financial acc 43 (53.8%) 12 (46.2 %) 58 (51.9%) management acc. 8 (10.0%) 1 (3.8%) 9 (8.5%) audit 7 (8.8%) 3 (11.5 %) 10 (9.4%) financial analysis 4 (5.0) 2 (7.7 %) 6 (5.7%) other 5 (6.3%) 3 (11.5%) 9 (7.5%) total 80 (100.0%) 26 (100.0%) 106(100.0%) *** significant at the 0.01 level questionnaire development to assess respondents‟ perceptions of acquired generic skills, this study applied skill items in the learning skills profile (lsp) instrument originally developed and formally published by boyatzis and kolb (1995). this instrument is designed to assess an individual‟s learning skills deemed important in business and management education. in boyatzis and kolb (1995), learning skills are defined as “generic heuristic(s) that enables mastery of a specific domain”, which are equivalent with the concept of generic skills that are dealt with in this study. applying this instrument to this research will permit us to use the set of scores of cronbach alphas based on a large representative sample accumulated by many prior studies. comparing the data with such a set of norms enables us to ensure the reliability of and internal consistency in this study. the original lsp uses a 72-item modified q-sort assessment instrument to capture respondents‟ learning skills. subjects are asked to place each of 72 skill statements into one of seven stacks reflecting their own level of job skill demand. the stacks are labeled: one for not relevant to job or career; two for a rarely required skill or activity; three for a sometimes-required skill or activity; four for a regularly used skill or activity; five for an important skill or activity; six for an essential skill or activity; and seven for a top-priority skill or activity. the 72 skill statements constitute 12 skill elements and these are also categorized into four skill types (see table 2). for the purpose of this research, the present study modified the card-based q-sort assessment into a questionnaire-based instrument more familiar to recipients. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 9 table 2: the types and elements of learning skill profile skill type skill element description 1. interpersonal skills (set of abilities representing people-oriented, feeling, sensing skills) a. leadership the ability to inspire and motivate others, to sell your ideas to others, to negotiate and build team spirit. b. relationship the ability to establish trusting relationships with others, to facilitate communication and cooperation and to work in teams. c. help the ability to be sensitive to others, to aid others in gaining opportunities to grow and to be self-aware. 2. information skills (set of abilities which enable one to take in and organise new information) d. sense making the ability to adapt, to change, to deal with new situations and to define new strategies and solutions. e. info. gathering the ability to be sensitive to and aware of organizational events, to listen with an open mind, and to develop and use various sources for receiving and sharing information. f. info. analysis the ability to assimilate information from various sources, to derive meaning and to translate specialized information for general communication and use. 3. analytical skills (set of cognitive thinking abilities that enable ones to process ideas) g. theory the ability to adopt a larger perspective, to conceptualize, to integrate ideas into systems or theories and to use models or theories to forecast trends. h. quantitative the ability to use quantitative tools to analyze and solve problems, and to derive meaning from quantitative reports. i. technology the ability to use computers and computer networks to analyze data and organize information and to build computer models or simulation. 4. behavioral skills (set of abilities associated with taking action and making things happen) j. goal setting the ability to establish work standards, to monitor and evaluate progress toward goals and to make decisions based on cost-benefits. k. action the ability to commit to objectives, to meet deadlines, to be persistent and to be efficient. l. initiative the ability to seek out and take advantage of opportunities, to take risks and make things happen. boyatzis and kolb (1993) descriptive statistics and reliability of lsp table 3 shows the descriptive statistics for the generic skill types and elements. each mean score with standard deviation was calculated and displayed for the overall sample, faculty, faculty with practical experience and practitioners. table 3 also reports cronbach alphas for each skill type and element. this study applied the lsp instrument because some previous studies illustrate the reliability of the lsp with reference to cronbach alpha. for example, boyatzis and kolb (1991) computed cronbach alphas for mba students‟ 12 skill elements, which ranged from .618 to .917, with an average of .778. a more recent study by kretovics (1999) also reported that the alphas for postgraduate students studying in a master‟s mba course ranged from .651 to .935, with an average of .830. similarly the present study obtained cronbach asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 10 alphas ranged from .641 (information gathering) to .893 (technology) for japanese accounting faculty/practitioners. the average scores of alpha were also computed as .751. additionally, as shown in table 2, this study also calculated cronbach alphas ranging for the four skill types and these ranged from .806 to .874, with an average score of .842. hence, compared with previous results, this study has sufficient reliability in applying the lsp instrument. table 3: descriptive statistics of skill types and skill elements (a) skill types group (n) overall (127) faculty (81) faculty with practical experience (26) practitioners (20) means (std. dev.) means (std. dev.) means (std. dev.) means (std. dev.) alpha 1 interpersonal skills 87.51 (12.657) 87.09 (12.634) 89.15 (11.602) 87.10 (14.440) .861 2 information skills 96.58 (11.066) 97.11 (11.505) 95.77 (10.977) 95.50 (9.638) .874 3 analytical skills 85.34 (13.522) 87.81 (14.341) 81.38 (10.845) 80.45 (10.909) .806 4 behavioral skills 90.04 (11.791) 90.62 (11.401) 90.77 (11.357) 86.75 (13.833) .825 average score 89.86 (10.336) 90.65 (10.618) 87.45 (10.686) 89.26 (9.158) .842 (b) skill elements group (n) overall (127) faculty (81) faculty with practical experience (26) practitioners (20) means (std. dev.) means (std. dev.) means (std. dev.) means (std. dev.) alpha a leadership 28.66 (4.811) 28.23 (4.776) 29.23 (4.776) 28.95 (4.936) .765 b relationship 30.82 (4.632) 30.95 (4.469) 31.04 (4.745) 30.00 (5.262) .771 c help 28.03 (4.858) 27.90 (5.034) 28.35 (4.098) 28.15 (5.244) .753 d sense making 32.06 (3.968) 32.07 (4.168) 32.42 (3.252) 31.55 (4.110) .703 e information gathering 32.37 (3.982) 32.69 (4.033) 31.92 (4.298) 31.65 (3.329) .641 f information analysis 32.15 (4.417) 32.35 (4.487) 31.42 (4.785) 32.30 (3.686) .749 g theory 30.09 (4.667) 30.41 (4.740) 30.04 (4.467) 28.90 (4.656) .752 h quantitative 27.59 (5.393) 28.83 (5.282) 25.81 (4.891) 24.90 (5.046) .822 i technology 27.65 (5.812) 28.58 (5.837) 25.54 (6.288) 26.65 (4.209) .893 j goal setting 30.43 (4.461) 30.81 (4.503) 30.65 (3.846) 28.60 (4.784) .697 k action 31.88 (4.166) 32.09 (3.988) 31.65 (4.988) 31.35 (3.856) .710 l initiative 27.72 (5.033) 27.72 (4.799) 28.46 (4.356) 26.80 (6.662) .752 average score 29.95 (3.445) 30.21 (3.539) 29.75 (3.052) 29.15 (3.562) .751 results a multivariate analysis of variance test (manova) was applied to determine whether a significant difference existed between faculty, faculty with practical experience and practitioner groups across the set of four skill types. for research purposes, four skill types of interpersonal skill type (inte), information skill type (info), analytical skill type (anal) and behavioral skill type (beha) were used as the dependent variables and the subjects‟ occupation group (job) was used as the independent variable. moreover, the manova model in this study incorporated a subject‟s age (age) as the control variable to asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 11 consider the impact of age difference across the job group demographics. a manova computed and compared the estimated scores for perceived importance of the four skill types within the three different groups to identify the overall effect. table 4 shows the result of this manova testing with a pillai‟s trace test. this result presents a significant difference (f = 2.360, p < .05) within the three job groups across the four skill types. the analysis result also reports a significant difference in scores of skill perception (f = 2.471, p < .05) within three different age groups across the four skill types. further, the score of box‟s m were calculated to test manova‟s assumption of homoscedasticity. a non-significant result of box‟s m 87.862 (f = 1.224, p = .116) indicates the successful rejection of the null hypothesis and that the covariances are not homogeneous. in addition, univariate analysis of variance tests (anova) were conducted to test for differences in the perceived importance of generic skill types needed for success by cpas. the directions of these differences are also identified by the anovas. each skill type of inte, info, anal and beha was used as the dependent variable of each four univariate anova. the attribute of job was used as the independent variable. age was also incorporated as the control variable with each univariate test, similar to the manova test. table 4: manova result effect pillai's trace f hypothesis df error df sig. intercept .984 1804.424 4.000 119.000 .000*** job .146 2.360 8.000 240.000 .018** age .152 2.471 8.000 240.000 .014** independent variable = job and age; dependent variables = info, beha, anal and inte box‟s m = 87.862 (f=1.224, df1=60, df2=3751.098, sig.=.116) *** significant at the 0.01 level, ** significant at the 0.05 level table 5 presents the result of four anova tests. these analyses discovered a significant difference within the three job groups only in terms of analytical skill type (anal) with the statistical evidence of f = 5.291 (p < .01). the other three anova for inte, info and beha failed to find any significant differences in skill perception scores within the three job groups. moreover, supplementary anovas were conducted to test whether the interaction effect between job and age had significant correlation with the perceived importance of each of the four skill types. these analyses reported no significant results for the interaction effect for all four anovas. the scores of adjusted r 2 for the four anova tests of inte, info, anal and beha were .055, .033, .089 and .081, respectively. levene‟s test of equality of error variances was conducted for each anova to test homogeneity of variance. f-values and p-values for levene‟s test were .636 (p = .746) for inte, .903 (p = .517) for info, 1.228 (p = .286) for anal and .572 (p = .799) for beha, respectively. accordingly, these rejections of null hypotheses indicate that the variances for all four anova are not homogeneous in each model. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 12 table 5: univariate anova result (a) inte (interpersonal skills) source type iii sum of squares df mean square f sig. corrected model 1720.937 4 430.234 2.843 .027** intercept 676385.357 1 676385.357 4468.991 .000*** job 265.157 2 132.578 .876 .419 age 1632.784 2 816.392 5.394 .006*** error 18464.795 122 151.351 total 992792.000 127 corrected total 20185.732 126 independent variable = job and age; dependent variable = inte f-value and p-value for levene‟s test are .636 and .746 r squared = .085 (adjusted r squared = .055) *** significant at the 0.01 level, ** significant at the 0.05 level asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 13 (b) info (information skills) source type iii sum of squares df mean square f sig. corrected model 985.166 4 246.292 2.080 .087 intercept 808653.343 1 808653.343 6829.410 .000*** job 134.212 2 67.106 .567 .569 age 921.900 2 460.950 3.893 .023** error 14445.716 122 118.408 total 1.200e6 127 corrected total 15430.882 126 independent variable = job and age; dependent variable = info f-value and p-value for levene‟s test are .903 and .517 r squared = .064 (adjusted r squared = .033) *** significant at the 0.01 level, ** significant at the 0.05 level (c) anal (analysis skills) source type iii sum of squares df mean square f sig. corrected model 2716.414 4 679.104 4.077 .004*** intercept 604207.971 1 604207.971 3627.265 .000*** job 1762.767 2 881.383 5.291 .006*** age 1335.299 2 667.650 4.008 .021** error 20322.027 122 166.574 total 947938.000 127 corrected total 23038.441 126 independent variable = job and age; dependent variable = anal f-value and p-value for levene‟s test are 1.228 and .286 r squared = .118 (adjusted r squared = .089) interaction effect between job and age was not significantly associated with the dependent valuable of anal. *** significant at the 0.01 level, ** significant at the 0.05 level asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 14 (d) beha (behaviour skills) source type iii sum of squares df mean square f sig. corrected model 1921.831 4 480.458 3.759 .006*** intercept 697653.131 1 697653.131 5457.764 .000*** job 622.347 2 311.174 2.434 .092 age 1664.529 2 832.265 6.511 .002*** error 15594.972 122 127.828 total 1.047e6 127 corrected total 17516.803 126 independent variable = job and age; dependent variable = beha f-value and p-value for levene‟s test are .572 and .799 r squared = .110 (adjusted r squared = .081) *** significant at the 0.01 level table 6 exhibits the estimated means of perceived importance in skill type needed for success by cpas among the three groups of accounting faculty, faculty with practical experience and current practitioners. in table 6, the results of the least square difference t-test (lsd) are also displayed. the lsds were applied to compare the difference in the estimated means among the three job groups and to identify the direction of these differences. the analysis result shows that the estimated means of the analytical skill type (anal) for the faculty group was significantly higher than that of the faculty with practical experience group (p < .05) and practitioner group (p < .01). in contrast, the mean score for the behavior skill type (beha) for the practitioner group was found to be significantly lower than that of the faculty group (p < .05). no significant differences were found for the rest of information skill type (info) and interpersonal skill type (inte). the direction of these differences in perception of skill types are identified as the inequality signs in table 6. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 15 table 6: estimates and univariate anova tests for skill types in terms of job faculty faculty with practical exp. practitioner univariate tests inequality sign estimates (std. error) rank estimates (std. error) rank estimates (std. error) rank f sig. info 97.640 (1.255) 1 96.954 (2.235) 1 94.651 (2.463) 1 .567 .569 beha 91.628 (1.304) 2 91.648 (2.322) 2 85.384 c (2.559) 2 2.434 .092 f > p anal 88.755 b (1.488) 3 82.061 (2.650) 4 79.207 (2.922) 4 5.291 .006 a f > f/p, p inte 87.765 (1.418) 4 90.778 (2.526) 3 85.992 (2.785) 3 .876 .419 f = estimated score for faculty; f/p = estimated score for faculty with practical experience; p = estimated score for practitioners least square difference t-test (lsd) technique was applied to adjust multiple comparisons a significant at the 0.01 level b significant for the lsd compared to faculty with practical experience (p < .05) and practitioner (p < .01) c significant for the lsd compared to faculty (p < .05) the rankings of perceived importance of generic skill types were also reported in table 6. these results revealed the ranking orders were similar among the three groups except for the analytical skill type (anal) and interpersonal skill type (inte). it was also found in table 6 that the faculty group perceived the analytical skill type as more important (ranked as third in importance) than the other two groups did (ranked as fourth in importance). this ranking result is consistent with the result of the lsd, which indicated a significantly higher score of anal for the faculty group than the other two groups. however, the significant difference in the behavioral skill type (beha) by the lsd is not explicit from the ranking order. although the lsd result presents a significantly lower score for practitioners than the other two groups, all the scores of beha for the three groups are commonly ranked as second in importance. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 16 table 7: estimates and univariate anova tests for skill elements in terms of job group (n) faculty (81) faculty with practical exp. (26) practitioners (20) univariate tests inequality sign skill elements estimates (std. error) rank estimates (std. error) rank estimates (std. error) rank f sig. information gathering 32.759 (.448) 1 32.543 (.798) 2 31.455 (.880) 2 .848 .431 information analysis 32.547 (.503) 2 31.829 (.896) 4 31.986 (.988) 1 .298 .743 action 32.404 (.470) 3 31.864 (.837) 3 30.934 (.923) 4 1.001 .370 sense making 32.335 (.452) 4 32.583 (.806) 1 31.21 (.888) 3 .768 .466 goal setting 31.131 (.499) 5 30.829 (.889) 6 28.191e (.980) 8 3.523 .033b f, f/p > p relationship 31.038 (.526) 6 31.685 (.937) 5 29.776 (1.033) 5 .963 .385 theory 30.804 (.523) 7 30.138 (.932) 8 28.41 (1.028) 7 2.096 .127 quantitative 29.097c (.589) 8 26.075 (1.05) 11 24.529 (1.157) 12 7.448 .001a f > f/p, p technology 28.854d (.653) 9 25.847 (1.163) 12 26.268 (1.282) 10 3.301 .040b f > f/p, p leadership 28.538 (.539) 10 30.207 (.960) 7 28.508 (1.058) 6 1.207 .303 help 28.188 (.547) 11 28.886 (.974) 10 27.708 (1.073) 9 .347 .707 initiative 28.094 (.559) 12 28.955 (.996) 9 26.259 (1.098) 11 1.716 .184 f = estimated score for faculty; f/p = estimated score for faculty with practical experience; p = estimated score for practitioners least square difference t-test (lsd) technique was applied to adjust multiple comparisons a significant at the 0.01 level for the univariate anova b significant at the 0.05 level for the univariate anova c significant for the lsd compared to faculty with practical experience (p < .05) and practitioner (p < .01) d significant for the lsd compared to faculty with practical experience (p < .05) and practitioner (p < .1) e significant for the lsd compared to faculty (p < .01) and faculty with practical experience (p < .05) this study also applied the anovas to investigate the differences in perceptions held by the three job groups towards 12 skill elements. using these supplementary analyses, the particular skill elements can be identified more specifically than by addressing the four skill type categories. the results are shown in table 7. of the total 12 generic skill elements, the anova results exhibited that only three skill elements had significant differences over the three groups. according to these results, it was found that the average asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 17 scores for the quantitative skill element were significantly different (f = 7.448, p < .01) across the three groups. the technology skill element and the goal setting skill element were also found to be significantly different in perception across the three groups (f = 3.301, p < .05 for the technology skill element; f = 3.523, p < .05 for the goal setting skill element). the lsds were additionally implemented with the anova tests and produced results where the estimated mean score for the quantitative skill element for the faculty group was significantly higher than those of practitioner (p < .01) and faculty with practical experience (p < .05). the estimated score for the technology skill element for the faculty group was also found to be higher than those of the practitioner (p < .05) and faculty with practical experience group (p < .1). in contrast, the lsd results showed that the score for the goal setting skill element for practitioners was significantly lower than those of the faculty group (p < .01) and faculty with practical experience group (p < .05). finally no significant differences were found for the rest of the skill elements. the directions of these differences in perception of skill types were identified as the inequality signs in table 7 as well. the ranking of perceived importance of generic skill elements are exhibited in table 7. according to this ranking order, significant difference in the score for the quantitative skill element and the technology skill element are consistent with the significant result in the aggregate score for the analytical skill type (anal) across the three groups shown in table 6. the significant result for the goal setting skill element is also reflected in the anova result in the behavior skill type (beha), because the goal setting skill element is one of three components for this skill type category. interpretation the analysis of results exhibited that the perceived importance in generic skill types and elements vary statistically in terms of the reported scores among all three faculty and practitioner groups. more specifically, the ranking of the analytical skill type (anal) was the third most important only for the faculty group, while the other two groups rated this skill type fourth. the result of the anova with the lsd for this skill type also indicated that accounting faculty tended to value the analytical skill type as more important than the other two groups. furthermore, the difference in views of the analytical skill type is reflected in the two analytical skill components of quantitative skill and technology skill, which were found to be statistically more important for the faculty group than for the other two groups. these findings are supported by francis and minchington (1999), who explored the gap in the quantitative skills being taught by educators and those that are used in practice by management accountants. they concluded that educators tended to place greater emphasis on mathematical skills in the classroom which are now largely performed by information technology. this distorted emphasis on quantitative skills is similarly confirmed by accounting faculty in the current japanese study. in the case of information technology skills, the latest study of hassall et al. (2005) implies the importance of information skills, which are no longer a priority to employers. other important generic skills are replacing the higher perceived importance of information technology skills. although the significant difference found in the analytical skill type among the three different groups was the distinctive feature of this japanese study, it is interpreted that the lower ranking of this skill type and skill elements among all groups are consistent with prior studies overseas. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 18 additionally, comparative analysis revealed that the ranking of the interpersonal skill type was viewed the lowest for the faculty group, while the other two groups rated this skill type third. it is noteworthy that the two groups of faculty with practical experience and practitioners include individuals who have practical experience in business. since both these parties commonly perceived interpersonal skills as more important than analytical skills, this finding can be interpreted that their practical experience allowed them to recognize the importance of interpersonal skills needed for success in accounting practice more than faculty who tend to use analytical skills frequently in their research activities. a similar result was found by the interview-based study of bui and porter (2009), which indicated that employers expect graduates to possess leadership and interpersonal skills, while educators tended to perceive that these skills are more necessary for senior, rather than entry-level accounting positions. they found that faculty expressed that it is not important for accounting programs to equip graduates with these competencies. consequently, the result of the present study confirmed the research question of rq1 that there is a difference in perceived importance of generic skills needed for success by cpas in terms of the analysis skill type and interpersonal skill type among accounting faculty, faculty with practical experience and practitioners in japan. however, it was also found that this expectation gap existed only in the lower array of the skill profile among each of the three groups. in contrast to the expectation gap in generic skill importance, all three faculty/practitioner groups commonly rated the information skill type as the most important and the behavioral skill type as the second most important. most of the skill elements containing these two skill types were also ranked at higher positions in the array of skill elements for each skill profile (table 7). they are the information gathering skill, the information analysis skill and the sense making skill in the information skill type, and goal setting skill in the behavioral skill type. according to the definitions of these skill elements in table 2, these skills are interpreted as the cognitive abilities of how to deal with particular data, information and situations to find the best solution. thus, the result of this study supports the hypothesis expressed in rq2 and confirmed that stronger emphasis is placed on thinking skills and judgment skills among accounting educators and employers in japan after the cpa law amendment of 2003. in response to the higher rating of the information skill type and behavioral skill type, it was found that japanese accounting faculty and practitioners viewed the interpersonal skill type relatively lower (ranked fourth for faculty; third for faculty with practical experience and practitioners). such a substantial lower rating for interpersonal skills in this japanese study was consistent with a chinese study of lin et al. (2005) reporting that computing techniques, which is a component of analytical skills, was perceived in their 18-skill ranking as the first and second most important skills for chinese faculty and practitioners respectively. in the study of lin et al. (2005), oral communication, teamwork and leadership skills, which are the components of the interpersonal skill type in this study, were rated in the middle of the ranking order (around eight to 10 out of 18) among all the interest groups. the interpersonal skill element was only rated as the fifth most important skill for practitioners and the seventh most important skill for faculty and students, but this skill was regarded less important than computing techniques (lin et al., 2005). asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 19 this lower importance of interpersonal skill type is highly contrasted to previous studies from other countries. for example, the us study of albrecht and sack (2000) revealing that faculty and practitioners in the us perceived that interpersonal skills, such as written and oral communication, were regarded as relatively more important skills among all the skills ranked. similar results were supported by de lange et al. (2006), which explored perceived importance of generic skills for graduates from australian universities, and found that the primary component of the skills required was perceived to be interpersonal/communication skills, followed by statistical/computing skills. the latest studies of carr et al. (2006) in new zealand and jackling and de lange (2009) in australia are also consistent with the findings of albrecht and sack (2000) and de lange et al. (2006). with regard to the perceived importance of generic skills, lin et al. (2005) expressed that different cultures place different emphasis on what learning contents are relatively more important, of which consequences were derived from the level of development in economics, technology and social/cultural influences. in this prior study, the lower ratings of communication skills by chinese respondents were caused by the influence of the oriental culture, where people are supposed to be humble and must strictly obey orders or instructions from their supervisors. in such a cultural setting, two-way communication is usually not encouraged and the value of communication skills might be understated (lin et al., 2005). similar empirical evidence is seen by matveev and nelson (2004), which reported that the lower power distance american managers had better competency of interpersonal skills than the higher power distance russian managers. for the cultural dimension, hostede (1986) argues that certain social hierarchies are normally acceptable to the society where human inequality occurs in areas including prestige, wealth and power. this cultural dimension is referred to as the power distance. according to hofstede (1980; 2001), the scores of power distance are 80, 93 and 54 for chinese, russian and japanese respectively, which means that people in these countries are classified as high power distance in comparison to the scores of western countries where power distance scores are estimated as 40 and 36 for the people from the us and australia respectively (hofstede, 1980: 2001). furthermore, from the cultural and societal perspective of japan, it may be interpreted that japanese faculty and practitioners in this study have thought of communication and interpersonal skills as the ability to deal only with japanese individuals who have similar cultural backgrounds and use only japanese language. in contrast to the present japanese research, prior studies in the us and australia were conducted in situations where immigrants and international students with diversified language and cultural backgrounds are actively involved in and make up a greater portion of society. in such countries, communication and interpersonal skills would expect to be applied with english as the universal language, with no regard to each individual‟s native language. this difference in the make-up of society may cause the importance of interpersonal skills among faculty and practitioners to vary between japan and other countries. consequently, with the above interpretations, the result of the present study confirmed empirically the research question of rq3 and ascertained that communication and interpersonal skills are regarded as less important than other generic skills among faculty and practitioners in japan, of which society has unique asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 20 cultural traits. it also became clear that the perceived importance of generic skills required for success by cpas among the japanese interest groups varies from those of their western counterparts. concluding remarks the purpose of this study was to compare the perceptions towards generic skills for cpas within japanese faculty and practitioner groups in order to assess the legislative outcome of the cpa law amendment of 2003. the analysis of this study also investigated how much the profiles of perceived skill importance differ between japanese accounting faculty/practitioners and those of their counterparts from other countries. the present research found that all three groups of faculty, faculty with practical experience and practitioners commonly perceived the information skill type as the most important and the behavioral skill type as the second most important. on the other hand, japanese faculty in tertiary schools valued interpersonal skills as the least important among the four skill types. this result was inconsistent with those of faculty with practical experience and practitioners, whose perceptions valued interpersonal skills as more important than analytical skills. this overview of interpersonal skills by accounting faculty may be caused in part by the classroom situation in japan, where the power distance dimension strongly prevails between lecturer and students. according to the prior study of lin et al., (2005), such a cultural set may relatively discourage the value of communication skills. in contrast to this perception by the faculty, it is interpreted that faculty with practical experience and practitioners evaluated the importance of interpersonal skills slightly higher, as they may be able to recognize the importance of such skills from communicating with clients through their work experience. however, this study confirmed that the expectation gap within these interest groups has been observed only in the lower array of the skill profile, and all three interest groups showed overall consensus of higher priority towards the information skill type and behavior skill type as a result of the cpa law amendment of 2003. in particular, participants in the three groups commonly tended to regard that analytical skills, including the quantitative skill element, were relatively less important for cpas than the information and behavior skill types. this result implies that all subject groups have recognized that the role of the cpa should change from the traditional arithmetic expert, whose main skills focused on calculation and desk theory, to the knowledge professional who supports clients by providing services dealing with information and professional judgment. along with this implication, aggestam-pontoppidan (2009) have encouraged further research to investigate the outcome of the assessment of the cpa law amendment of 2003 by examining how much the expectation gap in training generic skills has been narrowed among faculty, regulators and practitioners since the scheme reform. the purpose of the cpa law amendment of 2003 was to improve the quality of japanese cpas‟ competencies, which contains not only comprehensive professional knowledge and skills, but also a wide variety of generic skills in order to adapt to the new economic environment of the present generation (fsc, 2002). this study makes a clear contribution to answering the questions of whether or not the cpa law amendment has achieved its purpose, to the extent that accounting faculty and practitioners asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 21 placed common emphasis on information skills and behavioural skills specifically stated in the law. furthermore, comparisons with prior studies revealed that faculty and practitioners from western countries, such as the us and australia, were likely to regard communication and interpersonal skills as more important in the generic skill profile than their japanese counterparts (albrecht and sack, 2000 in the us; de lange et al., 2006; jackling and de lange, 2009 in australia). in developing our research question, the lower level of importance of these skills was initially assumed among japanese faculty and practitioners as the cpa law does not mention these skills (cpa law, article 8, paragraph 4). in response to this research question, the present study recognized that the perceived gap of these skills arises from differences in awareness in various countries towards communication itself in society. it was concluded that the cultural and societal traits including higher power distance and non-english environment in japanese society caused less attention to be placed on communication and interpersonal skills for cpas. the ies also have the fundamental premise that communication and interpersonal skills are abilities that work effectively in a cross-cultural setting, rather than in a purely domestic setting (ifac, 2003 paragraph. 17(e)). in this context, the cpa law amendment of 2003 in japan attempted to address and articulate the importance of global awareness and foreign language abilities in the official report of the subcommittee on certified public accountants system led by the financial system council (fsc, 2002). but this attempt has not been reflected properly in the cpa law or in the actual perceptions towards generic skills for cpas among japanese faculty and practitioners. they need to be made aware of candidates‟ communication and interpersonal skills from a global point of view. for this reason the cpa law should be amended to encourage these skill competences in the pre-qualification process. naturally, there are some limitations in this study. firstly, this study focused on the perceived importance of generic skills only, but did not compare the importance between generic skills and technical accounting skills. lin et al. (2005), conversely, attempted this comparison and obtained a useful implication towards the overemphasis of technical skills among chinese faculty and practitioners. further study should extend this research possibility in japan by incorporating a question for respondents about their perception of technical accounting skills. secondly, the demographic information of our sample revealed that a large portion of faculty came from a specific research area, such as bookkeeping and financial accounting. this feature may have affected the results, over emphasizing an external reporting viewpoint. a greater proportion of participants from other research specializations, such as audit or management accounting, may have produced different outcomes. despite these limitations, this study succeeded in identifying the perceived importance of generic skills for accounting professionals among japanese faculty and practitioners. the findings contribute not only to improving the quality of japanese cpas‟ competencies, but also to help standard setters and policy makers achieve smooth harmonization of global accounting education by providing empirical evidence from a country outside of western society. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 22 references auyeung, p. and j. sands (1996) a cross-cultural study of the learning styles of accounting students, accounting and finance, 36(2), pp.261-274. aggestam-pontoppidan, c. 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(2005) learning styles and typologies of cultural differences: a theoretical and empirical comparison, international journal of intercultural relations, 29(5), pp.521-548. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e1 www.macrothink.org/ajfa 24 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). http://creativecommons.org/licenses/by/3.0/ microsoft word 2523-9865-1-sm-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 50 the oversight committees in developing countries – public financial control and the expectations gap – some empirical evidence from sri lanka prem yapa school of accounting, rmit university, australia e-mail: prem.yapa@rmit.edu.au received: oct. 11, 2012 accepted: march 4, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.2523 url: http://dx.doi.org/10.5296/ajfa.v6i1.2523 abstract this paper examines whether it is possible to implement an effective financial control through public oversight committees and establish public sector accountability and transparency as expected by the general public in sri lanka. the time is ripe for a debate on whether the public sector governance in sri lanka is socially well placed to safeguard the general public over the last few decades. interviews with key stakeholders are analyzed using stakeholder theory. findings reveal that despite the summons were sent to some public institutions, they did not appear before oversight committees. the standing orders specify that any person or document can be summoned before an oversight committee, yet parliamentarians are not summoned before oversight committees under any circumstances. the public officers responsible for fraudulent acts are transferred or retired before the completion of hearings of oversight committees. a little attention is paid on the best practice of parliamentary scrutiny and its impacts on the public accountability. there had been a civil war in sri lanka over the last three decades. debate on the defence expenditure continues. this issue has to be further investigated in a future study. keywords: sri lanka, oversight committees, public sector, financial control asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 51 1. introduction over the last few decades the research has shown that parliamentary governments have used committees to achieve effective performance of their legislative responsibilities (mcgee, 2002; loney, 2004; victoria, 2000; world bank, 2006). sri lanka, as a democratically elected government, exercises oversight function in the financial performance of public institutions through committee on public accounts (copa) and the committee on public enterprises (cope). these committees allow the people to participate through written submissions and to appear before public hearings (by invitation) to canvass issues of concern. the committees report to the legislature on the use of public funds and other matters. they can have a major influence on revealing inefficiency or misuse of funds and in recommending improvements to policy, legislation and administration. the accounts of government organisations are audited by the auditor-general and form the basis of the investigations of copa and cope. the copa (formally named as public accounts committee) is the oldest oversight committee in sri lanka. this committee’s task is to probe the managerial efficiency and financial discipline of the government, its ministries, departments, provincial councils and local authorities. in doing so, the copa is to examine the sums voted by parliament along with the report of the auditor-general. during the course of its deliberations, the committee obtains evidence from the secretaries to the respective ministries, who are the chief accounting officers (cao), heads of departments and other responsible officers. the committee also regularly summons directors-general of public finance, state accounts and national budget or their nominated representatives. it is the duty of the caos to personally appear before the committee to explain and justify the financial activities of the departments under the purview of their ministries. the recommendations of the committee may contain directives to government departments and ministries and such directives are deemed to be those of parliament. copies of committee reports are distributed among officers of the ministries, departments, provincial councils and local authorities. the second oversight committee (i.e. cope) has been established to ensure the observance of financial discipline in public corporations and other semi governmental bodies in which the government has a financial stake. the cope is to report to parliament on accounts examined, budgets and estimates, financial procedures, performance and management of corporations and other government business undertakings. it has the power to summon the relevant officials and such other people as it thinks fit to obtain evidence and call for documents. both oversight committees report to the parliament and the recommendations contained in their reports are deemed to be directives to the respective corporations or statutory boards for compliance. the recommendations of the committee may contain directives to government departments and ministries and such directives are deemed to be those of parliament. copies of committee reports are distributed among officers of the ministries, departments, provincial councils and local authorities (warnapala, 2004; ceylon daily news, 8, october, 2008). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 52 the term 'expectations' could provide various connotations that, although similar, have meanings that are not identical. in an accountability framework these may include a perception of what users or general public believe as 'should be' the role of oversight functions and what users think 'will happen or realistically expect' of the provision of audit services. both are in turn influenced by a concept of the 'ideal' type of audit service. there have been a number of studies concerned with the public expectations by oversight authorities or auditors and what the profession believes their responsibilities to be (nagy, 2000). this paper raises a broad question that is whether it is possible to implement an effective financial control through public oversight committees and establish public sector accountability and transparency as expected by the general public in the democratic socialist republic of sri lanka. in order to perform a more enlightened analysis on this question, a few sub questions are formed as follows: 1. do the oversight committees have power to summon persons and documents? 2. do oversight committees have sufficient power to summon officers? 3. what documents are summoned before the oversight committee? 4. do oversight committees allocate sufficient time for hearings? 5. what roles does auditor general play? this paper aims to explain the public accountability in sri lanka. furthermore, the authors strongly feel that the time is ripe for a debate on whether the public sector governance in sri lanka is socially well placed with regard to safeguard the general public over the last few decades. this is the motivation for this study. 2. methodology primary data for this paper was gathered from two sources. firstly, semi-structured interviews were conducted with senior public officers to gain insights into oversight committee practices. the interviewees consisted of copa and cope committee membership, senior officers from the ministry of finance and the treasury department in sri lanka. secondly, similar interviews were conducted with some parliamentarians on the oversight aspect in the public sector. these respondents expressed their comments and opinions based on their experiences and present positions in their respective departments or ministries. in total twenty five interviews were conducted and five meetings attended to collect primary data for this study. some parliamentarians also agreed to take part in interviews. for most interviews, our records consisted primarily of notes taken during the meetings and additional notes were written up immediately following the meetings. fifteen interviews were taped and transcribed. in the other instances, notes taken during the face to face meetings and more extensive write ups immediately following interviews were used. these notes were confirmed with participants for validity. typically, interviewees were visited on more than one occasion. this approach enabled a rapport to build up and also made it possible to confirm points from earlier meetings, or clarify some issues relating to the practice of the oversight committees. some of these points also related to the authentication of textual materials relating to committees. based on the importance of the two committees, which is in the forefront of ensuring fair play in matters pertaining to utilising public funds on government and semi government institutions, following sections explain the role and the functions and the authority to summon persons and documents to copa and cope. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 53 the remainder of the paper is organised as follows. section 3 builds and draws the theoretical framework to explore the historical background of the oversight committees and its development. 4 explain the role and the operations of the committee on public accounts. section 5 explains the role and the operations of committee on public enterprises. using interview data and documentary records, the authority to summon persons and documents to oversight committees is explained in section 6. the final section provides findings, a discussion and concludes the paper with some topics for further research. 3. stakeholder theory and public sector resource management strategies stakeholder theory has given valuable insight on firm accountability towards the stakeholder. theory was enlightened by freeman (1984) through his innovative work. he discussed important elements on firm responsibility towards the stakeholder, “any group or individual who can affect or is affected by the achievement of the organisation objectives” (freeman, 1984). in the recent debate of corporate governance and public sector governance, the stakeholder literature has used to broaden the domain beyond the shareholder interest to more boarder perspective of stakeholder to states by taking the idea of non-shareholder stakeholder statute (even & freeman 1988; selznick, 1957), also known as other constituency statues to explain the accountability of the organisations to public at large (donaldson & preston, 1995; even & freeman, 1995). moreover, studies have been conducted, taking the conceptual context of stakeholder literature, to explain the public sector fund management and administration (tennert & schroeder, 1999; lisa, et al. 2005; hans, 2000; meijer, 2006). however, there are opponent view points from the prominent proponents of the theory. scholl has studied on the formation of joint project team to expand the scope of the state sector, central accounting system (cas) of the new york state government. he has described applicability of stakeholder theory to the public sector and accepted the capacity of the theory, to discuss the public sector performance (scholl, 2000). thus, this paper built a relationship between firm which we assume that represent public sector organizations such as (government organisations including parliament members) and its accountability towards the stakeholder which we assume that represent (nation’s stake through the oversight committees). we used the, mitchell et al.’s “concept of stakeholder identification typology” which they suggest as a dynamic model (mitchell, 1997). thus, the study intended to critically analyse the following three aspects. 1. the stakeholders (oversight committees which represent the general public through parliament) power to influence the firm (all public organisations). 2. legitimacy of the stakeholder’s (oversight committee’s, which represent the general public through parliament) relationship with the firm (all public sector organisations) and 3. the urgency of the stakeholder’s (oversight committee’s, which represent the general public through parliament) claim on the firm (all public sector organisations). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 54 “the broad view of the stakeholders, in contrast, is based on the empirical reality (mitchell, 1997)”. thus, this study has explored the empirical evidence through our study. 4. the committee on public accounts (copa) or public accounts committee (pac) as revealed in many studies there are evidence that powerful legislatures can undermine fiscal discipline, which highlights a possible dilemma for legislative strengthening work (wehner, 2003). there seems to be many historical examples of governments that have fallen because the people felt that the government was not acting or protecting in the interest of people. the stability of government relies basically on good governance and effective parliamentary scrutiny and felt interests of the people through various committees (saward, 1996). the capacity of public accounts committees to be instrumental in achieving high standards of ethical governance through holding governments to account has been overlooked for decades. it is important to gain the assistance of civil society, aid institutions, international financial agencies, and others who have an interest in honest stable government, the eradication of corruption and strong democratic institutions to overcome the ‘governance gap’ (loney,2004). the pac in sri lanka has a historical significance as an institution of parliamentary control similar to that in countries where westminster model of parliamentary government is practiced. in these countries the pac derives inspirations from the tradition and experience of the pac of the house of commons in the united kingdom. the parliamentary institutions in sri lanka began to develop with the introduction of the legislative council in 1833 under the recommendations made by the british government under the leadership of colebrooke and cameron1. the establishment of legislative council is a land mark in the development of the ceylon constitution and the eventual evolution of democratic parliamentary government in sri lanka. this council had to be consulted in most administrative matters than financial. subsequently, the council was able to obtain more financial control in 1839, 1867 and 1903 (pakeman, 1970; silva, 1973; warnapala 2004). along with these developments, in 1907, the finance committee was introduced and in 1915 the finance committee was given the power to examine the annual estimates before they were presented for the first reading in the council. during the period from 1918 to 1925 a series of legislative reforms were taken place in sri lanka (pakeman, 1970). the standing committee of public accounts was set up on 5 september 1923 as a result of the motion, which was placed before the legislative council in october 1921. the constitution of 1924, converted the finance committee into a consultative body acceptable to the majority in the council. the number of committees increased and in 1926 there were 80 committees and commissions including public accounts committee (warnapala, 2004). 1. george colebrooke, who had experience in colonial administration in india and java, visited ceylon in 1829 as a commissioner to inquire into the state of the island’s finance and administration. he was followed a years later by a legal colleague from scottish bar, charles hay cameron, whose function was to probe the judicial administration. there recommendations published in 1832 in four reports by colebrook on the administration of the government, on revenue, on compulsory service, and on establishment, and one report by cameron on judicial establishment, were of profound value, for their subsequent implementation began a long drawn-out process which resulted ultimately in the independence of ceylon within the commonwealth. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 55 the new constitution recommended by the donoughmore commission2 (1931-47) allowed ceylon to perform both legislative and executive functions. then the donoughmore constitution was brought in to being by an order in legislative council in 1931. the uni cameral legislature which was established under this constitution, the state council was entrusted with a dual function: it sat in executive as well as legislative (pakeman, 1970; ludowyk, 1966, warnapala, 2002). the pac has been set up under the standing order no. 125 of the parliament of the democratic socialist republic of sri lanka. the main purpose of the standing orders is to prescribe the procedure for the functioning of parliament in an orderly and meaningful manner. the duty of the pac is to examine the accounts showing the appropriation of the sums granted by the parliament to meet the public expenditure and such other accounts laid before parliament with the reports of the auditor general. according to standing order no.125 of parliament, the pac has the power to summon any person before the committee hearings and examine any records or documents. the standing order 125 outlines the following items: (1) there shall be a committee to be designated the committee on public accounts, nominated by the committee on selection. (2) it shall be the duty of the committee to examine the accounts showing the appropriation of the sums granted by parliament to meet the public expenditure and such other accounts laid before parliament as the committee may think fit, along with the reports of the auditor general on local authorities. (3) the committee shall, from time to time, report to parliament on the accounts examined, the finances, financial procedures, performance and management generally of any department, local authority and on any matter arising there from. (4) the committee may when it considers necessary appoint sub-committees of its own members to examine and report to the committee on all accounts and the finances and management of such departments, local authorities as the committee may direct. (5) the committee or any of its subcommittees shall for the performance of its duties have the power to summon before it and question any person and call for and examine any paper, book, record or other document and to have access to stores and property. (6) the quorum of the committee shall be four members. (as amended february 26,1993 published by the parliament secretariat, colombo, sri lanka). the pac’s main task is to investigate the managerial efficiency and financial discipline of the government, its ministries, departments, provincial councils and local authorities. in 1972, the constitution of sri lanka was changed and the name of the legislature house of representatives was changed to national state assembly. it was adopted with a unicameral (single chamber) legislature. this republican constitution introduced a highly centralised system of government with a strong executive and a constitutional head of state. the committees established under earlier constitution continued to function under the new constitution. (wijesekara, 2002; warnapala, 2004). the republic constitution of 1972 was 2 the commission (consist of four commissioners) under the chairmanship of the earl of donoughmore appointed to examine the working of the 1924 constitution and to consider any proposal for its revision. they presented their report to the secretary to the state in july 1928. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 56 replaced by the constitution of 1978 and it brought in a presidential system cum parliamentary system of government in sri lanka. the constitution of 1978 retained the unicameral legislature and elected executive president with an enormous plenitude of power. the constitution combines the basic features of the westminster parliamentary system with the executive presidential system. this constitution introduced proportional representation in the system of election. it resulted in greater diversity of representation with a higher likelihood of minority or coalition of government being formed (wijesekara, 2002; warnapala 2004). like other democratic governments, functions of the sri lankan parliament are law making, scrutiny of the executive, ventilation of public grievances and the control of public finance (wijesekara, 2002). the 1978 constitution introduced several changes in the structure of the committees and five more new committees were added including the second oversight committee cope. the constitution of the democratic socialist republic of sri lanka, in its article 148 states as follows: ‘parliament shall have full control over public finance. no tax, rate or any other levy shall be imposed by any local authority or any other public authority, except by or under the authority of a law passed by parliament or of any existing law’ therefore, even though the government and the treasury prepare the annual budget, its proposals cannot be implemented without the parliamentary approval. the annual budget includes all government expenditure for the coming financial year as well as the proposals for taxation and other revenue measures. the budget expenditure is set out in detail in the appropriation bill (pac, parliament secretariat, 2006). according to financial regulations of the government of sri lanka, it is the duty of the minister of finance to appoint each secretary to a ministry to be ‘the chief accounting officer (cao) of his ministry and delegates to him the responsibility for supervising departmental financial transactions, subject to the direction of the treasury (financial regulations of the government of sri lanka, 1992,p.45). according to this arrangement, the treasury retained the general control over government financial matters while the cao discharged his constitutional responsibility of supervision over the departments concerned in respect of their financial transactions. in the same manner, a head of department was made the accounting officer in respect of all financial transactions of his department, and he is individually responsible to the cao (warnapala, 2004,p.118). the tasks of the copa or pac are as follows: 1. to probe whether the allocated funds have been used by the respective ministries, departments, local authorities etc with the maximum efficiency and whether the financial regulations have been duly complied with. 2. if any excess has taken place to find out whether it was done with proper authority and whether they can be justified. if over expenditure is justifiable the committee can make suitable recommendations to parliament to allow the same. 3. if excess cannot be justified to make recommendations regarding action to be taken to prevent such occurrences in future. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 57 4. the committee can also make recommendations relating to underutilization of funds as well as over expenditure on extravagance (pac, parliament secretariat, 2006). it is interesting to note that the reports of copa are usually not debated in parliament though they may sometimes be referred to in the course of other debates. however, recommendations contained in such reports are considered to be directions to the parliament (pac, parliament secretariat, 2006). next section explains the role of cope – the second oversight committee to monitor state corporations and business undertakings in sri lanka. 5. the committee on public enterprises (cope) the duty of the cope is to report to the parliament on accounts examined, budgets and estimates, financial procedures, performance and management of corporations and other government business undertakings. the accounts of these organisations are audited by the auditor-general and form the basis of the investigations of the committee. the cope has the power to summon persons and documents before the examination purposes under the standing order 126 of parliament of sri lanka. the standing order 126 explains the authority as follows: (1) there shall be a committee to be designated the committee on public enterprises nominated by the committee of selection. (2) it shall be the duty of the committee to examine the accounts of public corporations and of any business or other undertaking vested under any written law in the government laid before parliament, along with the reports of the auditor general thereon. (3) the committee shall, from time to time, report to parliament on the accounts examined, the budgets and annual estimates, the finances, financial procedures, performance and management generally of any public corporation or of any business or other undertaking vested under written law in the government and on any matter arising there from. (4) the committee may when it considers necessary appoint sub-committees of its own members to examine and report to the committee on all accounts, the budgets and annual estimates, the finances and management of such public corporations or of any business or other undertaking vested under any written law in the government as the committee may direct. (5) the committee or any of its sub-committees shall for the performance of its duties have the power to summon before it and question any person and call for and examine any paper, book, record or other document and to have access to stores and property. (6) the quorum of the committee shall be four members. the cope has the power to summon the relevant officials and such other people as it thinks fit to obtain evidence and call for documents. the committee reports to parliament and the recommendations contained in their reports are deemed to be directives to the respective corporations or statutory boards for compliance. for example, the cope report (2007) revealed that the country has lost 600 million rupees (about 6 million us dollars) mainly due to malpractices of 20 state enterprises. among some of the institutions that financial malpractices took places are foreign employment bureau, sri lanka cashew corporation, national housing development authority, national gem and jewellery authority, exports asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 58 development board and the building material corporation, national transport commission, associated newspapers of ceylon ltd., sri lanka rupavahini (tv) corporation, sri lanka broadcasting corporation, the consumer affairs authority and the mahapola higher education trust fund (sri lanka -news desk, 2007). next section explains about the authority to summon persons and documents to oversight committees in sri lanka. 6. use of authority to summon persons and documents to oversight committees in order to obtain an understanding and evidence of the practice of summoning procedure of oversight committees in sri lanka, interviews were conducted with some members of parliament, senior officers of the ministry of finance and treasury department and oversight committee members. the researchers attended meetings with parliamentarians and officials of the ministry of finance and the treasury department in sri lanka during the latter part of 2008 and 2010 to obtain evidence associated with the process of summoning persons and documents to oversight committees. in most interviews, respondents extended their full cooperation to this study and encouraged researchers to conduct many more work in this area in sri lanka as there is a dearth of research into parliamentary accountability. this section reports the outcome of interviews. 6.1 oversight committee hearing process presently, there are about 300 public institutions in sri lanka. these public institutions are operated mainly with the public funds provided by the sri lankan government. therefore, the operations of these public institutions are under the close scrutiny by oversight committees on a regular basis. in the oversight committee hearing process, apparently, all the public institutions are not being summoned before committees. as revealed by the former auditor general and other respondents (interview 22, 3, 4) in sri lanka, the summoning to oversight committees is happening in the following manner: (a). the oversight committee secretariat prepares a list of public institutions that are to be summoned for investigations. (b). the ag is also contacted by the oversight committee secretariat to find his views on public institutions. (c). oversight committee members also suggest public institutions that are to be investigated. practically, all the deliberations in the oversight committee are based on the ag’s report. there is no formal pattern or guideline to summon public institutions before the oversight committee. the public institutions are summoned based on a certain priority system adopted by the committee secretariat. the hearing committee consists of the chairman, the secretary to the committee, director of public enterprises and his supporting staff and the auditor general and his supporting staff. the witnesses are summoned before the committee regularly for questioning (interview 1). basically the secretariat sends summoning letters to secretary of a cabinet ministry and he directs it to respective cao of respective ministries or departments. the cao has to prepare a report based on the ‘audit paragraphs’ of the ag. these reports are submitted to the secretariat normally one week before the committee asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 59 hearing. however, some ministries submit their reports on the same day as the committee proceedings are taking place. at the hearing stage of the committee, the members of oversight committee are provided with minutes of the previous meeting, standing orders, audit queries raised by the ag and additional comments made by the ag with respect to previous audit queries and sometimes the newspaper cuttings (media news on matters relating to the public institution) associated with a respective public institution. 6.2 do the oversight committees have power to summon persons and documents? as revealed by the interviewees, the duty of the oversight committee is to examine the sums voted by parliament along with the report of the auditor-general. in the course of its deliberations, the committee makes all the efforts to obtain relevant evidence from the secretaries of respective ministries, caos, heads of departments and other responsible officers. additionally, the committee regularly summons the directors-general of public finance, state accounts and national budget or their nominated representatives (interview, 6, 7, 8 and 25). the oversight committees in sri lanka, has the authority (under standing orders, 125 & 126) to summon any person such as present staff of any public institution, previous staff (or retired officers of any public institution) and documents. it is interesting to note that the parliamentarians or cabinet ministers are practically not being summoned for questioning. however, sometimes cabinet ministers are summoned to the committee as observers depending on the interest of the committee. during their observation time, some cabinet ministers provide comments relating to specific issues raised by the committee members or witnesses (interviews 12, 23 18, 20, 23 and 25). the oversight committees can summon people from government ministries, departments, local authorities (such as city councils) and provincial councils. the summoning of these institutions is done by the copa. the other public enterprises such as central bank, universities, public corporations are summoned by the cope. it is interesting to note that standing order does not say anything about state owned companies (soc) hence socs are not monitored under cope supervision. presently there are about 300 ministries and departments and about 325 local authorities and 8 provincial councils operating in sri lanka. the copa meets about 40 to 50 times a year. for a year generally 40 or 50 public institutions could be summoned before copa. as revealed by the committee records, some public institutions have never been summoned. however, all the 8 provincial councils were summoned during the year 2007 as copa realised that they are important for investigations. 6.3 do oversight committees have sufficient power to summon officers? another interesting point raised at interviews was whether the oversight committees have sufficient power to summon persons. according to standing orders 125 and 126, the committees have the full authority to summon respondents (public officers) before the committee. for example, during the past years, oversight committees have summoned only selected institutions. some institutions have not been called upon by the committees asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 60 (interview 2, 10, 9). as indicated in records, in 1993, the committee heard evidence from seven caos and twelve accounting officers. in 1995, the committee heard evidence from 13 caos and 60 accounting officers and in 1996, the committee heard 16 caos and 21 accounting officers (warnapala, 2004 p.123). as indicated by respondents to this study, over the past few years, nearly 150 caos and other officers have been summoned before the committees for various inquiries. the oversight committees have summoned following categories of individuals for hearings: • the officials of government departments, • ministry officials, • treasury officers, • chairmen and the board of directors of the public enterprises and government own business undertakings (gobu), • interest groups, • ex-officials, • exchairmen • board of directors of the public enterprises and gobu. it clearly indicates that the oversight committees have the full authority summon any public officer before the committees and examine the accounts and accounting procedures that have been followed with the assistance of the auditor general, the directors of the department of public finance, state accounts and national finance. the caos assisted by other relevant officers who explain and justify the finance activities and procedures of the departments for which they are responsible. as revealed by an interviewee, ‘some institutions are not summoned by oversight committees due to complications involved with regard to their nature of ownership. for example, mihin air3 and lanka transformers limited4 are operated as private institutions. however, when government offer tenders for 3 recently established local airline with the support of the government. 4 lanka transformers limited (ltl) was established in 1982, set up initially to produce distribution transformers to meet the local requirement. ltl, over the years has blossomed into the largest engineering organization within the power sector in sri lanka with an annual turnover exceeding slr. 5.4 billion (us$ 54 million).in addition to manufacturing of transformers for local and international markets, ltl has diversified into hot dip galvanizing, power generation, fabrication of steel structures including lattice steel towers for power transmission and telecommunication systems, turnkey construction of projects, project management, energy management, information technology, broadband networking, and a host of many engineering services. the significant factors in the ltl success story are the technical co-operation agreement with abb as of norway and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 61 various businesses, these institutions are considered as public sector companies. so there is some confusion as to whether these institutions are belonging to public or private sectors. direct political influence is involved in the summoning of such institutions to oversight committees. however, after a long debate on these matters in the parliament, mihin air was summoned by the oversight committee and in the hearing process the brother of the president of sri lanka influenced in many ways the witnesses. these are direct political interferences to protect the interest of the ruling political party. the other important issue is that majority of the members of oversight committees are from the ruling political party. very few members represent the opposition parties in oversight committees. it is important to amend the appointment of members to oversight committees. another important factor is that at the moment the oversight committees do not have the power to take appropriate legal actions against corrupt persons and institutions” (interview – 16). another interviewee (interview 24) mentioned that the oversight committees have the power to summon any body before the committees. however, parliamentary ministers are not summoned as witnesses. according to him the chairperson of the committee is appointed from the ruling party and he was appointed recently as the chairperson of cope with the majority support from the parliament. the government expects a chairperson from the ruling political party mainly to avoid unwanted troubles. it is important to note here that oversight committees are functioning as parliamentary device of control. however the committee confines itself to those points raised by the auditor general in his reports. the committee has the full power to question the persons summoned before the committee on any matter related to accounts under scrutiny by the committee. 6.4 what documents are summoned before the oversight committee? as revealed by some interviewees (interviews 2, 5, 8, 11, 13, 14, 15), the oversight committees have the power to summon documents to the hearing process as evidence. in the past, many documents have been summoned for investigation purposes. the documents tabled in the committee normally fall into five categories: (1) annual reports, (2) report of the auditor general, (3) comments on the report of the auditor general prepared by the particular public enterprise, (4) a profile prepared the department of public enterprises on the particular public enterprise , (5) strategic plans prepared by various public institutions. the company's well-trained engineers numbering over 60 and the competent staff. the company employs around 800 personnel directly and indirectly. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 62 the examinations are conducted primarily on the basis of above documents that provide the most important guidelines for the committee and its members. however, various other documents are also summoned depending on the nature of the investigation carried out by the committee. there have been some instances where licensing documents, deeds, and contractual agreements of the related parties and letters of appointments of various public officers have been summoned for authentication and verification purposes (interview 17,25 & 21). among the documents, the annual reports of ministries, departments, local authorities and corporations have been summoned from time to time to substantiate the evidence for the examinations of the committee. basically, the annual report of a public enterprise, in addition to the usual preliminary information relating to the board of directors and the senior management, furnishes information on such important matters as the report of board of directors, income and expenditure account, balance sheet, notes of the income and expenditure, the tax computation, relevant sections from the report of the auditor general and the board’s observation on the report of the auditor general. it is also a requirement that the annual report has to be published in all three languages ( i.e , sinhalese, tamil and in english) and submitted to parliament to be tabled by the minister concerned (warnapla, 2004 and interview 25). it was often revealed that the delay in submitting the report was partially due to the fact that it had to be published in three languages; this was a common excuse given by several organisations at the oversight committee hearings (interview 25). as revealed by some interviewees the major deficiency is the inordinate delay in submitting such reports to committees. 6.5 do oversight committees allocate sufficient time for hearings? at present there is no proper time management in the committee hearing process. the committee investigations are conducted on the basis of representations made by the ag and general treasury as well as experience of the committee chairman and members and the issues reported. hence, there is no plan of priority for hearing. mainly due to this weakness, there are instances where some areas which needs serious attention and examination being left without any examinations or investigations (interview 19, 22, 24,18). 7. findings, discussion and conclusions this section of the paper highlights the findings and provides a conclusion and some recommendations based on the study. the study analysed the oversight functions on public sector performance in order to achieve democratic rights of the general public. empirical data was analysed based on stakeholder theory which has been modified by mitchell et al,’s as “identification typology” model. this model helped us to identify unique features of the sri lankan case (mitchell et al,. 1997). according to standing order 125, the role of the copa is to examine the accounts showing the appropriation of the sums granted by the parliament to meet the public expenditure and such other accounts laid before the parliament along with the ag’s report. in this process the role of the ag is pivotal for asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 63 important decisions by the oversight committees. the role of the ag is to assist the parliament (legislature) to oversee the accountability of the executive and the constitutional arm of the legislature. therefore, the ag is expected under article 154 to audit all government expenditure and report to parliament within 10 months of the close of the financial year. article 154 (6) reads as follows: ‘the auditor general shall within ten months after the close of each financial year and as and when he deems it is necessary report to parliament on the performance and, discharge of his duties and functions under the constitution’. the major findings of this study are as follows: in terms of article 154 of the constitution of the democratic socialist republic of sri lanka, the ag has been given the power to audit of the accounts of the government departments, the office of the cabinet ministers, the judicial service commission, the parliamentary commissioner for administration, secretary general of parliament and the commissioner of elections, local authorities and the public corporations and business or other undertakings, vested in the government under any written law. thus the ag has a pivotal role to play in the oversight committee practices. the ag is also empowered to obtain assistance in the examination of any technical, professional or scientific problem relevant to the audit from any independent person or institution. these provisions imply that the mandate of the ag is beyond the conduct financial audit, non financial audit, value for money audit as well as environmental audits. with the recent reforms on the audit act, the ag is given more independence in financial and non financial matters. this indicates the nature of controls on public expenditure and the expectations of the stake holders as explained in the theory. the finance act no. 38 of 1971 empowers the ag to examine, accounts and finances, property of public corporations, organisations, systems and procedures, compliance with laws, rules and regulations, economy and efficiency aspects, and any other matters the ag deemed necessary. these provisions relating to the public corporations give wider mandate to the ag (finance act no. 38 of 1971, sri lanka). in accordance with these provisions, the ag’s report bears significant evidence on the use of public funding by various public institutions. the cope is dealing with public corporations and government undertakings and it has the power to summon persons and documents before the examination purposes under the standing order 126 of parliament of sri lanka. therefore, each report of the ag is referred to the copa or cope for further examination and investigation. it reveals that the copa or cope is the only channel through which parliament can directly examine the public institutions about their management of public funds. the committee reports on the accounts examined, the finances, financial procedures and performance and management of all government ministries, departments and local authorities (interview 22). the figure 1 shows the role of the copa and the cope. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 64 role of the committee on public accounts and committee on public enterprises parliamentary orders standing orders acts., policies reports copa &cope power to summon persons & documents performance evaluation public enterprises -reports-ag’s -dept. pe ag’s reports -ministries -departments. public enterprises etc. resources -financial -human composition -ruling opposition figure 1. role of the committee on public accounts and committee on public enterprises as shown in figure 1, copa and cope comprised of ruling party as well as opposition members, the ag and directors of the treasury. the copa (formally pac) originally consisted of four members (ceylon sessional papers 4, 1924). subsequently, the membership of copa increased to 7 in 1937 and again the membership was increased to ten in 1979. in 1993, again the membership was increased to 12 from year 1993 to 2001. in 2004, the membership was grown to 19 and in 2006 the number increased to 31 including the chairperson. the committee quorum is four members. the increase in the membership took place basically to give equal opportunity to all elected political parties involved in the parliament. given the inter-relationship of oversight committees and their composition from time to time, it is reasonable to assume as to how stakeholders are interested in the operations of the whole system. a unique feature in the committee is that a majority of the membership is vested with the ruling party. presently, most members of oversight committees are comprised of cabinet/ non-cabinet or deputy ministers of the government. traditionally, an opposition member was appointed as the chairperson of the copa, a legacy inherited from the house of commons. the appointment of the chairman from the opposition gives more confidence to the opposition. this tradition was maintained for three decades and appointment of a ruling party member as chairperson began after 1977. the current practice is to appoint a chairman to the oversight committee from the ruling party. as mentioned by an interviewee, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 65 “…..my experience with 2007 and 2008 cope proceedings indicated me that the chairperson for the committee should be appointed from the ruling partybecause then the chairperson has a vigorous power to conduct the committee hearings…” (interview 16). at present the summoning of persons and documents to oversight committee seems to be not taking place according to a systematic manner – or as expected by the stake holder perspective. in an accountability framework (as explained in the stake holder perspective), the expectation of general public is to ensure a systematic approach to oversight functions and particularly to summon appropriate persons or institutions before the committees. as revealed by many interviewees, there is no approved methodology to determine public institutions that are to be summoned before committees. basically the oversight committee chairperson and committee members decide which institution should be summoned based on available information with regard to a respective public institution. however, auditor general’s report and his recommendations is the basis for summoning public institutions for hearing process. the committee’s examination of the accounts usually involves calling before it various officials of the departments who are questioned in regard to specific items contained in the ag’s report. it is important to appoint a permanent staff to the secretariat to assist committees for the identification of the public institutions that are to be summoned for investigations using a logical basis. and the institutions that are to be summoned must be identified at least 3 months before the scheduled date of summoning so that witnesses could get ready for the examination process with relevant documents. it is also important to maintain executive summaries of all the investigations performed by the committee for reference purposes and for subsequent examinations. as revealed by respondents this practice is absent in the current system. in terms of provisions in articles 154(4) (a) of the constitution, the ag could obtain services of firms of qualified auditors in carrying out the audits of public enterprises, estates and state banks. this indicates that the ag’s department does not have sufficient staff to carry out various audit examinations associated with the numbers of institutions involved in the scrutiny process. this is an important issue identified by most of the respondents to this study. despite the summons were sent to some public institutions, they did not appear before oversight committees. for example, sri lankan airways, telecom (lanka) refused to give evidence or to appear before oversight committee indicating that they were not falling under the public sector category (interview 15, 16). as revealed by respondents, apparently no legal action had been taken against them for refusing to appear before committees. even though standing orders specify that any person or document can be summoned before an oversight committee, as indicated, the parliamentarians are exceptional persons. the cabinet ministers or deputy ministers or ordinary members of parliament (presently only very few members of parliament with out cabinet or ministerial portfolio in the sri lanka parliament) cannot be summoned under any circumstances. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 66 traditionally the copa and cope confine themselves to the issues raised in the ag’s report. however, the involvement of state in economic and social development pave the way for high investment in the public sector and the increase in public expenditure and revenue made it difficult to have a effective control over public finance. the volume of work of the committee has increased enormously with the increase in public expenditure. despite the growth of the public expenditure and revenue, increase in state agencies, the parliament in sri lanka has not been supplied with adequate information, development in information technology etc. therefore, the question arose as to the adequacy of traditional methods of control adopted by pac. due to inherent weaknesses in the committee system, many public officers who appear before the oversight committees have not taken any seriousness of the committee hearing process. the public officers responsible for fraudulent acts are transferred or retired before the completion of hearings of oversight committees. moreover, the follow–up actions on deliberations at the committee meetings of prior years appeared to be intentionally ignored. thus, a little attention is paid on the best practice of parliamentary scrutiny and how it impacts the public accountability in sri lanka. as a result of country financial assessment exercise conducted by the world bank in the recent past, the bank has granted us $ 494,000 financial assistance package to strengthen and enhance capacity of the two oversight committees – copa and cope. the financial assistance which came as a donor package is to be utilised to enhance capacity of the two committees with regard to obtaining documents \ relevant material, interactive workshops, train manpower and obtain advice and the conduct of awareness programs. us $ 284,000 would be utilised to propagate matters pertaining to training officials and obtaining advice with interactive workshops, seminars, recruitment etc. being organised to build capacity. another us $ 10,000 is to be spent on obtaining material, documents etc. another us $ 200,000 would be utilised to conduct awareness and educational programs (ceylon daily news 8 october 2008). the existence of instruments of control (using documents and persons) involved does not in itself enhance the purpose of accountability as revealed by many respondents to this study. rather, it depends to a greater extent on the attitude and involvement of members of parliament (or political power). very often procedural changes are introduced with a view to enhancing the effectiveness of parliamentary control over public spending, but the effectiveness of such procedures is subject to professional limitations of those involved in the whole process. reservations and concerns are raised very often in professional and academic forums with regard to inadequacy of professionalism and lack of dynamic involvement coupled with deficient knowledge and awareness among those interacted with good governance and accountability issues and control aspects. we suggest that the theoretical frame that we used in this paper eventually explain the exact nature of the dynamics involved in the public financial management area in sri lanka. both oversight committees, as a device of parliamentary control, face many criticisms due to the concerns of the stakeholders. as in the case of many reports tabled in the parliament, the reports of the oversight committees are not debated in parliament and most time it disappears without any notice. the reason, perhaps, is that most of the members of the parliament are asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 67 not interested in debating this because the accounts of three or four years back have been discussed, examined and enquired and placed before the parliament (warnapala,1997). peter keuneman5, who served on the oversight committee for a period of 16 years, described the oversight committee (copa) as an ornament in parliament. he was of the view that it rarely discussed the policy questions, and the examinations conducted by the copa were in the nature of post-mortems. in the light of above findings, a few suggestions cold be made to improve the future summoning process of oversight committees in sri lanka. the public oversight committees have been described as the ‘ultimate institutional judge’ in the ‘ex-post’ process of assurance in parliament regularity, propriety and ‘value for money.’ they are fulfilling public expectations on pubic money as important guarantors of ‘good governance’. it is clear from this empirical study that there should be a clear understanding of the ownership of certain institutions whether they are categorised under public or private entities. the members of parliament (including cabinet ministers) are to be summoned before the oversight committees during the investigations. it is apparent that a systematic record keeping mechanism ought to be introduced to track the past records associated with investigations of the oversight committees. the opposition party membership in the oversight committee ought to be increased for better transparency on matters relating to various investigations. suitable penalties must be imposed or recommended for those who have misused or misappropriated public funding. it is true that in the recent past, the secretary of the ministry of finance was held responsible and certain penalties were imposed on his misconduct on public funds. similar actions must be taken for other public officers who have violated the financial regulations. considerable delays have been observed in summoning persons and documents to committees. a corrective action should be taken to expedite this process. the standing orders associated with the copa and the cope appears to be outdated. there should be some clarity on the persons to be summoned before committees and revisions to standing orders are to be considered by the parliament without further delay. further research there had been a civil war in sri lanka over the last three decades. the defence expenditure of the government on the war has been an important issue and various debates have been taken place during the past both nationally and internationally. as revealed in interviewees of this study the military persons, related expenditures and documents had never been summoned before oversight committees’ examination in sri lanka. this issue has to be further investigated in a future study. references alam manzurul. 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(2006). report published by the commonwealth parliamentary association, parliamentary financial scrutiny; the role of public accounts committees, august microsoft word 1443-5663-1-rv _2_-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 132 accounting researchers in asia pacific: a study on publication productivity and citation analysis dr. teck heang lee (corresponding author) senior lecturer, department of business studies help university e-mail: lee.teck.heang@help.edu.my dr. ching seng yap assistant professor, graduate school of business universiti tun abdul razak e-mail: chingseng@unirazak.edu.my dr. yet mee lim associate professor, faculty of accountancy and management universiti tunku abdul rahman e-mail: limym@utar.edu.my dr. cai lian tam lecturer, school of medicine and health sciences monash university sunway campus e-mail: tam.cai.lian@med.monash.edu.my received: february 24, 2012 accepted: march 18, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1443 url: http://dx.doi.org/10.5296/ajfa.v4i1.1443 abstract research quality and productivity are the important dimensions that affect the employability and rewards of university faculty members. generally, the publication achievement of university faculty members can be measured by the number of papers published in reputable journals as well as the number of citations obtained from their publications. this study examines the publication productivity of accounting faculty members of asia pacific universities in the top accounting journals for the period 2000 to 2010. the present study also asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 133 measures the publication achievement using the number of citations of the researchers’ publications in these journals for the same period based on the search from google scholar, scopus and social science citation index. the study found that hun-tong tan is the most productive researcher in the top 18 accounting journals, followed by r. g. walker and michael bradbury. when a sub-set of the top 5 accounting journals is used, the top three researchers are hun-tong tan (ntu), clive s. lennox (hkust) and robert h. chenhall (monash u). using the citation count, the present study found that t.j. wong (cuhk), robert h. chenhall, and ferdinand a. gul (monash u) obtained the highest total citations from both google scholar and scopus. however, when social science citation index is used, t.j. wong, robert h. chenhall, and hun-tong tan are the top three. the results of this study provide the evidence of the contributions by the asia pacific universities’ faculties towards high quality accounting research and publications over the last decade. keywords: publication productivity, citation count, google scholar, scopus, social science citation index asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 134 1. introduction “publish or perish” is a common phrase used to describe the present situation of academic staffs’ performance in institutions of higher learning (bline, 2007). this is because faculty staff members are expected to secure research grants, to conduct research projects as well as to publish research papers to meet their research productivity assessments (everett, nue & green 2003). research activities and publication productivity represent one of the major key performance indicators (kpis) of the faculty members in most of the universities (kusairi & fatimah, 2008). according to hasselback, reinstein and schwan (2000), various parties such as the academic administrators, faculty members and potential doctoral candidates are interested to have information about the research productivity of academics. for example, individual faculty members need such information to justify their hiring, compensation and promotion, tenure decisions, faculty awards and research grants (pickerd, stephens, summers & wood, 2011). on the other hand, university administrators need such data to provide a fair and objective performance evaluation of their academics (hasselback, reinstein & schwan, 2003). information on research productivity of faculty members also helps potential doctoral candidates to identify research supervisors to provide suitable and relevant mentorship (pickerd et al., 2011). in view of the importance of information on research productivity, extensive research on publication productivity have been conducted in various business disciplines such as accounting (stammerjohan & hall, 2002; chan, chen, & cheng, 2005, chan & liano, 2009; chan, chang, tong, & zhang, 2011), finance (chan, chen, & steiner, 2004; heck & cooley, 2005), information systems (clark, warren, & au, 2009), knowledge management and intellectual capital (serenko & bontis, 2004), and marketing (cheng, chan, & chan, 2003; seggie & griffith, 2009). a review of literature in this area shows that most of the studies conducted to examine the research productivity were carried out in the western countries. very few studies were done on the research productivity in asia, despite the fact that researchers from asian countries have been actively publishing their research findings in reputable and high impact journals. hence, a research study that examines the research productivity of research in the asian countries would in turn fill up such a research gap. to make a contribution to the existing literature in research productivity, the present study aims to (1) examine the publication productivity of accounting faculty members in asia-pacific universities in the top accounting journals for the period 2000 to 2010; and (2) measures the publication achievement using the number of citations of the researchers’ publications in these journals for the same period based on the search from google scholar, scopus and social science citation index. since the study adopts two different methods (i.e. publication and citation count) in evaluating the publication performance of the accounting faculty members in the asia pacific, it should provide a most up-to-date and comprehensive examination to the accounting researchers in the region. hence, timely, reliable and convincing results could be expected from the present study. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 135 the structure of the latter part of this paper is as follows: section 2 reviews past empirical studies on accounting publication productivity. section 3 describes the productivity measures and data selection criteria for the present study. section 4 presents the results in accordance with the research objectives set forth in the introduction section. lastly, the paper concludes by discussing the implications and the limitation of the study. 2. literature review many studies have been conducted to examine the academic institutions’ and faculty members’ research productivity in the western countries. dyl and lilly (1985) conducted a study to examine the accounting publication productivity of academic institutions based on seven high-impact accounting journals from 1978 to 1981. their findings show that the number of publications per faculty member in accounting has been low. in addition, it is indicated that 45 percent of the articles in the selected accounting journals were accounted for by 25 institutions only. this implies a high level of concentration in publication. a later study conducted by jones and roberts (2005) found similar results. they examined 1,867 articles published in six highly-rated uk and six highly-rated us academic journals from 1996 to 2006. they also found that uk journals are dominated by authors from the uk and us universities and 90 percent of the us journals were published by authors from the us institutions only. the results show that very limited numbers of authors from institutions in non-english speaking countries published in the top-rated uk and us based academic journals. using 40 reputable accounting journals, hasselback et al. (2003) conducted a study to examine the most prolific accounting researchers in the us. forty eight hundred and ninety accounting faculty members graduated from the year 1968-1997 in the us were selected as the sample of the study. the study found that philip m. j. reckers, chee w. chow, william h. beaver, raymond j. chambers and wanda a. wallace were the top five most prolific authors in 40 journals for the period 1967-2001. not limiting to the accounting researchers in the us, heck (2009) examined the most prolific authors in the accounting literature from 1959-2008. heck analyzed 17,462 articles and 10,542 authors from 25 core us accounting journals and found that the top five most frequent appearing authors were joel s. demski, william h. beaver, chee w.chow, william r. kinney, jr. and thomas a. lee. the study also ranks the authors based on the number of papers published in the top five leading accounting journals namely accounting, organizations and society, accounting review, journal of accounting and economics, journal of accounting research, and contemporary accounting research. the ranking of authors in these five leading accounting journals are (i) joel s. demski, (ii) robert e. verrecchia, (iii) william h. beaver, (iv) robert libby and (v) william r. kinney, jr. in terms of research productivity in the asia pacific region, the present authors found three research studies on the universities of australia and new zealand. they are william and durden (1998), chan et al., (2005), and chan et al. (2011). william and durden (1998) measured the publication productivity of the accounting department of new zealand university for the period 1992-1997. this study provides a comprehensive evaluation by adopting different measures to assess research productivity. the research performance of the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 136 department was assessed based on such measures as publications in top ten accounting journals, publications in accounting journals using weighted rankings, publications in both australian and new zealand accounting journals, publications in unweighted accounting and non-accounting journals, and professional accounting publications. based on this comprehensive evaluation william and durden (1998) found that university of auckland and massey university performed well when they were measured by aggregate department publications in high-quality accounting journals. on the other hand, the study also found that there is a strong tendency across departments for high reliance on a few main researchers and hence when publication is measured based on a per faculty basis, larger departments in such universities as university of auckland and massey university tend to have a poorer performance. the study also found that victoria university and university of otago have published widely in professional journals, and university of waikato has performed well for both professional and academic journals. based on articles published in 18 leading accounting journals and a subset of top-five accounting journals, chan et al. (2005) measured the publication productivity of the academic institutions and their accounting faculty members in the asia pacific region. their performance was measured in a two-time period, from 1991 to 1996 and from 1997 to 2002. the results show that institutions from australia, hong kong and singapore dominate the top 20 list for both time periods. during the second time period (1997-2002), institutions from hong kong and singapore have gained significant improvement in the publication productivity ranking. the distribution of the publication is highly skewed--the top five, top 10 and top 20 institutions account for 32 %, 50 % and 70 % of all weighted number of articles respectively. chan et al. (2005) found that for the period of 19912002, michael firth, r. j. chambers, hun-tong tan, ferdinand a. gul and ken t. trotman are the most productive authors in the 18 leading journals. when the top-5 journals were used to rank the productivity of the accounting authors, the top five authors are hun-tong tan, wai fong chua, suil pae, greg b. clinch and margaret a. abernethy. the latest study in the asia pacific region was conducted by chan et al. (2011). this study examined the research productivity of the institutions of higher education in australia and new zealand for the period 1991-2010 using 48 high-quality accounting and finance journals. the study found an upward trend in research output for both australian and new zealand accounting and finance departments. the top five universities were found to be university of new south wales, university sydney, monash university, university of melbourne and university of queensland. massey university, the highest ranked university in new zealand, was found to rank number 8 in the study. the study also found that if a faculty member manages to publish five papers in the 48 journals, such a person would be the top 15 percent among the 1,245 australian and new zealand academic staff members. finally, this study shows that highly research productive academics are able to move to different jobs. this in turn indicates that research productivity gives rise to job mobility. 3. productivity measures and data selection criteria the present study adopts the data selection criteria based on chan et al. (2005). eighteen top ranked accounting journals were used in the present study. chan et al. (2005) provided the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 137 following justifications of adopting these journals. firstly, these journals are ranked as the most prestigious and influential in the accounting field. besides, these journals also obtained good quality ratings and have existed for a long period of time (e.g., the accounting review was established in 1926). the chosen journals cover both general scope (e.g., the accounting review) and specialized accounting topics (e.g., national tax journal). in line with chan et al (2005), of the 18 journals, a subset of top five journals was also selected for separate analyses. these top five journals are also ranked as the top accounting journals by hasselback et al. (2003), and brinn, jones and pendleburg (1996). the list of the top 18 accounting journals is presented in table 1. the impact factors of these journals in ssci and scopus as well their ranking in abdc and era are provided. table 1. list of the top accounting journals no. journal title ssci jif scopus snip abdc ranking era ranking 1. abacus 0.833 1.084 a a 2. accounting and business research 0.638 1.253 a a 3. the accounting review * 2.488 3.599 a* a* 4. accounting, organizations and society * 2.337 3.629 a* a* 5. auditing: a journal of practice and theory 1.021 1.770 a a 6. behavioral research in accounting not listed not listed a a 7. contemporary accounting research * 1.735 2.008 a* a* 8. journal of accounting and economics * 2.817 4.734 a* a* 9. journal of accounting and public policy 0.754 1.406 a a 10. journal of accounting literature not listed not listed a a 11. journal of accounting research * 3.346 3.995 a* a* 12. journal of accounting, auditing, and finance not listed 0.607 a a 13. journal of management accounting research not listed not listed a a* 14. journal of the american taxation association not listed not listed a b 15. journal of business finance and accounting 0.549 1.107 a a 16. national tax journal 0.688 0.852 a a* 17. review of accounting studies 1.972 1.956 a* a 18. review of quantitative finance and accounting not listed 0.702 b b notes. journals are sorted according to alphabetical order; * denotes the top 5 journals by chan et al. (2005) and the leading 5 journals by heck (2009); jif – journal impact factor; snip – source normalized impact per paper. 4. results the first research objective is to examine the publication productivity of accounting faculty members for the period 2000 to 2010. the name and the affiliation of the asia-pacific authors from the 18 accounting journals were collected for the period of 11 years from 2000 to 2010. unweighted number of article is computed by counting the number of articles asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 138 published by an author regardless the number of authors for that paper. when an article is authored by multiple researchers, the weighted number of article published per author is used to adjust for co-authorship and is measured by dividing one by the number of authors for that paper. based on the 18 accounting journals, hun-tong tan (ntu) is the most productive author in the 18 accounting journals, followed by r. g. walker (the u of sydney) and michael bradbury (unitec). when a sub-set of the top five journals is used, the top three most productive authors are hun-tong tan (ntu), clive s. lennox (hkust) and robert h. chenhall (monash u). refer to tables 2 and 3 for more information about the top 20 authors in terms of weighted number of articles published. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 139 table 2. the top 20 authors based on the 18 accounting journals rank author affiliation weighted number of articles unweighted number of articles 1 hun-tong tan *# nanyang technological university, singapore 11.08 24 2 r. g. walker # university of new south wales, australia 7.33 10 3 michael bradbury # unitec institute of technology, new zealand 6.70 10 4 ken t. trotman *# university of new south wales, australia 6.33 13 5 (tied) clive s. lennox *# hong kong university of science and technology 5.83 10 5 (tied) stewart jones # university of sydney, australia 5.83 10 7 ferdinand a. gul *# monash university sunway campus 5.50 13 8 robert h. chenhall # monash university, australia 5.17 7 9 suil pae * hong kong university of science and technology 5.00 6 10 guochang zhang # hong kong university of science and technology 4.83 7 11 firth, michael * hong kong polytechnic university 4.67 10 12 frank l. clarke * university of sydney, australia 4.17 7 13 david johnstone university of wollongong, australia 4.00 4 14 chih-ying chen singapore management university 3.83 5 15 robert w. faff the university of queensland, australia 3.75 10 16 steven f. cahan the university of auckland 3.50 10 17 chong m. lau university of western australia 3.33 7 18 roger simnett university of new south wales 3.17 8 19 (tied) terence bu-peow ng nanyang technological university, singapore 3.17 6 19 (tied) wai fong chua * university of new south wales, australia 3.17 6 note. * denotes 8 authors who also appeared in the top 18 journals compiled by chan et al. (2005) and # denotes 9 authors who also appeared in the 25 core accounting journals compiled by heck (2009). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 140 table 3. the top 20 authors based on the top 5 accounting journals rank author affiliation weighted number of articles unweighted number of articles 1 hun-tong tan * nanyang technological university, singapore 9.75 21 2 clive s. lennox hong kong university of science and technology 5.00 8 3 robert h. chenhall * monash university, australia 4.17 6 4 suil pae * hong kong university of science and technology 4.00 5 5 ken t. trotman * university of new south wales, australia 3.50 8 6 guochang zhang * hong kong university of science and technology 3.50 5 7 ferdinand a. gul * monash university sunway campus 3.33 7 8 wai fong chua * university of new south wales, australia 2.67 5 9 chul w. park sungkyunkwan university 2.33 5 10 peter f. chen hong kong university of science and technology 2.00 4 11 rachel f. baskerville-morley victoria university of wellington, new zealand 2.00 2 12 t. j. wong * chinese university of hong kong 1.83 4 13 james r. frederickson * hong kong university of science and technology 1.67 4 14 jong-hag choi hong kong university of science and technology 1.58 5 15 (tied) peter m. clarkson * the university of queensland, australia 1.58 3 15 (tied) terence bu-peow ng nanyang technological university, singapore 1.50 3 17 (tied) anne wyatt the university of queensland, australia 1.50 2 17 (tied) john roberts university of sydney, australia 1.50 2 17 (tied) zoltan p. matolcsy university of technology sydney, australia 1.50 2 20 jeong-bon kim city university of hong kong 1.33 4 note. * denotes 10 authors who also appeared in the top 5 journal list compiled by chan et al. (2005) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 141 the second research objective is to measure the publication achievement for the period 2000 to 2010 using the number of citations. the name of each author who appeared in the 18 journals was searched from three academic citation indexes – ssci, scopus, and google scholar. using the citation analysis method, the study found that robert h. chenhall (monash u), t.j. wong (cuhk), and ferdinand a. gul (monash u) obtained the highest total citations from both scopus and google scholar. however, when ssci is used, t.j. wong (cuhk), robert h. chenhall (monash u), and hun-tong tan (ntu) are the top three most productive authors. refer to tables 4, 5 and 6 for more information about the top 20 authors in terms of total citation. table 4. the top 20 most cited asia-pacific accounting authors in ssci rank author affiliation total citation 1 t.j. wong chinese university of hong kong 225 2 robert h. chenhall monash university 213 3 hun-tong tan nanyang technological university 183 4 joseph p. h. fan chinese university of hong kong 143 5 chul w. park sungkyunkwan university 135 6 ferdinand a. gul monash university sunway campus 130 7 donald j. stokes university of technology, sydney 122 8 wai fong chua university of new south wales 102 9 easton peter university of notre dame 100 10 peter m. clarkson university of queensland 98 11 andrew ferguson university of technology, sydney 85 12 ken t. trotman university of new south wales 82 13 margaret a. abernethy university of melbourne 81 14 james r. frederickson hong kong university of science and technology 78 15 jere r. francis university of melbourne 76 16 clive s. lennox hong kong university of science and technology 69 17 jeong-bon kim city university of hong kong 62 18 rachel f. baskerville victoria university of wellington 61 19 (tied) woody wu chinese university of hong kong 60 19 (tied) jong-hag choi city university of hong kong 60 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 142 table 5. the top 20 most cited asia-pacific accounting authors in scopus rank author affiliation total citation 1 robert h. chenhall monash university 376 2 t.j. wong chinese university of hong kong 371 3 ferdinand a. gul monash university sunway campus 299 4 joseph p. h. fan chinese university of hong kong 245 5 hun-tong tan nanyang technological university 212 6 chul w. park sungkyunkwan university 200 7 wai fong chua university of new south wales 185 8 charles j. p. chen city university of hong kong 172 9 donald j. stokes university of technology, sydney 171 10 michael firth hong kong polytechnic university 156 11 jeong-bon kim city university of hong kong 137 12 (tied) easton peter university of notre dame 132 12 (tied) margaret a. abernethy university of melbourne 132 14 (tied) james r. frederickson hongkong university of science and technology 117 14 (tied) andrew ferguson university of technology, sydney 117 16 (tied) y. t. mak national university of singapore 108 16 (tied) jere r. francis university of melbourne 108 18 rachel f. baskerville victoria university of wellington 105 19 ken t. trotman university of new south wales 100 20 chi-wen jevons lee hong kong university of science and technology 97 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 143 table 6. the top 20 most cited asia-pacific accounting authors in google scholar rank author affiliation total citation 1 t.j. wong chinese university of hong kong 1,218 2 robert h. chenhall monash university 1,030 3 ferdinand a. gul monash university sunway campus 907 4 joseph p. h. fan chinese university of hong kong 875 5 chul w. park sungkyunkwan university 652 6 hun-tong tan nanyang technological university 582 7 easton peter university of notre dame 498 8 wai fong chua university of new south wales 462 9 donald j. stokes university of technology, sydney 420 10 margaret a. abernethy university of melbourne 409 11 michael firth hong kong polytechnic university 408 12 charles j. p. chen city university of hong kong 384 13 jeong-bon kim city university of hong kong 367 14 clive s. lennox hong kong university of science and technology 359 15 y. t. mak national university of singapore 323 16 woody wu chinese university of hong kong 322 17 selto frank h university of melbourne 318 18 david c. hay university of auckland 314 19 (tied) hoque zahirul griffith university 310 19 (tied) james wendy griffith university 310 when the results of this study are compared with heck (2009), seven of the top 10 authors in the five leading accounting journals with at least five appearances. it is noteworthy to point out that two asia-pacific authors, hun-tong tan (ntu) and ken. t. trotman (unsw), are listed as the top 100 most prolific authors in the five leading accounting journals, ranked 21st and 51st respectively. nine of the top 10 authors of the 18 accounting journals compiled by the present study also appear in the list of 25 core accounting journals compiled by heck (2009). (refer to note in table 2) as this study adopts the data selection criteria from chan et al. (2005), it will be meaningful to compare the results of these two studies over two periods of time. based on the weighted number of articles, of the top 20 authors in the 18 journals and the top 5 journals in chan et al.’s study, eight and ten authors respectively remain in the list of this study, meaning that the current list contain about 50% new authors. (refer to note in table 2 & 3) in terms of the most cited articles authored by the asia-pacific researchers, “the management control system design within its organizational context: findings from contingency-based research and directions for the future” by robert h. chenhall (monash u), and “corporate ownership structure and the informativeness and accounting earnings in east asia” by joseph p. h. fan and t. j. wong (both cuhk) are consistently ranked as the top 2 articles with highest citations in all three academic citation indexes of ssci, scopus, and google scholar. refer to tables 7, 8 and 9 for the most cited 20 articles in the three indexes respectively. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 144 table 7. the top 20 most cited articles in ssci rank author, article title, journal title total cited 1 chenhall, r. h. (2003). management control systems design within its organizational context: findings from contingency-based research and directions for the future. accounting, organizations and society. 119 2 fan, j. p. h., & wong, t. j. (2002). corporate ownership structure and the informativeness of accounting earnings in east asia. journal of accounting and economics. 108 3 easton, p. d. (2004). pe ratios, peg ratios, and estimating the implied expected rate of return on equity capital. the accounting review. 66 4 chenhall, r. h. (2005). integrative strategic performance measurement systems, strategic alignment of manufacturing, learning and strategic outcomes: an exploratory study. accounting, organizations and society. 59 5 (tied) baskerville, r. f. (2003). hofstede never studied culture. accounting, organizations and society. 54 5 (tied) clarkson, p. m., emby, c., & watt, v. m. s. (2002). debiasing the outcome effect: the role of instructions in an audit litigation setting. auditing: a journal of practice & theory. 54 7 (tied) briers, m., & chua, w. f. (2001). the role of actor-networks and boundary objects in management accounting change: a field study of an implementation of activity-based costing. accounting, organizations and society. 48 7 (tied) ferguson, a., francis, j. r., & stokes, d. j. (2003). the effects of firm-wide and office-level industry expertise on audit pricing. the accounting review. 48 9 matsunaga, s. r., & park, c. w. (2001). the effect of missing a quarterly earnings benchmark on the ceo's annual bonus. the accounting review. 46 10 bartov, e., gul, f. a., & tsui, j. s. l. (2000). discretionary-accruals models and audit qualifications. journal of accounting and economics. 45 11 (tied) defond, m. l., & francis, j. r. (2005). audit research after sarbanes-oxley. auditing: a journal of practice & theory. 41 11 (tied) defond, m. l., & park, c. w. (2001). the reversal of abnormal accruals and the market valuation of earnings surprises. the accounting review. 41 13 how, i.-m., hu, b., hwang, l.-s., & wu, w. (2004). ultimate ownership, income management, and legal and extra-legal institutions. journal of accounting research. 40 14 (tied) chen, k. c. w., & yuan, h. (2004). earnings management and capital resource allocation: evidence from china's accounting-based regulation of rights issues. the accounting review. 38 14 (tied) ng, t. b. p., & tan, h. t. (2003). effects of authoritative guidance availability and audit committee effectiveness on auditors' judgments in an auditor-client negotiation context. the accounting review. 38 16 (tied) hay, d. c., knechel, w. r., & wong, n. (2006). audit fees: a meta-analysis of the effect of supply and demand attributes. contemparary accounting 37 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 145 research. 16 (tied) craswell, a., stokes, d. j., & laughton, j. (2002). auditor independence and fee dependence. journal of accounting and economics. 37 18 moores, k., & yuen, s. (2001). management accounting systems and organizational configuration: a life-cycle perspective. accounting, organizations and society. 36 19 (tied) fan, j. p. h., & wong, t. j. (2005). do external auditors perform a corporate governance role in emerging markets? evidence from east asia. journal of accounting research. 35 19 (tied) frederickson, j. r., & miller, j. s. (2004). the effects of proforma earnings disclosures on analysts' and nonprofessional investors' equity valuation judgments. the accounting review. 35 table 8. the top 20 most cited articles scopus rank author, article title, journal title total cited 1 chenhall, r. h. (2003). management control systems design within its organizational context: findings from contingency-based research and directions for the future. accounting, organizations and society. 228 2 fan, j. p. h., & wong, t. j. (2002). corporate ownership structure and the informativeness of accounting earnings in east asia. journal of accounting and economics. 189 3 bartov, e., gul, f. a., & tsui, j. s. l. (2000). discretionary-accruals models and audit qualifications. journal of accounting and economics. 109 4 eng, l. l., & mak, y. t. (2003). corporate governance and voluntary disclosure. journal of accounting and public policy. 108 5 chenhall, r. h. (2005). integrative strategic performance measurement systems, strategic alignment of manufacturing, learning and strategic outcomes: an exploratory study. accounting, organizations and society. 104 6 baskerville, r. f. (2003). hofstede never studied culture. accounting, organizations and society. 92 7 briers, m., & chua, w. f. (2001). the role of actor-networks and boundary objects in management accounting change: a field study of an implementation of activity-based costing. accounting, organizations and society. 87 8 easton, p. d. (2004). pe ratios, peg ratios, and estimating the implied expected rate of return on equity capital. the accounting review. 85 9 chen, c. j. p., & jaggi. b. (2000). association between independent non-executive directors, family control and financial disclosures in hong kong. journal of accounting and public policy. 80 10 aharony, j., lee, c. w. j., & wong, t. j. (2000). financial packaging of ipo 77 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 146 firms in china. journal of accounting research. 11 ferguson, a., francis, j. r., & stokes, d. j. (2003). the effects of firm-wide and office-level industry expertise on audit pricing. the accounting review. 70 12 defond, m. l., francis, j. r., & wong, t. j. (2000). auditor industry specialization and market segmentation: evidence from hong kong. auditing: a journal of practice & theory. 68 13 how, i.-m., hu, b., hwang, l.-s., & wu, w. (2004). ultimate ownership, income management, and legal and extra-legal institutions. journal of accounting research. 64 14 moores, k., & yuen, s. (2001). management accounting systems and organizational configuration: a life-cycle perspective. accounting, organizations and society. 60 15 hay, d. c., knechel, w. r., & wong, n. (2006). audit fees: a meta-analysis of the effect of supply and demand attributes. contemparary accounting research. 59 16 (tied) chen, k. c. w., & yuan, h. (2004). earnings management and capital resource allocation: evidence from china's accounting-based regulation of rights issues. the accounting review. 58 16 (tied) debreceny, r., gray, g. l., & rahman, a. (2002). the determinants of internet financial reporting. journal of accounting and public policy. 58 18 (tied) baxter, j., & chua, w. f. (2003). alternative management accounting research—whence and whither. accounting, organizations and society. 57 18 (tied) bouwens, j., & abernethy, m. a. (2000). the consequences of customization on management accounting system design. accounting, organizations and society. 57 20 fan, j. p. h., & wong, t. j. (2005). do external auditors perform a corporate governance role in emerging markets? evidence from east asia. journal of accounting research. 56 table 9. the top 20 most cited articles in google scholar rank author, article title, journal title total cited 1 chenhall, r. h. (2003). management control systems design within its organizational context: findings from contingency-based research and directions for the future. accounting, organizations and society. 657 2 fan, j. p. h., & wong, t. j. (2002). corporate ownership structure and the informativeness of accounting earnings in east asia. journal of accounting and economics. 629 3 bartov, e., gul, f. a., & tsui, j. s. l. (2000). discretionary-accruals models and audit qualifications. journal of accounting and economics. 391 4 easton, p. d. (2004). pe ratios, peg ratios, and estimating the implied expected rate of return on equity capital. the accounting review. 325 5 eng, l. l., & mak, y. t. (2003). corporate governance and voluntary disclosure. journal of accounting and public policy. 323 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 147 6 malina, m. a., & selto, f. h. (2001). communicating and controlling strategy: an empirical study of the effectiveness of the balanced scorecard. journal of management accounting research. 318 7 hoque, z., & james, w. (2000). linking balanced scorecard measures to size and market factors: impact on organizational performance. journal of management accounting research. 310 8 aharony, j., lee, c. w. j., & wong, t. j. (2000). financial packaging of ipo firms in china. journal of accounting research. 256 9 fan, j. p. h., & wong, t. j. (2005). do external auditors perform a corporate governance role in emerging markets? evidence from east asia. journal of accounting research. 246 10 chen, c. j. p., & jaggi. b. (2000). association between independent non-executive directors, family control and financial disclosures in hong kong. journal of accounting and public policy. 229 11 how, i.-m., hu, b., hwang, l.-s., & wu, w. (2004). ultimate ownership, income management, and legal and extra-legal institutions. journal of accounting research. 216 12 chenhall, r. h. (2005). integrative strategic performance measurement systems, strategic alignment of manufacturing, learning and strategic outcomes: an exploratory study. accounting, organizations and society. 215 13 chen, k. c. w., & yuan, h. (2004). earnings management and capital resource allocation: evidence from china's accounting-based regulation of rights issues. the accounting review. 212 14 baskerville, r. f. (2003). hofstede never studied culture. accounting, organizations and society. 208 15 hay, d. c., knechel, w. r., & wong, n. (2006). audit fees: a meta-analysis of the effect of supply and demand attributes. contemporary accounting research. 206 16 defond, m. l., & park, c. w. (2001). the reversal of abnormal accruals and the market valuation of earnings surprises. the accounting review. 202 17 briers, m., & chua, w. f. (2001). the role of actor-networks and boundary objects in management accounting change: a field study of an implementation of activity-based costing. accounting, organizations and society. 184 18 matsunaga, s. r., & park, c. w. (2001). the effect of missing a quarterly earnings benchmark on the ceo's annual bonus. the accounting review. 169 19 ali, a., chen, t.-y., & radhakrishnan, s. (2007). corporate disclosures by family firms. journal of accounting and economics. 168 20 bainess, a., & langfield-smith, k. (2003). antecedents to management accounting change: a structural equation approach. accounting, organizations and society. 161 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 148 5. concluding remarks based on 18 accounting journals, this study examined the accounting publication productivity of asia-pacific authors for an eleven-year period from 2000 to 2010 using both count method and citation analysis. the most productive authors have been consistently represented using both methods as well as across three prestigious academic databases – ssci, scopus, and google scholar. when the results of this study are compared with those of heck (2009), a substantial gap between asia-pacific authors and the usa and the european authors was revealed. specifically, only two authors from the asia-pacific region appeared in the list of the top 100 accounting researchers in the world. this finding implies that the accounting researchers from the asia-pacific region have a great challenge ahead in order to be on par if not better than authors from the other parts of the world. this study suffered from several limitations. first, the comparison made in this study with other relevant studies (e.g., heck, 2009) may not be valid as different studies selected different number and list of journals. second, even though the study used count method and citation analysis, the emerging methods, for examples, h-index (simultaneously measure quality and quantity of research output), and g-index (similar to h-index but places more weight to highly cited articles), were not utilized in this study. as different techniques may generate different results, the findings of this study will be interpreted within the scope of the selected journals and the techniques employed. nevertheless, the study has attempted to analyze research productivity using three widely used academic citation indexes, ssci, scopus and google scholar, which is relatively new among the research productivity studies it is recommended that future researchers compare productivity results using multiple methods to identify similarities and differences. besides, online accounting journals which are publicly available under the directory of open access journals (doaj) and accounting research network (arn) under the social science research network (ssrn) may be selected as they are freely downloadable by researchers and thus attract a larger readership among researchers. harzing’s publish or perish online tool can be utilized for data collection based on google scholar index. references bline, d.m. 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(1998). a study of accounting faculty publishing productivity in new zealand. pacific accounting review, 10, 75–95. microsoft word 3174-12073-4-sm-writer2-new2.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 140 gender difference in profit performance — evidence from the owners of small public accounting practices in taiwan chih-shun hsu department of accounting, tamkang university new taipei city, taiwan e-mail: cshsu@mail.tku.edu.tw lopin kuo department of accounting, tamkang university new taipei city, taiwan e-mail: lopinkuo@mail.tku.edu.tw bao-guang chang (corresponding author) department of accounting, tamkang university new taipei city, taiwan e-mail: baog@mail.tku.edu.tw received: jan. 30, 2013 accepted: april 8, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3174 url: http://dx.doi.org/10.5296/ajfa.v5i1.3174 abstract this study aims to investigate whether the significant difference of the firm’s profit performance exits between the male-owned and female-owned small accounting firms. using data from 1992-2008 small public accounting practice in taiwan, this study uses a panel data model to estimate the coefficients and to examine the association between gender variable and the firm’s profit performance. the findings reveal that the significant difference in profit performance exists between male-owned and female-owned firms in sample. the study can clarify the effects of owner’s gender on financial performance of businesses with the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 141 explanations that female owners adopt the different management strategies from the male owners. the study also implies that female-owned small businesses are easier to acquire external funds because of their lower risk preference, since the female owners can ensure stable collection of principal and interest. our study contributes to our understanding of the differences in the profit performance between male-owned and female-owned cpa firms. not merely can the results of this empirical study provide valuable research implications for women entrepreneurs in the professional accounting practice, but they also provide supplementary in existing accounting literature. keywords: gender differences, profit performance, small accounting practice, cpa firms, taiwan asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 142 1. introduction research on women businesses has received wide attention in western developed countries, especially in the u. s. and europe. however, few studies focus on the women businesses in professional service firms. these firms are knowledge-intensive in that they employ educated and certified professionals to provide clients with competent services. this is especially true in the accounting industry. certified public accountants (cpas) use their professional knowledge to offer clients such services as financial information auditing and financial statements preparation. the nature of these services contributes significantly to the transparency of financial information and the activation of capital markets. whilst a couple of studies that deal with how gender differences impacts the owner’s performance in cpa firms focus mainly on north america, e.g. us study by fasci and valdex (1998), and canadian study by collins-dodd, gordon, and smart (2004), the sample used in both studies were less representative, as they included a lower proportion of female owners, and the studies were limited to cross-sectional survey data. few studies use longitudinal database to explore the effect of gender difference on profit performance amongst asian entrepreneurs in the professional service firms. over the past two decades, taiwan has witnessed education popularization, for instance, widespread universities as of 2011, taiwan has 163 higher education institutions (ministry of education, 2012a). each year, the number of women graduates who are awarded accounting bachelor degrees and above is twice that of men (ministry of education, 2012b). this has resulted in more and more women entering the professional services industry, especially accounting professions. according to the taiwan financial supervisory commission’s “2008 report of business of the cpa firms”, nearly 80% (77.9%) of cpa professional assistants were held by women. on the level of practicing cpas, the proportion of women reached 33.1%. thus, women account for a significant portion of the accounting workforce. previous studies pointed out that women are often stereotypically treated as engaging in such soft industries as the general service sector or small-scale retail (du reitz & henrekson, 2003), but the studies only explore the performance of women businesses in these industries. yet, the truth of the matter is, the accounting industry has a high percentage of female accountants and attracts many outstanding women, so opportunities for female entrepreneurial hopefuls are clearly higher than other industries. this notwithstanding, accounting literature studies rarely explore whether significant differences exist between performances of female owners of cpa firms and their male counterparts. therefore our study attempts to address this issue. our study with longitudinal data is unique to many female entrepreneurial studies, and the findings contribute to our understanding of the differences in profit performance between male-owned and female-owned cpa firms. the results suggest that: (1) among relatively larger cpa firms, male-owned firms have higher profit performance than female-owned ones; (2) female-owned firms have lower profit performance probably due to their choice of non-attestation services as their main services; (3) female owners have a tendency to provide low-risk services. these findings can clarify the effects of owner’s gender on business asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 143 financial performance with support rendered by theoretical explanations in social feminism that female owners adopt different management strategies from male owners. in addition, our study suggests that it is easier for female-owned small businesses to acquire external funds because of their lower risk preference. fund providers are more willing to offer loans to less risk-seeking business owners as they can ensure stable collection of principal and interest. not only can results of this empirical study provide valuable research implications for women entrepreneurs in the professional knowledge-intensive industries, they also supplement existing accounting literature. the remainder of this study is organized as follows: section two provides an overview of theoretical framework of gender, entrepreneurship, and firm performance. section three explains the research methodology. sections four and five present respectively the empirical results and their implications. conclusions and suggestions are proposed in the last section. 2. literature review 2.1 gender role in business men and women are different in businesses because of unique learning experiences and ways of thinking and rationalizing. this difference is observed with the evidence suggesting that women are generally more risk averse than men (sexton & bowman-upton, 1990; powell & ansic, 1997; kepler & shane, 2007; gold, hunton, & gomaa. 2009), and that women owners are more likely to have business that is slow growing and less profitable (fasci & valdez, 1998; du reitz & henrekson, 2000). marlow and patton (2005) argued that gendered processes shape individuals’ assumptions regarding how men and women should play the entrepreneurial roles because socially constructed and learned ideas about gender and entrepreneurship influence men’s and women’s attitudes and behaviors by making a decision that matches their expectations and views of themselves. for example, empirical evidence suggests men have stronger entrepreneurial intentions than women due to gender stereotype (gupta, turbab, wasti, & sikdar, 2009). in the study of gender role in opportunity identification, detienne and chandler (2007) found that women and men have unique stocks of human capital which they adopt differently to identify entrepreneurial opportunities because they have different experiential backgrounds and different ways of thinking (carter & william, 2003, p. 30). two major schools of thought, namely: liberal feminist theory and social feminist theory, have been offered in the literature and may be applied to explanation of gender role in business. (fischer et al., 1993; carter & william, 2003; detienne & chandler, 2007; robb & watson, 2011). liberal feminist theory holds that men’s and women’s behaviors are different due to situational factors, while social feminist theory assumes gender differences in behavior are caused by dispositional factors (fischer et al., 1993). studies adopting a liberal feminist theory appear to assume that female-owned firms do not perform as well as male-owned firms and then set out to explain this underperformance on the basis of potential discrimination (ahl, 2006). previous empirical studies found women are in a more disadvantaged position relative to men in entrepreneurship, mainly because women asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 144 face more barriers in finance access (fay & williams, 1993; coleman, 2000; carter, shaw, lam, & wilson, 2007), or in education, family, and job market (rosa et al., 1996; fasci & valdez, 1998; alowaihan, 2004). in contrast to liberal feminist theory, social feminist theory suggests that men and women differ in their rationality (fisher et al., 1993). it posits that men and women exhibit fundamentally different views of the world due to differences in their socialization. gender socialization results in the appearance of difference mode of sharing and delivering knowledge. thus, according to this perspective, men and women differ in their traits, behaviors, and experiences. their differences will certainly be reflected in their motivation for entrepreneurship and business performance (johnsen & mcmahon, 2005). according to social feminist theory, gender differences are reflected on various aspects of entrepreneurship and business management, for example, female owners seek to take lower risks (sexton & bowman-upton, 1990; powell & ansic, 1997; kepler & shane, 2007); grow their business more slowly (fasci & valdez, 1998; du reitz & henrekson, 2000), or attain a better balance between their work and family life (watson, 2002; kepler & shane, 2007). kepler and shane (2007) found in their sample of us men’s and women’s new business ventures that male owners spend more effort searching for business opportunities, while female owners are significantly more likely to prefer businesses with a low risk/return ratio. fischer et al. (1993), in their study of 508 owners (40 female), indicate that at start-up, men have significantly higher levels of experience in managing employees, prior industry experience, and prior entrepreneurial experience. kalleberg and leicht (1991) found that men were more likely to be concurrently involved in more than one business venture. 2.2 prior empirical evidence on gender and firm performance the effect of the owner’s demographic differences on firm performance is a complicated issue, particularly since management literature examining gender effect on firm performance yielded results that are far from unequivocal. first of all, entrepreneur’s gender significant influences a firm’s financial performance. for instance, female owners are usually unfairly treated in the acquisition of entrepreneurship funds. it is known that many banks set a higher requirement of collaterals and interest rate or a lower credit line for female-owned small businesses than for male-owned ones (ahl, 2006; coleman, 2000; riding & swift, 1990). female owners have to bear high capital cost of business expansion, so it is harder for them to boost their firms’ financial performance. in addition to gender discrimination, women face numerous barriers in operating a business, barriers stemming from their family roles and a lack of socialization, education opportunities, and social connections (goffee & scase 1983; fasci & valdez, 1998; fischer et al., 1993). as a result, in terms of financial performance, female-owned businesses usually do not fare as well as male-owned businesses. similar findings can also be found among a wide array of studies using smes as empirical subjects. these studies include a british study on 600 small sole-proprietor firms across textile and clothing, service, and hospitality industries (rosa et al., 1996), a survey study of 372 small businesses in northeast us (chaganti & parasuraman, 1996), a study of female asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 145 underperformance in 4,200 small businesses in sweden (du rietz and henrekson, 2000), a survey study of 840 micro, small, and medium-sized enterprises in laos (inmyxai and takahashi, 2010), a performance contrast of 604 us accounting firms (fasci & valdez, 1998), and a comparative study of 560 small businesses in kuwait (alowaihan, 2004). most of these studies indicate that male-owned businesses generate significantly more sales revenue than female-owned ones, mainly because of their owners’ attitude in business operations. they mention that male owners are better at using strategies to expand their business and growth. in contrast, female owners are not good at business expansion and are also less concerned about how to boost their business growth. previous studies also found that owner’s gender is not a determinant of firm performance. kalleberg and leicht (1991), for instance, pointed out that while male owners stress product diversity, female owners are more concerned about product quality. despite their difference in business concerns and use of strategies, such gender difference does not significantly affect their business performance. however, why male and female owners adopt different strategies was not explained in their study. loscocco and leicht (1993) investigated economic success among femaleand male-owned small businesses in computer, food, and health industries in indiana. their findings echoed the conclusion of kalleberg and leicht (1991). the findings in collins-dodd et al. (2004) suggested that owner’s gender alone does not affect a firm’s financial performance; however, owner’s gender moderates the relations of firm characteristics (for example, number of full-time employees) and owner’s properties (for example, age, year of experience) to firm performance. both watson (2002) and johnsen and mcmahon (2005) examined the relationship between owner’s gender and firm performance (using roe and roa as proxy variables for firm performance) in an australian sample taken from bls. their findings also revealed that gender is not a significant determinant of firm performance and growth. the aforementioned studies provided empirical evidence of the relationship between owner’s gender and firm performance in a wide array of industries. however, most of these industries are small-sized manufacturing or service industries. among them, only fasci and valdez (1994) and collins-dodd et al. (2004) examined the relationship in the accounting industry, which is a professional service industry characterized by high knowledge intensity, low requirement of asset investment, and high demand for professional labor force (nordenflycht, 2010). it differs greatly from general manufacturing, retail or service industries, in which many economic activities are based on a bureaucratic structure. cpa firms have their distinct characteristics such as professional autonomy (for example, self-disciplinary mechanisms) and social status (for example, professional education and certification). they also have developed organizational characteristics (for example, sole-proprietorship, professional partnership, and professional firm) and a unique governance model (morris & empson, 1998; greenword, hinings, & brown, 1990). in their governance model, the responsibilities of the entrepreneur include not only management and operation of the firm but also strategic management of knowledge, that is, creation, maintenance, and update of professional knowledge. therefore, factors affecting a cpa firm’s performance may not be the same as those affecting performance of firms in other industries, and the entrepreneur’s gender, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 146 particularly, as one of determinants of firm’s performance is worth investigating. a review of previous studies also revealed the following limitations. first, in the application of theories, except for alowaihan (2004), johnsen and mcmahon (2005), and watson (2002), most previous studies do not employ a theoretical framework to explain women underperformance in business. fischer et al. (1993) pointed out that gender difference in education and unequal mechanisms for the two genders in society will not result in women underperformance. rather, women underperformance probably stems from potential differences related to socialization or social experiences. besides, in the choice of research subjects, previous research seldom used a longitudinal archival dataset of a single industry in a single nation to examine the effects of entrepreneur’s gender. a few studies obtained samples from a single nation, but across multiple industries. as the competitive environment varies from industry to industry, this heterogeneity of competitive environment may significantly affect the empirical results (lei & slocum, 2005). hence, it is not easy to verify whether entrepreneur’s gender is a determinant of firm performance using a sample drawn from multiple industries. finally, in the choice of a variable of financial performance, most previous studies used operating revenue of the year as a measure of firm performance (rosa et al., 1996; chaganti & parasuraman, 1996; alowaihan, 2004; du rietz & henrekson, 2000; inmyxai & takahashi, 2010; watson, 2002; kalleberg & leicht, 1991; collins-dodd et al., 2004). some studies used other variables, such as roa and roe, to measure firm performance (watson, 2002; johnsen & mcmahon, 2005). however, with the exception of fasci and valdez (1998), research scarcely focused on the relationship between owner’s gender and profit performance. profit performance is vital to a firm’s survival. it reflects a firm’s market strategies for its products or services and its owner’s ability to operate and manage the firm (palupu, healy, bernard, & peek, 2009). after having reviewed the literature and its arguments relating to gender and firm performance, this study is aimed at investigating the role of owner’s gender in the firm’s performance. we take social feminist view to argue that different socialization experiences shape different approaches to businesses among men and women owners. women tend to provide less risk business, however, lower risk brings lower profit, and ultimately women-led firms have underperformed. thus we expect that a profit performance for cpa firms will differ by gender, such that female owners are likely to underperform than males. 3. research methodology 3.1 data collection and sample data were extracted from “survey reports on the business of cpa firms” released by department of statistics, ministry of finance, or financial supervisory commission, executive yuan during 1992 and 2008. the sampling period spanned 17 years, and the subjects were registered cpa firms in taiwan1. because this study was concerned with the 1 financial supervisory commission, executive yuan, was mandated to conduct this survey since 2004. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 147 relationship between entrepreneur's gender and profit performance among cpa firms owned by one person, only sole-proprietor cpa firms were selected. cpa firms without data spanning at least two consecutive years or with missing values for any column were excluded. basically, the sample consisted of unbalanced panel data obtained from 7,281 cpa firms-year. 3.2 variable measurement dependent variable: based on fasci and valdez’s (1998) method, we used profit rate (profit) as a dependent variable in this study. among sole-proprietor cpa firms, not every owner gets paid on a monthly basis. some get their salary after annual closing of their total service revenue. to ensure congruence of this variable across the sample, we defined profit as the ratio of net income before tax plus owner's salary divided by total service revenue. research variable: entrepreneur’s gender (gender) is the research variable in this study. it is a dummy variable coded 1 for male and 0 for female. control variables: (1) number of employees (empo): the total number of employees in the cpa firm (including the owner) (see greenwood, prakash and deephouse 2005; chen, chang and lee 2008); (2) firm’s age (age) refers to how many years the firm has been in operation. it has been argued that a firm has more cost-down advantage if it can enter the market earlier. bröcheler, maijoor, and witteloostuijn (2004) and chen et al. (2008) also found that older cpa firms generally have better business performance; (3) service diversification (diverse): a cpa firm provides a variety of professional services. by providing diverse services, it can reduce risks, increase profits, and further enhance its competitiveness in the market. according to chen et al. (2008), service diversification is positively related to business performance (perf). we measured this variable using a herfindahl index (sherer, 1995; hitt, bierman, shimizu & kochhar, 2001), and deducted from 1. (4) human capital (hc): a cpa firm relies heavily on employees with professional accounting knowledge and experience to provide services to its clients. the human capital of these employees affects the cpa firm’s business performance. bröcheler et al. (2004) found that human capital significantly impacts a firm’s performance. this variable was measured by the experience and weight of each type of employees (partner, professionals, and other employees) in a cpa firm. according to the texas society of certified public accountants (1997-2000), the weights of experience of partners, professionals, and other employees among us cpa firms are in the proportions 6:2:1. (5) number of branches (branch) refers to the number of branches operated by the cpa firm (see greenwood et al., 2005; chen et al., 2008). 3.3 empirical model cpa firms without data spanning at least two consecutive years were not included in the sample. we attempted to use a panel data model to estimate the coefficients. however, whether a fixed-effect model or a random-effect model would be more suitable was determined by the results of hausman test (kennedy, 1992). our estimation model is as follows: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 148 ititit itititit ebranchhc diverseageempogenderprofit   65 43210   (1) 4. empirical results 4.1 descriptive statistics table 1 shows each variable’s descriptive statistics. the sample had an average profit rate of 18 percent and consisted of 77 percent male-owned firms. in other words, owners of this type of professional service firms were mostly male. the average business scale was nt$3.81 million. table 1. descriptive statistics (1992-2008, n=7.281) variable entire sample large-sized firms small-sized firms mean s.d. mean s.d. mean s.d. profit rate 0.18 0.21 0.20 0.13 0.18 0.26 gender 0.77 0.42 0.81 0.39 0.74 0.44 number of employees 3.81 3.14 6.01 3.00 1.55 0.82 age of the firm 11.29 8.48 12.22 7.61 10.33 9.20 service diversification 0.43 0.18 0.47 0.14 0.39 0.20 human capital 8.40 4.44 6.51 2.39 10.34 5.17 number of branches 0.07 0.26 0.08 0.28 0.06 0.24 profit differences between large and small firms became evident after we divided the sample into two groups, large and small, using the median of service revenue. large cpa firms had an average profit rate of 20 percent with a smaller standard deviation (0.13), and small cpa firms had an average of 18 percent with a higher standard deviation (0.26). in terms of each group’s gender composition, 81 percent of large cpa firms were male-owned, and 74 percent of small cpa firms were male-owned. this finding revealed that female owners tended to run smaller firms. in addition, to better understand differences among the four groups, we divided the sample into large and small cpa firms, first by gender and then by median of service revenue. unlike table 1, table 2 showed that large and male-owned cpa firms had a profit rate of 20 percent, which was higher than that of small and male-owned ones (17 percent). female-owned firms showed just the opposite. small and female-owned cpa firms had a higher profit rate (20 percent) than large ones (18 percent). among all large cpa firms, male-owned ones enjoyed a higher profit rate (20 percent) than female-owned ones (18 percent). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 149 table 2. descriptive statistics – by gender male (5,606 persons) female (3,058 persons) variable large-sized firms (2,992 persons) small-sized firms (2,654 persons) large-sized firms (1,441 persons) small-sized firms (1,578 persons) mean s.d. mean s.d. mean s.d. mean s.d. profit rate 0.20 0.13 0.17 0.25 0.18 0.11 0.20 0.29 number of employees 6.15 3.15 1.59 0.82 5.43 2.16 1.44 0.82 age of the firm 12.79 7.96 11.68 10.00 9.83 5.25 6.54 4.66 service diversification 0.48 0.14 0.40 0.19 0.45 0.15 0.36 0.20 human capital 6.67 2.53 10.74 5.30 5.84 1.49 9.23 4.59 number of branches 0.08 0.28 0.08 0.27 0.10 0.30 0.01 0.07 note: see table 1 for explanation for each variable. finally, table 3 presents the pearson correlation coefficients of the entire sample. the correlation coefficient between profit rate and owner’s gender was not significantly different from zero, and all the coefficients were smaller than 0.5 in absolute value, implying the level of autocorrelation was low. table 3. correlation matrix (entire sample) 1 2 3 4 5 6 7 1. profit rate 1 2. gender -.002 1 3. number of employees -.048** .115** 1 4. age of the firm -.071*** .213** -.139*** 1 5. service diversification -.015 .103*** -.249*** .067*** 1 6. human capital -.202*** .075*** -.423*** .198* -.211*** 1 7. number of branches -.021 .053*** -.085*** .093*** -.045*** -.014 1 * p <0.1 **p <0.05 ***p < 0.01 4.2 regression analysis our sample consisted of sole-proprietor cpa firms in taiwan from 1992 to 2008. we divided the sample into two groups, large and small, using scale of service revenues, and adopted a heteroskedastic panel data model. regression results are shown in table 4. the hausman test result did not reject the null hypothesis of using the random-effect model. hence, all the subsequent analyses were based on estimated coefficients of the random-effect model. first, we examined the effect of owner’s gender on profit performance. results indicated that asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 150 the effect was not statistically significant. according to fasci and valdez (1998), collins-dodd et al. (2004), and johnsen and mcmahon (2005), firm size generally has a significant impact on the earning power of smes. thus, using median of service revenues, we divided the sample into large firms and small firms and conducted regression analysis of each group respectively2. as shown in table 4, entrepreneur’s gender was not a significant factor affecting the profit performance of small-sized cpa firms. however, owner’s gender was a significant factor of profit performance among large-sized firms. the coefficient was 0.012 and significant at 5 percent (t=2.0134). in terms of standardized coefficients, the coefficient of large-sized cpa firms (0.0380) was about seven times of that of small-sized ones (0.0053), suggesting that owner’s gender had a relatively great influence on the profit performance of large-sized firms. table 4 . regression analysis results entire sample large firms small firms variable b beta t b beta t b beta t intercept -0.2144*** -0.0234 -7.5291 -0.3901*** -0.0159 -15.7724 -0.2359*** -0.0034 -4.7692 gender -0.0111 -0.0140 -0.8129 -0.0122** -0.0380 -2.0134 -0.0032 -0.0053 -0.2774 number of employees -0.0632*** -0.2100 -9.3984 -0.0787*** -0.2971 -13.1544 -0.1127*** -0.2568 -9.0858 age of the firm -0.0057* -0.0238 -1.6435 -0.0339*** -0.1815 -10.2907 -0.0031 -0.0109 -0.5276 service diversification -0.1003*** -0.0743 -6.1698 -0.0554*** -0.0625 --4.1407 -0.0748*** -0.0554 -3.3410 human capital -0.0246*** -0.0509 -2.5799 -0.0175** -0.0427 --2.1738 -0.0295* -0.0485 -1.7567 number of branches -0.0056 -0.0071 -0.5533 -0.0165** -0.0367 --2.1878 -0.0408** -0.0368 -2.0419 hausman test: χ2 (p value) 2.7752 (0.9050) 9.6391 (0.1407) 2.2923 (0.8909) 2 r 0.0536 7,281 0.1583 3,694 0.0893 3,587 sample size * p <0.1 **p <0.05 ***p < 0 to understand the effect of owner’s gender on profit performance among large-sized firms, we divided the sample of large-sized firms into two groups by owner’s gender, male-owned and female-owned. the results shown in table 5 suggested that for both male-owned and female-owned cpa firms, both number of employees (empo) and firm age (age) were 2 the total asset of each sample firm was absent in the chosen dataset. although we could obtain data about the number of employees of each firm, most cpa firms had a small and same number of employees. if we divided the sample by median of the number of employees, a large number of firms could not be properly classified. thus, we used service revenue as a proxy variable for firm size. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 151 negatively related to profit performance. however, service diversification (diverse) was positively related to profit performance. in other words, higher service diversification led to higher profit performance. the effect of human capital (hc) was positive for male-owned cpa firms but negative for female-owned ones. the effect of number of branches (branch) was not significant for both groups of firms. table 5. estimation result for large firms classified by gender male owners female owners variable b beta t b beta t intercept -0.3635*** － -12.8268 -0.4768*** -0.0148 11.0518 number of employees -0.0698*** -0.1978 -10.0830 -0.1023*** -0.3979 -9.3580 age of the firm -0.0398*** -0.2874 -10.7092 -0.0164** -0.0843 -2.4209 service diversification -0.0580*** -0.0674 --3.6864 -0.0428* -0.0574 -1.8455 human capital -0.0288*** -0.0406 --3.1479 -0.0361** -0.0816 -2.3541 number of branches -0.0124 -0.0357 --1.4177 -0.0087 -0.0230 -0.5611 hausman test: χ2 (p value) 6.3851 (0.2751) 0.1517 2,986 6.0465 (0.3017) 0.1775 708 2 r sample size * p <0.1 **p <0.05 ***p < 0.0 as different accounting services would entail different risks, we further analyzed the structure of services of each group of the sample to understand the service difference between male-owned and female-owned cpa firms. the results are presented in table 6. as shown in table 6, attestation affairs constituted the main services of male-owned cpa firms. male-owned cpa firms generated more revenues from these affairs than female-owned ones. among large-sized cpa firms, male-owned firms took a larger share of the revenue in the categories of financial statements attestation (1,111.63 thousand dollars, 58.64 percent), other attestation affair (206.06 thousand dollars, 55.57 percent), and income tax attestation affair (206.06 thousand dollars, 54.24 percent). in terms of overall revenue from financial affairs, male-owned firms garnered 58.14 percent of the share (1,1317.69 thousand dollars). similar findings can also be found among small-sized cpa firms and the entire sample. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 152 table 6. analysis of service composition by firm size and owner’s gender entire sample large-sized firms small-sized firms service male 5,606 firms-year female 3,058 firms-year male 2,992 firms-year female 1,441 firms-year male 2,654 firms-year female 1,578 firms-year mean percent mean percent mean percent mean percent mean percent mean percent financial service financial statements attestation 673.90 64.30 374.11 35.70 1,111.63 58.64 784.03 41.36 260.91 64.01 146.73 35.99 other attestation services 130.95 60.46 85.64 39.54 206.06 55.57 164.74 44.43 60.29 59.02 41.87 40.98 subtotal 804.85 63.64 459.76 36.36 1,317.69 58.14 948.78 41.86 321.20 63.01 188.60 36.99 taxes service income tax attestation 1,716.12 59.32 1,177.11 40.68 2,829.06 54.24 2,386.68 45.76 666.29 56.82 506.25 43.18 tax planning 25.93 45.11 31.55 54.89 42.48 38.39 68.16 61.61 10.35 47.85 11.28 52.15 application for tax remedies 29.96 81.06 7.00 18.94 51.35 79.97 12.86 20.03 9.83 72.39 3.75 27.61 other tax services 231.24 47.44 256.19 52.56 398.31 45.02 486.47 54.98 73.96 36.48 128.78 63.52 subtotal 2,003.25 57.65 1,471.85 42.35 3,321.20 52.92 2,954.18 47.08 760.43 53.91 650.07 46.09 consulting and others management and consulting 236.05 47.42 261.78 52.58 399.31 43.02 528.99 56.98 81.29 42.24 111.18 57.76 business registration 214.80 58.73 150.92 41.27 321.90 54.21 271.95 45.79 113.85 57.63 83.72 42.37 other services 445.02 56.14 347.70 43.86 747.01 54.73 617.82 45.27 160.50 44.80 197.72 55.20 subtotal 895.87 54.09 760.41 45.91 1,468.22 50.86 1,418.76 49.14 355.64 47.53 392.63 52.47 note: this table presents a comparison of revenue from each service shared by male-owned firms and female-owned ones in each group of the sample (entire, large-sized firms, small-sized firms). the above findings support the social feminist theory that men and women differ in rationality, mode of knowledge, and ways of sharing experiences and viewing the world. in the accounting industry, these differences would be reflected upon owners’ preference of services. essentially, attestation affairs involve higher risks than non-attestation affairs, mainly because the audit fee includes cost of audit effort and risk premium (simunic, 1980; lai, kuo, & fu, 2007), which is expected to assume responsibility for attestation failure. female owners seemed to have a systemic tendency to provide affairs of lower risks, which yielded relatively less profit. the aforementioned gender difference in risk preference is consistent with findings of previous research that women tended to use less risky and more robust strategies in making financial decisions (sexton & bowman-upton, 1990; powell & ansic, 1997; jianakoplos & bernasek, 1998; kepler & shane, 2007). this difference will also be reflected upon women’s motivation for entrepreneurship and business performance. as pointed out by cliff (1998), most female-owned firms are of a smaller size, mainly because women owners are less active in business expansion and more concerned about business expansion risks. 5. discussion traditional perspectives on the effects of gender difference on firm performance, attribute asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 153 women underperformance in business mainly to unequal accessibility of resources (for example, financial resources), constraints of social mechanisms on women’s competencies, and a social tendency that encourages women to receive historical and philosophical education (alowaihan, 2004) rather than practical business education. liberal feminist theory would suggest that there should be no difference in the relative performance of femaleand male-owned business if females are not discriminated against in terms of their access to important resources, i.e., education (ahl, 2006). however, our results showed that female-owned cpa firms, especially large-sized ones, generated a significant lower level of profits than male-owned ones despite the fact that they all received the same professional accounting education. hence, the barriers of social mechanisms (inequality) deemed by liberal feminist theory as the cause of women underperformance are seemingly unable to explain the phenomenon in this professional service industry. the findings in du rietz and henrekson (2000) indicated that female owners are comparable to male ones in profit performance but are less competent than male ones in overall sales performance. in contrast to male owners, female owners are less likely to set quick sales growth as their goal (sexton, 1989; rosa et al., 1996). in their business model, they prefer to view family and friends as a part of their business network. in this way, they can fulfill autonomy and maintain a balance between family and career through entrepreneurship (goffee & scase, 1985; carter & cannon, 1992; fasci & valdez, 1998). although sole proprietorship accounting firms enables female owners to achieve economic independence and a balance between family and career (fasci & valdez, 1998), this business model leads women to underperform in terms of revenue generated. in this study, we suggested, based on the social feminist theory, that female owners have a tendency towards providing low-risk services. one’s choice of managerial strategies is affected by his or her risk preference (schneider & lopes, 1986). female owners are less risk-seeking because they tend to adopt operational strategies that can avoid adverse situations and satisfy their need for stability (powell & ansic, 1997). this study advances the understanding of the difference between men and women in their choice to pursue entrepreneurial business. our results showed that female-owned cpa firms generated far less revenue than male-owned ones in the categories of attestation of financial reports and attestation of tax reports. in terms of revenue composition of female-owned cpa firms, revenue from non-attestation affairs took the largest share. it can be inferred that female owners preferred simpler and low-risk affairs, such as filing of tax applications and management consulting. unlike attestation affairs which required them to meet clients outside the office, these relatively more static affairs allowed them to better maintain a family-business balance. because these services generated relatively less profits in nature, female-owned cpa firms which depended heavily on them would certainly suffer a lower profit performance. previous research suggested that female owners are usually unfairly treated by banks and are difficult to access financing for entrepreneurship than male-owned ones (riding & swift, 1990; fay & williams, 1993; coleman, 2000; carter, et al., 2007). however, we argue that asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 154 profit maximization is not the primary factor considered by creditors in providing loans to owners. high returns mean high risks, however, what concerns the creditors is low credit risk, that is, higher assurance of principal and interest collection. although our empirical results indicated that female-owned cpa firms have lower profit performance, there is a smaller variation in their profit performance across different periods as the coefficient of variation for larger-sized female-owned firms (cv=0.61) is less than the one (cv=0.65) for male-owned firms. their lower profit performance appears to stem from their lower risk preference. fund providers may have higher intention to offer loans to less risk-seeking business owners because such lower risk preference can ensure stable collection of principal and interest. therefore, we infer that female owners should be secure and conservative for their loan repayments and bank loan officer should have higher intention to offer fund to female owners. in addition, we used a nationwide panel data obtained from a single nation to examine the relationship between owner’s gender and profit performance among cpa firms. the robust results we obtained can be an important reference source for stakeholders, especially fund providers, of the professional service firms. our results suggested that owner’s gender is an indispensable factor of potential risks in financing. for financers, female owners of the professional service firms are less likely to default due to their use of more secure and conservative management strategies. 6. conclusions and suggestions the impact of owner’s gender on firm performance has been a topic issue in previous research. however, the empirical comparison of financial performance in maleversus female-owned firms has produced mixed results. in this study, we employ social feminism and choose the accounting industry consisting of a relatively sufficient female owner sample to examine the correlation between owner’s gender and profit performance among cpa firms. our main findings are summarized as follows: first, among large-sized cpa firms, male owners had a higher profit performance than female ones. second, a plausible reason is that most female cpa owners concentrated on providing non-attestation services. third, female owners had a systemic tendency to provide services of lower risk. this tendency conforms to the argument of social feminist theory. in contrast to male owners, females are less risk-seeking in managing their business and setting up managerial strategies. this business style is less likely to guarantee high returns, thus affecting the profit performance of female owners. with national and long-term panel data ensuring the robustness of its evidence results, this study focuses on female small business owners with a predilection for low risk. in particular, the study points out business management features of these owners which lead capital fund providers, when making their fund lending decisions, to consider that these female business owners’ low-risk profit performance have lesser effect on bad debts of capital loan, and that loan interest can be steadily recovered. therefore, the lower profit performance of female business owners will not hinder their ability to obtain external funding. asian journal of finance & 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(2002). comparing the performance of maleand female-controlled businesses: relating outputs to inputs. entrepreneurship theory and practice, 26(3), 91-100. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 23 estimating the equity risk premium for economies in the asian region michael b cohen school of economics and finance, victoria university po box 14428, melbourne vic 8001, australia tel: +613 9919-1182 e-mail: michael.cohen@vu.edu.au abstract the equity risk premium (erp) is widely used in economic and financial analysis, yet it is difficult to find empirical estimates of the erp that are generally accepted. the paucity of data in asian economies exacerbates the problems of estimation. this study estimates the erp for the larger market-orientated asian economies and compares the estimates with those of the united states. surprisingly, of the seven economies examined, the erp of four cannot be statistically differentiated from that of the united states. jel classifications: g11, g12, e42 keywords: equity risk premium, asian economies, estimation asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 24 1. introduction the economic growth of an economy is affected by the decisions of myriads of individuals to acquire investment assets. the returns on such assets are, by their nature, uncertain. investors need to balance the expected return on their investments with the risks associated with those investments. in a market economy the financial markets adjust asset prices (and therefore rates of return) so that the returns reflect the risk appetite of the members of that economy. there is no a priori assumption about the risk preferences of individuals, save that they regard risk as undesirable. importantly there is no assumption that risk preferences of individuals remain constant over time, or are the same between various geographical areas. the concept of the equity risk premium (erp) provides an intuitive measure of the extent to which the members of an economy, in aggregate, need to be compensated for the riskiness of the productive assets of that economy. more specifically, the erp represents the amount that investors require to induce them to hold a well diversified portfolio of risky assets rather than the risk-free asset. the usefulness of the erp as an explanation of investor behaviour has led to its use in the fields of corporate finance, asset valuation, and portfolio management. while the meaning and usefulness of the erp is unambiguous, attempts to empirically estimate the erp have been fraught with difficulties. most empirical studies have been based on the economy of the united states, and to a less degree, other large western economies. this paper investigates the magnitude of the erp for the larger market-orientated economies of asia and finds that there is often not enough evidence to conclude that these economies have a significantly different erp to that of the united states of america. the analysis proceeds as follows; firstly the origins of the formulation of the erp are disused. the various methods by which the erp can be measured, and the empirical estimates for selected asian economies, are then presented. finally, the estimates obtained are compared to those for the united states over the same time period. 2. the origins the equity risk premium the concept of erp required the development of a model of asset pricing that was able to distinguish between the idiosyncratic and system risk of each asset. markowitz (1952) was the first to lay the basis for this type of analysis. over time markowitz's method of exposition has been refined and formalised so that it is now a standard part of the theory of finance (ross, westerfield, & jaffe, 2005; joshi, 2003; elton & gruber, 1995; brealey, myers, & allen, 2006). markowitz's formulation of portfolio risk has been identified as the beginning of what is now known as “modern portfolio theory” (rubinstein, 2002). if equilibrium prevails in the asset market, it is possible to determine the rate at which the future cash flows of any assets should be discounted, and the resulting amount will be the value (i.e. equilibrium price) of that asset. this extension to the markowitz model is due to asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 25 four authors, each of whom developed the theory independently, namely treynor (1961); sharpe (1964); lintner (1965); and mossin (1966). this important result, known as the “capital asset pricing model” (capm), states that the expected return on any asset is given by the following relationship: where: is the expected return on the asset i is the risk-free rate of interest is the expected return of the market portfolio, and is a measure of the sensitivity of the asset returns to market returns, measured by the ratio of the covariance of the returns to the market portfolio and the returns to asset i to the variance of the market returns. the term in the square brackets is the erp. the capm has been widely adopted by the financial sector. it is used in portfolio management as a means of rating portfolio managers (using a reward-to-variability ratio relative to the capital market line); in corporate finance (to find the required return on capital investments); in legal claims the courts have generally accepted discount rates for valuing future claims that are based on capm; and regulatory bodies routinely use capm to calculate the cost of capital for regulated industries and firms. empirical tests of the capm have however been troubling. the earliest tests (lintner 1965, for example) found a positive and significant intercept term whereas capm predicted a linear function that passed through the origin, and a market risk premium that was significantly less than that which was observed. however, the statistical methods used in these tests were subject to criticism and much debate about the correct form of test has ensued. roll (1977) raised a more important and fundamental objection to the empirical tests of capm. all empirical tests of capm test a joint hypothesis; that the market portfolio is mean-variance efficient and that the proxy for the market portfolio is accurate. the theoretical market portfolio consists of all assets available to an investor, and includes assets such as housing, human capital (e.g. education) and other non-market assets. roll was able to demonstrate that even a highly diversified portfolio consisting of all the current market assets does not necessarily provide a good proxy for the theoretical market portfolio (richard roll & ross, 1994). kandel & stambaugh (1995) show that even using generalized least squares it is not possible to estimate the model correctly if the extent to which the proxy for the market portfolio differs from the theoretical market portfolio is not known. 3. estimation of the equity risk premium there are three methods that can be used to estimate the erp in any economy; firstly, the erp can be “reversed out” of the capm and the observed market valuation in the equity asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 26 market of an economy. secondly, it is possible to survey investment professionals for a direct estimate of the value that they believe reflects their investment behaviour (graham & harvey, 2008). the third method is to use the actual returns on assets as an unbiased estimate for the expected returns on those assets. this is the approach that is most widely used, and it is the approach that is adopted in this paper. attempts to empirically estimate the erp are fraught with difficulties. these difficulties have arisen despite the fact that much of the empirical research has been conducted in economies where data availability is plentiful; for example in the united states of america good quality data is available from the year 1871. despite this apparent richness in the data, there is little agreement on the correct estimate of the erp for the united states (fernandez, 2009; claus & thomas, 1999). there have also been studies that estimate of the erp for smaller economies; for example australia (brailsford, handley, & maheswaran, 2007), new zealand (mcculloch & leonova, 2005) and portugal (alpalhao & alves, 2005). these studies too show little agreement as to the correct estimate of the erp. surprisingly, despite the importance of the erp to the economic performance of economies, that there have been only a few published studies that have estimated the differences of the erp between economies. the limited amount of data has often confined such studies to more advanced western economies (dimson, marsh, & staunton, 2003, 2006; ang & maddaloni, 2005) although developing economies have also been studied (salomons & grootveld, 2003; damodaran, 2008; sterken, hullegie, & salomons, 2004). the problem of estimating the erp is compounded in many economies in the asian region where far less data is available, where markets may at times be less liquid, and policy interventions may be more visible. these factors make any attempt at estimation even more daunting. practical matters can however not be delayed while additional data is collected and a workable solution is needed for problems and issues which require immediate analysis. this study investigates the possibility of estimating the erp for the larger market-orientated economies in the asian region with the data that is currently available, as well as estimating the extent to which such estimates are significantly different to that of the largest economy in the world, the united states. 4. empirical estimates of the erp for asian economies the population of the asian economies is approximately 4 billion people (60% of the world population). there are 46 different states in asia, and only the largest of these economies for which data of the return on equities and risk-free assets are considered. even for these economies there are differences in the data available and quality; shorter time series, less depth and breadth for the individual markets, and the possibility of greater regulation. these factors all contribute to the difficulties in estimating the erp. the available data for each of the asian economies analysed, together with the corresponding data for the united states of america (which is used as a base case) are listed in table 1. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 27 table 1. risk-free rates, returns on stock market indices, estimates of the erp, and results of t-tests for comparison with the united states. country series start date of series mean full period mean m7 1997 m7 2008 p(t<=t) compared to us china,p.r. money market rate m12 1993 3.97 3.56 return on hang seng index m12 1986 0.81 0.20 erp -3.64 -3.36 0.82778 korea money market rate m8 1976 11.23 5.78 return on kospi index m7 1997 0.53 0.53 erp -5.25 -5.25 0.11015 malaysia interbank overnight money m1 1971 4.79 3.69 return on klse index m12 1993 -0.08 0.06 erp -4.31 -3.63 0.9160 thailand money market rate m1 1977 8.48 4.13 return on set index m4 1975 0.48 0.02 erp -7.55 -4.11 0.6036 indonesia call money rate m5 1986 14.85 16.81 return on jakarta index m7 1997 0.83 0.83 erp -15.98 -15.98 0.0000 japan call money rate m1 1970 4.23 0.16 return on nikkei 225index m1 1984 0.08 -0.33 erp -2.30 -0.49 0.0000 pakistan call money rate m1 1970 8.21 7.51 return on kse index m7 1997 1.15 1.15 erp -6.36 -6.36 0.0073 united states federal funds rate m1 1970 6.51 3.79 return on dj index m1 1970 0.59 0.26 erp -5.92 -3.54 n.a. for each economy the mean for the full period of the available data series and the mean for the overlapping period for the following variables: proxy for the risk-free rate, the return on the domestic equity market and the equity risk premium. the final column is the t-static for the differences in means between each economy and the usa. the choice of a proxy for the risk free asset has been much debated in the literature. the desirable characteristics for the proxy asset are well established; it should have zero risk of default, be traded in liquid markets, and have a duration similar to that of the risky investment. for these reasons the 10 year treasury bond is often used in empirical studies of the erp in the united states. the use of the rate that prevails on the money market is a viable compromise for economies where a long-term treasury is not liquid or may not even exist; in such economies this is the best indicator of changes in the interest rate structure even though asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 28 it is at the very short end of the yield curve. in order to compare the erp between counties the rate which most closely approaches the money market rate is used, even though there might have been more suitable return series for individual countries. the data for each country was collected from the international financial statistics (ifs) database which is provided the international monetary fund. the details of the series used, as well as the start date for the series, for each of the economies, are listed in table 1. it is traditional to use a broad based stock index to estimate the representative risky asset for an economy. this choice of the proxy for the representative risky asset has been criticised since such an index is subject to survivorship bias; stocks of failed companies which have disappeared from the index are not represented in later time periods. never-the-less the correction of such a bias is mitigated in a comparison between countries if it can be assumed that the effect is similar across economies. the index used for each country is listed in table 1 and the relevant data is collected either directly from the relevant stock exchange or from the data provided by yahoo.com. the stock index contains sufficient information to derive the return on the index over any interval of time. in the present study monthly intervals are used, and the return on each index can be approximated by taking the natural logarithm of the change of the index over the month. the arithmetic mean of the returns for each economy is calculated over the full period for which data is available for that index, as well as for the period over which data is available for all markets (july 1997 to july 2008). these figures are reported in table 1. finally, in order to calculate the erp, the return on the market index for each period is subtracted from the return on the proxy for the risk free asset. the mean for the full period for which data is available for each economy, as well as the mean for the common period is again shown in table 1. 5. analysis of results the value of the erp in any economy is determined by the attitude of the marginal investor towards the trade-off between risk and return. there is no reason to suppose that the erp will be the same or different between different economies; further more it is possible to test this hypothesis given the data that was used in constructing the erp in this study. selecting a common period (july 1997 to july 2008) for each economy allows the mean erp of any two economies to be compared. this is the largest possible interval given the limitations of the available data. as so much work has already been undertaken on the erp for the united states it is of some interest to ask if the erp of the asian economies in this study are statistically different from that of the united states. since the variance of the estimate of the erp for each economy is different the appropriate test is a heteroscedastic student’s t-test. the results of the comparison for each economy to the us given in the last column of table 1. of the seven economies analysed, the erp of asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 29 four cannot be said to be different to that of the us. the three economies that show statistically different erp’s are indonesia, japan and pakistan. the very high rate of return available on the indonesian and pakistan money markets, and the “lost decade” in japan may be raised as reasons why these two economies are not comparable to the us over the sample period. the rather surprising implication of the analysis thus far is that the best estimate for the erp for the remaining countries might in fact be that of the united states economy. this result has the important advantage that the much more is known about the erp in the united states for which long and accurate time series of data are available. however before this result is taken is accepted are correct, further scrutiny is called for. two main areas of concern might be raised; are the statistical tests appropriate and are what theoretical justification can there be for these results. both these areas of concern are addressed below. 5.1 additional statistical considerations the sample period is comparatively short. there are only eleven years of monthly observations (132 observations in total). this period is the maximum period for which observations for all the economies studied is available; but the relatively small number of observations will lead to larger standard errors than would be the case with a larger number of observations. however the number of observations can be increased for some of the countries by examining the entire existing data series. using the same definitions and proceeds as before, table 2 shows the results of comparing the erp for each economy to that of the usa over the longest possible period for which data is avialable. table 2. results of t-tests for comparison of each country’s erp with the united states over the common period (m7 1997 – m7 2008) and the longest possible series for each country. country p(t<=t) compared to us m7 1997 – m7 2008 common period longest possible period for which data is available p(t<=t) compared to us for longest possible period china,p.r. 0.82778 m12 1993 – m12 2008 0.74976 korea 0.11015 m7 1997 – m11 2008 0.10016 malaysia 0.9160 m12 1993 – m9 2008 0.23224 thailand 0.6036 m4 1975 – m12 2008 0.00228 indonesia 0.0000 m7 1997 – m10 2008 0.0000 japan 0.0000 m1 1984 – m11 2008 0.0000 pakistan 0.0073 m7 1997 – m7 2008 0.0073 for each economy the t-static for the differences in mean erp between each economy and the usa. the first t-statistic is for the common period and the second for the maximum possible period, given the limitations of the available data collection. the result of using all the available data is that the erp for the thai economy switches from being indistinguishable from that of the usa to being statistically different. this result implies either there have been structural adjustments over time, or that the time period is asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 30 indeed too short to reach robust conclusions. in addition the start and end of the data window might introduce distortions into the statistical analysis if unusual events occurred during the relatively short time frame. one advantage of a long period of data collection is that unusual events are to some extend “diluted” by the relatively abundant normal conditions. in the present study the start date of the data window coincides with a period of strong economic growth in many counties followed by two recessions in the usa. one method of dealing with this problem would be to examine sub-periods within the data window to see if similar results are obtained; however given the already short data window this will exacerbate the problem of the variance of the standard errors and would not aid in the analysis of the problem at hand. the t-statistic is a parametric test and thus relies on a set of assumptions about the nature of the underlying variables. the result of the statistical tests used thus far might be the consequence of the violation of the assumptions underlying the t-test rather than the fact that the data series are similar. the wilcoxon signed-rank test and the kolmogorov–smirnov statistic are non-parametric tests of the distance between the empirical distribution functions of two samples (stephens, 1974). table 3 reports the results of the kolmogorov–smirnov statistic over the common data period as well as the t-statistic (for easier comparison). table 3. the wilcoxon signed-rank test, the kolmogorov–smirnov statistic, and the student’s t-test for comparison of each country’s erp with the united states over the common period (m7 1997 – m7 2008). country compared to the usa for the period m7 1997 – m7 2008 p(t<=t) for the heteroscedastic student’s t-test p-value for the wilcoxon signed-rank test p-value for the kolmogorov-smirnov test china,p.r. 0.82778 0.35030 0.03747 korea 0.11015 0.47610 0.00551 malaysia 0.91600 0.44520 0.17490 thailand 0.60360 0.23440 0.01241 indonesia 0.00000 0.00000 0.00000 japan 0.00000 0.00000 0.00000 pakistan 0.00730 0.01057 0.00001 for each economy the t-static and the p–values for the wilcoxon signed-rank test and the kolmogorov-smirnov test for the differences in mean erp between each economy and the usa for the period m7 1997 to m& 2008. the null hypothesis in the wilcoxon signed-rank test is similar to that under the student’s t-test, but does not rely on parametric assumptions, while the null hypothesis in the kolmogorov-smirnov test is that both series of data were drawn from the same underlying distribution. the lower the p-value the less likely the result (assuming that the null hypothesis is correct). the non-parametric tests lead to mixed results; the wilcoxon results support the parametric results obtained earlier (with thailand once again not significantly different to the usa), while the kolmogorov-smirnov test results show that there is only evidence that the erp in malaysia and the usa are similar. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 31 5.2 theoretical justifications for similarity of erp’s between countries it might seem improbable that the erp should be similar between two differ economies. if the economies were in some sense “closed” then local factors which affect the erp are likely to be different in each economy, resulting in different erp in each. factors which influence the risk appetite in an economy, expectations of future economic activity, saving rates and inflation all affect the erp and are mostly different between the countries studied. the risk appetite itself is a function of more than one local factor; the age distribution of the population being the most obvious. two recent rends would however mitigate against the arguments for a unique erp for each economy. firstly, the increasing extent to which economies have become integrated with one another, especially in financial markets. the asian financial crisis of 1997 saw the contagion of the currency markets of emerging markets (hunter, kaufman, & kreuger, 1999) while the present global financial crisis has brought many financial markets and economies into a form of synchronicity. the second factor that would tend to equate the erp between countries is the growth of portfolio investment and foreign direct investment across economic boundaries. since prices, and therefore returns, are set at the margin and as the flows of portfolio investment are often substantial, the erp might be heavily influenced by economic agents outside of the countries boarders. 6. conclusion knowledge of the erp is an important statistic for the efficient allocation and valuation of capital goods. the paucity of data in some economies has made estimates of this measure difficult, thus increasing the uncertainty in the estimates. this study has demonstrated that in the period under examination there is no reason not to reinforce the estimate of the erp in large market-orientated economies in asia with estimates derived from the economy of the united states. at the very least significant deviations from the united states estimate should be carefully evaluated before the statistic is used in further analysis. acknowledgement the author would like to thank an anonymous referee for helpful comments received. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1:e1 www.macrothink.org/ajfa 32 references alpalhao, r., & alves, p. 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(1961). market value, time, and risk. unpublished manuscript dated august, 8, 1961. microsoft word the euro-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 205 still on china’s exchange regime: the euro and its role as an anchor currency marco mele (corresponding author) school of political science, luspio university, rome, italy italian society of economist (s.i.e.) e-mail: marco.mele@luspio.it paola allegra baistrocchi economic and political consultant e-mail: allegra.baistrocchi@gmail.com received: february 24, 2012 accepted: march 20, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1450 url: http://dx.doi.org/10.5296/ajfa.v4i1.1450 abstract this study will demonstrate, through an econometric model in time series, if and how the chinese basket peg has changed in relation to the weight that the european single currency holds within it. specifically, utilizing frankel’s (1994) econometric model, as revisited by mele (2010) enriched by kalman’s filter, our objective is to verify if the eurozone crisis has affected the inner balance of the chinese basket-peg, swaying it from the euro towards a more favorable dollar. this research could be of great insight in predicting the effect of future crisis’, as a shift is already noticeable in our time series study spanning from 2010 till present day. keywords: exchange rate, china, econometric armax model, international currency asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 206 1. introduction the international economic system of the xxi century has been characterized by a global imbalance, where on the one hand there has been a deceleration of growth rates of gdps in both the united states and europe, whilst on other the other hand there has been an unhindered development of the so-called bric countries, which has allowed high growth rates for the global economy as a whole. however, in a system distinguished for its growth, brought about by the globalization process and reinforced by creative finance, numerous tension have emerged, and subsequently been transformed into what is commonly defined as “crisis’”. specifically, since 2010, a new fiscal and financial crisis has affected the eurozone. when confronted with data originating by both the oecd and the imf (2011) on a probable recession of eurozone countries, it is necessary to question whether the successes that the euro has achieved in aspiring to become an international currency will be lost in facing the european debt crisis. in detail, the functions of an international currency are closely linked in regimes in which other currencies are tethered to a key currency, so that it is able to become a unit of account for the system. this would suggest that in the past eight years the euro’s weight and presence as an official reserve has increased proportionally to its utilization as an anchor currency in multiple-currency baskets, where, up until now, the dollar was a key player. although ample research, amongst which frankel and chinn (1994), eichengreen (2006), wei (2007), ogawa and yoshimi (2008, 2009) and mele (2010), achieved important results in analyzing the euro as an anchor currency, second only to the dollar (especially with reference to the currency regime in china post 2005), the fiscal crisis of the emu brings us to believe that at an international level the euro is losing its role as an anchor currency. this paper will demonstrate, through an econometric model in time series, if and how the chinese basket peg has changed in relation to the weight that the european single currency holds within it. 2. the euro as an international currency: the case of anchor-peg regimes since the ‘60s, the dollar has carried out tehe predominant “unit of account” role on an international level, both in industrialized countries as well as in the so-called developing world. the escalation of the american sub-prime financial crisis, with its possible inflationist repercussions (due to accommodating monetary policies, attempted to assuage the crisis, but also to the chronic deficit of the current account of the united states’ balance of payment, which has allowed for countries such as china to amass great surplus’), allowed for the american currency, over time, to become a destabilizing factor for those economies that utilized the dollar as an anchor currency. subsequently, countries such as russia, kuwait and brazil have abandoned their dollar-peg currency systems, in favor of greater flexibility vis-à-vis new international currencies. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 207 countries that belonged to the so-called periphery of the area of influence of the dollar, have, since 2002, shown an increased interest in the euro as the currency unit of account, abandoning dollar-peg regimes in favor of basket-peg regimes, where along-side the dollar, the european currency has found increasing importance. cobham (2007), in his time series analysis (which covered a period from 1999 till 2006), highlighted how 33% more countries had chosen the euro as an anchor as opposed to the dollar. furthermore, according to his research, those countries that had, during those years, opted for dollar-peg regimes had done so with levels of correlation below 0,50. as pertaining to the case of asian countries, ogawa and yoshimi (2008) demonstrated, through an econometric model introduced by frankel (1993), that the weight of the euro had augmented in numerous basket-peg systems. this was the case, for example, of brunei, singapore and thailand. the two economists also established that, though to a lesser degree, this was also the case for malaysia and taiwan. in general, it was evident that the correlation between the asian currencies and the euro had increased, at the expense of the american currency, although the dollar still remained the main reference currency for the area. 3. the application of an econometric model for the chinese exchange rate regime the renminbi (rbm), legal tender for the people’s republic of china, has been tightly linked to the american dollar with a reference value to the fixed exchange rate of 8.28 renminbi to the dollar, (fig.1). source: our econometric processing with stata and gretl. ver. 1.8.4 software on rba data figure 1. progress of the chinese relative to the american dollar 1993-2006 on the 21st of july, 2005, in response to the international debate regarding the fact that the chinese currency was excessively undervalued (therefore favoring national exports), the chinese central monetary authority declared the revaluation of the renminbi to an exchange of 8.11 renminbi to the american dollar. it also brought about the adoption of a new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 208 exchange rate regime focused on the partial withdrawal of the dollar, in favor of an exchange rate based on a basket of international currencies. the decision to abandon the dollar-peg exchange rate system, which had thus far permitted for inflation control in low income china, could be interpreted as the first step towards a fluctuating exchange rate regime. this allowed the chinese authorities to pursue a double objective: external equilibrium and monetary sovereignty. this would have not been possible with a de facto link to a foreign currency. since 2006, the chinese have registered a rise in the value of the rbm, in regards to the dollar. this can be considered a consequence deriving from the reduction of the weight of the american dollar in favor of other currencies present in the chinese basket peg, (fig.2). source: our econometric processing with stata and gretl. ver. 1.8.4 software on rba data figure 2. progress of the chinese renminbi relative to the american dollar 2004-2012 with reference to the asian area, and particularly the chinese exchange rate regime, various empirical analyses have been conducted, from the nineties till today, with the aim of understanding if the chinese governing authorities (and other asian countries) had in fact adopted a basket-peg regime. following frankel and wei’s (1994) econometric model, other economists, such as shan (2005), ogawa (2006), eichengreen (2006), yamazaky (2006), yoshimi (2008) and zeleis (2009), favored this approach and obtained interesting results. this econometric model was preferred to others, such as the partial market equilibrium models or the computable general equilibrium models (which have been used by the centre d'etudes prospectives et asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 209 d'informations internationales and the bank of international settlements), because the empirical data has always proven it to be more accurate. however, though all using the frankel and wei methodology, the above-mentioned studies differ in number of observations and in characteristics used (such as ols, arma, and arch). nonetheless, the all presented the renminbi as the dependent variable, while utilizing, as regressors, the summation of the exchange rates of the three or more currencies in the basket with the addition of a dummy currency (the swiss franc), so as to check the presence of variations in the weight of the currencies used in the basket. the model used can therefore be exemplified as: δlnyrbm/k= α+β1δlneusd/frsv+ β2δlnejpy/frsv+β3δlneeuro/frsv +μt (1) taking into consideration a time series from the month of december 2006 to the month of march 2008, almost all of the works analyzed share the method of estimation used in frankel and wei’s approach. a review of these works illustrates how, though officially unlinked, the chinese currency still maintains significant ties with the american currency. it is relevant to point out that even if they are formally present in the basket, the other currencies do not emerge as statistically significant, as demonstrated by the p-values (figs. 3, 4, 5). *** levels of significance 1%;** levels of significance 5% figure 3. chinese evolution basket peg 2006-2008 frankel *** levels of significance 1%;** levels of significance 5% asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 210 figure 4. chinese evolution basket peg 2005-2006 ogawa *** levels of significance 1%;** levels of significance 5% figure 5. chinese basket peg 2005 – zeileis most econometric research carried out to verify the concrete weight of the various currencies in the chinese basket generally concurs in asserting an almost exclusive role to the dollar. however, through an alternative approach to frankel’s model, mele (2010) demonstrated how, on the contrary, the weight of the euro within the chinese basket-peg was progressively increasing. even though frankel’s approach is preferable to other econometric models, its simple implementation would misrepresent the real term results by sustaining a strong tie only to the american dollar. this would not take into consideration how the euro has grown in the course of these last few years as an intermediary for exchanges, becoming a medium both in the real market, as well as in the capital market. the euro has thus become the second most important currency, whose weight can be registered also in the chinese basket peg (as will be demonstrated below). but why does this role of the euro appear limited when utilizing frankel’s econometric model? an explanation could be hidden in the model itself: not in its formulation – which can be considered genuinely original and economically plausible – but rather in the method of estimation used. in particular, each variable – even the dummy variable itself – could be subject to non-stationary trends, as well as to autocorrelations between the explanatory variables. therefore, compelled by the need to analyze the actual weights of the currencies considered in the chinese basket, mele estimated frankel’s regression with a regressive technique in a time series employing a kalman's filter. the regression used can therefore be exemplified as: δd.lnyrbm/frsv= α+β1δd.lneusd/frsv+ β2δd.lnejpy/frsv+β3δd.lneeuro/frsv+μt (2) whose time series break down for each explanatory variable is: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 211 α 0,t= α0,t-1+ŋ0,t β1,t= β 1,t-1+ŋ1,t β2,t= β2, t-1+ŋ2,t β3,t= β 3, t-1+ŋ3,t *** levels of significance 1%;** levels of significance 5% from the results of the regression, it is possible to observe that the dollar is significantly present in the chinese basket peg, with a co-efficient value equal to 0.81. however, also the euro acquired notable relevance, strengthening its position not only in reference to the other currencies officially declared to be part of the chinese basket, but especially in comparison with the american dollar. the third currency analyzed, the yen, did not show significant signs of change within its currency position in the chinese basket peg. 4. the euro and the chinese basket peg in the era of the european crisis it will therefore be demonstrated, by utilizing the econometric time series methodology enriched by kalman’s filter, whether mele’s (2010) analysis on the weight of the euro in the chinese basket has undergone negative variations as a consequence of the emu crisis. specifically, it is interesting to attest if certain factors, such as the depreciation of the euro to the dollar in the summer of 2011 or greece’s risk of default, could lead the chinese authorities to re-entrust the dollar with a pre-eminent role, so as to create a sort of unofficial dollar-peg. this hypothesis is guided by the positive macroeconomic data released in january 2012, which highlighted the decrease of american unemployment and the revival of the american stock markets, which could renew the united states’ presence as a stable reference point. 4.1 the results armax model: from january 1st, 2010 till january 20th, 2012 estimate carried out with the use of kalman’s filter standard errors based on exact mv dependent variable: rmb adj-r-square: 0,8546 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 212 akaike’s criterion: -727,5478 schwarz’s criterion:-720,4125 hannan-quinn: -726,4782 observation: 180 p-value (0,000) (0,000) (0,000) (0,008) δd.lnyrbm/frsv= 0,00147*** + 0,9132 δd.lneusd/frsv*** + 0,102 δd.lneeuro/frsv*** + 0,0021 δd.lnejpy/frsv***+ e (3) *** levels of significance 1% the results obtained through the elaboration of data using stata version 11 with a dataset constructed at intervals of 5 daysclearly demonstrate, in the time series taken into consideration, how the role of the euro in the chinese basket has drastically decreased. in this period the value of the coefficient resulting from mele’s (2010) research decreased from 0,399 to 0,102. contemporaneously, the weight of the dollar increased from 0,813 to 0,913, a value that results into an exceedingly strong tie to the dollar – almost a dollar-peg. furthermore, it is also interesting to note the role of the japanese currency, which in the analysis of 2010 did not appear significant in its p-value. on the contrary, in the updated data of this analysis, a significant role emerged for the yen, even though limited to a value of 0,002. the precision of the econometric approach utilized is aided by the absence of a correlation between the variables and the adaptability of the independent variables in explaining the dependent variable. latter is visible through the recorded adjusted r-square value of 0,854. even the information criteria theorized by akaike (1974, 1976), schwarz (1978) and hannan-quinn (1979) seem to conform with the model, since their readings seem quite similar. 5. conclusions since the end of the gold standard, the american dollar has been considered the successor to gold as a medium for international exchange. this currency has, in a brief time span, with the aid of the seigniorage theory, inundated the globe and become the principle currency reserve of the world. the success of the dollar, however, did not live up to expectations when triffin’s paradox became a reality. this occurred when it became apparent that it was impossible to guarantee, in the long term, the convertibility of the dollar at the fixed parity price of 35 us$ per ounce, as established by the conference of bretton woods. following the nixon declaration, there was a collapse of the international monetary system based on fixed exchange rates with the dollar. this allowed the currency exchange markets to fluctuate, uncommitted to a pre-imposed dollar-gold rate. although the end of the bretton woods system did put an end to exchanges based on gold, it certainly did not eliminate the effects of the dollar on the international markets: both in asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 213 currency exchange, goods, as well as in the financial markets. however, this result is due to the fact that the us dollar has become an international currency. it was the only currency that, according to economic theory, was capable of doing so. it is for this reason that, even after the fall of the bretton woods system, the international globalized economic system has continued to use the dollar as its reference currency. nevertheless, if on the one hand the dollar continues to registers successes in the currency exchange markets, a new project originating from the old continent was about to present the international economic system with a new reference currency: the euro. this new currency was, in the course of a few short years, supposed to provide investors with a choice and offer a better way to allocate one’s savings (both private and public). the successes of the new currency were many, and in rapid succession. there were numerous documents, already in the first years since the euro was introduced, that attested to the fact that it abided by all the criteria that allow for a national currency to become international. the only postulation that still today is not fully satisfied is the fact that it is indeed too young, if compared to the dollar or the pound. nonetheless, for the first time, it was recorded that due to various factors, many of the global exchanges were increasingly occurring utilizing the euro instead of the dollar. these circumstances, paired with the rapid appreciation of the euro over the dollar, created for the emu’s currency a sense of international confidence. if there was, on one hand, the growing trust in the european currency, brought about by numerous countries (as, for example, the brics), on the other hand, it was apparent that the united states could not suffer such a pronounced depreciation for a long period of time. faced with the sub-prime financial crisis and the existence of twin deficits, the united states of america have become aware of the necessity to become again a benchmark for the economic markets. not only the monetary and financial markets, but especially in the foreign exchange market. and to achieve this goal, it was necessary to re-equip the american economy with a dollar-hegemony, so as to make it the only strong international currency. the current situation of the eurozone, trapped in a fiscal crisis and surrounded by a lack of confidence in its financial markets, is profoundly changing the characteristics and the future of the euro. this includes whether to utilize it as an anchor currency, in particular, for asian economies. whether the emu economy can revive and the euro can become an international currency are influenced by specific cyclical positions, by the policies pursued by the us and the emu, and (increasingly so) by the weight of external resources (in the european case) and external liabilities (in the case of the u.s. states and china). yet, it is not simple to predict how these forces will influence the euro, the dollar and the international exchange rate system. it is only possible to affirm that, as the analysis establishes, the negative effect of the crisis in the eurozone has been registered in the chinese basket-peg, to the benefit of u.s. currency, the dollar. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 214 references cobham, d. 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(2006). the chinese yuan after the chinese exchange rate system reform. china and world economy, 14, 39–57. http://dx.doi.org/10.1111/j.1749-124x.2006.00044.x ohno, k. (1999). exchange rate management in developing asia. working paper no. 1, asian development bank institute. http://www.adbi.org/research%20paper/1999/01/01/183.exchange.rate/ roosa, r. (1965). monetary reform for the world economy. harper and row, new york. triffin, r. (1960). gold and the dollar crisis. yale university press, new haven. yamazaki, k. (2006). inside the currency basket. columbia university and mitsubishi ufj trust and banking, december. zeileis, a. (2009). exchange rate regime analysis for the chinese. department of statistics and mathematics, wu wirtschaftsuniversität wien, research report series. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 47 the effects of corporate ownership structure on earnings conservatism: evidence from china fan-hua kung department of accounting, tamkang university tamsui, taipei county, taiwan, 25137 tel: 886-2-2621-5656 e-mail: kung@mail.tku.edu.tw chia-ling cheng department of accounting, fu-jen catholic university hsinchuang city, taipei county, taiwan, 24205 tel: 886-2-2905-2962 e-mail: 075024@mail.fju.edu.tw kieran james (corresponding author) department of accounting, economics and finance, university of southern queensland, toowoomba qld. 4350, australia tel: 61-7-46311456 e-mail: kieran_james@yahoo.com and jamesk@usq.edu.au mailto:kung@mail.tku.edu.tw mailto:075024@mail.fju.edu.tw mailto:kieran_james@yahoo.com mailto:jamesk@usq.edu.au asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 48 received: june 29, 2010 accepted: december 16, 2010 abstract this paper investigates the incremental effects of corporate ownership structure on earnings conservatism, examining data of chinese listed companies. we employ the concept of conditional conservatism to define earnings conservatism and adopt empirical models developed by basu (1997) and ball and shivakumar (2005) to measure the degree of earnings conservatism. our empirical results show that the earnings of companies with higher non-tradable shares have lower earnings conservatism. consistent with prior studies, this point demonstrates that the companies with state and concentrated ownership structures are more likely to depend on private communication to reduce information asymmetry and to resolve agency problems internally, thereby creating a low demand for earnings conservatism. the results of this study contribute to our understanding of how companies’ ownership structures affect the properties of earnings in emerging markets and post-communist markets. keywords: earnings conservatism, non-tradable shares, ownership structure, post-communist studies, split-share structure, state ownership jel classifications: m40, m41, m49 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 49 1. introduction in the 1990s, china launched the shanghai stock exchange and subsequently the shenzhen stock exchange. apart from allowing state-owned enterprises (soes) to obtain foreign capital, the purpose of establishing the stock exchanges was to boost the performance of soes through pressure and accountability in the capital market. however, due to political and economic concerns and the possibility of a foreign takeover of local soes, the chinese government refused a complete privatization of enterprises and intended to retain its position as the proprietor of businesses, in order to seize control of resource allocation within the country (allen et al., 2005). the country presently has some communist elements and some capitalist elements operating under broader communist party supervision, and to that extent we are largely in uncharted waters. the slovenian post-communist philosopher slavoj žižek (2010) has commented that china’s unique synthesis of capitalism and communism, rather than being unstable, has been a broadly successful experiment that has lasted 30 years. this chinese experiment can be seen as a longer and deeper version of the limited capitalism called the new economic policy (nep) that the marxist revolutionary vladimir ilyich lenin introduced to the former soviet union in the 1920s to kick-start growth after the civil war. the chinese government later devised a “binary equity structure” in which shares are divided into two categories: those owned by the government, legal persons and institutions, and those owned by investors to be traded in the capital market (tenev et al., 2002). 1 the two types of shares differ in that the former is not allowed to be publicly traded and its valuation is based on the net asset value of an enterprise, whereas that of the latter is based on market value. as a result, such a split-share structure allows only one-third of the public companies’ shares to be traded in the market, while a majority of the shares is held by the chinese government. under such circumstances, investors are unable to monitor operations. in the meantime, since the board and corporate executives are mostly appointed by the government, their management and supervision activities are not aimed specifically at maximizing the earnings of owners of tradable shares who have no say in supervision and decision-making processes. dividend payments also depend on holders of non-tradable shares. as a consequence, majority shareholders are able to enjoy most of the shareholder rights, despite investing only a small amount of capital, while the minority shareholders’ benefits are undermined. since non-tradable shares cannot be traded in secondary markets, their prices are based on the net asset value of corporations. transfers of non-tradable shares mostly require the approval of the boards of both buying and selling parties, authorities, and other relevant departments before contracts are signed to complete the transaction. de alessi (1974) suggested that since equities of soes are nontransferable, stock valuation does not reflect corporate value and performance. estrin and perotin (1991) argued that government, as the proprietor of soes, does not prioritize profit maximization. enhancing corporate performance is a secondary goal whose importance comes after political and economic ones have been achieved. 1 the ultimate controlling owner of state shares is the state council, but these shares are managed by the local bureau of the ministry of finance or other central and local government bureaus, as well as soes (green, 2003). asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 50 this paper investigates the incremental effects of state and concentrated ownership structure on earnings conservatism, examining data for chinese listed companies. we employ the concept of “conditional conservatism” to operationalize earnings conservatism. conditional conservatism is defined as the tendency to accelerate losses and defer gains. this characteristic of conservatism is referred to in the literature as asymmetric loss recognition timeliness (ball and shivakumar, 2005; beaver and ryan, 2005; pae et al., 2005). ball and shivakumar (2005) assert that conditional conservatism, which enhances relevance and representational faithfulness, is one of the primary attributes of financial reporting quality in capitalist countries. they also contend that conditional conservatism enhances contracting efficiency because it makes financial reporting more informative and useful, and thus allows stakeholders to monitor a company’s performance better. prior research suggests that the demand for earnings conservatism is determined either directly or in interaction with managers’ reporting incentives. as discussed above, china’s unique corporate ownership structure nevertheless induces agency problems. meeting the demand for earnings conservatism benefits the corporation and its stakeholders because it alleviates the agency conflicts (or information asymmetry). this paper maintains that the stakeholders’ economic and/or political interests provide important signals about the level of earnings conservatism that should be supplied to meet demand. since china’s government holds a majority stake, this concentrated ownership structure typically ignores minority shareholders’ demands and places higher reliance upon private forms of communication. therefore, there will be less demand for earnings conservatism in china than in pure capitalist economies such as hong kong, japan, singapore, taiwan, etc (ball et al., 2000). hence, we posit that the capital structure of higher non-tradable shares, or less proportionate outside investor interests, will diminish the demand for prompt disclosure of financial information and result in lower earnings quality. consistent with bushman and piotroski (2006) and lafond (2005), our overall results suggest that chinese companies with higher non-tradable shares report less earnings conservatism. as long as the constraints of dominant government involvement are imposed on the market economy, china will not have an infrastructure that encourages capitalist-style financial reporting. this paper provides additional support for discriminating among institutional determinants of financial reporting quality. in addition, it adds to the literature by identifying the extent to which conditional conservatism has been incorporated into current accounting practice in china. in particular, it takes into account the institutional, cultural, and political characteristics of a major emerging economy that whilst in the process of guided transition from communism to capitalism has even its capitalist activities monitored and controlled by the communist party. our results will have special relevance for other countries in transition from communism to some style of capitalism, whether marketor state-controlled, such as russia, vietnam, the former soviet union republics, and the eastern european countries. it takes a long period of time for social relationships, and expectations in relation to those asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 51 relationships, to adjust after a number of years of communism operating in a country (zinoviev, 1985). for example, in the former soviet union, communist social relationships and their related expectations did not completely stabilize until as late as the leonid brezhnev era in the late 1960s and 1970s. the remainder of this paper is structured as follows. the next section describes our hypothesis development. the following sections present our research design and sample selection process. we then discuss our empirical evidence. the last section contains a brief recap and summarizes the key findings of the study. 2. hypotheses development 2.1 institutional and political influences during the course of china’s institutional transformation, the majority of corporations listed on china’s stock exchanges are new restructured soes that have a distinctive capital structure consisting of non-tradable shares and public tradable shares. due to restrictions on public offerings in china, the percentage of shares available in the open market is relatively low. in 2003, the proportion of all non-tradable (tradable) shares was 64.45% (35.55%). 2 consequently, a high percentage of non-tradable shares in the typical corporation are controlled by a small number of controlling shareholders. 3 shleifer and vishny (1994) claim that privatization improves corporate performance and motivates executives. from a political perspective, government officials demanding that corporations pursue political and social goals will generate political costs that are borne by the soes. from a management point of view, the agency costs borne by proprietors and managers are manifest in soes because shareholders are less motivated to monitor executives and the binding mechanism of the market is nonexistent. complete privatization indicates that capital flow rights and voting rights are transferred simultaneously to private proprietors, making it difficult for them to discern political and management opinions. however, with partial privatization, corporations still are subject to government interference as political cost, despite the fact that their shares are traded on the capital market and monitored by shareholders. political involvement often occurs at the expense of corporate interest, for the purpose of achieving political goals. for instance, politicians may abuse their power to transfer some corporate resources into the hands of their supporters. from the perspective of agency theory, under a corporate governance framework, the equity structure of publicly traded companies in china is susceptible to both internal and external moral hazards. tian and estrin (2008) observe that in china, in times of high profitability, the state is motivated to influence corporate profit outcome. 2 based on existing regulations, state and legal person shares held by promoters are not traded in the open market. china securities regulatory commission (csrc) http://www.csrc.gov.cn/, accessed 19 december 2004. 3 in 2001, the largest shareholder stake in listed companies averaged 44.9 per cent (shi and weisert, 2002), indicating a severe concentrated share ownership for chinese listed companies. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 52 shleifer and vishny (1998) also propose that equities are better privatized than state-owned, because politicians and bureaucrats tend to take advantage of corporate benefits. in other words, state proprietorship has a detrimental effect on corporate performance. megginson and netter (2001) contend that private enterprises outperform their state-owned counterparts, saying that corporate performance is found to have improved after privatization. gupta (2005) points out that some privatized companies saw their performance improved thanks to the supervisory role that the stock market plays in terms of management. the continuing government involvement of chinese listed companies (i.e. the government remains a common controlling shareholder) is expected to affect management reporting incentives and threaten the transparency of accounting information. firstly, state ownership raises a query about whether financial reporting is and can be based on arm’s-length transactions. the lack of separation between ownership and management and close business relationships between promoters and listed companies thus presents a conflict of interest and raises the possibility of material related-party transactions. related-party transactions provide an easy mechanism for smoothing reported income and reducing financial reporting transparency (fan and wong, 2002). in addition, officials in control of soes are not entitled to residual claims, thus creating a bad alignment between their interests and those of the firm’s minority shareholders. since the government is in charge of appointing important personnel, and makes the final call on many matters, executives of soes in china may be more attentive to the government’s demand than safeguarding the interest of individual shareholders (chen et al., 2002). in addition, the problem of agency may surface as a result of the state being the controlling shareholder (lin and chen, 1999). government officials may use state proprietorship as a means to create jobs, subsidies, or other benefits as a form of bribery or in exchange for votes and support. this allows managers to manipulate financial reports to prevent a decline in state fiscal revenue or avoid an embarrassing report that reveals large losses (tang et al., 1999). we recall that, in the mao zedong era, the great leap forward of 1958-1959 was characterized not only by inefficiencies in production but also by grossly overstated production figures, the main form of “creative accounting” that occurs in a pure communist system (han, 1976, p. 131). finally, state shareholders, either state or state legal persons, usually have access to inside information, another factor that reduces the reliability of the published financial reports. 2.2 concentrated ownership structure la porta et al. (1998) claim that agency problem is prevalent in many emerging markets, where comprehensive legal protection and other governance mechanisms are not in place. wei et al. (2005) consider the agency problem to be particularly serious in china. the split-share structure incentivizes majority shareholders at the expense of minority shareholders’ interests. such imbalance exists because corporate insiders enjoy a marked separation of voting rights and cash flow rights. a lack of legal protection for external shareholders also contributes to the agency problem. as a result, the split-share structure asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 53 adopted by chinese corporations has led to ineffective governance of public companies in china, which in turn has weakened corporate values. previous studies took ownership structure as a variable for corporate governance. berle and means (1932) investigated the securities markets in the united states and found that shareholder supervision is diminished under a decentralized equity structure. when proprietors and corporate executives have conflicting goals and face information asymmetries, the executives shift their goals from “maximizing shareholder benefits” to “maximizing personal wealth.” in such cases, the proprietors will be forced to shoulder a tremendous agency cost. jensen and meckling (1976) propose the agency theory under the rationale that a separation of ownership and management will prevent executives from bearing the full burden of the post-decision consequences. in addition, since salaries are the incentive for hard work, profit-seeking executives may end up making inefficient decisions or compromising proprietors’ interests in pursuit of self-interest. la porta et al. (1999) discover that controlling shareholders of numerous publicly listed companies use pyramid structure, cross-shareholding, and interlocking directorates to expand their control rights beyond their current cash flow rights, and eventually gain total control of the company. when controlling shareholders obtain control rights asymmetrical to their equities holdings, they are likely to damage other shareholders’ interest by means of quid pro quo, hollowing out corporate assets and other activities of similar nature. research has been conducted to investigate the relationship between ownership structure and corporate performance with differing results. jensen and meckling (1976) propose the “convergence-of-interest hypothesis,” demonstrating positive correlation between insider stock holdings and corporate performance, whereas fama (1980), demsetz and lehn (1985), and mak and li (2001) show no correlation whatsoever. shleifer and vishny (1986), agrawal (1990), and kang and shivdasani (1997) propose that the greater the proportion of controlling shareholders’ holdings, the better the corporate performance. however, xiang and zhang (1996) and steiner (1996) disagree, arguing that the greater the proportion of controlling shareholder holdings, the greater the likelihood of those shareholders snatching corporate assets, with corporate performance worse off. nevertheless, another group of scholars maintain no correlation between insider stock holdings and corporate performance (agrawal and knoeber, 1996). a significant correlation can be found between equity structure and information disclosure. la porta et al. (1999) noticed a negative correlation between the level of ownership concentration and the level of accounting disclosure. chau et al. (2002) pointed out an apparent correlation between external ownership and information disclosure. meanwhile, in corporations with a greater proportion of insider holdings and family ownership, the level of information disclosure decreases. when corporate shareholder ownership exceeds a certain proportion, the majority shareholders tend to take advantage of the company to generate personal profits or sacrifice those of the minority shareholders. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 54 mckinnon and dalimunthe (1993) discover negative correlation between majority shareholders and the level of information disclosure. when majority shareholders have greater holdings, corporations tend to lower the level of information disclosure and are less willing to disclose much information. according to the corporate governance framework of the world bank, majority stockholders are placed under the internal corporate governance. following that line of thinking, majority shareholders’ stock holdings do not facilitate corporate governance and information disclosure; quite the opposite, greater holdings of majority shareholders may diminish a firm’s willingness to disclose information. fan and wong (2002) study corporate governance and the information content of accounting earnings and find that stronger corporate governance has a positive impact on the information content of accounting earnings, that is, higher credibility of the company’s financial statements. when controlling shareholders increase their control rights by means of pyramid structures, cross-holding, and the like, agency problem involving controlling and minority shareholders surfaces gradually. controlling shareholders tend to take self-interested actions when disclosing financial information and inevitably lower the credibility of the financial statements. as the control rights of controlling shareholders expand, or there is greater separation of control rights and cash flow rights, corporate governance deteriorates and the information content of accounting earnings is compromised. transparency and disclosure are the basic elements of corporate governance. the campaign themes of glasnost (openness) and perestroika (restructuring) used by the reforming last leader of the soviet union, mikhail gorbachev, include respectively accounting transparency and economic efficiency in production. higher transparency and disclosure allow corporate stakeholders to gain insight into how a company is run and governed. additionally, accurate and timely information disclosure can boost investors’ confidence and create market efficiencies. as ball et al. (2000) argue, concentrated ownership increases the likelihood that information will be communicated privately to the company’s controlling shareholders. the absence of strong information demand in companies with concentrated ownership is unlikely to encourage management to provide high quality financial reporting. this situation reduces financial transparency and is likely to lead to the expropriation of wealth from minority (nongovernment) shareholders. moreover, the existence of a high proportion of non-tradable shares implies low contestability of control, a situation that can lead to abuses by controlling shareholders as well as long-term inefficiencies and poor decisions. tradable shares generally are held by individuals who have few incentives and resources to perform a monitoring function (tenev et al., 2002). in contrast, widely-held companies experience information asymmetry problems between managers and shareholders, make more use of financial reporting in contracting and communicating, and therefore attract a demand for conservative reporting (ball and shivakumar, 2005). prior research posits that low ownership concentration or greater asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 55 proportionate outside shareholder interests encourages a higher level of earnings conservatism. the aforementioned literature and inferences lead to the following hypothesis: hypothesis: ceteris paribus, there is a negative association between the proportion of non-tradable shares and earnings conservatism. 3. research design 3.1 data and sample selection the sample comprises all publicly-listed nonfinancial companies during the period of 1994–2003. the empirical analysis begins in 1994 because few observations were available before 1994 for the china sample and the relation between earnings and returns in the sample was substantially weak. 4 more pertinently, china adopted a new accounting system in 1993, which was adapted to international accounting standards to improve information disclosure. after deleting observations with incomplete data and extreme values, the final sample consists of 7,353 firm-year observations. all data are collected from the databases of taiwan economic journal (tej). 3.2 specification of the empirical model following prior studies, basu’s (1997) conservatism model is used to test hypothesis concerned with the difference in the speed with which economic gains and losses are captured in accounting earnings. prior research indicates that earnings conservatism is influenced by company-specific attributes like company size, leverage, and profitability (ball and shivakumar, 2005). this study extends basu’s (1997) model by incorporating the link between earnings conservatism and company-specific attributes. the estimated general model is as follows: tititititititititititi ti ti rsizerdntarntardrd p x 6543210 1    titititititititititi rroardlevrlevrdsize 10987   titititi rdroa   11 (1) where: xit is the earnings-per-share for company i in year t; pit-1 is the stock price-per-share for company i at t-1; rit is inter-announcement stock returns measured from may of year t to april of year t+1; dit is a dummy variable set equal to one if rit is negative and zero otherwise; ntait is comprised of the average of the percentage of state ownership and non-tradable shares of company i. control variables are defined as follows: 4 there were only 77 observations in the 1993 sample and the earnings response coefficient (erc) is significantly negative. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 56 (1) company size (size) is the average of the natural logarithm of company i total assets. findings in some prior research indicate that company size strongly influences financial transparency (see jaggi and low, 2000). watts and zimmerman (1986) suggest the political costs hypothesis in positive accounting theory that large companies, subject to political costs, may defer reported earnings from current to future periods. however, most large corporations in china are soes with high state ownership. they tend to diminish the demand for promptly disclosing financial information. consequently, it is expected that there will be a negative association between company size and earnings conservatism. (2) leverage (lev) is the average of the long-term debt divided by total assets of company i. efficient contracting theory suggests that creditors can mitigate the agency conflicts between shareholders and creditors by contracting with companies using financial accounting numbers via a debt covenant (cotter, 1998; fields et al., 2001; jensen and meckling, 1976). earnings conservatism provides contracting parties with an additional tool to cope with conflict between debtholders and shareholders (ahmed et al., 2002; watts, 2003a). companies with a high level of leverage generally are under greater creditor scrutiny to ensure that they do not violate debt covenants (jaggi and low, 2000; jensen and meckling, 1976). anticipating this risk and substantial losses from aggressive accounting, creditors will demand more conservative accounting by setting tight debt covenants to minimize expected losses. ahmed et al. (2002) conclude that companies with high leverage tend to adopt conservative accounting to reduce refinancing expenses and subsequent costly borrowings or restructuring costs. it may be that lenders prefer to actively seek out or impose less onerous restrictions upon companies that adopt conservative accounting practices. although the level of financing provided by banks falls as publicly issued debt and equity financing becomes increasingly important, banks are the major supplier of funds in china. hence, chinese banks are expected to play a prominent role in mitigating agency problems by monitoring listed companies and encouraging conservative accounting reporting. (3) profitability (roa) is the average of company i return on assets. profitability also is potentially associated with companies’ demands for and cost of conservatism (see ahmed et al., 2002). companies with higher profitability are expected to use more conservative accounting because the cost of making a conservative accounting choice is lower than for low-profitability companies. hence, we include return on assets as a proxy for profitability to control for the potential cost of conservatism (ahmed et al., 2002). in addition, including a control for profitability also reduces the likelihood of an omitted-variables bias. equation (1) posits that using accounting earnings (a lagging variable) as the dependent variable and stock returns (a leading variable) as the independent variable estimates the slope coefficient better. a bad news dummy dit is included in the regression to distinguish bad news from good news. the slope coefficients β2 and β3 in equation (1) are used to measure asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 57 the responsiveness of reported earnings to the news captured in contemporaneous returns. these slope coefficients are termed “return response coefficients.” the bad news slope coefficient is steeper than the good news slope when conservatism exists. under conservative reporting, the slope coefficient β3, which measures the incremental response of earnings to bad news over the response to good news, is expected to be positive. coefficient β4 captures the marginal effect of sensitivity to bad news for companies where ntaitdit equals zero, and the interaction coefficient β5 captures the incremental earnings conservatism for companies where ntaitdit equals one. it also is expected that, for conservative reporting, the interaction coefficient β5 will be significantly positive. 4. results 4.1 descriptive statistics table 1 provides the patterns of annual distributions for non-tradable shares for the sample period. overall, soe reform in china has not resulted in a fundamental change in ownership patterns. the ownership structure of listed companies has been relatively stable. for non-tradable shares, the annual mean (median), although quite high, decreased slightly from 61.57% (63.33%) in 1994 to 59.02% (61.11%). this pattern implies that the ownership of most chinese listed companies was not diversified during the sample period. the proportion of non-tradable shares is high so only a small portion of these shares are traded in the open market. more than half of all shares are non-tradable. such a high proportion of non-tradable shares implies that external monitoring of management probably is deficient, and that there is either low demand for earnings conservatism from external user groups or that the demand that does exist is not fulfilled. table 1. summary statistics for non-tradable shares year n mean stddev min max 75th pctl median 25th pctl 1994 249 0.616 0.169 0 0.928 0.725 0.633 0.523 1995 290 0.605 0.161 0 0.928 0.716 0.621 0.518 1996 330 0.602 0.155 0 0.928 0.710 0.617 0.516 1997 568 0.608 0.137 0 0.928 0.708 0.624 0.527 1998 737 0.607 0.133 0 0.928 0.704 0.625 0.525 1999 839 0.582 0.147 0 0.928 0.696 0.608 0.502 2000 934 0.575 0.145 0 0.928 0.684 0.600 0.488 2001 1089 0.576 0.143 0 0.928 0.683 0.602 0.495 2002 1114 0.575 0.142 0 0.928 0.681 0.600 0.495 2003 1203 0.590 0.128 0 0.913 0.682 0.611 0.525 total 7353 0.588 0.142 0 0.928 0.694 0.611 0.509 a non-tradable shares (state shares, state legal person shares, domestic legal person shares, foreign capital legal person shares, and internal employee shares) for the sample companies that have a full set of available data and accounting years falling within the period 1994-2003. panels a and b of table 2 report the descriptive statistics for the data used to estimate basu’s (1997) model. the mean (median) annual returns (r) are 0.1218 (-0.0723) with a greater asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 58 variation over the sample period and a relatively high volatility (the standard deviation is 0.6743) that is characteristic of emerging markets. 5 the mean value of earnings variable (ni) is close to zero, having mean (median) and standard deviation values of 0.0255 (0.0186) and 0.0789, while the distribution of the ni variable tends to decrease over the sample period. both r and ni are right-skewed (means exceed medians), indicating a low level of earnings conservatism for the china sample. 6 also, the standard deviation of the ni variable always is smaller than the standard deviation of r, consistent with ball et al.’s (2000, p. 12) argument that accounting income is a lagged function of past and present years’ stock returns. table 2. descriptive statistics for variables panel a: pooled sample n mean median stddev min max ni 7353 0.026 0.019 0.079 -0.701 1.756 r 7353 0.122 -0.072 0.674 -0.862 8.485 roa 7353 0.016 0.042 0.337 -3.790 0.377 lev 7353 0.458 0.393 1.192 0 72.310 siz 7353 13.793 13.736 0.908 8.910 19.576 panel b: selected years year n ni r mean stddev mean stddev 1994 249 0.128 0.153 -0.064 0.357 1995 290 0.107 0.163 0.313 0.477 1996 330 0.071 0.149 1.300 1.115 1997 568 0.034 0.063 0.015 0.515 1998 737 0.027 0.066 -0.089 0.429 1999 839 0.030 0.053 0.758 0.726 2000 934 0.013 0.040 0.381 0.890 2001 1089 0.007 0.041 -0.212 0.221 2002 1114 0.006 0.051 -0.190 0.205 2003 1203 0.008 0.061 -0.083 0.242 a ni ( 1/ itit px ) represents earnings-per-share deflated by price at the beginning of year t. r (rit) denotes inter-announcement stock returns measured from may of year t to april of year t+1. roa is defined as a company’s net income divided by total assets. lev is the company’s leverage ratio, measured as total debts divided by total assets. siz is the natural log of a company’s total assets. 4.2 correlation analysis 5 the standard deviations of both r and ni in the china sample are very similar to the sample in ball et al. (2000) and to those of the four east asian country samples in ball et al. (2003). 6 ball et al. (2000, p. 12) state that the right skew of earnings indicates accounting conservatism because conservative accounting tends to incorporate economic losses as larger but less frequent capitalized amounts and to incorporate economic gains as smaller but persistent flows over time. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 59 table 3 provides the pearson correlation matrix for determinant and proxy variables for company-specific institutional factors. as shown in table 3, the correlations among the dependent variables ni and r are significantly correlated (+0.206) as expected, suggesting that accounting income does reflect information in companies’ contemporaneous economic incomes (ball et al., 2000). ni also is significantly correlated with profitability (roa) (+0.352), leverage (lev) (-0.088) and company size (siz) (+0.023). non-tradable shares (nta) is significantly correlated with roa (+0.025). these correlations indicate that the incremental effect of a hypothesized determinant of earnings conservatism should be properly identified and explained. 7 table 3. pearson correlation coefficients among variables ni r roa lev siz nta ni 1.000 r 0.206*** (0.000) 1.000 roa 0.352*** (0.000) 0.064*** (0.000) 1.000 lev -0.088*** (0.000) 0.001 (0.910) -0.305*** (0.000) 1.000 siz 0.065*** (0.000) -0.028** (0.015) 0.147*** (0.000) -0.050*** (0.000) 1.000 nta 0.011 (0.360) 0.005 (0.642) 0.026** (0.025) 0.018 (0.131) 0.013 (0.259) 1.000 a note. *, **, and *** indicate significance at the 10, 5, and 1 percent levels, respectively. the p-values are in parentheses. a ni ( 1/ itit px ) represents earnings-per-share deflated by price at the beginning of year t. r (rit) denotes inter-announcement stock returns measured from may of year t to april of year t+1. roa is defined as a company’s net income divided by total assets. lev is the company’s leverage ratio, measured as total debts divided by total assets. siz is the natural log of a company’s total assets. nta is the proportion of a company’s non-tradable shares. 4.3 multivariate analysis hypothesis of this study states that there is a negative association between the proportion of non-tradable shares and earnings conservatism. table 4 reports the estimation results of equation (1). as expected, the interaction coefficients β5 is significantly negative at the 1% level (-0.031; t=-2.80). the results support our hypothesis. specifically, they show that, after controlling for company-specific attributes including company size, leverage and profitability, companies with higher non-tradable shares have lower earnings conservatism. 7 watts and zimmerman (1990) and wong and wong (2001) discuss and explain the problems that emerge in empirical research within the positive accounting tradition when “correlated omitted variables” are not properly identified and controlled for. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 60 table 4. regression result of earnings conservatism tititititititititititi ti ti rsizerdntarntardrd p x 6543210 1    titititititititititi rroardlevrlevrdsize 10987   titititi rdroa   11 (1) variables pred.sign coef. t-stat. intercept ? 0.036*** 22.84 d ? -0.001*** -3.67 r -0.101*** -4.94 d*r + 0.223*** 2.99 nta*r ? 0.002 0.15 nta*r*d -0.031*** -2.80 size*r ? 0.007*** 4.87 size*r*d -0.010* -1.91 lev*r ? -0.003*** -5.77 lev*r*d + 0.001 0.21 roa*r ? 0.462*** 25.99 roa*r*d + 0.611*** 31.37 f value 131.07*** adj.r 2 (%) 18.70 no. of obs 7353 a note. *, **, and *** indicate significance at the 10, 5, and 1 percent levels. b 1/ itit px is company i’s earnings-per-share deflated by the price at the beginning of the year t; rit is company i’s compounded monthly return over the 12-month period. d is a dummy variable for bad news, code one if rit is negative; and zero otherwise. nta is the proportion of a company’s non-tradable shares. siz is the natural log of a company’s total assets. lev is the company’s leverage ratio, measured as total debts divided by total assets. roa is defined as a company’s net income divided by total assets. furthermore, as demonstrated in prior studies, institutional factors are associated with agency conflicts, particularly those arising from information asymmetry, so they create different levels of demand for earnings conservatism (watts, 2003b). as expected, we find that the incremental effects of profitability (+0.611; t=31.37) and company size (-0.010; t=-1.91) on earnings conservatism are significant with predicted sign. however, although the direction is as predicted, the interaction of leverage (+0.001; t=0.21) is not significant. this last result may be because banks, which are government-owned, also do not demand earnings conservatism. 4.4 alternative model of earnings conservatism by ball and shivakumar (2005) to check for the robustness of our results, we also apply the alternative empirical model of earnings conservatism developed by ball and shivakumar (2005) to test our hypothesis. ball asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 61 and shivakumar (2005) measure earnings conservatism as the asymmetric timeliness of accruals in economic loss recognition relative to economic gain recognition. they use operating cash flows to proxy for economic losses and gains during the year. we extend the ball and shivakumar (2005) model by incorporating the link between earnings conservatism and company-specific attributes to test our hypotheses as follows: titititititiit cfontacfocfodcfocfodacc 43210   titititititititi cfocfodsizecfosizecfocfodnta 765   tititititititi cforoacfocfodlevcfolev 1098   titititi cfocfodroa   11 (2) where acci is the mean of total accruals of company i multiplied by -1 and standardized by beginning period total assets. accruals are defined as earnings before exceptional items and extra-ordinary items minus cash from operations; cfoit is operating cash in year t dividend by beginning total assets; cfodit is a dummy variable set equal to one if cfoit is negative and zero otherwise. the result of equation (2) is given in table 5. the results based on the model of ball and shivakumar (2005) are largely consistent with our findings documented above. the interaction coefficients β5 is significantly negative at the 1% level (-0.709; t=-2.60). again, they show that chinese companies with higher non-tradable shares supply less earnings conservatism. therefore, hypothesis is supported, using an alternative empirical model of earnings conservatism. as expected, we find that the incremental effects of profitability (+3.401; t=12.42) and company size (-0.250; t=-2.23) on earnings conservatism are significant with the predicted sign. however, the interaction of leverage (+0.168; t=1.64) is statistically different from zero. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 62 table 5. regression result of alternative model of earnings conservatism titititititiit cfontacfocfodcfocfodacc 43210   titititititititi cfocfodsizecfosizecfocfodnta 765   tititititititi cforoacfocfodlevcfolev 1098   titititi cfocfodroa   11 (2) variables pred.sign coef. t-stat. intercept ? 0.009*** 3.11 cfod ? 0.012** 2.36 cfo + 0.030 0.30 cfod*cfo + 0.391** 2.54 nta*cfo ? 0.231 1.48 nta*cfo*cfod -0.709*** -2.60 size*cfo ? -0.011 -1.03 size*cfo*cfod -0.250** -2.23 lev*cfo ? -0.158* -1.78 lev*cfo*cfod + 0.168 1.64 roa*cfo ? -2.990*** -11.20 roa*cfo*cfod + 3.401*** 12.42 f value 36.56*** adj.r 2 (%) 12.61 no. of obs 2264 a note. *, **, and *** indicate significance at the 10, 5, and 1 percent levels. b accit is he mean of total accruals of company i multiplied by -1 and standardized by beginning period total assets.; cfoit cash from operations in year t standardized by beginning period total assets. d is a dummy variable for bad news, code one if cfoit is negative; and zero otherwise. nta is the proportion of a company’s non-tradable shares. siz is the natural log of a company’s total assets. lev is the company’s leverage ratio, measured as total debts divided by total assets. roa is defined as a company’s net income divided by total assets. 5. concluding remarks summarizing, the findings demonstrate an important link between the corporate ownership structure for chinese listed companies and earnings conservatism. consistent with bushman and piotroski (2006) and lafond (2005), these results indicate that earnings conservatism decreases with the presence of higher levels of non-tradable shares. companies with state and concentrated ownership structures are more likely to depend on private communication to reduce information asymmetry and resolve agency problems internally, thereby creating low demand for earnings conservatism. furthermore, the regression results show that companies with smaller size and higher profitability report more conservatively. collectively, the evidence in this study shows consistently that differences in earnings asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 63 conservatism arise from differential information demands. more specifically, the level of earnings conservatism is an equilibrium outcome of forces set in motion by market participants acting in their own self-interest, and reflecting differences in demand for conservative financial reporting. accounting reporting practices for chinese companies are focused more often on meeting the needs of the major shareholder (i.e. the chinese communist party) rather than the needs of investors. china has been undergoing a guided transition from a planned economy to a market-oriented economy but the market economy remains under the ultimate control of the communist party. we simply have a longer and deeper version of lenin’s new economic policy and, although many do get rich, communist social relationships and expectations still largely predominate (zinoviev, 1985). this is especially the case when we consider the higher levels of power within organizations. we recall that china started its reform efforts in the late-1970s under deng xiaoping in an environment where few elements of a well functioning financial market were in place. the evidence shows that china’s institutional transition is far from complete and will remain incomplete as long as preserving the dominant involvement of government remains the overriding objective of those in power. in such an environment, the demand for conservatism by minority shareholders remains less important and unlikely to be adequately met. this may or may not trouble westerners and other non-chinese used to a free-market system of the conventional type where capitalist business relationships are the norm. in 2005, the china securities regulatory commission announced an initiative to convert non-tradable shares into tradable shares. the new initiative (called “administrative measures on the split share structure reform of listed companies”) provides ground rules to allow for the conversion of the shares. many investors and analysts view this as a significant reform that will continue to shift the balance of share ownership from state ownership to public ownership by minority shareholders. future research may investigate the effectiveness of this split-share structure reform and examine whether the diffused ownership structure affects the attitudes of management and demands of stakeholders for earnings conservatism. acknowledgements we would like to thank professor ray ball and the journal editor dr g. wickramasinghe and the two anonymous reviewers. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e3 www.macrothink.org/ajfa 64 references agrawal, a. 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(2010). living in the end times. london and new york city, ny: verso copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 1 can the chinese two-tier-board system control the board chair pay? shujun ding accounting area, school of administrative studies faculty of liberal arts & professional studies, york university 4700 keele st., toronto, ontario m3j 1p3, canada tel: 1-416-736-2100 ext 20873 e-mail: sjding@yorku.ca zhenyu wu (corresponding author) department of finance and management science edwards school of business, university of saskatchewan 25 campus drive, saskatoon, saskatchewan s7n 5a7 canada tel: 1-306-966-7779 e-mail: wu@edwards.usask.ca yuanshun li finance department, ted rogers school of business management, ryerson university 350 victoria st., toronto, ontario m5b 2k3, canada tel: 1-416-979-5000 ext 6711 e-mail: yuli@ryerson.ca chunxin jia department of finance, guanghua school of management, peking university beijing 100871, china tel: 86-10-6275-7795 e-mail: cjia@gsm.pku.edu.cn abstract monitoring function of the chinese two-tier-board system is expected to affect firms' executive compensation in two ways: (i) improve firm performance which is considered as a partial basis of executive compensation (ii) monitor executives' behaviors to avoid over-pay. this article investigates if corporate governance mechanism indeed benefits in these two ways from major asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 2 characteristics of supervisory boards, one of the two monitoring organs in chinese publicly listed companies. we find that supervisory board size is negatively related to the board chair pay, presumably because the monitoring effects of the size of supervisory board on board chair's behaviors dominate those on firm performance. we also find a high level of board chair pay-supervisory board sensitivity in the chinese publicly listed companies. jel classifications: g34, g39 keywords: board chair pay; monitoring; corporate governance 1. introduction mr. levitt, the former chairman of sec, commented that "if there is anything that engages the public today about the business community, it is the issue of compensation" (levitt, 2005, p. 41). in the corporate governance literature, executive compensation has also received dramatic attention (e.g., nager, 2002; dutta, 2003; lin, 2005; ortiz-molina, 2007; balsam and miharjo, 2007), and some pioneer studies have investigated compensation-related issues from an ethical perspective (e.g., perel, 2003; ashely and yang, 2004; matsumura and shin, 2005; mahoney and thom, 2006; persons, 2006). in both mature and emerging markets, for instance, pay-performance relationship is considered critical for providing appropriate incentives for executives, and this issue has been extensively examined by academics (e.g. jensen and murphy, 1990; nichols and subramaniam, 2001; firth, fung, and rui, 2006; cordeiro, veliyath and romal, 2007; angel and mccable, 2008). unfortunately, the results are mixed although some show a significant pay-performance relationship (e.g., elston and goldberg, 2003; jensen and murphy, 1990; firth et al., 2006), which either has a low explanatory power or is not supported by other studies. the inconsistent pay-performance link, as well as the low pay-performance sensitivity, suggests that other factors may have contributed to the executive compensation level. among these factors, corporate governance mechanisms, especially board of directors and ownership structure, have been found to be some of the significant determinants of executive compensation (e.g. boyd, 1994; ryan and wiggins, 2004). boyd (1994), for example, finds that ceo's compensation is significantly higher in firms with a lower level of board control. these studies fall into the field of monitoring which is one of the useful tools for lowering agency costs. our study continues this stream of research by examining the monitoring effects of another corporate governance organ, the supervisory board, on board chair pay in china. to our best knowledge, this is the first study which investigates the board chair pay-supervisory board relationship. furthermore, prior studies examining executive compensation focus on mature markets, and the determinants of executive compensation in emerging markets are understudied (ramaswamy, veliyath, and gomes, 2000). our study is intended to fill this gap from the perspective of corporate governance. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 3 two of the most effective corporate governance mechanisms in the world are the anglo-american governance system and the german two-tier board system, and supervisory board is one of the typical features of the latter one. both mechanisms have been codified into the chinese corporate law since 1993 in a way similar to the japanese mechanism. however, the supervisory boards in china are designed loosely on the german model, and their major duties lie in monitoring the executives and the board of directors. therefore, the chinese governance mechanism is more likely a combination of the u.s., german and japanese systems. according to the amended corporate law effective on january 1, 2006, the board of directors in a chinese publicly listed company is responsible for its daily operation, while supervisory boards monitor the behaviors of the board and the management team. furthermore, supervisory boards are required to examine the financial affairs of the company. as board chairs in many of the chinese publicly listed companies also serve as the ceos, it is even more important to have the supervisory board to monitor their behaviors 1 . as stated in the china corporate governance survey published by the cfa institute, the monitoring functions of supervisory board in chinese publicly listed companies have been further clarified and strengthened by the revised version of the corporate law. wang (2005) also confirms this improvement of supervisory board's legal power and monitoring functions. these findings are in sharp contrast to the conventional wisdom that supervisory boards are just a decoration to the chinese corporate governance system (xi, 2006) and prior findings that they play very little role in publicly listed companies in china (e.g. dahya, karbhari, xiao, and yang, 2003). using data in 2005 and 2006 from the two stock markets in china, we examine the research questions using the meeting frequency and size of a supervisory board as proxies for its activities and characteristics, and show that supervisory boards influence board chair pay significantly. comparing with the conclusions made by prior research, therefore, we show the improvement of the legal and investment environment in china in recent years. therefore, our findings are able to provide important policy implications to authorities in china and other jurisdictions who are eager to improve the efficiency of corporate governance, and are of interest and of importance to better understand economic integration. as supervisory board serves as one of the two monitoring organs in the chinese two-tier-board corporate governance mechanism but its role has not been extensively examined, this study focuses on how the two-tier-board system affects the board chair pay in order to highlight part of its functionalities in chinese publicly listed companies. as mentioned before, board of directors is in charge of daily operations, while supervisory board monitors behaviors of both board of directors and the management team. therefore, examining the role played by a supervisory board in controlling the board chair pay in chinese markets contributes to the literature in several ways. first, as far as we are aware, this study is among the first to shed light on whether and, if yes, how supervisory boards influence board chair pay and the effectiveness of corporate governance mechanisms. second, with the dramatically increasing popularity of globalization and economic integration, it may provide developing nations with implications 1 note that according to the chinese corporate law, members serving on the board of directors and top management are not allowed to serve on the supervisory board. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 4 about effective corporate governance mechanisms by analyzing the unfolding governance reform in china. third, results presented in the current study have crucial implications for government policies and regulations. the corporate law in china, an important objective of which is to better integrate the anglo-american style corporate governance mechanism and the german system, was newly amended in 2005. results of our study highlight the improvement of legal environment and investor protection in china, and illustrate the legal approach in a more vivid way. the valuable experience and/or lessons from this process are instructive for other jurisdictions, especially emerging markets, to develop or refine their governance systems. fourth, it adds to the corporate governance literature methodologically by separating the indirect from direct effects of the size of supervisory board on board chair pay, and contributes to the compensation literature from an ethical perspective. the article is organized as follows. in section 2, we review the literature, discuss the background for the study, and list our hypotheses. data and methodology are introduced in section 3, followed by section 4 which presents and discusses the results. conclusions are made in section 5. 2. literature review and theoretical background in the past 75-80 years, pay-performance relationship has been one of the mainstream issues investigated by academic researchers in various fields of management. unfortunately, however, there is no final say about this relationship in the relevant literature. a seminal study in this field, jensen and murphy (1990), finds an increase in the ceo compensation of $3.25 on average per $1,000 increase in shareholders' wealth, but the pay-performance sensitivity is considered very low. recent studies, such as hall and liebman (1998), aggarwal and samwick (1999, 2003), fosberg (2001), and elston and goldberg (2003), find higher pay-performance sensitivities using more recent data, but empirical findings reported are still mixed. a new stream of research in the more recent literature focuses on the influence of corporate governance on issues about executive compensation (e.g., nager, 2002; dutta, 2003; lin, 2005; ortiz-molina, 2007; balsam and miharjo, 2007), and studies have done so by comparing public with private firms (e.g., ke, petroni and safieddine, 1999), by emphasizing on specific ownership structures (e.g., boyd, 1994; kraft and niederprum, 1999; hartzell and starks, 2003), and by taking into account investor protection (e.g., la porta, lopez-de silanes, shleifer, and vishny, 2000; ryan and wiggins, 2004). these studies shed light on this critical corporate governance issue from different aspects. most of their findings are summarized by a survey paper written by devers, cannella, reilly, and yoder (2007), who also address other recent developments in the literature on executive compensation. with the increasingly important role played by emerging markets, a new trend in the corporate governance literature has appeared, and it is to analyze the executive compensation issues in unique corporate governance mechanisms adopted by them. typical examples include yueh (2004), chen, firth, gao and rui (2006), firth, et al. (2006), and kato and long (2006), and these studies significantly add to the literature on corporate governance-executive compensation relationship in china, one of the most fast-growing emerging markets in the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 5 global economy in recent years. with the efforts made by various parties including the chinese government, the chinese market has been one of the largest public stock markets in the world, and it became the largest one in term of ipo proceeds. the fast growth of the chinese market has attracted the attention of both international investors and academic researchers, and therefore, corporate governance and investor protection issues have been the popular topics to address. the co-existence of board of directors and supervisory boards has been in place since the very beginning of chinese markets. this system has been stable until the beginning of the new millennium; at that time, listed companies are mandatorily required to implement independent directorships. but supervisory boards remain as one of the two monitoring organs. evidence on the role of supervisory boards is mixed. for example, xiao, dahya and lin (2004) found that supervisory boards rarely serve as an independent watchdog; rather, they are more likely to be honored guests and friendly advisors. dahya et al. (2003), however, provide interesting evidence regarding the role of supervisory boards; the market reacted negatively when a company failed to include the report of supervisory boards in its annual report. a recent study by firth, fung, and rui (2007) shows that the two-tier board does play a role, as both significantly positively affect the informativeness of earnings. despite the mixed evidence, people generally perceive supervisory boards as dysfunctional. our study thus is able to shed light on this important issue by employing more recent data, and contributes to the ongoing debate whether the dual-board structure is functioning as expected. it is widely accepted that chinese legal and investment environment has been dramatically improved in the past 15 years since early 1990s. whereas china started the economic transition in late 1970s, corporate governance and investor protection have not been clearly specified until the establishment of the two stock markets at the beginning of 1990s. in 1993, the first version of corporate law was enacted, and it underwent three major amendments within 15 years after that. the most recent one was done in 2005, and it became effective on january 1, 2006. the corporate law clearly states that china adopts a unique dual-board corporate governance system involving both board of directors and supervisory board. this is similar to the japanese and german two-tier-board systems, but it combines the major features of the german, japanese and the u.s. systems. in the chinese unique corporate governance system, supervisory board is not responsible for daily operations of the company, but serves as one of the two monitoring organs, together with the independent directors who are part of the board of directors in the u.s. system. most of the prior research has concluded that, while board of directors plays an important role in the chinese dual-board governance system, supervisory board is dysfunctional (xiao et al., 2004; xi, 2006). however, this situation has been dramatically changed with the newly amended corporate law being effective in 2006. according to this new version, members on the supervisory board are mainly responsible for monitoring the behaviors of top management team and members on the board of directors, and they are required and legally supported to examine the financial affairs of the company. using the information up to date, firth, et al. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 6 (2007) find that supervisory boards significantly increase earnings informativeness. using more recent data from 2001 to 2006, wu, li, ding, and jia (2009) show the significant monitoring effects of supervisory board on financial leverage of chinese publicly listed companies. however, the functionality of supervisory board in the chinese unique corporate governance system is still undetermined. another unanswered question is about the corporate governance-executive compensation relationship in chinese publicly listed companies. firth et al. (2006) find a significant pay-performance relation for two ownership structures in china. kato and long (2006) even report that the pay-performance sensitivity in china is higher than that in the u.s. using more up-to-date information. to add to this literature, one needs to look back at the executive compensation reform during the economic transition in china within the past 30 years. as well known, most of the publicly listed companies whose stocks are traded in the two stock markets in china were converted from state-owned enterprises, and therefore the compensation was highly restricted by the government at the early stage. this situation was gradually changed since mid-1980s, but not fundamentally until 1994 (mengistae and xu, 2004; yueh, 2004; firth et al., 2006; kato and long, 2006). starting 1994, these companies were allowed to set up their own compensation form with both fixed salary and performance-related pay for executives (liu and otsuka, 2004; kato and long, 2006), and doing so moved the chinese corporate governance system closer to the german and the u.s. ones. instead of looking at the pay-performance relationship in chinese publicly held companies, therefore, we focus on the influences of supervisory boards on the board chair pay. doing so allows us to help answer the two undetermined questions mentioned above, the effectiveness of supervisory board and the effects of corporate governance on board chair pay. thus, the major hypothesis of the current study is that supervisory board monitors the board chair pay effectively. there are two possible ways for supervisory board to affect the board chair pay; the first is to increase the board chair pay through enhancing the firm performance which is a partial basis of the board chair pay, and the second is to decrease the board chair pay by monitoring board chairs' behaviors to stop them from overpaying themselves. according to the above review of the literature and the discussion about the theoretical background of this study, we have the following two hypotheses: hypothesis 1: supervisory board meeting frequency in chinese publicly listed companies decreases the board chair pay. hypothesis 2: size of supervisory board in chinese publicly listed companies decreases the board chair pay. by testing the above two hypotheses, we highlight the effects of activities and characteristics of supervisory board on board chair pay. in the rich corporate governance literature, meeting frequency has been widely used as a proxy for board activities (e.g., vafeas, 1999), and board size has also been extensively chosen to measure board characteristics when agency issues are asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 7 addressed (e.g., jensen, 1993). previous studies also indicate that meeting frequency may be affected by past firm performance (vafeas, 1999), and that size may have a significant influence on efficiency of board activities (jensen, 1993). as research on monitoring effects of supervisory board in chinese publicly listed companies is rare, we follow the broad corporate governance literature to use supervisory board meeting frequency and supervisory board size to measure its activities and characteristics, respectively 2 . 3. data, variables, models, and estimation 3.1 data to answer the research questions raised above and to test the hypothesis, we adopt data of chinese publicly listed companies in the two chinese markets, the shanghai stock exchange and the shenzhen stock exchange, in 2005 and 2006. one of the major reasons to choose data in these two years is the availability of the information about individual executive's compensation. this information before 2005 is not available because disclosing individual information was not mandatory until that year. we extract data from the data sets published by two major financial market data collection companies in china, the gta and sinofin, whose products have been employed by prior studies such as sun and tong (2003), bai, liu, lu, song, and zhang (2004), wei, xie and zhang (2005), haw, qi, wu and wu (2005), kato and long (2006), and jia (2009). there are 1,345 observations from year 2005 and 1,410 from year 2006. to ensure the quality of the study, we cross-checked the accuracy of the information carried by the two data sets. whenever we found inconsistency between them, we manually checked the information disclosed in the original annual reports published on the websites of the shanghai stock exchange and the shenzhen stock exchange, and kept the correct information. 3.2 variables this study is to investigate the effects of supervisory board on board chair pay. prior research (e.g., firth, fung, and rui, 2006) focuses on the ceo compensation since it is widely accepted that ceo is the one who makes major decisions in a company. in china, however, the situation is different since the chairman of board of directors is the actual leader of a company (chen, et al., 2006). according to the corporate law first promulgated in 1993, the chairman of board of directors, instead of the ceo, is the legal representative of the public company. in addition, since most of listed firms in china were reorganized from soes, the chinese government is involved in firm management more often than dominating shareholders in corporations in mature markets. pistor and xu (2005) find that administrative governance is more important than legal governance in china's financial markets. the administrative governance extends to publicly listed companies mainly through the board chair, who usually comes from the government or soes. as discussed in the introduction section, in addition, board chairs in many of the listed companies in china are also their ceos, and represent the benefits of both shareholders and management teams. among the rich literature on ceo compensation, the 2 note that as the newly-amended corporate law is expected to improve the effectiveness of the dual-board corporate governance mechanism in chinese publicly listed companies, supervisory board’s functionality has been improved, and therefore we hypothesize that its activities and characteristics may help curb board chair pay. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 8 monitoring effects of independent directors on ceo compensation have been considered using u.s. listed companies with ceo as the board chair (e.g., core, holthausen, and larcker, 1999; anderson and bizjak, 2003; chhaochharia and grinstein, 2008; guedj and barnea, 2009) 3 . since supervisory board serves as one of the monitoring organs in chinese listed companies and is required to monitor behaviors of both board of directors and management team, it is of importance to investigate the effects of activities and characteristics of a supervisory board on board chair’s compensation. therefore, we make use of the executive pay received by the board chair (bcpay) as the dependent variable 4 . while research on the monitoring effects of supervisory board is rare, there is a rich literature on functions of board of directors, and therefore, we follow previous researchers (jensen, 1993; vafeas, 1999; jia, ding, li, wu, 2009; wu, et al., 2009) and measure characteristics of supervisory board using three variables. they are the meeting frequency of supervisory board (sbmf), its size (sbs), and the turnover of its chairman (sbcturnover), and they serve as the independent variables in this study. while sbmf and sbs are continuous variables, sbcturnover is a binary variable indicating whether there is a turnover of the chairman of the supervisory board in a year. while studying the monitoring effects of board meeting frequency on firm performance, vafeas (1999) indicates that a firm's board meeting frequency may be influenced by lagged firm performance and its risk-taking behaviors in the past year. under the agency theory (jensen, 1993), one also realizes that the size of supervisory board can also influence its meeting frequency. in other words, a supervisory board with a larger size tends to meet more to reach agreements. in the current study, the research objective is to investigate the monitoring effects of the activities and characteristics of supervisory board on board chair pay in chinese publicly listed companies. we have also mentioned before that supervisory board is responsible for monitoring behaviors of board of directors and management team. therefore, the potential influence of past performance and risk-taking behaviors on supervisory board meeting frequency needs to be considered. thus, we follow and further develop the method proposed in vafeas (1999) to separate the monitoring-induced supervisory board meeting frequency (misbmf) from the performance-and-risk-induced component using the following model: )1()var,,,,,( 1 iablescontrolrsbcturnoveibsizesbsriskfpfsbmf currentpastpastcurrent where the subscript "current" indicates variables in the current years and the subscript "past" indicates those in the past year. the variable ibsize indicates the number of independent directors on the board, and fppast and riskpast are firm performance and the risk taken by the firm, respectively, in the past year. since the residual ε1 is free of the influences of lagged firm performance, past risk taken by the firm, the size of the supervisory board, and other 3 the authors thank one of the anonymous reviewers for pointing out the recent studies on this topic. 4 to adjust for distributional bias, we use the natural log of (bcpay+1) as the dependent variable in our tests, since the values of this variable are not normally distributed. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 9 explanatory factors, it may be interpreted as a measure of misbmf, i.e., misbmf = ε1. control variables adopted for the current study include those measuring firm performance, risk taken by firms, agency effects, ownership structures of controlling shareholders, firm size, and industry effects. financial performance of a firm usually has two major categories, the accounting return measured by return on assets (roa) and return on equity (roe) 5 , and the stock return. to measure risk taken by firms, we use the debt-equity ratio (d/e) determined by long-term debt over total equity. other control variables include firm size (conyon, 1997; firth et al., 2006) measured by the natural log of total book value of assets (lnassets), and industries categorized by the chinese securities regulatory commission (csrc). corporate governance variables included the agency variable dual, a dummy variable indicating whether the chairman of the board of directors is also the ceo of the company, ownership structure variables such as gov, a binary variable indicating whether the government or government representative is the largest shareholder, govsoe 6 , a dummy measuring whether the government, government representative, or a state-owned enterprise is the largest shareholder, and herfindahl index (hhi) for the ten largest shareholders, excluding the largest one, as a control variable capturing ownership concentration. we also consider three variables to capture the potential effects of foreign shareholders among the ten largest ones. for is a dummy variable with a value of one for firms with a foreign shareholder as the largest one and zero otherwise, for10 is also a dummy variable indicating whether there is at least one foreign shareholder among the 10 largest ones, and for% is a continuous variable measuring the total percentage of ownership held by foreign shareholders listed among the ten largest ones. in the chinese markets, in addition, one of the unique features is the existence of non-tradable shares. following the literature (e.g., firth et al, 2006; wang and xu, 2004), we include, trade, the ratio of the number of tradable shares over that of total shares, as one of the control variables 3.3 methodology the ols model used to test monitoring effects of supervisory board on board chair pay is )2(21110 987 6543210       dummiesyeardummiesindustry nsinteractiovarstructureownershipvaragency lnassetsriskibsizefpsbssbmflnbcpay as discussed above, there are two aspects of the monitoring effects of supervisory board; the first is to help enhance the firm performance and then to increase the performance-related 5 note that we do not use tobin’s q to measure firm performance, but use roa and roe to measure it. the reason is that most of chinese publicly listed companies were converted from state-owned enterprises, and therefore a large portion of the shares are not tradable in the secondary market. as tradable and non-tradable shares have different market prices, using tobin’s q to measure firm performance may be biased. 6 our measurement of soe control adopts the method used in firth et al. (2006), which examined ownership structure in a finer way. our descriptive analysis shows the percentage of soes in our study is a little lower than that presented in prior studies (e.g. firth et al. 2006, 2007). two reasons may account for that difference. first, we are employing a more recent sample, i.e. year 2005 and 2006, while prior studies (e.g. firth et al. 2006, 2007) used data until 2000 or 2003. second, the privatization process has seen many family firms listed, which diluted the percentage of soes (e.g. ding, zhang, and zhang, 2008). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 10 component of board chair pay, and the second is to help induce board chairs to better behave themselves and avoid overpaying themselves. therefore, the main research questions in this study are tested by the signs for γ₁ and γ₂. if γi (i=1,2) is significantly positive, the first aspect of the monitoring effects dominates the second, while the second dominates the firm if γi is significantly negative. however, firm performance and risk may affect the board chair pay in two ways, one of which is an indirect relationship between characteristics of supervisory board and board chair pay. as stated above, the meeting frequency of supervisory board can be jointly determined by the size of supervisory board, the lagged firm performance, the past risk taken by the firm, and other control variables. thus, it is important to separate the monitoring-driven supervisory board meeting frequency (misbmf) from those effects. control variables which should be taken into consideration in equation (1) include the firm size (lnassets), ownership structure variables for the state-owned and foreign shareholders, and a dummy variable indicating whether there is a turnover of the chairman of the supervisory board (sbcturnover). including sbcturnover is consistent with the corporate governance literature (e.g., huson, 2001; goyal and park, 2002; fee and hadlock, 2004), and it is reasonable to believe that a firm with a turnover of the chairman of the supervisory board may meet more frequently to make the transition smooth. therefore, a 2sls model is adopted to illustrate this subtle effect with equation (1) as the first stage and model (2) as the second, at which we use misbmf to replace sbmf. doing so also further helps mitigate the potential endogeneity caused by the interaction between firm performance and characteristics of supervisory board, and strengthens the validity of the analysis. to better illustrate the monitoring effects of major features of supervisory board in chinese publicly listed firms, we further investigate the board chair pay-supervisory board sensitivity by characterizing the marginal effects of change in meeting frequency, as well as those of change in size of supervisory board, on the change in board chair pay. in the board chair pay-supervisory board sensitivity analysis, we use the change in the compensation of board chair (δbcpay) from 2005 to 2006 as the dependent variable, and the change in the supervisory board meeting frequency (δsbmf) between the two years and that in the size of supervisory board (δsbs) as the independent variables. major control variables include the change in firm size (δassets) from 2005 to 2006, the change in risk taken by the firm (δrisk) measured by the d/e ratio (δd/e), the change in firm performance (δfp), and twelve industry dummies. therefore, the basic model for the board chair pay-supervisory board sensitivity analysis is )3(36543210   dummiesindustryassetsriskfpsbssbmfbcpay the pay-supervisory board sensitivity analysis is pushed forward by controlling ownership structure of dominant shareholders following existing literature (e.g., chen et al., 2006; firth et al., 2006) to discover the marginal effects of supervisory board in firms with state-owned largest shareholders and those with foreign shareholders among the ten largest ones. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 11 4. results and discussion 4.1 descriptive statistics we present the descriptive statistics for the sample firms in table 1. in year 2005 and year 2006, the average board chair pay per year was rmb181,630, and the average of its natural logarithm was 7.809. the average supervisory board meeting frequency was 3.577 times in a year, and the average size of the supervisory board was 4.146 members. 35.5% of the companies experienced a turnover of the supervisory board chair. the average number of independent directors on the board of directors was 3.31. firm performance measured by roe was 4.6%, and the average risk taken by firms was an average d/e ratio of 0.231. board chairs in 12% of the firms were also the ceos, 27.3% of them had their largest shareholders government-controlled, and 1.9% of them had foreign largest shareholders. the average level of ownership concentration measured by hhi was 0.0205, and 45.2% of shares were tradable. the average firm size measured by the total book value of assets was rmb3,870 million. table 1 descriptive statistics mean s.d. n bcpay 181,630 351,411 2712 lnbcpay 7.809 5.824 2712 sbmf 3.577 1.676 2754 sbs 4.146 1.44 2762 sbcturnover 0.355 0.479 2648 ibsize 3.310 0.762 2762 roe 0.046 2.328 2742 d/e 0.231 1.037 2742 dual 0.12 0.326 2716 gov 0.273 0.446 2914 govsoe 0.509 0.5 2914 for 0.019 0.135 2914 for10 0.094 0.291 2914 for% 8.351 11.058 273 hhi 0.0205 0.0269 2762 trade 0.452 0.136 2762 assets (million rmb) 3,870 17,300 2742 lnassets 21.247 1.113 2742 description for the above table: the variable bcpay represents the board chair pay. the variable lnbcpay is the natural log of bcpay. sbmf measures the meeting frequency of supervisory board, and sbs is its size. sbcturnover is a dummy variable which measures whether there is a turnover of the chairman of supervisory board in a year. ibsize indicates the number of independent directors on the board. roe is the return on equity which is the ratio between net income and total equity. d/e is a firm’s debt-equity ratio calculated by long-term debt over total equity. dual is a dummy variable which indicates whether the chairman of the board of directors is also the ceo of the company. gov asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 12 is a binary variable indicating whether the government or government representative is the largest shareholder, and govsoe is another binary variable measuring whether the government, government representative, or a state-owned enterprise is the largest shareholder. for is a dummy variable with a value of one for firms with a foreign shareholder as the largest one and zero otherwise, for10 is also a dummy variable indicating whether there is at least one foreign shareholder among the 10 largest ones, and for% is a continuous variable measuring the total percentage of ownership held by foreign shareholders listed among the 10 largest ones. the herfindahl index (hhi) captures the major features of ownership concentration for the 10 largest shareholders, excluding the largest one. trade is the ratio between the number of tradable shares and that of total shares. the variable assets indicates the firm size measured by the total book value of assets, and lnassets is the natural log of it. 4.2 monitoring effects of supervisory board table 2 presents the results from estimating the monitoring effects of supervisory board on the board chair pay based on the ols and the 2sls models, respectively. empirical results obtained from the ols regressions, including or excluding the interaction terms, are presented in panel a. these interaction terms include those between firm performance and ownership structure variables, and those between supervisory board variables and ownership structure variables. results from the 2sls models are presented in panel b. it is clear that the empirical findings from these two models are consistent, and to some degree, they serve as a robustness test for each other. results from the first stage of the 2sls model, with the supervisory board meeting frequency (sbmf) as the dependent variable, are also presented in panel b of table 2. findings are summarized as follows. table 2 monitoring effects of supervisory board on board chair pay panel a. ols regressions and tobit analysis ols regressions tobit analysis coefficient s.d. coefficient s.d. coefficient s.d. coefficient s.d. sbmf -0.023 (0.070) -0.084 (0.081) -0.033 (0.108) -0.123 (0.125) sbs -0.125 (0.085) -0.251 ** (0.104) -0.189 (0.133) -0.380 ** (0.162) ibsize -0.280 * (0.160) -0.273 * (0.160) -0.453 * (0.278) -0.446 * (0.248) roe -0.086 (0.064) -0.134 (0.085) -0.144 (0.099) -0.238 * (0.143) d/e 0.143 (0.114) 0.112 (0.120) 0.223 (0.174) 0.174 (0.183) dual 4.378 *** (0.342) 4.316 *** (0.342) 6.183 *** (0.511) 6.084 *** (0.510) gov -0.125 (0.255) -2.717 *** (0.904) -0.153 (0.395) -4.083 *** (1.402) for -1.832 ** (0.830) 2.400 (3.588) -3.152 ** (1.327) 5.261 (6.114) roexgov 0.109 (0.128) 0.187 (0.201) roexfor 4.303 (5.073) 9.174 (10.434) sbmfxgov 0.287 * (0.151) 0.426 * (0.233) sbmfxfor -0.836 * (0.490) -1.497 * (0.808) sbsxgov 0.370 ** (0.170) 0.570 ** (0.264) sbsxfor -0.323 (0.724) -0.871 (1.244) asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 13 hhi 0.001 *** (0.004) 0.001 *** (0.004) 0.002 *** (0.001) 0.002 *** (0.001) trade 4.936 *** (0.910) 4.940 *** (0.909) 7.627 *** (1.415) 7.599 *** (1.412) lnassets -0.256 ** (0.112) -0.262 ** (0.112) -0.513 *** (0.176) -0.517 *** (0.176) industry dummies included and mixed included and mixed included and mixed included and mixed year dummy -0.470 * (0.241)) -0.471 * (0.241) -0.747 ** (0.373) -0.745 ** (0.372) constant 11.434 *** (2.351) 12.251 *** (2.369) 14.285 *** (3.685) 15.443 *** (3.707) n 2580 2580 2580 2580 adj./pseudo r 2 0.080 0.094 0.017 0.018 f-value 10.36 *** 8.79 *** lr chi-square 230.65 *** 245.74 *** *** p<0.01, ** p<0.05, * p<0.10. n is the number of observations. panel b. 2-stage models stage 1 stage 2: ols stage 2: tobit coefficient s.d. coefficient s.d. coefficient s.d. dep. var. sbmf lnbcpay lnbcpay misbmf -0.059 (0.089) -0.084 (0.139) sbs 0.078 *** (0.024) -0.257 ** (0.107) -0.390 ** (0.168) ibsize -0.023 (0.046) -0.318 * (0.166) -0.523 ** (0.260) sbcturnover 1.067 *** (0.065) roepast 0.008 (0.010) roe -0.146 * (0.086) -0.261 * (0.149) d/epast -0.055 (0.023) d/e 0.089 (0.121) 0.141 (0.187) dual 4.371 *** (0.355) 6.210 *** (0.534) gov -0.199 *** (0.071) -1.931 ** (0.787) -2.962 ** (1.235) for 0.056 (0.233) -1.089 (3.026) -0.882 (5.175) roexgov 0.120 (0.129) 0.208 (0.206) roexfor 4.534 (5.117) 9.809 (10.599) misbmfxgov 0.301 * (0.164) 0.455 * (0.257) misbmfxfor -0.565 (0.572) -1.065 (0.949) sbsxgov 0.416 ** (0.174) 0.645 ** (0.274) sbsxfor -0.292 (0.748) -0.820 (1.304) hhi 0.001 *** (0.000) 0.002 *** (0.001) trade 4.883 *** (0.927) 7.611 *** (1.455) lnassets 0.105 *** (0.031) -0.243 ** (0.115) -0.497 *** (0.182) industry dummies included and mixed included and mixed included and mixed year dummy -0.441 * (0.250) -0.710 * (0.391) constant 1.064 * (0.641) 11.732 *** (2.433) 14.733 *** (3.845) n 2540 2459 2459 adj./pseudo r 2 0.114 0.082 0.018 f-value 17.32 *** 8.33 *** lr chi-square 232.50 *** asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 14 *** p<0.01, ** p<0.05, * p<0.10. n is the number of observations. first, according to the results from the first stage of the 2sls model, a larger supervisory board size and an occurrence of a turnover of supervisory board chair significantly increase the number of meetings held by supervisory board members at the 1% level 7 . these results are as expected. the former effect is potentially due to the lower efficiency of reaching agreement among the members on a larger supervisory board, and the latter effect could show that, if there is a turnover of the chairman of supervisory board in a year, the supervisory board meets more to ensure a smooth transition. in addition, companies with the largest shareholder controlled by government are likely to hold less supervisory board meetings due to the special natures of state-owned or state-controlled enterprises. consistent with the results presented in the literature (vafeas, 1999; firth et al., 2006, 2007), furthermore, a firm with a larger size (lnassets) tends to have more supervisory board meetings. we do not find significant effects of risk taken by the firm in the past year or those of lagged firm performance on the meeting frequency of supervisory board. these results mainly indicate that the supervisory boards in chinese publicly listed companies are not responsible for their daily operation issues, but only for monitoring the behaviors of board of directors and those of top management team (xi, 2006; firth et al., 2006). after taking away the influences of the size of supervisory board, past risk taken by the company, and lagged firm performance, on the variable sbmf, we generate a new variable misbmf to measure the monitoring-induced supervisory board meeting frequency using the residuals from the first stage of the 2sls model, and use it at the second stage. second, while the effects of supervisory board meeting frequency on the board chair pay are insignificant, those of the size of supervisory board are significant at the 1% level. a larger supervisory board tends to reduce the compensation received by board chairs. a possible interpretation is that companies with larger supervisory boards tend to monitor the behaviors of board chairs more efficiently and to lower their compensations. we also find that the number of independent directors (ibsize) has a negative relationship with the dependent variable lnbcpay at the 10% significance level. more independent directors on the board of directors help lower the compensation received by board chairs. what should be further highlighted is that in government controlled companies, both the supervisory board meeting frequency and the number of members on the supervisory board increase the board chair pay significantly (at the 5% level). these results indicate that generally, the monitoring effects of supervisory board for enhancing firm performance may dominate those for avoiding overpays. in these companies, the executives, who are usually representatives of controlling shareholders, may be more likely to receive the fixed component of their compensations from their host organizations and the performance-related component from the publicly listed companies. in these state-controlled companies, therefore, a higher meeting frequency held by supervisory board is more likely to enhance the firm performance, 7 sbcturnover is the instrumental variable. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 15 which can consequently increase the performance-related component of executive compensation. generally, however, board chairs in state-owned or state-controlled companies are more likely to have lower compensation in the publicly listed companies than other board chairs. this may be explained by the fact that board chairs of these companies are also likely to be the government officials or their representatives of governmental and state-controlled organizations, and therefore, they may get paid in their host organizations. in addition, companies whose ceos are also board chairs tend to pay more to their board chairs, and this may be explained in two ways. first, this situation of owner-management reduces the principal-agent agency conflict caused by ownership separation, and therefore helps enhance the firm performance, which may increase the performance-based compensation of board chairs indirectly. second, since the ceos are also board chairs, they may have more significant influences on the board decisions about their compensations; in other words, this phenomenon that a ceo is also the board chair may reduce the monitoring effects of supervisory board. furthermore, control variables, such as ownership concentration (hhi), the percentage of tradable shares (trade), and firm size (lnassets), also influence the board chair pay significantly at the 1% level; the first two have positive effects, while the third one has negative effects. some industry dummies are also shown to be significant. these results are consistent with those presented by prior studies in the literature (e.g., murphy, 1999; firth et al, 2006). 4.3 board chair pay-supervisory board sensitivity results to further investigate the board chair pay-supervisory board relationship, we analyze the pay-supervisory board sensitivity in the full sample, and in the subsamples with special features of controlling ownership such as government control and foreign largest shareholders, respectively. empirical results are presented in table 3. in the full sample, the change in the size of supervisory board (δsbs) is positively related to the change in the board chair pay (δbcpay) at the 5% significance level. this result indicates that before and after the new corporate law became effective on january 1, 2006, when the change in the number of supervisory board members increased by 1 from 2005 to 2006, the change in the board chair pay increased by rmb14,970.89. this partially shows that the enforcement of new corporate law significantly improves the monitoring effects of supervisory board on firm performance from 2005 to 2006, which leads to a higher board chair pay. following extant research (e.g., chen, et al., 2006; firth, et al, 2006) in the literature, we also investigate the board chair pay-supervisory board sensitivity in sub-samples featured by ownership structures. as shown by the empirical results presented in table 3, we find a positive relationship between the change in sbs (δsbs) and the change in the compensation of board chairs (δbcpay) at the 1% significance level in firms with government-controlled largest shareholders. in these firms, when the change in the number of supervisory board members increased by 1, the change in the board chair pay increased by rmb41,911.81. hence, in government controlled firms, board chair pay was sensitive to the supervisory board size, but asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 16 not to the supervisory board meetings frequency, firm performance, financial leverage risk or asset size. in other words, it may be more effective to improve firm performance and board chair pay by increasing supervisory board size in government controlled firms than in other firms. in firms with foreign largest shareholders, however, we do not observe a positive relationship between δsbs and δbcpay. 4.4 robustness tests to further ensure the validity of the empirical results presented in this study, robustness tests are done using both different estimation methods and different variables to capture similar effects. as discussed above, the dependent variable lnbcpay, which measures the board chair pay, is left-censored since some of them do not get paid in these publicly listed companies. therefore, tobit models are used to deal with potential biases caused by this situation. two sets of the above analysis are replicated, and they are the tobit analysis based on model (2) and the 2-stage model with tobit as the second stage. results are presented in panels a and b of table 2, and no qualitative change has been found. to further address a potential overlap of the monitoring functions of supervisory board and independent directors, we rerun the tests by excluding the variable ibsize from the analysis, but do not find any qualitative change. we also test the results for robustness by using alternative proxies for financial performance, risk taken by firms, and ownership structure variables. we have found no qualitative change in the results. to check for multicollinearity, we examine the variance inflation factors (vif) for the variables. the vifs are all under 10, indicating that no multicollinearity problem is serious. the robustness of the pay-supervisory board sensitivity results is also tested by using alternative proxies for ownership structure, and no qualitative change is found. in a word, therefore, we conclude that hypothesis 1 is rejected, but hypothesis 2 is not. table 3 results from pay-supervisory board sensitivity raw sample gov=1 for=1 dep. var. δbcpay δbcpay δbcpay δsbmf -1909.247 -1251.789 17220.16 (2183.10) (4413.65) (19449.69) δsbs 14970.89 ** 41911.81 *** 40396.68 (7278.37) (14345.69) (78855.56) δroe 684.781 1761.114 -113567.1 (1661.69) (2857.51) (83809.20) δd/e 153.73 -11558.68 -382842 (3002.88) (16407.11) (276364.90) δassets 0.000 0.000 0.000 (0.000) (0.000) (0.000) industry dummies included and mixed included and mixed included and mixed constant -7513.121 -35933.94 -22906.36 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 17 (17402.66) (39434.24) (103279.40) n 1290 283 27 adj. r 2 0.002 0.024 -0.074 f-value 1.17 1.43 0.78 *** p<0.01, ** p<0.05, * p<0.10. n is the number of observations. 5. conclusions and future research china is one of the most fast-growing emerging markets in the global economy, and financial integration which has become increasingly popular is of importance for international investors. during the transition from planned to market-based economy in china since late 1970's, the corporate law was amended three times to further improve the efficiency of corporate governance mechanisms; the most recent one occurred in 2005 and became effective on january 1, 2006. the chinese governance mechanism combines the anglo-american and the german systems, and therefore requires having two monitoring organs, independent directors and supervisory boards. while supervisory boards in chinese publicly listed firms have not been considered to function well according to previous studies, the newly amended corporate law 2006 significantly strengthens the monitoring of supervisory boards to help improve the efficiency of corporate governance mechanisms. in the corporate governance literature, the roles of supervisory board are rarely addressed, and therefore, we are among the first to examine its effects on executive compensation. more importantly, we examine the board chair pay-supervisory board relationship by looking deeply into supervisory boards' characteristics and activities, such as their meeting frequencies and sizes. multiple contributions are made to both the academic literature and the practice. in more detail, findings in the current study do not only add to the literature on corporate governance under agency theory, but also provide crucial policy implications for both the chinese authorities and other emerging markets in the world. according to prior research in the corporate governance literature (shleifer and vishny, 1997), two layers of monitoring effects of supervisory board on executive compensation are observed. the first layer says that supervisory board helps induce the chairman of board of directors to better behave themselves and avoid overpaying themselves, and the second is that supervisory board may help enhance firm performance, a basis of the incentive component of executive compensation. these two layers of monitoring effects show the effectiveness of supervisory board in the dual-board corporate governance mechanism in china. the major finding of this study is that the size of supervisory board is shown to be negatively related to the board chair pay, presumably because the monitoring effects of the size of supervisory board on board chair's behaviors dominate those on firm performance. a larger supervisory board tends to meet more frequently, and the joint effects between meeting frequency and size of supervisory board are taken into account. the same monitoring effects as asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 18 above are found. we also find a high level of board chair pay-supervisory board sensitivity in the chinese publicly listed companies in year 2005 and year 2006. these results are counter-intuitive since they are opposite to the findings presented in previous studies. to some extent, these illustrate that the effectiveness of corporate governance mechanism in chinese publicly listed companies has been dramatically strengthened. this is partially shown by the improvement in the functionality of one of the important monitoring organs in the dual-board corporate governance mechanism in chinese publicly listed companies. prior research finds supervisory board’s functionality was very weak, and findings of this study indicate that it has been strengthened after the newly-amended corporate law was effective at the beginning of year 2006. future research can be done along this line by further investigating the effects of supervisory board on the unique corporate governance mechanism in chinese markets. for instance, effects of supervisory board characteristics and activities on firm performance, those on risk taken by firms, and those on financial frauds are three issues which are of importance and of interest for both academic researchers and policy makers acknowledgement we appreciate the helpful comments from two anonymous referees and participants at the 2008 research symposium on corporate governance in china and india, virginia beach, va, co-sponsored by corporate governance, old dominion university, and wiley-blackwell. references aggarwal, r.k., & samwick, a.a. 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(2004), wage reforms in china during the 1990s. asian economic journal, 18, 149-164. microsoft word 3119-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 160 corporate governance – performance relationship in microfinance institutions (mfis) sujani thrikawala (corresponding author) department of finance, waikato management school, university of waikato private bag 3105, hamilton 3240, new zealand tel: 64-7-838-8182 e-mail: sst7@waikato.ac.nz stuart locke department of finance, waikato management school, university of waikato private bag 3105, hamilton 3240, new zealand e-mail: smlocke@waikato.ac.nz krishna reddy department of finance, waikato management school, university of waikato private bag 3105, hamilton 3240, new zealand e-mail: krishna@waikato.ac.nz received: jan. 23, 2013 accepted: march 29, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3119 url: http://dx.doi.org/10.5296/ajfa.v5i1.3119 abstract the relationship between governance and the performance of microfinance institutions (mfis) is discussed in this paper. mfi performance encompasses both financial performance and outreach. good governance in terms of strengthening stewardship, achievement of mfis’ primary objectives and promoting further development of the industry have been asserted as key elements in the literature pertaining to mfi performance. similarly, several cases concerning poor governance have been analysed. good corporate governance has become more important due to the demand for transparency and accountability of funds utilised in microfinance activities. further, mfis need to have a asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 161 solid governance framework to minimise the possibilities of management failures which may jeopardise the efficacious application of received funds from governments and donors. in prior studies, the nature of corporate governance practised by mfis is less understood and no substantive work using multiple mfi outcomes over a number of years has been undertaken. the concerns raised in reviews of individual mfis and normative discussions of what should constitute best practice do point to the need for better understanding of the nature of corporate governance practised by the mfis and also, to understand the nature of the relationship that exists between institutional success and corporate governance especially for developing countries. this study therefore identifies and provides a framework for undertaking corporate governance research relating to mfis. keywords: microfinance institutions (mfis), corporate governance practices, financial performance, outreach. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 162 1. introduction economists and finance practitioners emphasize that the development of the financial service sector is a major factor for the economic development of a country and the economic well-being of its people as it supports people to smooth their income and increase their investment opportunities. it also impacts the social, economic and political environment of a country (calderón & liu, 2003; claessens, 2006; erdal, oguzhan, & ahmet, 2011; houssem & hassene ben, 2011; jeanneney, hua, & liang, 2006; king & levine, 1993). therefore, a country needs to have sound financial systems to offer appropriate access for people to obtain money to improve their standard of living. however, there are millions of people who do not have access to financial services, especially in developing countries and therefore the demand for financial services surpasses the available supply (barr, kumar, & litan, 2007; gobezie, 2005; kathryn, 2005). the microfinance industry has directed to change all that by building a financial market to meet diverse financial needs of under-served people (armendáriz de aghion & morduch, 2004; hermes & lensink, 2011) and emerged merely with the objective of alleviating poverty, especially in developing countries (brau, hiatt, & woodworth, 2009; daley-harris, 2006). in developing countries, the formal banking sector serves only around 20 per cent of the population and the rest of them are catered to by mfis (berenbach & churchill, 1997; robinson, 2001). awareness of the microfinance industry has increased in recent years, bringing the number of mfis from 618 in 1997 to 3,133 in 2005 (daley-harris, 2006). it is estimated that in 2007, there were around 10,000 mfis issuing loans around the world (ming-yee, 2007). consequently, foreign capital investments (both debt and equity) in this industry has more than tripled to usd4 billion (reille & forster, 2008) between 2004 and 2006. at the end of 2010, these investments had quadrupled and were calculated to be valued at usd 13 billion (reille, forster, & rozas, 2011). according to the consultative group to assist the poor (cgap, 2004) approximately 90 per cent of one billion usd of mfi funds are mainly from taxpayers of developed countries. however, investors, creditors, donors and others stakeholders such as employees, clients and governments are now demanding transparency and accountability of funds used in the microfinance activities. in addition, the global financial crisis that started in 2007 has reduced funding availability to mfis and donations have become more difficult to obtain and this increases the pressure to show performance and due diligence (brown & gladwell, 2009; brunnermeier, 2009; erkens, hung, & matos, 2012; van gool, verbeke, sercu, & baesens, 2012). any mfi that neglects adequate control and monitoring may suffer loss of reputation and face increased challenges in terms of achieving a sustainable position in the industry (caudill, gropper, & hartarska, 2009; hartarska & nadolnyak, 2007; lapenu & pierret, 2006; sinclair, 2012). 2. objective of the study according to the centre for the study of financial innovation (csfi, 2008) and other researchers (hartarska, 2005; hartarska & nadolnyak, 2007; mersland & strøm, 2009; rock, otero, & saltzman, 1998), the nature of corporate governance practised by mfis is less asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 163 understood and no substantive work using multiple mfi outcomes over a number of years has been undertaken. this indicates that there is an emerging consensus to conduct more studies on corporate governance of mfis to analyse the relationship between institutional success and corporate governance especially for developing countries. the objective of this study is to identify the relationship between governance and performance of mfis. mfi performance comprises both financial performance and outreach. this paper pursues direction from prior studies and recommends significant corporate governance practices for mfis that can be used as a new approach to enrich their financial performance and outreach. this paper argues that the mfis which maintain good corporate governance practices will be financially and socially sustainable. 3. significance of the study prior studies conducted in different industries and sectors show that good corporate governance practices leads to improved financial performance in companies (brickley, coles, & terry, 1994; chung, wright, & kedia, 2003; dalton, daily, ellstrand, & johnson, 1998; hossain, cahan, & adams, 2000). in mfi performance literature, good governance have been emphasised as the key elements for strengthening stewardship, achieving mfis’ primary objectives and promoting further development of the industry (csfi, 2008; cull, demirgüç-kunt, & morduch, 2007; gant, de silva, atapattu, & durrant, 2002; hartarska, 2005; labie, 2001; mersland & strøm, 2009; rock et al., 1998; van greuning, gallardo, & randhawa, 1998). in addition, some mfi studies point out that the poor governance leads to the poor financial performance and outreach (aboagye & otieku, 2010; bassem, 2009; hartarska, 2005; kyereboah-coleman, 2007; kyereboah-coleman & osei, 2008). prior studies in the mfi area are descriptive or normative about what ought to be done. elsewhere in the finance literature, empirical studies using micro-econometrics have analysed the economic behaviour of firms. the concerns raised in reviews of individual mfis and normative discussions of what should constitute best practice do point to the need for better understanding of the nature of corporate governance practised by the mfis and also, to understand the nature of the relationship that exists between institutional success and corporate governance especially for developing countries. in this paper a proposed method is described. the advantages of the approach and consequential contribution are noted. 4. literature review in the microfinance literature, governance first appeared in 1997 and emphasised the relationships between boards of directors and the management of mfis (lapenu & pierret, 2006). further, existing literature emphasises the importance of corporate governance for the microfinance sector as it is a significant factor for enhancing the viability of the industry (hartarska, 2005; labie, 2001; mersland, 2011; mersland & strøm, 2009; varottil, 2012). kirkpatrick and maimbo (2002, p. 293) point out that “five years after the notable paper by berenbach and churchill (1997) on microfinance regulation and supervision, the appropriate level of government-supplied regulation in the industry remains unclear. although subsequent studies have successfully identified the basic options available to regulators, namely, no asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 164 regulation, self-regulation, existing banking regulation, and special regulations, the literature has yet to establish a clear set of core principles which national regulators can translate into specific performance benchmarks, guidelines, rules and regulations.” most previous studies in this area are related to consultancy reports and general guidelines on governance. these guidelines and consultancy reports are usually applied to all industries, though some of guidelines are given for specific industries. however, general guidelines on corporate governance have not been put into practice by mfis (arthur, garvey, swan, & taylor, 1993; mersland, 2009). besides, general guidelines for corporate governance are not adequate for mfis as there are cultural and regional differences that require the development of a specific framework for corporate governance (gant et al., 2002). varottil (2012) stated that mfis need a specific corporate governance framework even when they are examined through a theoretical perspective. as stated by labie (2001), an agency costs’ framework can be applied to the microfinance sector and he emphasises outreach performance rather than financial performance should be a priority for mfis. this is highly important for mfis compared with traditional firms in terms of assessing their corporate governance. however, mersland and strøm (2009) state that an agency cost framework cannot be applied to mfis to deal with the relationship between financial performance and outreach. in the microfinance sector, corporate governance issues are subjected to a different set of factors that successfully target the core of the relationship between financial performance and outreach. further, the researchers examined the relationship between firm performance and corporate governance in mfis by using secondary data of third-party rating agencies and suggest that there is a relationship between mfi performance and governance. bassem (2009) uses a self-conducted survey, annual reports and mixed market data for his study on governance and performance of mfis in mediterranean countries and highlights that governance mechanisms can improve the performance of euro-mediterranean mfis in relation to outreach and sustainability. lapenu and pierret (2006, p. 10) convey that the “good functioning” of the board of directors is not enough to guarantee the success of mfis. other governance mechanisms probably play a more important role. it is necessary to broaden the scope of a study to include all stakeholders involved (employees, managers, elected officials, clients, donors, bank partners, shareholders, the government, etc.) as well as any organisational form with a “governing” role that may have been set up at the inception of the institution . mersland (2011) recommends in his study that stakeholders such as donors, depositors, local communities and bank associations can provide a monitoring system to boost the existence of mfis. however, the increasing popularity of microfinance as a development and anti-poverty tool has pushed the industry towards financial self-sufficiency and created a tension between the mfi’s dual mission of financial self-sufficiency and social orientation (sinclair, 2012). furthermore, varottil (2012) and sinclair (2012) point out that the commercialisation of mfis from non-profit institutions to for-profit institutions has created several issues in the industry. even if the commercialisation of mfis has assisted in scalability and outreach by broadening asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 165 the scope of financial support for poor people, it has caused mfis to turn back their social goals. according to arena (2012), at present microfinance providers of are drifting away from their mission and corporate governance is being blamed, because the existing corporate governance practices available to mfis are only influencing their ability to raise capital and that has created a perception that private interests are benefiting from the vulnerability of the poor. it is necessary to find out to what extent corporate governance pays attention to the interests of the poorer sections of society as stakeholders (mersland & strøm, 2010). through the application of social corporate governance, mfis can pay more attention to the poor stakeholders and mitigate the problem of getting away from the mission. as arena (2012, p. 269) stated, “unlike traditional corporate governance mechanisms, the social corporate governance is designed to vindicate the organisation's social and development goals. the social corporate governance mechanisms, when properly balanced against traditional corporate governance structures, alleviate the tension between financial and social development goals and provide a solution to mission drift in microfinance.” by shifting from financial aspects of governance, it is timely and important to focus on social aspects of governance to identify the appropriate corporate governance mechanisms for mfis. the financial feasibility of mfis can develop by having a rational approach toward financial objectives (mersland, 2011). 5. corporate governance for mfis even though many studies have been conducted to identify the relationship between corporate governance practices and firm performance, there are limited scholarly studies conducted for the microfinance industry in relation to corporate governance. the empirical analysis of good corporate governance practices in relation to mfis is still at an immature stage and it is important to conduct more studies in this field to enhance mfis’ development (bassem, 2009; cull et al., 2007; hartarska, 2005, 2009; hartarska & nadolnyak, 2007; mersland, 2009; mersland & strøm, 2009). however, there is plenty of empirical evidence in the financial literature that supports the view that good corporate governance enhances the performance of a firm. the same rationale recommends that good governance practices of mfis would enhance their performance and reduce risk. therefore, it is important to examine the empirical evidence of corporate governance mechanisms that improves firm performance. previous studies done by different scholars have recognised certain aspects, such as board composition and characteristics, and their impact on firm performance (bhagat & black, 1999; daily & dalton, 1997; kula, 2005; lorsch & maciver, 1989; muth & donaldson, 1998; roberts, mcnulty, & stiles, 2005). they revealed many factors to measure the corporate governance practices of a firm, such as number of directors/non-executive directors, board diversity, board size, director ownership, board compensation, ceo/chairman duality, education qualifications of board members, performance assessment of board, number of board meetings, debt and dividends (bathula, 2008; bhagat & black, 1999; daily & dalton, 1997; huse & solberg, 2006; kyereboah-coleman & biekpe, 2006; lorsch & maciver, 1989; roberts et al., 2005; singh & vinnicombe, 2004; solomon, 2004). a number of studies have asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 166 also investigated the relationship between corporate governance mechanisms and organisational performance (kiel & nicholson, 2003; pearce & zahra, 1989; rose, 2007; wan & ong, 2005). 5.1 board diversity in recent years, the phrase ‘board diversity’ has become entrenched in the corporate governance vocabulary. the alliance for board diversity in 2010 found that 72.9 per cent of directorships in fortune 100 companies were held by white men and the rest were held by minorities and women. the board diversity concept suggests that boards should reflect the structure of society and properly represent the gender, ethnicity and professional backgrounds of those within it. boards of directors in a company need to have the right composition to provide diverse viewpoints (milliken & martins, 1996). board diversity supports on the basis of moral obligation to shareholders, stakeholders and for commercial reasons by obtaining extensive decisions (daily & dalton, 2003; kasey, thompson, & wright, 1997; mattis, 2000). gender diversity is considered part of the broader conception of board diversity (milliken & martins, 1996) and many scholars (huse & solberg, 2006; singh & vinnicombe, 2004; walt & ingley, 2003) have shown that few women sit on corporate boards. even though daily, certo, and dalton (2000) found similar results in usa, they also found that women’s representation on boards is gradually increasing. most women directors are not from the corporate sector but are usually outsiders or non-executive directors (hillman, cannella, & harris, 2002). when compared to men, most women directors possess staff/support managerial skills, such as legal, public relations, human resources and communications rather than operating and marketing skills. however, gender is one of the most discussed issues, not only in the corporate governance research but also in political and societal environments. several scholars have empirically tested the consequences of women directors on firm performance (carter, simkins, & simpson, 2003; farrell & hersch, 2005; fields & keys, 2003; smith, smith, & verner, 2006). according to smith et al. (2006), women directors on boards have a significant positive impact on firm performance. carter et al. (2003) find a positive relationship between gender diversity and firm performance. in the mfi context, bassem (2009) notes that board diversity with a higher percentage of women enhances mfi performance. based on the indication given by many empirical studies, it is important to further explore the impact of gender diversity of boards on mfi performance as it leads to better corporate governance provides diverse viewpoints, values and new ideas to the boards and provokes lively boardroom discussions (burke, 1997; daily, certo, & dalton, 1999; huse & solberg, 2006; pearce & zahra, 1991; singh & vinnicombe, 2004). therefore, this study argues that mfi boards are likely to have a high level of diversity. 5.2 board size board size is the number of members on a board. there is a belief that the number of directors can affect the performance of a company, especially its financial performance. a asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 167 number of scholars have contended that larger boards have their benefits and when board size increases firm performance also goes up as more board members provide greater monitoring, advice and make available better linkages to the external environment (adams & mehran, 2003; coles, daniel, & naveen, 2008; hillman & dalziel, 2003; klein, 1998; pfeffer, 1972). it is easier for larger boards to monitor their managers’ activities more effectively, but it would be difficult for the ceo to control the board (pearce & zahra, 1989). due to the complexity of the organisation, the ceo of the organisation needs many advocates (klein, 1998). in non-profit organisations, when the board has a higher number of trustees, it is easy for them to deal with operational issues and wield more control over operating activities (oster, 1995). also, charitable organisations can improve their efficiency with larger boards (tinkelman, 1999). mersland and strøm (2009) note in their mfi study that most mfis have a board of seven to nine directors. bassem (2009) states that large boards with a range of expertise provide better performance for mfis. however, yermack (1996) points out larger boards are related with lower performance for mfis. furthermore, armendariz and labie (2011) emphasise that it is important for mfis to select board members with an appropriate background who are able and willing to dedicate the time that effective monitoring requires. the appropriate number of board members has been a matter of continuing debate and research gives mixed results (dalton, daily, johnson, & ellstrand, 1999; hermalin & weisbach, 2003; jensen, 1993; yermack, 1996). it can be seen that the number of members on a board influences firm performance as numbers affect the ability of the board to carry out its functions. therefore, it is important to consider board size for further studies for differently structured firms such as mfis. 5.3 independent directors the reason for using this variable is due to the different ideas about the impact of outside directors and also to assess the composition of the board. lorsch and maciver (1989, p. 17) state that “there has been a growing predominance of outside directors who are there not only to provide a new perspective to top management’s thinking, but also to provide the necessary oversight only possible from an outsider”. agency theory is highly concerned about board independence and the balance between executive and non-executive directors on the board (bathula, 2008). lorsch and maciver (1989) highlight that 74 per cent of directors are outsiders and among them, 69 per cent are non-management personnel with no other contacts with the organisation. agency theorists highlight that independent boards will increase firm performance (dalton et al., 1998; hillman, cannella, & paetzold, 2000; lynall, golden, & hillman, 2003; van den berghe & levrau, 2004). as illustrated by dahya, dimitrov, and mcconnell (2008), there is a positive relationship between firm performance and the proportion of outside directors. in an mfi context, hartarska (2005) used rated and unrated mfis in eastern europe to investigate the relationship between corporate governance and mfi success and his results show that more independent boards give better return on assets (roa) whereas lower financial performance and outreach showed for the boards with employee directors. lapenu asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 168 and pierret (2006) highlight the tradeoffs between outreach and financial performance of mfis, finding tradeoffs to be influenced by stakeholders’ representation on the board and providing strong support for independent boards with limited employee participation. based on the findings stated above, this study argues that mfi boards are likely to have more independent stakeholders. 5.4 ceo/chairman duality ceo/chairman influence on the board is recognised as ceo/chairman duality, which is one of the important practices in corporate governance. duality is when the roles of ceo and chairman are carried out by the same person. fama and jensen (1983) note that firms that separate the two functions have improved performance. agency theoreticians highlight the separation of the role of ceo and chairperson (dalton et al., 1998; jensen, 1993; muth & donaldson, 1998). jensen (1993) argues that if the function of the chair is to hire, fire, evaluate and compensate the ceo then this cannot be done when both roles are combined. therefore, the chairperson function must not be under the control of the ceo. ceo duality restricts the independence of board and reduces the ability of boards to perform their oversight and governance roles (millstein & katsh, 2003). in the mfi context, mersland and strøm (2009) state that ceo/chairman duality has a positive influence on outreach of mfis and when there is a female ceo, mfi improves its’ financial performance. further, they highlight that they cannot approve whether the mfi is better governed when the ceo and chairman are seperated. therefore, it is important to use this characteristic to understand the power of a firm, whether both important positions belong to one person or not. if both roles are performed by one person, boards of directors will be ineffective in discharging their monitoring duties, as opportunistic behaviour by the ceo will reduce firm performance. thus, the ceo/chairman influence on the board is used to clarify the impact on firms’ performance. similar reasoning can be applied to the microfinance industry where ceo/chairman duality has a positive effect on firm performance due to the effectiveness of decision making and monitoring (allen and gale, 2000). 5.5 ownership type many policy papers report that the most appropriate ownership type for mfis is a shareholder firm that can be regulated by the banking authorities and remain independent from donors (christen & rosenberg, 2000; hardy, holden, & prokopenko, 2003; jansson, rosales, & westley, 2004). such mfis will be able to benefit from corporate governance due to private ownership. this underlines a need to transform non-profit mfis to for-profit ownership (ledgerwood & white, 2006). prior studies have pointed out that most mfis are now commercialising their institutions from non-profit to for-profit as shareholder firms can perform better than non-profit organisations (hardy et al., 2003; ivatury & reille, 2004; ledgerwood & white, 2006) and are a solution to provide low-cost credit to greater outreach (varottil, 2012). however, in recent mfi studies, hartarska (2005), mersland and strøm (2009) and sinclair (2012) find that the for-profit organisations’ ownership structure does not advance mfis’ asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 169 performance. mersland and strøm (2009) further reveal that ownership of mfis does not matter for firm performance. however, the relationship between firm performance and ownership is ambiguous and needs to be investigated. based on the recent findings stated above, this study emphasises the need to consider the proportion of majority ownership of the firm; whether the mfi is a non-profit organisation, for-profit organisation, member-based cooperative, or shareholder-owned firm and which of these structures is likely to demonstrate better performance. 5.6 corporate mission the relationship between firm performance and mission statement has commonly been discussed in the strategic planning textbooks but remains unanswered (bart & baetz, 1998). more focus has been given to identifying the components of the mission statement. very few studies have focused on mission statement and firm performance research. bart, bontis, and taggar (2001) point out that mission statements have a positive relationship with performance and can make a positive contribution towards performance. they also find there are intervening variables which need to be considered when assessing the relationship between mission statement and performance. zachary, dana, and israel (2008) reveal that some israeli firms with formal and written mission statements demonstrate improved performance. in mfi related studies, some scholars are highly concerned about the clear definition of social goals which help to structure mfi activities to reach more borrowers. arena (2012) notes mfis have a problem with drifting away from their mission and corporate governance is being blamed. rock et al. (1998) state that it is important for mfis to define their mission clearly and to accurately communicate it to the institutional stakeholders, such as donors, lenders, staff and clients. johnson, malkamaki, and wanjau (2006) explain how donor agencies were focusing on the results that mfis achieve and were checking whether they were connected directly to the goals and objectives of mfis. however, no studies have been conducted on how or the extent to which the mission of mfis affects the performance of mfis. it is argued that mfis need to concentrate more on their dual mission, and therefore it is important for mfi studies to consider the relationship between the mission of mfis and their performance. 5.7 internal and external auditors selecting the firm’s auditor is an internal governance mechanism and links with firm performance. the internal auditor’s functions offer firms an independent assurance and consulting service to evaluate and improve the effectiveness of risk management, control and governance processes (institute of internal auditors [iia], 1999). the execution of internal audit functions are highlighted in the prior literature (antoine, 2004; goodwin & kent, 2003; mccollum, 2006) and governance reports (iia professional guidance, 2002; new york stock exchange [nyse], 2002) as a mechanism for improving a company’s internal governance. if internal auditors report directly to the board and they are independent, then there is good accountability and transparency available in the firm (mersland & strøm, 2009; sinclair, 2012). this study, therefore, will consider internal auditors as a good corporate governance asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 170 mechanism to enhance mfi performance. agency theorists note a number of external controls for self-serving agents; among them are external audits (cohen, krishnamoorthy, & wright, 2002). the external auditor is considered to have an effect on the efficiency of corporate governance. fan and wong (2005, p. 37) stated that “our overall results suggest that external auditors play a governance role in east asia”. the monitoring function performed by external auditors is believed to play an essential role in ensuring the quality oversight that the companies have achieved in their financial reporting practices. also, external auditors can provide an assurance about the quality of accounting information which is publicly reported and enable to attract outside stakeholders (becker, defond, jiambalvo, & subramanyam, 1998; klein, 2002; peasnell, pope, & young, 2005). where a firm conducts external audits or reports directly to the board, and whether it issues an audited report, highly affects the performance of mfis. bassem (2009) and mersland and strøm (2009) highlight that audited financial statements improve mfi performance and need to be considered for further studies. 5.8 type of donors the community investment movement has clearly demonstrated that investments offering minimal returns but with social value are successful for all stakeholders particularly for the microfinance industry. the affordable housing market in the usa is such a segment. it has numerous government incentives for investors, like guarantee funds and the community reinvestment act (cra) to motivate banks. thus, the proportion of funds received from non-governmental institutions and/or foreign funds needs to be evaluated (martyn & gousmett, 2011). in non-profit organisations, large donors are acting in a similar way to blockholders in for-profit organisations by ensuring that the organisation’s resources are used in an effective manner (de andrés-alonso, romero-merino, & cruz, 2006). most of large donor funds have their own mfis and actively manage all their mfis (sinclair, 2012). frumkin and kim (2001) state that large donors act like efficient monitors with their skill and power by demanding detailed plans, budgets and information for each project. it is important to consider types of donors as they represent the vertical relationship with the mfi (mersland, 2009). 5.9 regulatory and commercial environment among the external factors, the level of regulation in the microfinance sector and the commercial environment influence the manner in which mfis deal with their performance. the current study takes into consideration the country-specific macroeconomic variables such as inflation rate, gdp growth rate, banking and financial reforms as these are considered to be the external dimension of the firm (mersland, 2009) and they also affect the performance of mfis (meyer, 2002; sinclair, 2012). bassem (2009) states that international ratings and external governance mechanisms assist mfis to reach their financial goals. the mfi sector needs specific, dedicated and qualified regulators who understand this sector particularly (sinclair, 2012). further, he states that the rating agencies should reduce due diligence expenses and provide more information about mfi investments. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 171 even though a proper regulatory environment can streamline mfi activities, the available evidence indicates that it increases the cost of operation, but it is not clear whether it impacts the profitability of mfis (cull et al., 2007). therefore, it is confirming that the external governance mechanism plays a limited role in mfi performance (hartarska, 2009; hartarska & nadolnyak, 2007). however, the implications arising from the regulation and commercial environment of mfis cannot be ignored in the governance framework (varottil, 2012). it is argued that better reforms can improve mfi performance (christen & rosenberg, 2000; hardy et al., 2003; jansson et al., 2004; sinclair, 2012). based on the related studies, it is important for mfis to have better regulatory and commercial environments to perform their activities. 6. conclusion this study identifies significant corporate governance factors that influence both the financial performance and outreach of mfis. good corporate governance practices relate to both the internal and external areas of mfi activities including for example fiduciary responsibility and social impact of funded activities. it is important to determine those corporate governance practices that have the greatest impact on the mfi performance and accordingly afford the potential to contribute the greatest significant impact on improving mfis’ performance in long run. little consideration has previously been given to the mapping of outcomes with the mfi mission statement, measuring impact and evaluating processes for enhanced outreach. the audit function, both internal and external, in mfis by providing more transparence and accountability for stakeholders, which will be of significant value to donors and investors. this study makes an advanced contribution to the understanding of corporate governance practices in mfis, identifying and developing an appropriate governance structure. this governance structure mechanism will enable mfis to conduct their operations with special reference to the social performance approaching poor people who require economic development for their lives. in prior studies, the nature of corporate governance practised by mfis are less understood and no substantive work using multiple mfi outcomes over a number of years has been undertaken. the concerns raised in reviews of individual mfis and normative discussions of what should constitute best practice do point to the need for better understanding of the nature of corporate governance practised by the mfis and also, to understand the nature of the relationship that exists between institutional success and corporate governance. this study points to the need for further empirical research for mfis using micro-econometric techniques, such as regression analyses of panel data to support the conceptual literature currently available. insights for national policy makers regarding corporate governance practices, within specific countries, flows from the analysis undertaken. a positive impact of this study for the microfinance industry is to observe how mfis can be strengthen to achieve better performance. the findings should encourage mfis to consider further significant governance factors which will improve and sustain the industry. the relationship between funding and outreach is an example that informs donors’ desire and decisions. the negative side is that the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 172 donors and investors may avoid mfis that are not considering the good governance practices. the microfinance sector needs to be more effective if it wants to become the miracle cure for poverty. now the sector is attempting to reinvent itself. this study also point out guidance for selecting directors for mfi boards based on their academic and professional qualifications. the role of board members in terms of their fiduciary responsibility can be extended to improve the outreach and impact for the betterment of mfis’ overall performance by progress monitoring. for instance, appointing directors who have finance qualifications to monitor the financial activities of the mfi, a social director who ensures that the mfi adheres to its social mission and a director representing the borrowers of the mfi; 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(2008). mission statement and performance: an evidence of "coming of age". organization development journal, 26(2), 49-62. microsoft word paper-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 52 the global financial crisis impact on ethnic diversity of sri lanka boards nirosha hewa wellalage (corresponding author) department of finance, university of waikato management school hamilton, new zealand tel: 64-(7)-838-4466 ext 6687 e-mail: nirosha@waikato.ac.nz stuart locke and frank scrimgeour university of waikato, hamilton, new zealand received: january 5, 2012 accepted: january 26, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1243 url: http://dx.doi.org/10.5296/ajfa.v4i1.1243 abstract this study investigates the link between ethnic minority directors and agency conflict in sri lankan listed companies during a global financial crisis. due to social and economic pressures in recent decades, ethnic minorities now make up a larger proportion of directors on corporate boards in sri lanka. in addition, the global financial crisis has increased demand for boards to strengthen their ethnic diversity in workplaces. this study shows that while sri lankan boards increased the number of ethnic minority directors during the global financial crisis, heterogeneous boards increased company agency costs. this evidence provides insights for governments and policy makers as they consider board ethnic diversification in an emerging and highly uncertain environment. keywords: ethnic minority directors, board structure, agency costs, sri lanka jel classification: g34 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 53 1. introduction the large corporate failures that occurred at the beginning of the 21st century may have damaged confidence in many economies. fraud and bribery were seen as contributing to company collapses. europe was significantly impacted by the global financial crisis in 2007. it affected the asian region in late 2008 and led to the realisation that if boards wanted to improve their corporate governance practices they needed to diversify their composition. as a result, corporate board structure has been debated extensively and subsequently improved in several countries. legislation includes the higgs review (2003), and corporate governance best practice in sri lanka (2008) which recommended more recruitment of non-executive directors from diverse backgrounds, including ethnic minorities, to maintain board independence. according to mattis (2000), boards need to represent the diversity of the firm’s customer base and labour force. if a board discriminates against a specific group, especially ethnic minorities, this implies arbitrage possibility, because underutilised valuable human capital (gregoric et al., 2009). therefore, a well-diversified board with many ethnic minority directors can be instrumental for company success in financial hard times, especially in a global financial crisis. the global financial crisis has increased demand to strengthen board ethnic diversity in the workplace, because during the hard times company willingness to follow business ethics which are watching by stakeholders due to less incline to commit misconduct. the influence of different viewpoints of diversified directors can improve firm creativity, especially in a complex and competitive environment (macfarlane et al., 2010). however, hill (2004) says due to the global financial crisis and lack of financial resources, few women and minority ethnicities are recruited to boards across all industries. in addition, there is a high financial cost involved in recruiting, co-ordinating and accommodating diversified employees and boards (hambrick et al., 1996). this may be another reason for less board ethnic minority recruitment in a global financial crisis. ethnic minorities were underrepresented on corporate boards in early years, but that began to change in the late 1990s (farrell & hersch, 2005). however, that change has been slow. brammer et al. (2007) show from their 463 study sample of uk listed firms, only 0.2% have non-white board directors. homogenous board “group thinking” can be harmful, especially in a global financial crisis, because board members thinking patterns are too similar in decision-making processes (“corporate governance”, 2011). therefore, corporate boards need to be more diversified to provide greater knowledge, creativity and competitive edge to a company. the competitive global market provides a compelling business argument for more diverse boards with minority directors. if the homogeneity of corporate boards raises significant ethical, economic and social issues, then a more diverse board with increased ethnic minority representation may help solve that situation. board internationalisation is another reason for adding more non-national directors (minority directors). due to globalisation, in 2009 european boards averaged 23% non-national directors, an increase of 11% since 2008 (“boards in turbulent times”, 2009). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 54 to overcome the influence of the global financial crisis, most emerging economies try to strengthen rules and regulations. due to high uncertainty and weak legal regulations, most of the emerging markets have faced recession in recent years. through board diversity, most developed markets try to maximise their profit in financial hard times, because board diversity increases board monitoring. emerging markets’ institutional structures and practices are different from developed markets so applying the same board diversity argument to emerging markets remains doubtful. though there have been studies of ethnic diversity on top management (marimuthu, 2008; roberson & park, 2007) and its effect on firm financial performance, this is the first study to especially concern itself with board ethnic diversity during a global financial crisis period. moreover, this study shows board ethnic diversity impacts on firm principal-agent (pa) and principal-principal (pp) agency costs. although there have been contemporary studies on board diversity and pa agency costs, pp agency costs and board ethnic diversity relationship has not been widely discussed in prior literature. this is first study to provide evidence of board ethnic diversification and its impact on pa and pp agency costs in emerging market firms. additionally, studies on board ethnic diversity present reverse causality and endogeneity issues and due to this, it is still unclear whether more successful firms have greater capacity to adopt more ethnic diversity or if more ethnic diversified boards lead to better performance. however, this study controls potential endogeneity effect in regression technique. the next section reviews prior research, develops the hypotheses and is followed by discussion of data, variables, methods and procedures used for this empirical study. the results and conclusion then follow. 2. literature review cultural differences, ethnicity and demographic differences are known to affect business practices, organisational structure, account disclosure and audit practices (haniffa & cooke, 2002; yatim et al., 2006). a uk-based study finds that many institutional investors prefer diversified boards with more female or minority directors (brammer et al., 2007). this may be because minority directors promote more effective global relationships, and ethno-cultural diversity makes corporate leaders more sensitive to other cultures, especially in business internationalisation (wang & clift, 2009). however, based on the theory of stereotype threat, majority members may underestimate minority contributions (frances & lmartins, 1996) and ethnic minority directors may not be able to perform well in the workplace, especially in an economic downturn. carter et al. (2003) study fortune 1000 companies and find companies with two or more ethnic minority board directors perform better than companies with no ethnic minority directors. erhardt et al. (2003) using 127 us large companies, suggest a positive association between ethnic minority directors’ percentage and financial performance of the company. this may be because directors from different ethnic backgrounds have a broader view and a large pool of information to contribute to the decision-making process. similar to the above findings, carno and chen (1998) posit ethnic diversity of board directors increases the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 55 decision-making quality of the company and strategic analysis. further, introduce ethnic diversity on corporate board leads to increase competitive advantage and strategic analysis ability of the firm. ethnic diversity increases board independence, because people with different cultural backgrounds raise more questions than do a homogenous group of directors (carter et al., 2003; laughlin, 1992). in emerging market findings, haniffa and cooke (2002) find the ethnic background of directors is significantly related to company financial performance. using malaysian top 100 non-financial companies listed on the stock exchange over a six years, marimuthu (2008) explains that ethnic diversity enhances firm financial performance. furthermore, he explains a one unit increment of board ethnic diversity leads to an increased six units in firm performance. johnson & mitton (2003) and gomez & jomo (1997) explain malaysian ethnic-favoured firms appear to have poor corporate governance practices and higher agency costs due to being ethnically favoured and politically connected. board independence is critical for boards to function and to align the interests of shareholders. in other words, more ethnically diversified boards are more independent and reduce agency conflict. however, a diverse top management team leads to conflict of interest and increases the agency costs, especially in high uncertainty markets. using 227 malaysian public listed companies, foo & zain (2010) find that high ethnic minority director levels increase information asymmetry in malaysian firms. thus, increasing ethnic diversity in the board room could have adverse consequences for the company. davidson (2002) argues that women and minority workers are disadvantaged compared to their white male counterparts and for this reason the minority may underperform. this may be based on the theory of tokenism, which explains minority members face difficulties performing to their potential in the workplace because the tokens are forced into stereotypical categories defined by the dominants (reskin et al., 1999). moreover, based on the stereotype threat, research indicates that minority groups underperform in the workplace, because they feel they are being judged as group rather than individuals (spencer et al., 1999; steele & aronson, 1995). 2.1 agency costs costs associated with a lack of goal congruence between two parties were brought to the fore by ross (1973) and were further explored by jensen & meckling (1976). these costs are often referred to as agency costs and can occur between a principal and agent (pa) and also between principal and principal (pp). a pa problem arises when agents pursue their own goals rather than the goals of the principal. it is the result of conflicting interests among managers and owners and asymmetric information (chrisman et al., 2004). the pp situation is best described as a firm with one large shareholder and a fringe of small shareholders (villalonga & amit, 2006). in such a firm, the traditional pa agency conflict is alleviated due to the large shareholder’s greater incentives to monitor the manager, but, a second type of conflict emerges as large shareholders exercise their substantial control and influence over firm matters and, as agency theory suggests, they have incentives to consume the firm's resources at the expense of the minority shareholders (anderson & reeb, 2004). due to weak rules and regulations and a weak organisational and institutional environment, asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 56 pa agency costs may prevalent in sri lanka. on the other hand, due to the fact that more than 64% of sri lankan-listed businesses are family firms, family or individual expropriation can be common in sri lanka. therefore, pa and pp agency costs compound issues in the sri lankan market. 2.2 ethnic minority in sri lankan boards sri lanka, a lowermiddle-income island located in the indian ocean, has made considerable progress in human development, such as literacy and life expectancy. there is nothing in the languages or religious systems in sri lanka that officially promotes the social segregation of their adherents; however, based on language and religion, there are four major ethnic groups in sri lanka. the sinhalese are the largest group, representing approximately 74% of the total population. the tamils are the major ethnic minority and make up 18% of the population. around the world companies are facing increasing pressure to appoint ethnic minority senior officers and management. many recent proposals of governance reform explicitly stress the importance of ethnic diversity in the boardroom. however, this is significantly high in sri lanka compared to the us and other developed countries. figure 1.1 shows minority directors in sri lankan companies since 2006 (excluding the banking and finance sector). this figure is roughly constant and has stayed around 40% since 2006. however, a us based study shows that in 2010 only 9% of directors from s & p 500 companies are of ethnic minority ("hot topics", 2011). notably, this figure is down from 12% in 2008 and 2009 and 11% in 2007. this shows the ad-hoc manner of ethnic minority recruitment in us boards. nevertheless, figure 1.1 clearly shows minority board representation has increased in sri lanka since 2006. this may be due to the following reasons. the first major reason is corporate governance reform in sri lanka (2008) has promoted board independence. based on agency theory, boards that have more ethnic minority directors may be more effective in monitoring on behalf of shareholders. therefore, companies may select non-executive directors form ethnic minority groups. the second reason is the global financial crisis, which resulted in sri lankan firms increasing board diversity through ethnic minority directors. according to hoffman & maier (1961), it may be that group diversity increases problem solving capacity in sri lankan firms in financial crisis. moreover, an ethnically diversified board may have “signalling value” for sri lanka. therefore, sri lankan companies add more ethnic minorities in a global financial crisis. another reason is that after the civil war, the majority of businesses expanded into northern and east areas of sri lanka, which have more ethnic minorities. therefore, after 2009, ethnic minorities engage more in investment and they became board directors and hold more shares. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 57 figure 1. ethnic minority representation in sri lankan listed companies’ boards based on social psychology, zander (1979) finds that group loyalty depends on similarities of group members. further, adams & ferreira (2002) explain this kind of trust is specially required in high environmental uncertainty. this finding is consistent with kanter (1977) who explains that in a high uncertainty environment, costs are created when adding more ethnic minorities. also based on social choice literature, arrow (1951), explains collective decision making increases the cost of communication. this is because conflicts of interest may increase in heterogeneous groups. therefore, adding more ethnic minority directors in sri lankan firms, especially in a global financial crisis, needs further attention. 3. methodology 3.1 data the sample for the panel data analysis embraces non-financial firms listed on the colombo stock exchange (cse) before and during the recent global financial crisis. like other asian countries, sri lanka felt the global financial crisis later than western countries (rathnayake, 2009). based on stock market price index changes, this study identified the global financial crisis effect in sri lanka in the last quarter of the 2008 financial year. therefore, using the year 2008 as a benchmark, this study use two sample of data sets. that is, the global financial crisis data set (2009) and the before the crisis dataset (2007). the data is gathered from two cse publications (fact book 2008 and handbook of listed companies 2007) and individual companies’ audited annual reports. as at 2009, the cse had 203 listed non-financial companies representing 19 business sectors. from that 203, four companies did not provide all relevant data. instead of choosing a random sample, this study includes the remaining 199 companies. dependent variablefollowing ang et al. (2000) and singh & davidson (2003), the assets utilisation ratio is used as a pa agency proxy for this study. assets utilisation is defined as total sales divided by total assets. pa agency cost is inversely related with the assets utilisation ratio. john & knyazeva (2006) explain that when firms have poor governance they may have a higher dividend payment policy. moreover, deangelo & skinner (2004) find that asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 58 firms with high agency conflicts are more likely to pay dividends than firms with fewer agency conflicts. therefore, this study employed dividend payout ratio as proxy for pp agency costs. similar to faccio et al. (2001), dividend payout ratio is defined as total dividend payment divided by net sales. explanatory variablesas proxies for the ethnic diversity of the board of directors, two variables were used. the first variable is the percentage of minority directors (mino) on the board. this is calculated as the number of minority directors divided by the total number of board directors. the second variable is dummy variable (dmino), which takes a value of 1 when at least one minority director is present on the board and 0 otherwise. the following variables are included in this study. board size (board), defined as logarithm of the total number of directors. owner is dummy variable, which takes a value 1 if company is local, otherwise 0. leverage is calculated as the ratio of total debts to total assets (debt), firm size (lnsales) is defined as logarithm of the total sales of the company. as a performance measure, the return on assets (roa) and firm maturity (age) are measured by the number of years operating in the industry. descriptive statistics for all variables are presented in table i. table 1. descriptive statistics variable obs mean crisis st. dev crisis mean-health st. dev crisis pa 197 .8642145 .7122445 .872132 0.738975 pp 197 .125082 .5089497 .093886 0.365995 mino 196 .3984105 .2704389 .395126 .2641468 dmino 196 .877551 .3286431 .873684 .33384 board 194 7.309278 2.001869 7.25883 1.954178 owner 199 .567 .4966258 .5678939 .496626 lnsales 197 13.53964 2.237536 13.36782 2.238855 lndebt 199 .2336866 .19302 .3099313 0.193580 roa 198 .0249774 .0776468 .034171 0.082983 lnage 197 .1680019 .758504 0.153698 0.700688 table 1 indicates descriptive statistics of variables. statistics for each variable in the global financial crisis period and economically stable period are reported separately. overall results indicate there is no significant difference in board and firm characteristics in these two time periods. however, results shows that slightly higher pa and pp agency costs occur in a global financial crisis. this may be because a global financial crisis leads to high information asymmetry problems. this is confirmed by renaud (2003) who explains that during the crisis and due to a lack of limited liable information, agency conflict increases in emerging economies. considering the explanatory variables, results indicate that firms employ more minority directors in recession time. additionally, the dmino variable indicates that in a global financial crisis sri lankan listed firms try to recruit at least one minority director. it asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 59 may be firms believe that through a diversified board with a full range of talent and expertise, managers can improve firm performance in an economic downturn (“corporate governance”, 2011). it may also be that in a global financial crisis boards with more ethnic minorities equip a company better to serve customers from different cultural backgrounds (fields, 2011). further descriptive statistics indicate that in a global financial crisis board size is slightly higher than in non-financial crisis periods. this may be due to more ethnic minority recruitment in financial crisis time, and so board size may increase along with board diversity. considering control variables, except firm debt level, other variables’ mean values do not show significant difference between global financial crisis and non-financial crisis time. however, firms debt indicates that companies acquire less debt in recession. this may be because tighter monitoring during a recession leads to a decline in accessing bank debt (borensztein & lee, 2002). this may be significant in sri lankan markets because banks remain the main provider of debt (colombage, 2007). figure 1.2 further elaborates pa and pp agency costs variables and board ethnic diversity1 variable behaviour in global financial crisis and non-global financial crisis periods in sri lankan listed firms. a kernel density graph indicates there is similar pattern of pa agency costs distribution during a global financial crisis and financially healthy times. however, it clearly shows companies do not pay as much in shareholder dividends during non-crisis times, and are more likely to pay more dividends during a financial crisis. this may be because in an economic recession firm growth is slower and to avoid agency conflicts firms pay-out their excess cash flows as dividends. in economically stable times when firm growth is stronger, excess cash flows are used for further investments. the ethnic diversity density graph shows firms to be more concerned about board diversity in financial crisis periods than in stable economic times. it may be firms try to increase financial performance through board diversification. diversified board members levels of innovation and creativity help to drive high company performance even in a financial crisis. 1 board diversity (diversityt), which is measured by blau index. the blau index is calculated by where p is the proportion of board members in each category and n is the total number of board members. the blau index value range for diversity is 0 from 0.5, which can be achieved only when a board has equal numbers of minority and majority board directors. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 60 figure 1.2: kernal density of variables 3.2 method panel data analysis is the most efficient statistical method, widely used in econometrics and social science (madalla, 2001). the panel data structure allows for taking into account the unobservable and consistent heterogeneity, which are specific features of each company. however, panel data also give rise to statistical problems in regression analysis. in particular, it is important to determine whether there are fixed effects present in the variables. this study uses hausman’s specification test to differentiate between random and fixed effects of 0 .2 .4 .6 d en si ty 0 1 2 3 4 salesassets non res kernel = epanechnikov, bandwidth = 0.1962 kernel density estimate 0 1 2 3 d en si ty 0 1 2 3 4 diversity non res kernel = epanechnikov, bandwidth = 0.0563 kernel density estimate 0 5 1 0 1 5 2 0 d en si ty 0 1 2 3 4 non res kernel density estimate asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 61 variables2. on the other hand, board diversity studies have become more complicated in recent years due to their causality effect (campbell & mínguez-vera, 2007). to control the effect of inverse causality there needs to be an econometric method that can deal with endogeneity and with the presence of unobservable fixed effects that are associated with each company and correlated with the rest of the explanatory variables. to overcome this econometric problem, this study used a panel 2sls regression technique. in the first step, board ethnic minority is determined by using ols regression techniques and in the second step, values determined for ethnic minority are used to determine agency costs. the models are formulated using assets utilisation ratio and dividend payout ratio as proxies’ proxy for pa and pp agency costs. therefore, this study estimates following model: (1) (2) (3) where ac represents firm pa and pp agency costs proxies, mino represents two alternative variables (mino and dmino), and ins represents the instrumental variable for this study, cv represents all control variables. this study conducted a breusch-pagan/cook-weisberg test for heteroskedasticity for all regression variables and the results indicate there is no heteroskedasticity is existing in this study sample. 4. results table 2 indicates 2sls regression results for minority directors during times of global financial crisis and non-global financial crisis. columns 2-5 report pa agency costs results and 6-9 report pp agency costs results. the coefficients of mino and pmino variables are negatively and statistically significant at 1% level for pa agency costs in global financial crisis time and insignificant in a non-global financial crisis. this result indicates minority director percentage has no impact on firm pa agency costs in non-recession time and increases pa agency costs in times of global financial crisis. this finding is also consistent with foo & zain (2010) who explain malaysian boards with high levels of minority directors increase information asymmetry problems. further, this finding is consistent with cox (1991) and hambrick et al. (1996) who explain diversity within top management brings potential costs to an organisation due to interpersonal conflicts and communication problems. results confirm this conflict becomes worse in times of financial crisis because an uncertain environment increases communication difficulties and group conflicts. another possible 2 the test statistics have p>0.05 for pa and pp agency costs proxies, so the null hypothesis of no correlation is accepted and random-effects model is appropriate for this study. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 62 explanation is information asymmetry, which has been identified as one of the challenges facing emerging economies (murray, 2008). in economic turbulent times, this information asymmetry problem can worsen and increase agency costs with heterogeneous top managers. therefore, pa conflict can be highlighted during economic uncertainty periods with high representation of ethnic monitory directors. when recruiting top managers, it is important to look at the skill base of the team and see how best to complement it. nevertheless, to achieve “signalling” benefit from investors in economic turbulent times sri lankan listed firms increase their ethnic minority directors without considering their skills, experience, or suitability to the company. this increased pa agency costs with ethnic minority directors during the recent economic recession in sri lanka. another possible explanation is the appointment of ethnic minority directors to sri lankan boards may express “pork barrel” behaviour. this means, after using political influence to appoint a board director, politicians try to get returns for their political campaign or support from the firm. politically controlled personal management became widespread in the sri lankan economy soon after the end of the civil war in 2009. as politicians keep their power over appointees, the carrier path and incentives for directors (especially ethnic minority directors) of sri lankan firms are very much driven by political motivations. this may be another reason for increases in pa agency costs in recent years in sri lanka. further, results indicate that regardless of economic downturn, large boards increase sri lankan listed firms’ pa agency costs. this finding is consistent with jensen (1993) and lipton & lorsch (1992) who suggest that when board size is increased the agency problem positively significantly increases within the board. due to the high existence of family businesses listed on the cse (masulis et al., 2009), the possibility of free-rider problems can increase along with board size. these large boards often move into a more figurative role, rather than fulfilling the intended functions as part of management. moreover, the owner variable is significantly negatively related with pa agency costs’ proxy, indicating local ownership increases pa agency conflict. compared to foreign owned firms, locally owned firms’ board recruitment can be biased. political and family intervention is common in countries with weak legal structures like sri lanka. sri lanka’s central government and its committees are the ultimate authorities over the selection and appointment of board chairpersons and most of the top directors of almost all state-owned listed companies. therefore, local firms’ ethnic minority directors may not be well diversified by way of skills and experience and they reinforce agency conflict in the firms. interestingly, results show firm debt has a significant negative impact on pa agency conflict in a global financial crisis. this may be because banks closely monitor firms to ensure they operate more efficiently by better utilising assets and limiting perk consumption as the firm attempts to improve its reported financial performance to the bank (ang et al., 2000). table 2 further indicates board minority-director percentage, or the presence of minority directors on a board, does not have significant impact on pp agency costs in a global financial crisis. tunnelling and expropriation of minority shareholders by majority shareowners is prevalent in emerging markets (claessens et al., 2000). this study indicates, mino and dmino variables have significant negative impact on pp agency costs’ proxy in stable asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 63 economic times, showing 1% significant negative relationship between firm pp agency costs and minority variables. this indicates board ethnic diversity increases firm monitoring and condenses expropriation and tunnelling of minority shareholders. however, results indicate that board ethnic diversity is only an effective mechanism for mitigating pp agency costs in stable economic times. finally, results show the owner variable shows a 1% statistically significant negative relationship with pp agency costs. table2. regression results of board ethnic diversity and agency costs pa-financial crisis pa-non financial crisis pp-financial crisis pp-non financial crisis variable coefficient-ols (2) coefficient-2sls (3) coefficient-ols (4) coefficient-2sls (5) coefficient-ols (6) coefficient-2sls (7) coefficient-ols (8) coefficient-2sls (9) constant -.4224061 (.3507244) -.4099763 (.3590398) -.6232533*** (.184966) -.6265047*** (.1917891) .6619877** (.3293341) .5935541** (.2967112) .1914518 (.1278533) .1746436 (.1234031) % of minority directors (mino) -.3912622** (.1755619) .0199208 (.101011) -.4498976 (.3456206) -.2671727** (.1277529) presence of minority directors (dmino) -.2897845** (-.2897845) .0365868 (.1857347) -.2249264 (.1691991) -.145774** (.0689892) board size (board) -.0410255* (.0242427) -.0393689 (.0243185) -.0406893*** (.0127133) -.0406385*** (.012713) .0000766 (.0196331) .0021207 (.0191457) -.0052758 (.0086517) -.004816 (.0085743) leverage (debt) .0046207** (.0025959) .0049334** (.0026583) .0020466 (.0013286) .0020696 (.0013089) -.0026878 (.0022387) -.0028111 (.002158) -.0010945 (.0009004) -.0009293 (.0009054) firm size (lnsales) .1321207*** (.0240225) .137823*** (.0241171) .1360854*** (.0121676) .1364697*** (.0120956) -.0164613 (.0195401) -.0109039 (.0190178) .0084938 (.008052) .0107882 (.0080462) performance (roa) .1777375 (.6084797) .0501268 (.6154137) .44723 (.3491161) .4349182 (.341048) .2947512 (.4912113) .2011843 (.487951) .2819799 (.2343633) .1869511 (.2379057) local ownership (owner) -.2378569** (.0961501) -.2555889* (.0990612) -.1788843*** (.0512415) -.1783686*** (.0512415) -.1479504* (.0819049) -.1495568** (.0806333) -.1054102*** (.0358384) -.1021027*** (.0348608) firm age (age) -.0772082 (.0659737) -.071145 (.0661754) -.1270228*** (.0504975) -.1261209* (.050798) .0196904 (.0534401) .0265202 (.0520977) .0972349*** (.034544) .1031176*** (.0340567) regression summary f r2 10.74 (0.000) 0.2016 20.35 (0.000) 0.1875 15.68 (0.000) 0.1750 18.75 (0.000) 0.2101 11.13 (0.000) 0.3841 19.31 (0.000) 0.2139 16.69 (0.000) 0.7400 11.03 (0.000) 0.3885 * significant at 10% level; **significant at 5% level; ***significant at 1% level; this model provides standard errors which are in parentheses 5. conclusion and implications this study offers new insights into the relationship between board ethnic diversification and agency costs in a sri lankan context. approximately 40% of sri lankan listed board members are from ethnic minorities. the recent global financial crisis is one reason for recruiting more ethnic minorities on to corporate boards in sri lanka. though ethnic diversification adds value to sri lankan firms in financial stable times, this study indicates board ethnic diversity increases agency conflict during times of high financial uncertainty, such as a global financial crisis. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 64 the reason for the high percentage of ethnic minority directors on sri lankan boards may be due to restructuring or downsizing of firms during an economic; firms try to keep low paid ethnic minority directors rather than highly paid ethnic majority directors. ethnic minority directors may only increase number of ethnic minority representation and not be effective in the company. moreover, especially in global financial crisis, external governance bodies and stakeholders are more likely to consider board diversity. ideally, board diversity should increase the talent and skills of the board. however, most probably, board members are selected from personal or political contacts of the ceo or other board directors (langevoort, 2011). this is prevalent in emerging markets. therefore the recruiting process needs to be more transparent and consideration given to any potential director’s knowledge and appropriateness for the company. as a country with many ethnic minorities, it is required to have some social programmes in place to reduce the effect of being minority in a social group. it can decrease boundary heightening and exaggeration by dominants emphasis the difference between minority and majority in work places. this leads to a reduction in negative workplace experiences for minority groups, helps to reduce the “token” experience of minority directors and hence improves monitoring and reduces agency conflicts. as a country with mostly family businesses on their stock exchange, managers and top leaders require training. vocational training institutions that target geographical areas where there are more ethnic minority groups can increase minority directors’ management ability in sri lanka. this is the best solution for skill mismatching. then boards can recruit qualified minority directors. although a positive relationship between ethnic minority in the boardroom and firm performance is often cited in the previous literature and popular press, this study shows environmental uncertainty creates costs when adding more ethnic minority board members. an efficient board may be 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(1979). the psychology of group processes. annual review of psychology, 30, 417-451. http://dx.doi.org/10.1146/annurev.ps.30.020179.002221 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 106 volatility spillovers between new zealand stock market returns and exchange rate changes before and after the 1997 asian financial crisis daniel fs choi (corresponding author) department of finance, waikato management school, university of waikato private bag 3105, hamilton, new zealand tel: +647 838 4973 e-mail: dfschoi@waikato.ac.nz victor fang department of accounting and finance, monash university 900 dandenong road, caulfield east, vic, 3145, australia tel: +613 9903 2183 e-mail: victor.fang@buseco.monash.edu.au tian yong fu portfolio risk management, ge money, 8 tangihua street, auckland 1010, new zealand tel: +649 355 1930 e-mail: tianyong.fu@ge.com abstract researchers in the last decade have been investigating the interdependence of stock returns and exchange rate changes within the same economy. kanas (2000) and yang and doong (2004) find that for the g-7 countries, in general, the volatility of the stock market spills over to the exchange rate market but that volatility spillovers from the exchange rate market to the stock market are insignificant. chen, naylor, and lu (2004) find that nz individual firm returns are significantly exposed to exchange rate changes. this study complements their work by investigating the volatility spillover between the stock market and the foreign exchange market within the nz economy. keywords: new zealand, egarch model, volatility spillover, asian financial crisis jel classifications: e44, g01 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 107 1. introduction volatility spillovers between stock market returns and exchange rate changes within the same economy have been examined over time and across different countries. kanas (2000) and yang and doong (2004) find unidirectional volatility spillovers from stock market returns to exchange rate changes in the g-7 markets. the market capitalization of each of the g-7 countries is large and multinationals in the g-7 are fairly well-diversified. chen, naylor, and lu (2004) point out that in a large market with well-diversified firms, domestic factors could be more important than international factors. in contrast, the new zealand market is very small relative to the us market and firms in nz are much less diversified. using a two-factor model, chen et al. find that nz firm returns (the first moment) are significantly explained by exchange rate changes. however, chen et al. do not examine the volatility (the second moment) spillover between the stock market returns and exchange rate changes within the nz economy. in this paper, a multivariate egarch model is used to investigate the volatility spillover between stock market returns and exchange rate changes in nz. the egarch model takes into account new zealand’s asymmetric, or down-market effects. the sample period spans from 1990 to 2004. the 1997 asian financial crisis (afc) occurs in the middle of our sample period. it is thus appropriate to examine the change in volatility spillover effects before and after the afc. our empirical evidence shows that in the full sample the volatility of the nz stock market returns spills over to all three exchange rates changes; only the nzd/usd volatility spills over to the stock market returns. the stock market returns maintain unidirectional volatility spillover to the nzd/aud in the full sample as well as each subperiod. in the pre-afc period, there are bidirectional volatility spillovers between the stock market returns and the nzd/usd and the twi index. however, there are only unidirectional volatility spillovers from the nzd/usd and the twi index to stock market returns in the post-afc period. 2. literature review brailsford (1996) is the first to investigate volatility spillovers between the nz and australian stock markets. he finds that, after controlling for the effects of the us volatility, the australian market volatility spills over to the nz market but not the reverse. however, brailsford does not study the volatility spillover between exchange rate changes and stock market returns within either the nz or australian economy. kanas (2000) studies volatility spillovers between stock returns and exchange rate changes in six industrialized countries, namely, the us, the uk, japan, germany, france, and canada. he finds evidence of spillovers from stock market returns to exchange rate changes for all countries except germany. on the other hand, the volatility spillovers from exchange rate changes to stock returns are completely insignificant. yang and doong (2004) expand kanas’ sample to the g-7 by including italy. their empirical evidence shows stock price movements will impact on future exchange rate movements, but exchange rate changes have less direct effect on future stock returns, which is similar to kanas’ findings. chen, naylor, and lu (2004) observe that in large markets like the us, domestic factors are a major concern over international factors. furthermore, us multinational firms tend to be fairly diversified. these two points may explain why there is unidirectional volatility spillover from stock market returns to exchange rate changes. in contrast to the us market, chen et al. point out that the nz market is very asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 108 small but open to the international economy. moreover, most nz firms are not very well-diversified. dungey (1999) argues that it is the international factor that mainly affects the volatility of nz dollars. he points out that the nz currency is mainly affected by international factors as more than 50% of the decomposition of the nz dollar volatility in the foreign currency market is due to overseas impacts. moreover, the nz stock market is small, illiquid, limited in diversification, and exposed to exchange rate volatility. in other words, volatility shocks in the local nz stock market can have little effect on the movement of the nz currency. it is thus very likely that nz stock returns are impacted by exchange rate changes. the nz currency has been floating independently on the international exchange market since 1985. the nz dollar takes price-taker positions because of its relatively small capitalization in the foreign exchange market. the reserve bank of new zealand (rbnz) has no intervening monetary policy to intervene for nz dollar value within the sample period (the nz government amended the rbnz guidelines in 2006 to allow the central bank to actively trade to support or dampen the nzd if it was appreciating or falling too rapidly.) nz is not a world leader in industrial or commercial areas and the gdp figures show that nz is small and easily affected by international economical movements. local nz firms are less diversified, having either exports and/or imports orientations. the close linkage among local nz companies ensures none of the firms can be exempted from international influences. moreover, although the nz stock market is very small and less liquid than many overseas markets, the nz stock exchange is efficient with high market awareness, especially to the exchange rate uncertainty. all these unique and important characteristics of the nz economy attract us to use its data for investigating how the nz stock market volatility responds to the exchange rate variability. a recent study of alaganar and bhar (2007) indicates that the firstand second-order effects of exchange rate changes impact significantly on diversified portfolios in the us share market. they use weekly returns of 16 world equity benchmark series (webs) in the study while each webs series represents a diversified portfolio of investing in foreign shares in a country outside of the united states. the diversification technique is efficiently applied in webs while tracking the performance of a foreign country’s morgan stanley capital international (msci) index though webs are traded only in us dollars. alaganar and bhar employ the gjr and garch-m models in testing the impact of exchange rate volatility on returns of diversified country index portfolios. they find that the exchange rate uncertainty is priced as a factor in webs returns. they point out that the second moment exchange rate information is important for diversifications in the stock market. the exchange rate risk is priced in returns and the exchange rate volatility is important to investors. the extent to which similar findings will hold for smaller economies remains open. chen et al. use a two-factor model with the market returns and exchange rate changes as factors to explain individual firm returns. their empirical results show that sample firm returns are significantly impacted by exchange rate exposure. this paper differs from chen et al.’s study in that the investigation focuses on the volatility spillover between stock market returns and exchange rate changes in nz. pinfold et al. (2001) point out that the nz stock market is characterized by down market conditions. as a result, filtering away the leverage effect in volatility spillover tests is essential. the egarch model handles the leverage effect very efficiently. in this paper, a multivariate egarch model is used to take into account new asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 109 zealand’s asymmetric, or down-market effects. 3. data and methodology 3.1 data and descriptive statistics daily nz total market index prices were collected from datastream. the usa and australian markets are the two largest export markets for nz firms. the exchange rates nzd/aud and nzd/usd as well as the twi index were collected from the reserve bank of new zealand. the sample period spans 15 years from january 1990 to december 2004. there are 3,866 daily observations. the 1997 asian financial crisis (afc) occurs right in the middle of the sample period. the full sample data were split into two approximately equal sub-periods – the pre-afc period (january 1990 to june 1997) and the post-afc period (august 1997 to december 2004), each covering 7.5 years. in this study, the stock market returns and all exchange rate changes are defined as log relative returns. table 1 shows summary statistics of stock and foreign exchange market returns. the jarque-bera test is performed for the stock market returns and exchange rate returns in order to test the normality of each series. the results show that the distribution of the stock market returns and exchange rate returns are not normal. the egarch model is used to examine the dynamic volatility relationship between nz stock market returns and foreign exchange rate changes. table 1 also contains the results of augmented dickey-fuller (adf) unit root tests. all stock and exchange return series are integrated with i(0), i.e., stationary, as all t-statistics are highly significant at the 1% level. table 1. summary statistics statistics stock return exchange rate return total market index nzd/aud nzd/usd twi index observations 3867 3867 3867 3867 mean 0.00013 0.00005 0.00005 0.00003 median 0.00000 0.00009 0.00017 0.00020 maximum 0.09153 0.03408 0.04298 0.03547 minimum -0.12788 -0.03632 -0.03619 -0.03214 std. dev. 0.00955 0.004474 0.006132 0.004808 skewness -0.41425 -0.07996 -0.07939 -0.32546 kurtosis 17.76697 7.77129 7.11378 7.11155 jarque-bera 35246.08 3672.17 2730.81 2792.07 adf test -41.07 -66.76 -37.83 -38.33 note: this table presents basic descriptive statistics of daily stock and foreign exchange returns of the new zealand market. 3.2 methodology the relationships between the movements of the stock market volatility and exchange rate fluctuations within an egarch model, developed by nelson (1991), are examined. the multivariate egarch asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 110 models can effectively capture the asymmetric effects of innovations on volatility in stock market returns while the conditional volatility of currency movements can be included in the model at the same time. this important feature of the model gives direct and explicit measurement of the role of exchange rate fluctuations in explaining the time series behaviour of the stock market volatility. similarly, egarch models can test whether the exchange rate volatility effects are asymmetrical in the foreign exchange market, that is, whether appreciations and depreciations of the nz dollar in the past have the same impacts on the future exchange rate volatility. this means that the egarch model tests the leverage effect in the stock market and also the asymmetric effects in the foreign exchange market. the model is specified by the following equations: (7) (6) )( (5) )( (4) )()()(exp )3( )()()(exp (2) (1) ,,, 12111 11111 1212,211,20,2 1112,111,10,1 1 ,2 1 ,20,2 1 ,1 1 ,10,1 fx t r tfxrtfxr fx t fx t fx t fx t r t r t r t r t fx t fx t r t fx t r t fx t r t r t fx t p j jtj p j jtjt r t p j jtj p j jtjt hhh zzezzf zzezzf hnzfzfh hnzfzfh fxrfx fxrr   where rt and fxt denote the stock market returns and exchange rate changes. the twi index, nzd/aud and nzd/usd, for fxt respectively, are used to examine the exchange rate effects to stock market returns. the number of lags, denoted by p in equations (1) and (2), is determined by the akaike information criteria (aic). the analysis searches for a dynamic relationship between stock market returns and exchange rate changes. the coefficients 1,j and 2,j in equations (1) and (2) show the effects of exchange rate changes to stock market returns and the reverse effects respectively. in equations (3) to (7), r th and fx th denote the conditional variance of stock market returns and foreign exchange rate changes. r tz 1 and fx tz 1 denote the standardized innovations of nz stock market returns and exchange rate changes, respectively. the coefficients 1,2 and 2,1 show whether volatility spillovers exist across the stock market and the foreign exchange market. in particular, 1,2 ( 2,1) indicates volatility spillover effects sourced from the foreign exchange (stock) market to the stock (foreign exchange) market. moreover, the coefficients 1,1 and 2,2 show the volatility clustering in the stock market returns and exchange rate changes. although volatility autocorrelations are often identified in international stock markets, it is not clear if volatilities in the nz currency are autocorrelated. a statistically significant 2,2 provides evidence that volatility in the foreign exchange market is significantly affected by the historical asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 111 volatility changes in the exchange rates. finally, the coefficients 1 and 2 indicate volatility persistence in the stock market and foreign exchange market, respectively. egarch models facilitate an examination of the asymmetric effects in volatility impacts. as mentioned above, the past volatility shocks can have asymmetric effects on future volatility changes in the market. the coefficients 1 and 2 in equations (5) and (6) reveal asymmetry effects in the stock market and foreign exchange market, respectively. a positive (negative) and statistically significant 1 indicates good (bad) news in the stock market has greater impact on the volatility of the stock index. likewise, the coefficient 2 shows if appreciations in the nz dollar have the same impact on the exchange rate volatility as depreciations. egarch models are estimated by using a maximum log likelihood function specified by the following equation: t t tttt hhntl 1 1'ln5.02ln5.0 where is the 11×1 parameter vector to be estimated. n is the number of equations and as the volatility spillover between stock and foreign exchange markets is analysed n=2. t is the number of observations in the sample; ht is a 2×2 time-varying conditional variance-covariance matrix with diagonal elements given by equations (3) and (4). fx t r tt ' is the vector of innovations from the stock market and the foreign exchange market at time t. 4. empirical results 4.1. full sample period results the analysis provides evidence of bidirectional volatility spillovers between the nz stock market returns and exchange rate changes when the exchange rate used is nzd/usd. the current study finds that there is significant volatility clustering, persistence, and asymmetry. volatility clustering ( 1,1 and 2,2). table 2 presents the conditional variances of the stock market returns and exchange rate changes which are significantly impacted by their own standardized innovation in the past. the coefficients 1,1 and 2,2 in equations (3) and (4) are statistically significant at the 1% level, in all cases, indicating volatility clustering in both the nz stock market and the fluctuations of the nz dollar in the international foreign exchange market. volatility persistence ( 1 and 2). volatility persistence in stock market returns and exchange rate movements is also evident. the coefficients of volatility persistence (measured by 1 and 2) are statistically significant at the 1% level. these results are consistent with those of najand and yung (1991). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 112 table 2. volatility spillover between stock returns and exchange rate changes (full sample period: january 1990 december 2004) panel a: stock volatility exchange rate 1,0 1,1 1,2 1 1 nzd/aud -0.2472 *** 0.243 *** -0.0001 0.973 *** -0.141 *** (-10.07) (28.24) (-0.01) (380.80) (-5.38) nzd/usd -0.289 *** 0.164 *** 0.092 *** 0.969 *** -0.348 *** (-14.16) (30.28) (14.74) (466.89) (-12.63) twi index -0.142 *** 0.058 *** -0.003 0.984 *** -0.698 *** (-4.97) (5.02) (-0.21) (310.26) (-6.01) panel b: exchange rate volatility exchange rate 2,0 2,1 2,2 2 2 nzd/aud -4.518 *** 0.087 *** 0.309 *** 0.582 *** -0.022 (-11.93) (4.16) (14.64) (16.73) (-0.53) nzd/usd -0.078 *** 0.019 *** 0.194 *** 0.991 *** -0.109 *** (-5.15) (3.08) (22.36) (694.04) (-4.94) twi index -6.719 *** 0.177 *** 0.328 *** 0.396 *** -0.012 (-50.83) (5.54) (10.97) (33.27) (-0.20) note: above are the results of egarch models, where α1,1 and α2,2 indicate volatility clustering in the stock returns and exchange rate changes, respectively; α1,2 (α2,1) is the volatility spillover from the exchange rate changes (stock returns) to stock returns (exchange rate changes); γ1 and γ2 are volatility persistence in the markets, δ1 and δ2 are the asymmetry in the volatility effects. t-statistics in parentheses, *** denotes significance at the 1% level, two-tailed asymmetry ( 1 and 2). the asymmetry coefficients 1 are negative and statistically significant at the 1% level in all cases, suggesting strongly significant leverage effects in the nz stock market. bad news that results in stock decline in the market leads to a more volatile stock movement. this finding is consistent with the general leverage effect evidenced in the literature. at the same time, the asymmetry coefficient 2 is only statistically significant when nzd/usd is used in the model. this implies that currency depreciations in nz dollar against the us currency result in more volatility in the international foreign exchange market. this case, however, is not applicable to other exchange rate variables for the nz dollar. volatility spillover ( 2,1 and 1,2 ). looking at the volatility spillover coefficients, we notice significant volatility spillover effects from the stock market to the foreign exchange market. the coefficient 1,2 (table 2, panel b) has high statistical significance for all exchange rate measurements. the results are consistent with the findings of kanas (2000) that volatility changes in the stock returns have impacts on the movements of foreign currency. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 113 the volatility of foreign exchange rate changes also spill over to the stock market returns. the coefficient 2,1 (table 2, panel a) is statistically significant at the 1% level when nzd/usd is applied as the foreign exchange rate in the model. this indicates that the volatility changes in nzd/usd exchange rate have spillover effects on the stock market returns. however, the spillover effects are not significant when the nzd/aud and the twi index are used in the model. 4.2. sub-periods results the 1997 asian financial crisis (afc) occurred in the middle of the sample period. the full sample period is thus partitioned into pre-afc and post-afc sub-periods. there is consistent unidirectional volatility spillover from nz stock market returns to nzd/aud in the two sub-periods. for both nzd/usd and twi index, in the pre-afc period, the volatility spillover between nz stock market returns and these two exchange rate changes are bidirectional; in the post-afc period, there is only unidirectional volatility spillover from the two exchange rate changes to the stock market returns. all egarch models exhibit significant volatility clustering, persistence, and asymmetry. in the following, we report only the evidence of volatility spillovers. nzd/aud and stock market returns. there is consistent unidirectional volatility spillover from the stock market returns to nzd/aud in the full sample and both the two sub-periods. it can be seen that the coefficients α2,1 in panel b of tables 2, 3, and 4 are statistically significant, while the coefficients α1,2 in panel a of tables 2, 3, and 4 are insignificant. nzd/usd and stock market returns. in the full sample, the volatility of stock index returns spills over to the three exchange rate changes (table 2, panel b, α2,1). these spillover effects are maintained in the pre-afc period (table 3, panel b, α2,1) but vanish in the post-afc period. twi index and stock market returns. in the full sample, the volatility of stock index returns spills over to exchange rate changes (table 2, panel b, α2,1). in this instance, this spillover effect is only maintained in the pre-afc period (table 3, panel b, α2,1) but vanishes in the post-afc period (table 4, panel b, α2,1). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 114 table 3. volatility spillover between stock returns and exchange rate changes (pre-afc, 3 january 1990 – 30 june 1997) panel a: stock volatility exchange rate 1,0 1,1 1,2 1 1 nzd/aud -0.092 *** 0.123 *** -0.010 0.990 *** -0.025 (-3.97) (8.54) (-1.02) (395.56) (-0.46) nzd/usd -0.490 *** 0.258 *** -0.052 *** 0.969 *** -0.284 *** (-8.10) (9.96) (-3.59) (466.88) (-6.68) twi index -0.134 *** 0.141 *** -0.025 *** 0.985 *** -0.101 ** (-4.49) (8.39) (-2.35) (304.96) (-2.09) panel b: exchange rate volatility exchange rate 2,0 2,1 2,2 2 2 nzd/aud -8.418 *** 0.112 *** 0.380 *** 0.221 *** 0.181 *** (-9.24) (3.52) (11.41) (2.65) (3.18) nzd/usd -1.102 *** 0.064 *** 0.210 *** 0.991 *** -0.095 *** (-10.67) (3.47) (11.50) (694.04) (-2.10) twi index -2.437 *** 0.091 *** 0.222 *** 0.782 *** -0.097 ** (-9.99) (3.08) (12.89) (35.76) (-2.13) note: please see table 2 for variable definitions. t-statistics in parentheses; ***(**) denote significance at the 1% (5%) level, two-tailed asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 115 table 4. volatility spillover between stock returns and exchange rate changes (post-afc, august 1997 – 31 december 2004) panel a: stock volatility exchange rate 1,0 1,1 1,2 1 1 nzd/aud -0.531 *** 0.280 *** -0.033 0.945 *** -0.353 *** (-5.92) (18.63) (-1.32) (106.23) (-8.31) nzd/usd -6.728 *** 0.056 *** 0.067 *** 0.288 *** -0.460 * (-12.16) (5.42) (2.53) (4.79) (-1.85) twi index -1.015 *** 0.324 *** 0.053 *** 0.984 *** -0.062 ** (-9.42) (22.52) (3.74) (310.26) (-2.19) panel b: exchange rate volatility exchange rate 2,0 2,1 2,2 2 2 nzd/aud -0.855 *** 0.081 *** 0.120 *** 0.921 *** -0.103 (-3.23) (3.58) (4.68) (38.24) (-1.1037) nzd/usd -4.935 *** -0.007 0.121 *** 0.492 *** -0.871 *** (-3.80) -0.2975 (3.91) (3.67) (-3.67) twi index -6.097 *** -0.003 0.067 *** 0.396 *** -0.635 *** (-2.39) (-0.10) (5.19) (33.27) (-3.12) note: please see table 2 for variable definitions. t-statistics in parentheses; ***(**,*) denote significance at the 1% (5%, 10%) level, two-tailed it is clear that the 1997 asian financial crisis is a critical event for the volatility transmission between the foreign exchange market and the stock market in nz. before the crisis, there were bidirectional volatility spillovers between exchange rate changes (nzd/usd and twi index) and the stock market returns within the nz economy (table 3, 1,2 in panel a and 2,1 in panel b). after the crisis, only the volatility of nzd/usd and twi index changes spill over to the stock market returns (table 4, 1,2 in panel a and 2,1 in panel b). this is consistent with the view that the nz currency is driven by international factors instead of domestic factors. 5. summary and conclusions this paper examines volatility spillovers between stock market returns and exchange rate changes within the new zealand economy. down-market effects, in the nz stock market, are effectively controlled by incorporating the leverage effect in the egarch framework. the 1997 asian financial crisis (afc) occurs in the middle of our sample period encouraging us to partition the full sample period into pre-afc and post-afc sub-periods. there is consistent unidirectional volatility spillover from nz stock market returns to nzd/aud changes in the full sample and each of the two sub-periods. for both the nzd/usd and the twi index, the volatility of nz stock market returns spills over to both the nzd/usd and the twi in the pre-afc period but not in the post-afc period. however, the volatility of nzd/usd and twi index changes spills over to asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 116 the stock market returns both before and after the afc. our empirical evidence agrees with chen et al. (2004) that the small and open nz stock market is exposed to and impacted by foreign currency movements. acknowledgment the authors wish to thank vincent xiang, monash university, for his assistance in conducting empirical tests. we acknowledge helpful comments and suggestions from associate professor stuart locke, university of waikato. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e5 www.macrothink.org/ajfa 117 references alaganar, v.t., & bhar, r. (2007). empirical properties of currency risk in country index portfolios. quarterly review of economics and finance, 47, 159–174. brailsford, t.j. (1996). volatility spillover across the tasman. australian journal of management, 21 (1), 13–27. chen, j., naylor, m., & lu, x. (2004). some insights into the foreign exchange pricing puzzle: evidence from a small open economy. pacific-basin finance journal, 12, 41– 64. dungey, m. (1999). decomposing exchange rate volatility around the pacific rim. journal of asian economics, 10, 525–535. kanas, a. (2000). volatility spillover between stock returns and exchange rate changes: international evidence. journal of business finance & accounting, 27 (3) & (4), 447–467. najand, m., & yung, k. (1991). a garch examination of the relationship between volume and price variability in futures markets. journal of futures markets, 11 (5), 613–621. nelson, d. (1991). conditional heteroskedasticity in asset returns: a new approach. econometrica, 59, 347–370. pinfold, j.f., wilson, w.r., & li, q. (2001). book-to-market and size as determinants of returns in small illiquid markets: the new zealand case. financial services review, 10, 291–302. yang, s., & doong, s. (2004). price and volatility spillovers between stock prices and exchange rates: empirical evidence from the g-7 countries. international journal of business and economics, 3(2), 139-153. sophistication of institutional investors and asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 75 institutional investors and accounting restatements paul hribar henry b. tippie college of business, university of iowa iowa city, ia 52242-1994, united states tel: 1-319-335-1008 e-mail: paul-hribar@uiowa.edu nicole thorne jenkins owen graduate school of management, vanderbilt university 401 21 st avenue south, nashville, tn 37203, united states tel: 1-615-343-0553 e-mail: nicole.jenkins@owen.vanderbilt.edu juan wang (corresponding author) school of accountancy, singapore management university 60 stamford road, singapore 178900, singapore tel: 65-6828-0986 e-mail: juanwang@smu.edu.sg abstract this paper investigates the role that institutional investors play in the market reaction to accounting restatements. we show that transient institutional investors, defined as institutions with short investment horizons and high portfolio turnover, significantly reduce their holdings in a restating firm at least one quarter prior to the quarter of the restatement announcement. this result holds after controlling for factors such as return momentum, unexpected earnings, size, book-to-market, and the portfolio weight of the firm to the institution. second, using previously identified predictors of earnings manipulation, we show that institutional investors react most negatively to an increase in the days sales in receivables and high accruals. finally, we demonstrate that the market reaction to accounting restatements for firms with higher levels of transient institutional ownership is more negative in the period prior to the restatement announcement. taken together, these results suggest that institutional investors act as though they partially anticipate potential accounting irregularities and adjust their holdings downward prior to the restatement announcement. keywords: institutional investors, accounting restatements jel classifications: g30, m41 mailto:paul-hribar@uiowa.edu mailto:nicole.jenkins@owen.vanderbilt.edu asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 76 1. introduction recent scandals in accounting have led to a heightened interest in both the causes and consequences of accounting restatements (see, among others, palmrose and scholz, 2004; hribar and jenkins, 2004). one of the most striking findings from this set of studies is the substantial loss in market value when a firm restates earnings, which averages 9% across all restatements and over 20% when the restatement is deemed fraudulent or initiated by the auditor (palmrose, richardson, and scholz, 2004). despite the number of studies that document the overall market reaction to the restatement, however, little evidence exists on how different types of investors anticipate and respond to this event. in this paper, we focus on institutional investors and examine the role that institutional investors play in determining the market reaction to accounting restatements. in particular, we address three research questions. first, we ask whether actively trading institutional investors reduce their holdings prior to the restatement announcement. prior research has documented the role of institutional investors as information intermediaries and their sophistication in processing accounting information. for example, institutional investors serve as arbitrageurs and mitigate documented mispricing in equity stocks (e.g. bartov, radhakrishnan, and krinsky, 2000; collins, gong, and hribar, 2003). the trading behavior of institutions also appears to predict corporate events such as breaks in consecutive positive earnings surprises (ke and petroni, 2004) and dividend increases (amihud and li, 2006). however, studies that have attempted to identify the source of institutional investors‟ information advantage suggest that institutional investors‟ information advantage is mainly obtained from private information disclosed from firm management, rather than from institutions‟ superior ability to process public information. in contrast, an accounting restatement represents an event that managers are ex-ante unlikely to share with analysts and institutions in private conversations. therefore, it remains an open question as to whether institutional investors will be able to predict this event. second, we ask whether there is evidence that the change in institutional holdings is related to financial statement indicators that have been shown to predict earnings manipulation. using the factors documented by beneish (1999) to be associated with the likelihood of earnings manipulation, we examine how these earnings manipulation predictors relate to changes in institutional holdings prior to an accounting restatement. identifying which earnings manipulation predictors are associated with changes in institutional holdings provides evidence about the signals that actively trading institutional investors use in adjusting their holdings of a company. it also provides additional assurance that reductions in holdings prior to the restatement are, at least partially, information-based. third, we ask whether the presence of actively trading institutional investors affects the price formation process surrounding the restatement announcement. we compare the preannouncement period returns for firms with different levels of institutional ownership to determine whether the prices of firms with higher levels of institutional ownership reflect the bad news associated with a restatement in a more timely fashion. prior research suggests that the presence of institutional investors speeds the process at which information gets impounded into price (el-gazzar, 1998; jiambalvo, rajgopal, and venkatachalam, 2002; ayers and freeman, 2003; balsam, bartov, and marquardt, 2002). if actively trading institutional investors acquire information such that they are able to partially anticipate an impending restatement, then we expect that the stock price of firms with higher levels of actively trading institutional ownership will reflect the information content of the accounting restatement more timely in the pre-announcement event period. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 77 in all of our tests, we use bushee‟s (2001) classification of institutions based on institutional investors‟ past investment behavior. we focus on „transient‟ institutional investors, as they are the institutions that actively manage their portfolios and trade frequently over short-term. as such, transient institutions‟ trading behavior is most likely to reflect short-run, information-based trading patterns (collins, gong, and hribar, 2003; ke and ramalingegowda, 2005). we examine a sample of 364 restatements from 1997 through 2002 and summarize our major findings as follows. first, we find that actively trading institutional investors (i.e. transient institutions) reduce their holdings in restating firms at least one-quarter prior to the quarter of the restatement announcement. this result holds after controlling for the average change in institutional holdings, the portfolio weight of the restating firm to the institutions, return momentum, seasonal change in earnings, size, book-to-market ratio, and industry and year fixed effects. we find no evidence that other groups of institutions anticipate restatements and reduce their holdings early to avoid the negative returns associated with restatements. further, of the factors that predict earnings manipulation, we find that institutional investors reduce their holdings in response to increases in days sales in receivables (i.e. a decrease in accounts receivable turnover) and to high accruals. finally, we show that restating firms with high levels of transient institutional ownership exhibit more negative returns prior to the restatement announcement, relative to firms with low levels of transient institutional ownership. this finding is consistent with the notion that higher levels of holdings by actively trading institutional investors allow information to be incorporated into price in a more timely fashion. this study makes the following contributions. first, this study adds to the literature on the information environment of institutional investors by showing that actively trading institutional investors can anticipate impending restatements. on the one hand, previous research finds that actively trading institutional investors are, on average, informed users of information (see, among others, collins, gong, and hribar, 2003; ke and ramalingegowda, 2005). on the other hand, empirical evidence also suggests that actively trading institutional investors may not be as sophisticated as commonly thought; these institutional investors may merely chase return momentum or underperform market portfolios (see, for example, cohen, coval, and pastor, 2005; kacperczyk, sialm, and zheng, 2005). the finding in this study adds to this line of research by providing evidence on the ability of institutional investors to anticipate restatements. although the magnitude of the advance trading makes it unlikely that the institutions actually have specific information about an impending restatement, the advance reduction in institutional holdings is consistent with institutional investors expecting bad news of some form. the results further shed additional insight on the information source of institutional investors by showing that superior ability to process public information is likely the source of information advantage by institutional investors concerning restatement events. previous work either assumes that institutional investors have information advantage without testing the information source (see, for example, walther, 1997), or finds that institutional investors have information advantage because of private information disclosed from firm management (see, among others, ke and petroni, 2004; bushee and goodman, 2007; ke, petroni, and yu, 2008). our results provide evidence that the information advantage of institutional investors to anticipate a forthcoming restatement is likely attributable to institutions‟ superior ability to process public information related to restatements. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 78 finally, our work has implication for research examining the role of total institutional ownership in market reactions around accounting events (e.g., bartov, krinsky, and radhakrishnan, 2000; ayers and freeman, 2003). our study underscores the importance of differentiating among institutions with various investment styles, and shows that the market reactions to restatement events vary cross-sectionally, based on the level of different institutional ownership and the ability of sophisticated investors to predict the restatement event. the remainder of the paper proceeds as follows. the next section reviews the relevant literature. section 3 discusses the sample selection and variable measurement, and provides descriptive statistics. section 4 describes our research design and discusses the empirical results. section 5 concludes. 2. the literature on the information advantage of institutional investors 2.1 institutional investors’ trading behavior and their information advantage prior research documents that institutional investors have information advantage. with the advantage of private information gathering and/or public information processing, some institutional investors appear to engage in informed trading in response to future information. for example, institutional investors trade actively in anticipation of impending events, such as breaks in consecutive earnings increases (ke and petroni, 2004), future earnings implication of current accruals (collins, gong, and hribar, 2003), future dividend increases (amihud and li, 2006), and future abnormal returns around subsequent earnings announcements (ali et al., 2004). there is also evidence that institutional investors acquire and strategically trade on predisclosure information. for example, el-gazzar (1998) finds that the higher the institutional ownership, the smaller the market reaction to earnings releases, consistent with institutional investors acquiring predisclosure information and trading on this predisclosure information to mitigate the market response when earnings is announced. bartov, radhakrishnan, and krinsky (2000) and ke and ramalingegowda (2005) both show that post-earnings-announcement drift is negatively correlated with institutional ownership, suggesting that institutional investors trade on the implication of current earnings surprises on future earnings. balsam, bartov, and marquardt (2002) demonstrate that sophisticated investors, as measured by the level of institutional ownership, recognize accrual management prior to the release of 10-qs and trade on the unexpected accruals before the 10q filing date. building on prior research, this study directly examines the trading behavior of institutional investors prior to an accounting restatement. we use accounting restatements as our event for several reasons. first, accounting restatements represent economically significant events, associated with substantial loss in market value on the restatement date. second, to the extent that these restatements involve an inappropriate application of gaap that is reflected in past financial statements, it is reasonable to expect that a sophisticated investor would have a greater chance of identifying these firms through superior knowledge of financial statements and/or more resources to spend on analyzing the statements. 1 third, accounting restatements represent a setting where it is less likely that management would communicate this information to external shareholders such as institutional investors, as the restatements often tp 1 for example, to the extent that a restatement involves accruals, a deeper understanding of the financial statement ratios and a detailed analysis might help identify potentially problematic accounting. similarly, an understanding of earnings management incentives and the ability to identify „red-flags‟ help identify situations where earnings manipulation is more likely to occur. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 79 are initiated by third parties (such as the auditor), and can involve fraudulent actions on the part of management. 2 p as a result, we believe that our setting is one in which the informed trading by institutional investors is most likely to be explained by superior processing of public information rather than by private information acquisition. institutions exhibit significant variation in investment style, reflected in portfolio diversification and portfolio turnover (e.g., bushee, 1998, 2001; bushee and noe, 2000). for each year, bushee (2001) classifies institutional investors into one of the three groups: transient (transient), dedicated (dedicated), and quasi-indexing (qix), using both factor analysis and cluster analysis based on each institutional investor‟s past investment behavior (for the institutional classification scheme, refer to appendix ii characteristics of different types of institutional investors). following bushee (1998, 2001), we analyze transient, dedicated and quasi-indexing institutions, respectively. transient institutions are characterized as having short investment horizon and high turnover to maximize short-term profits. dedicated institutions are committed to providing long-term capital and having more concentrated portfolio holdings in a limited number of firms. quasi-indexers generally follow a passive, buy-and-hold strategy with diversified holdings. as such, both dedicated and quasi-indexing institutions are characterized as having less active portfolio management than transient institutions. while we do not expect that these institutions are less sophisticated than transient institutional investors, their investment styles are such that they are less likely to be actively engaged in information processing to make short-term trading decisions. 3 therefore, if any evidence exists that institutional investors anticipate restatements, we expect it to be greatest among transient institutional investors. this classification scheme increases the power of our empirical tests, because it allows us to focus on the set of institutions that are most likely to exhibit short run, information-based trading (i.e., transient institutional investors). however, our empirical tests include analysis on total institutional holdings as well as dedicated and quasi-indexing institutions, respectively, in order to provide a contrast concerning how each type of institutional investors behaves surrounding the restatement announcement quarter. 2.2 institutional investors and price formation in order to examine the role of institutional investors in price formation, we analyze the market reaction surrounding the restatement and examine the extent to which institutional investors accelerate the incorporation of restatement related information into stock price. prior research suggests that variation in predisclosure information environment comprises one source of the cross-sectional differences in the market reactions to earnings related information. for example, el-gazzar (1998) finds that institutional ownership is negatively associated with the market reaction around earnings releases, consistent with institutional investors acquiring predisclosure information and mitigating the market response when earnings information is released. in a similar vein, jiambalvo, rajgopal, and ventkatachalam (2002) show that firms favored by institutional investors incorporate future earnings into prices earlier than other firms. ayers and freeman (2003) find a similar result as jiambalvo, rajgopal, and ventkatachalam (2002) after controlling for analyst following, and show that returns from high-institutional-ownership portfolios have a greater price lead by six months tp 2 even if management was willing to communicate this type of news to institutional investors, it is reasonable to expect that the dedicated institutions would have access to firm management that is as good as or better than transient institutions. because we find that dedicated investors do not reduce their holdings in advance of the restatement, this suggests that dedicated institutional investors have not been forewarned of the restatement. tp 3 we thank brian bushee for providing the institutional classifications. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 80 over those from low-institutional-ownership portfolios. taken together, these studies indicate that information acquisition by institutional owners accelerates the impounding of earningsrelated information into price. building on this literature, if transient institutional investors can partially anticipate the restatement, we expect that having a greater transient institutional ownership will increase the amount of information to be impounded into price prior to the actual restatement announcement. put it another way, we predict that firms with high levels of transient institutional ownership will exhibit more negative stock returns in the prerestatement-announcement period, relative to firms with low levels of transient institutional ownership. the returns-based analysis also provides a necessary complement to the institutional holdings-based tests because institutional holdings are only tabulated on a quarterly basis. for example, if a restatement happens in the third month of a given quarter, our institutional holdings tests will only capture reductions in holdings that occur more than two months before (i.e., we find that transient institutions reduce holdings at least one quarter prior to the restating quarter). by examining the daily returns around the actual restatement announcement conditional on institutional holdings, we are able to capture the impact of institutional trading (i.e. a change in the stock price) that occurs closer to the event date, with no need to measure the change in institutional holdings on a daily basis. finally, finding a more negative market reaction to the accounting restatement in the pre-event period for firms with higher levels of institutional ownership provides more assurance that the tests on changes in institutional holdings do not just capture uninformed trading patterns related to return momentum, and are at least partially due to information-based trading. as mentioned above, our empirical tests consider each group of institutions classified by investment style (i.e., transient, dedicated and quasi-indexing institutions). these additional tests are performed to demonstrate that the hypothesized phenomena exists primarily for firms with high levels of transient institutional ownership, and that different types of institutional ownership lead to different price formation paths. 3. sample selection and variable measurement 3.1 sample selection accounting restatement data are obtained from the u.s. general accounting office (gao, 2003), which contains accounting restatements announced in the period january, 1997 to june, 2002. the general accounting office (2003) constructed a sample of 919 restatements containing firms that are required to restate their financial statements because of material accounting irregularity and/or frauds. 4 the gao (2003) database is comprised of the name, ticker symbol, and exchange of the restating firm, the restatement announcement date, the number of shares outstanding, the initiator of the restatement, and the reason(s) for the restatement. 5 4 the gao (2003) states “we focused on financial restatements resulting from accounting irregularities, including so-called aggressive accounting practices, intentional and unintentional misuse of facts applied to financial statements, oversight or misinterpretation of accounting rules, and fraud. ┄as a general rule, we also excluded restatements resulting from accounting policy changes because they did not necessarily reveal previously undisclosed, economically meaningful data to market participants. ” 5 we do not include accounting restatements announced after june 2002, because these restatements are more likely to result from the regulatory changes required under the sarbanes-oxley act (the sox) (chen, cheng, and lo, 2009). consistent with this view, prior research documents that the post-2002 restatements have a small impact on net income of the restating firms (e.g., plumlee and yohn, 2009). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 81 we obtain data on institutional ownership from thomson financial cda/spectrum dataset. 6 financial statement data are collected from crsp/compustat merged industrial quarterly. returns data are collected from crsp daily stock returns file for nyse, amex, and nasdaq firms. we mitigate the confounding events following the two procedures. first, to rule out earlier public announcements about an impending restatement as the source of any pre-restatement trading, we search factiva starting with the date given in the gao (2003) database, and look back six months earlier for any articles, press releases, etc. that might indicate the possibility of a restatement. for those with an earlier date, we use the date of the earliest article in the factiva dataset related to the restatement as our event date. this affects a total of 45 observations. second, we remove the firms whose restatement announcement date is in the window (-2 to +2) around the earnings release. specifically, we remove 23 restatements, of which 20 observations announce restatements exactly in the same day as the earnings release date. we remove these observations to mitigate concerns that any institutional trading or market reactions in response to the restatement information are confounded by disclosed earnings information which is not attributable to the restatement news. the final sample consists of 364 restatements on 334 unique firms. 3.2 variable measurement the variables used in our empirical tests are defined in appendix i variable definitions and discussed below. 3.2.1 institutional holdings variables bushee (2001) classifies institutional investors into one of the three groups each year: transient, dedicated, and quasi-indexing institutions. this classification uses both factor analysis and cluster analysis based on each institutional investor‟s past investment behavior (for details, refer to bushee, 1998, 2001; bushee and noe, 2000). because the classification is highly stable over time, we follow ke and ramalingegowda (2005) to assign each institutional investor into the type that is the most frequent type for this institution over the classification period. the institutional holdings variables are as follows for each firm-quarter: beginning level of aggregate institutional holdings of firm j‟s shares outstanding by a certain group of institutions ( , 1j qinstitution ), mean-adjusted change in aggregate institutional holdings of firm j‟s shares outstanding by a certain group of institutions ( qjninstitutioadj ,_ ), and beginning weighted mean portfolio weight of firm j in the portfolio held by a certain group of institutions ( , 1_ j qpw institution ). , 1j qinstitution denotes either the holdings by total institutional investors (inst), or holdings by transient (tra), dedicated (ded), or quasiindexing institutional investors (qix). qjninstitutioadj ,_ is the mean-adjusted change in aggregate institutional holdings by a certain group of institutions (i.e., total, transient, dedicated, and quasi-indexing institutions, respectively) over the calendar quarter q for firm j. the adjustment is made by subtracting the average change in aggregate holdings by each group of institutions (i.e., total, transient, dedicated, and quasi-indexing institutions, respectively) across all firms on the cda/spectrum database over the same calendar quarter q, in order to control for time trends in the change in holdings by each group of institutions 6 cda/spectrum obtains their data from the sec‟s 13-f form. sec requires all institutions with greater than $100 million of equity securities to report their holdings each calendar quarter on 13-f form. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 82 (abarbanell, bushee, and raedy, 2003). following ke and petroni (2004) and ke and ramalingegowda (2005), , 1_ j qpw institution measures the portfolio weight of firm j to the institutions‟ total holdings at the end of quarter q-1. , 1_ j qpw institution is calculated as , , 1institution j qmv / , , 1institution all qmv , where , , 1institution j qmv is the market value of firm j held by a certain group of institutions (i.e., total, transient, dedicated, and quasi-indexing institutions, respectively) at the end of quarter q-1, and , , 1institution all qmv is the market value of all firms held by the same institutions (i.e., total, transient, dedicated, and quasi-indexing institutions, respectively) at the end of quarter q-1. 3.2.2 returns and other control variables we measure cumulative market-adjusted abnormal returns using an equally weighted index over various windows surrounding the restatement announcement date. we measure 90-day (day -92 to day -3) cumulative abnormal returns prior to the restatement announcement to capture the pre-announcement market reaction. we measure 5-day (day -2 to day +2) cumulative abnormal returns around the restatement announcement to capture the immediate market reaction to restatements. earlier research shows that institutional holdings are systematically related to firm size and book-to-market (gompers and metrick, 2001), seasonally adjusted changes in earnings (bartov, radhakrishnan, and krinsky, 2000; ke and ramaligegowda, 2005), and return momentum (badrindath and wahal, 2002). accordingly, we include these variables to isolate the potential impacts of these firm-specific characteristics on institutional trading behavior around restatement announcements. we measure firm size ( 1qlnsize ) by the natural log of book value of total assets (data44) at the beginning of the observation fiscal quarter q. book-to-market ( 1qbm ) is the ratio of common book equity to total market capitalization at the beginning of the observation fiscal quarter ( 59 / ( 14* 61)data data data ). pricedeflated seasonal earnings change ( 1que ) prior to the observation fiscal quarter is the difference in earnings per share before extraordinary items (data9) from fiscal quarter q-5 to q-1, scaled by the ending price at fiscal quarter q-2. we include two momentum controls, which we compute using the buy-and-hold daily returns for one calendar quarter ( 1qretq ) and for two through four calendar quarters ( 24qretq ) prior to the observation calendar quarter q, to capture short and longer term return momentum. 3.3 descriptive statistics table 1, panel a provides the descriptive statistics for 364 restatement announcement quarters. among the different types of institutions, quasi-indexers have the largest average holdings, consistent with the popularity of index funds (ke and ramalingegowda, 2005). all types of institutions show a negative change in institutional holdings in the quarter of the restatement, although transient institutions exhibit the largest decrease in holdings, consistent with the short-term focus of transient institutions. consistent with the earlier studies, the sample firm size ( size ) is highly skewed. the mean of total assets at the beginning of the restating quarter is $4,460.46 million, while the median is $363.28 million. the mean of book-to-market ratio ( bm ) at the beginning of the restating quarter is 0.58. the mean pricedeflated quarterly change in eps before extraordinary items prior to the restating quarter (ue ) is -0.03. table 1, panel b reports the descriptive statistics for 113,658 compustat firm-quarters. 113,658 compustat firm-quarters are obtained by excluding the restating asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 83 firms from the computat population for the period 19972002. comparing with 364 restatement firms, the compustat firms have lower level of ownership by total, transient, dedicated, and quasi-indexing institutions. moreover, the compustat firms on average have a positive change in total, transient, dedicated, and quasi-indexing institutional ownership over a quarter, whereas 364 restatement firms have significantly negative change in total, transient, and quasi-indexing institutional ownership, consistent with the notion that restatement events trigger reduction in institutional holdings when restatements are announced. with regard to firm-specific controls, the compustat firms are smaller and more profitable than the 364 restatement firms, consistent with prior studies (myers et al., 2003). taken together, our restatement firms have different firm characteristics than the compustat population, which provides further support to our model specifications of using the restating firm as its own control rather than using a cross-sectional research design. 7 table 1. descriptive statistics mean std. q1 median q3 panel a: restatements inst (%)q-1 41.46* 26.27 18.54 40.60 63.76 ∆adj_inst (%)q -1.70* 8.20 -3.45 -0.37 1.70 pw_inst (%)q-1 0.03* 0.07 0.00 0.00 0.02 tra (%)q-1 11.62* 10.85 2.27 8.85 18.45 ∆adj_tra (%)q -1.17* 5.17 -2.08 -0.17 0.95 pw_tra (%)q-1 0.05* 0.09 0.00 0.02 0.05 ded (%)q-1 11.53* 9.72 4.27 8.83 16.45 ∆adj_ded (%)q -0.25 3.51 -1.06 -0.08 0.88 pw_ded (%)q-1 0.05* 0.18 0.00 0.01 0.02 qix (%)q-1 19.26* 13.79 5.48 19.33 30.92 ∆adj_qix (%)q -0.54* 3.94 -1.56 -0.12 0.97 pw_qix (%)q-1 0.03* 0.07 0.00 0.00 0.02 size q-1 4460.46* 27656.77 79.81 363.28 1723.60 lnsize q-1 6.00* 2.10 4.38 5.90 7.45 bm q-1 0.58* 0.83 0.21 0.41 0.78 ue q-1 -0.03* 0.24 -0.03 -0.01 0.00 retq1 q 0.01 0.40 -0.24 -0.01 0.19 retq24 q 0.10* 0.74 -0.35 -0.01 0.29 panel b: compustat firms inst (%)q-1 33.06* 26.00 9.63 27.91 53.67 ∆adj_inst (%)q 0.11* 6.44 -1.77 -0.07 1.94 pw_inst (%)q-1 0.02* 0.17 0.00 0.00 0.01 tra (%)q-1 9.85* 10.53 1.56 6.49 14.79 ∆adj_tra (%)q 0.04* 4.17 -0.94 -0.06 1.01 pw_tra (%)q-1 0.05* 0.42 0.00 0.01 0.04 ded (%)q-1 9.52* 9.02 2.82 7.12 13.79 7 in untabulated analysis, we also examine how tobin q affects our findings (see appendix i on the measurement of tobin q). first, we compare the tobin q between our restatement firms and the compustat population. the mean of tobin q for the restatement firms is 2.26, while that for the compustat population is 2.14, with the mean difference not significant at the 1% level. further, we repeat the analyses in table 3, 4, and 5 by adding tobin q in equation (1), (2), and (3). our results remain robust. since research that examines change in institutional ownership does not typically include tobin q as an explanatory variable (see, for example, bushee and noe, 2000; ke and ramalingegowda, 2005), we do not include tobin q in the tables. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 84 ∆adj_ded (%)q 0.03* 3.25 -0.80 -0.04 0.92 pw_ded (%)q-1 0.05* 0.49 0.00 0.00 0.02 qix (%)q-1 15.99* 14.16 3.33 12.30 26.27 ∆adj_qix (%)q 0.02* 3.62 -0.87 -0.03 0.98 pw_qix (%)q-1 0.02* 0.11 0.00 0.00 0.01 size q-1 3440.35* 26216.14 61.06 238.46 932.48 lnsize q-1 5.56* 2.04 4.11 5.47 6.84 bm q-1 0.59* 6.53 0.29 0.53 0.87 ue q-1 0.03 6.06 -0.01 0.00 0.01 retq1 q 0.03* 0.38 -0.15 0.00 0.16 retq24 q 0.11* 0.78 -0.24 0.02 0.30 note. panel a provides descriptive statistics for the sample of 364 restatement announcement quarters from 1997 to 2002. panel b provides descriptive statistics for 113,658 compustat firm-quarters from 1997 to 2002, obtained by excluding the restating firms from the compustat population for the period 19972002. see appendix i for variable definitions. * denotes two-tailed significance at the 5% level for the mean of the variable of interest. table 2 presents correlations for the sample of 3,276 firm-quarters to test hypothesis 1 (i.e., 364 restatements*9 quarters with each restating firm centered on the restatement announcement quarter). the correlations show that the mean-adjusted change in total institutional holdings for each firm-quarter ( _ qadj inst ) is significantly negatively correlated with the beginning level of total institutional holdings ( 1qinst ), suggesting that it is important to include the level of institutional holdings as an explanatory variable in any specification where the change in institutional ownership is the dependent variable. moreover, the change in total institutional holdings for each firm-quarter ( _ qadj inst ) is significantly positively correlated with the stock returns over the most recent quarters ( 1qretq and 24qretq ), consistent with momentum trading of institutional investors. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 85 table 2. correlations among variables uinst% u q-1 u∆adj_inst% u q upw_inst%u q-1 ulnsize u q-1 ubm u q-1 uue q-1u uretq1u q uretq24 q inst% q-1 -0.091 0.300 0.559 0.028 -0.015 0.064 0.142 ∆adj_inst% q -0.026 0.003 0.023 -0.016 0.004 0.144 0.054 pw_inst% q-1 0.752 0.081 0.503 -0.027 -0.004 0.066 0.097 lnsize q-1 0.592 0.055 0.754 0.023 0.002 -0.005 -0.001 bm q-1 -0.111 -0.080 -0.352 0.012 0.138 -0.046 0.011 ue q-1 0.042 0.093 0.080 -0.002 -0.119 0.025 0.000 retq1 q 0.095 0.154 0.209 0.064 -0.210 0.170 0.058 retq24 q 0.235 0.076 0.347 0.124 -0.317 0.193 0.075 note. this table provides the correlation between each of the variables used in our empirical tests. the correlations are computed using 3,276 firm-quarters (=364 restatements * 9 quarters with each restating firm centered on the restatement announcement quarter). the 364 restatements are announced from the period 1997 to 2002. pearson (spearman) correlations are above (below) the diagonal. bold figures indicate two-tailed significance at the 1% level. see appendix i for variable definitions. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 86 4. research design and empirical results 4.1 institutional investors’ trading patterns surrounding announcements of restatements we begin by examining the changes in institutional holdings without including any additional controls. the pattern of mean-adjusted changes in holdings over time by total and by different types of institutional investors is depicted in figure 1. panel a shows that total institutions in general sell intensively in the restating quarter (mean-adjusted change in institutional holdings is -1.70% of the restating firm‟s shares outstanding), but there is no visual evidence of substantial selling in advance of the restatement (mean-adjusted change in institutional holdings is -0.04% of the restating firm‟s shares outstanding). however, after partitioning institutional investors into transient, dedicated, and quasi-indexing institutions in panel b, we see preliminary evidence that selling by transient institutions begins one quarter before the restating quarter, with a reduction in holdings of -0.29% of the restating firm‟s shares outstanding, which represents an decrease of 2.4% of the restating firm‟s aggregate transient institutional holdings (=0.29%/11.84%, 11.84% is the mean of the restating firm‟s beginning aggregate transient institutional holdings). we also see a decrease in holdings by the quasi-indexers of -0.32% of the restating firm‟s shares outstanding, which represents a decrease of 1.6% of the restating firm‟s aggregate quasi-indexing institutional holdings ( = -0.32%/19.64%, 19.64% is the mean of the restating firm‟s beginning aggregate quasi-indexing institutional holdings). interestingly, dedicated investors appear to increase their holdings by 0.46% of the restating firm‟s shares outstanding in the quarter prior to the restatement, and this increase in holdings corresponds to 4.3% of the restating firm‟s aggregate dedicated institutional holdings ( = 0.46%/10.78%, 10.78% is the mean of the restating firms‟ beginning aggregate dedicated institutional holdings). one possibility is that dedicated investors are committed to firms for the long term and, conditional on not knowing whether a firm will restate, the decline in share price of restating companies in the quarter prior to a restatement makes it a relatively attractive time to purchase shares. 8 this result suggests that it is unlikely that management has privately communicated the possibility of future bad news, because all types of institutions reduce their holdings after the restatement is announced. overall, the pattern of the mean-adjusted changes in holdings suggest that all types of institutional investors sell shares in the quarter of the restatement, but it is primarily the transient institutions that appear to sell more holdings one quarter in advance. t 8 currently, our tests cannot say whether transient or dedicated investors have a „better‟ investment strategy, because we do not have a sample of firms that have the characteristics of restating firms that never end up having a restatement. therefore, our paper is not intended to say that transient institutions are more sophisticated or follow a better investment strategy by reducing their holdings prior to the restatement, because our sample is composed of only ex-post restatement firms. it could well be that across all firms, buying firms with the characteristics of a restating firm in the quarter prior to the restatement is a better investment strategy than selling these firms, depending on the number of firms that share these characteristics and the difference in stock returns if a firm restates or not. we leave this question to future research. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 87 panel a. total institutional holdings panel b. by institutional type -2 -1.5 -1 -0.5 0 0.5 1 -4 -3 -2 -1 0 1 2 3 4 quarter relative to the restatement m e a n -a d ju st e d c h a n g e i n t o ta l in st it u ti o n a l h o ld in g s o f th e f ir m 's s h a r e s o u ts ta n d in g ( % ) -1.4 -1.2 -1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 -4 -3 -2 -1 0 1 2 3 4 quarter relative to the restatement m e a n a d ju st e d c h a n g e i n a g g r e g a te i n st it u ti o n a l h o ld in g s o f th e f ir m 's s h a r e s o u ts ta n d in g ( % ) transient dedicated quasi-index asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 88 figure 1. mean-adjusted change in institutional holdings of the restating firms‟ shares outstanding relative to the quarter of an accounting restatement because there are additional factors that may be associated with changes in institutional holdings, our formal examination of the first research question uses a regression design that allows us to include a number of other determinants of institutional trading. to establish the statistical significance of the changes in holdings in the quarters prior to the restatement, we use the firm as its own control. in particular, we acquire data for each restating firm for 9 quarters, centered on the restatement announcement quarter, and measure the changes in institutional holdings in the quarters of interest relative to average changes in holdings. we choose 9 quarters centered on the restatement announcement quarter (i.e., -4 to 4 quarters around the restatement announcement quarter) following prior work (e.g., abarbanell, bushee, and raedy, 2003). we use this approach instead of a matched sample or cross-sectional design for two main reasons. first, using the firm as its own control and measuring the changes in institutional holdings relative to the restatement date allows us to hold constant other firm characteristics that are more likely to vary significantly in a cross-sectional research design than over the 9-quarter event period that we examine. second, the use of this within-subjects research design provides a more powerful test because the cross-sectional differences between firms are not included in the error variance. this is particularly important when observations are limited as is the case with the restatement database. therefore, we carry out the regression for total institutional ownership, as well as for each group of institutions classified by investment style using the following regression model: , 0 1 2 3 , 1 4 , 1 5 , 6 , 7 , 1 8 , 1 9 , 1 _ % 1 2 % _ % 1 24 j q j q j q j q j q j q j q j q adj institution restate prerestate prerestate institution pw institution retq retq lnsize bm ue yeardummies industrydummies (1) where qjninstitutioadj ,_ is the mean-adjusted change over quarter q in aggregate institutional holdings by institution for firm j, where institution denotes holdings by all institutions ( inst ) or holdings by transient ( tra ), dedicated ( ded ), or quasi-indexing institutions (qix ) for each firm. restate is equal to one if the firm announced a restatement in that quarter and equal to zero otherwise. 1prerestate ( 2prerestate ) is equal to one if the institutional ownership measurement quarter is one (two) quarter(s) prior to the restating quarter and equal to zero otherwise. the beginning level of institutional holdings (b , 1j qinstitution ) and the beginning portfolio weight of firm j ( , 1_ j qpw institution ) are included in order to control for the effects of level and concentration of institutional holdings on changes in institutional ownership (ke and petroni, 2004; ke and ramalingegowda, 2005). 9 9 we attempt to control for potential endogeneity in several ways. first, our explanatory variables in the models (equation (1) and (2)) are measured with a lag with the dependent variables (i.e., change in different institutional ownership). such model specifications mitigate the potential endogeneity that both change in institutional ownership and our explanatory variables are jointly and contemporaneously determined by certain omitted firm features. next, we use the restating firm as its control and examine each restating firm for 9 quarters, centered on the restatement announcement quarter. using the firm as its own control and measuring the change in institutional holdings relative to the restatement date allows us to hold constant other firm characteristics that more likely to vary significantly in a cross-sectional research design than over the 9-quarter event period that we examine. accordingly, our time-series asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 89 we posit that transient institutional investors begin to sell restating firms prior to the quarter of the restatement announcement. this implies a significant negative coefficient on prerestate1 (βb1b<0) for holdings by transient institutions. we also examine institutional trading two quarters prior to the restatement quarter using prerestate2, to determine whether there is evidence of informed trading even further in advance. we expect the coefficient on 1,_ qjninstitutiopw to be negative, as institutions are more likely to unwind their positions if their beginning holdings are more concentrated on a given firm (ke and petroni, 2004). the coefficients on the momentum control variables, ,1j qretq and ,24 j qretq , are expected to be positive, as institutions have been shown to trade on return momentum. firm size ( , 1j qlnsize ), book-to-market ratio ( , 1j qbm ), and price-deflated seasonal earnings change ( , 1j que ) are included to control for the effects of firm-specific characteristics on the cross-sectional differences in institutional trading behaviors. we control for outliers by eliminating observations if the absolute value of studentized residuals or dffits influence statistics are greater than or equal to 1.9. table 3 presents the results of estimating equation (1) regarding institutional trading patterns surrounding restatement announcements, controlling for the firm-specific determinants of institutional trading behavior. table 3 shows that institutional investors as a whole do not appear to anticipate the impending restatement (coefficient on 1preresate =-0.077, p-value=0.76), although they significantly reduce their holdings during the restating quarter (coefficient on restate = -1.053, p-value=0.00). table 3 also presents the estimation of equation (1) for transient ( tra ), dedicated ( ded ) and quasi-indexing institutions ( qix ), respectively. as predicted, the coefficient on 1prerestate is significantly negative for transient institutions (coefficient=-0.391, p-value=0.02), indicating that transient institutions predict accounting restatements and start selling one quarter in advance to avoid the negative announcement returns associated with the restatement announcements. this finding supports the notion that institutional investors are able to anticipate accounting restatements at least one quarter ahead. nevertheless, it is still the case that the greatest amount of institutional selling by the transient institutions occurs during the restating quarter, as evidenced by a more negative coefficient on restate (coefficient=-0.776, p-value=0.00) relative to the coefficient on 1preresate . as expected, the coefficient on , 1_ j qpw tra is significantly negative (coefficient=-1.640, pvalue=0.01), consistent with the notion that the higher the beginning portfolio concentration, the more selling by transient institutions in the current observation quarter. in contrast, there is no evidence that other groups of institutions (i.e., dedicated and quasi-indexing) sell the restating firm in advance of the restatement. in particular, dedicated institutions appear to significantly increase holdings one quarter prior to the restatement announcement quarter (coefficient=0.251, p-value=0.04), consistent with the institutional investors‟ trading patterns surrounding announcements of restatements as illustrated in figure 1. again, this evidence suggests that it is research design alleviates the potential endogeneity that change in institutional holdings may be caused by certain omitted firm characteristics correlated with restatement events. lastly, we control for potential endogeneity by choosing the determinants of the change in institutional holdings based on the extant literature (e.g., ke and ramaligegowda, 2005), in order to include factors that likely affect change in institutional holdings. in doing so, we reduce the likelihood of omitted correlated variable problems in this study. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 90 unlikely that management has privately communicated the possibility of future bad news to institutional investors. quasi-indexers do not appear to trade significantly one quarter ahead of the restatement quarter. the lack of selling by dedicated and quasi-indexing institutions underscores the importance of focusing on the appropriate set of institutions when examining short term information-based trading. table 3. institutional trading around announcements of accounting restatements dependent variable independent variables ∆adj_inst% q ∆adj _tra% q ∆adj_ded% q ∆adj_qix% q intercept -0.946 (-1.30) 0.070 (0.14) 0.392 (1.07) -0.571 (-1.40) restate -1.053*** (-4.21) -0.776*** (-4.54) -0.064 (-0.53) -0.350** (-2.52) prerestate1 -0.077 (-0.30) -0.391** (-2.27) 0.251** (2.04) -0.234 (-1.64) prerestate2 0.113 (0.44) -0.040 (-0.23) 0.049 (0.40) 0.202 (1.40) institution% q-1p a p -0.022*** (-5.71) -0.064*** (-10.79) -0.033*** (-7.72) -0.028*** (-6.50) pw_institution% q-1 -3.316*** (-2.78) -1.640*** (-2.61) -0.128 (-0.54) -0.818 (-1.27) retq1 q 1.977*** (9.48) 1.252*** (8.79) 0.115 (1.12) 0.741*** (6.41) retq24 q 0.564*** (5.09) 0.080 (1.02) 0.052 (0.99) 0.262*** (4.35) lnsize q-1 0.343*** (5.88) 0.182*** (5.46) 0.032 (1.51) 0.201*** (5.98) bm q-1 -0.153* (-1.89) -0.201*** (-3.04) 0.018 (0.42) -0.125*** (-2.61) ue q-1 -0.138 (-0.49) 0.025 (0.10) 0.002 (0.07) 0.262 (1.52) year fixed effects included included included included industry fixed effects included included included included adjusted rp 2 p 0.063 0.085 0.024 0.044 note. this table presents the estimated equation (1) to test whether institutional investors anticipate the restatement at least one quarter in advance. the sample consists of 3,276 firm-quarters (=364 restatements * 9 quarters with each restating firm centered on the restatement announcement quarter). the 364 restatements are announced from the period 1997 to 2002. see appendix i for variable definitions. a institution denotes holdings by total institution (inst), holdings by transient (tra), dedicated (ded), and quasi-indexing institutions (qix) for each firm-quarter, depending on the column being examined. for brevity, year and industry variables are omitted from the table. outliers in the regressions are deleted when the absolute value of studentized residuals or dffits influence statistics is greater than or equal to 1.9. ***, **, and * denote two-tailed significance at the 0.01, 0.05 and 0.1 levels, respectively. t-statistics are presented in parentheses. to learn more about the types of information that institutions might be using, we add variables that have been shown in the past to predict earnings manipulation. beneish (1999) develops a asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 91 model using the accounting factors to predict accounting enforcement actions by the sec for violating gaap. we include these factors in our model and estimate the following regression: 10 , 0 1 2 3 , 1 4 , 1 5 , 6 , 7 , 1 8 , 1 9 , 1 10 , 11 , 12 , 13 , _ % 1 2 % _ % 1 24 j q j q j q j q j q j q j q j q j q j q j q j q adj institution restate prerestate prerestate institution pw institution retq retq lnsize bm ue dsri gmi aqi sgi 14 , 15 ,j q j qdepi tata yeardummies industrydummies (2) where all the variables except the accounting factors are defined in equation (1). the accounting factors are defined in appendix i variable definitions and are discussed below. days sales in receivables index ( qdsri ), measures the number of days in accounts receivables this year relative to last year, potentially useful for detecting revenue recognition-based earnings management. gross margin index ( qgmi ) measures the reduction in the gross-margin year over year, evidence of potential profit pressure. asset quality index ( qaqi ) measures the percentage of „soft‟ assets that are potentially more malleable. sales growth index ( qsgi ) measures sales growth, as high growth firms often face greater capital market pressures and may have greater incentive for earnings manipulation. depreciation index ( qdepi ) measures depreciation rates relative to total ppe for possible changes in depreciation policies, estimated useful lives, etc. total accruals to total assets ( qtata ) is a catchall for any potential accrual based earnings management not captured by the other measures. note that all factors are defined such that a higher number increases the likelihood of earnings manipulation. some of these measures are intended to try to provide flags about possible manipulation, while others are simply incentive variables intended to capture firms with greater incentives to manage earnings. because we use quarterly changes in institutional holdings, we define these 6 factors based on the trailing four quarters of data available to the institutions prior to the reported end of quarterly holdings. since these variables are mainly based on year-to-year changes which introduces a potential problem when the denominator is small, we winsorize each variable at the 1% and 99% of its distribution following beneish (1999). results of estimating equation (2) are presented in table 4 for each of the institutional types. looking at the column related to transient institutional investors, of the six factors included in the model, two are significant in the predicted direction. ,j qdsri , which measures an increase in the accounts receivable balance relative to sales, is negatively associated with change in transient institutional holdings (coefficient =-0.183, p-value=0.09). total accruals ( ,j qtata ) is also negatively associated with changes in transient institutional ownership (coefficient = -1.110, p-value =0.00). none of the other factors are associated with changes in institutional holdings. overall, the results of including the earnings manipulation variables shows that institutions are more likely to reduce their holdings when there is an increase in the days sales in receivables or high accruals. however, 1prerestate continues to be significantly negative one quarter in advance (coefficient=-0.401, p-value=0.04), suggesting that institutional investors use other 10 beneish includes two additional measures in his model, leverage and sg&a expense, neither of which is related to sec enforcement actions. as a result, we do not include them in our regression. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 92 information in addition to these two factors when deciding to reduce their holdings before the restatement announcement. 11 table 4. institutional trading and financial statement predictors of restatements independent variable ∆adj_inst% q ∆adj _tra% q ∆adj_ded% q ∆adj_qix% q intercept -0.226 (-0.25) 0.008 (0.01) 0.989** (2.08) -0.140 (-0.27) restate -1.215*** (-4.45) -0.877*** (-4.57) -0.141 (-1.06) -0.404*** (-2.66) prerestate1 -0.023 (-0.08) -0.401** (-2.07) 0.228* (1.70) -0.115 (-0.74) prerestate2 0.140 (0.49) -0.062 (-0.32) -0.000 (0.00) 0.176 (1.11) institution% q-1p a p -0.025*** (-5.60) -0.068*** (-10.21) -0.040*** (-7.89) -0.030*** (-6.20) pw_institution% q-1 -3.332*** (-2.69) -2.106*** (-3.00) -0.062 (-0.25) -0.781 (-1.16) retq1 q 1.991*** (9.04) 1.258*** (8.17) 0.204* (1.87) 0.742*** (6.06) retq24 q 0.659*** (5.32) 0.205** (2.27) 0.040 (0.68) 0.277*** (4.12) lnsize q-1 0.368*** (5.64) 0.248*** (6.46) 0.024 (1.02) 0.213*** (5.66) bm q-1 -0.143* (-1.68) -0.169** (-2.39) 0.013 (0.29) -0.136*** (-2.70) ue q-1 -0.153 (-0.52) -0.122 (-0.46) 0.115 (0.48) 0.334* (1.85) dsri q -0.589*** (-3.95) -0.183* (-1.72) -0.247*** (-3.48) -0.060 (-0.72) gmi q -0.017 (-0.19) 0.027 (0.39) -0.025 (-0.55) -0.033 (-0.65) aqi q 0.026*** (3.19) 0.008 (1.42) 0.001 (0.34) 0.001 (0.20) sgi q 0.073 (0.98) 0.030 (0.58) 0.021 (0.57) 0.051 (1.24) depi q -0.442 (-1.16) -0.078 (-0.30) -0.245 (-1.25) -0.397* (-1.86) tata q 0.244 (0.54) -1.110*** (-3.53) 0.677*** (2.94) 0.115 (0.46) year fixed effects included included included included 11 the correlations among the variables indicate that firm size (lnsizeq-1) is positively correlated with total institutional holdings (inst% q-1) and the portfolio weight of the firm to institutions (pw_inst% q-1). this is expected because larger firms usually attract more institutions and these institutions allocate higher weight of their holdings to larger firms (gompers and metrick, 2001; wang, 2010). to assess the impact of multicollinearity, we compute the variance inflation factors (vif) for each of the independent variables used in table 3 and 4 (except year and industry dummies). the measures indicate no substantial multicollinearity among the independent variables, with firm size to be the most collinear variable, having the highest vif value of less than 3 (kennedy, 2003). in order to ensure that the results in table 3 and 4 are not sensitive to the inclusion of firm size, we exclude firm size and repeat the analysis of table 3 and 4. the untabulated results remain qualitatively similar. we choose to include firm size as an explanatory variable to be consistent with prior research (e.g., ke and petroni, 2004). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 93 industry fixed effects included included included included adjusted rp 2 p 0.078 0.095 0.036 0.047 note. this table presents the estimated equation (2) to test whether institutional investors anticipate the restatement at least one quarter in advance, adding controls of financial statement predictors of accounting restatements. the sample consists of 3,276 firm-quarters (=364 restatements * 9 quarters with each restating firm centered on the restatement announcement quarter). the 364 restatements are announced from the period 1997 to 2002. see the appendix for variable definitions. p a institution denotes holdings by all institution (inst); holdings by transient (tra), dedicated (ded), and quasi-indexing institutions (qix) for each firm-quarter, depending on the column being examined. for brevity, year and industry variables are omitted from the table. outliers in the regressions are deleted when the absolute value of studentized residuals or dffits influence statistics is greater than or equal to 1.9. ***, **, and * denote two-tailed significance at the 0.01, 0.05 and 0.1 levels, respectively. tstatistics are presented in parentheses. finally, in untabulated results we redo the analysis for tables 3 and 4 using only the restatements that occur after the implementation of regulation fair disclosure (reg fd). 12 this reduces the number of restatements to 162 and reduces the sample to 1,458 firm-quarter observations (=162 restatements * 9 quarters with each restating firm centered on the restating quarter). the results are qualitatively the same, which provides additional evidence that information advantage via private communications with management are unlikely to be the source of informed trading by institutions with respect to a restatement, because after reg fd managers are prohibited from privately sharing material information to select investors and therefore transient institutional investors are less likely to obtain private information disclosed from firm management after reg fd. note that institutional investors‟ information advantage is either from private information obtained from firm management and/or from superior analysis of public information. consequently, after reg fd if institutional investors continue to have information advantage, the information source of institutional investors is likely from their superior processing of public information because after reg fd private information acquisition from firm management is less likely to be the information source of institutional investors with respect to a restatement. 4.2 the market reaction to restatements as a function of institutional ownership our second set of tests examines the stock price reaction as a function of levels of different institutional ownership. based on the evidence in the previous section that transient institutional investors reduce their holdings in restating firms at least one quarter prior to the restatement, we next examine whether greater levels of transient institutional holdings affect the price formation process, such that greater transient institutional ownership accelerates the impounding of restatement related information into stock price in the pre-announcement window. we begin by presenting descriptive evidence on this hypothesis. figure 2 charts the stock price reaction to the accounting restatement, beginning 92 days prior to the restatement announcement until 2 days after the restatement announcement. we chart the cumulative abnormal returns for firms with 9% or greater transient institutional ownership (high_tra) and firms with less than 9% transient institutional ownership (low_tra), respectively, with levels of transient institutional ownership measured at the end of two quarters prior to the restating quarter (i.e., 12 regulation fair disclosure (reg fd), effective on october 23, 2000, states that managers may not privately disclose material information to select financial analysts and institutional investors. the sec commissioners believed that managers provided material, advanced knowledge of earnings results and other important nonpublic information to select investors, who then traded profitably at the expense of less informed investors. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 94 prior to the date when the cumulative abnormal returns start to accumulate). 9% of transient institutional ownership is the sample median. the two lines show that high_tra firms exhibit more negative returns over the 90 days prior to the restatement announcement (i.e., day -92 to day -3). specifically, three days prior to the announcement, high_tra firms have a cumulative abnormal return of -16.4%. this compares to the low_tra firms, which have cumulative abnormal return of -9.5% three days prior to the announcement. during the event window which is defined as day -2 to +2 around the restatement announcement date, however, the high_tra firms exhibit similar negative returns as the low_tra firms. in particular, in the five day window (day -2 to day +2), the cumulative abnormal returns of high_tra firms goes from 16.4% to -24.3%, while those of low_tra firms drop from -9.5% to -16.0%. overall, these results suggest that the presence of transient institutional investors gets the information content of restatement impounded into stock price early in the pre-announcement period. figure 2. cumulative abnormal returns by high and low transient institutional ownership note. this figure charts the cumulative abnormal returns to firms that have an accounting restatement from 92 days to until 2 days after the restatement. the sample consists of 364 restatements over the period 1997 to 2002. low_tra signifies firms with less than 9% (the sample median) transient institutional ownership, while high_tra indicates firms with greater than or equal to 9% transient institutional ownership. to formalize this result, we also use a regression based design that attempts to control for other influences on price. we estimate the 90-day cumulative abnormal returns in the period prior to the restatement announcement (day -92 to day -3) as a function of the level of different asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 95 institutional ownership. we control for size ( lnsize ), book-to-market ( bm ), return momentum ( 24retq ), unexpected earnings ( ue ), year and industry fixed effects. these variables are defined in equation (1). we also include a restatement reason indicator core , which is equal to 1 when the restatement involves revenue recognition, cost of sales or operating expenses, or loan loss provisions and equal to 0 otherwise (hribar and jenkins, 2004); and a restatement initiator indicator auditor , which is equal to 1 when the restatement is initiated by the auditor and equal to zero otherwise, in order to capture the fact that these restatements tend to cause more negative returns (palmrose, richardson, and scholz, 2004). to measure the effect of institutional holdings on the abnormal returns, we form scaled deciles based on the level of institutional ownership for transient ( _tra rank ), dedicated ( _ded rank ) and quasiindexing institutional ownership ( _qix rank ), respectively (ayers and freeman, 2003). with regard to _tra rank , we group the 364 restating firms into ten groups based on the level of aggregate transient institutional holdings of the restating firm‟s shares outstanding at the end of quarter q-2 ( 2%qtra ) (i.e., group 0~9). we then divide this decile ranking by 9. for example, tra_rank q-2 is equal to 0 (i.e., 0/9) for the firms with the lowest tra%q-2 and equal to 1 (i.e., 9/9) for the firms with the highest tra%q-2. likewise, we measure _ded rank and _qix rank . 13 all the independent variables except 24retq , core and auditor are measured at the end of two quarters prior to the restating quarter, so that the independent variables are measured before the date when the pre-announcement cumulative abnormal returns (car90) starts to accumulate. the regression model is as follows: 0 1 , 2 2 , 2 3 , 2 4 , 5 , 2 6 , 2 7 , 2 8 9 90 _ _ _ 24j q j q j q j q j q j q j q car tra rank ded rank qix rank retq lnsize bm ue auditor core yeardummies industrydummies (3) table 5 presents the results of estimating equation (3). table 5, column (1) provides the results for the full restatement sample (i.e., 364 restatements). consistent with the expectations, firms with a large number of transient institutional investors exhibit significantly more negative returns in the pre-announcement period (coefficient=-0.192, p-value=0.02). this is not true of any of the other types of institutional investors, with , 2_ j qqix rank and , 2_ j qded rank not significantly different from zero. also, the magnitude of the coefficient is substantial, with the difference to be 19.2% between firms with high transient institutional ownership and firms with low transient institutional ownership. in addition, it appears that restatements that involves revenue recognition, cost of sales or operating expenses, or loan loss provisions have significantly larger preannouncement negative returns relative to the other restatements. taken as a whole, the results suggest that the presence of transient institutional ownership accelerates the impounding of the restatement news into price, causing more negative pre-announcement returns for firms with high transient institutional ownership than firms with low transient institutional ownership. table 5, column (2) provides the results for the sub-sample of the 13 the results are qualitatively similar using scaled quintile ranking to construct tra_rank, ded_rank, and qix_rank. that is, we form the 364 restating firms into 5 groups (i.e., group 0~4) based on the level of aggregate transient (tra%q-2), dedicated (ded% q-2), and quasi-indexing institutional holdings (qix% q-2) of the firm‟s shares outstanding and then divide this quintile ranking of transient, dedicated and quasi-indexing by 4, respectively. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 96 restatements that occur before the implementation of reg fd (i.e., before october 23, 2000; 202 restatements). consistent with the prediction, firms with a large number of transient institutional investors continues to exhibit significantly more negative returns in the pre-announcement period (coefficient=-0.171, p-value=0.09). likewise, table 5, column (3) provides the results for the sub-sample of the restatements that occur after the implementation of reg fd (i.e., after october 23, 2000; 162 restatements). as expected, firms with a large number of transient institutional investors continues to exhibit significantly more negative returns in the pre-announcement period (coefficient=-0.380, p-value=0.01). table 5. the market reaction to accounting restatements and levels of different institutional holdings dependent variablecarp90 independent variables (full restatement sample) (1) (pre-regulation fd sub-sample) (2) (post-regulation fd sub-sample) (3) intercept -0.285* (-1.67) -0.494** (-1.75) -0.394** (-1.83) tra_rank q-2 -0.192** (-2.01) -0.171* (-1.34) -0.380** (-2.34) ded_rank q-2 -0.063 (-0.77) -0.133 (-1.21) 0.061 (0.49) qix_rank q-2 0.059 (0.51) 0.010 (0.06) 0.136 (0.80) retq24 q 0.118*** (3.47) 0.196*** (4.18) 0.016 (0.30) lnsize q-2 0.029** (1.82) 0.050** (2.02) 0.032* (1.56) bm q-2 0.095*** (2.86) 0.179*** (2.88) 0.031 (0.72) ue q-2 -0.549*** (-3.51) -0.848*** (-2.68) -0.475** (-2.61) auditor -0.078 (-0.85) -0.158* (-1.44) 0.065 (0.36) core -0.141*** (-2.89) -0.091* (-1.33) -0.106* (-1.40) year fixed effects included included included industry fixed effects included included included adjusted rp 2 p 0.156 0.251 0.074 note. this table examines the market reaction to the restatement announcement over the 90-day pre-announcement period (i.e., day -92 to day -3 prior to the restatement announcement) on levels of different institutional holdings using equation (3) below. the first column presents the result for the full restatement sample (i.e., 364 restatements announced from 1997 to 2002). the second column presents the results for the restatements that occur before the implementation of regulation fd (i.e., 202 restatements announced from 1997 to october 23, 2000). the third column presents the results for the restatements that occur after the implementation of regulation fd (i.e., 162 restatements announced from october 23, 2000 to 2002). for brevity, year and industry variables are omitted from the table. ***, **, and * denote one-tailed significance at the 0.01, 0.05 and 0.1 levels, respectively. t-statistics are presented in parentheses. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 97 taken as a whole, the results suggest that the presence of high transient institutional ownership gets the information content of restatement impounded into stock price early in the preannouncement period. furthermore, the finding that firms with higher transient institutional ownership exhibit more negative returns for both the restatements occurring before and after reg fd provides additional evidence that information advantage via private communications with management is unlikely to be the source of informed trading by institutions with respect to a restatement. therefore, the information advantage of institutional investors is likely attributable to institutions‟ superior ability to process public information. 4.3 additional tests we perform additional tests to ensure further the robustness of our inferences. for brevity, we focus on transient institutional investors only because the preceding results indicate that only transient institutional investors appear to anticipate impending restatements. 4.3.1 institutional investors‟ trading around the restatements that affect core earnings we extend our analysis to examine whether institutional investors are differentially able to predict restatements that affect core earnings, as opposed to those that do not affect core earnings. following hribar and jenkins (2004), we define core earnings as restatements related to revenue recognition, cost of sales or operating expenses, or loan loss provisions. we then examine the following regression: , 0 1 2 3 4 5 6 7 , 1 8 , 1 9 , 10 , 11 , 1 1 _ 1 2 * * 1 * 2 _ 1 24 j q j q j q j q j q j q adj institution restate prerestate prerestate core core restate core prerestate core prerestate institution pw institution retq retq lnsize 2 , 1 13 , 1j q j qbm ue yeardummies industrydummies (4) all the variables are defined in equation (1), (2), and (3). we include the main effect of core in the model for completeness, but do not have an ex ante prediction of its coefficient. however, we expect that the interactions between core and restate , 1prerestate and 2prerestate will be significantly negative if institutional investors sell more holdings preceding restatements that affect recurring/core operating earnings than those that do not affect core earnings. untabulated results show that transient institutions reduce their holdings in the restatement quarter by a significantly greater amount when the restatement affects core earnings. also, the coefficient on prerestate1 remains negatively significant, consistent with our prediction that transient institutions sell holdings in advance of restatements. however, the interaction between core*prerestate1 is not statistically significant. other results are not qualitatively different from those reported in table 3. in summary, although a restatement of core earnings affects the magnitude of the sell-off in the restating quarter, it appears to have no differential impact on institutions‟ trading in advance of the restatement announcement. 4.3.2 institutional investors‟ trading after the restatements we also extend the analysis on how institutional investors trade after the restatement announcement quarter by adding two post-restatement dummies in equation (1) and equation (2), i.e., 1postrestate ( 2postrestate ) , which is equal to 1 if the institutional ownership measurement quarter is one (two) quarter (s) after the restatement announcement quarter and equal to zero otherwise. we provide the regression results in table 6. table 6, column (1) and (2) asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 98 reports the result based on equation (1) and (2), respectively, after including 1postrestate and 2postrestate . the coefficients on 1postrestate and 2postrestate are not significant in both column (1) and (2), suggesting that transient institutional investors do not trade significantly after the restatement announcement quarter. as expected, transient institutional investors sell holdings one quarter before the restatement announcement quarter after adding these two post-restatement dummies. overall, the results in table 6 demonstrate that transient institutional investors respond to restatements by selling more holdings preceding the restatements, but not after the restatements. table 6 transient institutional trading after announcements of accounting restatements independent variables dependent variable ― ∆adj _tra% q (1) (2) intercept 0.068 (0.13) -0.002 (0.00) restate -0.765*** (-4.28) -0.858*** (-4.26) prerestate1 -0.382** (-2.13) -0.384* (-1.89) prerestate2 -0.032 (-0.18) -0.046 (-0.22) postrestate1 0.070 (0.38) 0.102 (0.49) postrestate2 0.010 (0.05) 0.041 (0.19) transient% q-1 -0.064*** (-10.81) -0.068*** (-10.16) pw_transient% q-1 -1.668*** (-2.66) -2.144*** (-3.05) retq1 q 1.265*** (8.85) 1.279*** (8.26) retq24 q 0.076 (0.97) 0.229** (2.54) lnsize q-1 0.182*** (5.47) 0.248*** (6.46) bm q-1 -0.199*** (-3.01) -0.169** (-2.37) ue q-1 0.023 (0.09) -0.120 (-0.45) dsri q -0.188* (-1.76) gmi q 0.026 (0.39) aqi q 0.008 (1.42) sgi q 0.029 (0.56) depi q -0.083 (-0.32) tata q -1.120*** (-3.55) asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 99 year fixed effects included included industry fixed effects included included adjusted rp 2 p 0.085 0.095 note. this table presents the sensitivity check on how transient institutional investors trade after restatement announcements. specifically, we add two dummy variables postrestate1 and postrestate2 in equation (1) and (2), respectively, in order to capture how transient institutional investors trade after accounting restatement announcements. postrestate1 (postrestate2) is equal to 1 if the institutional ownership measurement quarter is one (two) quarter (s) after the restatement announcement quarter and equal to zero otherwise. for brevity, year and industry variables are omitted from the table. outliers in the regressions are deleted when the absolute value of studentized residuals or dffits influence statistics is greater than or equal to 1.9. ***, **, and * denote two-tailed significance at the 0.01, 0.05 and 0.1 levels, respectively. t-statistics are presented in parentheses. 5. conclusions this paper provides direct evidence that actively trading institutional investors reduce their holdings prior to a restatement and that they play a role in the price formation process surrounding the restatement event. first, we show that transient institutions, which are shortterm focused, reduce their holdings at least one quarter prior to the restating quarter. because of the setting in which our analysis is performed (i.e. accounting restatements), it is unlikely that the information advantage of transient institutions is due to private communications with firm management. rather, the information advantage that we document most likely results from institutional investors‟ superior ability to process public information due to better knowledge and/or resources. second, of the factors that have been shown to be associated with earnings manipulation, we show that changes in days sales in receivables and accruals lead to reductions in holdings by transient institutional investors, consistent with institutional investors making informed trading based on financial statement information to reduce their exposure to a potential restatement. lastly, our analysis shows that the market reaction to the accounting restatement is more negative prior to the restatement announcement for firms with higher levels of transient institutional ownership. overall, our results demonstrate that institutional investors anticipate impending restatements and play an important role in the price formation process for firms that are forced to restate their financial statements. acknowledgement we have benefited from useful comments and suggestions provided by dan bens, patty dechow, jim ohlson, beverly walther, charles wasley, jerry zimmerman and workshop participants at the university of arizona, arizona state university, penn state university, rice university, university of rochester, washington university in st. louis, and the 2005 fars mid-year meeting. we especially thank brian bushee for the institutional investor classification data. references abarbanell, j., bushee, b., & raedy, j. 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(2010). transient institutional investors and insider trading signals. international journal of accounting and information management (forthcoming) appendixes appendix 1.variable definitions variables measurement institutional ownership variables inst%q-1 = level of total institutional ownership of the firm‟s shares outstanding at the end of quarter q-1. ∆adj_inst%q = mean-adjusted change in total institutional holdings of the firm‟s shares outstanding over calendar quarter q. the adjustment is made by subtracting the average change in total institutional holdings across all firms in the cda/spectrum database over the same calendar quarter q, in order to control for time trends in the change in total institutional holdings (abarbanell, bushee, and raedy, 2003). pw_inst%q-1 = weighted mean portfolio weight of the firm held by all institutions at the end of quarter q-1. pw_instj,q-1=mvinst,j,q-1/mvinst,all,q-1, where mvinst,j,q-1 is the market value of firm j held by all institutions at the end of quarter q-1. mv inst,all q-1 is the market value of all firms held by the same institutions at the end of quarter q-1. tra%q-1 = level of aggregate transient institutional holdings of the firm‟s shares outstanding at the end of quarter q-1. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 102 ∆adj_tra%q = mean-adjusted change in aggregate transient institutional holdings of the firm‟s shares outstanding over calendar quarter q. the adjustment is made by subtracting the average change in aggregate transient institutional holdings across all firms in the cda/spectrum database over the same calendar quarter q, in order to control for time trends in the change in transient institutional holdings (abarbanell, bushee, and raedy, 2003). pw_tra%q-1 = weighted mean portfolio weight of the firm held by all transient institutions at the end of quarter q-1. pw_traj,q-1=mvtra,j,q-1/mvtra,all,q-1, where mvtra,j,q-1 is the market value of firm j held by all transient institutions at the end of q-1. mv tra,all q-1 is the market value of all firms held by the same transient institutions at the end of q1. tra_rank q-2 =scaled decile ranking across the restating firms (i.e., 364 restating firms) based on the level of aggregate transient institutional holdings of the firm‟s shares outstanding at the end of quarter q-2 (tra%q-2). specifically, we group the 364 restating firms into ten groups based on tra%q-2 (i.e., group 0~9) and then divide this decile ranking by 9. for example, tra_rank q-2 is equal to 0 (i.e., 0/9) for the firms with the lowest tra%q-2 and equal to 1 (i.e., 9/9) for the firms with the highest tra%q-2. ded%q-1 = level of aggregate dedicated institutional holdings of the firm‟s shares outstanding at the end of quarter q-1. ∆adj_ded%q = mean-adjusted change in aggregate dedicated institutional holdings of the firm‟s shares outstanding over calendar quarter q. the adjustment is made by subtracting the average change in aggregate dedicated institutional holdings across all firms in the cda/spectrum database over the same calendar quarter q, in order to control for time trends in the change in dedicated institutional holdings (abarbanell, bushee, and raedy, 2003). pw_ded%q-1 = weighted mean portfolio weight of the firm held by all dedicated institutions at the end of quarter q-1. pw_dedj,q-1=mvded,j,q-1/mvded,all,q-1, where mvded,j,q-1 is the market value of firm j held by all dedicated institutions at the end of q-1. mv ded,all q-1 is the market value of all firms held by the same dedicated institutions at the end of q1. ded_rank q-2 =scaled decile ranking across the restating firms (i.e., 364 restating firms) based on the level of aggregate dedicated institutional holdings of the firm‟s shares outstanding at the end of quarter q-2 (ded%q-2). specifically, we group the 364 restating firms into ten groups based on ded%q-2 (i.e., group 0~9) and then divide this decile ranking by 9. for example, ded_rank q-2 is equal to 0 (i.e., 0/9) for the firms with the lowest ded%q-2 and equal to 1 (i.e., 9/9) for the firms with the highest ded%q-2. qix%q-1 = level of aggregate quasi-indexing institutional holdings of the firm‟s shares outstanding at the end of quarter q-1. ∆adj_qix%q = mean-adjusted change in aggregate quasi-indexing institutional holdings of the firm‟s shares outstanding over calendar quarter q. the adjustment is made by subtracting the average change in aggregate quasi-indexing institutional holdings across all firms in the cda/spectrum database over the same calendar quarter q, in order to control for time trends in the change in quasi-indexing institutional holdings (abarbanell, bushee, and raedy, 2003). pw_qix%q-1 = weighted mean portfolio weight of the firm held by all quasi-indexing institutions at the end of quarter q-1. pw_qixj,q-1=mvqix,j,q-1/mvqix,all,q-1, where mvqix,j,q-1 is the market value of firm j held by all quasi-indexing institutions at the end of q-1. mv qix,all q-1 is the market value of all firms held by the same quasi-indexing institutions at the end of q-1. qix_rank q-2 =scaled decile ranking across the restating firms (i.e., 364 restating firms) based on the level of aggregate quasi-indexing institutional holdings of the firm‟s shares outstanding at the end of quarter q-2 (qix%q-2). specifically, we group the 364 restating firms into ten groups based on qix%q-2 (i.e., group 0~9) and then divide this asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 103 decile ranking by 9. for example, qix_rank q-2 is equal to 0 (i.e., 0/9) for the firms with the lowest qix%q-2 and equal to 1 (i.e., 9/9) for the firms with the highest qix%q-2. restatement variables core = restatement reason indicator, which is equal to 1 if the restatement involves revenue recognition, cost of sales or operating expenses, or loan loss provisions and equal to 0 otherwise. auditor = restatement initiator indicator, which is equal to 1 if the restatement is initiated by the auditor and equal to 0 otherwise. retstate = restatement quarter indicator, which is equal to 1 if the firm announced a restatement in that quarter (restating quarter) and equal to 0 otherwise. prerestate1 = pre-restatement quarter indicator, which is equal to 1 if the observation quarter is one quarter prior to the restating quarter and equal to 0 otherwise. prerestate2 = pre-restatement quarter indicator, which is equal to 1 if the observation quarter is two quarters prior to the restating quarter and equal to 0 otherwise. postrestate1 = post-restatement quarter indicator, which is equal to 1 if the observation quarter is one quarter after the restating quarter and equal to 0 otherwise. postrestate2 = post-restatement quarter indicator, which is equal to 1 if the observation quarter is two quarters after the restating quarter and equal to 0 otherwise. control variables lnsizeq-1 = log of book value of total assets (data44) at the end of quarter q-1. bmq-1 = ratio of common book equity to total market capitalization at the end of quarter q-1 (data59/ (data14*data61)). retq1q = daily buy-and-hold returns over one calendar quarter prior to the calendar quarter q (i.e., from the end of calendar quarter q-2 to the end of q-1). retq24q = daily buy-and-hold returns over calendar quarters 2 to 4 prior to the calendar quarter q (i.e., from the end of calendar quarter q-5 to the end of q-2). ue q-1 =seasonal unexpected earnings per share before extraordinary items (data9) in quarter q-1, measured by the change in earnings per share before extraordinary items from fiscal quarter q-5 to q-1, scaled by the ending price of fiscal quarter q-2. industry dummies = defined by the following sic codes adapted from barth, beaver and landsman (1999): mining, construction and extractive industry (1000-1999, 2900-2999); food, textiles, chemicals and pharmaceuticals (2000-2111, 2200-2799, 2800-2824, 28302836, 2840-2899); manufacturers and computers (3000-3999, 7370-7379); utilities and transportation (4000-4899, 4900-4999); retail (5000-5999); financial services (6000-6411, 6500-6999); service (7000-7369, 7380-8999). earnings manipulation variables dsriq = ratio of days sales in accounts receivable to the corresponding measure in the prior year, measured as t t-1 1 re (data2)/sales (data 12) re /sales t t ceivables ceivables . dsri is based on the trailing four quarters of data available to the institutions prior to the reported end of quarterly institutional holdings and is winsorized at the 1% and 99% percentiles (beneish, 1999). gmiq = ratio of gross margin percentage to the correspoinding measure in the prior year, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 104 measured as t-1 t-1 t-1 t t t sales (data 12)-costs of goods sold (data 41) / sales (data 12) sales (data 12)-costs of goods sold (data 41) sales (data 12) . gmi based on the trailing four quarters of data available to the institutions prior to the reported end of quarterly institutional holdings and is winsorized at the 1% and 99% percentiles (beneish, 1999). aqiq = percentage of total assets not in current assets or ppe relative to the corresponding measure in the prior year, measured as t t t-1 t-1 -1 current assets (data 4)+ppe ( data 8) current assets +ppe 1 / 1 total assets (data 6) total assetst t aqi is set to be one if the assets at year t-1 consist exclusively of current assets and ppe. aqiq is based on the trailing four quarters of data available to the institutions prior to the reported end of quarterly institutional holdings and is winsorized at the 1% and 99% percentiles (beneish, 1999). sgiq = sales growth index, measured as t t-1 sales (data 12) sales . sgi is based on the trailing four quarters of data available to the institutions prior to the reported end of quarterly institutional holdings and is winsorized at the 1% and 99% percentiles (beneish, 1999). depiq = ratio of the rate of depreciation in year t-1 versus the corresponding rate in year t, measured as 1 +1 1 depreciation (data14 -data 65) depreciation ppe (data8) t t t / t +t t depreciation depreciation ppe . depi is set to be one if amortization of intangibles (data 65) is missing. depi is based on the trailing four quarters of data available to the institutions prior to the reported end of quarterly institutional holdings and is winsorized at the 1% and 99% percentiles (beneish, 1999). tataq = ratio of total accruals to total assets, measured as tincome before extraordinary items (data 18)-cfo (data308) total assetst (data6) t t tata is based on the trailing four quarters of data available to the institutions prior to the reported end of quarterly institutional holdings and is winsorized at the 1% and 99% percentiles (beneish, 1999). market reaction variables car90 = cumulative abnormal return from day -92 to day -3, where day zero is the date of the restatement announcement. other variables tobin q = (book value of total assets (data 44)book value of equity (data 59) + market value of equity (data 14*data61))/book value of total assets (data44) (coles, daniel and naveen, 2008) appendix 2. characteristics of different types of institutions abc asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e4 www.macrothink.org/ajfa 105 transient dedicated quasi-indexers portfolio turnover factor mean 1.472 -0.228 -0.442 pt1 mean 0.774 0.414 0.368 pt2 mean 0.557 0.231 0.229 stab1 mean 0.335 0.578 0.569 stab2 mean 0.461 0.713 0.700 portfolio concentration factor mean -0.196 2.122 -0.292 lbph mean 0.032 0.382 0.026 lbpf mean 0.014 0.213 0.009 aph mean 0.009 0.063 0.008 conc mean 5.910 14.772 5.817 description for the above table. a this table is based on table 1 of bushee, b. (2001). do institutional investors prefer near-term earnings over long-run value? contemporary accounting research, 18, 207-246, and table 5 of bushee, b. (1998). the influence of institutional investors on myopic r&d investment behavior. the accounting review, 305-333. b the classification of transient, dedicated, and quasi-indexing institutions is institution-year specific, based on a factor analysis and cluster analysis. first, a portfolio turnover factor (a portfolio concentration factor) is created based on the variables listed below the portfolio turnover factor (the portfolio concentration factor) in the table above. next, a cluster analysis is performed to group institutions with similar turnover and concentration factor into transient, dedicated, and quasi-indexing institutions, respectively. the variables used in the factor analysis are calculated at the end of each calendar quarter for every institution on the spectrum database. quarterly values are averaged over all available quarters to calculate year-end values for each institution-year. c the above table indicates that transient institutions have short investment horizon (high turnover factor) and small stakes in portfolio firms (low concentration factor), suggesting that transient institutional investors trade actively over short-term to maximize trading profits. dedicated institutions have long investment horizon (low turnover factor) and large stakes (high concentration factor) in portfolio firms, consistent with the “relationship investing” role. quasi-indexers have long investment horizon (low turnover factor) and small stakes (low concentration factor) in portfolio firms, consistent with a passive buy-and-hold indexing strategy. pt1 = institution‟s quarterly portfolio turnover percentage= 1 , 1| | /( )kt kt kt k tw w w w , ktw is portfolio weight (shares held times stock price) in firm k at end of quarter t. pt2 = institution‟s quarterly portfolio turnover percentage using only sales transactions stab1= percentage of the institution‟s holdings held continuously for two years (= wktltktwkt /)*( , where wkt=portfolio weight (shares held times stock price) in firm k at end of quarter t, ltkt=1 if the institution held firm k continuously for prior eight quarters, 0 otherwise) stab2 = percentage of the institution‟s portfolio firms held continuously for two years. lbph =percentage of the institution‟s holdings held in large blocks (greater than 5%) lbpf =percentage of the institution‟s portfolio firms held in large blocks (greater than 5%) aph = the institution‟s average percentage ownership in its portfolio firms. conc = the institution‟s average investment size in its portfolio firms (millions $) microsoft word revised paper-writer2-new-final.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 446 day of the week effect, annual returns and volatility of five stock markets in southeast of asia mansooreh kazemi lari (corresponding author) dept. of mathematical science, faculty of science universiti teknologi malaysia (utm), 81310, johor bahru, johor, malaysia tel: 60-12-665-7562 e-mail: kazemilari_m@yahoo.com abbas mardani dept. of management, faculty of management and human resource development, universiti teknologi malaysia (utm), 81310 johor bahru, johor, malaysia tel: 60-17-665-1841 e-mail: abbas.mardani.2000@gmail.com mohsen aghaeiboorkheili ibnu sina institute of fundamental science studies university teknologi malaysia, 81310 utm skudai, malaysia e-mail: drmohsenaghaei@yahoo.com received: december 6, 2012 accepted: june 12, 2013 published: june 12, 2013 doi:10.5296/ajfa.v5i1.2811 url: http://dx.doi.org/10.5296/ajfa.v5i1.2811 abstract in this study, we analyze the annual returns, returns fluctuation and the day of the week effect for five stock markets in southeast of asia (indonesia, malaysia, philippine, singapore and thailand) from 31, december 2007 to 31, december 2011. non-parametric tests and parametric test are used for equality of variance returns and equality of mean returns on the daily returns of the week. graphical representation of indexes annual changes and their correlation were explored to employ this analysis. the results indicate that all of the indexes experienced high negative changes in 2008 and after this decline, market index growth enormously. especially indonesia experienced the highest increase. there was generally high volatility of returns. the results of the levene’s test of the equality of standard deviations of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 447 the returns at the 5 percent confidence level reject the null hypothesis that mean returns are not equal across the days of the week for all the markets except for indonesia and malaysia. keywords: annual returns analysis, dayoftheweek effect, volatility of returns asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 448 1. introduction seasonality or calendar anomalies such as month of the year and day of the week effects has remained a topic of interest for research since a long time ago in both developed and developing countries. in stock markets, various studies have been extensively conducted and published on financial market anomalies which deal with the cross-sectional and time series patterns of world market returns using annual return data. seasonality in stock returns was first reported by wachtel (1942). rozeff and kinney (1976) documented the january effect in new york exchange stocks, and brown, keim, kleidon, and marsh (1983) studied the australian stock market seasonality. keim (1983) studied the seasonality and size effects in stock returns while gultekin and gultekin (1983) examined the presence of stock market seasonality in 16 industrial countries. mills and coutts (1995) studied the calendar effect in ftse 100, mid 250 and 350 indices for the period 1986 and 1992. choudhry (2000) reported january effect on the uk and us stock returns. chordia, roll, and subrahmanyam (2001) studied nyse-listed stocks from 1988 to 1998 and found a strong day-of-the-week effect where trading activity is relatively high on tuesdays and low on fridays. fountas and segredakis (2002) studied 18 markets and reported seasonal patterns in returns. meanwhile, ariel (2012) has also conducted similar studies on us market indices from 1963 to 1981. although calendar anomalies in developed equity markets have been investigated extensively, little attention has been paid to asian markets. moreover, most studies of asia anomaly focused more on seasonal or cross-sectional of stock returns. these tests are different from time series tests, which emphasize on the predictability of return rates over time (claessens, 1995). to the best of the author’s knowledge, empirical research on the day-of-the-week effect in asian stock markets is fragmented, thus this current study attempts to fill this gap. in this paper, we examine the characteristics of daily and annual returns and the volatility of returns of five southeast financial market indexes namely: kuala lumpur composite (malaysia); jakarta composite (indonesia); manila composite (philippines); straits times (singapore); set (thailand). 2. literature review the efficient market hypothesis (emh) is considered one of the most debated and investigated issues in finance literatures. it states that a market is considered to be efficient if it reacts and responds quickly and accurately to all available information. fama (1970) classified market efficiency into three forms: weak-form emh, semi-strong form emh, and strong form emh. over the last decades, however, numerous empirical studies have indicated persistent and potentially exploitable days-of-the-week patterns in both stock returns and volatility in many countries. these daily anomalies present a challenge to the emh and have attracted much attention from economists and market practitioners. from a financial perspective, there are three important reasons for examining the daily anomalies in the markets. firstly, the discovery of anomalous patterns in stock returns is important because of their effects on the trading strategies of investors (berk & güven, 2003). secondly, it provides extra information for rational decision-makers to become more aware of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 449 variations in stock returns volatility due to the day-of-the-week effect. rational decision-makers can also determine whether high or low returns are associated with a correspondingly high or low volatility for a given day. if investors can identify a certain pattern of volatility, it becomes easier to make investment decisions based on both projected returns and risks associated with a particular security (kiymaz & berument, 2003). thirdly, the investigation of anomalous patterns may reveal evidence about the extent of market efficiency. 2.1 day-of-the week effect the earliest examination of the day-of-the-week-effect in stock returns seems to go back to the study by cross (1973) and around the period of 1980s; french (1980), lakonishok and levi (1982), gultekin and gultekin (1983), keim (1983), keim and stambaugh (1984), rogalski (1984), theobald and price (1984), harris (1986), smirlock and starks (1986) , jaffe and westerfield (1989) had investigated this effect across different markets. this topic continues to be one of the most researched topics even until today, for example; balaban (1995), chusanachoti and kamath (2002), kiymaz and berument (2003), kohers et al. (2004), kok and wong (2004), brusa et al. (2005), cai et al. (2006), chukwuogor-ndu (2007), kenourgios et al. (2008), marrett and worthington (2009), anwar and mulyadi (2009), blau, van ness, and van ness (2009), christophe, ferri, and angel (2009), naliniprava (2010), sutheebanjard and premchaiswadi (2010) , worthington (2010), faryad, kashif, and rana (2011), mine and ikram (2011), abdullah et al. (2011), ulussever et al. (2011) and al-jafari (2012) had revealed evidence of the presence of day-of-the-week effect. on the contrary, some researchers have found no evidence for the days-of-the-week effect on stock markets. for instance, santesmases (1986), pena (1995), gardeazabal and regulez, (2003) documented on insignificant weekday effects on the spanish stock market. brooks and persand (2001) also found no day-of-the-week effect in the philippines stock market. marashdeh (1994) and davidson and peker (1996) concluded that there is no day-of-the-week effect on the malaysian stock market. demirer and karan (2002) studied in the turkish stock market and did not find clear evidence of “the effect” even though they noted that friday returns were “consistently high”. aly et al. (2004) studied the egyptian market and showed that there was no significant difference between daily mean returns. in a study for a small offshore market of mauritius, agathee (2008) suggested no significant existence of the calendar effect. 3. research methodology in this section, we apply some tests to determine the day-oftheweek effect, daily returns and volatility returns. the data consist of daily closing prices excluded public holidays of the following indexes: kuala lumpur composite (malaysia) index; jakarta composite (indonesia) index; manila composite (philippines) index; straits times (singapore) index and set (thailand) index for the period 2008-2012. during this period trading will be conducted monday to friday. to interpret the trends of returns and depict the annual trends in the stock market movement, we use the closing index values. the logarithmic return of daily stock returns is defined as: ln (pt) ln (pt-1). where pt is a daily return of stock at time t. basic statistics of return are used to find out the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 450 distributions of daily returns and volatility such as standard deviations, variance, coefficient of variation, skewness and kurtosis. since the distributions of the returns are non normal, we use the kruskal-wallis one way analysis of variance which is a nonparametric method for testing equality of means (hourvouliades, 2009). to examine the difference in the returns across the days of the week, the kruskal-wallis test is calculated for checking the equality on mean returns as: where k is the number of samples; nj is the number of observations in jth sample; n = ∑ nj is the total number of observations; rj is the sum of ranks in the sample when n values are ranked together. for the equality of variance across the days of the week, we employ the levene’s homogeneity test for equality of variance across the days of the week where dij=| rijmij|, rij is the return for week i and weekday j for j =1, 2…, j and j = 5. the bartlett’s test is also employed to check the equality of variance is called homogeneity of variances that is more sensitive than levene’s test (snedecor & cochran). the bartlett’s statistic is as follows: where a is the number of samples, v = degree of freedom, . when the degrees of freedom are different, above test is not used. the test criterion is as follows: where is an estimate of the σ2 from the sample i, a = the number of samples, vi is the degree of freedom of samples i. 4. results asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 451 4.1 returns analysis of the week table 1 report the basic statistics of returns for each day of the week in total observations of 1042 to specify the distributional properties of malaysia, indonesia, philippines, singapore and thailand. indonesia and malaysia have negative returns on monday and tuesday. thailand has negative returns on monday and thursday and philippines have negative returns on monday and tuesday and friday while the singapore has negative return all days except wednesday. 4.2 volatility of returns in terms of statistics in table 1, lowest and highest returns are recorded in jakarta composite (indonesia) and set (thailand) as a result of high volatility in these returns. the other indicators of return volatility consist of skewness, kurtosis, standard deviation, variance and coefficient of variation had also the high values. the coefficient of variation for indonesia has a positive return while in thailand is negative return in the same days on thursday. however this indicator was also very high for philippines on friday. moreover malaysia has highest kurtosis and skewness on monday. this reflects the paucity of the returns relative to their respective standard deviations. it is important to note that the daily returns for all indexes are skewed to the left except for straits times (singapore) exchange that seem to be more skewed to the right. malaysia and thailand recorded the highest return on monday, indonesia on wednesday, philippine on tuesday and singapore on thursday. indonesia, malaysia and thailand experienced their lowest return on monday while philippine and singapore experienced their lowest return on friday. so malaysia and thailand recorded the highest and lowest return on monday. the highest standard deviation occurred on monday for all of the stock markets. the lowest standard deviation mostly occurred on wednesday for malaysia, philippine and thailand. the daily returns exhibited greatest volatility on monday for all of the markets except for philippine on thursday. 4.3 annual returns analysis in the period 2008 to 2012, all of the countries experienced a decline in the end of 2008. after this drop in the last of october of 2008, indonesia, thailand and philippine have grown enormously: jakarta composite (indonesia) by 244 percent; set (thailand) by 167 percent; manila composite (philippines) by 156 percent while malaysia had a steady trend by 82 percent. singapore reached a minimum value in march of 2009 then went up by 82 percent. table 3 shows the annual closing returns of the indexes. in figure 1, we consider the annual returns and represent the percentage changes related to annual returns of table 3. during the period (31, december 2007 until 31, december 2011), annual returns of indonesia increases 39.2 percent; malaysia 6 percent; philippine 20.7 percent; singapore 24 percent and thailand 19.5 percent. the markets generally declined in 2008 and gained in 2009. the five closing index values for the period 2008-2012 applied to a regression analysis. the correlation coefficient matrix indicates the correlation among all of the indexes that asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 452 calculated by pearson correlation coefficient is shown in table 4. all of pair markets have similar and positive correlation between 0.4 and 0.63. the highest correlation 0.628 was between the jakarta composite (indonesia) and the straits times (singapore) index. 4.4 the day of the week effect the kruskal-wallis test is used to examine the day of the week effect by following null hypothesis and the alternate hypothesis for each stock market. h0: there is equality among the days of the week returns; h1: there is not equality among the days of the week returns. if the assumption reject the equality among the days of the week returns, this means that there is a difference in the returns across the days of the week and exist the presence a day-of-the-week effect on the returns that in our study accrues only in indonesia. the results of kruskal-wallis test at the 5 percent level show that the chi-square statistics values are not significant for all markets except indonesia. in terms of what obtained in table 5, these results support the existence the day of the week effect just indonesia stock return in terms of the result of analysis of daily returns for the kuala lumpur composite (malaysia); jakarta composite (indonesia); manila composite (philippines); straits times (singapore); set (thailand) stock markets from 2008 to 2012. 4.5 homoskedasticity the equality of the standard deviations examined by the levene’s test employed across the day of the week. as a result of table 6, the assumptions of homoscedasticity were met in indonesia and malaysia. philippine, thailand and singapore have highly significant levene’s statistic (at the 5 percent level) respectively. it can be concluded that in the indonesia and malaysia markets, the daily return seasonalities are not accompanied by any volatility seasonality and investing on the low or high return during weekdays does not necessarily means that risk is also low or high. it is interesting to note that for philippine that has a highly significant levene’s statistic, the highest return occurs on wednesday, the same day that the markets experiences the lowest standard deviation. in thailand and singapore that have high significant levene’s statistic, the lowest return occurs on monday when the market experiences the highest standard deviation. this observation seems compatible with the trade-off of normal risk return for higher returns as well as relationships among higher risk returns and lower risk returns. 5. conclusion this study analyzed the day-of-the-week effect, annual returns and the volatility of daily returns of five southeast of asia stock markets. the results of the kruskal-wallis test show the presence of the day of the week effect only in indonesia and other stock returns including malaysia, philippine; singapore and thailand do not provide the existence of the daily effect. we attempted to investigate the high volatility in daily observation of southeast of asia stock market. indonesia and thailand recorded the maximum and minimum returns. the results of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 453 the other indicators of return volatility had also high value of these two indexes. philippine, thailand and singapore have high significant levene’s statistic value at the 5 percent level, respectively. so, the assumptions of homoscedasticity were met in indonesia and malaysia. all of five stock return indexes decreased significantly in last of 2008 then they increased between beginning of 2009 and 2012. the changes in annual closing values of the indexes indicate that in general, the markets seem to gain and lose simultaneously. however indonesia experienced the greatest percentage increase in this period, malaysia experienced the lowest increase between other markets. generally, all of the stock markets in this study have grown after a decline in the last months of 2008. the correlation coefficient matrix indicates that the correlation among all of the indexes is positive; 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(2010). the decline of calendar seasonality in the australian stock exchange, 1958–2005. annals of finance, 6(3), 421-433. http://dx.doi.org/10.1007/s10436-008-0111-9 table 1. basic statistics of returns monday tuesday wednesday thursday friday mean indonesia -0.001506 -0.000434 0.002308 0.000173 0.000860 malaysia -0.000897 -0.000152 0.000665 0.000319 0.000317 philippines -0.000678 -0.001365 0.002142 0.000882 -0.000134 singapore -0.001024 -0.000845 0.001108 -0.000297 -0.000377 thailand -0.001167 0.000248 0.000731 -0.000128 0.000848 median indonesia -0.000097 0 0.002926 0.000600 0.0004352 malaysia 0 0 0.000864 0.000197 0 philippines 0 -0.000728 0.001983 0.000389 0 singapore 0 -0.000182 0.001506 -0.000234 0 thailand 0 0 0.002096 0.000698 0.001192 maximum indonesia 0.073628 0.062383 0.076234 0.052681 0.068192 malaysia 0.040551 0.028005 0.026538 0.028701 0.033750 philippines 0.049837 0.070560 0.043754 0.046251 0.045872 singapore 0.063639 0.055912 0.049232 0.075305 0.056203 thailand 0.075487 0.052919 0.032799 0.060994 0.041853 minimum indonesia -0.105675 -0.080103 -0.0109539 -0.092997 -0.071555 malaysia -0.099785 -0.039179 -0.035180 -0.031940 -0.036807 philippines -0.0130887 -0.056743 -0.049229 -0.053232 -0.086981 singapore -0.062165 -0.042293 -0.068388 -.0.053965 -0.086960 thailand -0.110902 -0.042844 -0.071271 -0.054430 -0.100994 standard deviation asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 458 indonesia 0.018976 0.016591 0.017791 0.016336 0.014639 malaysia 0.011135 0.008245 0.007880 0.008568 0.008458 philippines 0.016691 0.014716 0.012370 0.013539 0.013838 singapore 0.017644 0.013336 0.014492 0.015295 0.014100 thailand 0.019354 0.015175 0.013410 0.014647 0.014276 skewness indonesia -0.0568902 -0.290924 -0.895448 -1.162683 -0.464237 malaysia -3.178384 -0.456030 -0.520078 -0.330540 -0.184831 philippines -2.558812 0.238628 -0.141149 -0.574296 -0.935930 singapore 0.020217 0.282502 -0.375711 0.626146 -1.294918 thailand -0.812219 0.276306 -1.060338 -0.024374 -1.879603 kurtosis indonesia 6.780524 3.648543 9.451008 6.039140 5.837154 malaysia 30.128948 3.676943 3.351936 2.200489 3.973636 philippines 17.893892 4.868837 2.158542 2.367858 7.710789 singapore 1.916244 2.073026 3.843113 4.210506 10.754751 thailand 6.19498 1.422250 3.652336 3.372682 13.610629 variance indonesia 0.000360 0.000275 0.000317 0.000267 0.000214 malaysia 0.000124 0.000068 0.000062 0.000073 0.000072 philippines 0.000279 0.000217 0.000153 0.000183 0.000191 singapore 0.000311 0.000178 0.000210 0.000234 0.000199 thailand 0.000375 0.000230 0.000180 0.000215 0.000204 coefficient of variation indonesia -1259.94094 -3819.90647 770.677314 9451.018148 1701.459505 malaysia -1241.098953 -5441.92199 1184.489460 2685.491843 2671.388063 philippines -2460.941227 -1078.05209 577.443001 1534.280927 -10291.50842 singapore -1723.186503 -1578.68767 1307.890448 -5147.52037 -3735.476078 thailand -1658.617323 6114.57897 1834.646440 -11441.4353 1683.623564 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 459 table 2. summary of maximum/minimum returns/standard deviations of five stock markets for the period december 31, 2008december 31, 2011 country/index max day of min day of (standard deviation) mean occurrence (standard deviation) mean occurrence jakarta composite 0.002308 wednesday -0.001506 monday (indonesia) 0.018976 monday 0.014639 friday kuala lumpur composite 0.000665 wednesday -0.000897 monday (malaysia) 0.011135 monday 0.007880 wednesday manila composite 0.002142 wednesday -0.001365 tuesday (philippines) 0.016691 thursday 0.012370 wednesday straits times 0.001108 wednesday -0.001024 monday (singapore) 0.017644 monday 0.013336 tuesday set 0.000848 friday -0.001167 monday (thailand) 0.019354 monday 0.013410 wednesday table 3. annual closing index values and two important dates end of year (indonesia) (malaysia) (philippines) (singapore) (thailand) 2007 2745.83 1445.03 3621.6 3482.3 858.1 oct 2008 1111.39 832.44 1704.41 1600.28 384.15 2008 1355.41 876.75 1872.85 1761.56 449.96 2009 2534.36 1272.78 3052.68 2897.62 734.54 2010 3703.51 1518.91 4201.14 3190.04 1032.76 july 2011 4193.44 1558.01 4550.53 3215.27 1144.14 2011 3821.99 1530.73 4371.96 2646.35 1025.32 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 460 figure 1. percent changes in yearly returns in five selected southeast stock markets table 4. correlation coefficient, regression results correlation matrix jakarta composite (indonesia) kuala lumpur composite (malaysia) manila composite (philippines) straits times (singapore) set (thailand) jakarta composite (indonesia) 1 0.553046 0.469881 0.628018 0.543608 kuala lumpur composite (malaysia) 0.553046 1 0.476428 0.564179 0.481748 manila composite (philippines) 0.469881 0.476428 1 0.402785 0.425613 straits times (singapore) 0.628018 0.564179 0.402785 1 0.605116 set (thailand) 0.543608 0.481748 0.425613 0.605116 1 table 5. the result of kruskal-wallis test (equality of means) index/country jakarta composite (indonesia) kuala lumpur composite (malaysia) manila composite (philippines) straits times (singapore) set (thailand) chi-square *10.4711 2.4123 9.3381 7.4712 8.8693 p-value 0.0332 0.6604 0.0532 0.1130 0.0644 note: *denote significant at 5% level. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 461 table 6. results of equality of variance test across day of the week for the period 20082012 countries/index levene’s test bartlett's test statistics p-value statistics p-value jakarta composite (indonesia) 1.6968 0.1484 16.480 0.0024 kuala lumpur composite (malaysia) 1.1307 0.3405 32.9826 0.0000 manila composite (philippines) 8.1602* 0.0000 98.4733 0.0000 straits times (singapore) 3.9776* 0.0033 20.5923 0.0004 set (thailand) 4.4783* 0.0014 35.9643 0.0000 note: *denote significant at 5% level. microsoft word last review 2864-11045-1-sm_1_-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 462 lean manufacturing practices and environmental performance in malaysian automotive industry siti norhafizan hibadullah, nursyazwani mohd fuzi, auni fatin nadia chiek desa & farah izzaida mohd zamri dept. of accounting and finance, universiti pendidikan sultan idris 35900 tanjung malim, perak, malaysia tel: 60-019-456-1429 e-mail: ctnorhafizan@yahoo.com nurul fadly habidin (corresponding author) dept. of management and leadership, universiti pendidikan sultan idris 35900 tanjung malim, perak, malaysia tel: 60-017-571-7027 e-mail: fadly@fpe.upsi.edu.my received: december 13, 2012 accepted: june 12, 2013 published: june 12, 2013 doi:10.5296/ajfa.v5i1.2864 url: http://dx.doi.org/10.5296/ajfa.v5i1.2864 abstract toyota production system (tps) a systematic approach to identify and eliminate waste activities through continuous improvement and understand the principles of lean such as identification of value, elimination of waste and generation of flow (of value to the customer). this paper explores between lean manufacturing practices (supplier management, employee involvement, just in time, customer focus and statistical process control to monitor quality) and environmental performance outcomes (operational and innovation performances). the purpose of this study is to proposed structural relationship lean manufacturing practices and environmental performance model for malaysia automotive industries. the conceptual model using structural equation modeling (sem) has been proposed. base on the proposed conceptual model and reviewed, research hypotheses are being develop, the paper culminates with suggested future research. keywords: lean manufacturing, environmental performance, performance measurement, toyota production system automotive industry asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 463 1. introduction the automotive industry in 21st century has forced most of the leaders in several sectors to implement more competitive manufacturing system. compared with other industries in the manufacturing sector in malaysia, the global industry has been identified to improve the industrialization process so that malaysia can be a developed nation by 2020. under the national automotive policy (nap), to assist the transformation and integration of the local automotive industry optimally into the regional and global industrial network an increasingly liberalized and competitive. lean manufacturing (lm) is a unified, comprehensive set of philosophies, rules, guidelines, tools, and techniques for improving and optimizing discrete processes. while lean was created in large volume, repetitive manufacturing for the automotive industry sector, lean principles and benefits apply to all processes such as health care and service. lm is defined as an assembly-line manufacturing methodology developed originally for toyota and the manufacture of automobiles. it is also commonly referred to as the toyota production system (tps). its aim is to get the right things to the right place at the right time, also to increase efficiency and decrease waste by receiving goods only as they are needed in the production process. the principles of lean manufacturing were developed by taiichi ohno, a toyota engineer. in addition, principles allow the company to meet demand, reduce inventory, maximize the use of multi-skilled workers, flatten the management structure and focus resources where needed (chen and taylor, 2009). lm is one of the initiatives projects have been trying to adopt in order to become more profitable and competitive in the global marketplace. besides that, prakash and kumar, (2011) pointed out that lm processes are being used predominantly in the automotive industry such as tps have since built their reputation as quality leaders and boast one of the fastest growing market shares in the automotive industry. thus, these manufactures started using various tools and increase practices identified as key elements of lean approach such as just-in-time (jit), kanban, setup time reduction, total productive maintenance (tpm) , production cells, employee involvement (ei), quality circles etc. lean concepts on the improvements in the entire business process as opposed to incremental improvements. it is the business process system that can significantly improve a company’s profitability. besides that, in the globalization of market, the manufacturing performance balance comes from tracking not only financial performance measure such as operating income, sales growth and sales revenue, but non-financial ones as well. this is because non-financial measures are likely to facilitate organizational decisions and actions that support strategies based on the stakeholders need (hoque and james, 2000). it has also been suggested (kaplan and norton (1992; 1996a, 1996b) that non financial performance measure helps manager to assess changes in the business environments, determines and evaluates progress towards the firm’s goal, and a firm achievement of business performance. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 464 2. literature review 2.1 lean manufacturing practices (lmp) lm is one of the initiatives that many major manufacturing plants in asean, especially in malaysia have been implement in order to remain competitive in an increasingly competition and globalization. lee, (2008) presented a report about the automotive industry worldwide likewise face increasing pressures in the environmental arena. one of the best ways for achieving improvement in environmental performance, as well as to maintain the product quality and cost goals at the plant level, is unique partnerships with producers. in addition, shah and ward, 2003 noted that lm represents a multifaceted concept that may be grouped together as distinct bundles of organizational practices. a list of bundles of lean practices includes total quality management (tqm), tpm, jit and shop floor involvement, pull, flow, low setup, controlled processes, and involved employees. lmp enhance manufacturing productivity by reducing setup times and work in process inventory improving throughput times, and thus improve environmental performance (al asyraf et al., 2012). definitions of the construct of lmp incorporated in table 1. table 1. construct definition construct definition supplier management suppliers are important factors for the business success of the buying firm because they contribute, among others, to its product quality, flexibility, and costs. in order to being able to fully exploit the potential of supply market, it is necessary for a buying firm to handle its suppliers (akamp and muller, 2012). employee involvement employees must be involved if they are to follow the need for creativity and if they are to be committed to changing their behaviour at work, in new and improved ways (kuye and sulaimon, 2011). just in time production strategy that strives to achieve excellence in manufacturing by reducing setup times and in-house lot sizes through the use of group technology for innovation, cross-training of employees, and sound preventive maintenance (chong et al, 2001). customer focus customer focus practices involve the establishment of links between customer satisfaction and their needs and internal processes (sousa, 2003). statistical process control to monitor quality spc is a powerful technique for monitoring, managing, analyzing and improving process performance by statistical methods (chen et al, 2008). based on the current definitions above, lm is a business improvement philosophy that has asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 465 developed over many years such as lean manufacturing tools, it is a method to better focus in business on the true needs of the customer to help eliminate waste from being built into system. a summary of lm practice benefits is given in table 2. table 2. benefit of lm practices 2.2 the relationship between lmp and ep jusoh et al., (2008) investigated the performance measurement that gave effect on performance of malaysian manufacturing firm. in this study, they used 29 performance measure item taken from hoque et al., (2001) which was originally adopted from kaplan and item author benefit employee involvement kuye and sulaimon, 2011  improved employee’s morale or job satisfaction and enhances productive efficiency;  provides employees the opportunity to use their private information; and  through employee involvement, resources required to monitor employee compliance (e.g., supervision and work rules) can be minimized, hence reducing costs just in time chong et al., 2001  reduced operating time;  decreased unit cost; and  improved labor productivity yasin et al., 1997  improved communication internally and externally;  jit tends to foster organizational discipline and managerial involvement; and  enhancing customer satisfaction statistical process control chen et al., 2008  increase efficiency and reduce resistance;  reliable measurement system; and  establishing coordination and operation of the cross functional group supplier management shin et al., 2000 and prajogo et al., 2012  long-term relationship with supplier;  supplier involvement in the product development process;  reduced number of suppliers; and  a quality focus where quality performance is the number one priority in selecting suppliers customer focus hongyu et al., 2006  acquire information about the customers in large or medium sized marketplaces;  high quality service; and  to obtain a quantified data to assess the employees performance and efficiency at work asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 466 norton (1992) and developed nine items which were self constructed from literature. the finding result found that firm performance was positively affected from the overall performance measure usage. they also argued that when firms applied financial performance measures alone it was not sufficient to measure organizational performance. study by yang et al., 2011 suggest that prior lean manufacturing experiences are positively related to environmental management practices. improved environmental performance may benefit firms with respect to their consumers such as customer firm identification, customer satisfaction and loyalty leading to improved company image. therefore, the relationship of lean manufacturing and environmental management practices become synergistic in terms of their focus on eliminate waste and inefficiency. beside that, shah and ward, (2003) pointed out that contextual factor have been suggested as possible obstructions to implementing lean production systems. specifically, four bundles in examining the relationship between implementation and operational performance because interested in evaluating the synergistic effects of implementation of all complementary facets of lean such as jit, tpm, tqm and human resource management (hrm). however, in different perspective, evidence of positive effects of lean manufacturing on innovation performance is presented by chen and taylor 2009, this study highlight that lean organizations to instill creativity and improve innovation capability. techniques and strategies for an organization to achieve balance between successful lean practices and continuous product innovation will also be presented. ideologies that appeared prior to it, including tqm and jit production. an organization that effectively accommodates both lean and innovation will benefit the most and be competitive in the long term. a research finding of lm performance is given in table 3. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 467 table 3. the research finding on lean manufacturing performance elements authors findings environmental loureiro et al., (2012)  these consumers valued environmental performance much more than activities related to labor practices and community development; and  reducing costs and increasing productivity and also increasingly consumer satisfaction yang et al., (2011)  enhanced environmental performance; and  reduces the negative impact of environmental management practices on market and financial performance operational prajogo, (2012)  increase long-term relationship; and  improve supplier assessment and logistic integration machuca et al., (2011)  manufacturing strategies play a fundamental role in the assessment of new technologies; and  increase in the use of technology in manufacturing plant jabbour, (2012)  environmental issue tends to influece operational performance(op) in a positive;  reduction in production costs; and  improved organization of the productive environment innovation brio and junquera, (2003)  leadership style; and  increase size on the company’s competitive activity (innovative activity) cordero, (2005)  motivate employee; and  increase financial rewards 2.3 hypotheses development figure 1 showed research framework that represent how lmp and environmental performances are related. in brief, lean manufacturing implementation (e.g., supplier management, employee involvement, just in time, customer focus and statistical process control to monitor quality) assist organizations to improve environmental performance. thus, we hypothesize, h1: there is a positive and direct significant relationship between lmp and environmental performance in malaysian automotive industry. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 468 3. a proposed research model this paper proposed a conceptual model has been used to present the relationship between lmp and ep as presented in figure 1. this proposed model has adopted the conceptual proposed by yang et al. (2011). however, some amendments especially on lmp and ep constructs have been made. *note: lmp= lean manufacturing practices, sm= supplier management, ei= employee involvement, jit= just in time, cf= customer focus, spc= statistical process control, ep= environmental performance, op= operational performance, ip= innovation performance figure 1. a proposed conceptual model for sme framework 4. methodology in this study, sampling method by using structured questionnaire. a survey is considered as the most economical among methods available for data collection due to its ability in performing efficient data collection (moser and kalton, 1971). in general, a survey typed questionnaire approach is relatively low cost of money, time saving, and simple approach. moreover, by using survey methods, it can clarify the question the survey respondents and recording their responses to be used as data for analysis (chang, 2002). therefore it had been used by the authors. the population of this study comprised in malaysian automotive industry. questionnaires will distribute to respondents from the listing of automotive industry obtained from malaysian automotive component parts association (macpma), proton vendors association (pva), and kelab vendor perodua. to analyze the data, two statistical techniques were adopted. the statistical package for the social sciences (spss) version 17 was used to analyze the lmp ep h1 e8 sm ei jit cf e1 e2 e3 e4 1 1 1 1 spc e5 1 e7 ip op asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 469 preliminary data and provide descriptive analyses about thesis sample such as means, standard deviations, and frequencies. sem using amos 6.0 will use to test the measurement model. structural equation modeling (sem) techniques was utilize to perform the require statistical analysis of the data from the survey. exploratory factor analysis, reliability analysis and confirmatory factor analysis to test for construct validity, reliability, and measurements loading were performed. having analyzed the measurement model, the structural model was then tested and confirmed. 5. conclusion on the whole, the aim of this paper is to explore the extent of lmp in malaysian automotive manufacturing industry. the main contribution of this paper was to persuade managers to take an attention on the relationship between lmp and environmental performance. in general, lm is an arrangement of techniques and activities for running a production industries or service operation. in addition, they have the same core principle: the elimination of all non value adding activities and waste from the business. hence, the top employee should understand and emphasis the importance to overcome this resistance for the successful implementation of lean manufacturing tool in their firms. acknowledgement the researchers would like to acknowledge the ministry of higher education (mohe) for the financial funding of this research thought fundamental research grant scheme (frgs), and research management centre (rmc), upsi for research university grant (rug). references akamp, m., & muller, m. 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(2006). design of customer satisfaction measurement index system of ems service. the journal of china universities of posts and telecommunications, 13(1). copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 1948-7647-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 73 the ex-dividend-day price behaviour of blue-chip stocks: international evidence anders isaksson ph.d. assistant professor, umeå school of business and economics umeå university, 901 87 umeå, sweden tel: 46-90-786-7879 e-mail: anders.isaksson@usbe.umu.se md mohibul islam lecturer, university of liberal arts bangladesh e-mail: mohibul00@yahoo.com received: june 14, 2012 accepted: january 25, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.1948 url: http://dx.doi.org/10.5296/ajfa.v5i1.1948 abstract to explain the ex-day stock price behaviour, previous research has mostly focused on dividend yield and expected return. most of these studies concentrated on the us markets and were conducted in a stable economic condition. this paper examines the most liquid common stock (blue-chip) prices behaviour on the ex-day in a period of financial crisis and covers four major capital markets from different geographic locations (the us, the uk, japan, and china). on the new york and shanghai stock exchanges, we observe that the stock prices drop does not differ from the dividend amount on the ex-dividend day and there is no evidence of abnormal return and short-term trading. on the tokyo stock exchange, the stock prices fall less than the dividend amount, which is in contrast to the london stock exchange, where the stock prices fall more than the dividend amount. on the tokyo and london stock exchanges, we observe abnormal return and short-term trading around the ex-day. possible explanations for these differences can be financial crisis (in the uk) and short-term trading (in the japan) keywords: ex-dividend day; abnormal return; short-term trading; blue-chip stocks; arbitrage opportunity jel classification: g14; g15; g35 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 74 1. introduction in a market with no transaction costs and no taxes, the stock prices should drop by the same amount as the dividend paid on the ex-dividend day (campbell and beranek, 1955; elton and gruber, 1970). however, more than fifty years of research have concluded that the stock price drop differs from the dividend amount on the ex-dividend day. several types of interpretations are advanced in the literature to explain such behaviour. among all these studies, the most pronounced rationales are (i) the tax explanation (elton and gruber, 1970; litzenberger and ramaswamy, 1979; poterba and summers, 1984; barclay, 1987; lasfer, 1995; bell and jenkinson, 2002; lasfer and zenonos, 2003; chen et al. 2011); (ii) the cost of trading as well as the associated risk (kalay, 1982; heath and jarrow, 1988; lakonishok and vermaelen, 1986; boyd and jagannathan, 1994; michaely and vila, 1996); and (iii) the market microstructure (frank and jagannathan, 1998; bali and hite, 1998). if the stock prices drop differs from the dividend amount, it signals the inefficiency of a capital market. short-term investors would be interested in such inefficiency of the market (those who buy and sell stocks in a short run and try to make a profit by using the inefficiency of a market) to make an arbitrage profit. elton and gruber (1970), litzenberger and ramaswamy (1979), poterba and summers (1984), and barclay (1987) pointed out a strong positive relationship between the dividend yield and the expected return. lasfer and zenonos (2003) examined the stock price behaviour on the european markets (france, germany, the uk, and italy). most of these studies focused on the dividend yield and the entire stock market. study observed mean drop of stock prices on the new york stock exchange is 0.7767 which is due to the higher taxation on dividend income than capital gain (elton and gruber, 1970). similarly, further tax evidence has been observed on the chinese stock exchange for the large dividend yield stocks (nikolaos et al., 2006) and london stock exchange (lasfer and zenonos, 2003, mean price drop 0.701). furthermore, insignificant evidence of tax hypothesis has been observed on the tokyo stock exchange (kato and lowenstein, 1995) where ex-day stock prices (mean drop of stock prices is -0.9317) are influnced by the year end effect. however, no study has concentrated on the liquidity of the stocks and the quality of information available to the investors and market makers to adjust the stock prices. furthermore, no single study has compared four key capital markets which represent three major geographic locations (asia, europe and america). this study concentrates on the most liquid common stocks, known as the blue chips of a stock market. secondly, the aim of this study is to explain the ex-day stock price behaviour of four major stock markets which represent three different geographic locations and very dissimilar market structures (different tax codes and trading rules and legislation). the reason why we choose these four capital markets is because these markets represent maximum market capital in asia, europe and america and the indexes are the key indicators for an investment decision to any investors. blue-chip indexes are chosen because they hold the most important stocks of a certain market which are preferred by the investors. blue-chip stocks represent maximum market capital and function as a benchmark of the market movements (downside or upside). blue-chip indexes asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 75 have been proven to be an efficient empirical proxy for all-shares market indexes (annaert et al., 2011). investors are well aware of the market information of these stocks and, along with the market makers, continuously adjust valuation models. by focusing on only the largest stocks we avoid potential small firms effects, e.g. effects lack of liquidity or infrequent trading (franks et al. 2009; amihud & mendelson, 2012; roll, 2012) or other firm size effects (chan, chen, & hsieh, 1985). this paper also limits the market inefficiency by choosing most liquid common stocks as liquidity of stocks facilities market efficiency (fowler and gottesman 2000; jones, 2001; amihud, 2002; tarun et al., 2008). secondly, we examine abnormal return and relative trading volume to find out the relevancy of arbitrage opportunity, which might exist on the ex-dividend day (due to the fact that the stock price drop differs from the dividend amount). 2. prior research of stock price behaviour on the ex-dividend day the oldest study of stock price behaviour on the ex-dividend day was by campbell and beranek (1955), in which they argued that the stock prices drop less than the dividend amount. however, the debate on the stock price drop (it is expected that the drop in stock prices is equal to the dividend amount) on the ex-day and the rationale behind it became widespread after the publication of elton and gruber (1970). their paper suggested that the stock prices fall less than the dividend amount on the ex-dividend day due to the effect of taxation. moreover, their findings explained that the investors who are in higher tax brackets are interested in lower dividend yields, whereas lower-tax-bracket investors prefer the opposite. litzenberger and ramaswamy (1979), poterba and summers (1984), barclay (1987), and whitworth and rao (2010) also concluded there was significant evidence of clientele effect. kalay (1982) was the first researcher who challenged the tax hypothesis as a cause of differentiation in price drop on the ex-day. he supported short-term trading and transaction costs. a recent study by bali and francis (2011) also argued in favour of transaction cost and explained that tax can be a component which can affect the investors’ investment decision but cannot influence the ex-day stock prices. heath and jarrow (1988) expounded that the actual ex-day price drop is unknown and short-term trading around the ex-day is risky and this risk is not trivial (michaely and vila, 1996). heath and jarrow’s research (1988) also implied that ex-dividend-day returns must include a risk premium. for instance, boyd and jagannathan (1994) added a risk premium to the discount rate when they modelled the ex-dividend-day return. kato and lowenstein (1995) focused on the japanese market, where investors have no difference in taxation concerning either short-term or long-term trading. according to them, japanese industry is unique (‘most of the japanese firms are affiliated with different business groups, or keiretsu, and engage themselves in trading and reciprocal shareholding’, p. 818) and likely to be influenced by the corporate traders. their study supported short-term trading. lasfer’s study (1995) was on the uk market and presented the effect of the changes before and after the income and corporation taxes act 1988. his model concluded a significant positive return on stock prices before 1988 due to the differentiation in taxation (both on asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 76 capital gain and dividend). additionally, the model presented an insignificant return after 1988, when there is no significant difference in taxation laws regarding both dividend and capital gain. finally, he argued that dividend yield and the duration of the settlement period generate a positive return on the ex-day, not the bid-ask-spread, transaction costs, short-term trading, or other means of dividend distribution strategies. nikolaos et al. (2006) suggested that the price drop for taxable dividend is more than the dividend amount if the taxation on dividend is higher than the capital gain. their paper is based on the behaviour of common stocks on the chinese stock exchange and they focused on both taxable and non-taxable cash dividend. booth and johnston (1984) introduced an institutional and a professional short-term-trading hypothesis. these two hypotheses differ regarding tax treatment. they found that the ex-dividend day is an important input in the trading strategy for investors and traders (i.e. the market makers). shantanu et al. (2004) found strong evidence of short-term trading around the ex-dividend day and pressure on the short-term trader to buy before the event date and sell afterwards. they re-examined the behaviour of stock prices and the volume of all listed companies on the canadian stock market from 1996 to 2003. short-term trading is also supported by eades et al. (1984); lakonishok and vermaelen (1986); and naranjo et al. (2000) for higher yield stocks. david and jarrow (1988) performed their study based on two assets, risky stocks and riskless bonds, to find the possible arbitrage opportunity on the ex-dividend day. they argued that although the stock price drop differs from the dividend amount, no trading strategies can generate any arbitrage profit. dai and rydqvist (2009) investigated the arbitrage opportunity around the ex-dividend day on the norwegian stock market. they explained that the arbitrageur cannot predict the step-up amount, which takes one year to complete after the trade. the study introduced a risk of miscalculating the actual step-up amount, but there is a possibility of diversifying it. they also concluded that the uncertainty about the future cash flow can prevent arbitrage opportunities. elton et al. (1984); kalay (1984); and lakonishok and vermaelen (1986) explained the possibility of an arbitrage opportunity based on a short-term-trading hypothesis. they concluded that although an arbitrage opportunity exists, it is not possible to seize that opportunity because of transaction costs. 3. methodology the objective of this study is to examine the ex-day stock (blue-chip) price behaviour. in general, before the ex-dividend day, an individual investor has two choices (no short-selling, call-option, or put-option strategy): 1. hold the stocks on the cum-day and receive dividend as income. 2. sell the stocks on the cum-day and receive the share value. if an investor chooses to sell his/her share on the cum-day, he/she will receive only stock prices and lose the claim on the dividend. under this assumption, an investor does not need to wait for the dividend payments. on the other hand, if an investor chooses to keep the stock on the cum-day (assuming that other market or unsystematic influences are constant and there is asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 77 no effect of taxes), then he/she is entitled to receive the total wealth, which is equal to the stock prices plus the dividend amount. let op = stock price on the ex-dividend day 1p = stock price on the cum-dividend day d = dividend amount if an investor holds the stocks on the cum-dividend day, he/she will receive stock prices plus the dividend amount, which is expressed as dpp o 1 (1) if we deduct ‘ op ’ from both sides of the equation (1) and divide the remaining value by the dividend ‘ d ’, we receive (equation 2) 11            d pdp d pp rpr ooo (2) this ratio is known as the raw price ratio (rpr), which explains the price changes from the cum-dividend day to the ex-dividend day. this ratio illustrates the changes based on the amount of dividend paid out on the ex-day. the null hypothesis h1 is developed from the equation (2), which is h1: the mean (median) of the rpr = 1 hyptotheis 1 states that stock prices should drop by the same amount as the dividend paid on the ex-day. one criticism of this ratio is that the rpr is subject to the market influence from the cum-dividend day to the ex-dividend day. to adjust this bias, we computed the market-adjusted price ratio (mapr). is the return of the market index. the value of the mapr is equal to the cum-dividend-day stock price minus the discounted (by daily market return) ex-day price, which is divided by the dividend amount. the mapr is expressed as d r p p mapr m o     11 (3) the hypothesis h2 is developed from the equation (3), which is expressed as asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 78 h2: the mean (median) of the mapr = 1 hyptotheis 2 states that the drop of stock prices should be equal to the dividend amount after adjusting the market influences (if any) to determine the daily stock prices. we also compute the raw price drop (rpd) ratio 1 1     p pp rpd o (4) the theoretical value of the rpd is equal to the dividend yield, which is expressed as h3: the mean (median) of the rpd = dividend yield and the market-adjusted price drop (mapd) ratio 1 1 1            p r p p mapd m o (5) the theoretical value of the mapd is also equal to the dividend yield and it is expressed as h4: the mean (median) of the mapd = dividend yield h3 and h4 illustrate that mean (median) raw price drop and market-adjusted price drop of each stock should be equal to their dividend yield. in addition, we compute the dividend yield, d 1  p d d (6) the raw ex-dividend-day return, or 1 1     p dpp r o o (7) and the market-adjusted ex-dividend-day abnormal return, maar mo rrmaar  (8) the null hypothesis h5 is developed from the equation (8), which is true if the value of the maar is equal to 0. the hypothesis h5 is expressed as h5: the mean (median) of the maar = 0 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 79 during the ex-day trading, stocks cannot have abnormal return (after adjusting market influences) and it should be zero which is demonstrated in h5. furthermore, we compute the relative trading volume (rtvt) for the day ‘t’ around the ex-dividend day (t = -5 to + 5) i it t avtv v rtv  (9) where itv = the trading volume on the day ‘t’ for the stocks ‘i’ and iavtv = the average trading volume of a company ‘i’ estimated over the period of -30 to -5 and +5 days relative to the ex-dividend day. the theoretical value of the rtv is equal to 1 and it is expressed as h6: trtv (relative trading volume) = 1 h6 illustrates the level of significance of an investor to trade around the ex-day to grab the abnormal return (if any). 3.1 data collection the data we collected to examine the stock price behaviour on the ex-dividend day covers the fiscal years 2005 to 2009. we selected companies from the new york stock exchange (nyse), tokyo stock exchange (tse), shanghai stock exchange (sse), and london stock exchange (lse). as a proxy for blue-chip stock (weiss and lowe, 1988; cho and engle, 1999; hearn, 2010), our sample of companies was selected to meet these specific criteria:  listed under the s&p 100 index, topix 100 index, sse 180 index, or ftse 100 index.  should have paid a cash dividend.  stock prices must be available thirty-five days prior to, and five days after, the ex-dividend day. our final sample consisted of 1,733 observations from the nyse, 951 from the tse, 887 from the sse, and 1,106 from the lse. from thomson reuters datastream, we collected daily stock prices, daily trading volumes, cash dividend amounts, cumand ex-dividend dates, and the annual market capital of each company. finally, we compiled daily index prices (s&p 100, topix 100, sse 180, and ftse 100) from the same thomson reuters datastream. 4. empirical findings and analysis table 1 shows the theoretical (hypothesized value) mean and median values of the rpr, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 80 mapr, rpd, mapd, maar, and rtv of the nyse, tse, sse, and lse. a t-statistic is used to analyse the differences between the theoretical and mean values. additionally, the wilcoxon signed-rank test is used to examine the differences between the median and corresponding theoretical values. a t-test is also used to compute the maar. table 1. theoretical values of the rpr, mapr, rpd, mapd, maar, rtv (-1 to -5), and rtv (1 to 5) of the nyse, tse, sse, and lse theoretical values nyse tse sse lse mean median mean median mean median mean median rpr 1 1 1 1 1 1 1 1 mapr 1 1 1 1 1 1 1 1 rpd 0.0069 0.0062 0.0084 0.0074 0.0162 0.0123 0.0121 0.01 mapd 0.0069 0.0062 0.0084 0.0074 0.0162 0.0123 0.0121 0.01 maar 0 0 0 0 0 0 0 0 rtv(-1 to -5) 1 1 1 1 1 1 1 1 rtv (1 to 5) 1 1 1 1 1 1 1 1 4.1 new york stock exchange table 2. mean, median, t-test, and wilcoxon signed-rank test (z-value) values of the rpr, mapr, rpd, and mapd of the nyse mean t-test median z-value (median) standard deviation (mean) rpr 1.0514 0.3204 0.9016 0.694 3.7349 mapr 1.0073 0.0435 0.8788 0.407 3.9322 rpd 0.0073 0.4563 0.0065 0.642 0.0183 mapd 0.0077 0.9564 0.0066 0.512 0.0185 dividend yield 0.0069 0.0062 0.004 the mean (median) value of the rpr and the associated t-statistic (z-value) suggests that there are no statistical differences between the mean (median) and corresponding theoretical value 1.00 (1.00). the mean (median) of the mapr and the related t-value (z-value) also shows insignificant differences between the mean (median) and theoretical value 1.00 (1.00). these results argue that stock prices drop by the same amount as the dividend paid on the ex-day. the mean (median) of the rpd ratio, mapd ratio, and associated t-values (z-value) also suggests that stock prices drop by the same amount as the dividend paid. the findings asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 81 also contend that there is no significant (p-value: 0.362. see table i in appendix) maar and thus no evidence of short-term trading (before the ex-day, the p-value of the rtv is 0.300, and afterwards it is 0.197. see table i in appendix) before and after the ex-date. this study is generally inconsistent with campbell and beranek (1955) and elton and gruber (1970) (they documented that stock prices fall less than the dividend amount) but agrees with barclay (1987) (the pre-tax-period stock price drop is equal to the dividend amount). our findings are also inconsistent with fedenia and grammatikos (1991) and lamdin and hiemstra (1993), who argued that equal taxation on dividend and capital gain for the individual investor reduces the price-drop ratio but does not eliminate it. a similar outcome was also concluded by cloyd and weaver (2006). 4.2 tokyo stock exchange table 3. observes the mean, median, t-test, and wilcoxon signed-rank test (z-value) values of the rpr, mapr, rpd, and mapd from the tse mean t-test (mean) median z-value standard deviation (median) rpr 0.3927 -3.0582 0.7044 0.005 3.3465 mapr 0.4147 -2.9328 0.7071 0.007 3.3633 rpd 0.0054 -2.6566 0.006 0.056 0.0185 mapd 0.0056 -2.4838 0.0061 0.067 0.0188 dividend yield 0.0084 0.0074 0.005 on the tse, the mean (median) of the rpr and mapr (see table 3) and associated t-test (z-value) shows significant statistical differences between the mean (median) and corresponding theoretical value 1.00 (1.00). the values of the rpr and mapr suggest that the stock price drop is less than the dividend amount on the ex-day. the median values (0.0560 and 0.0670) of the rpd and mapd indicate no significant differences (in the borderline of the 0.05 level) between the observe and theoretical values. however, the t-values (-2.6566 and -2.4838) rejected the null hypothesis. the rpd and mapd are less than the dividend yield, which also supports that the price drop is less than the dividend amount. the value of the maar (p-value: 0.000. see table i in appendix) suggests significant differences from its theoretical value, which is an indication of abnormal return around the ex-dividend day. the result of the rtv supports (p-value: 0.008) short-term trading before the ex-dividend day. however, there is no evidence (p-value: 0.270) of short-term trading after the ex-dividend day. findings suggests that the stock prices drop less than the dividend amount is due the noise traders who work as a proxy in an efficient market to determine the true prices which is also supported by paul (2006). our result is inconsistent with kato and lowenstein (1995), whose study concluded that the stock prices rise on the ex-day. however, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 82 our study is consistent with dhatt et al. (1994), who argued the existence of excess return around the ex-day in japan. 4.3 shanghai stock exchange table 4. observes the mean, median, t-test, and wilcoxon signed-rank test (z-value) values of the rpr, mapr, rpd, and mapd from the sse mean t-test (mean) median z-value (median) standard deviation rpr 0.9117 -0.2538 0.94 0.858 4.102 mapr 0.966 -0.0988 0.9249 0.906 4.0599 rpd 0.0174 0.4375 0.0175 0.039 0.0319 mapd 0.0178 0.5576 0.0171 0.036 0.032 dividend yield 0.0162 0.0123 0.0136 the mean (median) values of the rpr and mapr (see table 4) and associated t-statistic (z-value) demonstrate no statistical differences between the mean (median) and theoretical values. these results argue that on the sse, stock prices drop by the same amount as the dividend paid on the ex-dividend day. the findings for the rpr and mapr are also explainable by the rpd and mapd. the mean (median) values of the rpd and mapd and related t-values (z-values) show no statistical differences between the mean (median) and theoretical values (dividend yield). the p-value (0.632. see table i in appendix) of the maar shows no significant evidence of abnormal return and thus no indication of short-term trading (before the ex-date, the p-value of the rtv was 0.822 and after the ex-date 0.493, suggesting insignificant differences from its theoretical value. this evidence is inconsistent with nikolaos et al. (2006), who suggested that for the taxable dividend, stock prices fall more than the dividend amount (on the chinese market). 4.4 london stock exchange table 5. observes the mean, median, t-test, and wilcoxon signed-rank test values of the rpr, mapr, rpd, and mapd from the lse mean t-test (mean) median z-value (median) standard deviation rpr 5.9173 3.3795 0.9938 0.169 25.4532 mapr 5.9512 3.4041 0.9879 0.158 25.4432 rpd 0.0144 2.123 0.0129 -3.69 0.0199 mapd 0.0146 2.2387 0.013 0 0.0201 dividend yield 0.0121 0.01 0.0119 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 83 the mean of the rpr and mapr (see table 5) and associated t-values (z-values) suggests a significant difference between the theoretical and observe values. however, the wilcoxon (z-value) test accepts the null hypothesis. a higher standard deviation (rpr: 25.4532 and mapr: 25.4432) supports the results obtained by the t-test. the value of the t-test is also supported by the higher differences between the mean (the rpr and mapr) and theoretical values. this suggests that stock prices fall more than the dividend amount. we can also explain the stock price behaviour by the mean (median) of the rpd and mapd. the mean (median) of the rpd and mapd and related t-values (z-values) rejects the null hypothesis. comparing the dividend yield with the mean values of the rpd and mapd, we can conclude that the stock prices drop more than the dividend amount. too high rpr compare to previous studies (lasfer and zenonos, 2003 and lasfer, 1995) can be due to the investor’s expectation to determine the ex-day stock prices and financial instability1. a too-high standard deviation and a too-high value of the rpr and mapr and associated t-values suggest that the market is experiencing higher volatility compared to the other markets. further studies are required to find evidence against such volatility in the uk market. we also observe significant evidence of the maar (p-value: 0.003. see table i in appendix) and of short-term trading (p-value: 0.000) before the ex-dividend day but no indication of short-term trading (p-value: 0.593) after the ex-day. our study is consistent with lasfer and zenonos (2003) regarding the european firms and has documented positive abnormal return from the lse. 5. conclusions this paper examines the stock price behaviour of blue-chip stocks on the ex-dividend day. four capital markets are selected for this study. the reason for this market selection is to examine the behaviour of the most liquid common stock prices on the ex-divided day under different legislation and trading rules. the sample period of this study covers 2005 to 2009, when each capital market experienced a financial crisis and higher volatility. this study also compares asian, european, and american capital markets and how they react according to the information flow in a financial crisis. the empirical evidence of the nyse’s and sse’s rpr, mapr, rpd, and mapd suggests that stock prices drop by the same amount as the dividend paid on the ex-day. the null hypotheses h5 and h6 are true in both markets, suggesting no indication of abnormal return and thus no evidence of short-term trading before and after the ex-day. the null hypotheses h1, h2, h3, and h4 are rejected by the tse. and they argued that the stock price drop is less than the dividend amount. the value of the maar suggests a statistically significant amount of abnormal return and the value of the rtv supports short-term trading. on the lse, the values of the rpr, mapr, rpd, and mapd demonstrate that stock prices fall more than the dividend amount, which is not consistent with the taxor transaction-costs hypothesis. higher standard deviation refers to the higher 1 “one after another, ltcm’s partners, calling in from tokyo and london, reported that their markets had dried up. there were no buyers, no sellers. it was all but impossible to maneuver out of large trading bets.” wall street journal, november 16, 1998. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 84 volatility of the market and the reason for such volatility can be explained by the financial crisis. most of the ftse 100 companies are financial institutions. they carried a high risk during the financial crisis and investors were scared to hold the stocks. however, further research is required to find the explanation for such volatility. the value of the maar and rtv suggests an abnormal return around the ex-day and thus short-term trading. 5.1 limitations and suggestions for further studies even if our study follows common practice in measuring ex-dividend-day price behaviour we acknowledge that there might be some limitations in our research. one limitation can be that our studied period (2005 to 2009) is not be generalizable to other periods and that some of our findings might be an effect of market conditions at that time (even if our analysis of our data does not indicate this). our analysis is also based on the assumption that blue-chip stocks are a good proxy for capturing ex-dividend-day price behaviour. the limitation with this might be that by limiting the effect of market anomalies (e.g. small firm effects) we are not able to analyse how these potential anomalies might affect ex-dividend-day price behaviour. hence as a suggestion for future research it might be interesting to study how differences in liquidity and risk (e.g. small versus large stocks) affect ex-dividend-day price behaviour. furthermore, further study can present tax, transaction costs and tic size in a same mathematical model by considering the sensitivity of the daily stock prices movement to see how much investors value each variable to calculate the actual ex-day stock prices. in addition, stocks can be classified based on the liquidity and price volatility to find the relationship between the price efficiency of a stock and investors decision around 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(2006). does liquidity affect securities market efficiency?. no 159, working paper, regulation2point0. http://econpapers.repec.org/repec:reg:wpaper:159. weiss, g., & lowe, j. (1988). dividends don’t lie: finding value in blue-chip stocks. chicago, il: longman financial services publishing. whitworth, j., & rao, r. p. (2010). do tax law changes influence ex-dividend stock price behavior? evidence from 1926 to 2005. financial management, 39(1), 419-445. http://dx.doi.org/10.1111/j.1755-053x.2010.01078.x asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 88 appendix i. p-values of the maar and rtvt market measure p-value nyse maar 0.362 rtv (-1 to -5) 0.3 rtv (1 to 5) 0.197 tse maar .000** rtv (-1 to -5) .008* rtv (1 to 5) 0.27 sse maar 0.632 rtv (-1 to -5) 0.822 rtv (1 to 5) 0.493 lse maar .003* rtv (-1 to -5) .000** rtv (1 to 5) 0.593 significance levels: * *indicates p < 0.001, * indicates p < 0.01. microsoft word 2787-10789-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 89 the value relevance of audit report, auditor type and auditor tenure: evidence from iran bahman banimahd department of accounting, science and research branch islamic azad university (iau), tehran, iran tel: 98-91-2567-1123 e-mail: dr.banimahd@gmail.com zahra poorzamani department of accounting, science and research branch islamic azad university (iau), tehran, iran tel: 98-91-2350-2196 e-mail: zpoorzamani@yahoo.com saeid ali ahmadi (corresponding author) science and research branch, islamic azad university (iau), tehran, iran tel: 98-91-6364-3340 e-mail: saeidaliahmadi@yahoo.com received: dec. 2, 2012 accepted: january 30, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.2787 url: http://dx.doi.org/10.5296/ajfa.v5i1.2787 abstract the aim of this paper is to investigate the value relevance of the audit report, auditor type and auditor tenure in the iranian context. this study evaluates the effects of various independent variables on the value relevance using a multiple regression analysis approach for 156 companies listed on the tehran stock exchange (tse) over a 10 year period. the results indicate that audit report has not the value relevance. hence, unqualified audit report and other audit report are not different in capital market. empirical results showed that the auditor type has a positive impact on the value relevance. this result is consistent prior studies. thus, the value relevance of firms audited by government audit has more than firms audited by private audit. also, when the tenure of auditors is long, it has a negative impact on the value relevance. this result is consistent prior studies. the empirical evidence indicates that audit asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 90 report is not valued by the capital market in iran and that audit privatization impact on the value relevance in capital market. hence, the market regulators proposed that the more monitoring considered on audit quality to improve the value relevance in capital market. the results presented in the paper have important implications for both the auditing profession and regulators in iran. keywords: value relevance, audit reports, type of auditor, tenure of auditor asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 91 1. introduction one of the primary issues in accounting-based capital market researches in recent years has been the value relevance of accounting information. the related studies indicate that summarized accounting measure is associated with firm value (brown et al., 1999; barth et al., 2001; holthausen and watts, 2001; lee and wang, 2003). value relevance is defined as the ability of financial statements information to capture or summaries information that affects shared value (francis and schipper, 1999). empirically, an accounting amount is deemed value relevant if it has an association with equity market values and, if the accounting number increases the power of the estimating equation in estimating market values, then an accounting number is deemed relevant with some reliability (barth, 2006). this study is examined the value relevance of the audit report, type of auditor, and tenure of auditor in iran context. auditors, by doing audits in accordance with the generally accepted auditing standards (gaas), will attest to the fairness of corporate financial reports by detecting and reporting material deviations from the generally accepted accounting standards to various stakeholders (lin and et al, 2009). hence, independent audit can decrease the asymmetry information and agency problem. audit opinion about accounting information by the decrease of agency problem can provide the usefulness of accounting information to the capital market participants. the usefulness of accounting information can effect on the decision making of users. so, in order to increase the usefulness of accounting information, auditors add the assurance of financial information which it can results to increase the value relevance. hence, when audit report has value relevance, it can improve decisions of users about rational investment, credit, and etc. thus, it expected that audit report (i.e. unqualified audit report or other audit report) can effect on positively the value relevance and a positive signal send to capital market. private audits or audit organization audited companies listed in tehran stock exchange (tse). audit organization is the biggest audit firm in iran context and because of law support have high independent. thus, it expected that type of audit (i.e. private audit or audit organization) can impact on positively the value relevance and a positive signal transfer to capital market. because the acquaintance of audit firms with accounting information system, firm’s productions, the firm policies, and the industry activates and so on, audit firms tendency to preserve the relation to clients. if the tenure of auditor is long time, auditor independent may decline and thus, the value relevance of accounting information decrease in during time and a negative signal convey to capital market. so, it expected that tenure of auditor can impact negatively on the value relevance. this study investigates the value relevance of audit phenomena after audit privatization and the increase of audit competition in iranian audit market. this may affect agency costs, audit independent and other factors that can impact on the value relevance of accounting information. audit privatization happened in 2001 in iran by establishing iranian association of certified public accountants (iacpa). audit privatization result to decline the government auditor monopoly over the audit of government controlled companies listed in tse. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 92 this study have motivated by tow factors. first, a key distinction between our study and prior study (such as lin and et al (2009)) is the differences in the research design. against the prior studies, this research uses a longer test window. the longer test window captures stock price changes based on both information before public disclosure and information drifts after disclosure (lin and et al, 2009). second, because of audit privatization and the increase of competition among auditors in the emerging capital market of iran may be the value relevance of audit factors such as audit report, type of auditor and the tenure of auditor differed from the other countries. so, these variables should be empirically examined in the emerging capital market of iran. the primary and main question of this study is whether audit report, type of auditor and tenure of auditor has value relevance in the emerging capital market of iran or not. this paper contributes to the auditing literature on the audit privatization and their effects on the value relevance in an emerging market. considering occur audit privatization in capital market, the value relevance of audit factors have survey less than the other subject of value relevance studies and so, need to more explore in the developed and developing countries. the remainder of the paper is organized as follows: section 2 illustrates audit and accounting environment in iran. section 3 introduces relevant prior studies. section 4 describes hypothesis development. section 5 describes research methodology. section 6 presents sample selection. section 7 presents and discusses the empirical results of this study. finally, section 8 gives a brief summary and conclusion. 2. audit and accounting environment in iran emergence of a developing financial market due to privatization and economic growth and development have increased the need for accountants and auditors in iran, and have caused the accountancy-related issues to be more seriously addressed. the legal system is considered as an important factor affecting on accounting system (nobes, 1983), and particularly in iran, the legal system is probably the most influential determinant of accounting discipline. 2.1. audit organization (ao) audit organization, established in 1987, is a governmental institution which takes the responsibility of accounting and auditing in iran. the organization is a part of ministry of economic affairs and finance, and includes accounting and auditing standards setting committees which are legal authorities to set accounting and auditing procedures. audit organization is the only regulatory body in charge of setting accounting and auditing standards in iran. by the end of 2011, 32 accounting standards and 37 auditing standards had been passed in committees. audit organization has the responsibility for auditing governmental companies and most other organizations with public ownership. in fact, audit organization is by far the biggest auditor firm in iran. approximately half the audits in iran are conducted by audit organization. this situation is frequently objected by private audit firms and has created an intense competitive audit market for non-governmental auditors to attract more clients from asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 93 the other half of audit market and also attempt to reduce audit organization market share (farajzade and makarem, 2011). 2.2. tehran stock exchange (tse) tehran stock exchange (tse) was founded in 1967. in the first year, only six companies were in the tse list. in 1989 along with the revitalization of the private sector and privatization of the state-owned enterprises, a new economic program began to develop the promotion of private sector activities. this coincided with the time that the first five-year national development plan in the country was at the initial stage of designing. in fact, the tse has grown as one of the most important executive mechanism for promoting the national economy. this aimed at the environment facilitating contribution of the private sector in productive programs actively, transferring some state duties to the private sector and mobilizing private savings into investment programs. since then the stock exchange market has grown continuously till today. in recent years, the tse has evolved into an exciting and growing marketplace for many investors. now there are more than 460 companies in the tse investors' trade-in securities hall. the new capital market law was passed in november 2005, forty years since the establishment of the tse. under the new law, tse would be restructured and incorporated in the private investment. (pourheydari and ali ahmadi, 2008) 2.3. iranian association of certified public accountants invoking a bill ratified by parliament, iranian association of certified public accountants (iacpa) was established in 2001. based upon the bill, government is allowed to use professional services of certified public accountants. only iacpa members are permitted to establish audit firms. currently, auditing of governmental companies is mostly carried out by ao and other entities are audited by other audit firms. although ao is not prohibited from auditing of non-governmental companies, its major activity is concentrated on public sector. iacpa is ambitiously exerting pressure on the government to gain the power to set accounting and auditing standards, and also to enjoy the right to audit more government-affiliated firms (farajzade and makarem, 2011). according to tse regulations, all listed companies are required to prepare audited financial reports confirmed by reliable auditors. reliable auditors are those audit firms that meet additional criteria set by tse. by the end of 2011, more than 100 audit firms along with ao were adopted by tse as reliable auditor (farajzade and makarem, 2011). 3. literature review in this section the several of studies have been presented that are approximately related to the value relevance of audit factors such as audit report, type of auditor and tenure of auditor. ittonen (2012) review the archival literature on market reactions to qualified audit reports and to seek to identify the different approaches used in those studies. the result suggests that there are three main approaches used in the literature: the short-window approach, the long-window approach, and the indirect approach. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 94 kang-tao and ying-li (2011) investigates whether audit quality can increase the value relevance of fair value accounting. the results indicate that fair value accounting information has incremental value relevance and big 4 auditing firms can improve the value relevance of fair value accounting information. the relationship between audit quality and value relevance of accounting information is explored by lee and lee (2011). they survey the effect of a firm’s future profitability on its book value, when estimating the explanatory power of book value to stock return. the results show that when the big-five of audit firm audited the earnings and book value, it explains more variations in stock return than those audited by other firms. hence, the value relevance of earnings and book value for firms which audited by the big-five of audit firms are more than other firms. the market reaction to auditor switching from big 4 to third-tier small accounting firms is investigated by chang and et al. (2010). they used the period of 2002 to 2006. based on regulatory changes, they separate sample period into two segregate periods. the result showed a relatively more positive stock market reaction to clients switching from a big 4 to a smaller third-tier auditor in period 2. when an audit quality is decrease, this relatively more positive reaction in period 2 reflects companies seeking better services rather than a lower audit fee. bich ngoc (2010) explored the value relevance of accounting information for investment by large listed company in vietnamese stock market. he addresses that whether accounting information affects the decision of investor and the frequency of the use of information by investors. the result of this research shows that accounting information is an important reference source when investors make investment decisions. ittonen (2009) investigated the relevance of auditors’ going concern and internal control reports to investors. the sample consists of russell 3000 index firms. it includes 237 firms with going concern audit reports. the results confirm that the audit reports studied contain some relevant information to the investors. ghosh and moon (2005) address that whether auditor tenure impair audit quality or not. the result shows that earnings response coefficients increase with the length of audit firm tenure, consistent with earnings having a greater influence on equity prices as auditor tenure increases. balsam and et al. (2003) examined the relationship between quality and information content of earnings regarding audit quality. they concluded that the audit quality in companies with a high earnings quality and information content of earnings is more than those companies which possess a low range of the two mentioned factors. martinez and et al. (2003) examine the reaction of spanish capital market to qualified audit reports. they address whether there is a relationship between audit qualifications and stock prices in the context of the spanish market. the event study methodology for this purpose used. the results indicate that qualified audit reports do not have information value for investors. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 95 4. hypothesis development the audited accounting information is to enable the auditor to state an opinion as to whether financial statement present fairly. audit opinions are public documents used by auditors as a method in communicating the results of the work to the principal and other users of the report. audit reports are useful in the decision making of users if it can convey a signal to users and lead to reaction in capital market. thus, audit reports can have value relevance and the unqualified or other audit report can different the value relevance in market capital. so, it expected that the value relevance increase when firm have unqualified audit report. to examine the effects of audit report on the value relevance, the following hypotheses are set: h1: audit report has the value relevance in iran context. accounting and audit information is value relevance if it effect on the users decision making. firms which audited by independent auditors can assure to users about disclosed information. thus, the assurance conveys a positive signal to capital market and result to market reaction. as discussed before, audit organization (ao) is as the biggest iranian audit provider and it concentrates on governmental companies and the most other organizations with public ownership. this provides audit organization with a considerable independence; enabling it to conduct its audits without fear of losing its clientele. thus, we expect that audit organization have the value relevance more than the private audit. to examine the effects of the type of auditor on the value relevance, the following hypothesis is empirically tested: h2: auditor type has the value relevance in iran context. independent audits enhance the credibility of corporate financial reports and assist investors to make rational decisions in the capital market. the users are perceived to gain benefits from the increased credibility. these benefits are typically considered to be that the quality of investment decisions are improved when they are based on reliable information. but, when the tenure of auditors is long, it may have a negative effect on the value relevance and hence, a negative signal convey to the capital market because auditors who perform over the long term may give up their independence to maintain close relationships with their clients. so, it expected that the value relevance is decrease when the tenure of auditors is long term. to examine the effects of the tenure of auditor on the value relevance, the following hypotheses are set: h3: auditor tenure has the value relevance in iran context. in order to examine the combine of independent variables such as the audit report, auditor type and the tenure of auditor, the following hypotheses are set: h4: audit report and auditor type have the value relevance in iran context h5: audit report and auditor tenure have the value relevance in iran context h6: auditor type and auditor tenure have the value relevance in iran context h7: audit report, auditor type and auditor tenure have the value relevance in iran context asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 96 5. research methodology in this paper in order to test of hypothesis we used seven equations have been developed to test h1-h7. this research for the test of hypothesis applied a long test window. the long test window is base on the value relevance studies. the ohlson (1995) model used in the value relevance studies. ohlson model (1995) indicates that value is a weighted function of earnings and book value. according to research of brown and et al. (1998), in this research we used lagged price as a scale proxy to deflate price per share, book value per share and earnings per share. we define value relevance as the association between accounting information and equity market values (francis and schipper, 1999; and barth, beaver and landsman, 2001). in this paper depended variable is price per share and independent variables include the book value per share, earning per share, report of audit, type of auditor and tenure of auditor. equations are illustrated as the following: (1) (2) (3) (4) (5) (6) (7) where itp is price per share at four month after the end of fiscal year; iteps is earnings per share at the end of fiscal year; itbv is book value per share at the end of fiscal year; itar is report of audit. it is dummy variable and set 1 if firm has an unqualified audit opinion, but 0 otherwise; itat is type of auditor. it is dummy variable and set 1 if firm audited by audit organization, but 0 otherwise; itate is tenure of auditor in firm. 6. sample selection our sample covers listed companies in tehran stock exchange (tse) across the period from 2001 to 2010. the sample selection criteria are: 1. the end of fiscal year is march 201, 2. data is available at least for seven years in period 2001 to 2010, and 1 the end of fiscal year in iran (i.e. esfand 29) is equal march 20 data. itit4 1it it 31it it 2 1 1it it ar p eps p bv p p    itit4 1it it 31it it 2 1 1it it at p eps p bv p p    itit4 1it it 31it it 2 1 1it it ate p eps p bv p p    itit5it4 1it it 31it it 2 1 1it it atar p eps p bv p p    itit5it4 1it it 31it it 2 1 1it it ateat p eps p bv p p    itit6it5it4 1it it 31it it 2 1 1it it ateatar p eps p bv p p    itit5it4 1it it 31it it 2 1 1it it atear p eps p bv p p    asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 97 3. the company is not loss frequently for three years. in order to increase the numbers of firms in sample, we set second criterion. summary of sample criteria presented as follow. table 1. summary of sample selection criteria firms that listed on the tse between 2001 to 2003 the number of listed firms the percentage of total population 364 100 deduct: firms with fiscal year-end other than 20 march (48) (13.18) firms with missing data (136) (37.36) firm with loss frequently for more three years (24) (6.59) final sample 156 42.87 7. results descriptive statistics of this paper are showed in tables 2 and 3. price per share has a high standard deviation. the percent trend of type of audit indicates that audit privatization increase in the iranian capital market during the last decade. also, the percent trend of unqualified audit opinion is increase in the iranian capital market during the last decade. table 2. descriptive statistics of qualitative variables percent number of unqualified audit opinion percent number of type of auditn 5 28 6181 132 2001 8 42 5477 142 2002 9 52 4364 150 2003 1057 3147 153 2004 1160 3148 154 2005 1264 2742 155 2006 1265 2741 154 2007 1162 2539 156 2008 1265 2336 154 2009 1159 2436 150 2010 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 98 table 3. descriptive statistics of quantities variables variables n mean std. deviation adjusted price per share 1437 1.09 0.82 adjusted book value per share (bvps) 1487 0.60 0.56 adjusted earnings per share(eps) 1427 0.16 0.26 tenure of audit 1487 3.60 2.52 the based on the result of limer test and hausman test (gujarati, 2004), we used the fixed effects regressions for testing of hypothesis. table 4 presents regression summary statistics corresponding to the equations. the coefficient estimates, tstatistics, and adjasted-r2 values are presented in table 4. at or below a significant level 0.05, the f-statistic is significant. this means that the whole of model is statistically significant in predicting price per share. the coefficients estimates ( t-student) in 1 to 7 model for earnings per share (eps) are positively significant ( t1=5.52, t2=5.37, t3=4.49, t4=5.35, t5=4.81, t6=4.58, t7=4.58, significant at or below the 0.05 level). the coefficients estimates ( t-student) in 1 to 7 models for book value per share is positively significant (t1=6.83, t2=7.34, t3=8.19, t4=7.32, t5=8.19, t6=8.55, t7=8.78, significant at or below the 0.05 level). earnings per share and book value per share have the value relevance for iranian investors. regarding our h1 hypothesis, table 4 reveals that audit reports is not significant (β=-0.035,t=-0.60, significant at or below the 0.05 level). this result indicates that unqualified audit report and other audit reports are not different the value relevance in capital market and not lead to market reaction. this result is inconsistent with hypothesis. in the other words, the value relevance of audit reports is not increase in capital market after implement audit privatization in iran. regarding our h2 hypothesis, table 4 shows that type of auditor is positively significant (β=0.33,t=4.20, significant at or below the 0.05 level). this result suggests that firms audited by government audit have the value relevance higher than private audit. this finding is consistent with hypothesis. in the other words, audit organization with a considerable independence, enabling it to conduct its audits without fear of losing its clientele and hence, the value relevance the firms audited by audit organization are higher than the private audit. in all, firms audited by audit organization give a positive signal to the capital market and lead to the market reaction. thus, audit privatization causes to different the value relevance between government audit and private audit. regarding our h3 hypothesis, table 4 reveals that the tenure of auditors have negatively significant (β=-0.06, t=-5.58, significant at or below the 0.05 level). this finding is consistent with hypothesis. this result indicates that the tenure of auditors have a negative effect on the value relevance because auditors who perform over the long term may give up their independence to maintain close relationships with their clients. also, the result indicate that asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 99 the long term of the tenure of audit convey a negative signal to the capital market and result to decrease the value relevance. regarding our h4 hypothesis, table 4 shows that type of auditor is positively significant but audit reports is not significant (β=0.33,t=4.12, β=-0.0001,t=-0.00, significant at or below the 0.05 level). this result indicate that firms audited by government audit have the value relevance higher than private audit and result to market reaction but unqualified audit opinion and other audit reports are not different the value relevance in capital market and not lead to market reaction. regarding our h5 hypothesis, table 4 reveals that the tenure of auditor have negatively significant but audit reports is not significant (β=-0.06,t=-5.57, β=-0.05,t=-0.86, significant at or below the 0.05 level). this result indicates that the tenure of auditors has a negative effect on the value relevance and a negative signal send to market capital. in the other words, when the tenure of auditor is long term, the value relevance decrease. however, unqualified audit report and other audit reports are not different the value relevance in capital market and not a signal convey to capital market. regarding our h6 hypothesis, table 4 appears that firms with the tenure of auditors and type of auditor is negatively and positively significant in turn (β=-0.06,t=-5.93, β=0.33,t=4.13, significant at or below the 0.05 level). this finding shows that the tenure of auditor has a negative effect on the value relevance and a negative signal send to market capital and firms audited by government audit have the value relevance higher than private audit and result to market reaction. regarding our h7 hypothesis, table 4 appears that that audit reports is not significant (β=0.01,t=0.18, significant at or below the 0.05 level). however, firms with the tenure of auditor and type of auditor is negatively and positively significant in turn (β=-0.06,t=-5.85, β=0.35,t=4.51, significant at or below the 0.05 level). this finding shows that unqualified audit report and other audit reports are not value relevance in capital market and not lead to market reaction but the tenure of auditors has a negative effect on the value relevance and a negative signal send to market capital and firms audited by government audit have the value relevance higher than private audit. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 100 table 4. summary statistics from equations variables model 1 model2 model 3 model 4 model 5 model 6 model 7 α 0.79 (20.22)* 0.66 (14.72)* 0.95 (20.91)* 0.66 (12.49)* 0.96 (19.51)* 0.86 (14.42)* 0.83 (14.29)* bv 0.35 (6.83)* 0.39 (7.34)* 0.44 (8.19)* 0.38 (7.32)* 0.44 (8.19)* 0.47 (8.85)* 0.47 (8.78)* eps 0.56 (5.52)* 0.55 (5.37)* 0.49 (4.79)* 0.54 (5.35)* 0.49 (4.81)* 0.46 (4.58)* 0.46 (4.58)* audit reports -0.035 (-0.60) -0.0001 (-0.00) -0.03 (-0.48) 0.01 (0.18) auditor type 0.33 (4.20)* 0.32 (4.12)* 0.33 (4.13)* 0.35 (4.51)* tenure of auditor -0.06 (-5.58)* -0.06 (-5.57)* -0.06 -(5.93)* -0.06 (-5.85)* r-sq 0.06 0.05 0.08 0.05 0.08 0.07 0.07 ftest 50.80* 57.24* 62.43* 42.70* 46.75* 42.37* 41.90* * significant at or below the 0.05 level. the numbers in parenthesis is t-student. 8. conclusion and remarks the use of accounting information in stock market users’ fundamental valuation models is well documented in the accounting literature and also, the value relevance of accounting information has been the interest issues for capital market researches in recent years. accounting information is relevant if it is capable of making a difference in decision made by investors; even if already know from other sources (sfac no.8, fasb, 2010, paragraph qc6). the demand for an audit function is based on the belief that auditors facilitate market transactions by providing an opinion on financial statements, which should help to reduce the information asymmetry between the company and its potential investors (dye, 1993; titman and trueman, 1986). in addition, central to this demand is the belief that auditors’ opinions convey the useful information to external users of financial statements (chow, 1983). thus, it expected that audit have the value relevance in capital market. this study investigates the value of relevance of audit report, the type of auditor and the tenure of auditor in the iranian context. we use a long test window for the test of hypothesis. the results of descriptive statistics are following. the percent trend of type of auditor indicates that audit privatization increase in the iranian capital market during the last decade. also, the percent trend of unqualified audit opinion is increase in the iranian capital market during the last decade. earnings per share and book value per share is significant in the all equations and hence, those have the value relevance in the capital market. this result is consistent with lee and lee (2011) and pourheydari and ali ahmadi (2008). the results indicate that audit report have not the value relevance in capital market. thus, between unqualified audit report and other audit reports is not different in capital market. the results indicate that the type of auditor has the value relevance in capital market. thus, between asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 101 audit organization and private audit is different in capital market. this finding is consistent with prediction on lin and et al (2009), holthausen and verrecchia (1988), kothari (2001), krishnan (2003), watkins et al. (2004). the results indicate that the tenure of auditor is the value relevance in capital market. thus, between the long time and the short time of the tenure of auditor is different. this result is consistent to ghosh and moon (2005). on the basis of results we recommend that market regulators which to decrease the negative effect of the tenure of auditor on the value relevance determine the time period for the tenure of auditors. considering the research results, we find audit privatization and increase competition in audit can impact on the value relevance. so, we suggest to market regulators and iranian association of certified public accountants (iacpa) to exactly monitor and control on the presented services of private audit firms to improve the value relevance of accounting information in the capital market. this study contributes to the empirical evidence on the value relevance of audit factors in emerging markets and also, to reveal the effect of audit privatization on the value relevance in emerging markets. references barth, m. 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(2004). audit quality: a synthesis of theory and empirical evidence. journal of accounting literature, 23, 153-193. microsoft word 2777-10734-1-sm-writer2-new-final an e receive doi:10.5 abstra this stu compan profitab mature the fin dividen returns. between model explain pricing as portf for eme keywo jel cod empiric ed: nov. 28 5296/ajfa.v4 ct udy examin nies on the bility and re markets. fu ndings can nd payouts a . a positive n payouts an is able to ed by cap in the india folio manag erging mark rds: profita de: c22, c3 cal inve in t professor o srivid assista sgtb k , 2012 a 4i2.2777 nes the profi bse from eturns is em urther the ob be explaine and are ther e relationshi nd beta is o explain re m. thus th an context. gers. the st kets. ability, divi 33, g12, g1 estigati the indi s of finance, univer dya subrama ant professo khalsa coll e-mail: sri accepted: d url: http itability ano january 19 mpirically c bserved rela ed by the f refore perce ip between obtained con eturns on p e 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) show that yiadom and profitability g india) hig ms pay high ock prices. dend today stors value theory in w o choices m ng to pay a ors finance mpirical evid re informat wing firm. a profitability find that t e. the posit d williams ( would buy owing to the s as less ris n journal of f rofitability he above stu , which exp ion is justif ave borne h regarded as alies has to strategies w profitability ofitable then t low return ompensation by beta) an arned by fir rs as divide primary in current and agyei(201 y. aivazian, gh profits t her dividen the bird i y to a highl high payout which they s made under premium fo consumptio dence to sup tion about an increase y and there the initiatio tive relation 1985). con that stock eir informa sky it will a finance & ac issn 19 2012, vol. www.macrothi portfolios udies could poses entrep fied if we e higher oper the reward be carried o which can g y anomaly f n investors p ns. this wo n for bearin nd share va rms may b ends. acco ndicator of d past year’ 1) show sig , booth and tend to me nds we next in the hand ly uncertain ut firms mor show that i r uncertainty for dividend on out of di pport the si the health in dividend efore its sha on of divid n between d nsequently i and drive i ation conten also result i ccounting 946-052x 4, no. 2 ink.org/ajfa to high d be that preneurs examine rating or d for risk out from generate from the perceive uld be a g higher alues are be either ording to a firm’s s profits gnificant d cleary ean high explore d theory n capital re highly. nvestors y. their ds due to ividends gnalling h of the d payout are news dend has dividend f a more its price nt but if in lower cost of the valu where x required that in evidenc several and me dividen inverse ceteris shows t lernen risk and risky an states th investor this pa profitab the anom not the anomaly possible  wh  do  can the slop  can capm?  are the obj 1. is t 2. do perspec equity/requ uation equat x is the ex d returns of nvestors per ce in the l l studies hav erville (197 nd payouts t relationship paribus firm the managem (1973) and d high divid nd hence inv hat high pro rs and henc aper has b bility anoma maly for th e investor. y in the in e explanatio hat is the rel more profi n profitabili pe of the ma n the fama ? e there any jectives of t the profitabi es the rel ctive? uired return tion xpected stre f investors a rceive high iterature on ve explored 72) docume han the flow p between p ms with low ment’s perc d gu and k dend payou vestors dem ofitable firm e they are w een motiva aly in the i e mature m to fill this dian stock ons. we spe lationship b itable firms ity anomaly arket factor a french m links betwe the study are ility anomal lationship b ns. this will am of divid and v is the h dividend n relationsh d the relatio ented that w of returns payouts and wer payout ception of u kim (2002) ut. this wou mand a lowe ms pay high willing to ac ated by the indian stock markets has b s void in t market, inv ecifically ex between firm pay higher y be explain bear a relat multi factor een fama fr e ly in returns between p 350 l positively v dends/cash e equity val paying com hip betwee onship of div investors a s obtained f d beta. beav ratios are uncertainty w purport an uld mean th er premium. her dividen ccept lower e following k market th been analys the literatu vestigates th xamine the f m profitabili dividends? ned by cap tion with div model exp rench size a s empiricall profitability asian y impact firm flows to in lue. mpanies as en dividend vidends pay are assured from higher ver, kettler more risky with respect n inverse re hat higher d . thus we h nds which ar returns. g research hus far has n sed from the re this pap he reasons following pr ity and stoc m based m vidend payo plain returns and value fa ly validated and retur n journal of f m values as nfinity, k is less risky d payments youts with m of the flow r stock price and schole . this is be t to firm’s e lationship b dividend pa have a count re viewed a gaps. first not been co e point of vi per examine for its exis ropositions k returns? arket factor outs? s that are p actors and fi d in indian c rns reflect finance & ac issn 19 2012, vol. www.macrothi s one can s the cost of is reconfir s and mark market beta ow of return es. this lead es (1970) as ecause payo earnings. br between sy aying firms ter argumen as less risky tly a study onducted. s view of the f es the prof stence and e r and therefo possibly mi irm payouts context? firm or ccounting 946-052x 4, no. 2 ink.org/ajfa see from (1) f equity/ rmed by ket beta. a. logue ns from ds to the ssert that out ratio reen and stematic are less nt which y by the y of the secondly firm and fitability explores fore does issed by s? investor 3. can capm 4. do the pap explain contain 2. data the sam study u rights a index re trading represen used as the line percent market shares o book va alternat calculat divided average data on thomso been us has bee we use ratio is total pro 3. meth 3.1 test we form t-1, the the ran monthly portfoli compan n the profi and fama f the risk fac per is organ s the metho s summary, a mple used ses month e and stock sp epresents n activity, an ntative of m s the market es of s&p5 age return s capitalisati outstanding alue per sha tive measur ted as the i d by the aver e total assets n share pric onone datab sed as risk-f n obtained e the firm’s calculated ofit after tax hodology t the relatio m single sor securities a nked securit y excess ret io consisting nies with hi itability ano french? ctors bear a nised as fol odology fol , policy imp consists of end closing plits) from early 93% nd covers all market perf t proxy. it i 500 (usa). series for fu ion is used a g. price to b are represen es for profi income ava rage commo s. ces, market base of tho free proxy a from the rb dividend pa as equity d x. data on t on between p rted portfol are ranked ties are then turns are es g of 20% o ighest attrib omaly be c fundamenta llows. secti llowed. sec plications an 493 compa adjusted sh jan 1996 t of the total l 20 major i formance. t is a broad b the mont urther estima as the size p book (inver nts the secur ts viz return ailable to co on equity. r index all c mson reute as is the sta bi monthly ayout ratio t dividend tha this has been profitability lios based o on the basi n classified timated for f companie bute under c 351 captured by al relation w ion 2 descri ction 4 give nd concludi anies that f hare prices ( to dec 201 l market cap industries o the bomba based value th end shar ation. proxy. it is c rse of be/m rity price ov n on equity ommon stoc return on as company ch ers. the im andard pract handbook o to represent at is paid to n obtained f y and return on each mea is of the pr d into five p these portf es with lowe consideratio asian y standard with corpora ibes the dat es the emp ng remarks form part o (adjusted fo 10 (180 mo pitalization f the econo ay stock e e weighted re price ser calculated a me) is used ver a comp y and return ckholders f ssets is calc haracteristic plicit yields tice in finan of statistics t the divide o equity sha from cmie ns asure of pro ofitability d portfolios p folios for th est attribute on. p1 and n journal of f asset pricin ate payouts? ta and their irical result . of bse-500 or capitalisa onthly obser on bse, ac my. hence xchange (b index which ries have b as the natura d as the val any’s book on assets. r for the mos ulated as ne cs has been s on 91-day nce literatur . nd decision are owners e-prowess. fitability. in definition un p1 to p5 and e next 12 m e while p5 c p5 are refe finance & ac issn 19 2012, vol. www.macrothi ng models ? r sources. s ts. the last 0 equity ind ation such a rvations). b ccounts for the sample bse) -200 h is constru een conver al log of pri alue proxy. k value. we return on e st recent fis et income sc n obtained f y treasury bi re. the data n. dividends as a percen n december under consid nd equally-w months (t). p consists of t ferred hence ccounting 946-052x 4, no. 2 ink.org/ajfa such as ection 3 t section dex. the s bonus, bse-500 95% of is fairly index is ucted on rted into ce times price to use two equity is scal year caled by from the ills have a for this s payout ntage of r of year deration. weighted p1 is the top 20% eforth as corner p we def decemb repeated in the fi portfoli 3.2 rela to estim regressi is profit where profitab constru corner p 3.3 asse capm version where r risk free rmt – r et is the a (interc b is the the ca market signific if there capm 3.4 rela the pur firms a individu return u portfolios in fine a year a ber of each d till we rea first step of o ios created, ationship be mate relatio ion where t ts. we estim λ0 is a co ble firms p cted profita portfolios. et pricing te regressions of the mark rpt – rft is e return (rft rft is the exc error term, cept) is a m sensitivity apm implie returns. h cantly positi e is a signi anomaly ex ation betwe rpose of est are perceive ual firm by using rollin n the study. as calendar h year beg ach decemb our method and ascerta etween prof onship betw the dividend mate the foll nstant. a s pay higher ability sorte est capm s are run on ket model e the monthly ft), cess market measure of ab coefficient es that exce hence, the ive (negativ ificant posi xists. een beta and timating the ed to be le regressing ng three ye the portfol year from j ginning in ber 2009. dology we ob ain the relati fitability and ween divide d payout is lowing equa payout significant dividends ed portfolio m n each of th equation. rpt y excess ret return i.e re bnormal pro of market f ess returns expected ve) value of tive or neg d payouts e relation be ess risky by a firm’s ex ear regressio 352 lios are re-b january to d december bserve the u ionship betw d payouts end payout the depend ation t i,t = λ0 + λ1 positive va and vice v os and calc he five port – rft = a + turn on the eturn on ma ofits and factor. on a portfo value of a f ‘a’ (interce gative inter etween beta y investors xcess month ons over th asian balanced at december. s 1995 and unadjusted m ween profita ts and profi dent variable profits i,t + alue of λ versa. to c culated the tfolios usin b (rmt – rft portfolio i. arket factor m olio should a (the inter ept) implies cept in the a and payou . we first hly stock re he entire tim n journal of f the end of d sample secu d portfolio mean exces ability and r fitability we e and the ex ε t λ1 would in confirm the average pa ng the famil t) + et e. return on minus risk f be fully ex rcept term) s extra-norm e capm sp ts is to eval estimate st turn against me period. finance & ac issn 19 2012, vol. www.macrothi december o urities are s formation ss returns ac returns. e run a pan xplanatory ndicate that ese results ayout ratio liar “excess n portfolio free return, xplained by ) should b mal profits pecification luate if high tock beta f t the excess the variab ccounting 946-052x 4, no. 2 ink.org/ajfa of year t. sorted in process cross the nel ols variable (2) t more we also s of the s return” (3) p minus y excess be 0. a (losses). , then a h payout for each s market ble beta measure systema time ser where y x is the α the in once th the rela where b γ1 in thi relation and calc 3.5 asse if a ca portfoli and fre the ff where lmht i s and h the oth we esti split int the end stocks o for all t four po groups. year t to es the co atic risk of t ries regressi yi is the exc e excess ma ntercept and he value of ation betwee beta is the e is equation s nship betwe culated the et pricing te apm anoma ios that are ench (1993) model is g rpt – smbt is the s the month are the sens her two term imate the sm to two grou of decemb of the comp the compani ortfolios viz monthly e o december movement the equity s ion for each cess monthl arket return, d βi (beta) is beta is ava en beta and estimated y shows the r en beta and average bet est-fama f aly exists th missed by specified a iven by: – rft = a + b e monthly re hly return on sitivity coef ms are same mb and lm upsbig (b) ber of every panies inclu ies. the sto z. s/l, s/h, equally weig r of year t. of security security of f h firm in the yi = α +βi x y return of the stock b ailable for e payouts usi beta i,t = γ0 + early beta f elationship d payouts, w tas of the co french (ff) hen we atte capm can as follows. . b (rmt rft) eturn on the n the price-t fficients of as defined mh as follow ) and small y year in the uded. the p ocks are now , b/l, b/h. ghted return 353 y return wi firm i. the v e sample as x a firm i , beta for firm each firm ov ing panel o + γ1 payout from equati between be we construc orner portfo model empt to eva n be explain + s(smbt ) e size mimic to-book mim smbt and l in equation ws. in each (s) based e sample pe price to boo w split into . from the i n series are asian ith the ma value of βi follows m i. ver the enti ls in the fo ts i,t +ε t on 4 and γ0 eta and payo cted port olios. luate if the ned using th + h(lmht ) cking portfo micking por lmht n (3). year of the d on whethe eriod is abov ok equity ra two equal p intersection e calculated n journal of f rket return is obtained re sample p ollowing eq 0 is the inte outs. to con tfolios on th excess retu he three fac )+ et olio, rtfolio, sample per er their mark ve or below atio is calcu p/b groups. n of the two for all por finance & ac issn 19 2012, vol. www.macrothi n and is ca from the fo period, we quation ercept. the nfirm our re he basis of urns of the ctor model o riod t, the st rket capitali w the median ulated in thi . then we c o size and t rtfolios from ccounting 946-052x 4, no. 2 ink.org/ajfa alled the ollowing (4) estimate (5) value of esults on payouts stylized of fama (6) ocks are zation at n for the is month construct two p/b m jan of the fam of stock minus t minus b average the two price to the thir indepen if the in regressi sectiona sample i.e s and stocks characte the ff m 3.6 rela we nex small an be mor value fa where γ factors size, p/b 4. emp we beg unadjus table 1 panel a 2 constr morandi ma and fren k returns2. t the risk-free big (smb). e of the mon o small size o book it is f rd factor is ndent of size ntercepts fro ions are sig al patterns portfolio re d h for these with partic eristic patte model. ationship be xt evaluate nd low p/b e risky visactors with γ0 and γ3 are with divide b and comp pirical resu gin the em sted returns . unadjuste a. roe sort ruction metho iere(2012). nch model u the first fac e return. th to calculat nthly return e portfolios free from va lmht whic e factor. om the ff r gnificant, th in average eturns to th e factors. w cular attribu erns in the s etween divid if ff size a firms tend -a-vis big a dividend pa e intercepts ends if any. pute the ave ults mpirical resu . ed average m ted portfolio odology for s uses three e ctor is the ex he second i te the mont ns of the tw (s/l, s/h) alue effects. smb=(s/l ch is related lmh=(s/ regressions en this imp stock return e size and v we further v utes i.e. sm sample port dend payou and value f to pay low and high p/ ayouts respe size i,t = γ0 p/b i,t = γ3 and γ1 an to confirm erage values ults by est monthly exc os size and valu 354 explanatory xcess mark is the risk thly return o wo big size p as this fact . l+s/h)/2-(b d to value. /l+b/l)/2-( are insigni plies that the ns that are value risk f verify if the mall (big) tfolios shall ut, size and v factors have wer dividend /b firms. ectively we 0 + γ1 payou 3 + γ4 payou nd γ4 would m these resul s of dividen timating the cess returns ue factors has asian variables f et return wh factor in re of the smb portfolios (b tor has abo b/l+b/h)/2 it is constru (s/h+b/h)/ ificant and t e ff specifi missed by factors is sh corner port size, low support the value factor e their track ds and hence to estimat estimate th uts i,t +ε t uts i,t +ε t indicate the lts we also c nd payouts f e relationsh s on profitab s been adopte n journal of f for explainin hich is the m eturns relati b factor we b/l, b/h) f ut the same 2 ucted as fol /2 the intercep ication is ab capm. gr own by hig folios (p1 a (high) p/b e strong per rs ks in firm p e are percei e the relati e two panel e relationshi construct po for corner po hip between bility sorted ed from sehg finance & ac issn 19 2012, vol. www.macrothi ng the cross market inde ing to size subtract the from the av e weighted llows such t pts from the ble to captu reater sensi gher factor l and p5) com ratio. suc rformance i payout ratio ived by inve ionship of s l ols as fo ip of size an ortfolios bas ortfolios. en profitabi d portfolios gal, subrama ccounting 946-052x 4, no. 2 ink.org/ajfa s section ex return – small e simple erage of -average (7) that it is (8) e capm ure cross tivity of loadings mprise of ch stock if any of s i.e. do estors to size and llows (9) (10) nd value sed on lity and niam and p1 mean 0.023 panel b p1 mean 0.026 table 1 less pro less pro p.a. and signific stocks. whereas thus w results o is it pos he is w informa one risk between table 2 payout β0 0.255* *denot results roa) a lower p of other the ave roe an sorted 3 the eq random e t stat 2.461 b. roa sor t stat 2.789 1, panel a s ofitable stoc ofitable and d hence is r cantly highe the lowest s the highes we find a neg obtained for ssible that th willing to a ation contai k factor wh n profitabili 2. empirical i,t = β0 + β1 t(β0) 38.475 es significa of panel o are more li profits would r empirical erage value nd roa) s portfolio i quation has b effects metho p2 mean t0.017 2 rted portfolio p2 mean t0.032 3 shows that cks as comp d more profi robust. pan er for low t profitabili st profitabil gative relat r mature ma he indian in accept lowe ined in prof hich could b ity and payo l results of t profitability roe β1 0.032* ance at the 5 ols regress ikely to pa d adopt low studies (b es of payou strengthen o is 20.12 % een estimated od based on w p3 -stat me .205 0.0 os p3 -stat me .141 0.0 the unadjus pared to mo itable stock el b shows profitability ity portfolio lity portfoli ion between arkets. nvestor find er returns? fits which c be linked to outs. the panel ol y i,t + ε t t(β1) * 3.222 5% level usi sion3 (table ay higher d wer payouts. baker, farre uts calculate our results. %( 18.01% d using fixed wu-hausman 355 ean t-stat 14 1.927 ean t-stat 21 2.554 sted returns ore profitab ks is 1% per s that sortin ty stocks as o produces io produces n profitabil ds high prof to answe could contr o dividend p ls regressio β0 2 0.24 ing a two ta e 2)show th dividends w . the results elly & edel ed for corne we find th %) and for d effects pane statistic. asian p4 t mean 7 0.017 p4 t mean 4 0.019 s on roe s le stocks. t r month (t-s ng on roa s compared an abnorm an abnorm ity and retu fitable stock r this ques ribute to the payouts. he on of payou t(β0 44* 18. ailed t-test at firm with while compa s appear to lman rb, 1 er portfolio hat average high roe el ols metho n journal of f t-stat 2.459 t-stat 2.648 sorted portf the return d stat=2.01) w the averag d to that of mal return o mal return of urns which i ks to be less stion we w e risk argum ence we calc uts on profit roa 0) β1 16 0.2 h larger pro anies that h be consisten 985, pruitt s sorted on e payout for e (roa) s od, which has finance & ac issn 19 2012, vol. www.macrothi p5 mean 0.015 p5 mean 0.015 folios are la differential b which is abo ge returns a f high prof f 2.6 % pe f 1.5 % per is in contra s risky due t want to exp ment. we v culated the tability. t( 231* 2. ofits(both r have compa nt with the t & gitman n profitabili r low roe sorted port s been chosen ccounting 946-052x 4, no. 2 ink.org/ajfa t stat 2.197 t stat 2.215 arger for between out 12% re again fitability r month r month. ast to the to which lore the visualise relation β1) .074 roe and aratively findings n, 1991). ity (both e (roa) tfolio is n over the 29.67 % current send a p table 3 panel a portfolio p1 p2 p3 p4 p5 panel b portfolio p1 p2 p3 p4 p5 capm on roe more pr a profit for less that les statistic large am sobered with tha per mo intercep presenc factor is and me that inv findings indicate perspec hence s %( 31.14% t profits ma positive sign . empirical . roe sorte o a 0.0 0.0 0.0 0.0 0.0 b. roa sorte o a 0.0 0.0 0.0 0.0 0.0 results (ta e sorted por rofitable sto tability anom s profitable ss profitabl cally signifi mount of va d down due at obtained nth for les pt of the lo ce of a profi s able to ex erville (197 vestors per s of scherr ed a negativ ctive who is hould provi %). corpora ay contain nal leading l results bas ed portfolios 012 007 004 007 006 ed portfolios 014 020 009 009 004 able 3) show rtfolios is 1. ocks. the si maly within stocks(p1) e firms are cant which ariation in co e to the con for roe. t s profitable ower profita fitability ano xplain part o 2) who find ceive profi rer and ma ve relationsh s developin ide less retu ate dividend information to stock pri ed on one f s b 1.166 1.086 1.026 0.961 0.988 s b 1.177 1.124 1.125 0.994 0.930 w that the e .2% per mo ignificant in n the capm is higher a e more risk means that ommon stoc ntribution of the extra no e stocks and ability portf omaly withi of the profit d negative r itability as athison (199 hip between ng a trading urns. 356 d policy ten n about futu ice apprecia factor capm t(a) 2.07 1.81 1.24 2.37 2.00 t(a) 2.48 2.81 2.30 2.63 1.69 extra norma onth for less ntercepts of m framewor as compared ky. the be t the marke ck returns. w f beta. resu ormal return d 0.4% per folio (p1) i in the cap ability anom relation bet an “invers 96), gu and n profitabili g strategy a asian nds to vary ure profits ation. m 78 7 40 74 08 5 0 00 5 9 al returns (a profitable s f corner port rk. we how d to more p eta coefficie t return fac we find tha ults on roa n (after adju r month for is statistica pm framewo maly. these tween profi se surrogate d kim (200 ity and syst a highly pro n journal of f y directly w and hence t(b) 17.810 23.961 23.269 24.803 30.003 t(b) 18.223 13.681 23.582 26.171 27.33 after adjustin stocks and 0 tfolios conf wever find th profitable st ent of both tor is impor at the alphas a sorted po usting for m r more pro ally signific ork. we rec e results are tability and e” of busin 02) and le ematic risk. ofitable firm finance & ac issn 19 2012, vol. www.macrothi with current large payo adj. r 0.638 0.762 0.751 0.774 0.833 adj. r 0.664 0.527 0.768 0.803 0.816 ng for mark 0.6% per m firm the pre hat the mar tocks(p5), s h portfolios rtant in cap s of p1 and ortfolios are market risk) ofitable stoc cant confirm confirm that e in line wit d beta. they ness risk. p ee and jang . from an in m is less ri ccounting 946-052x 4, no. 2 ink.org/ajfa t profits. uts may r2 r2 ket risk) month for sence of rket beta showing s is also pturing a p5 have e in line is 1.4% cks. the ming the t market h louge y reason previous g (2006) nvestors isky and table 4 beta i,t = *denot the res dividen risky in more ri adequat that sinc table 5 value f panel a portfolio p1 p2 p3 p4 p5 panel b. portfolio p1 p2 p3 p4 p5 the ff roe an that bot size an predom model a are robu 4 the e the fixed 4. empirical = γ0 + γ1 pay γ0 0.967* es significa sults of pa nd payouts ( nvestments w isky. this te funds res ce beta show 5. empirical factors. .roe sorted o a -0.0 0 -0.0 0.00 0.00 . roa sorte o a 0.00 -0.0 0 0.00 0 results (ta nd roa) o th smb and nd value f minantly cap absorbs the ust to choic equation has d effects meth l results of t youts i,t +ε t t(γ0) 20.949 ance at the 5 anel ols4 (table 4). f while firms is expected sulting in lo ws a negativ l results fo d portfolios b 0053 1.066 1.024 002 0.969 02 0.927 01 0.997 d portfolios b 02 1.084 003 0.965 1.070 02 0.961 0.927 able 5) show owing to co d lmh coef factors in ptured by va e profitabilit e of profitab been estimate hod based on the panel ol γ 9 5% level usi show that firms with h with persis d as firms ow/no divid ve link with r the three s s h 6 0.686 0 4 0.415 0 9 0.420 0 7 0.324 0 7 0.420 s h 0.523 0. 1.090 0. 0.502 0. 0.371 0. 0.429 -0 w insignific ntribution o fficients are explaining alue factor a ty sorted re bility proxy ed using rand wu-hausman 357 ls regressio γ1 -0.074* ing a two ta market be high payou stently low which are dends are typ h payouts, it factor fama h t(a) 0.522 -0.1 0.322 -0.1 0.284 -0.8 0.137 0.87 0.269 0.60 t(a) 554 0.367 827 -0.78 210 0.085 082 0.809 0.224 0.120 cant intercep of both size e higher for profitabilit and margina eturns that a y i.e. roe a dom effects p n statistic. asian on of beta o t(γ1) -3.235 ailed t-test eta is signi uts (profitab payouts (pr less profit pically mor t absorbs a p a french m t(b) 20 20.983 08 26.944 801 26.057 78 25.952 09 35.901 t(b) 7 20.776 80 23.239 5 26.922 9 28.403 0 32.142 pts for lowe e and value r p1 as comp ty based r ally by size are missed and roa. panel ols me n journal of f on dividend a 0 ficantly neg bility) are p rofitability) table and h re risky (hig portion of r model based t(s) 3 7.794 4 6.302 7 6.530 2 5.248 1 8.748 t(s) t 5.821 15.234 7.333 2 6.370 8.626 est profitabi e factors. ff pared to p5 returns. th e factor. hen by capm. ethod, which finance & ac issn 19 2012, vol. www.macrothi payouts adj.r2 .002 egatively re perceived to are perceiv hence do n gher beta). returns in ca on market t(h) ad 5.759 0. 4.742 0. 4.277 0. 2.159 0. -5.433 0. t(h) ad 5.931 0.7 11.108 0.8 2.950 0.8 1.350 0.8 -4.341 0.8 ility portfol f regression 5 confirming he alpha o nce the thre . further ff h has been cho ccounting 946-052x 4, no. 2 ink.org/ajfa elated to o be less ved to be not have we find apm. , size & dj.r2 791 839 830 816 886 dj.r2 789 884 845 850 873 lios(both ns show g role of f p1 is ee factor f results osen over when w roe an profitab relative distress give low next we table 6 dividen size i,t = p/b i,t = γ0 22.817 our pa payouts portfoli exhibit 19.17 % high p/b one mig instance their bu hand 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(199 f finan )00826-z returns efficiency. 93.tb04702 nds, dilutio matic-risk d //dx.doi.org financial p rg/10.2307/ he new issue 95.tb05166 interactions firms. 91.tb00388 nvestment s market effic s of finance diere, l. p. dia. interna ijef.v4n4p1 explaining econom )90025-4 reflect infor w, 71, 289-3 stock retu determinan nomics, 61, asian monality in econom 95). market ncial ec to buying journal 2.x n and taxes determinant g/10.1016/j. olicy and m /3665142 es puzzle. j 6.x between t financial 8.x trategies fo iency. in co (pp. 939-94 (2012). a tional journ 21 invetsor pr mics, rmation in 15 urns, the c nts of divide 99-108. n journal of f the determ ics, 4 t underreact onomics, winners a of finan s:a signallin ts of the u tourman.20 market expe journal of f the investm review, or reit inv onstantinide 47). search for nal of econ reference fo 1984(13) accruals an chicago mb end policy finance & ac issn 19 2012, vol. www.macrothi minants of e 41, 4 tion to open 39, 1 and selling nce, 48, ng equilibriu us airline i 006.03.012 ectations. f finance, 50 ment, financ 26(33), vestors. rea es, m. harr rational so nomics and for cash div ), 2 nd cash flow ba a jou of banks in ccounting 946-052x 4, no. 2 ink.org/ajfa expected 401-439. n market 181-208. g losers: 65-91. um. the industry. financial 0, 23-51. cing and 409-30. al estate ris and r. urces of finance, vidends. 253-282. ws about urnal of n ghana. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e9 www.macrothink.org/ajfa 175 acknowledgement of reviewers editorial board would like to thank the following for refereeing the articles submitted to the journal during 2009. professor alan farley school of accounting victoria university, australia professor beverley jackling school of accounting victoria university, australia associate professor jeffrey faux school of accounting victoria university, australia dr nick sciulli school of accounting victoria university, australia dr lalith seelanatha school of accounting victoria university, australia dr sisira colombage department of accounting and finance monash university, australia dr abeyrathna gunesekarage department of accounting and finance monash university, australia dr shrimal perera department of accounting and finance monash university, australia associate professor prem yapa school of accounting rmit university, australia dr bruce berton school of accounting and finance university of dundee, uk associate professor zhenyu wu department of finance and management science university of saskatchewan, canada associate professor michael j tomas iii school of business administration university of vermont, usa professor marc deloof louvain school of management university of antwerp, belgium professor bahram adrangi pamplin school of business university of portland, usa associate professor tom aabo aarhus school of business university of aarhus, denmark professor milind sathye discipline of accounting, banking and finance university of canberra, australia dr shyam batti school of accounting & finance university of wollongong, australia associate professor jeremy berkowitz department of finance university of houston, usa professor k.c chen craig school of business california state university, usa associate professor, darren henry school of economics and finance la trobe university, australia dr faruk balli department of economics and finance massey university, new zealand professor christoper wright commerce division lincoln university, new zealand dr samanthala hettihewa school of business university of ballarat, australia professor julie cotter school of accounting, economics and finance university of southern queensland, australia dr peter j phillips school of accounting, economics university of southern queensland, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e9 www.macrothink.org/ajfa 176 and finance australia dr michael brian cohen school of economics and finance victoria university, australia associate professor steven dellaportas school of accounting, economics and finance deakin university, australia assistant professor haizhi wang stuart school of business illinois institute of technology, usa professor ajay pandey finance & accounting area indian institute of management-ahmedabad, india associate professor susela devi department of financial accounting and audit university of malaya, malaysia associate professor chun yip desmond yuen department accounting and information management university of macau, china dr anil mishra school of economics and finance university of western sydney, australia professor anona armstrong centre for international corporate governance research victoria university, australia dr nada kulendran school of economics and finance victoria university, australia associate professor jane bisman school of accounting charles sturt university, australia assistant professor seoungpil ahn department of finance and accounting national university of singapore, singapore mr nigel finch discipline of accounting university of sydney, australia assistant professor juichin chan department of accounting howard university, usa dr bhagaban das postgraduate department of business management fakir mohan university, india dr mehdi sadeghi department of accounting & finance macquarie university, australia professor huey-lian sun school of business & management morgan state university, usa microsoft word 2762-10672-1-sm(1)-writer2-new asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 1 value added tax and consumer spending: a graphical descriptive analysis alexander m. g. gelardi associate professor university of st. thomas received: nov. 26, 2012 accepted: december 20, 2012 published: june 1, 2013 doi:10.5296/ajfa.v5i1.2762 url: http://dx.doi.org/10.5296/ajfa.v5i1.2762 abstract the us has been considering introducing a national consumption tax federally. this would be in addition to the states’ sales taxes. since a consumption tax would be an added cost to the consumer, it would be expected that there could be some behavioral change by consumers. this paper uses graphs to describe and analyze whether consumers in the uk and canada altered their behavior when those countries introduced their value added tax (or goods and services tax). both retail volume and the percentage change from the prior year (on a monthly basis) were used in the graphic depictions. it was found that there was no or little major behavioral change when the new taxes were introduced. however, when the tax rates were changed substantially, consumers did adapt their behavior to take advantage of the changes by engaging in arbitrage behavior. us consumers are likely to act in a similar manner as uk and canadian consumers. keywords: value added tax, consumer behavior, consumption tax, united kingdom canada united states asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 2 introduction consumption taxes are indirect taxes. they can be single stage (e.g., sales tax) or multi-stage (value-added tax). the first major country to have a value-added tax (vat) was france in 1954. since then, at least 135 countries (including all the european union countries) have adopted a vat, under a variety of different names. a common alternative name is the goods and services tax (gst), used in a number of countries including canada. vat and gst are multi-stage consumption taxes with credits. the united states has debated establishing a national sales tax or national vat for many years, even introducing legislation national retail sales tax act of 1997 (h.r.1325). this act never became law. although there is no vat nationally in the us, some states have some modified version michigan has the ‘single business tax’ and new hampshire has the ‘business enterprise tax’. the u.s. treasury has also looked into introducing a vat type tax to replace the corporate tax (u.s. treasury, 2007). as a more comprehensive tax reform, graetz has proposed that most taxpayers would be removed from paying income tax but there would a national vat instead (graetz, 2010). with the us considering enacting a vat style national consumption tax, possibly a multi-stage one, this paper looks at the possible impact on consumer retail spending that such a tax may have. two countries with similar economies and common law legal structures, namely the united kingdom (uk) and canada, will be analyzed. the paper will look at two aspects, the introduction of a valueadded tax on consumer spending and the change of rate of the vat on consumer spending. the study will observe if there is any arbitrage effect of these events. consumer behavior in the united states will be used as a control variable. the united kingdom introduced its value added tax in april1973 at the rate of 10% as part of the uk’s entry into the european economic community. the vat superseded the purchase tax, a hidden tax charged at various rates. over the years the rate of vat changed a number of times. between1975 and 1979, there was a “higher rate” on luxury goods. luxury goods included domestic electrical appliances, radios, tvs and hi-fi equipment, furs and jewellery. canada introduced its goods and services tax in january 1991 at the rate of 7%. the rate remained stable for about 15 years. when introduced, the gst replaced the manufacturers' sales tax (mst), a hidden tax charged on manufacturers at a 13.5% rate. like the us, but unlike the uk, canada has a federal system of government. the provinces (except alberta) also charge a sales tax in addition to the federal gst (at rates between 7% and 10%).1 the three territories do not charge their own sales tax. thus, the federal consumption tax is in addition to the provincial sales tax. to the consumer, the sum of the two taxes is the burden that is payable. if the us were to introduce a national consumption tax, it would be more like canada. most us states (45 out of the 50) have their own sales tax (counties and municipalities can also have their own sales taxes, even in some 1 some provinces, mainly in the maritimes and ontario, harmonize their sales tax with the gst. british columbia has also harmonized in 2010, but in a referendum in august 2011, the citizens of bc voted to return to the provincial sales tax regime. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 3 cases where there is no general state sales tax). this would mean that any national consumption tax in the us would be in addition to the state and local sales taxes. this paper is organized as follows: after this introduction there is the literature review followed by the section setting out the research questions. the methodology section is next, followed by the graphical results and comments. the paper ends with the concluding remarks and speculation of the us consumers’ behavioral changes. literature review a number of studies have examined whether the us should introduce a national sales tax or a national valued-added tax (metcalf, 1995; mikesell, 1997, 2003; zodrow, 1999; gale, 2005; the president’s advisory panel, 2005). a national value-added tax is still a matter of debate. in 2005 the president’s advisory panel recommended against a national consumption tax, mainly due to the administrative costs and possible regressivity. there is a common perception that a national consumption tax would be regressive (gale, houser and sholtz, 1996). further, it has been suggested that if the burden of a national sales tax falls more heavily on the lower income taxpayers, then the volume of retail sales may decrease (feenberg, mitrusi and poterba, 1997). however, it is not necessarily the case that a national sales tax cannot be progressive (metcalf, 1997). in fact, the vat system in the dominican republic has been found to be progressive (jenkins, jenkins and kuo, 2006). caspersen and metcalf (1995) state that a value-added tax in the u.s. could be only mildly regressive or even progressive. it has been found that the introduction of vat in the uk in 1973 had only small distributional effects (whalley, 1975). few studies have examined the impact on inflation due to the introduction of a national retail consumption tax. esenwein and gravelle (2004) in a congressional research service paper stated that the introduction of a consumption tax would likely give a one-time price inflation to avoid an economic contraction. however, this is not certain. it has been suggested that retail prices rise by the amount of the retail sales tax when looking at states in some circumstances only (poterba, 1996). thus, there is uncertainty as to the effect of introducing a national consumption tax. it has been suggested that when a consumption tax replaces an income tax, individuals tend to save more initially and to consume less. later, however, consumption eventually overtakes that of the original path, and there is higher consumption and a greater capital stock. (fullerton, shoven and whalley, 1983). inflation has many drivers. retail price increase is a major one. in turn consumer purchasing behavior effects retail prices. consumers may alter their buying behavior at two sets of different times. the first time a vat would be at the time of the introduction the vat. the other times would be when the vat rate changes. there have been few studies on the effect of vat on consumer retail spending behavior. barrell and weale (2009), looking at quarterly data, found weak evidence of changes in consumer behavior when the european countries reduced their vat rates. when the u.k. announced that hot foods sold retail would attract vat, the market value of greggs, a bakery that sells hot sausage rolls and other baked goods, dropped by £20 ($32) million (wallop and chan, 2012). since share prices are the present asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 4 value of expected future earnings, this indicates that the market expected that consumers would purchase less of greggs’ goods. this study examines retail volume both at the introduction of a national consumption tax and at the times the tax rate is changed. some insight for the us can be obtained by observing consumer behavior in the uk and canada, countries which have similar economies to the us. research questions this study is designed to extend prior research by investigating the following questions: a) did the introduction of a national value-added tax result in a decrease in the retail volume index in the united kingdom and canada? b) did any increase (decrease) in the rate of a national value-added tax result in a decrease (increase) in the retail volume index of the united kingdom and canada? methodology many factors influence how consumers spend. to look at the possible effect of the introduction, and rate changes, of a vat on consumer behavior, it is necessary to observe the behavior as close to the change as possible. otherwise, it would be difficult to make the case that it was the change that caused or impacted the change in behavior. retail volume data are generally given as annual and quarterly means. these time periods are too long to make a reasonable case for the analysis. fortunately, the organization of economic co-operation and development (oecd, 1960-2008) does have data on retail volume on a monthly basis for the us, uk and canada. data from the oecd, main economic indicators are used in all the graphs. an event-type statistical study would be the best way of analyzing the behavioral changes of consumers due to the vat introduction or change in rate. however, due to the limited observations (n), formal statistical analysis would not be meaningful. this paper, instead, presents a graphical descriptive analysis. each introduction of, or change in the rate, of the vat will have two graphs. the first graph will show the level of retail sales in the particular month. these sales are scaled so that the average of the year 2000 is 100. this makes comparisons more insightful. however, the observation of retail volume does not take into account any seasonality. thus, the second graph shows the percentage change in the month from the same month in the prior year. for example, the percentage change for april 1973 is the change of the retail volume in april 1973 from the retail volume of april 1972, as a percentage. this would account for any variation in retail volume due to seasonality. as consumer behavior is subject to many factors other than consumption taxes, the graphs will show the three months before the introduction (or rate change), the month of the introduction or rate change and the three months after. that is, there will be seven months observed in each graph. taking both graphs should strengthen the conclusions from the observations. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 5 as mentioned above, the uk introduced vat in april 1973 and canada introduced gst in january 1991. both events had been publicized in advance. this was also generally the case for the changes in the vat (or gst) rates. the public knew in advance that the rate change would occur. sometimes, the advance notice was some months; for example’ the new labour party government in the uk announced in its november 1974 budget that it would introduce the higher rate tax on luxuries from april 1975. other times the advance notice was very short. the new conservative party government in the uk, in its mid june 1979 budget, announced the increase of the vat rates to 15% (from both the 8% standard rate and the 12.5% higher rate) to be effective about a week later. this study will show whether consumers made their strategic purchasing choices, having prior knowledge of the changes. in the graphical observations the us retail volumes were used as a control. also, the retail volumes in canada and the united kingdom were also used as controls where the was no change in those countries (but the other country introduced the tax or had a rate change). for example, when the uk introduced vat in april 1973, canada did not and so both canada and the us were used as controls. similarly, when canada introduced gst in january 1991, both the uk and the us were used as controls. these added controls would strengthen the observational analysis. results introduction of a value added tax system nationally united kingdom introduction of value added tax in april 1973 figure 1. uk introduces vat april 1973: retail volume index asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 6 the retail volume decreased somewhat from march 1973 to april 1973 for the uk. it then rose slowly for the next three months. the main event at this time that influenced taxpayers was the introduction of vat in april 1973. the retail volume increased in march 1973, prior to the introduction. this would indicate that consumers anticipated the introduction of vat by bringing forward their purchases in the months prior to that in which vat took effect. the behavior of the uk differs from that of the us and canada. from march 1973 to april 1973, the retail volume increased slightly for canada and decreased slightly for the us. overall the us was fairly stable and canada had a slight movement but not really significant. since the retail volume change in the uk occurred at the time of the introduction of vat and differed from those of us and canada, this indicates that the introduction the vat in the uk caused consumers to amend their behavior. figure 2. uk introduces vat april 1973: percentage change in retail volume from same month of prior year here it can be seen that the percentage change in the retail volume from the same month of the prior year is much more substantial for the uk from march to april. there are decreases for both canada and the us, but these are not as steep. also, it is noted that the percentage change increased in the months leading up to the introduction of vat. this is likely to be the result of the early announcement that a vat would be imposed. consumers seem to have increased their purchasing in the months before the introduction of the tax and reduced their purchases once the tax was imposed. in other words, consumers seem to have indulged in arbitrage. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 7 the two graphs taken together indicate that the introduction of vat in the uk caused a timing behavioral change in consumer purchasing decisions. consumers anticipated the introduction of vat by making purchases before april 1973. thus, a drop in purchasing by the consumer occurred at, and after, the introduction of vat. canada introduces gst in january 1991 figure 3. canada introduces gst january 1991: retail volume index the introduction of gst in canada seems to have had a very small effect. the retail volume decreased slightly from december 1990 to january 1991 and to february 1991 before increasing again. however, this is not a different pattern from that shown by the uk or the us (though the us had a small and sustained increase to february 1991 and the next few months). part of the reason for this lack of effect could be that, since the gst supplanted the mst (of 13.5%), there was no major change in the prices that the consumers saw. furthermore, the provinces still charged their provincial sales tax and so the gst would have been only part of the overall tax on a product. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 8 figure 4. canada introduces gst january 1991: percentage change in retail volume from same month of prior year. canada shows a substantial drop in the percentage change in retail volume (from the same month of the prior year) from december 1990 to january 1991. this drop continues, albeit less steeply, for the next couple of months before rising from march 1991 to april 1991. the us has a similar decrease from december 1990 to january 1991. however, the us also has declines in the prior months. there is a sharp increase in february 1991 which continues, albeit not quite as steeply, for the next months. the uk has a very small decrease from december 1990 to january 1991. thus, it is difficult to state that the drop in the percentage change in retail volume in canada in january 1991 (when compared to the prior january), was due to the introduction of gst. the similar drop in the us for the same month could mean that there was another confounding factor. thus, the two graphs to not support the case that the introduction of the gst influenced consumer behavior. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 9 the change in vat rates the united kingdom decreases its vat rate to 8% (from 10%) in july 1974 figure 5. uk decreases the rate of vat to 8% in july 1974: retail volume index when the uk reduced the rate of vat in july 1974, from 10% to 8%, the retail volume showed no major change for that month. it was fairly steady for the months prior and following the change. both the us and canada had fairly similar results. both showed steady retail volumes for the months to august 1974 and then a slight decline after that time. this graph gives no evidence of any behavioral change. figure 6. uk decreases the rate of vat to 8% in july 1974: percentage change in retail volume from same month of prior year. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 10 again the change in the percentage change in retail volume from the prior year’ month does not seem to be affected by the small drop in the rate of vat to 8% in july 1974. the line representing the percentage change does is approximately linear from may to september 1974. the us and canada both have substantial percentage relative increases in july and august 1974. the uk does not have such a sharp increase. the two graphs do not support the case that the small change in the vat rate caused any behavioral change in purchasing. the united kingdom introduces the higher vat rate of 25% for luxuries in may 1975 figure 7. the uk introduces the higher vat rate of 25% for luxuries in may 1975: retail volume in may 1974 the uk introduced a higher vat rate of 25% for consumer goods that were regarded as luxuries. luxury goods were mainly consumer goods such as domestic electrical appliances, radios, tvs and hi-fi equipment, furs and jewellery, as well as services related to them, such as repairs of those items. in the month before the uk introduced the higher rate for luxuries, the retail volume increased substantially. the retail volume after the change dropped in may, the month in which the rate changed and was steady for some months afterwards. this would indicate that consumers anticipated the change by increasing their purchases of these items before the rate change. the uk’s graph is in contrast to those of the us and canada, which had only small movements in retail volume over the period in question. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 11 figure 8. the uk introduces the higher vat rate of 25% for luxuries in may 1975: percentage change in retail volume from same month of prior year in this case the percentage change from the same month of the prior year shows a very similar story to figure 7 (the retail volume). the uk shows a marked increase of more than 10% for april 1975 over april 1974, whereas there was a small decrease in march 1975 (over march 1974). in may 1975 there is a decrease from the same month the previous year (of about 2%). again, this indicates that consumers anticipated the rate change on luxury goods by purchasing more in april and less after the rate change. the slide in the percentage change continues for the months after may 1975. the us and canada, again, show very similar graphs to each other with an increase in the relative percentage change in may 1975 and then a small variation in the months after may 1975 (canada increases slightly then decreases, whereas the us decreases slightly). taken together the two graphs show that there was a substantial increase in consumer spending in the month prior to the introduction of the higher rate tax for luxuries. once the higher rate tax was implemented, spending decreased. this would indicate that consumers again used arbitrage by adjusting their behavior as a result of the new higher rate, even though that higher rate was for a limited class of goods. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 12 the united kingdom decreases its vat rate for luxuries to 12.5% (from 25%) in april 1976 figure 9. the uk decreases its vat rate for luxuries to 12.5% (from 25%) in april 1976: retail volume when the uk reduced the higher rate for luxury goods, the retail volume increased only slightly (from march 1976 to april 1976). this increase was not in any substantial way different for the small increases in canada and the us. the retail volume increased slightly again from april to may 1976 and then declined for a month. this would indicate that the drop in the luxury goods rate had no differential effect on consumer behavior. the us had very little variation, whereas canada did have a small increase in march and april followed by a small decrease in may. thus, overall there were no major observed differences between the uk graph and the other two countries’ graphs around the month that the vat rate for luxury goods changed. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 13 figure 10. the uk decreases its vat rate for luxuries to 12.5% (from 25%) in april 1976: percentage change in retail volume from same month of prior year the picture given by this graph is substantially different from that given figure 9. at first sight the observation in the uk that the percentage change in april 1976 dropping substantially is counterintuitive. since the rate of vat for luxuries was reduced, it would be expected that the percentage change would be increased due to greater consumer spending. however, the percentage change is calculated on a year to year by month basis, thus the percentage change for april 1976 is from april 1975. in may 1975, the rate for luxuries was increased substantially (from the standard/general rate of 8% to 25%). figures 7 and 8 in the previous section show that in the month prior to that large rate change (i.e., april 1975), consumers increased their purchases substantially. thus, it would appear that the unusually high retail volume in april 1975 made the comparison with volume in april 1976 a special case and thus lead to the counterintuitive result. the uk’s percentage change in may 1976 shows a marked increase (from 4.5 approximate in february and march 1976 to + 3.2 in may). part of this is, again, due to the changes a year before; however, looking at the results for may, june and july 1976, they are much more similar to those of the us and canada. it is interesting to see that again, where there is no change in the vat rate in canada, the results of canada and the us are very similar. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 14 the united kingdom increases its vat rate to 15% in july 1979 figure 11. the uk increases its vat rate to 15% (from standard of 8% and 12.5% for luxuries) in july 1979: retail volume in may 1979, the conservative party won the general election and became the government (unlike in the us, the winning party forms the government on the day after the election results are known). in its budget in the middle of june, it announced that it would increase the standard rate of vat to 15% (and abolish the special rate on luxuries, which at that time was 12.5%). the new rate would be effective about a week after the budget (which would have been in the latter part of june); thus, in this analysis the retail volume of july is used. as can be seen, there is an increase in the retail volume in june (probably in the week between the budget and the start of the new rate).2 the retail volume decreased in july. this would indicate that again, consumers changed their behavior by bringing forward their spending. thus, again, consumers took advantage of the change to indulge in arbitrage behavior. over the period there is little change in the retail volume of the us or canada. the consumers in these countries had no reason to alter their buying habits. 2 as an anecdote, the author was in public practice in england at the time and, having listened to the budget, did engage in arbitrage by making some purchases in that week to take advantage of the current lower existing vat rate, rather than later, as originally planned. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 15 the united kingdom increases its vat rate to 15% in july 1979 figure 12. the uk increases its vat rate to 15% (from standard of 8% and 12.5% for luxuries) in july 1979: percentage change in retail volume from same month of prior year the percentage change in retail volume from the year before, shows similar results to that of the retail volume graph, above. the percentage change increases dramatically for june 1979 from may and then drops much more to july 1979. this is consistent with the expectation that a large increase in the vat rates would have on spending habits. the consumers, again, seem to have brought forward their buying. the us percentage change in retail volume is fairly stable, remaining in the 0 to +2% (approximate) range. canada, on the other hand, has more variation but not in any way to the same degree as the uk. the two graphs taken together would indicate that the vat rate increase was a driver of the uk results. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 16 canada decreases its gst rate to 6% in july 2006 figure 13. canada decreases its gst rate to 6% in july 2006: retail volume in july, 2006 canada reduced its gst rate from 7% to 6%. there is a slight increase in the retail volume from june 2006 to july 2006. this increase continues into august and september. there is a decrease in volume in may and june. the us shows a decrease in retail volume to june and an increase to july followed by a decrease in august and september. the uk has an increase to june, static to july and an increase in august. the us and uk results show no consistent pattern. since the drop in retail volume for canada reversed in july 2006, the results could indicate some behavior change due to the small rate change in the gst rate. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 17 figure 14. canada decreases its gst rate to 6% in july 2006: percentage change in retail volume from same month of prior year canada shows a decrease in the relative percentage change from the same month the year before for june and july followed by an increase in august and september. the uk is fairly static over the period, varying between approximately +3% and +4%. these results on their own would indicate the possibility that the drop in the gst rate had an effect on the canadian consumers’ purchasing decisions. however, a very similar pattern to the canadian graph is seen with respect to the us, though the us has a decrease in september in contrast to canada’s substantial increase in september. taking the us and canada together, it is difficult to make a strong case that the change in the gst rate had an impact on taxpayers’ buying habits. taking both figures 13 and 14 together, the case that the change in the rate of gst from 7% to 6% had effected the buying decisions of consumers is only weakly confirmed. conclusion this paper described the changes in retail volume at the time of introduction of a national multi-stage consumption tax in the uk and canada and at the time of any rate changes in those countries. the us was used for control purposes. two graphs were used for each change, the first had the retail volume in the months and the second graph has the percentage change from the same month a year prior. whether consumers engage in any arbitrage behavior was examined. overall, the introduction of a vat in the uk showed some behavioral change, whereas the introduction of gst in canada did not. the result for canada could have been driven by the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 18 fact that the gst replaced a fairly high (13.5%) existing, albeit hidden, consumption tax. also, the canadian provinces (except alberta) had their own sales tax. in the uk, most of the rate changes had a behavioral effect. this was evidenced most strongly in the new higher rate of 25% for luxuries in may 1975 and the increase of the standard vat rate to 15% (from 8%) in july 1979.3 overall, a strong arbitrage effect was noted. the uk rate decrease from 10% to 8% in july 1974 did not indicate any behavior change. there appeared to be a behavioral effect for the drop in the luxuries’ higher vat rate to 12.5% in april 1976, when looking at the percentage change graph. however this was counter to expectation. the anomaly was mainly due to the behavioral changes in april 1975, when the higher rate for luxuries was introduced. in canada, the gst rate decrease in july 2006, dropping to 6% from 7%, there is a weak case to indicate that consumers engaged in arbitrage by adapting their purchasing timing. this is possibly due to the small decrease relative to the combined gst and provincial sales taxes. the question arises of how this paper may shed some light on what may occur if the us decides to implement a national multi-stage consumption tax. the assumption would be that any such national vatlike tax would be in addition to, and not instead of, the federal income tax. both canada and the uk added their national consumption taxes to their existing income taxes. the us is more like canada than the uk, in that it has a federal system, wherein the states (like the provinces) have their own sales tax. canada did not show any behavioral change on the introduction of its gst. however, since canada replaced its mst and the us would not be doing the same, direct comparison may not be completely helpful. the us situation would seem to be somewhat in between the uk and canadian situations. thus, it is possible that there would be some, though perhaps small temporary behavioral change in us consumers on the introduction of a vat style tax. once a national vatstyle tax is introduced into the us, another question is whether there will be any behavioral changes if the tax rate changes. the analysis of the changes made by the uk and canada would indicate that there could be some behavioral changes, particularly arbitrage, by consumers. the behavioral change would be more acute where the rate change is substantial, either increased or decreased. the analysis of the canadian rate change would indicate that any rate change that is small, at least small in relation to the total of the federal vat and state/local sales tax rates, would result in little or no consumer behavioral changes. references barrell, r., & weale, m. (2009). the economics of a reduction in vat. national institute discussion paper no 325. london: national institute of economic and social research. 3 also, at this time the higher tax on luxuries was abolished, effectively raising the rate from 12.5%. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 19 caspersen, e., & metcalf, g. e. (1995). is a value added tax progressive? annual versus lifetime incidence measures. nber working paper no. w4387. retrieved from http://ssrn.com/abstract=406043 esenwein, g. a., & gravelle, j. g. (2004). the flat tax, value-added tax and national retail sales tax: an overview of issues. crs report for congress:rl32603. washington; library of congress. feenberg, d. r., mitrusi, a., & poterba, j. m. (1997). distributional effects of adopting a national retail sales tax. nber working paper no. w5885. retrieved from http://ssrn.com/abstract=225667 fullerton d., shoven j. b., & whalley j. (1983). replacing the u.s. income tax with a progressive consumption tax: a sequenced general equilibrium approach. journal of public economics, 20(1), 3-23. http://dx.doi.org/10.1016/0047-2727(83)90018-x gale, w., houser, s., & scholz, j. k. (1996). distributional effects of fundamental tax reform, in h. aaron and w. gale (eds.), economic effects of fundamental tax reform. washington: brookings institution. gale, w. g. (2005). the national retail sales: what would the rate have to be?. tax notes. 889-911. graetz, m. j. (2010) 100 million unnecessary returns. new haven: yale university press, (revised edition). jenkins, g. p., jenkins, h., & kuo, c-y. (2006). is the value added tax naturally progressive? 2006 queens university working paper. metcalf, g.e. (1995). value-added taxation: a tax whose time has come? the journal of economic perspectives, 9(1), 121-140. http://dx.doi.org/10.1257/jep.9.1.121 metcalf, g. e. (1997). national sales tax: who bears the burden? policy analysis, no 289: the cato institute. mikesell, j. l. (1996). the american retail sales tax: consideration on their structure, operations and potential as a foundation on a federal sales tax. national tax journal, 49(2), 165-76. mikesell, j. l. (1998). changing the federal tax philosophy: a national value-added tax or retail sales tax? public budgeting & finance, 18(2), 53-68 http://dx.doi.org/10.1046/j.0275-1100.1998.01134.x organization of economic co-operation and development. (1960-2012). main economic indicators, paris: organization of economic co-operation and development. poterba, j. m. (1997). retail price reactions to changes in state and local sales taxes. national tax journal, 49(2), 149-65. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 20 the president’s advisory panel. (2005). simple, fair & pro-growth: proposal to fix america’s tax system. report of the president’s advisory panel on federal tax reform. mack, c., chairman. united states treasury, office of tax policy. (2007). approaches to improve the competitiveness of the u.s. business tax system for the 21st century, washington dc: u. s. department of the treasury. wallop, h., & chan, sp. (2012). budget 2012 greggs shares fall on vat blow. march 22. the daily telegraph. retrieved from http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/9160195/budget-2012greggs-shares-fall-on-vat-blow.html whalley, j. (1975). a general equilibrium assessment of the 1973 united kingdom tax reform. economica, 42(166), 139-161. http://dx.doi.org/10.2307/2553589 zodrow, g. r. (1999). the sales tax, the vat and taxes in-between – or is the only good nrst a ‘vat in drag’? national tax journal, 52(3), 429-442. microsoft word 2028-7955-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 231 public debt and the crisis of development in nigeria econometric investigation chris o. udoka department of banking & finance university of calabar, calabar, cross river-nigeria e-mail: udokaco@yahoo.com samson ogege department of finance, faculty of business administration university of lagos, lagos, nigeria tel: 234-080-3669-1036 e-mail: ogegesamson@yahoo.com received: july 1, 2012 accepted: september 13, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.2028 url: http://dx.doi.org/10.5296/ajfa.v4i2.2028 abstract the study examined the extent of public debt crisis and its consequences on economic development using data from nigerian economy for the period 1970 to 2010. it employed the error correction framework and co-integration techniques to test the relationship between per-capita gross domestic product and macroeconomics variables. the test reveals that there is long relationship between dependent and the independent variables. this implies that political instability may reduce rate development and other independent variables are responsible for the underdevelopment of nigeria. hence, to avoid the crisis of economic development in nigeria public debt should be reduce to a minimal level. keywords: public debt, economic development, co-integration, unit root asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 232 1. introduction the act of borrowing creates debt. debt, therefore, refers to the resources of money in use in an organization which is not contributed by its owners and does not in any other way belong to them. it is a liability represented by a financial instrument of other formal equivalent. when a government borrows, the debts is a public debt, debts are incurred by government through borrowing in the domestic and international markets to finance domestic investment. therefore, the national debt is seen as all claims against the government held by the private sector of the economy, or by foreigners, whether interest-bearing or not (and including bank held debt and government currency, if any); less any claims held by the government against the private sector and foreigners. in the same vein, public debt burden refers to the economic hardship which the public debt imposes. the hardship may take the form of waste of productive efficiency (misdirection of production) for the economy as a whole or undesirable economic burdens imposed upon particular classes. one concept of burden pertains to the current amount of goods and services which the private sector forgoes in to enable the burden relate to the amount of goods and services forgone by the people during their lifetimes (anyanwu, 1993). the debt burden in nigeria has resulted in various distortions in the macro-economy. essentially, these distortions are structural in nature, and thus affect the level of per capita incomes and are instrumental to the rising poverty in the country. the latter has attracted the attention of various authors and nigerian economic planners. the various points of view are all agreed that the condition of africa in general and that of nigeria in particular have now deteriorated to an economic and political catastrophe (nzotta, 2004). basically, nigeria began to experience debt problem from the early 1980s when foreign exchange earnings plummeted as a result of the collapse of prices in the international oil market and external loans began to be acquired indiscriminately. the debt crisis, which is the combination of accumulated debt stock and difficulty servicing, has imposed several burdens on the nigerian economy. this is reflected in the fall in real growth rates, investment rate and export earning since 1980. the debt burden has clearly been a constraining factor on rapid economic recovery growth and development with the debt increasing at an alarming rate. funds which should have been used for economic development are channeled towards servicing the debt. the constraining effect of the debt burden services is more pronounced as the economy has failed to grow sufficiently to reduce the burden to a sustainable level. public debt is an amount of money owned by the government to institutions, government agencies and other bodies’ resident in or outside nigeria. the debt crisis has also generated controversy as to the exact meaning of debt and external debt (nzotta, 2004). the imf (1988) defined debt as a liability represented by a financial instrument or other formal equivalent owed to other parties. the world bank (1988) defined gross external debt as the amount, at any time of disbursed and outstanding contractual liabilities of residents of a country to non-residents to repay principal with or without interest, or to pay interest, with or without principal. thus, the major objective of this paper is to assess the extent of public debt burden on nigerian economy from 19702010 and to bring out if there is any relationship between public debt burden and economic growth of the nation. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 233 2. theoretical framework 2.1 debtcum – growth model the first stand of thought in the debtcum – growth theory is the substituting school of thought. it considers external debt as a substitute for domestic savings and investment and therefore domestic savings and investment are crowded out as a result (krugman, 1988; alesina & tabellini, 1990; tornell & velusco 1992). the thinking is that the returns from investing in a country are seen as being subjected to a high marginal tax by creditors and this may discourage domestic and foreign investors. this is the familiar debt overhang theory. it is also argued that foreign savings may be used for consumption rather than for investment. however, studies by cohen and sachs (1986) and cohen (1992) present endogenous growth models where capital accumulation is the driving force for growth. 2.2 threshold school of thought (debt latter curvethesis) the burden of external debt is the concern of threshold school of thought which emphasizes the non-linear relationship between debt and growth (calvo, 1998). it links debt and growth to problem of capital flight where at high debt levels growth falls. according to the threshold theory, the fall in growth is due to the higher distortionary tax burden on capital required to service the debt. it leads to lower rate of return on capital, lower investment and, hence, lower growth. it maintains that low debt regimes have higher growth rate and lower strand of thought in the debt – growth nexus sees external debt as capital inflow with positive effect on domestic savings and investment and thus on growth which leads to poverty reduction via appropriate targeting of domestic savings and investment (calvo, 1998). such foreign capital inflows help to finance a chronic shortfall of domestic savings over investment, the gap in the current account. there should be no problem with the theory as the funds are channeled into production investment which allows the country to grow and generate future export earnings to repay the loan. profligacy theory the profligacy thesis attempts to correct the weakness of growth – cum debt theory by focusing on the institutional arrangement under which a loan was contracted. the profligacy thesis, a component of the system stability theory, recognizes that the debt crisis arose from weak institutions and policies that have wasted resources through unbridled official corruption and damaged living standards and development. these policies led to distortions in relative prices and encouraged capital flights – as seen in substantial external liquid funds of private citizens of debtor countries in foreign banks. (nyong, 2005) in summary, many factors are identified as responsible for the dissonance between debt and growth in low income countries. these include (1) adverse terms of trade (ii) waste of resources due to policy deficiencies, poor governance, and weak institutions in public sector dominated economies (iii) inadequate debt management reflected in unrestrained borrowing at unfavorable terms. (iv) non-concessional lending and in financing policies motivated in part by the desire of lenders to promote their own exports (stephens, 1999) (v) political factors such as social strive or tension with devastating economic consequences nyong, 2005). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 234 conceptual issues on public debt when the government spends more than it receives which results in the use of some sort of security to cover the deficiency which normally lead external debt as source of fund. the aggregate of securities over timeless redemption is called the national debt (ajayi, 1991). the fore-going statement points to the fact that government accumulates debt simply by running deficits through borrowing on the distribution of such securities. also, national debt consists of all securities issued by the federal government and held by the central bank of nigeria, individual and foreigners, government agencies and trust funds, private sector as well as those held by commercial banks. on the concept of debt burden, cohen (1992) posited that external debt does not constitute a burden when contracted loans are optimally deployed and the returns on investment is enough to meet maturing obligations, while the surviving of the domestic economy is not undermined. he added that where the reverse is the case, then a debt service burden will emerge. to properly gauge the gravity of debt burden on nigerian economy, anyanwu (1997) argues that neither the overall level of indebtedness nor the aggregate level of debt service payment is an adequate measure of a region or country’s problem. he suggested that they should be used in combination with other debt indicators to get a more accurate picture of the situation. according to nzotta (2004), these other indicators include: the external debt of gdp ratio of debt service to federally collected revenue, the ratio of interest payments to debt stock, and the ratio of outstanding debt stock to gdp. these indicators according to him show the degree of the severity or intensity of external debt burden. nzotta (2004) described debt service burden as the weight of debt service payment relative to the proportion of national income devoted to servicing of economy. they concluded that debt service problem would arise when maturing obligations cannot be redeemed owing to either bad leadership or insolvency problem. nigerian public debt various approaches have been adopted towards making public debt sustainable. under the structural adjustment programme (sap), nigeria adopted the following strategies to ameliorate domestic debt: acquisition of domestic debt, restructuring of domestic debt, and servicing of domestic debt. on the external front, the following strategies were employed: embargo on new loans, limit on debt servicing payments (maximum 30% of export earnings); debt restructuring through refinancing, rescheduling, buyback, issuance of collateralized bonds, and the provision of new money, and debt conversion schemes. in spite of these and international debt reduction strategies such as the baker plan (1985), the paris club plan (1987), the africa development bank (adp) plan. the brady plan (1989), the imf facilities (structural adjustment facility, external fund facility, the enlarged access policy, the enhanced structural adjustment facility, and compensatory and contingency financing facility have not change the picture from what it used to be for mostly africa countries. despite the world bank facilities (structural adjusted lending, the reduction facility, the special programme of assistance and the trade investment and policy loan), toronto and trinidad terms enhanced toronto terms, the housten terms and the naples term, nigeria’s public debt continuous to grow like an avalanche. (ajayi, 1991; ani, 1997; (anyanwu, 1997). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 235 nigeria's external and domestic debts: external debts nigeria’s external indebtedness dates back to pre-independence period. however, the quantum of the debt was small until 1978. the debts incurred before 1978 were mainly long-term loans from multilateral and official sources such as the world bank and the country’s major trading partners. the debts were not much of a burden on the economy because the loans were obtained on soft terms. moreover, the country had abundant revenue receipts from oil, especially during the oil boom of 1973-1976. the total external debt outstanding as at 31st december 2004 stood at us$35.94 billion as against us$32.92 billion in december 2003, indicating an increase of us$3.03 billion or 9.20 percent. as was the case in the year 2003, the increase in the debt stock was largely as a result of the interest component of additional payment arrears that accumulated, and continued depreciation of the us dollar against other currencies in which the debts were denominated. the additional interest of us$1.54 billion was made up of contractual interest of us$1.30 billion and late/penalty interest of us$0.233 billion, but the increase due to the effect of the depreciation of the us dollar was approximately us$1.49 billion. a further breakdown of the total debt outstanding showed that the principal balance was us$30.29 billion; principal arrears amounted to us$1.94 billion, interest arrears and late interest were us$3.36 billion and us$0.357 billion respectively. the increase in the external debt stock was due primarily to arrears that were incurred as a result of non-servicing of the non-oda (non-official development assistance) bilateral debt: arrears on this debt accounted for 96.6 percent of total arrears. debt servicing the total external debt service payment for the year 2004 was us$1.75 billion compared to us$1.81 billion in 2003, reflecting a decrease of us$0.054 billion or 3.01 percent. the external debt service payments of us$1.75 billion comprised of principal repayments of us$1.17 billion, and interest payments and commitment charges of us$0.589 billion. it is important to note that the us$1.75 billion debt service paid in 2004 is actually well below the debt service due for the year of us$2.99 billion. this arises because nigeria has not fully serviced its paris club debts, as an amount of us$2.23 billion was due but only us$0.99 billion was paid. the shortfall transforms into arrears and attracts severe penalty interest. this very process has contributed to the explosion in nigeria’s external debt stock over the years. (dmo, 2010) domestic debts domestic debt is defined as debt denominated in local currency. the management of domestic debt in nigeria has hitherto been conducted by the central bank of nigeria (cbn) through the issuance of government debt instruments, which consisted of: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 236 • nigerian treasury bills • nigerian treasury certificates • federal government development stocks • treasury bonds • ways and means advances. it is important to note that the above given position does not include contractor debts and supplier credit owed by the government, which are estimated at about n650 billion. neither does it include contingent liabilities, which are loans guaranteed by the federal government, nor inter-agency debt. in the year 2004, the dmo made plans to build on the success of the 1st fgn bonds floatation that were first issued in 2003. the dmo embarked on the arrangements to commence the issuance of bonds on a regular basis in small tranches that the market could accommodate. the dmo commenced the smoothening and restructuring of the treasury bills in 2004. the restructuring entailed extending the maturities of the existing treasury bills by issuing tenors of 6, 12, 24, and 36 months, to refinance part of the existing 91-day treasury bills 3. methodology based on the objective of the study and on the basis of what has been discussed in the theoretical framework, the following model will be specified. the paper attempts to assess the impact of public debt and the crisis of development in nigeria .the knowledge of economic theory suggests that a critical factor in assessment of economic development is the per-capita gross domestic product (pcgdp). however, our model shall contain gross domestic product as the dependent variable, while foreign reserve, debt stock, investment, debt service payment, total trade/ gdp ratio and political stability are the explanatory variables. therefore, this applies to the error correction method to a regression model based on the traditional relationship between public debt and economic development distilled from the literature. the idea is to subject the variables to stationarity test and subsequently remove the nonstationary trends by differencing before regressing. this removes the possibility of the so-called spurious regression. the analysis here is primarily based on engle and granger (1987). the idea is to determine the order of integration of the variables, that is, we test whether they are stationary in their levels or whether they have to be differenced once or more before they become stationary. testing for unit roots is carried out by using an augmented dickey-fuller (adf) test. gdp = f( fr, dsk, frinv,dsp, open, pol) the above model is hereby written in log —linear form as: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 237 (l) gdp= bo + b1fr(l) + b2dsk(l) + b3frinv(l) + b4dsp(l) + b5open(l) + b6pol(l) + µt where: fr = foreign reserve dsk = total debt stock frinv = foreign investment dsp = debt service payment open = openness of the economy (total trade /gdp ratio) pol = political instability dummy = 1 military regime and turbulent years, 0 otherwise μ = scholastic error sign. “the data analysis technique consists of an approach designed to capture the long-run relationship between the dependent and independent variables, but avoiding spurious influences. these are the co-integration and error correction techniques which have received prominent attention in literature (see adam, 1992, engle and granger, 1987, and thomas 1993). the aim of the new framework was to ascertain the time characteristics of data, overcome the problems of spurious correlation often associated with none —stationary time series data, and generated long-run variable relationship simultaneously. within this dispensation, an important starting point for research is an assessment of the degree of integration of the relevant variables and to check whether they are co-integrated or not. it should be noted that an important issue in econometrics is the need to integrate short-run dynamics with long-run equilibrium. the analysis of short-run dynamics is often done by first eliminating trends in the variables, usually by differencing. the theory of co-integration development in granger (1981) and elaborated in engle and granger (1987) addressed this issue of integrating short-run dynamics with long-run equilibrium. similarly, it is important to note that the usual starting point of ecm modeling is to assess the order of integration of both the dependent and independent variables in the model. the order of integration ascertains the number of time a variable will be differentiated to arrive at stationary. dickey-fuller (df), augmented dickey-fuller (adf) and sargan rhargava durban-watson (srdw) are the widely used test for stationary for both individual time series and residual from ols regressions. co-integration is based on the properties of the residuals from regression analysis when the series are individually non-stationary. the original co integration regression is specified as follows: at= tt   10 (1) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 238 where a represents the dependent variables,  stands for the independent variable, and e is the random error term. 0 and 1 are intercept and slope coefficients respectively. to include the possibility of bi-directional causality, the reverse specification of equation 1 is considered. to provide a more defensive answer to the non-stationarity in each time series, the dickey-fuller (1979) regression is estimated as follows for a unit root: ∆et = -λet-1 + wt (2) if x equals zero e is non-stationary. as a result, a and b are not co-integrated. in other words, if x is significantly different from zero a and b is found integrated individually. given the inherent weakness of the root test to distinguish between the null and the alternative hypothesis, it is desirable that the augmented dickey-fuller (adf) (1981) test be applied. the desirability is warranted because it corrects for any serial correlation by incorporating lagged changes of the residuals. to be co-integrated, both a and b must have the same order of integration (eagle and granger, 1987 ). the adf regression is specified as follows: 1 tot   +     m ij ttj  1 (3) where ∆ is the first difference operator and μt is the new random error term. m is the optimum number of lags needed to obtain “white noise”. this is approximated when the dw value approaches 2.0 numerically. the null hypothesis of non co-integration is rejected, if the estimated adf statistics is found to be larger than its critical value at 1 or 5 or 10 per cent level of significance. if at and bt are found to be co-integrated, then there must exist an associated error-correlation model (ecm), according to engle and granger (1987). the usual ecm may take the following form: ∆gt = σo et-1 +   t j 1 1 ∆at-j +   t j j 1  ∆bt-j + vt (4) where ∆ denotes the difference operator et-1 is the error correction term, t is the number of lags necessary to obtain white noise and vt is another random disturbance term. if σo et-1 is significantly different from zero, then a and b have long-run relationship. the error-correction term (et-i) depicts the extent of disequilibrium between a and b the ecm, reveals further that the change in at not only depends on lagged changes in bt, but also on its own lagged changes. it is appealing due to its ability to induce flexibility by combining the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 239 short-run and long-run dynamics in a unified system. also, the estimates of the parameters of the ecm are generally consistent and efficient (granger, 1969). table 1. stationary test variables adf test order of integration log gdp 0.04925 (-29969) 1(1) log fr -3.7333 (-3.0114) 1(0) log frinv -3.6876 (-2.9798) 1(0) log dsp -2.0299 (-2.9798) 1(1) a log open -3.5063 (-2.9850) 1(0) log open -4.2833 (-2.9798) 1 (0) log inv -3.3697 (-2.9798) 1 (0) log infl -1.3068 (-2.9969) 1(1) a log infl -40706 (-3.0038) 1 (0) log open 0.8224 (-2.9798) 1(1) a log open -4.1436 (-2.9850) 1(0) log ms -1.1022(-2.9798) 1(1) a log ms -3.0994 (-2.9850) 1(0) source: authors’ computation (2012) table 2. johansen co-integration test results sample: 1970 – 2010 series: log gdp, log fr, log dsk, log dsp, log open, eigen value likelihood ratio 5% 1% hypothesized critical critical no. of ce(s) value value 0.84 114.3228 94.15 103.18 none** note:* (**) (denotes rejection of the hypothesis at 5% (1%) significance level. l. r. test indicates 2 co-integration equation(s) at 5% significance level. lags interval: 1 to l source: authors’ computation (2012) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 240 table 3. long-run capital adequacy determinants model estimates modeling log (pcgdp) by ols sample: 1970 – 2010 variable co-efficient t-value log pcgdp log fr log open log dsp 0.6772 -0.1325 0.2896 0.6427 3.4397*** -1.2558 5.1303 30.9551*** notes: adj. r2 = 0.72 f = 21.327 a= 0.45 r2 = 0.75 prob(f--statistic)=0.00000 dw = 1.87 schwarz information criterion 1.561 * significant at 1% level ** significant at 5% level *** significant at 10% level a = s. e. of regression source: authors’ computation (2012) table 4. short-run over — parameterized capital adequacy determinants model model log (pcgdp) by ols sample: 1970— 2010 variables constant ∆ logcad(-1) ∆ logfr ∆ logfr(-1) ∆ logdsk ∆ log dsk (-1) ∆ frinv ∆ frinv(-1) ∆ logdsp ∆ logdsp(-l) ∆ log open ∆ log open (-1) pol ecm(-1) co-efficient 1.2840 -0.5866 -0.2160 0.1434 0.9177 0.5939 -0.0096 -0.0175 -0.3253 0.6758 -0.1542 -0.1861 -0.0933 -0.5414 t-value 2.6798 -3.9531*** -0.8619 0.7085 3.5113*** 0.7142 -0.8264 -1.5620 -1.0929 1.8781 -0.5330 -0.6258 -0.5043 2.4385** notes: r2 = 0.93 f=10.01 a=0.200 adj r2 = 0.83 prob (f — statistic) = 0.007975 dw= 136 schwarz information criterion = 0.7 05 source: authors’ computation (2012) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 241 table 5. short-run parsimonious model estimates modeling log (pcgdp) by ols sample: 1970 – 2010 variables co-efficient t-value constant log pcgdp (-1) log fr log dsk log frinv (-1) log dsp log open (-1) pol ecm (-1) 1.648 -0.6818 0.0265 0.8227 -0.0193 -0.1811 -0.2630 -0.2672 0.44711 -1.2350 0.3498 -10.5611 3.9047 -3.816*** 0.357 3.1236*** -5.0554*** -0.5548 -1.3896** -1.4278 2.2388** -4.7628*** 3.5534*** -2.9942*** notes: r2 = 0.89 f = 10.09 a = 0.24 *** significant at 1% adj r2 :0.80 prob (f-statistic) = 0.000266 ** significant at 5% dw=2.11 schwarz information criterion = 1.10 * significant at 10% source: authors’ computation ( 2012) 4. empirical results and findings it was discovered through this study that, there were long run relationship between total debt stock, debt service payment and political instability. also, all the variables employed in this study were all stationary at their first difference except foreign investment that is stationary at its level. there are some major findings that this study has revealed. from the result of the study, one could see that total debt stock has a positive relationship with per-capita gross domestic product in nigeria. its high coefficient and very strong level of significance even at one percent suggests that increase in total debt stock leads to an increase in per-capita gross domestic product. also even other independent variables are relevant. lastly, the political dummy used as proxy for political instability was appropriately signed indicating that intermittent coup d’etat and incessant political upheaval may serve to scare away potential foreign investors thereby, reducing per-capital gross domestic product and increasing our debt profile in nigeria. 5. conclusions asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 242 the primary objective of the study was to analyze the effect of debt burden (both internal and external) on the growth of nigerian economy. nigeria has relied much on public debt to finance its development projects in the past two decades ago with public debts which put its debt profile so high. from the analysis above it was reviewed that pcgdp which was used to represent the nigerian economic development as well as the dependent variable. meaning that rate of development of the nigerian economy relies strongly on the contribution of the explanatory variables. thus, before the debt write-off by the paris-club and london club the result shows that the impact on nigeria economy was much compared to present time. though, the exit from the paris club and london club actually reduced nigeria’s external debt, whereas the domestic debt and the effect created by the huge debt before the debt write-off still have lag effect on the economy. therefore, based on the above findings we recommended that nigeria should not borrow now either internally or externally. more so with the conformable position of our external reserve we believe that the nigerian economy will certainly improve tremendously references adam, c. s. (1992). recent developments in econometric methods: an application to the demand for money in kenya. economic research consortium special paper 15. ajayi, s. i. (1991). macroeconomic approach to external debt: the case of nigeria. aerc research paper eight, nairobi, december. http://idl-bnc.idrc.ca/dspace/bitstream/10625/11779/1/90214.pdf alesina, a., & tabellini, g.(1990). external debt, capital flight and political risk. ani a. (1997). details of budget 1997: text of the 1997 federal budget breakdown presented in abuja,monday, january 20, 1997 by minister of finance, chief anthony ani, daily champion, january 21 anyanwu j. c. (1997). monetary economics: theory, policy and institutions. hybrid publishers ltd, onitsha. calvo, g. (1989). growth, debt and economic transformation: the capital flight problem;in coricelli, f. and hahn, f. (eds), new theories in growth and development, st. martins press, pp. 847-868 central bank of nigeria. annual report and statement of accounts various issues cohen, d., & sachs, j. (1986). growth and external debt under risk of debt repudiation. european economic review, 30, 529-550. cohen, d. (1992). large external debt and (show) domestic growth: a theoretical analysis. journal of economic dynamics and control, 19, 1144-1163. dickey, o.a., & fuller w. a. (1981). likelihood ratio statistic for auto-regression times series with a unit root. econometrical, 4, 1057-1071. engle, r.f., & granger, c. w. j. (1987). co-integration and error correction. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 243 granger, c. w. j. (1969). investigating causal relations by econometric models and cross-spectral methods. econometrica, 37, 424-438. http://dx.doi.org/10.2307/1912791 krugman, p. (1988). financing vs forgiving a debt overhang. journal of development economics, 22, 253-268. http://dx.doi.org/10.1016/0304-3878(88)90044-2 nyong, m. o. (2005). international economics: theory, policy and application. calabar, wusen publishers. nzotta, s. m. (2004). money, banking and finance. owerri;hudson-jude nigeria publishers. stephens, m. (1999). the changing role of export credit agencies (wasshington dc, imf) thomas, r. c. (1993). introductory econometrics, theory and applications. second edition (eds). robert mil michael t. summer and george zia. longman economic series. london and new york. tornell, a., & velasco, a. (1992). the tragedy of the commons and economic growth; why does capital flow from poor to rich countries. journal of political economy, 100, 1208-1231. http://dx.doi.org/10.1086/261858 microsoft word 1689-6677-1-sm (1)-writer3-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 144 due process and budget implementation: an evaluation of nigerian public sector auditing olurankinse, felix department of accounting adekunle ajasin university akungba-akoko, ondo state, nigeria received: april 22, 2012 accepted: july 19, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1689 url: http://dx.doi.org/10.5296/ajfa.v4i2.1689 abstract as the state is experiencing growth in her population, so is the increase in the demand of the people in terms of provisions of social and infrastructural facilities. as economist will say ‘human wants are unlimited but the means to satisfy them are limited. there is therefore the need to utilize these scarce resources to the full benefit of the citizenries. to do this, we need an appropriate tool of accounting called budget that will serve as a composite framework of implementing government policies. budget in the public sector of nigeria has almost become a ritual or a yearly affairs which though good in content but without appreciable results. the issue of budget implementation has long been a source of concern to the public. as good as our budget is mostly in terms of preparation and contents; it is kept in shelves after approval as a historical book and never consulted. there are wide range of disparity between budget and accomplishments. it is against this background that government and auditors introduce new measures and strategies aimed at checking wasteful expenditures and keeping budget in line with global practice. the objective of the paper therefore is to examine few of these measures and to determine their implications on budget implementation. the paper concluded that all the new audit trends are indispensable for the efficiency and effectiveness of budget performance. however, the paper recommended the need to enact enabling laws that will ensure the workability of these new audit concepts. keywords: due process, cost audit, value for money, efficiency, effectiveness, economy. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 145 introduction the term public sector simply refers to the part of the economy that is controlled by the government for the purpose of providing basic government services. these basic services that the government need to provide are so enormous due to increase number of people they service. as economist would put it “human wants are unlimited, but the means to satisfy them are limited’’, this therefore call for the use of an efficient management tools that will harness the limited resources for optimal use. one of the machineries of government that can be used for this purpose is budget. budget making and budget implementation involve the process of identification of public needs and the determination of the quality of goods and services to satisfy these needs through the political process, by economic analysis with the overall development plan objectives. government prepares budget inform of public policy to serve as a driver through which her mission could be achieved. as good as our budget is, the performance of which can be measured in terms of accomplishment is nothing to write home about. budget accomplishment is far from reality and the disparity between budget and accomplishment are so wide and kept on abating as years pass by. the question that could readily come to mind is why is re occurrence of budget failure? could it be that it is ill conceived or ill planned? could it be ascribe to poor monitoring and implementation?. the need to provide answers to these questions gave impetus for this study. due process literature review and theoretical framework the practice of budgeting, as it is now understood, originated in the central government of great britain. it later developed gradually, as a result of parliament’s struggle to obtain control over the finance of the crown. in 1217, it was declared in magna charta that “no cottage or aid shall be imposed in the kingdom unless by the common council of realm. after the revolution of 1688, parliament now approved the right to authorized expenditure by the crown as well as taxation apart from items in the sovereign’s civil list, which was gradually reduced until it covered only the personal expenses of royal family”. (bendlebury, 2005). parliament now began to fix government total expenditure and to prescribe or appropriate the amount to be spent for parliamentary purposes (california department of finance, 1998). a budget is a framework for revenue and expenditure outlays over a specified period usually one year. it is an instrument stipulating policies and programmes aimed at realizing the development objectives of a government. budgeting and its process in nigeria remain problematic both in the areas of preparation and implementation, hence, the need for adequate control aimed at improving effective resources utilization at the budget implementation stage. to achieve these objectives, there is need for the introduction of new audit waves such as the value for money audit, due process, cost audit and so on. omolehinwa (2003) viewed budget as the plan of dominant individuals in an organization expressed in monetary terms and subject to the constraints imposed by other participants and the environment indicating how the available resources may be utilized to achieve whatever the dominant individual agreed to be the organization’s proprieties”. meigs and meigs, (2004) defined budgets as a comprehensive financial plan, setting forth the expected route for achieving the financial and operational goals of an organization”. budgeting in the early stage of its evolution was primarily concerned with serving the purpose of legislative asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 146 accountability (johnson, 1992), jones and bendlebury (2005) argued that the origin of a budget could be traced back to britain when the parliament attempted to exercise control over the activities of central government. according to nigeria’s finaical regulations (2000), before ministries and spending agencies can incur an obligation to make expenditures, they must secure spending authorization from the ministry of finance through the use of warrants. this warrant will authorize officers controlling votes to incure expenditure in accordance with the approved estimates subject to any reserved items. if the appropriation act has not come into operation at the beginning of the year, a provisional general warrant may be issued to ensure continuity of the services of government at a level not exceeding those of the previous year. the length of period of spending authorization is determined in functional cash flow forecast for the period when payments are anticipated. during the phase of budget implantation, there are many possibilities for interventions and manipulations in view of the fact that officials have a great amount of discretionary power to decide which spending ministry or agency will be granted spending authorization (federal republic of nigeria, 2000). in spite of the specific nature of appropriation laws, the commitment phase of the expenditure process is a fertile ground for corrupt activities. the most frequent is the partial or total disregard of procurement regulations and procedures, where they exist.procurement procedure and regulations specify the price and quality of goods and services that are authorized in the budget. they also specify the delivery schedule, terms of delivery and payment as well as contingent supplementary services such as maintenance and warranties. in addition, they specify the procedure, which will have to be followed by competing bidders’ prescription for price quality and quantity as well as terms of delivery. these are often disregarded in favour of one supplier who is ready to offer a bribe to corrupt officials. another possible case of corruption is the ordering of goods and services, which are not authorized in the budget. in this case, corrupt officials will simply disregard the budget as approved by the legislature and will purchase, for instance, luxury cars instead of trucks or other needed equipment. system of budgeting and implementation: an overview budgeting in the public sector is a document or a collection of documents that refers to the financial condition of the government (turns, 2006). a budget is prospective in the sense that it refers to expected future revenue and expenditure, in the federal government circle the budget is greatly limited in legal status. it is the official recommendation of the president to the congress. in other to provide for a responsible government, budgeting is generated to a cycle. the cycle allows for the system to absorb and respond to new information and in doing so the government is held accountable for its action though it should be recognized that many factors curtail the extent to which the president can make major changes in the budget. in some states, preparation and authority is not always given to governors while some have responsibility for preparation and submission, some share budget making authority with other elected administrative officer, civil servant, political appointees, legislative leader, or some combination of these officers. in the federal government level, preparations start from, large agencies. the agencies begin by assessing their programmes and considering which programmes required revision and whether new programmes should be recommended. at asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 147 same time, estimates are made by the president’s staff regarding anticipated economic trends in order to determine available revenue under existing tax legislation. the budget approval in the public sector (government) occurs at three stages namely ministerial approval, executive approval and legislative approval. the preparation of budget phase commences five months before the beginning of the fiscal year. guidelines are issued from the ministry of budget and planning in a form of circular. when the circular demanding the budget estimates to prepare is received by each ministries and department, a departmental committee of budget estimate is set up by each ministry and extra ministerial department. the committee is headed by the ministerial head of budget and personnel. it has its function as consideration and reconciliation of the budget proposals submitted by various departmental branches, division and units of the ministry. ministerial approval phase each ministry submits their estimates to the ministry of budget and planning for further consideration and approval. the ministry of budget and planning in turn set up a committee called “draft committee” for the review of draft estimates submitted by the ministries. these committee asked each ministry or department to come and defend its proposals; having concord on the proposal, the budget department aggregate the budget in the form of a consolidated estimates of revenue and expenditure. this is sent to the presidents for its approval. ii. executive council approval phase the president on receipt of the advanced proposal as approved by the budget and planning present the draft estimate before his cabinets members known as the council of ministers for further consideration and approval. this council discusses and agrees the estimates with the president’s political priorities of government and therefore the president gives his executives approval of the draft estimates before sending it to house of legislature inform of appropriation bills. iii. legislative approval stage the national assembly comprises the house of representative and the house of senate. the president presents his budget package to the national assembly at a joint meeting of the two houses of assembly. this meeting is known as budget session. it is up to the national assembly to approve, modify or rejects the bills. in each house there are standing committees, which relates to the ministries and departments. at such committees, each ministries and departments are invited to defend the increasing budgeting allocation, in justification of their programmes. the house debates the bill and makes modifications where necessary. after the house must have considered and reconciled the budgets estimates in the light of national economic and priorities then the appropriation committee is brought for appropriation purposes. if the house are convinced and satisfied with the proposals, each of them will approve the budget. where there are discrepancies in opinion on some particular items, the two houses appoint finance committee that would resolve such differences. the resolution of the finance committee is final on the difference. afterward they both sit to approve the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 148 budget. on approval of the national assembly the budget is sent back to the president for his assents and signature. and consequently it becomes the appropriation act. these will now be printed and distribute to the ministries and department inform of approved estimates. new trends in cost monitoring and auditing value for money audit the scope of government auditing has been widened over the years by the demand for independent verification of information to the extent that it can no longer be limited to the audit of financial operations. government auditing now extends to financial audit, regulatory audit, economy, efficiency, and effectiveness audit. the audit objectives has been viewed traditionally as an independent examination of the financial statements of an entity followed by the expression of independent opinion as to the truthfulness and fairness of the financial statement against the criteria of generally accepted accounting principles and standards however, in the case of government accounting, the general absence of the profit motive and the presence of the provision of social and economic services have combined to extend the audit objective to include an ascertainment of whether the establishment being audited is achieving the purposes for which its programmes are authorized and whether it is doing so economically, efficiently and effectively. value for money is the concept that seeks the maximization of the use of scarce resources for the welfare of the public by ensuring that activities and programmes are carried out at low cost and to high standard. in order to achieve this phenomenon, three elements are usually covered and these are: economy, efficiency and effectiveness. according to afemishe (2003), these three elements of value for money can be described as follows: a. economy is the practice by management of the virtues of thrift and good housekeeping. an economical operation acquires resources in appropriate quality and quantity at the lowest cost. b. efficiency is making sure that the maximum useful output is gained from the resources devoted to each activity, or alternatively, that only the minimum level of resources are devoted to achieving a given level of output. the efficiency of an operation could be said to have increased if either lower cost were used to produce a given amount of output, or a given level of cost has resulted in increased output. c. effectiveness is ensuring that the output from any given activity is achieving the desired results. there is, therefore, the need to establish that the desired goals are being achieved in order to evaluate effectiveness. the type of interrelationship among these three elements is that all of them must be in place before the assessment of value for money can be said to complete. right things must be done, using the right method and at minimum cost. for instance, as much as effectiveness is linked with the achievement of set objectives, it is also important to expect that the objectives are achieved by the application of the right methods that is, efficiency. the use of a sledge asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 149 hammer to kill a housefly, though effective is not efficient. the application of value for money concept to auditing leads to the concept of value for money (vfm) audit. it is applicable to both the private and public sector, but more emphasis has been placed on its application to the public sector. it is related to the extent to which funds are spent economically, efficiently and effectively. it is also referred to as comprehensive audit or efficiency audit. due process on a continuous basis and in both the private and public sectors, efforts are usually made, to seek how to improve on the ways activities are carried out, if there is to be progress in the results being sought to be achieved. more importantly, in the public sector, those at the helm of affairs must make deliberate effort to improve on the system already put in place in all the three tiers of government if they must remain relevant in the global village which the world is turning into. the concept of control as applicable to the public sector has been undergoing various changes from one country to the other in the recent past. each nation has been formulating policies aimed at improving resources utilization at the budget implementation stage. considerable efforts have been made to find new techniques of control and to introduce institutional changes and improvements to the types of controls applied. in an effort to exercise control on the expenditure of government, it is not sufficient to rely on the fact that expenditure items have been provided for in the approved budget (via the appropriate act). at the implementation stage, approval for releasing the money must be tied to availability of funds to the extent to which the revenue budgeted for has been earned. therefore the process of controls involved under the overall expenditure control structure should cover monitoring of the activities, for example, contract approval for payment and release of funds. there must be commitment by top management staff at the relevant tier of government to the new ways of doing things (corporate governance). in nigeria, the relatively long period of military rule had almost eroded the basic economic structures that had been developed since independence. consequently, the obasanjo administration was faced with the task of seeking ways of reversing the trend of decadence in the nation.at the inception of his government in 1999, the president emphasized that his administration had adopted transparency, equity, justice and accountability as its guiding principles and policy imperatives. these principles are to ensure commitment to public policies and good governance (nwankwo, 2004). budget monitoring and price intelligence unit (bmpiu) it has always been a recurrent observation of those reviewing the budgetary performance of governments in nigeria that implementation is our problem. the problems experienced during implementation may as well have originated in formulation. therefore the axiom “prevention is better that cure” could be appropriate here. it is on the basis of this view that evaluation of completed programmes and projects were initiated as an ex-post control but with an impact that goes beyond the budget implementation phase. the evaluation consists of an assessment of progress and its impact, so that areas of success and failure in implementation can be identified. evaluation in the context of the above explanation serves asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 150 mainly to link formulation and implementation of budgets and is used by the executive. it is also possible to view evaluation as a tool for ensuring both transparency and accountability. due process involves ensuring strict compliance with laid-down rules and procedures, guiding the process of contract invitation, contract award and contract implementation. this is with a view to ensuring that government’s resources are managed in such a way that they are not wasted. the bmpiu has become synonymous with due process. in fact, it has become to be known as the due process unit because of the emphasis on the need to follow due process in all the different tiers of government and parastatals. it is noteworthy that the term “due process” simply means the appropriate way or proper method or expected approach or normal way of doing something. it is, therefore, merely an awakening or revival of the application of the procedures already put in place earlier but for some time abandoned due to corruption and moral decadence. cost audit cost audit is the detailed checking of costing system, techniques and accounts to verify their correctness and to ensure their adherence to the objectives of cost accounting. chukwu (2005) opines that cost audit is a systematic and accurate recording of detailed transactions and operations of manufacturing, contracting, extracting, transporting, supplying, servicing etc. so as to show the actual cost of each individual piece of work, service or separations of the business. cost audit is, therefore the verification of the correctness of cost accounts and adherence to the cost accounting plans. one of the basic principles of auditing is that the auditor should not only be seen as independent but must be truly independent. in order to ensure the total independent of the auditors in the public sector, the auditing system must be overhauled with particular reference to the appointment and removal of auditor especially at the higher level. furthermore, the staff of the office of the auditor-general of the federation must be properly trained to focus on relevant value-for-money audits in support of government budget implementation objectives. method and discussion of findings. the study covered a period of ten years between 2001 and 2011. this period is believe to be good enough to make a position in respect of budget implementation and due process as it falls within the period of democratic dispensation in ondo state. the design used for this study is survey design. the paper makes use of structured questionnaires as a source of data collection. a sample size of five hundred (500) respondents was chosen through purposive sampling .data collected were analyzed with the use of descriptive analysis. five hundred questionnaires were distributed and administered to the budget officers and accounting officers of the various units of government in the following order: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 151 units of government number of questionnaires distributed ministries 100 agencies 100 corporations 100 institutions 100 local government 100 500 the questionnaires were structurally designed and contain questions that can illicit answers on the five (5) key areas that bothered on due process and budget implementation. these key areas are: i awareness of budget formulation ii adequacy of budget formulation iii adherence to budgetary provisions iv due process compliance v effectiveness of monitoring and implementation. discussion of findings four questions each were set on each of the 5 key areas of budgeting that were looked into. each questionnaire contain 20 questions and this sum up to a total of 10,000(20x500) in all that were administered. out of the 500 questionnaires that were administered, only 420 were returned. the break down of the returned questionnaires is as follows: ministries 90 agencies 80 corporations 75 institutions 85 local governments 90 420 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 152 result of responses of questionnaires administered questions type yes % no % total % q1. whether there is awareness 700 35 1300 65 10,000 100 of budget formulation q2. whether there is inadequacy 820 41 1180 59 10,000 100 of budget formulation q3. whether budget provisions are 900 45 1100 55 10,000 100 adhere to q4. whether there is compliance 750 37.5 1250 62.5 10,000 100 with due process q5. whether budgets are effectively 650 32.5 1350 67.5 10,000 100 monitored & implemented source: questionnaires administered 2012 the responses from the questionnaires administered as can be seen from the result indicate a higher percentage of ‘no’ response in comparison with the ‘yes’ response for virtually all the questions in the questionnaires that were administered. what the result suggests is that the people that are concern with budget formulation are not fully carried along and this accounted for the inadequacy of budget formulation. besides, there is lack and disrespect for due process because of low level of compliance with budgetary provisions. in terms of monitoring and implementation, 67.5% of the responses show that budget are not well monitored and not fully implemented and this is evidence by so many uncompleted and abandoned projects littered around. conclusion the essence of this paper is to provide a way of getting out of the jinx of continual and repited adverse budgetary performance. the paper reveals the need for due process in budget implementation in order to secure best value in terms of allocation and utilization of scarce resources that are available to the society. the paper identified the overall characteristics of a good public procurement system to include a strong legal, organizational and professional framework to make the system robust and effective. furthermore, the paper highlighted the need for a budget implementation process to be carried out under the constraint of value-for-money, accountability and transparency. it highlighted and discussed, in same details, the elements of value-for money; economy, efficiency and effectiveness. a good public procurement system delivers value-for-money in procurement activities. finally, the due process mechanism has been discovered to have “struck the right chord” confirming that system control is the correct way asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 153 to go where moral suasion, threats, probes and emphasis on reparation have proved unsuccessful in guarding resources. therefore, the study has shown that due process, value for-money audit and cost audit are necessary and imperative in budget implementation. due process” mechanism is a model which has proved its effectiveness. recommendation and policy implementation there is the need to encourage professionalism in post project review technique of value for money concept, performance measurement and benchmarking so that the continuous process and improvement suggested here can be imbibed as a national corporate culture. it is recommended that due processes and value-for-money audits should remain in our policy for economy, efficiency and effectiveness in the use of resources. it is important to underpin the due process mechanism with structures, systems, and skills in order to ensure that it endures. due process is too centralized and must be decentralized in order to move procurements by the spending units from the threshold of the resident due process team. references ademikhe, s.t. (2005). pedagogy of the probe panel and auditing. the nigeria accountant, 3(4), 33-46. afemikhe, s.o. (2003). the pursuit of value for money. ibadan, nigeria spectrum books limited, 75162. bendlebury, a. (2005). controlling government spending: the ethos, ethnics and economics of expenditure management. new york, oxford university press, 85-102 chekwu, i. k. (2205). management resources. full implementation resources and budgeting. retrieved from www.humtreasry.gov.uk/documents/publicaspendingandservicies california department of finance. (1998). budgeting and the issues involved. retrieved from http:/www.dof.cagor/fiscalhistory.htm. chartered institute of management accountant. (1982). journal of management accounting, 5(2), 37-45 johnson, i. e. (1992). public sector accounting and financial control, lagos, nigeria, financial training ltd, 132-144 meig. w., & meig, f. (2004). accounting the basic business decision new york, usa, mcgraw-hill book company, 51-68 moss, d (2000). comments on the fatal defect in the federal accounting system. public budgeting and finance, winter, 20(4), 12-25 nwankwo, s. (2004). due process in public accounting. the nigerian accountant 5(2), 34-42. okunrounmu, t.o.(2006) transparency, probity and accountability fiscal operation as a panacea for economic development. cbn economic and financial review, 3(4), 91-103. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 154 olowu, j., & erero, h. (1995). explanation on 1991 budget and the national rolling plan (1991-1993). nigeria institute of management review, 3(2), 42-53. omolehinwa, e. (2003). government budgeting in nigeria, lagos, nigeria, pumark nig ltd, 1-14. turn, a.j. (2006). use of budgetary techniques in service companies. journal of institute of chattered accountant of nigeria, 36(2), 34-42. uzoma, a. m. (1994) relation of the budget to employee motivation. the role of participation in the budget-construct revisited. nigeria financial review, 1(5), 40-50. world bank evaluation department. (1998). public sector performance the critical role of evaluation. retrieved from http./inweb18.worldbank.org. microsoft word 3023-11596-1-rv-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 104 the effect of deposit insurance on risk taking in asian banks enerelt enkhbold national university of mongolia e-mail: eenkhbold@adb.org batnairamdal otgonshar resource investment capital llc & origo partners plc ulaanbaatar, mongolia e-mail: nagi.otgonshar@resource-cap.com received: jan. 9, 2013 accepted: april 1, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3023 url: http://dx.doi.org/10.5296/ajfa.v5i1.3023 abstract this paper uses a panel database of 401 banks in 31 asian countries over the period from 2000 to 2010 to examine the effects of deposit insurance on banks’ risk-taking incentives. we find that risk-taking incentives vary with bank size and risks. in addition, differentiated premiums may not accurately reflect the level of risk that a bank poses. in the presence of a deposit insurance scheme, the pattern of the non-linear relationship between bank size and risk-taking significantly changes. our results suggest that market discipline exercised by banks is stronger in the presence of mandatory deposit insurance scheme. government-funded deposit insurance funds allow asian banks to take a higher risk. a risk-based deposit insurance scheme functions more effectively in the countries with good regulatory framework and institutional quality. keywords: deposit insurance, asia, emerging markets, bank risk jel classification codes: g21, g22, g28 1. introduction asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 105 the deposit insurance system has proliferated around the world in the last two decades and the relationship between deposit insurance, and bank risk-taking has been extensively studied in the banking literature. there are currently 104 countries with explicit or implicit deposit insurance scheme in operation worldwide and twenty years ago, it was only less than twenty countries adopted a deposit insurance scheme, according to the international association of deposit insurers (iadi). in spite of its widespread use, empirical studies provide conflicting results on the impact of (explicit) deposit insurance schemes on the risk-taking of banks. the regulators can prevent bank runs with a generous deposit insurance scheme (morrisons & white, 2006). explicit or implicit deposit potentially reduce the likelihood and severity of bank runs during a financial crisis and thus can be an effective financial tool for governments to ensure the safety and soundness of the financial system and to protect depositors from losses by insolvent banks during crisis times. further deposit insurance can help to restore depositors’ confidence and thus promote financial intermediary development. in spite of the positive effects of deposit insurance, there is a widespread consensus that guarantees of depositors and creditors induce banks to take excessive risks. the voluminous literature indicates adverse consequences of deposit insurance related to moral hazard and adverse selection. according to the moral hazard theory, the insurant tends to be less careful about risk behavior since the potential loss is protected by the deposit insurer. the moral hazard problem associated with deposit insurance is usually interpreted in terms of an incentive for a bank to increase the risk in search for higher profits (forssbæck, 2011). martin (2006) argues that complete deposit insurance weakens market discipline and increases the chance of banking failures. depositors and banks protected from the negative consequence of risk-taking will not hesitate to engage in risky banking practices. on the other hand, a handful of contrasting studies find no significant relationship between deposit insurance and bank risk taking. the aim of this study is to assess the impact of deposit insurance on bank riskiness in asian countries – it extends the current analyses into the asian context. in the literature, there are a number of tests for the impact of deposit insurance on bank risk-taking in the us and europe but very few in asia. several studies include the data of asian banks in their sample set, but their primary research focus was not on the continent (angkinand & wihlborg, 2007; demirguc-kunt & detragiache, 2000). the institutional background of the asian banking system is special for several reasons. firstly, emerging markets dominate the asian economy. secondly, asian governments heavily regulate the financial sector, though several countries attempt to liberalize their economies. finally, non-listed banks outnumber listed banks in asia, and comparably weak transparency is likely to generate a moral hazard and contribute to bank runs. to examine the impact of deposit insurance, we test for bank characteristic measures on the risk-taking behavior of 401 depository banks in 31 asian nations of which 20 have explicit deposit insurance. the data set covers the period from 2000 to 2010. different proxies are used for overall default risk, credit risk and liquidity risk. we also investigate the effects of a state-funded deposit insurance scheme, deposit premium and types of membership of the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 106 insurance fund on banks’ risk-taking. the key findings are as follows: firstly, risk-taking differs across bank size and the pattern of non-linear relationship between risk-taking and bank size changes across bank risks in the presence of explicit deposit insurance. secondly, a mandatory deposit insurance scheme disciplines banks to monitor one another’s risk-taking. the findings suggest that the increase in government funding of deposit insurance incentivizes banks’ risk-taking and existing risk-based premium systems functions better in countries with stronger institutional environments. the paper is organized as follows: section ii reviews the empirical literature on deposit insurance and bank risk. section iii introduces the data and methodology, hypotheses and variables in detail. section iv discusses the empirical findings of this study, and section v presents the conclusion. 2. previous empirical evidence most research indicates that deposit insurance is responsible for excessive risk-taking in the financial sector. several studies identified a positive relationship between deposit insurance and banking instability. wheelock (1992) finds that deposit insurance is more likely to exacerbate bank failures. he also finds that despite strict regulation lessened risk-taking, a high proportion of insured banks resulted in higher bank failure rates in kansas during the 1920’s. he noted deposit insurance has been one of the important causes of bank failures during the 1920’s (alston et al., 1994). chernykh and cole (2011) analyze bank-level data for 800 institutions in the russian federation over the period 2004-2006 and used several types of accounting information. they find that the ratio of equity to total assets ratio declined while the ratio of loans to total assets increased after the implementation of deposit insurance and conclude that deposit insurance created a moral hazard problem in the form of increased risk-taking. furthermore, grossman (1992) pointed out that the combination of deposit insurance and deregulation leads banks to undertake more risk. he adds that flat rate insurance creates a moral hazard problem since banks do not bear costs associated with engaging in their risky behavior. wheelock and kumbhakar (1995) conclude that insured banks are prone to increase risk-taking in order to avoid subsidizing other insured banks. they argue that a voluntary deposit insurance scheme in which premiums are not sufficiently sensitive to differing risk levels attracts risk-prone banks; however, they find no evidence that deposit insurance encourages depository institutions to hold smaller reserves. using panel data for 61 countries over the period 1980-1997, demirgüc-kunt and detragiache (2000) conclude that the explicit deposit insurance increases the likelihood of bank failures where the institutional environment is weak. according to their study, the adverse impact of deposit insurance on financial stability is more likely to be stronger when the insurance coverage offered to depositors is more extensive, and where the system is funded and managed by the government. hovakimian, kane and laeven (2002) likewise find that in poor institutional environments asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 107 that are low in political conditions and high in corruption, explicit deposit insurance has adverse effects. laeven (2002a) stretches further to acknowledge that existing insurance schemes create moral hazard for banks but the magnitude of incentive problems differs due to variation in governance structures and institutional environments. he (2002 a, b) investigates the effect of deposit insurance on risk-taking measured by implicit value of deposit insurance services and suggests that a deposit premium has some power in forecasting bank failures because the cost of insurance reflects the riskiness of deposit-taking institutions. analyzing bank-level data for 100 countries including 41 emerging markets, angkinand and wihlborg (2006) find a robust estimation for a non-linear relationship between deposit insurance coverage and bank risk-taking. they note that effects of ownership structure on risk-taking differ through market discipline and optimal deposit insurance coverage varies in countries in asia and eastern europe. davis and obasi (2009) test the impact of a design package of deposit insurance and bank risk taking activity and report that design features have different effects on the different financial soundness ratios. they emphasize the impact of a deposit insurance system on bank asset-side risk. banks with a high share of large depositors undertook relatively less risk before the insurance system established in the context of bolivia, but banks appear to take higher risk and do not seem to compensate increasing risk by adjusting requirements for collateral and maturity after the introduction of deposit insurance (ioannidou & penas, 2010). this is consistent with the fact that large depositors have greater ability to monitor banks in unguaranteed circumstance as proposed by england (1988). distinguin et al. (2011) showed that the adoption of the formal deposit insurance encouraged risk taking incentives for european banks in the 1990s. their study also supports the view that explicit deposit insurance favors market discipline when some creditors are excluded from deposit insurance coverage. by contrast, some studies failed to find negative or positive relationship between deposit insurance and bank risks. karels and mcclatchey (1999) show that the introduction of deposit insurance has not led to increased risk-taking in the us credit union industry. gueyie and lai (2003) find no empirical support for the hypothesis that the adoption of official deposit insurance creates moral hazard. they conclude that the risk-based deposit insurance is unlikely to have an effect on bank risk. areta and eichengreen (2002) find explicit deposit insurance reduced the likelihood of a banking crisis in their extensive analysis of developing countries. hoggarth et al. (2004) added that insurance systems with limited coverage have a smaller probability of a banking crisis. gropp and vesala (2001) find that explicit deposit insurance in the banking system may significantly reduce banks’ incentive to take risks if non-deposit creditors are left out in the european case. they used different proxies including charter value. in their sequel paper, gropp and vesala (2004) showed that the implementation of explicit deposit insurance significantly decreases bank risk-taking in their study on the large homogeneous sample of 73 european union bank level data using tobin’s q as a proxy to bank charter value. according to hamada (2011), depositors’ behavior varies with regard to the regulatory and economic circumstances. he finds that depositors became much more cautious after the introduction of explicit deposit insurance in indonesia. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 108 3. data and methodology 3.1. methodology deposit insurance can weaken the market discipline and encourage banks’ incentives to take on too much risk in search for higher profits. depending on country’s institutional circumstances and economic development, banks operate in environments with different design features of deposit insurance scheme. consequently, we focus on measures of banks’ risks: overall default risk, asset (credit) risk and liquidity risk. hypothesis 1: the presence of a deposit insurance scheme generates incentives that lead banks to take on excessive risk. hypothesis 2: a deposit insurance scheme with a mandatory membership encourages market discipline exercised by banks. hypothesis 3: combined with good regulatory framework and institutional quality, a risk-based premium system eliminates the free-rider problem and discourages banks’ risk-taking. to test these hypotheses, we employ information on asset and liability structure, sources of income, along with information on country specific variables. the specification used here follows forssbæck (2011). this paper uses three measures of bank risks overall default risk, liquidity risk and credit risk. the main model of this study is as follows: = + + + + (1) where represents a set of dependent variable of risks (or risk-taking) of individual banks, represents a vector of control variables unique to bank j at the period t-1, stands for a vector of country-specific variables in country at the period t-1 and represents a vector of indicators describing the deposit insurance system in country at the period t. at the bank-level, in line with cebenoyan et al. (1999), we include bank size. to account for the non-linear relation between banks’ risk-taking and asset size, the square of asset size is used in the analysis. the choice of control variables at the country level is largely made on the basis of angkinand and wihlborg’s (2010) study. thus, real gdp growth, the real interest rate and the inflation rate are included. an additional country-level control is the index of legal enforcement. definitions of all variables used in this paper are presented in table 1. a more detailed description of the variables is presented in the data section. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 109 table 1. definition of variables we interact our deposit insurance variables with some of bank variables. these interaction variables allow us to account for the effects of deposit insurance’s features on banks’ characteristics and risk-taking. similar to other studies on risk-taking, we expect that the deposit insurance dummy is positively related to banks’ risk taking. on the other hand, increasing bank size will positively affect overall risk and other risk measures in the presence of a deposit insurance scheme. if the mandatory membership encourages banks’ risk-shifting to one another at the expense of a deposit protection system, the coefficients on the interaction variable, deposit insurance membership dummy multiplied by deposits due from banks over total assets, shall be significant. if this holds true, banks will witness an increase in interbank deposits over total assets. variables definition dependent variables: risk variables = rijt proxy to: z overall default risk npl credit risk liquid liquidity risk independent variables: bank variables = x jt ta ta2 nii depba td tier1 country-specific variables = m it rint gdp inf law deposit insurance variables = d it di diprem fund dimem cov ratio of liquid asset to total deposits and short-term borrowing where k is a percent of equity to total assets, μroa is the ratio of net profit over average total assets, σroa represents the standard deviation of return on assets on the considered period. the natural logarithm of it is used in regression analysis. ratio of non-performing loans to gross loans annual percent changes of real gdp natural logarithm of total assets the square of ta ratio of non-interest income to gross income ratio of deposits due to banks to total deposits ratio of total customer deposits to total assets ratio of tier 1 capital to risk-weighted assets average nominal interest rates on deposits by country minus inflation rates = 1 if the coverage of deposits insurance is higher than four times 22,382.8 (the sample mean) or full, = 0 otherwise annual inflation rate the index of law enforcement from the worldwide governance = 1 if deposits are protected by an official deposit insurance = 1 if a country adopted the differential premium system, and = 0 = 1 if public sector provides funding, = 0 otherwise = 1 if the membership is mandatory, = 0 otherwise asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 110 to test the third hypothesis, we run regressions using the interaction variables associated with risk-based deposit insurance premium, law enforcement and the tier 1 capital ratio. if an increase in the tier 1 capital ratio interacted with risk-based premium dummy positively affects bank risks, we may conclude that risk-based deposit insurance premiums do not properly reflect risks posed by banks. we also expect that higher law enforcement index strengthens risk-based deposit insurance systems. we investigate the effects of a deposit insurance system on bank risks by employing generalized least squares. the feasible generalized least square model (fgls) allows us to estimate the equation (1) using the unequally spaced panel data where the unbalance is due to random attrition.1 as described in the data section, our panel is unbalanced and consists of 2,940 bank-year observations. 3.2. data and empirical design in examining the impact of deposit insurance on banks’ risk-taking, the panel data of asian banks are used. this data set contains the annual information about 401 banks from 2000 to 2010. there are very few prior studies that solely focus on asia, and most of those prior studies analyzed the data mainly of developed and high income countries. some important economies, including china and india, are left out of the research due to their relatively late liberalization in financial markets (e.g. demirgüç-kunt & detragiache, 2000). the number of banks studied is presented in table 2. 1 see baltagi and wu (1999) and biørn (2004) for details asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 111 table 2. number of banks per country used in this study accounting data for individual banks are from bankscope fitch ibca. first, 25 top banks from each country were selected based on total assets size (625 banks). in addition to data from twenty countries with a deposit insurance scheme, the data of eleven countries with no deposit insurance scheme are included to compare risk-taking behavior under different conditions. although lao dpr does not have an official deposit insurance system, the iadi includes it in the list of the countries with effective deposit protection systems worldwide, and thus laos is included in the eleven countries in this study. the number of banks available in the bankscope database varies. for kyrgyzstan, laos, oman, sri-lanka, tajikistan, uzbekistan, yemen, iran, syria, saudi arabia, qatar, maldives and cambodia, each individual sample contains less than 25 banks in the bankscope database. the data used for commercial banks of mongolia in this study were obtained from the bank of mongolia. countries number of banks the year deposit insurance was introduced/revised coverage bangladesh 19 1984 bdt 100,000 cambodia 14 china 15 hong kong 16 2006 hkd 100,000 india 5 1962 inr 100,000 indonesia 19 2005/2008 idr 2,000,000,000 iran 13 japan 10 1971 jpy 10,000,000 kazakhstan 18 1999/2003 kzt 5,000,000 korea, republic of 11 1996 krw 50,000,000 kyrgyzstan 6 2008 full laos 5 full malaysia 15 2005 myr 60,000 maldives 1 mongolia 15 full nepal 21 oman 5 1995 omr 20,000 pakistan 21 qatar 11 saudi arabia 11 singapore 11 2005 sgd 20,000 sri-lanka 12 1987 lkr 100,000 syria 13 taiwan 12 1985 twd 1,000,000 tajikistan 4 2003 full thailand 16 1997 full the philippines 18 1963 php 500,000 united arab emirates 22 uzbekistan 14 2007 uzs 1,552,500 vietnam 19 1999/2000 vnd 30,000,000 yemen 9 2008 yer 2,000,000 total 401 note: the data are from the iadi database and the worldwide deposit insurance database (demirgüç-kunt et al., 2005) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 112 central banks, governmental financial institutions, development banks, micro-finance institutions and investment banks were excluded from the sample due to their differing nature of business and risk-taking behavior. all accounting data are converted from local currency to u.s. dollars. banks with available time series less than two consecutive years and turkmenistan and myanmar, where only state-owned bank data were available, were eliminated in this study. hence, our final sample consists of an unbalanced panel containing 401 banks from 31 countries in asia, comprising 2,940 observations and spanning eleven years, as presented in table 2.2 in addition, we used the macroeconomic and country-specific variables that might affect bank risk. we retrieve the information about deposit insurance across countries from the world bank deposit insurance database developed by demirguc-kunt et al. (2005) and the website of the iadi. due to incompleteness and the limitation of data availability in the bankscope database, we avoid using the ownership data of banks in this study. however, the previous research finds that corporate governance and ownership structure have an impact on bank risk-taking, and familyor company-owned banks were more apt to take higher risk while foreign-owned bank took less risk during the 1997 east asian crisis (laeven, 1999). the data on a number of country-specific variables, associated with legal systems, are collected from the world bank governance indicators (kaufmann et al., 2010). a detailed discussion of our dependent and independent variables are as follows: risk variables: this study particularly focuses on the effect of deposit insurance on bank risk-taking incentives. the dependent variables are proxies to bank risks – overall default risk, credit risk and liquidity risk. most of deposit-taking banks in asia are privately-held and for those publicly listed banks, the historical daily stock price in the bankscope database covers a period of less than three years. therefore, we did not use the deposit insurance premium which is derived from the option pricing model and indicators of systematic and unsystematic bank risks, calculated from asset pricing models. instead, a standard z-score was used as a proxy for the distance to default. it has been one of the most commonly used measures of bank default risk in the literature (e.g. roy, 1952, hannan et al., 1988). unlike the distance to default developed moody’s kmv, the z-score can be easily obtained from the accounting data and is estimated as follows: − = (2) where is a percent of equity to total assets, is the ratio of net profit over average total assets, and represents the standard deviation of return on assets. a higher value of z-score indicates a low default risk of a bank. due to the higher dispersion of z-score obtained from the equation (2), a log transformation of this variable is used in all specifications. 2 descriptive statistics and correlation matrix of the data are available from the authors upon request asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 113 npl ratio, , defined as the ratio of non-performing loans to gross loans is a proxy for credit risk. a npl ratio shows the asset quality of a bank and how much proportion of total loans is classified as being in or close to default. for liquidity risk, the ratio of liquid assets to total deposits and short-term borrowing is used and denoted as . when banks hold more reserves and liquid assets, they are safer to meet financial obligations. increases in z-score and liquid, and decreases in npl indicate a reduction in the riskiness of banks. bank variables natural logarithm of total assets, , is included as a proxy of bank size. larger banks are assumed to have a greater capability to diversify their risks and stabilize the cash flow from their business. however, they may be incentivized to take higher risk due to their systematic importance (i.e. too-big-too-fail). the square of the log of total assets, 2, is used to test a non-linear relationship between risk-taking and bank size. we also control for the diversification of banks’ sources of income defined as the ratio of non-interest income to gross income ( ). diversification of income sources eliminates a bank’s risk exposure (smith et al., 2003). this is a proxy to a bank’s business model. a negative relationship exists between bank risk and diversification of income sources. a share of deposits due to banks in total assets, , is considered the market discipline variable. in many countries, interbank deposits and subordinated debt are excluded from deposit insurance and government guarantee. uninsured depositors are more incentivized to discipline banks. due to missing data on subordinated debt for several asian countries, we limited market discipline variables to interbank deposits. a share of total customer deposits in total assets, , is a proxy to the capital structure of a bank, and it represents how much of assets are financed through customer deposits. tier 1 capital ratio ( 1), defined as the ratio of tier 1 capital to risk-weighted assets, is a measure of the capital adequacy of a bank. most countries follow the basel capital accord to estimate the capital adequacy ratio. tier 1 capital, consisting of core equity capital instruments, absorbs losses before all other equity capital instruments. country-specific variables in the regression analysis, country-level variables are included. the real interest rates ( ), real gdp growth ( ) and the inflation rates ( ) are deployed to control the differences among the countries and to minimize the omitted variables bias. due to missing data on real gdp growth, real interest rates and inflation rates for some countries in the world bank database, we use the real discount rates for india, saudi arabia, and taiwan as proxy to the real interest rates. as a proxy to the quality and enforcement for a country’s legal system, the index of legal enforcement ( ), from the worldwide governance indicators, developed by kaufmann et al. (2010), is used. the index has a scale of -2.5 to 2.5 and higher value indicates better outcome. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 114 deposit insurance variables a dummy variable, , was constructed to define the status of a deposit insurance scheme (except for a government guarantee). for the year deposits are protected by an official deposit insurance scheme, this variable takes the value of 1 and is 0 otherwise. during the sample period covered in this study, asian countries adopted mandatory insurance system except for sri lanka and tajikistan. thus, an endogeneity problem between variable and risk proxies does not exist in the regression analysis. in many asian countries, a flat-rate premium is paid by the insured banks. among countries covered in this sample, six countries have adopted the risk-based differential premium system. we use the second dummy variable, , which takes the value of 1 if a country adopted the differential premium system and the value of 0 otherwise. as pointed out by demirgüç-kunt and huizinga (1999), funding of deposit insurance has an effect on bank risk-taking incentives. thus we created another dummy variable, , that takes 0 if the private sector provides the source of the deposit insurance fund and 1 otherwise (if the government or both public and private sectors fund the deposit insurance scheme). to examine the effect of deposit insurance membership on risk-taking incentives, a dummy variable, , is included in the regression analysis. this dummy variable takes the value of 1 if the membership of a deposit insurance system is mandatory and 0 otherwise. the insurance coverage provided to depositors has an effect on bank risk-taking incentives. is a dummy variable that takes the value of 1 if the coverage of deposit insurance is higher than four times the sample mean of deposit insurance coverage (usd 22,382.8) or full. countries offering full guarantee on deposits are treated as they have full insurance coverage. 4. empirical results table 3 presents the estimation results of the equation (1) where independent variables include interaction terms between the deposit insurance dummy and bank variables. in all specifications woolridge’s test rejects the null hypothesis implying that the autocorrelation exists in the residuals. thus, each equation is estimated using fgls method with white type standard errors robust to time-varying residual variance and correlation over time within cross-section units. columns (1)-(3) of table 4 report the results of our main model with interaction variables between di and ta, and di and ta2. columns (4)-(6) of table 4 show the results of the same model with the interaction term between di and depba. the results of the main regressions essentially support the prediction of a non-linear relationship between bank size and risk-taking incentives. the influence of ta in each specification is consistent with too-big-to-fail argument where larger banks have more incentives to undertake risky investments because they become recipients of beneficial policies from the governments. when bank risks are measured by z-score and npl, the pattern of relationship between bank size and risk is concave-shaped (r1), as illustrated in graph 1. in all specifications, the signs of the coefficients on ta are different from those of the coefficients on ta2 and they are all statitiscally significant. in specifications 3 and 6, the negative coefficient on 2 suggests that largest banks are more leveraged but hold less asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 115 liquid assets. as financial intermediaries between investors and economic agents, banks have to attract more deposits, thereby increasing their leverage and have to allocate their funding into income-bearing assets to make profits. given that the ta2 coefficients tend to be positive when risk is measured as z-score and significantly negative in npl estimations, larger banks have a greater potential to reduce risks by exploiting economies of scale. figure 1. relationship between risks and bank size in the interaction terms used in main regressions, we find that the pattern of non-linear relationship between bank size and risks is likely to change, as illustrated in graph 1. the signs of the ta and ta2 coefficients are opposite to those of the coefficients on the interaction terms, di x ta and di x ta2. on the other hand, the relationship between risk-taking and bank size becomes convex (r2) in terms of z-score and npl when a country adopts explicit deposit insurance. for instance, the effect of bank size is positive and the effect of the square of bank size is negative in countries with a deposit insurance scheme. the negative effect of di x ta is significant but the positive effect of di x ta2 is statistically insignificant in npl estimation. the coefficient on the interaction term, di x ta2, is significantly positive for liquidity risk estimation. d e f a u l t & c r e d i t r i s k s bank size r1 r2 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 116 table 3. results from estimation with deposit insurance variables in column (4)-(6) of table 3, the coefficients on the deposit insurance dummy are mostly significant. the di coefficient becomes negative at 10% level when risk is measured by npl. in contrast, it has a significant positive effect on banks’ liquidity. given the theoretical argument that the introduction of deposit insurance helps stabilize the financial market in the short run, this positive effect of explicit deposit insurance is not necessarily surprising. there are a number of cases in asia where the deposit insurance helped prevent bank runs in the short term (i.e., asian financial crisis in 1997 and mongolia in 2008). in liquidity risk estimations, the statistically significant positive coefficients of nii explain that revenue diversification increase bank liquidity; thus decrease liquidity risk. this finding is in line with what the modern portfolio theory suggests. it implies that banks liquidity risk can be reduced through diversifying their income sources. in z-score regressions, depba is negatively correlated with z-score. it implies that an increase in interbank deposits may have a negative effect on overall default risk because of the contagion risk involved. in the case of blanket guarantee, we observe that interbank deposits tend to increase because the guarantee encourages banks to increase investments in the protected assets. the coefficients are statistically insignificant in other estimations (except in specification 6 where the dependent variable is liquid). however, the empirical results on the interaction term, di x depba, are mixed and additional test results are discussed below. these (1) (2) (3) (4) (5) (6) variables z npl liquid z npl liquid ta -0.736*** 0.020** 0.111*** -0.691*** 0.019* 0.097*** (0.231) (0.010) (0.040) (0.229) (0.010) (0.035) ta2 0.025*** -0.001*** -0.005*** 0.023*** -0.001*** -0.005*** (0.008) (0.000) (0.002) (0.008) (0.000) (0.002) td -0.697 -0.075 -0.294 -0.675 -0.080 -0.318 (0.457) (0.080) (0.559) (0.459) (0.081) (0.567) depba -0.745* -0.033 0.196 -0.658 -0.010 0.733* (0.413) (0.077) (0.196) (0.449) (0.083) (0.378) nii -0.081 0.019 0.110** -0.080 0.020 0.117** (0.112) (0.021) (0.053) (0.112) (0.021) (0.054) di 0.073 -0.023*** 0.122* (0.055) (0.009) (0.066) di x ta 0.057** -0.009* -0.024 (0.028) (0.005) (0.016) di x ta2 -0.003** 0.000 0.002* (0.002) (0.000) (0.001) di x depba -0.150 -0.058 -0.984 (0.327) (0.063) (0.663) gdp 0.416 -0.431*** -0.365 0.538 -0.449*** -0.505 (0.331) (0.103) (0.819) (0.333) (0.104) (0.849) inf 0.258 0.257* 0.109 0.148 0.277** 0.245 (0.552) (0.135) (0.312) (0.551) (0.134) (0.278) rint 0.008 0.186 -0.084 -0.094 0.207 0.074 (0.565) (0.135) (0.855) (0.562) (0.132) (0.801) law 0.135* 0.009 -0.107 0.112 0.012 -0.100 (0.072) (0.011) (0.079) (0.070) (0.010) (0.083) intercept 8.407*** 0.176*** 0.112 8.206*** 0.177*** 0.110 (1.479) (0.056) (0.351) (1.476) (0.057) (0.359) wald chi2 41.12 112.92 33.42 40.46 97.63 31.72 wald p-stat 0.00 0.00 0.00 0.00 0.00 0.00 no. of obs. 1,899 1,702 1,789 1,899 1,702 1,789 number of banks 327 294 301 327 294 301 the table reports coefficient estimates from panel fgls. standard errors in parentheses are based on white type standard errors robust to time-varying residuals and correlation over time within cross-section units. see table 1 for variable definitions. *, **, *** indicate statistical significance at the 10%, 5% and 1% percent, respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 117 conflicting results may be due to the weakened market discipline exercised by banks when deposit insurance is adopted. the negative correlation of economic growth with npl suggests that credit risk is significantly lower in years and countries with relatively high economic growth. the results obtained from specifications 1 and 4 indicate that the higher economic growth is positively correlated with overall risk-taking by banks, measured by z-score. a possible explanation for this correlation is that banks in faster-growing economies have a greater incentive to assume higher risks. on the other hand, risk-taking is a well-spring of the economic growth and continuously higher economic growth also encourages banks’ risk-taking in return. however, the coefficient on gdp is negative but statistically insignificant in liquidity risk estimations. the significant positive coefficients on inf indicate that an increase in inflation leads to higher credit risk. hence higher inflation may result in lower payment capacity of borrowers. in line with our expectation, banks’ risk-taking is lower in countries with higher legal enforcement (law). the results of estimations of the equation (1) with interaction terms between deposit insurance features and bank variables are presented in table 4. the results are largely consistent with those presented in table 3. the coefficients on cov appear negative and significant in all specifications. an increase in deposit insurance coverage leads to increased credit and liquidity risks undertaken by banks. the negative coefficient on cov in npl specification indicates that higher coverage is negatively related to credit risk. a possible explanation for this correlation might be that regulators require a significant improvement in their risk management and a reduction in asset risks in return for providing higher deposit insurance coverage. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 118 table 4. results from estimation with deposit insurance features when we consider the interaction term, dimem x depba, the mandatory membership of a deposit insurance scheme has a significant positive effect on bank risks. the negative coefficient on dimem x depba in npl estimation and the negative coefficient in liquid estimation indicate that market discipline exercised by banks is stronger when the membership is mandatory for all banks. since banks are able to obtain better information about other banks where they allocate funds as opposed to retail depositors, they have a greater ability to monitor and discipline other deposit-taking financial institutions. the negative effect of government-funded deposit insurance schemes is confirmed by the statistically significant positive coefficient in npl estimation and the statistically negative coefficient in liquid estimation. the coefficient on fund is insignificant but negative in terms of z-score. since higher value of this variable from 0 to 2 represents the rising share of the government financing, this may indicate that risk-taking rises with the increasing share of the government financing in a deposit insurance scheme. thus, the results indicate that government-funded deposit insurance funds allow banks to take a higher risk. this is (1) (2) (3) variables z npl liquid ta -0.025 -0.014*** -0.005 (0.033) (0.004) (0.010) td -0.981*** 0.033 0.011 (0.308) (0.030) (0.082) depba -0.881 0.332*** -1.032*** (1.397) (0.051) (0.196) nii 0.084 0.000 0.028 (0.138) (0.027) (0.018) dimem x depba -0.104 -0.267*** 0.892*** (1.360) (0.075) (0.194) cov -0.146** -0.008** -0.022** (0.064) (0.004) (0.011) fund -0.086 0.050*** -0.049*** (0.073) (0.010) (0.018) gdp -0.922 -0.130 0.198 (0.698) (0.117) (0.126) inf 0.507 0.256** 0.188 (0.631) (0.104) (0.148) rint 0.022 0.254** 0.212 (0.788) (0.100) (0.172) law 0.023 0.026** 0.022 (0.111) (0.011) (0.033) intercept 4.036*** 0.204*** 0.483** (0.611) (0.069) (0.214) wald chi2 24.11 288.28 97.94 wald p-value 0.01 0.00 0.00 no. of obs. 979 874 992 no. of banks 198 180 187 the table reports coefficient estimates from panel fgls. standard errors in parentheses are based on white type standard errors robust to time-varying residuals and correlation over time within cross-section units. see table 1 for variable definitions. *, **, *** indicate statistical significance at the 10%, 5% and 1% percent, respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 119 consistent with the findings by demirgüç-kunt and detragiache (2000). if the fund amount that consists of premiums paid by member banks is not sufficient to cover losses caused by bank failures, the shortfall is made up by taxpayers. table 5 presents the estimation results using risk-based premium interaction variables. a risk-based deposit insurance scheme has negative effects on z-score and liquid when we consider the effect of diprem. it implies that differentiated premiums do not accurately reflect the level of risk that a bank poses. in practice, risk-based deposit insurance is technically difficult to be managed and administratively demanding. however, we find that the coefficient on diprem is negative but statistically insignificant when risk is measured by npl ratio. the coefficients on diprem x tier1 indicate that risk-based deposit insurance tied to the regulatory capital ratio (or prudential norms) can reduce banks’ risk-taking. the coefficients on diprem x tier1 in z-score and liquid specifications are significant positive. when risk is measured by npl ratio, the effect of diprem x tier1 is negative and statistically significant. the positive significant effect of diprem x law is supportive of the hypothesis 3. a risk-based deposit insurance scheme works more effectively in countries with high judicial quality and legal enforcement. table 5. results from estimation with risk-based premium interactions (1) (2) (3) variables z npl liquid ta -0.087*** -0.004*** -0.023*** (0.009) (0.001) (0.003) td 0.034 0.037*** 0.184*** (0.084) (0.008) (0.024) nii 0.180** 0.001 0.115*** (0.086) (0.003) (0.023) depba -1.743*** -0.002 0.429*** (0.230) (0.012) (0.062) diprem -0.550*** -0.005 -0.058* (0.065) (0.004) (0.033) diprem x tier1 2.082*** -0.037*** 1.098*** (0.325) (0.014) (0.187) diprem x law 0.510*** -0.016*** 0.019 (0.040) (0.003) (0.018) gdp -1.608*** -0.006 0.318*** (0.303) (0.023) (0.115) rint 3.982*** 0.032 0.515*** (0.574) (0.041) (0.149) inf 5.751*** -0.038 0.023 (0.517) (0.045) (0.161) law 0.244*** -0.004* -0.020** (0.035) (0.002) (0.009) intercept 3.917*** 0.090*** 0.399*** (0.162) (0.015) (0.050) wald chi2 1682.47 665.58 554.17 wald p-value 0.000 0.000 0.000 no. of obs. 747 716 757 number of banks 156 150 151 the table reports coefficient estimates from panel fgls. standard errors in parentheses are based on white type standard errors robust to time-varying residuals and correlation over time within cross-section units. see table 1 for variable definitions. *, **, *** indicate statistical significance at the 10%, 5% and 1% percent, respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 120 our robustness checks are based on three variations to the estimation process. firstly, we estimate all specifications presented in tables 3-5 with time dummies. these regressions show no significant qualitative differences in the results. hence we do not report the results here (available upon request from the authors). secondly, we replace npl ratio as a credit risk proxy with the ratio of loan loss reserves to total loans denoted as llp. this variation is suggested by the fact that loans loss provision ratio may be more accurate to measure asset risk in terms of bank’s preparedness to writing-off bad loans. the results are presented in table 6. the coefficients of the deposit insurance variables are basically similar to those obtained in the previous specifications. thirdly, we apply a feasible two-stage least square model to analyze the influence of tier 1 capital ratio interacted with the deposit premium dummy, diprem. tier 1 capital ratio can be endogenous because bank assets and capital structure determines the capital adequacy. in the first stage, tier 1 capital ratio is defined as a function of the bank variables and the macroeconomic and country-specific variables. in the second stage, we incorporate the tier 1 capital ratio, tier1hat, predicted by the first stage as explanatory variables together with the macroeconomic and country-specific variables, bank variables and deposit insurance variables. table 7 presents the results obtained from the feasible two-stage least squares. the results are largely consistent with those presented in table 4. however, we find that the most coefficients become insignificant in liquidity risk estimation. the significantly positive effect of diprem x tier1hat on z-score confirms that the twin effects of a risk-based deposit insurance scheme and the regulatory prudential norms discourage banks’ risk-taking. since a risk-based premium system eliminates the free-rider problem and discourages banks’ risk-taking in countries with higher institutional quality, the empirical results on diprem x law are consistent with the hypothesis 3. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 121 table 6. the relationship between loan loss reserves and deposit insurance (1) (2) (3) (4) variables llp llp llp llp ta 0.006 0.005 -0.004* -0.005*** (0.006) (0.006) (0.002) (0.002) ta2 -0.000** -0.000* (0.000) (0.000) td -0.014 -0.016 0.011 0.013 (0.037) (0.037) (0.028) (0.015) depba 0.002 -0.008 -0.076 -0.012 (0.055) (0.053) (0.052) (0.024) nii 0.022 0.023* 0.025 0.007 (0.014) (0.014) (0.016) (0.005) di -0.012** (0.006) dita -0.004* (0.002) dita2 0.000* (0.000) didepba 0.010 (0.059) dimem x depba 0.153* (0.081) cov -0.002 (0.004) fund 0.035*** (0.009) diprem 0.006 (0.008) diprem x tier1 0.023 (0.034) diprem x law -0.018*** (0.005) gdp -0.212*** -0.225*** -0.132 0.018 (0.061) (0.062) (0.108) (0.032) inf 0.155** 0.165** 0.136* 0.030 (0.076) (0.077) (0.082) (0.048) rint 0.212*** 0.224*** 0.169** 0.120** (0.070) (0.070) (0.073) (0.057) law -0.007 -0.005 0.001 -0.003 (0.004) (0.004) (0.006) (0.006) constant 0.058* 0.061* 0.057 0.100*** (0.035) (0.037) (0.051) (0.025) wald chi2 83.1 75.2 105.06 82.93 wald p-value 0.00 0.00 0.00 0.00 no. of obs. 1,938 1,938 1,009 770 number of banks 317 317 195 156 the table reports coefficient estimates from panel fgls. standard errors in parentheses are based on white type standard errors robust to time-varying residuals and correlation over time within cross-section units. see table 1 for variable definitions. *, **, *** indicate statistical significance at the 10%, 5% and 1% percent, respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 122 table 7. endogenous tier 1 capital ratio and banks’ risk-taking 5. conclusions this paper examines whether implicit or explicit deposit insurance encourages bank risk-taking in emerging markets dominated asia. testing the data set of 401 banks in 31 asian countries over the period from 2000 to 2010 with three risk proxies for bank risk-takingcredit, liquidity, and overall default risks, we find that the implementation of deposit insurance helps to stabilize the banking system but also leads banks to undertake excessive risk. risk-taking incentives vary with bank size and risks. differentiated premiums may not accurately reflect the level of risk that a bank poses. we also find that higher deposit insurance coverage significantly encourages banks’ risk-taking. during the presence of a deposit insurance scheme, the pattern of the non-linear relationship between bank size and risk-taking becomes convex. in addition, our results suggest that market discipline exercised by banks is stronger in the presence of mandatory deposit insurance scheme. government-funded deposit insurance funds allow asian banks to take a higher risk. 1st stage 2nd stage variables tier1hat variables z npl liquid ta -0.017*** ta -0.024 -0.017*** -0.005 (0.006) (0.033) (0.005) (0.010) td -0.166** td -0.955*** 0.044 0.002 (0.070) (0.326) (0.031) (0.080) nii 0.033 nii 0.048 -0.001 0.027 (0.032) (0.147) (0.023) (0.017) gdp 0.189 depba -0.867*** 0.029 -0.142 (0.149) (0.329) (0.057) (0.091) inf -0.298 diprem -0.441* 0.003 -0.047 (0.227) (0.243) (0.084) (0.089) rint 0.061 diprem x tier1hat 3.209* 0.079 0.149 (0.210) (1.723) (0.619) (0.594) law 0.008 diprem x law 0.173** -0.044*** 0.015 (0.011) (0.069) (0.015) (0.027) constant 0.516*** gdp -0.518 -0.083 0.241* (0.124) (0.596) (0.119) (0.132) inf 0.603 0.241** 0.148 (0.738) (0.114) (0.147) rint -0.037 0.222** 0.176 (0.858) (0.095) (0.155) law -0.019 0.036** -0.006 (0.121) (0.015) (0.031) constant 3.860*** 0.286*** 0.452** (0.621) (0.078) (0.218) wald chi2 36.59 wald chi2 27.83 36.59 17.5 wald p-value 0.00 wald p-value 0.00 0.00 0.09 observations 1,755 observations 979 874 992 number of id 316 number of id 198 180 187 *, **, *** indicate statistical significance at the 10%, 5% and 1% percent, respectively. the table reports coefficient estimates from panel fgls. standard errors in parentheses are based on white type standard errors robust to time-varying residuals and correlation over time within cross-section units. see table 1 for variable definitions. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 123 the policy implication of this study suggests that asian governments should encourage private sector involvement in deposit insurance schemes and define optimal levels of the insurance coverage and risk-adjusted premium. when regulators assess bank risks inaccurately, the insurance premium does not help mitigating risk-taking. a country should have strong banking supervision and design high quality regulations to adopt the risk-based deposit insurance. the finding is supportive of our hypothesis that good institutional background and legal environment mitigates banks’ risk-taking. in the case of a blanket guarantee, banks should be left out of implicit insurance coverage immediately after stabilizing a turbulent situation in the market at times of distress. this helps to prevent banks shifting risks to the government, insurers, or other banks. for many of the asian banks, the important data such as market value, ownership structure, banks executive compensation have not been publicly available or sufficiently collected for quantitative analyses. this is mainly because such information is legally private or has recently been allowed for public access. it is worth further studying the effect of deposit insurance on risk taking in asian banks using those data when they become sufficiently available. references alston, l., wayne g., & david w. 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(1995). which banks choose deposit insurance? evidence of adverse selection and moral hazard in a voluntary insurance system, journal of money, credit and banking, 27(1), 186-201. http://dx.doi.org/10.2307/2077858 the international association of deposit insurers (2012). the list of countries with deposit insurance. retrieved from http://www.iadi.org microsoft word preholiday returns and volatility in thai stock market (final editted)[1]-1.docx asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       41   www.macrothink.org/ajfa   preholiday returns and volatility in thai stock market nopphon tangjitprom martin de tours school of management and economics, assumption university bangkok, thailand tel: (66) 8-5815-6177 email: tnopphon@gmail.com received: 2010-12-07 accepted: 2011-04-28 doi:10.5296/ajfa.v2i2.525 abstract the purpose of this paper is to examine the holiday effect in thailand. the holiday effect is the phenomenon in which the stock returns are abnormally high before holidays. there is no complete explanation for this phenomenon though there are many studies that state that the holiday effect has existed in the stock markets all over the world. although there are many studies that have addressed the existence of abnormal returns during holiday periods a few studies have provided specific reasons for the existence of this phenomenon. this paper aims to study the holiday effect in returns and volatility of the stock exchange of thailand. moreover, this study examines whether the abnormal stock returns observed are associated with higher volatility during preholiday periods. furthermore, it examines whether the holiday effect depends on the number of days in each holiday period and whether it varies between state and cultural holidays. various garch models are employed to capture the volatility clustering nature of the stock market. out of the three garch models considered, egarch (1,1) model shows the best performance. the results show that preholiday returns and volatility are abnormally high. furthermore, the longer holiday periods tend to show higher preholiday returns. however, the impact of cultural factors on abnormal returns prior to cultural holidays is not so pronounced when compared to the impact of cultural factors on abnormal returns prior to non-cultural holidays. keywords: holiday, calendar anomalies, market efficiency, stock exchange of thailand jel classifications: g1, c01, g11 asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       42   www.macrothink.org/ajfa   1. introduction market timing is one of the important strategies employed to make profits in stock markets. there are numerous studies addressing the situation that the daily stock returns are abnormally high for some specific days or periods during the calendar year. the existence of these abnormal returns is known as calendar anomalies or calendar effects. one of the dominant phenomena among the calendar anomalies is the situation that the stock returns are abnormally high on the trading day before the market closing day. the abnormal returns could exist both on the day before the normal weekend closing and on the day before the holidays. the abnormal returns on friday, the trading day before the normal weekend closing, are known as weekend effect or turnof the week effect. meanwhile, the existence of abnormal returns on the day before the holidays is known as holiday effect. although many studies have investigated the existence of abnormal returns during holiday periods around the world, only a few have attempted to explain why such abnormal returns exist. this paper aims to examine whether the higher returns during the preholiday periods are associated with higher volatility. the results from this study contribute to existing literature by associating the abnormally high stock returns to the higher level of volatility. therefore, high preholiday returns are not abnormal returns but they are the rewards for risk taking by investors during preholiday period with higher volatility. to addresses the holiday effect in the thai stock market, the regression analysis with dummy variables technique is employed. the ordinary least squares estimator and simple t-test are employed to test the difference of returns between preholiday and non-preholiday periods. furthermore, the generalized autoregressive conditional heteroskedasticity or garch model is applied in the analysis in order to capture the time varying volatility which is common in stock market returns. the original garch specification is modified by adding dummy variables in the variance equation to address the effect of preholiday periods. the asymmetric garch model known as the exponential garch or egarch is also utilized in order to compare the results with those from normal garch model. the lags of stock returns are included in the mean equation to account for possible autocorrelation. in addition, the volatility measurement from the variance equation is included in the mean equation. the combination of the above two models is referred to as the garch-in-mean equation. some attributes of holiday periods are included in the analysis to examine the differences in preholiday returns among those different groups of attributes. the classification of holidays into cultural and state holidays is used to determine the differential effects on the preholiday returns. the number of days for each holiday period is also examined to see whether it will affect the preholiday returns differently. 2. literature review the existence of abnormal returns in the stock market appearing before holidays is one of the market anomalies which could not be completely explained. however, the phenomenon that the stock returns are abnormally high during the trading days before the market closures has existed in stock markets as reported in many previous studies. french (1980) showed that the stock returns were consistently high on fridays and low on mondays. rogalski (1984) found that the asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       43   www.macrothink.org/ajfa   negative average returns on mondays could be attributed to the average negative returns during the market closure which was measured using the closing price on fridays and the opening price on mondays. roll (1983) explained that there were relatively higher returns for small-sized firms during the trading days before new year day. lakonishok and smidth (1984) also found that the stock prices tended to increase during the last trading day prior to christmas day for anysized firms. the existence of high returns during christmas period is referred to by them as another mystery in the stock market. several researchers term this phenomenon as the turn-ofyear effect in which the returns are abnormally high during the turn-of-the-year and turn-of-week or weekend effect, when the returns are abnormally high during the day before weekends. if these abnormal returns occur in fact at turn-of-year, the abnormal preholiday returns should occur only during christmas and new year holidays. however, there were other studies that found abnormal preholiday returns during the other holidays, not only on christmas and new year day. lokonishok and smidt (1988) showed that the preholiday returns were twenty-three times higher than average returns on the other ordinary days. they also pointed out that preholiday abnormal returns were higher than abnormal returns on fridays. this situation is known as weekend effect. meanwhile the returns on post-holiday days were negative, although insignificant, and were much more negative than monday returns. ariel (1990) showed that the returns on preholiday trading days were significantly high compared to those on the other days. his studies revealed that the average preholiday returns were around nine to fourteen times greater than the returns on non pre-holiday days. these abnormal preholiday returns are results of purchasing pressure made by investors who would like to close their short position before holidays. chan, khanthavit, and thomas (1996) studied this holiday effect by distinguishing between state holidays and cultural holidays in malaysia, india, singapore and thailand. except for thailand, the result showed that the other three countries had significant abnormal returns during preholiday periods for cultural holidays while all four countries did not have abnormal preholiday returns for state holidays. seiler (1993) studied the effect of market to stock returns by focusing on special closings besides the common holidays. the stock returns prior to these special closings showed above-average returns. he divided these special holidays into institutional special closings that were related to stock exchange and non-institutional special closings that were exogenous to stock exchange. the stock returns prior to institutional special closings were 30.96 times greater than the average while the stock returns prior to noninstitutional special closings were 11.04 times higher than the average. picou (2006) examined the holiday effect internationally by examining six major exchanges, us, australia, hong kong, uk, japan, and canada. he found that the holiday effect still existed and there were some commonality for the holiday relation among six exchanges. this was the evidence for the holiday effect spillover, which created the opportunity to make profit. for volatility measurement, kiymaz and berument (2003) employed the conditional volatility model to address the difference in volatility level among different trading days of the week. they found that the volatility was abnormally high for some specific weekdays. these week days were different in each country. for example, the highest volatility of stock returns was on mondays for germany and japan but fridays for canada and us. asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       44   www.macrothink.org/ajfa   normally, the stock market is characterized by time varying volatility, which could be captured by conditional heteroskedasticity. the first acceptable model to explain this conditional heteroskedasticity is autoregressive conditional heteroskedasticity or arch model proposed by engle (1982). bollerslev (1986) introduced the general model for arch as generalized autoregressive conditional heteroskedastics, or garch model. akgiray (1989) showed the empirical evidence that garch(1,1), which was parsimonious, could capture the volatility of stock returns better than the other volatility models like exponential weighted moving average (ewma) or autoregressive conditional heteroskedasticity (arch) models. after the introduction of capital asset pricing model or capm (sharpe, 1964; lintner, 1965; mossin, 1966; black, 1972) it became the dominant and most popular asset pricing model. this model is based on the basic principle that risk should be priced by rational risk-averse investors. engle, lilien, and robins (1987) introduced an extension to the garch model by including the volatility measure from variance equation to mean equation as using the volatility to capture the risk premium as the concept that the risk should be priced by rational investors. the model was known as garch in mean or garch-m model. another popular extension of garch model was proposed by nelson (1991) as exponential garch or egarch. egarch could improve garch model by allowing asymmetric responses of conditional variance to the movement of return. 3. data and methodology the daily data for set index are gathered for the period from 1994 to 2009. normally, stock exchange of thailand implements the same holidays as announced by the central bank, bank of thailand. the common holidays for thai stock market are: a) new year’s eve and new year’s day b) makha bucha day c) chakri day d) songkran festival e) national labor day f) coronation day g) visakha bucha day h) mid year’s closing day i) asarnha bucha day (in the past, the holiday is buddhist lent day) j) h.m. the queen’s birthday k) chulalongkorn day l) h.m. the king’s birthday m) constitution day asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       45   www.macrothink.org/ajfa   in some years there were special holidays besides the common holidays mentioned above. the stock return is computed as the log difference of daily stock prices between two consecutive trading days as follows: 𝑅! = 𝑙𝑛 !! !!!! (1) a test for stationarity is conducted on the stock return series to ensure the stationarity property because the non-stationary data leads to spurious regression problem. the adf test is conducted to test the null hypothesis that the data series has unit root problem. furthermore, the kpss test is performed to test the null hypothesis that the data is stationary in order to confirm with the result from adf test to ensure that the data have no unit root and are stationary. then the following regression equation is estimated to test the holiday effect: 𝑅! = 𝛽! + 𝛽!𝐷!"# + 𝜀! (2) where rt is the daily stock return; dpre is the dummy variable for pre-holiday; εt is a white noise error term. the interpretation of the above regression is that β0 is the average returns of other days (non-preholiday). the coefficient β1 will represent the difference between the preholiday and non-preholiday returns. in order to model the volatility stock returns the garch(1,1), egarch(1,1) and garch(1,1)-m models are employed. as in the model employed by kiymaz and berument (2003) the lag of stock returns is included in mean equation to avoid the serial correlation problems. the mean equation for both garch(1,1) and egarch(1,1) after the above modification would be: r! = β! + β!d!"# + β!r!-­‐! + ε! (3) the modified variance equation of garch(1,1) would be: ℎ! = 𝜔 + 𝛼𝜀!!!! + 𝛽ℎ!!! + 𝛿!𝐷!"# (4) the modified variance equation of egarch(1,1) would be: log  (h!) = ω+ α !!-­‐! !!-­‐! + γ !!-­‐! !!-­‐! + β log h!-­‐! + δ!d! (5) the variance equation of garch(1,1)-m is similar to garch(1,1) but the volatility measured in the variance equation is included in mean equation in the form of square root of variance. the mean equation of garch(1,1)-m would be: r! = β! + β!d!"# + β!r!-­‐! + β! h! + ε! (6) moreover the assumption of gaussian distribution for the errors may not be appropriate for garch model. hence, the generalized error distribution introduced by box and tiao (1973) has been used in research papers that employed the garch model. consistent with this practice this paper also employes the garch model with the generalized error distribution. asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       46   www.macrothink.org/ajfa   furthermore, the paper examines whether the number of days in each holiday has an effect on the preholiday returns. the regression model employed is as follows: 𝑅! = 𝛽! + 𝛽!𝐷! + 𝛽!𝐷! + 𝛽!𝐷! + 𝜀! (7) where rt is the daily stock return;, d1 is the dummy variable for pre-holiday with consisting of oneday holiday period or twodays holiday period; d2 is the a dummy variable for pre-holiday with consisting of threedays holiday period; d3 is the dummy variable for pre-holiday before holiday periodconsisting of more than three days. for volatility measurement equation 6 is modified by adding the lagged stock returns and this equation is known as mean equation in both garch and egarch models. for garch-m model the standard deviation measured by square root of conditional variance is added to mean equation. the variance equation would follow equations 4 and 5 but replace the dummy variables with dummy variables from equation 7. finally, the distinction whether state holidays and/or cultural holidays can affect the preholiday returns is examined. cultural holidays based on the definition by chan, khanthavit, and thomas (1996) are songkran days and buddhist holidays like macha bucha, visakha bucha, asarnha bucha, and the buddhist lent day. other holidays are classified as state holidays. the regression equation estimated is as follows: r! = β! + β!d!"#"$ + β!d!"#$"%& + r!-­‐! + ε! (8) where rt is the daily stock returns; d1 is the dummy variable of preholiday for cultural holidays; d2 is the dummy variable for preholiday for state holidays. for volatility measurement, the dummy variables in mean equation and variance equation would be replaced by dummy variables from equation 8. 4. analysis and result table 1 reports frequencies for for holidays consisting of one to five days. from the stock exchange of thailand during 1992 to 2009 the total number of trading days was 3,923 days. during this period, there were 206 holidays which could be classified into 142 state holidays and 64 cultural holidays. asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       47   www.macrothink.org/ajfa   table 1. frequencies for holidays classified according to the number of days in each holiday period number of days in the holiday period frequency 1 75 2 1 3 100 4 24 5 6 table 2 reports the descriptive statistics and the result of unit root tests on set returns. as the table the average of the daily stock returns during the study period is -0.0207%. the stock returns series shows high excess kurtosis or is leptokurtic. this indicates volatility persistence and should be modeled by conditional heteroskedasticity models like garch. for the adf tests, the null hypothesis of a unit root could be rejected meaning that there is no unit root in the daily stock return series. the stationary of series is confirmed by kpss test also as the null hypothesis of stationary could not be rejected. therefore, the stock series is stationary and could be used in further analysis without any transformation. asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       48   www.macrothink.org/ajfa   table 2. descriptive statistics and unit root test results for set return descriptive statistics unit root and stationary test mean -0.000207 adf test median -0.000367 no intercept and trend -56.6632** maximum 0.113495 with intercept only -56.6632** minimum -0.160633 with intercept and trend -56.7063** std. dev. 0.017468 kpss test skewness 0.064731 with intercept 0.3852 kurtosis 9.223285 with intercept and trend 0.0827 **significant at 5% * significant at 10% table 3 reports the result of various models capturing preholiday returns and volatility. the constant of ols regression equation shows that the returns of non-preholidays are negative at 0.0412. the coefficient of the dummy variable representing the difference in average returns between preholiday and other days is 0.3910% reflecting that the preholiday returns are significantly higher than non-preholiday returns. the ols regression suffers from the conditional heteroskedasticity as per the arch-lm test. conditional heteroskedasticity models such as garch(1,1) or egarch(1,1) would be more attractive than normal ols regression as they capture volatility in stock returns. the results of both garch model and egarch model are consistent as both can eliminate the conditional heteroskedasticity and the preholiday still shows higher returns than non-preholiday. however, the garch-m model cannot eliminate the conditional heteroskedasticity and therefore garch-m model is not appropriate to be used in further analysis. the coefficient of asymmetric term (γ) of egarch model is -0.049 which is significant at the five per cent level. the value of as the akaike information criteria (aic) and schwarz bayesian information criteria (sic) for garch model is -5.5541 and -5.5492, respectively. the aic and sic for egarch model are -5.5645 and -5.5501, respectively. this means that the performance of the egarch model is better than that of the garch model. the coefficient of dummy variable representing preholiday in variance equation from both garch and egarch models is positive meaning that the volatility would be higher during the preholiday period. therefore, the higher returns during preholiday periods come with higher volatility. asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       49   www.macrothink.org/ajfa   table 3. test of preholiday returns and volatility variable ols garch(1,1) egarch(1,1) garch(1,1)-m mean equation constant -0.000412 -0.000138 0.000250 -0.002204 dpre 0.003910** 0.003237** 0.003266** 0.003657** rt-1 0.081487** 0.078491** 0.114905** ℎ 0.154426 variance equation constant 0.000006 -0.482098 0.000189 α 0.115105** 0.219027** 0.109967** β 0.861138** 0.963238** 0.500793** γ -0.049052** dpre 0.000032** 0.178332** -0.000253** arch(5) 418.7093** 1.3118 0.8364 54.1836** arch(10) 478.0745** 2.1861 1.1906 83.3482** aic -5.2585 -5.5541 -5.5645 -5.4949 sic -5.2553 -5.5492 -5.5501 -5.4821 **significant at 5% * significant at 10% after confirming that abnormal returns on preholidays have existed in thai stock market, further investigation is carried out to see whether the number of days during holiday periods can affect the level of preholiday returns. table 4 reports the results of various models capturing the preholiday returns and volatility based on the number of days in each holiday period. from ols regression, the coefficient of dummy variable representing the difference in average returns between preholiday consisting of one-and-two-days is 0.25% while the preholiday returns for three-day holiday period is 0.3817% and the preholiday returns for more than three days is 0.7792%. this means that the longer the holiday period the higher will be the level of preholiday abnormal returns, though only the preholiday returns for holidays consisting of more than two days has shown significant differences from those for non-preholidays. all garch models show that they can be used to capture conditional heteroskedasticity. the significance of the asymmetric term of the and the lower value of aic and sic shows that egarch model is better than garch and garch-m models. the garch models where the volatility of the longest holiday periods is considered perform better than the other garch models. therefore, the long holiday period will lead to higher abnormal preholiday returns that come with higher volatility. asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       50   www.macrothink.org/ajfa   table 4. preholiday returns and volatility based on number of days for each holiday period variable ols garch(1,1) egarch(1,1) garch(1,1)-m mean equation constant -0.000412 -0.000143 -0.000249 0.000624 d1 0.002500 0.002203 0.002800* 0.002288 d2 0.003817** 0.002732** 0.002975** 0.002793** d3 0.007792** 0.005554* 0.005586* 0.005702** rt-1 0.080028** 0.078609** 0.081888** ℎ -0.056210 variance equation constant 0.000006 -0.503737 0.000006 α 0.115602** 0.222532** 0.117237** β 0.859258** 0.960941** 0.858281** γ -0.051984** d1 0.000038 0.178525* 0.000035 d2 0.000021 0.090299 0.000021 d3 0.000064* 0.434052** 0.000068* arch(5) 417.6787** 1.0804 0.6376 1.1032 arch(10) 476.8141** 1.8906 0.9744 1.9377 aic -5.2581 -5.5587 -5.5638 -5.5577 sic -5.2516 -5.5395 -5.5430 -5.5369 **significant at 5% * significant at 10% finally, the preholiday returns are further examined to see whether they are related to the holiday type, cultural holidays and state holidays. table 5 reports the results of various models capturing the preholiday returns and volatility with the distinction between state holidays and cultural holidays. the result based on the ols regression shows that the returns on state holidays are statistically significantly higher than non-preholiday returns by 0.4186%. the returns on cultural holidays are only 0.3299% higher than non-preholiday returns. however, this difference is not statistically significant. based on wald’s coefficient test the returns on state holidays and cultural holidays are not statistically different. the results from all garch models show similar results that they can capture the conditional volatility. the returns are abnormally high only for state holidays but not for cultural holidays, and only state holidays show a positive effect on the asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       51   www.macrothink.org/ajfa   volatility level. this finding contradicts those of previous research that show abnormal preholiday returns come with cultural preholidays and not with state preholidays. table 5. preholiday returns and volatility for state holidays and cultural holidays variable ols garch(1,1) egarch(1,1) garch(1,1)-m mean equation constant -0.000412 -0.000141 -0.000263 0.000630 state1 0.004186** 0.003518** 0.003736** 0.003550** cultural1 0.003299 0.002131 0.001742 0.002186 rt-1 0.081207** 0.078469** 0.082863** ℎ -0.056679 variance equation constant 0.000006 -0.463816 0.000005 α 0.114073** 0.214481** 0.115450** β 0.862990** 0.964987** 0.862323** γ -0.049170** state 0.000037** 0.225726** 0.000036** cultural 0.000018 0.052922 0.000020 arch(5) 418.7093** 1.2399 0.9577 1.2695 arch(10) 478.0745** 2.1526 1.3487 2.2117 aic -5.2581 -5.5591 -5.5641 -5.5579 sic -5.2532 -5.5431 -5.5465 -5.5403 **significant at 5% * significant at 10% 1the test statistics of wald’s f test between coefficient of state holiday dummy and cultural holiday dummy is 0.113870, which is not significant at 10%. during the sample period of this study, the stock market performance in thailand may have been affected by the asian crisis in 1997. in order to control for this event a dummy variable representing the period of asian crisis in thailand is introduced into the model. the period of asian crisis in thailand is the period between 1996 and 1998. this dummy variable would be added to both mean and variance equations to control the effect on both mean and volatility levels. table 6 reports the results of the egarch model after controlling for the asian crisis. the negative coefficient of the dummy variable for asian crisis in the mean equation shows that the returns are abnormally low during the crisis period. moreover, the positive coefficient of the dummy variable for asian crisis in the variance equation shows that the level of volatility is asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       52   www.macrothink.org/ajfa   higher during the crisis period. the other coefficients show qualitatively similar results obtained from the models estimated earlier. this implies that the effect of the asian crisis does not alter the abnormal returns and higher volatility during the preholiday periods. furthermore, it does not alter the results related to the number of holidays and state holidays and cultural holidays reported earlier. table 6. the egarch result after controlling for the asian crisis in 1996-1998 variable model 1 model 2 model 3 mean equation constant 0.000108 0.000102 0.000099 dpre 0.003405** d1 0.002470 d2 0.003313** d3 0.005935** state 0.003641** cultural 0.001884 rt-1 0.076572** 0.076072** 0.075986** d1996-1998 -0.003210** -0.003227** -0.003227** variance equation constant -0.548994 -0.580894 -0.528907 α 0.225075** 0.229726** 0.220699** β 0.956492** 0.953094** 0.958448** γ -0.052011** -0.055949** -0.052137** dpre 0.174998** d1 0.169166 d2 0.086976 d3 0.451380** state 0.219654** cultural 0.060436 d1996-1998 0.032669** 0.034581** 0.031467** **significant at 5% * significant at 10% asian  journal  of  finance  &  accounting   issn  1946-­‐052x   2010,  vol.  2,  no.  2,    x:  e3       53   www.macrothink.org/ajfa   5. conclusion this research investigated the holiday effect in the thai stock market. the overall market performance is examined from set index, which is the market value-weighted index of all stocks traded in the stock exchange of thailand. the result confirms that the holiday effect exists in thailand because the stock returns are abnormally high during the preholiday trading day. even after the model is adjusted to account for conditional heteroskedasticity by various garch models, the result is still the same in which the returns for preholiday periods are statistically higher than non-preholiday periods. however, there is an interesting issue that the preholiday period with abnormally above-average returns comes with higher volatility level. the higher volatility may arise from the fact that most holidays in thailand are not the same as those in the other countries. there is only the new year holiday which is a holiday for all countries including thailand. this may create uncertainty in investors as it is unpredictable as to what will happen to global markets during the market closure on thai holidays. furthermore, the preholiday returns are higher for the long holiday periods. only the preholiday with more than two days show statistically significantly higher returns compared to those during non-preholiday periods while the preholiday periods with one to two days show higher returns that are not statistically significant. after distinguishing between state and cultural holidays, only state holidays show statistically significantly higher returns compared to those during nonpreholiday periods while the returns during cultural holidays are not statistically significantly higher. however, there is no statistical difference between preholiday returns between state and cultural holidays. further, the asian crisis has similar effects on returns during preholiday and cultural holiday periods. however. there are abnormal returns and higher volatility during preholiday periods. the abnormal preholiday returns exist in thailand, especially for state holidays and holidays with more than two days. however, the magnitude of these abnormal preholiday returns is too small to take advantage of for making profits because the transaction costs of 0.83% coming from the minimum standard roundtrip commission fees in thai stock market at 0.3% and the average bid-ask spread computed from the tick size at around 0.53%. moreover, investing during preholiday comes with higher volatility, implying higher risks. therefore, it is questionable that the preholiday returns are really profitable rational risk-averse investors. even though it is difficult to exploit these preholiday returns, the evidence of the existence of preholiday abnormal returns could give a clue to investors on the timing of investments. furthermore, the higher preholiday volatility reflects investors’ behavior during market closure on thai holidays, which can create abnormal buying and selling activities during preholiday trading days. references akgiray, v. 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(1964). capital asset prices: a theory of market equilibrium under conditions of risk. journal of finance, 19, 425-442. microsoft word an evaluation-writer2-new an c op receive doi:10.5 this pa technol ait and very use abstra single c the sub champi of singl panel d intra-tra bilatera substan that ec cultural keywo n evalu commu scho pen univers ed: october 5296/ajfa.v4 aper is bas logy (ait) d participan eful. ct currency fo b region’s on of the in le currency dynamic o ade potentia al potential i ntial intra-tr cowas di l to improve rds: gravity uation o unity o ool of busin sity, malays r 18, 2012 4i2.2541 sed on my campus, a nt of 2nd in or west afri problems. ntroduction is to impro ordinary le al within w in ecowa rade potenti iversify its e intra-trade y model, in of intra f west an ness, univer sia (accra i e-mail: an accepted url: http y ph.d thes ccra ghana nternational ica countrie attentions of single cu ove intra reg east square west africa as using tim ial between export 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appropriate ks, and inte the ecow ade in the l t of exchang n journal of f se the cost the region’s r states visn relation t ctiveness. w there is s ve adminis reduce poli evelopment one of the ntra-trade th hare of intr 08, which is h as com w that of n in trade co by de na ntra-trade p s the hope a est africa. t ising coton osting regio rade integra form of trad moval of tari nd adopted a -regional tr low but ste ecowas c voiding to b trade betw barriers. go ariff; by con rt tariffs. implement taxation, la ense compe was leader long term t ge rate vola finance & ac issn 19 2012, vol. www.macrothi t of trade b s industries, -`a-vis third to trade, ec with organi scope to strative eff itical contam t of nations e major ec hrough the ra-ecowa s not differe mesa and the europe osts as resu ardis, de sa positive resp and need fo trade libera nou treaty. onal integra ation by cr de integrati iffs and qua a common rade in wa eady progr countries to be penalised ween wae oods import ntrast expor it worth no tation: bure ack of subetition from rship had through cre atility. ccounting 946-052x 4, no. 2 ink.org/ajfa between , as well d parties. conomic isational increase ficiency, mination (see for conomic creation as trade ent from sadc e whose ult of the antis and ponse to or single alisation besides tion and reating a ion. the antitative external aemu is esses in join the d by the mu and ted from rts from oted that eaucratic regional m outside been to eation of in april to creat west a senegal (waem howeve tariff b taxation compet commi been ci through highly c ecowa concent reveals exports import manufa to whet the bas coincid existenc trade w similar potentia ecowa recogn countrie previou intra-tra the stu literatur ecowa literatur to deal the par informa underly the cu unobser l 2000, the te the west african cou l and togo mu) to facil er, the regi barriers, bur n, lack of s ition from o ission for a ited as the h export co concentrate as, which tration inde that its ex more than more than actured good ther these co sic theory o ence of wa ce of unexh within the blo concern ha al in the ec as bloc w nising the im es for policy us studies i ade potentia udy contribu re in sever as and int re. the exis with endog rameter est ation about ying dynami urrent study rved heterog e gambia, g t african m untries (ben o) that are m litate the int on is const reaucratic c ub-regional outside the africa(unec major caus oncentration ed given cre is 69.36 ex of 78.07. xport is co n three time n six times ds accounts ountry can m of economic ants. the r hausted intra oc may low ad been expr cowas. th which faile mportance y formulati in dealing al among th utes to the g ral ways. t tra-ecowa sting estima genous in gr imates. it t the earlie ics may be y employs geneity amo ghana, guin monetary zo nin, burkina members of tegration. raint by bo customs an l harmonisa region and ca), 2010) se of low i n index pre edence to th from 2006 an exam ncentrated es of primar the volum s for more t meaningful cs posits tha relevance o a-trade pote wer but level ressed by o he study inv d to revea knowledge on especial with the e ecowas general bod the study as trade po ated intra-e ravity mode is rare for r times and obscured b dynamic p ong cross se 317 nea, nigeria one (wam a faso, co f the west oth legal an nd inspectio ation of the d homogene . specific intra-west esented in t he earlier li -2009 is o mination of on primary ry commod me of manu than 65% o trade amon at meaningfu of the com ential within l of intra-tra ogunkola (1 vestigated tr aled the in of individ ly as they g issues; this s members. dy of know explores b otential usin ecowas tr el estimatio r single cro d aggregat by aggregati panel estim ectional uni asian a, and sierra mz) with int ote d'ivoire, african ec d policy fra on procedu e national re eity of expo cally, low ex africa trad table 1 sho iterature. th only compa import and y commodi dities as com ufactured g f ecowas ng themselv ful trade can mmon curre n the ecow ade which is 998) which rade potenti nter-countrie dual trade p gear for the s study the . ledge by fil both intra-c ng gravity m rade potent on which ca oss-section e time seri ion biases ( mation whic its. n journal of f a leone ann tention of m , guinea-bi conomic an amework w ures, corrup egulatory fr rts (united xport divers de (odularu ows that e he export c arable to th export stru ities (see t mpared to t oods expor s total impo es. n only take p ency to intr was bloc ot s paramoun h lead to the ial of indivi es potential potential wi currency un erefore see lling the vo ountry trad model whic ial by ogun asts doubt o survey to ies data ha bond, 2002 ch addresse finance & ac issn 19 2012, vol. www.macrothi nounced the merging wi issau, mali nd monetary which includ ption, inapp frameworks, nations ec sification in u, 2009). a ecowas e concentratio he cemac ucture of ec table 2). t those impor rted. howe ort raising d place when tra-trade hin therwise the nt will rema e evaluation idual countr al within th ith other in nion and fa eks to expl oid in the a de potential ch is missin nkola (1998 on the magn provide su ave possibi 2; shepherd es the cont ccounting 946-052x 4, no. 2 ink.org/ajfa eir intent ith eight i, niger, y union des high propriate , intense conomic ndex has a glance export is on in the c export cowas the bloc rted and ever, the doubt as n there is nges on e cost of in same. of trade ries with he bloc. ndividual ailure for lore the cademic l within ng in the 8) failed nitude of ufficient lity that d, 2008). trols for the res method five. table 1 tr a m a ca ca ce ce c ea ec eu n sa sa u source: u table 2 commod sitc 0+ sitc 0+ sitc 0+ sitc 3 sitc 5+8 source: c st of the st dology and d . export tr rade bloc arab com market asean acm aricom efta emac omesa ac cowas u27 nafta aarc adc uemoa unctad, 20 2. structure dity classifica 1+2+3+4+68+ 1+2+3+4+68 1+2+4+68 8 less 667 and calculated fro tudy is org data at sect rade concen expor conce index 1995mmon 57.88 20.05 28.44 37.80 15.30 63.69 44.02 32.13 75.45 8.95 9.54 17.12 32.87 40.53 011 of ecowa ation +667+971 d 68 om unctadanised as f tion three. t ntration inde rt product entration x e c in -1999 2 8 6 5 2 4 2 0 4 0 1 9 7 2 4 3 3 5 7 1 9 2 1 7 3 3 4 as commod -wdi statistic 318 follows; sec the section ex of variou export produ oncentration ndex 2000-2004 62.28 20.72 21.40 42.37 16.63 72.45 46.93 30.94 75.67 10.18 9.68 16.17 34 41.15 dity export ex 3.5 3.4 1.4 6.7 0.1 cs, 2011 asian ction two l takes the re us trade bl uct export concentr index 2005-200 59.72 18.86 20.88 45.55 14.54 76.63 46.76 27.74 68.85 9.85 9.21 16.84 35.04 40.07 and import port/ import 55 45 42 76 15 n journal of f ooks at the esults and c ocs(1995-20 product ration e con ind 08 20 56 21 16 43 14 78 43 28 69 24 9. 9. 35 42 t, 2010 % o 33 33 21 13 65 finance & ac issn 19 2012, vol. www.macrothi e literature concludes at 009) export produ ncentration dex 006-2009 6 1.05 6.99 3.63 4.38 8.07 3.60 8.23 9.36 4.89 75 35 5.33 2.28 of total impo ccounting 946-052x 4, no. 2 ink.org/ajfa review, t section uct rt 2. liter there is decades the int proença kennan longab africa i all con achievin coordin looked within t based o univers function (1962) econom countrie study th trade b decreas where ijt = as a cou im an bilatera ijd = t the dest g =con the ass country while sm rature revi ssue of intr s resulting i tra-ecowa a,2005)), s n ,2010), baugh, 2008 in particular clude that ng its objec nation in gen at regional the zone. in on the grav sal gravitat n of the ma proposed t mic factors o es, and eco he determin between a p se as the tran trade flows untry’s expo d jm = t al trade flow the econom tination cou nstant. sumption is y can trade w maller coun iew aregional tr in number o as (ogunk south asia southern 8) and afric r have been the experie ctives of in neral. the s l level pote n terms of m vity model. tion”, whic asses of the o apply ne on trade ch onomic forc nants of int pair of cou nsaction cos s from orig orts, import he econom ws. mic force tha untry; it is u s that the ec with all its ntries tend to rade have be of works fro kola,1998), (wadhaw, africa (si a (uneca n slightly va ence of reg ncreasing in studies mig ential and f methodolog the gravity h states tha e objects an ewton’s law hanges. he es that affe ternational untries shou sts increase ijt in country s or total tra mic forces o at negatively sually repre conomic siz trading part o trade less. 319 een an imp om number european , 2009), imwaka,201 a, 2010). t ary, the gen gional inte ntra-regiona ght have suf failed to lo gy, the anal y model ha at the force nd the dista w to interna used econo ect trade flo trade flows uld increas e. the mode ij i ij d mm g i to destin ade value. of the two y affects tra esents chang ze of a trad tners. there . asian ortant part o r of regiona n union (m sub-saharan 10; haggbl the empiric eral conclus gration in al trade in p ffered from ook at intra yses of all as been der e of attract ance betwee ational trade omic forces ows betwee s. thus the e as their el can be exp jm nation coun countries t ade flows b ges in transa ding country efore, larger n journal of f of the acade al blocs trad martínez-g n africa ( lade, jayn al evaluatio sion seems africa has particular an aggregate b a-country le empirical li rived from n ion betwee en the two e flows to s of the orig en the two s e model pre economic pressed as f ntry j ; usu hat have a between the action costs y usually de r countries finance & ac issn 19 2012, vol. www.macrothi emic for nu de potential galán,fontou (keane, ca ne, tschirle on of intra-r to be simila s been a fa nd fostering biases as th evel trade p literature ha newton’s “ en two obje objects. ti study the e gin and des sets of coun edicts that sizes incre follows: ually it is ex positive e origin coun s. ecides how tend to trad ccounting 946-052x 4, no. 2 ink.org/ajfa umber of such as ura and alì and ey, and regional, ar. they ailure in g policy hey have potential ave been “law of ects is a inbergen effect of stination ntries to bilateral ease and (1.2) xpressed ffect on ntry and much a de more, previou positive accord internat found t tradition assumi trade sh the exp relaxing bergstr from a from su partner. foundat endowm hecksch varying compet (1998) assumin the theo 3. meth 3.1 the the mo from th where 0 their uti us literature ely affect a ing to de tional trade that the gr nal hecksc ing identica hares in eac penditure fu g many assu and (1985) general equ upply and d . bergstrand tion. he em ment level a her-ohlin m g models ition model and anders ng that each oretical foun hodology an e gravity mo odel develo he utility of a ijq is the the elasticit ility subject e justifies t country’s tr eardorff (19 e theories h ravity equat cher-ohlin al homothet ch country, unction to s umptions fro theoretical uilibrium fra demand side d (1989) ex mploys tradi and taste pr model and l stemming ls as well as son and van h country is ndation of th nd data model oped here is a representa consumpti ty of substi t to the subj the role of rade flows ( 998), theor has been gr tion is con model (h-o tic preferen anderson ( study differ om the cob lly justifies amework by es based on xtending hi ing partners reference to linder hypo from diffe s product di n wincoop ( specialized he gravity m s the varian ative consum      j iu ion by cou itution betw ect constrai y 320 gdp in th (anderson 1 retical just radually str nsistent wit o model) o nces for com (1979) theor rentiated tra bb-douglas s the gravity y setting up n the assum is earlier w s’ per capit o test wheth othesis. erent gener ifferentiatio (2003) have d in a single model. nt of sousa mer in coun      11   ijj q untry i con ween goods int  j iji qp asian he gravity 1979; bergs tification fo rengthened th internati or imperfec mmodities retically jus aded goods production y model in p a world tra mption of a work in 198 ta income t her the gra ral framew on models h e also justifi e good. this a and loch ntry i , which   1    nsumers of . the consu n journal of f model and strand 1989) or the gra since the onal trade ct competit across coun stified the g in a group function. n a microec ade general single fact 85 based on to represent vity model works inclu have been d ied theoretic s probably c hard (2003). h is assumed f goods fro umers in co finance & ac issn 19 2012, vol. www.macrothi d gdp is f ). avity mode 1990s. it h theories b tion trade t ntries and d gravity mod p of countr conomic fou l equilibrium tor for each n a microec t a country’ is in line w uding mono developed. d cally the gr closes the cu . the mod d to be om country ountry i m ccounting 946-052x 4, no. 2 ink.org/ajfa found to el under has been ased on theories. different del using ries, and undation m model h trading conomic ’s factor with the opolistic deardoff ravity by urtain of del start (3.1) j and maximise (3.2) with y in coun price re where that eac transit. therefo it is dec income from eq combin iy the incom ntry i . assum eceived by s ijc is the c ch good tr the result o ore, the valu creasing in is income i quation (6) ning equatio me of country ming that t seller in j b cost of trade ransported of the consu ij p q ue of import ijc if  is equal to t y we obtain t on (5) and e y i and p rade costs a be e. assuming from count umer utility   ( (1       j i ij p y p t of country ij ym 0 . the ma the importer  i ijj my the equilibri j p( equation (7)        i ij c yy m 1 321 ijp the price are borne b ijiij cpp  g an iceberg try j to co maximizati     1 ) ) 2         ijj ij p p y i from co        ijjj i i cp p y arket cleari r i spendin      ji iy ium scaled p  ij j y p  1 ) gives         i ij j y y 1 asian e of good fr by seller an g form for t ountry i , a ion problem  ountry j i      ing conditio ng:      ijjj i cp p prices:          ij ij i c p y            ij ij i c p p n journal of f rom country nd take the trade costs a proportion m is: s given by: on implies t finance & ac issn 19 2012, vol. www.macrothi y j for con ‘iceberg’ fo amounts to 1ijc “m that the exp ccounting 946-052x 4, no. 2 ink.org/ajfa nsumers orm, the (3.3) suppose melt” in (3.4) (3.5) porter j (3.6) (3.7) (3.8) we can taking where iy , ed ied is t is th the pr determi 3.2 eco intra-ec section predicte the futu one, it i n rewrite equ logarithm o tijm ln , ijm is the jy is the g ijd is the tr jd is expor export con he error term ropose mod inant. owas intra cowas tr to predict ed by the m ure direction implies a po uation (8) a le of equati iy  ln21 e volume of gdp of coun rade barrier rt concentrat ncentration o m del for thi a-trade pot rade potent trade, with model ( xp ) t n of trade f otential for e s m where et (ln fc  ion and subs jti yy  ln ,3, bilateral tra ntry i and r between tion index o of the host is study ta tential ial is analy h rest of t to actual/ob for ecowa expansion o 322        ij i ij c yy gm 1       iy p g ,ln  iij edd stitute equa ijt d ln4, ade between county j country i of partner co country akes the fo ysed using the countrie bserved trad as. if the v of trade with asian        j jy 1         ij ij c p p ),  jed ation (10) gi ied ln5 n country i and county ountries form (3.11) the model es in the s de ( xa ), ( xp value of ( p h that partic n journal of f ves i ed ln5 and country y j ) to estima estimates ample. the xx ap / ) is th xx ap / ) for cular country finance & ac issn 19 2012, vol. www.macrothi tjd  y j ate the int from the p e ratio of t hen used to r a country ry exist. ccounting 946-052x 4, no. 2 ink.org/ajfa (3.9) (3.10) (3.11) (3.12) tra-trade previous trade as analyze exceeds 3.3 esti since th panel e the prob time se econom squares forecast a num differen confron equilibr long-run preferre howeve have lo since th informa obtaine kao (19 and gra levels re panel c estimate pedroni mark an method serial c unbiase errors b the regr standard and do the fm favour cointegr relation by lead feedbac 1 see ca imation tec he data con stimation th blem of stat eries are n metric theory s cannot be ting perform mber of met nces of the s nted with a rium. as lon n relationsh ed method e er, it has be ow power a he time seri ation set. th d. 999), and p anger (1987 egression. t cointegration e the long r i (2000) pr nd sul (200 ds of panel c orrelation t ed estimator by augment ressors in f d errors tha ols estimat mols estim of panel ration equat n with kao-a d and lagge ck (saikkon amareroy & t chnique nsidered va hat takes tim tionarity in not stationa y shows, wh e applied b mance. thods are s series and t a new prob ng as the fir hip between estimation t een widely a against stati es dimensio herefore, ga edroni (199 7) framewor the present n. since th run relation roposes full 01) recomm cointegratio o the ols r of the lon ting the stat first differen at can be use tors have no mator especi dols est tion which adf test. ed differen nen,1991). l tamarit (2002 ary both ov me series p econometri ry. that is hen the var because the suggested t hen putting blem; loss rst differenc n these varia time series acknowledg ionary alter on is extend ains in pow 99, 2004) pr rk, which in study empl ese tests on nship, appro ly modified mend the dy on estimatio estimator. t ng-run para tic regressio nces. both ed for infere ormal limiti ially in sma timation, th relates direc in the dol nces of the lead and la 2) for strength 323 ver time an properties o ics studies. s, their me riables are n ere might to solve th g them into of informa ces of the v ables becom data becau ged that stan rnatives. pa ded by the c wer are expe roposed pan ncludes testi loyed kao( nly detect t opriate meth d ordinary ynamic ordi on. fmols to correct f ameters, do on with lea fmols an ence. accor ing properti all samples he dols ct intra-trad ls framew explanator agged diffe h and weakne asian d across co f the data i empirical ean and va non-stationa be a spuri his problem regressions ation that i variables are mes impossi use of the w ndard unit r anel tests m cross section ected, and m nel cointegr ing the stati 1999)1 ad the presenc hod should least squar inary least s s estimation for the endo ols uses a ads, lags, an nd dols p rding to ka ies, and the s. on the b method is de after iden ork, the lon ry variables erences of t ess of the test n journal of f ountries, the nto conside l studies sho ariances dep ary, the stan ous regress m. one of t . however, s importan e used, dete ble. cointeg weakness of oot and coin make progre n, inference more reliab ation tests s ionarity of t f test to det ce of cointe be employe re (fmols squares (do n corrects fo ogeneity bia parametric nd contemp provide cons ao and chian e dols esti asis of the s used to ntifying the ng run regre s to contro the depende t. finance & ac issn 19 2012, vol. www.macrothi e study con eration. thi ow that mo epend on ti ndard ordina sion which them is tak in this case nt for the l ermining a p gration has f the standa integration t ess in this e relies on a ble evidence similar to th the residual etect the pre egration but ed. in this d s) estimatio ols) as alt for endogen as and to o c adjustmen poraneous v sistent estim ng (2000), imator outp earlier find estimate l panel coint ession is aug ol for endo ent variable ccounting 946-052x 4, no. 2 ink.org/ajfa nsidered is brings st of the ime. as ary least h affects king the e we are long-run potential become rd ols. tests can respect. broader e can be he engle s from a sence of t do not direction on while ternative neity and obtain an nt to the values of mates of fmols performs dings in long-run tegration gmented geneous e can be include equation where p (aic, b root com the expl 3.4 dat the dat study u ecowa guinea, these (imf-d on tra organis regressi bilatera (0.0000 at best a 4. estim as requ series v series phillips conduct pesaran employ observe appropr results g regressi table 3 estimate cointegr among 2 the unit 3 the resu d to accoun n p is the lag bic). equat mponent fro lanatory var ta collectio ta for this ses annual b as countri , guinea-b data were dot)/intern ade and de sation (wt ion. all the al trade wer 01) to all tra and is comm mation res uired for e variables we and pooled s-perron (pp ted on the 2 n and shin yed for test ed nonstatio riateness of gave eviden ion3. 3 presents k es of gravit ration is fai the variabl ts root results a ults is available nt for seria g length with tion (5) is th om the regr riables to th n study is se bilateral tra ies (benin, bissau, libe e obtained national fina evelopment to). the n variables u re corrected ade flows. t monly used ults econometric ere examin d (panel) p) test, the 256 individ test (2003 cross-secti onarity in th f pooling th nce of effici kao (1999) p ty models fo iled to be a les under c are not reported e on request al correlatio xz   hin a releva he dols re ression by s he ols regr condary da ade, gdp , burkina f eria, mali, from int ancial stati t (uncta necessary tr used in the s d using the though the in the polic c analysis, ed, using th data sets e kwiatkow dual data ser 3), the bre ional indep he datasets2 he cross-se iency in po panel coint for all the co accepted ind onsideration because of the 324 on (see stoc p pi x     ant range to egression. t imply addin ression ata covering data and o faso, cape niger, nig ternational stics (imfad), unco ransformati study entere e ad hoc m approach h cy literature stationarity he availabl the augm wski, phillip ries and the eitung test pendent pan 2. also cho ection param oling the cr tegration tes ountry. tab dicating the n. the pan size but is avai asian ck and wa titx   o determine the dols ng leads and g a period o other social e verde, cô geria, seneg monetary ifs) databa omtrade ion is done ed in as natu method by a has no theor e (shepherd, y/non-statio e unit root mented di ps, schmidt e levin, lin (2000) and nel unit roo ow poolabil meters as a ross-section st while tab ble 3 shows e presence w nel estimate ilable on reques n journal of f tson, 1993) by some in specificatio d lags of th of 31 years and econom ôte d'ivoire gal, sierra fund -d ase, united database e to avoid ural logarith adding sma etical basis ,2009) narity prop tests for bo ckey-fuller t, and shin n and chu t d the hadri ot tests. th ity test was against indi n parameters ble 4 presen that the nu with cointeg es with each st. finance & ac issn 19 2012, vol. www.macrothi ). in particu nformation c on removes he first diffe s (1980-201 mic indicato e, gambia, leone and direction o nation con and world d possible s hm. the zero all positive but is appr perties of t oth individ r (adf) t n (kpss) te test (2002), i test (200 he results g s conducted ividual mod s against in nts the pane ull hypothes gration rela h of the co ccounting 946-052x 4, no. 2 ink.org/ajfa ular, the criterion the unit rence of 10). the ors of 15 ghana, d togo). of trade nference d trade spurious os in the number roximate the time dual data test, the est were , the im, 0) were generally d for the dels and ndividual el dols sis of no ationship ountries’ a bilatera explain the var all the signific are both bilatera with tra and par credenc africa a table 3 adf t-stat prob. b-benin, gb-guin ** table 4 host cou benin burkina f cape ver cote d'iv gambia, ghana guinea guinea b liberia mali niger nigeria senegal sierra leo togo source: a al trade flow 45.1% and riables are a countries. cant except h positive b al trade in e ade literatur rtner country ce to odula as whole is . kao (1999 b bf -3.58 -4.29 0.005 ** 0.000 ** , bf-burkina nea bissau, lb 4. dols pan unry(i) r g 2. faso 2. rde 3. voire 2. the 3. 1. 2. bissau 3. 2. -2 0. -4 1. one 0. 0. athour’s calc w with the d 99.6% of also genera the gdp for mali w but insignifi ecowas an re. the trad y shows ne aru(2009) a homogenei 9) panel co cd cv 9 -3.59 -5.4 0 0.000 ** 0.0 ** a faso, cvb-liberia, m-m nel cointeg regressors gdpi gd .303* 1.7 .36* 4.5 .156* 3.5 .007* 0.9 .901* 1.4 .621* 2.6 .172* 1.3 .929* 1.5 .252* 1.5 2.335* 5.7 .048 3.4 4.03 2.7 .618* 0.8 .287 3.3 .606* 2.1 ulation, 2012 e rest of ec the variatio ally correctly p variables which is sign icant. the im nd distance de facilitati gative and and uneca ty of export ointegration v ga g 46 -2.63 -6 00 0.004 ** 0. ** -cape verde, mali, n-niger gration of gr dpj distan 96* -2.836 71* -6.807 19* -5.980 36* -1.249 88* -4.037 01* -3.207 62* -2.381 66* -4.641 21* -2.329 44* -2.952 61* -2.498 64* -0.208 35* -0.629 40* -3.517 99* -1.331 325 cowas c on in bilate y signed. t for host an nificant neg mplications e or barriers ion indicato significant a(2010) cl t. test gh gu 6.00 -3.28 .000 * 0.001 ** , cd-cote d r, ng-nigeria gravity mod nce edi 6* 1.649 7* 24.550 0* 18.907 9* -1.422 7* 0.530 7* -13.53 1* -7.312 1* -4.129 9* -1.164 2* 5.703 8* 0.0914 81 5.687 9* -0.308 7* 9.029 1* -3.179 asian ountries ge eral trade ac the distance nd partner gative and t s are that ec s impede bil or, exports effect on m aim that th gb lb -1.69 -2.44 0.045 ** 0.007 ** d’ivoire, ga a, sg-senegal del edj * -4.802 0* -12.82 7* 2* -0.265 0.0787 30* -6.675 2* -3.705 9* -14.34 4 -6.046 * -14.66 4 -8.386 * 1.377 82 1.6304 * -16.39 9* -0.632 n journal of f enerally fit cross our sa e is negative countries a then niger conomic exp lateral trade concentrati most of the c he problem m n -2.48 -1.61 0.006 ** 0.05 4* -gambia, gh l, sl-sierra le diagn adjus 2* 0.996 20* 0.813 0.535 5* 0.990 7 0.796 5 0.888 5* 0.970 42* 0.451 6* 0.588 61* 0.997 6* 0.997 * 0.982 4 0.983 98* 0.886 2 0.863 finance & ac issn 19 2012, vol. www.macrothi the data w ample of co e and signif are all posit and nigeri pansion is g e. this is co ion of host countries. t of ecow ng sg -3.28 -3.98 0.001 ** 0.000 ** h-ghana, gu eone, tg-tog nostic statistic sted r2 d2.0 1.9 2.0 2.0 1.9 1.9 1.9 1.9 1.9 2.0 1.9 1.9 2.0 1.9 2.0 ccounting 946-052x 4, no. 2 ink.org/ajfa well and ountries. ficant in tive and ia which good for onsistent country this lend was and sl tg -2.26 -2.4 0 0.012 ** 0.00 ** u-guinea, go cs -w stats 019 958 047 090 933 967 973 937 990 045 978 976 043 960 028 40 08 4.1 intr having proceed section potentia analyze exceeds country country looks b true for due to timing o country mis-attr the stu partners a green table 5 between between countrie also hav the wa countrie as a det zone. ra-ecowas estimated d to estimat are used t al (p) as pre e the future s one, the i y. table 5 y’s potential bit confusing r the reverse discrepanci of export/im y attribution ribution and udy therefor s in ecow n field whic 5 shows a n waemu n the two es were init ve low trade aemu show es raising th terminant o s trade pot the gravity te intra-eco to predict i edicted by e direction mplication give the i l with each g but that is e because o ies in recor mport, shipp n & treatm d smuggling re presents t was. the po h need to b considerab u countries blocs with tially attrib e potential ( ws guinea he issue of of intra-trad tential y model for owas trad ntra-ecow the model t of trade f is in terms intra-trade p of the eco s the case. of difference rding of bil ping & insu ment of pr g. trade potent otential of m be exploited ble trade po and wam hin ecow uted to com (see tables bissau see colonial ex de because g 326 r bilateral t de potential was trade to the actua for intra-ec s of potentia potential in owas coun the trade e in bilatera lateral trade urance cost, rocessing tr tial of each more than 10 d and is rep otential wit mz countri was. the mmon curre 5 and 6). a ems to hav xperience w guinea biss asian trade flows l. the mode among the al trade (a) cowas co al expansio n ecowa ntry. the re e potential o al trade rep e between t classificatio rade, mis-i country ba 000 times th presented by thin the reg ies indicatin low trade ency of cfa a critical loo ve high trad which have b sau is the o n journal of f for ecow el estimates countries. ; that is, (p ountries. if on of trade w as. the est esult put for of country s orted by ea trading part on of goods nvoicing, t ased on the he current tr y “-“. the r gion. there ng existenc potential b a franc but ok at the tra de potential been record only portugu finance & ac issn 19 2012, vol. www.macrothi was count s from the p the ratio p/a) is then f the value with the re timate show rth argumen say a with ach country tners as a r s, re-export transfer pri reported tra trade is clas results pres e is huge p ce of trade between w t wamz c ade potentia l with mos ded in the l uese countr ccounting 946-052x 4, no. 2 ink.org/ajfa tries, we previous of trade n used to of p/a spective ws each nt which b is not . this is result of , partner icing & ade with sified as ented in potential e barrier waemu countries al within st of the iterature ry in the table 5 b b bf 0.1 cv 983 cd 1.3 ga 0.2 gh 1.1 gu 1.9 gb 938 lb 0.5 m 0.2 n 0.3 ng 0.8 sg 0.9 sl tg 0.5 **b-benin lb-liberia source: a table 6 source: a 5. intra-eco bf c 0.16 1 3 3 0.79 2. 9 9. 0 0.35 7 8 0. 1 5 0.20 3 1.67 7 16.87 5. 8 1.88 4. 4 0.43 n, bf-burkina f a, m-mali, n-ni author’s estim 6. intra-wae author’s estim owas trad cv cd g 0.93 0.38 0.20 0 .26 0 .82 0.20 1.41 0 0.22 0 .23 0.20 0 0.21 0 0.46 2 1.83 .34 1.18 2 .0 0.66 0 0.20 0 1.64 0 faso, cv-cape ger, ng-nigeria mate, 2012 emu trade b b bf 0.1 cd 1.3 gb 938 b 0.5 m 0.2 n 0.3 sg 0.9 tg 0.5 mate, 2012 de potential ga gh 46.82 0.18 .38 .64 1.87 0.204 .20 .73 0.73 .24 .22 0.35 0.20 24.44 1.25 9.88 0.62 .635 2.60 .20 0.20 .64 2.18 verde, cd-co a, sg-senegal, sl e potential bf cd 0.16 0.9 1 0.3 3 0.79 8 0.2 1 0.2 5 0.20 0.4 3 1.67 1.8 8 1.88 0.6 4 0.43 1.6 327 estimates gu gb 1.07 9.12 0.20 1.22 3.75 2.62 1.89 0.59 2.36 0.47 1.14 0.20 0.50 1.71 1.25 0.60 0.83 3.15 ote d’ivoire, ga l-sierra leone, d gb m 93 0. 38 9.12 0. 3.75 0. 20 21 0.20 46 83 0. 66 0.60 0. 64 0. asian lb m 2.79 0.21 6.25 0.11 727 0.71 0.90 0.20 0.63 0.21 47.2 0.32 1.98 0.95 0.48 11.89 1.55 0.37 0.20 0.25 0.38 a-gambia, gh tg-togo m n s .21 0.08 0 .11 0.65 0 .90 1.36 0 0 0 0.20 0 .95 0 .37 6.58 .38 0.21 0 n journal of f n ng 0.08 299 0.65 830 3.47 1.36 0.96 5.94 0.28 16.86 6.79 0.73 0.32 0.20 0.21 16.3 1.35 6.58 0.86 704 1.92 0.21 130 h-ghana, gu-g sg tg 0.12 1.96 0.79 1.14 0.82 0.91 0.21 0.21 0.26 0.21 0.20 0.76 0.27 0.73 0.42 finance & ac issn 19 2012, vol. www.macrothi sg sl 0.12 0.79 0.38 0.82 1.7 3.05 0.2 6 0.27 0.3 0.35 7.2 0.21 0.2 0.21 0.2 0.21 0.76 0.79 3.2 4.4 0.20 0.42 guinea, gb-guin ccounting 946-052x 4, no. 2 ink.org/ajfa l tg 1.96 1.14 77 0.91 26 0.33 33 1.55 21 0.39 20 24 0.26 0.20 0.27 23 0.367 46 0.73 nea bissau, table 7 source: a 5. conc in this p panel d techniqu which existenc trade p whether should b zone an effect w to trade the stu promoti be purs with ex referen anderse http://dx 7. intra-wam author’s estim clusion paper, we h data for the ue. the stu mainly exi ce of trade b potential of r currency be noted th nd is coinci which needs e expansion udy recomm ion includin sued. furthe xhausted trad nces en, p. g. ( x.doi.org/10 mz trade p ga gh gu lb ng sl mate, 2012 have estimat year 1980 udy finds ev ist between barriers but guinea bi union is th at guinea b identally ha s to be looke in ecowa mends that ng policies er export di de potential (1993). the 0.1080/0003 potential ga gh 0.2 0.20 0.73 0.7 0.22 0.3 29.88 0.6 0.20 0.2 ted the intra to 2010 ha vidence of h n waemu t low trade p issau with he key to d bissau is the as high trad ed at. the s as. integration of tariff ha iversificatio l. e 45-rule 3684930000 328 h gu l 204 2.62 0 0.59 0 73 0 35 1.14 62 1.71 0 20 0.83 0 a-trade poten as been ana high un-exh u and nonpotential wi the rest of diminished e only portu de potential study further n of the two armonisation on is require revisited, 00093 asian lb ng 0.20 5.94 0.21 16.86 0.32 0.73 0.32 0.48 0.20 1.92 ntial in eco alyzed usin hausted intr -waemu ithin the w f waemu intra-trade uguese colo raising the r identified o blocs is v n and cultur ed to expan applied ec n journal of f sl 0.26 0.33 7.21 0.24 3.23 owas usin g the panel a-trade pote countries g aemu and u countries potential w onised count issue of la export dive very impor ral especial nd intra-trad conomics, 2 finance & ac issn 19 2012, vol. www.macrothi ng gravity m l dols est ential in ec given suspi d wamz. t raises que within wae try in the w anguage or ersification rtant for int lly language de among c 25(10), 127 ccounting 946-052x 4, no. 2 ink.org/ajfa model. a timation cowas icion of the high estion of emu. it waemu colonial as a key tra-trade e should countries 79-1284. anderso puzzle. http://dx anderso publish baldwin impact no. 32 commi bergstr and the 1216-12 bergstr microec statistic bergstr and the statistic bond, s cemmap breitun econom de nar eurozon deardor matter univers dickey, journal engle, represe http://dx grossm cambri hadri, k on, j. e., & am x.doi.org/10 on, k. 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(20 an economy financial model, the economic j n internatio e review o on, monopo the review ro data me ts for pane 053(00)1500 single curr cussion pap g inequality law, 1(3) estimators f 31. ation and metrica, rowth in th ata. econom finance & ac issn 19 2012, vol. www.macrothi lution to the ), 1 work, edwa 008). study y economic affairs, e linder hy journal, 10 onal trade of econom olistic com of econom ethods and p el data. adv 06-6 rency’s eff pers, n.2008 y: does the ), 353-76. for autoreg error cor 55(2), 2 he global ec metrics. ccounting 946-052x 4, no. 2 ink.org/ajfa e border 170-192. ard elgar y on the c papers european ypothesis 00(403), : some ics and petition, mics and practice. vancesin fects on 8-1. e cause oxford gressive, rrection: 251-276. conomy. haggbl intra-re level, departm im, k. s journal kao, c data, jo keane, africa, krugma industry econom levin, a finite s mark, n panel da martíne europea odularu trade ex pedroni multipl http://dx pedroni time s 597-625 phillips biometr shepher trainin the paci simwak develop ade, s, jay egional ma food secu ment of agr s., pesaran, l of econom c. (1999). s ournal of ec j, calì m., overseas d an, p. r., & y,’ in c. b my: the com a., lin, c.sample prop n.c., & su ata. mimeo ez-galán, e an union: a u, g. o. (2 xpansion. af i, p. (1999) le regress x.doi.org/10 i, p. (2004) series tests 5. http://dx. s, p. c. b., rika, 75(2), rd, b. (200 g network ific (escap ka, k., (20 pment com yne, t. s., aize trade in urity collab ricultural, f , m. h., & s metrics, 115 spurious re conometrics & kennan developmen & venables, bliss and j mmunity’s -f., & chu, perties. jour ul, d. (1999 , ohio state e, fontoura a recent ap 2009) expo frican journ ). critical v sors. oxfo 0.1111/1468 . panel coi s with an a doi.org/10. & perron, 335-346. h 09). behind on trade, u p). 010) an e mmunity 158 , tschirley n southern borative w food, and re shin, y. (20 , 53-74. http egression an s, 90, 144. h n, j. (2010). nt institute a. j. (1990 . b. de ma southern fr c.-s. j. 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(20 or zambia a , michigan roots in he /s0304-407 sts for coin 16/s0304-4 -regional tr competitiv th diversity niversity pre n panel da 5. ntegration v ade potenti n strategy f ), 032-038 n heteroge and statist e sample p esis, econom ot in time 5.2.335 g, asia-pac cial comm potential in h, germany. finance & ac issn 19 2012, vol. www.macrothi 008). poten at the sub-n n state un eterogeneou 76(03)00092 ntegration i 4076(98)000 rade in subveness of pe ty in the e ess, cambri ata: asympt vector estim ial in an e for intra-ec eneous pan tics, 61, properties of metric the series reg cific resea mission for a n southern . ccounting 946-052x 4, no. 2 ink.org/ajfa ntial for national niversity, us panels. 2-7 in panel 023-2 -saharan eripheral european dge. totic and mator for enlarged cowas els with 653-70. f pooled ory, 20, gression. arch and asia and african tinberg econom to analy wadhw studies integra commi gen, j. (19 mic policy. n yze internati wa, d. (2009 in trade a tion in as ission for a 962) shapi new york: ional trade 9). assessin and investm ia and the sia and the ing the wo the twent flows. ng the poten ment, in: cha e pacific, pacific (es 331 world econo ntieth centu ntial for gro allenges an 67, 36-65. scap). asian omy: sugg ury fund. th owth of intr nd opportun united n n journal of f gestions for he first use aregional t nities for tr nations eco finance & ac issn 19 2012, vol. www.macrothi r an intern of a gravit trade in sou trade and f onomic and ccounting 946-052x 4, no. 2 ink.org/ajfa national y model uth asia, financial d social microsoft word ajfa_nangia-writer2-new2 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 86 business valuation: modelling forecasting hurdle rate dr. v.k. nangia professor& head, department of management studies indian institute of technology roorkee, roorkee 247667, uttarakhand, india e-mail: nangvfdm@iitr.ernet.in dr. rajat agrawal assistant professor, department of management studies indian institute of technology roorkee, roorkee 247667, uttarakhand, india e-mail: rajatfdm@iitr.ernet.in k. srinivasa reddy (corresponding author) doctoral student (ph.d), department of management studies indian institute of technology roorkee, roorkee 247667, uttarakhand, india e-mail: srinuddm@iitr.ernet.in received: june 25, 2011 accepted: november 18, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.724 url: http://dx.doi.org/10.5296/ajfa.v3i1.724 abstract consolidation, combination and diversification (ccd’s) in the emerging globalized market leads to competition and escalating the monopoly power. given the increasing liberalization of rules, regulations and law, a number of firms are going beyond national borders and making deals triumphant. we suggest an innovative firm valuation model for m&a in the area of corporate finance that is nrr approach 1.0. the methodology is divided into five phases, modeling forecasting hurdle rate, finding sales growth rate, computation of free cash flows & estimation of future free cash flows and finally determination of firm value under nrr approach. the findings suggest that nrr approach considers various imperative factors while valuing target firms for the benefit of shareholders. the value of study could be credited by nrr approach 1.0. and this is the first of its kind model considers political, transfer and commercial risk factors while estimating hurdle rate. hence, approach is the first version of development thought and has limited scope to validate in other industries. we asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 87 believe that nrr model shall be of great help to m&a advisory firms and investment bankers while negotiating deal value in acquisition process. this would be help in exploring new dimensions of judgment and approach for academia as well as for the benefit of target firm shareholders in corporate arena. keywords: business valuation, mergers, acquisitions, hotel & tourism, forecasting jel classification: g30; g31; g34 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 88 1. introduction there is no more dramatic activity in corporate finance than the acquisition of one firm by another or merger of two firms. in investment perspective, a firm should estimate future cash flow generating capacity of target firm and determination of enterprise value to be acquired for the benefit of shareholders (pandey, 2009). mergers and acquisitions (m&a) is a response to new technologies or market conditions which require a strategic change in company’s direction or use of resources (ray, 2010). m&a and restructuring are a big part of the corporate finance world. the key principle behind buying a company is to create shareholder value over and above that of the sum of two companies (pandey, 2009). the recent m&a boom in india has been comprised exclusively of friendly deals. since economic liberalization in 1991, india has experienced only a handful of hostile takeover attempts. over the past few years, m&a transactions has grown-up greatly, in particular indian deals have risen from $4.9 billion in 2006 to $6.7 billion in 2009 (grant thornton – dealtracker, 2008). economic analysis, business professionals and research evidence indicate that corporate restructuring, mergers, acquisitions, takeovers, and leveraged buyouts are playing an important role in helping the economy adjust to major competitive changes. jensen, m.c. (ross et al., 2005, p. 808) hence, we focus on valuation part while acquiring or buying a target firm as a whole. business valuations are performed and conventionally categorised into three groups (west & jeffrey, 1999). these are transaction based approach, tax-based approach and litigation based approach. first, the transaction based approach is found in mergers, acquisitions, divestitures, employee stock option plan (esops), buy-sell agreements, leveraged buyouts, fairness & solvency options and debt/equity financing (fernandez, 2002; 2007a & 2007b). second, tax-based valuations occasionally occurred in the case of gift & estate taxes, estate planning, charitable contributions, creation of family limited partnerships (flps) and granting of stock options. finally, litigation-driven valuations are most common in divorce of partnership, bankruptcy, shareholder actions, breach of contract and a variety of break-up transactions the present study of ‘firm valuation and cash flows’ is fall under the method of ‘transaction based approach’. the present conceptual study suggests a new valuation model by undertaking two case examples in the indian tourism & hospitality industry. the remaining study is organized as follows: section 2 describes indian tourism & hospitality industry, section 3 presents company profiles; section 4 construe the literature review, section 5 state the valuation method and results discussed in section 6. finally, conclusions presented in section 7. 2. indian tourism & hospitality industry indian culture replicates by the philosophy of "atithi devo bhava", mean that "the guest is god" in sanskrit language. tourism has been a major social phenomenon of societies all over the world. it is driven by the natural urge of every human being for new experiences, the asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 89 desire to be educated and entertained. the basic human craving for new experience and knowledge has become stronger, as communication barriers are getting overcome by technological advances. we describe that the progress in air transport and development of tourist facilities has encouraged entrepreneurs to venture beyond cross-borders. hence, tourism is considered to be a tool of economic development and employment generation for developing nations. it is one of the largest focused industries in service sector globally, in terms of revenue and foreign exchange earnings. tourism plays an important and effective role in achieving the growth and sustainable development of a nation. after 1990’s liberalization policy, india’s performance in tourism sector has been quite impressive. during 2002-09, country witnessed an impressive growth in foreign tourist arrivals (ftas) from 2.38 million to 5.11 million. due to the global slowdown & financial crisis, terrorist activities, h1n1 influenza pandemic, etc., the growth rate in ftas in 2009 fell by 3.3 per cent. foreign exchange earnings (fees) from tourism increased from $ 3.2 billion in 2002 to $ 11.75 billion in 2009 (ministry of tourism, government of india). the recently held common wealth games (cwg) – 2010 at new delhi, pushed indian tourism and hospitality sector to grasp budding opportunities in the welcoming world. it is expected that the industry will record strong growth over the next years, resulting from the growing international tourist arrivals, and other developments in heritage and culture occasions. government also seems to keen on growth of tourism sector, which was apparent from its policy decision such as recent delinking of hotels from the high risk category of real estate business, so that the sector can get passable loans at lower interest ([india infoline data warehouse]); and permitting the industry to raise external commercial borrowings (ecbs). the demand for travel and tourism in india is expected to grow by 8.2 per cent between 2010 and 2019 and would be placing india at the third position in the world. according to a report by rncos, medical tourism will grow at a compound annual growth rate of over 27 per cent during 2009–12 to generate revenues $ 2.4billion by 2012. the number of medical tourists is anticipated to grow at a cagr of over 19 per cent to reach 1.1 million by 2012. further, the report adds that india’s share in the global medical tourism industry will climb 2.4 per cent by the end of 2012. according to federation of hotel & restaurant associations of india (fhrai), india currently has over two lakh hotel rooms spread across hotel categories & guest-houses and is facing a shortfall of over one lakh rooms. the members include hotels and restaurants are depicted in table 1 below. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 90 table 1. break-up of fhrai members as on aug 23, 2010 category east north south west total hotels rooms hotels rooms hotels rooms hotels rooms hotels rooms 5 stat deluxe 9 1365 36 8492 23 4088 37 9230 105 23175 5 star 3 322 34 3971 30 3871 38 4213 105 12377 4 star 11 784 44 3665 45 4099 35 3075 135 11623 3 star 32 1566 88 3910 186 10921 121 7091 427 23488 2 star 11 340 20 743 32 1363 37 1495 100 3941 1 star 1 42 5 78 6 225 6 233 18 578 heritage 29 1085 8 340 8 318 45 1743 un-classified 198 7471 442 16514 332 16898 393 14978 1365 55861 restaurants 135 12483 517 44134 252 23422 229 150620 1133 230659 associates 17 60 41 30 148 organizations 1 1 1 1 4 total 418 1276 956 935 3585 source: federation of hotel & restaurant associations of india (fhrai) 3. case illustration approach to achieve the objective of study, we undertake two case examples while validating new valuation model, namely the oberoi hotels (formerly eih ltd) and the leela hotels (formerly hotel leelaventure ltd). 3.1 the oberoi hotels (eih ltd) eih ltd is the flagship company of oberoi group and the largest chain of hotels in india. it is in the business of luxury hotels, restaurant, management contracts and travel and tours. the oberoi group, founded in 1934, employs more than 12000 people worldwide and operates 28 hotels & three cruisers in five countries under the luxury ‘oberoi’ and five-star ‘trident’ brands. apart from the core business, it is engaged in flight catering, airport restaurants, travel and tour services, car rentals, project management and corporate air charters. trident hotels are five-star hotels that have established as a reputation for excellence and are acknowledged for offering quality and value. these hotels combine state of the art facilities with dependable service in a caring environment, presenting the ideal choice for business and leisure travelers, presently there are nine trident hotels in india. mr. p.r.s. oberoi is the chairman and chief executive officer of eih limited (the oberoi group). he is also the chairman of oberoi hotels private limited, the major shareholder of eih limited, known as ‘biki’. mr. oberoi is the son of late rai bahadur m.s. oberoi, the founder of the oberoi group. in january 2008, oberoi awarded as ‘padma vibhushan’, india’s second highest civilian honor, in recognition of his exceptional service (hospitality and tourism) to the country. in august 2010, oberoi hotels pvt ltd, aravali polymers llp and prithvi raj singh oberoi sold 55.47 million shares, representing approximately 14.12 per cent of the share capital of the company to reliance industries investment and holding pvt ltd. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 91 3.2 hotel leelaventure ltd hotel leela venture ltd was incorporated in 1981. leela entered into collaboration with penta hotels, uk to set up and operate 5-star hotels, which was subsequently transferred to kempinski hotels, a european chain of 5-star deluxe hotels, owned by lufthansa, the german airline. in 1986, the company set up their first 5-star deluxe hotel namely leela penta, in mumbai. the hotel was renamed as leela kempinski in 1988, subsequent the change in their marketing and sales tie-up. leela operates in both, the leisure and business sectors. the leela palaces and resorts include a chain of five star luxury hotels and resorts. the company properties include the leela kempinski in mumbai, the leela palace in goa, the leela palace kempinski in bangalore and the leela kovalam in kerala. the company became a popular name in the hospitality industry in india because of their high quality of service and customer relations. in a nut shell, leela operates six hotels in various locations mumbai, bangalore, goa, kovalam, udaipur and gurgaon comprising 1523 guest rooms and 90 serviced apartments. leela group is engaged in the business of ready-made garments and luxury hotels and resorts, founded in 1957 by capt. c.p. krishnan nair. it was in 1957 when capt. nair, after completing his stretch in the army, set up a small industrial unit in suburban mumbai. inspired by the handloom weaving industry in cannanore, kerala was india’s first and only lace manufacturing plant ‘leela scottish lace ltd’. 4. review of literature the review of literature includes associated studies on business valuation, merger valuation, factors effecting on valuation and estimation of free cash flows; however these are organized in sequence to support the study. most of the academicians and researchers have studied comparison of dcf, ddm and ri methods (plenborg, 2002; bailey et al., 2008; velez-pareja & tham, 2010), effect of earnings management on firm value (chaney & lewis, 1995), cultural distance and firm valuation (antia et al., 2007), tobin’s q as an estimate of market valuation (yermack, 1996), predicting future cash flows (misund et al. 2008) and impact of mergers on firm value (ma et al., 2010). antia et al (2007) examines the value impact of cultural differences that exist between foreign subsidiaries and headquarters of u.s. multinational corporations (mncs). they found negative relationship between cultural distance and firm valuation. most of the individual cultural attributes that make up the index have a negative effect on firm valuation. the findings are consistent with the notion that cultural differences decrease firm value by imposing a barrier to the exploitation of internalization advantages. bai et al (2004) investigate empirically the relationship between governance mechanisms and the market valuation of publicly listed firms in china. they construct measures of corporate governance and market valuation for all publicly listed firms on two stock markets in china from the firm’s annual reports during 1999-2001. their results support several theoretical predictions that both high concentration of non-controlling shareholding and issuing shares to foreign investors have positive effects on market valuation. fernandez (2007b) summarizes compendium of ten methods including: free cash flow; equity cash flow; capital cash flow; adjusted present value; business’s risk adjusted free cash flow and equity cash flow; risk-free asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 92 rate-adjusted free cash flow and equity cash flow; economic profit; and economic value added. these ten methods always give the same value. finally, he concludes by analyzing ten methods of company valuation using discounted cash flows and nine different theories about the vts. lin & su (2008) investigate the relationship between industrial diversification and firm valuation for a sample of 816 publicly listed firms in china. they found that when the decision to diversify is modelled as an endogenous choice based on firm characteristics, multi-segment firms have significantly higher tobin's q than single-segment firms, even after controlling for factors such as ownership structure, ownership concentration, and growth opportunities. misund et al (2008) suggest that contemporaneous earnings are more useful than current operating cash flow in predicting future cash flows and more relevant for company valuation. they found that the value relevance of cash flows actually decreased in the recent oil industry upheaval. bailey et al (2008) states that residual income model (rim) provides better estimates of firm value than two other commonly used dcf and ddm models. further, there is less need to forecast returns as far into the future and with this model, a terminal value based upon a constant future return (or relatively low growth rates) can be used. on the other hand, plenborg (2002) compares dcf and rim. the two valuation approaches are compared on the basis of analytical attractiveness. rim yields more accurate firm value estimates, while in others the dcf approach yields more accurate estimates. finally, the framework for forecasting is often based on accrual accounting and the budget control is generally based on accounting numbers rather than cash flow numbers. interestingly, velez-pareja & tham (2010) compute cash flows namely, cash flow to debt (cfd), cash flow to equity (cfe), capital cash flow (ccf), free cash flow (fcf) and tax savings (ts). they use direct and indirect methods to derive the relevant cash flow profiles for the different stakeholders. these cash flows are the basis for the valuation of a firm or project. other studies include, wilcox et al (2001) uses event analysis to examine 44 m&a events involving 89 partners in the telecommunications industry. their study formulates and tests hypotheses relating the impact of near and far diversification, and the size of the firm, on market valuation. their results suggest that while overall these events weight positively on market value, m&a involving near-diversification and larger firms tend to experience greater valuation effects. yermack (1996) evidences the consistent with theories that small boards of directors are more effective, using tobin’s q as an approximation of market valuation. the study found an inverse association between board size and firm value in a sample of 452 large u.s. industrial corporations during 1984-91. the results are robust to numerous controls for company size, industry membership, inside stock ownership, growth opportunities, and alternative corporate governance structures. in summary of the above literature, there is no method or model or theory that undertakes macro and political factors while determining firm value, particularly in m&a practice. on the other hand, time has been changed from home-made to local market, public to private, domestic to international and multinational to globalization, since the modern business needs asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 93 new financial models, theories, methods, approaches and innovations for the next generation corporate finance to protect the stakeholders believe and trust. consequently, it gives us an opportunity to introduce new model in valuation, particularly our study is aimed to suggest a method for hotels and resorts with the help of two case examples. 5. research method 5.1 objective of the study m&a have become a popular vehicle for cash-full and rising companies to rapidly access new markets, assets and capabilities. the motive behind our study is to develop new financing models in the upcoming area of m&a advisory. exclusively, it suggests a new valuation cum forecasting model to build theories, concepts and strategies in the emerging field of corporate finance. 5.2 data collection and analysis we have collected data from recognized sources and used as the background of study, literature review, two case examples (eih and leela) and other imperative factors, which is required for modelling a new valuation model. the main profile of case examples extracted from leading business news papers, referred publications and company’s official sites, for example india infoline data warehouse. the data including market capitalization, market share and financial statements of both companies and industry information were absorbed from cmie prowess database, fhrai and ministry of tourism. the financial data of two case examples has been analyzed under nrr approach, expressed in methodology section below. 5.3 valuation methodology growing importance of ‘business valuation’ as a specialized area in corporate finance, we suggest a new method, namely the process which is modeling forecasting hurdle rate (fhr), modified net asset valuation model, computation of goodwill and firm valuation. first, we compute fhr, then statement of free cash flows (fernandez, 2003; 2007b), estimating future sales growth rate, there after future free cash flows and finally determination of enterprise value (vc). the nrr methodology flow chart is presented in figure 1 below. however, this model is first version and final edition of nrr approach will be developed accordingly. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 94 figure 1. firm valuation and cash flows nrr approach asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 95 5.3.1 forecasting hurdle rate (fhr) forecasting is the process of estimation in unknown situations from the historical data for the purpose of future decision making. there are various models suggested by economics and finance scholars. here, we develop a model that named as “forecasting hurdle rate” by using various economic, political, industry, financial and production factors. the main objective of model is to find out the relative rate for estimating sales or revenues. the acquirer may consider various above said factors while valuing the business or company. forecasting hurdle rate (fhr) = 1 dnsgr 2 ghgr ms grat ms ddt pcms grat pcms ddt wpi. gr cm. r ex. r prst tr 100 (1) where, dnsgr is domestic net sales growth rate, ghgr is global hospitality growth rate, ms is market share of select case, grat is growth rate in arrival of tourists, ddt is domestic demand in tourism, pcms is prime competitor market share, wpi.gr is whole sale price index of food articles (growth rate against five preceding years), cm.r is commercial risk, ex.r is exchange risk (rupee vs. us$), prst is political risk for special transactions, tr is transfer risk and log is logarithm. 5.3.2 estimating future free cash flows (ffcf) before estimating ffcf, first we compute the statement of free cash flows on the basis of last year (2009-10) financial information. the fcfs are the fundamental base to project the ffcf (damodaran, 1996) with respect to cash flow productive rate. fcf is computed under the regulations of indian accounting practices. after, computing various ratios with respect to sales and assets, the same percentage has undertaken to estimate future free cash flows. this is an abridged formulae and stating that consider while estimating firm value under dcf method. since, it has been suggested for further research to the next version of nrr. estimated sales = c e current sales (2) (estimated sales growth rate = five years average sales growth rate1 + fhr) 5.3.3 modified net asset valuation model (mnavm-nrr approach 1.0.) wholly, we compute total value of company or business by using ‘net asset valuation model (navm)’. this model primarily used to compute the total value of company in terms of equity and debt. it would be a considerable method for evaluating business value as a part of m&a negotiations. vc = mve + vd + vg (3) 1 average growth rate for sales computed on year-on-year (yoy) basis and we ignore the current year sales growth rate, i.e. 2009-10 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 96 where, vc = total value of the company; mve = modified value of equity2; vd = value of debt; vg = value of goodwill3 5.3.4 computation of goodwill goodwill factor has not been considered as a separate element in most of the methods (plenborg, 2002; bailey et al., 2008; velez-pareja & tham, 2010), though nrr considers goodwill as an elective in service industries. for example, hospitality is the leading service industry which creates name and fame of an organization in the mindset of visitors and society. moreover in five star categories, room occupancy ratio is mainly depends upon the name of ‘brand & identity’. for justification and address this hospitality experience, we modified ‘average profits method’, while computing goodwill of an organization to consider different risks connected with business cycles, economic & financial melt-down and sub-prime mortgage crisis. the consideration of goodwill is equal to ‘average value of last five years profits or current year profit, whichever is higher. 6. results and discussions to achieve the objective of study, we took net asset valuation model (navm) as the better comparison method. first, we present value of two selected companies under both methods in table 2 below. navm comprises value of equity (ve) and value of debt (vd), where this study uses modified value of equity (mve), value of debt (vd) and value of goodwill (vg) in nrr model. therefore, we use fhr as the relative rate to maximise the value of equity in each case and computed value of goodwill by modifying ‘average profits method’. because the selected hospitality industry and its business mainly depend upon name &fame, quality of service and development of tourism, etc. the study suggests valuation of hotels under nrr approach would be first bargaining price in m&a process. 2 see figure 1 and case examples in table 2 3 see figure 1 and case examples in table 2 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 97 table 2. valuation of eih limited and hotel leela under nrr approach (in rs. crore) particulars eih limited hotel leela nrr approach navm nrr approach navm a modified value of equity amount amount amount amount first max 5925.75 2210.60 second max 5878.59 2193.15 average market cap 5902.17 2201.88 forecasting hurdle rate (fhr) 5.30 4.92 modified value 6214.99 2310.10 value of equity on sept 30, 2010 5350.7 2047.72 b value of debt total borrowings 1254.39 1254.39 2878.66 2878.66 c value of goodwill five years average profit 161.98 107.78 current year profit 57.23 41.02 maximum value 161.98 107.78 enterprise value (a+b+c) 7631.36 6605.09 5296.54 4926.38 prior to detail discussion on value comparison between nrr and navm, describes that ‘average market cap’ is the average of first max and second max (see figure 1). further, modified value can be defined as multiple of average market cap and fhr. conversely, value of goodwill equals to maximum value of five years average profit and current year profit. for nrr approach, enterprise value of (vc) of eih and hotel leela is rs.7631.35 crore and rs.5296.54 crore. moreover from the acquirer’s point of view, the value is opening bidding price, conversely from the target firm point of view, this is reasonable but not finally decided price. debt/equity (d/e) ratio in both cases 0.89 and 1.41 respectively. the enterprise value of eih and leela under nrr approach is higher than navm, i.e. rs.1026.27 crore and rs.370.16 crore respectively. therefore, shareholders of target firm would be getting a reward price of his own shares under this model. at the end of day, the existing shareholder should not feel sting. second face of the objective of study presents future free cash flows (ffcf) by estimating the sales growth rate and referred ratios with respect to sales. figure 2 shows the ffcf of eih and hotel leela for the period 2011 to 2020, which is estimated on the basis of ‘2010’ financial data. the sales will grow by 14.07 per cent and 17.54 per cent in each case of eih and hotel leela. according to future plans of two companies, the sales will grow additionally by 10 per cent from 2013 onwards. the compensation paid to employees is occupied as the most operating expenses in both cases and will increase additionally by 6 per cent annually as incremental cost. the remaining operating expenses as the same referred ratios in base year. further will am cent in non-ope ‘increas assume nopla inferenc while e 7. conc entrepr making phases/ embark firm va value b the outc attract investm since th income exclusi on busin -40 -20 20 40 60 80 f c f ( ` c ro re s) , we estima mplify at 5 p eih ltd an erating inco se/decrease that no cha at, operatin ce and disc stimating fi clusions reneurs hav g purpose. stages by c ks on hospit aluation und y adding up come value the shareho ment banker he nrr ap based mo ively, we ac ness valuati 00.00 00.00 0.00 00.00 00.00 00.00 00.00 20 10 figure 2. ate the gros per cent ann nd 40 per c ome will ris in working ange till 202 ng expense cussion. ff irm value un e a curiosit the prese considering tality case e der indian a p value of g from the n olders of ta rs and m&a pproach see odels like r cknowledge ion inspire u 20 11 20 12 eih limited hotel leela 线性 (eih li 线性 (hotel l . ffcf of e ss taxable a nually in bo ent of 2010 se annually g capital’ is 20. further, s and comp cf can be nder discou ty knowing nt study s diverse imp examples (o accounting p goodwill an nrr approa arget firm. a advisory ems to be a ri to dcf e fernandez us to develo 20 13 20 14 mited) leela) 98 eih and hot amount agai oth cases. c 0 capital exp by 10 per c s computed study also c pensation e discounted unted cash fl about the v suggests a perative fac oberoi and practices. n d it is more ach is reaso we hope firms in m an attractiv f (plenborg z (2002, 20 op this first 20 15 20 16 yea asian tel leela, 20 inst sales, o capital expe penditure in cent in both d with respe computed s expenses w d for presen low (dcf) value of his new firm ctors in bus leela) to v nrr approa e than the n onable, fair this model modelling v ve under as g, 2002; v 03, 2007a version of n 20 16 20 17 20 18 ar n journal of f 201 010-2020 on the other enditure wi n case of h cases. the ect to sales selective rat ith respect nt value aga method. s company valuation siness envir validate the ch results s navm. the and relative may give valuation fo sset based m velez-pareja & 2007b) f nrr appro 20 18 20 19 20 20 finance & ac issn 19 11, vol. 3, n www.macrothi r hand depr ill increase hotel leela. balance sh s in both ca tios like ebi to sales fo ainst discou for future d model in ronment. th e nrr appr show fresh b study belie e value, wh much atten or hotels & models com a & tham, for his cont ach 1.0. 20 20 ccounting 946-052x no. 1: e6 ink.org/ajfa reciation at 5 per finally, heet item ases and it, fcf, or better unt rate, decision various he study roach in business eves that hich may ntion to resorts. mpare to , 2010). tribution asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 99 however, study has certain limitations. we have not considered inflation rate while estimating operating expenses in free cash flow process. the model has two facets, uses both environmental and accrual accounting information. hence, it has not aimed to compare with any rim, ddm or dcf methods. the nrr approach mainly fits for service entities like hospitals, hotels & restaurants, spa, tours & travels and educational institutions. finally, this model could not match the requirements of businesses other than services. future researchers with in this area may apply nrr 1.0. valuation model to validate in manufacturing business, conversely comparison of different valuation models and primary research on valuation practitioners. further, model could be improved by altering any of the variables to be fit for valuation consultants. endnotes forecasting hurdle rate has computed by using various parameters, which compiled from believable sources. dnsgr domestic net sales growth rate in hospitality 0.13 ghgr global hospitality growth rate 0.06 ms market share of select case eih and leela 0.16, 0.09 grat growth rate in arrival of tourists 0.093 ddt domestic demand in tourism 0.082 pcms prime competitor market share (taj group of hotels) 0.28 log wpi.gr log whole sale price index (food articles) change {(2010 index – average of 2005-2009 index)/ average of 2005-2009 index}× 100 1.4845 log cm.r log commercial risk log 3 log ex.r log exchange risk (rupee vs. us dollar) {(present rate – 184 day average)/184 day average} × 100 present rate on sept 30, 2010. 0.45 log prst log political risk for special transactions log 2 log tr log transfer risk log 3 fhr forecasting hurdle rate (%) (eih and leela) 5.30, 4.92 note: market share computed by compiling sales for the year 2009-10; total industry sales: rs. 5268.94 crore acknowledgements: the abridged version of this paper has been presented at international finance conference (fincon-2011) organized by management development institute, gurgaon and university of connecticut business school, usa during jan 07-08 and thanks to the participants for their valuable comments and feedback. we also thank mr. deepak bhat, information officer, centre for monitoring indian economy (cmie) private limited, mumbai and his intuitive suggestions on the manuscript is profoundly acknowledged. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 100 references antia, m., lin, j.b. & pantzalis, c. 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(2001). valuation of mergers and acquisitions in the telecommunications industry: a study on diversification and firm size. information & management, 38(7), 459–471. http://dx.doi.org/10.1016/s0378-7206(00)00082-3 yermack, d. (1996). higher market valuation of companies with a small board of directors. journal of financial economics, 40(2), 185-211. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e6 www.macrothink.org/ajfa 102 http://dx.doi.org/10.1016/0304-405x(95)00844-5 further readings bindal, h. (2010). make the most out of india growth story. et investor’s guide -the economic times, 2 (oct 18). india infoline data warehouse, available at: www.indiainfoline.com, last accessed on sept 21, 2010. roy, d. (2010). attrition hits indian hospitality. available at: http://economictimes. indiatimes.com/features/financial-times/attrition-hits-indian-hospitality-industry /articleshow/6675470.cms, last accessed on oct 10, 2010. peck, s. & temple, p. (2002). mergers and acquisitions – critical perspectives on business and management (eds). routledge – taylor & francis group. ragozzino, r. (2006). firm valuation effects of high-tech m&a: a comparison of new ventures and established firms. journal of high technology management research, 17(1), 85–96. http://dx.doi.org/10.1016/j.hitech.2006.05.006 tourism & hospitality, india brand equity foundation, (2010), available at: http://www.ibef.org/artdispview.aspx?in=74&art_id=26026&catid=120&page=1may, last accessed on sept 30, 2010. west, t.l. & jeffrey, j.d. (1999). handbook of business valuation, second edition. john wiley & sons inc. appendix i: financial analysis of eih limited and hotel leelaventure limited, 2006-2010 hotel oberoi (eih limited) hotel leelaventure limited 2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 total borrowings/net worth ratio 0.68 0.67 0.62 0.72 0.89 1.28 1.06 2.19 1.20 1.40 net profit ratio (np) 24.96 21.34 19.33 18.07 6.95 22.36 32.07 27.69 30.72 9.12 return on net worth (ronw) 18.06 17.07 16.64 12.02 4.04 8.87 14.01 15.97 7.13 2.00 return on capital employed(roce) 13.86 14.20 15.57 10.61 3.15 5.67 9.59 7.24 4.14 1.24 return on assets(roa) 8.73 8.66 8.60 5.94 1.86 3.54 6.04 4.54 2.94 0.77 return on fixed assets(rofa) 13.83 13.25 12.33 8.60 2.63 4.73 7.38 5.66 3.32 0.84 current ratio(cr) 1.40 1.15 1.06 1.20 1.32 3.81 1.93 3.11 1.53 1.44 quick ratio(qr) 1.25 1.02 0.94 1.10 1.20 3.55 1.66 2.92 1.40 1.28 debtors turnover ratio(dtr) 5.17 6.11 5.76 3.87 3.25 1.64 2.18 1.78 1.15 1.45 asset turnover ratio(atr) 0.35 0.41 0.44 0.33 0.27 0.16 0.19 0.16 0.10 0.08 fixed assets turnover ratio(fatr) 0.55 0.62 0.64 0.48 0.38 0.21 0.23 0.20 0.11 0.09 note: authors computed manually and the formulae may varies with other studies microsoft word revised exploring-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 189 exploring the herding behaviour in indian mutual fund industry ms. archana patro participant, fellow programme in management indian institute of management indore prabandh shikhar, rau-pithampur road, indore 453331 mp, india e-mail: f09archanap@iimidr.ac.in prof. a. kanagaraj faculty of finance and accounting indian institute of management indore prabandh shikhar, rau-pithampur road, indore 453331 mp, india e-mail: kanagaraj@iimidr.ac.in received: march 6, 2012 accepted: april 5, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1478 url: http://dx.doi.org/10.5296/ajfa.v4i1.1478 abstract the present study analyzes the trading activity of indian mutual funds and investigates whether indian mutual fund managers are engaged in herding behaviour. results are compared with previous studies in mature as well as developing markets to determine the level of maturity of the indian capital market. measure of herding developed by lakonishok et al. (1992) has been used. the study found strong evidence of herding in the overall sample. managers herd primarily when they trade in large capitalization stocks or stocks that belong to the most famous indices. the herding effect seems to affect both purchases and sales of stocks. the level of herding is more in indian stock market as compared to developed markets. furthermore, the indian mutual funds tend to herd more often when purchasing than when selling a stock, and when trading large stocks. the study will contribute to the discussion regarding market efficiency and traditional asset pricing models validity. evidence on herding by institutional investors, could explain whether there are different types of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 190 investors having different trading pattern. investigating herding on indian mutual funds would help researchers, investors, traders and regulators. keywords: mutual fund, herding, behavioural finance, lsv measure, institutional investors asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 191 1. introduction as we go through the underlying assumptions for efficient market hypothesis (emh) and the capital asset pricing model (capm), it triggers certain questions among the researchers about the validity of these assumptions in the real world. (frankfurter and mcgoun, 2001) says this is because the assumptions imply investors are totally keen, penetrating and rational in calculating the numbers that are required for making investment decisions. it might be the reasons of their simplicity and suitability for advanced mathematical models, these assumptions have formed a foundation that had not been questioned for several decades. behavioural finance has upset the very foundation of traditional finance theories. according to behavioural finance it is the vary phenomena of human natural tendency to behave differently to different situations. one such phenomenon is herding. it is defined as heavy buying or selling by specific groups of investors in the same stocks over a period of time. it is defined as a group of investors following each other into or out of the same securities over some period of time (lakonishok et al. 1992; sias 2004).herding becomes more important if finance professionals and experts exhibit such behaviour, as they are supposed to be the most rational and efficient persons according to the traditional approach. if these individuals will not verify the traditional approach with their behaviour, the concept cannot hold at all. there is a popular belief that institutional investors are irrational herding into and out of stocks without fundamental justification. because of high trading volumes institutional herding is suspected to dilute the information quality of stock prices, exacerbate stock price volatility, and destabilizes capital markets by driving prices away from fundamentals (scharfstein and stein, 1990). this paper test for herding by indian mutual funds. the present study is focused on mutual funds as majority of corporate equities are held by them, and their trade volume proportion is higher for institutional herding to be observed. the indian mutual fund industry has witnessed a significant growth in the past few years driven by several favourable economic and demographic factors such as rising income levels and the increasing reach of asset management companies (amcs) and distributors. further enabling support from the regulator sebi and proactive initiatives from the industry bodies cii and amfi, which are likely to be the key components in defining the future shape of the indian mutual, fund industry as said by abizer diwanji head financial services kpmg india. the low penetration levels combined with rapid growth in the assets under management in recent years will find a place for the high growth potential of the indian mutual fund industry. india has been amongst the fastest growing markets for mutual funds since 2004, witnessing a cagr of 29 percent in the five-year period from 2004 to 2008 as against the global average of 4 percent industry assets under management is likely to continue to grow in the range of 15 to 25percent from the period 2010 to 2015 based on the pace of economic growth, kpmg (2009) looking at the importance of mutual funds in indian economy, the purpose of this study is to investigate to what extent the indian mutual fund industry exhibit herding behaviour. the paper also analyze the data in relation to the results obtained from previous studies in mature as well as developing markets, and thus provide financial research with valuable insights into asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 192 the level of maturity of the indian capital market. thus the paper contributes to the body of literature by analyzing the herding behaviour for a very recent time period, giving fresh estimates of herding based on data on a changing indian financial market. 2. literature review herding refers to the human tendency to imitate the behavior of others, which leads to a group of people acting in a similar way (lemieux, 2003, 2004). the tendency to trade in the same direction can be categorized into intentional and unintentional herding. scharfstein and stein (1990) tried to explain intentional herding by stating that fund managers may disregard their private information and trade with the crowd due to the reputation risk of acting differently from their peers. an alternative theory points out that fund managers might gather private information from the prior trades of better-informed managers and trade in the same direction (bikhchandani et al., 1992).the approach to unintentional herding by froot et al.(1992) is that managers may trade together solely because they receive correlated private information, e.g. by analyzing the same indicators. examining herding behavior can grant investors a higher degree of understanding regarding the price formations in financial markets. chang et al. (1999) show the study of herding behavior is important as share prices are substantially affected by market participants’ investment behavior. it has been linked to some market inefficiency, which cannot be explained by the rational asset pricing model, when an investor’s investment decision is based on collective information rather than private information, it might drive stock away from its fundamental value. therefore, herding behavior is a signal of market inefficiency. consequently, the existence of herding behavior suggests that the real world market is not as efficient as the rational asset pricing model might expect. extensive research has investigated the level of herding behavior in developed as well as developing markets. the findings are contradictory from country to country. christie and hwang (1995) have found that there is no significant herding in us markets, as securities return dispersion increases instead of decreasing during periods of large price movements. chang, et al. (1999) displays similar results, namely there is no significant level of herding in the united states, hong kong and japan. caparrelli, et al., (2004) also found that herding is only present during extreme market conditions in the italian market. furthermore, nofsinger and sias (1999) use their own approach and show that herding behavior is in fact present in us market as they find that there is a strong positive correlation between changes in institutional ownership and excess returns measured over the same period in the market. these findings provide evidence that there has been a high level of herding behaviour among institutional investors in us markets. iihara, et al., (2001) examine the herding behaviour observable in three groups of investors individual, institutional and foreign, in the tokyo stock exchange (tse) using the approach of nofsinger and sias (1999). their finding illustrates that japanese individual and institutional investors are more likely to engage in positive feedback trading strategies and are therefore more likely to herd, while foreign investors’ investment decisions tend to be based on information. therefore, their result is consistent with nofsinger and sias (1999). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 193 for instance, demirer and kutan (2005) investigate the potential existence of herding behavior in chinese stock markets by using the approach proposed by christie and huang (1995). they examine both a-share and b-share in shanghai and shenzhen stocks markets. in addition, they expect that herding levels would be different between the shanghai and shenzhen exchanges because of different market characteristics, namely the former has a larger market size; the former consists of large state-owned enterprises, while the latter consists of mainly manufacturing and export companies; and the former is considered as being more informed. thus, they expect that there would be a higher level of herding behavior in the shenzhen stock market. their research results are similar to that of with christie and hwang (1995) and being favorable towards rational asset pricing models. nonetheless, tan et al. (2007) find conflicting result in their study of herding behavior in both shanghai and shenzhen stock exchanges by following the csad approach. their finding shows that herding behavior exists in both shanghai and shenzhen, a-share and b-share markets. chang et al. (1999) also demonstrate that there is evidence of herding behavior in south korea and taiwan. they argue that this behavior may be a result of incomplete information disclosure in emerging markets and the greater importance of macroeconomics with regard to investor decision-making, in turn making them more likely to herd around. institutional investors may herd not so much because of imperfect information, although this might happen as well, but primarily (and for the long term) due to reputational concerns (bernhardt et al. 2006) and compensation structures (clarke and subramanian, 2006). an investment manager will probably not face personal professional damage if he fails when the others have failed as well, but is very likely to lose his job if he significantly under performs the market (hirshleifer and teoh, 2003). consequently, this could lead to permanent behavioral biases for the investment managers, since a risk-averse manager has a large incentive to follow the market consensus to avoid professional implications. krous (1972) et al. first uses 229 monthly data of mutual funds and bank trust institutions from jan.1968 to sep. 1969 to test institutional group behavior. they find that mutual funds tend to imitate the strategies of their more successive counterparts, and they call it “follow leaders" strategy. lakonishok, shleifer and vishny (1992) use the percentage of investors that are in one-side markets to study whether there exists herding between managers of stock funds exemption from duty in america, and they further test this based on classifications according to sizes of shares, historical performance and asset scale of funds, etc. they find that these funds do not exhibit significant herding but there exists a little herding in transactions of stocks of small companies. grinblat, titman and wemers (1995) study on portfolios of 274 mutual funds in a period of 1974-1984 and get a similar result. generally, lsv method is most widely used for its simplify and the availability of data. wemers (1999) takes all the funds in american stock markets between 1975-1994 as the object of the study, and find herding is very obvious for total funds based on a further study, and the herding tendencies of different funds have great differences. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 194 shidonghui (2001) analyzes the herding behavior of chinese investment funds, and the results show that more than 75% of funds are at the same side in markets, herding is very serious. júlio lobão(2002) test for herding by portuguese mutual funds over the period of 1998 to 2000 and found strong evidence of herding behaviour for portuguese mutual funds. furthermore, their results suggest that the level of herding is 4 to 5 times stronger than the herding found for institutional investors in mature markets. the herding effect seems to affect, as likely, purchases and sales of stocks. there seems to be a stronger tendency to herd among medium-cap funds rather than very large or very small funds, and among funds with fewer stocks. lastly, herding seems to decrease when the stock market is doing well or is more volatile. yuan ke and chen hao (2003) test completely the herding of investment funds in stock markets of shanghai and shenzhen by referring to the method (lsv method) of lakonishok (1991), and find there exists strong herding between mutual funds in chinese stock markets. qi bin et al. (2006) use the classic lsv method and the method extended by wermers to study empirically behaviors of institutional investors of which the preventatives are mutual funds in china. angelo manganaro (2007) investigates the tendency to herd by 124 swedish equity mutual funds over the period of 2000 to 2007. by employing the measure developed by lakonishok et al. (1992) they found strong evidence of herding in the overall sample. nikolaos theriou1 (2010) analyzed portfolio holdings of 31 mutual funds using the methodology proposed by lakonishok et al. (1992). the study concludes that mutual fund managers undoubtedly herd, with the extent of herding being irrelevant to the price movements observed in the market. managers herd primarily when they trade in large capitalization stocks or stocks that belong to the most famous indices. empirical studies on herding in indian context are very few.gokhan sonaer (2011) examines whether herding by actively managed equity funds affects their performance. first the effect of herding on stock returns is re-examined and evidence is found that, during the herding quarter, stocks bought intensely by herds outperform stocks sold intensely by herds. controlling for subsequent quarter herding, this performance difference reverses, an indication that herding drives prices away from their fundamental values. it is also shown that herding funds benefit from this activity during the quarter in which they herd. introducing the concept of leader and follower funds this study shows that the subsequent quarter performance of funds that lead the herd is superior to that of follower funds. sanjay sehgal and neeta tripathi (2009) in their paper empirically evaluate if foreign institutional investors (fiis) adopt positive feedback and herding strategies in the indian environment and found that fiis exhibit return chasing behavior when they use monthly data. however, they do not seem to be working on the positive feedback strategy when they used daily files. this may be owing to the fact that they wait for the market information to crystallize and do not react to it in an instantaneous manner. the study also observes that the fiis display strong herding behaviour based on quarterly shareholding pattern. the herding behaviour seems to be stronger at the aggregate level than at the individual stock level. this asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 195 may be explained by the fact that fiis are more cognizant of corporate fundamentals at the individual stock level. further, the market cycle behaviour may vary from such cycles for individual stocks. their findings have strong implications for domestic financial institutions, portfolio managers, wealth managers and other investors as well as market regulators who wish to have better understanding of fiis behaviour as the later are the dominant investors in the indian equity market. paulo lao and harminder singh (2011) in their study examine herding behavior in the chinese and indian stock markets. the study employs the cross sectional absolute deviation (csad) approach proposed by tan, chiang, mason and nelling (2008) to measure herding behavior. the findings suggest that herding behavior exists in both the chinese and indian stock markets depending on some market conditions. in the chinese market, herding behavior is greater when the market is falling and the trading volume is high. on the other hand, in india the study finds herding behavior during the up market. herding behavior is more predominant during large market movements in both markets. relatively, there is lower prevalence of herding behavior detected in the indian stock market. however, chinese and indian stock markets are believed to be riskier and less mature than the developed stock markets. even though the herding behavior has been examined in some studies, we have tried to contribute to the literature by proving the evidences of herding in indian mutual funds. through this paper the present study covers a recent time period, to our knowledge, not investigated before in indian context 3. objective of the study the following hypotheses are to be tested in the study. hypothesis 1: the indian mutual funds exhibit herding behavior. hypothesis 2: higher level of herding is found in the trading of small capitalization stocks. managers of larger funds have more resources and should therefore be able to extract more accurate private information. smaller funds with fewer resources will more often have to mimic each other’s trading decisions, bikhchandani et al. (1992). hypothesis 3: the tendency to herd increases with the number of funds trading a specific stock within the period. the expected level of herding in the indian fund market is higher than for more developed markets. less developed markets have lower information efficiency; therefore the investors may base more of their decisions on information from the trades of their peers, bikhchandani et al. (1992). 4. research methodology the database created for the analysis of the study consists of the portfolio holdings of 30 indian domiciled equity mutual funds. while selecting the sample, certain criteria have been followed. schemes which are in operation and are non index equity diversified have been asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 196 selected.futher growth funds were included in the sample. the target sample of the study was collected from the website of the association of mutual funds in india (amfi).portfolio holdings database quarter wise from the quarter june2009 to june 2011, i.e. for 10 quartes was created for the study. after extracting required information from the first and the last quarter of holdings, the remaining sample covers 9 quarters over the period of march 2009 to june 2011.over the whole sample size of 500 different indian stocks are traded by at least one fund. the number of stocks within a quarter traded by at least one fund summed over the total period provides with 1893 stock-quarters. finally, the dataset consists of 8256 observations of changes in stock holdings in indian equity by the funds. the study uses the measure of herding designed by lakonishok et al. (1992), the so-called lsv measure. lakonishok schleifer vishny (lsv, 1991) can be regarded as the pioneers of empirical tests of herding behaviour this is the measure most widely used in empirical studies of mutual fund herding behaviour. the lsv measure estimates the degree of correlated trading among a specific group of investors. herding behavior is defined as the average tendency of mutual funds to trade a given asset (stock) in the same direction under the same time period above what would be expected if the funds were trading independently. the lsv herding measure, hm, for stock i in period t is defined as: hmi, t = │pi, tpt│-afi, t (1) where pi, t = and pt = (2) bi, t (si,t) is the number of funds that buy (sell) the stock i during the period t. thus, pi, t is the proportion of funds trading the stock i, t during the period t that were buyers. pt is the average proportion of trades over all funds that were purchases in the period t. pt corrects for the expected proportion of buyers under the null hypothesis of independent trading. it is calculated separately for each time period, since it could depend on the net capital inflows to the funds during the period. the first part of the lsv measure, |pi, t − pt|, is defined in absolute value and as a result the expected value would under random variation differ from zero. the adjustment factor, afi corrects for this randomness. afi, is the expected value of |pi,t − pt| estimated under the assumption that the direction of the trades follows a binominal distribution with bi, and t si,t as possible outcomes. under the null hypothesis of independent trading the probability of bi, equals pt .the adjustment factor accounts for bias that would occur in |pi, t − pt| for stocks traded by a low number of funds. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 197 a positive value of hmi t gives evidence of herding within a stock-quarter. the calculated values of hmi,t are averaged for a given subgroup of funds and then over time periods. the adjustment factor and pt for each subgroup of funds are based only on the trading of that subgroup. the measure hmi,t is expected to be calibrated to zero, if no herding actually exists. since the first expression of the lsv measure hmi, t is defined in absolute value (|pi,t pt|), without inclusion of the adjustment factor afi,t, the measure is likely to take positive values, even where no herding exists. the ordinary lsv measure does not take into account if the herding behaviour is more pronounced in one direction of the trading. wermers (1999) modified the measure and designed a buy-side and a sell-side herding measure, bhmi,t and shmi,t respectively. the measures are calculated in the same manner as the ordinary lsv measure, but conditioned: bhmi,t = hmi,t│pi,t > pt (3) smei,t = hmi,t │pi,t < pt (4) the bhmi,t measure includes the stock-quarters where the tendency to buy, pi,t , is higher than the average tendency, pt , for the period. the shmi,t measure calculates herding within the stock quarters where the tendency to buy is lower than the average tendency. 5. data analysis and discussion table 1. summary statistics for indian equity mutual fund holding database (june 2011-09) quarter wise portfolio data quarters q1 q2 q3 q4 q5 q6 q7 q8 q9 average a. fund counts no. of active funds in database 30 30 30 30 30 30 30 30 30 30 b. net asset fund value total net assets of funds (avg) in percentage 98.20 99.58 99.07 96.03 95.62 92.89 69.68 83.84 26.75 84.62 c.asset counts number indian stocks held per fund 40 42 38 36 32 30 28 34 37 35.222 d. trading statistics total number of trades 923 952 918 956 999 1003 952 800 753 917.33 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 198 total trades that are buys 326 267 294 406 358 392 383 313 249 332 percent of trades that are buys 35.32 28.04 32.02 42.46 35.83 39.08 40.23 39.13 33.07 36.13 e.number of stocks traded by ≥ 1 fund 179 173 161 165 165 188 173 139 152 166 ≥ 2 funds 72 31 18 12 23 21 20 19 22 26 ≥ 5funds 18 4 4 7 8 12 8 11 9 9 ≥ 10funds 2 3 2 2 8 3 4 6 5 4 ======================================================= =============== notes: the indian equity mutual fund holdings database of my sample contains of portfolio holdings data from the period march 2009 to june2011.summary statistics of the funds in the sample are reported above as for the first quarter within each year and for the average values of the overall sample in the rightmost column. panel a records how many funds counted for in each quarter. panel b presents the total net assets held by the funds in the dataset. panel c displays summary statistics on the average number of indian stocks held per fund. panel d presents trading statistics of the total number of trades, the proportion of the trades that are buys and the number of distinctive stocks traded by at least a given number of funds within the quarter. table above displays summary statistics of the holdings in the indian equity mutual fund database. the average number of funds trading during a quarter is 30 mutual funds. the number of stocks in funds peaks with 42 different stocks in their portfolio in the first quarter of the year 2011. the drop before 2010 is consistent with mergers of some stocks in the funds during that period. therefore the average total net asset value of the funds within a quarter has also been increased due to the more equity holdings of the mutual funds. on an average it can be seen that, there is an increasing trend in the trade quantity by the funds in india. in the majority of quarters the purchases outweighed the sales, with a total average of trades that were buys of 54.3 percent. in the last panel the number of distinctive stocks traded within a quarter by at least a certain number of funds is presented. the average number of stocks within a quarter traded by at least 1 fund is 166. the number of stocks traded decreases substantially between each level of minimum funds. 6. findings of the study the study came out with an overall herding measure of 13 for the indian mutual fund industry. the results of the analysis provide evidence of herding in the indian mutual funds, consistent with findings of other studies for developing markets. table 2. mutual funds quarter wise mean herding measure from march09 to june 2011 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 199 quarters no of stocks traded lsv measure march11-june11 179 15.56 dec10-march11 173 14.42 sep10-dec10 161 9.50 june10-sep10 165 10.72 mar10-june10 165 12.15 dec09march10 188 13.76 sept09-dec09 173 12.15 june09-sept.09 139 7.85 april09-june09 152 25.36 above is the data for the herding measure for each quarter that i have calculated. we can observe from the data there is a clear tendency of herding in indian mutual funds. the herding was highest in the quarter of june 2009 and then suddenly decreased again coming to the value of 15 by the quarter june2011. the study only shows the evidence of herding but the reason behind the same has yet to be explored in further extension of the study. the table below presents the results from studies conducted using the lsv measure of herding. grinblatt, titman and wermers (1995) investigate the behaviour of 274 mutual funds and they find only weak evidence of herding. when imposing a higher number of minimum funds active in a stock, their computed figures of herding behaviour increase and are highest among growth and income funds. the study by wermers (1999) is the most extensive, with a remarkable 2 424 different funds in the sample. he obtains a low level of herding among mutual funds for the overall sample in the period 1975 to 1994. when dividing into subgroups formed by investment objective he finds higher herding tendency among growth-oriented funds. also, the effect of herding in small and past-winner stocks seemed to be more prominent. the 268 uk mutual funds investigated by wylie (2005) showed a similar tendency to herd as for the us investors. as noted above, the results from less developed markets, as the portugal and polish financial markets could be considered to be, present a much higher level of herding behaviour. the latest study conducted on herding behaviour is by walter and weber (2006) on a sample of 60 german mutual funds. their figures of herding are close to those from the mature markets. table 3. summary of results of the lsv measure of herding in previous studies study market period fund counts no. of funds trading fund counts ≥1 lakonishok et al (1992) usa 85-89 769 2.7 grinblatt et al.(1995) usa 74-84 274 2.5 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 200 loboa and serra (l998) portugal 98-00 32 11.38 voronkova and bohl (2005) poland 99-02 17 14.6 walter and weber (2006) germany 98-02 60 2.67 present study india 2009-11 30 13.49 notes the column fund counts displays the number of distinctive funds used in the different studies. the number of funds trading indicates the minimum number of active funds within a stock quarter to be included in the computed average herding value ================================================================== === when a graph is plotted using the lsv measure that was calculated with from various quarters trend of herding can be observed. it was much higher in the year 2009 and then decreased and slightly increased thereafter. but there is a positive sign of existence of herding during all the quarters of the sample period. lsv measure 0 5 10 15 20 25 30 m arc h1 1ju ne 11 dec 10 -m arc h1 1 sep 10 -d ec 10 ju ne 10 -s ep 10 m ar1 0ju ne 10 dec 09 m arc h1 0 sep t09 -d ec 09 ju ne 09 -s ep t.0 9 apr il0 9ju ne 09 lsv measure lsv values inpercent graph1. the trend of herding measure over the quarters table 4. buy side and sell side level of herding asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 201 mean buyand sell-herding levels [bhm and shm in percent] for number of funds trading in the quarter >1 a. mean buy-side herding results bhm for all funds in database 11.25 b. mean sell-side herding results shm for all funds in database 8.23 the mean herding levels, conditioned on if the proportion of buyers is higher or lower than the average within a quarter, are reported in table 4 above. buy-side herding seems to be more prominent than the sell-side herding for our sample of funds. we can conclude that the indian equity mutual funds tend to herd more often when purchasing a stock. this is similar to the results from some previous studies, e.g. wylie (2005), but other researchers have also reported the opposite conclusion, e.g. wermers (1999). table 5. mean herding levels by stock size the paper classifies the traded stocks in sub-groups in terms of market capitalization of the stocks. the stocks have been divided by ranking the stocks on their market value at the beginning of each quarter. three groups of stocks have been computed, so called small cap, mid cap, and large cap. the indian mutual funds seem to herd more in large stocks compared to smaller stocks, with an average level of hm in large capitalized stocks of 7.68 percent. in small stocks the funds herd in a level of 5.75 percent and the difference to large stocks is 1.93 percent less. the probability of the two means to be the same is 0.0425, i.e. the difference in means is significant at the 5 percent level. this contradicts the theories of herding behaviour, which foresees a higher tendency to herd in smaller stocks. other studies have also received results that could not confirm the theories of more elevated herding in small stocks; see e.g. walter (2006). 7. summary and conclusions hm and difference in mean in percent stock size for number of funds trading in the quarter>1 a. mean herding results hm for stock-quarters in subgroup s1 (small cap) 5.75 hm for stock-quarters in subgroup s2 (medium cap) 7.02 hm for stock-quarters in subgroup s3 (large cap) 7.68 b. differences mean difference in mean s1− s3 -1.93 (p-value) 0.0425 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 202 the study provides evidence of the tendency of mutual funds in india to form herds while trading the stocks. the overall hm computed over all stock-quarters is 13 percent, under the restriction of at least 1 fund trading a specific stock within the quarter. the result can be interpreted as if 100 funds trade a given stock, then approximately 13 more funds trade on the same side of the market, than would be expected if the fund managers chose their stocks independently as interpreted by earlier study of herding on portugese mutual funds by júlio lobão (2002). the indian mutual funds seem to herd more than the mature markets. the study also concludes that large cap stocks herd more than small caps, which support our hypothesis. the dataset consists of a clear defined group of funds, investing in the same type of holdings and based on consistent reported snapshots of holdings. hence, the difference compared to the more developed markets could to some extent depend on those facts applied to a sample of funds during a different time period. however there are certain limitations of the present study. the sample does not cover a large proportion of the market. as far as the measure is concerned, although it has been used widely, due to its simplicity and conceptual clarity, it carries certain drawbacks. first of all, the lsv measure cannot identify the reason managers are lead to similar decisions (voronkova and bohl, 2005). the study has made certain assumptions such as increase or decrease in the nav (net asset values) of the stocks of a company to determine the buy and sell of a particular stock in comparing the results quarter wise. to make it more reliable the future extension of the study should also track the change in the stock price accompanied with the nav values to determine the buy and sell of a stock. further the study has not taken in to consideration other factors such as stock splits and mergers due to which there is a change in the weight holdings of the portfolios which cannot be truly regarded as buy or sell which should be taken as an adjustment in the further extension of the study. evidence on herding by a particular type of investors such as institutional investors, could help in identifying different types or styles of investors with different trading pattern. investigating herding allows us to further understand investors’ thought processes and its effect on their investment decisions such as high market volatility and market destabilization. the future extension should try to study the characteristics of the mutual funds with herding. such as what is the difference in herding among different size mutual funds and stocks etc. furthermore, the present study does not measure the effect of the herding behaviour on the stock prices, which is a very important aspect of this issue to explore. future research should try to study the factors, which leads to the herding behavior in indian financial market. after determining the variable characteristics such as age, management tenure, size, cash flows, turnover, expenses and previous quarter return. the research should try to find the most closely related characteristic to these herding intensity measures. future studies should next investigate whether industry herding is caused by mutual fund managers’ attraction to certain industry characteristics such as past returns, size, and book to market. and proceed to examine the impact of herding on mutual fund performance. implication of measuring herding in a particular country is that while investing one need to hold larger number of securities in his portfolio to achieve the same degree of diversification asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 203 than in an otherwise normal market where there is no herding. furthermore, in a market where investors herd stock prices would stop reflecting true values of businesses leading the way to speculative trades. study has strong implications for the domestic financial institutions, portfolio managers, wealth managers and other investors as well as the policy makers as they shall be interested in understanding the trading behavior of dominant investor group in the market references agudo, l.f., sarto, j. l. and vicente, l. (2008). herding behavior in spanish equity funds. applied economics letters, 15, 573–576. http://dx.doi.org/10.1080/13504850600706974 ananthanarayanan, s., krishnamurthi, c., & sen, n. (2004). foreign institutional investors and security returns: evidence from indian stock exchanges, working paper, isb (indian school of business), hyderabad angelo manganaro. (dick von martens2007). herding behavior in the swedish mutual fund industry, stockholm school of economics master thesis in finance banerjee, a.v. (1992). a simple model of herd behavior. quarterly journal of economics, 107, 797–817. http://dx.doi.org/10.2307/2118364 bikhchandani, s., hirshleifer, d., & welch, i. (1992). a theory of fads, fashion, custom, and cultural change as informational cascades. journal of political economy, 100, 992–1026. http://dx.doi.org/10.1086/261849 chu ying, & qin ping. (2007). an empirical study of herding behavior of mutual funds in china (working paper) chang, e. c., cheng, j. w., & khorana, a. (2000). an examination of herd behavior in equity markets: an international perspective. journal of banking and finance, 24(10), 1651 1679. http://dx.doi.org/10.1016/s0378-4266(99)00096-5 chiyachantana c.n., jain, p.k. jiang, c., & wood, r.a. (2004). international evidence on institutional trading behavior and price impact. the journal of finance, lix(2). demirer, r. and kutan, a. m. (2006). does herding behavior exist in chinese stock markets?. journal of international financial markets, institutions and money, 16(2), pp. 123 142. http://dx.doi.org/10.1016/j.intfin.2005.01.002 de bondt, w. f. m., & forbes, w. p. (1999). herding in analyst earnings forecasts: evidence from the united kingdom. european financial management, 5, 143–63. http://dx.doi.org/10.1111/1468-036x.00087 froot, k.a., scharfstein, d.s., & stein, j. c. (1992). herd on the street: informational inefficiencies in a model with short-term speculation. journal of finance, 67, 1461–84. http://dx.doi.org/10.2307/2328947 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 204 grinblatt, m., titman, s., & wermers, r. (1995). momentum investment strategies, portfolio performance, and herding: a study of mutual fund behavior. american economic review, 85, 1088–105 greg n. gregoriou. (2007). diversification and portfolio management of mutual funds, ed., pp 167-197, palgrave macmillan, new york 2007, ssrn id 302937 júlio lobão, & ana paula. (march 11,2002). herding behavior evidence from portuguese mutual funds serra thesis draft kpmg june. (2009). indian mutual fund industry: the future in a dynamic environment outlook for 2015 une 2009 lakonishok, j., shleifer, a., & vishny, r. w. (1992). the impact of institutional trading on stock prices. journal of financial economics, 32, 23–43. http://dx.doi.org/10.1016/0304-405x(92)90023-q lobao, j., & serra, a.p. (2002). herding behavior evidence from portuguese mutual funds.(working paper) nofsinger, j. r., & sias, r. w. (1999). herding and feedback trading by institutional and individual investors. journal of finance, 54(6), 2263 2295. oehler, a. (1998). do mutual funds specializing in german stocks herd?, financial markets and portfolio management, 12(4), pp. 452 465 meng-fen hsieh (2010) positive trading effects and herding behavior in asian markets: evidence from mutual funds. the international journal of business and finance research, 4(2). sharma, v. (2004). two essays on herding in financial markets, ph.d. dissertation, virginia polytechnic institute & state university. sias, r.w., (2004). institutional herding. the review of financial studies, 17(1), 165-206. http://dx.doi.org/10.1093/rfs/hhg035 walter, a., & weber, f. m. (2006), herding in the german mutual fund industry. european financial management, 12, 375-406. http://dx.doi.org/10.1111/j.1354-7798.2006.00325.x w. sias spring. (2004). institutional herding richard. the review of financial studies , 17(1), pp. 165±206 www.valueresearchonline.com www.amfiindia.com www.mutualfundsindia.com    microsoft word 1067-4377-1-rv[1]-writer2-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 138 internet financial reporting in malaysia: the preparers’ view dr kiew-heong yap (corresponding author) faculty of business and accountancy university of malaya, 50603 kuala lumpur tel: 60-1-6371-7660, 60-3-6250-1367 e-mail: ayapkh@gmail.com dr zakiah saleh faculty of business and accountancy university of malaya, 50603 kuala lumpur e-mail: szakiah@gmail.com received: november 8, 2011 accepted: november 18, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.1067 url: http://dx.doi.org/10.5296/ajfa.v3i1.1067 abstract this paper reports the opinion and awareness of the internet financial reporting (ifr) from the preparers’ perspectives and examines the individual firm motives to engage the ifr. the researchers interviewed ten senior managers using semi-structured and in-depth questionnaires to seek their views and opinions on ifr issues. among the three main motivations to engage in ifr are: first, companies want to be more transparent in disseminating company information. second, the companies use the internet to promote their products and services to create a good brand name in the industry. lastly, these companies are a strong believer of good corporate governance best practices in promoting greater transparency. 90% of the respondents claimed ownership structure influenced ifr, and 70% of the respondents agreed industry members and firm size influenced such reporting practice. as for corporate governance mechanisms, only 34% of the respondents agreed corporate governance influenced ifr. this paper bridges the gap by interviewing preparers concerning influences of corporate governance and ownership structures on ifr. among the more significant issues highlighted by the respondents are the security of the web site, timeliness of reporting and adoption of xbrl. keywords: internet financial reporting, preparers’ views asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 139 1. introduction internet is becoming a popular mean of communication with all stakeholders. many corporations in developed and developing economies have a dedicated web site to communicate financial information with the investors. this reporting practice is called internet financial reporting (ifr). ifr can be defined as ‘the public reporting of operating and financial data by a business enterprise by the world wide web or related internet-based communications medium” (lymer et al., 1999, p.2). internet reporting activities are largely driven by preparers who use it to market their products or services. reporting companies may be motivated by the benefits of communicating information by the internet. these benefits included: providing companies for global marketing, decreasing the distribution cost of hard copy financial statements, communicating information cheaper, wider and faster; and facilitating interaction with stakeholders (xiao et al., 2002). there have been much empirical work carried out for ifr by the practitioners and academicians from the developed economies, however, only limited studies have offered some reasons about the relationship between the opinion, motivation and influences of ifr, especially for malaysia. past malaysian studies were mainly descriptive in nature (nik salleh and mohamad, 2000; jamaliah et al., 2001; mohamad et al., 2003), and examined few factors that influenced the ifr (hassan et al., 1999; ismail and tayib, 2000; gan and susela, 2002; abdul hamid et al., 2004). the study on the perception of preparers was solicited by mailed questionnaire (hassan et al., 1999; ali khan and ismail, 2009). this paper argues further research could try other approaches, such as in-depth interviewing with the preparers. according to saunders et al. (2009), semi-structured and in-depth interviews provide an opportunity to the researchers to ‘probe’ answers, where he/she wants an explanation from interviews to build on their responses. interviewees may use ideas or words in a specific way, and probing of these meanings will add depth and significance to the data collected. they may also lead the discussion into areas that are important for understanding and had not been previously considered by the researchers. therefore, this study tries to bridge the gap by interviewing ten senior managers to seek their views and opinions on influences of corporate governance and ownership structures on ifr. this paper reports the opinion and awareness of the ifr from the preparers’ perspectives and examines the individual firm motives. views on the influences of corporate governance mechanisms and ownership structures are sought and the disclosure theories are used in the data interpretation process. ifr issues highlighted by the respondents are presented. the remainder of this paper is organised as follows. section 2 reviews the prior interviews studies of ifr. section 3 outlines the research method. section 4 discusses the result of the in-depth semi-structure interview with the respondents. this section is divided into 3 sub-sections – section 4.1 presents the opinion and awareness of the managers; and section 4.2 discusses the individual firm motives. the interview data obtained from each respondent are analysed to find out the themes and summarised into tables. views on the influences of corporate governance mechanisms and ownership structures are presented in section 4.3. the disclosure theories are used in the data interpretation process (section 4.4). lastly, ifr issues highlighted by the respondents are discussed in section 4.5. finally, the results are concluded asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 140 in section 5. 2. literature review 2.1 interviews studies on the views of interested parties on ifr started since 1999. the internet has been described as “a new platform for distributing financial information” (hassan et al., 1999, p.1). it is a platform that shows distinctive and attractive features, which makes it an effective choice when compared with the traditional platform. hassan et al. (1999) studied the opinions of malaysian chief financial officers (cfo) on the usefulness, benefits and costs of the internet disclosure and reporting of financial information. they used a mailed questionnaire to seek the opinions of the controllers, which achieved a response rate of 35.04%. the findings suggest the benefits, to both the companies and the users of financial information, are perceived to be greater than the costs of adopting the internet as another medium of communicating and disclosing corporate financial information. increasingly, companies are using the internet to present financial information. however, there is little published literature on the extent of this new medium that is shaping the future of corporate reporting practices (xiao et al., 2002). to widen the participation in the debate, they propose the non-technological and technological factors will decide the future of ifr; there is a range of different views in other areas obtained from 17 u.k. experts including regulators, auditors, academics, reporting companies and users of corporate reports. some opinions are non-technologically driven such as resistance to changes in technology, regulators are slow to react and users are not interested in reading financial reports, whereas, others pay more attention to technology factors. some experts adopt a more progressive or even radical perspective, while others do not foresee any financial reporting changes within the short period of time. the experts did not address some important issues such as the relative importance of the identified contingency factors that will affect the changes related to internet; the state of these factors will take effect, and the integration impact of internet with data processing systems. a study by beattie and pratt (2003) reports the findings of a u.k. study about the views of 500 individuals from preparers, various user groups and auditors on newly emerging practices and specific change proposals. they found users like the scope expanded by the web. all groups found the range of navigation aids; search aids and file formats were least useful. file format preferences vary across the groups. paired group comparison shows the views of the preparers and users differ substantially, while expert and non-expert users hold the same views on many issues. generally, auditors’ views fall between the views of preparers and users. this study has three specific limitations. first, the extent to which members of proshare and uksa representing the private shareholders population is unknown. second, it is unclear how or why industry membership might influence the views of financial company finance directors, because these views were not sampled. third, this study considered the u.k. settings and participants only. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 141 jones and xiao (2004) report the results of a delphi study into corporate financial reporting by 2010, in which 20 u.k. experts in accounting and the internet, representing regulators, auditors, academics, reporting companies and users, took part in the study. they conclude the financial reporting package would change into “a core of general-purpose, standardised information (in both the hard copy and internet version) with a non-core general purpose and customised information” (jones and xiao, 2004, p.1). prior studies suggested radical changes such as raw data disclosure and real-time reporting would not occur, at least to the core package. regulators will adopt a minimalist approach while auditors will be cautious and reactive. standardisation and customisation will be the fundamental dilemma of internet financial reporting in the future. most recent study by ali khan and ismail (2009) examined the factors that influence malaysian companies to engage in ifr. this paper sought the opinions of preparers of financial information by a mailed questionnaire. the findings suggest three factors that firms perceive as important: (1) enhance corporate image, (2) company teller with the technology development, and (3) competitors in the industry. however, ‘the need to keep information updated’, ‘required expertise from the company’ and ‘concern over security of information’ are the three main factors that inhibit companies from adopting ifr the most. the researchers suggest further studies could try other approaches, such as interviewing companies and preparers to gain an in-depth understanding about the factors influencing malaysian companies to engage in ifr. 2.2 determinants of ifr many researchers conducted empirical studies to identify factors associated with ifr, firm-specific determinants include industry type, firm size and profitability (debreceny et al., 2002; ettredge et al., 2002; marston and polei, 2004; debreceny and rahman, 2005; bonson and escobar, 2006). it can be concluded certain specific firm characteristics such as firm size appear to be statistically associated with the extent of ifr. xiao et al. (2004) argue ifr is responsive to specific environment attributes. this study found state share ownership is negatively related to ifr, legal person ownership is positively associated with ifr. the negative relationship proves the state owners have privileged access to private information, whereas the legal person shareholders have motivation to oversee company management. the authors argue important determinants of disclosure choice in the developed economies may not apply to chinese environment. abdelsalam et at. (2007) found analyst following, director ownership, director independence and ceo duality is related to ifr. however, the results of the random sample of 110 top quartile listed companies may not generalise to smaller listed companies on the exchange. more recent ifr study link ifr to corporate governance mechanisms. the findings by kelton and yang (2008) show u.s. firms with weak shareholder rights, a low percentage of block holder ownership, a higher percentage of independent directors, a more diligent audit committee and a higher percentage of audit committee members with financial expertise are more likely to have ifr. the findings may not generalise to listed companies from other asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 142 stock exchanges. future study may examine other characteristics such as reporting frequency and information quality. prior interview studies mainly focused on issues related to ifr; whereas determinant studies examined the relationships between various factors to its influence on ifr. this paper tries to link the ifr practices to its determinants by examining from the preparers’ views about the influences of corporate governance mechanisms and ownership structures on ifr. this study uses the disclosure theories to interpret the results, because it improves our understanding on ifr practices. 3. research method many researchers put much effort examining the initial financial disclosure, and studying the managements’ decisions in voluntarily non-obligatory disclosure. however, there are limited empirical findings available about what drives the companies to incur extra distribution costs related to internet reporting. currently, limited empirical evidence about internet disclosure is available in the malaysian accounting literature; however, the internet’s potential role for communicating company information has been debated more in advanced countries such as the u.k. and u.s. this study extends prior studies by interviewing the preparers of malaysian listed companies about their views and opinions, specifically on the influences of corporate governance and ownership structures on ifr practices. the interview questions are divided in two categories: the first category included five open-ended questions dealing with opinion, needed financial information, reporting format and other issues about ifr. the questions began with a short paragraph providing a definition of internet reporting. the second category included eight theme-guided questions dealing with internet regulation, influences of ifr from various parties or sources such as industry members, firm’s size, financial performance (profitability), beta (systematic risk), auditor type, ownership structure and board governance structures. it was also made clear these questions are only related to the ifr of the sample companies. the researchers' pilot tested the questionnaire using four individuals (two audit partners; one regulator and one academician) and changed the content accordingly. the researchers emailed the questionnaires to the investor relations department of the sample companies, with an explanatory letter giving the background to the study and an assurance of confidentiality of responses. the first mailing to all sample companies took place in may 2009. 3.1 sampling sampling is important; as the researchers cannot possibly study everything everyone is doing everywhere. in qualitative research, punch (2005) admits there are no summarised sampling strategies because of a great variety of purposes, approaches and settings for research. huberman and miles (2002) mentioned qualitative researchers usually studied small samples size, which are examined in depth and nested in their context, in contrast to quantitative researchers who aim for larger context numbers such as seeking statistical significance and stripped cases. punch (2005) argues the basic ideas of specific sampling strategies change is to reflect the study’s purposes and questions. he stresses the direction should be coherent and asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 143 consistent with the study logic. purposive sampling is employed in this study to select the companies to be sampled. the sampling is confined to listed companies that disseminate information on their company web page. selection of rich case information for an in-depth study influences the logic and power of purposive sampling (patton, 2002). information rich refers to those cases where the researchers can learn many centrally important issues for the research objective. this study used two of the strategies under purposefully selecting information-rich cases (patton, 2002) in deciding on the sample. first, is the intensity of sampling. this sampling strategy consists of information – rich cases that show the interested phenomenon intensely but not extremely (patton, 2002). to discover the variation type under the investigated situation, exploratory work needs to be done under this sampling strategy. companies chosen to be the sample in this part of the study are the listed companies that report a significant amount of information on their company web page. this coincides with the strategy suggested above. as the purpose of the study is to identify what motivates the firms to engage in ifr, it seems proper to study only companies that are practising it. reviewing their company homepage assesses this practice. to meet the intensity criteria stated by patton (2002), this study finds the potential sampling through the list of companies that ranked the highest score under the corporate governance survey 2008, by their compliance with the corporate disclosure and governance. one of the key areas covered is shareholders and investor relations, which emphasised improving the accessibility and transparency of financial disclosures to investors. the second strategy adopted is to use the maximum variation sampling (patton, 2002). this aims at describing and capturing the main principles, outcomes or themes that affect most variation in participants (patton, 2002). the objective in this study is to explain ifr phenomenon in malaysia without any limit on the industry type. in the prior studies, the industry type is considered to be significant in influencing ifr. this study tries to see the various responses across the various industries for malaysia. 3.2 data collection the researchers used search engines, e.g. yahoo and google to find web pages of the top 120 sample companies that ranked the highest score under the corporate governance survey 2008, of which only 17 companies included the investor relations contact on the internet. reviews of the potential respondents were conducted prior to select the particular respondents. then, the researchers made a telephone call to arrange an appointment with these investor relations’ personnel. they confirmed the appointment after a few follow up calls; finally, the researchers interviewed senior managers from ten companies. appendix 2 lists the details of the companies and the persons interviewed. in addition, company backgrounds by their internet reporting were investigated. the information served to confirm the reliability of the interview responses and allowed more direct and detailed probing in the interviews. the researchers used a standardised set of questions to interview the respondents. these asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 144 questions served in extracting the required information from them. the purpose of using open-ended questions is to invite participation from the respondents during the conversation (cooper and schindler, 2006; saunders et al., 2009). since, all the respondents are high-ranking personnel with a busy schedule, time management is important. only respondents who were seen to be more receptive were probed to get more in-depth responses. if time permitted respondents were asked concerning the aspects of the emerging theory. every respondent was asked the same questions. some respondents were asked further questions to gain more information. appendix 1 sets out the list of questions asked during the interview sessions. the researchers emailed a letter with a set of questionnaires with a standard definition of internet reporting to the interviewees. during the interview, the researchers briefly explained the definition and the concept of internet reporting to all the respondents, as some of them did not read the letter emailed to them earlier thoroughly. the main purpose of the interview was to identify what motivates them to disclose financial information by the internet. the researchers began by asking the respondent’s opinion before going to the main questions. then, by asking a question that is broad in nature, the researchers can identify their real motivation. the main objective is to gain the information about their opinion and experience, followed by more specific questions. english was the main language used during the interview. the researchers taped the conversation with respondents and transcribed literally to help data analysis. the researchers took note of the important points highlighted by the respondents during the interview. the overall duration of the interviews ranged between 30 and 60 minutes. the researchers interviewed all respondents during may 2009 to august 2009. 3.3 data analysis techniques the data transcription took a long time as the researchers listened to the tape several times to transcribe all the conversations properly. while listening to the tape, the researchers noted emerging or interesting points. this initial process helped the researchers to be more prepared to investigate the subsequent respondents. the emerging pattern was evident from the initial analysis. the researchers began post interview analysis immediately after collecting data for each interview. for each respondent, the average total transcription was four to five pages of a4, single spaced and font 11 arial characters. the researchers read each respondent transcript several times. the reading was done simultaneously with the transcription process to get the big picture. the researchers identified the underlying themes based on the evidence collected from the transcribed data. data reduction process continued by making summaries of the patterns emanating from the evidence. the following stage of the data analysis process was cross-analysing and comparing the coded summarised data with the respondents’ profile, such as their stakeholders, nature of their business, their products or services offered. the researchers referred to the interview guide and the research question simultaneously asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 145 during the interpretation process to elaborate the findings according to the research questions. this study identified the perception of the local companies practising internet reporting. second, the influences of various factors on ifr were identified. third, this study examined the applicability of disclosure theories to understand the companies’ motivation and determinants of ifr. the analysis focused on five aspects. first, the analysis identified opinions of the preparers. second, it explored the motivations of engaging internet reporting. third, it identified the influences of firm characteristics, corporate governance mechanisms and ownership structures on ifr. fourth, it discussed finding based on disclosure theories, namely agency theory and institutional theory. finally, it discussed issues relating to ifr. even though, the divided scope was clearly stated, the researchers are aware these aspects overlap in the sense that the first aspect of opinions cannot be simply ignored in considering the motivation, influence or in finding support for the disclosure theories. this strategy is meant to help the researchers in interpreting the findings. the first, second and third aspects were discussed in narration form. to explain the motivations and influences, tables (table 1 to table 4) were developed and examined to give detailed explanation. this fourth part was explained through the lens of disclosure theories. 4. results of interview 4.1 open questions: opinions on internet reporting this section is mainly narrative. it tries to get into the thoughts of the respondents, and to understand the real meaning of what they were trying to reveal. to make the discussion meaningful, the discussion proceeds from two different aspects of awareness: their understanding on internet reporting and the perceived benefits of internet reporting. this is the first and most important question posed to the interviewees during the interview sessions. the objective is mainly to get an overall idea of the interviewees’ understanding on the internet reporting issues. the data is then cross-analysed with the respondent’s profile. all the managers interviewed knew what is internet reporting. all the respondents agreed: internet reporting is just another channel of communication to promote continuous disclosure and it is a way forward. all the respondents highlighted the importance of having such activities. for example c1, c2 and c7 said: the company should be transparent, responsible and accountable to shareholders through release of timely company information by the internet. the reporting must be relevant and include all necessary documents. another respondent admitted: asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 146 i think certain size and background of company may be stronger in internet disclosure, which leads to variation in quality of reporting by the internet. (c3) the above data shows the awareness of internet reporting is quite high among the respondents. most of the respondents agreed this technology can reach more potential users and they can access the companies’ financial information easily by the internet. it also enhances the speed of reporting and disclosure can be shortened. presentation of information is under the companies’ full control at any point of time. in finding some reasoning to why the companies disclose by the internet, further analysis was done on the respondents’ background. most of the respondent’s interviewed were from the investor relations department. for example, respondents from c1, c3, c4, c5, c7 and c8 were managers or top managers holding a post in the investor relations department. the process of preparing public reporting of operating and financial data by the world wide web seems to fall under the responsibility of the investor relations department. of course, to prepare the accounting or financial report, the finance or accounts department is fully responsible. the public reporting documents are then sent to the investor relations to include other investor relation information to be released to investors. for example, respondents clearly stated the process of preparing investor relations materials: our company fully complies with all disclosure requirements set by regulators, such as securities commission and bursa malaysia. (c1 and c7) our reporting is based on the basic requirements of the stock exchange, bursa malaysia. (c2, c5 and c6) when setting up a corporate information web site, the most commonly consulted information source appears to be the competitors’ web sites. it is possible, therefore, for the companies to copy the best features of the innovators for their ongoing improvement on the companies web sites (c3, c5, c6 and c8). respondents said: we refer to the overseas web sites to get new ideas, especially from those agencies’ award winners, as they are more informative, comprehensive and well-designed. we only compare with the best companies irrespective of its size and where it is located. (c7) usually, the decision to make information available in the public domain has already been asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 147 decided by company officers, notably preliminary announcements, quarterly reports and annual reports. according to several interviewees, regulation can put a brake on further developments. for example, to avoid misleading investors, the dissemination of forecast information has to be treated cautiously. 4.2 theme guided questions: motivations a detailed matrix table of the data was developed based on the simplified coded data identified from the transcripts. the description of the data display is similar to huberman and miles (2002) who define display as a compressed, organised information collection that allows conclusion drawing and action. to understand what is happening one needs to refer to the data display (huberman and miles, 2002), and to see the patterns, regularities, and the causal relationship. subsequently, the disclosure theories are used to interpret the finding because the core issues emanating from the finding are encapsulated in the preparers’ perspective. the researchers listed the simplified coded motivation first before constructing the matrix table. the motivations identified from the interview data are as follows: m1 –to be more transparent in communicating company information. they want to ensure the public have good access to company information. it helps investors to invest and convince potential investors the company is a good stock in which to invest. m2 – promoting their products and services to create a good brand name in the industry. m3 – a strong believer of good corporate governance best practices. m4 – to compete for finance. m5 – to set a good example for other listed companies to follow. m6 – to project a good corporate image. m7 – wanting to be known by all, and not just an item on the stock exchange. the above information is distilled after several rounds of reiteration. the motivations with the same meaning are grouped into seven (7) core codes. the data is then cross-analysed with the company profile. the matrix table is then developed as shown in table 1. to ensure no data is missed out and ensure analysis is completed, the researchers listened to all the respondents’ recorded interviews and revisited the transcripts several times. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 148 table 1. code matrix display – motivation of internet reporting motivation of interviewees c1 c2 c3 c4 c5 c6 c7 c8 c9 c10 total n=10 m1 – to be more transparent         8 m2 – promoting their products and services to create a good brand name in the industry     4 m3 – strong believer of good corporate governance best practices      5 m4 to compete for finance   2 m5 – to set a good example for other listed companies to follow   2 m6 – to project a good corporate image  1 m7 – wanting to be known by all, and not just an item on the stock exchange   2 n=number of respondents 4.3 theme guided questions: influences the researchers asked the respondents the influences of ifr under the themes guided questions. table 2 shows the results of these questions. all respondents claimed ownership structure influenced ifr, and seven (7) respondents agreed industry members and firm size influenced such reporting practice. table 2. influences of firms’ characteristics c1 c2 c3 c4 c5 c6 c7 c8 c9 c10 n=10 industry members        7 firm size        7 financial performance      5 beta (systematic risk)    3 auditor type (big 4 or non-big 4)  1 ownership structure           10 board governance structure      5 n=number of respondents the researchers asked respondents to say to what extent they disagreed or agreed with the influences of ownership and corporate governance mechanism on a likert-scale of 1 (strongly disagree) to 7 (strongly agree). responses are summarised and analysed in tables 3 and 4. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 149 as shown in table 3, in total 90% of the respondents agreed family owned (10); institutional owned (8); government owned (10); foreign owned (9) and director owned (8) influenced the ifr practice. all 10 respondents said the family-controlled firms are not likely to disclose voluntary information above the mandatory requirements because there is a low demand for public disclosure. according to the respondents, larger equity institutional investors will oversee company management and policies because they have the voting power to pressure self-serving management. as for foreign owned firms, because of the geographical separation between management and foreign owners, the demand for disclosure is also greater. table 3. influences of ownership level of agreement ownership n 1 2 3 4 5 6 7 family owned 10 0 0 0 0 1 8 1 institutional owned 10 0 1 0 1 0 6 2 government owned 10 0 0 0 0 2 6 2 foreign owned 10 0 0 0 1 0 7 2 director owned 10 0 0 0 2 1 5 2 1 (2%) 4 (8%) 45 (90%) n=number of responses level of agreement on a scale of: 1=strongly disagree 2=disagree 3=slightly disagree 4=neutral 5=slightly agree 6=agree 7=strongly agree the results concerning the influence of corporate governance mechanism on ifr varied widely. this shows respondents were largely unsure about its influence, with 34% of respondents agreeing the corporate governance mechanism influences ifr and 49% of the respondents indicating the corporate governance mechanism does not influence ifr. four (4) respondents said audit committee size was neutral to ifr practice and three (3) respondents had the opinion audit committee meeting frequency was also neutral to ifr practice. four (4) respondents disagreeing the audit committee financial expert influences ifr, while five (5) respondents agreeing audit committee financial expert influences ifr. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 150 table 4. influences of corporate governance mechanism level of agreement corporate governance n 1 2 3 4 5 6 7 board size 10 1 7 1 1 0 0 0 non-executive dir. 10 1 2 1 2 2 2 0 independent dir. 10 1 2 1 0 2 3 1 ceo duality 10 1 1 3 2 2 1 0 director with finance & acc. 10 1 1 2 1 0 4 1 family director 10 1 2 3 2 0 1 1 multiple directorship 10 1 2 1 1 0 4 1 audit committee size 10 1 3 1 4 0 1 0 ac financial expert 10 1 2 1 1 0 4 1 board & ac meeting frequency 10 1 2 1 3 0 2 1 49 (49%) 17 (17%) 34 (34%) n=number of respondents level of agreement on a scale of: 1=strongly disagree 2=disagree 3=slightly disagree 4=neutral 5=slightly agree 6=agree 7=strongly agree 4.4 applicability of disclosure theories several theories, such as positive accounting theories and institutional theory, determined the accounting choice and disclosure. the interview data reveals the respondents place high regard on the environmental actors as argued by institutional theory. for example, c4 states: for xbrl implementation, u.s. companies converted data from june 2009 onward. japan presented their annual report 2008 in xbrl format. our neighbouring country, singapore companies incorporated after 1/11/2007 are required to present annual return in xbrl format, 29 thai companies participate in a pilot project to develop reporting in xbrl. malaysia companies are not doing it yet. eventually, we will follow others. c2’s explanation for their reporting format: we benchmark ourselves against other exchanges such as australia, new york, singapore and hong kong. we also refer to award winners and foreign companies. from the institutional perspective, external factors appear to assert the normative and asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 151 coercive pressure to institutionalise c4 and c2. c4 further mentioned the majority of their partners come from overseas companies where the ifr in xbrl format is very significant and common. the above data also confirms c4 and c2 are giving higher priority to the demands of relevant actors. they see the importance of sharing the same feeling towards ifr. to enhance the companies’ reputation they chose to adopt this practice to gain greater legitimacy. clearly, c4’s incentive to adopt ifr in xbrl format appears to draw on this notion. political costs theory can explain the relationship between industry and disclosure. indeed, according to watts and zimmerman (1990), industry member being related to size is associated with political costs. industry type may also change the proprietary costs. signalling theory argues companies in the same industry are more likely to have the same disclosure level, to gain positive market appreciation. according to respondent c1: our company takes into account what the competitors are doing for competitive position and assessment. the relationship between size and disclosure can be explained from several theoretical arguments. watts and zimmerman (1990) argue higher political costs in larger companies resulted in them having a higher disclosure level to reduce political costs and improve market confidence. in addition, larger companies are likely to have more advanced information systems, therefore, additional disclosure will supposedly cost less in comparison with the smaller companies. at the same time, as company size increases, the proprietary costs for competitive advantages of additional disclosure are smaller (verrecchia, 1983). respondents c2 and c3 said: bigger companies may have better data presentation to convince the company is doing well, to gain confidence from public and investors. they have greater resources to report by the internet (c2). bigger firms tend to have their own web site. smaller companies may not have a dedicated investor relation team to take care of such function, because they may not have sufficient resources and budget. there are some smaller companies cannot even differentiate between investor relations, corporate communication and public relations (c3). the greater proportion of equity capital structure, the higher the level of information expected by shareholders, thus, incurring higher monitoring costs. the agency cost reduction has the same argument. however, the same problem exists regarding inside versus outside equity. when there is a larger equity from inside, additional disclosure becomes unimportant since the internal owners have greater access to company information. respondent c1 stressed: asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 152 family owned firms require a lower level of disclosure. as for institutional owned, they demand a higher level of disclosure, otherwise, the institutional investors could dispose of their investments if they are unhappy with the company’s disclosure! another respondent c2 argued: institutional owned tends to be more transparent to attract investment and gain confidence from investors. family/director owned tends to be more secretive, i.e. they may “hide” information from the public to protect cronies such as related-party transactions. 4.5 issues of internet reporting the researchers asked the respondents for any issues pertaining to internet reporting. a number of issues have been sub-grouped for easy comparison. 4.5.1 regulation of reporting although there was a general agreement ifr will at least be allowed, there were disagreement on the extent and necessity of regulations. some respondents adopted a dynamic perspective, while others expressed a static view. because the internet represents a radical change in the commercial process, six (6) respondents expected the need for new regulations. however, all thought it is important whatever controls are developed and used, they should not hinder the freedom of a company’s management to present useful information on the internet. others believed no regulation would be necessary, because they assume a company will only present audited or reviewed information on the web page. furthermore, the exact reproduction of the hard copy on the web will give rise to legal issues. 4.5.2 security of the web site web site security is the main concern of all the respondents. it may not be easy to control the access of the web site or its underlying database. needless to say, hackers and hostile intruders can and do find loopholes in the company’s security net, they may change the data without the company’s knowledge. for example, c1, c2, c5 and c6 said: there is a potential risk by irresponsible hackers to alter the content of information on company web pages. even if the security is adequately provided, the chances of fraudulent information being communicated through similar technologies and chat rooms still exist and the company can be adversely affected by such information. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 153 4.5.3 timeliness of reporting the internet improves the availability of financial information to company users, it helps to increase the frequency of reporting from annually or quarterly to monthly, weekly, daily or even almost instant annual reports. the internet facility is a pre-requisite in order to achieve a high frequency of reporting. for example, after the company released the announcements, such information should be provided instantly on the company web page else it will lose value fast, as the delivery to users is too late relative to the duration it covers. a major change in most accounting systems is required, because more frequent reporting for events, such as updates of estimates, judgements and market prices would need a real-time entry. the respondents highlighted: my concern is we need to do a lot of regular updates to ensure timely information is posted on our web site (c3). continuous disclosure requires constant efforts to update and change the web’s information (c5). omission of material transactions caused by late release by authorised personnel may occur (c6). 4.5.4 extensible business reporting language (xbrl) xbrl international promulgates a computer language using an emerging technology. it is a global consortium of over 200 technology, accounting and financial services. within xbrl, a predefined and unique data tag is assigned to each piece of financial data. these data tags act as the barcodes to identify the content and structure of information. the xbrl proponents claim to have the ability to affect users’ financial information acquisition and processing, as their decisions and judgements are based on its output. the main facility offered by xbrl is its ability to acquire and integrate the financial information from a company’s financial statement and code it. for users who are using this software application, the coded financial statements will facilitate the extraction process, and simultaneously show all identically coded information from annual reports and footnotes (hodge, kennedy and maines, 2004). many developed countries are adopting xbrl coded financial statements in view of the above benefit. these countries include canada, germany, hong kong, japan, singapore, the u.k. and u.s., as well as the iasb (xbrl news, 2002). however, according to c4: since 2008, our neighbouring countries such as thailand and singapore began to instruct their listed companies to use xbrl coded financial statement on the internet. many listed companies in malaysia are yet to adopt ifr on their corporate web sites, some of them are struggling to set asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 154 up a company web site! according to dull et al. (2003), through the professional bodies, software companies and accounting firms’ support, xbrl is becoming an emerging financial reporting standard. malaysian regulatory agencies and/or the stock exchange should seriously consider encouraging the listed companies to adopt xbrl in view of the above benefits and adoption by the neighbouring countries. 4.5.5 internet reporting is “individual driven” company personnel to varying degrees and seniority can carry out the investor relations function, but involvement by directors is generally considered to be desirable in the managing and executing of the activities. according to the respondents, the majority of the board of directors clearly accepted the principal responsibilities of communication. the influence of one senior member may affect the company decision to set up or improve an existing web site. usually, a senior executive is responsible for the web site project, together with substantial involvement from the directors. c1, c8, c9 and c10 stressed, the board is the key driver to greater transparency beyond the mandatory disclosure compliance. the interview results suggest it is generally a high level decision with close participation from one or more directors to improve greater transparency of information. 5. conclusion this paper bridges the gap by interviewing ten senior managers to seek their views and opinions concerning influences of corporate governance and ownership structures on ifr. relatively, all the respondents interviewed provided good cooperation and the insights gained from the interviews are very valuable for this study. it provides a clear picture concerning the manager’s perception, awareness and understanding on the concept of ifr. all the managers interviewed knew what is internet reporting. most of the respondents agreed the internet offers easy access to company financial information. more potential users can be reached through this technology. information publication time is under the absolute control of the companies. therefore, internet disclosure enhances disclosure speed. the main motivation as to why companies disclose information by the internet is identified from the interview data. among the three main motivations are: first, companies want to be more transparent in disseminating company information. they want to ensure the public have good access to company information. the information helps investors to make investment decisions and persuade prospective investors to invest in the firm. second, the companies use the internet to promote their products and services to create a good brand name in the industry. lastly, these companies that used internet to disseminate information are a strong believer of good corporate governance best practices in promoting greater transparency. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 155 this study identifies the emergent pattern and discusses the influences of ownership structures and corporate governance mechanisms on ifr. 90% of the respondents claimed ownership structure influenced ifr, and 70% of the respondents agreed industry members and firm size influenced such reporting practice. as for corporate governance mechanisms, 34% of the respondents agreed corporate governance influenced ifr. this study identifies issues concerning web-based business reporting from the preparers’ perspective. among the more significant issues are the security of the web site, timeliness of reporting and adoption of xbrl. the sample size of this study is small and it may not represent the views of other preparers from all listed companies. extending to bigger sample size could carry out in future research. it would also be useful to adopt a longitudinal approach, which can help to shed further light on the evolving process of internet-based disclosure practices and its adoption. references abdelsalam o.h., bryant s.m. & street d.l. 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(2004). the determinants and characteristics of voluntary internet-based disclosures by listed chinese companies. journal of accounting & public policy, 23, 191-225. http://dx.doi.org/10.1016/j.jaccpubpol.2004.04.002 appendix 1 questionnaire interview on internet reporting (ir): the interview will be divided into 2 types of questions:  open-ended questions;  theme guided questions. all these questions are related to ir. let me briefly define what ir is. ir means reporting corporation information via the company’s web site. currently ir is voluntary in nature with no specific regulations. therefore, there is a disparity of ir practices among companies. list of questions are as follows: open-ended questions 1. what is your perception on internet reporting? 2. why does your company disclose information on company web site? 3. what motivate you to disclose? 4. how do you come out with the reporting format? 5. any other issues pertaining to internet reporting? asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 158 themes guided questions: 1. do you think statutory body/accounting standard body/securities regulator should regulate company internet reporting? why? how? 2. do you think industry members have any influence on company internet reporting? why? how? 3. do you think firm size has any influence on your company internet reporting? why? how? 4. do you think financial performance (profitability) has any influence your company internet reporting? why? how? 5. do you think beta (systematic risk) has any influence your company internet reporting? why? how? 6. do you think auditor (big-4 or non big-4) has any influence your company internet reporting? why? how? 7. do you think ownership structure has any influence on your company internet reporting? why? how? think in term of ownership structure’s influence on internet reporting. please put the most appropriate response number on the side of each ownership structure, using the scale below strongly disagree 1 disagree 2 slightly disagree 3 neutral 4 slightly agree 5 agree 6 strongly agree 7 family owned institutional owned government owned foreign owned director owned 8. do you think board governance structure has any influence on your company internet reporting? why? how? asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 159 think in term of board governance structure’s influence on internet reporting. please put the most appropriate response number on the side of each board governance structure, using the scale below: strongly disagree 1 disagree 2 slightly disagree 3 neutral 4 slightly agree 5 agree 6 strongly agree 7 board size non-executive director independent director ceo duality director with finance & accounting qualification family member of founder on board director sits in more than 1 board size of audit committee audit committee with finance & accounting qualification board and audit committee meeting frequency personal details: position in the company: no of years at the managerial level: area of expertise and experience: appendix 2 profile of respondents asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 160 respondent c1 is an accountant by profession and was attached to the accounting and auditing industry for 8 years before joining the company in 1988. he was initially attached to the finance division in the head office, and transferred to the group company in hong kong in 1990. he returned to head office in 1994 and was appointed senior general manager in 2001 and chief operating officer in 2008. his portfolio includes supervision of the company’s banking operations, finance, property and information technology divisions. respondent c2 has 22 years in the finance and accounting profession. she is involved in tax planning, auditing, financial management and project management. she holds a master of business administration (mba) from the university of lincoln (u.k.). respondent c3 is the head of investor, finance. she has more than 14 years of managerial experience. her responsibilities in the company include public release to bursa, placing relevant information on the company web site, and meeting with analysts, fund manager and shareholders. she also holds analyst teleconferences and media conferences, and attends road shows to update investors on the company’s outlook. respondent c4 is the chief executive officer of the company. he has more than 10 years of experience in investor relations and corporate finance. respondent c5 is the investor relations manager of the company. he has more than 5 years of experience in finance and investor relations. respondent c6 is the independent director of the company for 9 years. he has more than 15 years at the managerial level. his area of expertise and experience includes accounting, finance and corporate management. he holds master of business administration (mba) from the university of malaya. he is also a member of the malaysian institute of accountants. respondent c7 is the head of group investor relations. he has more than 10 years at the managerial level. his area of expertise and experience includes accounting, auditing, finance, strategic planning, performance management and investor relations. respondent c8 is the head, investor relations from ceo’s office. she has 16 years at the managerial level. her portfolio includes investor relations. respondent c9 is the senior manager of corporate planning. he has 6 to 7 years at the managerial level. his portfolio includes accounting, corporate finance and treasury. respondent c10 is the assistant manager of corporate planning. he has 5 years at the managerial level. his area of expertise and experience includes audit, finance and business development. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e9 www.macrothink.org/ajfa 161 details of the respondents company industry designation expertise & experience c1 finance chief operating officer investor relations head, accountant, past senior general manager c2 construction/property finance manager tax, audit, group accounts & business plan c3 trading/services head of investor relations internet-based corporate reporting, liaise with investors c4 finance chief executive officer corporate finance, investor relations c5 construction/property investor relations manager finance & investor relations c6 plantation independent director accounting, finance & corporate management c7 finance head group investor relations accounting, auditing, finance, strategic planning, performance management and investor relations c8 finance head of investor relations from ceo’s office investor relations c9 plantation corporate planning senior manager accounting, corporate finance and treasury c10 plantation assistant manager corporate planning audit, finance and business development microsoft word 3216-12183-1-rv-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 197 evidence to support multifactor asset pricing models: the case of the istanbul stock exchange ulas unlu the university of nevsehir, department of accounting and finance 50300, nevsehir/turkey e-mail: ulasunlu@gmail.com received: feb. 4, 2013 accepted: april 12, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3216 url: http://dx.doi.org/10.5296/ajfa.v5i1.3216 abstract the objective of this study is to test, instead of the single factor capm, the power of three factor, four factor and five factor models to explain stock returns for the istanbul stock exchange (ise). the test results of all models in the ise indicate that the models are applicable. during the period covering july 1992-june 2011 it is consequently established that, in addition to the market risk, size, book to market ratio, momentum and liquidity factors also constitute significant risk factors that affect the expected stock returns in the ise and that the risk premiums belonging to these five factors are priced by the market. keywords: fama and french three factor model, four-factor pricing model, five factor pricing model, asset pricing, emerging markets jel cod: g11, g12 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 198 1. introduction the validity of asset pricing models bears vital importance for individual and institutional investors planning to invest in securities. as it is known, the most widely known and used asset pricing model in capital markets is capm (capital asset pricing model) as developed by sharpe (1964), lintner (1965) and mossin (1966), which represents a balance model that prices a certain asset relying on certain assumptions with consideration of the relation between the risk and the expected return. during the 1970’s, capm was widely advocated owing to the facilities it provided such as its provision for measuring risks with a single variable. in parallel with the developing capital markets during the 1980’s and 1990’s however, controversies appeared as to the adequacy of capm to explain the stock returns. nevertheless, many researchers show that the anomalies they detected could not be foreseen by the model. examples to these are size anomaly by banz (1981), reinganum (1981), keim (1983); book to market effect by stattman (1980), rosenberg, reid and lanstein (1985), chan, hamao, and lakonishok (1991); price-earning effect by basu (1983); and momentum effect by jegadeesh and titman (1993). the fact that no non-market factor (size, book to market ratio, momentum, liquidity, etc…) other than market risk is included in capm, indicates that excessive returns created by such variables, which are thought to lead anomalies, cannot be foreseen by the model either. focus switched towards multifactor models for capital markets as capm fell insufficient to explain stock returns. these models present evidence that company specific characteristics are usually very successful in explaining horizontal-section stock returns. the purpose of this study is to test the power of the three factor, four factor and five factor models, which attract intensive attention in international markets, to explain asset prices in the istanbul stock exchange (ise). it is believed that testing alternative asset pricing models will fill an important gap for the turkish capital market. this study further represents an initial work for the ise that tests the five factor asset pricing model, which is created by adding liquidity as a risk factor to the four factor model. in addition, it is considered that the study bears importance in that it shows whether small company premium, value premium, momentum and liquidity premium are priced in the ise as far as the investors are concerned. 2. literature review as capm fell insufficient to explain security prices, various studies were conducted on multifactor models in capital markets and alternative asset pricing models were suggested to remedy the deficiencies of capm. fama and french suggest a multifactor model to explain expected stock returns in the studies they conducted in 1993 and 1996. in the three factor model by fama and french, the rm-rf, smb and hml risk factors affect the expected return of stocks. fama-french (1993, 1996) predicted this model for the below equation: iiifmiifi hmlehsmbesrrerre   )()()])([)( asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 199 the beta coefficients mentioned in the equation represent sensitivity coefficients that express the slope of the multiple regressions that is made between e(ri) – rf and rm-rf, smb and hml. here, smb covers the size risk factor on the returns and hml covers the b/m ratio risk factor in the returns. the validity of the three factor model proposed by fama and french (1993, 1996) was supported by the studies conducted in many markets. griffin (2003) tested the three factor model for japan, england and canada for the period of 1981-1995 and found the power of the model significant for explaining the change in of cross-section stock returns. lam (2002) reached findings that support the three factor model in the study he conducted during the period of 1980-1997 for 100 companies that were traded in the hong-kong stock exchange. ajili (2003) tested the three factor model for the french market during the july 1976 – june 2001 period and the characteristic model of daniel-titman (1997). it was established that power of 6 portfolios, which were determined as dependent variables, to explain the expected returns was 90,5% on average. cao, leggio and schniederjans (2005), included within the model 367 stocks that were quoted in the shanghai stock exchange (shse) during the period of 01 december 1999 31 december 2002. the focus of the study is to compare the explanatoriness of capm and the fama – french three factor model with the artificial neural network model and linear models. the result showed that the composed linear models produced much mode significant results compared to the artificial neural networks. iqbal and brooks (2007) compared two asset pricing models (capm and fama and french three factor) in pakistan's karachi stock exchange (kse). they applied garch and egarch as the method and used the daily, weekly and monthly data. the study used 89 stocks that were traded in the karachi stock exchange (kse) during the period of 09 march 1999 – 08 march 2005. the kse-100 index was used as the market index. it was concluded that the risk factors in the fama and french three factor model were more significant than the capm. in the meanwhile, the authors recommend using daily data instead of monthly data. in their study conducted for the australian market, o’brien, brailsford and gaunt (2008) took 1982-2006 as the sampling period and compared capm with the three factor model. it was concluded that the three-factor model represented a very successful model for explaining the change in returns and that it explained nearly 70% of the changes in returns. 3. the four-factor model the four factor model represents an asset pricing model developed by carhart (1997) owing to the fact that the three factor model of fama-french (1993, 1996) could not explain the momentum effect presented by jegadeesh-titman (1993). during a study by jegadeesh and titman (1993), the portfolios created using a strategy, which is based on the assumption that within a period of 3-12 months (short-term), the stocks that made gains (led to losses) in the past will make gains (lead to losses) in the future, obtained abnormal returns of 1% in each consecutive year. when the literature is examined, it is seen that very small number of studies paid regard to the power of adding the momentum factor to smb and hml factors of fama and french (wml-winners minus losers) in explaining stock returns. (carhart 1997, jegadeesh 2000, liew and vassalou 2000, kim and kim 2003, l’her; asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 200 masmoudi; suret 2004, bello 2007, carmichael and coën 2008, lam; li; so 2009; unlu, 2012). the four factor model was first tested by carhart (1997). carhart (1997) created the four factor model by augmenting the momentum factor of jegadeesh and titman (1993) to the three factor model of fama-french. the four factor model is tested as follows (carhart, 1997: 61): iitititititit yrprphmlhsmbsrmrfbr   1 the thing involved here is the return of the rmrf; nyse, amex and nasdaq indexes on the one month treasury bill. these are smb and hml fama-french factors. on the other hand, pr1yr represents the difference between the highest 30% returns 11 months ago and the lowest 30% returns 11 months ago. as a conclusion, carhart (1997) suggests that the four factor model can be used in explaining stock returns. liew and vassalou (2000) examined the relation between the macroeconomic risk factors and the profitability of smb, hml, wml transaction strategies for 10 developed markets comprised of australia canada, france, germany italy, japan, the netherlands, switzerland, england and the usa. whereas this study represents an evidence for the wml factor, the findings obtained are not as strong as the smb and hml factors. by using monthly data, l’her, masmoudi and suret (2004) looked into the power of four factors, which are rm-rf, smb, hml and wml, to explain stock returns during the period of 1960 – 2001 for the canadian equity market. it was concluded that the four-factor model was valid for the canadian market. naceur and chaibi (2007) researched into the best asset pricing model in the tunisian stock exchange (tse) for calculating the capital cost. the result of the study, the four factor model of carhart (1997) was the best model to estimate the capital cost for the tse. lam, li and so (2009) examined the power of the four factor model, which was created by adding the momentum factor to the three factor model of fama-french, in explaining the change in stock returns concerning the hong kong market. the study concluded that the coefficients of the four factor model are significant; alpha coefficients are not significantly different from zero and thus showed that the model is applicable. unlu (2012) tested the four factor model in the ise for the period of july 1992 – june 2008 and the results showed that the four factor model was significant for the ise. 4. the five factor model the liquidity of a stock means that it can easily be purchased and sold rapidly on lower costs in the secondary market. pastor and stambaugh (2003) added the liquidity factor to the four factor model in their studies for the nyse, amex, and nasdaq stocks and tested the five factor model. amihud (2002) was used as the liquidity measurement method. the study concluded that liquidity represented an important risk factor. on the other hand, chan and faff (2005) added the liquidity factor as the four factor to the three factor model for the australian market. the study, which used turnover rate as the liquidity measurement, determined that the liquidity asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 201 factor was priced by the market. in their studies, nguyen and tribhuvan (2009) added the liquidity factor to the three factor model and examined the role of liquidity in stock pricing. in the study where the nyse and amex stocks were used, it was established that liquidity could be used as an important systematic risk factor. 5. data structure and method the study took july 1992 – june 2011 as the sample period and used monthly data. data on stock returns, index closing and balance sheets was obtained from the ise and treasury bill rates was obtained from the official website of the turkey undersecretariat of treasury. stock transaction amounts and the number of stocks were taken from datastream. the financial ratios in the study were calculated from the 31 december 1991 and 31 december 2010 end-year balance sheet data of the companies. presuming that the company profits arrived to the investor before the balance sheets were declared, results in look ahead bias. the returns were calculated for the 01 july 1992 – 30 june 2011 period in order to prevent this (fama and french 1993, 1996). the ise-100 index was used as the index return. the annual compound reference treasury bill rates was converted into monthly values and used as risk-free interest rate in the study. the portfolios were created using the fama and french (1993, 1996) methodology and factors of size and b/m ratio were used as criteria. firm size was measured by market capitalization or market value of equity. the b/m ratio is calculated by dividing the per-stock book value into the stock’s market price. the portfolios were created in the june of each t year and the balance sheet data in the t-1 year's december were paired with the stock returns in the t year's june. as the firm size was calculated as of the month of june, the b/m ratio was calculated by dividing the book value in the t-1 year’s december into the market value in the t-1 year’s december. the returns for the three factor model, four factor model and the five factor model are monthly, and on the other hand, 6 pcs portfolios were created according to the b/m ratio and these were used as dependent variable in the models. 2 pcs (small and large) portfolios were determined for the size effect and 3 pcs (low, medium and high) portfolios were determined for the b/m effect. a total of 6 intersection portfolios were created for the size effect and the b/m ratio effect (low = 30%, medium = 40%, high = 30%) and (smb and hml) were used for the calculation of (s/l, s/m, s/h, b/l, b/m, b/h) risk factors. the portfolios created were calculated in a manner to cover the period between each t year's july until each t+1 year's june and they were revised in the june of each year. in order to enable the calculation of the momentum factor, the stocks were sequenced as the t year’s july and t-1 year’s june and their performances between the months of t-2 and t-12 were taken into consideration (fama and french, 2007, l’her; masmoudi; suret, 2004, lam; li; so, 2009). the stocks were divided into two groups according to their size measurements, which are s (small) for 50% and b (big) again for 50%. later, 6 pcs equally weighted portfolios were created, representing namely the 70% portion with the best return (momentum) labeled as w (winner), the average 40% labeled as n (neutral) and the lowest 30% portion labeled as l (loser), and these were used for the calculation of the “wml” risk asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 202 factor. “turnover ratio” was used the liquidity criterion as similar to chan and faff (2005) and eckbo and norli (2005). the turnover ratio is found by using the monthly transaction amount and the number of stock certificates present in the market. that is to say, the turnover ratio of a stock was calculated by dividing the monthly transaction amount into the number of stock present in the market. 6 pcs equally-weight portfolios were created in order to calculate the liquidity risk factor. five pcs risk factors were determined in order to explain the stock returns. these are the risk factors of rm-rf (the difference between the market return and the risk-free interest ratio), smb (the difference between the return of the portfolio that is composed of the small stocks with low market values and the portfolio that is composed of large stocks with high market values), hml (the difference between the return of the portfolio that is composed of the stocks with high b/m ratio and the return of the portfolio that is composed of the stocks with low b/m ratio) and wml (the difference between the return of the winner stocks portfolio and the return of the loser stocks portfolio) and lmh (the difference between return on the two portfolios with low turnover and return on the two portfolios with high turnover) (e(rm) – rf) represents the market premium and it is the return of the market over the risk-free interest ratio. smb represents the size premium, hml represents the value premium, wml represents the earning premium and lmh represents liquidity premium. the returns of the 6 portfolios, which were created according to size and b/m ratio, on the risk-free interest ratio were used as dependent variables in time series regressions. the following regression models were created in order to estimate the stock returns: iiifmiifi hmlehsmbesrrerre   )()()])([)( (1) iiiifmiifi wmlewhmlehsmbesrrerre   )()()()])([)( (2) iiiiifmiifi lmielwmlewhmlehsmbesrrerre   )()()()()])([)( (3) the beta coefficients mentioned in the equation represent sensitivity coefficients that express the slope of the multiple regressions that is made between e(ri) – rf and rm-rf, smb, hml, wml, lmh. as it is known, if the alpha value reached in the asset pricing models is significantly different from zero, this means that there is a pricing error in the models and there is a factor or are factors that cannot be explained by the models (black; jensen; scholes 1972, fama and french, 1993). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 203 the f (grs) test of gibbons, ross and shanken (1989) is usually recommended during studies in order to determine whether the alpha value is significantly different from zero (fama and french 1996, campel; lo; mckinlay 1997, gregory; tharyan; huang 2009). the grs test statistic is; kntnkk f n knt j      , 111 )1( )(    h0 = all αi coefficients obtained from multiple factor models are equivalent to zero (αi = 0).  h1 not all αi coefficients obtained from multiple factor models are equivalent to zero (αi ≠ 0).  the acceptance of the zero hypothesis will also show that the multi-factor asset pricing models, which constitute the basic purpose of the study, can be used for the ise to explain the stock prices (fama and french 1996). 6. findings the regression results pertaining to the three factor asset pricing model have been given in table 1. table 1. three factor regression of montly excess returns: from july 1992 to june 2011 hmlehsmbesrrerre   )()()])([)( ri-rf α β s h ad.r2 dw f sl -0,003 0,694 0,618 -0,191 0,726 2,05 76,18 (-0,355) (13,803)* (5,434)* (-2,415)** [0,000] sm -0,016 0,612 -0,618 -0,869 0,811 2,11 124,53 (-0,658) (10,642)* (-4,755)* (-9,610)* [0,000] sh -0,009 0,759 0,388 0,235 0,719 2,12 73,75 (0,273) (14,848)* (3,369)* (2,936)* [0,000] bl -0,013 0,733 -0,648 -0,887 0,868 2,09 187,65 (-0,455) (14,077)* (-5,505)* (-10,840)* [0,000] bm -0,015 0,747 0,406 -0,030 0,737 2,22 80,562 (-0,751) (14,929)* (3,591)* (-0,385) [0,000] bh -0,006 0,669 -0,418 0,685 0,763 2,19 88,03 (-0,766) (13,786)* (-3,810)* (8,983)* [0,000] grs-f test: 0,955 [0,432] the p value are in parentheses ***, **,* show significance at the 10, 5, and 1% levels, respectively. probability values of grs-f test are in brackets. when table 1 is examined, the f values and probability values of all models, which were asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 204 created according to the regression results of the fama-french's three factor model, show that the established models are meaningful. it is seen that not the entirety of the alpha values is different from zero. in addition, the grs f test result’s being 0,655 and that the probability value’s being 0,432 mean that the zero hypothesis is accepted, in other words that the three factor model is valid for the ise. table 2. four factor regression of montly excess returns: from july 1992 to june 2011 iiiifmiifi wmlewhmlehsmbesrrerre   )()()()])([)( ri-rf α β s h w ad.r2 dw f sl 0,006 0,677 0,558 -0,283 -0,271 0,748 2,15 64,105 (0,754) (13,915)* (5,018)* (-3,434)* (-2,844)* [0,000] sm -0,009 0,600 -0,659 -0,931 -0,183 0,817 2,11 95,87 (-0,923) (10,457)* (-5,021)* (-9,554)* (-1,690)*** [0,000] sh -0,000 0,741 0,332 0,148 -0,259 0,736 2,22 101,14 (-0,043) (14,920)* (2,923)* (1,760)*** (-2,627)* [0,000] bl -0,007 0,723 -0,681 -0,937 -0,150 0,869 2,12 143,71 (-0,791) (13,877)* (-5,718)* (-10,606)* (-1,455) [0,000] bm -0,004 0,728 0,340 -0,131 -0,300 0,764 2,23 69,50 (-0,786) (15,201)* (3,111)* (-1,614) (-3,154)* [0,000] bh -0,000 0,659 -0,455 0,630 -0,166 0,760 2,15 68,38 (-0,048) (13,624)* (-4,116)* (7,677)* (-1,731)*** [0,000] grs f test: 1,103 [0,295] the p value are in parentheses ***, **,* show significance at the 10, 5, and 1% levels, respectively. probability values of grs-f test are in brackets. when regression results of the four factor model are examined, the f values and probability values of all models show that the established models are significant. not the entirety of the alpha values is different from zero. it was established that the grs f test result is 1,103 and the probability value is 0,295. this result means that the zero hypothesis is not rejected, meaning that the four factor model is also valid for the ise. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 205 table 3. five factor regression of montly excess returns: from july 1992 to june 2011 lmielwmlewhmlehsmbesrrerre   )()()()()])([)( ri-rf α β s h w l ad.r2 dw f sl 0,006 0,346 0,589 -0,285 -0,264 0,332 0,753 2,17 52,83 (0,724) (1,748)* (5,271)* (-3,495)* (-2,758)* (-1,728)*** [0,000] sm -0,010 0,096 -0,593 -0,935 -0,162 0,700 0,833 2,10 86,08 (-1,036) (12,405)* (-4,670)* (-10,665)* (-1,486)*** (3,001)* [0,000] sh -0,001 0,145 0,387 0,144 -0,240 0,598 0,761 2,26 55,24 (-0,112) (17,365)* (3,522)* (1,792)*** (-2,546)* (2,958)* [0,000] bl -0,008 0,096 -0,622 -0,942 -0,131 2,970 0,881 2,21 127,37 (-0,895) (10,774)* (-5,390)* (-11,155)* (-1,823)*** (1,059) [0,000] bm -0,004 0,167 0,393 -0,135 -0,282 0,563 0,782 2,12 62,28 (-0,573) (11,243)* (3,694)* (-1,734)*** (-3,094)* (2,883)* [0,000] bh -0,000 0,296 -0,421 0,627 -0,155 0,363 0,766 2,02 56,84 (-0,090) (12,235)* (-3,803)* (7,749)* (-1,741)*** (1,790)*** [0,000] grs f test: 0,512 [0,725] the p value are in parentheses ***, **,* show significance at the 10, 5, and 1% levels, respectively. probability values of grs-f test are in brackets. the examination of table 3 established that just like the three factor and four factor models, f values and probability values of the established models were significant for the regression results yielded by the five factor model and that not the entirety of their alpha values was different from zero. the grs f test result was found to be 0,512 and the probability value was found to be 0,725. this result shows that the five factor model can be used in explaining securities’ returns in the ise. when the regression results are examined, it is seen that the r square vales of the three factor and four factor models are close to each other. the addition of the liquidity factor to the four factor model has meaningfully increased the r square value. it is seen that the coefficients of the rm-rf, smb, hml, wml and lmh, which constitute systematic risk factors, are meaningful in almost all models. the regression findings revealed the finding that the portfolio of the companies with small market value (sl and sh) has a positive smb slope whereas the portfolio of the companies with large market value (bl and bh) has a negative smb slope. this finding points to the effect of company size. furthermore, the fact that the portfolio of the companies with high b/m ratio (sl and sh) has a positive hml slope and the portfolio of the companies with low b/m ratio (bl and bh) has a negative hml slope points to the presence of the value effect. the obtained results are consistent with the findings of fama and french (1996). it was nevertheless determined that all wml slopes are negative and all lmh slopes are positive. this results shows that the wml and the lmh factors are not related with the firm size or asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 206 the b/m ratio. 7. conclusion the purpose of the study is to test the alternative asset pricing models for the ise. this paper aims to fulfill this gap and contributes to empirical literature on this subject. the obtained findings point to the existence of the size and value effects for the ise. it is also determined that the factors of momentum and liquidity should be preferred during the creation of asset pricing models. it is consequentially established that the three factor, four factor and five factor models are valid in the ise, and that in addition to the market risk, factors of firm 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(2012). testing four-factor pricing model in ise. iktisat, isletme ve finans dergisi, 27 (313), 57-83. microsoft word 1560-6159-2-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 259 prior return patterns in sector returns: evidence for emerging markets sanjay sehgal professor of finance, university of delhi sakshi jain research associate, university of delhi received: march 28, 2012 accepted: may 5, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1560 url: http://dx.doi.org/10.5296/ajfa.v4i1.1560 abstract in this paper, we examine if there are any prior return patterns for sector returns for bricks markets from january 1993 to february 2008. for short-term portfolio formation windows (up to 12 months), india and s.africa report momentum behavior while south korea reports reversals. for long-term formation windows (up to 60 months), brazil exhibits momentum patterns which disappear for 60-12-12 strategies. india and russia momentum patterns continue even for long-term portfolio formation windows south korea, south africa and china show weak reversals for long-term portfolio formation windows. we construct a sector factor based on liu and zhang (2008) argument that winner sector exhibit higher risk owing to stronger growth potential. we observe that a large part of prior return patterns in stock returns are absorbed by similar patterns in sector returns. our findings shall be useful for portfolio managers and academicians with better insights about prior return patterns in sector data. the study contributes to the asset pricing and behavioral finance literature for emerging markets. keywords: capm, momentum, contrarian, fama french model, sector returns, behavioral finance jel code: c51, c52, g12, g14, g15 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 260 1. introduction goldman sachs in 2001 coined the term brics for the fast developing economies of brazil, russia, india and china and they collectively may rival the g7 economies in terms of global growth by 2050. the economists at goldman sachs believe that the bric countries will grow at a significantly higher rate than the developed economies. the brics acronym has been extended to bricks in this paper, which includes the emerging economies of south korea (k) and south africa (s). korea is an industrial leader in electronics, ship-building and global trading and south africa is the economic force of the african continent and hence are important emerging markets. these financial markets have attractive investment opportunities with a striking risk/return ratio. over the last decade, these economies have contributed one third in terms of gdp growth. bricks represent one of the most active segments of emerging markets. they are on the radar of global portfolio managers owing to the belief that emerging markets exhibits low degree of co-relation with mature markets. during recent years, with liberalization and deregulation in these emerging markets, global investors have many opportunities to invest. these investors are continuously on the look out for trading strategies that can exploit observable market inefficiencies and generate extra normal returns. researchers have found that simple trading strategies based on past cross-section of stock returns can generate extra normal profits. practitioners and investors try to exploit the persisting anomalies (value effect, size effect, the january effect, lead-lag effects, mean reversal of long-term losers, and momentum of short-term winners) of stock market to earn profits. among them, long-term reversals (contrarian) and short-term continuation (momentum) have received particular attention over the last three decades. the contrarian strategies perform well for very short term (up to 3 months), see lo and mackinlay (1990) and long term (3 years 5 years), see de bondt and thaler, (1985, 1987) while momentum strategies perform well for short term (between 3months 12 months), see jegadeesh and titman, (1993). in the last three decades, these prior return patterns in stock returns have been extensively evaluated for mature1 as well as emerging markets2. since the end of nineties, a body of literature has emerged that concentrates on prior return patterns in sector returns and which advocates that these sector patterns tend to drive prior return patterns in stock returns. the belief here is that the stocks within a sector have a lot in common in terms of business perspectives and hence winner stocks may owe there success to being a part of winner sectors while loser stocks may belong to poor performing sectors. there is also some empirical evidence which suggests that the role of sector factor in stock returns is over emphasized. moskowitz and grinblatt (1999) were the first to document strong momentum effect in industry components of stock returns. asness, porter and stevens (2000) find that within-industry momentum has predictive power for the firm’s stock returns beyond that captured by across industry momentum and also there is a significant short-term (one-month) industry momentum effect. neal (2000) provides evidence of industry momentum over intermediate time horizons by the performance of industries in mutual funds. serra (2000) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 261 document that cross-market diversification seems better than cross-industry diversification, for emerging markets, returns are driven by country factors and not by the industrial composition of indices. nijman, swinkels and verbeek (2004) suggest that positive expected excess returns are primarily driven by individual stock effects, while industry momentum plays a less important role and country momentum is even weaker. du and denning (2005) find that industry momentum is mainly due to common factors and not industry-specific risk. scowcroft and sefton (2005) indicate that price momentum is driven by industry momentum. menzly and ozbas (2006) find strong cross-industry momentum for industries related to each other through supply chain. bonie and kent (2006) report that short-term industry price momentum phenomenon is partly explained by returns of firms with more analyst coverage leading those with less analyst coverage. phylaktis and xia (2006) show that global and industry effects are dominated by country effects in emerging markets, which is contrary to the evidence on mature markets. chen, benett and zheng (2006) suggest investors should emphasize sector based approach in developed countries but continue country-based allocation strategies for emerging markets. saffieddine and sonti (2007) report firms with highest industry growth quintile have significantly higher momentum compared to industries in lowest growth quintile. liu and zhang (2008) document that growth rate of industrial production is a risk factor in asset pricing tests and can explain more than half of stock momentum profits. fraulo and nguyen (2009) replicate moskowitz and grinblatt’s work and find that industry momentum strategies do provide greater returns than individual stock momentum strategies and also the optimal time horizon of industry momentum strategy has no correlation with the size of the industries. they also find that the (6, 6) and (12, 12) strategies are unaffected by the one-month return, confirming our previous intuition that these strategies are uncontaminated by any potential short-term effects due to microstructure or liquidity. while focusing in industry patterns in stock returns, it is important to understand that industry classification systems which are currently in vogue. there are several3 industry classification systems which are being used worldwide. amongst these global industry classification system (gics) provided by standard & poor's (usa) in collaboration with morgan stanley capital international (msci) is extremely popular and hence extensively employed by market players as well as empiricists. gics is a four digit classification system involving 10 sectors, 24 industry groups, 68 industries and 154 sub-industries. one may discern different prior return patterns for each stage of industry classification that is sector, industry group, industry and sub-industry. there is limited literature for emerging markets that covers sector based prior return patterns. in this paper we examine the following propositions for bricks which is a fast growing emerging market basket closely tracked by global investment managers. (1) are there any prior return patterns at sector, industry and industry group level? (2) do these prior return patterns differ for short-term (up to 12 months) and long-term (24-60) portfolio formation windows? (3) do winner and loser sector exhibit different growth potential, the information about which then can be used to construct a sector factor as suggested by liu and zhang asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 262 (2008)? (4) can the sector factor capture prior return patterns in stock returns that are missed by capm and the fama french three-factor model? the main focus of the study is to test prior return patterns for sector returns especially for emerging markets. we find in case of sector returns, for short-term portfolio formation windows (up to 12 months), india and s.africa reports momentum behavior while s. korea reports reversals. for long-term formation windows, brazil exhibits momentum patterns which disappear for 60-12-12 strategies. for india and russia momentum patterns continue even for long-term portfolio formation windows. s.korea, s.africa and china show weak reversals for long-term portfolio formation windows. the differences in growth rate of sectors of winners and losers may be able to explain risk as documented by liu and zhang (2008). it is expected that the sector factor, which mimics the growth risk differences between corner portfolios, should be able to provide a better explanation based on short-term prior return formation. in case of long-term portfolio formation, the sector factor is likely to absorb cross-section of average returns in case of brazil, russia and india’. we construct a sector factor based on liu and zhang (2008) argument that winner sector exhibit higher risk owing to stronger growth potential. our results are stronger for short-term portfolio formation windows for all the sample countries and for long-term portfolio formation windows in case of brazil, russia and india. the remainder of the paper is structured as follows: section 2 gives a brief description of data and their sources. in section 3, we test for any prior return effects in sector, industry and industry group. section 4 describes the methodology employed and examine the evidence for four-factor model with constructed sector factor as the additional factor to fama-french three factor model and the empirical tests carried out related to sector momentum portfolios. section 5 concludes. 2. data and their sources data comprises of monthly share prices adjusted for stock splits, stock dividends and rights issues for bricks markets and has been obtained from thomson reuters datastream software. the sample period is from january 1993 to february 2008 except for russia where the sample period is january 2000 to february 2008 due to paucity of data. exhibit a gives the number of securities that have been used for analysis along with market indices and their description for the sample countries. the companies account for a reasonable part of market capitalization and trading activity in their respective markets. hence, our data set fairly represents market performance. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 263 exhibit a: data description for sample countries country no. of securities market index index description brazil 195 brazil bovespa bm&fbovespa s.a. ia a security market index with base year 1968 and base value of 100. it is a total return index and handles about 85% of the total volume traded on country's nine stock exchanges. russia 75 russia rts index the russian trading system index is a capitalization-weighted index. the index was developed with a base value of 100 in 1995. it uses free float adjusted weights. india 450 india bse-200 (sensex) bse-200 index is a free-float value weighted index that represents nearly 93% of the total market capitalization on the bombay stock exchange. the financial year 1989-90 has been chosen as the base year. china 600 shanghai se a share the shanghai a-share stock price index is a market capitalization-weighted index. the index was developed with a base value of 100 on december 19, 1990. it comprises of all the a-shares which are restricted to trading by local investors and qualified institutional foreign investors. korea 500 korea se composite (kospi) the kospi 200 index consists of 200 korean stocks which constitute 93% of the total market value on the korea stock exchange. the index was developed with base value of 100 in the year 1990. south africa 250 ftse/jse africa all share the ftse/jse all africa index series is designed to represent the performance of the top african companies listed on johannesburg stock exchange. companies included consist of top 99% of the total pre-free float market capitalization. the ftse/jse africa index series replaced the jse actuaries indices on the 24th of june 2002. monthly share prices for estimation purposes and further analysis have been converted to percentage monthly return series. the stylized portfolios are formed on basis of past percentage returns4 and characteristics and past sales growth5 (estimated as compounded asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 264 value of net sales). 91-day6 treasury bills for each country have been used as risk free proxy. value-weighted market index has been used as surrogate for aggregate economic wealth. data for above said firm characteristics and market index has also been obtained from thomson reuters datastream. global industry classification system (gics) is an industry classification system, developed by standard & poor's (usa) in collaboration with morgan stanley capital international (msci). it comprises of 10 sectors, 24 industry groups, 68 industries and 154 sub-industries. gics was developed in response to the financial community’s need for one complete, consistent set of global sector and industry definitions. the gics standard can be applied to companies globally, in both developed and developing markets. in our work information for sectors, industry group and industry have been used. the 10 prominent sectors are energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services and utilities. the data for sector, industry group and industry classification has been obtained from world scope, reuters financials & compustat global. 3. prior return patterns in sector returns in this section, we evaluate if there are any prior return patterns in sector, industry group and industry data and also show how these patterns differ for short-term and long-term portfolio formation windows. the portfolios have been formed on basis of (i months-j months strategy) where i months represent portfolio formation window and j months represent portfolio holding period. two types of strategies have been employed (i) short-term strategies, 6 months-6 months (6-6) and 12 months-12 months (12-12), (ii) long-term with skipping one year between portfolio formation and holding periods, 24 months-12 months -12 months (24-12-12), 36 months-12 months -12 months (36-12-12), 48 months-12 months -12 months (48-12-12), and 60 months-12 months -12 months (60-12-12). the 12 months have been skipped to control for any short-term prior return effects as that may hamper any clear judgment of returns, as suggested by fama and french (1996). calendar year (january to december) has been followed from for purpose of evaluation. short-term portfolio formation we verify if there are any momentum patterns in sector return for bricks countries. for 6–6 investment strategies, in december of year t-1, we categorize the sample securities into 10 sectors according to global industry classification system (gics). gics was developed by standard & poor's (usa) in collaboration with morgan stanley capital international (msci). it comprises of 10 sectors, 24 industry groups, 68 industries and 154 sub-industries. the excess monthly return for each sector is then calculated from july to december by taking the simple average of returns on securities that form part of each of these sectors. the individual sectors are then ranked on basis of past six month’s average monthly past excess returns. the ranked sectors are then classified into quintiles, k1 to k5. k1 comprises of sectors with lowest average past returns and k5 comprises of sectors with highest average past returns. equally weighted excess returns are estimated for sector portfolios for the next six months (i.e. january to june of year t). the portfolios are then rebalanced in the month of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 265 june for year t based on ranking of six month’s average monthly past sectoral returns i.e. january to june of year t. the process is repeated till we reach the end of our sample period. for 12-12 strategies, estimation has been done in similar manner except that portfolio formation and holding windows are reset to 12 months. the portfolios for industry group and industry have also been constructed in the same manner, where the ranked industry group is classified into quintiles as ig1 to ig5, ig1 and ig5 comprise of industry group with lowest and highest average past returns. in case of industry classification, the industries are labeled from i1 to i5, where i1 and i5 comprise of bottom and top 20% of industries. short-term prior return patterns for sector, industry group and industry are reported in table 1, panel a. we specifically evaluate zero investment long-short portfolio strategies involving buying past winners (losers) and selling past loser (winners) when there is momentum (reversal). for 6-6 strategies, south korea and brazil provide strong momentum profits at all levels (sector, industry group and industry). south korea reports the highest monthly returns of 3.2% at sector level, while brazil provides the highest return of 3.8% and 4.1% on monthly basis at industry group and industry level. india, s.africa and russia also report momentum profits at all levels. for china, the prior return patterns at all the three levels are negligible. for brazil, south africa and china, the returns increase as we move from sector to industry level, however india does not report any clear patterns. for 12-12 strategies, the prior returns become weaker compared to 6-6 strategies. for brazil and china, the returns are negligible and in fact die out in case of former. india reports momentum only at sector level, while south africa reports strong momentum at industry group and industry level. for korean market, there are strong reversals at all the three levels. in sum: for 6-6 strategies, we report momentum for all the sample countries with exception of china. for 12-12 strategies, in case of india and south africa the momentum pattern persists, south korea reports strong reversals, and the prior return patterns die out for other bricks markets. strategy k1 k5 k5‐k1 ig1 ig5 ig5‐ig1 i1 i5 i5‐i1 6 months ‐ 6 months 0.012 0.024 0.013 ‐0.006 0.031 0.038 ‐0.005 0.036 0.041 12 months ‐ 12 months 0.014 0.022 0.007 ‐0.001 0.018 0.019 0.007 0.021 0.014 6 months ‐ 6 months 0.060 0.078 0.018 ‐ ‐ ‐ ‐ ‐ ‐ 12 months ‐ 12 months 0.069 0.072 0.003 ‐ ‐ ‐ ‐ ‐ ‐ 6 months ‐ 6 months 0.020 0.030 0.010 0.014 0.029 0.015 0.014 0.025 0.011 12 months ‐ 12 months 0.019 0.031 0.013 0.014 0.022 0.008 0.016 0.020 0.004 6 months ‐ 6 months 0.024 0.020 ‐0.003 0.018 0.020 0.001 0.009 0.017 0.008 12 months ‐ 12 months 0.022 0.018 ‐0.004 0.020 0.018 ‐0.002 0.012 0.016 0.004 6 months ‐ 6 months 0.001 0.034 0.032 0.009 0.032 0.024 0.004 0.035 0.031 12 months ‐ 12 months 0.027 0.009 ‐0.019 0.028 0.014 ‐0.014 0.023 0.009 ‐0.014 6 months ‐ 6 months 0.011 0.021 0.011 0.006 0.024 0.018 0.004 0.026 0.022 12 months ‐ 12 months 0.015 0.015 0.000 0.007 0.018 0.010 0.006 0.028 0.022  brazil russia  india china south korea  south africa table 1: panel a: mean excess returns on sectoral momentum portfolios (short‐term) sector industry group industry long-term portfolio formation asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 266 in case of long-term strategies, (24-12-12, 36-12-12, 48-12-12, and 60-12-12), for 24 months-12 months-12 months strategy, in december of year t-2, sample securities have been categorized into 10 sectors according to gics. the excess monthly return for each sector is then calculated from january to december by taking the simple average of returns on securities that form part of each of these sectors. the individual sectors are then ranked on basis of past twenty four month’s average monthly past excess returns. the ranked sectors are then classified into quintiles, k1 to k5. k1 comprises of sectors with lowest average past returns and k5 comprises of sectors with highest average past returns. equally weighted excess returns are estimated for sample portfolios skipping 12 months between portfolio formation and holding windows (i.e. january to december of year t-1) and the portfolios are rebalanced every 12 months based on double sorting criteria for the year t. for 36-12-12, 48-12-12 and 60-12-12 strategies, estimation has been done in similar manner. the portfolios for industry group and industry have also been constructed in the same manner. the results are reported in table 1, panel b. for 24-12-12 strategies, russia (2.3% on monthly basis) and india (3.0% on monthly basis) reports strong momentum at sector level. brazil reports weak momentum at all levels while china, south korea and south africa report weak reversals. for 36-12-12 strategies, same patterns are observed as 24-12-12 strategies. for russia and india the momentum patterns have become strong at sector level. brazil reports momentum behavior in all the three cases and the returns are stronger than 24-12-12. for 48-12-12 and 60-12-12 strategies, the countries report similar patterns. in sum: brazil and russia report momentum up to 48-12-12 and for 60-12-12; while the former reports weak contrarian patterns at sector level, while latter reports small momentum returns at sector, level. india reports strong momentum at sector level up to 60-12-12 strategies, however for industry and industry group, weak reversals patterns emerge. china reports predominantly weak reversals pattern for all long-term portfolio formation windows. further, in case of china, returns at sector level are always better than industry and industry group level. for south korea, we observe weak reversals for all strategies except 60-12-12 strategies, where the momentum patterns emerge at sector level. in case of s. africa, all the long-term strategies report weak reversals. in sum, at the sector level, russia and india report long-run momentum patterns which are stronger than that for short-term portfolio formation strategies. brazil also exhibits momentum patterns but that are weaker for long-term compared to short-term and which disappear at 60-12-12. s.korea, s.africa and china show weak reversals for long-term portfolio formation windows. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 267 strategy k1 k5 k5‐k1 ig1 ig5 ig5‐ig1 i1 i5 i5‐i1 24 months‐12‐12 months 0.019 0.026 0.006 0.018 0.019 0.001 0.020 0.025 0.004 36 months‐12‐12 months 0.017 0.028 0.011 0.015 0.031 0.016 0.019 0.027 0.008 48 months‐12‐12 months 0.014 0.025 0.011 0.015 0.032 0.018 0.013 0.031 0.018 60 months‐12‐12 months 0.025 0.019 ‐0.006 0.023 0.029 0.006 0.026 0.026 0.000 24 months‐12‐12 months 0.051 0.074 0.023 ‐ ‐ ‐ ‐ ‐ ‐ 36 months‐12‐12 months 0.036 0.077 0.041 ‐ ‐ ‐ ‐ ‐ ‐ 48 months‐12‐12 months 0.045 0.081 0.036 ‐ ‐ ‐ ‐ ‐ ‐ 60 months‐12‐12 months 0.053 0.056 0.004 ‐ ‐ ‐ ‐ ‐ ‐ 24 months‐12‐12 months ‐0.005 0.025 0.030 0.036 0.022 ‐0.014 0.032 0.025 ‐0.008 36 months‐12‐12 months ‐0.006 0.022 0.028 0.033 0.028 ‐0.005 0.034 0.029 ‐0.004 48 months‐12‐12 months ‐0.003 0.022 0.025 0.034 0.028 ‐0.006 0.031 0.030 ‐0.001 60 months‐12‐12 months 0.000 0.020 0.021 0.037 0.026 ‐0.011 0.036 0.030 ‐0.006 24 months‐12‐12 months 0.023 0.019 ‐0.004 0.021 0.015 ‐0.006 0.021 0.018 ‐0.003 36 months‐12‐12 months 0.022 0.018 ‐0.004 0.022 0.015 ‐0.007 0.024 0.016 ‐0.008 48 months‐12‐12 months 0.022 0.017 ‐0.005 0.021 0.014 ‐0.007 0.021 0.015 ‐0.006 60 months‐12‐12 months 0.021 0.020 ‐0.001 0.024 0.014 ‐0.010 0.028 0.018 ‐0.010 24 months‐12‐12 months 0.017 0.012 ‐0.006 0.026 0.011 ‐0.015 0.025 0.015 ‐0.009 36 months‐12‐12 months 0.029 0.030 0.001 0.036 0.021 ‐0.015 0.029 0.025 ‐0.004 48 months‐12‐12 months 0.028 0.020 ‐0.008 0.037 0.019 ‐0.018 0.037 0.022 ‐0.016 60 months‐12‐12 months 0.012 0.026 0.014 0.022 0.020 ‐0.002 0.016 0.020 0.005 24 months‐12‐12 months 0.016 0.009 ‐0.007 0.010 0.006 ‐0.004 0.021 0.012 ‐0.008 36 months‐12‐12 months 0.016 0.016 0.000 0.022 0.011 ‐0.011 0.020 0.010 ‐0.009 48 months‐12‐12 months 0.021 0.011 ‐0.010 0.021 0.005 ‐0.016 0.017 0.011 ‐0.006 60 months‐12‐12 months 0.019 0.015 ‐0.004 0.021 0.012 ‐0.010 0.022 0.008 ‐0.014 brazil russia india china south korea south africa table 1: panel b: mean excess returns on sectoral momentum portfolios (long‐term) sector industry group industry 4. economic rationale for the prior return sector factor the explanation of returns by sector factor could be linked to the differences in growth rate of sectors of winners and losers. the sector growth rates may be able to explain risk; this is motivated by the work of liu and zhang (2008). they find that recent winners have temporarily higher loadings for growth rate of industrial production than recent losers, and the combined effect of growth rate of industrial production loadings and risk premiums account for more than half of momentum profits. they also suggest that expected-growth risk is priced and that the expected-growth risk increases with expected growth. however, presence of other factors which may have caused differences in winner and loser cannot be ruled out. in this paper, the sector growth rate has been estimated as follows: for 6-6 strategy, in december of year t-1, we categorize the 10 sectors on basis of past sales growth (psg) according to global industry classification system (gics). the past sales growth is estimated as three year compounded growth rate in sales using the formula st+3= st (1+r)3, where st+3 and st are sales revenue in year t+3 and t respectively. these 10 sectors are then classified in to quintiles q1 to q5, where q1 comprises of bottom 20% sectors (loser sectors) and q5 comprises top 20% of sectors (winner sectors). mean value of psg is calculated for q1 and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 268 q5 using the sector following in these quintiles on period to period basis. the sector growth is then computed by taking the average over time. the estimation for 12-12 sector growth rate has been done in similar manner. the 24-12-12 prior return strategy construction that sorts sectors based on their past 24 month’s past sales growth, skips 12 month for controlling the short-term momentum effect, and hold the resulting portfolios for the subsequent 12 months. the estimation for 36-12-12, 48-12-12 and 60-12-12 strategies have been done in similar manner and we leave a gap of 12 months between portfolio formation and portfolio holding windows to control for any short-term momentum effects. these results are reported in table 2 for all the bricks markets at sector level. for both 6-6 and 12-12 strategies, we observe for all the countries that winner sectors (q5) exhibit higher growth rates as they comprise of high growth companies compared to loser sector and hence they may be exposed to higher growth risk. our results are consistent with liu and zhang (2008) argument and suggest that the sector factor proxies for a risk factor in returns. for long term portfolio formation windows, in case of india and russia portfolio performance is consistent with growth risk story i.e. the winning sectors exhibit higher growth risk vis-a-vis losing sectors. however there are contradictions for other sample countries for one or more portfolio formation periods. hence, ‘we expect the sector factor, which mimics the growth risk differences between corner portfolios to perform better for portfolios based on short-term prior return formation. in case of long-term portfolio formation, the sector factor is likely to absorb cross-section of average returns in case of brazil, russia and india’. strategy brazil russia india china  s.korea s.africa 6 months ‐ 6 months q1 ‐0.612 ‐0.035 0.053 0.033 0.031 0.036 q5 ‐0.228 0.438 0.463 0.348 0.239 0.364 12 months ‐ 12 months q1 ‐0.612 ‐0.015 0.049 0.033 0.026 0.026 q5 ‐0.263 0.413 0.298 0.348 0.235 0.334 24 months‐12 months‐12 months q1 ‐0.342 0.312 0.102 0.212 0.123 0.241 q5 ‐0.496 0.326 0.233 0.264 0.130 0.247 36 months‐12 months‐12 months q1 ‐0.326 0.205 0.112 0.175 0.127 0.242 q5 ‐0.516 0.253 0.143 0.198 0.159 0.232 48 months‐12 months‐12 months q1 ‐0.347 0.151 0.108 0.192 0.121 0.209 q5 ‐0.148 0.230 0.195 0.230 0.157 0.274 60 months‐12 months‐12 months q1 ‐0.373 0.291 0.142 0.210 0.124 0.271 q5 ‐0.505 0.182 0.136 0.147 0.133 0.267 table 2: sector growth rates  5. role of sector factor in stock returns in this section, we test whether prior return patterns in stock returns are absorbed by similar patterns in sector data. we sort securities on basis of average past excess returns, for 6-6 strategies, in december of year t-1, the individual securities are ranked on basis of past six asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 269 month’s average monthly past excess returns. the ranked securities are then classified into quintiles, p1 to p5. p1 comprises of bottom 20% stocks on basis of average past period returns and p5 comprises of top 20% stocks on basis of average past period returns. we estimate the return on zero investment portfolio based on these prior return patterns in stock returns which involves buying winners (losers) and selling losers (winners) as in case of momentum (contrarian) as in case of sector data. we regress the return on zero-investment prior return stock portfolio on the sector factor (zero-investment prior return sector portfolio). the results of which are reported in table 3. estimations for 12-12 and long-term strategies have been done in similar manner. it can be clearly seen that returns on prior return stock portfolio load on the returns for sector factor. as expected our results are stronger for short-term portfolio formation windows for all the sample countries and for long-term portfolio formation windows in case of brazil, russia and india. thus, most of the prior return patterns in stock returns are absorbed by similar patterns in sector returns. further, the sector factor seems to be proxying for growth risk differences between winner and loser sectors and hence should be treated as an additional risk factor in a multi factor asset pricing framework. α β t(α) t(β) α β t(α) t(β) 6 months ‐ 6 months ‐0.001 0.085 ‐0.075 0.635 ‐0.003 ‐0.992 ‐0.258 ‐3.596 12 months ‐ 12 months 0.006 0.068 0.772 1.022 0.000 0.451 ‐0.080 3.986 24 months‐12‐12 months 0.021 0.260 1.627 2.715 ‐0.006 0.777 ‐1.310 4.842 36 months‐12‐12 months 0.010 0.222 0.606 1.366 ‐0.010 0.300 ‐2.249 1.700 48 months‐12‐12 months 0.017 ‐0.507 1.466 ‐4.184 ‐0.008 0.559 ‐1.509 2.728 60 months‐12‐12 months 0.017 ‐0.806 1.133 ‐4.746 ‐0.013 0.250 ‐2.460 1.140 6 months ‐ 6 months ‐0.001 0.436 ‐0.034 4.666 ‐0.019 0.631 ‐1.074 4.310 12 months ‐ 12 months 0.000 1.009 0.373 2.387 ‐0.006 0.487 ‐1.119 2.441 24 months‐12‐12 months 0.029 0.396 1.652 3.332 ‐0.014 0.519 ‐2.484 9.206 36 months‐12‐12 months ‐0.008 0.750 ‐0.595 9.201 ‐0.010 0.349 ‐1.857 7.265 48 months‐12‐12 months 0.025 1.141 1.064 7.468 ‐0.017 0.484 ‐2.818 7.520 60 months‐12‐12 months 0.032 1.075 1.021 5.013 ‐0.009 0.248 ‐2.161 6.284 6 months ‐ 6 months ‐0.014 0.421 ‐1.146 3.220 ‐0.003 0.284 ‐0.346 2.394 12 months ‐ 12 months 0.007 0.180 1.229 3.260 0.009 0.239 1.814 3.669 24 months‐12‐12 months ‐0.002 0.275 ‐0.375 5.480 0.004 0.026 0.589 0.249 36 months‐12‐12 months ‐0.005 0.141 ‐1.060 2.812 ‐0.006 0.202 ‐0.847 2.389 48 months‐12‐12 months 0.001 0.253 0.254 5.684 ‐0.006 0.011 ‐0.984 0.105 60 months‐12‐12 months ‐0.005 0.207 ‐0.845 3.354 ‐0.010 0.091 ‐1.722 1.094 table 3: zero investment prior return stock portfolio on the sector factor brazil china s.africaindia s.korearussia 6. summary and conclusion several academicians have documented the importance of allocation decision within a stock portfolio. the body of literature focuses mainly on prior return patterns in stock returns, however there is limited focus on prior return patterns for sector returns especially for emerging markets. in this paper we examine the following propositions for bricks markets (1) are there any prior return patterns at sector, industry and industry group level for short-term (6-6 and 12-12) and long-term (24-12-12, 36-12-12, 48-12-12 and 60-12-12) strategies? (2) do these prior return patterns differ for short-term (up to 12 months) and long-term (24-60) portfolio formation windows? (3) do winner and loser sector exhibit different growth potential, the information about which then can be used to construct a sector factor as suggested by liu and zhang (2008)? (4) can the sector factor capture some of the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 270 prior return patterns in stock returns thereby implying that winning stocks may belong to winning sectors while losing stocks may belong to losing sectors? the data period is from january 1993 to february 2008. we find that for 6-6 strategies, the sector returns for sample countries exhibit momentum patterns with exception of china. for 12-12 strategies, in case of india and south africa momentum pattern persists. south korea reports strong reversals however prior return patterns die out for other bricks markets. for long-term portfolio formation windows, at the sector level, russia and india report long-run momentum patterns which are stronger than that for short-term portfolio formation strategies. brazil also exhibits momentum patterns but are weaker for long-term compared to short-term and disappear for 60-12-12 strategies. s.korea, s.africa and china show weak reversals for long-term portfolio formation windows. the differences in growth rate of sectors of winners and losers may be able to explain risk as documented by liu and zhang (2008). for both 6-6 and 12-12 strategies, we observe for all the countries that winner sectors (q5) exhibit higher growth rates as they comprise of high growth companies compared to loser sector and hence they may be exposed to higher growth risk. for long term portfolio formation windows, in case of india and russia, portfolio performance is consistent with growth risk story; however there are contradictions for other sample countries. it is expected that the sector factor, which mimics the growth risk differences between corner portfolios, should be able to provide a better explanation based on short-term prior return formation. in case of long-term portfolio formation, the sector factor is likely to absorb cross-section of average returns in case of brazil, russia and india’. next, we test whether prior return patterns in stock returns are absorbed by similar patterns in sector data. we find that the returns on prior return stock portfolio load on the returns for sector factor. as expected our results are stronger for short-term portfolio formation windows for all the sample countries and for long-term portfolio formation windows in case of brazil, russia and india. our findings are relevant for investment analysts and portfolio managers who are continuously tracking global markets, in pursuit of abnormal returns. the findings also provide the academicians with better insights about prior return patterns in sector data and their impact on prior return stock patterns. the present research contributes to both asset pricing as well as behavioral finance literature for emerging markets. it is suggested that the work may be extended to other emerging markets as there is very limited literature on the subject. notes 1. debondt and thaler (1985, 1987), jegadeesh and titman (1993), rouwenhorst (1998), chan, jegadeesh and lakonishok (1999), jegadeesh and titman (2002), lewellen (2002), lo and mackinlay (1990), ball, kothari and shanken (1995), banz (1981), chan, lakonishok and hamao, basu (1977, 1983), bhandari and weiss (1996), rosenberg, reid and lanstien (1985), lakonishik, shliefer and vishny (1994), (litzenberg and ramaswamy(1979), fama and french (1996), conrad and kaul (1998), berk, green and naik (1999), chordia and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 271 shivkumar (2000), lee and swaminathan (2000), jegadeesh and titman (2002), daniel, hirshliefer, and subrahmanyam (1998), barberis, shliefer and vishny (1999), hong and stein (2000) and goetzmann and massa (2002), ahn, conrad and dittmar (2003), scott, stump and xu (2003), kent, hirshleifer and subrahmanayam (2004), shen, szakmary, and sharma (2005), miffre and rallis (2007), antoniou, lam and paudyal (2007), chen, chen, hsin, and lee (2010). 2. there is a lot of evidence for the mature markets; however little evidence exists about the factors which drive the cross-section of returns in emerging markets. rouwenhorst (1999), froot et al. (2001), chui et al. (2000), kim and wei (2002), hameed and kusnadi (2002), lin and swanson (2004) and, swanson and lin (2005). 3. international standard industrial classification of all economic activities, global industry classification standard (gics), standard industrial classification (sic), thomson reuters business classification (trbc), north american industry classification system (naics), u.s. securities and exchange commission (sec) are the several industry classification systems. 4. percentage returns estimation is based on capital gains component. there is no dividend component as in india, dividend yields of companies are very low, gupta (2000). also, all the bombay stock exchange (bse)-500 index series do not include any dividends while computing index values. hence, dividend inclusion in individual stock returns may bias the estimators of our proposed time series regressions. 5. past sales growth is estimated as three year compounded growth rate in sales using the formula st+3= st (1+r)3, where st+3 and st are sales revenue in year t+3 and t respectively. r is compounded growth rate in sales termed as past sales growth. 6. annualized implicit yields on 91-day t-bills available for all weekly auctions over the study period have been used. we select the implicit yield for the last week of each month to match with month end closing prices of sample stocks. the end of month annualized implicit yields is divided by 12 to generate approximate monthly risk free yields. references ahn, d.h., conrad, j., & dittmar, r.f. 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moving the de importa area. pr capital internat countrie karolyi cheong volatilit many r great po and jap literatur done on the sca co-mov the mal if there if each strong weak m 2008). 2. obje the ma liberaliz greater oduction stock marke and uk m o middle siz eralization s. the curre al of tariff b ment channe es such as g es in intern vements bet ic markets a he rest of t s around th g rapidly acr egree of int ant issue in rimarily, re flows and f tional portf es. several i and stultz, g and abu ty, integratio researchers ortion of th pan. only o re on volati n volatility c arcity of suc vements bet laysian stoc are any com individual linkage red market linka ectives of th alaysian eco zation, grea financial d ets have gro markets. wi ze. these g by removin ent trend in barriers, issu els (nurasyi goods, labor national inv tween stock and increase the world. he world h ross countri terdependen financial ec searchers a financial ma folio diversi studies (eu , 1996; sham hassan, 20 on and vola have studi hese studies of late, asia lity co-mov co-moveme ch literature tween mala ck market’s mmon force stock index duces the in age offers po he study onomy in re ater openne developmen own especia ith the exce governments ng statutory n asia witne uance of sec kin, farrah r, finance an vestment an k markets g ed their abil in view o have grown ies nce between conomics an and policym arket integr ification as un and shim msuddin an 007; mukhe atility transm ed the mov s generally an stock ma vement of st ent between has spurred aysian mark linkages wi es driving th x or return nsulation of otential gain ecent years ss to world t. the incre 157 ally fast, wi eption of ja s have grad y controls esses the es curities ove and shahn nd personne nd capital globally. th lity to react of these dev n stronger a n the inter nd is eviden makers are a ration; as su s well as th m, 1989; b nd kim, 200 erjee and b mission hav vements of focuses on arkets are g tock market n the asian s d the interes ket with maj ith other sto he long-run is driven s f domestic ns from int has been ch d trade, a hi eased libera asian ith total trad apan, howe dually move over their stablishmen erseas and t az, 2008). o el have flow movements hese factors t promptly t velopments and trends rnational eq nced by the attracted to uch linkages he macroeco ecker et al 02; syriopou bose, 2008) ve increased f aggregate volatility i given some ts is sparse. stock marke st of this stu jor stock m ock markets movement solely by it market fro ernational d haracterized igher degre alization an n journal of f ding volum ever, asia’s ed towards i foreign exc nt of multin he availabil on a global wed smoothl s leading to have reduc to news and , the linkag of stock m quity marke numerous s o questions s have serio onomic pol 1990; koc ulos, 2005; ) have conc d in recent y stock mark in united s considerabl comparativ ets with the udy to inves markets. the s can be ana of stock in s own fund om any glo diversificati d by a trend e of financ nd openness finance & ac issn 19 2012, vol. www.macrothi mes that nea s stock mar internationa change and national ente lity of inter level, inter hly bringing o the form ced the isol d shocks ori ages betwee market vola ets has bec studies done about cros ous implicat licies of co ck and kock ciner, 2006 cluded that years ket volatilit states (us), le attention ively, little h developed stigate the v e notion of alyzed to de ndexes or ret damentals. b obal shock ions (priyan d towards in cial integrat s have mot ccounting 946-052x 4, no. 2 ink.org/ajfa arly rival rkets are alization d capital erprises, rnational rnational in rapid ation of lation of ginating en stock atility is come an e on this s-border tions for oncerned k, 1991; 6; zaidi, t market ty and a europe n but the has been markets. volatility whether etermine turns, or besides, whereas nka et al ncreased ion, and tivated a high rat study i behaves informa study tr econom can hav the cho as the malays malays 1989 w retail/in infrastru the trad decemb market factors. ringgit have sh the ma liberaliz greater high ra market kuala impress to 132% among reason, the cou market emergin financia market takes p co-mov degrees a lot of of one co-mov serves t te of increa s to invest s on the in ation and e ries to enc mic activitie ve ramificati oice of mal focus of th ia has und ian and sin was a milesto ndividual, i ucture was ding particip ber 2007 (n like the u the real g t has strengt hown favora alaysian eco zation, grea financial d ate of incre liberalizatio lumpur s sive. the ra % by the end the highest this study s untry. the a becomes re ng market. al crisis of volatility ( place in oth ves with tha s on its corp f work has b market on vement with to fill that ase in crosstigate close nternational conomic sh capsulate ho s in malays ions on the aysia’s stoc his study m dergone a ngaporean c one in the d institutional developed pation by re nurasyikin e s, malaysia gdp 2006 thened. fur able result a onomy in re ater openne developmen ase in cros on of dece tock exch atio of mark d of 2001 (b t market ca span the yea analysis of t elevant for in addition 1998, also garay, 2003 her major at market. porate capita been done o another. w h a focus on gap and to -border capi ely and dee l financial hocks from ow stock m sia and the malaysian ck market co makes the a robust dev companies f development l, and fore accordingly tail investor et al 2008). an capital m beats the fo rther to this and the impl ecent years ss to world t. the incre ss-border ca mber 1988, ange (kls ket capitaliz beck et al 2 apitalization ars of devel the possible our unders n, malaysia created an 3). with vo markets an such volati al budgeting on market li what the lite n the malay o contribute 158 ital and dire eply under arena and m the interna market vola dynamics o stock mark o-movemen analysis esp velopment from their t of malays eign investo y. recent s rs has grow despite the market rem forecasts at , the reform lementation has been ch d trade, a hi eased libera apital and d , expansion se) (now ation over g 2003), comp n ratios in lopment of t e impact of standing of a's capital ideal labora olatility bein nd how vo ility co-mo g decisions, inkages, ma erature lack ysian marke e to this are asian ect investm stand how how they ational stoc atility has i of major st et. nt against ot pecially rel since the respective s sia’s equity ors increas tatistics fro wn from 28% e issues faci mains compe 5.9%; infla ms of govern n of the 9th m haracterized igher degre alization an direct inves n in the stoc known as gdp was 6 parable to th the emergin the stock m these event the functio control me atory to inv ng contagio olatility in ovement can investor’s arket integra ks are stud t in relation ea by exam n journal of f ment flows. t the malay react on d ck markets. implications ock market ther interna levant. the late 1980s. stock excha market. equ ed substan om bursa m % in 2005 to ng the key p etitive due ation is man nment-link malaysian p d by a trend e of financ nd openness stment flow ck market c bursa ma 0% in 1985 hat of develo ng markets arket, and f ts in the be oning of cap asures, intr vestigate the ous, it is cru the malay n impact m decisions an ation, influe ies on stoc n to world m mining volat finance & ac issn 19 2012, vol. www.macrothi the purpos ysian stock different inf . conspirin ns on financ ts around th ational stock e capital m . the delis anges at the uity investm ntially, and malaysia sho o 36% at th player of th to several anageable w companies plan is on tr d towards in cial integrat s have mot ws. after th capitalizatio alaysia) wa 5, but had in oped countr s universe. financial op ehavior of th pital marke roduced du e behavior ucial to kno ysian stock malaysia in nd business ences and sp ck market v markets. th atility co-mo ccounting 946-052x 4, no. 2 ink.org/ajfa e of this k market flows of gly, this cial and he world k market market in sting of e end of ments by market ows that he end of he global positive while the (glcs) rack. ncreased ion, and tivated a he stock on of the as truly ncreased ries, and for this ening of he stock ets in an ring the of stock ow what market varying s cycle. pillovers volatility his study ovement between (us), u north a address i. market ii. movem 3. liter on a br time an that exi literatur of 1987 period a us and countrie there h prior to adoptin (1970), found l found i through between policies investm of whe 1960–1 conver markets initially japan, b these particul bose, 2 among (1989). canada nationa n the malay united king america, eu sed: what is the with that of how much ments and inn rature revi rief review nd studies o ist among res, there is 7. earlier fi after the cra d the interde es from eur have been nu o the crash ng simple c levy and s little or no in these pa h internation n the stock s in each ments, and a eatley (1988 985, suppor sely, since s or stock pr y had been but the pos studies hav larly betwee 2008). g the early analyzing a, switzerla l stock mar ysian stock gdom (uk) urope and a e degree and f us, uk an h of the mo novations o iew of the fina of co-integr world mar a glaring d indings foun ash as early ependence rope and as umerous stu in 1987. u correlation a sarnet (1970 correlation apers are th nal portfolio markets ar country, h a low degree 8) who used rts the notio the stock m rice co-mov conducted st-asian cri ve consisten en those wit contributio g the daily and, germa rkets with market wit and japan r asia respect d nature of v nd japan sto ovements in or shocks in ancial litera ration, co-m rkets are w difference in nd vague c contributio of other sto sia. udies exami using weekl and regress 0), grubel a between n hat nationa o diversific re explained higher taxe e of informa d data on th on of equity market crash vement has for develop ses literatur ntly indicat th close eco ns to the l stock mark any, us an us were e 159 th three ma representing tively. the volatility co ock markets n the mala the us, uk ature, much movement, c widely avail n the finding correlation b ons to the li ock market ining the re ly or month sion method and fadner national stoc al stock ma ation is pos d by barrier es and tran ation about the us and y market int h of octob been studie ped market re has start ated strong onomic ties literature af ket returns o nd the uk, established asian ajor stock m g three maj following t o-movemen s? ysian stock k and japan research o contagion, c lable. on a gs before an between sto terature afte s but the la elationships hly data fro ds, studies (1971), ag ck markets. arkets are s ssible. the rs of interna nsaction co foreign sec seventeen egration. ber 1987, th ed extensive ts, such as ted to focus linkages a or geograp fter the ma of australia substantia with a one n journal of f markets, nam or regions o two researc nt between t k market ca n stock mark n stock ma correlation, a closer exa nd after the ock markets er the mark ater studies among nati om the 1960 by grange mon (1972) . general c segmented low degree ational capi osts on in curities. nev other count he integratio ely. though those of th s on emergi among wor phic proxim rket crash a, hong ko l interdepen e or two da finance & ac issn 19 2012, vol. www.macrothi mely unite of the worl ch questions the malaysi an be expla kets? arket volatil spillover, amination o stock mark s as oppose ket crash foc incorporate ional stock 0’s and 197 er and mor ) and ripley onclusions and risk re es of co-mov ital flows, d nternational vertheless, ntries for the on of globa h most of the he us, euro ing asian m rld equity m mity (mukhe are eun an ong, japan, endence am ays lag aga ccounting 946-052x 4, no. 2 ink.org/ajfa ed states ld that is s will be an stock ained by lity over linkages of these ket crash ed to the cused on ed more markets 70’s and genstein y (1973) that are eduction vements differing capital findings e period al equity e studies ope, and markets. markets, erjee and nd shim france, mong the ainst us innovat equity m ascertai pacificsingapo thailan of pacif and lam markets large nu using d bi-direc returns cross-m york an of equit austral with the lakshm assessin daily re singapo results i market mukher a defini do not unique but also hyginu markets the obs both ma of the a manage of stock 4.data 4.1 sam as the stock m tions and sh markets of t in the influ -basin’s sto ore, hong k nd had little fic-basin co mba (1998) s concluded umber of cro daily and int ctional linka can signifi market inter nd tokyo m ty markets ia, china, h e stock mark mi and gam ng investme eturns from ore stock m indicate tha and that o rjee and bo ite informat uniquely in role in the o to be influ us (2006) fin s that are si served volat arkets. as s authorities. ement practi k market vo and metho mpling desig study inve markets in th hocks. park the pacificuence of u ock movem kong and n linkage to ountries are ) who empi d that marke oss-border l traday price ages betwe cantly influ dependence markets. joh in asia wit hong kong ket in japan mini (2004) ent and lev m 1992 to 20 market and t at there is a of hong k se (2008) e tion leadersh nfluence the integration uenced by in nd results f imilar to tho tility and c such, policie consequen ices in finan olatility. odology gn stigates the he world, th k and fatem basin coun us compar ments. aus new zealan any of thes e influenced irically exam ets that are listings exer e and stock en us, eur uence the do e in returns hnson and s th japan’s e g, malaysia, n. ) investigate verage deci 002, they in the markets high degree kong, us, xamined th hip from the e integratio of asian m nformation f for the distr ose in devel o-movemen es to mitiga ntly, defensi ncial institu e volatility hree regions 160 mi (1993) ntries to thos red to uk stralia is se nd exhibite se markets w d by domes mined the l geographic rt significan returns data urope and a omestic ret s and volati soenen (200 equity mark , new zeal ed the imp sions as vo nvestigated s of us, uk e of volatilit japan and e stock mov e us marke on of asian markets. the from most o ribution of loped stock nt can be e ate the obse ive measure utions, may co-moveme s were ident asian and examin se of the us k and japa ensitive to d moderate with the con stic factors. linkages be cally and ec nt influence a, lin, engl asian count turns as in t ilities is bi02) investig ket. they fou land, and si portance of olatility is d the volatil k, hong k ty co-movem uk (in th vements of et to all asi n markets w e us marke of the major realized vo k markets. t explained by rved volatil es, such as be the best ent of the m tified name n journal of f ned the lin s, uk and j n at differ the us m e linkages. k nclusion tha . neverthele etween the p conomically e over each o le and ito (1 tries. they the case of -directional gated the de und that the ingapore ar volatility i synonymou ity co-mov ong and jap ment betwe hat order). indian stock an markets while japan t is seen no r asian mar olatility in tw the results s y external f lity may be improved t policies to malaysian ly north am finance & ac issn 19 2012, vol. www.macrothi nkages betw japan. the ring levels market whe korea, taiw at stock mov ess, janakir pacific-bas y close and/ other. 1994) exam found that f japan and l between t egree of int e equity ma re highly in in stock m us with risk vement betw apan. the em een singapo in anothe k market an but the us is found to ot only to in rkets. two emergin suggest tha factors com outside the regulation o contain the market wit merica, eur ccounting 946-052x 4, no. 2 ink.org/ajfa ween the findings on the ere else wan and vements ramanan sin stock /or have mined the foreign us and the new tegration arkets of ntegrated market in k. using ween the mpirical ore stock er study, nd found indexes o play a nfluence, ng stock at part of mmon to e control and risk e impact th major rope and asia. b uk stoc the vibr 4.2 per the dat united of 2252 the spe stock m liberaliz greater characte monthly from m formula table 1 this stud trading (malays occur in lag. con market table 1 country index local ti gmt sample period observa 4.2 dat 4.2.1 co table 2 from th uk; the integrat based on the ck markets rancy and ro riod selectio ta used for kingdom (u 2 observatio ecific reaso market in t zation, grea financial d eristics of y data may malaysia, u ae y1 = (lnpt below prov dy with the is: japan, sian stock n japan will nspicuously on the same . market in y jap nikk ime 09:0 00:0 4.1.2 27.2 ations 2252 ta descripti orrelation a represents he tables, al e uk has i tion with m e criteria of were chose obustness o on r the study uk) and ja ons in each o n to choose the 21st. ce ater openne developmen capturing a block out in us, uk, an – lnpt-1) * vides inform eir indices a malaysia, t market) ov l affect the y, shocks fr e day but gi ndices, mark pan kei 225 0 – 15:00 0 – 06:00 2000 – .2009 2 ion analysis the correlat ll markets s integration malaysia but leadership en to represe f japan stoc were daily apan from ja of the select e the time-f entury as t ss to world nt. the rati all possible nteractions nd japan w 100. mation on th and the sam the uk and verlaps with malaysian om the us ives effect t ket operatin malays kl co index (klci) 09:00 – 16 01:00 – 08 – 3.1.2000 27.2.2009 2252 tion coeffici hows at lea with us an a weaker in 161 and influen ent norther ck market w y stock retu anuary 2000 ted markets frame was t the malays d trade, a hi onale of us e interaction that last for were subseq he operating mple period. d us. the h the exchan stock mark and uk m the followin ng times an sia uk omposite ft 6:00 08 8:00 08 – 4. 26 22 ients betwe ast a single i and japan; a ntegration is asian nce in their r rn america will represen urns from m 0 to februa s. to analyze t sian econom igher degre sing the da ns within t r only a few quently com g times of th the order operations nges in jap ket on the ve markets do n ng day. nd sample p k tse 100 8:00 – 16:20 8:00 – 16:20 1.2000 6.11.2008 252 een daily ma integration and the jap s visible wit n journal of f respective r and europe nt the asian malaysia, u ry 2009 and the perform my moves e of financ aily returns the market. w days. the mputed for he various s in which th timing of t an and conc ery same da not overlap w period us dow jo (djia) 09:30 – 14:30 – – 3.1.200 2252 arkets return namely the panese mark th uk. finance & ac issn 19 2012, vol. www.macrothi regions, the e respective n region. united state d adjusted t mance of m towards in cial integrat data is du . using we e daily stock y1 data us selected mar he markets o the bursa m ncurring sho ay without a with the m ones industria – 16:00 – 21:00 00 – 15.12.200 ns from 200 e us integra ket shows ccounting 946-052x 4, no. 2 ink.org/ajfa e us and ely while es (us), to a total alaysian ncreased ion, and ue to its eekly or k returns sing the rkets for open for malaysia ocks that any time malaysian al average 08 00-2008. ates with a strong table 2 index nikkei klci ftse100 dowjo * and ** 4.2.2 d figure respecti price in correlat some c proven downw 2. correlatio i 0 ones denotes statis escription o 1 shows th ively over t ndices show tion discuss comparing m to be corr ard trend af on coefficie nikkei (japan) 1.000 0.116* 0.048** 0.018 stical significa of market in he plot of st the period o ws similar t sed earlier ( movements related too fter 2007 an ents between k (m 1 -0 0 ance at the 1% ndices and r tock price i of 8 years. o trends and (table 2). m with the j (table 2) nd this is sup 162 n daily ma klci malaysia) .000 0.031 .005 % and 5% resp returns indices and on compar pattern and malaysian s japanese st . all mark pported by asian rket return ftse (uk) 1.000 -0.061 pectively returns of rison, the m d this is su stock price tock market ket indices the global e n journal of f s: 2000 – 20 e100 1* us, uk, m movement of ubstantiated indices and t and it ha exhibits a economic cr finance & ac issn 19 2012, vol. www.macrothi 008 dowjon (us) 1.000 malaysia an f us and u d by the sig d returns do as been stat a consistent risis. ccounting 946-052x 4, no. 2 ink.org/ajfa nes nd japan uk stock gnificant oes have tistically t dip or figure 1 4.2.3 st table 3 on com 1. plot of st tatistical de provides so mparing the stoc tock price in escription of ome statisti e mean for k price in ndices and r f the marke cal properti the logged ndices 163 returns for 2008 ets ies of daily stock mark asian us, uk, ja market retu ket indices, st n journal of f apan & mal urns for the malaysia tock retur finance & ac issn 19 2012, vol. www.macrothi laysia from four stock m exhibits the rns ccounting 946-052x 4, no. 2 ink.org/ajfa m 2000 – markets. e lowest positive mean i period positive be draw tends to thus im table 3 index mean median maximu minimu std. dev skewne kurtosi jarque observa japan e dispersi deviatio is that t the stoc market standard theory o return ( to furth jarquewith tho returns most ex volatilit as a co also cha of volat 4.3 dat most st laid th e mean retu s a categor compared e excess ku wn from the o contain ex mplying the p . descriptiv um um v. ss s -bera ations exhibits the ion or spre on is used b the standard ck’s averag is characte d deviation of investme as opposed her test whe bera test st ose from the series for a xtreme valu ty is compa oncluding re aracterized tility compa ta analysis tudies on th he emphasi urns of 0.0 ry of return to other m urtosis abov ese values xtreme value presence of ve statistics nikke (japan) -0.041 -0.01 13.23 -12.11 1.64 -0.34 9.77 4346.69 2252 e highest st ead in the by investors d deviation e return, th erized by t n exhibited ent, malays to high risk ether the ser tatistic mea e normal di all four mar ues for the aratively mu emark, mala by presenc ared to other techniques he co-move is on usin 04 as comp ns and mala more establi ve 3 and are are the dist es. this is s variances in for daily m ei ) kl (ma 0.0 0.0 4.5 -9.9 0.9 -0.8 11. 9 743 225 andard dev series and as a gauge is a measur he more vol the trade-o is the lowe ia can be su k, high retur ries is norm asures the d stribution. a rkets. it can daily mark uch higher in aysian stock e of varianc r markets in ements betw ng garch 164 pared to ne aysia record shed marke e seen to ha tribution of supported by n the stock market retur lci alaysia) 004 03 50 98 99 87 .73 37.03 52 viation of 1 is a measu for the amo re of volatil latile the st off between est among t ummoned a rns). mally distrib difference o according t n be said th ket returns n the malay k market ex ces in the s n the analyz ween the sto h, var o asian egative mea ded a posit ets. all ma ave heavy t f stock mar y the negati market indi rns in local ftse10 (uk) -0.022 0.02 9.38 -9.27 1.32 -0.14 9.93 4509.42 2252 .64. standa ure of risk ount of exp lity: the mo ock is said n risk and the markets as a market buted, the ja f the skewn to the test, n hat the mala compared ysian marke xhibits a pos stock marke zed period o ock market or co-integ n journal of f an recorded ive return d arkets have ails. the im rket indices ive skewnes ices. l currency t 0 do (us -0.0 0.0 10 -8.2 1.2 -0.0 11 69 22 ard deviatio of a stock ected volati re a stock’s to be. acc return. as with 0.99. t with lowe arque-bera w ness and ku normality is aysian stock to others. et. sitive return et indices w of 2000-200 t returns of gration met finance & ac issn 19 2012, vol. www.macrothi d in other m during the e distributio mplications s in these c ss in all the terms: 2000 owjones s) 013 04 0.50 20 29 01 1.63 989.21 252 on is a mea k market. s ility. the ba s return vari cordingly, th for malay . and going st risk and was compu urtosis of th s rejected fo k market sh this indica n with low r with a highe 08. f different c thods to t ccounting 946-052x 4, no. 2 ink.org/ajfa markets. analysis ons with that can countries markets 0 – 2008 asure of standard asic idea ies from he stock ysia, the g by the positive ted. the he series or all the hows the ates that risk. it is r degree countries test the co-mov (2004), study. the est based autoreg 4.3.1 th a comm tend to changes serially conditio conditio (1982) conditio model t where ω model g large sh bollersl conditio model t the inte model i conditio of whic non-neg nelson’ firstly, in stock effect c defining movem vements. me and chin timation of using a u gression (va he univaria mon observ be followe s, in either correlated onal hetero onal on the and genera onal varianc the conditio ω and αi are given by eq hocks to the lev extende onal varian to be consid ention of g is common onal varianc ch σt 2 is a f gative const ’s (1991) eg egarch k return indi can be capt g the down ments. as no ethodologic (2008), wh f volatility c univariate ar). ate garch ation about ed by larger r direction. d. the eco oscedasticity ir past real alized (gar ce as a deter onal varianc e non-negat quation (1) dependent ed engle’s s ce equation derably redu garch is th nly used in ce is given b function of tants. garch sp represents ices based o tured and n n movement oted in ham cally, this re hich develo co-moveme garch h model and t the unexpe r shocks, an in other w nometric t y (arch), izations. th rch) by b rministic fu e is given b tive constan above and i variable. specification n. this repr uced and all hat it can re its most si by : ∑ f lagged val ecifications a more succ on a general nelson was ts are more ilton (1994) 165 esearch is ba oped in thei ents in the m model wit d asymmetr ected comp nd small sh words, the term descri , which sta he standard bollerslev ( unction of la by: nts (in orde is formulate n by introdu resentation lows past co epresent a h imple form lues of εt 2 a s possess so cessful atte lized expon the first in influential ), evidence asian ased on the ir works th malaysia, u th asymme ry extension onent of as hocks tend t volatility o ibing this ates that th d arch mo (1986). in agged squar er for σt 2 to ed to depict ucing lagge allows the onditional v higher order m, the gar …… . ∑ and ω ,{αi}, ome advanta empt to mod nential distri nvestigator for predict on asymme n journal of f papers of l he model im us, japan a etric exten ns set returns i to be follow of asset retu feature is he variance odel was in his model, red residual be non-neg t volatility ed condition number of variances to r arch pro rch(p,q) m ∑ , i=1…p an ages over th del excess c ibution. sec to model l ting volatili etry in stock finance & ac issn 19 2012, vol. www.macrothi laksmi and mplemented and uk ma nsions and is that large wed by mo urns appear the autore e of time s ntroduced b engle def ls. in the ar gative). the as the clust nal variance f parameter o enter equa ocess. the g model, in wh nd {βi}, j=1 he garch conditional condly, the l leverage ef ity than the k price beha ccounting 946-052x 4, no. 2 ink.org/ajfa d gamini d in this arkets is vector e shocks re small rs to be egressive series is by engle fines the rch (q) 1 e arch tering of es in the rs in the ation (1). garch hich the 2 1…q are models. kurtosis leverage ffects by upward avior has been fo more th to corpo increase exponen equatio the eg since th than neg the th glosten given b where 0), have bad new news im bad or n 4.3.2 ve the va reduced var ca general by inclu the lags of var alternat ound by man han positive orate debt, e the risk of ntial egar on (3) allow garch mo his coeffici gative retur hreshold ar n, jaganatha y: dt = 1 if εt < e differentia ws has an im mpact is asy negative new vector autore ar model w d-form equa an capture izing the un uding for ea s of all the o r models as tive to the ny research e surprises d a sharp dec f holding sto rch model ws positive a del is asym ient is typic rn shocks as rch or ta an and run < 0, and 0 o al effects on mpact of (α ymmetric. h ws. egression (v was develop ations that h the evolut nivariate ar ach variable other variab s a theory-f "incredibl hers, such th do. since a l cline in stoc ocks. the g can be repr and negativ mmetric beca cally negat ssuming oth arch was nkle (1993) otherwise. i n the condit α + γ). if γ > hence it can var) mode ped by sims have unifor tion and th r models. a e an equatio bles in the m free method e identifica 166 hat the nega lower stock ck prices inc general notio resented as f ve values of ause the lev tive, positiv her factors r s introduced ). the spec in this mod tional varian >0, the lev n be seen tha el s (1980) wi rm sets of l he interdepe all the vari on explainin model. base d to estima ation restri asian ative surpri k price reduc creases corp on is that εt follows: f εt to have vel |εt-i | /σ t-i ve returns s emains unc d independ cification fo del, good ne nce: good n erage effect at markets a ith the purp lagged depe endencies b ables in a v ng its evolu ed on this fe ate economi ictions" in n journal of f ses seem to ces the valu porate lever has a norm different im i is included shocks gene hanged. ently by z or the cond ws (εt > 0), news has an t exists. inv are more vo pose of estim endent varia between mu var are tre tion based o eature, sim ic relationsh structural finance & ac issn 19 2012, vol. www.macrothi o increase v ue of equity rage and co mal distributi 3 mpacts on v d with coeff erate less v zakoian (19 ditional var 4 , and bad ne n impact of versely if γ olatile when mating unre ables as reg ultiple time eated symm on its own ms advocates hips, thus b models. s ccounting 946-052x 4, no. 2 ink.org/ajfa volatility y relative ould thus ion. the volatility. ficient γi. volatility 990) and riance is ews (εt < α, while ≠ 0, the n there is estricted gressors. e series, metrically lags and s the use being an ince no restricti can be model o can be u study, th where z uk, an respecti innovat the est express where innovat after a u althoug in orde triangul compon in the s the ort varianc decomp in gene non-line used to 5. find 5.1 uni table 4 ions are im a flexible a of the actua used for the he var mo z(t) is a 4 x nd japan), ively , 4 x 1 tion vector. imated var sed as: is a lin tions. the i, unit random gh they may er to captur lar matrix v nent of b(s) periods to a rthogonaliza e in the t+ position of t erating fluct ear function calculate th dings ivariate gar 4 reports the mposed on th approximati al economic e purpose o odel is expre x 1 column c is the 1 and 4 x 5 by construc r can be inv near combi , jth compo m shock in th be contemp re ‘pure’ re v is chosen t )v in equati a shock of o ation also +1 step ahe the forecast tuations in ns of the es he confiden rch analy e parameter he structura ion to the re c structure. of stylizing e essed as: vector of r determinist matrices of ction, e(t) is verted to fo ination of c onent of b(s he jth mark poraneously esponses, it to obtain th ion (7) belo one standard provides σ ead forecast error varian its own an timated par ce bands (s ysis and asy r estimates 167 al relationsh educed form as structur empirical re rates of retu tic compon f coefficient s uncorrelat orm the mov current and (s) shows th ket. the e(t)s y correlated t is importa he orthogona ow represen d error in th σcij 2(s) whi t of zi that nce gives a nd other var rameters, m soydemir, 20 ymmetric ex from fitting asian hips betwee m of the co ral models egularities a urn of four nent compr ts, m is the l ted with all ving averag d past onehe response s are seriall d. ant to trans alized innov nts the impu he jth marke ich is the is account measure of riables. as monte carlo 000). xtensions g an autore n journal of f en variables rrectly spec tend to be among time stock mark ised of a lag length, a the past z(s ge represent -step-ahead of the ith m y uncorrela sfer the err vations u fro ulse respons et: component ted for inno f how impor impulse re integration egressive err finance & ac issn 19 2012, vol. www.macrothi s, the var cified but u misspecifie e series data kets (malay constant, a and e(t) is t s). tation of the forecast e market in s ated by cons ror terms. a om e=vu. t se of the ith t of foreca ovation in rtant one va esponses are n techniques rror specific ccounting 946-052x 4, no. 2 ink.org/ajfa r system unknown ed, var a. in this 5 ysia, us, a(s) are the 4 x 1 e system 6 errors or periods struction, a lower the i,jth h market 7 ast error zj. this ariable is e highly s will be cation or ar (p) the ar table, m did not was ob compon with the table 4 2000-20 paramet ar (1) ar (2) ar (3) ar (4) ar (5) ar (6) ar (7) aic sic log like numbers * denotes table 5 malays of reac tarch dynami from t minimu capture coeffici model for j r specificat malaysia, u indicate sig btained. evi nent ar (7) e parameter 4. paramete 008 ter estimates: elihood s in the parent s statistical sig reports the ia, uk and tions towar h), leverage ics of the sto table 5, the um aic/sic s volatility ients and its japan, mala tion appear s and uk h gnificance a idently, jap ). the estim r estimates o er estimate : theses are p-va gnificance at e results of f us from 20 rds shocks e effects an ock markets coefficients c values an dynamics o s implication aysia, uk an s to indicat has the first at ar (1) a pan only sh mation of fitt of fittings fo s from fitt nikkei (japan) -0.04 (0.09) -0.02 (0.24) -0.027 (0.38) -0.02 (0.30) -0.02 (0.30) -0.02 (0.24) 0.04* (0.05) 3.82 3.84 -4284.28 alues the 1% level. fitting gar 000 – 2008 and its co nd subseque s. s of the α1, β nd maximum of all the sto ns are show 168 nd us for th te an autore order comp and the fittin howed a si ting for ar or garch ting ar (p klci (malaysi 0.17* (0.00) 2.78 2.79 -3131.35 rch (1, 1), . the empir orresponding ently which β1 and γ1 ar m log like ock market wn in table 6 asian he period 20 egressive c ponent of a ng was repe ignificant f r is importan (1, 1), egr ) for japan a) ft (uk -0. (0. 3.3 3.3 -38 egarch a rical results g volatility h fitting wo re all signifi elihood valu ts and the su 6 below. n journal of f 000 to 2008 omponent. ar (1) and i eated until fitting with nt to be det rach and t n, malaysia tse100 k) 07* 00) 9 9 811.67 and tarch will be abl (values fro uld best ca icant for all ues, the eg ummary of finance & ac issn 19 2012, vol. www.macrothi 8. as reporte is significan a significan the sevent termined to tarch. a, uk & u dowjone (us) -0.08* (0.00) 3.34 3.34 -3757.02 h models fo le to provid rom egar apture the v l markets. b garch mo f selected pa ccounting 946-052x 4, no. 2 ink.org/ajfa d in the nt. japan nt fitting th order proceed us from es or japan, e details ch and volatility based on odel best arameter table 5 japan & model nikkei ar (1) ar(2) ar(3) ar(4) ar(5) ar(6) ar(7) ω α1 β1 γ1 aic / sic log like klci (m ar (1) ω α1 β1 γ1 aic / sic log like ftse (u ar (1) ω α1 β1 γ1 aic/sic log like djia (u ar (1) ω α1 β1 γ1 aic / sic log like numbers * denotes 5. parameter & malaysia l i (japan) c elihood malaysia) c elihood u.k.) elihood u.s.) c elihood s in the parent s statistical sig r estimates from 2000 garc -0.01 (0 0.00 (0 0.00 (0 -0.01 (0 -0.02 (0 -0.02 (0 0.01 (0 0.03* ( 0.09* ( 0.89* ( 3.52 / 3 -3939.8 0.19* ( 0.01* ( 0.13* ( 0.86* ( 2.52 / 2 -2829.2 -0.08* 0.01* ( 0.11* ( 0.88* ( 2.86 / 2 -3216.2 -0.05* 0.01* ( 0.08* ( 0.91* ( 2.86 / 2 -3214.3 theses are p-va gnificance at of fitting g -2008 ch (1,1) 0.77) .90) .93) 0.57) 0.35) 0.42) .51) 0.00) 0.00) 0.00) 3.54 81 0.00) 0.00) 0.00) 0.00) 2.53 20 (0.00) 0.01) 0.00) 0.00) 2.87 23 (0.02) 0.00) 0.00) 0.00) 2.87 32 alues. the 1% level. 169 garch (1 ega -0.01 0.01 0.01 -0.01 -0.02 -0.01 0.03 -0.13 0.18* 0.97* -0.09 3.50 -3915 0.19* -0.18 0.22* 0.97* -0.08 2.49 -2797 -0.03 -0.08 0.09* 0.98* -0.13 2.82 -3167 -0.06 -0.08 0.10* 0.98* -0.12 2.82 -3164 asian , 1), egra arch (0.75) (0.57) (0.69) (0.67) 2 (0.41) (0.62) (0.20) 3* (0.00) * (0.00) * (0.00) 9* (0.00) / 3.53 5.29 * (0.00) 8* (0.00) * (0.00) * (0.00) 8* (0.00) / 2.50 7.29 3* (0.01) 8* (0.01) * (0.00) * (0.00) 3* (0.00) / 2.83 7.61 6* (0.01) 8* (0.00) * (0.00) * (0.00) 2* (0.00) / 2.83 4.89 n journal of f ach and ta ta 0.0 0.0 0.0 -0.0 -0.0 -0.0 0.0 0.0 0.0 0.8 0.1 3.5 -39 0.2 0.0 0.0 0.8 0.1 2.5 -28 -0.0 0.0 -0.0 0.9 0.1 2.8 -31 -0.0 0.0 -0.0 0.9 0.1 2.8 -31 finance & ac issn 19 2012, vol. www.macrothi arch for u arch 00 (0.88) 01(0.68) 01 (0.71) 00 (0.84) 01 (0.49) 01 (0.64) 02 (0.31) 04* (0.00) 04* (0.00) 89* (0.00) 1* (0.00) 50 / 3.53 920.76 20* (0.00) 02* (0.00) 08* (0.00) 86* (0.00) 7* (0.00) 51 / 2.52 816.15 07* (0.00) 01* (0.00) 01 (0.14) 92* (0.00) 7* (0.00) 82 / 2.83 171.50 06* (0.02) 01* (0.00) 01* (0.02) 93* (0.00) 4* (0.00) 82 / 2.83 169.50 ccounting 946-052x 4, no. 2 ink.org/ajfa us, uk, table 6 egrac on com malays models. longer p market longer t interest 0.97 to all the m (0.17) i that the experien on mal externa persiste days it estimate japan w volatilit maximu 6 represents ch and tar mparing the ia exhibits . this impl period than shows less time to diss ing to note 0.98. this markets. re s comparati leverage ef nced marke laysia too. o l volatility ence of a vo takes until ed coefficie which has a ty dynamics um log lik s the summ rch for ja e results an comparativ ies that the n it does in market effi sipate. the β that all fiv shows that eferring to e ively higher ffect is high ets. the imp on the who y movemen olatility sho l half of th ents, half-li a half-life o s of all the kelihood. mary of sele apan, malay nd its impli vely higher effects of other stock iciency than β1 paramete ve markets e long term e egarch a r than that e her in the m pact of bad ole, it can nts in maj ock is its ha he initial sh fe of a shoc of 34 days markets ba 170 ected param ysia, uk and ications for r α value th shocks in e k markets. t n the other m ers capture l exhibit very effects have and tarch exhibited by malaysian an and good n be seen tha jor market alf-life (boll hock is abs ck to varian . egarch ased on the asian meters estim d us from 2 the malay han the oth earlier perio this may im markets as t long term in y similar β1 e similar inf h models, m y us (0.14) nd uk stock news and sh at the mala s. the sta lerslev et al sorbed in th nce is 69 d h model is criteria of m n journal of f mates of fitt 2000 – 2008 ysian marke her three m ods tend to mply that th the effects o nfluences on values betw fluences on malaysia an ) and japan k markets as ocks has a m aysian mark andard repr l 1994). it m he variance days for all the best m minimum a finance & ac issn 19 2012, vol. www.macrothi ting garc 8 based on et, we can markets in a linger arou he malaysia of the shock n volatility. tween the ra market vola nd uk’s γ1 (0.11). thi s compared much great ket is vulne resentation measure ho e and based markets ex model to ca aig/sig val ccounting 946-052x 4, no. 2 ink.org/ajfa h (1,1), table 5. see that all three und for a an stock ks take a what is anges of atility in value of is means to other er effect erable to of the ow many d on the xcept for apture to lues and table 6 tarch model fittings garch egarc tarch garch egarc tarch egarc tarch tarch tarch tarch egarc best represen model 5.2 res before the pric variable augmen of a un and ph differen table 7 indicate and 1 re japan in 6. summary h for japan, para coef h (1,1) α1 ch α1 h α1 h (1,1) β1 ch β1 h β1 ch γ1 h γ1 h α1 h α1+ γ h α1+ β ch ln(0.5 ln(α1 n-tative base aic/ & m likel ults for vec running the ce series for e is non-st nted dickey it root as th illips-peron nces. 7 shows the e that there espectively. n lag 3. las y of selected , malaysia, ameter fficients γ1 β1 5) + β1) ed on m /sic ax log lihood tor autoreg e var test, r each of the tationary us y–fuller test he null hyp n (pp) tests parameter is a unidir similarly u tly, japan a d parameter uk & us f implicatio effects of periods long term volatility shock effe leverage e good news bad news degree of half-life min to captu movement gression (va , a unit root e markets. in sing an au t and the ph othesis. th s reveal tha estimates o ectional cau uk has a un ppears to ca 171 r estimates from 2000-2 on f shocks in ea m influences ects effects s effects effects volatility ure the m ts ar) and imp t tests was n statistics, utoregressiv hillips–perr he results fro at all the s obtained fro usality from nidirectiona ause the us asian of fitting g 2008 nikke (japan) arlier 0.10 0.18 0.04 s on 0.89 0.97 0.89 -0.09 0.11 0.04 0.15 0.93 34 days market egarc pulse respo done to ana a unit root e model. t ron test. bot om the aug series are s om fitting a m us towar al causality s stock mark n journal of f garch (1 ei ) klci (malaysia 0.13 0.23 0.08 0.87 0.97 0.83 -0.08 0.17 0.08 0.25 0.94 69 days ch egarch nse analyse alyze timetest tests wh the most f th these test gmented di tationary in var mode rds malaysi towards us ket in the fir finance & ac issn 19 2012, vol. www.macrothi , 1), egra a) ftse (u.k) d ( 0.11 0 0.09 0 -0.01 0.88 0 0.98 0 0.92 0 -0.13 0.17 0 -0.01 0.16 0 0.91 0 69 days 6 h egarch e es series prop whether a tim famous tes ts use the e ickey-fuller n the form el. the var ia and uk s in lag 1 an rst lag. ccounting 946-052x 4, no. 2 ink.org/ajfa ach and djia (u.s) 0.08 0.10 -0.01 0.91 0.98 0.93 -0.12 0.14 -0.01 0.13 0.92 69 days egarch erties of me series t is the xistence r (adf) of first r results in lag 3 nd 3 and table 7 japan(japan(japan(m’sia (m’sia (m’sia (uk(-1) uk(-2) uk(-3) us(-1) us(-2) us(-3) c *, ** and the an decomp relative briefly, in a seq mention of the f assump passed not the error va other m 7. vector au nik -1) -0.03 -2) -0.03 -3) -0.03 -1) -0.06 -2) 0.08 -3) 0.03 0.02 0.01 0.04 0.01 0.00 0.00 -0.04 d *** denotes nalysis proc position of v e importance , the forecas quence due t ning: firstly four markets ption that th on to the ot other way ariance of o markets (frie utoregressio kkei (japan) 3 (0.171) 3 (0.15) 3 (0.14) 6 (0.11) ** (0.03) (0.41) (0.6) (0.6) *** (0.09) (0.65) (0.95) (0.94) 4 (0.24) statistical sig ceeded to o variance of e of the vari st error vari to its own s y, the variabl s. second, t he contemp ther markets around. a ther market edman and s on estimate klc 0.05 0.02 0.01 0.16 -0.02 0.03 -0.0 0.01 0.00 0.01 0.00 0.04 0.00 gnificance at th obtain the v the forecas ious market iance decom shocks versu les are orde the forecast poraneous e s will occur leading mar ts while its shachmurov 172 for japan, m ci (malaysia 5* (0.00) 2 (0.2) 1 (0.35) 6*(0.00) 2 (0.32) 3 (0.2) 1 (0.5) 1 (0.6) 0 (0.8) 1 (0.66) 0 (0.80) 4* (0.00) 0 (0.73) he 1%, 5% an variance de t errors of t ts in causing mposition ex us shocks to ered in acco t error varia effects of in r only in the arket is one own foreca ve, 2005) asian malaysia, u a) ft (u. 0.0 -0.0 0.0 0.0 0.03 0.09 -0.0 -0.0 -0.1 0.09 0.0 0.02 -0.0 nd 10% respec ecompositio the returns o g the fluctua xplains the o the other rdance with ance decomp nnovations e markets th which expl ast error is n n journal of f uk & us fr se k) 1(0.73) 02 (0.21) 1 (0.7) 1(0.7) 3 (0.4) 9 (0.8) 08* (0.00) 08* (0.00) 10* (0.00) 9* (0.00) 1 (0.73) 2 (0.25) 02 (0.37) ctively ns between of a given m ations in ret proposition markets. tw h the sequen position is e in a certai hat close lat lains a large not explaine finance & ac issn 19 2012, vol. www.macrothi rom 2000 – djia (u.s) 0.03** (0. -0.02 (0.16 -0.01 (0.4) 0.00 (0.9) 0.07* (0.0 0.02 (0.6) 0.04* (0.0 -0.01 (0.6) 0.06* (0.0 -0.08* (0.0 -0.10* (0.0 0.07* (0.0 -0.01 (0.69 n the marke market indic turns of tha n of the mov wo points ar nce of closin estimated u in market w ter on the sa e percentag ed by innova ccounting 946-052x 4, no. 2 ink.org/ajfa 2008 04) 6) ) 00) 00) ) 00) 00) 00) 00) 9) ets. the cates the t market. vements re worth ng times under the which is ame day, ge of the ations in table 8 variance of: u.s japan malay u.k table 8 15-day then mo times. e explain as show percent about 9 varianc effect o account by us effect o system, markets compar two ob table 8 influenc though domesti wider a state-ow firmly, price in 8. variance d e decomposit ysia 8 presents t horizons. w oves to japa entries show ed by the m wn in tabl age of thes 95% to 99% e of the oth of less than ts for appro and uk wi on malaysia , this signif s and is no ratively, oth bservations a 8. first, as ce a sizable all the co ic policies: and broade wned enterp the varianc ndices amon decomposi tion in marke the decomp we begin by an, malaysi w the perce market in the le 8, result se stock m %. almost a her markets. 1% of its f oximately 2. ith error var an market’s fies that the ot open an her markets are notable all markets e fraction o ountries in the openin er range of prises but t ce decompo ng the four c tions for us ets horizon (days) 5 10 15 5 10 15 5 10 15 5 10 15 positions of y considerin ia and uk. entage forec e first row. s indicate t market innov all the mark in the case forecast erro .75% of imp riances of 0 s forecast er e malaysian nd vulnerab do not seem from the va exhibit an of the daily the analys ng of differ f financial the analysis osition analy countries is 173 s, uk, japa inno n djia (u.s 99.3 99.3 99.3 0.01 0.02 0.02 0.34 0.34 0.34 0.70 0.70 0.70 f the foreca ng the effec the market cast error v that all the vations exp kets accoun e of malays or variances mpact on ma 0.34% and 0 rror varianc n market is ble to shoc m to exert a ariance deco n exogenous y forecast er sis have im rent sectors and institu s proves fo ysis shows minimal. asian an & malay ovation in ma a s) nikkei (japan) 6 0.31 5 0.31 5 0.31 98.77 2 98.76 2 98.76 4 2.75 4 2.76 4 2.76 0 0.30 0 0.30 0 0.30 ast error va ct of a shock ts have been variance of t e stock mar plained by nts for less ia, all stock s except for alaysia’s for 0.04% resp ce explaine the least ex cks occurrin any consider ompositions s market tre rror varianc mplemented s of the eco tional refor oreign parti that the de n journal of f sia from 20 arket of: kl (m 0.3 0.3 0.3 0.3 0.3 0.3 96. 96. 96. 0.2 0.2 0.2 ariance for k that origin n ordered a the market rkets are ex their own than 3% of k market see r japan. jap recast error ectively. w d by the ot xogenous m ng in leadi rable influen s of the stoc ends and no ce of anoth significant onomy to f rms, and th icipation ha gree of co-m finance & ac issn 19 2012, vol. www.macrothi 000-2008 lci malaysia) 4 4 4 9 9 9 .72 .72 .72 23 24 24 5-day, 10nates in the according to in the first xogenous s innovations f the foreca em to have m pan tops the variances f with such a m ther market market amon ing stock m nce on mal ck markets o market is her market. nt changes foreign inve he privatiz as been ne movement ccounting 946-052x 4, no. 2 ink.org/ajfa ftse (u.k) 0.77 0.78 0.78 0.12 0.13 0.13 0.04 0.04 0.04 98.67 98.67 98.67 day and us and o closing column ince the s equals ast error minimal list and followed minimal ts in the ng these markets. aysia. index in s said to second, in their estors, a ation of gligible. in stock continu respons obtainin informa that the variable the no market here is s figure noted th horizon signific peak re of the s day 3 o from th reaches shows t peak re time di fourth a panel an malays and uk hence, w sensitiv uing on from se of malay ng this resu ation contai e unit is the e is set equa ormalized c to other ma set to malay 2 shows th hat the resp ntal axis. if cant. the fir sponse occu shock takes onward. co he uk mark s its peak on the respons sponse occu fference as and final pa nd seen to ia’s respons k did not m we can say ve to other m m the analy ysia to shock ult is to hav ned in such standard de al to one sta coefficients arkets to a p ysia. he impulse ponse becom f the bands rst panel sho urs from the a longer pe ontinuing on ket. althoug n the third d se of the m urs on day t us is one anel shows have one d se to shock make a susta y that malay markets. ysis on varia ks in us, ja ve an insigh h shocks. th eviation of t andard erro will repre positive, on response of mes statisti are far fro ows the res e first day to eriod of alm n, the secon gh not signi day and sub malaysia stoc three (i.e. da day behind malaysia’s day lag. fro from japan ained impac ysia is mos 174 ance decom apan and u ht on the ef he impulse r the orthogo or of innova esent simula ne-standard f malaysia cally insign om the zero sponse to a o the end of most five da nd panel re ificant peak bsides from ck market t ay four in th d. by day s stock mar om all four n is the high ct as the m st sensitive asian mposition, th uk were inv fficiency of response co onalized inn ation at s = ated impuls deviation s to the othe nificant whe o line, then shock in th f the second ays to subsid epresents m k response o m the fourth to a shock he plot). th four, the im rket respons panels, it’s hest approx magnitude is to shocks f n journal of f he pattern o vestigated. t f malaysian oefficients a novation. th 0 (laksmi a se response shock. the er stock ma en the lowe n the respon e japanese d day of the de though n malaysia’s re occurs with day onwar in the us here is a one mpact of the se to its ow notable tha imately 0.1 s between 0 from japane finance & ac issn 19 2012, vol. www.macrothi of dynamic the primary n market du are normaliz he initial sh and gamini es of one market in r arkets. it sh er band cro nses are sa market. sig e shock. the not significa esponse to h a one day rds. the thi market. ma e day lag du e shock fad wn domestic at the magn 3. shocks f 0.01 and 0.0 ese market ccounting 946-052x 4, no. 2 ink.org/ajfa impulse y aim of ue to the zed such hock in a i, 2004). selected response hould be osses the id to be gnificant e impact ant from a shock lag and rd panel alaysia’s ue to the des. the c shocks nitude of from us 03 only; but less f 6. conc on a sta a positi positive have ex compar to be le low deg respon malays varianc markets that the japan is sustaine market as a c market figure 2. re clusion atistical not ive mean re e return (as xposed mal red to other ess vulnerab gree of vul nse exhibite ia. japan t es followed s as its effe magnitude s the highes ed impact. h but less sen oncluding and other m esponse of m te, malaysia eturns of 0 opposed to laysia to be markets in ble to extern lnerability d the minim tops the li d by us wi ects account of malaysi st with appr hence we c nsitive to oth remark, the markets in malaysia to a exhibited i .004 and ca o high risk, e susceptibl the analysi nal volatilit from us a mal effect o st and acc ith 0.34%. m ts for hardly ia’s respons roximately can say that her markets e observati the analysi 175 shocks in u is the lowes an be summ , high retur le to shock is. the anal ty movemen and japan o of forecast counts for malaysia h y 0.4%. th e to shock f four days. t malaysia i s. on that the is is minim asian us, uk & j st standard d moned as a rns). the an s and havin lysis further nts in major only. the a error varian approximat as hardly a he variance from shocks from is most sens e co-movem mal is not in n journal of f japan from deviation of a market wi nalysis of u ng a higher r proved the r markets b analysis of nces from a tely 2.75% ny impact o decomposit m us and u sitive to sho ments betw n line with finance & ac issn 19 2012, vol. www.macrothi m 2000 – 200 f 0.99 toget ith lowest r univariate g r leverage e e malaysian but is subjec var and all markets % of foreca on the us tion results uk did not ocks from j ween the m the finding ccounting 946-052x 4, no. 2 ink.org/ajfa 08 her with risk and garch effect as n market cted to a impulse towards ast error and uk showed t make a japanese alaysian gs in the existing markets does no the an yielded the anal and low is less v characte investm the fin transmi news an of shoc stock m investor investm with re malays complet contagi scope diversif malays between we nee take ind stock m as seen malays identity all, it is country referen agmon co-mov finance becker, and th http://dx g literature. s are vulner ot much affe nalysis of v some enco lysis, malay w risk (lowe vulnerable t eristics cou ments as ma ndings also ission from nd bad new ks are persi market can b r could inc ment with an egard to the ian market tely segmen on in the re for reapin fication, at ian market n mature ma ed to take in discriminate market. the n in the rece ia. perhaps y and is now s often state y. nces n, t. (1972 vements in e, 27, 839-8 , k. g., finn he japane x.doi.org/10 contrary to rable to mo ect others is volatility co ouraging ou ysia is the o est standard to external uld well be alaysia portr o highlight other coun ws has an inf istent too. a be character rease their ny given lev policy impl co-moveme nted and do egion. the ng risk mi least in th is not of arkets such nto consider e cue from o importance ent world f , the klci w dependen d that the st 2). the r n the unite 855. http://d nerty, j. e. & ese stock 0.1111/j.154 o the findin ovements w also quite c o-movement tcomes to b only market deviation). market mov e manipula rays a safe h ts that the ntries have fluence on t as these sho rized as less return at an vel of return lications of ent with oth oes not yet degree of c inimization he short ter a very hig as that of u ration both other world e of regiona financial tur i (malaysian nt on other d tock market elations am d states, u dx.doi.org/10 & gupta, m markets. 40-6261.199 176 ngs in the li with the us contrary to nt between be considere in the analy . the analys vements tho ated by inv haven for in ere are no only a min the volatility ocks take a s efficient fr any given le n. f our this stu her markets warrant an co-moveme and retur rm by inve gh order. th us, uk or j the local, r d markets to al economic rmoil which an stock ind domestic va t is also a b mong equi united king 0.1111/j.154 m. (1990). t the jo 90.tb02438 asian iterature, it market. a the findings malaysia a ed by mark ysis with a p sis also pro ough it is r vestors in t nvestment di asymmetr nimal effect y of the ma longer peri rom the theo evel of risk udy, the find in the study ny immedia ents also ind rn maximi esting in m his leaves japan. regional and encapsulate c and politic h did not m dex) has “m ariables wh barometer of ity market gdom, germ 40-6261.19 the internat ournal of .x n journal of f has been o dditionally, s in the liter and us, uk et analyst a positive retu ved that the eceptive jap their effort iversificatio ic effects t on malays alaysian ma iod to dissip ory of mark k or could r dings sugge y is neither ate concern dicates that zation ben malaysia, as sufficient r d global eve e the movem cal events n make an imp matured” an ich need fu f the econom s: a stud many, and 72.tb01315 ional relati finance, finance & ac issn 19 2012, vol. www.macrothi observed tha , malaysian rature. k and jap and investor urns (positiv e malaysian apan and us t to diversi ons. and the v sia. but loc arket and the pate, the m kowitz. as reduce their est that the n fully integr regarding t there is sti nefits of p integration room for sw ents and sho ments of m need to emp mpressive im nd now has urther studie mic well be dy of shar japan. jou 5.x ion between 45, 129 ccounting 946-052x 4, no. 2 ink.org/ajfa at asian n returns an have rs. from ve mean) n market s. these ify their volatility cal good e effects alaysian such, an r risk of nature of rated nor possible ill much portfolio n of the witching ould not alaysian phasized mpact on its own es. after eing of a re price urnal of n the us 97-1306. beck, develop http://dx bollersl econom bollersl in hand chin, w fraction http://dx ciner, c review http://dx engle, varianc eun, c journal http://dx friedma the intro garay, u markets glosten expecte finance morgen lexingt grubel, journal hyginu http://pa janakira pacificmoney, johnson comov t., demirg pment an x.doi.org/10 lev, t. (198 metrics, 31, lev, t., eng dbook of ec w. c. (200 nally integ x.doi.org/10 c. (2006). a of econom x.doi.org/10 r. f. (198 ce of uk inf . s., & sh l fina x.doi.org/10 an, j., & sh oduction of u., (2003). s. http://ww n, l. r., ja ed value an e, 48, 1779nstern, o., ton, ky: he , h., & fa l of finance us. l, (2006 apers.ssrn.c amanan, s. -basin stoc 8, 155 – 17 n, r. and ement. guc-kunt, nd structu 0.2307/2328 86). general 307-327. ht gle r., & ne conometrics 08). volatil grated appr 0.3844/ajass a further lo ics and fin 0.1016/j.qre 2). autoreg flation. eco him, s. (198 ancial 0.2307/2330 hachmurove f the euro. p the asian f ww.westga.e aganathan, nd the volat -1801. http: & granger eath-lexing adner, k., ( e, 26, 89-94 6). volatility com/sol3/pa & lamba, ck markets. 73. http://dx soenen, l the jo a. & lev ure, (wor 8726 lised autor ttp://dx.doi. elson, d. 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(200 s. internati d heterosced asian mechanism ournal of )19:3<149:: emerging e review of f equity inte 0304-405x( 7). long pe ional resea dastic mode n journal of f of stock m forecastin aid-for7 european an financial a egration. jo (88)90060-8 ersistence v arch journa el, unpublis finance & ac issn 19 2012, vol. www.macrothi market mo ng, 19, 1 735>3.3.co nd develope analysis, 16 ournal of f 8 volatility an al of finan shed manus ccounting 946-052x 4, no. 2 ink.org/ajfa ovement: 149-176. o;2-3 ed stock 6, 41-60. financial nd links nce and script. microsoft word 3366-12632-2-sm-writer3-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 306 analysis of financial stability of indian non life insurance companies bashir ahmad joo associate professor, the business school university of kashmir, srinagar, pin code: 190006 email: bjazra2000@yahoo.co.in received: march 11, 2013 accepted: may 48, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3366 url: http://dx.doi.org/10.5296/ajfa.v5i1.3366 abstract world over after liberalization insurance sector has undergone significant transformation. this is also true with indian insurance market, where insurance penetration and density is very low compared to other countries. therefore, many foreign insurance companies were lured to make entry in indian insurance in order to insulate positive spread from large untapped insurance market, mainly by entering into joint venture with local partners. thus indian insurance market after liberalization was assaulted by the pressure of globalization, competition from multinational insurance companies and lavish underwriting chase which are seen as threats as well as opportunities for insurance companies. however, entry of new players has resulted into heavy underwriting losses for indian public and private insurers. but heavy underwriting losses had reverse impact on their solvency margins. in present paper, the insurance solvency international ltd. (isi) predictors have been employed in this paper to study the solvency position of indian non life insurers. further, study highlights the extent of relationship between various factors and solvency of non life insurers in india by using multiple regression analysis. the result of the study has shown that claim ratio and firm size have greater impact on solvency position of insurance companies. keywords: isi standards, solvency, combined ratio, expense ratio, claim ratio, underwriting losses, operating margin, investment income jel classification: g20, g22, g32, m40 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 307 introduction the insurance sector in india is passing through a period of structural changes under the combined impact of financial sector reforms in general and insurance sector in particular. the market for insurance services previously was monopolized while the market place was regulated and insurance companies were expected receive assured spread over their cost of funds and systematic demand for their products. this phase in indian insurance business was the result of sheltered markets and administered prices for various insurance products. it is said that a resilient and well regulated insurance industry can significantly contribute to economic growth and efficient resource allocation through risk transfer and savings mobilization. in addition, it can enhance wealth management avenues in the country. all these contributions of the sector can only be achieved when the sector is organized and competitive. the competitive insurance markets are in the national interest because they generally offer business houses and individuals’ greater choice and better value than alternative approaches (skipper jr. & klein, 2000). in recent times restrictive markets have been made competitive through a combination of liberalization and deregulation. consequently indian insurance industry was liberalized in january, 2000, with the passage of the irda act. the liberalization was brought about with the objectives to increase coverage of population, better choice of products with informed decisions, promote competition, encourage the entrance and joint partnership of foreign players with the indian insurers, so as to boost innovation, advance economy of operations, enhance customer centricity and service excellence, improve the efficiency of the public sector companies and above all to create economic activity for the purpose of benchmark growth rate. the historical perspective of the general insurance companies reveal that the rapid expansion of insurance companies since nationalization had given rise to a number of problems related to the image, operational efficiency, productivity, and the quality of portfolio of the system as a whole and there have been persistent complaints about deterioration in customer service (rohit & manjit, 2009). close on the heels of the success of the privatization initiatives in the banking sector, insurance sector reforms were initiated following the report of malhotra committee (1993). the reforms were aimed at creating more efficient and competitive financial system suitable for the requirement of the economy. the year 1999 saw a revolution in the indian insurance sector, as major structural changes took place with the ending of the government monopoly and the passage of the insurance regulatory and development authority (irda) bill, lifting entry restrictions for private players, and allowing foreign players to enter the market with some limits (26 percent) on direct foreign ownership. the insurance industry has been maintaining its constant growth rate of 15% to 16% over the last few years. as a result, the insurance penetration rose to 4.6 % in the year 2009-10 for life segment and remained stagnant at nearly 0.6% in the case of non-life insurance (insurance regulatory and development authority (irda) , 2009-10). one of the reasons for low penetration in general insurance has been lack of concerted efforts to effectively tap the retail segment (parekh, 2007). the reforms of indian insurance sector brought substantial changes in the level of competition, business environment, managing strategies, service quality and advance asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 308 technology front. the wind of liberalization, globalization and privatization has opened new vistas in the insurance industry in the generation of intensely competitive environment. the post-liberalized insurance industry in india has been witnessing a discernible shift from the sellers' to the buyers' market (rohit & manjit, 2009). further, industry will become more professional (shenhbargraman, 2001) and lowering the entry barriers and growing sophistication of customers will make insurance market oligopolistic. the reformed insurance industry has offered a plethora of new customer friendly products, new delivery channels like bancassurance, corporate agents, brokers and direct selling through the internet, greater use of computerization and information technology. the reforms at this stage need to be reviewed in order to assess their compatibility vis-a-vis the growth and performance of insurance industry in india. the deregulation of general insurance industry in india is having far reaching consequences in terms of market size, structure and operational practices. the effects of privatization and deregulation on the firm's performance have received bulk of attention at national and international level and research has revealed that liberalization has positive long-term effect on economic growth and firm's performance (dollar, 1992; chennappa, 2006; sinha, 2006; oetzel & banerjee, 2008). however, available literature on insurance sector has neither stated that whether the indian industry stand in compliance with solvency norms applicable at international levels nor the significant factors have been highlighted which affect financial stability of insurance business and subsequently to solvency position of insurers. the present study therefore attempts to fill this research gap so as to highlight whether indian insurance industry has been able to satisfy it or not. further, this study analyses the factors responsible for jeopardizing solvency status of indian non life insurers. objectives of the study the study has the following broad objectives; 1. to study the solvency position of indian non life insurance companies with respect to prescribed solvency norms set by insurance solvency international limited (isi). 2. to make regression analysis of the factors having impact on the solvency position of indian non life insurance companies. review of literature rao (2007) opined that a land mark year in the history of indian insurance industry was 1999-2000. the year 2007 is going to another watershed for the industry because de-tariffication from first january 2007 has totally changed the complexion of the non-life insurance industry. since financial inclusion is being emphasized in various levels, the insurance industry will have to play a vital role by providing health insurance and other insurance products for the poor. (jain, 2004) revealed that waves of liberalization have done wonders to develop the insurance to the status of a career with a bright future. the average mindset, particularly of younger generation in india is very amenable to these changes in insurance as an avenue where exhilarating opportunities are opened up in changed environment. after ten years in competitive market, the indian insurance industry has asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 309 exhibited a healthy growth trend of new business and market share. the total premium underwritten rose to rs 35,816 crores, registering a growth of 13.44 per cent in 2009-10. in addition to this, even today “insurance is treated as vital economic activity and there is an excellent scope for its growth in the emerging markets". the opening up of the insurance sector has raised high hopes both in india and abroad. the recent de-tarrification in the non-life domain has provided a great deal of operational freedom to the players” (rao, 1998; roa, 2007a). studies have also looked at the insolvency prediction abilities of "insurance regulatory information system (iris) ratios iris (brockett et al., 1994), the national association of insurance commissioners (naic) ratios (cummins et al., 1995). although the issue of insolvency was dealt with rigor in most of the studies, but none of them have attempted to see what actually contributes to difference in financial strength. the factors that are significant for assessing non life insurers’ solvency include firm size, investment performance, liquidity, operating margin, combined ratio, claims ratio, underwriting result and premium growth. the financial health of any organization is influenced by, among other factors, the size or total assets of the firm. as regulators are less likely to liquidate large insurers, it is expected that small insurers are more vulnerable to insolvency (barniv & hershbarger, 1990; (cummins, harrington, & klein, 1995). variables used to measure firm size include total premium, total admitted assets, and capital and surplus. investment performance discloses the effectiveness and efficiency of investment decisions. as such, investment performance becomes critical to the financial solidity of an insurer. (kim, anderson, amburgey, & hickman, 1995) find that investment performance is negatively correlated to insolvency rate. there are two key components of an insurer's total operating income: investment income and underwriting income. we have discussed the effect of investment performance. as for underwriting income, combined ratio (rejda, 2002) is used measure its performance. according to (browne & hoyt, 1995) the combined ratio is positively correlated to insolvency rate. liquidity is the capability of an insurer to pay liabilities, which include operating expenses and payment for losses/benefits under insurance policies, when due. for an insurer, cash flow (mainly premiums and investment income) and liquidation of assets are the two sources of liquidity (hampton, 1993). (lee & urrutia, 1996) found that the current liquidity ratio is a significant indicator of solvency. the stability of the liquidity ratio is a necessary measure of corporate solvency (dambolena & khoury, 1980). intuitively, being profitable means that insurers are earning more revenues than being disbursed as expenses. (kramer, 1996) found a positive relationship between operating margin and financial solidity, that is, operating margin is negatively correlated to the rate of insolvency. however, given the indian scenario, the research evidences cover financial performance of insurers and as such it becomes imperative to highlight the solvency and factors affecting solvency of the insurers. the present study is just a step towards the area, which surely highlights the functional areas of insurer’s performance and its impact on the solvency of insurance enterprises. research methodology the research design which has been formed for this research article are standards prescribed asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 310 by insurance solvency international limited (isi), used by (joo, 2005) while evaluating performance of insurance sector in india, which related various key ratios of insurance sector with the standards prescribed by isi. as per these standards, the ratio of net premium to shareholders funds, when less than 300 percent, the ratio may be termed as ideal one applicable to non life insurers. the change in net premium highlights the fluctuating pattern of business underwritten by the insurers and as per the standard, ideal growth is one which falls in the range of ±25 percent. the third ratio which highlights the greater thrust on underwriting profitability in terms of investment income should never be less than -25 percent. the negative sign of the ratio indicates that cushion of investment income should not set off underwriting losses by more than 25 percent. the ratio, while highlighting importance of investment income in insurance business, necessitates the importance of underwriting profitability of the concerns. the fourth ratio of the standard, i.e., technical reserves/shareholders funds, highlights the importance of technical reserves for the insurers. since the reserves serve as cushion in the adverse selection of business, the standard highlights the minimal requirement of less than 350 as per international solvency standard. since capital forms part of shareholders’ funds, the ratio highlights more important role of technical reserves in insurance concerns. the fifth ratio of the standard while taking into account technical reserves and shareholders’ funds indicates the desirable business volume which should be supported by adequate reserves and capital. the benchmark standard for the ratio states that it should be never less than 150. lastly, the ratio of pre-tax profits to net premium highlights the importance of operational and non operational profitability of the companies. the standard prescribes that the ratio should be greater than 5 percent to meet isi standard of solvency. the period of study ranges from 2004-05 to 2008-09 i.e. for 5 years and companies selected for the purpose of study include both public and private sector insurers. the required data was collected from the annual reports of the concerned companies. insurance company’s specific factors hypothesis expected effect h1 firm size + h2 investment performance + h3 liquidity ratio + h4 operating margin + h5 combined ratio h6 claims ratio h7 underwriting profitability + further, in present study above given seven hypotheses will be tested with the help of multiple regression analysis in order to see impact of various factors on the solvency margin of insurance companies. however available solvency margin (asm) has been used as dependent variable for the 12 non-life insurers in the industry for the period 2004-05 to 2008-09 to prove the hypothesis given above instead of using the irda’s minimum required asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 311 solvency margin. multiple regression model has been employed to include various independent variables and their impact on solvency margin has been tested by using following equation: solvency(y) = market shareoperating marginfirms sizeinvestment  yield) liquiditycombined ratioclaim ratiounderwriting  performance results and discussion the “index of performance” was developed by insurance solvency international limited as a composite measure of overall performance of insurance companies. in this index, six ratios are employed viz net premiums to shareholders funds, change in net premium, underwriting profits to investment income, technical reserves to shareholders funds, technical reserves plus shareholders funds to net premiums and pre-tax profits to net premiums. the analysis in this context is presented separately for public and private insurers as under: a) isi standard and public sector insurance companies. the benchmark isi standard, for these ratios, along with prescribed ratio for public sector insurers for a period of five years from 2004-05 to 2008-09 are presented in table 1. as is evident from the analysis of net premium to shareholders funds ratio, the ratio is within the benchmark isi standard of less than 300 for all public sector insurers for the period of study and as such they are able to meet this standard during the period of study. the ratio of change in net premium for all public sector insurance companies is within the benchmark of ±25 for all years of study period. similarly, all public sector insurers are able of meet the isi standard of less than 350 over the study period in the respect technical reserves to shareholders funds. however, it surprising to note that benchmark of less than -25 for underwriting profits to investment ratio in case of public sector insurers is more than the set standard for all years of study period and as such public sector insurers were not able to meet isi standard in this respect. further, it is evident from the analysis of technical reserves plus shareholders funds to net premiums that only new india and united insurers are able to meet isi standard of less than 150 for all years of study period. while oriental and national insurers have failed to meet the isi standard for all years of study period in respect of technical reserves plus shareholders funds to net premiums. it is also clear from the analysis of pre-tax profits to net premiums that all public sector companies are able to meet benchmark standard of greater than 5 in this respect except for oriental during 2008-09 (-2.88) and national for years 2004-05 (4.99) 2005-06 (-2.22) and 2008-09 (-3.90). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 312 b) isi standard and private sector insurance companies the analysis of isi standard benchmark analysis ratio for private sector insurance companies is presented in table 2. the analysis of net premiums to shareholders funds reveals that all private sector insurers and the period of study are able to meet isi standard of less than 300. the ratio of change in net premium for all private sector insurers presents fluctuating picture as almost in all years of study period, the companies are not able to meet the benchmark standard of ± 25 except for few years when they are able to meet to this standard. similar picture was witnessed for all companies in the private sector over the period of study in respect of underwriting profits to investment ratio, where companies are far away from set standard of less than -25. however, it is evident from the analysis of technical reserves to shareholders funds that private sector insurers have been able to meet the benchmark standard of less than 350 for all years of the reference period. the ratio of technical reserves plus shareholders funds to net premium computed in respect of private sector insurers for the study period shows that all private companies are able to meet the isi standard of less than 150 in this respect except in case of reliance for 2004-05 (282.14), 2005-06 (366.49), 2006-07 (170.20) and cholamandalam for 2004-05 (158.67). the last ratio in the category of isi standard index is pre-tax profits/net premiums. this ratio depicts mixed picture as all companies in private sector have been able to meet the standard of less than 5 for few years of study period and have failed to meet the standard for remaining years. moreover, the ratio for the hdfc ergo could not be computed, due to non availability of technical reserves. the analysis reveals that public sector insurers are generally better placed in terms of the isi standard, however, what is seemed to be worrisome is that the standard of underwriting profitability to investment income, which has never been met by the public sector insurers. moreover the absolute value of the standard reflects that underwriting losses damages overall profitability position of the public insurers and the trend seems to be on surge. the analysis of private sector insurers on the other hand reveals heavy fluctuation in net premium and they are not able to meet the benchmark standard. analysis also reveals that underwriting profitability too has been under strain as such the sector does not meet the prescribed standard by isi and consequently pre-tax profits/net premium is also affected, which lead to the sectoral inability of meeting the isi standard. regression analysis of solvency of non-life insurers the irda has issued a strict guideline towards maintenance of a ‘statutory’ solvency reserve. solvency margins for each class or line of business are clearly specified irda (assets, liabilities, and solvency margin of insurers) regulations, 2000. these regulatory guidelines are helpful in finding out the ‘solvency ratio’ [the ratio of the total amount of available solvency margin (asm) to the total amount of required solvency margin (rsm)] at the firm level. the determination of “required solvency margin” (rsm) differs from life segment to non-life segment of insurance business. again, depending on the line of business the practice of required solvency margin varies among different non life insurers. in addition to this, required solvency margin of non life insurers is based on either net premiums (rsm-np) or asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 313 on net incurred claims (rsm-ic) and ultimately the required solvency margin shall be the higher of the amounts of rsm-np and rsmic. the last and final step towards calculation of the solvency ratio is to estimate the total “available solvency margin” (asm). the calculation of both asm and rsm also depends on the irda (actuarial report and abstract) regulations, 2000 and it requires specific information relating to the insurance business. these specific business information are neither available from annual report, nor does irda make public its actuarial report and abstract. however, in present study asm has been calculated with the help of financial information available. in this context, an analysis of solvency ratio has been attempt by using regression analysis by taking the solvency ratio as dependent variable and various factors as identified in various research studies as independent variables. the independent variables and their description used for multiple regression analysis in presented here under: independent variables description firm size total assets to earned premiums investment performance investment income to earned premiums liquidity ratio liquid assets to current liabilities operating margin total income to total outgo combined ratio sum of loss ratio and expense ratio (financial basis) claims ratio net claims incurred to premiums earned underwriting profitability profits from operations, excluding investment and other income based on the results depicted in table 3 above it is inferred that against expectation, the non-life insurers’ solvency is affected by the firm size. several factors may be responsible but the most obvious one seems to be the nature of business done by the non-life insurers. the policyholders’ liabilities are borne by the insurer for a year and hence the fund created will be for a particular financial year. unlike life insurers, the non-life insurers have no net accretion to the total investible funds each year. a typical non-life insurance policy (say health, motor vehicle, etc.) expires exactly after a year from the date of purchase/ commencement. one of the predictors claims ratio suggest that it has the expected sign and strongly suggests that higher claim ratio has been contributing negatively to overall insurer solvency status. size of firms, which is again significant, is also going to contribute to higher income and hence contribute towards solvency. but, the two predictors operating margin and underwriting result proxies by the combined ratio were significant but yielded unexpected relationship with solvency. these results may be due to the fact that most of the firms are still trying to establish themselves in the industry and initially spending more compared to total assets, income and underwriting profits. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 314 table 3. results of multiple regression analysis for solvency margin of non life insurance industry model un-standardized coefficients std error t p>t beta y-intercept 3.6321 0.6918 5.25025 <0.0001 market share 0.02643 0.02045 1.29249 0.20201 operating margin -0.0377 0.01288 -2.92582 0.00512 firm size 0.00711* 0.00115 6.18232 <0.0001 investment income -0.01189 0.01641 -0.72417 0.47227 liquidity 0.00547 0.00519 1.05453 0.29661 combined ratio 0.00563 0.00241 2.3403 0.02322 claims ratio -0.06466* 0.01461 -4.42486 <0.0001 underwriting performance 7.84811e-8 4.21582e-6 0.01862 0.98522 r square adjusted r square 0.61658 0.55643 observations 60 * at 1 percent level of significance conclusion the analysis of solvency margins highlights the upper hand of public insurers over the private insurers as isi standard, the status if monitored closely reflects that the reserves built in pre-liberalization era has helped the sector to reflect comparatively good financial strength. however, since the study is not aimed at comparative analysis of the two sectors, the analysis reveals that irda in general and individual companies in particular need to redesign their underwriting policy, which should be aimed at competitive and profitable business. the practice of subsidizing of investment income to meet underwriting losses, which is in practice in full force should be redesigned to exclude investment side from corporate functioning. the benchmark be made, reflecting only operational performance, which in the long run should aim at profitable underwriting of the insurance companies. the use of financial ratios and multiple regression to see the impact of increasing financial performance on insurers’ solvency does not support the fact that there is negative impact on the non-life segments of the insurance industry. based on their financial performances, it seems each player in the market is contended or they are together improving their ratios and hence there is no significant shift observed to strengthen the hypothesis. however, as ratios are important for future sustainability, firm size was observed most significant variable, having impact on solvency margin. indian insurance industry is growing and the first job assigned to irda is to regulate and protect policyholder’s interest and then help the development and growth of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 315 the industry. till 1999, most of the reserves of the public insurers were in the form of central govt. and state govt. bonds and securities. most of their assets were secured and guaranteed by the govt. after liberalization also more than 50 percent of such investments in securities and bonds were with the govt. if short run solvency is heavily dependent on the size of the insurers and the growing loss ratio, it is time for the insurers to re-think and devise the underwriting policy to embrace the risks associated and price the products accordingly with stressing profitable pricing. any relaxation on this ground might prove to be costly and in the future sustainability may get affected to a great extent. the significance of these variables may help the regulator to decide whether or not to give insurers enough freedom to invest in the stock markets and other investment channels with attractive rates of return. from the statistical analysis of the 12 non life insurance companies it can be concluded that they have performed successfully in the grabbing the market in deregulated environment. the required solvency norms have been adhered to, however, growing underwriting losses and unsound product pricing may not be a sustainable strategy in a long run to acquire market share. the higher claims ratio, which is 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(2006). operating efficiency of life insurance companies: a data envelopment approach. the icfai journal of risk and insurance, 3(4), 29-37. sinha, r. p. (2007). productivity and efficiency of indian general insurance industry. the icfai journal of risk and insurance, 4(2), 33-43. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 317 skipper jr., h. d., & klein, r. (2000). insurance regulation in the public interest: the path towards solvent, competitive markets. georgia state university. georgia: center for risk management and insurance research. table 1. analysis of isi standard benchmark of public sector insurers companies years n et p re m iu m s/ s h ar eh ol d er s f u n d s c h an ge in n et p re m iu m u n d er w ri ti n g p ro fi ts /i n ve st m en t in co m e t ec h n ic al r es er ve s/ s h ar eh ol d er s f u n d s t ec h n ic al r es er ve s + s h ar eh ol d er s f u n d s/ n et p re m iu m p re -t ax p ro fi ts / n et p re m iu m isi standard < 300  25 > -25 < 350 > 150 > 5 new india 2004-05 90.24* 7.16* -118.90** 96.52* 217.78* 20.48* 2005-06 90.32* 11.49* -148.67** 95.84* 216.83* 19.70* 2006-07 75.33* 4.43* -75.57** 96.68* 261.08* 35.59* 2007-08 69.00* 6.09* -85.19** 97.13* 285.69* 31.62* 2008-09 71.69* 9.10* -192.97** 97.27* 275.17* 5.66* oriental 2004-05 156.35* 9.10* -236.54** 92.95* 123.41** 21.27* 2005-06 151.96* 12.73* -225.71** 93.92* 127.62** 13.37* 2006-07 132.83* 7.61* -160.18** 95.06* 146.86** 23.40* 2007-08 141.94* 6.89* -198.94** 95.06* 137.42** 15.38* 2008-09 155.39* 6.63* -392.85** 94.93* 125.45** -2.88** national 2004-05 232.86* 12.90* -352.92** 91.78* 82.36** 4.99** 2005-06 241.71* -5.27* -484.48** 90.99* 79.02** -2.22** 2006-07 193.07* 3.15* -272.58** 93.02* 99.98** 16.47* 2007-08 193.66* 9.07* -339.37** 93.58* 99.96** 5.70* 2008-09 242.81* 13.38* -475.77** 92.91* 79.45** -3.90** united 2004-05 107.05* 0.99* -246.00** 95.07* 182.23* 14.65* 2005-06 94.42* 2.45* -212.61** 95.76* 207.33* 20.34* 2006-07 87.51* 6.62* -170.78** 96.31* 224.32* 21.93* 2007-08 84.69* 13.86* -154.85** 96.87* 232.46* 24.36* 2008-09 89.77* 18.39* -134.98** 97.19* 219.66* 15.72* source: compiled and computed from the annual reports various public sector insurance companies from 2004-05 to 2008-09. * meets isi standard ** does not meet isi standard asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 318 table 2. analysis of isi standard benchmark of private sector insurers companies years n et p re m iu m s/ s h ar eh ol d e rs f u n d s c ha ng e in n et p re m iu m u n d er w ri ti n g p ro fi ts /i n ve st m en t t ec h n ic al r es er ve s/ s h ar eh ol d er s r es er ve s + s h ar eh ol d e rs f u n d s/ n et p re -t ax p ro fi ts / n et isi standard < 300  25 > -25 < 350 > 150 > 5 royal sundaram 2004-05 155.09* 28.99** -154.17** 64.48** 2.65** 2005-06 212.06* 47.25** -154.30** 47.16** 3.42** 2006-07 234.19* 12.36* -56.32** 1.71* 43.43** 8.15* 2007-08 251.66* 33.65** -328.74** 4.04* 41.34** 1.07** 2008-09 268.40* 34.15** -345.26** 5.75* 39.40** 1.63** bajaj allianz 2004-05 268.34* 67.34** 361.42* 38.51* 51.62** 16.06* 2005-06 261.61* 45.78** 206.94* 58.79* 60.70** 11.71* 2006-07 207.86* 20.01* 69.25* 72.70* 83.08** 13.96* 2007-08 245.18* 68.80** -67.56** 80.91* 73.79** 11.86* 2008-09 281.24* 33.62** -171.25** 83.61* 65.28** 7.92* tata aig 2004-05 207.82* 37.71** 22.94* 48.12** 9.39* 2005-06 172.70* 29.64** -4.44* 57.90** 7.98* 2006-07 156.54* 13.33* -42.11** 7.71* 68.81** 8.66* 2007-08 174.57* 18.92* -128.10** 13.45* 64.99** 5.93* 2008-09 173.19* 29.44** -251.70** 11.56* 64.41** 1.62** reliance 2004-05 44.77* 79.33** -54.89** 26.30* 282.14* 11.64* 2005-06 36.35* -10.36* 58.18* 33.24* 366.49* 37.94* 2006-07 94.16* 339.79** -204.34** 60.27* 170.20* 0.92** 2007-08 158.16* 293.04** -752.05** 82.35* 115.29** -16.96** 2008-09 174.25* 44.67** -402.73** 85.81* 106.64** -3.61** iffco tokio 2004-05 187.33* 76.06** 49.14* 20.20* 64.17** 10.07* 2005-06 170.88* 103.74** -78.51** 21.40* 71.04** 5.04* 2006-07 184.54* 14.49* -63.61** 25.86* 68.20** 7.75* 2007-08 210.48* 16.81* -282.84** 27.61* 60.63** 1.85** 2008-09 182.02* 30.21** -499.44** 46.02* 80.23** 0.83** icici lombard 2004-05 128.66* 147.18** 9.78* 11.79* 86.89** 16.79* 2005-06 196.79* 128.70** -92.59** 34.30* 68.25** 7.43* 2006-07 134.56* 45.35** -96.38** 57.65* 117.16** 7.51* 2007-08 145.65* 46.93** -97.38** 64.93* 113.23** 8.31* 2008-09 123.15* 25.94** -235.63** 74.85* 141.98** 0.01** cholaman dalam 2004-05 63.02* 85.12** -221.90** 158.67* -3.73** 2005-06 69.42* 10.15* -263.74** 144.05** -2.54** 2006-07 89.66* 29.15** -29.14** 111.53** 10.84* 2007-08 170.49* 95.52** -202.23** 2.75* 60.27** 4.24** asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 319 2008-09 251.94* 54.85** -258.18** 7.19* 42.55** 3.08** hdfc chubb 2004-05 112.28* 51.40** -290.81** 89.06** -5.95** 2005-06 115.17* 7.01* -111.99** 86.83** 3.34** 2006-07 112.31* -2.35* -124.98** 89.04** 1.78** 2007-08 100.03* 6.96* -540.05** 99.97** -11.18** 2008-09 89.74* 19.61* -550.10** 111.44** -14.05** source: compiled and computed from the annual reports various private sector insurance companies from 2004-05 to 2008-09. * meets isi standard ** does not meet isi standard microsoft word efficiency or persistence empirical evidence-writer2-new fina contr receive doi:10.5 abstra today, times o detectio statistic in pract classifie january property keywo ancial m e ractual teac t ed: may 21, 5296/ajfa.v4 ct: the assump of crisis, an on of long m cal analysis tical terms, ed into thre y 2000 to d y of of long rds: efficie market empiri her in finan ihec c tel: 216-22 , 2012 a 4i2.1827 ption of eff nd is challe memory. th such as r/s our researc ee groups a december g rang depen ency, long s betwe cal evi flife nce, money carthage pr 2-80-2093 accepted: de url: htt ficient capit enged by r his study aim s, its corolla ch was cond according to 2010. the ndence tend memory, a 379 een eff idence el kaouther, and banks, résidence-2 e-mail: fl ecember 15 tp://dx.doi.o tal markets research sho ms to test th ary named h ducted on d o their leve results ob d to be assoc analysis r / asian ficiency on dai , phd institute of 016 tunis, flifelkaouthe 5, 2012 p org/10.5296 is very con owing that he existence hurst expon daily data on els of devel btained allo ciated with s, hurst ex n journal of f y and p ly data f higher com tunisia er@yahoo.f published: d /ajfa.v4i2.1 ntroversial, the pricing of the pers nent and the n stock retu lopment ov wed us to relatively th xponent, ar finance & ac issn 19 2012, vol. www.macrothi persiste a mmercial s fr december 1 1827 especially g was disto sistence effe e arfima urns of 21 c ver the peri conclude hin stocks rfima mod ccounting 946-052x 4, no. 2 ink.org/ajfa nce: tudies 7, 2012 in these orted by ect using process. countries od from that the del 1. intro validat efficien assess t accord events anticipa using so we can on certa long as in the sp unpre indepe havin normal to the n these c are norm existenc because driving refereed howeve can be price qu memory impacts prices a term wh in gener memory them an 1 in his the by brown, 2 the phen joseph inte seven-year mean are ex series. oduction ed by thous nt capital m the securitie ing to the th and accurat ated events ome mathem n say 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del. efficient wh nable to infl can preven achelier1, th plementatio an use the p on, that is is no exces mpirically to ory. this m autocorrelati ed in the jar brium: "mea he theory of et may hav d. low auto ilibrium val he price sl rates....lon alue. these o the standar fficiency im of returns) w predict futu , backed march 29 most pricing mod known as joseph even lean cows se est (mignon (199 ng memory in tim 380 g on all fina market is e t at any time nancial mar tations expr sting course hen investor fluence the nt and suppr he differenc on of the eve past to make to say that sive deviati o uncorrelat means that t ion in the rgon of fam an reverting f random wa e a memory ocorrelation lue. conver owly integ ng memory differences rd equilibriu mplies that th which mean ure returns to 9, 1900, he introd dels in finance, in effect. (mandelb even large monito 98), p.191). this m me series, refers t asian ancial mark efficient wh e is reflected rkets incorp ressed abou es, and it wo rs with insi price of sec ress insider t ces between ent. e future prof t the distrib ion from th ted price ser the action o series of p ma, knowle g behavior" alk and mar y effect. em ns mean a s rsely, high grates inform reflects la persist and um. he return ser s the absenc o from past duced the use of th ncluding the blac rot and wallis 19 or and joseph con means that the pe o lasting consequ n journal of f kets in the w hen all relev d in the pric orate the co ut future eve ould be usel de informat curities, wh trading. n pt and pt-1 fits. bution of de e mean. th ries. stock m of arbitrageu prices is ra edgeable pro . the mark rtingale. mpirically, t hort memor autocorrelat mation on asting devia d cannot be ries are char ce of serial c returns. the he brownian mov ck-scholes (1973) 68). it refers to a ncludes that this w eriods when the se uences but not a p finance & ac issn 19 2012, vol. www.macrothi world, the th vant inform ce of securit onsequences ents. all kn less to try to tion or a m hich will be noted t are eviations fo he deviation market fluc urs is effec apidly disap ofessionals, ket is efficie the series o ry. in this c ations reflec the fundam ations betw reduced in racterized b correlation b e controver vement in finance ). a passage in the b was a planned ser eries is above (or permanent shock ccounting 946-052x 4, no. 2 ink.org/ajfa heory of mation to ties. s of past nown or o predict monopoly e true as e: ollows a n returns ctuations tive, the ppearing , end by ent, well of prices case, the ct a long mentals, ween the the long by a zero between sy about e (discovered bible where ries of r below) its to the said this is profitab simultan thus, th finance several were us fact that highligh fox an jacobse finally, market the obj sample importa between sample uk, the south a emergin in what long me r/s and present 2. liter the ph astronom depende (1951, (1978), been th diebold rudebu structur the inte from m figar the dev process that the pr bility (low neously adv he ability to , both from l statistical t sed. indeed, t the s& p5 hts the depe d farahman en (1996) st , golaka an using daily jective of th of 21 stock ance in the e n long mem includes th e japan, and africa, egy ng powers o t follows we emory, we w d the arfi the results. rature revi henomenon mer newco ence structu 1957), man the search he subject o d and rud usch (1991) re interest ra erest in rese modeling the rch (fractio velopment o ses, they are roponents o dependence vocate the a predict futu an academ tools for th , the study o 500 can be c endencies lo nd (1999) tudied the lo nd nath (200 y nifty ind he paper is k markets w economy, as mory in stoc he developed d the usa, ypt, saudi a of turkey, i e will expos will then se ima model iew of long m omb and th ure of long ndelbrot an for depend of many co debusch (19 ) on consum ates or lo ( earch on lo e volatility onally see b of these var e relatively of efficienc e where de absence of lo ure perform ic or practic he developm of hsieh (19 considered f ong-term ret studied the ong-term de 01) attempt dices. to test stoc with a wider s an attempt ck returns an d stock mar it also inclu arabia, sou indonesia, b se, first, a li et out, in th l, then we memory app he chemist g-term beca nd wallis ( dence struct ontributions 989) and s mption, she (1991) on th ng memory of the serie bollerslev a rious resear rare in the 381 cy seem to ependence b ong memor mance from p cal point of ment of chao 991) in the following a turns of the e returns of ependencies ted to test th ck index ret developme t to provide nd the level rkets of us udes, in add uth korea, brazil, mexi iterature rev he second se will show peared in t student. t ame import (1968), ma tures in lon . among th sowell (19 ea (1991) a he stock ma y is further es through a and mikkel rch studies literature. b asian o accept th between ob ry in these s past one is o f view. os theory on u.s. marke random wa dow jones f major ma s indices of he presence turns for lo nt spectrum e further inte l of stock m sa, the fran dition to the argentina, ico, china, view of rese ection, the c the empiric he year 18 the fact th tant researc ndelbrot (1 g-term econ hese studies 992) on the and backus arket. highlighted arfima p lsen (1996) of the fore baillie (199 n journal of f e predictab bservations ame series. observed to b n economic t raises man lk, the same industrial. o arket indice seven indus of long me ng memory m in terms o ernational e market devel nce, the ger e emerging m australia, india and r earches mad concept of h cal evidenc 895 from o hat time ser ch topic in 972) and m nomic and s may be m e real prod s and zin ( d by recent process, lead integrated ecast series 96), doukha finance & ac issn 19 2012, vol. www.macrothi bility of sh of short-te be a crucial c and financ ny doubts a e way peter opong, mu es of engla strialized co emory in th y using data of size, liqui evidence on lopment. w rmany the i markets of those of th russia . de on the co hurst expon ce. finally, observations ries may e n economic mcleod an financial se mentioned t duct, dieb (1993) on t developmen ding to the garch). through a an et al. (20 ccounting 946-052x 4, no. 2 ink.org/ajfa hort-term erm) but l issue in cial data about the rs (1994) ulholland, and, and ountries. he indian a from a idity and n the link while the italy, the tunisia, he seven oncept of nent, the we will s of the exhibit a s. hurst nd hipel eries has those of old and the term nts back process despite arfima 003) and robinso integrat davidso nonline includin of exch markets timotej analysis to perfo suggest czech r of lrd time w represen david, showing evidenc of the volatilit dissimil manage we pro indices averag david g country period f present 3. meth to dete mandel standard floods. ahurs the in hydrolo could e capacity on (1994, 2 tion. on and tera earity of tim ng for exam hange rates s (willinger j jagric, bo s of long-ra orm an anal t that we ca republic, h d (poland an window, th ntative for t mcmillan, g that afric ce of long m uk and u ty is mixed. lar across m ement strate opose to co through m e) and the w g. mcmilla y indices cla from janua in long mem hodology ect the dep lbrot sugge d deviation st exponent nvention of ogical series exhibit the l y by the sta 2003) provid asvirta (200 me series. mple: financ (ferrara an r et al (1999 oris podobn ange depend lysis of lrd an divide the hungary, ru nd slovakia he results the markets pako and can marke memory in v usa show . these resu markets and egies. ntinue the modeling a work of tim an, pako th assified into ary 2000 to mory time s pendence o ests using t ) that was o t f hurst is s. this is fr long memor andard devia de an overv 02), in turn since then ce on a serie nd guégan 9)). nik, marko dence (lrd d in the cap e stock mar ussia, and s a). addition show som in transitio thupayaga ets (largely) volatility is short mem ults show th this may ha work on lo arfima ( motej jagric upayagale, o three grou december series. of long-term the statistic originally d the study from his stu ry process. ation of t s 382 view of the n, they studi n, this conc es of inflati (2001)) an kolanovic d) based on pital market rkets into tw slovenia), a nally, if the me addition on economie ale, (2009) ) display a very mixed mory in retu hat the behav ave implica ong memory (auto regr c, boris po (2009) by e ups accordin 2010. such m or the p c r/s also developed b y of long-t udy of the i the empir successive d asian processes o ied the non cept has be ion rates (b nd price ser (2005) in t the hurst e ts of six tran wo groups: and markets hurst expo nal propert es. in their ar predictable d. in compa urns while vior of equi ations for po y with a stu ressive fra dobnik and expanding t ng to their l h a model a presence of called (res y hurst (19 term statist ideal capac rical law of discharges o n journal of f of long mem n-stationary, een applied aillie et al ( ries of shar heir paper, exponent. a nsition econ markets wi s with no or onent is esti ties, which rticle they f e componen arison, resul evidence o ity market r ortfolio dive udy of the actionally i d marko ko the sample b evels of dev aims to refl f long mem scaled ran 951) at its a tical depen ity of a wa f hurst is by of a river; h finance & ac issn 19 2012, vol. www.macrothi mory and fr , long mem d in variou (1996)), on res traded presents a an estimator nomies. th ith strong l r only a we imated on a h we belie funds some nt in return lts from the of long mem returns and r ersification dynamics integrated olanovic (20 by the choi velopment lect the phe mory pheno nge or ran analysis on ndence on ater tank th y dividing hurst found ccounting 946-052x 4, no. 2 ink.org/ajfa ractional mory and s fields, a series in stock wavelet r is used e results lrd (the eak form a sliding eve are e results ns; while e control mory in risks are and risk of stock moving 005) and ce of 21 over the enomena omenon, nge over the nile various at hurst the tank that this ratio is and 1. i behaved proport bresc the sta from its the aver with r the ran study, h constan the hu used to r/s ~ t hurst's <h <1. in his a to the h ch = 22 ch is a for a pa specify if h = process if ½ < increase series t proportion if water lev d as t1 / 2 ional to th caled range atistical r/s s mean divi rage; the sta q : the extent st: the st nge r is alw hurst found nt h is called urst exponen classify tim th law can be article in 19 hurst expon 2h-1-1 measure of ast and a fut three types = ½ then ch s is called sh < h < 1, th es, these ar thus has th nal to th, w vels were in 2. the fact is known a e statistic is defined ided by its s atistical r/s q rs tandard dev ways positi d that the s d hurst exp nt h is defin me series acc apprehende 997, mignon ent. f long-term ture sufficie s of depende h = 0, there hort memory he autocorre re the chara he effect of where h is a ndependent that the r s the "law o as the range standard dev s denoted by max ∑ viation of th ive. therefo statistic r/s ponent (0<h ned as h ~ cording to t ed through r n has determ m correlation ent long ch encies based efore the pr y. elations are acteristics o f dependenc 383 a constant c of the river ratio of the of hurst" or e r of the p viation (st) y qt is writx x1t ∑ x he series. fore, the sta s behaves li h<1) which h ~ log qlogt~ is p their depend r/s which i mined a cor n between p h> 0 if h > d on the val rocess has n e positive an of a long m ce of josep asian called hurs r, hurst sho e capacity r "th law". partial sums . thus, a tim tten: min ∑x x ⁄ atistic r/s i ike th, wh is given by articularly i dence struct s asymptoti rrelation me past observa ½ when h lues of h an no depende nd decrease memory proc ph long ter n journal of f st exponent ould have fo of the stan s of deviatio me series x x x⁄ is always n ere h is a : interesting i ture. ically propo easure of lo ations and f ~1, ch then nd ch. nce on long e very rapid cess, we can rm. this is finance & ac issn 19 2012, vol. www.macrothi usually be found that th andard devi ons of a tim xt, t = 1 ..... non-negative mean of 0. insofar as th ortional to t ong-term ch future obse n increases. g-term, this dly when th an say here called per ccounting 946-052x 4, no. 2 ink.org/ajfa etween 0 his ratio iation is me series t, xt is e. in his .73. the he value th with 0 h linked ervations we can s type of he delay that the rsistence phenom probabi if 0 < correlat of decli long-ter therefo measure that the reason t clo's the stat it is ver theoreti as a so tests the the mo the we the mo include concern with: (kt) is φ is the subsequ menon in ca ility that it i < h < ½, tion is nega ine. this is rm depende ore, the hu e of the inte e statistic r that lo (199 modified r tistical r/s ry sensitive ical distribu lution to the e null hypot odified r/s, q s q ights wj (q) odified r/s s not only th ning the cho the integer estimator o uently wj (q ase "if the s is also on th we are tal ative this is a particula ency." urst exponen ensity of lon r/s does not 91) develop rescaled ran (rescaled r to the depe ution is unkn ese problem thesis of sho denoted qm rs q 1t x ) have been statistic di he standard oice of q, aq part of kt. of the autoc q) become: series has b he rise next p lking about explained b ar form of lo nt, which i ng-term dep t determine ped the mod nge statisti ange) introd endence of nown. ms, lo (199 ort memory mt is written1s q ma x 2t suggested b iffers from d deviation o andrews (19k ou orrelation c ω 384 been on the period." t anti-persis by rising ph ong memor is determin pendence in e whether (h dified r/s st ic (1991) duced by h short-term 1) develope y against the n: ax x 2t ω q by newey a the r/s on of the series 991)) providu k 3t2 coefficient o ω 1 jk asian e rise the pr stent proce hases which ry, which w ned from an n a time seri h) is statist tatistic. hurst in 195 and also it i ed the modif e alternative x m x and west (1 nly by its tr s but also th des the follot 2 φ1 φ of order 1. jk n journal of f revious peri ss that is t tend to be f was named " nalysis of t ies. but the ically signi 1 has a maj is not a stat fied r/s sta e of long me in x x x 987). aditional de he weighted owing rule: finance & ac issn 19 2012, vol. www.macrothi iod, there i to say that followed by "anti-persis the r/s pro e major draw ificant, it is or drawbac tistical test atistic from emory. x x enominator d autocovari ccounting 946-052x 4, no. 2 ink.org/ajfa s a high the ch y phases tence of ovides a wback is for this ck is that since its where it since it ances. lo (199 number with the from h robustn weak de distingu dthe arfim these m are a ge integer. recall t nonstati (i (d)), known thus, th infinite memory existenc non-inte memory series, short-te long-ter on a sin a series the sim discrete hosking notewor d = h – therefo paramet if 0 autocor 91) defined r of observa e values tab his article “l ness of the m ependence, uish short m arfima ma models models have eneralizatio . that the arm ionary so it therefore t as arima he presence memory, an y. these tw ce of a para eger coeffi y process. t because it erm and on rm moveme ngle parame of long-ter mplest arf e time: it is d g (1981), g rthy relation –1/2 ore, it is po ter “d”. <d <1/2: rrelations ar the statistic ations. statis bulated by l long-term m modified r and on the memory of lo model are the long e been deve on of arim ma (p, q) i must be int they should (p, d, q) mo e of a unit r nd no unit r wo classical ameter “d” cient is pa the arfim contains a the other ha ents in the se ter, the hur rm, it canno fima proce defined as f geweke an n between t ssible to pe arfima re positive a c v by v stics v allow lo (1991), (m memory in r/s statistics other hand ong memor g memory p eloped by g ma of box-j is used when tegrated. in d be stationa odel where root (d = 1 i root (d = 0) l models do of fraction articularly in ma model i part of an and, a param eries studied rst exponent t claim to e ess is the a follows: 1 nd porter-h the paramet erform a cla process i and decreas 385 √ where ws a test on mignon (20 stock mark s in many f its superior ry. process that granger and jenkins in w n the proces n other word ary after "d d is integer in the arim correspond o not take nal different nteresting is a signific n arma tr meter of fra d. against t t h, and if h explain the b arfima (0 l x hudak (198 er of arfim assification is a station se hyperboli asian q is the m n the value o 002)). ket pray" lo forms of he rity to the tr t identifies t d joyeux (1 which diffe ss is station ds, the time d" different r. ma models ds to the cas into accoun tiation. how since it all cant develop raditional si actional inte the fractiona he can actual behavior in 0, d, 0) or u 83), lo (19 ma process of time ser nary proce ically to 0. n journal of f odified r/s of h by com o (1991) sh eteroskedast aditional r/ the phenom 1980) and h erentiation e nary. howev series are in iations in t s) refers to t se of short m nt the inter wever, the lows to cha pment in the ide to refle egration des al gaussian lly characte the short ter fractional 991), show ses and the ries based o ess with lo when the d finance & ac issn 19 2012, vol. www.macrothi s statistics a mparing the howed a sid ticity and g /s when it s mena of pers hosking (19 exponent of ver, if the pr ntegrated of time this pr the phenom memory, or rmediate ca presence of aracterize t e modeling ect the beh signed to cla noise depen erize the beh erm. noise param wed that the hurst expo on the value ong memo delay increa ccounting 946-052x 4, no. 2 ink.org/ajfa nd t the estimate de of the generally serves to sistence. 981) and f was an rocess is f order d rocess is menon of even no ases: the f such a the long g of time avior of arify the nds only havior of meter in ere is a nent h: es of the ry. the ases, the spectral when th if d = of longif -1 / spectral frequen 4. emp adata the col daily da over the emergin january bpreli as a fir the pre presenc suggest tests us schmid and pp, accepta presenc such pr white range o the firs be seen three te the n the stu symmet distribu distribu equal to l density is he frequency o, the arf -term depen / 2 <d <0, t l density is ncy, tends to pirical evid abase llection, pro ata provided e 21 countr ng powers y 2000 to de iminary stu rst step towa sence of lo ce of unit r tive of rand sed in the dt and shin. , respectivel ance of the ce of a syst roperties m e test for ra f non-indep st three colu n from this t sts for all 1 normality o udy of the n try (called utions of ra ution is sym o 3. s concentrat y tends to z fima proce ndency. the process dominated o zero). dence ocessing and d by eurone ries ranked and 7 other ecember 20 udy ard explorin ong memor roots in the om walk an paper are t . (1992), an ly. assumption tematic patt might signal andomness a pendence in umns in tab table, the hy 4 markets in of returns: normality o skewness) ates of retu mmetrical th ted around zero. we are ess reduces is anti-pers by high-fre d preparatio ext and emd by their ec r emerging 010. ng the statis ry, a battery e returns s nd hence of the augme nd phillipsn of station tern or som l long mem and the bd the data su ble 4 provid ypothesis of n the sampl f returns is ) noted sk urns that fo hat is to sa 386 low freque e facing a pe to the stand sistent, the equency co on of data fo db databas conomic pow powers). t stical proper ry of tests eries. the f no memory ented dicke -perron (19 narity, using me form of mory. for t ds test, sugg uch as linear de the result f unit root in le. treated usi k and flatt ollow norm ay, the zero asian encies (slow ersistent pro dard arma autocorrela omponents ( or empirical e. our samp wer (compo the study is rties of the r is conducte rejection o y in the retu ey–fuller (1 88), referre g the previo dependence this reason, gested by b r and non-lin ts pertaining n stock retu ing tests tha tening (call mal distribut o skewness n journal of f w cycles), ocess (1/2 < a process a ations altern (spectral de tests were m ple is compo osed of 7 e s spread ov return series ed. the firs of the unit urns series. 1981), kwi ed to hereaf ous tests, do e in the dat , the paper brock et al. near depend g to the uni urns is gener at are based led kurtosi tions, it is s and the k finance & ac issn 19 2012, vol. www.macrothi it tends to <h <1). and has no s nate in sign ensity simila made, large osed by the economic po ver the peri s and to pre rst set tests root hypot the three u iatkowski, fter as adf oes not exc ta. the pres r also prov (1996), for dence and c it root tests rally rejecte d on coeffic is) ku not necessary kurtosis co ccounting 946-052x 4, no. 2 ink.org/ajfa infinity structure and the ar to the ely, from indexes owers, 7 od from e-test for for the thesis is unit root phillips, f, kpss lude the sence of ides the r a wide chaos. . as can ed by all cients of ted. for that the efficient several jarqueskewne coeffici the jar chi-squ if the j assump in view kurtosis high pro moreov asymme coeffici skewed found t non-nor a norm applied active in that this aware o hypothe the u *the d for hav stationa dickeythat is t overall the dec accept t than the drawn f value th to conf robust t l tests can v bera. he fo ess and ku ients follow rque-bera t are distribu jarque-bera ption is acce w of the sha s "kurtosis" obability of ver the coef etry which ient is negat d, in which t that the ja rmality of th mal distribut the statistic n this perio s type of di of the abov esis of norm unit root tes dickey and ving a pre ary characte -fuller (ad to say the results of a cision rule the null hyp e critical va for all stoc his highligh firm these r to heterosce verify the a ocuses on i urtosis.il is w a standard test constru ution with tw a statistic i epted, otherw ape paramet is less than f extreme po fficient of s contradicts tive (sp500 the weight o arque-bera he data stud ion is in pra cal propertie d of study w istribution u ve, but, like mal distribut sts fuller dictable ran er or not df). recall existence o adf tests. is: if the c pothesis of alue, we rej ck market s hts the prese results we a edasticity. acceptance indicators m based on normal dist ucted from wo degrees o s less than wise it is rej ters and the n 3 (except f oints and th skewness w s the criter 0, ftse jse of below av test has a died. actice very r es of the no would never underestima e the assum tion by conv ndom varia of return s that the nul of at least o calculated v f nonstationa ect the null series, the d nce of a uni applied the 387 of the norm measuring th the fact th tribution: two indep of freedom. n the theore jected. see eir significa for the sse he series stu which is diff rion of a li e and mibt verage retur a high valu rarely obser ormal distrib r have happ ates the rea mption of e venience. able, it mu series, we ll hypothesi one unit roo value of the arity. if the l hypothesis dickey ful it root and t phillips-pe asian mality assum he shape of hat the asym pendent nor . etical value appendix 1 ance, over t and ise-10 udied exhibi ferent from inear gaus tel) we say rns is domin ue for all rved in fina bution, the p pened! the m l risk assets efficient ma ust be stati propose to is is non-sta ot. the tabl e t-statistic e calculated s of nonstat ler statistic therefore th erron test wh n journal of f mption, the f the distrib mptotic dis rmal variab of chi-squ . the period s 00) for all se it thinner tai zero indica sian distrib y that 'there nating and v indices w ancial marke performance most import s. the acad arkets, cont onary. in o o apply the ationarity of le in appen exceeds the d value of th ionarity, the s are great e detection ho has the finance & ac issn 19 2012, vol. www.macrothi e best know bution speci stributions o bles and fo uare, the no studied in t eries. this im ails than the ates the pre bution, mor e is a tail ne vice versa. a which confi ets. thus, if e displayed rtant conseq demic world tinues to ap order to gr e unit root f the series ndix 1 pres e critical va he t-statisti e conclusio ter than the of non-stat advantage o ccounting 946-052x 4, no. 2 ink.org/ajfa wn is the ially the of these ollows a ormality otal, the mplies a normal. sence of re if the egatively also we rms the f we had by most quence is d is well pply the rasp the test of studied, sents the alue, we c is less ons to be e critical ionary. of being * philli phillips regulate relate th asympto to refer the tabl in light index se results series. beyond applicat test pre *test-k the spe no unit the dec accept t critical the res statistic null hyp test o the te heterosc (1979)3 the squ regressi if, at le homosc 3 in statisti regression m variables. ips perron s and perro e the proble he phillips otic distribu r to tables o e in annex of the resu eries is grea obtained us d the tests tion of the d sented belo kwiatkows ecificity of root agains cision rule the null hyp value, we r sults, report c on the inde pothesis of of homoske st of hom cedasticity. but we ret uare of the r ion equationε a east, one of cedasticity i ics, the breusch– model. it tests w test (1988) on (1988) p em of autoc perron tests utions of ph of critical v 1. ults obtained ater than th sing the dic that have dickey ful w. ki, phillips the kpss t st the alterna is: if the ca pothesis of reject the nu ed in the ta ex series are stationarity edasticity, w moscedastici several te tain that of residue and n: a x b f the regress in favor of t –pagan test (nam whether the estima propose a c correlation s are identi hillips-perro alues of di d, we find th e critical on ckey fuller attempted ler test othe s, schmidt a est of kwia ative hypoth alculated va f stationarity ull hypothes ables in ann e all higher of the serie white test ity is usef ests exist t f white. thi d one or mo b x a sion coeffic the alternati med after trevor ated variance of t 388 correction n and/or hete cal to those on test and d ickey-fuller hat the calc ne. this com test, that is to provid er strategies and shin (1 atkowski et hesis of the alue is less y. if the cal sis of station nex 1 indica than the cri es indices. ful since i to detect h is test is ba ore explana x b x cients is sig ive hypothe breusch and adr the residuals from asian non-parame eroscedastic e used by d dickey full r. the resul ulated valu mes to conf s to say the de solutions s have been 1992) al (1992) i presence of than the co lculated val narity. ate that the itical values it allows t eteroscedas ased on a si atory variab x ⋯ gnificant, w sis of hetero rian pagan) is u m a regression are n journal of f etric of dic errors. the dickey fulle ler are ident lts obtained e of the phi firm, just fo presence o s to proble n developed s to test the f a unit root orresponding lue exceeds calculated v s given; ther to detect a sticity as b gnificant re les in level a x b e reject the oscedasticit used to test for h e dependent on th finance & ac issn 19 2012, vol. www.macrothi ckey fuller e models o er. furtherm tical, it is su d are instruc illips perron or these ind of a unit roo ems raised d, such as th e null hypot t. g critical va s the corres values of th erefore we re and correc breusch and elationship b ls and squa b x υ e null hypot ty. heteroscedasticity he values of the ccounting 946-052x 4, no. 2 ink.org/ajfa r test to n which more the ufficient ctions in n for the ices, the ot in the by the he kpss thesis of alue, we ponding he kpss eject the t errors d pagan between ared in a thesis of y in a linear independent if the v signific presente the res assump note th financia but this test a the tes returns, where t q: the n φ(k): is statistic hypothe of the r annex 1 since th from t heterosc pt = ln p value that cance, we c ed in table 1 sults obtaine ption of hete hat the rejec al time serie does not co absence of s st is implem , so for this t: is the nu number of de the estimat cal bp (q) esis of no s random wal 1 (these resu he series of the white cedasticity. pt , pt is the emerges is concluded t 1 of annex: ed by apply eroscedastic ction of hom es which is onfirm the e serial corre mented for t test we app umber of obs elays. ted autocorr ) follows a erial correl lk model, s ults are obta returns hav test, we this test is price at “t” s to lower; that the mo ying the wh city is accep moscedastici the arch efficiency m elation: box testing the ply to the q bp servations o relation coe a chi-squar ation, the re since in this ained for a d ving the cha decided t s given by: b v δ j ∑ 389 (usually a odel is hom hite test con pted among ity can be d effect, this markets. x-pierce te presence o statistic giv t δ k of the series efficient of o re with (qejection of s case, the delay equal aracter of he to apply q δ ∆∑ ∆ asian a = 5%) fo moscedastic nfirm the h fifteen to tw due to an ef may indica est of serial cor ven by: s. order k. -1) degrees the null hy returns do to 36). eteroscedast the test o ξ k j ∆ n journal of f or a given c. the resu heteroscedas wenty count ffect frequen ate that prof rrelation in s of freedo pothesis im not follow ticity is wha of box-pie finance & ac issn 19 2012, vol. www.macrothi level of st ults of this stic series s tries in the s ntly encoun fitability is the series om under t mplies the in a white no at has been erce correc ccounting 946-052x 4, no. 2 ink.org/ajfa tatistical test are since the sample. ntered in not (iid) of stock the null nvalidity oise, see detected cted for the box degrees the resu therefor by cons correlat reflectio return s account and ther the te to valid of finan of effic depende perfect, valid in this per (1987) alternat to char propose integral are sepa the bd distribu as a test -either -either -either -either brock, when th structur divide t 4 the bds from indep x-pierce tes s of freedom ults obtaine re the assum s, the correc tion; one c on of hetero series are h t heterosced refore the p est of the h date the non ncial time s ciency. if th ence in the , it does no n a linear fra rspective, a says bds tive hypothe racterize th ed the bds ls. defining arated by a ds statistic uted (iid) ag t of nonline from a depe from a non from a depe from a depe dechert an he data set ral changes the total per s test is a portma endence, includin st corrected m. the resu d, of traditi mption of ra cted test of can possibl oscedasticit heterospecif dasticity ass past returns, hypothesis ( nlinearity, w eries. tests hey show, e behavior ot mean tha amework. h a test of no test. it che eses includi he nonlinear s test, which g a length e length e in c tests the gainst an un earity. a reje endence stru -stationarity endence stru endence stru nd scheinkm s consist o in the data riod into sub anteau test for tim ng linear depen-d for heteros lts of both t ional box-p andom walk box-pierce ly explain ty in the ser fic but has sumption th are not goo (iid) presen we use the b of non-line for exampl of the seri at these resu however, the nlinearity h ecks the nu ng the nonl r behavior o h measures e, the correl the phase sp e null hypo nspecified al ection of th ucture follo y of the seri ucture follo ucture throu man (1996) f at least 5 can cause a b periods to me based depende dence, non-linear 390 scedasticity tests are giv pierce test s k of stock pr e for heteros this contra ries. it is th no serial c at the weak od predictor nce of non-l bds test4 t earity rule o le, that the ies, showin ults are fin e functionin has been m ull test of e linear depen of returns, the statistic lation integ pace. othesis of alternative a he null hypo owing a line ies studied owing a non ugh a nonlin ) show tha 500 observa a release of o perform se ence in a series. it dependence, or c asian y also follow ven in the t series return rices is not c scedasticity adiction of herefore app orrelation. k sense for th rs for future linear: the hat checks on the short tests do no g by this t nal and con ng of financ made by bro efficiency (r ndence due brock, dec cal signific gral is the p a series in and can be u othesis can t ear stochasti nlinear stoch near determ at a satisfac ations, how the null hyp eparate anal t can be used fort chaos. n journal of f ws a chi-squ table in app ns exhibit a checked. indicated th the result parent from we can co his country e returns. bds test (1 almost alwa tcomings of ot detect an that market clusive. su cial markets ock, decher random wa to market im chert, and s ance of cor robability t ndependent used, under hen arise: ic process hastic proce ministic proc ctory conve ever, hsieh pothesis yie yzes bds. testing against a v finance & ac issn 19 2012, vol. www.macrothi uare law wi pendix 1. in autocorrelat he absence ts obtained these tests onclude, tak sample is c 1987) ays the non f conventio ny autocorr ts are effici uch results a s is not linea rt and sche alk) against mperfection scheinkman rrelations fo that any tw tly and ide r certain con ess cess ergence is o h (1991) no elds. so, it i variety of possibl ccounting 946-052x 4, no. 2 ink.org/ajfa ith (q-1) n light of ion, and of serial by the that the king into checked, linearity nal tests relations ient and are only ar. from einkman t several ns. n (1996) ollowing o points entically nditions, obtained otes that s best to le deviations a secon too larg integral with ze returns the tes tradition markets nonline market from 2 values a 5. resu astud as the e and the second from th phenom hurst e does no we can us with the case 5%. the res the retu and me r/s see statistic can con develop the abs the grou informa characte asymme nd problem ge value of ls will be al ro correlati σ. st strategy i nal tests, so s, the applic ear dependen imperfectio to 6, we see are below 1 ults dy of persis earlier, we c erefore we c table in the he results o menon of pe exponents ar ot determine n work arou h statistical v e of one-sid sults show t urns of follo erval. for th ems to be sh c r/s is sen nclude that ped one. sence of lon unds that th ation and an erized by v etry. with this a e will tend ways equal on, in what is considere ome variab cation of thi nce. we us ons. on read e that the b , 96. tence over can estimat can deduce e appendix 2 of the table, ersistence t re greater th e whether t und this pro v that we c ded test thes that only six owing mark he rest of th hort-term m nsitive to the long mem ng memory hey are infor ny new one arious instit nalysis con to retain al to one, and t follows, th ed as new bles prove l is test still s e this test a ding the tab bds statistic periods wi e the hurst e the estima 2. we note th thus demon han 1/2 and he estimate blem by ap compare it w se values are x rounds am ket indexes: he series, th memory, thi e presence o mory is a ch y dynamics rmationally e is fully arb tutional rigi 391 ncerns the ch ll the pairs d similarly, he value of technique t linearly cor shows the o as a prelimin ble in annex c rejects the ithout cons exponent h ate (d) from hat accordin nstrating the d d > 0. ne ed value of pplying the with the crit e 1,620 1,7 mong the tw : lq 45, ss he memory is confirms of a short-t haracteristic can be rati y efficient. p bitraged aw idities that asian hoice of the (xi, xj) an a value too e will be s to study eff rrelated, thu opposite. it nary and im x 2, where w e null hypot idering the h from the a m the relatio ng to the m e presence evertheless, h is signif method of tical values 47 at the re wenty-one e se compos detected fr what we h erm memor c of efficie ionalized fo prices tend t way. thin m perpetuate n journal of f e distance e d the value small may et as the sta ficiency. fo us justifying reveals the mportant too we took the thesis of ran e different t application onship: d method r/s, of long me the traditio ficantly diff r/s amend given by l spective thr exhibit long site, tunind rom the trad ave previou ry in the ret nt markets or developed to reflect al markets, on information finance & ac issn 19 2012, vol. www.macrothi to the exte es of the cor lead to us i andard devi or if, in rel g the effici types of lin ol in the ana e values of m ndom walk, trends of the meth h . all series e emory beca onal statistic ferent or no ded, which p lo (1991), w reshold of 1 g term depe dex, egx, t ditional ana usly mentio turn series, at the exp d stock ma ll publicly a the other h nal inefficie ccounting 946-052x 4, no. 2 ink.org/ajfa nt that a rrelation integrals iation of lation to iency of near and alysis of m going , the test hod r/s, see the exhibit a ause the c of r/s ot to 1/2. provides which in 10% and endence: tadawul alysis of oned, the thus we pense of rkets on available hand, are ency and inappro adequat creditor develop in addit of impo speciali encoura markets bstud for the between the stud table in the tab be asso long me stock m 6. conc a mark returns is impo market presenc which d sustaina the pro only six market can infe for the short-te seems t markets the per time req market informa time. w opriate infor te regulator rs were foun pment. tion, the pre ortant insti ized broker age specula s from their dy of persis e sake of ri n detection dy period in n appendix 3 ble shows th ciated with emory may markets work clusion ket is inform since all in ssible to ma price and it ce of long m decays slow able betwee ocedure of t x rounds am indexes lq er a violatio other serie erm autocor to be close s that the tre rsistence co quired for t where inf ation is also we are far fr rmation acq ry environm nd to be str esence of pr itutional asp s, tend to b ative activit r fundament stence over igor we wi of long-ter n each index 3. hat the owne stock mark y be linked ks. mationally formation, k ake abnorm ts fundamen memory in wly when en market pr the heuristic mong the tw q 45, sse c on of the as es there wa rrelation, m ely linked to end is up. ompletely d the integrati formation o very slow om ideal m quisition and ment, especi rongly asso rice manipu pects in re be typical c ties and m tals and thei periods wi ill try to sh rm persisten x bullish an ership of lo ket indicatin to particula efficient if known or a mal profits by ntal value. b that persist the delay i rice and its c r / s amen enty-one ex composite, sumption of as evidence more it was o countries destroys the ion of infor fits very s w, but mostl arket define 392 d dissemina ially in rela ciated with ulations, use elation to l characteristi may explain ir slow adju ith differen how in this nce and the nd bearish p ong-term dep ng an upwar ar character it is impos anticipated, y speculatin but this def tence is cha increases an fundamenta nded, which xhibit long t tunindex, f weak form e of a shor s observed s whose lev e hypothesi rmation in t slowly. in ly because ed by the pr asian ation about ation to pro h low levels e of inside in listing requ ics of thin m n the depar ustment to n nt trends s paragraph market tren periods, the pendence o rd trend, a p ristics of th ssible to pr is already i ng on the di finition of e aracterized b nd this lea al value. h provides u term depend egx , tad m of efficien rt memory that the ch vel of devel is of marke the price. a a market of overreac roponents o n journal of f firms issuin operty rights of financia nformation uirements an markets. th ture of sto new informa h if there is nd, for this results are n market in phenomeno he environm redict future ncorporated fference be efficiency is by an autoc ads to the e us with stati dence: the f awul and m ncy in these that is to haracteristic lopment is et efficiency a persistent antipersist ctions that f the rationa finance & ac issn 19 2012, vol. www.macrothi ng equities s and prote al and stock and the ina and the abs hese charac ock prices ation. s some con s reason we summarize ndex returns on that sugg ment in whi e returns fr d in the pric etween the o s challenge correlation existence o istical v sho following re merval there e markets. w say, a pres c of long m relatively l y since it s market wo tant integra are correct ality of inve ccounting 946-052x 4, no. 2 ink.org/ajfa , lack of ection of k market dequacy sence of cteristics in these nnection divided ed in the s tend to gests that ich each rom past ce. so, it observed d by the function of a gap ows that eturns of efore we whereas sence of memory low and signals a uld be a ation of ed, over estors. howeve exponen replicat referen andrew matrix backus structur http://dx baillie, journal bernste portfoli bollersl volatilit david g studies http://dx davidso journal http://dx diebold journal http://dx diebold index: http://dx doukha depend dufréno applica http://dx frieder, journal http://dx er the analy nt suspect b ted using lo nces ws, donald w estimation. , d.k., & s re of inte x.doi.org/10 r.t. (199 of econom ein, peter l io managem lev t., & m ty. journal g. mcmilla in x.doi.org/10 on, j., & t l x.doi.org/10 d, f.x., & g l o x.doi.org/10 d, f.x., & a real x.doi.org/10 an, p., oppe dence. birkh ot g., & m ations to m x.doi.org/10 , l., & subr l of x.doi.org/10 ysis conduct bias caused o statistics t w k. (1991 . econometr .e. zin. (19 rest rates. 0.2307/2077 96). long m metrics 73, 5 . (1999). a ment, 25(2), mikkelsen i of derivativ an, & pako econo 0.1108/1086 terasvirta, t of 0.1016/s030 g.d. rudeb of 0.1016/0304 g.d. rudeb time ana 0.1016/0304 enheim, g., hauser, berl mignon v. ( macroeconom 0.1007/978rhmanyam, financial 0.1017/s002 ted here and d for examp to cancel th ). heteroske rica, econo 993). long-m journal 7735 memory pro 5-59. http://d new look , 1-2. http:// .o (1996). ves, 4(3), 63 thupayaga omics 6737091099 t.t. (eds.) econ 04-4076(02 busch. (1989 monetary 4-3932(89)9 busch. (199 alysis. jou 4-3932(89)9 & taqqu, m lin. (2002). rec mics and f -1-4757-36 a. (2005). b l and 2210900000 393 d the metho ple by short his bias. edasticity an ometric soci memory infl of money, ocesses and dx.doi.org/1 k at the effi /dx.doi.org/ modeling a 3-71. ale. (2009). and 95726 (2002). lo nometrics, 2)00088-x 9). long-mem ec 90003-2 91). forecas urnal of 90003-2 m.s. (2003) cent develop finance. k 15-1 brand perce quantita 01745 asian odology allo t term depe nd autocorr iety, 59(3). ation uncer , credit a d fractional 10.1016/030 icient mark 10.3905/jpm and pricing the efficien finance, ong memory mory and p conomics, sting output monetary ). theory an opments in n kluwer acad eptions and ative a n journal of f owed for det endence. th relation con tainty: evid and banki l integration 04-4076(95) ket hypothe m.1999.390 long memo ncy of afric 26(4 y and nonl 110(2), ersistence i 24, t with the c economic nd applicat nonlinear c demic publ the market nalysis, finance & ac issn 19 2012, vol. www.macrothi termining th his study sh nsistent cov dence from ing, 25, 6 n in econo )01732-1 esis. the jo 0965 ory in stock can equity m 4), 2 linear time 1 in aggregate , 1 composite cs, 24, 1 tions of lon cointegrati lishers, 299 t for commo 40(1), ccounting 946-052x 4, no. 2 ink.org/ajfa he hurst hould be variance the term 681-700. ometrics. urnal of k market markets. 275-292. e series. 105-437. e output. 189-209. leading 189-209. ng-range ion with 9 pages. on stock. 57-86. geweke series m geweke series http://dx hosking http://dx hsieh, d of finan hurst, h society jacobse 93-417. lo, a.w http://dx lo, an econom malkiel econom malkiel the fin mand covarian mandel researc mcleod reassess http://dx mignon paris. mignon nath, utiicm e j., & port models. the e j., & s. p models. x.doi.org/10 g, j.r.m x.doi.org/10 d. (1991). c nce, 46, 183 h.e. (1951) of civil en en, b. (1996 . http://dx.d w. (1991). l x.doi.org/10 ndrew w. ( mics. second l, burton g mic perspec l, burton g nancial revi delbrot, nce to r/s a lbrot, b.b., ch, 4, 909-9 d, a.i., & sment of x.doi.org/10 n v. (1998). n, v. (1997) , golaka c. m conferen ter-hudak s ory related porter-huda journa 0.1111/j.146 . (1981). 0.1093/biom chaos and n 39-1877. ht ). long-term gineers, 11 6). long term doi.org/10.10 long-term 0.2307/2938 (2008). eff d ed. londo g. (2003). t ctives, 17(1) g. (2005). r iew, 40(1), b.b. (1972 analysis. an & wallis, j 918. http://d k.w. hip the hurst 0.1029/wr . marchés fi ). long-term (2001). lo nce paper. s. (1990). t d fields, 86, ak. (1983). t al of 67-9892.19 fraction met/68.1.165 nonlinear d tp://dx.doi.o m storage c 6, 770-799. m dependen 016/s0927memory in 8368 ficient mark on: palgrave the efficien , 59-82. http reflections o 1-9. http://d 2). statistic nnals of eco j. (1968). n dx.doi.org/10 pel (1978). phenomen 014i003p00 inanciers et m memory a ong memor 394 the estimati , 87-104. the estimat time 83.tb00371 nal differ 5 dynamics: a org/10.1111 capacity of . nce in stock -5398(96)00 n stock mark rkets hypot e macmillan nt market h p://dx.doi.o on the effic dx.doi.org/1 cal methodo onomic and . joseph and 0.1029/wr preservatio non. wate 0491 modélisatio and chaos. s ry and india asian ion and app tion and app series .x rencing. b applications 1/j.1540-62 reservoirs. returns. jou 0009-6 ket prices. e thesis. the n. hypothesis a org/10.1257/ cient marke 10.1111/j.07 ology for n d social mea d operationa r004i005p00 on of the r er resourc on des renta springer ve an stock m n journal of f plication of plication of analysis, biometrika, s to financia 61.1991.tb0 transaction urnal of emp econometri new palgr and its criti /089533003 et hypothes 732-8516.20 non-periodic asurement, al hydrology 0909 rescaled adj ces resear abilités bour erlag. market-an e finance & ac issn 19 2012, vol. www.macrothi f long-memo f long memo 4, 2 , 68, 1 al markets. 04646.x ns of the a pirical fina ica, 59, 127 grave dictio tics. the jo 3321164958 sis: 30 year 005.00090.x c cycles: f 1, 259-290. gy. water re djusted rang rch, 14, 4 rsières. eco empirical ev ccounting 946-052x 4, no. 2 ink.org/ajfa ory time ory time 221-238. 165-176. journal merican ance, 33, 79-1313. onary of urnal of 8 rs later. x from the . esources ge, i: a 491-508. onomica, vidence. newey, heteros 703-708 olsen ( analyst opong, equity 267-282 peters, econom robinso long http://dx robinso sixth w scheink univers shea, g interest http://dx timotej hypoth 43(4), 7 willing depende , whitney skedasticity 8. http://dx. (1998). beh ts journal, 5 k.k., mulh indicies: a 2. http://dx. edgar e. (1 mics. new y on, p. m., & memory x.doi.org/10 on, p.m. (1 world congr kman, j., & sity. g.s. (1991). rate x.doi.org/10 j jagric, bo hesis hold?: 79-103. ger, taqqu, ence. finan k; west, y and autoc doi.org/10.2 havioral fin 54(02), 10-8 holland, g., an applicati doi.org/10. 1994). frac york: john w & m. henry y. journ 0.1016/s030 994). time ress. http://d & xiong, w . uncertaint term 0.1007/bf0 oris podobn : evidence ,m., & te nce and stoc & kenne correlation c 2307/19136 nance and ib 8. http://dx.d , fox, a.f., ion of hurs 1016/s0927 ctal market wiley & so y. (2003). h nal of 04-4076(02 e series with dx.doi.org/1 w. (2003). ty and impl structure. 01206277 nik, & ma from six t everovsky, chastics, 3, 395 eth d (198 consistent c 610 b implicati doi.org/10.2 & farahma st and bds 7-5398(99)0 analysis: a ons. higher orde econom 2)00208-7 h strong de 10.1017/cc overconfid lied varianc empiric arko kolano transition e v. (1999) 1-13. http:/ asian 87). a sim covariance ons for sto 2469/faj.v54 and, k. (199 s tests. jou 00004-3 applying ch r kernel se etrics, ependence. a col052144 dence and s ce bounds i cal eco ovic. (2005 economies. . stock m //dx.doi.org/ n journal of f mple, posit matrix. ec ck, price v 4.n2.2161 99). the beh urnal of emp haos theory emiparametr volume, advances in 4594.002 speculative n long-mem onomics, 5). does th eastern eu arket price /10.1007/s0 finance & ac issn 19 2012, vol. www.macrothi tive semiconometrica volatility. f havior of so mpirical fin y to investm ric m-estim 114(1), n econome e bubles. p mory model 16, 2 he efficient uropean eco es and lon 0078000500 ccounting 946-052x 4, no. 2 ink.org/ajfa definite, a, 55(3), financial ome uk nance, 6, ment and mation of 1-27. etrics, 1, rinceton ls of the 287-312. market onomics, g range 049 append cac sp5 ftse mibt s$p/t nikke da lqise-1 bove ipc sse com nift mice tunin egx kos ftse tadaw merv sp/as dix 1. calcu sk c 40 0.394 00 -0.094 e100 0.069 tel -0.609 tsx 0.255 ei225 0.555 x 0.741 -45 1.173 100 1.173 espa 1.173 c 0.373 mposite 1.566 ty 0.35 ex 0.35 ndex 0.35 x 30 0.309 spi -0.23 jse 0.741 wul 0.275 val 0.701 sx50 0.275 ulation of s k ku 4002 2.10322 4044 2.30954 9159 2.02373 9381 2.57556 5913 1.92178 5232 2.23985 1152 2.45005 3229 3.64680 3229 3.64680 3229 3.64680 3146 1.59505 6885 5.22842 994 1.63265 994 1.63265 994 1.63265 9711 1.75299 3072 1.81978 1152 2.45005 5576 2.15130 1316 2.46221 5576 2.15130 statistics jb 7 165.3771 6 58.9987 2 112.5762 6 161.14 1 162.0988 7 203.5808 7 276.5251 5 708.4385 5 708.4385 5 708.4385 5 290.8353 6 1739.25 4 272.4151 4 272.4151 4 272.4151 4 218.1046 4 192.0314 7 276.5251 3 115.6757 3 264.9612 3 115.6757 396 augmented adf test -0.883028 -1.125635 -0.581993 -1.028095 -0.712938 -0.221833 2.412442 -0.756041 -0.756041 -0.756041 1.813961 0 -0.675308 0.471062 0.471062 0.471062 0.08139 0.38657 2.412442 2.408518 -0.424588 2.408518 asian phillips perron test kps -1.909149 0.93 -1.97652 0.5 -2.05624 1.24 -1.138692 0.38 -1.145514 3.65 -2.067614 0.67 1.439008 5.47 -1.563469 1.58 -1.563469 1.58 -1.563469 1.58 0.519614 6.0 -1.296607 2.39 -0.775398 5.0 -0.775398 5.0 -0.775398 5.0 -0.05649 5.46 -1.347061 4.59 1.439008 5.47 -1.415932 5.3 1.064622 3.78 -1.412094 5.3 n journal of f ss test white t 33378 49.645 17874 162.66 45823 70.647 89724 30.619 55343 46.713 74326 68.027 71842 1.3567 88478 8.8954 88478 8.8954 88478 8.8954 02364 7.6290 99185 51.487 14026 15.368 14026 3.8568 14026 10.306 61516 14.959 93266 25.165 71842 15.73 36574 6.0848 82724 87.923 36574 6.0848 finance & ac issn 19 2012, vol. www.macrothi test bp 519 93.505 621 90.096 741 91.362 981 52.727 394 77.706 753 88.534 799 70.828 463 88.982 463 88.982 463 88.982 063 88.926 741 53.727 807 83.986 88 89.902 639 91.008 95 88.037 599 94.214 33 95.749 847 67.116 398 96.715 847 67.116 ccounting 946-052x 4, no. 2 ink.org/ajfa corrected bp 0.924 0.904 0.918 0.696 0.825 0.903 0.747 0.865 0.865 0.865 0.91 0.541 0.894 0.925 0.917 0.913 0.918 0.928 0.715 0.95 0.715 append dix 2．bds s s test cac 40 sp500 ftse100 mibtel s$p/tsx nikkei225 dax lq-45 ise-100 bovespa ipc sse composite nifty micex tunindex egx 30 kospi ftse jse tadawul merval sp/asx50 m=2 0.199275 0.194668 0.199484 0.200159 0.199943 0.199491 0.199230 0.204226 0.200639 0.201991 0.205602 0.201384 0.204708 0.202683 0.206120 0.202295 0.201379 0.202732 0.206939 0.205602 0.198840 397 m=3 0.339375 0. 0.331305 0. 0.339653 0. 0.340773 0. 0.340754 0. 0.339799 0. 0.338960 0. 0.347457 0. 0.341248 0. 0.343534 0. 0.349702 0. 0.342999 0. 0.347868 0. 0.345584 0. 0.350577 0. 0.344421 0. 0.343122 0. 0.344788 0. 0.350932 0. 0.349702 0. 0.339053 0. asian m=4 m= .437110 0.504 .426298 0.491 .437364 0.505 .439051 0.507 .439325 0.508 .437821 0.505 .436134 0.503 .447681 0.517 .439326 0.507 .442407 0.511 .450469 0.520 .441986 0.510 .447624 0.516 .446030 0.516 .451900 0.522 .444074 0.513 .442448 0.511 .444075 0.513 .450755 0.519 .450469 0.520 .436813 0.504 n journal of f =5 m=6 4935 0.55165 1704 0.53625 5101 0.55168 7463 0.55479 8052 0.55578 5855 0.55281 3358 0.54952 7762 0.56667 7518 0.55463 1357 0.55923 0933 0.57015 0891 0.55864 6912 0.56503 6349 0.56541 2912 0.57268 3492 0.56162 1916 0.56036 3062 0.56090 9802 0.56741 0933 0.57015 4648 0.55139 finance & ac issn 19 2012, vol. www.macrothi 55 58 80 96 81 10 20 79 35 35 55 40 31 13 89 26 66 07 14 55 90 ccounting 946-052x 4, no. 2 ink.org/ajfa calcula append ation of the r cac sp5 ftse mibt s$p/t nikke da iselqbove ip sse com nif mic tunin egx kos ftse tada merv sp/as dix 3． ca d s$ mi r/s statistic hur c 40 0.835 500 0.543 e100 0.535 tel 0.598 tsx 0.577 ei225 0.553 ax 0.554 -100 0.547 -45 0.604 espa 0.575 c 0.561 mposite 0.619 ty 0.582 cex 0.573 ndex 0.653 x 30 0.590 spi 0.564 e jse 0.545 awul 0.648 val 0.600 sx50 0.538 alculation o p dax p/tsx ibtel and hurst e the analysis r rst d 308 0.335308 747 0.043747 220 0.035220 891 0.098891 033 0.077033 416 0.053416 691 0.054691 952 0.047952 082 0.104082 024 0.075024 213 0.061213 408 0.119408 119 0.082119 438 0.073438 710 0.153710 355 0.090355 964 0.064964 904 0.045904 590 0.148590 424 0.100424 832 0.038832 of the hurs th period hurst 1 0.566 2 0.563 3 0.578 4 0.571 1 0.587 2 0.573 3 0.560 4 0.591 5 0.573 1 0.564 2 0.571 398 exponent r / s cm 0.591752 0 0.062523 0 0.050037 0 0.146933 0 0.112701 0 0.076861 0 0.078767 0 0.068735 0 0.155217 0 0.109607 0 0.088564 0 0.180024 0 0.120574 0 0.107169 0 0.237492 0 0.133441 0 0.094239 0 0.065704 0 0.228740 0 0.149375 0 0.055308 0 st exponent he analysis r / s d c 0.066 0.0 0.063 0.0 0.078 0.1 0.071 0.1 0.087 0.1 0.073 0.1 0.060 0.0 0.091 0.1 0.073 0.1 0.064 0.0 0.071 0.1 asian the analy hurst d 0.441819 -0.05 0.537867 0.037 0.541490 0.04 0.561448 0.06 0.555388 0.05 0.534178 0.034 0.555212 0.05 0.528830 0.02 0.578024 0.07 0.530557 0.030 0.546901 0.046 0.566038 0.066 0.553105 0.053 0.536975 0.036 0.600180 0.100 0.572732 0.072 0.528225 0.02 0.510559 0.010 0.574739 0.074 0.564870 0.064 0.542355 0.042 t on returns the an cm hurst 096 0.563 092 0.516 114 0.521 103 0.457 128 0.548 107 0.517 086 0.509 134 0.519 106 0.563 092 0.514 103 0.451 n journal of f ysis r / s modifie d cm 8181 -0.07748 7867 0.05389 1490 0.05920 1448 0.08891 5388 0.07980 4178 0.04852 5212 0.07954 8830 0.04077 8024 0.11423 0557 0.04327 6901 0.06717 6038 0.09586 3105 0.07639 6975 0.05259 0180 0.14898 2732 0.10608 8225 0.03990 0559 0.01474 4739 0.10916 4870 0.09409 2355 0.06047 s alysis r / s mod d cm 0.063 0.092 0.016 0.022 0.021 0.030 -0.043 -0.058 0.048 0.070 0.017 0.024 0.009 0.012 0.019 0.027 0.063 0.091 0.014 0.020 -0.049 -0.066 finance & ac issn 19 2012, vol. www.macrothi ed v 89 0.63 98 1.35 03 1.39 19 1.61 09 1.55 21 1.31 45 1.55 76 1.27 31 1.85 71 1.28 79 1.45 69 1.69 97 1.52 95 1.34 84 2.21 86 1.77 04 1.25 45 1.09 68 1.82 96 1.67 74 1.40 dified v 1.75 1.13 1.21 0.7 1.55 1.17 1.08 1.2 1.75 1.15 0.6 ccounting 946-052x 4, no. 2 ink.org/ajfa s ft ca nik fts n k tun tad sp/ eg sp500 tse100 ac 40 kkei225 se jse nerval kospi nindex dawul /asx50 gx 30 3 0.575 4 0.571 1 0.565 2 0.560 3 0.575 4 0.573 1 0.565 2 0.561 3 0.575 4 0.573 1 0.568 2 0.563 3 0.572 4 0.575 1 0.565 2 0.561 3 0.577 4 0.571 1 0.557 2 0.582 3 0.593 4 0.565 5 0.566 1 0.559 2 0.584 3 0.570 1 0.559 2 0.580 3 0.573 1 0.565 2 0.559 1 0.558 2 0.578 3 0.587 4 0.583 5 0.569 1 0.558 2 0.582 3 0.575 1 0.566 2 0.565 3 0.609 4 0.571 399 0.075 0.1 0.071 0.1 0.065 0.0 0.060 0.0 0.075 0.1 0.073 0.1 0.065 0.0 0.061 0.0 0.075 0.1 0.073 0.1 0.068 0.0 0.063 0.0 0.072 0.1 0.075 0.1 0.065 0.0 0.061 0.0 0.077 0.1 0.071 0.1 0.057 0.0 0.082 0.1 0.093 0.1 0.065 0.0 0.066 0.0 0.059 0.0 0.084 0.1 0.070 0.1 0.059 0.0 0.080 0.1 0.073 0.1 0.065 0.0 0.059 0.0 0.058 0.0 0.078 0.1 0.087 0.1 0.083 0.1 0.069 0.1 0.058 0.0 0.082 0.1 0.075 0.1 0.066 0.0 0.065 0.0 0.109 0.1 0.071 0.1 asian 109 0.766 103 0.523 094 0.451 086 0.397 110 0.419 106 0.572 094 0.421 089 0.592 110 0.539 106 0.604 099 0.441 091 0.467 104 0.437 109 0.446 094 0.510 089 0.514 113 0.501 103 0.572 082 0.367 120 0.532 138 0.522 094 0.531 096 0.599 085 0.542 123 0.539 101 0.523 085 0.368 117 0.533 107 0.622 094 0.544 085 0.615 084 0.525 114 0.527 128 0.549 123 0.510 101 0.696 084 0.456 120 0.530 109 0.522 096 0.528 094 0.526 162 0.581 103 0.393 n journal of f 0.266 0.445 0.023 0.032 -0.049 -0.066 -0.103 -0.133 -0.081 -0.107 0.072 0.105 -0.079 -0.103 0.592 1.272 0.539 1.112 0.604 1.309 -0.059 -0.079 -0.033 -0.045 -0.063 -0.083 -0.054 -0.072 0.010 0.014 0.014 0.019 0.001 0.001 0.072 0.105 -0.133 -0.168 0.032 0.045 0.022 0.031 0.031 0.044 0.099 0.147 0.042 0.059 0.039 0.055 0.023 0.032 -0.132 -0.167 0.033 0.047 0.122 0.184 0.044 0.063 0.115 0.172 0.025 0.035 0.027 0.038 0.049 0.071 0.010 0.014 0.196 0.312 -0.044 -0.060 0.030 0.042 0.022 0.031 0.028 0.039 0.026 0.036 0.081 0.119 -0.107 -0.138 finance & ac issn 19 2012, vol. www.macrothi 1.2 1.27 0.7 0.5 0.55 1.6 0.5 1.25 1.15 1.22 0.6 0.77 0.58 0.65 1.1 1.13 1.01 1.9 0.5 1.25 1.15 1.22 1.9 1.3 1.35 1.17 0.4 1.29 2.3 1.37 2.22 1.19 1.29 1.52 1.09 5.1 0.7 1.3 1.2 1.23 1.18 2.07 0.4 ccounting 946-052x 4, no. 2 ink.org/ajfa bov n is sse c l m downtr uptrend vespa nifty ipc se-100 composite lq-45 micex rend d 5 0.591 6 0.586 1 0.554 2 0.591 3 0.571 1 0.559 2 0.581 3 0.577 4 0.616 1 0.555 2 0.577 3 0.573 1 0.572 2 0.560 3 0.598 4 0.580 5 0.580 6 0.573 1 0.582 2 0.563 3 0.571 4 0.587 5 0.573 1 0.559 2 0.588 3 0.571 1 0.558 2 0.601 3 0.573 400 0.091 0.1 0.086 0.1 0.054 0.0 0.091 0.1 0.071 0.1 0.059 0.0 0.081 0.1 0.077 0.1 0.116 0.1 0.055 0.0 0.077 0.1 0.073 0.1 0.072 0.1 0.060 0.0 0.098 0.1 0.080 0.1 0.080 0.1 0.073 0.1 0.082 0.1 0.063 0.0 0.071 0.1 0.087 0.1 0.073 0.1 0.059 0.0 0.088 0.1 0.071 0.1 0.058 0.0 0.101 0.1 0.073 0.1 asian 134 0.462 126 0.529 078 0.513 134 0.392 103 0.516 085 0.524 119 0.541 112 0.531 175 0.518 079 0.512 113 0.517 106 0.524 106 0.513 086 0.525 146 0.522 118 0.516 117 0.523 107 0.531 120 0.336 091 0.521 103 0.512 128 0.488 107 0.525 085 0.540 130 0.522 103 0.523 084 0.546 150 0.287 107 0.552 n journal of f -0.038 -0.052 0.029 0.041 0.013 0.019 -0.108 -0.139 0.016 0.022 0.024 0.034 0.041 0.058 0.031 0.043 0.018 0.025 0.012 0.016 0.017 0.023 0.024 0.034 0.013 0.019 0.025 0.036 0.022 0.031 0.016 0.023 0.023 0.032 0.031 0.043 -0.164 -0.204 0.021 0.029 0.012 0.017 -0.012 -0.017 0.025 0.036 0.040 0.057 0.022 0.031 0.023 0.033 0.046 0.066 -0.213 -0.256 0.052 0.075 finance & ac issn 19 2012, vol. www.macrothi 0.7 1.27 1.14 0.3 1.18 1.23 1.5 1.32 1.19 1.11 1.19 1.27 1.11 1.17 1.19 1.13 1.22 1.27 0.3 1.17 1.09 0.9 1.21 1.3 1.19 1.18 1.27 0.2 1.4 ccounting 946-052x 4, no. 2 ink.org/ajfa title: times new roman; size-20; double line spacing; paragraph spacing: before paragraph-1 line; after paragraph-1 line; center asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 16 price–performance and liquidity effects of index additions and deletions: evidence from chinese equity markets yuelin li department of accounting and finance, macquarie university north ryde, sydney, australia, 2109 tel: 61-2 -9113 7729 e-mail: yuelin.li@students.mq.edu.au mehdi sadeghi (corresponding author) department of accounting and finance, macquarie university north ryde, sydney, australia, 2109 tel: 61-2-9850-8527 e-mail: msadeghi@efs.mq.edu.au abstract we investigate the impacts of index revisions on the return and liquidity of chinese equities, using a sample of 69 stocks added to or deleted from the s&p/citic 300 index over the period october 2004–august 2007. our findings show that stock prices respond positively to index additions, and negatively to index deletions. furthermore, our study provides evidence in support of a long-term improvement in liquidity for both stock additions and stock deletions. overall, the results are largely consistent with prior empirical findings, and also appear to be in line with the predictions of some behavioral finance models. keywords: chinese equity market, index additions and deletions, abnormal returns, liquidity changes jel classifications: g14, g15 mailto:yuelin.li@students.mq.edu.au mailto:msadeghi@efs.mq.edu.au asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 17 1. introduction modern portfolio theory has demonstrated the importance of international diversification in selecting an optimal portfolio. emerging markets are attractive alternatives for international diversification, offering substantial potential rewards in added return, and the opportunity to reduce diversifiable risk. previous studies from emerging economies suggest that stock returns are homogeneous within each market, as the stocks move closely together, and heterogeneous externally because of the low correlation that they have with returns in developed markets. as a result, investing in funds that mimic emerging market equity indices is a viable diversification choice for fund managers in developed countries. china is the world’s biggest emerging economy and its exceptional economic growth rate over the past two decades has been largely boosted by foreign investments. most of these investments are in direct form (fdi) 1 . china began to open its market to indirect (portfolio) investment in 1990s. concerned that capital flows might “destabilize” markets, china initially restricted access by foreign investors, establishing separate classes of shares for domestic investors (a shares) and for foreigners (b shares). other than proprietorship, these shares are legally identical, with the same voting rights and dividends. the rule changed in march 2001 when domestic investors were allowed to trade b shares as well. apart from investing in b shares, foreigners may also now invest in h shares─the shares listed on the hong kong stock market. in 2003, the chinese government also introduced the qualified foreign institutional investors scheme 2 that allowed for the entry of foreign investors into the domestic a-share market. in the light of these developments, more and more foreign investors have become interested in investing in the chinese markets. 1 china is now the world’s second largest host for foreign direct investment, after the united states. 2 financial times reported on july 1, 2003 (p. 19) that qualified foreign institutional investors (qfii) include ubs investment bank, morgan stanley, nomura securities, goldman sachs, and citigroup, which all began to invest in chinese a-shares. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 18 investors seeking international diversification by investing in china may consider “indexing” as a cost-effective and logical step toward achieving their goals. according to indexing rules, a fund manager attempts to replicate in his portfolio the result of the investment target by holding all, or in the case of very large indices, a representative sample of stocks. although indexing is generally considered a passive investment strategy, index fund managers must actively minimize the tracking errors 3 of their portfolio as a result of changes in the composition of the indices that they follow 4 . in response to the accelerating trend to create index funds, or to have benchmarks by which the performance of fund managers can be evaluated, several equity indexes have been developed for china. these include the ftse/xinhua 400 index covering both china’s a share and b shares and the s&p/citic 300 index, which gauges the broad market performance of china’s a-shares universe, comprising over 1200 stocks traded on the shenzhen and shanghai exchanges. conventional finance theory based on the efficient market hypothesis (emh) considers shares with identical risk and return as perfect substitutes for each other. this makes market demand for securities elastic and horizontal, implying that changes in the composition of equity indices, which may cause an increase or decrease in demand for shares, would have no impact on share prices. empirical evidence, however, documents that index changes can put upward or downward pressure on share prices and abnormal returns are found when stocks are added to or deleted from an index. positive abnormal returns are usually associated with index additions: increases in demand by index fund managers, who must adjust their portfolio 3 tracking error is defined as the annualized standard deviation of the difference in returns between an index fund and its target index. 4 the composition of an index can change due to various factors such as mergers or acquisitions, bankruptcy, restructuring and lack of representation. changes can also occur when firms are dropped from an index due to poor performance and loss of status in the industry. alternatively, they may be added to an index due to their superior performance and elevated status in their industry. http://en.wikipedia.org/wiki/mutual_fund asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 19 weights, push stock prices up. on the other hand, index deletion usually leads to negative price reaction, due to a decrease in demand by index managers for the stocks. index additions and deletions have attracted considerable interest from academics and practitioners because of their implications for the emh. when a market is efficient, prices move randomly, implying that index revision events reduce the ability of investors to profit from the anomalies. there are two theoretical perspectives on the effects of stock addition and deletion: (i) a demand-based explanation; and (ii) an information-based explanation. the demand-based explanation sees index changes as information-free events. for example, shleifer (1986), employing the downward-sloping demand curve hypothesis, showed that the price effects following the index changes are due to the demand from index tracking. these effects can be temporary or permanent. the temporary effect is explained by the price pressure hypothesis, predicting a reversal of initial price increases in the long run (harris and gurel, 1986). the permanent effect is explained by the imperfect substitute hypothesis, which assumes that there would be no price reversal, as the new price reflects changes in the distribution of security holdings in equilibrium 5 . information-based explanations include the information hypothesis and the liquidity hypothesis. unlike the demand-based explanations, information-based explanations assume that index changes are not information-free events. some studies, such those by dhillon and johnson (1991) and jain (1987), support the information hypothesis: they show that the addition of a stock to the index conveys favorable news about the firm’s prospects and a permanent price increase can result following the stock addition. amihud and mendelson (1986), beneish and whaley (1996), and hegde and mcdermott (2003) contend that the price reactions can be explained by changes in market liquidity. according to the liquidity 5 refer to beneish and whaley (1996), lynch and mendenhall (1997), kaul et al. (2000), and wurgler and zhuravskaya (2002) for more details. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 20 hypothesis, the price increase at index inclusion is from the increased liquidity due to the greater visibility of the stock when it is added to the index, greater interest from institutional investors, higher trading volume, and lower bid–ask spreads. amihud and mendelson (1986) suggest that the increase in stock liquidity is positively related to the firm’s value through the reduction in the cost of capital (becker-blease and donna, 2006). previous studies, such as harris and gurel (1986), and hegde and mcdermott (2003) report liquidity increases following s&p500 index additions, while deletions appear to reduce liquidity. the above theories largely explain the impacts of s&p index additions and deletions in the context of symmetric excess returns. however, price responses to index revisions are not always symmetric. according to merton (1987), index inclusion can increase the recognition of a firm, leading to increases in its value as investors use it to construct their optimal portfolios. however, index deletions are not necessarily accompanied by reduced recognition, causing asymmetric price effects. chen et al. (2004) studied the s&p 500 index and revealed a permanent increase in the price of added firms and a temporary decline in the price of deleted firms. they explained this asymmetric effect by the investor awareness hypothesis, suggesting that an index addition can potentially lead to investor awareness due to enhanced monitoring and reduction in the information asymmetry component of the bid–ask spread. however, index deletion does not necessarily lead to a reduction in investors’ awareness to prompt negative abnormal returns. elliot et al. (2006) found more evidence in support of the investor awareness hypothesis. from an analytical survey of all existing theories on index additions to the s&p 500 index, they found that increased investor awareness is the primary factor behind the cross-section of abnormal announcement returns. hacibedel (2007) also found a permanent long-term price impact for index additions, but not for deletions. this is consistent with the findings of chen et al. (2004). however, hacibedel attributed this asymmetry to the mild segmentation of emerging markets. according to this hypothesis, the inclusion of stocks in a global benchmark index intensifies the process of companies’ asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 21 integration in the world markets, enhancing their stocks’ returns, while, this does not happen when stocks are deleted from an index 6 . the objective of this study is to examine the efficiency of the chinese equity market in reaction to index additions and deletions. more specifically, the focus of our research is to: i. investigate the effects on the price, performance and liquidity of the chinese equity market resulting from the addition of stocks to and deletion from the s&p/citic 300. ii. discuss which explanations raised by previous research best explain the effects on the chinese market of stock additions and deletions. since our findings are not entirely consistent with previous studies, we have also attempted to provide other possible explanations for price and liquidity changes caused by index revisions in the chinese equity market. several factors motivated our research. first, existing research from developed markets interprets results inconsistently and offers competing explanations. for instance, shleifer (1986) suggested that the positive stock reaction to index addition is consistent with the imperfect substitute hypothesis, in which the effect persists in the long term, while harris and gurel’s (1986) study supports the price pressure hypothesis, predicting a reverse in the price increase effect. jain’s (1987) results support neither the imperfect substitute hypothesis nor the price pressure hypothesis, showing that the index changes are not information free. furthermore, evidence from dhillon and johnson’s (1991) research is consistent with the imperfect substitute hypothesis and the information hypothesis, but not with the price pressure hypothesis. thus, there is a need for further research to find more compelling evidence on the impacts of index additions and deletions on share prices. 6 mild segmentation refers to markets which fall in between segmentation and integration. errunza and losq (1985) conducted a theoretical and empirical investigation of the implications of investment under mild segmentation. we plan to examine whether chinese markets are mildly segmented in a separate study. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 22 second, studies of index additions and deletions on emerging markets are rare. noticeable exceptions are the papers by hacibedel and bommel (2006), and hacibedel (2007) who investigated the performance of stock additions to the morgan stanley capital international emerging market index (msci em) for 24 countries 7 . however, they explained the overall response of emerging markets to the index changes. our study examines the specific characteristics of a single emerging market, the chinese stock market. third, previous studies indicate that there are significant differences in the character of price processes in emerging countries as compared with those seen in developed markets. emerging markets are generally considered to have higher volatility, higher long-term returns, higher transaction costs, and greater predictability (bekaert and harvey, 1997). chan et al. (2007) also portrayed chinese financial markets as imperfect and incomplete markets, with high transaction costs and information asymmetry. these differences can have pronounced impacts on the magnitude of excess returns due to index additions and deletions. as a result, it would be interesting to see how findings of such event studies on emerging markets differed from those presented in the studies that are based on mature markets. fourth, s&p/citic inclusions are expected to attract more foreign investment into china. since foreign investment in emerging economies is much more important than in developed economies, stock inclusion in the internationally recognized s&p/citic 300 index can have more profound price and liquidity impact than stock inclusion in a mature market. this study provides an opportunity to test how price and liquidity effects of index inclusion in china are different from those in mature markets. fifth, the chinese equity market was very volatile during our study period, even compared with other emerging markets, and when global capital markets were exhibiting extremely low volatility. friedmann and sanddorf-köhle (2002), who analyzed volatility dynamics in the chinese stock market, found that good news increases volatility in b-share indices more than bad news does. if the market interprets stock additions as good news and stock deletion as 7 they found evidence of positive (negative) permanent price impacts upon index inclusion (exclusion). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 23 bad news, then stock additions can increase the volatility of returns more than stock deletions can 8 . the asymmetry in volatility is translated into the degree of statistical significance of cumulative abnormal returns coefficients. by conducting this study, we should be able find out how the statistical significance of these coefficients varies across index additions and deletions in the chinese equity market. finally, this research is motivated by the importance, the scale of growth, and the increased public attention to the development of chinese economy. this has made investors increasingly look towards the chinese equity market as a source of higher returns and further diversification. as a result, studies like ours are expected to add to the stock of information investors require to help them to make a better investment decision. the rest of this study is organized as follows: section ii outlines our methodology, data and hypothesis development. empirical findings are discussed in section iii. section iv articulates our conclusions, and describes the limits of our study. 2. data and methodology 2.1 data the data used in the present study were sourced from s&p/citic index information services co., ltd. and datastream. data series consisting of daily stock prices, bid and ask prices, and volume of trade were collected from datastream. the rest of the data, such as the announcement dates of the additions and deletions, and daily index time series, were collected from s&p/citic index information services co., ltd. 8 according to kyle (1985) and several other studies, much of the information is revealed in the volatility of stock prices, rather than the prices themselves. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 24 our sample consists of 69 (69) s&p/citic listed firms that were added to (deleted from) the s&p/citic 300 index from october 2003 to august 2007 9 . based on prior research, we used the following criteria to select our samples. i. the firms were not involved in a merger or an acquisition event that led to their addition to or deletion from the s&p/citic 300 index. ii. the firms’ stocks did not split in the period during the study period. iii. the firms had historical data available for a period commencing 150 trading days before and ending 150 trading days after the announcement dates. we applied criteria (i) and (ii) to minimize the effects of confounding events. according to the information provided by s&p, the deleted firms in our sample were all removed for financial reasons such as unstable income and low profitability, and no company was involved in a merger or acquisition 10 . criterion (iii) was used to make sure that there were sufficient pre-event and post-event data to determine the estimation periods. it is interesting to note that criterion (iii) can introduce survivorship bias for the deletion samples because it excludes companies that collapsed following stock deletion and they are more likely to experience significant negative returns. consequently, it is possible that estimated abnormal returns for the deletion samples in our study have become upwardly biased. however, this issue was unavoidable, because our tests required a certain number of post-event observations and we had to exclude companies with insufficient data. 9 there is also a smaller index called s&p/citic 50 whose constituents are the largest companies from the s&p/citic 300. from a portfolio diversification perspective, seddik meziani (2008) found that us investors seeking exposure to china stand to gain the most from funds tracking the s&p/citic 50 index than from those tracking the ftse/xinhua china 25 index or the halter usx china index. however, the number of additions and deletions for this index was very small compared to s&p citic 300, so we could not use it in our study. 10 one exception was the removal of sh600207, not because of financial problems this company had, but to provide space for icbc sh601398 as a newly appointed public company. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 25 the s&p/citic 300 index examined in this paper is one of several s&p/citic indices 11 codeveloped by standard & poor and citic securities company ltd. (s&p/citic index information services co., ltd.) for the china and the chinese offshore markets. its constituents consist of the 300 enterprises with the largest float-adjusted market capitalization and liquidity, drawn from the entire universe of listed a-share companies in china. the s&p/citic indices, in general, are weighted by market capitalization and provide a complete product for exposure to chinese companies and the chinese markets. they are calculated according to standard & poor’s global index methodology, providing consistency, transparency and liquidity services for both chinese and global investors. s&p/citic indices serve as investment benchmarks for the entire chinese stock market and a variety of sub-markets. according to s&p policy, a stock addition is generally made only if a vacancy is created by a stock deletion. the selection criteria for the addition of a new constituent stock are consistent with those of other constituents, namely size, liquidity, profitability and sector representation. for deletion, a guiding principle of index management is the minimization of turnover among index constituents. the possible reasons for deleting a stock from the s&p/citic index include acquisition by another company, bankruptcy, and reorganization. a company may also lose eligibility criteria for stock inclusion due to size or liquidity requirements. s&p/citic indices only cover the chinese a share market. 2.2 methodology 2.2.1 price effect to estimate abnormal share price returns, an event study methodology was applied. the estimated abnormal return is the difference between the realized return observed from the 11 s&p/citic indices only cover the chinese a share market. we also examined ftse/xinhua indices, because they cover both china’s a shares and b shares. however, we did not obtain enough observations (only four) for b shares and they were too limited to warrant a meaningful outcome. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 26 market and the benchmark return. the return to the market portfolio is estimated via both ordinary least square (ols) and scholes and william (1997) procedures. the latter method is usually used when stocks do not trade at the same level of frequency as the market index and ols may produce biased beta estimates. this problem is exacerbated for infrequently or thinly traded stocks as the sampling interval is reduced 12 . the advantages of these models are that they control for the effect of market movements through the market portfolio, and also allow for an individual security’s responsiveness as measured by beta. return on the s&p/citic 300 index was used as a proxy for the market rate of return. defining an event date is an important issue in event studies. we defined the event date as the day that a stock is added or deleted from the s&p/citic 300 index. s&p/citic index information services co., ltd. announces the stock addition and deletion after the close of trading, so the trading day following the day on which the index announcement is made is regarded as the event day. for each event, the return time series data are divided into an estimation period and an event window. the estimation time series data are used to calculate the benchmark parameters, and the event window period is used for computing prediction errors based on the estimated parameters. the abnormal returns are represented by the prediction errors. the abnormal returns over the event windows can be interpreted as a measure of the effect of the event on the value of the firms, which is reflected in their share price. the length of the event window varies across prior studies. dhillon and johnson (1991) estimated the event window over the period starting 10 days before the event and ending 20 days after the event. harris and gurel (1986) extended the post event window by 10 days (–10, 30). shleifer (1986) has symmetric pre-event and post-event windows, which are 20 days before to 20 days after the event. since the chinese market is relatively less efficient and the impact of events can last longer, we extended the event window from 30 days before to 45 days after the event. the asymmetric event window was chosen to examine the 12 the frequency of trading declines with the reduction in the sampling interval. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 27 longer-term effect of excess returns on post-event periods. however, it is likely that the analysis based on a long event window becomes biased by noise from other events, especially in such a large market in china. as a result, we repeated the tests based on shorter windows of (–5, 5), (–10, 10), (–20, 20) to make sure that our estimates are robust. the normal returns of stocks are the expected returns if there are no events. the normal returns are estimated over a period of time outside the event window (peterson, 1989). for applications in which the determinants of the normal return are expected to change due to the event, the estimation period can fall on both sides of the event window. in this study, the estimation period commences 150 trading days before and ends 150 trading days after the announcement dates, excluding the event period of day –30 to day 45. as a result, the estimation period consists of day –150 to day –31 and day 46 to day 150. to avoid biasing the parameter estimates in the direction of the event effect, we did not allow the event period to overlap with the estimation period. the following section describes the event study methodology that we used in our study. mackinlay (1997), and kothari and warner (2004) have provided a survey of event study models, and we closely follow their papers to describe the models here. we define the market model we used in our study according to the following equation: itmtiiit rr   , (1) where:  rit is the return on firm i at time t.  rmt is the corresponding return on the s&p citic 300 index at time t.  i is the intercept term.  i is a parameter that measures the sensitivity of rit to the market index. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 28  it is a random variable that by construction has an expected value of zero, and is assumed to be uncorrelated with rmt. beta for the scholes and williams (1977) model was estimated as follows: m jjj j p̂21 ˆˆˆ ˆ *      (2) where:  is the ols slope estimate from the simple linear regression of rjt on rmt–1.   j̂ is the ols estimate from the regression of rit on rmt+1.  mp̂ is the estimated first-order autocorrelation of rm. as in ols, the intercept estimator forces the estimated regression line through the sample mean: .ˆˆ ** mestjjestj rr   (3) where:  jr is the mean return of stock j over the estimation period,  .mestr is the mean market return over the estimation period. using the estimates from equation (1), the abnormal returns of each security over a test period were estimated according to the following relationship:  mtiiitit rrar  ˆˆ  (4) j ̂ asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 29 where the coefficients i̂ and i̂ are ordinary least squares estimates of i and i. in addition, the average abnormal return (or average prediction error) aart was calculated. the daily abnormal returns were averaged using the below formula: 1 n jt j t a aar n    (5) where t is defined as the trading days before the event date. over an interval of two or more trading days beginning with day t1, and ending with day t2, the cumulative average abnormal return is as follows: jt t tt n j tt a n caar    2 1 21 1 , 1 (6) for each day in the event period, the cross-sectional variance of the standardized abnormal return is then calculated as follows: 2 2 1 1 1 1 1t n n sar it jt i j s sar sar n n            (7) the standardized cross-sectional test statistic is thus:   1 2 t t t sar tsar z n s  (8) asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 30 the individual standardized cross-sectional test for market model abnormal returns is reported to perform well even if there is an increase in the variance within the event period, and the sample contains small and thinly traded companies (boehmer et al., 1991) 13 . 2.2.2 liquidity effect two proxies were used in our study to measure market liquidity, the bid–ask spread and the volume of transactions. the bid–ask spread represents the difference between prices quoted by a liquidity supplier to the buyer and seller of a security. an increase in the volume of trade and a drop in spread signal improvement in market liquidity. a problem with using the bid–ask spread for this purpose is that if events reveal important information and cause higher information asymmetry in the market, the bid–ask spread widens in the short term, making the long-term impacts of liquidity changes harder to measure 14 . an increase in bid–ask spread in a quote-driven market arises from the reaction of designated market makers as the adverse selection costs increase 15 . in order-driven markets (such as chinese equity market), public limit traders raise their bid–ask spread in reaction to a higher adverse selection cost 16 . the 13 index changes may result in an increase in the volume of trade, leading to an increase in return volatility. 14 many researchers discuss how asymmetric information and adverse selection costs affect the bid–ask spread in the market. interested readers may refer to aharoney and swary (1980), easley and o’hara (1987), glosten and milgrom (1985), glosten and harris (1988), rendleman et al. (1982), and venkatesh and chiang (1986), for previous empirical evidence. 15 of three components of the bid–ask spread, i.e., adverse selection cost, inventory cost, and order-processing cost, the first one is more directly affected by information asymmetry. according to stoll (1989), as much as 43% of the bid–ask spread is due to adverse selection cost. 16 the inverse relationship between adverse selection cost and liquidity is a central hypothesis in the theory of limit-order book markets. earlier studies, such as one by frey and grammig (2006) provided empirical support for this theory. a direct relationship between adverse selection costs and bid–ask spreads was also established by glosten (1994) proposition 3. this author presented a theoretical model of price revisions due to the information conveyed by trading throughout the limit order book mechanism. http://www.springerlink.com/content/?author=joachim+grammig http://www.springerlink.com/content/h02085uh2605/?p=01a32a7cac0742d4b3406d8c620b74d5&pi=0 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 31 impacts of adverse selection costs on the bid–ask spread as the price of immediacy is similar in both trading systems (chung, 1999) 17 . in the methodology of liquidity analysis, we closely follow hegde and mcdermott (2003), computing the percentage change in percentage bid–ask spread, and the percentage change in trading volume. we define the quoted percentage spread as the difference between the ask price and the bid price for each firm, divided by the midpoint of the spread. the midpoint spread is the mean of the ask price and the bid price for each firm. the ratio of the daily average percentage spreads (i.e., percentage change in percentage bid–ask spread) were constructed over various event intervals to their counterparts in the pre-addition/deletion period over trading days (–150, –16). if either the bid or the ask prices were less than zero, the quotes were omitted. we use a one-tail t-test to measure the statistical significance of this coefficient. the volume of trade was computed as the daily average of the transaction size. we examined the mean of the daily trading volume ratios. the trading volume ratio (i.e., percentage change in trading volume) for a stock is defined as the ratio of average trading volume over the indicated event time interval to average trading volume in the preaddition or predeletion period. these volume ratios are more robust than examining trading volumes in levels as they control for the effects of large-volume stocks in each of our addition and deletion samples. the event intervals were the same as those for measuring the daily average percentage spread, i.e., (–150, –16). the statistical significance of the percentage change in the volume is also estimated according to the 1-tail t-test. 3. results in light of the insights we developed in the previous sections, we applied a number of tests for the evidence of abnormal returns and changes in liquidity due to s&p/citic 300 index 17 according to chung (1999) study, the cost of adverse selection in an order-driven market is between 30 to 34% of the bid–ask spread. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 32 additions and deletions. three of these tests are relevant to abnormal returns, two to the change in bid–ask spread, and two to the change in the volume of trade. our findings have certain implications for the emh, which predicts that stock prices reflect all publicly available information and market prices represent the fair value of the shares. if this hypothesis holds, any large-scale trade on shares because of index inclusion or exclusion will have no significant impact on their return and liquidity. 3.1 price effects table 1 and table 2 present mean cumulative abnormal returns (cars) for the added and the deleted firms, respectively. to test the robustness of our findings, we have used both the ols market model and the scholes–williams market model as the benchmarks for estimating normal return. our results show that the magnitudes of cars and the level of their statistical significance from the application of two methods are similar. nevertheless, we discuss the results from the scholes–williams model to avoid nonsynchronous trading bias, as shares in emerging equity markets are likely to trade less frequently. table 1 presents the estimated cars for various intervals in the preand post-event periods. the coefficient for cars, accumulated over the interval day –30 to day 0, is –5.93% and statistically significant at the 5% level. the cars coefficient estimated over the shorter interval of day –5 to day 0, increases to –1.88% and remains statistically significant at the 5% level. cars increase to the highest level of –0.83% on the event day (day 0) and become marginally significant at the 10% level, then start to decline. this coefficient remains negative, although statistically insignificant, over the interval day 0 to day 30, then decreases to –3.24% over the interval day 0 to day 45 and becomes marginally significant at the 10% level. figure 1 illustrates the continuous change in cars over the event window, providing further support for the findings in table 1. according to this figure, cars show an upward trend starting on day –14, reach their peak level on day 13 and decline thereafter. based on this evidence, we can conclude that the chinese stock market response to index additions is positive, even though the estimated coefficients for cars remain negative asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 33 throughout the event period. a possible cause of negative cars throughout the event period is market manipulation by informed traders. table 1. cumulative abnormal return and relevant statistics for stock addition to the s&p/citic 300 index ols market model scholes–williams market model intervals cumulative abnormal return t-statistic cumulative abnormal return t-statistic (–30, 0) –6.22% –2.40** –5.93% –2.31* (–5, 0) –1.97% –2.03* –1.88% –1.95* 0 –0.90% –1.58$ –0.83% –1.45$ (0, +5) –1.54% –1.65* –1.32% –1.37$ (0, +30) –2.55% –1.23 –2.59% –1.25 (0, +45) –3.56% –1.59$ –3.24% –1.41$ symbols $,*, **, and *** denote statistical significance at the 0.10, 0.05, 0.01 and 0.001 levels, respectively, using a 1-tail test. figure 1. cumulative abnormal return for stock addition to s&p/citic 300 index during event period since the chinese a share market is dominated by investors who possess little knowledge of stock investment, they can be easily manipulated by informed syndicate speculators (kang et -9.00% -8.00% -7.00% -6.00% -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% -40 -30 -20 -10 0 10 20 30 40 50 c a r s trading days asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 34 al., 2002), who send false signals to encourage sales of shares prior to an inclusion announcement and pose as buyers in the market. this can put downward pressure on prices, making excess returns temporarily negative. however, the announcement of the addition as good news leads other uninformed investors to buy the added firms back, causing stock prices to increase and provide syndicate speculators with some windfall profits. as reflected in table 1 and figure 1, negative cars are less significant after the event, since the informed traders and the uninformed investors take opposite positions in the shares of the added firms. buying the added firms partially offsets the negative effects of earlier selling behavior, making post-event cars still negative, but statistically insignificant. table 2 cumulative abnormal return and relevant statistics for stock deletion from the s&p/citic 300 index ols market model scholes–williams market model intervals cumulative abnormal return t-statistic cumulative abnormal return t-statistic (–30, 0) 1.40% –0.762 –0.70% –0.37 (–5, 0) 0.84% 1.07 0.93% 1.14 0 –0.56% –1.83* –0.56% –1.79* (0, +5) –1.26% –2.18* –1.27% –2.09* (0, +30) –6.26% –3.31*** –6.47% –3.38*** (0, +45) –4.35% –2.27* –4.74% –2.47** symbols $,*, **, and *** denote statistical significance at the 0.10, 0.05, 0.01 and 0.001 levels, respectively, using a 1-tail test. table 2 documents the results for stock deletion from the s&p/citic 300 index. the estimated coefficient for cars over the interval day –30 to day 0 is –0.70% and statistically insignificant. this coefficient becomes positive and remains insignificant over the interval day –5 to day 0. the abnormal return on the event day is –0.56% and significant at the 5% level. the estimated cars decline continuously during the post-event period, reaching the minimum level of –6.47% over the interval day 0 to day 30, and become highly significant at the 0.1% level. the increase in the statistical significance of negative cars during this period can be attributed to an increase in selling activities of informed traders in reaction to the stock deletions, and a corresponding decline in the volatility of returns. according to asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 35 hellwig (1980) and wang (1994), informed trading leads to a decline in the volatility of stock returns. however, as the dissemination of deletion information and selling activities decline over a longer period, this coefficient increases to –4.74% over the interval day 0 to day 45 and becomes statistically less significant at the 5% level. figure 2 shows the change in cars due to index deletion and provides further evidence of the impact of such events on share prices. according to this figure, the decline in cars starts on day –17 and reaches the minimum level of –6.76% on day 29, before rising to –5.00% on day 45. similar to stock addition arguments, positive coefficients for cars in the figure 2. change in cumulative abnormal return for stock deletion from s&p/citic 300 index during event period pre-deletion period might have been caused by the spread of false information by syndicate speculators, encouraging uninformed investors to buy underperforming firms, pushing prices up. once the deletion is announced, the overall market view about deleted firms is revised, leading to post-event negative effects. the evidence provided in table 2 and figure 2 is generally consistent with previous findings, suggesting that the chinese market response to index deletion is negative. -8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% -40 -30 -20 -10 0 10 20 30 40 50c a r s trading days asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 36 table 3 – cumulative abnormal return difference between stock addition to and deletion from s&p citic 300 index intervals cumulative abnormal return difference t-statistic (–30, 0) –04.98% –2.93*** (–5, 0) –2.54% –1.37$ 0 0.00% 0.00 (0, +5) 0.21% 0.19 (0, +30) 4.14% 2.16** (0, +45) 1.77% 0.98 symbols $,*, **, and *** denote statistical significance at the 0.10, 0.05, 0.01 and 0.001 levels, respectively, using a 1-tail test. if pre-addition negative and pre-deletion positive cars are actually caused by the activities of syndicate speculators, then differencing this variable for the added and the deleted firms should partially neutralize the noise from these activities (canceling each other out as random errors), and reveal the impact of the index revisions more clearly. table 3 shows the estimated coefficients for the car differences between the added and deleted firms during the event period. the estimated coefficient for this variable over the interval day –30 to day 0 is –4.98% and is statistically significant at the 1% level. it then rises and reaches 0.00 on the event day, then becomes positive during intervals after the event day. this coefficient reaches 4.14% over the interval day 0 to day 30 and becomes highly significant at the 1% level. figure 3 provides further evidence for the findings in table 3. according to this figure, the estimated coefficient for cars starts to rise from day –15 and reaches its maximum level of 5.08% on day 28 during the post-event interval, becoming highly significant at the 0.1% level. based on the evidence in table 3 and figure 3, we can conclude that the estimated car differences between index addition and index deletion reduces noise and reveals the net impacts of these events more clearly. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 37 figure 3. cumulative abnormal return difference between added firms to and deleted firms from s&p/citic 300 index during the event period the prolonged effects of the index addition and deletion on cars indicate that these events are likely to contain information, thus sending signals about the health of the added and deleted firms to the market. to test this hypothesis, we compared the cumulative returns for the added and deleted firms with cumulative return for the market over the period from day –150 to day 150 18 . figure 4 shows the cumulative return for the added firms return and market return. the general trend shows that they both slope upwards; however, the added firms’ performance is far better than the market, suggesting that these firms may have been added to the index due to their superior performance prior to the event. to the extent that their performance has led to their inclusion in the index, the stock addition cannot be considered an information-free event. 18 we believe that if index inclusion and exclusion contain information, this information must have been reflected in share prices earlier than the beginning of the event window and should extends for some time afterwards. as a result, we have used a sample of data that extends from 150 days before to 150 days after the event. -14.00% -12.00% -10.00% -8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% -40 -30 -20 -10 0 10 20 30 40 50 c a r s a d -c a r s d el trading days asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 38 figure 4. cumulative firm return and market return for stock addition to s&p/citic 300 index the cumulative returns for the deleted firms compared with the market are shown in figure 5. they show a positive upward trend for the market, whereas the returns for the deleted firms are largely negative and below the market return. this suggests that poor performance may have been the main reason for exclusion of deleted firms, and this event is not an information-free event. the evidence in figure 4 and in figure 5 largely rules out the demand-based explanations in our findings, as both the price-pressure hypothesis, and the imperfect-substitute hypothesis assume that index additions and deletions are information-free events 19 . 19 our interpretation of information effects in figures 4 and 5 is based on the cumulative returns only. we have also estimated firms’ and market performance risk-adjusted cumulative returns (cumulative return adjusted by standard deviation). for index additions, the risk-adjusted cumulative return for the firms is 10.742, compared -10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% -150 -140 -130 -120 -110 -100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 m ea n c u m u la ti v e r et u rn trading day mean cumulative firm return mean cumulative market return asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 39 3.2 diagnostic tests to diagnose any potential problems in our findings we examined the parameters of the applied models and the return distribution. we deemed this investigation necessary because the ols market model applied in this study was developed under the emh, with the assumption that the distribution of returns is normal. this assumption is more relevant to developed markets. however, the chinese equity market is a newly developed market and thus less efficient than developed markets. as a result, the distribution of returns on shares might not be normal. the normality of the distribution of returns on stocks was tested by investigating estimated skewness and kurtosis coefficients over the estimation period. ignoring these elements will cause the model to understate the risk of the variables with high skewness or kurtosis. if the returns are not normally distributed because of the degree of skewness, or because the tails are too “fat”, t-statistics may not be valid. from our estimates, the skewness coefficient for addition is 0.04 and for deletion is –0.18. the kurtosis coefficient for addition is 0.31 and slightly higher than that of deletion (–0.01). these coefficients are all low and negligible. based on these findings, we have concluded that our estimated t-statistics are reliable. in another diagnostic test, we measured the magnitude of estimated betas to see how robust the market model is. according to this model, beta coefficients are a measure of a stock’s volatility in relation to the market. the betas in our study are measured over the estimation period, i.e., (–150, –31) and (46, 150). we thoroughly investigated individual betas for each firm and did not find any abnormality. the estimated average beta for addition (deletion) is 0.98 (1.13) and not significantly different from the theoretical value of 1. we also investigated whether the s&p/citic 300 index properly represents the chinese stock market, compared with other proxies. we verified this question by investigating the properties of the with 2.121 for the market. for stock deletions, the corresponding figures are 0.357 and 2.035 respectively. this provides further evidence that chinese index additions and deletions are not information-free events. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 40 figure 5 cumulative firm return and market return for stock deletion from s&p/citic 300 ftse/xinhua 400 index 20 as another proxy for the chinese equity market. our findings show that the correlation between the ftse/xinhua 400 index and the s&p/citic 300 index is very high (98.45%), and the results produced by using the ftse/xinhua 400 index are quite similar to those based on the s&p/citic 300 index. this leads us to believe that s&p/citic 300 index is a reasonable proxy for the chinese equity market and the test results based on this index are robust. as we discussed earlier, since it is possible that the analysis based on the long event window in table 1 and table 2 may be biased by noise from other events, we estimated car coefficients for shorter windows of (–5, 5), (–10, 10), (–20, 20), and the results are reported 20 the ftse/xinhua 400 index is one of the indices established by ftse/xinhua index limited (fxi), which is a joint venture between the global index provider ftse group and xinhua finance. the company was created to facilitate the development of financial indices for the chinese market; it provides combined coverage of the shanghai, shenzhen and hong kong exchanges. -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% -150 -140 -130 -120 -110 -100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 m ea n c u m u la ti v e r et u rn trading day mean cumulative firm return mean cumulative market return asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 41 in table a1 and table a2 in the appendix. these results are consistent with our findings in table 1 and table 2, suggesting that our tests are robust. table 4. average daily percentage changes in percentage-spread and in the trading volume due to s&p/citic 300 index addition and deletion addition deletion percentage change in percentage spread percentage change in trading volume percentage change in percentage spread percentage change in trading volume short term (–15, –1) 40.26%*** 14.39%** 4.10% 1.57% (3.35) (2.34) (0.36) (0.44) (–10, –1) 47.02%*** 21.73%** 6.93% 0.56% (3.90) (2.90) (0.58) (0.14) (–5, –1) 54.78%*** 19.87%* 11.82% 5.12% (3.58) (1.70) (0.83) (0.81) (0, 5) 4.51% 80.88%*** 4.16% 42.97%** (0.40) (5.68) (0.38) (2.64) (0, 10) 19.53%$ 58.64%*** 3.29% 21.46%* (1.64) (4.86) (0.30) (1.88) (0, 15) 23.44%* 42.32%*** 3.23% 15.15%* (2.08) (3.88) (0.29) (1.84) long term (16, 30) 42.20%*** 52.44%*** 3.03% 40.37%*** (3.46) (6.39) (0.27) (3.96) (16, 45) 26.70%** 45.40%*** 2.13% 48.08%*** (2.37) (7.51) (0.19) (7.51) (16, 60) 20.02%* 40.02%*** –0.37% 49.44%*** (1.83) (7.93) (–0.03) (10.06) (16, 75) 15.87%$ 41.80%*** –1.49% 54.29%*** (1.48) (7.98) (–0.14) (12.08) symbols $,*, **, and *** denote statistical significance at the 0.10, 0.05, 0.01 and 0.001 levels, respectively, using a 1-tail test. 3.3 liquidity effect in this section, we examine the liquidity effects of changes in the composition of the s&p/citic 300 index by calculating the percentage change in percentage spread and percentage change in trading volume of the added and the deleted firms. tests were extended asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 42 to different event windows to distinguish between the shortand long-term effects of the events. according to the evidence in table 4, both percentage changes in percentage bid–ask spread and percentage changes in the volume of trade are significantly positive prior to stock additions. the volume of trade reaches a peak of 21.73% over the interval day –10 to day –1, while the percentage change in percentage spread rises as high as 54.78% over the interval day –5 to day –1, and becomes highly significant at the conventional statistical levels. the percentage change in the volume of trade continues to increase after addition to its highest level of 80.88% over the interval day 0 to day 5, before declining to 42.32% over the interval day 0 to day 15. in the longer term, this variable increases again to 52.44% over the interval day 16 to day 30, then gradually declines to 41.80% over the interval day 16 to day 75 and remains highly significant at the 0.1% level throughout the post-addition period. generally speaking, the magnitude of the percentage change in percentage spread declines in the post-addition period, reaching a peak of 23.44% in the short term over the interval day 0 to day 15, then increasing to its highest level of 42.20% in the long term over the interval day 16 to day 30, and becomes highly significant at the 0.1% level. the coefficient for this variable gradually declines to 15.87% over the interval day 16 to day 75 and remains significant at the 10% level. previous studies, such as that by hegde and mcdermott (2003), found that an increase in the volume of trade is accompanied by a decrease in the bid–ask spread following a stock addition to s&p 500 index. in our study, an improvement in liquidity is supported by an increase in the volume of trade in the entire event window; however, there is not a decrease in the bid–ask spread in the short-term 21 . the excess spread increases steadily before the announcement then starts to decline after the event. this outcome may have arisen from liquidity suppliers’ behavior: they may revise their short-term bid–ask spread upwards due to 21 this experience is not unique to chinese market. lakhal (2004) found similar pattern of change in the bid–ask spread around the event day in the (order-driven) french market. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 43 increases in adverse selection cost. however, as asymmetric information declines over time, the bid–ask spread is revised downward. as a result, we can conclude that the changes in the bid–ask spread provide evidence of improving market liquidity in the long term. for stock deletions, the percentage changes in percentage bid–ask spread is not significant prior to or after the event. on the other hand, the percentage change in the volume of trade continuously increases, reaching its maximum level of 42.97% over the interval day 0 to day 5, and becomes significant at the 1% level. this variable continues to rise to its highest level of 54.29% over the interval day 16 to day 75, and becomes highly significant at the 0.1% level. the trade volume increase following a deletion is not consistent with previous studies from developed markets; however, it is consistent with another characteristic of the chinese equity market, which prohibits short sales. baker and stein (2002) suggested that, in a world with short-sales constraints, market liquidity can be a sentiment indicator. according to this view, an unusually liquid market is largely dominated by irrational investors who tend to under-react to the information embodied in either order flow or equity issues. thus, high liquidity is a sign of positive sentiment among irrational investors, which may also have affected cars in the event study tests. on the other hand, differences in liquidity effects due to index addition and index deletion may have arisen from the extent of investors’ awareness about the events. according to chen et al. (2004) investors’ awareness can increase following an index addition, but does not easily diminish following a deletion. this can lead to an upward revision of the bid–ask spread after an addition, but not an equivalent downward revision after a deletion. based on the evidence discussed so far, we can conclude that market reaction to a stock addition (deletion) has been generally positive (negative) because of an increase (decrease) in return and liquidity compared with a bench mark. however, these effects are not symmetrical. for instance, a comparison between findings in table 1 and table 2 suggests that the magnitude of the price response to additions is less than that for deletions. a comparison of figure 4 and figure 5 also shows that the drop in cumulative return for deleted asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 44 stocks totally disappears around day 100 and the trend becomes horizontal for the rest of the study period, while for stock additions the positive trend in cumulative returns continues to day 150, at a rate that is much higher than that of the market. the latter evidence suggests a permanent price increase for index additions, and a temporary price decline for deletions. these are consistent with the findings of chen et al. (2004) for developed markets, and especially with the results of the investigations by hacibedel and bommel (2006), and hacibedel (2007) for the emerging markets. 4. conclusion and limitations we have investigated the impacts of index addition and deletion on the price and liquidity of a sample of stocks that were added to or deleted from s&p/citic 300 index over the period october 2003 to august 2007. we used an event study methodology to estimate cumulative abnormal returns in the days surrounding the event for testing the price effect. changes in liquidity of the added and deleted stocks were examined by comparing the percentage change in the percentage bid–ask spread and in the trading volume after the event, to a base period before the event. our findings for index addition show that cumulative abnormal returns (cars) are negative before the event day, then start to increase and accumulate for several days after the event day. for deleted firms, cars are positive before the announcement day, and then start to decline and become increasingly negative after the event day. we suspect that the significant negative (positive) cars prior to addition (deletion) are caused by the flow of false information from informed syndicate speculators to uninformed investors, urging them to sell (buy) affected shares. this puts temporary downward (upward) pressure on stock prices and affects cars accordingly. after the event, the uninformed investors revise their view about the added or deleted shares, causing an increase in cars for the addition and decrease in cars for the deletion. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 45 trend analysis based on the cumulative returns for the added and the deleted firms also reveals that stock addition or deletion is not an information-free event. it is, in a sense, the performance of the firms that leads to their addition or deletion in the first place. this rules out the demand-based (information-free) explanations of price change, leaving some room for the information hypothesis to partially explain the index revision effects. furthermore, we found evidence of improved liquidity for stock additions and deletions in the longer term. for stock additions, we found a significant increase in the bid–ask spread before the event and a decline after the event, while the volume of trade showed significant increases before and after the event. the positive change in the bid–ask spread in the pre-event period, despite substantial increases in the volume of trade, is attributed to the increase in uncertainty and asymmetric information around the event period. according to the adverse selection models, the bid–ask spread widens in reaction to the increase in asymmetric information if liquidity suppliers suspect that informed traders may benefit from superior information they possess at their expense. however, for stock deletion, the volume of trade increases without significant change in the bid–ask spread. this has been attributed to short-sale constraints by baker and stein (2002). according to this view, an unusually liquid market is largely dominated by irrational investors who tend to under-react to the information embodied in either order flow or equity issues. thus, high liquidity is a sign of a positive sentiment by irrational investors, which may also have affected cars in the event study tests. based on the evidence discussed in sections 3.1 and 3.2, we can conclude that market reaction to a stock addition (deletion) has been generally positive (negative) because of an increase (decrease) in return and liquidity compared with a bench mark. however, these effects are not symmetrical. a comparison of findings in table 1 and table 2 suggests that the magnitude of the price response to the additions is less than that of the deletions. a comparison of the evidence in figure 4 and figure 5 also shows a permanent price increase for index additions, and a temporary price decline for the deletions. these findings are consistent with the findings of chen et al. 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(2008). fdi in china: facts and impacts on china and the world economy, working papers, iuj research institute, international university of japan. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 51 appendix appendix 1. cumulative abnormal return for index additions during shorter event periods table a1. cumulative abnormal return for stock addition to s&p/citic 300 index ols market model scholes-williams market model event window cumulative abnormal return t-statistic cumulative abnormal return t-statistic (–20, 0) –6.58% –3.787*** –6.45% –3.703*** (–10, 0) –5.28% –3.926*** –5.19% –3.881*** (–5, 0) –1.96% –2.029* –1.85% –1.921* 0 –0.89% –1.552$ –0.80% –1.392$ (0, +5) –1.41% –1.535$ –1.16% –1.224 (0, +10) –0.68% –0.643 –0.39% –0.367 (0, +20) –1.46% –0.914 –1.34% –0.831 note: the symbols $,*,**, and *** denote statistical significance at the 0.10, 0.05, 0.01 and 0.001 levels, respectively, using a 1–tail test. estimation period (–150, –21) and (+21,+150) asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e2 52 appendix 2. cumulative abnormal return for index deletions during shorter event periods table a2: cumulative abnormal return for stock deletion from s&p/citic 300 index ols market model scholes–williams market model event window cumulative abnormal return t-statistic cumulative abnormal return t-statistic (–20, 0) 4.88% 2.493** 5.54% 2.732** (–10, 0) 3.06% 2.632** 3.31% 2.819** (–5, 0) 1.00% 1.257 1.15% 1.422$ 0 –0.57% –1.832* –0.60% –1.872* (0, +5) –1.25% –2.133* –1.44% –2.383** (0, +10) –2.89% –3.798*** –3.11% –3.770*** (0, +20) –5.40% –4.158*** –5.47% –4.075*** note: the symbols $,*,**, and *** denote statistical significance at the 0.10, 0.05, 0.01 and 0.001 levels, respectively, using a 1-tail test. estimation period (–150, –21) and (+21,+150) microsoft word the impact of regulatory-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 216 the impact of regulatory and supervisory structures on bank risk and efficiency: evidence from dual banking system nafis alam assistant professor, nottingham university business school, the university of nottingham malaysia campus e-mail: nafis.alam@nottingham.edu.my received: march 13, 2012 accepted: april 5, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1507 url: http://dx.doi.org/10.5296/ajfa.v4i1.1507 abstract james madison once said “if men were angels, no government would be necessary”. madison’s view has direct implications for efficient bank supervisory and strong regulatory strategies. on the onset of 2007-08 subprime crisis banking system across the globe were left exposed to financial tsunami due to over-expansion and excessive risk concentrations. this incident should provide regulators wake up call to further develop and strengthen the regulatory system with new and strict monitoring mechanism. in the given context, this paper will investigates the linkages between bank regulatory and supervisory structures associated with basel iii’s pillars and various aspects of banks’ efficiency and risk. the analysis will be focussed on dual banking system over the period 2006-2010. our results suggest that regulations and strict monitoring of banking operation, and higher supervisory power of the authorities, increase the technical efficiency for islamic banks but decreases convention banks efficiency. we observe the opposite effect in the case of restrictions on bank activities, with higher restrictions having a reduction in risk taking of islamic banks while increasing the risk taking of conventional banks. results also indicate that islamic banks are better prepared towards the implementation of basel iii guidelines compared to their conventional counterparts. keywords: dual banking, banking regulation, bank performance, bank risk jel classification: g15, g21, g28, c14 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 217 1. introduction the banking system around the globe has been in recent years going through some of the most intense criticism and scrutiny. in part many believe the lack of regulations and supervisory structures have brought the world to a brink of financial collapse, while on the opposite side of that coin many believed the years of prosperity the world had experienced just prior to the collapse were largely in part due to the deregulation or lack of regulation hence a near free market with regard to the financial sector (reinhart and rogoff. 2008; brunnermeier & pederson, 2009). could there possibly be better efficiency and possibly profitability where a properly implemented regulatory and supervisory framework is in place? would evidence suggest so? this paper will try to resolve some of the myth by providing empirical support. banking regulations can generally be defined as the frameworks controlling the creation, operation and liquidation of banks in an economy. these regulations are put in place by central banks and finance ministries and the control is exerted usually through monitoring carried out by specialized banking supervisory authorities. spong (2000) from the federal reserve bank of kansas city highlights a few important reasons for introducing bank regulations. the most basic reason for introducing regulations is to protect depositors from undue risks to their deposits. businesses and individuals alike hold significant portions of their funds in banks and there are valid concerns from them with regards to protection of their funds. as a result, authorities respond to such concerns with regulations attempting to protect the bank depositors. meanwhile, with enormous amounts of transactions conducted daily by businesses and individuals, a stable framework is required to ensure smooth and acceptable methods of the payments system are in place in an economy. bank regulations try to provide this stable framework which seeks to assure certainty and safety to users of the banking payment system which is critical for the wellbeing of the economy. moreover, apart from maintaining public confidence, banking regulations also try to create a regulatory environment where banks are expected to be efficient and competitive; and are also expected to provide reasonable levels of banking services throughout the economy. the traditional view of the impact of bank regulation is that higher capital requirements will have a positive effect on the banking sector. however, some studies indicate that capital requirements increase banks’ risk-taking behaviour (e.g. blum, 1999; calem and rob, 1999). barth et al. (2004) find that while stringent capital requirements are associated with fewer non-performing loans, capital stringency is not robustly linked with banking sector stability, development or bank performance (measured with overhead and margin ratios) when controlling for other supervisory regulatory policies. in theory, there tends to be support for both the official supervision approach and the private monitoring approach to bank supervision. the official supervision approach argues that official supervisors have the capabilities to avoid market failure by directly overseeing, regulating, and disciplining banks. by contrast, the private monitoring approach argues that powerful supervision might be related to corruption or other factors that impede bank asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 218 operations, and regulations that promote private monitoring will result in better outcomes for the banking sector. if this would have been the case the world should not have witnessed global banking crises. in another aspect of banking has been the recent rise of islamic finance, while the rest of the world and industry continues on with the business of arguing as to what level of banking regulations is needed, there in many corners of the world is the rise of a different type of banking system, in this aspect it encompasses a wide array of concepts from fully fledged financial institutions to normal financial institutions having an islamic financing arm that offers saving schemes, loans or bonds commonly known as sukuk. however like every system that is theological based it is often open for interpretation and often it is done nationally or regionally, the islamic finance industry has also been riddled with many of such issues many of which could boil down towards lack of proper supervision and many is simply due to the lack of compliance and regulatory measures. when reading such a paper it is easy to dismiss the importance of islamic banking whether because it is through our own ignorance, lack of understanding to the system, prejudices and to a certain extent familiarity with conventional banking. however islamic financial markets are among the fastest growing financial products in the world. this will see further growth in years to come as more and more countries are embarking on islamic banking and discovering the benefits of using islamic finance over conventional financing schemes. as highlighted by perry & rehman (2011) “while many of the conventional banks suffered major loses in the aftermath of the sub-prime mortgage crisis, most banks following the islamic system were largely profitable”. however there exist some dark clouds over the horizon for it to be accepted universally as a mainstream bank but mostly as an alternative. thus one of the major contributions of this paper is to empirically verify the role of regulatory and supervisory structure on the efficiency and risk taking for both conventional banks and islamic banks under dual banking system. for the best of the knowledge of author this will be first quantitative study to highlight the banks’ risk and return in dual banking system. another motivation for this study is to substantiate if the efficiency and risk taking for islamic banks and conventional banks varies under given regulatory and supervisory structures. the new regulation underlining basel iii aspires to make the global banking system safer by redressing many of the flaws that became visible in the recent financial crisis. improving the quality and depth of capital and renewing the focus on liquidity management is intended to spur banks to improve their underlying risk-management capabilities. this will raise the biggest challenge for banks, without compromising with the returns they need to incorporate higher level of risk management tools. with the onset of basel iii regulations it is imperative to know which banking system islamic or conventional are better equipped to withstand any future financial turmoil. existing literature on regulation and supervision linkage with banks’ risk and efficiency is limited and purely focusses on individual countries, single banking system or simple accounting ratios. (barth et al., 2003 a,b; demirguc-kunt, et al., 2004 barth et al., 2004; beck asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 219 et al., 2006; berger et al., 2008). this paper will be step forward and contribute two fold to the existing literature by first investigating the impact of bank regulatory and supervisory structure on both conventional and islamic banks’ efficiency as well as on their risk. secondly this paper will also assess the readiness of dual banking system towards the implementation of basel iii. the chosen period of analysis is 2006-2010 for eleven major dual banking systems (egypt, bahrain, bangladesh, indonesia, kuwait, malaysia, pakistan, qatar, saudi arabia, turkey, and uae). overall our results show that that regulation and supervision are positively related for conventional bank technical inefficiency and negatively related for islamic bank technical inefficiency. in case of impact of regulatory and supervisory practices on bank risk taking we did not find any major differences between the two types of bank. the rest of this paper is organized as follows: section 2 includes a literature review while section 3 presents the methodology, variables and data. the empirical results are explained in sections 4 and section 5 concludes the paper. 2. literature review if we focus on regulation literature the declaration here is that most if not all the literature whether calling for more or less regulation will be applicable to the financial services industry regardless of whether it is conventional or islamic. it is hoped that after this paper is written there would be better research into regulations that would be specifically for dual banking, especially so if there is relevance that special regulatory and supervisory framework is required. one of the biggest critique and vocal in regard to the issue of bank regulations are barth, caprio and levine. barth, caprio and levine, (2008) noted that most countries with a functioning financial system had made significant changes to their bank regulatory framework, this is especially so in many developing and asian countries after the east asian financial crisis of the late 1990s. they do not appear to submit that it might be for the better since mostly it has been about following the basel guidelines, strengthening capital requirements and the empowerment of supervisory bodies. the criticism by these authors is there is little evidence to suggest the implementation of these measures lead to a major improvement of the banking system in regard to their efficiency, stability and corruption. another aspect criticized were the implementation of private monitoring though consistent with the third pillar of basel ii, it does not appear that these have brought about as much an effect as hoped for by policy makers. it was further argued that where banks introduced forced to curtail their non-lending activities then this brought forth further issues in regards to their profitability and to an extent their efficacy. often many regulations tend to be knee-jerk reactionary measures at time of crisis it is claimed, this isn’t farfetched from the truth as it is indeed being seen to a large extent till today. they pointed out that in malaysia’s case upon the east asian crisis most banks had to cease with the vast majority of their non-lending activities; however where it appears to come off as a bad policy, the vast majority of malaysian banks emerged from the more recent crisis in a far stronger position than many blue-chip banks in usa. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 220 in the subject of bank regulations, there is also evidence in regard to the microeconomics aspect to it. according to barth, caprio & levine (2007) data shows little evidence that a strengthened ability of supervisory framework in regard to monitoring and discipline of banks have an impact in improving bank efficiency or even banking and the commercial sector relationships. however there is a positive effect with regard to increased supervision and corruption in the banking sector. again there was a call that a private monitoring of banks had a better effect in regard to their efficiency. where corruption is a major issue in the banking industry, the academicians were of opinion that proper disclosure could bring forth better banking efficiency on condition that the legal system was a fully developed and strong one. in their earlier paper, (barth, caprio, levine, 2004) using data from 107 countries in regard to their supervisory and regulatory scope they examined the relationship between this and how it affects development in the sector, fragility and efficiency. it thoroughly examines issues in regard to restrictions on banking activities, barriers to entry especially in regard to foreign banks, capital requirements, deposit insurance, powers of the supervisory body together with its resources and independence, stringency of loan classification including guidelines to this regard, disclosures and finally to the extent in which government ownership influences the banking sector. when it came to the issue of state ownership of banks, there has always been negativity towards this concept especially in many developed countries. it was pointed out by their findings that there was again no evidence to suggest that ownership by state had any positive effects on efficiency and on the contrary it also showed more corruption and poor development in the financial services industry. they submitted that a better way forward for the development of a proper banking and financial industry was to have forced disclosures of accurate information, privatization of banks and for there to be incentives for corporate control of the banks. it should however be noted that this paper was written prior to the financial crisis and it is quite unlikely that governments would be willing to have a completely unregulated financial services industry as seen in the previous decade. often, when dealing with the issue of islamic banking, a very red flag is often raised that many of these products come from countries where there are greater rates of corruption or in some cases a weak legal system, beck et al. (2006) examines the relationship on the need of bank supervision with regard to corruption and lending. according to their paper, the main research question was “which commercial bank supervisory policies ease or intensify the degree to which bank corruption is an obstacle to firms raising external finance?” their findings were again fairly consistent with available literature. they submitted 3 main conclusions. firstly evidence shows that a powerful supervisory agency with broad powers does not better regulate or facilities efficient corporate finance. the evidence suggests that in countries with greater supervisory powers especially with regard to intervening, the data suggest that there would be more likelihood of corruption with these than in places without such supervisory or regulatory agencies. secondly, a regulatory and supervisory framework that allows for interventionism tends to be a tool for politicians to manipulate, it often brings forth evidence that where such a system is in place, it also brings poor state governance. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 221 thirdly, their analyses are consistent that private monitoring is a better solution. this is especially so with greater information disclosures and without distortions in the market. their data suggest that where private monitoring coupled with forced accurate information disclosure that there is an overall benefit to the integrity of the financial system of a nation and this will only work if there is already in place a good legal system. politics aside, the authors were of opinion that supervision of financial institution clearly mattered, but the question to be asked is who the better ones to supervise are. their results which are non-ideological suggest that better information and supervision are the best way forward in regard to reducing corruption in the banking sector especially with regard to lending. in hindsight, the authors could only have wished more of their suggestions were taken into account sooner with regard to bank regulations and supervision especially with the onset of the subprime crisis in the usa. in a paper (demirgüç-kunt, laeven & levine. 2004) that examined the impact of bank regulations, market structure and national institutions on the profitability of banks, the finding was that stricter barriers to entry and bank activities may increase cost of financial intermediation. the authors also presented evidence consistent with literature that regulations or stricter regulatory requirements did not bring about much benefit in regard to bank stability, it also impeded firms’ ability to access financing from external sources. it also played a negative role in regard to the valuation of a bank. it also meant that overall development in the financial services industry would suffer a setback. literature in regard to bank diversification into non-traditional income sources also exist and also are of the tangent on whether regulation in this regard affects their efficiency. according to literature, (laeven & levine, 2007) analysing dominant banking players in the industry and the impact of regulations, they attempted to show that diversified banks did not do as well as specialized ones, this is especially with regard to their investment funding and related activities. laeven & levine (2007) study is very much relevant to this paper as it is studying the effects on regulation and supervisory using evidence of a dual banking system. generally it is accepted by the authors that diversification has a negative impact on bank performance, however instruments in which that could be put in place to overcome these impacts. their findings were that firstly highly diversified banks performed much worse than those who had specializations. secondly, it also depended on who the owners of such banks were, where it was state ownership then it had a very detrimental effect on performance but where it was a private enterprise regardless of domestic or foreign they were able to mitigate the negatives. often bank regulations are steeped in bureaucracy in regard to market entry. while it is often true that not everyone should be given a bank operating license just because they ask for one, it is generally accepted that in many countries where there are ease in regulations to market entry the dynamism of the financial sector improves by leaps and bounds. according to casu & girardone (2006), a level playing field was the main objective for deregulation in the banking sector. the easing of entry somewhat made it easier for entry into the single market, but the main effects to it was a series of major consolidation. while their focus was more asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 222 towards competition within the banking industry and its effects on efficiency and probability in the european union many of the lessons from there could also be applied in regard to the analysis of the dual banking study this paper is on. their findings further submitted that where the regulations attempted to make it easier for market entry it also brought about concentration and in all the european countries studied this was fairly consistent as deregulation brought on waves of consolidation and mergers between financial institutions. they concluded that “the relationship between competition and efficiency is not a straightforward one: increased competition has forced banks to become more efficient but increased efficiency is not resulting in more competitive eu banking systems.” it appears that more than one team of academicians are agreeable with regards to private monitoring of banks, hence it does not appear to be a largely american school of thought or one that is primarily propagated by american based institutions, even in britain and continental europe there appears to be broad support for this issue. according to delis, molyneux & pasiouras (2009), there is an indication that regulations and incentives that promote private monitoring have a positive impact on productivity even where they utilized data and regression analysis that is different from the others. in their study of banks, basel ii, productivity and regulations, they concluded that there is an overall call by many international organizations and governmental bodies to implement a regulatory and supervisory framework that consist of stringent capital requirements, tighter supervisory controls and an empowered monitoring by the private sector there are little consensus in regard to which would work best, it is arguable that different countries may require different types of frameworks and there is no one size fits all system often pushed on by american academics or policy makers. it has been the case that only in recent years there have been more cross country studies and usually it is not significantly different in systems or wealth levels. in a contrasting method of measuring efficiency of the banking system, pasiouras, tanna & zopounidis (2009) focussed on the role of regulatory and supervisory framework and their impact on banking efficiency utilizing a stochastic frontier analysis. again it used a fairly large dataset with studies in 74 countries. their main area of research was the effect of the regulations called upon by the three pillars of basel ii. their findings point towards that cost efficient banks are not necessarily efficient in generating profits. cost and profit efficiencies were significantly affected in a positive manner where there were requirements for disclosure of information, however the reverse was true where there were highly powerful supervisory frameworks in place, and hence the two are not mutually exclusive. their submission in regard to regulating banks is in order for it to be done effectively then account needs to be taken among competition, efficiency and financial stability, this is especially so due to the effects that an improper and dysfunctional banking system could do to an economy of a nation as evidenced by the numerous financial crisis that occurred as a result in the 20th century that as infrequent as they were the damage they did often eclipsed those of many natural disasters. overall the literature review can be summed up that most academicians submit that bank regulations and supervision does have an impact with regards to bank efficiency and risk asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 223 taking. much of the literature has also called on policy makers to maintain deregulations and allow banks to self-regulate themselves. it is a difficult to evaluate whether much of the academicians submit that due to conviction of the free market system or is it genuinely the case. often these academics come from countries where there are legal systems that could be considered to be among the most advanced in the world and had general high standards of rule of law. however, the literature submitted even where it is done comparatively it does submit that in most cases extra regulations will have an impact on the efficiency of a bank. the level of supervision in the financial services industry has a strong and adverse effect with regard to efficiency of a bank, this is especially so where the supervisory is a state supported establishment and has broad interventionist powers. an aspect of regulations and supervision is where they come with restrictions. while evidence tend to point towards efficiency having a negative effect where a bank diversifies its financial type activities, it is often the case instead that where a restrictive banking system will in turn prevent the proper development of the financial services industry. this might be where a lot of developing countries may face hurdles and this research will try to empirically support this notion. thus it can be seen from the above discussion that there seems to be no study which focussed on regulation and supervisory impact on bank efficiency and risk taking in dual banking system and only handful of studies focussed on regulation impact on bank risk and return. the next section outlines the details of the methodology and data used. 3. methodology 3.1 efficiency estimation the methodology employed by this paper is that of a frontier data envelopment analysis (dea) model. the dea model of data analysis with regard to bank efficiency has generally been favoured by most academics (berger et al., 1993; berger & humphrey, 1997; casu & molyneux, 2000). despite criticism from some academics (simar & wilson, 2011; ramalho, ramalho & henriques, 2010) it is generally accepted by most academics that the dea model is a sound technique for efficiency estimation. mcdonald (2009) examined the second stage dea efficiency analyses and found that there are good arguments for treating dea efficiency scores as descriptive measures in a second stage analyses. he summed it up that dea method was simply the better one as it was relatively simple to use and a broad range of people could understand its usage and the idea behind it. in the generic situation of n banks, with each of them consuming m different inputs to produce s different outputs and constant returns to scale, this translates into the following linear programming problem being solved n times; each time for a different bank in the sample: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 224 where θ is a scalar,  is a vector of ones and finally x and y are the m× n input and s × n output matrices respectively. in this context θ is the technical efficiency score of each bank and is measured relative to an estimate of the true production frontier which is known as the best practice frontier. when the value of θ is unity the bank operates on the efficient frontier and is therefore deemed efficient. data being pooled across 11 countries, selected on the basis that they are oic member states and have an established dual banking system. an “intermediation” approach is being utilized as there is an assumption that all banks will have a certain amount of regulated framework and all will have to utilize capital, assets and some form of liabilities to function. according to berger & humphrey (1997), this is the normal practice in vast majority of financial services industries. accordingly, we consider personnel expenses, fixed assets and deposits plus short term funding as inputs and total amount in loan disbursement and total earning assets as outputs. the estimated efficiency scores are then regressed against a set of regulatory, bank-specific and macro variables as explained in section 3.2. 3.2 regulation and bank performance the modelling framework adopted to estimate the relationship between regulation, efficiency, and risk is built on from the approaches suggested by pasiouras (2008), kwan and eisenbeis (1997), and altunbas et.al (2007). we specify a system of equations and estimate these using zellners’s (1962) seemingly unrelated regression (sur) approach. sur will allow for simultaneity between banks’ risk and efficiency with regulatory and supervisory structure while also controlling for other important environmental factors. it is believed that sur can overcome contemporaneous cross-equation error correlation. there are two main motivations for use of sur. the first one is to gain efficiency in estimation by combining information on different equations. the second motivation is to impose and test restrictions that involve parameters in different equations. the system of equations estimated is as follows: ineffij = α + bspowerj+ ccaprqj + dprmonitj + eactrsj + fnltaij + gtaij + hladij + ilatacj + joetacj + kllptacj + lgdpj + mllrij + yearj ……………… (2) llrij = α + bspowerj+ ccaprqj + dprmonitj + eactrsj + fnltaij + gtaij + hladij asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 225 + ilatacj + joetacj + kllptacj + lgdpj + m ineffij j + yearj ……………… (3) definitions of all variables are provided in appendix 1. equation 2 and 3 examine the impact of regulatory and supervisory structure on bank efficiency and risk taking behaviour. individual bank inefficiency (ineff) is the managerial technical inefficiency, which measures how far the bank is from the estimated efficient frontier (1θ). it is obtained as the distance of a bank’s observed technical efficiency from the estimated efficient frontier as explained in section 3.1. a number of bank-specific and country specific variables are also included that are believed to also explain the variation in bank risk and inefficiency across dual banking system. loan loss reserves as a fraction to total assets (llr) is used as measure of banking risk which is primarily used as measure of tier 2 capital. the treatment of loan loss reserves as capital has received considerable attention in the wake of the financial crisis (ng and roychowdhury, 2011). higher levels of reserves are suggestive of greater banking risk accounting for any future bad times. of course, this estimation as measure of riskiness can be questionable and backward looking but accounting ratio like this has been widely used across literature to assess bank appetite for risk. to account for basel ii and basel iii’s pillars on bank regulation and supervision we use the data from barth et.al (2001b, 2006, 2007b) world bank database. spower is a measure of the power of the supervisory agencies. it is calculated on the basis of the answers to 14 questions indicating the extent to which supervisors can change the internal organizational structure of the bank and/or take specific disciplinary action against bank management and directors, shareholders, and bank auditors. higher values of this variable indicate greater power of supervisory authorities to get involved in banking decisions. strong official supervision may signal efficient banking institutions, preventing managers from engaging in excessive risk-taking behaviours. caprq is an index of capital requirements, accounting for both initial and overall capital stringency. the former indicates whether the sources of funds counted as regulatory capital can include assets other than cash or government securities and borrowed funds, as well as whether the regulatory or supervisory authorities verify these sources. the latter indicates whether risk elements and value losses are considered while calculating the regulatory capital. caprq can take values between 0 and 8 with higher values indicating more stringent capital requirements. prmonit is an indicator of private monitoring that takes values between 0 and 8 with higher values indicating higher disclosure requirements and more incentives to increase private monitoring. barth et al. (2006, 2004a) provide evidence that regulations that enhances and facilitates private monitoring can significant boost bank efficiency. more recently, pasiouras (2008) shows that encouraging and facilitating private monitoring of banks can boost efficiency. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 226 actrs indicates the level of restrictions on banks’ activities. it can take values between 0 and 4 with higher values indicating higher restrictions. it is determined by considering whether securities, insurance, real estate activities, and ownership of non-financial firms is unrestricted (=1), permitted (=2), restricted (=3) or prohibited (=4). we construct an overall index by calculating the average value over all four activities. according to barth et al. (2001, 2003a,b), activity restrictions may have an important impact on bank efficiency by reducing competition and limiting economies of scope, which results in lower efficiency levels. for the explanatory variables we used a broad range of variables that are believed to be important in explaining the performance and risk taking propensity of banks. the bank-specific variables include net loans to total assets (nlta) as rapid loan growth may increase risk and impact adversely on bank efficiency in the long run. banks that are more liquid may be more efficient in the sense that all other things being equal, an efficient bank can produce more output part of which includes liquid and other assets so we account for this by using liquid assets to deposits ratio (lad). bank size, through economies of scale, may influence the relationship between risk and efficiency so we control for the assets size of banks (ta). big banks typically are more diversified and gain from other size advantages (hughes et.al, 2001) so it is important to control for this factor. generally, the effect of a growing size on efficiency has been proved to be positive to a certain extent (athanasoglou et al., 2008; fiordelisi and molyneux, 2010). finally, a range of country-specific banking variables are included to take account of broad banking system differences across the nations. these include indicators of country banking system liquidity measured by banking system liquid assets to total assets in country (latac), efficiency measured by banking system operating expenses to total assets in country (oepac) and risk measured by banking system loan-loss provisions to total loans in country (llptac). while these variables are similar to the bank-specific indicators they provide another aspect to the analysis in that they control for country differences in efficiency and risk. in other words they help to show if country-specific financial differences impact on bank-specific risk and efficiency. the average annual growth rate of per capita (gdp) is an environmental variable used to control for local economic conditions. a high level of per capita gdp captures the cyclical conditions of the macroeconomic environment. it is also expected to capture the implications for bank efficiency stemming from operating in different economic environment, as demand for financial products depends on the level of economic activity. empirical studies tend to find that countries with relatively high gdp growth are characterised by more efficient banking institutions (e.g., demirguc-kunt and maksimovic, 1998; schure et al., 2004; yildirim and philippatos, 2007). yearly dummy variables are included to control for time effects. 3.3 data the dataset used in this study is composed of conventional and islamic banks from eleven countries (egypt, bahrain, bangladesh, indonesia, kuwait, malaysia, pakistan, qatar, saudi arabia, turkey, and uae) having a dual banking system. they are sourced either from data collected by bankscope database or done by manually referring to the annual reports of these asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 227 banks for year 2006-2010. the reasoning for a 5 year data test is because it would yield a better dataset due to accuracy and also where the islamic banking system was newly established it would have had sufficient time to mature. the other reasoning to it is that it would also be able to monitor the overall performance during the recent financial crisis. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 228 table 1. sample description: number of banks and average asset size by country islamic banking (ib) country /year 2006 2007 2008 2009 2010 total by country avg. asset of all ib in 2010 (milln. usd) bahrain (12)* 13 15 17 17 17 79 2422 bangladesh (15) 3 3 3 3 3 15 709 egypt (19) 2 2 2 2 2 10 3854 indonesia (5.5) 3 3 4 4 4 18 1602 ksa (57) 2 2 3 3 3 13 19897 kuwait (35) 3 3 3 3 3 15 17960 malaysia (22.6) 10 12 16 16 16 70 5121 pakistan (6.4) 5 6 6 6 6 29 555 qatar (20) 3 3 3 3 3 15 9668 turkey (4.5) 4 4 4 4 4 20 6480 uae (18) 7 7 9 9 9 41 8458 total by year 55 60 70 70 70 320 conventional banking (cb) country /year 2006 2007 2008 2009 2010 total by country avg. asset of all cb in 2010 (milln. usd) bahrain 9 9 9 9 9 45 10410 bangladesh 25 25 25 26 26 127 1815 egypt 12 12 12 12 12 60 9832 indonesia 34 35 36 36 36 178 6897 ksa 8 8 8 8 8 40 31965 kuwait 6 6 6 6 6 30 18712 malaysia 13 13 13 13 13 65 35924 pakistan 16 16 16 16 16 80 4221 qatar 5 5 5 6 6 27 17369 turkey 21 21 21 21 21 105 21275 uae 11 12 12 12 12 59 24729 total by year 160 162 163 165 165 816 source: bankscope database and author calculation. * figure in parenthesis shows islamic banking asset as percentage of total banking asset 4. empirical results asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 229 the banks’ efficiency scores for both conventional and islamic banking are estimated relative to a common best practice frontier by pooling the data across countries. this approach allows for estimating efficiency differentials not only between banks within a country but across countries as well using the same benchmark technology. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 230 figure 1. technical efficiency scores by year and bank type figure 1 (a) illustrates the average dea efficiency scores by year and by bank type. overall the result shows that on an average technical efficiency of conventional banks have outperformed islamic banks efficiency except for year 2008 and 2009. this proves during the normal times conventional banks are able to achieve high level of technical efficiency than their islamic counterparts which can be due to the bigger size effect of conventional banks. one interesting observation is that conventional banks suffer a big setback during crisis time and were outdone by islamic banks. if we focus on country specific performance as presented in figure 1(b), saudi arabia achieved the highest level of efficiency in both banking system whereas bahrain performance was the worst. one plausible explanation of this result is that those countries (ksa & kuwait) which have high islamic banking assets as of total banking assets and less number of islamic banks are able to operate at better efficiency levels. this gives an insight that with lesser competition from similar type of banks yield higher efficiency level. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 231 figure 2. technical efficiency scores by country and bank type the next section of analysis deals with the impact of regulatory and supervisory structures on banks’ efficiency and risk taking behaviour. first we will regress dea inefficiency scores against bank regulatory and supervisory practices in the presence of bank specific variables and then next regression will use loan loss reserve (llr) as dependent variable with regulatory and supervisory practices as independent variables in presence of bank specific variables. the results of regression are reported in table 2 and 3. each table present output for overall sample, conventional bank and islamic bank sample. estimates from the inefficiency equation (equation 2) derived from the simultaneous estimation are reported in table 2. the inefficiency equation uses inefficiency estimates (ineffij) obtained from dea used in equation 1 as the dependent variable. the columns report the results obtained for three estimations of the system – for all banks, conventional banks and islamic banks in our sample. it can be observed from table 2 that spower has a statistically significant and negative impact on both overall sample and islamic banks but positive impact for conventional banks. in other words, higher supervisory power increases the technical efficiency of islamic banks but reduces the efficiency of conventional banks. it can be due to the fact that islamic banks apart from national banking laws are also governed by shariah laws which are keeping in check some undesired activities of islamic banks thus increasing their given efficiency level. conventional bank since facing some competition from islamic counterpart has shown decline in efficiency with strict supervisory power. our result for islamic banks is consistent with the findings of pasiouras (2008) for technical efficiency. thus, we find evidence to support the argument of the official supervision approach that powerful official supervision can improve the corporate governance of banks (stigler, 1971). this efficiency increases further if we have some inbuilt supervisory mechanism as embedded in islamic banking system. capitrq has a negative and statistically significant impact on inefficiency on both islamic and conventional banks. therefore, higher capital requirements increase the technical asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 232 efficiency of banks. this could be explained by a number of reasons. for instance, vanhoose (2007) mention that high capital requirements may result in lower levels of bad loans thus reducing the probability of financial distress, which also increases the importance of substitutes for other potentially higher earning activities such as investment activities. if we focus on prmonit variable we find negative impact on islamic bank inefficiency and direct impact on inefficiency of conventional banks. in other words higher the level of scrutiny by regulatory body islamic banks were able to operate at high efficiency level but not the case for conventional banks. this can be due to fact islamic banks incorporate both high corporate governance level as well shariah governance level which help them to reduce corruption and ambiguity in bank lending, and improve the functioning of islamic banks as true financial intermediaries. as fernandez and gonzalez (2005) mention, under this combined approach of higher spower and prmonit, a greater quality of information provided by a system that enhances private monitoring through accounting and auditing requirements might boost supervisors’ abilities to intervene in managerial decisions in the right way and at the right time. turning to our last regulatory variable, the positive and statistically significant impact of actrs on technical inefficiency indicates that lower restrictions result in higher operational efficiency. this is consistent with the view that less regulatory control allows banks to engage in various activities and operate under economies of scale. in other words, our results imply that when banks are restricted in offering a limited number of services, they can potentially acquire expertise and specialization in specific market segments and be more profit efficient. the result does not differentiate by type of banks. if we put our attention on other bank specific variables, the results for the full sample suggest that inefficient banks hold more loan loss reserves however results vary across types of banks. there appears to be positive relationship between loss reserve and efficiency for conventional banks, and an inverse relationship for islamic banks which signify that inefficient conventional bank takes on more risk than their islamic counterpart. this can be a useful result to prove that islamic banks suffer fewer damages and experienced no banking failures during the recent credit crunch of 2007-2008. further on we can observe that technical inefficiency is positively related to asset size whereas bank lending appears to be inversely related to inefficiency suggesting that efficient banks are more successful in expanding their loans business. evidence on the relationship between bank liquidity and inefficiency is mixed. inefficient islamic banks maintain higher liquidity level while inefficient conventional banks maintain lower level of liquidity which makes them more prone to bank runs. viewing the country-specific indicators, overall it seems that banking system liquidity and banking system operating cost are positively linked to inefficiency while loan loss provision is negatively related to inefficiency. however the relationship does not vary across two types of bank. in addition, gdp has a positive and statistically significant effect on technical efficiency for both types of banks. table 2. bank cost inefficiency ineffij as dependent variable asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 233 variables all banks conventional banks islamic banks spower -0.087* 0.013** -0.071** caprq -0.042** -0.078** -0.027* prmonit -0.142* 0.082* -0.108* actrs 0.032** 0.038** 0.028** llrij 0.057** 0. 162** -0.010** nltaij -0.073** -0.092** -0.052* taij 0.292** 0.028** 0.779** ladij 0.022** 0.008* -0.047** latacj 0.124** 0.108** 0.214** llptacj -0.713** -0.782** -0.662* oetacj 1.103** 1.207** 0.018** gdp　 0.318* 0.174* 0.292* observations 1136 816 320 r2 0.429 0.627 0.381 notes: * and ** indicate significance at the 5% and 1% levels, respectively. estimates from the risk equation (equation 3) derived from the simultaneous estimation are reported in table 3. the risk equation uses loan-loss reserves as fraction of total asset (llrij) as the dependent bank-risk variable. the columns report the results obtained for three estimations of the system – for all banks, conventional banks and islamic banks in our sample. it can be observed from table 3 that spower has negative impact on both islamic banks and conventional banks but the relationship is not significant which is in line with barth et.al (2004). with respect to caprq and prmonit we can establish statistically significant and negative relationship for both conventional banks and islamic banks. it can be interpreted in sense that higher the capital requirement and better the monitoring and scrutiny of banking sector lower will be risk taking behaviour of these banks. it can be owing to the fact that higher capital requirements may represent entry barriers for newcomers, which would restrict competition and allow existing banks to accumulate power, resulting in a more prudent and less-risky behaviour. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 234 in case of actrs we find significant and contrasting result for conventional and islamic banks. actrs has positive relationship with conventional banks which signifies that if regulators imposed restriction on banks activities conventional banks tend to embark on more risky venture. islamic banks shows a negative relationship with actrs which signifies that islamic banks takes on less risk even when their activities are restricted in the financial market. it can be explained in the sense that islamic banks with inherent shariah regulation and restrictions are able to avoid many risky ventures. if we focus on bank specific variables we observe that for the full sample there is a positive relationship between inefficiency and bank risks. banks with higher loan loss reserves tend to be inefficient. this is the case for conventional banks although it can be seen that there is an opposite relationship for islamic banks. the positive relationship for conventional banks can be due to the fact that inefficient conventional banks take on more risk to improve their performance over the long run. the negative relationship for islamic banks can be result of cost constraints impediment which restricts the ability of inefficient islamic banks to take on more risks. possibly, islamic banks are more reserve constrained and this may be the reason behind this result. the table also shows that net lending (nltaij) is negatively related to risk suggesting that loan growth is inseparably linked to loan loss reserve levels. bank asset size (taij) also seems to be important as large conventional banks appear to be more risky than their smaller islamic counterparts and islamic banks also seem to have a lower loan loss reserve level which is obvious since most of the islamic loans are backed by real assets. this can be also interpreted that there are potential diversification benefits associated with size as noted by altunbas et al. (2007). there also appears to be a mix relationship between liquidity and risk as conventional banks with higher liquidity levels have higher reserve levels while islamic banks have lower reserve associated with higher liquidity. this suggests that banks with higher liquidity levels take on more risks which confirm to the basel guidelines whereby banks are encourage being more liquid to cover the risks being taken. this result also confirms that islamic banks tend to be more liquid and less risky compared to conventional banks in the dual banking system. finally, the country specific banking sector variables also suggest that the level of liquidity (latacj) and loan loss provision (llptacj) in the respective country’s financial system are positively related to overall banking sector risks. in other words banking systems will take on more risks if they are more liquid and banks are provisioning for loan loss at a higher level. there do not appear to be major differences in the relationships across conventional banks and islamic banks. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 235 table 3. bank risks llrij as dependent variable variables all banks conventional banks islamic banks spower -0.056 -0.021 -0.054 caprq -0.040** -0.029** -0.071* prmonit -0.018* -0.036* -0.011* actrs -0.107** 0.041** -0.087** ineffij 0.009** 0.527** -0.016** nltaij -0.029** -0.012** -0.027** taij 0.054* 0.308* -0.023** ladij 0.042** 0.067* -0.071** latacj 0.052** 0.026** 0.071** llptacj 0.674** 1.210** 0.748** oetacj 0.941** 1.017** 0.015** gdp 0.276* 0..308* 0.163* observations 1136 816 320 r2 0.521 0.417 0.394 notes: * and ** indicate significance at the 5% and 1% levels, respectively. nevertheless, the main findings from table 2 and 3 prove that regulation and supervision are positively related for conventional banks’ technical inefficiency and negatively related for islamic banks’ technical inefficiency. in case of impact of regulatory and supervisory practices on bank risk taking we did not find any major differences between the two types of bank. 5. conclusions this paper extends the literature on bank efficiency and risk taking by providing for the first time empirical evidence on the association between risk and efficiency with regulation and supervisory approaches in the dual banking system. our sample consisted of a panel dataset of 1136 observations covering the period 2006-2010, from 165 conventional banks and 70 islamic banks operating in 11 countries which have distinction of “dual-banking system”. considering the conflicting theoretical views in the literature and on-going debate on the superiority of the two alternative banking systems in form of conventional and islamic banking system, we focused on regulations related to capital requirements, official supervisory power, market discipline, and restrictions on bank efficiency and risk taking behaviour. the efficiency scores used in our models are estimated using input-oriented dea methodology. we also consider risk measures calculated using traditional loan loss reserve ratio as requirement for tier 2 capital. our results indicated that islamic banks efficiency were positively influenced by regulations related to the second and third pillars of basel ii, namely higher supervisory power, and disclosures while conventional banks efficiency were negatively influenced. stricter regulations, related to the first pillar (i.e. capital requirements) had a positive impact on technical efficiency for both groups of banks. higher capital requirements also induce lower level of risk behaviour for both types of banks. we observed the opposite effect in the case of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 236 restrictions on bank activities, with higher restrictions having a negative influence on risk taking behaviour of conventional banks while reducing the level of riskiness of islamic banks. moreover, our findings on pillar 3 of basel ii, market discipline, indicate that excessive private monitoring and regulatory restrictions on bank activities can affect the efficient operation of banks. a message that emerges from this analysis is that there is a strong link between bank efficiency and bank regulatory and supervisory policies that obstructs private sector monitoring, bank activities. it is also conclusive that islamic banking system works well within stricter regulatory environment compared to their conventional counterpart. basel ii suggested that stricter regulations could hamper banking efficiency. the existence of a powerful supervisory body could also lead to inefficiency. dea scores from this paper suggest that this may not necessarily be the case especially where a country is a developing one and does not have a proper framework to control corruption. islamic banks appear to be efficient in difficult conditions where it does not have the traditional safeguards such as a fully function and trustworthy legal system. the efficiency of islamic banks where compared against its peers in the conventional side has not shown any advantages or disadvantages in regard to the system itself, many of the factors boiled down to the bank itself rather than anything else. usually it appeared that full-fledged islamic banks were not as efficient as those that are subsidiaries of larger conventional banks, this was definitely the case in malaysia and the gcc region. however it does appear that issues such as capital requirements and liquidity requirements had less of an impact on islamic banks than their conventional counterparts. on the basis of above assertions it will not be wrong to say that islamic banks are better equipped towards the implementation of basel iii guidelines. further areas of study should seek to investigate the consistency of our dual banking findings applied to a more representative and contemporary sample of both 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(2007). theories of bank behaviour under capital regulation. journal of banking and finance, 31, 3680-3697. http://dx.doi.org/10.1016/j.jbankfin.2007.01.015 yildirim, h.s., & g.c. philippatos, (2007). efficiency of banks: recent evidence from the transition economies of europe (1993-2000). european journal of finance,13, 123-143. http://dx.doi.org/10.1080/13518470600763687 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 242 appendix 1. information on regulatory, bank specific & country specific variables variable category description source/database regulatory variables spower supervisory power this variable is determined by adding 1 if the answer is yes and 0 otherwise, for each one of the following fourteen questions: (1) does the supervisory agency have the right to meet with external auditors to discuss their report without the approval of the bank? (2) are auditors required by law to communicate directly to the supervisory agency any presumed involvement of bank directors or senior managers in illicit activities, fraud, or insider abuse? (3) can supervisors take legal action against external auditors for negligence? (4) can the supervisory authorities force a bank to change its internal organizational structure? (5) are off-balance sheet items disclosed to supervisors? (6) can the supervisory agency order the bank's directors or management to constitute provisions to cover actual or potential losses? (7) can the supervisory agency suspend director’s decision to distribute dividends? (8) can the supervisory agency suspend director’s decision to distribute bonuses? (9) can the supervisory agency suspend director’s decision to distribute management fees? (10) can the supervisory agency supersede bank shareholder rights and declare bank insolvent? (11) does banking law allow supervisory agency or any other government agency (other than court) to suspend some or all ownership rights of a problem bank? (12) regarding bank restructuring and reorganization, can the supervisory agency or any other government agency (other than court) supersede shareholder rights? (13) regarding bank restructuring & reorganization, can supervisory agency or any other government agency (other than court) remove and replace management? (14) regarding bank restructuring & reorganization, can supervisory agency or any other government agency (other than court) remove and replace directors? wb (barth et al., 2001, 2004, 2006) caprq capital requirements this variable is determined by adding 1 if the answer is yes to questions 1-6 and 0 otherwise, while the opposite occurs in the case of questions 7 and 8 (i.e. yes=0, no =1). (1) is the minimum required capital asset ratio risk-weighted in line with basle guidelines? (2) does the ratio vary with market risk? (3-5) before minimum capital adequacy is determined, which of the following are deducted from the wb (barth et al., 2001, 2004, 2006) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 243 book value of capital: (a) market value of loan losses not realized in accounting books? (b) unrealized losses in securities portfolios? (c) unrealized foreign exchange losses? (6) are the sources of funds to be used as capital verified by the regulatory/supervisory authorities? (7) can the initial or subsequent injections of capital be done with assets other than cash or government securities? (8) can initial disbursement of capital be done with borrowed funds? prmonit private monitoring this variable is determined by adding 1 if the answer is yes to questions 1-6 and 0 otherwise, while the opposite occurs in the case of questions 7 and 8 (i.e. yes=0, no =1). (1) is subordinated debt allowable (or required) as part of capital? (2) are financial institutions required to produce consolidated accounts covering all bank and any non-bank financial subsidiaries? (3) are off-balance sheet items disclosed to public? (4) must banks disclose their risk management procedures to public? (5) are directors legally liable for erroneous/misleading information? (6) do regulations require credit ratings for commercial banks? (7) does accrued, though unpaid interest/principal enter the income statement while loan is non-performing? (8) is there an explicit deposit insurance protection system? wb (barth et al., 2001, 2004, 2006) actrs restrictions on banks activities the score for this variable is determined on the basis of the level of regulatory restrictiveness for bank participation in: (1) securities activities (2) insurance activities (3) real estate activities (4) bank ownership of non-financial firms. these activities can be unrestricted, permitted, restricted or prohibited that are assigned the values of 1, 2, 3 or 4 respectively. we use an overall index by calculating the average value over the four categories. wb (barth et al., 2001, 2004, 2006) bank specific variables ineffij technical inefficiency for bank i in country j dea analysis and author calculation llrij loan-loss reserves for bank i in country j bankscope and author calculation nltaij net loans to total assets for bank i in country j bankscope and author calculation taij total assets for bank i in country j bankscope and author calculation ladij liquid asset to short term deposit for bank i in country j bankscope and author calculation asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 244 yearj yearly dummy variables for 2006 to 2010 author country specific variables latacj banking system liquid assets to total assets in country j bankscope and author calculation oetacj banking system operating expenses to total assets in country j bankscope and author calculation llptacj banking system loan-loss provisions to total loans in country j bankscope and author calculation gdp real gdp growth imf asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 54 are larger self-managed superannuation funds riskier? peter j phillips school of accounting, economics and finance university of southern queensland west street, toowoomba, queensland, australia 4350 tel: 617 46 315490 email: peter.phillips@usq.edu.au abstract in this paper, we examine the relationship between the portfolio size and allocation to risky assets that characterises self managed superannuation funds (smsfs). in particular, we investigate whether the allocation to risky assets is higher for higher valued smsfs. at this early stage of smsf research the gathering of facts about these economic entities is necessary to guide policy makers and regulators. this study contributes to this small but growing body of factual knowledge regarding the microstructure of smsfs in australia. the results show that the percentage of the portfolios‟ investable funds allocated to risky assets has no clearly defined relationship with portfolio size. a high net worth smsf will, on average, have a greater absolute dollar amount invested in risky assets but the portfolio weightings may be such that a high valued fund has a lower percentage of its portfolio invested in risky assets than a much smaller fund. there is not a strong tendency for higher net worth smsfs to bear greater risk through increasing allocations to risky assets but there is, nevertheless, a tendency for higher net worth smsfs to have higher allocations to risky assets. keywords: self managed superannuation, net worth, risk jel classifications: g11, g23, g28 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 55 1. introduction self managed superannuation funds (smsfs) are retirement or pension savings funds that are managed by the owners or trustees of the funds. these are generally non-professional investors. since a smsf is a retirement fund for five or fewer members, each smsf represents the savings of a small group of family or friends. the self-managed nature of these entities raises many important economic questions. the question that is investigated in this paper is: do higher valued smsfs have higher allocations to risky assets? this is an important question that cannot be answered by referring to the australian taxation office‟s aggregated smsf data. of course, it should be expected that smsf trustees will allocate their investable funds between low risk assets such as cash and fixed interest securities and risky assets such as shares in a manner that reflects their level of risk aversion. in this case, the portfolio‟s size should not be a factor in determining the percentage of the portfolio‟s investable funds that will be allocated to risky assets. a high value fund may just as likely be allocated almost entirely to cash as a low value fund. the only way to empirically investigate the relationship between smsf net worth and allocation to risky assets is by investigating the portfolio structures of individual smsfs. we investigate this relationship using a unique and pure dataset consisting of two independent samples of a total of 141 smsfs. the implications of the research question are significant. the value of savings contained in self managed superannuation funds is approximately $300 billion. compulsory contributions to superannuation increase this by a considerable amount each year. whilst there is no intention to draw conclusions for the general population of smsfs on the basis of the funds contained in this sample, this investigation provides some of the first pieces of information regarding the relationship between fund size and allocation to risky assets. this is important for the policy makers and regulators who are charged with the responsibility of overseeing the management of smsfs. in addition, preliminary studies of this sort provide the foundations for further economic analysis of the self managed superannuation phenomenon and its implications for australia‟s retirement income stream. in this paper, the relationship between smsf net worth and allocation to risky assets is explored. two independent samples of smsfs are available for this study—one consisting of 100 portfolios and one consisting of 41 portfolios. in the context of smsf research this sample size is quite significant and the independent nature of the two samples adds a degree of rigour to the investigation. in order to examine the relationship between net worth and allocations to risky assets, the funds in each sample are separated into various categories of net worth. the allocations to risky assets that characterise the funds in each category were determined. on the basis of the raw data alone, it is clear that there is no discernible relationship between smsf portfolio size or net worth and the percentage of the portfolio allocated to risky assets. this is confirmed by a basic statistical (chi-square) test, which reveals that the variables are independent. on the basis of the results, the funds in the sample asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 56 do not show any tendency to become riskier as their net worth increases. rather, the smsfs in the highest net worth category are characterised by lower allocations to risky assets than other lower net worth fund categories. viewed from another aspect, this investigation also makes another contribution. concerns have been raised about the large allocation to cash that characterises smsfs (see phillips, cathcart and teale (2007)). cash in bank accounts and term deposits—and, to a lesser extent, fixed interest securities—generates a very low rate of return and may be vulnerable to erosion by inflation over long time periods. again, the australian taxation office publishes aggregated data that provides an indication of the percentage of the portfolio that the average smsf trustee allocates to cash. on average, the smsfs in our sample allocate a larger percentage of their portfolios to cash assets than the ato‟s aggregate. furthermore, a number of the funds have very large allocations to cash. whilst the risk that characterises smsfs may be of interest to policy makers and regulators, the cash allocations may be viewed with equal importance. in the long run, the terminal values of smsfs may be just as a adversely affected by excess volatility as the low real returns associated with holding a large percentage of the portfolios in cash. this paper is organised as follows. in section 2 some of the relevant economic theory is presented. this focuses on the theoretical importance of utility function configuration in economics. the literature survey highlights the absence from the literature of investigations into the relationship between smsf net worth and allocations to risky assets. the research and the methodology deployed herein is linked to seminal work on investor utility of wealth functions produced during the 1970s, especially the empirical investigations undertaken by blume and friend (1975). in section 3, the data are described. the data consist of two independent sub-samples comprising a total of 141 self managed superannuation funds. in section 4, the analysis of the data is presented. this involves a cross-classification analysis (using a chi-square test statistic) to examine the relationship between smsf net worth and allocations to risky assets exhibited by the self managed superannuation funds in the sample. in section 5, the implications of the results are discussed. this is followed in section 6 by conclusions and suggestions for future research. 2. background and existing studies there exists a body of economic theory that provides some insights into the relationship between net worth and allocation to risky assets. depending on the type of risk aversion an individual exhibits, that individual will have different preferences for risky assets as his or her wealth changes. there are two ways in which the individual‟s preferences for risky assets may be described: (1) absolutely; or (2) relatively. individuals may exhibit increasing, constant or decreasing absolute risk aversion. just which will decide the amount of dollars they hold in risky assets as their wealth changes. with regard to relative risk aversion, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 57 individuals may exhibit increasing, constant or decreasing relative risk aversion. just which of these will decide the percentage of their wealth they invest in risky assets as their wealth changes. an individual who exhibits increasing, decreasing or constant relative risk aversion will hold a lesser, greater or unchanged percentage of his or her wealth in risky assets as his or her wealth increases 1 . formally, the arrow-pratt measures of absolute and relative risk aversion are measures of how the investor‟s absolute and relative risk aversion behaves with respect to changes in the investor‟s wealth. these measures, which were derived by pratt (1964) independently of kenneth arrow‟s similar efforts, hold a place of some prominence in the literature: )( )( )( wu wu wra (1) )( )( )( wu wu wwrr (2) where )(wra is the arrow-pratt measure of absolute risk aversion and )(wrr is the arrow-pratt measure of relative risk aversion. these measures have a very desirable property. the numerical estimates of equation (1) and equation (2) do not depend upon the units in which the utility is measured. this is a significant advance over the naïve measure of risk aversion computed simply by taking the second derivative of the utility of wealth function, ).(wu the first derivative of )(wra with respect to wealth, )(wra , will be positive, zero or negative depending on whether the investor exhibits increasing, constant or decreasing absolute risk aversion or, equivalently, if the investor holds fewer, the same or more dollars in risky assets as wealth increases. the first derivative of )(wrr , )(wrr , will be positive, zero or negative depending on whether the investor exhibits increasing, constant or decreasing relative risk aversion or, equivalently, if the investor holds a lower, unchanged or higher percentage of wealth in risky assets as wealth increases. importantly, the arrow-pratt 1 further discussion can be found in texts on portfolio theory and is therefore omitted from the present article. see elton et al. (2003). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 58 measures of absolute and relative risk aversion show that risk aversion may vary as wealth changes. hence, as additional savings are added to self managed superannuation funds and the fund advances (or declines) due to the returns generated by the constituent assets, the trustee‟s risk aversion may vary. there are both theoretical and empirical investigations extant in the literature that are relevant to the present investigation. theoretical investigations derive mathematically the various relationships that exist between risk aversion, wealth and the demand for risky assets (see tobin (1958), pratt (1964) and cass and stiglitz (1972)). these have played a fundamental role in the development of various branches of financial economics, including asset pricing and the determination of the market price of risk (see landskroner (1977)). empirical investigations, which are relatively few and far between, into the type of relative risk aversion that characterises individuals, have generally been conducted using data on households‟ assets. a large number of investigations into the risk aversion of individuals have also been undertaken through economics experiments and psychological questionnaires (see, for example, donkers, melenberg and van soest (2001)). however, these studies are often discounted because it is impossible to design experiments or questionnaires involving significant monetary stakes (campbell, 2003, p.53). the first major empirical investigation into the nature of household‟s utility of wealth functions was undertaken by friend and blume (1975). using data from the 1962 and 1963 federal reserve board surveys, these researchers concluded that the assumption of constant relative risk aversion is a “… fairly accurate description of the market place.” in order to arrive at this conclusion, the authors derived a number of equilibrium expressions that were compatible with the federal reserve board‟s cross-sectional data. of particular interest is the following relationship: kkm fm k ct rre )1( 1)( 2 (3) where mr is the return on the market portfolio of all risky assets, fr is the return on the risk-free asset, m 2 is the variance on the market portfolio, kt is the average rate of tax for investor k and kc is the arrow-pratt measure of relative risk aversion. if this relationship holds and if investors agree on the market price of risk then, by simple algebraic manipulation of the equation (3) an estimate of kmfm crre 12 ]/)([ is given by asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 59 )1( kk t . according to friend and blume (1975, p.908), this means that “ )1( kk t provides an estimate of kc 1 up to a multiplicative constant, so that )1( kk t can be used to assess how kc 1 and, thereby, how kc varies with net worth.” the empirical results generated by friend and blume (1975) indicated that )1( kk t was invariant to net wealth, leading them to conclude that relative risk aversion was constant. in a study produced a short time later, the same authors (marshall blume and irwin friend) again concluded that households exhibit constant relative risk aversion. blume and friend (1975) 2 , using data from income tax returns filed during 1971 as well as the federal reserve board‟s 1962 survey, again examined the utility of wealth functions of american households. this time, however, the authors deployed slightly different assumptions in their work. the authors‟ first study was based upon the assumption that investors have homogenous expectations. suspecting the possibility that heterogeneous expectations may have interfered with the conclusions of their previous investigation, blume and friend (1975) used a sample more plausibly characterised by homogenous expectations (blume and friend, 1975, p.602). as mentioned above, the conclusion of constant relative risk aversion generated in the earlier paper was supported. the other empirical study into the nature of individuals‟ relative risk aversion that is of particular note is cohn, lewellen, lease and schlarbaum (1975). these authors used data obtained from a survey of customers of a large nation-wide brokerage house (in the united states). their methodology differs markedly from that of friend and blume. specifically, where the friend and blume studies are based upon the derivation of various theoretical relationships between household wealth and utility functions, cohn et al. (1975) explored only the empirical relationship between household wealth and investment in risky assets. cohn et al. (1975) found that, as wealth increases, the proportion of wealth invested in risky assets also increased. that is, higher net worth households invested a larger percentage of their wealth in risky assets than lower net worth households. cohn et al. (1975), therefore, generated evidence in favour of a decreasing relative risk aversion assumption (in contrast to blume and friend‟s constant relative risk aversion conclusion). the empirical studies discussed above are the seminal investigations into the nature of household risk aversion and retain a place of prominence in the literature. in some ways, the work presented in this paper resembles these studies. in particular, the methodology deployed herein is essentially the same as that deployed by cohn et al. (1975). however, whereas these studies focussed on the risk aversion of investors in the american economy, we are interested 2 the study just discussed was friend and blume (1975). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 60 in investigating the relationship between smsf net worth and allocations to risky assets. in this paper, we take some small steps towards a more complete understanding of microeconomic characteristics of smsfs by examining the relationship between smsf net worth and allocations to risky assets exhibited by a sample of australian smsf trustees. our objective is not to examine risk aversion but determine whether there is a tendency for larger smsfs to hold a greater percentage of risky assets than smaller smsfs. the data used in this paper are discussed in the next section. 3. the data in order to complement the existing studies and take some steps towards a more complete understanding of self managed superannuation funds, some unique and pure smsf data was gathered. the data gathered for this investigation consists of two independent samples of smsf portfolio microstructures. 100 of the smsf microstructures were obtained from a large financial planning and superannuation administration firm based in one of australia‟s capital cities. the other 41 smsf microstructures were obtained from an accounting and financial services firm based in one of australia‟s regional centres. the 100 smsfs whose portfolio structures constitute the first part of the sample were drawn more or less at random from the total number of smsfs administered by the financial planning and superannuation administration firm. the other 41 smsfs represent a complete sub-population of just over 100 smsfs overseen by the accounting and financial services firm. these 41 smsfs are those funds overseen by the accounting and financial service firm that contain a mixture of assets directly managed by the trustees and are not „shells‟ established merely to hold particular assets such as commercial property. the data contained in this sample has several desirable properties: (1) a self managed superannuation fund cannot have liabilities (except under some very limited conditions). hence, the net worth of the smsf is unambiguous and we do not need to consider the effects of leverage on the portfolio returns. essentially, the net worth of the fund is equal to the size of the fund‟s portfolio; (2) because the smsfs in this sample have been subjected to annual audits, the data should exhibit a high degree of accuracy; (3) the data is self-contained and there is no need to rely on surveys or questionnaires of investors; and (4) unlike household balance sheet studies or investigations into the demand for risky assets, the smsf data is isolated from and uncomplicated by insurance issues. simply, the limitations of survey-based data such as that analysed by friend and blume (1975) 3 in their analysis of the demand for risky assets and the risk aversion of american households are mitigated quite substantially. there is nothing unique or special about the smsfs in the sample that would lead to a conclusion that the smsfs are not representative of the broader population of self managed 3 also see blume and friend (1975). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 61 superannuation funds in australia. given the difficulty in obtaining smsf data, the sample is quite significant and exceeds by three-to-one the sample of smsfs gathered by phillips, cathcart and teale (2007). furthermore, the fact that the overall sample consists of two independent samples of portfolios from independent sources and geographical locations adds a large degree of substance to the investigation. essentially, concerns that may be held about the idiosyncrasies of any particular individual sample of smsfs are eased. it should also be noted that the 100 smsfs that constitute the first part of the sample have benefited from professional administration whilst the 41 smsfs that constitute the second part of the sample have not. although both samples‟ trustees may have benefited from advice in choosing investments (as clients do for example upon calling a stock broker), the trustees remain responsible for their self managed superannuation fund. all of the smsf portfolios contained in the sample are reasonably large portfolios containing an asset mix of cash, fixed interest securities, managed funds and domestic and overseas shares. some of the funds contain real assets such as real estate. bearing in mind that each smsf represents the retirement savings of a small group of people up to a maximum of five members, the portfolios are quite large. the average size of each of the 100 portfolios in the first part of the sample was $796611 at june 30 2007. the largest portfolios have a value of just over $4 million whilst the smallest portfolios have a value of just under $200 000. most of the smsfs were formed sometime over the last five to fifteen years but a few of the funds were initiated more than twenty years ago. the average size of the 41 portfolios in the second part of the sample was approximately $400 000 at june 30 2004. most of the smsfs were formed sometime over the last ten years. taken together, the data available for this investigation consists of 141 smsfs with an average size of approximately a half-million dollars. this is a substantial sample in the context of smsf research. the samples are summarised in table 1 below. table 1. self managed superannuation funds: summary of portfolio structure asset class mean % (100 portfolios) mean % (41 portfolios) cash 11 22 fixed interest 13 2 listed shares 40 47 unlisted shares 5 < 1 overseas listed shares 1 < 1 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 62 overseas unlisted shares 2 0 managed investments 10 5 listed unit trusts 4 14 unlisted unit trusts 12 0 real estate 2 10 total 100 100 notes: the asset categories are self-explanatory. for the „41 portfolios‟ there was no distinction made between listed and unlisted unit trusts in the portfolio structure summaries obtained for this research. all unit trusts were simply classified as „listed unit trusts‟. hence, it could very well be the case that the allocation between listed and unlisted unit trusts diverges less between the two parts of the sample than the figures in the table appear to show. a simple comparison of the two samples reveals some interesting results. apart from one or two of the asset categories, the average allocations appear to be quite similar. this is quite reassuring. because the samples are independent, the similarity of the asset allocations provides us with a greater degree of confidence in the results of the analysis. upon close inspection it is apparent that the sample of 41 smsfs tend to allocate a far larger amount to cash than most financial advisors would recommend (except for the most conservative of investment strategies which, of course, would also contain a far lower allocation to shares than the smsfs exhibit). the trustees of the 41 smsfs appear to lack awareness regarding the importance of fixed interest investments. whilst such investments are very low risk, the yield is usually much more than that which could be obtained from holding cash in bank accounts. developing such awareness in clients is one benefit likely to accrue to smsf trustees who seek financial advice. of course, many of the other benefits of financial advice are not apparent from the summary data presented in table 1. for example, the diversification of the shares component is of vital importance (see phillips, cathcart and teale (2007)). 4. the analysis a risk free asset is one for which the standard deviation of the possible divergence of actual returns from expected returns is zero. for the purposes of this investigation, cash is the risk free asset (leaving aside considerations of inflation risk (see cohn et al. 1975)). all other assets, which have positive standard deviation of returns, are risky 4 . before proceeding to the formal statistical analysis of the relationship between smsf portfolio size and allocation to 4 the risk varies, of course. some securities are more risky than others but this is not a salient point for the purposes of this investigation. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 63 risky assets, much can be learned about this relationship through the informal method of analysing data-plots or charts. of course, the value of this particular activity lies in the light that it can shed on the characteristics of the smsfs in the samples. not only does an analysis of a small number of data-plots provide contextual completeness for the investigation, it also provides some important insights into the operation of individual smsfs that cannot be obtained through an analysis of the aggregated data such as that which is available from the australian taxation office. for the 100-portfolio sample, figure one below presents a chart of the total fund size for each portfolio. this may be compared with the data presented in figure two, which shows the percentage invested in cash for each portfolio in the 100-portfolio sample. an inspection of figures one and two does not reveal any obvious relationship between fund size and allocations to cash. the larger portfolios appear, from what must be a very cursory inspection at this stage, to be just as likely to exhibit low allocations to cash as they are to exhibit high allocations to cash. indeed, the largest fund in the sample exhibits among the highest allocations to the risk free security (30 percent) whilst one of the smallest funds in the sample exhibits the lowest allocation to the risk free security (0 percent). the percentage allocations to the risk free securities appear to reveal no structure or pattern across the funds in the 100-portfolio sample. this tends to indicate that we should expect to find that the riskiness of the smsfs is independent of the size of the smsf. however, it is necessary to undertake formal statistical analysis in order to determine in a rigorous manner whether any such relationship exists. figure 1. fund size: 100-portfolio sample asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 64 figure 2. percentage allocations to cash: 100 portfolio sample to analyse the relationship between smsf portfolio size and allocation to risky assets, we must determine the percentage of the smsf portfolios‟ investable funds are allocated to cash in various categories of fund sizes. this provides the basis for the formal, cross-classification analysis. because the portfolios contained in the two sub-samples diverge quite significantly in average size, each sub-sample is analysed separately. to extract the appropriate information required for statistical testing, the portfolios in the 100-portfolio sub-sample were divided according to net worth into five groups: $0 to $500,000; $500,000 to $1,000,000; $1,000,000 to $1,500,000; $1,500,000 to $2,000,000; and $2,000,000 +. the portfolios in the 41-portfolio sub-sample were also divided according to net worth into five groups: $0 to $100,000; $100,000 to $200,000; $200,000 to $300,000; $300,000 to $400,000; and $400,000 +. the percentage of each portfolio devoted to risky assets and the number of dollars devoted to risky assets was then computed. the computations, which form the basis for the statistical tests, are presented in the tables below. table 2. ratios of risky assets to total portfolio net worth net worth (100 portfolios) % invested in risky assets net worth (41 portfolios) % invested in risky assets $0 to $500,000 87.88% $0 to $100,000 92.3% $500,000 to $1,000,000 90.58% $100,000 to $200,000 80.6% $1,000,000 to $1,500,000 96.09% $200,000 to $300,000 91.2% $1,500,000 to 98.33% $300,000 to 73.6% asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 65 $2,000,000 $400,000 $2,000,000 + 88.22% $400,000 + 69.7% table 3. average dollars invested in risky assets net worth (100 portfolios) $ invested in risky assets net worth (41 portfolios) $ invested in risky assets $0 to $500,000 $260,289 $0 to $100,000 $55,574 $500,000 to $1,000,000 $623,325 $100,00 to $200,000 $154,873 $1,000,000 to $1,500,000 $1,185,128 $200,000 to $300,000 $221,337 $1,500,000 to $2,000,000 $1,645,347 $300,000 to $400,000 $241,491 $2,000,000 + $2,205,564 $400,000 + $443,540 casual investigation of the data presented in tables 2 and 3 suggests two things. first, the proportion of total portfolio net worth invested in risky assets does not appear to exhibit a stable relationship with total portfolio net worth. those smsf trustees with a portfolio net worth in the third bracket of our cut-offs, $1,000,000 to $1,500,000 and $200,000 to $300,000, invested a higher percentage of total portfolio net worth in risky assets than those smsf trustees whose portfolio net worth was located in the second bracket of our cut-offs, $500,000 to $1,000,000 and $100,000 to $200,000. however, the smsfs in the highest net worth category invested a lower amount in risky assets than funds in some of the lower net worth categories. second, in both sub-samples the dollars invested in risky assets increases as portfolio net worth increases. this is a consistent pattern across the entire range of portfolio net worth categories and both sub-samples but is not particularly surprising. it is, after all, to be expected that a very large portfolio may have a larger dollar amount invested in all asset classes than a very small portfolio. in order to investigate the relatedness of the proportion of total portfolio net worth invested in risky assets and total portfolio net worth, a cross-classification analysis is undertaken. a cross-classification, cross-tabulation or contingency analysis is a non-parametric asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 66 methodology that permits the investigation of the relationship between variables when one or both of the variables is categorical in nature with a nominal or ordinal scale (see, for example, sheskin (2000)). a cross-classification analysis is a simple statistical technique with few underlying assumptions 5 that permits the detection a relationship or association between two variables. it is particularly well suited to this investigation because there is a strong likelihood that the variables are non-normally distributed (see smith (1975)). indeed, when regression analysis is attempted, it quickly becomes clear that the variables (portfolio size and percentage allocations to particular asset classes) are not normally distributed. a non-parametric methodology is therefore desirable. the cross-classification analysis undertaken here is essentially the same as the test deployed by cohn et al. (1975) and therefore has a history of being utilised in this sort of investigation. to undertake a cross-classification analysis, the data must be tabulated in contingency tables. in the table below, the table‟s variables are (1) categories of portfolio net worth; and (2) percentage invested in risky assets. each cell of a contingency table represents a unique combination of the variables. for example, the first cell in table 4 (below) represents portfolios with a net worth of between $0 and $100,000 and 0% to 40% invested in risky assets. the contingency tables are frequency tables in the sense that each cell of the table represents the frequency of observations associated with that combination of variables. the analysis of these frequencies permits the identification of the presence or absence of a relationship between the two variables. the relevant test statistic is pearson‟s chi-square statistic. table 4. percentage of portfolio in risky assets vs portfolio net worth (cross-classification analysis) portfolio net worth (41 portfolios) 0% to 40% invested in risky assets 40% to 60% invested in risky assets 60% to 75% invested in risky assets 75% to 100% invested in risky assets total $0 to $100,000 0.00 0.00 0.00 1.00 1.00 $100,000 to $200,000 0.1428 0.00 0.00 0.8571 1.00 $200,000 to $300,000 0.00 0.00 0.00 1.00 1.00 $300,000 to $400,000 0.1428 0.00 0.2857 0.5715 1.00 5 these are simply the assumptions underlying the chi-square test because, in essence, that is what a cross-classification is. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 67 $400,000 + 0.1764 0.1764 0.1764 0.4708 1.00 table 5. percentage of portfolio in risky assets vs portfolio net worth (cross-classification analysis) portfolio net worth (100 portfolios) 0% to 40% invested in risky assets 40% to 60% invested in risky assets 60% to 75% invested in risky assets 75% to 100% invested in risky assets total $0 to $500,000 0.00 0.04166 0.04166 0.9166 1.00 $500,000 to $1,000,000 0.0344 0.0344 0.00 0.9310 1.00 $1,000,000 to $1,500,000 0.00 0.00 0.00 1.00 1.00 $1,500,000 to $2,000,000 0.00 0.00 0.00 1.00 1.00 $2,000,000 + 0.00 0.00 0.2222 0.7777 1.00 in tables 4 and 5, the data are tabulated according to portfolio net worth (rows) and proportions of total portfolio net worth invested in risky assets (columns). tables 4 and 5 show the percentage of smsfs at different portfolio net worth levels that have certain proportions invested in risky assets. for example, the figure 0.1428 in row 3, column 2 of table 4 means that 14.28% of the self managed superannuation funds in the 41-portfolio sub-sample with a net worth of $100,000 to $200,000 had between 0% and 40% of total portfolio net worth invested in risky assets. whilst the data are presented here as percentages of the self managed superannuation funds that held particular percentages of their net worth in risky assets, the data were also arranged in contingency tables displaying the absolute number of funds with particular percentages of their net worth invested in risky assets. the analysis of the absolute values yielded the same statistical results as the analysis of the contingency tables above. in order to assess the statistical significance of the relationship between the variables, a chi-square )( 2 test of the cross-classifications was undertaken. as mentioned previously, this type of statistical analysis is particularly well suited to this investigation because there is a asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 68 strong likelihood that the variables are non-normally distributed. furthermore, this methodology has been deployed in well-known studies that have a similar theme to the present investigation. formally, the chi-square statistic is used to test whether the allocations (dollars and percentages) to risky assets and total portfolio net worth are statistically independent. chi-square permits testing of the following type of hypothesis: the percentage of total portfolio net worth invested in risky assets is associated with the total net worth of the portfolio. as a distribution-free test, chi-square is appropriate for the type of data contained in the cross-classification tables. the results are presented in table 6 below: table 6. results of the analysis: chi-square test statistics sub-sample 2 asymptotic significance (2 sided) 100-portfolios (percentage of risky assets) 0.3785 0.464 40-portfolios (percentage of risky assets) 0.3705 0.451 in table 6, the pearson chi-square ( 2 ) tests the hypothesis for each sub-sample: that total portfolio net worth and the percentage of net worth invested in risky assets are independent. the lower the significance level, the less likely it is that the two variables are unrelated. for both sub-samples, the chi-square statistics relevant to the first hypothesis, 0.3785 and 0.3705 for each sub-sample respectively, are not significant. this leads to the conclusion that total portfolio net worth and the percentage of net worth invested in risky assets are not dependent. the fact that these results are the same for both of the independent sub-samples means that we can have a reasonable degree of confidence in the soundness of the analysis and rigour of the outcomes. the conclusions that may be drawn from this analysis can be stated as follows. the statistical analysis revealed the independence of total portfolio net worth and the percentage of net worth invested in risky assets. there is no tendency for either larger (smaller) portfolios to be riskier than smaller (larger) portfolios. 5. discussion of results the smsf portfolio data obtained for this study presented a unique opportunity to contribute to the fledgling research programme that investigates the economic characteristics of smsfs. in the analysis presented above, the relationship between portfolio size and allocations to risky assets exhibited by two independent sub-samples of australian smsfs was examined. using a non-parametric cross-classification analysis with a chi-square test statistic, it was concluded that the portfolios being considered in this study exhibited no discernible relationship between portfolio size and allocations to risky assets. that is, the percentage of asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 69 total portfolio net worth allocated to risky investments did not change in any consistent way—positively or negatively—as total portfolio net worth changed. interestingly, some of the highest valued smsf portfolios in the sample exhibited lower allocations to risky assets (or, to put it differently, higher allocations to cash) than funds with a much lower net worth. this is to be expected if smsf trustees form their portfolio strategies on the basis of their risk aversion (and their other economic vital statistics) and is comforting to the extent that there does not appear to be a tendency for the smsfs to become more speculative either when they are in their early stages of development (and have a low net worth) or when they are in a more advanced state (and have a high net worth). this result implies that, at least within the smsfs in the sample, there is no tendency for the trustees to take on more risks as the value of their portfolios increases. whilst the absolute dollar value of funds invested in risky assets increases as the funds increase in size, the relative (percentage) allocations exhibit no particular relationship with net worth. for the funds in the 100-portfolio sample, there is a tendency for the weighting of risky assets to increase as the portfolios increase in size. however, the trend is interrupted by the much lower allocation to risky assets exhibited by funds in the largest size category. these funds exhibit only slightly higher allocations to risky assets than the funds in the lowest size category. similarly, for funds in the 41-portfolio sample, there is actually a trend towards decreasing allocations to risky assets as the fund size increases. however, this „trend‟ is also interrupted by the higher allocations to risky assets exhibited by funds in the middle size category. the results certainly suggest that there is no consistent relationship between fund size and allocations to risky assets. as mentioned earlier, when viewed from another aspect, this investigation provides important insights into another characteristic of smsf portfolio structure: cash allocations. the high proportion of their portfolios that smsf trustees allocate to cash has been noted (phillips, cathcart and teale 2007). the data presented in table 1 (above) indicate that smsf trustees in the sample allocated between 11 and 22 percent of their portfolios to cash. this is consistent with the most conservative investment strategies. once more, however, close inspection of individual smsf portfolio microstructures is the only way to shed more light on the behaviour of individual smsf trustees. the actual cash allocations—not averages—of the funds in the 100-portfolio sample are presented in figures 3 and below, which display the dollar allocations and percentage allocations respectively. these have been ordered (lowest to highest) to permit easier inspection of the data. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 70 3. smsf dollar allocations to cash: 100-portfolio sample figure 4. smsf percentage allocations to cash: 100-portfolio sample it is clear from the data presented in figures 3 and 4 that, whilst the average cash allocation for these funds is 11 percent, a number of funds exhibit much higher allocations. some of these allocations may be explained as temporary cash allocations of newly established smsfs. this is the case for fund 80 (see figure 3). however, funds 84 and 91 (figure 3) have been long established, as have all of the other funds with 20+ percent allocations to cash. when the funds are examined individually, marked deviations from the averages presented in aggregated data emerge. at least 10 to 15 percent of the funds in the 100-portfolio sample have extremely high cash allocations. investments in fixed income securities are far from risk-free and were considered to be risky assets for the purposes of the analysis presented previously. the allocations to both cash and fixed income securities within smsfs are important pieces of information for economists and policy-makers to be aware of. the allocations to fixed income securities for each of the funds in the 100-portfolio sample are presented in figure 5. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 71 figure 5 . smsf dollar allocations to fixed income: 100-portfolio sample the average investment in fixed income securities is 13 percent but the percentage investments can be quite considerable when the smsfs are examined individually rather than in aggregate. for many of the smsfs in this part of the sample, an allocation of more than 20 percent of investable funds to fixed income securities is clearly evident from the data presented in figure 6. figure 6. smsf percentage allocations to fixed income: 100-portfolio sample in order to complete the analysis of the relationship between fund size and allocations to risky assets, it is certainly worthwhile considering the relationship between fund size and allocations to cash, risky assets and fixed income securities with the additional power that may attend the deployment of regression analysis. to this end, three log-linear regressions were undertaken. formally, in each of three cases, the log-linear regression equation that is analysed herein (with the data transformed by natural logarithms) is presented below. ordinary least squares is used to estimate the regression equation: iii uxy 121 lnln (4) asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 72 where the dependent variable yi is the percentage allocation to (1) fixed income securities of smsf i; (2) cash of smsf i; and (3) risky assets of smsf i, respectively, and the independent variable x1i is the size of fund of the i th smsf. the results of the regression estimations are presented below: regression analysis: fixed income securities and fund size 067.0r057.0r 65.262.1 )144.0()91.1( ln3834.010.3ˆln 22 1 t xy ii (5) regression analysis: cash and fund size 028.0r01814.0r 682.1286.0 )1541.0()04.2( ln2593.05850.0ˆln 22 1 t xy ii (6) regression analysis: risky assets and fund size 0245.0r0145.0r 5697.193.1 )0607.0()8042.0( ln09533.055.1ˆln 22 1 t xy ii (7) the numbers in the parentheses are the ols standard errors. the ratio of the explained sum of squares to the total sum of squares is very low for each of three regressions. the anova statistics reveal that, in each regression, the regression only explains a very insignificant amount of the variation in the dependent variable (the natural logarithm of the smsf size). despite the low explanatory power, the coefficients for the independent variables are asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 73 significant at the 0.05 or 0.10 levels. with approximately normally distributed residuals and no distinct patterns in the plot of the residuals, the regressions are fundamentally sound and the results should be reasonably robust. the results imply that there is a tendency for smsf trustees to decrease the allocation to fixed income securities and cash as their smsf increases in size. and there is a tendency for smsf trustees to increase the allocation to risky securities as their smsf increases in size. this very elementary piece of regression analysis complements the robust results produced earlier using the non-parametric cross-classification analysis and provides additional statistical insights into the asset allocation of smsfs. both small and large smsfs are likely to exhibit high allocations to cash (and fixed income securities). as mentioned previously, high cash allocations of 10 to 20 percent are associated with a conservative or moderately conservative investment strategy. however, within the portfolios themselves, a conservative investment strategy is not consistently applied. a conservative investment strategy, whilst calling for cash allocations of 10 to 20 percent, would only be consistent with an equity portfolio amounting to approximately 10 to 20 percent of the overall portfolio. almost half of the investable funds of the average smsf portfolio are allocated to australian shares. for example, fund 14 has an over 50 percent cash allocation. it also has 37 percent allocated to australian shares. likewise, fund 42 has a 47 percent allocation to cash and a 40 percent allocation to australian shares. this is a pattern that characterises many of the funds in the sample and indicates a potential problem with the formulation of the investment strategy. all funds are required by law to have an investment strategy outlining the objectives of the fund and the asset classes in which it may invest. high cash allocations combined with high allocations to australian shares may be the result of poor investment strategy construction. all investment strategy documents contain some flexibility regarding the asset class weightings. it would seem that the smsfs have very flexible or broadly defined weightings schedules. this does allow smsf trustees a certain freedom in designing a portfolio that they feel is consistent with their expectations and risk aversion but may result in a lack of structure within the portfolio. this can be compounded if inexperienced trustees, far from taking advantage of the flexibility associated with broadly defined weightings schedules to design portfolios well-suited to personal and market conditions, design portfolios with random structures. the investment strategies of smsfs and the consistency with which they are applied is an important area for further research. following more extensive investigations of the economic properties of smsfs, economists may be in a position to provide more guidance on the optimal management of smsf portfolio. for example, balanced superannuation funds follow a „constant proportional‟ investment policy whereby the proportions invested in various assets in the fund are maintained by frequent trading, especially after significant market movements. for smsf trustees with particular types of risk aversion, the emulation of such a strategy may be asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 74 encouraged, providing there were no mitigating circumstances uncovered in the course of the investigation of smsfs. it is easy to foresee, however, that a constant proportional strategy may be too cumbersome for many smsf trustees to perform well and since many self managed superannuation funds may be too small to justify the higher transactions costs that may be involved, it may be more desirable for advisers to recommend the allocation of the capital of the smsf to managed investments that do follow a constant proportional or balanced investment policy. 7. conclusion in this paper, the relationship between smsf portfolio size (or net worth) and allocations to risky assets was examined. based on the analysis of two independent samples of smsfs, it was determined that there is no discernible relationship between the two variables of interested. rather, funds with the largest net worth in both samples exhibit lower allocations to risky assets than funds with lower net worth. the allocations to non-risky cash assets in both samples are quite high on average and within the samples some trustees have allocated very large portions of their portfolios to cash. this suggests a conservative investment strategy which is of course entirely acceptable if that is what the risk aversion of the trustees calls for. interestingly, however, the high cash allocations are often combined with high allocations to risky assets, especially australian shares. the portfolios exhibit a dichotomy: high allocations to a risk free asset and high allocations to risky assets. it would appear as though the flexibility afforded by loosely constructed investment strategies is a likely source of this smsf characteristic. the investigation of smsf investment strategy documents vis-à-vis the portfolios actually constructed by their trustees would be a very interesting task for future research. references blume, m. and friend, i. 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(1975), “discussion,” journal of finance, vol. xxx, no. 2, may, pp.621-623. tobin, j. (1958), “liquidity preference as behaviour towards risk,” review of economic studies, no. 67, february, pp.65-86. asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 34 corporate governance, sustainability and the assessment of default risk christina james-overheu school of accounting, economics and finance, university of southern queensland springfield, qld, 4300 australia tel: 61 7 3470 4546 e-mail: cjames@usq.edu.au and julie cotter (corresponding author) school of accounting, economics and finance, university of southern queensland toowoomba, qld, 4350 australia tel: 61 7 4631 2916 e-mail: cotter@usq.edu.au abstract this paper investigates whether the quality of a firm‟s corporate governance practices and its sustainability disclosures are inversely related to its assessed default risk. it is expected that high reported standards of corporate governance will reduce the assessment of a company‟s default risk by lenders, underwriters and ratings agencies, and therefore reduce the cost of debt for such companies. a corporate governance index based on annual report disclosures was developed to rate each company‟s corporate governance quality. derivation of this index was centred on corporate governance indicators suggested by prior research and best practice; particularly the australian stock exchange “principles of good corporate governance and best practice recommendations”. it is similarly expected that the voluntary disclosure of sustainability information (corporate social reporting or csr) will enhance a firm‟s management reputation. the assessment of default risk is captured by a firm‟s individual credit rating supplied by standard and poor‟s. our results indicate that neither annual report disclosures about corporate governance practices nor sustainability disclosures are significantly related to assessed default risk when firm size is controlled. key words: corporate governance, sustainability, disclosure, default risk, credit rating jel classifications: g32, g34, m14 mailto:cjames@usq.edu.au mailto:cotter@usq.edu.au asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 35 1. introduction this paper investigates whether the quality of a firm‟s corporate governance and its sustainability disclosures are inversely related to its assessed default risk. lenders are an important group of annual report users, and it is therefore important to know whether such disclosures made in these reports are useful for assessing default risk. we investigate this relationship in the australian setting. it is expected that high perceived standards of corporate governance will reduce the assessment of a company‟s default risk by lenders and underwriters, and therefore reduce the cost of debt for such companies. it is further expected that the voluntary disclosure of sustainability information will signal effective management and therefore reduced perceived default risk. there have been several recent studies investigating the relationship between corporate governance and the cost of debt or factors expected to be closely related to it. their results indicate support for a relationship between aspects of corporate governance quality and the cost of debt. (bhojraj and sengupta 2003, anderson, sattar and reeb 2004, ashbaugh-skaife, collins and lafond 2006) the most recent of these studies by ashbaugh-skaife et al. (2006) found that credit ratings are negatively associated with the number of blockholders and ceo power, and positively related to takeover defences, accrual quality, earnings timeliness, board independence, board stock ownership and board expertise. the majority of prior studies restricted their analysis to a limited set of governance variables, for example bhojraj and sengupta (2003) investigated board independence and institutional ownership, while anderson et al. (2004) examined board characteristics and the cost of debt for s & p 500 firms in the united states and found cost of debt to be inversely related to board size and independence and also audit committee independence, size and meeting frequency. in this study we take a thorough approach to the measurement of governance practices and develop a comprehensive corporate governance index. our index is centred on corporate governance disclosures related to the asx principles of good corporate governance and best practice recommendations. this approach allows us to test whether these governance practices disclosed in the annual reports are useful when assessing default risk. regulatory bodies around the world have attempted to define what constitutes high quality corporate governance. the australian stock exchange (asx) issued ten core “principles of good corporate governance and best practice recommendations” to apply to company reports for the first financial year after 1 january 2003 (effectively the year ending 30 june 2004 for most australian companies). since this time firms have been obliged to report any departures from the principles, but they were encouraged to assess their compliance as early as possible. thus, while disclosure about corporate governance practices was voluntary in australia in 2003 and prior, a considerable amount of disclosure was present. 1 one potential factor that motivates a company and its directors to voluntarily disclose information regarding corporate governance is that these disclosures reduce the apparent risk of investment in the company, and hence its external financing costs. effective corporate governance allows accurate performance monitoring, and promotes stability and market and investor confidence, and hence reduces perceived risk. “corporate governance deals with the ways in which suppliers of finance to corporations 1 there are several reasons why companies might have chosen to voluntarily disclose information about their corporate governance policies and practices. the research literature provides evidence that annual report disclosures reveal credible, relevant information that is priced by investors, reduces estimation risk and information asymmetry, and reduces the cost of equity capital for firms with a low analyst following. (lang and lundholm 1996, botosan 1997, botosan and plumlee 2002, lundholm and myers 2002) asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 36 assure themselves of getting a return on their investment,” per shleifer and vishny (1997). 2 agency theory suggests that stakeholders seek to reduce information asymmetry. financiers need the management expertise but this leaves managers with significant control rights and the question of how financiers can ensure these are not exercised for the benefit of shareholders or managers‟ personal gain at the expense of bondholders (jensen and meckling 1976). to the extent that governance is an important determinant of default risk, its perceived strength can have a significant effect on estimating that risk. weak governance can impair a firm‟s financial position and ability to repay its debts. a firm‟s credit rating reflects a rating agency‟s opinion of an entity‟s overall creditworthiness and its capacity to satisfy its financial obligations (standard & poor‟s, 2002) although the detailed methodology used for developing corporate credit ratings by firms such as standard & poor‟s (s & p) and moody‟s is not public information, it is reasonable to assume that an assessment of a company‟s internal regulation and corporate governance practices would be a factor in assessing the default risk level for lenders. a number of us studies have found a positive association between aspects of corporate governance and firm value (lundholm and myers 2002; botosan 1997; botosan and plumlee 2002; lang and lundholm 1996, 2000) and a few have extended this to explore the association between aspects of corporate governance and perceived credit risk and therefore cost of debt. (sengupta 1998; bhojraj and sengupta 2003; gompers, ishii and metrick 2003; ashbaugh-skaife et al. 2006, and anderson et al. 2004) s & p have described their rating methodology as encompassing four main areas: industry risk (operating risk), business risk (specific company risk factors and keys to success), financial risk (based on quantitative ratios and a qualitative review of financial policy) and liquidity risk (financing needs and cash flow). 3 s & p describe their ratings in the introduction to the code of practices and procedures as “a valuable tool in the global capital markets for the evaluation and assessment of credit risk.” research has also suggested that firms may (successfully) use corporate social and environmental (sustainability) reporting to “legitimise various aspects of their respective organisations” (deegan (2002) p.282). if the motivation for disclosing this additional voluntary information is to increase the credibility and enhance the reputation of the management of the organisation, then this should reduce the perceived risk of that organisation from a lender‟s perspective, if they accept the intended message. this view is further supported by research suggesting that organisations may use corporate social responsibility and sustainability reporting as a vehicle for reputation risk management (bebbington et.al. (2008) and commentary by unerman (2008)). schneider (2008) argues that the market values a firm‟s environmental performance in assessing risk and a firm‟s cost of debt capital. again, agency theory is applicable as the debt market may perceive a proactive environmental strategy as an indication that management are not pursuing short-term profit strategies for the benefit of shareholders at the expense of bondholders. a proactive management stance on sustainability issues could similarly be positively interpreted. firms with superior sustainability may disclose more information about their sustainability to differentiate themselves from firms with inferior sustainability. voluntary disclosure theory (see dye 1985) predicts that high quality companies have incentives to report more extensively to distinguish themselves from lower quality companies. this theory has been applied to voluntary environmental performance disclosure (clarkson et al. (2008)). these authors demonstrate a positive relationship between environmental performance per se and the level of voluntary environmental disclosures. this prior research and theory suggests that 2 scleifer & vishny (1997) p.742 3presentation made by chris dalton, managing director, standard & poor‟s australia & new zealand, melbourne financial services symposium, wednesday 17th march 2004. asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 37 voluntary sustainability reporting can be used to indicate underlying superior performance in sustainable practices. we use the following hypotheses to test the relationships between corporate governance practices and sustainability disclosures found in annual reports and assessed default risk in the australian setting: h1 credit ratings are positively related to the quality of corporate governance practices h2 credit ratings are positively related to the voluntary disclosure of sustainability information the methodology used to test these hypotheses is described in the next section. for the purposes of this paper quality of corporate governance is defined as a high score on our corporate governance index. the quality of sustainability disclosures is not measured directly; instead the volume of sustainability or csr information (as identified by the firm) disclosed in the annual report or as a separate statement is used as the proxy, given that any disclosure on this issue is voluntary. the methodology section is followed by the results of our analysis and conclusions. 2. methodology 2.1 development of a corporate governance index a corporate governance index based on annual report disclosures was developed to rate each company‟s corporate governance quality. derivation of this index was centred on corporate governance indicators suggested by prior research and best practice, such as the australian stock exchange “principles of good corporate governance and best practice recommendations” (asx principles). table 1 summarises the corporate governance index. the maximum possible score was 26 (7 disclosure, 15 independence, 2 external audit, 2 procedures). each company‟s corporate governance score (cgscore) was calculated by dividing their total score by this maximum possible score, to express it as a proportion for ease of comparability 4 . table 1 – corporate governance index disclosure maximum the annual statements contain a statement addressing corporate governance. 1 or 0 1 reference is made to the asx corporate governance principles 1 or 0 1 an assessment is made regarding current compliance with the asx principles 1 for a general overview 2 if the review is detailed 2 the qualifications of the board members are disclosed 1 or 0 1 4 as an additional check, the models were also computed using the raw corporate governance scores (not scaling by 26) and this made no impact on the correlation or regression results. asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 38 table 1 continued… the relevant experience of the board members is disclosed 1 or 0 1 members‟ attendance at meetings is disclosed 1 or 0 1 total disclosure 7 independence ceo not same person as board chairman 1 or 1 board board size (average membership) noted only proportion non-executive members x/1 1 proportion of independent members x/1 1 independent chairperson 1 or 0 1 number of meetings during year: six or more less than 6 not disclosed 1 point 0 points 0 points 1 audit committee committee size (average membership) noted only proportion non-executive members x/1 1 proportion of independent members x/1 1 independent chairperson 1 or 0 1 number of meetings during year: four or more less than 4 not disclosed 1 point 0 points 0 points 1 remuneration committee committee size (average membership) noted only proportion non-executive members x/1, zero if no committee 1 proportion of independent members x/1, zero if no committee 1 independent chairperson 1 or 0 1 nomination committee committee size (average membership) noted only proportion non-executive members x/1, zero if no committee 1 proportion of independent members x/1, zero if no committee 1 independent chairperson 1 or 0 1 total independence 15 external audit „big four‟ audit 1 or 0 1 proportion of audit/other fees x/1 1 total exteranal audit 2 asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 39 table 1 continued… procedures role/duties of board clear (e.g. charter) 1 or 0, 0 if not disclosed company has a code of conduct 1 or 0, 0 if not disclosed total procedures 2 maximum possible score 26 2.1.1 disclosure the first points in the index were awarded for a company making a statement on their corporate governance policy, for including a reference to the asx principles, and for making an assessment of whether the company currently complies with asx principles (1 point for a general statement about the extent of compliance, 2 points for a detailed consideration of the principles). the remainder of the index was an assessment of whether in fact the principles were already being applied. the index includes a point each for disclosure of the board members‟ qualifications and experience, and another for disclosing their attendance at meetings. these disclosures are required for stakeholders to judge the competency of the board. the index does not endeavour to make an assessment of actual board competency on the basis of these disclosures, since to do so would be highly subjective. 2.1.2 independence to assess the strength of the oversight role performed by the board an assessment was made of the independence of the board and relevant committees (ashbaugh-skaife et al. 2006, anderson et al. 2004). independence has been a common essential requirement in all the regulatory recommendations regarding corporate governance. a board independent of the company and free from undue influence from any major shareholder enables the directors to carry out their oversight role in the best interests of all shareholders and to ensure that management is accountable to stakeholders. the number of members of the board and the recommended committees (audit, remuneration and nomination) was noted, and the proportion of independent members was calculated. in the absence of such a committee, the proportion was set to zero. 5 points were also included to note the separation of the role of ceo and chairperson (balatbat, taylor and walter 2004) and for an independent chairperson. as a further measure of the strength of the oversight role performed by the board, the number of board and audit committee meetings was considered. following the horwarth report (2002) recommendations, strong oversight was defined as the board meeting at least six times annually and the audit committee at least four times annually. two measures were used for independence of directors. the first was simply whether the director is a non-executive director or not (clarkson et al. 2006). annual reports sometimes imply that the term non-executive indicates an independent director. as the horwarth (2002) report points out, however, being a non-executive director merely means that a director is not currently a manager and is often far from meaning that the director is independent of the company. the second measure therefore took into account 5 having regard to possible difficulties faced by smaller companies, it was permitted for a company to have combined remuneration/nomination committees provided that the duties of the combined committee were clearly stated to include both oversight roles. if a company did not have a committee performing either role, then the score was given as zero. asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 40 the recommendations for best practice per the ifsa “blue book” 2004 and asx principle 2, and strictly applied a director was only considered independent if he/she satisfied all of the following:  non-executive  had an interest in less than 5% of the company‟s voting share capital,  had not held an executive position in the company in the past three years  had not had any material interest in a contractual relationship/consultancy with the company other than the directorship and had no other obvious personal connection with executive directors.  had not served on the board for a prolonged period likely to materially effect independence (as a guide this study presumed 10 years to be the maximum) this was assessed based on information gleaned from the 2003 annual report of the company, particularly disclosure of directors‟ interests, related party transactions and general description of directors‟ positions held. 2.1.3 external audit as the board is also responsible for the appointment of the external auditors, it was noted whether or not a leading external audit firm had been appointed. audit firm size was used as a proxy for quality (clarkson et al. 2006; deangelo 1981; francis, khurana and pereira 2003). one point was awarded for a “big four” audit firm. the proportion of audit fee charged compared to the fees for other services provided was also calculated. it is assumed that an auditor will be more independent the higher the proportion of the fee relates to the audit, as this reduces potential conflicts of interest. 2.1.4 procedures finally, points were awarded a company for having adopted procedures suggested by asx principles 1 and 3. one point was awarded if the company laid down guidelines for board/management duties (e.g. charter). a further point was awarded if the company disclosed that it had a code of conduct. 2.2 assessment of sustainability the published annual financial reports of each of the companies in the sample were examined for the inclusion or otherwise of a statement on corporate social responsibility (csr) or sustainability. in addition, sample firms with separate sustainability or csr reports were identified. the total number of pages devoted to sustainability reporting was captured for each company. 2.3 sample and data assessed default risk is captured by an independent assessment of the risk to lenders a firm‟s individual credit rating supplied by standard and poor‟s (s & p). companies often acknowledge the importance of credit ratings in raising non equity finance. indeed, many quote their credit rating (particularly if it has improved during the period) in their annual report, as an indication of their risk standing. credit ratings for 82 australian companies were obtained from s & p for the financial year to 30 th june 2004. however several of these companies were excluded from our final sample. s & p rates entities at their request as well as rating companies for their own database. entities may seek a credit rating asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 41 in order to obtain finance, or in contemplation of listing. the original list contained a number of private (pty ltd) companies as well as subsidiaries of other companies not publishing separate financial data. there were also a number of delistings and mergers/demergers and one company under voluntary administration. the final sample ultimately consisted of 38 companies which met the criteria of being non finance/banking/insurance 6 and which held an s & p credit rating in 2004 and filed an annual report in 2003. the mean market capitalisation for this sample is m$5,841; with this measure of firm size varying between m$96.2 and m$44,239. table 2 reconciliation original data set to final sample no. 2004 s & p rated (non banking/finance) 82 exclusion reason delisted 7 no information government 4 no information pty or trust 23 subsidiary 7 merger/demerger 1 start up during year 1 voluntary administration 1 final sample 38 the information for constructing the corporate governance index, sustainability disclosures, and for the control variables was obtained from the 2003 annual reports, and from the databases aspecthuntley datanalysis, aspecthuntley finanalysis and connect 4. in 2003 there was no obligation for companies to report their degree of compliance with the asx principles, therefore the inclusion of a corporate governance statement was voluntary. the main areas of the report where such information was found were the board of director‟s report, any corporate governance statement made, details of directors‟ qualifications, experience, past employment and directorships if given, details of shareholdings and directors‟ interests and notes to the financial statements, particularly related party transactions. 2.4 descriptive statistics the s & p global (long term) credit rating scale ranges from aaa (extremely strong capacity) to d (payment default). this was converted to a 22 point ordinal scale such that aaa equated to 22, bb (less vulnerable) equated to 11 and d equated to 1 (see table 3). this is similar to the scale used in usa studies by anderson et al. (2004) who used credit ratings to control for differences in default risk, by reeb, mansi and allee (2001), and by ahmed et al. (2002); although this latter study followed compustat‟s 6 insurance and financial service companies were excluded, as the regulations affecting such companies regarding governance practices are substantially different from other listed companies. asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 42 conversion of ratings with larger values corresponding to a less favourable debt rating. s & p defines its issuer credit ratings as an assessment of the firm‟s financial capacity and willingness to pay its financial obligations, „based on current information furnished by obligors or obtained by standard & poor‟s from other sources it considers reliable. 7 a „key dimension‟ of the ratings are financial ratios for measuring performance and financial structure. descriptive statistics for the sample are shown in table 4. the highest credit rating in the sample was aa(sprate = 19) and the lowest was ccc (sprate = 5), while the median was bbb+ (sprate = 15). table 4 also shows descriptive statistics for our corporate governance index and its key components, sustainability disclosures, and several firm characteristics. the highest cgscore was 96.9% (25.2/26), while the lowest was 42.7% (11.1/26). the mean and median corporate governance scores were 74.9% and 80.3% respectively. the mean disclosure score (discl) was 82.7% (5.8/7), with a wide range between 14.3% and 100%. only one company made no corporate governance statement and 18/38 companies (47%) scored 7/7. the mean board size was 8 members and 3 members for the audit committee. the mean score for overall independence (indep) was 72%, again with a range from 31% to 99%. the mean proportion of board member independence (bdind) was 49%, with 19/38 companies (50%) having a majority independent board. for audit committees the mean proportion of member independence (acind) rose to 68%, with 34/38 (89%) companies assessed as having a majority independent audit committee and 10/38 (26%) fully independent. the mean proportion of non executive directors on the board was 75% for the sample, with 100% on audit committees. ten of our sample companies issued a separate sustainability or csr report. when both annual and separate report disclosures were considered, there was substantial variation in the extent of sustainability reporting; with the number of pages devoted to these disclosures ranging between 0 and 82, with a mean (median) of 11.63 (2.00). table 3 – credit rating scale rating scale index s & p description aaaaaa 22 extremely strong capacity aaaa ++ 21 aaaa 20 very strong capacity aaaa- 19 aa ++ 18 aa 17 strong capacity aa- 16 bbbbbb ++ 15 bbbbbb 14 adequate capacity bbbbbb- 13 bbbb ++ 12 bbbb 11 less vulnerable 7 standard & poor‟s website: http://www2.standardandpoors.com asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 43 table 3 continued… bbbb- 10 bb ++ 9 bb 8 more vulnerable bb - 7 cccccc++ 6 cccccc 5 currently vulnerable cccccc- 4 cccc 3 currently highly vulnerable cc 2 administration/bankruptcy dd 1 payment default notes: global rating scale source: presentation made by chris dalton, managing director, standard & poor‟s australia & new zealand, melbourne financial services symposium, wednesday 17 th march 2004 www.users.bigpond.com/bradleyjon/sp/standard_poors.ppt standard & poor‟s credit ratings definitionshttp://w.0.standardandpoors.com.au/ table 4 descriptive statistics for the sample of 38 companies (based on 2003 data) measure mean median std dev minimum maximum sprate 14.454 15.000 2.818 5.000 19.000 cgscore 0.749 0.803 0.177 0.427 0.969 discl 0.827 0.929 0.235 0.143 1.000 indep 0.720 0.774 0.223 0.309 0.989 audit 0.799 0.804 0.114 0.500 0.977 proc 0.645 0.500 0.347 0.000 1.000 bdind 0.493 0.497 0.214 0.000 0.917 acind 0.682 0.667 0.264 0.000 1.000 bdsize 7.686 7.958 2.427 4.000 14.500 acsize 3.189 3.000 1.337 0.000 6.000 sust 11.630 2.000 22.488 0.000 82.000 size 8.078 7.951 1.273 4.977 10.675 lev 0.437 0.266 0.583 0.000 2.650 grow 0.892 0.966 0.151 0.357 1.000 per 0.123 0.106 0.088 0.020 0.528 notes: sprate = standard & poor‟s credit rating for the firm at 30 june 2004 cgscore = the proportional score (x/26) on the corporate governance index http://www.users.bigpond.com/bradleyjon/sp/standard_poors.ppt http://www.standardandpoors.com.au/ asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 44 discl = is the disclosure score from the corporate governance index expressed as a proportion, x/7 indep = is the independence score from the corporate governance index expressed as a proportion, x/15 audit = is the external audit score from the corporate governance index expressed as a proportion, x/2 proc = is the procedure score from the corporate governance index expressed as a proportion, x/2 bdind = the proportion of independent directors on the board during the annual report period acind = the proportion of independent directors on the audit committee during the annual report period bdsize = the mean number of directors on the board during the annual report period acsize = the mean number of directors on the audit committee during the annual report period sust = total number of pages devoted to sustainability reporting size = natural log of book value of assets lev = book value long term debt/market value common equity end of year grow = measure for growth: proportion of tangible assets to total assets per = ratio of cash flows (ebitda) to total assets, where ebitda is earnings before interest, tax, depreciation and amortisation. all 38 companies in the sample were audited by one of the „big 4‟ audit firms, so any variation in audit score was in respect of the relative proportion of audit/non audit related fees paid to the audit firm during the year. one firm provided no breakdown of audit firm fees, (and therefore scored 1/2 for having a big 4 audit firm only), otherwise the minimum proportion of audit/non audit fees was 16% and the maximum 95%, with a mean of 61%. firms were more likely to have a code of conduct (31/38 firms or 82%) than a board charter explicitly outlining the role of the board (18/38 or 47%). many of the companies, however, had introduced a charter since the 2003 year end or stated that they were reviewing corporate governance procedures in the light of the asx principles and intended introducing one for 2004. 3. analysis the following model (model 1) was used to test hypotheses 1 and 2 that a firm‟s credit rating is positively related to the quality of its corporate governance practices and the voluntary disclosure of sustainability information: spratet+1 = α + β1cgscoret + β2sustt +β3sizet + β4levt +β5growt + β6pert + μt where year t is 2003, spratet+1 is the s & p credit rating for the firm at 30 june 2004, cgscore is the proportional score (x/26) on the corporate governance index and sust is the number of pages devoted to sustainability reporting. following prior research and the factors suggested by s & p, several control variables were also included. larger firms and higher performing firms are associated with lower risk and are therefore expected to have a higher credit rating and a lower cost of debt (sengupta, 1998; bhojraj and sengupta, 2003; anderson et al. 2004; balatbat et al. 2004). the natural log of book value of assets captures firm size (size). firm performance (per) is measured as the ratio of cash flows (ebitda) to total assets, where ebitda is earnings before interest, tax, depreciation and amortisation. on the other hand, high leverage and growth firms are associated with higher risk and therefore a higher asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 45 cost of debt and a lower credit rating (sengupta 1998; bhojraj and sengupta 2003; anderson et al. 2004; balatbat et al. 2004). book value long term debt/market value common equity measures leverage (lev). growth firms (grow) are captured by the proportion of tangible assets to total assets. the regression results for this model are shown in table 5. corporate governance index scores (cgscore) is not significantly related to credit rating. indeed, it is insignificant in the wrong direction. further, sustainability disclosures (sust) are not significantly related to credit rating. the only significant variables were size, lev and grow. size was positively related to credit ratings and leverage negatively correlated, as expected. however growth was positively associated with credit ratings, which is surprising as growth is generally associated with increased risk. table 5 – regression results for the sample of 38 asx listed companies (dependent variable is s & p rating 2004; other variables based on 2003 annual reports. figures in parenthesis are t statistics) variable predicted sign model 1 model 2 model 3 intercept -0.788 (-0.212) 0.128 (0.027) 1.111 (0.315) cgscore + -0.317 (-0.152) sust + -0.003 (-0.192) -0.007 (-0.372) -0.005 (-0.278) discl + -1.444 (-0.653) indep + -0.669 (-0.310) audit + -0.735 (-0.196) proc + 1.350 (1.059) ceo chair + -1.576 (-1.666) bdind + 0.433 0.211 bdsize + -0.092 (-0.468) size + 1.277 (4.160)** 1.337 (3.913)** 1.308 (3.305)** lev _ -1.306 (-2.073)* -1.275 (-1.903)* -1.519 (-2.378)* grow _ 6.889 (2.798)** 6.242 (2.456)* 5.917 (2.362)* per + -3.022 (-0.730) asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 46 table 5 continued… adj r2 0.437 0.412 0.459 f 5.780** 4.244** 5.485** notes: *significant at <0.05, ** significant at <0.01; as the sign of the variables is predicted, the p values shown are one tailed ceochair = a dichotomous variable, being 1 if the ceo position is separate from the board chair (i.e. not the same director), otherwise 0, during the annual report period other variable definitions are the same as shown for table 4 table 6 – pearson and spearman correlations for 38 asx listed companies (pearson correlations are above diagonal; p values are shown in parenthesis) s p r a t e c g s c o r e s u s t d is c l in d e p a u d it p r o c c e o c h a ir b d in d b d s iz e s iz e l e v g r o w p e r s p r a t e 0.049 (0.770) 0.225 (0.175) -0.169 (0.310) 0.139 (0.406) 0.076 (0.649) 0.020 (0.907) -0.215 (0.194) 0.152 (0.361) 0.325* (0.046) 0.523** (0.001) -0.362* (0.026) 0.381* (0.018) 0.053 (0.753) c g s c o r e 0.053 (0.751) 0.196 (0.238) 0.711** (0.000) 0.918** (0.000) -0.009 (0.957) 0.529 (0.001) 0.587** (0.000) 0.681** (0.000) 0.298 (0.069) 0.244 (0.139) -0.095 (0.569) -0.194 (0.243) 0.220 (0.185) s u s t 0.400* (0.013) 0.595** (0.000) -0.024 (0.886) 0.286 (0.082) -0.271 (0.100) 0.056 (0.741) 0.023 (0.892) 0.315 (0.054) 0.315 (0.054) 0.409* (0.011) -0.174 (0.295) -0.044 (0.793) 0.120 (0.474) d is c l -0.096 (0.566) 0.707** (0.000) 0.369* (0.022) 0.406* (0.012) -0.300 (0.067) 0.528** (0.001) 0.523** (0.001) 0.370* (0.022) 0.055 (0.745) -0.063 (0.706) 0.125 (0.454) -0.160 (0.338) 0.062 (0.710) in d e p 0.154 (0.357) 0.882** (0.000) 0.529** (0.001) 0.415** (0.010) 0.072 (0.668) 0.270 (0.102) 0.453** (0.004) 0.704** (0.000) 0.395* (0.014) 0.391* (0.015) -0.178 (0.284) -0.202 (0.225) 0.269 (0.102) a u d it 0.115 (0.492) -0.036 (0.828) -0.176 (0.290) -0.329* (0.044) 0.014 (0.935) -0.031 (0.854) -0.056 (0.740) 0.016 (0.924) 0.010 (0.951) 0.020 (0.907) -0.060 (0.720) 0.106 (0.525) -0.028 (0.869) p r o c -0.023 (0.893) 0.544** (0.000) 0.187 (0.261) 0.466** (0.003) 0.257 (0.119) 0.034 (0.838) 0.498** (0.001) 0.237 (0.152) -0.076 (0.651) -0.143 (0.391) -0.039 (0.818) 0.031 (0.852) 0.015 (0.931) c e o c h a ir -0.277 (0.092) 0.548** (0.000) 0.216 (0.192) 0.376* (0.020) 0.443** (0.005) -0.077 (0.644) 0.447** (0.005) 0.294 (0.073) -0.041 (0.807) -0.003 (0.986) -0.146 (0.383) -0.164 (0.326) 0.237 (0.152) b d in d 0.076 (0.651) 0.707** (0.000) 0.481** (0.002) 0.305 (0.063) 0.771** (0.000) 0.046 (0.783) 0.187 (0.262) 0.294 (0.073) 0.424** (0.008) 0.489** (0.002) -0.101 (0.546) -0.287 (0.081) 0.237 (0.152) asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 47 table 6 continued… b d s iz e 0.308 (0.060) 0.338* (0.038) 0.459** (0.004) 0.114 (0.495) 0.480** (0.002) 0.029 (0.861) -0.119 (0.477) -0.050 (0.767) 0.462** (0.004) 0.667** (0.000) -0.137 (0.412) -0.139 (0.404) 0.269 (0.102) s iz e 0.494** (0.002) 0.360* (0.026) 0.595** (0.000) 0.156 (0.350) 0.468** (0.003) -0.122 (0.466) -0.107 (0.524) -0.040 (0.810) 0.507** (0.001) 0.651** (0.000) -0.032 (0.850) -0.082 (0.625) 0.174 (0.295) l e v -0.115 (0.490) 0.025 (0.882) -0.039 (0.817) 0.162 (0.330) 0.001 (0.996) 0.030 (0.857) -0.004 (0.981) 0.102 (0.542) 0.003 (0.985) 0.001 (0.997) 0.084 (0.618) -0.235 (0.155) -0.076 (0.650) g r o w 0.347* (0.033) -0.264 (0.109) -0.054 (0.748) -0.206 (0.215) -0.340* (0.037) 0.167 (0.316) 0.073 (0.663) -0.236 (0.154) -0.302 (0.065) -0.382* (0.018) -0.174 (0.297) -0.307 (0.061) 0.091 (0.587) p e r 0.014 (0.932) 0.306 (0.061) 0.152 (0.361) 0.219 (0.187) 0.320 (0.050) -0.270 (0.101) 0.062 (0.712) 0.325* (0.046) 0.262 (0.113) 0.232 (0.162) 0.155 (0.351) 0.064 (0.704) -0.148 (0.375) notes: *significant at <0.05, ** significant at <0.01 (two-tailed) variable definitions are the same as shown for table 4 a correlation matrix showing both pearson and spearman‟s rho correlations is presented in table 6. given the small sample size and non-normal distributions for some of our variables, the following discussion focuses on the spearman‟s rho results. sust is significantly positively correlated with cgscore and size, and gcscore is positively correlated with size. however none of these correlations are high enough to induce multicollenearity problems into the model. interestingly, sust is significantly positively correlated (ρ = 0.400) with credit rating (sprate). however as the results in table 5 show, this relationship becomes insignificant when firm size is controlled. these results suggest that larger firms have both better credit ratings and corporate governance and sustainability disclosures. in order to determine whether one particular aspect of the cgscore was driving the (lack of) results, it was decided to disaggregate the index into its constituent parts as per the corporate governance index shown in table 1 (model 2). discl is the disclosure score from the index expressed as a proportion (x/7). indep is the independence score (x/15). audit is the external audit score (x/2), while proc is the procedure score (x/2). in the interest of parsimony, per was dropped from these regressions. again the only significant variables were size, lev and grow, all with the same signs as the previous models. all the disaggregated cgscore elements were insignificant, and all except one still had signs contrary to prediction (i.e. negative). the only corporate governance variable with a positive sign was proc (the proportion of score for having a board charter and a code of conduct), but still not a significant influence on credit ratings. spearman‟s rho correlations between these variables indicate that indep is positively correlated with size (possibly larger companies are able to have an increased board size and accommodate more independent outside directors thus enabling a more independent governance structure overall). the individual corporate governance indicators also tended to be correlated with each asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 48 other: indep positively related to discl and discl positively correlated with proc. sust is positively correlated with discl and indep suggesting that independent boards are more likely to disclose both corporate governance and sustainability information. cgscore was further disaggregated based on individual aspects of corporate governance found to be significant in prior research (model 3). ashbaugh-skaife et al (2006) found credit ratings to be positively related to board independence and negatively associated with increased ceo power (i.e. negatively associated with the ceo and board chair being the same person). anderson et al. (2004) found cost of debt to be inversely related to board size and independence and also audit committee independence, size and meeting frequency. board and audit committee and independence and size are likely to be correlated, so it was decided to test board independence, board size and separation of ceo/board chair. again the variables size, lev and grow were significant, all with the same signs as the previous models. bdind was positive and bdsize negative (contrary to expectations for bdsize) but both had no explanatory significance regarding the proxy for cost of debt (credit ratings). ceochair was marginally significant but was negatively related to the credit ratings, in other words having a separate ceo/board chair had a negative effect on ratings. ceochair was not highly correlated with any other variable in this model. bdind was significantly positively correlated with firm size and therefore might be significant but this is masked by the correlation. bdsize was also significantly correlated with firm size. sust is positively correlated with both bdsize and bdind. we also tested whether industry type or cross-listing were influential. specifically it was expected that mining might be higher risk (negative relationship with credit ratings) and real estate might be lower risk (positive relationship with credit ratings), and cross listing might affect corporate governance positively (so improve credit ratings). however results of these additional tests indicate that none of these variables were influential. table 7 presents diagnostic tests for each of the regression models shown in table 5. the breusch-pagan-godfrey test indicates that there is heteroscedasticity for models 1 and 2. these models were therefore re-estimated using white‟s correction. this yielded results essentially the same as those shown in table 5. jarque-bera test statistics indicate that the residuals for each of our models do not depart from the normal distribution. durbin-whatson statistics indicate no autocorrelation of residuals for model 1, while models 2 and 3 fall within the indecision areas indicating possible autocorrelation (tabachnick & fidell, 1996). table 7 – diagnostic test statistics (figures in parenthesis are probabilities) test statistic model 1 model 2 model 3 breusch-pagan-godfrey 2.491 (0.044) 2.833 (0.019) 1.777 (0.123) jarque-bera 0.307 (0.858) 0.198 (0.906) 0.592 (0.744) durbin-whatson 2.020 1.778 1.596 ramsey reset 3.035 (0.064) 3.347 (0.050) 4.013 (0.030) asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 49 ramsey‟s reset (regression specification error test) is a general test for misspecification of a model‟s functional form [brooks (2002); gujarati (2003)]. results of these tests indicate that model 1 is not misspecified, while model 3 is misspecified and model 2 is marginal. a significant f statistic from the reset test is indicative of non-linear parameters in the model or a relevant variable omitted from the model [brooks (2002); gujarati (2003)]. ols estimation produces biased and inconsistent parameter estimates when non-linear parameters are assumed linear in the model (kmenta, 1971). overall, the results of diagnostic tests indicate some potential concerns with models 2 and 3, while model 1 results can be considered reliable. 4. conclusions and future directions our results indicate that australian annual report disclosures about corporate governance practices are not useful for the assessment of default risk. this result is in contrast to prior research conducted in the us that finds significant relationships between some aspects of corporate governance quality and factors associated with the cost of debt. our results also indicate that australian annual report disclosures about sustainability practices are not useful for the assessment of default risk when firm size is controlled. it appears that larger firms have both better credit ratings and corporate governance and sustainability disclosures. there are several potential reasons for the disparity between our corporate governance results and those found in the us. first, the disclosures recommended by the asx corporate governance principles may be inadequate for the purpose of assessing default risk. they do not provide information about several of the factors found to be significantly related to credit ratings and measures of the cost of debt used in prior research. these include institutional ownership, the presence of blockholders, board stock ownership, and indicators of takeover defences, board expertise, disclosure and accruals quality and earnings timeliness. alternatively for 2003, a year prior to the introduction of mandatory reporting by exception required by the asx corporate governance principles, it may simply be difficult for lenders (and for standard and poor‟s) to make more than a cursory assessment of corporate governance practices or to make comparisons between firms due to lack of disclosure and the non uniformity of where in the annual report any disclosure is made. future studies may wish to examine data from prior to contemplation of the asx principles, perhaps in comparison with a post asx cg principles sample, or to conduct a longitudinal study. recent research in australia suggests that firms provide quality disclosure only when these requirements are „black letter‟ or mandatory (clarkson et al. 2006). there have also been changes to sustainability reporting practices over the past few years. the kpmg survey of g250 companies drawn from the fortune global 500 list (2007), published in 2008, states that “corporate responsibility reporting has gone mainstream” with a rise in csr reporting in large companies from 79% presenting a stand-alone report compared to 52% in a similar survey from 2005, and a further 4% of companies incorporating csr data in their annual reports. kpmg argue this clearly indicates an economic incentive for such corporate reporting. the survey report suggests that volume does asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 50 not necessarily equate to quality. many csr reports lack integration with the financial data. most reporting companies appear to have corporate governance and sustainability strategies, but few give details regarding implementation and monitoring of these. other criticisms include a lack of stakeholder reference and feedback, a comparative lack of environmental and social detailed information, and despite a growing trend in formal assurance, this has still not been widely adopted. aspects to watch for the future do include supply chain relationships as sustainability issues grow beyond an individual corporation, and the role of corporate governance and csr reporting in corporate risk management strategy. similarly the latest biannual sustainability reporting, transparency and disclosure benchmarking survey from sustainability inc, “tomorrow‟s value”, published in conjunction with the united nations environment programme (unep) and standard & poor's, exposes a shift in corporate attitude to reporting. firms are beginning to seek strategic advantage in the area of sustainability and see opportunities for value creation rather than simple risk management. financial markets also value the additional information for investors. many firms have included sustainability issues in their core business strategy but few appear to be using their influence to lobby for change outside their organisation (sustainability 2006). this may of course reflect a lack of real commitment and a wish concentrate on internal “good news”. it seems likely that a similar project to the one reported in this paper, drawn on more recent data, may find more significant results. it is also possible that with a relatively small sample, even though the residual degrees of freedom were never less than 30 in any of the models, the peculiarities of the sample may drive the results. the sample size in this study was limited by the availability of the data – a lack of s & p credit ratings for many australian firms. in order to increase the sample size, future studies might seek alternatives to credit ratings, such as corporate-debt yield spreads (anderson et al. (2004)), as the measure for the cost of debt. acknowledgement we are grateful for advice and encouragement from christina‟s master of financial management supervisor, allen craswell, her examiner, and julie walker, pam kent and ping-sheng koh. research assistance was provided by norziana lokman. references ahmed, a.s., billings, b.k., morton, r.m. & stanford-harris, m, (2002), “the role of accounting conservatism in mitigating bondholder-shareholder conflicts over dividend policy and in reducing debt costs”, the accounting review , vol. 77, no. 4, october 2002 pp. 867-80 anderson, r.c., sattar m.a. & reeb, d.m., (2004), “board characteristics, accounting report integrity, and the cost of debt”, journal of accounting and economics, vol. 37, issue 3, pp. 315-342 ashbaugh-skaife, h., collins, d.w. & lafond, r., (2006), “the effects of corporate governance on firms‟ credit ratings”, journal of accounting and economics, vol. 42, issue 1/2, pp. 203-243 balatbat, m.c.a., taylor, s.l. and walter, t.s., (2004), “corporate governance, insider ownership and asian journal of finance & accounting issn 1946-052x 200x, vol. 1, no. 1: e1 www.macrothink.org/ajfa 51 operating performance of australian initial public offerings”, accounting and finance, vol. 44, issue 3, november 2004, pp. 299-328 bebbington, k.j., larrinaga-gonzales, c. & moneva, j. 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(www.horwarth.com.au) kpmg international survey of corporate responsibility reporting (2008), kpmg international, p.4 link accesses 16/4/09 http://www.complianceweek.com/s/documents/crsurvey.pdf lang, mark h. and lundholm, russell j., (1996), “corporate disclosure policy and analyst behaviour”, the accounting review, vol. 71, no. 4, pp.467-492 lang, mark h. and lundholm, russell j., (2000), “voluntary disclosure and equity offerings: reducing information asymmetry or hyping the stock?”, contemporary accounting research, vol. 17, issue 4, winter 2000, pp. 623-662 lundholm, r. and myers, l.a., (2002), “bringing the future forward: the effect of disclosure on the returns-earnings relation”, journal of accounting research, vol. 40, issue 3, june 2002, pp.809-839 reeb, david m., mansi, sattar a. & allee, john m. 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(1996), using multivariate statistics 3 rd edition, harper collins college publishers, new york unerman, jeffrey (2008), “strategic reputation risk management and corporate social responsibility reporting”, accounting, auditing and accountability journal, vol.21, no. 3, 2008, pp. 362-364 http://www.sustainability.com/aboutsustainability/news_article.asp?id=862 http://www.sustainability.com/ asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 87 entry mode strategies and performance of japanese mncs in australia and new zealand: the role of japanese employees sriya kumarasinghe (corresponding author) department of accountancy & business law, university of otago po box 56, dunedin 9054, new zealand tel: 64-3-479-8120 e-mail: sriya.kumarasinghe@otago.ac.nz yasuo hoshino graduate school of accounting, aichi university & university of tsukuba 2-10-31, tsutsui, higashi-ku, nagoya 461-8641, japan e-mail: hoshino@aichi-u.ac.jp abstract this study investigates different entry modes and staffing practices, and their influence on performance in japanese subsidiaries in australia and new zealand. data from 275 japanese subsidiaries were derived from the toyo keizai data bank of japanese overseas investments (kaigai shinshutsu kigyou souran) for the period from 2003 to 2008. the major assumption of this paper is that japanese multinational corporations (mncs) use their staffing policies as a means of exerting more influence on performance combined with other factors such as experience, industry, and the type of ownership. the study reveals that within the sample japanese subsidiaries in australia have a higher percentage of high performance companies than in new zealand. the existence of japanese employees, ownership and industry are shown as predictors of performance. keywords: japanese multinational corporations, ownership, performance, staffing policies, australia, new zealand jel classifications: g320, g340 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 88 1. introduction with the globalization of trade activities the spread of multinational corporations (mncs) has become very fast and complex. during the last few decades japanese foreign direct investment (jfdi) and mnc activities have spread all over the world attracting much attention from business researchers and academic scholars. ownership structures (kasuga, 2008; cieslik & ryan, 2009), entry mode and performance outcomes (konopaske et.al, 2002; anand & delios, 1997; nitsch et.al, 1996; ito & rose, 1994), establishment and survival (delios & ensign, 2000), subsidiary size and autonomy (beamish & jae, 2005; johnston & menguc, 2007) and performance between wholly owned subsidiaries and joint ventures (makino & kent, 2000) were the issues discussed extensively. previous studies have focused on geographical locations such as united states (alba et.al, 2008), europe (mansour & hoshino, 2002), canada (delios & ensign, 2000), china (beamish & ruihua, 2002), thailand (siripaisalpipat & hoshino, 2000), taiwan (yeh & hoshino, 2000), and australia (ben_youssef & hoshino, 2007). the triangle of new zealand, australia and japan is a crucial one for the following reasons. new zealand’s trading relationships are becoming increasingly based around the pacific rim countries. new zealand’s three largest export markets – australia, japan and the united states – accounted for 43% of new zealand’s exports and 40% of imports in the year ended 2007. the two-way trade amounted to $15.3 billion with australia taking 21% of new zealand’s exports and supplying 21% of imports (statistics new zealand, 2008). on the other hand, japan has been a leading trading partner of both australia and new zealand for many years. today, almost all major japanese mncs have a significant share in the australian market. it is japan’s biggest foreign direct investment (fdi) destination in the asia pacific. the factors such as improvement of infrastructure, rapid development in australia, government policies, trade friction between japan and the us in 80s, the high value of the japanese yen, high domestic labour cost, stagnation of the japanese economy, and rapid globalization have contributed to this trend (de silva, 2006). such inter-connectedness creates a significant impact on these three countries’ economies. regardless of the factors mentioned above, there exists a gap in empirical research on fdi in the pacific region, especially in new zealand (scott-kennel, 2004). therefore, the primary objective of this paper is to provide empirical evidence on japanese fdi performance in australia and new zealand. according to our knowledge this research is the first to examine the impact of ownership structure, entry mode, industry, and firm-specific characteristics on the performance of japanese subsidiaries in new zealand and also to conduct a comparison with the japanese subsidiaries in australia. this paper will attempt to investigate whether the staffing policies in japanese subsidiaries combined with their entry mode choices and ownership strategies would be the possible indicators of their financial performance. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 89 this paper aims to contribute to the existing literature by providing additional information on japanese foreign direct investment (jfdi) in australia and new zealand and also by analyzing japanese subsidiaries in australia and new zealand as one set of data to represent the jfdi in the pacific region. we assume that mutual inter-dependence of australia and new zealand in their economic efforts and the cultural closeness will allow combined research and side by side comparisons. the flow of the paper is as follows. section 2 briefly reviews relevant theoretical and empirical literature on jfdi. section 3 presents the data sources, sample composition, and the model to be tested. section 4 interprets the results and section 5 summarizes the findings of the study with comments, limitations and future research possibilities. 2. literature on entry mode strategies and firm performance 2.1 the choice of entry mode the choice of entry mode into foreign markets is one of the most important decisions made by the mncs. after making decisions on whether to orient towards the global market, local and overseas, or local market, and whether they go for an equity-based entry mode, they take the second step of deciding on the percentage of ownership. in closed markets with high tariffs on imported goods, mncs have no other choice than starting local production. there they form joint ventures with local partners. japanese firms clearly intend to adopt 100% ownership if the host country permits them to do so (okamoto, 1998). whichever approach is to be adopted, the primary objective is to optimize performance. in previous research on entry mode and performance of 173 japanese fdi in 1994 in western europe, it was predicted that the greenfield 1 , wholly-owned subsidiaries would perform best, followed by joint ventures and acquisitions. the results provided strong evidence of poor performance by acquisitions versus greenfield and joint ventures (nitsch et al., 1996). research by harzing (2002) on management of entry modes reported that greenfield companies are more strongly controlled by the headquarters than in acquisitions and have a higher level of expatriate presence. research by ogasavara and hoshino (2007) examined entry mode strategies based on non-conventional forms of joint ventures and found that japanese-japanese joint ventures with a partner that has previous experience in the local market performed better than wholly-owned subsidiaries and traditional international joint ventures. according to a recent research by the same authors on japanese subsidiaries in brazil, the accumulation of both international and local experiential knowledge can positively affect subsidiary performance (ogasavara and hoshino, 2009). having noted the previous research findings, we hypothesize: 1 greenfield firm is a firm enters a foreign market via fdi setting up an entirely new plant (gorg, 2000). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 90 h1 a. subsidiaries which used greenfield as the initial entry mode will perform better than mergers and acquisitions in australia and new zealand. h1 b. wholly-owned subsidiaries will perform better than joint-ventures in australia and new zealand. 2.2 industry previous research has confirmed that promotion of exports and securing imports were to be the primary rationale for jfdi. there are other motivations for jfdi such as labour cost and resource access. like canada, sweden and norway, australia has been attracted by both the natural resource industries and technologically sophisticated industries. delios and ensign (2000) found that region and industry drew jfdi to canada and influenced the subsidiary survival. a recent work by rasouli and hoshino (2007) on 263 japanese subsidiaries in india examined the effects of equity ownership, size, entry strategy and subsidiary age on the sales growth ratio and the subsidiary’s survival. they concluded that mncs prefer to acquire high levels of ownership in the manufacturing sector. the results of their research further indicated that: capital; age of the venture; the number of employees; and, full ownership, affect survival of the subsidiary. mansour and hoshino (2002) also examined the impact of firm and industrial factors on entry mode choice of the japanese mncs in europe. their research was based on 324 japanese firms in europe over the period of 1994 to 1998. the study found that international experience and resource-based industries had a positive influence on the choice of shared ownership structure. additionally they found that firm size and intangible assets, measured by the r&d and advertising, were not significantly related to entry mode. conducting a research on japanese subsidiaries in australia between 1992 and 2002 ben_youssef and hoshino (2007) confirmed the influence of affiliated industry on the performance in japanese subsidiaries. incorporating the above literature we hypothesized the following. h2. industry type has a significant influence on the performance of a japanese subsidiary in australia and new zealand. 2.3 staffing policies of japanese subsidiaries the parent-subsidiary relationship is a fundamental aspect of corporate control and governance in mncs. empirical research on the ownership policies of the mncs towards their subsidiaries has revealed that the parent companies intervene in the subsidiary activities not only through the ownership but also through the direct participation in the management team. particularly for japanese mncs their management practices have been seen as significant contributing factors in japan’s economic success, thus many enthusiasts attempt to apply such specific approaches to other countries. in the case of japanese subsidiaries in asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 91 australia, some japanese management practices have been effective while others failed, but appeared as trying to keep japanese identity through incorporating them into the management systems in their subsidiaries in the overseas (bamber et.al, 1992). expatriate managers play an important role in representing and implementing the corporate objectives of a mnc. they often serve as a control mechanism to ensure achieving corporate goals and objectives (beamish & inkpen, 1998). beamish and inkpen (1998) found the number of japanese expatriates have been declining for some time. they assumed that the japanese mncs will shed their ethnocentric bias and hire the best managers they can find whether japanese or non-japanese. konopaske et al. (2002) carried out research on the role of staffing as a moderating factor between entry mode strategy and performance of japanese mncs in the worldwide. they hypothesized fdi performance based on the firm resources, organization structure, technology transfer, and ethnocentric and polycentric staffing. revealing significantly different results between the wholly owned subsidiaries and the joint ventures, they reported that ethnocentric staffing was negatively related to the performance in joint ventures, but in the case of wholly owned subsidiaries, ethnocentric staffing was positively and significantly related. assuming japanese parent companies wish to ensure that japanese management systems are adopted in their subsidiaries by sending japanese expatriates to the host countries, we hypothesize, h3 a. subsidiaries with japanese employees in the staff will perform better than subsidiaries without japanese employees in australia and new zealand. h3 b. subsidiaries with japanese chief executive officer (ceo) will perform better than subsidiaries without a japanese ceo in australia and new zealand. 3. methodology 3.1 scope of the study the main objective of this study is to examine the influence of different entry mode strategies, ownership structures, industry, and staffing policies on the subsidiary performance in australia and new zealand. it also intends to explore the differences of jfdi between the two countries. 3.2 sample the sample consists of 31 (6.4% of the population) japanese subsidiaries in new zealand and 244 (9.7% of the population) japanese subsidiaries in australia. the data was extracted from the toyo keizai data bank of japanese overseas investments (kaigai shinshutsu kigyou asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 92 souran (ksks)) published between 2003 and 2008. ksks has been publishes annually since 1970 and has been used widely (cieslik & ryan, 2009; kasuga, 2008; ogasavara & hoshino, 2007; ben_youssef & hoshino, 2007; rasouli & hoshino 2007; konopaske et.al, 2002; delios & ensign, 2000). it provides a list of overseas investment activities of japanese corporations. the total number of observations for new zealand was 485 and for australia, the number was 2,504. the sample was selected based on the availability of performance data. there were only a small number of subsidiaries with performance data and we included them all. subsidiaries with at least two years experience have been used by previous researchers such as woodcock et.al. (1994), nitsch et.al. (1996), and ben_youssef & hoshino (2007). we also followed the same rule. the 31 subsidiaries in the new zealand sample included 12 firms involved in wholesale and retail trading, 8 in the travel and hotel industry, 7 in the agriculture sector, and 4 in the real estate and finance sector. among the australian sample, there were 79 in wholesale and retail business, 42 in agriculture, 37 in manufacturing, 36 in real estate and finance, 25 in travel, 8 in mining, 6 in transport and logistics, and 11 others in miscellaneous businesses including education and consultation services. 3.3. measures the dependent variable, independent variables and control variable were all derived from the ksks database and are discussed below. 3.3.1. dependent variable the primary objective of our research was to find out whether there were any significant influences of ownership structure, entry mode strategies, industry and the staffing policies on the performance. secondly, to investigate whether there were any differences in those attributes among the japanese subsidiaries in new zealand and australia. therefore the dependent variable was performance. financial performance data was not available to the public but there was only one subjective measure of performance available in the ksks database. the senior managers of the subsidiaries assessed the performance of their company in terms of loss, break-even, or gain for the given financial year. this was the only performance indicator the firms disclosed to the databank and it has been used as a proxy for performance in previous research on japanese subsidiaries (cieslik & ryan, 2009; kasuga, 2008; ogasavara & hoshino, 2007). although the measure is subjective by nature, it indicates the performance in a relatively comparable manner. therefore we believe it is appropriate for our requirement. the japanese subsidiaries in the sample have been engaged in business activities the respective countries for about 20 years on average. considering the economic objectives of an organization we assumed that the investors expect a profit over their investment straight from the year of establishment or at least after a few years of establishment leaving some time to recover the initial costs. not a single firm would expect to break-even after 20 years of experience. therefore we assumed that the break-even would be asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 93 closer to loss than gain. based on that argument we created a dichotomous variable for performance in which a gain was considered as high performance = 1 and break-even and loss were considered as low performance =0 (ogasavara and hoshino, 2007). 3.3.2. independent variables based on our hypotheses, initial entry mode, ownership, industry, and staffing policy were considered as independent variables. ownership, industry and staffing policy have more than one variable. table 1. description of the sample by ownership structure description new zealand % of nz total australia % of aus total total % of total ownership 1 wholly-owned joint ventures total ownership 2ª wos (j) wos (dj) jv (jj) jv (jdj) jv (jjl) jv (djl) jv (jdjl) jv (jl) total 23 8 31 12 11 4 1 3 31 74.2 25.8 100 38.7 35.5 12.9 3.2 9.7 100 181 63 244 153 28 22 13 6 8 2 12 244 74.2 25.8 100 62.7 11.5 9 5.3 2.5 3.3 0.8 4.9 100 204 71 275 165 39 26 13 7 11 2 12 275 74.2 25.8 100 60 14.2 9.5 4.7 2.5 4 0.7 4.4 100 ª wos (j) = japanese wholly-owned, wos (dj)= domestic japanese wholly-owned, jv (jj) = japanese-japanese joint ventures, jv (jdj) = japanese and domestic japanese joint ventures, jv (jjl) = multiple japanese companies and local joint ventures, jv (djl) = domestic japanese and local joint ventures, jv (jdjl) = japanese, domestic japanese, and local joint ventures, jv (jl) = japanese and local joint ventures in the sample of new zealand, 23 subsidiaries were wholly-owned and 8 subsidiaries were joint ventures. from the 23 wholly-owned subsidiaries, 12 were owned by japanese companies registered in japan and 11 were owned by japanese companies registered in australia. among the joint ventures, 4 joint-venture subsidiaries were japanese-japanese, and 1 was a joint venture in which the investors were several companies in japan and one company in australia. three other joint-ventures were funded by japanese and australian firms registered in australia. in the australian sample, 182 subsidiaries were wholly-owned by companies registered in japan and 62 were joint ventures. we found 20 domestic japanese wholly-owned, 23 japanese-japanese joint ventures, 12 japanese and domestic japanese joint ventures, 7 traditional (japanese and local) joint ventures, 6 domestic asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 94 japanese and local joint ventures, and 2 japanese, domestic japanese, and local joint ventures (see table 1). for ownership 1, we identified the subsidiary as wholly-owned or joint venture. for ownership 2, subsidiaries with more than 95% of japanese ownership were labeled as wholly-owned, and the others were considered as joint ventures. for ownership 2, we further distinguished the composition of ownership based on the information on the affiliated firms. some parent companies of the wholly-owned subsidiaries were established in japan, and some were registered in the host country. similarly, we found six combinations of joint ventures among those subsidiaries. they were labeled as japanese-japanese; japanese and domestic japanese; japanese, japanese and a local; domestic japanese and a local; japanese, domestic japanese, and a local; and japanese and a local; the traditional type of joint venture. table 2. description of the sample by industry description new zealand % of nz total australia % of aus total total % of total industry 1 manufacturing* service total industry 2 agriculture mining travel manufacturing** retail/wholesale real est/finance transport/logistic other total 6 25 31 7 8 12 4 31 19.4 80.6 100 22.6 25.8 38.7 12.9 100 72 172 244 42 8 25 37 79 36 6 11 244 29.5 70.5 100 17.2 3.3 10.2 15.2 32.4 14.8 2.5 4.5 100 78 197 275 49 8 33 37 91 40 6 11 275 28.4 71.6 100 17.7 2.8 12 13.4 33.1 14.4 2.2 4.4 100 * in this category we identified manufacturing subsidiaries which involved in making or processing goods by means of industrial machines ** for industry 2 we identified manufacturing subsidiaries which involved in large scale industrial operations only. subsidiaries involved in timber, paper and food processing were added into the agriculture sector asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 95 industry also first categorized as manufacturing and service and labeled as industry 1. for industry 2, each subsidiary was identified with its industry sector. subsidiaries involved in timber, paper, or food processing were included as agriculture related businesses. only the large scale industrial operations were considered as industrial firms (see table 2). for staffing, there were three variables. they were, number of japanese employees in the firm, existence of japanese employees in the company work force, and existence of japanese chief executive officer (ceo). 3.3.4. control variable subsidiary performance can be affected by various factors at various levels. number of years in operation since establishment was used as a proxy for age and it has been identified as a highly influencing factor of subsidiary performance (konopaske et al, 2002; johnston & menguc, 2007). therefore we included company age as a control variable for this study. in order to minimize the effect of relatively skewed data, we introduced age in its log transformation. 3.3.5. statistical methods spss statistics package 17.0 was used to run the correlation analysis, cross-tabulation, t-test and logistic regression to test the hypothesized models. 4. discussion based on some previous research, the purpose of our research was to investigate to what extent initial entry mode, ownership, industry and the staffing policies would be the predictors of the performance of japanese subsidiaries in australia and new zealand. we applied several logistic regression models. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 96 table 3: means, standard deviations and correlations among all the variables (n=275) variables initial entry age(ln) japanese emp japanese emp exist perform indus 1 indus 2 owner ship 1 owner ship 2 initial entry 1.000 company age (ln) -.224 ** 1.000 japanese emp -.028 -.002 1.000 japanese empexist .089 .055 .580 ** 1.000 performance -.110 .208 ** .065 .110 1.000 industry 1 .002 .203 ** -.197 ** -.132 * .195 ** 1.000 industry 2 -.056 .021 -.173 ** -.098 .174 ** .574 ** 1.000 ownership 1 .001 .174 ** -.145 * -.031 -.118 .090 .117 1.000 ownership 2 .057 -.136 * -.020 -.047 .099 .029 -.049 -.846 ** 1.000 japanese ceo .092 -.040 .118 .217 ** -.029 .008 .012 .101 -.088 ** significant at the 0.01 level (2-tailed). * significant at the 0.05 level (2-tailed). initial entry (greenfield=1, otherwise =0) japanese emp (no. of japanese employees) japanese emp exist (exist =1, otherwise =0)) performance (low (loss & break-even) =0, high=1) industry 1 (manufacturing=1, service =0) industry 2 (agriculture, forestry and fishing=1, mining=2, travel and hotel=3, manufacturing=4, retail and wholesale=5, real estate and finance=6, logistics and transport=7, other =8) ownership 1 (wholly-owned subsidiaries which own more than 95% =1, otherwise=0) ownership 2 (wos (j) = 1, wos (dj) = 2, jv (jj) = 3, jv (jdj) = 4, jv (jjl) = 5, jv (djl) = 6, jv (jdjl) = 7), jv (jl) = 8 japanese ceo (exist=1, otherwise=0) table 3 shows the means, standard deviations, and correlation coefficients for all the variables. low coefficients suggest that the variables have little or no co-linearity. higher correlations were observed between japanese employees and existence of japanese employees (labeled as japanese emp exist), industry 1 and 2, and ownership 1 and 2. therefore we refrained by using japanese employees and ownership 2, and industry 2 in the regression analysis. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 97 table 4: t-test results for japanese subsidiaries in australia and new zealand (n=275) mean std. deviation mean difference f df t initial entry .5782 .49475 .0028 .004 38 .029 age 2.8693 .53588 .1193 4.713 48 1.168* japanese emp exist .7421 .43837 -.0002 .000 39 -.002 industry 1 .2836 .45158 -.0652 2.857 39 -.756 ownership 1 .7418 .43843 -.0362 .665 37 -.433 japanese ceo .8255 .38027 .0149 .175 38 .206 performance .6364 .48192 -.2446 2.061 37 -2.692** ** significant at 0.01 level, * significant at 0.05 level the t-test results confirmed that only the age (t=1.168 (48), p<.05) and performance (t=2.692 (37), p<.01) were significantly different between australia and new zealand (table 4). the mean differences between initial entry, existence of japanese employees, industry 1, ownership 1, and japanese ceo remained insignificant. these results indicated that the samples from the two countries were close enough to pool together to examine the predictors of the performance in japanese subsidiaries. the dependent variable of our research is a dichotomous variable with 0 representing low performance and 1 representing high performance. to evaluate the extent to which from entry mode, ownership, employees, and industry were associated with the performance we used binary logistic regression analysis. except the control variable age, all other predictors were categorical variables. at first we tested the model for each country and then for the grouped data excluding the control variable. at the second stage we repeated the same including the control variable, age. the results are presented in table 5. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 98 table 5: binary logistic regression models for performance of japanese subsidiaries in australia and new zealand (excluding age) variables model 1 model 2 model 3 australia (n=244) new zealand (n=31) total (n=275) age initial entry japanese emp exist industry 1 ownership 1 japanese ceo constant ni -.371(1.440) .608(2.984) -1.209(13.723)*** -.730(3.721) -.214(.231) 1.640(8.870)** ni -1.046(788) 3.417(5.218)* -3.745(4.835)* -2.353(3.079) -.634(.681) .532(.742) ni -.407(.2.041) .798(6.016)* -1.256(16.452)*** -.814(5.521)* -.198(.239) 1.425(8.216)** model coefficients chi-square nagelkerke r sq -2 log likelihood 19.799** .120 259.173 16.115** .545 26.05 26.471*** .137 302.015 *** significant at 0.001 level, ** significant at 0.01 level, * significant at 0.05 level notes: within brackets is wald statistics. dependent variable is performance (low=0, high=1), ni = not included as shown in the table 5, all the model coefficients were statistically significant (model 1: p<.01, model 2: p<.01, model 3: p<.001, model 4: p,.001, model 5: p,.05, model 6: p,.001). without the influence of age, industry was a predictor for the performance in australia, and for new zealand the performance was significantly influenced by the existence of japanese employees and industry. for the total sample we found japanese employees, industry and the ownership as significant predictors. when the control variable age was inserted into the models as a predicting variable, there wasn’t any change in the results in model 5 for new zealand, but some changes appeared in model 4 and 6 for australia and for the total sample respectively. including age, industry and ownership appeared as significant for the model for australia. age, the existence of japanese employees, industry and ownership were significant predictors for the total sample (table 6). asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 99 table 6: binary logistic regression models for performance of japanese subsidiaries in australia and new zealand (including age) variables model 4 (age included) model 5 (age included) model 6 (age included) australia (n=244) new zealand (n=31) total (n=275) age initial entry japanese emp exist industry 1 ownership 1 japanese ceo constant .637(4.416)* -.271(.737) .523(2.154) -1.092(10.818)** -.918(5.399)* -.188(.179) -.083(.007) .935(.512) -.670(.264) 3.386(4.705)* -3.356(3.990)* -2.275(2.925) -.686(.189) -2.523(.308) .611(4.449)* -.305(1.100 .719(4.782)* -1.135(12.973)*** -.968(7.264)** -.167(.168) -.274(.771) model coefficients chi-square nagelkerke r sq -2 log likelihood 24.329*** .145 254.643 16.647* .559 25.518 31.049*** .159 297.437 *** significant at 0.001 level, ** significant at 0.01 level, * significant at 0.05 level notes: within brackets is wald statistics. dependent variable is performance (low=0, high=1), ni = not included going one step further we tested three more models with age and country interactions for the total sample (see table 7). since we found significant differences in age and performance between the two countries we assumed that there would be some different results by introducing the interactions of age and country. the model coefficients for the all three models became significant (model 7: p<.001, model 8: p<.001, model 9: p<.001). age and industry interaction appeared as significant in the model 7. for the model 9 we inserted only the interaction variables. the interactions of japanese employees, industry, and country with age showed as significant predictors. country and japanese employees also became significant. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 100 table 7: binary logistic regression models for performance of japanese subsidiaries in australia and new zealand with country and age interactions variables model 7 (age interactions) model 8 (country interactions) model 9 (country and age interactions) (n=275) (n=275) (n=275) initial entry japanese emp exist industry 1 ownership 1 japanese ceo age x entry age x japanese emp exist age x industry 1 age x ownership 1 age x japanese ceo age x country country x entry country x japanese emp exist country x industry 1 country x ownership1 country x japanese ceo constant -2.177(1.316) -.553(.083) 2.912(2.036) .182(.009) -2.307(1.198) .650(1.005) .459(.475) -1.439(4.004)* -.331(.244) .616(.761) ni ni ni ni ni ni 1.620(8.806)** -2.395(1.157) 5.920(4.072)* -7.280(4.606)* -4.820(3.708)* -1.633(.293) ni ni ni ni ni ni 1.020(.801) -2.648(3.129) 3.045(3.162) 2.066(2.629) .736(.227) 1.525(8.763)** ni ni ni ni ni .034(.008) .906(4.003)* -1.784(8.456)** -.791(3.121) -.026(.003) .601(17.970)*** -.934(1.987) 1.948(4.984)* .644(.992) -.297(.166) -.196(.115) -1.358(3.820)* model coefficients chi-square nagelkerke r sq -2 log likelihood 35.165*** .179 293.321 42.835*** .215 285.650 50.401*** .249 278.085 *** significant at 0.001 level, ** significant at 0.01 level, * significant at 0.05 level notes: within brackets is wald statistics. dependent variable is performance (low=0, high=1), ni = not included part (a) of the hypothesis 1 on greenfield entry was not supported. it did not appear as a significant predictor in any of the models. the reason might be the longer years of experience in the host country. in part (b) of hypothesis 1 we assumed that wholly-owned subsidiaries would perform better than joint ventures. this was not supported for new zealand where the majority of the subsidiaries were wholly-owned but only 42% of the subsidiaries had high performance and the ownership variable in the model was insignificant. sole ownership was a asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 101 significant predictor for performance in the total sample and in australia where 66% of the subsidiaries were high performers but the sign was negative. the other interesting revelation was to find that only 4 japanese subsidiaries in our new zealand sample had local partners and the rest of the subsidiaries which consisted of 27 firms were owned by japanese companies only. twenty three subsidiaries were wholly-owned subsidiaries, and 4 subsidiaries were owned by japanese-japanese firms. among japanese subsidiaries in australia 162 firms were recorded as high performers. two hundred and four australian subsidiaries were wholly-owned and only 71 were joint ventures. within those 71 firms, only 28 joint ventures had foreign partners. this finding for the australian sample confirmed the findings by woodcock et al. (1994), siripaisalpipat and hoshino (2000) and cieslik and ryan (2009). hypothesis 2 on industry was supported. the influence of industry was significant in both countries. even though the close proximity of australia and new zealand means they share some similar demographic characteristics, it seems that the two countries have some different aspects therefore japanese mncs approached the two countries with different strategies. the control variable age was significant with australian data and with the total sample, but not significant with new zealand data, but appeared its influence in the increased chi square values and likelihood ratios (see table 5 and 6). the majority of jfdi in new zealand focused on the trade and travel sectors and they have reported both high and low performance. there were 24 subsidiaries in the service sector and 12 of them were high performers and 12 were low performers. in the manufacturing sector there were 7 subsidiaries, 6 of which were low performers. subsidiaries in travel and retail markets were able to enjoy high profits. in australia retail (41%) was the leading sector followed by the real estate sector (17%). agriculture (13.6%), manufacturing (11.7%) and travel (9%) were lined up next. 72% of the service sector firms were high performers. in the manufacturing sector, the proportion of high performance was 52%. with the economic deregulation of the mid 1980s new zealand became a more open economy compared with other international capital markets, but due to strict environmental policies, new zealand is still a restricted economy for the manufacturing sector. that led japan, as a foreign manufacturer, to select their investments very carefully ending up with less manufacturing plants in new zealand which has been a positive contribution for new zealand’s clean green environment efforts. according to everett (1996), foreign investment funds have found banking and finance, manufacturing, and property as the most attractive sectors in new zealand. trade has been identified as a sector dominated by foreign majority-owned firms. the relationship we found here between japanese subsidiaries and trade sector confirms everett’s findings. they have seemed as heavily involved in trade and travel which are not labour intensive or high-tech industries. ranft and marsh (2008) depict that performance is higher when firms enter low knowledge-intensive environments or high knowledge intensive environment regardless of the mode of entry. in the markets with lower knowledge-based resources, performance would be higher because the market is less asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 102 problematic, and when intensity increases performance declines to a point. however, in high-knowledge intensive environments there is a positive relationship between knowledge intensity and performance (ranft and marsh, 2008). hypothesis 3 on japanese employees was partially supported. having a japanese ceo was not an influencing factor for better performance, but existence of japanese employees showed a positive and significant influence in new zealand than in australia but it doesn’t seem to be a positive factor for better performance because the majority of the firms were low performers. 92% of the subsidiaries in new zealand had japanese employees while it was around 77% in australia. as konopaske et al (2002) found out in their research the results in this study also indicated that the staffing approach has a significant impact on performance. there may be some other aspects behind those staffing policies and that is beyond the scope of this study. this study extends our understanding of the influence of ownership and staffing policies on japanese subsidiary performance in australia and new zealand. greenfield initial entry and japanese ceo had not been proven as influencing factors for better performance in the recent years. since the average age of the subsidiaries in both countries is nearly 20 years therefore, the influence of entry mode and ceo may have disappeared. industry, ownership, japanese employees, and subsidiary age were seen as predictors of performance in australia and new zealand the impacts were both positive and negative. 5. conclusion in this study we investigated the influence of entry mode, ownership structure, industry, staffing policy on subsidiary performance in australia and new zealand. to test our model we used logistic regression. our hypotheses were partially supported indicating significant influence of related industry, existence of japanese employees, and ownership on the performance of australian and new zealand subsidiaries. the moderating factor, age, became significant with japanese employees, ownership and industry as predictors of performance. this research was not free from limitations. the results were drawn on a sample of subsidiaries in australia and new zealand. therefore the findings are country and region specific. this is a part of on-going research. the analysis was limited to the companies with performance measure and it was subjective. in order to derive strong conclusions, more quantifiable measures need to be added to the performance variables and also the sample size for new zealand need to be increased. these issues will be addressed in another paper. in this paper we also did not address the issue of the direct investments in new zealand by australian companies which affiliate with japanese investors. subsidiaries rely on multiple sources for competitive advantage and parent companies play an important role in providing resources associated with these competitive advantages. the empirical evidence shows that the majority of the subsidiaries are the dominant, or the only firm of that industry, in new zealand. they have collaborative linkages with the parent companies, involving two-way transfer of resources including unique product or service related technologies. local firms asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 1: e1 www.macrothink.org/ajfa 103 also improve their capabilities through the links with the subsidiaries. therefore, local industry movements and strategic location need to be addressed in a separate paper. acknowledgement an earlier version of this paper was presented at the performance measurement association conference in dunedin, new zealand in april 2009. we thank session participants and also the anonymous reviewers of the asian journal of finance and accounting for their helpful comments and suggestions. all errors and omissions are the responsibility of the authors. references alba, j. d., park, d., & wang, p. 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(2000). the effects of mergers and acquisitions on taiwanese corporations, review of pacific basin financial markets and policies, 3(2), 183-199. microsoft word literature paper-writer4-new corp receive doi:10.5 abstra the im studies the two relation diversif keywo porate d fa un fa un fa un ed: may 13, 5296/ajfa.v4 ct mpact of cor from the p o variables. h nship that fication and rds: produc diversi r me aculty of m niversiti tek aculty of m niversiti tek aculty of m niversiti tek , 2012 a 4i2.1786 rporate dive past. in add however, th state in th d summary o ct diversific ification review eysam doae management knologi mal e-mail: dm dr. mela management knologi mal e-mail: dr. nik int management knologi mal e-mail: accepted: j url: htt ersification ition, schol here are som his paper. of related st cation, inter 56 n and f w of lit ei (correspo and human laysia, skud meysam2@l ati b. ahma and human laysia, skud m-melati@ tan norhan a and human laysia, skud m-norhan@ june 28, 201 tp://dx.doi.o on financia lars found p me theories in this pa tudies. rnational div asian financi terature onding auth n resource dai, johor b live.utm.my ad anuar n resource dai, johor b @utm.my adb hamid n resource dai, johor b @utm.my 12 publ org/10.5296 al performa positive or and motiva aper, we tr versification n journal of f ial perf e hor) developme ahro, malay y developme ahro, malay d developme ahro, malay lished: dece /ajfa.v4i2.1 nce has bee negative re ation which ry to show n, financial finance & ac issn 19 2012, vol. www.macrothi formanc ent ysia ent ysia ent ysia ember 1, 20 1786 en subject elationship b h explain the w measurem l performan ccounting 946-052x 4, no. 2 ink.org/ajfa ce: a 012 of some between e part of ment of nce introdu the cor finance paper d research definit there a from th activitie industri kaka, 2 of their scholars industry line of b moreov product means a a firm a corpor ansoff unrelate three di mode (d diversi it intro measure entropy determi sic cod way for for usin cannot problem concent herfind as noted uction rporate dive in last thr discusses th h. ions are many de he diverse, es (r. pitts ies, it is call 2007; 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mcc as the total s 57 ial perform m & mathu he definitio diversificati and differe when a firm m (barney, 2 furthermore rently busin enters new new segmen . corporate d (geographi nd of produ , ireland, & rsification on. also, pr tion degree 991). thods of co trial classifi agreement o hackman, 20 business ac artin and sa ed if a firm important t rfindahl ind connell, br square of th asian ance has be ur, 2008; sa ns, measur ion. howev ent that sho m operates 2010; m. hi e, diversific ness (hilleb sector (iaco nt (denis, d diversificati ic) diversifi uct and inter & hoskisson as product roduct dive e, diversific omputing b fication (sic of which me 007). cording to i yrak (2003) m operates i than others dex, which rue, & flynn he sales sha n journal of f een subject antalo & b rement and ver, diversifi ows a discr in more tha itt & ireland ation mean randt & ca obucci & r denis, & sar on classifie cation. prod rnational div , 2007). t diversific rsification c cation type based on t c) codes, he easurement its activity, w ) noted that n many ind for the firm h was intro n, 2009; mc are of each p finance & ac issn 19 2012, vol. www.macrothi of many st becerra, 200 d results of fication wor repancy in t han one bus d, 1986; ibr ns increased annon, 1990 rosa, 2005), arin, 1999) o ed into two duct divers versification cation (rela can be divi and divers the busines erfindahl in t is the best which is the t there is a p dustries, si m. for solv roduced for cvey, 1972) product of ccounting 946-052x 4, no. 2 ink.org/ajfa tudies in 08). the f related d comes the firm siness or rahim & d activity 0). other , or new or a new groups, ification n means ated and ded into ification ss count ndex and t one for e easiest problem c codes ving this r firm’s ). the firm equatio where, of produ the hig index al the last spread diversif other in total sal and rela palepu, in addit better t range o index is equatio where, segmen as it m related addition increasiln n. diversi wringle in four (1974) vertical and unr because could t adition on 2.1: her pi is the sal uct units of gh herfinda lso is know t measurem into other fication rese ndexes. the les/assets d ated diversi 1985). park tion, chatte than other d of using entr s measures a on 2.1: tot pi is the sh nts mentioned, t and unrela n, if total en ing levels o ification ty ey (1970) d majors wh extended t l, dominant related bus e of the firm transfer cor nally, some rfindahl in les share of f the firm. w ahl index is wn as herfin ment is entro r subjects. earches. th e elements divide acros ification in k and jang erjee and b diversificati ropy index as equation al entropy hare sale of the main pr ated diversi ntropy is n of diversific ype defined dive hich are sin these four constrained siness. how m’s uncomp re skill to n scholars use dex h f product i in when this in , the more dahl-hirsch opy index w jacquemin e index has are the num s industry p a firm (am (2011) said blocher (199 ion measur (c. j. chen n 2.2: y index e segment i in rivilege of fication in ear zero, it cation, and t ersification t ngle, domin parts into d, dominant wever, he s plete report new busine ed another 58 p ; 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how entropy in h are differe ties, the am of part of u & hoskisson and decom or diversific ges cause t ). the total he number o ermine the & berry, 19 comes grea entropy is 0 the firm’s p ersification. dominant, d ained, relate count thes ated divers ification co and rumelt ccounting 946-052x 4, no. 2 ink.org/ajfa number versified. 72). this wever, it ndex in ent from mount of unrelated n, 1989; posable. cation is he wide entropy of firm’s score of 979)). in ater with 0 e portfolio rumelt dominant d linked se ratios ification ould not. t‘s ideas together rao, 19 diversi scholar (na be internal establis merger (n. ber interna internat hitt, et perform strategy as a m (1987) which internat exploit internal (ghosh kogut, geograp firms w markets firm in resourc in addi borders more ef addition compet also ach of thes internat relation 1989), (siddha internat r which are 998). ification m rs define mo erg, 1973; l l developm shing a new and acquisi rg & pitts, 1 ational div tional diver t al., 2007) mance (cap y. matter of fac argued tha gives firms tional diver the benefit lization of al, 1987; w 1993), an phic market with strong s (bartlett & internation es, which is ition, multi s by standar fficiently an nal compet itive enviro hieve a grea e argumen tional diver nship (dani other studi arthan & la tional divers e single, mo mode ode of dive lamont & a ment takes w business ( ition, it mu 979). ersification sification m ). this stra par & kota ct, internatio at internati s the oppo rsification h ts of interna markets ha w. kim, hw nd sharing ts (hamel, 1 competenci & ghoshal, al markets s expected t inational fir rdizing prod nd effective titive advan onment) and ater bargain nts support sity and per els & brac ies have sh all, 1982). m sification an oderately div ersification anderson, advantage (datta, et al st pay atten n means a firm ategy is a be, 2003). onal divers onal divers rtunity for has been d alization in as advantage wang, & bu core comp 1991). ies that are 1999). thu is, the high to lead to hi rms have t ducts, ration ely (kobrin ntages by d cross-bord ning power the view rformance. a cker, 1989; hown either most of thes nd performa 59 versified an as internal 1985; r. p of interio l., 1991). in ntion to the m acts in the growth str this effec ification of sification o greater gr developed o internation es such as urgers, 1989 petencies a developed us it is argu her will be t igher perfor the opportu nalizing pro n, 1991). fu exploiting der transact with increa that a posi although s gomes & r a negativ se studies ha ance is linea asian nd highly di developme itts, 1976; r or resource n contrast, i weaknesses e market wh rategy that t is stated ffers severa offers prosp rowth. the on the theo nal markets economies 9; w. c. ki among diffe at home ca ued that the the exploita rmance (hym unity to in oduction, an urthermore, market im tions (such ased size (s itive, linear ome studies ramaswam ve relations ave assumed ar (gomes & n journal of f iversified (l nt and merg r. a. pitts, es and cor if a firm lik s and streng hich is not in has a maj by ansoff l advantage pective ma most acce oretical assu (caves, 20 of scale, s im, hwang erent busin an utilize th e higher the tion of tang mer, 1976). tegrate thei nd/or allocat , multinatio mperfections as transfer sundaram & r relationsh s have demo my, 1999; 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(2 fication on n create or ment opport nused borro n value-des y: the effici ake some sy d diversifica theory: pen le resources cities by app e where app has differenc heory: this 4). because its market diversificat position and diversificat caves, 1981; ome signific n their varia sented. oped count n and perfor melt. rume ated divers (2003) exam in service f ound out tha n german s olmsted (20 rsification a concluded t formance. 006) invest a sample o destroy va tunities or owing powe troying mer ency theory ynergies (m tion) and op nrose (1959) s that are kn plying dive lying the un ces in speci theory stem e, diversified power inc tion, it incre d use predat tion increas ; r. a. mille cant researc ables and fin tries rmance stud lt (1974; 1 sification, b mined the r firms in sam at there wa ervice firms 005) found and financia the more re tigated betw of large uk 61 alue. manag paying out er and larg rgers. y suggests t mat nor, 200 perational s ) developed nown as its ersification s nused resou ificity (c. a mmed from d firms act creases (edw eases the m tory pricing es market p er, 1973). ches from ndings. in a dy has start 982) noted because fir relationship mple of 81 as a curvilin s. d a positive al performan elated prod ween corpor k firms. th asian gers can sp t to shareh ge fcf are that diversif 03). these s ynergy (rela d resource b competitiv strategy. th urces (c. m a. montgom m a fear of m in many ge wards, 195 market powe g to improv power; then developed addition, at t ed from us d that relate rms in rela between in major ger near relation e relation nce among duct and int rate social p hey found n journal of f pend free c holders. so, more prob fication occ synergies ar ated diversi ased theory ve advantage his view imp ontgomery, ery & wern market bein eographic m 5). furtherm er. by havin e its profita n, more pro and develo the end of th sa. one of ed diversific ated form nternational man service nship betwe between re media firm ternational performanc out eviden finance & ac issn 19 2012, vol. www.macrothi cash flow (f , the theor bable to un curs once m re such as f ification). y which stat es and firm plies that a f , 1994) whe nerfelt, 1988 ng monopol market and more, when ng market p ability. res ofit can gain oping count the each par the first au cation mak can transf diversifica e firms acr een multinat elated prod ms in united diversificat ce and geog nce of a sig ccounting 946-052x 4, no. 2 ink.org/ajfa fcf) in ry states ndertake managers financial es every can use firm can ere these 8). lized (c. produce n a firm power, it earchers n for the tries are rt a table thors on kes more fer core ation and oss four tionality duct and d states. tion, the graphical gnificant positive regions diversif social p qian et regiona leverag regiona diversif impact maximi regions bobillo perform the uni externa and firm kahlou risk in herfind there is linear re some s utilized financia diversif diversif profitab diversif of relate some o 1993-20 depende variable control profitab associat e relationsh of the wo fication and performance t al. 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mportant. a on the f study). table 1 label gts01 gts03 gts10 gts15 gts16 gts27 source: g 3.2 par indones forms o show th public h account indones enginee from st signific data w survey. few pub asked th interest regardin made on second complet describe easily. f eight re hundred respond enginee 3.3 des descrip . good tea the teach the teach the teach my lectur the teach the teach my work graduate care rticipants sian nation of universit hat there a higher educ ting and eng sia. the en ering, indus tudents ma cant and hen ere collecte the data c blic places w hem wheth ed in parti ng good tea nce. a than request w te a simple ed previous five hundre esponses w d and fou dents were ering studen scriptive sta ptive statisti aching scale hing staff pu hing staff no hing staff of rers were ex hing staff w hing staff m . eers australia nal educatio ties, institut are nearly 3 cation institu gineering u ngineering strial engine ajoring in nce excluded ed only from collection pr where they her they we icipating in aching. to nk you was was made. e anonymou sly). the p ed and eigh were usable. urty eight accountin nts. atistics ics for the se es ut a lot of ti ormally gav f this course xtremely go worked hard made a real e (2011) on systems tes, college 3,000 highe utions (see w undergradua students in eering, and other engin d from the f m responden rocess starte usually han re accounti n an anony avoid any i immediatel those who us (indones rocess work hty three res two hund respondent ng students even-item s 335 ite ime into com ve me helpfu e motivated ood at expla to make the effort to und allow high es, academi er education www.dikti. ate students ncluded in t chemical e neering rel final data. nts who we ed by rando ng out (such ing or engin ymous surv inconvenien ly given to o voluntaril sian translat ked well an sponses we dred and ei s were m s, and two scales are pr asian m mmenting o ful feedback d me to do m aining thing eir subjects derstand diff her educatio ies, and po n institutio go.id). the attending u this study engineering lated areas, ere happy to omly approa h as shoppi neering stu vey and an nce, the req students wh ly agreed ted) questio nd response re received ighty respo male. three o hundred resented in t n journal of f on my work. k on how i w my best work s. interesting. ficulties i m on institutio olytechnics. ns in indon participants universities were those g. there we , but the n o voluntaril aching univ ing malls an dents, and nswered ten quest to eac ho rejected to participa onnaire with es were rec , and five h ndents wer hundred and five table 2. finance & ac issn 19 2012, vol. www.macrothi . was going. rk. . might be hav ons to be ru the latest nesia inclu ts in this stu in two big e majoring ere some re numbers w ly participat versity stude nd food cou whether th n simple q ch student w the request ate were a h ten quest corded quic hundred and re female, a and twent responden ccounting 946-052x 4, no. 2 ink.org/ajfa ving with un in the t figures uding 82 udy were cities in in civil esponses were not te in the ents at a urts) and hey were questions was only t, and no asked to tions (as ckly and d twenty and two ty three ts were table 2 mea std dev minimu maximu 4. anal 4.1 ove it can b all seve received how stu 5), 4.07 mean sc with me indicato “make mean sc some co tootoon 4.2 stud the me compar the init that rec students and “de 2. good teac comme on studen work an 4.05 0.84 um 3 um 5 lyses and fi erall studen be seen from en of the g d very high udents are g 7 (out of 5), cores: “exp ean scores ors received a real effor cores of 3.4 onsistencies nchi et al. (2 dents’ perce eans of the red to those tial indicati ceived simi s: “commen esign the co ching descri ent ts’ k giv helpf feedba on ho stude are go 4.07 4 1.00 1 5 indings t perception m the descr good teachi h mean sco going”, and and 4.05 (o plain things of 3.85 (ou d moderate rt to underst 48 (out of 5 s with the f 2002), and eptions of g scores on of engineer ions from th ilar scores nt on studen ourse very w iptive statist g ve ful ack ow nts oing motiv stude to do best w 7 3.4 0 1.2 1 5 ns of the lev riptive analy ing indicato res: “comm “design the out of 5) re very well” ut of 5) and mean scor tand difficu ) and 3.35 ( findings by xiao and d good teachin good teach ring underg he descripti from both nts’ work”, well”. the re 336 tics (n = 52 good teachi vate ents their work expl thin ver we 48 3.8 25 0.9 1 2 5 5 vel of impor ysis (table ors as imp ment on stu e course ve spectively. and “work d 3.70 (out res: “motiv ulties studen (out of 5) re feldman ( dyson’s (199 ng by area o hing scales graduate stud ive statistic the accoun “give helpf esults of the asian 8) ing indicato lain ngs ry ll work to m the subj intere 85 3.7 97 1.0 1 5 rtance of go 2) that und ortant. the udents’ work ry well”, wi two of the k hard to ma of 5) resp vate student nts might be espectively. 1976), holm 99). of study of accounti dents are sh s showed th nting and th pful feedbac e compariso n journal of f ors hard make eir ects esting ma e un di stud be h th 70 04 1 5 od teaching dergraduate ere were th k”, “give h ith mean sc indicators ake their su ectively. t ts to do the e having wit . these ove mes and pap ing undergr hown in tab hat there we he engineer ck on how st on of the me finance & ac issn 19 2012, vol. www.macrothi ake a real effort to nderstand ifficulties dents might having with heir work 3.35 1.31 1 5 g indicators students pe hree indicat helpful feed cores of 4.05 received qu ubjects inter the remain eir best wo th their wor erall results apageorgiou raduate stu ble 3. ere three in ring underg tudents are ean scores f ccounting 946-052x 4, no. 2 ink.org/ajfa design the course very well 4.05 0.90 1 5 s erceived tors that dback on 5 (out of uite high resting”, ning two ork” and rk”, with indicate u (2009), dents as ndicators graduate e going”, for these three in by the a students similar mean sc good te students students very we the an account indicato four ind were si which t students students the com differen 3.62 fro “work h with a s enginee the com showed students best wo their wo conseq is quite design o on the undergr of good importa on the the sub undergr differen motivat students ndicators con accounting s. these in perceptions cores also sh eaching ind s of 4.02 an s’ work”, g ell” indicato alysis of th ting and the ors were qu dicators co ignificantly the level o s were com s. mparison of nce, with a om the eng hard to mak score of 3.9 ering underg mparison o d quite large s of 3.89 an ork” and “m ork” indicat quently, thes e clear that of the cours ir progress raduate stud d teaching, ant but to a other side, bjects inter raduate stud nces obtaine te students a s. while acc nfirmed tha undergradu ndicate that s regarding how that th dicators, w nd 4.09, 4.0 give helpful ors. he descripti e engineerin uite differen nfirmed tha different th f importanc mparatively f mean scor score of 3. gineering un ke their subj 97 from the graduate stu of mean sco e difference nd 2.83, and make a real tors. se findings t both acco se, the lectu s, as the dents also co while engi slightly less accounting resting as dents consid ed from this and the lect counting un at there were uate student both accou the import ese three in with scores 08 and 4.05 l feedback o ive data sho ng undergra nt. the resu at the score han those g ce of these higher to res for the “ 99 from th ndergraduat bjects intere accounting udents. ores for the es, with sco d 3.82 and l effort to u can only pr ounting and urers’ comm most imp onsider the ineering un ser extent. g undergrad an import der this ind s study are turers’ effor ndergraduat 337 e no signifi ts and those unting and ance of the ndicators rec from acco 5, and 4.01 on how stud owed an in aduate stude ults of the c es given by given by th e indicators those perc “explain th he accountin te students. esting” indic undergradu e two remai ores from ac 2.60, respe understand d rovide some d engineeri ments on the portant ind lecturers’ a ndergraduate duate studen tant indicat dicator only in the stude rts to under te students c asian icant differe e given by t engineering ese three ind ceived the h ounting an and 4.11, r dents are go nitial indica ents for the comparison y the accou he engineeri perceived ceived by th hings very w ng undergra the comp cator showe uate student ining good ccounting a ctively for difficulties s e partial of ing undergr eir work, an icators of ability to exp e students a nts consider tor of goo as moderat ent percepti stand the di consider the n journal of f ences betwe the enginee g undergrad dicators of g highest score nd engineer respectively oing”, and “ ation that th remaining n of the mea unting unde ing undergr by accoun he engineer well” indicat aduate stude arison of m ed a quite m ts and a sco teaching in and enginee “motivate s students mi support for raduate stu nd feedback good teac plain as an also conside r the lecture od teaching tely importa ons on the ifficulties th ese two as im finance & ac issn 19 2012, vol. www.macrothi een the scor ering underg duate studen good teachi es among th ring underg y for “com “design the he scores f four good t an scores f ergraduate raduate stud nting underg ring underg ator showed ents and a mean scores moderate dif ore of 3.28 f ndicators, h ering underg students to ight be hav p1. on one udents cons k from the l ching. acc important i der this indi ers’ efforts g, but eng ant. the no lecturers’ e hat are face mportant in ccounting 946-052x 4, no. 2 ink.org/ajfa es given graduate nts have ing. the he seven graduate ment on e course from the teaching for these students dents, in graduate graduate d a slight score of s for the fference, from the however, graduate do their ing with e side, it ider the lecturers counting ndicator icator as to make gineering oticeable efforts to d by the ndicators of good importa students apparen the ch enginee althoug matters subjects and hen seeming table 3 account (n =323) mea std d minimu maxim enginee (n =205) mea std d minimu maxim t sig notes: * s d teaching, e ant. appare s and to em ntly they do haracteristics ering discipl gh sharing s as the engi s and area w nce for acc gly are mor . students’ comm on stude wor ting ) an 4.0 dev 0.8 um 3 mum 5 ering ) an 4.0 dev 0.8 um 3 mum 5 -0.9 0.3 significant at p engineering ently the en mpathize w o not contrib s of the di line is more some levels ineering dis which requi counting un re valuable a perceptions ment n ents’ rk gi help feed on h stud are g 02 4. 85 0. 3 1 5 5 09 4. 84 1. 3 1 5 5 921 0.3 57 0.7 < 0.01 g undergradu ngineering s with the stud bute to the t isciplines m e technical a s of techni scipline. ad ire discussio dergraduate and appreci s of good te ive pful back how dents going mot stud to their wo 08 3 99 0 1 5 05 2 03 1 1 5 319 9.7 750 0.0 338 uate student students do dents’ situa transfer and may also c and precise ical feature dditionally, on and anal e students, iated. eaching by a good teach tivate dents o do r best ork exp thi ve w .89 3. .99 0. 1 2 5 5 .83 3. .35 1. 1 2 5 5 719 4.0 000* 0.0 asian ts consider not regard ation as imp d communic ontribute to in nature w s and preci parts of the ysis which motivationa area of study hing indicato plain ngs ery ell work to m th sub inter 99 3. 87 0. 2 5 62 3. 08 1. 2 5 083 7.5 00* 0.0 n journal of f these two in d lecturers’ portant to t cation of ski o these res while the acc ision, is no e accounting are more qu al supports y ors k hard make heir jects esting m un d stud be h th .97 .92 2 5 .28 .07 1 5 598 000* finance & ac issn 19 2012, vol. www.macrothi ndicators as efforts to m their learnin ills and kno sults, in wh counting di ot as firm i g discipline ualitative in from the l make a real effort to nderstand difficulties dents might having with heir work 3.82 1.02 1 5 2.60 1.38 1 5 10.867 0.000* ccounting 946-052x 4, no. 2 ink.org/ajfa s not too motivate ng since owledge. hich the scipline, in those involve n nature, lecturers design the course very well 4.01 0.92 1 5 4.11 0.88 1 5 -1.239 0.216 4.3 stud the me compar from th in all g “give h of the m only in students students difficult suggest some ra women tendenc expect m in gene overall provide female indicato dents’ perce eans of the red to their he descriptiv good teachin helpful feed mean scores ndicator tha s, in which s was com t to make tions regard ationalizatio are suppos cy that ma more feedba eral, we cou good teach e a reasona and male un ors of good eptions of g e scores on male coun ve statistics ng scales w dback on ho s confirmed at was sign the level o mparatively a presumpt ding the dif on about thi sed to be mo ale undergra ack provide uld make a hing scores able level o ndergraduat teaching. good teachin n good tea nterparts’ sc showed tha were similar w students that “give nificantly d f importanc higher to t tion on wh fferences b s. it is said ore modest aduate stud ed by their l conclusion of the fema of support f te students h 339 ng by gende aching scale cores are sh at the score r to those o are going” helpful feed different be ce of this in that perceiv hat factors a etween ma that men ar and tender. dents, comp lecturers. n that there ale and mal for p2, and have simila asian er es of fema hown in ta es made by of their mal ” indicator. dback on ho etween fem ndicator per ved by thei affect this sculine and re supposed . hence, as paratively were no si le undergrad d hence can ar perception n journal of f ale undergr able 4. the female unde le counterpa the results ow students male and m rceived by m r female co difference. d feminine d to be asser a conseque to their fe ignificant d duate stude n provide s ns regarding finance & ac issn 19 2012, vol. www.macrothi raduate stud e initial ind dergraduate arts, except s of the com are going” male underg male underg ounterparts hofstede’s traits may rtive and tou ence there m emale coun differences b ents. these some eviden g the impor ccounting 946-052x 4, no. 2 ink.org/ajfa dents as dications students t for the mparison was the graduate graduate . it was s (2001) provide ugh, and may be a nterparts, between findings nce that rtance of table 4 females (n =280) mean std de minimu maximu males (n =248) mean std de minimu maximu t sig notes: * s 4.4 stud the me year of the init undergr undergr the res their be second perceiv by the s the des year un 4. students’ comme on student work s ) n 4.10 ev 0.85 um 3 um 5 ) n 4.00 ev 0.83 um 3 um 5 1.320 0.187 significant at p dents’ perce eans of the study are sh tial indicatio raduate stud raduate stud sults of the est work” w year unde ed by the fi second year scriptive sta ndergraduate perceptions ent ts’ k giv helpf feedba on ho stude are go 3.88 1.08 1 5 4.23 0.90 1 5 0 -3.95 7 0.000 < 0.01 eptions of g scores on hown in tab ons from th dents in al dents, excep compariso was the only ergraduate s irst year und r undergradu atistics and e students s s of good te g e ful ack ow nts oing motiv stude to do t best w 8 3.5 8 1.2 1 5 3 3.4 0 1.2 1 5 53 0.85 0* 0.39 good teachin good teach bles 5a to 5 he descriptiv l good teac pt for the “ n of the m indicator th students, in dergraduate uate student d the compa showed that 340 eaching by g good teachi vate ents their work expl thin ver wel 53 3.8 23 1.0 2 5 5 44 3.8 27 0.9 2 5 5 51 -0.7 95 0.45 ng by year o hing scales o 5c. ve statistics ching scale “motivate s mean scores hat was sign n which th e students w ts (see tabl arison of th t there were asian gender ing indicato ain ngs ry ll work to m the subj intere 81 3.6 00 0.9 1 5 88 3.7 95 1.0 1 5 54 -1.0 51 0.3 of study of undergra showed tha es were sim students to confirmed nificantly d he level of was compara le 5a). he mean sco e no signific n journal of f rs hard make eir ects esting ma e un di stud be h th 65 99 5 74 07 5 037 00 aduate stude at the scores milar to tho do their be that “motiv different bet importance atively high ores for sec cant differe finance & ac issn 19 2012, vol. www.macrothi ake a real effort to nderstand ifficulties dents might having with heir work 3.28 1.33 1 5 3.40 1.29 1 5 -1.063 0.288 ents based s made by f ose of seco est work” in vate studen tween first y e of this i her to that pe cond year a ences betwe ccounting 946-052x 4, no. 2 ink.org/ajfa design the course very well 4.00 0.96 1 5 4.09 0.85 2 5 -1.128 0.260 on their first year ond year ndicator. nts to do year and ndicator erceived and third een good teaching howeve undergr undergr indicato students students (see tab a poss relative some ch consequ results perceiv study. in gene overall students some ev of indic g scores of er, the ana raduate stu raduate stud or that was s. the level s was comp ble 5c). ible explan ely younger hallenges in uently they indicated t ed as less eral, we cou good teach s. these fin vidence that cators of goo f the secon alysis and c udents show dents, in w s significan l of importa paratively h nation of th students w n dealing w may need that this “m important o uld make a hing scores ndings prov t undergrad od teaching nd year and comparison wed similar which “moti ntly differen ance of this igher to tha his differenc who most ha with a new more assu motivate stu once the stu conclusion s of the fir ide a reason duate studen g irrespectiv 341 d third year s of the sc r results to ivate studen nt between s indicator p at perceived ce was tha ad just com environme urance and udents to d udents reac n that there rst year, se nable level nts have sim ve of their y asian r undergrad cores made o those of nts to do th first year perceived b d by the thir t first year mpleted their ent and a n encouragem do their be ch the secon were no si cond year of support milar percept ear of study n journal of f duate stude by first y f first year heir best w and third y by the first y rd year unde undergradu r high scho new univers ment from t est work” i nd or third ignificant d and third y for p3, and tions regard y. finance & ac issn 19 2012, vol. www.macrothi ents (see ta year and th r and seco work” was t year underg year underg dergraduate duate studen ools and mi sity culture. their lecture indicator w year level differences b year underg d hence can ding the imp ccounting 946-052x 4, no. 2 ink.org/ajfa able 5b). ird year nd year the only graduate graduate students nts were ght face . hence, ers. the would be in their between graduate provide portance table 5 and sec first yea (n =247) mean std de minimu maximu second year (n =166) mean std de minimu maximu t sig notes: * s 5a. students ond year stu comme on studen work ar ) n 4.05 ev 0.84 um 3 um 5 ) n 4.11 ev 0.81 um 3 um 5 -0.72 0.472 significant at p ’ perception udents) ent ts’ k giv helpf feedba on ho stude are go 4.10 0.98 1 5 4.06 1.00 1 5 1 0.41 2 0.67 < 0.01 ns of good t g ve ful ack ow nts oing motiv stude to do best w 0 3.7 8 1.1 1 5 6 3.3 0 1.2 1 5 15 2.82 78 0.00 342 teaching by good teachi ivate ents their work expl thin ver we 71 3.8 15 0.9 1 2 5 5 37 3.8 26 0.9 1 2 5 5 21 -0.1 05* 0.89 asian y year of stu ing indicato lain ngs ry ll work to m the subj intere 5 3.7 7 0.9 2 5 7 3.6 8 1.0 1 5 36 1.2 92 0.1 n journal of f udy (compar ors hard make eir ects esting ma e un di stud be h th 74 98 2 5 61 09 1 5 97 96 finance & ac issn 19 2012, vol. www.macrothi risons betw ake a real effort to nderstand ifficulties dents might having with heir work 3.39 1.29 1 5 3.37 1.31 1 5 0.147 0.883 ccounting 946-052x 4, no. 2 ink.org/ajfa ween first design the course very well 4.05 0.92 1 5 4.05 0.83 2 5 -0.063 0.950 table 5 second second year (n =166) mean std de minimum maximu third year (n =115) mean std de minimu maximu t sig notes: * s 5b. students and third ye comme on student work ) n 4.11 ev 0.81 m 3 um 5 ) n 3.95 ev 0.89 um 3 um 5 1.546 0.123 significant at p s’ perception ear students ent ts’ k giv helpf feedba on ho stude are go 4.06 1.00 1 5 4.00 9 1.08 1 5 6 0.48 3 0.63 < 0.01 ns of good t s) g ve ful ack ow nts oing motiv studen do th best w 6 3.3 0 1.2 1 5 0 3.1 8 1.3 1 5 81 1.4 31 0.1 343 teaching by good teachi ivate nts to heir work exp thi very 37 3. 26 0. 1 2 5 15 3. 35 0. 1 2 5 31 0.4 54 0.6 asian y year of stu ing indicato plain ings y well w ha mak sub inte .87 3 .98 1 2 5 .81 3 .99 1 2 5 493 -0 622 0 n journal of f dy (compar rs work ard to ke their bjects resting m rea und dif st m h wi 3.61 1.09 1 5 3.73 1.07 2 5 0.927 .355 0 finance & ac issn 19 2012, vol. www.macrothi risons betwe make a al effort to derstand fficulties tudents might be having ith their work d v 3.37 1.31 1 5 3.21 1.34 1 5 1.025 0.306 ccounting 946-052x 4, no. 2 ink.org/ajfa een design the course very well 4.05 0.83 2 5 4.05 0.96 1 5 0.018 0.985 table 5 and thir first yea (n =247) mean std de minimu maximu third year (n =115) mean std de minimum maximu t sig notes: * s 5c. students rd year stud comme on student work ar ) n 4.05 ev 0.84 um 3 um 5 ) n 3.95 ev 0.89 m 3 um 5 1.044 0.297 significant at p ’ perception dents) ent ts’ k giv helpf feedba on ho stude are go 4.10 0.98 1 5 4.00 9 1.08 1 5 4 0.88 7 0.37 < 0.01 ns of good t g ve ful ack ow nts oing motiv studen do th best w 0 3.7 8 1.1 1 5 0 3.1 8 1.3 1 5 86 3.8 76 0.00 344 teaching by good teachi ivate nts to heir work exp thi very 71 3. 15 0. 1 2 5 15 3. 35 0. 1 2 5 71 0.4 00* 0.6 asian year of stud ing indicato plain ings y well w ha mak sub inte .85 3 .97 0 2 5 .81 3 .99 1 2 5 414 0 679 0 n journal of f dy (compar rs work ard to ke their bjects resting m rea und dif st m h wi 3.74 0.98 2 5 3.73 1.07 2 5 .123 .902 0 finance & ac issn 19 2012, vol. www.macrothi risons betwe make a al effort to derstand fficulties tudents might be having ith their work d v 3.39 1.29 1 5 3.21 1.34 1 5 1.246 0.213 ccounting 946-052x 4, no. 2 ink.org/ajfa een first design the course very well 4.05 0.92 1 5 4.05 0.96 1 5 -0.034 0.973 5. conc the ove seven o undergr commen importa students teaching undergr lecturer difficult three at finally, indicato the res wishing noted t opportu with the learned evidenc the stud indicato students referen botas, educatio blackm evaluati http://dx crumbl of co http://dx emery, student http://dx feldma higher clusions erall results of the goo raduate stu nts on thei ant indicato s also feel g, but its i raduate stu rs’ efforts to ties that are ttributes as i , overall, un ors of good sults of this g to improv that as mu unity for the e unique ch and appli ce that the g dents, and h ors for stud s. nces p.c.p. 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it seem ptcy of co on techniqu d modeling es used in ents (etemad earch theor ptcy always community ptcy. but it manageme bankruptcy the risk of e the comp ptcy has bee –ching yeh affect the ec r variety of read of crisi al.2009). survival of ge investme and is out asting firm t in stock m nkrupt annu ll their prop ng creditors nd inventor any value is mportant as ases, bankru cking debt h bankruptcy hances becau t value of th ms necessar mpanies. s ues in bank g technique building di, 2007 ). ries and bac s has divert . it is very can be claim ent, investor y, not only t f your port pany's finan en a challen h et al.2010 conomy of public and s to other p f the existin ent in the s of stock. t ms that are market with t ually becaus perties with s may dela ry depreciati s spent for l 1 and 2. uptcy cost i have never b y likelihood use of the c he company ry to find statistical t kruptcy pre es and has these mod ckground ed wide ran difficult to med that it rs, creditors o prevent th tfolio (etem ncial bankru 49 nging issue 0). bankrupt the country d commercia parts of the f ng company stock excha therefore w going bank the lower ri se such situ low price. ay liquidati ion increase lawyers’ fee is high. it j been bankru d and reduc costs of bank y, enhancing a model th techniques ediction. th focused o dels is the nge of indiv o provide a will be influ s, competito he risk of bu madi, 2007 ) uptcy, becau asian for many sc tcy is impo y. in fact, b al organizat financial sy y in stock e ange, becau with the de kruptcy, ca sk (rekabd ations: ing the ass es. e, court cos ust occurs f upt. so, fina ce earnings. kruptcy. inc g its capital hat can pre are consid his model n signs bu informatio viduals, orga an accurate uenced ban ors, and leg urning their ). hence, t use in case n journal of f cientific stu rtant in fina ankruptcy p tions. becau stem and ca exchange is use perhaps esign and p an be gave ar et al,200 sets. then st, and organ for the com ancial provis as a 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(such as b but, the form gistic funct c regression formance of el based on 9 to %92 an 88).lennox( sh compani include pr economic cy d with disc e bankruptcy esults of t t, and multip dict corpor nant analys ng some w company. . success or 11 e independen ) likelihood z move into 0.5.logit an hood of the ween 0 and e dependent ankruptcy a mer uses cu ion. , a p a 51 n model, th f designed m n multiple d nd was accu (1999)exam ies since 1 rofitability, ycles. the criminant an y likelihood the applica ple-discrim rate bankru sis. logit m weights to in this ranki r failure lik 1 e nt variables d is a numb +∞, p(z) w analysis inst event. thu 1. t variable,w and non-ban umulative li a = asian e model wa model by th discriminan uracy of dis mined the re 1978-1994. financial le results show nalysis in p d of manufa tion of 3 minant analy uptcy from t model has w ndependent ing is used kelihood in t 1 ... s, and a an er between will tend to tead of pre us dependen was qualitati nkruptcy)pr 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this me achieve classifi multiva point, it the dis equatio :t where ‘ companx : t :coe u :is th the firs corpora had mo 3.1 var to iden principa large nu several the who highest collecti this ap variable varianc called t analyzin le-discrimin stinct group the groups ch predictio uisite for md of ratio-b ed: the firs s companie thod, a com ed score and ication w ariable-discr t was regard scriminant on 1 gives the value th ‘ k’ represe nies. ‘ fkm’ the value fo efficients as he constant st time altm ate failure.t deling more riables ntify the m al compone umber of in principal c ole variance amount in ons of varia proach will e with each ce explained the specific ng principa nant analysi ps with diff and predict ons, some da is that based mode st group in es that are s mpany was d the maxim was done riminant an ded as a non function, a the general hat the disc nts either th is also know or the financ sociated wi term or the man (1968) this study a e than one v most importa ent analysis nitial variab omponents e. at first sp n total var ables that ha l apply to se factor is cal d by each fa c value. th al compone s is a multiv ferent quali t the likelih quantitativ a data item els for sign ncludes com still a going attributed to mum similar based o nalysis mode n-bankrupt c and the fin specificatio u u x criminant fu he group of wn as the sc cial ratio ‘i’ ith each fina intercept. suggested m lot attentio variable. ant financia was used. bles into a are to revie pss, selects c iance. this ave the high elect the thir lled factor l factor equal he first spec ents, the va 52 variable me ities. this s hood of a co ve independ m could be c naling corp mpanies tha g concern. o a bankrup rities. on optimu el. if the sco company.t nancial rati on of the mu x unction gen f collapsed core. ’ for compan ancial ratio multiple dis on because f al ratios fo in principa small num ewed so tha combination s collection hest contribu rd, fourth an lodding and to the squa cific value 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ncial inform should hav 2010. git model egression m c values.to e change tot express initi bles of the s (roe) er io ng capital ra le was the l ion of the s an since 200 t companies ran, based o capital must es was base should be m r should end mation of the ve 10 succ model fitness o choose t tal percenta ial changes. study includ atio ikelihood o study includ 00-2010. to s were used on which th t declare ba d on the fol manufacturin d in septem e companie cessive yea s was tested 53 the number age cumulat thus after de: of bankruptc ded all man o measure m d. bankrupt he firms wit ankruptcy o llowing con ng. mber. s should be ars of activ d based on th1 1 asian r of main tive so that r examining cy or nonb nufacturing model fitnes tcy measure th minimum or capital lo nditions: accessible. vity in stoc he followine e ε n journal of f variables c the this ma g 22 financi bankruptcy o companies ss, the data o e in this stud m accumulat oss. sample ck exchang ng equation: finance & ac issn 19 2013, vol. www.macrothi can be con ain compone ial ratios, 7 occurrence. s accepted i of 55 bank dy was act ted loss, eq e selection ge of tehra ccounting 946-052x 5, no. 1 ink.org/ajfa nsidered ents, 80 7 factors in stock rupt and 141 of qual with of non an since table 1 table 2 0.000 table 3 ro inv co pro de de de co accord conclud coeffici gives th 48 table 4 observed b percent estimat bankrup .1 regressi coeffi nagel 0.273 .2 significa 3. logistic r oe ventory turnov llection period oduct of work bt ratio bt to equity ra bt coverage ra nstant ing to likeli ded that the ient it identi he following7.667 0.00 4. to accura bankruptcy tion accurac pt companie ion statistics icient of deter kerke ant regressio sig. regression c ver d ing capital rat atio atio ihood value e model is ifies %27 o g formula: 024 0.0.005x ε ately estima 0 1 cy was %81 es shown in s co co rmination 0. on test 7 coefficients sig. 10.000 10.09 10.761 10.927tio 10.005 10.004 10.691 10.054 e in significa 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(2011). inant analys m khalili a ess article d n license (h 59 . bolanle, a diction: a co predicting sis fulmer a araghi and s distributed http://creativ asian a. (2009). l omparison o bankruptcy and compa sara makva under the vecommons n journal of f learning tec of some sta y by using re them. ac ndi. terms and s.org/license finance & ac issn 19 2013, vol. www.macrothi chniques. b atistical mo ohlson logi ccounting a d conditions es/by/3.0/). ccounting 946-052x 5, no. 1 ink.org/ajfa banco de odels. it model nd audit s of the microsoft word 3802-14520-1-ed-new2.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 419 the relationship between organization strategy, fixed-assets investment and earnings quality shen-ho chang department of accounting, feng chia university, taiwan no. 100, wenhwa rd., seatwen, taichung, taiwan 40724 e-mail: shchang@fcu.edu.tw teng-shih wang program in business, feng chia university, taiwan no. 100, wenhwa rd., seatwen, taichung, taiwan 40724 e-mail: t.swang0617@gmail.com shaio yan huang (corresponding author) advanced institute of manufacturing with high-tech innovations department of accounting and information technology national chung cheng university, no. 168 university rd., minhsiung township, chiayi county 62102, taiwan e-mail: actsyh@yahoo.com.tw an-an chiu department of accounting and information technology national chung cheng university no. 168 university rd., minhsiung township, chiayi county 62102, taiwan e-mail: ananchiu2009@gmail.com received: june 2, 2013 accepted: june 20, 2013 published: june 20, 2013 doi:10.5296/ajfa.v5i1.3802 url: http://dx.doi.org/10.5296/ajfa.v5i1.3802 abstract one of the important sources for investors to evaluate is the information provided in the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 420 financial statements disclosed by firms. past researches consider that worse financial statement quality has higher information risks from the aspect of information risks but they ignore the investors’ degree of tolerance and aversion towards risks. furthermore, the accounting signals hidden behind financial statements can be considered as important information for investors to evaluate the futurity of enterprises. thus, it is our main research topic as how to apply accounting signals on investment risks. this study uses data of the u.s. during 1991-2008 to review the influence of accounting signals on investment risks. result finds that in the investment management essentials in firm-wise, the accounting signals for capital expenditure ratio per person can lower the investment risks no matter in cost leadership firms or differentiation strategy firms. for the investment management essentials in industry-wise, we have the below findings: in cost leadership strategy samples, there is competitive convergence if enterprises over-pursue the fixed asset turnover ratio. in the samples that adopt differentiation strategy, increasing the ixed asset turnover ratio can enhance organization’s competitiveness and reduce investment risks. this is the first study that applies capability index of accrual quality (investors’ degree of tolerance and aversion towards risks) on researches of accounting signals and discovers that competitive convergence exists in organizations that adopt cost leadership strategy. keywords: earning quality, investment risks, accounting signals, organization strategy, competitive convergence asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 421 1. introduction this study is an extension of the research of soliman (2008) and a review of the influence of accounting signals on investment risks. investment risks are defined as the risks of investors' uncertainty on future investment or investment losses. in another word, investors invest in securities based on the information on financial statements disclosed by company managers and such investment causes uncertainty. it is suggested that the acquisition and use of information on financial statements is regarded as one of the methods to reduce investment risks. for example, market participants can assess a firm’s capability of solvency and liquidity through the cash flows information; or, to conduct business valuation using accruals in earnings. however, earnings information can have estimated errors under intentional or unintentional management of managers. francis, lafond, olsson and schipper (2005) pointed out intentional error was caused by the earnings management of managers whereas unintentional error was caused by management lapses and environmental uncertainty. not to mention whether such errors are caused by the intentions of managers, the measurement errors for accruals will affect accrual quality and lead to two results: 1. earnings after tax will diverge from the actual cash receipts; 2. the more the undetected estimated errors included in earnings after tax, the higher the uncertainty is. therefore, investors use financial information that includes uncertain accrual items during investment decision-making process when they are not disclosed with full information and there are risks caused by the uncertainty. this is called investment risks. in the past, standard deviation of residuals for regression model has been the major measurement of investment risks (e.g francis et al., 2005; core, guay and verdi, 2008 ; kim & qi, 2010; mashruwala & mashruwala, 2011). for investors, however, assessment of investment risks should consider the degree of tolerance and aversion towards risks instead of the information risks of objects. chang, huang, chiu and huang (2012) established a basic capability index of accrual quality, as know as cbaq with loss function in mathematical model deduction. the index is built based on investors' degree of tolerance and aversion towards risks. it also found that higher the capability index of basic accrual quality, the lower the investment risks. investors should also respect the accounting signals from firms while considering information risks and their degree of tolerance and aversion towards risks. the earnings information provided in financial statements is an important reference on the capital market for investors. nissim and penman (2001) were the first to convert accounting-based valuation analysis to option-based analysis and pointed out current financial indicators in the analysis of current financial statement can be seen as current ratios as predictors of the future ratios that determine equity payoff. soliman (2008) used dupont analysis to point out the accounting signals in the analysis in fact provides incremental information about firm’s characteristics. in long term, the accounting signals also provide market participants the incremental information about future earnings. this paper thinks the accounting signals financial indicators from dupont analysis can reflect the current operation situation of a firm but there are few researches on its relationship with the investment risks evaluated by investors. hence, we attempt to combine the accounting signals obtained from dupont analysis and review asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 422 their relation. to review our research topics, we apply the capability index of accrual quality that considers investors’ degree of tolerance and aversion towards risks established by chang et al.(2012) and take this as the proxy for investment risks. afterwards, we review whether the capability index of accrual quality used in this paper has the same propensity as the accrual quality by the firm characteristics variable proposed by dechow and dichev (2002) and verify the usefulness of capability index of accrual quality as investment risks. then, we will break down two levels of accounting signals indicators using dupont analysis strategy level and internal management level – and review their relationship with investment risks. our results show that firm scale is positively associated with the capability index of accrual quality that means larger firms have more stable operations which will reduce estimated errors and investment risks. standard deviation of revenue, standard deviation of cash flows and number of surplus are negatively associated. when the firms face environment with higher uncertainty or greater number of surplus, the investment risks will increase. for the influence of investment management on investment risks, we find that the increase respect on automation can reduce risks no matter the firms adopt cost leadership or differentiation strategies if we put aside industry effect in investment management. the enhancement in automation helps firms to adapt to uncertainty in the environment. in samples adopt cost leadership strategy, there is competitive convergence proposed by porter (1996) if enterprises over-pursue the turnover of fixed assets. that means enterprises will have similar strategy if they improve quality, production cycle and relationship with partners and vendors by simulating each other. this will result in deterioration where there is no winner in the market so the investment risks increase. in the samples that adopt differentiation strategy, increasing the turnover of fixed assets can enhance organization’s competitiveness and reduce investment risks. when we inspect the relation between investment management and investment risks, this study interprets that no matter which strategy is adopted – cost leadership or differentiation – the enhancement of automation equipment should be taken into consideration. for firms that adopt cost leadership strategy, the use of automatic production can reduce the uncertainty factors from non-fixed assets and investment risks in the case of low gross profit rate. on the contrary, in the case of high gross profit rate, firms adopt differentiation strategy can adjust production methods in a speed that surpasses the industry by automatic production and provide better differentiated products or services to customers. the major contribution of this study is to consider investors’ degree of tolerance and aversion towards risks in the capability index of accrual quality and apply it on the research of firm’s accounting signals. different from past researchers which only adopt standard deviation of residuals as the measurement of information risk, this study not only considers the degree of tolerance and aversion towards risks in the capability index of accrual quality, but also applies it on the research of accounting signals analysis in capital market. this study also points out the influence of accounting signals input on investment risks. rest of this paper includes literature review which addresses literature related to business valuation process, organization strategies, and accounting signals. research design includes deduction of capability index of accrual quality, definitions of related variables and explanation of sources. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 423 next will be empirical results which include descriptive statistics, regression analysis and sensitivity analysis. last section is our conclusions and practical implications of this study. 2. literature review organization strategy and business valuation organization strategies are like nautical maps which provide clear guidelines of the competitive markets for enterprises. porter (1996) suggests that organization strategies should be classified as differentiation strategy and cost leadership strategy. firms are able to maintain their differences with rivals by using strategies. kaplan and norton (2000) point out strategy map can assist employees to understand the relation between their jobs and organization’s goals and how to achieve such goals by coordination and cooperation and also to create organization values by connecting organization assets. palepu, healy, bernard and peek (2007) mention organization strategy analysis is the starting point for the analysis of financial statement. it can be divided as industry choice, competitive positioning analysis and corporate strategy analysis. competitive positioning analysis includes cost leadership and differentiation. these two strategies can both build continuous competitive advantages. brealey, myers and allen (2011) note that economic rents1 are earned only at two points of time when the industry has not settled down to equilibrium or when the firm has something valuable that competitor does not have. therefore, the nature of organization strategies is to provide organization a clear guideline and create competitive advantages and create continuous advantages using strategies so to create more economic values. porter (1996) mentions a lot of organizations mix up organization strategies with operational effectiveness and take the operational effectiveness tools as organization strategies, so organization does not have sustainable advantages. hence, he defines the relationship between organization strategies and operational effectiveness. both of them are the basic requirements to achieve superior performance of organization. organization strategies can help organization to outperform its rivals – normally through cost leadership or differentiation. operational effectiveness means performing similar activities better than rivals perform them. in the discussion of organization strategy maps, kaplan and norton (2000) think to increase shareholder value, revenue growth and productivity should be addressed. revenue growth focuses on introducing new sources of revenue and increase customer profitability; while productivity focuses on improving the cost structure and use of assets. palepu et al. (2007) suggest value of a firm is determined by its profitability and growth from the aspect of business valuation. the firm’s profitability and growth are influenced by its product market and financial market strategies. the product market strategies are implemented through the firm’s competitive strategy, operating policy and investment decisions while financial market strategies are implemented through financing and dividend policy. fairfield and yohn (2001) mention the return on assets can be decomposed into asset turnover and profit margin. compared with current profitability, it is more useful to provide the 1 economic rents are the profit that cover the cost of capital.(brealey et al., 2011) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 424 insights into the firm’s strategy with asset turnover and profit margin. soliman (2008) believes the accounting signals in the dupont analysis can be the variables to measure the firm’s operation structure. in particular, the analysis decomposes a firm’s return on net operating assets (rnoa) into profit margin (pm) and asset turnover (ato) where pm is often derived from pricing power, for example product innovation, product positioning, brand name recognition, first mover advantage, and market niches. ato measures asset utilization and efficiency, which generally comes from the efficient use of property, plant, and equipment; efficient inventory processes; and other forms of working capital management. therefore, the information provided by financial statements assists external investors, analysts and creditors to further understand the current strategy position and operation conditions of a firm. palepu et al. (2007) also mention that the purpose of ratio analysis is to evaluate the effectiveness of the firm’s policies. it can also help analyst regarding the firm performance and prospect. business valuation theories and accounting signals the main target of financial statements is to understand the determinant factor of a firm's value. ohlson (1995) indicates that the value of a firm can be expressed as a function of the firm’s book value and future abnormal earnings, or future return on equity in excess of the cost of capital. on the other hand, nissim and penman (2001) point out that financial statements state the equity value of a firm and it is determined by future earnings power. soliman (2008) uses the residual income model to show stock price can be rewritten in terms of roe and reported book value plus an infinite sum of discounted residual income, as equation (1):          1i i e 1ite1tt tt r1 brroeebp (1) where, pt: stock price in t period bt: reported book value in t period et(.): expectation that provide information in t period roet+1: return on equity in t+1 period et(dt+i): expected future dividends in t+1 period based on the information that can be provided in t period re: cost of equity capital ohlson (1995) and feltham and ohlson (1995) highlight the theoretical importance of roe in business valuation. fairfield and yohn (2001) mention that net operating return on assets can be decomposed into asset turnover and profit margin. asset turnover measures the firm’s ability to generate revenues from its assets while profit margin measures the firm’s ability to control the costs incurred to generate the revenue. they are both part of the firm’s strategy. palepu et al. (2007) point out that roe is the starting point of a systematic analysis of a asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 425 firm’s performance and it is the comprehensive indicator for firm’s performance which provides managers the information on employing its assets profitably and generating returns. roe can be decomposed into roa and a measure of financial leverage. soliman (2008) uses the dupont analysis to decompose roe into the three multiplicative ratios of profit margin, asset turnover, and leverage. the decomposition is shown as equation (2): bvequity assets assets sales sales ni leverage financialroaroe  (2) palepu et al. (2007) mention firm’s growth and profitability are influenced by its product market and financial market strategies. the product market strategies is implemented through the firm’s competitive strategy, operating policy (including managing revenue and expenses) and investment decisions (including managing working capital and fixed assets). financial market strategy ate implemented through financing (including managing liabilities and equity) and dividend policy (including managing payout). porter (1996) mentions that organization strategy and operating effectiveness are essential for superior performance. thus, this paper will focus on the decomposition of roa and the presentation of product market strategy as well as the operating and financial policies. for business strategies, porter (1996) indicates the establishment of differences with rivals to stand out in the crowd. the two methods to stay different with rivals are providing customers with higher values and providing lower costs but with the same values of the rivals. nissim and penman (2001) use the decomposition of rnoa and have the following results: pm measures the firm's ability to control the costs incurred to generate sales and gives insight into the sensitivity of operating income to product price and cost structure. ato captures the firm's efficiency in using operating assets to generate sales and is often interpreted as a measure of asset utilization by managers. fairfield and yohn (2001) also point out that profit margin, reflects the firm’s operating efficiency while asset turnover reflects the firm’s asset utilization. for example, discount stores tend to have relatively higher asset turnovers and lower profit margins than luxury or specialty stores. palepu et al. (2007) mention a firm following the differentiation strategy seeks to be unique in its industry with product that is positioned to be highly valued by customer. on the other hand, cost leadership achieves superior performance by economics of scale and scope, economies of learning, efficient production, simpler product design, lower input costs, and efficient organizational processes. soliman (2008) points out that pm and ato present different structures about a firm's operations. pm is often derived from pricing power, such as product innovation, product positioning, brand name recognition, first mover advantage, and market niches. ato measures asset utilization and efficiency, which generally comes from the efficient use of property, plant, and equipment; efficient inventory processes; and other forms of working capital management. there are two sources to affect ato and pm differently from competitiveness aspect. large profit margins often draw new entrants into the marketplace or quick imitation of new ideas from existing rivals resulting in high profit margins reverting to normal levels. unlike profit margin, however, asset turnover is more difficult to imitate another firm's efficient production processes so it is not threatened by rivals easily. hence, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 426 this paper thinks a relative proportion of pm and ato can distinguish organization strategies with roa. firm with larger profit margins and lower asset turnover will tend to differentiation while firms with lower profit margins and higher asset turnover will tend to cost leadership. palepu et al. (2007) indicate gross margin is influenced by two factors: 1) the price premium that a firm’s products or services command in the marketplace and 2) the efficiency of the firm’s procurement and production process in terms of operating management. in terms of investment management, it is divided into working capital management and management of non-current assets. operating working capital focuses on trade receivables, inventories and trade payable. they are short-term investment management which influences the normal operation of a firm. another area of investment management concerns the utilization of a firm’s non-current asset which is long-term management. this paper employs hierarchical decomposition of roa and classifies fixed asset turnover ratio and capital expenditure ratio per person as non-current assets. fixed asset turnover ratio measures if a firm can use fixed assets to create benefits. capital expenditure ratio per person determines if a firm uses high technology equipment in production. when a firm has higher fixed asset turnover ratio, that means it can effectively use fixed asset equipment and improve its roa. when the firm has higher capital expenditure ratio per person, it can react to the environment uncertainties quickly and create more values with the assistance of high technology. accounting signals and investment risks healy and palepu (2001) think asymmetric information and incentive problems lead to managers and outside investors’ demand on financial reports and disclosure of finance. beaver (2002) indicates information on financial statements presents clear and related standard for decision makers in making decisions and for the individual parties to make contracts. for investors, the earnings information on financial statements evaluates the results of managers for the past year (nwaeze, yang and tin, 2006; banker, huang and natarajan, 2009) and updates its judgment on the firm’s value. kothari (2000) mentions market participants seek high-quality financial information because it mitigates information asymmetry between the management of the firm and outside investor. reduced information asymmetry has desirable effects on the cost of capital and the volatility of security prices. hence, investors and analysts can understand the managers’ efforts and current value of a firm and obtain desirable returns on equity with the information on financial statements. beaver (1998) argues that one theoretical link between earnings and share prices is that current earnings provide information to predict future earnings. lev and thiagarajan (1993) show that signals of the current accounting data can predict future earnings change. these signals include information about changes in inventories, accounts receivables, gross margins, selling expenses, capital expenditures, etc. abarbanell and bushee (1998) find that fundamental signals provide information about future returns that is associated with future earnings news by fundamental accounting analysis. nissim and penman (2001) believe profitability and growth are the driven forces for equity values. they also lay out a structured financial statement to analyze that profitability and growth facilitate forecasting and valuation. soliman (2008) finds that the information in the accounting signal is in fact incremental to asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 427 accounting signals in predicting future earnings by the dupont analysis. in conclusion, fundamental accounting signals on financial statements can assist investors to understand the internal strategies of organization, allocation of assets and profitability and provide incremental to accounting signals for investors to predict future earnings. to enhance the profitability information, gaap allows managers to mitigate the timing and matching issues of cash basis by accrual processes in order to reflect the earnings of organization. therefore, the composition of earnings can be divided into accruals and cash flows. accruals focus on the timing of income and expenditures that are recognized in earnings, while cash flows focus on cash income and expenditure on a cash basis. dechow and dichev (2002) think that accruals shift or adjust the recognition of cash flows over time so the adjusted numbers can better measure a firm’s performance. however, accruals are frequently based on assumptions and estimates that, if wrong, must be corrected in future accruals and earnings. the estimation errors and their subsequent corrections will reduce the beneficial role of accruals. mcnichols (2002) classifies accounting literature regarding earnings quality into three categories: 1. earnings are defined as high quality if earnings are persistent, an attribute based solely on the time-series properties of earnings. 2. earnings are defined as high quality if earnings accurately represent the economic implications of underlying transactions and events. 3. earnings quality is defined in terms of the relation between accruals and cash flows. hence, this paper defines information risk as risks that incurred because investors make their decisions using accruals that include uncertainties. if the earnings quality is good, it will reduce the asymmetry in information between managers and investors. reversely, the asymmetry in information between managers and investors will increase if earnings quality is poor. nonetheless, market participants should not only rely on the information risks of the object itself, they should also consider their degree of aversion and tolerance towards risks. in addition, they should evaluate a firm’s decision positioning, business value and investment risks by accounting signals. thus, this paper will review the influence of accounting signals on investment risks by decomposition. 3. research design empirical model past researches believe the use of accounting signals help investors or analysts to understand the organization operations and predict future earnings (e.g. lev & thiagarajan, 1993; abarbanell & bushee, 1998; nissim & penman, 2001; fairfield & yohn, 2001; soliman, 2008). soliman (2008) proposed a way that investors can reduce asymmetric information in accounting signals. by the decomposition of the dupont analysis model, market investors could get superior performance using the dupont model while analysts could correct their prediction by the dupont components. however, whether a firm’s financial statement can reflect the true value is the most concerned information for outside investors who pursue for high earnings quality. to enhance the earnings information quality for assisting investors or shareholders in valuating managers’ performance, gaap allows managers to mitigate the timing and matching issues of cash basis by accrual processes in order to reflect the earnings of organization. nevertheless, managers may mislead investors of the true business value intentionally which results in investment risks. investment risks were measured mainly by accrual quality (residual standard deviation) in the past (francis et al., 2005; core et al., 2008; asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 428 kim & qi, 2010; mashruwala & mashruwala, 2011) where worse accrual quality would lead to high information risks. however, for the investors, investment risks are defined as the uncertainty of losses incurred because investors make investment decisions based on the financial information disclosed by managers. so this paper regards investment risks as the ability that investors can tolerate the information risks. we consider the investors’ tolerance range towards information risks instead of only the dispersion degree of information itself. this paper employs the estimation model of information risks proposed by francis et al. (2005) with assistance of formulas of fundamental capability index of accrual quality by chang et al. (2012) to probe the investment risks applied in this paper. dechow and dichev (2002) suggested that estimate of the accrual quality requires a lengthy time-series. in addition, the regression approach requires information about future cash flows, which reduces its usefulness in model settings. therefore, it is valuable to identify observable firm characteristics that act as instruments for the propensity to make estimation errors. this paper will adopt the firm characteristics suggested in this research, such as operation cycle, firm size, cash flows, revenues, earnings and number of deficits as variables to examine the influence of firm characteristics and investment risks. the regression model is as equation (3) below: caqi α f (ave.opcycle i , ave.size i , std. sale i ,std.ocfi, std.earningsi , prop.ni i) (3) where, caqi: investment risks of i companies. ave.opcyclei: average operation turnover days of i companies. ave. size i: average firm size of i companies. std.salei: standard deviation of operation income of i companies. std.ocfi: standard deviation of cash flows of i companies. std.earningsi: standard deviation of earnings of i companies. prop.ni i: number of deficits of i companies. after that, this paper reviews the influence of accounting signals on investment risks by dupont components concept proposed by soliman (2008). different from the research model suggested by soliman (2008), this paper first differentiates organization strategy level by profit ratio and asset turnover ratio in the dupont components and probes the role that management plays in strategy level. palepu et al. (2007) suggested that there were two types of internal management essentials, one is operations management, another is investment management. operations management focuses on the short-term performance within the organization whereas investment management focuses on the assets management in long term. the investment risks index in this paper employs the accrual quality model proposed by francis et al. (2005) with the assistance of the firm-specific regression estimate of the accrual quality in a lengthy time-series and the capability index of accrual quality. we obtain model (4) to review the probing questions in this paper: caqi α f (ave.fati , ave.pcei , ave.fat_sici , ave.pcce_sici , controli；firm strategyi) (4) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 429 where, caqi: investment risks of i companies. ave.fati: fixed assets turnover ratio of i companies. ave.pcei: capital expenditure ratio per person of i companies. ave.fat_sici: difference between fixed assets turnover ratio and industry average number of i companies. ave.pcce_sici: difference between capital expenditure ratio per person and industry average number of i companies. controli: control variable of i companies. firm strategyi: firm strategy of i companies. investment risks under capability index of accrual quality business value is the discount free cash flow of a firm in the future. hence, investors tend to estimate a firm’s future cash flows from the disclosed financial information. nonetheless, financial information includes earnings information from two different accounting bases – net profit after tax on accrual basis and operating activities cash flows on cash basis. if the difference between these two is great it implies net profit per book is unable to receive cash. accruals (e.g. estimation and assumption) are the major reason for the different. therefore, accrual quality should also be considered for investment valuation. so this paper employs residuals to measure the method by accrual quality measurement method proposed by francis et al. (2005), as shown in equation (5): t,it,i5t,i41t,i3t,i21t,i10t,i ppevrecfocfocfotca   (5)� where, t,it,it,it,it,i stdebtcashclcatca  (total current accruals of i companies); t,ica changes in current assets of i companies (compustat #4); t,icl changes in current liabilities of i companies (compustat #5); t,icash changes in cash of i companies (compustat #1); t,istdebt changes in current liabilities due within one year of i companies (compustat #34); 1t,icfo  operating cash flows of i companies in t-1 period; t,icfo operating cash flow of i companies in t period (compustat #308); 1t,icfo  operating cash flow of i companies in t+1 period; t,ivre changes in income of i companies in t period (compustat #12); t,ippe assets, plants and equipment of i asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 430 companies in t period respectively (compustat #7); t,i residuals of i companies in t period 2. dechow and dichev (2002) used standard deviation of the residuals as a firm-specific measure of accrual quality, where a higher standard deviation signified lower quality. chang et al. (2012) employed the investors loss function concept. when investors faced an investment target with multiple t , the standard deviation incurred will hinder investors to measure its accrual quality. therefore we should assume investors’ tolerance range is a 90% probability distribution3 formed by potential investment target. we will learn that the investors’ tolerance range is 3.29 times standard deviation of the potential investment target and this is the numerator of capability index of accrual quality. then we assume investor’s investment criteria is to choose t standard deviation of the investment target (as known as p hereinafter) that equals to t standard deviation of the potential investment target (as known as t hereinafter) at the most. the measurement allowance of numerator of capability index of accrual quality is 3.29 times t standard deviation of the investment target which is considered as the denominator of capability index of accrual quality. when the standard deviation of residuals for all potential investment targets and investment target are equal, the capability index of accrual quality should be 1. this measurement index is called capability index of accrual quality in this paper4 (as known as caq hereinafter). formula (6) is shown as: p29.3 lsluslcaq   (6) where, usl: maximum tolerance incurred by t of the potential investment target (refer to usl= tt z   )2/1(  ) ; lsl: minimum tolerance incurred by t of the potential investment target (refer to lsl= tt z   )2/1(  ) ; t : mean of t of the potential investment target (mean)5; t : standard deviation of t of the potential investment target (standard deviation); 2 res idua l s a re ca lcula ted by fi rm spec i f ic regress ion approach in th i s paper. 3 in s ta t i s t ic s , p robabi l i ty d i s t r ibu t ion normal ly uses 90%, 95% and 99%. the to le rance range fo rmed by 90% probabi l i ty d i s t r ibu t ion i s na r rower so we apply th i s a s to le rance range t . 4 different from research of chang et al. (2012) which uses residuals estimation approach suggested by dechow and dichev (2002), we replace it by the estimation model of francis et al.(2005). 5 thi s paper appl ie s f i rm spec i f ic regress ion approach and regress ion assumpt ion t =0. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 431 p : standard deviation of t of the potential investment target and assume p > 0. assume that usl and lsl remain unchanged while caq value and p change in inverse direction. if t of the potential investment target is distributed discretely, p is larger while caq value is smaller and vice versa. from now on, we include accrual quality into the tolerance range and decision rules of investors ( p ≦ t ) which signifies accrual quality is extended as a capability index of accrual quality that can do relative comparison. chang et al. (2012) suggested computing the caq of investment target to learn the accrual quality among investment targets when investors are choosing investment targets. in addition, investors can estimate the loss probability that incurs when t of investment target falls outside the tolerance range by the number of caq of investment target. since this risk is caused by uncertainty, it is called accrual quality measures of investment risks (named as iri hereinafter). capability index of accrual quality is converted into investment risk value so that investors can measure the degree of risk of a target within their investment criteria. in a normal assumption, investment risks are indicated as below6: )()(1ir t t t t i lsl zp usl zp         )645.1(2 aqczp  (7) in equation (7) we can learn that when caq value is greater, iri value is smaller, which implies a lower investment risk. on the contrary, when caq value is smaller but iri value is greater, that implies a high investment risk. as long as we know the capability index of accrual quality we can have an insight into the investment risks. in another word, the difference between investors’ prediction of investment target and the actual situation is huge because of the poor financial statement quality which leads to increased investment risks. therefore, this paper considers capability index of accrual quality as investment risks of accrual quality measurement, that is, the standard deviation of residuals and investment risks of accrual quality measurement have corresponding mathematical relationship. firm characteristics variable dechow and dichev (2002) mentioned that the estimation of accrual quality requires a lengthy time-series. in the regression approach requires information about future cash flows, which reduces its usefulness in the model settings. the observation of firm characteristics can be the instruments for the propensity to make estimation errors. hence, this paper applies the variables from the model of dechow and dichev (2002) as firm characteristics measure 6 when const ruc t ing c a q , we assume = . t p asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 432 variables. they include average operating cycle7 , firm size (compustat #6), standard deviation of revenues (compustat #12), standard deviation of cash flows (compustat #308), standard deviation of earnings (compustat #172) and number of deficits. dechow and dichev (2002) pointed out longer operating cycles indicated more uncertainty, more estimation and errors of estimation. this paper thinks more estimation and errors of estimation will increase information risks and therefore increase investment risks. dechow and dichev (2002) expected large firms have more predictable and stable operations, and therefore less estimation errors. hence, this paper thinks larger firms will have less investment risks. for standard deviation of revenues, dechow and dichev (2002) mentioned the volatility of revenues indicated higher uncertainty in the operating environment, and therefore large use of approximations and estimation, and reflected greater estimation errors. this paper believes that more uncertainty in operating environment causes more measurement errors and greater investment risks. dechow and dichev (2002) stated that cash flow can be a variable for uncertain operating environment. so this paper suggests that greater changes in cash flow will have higher investment risks. for the standard deviation of earnings, dechow and dichev (2002) pointed out that earnings are the sum of accruals and cash flows. volatility of cash flows and accruals would lead to poor earnings quality. hence, this paper believes higher standard deviation of earnings will have higher investment risks. dechow and dichev (2002) pointed out that losses were negative impact to a firm’s operating environment. accruals would involve continuous estimation errors. hence, this paper thinks more frequent number of deficits in a firm will have higher investment risks. organization strategy in accounting signals and management factors to enhance a firm’s value, managers pursue profitability and growth. porter (1996) believed that organization strategy and operation performance could assist organization to improve its performance. this paper suggests that there are two levels for managers to improve performance from a business value aspect and they are strategy level and driving factor level. strategy level includes differentiation strategy and cost leadership strategy. poter (1985) mentioned that managers could ensure the firm maintains its competitiveness with the help of differentiation strategy and cost leadership strategy. differentiation strategy is to differentiate the products with higher values and uniqueness in order to compete successfully. a firm that has high profit and lower asset turnover ratio tend to apply differentiation strategy. cost leadership strategy is a firm achieving high effective use of assets to lower the costs and therefore wins market share. it is suitable for firms that have low profit but high asset turnover ratio8. first, this paper decomposes profit margin which is decomposed by roa into net profit margin and gross profit. the combination of gross profit ((compustat # 12 compustat # 41)/ compustat # 12) and asset turnover ratio (compustat # 12/ compustat #6) can better present the strategy applied in a firm. this is called the strategy level in this paper. 7 operating cycle is inventory turnover days plus accounts receivable turnover days. its formula is 360/(cost of goods sold)/(average inventory)+360/(sale/average ar), where sales (compustat # 12); cost of goods sold (compustat # 41); ar (compustat # 2); inventory (compustat # 3) 8 palepu et al. (2007) pointed cost leadership approach includes scale economy, effective production, simplified product design, low capital invested and effective organizational processes. however firms applying this approach may face low price competition from rivals and therefore their returns are lower. similarly, horngren, datar and rajan (2008) mentioned organization can achieve cost leadership by impoveing productivity and effectiveness, eliminating wastes and cost control. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 433 after that, we decompose asset turnover ratio into fixed asset turnover ratio (compustat # 12/ compustat #7) and capital expenditure ratio per person (compustat #7/ compustat #29). fixed asset turnover ratio focuses on the effective use of fixed assets while capital expenditure ratio per person focuses on the investment of equipment, that is the degree of automation of a firm. the decomposition is shown as follows: assets employee employee fixassets fixassets sales sales ni assets sales sales ofitprgross ofitprgross ni assets sales sales ni atopmroa     (8) compared with past researchers which only considered firm-specific driving factor as measurement variable, this paper considers difference in industry mean as driving factor in order to review the firm-specific driving factors from industry aspect. hence, we apply the mean of fixed asset turnover ratio (fixed asset turnover ratio is deducted by 3 digits of sic) and the capital expenditure ratio per person (capital expenditure ratio per person is deducted by 3 digits of sic) as the industry-specific driving factor variables. sources table 1 shows the data collection processes. samples are collected from compustat research insight. we collect data mainly base on the three dimensions in this paper and integrate the data into our regression model by matching. the study period is 1991~20089. for the collection processes of investment risks data, we collect 73,083 samples with search criteria: cash flows, properties, plants and equipment, changes in revenues, changes in current assets, changes in current liabilities, changes in cash, changes in current liabilities due within one year. there are 67,245 samples after exempting 1% of finance and insurance industry and extreme values. this study also matches the cash flows data of prior and later periods because they are involved in computing investment risks. so the samples left are 60,952. lastly, we estimate residuals by firm-specific regression method so the longevity should be 8 years at 9 to accommodate the deflated total assets of prior period and cash flow data of prior and later periods, the data collection period is 1990~2009. managerial level strategy level asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 434 least. after exempting 3,747 unqualified samples, we have 53,430 samples left. table 1. sample selection companies collected for investment risks data – by year cash flows, properties, plants and equipment, changes in revenues, changes in current assets, changes in current liabilities, changes in cash, changes in current liabilities due within one year – samples by year 73,083 exempting samples in finance and insurance industry and 1% of extreme values in accruals, cash flows and changes in revenues – samples by year 67,245 companies – cash flows in prior and later periods 60,952 longevity of at least 8 years 3,747 3747 accesible companies – samples by year 53,430 source: compustat 4. empirical results regression analysis of caq and firm characteristics we follow the research of soliman (2008) to review the influence of accounting signals from asymmetric information on outside investors and propose the capability index of accrual quality as the proxy of investment risks from the loss function concept. to verify the effectiveness of the investment risks applied in this study, we employ the firm characteristics proposed by dechow and dichev (2002) as our testing variable to verify if its relationship with caq is consistent with past researches and test the relationship between accounting signals and investment risks. table 2 probes if the relationship between firm characteristics and investment risks we infer is the same as dechow and dichev (2002). panel a is the basic descriptive statistics. the means for caq we infer and related firm characteristics such as operating cycles, firm size, standard deviation of revenues, standard deviation of cash flows, standard deviation of earnings and number of deficits are 6.055, 151.306, 5.778, 0.297, 0.100, 0.134 and 4.867 respectively; where caq, operating cycles and number of deficits are discretely distributed. panel b is the correlation coefficient between caq and firm characteristics where we can learn that caq we infer shows positive correlation with firm size but it shows negative correlation with other firm characteristics. panel c is regression analysis of this paper. we can learn that caq and firm size are positively correlated which signifies that larger firm size will have greater caq. larger firm is more stable in operations so the estimation errors are less and therefore reduces investment risks. moreover, greater standard deviations of revenues or cash flows indicate higher uncertainty in the environment and therefore managers use more estimation and result in more estimation errors. the capability index of accrual quality becomes worse and investment risks are higher. in addition, the two variables of environment uncertainty show asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 435 negative correlation with caq we infer. it implies when there is higher uncertainty in the environment, capability index of accrual quality becomes worse and investment risks are higher. when a firm has more deficits it is a negative impact to it. capability index of accrual quality becomes worse and investment risks are therefore higher. the empirical result in this paper also indicates significant negative relationship between caq and number of deficits which signifies that higher number of deficits leads to higher investment risks. therefore, the capability index of accrual quality we infer considering loss function concept is useful, and therefore we will conduct test analysis with accounting signals in next section. table 2. descriptive statistics and correlation between the caq and selected firm characteristics(n=3,335) panel a descriptive statistics 25% median 75% mean standard deviation dependent variable caq 1.759 3.831 7.675 6.055 7.429 independent variable ave.opcycle 74.513 113.822 174.380 151.306 245.232 ave.size 3.996 5.779 7.512 5.778 2.396 std. sale 0.139 0.235 0.380 0.297 0.233 std.ocf 0.044 0.072 0.118 0.100 0.091 std.earnings 0.042 0.083 0.173 0.134 0.137 prop.ni 1 4 8 4.867 4.179 panel b pearson correlations between the caq and selected firm characteristics ave.opcycle ave.size std. sale std.ocf std.earnings prop.ni pearson -0.112 0.398 -0.277 -0.367 -0.362 -0.382 p-value 0.000 0.000 0.000 0.000 0.000 0.000 panel c regressions where the dependent variable is the caq and the independent variables are firm characteristics cons ave.opcycle ave.size std. sale std.ocf std.earnings prop.ni adi r^2 coef. 6.068 -0.001 0.599 -3.204 -7.638 -0.010 -0.343 0.214 p-valu e 0.000 0.218 0.000 0.000 0.002 0.995 0.000 variable definition: caq is the investment risks proposed by this study. it is the estimated residuals calculated by residuals estimation approach by francis et.(2005) and is converted into the tolerance range of investors. ave.opcycle average operating cycles are calculated by inventory turnover days plus account receivable turnover days, the formula is 360/(cost of goods sold)/(average inventory)+360/(sale/average ar); where, sales (compustat # 12); cost of goods sold (compustat # 41); ar (compustat # 2); inventory (compustat # 3). it is then converted back into firm level by average. ave.size is firm size. it is calculated by inputting total assets (compustat #6) into the natural logarithm function and converted back into firm level by average. std. sale is standard deviation of revenues. revenues are deflated by average total assets and obtained the standard deviation. std.ocf is standard deviation of cash flows. cash flows are deflated by average total assets and obtained the standard deviation. std.earnings is current earnings (compustat #172) deflated by average total assets and obtained the standard deviation. prop.ni is the number of deficits. if current earnings equal to 1, it is converted to firm level by accumulation. regression analysis of caq and accounting signals next is a further test to structuralize the influence of accounting signals test on investment risks. panel a in table 3 is the descriptive statistics of samples in second phrase and panel b is the pearson correlation coefficient of all samples. for descriptive statistics (panel a), the mean and standard deviation of caq are 5.975 and 7.156 respectively. the means of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 436 accounting signals are: 10.318 for fixed asset turnover ratio, 0.192 for capital expenditure ratio per person, -0.346 for difference between fixed asset turnover ratio and industry mean, -0.002 for difference between capital expenditure ratio per person and industry mean. for control variables, 5.788 for mean of firm size, 0.298 for mean of standard deviation of revenues, 0.100 for mean of standard deviation of cash flows, and 4.885 for mean of number of deficits. table 3. descriptive statistics and correlation between the caq and factors of production(n=3,232) _ roa model panel a descriptive statistics 25% median 75% mean standard deviation dependent variable caq 1.768 3.826 7.589 5.975 7.156 independent variable ave.fat 2.221 5.482 12.011 10.318 14.635 ave.pce 0.018 0.036 0.097 0.192 0.478 ave.fat_sic -5.020 -1.465 0.650 -0.346 11.870 ave.pce_sic -0.031 -0.010 0.010 -0.002 0.281 control variable ave.size 4.005 5.779 7.511 5.788 2.385 std. sale 0.140 0.236 0.381 0.298 0.233 std.ocf 0.044 0.071 0.117 0.100 0.090 prop.ni 1 4 8 4.885 4.195 panel b pearson correlations caq_90 ave.fat ave.pce ave.fat _sic ave.pce _sic ave.size std. sale std.ocf prop. ni caq_90 pearson 1.000 sig ave.fat pearson -0.185 1.000 sig 0.000 ave.pce pearson 0.248 -0.232 1.000 sig 0.000 0.000 ave.fat_sic pearson -0.206 0.585 -0.325 1.000 sig 0.000 0.000 0.000 ave.pce_sic pearson 0.267 -0.245 0.810 -0.406 1.000 sig 0.000 0.000 0.000 0.000 ave.size pearson 0.408 -0.313 0.266 -0.225 0.213 1.000 sig 0.000 0.000 0.000 0.000 0.000 std. sale pearson -0.279 0.433 -0.239 0.311 -0.232 -0.414 1.000 sig 0.000 0.000 0.000 0.000 0.000 0.000 std.ocf pearson -0.372 0.231 -0.165 0.166 -0.158 -0.602 0.428 1.000 sig 0.000 0.000 0.000 0.000 0.000 000 0.000 prop.ni pearson -0.383 0.128 -0.155 0.099 -0.154 -0.533 0.296 0.564 1.000 sig 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 variable definition: caq is the investment risks proposed by this study. it is the estimated residuals calculated by residuals estimation approach by francis et.(2005) and is converted into the tolerance range of investors. ave.fat fixed asset turnover ratio is calculated by revenues divided by fixed assets(compustat # 12/ compustat #7) and converted into firm level by average. ave.pce capital expenditure ratio per person is calculated by fixed assets divided by number of employees (compustat #7/ compustat #29) and converted into firm level by average. ave.fat_sic difference between fixed asset turnover ratio and industry mean is calculated by fixed asset turnover ratio in firm level minus the mean of fixed asset turnover ratio in such industry. ave.pce_sic difference between capital expenditure ratio per person and industry mean is calculated by capital expenditure ratio per person in firm level minus mean of capital expenditure ratio per person in such industry. ave.size is firm size. it is calculated by inputting total assets (compustat #6) into the natural logarithm function and converted back into firm level by average. std. sale is standard deviation of revenues. revenues are deflated by average total assets and obtained the standard deviation. std.ocf is standard deviation of cash flows. cash flows are deflated by average total assets and obtained the standard deviation. prop.ni is the number of deficits. if current earnings equal to 1, it is converted to firm level by accumulation. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 437 as for correlation coefficient, only the difference between capital expenditure ratio per person and industry mean has higher correlation coefficient (0.810) among all variables. other independent variables are lower to moderate correlated. however, the capital expenditure ratio per person and difference between capital expenditure ratio per person and industry mean are not put on the same regression, so there is no collinearity for the variables in this paper. for the correlation between caq and accounting signals, fixed asset turnover ratio and difference between fixed asset turnover ratio and industry mean have significant negative correlation, but capital expenditure ratio per person and difference between capital expenditure ratio per person and industry mean have significant positive correlation. this paper then designs the strategy hierarchy based on the concept of a relative proportion between profit margins and asset turnover ratio, where lower profit margins and higher asset turnover ratio is cost leadership firm, higher profit margins and lower asset turnover ratio is differentiation strategy firm. there are 416 and 1284 samples respectively. table4 is the regression analysis after classifying the strategies. there are mainly two parts – firm-specific accounting signals and industry-specific accounting signals. in model1 and model2, they show the influence of firm-specific accounting signals on investment risks. regression result shows that no matter in cost leadership strategy (model1) or differentiation strategy (model2), if a firm emphasizes on the capital expenditure ratio per person will reduce investment risks. that means no matter which strategy a firm applies, it can reduce investment risks if it focuses on the degree of automation. therefore we can infer that the improvement in automation can allow the organization to use flexible manufacturing technology to adapt to environmental uncertainty. for example, foxconn (oem factory for apple) concerned about the investment in automation equipment after a series of suicides in china and increasing salary issues. for model3 and model4, they show the influence of industry-specific accounting signals on investment risks. regression result shows that in cost leadership strategy firm (model3), difference between fixed asset turnover ratio and industry mean has significant positive correlation with investment risks. however in differentiation strategy firm (model4), the correlation is negative. it signifies that if the fixed asset turnover ratio in cost leadership strategy firm is higher than industry mean, the investment risks are higher; while in differentiation strategy firm, the situation is reverse. a firm following cost leadership strategy reduces its production costs and earns by sales at the expense of profits. hence, enhancing fixed asset turnover ratio can effectively reduce costs. there are two methods to do so: increasing sales with unchanged fixed assets or reducing fixed assets held with unchanged sales. firms following cost leadership usually use loosen credit policy or benchmark policy to enhance the effective use of fixed assets. however dramatic changes in environment such as the financial tsunami or economic crisis will bring greater operation risks. porter (1996) mentioned the competitive convergence that rivals imitate one another’s improvements in quality or supplier partnerships so that the strategy of each firm tends to be the same. it will lead to wars of attrition that can be stopped only by limiting competition. hence, for a firm following cost leadership strategy, it produces with high effective method. there will be competitive convergence if a firm emphasizes too much on imitating to improvement quality asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 438 and leads to wars of attrition which causes higher uncertainty in a firm’s operation and therefore higher investment risks. table 4. regressions result where the dependent variable is the caq and the independent variables are factors of production_ roa model cost leadership differentiation cost leadership differentiation model1 model2 model3 model4 coef p-value coef p-value coef p-value coef p-value ave.fat -0.023 0.182 0.012 0.629 ave.pce 2.593 0.009 1.643 0.000 ave.fat_sic -0.066 0.013 0.094 0.000 ave.pce_sic 0.220 0.891 0.251 0.689 ave.size 0.215 0.297 0.685 0.000 0.319 0.116 0.755 0.000 std. sale -2.078 0.205 -6.034 0.000 -2.667 0.099 -7.051 0.000 std.ocf -10.323 0.080 -13.753 0.000 -9.491 0.110 -14.629 0.000 prop.ni -0.429 0.000 -0.294 0.000 -0.448 0.000 -0.304 0.000 cons 9.292 0.000 5.544 0.000 9.388 0.000 6.280 0.000 f-value 17.62 61.71 16.78 61.21 p-value 0.000 0.000 0.000 0.000 r^2 0.205 0.225 0.198 0.223 adj r^2 0.194 0.221 0.186 0.220 a. variable definition: caq is the investment risks proposed by this study. it is the estimated residuals calculated by residuals estimation approach by francis et.(2005) and is converted into the tolerance range of investors. ave.fat fixed asset turnover ratio is calculated by revenues divided by fixed assets(compustat # 12/ compustat #7) and converted into firm level by average. ave.pce capital expenditure ratio per person is calculated by fixed assets divided by number of employees (compustat #7/ compustat #29) and converted into firm level by average. ave.fat_sic difference between fixed asset turnover ratio and industry mean is calculated by fixed asset turnover ratio in firm level minus the mean of fixed asset turnover ratio in such industry. ave.pce_sic difference between capital expenditure ratio per person and industry mean is calculated by capital expenditure ratio per person in firm level minus mean of capital expenditure ratio per person in such industry. ave.size is firm size. it is calculated by inputting total assets (compustat #6) into the natural logarithm function and converted back into firm level by average. std. sale is standard deviation of revenues. revenues are deflated by average total assets and obtained the standard deviation. std.ocf is standard deviation of cash flows. cash flows are deflated by average total assets and obtained the standard deviation. prop.ni is the number of deficits. if current earnings equal to 1, it is converted to firm level by accumulation. b. cost leadership is cost leadership strategy. firms with higher fixed asset turnover ratio than industry mean and lower profit margins than industry mean are samples for cost leadership strategy. differentiation is differentiation strategy. firms with lower fixed asset turnover ratio than industry mean and higher profit margins than industry mean are samples for differentiation strategy. by contrast, a firm following differentiation strategy pursues high profit margins and differentiates the market with its uniqueness. the firm can react immediately to customer's demands and produce customized products. hence, the firm can increase the fixed asset turnover ratio by purchase or upgrading flexible manufacturing system to accommodate to special customized orders and shorten the duration of customer's reaction and thus create higher sales revenues as well as improving its competitiveness to lower the investment risks. in addition, this paper further analyzes samples surpasses industry mean by roa to examine if firms with better performance have the same situation as they do before differentiating asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 439 performance. regression result and table4 show the same result. when considering firm-specific accounting signals, the capital expenditure ratio per person reduces investment risks. however when considering industry-specific accounting signals, cost leadership strategy tends to have competitive convergence problem. for differentiation strategy, it show an enhancement in effectiveness of fixed assets and we can infer that it improve organization competitiveness. table 5. regressions result where the dependent variable is the caq and the independent variables are factors of production under the firm performance outperform than industry performance_ roa model cost leadership differentiation cost leadership differentiation model1 model2 model3 model4 coef p-value coef p-value coef p-value coef p-value ave.fat -0.013 0.506 0.014 0.590 ave.pce 2.625 0.023 1.387 0.000 ave.fat_sic -0.068 0.025 0.094 0.000 ave.pce_sic 0.286 0.878 0.512 0.414 ave.size 0.141 0.594 0.595 0.000 0.255 0.327 0.636 0.000 std. sale -1.920 0.391 -7.661 0.000 -2.440 0.265 -8.316 0.000 std.ocf -34.247 0.012 -20.769 0.000 -34.584 0.011 -22.431 0.000 prop.ni -0.417 0.016 -0.307 0.000 -0.419 0.016 -0.314 0.000 cons 10.904 0.000 6.653 0.000 11.016 0.000 7.482 0.000 f-value 11.1 54.6 10.84 54.92 p-value 0.000 0.000 0.000 0.000 r^2 0.201 0.228 0.198 0.229 adj r^2 0.183 0.223 0.179 0.224 a. variable definition: caq is the investment risks proposed by this study. it is the estimated residuals calculated by residuals estimation approach by francis et.(2005) and is converted into the tolerance range of investors. ave.fat fixed asset turnover ratio is calculated by revenues divided by fixed assets(compustat # 12/ compustat #7) and converted into firm level by average. ave.pce capital expenditure ratio per person is calculated by fixed assets divided by number of employees (compustat #7/ compustat #29) and converted into firm level by average. ave.fat_sic difference between fixed asset turnover ratio and industry mean is calculated by fixed asset turnover ratio in firm level minus the mean of fixed asset turnover ratio in such industry. ave.pce_sic difference between capital expenditure ratio per person and industry mean is calculated by capital expenditure ratio per person in firm level minus mean of capital expenditure ratio per person in such industry. ave.size is firm size. it is calculated by inputting total assets (compustat #6) into the natural logarithm function and converted back into firm level by average. std. sale is standard deviation of revenues. revenues are deflated by average total assets and obtained the standard deviation. std.ocf is standard deviation of cash flows. cash flows are deflated by average total assets and obtained the standard deviation. prop.ni is the number of deficits. if current earnings equal to 1, it is converted to firm level by accumulation. b. cost leadership is cost leadership strategy. firms with higher fixed asset turnover ratio than industry mean and lower profit margins than industry mean are samples for cost leadership strategy. differentiation is differentiation strategy. firms with lower fixed asset turnover ratio than industry mean and higher profit margins than industry mean are samples for differentiation strategy. sensitivity test the decomposition of accounting signals is based on roa in this paper. soliman (2008) pointed out rnoa decomposition can capture the operation situation without the effects of financial leverage. hence, this paper employs rnoa to conduct sensitive test. table6 is the analysis result for rnoa where the regression result indicates capital expenditure ratio per person reduces investment risks no matter for cost leadership strategy or differentiation strategy in firm-specific accounting signals. compared with cost leadership strategy, firms following differentiation strategy also show the improvement in fixed asset turnover ratio can reduce investment risks. nevertheless, the industry-specific accounting signals shows influence on investment risks only in differentiation strategy firms. if the firms pursue asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 440 improvement in fixed asset turnover ratio will reduce investment risks. after differentiating samples with better performance (table7), capital expenditure ratio per person reduces investment risks no matter for cost leadership strategy or differentiation strategy in firm-specific accounting signals. table 6. regressions where the dependent variable is the caq and the independent variables are factors of production _ rnoa model cost leadership differentiation cost leadership differentiation coef p-value coef p-value coef p-value coef p-value ave.fat -0.004 0.766 0.065 0.089 ave.pce 2.017 0.010 1.616 0.004 ave.fat_sic -0.002 0.916 0.159 0.000 ave.pce_sic -0.930 0.421 -0.591 0.559 ave.size 0.390 0.015 0.665 0.000 0.480 0.003 0.720 0.000 std. sale 0.318 0.815 -8.548 0.001 -0.333 0.803 -8.595 0.000 std.ocf -47.455 0.000 -58.036 0.000 -49.537 0.000 -57.381 0.000 prop.ni -0.294 0.002 -0.292 0.007 -0.314 0.001 -0.301 0.005 cons 8.351 0.000 9.405 0.000 8.498 0.000 10.483 0.000 f-value 24.26 35.33 22.64 37.14 p-value 0.000 0.000 0.000 0.000 r^2 0.351 0.210 0.336 0.218 adj r^2 0.337 0.204 0.321 0.212 a. variable definition: caq is the investment risks proposed by this study. it is the estimated residuals calculated by residuals estimation approach by francis et.(2005) and is converted into the tolerance range of investors. ave.fat fixed asset turnover ratio is calculated by revenues divided by fixed assets(compustat # 12/ compustat #7) and converted into firm level by average. ave.pce capital expenditure ratio per person is calculated by fixed assets divided by number of employees (compustat #7/ compustat #29) and converted into firm level by average. ave.fat_sic difference between fixed asset turnover ratio and industry mean is calculated by fixed asset turnover ratio in firm level minus the mean of fixed asset turnover ratio in such industry. ave.pce_sic difference between capital expenditure ratio per person and industry mean is calculated by capital expenditure ratio per person in firm level minus mean of capital expenditure ratio per person in such industry. ave.size is firm size. it is calculated by inputting total assets (compustat #6) into the natural logarithm function and converted back into firm level by average. std. sale is standard deviation of revenues. revenues are deflated by average total assets and obtained the standard deviation. std.ocf is standard deviation of cash flows. cash flows are deflated by average total assets and obtained the standard deviation. prop.ni is the number of deficits. if current earnings equal to 1, it is converted to firm level by accumulation. b. cost leadership is cost leadership strategy. firms with higher fixed asset turnover ratio than industry mean and lower profit margins than industry mean are samples for cost leadership strategy. differentiation is differentiation strategy. firms with lower fixed asset turnover ratio than industry mean and higher profit margins than industry mean are samples for differentiation strategy. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 441 table 7. regressions result where the dependent variable is the caq and the independent variables are factors of production under the firm performance outperform than industry performance _ rnoa model cost leadership differentiation cost leadership differentiation coef p-value coef p-value coef p-value coef p-value ave.fat -0.032 0.332 0.086 0.309 ave.pce 2.480 0.044 3.222 0.002 ave.fat_sic -0.032 0.523 0.092 0.219 ave.pce_sic -0.107 0.951 0.620 0.755 ave.size 0.243 0.389 0.736 0.022 0.376 0.185 0.743 0.019 std. sale 2.587 0.273 -8.431 0.059 1.102 0.634 -8.548 0.027 std.ocf -57.517 0.000 -67.291 0.001 -59.338 0.000 -75.112 0.000 prop.ni -0.255 0.196 0.233 0.414 -0.288 0.155 0.268 0.359 cons 9.547 0.000 7.544 0.016 9.715 0.000 9.796 0.002 f-value 9.47 13.66 8.24 11.75 p-value 0.000 0.000 0.000 0.000 r^2 0.339 0.318 0.308 0.286 adj r^2 0.303 0.295 0.271 0.262 a. variable definition: caq is the investment risks proposed by this study. it is the estimated residuals calculated by residuals estimation approach by francis et.(2005) and is converted into the tolerance range of investors. ave.fat fixed asset turnover ratio is calculated by revenues divided by fixed assets(compustat # 12/ compustat #7) and converted into firm level by average. ave.pce capital expenditure ratio per person is calculated by fixed assets divided by number of employees (compustat #7/ compustat #29) and converted into firm level by average. ave.fat_sic difference between fixed asset turnover ratio and industry mean is calculated by fixed asset turnover ratio in firm level minus the mean of fixed asset turnover ratio in such industry. ave.pce_sic difference between capital expenditure ratio per person and industry mean is calculated by capital expenditure ratio per person in firm level minus mean of capital expenditure ratio per person in such industry. ave.size is firm size. it is calculated by inputting total assets (compustat #6) into the natural logarithm function and converted back into firm level by average. std. sale is standard deviation of revenues. revenues are deflated by average total assets and obtained the standard deviation. std.ocf is standard deviation of cash flows. cash flows are deflated by average total assets and obtained the standard deviation. prop.ni is the number of deficits. if current earnings equal to 1, it is converted to firm level by accumulation. b. cost leadership is cost leadership strategy. firms with higher fixed asset turnover ratio than industry mean and lower profit margins than industry mean are samples for cost leadership strategy. differentiation is differentiation strategy. firms with lower fixed asset turnover ratio than industry mean and higher profit margins than industry mean are samples for differentiation strategy. test of risk confidence interval for investors this paper applies 90% confidence interval of investors as the calculation standard for investment risks. to ensure the robustness of the study, we also apply 95% and 99% confidence intervals in calculation and regarded as part of the robustness test. regression result shows 95% and 99% confidence intervals have the same result with 90% confidence intervals. hence this paper argues that capital expenditure ratio per person for firm-specific accounting signal can reduce investment risks. for industry-specific accounting signals, it focuses more on fixed asset turnover ratio. for firms following cost leadership strategy, there will be competitive convergence problem if the fixed asset turnover ratio surpasses industry mean and therefore increases investment risks. for forms applying differentiation strategy, it will enhance organization competitiveness and reduce investment risks when fixed asset turnover ratio surpasses industry mean. 5. research conclusions the earnings information on financial statements is summarized by accruals basis which includes the managers’ valuation and estimation on earnings figures. there can be valuation asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 442 or estimation errors intentionally or unintentionally, indirectly leading to information risks when investors use the information. therefore, dechow and dichev (2002) proposed the accrual quality concept by matching of cash flows and accruals earnings which are applied by many subsequent researches as proxy for information risks. yet investors also evaluate their degree of aversion and tolerance towards risks other than considering only the information on financial statements when they make decisions. moreover, it has become an important evaluation approach to get an insight into the strategy implementation and internal management activities of a firm from financial statements. therefore, we apply the capability index of accrual quality which include investors' degree of aversion and tolerance towards risks suggested by chang et al. (2012) as the proxy for investment risks and review the influence of accounting signals on investment risks by extending the point of view of soliman (2008). for the factors of investment management in firm-wise, our result shows that capital expenditure ratio per person can reduce investment risks no matter for firms following cost leadership strategy or differentiation strategy. in another word, the enhancement in automation can assist the firms to use manufacturing technology to adapt to environment uncertainty. in addition, in industry-wise, our result finds that the difference between fixed asset turnover ratio and industry mean plays different roles in cost leadership strategy and differentiation strategy. samples following cost leadership strategy show competitive convergence effect which is proposed by porter (1996) when they over-pursue fixed asset turnover ratio. it means firms imitate each other to improve quality, production cycle or supplier partnerships so their strategies tend to be the same and this will lead to wars of attrition so there is no one wins in the market and increase investment risks. for samples following differentiation strategy, improvement in fixed asset turnover ratio can enhance organization competitiveness and reduce investment risks. to conclude, there are two parts for the practical implications of this paper. in firm-wise, we find that capital expenditure ratio per person can significantly reduce investment risks, simplifying that enhancement in automation equipment or technical equipment can assist firms to handle the uncertainty in environment. a well-known sample is foxconn which invested over $10 billion in machines after the salary increase and labor safety problems. its main purpose is to reduce labor cost and improve work efficiency by automated manufacturing. therefore, this paper believes automated manufacturing processes can help firms to effectively accommodate to uncertain environment and quickly adjust the manufacturing pace to meet customer’s needs. with the threat of japanese and korean styles cars, the lean manufacturing at ford is another example which converts traditional manufacturing to high automated manufacturing. in industry-wise, we find that difference between fixed asset turnover ratio and industry mean plays different roles in two strategies especially we find there is competitive convergence effect in cost leadership strategy firms. for example, most of the dram factories were oem factories in the past. they lacked the support of the core technique so they could only get orders by lowering their costs. the most direct way to lower costs is plant expansion and therefore increases the effective use of fixed assets to compete with rivals. therefore, oem asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 443 factories have high profits during an economy upturn, but they also face great losses during downturn. to avoid this, we think firms following cost leadership strategy should think outside the box and prevent to over-pursue fixed asset turnover ratio and avoid the competitive convergence effect. there are limitations for this research. the classifications of organization strategies are mainly based on the financial ratio in past literature instead of case study, therefore, we fail to probe into a single study sample and make conclusion. in addition, we only analyze samples in long run so the newly established firms might be exempted from our samples. however, these are always some high-growth firms which our conclusions do not include. references abarbanell, j., & bushee, b. 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(2008). the use of dupont analysis by market participants. the accounting review, 83(3), 823-853. http://dx.doi.org/10.2308/accr.2008.83.3.823 microsoft word 2020-8089-1-sp-writer2-new an receive doi:10.5 abstra purpos countrie widespr expecta detectin investig taiwan design/ percept investi ed: june 28, 5296/ajfa.v5 ct se – corpor es and taiw read mistru ation gap—t ng corporate gates how au . /methodolo ions on frau igation ch departm departm school u , 2012 a 5i1.2020 rate fraud is wan as well. ust and criti the gap betw e fraud, as uditors and ogy/approa ud, using qu of aud detect hih-shun hs ment of acc new t e-mail: cs fa ment of acc new t e-mail: ku k l of accoun university o toow e-mail: j accepted: s url: h s an issue th as a result icism. it is ween the us perhaps ev users perce ach – a tot uantitative a 30 ditors’ r tion in t su (correspo counting, t taipei city, shsu@mail. an-hua kun counting, t taipei city, ung@mail.t kieran jame nting, econo of southern woomba, au jamesk@us eptember 1 http://dx.doi hat has beco t, external a s premised sers’ expect videnced in eive the aud tal 964 res analysis app asian respon taiwan onding auth tamkang un taiwan tku.edu.tw ng tamkang un taiwan tku.edu.tw es omics and f n queenslan ustralia sq.edu.au 3, 2012 i.org/10.529 ome increas uditors in th that this is tations of au audited fin ditors’ respo spondents w proach. n journal of f nsibility n hor) niversity niversity finance, d published: 96/ajfa.v5i1 singly preva hese countri s a manifes uditors and nancial state onsibility fo were survey finance & ac issn 19 2013, vol. www.macrothi y for fr june 1, 201 .2020 alent in the ries continua station of th d their actua tements. th or fraud dete yed regardi ccounting 946-052x 5, no. 1 ink.org/ajfa raud 13 western ally face he audit al role in his study ection in ng their finding corpora materia believed surveye fair view designe origina taiwan bankers to our u keywo gs – the f ate fraud. th al fraud du d that audit ed groups th w of financ ed for such d ality/value , especially s. this pape understandin rds audit e findings ind he auditors uring an au tors should hat auditors cial stateme detection. – the find y company er fills a voi ng of fraud expectation dicate that strongly di udit, compa be responsi should wo nts, or for f dings have i y directors id in researc in taiwan. gap, audito 31 a gap exi isagreed tha ared with t ible. howev ork to detect fraud detec important i and mana ch in this a ors’ respons asian ists on aud at they were the non-au ver, there w t fraud that ting only w mplications agers, finan rea and mak sibilities, fr n journal of f ditors’ respo e responsib ditor group was a genera materially when the aud s for audito ncial analys kes an inter aud detectio finance & ac issn 19 2013, vol. www.macrothi onsibility to ble for detec ps’ which al consensu affects the dit was spe ors and the sts, investo resting cont on, taiwan ccounting 946-052x 5, no. 1 ink.org/ajfa o detect cting the strongly us by the true and cifically users in ors, and tribution introdu the rol the fina of fraud porter, professi manage compet sikka e because negotiat of respo 1980s. such as aicpa and ma indeed recomm emphas (porter, this stu audit. u to cons manage order to stateme recogni assuran public i corpora auditors 1997). internat about th duties ( koh and howeve issues s now bei (huang respons uction e of auditin ancial statem d detection 1997). the ion resulted e the inter ing public d et al. (1998) e the socia tion and the onsibility fo efforts hav s the us c a (1987); uk acdonald co suggested t mended a gr size less the , 1997). udy is focu under the cu sider fraud ement, but t o have a re ents arising ized the au nce’ is not u in general. ate fraud du s is caused tional litera he auditor’s (i.e., beck, d woo, 200 er, few em such as the ing paid to g et al, 199 sibilities and ng had not, ments. this n as an aud e phenomen d from its pu rplay betwe duties and o argued that al context e meaning or detecting ve been ma cohen comm k davison ommission b that auditor radual incre e issue of a sed on the urrent taiw d in an audi the auditor easonable a from error ditor’s dete understanda auditors to uring the au by a lack o ature contrib s responsib 1973; stee 01; leung a mpirical surv responsibil the legal lia 98; tung, d the develo until 1920, is now rega dit objective non of down ursuit of pro een its ow obligations ( t there is no of auditin of audit is c g fraud has ade to narro mission by report and by cica (1 rs have an i ease in frau auditors det auditors’ re wanese audi it of financ is required assurance o r or fraud. ection respo able or sati oday are stil udit process of satisfacto butes much ilities of fra en, 1990; h and chau, 20 vey studies lity to detec ability issue 1998; and opment of e 32 been to giv arded as the e is indeed nplaying au ofessional ( wn (financi (humphrey o possibility ng changes changing. p stirred the a ow the exp aicpa (1 benson co 1988) in ca important ro ud detection tecting frau esponsibiliti iting standa ial stateme to maintain of detecting although onsibility, t isfactory to ll facing se . it has also ory explana h on the ex aud detectio humphrey, m 001; lin an s in taiwan ct and repo e associated liu, 2002) expectation asian ve an opinio e major obje d downplaye uditors’ resp and financi al and bra and moize y to eliminat s continuou public critic auditing pro ectation ga 978) and t ommittee by anada (1988 ole in detec n and repor ud as oppos ies to detec rd, sas 43 ents, the dete n an attitude g material m the accoun the rather v the users rious critici o been supp ations of the xpectations on and the moizer, and nd chen, 20 n are availa ort fraud, al d with audit ). neverthe ns gaps in w n journal of f on on the tr ective, wher ed (brown, ponsibilities al) interests and-name) r, 1990; pow te the auditi usly throug cism of the ofession int p by setting he treadwa y aicaw ( 8). these w cting corpor rting. it is n ed to audit ct fraud dur : the audit ection respo e of profess misstatemen nting profes vague mean of financial ism for fail posed that t eir role in s gap, especi public’s pe d turley, 19 04; fadzly able on fun lthough incr or negligen eless, the d western coun finance & ac issn 19 2013, vol. www.macrothi ruth and fai reas the imp , 1962; lee s by the acc s and its atte interests a wer 1995). ing expecta gh interacti profession’ to activity s ng up comm ay commis (1985a and working part rate fraud a noted that t tors reportin ring the tim tor’s respo onsibility re sional skept nts in the f ssion has g ning of ‘rea al statement ling to detec this problem society (hu ially on the erception of 993a; porte and ahmad ndamental reasing atte nce and audi debate on a ntries, espe ccounting 946-052x 5, no. 1 ink.org/ajfa irness of portance e, 1970; counting empts to and any ation gap ion and ’s denial since the missions, ssion by 1985b); ties have and they hey still ng fraud me of the onsibility ests with ticism in financial gradually asonable ts or the ct major m facing umphrey, e debate f her/his er, 1993; d, 2004). auditing ention is it failure auditors’ cially in the uk professi the pur precise, busines financia respons gap exi auditor’ can be other w the stu emphas previou investig conclus the au for a lo fraud. i inceptio “stated rather t 1997, p since th respons busines (lee, 19 professi its own by the was ac criticism the “gr denial o activitie usa (a canada consiste even so detectio k and us, ion in taiw rpose of the , the main f ss environm al statemen sible for”. s isting amon ’s duty to d compared words, we ca udy is struct sizing the au us empirical gation resul sion section uditor resp ong time, th it is perhap on. the aud audit objec than by a ch p. 15). he 1920s, t sibility to de ss transactio 986). hump ion’s pursui (financial a end of the ctually deni m of auditor eed-is-good of responsib es to investi aicpa, 197 a (cica, 1 ently indica ome of the on. howeve over the l an. e study is to focus of the ment. the st nts and co such compa ngst taiwan detect fraud with the re an undertake tured as fol uditor’s res l research. t lts in the f . ponsibility f ere has been ps true to sa ditor’s respo ctive for ove hange in th the accoun etect fraud. ons which m phrey et al ( it of a self-i and brand-n 1960s, frau ied by the rs to assum d” decade o bility for de igate the iss 78, cohen c 988, mcdo ate that the m e auditors t er, the accou last two de provide ad e study is to tudy attemp mpare thei arison inten n’s users. t s and relate esults of the e an interna llows. the s ponsibility the fourth s fifth section for fraud d n controver ay that the onsibility to er 400 years he demand o ting profes this has be make it une (1993b) and interested ro name) intere ud detection accounting me a broader of the 1980 etecting fra sue. a num commissio onald comm majority of themselves, unting prof 33 ecades are dditional evi o investigate pts to surve ir perceptio nds to exam the finding ed audit pro e relevant s ational comp second sect to detect fr section look n. the stud detection rsy about th role of the o detect frau s and was r of clients o sion has fo een a result economic fo d power (19 ole and its a ests and any n as an audi g professio r responsibi 0s. political aud has stirr mber of work on); uk (ic mission). t financial st believe th fession still asian relevant to idence on th e whether th ey the taiw ons on “w mine whethe s contribute ocedures. fu studies carr parison of a tion provide raud. the th ks at the res dy then fini e auditor’s auditor ha ud, as noted removed as of accountin ocused prog t of the incr or the audit 995) attribut attempts to y competing itor’s respon on (porter, lity for frau l pressures red the aud king commi caew, 198 the survey tatement use he auditor h rejects exte n journal of f o the grow he audit exp here is such wanese aud what auditor r there is an e to our un urthermore, ried out in audit expect es brief hist hird section earch metho ishes with alleged resp as not been d by willing an objectiv ng firms” (c gressively l ease in size tor to exam te the chang manage the g public duti nsibility wa 1997). ho ud detection arising fro diting profes issions were 5a, davison findings o ers and the holds respo ending audi finance & ac issn 19 2013, vol. www.macrothi wth of the pectation ga h a gap in t ditors and rs should an audit exp nderstanding , the study other coun tation gaps. torical back n offers a re od, followe the discuss ponsibility t well define gham (1975 ve by the pr cited in hu less on the e and compl mine all tran ge to the acc e interplay b ies and obli as not assum owever, the n continued om the prof ssion into in re establishe n committ of the comm general pub onsibility fo itor’s respo ccounting 946-052x 5, no. 1 ink.org/ajfa auditing ap. to be taiwan’s users of be held pectation g of the findings ntries. in kground, eview of ed by the sion and to detect ed since 5), was a ofession umphrey, alleged lexity of nsactions counting between igations. med and e public through fession’s nitiating ed in the ee); and missions blic, and or fraud nsibility to detec to detec manage it shou circums with the auditor’ has gra detectio “…the plan, pe detectin 18)….. appropr or disco howeve bank in missing threaten (1998) respons imposin four add evaluati regulato neverth auditor’ au316 skeptici misstate misstate account argues them re in the respect 1987. t respons 2004), manage that ma cting fraud. ct fraud and ement, not o uld be noted stances whe e acknowle ’s acceptanc adually mo on. this can fact that an erform and ng material the audito riate level o over the frau er, compani n uk, etc.), g. public pr ned regulato suggest that sibilities and ng additiona ditional resp ion of inter ors; and aud heless, the ’s responsib (pcaob, ism, discus ement due t ement due t ting profess that the aud esponsible fo taiwanese to the audi taiwan’s s sibilities. th is that res ement. how aterial miss this oppos d the respo on the audito d, neverthe ere fraud ma edgement th ce of some oved in the n be seen by audit is car d evaluate t misstateme ors should of managem ud… (para. ies continue , substantial ressure has ory legislati t one of pos d enhancem al responsib ponsibilities rnal control ditor associa accounting bilities. th , 2002), w ssion amon to fraud, an to fraud. th sion contin ditors expe for fraud. arena, virt itor’s respon sas 14 is he core con sponsibilitie wever, audit tatements i sition is refl onsibilities t or of the co eless, that a ay exist. po hat sound au responsibi e direction y the extract rried out ma their audit w ents in the fi as soon a ment, the boa 41). (apb, ed to collap l fraud cont mounted, p ion (sikka ssibilities to ment of aud bilities on a s which the systems; c ation with in g profession his is reflec which emph ng engagem nd obtaining he duty on nues to stre ct to minim ually no ch nsibility to the major ncept of taiw es to preve ors should in the finan 34 ected by the to prevent a ompany” (c auditors are orter (1997) udit proced ility to dete of recogn ts from the u ay, however work in or financial sta as practica ard of direc , 1995)” pse (enron a tinued to oc parliament et al., 1998 o reduce the ditor indepe auditors with e profession compliance nterim finan n has given cted, under hasize the ment perso g the inform fraud detec ess it is the mize legal l hange has detect fraud r auditing wan’s sas ent and det plan and p ncial statem asian e clear state and detect ica 1988, i e required ) indicates th dures should ect fraud. si izing incre uk sas 11 r, act as a d rder to have atements ari able commu ctor or the a and worldc ccur, and fu members w 8; dunn and e expectation endence. o h regard to n might cons reporting; d ncial inform n increase the uk is importanc onnel rega mation neede ction remain e duty of m iability by occurred in d since the standard w 14, in simi tect fraud a erform thei ments arisin n journal of f ement that “ fraud firml icaew 198 to remain hat such req d uncover m ince the 19 eased respo 10 (apb, 19 eterrent (pa e a reasona sing from e unicate the audit commi com in us, unds continu were critical d sikka, 19 n gap is exp ’malley (19 detecting f sider: mana direct repor mation. to the bre sa240 (ap e of exerc arding the ed to identi ns publicly managemen avoiding le n the audit taiwan sa which regul ilar vein to and errors r audit wor g from frau finance & ac issn 19 2013, vol. www.macrothi “the auditor ly rest on c 85). alert to su quirement, major fraud 980s, the pr onsibility fo 995) ara. 17)…. a able expect error or frau eir findings ittee if they bcci and ued to disap l, and gove 999). koh a pansion of a 993) also a fraud by sug agement and rting by aud eadth and d pb, 2005) cising prof risks of ify risks of disavowed nt. vanasco egal claims ting standar as 14’s ince lates the a us sas 53 lie with c rk with due ud or error ccounting 946-052x 5, no. 1 ink.org/ajfa was not company uspicious together s, imply ofession or fraud auditors tation of ud (para. s to the y suspect barings ppear go ernments and woo auditor’s agrees to ggesting d auditor ditors to depth of and us fessional material material and the o (1998) holding rds with eption in auditor’s 3 (chen, company e care so r can be uncover during h prior to auditor’ to sanct informa fraudul procom the us billion) account in losse subsidia the 199 made b avoidin authoriz (usd $ the abo public c respons and the influenc governm raise cp not pur supervi taiwan the cpa in taiw develop donatio publicat relating efficien public account in sept debates auditor red. no resp her/his audi o 2000, the ’s duty to de tions impos ation about lent activiti mp informati enron finan fallout roc ting profess es relating aries by ch 90s, well-kn y its ceo w ng short-term zation, and $330 million ove corpora confidence sibility to de general pub ced by circ ment author pa audit sta rsuing the id sor and ov n cpa asso a act amen wan, the c pment foun ons by cpa tions and h g to income ncy, but also good and i tancy profes tember 200 s on the au r’s respons ponsibility it. taiwan pro etect fraud sed on erran monitoring es across b ics ltd. was ncial fraud. cked the ta sion. other to the inv hung-shing nown fraud which resul m investme taiwan int n) in 1994 b ate frauds i in auditors etect and re blic do not cumstances rity, financi andards and dea of emp verseer, the ociation’s s ndment 2007 current aud ndation (ar a associati holding acco sources at o renders it interest. th ssion. 06, taiwan uditor’s resp ibility to co for reportin ofessional b was not dis nt auditors id process and usiness hav s one case i . by the end aiwanese m fraud episo estment in bank result d cases are lted in a los nt loss real ternational because of th n taiwan h s but have a eport fraud. favor the st that led t ial supervis d effect a rob ploying an o practice r elf-regulato 7 (wu, 2007 dit standard rdf). as a f on, with th ountant pro the associa ineffectual his is not c auditing se ponsibilities onsider frau 35 ng fraud is i body’s syste scussed in th dentified by d its outcom ve increased infamous en d of june 2 market and odes includ 2004, and ted in nt$ tung-lung ss of nt$2. lization by t securities c he false tran have not on also placed however, t tatus quo. to the pass sory comm bust practic outside regu review syst ory function 7). ds regulati foundation, he exceptio ofessional tr ation not on l when it co conducive t etting body s to detect ud in an au asian involved wh em of practi he public do y the monito mes. d in the last nough to be 004, procom brought ab de infodisk d the illega $11 billion b metal ind 4 billion (u the shift to company s nsaction ma nly resulted d the spotlig the governm age of sar mission, bega ce review s ulatory agen tem has sti ns, which a ng body i , ardf’s in on of some raining sem nly hampers omes to pro to the healt y, respondin t and repor udit of finan n journal of f hen the audi ice review omain. littl oring of aud t two decad deemed the mp’s nt$40 bout scathin technology l over-due bad-debt lo ustry co’s usd$80 mil long-term i suffered los ade by a jun in huge lo ght of the d ment, variou rbanes-oxle an seriously system in ta ncy such as ll relied on re supporte is account ncome deriv income de minars. the s ardf in moting aud thy develop ng to the pu rt fraud, iss ncial statem finance & ac issn 19 2013, vol. www.macrothi itor discove with respe le publicity ditors’ perfo des. among e taiwan ve 0 billion (u ng criticism y’s nt$4.28 loans mad oss in 2000. fraudulent llion) in 19 investment s of nt$10 nior staff. osses of mo debate on a us pressure ey act (so y to explore aiwan. reg s pcaob t n the most ed and endo ting resear ves mainly f erived from conflict of its standard dit standards pment of t ublic critic sued sas ments. the t ccounting 946-052x 5, no. 1 ink.org/ajfa ers fraud ct to the is given ormance, gst them, ersion of usd$1.3 m of the 8 billion de to its . during activity 998 from without 0 billion oney and auditors’ e groups, ox), the ways to rettably, to be its part on orsed by rch and from the m selling f interest d-setting s for the taiwan’s ism and 43: the taiwan’s sas 43 respons 2006). spells o maintai detectin eviden the deb gaps w well as define t envision term b recomm (1993) auditors reasona expecta ‘reason ‘deficie numero many c usable r that sha reasona baron e questio officers existenc respons partners falsifica further one tho 47% of the st compris were th ‘financi audit fi 3 adopted cu sibility to re it points o out the resp in an attitud ng material nce from em bate about t ithin the ac between pu the term ‘e ned both by became pre mendations extended th s’ perform ableness ation-perform ableness ga ent standard ous empiric countries. b responses ( areholders able or even et al. (1977 onnaires we s (83); fina ce of audit sibility to d s of large f ation. evidence i ousand resp f those quest teen survey sed 1,737 u hose who sa ially aware’ inancial sta urrently, ref eport fraud, out that the ponsibility a de of profe misstateme mpirical st the auditor’ ccounting p ublic expec expectation y the indep evailing us of the coh he definitio mance as p and expe mance gap ap’ and the ds gap’ and t cal studies o beck (1973) 46% respon expect from n possible. 7) conducted ere sent to l ancial mana expectation detect the de firms were n the 1980s pondents we tioned belie y (1990), c usable respo aid they we ’, were thos atements, an ferring to u , and consi detection as adherenc essional ske nts in the fi udies s responsibi profession i ctations and gap’ as di endent acco sage in th hen report ons as the g perceived ected per p’, and p ‘performan the ‘deficien of the audit ) surveyed nse rate). b m the aud d a survey arge firm a agers (79); n gap where eliberate m the group p s was provi ere interview eved that au conducted ondents who ere chairma e in a positi nd who ow 36 s sas 99 a ideration of responsibil ce to gaas epticism in inancial stat ility to dete itself conce d auditor per ifference of ountant and he auditing on auditors gap betwee by society rformance, proposed t nce gap’. th nt performa expectation australian beck’s findin ditors far ex in 1975 to audit partner and financ eby non-au material falsi proclaiming ided by the wed by telep uditors shou by means o were divi an, director ion to influe wned shares asian and uk sas f fraud risk ity rests w s, namely t order to ha tements aris ect fraud rev rning the p rformance. f the levels d by the use g literature s’ responsib en society’s y. by em she a two major he latter is ance gap’. n gap have shareholde ngs were th xceed what learn the ex rs (105); sm cial analyst uditors thoug ification of g least resp e macdonal phone and, ld actively of face-to ded into thr or senior p ence audit a s and active n journal of f s 110, recog factors dur with manage that the aud ave a reaso sing from er veals that th proper cond liggio (19 s of expect er of financ after the bilities (aic s expectatio mbracing th dopted th r compone constructed been condu ers in 1972 hat the profe t the audit xtent of any mall firm c ts (52). th ght auditors f the financi ponsibility t ld commiss as far as fra seek fraud. -face interv ree categori partner in a appointment ely manage finance & ac issn 19 2013, vol. www.macrothi gnizes the a ring the au ement. how ditor is req onable assur rror or fraud here are exp duct of an a 74) was the ted perform cial stateme e conclusio cpa, 1978) ons of audit he notion the title ents, name d as the sum ucted since 2 and obtain fessional ass tor would c y expectatio cpa (35); ba he study fo s should tak ial statemen to detect de sion (cica aud was con views in t ies: (1) ‘inf a company; ts and famil ed their ow ccounting 946-052x 5, no. 1 ink.org/ajfa auditor’s dit (ma, wever, it quired to rance of d. pectation audit, as e first to mance as nts. the ons and ). porter tors and of the ‘audit ely, the m of the 1970 in ned 711 surances consider ons gap. ank loan ound the ke more nts. the eliberate a, 1988). ncerned, the uk, fluential’ (2)the liar with wn share portfoli audited detectio expecta humph 1991. a categor analysts even au they did porter auditors of those usable general non-aud perform 11%, 5 1989 s expecta the 199 and unr porter a has imp auditors recomm strength enhanci to narr educate oth existenc designe respons and jag low, f ahmad (2005) sohlima the exis of audit io or financi financial s on is an im ations gap re hrey et al. (1 a 38% resp ies of inte s, bankers, uditors saw d not feel th (1993) con s’ interest g e responsib 1,184 respo public) r ditors. the mance gap, d 8%, and 31 study in b ation-perform 99 study sh reasonablen and gowth proved so th s have incr mended four hened moni ing educatio owing the ed about the her studies ce of the ex ed to asce sibilities and ger (1993) i foo, and k (2004) in in banglad an (2006) in stence of the ted financia ial affairs; ( statements. mportant par egarding fra 1993a) cond ponse rate erviewees and financi auditors as hat auditors nducted a s groups abou bilities, and onses from revealed th e study cal deficient sta 1% respectiv oth nz an mance gap howed the s ness expect orpe indica hat the perf reased to a r measures itoring of au on of the au reasonable e audit funct in emerg xpectation g ertain the d the audit in the repu oh (1988) malaysia; desh; dixo n egypt; si e audit expe al statement, (3) the rema the survey rt of the au aud detectio ducted a que was achiev were: audi ial journalis having a ro currently of survey in n ut auditors’ e the respons four group he presence lculated the andards gap vely. in 199 nd the uk has change sizes of the ation gap h ated (2004) formance ga level that to be impla uditors’ per uditing pract eness gap, tion and wh ing econom gap. most of opinions o objectives. ublic of sou and best, b lin and c n, desira a idani (2007) ectation gap , and audito 37 ainder of th y revealed uditor’s job, on gap of co estionnaire ved which itors, accou sts. the evi ole to ensur ffer signific new zealan existing res sibilities au ps (auditors e of an e e size of p, and unre 99, porter a k and fou ed significa deficient p have chang that audito ap has narro more than anted to nar rformance; i titioners; an they sugge hat auditors mies have f these stud of differen they are, f uth africa; buckby an chen (2004) and baldac ) in lebano p in the area or’s indepen asian e responden that the w , and showe onsiderable survey betw equated to untants, fin idence indic re that all sig cant protecti nd in 1989 sponsibilitie uditors shou s, auditees, expectation the gaps a asonablenes and gowtho und that th antly over th performance ged to 6%, ors’ perform owed. how n offsets thi rrow the pe improving q nd introduci ested the n can reasona provided dies were un nt interest for example leung and nd tan (200 ) in china; cchino (200 on. most stu a of the aud ndence or ac n journal of f nts who wer widely held ed clearly t proportions ween octob o 935 usabl nancial dir cated that p gnificant fra ion against to ascerta es, the stand uld take upo financial co gap betw and found ss expectati orpe (2004) he composi he decade f e gap, defic 53%, and mance of th ever, societ is improvem erformance quality cont ing new aud need for so ably be expe the eviden ndertaken by groups ab e, the invest d chau (200 01) in sing chowdhur 05) in malt udies above itor’s respo ccountability finance & ac issn 19 2013, vol. www.macrothi re not famil opinion th that there e s. ber 1990 and le replies. rectors, inv preparers, u aud is detec fraud. ain the opin dard of perfo on themselv ommunity, ween audito that the d ion gap con ) replicated ition of th from 1989 t cient standa 41%, respe heir respons ty’s expecta ment. they gap: contin trols in aud diting stand ociety to b ected to ach nce identify y means of bout the a tigations by 01) in hong gapore; fad ry, inn and ta; woodh e consistentl onsibility, re ty. ccounting 946-052x 5, no. 1 ink.org/ajfa liar with hat fraud exists an d march the six vestment sers and cted, but nions of ormance ves. the and the ors and deficient ntributed porter’s he audit to 1999. ards gap, ectively. sibilities ations of y further nued and dit firms; dards. as be better hieve. ying the f surveys auditor’s y gloeck g kong; dzly and d kouhy ead and ly found eliability results examin away fr the 20th account survey r is pertin despite so-calle researc whethe worth expecta order to 1. the ordinary 2. the audit ex 3. the exists a 4. the exists a 5. the where t 6. the the true 7. the perpetra between 8. the (such a entity. 9. the (such a enrich e 10. the falsifica from a stri ed. they co rom fraud d h century, is tancy profe respondents nent to note general ex ed ignorance ch method er the accou investigatin ations gap w o examine th e auditor s y audit exam e auditor sh xamination e auditor sh among empl e auditor sh at the manag e auditor sh the irregular e auditor sh e and fair vie e auditor s ated and co n affiliated e auditor sh s embezzlem e auditor sh as petty cash employees b e auditor ations and ing of emp onfirm the detection as s not a view ession and a s who want e also that s xhortations e gap. d unting profe ng. this em with respec his issue, th hould be h mination. hould be he specifically hould be hel loyees below hould be hel gement leve hould be he rities are a r hould be he ew of finan should be oncealed thr companies) hould be he ment) that s hould be he h theft, pay below mana should be misreprese irical studie historical a the main au w shared by audit benefi ed the audit such views from the p fession in t mpirical in ct to the au he following held respon eld responsi y designed f ld responsib w managem ld responsib el. eld responsi result of unr eld responsi ncial stateme held respon rough relate ). eld responsi serve to per eld responsi yroll paddin agement lev held resp entations of 38 es stretchin analysis ma audit objecti the public. ficiaries, the tor’s role to have, in br profession taiwan has nvestigation uditor’s resp g statements nsible for th ible for fail for such det ble for failu ment level. ble for failu ible for fail recorded tra ible for fail ents. nsible for ed party tra ible for fail rsonally enr ible for fail ng, theft of vel. ponsible for f financial asian ng over the ade earlier, n ive, which s not only d ey differ co o embrace fr oad terms, and educat met the pub n are to a ponsibilities s are develo he failure t lure to dete ection. ure to detect ure to detect lure to dete ansactions. ure to detec failure to ansactions ( lure to dete rich manage lure to dete stocks) tha r failure to statements n journal of f last 40 yea namely that solidified in do the views onsiderably. raud detecti remained c ional publi blic’s expec scertain th s to detect oped and tes o detect m ct material material fra material fra ect material ct fraud tha detect mat (i.e., shares ect the type ers, officers ect the type at are comm o detect m s that are c finance & ac issn 19 2013, vol. www.macrothi ars or so ha at the gradu n the second s differ betw the percen ion is subst consistent ov icity to cha ctations is he nature o corporate f sted: material frau fraud in a raud when c raud when c fraud in si at materially terial fraud trading irr e of materia s, or directo e of materia mitted to pe material, de committed ccounting 946-052x 5, no. 1 ink.org/ajfa ave been ual move d half of ween the ntage of antial. it ver time ange the an issue of audit fraud. in ud in an detailed collusion collusion ituations y affects d that is regularly al frauds ors of an al frauds ersonally eliberate for the purpose a choic asked t respond detectio analyzin choice, (coded side of t the an wilcoxo establis signific means signific be claim (siegel for the group c top-500 financia prepare a total non-res explana auditee member is a very investig as the instituti with re surveye differen the surv stateme results respond table 3 it is ack e of defraud ce of six alt to give one dents may n on, the ‘don ng. therefo were calcu 5)’ on the le the scale. nalysis is on-mann-w sh whether a cant. the w of the two cant differen med that the and castell e purpose o consisting 0 public co al analysts ers of financ of 964 ques spondents w ation, 340 o group, and rs surveyed y satisfactor gation resu respondent ional invest espect to ac ed opinions nce of opin vey results a ent response which exa dent groups . knowledged ding the inve ternative res e level of a not have bac n’t know (c ore, the fiv ulated by us eft hand sid made of whitney tes apparent dif wilcoxon-ma population nces were fo e auditors a lan, 1989) f this study of financia ompanies; a and bank lo cial statemen stionnaires w was done by of which w d 213 to the d, there were ry response ults t group of t tors, and ba ccounting in s of auditor nions within are exhibite es are provi amine whet . the summ d that, altho esting publi sponses for agreement. ckground kn coded 0)’ ch ve choices o sing the fiv de of the sca f the diff st. the wi fferences of ann-whitne ns without h found amon re expected y, three gro al directors, and the gro oan officers nts. were mailed 669 duplic went to mem members o e 341 usabl e rate within the users of ank loan of nformation, r’s respons n the user gr ed in table ided. in add ther differe mary and ov ough judgm 39 ic. each statem in order to nowledge a hoice is giv of level of ve-point lik ale to ‘stron ferences in wilcoxon-ma f opinion b ey test was c having to t ngst five gro d to be held oups were s , ceos, or oup of use s. the subg d. in order t cate copies o mbers of th of the users le responses n an east-as f financial fficers, who , the analys sibility betw roup was al 1, where th dition, tabl ences are e verview of ment of the asian ment is desi o eliminate about the au ven in the f agreement kert scale, v ngly disagre n the me ann-whitney etween the chosen beca test for nor oups within responsible selected. th r accountin rs of finan groups of th to increase t of the quest he auditor g of financia s, a 35% ret sian context statements o represent sis is thus ween the fi lso identifie he means an le 2 shows evident in the respon performanc n journal of f igned, and t the bias o uditor’s resp questionnai t, excluding varying from ee (coded 1 ean rankin y test has survey grou ause it could rmality of d these table e for the de hey are aud ng manager ncial statem he auditee a the respons tionnaire an group, 116 l statements urn rate for t. consists of different b undertaken ive major r ed. the desc nd standard wilcoxon-m the opinio dents’ opin ce of audito finance & ac issn 19 2013, vol. www.macrothi the respond of analysis ponsibility f ire but excl g the ‘don’ om ‘strongl )’ on the rig ng based been ado ups are stat d test differ distribution es of results etection of th ditor group, rs from ta ments, consi are regarde se rate, follo nd original l to member s group. of r data analy f financial a beneficiary n by compa respondent criptive stat deviations mann-whit on results b nions is prov ors’ respons ccounting 946-052x 5, no. 1 ink.org/ajfa dents are that the for fraud luded in ’t know’ y agree ght hand on the opted to tistically rences in . where s, it may he fraud auditee aiwanese isting of d as the ow-up of letters of rs of the f the 964 sis. this analysts, interests aring the groups. tistics of for each tney test between vided in sibilities involve study, 3 so arbit on ave auditor’ results o stateme when co stateme when co stateme materia commit the ove the fina stateme instituti are resp them. t stateme in a det stateme materia stateme perpetr stateme delibera the purp it is int signific accordin auditors which t existing the fina caused fair view there i es a range o 3 has been s trariness wil erage, in the ’s responsib of less than ent 3: the a ollusion exi ent 4: the a ollusion exi ent 9: the al frauds (s tted to perso erall group ancial analy ent 9 whic ional invest ponsible for the auditor g ent 2: the a tailed audit ent 6: the ally affects t ent 7: the a rated and co ent 10: the ate falsifica pose of defr eresting to cant differen ng to the s perceive th they are re g auditing st ancial statem by delibera w of the fin s a strong c of spectrum selected as t ll decrease, e overall gr bility for fr three. thes auditors sho ists among e auditors sho ists at the m auditors sh such as pet onally enric perception yst group, bu h are not tor groups a r fraud dete group consi auditors sho examinatio auditors sh the true and auditors sho oncealed thr e auditors s ations and m rauding the note, howev nces in the m wilcoxon-m heir respons easonably e tandards ex ments be pr ate falsificat nancial state consensus b ms, rather th the point of and objecti roup analys aud detecti se three stat ould be held employees b ould be held anagement hould be he tty cash the ch employee of the abov ut bank loan auditor’s d agree with ection. by c iders only th ould be held on specifical hould be he d fair view of ould be held rough relate should be h misrepresent investing p ver, that the mean respon mann-whitn sibilities on expected to xpress that a resented wi tions or dis ements. by both aud 40 han a point f differentiat ivity increas sis, three of on. this is tements are: d responsib below the m d responsib level. eld respons eft, payroll es below ma ve three state n officer gr duties. it s all the ten contrast, th he following d responsib lly designed eld respons of financial d responsib ed party tra held respon tations of fi public. e above fou nses betwee ney test in nly within th o perform t auditors sho ith a true an stortions wo ditor and no asian of measure tion (averag se. f the statem shown in t : ble for the fa management ble for the fa sible for the l padding, anagement l ements is co roup only ag should be statements e auditor g g statement ble for the fa d for such d sible for th statements. ble for the fa ansactions. nsible for t inancial sta ur responsib en the audito n table 2. he existing a the duty to ould issue th nd fair view ould have m on-auditor g n journal of f ement, for t ge of sum b ments are no the table 1 failure to de level. failure to de e failure to or theft of level. onsistent wi grees with t noted that which claim roup agrees s as their re failure to de detection. he failure to failure to de the failure tements tha bilities do no or group an the results auditing sta o detect. th he audit rep w. any mate material effe groups that finance & ac issn 19 2013, vol. www.macrothi the purpose by 1 to 5). b ot perceive 1, by having etect materi etect materi o detect the f stocks) wh with the resp the stateme both audi m that the s only with esponsibiliti etect materi o detect fra etect materi to detect m at are comm ot have stat nd the audite s indicate andard requi he prescrip port stating terial missta ects on the auditors sh ccounting 946-052x 5, no. 1 ink.org/ajfa e of this by doing d as the g means ial fraud ial fraud e type of hich are onses of nt 3 and itee and auditors h four of ies: ial fraud aud that ial fraud material, mitted for tistically ee group that the irements, ptions in whether atements true and hould be held res and for (statem howeve the scop detect a level. t investor be foun stateme general respons to sum duties t perpetra through discuss the pa regardin expecta respons agrees o appears needs to to ensu maintai be incr self-reg confide suggest professi their in public capaciti principl the fac rather s indicati and affe auditors sponsible fo detection o ment 6). er, the nonpe of existi all type of f the signifi r groups, an nd in the co ent 3. the r ized conclu ses between m up, the res to detect the ated by em h related-par sion and co aper has in ng the aud ation gap sibility from only with th s that adequ o be conside ure that the ining the fra reased, not gulation is n ence in the ted that the ionals but i nvolvement, awareness ies can, wh les of what ct that audit see their ro ion that the fect the relia s should ac or fraud det of fraud that -auditor gro ing auditing frauds inclu cant differe nd between omparison b results of w usion that ca n the groups sults indicat e material f mployees b rty transacti onclusions nvestigated, itor’s respo existing in m auditors w he detection uateness of ered and ma e accountin aud detectio t merely r not enough e adequacy auditing st include dis financial s heightened hile function is termed ‘c tors in taiw ole as expr y still need ability of th ct as a watc tection in a t materially oup would n g standards uding the co ences of o the auditor between au wilcoxon-ma an be drawn . te the existe fraud, durin below mana ions. table , amongst onsibility to n taiwan. with respec n responsib the auditin aintained. ng professio on standards relying on for building of the dis andards-set tinguished statement a d, so that c ning under commonly a wan do not s ressing an d to be awa heir audit r chdog that 41 design spec y affects the not merely but expect ollusion am opinions are r and bank uditor group ann-whitne n about the ence of the ng an ordina agement le 3 provides auditor an o detect co the nonct to detect bility require ng standard on is perce s, it is sugg the self-re g up the con sciplinary p tting body m members f audit proced cpas in th a self-regu accepted’. see the dete independen are that und reports. fur is responsi asian cifically to true and fa expect the t auditors to mongst the e e between loan officer p and finan ey test (see t statistically expectation ary audit ex evel; and th a summary nd non-aud orporate frau -auditor gr ting fraud t ed in the ta with respec eived by in gested that p egulation a nfidence of procedures must not ju from divers dures can b heir financia ulatory inst ection of fra nt opinion detected frau thermore, f ible for rep n journal of f search for f air view of f auditor’s re o expand th employees b the audito r group. th ncial analyst table 2) rev y significan n gap in ter xamination; hat materia and overvie ditor group ud. the fin roups are than the au aiwanese ex ct to the au terested ou publicity of as a monit f the public. of the pro st be compr e sectors o be made mo al audit an titution, bet aud as their on financia ud could di from an eth porting any finance & ac issn 19 2013, vol. www.macrothi fraud (state financial sta esponsibility he responsi below mana or and inst he similar re t group, ex veal that the nt difference rms of the a that materi al fraud co ew of the op ps, the per ndings indi expecting uditor group xisting stan uditor respo utside partie f disciplinar toring mec . to increas ofession, it rised of acc of society. t ore transpar nd standards tter conform r responsibi al statemen istort their hical viewpo suspicion ccounting 946-052x 5, no. 1 ink.org/ajfa ement 2) atements y within ibility to agement itutional esult can xcept for ere is no es of the auditor’s ial fraud oncealed pinions. ceptions cate the greater p, which dards. it nsibility es to be ry action chanism. se public is also counting through rent and s-setting m to the ility, but nts is an findings oint, the of fraud rather th educati regard t still exi technica maintai indepen users in precise sufficie reasona concern be requ have do the stu suggest submitt extendin future r sending study in aspects perpetra referen aicpa respons aicpa (treadw apb. (2 an audi auditin council baron, irregula beck, g accoun best, p. han remaini ion and com their role, b ist. not on al compete in professio ndence and n taiwan, o and detail ntly standa able assuran ns they have uired to add oubts about udy contribu tions provid ted that the ng the inter research ma g a large-sc nto this are of auditing ated and det nces . (1978). re sibilities, a . (1987). r way commis 2005). isa it of financ ng practices l, london. c., johns arities: are w g.w. (1974 nting and bu ., buckby, s ing silent. mmunication by closing nly must au ence require onal attitud service abo on the other led engage ardized to a nce). howev e about the a paragraph the viability utes our un ded in an at e investigat rnational lite ay consider cale self-adm ea could als g for fraud tected will a eport conc aicpa, new report of th ssion), aic (uk and ir cial stateme s board. ( son, d., s we closing t 4). the rol usiness rese s. and tan, n may be a k the ‘misun uditors kno ed to fulfil des. in pa ove reward m hand, may ement letter avoid confu ver, it must company. i h to the aud y of the aud nderstanding ttempt to br tion finding erature rega r both longi ministered q so be under . detailed m also be imp lusions and w york. he nationa pa, new yo reland) 240 ents, icaew (2004). eth searfoss, d the expecta le of the a earch, 4, 11 c. (2001). 42 key to solvi nderstanding ow what th ll them sat articular, th must be inst y need to be r and the usion amon also be flex it is sugges dit report ex ditee compa g of the aud ridge the ex gs make a arding the au itudinal stud questionnai rtaken to in micro case portant (see d recommen al commiss york. 0: the audit w, london. hical stand d. and sm ations gap?” auditor in m 7-122. evidence o asian ing part of t g gap’ altho heir respons tisfactorily, he professi tilled in them well inform audit repo gst readers xible enoug sted that the xplaining th any. ditor’s duty xpectation g particular udit expecta dies and co ire to remo nvestigate t studies of e.g. lam et ndations of sion on fra tor’s respo dards for a mith, c. (1 ” journal of modern soc of the audit n journal of f the problem ough the ex sibilities are they must ional stand m. med through rt. such a as to its b gh for audito e auditors in he position i y to detect f gap in taiw and valuab ation gap. mparative s ve any pote the function how major t al., 2011). f the comm audulent f nsibility to auditors, f 1977). unc f accountanc ciety: an e expectation finance & ac issn 19 2013, vol. www.macrothi m as to how xpectation g e, and pos t also deve dards of i h the provis a report sh basic messa ors to repor n taiwan ex in cases wh frauds and wan. moreov ble contribu studies ove ential bias. nal and ope r frauds we mission on a financial re consider f financial r covering c cy, 144(4), empirical ap n gap in sin ccounting 946-052x 5, no. 1 ink.org/ajfa auditors gap may sess the elop and ntegrity, sion of a ould be age (i.e., rt clearly xplicitly here they possible ver, it is ution to rseas by further erational ere both auditors’ eporting fraud in eporting orporate 56-66. ppraisal. ngapore. manage brown, 37(4), 6 burrow hologra accoun cheng, assuran chowdh banglad http://dx cica. canadia desira, in http://dx dixon, gap http://dx dunn, j accoun fadzly, manage farrel, busines flint, d and bus gloeck, workin huang, auditing august, humph issue in humph auditors erial auditin r. g. (19 696-703. wes, a.w., am of postnting, 15(6), h. (2004) nce. account hury, r., in desh. x.doi.org/10 (1988). re an institute j. and bald malta. x.doi.org/10 r., woodh in eg x.doi.org/10 j. and sikk ntancy and b m.n. and erial auditi b. and fran ss fraud: sa d. (1971). t siness resea , j.d. and j ng paper, sc c., lin, l g attestation , pp. 76-82. hrey, c. (19 n auditing, p hrey, c., tu s and frau ng journal, 962). chang kastantin, enron discl 797-811. h ). the resp ting resear nnes, j. and manageri 0.1108/0268 eport of th of chartere dacchino, p manage 0.1108/0268 head, a.d. gypt. m 0.1108/0268 ka, p. (1999 business af d ahmad, ng journal, nco, j. (199 as no.82. w the role of t arch, 1(4), 2 ager, h. (19 chool of acc l.y. and ch n: recent lit 997). debati paul chapm urley s. and ud?” accou , 16(3), 133 ging audit o j. and nov losure: a c http://dx.doi ponsibility rch monthly kouhy, r. al au 869005106 he commiss ed accounta . j. (2005). erial a 869005106 and sohlim managerial 8690061065 9). auditors ffairs, basild z. (2004) , 19(7), 897 99). the ro western crim he auditor i 287-293. ht 993), the au countancy, hen, h. (19 tigation cas ing audit ex man publishi d moizer, p nting, aud 43 -44. http://d objectives a vicevic, m critical reali i.org/10.101 for financ y, 220, 53-58 (2005). th uditing 19719 sion to stu ants, toront jurors’ and auditing 11230 man, m. (20 auditin 53026 s: keeping don, uk. . audit ex 7-915. http:/ ole of the au minology re in modern s ttp://dx.doi. udit expecta university 998). the d ses. accoun xpectations ing, london p. (1993b). diting, and asian dx.doi.org/1 and techniq . (2004). t ist commen 16/j.cpa.200 ial stateme 8. (in chine he public se journal, udy the pub to. d self-percep journa 006). an in ng jou the public xpectation //dx.doi.org/ uditor in th eview, 2(1), society: an org/10.1080 ation gap in of pretoria. discussion ting resear . in shere n, pp. 3-29. protecting accountab n journal of f 10.1108/026 ques. the a the sarbane ntary. critic 03.06.006 ents audit: ese) ector audit e , 20( blic’s expe ptions of th al, 20( nvestigation rnal, 2 in the dar gap: the /10.1108/02 he preventio 1-12. exploratory 0/00014788 n the repub on the liab rch monthly m, turley against det bility journ finance & ac issn 19 2013, vol. www.macrothi 6869001103 accounting nes-oxley a cal perspec it is not expectation (8), 8 ectations of he statutory 0(7), 6 n of the exp 21(3), 2 rk, associa case of m 2686900410 on and dete y essay. acc 8.1971.9728 blic of south bility of ta y (in chines s, editors. tection: the nal, 6(1), 3 ccounting 946-052x 5, no. 1 ink.org/ajfa 385579 review, act as a ctives on absolute ns gap in 893-908. f audits, auditors 691-706. pectation 293-302. ation for malaysia. 0549420 ection of counting 8980 h africa, aiwanese se), 153, current case of 395-411. http://dx humph perspec http://dx humph an emp icaew icaew london koh, h journal koh, h auditing lam, j. unpubl lee, t. lee, t. leung, audit ex 14, 181 liggio, contem lin, z.j republi liu, c.w of mana low, a and aud lys, t. 65-93. h ma, x. securiti mitchel for acc x.doi.org/10 hrey, c.g. ctive on the x.doi.org/10 hrey, c.g., m pirical inves w. (1985a). r w. (1985b). n. h.c. and w l, 13(3), 147 .c. and wo g journal, 6 , james, k. lished work (1970). the (1986), com p. and ch xpectations: -200. http:/ c.d. (197 mporary bus j. and chen ic of china. w. (2002). agement (in a.m., foo, s ditors—som and watts, http://dx.do r. (2006). ies market m ll, a., sikk ountancy an 0.1108/0951 and moize e auditing f 0.1016/1045 moizer, p. a stigation. ac report of th the audito woo, e. (19 7-154. http: oo, e. (2001 6(3), 176-88 and leung king paper, u e nature of a mpany audi au, g. (200 : some evid //dx.doi.org/ 74). the ex siness, 3, 27 n, f. (2004) . internation cpa's licen n chinese), s.l. and ko me empirical r.l. (1994) oi.org/10.230 auditor’s r monthly (in a, p. and w nd business 1357931002 er, p. (1990 function. c 5-2354(90)0 and turley, w ccounting a he working p or and fra 998). the //dx.doi.org ). the audit 8. , j.k.-s. (20 university o auditing and iting (3rd ed 01). the pr dence from /10.1016/s0 xpectation 7-44. ). an empir nal journal nsing requir 19(1), 109oh, h.c. (19 l evidence. s ). lawsuit a 07/2491440 role in cap n chinese), 1 willmott, h. s affairs, uk 44 27512 0). from te critical per 03021-7 w. s. (1993 and business party on fr aud: repor expectation g/10.1108/0 tor-manage 011). the re of southern d its objecti d.), chapma roblematic r hong kon 0897-3660( gap: the a rical study o l of auditing rement, leg 145. 988). the ex singapore a against audi 0 pital market 123, 31-41. . (1998), th k. asian echniques rspectives o 3a). the aud s research, raud (davis rt of lord b n gap in au 0268690981 er expectatio ebuilding of n queenslan ives. accoun an and hall relationship ng. advance 01)14010-9 accountant’s of audit ‘ex g, 8(8), 92-1 al liability, xpectation g accountant, itors. journa t: fraud det he accounta n journal of f to ideologi on accounti dit expectati 23(91a), 3 son report), benson’s co uditing. ma 0208038 on gap in au f a life after nd, toowoom ntancy, 81, , london. p between a es in interna 9 s legal wa xpectation g 115. and the aud gap between , 4, 10-13. al of accou tection resp ants’ laund finance & ac issn 19 2013, vol. www.macrothi ies: an alt ing, 1(3), 2 tions gap in 395-411. , icaew, l committee, i managerial a uditing. man r jail time fo mba, austra 292-296. audit report ational acc aterloo. jou gap’ in the p dit market. n financial unting resea ponsibility. dromat, ass ccounting 946-052x 5, no. 1 ink.org/ajfa ternative 217-238. britain: london. icaew, auditing nagerial or fraud. alia. ting and ounting, urnal of people’s journal analysts arch, 32, gre-tai sociation o’mall accoun o’sulliv accoun pcaob compan porter, and bus porter, issue. i london porter, unitedk institute power, on acco sidani, auditing siegel, ed.), m sikka, journal http://dx sikka, p expecta 299-330 steen, m tung, k metal in vanasc http://dx willing detectio woolf, austral ey, s.f. (1 nting horizo van, n. (1 nting and bu b, (2002), a ny account b. (1993). siness resea b. (1997). n shere m n, pp. 31-54 b.a. and kingdom in e of charter m. (1995). ounting, 6(4 m.j. (200 g journal, 2 s. and cast mcgraw-hill p. (2004). l of x.doi.org/10 p., puxty, a ations gap: 0. http://dx. m. (1990). a k.p. (1998) ndustry. acc o, r. (199 x.doi.org/10 gham, j.j. (1 on of fraud. e. (1987). lia, 57(9), 22 1993). lega ons, 7, 82-8 1993). aud usiness rese au 316: c ting oversig an empiric arch, 24(93 auditors’ r , turley s, . d gowthrop n 1999 and red accoun auditing, e 4), 317-339. 07). the a 22(3), 288-3 tellan, j. (19 l, singapore some que disclo 0.1057/palg a., willmott some theo doi.org/10. audits and a . the preve counting re 98). fraud 0.1108/0268 1975). discu the cpa jo bridging t 2-23. al liability 7. itors’ liabil earch, 23(9 consideratio ght board, n cal study of 3), 49-68. ht responsibilit editors, cu pe, c. 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(2007). ment. accou . descriptiv overall gro means s.d 3.75 1.0 4.31 0.6 2.53 1.0 2.69 1. 3.63 0.9 4.14 0.6 3.85 0.8 3.31 1.0 2.98 1.0 3.89 0.8 tes that statist group (p≦0.05 2. auditin on-mann wh nt 1 nt 2 nt 3 nt 4 nt 5 nt 6 nt 7 nt 8 nt 9 nt 10 ates that no st urvey groups r the changi unting resea ve statistics oup auditors d. means s.d 04 2.71 0.9 63 4.00 0.5 08 1.83 0.6 15 1.78 0.6 98 2.64 0.9 65 3.83 0.6 80 3.13 0.8 09 2.23 0.7 09 2.26 0.8 86 3.09 0.8 tically genera 5), based on w ng function hitney test t auditors vs. auditess z s pr -9.65 0 -6.68 0 -10.19 0 -10.27 0 -9.14 0 -5.00 0 -7.66 0 -10.05 0 -9.75 0 -8.92 0 tatistically gen regarding this ing environ arch month by subgrou s auditees d. means s.d 97 4.38* 0.73 53 4.51 0.74 62 3.36* 0.80 61 3.37* 0.81 92 4.11* 0.59 66 4.26 0.57 89 4.16* 0.58 71 3.86* 0.80 81 3.76* 0.69 89 4.37* 0.66 alised conclus wilcoxon-man n expected o responses a finan sig. rob. z .00 -6.9 .00 -4.4 .00 -1.8 .00 -3.5 .00 -6.4 .00 -4.1 .00 -6.8 .00 -7.5 .00 -3.6 .00 -7.1 neralised conc statements. 46 nment in cp hly, 265, 12ups of respo financial a d. means 3 3.82* 4 4.33 0 2.10 1 2.33 9 3.72* 7 4.21 8 4.09* 0 3.46* 9 2.77 6 4.01* sion can be d nn-whitney te d of audito s auditors vs. ncial analyst sig. prob. 98 0.00 42 0.00 83 0.07 54 0.00 42 0.00 13 0.00 83 0.00 55 0.00 64 0.00 13 0.00 clusion can be asian pa practice -19. ndents nalysts institu s.d. me 0.82 4.7 0.56 4. 0.94 3.8 1.12 4.0 0.85 4.6 0.69 4. 0.59 4.4 1.05 4.3 1.05 4.3 0.62 4.6 drawn about t est. ors toward ts aud v inst'l in z -7.36 -6.18 -7.64 -7.67 -7.23 -6.78 -5.97 -7.95 -7.75 -6.65 e drawn about n journal of f e: the implic utional investo eans s.d 72* 0.46 .68 0.48 88* 0.88 00* 0.91 60* 0.50 .68 0.48 40* 0.50 36* 0.70 32* 0.75 60* 0.50 the difference d fraud de ditors vs. nvestors b sig. prob. 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 the difference finance & ac issn 19 2013, vol. www.macrothi cation of c ors bank loan d. means 6 3.93* 8 4.28 8 2.42 1 3.25* 0 4.05* 8 4.08 0 3.95* 0 3.58* 5 2.48 0 3.95* e in opinions etection res audito vs. bank loan o z -6.47 -2.90 -4.45 -7.36 -6.44 -2.09 -4.36 -7.76 -2.12 -5.46 e in opinions b ccounting 946-052x 5, no. 1 ink.org/ajfa cpa act n officers s.d. 0.35 0.55 0.84 0.98 0.32 0.47 0.32 0.71 0.85 0.39 from the sults of rs officers sig. prob. 0.00 0.00 0.00 0.00 0.00 0.04 0.00 0.00 0.03 0.00 between table 3 st st st st st st st st st sta a:  in b: √ in . summary tatement 1 tatement 2 tatement 3 tatement 4 tatement 5 tatement 6 tatement 7 tatement 8 tatement 9 atement 10 ndicates the ndicates the and overvie auditors a √    √     statement i statement i ew of the su audite √b √ √ √ √ √ √ √ √ √ is not consid s considere 47 urvey group ees fin an dered as the ed as the aud asian ps’ opinions nancial nalysts i √ √   √ √ √ √  √ e auditor’s r ditor’s respo n journal of f institutional investors √ √ √ √ √ √ √ √ √ √ responsibilit onsibility. finance & ac issn 19 2013, vol. www.macrothi bank loa officers √ √  √ √ √ √ √  √ ty. ccounting 946-052x 5, no. 1 ink.org/ajfa an s microsoft word 1690-6680-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 290 disclosure quality and firm's characteristics: evidence from iran nasrollah takhtaei accounting department, dezfoul branch, islamic azad university, dezfoul, iran e-mail: nasrollah_takhtaei@yahoo.com zahra mousavi accounting department, andimeshk branch, islamic azad university, andimeshk, iran received: april 22, 2012 accepted: may 30, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1690 url: http://dx.doi.org/10.5296/ajfa.v4i2.1690 abstract our paper aims to examine the relationship disclosure quality and firm characteristics for a sample of 80 firms listed in the iran financial market during 2006-2009. we use a linear regression analysis to examine the association between the disclosure quality and firm's characteristics measured by variables such as current ratio, acid ratio, firm size and p/b ratio.the results of study show that the disclosure quality is having positive and significant relation with current acid and p/b ratios. also, we find that there is a significant and negative association between disclosure quality and firm size. keywords: disclosure quality, transparency, financial reporting asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 291 1. introduction disclosure is a comprehensive term in accounting and includes all of the financial reporting process approximately. one of the primary principles of accounting is disclosure principle of all the material and relevant facts in regard to financial events and transactions of profit-seeking organization particularly public companies. adequate, proper and complete terms are characteristics that are often used in order to describe the disclosure. in accounting and auditing texts, according to the perception of the every author with regard to disclosure, expressions of adequate disclosure, proper disclosure and complete disclosure, in terms of, have been referred to as well. however, the most common theories among these mentioned concepts, adequate disclosure is that as least indicate required disclosure and is consistent with this negative phrase (financial statements must not be misstatement). adequate and proper characteristics are more positive concepts. proper disclosure is based on the ethics that all potential users be considered the same with regard to the financial information disclosure. complete disclosure indicating the present of all information in a way that financial statement show complete picture concerning events and transactions of business enterprise. although, it is necessary to be presented financial statement completely but, it is not included unimportant information. because, users of financial statements may pay attention to less important information and as a result of this, neglect important events and operations (alivar, 2006 ). the purpose of disclosure in financial reporting, presenting the required information in order to achieve the following goals: 1) performance valuation of business enterprise 2) judgments on how existing resources are used by business enterprise and 3) predict the trends of business enterprise's profitability in the future. therefore, information is presented by use of financial reports must be reliable, relevance, proper and complete. the needs and requirements of main investors, investment companies, creditors and analytics should be considered. as a rule, performance valuation of business enterprise, judgments on how existing resources are used by business enterprise, and predict the trends of business enterprise's profitability in the future can take into account as the purpose of financial information disclosure. the subject of information disclosure is not only limited to the exclusive users but also consists of people's necessity in the society such as professional institutions, creditors, government, investors and other decision-makers. disclosure increase transparency while market transparency is observed as a fundamental mechanism in order to decrease the information asymmetry among the market's participants (bleck and liu 2007). disclosure helps the stockholders and other participants in market to organize their operations favorably. the investors can buy and sell stocks accurately and have control over the company with the help of proper disclosure of information (kanda 2001). increasing the information disclosure is useful for the users who are not able to determine future viewpoint of the company (dastgir and bazazzadeh 2003). the high level of disclosure will make reliability of investors in companies increase and hence efficiency in capital market. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 292 prior research indicates that it can be a significant relationship between some of the financial characteristics and firms' disclosure quality. (naser and al-khatib 2000; naser, al-khatib et al. 2002; abd-elsalam and weetman 2003; hassan, giorgioni et al. 2006; dahawy 2009; hussainey and mouselli 2010). using a sample of 80 iranian firms on the period of 2005-2009, we first examine the relationship between disclosure quality and firm's characteristics. we use current ratio, acid ratio, price–to–book ratio and firm size for the firm characteristics. the results of our study show that there is a positive and significant relationship between disclosure quality and current ratio, acid ratio, price–to–book ratio, while there is a negative and significant relationship between disclosure quality and firm size. the reminder of the paper is structured as follows: section 2 reviews previous literature relevant to this paper. section 3 establishes the hypotheses. section 4 details research method and sample selection. section 5 presents the results of the findings and analysis. finally, section 6 provides the conclusion of the study. 2. literature review dohawy(2009) investigated the relationship between company characteristics and disclosure level. the study is based on the manual examination of the disclosure of the most activity traded 41 companies listed on the cairo and alexandria stock exchange (case), using a disclosure checklist issued by the egyptian capital market authority (cma). a quantitative analysis is then used to test the relationship between corporate characteristics and disclosure level. the findings of research indicate that the degree of disclosure by egyptian companies is affected by the highly secretive egyptian culture. the results further indicate that the degree of affiliation of the auditor with an international firm is the most significant variable affecting the level of disclosure by egyptian companies and are then compared to their counterparts in previous studies. hussainey and mouselli(2010) studied the relationship between disclosure quality and stock returns in the uk. the purpose of the their study was to update and re-examine the role of corporate narrative reporting in improving investors' ability to better forecast future earnings change. they also construct a risk factor for disclosure quality and test whether such a factor is useful in explaining the time-series variation of uk stock returns. their paper contributes to the market based accounting research in three crucial ways. firstly, it offers updated evidence on the usefulness of corporate narrative reporting to investors. secondly, in offers evidence that the disclosure quality factor is a significant risk factor in the uk and finally, it finds that fama-french might contain disclosure quality related information. abd-elsalam and weetman(2003) measure the accounting disclosure in egypt linking it with the inception of the required implementation of ias in egypt. moreover, they investigated the correlation between some variables and level of disclosure. their results show that ias disclosure level was associated with audit firm type, business type, leverage, liquidity and legal form. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 293 previous research provide evidence that there is no significant relationship between leverage and level of the disclosure (cooke 1989; ahmed and nicholls 1994; wallace, naser et al. 1994; meek, roberts et al. 1995; wallace and naser 1996; naser 1998; camfferman and cooke 2002; archambault and archambault 2003; ali, ahmed et al. 2004; alsaeed 2006; mangena and tauringana 2007) however, naser and al-khatib(2000)naser and al-khatib and naser, al-khatib et al. (2002) and hassan, giorgioni et al. (2006) reports findings that there is a significant relationship between leverage and disclosure level. arabmazaryazdi and arzitoun(2005) investigated the financial disclosure on companies financial reporting. the purpose of the study was the examination of the relationship between companies' characteristics and disclosure. as an actual, it is attempted to be assessed the aspects of information disclosure's quality and quantity in iran meanwhile examining the annual reports. the trend of information disclosure was examined in the formats of three company's characteristics such as assets amount, profit margin, and industry nature. in the study, disclosure index has consisted of 55 items that take into consideration 109 items with the subsidiary items. these items cover the contents of an annual report absolutely. the items have been selected in accordance with the presented policies and then suitable adjustments. the results indicates that 1) the relationship between company size (total assets) and company disclosure number is positive and significant statistically 2) the relationship between profit margin and company disclosure number is positive and significant statistically 3) the company size (total assets) has a better relationship with disclosure level other than profit margin 4) there is no significant relationship between company industry type and company disclosure number that it means nature of industry has no effects on disclosure level in reporting annually. 3. development of hypothesis wallace, naser et al. (1994) argued that firms with a low liquidity position might disclose more information to justify their liquidity status on the other hand, belkaoui and kahl(1978) found no relationship between liquidity and disclosure. also, belkaoui and kahl(1978) and cooke (1989) suggested that the soundness of the firm as portrayed by high liquidity is associated with greater levels of disclosure (barako, hancock et al. 2007). therefore: h1: there is significant relationship between the disclosure quality and current ratio. h2:there is significant relationship between the disclosure quality and acid ratio. most studies indicated that is a positive relationship between disclosure quality and firm size (naser and al-khatib 2000; street and bryant 2000; alsaeed 2006; mangena and tauringana 2007). based on the previous studies, the following hypothesis is developed: on other hand firms with weak liquidity ratios may wish to disclose more information to explain the reasons for such situation and to assure investors of its short – term nature. thus liquidity may have effect on disclosure (laidroo 2009): h3: there is significant relationship between the disclosure quality and firm size. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 294 akerlof(1970) stated that a well–run firm ( with higher profitability and higher growth rates would want to distinguish itself from a lemon . it means that if the company is performing well its superiority can be signaled (ross spring, 1977), information asymmetry between investors and managers reduced and agency costs reduced (jensen and meckling 1976) through increased disclosure (laidroo 2009). thus: h4: there is significant relationship between the disclosure quality and price-to-book value. 4. methodology 4.1 sample selection the study sample comprises all non-financial listed companies traded on the tehran stock exchange. during data collection, some companies that possess the following conditions or presented insufficient data to construct all variables have excluded: 1. due to their having a nature of operation different from other corporates, investment and financial corporates have been omitted from sample of research. 2. the firms with fiscal year not ending to 20 march (year-endin iran), were excluded from sample of research. 3. loss firms are excluded from our sample. 4. required information such as financial statements and notes to financial statements, summary of decisions taken by regular general meeting having been published by stock exchange organization are available. finally, a total of 80 companies out of the total population are selected. the same procedure is applied for years 2005 till 2009 with a total of 320 companies out of the total population are chosen. 4.2 research method the correlation analysis is used in this study. correlation researches are researches that researcher try to determine relationship between different variables using with correlation coefficient. in these researches, appointment coefficient is criterion that this criterion describes relationship between independent and dependent variables. amount of this coefficient states what percentage of changes in dependent variable is described by independent variable. the linear regression method has been used extensively to link the disclosure quality and firm characteristics. also, we used descriptive statistics such as central indexes as well as dispersion for data analyzing. 4.3 variables definition 4.3.1 dependent variable disclosure quality disclosure quality number allocated to the companies by use of tehran stock exchange. in this study the annual scores is used to measure the disclosure quality of the listed firms in asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 295 tehran stock exchange. disclosure quality scores in measured based on timeliness, reliability of disclosed information. to measure the scores of disclosure quality the weight of reliability is 1/3 and the weight of timeliness is 2/3. 4.3.2 independent variables current ratio: current assets divided by current liability. acid ratio: (current assets minus inventory) divided by current liability. firm size: total asset is used as a proxy for firm size. price to book value (p/b): market value divided by book value stock. 5. data analysis 5.1 descriptive analysis table 1 provides the descriptive statistics for all variables utilized in this study. this table reports the mean, minimum, maximum, mean, variance and standard deviation. this table presents the summary of descriptive statistics of variables. the results indicates that number of companies investigated in this study are 240, the minimum and maximum number allocated for the firms' disclosure quality are 2 and 100, the minimum and maximum current ratio are 0.24 and 3.79, the minimum and maximum acid ratio are 0.04 and 3.79, the minimum and maximum for firm size variable are 4.29 and 7.83, the minimum and maximum for price-book value are 0 and 3.14 respectively. with regard to disclosure quality, the mean is equal to 54.3220, which indicate the allocated number average of disclosure quality for firms listed in tehran stock exchange is 54. concerning current ratio, the mean is equal to 1.2488, which shows current assets are more than current liabilities and companies are able to pay the liabilities. the mean acid ratio is 0.7253, which in terms of this variable shows current assets are less than current liabilities and companies are not able to pay the liabilities. the mean firm size is 5.7829, that we state the average price-book value for firms per year are 5.7829. in regard to the last of variables studied, we observed that the average price-book value for firms per year is 0.6218. 5.2 correlation analysis table 2 presents the correlation matrix of the variables, from which, it has observed that thecorrelation between disclosure quality and current ratio is 0/145. also, pearson correlation between disclosure quality and acid ratio, firm size and p/b ratio are 0/131, -0/138, and 0/212. table 3 indicates the multiple regressions, r square, adjusted r square and standard deviation of the estimation. the r, r square and adjusted r square are equal to 0.262, 0.069 and 0.052 respectively which it means that there is a poor correlation between disclosure quality as dependent variable and other investigated dependent variables in this study. furthermore, indicate that 5 percent of changes (variance) of disclosure quality are asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 296 determined by use of investigated independent variables in this study and 95 percent of change is conditional upon variables that have not been investigated in this study. in other words, the regression model is not able to fit the investigated data. table 4 shows the r square significance test. f indicates if the regression model of our study is model proper or not. as f=4.255 and sig=0.002 and p-value is less than 0.05; consequently it shows that variables have high determination power and are able to describe the dependent variable variance. in other words, our study model regression is a suitable model and by use of the model is able to determine variation of the disclosure quality in accordance with the investigated independent variables. table 5 points out results with regard to regression effect coefficients of investigated independent variables in this study on disclosure quality as dependent variable. 6. conclusion the subject of information disclosure is not only limited to the exclusive users, but also consists of people's necessity in the society such as professional institutions, creditors, government, investors and other decision-makers. disclosure increase transparency while market transparency is observed as a fundamental mechanism in order to decrease the information asymmetry among the market's participants. disclosure helps the stockholders and other participants in market to organize their operations favorably. the investors can buy and sell stocks accurately and have control over the company with the help of proper disclosure of information. increasing the information disclosure is useful for the users who are not able to determine future viewpoint of the company (dastgir and bazazzadeh 2003). the high level of disclosure will make reliability of investors in companies increase and hence efficiency in capital market. the objective of this study was focused on the relationship between disclosure quality and some firm's financial characteristics in tehran stock exchange. our paper aims to examine the relationship disclosure quality and firm characteristics for a sample of 80 firms listed in the iran financial market during 2006-2009. we use a linear regression analysis to examine the association between the disclosure quality and current ratio, acid ratio, firm size and p/b ratio. the results of study show that the disclosure quality is having positive and significant relation with current, acid and p/b ratios. also, we find that there is a significant and negative association between disclosure quality and firm size. references ahmed, k., & d. nicholls. 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(1994). the relationship between the comprehensiveness of corporate annual reports and firm characteristics in spain. accounting and business research, 25(97), http://dx.doi.org/10.1080/00014788.1994.9729927 acknowledgment the research is financed by islamic azad university, dezfoul branch. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 299 appendices table1. descriptive statistics of variables variables n minimum maximum mean std. deviation variance statistic statistic statistic statistic std. error statistic statistic disclosure 240 2.00 100.00 54.3220 1.49544 22.97339 527.777 current 240 .24 3.79 1.2488 .03528 .54656 .299 acid 240 .04 3.79 .7253 .02997 .46435 .216 size 240 4.29 7.83 5.7829 .03740 .57943 .336 p/b 240 .00 3.14 .6218 .03447 .53402 .285 table 2. correlations matrix disclosure current acid size p/b disclosure pearson correlation 1 .145* .131* -.138* .212** sig. (2-tailed) .026 .044 .035 .001 n 236 236 236 236 236 current pearson correlation .145* 1 .861** -.251** .107 sig. (2-tailed) .026 .000 .000 .098 n 236 240 240 240 240 acid pearson correlation .131* .861** 1 -.150* .047 sig. (2-tailed) .044 .000 .020 .471 n 236 240 240 240 240 size pearson correlation -.138* -.251** -.150* 1 -.122 sig. (2-tailed) .035 .000 .020 .059 n 236 240 240 240 240 p/b pearson correlation .212** .107 .047 -.122 1 sig. (2-tailed) .001 .098 .471 .059 n 236 240 240 240 240 table 3. model summary model r r square adjusted r square std. error of the estimate 1 .262a .069 .052 22.36227 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 300 table 4. anova (analysis of variance) model sum of squares df mean square f sig. regression 8511.116 4 2127.779 4.255 .002a residual 115516.410 231 500.071 1 total 124027.525 235 a. predictors: (constant), pb, acid, size, current b. dependent variable: disclosure table 5. coefficientsa model unstandardized coefficients standardized coefficients b std. error beta t sig. (constant) 66.536 16.779 3.966 .000 current 1.271 5.395 .030 .235 .814 acid 3.915 6.205 .079 .631 .529 size -3.759 2.621 -.095 -1.434 .153 1 p/b 8.398 2.812 .192 2.986 .003 a. dependent variable: disclosure table 6. coefficientsa model unstandardized coefficients standardized coefficients b std. error beta t sig. (constant) 48.709 2.240 21.745 .000 1 p/b 9.244 2.791 .212 3.312 .001 a. dependent variable: disclosure table 7. excluded variablesb model beta in t sig. partial correlation collinearity statistics tolerance current .122a 1.910 .057 .124 .986 acid .119a 1.874 .062 .122 .997 1 size -.114a -1.785 .075 -.116 .986 b. p/b microsoft word 1694-6687-1-rv-writer2-new-final asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 313 the role of macroeconomic factors in explaining the cost of capital: evidence from a group of emerging economies nicholas apergis (corresponding author) department of banking & financial management university of piraeus, 80 karaoli & dimitriou, 18534 piraeus, greece e-mail: napergis@unipi.gr sofia eleftheriou department of business administration university of piraeus, 80 karaoli & dimitriou, 18534 piraeus, greece e-mail: sofelef@webmail.unipi.gr received: april 23, 2012 accepted: may 9, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1694 url: http://dx.doi.org/10.5296/ajfa.v4i1.1694 abstract this study analyzes the dynamic relationship between the cost of capital and macroeconomic factors for a group of emerging markets spanning the period 1996-2009 and using the gmm estimator methodology, suggested in arellano and bond (1991). the empirical findings indicate that these macroeconomic factors play a significant role in explaining the cost of capital in the emerging markets. keywords: cost of capital, macroeconomic factors, emerging countries, panel data, gmm methodology asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 314 1. introduction and literature 1.1 general issues the cost of equity capital is considered as a crucial factor in assessing investment opportunities across international capital markets. the general approach is to use the capital asset pricing model (capm) to assess the cost of the equity capital. this general employment is based on the fact that once the future payoffs from capital market investments are risky, then the return employed to assess the net present value of such investments should be generated by a comparable risky alternative investment opportunity, such as investments in the stock market. in other words, the capm predicts that the expected return can be employed as a discount rate in assessing the net present value of a capital market investment. in a globalized world characterized by increased capital mobility, valuation is highly important in emerging markets, especially for privatization, joint ventures, mergers and acquisitions and restructuring. however, the valuation issue turns to be more difficult in emerging markets due to higher risks, such as macroeconomic volatility, capital controls, political and regulatory changes, enforced contract and investor rights and corruption. macroeconomic volatility, which is the main theme of our study, seems to be extremely important for emerging markets, where the financial collapse and subsequent recession have generated increased nonperforming bank loans. at the same time, there is no general consensus among academics and practitioners as to the best approach to use in estimating the cost of capital with regard to firms operating in emerging markets. these markets are considered to be less integrated on a regional and/or world level, and the approach adopted to evaluate the cost of capital may affect local market volatility. (graham and harvey, 2001) argue that the cost of capital in emerging markets also receives a downward adjustment due to diversification effects. a potential reason for this is that the higher, vis-à-vis the developed markets, systematic risk for these economies should be added and reflected in the cost of capital. finally, the risks associated with emerging markets are by majority considered as extra premia added to the discount factor (the cost of capital) used to calculate the present value of future cash flows, a procedure used extensively by firms to evaluate the potential profitability of future investment projects. however, certain studies document the invalidation of a simple association between risk and return, as the capm predicts (lakonishok and shapiro, 1986). moreover, fama and french (1993) denote that more factors than firm’s fundamentals and market risk could be responsible for determining a firm’s financial aggregates, such as stock returns. swanson et al. (2001) indicate that firm’s fundamental signals provide value relevant information about the effects of certain macroeconomic variables on the market’s expectation about changes in future cash flows and stock prices. al-qenae et al. (2002) investigate the effect of earnings and certain macroeconomic variables on stock prices for the kuwait stock market. their findings show that there exists a significant relationship between stock prices and earnings as well as macroeconomic variables, such as inflation and interest rates. by contrast, johnson et al. (2000) do not find any relation between stock prices in 25 emerging economies and the extent of certain macroeconomic variables. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 315 the absence of a simple association as it is predicted by the capm turns stronger for the case of emerging markets, which are less efficient and less liquid vis-à-vis the developed markets. harvey (1995) shows that such markets are characterized by low betas, which make the evidence predicted by the capm less valid while the simple capm model should incorporate country risk ratings as an additional explanatory variable in determining expected returns. within a different strand of the investigation bekaert and harvey (2000) and sokalska (2001) argue that it is the local macroeconomic environment that seems to be more important in determining stock price movements. 1.2 macroeconomic conditions and capital markets the arbitrage pricing theory (apt), as it was introduced by ross (1976), initiated the use of variables that are associated with the macroeconomic environment of the firm. chen et al. (1986) express the equity returns as a function of macroeconomic variables within their ‘macroeconomic factor model’. they conclude that stock returns are affected by certain macroeconomic variables mainly through the variables of the discount rate and expected dividends. the majority of relevant studies investigate the association between financial aggregates and macroeconomic variables for the u.s. (clare and thomas, 1994; gjerde and saettem, 1999; flannery and protopapadakis, 2002). other studies pursue a similar investigation for the economies of east asia (bailey and chang, 1996; ibrahim and aziz, 2003), while a third group of studies investigate the issue for groups of countries. within this part of the literature, bilson et al. (2001) suggest that consumer prices and real economic activity are not capable of explaining stock returns in a group of emerging economies, while exchange rates and money supply can do the job. moreover, wongbangpo and sharma (2002) investigate the relevance of the macroeconomic environment in explaining stock returns for five asean economies, while rapach (2002) argues that inflation does not seem to be a significant variable in explaining stock price movements. their results display that stock prices are positively related to output growth, which seems to be the sole macroeconomic variables that seems to be important. tsoukalas (2003) finds a strong relationship between stock prices and the macroeconomic environment of firms listed on the cypriot stock market. chaudhuri and smiles (2004) provide empirical support about a strong long-run relationship between stock prices and real macroeconomic activity, as it is described by real income, real private consumption and real oil prices for the australian stock market while hammoudeh and aleisa (2004) show that the primary determinants of stock prices are inflation and variables associated with public finance. in general, the findings of the majority of the above studies have generated mixed results, depending not only on the set of macroeconomic variables used, but also on the methodological approach followed. the primary goal of this study is to explore the role of macroeconomic factors in explaining the cost of equity capital for a group of emerging countries. such economies usually attract the international investor’s interest, while they are usually characterized by capital markets that offer very high returns, associated, however, with very high volatility of returns. the novelty of the study is that it uses a sample of countries never examined before in the relevant literature while it makes use of the gmm estimator methodology, suggested in arellano and bond (1991). the results of our study are expected to contribute to enrich the present asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 316 literature and add significant value to investors, market practitioners as well as regulators. in particular, portfolio managers and investors are expected to find results useful for determining the future behavior and performance of the firms’ cost of capital, for identifying investment approaches, pursuing available investment opportunities, and reducing the likelihood of high value losses in the market. in addition, market regulators are expected to find the results useful in avoiding any unexpected catastrophes, controlling market strategies and assessing the degree to which the stock market may need to be reformed. 2. data and methodological approaches 2.1 data the study makes use of quarterly data for a group of countries spanning the period 1990-2009. the data set includes stock market prices, proxied by the country’s capital market index, while a number of manufacturing firms were used from each country along with their stock prices. data was obtained from bloomberg. the appendix provides information about the countries used along with the number of firms from each country from which those stock prices were obtained. the data set also consists of macroeconomic factors. the macroeconomic variables set includes certain important macroeconomic factors, such as the production capacity of the economy as it is proxied by gdp (y)-since the variable affects the value of firm’s cash flows, the consumer price index (p)-since the variable directly affects the nominal value of cash flows, the liquidity in the economy as it is proxied by the m1 (m) definition of money supply, the effective exchange rate (e), the short-term interest rate (r), the trade deficit (tr), as it is defined by the difference between exports and imports as a percentage of the country’s gdp and the government deficit (def), as a percentage of the country’s gdp. data on macroeconomic fundamentals was obtained from the imf’s international financial statistics (ifs) database. only non-financial firms listed on stock exchanges are involved. the reason is that financial firms have, on average, higher leverage (fama and french, 1995). 2.2 methodological approach the focus of the empirical analysis is the impact of certain macroeconomic variables on excess stock returns. our benchmark model planned to be tested in this study is an extension of the standard capm mode, expressed as: rit – rtf = b0 + b1 (rt m – rt f) + b2 δr1t + b3 δr2t + .... + bk δrkt + uit where ni ,...,1 for each firm in the ith country in the panel, tt ,...,1 refers to the time period, rit is the variable of stock returns for the stock i, rt f is the risk-free rater, rt m is the local index return, while the rkt denote factors, such as the macroeconomic variables. finally, δ denotes first differences and u’s are random variables, i.e. white noises with n(0, σ2). the parameter b1 is expected to be positive. the model has been estimated using the gmm estimator, suggested by arellano and bond (1991), while only statistically significant lags are used in the estimation. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 317 3. empirical results 3.1 panel unit root tests at the outset, the statistical properties of all the variables under investigation are examined by testing for the presence of unit roots. there are a variety of panel unit root tests, which include maddala and wu (1999), hadri (2000), levin et al. (llc, 2002), im et al. (ips, 2003), and carrion-i-silvestre et al. (2005), among others. consider the following autoregressive specification: ititiitiit xyy   1 (1) where ni ,...,1 for each firm in the panel; tt ,...,1 refers to the time period; itx represents the exogenous variables in the model, including fixed effects or individual time trend; i are the autoregressive coefficients; and it are the stationary error terms. if 1i , ity is considered weakly trend stationary, whereas if 1i , then ity contains a unit root. the hadri (2000) and levin et al. (2002) panel unit root tests assume that the error terms, it , are independently and normally distributed random variables for all si' and st' with mean zero and constant variance. this assumption implies that the coefficient of 1ity is homogeneous across all cross-section units of the panel and individual processes are cross-sectionally independent. in the case of dynamic panel data models, the recognition of parameter heterogeneity is important to avoid potential biases, which could emerge due to an improper specification. in light of parameter heterogeneity, the ips panel unit root test is utilized which allows for heterogeneous autoregressive coefficients. such heterogeneity could occur due to the different economic conditions and stages of economic development in each country. im et al. (2003) suggest averaging the augmented dickey-fuller (adf) unit root tests, while allowing for different orders of serial correlation, itjit p j ijit ui    1 . substitution of this expression into (1) yields: ititijit p j ijitiit xyy i     11 (2) where ip represents the number of lags in the adf regression. the null hypothesis is that each series in the panel contains a unit root ( )1:0 iih  . the alternative hypothesis is asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 318 that at least one of the individual series in the panel is stationary ( )1:0 ih  . im et al. (2003) specify a bart  statistic as the average of the individual adf statistics as follows:    n i i t n bart 1 1  where i t  is the individual t-statistic for testing iih  1:0  from (2). the bart  statistic is normally distributed under the null hypothesis, with the critical values for given values of n and t provided by im et al. (2003). the llc test allows heterogeneity of individual deterministic effects and heterogeneous serial correlation structure of the error terms assuming homogeneous first order autoregressive parameters. they also assume that both n and t tend to infinity but t increases at a faster rate, such that n/t→0. thus, a procedure is developed that uses t-statistics of the estimator to evaluate the hypothesis that each individual time series contains a unit root against the alternative hypothesis that each time series is stationary. the test also makes use of the adf regression methodology, with the adf regression defined as: pi δyit = αi + γi yi,t-1 + σbijδyi,t-j + εit (3) j=1 moreover, the test implements a separate adf regression for each country where the lag order is permitted to vary across individual countries. the appropriate lag order is chosen by allowing the maximum lag order and then uses the t-statistic for the coefficients of the lag terms to determine if a smaller lag order is preferred. next, it runs two separate regressions, such as: pi δyit = ai + σbijδyi,t-j + eit (4) j=1 and pi yi,t-1 = ai + σbijδyi,t-j + vi,t-j (5) j=1 and we save the residuals (eit and vi,t-j). we divide the saved residuals by the regression standard error of the regression for normalization purposes and, next, we run the regression: eit = ρ vi,t-j + εit (6) with the null hypothesis being h0: ρ1 = ... = ρn = ρ = 0 and the alternative hypothesis h1: γ1 = .. = γn = γ < 0 for all i. llc show that the asymptotic properties of the regression estimators are a mixture of properties derived for stationary panel data and properties derived in unit roots testing. this test seems to have certain limitations, such as that it depends seriously asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 319 upon the independence assumption across individual regressions and hence not applicable if cross sectional correlation is present. in addition, a limitation is associated with the fact that the autoregressive parameters are considered identical across the panel regressions (see the above null hypothesis). however, this null hypothesis makes sense under some cases. as maddala and wu (1999) point out, the alternative hypothesis is too strong to be valid in any empirical case. maddala and wu (1999) offer a strategy that seems to overcome the limitations of both llc and im et al. tests. they suggest a non-parametric fisher-type test, which is based on a combination of the p-values of the t-statistics for a unit root in each cross-sectional unit (the adf test). the testing approach has the advantage of allowing for as much heterogeneity across units as possible. under the hypothesis that the test statistics are continuous, the significance of p-values is independent in a uniform manner, e.g. they uniform (0,1) variables and -2logp has a chi-squared distribution with two degrees of freedom. using the additive property of the chi-squared variables, the statistic: n λ = 2 σ log(pi) is constructed, which has a chi-squared distribution with 2n degrees i=1 of freedom. the advantage of this test is that it does not require an infinite number of groups to be valid, so we do not have to assume that all groups must have the same type of non-stochastic components. in addition, t is not necessarily assumed to be the same for all the cross-section units, its critical values are not sensitive to the choice of lag lengths in the adf regressions, and finally, it does not have to assume that none of the groups have a unit root under the alternative hypothesis. the hadri (2000) lagrange multiplier (lm) test is closely related to that of the carrion-i-silvestre et al. (2005) test. it has the advantage of combining both stationary and non-stationary variables and permits a formulation for a residual-based lm test of stationarity. hadri adopts the following representation: yit = zit’γ + rit + εit (7) where zit is the deterministic component, rit is a random walk process defined as rit = ri,t-1 + uit, with uit→iid(0, σu 2) and εit is a stationary process. the null hypothesis of trend stationarity corresponds to the hypothesis that the variance of the random walk is zero. the yit process from above can be written as yit = zit’ γ + eit, where: t eit = σuij + εit (8) j=1 the residuals from the above regression (eit) are obtained. this time the statistic can be written as: n t lm = 1/n σ (σsit 2/t2/σε 2) (9) i=1 t=1 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 320 where σε 2 is the consistent newey and west (1987) estimate of the long-run variance of residuals, while sit is defined as above. the lm statistic is consistent and has an asymptotic normal distribution as both t and n→. the main advantage of this test is that the moments of the asymptotic distribution are exactly derived, while the disturbance terms can be heteroskedastic across i. finally, it is also possible to allow for serial dependence substituting the assumption that the errors εit are i.i.d. normally distributed over t with the assumption that they satisfy the strong mixing regularity conditions of phillips and perron (1988). in this case we replace σε 2 by the long-run variance, defined as: n σ2 = 1/n σ limt-1 (sit 2) (10) i=1 t→ a consistent estimator of the above variance is obtained using again the estimators provided by newey and west (1994). the results in table 1 point out that the hypothesis that all the macroeconomic variables under study contain a unit root, is accepted at the 1% significant level in all tests, suggesting that these variables are i(1). by contrast, excess returns for individual stocks as well as for market indexes are shown to be i(0) variables. table 1. panel unit root tests ips panel unit root tests variables without trend with trend y -2.11(3) -2.28(3) δy -5.30(1)* -5.66(2)* m -1.09(2) -1.36(2) δm -4.93(2)* -5.18(2)* fdef -1.71(2) -1.94(2) δfdef -4.83(1)* -4.97(1)* p -1.83(3) -1.94(3) δp -5.48(1)* -5.82(1)* def -2.13(2) -2.34(2) δdef -5.21(1)* -5.74(1)* ri-r f -7.71(2)* -7.84(2)* rt m – rt f -6.58(2)* -6.82(1)* llc panel unit root tests variables with trend y -2.03 δy -5.28* m -1.14 δm -4.84* fdef -1.55 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 321 δfdef -4.94* p -1.62 δp -5.27* def -2.19 δdef -5.38* ri-r f -6.42* rt m – rt f -6.94* handri (hom) panel unit root tests variables with trend y 22.03* δy 1.09 m 15.24* δm 1.14 fdef 16.55* δfdef 1.44 p 17.62* δp 1.18 def 22.19* δdef 1.34 ri-r f 1.37 rt m – rt f 1.23 handri (het) panel unit root tests variables with trend y 20.32* δy 1.14 m 13.22* δm 1.07 fdef 12.73* δfdef 1.39 p 14.02* δp 1.25 def 18.14* δdef 1.27 ri-r f 1.41 rt m – rt f 1.37 fisher-adf variables y 20.45 δy 104.46* asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 322 m 17.83 δm 98.77* fdef 18.51 δfdef 92.34* p 17.63 δp 112.52* def 19.75 δdef 108.75* ri-r f 112.57* rt m – rt f 108.47* fisher-pp variables y 24.58 δy 117.17* m 19.72 δm 99.93* fdef 21.56 δfdef 97.88* p 19.59 δp 119.69* def 24.17 δdef 129.82* ri-r f 116.55* rt m – rt f 113.07* numbers in parentheses are the augmented lags included in the unit root test, while δ denotes first differences. * denotes statistical significance at 1% 3.2 dynamic heterogeneity an issue that it is of major concern is the heterogeneity of the firms included in this data set. in particular, through time and across countries, the effect of accounting information on stock returns was investigated. in the statistical framework of this study we first test for heterogeneity and then by controlling for it through appropriate techniques (holtz-eakin, 1986; holtz et al., 1985). the dynamic heterogeneity, i.e. variation of the intercept over countries and time, across a cross-section of the relevant variables can be investigated as follows: in the first step, an adf(n) equation for each relationship in the panel is estimated; then, the hypothesis of whether regression parameters are equal across these equations is tested. next, a similar test of parameter equality is performed by estimating a n-order autoregressive model for each of the relationships under investigation. standard chow-type f tests under the null of parameter equality across all relationships are also performed. heterogeneity in cross-sectional parameters is indicated if the results reject the null hypothesis. finally, homogeneity error asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 323 variance across groups is also examined as another measure of dynamic heterogeneity. white's tests for group-wise heteroscedasticity are employed to serve this objective. the results of this procedure are reported in table 2. the empirical findings indicate that the relationship under consideration is characterized by heterogeneity of dynamics and error variance across groups, supporting the employment of panel analysis. table 2. tests of dynamic heterogeneity across groups specification adf(3) ar(3) white’s test 28.16* 38.92* 68.37* adf(3) reports the parameter equality test (f-test) across all relationships in the panel. ar(3) displays the f-test of parameter equality conducted in a third-order autoregressive model of the relationships. white’s test reports the white’s test of equality of variances across the investigated relationships in the panel. δ denotes first differences. * denotes statistical significance at 1%. 3.3 gmm results the results concerning the gmm estimations are summarized in table 3. the gmm estimator, suggested by arellano and bond (1991), ensures both efficiency and consistency since all slope coefficients are estimated simultaneously. the sargan test ensures the validity of instruments used. in our model the coefficients are shown to have the expected theoretical signs and they are statistically significant at the 1 percent significance level. the empirical findings seem to lead us to the following observations: ► the empirical evidence with respect to the impact of inflation on stock prices is inconclusive. in particular, chen et al. (1986), flannery and protopapadakis (2002) and wongbangpo and sharma (2002) argue that inflation is negatively associated with stock returns. in the same framework, maysami and koh (2000) argue that higher inflation usually leads to upcoming tighter economic policies that are expected to have a negative impact on financial aggregates. by contrast, according to clare and thomas (1994) and ibrahim and aziz (2003), this association turns out to be positive, which is probably explained by the inadequacy of the hedging role of stocks against inflation. our results indicate that inflation is a factor that has a positive impact on excess stock returns in our emerging economies sample. ► evidence in the literature displays that there is a positive association between output and stock returns (park, 1997). this association is mainly due to the reaction of stock market participants to macroeconomic variables tight to higher (lower) output, such as high (low) employment, which in turn, are positively related to earnings and future business conditions. hassapis and kalyvitis (2002) also show that there exists a positive association between stock returns and future growth, which is probably due to the link between anticipated economic growth and the current price of capital. our empirical findings confirm the above arguments by reporting a positive association between income and excess stock returns. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 324 ► mukherjee and naka (1995) and cheung and ng (1998) report a positive association between money supply and stock prices, on the grounds that money supply changes have a positive impact on real economic activities variables. gan et al. (2006) also display that opportunity costs of holding cash rise with higher interest rates and the trade-off and the trade-off to holding other interest-bearing assets would lead to lower share prices. our empirical findings are consistent with these arguments by reaching a positive relationship between excess stock returns and money supply. ► in terms now of budget deficits, the relationship between stock prices and such deficits is important, because large deficits tend to undermine investor’s confidence through the inability of firms to raise capital on favorable terms. at the same time, large budget deficits affect stock prices through their impact on inflation as well as through expected future taxes and rising interest rates. bulmash and trivoli (1991) find a positive association between those deficits and stock returns. adrangi and allender (1998) provide evidence that a negative association between stock returns and budget deficits in many countries is documented. the empirical results of this study reveal a positive association between government deficits and excess stock returns, implying that in emerging economies these deficits act as a boost-up mechanism for the economy, thus, leading to higher stock returns. ► the current literature on the link between stock prices and the trade account deficit is small. very few authors discuss the association between stock price shocks and global imbalances, such as fratzscher et al. (2007), barnett and straub (2008) and fretzscher and straub (2009). the literature generates mixed results across countries. in our case, the association turns out to be positive, probably indicating that the presence of a trade deficit is expected to depreciate the domestic currency, thus, leading to higher exports and higher growth. ► the relationship between stock returns and interest rates is negative, a piece of evidence supported by chen (1991), gjerde and saettem (1999) and maysami and koh (2000). this negative association implies that interest rates represent not only the opportunity cost of investments in the stock exchange market, but also the higher borrowing cost from the banking sector, considering that our economies under study belong in a bank-based borrowing system. ► the constant terms turns out to be statistically insignificant, implying that by introducing the macroeconomic factors in the capm model keeps pricing errors very low. ► finally, the local indices are shown to be statistically insignificant, indicating that this factor as well is capable of explaining some of the volatility of stock returns. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 325 table 3. gmm results dependent variable coefficient t-statistic b0 0.047 1.12 b1 0.026 4.59* b2 0.326 4.71* b3 0.178 4.82* b4 0.306 5.94* b5 0.247 8.05* b6 0.426 5.24* b7 -0.142 5.48* r-squared 0.71 sargan test 0.917 * denotes statistical significance at 1%. 4. conclusions and implications our study investigated the relationship between excess stock returns and the macroeconomic environment for a sample of emerging economies. the empirical results recommend that potential investors should pay attention to information emerging from the macroeconomic environment. our empirical findings have important implications for the association between the macroeconomic environment, the cost of capital and the capital budgeting process. in particular, the macroeconomic environment seems to be a crucial factor for capital budgeting. in calculating discount rates (the cost of capital) firms tend to incorporate the risks associated with macroeconomics to this discounting factor, an approach that will affect investment project strategic evaluation decisions. this also indicates that practitioners might not even apply the capm rule to evaluate their investments and to estimate their equity cost, implying that financial theory may have to reconsider and reevaluate the assumptions and implications of mainstream theories in capital budgeting and, thus, have to turn to alternative evaluation methods, such as the payback method. in addition, the monetary authorities should also benefit from the empirical findings of this study, especially those that implement an inflation-targeting based monetary policy, considering the close tights of the stock market with the macroeconomic environment. a future research agenda could use an expanded set of macroeconomic variables, which might provide alternative information contents about their impact on stock returns. acknowledgement the authors wish to thank two referees from the journal whose comments improved the quality of the paper. needless to say, the usual disclaimer applies. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 326 references adrangi, b., & allender, m. 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(2001). the contribution of fundamental analysis in the presence of inflation and a currency devaluation. working paper, texas a & m university. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=260596 tsoukalas, d. (2003). macroeconomic factors and stock prices in the emerging cypriot equity market. managerial finance, 29, 87-92. http://dx.doi.org/10.1108/03074350310768300 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 329 wongbangpo, p., & sharma, s. c. (2002). stock market and macroeconomic fundamental dynamic interactions: asean-5 countries. journal of asian economics, 13, 27-51. http://dx.doi.org/10.1016/s1049-0078(01)00111-7 appendix countries number of firms argentina 175 brazil 284 chile 128 czech 235 egypt 42 india 570 indonesia 355 israel 140 malaysia 367 mexico 322 pakistan 60 peru 55 philippines 110 thailand 158 south africa 140 venezuela 85 business ethics and accounting students: australia, south asia and east asia asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 146 business ethics and accounting students: australia, south asia and east asia soheila mirskehary deakin business school, faculty of business & law, deakin university, australia tel: 6139244 5537 e-mail: soheilam@deakin.edu.au ali yaftian (corresponding author) school of accounting, victoria university po box 14428, melbourne, victoria 8001, australia tel: 613 9919 5305 e-mail ali.yaftian@vu.edu.au guneratne wickremasinghe school of accounting, victoria university po box 14428, melbourne, victoria 8001, australia tel: 613 9919 1477. e-mail guneratne.wickremasinghe@vu.edu.au abstract recent corporate collapses around the world show that there are no national boundaries for these occurrences. australian corporate collapses including hih insurance, one.tel, ansett australia and harris scarfe have raised public expectations of investigation of the causes of collapses (mirshekary et al., 2005). the main reason for the collapse of hih was mismanagement with an emphasis more on the directors’ personal qualities such as integrity, honesty and morality rather than tougher legislation and rules. accounting students are our future business leaders. the teaching of ethics in the classroom to multicultural groups of students provides an opportunity to facilitate the sharing of knowledge and to increase interaction and debate around different approaches to ethics among students from different countries. this study uses previous literature to explain the attitudes of accounting students towards academic and business/accounting ethics at an australian university which is a multi-campus institution undertaking programs and activities at regional, national, international levels and by distance education. mailto:soheilam@deakin.edu.au mailto:ali.yaftian@vu.edu.au mailto:guneratne.wickremasinghe@vu.edu.au asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 147 the study reports the results of cross-cultural investigations of students’ ethical perceptions on moral values, academic and accounting/business vignettes, given that all students share the same learning opportunities, knowledge of ethics and interaction with their peers and lecturers. the results indicate no significant differences in responses between the students from australia, south asia and east asia. keywords: business ethics, accounting students, distance education, manova jel classifications: m41, m49, m40 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 148 1. introduction recent collapses such as enron, hih and other international businesses have resulted in a tightening of legislation, as well as reforms to corporate governance. justice owen (2003) believed that the effect of corporate governance reform should be based more on personal integrity, honesty and truthfulness rather than tougher legislation and corporate governance rules. educational institutions have a vital role to play in shaping the new reforms and creating a more ethical business environment. multiple innovations and global communications throughout the world will have an effect on business ethics. multinational corporations are more likely to be at risk due to ethical issues that result from cultural diversity of local staff in host countries. salter et al. (2001) discussed this issue and recommended two solutions to overcome the cultural constraints that global audit firms are facing as they are dependent on the judgment, norms and standards of their staff in each country. one is to accept the local standards of the staff. while such a solution may have been acceptable in the past it is unlikely to be acceptable now. a high and consistent standard of auditing is incompatible with audit and ethical standards that fluctuate nationally. the second solution is to train auditors to achieve common standards of ethical behaviour. while training is an alternative solution, it has a root in culture. salter et al. (2001) provide evidence on cultural motivations in ethical training and examine how training can affect ethical attitudes of college students as future professionals and managers. they have examined the attitudes of accounting students in the uk and in the us that are similar in terms of training. however, these two countries have distinct cultures. this study examines attitudes towards a variety of cheating scenarios in academic and business environments. the sample consisted of students who study in the same classroom but come from different cultural backgrounds. this research will make a significant contribution to evaluating cultural differences with respect to ethical dispositions. specifically this research addresses the degree of differences in the ethical orientations of a potential pool of future accountants/auditors in australia, south asia and east asia. the results of this study will also enhance current knowledge on whether business ethics is humanity-based or culture-based. the findings will assist in developing both a national and an international code of ethics and impose the same ethical practices to take into account the differences in ethical orientations and cultural norms. 2. literature review in the 1970s, insider trading scandals tarnished the reputations of some financial institutions and since that time business ethics has become a prime academic growth industry. introducing courses in business ethics or integrating ethics into the existing courses has been recommended by some researchers (lewin (1983); salmans (1987); vogel (1987); felicetti and stewart (1998)). lewin (1983) believes that courses in ethics would bring some positive changes to the business world. according to him some alumni who had taken ethics courses had seen it as a helpful experience. vogel (1987) emphasised the teaching of ethics at asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 149 business schools. he believes schools can teach the nation’s future business leaders how to manage their companies, divisions or units, how to behave ethically, how to be honest in dealing with customers and how to minimise the violations of company policies or the law. salmans (1987) stated “many academics believe that ethics should be integrated into every course from accounting to organizational behaviour, to underscore its importance” (p. 64). felicetti and stewart (1998) assessed the attitudes of australian business students toward the teaching of business ethics. they found business majors who had taken a business ethics course placed greater importance on the teaching of a business ethics course and found the experience to be more valuable than those who had not taken such a course. contrary to the above findings that teaching ethics is important, peppas and diskin (2001) examined the attitudes of current students enrolled at a large university in the southern usa towards professional and business ethics. they found that taking a course in ethics did not significantly affect students’ attitudes towards professional morality. becker and fritzsche (1987) conducted an initial cross-cultural study on the ethical attitudes of marketing managers in france, germany and the us. their questionnaire consisted of seven statements on the code of ethics and eight statements on business practices. they found that french managers are more optimistic than those of the other two countries about the effect that ethical codes may have on business activities. in contrast, german managers appeared to be more pessimistic concerning the efficacy of the ethical code. on the basis of the business practice statements, the french managers were categorized as idealistic, the germans as pessimistic and the us managers as realistic. research has indicated that changes in students’ ethical decision making may be due in part, to ethics education. there are many cross cultural studies which compared the ethical disposition of business students. these studies found significant differences between the attitudes of students of different countries (tsalikis and nwachukwu (1991); waugh et al. (1995); whipple and swords (1992); nyaw and ng (1994); tsalikis and latour (1995); kennedy and lawton (1996); haswell et al. (1999); o’leary and cotter (2000)). tsalikis and nwachukwu (1991) compared the ethical perceptions of american and nigerian students in the three scenarios of relativism, egoism and justice. they found that ethical reactions to bribery and extortion differ among american and nigerian students. nyaw and ng (1994) examined students’ reaction to ethical dilemmas as employees, supervisors, customers, suppliers and business competitors from canada, japan, hong kong and taiwan. their results indicated that with the exception of health and safety issues, the responses to the ethical constructs vary by the country of origin of the respondents. like tsalikis and nwachukwu who compared american and nigerian views on bribery and extortion, tsalikis and latour (1995) investigated the differences in the perceptions of bribery and extortion of american and greek students. the results showed that the reactions to bribery and extortion vary according to the nationality of the person. kennedy and lawton (1996) examined ethical outlooks of ukrainian and american students. they used ethical values such as alienation and asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 150 religiousness to compare the ethical behaviours of students from two countries. they found dramatic differences between the two countries. these differences may be due to the differences among national cultures, ideologies, or economic conditions. haswell et al. (1999) studied ethical values in areas such as cheating among students in australia, south africa and the uk by administering a survey of professed ethical behaviour. they found differences in the ethical propensities of students across the three countries. o’leary and cotter (2000) studied the ethical attitudes of final year accountancy students in ireland and australia. they found major differences between the attitudes of students of the two countries and indicated that there may be several reasons for these differences such as cultural, economic and social and ethics education. apart from the different degrees of emphasis on education in the two countries, the authors believed that the reason for the differences could be the type of training received by students in the two countries. contrary to the findings of the above surveys, few cross cultural studies on the ethical values of business students found a similarity in the students’ ethical attitudes across countries (preble and reichel (1988); kowalski and kowalski (1990) lysonski and gaidis (1991) small (1992); okleshen and hoyt (1996)). the ethical attitudes and self-reported computer abuse of canadian and swedish students were investigated by kowalski and kowalski (1990). they found no strong correlations between ethical attitudes, computer abuse behaviour and country, level of education, sex, work experience, computer ownership and media exposure. lysonski and gaidis (1991) examined the reaction of business students in the usa, denmark, and new zealand to a set of ethical scenarios such as coercion and control, conflict of interest, physical environment, paternalism and personal integrity. they found that students’ reactions tended to be similar regardless of their country of origin. small (1992) investigated ethical behaviours of western australian business students and compared the results with the results from the united states and israeli business students from an earlier study (preble and reichel ,1988). he found a similarity in ethical attitudes of western australian, american and israeli students. okleshen and hoyt (1996) had slightly different views toward using ethical dilemmas. they investigated american and new zealander (nz) students’ reaction to existing ethical attitudes among students from the two countries. they found that experience in an ethics course produced homogeneity and no significant difference in ethical values. their ethical perspectives of multilayered ethical constructs were fraud, coercion, power, influence dealing, self interest, and deceit. the results revealed that american students had less tolerance than nz students in situations involving the ethical constructs of fraud, coercion and self-interest and there were significant differences in the decision methods utilized by the us and nz students. while a review of the literature on cross cultural studies showed significant differences in the ethical attitudes of students across countries, it is evident that the results of different studies have been contradictory. many cross cultural empirical studies suggest that cultural factors have an effect on the ethical attitudes and have resulted in cross-cultural differences amongst students/managers. the existence of cross-cultural differences amongst students is related to asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 151 such cultural factors as understanding and interpreting ethical behaviours. teaching ethics in classes with multicultural groups of students provides an opportunity to facilitate the sharing of knowledge and increase interaction and debate around different approaches to ethics amongst students. australia has been rated at 8.8 based on 2003 corruption perceptions index (cpi). cpi ranges from a high of 10 points for a country considered highly clean to a low of 0 for a country considered highly corrupt. given that international students study in australian universities and share the same learning opportunities, knowledge, understanding of ethics and interaction with their peers and teachers, this current study investigates cross-culturally whether the differences in ethical perceptions are attributed to a whole host of factors such as economic development and cultural values in the country of origin. 3. the teaching of ethics across nationalities several studies have been conducted to examine ethical attitudes of final year accountancy students at international level. the majority of cross cultural studies have conducted surveys among students from different countries comparing their results. there is insufficient evidence to identify whether students’ ethical behaviours are homogeneous among cultures, according to their nationality, gender and the level of education. a study by okleshen and hoyt (1996) found homogeneity in ethical orientation among students from the usa and new zealand that probably resulted in a cross cultural levelling of ethical values. their study was different from those of many others as they looked at the implication of having experience in an ethics course and found that experience in an ethics course produced homogeneity and no significant difference in ethical values. on the other hand, they focused on students from two highly industrialized countries. the majority of international students in australian universities and the population of the current study come from south asian and east asian countries or countries in less advanced stages of economic development and stability. shenker (1990) (cited in vanasco 1994, p. 21) noted that “maturing ethically is a lifelong process that can benefit from training during the college/professional years but that also must be nurtured through an individual’s career”. this is consistent with the discussion by donalson (1990) who provides an explanation of ethics (cited in vanasco (1994)) as the customs or standards which a particular group or community acts on. farmer and richman (1964) pointed out the causes of different codes of ethics are primarily economic development, educational levels and cultural values of societies (cited in vanasco 1994). many universities in australia have attempted to teach ethics as a separate unit or as part of a course within business programs. the objective of the current study is to look at how the same ethics education and training can impact upon ethical beliefs and whether significant differences exist in the ethical behaviours of students according to their cultural background. the majority of the research discussed earlier has documented that students from different countries differed significantly on their views of what was ethical. the reasons given for the differences in ethical beliefs were explained as pertaining to economics, ethics education and cultural values. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 152 the current study investigates the effects of ethics education between australian, south asian and east asian students. all students receive the same coverage of the joint code of professional conduct in their auditing course. in general, all international students studying in australian universities receive the same degree of emphasis and the same type of ethical training in their relevant courses. therefore, cross-national differences between these groups could be attributed to cultural, economic and social factors. we are not aware of any study that has examined the extent to which ethical beliefs vary across cultures completing the same course (or courses in which ethics is incorporated) or the same degree of ethics education. there are currently two surveys by painter-morland et al. (2003) and walker & jeurissrn (2003) that have looked at online teaching of students from different countries in one class. painter-morland et al. found that online teaching methods create an environment within which important ethical knowledge and skills might be developed. they found positive responses by participants in online learning. walker and jeurissen (2003) reported the findings on international mba students’ perceptions toward a hybrid business ethics course. they used a questionnaire and an interview and showed a high level of intercultural dialogue between participants about supporting idea sharing and the exchange of cultural perspectives outside the physical boundaries of the classroom. no attempt has been made to differentiate and report the results of cross-cultural investigations of students’ ethical perceptions, given that all students share the same learning opportunities, knowledge, understanding of ethics and interaction with their peers and lecturers. 4. methodology the primary purpose of this survey was to determine if business students at an australian university have significantly different attitudes toward business ethics than university business students from south asian and east asian countries. the university operates across multiple campuses which undertake programs and activities on regional, national and international campuses and also by distance education. it has a mix of australian and international students. the questionnaire was administered in week 7 (january 2005) by lecturers/tutors to internal students on six campuses and to all external (off-campus) students by the division of teaching and learning services. the total cohort was 422 undergraduate and postgraduate students undertaking an auditing course in that term. considering the voluntary nature of the questionnaire, the achieved response rate of 42 percent was deemed sufficient for the study (175 usable responses). it is not as high as the response rates of similar studies but it is a good rate of response in this situation as it also included posting the questionnaire to the distance students. the set of hypotheses to be tested by this survey include: 1. there is no significant difference in guiding principles in everyday life (personal values) between respondents from different geographic regions 2. there is no significant difference in ethical attitudes in academic and business situations between respondents from different geographic regions of interest was whether incorporating a unit on ethics in a course of an australian university has an effect on certain ethical values. basic demographic information regarding the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 153 academic degree, gender, age, work experience, visa status and country of residence was collected from the students. descriptive statistics were calculated for each item in the survey. nationality has been classified based on the major region classification. for the purpose of this research, nationalities were classified as australia, east asia, south asia and other countries. countries such as pakistan, sri lanka, india, bangladesh and nepal were classified as south asia. countries such as hong kong, the philippines, china, malaysia, cambodia, indonesia, south korea, japan, taiwan, thailand, singapore, vietnam and myanmar were classified as east asia. all other countries include south africa, mauritius, fiji, italy, colombia, poland, lebanon and the czech republic. differences among the attitudes of australian, south asian, east asian and students from other countries were evaluated using anova (analysis of variance) and manova (multivariate analysis of variance). 4.1 sample the sample for this study consisted of students enrolled in the bachelor of business (accounting) degree, a three-year undergraduate qualification and the master in accounting degree, a two-year postgraduate degree, designed to equip graduates from non-accounting disciplines with the necessary skills for employment in the accounting profession. students in both courses were taking auditing in the spring/summer term in 2004-05 as one of their core units. the students were familiar with accounting and business practices from their previous studies. 4.2 research design and findings the first part of the questionnaire consisted of questions on 12 values as guiding principles in everyday life. the second part included two sets of 15 statements each of which was adapted from smyth and davis (2004). the survey instrument contained two sections: 12 questions using a seven-point likert scale; and 30 vignettes of academic and business situations. comprehensive demographic information was also collected. the twelve questions in the first section explored the importance placed by the respondents on the guiding principles in their life. the seven-point likert-type scale ranged from 1 being not important to 7 being extremely important. the second section included two sets of 15 statements, one set asking ethical situations in the academic environment and the other set asking roughly equivalent situations in a business setting. each of the vignettes asked respondents to exercise their actions (not right or wrong answers) on a seven-point likert-type scale with 1 definitely would not (not dishonest at all) and 7 definitely would (very severe dishonesty). students were not told that the statements from each set would be eventually paired for our analysis. a total sample of 175 usable questionnaires was obtained. nineteen usable questionnaires were received from australian students, 34 from south asian students (from 5 countries in south asia), 104 from east asia (from 14 countries) and 18 from other countries. table 1 summarizes the frequencies for the demographic data. the majority of the sample from australia, east asia and other countries was females. the majority of south asian students were males. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 154 table 1. sample characteristics (%) characteristics australia south asia east asia all others respondents 19 34 104 18 gender female 78.9 20.6 67.3 61.1 male 21.1 79.4 26.9 33.3 no answer 5.8 5.6 age (yrs) 17-21 15.8 20.6 12.5 22.2 22-26 21.1 58.8 52.9 27.8 27-31 31.6 11.8 17.3 33.3 32-36 21.1 8.8 6.7 11.1 37 and over 10.5 0.0 2.9 0.0 no answer 7.7 5.6 work exp. (yrs) below 1 yr 15.8 29.4 44.2 38.9 2 to 5 yrs 10.5 44.1 28.8 33.3 6 to 10 yrs 26.3 11.8 7.7 11.1 11 to 15 yrs 26.3 2.9 5.8 11.1 16 to 20 yrs 5.3 0.0 1.0 0.0 over 20 yrs 5.3 0.0 1.0 0.0 no answer 10.5 11.8 11.5 5.6 program undergraduate 78.9 58.8 65.4 77.8 postgraduate 10.5 38.2 19.2 16.7 other 10.5 2.9 15.4 5.6 no answer campus on-campus 5.3 94.1 92.3 83.3 off-campus 89.4 5.9 7.7 16.7 no answer 5.3 visa australian permanent resident 15.8 11.8 1.9 5.6 australian citizen 84.2 0.0 1.0 11.1 student visa 0.0 85.3 87.5 55.6 working visa/other 0.0 2.9 9.6 27.8 no answer asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 155 figure 1 shows the sample distribution as discussed above. the majority of international students in this sample are from east asian countries. figure 1. distribution of sample by geographic regions twelve questions explored the principles in everyday life (see table 2). there were significant differences among students with regard to wealth, world peace, self-discipline, authority, social justice, honouring parents and elders and curiosity. australian students evaluated wealth 1 , world peace 2 , authority 3 , social justice 4 and honouring parents and elders 5 as less important than the other groups. it is of interest to note that australian students rated all other guiding principles except self-discipline, family security and curiosity much lower than students from the other geographic regions. east asian students gave the least importance to self-discipline 6 and curiosity 7 . south asian students ranked most guiding principles except family security, a varied life and curiosity, as more important in their everyday life than the other groups. 1 wealth consists of material possessions such as money 2 a world peace is a world free of war and conflict 3 authority is the right to lead or command 4 social justice is correcting injustice and care for the weak 5 honouring parents and elders is showing respect 6 self-discipline is self-restraint, resistance to temptation 7 curiosity is interest in everything all others 10.29% east asia 59.43% souh asia 19.43% australia 10.86% asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 156 table 2. results for guiding principles in everyday life means guiding principles in everyday life australia south asia east asia all others anova (f) q1 an exciting life 4.74 5.26 5.16 5.33 0.739 q2 wealth 4.47 5.59 5.37 5.17 3.810* q3 a world peace 5.43 6.58 6.18 6.13 3.077* q4 self-discipline 5.37 6.06 5.27 6.00 4.434* q5 family security 6.63 6.44 6.20 6.61 1.339 q6 a varied life 4.89 5.45 5.00 5.61 2.404 q7 authority 4.00 5.29 4.88 4.56 3.904* q8 social justice 5.11 6.06 5.48 5.56 2.858* q9 protecting the environment 5.42 6.06 5.54 5.44 2.110 q10 influential (having an impact on people and events) 4.47 5.24 4.78 4.83 1.416 q11 honouring parents and elders 5.47 6.56 5.74 6.44 5.958* asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 157 the second part of the questionnaire with 15 pairs of questions was designed to measure ethical attitudes in academic and equivalent business situations. all results are tabulated in table 3. according to the results, there was no significant difference in pairs of ethical values among australian students, south asian students, east asian students and students from other countries except the pair “missing a class in an academic environment and missing work in an equivalent business situation”. the wilks’ lambda test is significant at 90% for this pair. further post hoc tests of multiple comparisons showed that there was a significant difference at 95% “for missing work” between students from south asia and east asian regions. east asian students were found to be more unethical than south asian students. 12 curious 5.00 5.47 4.83 5.61 3.304* * significant at 0.05 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 158 table 3. results for academic and business activities activities means australia south asia east asia all others manova f/(p) q13 to show a paper longer 2.95 3.64 3.21 2.38 1.935 q28 taking longer time for lunch 2.26 2.21 2.75 2.00 (0.075) q14 telling a false reason for missing a class 2.79 2.48 3.23 2.39 1.975 q29 telling a false reason for missing work 3.26 2.03 2.96 2.28 (0.069) q15 doing less work in a group project at class 1.95 2.45 2.47 2.00 0.637 q30 doing less work in a group project at work 1.79 2.09 2.06 1.56 (0.701) q16 looking at another student's paper 1.32 1.71 1.82 1.76 0.836 q31 obtaining a competitor's list to steal customers 2.11 2.26 2.30 1.65 (0.543) q17 allowing another student to look at your paper 1.37 2.03 2.08 2.67 1.757 q32 showing a friend (competitor) your customer list 1.21 1.97 2.02 1.67 (0.107) q18 writing a paper for another student 1.53 1.76 1.71 1.89 0.985 q33 writing a report for a co-worker 2.05 2.79 2.50 2.00 (0.435) q19 asking another student to sit exam for you 1.05 1.56 1.47 1.17 1.152 q34 signing someone's name to authorize an expenditure 1.26 2.12 1.81 1.28 (0.332) asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 159 q20 preparing unauthorized materials but not using 1.58 1.56 1.77 1.72 0.607 q35 filling out a false expense report but not turning it in 1.42 2.00 2.04 1.83 (0.724) q21 using unauthorized materials in exam 1.37 1.29 1.57 1.12 1.050 q36 filling out a false expense report and turning it in 1.32 1.82 2.08 1.76 (0.393) q22 using sources but not included in the bibliography 2.26 2.26 2.12 2.06 0.175 q37 falsifying information on a job application 2.05 2.12 2.17 2.00 (0.983) q23 using direct quotes without reference 1.95 2.03 2.14 1.89 1.258 q38 presenting the ideas of a co-worker as yours 1.47 2.22 2.15 1.39 (0.277) 5. conclusion the purpose of this paper was to investigate whether responses of students from diverse cultural backgrounds to academic and business vignettes differ across regions. the manova results indicate that with the exception of giving false reasons for missing work in the business environment, the responses to the academic and business situations are similar amongst the regions. a comparison of gender distribution indicates that there are more male accounting students from south asia than those from the other regions. this study found that australian students rated nine out of twelve guiding principles lower than the ratings provided by the other groups. south asian students ranked nine out of twelve principles more important than the other groups in regions. contrary to the findings of several studies in other countries, this study found that there are no statistically significant differences between australian, south asian, east asian students and the other students in their ethical attitudes toward academic and business situations. considering the recent efforts towards harmonisation of standards and australian adaptation of international accounting & auditing standards, unique findings of this study suggest that asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e7 www.macrothink.org/ajfa 160 the same ethical training (a course or part of a course), learning opportunities, knowledge and interaction with peers and lecturers have resulted in students having similar ethical attitudes, even though they come from diverse cultures. the main limitation of this research is the small number of australian students (19) compared with the number of students from south asia (34), east asia (104) and other countries (18). further research with larger cohorts of students from each nationality will be aimed at overcoming this limitation. acknowledgements the authors wish to thank participants at the 6 th annual conference of the asian academic accounting association for helpful comments on previous versions of the paper. 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http://dx.doi.org/10.5296/ajfa.v5i1.3210 abstract this paper discusses the theoretical frameworks for a corporate disclosure research. it introduces the general nature and types of theories. it then compares and contrasts views of what constitutes a theory. there was no single view of theory. there were differences in approaches and interpretations. the conception of a theory and its relationship with research is discussed in light of both quantitative and qualitative methods of research and their contribution to theory are assessed. both quantitative and qualitative methods contributed to theory building, theory testing, and substantiating, or refuting their propositions. although, positive accounting theory had grown as one of the most significant accounting research program, the broad theories of accounting included interpretive and normative theories as well. the review of the literature revealed that there were a number of theories associated with corporate accounting and disclosure, amongst them were agency theory, signaling theory, the accountability theory, legitimacy theory, contingency theory, stakeholder theory, and resource dependency theory. keywords: corporate disclosure; theoretical framework; normative accounting theory; positive accounting theory; agency theory; signaling theory asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 184 1. introduction this paper discusses the theoretical frameworks for a corporate disclosure research. it introduces the nature and types of theories in general. it then compares and contrasts views of what constitutes a theory including the views prevalent in the field of accounting research. the distinction between a theory and related concepts like hypothesis, paradigm, model and concepts is made. the conception of a theory and its relationship with research is discussed. a quantitative and qualitative method of research and their contribution to theory is assessed. theories used in accounting research are traced, and the most commonly used theory was identified depending upon the type of corporate disclosure study envisioned. the contributions, controversies, and gaps in the identified theory was discussed and analyzed. there are several conceptions of theory; each of them differed in terms of their nature and scope. dominant views of theory in the field of accounting were interpretive, normative and positive. researchers were using qualitative or quantitative methods based on the paradigms of their research and ontological or epistemological assumptions. stam (2010) defined theory as a ‘systematic representation’ of a valid problem expressed, as far as possible, mathematically, in the natural sciences or logically in the life and social sciences. the aims of systematic representations are to develop explanations of a problem, describe the delineating features of a phenomenon, and provide predictions (stam, 2010). stam (2007) explained that there were three significant opinions of theory in the twentieth century. they were reductionism, instrumentalism, and realism. the reductionism viewpoint was the ability of a theory to be reduced to observables. the instrumentalism viewpoint used theory as instruments to do things and the realism considered theory as statements about phenomena that actually existed in the world. stam (2007) explained that observations, gradually, got separated from theory as ‘deductive-nomonological’ framework came into existence in the context of behaviorist’s interpretation of the theory. however, the development of inferential statistics encouraged broader use of theoretical models and that led to the demise of behaviorism (stam, 2007). an uncertainty is evident in what constitutes a theory (gelso, 2006). a common misunderstanding was with broad un-testable philosophies of human life. these are comprehensive theories, which are never disproved totally, although some aspects of them could be disconfirmed (gelso, 2006). generally, a theory was a statement of the hypothesized, assumed, or even factual relationship amongst variables with the theoretical proposition explaining the relationships between constructs that can ultimately become an uncontested fact. but, the eventual quality of a theory depends upon its ability to explain why the variables are related and what causes that expected relationship (gelso, 2006). harlow (2009) believed that the word theory had several meanings. for natural scientists, theory suggested a decisive law or a system of law, and for others, it was a construct or a set of constructs for comprehending a phenomenon. harlow (2009) proposed a case study method of research using inductive or deductive reasoning to test and develop a theory. wacker (2008) defined a theory as “an explained set of conceptual relationships” (p.5). a asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 185 theory must be able to explain the frequently asked questions of a conceptual relationship in the order who, what, when, where, and how. followed by what, would, should, or could question (wacker, 2008). these questions provided the four fundamental properties of the definition of a theory. wacker (1998) identified the four properties as: (a) definitions of variables; (b) the domain of theory application; (c) relationship between variables; and (d) predictions. wacker (1998) further elaborated that a theory will be construed as ‘good’ only if it explains the conceptual relationships in such way that it can be used for empirical testing and possesses certain restrictions on the four properties just described. therefore, the normal array of virtues of a theory is that it should be unique, with fewer assumptions, conservative, generalizable, internally consistent, generate more research in new areas, at an appropriate level of abstractions, and empirically risky enough to be refuted (wacker, 1998). corley and gioia (2011) defined a theory as a statement of concepts showing interrelations between such concepts that provided the explanations about how and why such a relationship existed. there were two identifiers of theoretical contributions: originality and utility. hence, the ability to generate original ideas to explain a phenomena thereby creating knowledge, which has a practical utility, is making theoretical contribution (corley & gioia, 2011). miller and bahnson (2010) explained that the purpose of accounting theories was to ensure better accounting practice. in pursuit of this, a normative accounting framework was used to search for practices that should be used instead of describing practices that are actually used. hence, normative accounting theory was prescriptive in nature. miller and bahnson (2010) argued that accounting and reporting should be prescriptive because pragmatic considerations contaminate them rather than improve them. hence, it is built around what should be done without any regard to what actually is being practiced (miller & bahnson, 2010). jeanjean and ramirez (2009) traced the changing shift between normative theories and the professional world of accounting and found two categories of normative accounting research. one was designed for policy prescription, and the other was for framework building. two approaches were identified as inductive and deductive. the deductive approach used theory building based on observation of practices. however, inductive approach started with an abstract idea from accounting knowledge so that rules could be generated to guide the practice of accounting. therefore, the natural outcome of normative theory was framing the standards of practice, assisting the profession in designing solutions to the problems encountered by them (jeanjean & ramirez, 2009). collin, tagesson, anderson, cato, and hansson (2009) explained that there were two theories that explained accounting choices. based on the scientific literature, positive accounting theory (pat) and institutional theory (it) offered explanations and predictions of accounting choices. pat provided the set of predictions regarding accounting choices affecting the wealth of stakeholders and emphasized on the existence of agency problems. hence, collin et al. (2009) considered pat as an appropriate theory in explaining accounting choices of companies that had agency problems. it, on the other hand, was used to explain accounting asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 186 choices based on institutional pressures the organizations were exposed, be it normative, coercive, or mimetic. the methodology used tended to be more case studies based and ideographic (collin et al., 2009). theories renowned in accounting are mostly those adapted from other disciplines (malmi & granlund, 2009). malmi and granlund (2009) argued that theories in management accounting research should endeavor to suggest explanations that were useful to managers, organizations, and society at large. yi, davey, and eggleton (2011) suggested a comprehensive theoretical framework using a multi-theory approach including agency theory, stakeholder theory, signaling theory, and legitimacy theory in the framework to study disclosure decisions. agency theory was based on the concept of separation of ownership and management creating a principal-agent relationship. disclosures were considered part of the monitoring package to reduce the information asymmetry and agency problems with their resulting costs. yi et al. (2011) described that stakeholder theory extended the shareholder point of view to include several stakeholders in a relationship between them and the organization. there were two sources of accountability under the stakeholder theory: ethical responsibilities, and managerial responsibilities. the proponents of signaling theory suggested that information asymmetry could be reduced by sending signals to interested parties (yi et al., 2011). another theory, legitimacy theory, as suggested by yi et al. (2011) explained the relationship between the organization and society at large in terms of a “social contract”. chen and roberts (2010) described the theoretical considerations for a social and environmental accounting research. they suggested that using legitimacy theory, institutional theory, resource dependency theory, and stakeholder’s theory could make appropriate interpretations of business activities. however, the choice of the theory would depend on the focus of the study. the theories were believed to share the similar ontological views and were largely considered as system-oriented theories (chen & roberts, 2010). kakkuri-knuuttila, lukka, and kuorikoski (2008) analyzed the interpretive research in management accounting. management accounting researchers were found to apply qualitative methodology to interpret case studies to offer insights regarding the practice of accounting in different organizational contexts. accordingly, the conceptions of a theory in this format of research were “making sense” of human actions and describe how the research subjects interpreted the context within the framework of subjectivism (kakkuri-knuuttila et al, 2008). baker (2011) opined that accounting research was fragmented into paradigmatic lines, and such fragmentation was a recent phenomenon. there were very few divisions in accounting research till the 1970s, and baker (2011) stated that, by the end of 1980s, there was a major shift in accounting research from a normative framework to an empirical and positivist research. the positivist research was based on a scientific model, in which hypotheses were proposed, numerical data collected, and data analysis was carried out to test the hypotheses and make inferences using mostly quantitative methods (baker, 2011). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 187 with this background, the rest of the paper is devoted to reviewing the existing literature and making recommendations for theoretical frameworks for a disclosure research and finally some conclusions are drawn based on the review of relevant literature. 2. review of literature there is confusion about what constitutes a theory (gelso, 2006) as the word theory has several meanings (harlow, 2009). it is a ‘systematic representation’ of a valid problem expressed, as far as possible, mathematically in the natural sciences or logically in the life and social sciences (stam, 2010). for natural scientists, it was a decisive law or a system of law, and for social scientists, it was a construct or a set of constructs for comprehending a phenomena (harlow, 2009). in social sciences, a common misunderstanding about theory was with broad un-testable philosophies of human life, assertions of faith, and at times propositions that were not made with testability considerations (gelso, 2006). these overarching theories were not scientifically useful, as they could not generate research that could be tested for validity (gelso, 2006). wacker (2008) defined a theory as “an explained set of conceptual relationships” (p.5). corley and gioia (2011) echoed similar opinion when they explained the theory as statement of concepts showing interrelations between those concepts that provided the explanations about how and why such a phenomenon occurred. another is the deductive-nomonological viewpoint, in which theory is considered as statements that have a precise relationship to the events requiring explanation (stam, 2007). in accounting, theory is a framework that ensures better accounting practice, like the conceptual framework (miller & bahnson, 2010). hence, it is built around what should be done without any regard to what actually is being practiced (miller & bahnson, 2010). in that sense one of the outcomes of a theory in accounting is framing the standards of practice, and assisting the profession in designing solutions to the problems encountered by them (jeanjean & ramirez, 2009) and provide explanations and predictions of accounting choices (collin et al., 2009). in management accounting, theories suggest explanations that are useful to managers, organizations, and the society at large (malmi & granlund, 2009). the conceptions of a theory in this format were “making sense” of human actions and describing how the research subjects interpreted the context within the framework (kakkuri-knuuttila et al., 2008). therefore, a theory is ultimately tested and becomes an uncontested fact (gelso, 2006) but retains the characteristics of refutability (wacker, 1998). another way of looking at a theory was by finding out what constitutes a good theory. to that direction, wacker (1998) identified four properties of a good theory; they were (a) definitions of variables; (b) the domain of theory application; (c) relationship between variables; and (d) predictions. hence, a theory is a statement that defines the variables, outlines the domain it can be used, explains the relationships, and provides predictions about the occurrences of those variables (wacker, 1998). it also needs to be original in conception or improving the abstraction level, and needs to have utility in explaining or predicting the relationships (corley & gioia, 2011). there were several views of theory in accounting, but there were three views that were prominent in the literature: interpretive view, normative view, and positive view. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 188 interpretative views were reflective in field studies, case studies, and action research mostly fitting into the qualitative strand of research. management accounting researchers evidently preferred qualitative research (parker, 2012). case studies featured in these researches, typically addressed the "why" question, and investigated a phenomena in actual practice involving non-quantifiable variables in which context was important to be studied (cooper & morgan, 2008). case studies are popularly used for verifying or developing theoretical frameworks using explanations, strengths, and weaknesses identified either by inductive or deductive reasoning (harlow, 2009). action research is another qualitative research methodology that creates rich data by an involved participation as an insider in an organization with a clear intention to achieve a chosen result (ansari & bell, 2009). the researcher adds to the body of existing theoretical knowledge with a heuristic value because the action researcher not only observes what is happening in a real world but also participates in action to achieve the desired goal (ansari & bell, 2009). the legitimate problem-solving objective of action research deals with the "crisis of relevance" in accounting research and provides real experiences in a collaborative exercise. it seeks solutions to practical problems and generates new knowledge with the active involvement of a researcher and client working on a real-life project (giuliani, 2009). another view of accounting theory was the normative view. jeanjean and ramirez (2009) traced two categories of normative accounting research. one was designed for policy prescription, and the other was for framework building. the natural outcome of normative theory was framing the standards of practice, assisting the profession in designing solutions to the problems encountered by them (jeanjean & ramirez, 2009; miller & bahnson, 2010). the purpose of a theory in accounting is to ensure better accounting practice (miller & bahnson, 2010). in pursuit of this, miller and bahnson (2010) proposed that a normative accounting framework was to be used to search for practices that should be used instead of describing practices that are actually used. the accounting and reporting should be prescriptive because pragmatic considerations contaminate them rather than improve them; hence, it is built around what should be done without any regard to what actually is being practiced (miller & bahnson, 2010). the third view was a positivist view of accounting theory. baker (2011) informed that, by the end of 1980s, there was a major shift in accounting research from a normative framework to an empirical and positivist research. ashton et al. (2009) expressed the same view, as they found relatively little research that could be categorized as normative covering the study period between the years 2001 and 2007. bisman (2010) explained that there was no doubt about the growth in accounting research using interpretive approaches but positive accounting theory based on objectivist ontology had dominated the literature. ashton et al. (2009) explained that there was increased popularity of positivist approaches to research. the positivist approach is the scientific approach that is appropriately identifies, explains and predicts accounting phenomena. it was founded on the ontological view that "the reality of accounting can be discovered by the use" (bisman, 2010, p. 6). based on their literature review, collin et al. (2009) elucidated that positive accounting theory (pat) was one of the theories that offered explanations and predictions about accounting choices affecting the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 189 wealth of stakeholders based on the concept of agency problems. positive accounting theory posits that agency costs will vary from company to company depending upon political and social influences (broberg, tagesson, & collin, 2010). there were other theories used in accounting and especially disclosure studies. yi et al. (2011) described stakeholder theory as extending the shareholder point of view to include several stakeholders in a relationship between them and the organization. signaling theory suggested that information asymmetry could be reduced by sending signals to interested parties and legitimacy theory as explained by yi et al. (2011) was based on a "social contract" between the organization and society at large. chen and roberts (2010) described the theoretical framework for a social and environmental accounting and disclosure research using legitimacy theory, institutional theory, resource dependency theory, and stakeholder's theory. aston et al. (2009) found many management accounting researchers were using contingency theory. there are concepts related to theory like paradigms, hypothesis, model and concept. morgan (2007) described four perspectives of paradigms. the first way of looking at a paradigm was as worldviews; researchers may have based on their experiences, beliefs, morals, values, and a set of assumptions about how the world works that may impact every aspect of their research (morgan, 2007). the second version of a paradigm is to consider them as epistemological stances like realism and constructivism within the philosophy of knowledge and ways of creating that knowledge (morgan, 2007). the third view of paradigm is more specific and deals it as the "shared beliefs within a community of researchers" (morgan, 2007, p. 53) about the questions and procedures of answering those questions. the fourth and the last version of the paradigm are considered as the set of rules that can be used for generalizations, models, values, and examples of solutions for similar researches done in the given field (jeanjean & ramirez, 2009). taneja, taneja, and gupta (2011) explained that such perspectives help researchers to take philosophical examinations of phenomena’s ontological and epistemological assumptions. model, on the other hand, is a semantic conception of a theory. morgan (2007) opined that a theoretical model would comprise of four features: variables or phenomena of interests, laws of interaction of these variables, boundaries of the theory, and system states. gelso (2006) explained that theories offered propositions, and hypotheses were consequential to such propositions. hypotheses are proposed relationship between variables (perkins, 2010) that are tested empirically in inferential research to draw inferences about the unobserved from the observed phenomena (gelson, 2006). concepts are the primary elements of theory and a phenomenon that can be observed. however, phenomena, which cannot be observed, and hence must be inferred, are constructs. they become concepts from constructs when they are derived or used in a particular theory. these could be physical phenomena (concepts) or abstract, theoretical constructs (kimberlin & winterstein, 2008). research, in accounting, suggests solutions to practical problems, and investigates relationships between phenomena to contribute to the body of knowledge. research needs to provide answers to the questions of what, why, when, how, where, and who about a phenomena (ellis & levy, 2008). the goal is reflected in the overall intent or objective of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 190 the research, and the research questions or hypotheses are specific questions the researcher intends to find answers (ellis & levy, 2008). social researchers need to forsake the idea of building a grand theory mirroring the natural science rather concentrate on small hypotheses closer to social actuality (andersen & kragh, 2010). qualitative research could be used for theory building excise or theory testing (andersen & kragh, 2010) by seeking explanations and building interrelationships. a case study involving a theory except in case of descriptive case studies (harlow, 2009) provides the map for theory building. they could be used either to test a particular theory, develop a new theory, or a combination of both. research will begin with a review of literature (ellis & levy, 2008; harlow, 2009) that could be used to identify existing theoretical expositions of the topic. developing a theory is a circular process of testing the idea against data, reframing the idea, and retesting until trustworthy conclusions can be reached (harlow, 2009). researchers use theory to make predictions and test these predictions empirically to emphasize the strength and weaknesses of different theories (colin et al., 2009). colquitt and zapata-phelan (2007) examined the two ways an empirical research can contribute to theory: (a) to test a theory in the spirit that a theory, which was not mortally endangered, would not remain alive for long; (b) building a theory usually following inductive reasoning. ketchen and hult (2011) suggested three tools to build a theory. the first metric of quality theorizing was that theory had to be interesting to capture attention of others so that it could be built upon by other researchers. the second metric was generalizability, and the third was accuracy and simplicity. tacq (2011) described that quantitative research used post positivistic approach reducing the phenomena to variables and hypotheses using measurements, experiments and surveys to collect data and carried out statistical analysis with an emphasis on testing of theories. on the other hand, qualitative methods primarily used constructivist perspective in developing a theory or pattern. zahra and newey (2009) conceptualized that theory-building research could impact theories by adding or polishing explanatory and predictive abilities to address focal issues of a theory. richardson (2012) commented research could contribute to accounting practice immensely without actually contributing to the original theory but simply adding to the body of knowledge by assessment of the anomalies or evaluate boundaries thereby becoming producers of theoretical insights. 3. recommendations and conclusions collin et al. (2009) opined that positive accounting theory offered explanations and predictions of accounting choices affecting the wealth of stakeholders and emphasized on the existence of agency problems. positive accounting theory posits that agency costs will vary from company to company (broberg, tagesson, & collin, 2010). based on these premises and others, an agency theory has evolved. yi et al. (2011) explained that agency theory was based on the concept of separation of ownership and management creating a principal-agent relationship. christopher (2010) reviewed the extant literature through a theory building approach and traced opinions that agency theory provided the structural platform to determine contractual relationship and obligations between the major parties in an organization. bauwhede and willekens (2008) used agency theory to study the disclosure on corporate governance in the european union and concluded that their results supported asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 191 the theoretical argument about companies disclosing corporate governance information in order to reduce information asymmetry and the agency costs. henry (2010) proposed that corporate governance disclosure would reduce the agency conflicts and thus results into a reduction of agency costs. kelton and yang (2008) used the agency theory to study the impact of corporate governance on internet financial reporting. kent and stewart (2008) based their study on the belief that well-governed firms would increase their disclosures as a means of mitigating agency problems existing between the management and shareholders. taylor, tower, van der zahn, and neilson (2008) studied the financial instrument disclosure practices of australian companies using agency theory as their conceptual framework. tsamenyi, enninful-adu, and onumah (2007) used the agency theory to study the disclosure and corporate governance in ghana. chen, elder, and hsieh (2007) examined the relationship between corporate governance and earnings management in the taiwanese market using agency theory. hence, agency theory under a positive accounting outlook, may provide a sound theoretical basis for studying disclosure decisions made by corporations. however, there are some areas of controversies and unanswered questions. agency theory posits a positive correlation between profitability and disclosure. the same, positive and significant, a relation between profitability and disclosure was found (aerts, cormier, & magnan, 2007; akhtaruddin, hossain, hossain, & yao, 2009; li, pike, & haniffa, 2008). on the other hand, ho and taylor (2007) reported a negative relationship between disclosure and profitability. furthermore, an insignificant impact of profitability on the levels of disclosure was found (aljifri, 2008; ferrer & ferrer, 2011; mia & al-mamun, 2011). hence, there are three different perspectives using the same theory. another area of controversy is the relationship between leverage and disclosure. agency theory proposes higher incentives to disclose information by leveraged firms to reduce agency costs (kang & gray, 2011). however, higher leveraged firms disclosed less information as compared to other firms (aerts et al., 2007; cormier, aerts, ledoux, & magnan, 2009). on the other hand, leverage did not have any significant impact on the levels of disclosure (akhtaruddin et al., 2009; aljifri, 2008; ho & taylor, 2007; mia & al-mamun, 2011). although, there are some controversies and unanswered questions related to agency theory, it provides the structural platform and theoretical framework for disclosure decisions (kelton & yang, 2008). most of the theories prevalent in accounting were borrowed theories from other disciplines, and hence there was a need for efforts to theorize in accounting contexts. qualitative and quantitative research could both make contributions to theory either in building it, testing it or improving it. the choice of methods would depend upon the ontological and epistemological assumptions involved in research. there were three views of accounting theory, interpretive, normative, and positive. accountants need prescription in many things they do and hence normative accounting theory would serve that purpose. management accountants and other emerging fields in accounting could continue to use interpretive view of accounting and engage in qualitative research using contingency theory. financial accounting and other allied areas could continue to use quantitative methods in a positive accounting framework. specialty fields like social responsibility accounting, intellectual asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 192 capital, and environmental disclosure studies fit well into the legitimacy theory and stakeholder's theory. many disclosure studies especially mandatory disclosure studies, and research in auditing, and taxation would benefit from using the institutional theory. generally, agency theory provides the required framework to evaluate accounting choices and disclosure decisions in market-based studies. references aerts, w., cormier, d., & magnan, m. 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(2009). maximizing the impact of organization science: theory-building at the intersection of disciplines and/or fields. journal of management studies, 46(6), 1059-1075. http://dx.doi.org/10.1111/j.1467-6486.2009.00848.x copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 1143-4707-1-rv _1_-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 25 customer service impacts on bank policy in bangkok, thailand: a qualitative approach dr paul tj james graduate school, bangkok university rama 4 road, klong-toey, bangkok, 10110, thailand e-mail: paul.j@bu.ac.th received: december 6, 2011 accepted: january 8, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1143 url: http://dx.doi.org/10.5296/ajfa.v4i1.1143 abstract becoming more customer focused in the banking industry of thailand and measuring service quality levels is beginning to be understood to be a very useful tool to help manage the relationship between the business and its main stakeholder. this paper interogates a broader, deeper and more involved understanding of the issues generated within the thai service-banking context; and to consider more implicitly the issues and questions raised, this empirical groundwork utilised an interpretive approach to understand the perceptions of bank customers. the population for this research were new customers of 6 months or less and had recent and on-going experiences of local bank practices, reflecting the criteria of theoretical purpose, relevance and appropriateness. a random sampling process targeted to a closed list of new customers (385) who spoke adequate levels of english was applied – all respondents were thai resulting in a total of 18 customers determined as the resultant sample frame. overall results, included 5 key-themes (staff related; service process; technology/media; product related; and customer related) and 25 sub-themes distributed across three areas (service design elements; service delivery elements; and post-service management). the limitations of such a small study should be noted. these results may be considered adequate for exploratory analysis only and a larger, more involved study is needed to validate the present study. keywords: banks, qualitative methods, customers, thai asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 26 1. introduction becoming more customer focused in the banking industry of thailand has now become a rallying call for banks who want to survive and even grow (cui, lewis and park (2003); naumann and giel (1995). thai banks are now emphasizing improved customer service to retain their customers and compete with large multinational firms (moon and stone, 2003). this has created the possible break-down of demarcation lines between the various classes of financial institutions as the entry of multi-national banking consortiums has also created more complex consumer responses resulting from increased competitive market positions. consequently, the level of increasing competition and changing consumer demands in the banking sector in thailand has led every bank leader to consider the impact of the ordinary consumer on their bottom line (rotchanakitumnuai and speece, 2003). further, pressures surrounding the thai banking industry from around the world have influenced major operating changes through liberalization of the economy of which the thai banking sector has been central to these developments while the thai banking sector is still not completely deregulated (gerrard and cunningham, 2003) and foreign banks are not yet allowed to engage with customers in the market directly. nash (1993) reported that many customers in the uk were dissatisfied with the relationship they have with their bank and this aspect has also been identified as a growing issue for the thai banking industry. this raises the first research question what is the customer perception of bank service quality? measuring service quality levels is beginning to be understood to be a very useful tool to help manage the relationship between the business and its main stakeholder – the consumer. a major cause of issues resulting from a breakdown in this relationship is the level of discontent between what the company promises and what customers receive (parasuraman, ziethaml and berry, 1985). the tumultuous change patterns associated with the banking industry in thailand in the last eight years has created complex developments in the use of technology, marketing practices and banking strategy resulting in different patterns of consumer treatments. bank consolidation practices and the need to reduce non-performing accounts have led the industry to seek more appropriate ways to match consumer needs. consequently, research that inquires into how banking practices develop closer links with their customers has been very thin on the ground in thailand. the need therefore for this type of research is overwhelming in order to help consolidate present practices and also to stimulate new methods to communicate more effectively between banks and customers. further, this indicates that the banking sector is possibly still internally oriented (monopolized) and has yet to move to a more mature market oriented sector. the conditions therefore suggest that it is perhaps now pertinent to explore the relationship between the banking sector and the consumer – especially in terms of service requirements and developments. this raises the second research question what is the character of bank-customer service interaction? 2. service quality in thai banks this literature review attempts to bring together some of the more important aspects of service quality that faces the asian banking industry and more specifically, within the thai banking sector. in this respect, a cursory review of the literature suggests that service quality asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 27 and performance in the bank industry in thailand appears to be underpinned by notions of customer value; customer retention and loyalty; delivering services to meet and exceed customer expectations; and service assessment mechanisms and these aspects will be discussed below. services in general now account for over 70 per cent of production and employment in many developed countries (moore, 1999). more importantly, services account for 46.7% of gdp in thailand with services in the banking sector accounting for nearly 75% of this [1]. in monitory terms, the need to manage banking service is therefore considered crucial to the thai economy. etzel, walker and stanton (2001) indicates that services are identifiable, intangible activities that are the main object of a transaction designed to provide want-satisfaction to customers. similar but distinct definitions prevail in the literature most notably, parasuraman, ziethaml and berry, 1985; bessom (1973); james (2005); and grönroos (2001). the thai banking industry is learning that they cannot maximize value to customers if they supply products that are perceived as defective, late or ineffective (harrison and st john, 1996). to enhance such productive involvement, thai banks have been advised to develop better relationships (hines, 1994; kumar, 1996; womack and jones, 1996). further, as purvis (1993) indicated that in order to remain and/or increase profitability, banks must continue to cut costs and offer better and more comprehensive services to their customers in order to retain more customers and provide more effective service delivery designs. the literature continuously suggests that customer retention is economically more advantageous to a bank than constantly attempting to seek new customers through more expensive marketing activities (reichheld and sassar, 1990; sheth and parvitiyar, 1995) and that this consequently is underpinned by the notion that building and maintaining long-term customer relationships is central to improved bank performance (ennew and binks, 1996). there would appear to be three main studies which examined the nature and importance of benefits (residual and actual) customers had derived from longer-term relationships with service providers and these can be applied here to banks in thailand. these are beatty et al. (1996); beatty (1999) and gwinner et al. (1998). however, an examination of these studies suggests that these are not the only crucial factors as the nature of banking services requires more than just the managerial determination of service standards; it requires an adept management style that allows different perceptions from different parties to the service act to be amalgamated so that all service elements match consumer expectations and demands; and in turn match service quality through delivery to those consumer expectations. service quality is however, perhaps by its very nature a dynamic concept – both in terms of consumer perceptions as well in practical application (oliver and rust, 1993). the work of avkiran (1994; 1999) may be useful to consider here who proposed that perceived service quality is a global judgement or attitude relating to the superiority of the service; whereas satisfaction is related to a specific transaction. thus, consumer perceptions of the organisational service intent are important in the construct of service quality. underpinning this possible service quality construct appears to be the notion of customer value. in addition to this, chalermratana (1996) suggests that service quality should not be considered an asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 28 engagement in a static process, but a process that encompasses pre-service elements, during-service elements, and post-service elements. this appears to be the chief theoretical foundation of service quality models introduced by berry et al., (1985); grönroos, 1983; and further zeithaml parasuraman and berry (1990). in this respect, parasuraman , ziethaml and berry, (1985, 1988) first developed a framework of service quality construct dimensions that are widely cited and discussed. this raises the third research question what is the impact of bank-customer service response? clearly of issue is the notion of whether banking organisations and consumers alike are capable of accurately assessing consistently the required levels of service quality and how this helps develop effective processes to enhance the consumers experience of the service provision. antonides and van raaij (1985) cited in parasuraman et al, (1985) point out that people differ in their perceptions of reality, their experiences and personal situations and respond in a mostly individual way when asked about their service quality requirements. this situation is compounded negatively through the notion that perceptions of service quality may be substantially affected by the expectations prior to or actually created in the service delivery (avkarin, 1999). for example, houston, battencourt, and wenger (1998) conclude that as the waiting time increases consumer perceptions of service quality drops. 3. methodology to gain a broader, deeper and more involved understanding of the issues generated within the thai service-banking context and to consider more implicitly the issues and questions raised, this empirical groundwork utilised an interpretive approach (walsh, white, and young, 2008) to understand the perceptions of bank customers. customers were considered specialist knowledge agents as their opinions and experiences influenced policy application in the bank. the research used a semi-structured questionnaire, which provided an appropriate element of context and flexibility (cassell and symon, 2004) and this further aided by applying an inductive/theory building approach (glaser and strauss, 1967). given the lack of appropriately focused research in this area, this methodology is seen as suitable for creating contextual data for the purpose of forming richer theory development (cayla and eckhardt, 2007). the population for this study was customers of the main branch located in bangkok, thailand chosen through applying the approach of carman (1990). after discussions with top management – new customers of 6 months or less would take part in the research and this reflected the criteria of theoretical purpose, relevance and appropriateness (glaser and strauss, 1967). it also indicated the importance given by the bank to the research bearing. a random sampling process targeted to a closed list of new customers (385) who spoke adequate levels of english was applied – all respondents were thai. this was chosen primarily because the customers had recent and on-going experiences of local bank practices and was well placed to offer specific thoughts and impressions of their new experiences. using glaser’s (2004) sampling processes, a total of 18 customers were thus determined as the resultant sample frame, which was also considered the result of convenience sampling process first initiated by harrel and fors (1992). similar studies on service quality had used a sample size of 62 (llosa, chanson, and orsingher, 1998) and 20 (colgate and norris, 2001). a requirement in terms of rigour was to ask each respondent the same set of questions creating a notion of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 29 determination of question context that the researcher used as a template to create a flexible and open questioning arena. each interview was audio recorded for future analysis. interviews were conducted in english and took approximately 60 minutes. all interviews were recorded digitally after gaining explicit permission, and were later transcribed verbatim using nvivo software. the conduct of the interviews follows a similar process used by gray and wilcox (1995) with each individual group being asked the same set of questions modified through ancillary questioning (probes and follow-ups) in the same way as balshem (1991). to increase the reliability of the data, the actual transcription was returned to each respondent – via e-mail for correction, addition or deletion and return, which followed the process of validated referral (reeves and harper, 1981). whole-process validity was achieved as the respondents were considered widely knowledgeable of the context and content associated with the research orientation (tull and hawkins, 1990). each interview was initially manually interrogated and coded initially using the evernote software according to sub-themes that 'surfaced' from the interview dialogue using a form of open-coding derived from glaser (1992a); and straus and corbin (1990). this treatment was also reinforced and extended through the use of thematic analysis conducted using the nvivo 9 qualitative software package similar to walsh et al. (2008). each interview was treated and coded independently. in this way, no portion of any interview dialogue was left uncoded and the overall outcome represented the shared respondents views and perspectives through an evolving coding-sequence (buston, 1999). various themes were sensed from the use of the software packages, as well as from the initial manual-coding attempts. this dual form of interrogation was an attempt to increase the validity of the choice of both key themes and sub-themes through a triangulation process. nvivo 9 was further used to explore these sub-themes by helping to pull together each of these sub-themes from all the interviews (harwood and garry, 2003). in this way, it was possible to capture each respondent's comments across transcripts (riessman, 1993) on each supported sub-theme and place them together for further consideration and analysis. 4. theme outcomes overall, 5 key-themes (staff related; service process; technology/media; product related; and customer related) and 25 sub-themes distributed across three areas (service design elements; service delivery elements; and post-service management). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 30 table 1. theme assessment key themes sub-themes service design elements service delivery elements post-service management 1 staff related management/ administration process design training staff performance personal characteristics communication process product knowledge bank process knowledge staff performance training staff control staff skills 2 service process service distribution personal characteristics service evaluation training method/practice training service promise service failure assessment 3 technology/media technology media/marketing practices technology media/ marketing practices training service promise service failure assessment 4 product related product material service promise product relevance service promise training service promise service failure assessment 5 customer related customer orientation customer needs customer expectations service experience motivation bank recommendations training service promise service failure assessment 5. research findings following on from accepted qualitative practices, the outcomes of this research are presented and any comments or inferences are drawn at the same time. the outcomes are stated below where the discussion focuses on the research questions, main themes, sub-theme elements within each key theme and the breadth of respondent illustrations/extractions as used in the reporting of this research (numbers do not infer relative importance) are presented in table 2, below. the discussion format used in this paper reflects the respondent’s voice through a streamlined and articulated approach for reporting. consequently, the style adopted for reporting and illustrating the data is greatly influenced by gonzalez, (2008) and also daniels et al. (2007) and is discussed below, focusing on the raised research questions and the resultant main themes. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 31 table 2. sub-themes discussed in this paper (other sub-themes are considered of less persuasive significance) research questions main themes sub-themes no. refs what is the customer perception of bank service quality? (q1) staff related (sr) staff performance c2, c4, c5, c7, c8, c9, c11, c14, c16, c18 (10 = 57 total) product/process knowledge c1, c13, c17 (3 = 27 total) service process (sp) service evaluation c2, c3, c6, c7, c8, c9, c11, c12, c13, c15, c17 (11 = 54 total) personnel characteristics c2, c4, c6, c10, c11, c13, c17 (7 = 27 total) what is the impact of bank-customer service response? (q2) technology/media (t/m) media/marketing practices c2, c4, c8, c11, c13 (5 = 36 total) customer related (cr) bank recommendations c1, c16 (2 = 24 total) customer expectations c5, c12, c17 (3 = 9 total) customer orientation c2, c11 (2 = 11 total) customer needs c5, c8, c14 (3 = 22 total) what is the character of bank-customer service interaction? (q3) product related (pr) product material c1, c6, c14 (3 = 13 total) service promise c15, c18 (2 = 12 total) totals 5 11 57 = 292 total 6. major theme discussion the following discussion uses the five key-themes (contained in table 1, above) as its basis and consequent sub-themes in terms of where the sub-theme would appear to have most influence. this discussion attempts to correlate the relevant issues that the research question demands to be answered by using the sub-questions. answering the sub-questions appears to answer the main question posed. 6.1 what is the customer perception of bank service quality? this is informed by key theme 1 (staff related); and key theme 2 (service process). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 32 6.1.1 key theme 1 staff related staff performance staff performance appears to be accepted by customers as a major influence in the face-to-face contact with the bank mirroring a similar outcome to newman (2001). for example, one response (c4) which typifies a significant minority of customers (8) indicates that, yes, it is very important, yes because you spend a lot of time working out which bank to use and what products may be we should use. so i think the performance is extremely important… it’s very important. further, another customer (c9) comment which typifies a significant minority of customers (4) suggested that, some of it [staff interaction], i think, is outstanding. some of it less so. obviously i find that the standard varies a little… which appears to indicate that staff performance was considered by customers to vary and may reflect wider variations in adopted banking standards. the exact level of influence can be illustrated by a customer (c11) who typified a significant majority (11) in that, staff performance is the bank quality. poor staff performance means the bank does not care about its customers. this... [bank] …has much to learn about meeting customer needs. one customer (c2) comment which is representative of a small minority (6) takes this further and indicates that staff performance, ...is important in the context of the initial interview when we go to open an account. it does make big a difference. you must have good quality staff for those times… from the evidence, there does appear to be a difference in customer perception between some staff. this appears to contradict the findings of naumann and giel (1995) where employees’ perceptions of service and actual customer perceptions of service quality tend to match. reasons for this may be, for example, as one customer (c14) who typifies some customer comments (7) stated that ...there is a mixed ability group delivering direct customer service. one customer (c5) further highlights this as ...you can't compare some of the staff. it would seem as if some are more mechanical. however, another customer (c18) indicates ...i find that the front staff offers me quite a lot of ideas and information to help with my finances. i find z very worthy, extremely well prepared but i'm not quite sure why i don't find his input more valuable. thus, the evidence from this study does not seem to mirror williams and attaway (1996) in terms of the need for thai bank staff to service customers more effectively or bove and johnson (2000) whose study reflects the importance of customer loyalty and the development of a strong relationship between the customer and a single member of staff. however, another customer (c8) comment which appeared to represent a small minority (5) indicated ...i think that some members of staff are not given the same kind of remit as they are given less bank products to introduce or manage. this in itself may underpin why many customers appear to feel that some staff aren’t totally equipped to deal with customers. this aspect is typified further by another customer (c16) who states ...i think the problems are based, …on personality, shaped by their own experiences of where they’ve come from and some are obviously limited in that experience…and of course customer training. a small group of customers appeared to anticipate problems associated with staff performance (6). as one customer (c5) suggested …it didn’t really affect my overall perception of the bank capability. i think, i was disappointed and i hoped that it wasn’t going to happen again. customers appeared to evaluate staff performance as an individual, develop asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 33 opinions and then share these with their peers and family. it was noted from the evidence (4) that this process appeared to alleviate stress created by perceived ill-performing staff and was used by many customers as a sounding board. this naturally affected customer perception as individual viewpoints were either strengthened or reduced as a consequence of this type of group discussion. this point was taken up by a significant minority of customers (4) which was typified by one customer (c7) who suggested that ...we don't have the opportunity to discuss at the bank bad staff practice mostly because the staff don’t allow us to feedback to them our disappointments or concerns and to stimulate any kind of positive change. this suggested that there is little evidence that the bank actually wanted to stimulate customers in giving them appropriate feedback on bank staff performance. product/process knowledge product knowledge appeared to be central to a customer’s perception of quality of service delivery of a bank product. many customers (12) appeared to feel that product knowledge allowed them to trust the staff and the message given and thus have greater confidence in the staff. here, one customer (c17) indicated ...yes, i think that’s very important, for them to appear to put across a sort of positive picture and also to be able to structure their selling process. some of the best ones have been where the representative has laid out a sort of framework of what they’re going to discuss and actually followed that through. a number of customers (7) appeared to suggest that the level of product knowledge gave an indication of the flexibility of delivery. this is highlighted by one customer (c13) who stated that ...the product content i can get from a brochure and i want somebody to make me stop and point out appropriate alternatives and i guess become more confident and more perceptive as a result of that. they have not done this at all. customers perceived differences in the demonstration of product knowledge between management and sales staff. one customer (c1) who typifies the customer comment (8) stated that some management ...knows their stuff very well, whereas many of the others are struggling. this suggests that more experienced staff are perceived as being more adept at dealing with diverse customer requirements. this has concerns over what customer training programmes are utilised and to whom this training is being directed to. 6.2.2 key theme 2 service process service evaluation customers appear to understand that the effort they put into the evaluation is seen as a superfluous exercise. most customers (8) appeared to use the bank service evaluation form as the only means of staff evaluation (duclos, vokurka and lummus, 2003). this is embodied by one customer (c3) who states that ...we get this form at the end of the new account opening. to me this isn't sufficient, but it is the only form we have for giving feedback on the staff performance and the process used by the staff. this is further illustrated by another customer (c11) who typifies a minority (4) and states ...i'm not quite sure that any evaluation is taken quite seriously enough by the bank. i feel that they just give it to us and then it's wasted. another customer (c8) suggested that ...well, we have a questionnaire at the end of the new account process, which we are invited to fill in frankly. and i think people do…but nothing happens…does it? this may indicate why many customers (9) appear to consider that the comments made on the evaluation form are not taken seriously by bank staff asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 34 or are just taken as lip-service resulting differences indifferences between customer satisfaction and service quality (reeves and bednar, 1994). however, to add to this a minority of customers (4) reported that they were aware of some changes being made as a consequence of action taken through the bank assimilation of customer comments and any consequent new ways of building relationships with customers (trim and lee, 2006). this is illustrated by one customer (c15) who stated ...certainly there was [improvements]… i think there was the extension of banking times and also more atm facilities. which personally i wouldn't have gone for, but i think some customers would have found it to be a good thing. another customer (c12) indicated that ...the bank has appeared to have modified the product ranges and how they deal with customers once or twice. i don’t know whether it’s our job to tell the bank what they should do they are the professionals. however, a significant minority of customers (7) perceived that they considered many of the improvements as superficial in nature, leading to an ineffective unilateral customer development kahn (1998). this was revealed by one customer (c7) who stated that ...most of the changes are related to administration. very few relate to the service process or address staff weaknesses. they still behave in the same way as before. a minority of customers (5) do not perceive any changes to the service delivery element and this is typified by one customer (c6) who stated ...have they? i’ve not seen this. this may be seen as raising an issue if changes are made to service provision how are these changes communicated to customers? many customers (6) appeared to find the evaluation process useful. this is illustrated by one customer (c13) who stated that …i think it's useful in a couple of ways. one that, i think it's good to be reflective at the end of a discussion with staff about your problems and how they can help solve them. and secondly, that one hopes that points will influence the future bank customer strategy. however, another customer (c17) responded …well it was the only one [bank] that i use – nothing changes really. some customers (3) perceived that there were problems with the evaluation form in its present state and this is illustrated by one customer (c2) who indicated that …because they ask you to comment on the whole banking experience, i actually found that very hard. because i want to distinguish between different situations and different people and that's not always possible. a small minority (4) voiced the opinion that customers don't complete the evaluation forms at all because the bank management may not respond to any future loan favourably – especially if they are negative about a particular service offering. as a consequence, some customers (3) appeared to make a personal choice of not taking their opportunity to make written or verbal comments. this point is illustrated by one customer (c9) who stated ...what's the point; nothing will really change, will it? and i don’t want to risk my loan application. this is a situation of concern, as this focuses in on matters of trust and organisational policy. personnel characteristics many customers (9) appeared to portray what characteristics of good staff that they thought were useful and valuable, as staff has been found to influence the quality and delivery of products and services to external customers (zeithaml et al., 1990; and schneider and bowen, 1995). however, there was a minority (4) who did not have an opinion asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 35 even when urged. of the customer opinions that were vocalised, and typified by one customer (c10) who stated ...i think clarity in the interaction between the customer and the staff. somebody who has a clear idea of what customers need and how to solve their problems as well as having time to talk. for these customers it was clear from the evidence that they wanted a more relaxed style of interaction with more interaction rather than a serious, bureaucratic administration type process. this appears to corroborate an outcome from newman (2001); and geyskens, steenkamp and kumar (1999). another customer (c4) further suggested that ...i think, a sense of humour is important, it helps to keep you interested. one customer (c6) submitted that ...i'm sure no.1 for me is that they've got to have some sort of confidence which has something to do with thoroughness and preparation i suspect [laughter]. they have got to have some substance as well. they can't just can’t offer new things without any knowing what i want. many customers (8) made comments on what they saw as a representative of poor staff interactions with customers (ghoshal and westney, 1991). one customer (c11) comment epitomized this aspect as a staff member who ...he used outdated information… there were expectations for getting involved in trying to understand what the bank could offer. instead i was appalled at the childish way they treated you. this affected customers perception as another customer (c2) indicated ...it made me take the bank less seriously. another customer (c13) comment characterised poor customer interactions as …being boring monotone, and telling, rather than explaining. unfortunately, some of the staff behaved this way – with a rather superior attitude. this had obviously created issues with customers as a number reported that they just stopped the process and left to talk to someone in another branch – and in one customer’s (c17) view – i’m never going back again. these concerns illustrate the fragility of customer relations during the initial stages of customer involvement with the bank (rowley, 2000). 6.2 what is the impact of bank-customer service response? this is informed by key theme 3 (technology/media); and key theme 5 (customer related) 6.2.1 key theme 3 technology/media media/marketing practices many customers (9) enthused that the literature provided was helpful and presented enough detail for understanding the bank’s products – and in a majority of these customers (7) – as depicted by one customer (c11) ...too much detail, and too complicated to be of practical use indicating that mahadevan’s (2003) notion that useful data should be shared effectively is a major issue to consider. however, it appears that there were differences between customer service staff and other administrative staff in how they used this media and in the variety of media utilised. other administrative staff appeared to be more structured in their presentation of bank products, whereas customer service predominantly were reported to refer to a variety of products that illustrated alternatives in terms of cost as well as diversity. as one customer (c4) indicated who typified a majority of customers (12) ...customer service staff were more confident with their product presentations. it was as if they were better trained than other staff. they used a variety of tools. they looked like professionals to me. however, a significant minority (7) indicated that the usefulness and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 36 appropriateness of some media were brought into question (underpinning hughes, 2002) which purports that new opportunities are evolving for customer relationships to be nurtured as some were never used or were considered by customers as superficial and superfluous to their needs, such as calculators and loan payback sheets. moreover, customers perceived that the appropriateness of the overall media package received was becoming less relevant to their needs illustrating the impact of ethnocentrism (kaynak and kara, 2002) as depicted by one customer (c8) ...i question the volume and coverage of materials given as explanations to products as i am concerned that the material is too complex for me so how can i assess them properly? another example, linked to customers (7) appeared to want more useful product as one customer (c2) commented ...the service representative of [bank] was dwelling on outdated, more expensive and less flexible products and was noticeably behind the times. on this, another customer (c13) attested that they needed ...more focused and useful products for different lifestyles… ...and thus there was less choice available due to a lack of competition. this appears to support rust and zahorik (1993) in terms of attempts at customer retention. 6.2.2 key theme 5 customer related bank recommendations many customers (8) appear to want to recommend the bank to close colleagues or even sub-ordinates of theirs now realise that brand management and brand image (nicholls et al., 1995) requires careful consideration (park, jaworski and macinnis, 1986). for example, one customer (c1) indicated ...when we’re happy we tell other people, y’know who are close to us. although, a small minority of customers (5) signified their reservations related to the management of the bank through lack of trust or commitment (morgan and hunt, 1994) and how the staff managed customers as depicted by one customer (c16) who stated that ...our family has a lot of money here, and i lost money on investments. it is just not fair. we trust them and they do this to us. further, a significant minority of customers (9) as illustrated by one customer who indicated that they were ...expected to bank with a particular bank because of work requirements. this is not good at all. not good... this suggested that some customers had little choice about what bank they went to and therefore the service they could expect and that this may be a weakness in some bank brand management (abele, wright and starkey, 2003b). customer expectations – a significant minority of customers (7) reported that they had expectations on how they would participate in the services that the bank provided. for example, one customer indicated (c12) that because ...some staff were given the authority to make certain decisions that have had a negative effect on us using the bank. for example, another customer (c5) suggested that ...the choice of credit card and the level of credit were determined by bank staff... which perhaps reflected some inflexibility in the administrative arrangements of the banking process rather than towards meeting customer needs. this outcome corroborates the work of malhotra et al (2005). further, another customer (c17) suggested that ...customers can have all the expectations they want, but the bank is there to make money, so they will try to give customers the best deal possible, as long as the risk is manageable and that the bank gets their cut. when applying the disconfirmation paradigm developed by parasuraman et al. (1988) it can be concluded that customers in this study tend not be a satisfied group. nor was there any evidence of delighted customers, a term first asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 37 coined by oliver, rust and varki (1997) describing customers whose expectations are exceeded by their banking experiences. customer orientation a small minority of customers (7) appeared to consider that the bank was administratively oriented, rather than customer oriented (sturdy, 2000) with management appearing to concern themselves with bank administrative quality and product/information quality (dwyer, schurr, and oh, 1987). this was typified through one customer’s viewpoint (c11) that indicated …we had to follow the bank procedure exactly. and when we got it wrong we had fill another form in this was ridiculous. it was anticipated by some customers (4) that banks should have changed over the past five years as indicated by one customer (c2) who stated …you’d think that they would have got it right by now. all that money in changing how the bank looks and they still can’t remember my name! the evidence from customers does not appear to support the view of banks as supportive nor as customer oriented as required (jayawardhena and foley, 2000); rubin, 1995). customer needs – whilst the evidence indicated that some bank staff meets customer’s needs by attempting to be responsive and outward customer orientation, a significant minority of customers (9) suggested that most bank staff did not (supporting axson’s 1992, notion of a major gulf in views between the bank and the customer) as typified by one customer (c14) who indicated …i can’t remember when they [bank staff] went out of their way to help you. again, when applying the disconfirmation paradigm developed by parasuraman et al. (1988) it follows those customers in this study may not be a fully satisfied group. the findings revealed that service evaluation mechanisms do not appear to be trusted (merrilees and fry, 2003) or understood effectively by customers and therefore levels of customer anxiety appears to be high. as one customer (c8) suggests …if we give them negative evaluations it may affect my credit standing or my brothers or sons. so i won’t take the risk. this appears to support the outcomes of darby and karni (1973) in a study of the effects of customer misinformation. consequently, this may be an issue of concern for the bank management. further, the notion of trust between staff and customers appears to be deficient as the relational exchange between service providers and customers, is not simply a series of independent transactions (e.g. berry, 1983; and jackson, 1985) leading to the desired level of customer satisfaction (geyskens, steenkamp and kumar, 1999). as such the evidence points to a customer need to develop a relationship that is likely to rely on such issues as trust, equity, responsibility, and commitment confirming the work of gundlach and murphy (1993). customer expectations and bank customer orientation appear from the evidence to indicate a wide gap between both realities and this corresponds with the findings from the possible lack of visibility in the banks understanding of customer needs (based on dick and basu, 1994). for example, one customer (c5) who typifies a large portion of the sample (12) suggested that …if the bank will only listen to us, i know they will benefit financially in the end. consequently, further research is needed to explore the reasons for such differences and the possibilities surrounding the closure of customer expectations and bank customer orientations (aaker, 1995). this appears to support the work of donthu and yoo (1998) who argued that cultural influences on service quality expectations are profound and consequently, the result asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 38 here leads to the suggestion that bank strategies affecting service quality must address what customers expect. the bank would appear to view customers as necessary, but not the focus for bank processes. consequently, at issue is the development of a consumer orientation in which to build more effective measures to communicate with the consumer. retaining customers has therefore become even more important, as well as more intensified efforts at customer relations (based on leung, 1997). 6.3 what is the character of bank-customer service interaction? this is informed by key theme 4 (product related) 6.3.1 key theme 4 product related product material – only a small number of customers (4) appeared to indicate that the material provided to customers was standardized and yet supportive and flexible (polonsky, suchard and scott, 1999) in terms of the advice and information provided and thus krepapa et al. (2003) are justified in claiming that management should be able to think in terms of identifying unmet customer needs through the media. as one customer (c1) suggested …yes, they do provide sufficient material, but sometimes it is out of date. in contrast, another customer (c6) indicated ...the material is not very good. it does not provide us with all that we need to know in order to make useful financial decisions – but then aren’t they all like that? however, other customers (8) failed to link the banks web-site with printed material, as one customer (c14) depicted …oh the net is different. it’s not paper is it. you can’t take it to the bank and say this is what you stated. this indicated that some customers may not be experienced enough to assess the effect of the internet on bank operations, or that customers do not trust the bank unless it is directly from them in writing. this appears to confirm one of the outcomes found by rotchanakitumnuai and speece (2003); and verhoef, reinartz and krafft (2010). service promise – a significant majority of customers (11) indicated that they had experienced a failure in the service promise (supporting grönroos, 1996) and that this was not an isolated event – meaning that this occurred more than once. for example, one customer (c18) stated that …opening hours are often changed without notice and contrary to those that are indicated in the brochure. they don’t seem to consider us customers suggesting that the outcomes from howcroft and durkin (2000) may have not been headed as customer interaction is an important facet of bank management. another customer (c15) suggested ...the bank says that it will transfer a fixed amount every month to my other account; but often the bank sends it twice or even not at all. we don’t trust them – even when they state it in writing. i mean, they put it in writing that no matter what process errors occur – it is always the customers fault! that’s not good, is it? this appears to illustrate the well accepted notion of parasuraman, ziethaml and berry (1985) in that central to the nature of service quality is the dissatisfaction gap between what the company promises (carlzon, 1987) and what is received and delivered to the customer (harrel and fors, 1995). customers appeared to indicate that the material provided to customers was standardized and yet supportive and flexible in terms of the advice and information provided. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 39 7. summary of outcomes a model of outcomes, the relationships to the research questions and perceived client experiences can be seen in figure 1, below (as taken from table 2). the model illustrates the conceptual development, relationships perceived to correspond to each research question and how they influence the bank service perceptions. figure 1. relationships to the research questions and perceived client experiences 8. conclusion clearly, from the evidence presented here, thai banks may need to re-examine their broader service development and implementation processes if they are to address the issues surrounding the management of the bank-customer relationship – mirroring the outcomes found by nunaz and yulinsky (2005). the evidence presented here suggests that customers have established views about what constitutes good practice when bank staff interacts with them. it is, therefore, of importance for banks to explore the reasons for bank customers in thailand in order to ensure that customer views are taken into consideration (azvine and nikravesh, 2002) when developing new bank products, changing the banking system through responses to competitive forces and highlighting the increasing importance of the understanding changing consumer behaviour and attitudes (byers and lederer, 2001) in thailand’s financial industries. staff appeared to have difficulty in dealing effectively with customers in a way that helped reduce the perceived bureaucracy from bank processes (following on from winsted, 1997a). this will lead to more capable staff and providing significantly greater and more useful information based on customer preferences (azvine and nikravesh, 2002). in regard to any generalisations that can be made from the outcomes of this paper, it must be understood that this study was a small-scale study and that care must be used not to extend the meanings and reported experiences out of the bank interview context. in this respect, much more research asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 40 must still be carried out, possibly to widen the scope to include all banks in thailand. the limitations of such a small study should be noted. these results may be considered adequate for exploratory analysis only and a larger, more involved study is needed to validate the present study. furthermore, very few empirical studies have been carried out in thailand that investigate the customer, service design elements, service delivery elements and post-service management factors/issues, which contribute to the establishment and strengthening of relationships between customers and banks. in this respect, future research needs to be aimed at attempts to understand an increasingly complex and challenging banking sector situation. references aaker, d. a. 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(1990). delivering quality service. balancing customer perceptions and expectations. the free press, new york, ny, us. microsoft word state of information-writer2-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 125 state of information technology auditing in botswana nugi nkwe dept. of accounting and finance, university of botswana private bag ub00701, gaborone, botswana tel: 267-355-4065 e-mail: nugi.nkwe@mopipi.ub.bw received: august 19, 2011 accepted: november 24, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.894 url: http://dx.doi.org/10.5296/ajfa.v3i1.894 abstract this article summaries the state of information technology auditing in botswana. it looks at the adoption rate of it and challenges and successes of it auditing and how it has changed auditing in botswana. a number of developing countries are adopting information technology (it) and this is happening at fast pace but problems which are coupled with it are not fully addressed. one of the areas which are still lagging behind is information technology auditing. a lot of researchers have found that information technology is the best technology to have come to this world but it has brought certain ills with it. to try and curb these ills, information technology auditing is a major area to be considered. botswana has to act quickly and adopt information technology. keywords: accounting, information technology, information technology auditing, botswana asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 126 1. introduction many companies the world over are aware of the benefits of information technology auditing which results in efficiency and profitability. botswana is in line with other countries who have embraced information communications technology (ict) and information technology auditing (it auditing) is emerging lately due to the embracement of ict. the government of botswana has invested and still to invest more in ict infrastructure. the government intentions are captured clearly in the vision 2016, through its pillar “educated and informed society”. ict has had a radical impact on businesses and governments; governments are going the e-government route, banking sector is adopting internet banking and mobile banking and universities are going the e-learning route .all this new developments need to be closely managed and controls which are fit to each have to be identified and be in place. different organizations and industries face different ict problems. institutions such as botswana information technology society (bits), institute of auditors botswana (iia), botswana institute of accountants and others are starting to brainstorm solutions to curb emerging problems brought by ict. from accountants perspective ict has brought new ways of going through a transaction which does not only involve figures, sometimes it goes way into technology and most of the time the accountants are lost on the way. from technology point of view, emerging technologies have made it even more complex for it personnel to keep track of their assets and resources. measuring performance and efficiency of it assets and resources is gradually approaching zero. crime perpetrated using computers is on the rise and it personnel need to make sure their instruments work well and to the best interest of the business and not aliens. in today’s business environment, technology is critical to the smooth running and operations of any company. for that reason, kpmg (2009) believes that it audit is an essential component of overall audit activity. all too often, however, audit departments operate in ‘silos’ where it audit is undertaken in isolation from other audit activity and, indeed, other it assurance activity. for a wholly independent and impartial view, we believe that it audit should be delivered as part of an audit, involving the wider audit team and, where appropriate, other specialists .in the current information society, ict and auditing are intertwined or heavy coupled. the intertwine of the two is brought by the fact that it is responsible for designing, implementing and maintaining many controls over an organization’s business processes .it has a critical role in collecting, processing and sorting data that is summarized and reported in financial statements (canon and crowe, 2004, p.31). (“new developments in auditing”2010) pointed out that the government of botswana is faced with a mammoth task of increasing information technology and accountants personnel who are currently labeled as scarce skills. the two disciplines are essential for it auditing maturity more especially in the current turbulent times. 2. accountancy and auditing in botswana auditing is one of the oldest professions in the world, as put by richard brown (1905, quoted in mautz &sharaf, 1961) as follows: asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 127 “the origin of auditing goes back to times scarcely less remote than that of accounting…whenever the advance of civilization brought about the necessity of one man being intrusted to some extent with the property of another, the advisability of some kind of check upon the fidelity of the former would become apparent.” for all these years, auditing is forced to adapt to the changing environment within the accounting sphere.iia (2010) found some of the changes as follows: • 1999: “bull market” and y2k • 2001: terrorism, bcp, and disaster recovery • 2002: enron, worldcom, and financial scandals • 2002-2003: sarbanes-oxley and pcaob • 2004-2007: sox, sox, and sox • 2008: implosion of the economy • 2009: economic crisis; realignment of coverage botswana too recognize the need to have auditors, the president of iia-botswana lesetedi lesetedi has said that internal auditors compromise a critical component of good governance essential for efficient operations and internal control of an organization. chief internal auditor at burs said integral audits determine the information reliability, compliance, assets security, economic prudence and well defined goals within organization (the voice, 2007). in botswana, accountants act was formulated in 1988(bia report 2009).auditing cannot be traced far back but since its adoption it has grown tremendously. mr duncan majinda, ceo of bia on his interview (mmegi, 2010) stated that botswana will implement two acts; accountants act and financial reporting act. accountants act (revised) had to be reviewed due to the fact that it had become archaic and out of line with modern running of the profession while the financial reporting act (new)establishes a botswana accounting authority oversight as the umbrella body of the profession, it will be the regulator of the profession . the former minister of finance, mr gaolatlhe in his speech(2008) said, ministry in conjunction with the institute of internal auditors (iia) botswana has fully embraced his excellency the president, lt. general seretse khama ian khama’s principles referred to as the 4d s, namely democracy, development, dignity and discipline. as democracy is an important cornerstone of good governance and prudent economic management, so is internal audit as it is one of the four pillars of good corporate governance. therefore internal audit would want to see affairs of corporate entities run in a democratic and transparent manner where there are consultations with all stakeholders. auditing firms and the government undertake different types of audits e.g. statutory audit nonstatutory audit, external audit, internal audit, final audit, social audit, performance audit, even though the frequency is dependent on each. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 128 3. information technology in botswana information technology (it) can be defined as phrase that covers all forms of technology that are used to create, store and distribute information in all its formats, mostly using computers.”according to ndcc 54.59.01 information technology means the use of hardware, software, services and supporting infrastructure to manage and deliver information using voice, data and video”. diffusion of it in botswana is growing at a fast rate and this is captured clearly by mutula & jain(2001), in recognition of the opportunities and challenges occasioned by it, member states of the southern african development community (sadc) in 1999 identified areas that needed to be addressed for the region to realize an information society. among key areas identified were: improving and broadening equitable access to information and communications technology (ict); reducing costs related to it; developing an sadc-wide infrastructure; encouraging the growth of software and hardware development facilities; and improving human resource capacity. the importance of policies related to national information and communication infrastructures a favorable regulatory environment, the liberalization of the telecommunication sector and the strengthening of the education sector was also emphasized (sadc secretariat, 1999) botswana has set measures to increase diffusion of it. some of the strategies adopted by the government are national ict policy –vision 2016, national ict policy -ministry charter and others. 3.1 national ict policy-vision 2016 the vision 2016 is a policy that is aimed at trying to bring botswana to an information society. the policy is advocating for availability of ict equipment, access to ict resources (telephones, radio and tv services) and others. there is a dedicated policy within vision 2016, addressing it and this is information technology policy which is detailed in national development plan (ndp9). 3.2 national ict policy-ministry charter the government through its ministries has spent and continues to spend on technology. the government is embracing technology as an efficiency tool ( iyanda & ojo,2008).the ministry charter is tasked with enhancement of research ,science and technology and improve the quality of and access to mass media services in botswana. according to botswana government, 2004 p1.3bn (us$200m) was allocated for technology programs in the ndp 9 through several ministries. in 2004, the ministry’s budget was p144million (budget speech 2003). 3.3 ict adoption and usage most businesses use the internet primarily for collaboration purposes (sairosse & mutula, 2004). the government is the biggest consumer of ict and government use of it is asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 129 particularly visible through the central government site and use of ict in the control of national income and expenditure sources (uzoka & ndzinge, 2009) the rankings of e-readiness survey have become an established benchmark for countries seeking to harness the information system’s potential to drive business efficiency, improve the provision of public services and encourage the integration of local economies with the global economy (lane et al., 2004). botswana was ranked 3rd in the networked readiness index (nri) in africa in 2003 and 2004. globally, botswana ranked 55 in 2003 and 50 in 2004 (bitz et al., 2006). however, the 2008 ranking places botswana in the 5th position among african countries and 78th position globally (the economist intelligence unit limited, 2008). 4. impact of it on auditing technologies such as electronic data interchange (edi), image processing, and electronic file transfer (eft) will make traditional audit trails disappear. these technologies will greatly change the nature of the audit process, which traditionally has relied on source documents in paper form. to audit on-line systems, auditors will have to incorporate on-line audit software as their primary audit tool and gather evidence electronically. the use of such technology will free the auditor from many mundane audit tasks and allow the auditor to use this time for higher level tasks, such as understanding the client's business and assessing various risks (bierstaker, burnaby & thibodeau, 2001).university of botswana and other institutions which produce accounting and information systems students are faced with a great challenge of producing students who can cope with the ever changing accounting, auditing and technology landscape. 5. information technology auditing information technology auditing (it auditing) began as electronic data process (edp) auditing and developed largely as a result of the rise in technology in accounting systems, the need for it control, and the impact of computers on the ability to perform attestation services. the last few years have been an exciting time in the world of it auditing as a result of the accounting scandals and increased regulation. it auditing has had a relatively short yet rich history when compared to auditing as a whole and remains an ever changing field (wikipedia encyclopedia) according to wasik (1991) and christy (1995), cais or information technology (it)based accounting systems are more easily manipulated fraudulently than manual accounting systems especially in advanced systems. businesses in botswana have introduced a couple of it-based systems and they depend a lot on them. this is a great risk, it auditing in botswana is still at its infancy stage. big auditing firms in botswana like kpmg, enerst & young and deloitte are still working hard to establish it auditing departments in their firms. the institute of internal auditors botswana, are also looking at the situation, mr maboane ,iiab public affairs officer stated that the institute is looking for ways to improve the adoption of it auditing in botswana. currently the adoption is at a worrisome pace. the situation is not only lacking on the industry side even academically there is not enough research on the area asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 130 of it auditing in botswana. is audit’s relationship to financial auditing has been described as changing from being a “fly on the back of a giant gorilla” ten years ago, to “driving” the audit today, to “taking over” the audit within the next five years (bagranoff & vendrzyk,2000).botswana too, is suppose to move in the same direction as other countries and adopt it auditing. 6. drivers auditing is one of the areas that are highly dynamic. the environment and other factors dictate the way auditing is carried out. hinson (2007) stated that there are four main areas which drive it auditing; political, economic, social and technical aspects. political although accounting laws have mandated audits of corporate finances by independent, qualified auditors for many years, we are gradually witnessing the introduction of laws and regulations requiring auditors to review computer systems, information processing, and other aspects such as corporate governance, health and safety, and so on. professional standards are being documented and recommended for computer and other auditors by isaca, iia, aicpa, and similar organizations. economic as the development and implementation of it has progressed incessantly since the 1940/50s, information processing has become absolutely essential to most modern organizations, hence risks to information assets are more important than ever. stakeholders and managers are looking to assess and manage their information risks and so are turning to specialist it auditors for their independent, competent assessment of it-related risks. social there are many professional groups of it auditors, collectively comprising a relatively supportive and close-knit community within the wider worlds of audit, risk/security management, and governance. “bridging” or interpreting between the it and business worlds has been an important role for it auditors, given the number of business people with limited it expertise and vice versa. thankfully, this is becoming less of an issue as it knowledge spreads into the wider business and it people are increasingly taking business/management qualifications. technical the advance of it and telecommunications technologies creates a never-ending stream of issues of concern to it auditors, while at the same time it is a source of new tools and techniques to do our jobs more effectively. the internet is a good example: ebusiness and internet connectivity substantially changes the organization’s information security challenges, and provides it auditors with access to a global knowledge base on auditing, technology, risk, control, security, governance, and every other topic imaginable. hinson 2007: pest analysis asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 131 there is growth in the use of it in different sectors: individual, business access and government access. the growth in adoption of it is major stimulus for adoption of it auditing. individuals are accessing internet a lot these days, visiting sites such as facebook and other social networksites. businesses are moving towards e-business. business to business transactions is predominantly online such as orders and payments. government is adopting new forms of availing services to the public. the services are mostly computer based. 6.1 e-government: botswana is investing heavily on e-government. there is an increasing interest in the use of e-services by the public. the government has a website which provides a lot of information on different aspects of botswana; on the website one can download the requirements and application forms for visa without being in physical contact with the department of immigration. major projects to facilitate e-government are under construction within several government’s ministries and departments. for example: department of town and regional planning (dtrp), has spent over p 30million to date on the development of planning portal (ditogamaano 2008). the portal was to necessitate digital planning of the country. t he public can have information at the figure tips availed by the portal .information such as trends in change of use, allocations and others will be readily available. national id system: botswana was the first in the sadc region to develop a national id system with automatic fingerprints identification system (afis).the card called “omang” (high tech security solutions, august 1999). e-passport: the introduction of the new passport with new technologically advanced features is one way of the government to try and bring botswana up to par with other countries. the features found in the new passport will allow the department of immigration to be effective and efficient. the goal is to have a linkage with other government’s department s. e-license: motor vehicle license is another area the government is trying to improve. the public used to have a lot of grievances regarding the old paper passed licensing system. the problems spanned areas such as replacements and others. with the aid of computers, replacements and renewals are a piece of cake. the intention is to have the three; passport, license and identity card link together to avoid capturing data at different sources. as hammer (1990) stated that capturing data at multiple sources may result in redundancy and multiple versions of the truth. the government’s e-governance intentions are clear thus the same should be extended to it auditing. all the above efforts will results in crimes such as identity thefts and others, it auditing is unavoidable as part of e-government’s initiatives. there are a lot of e-government initiatives which are ongoing such as tribal land management systems and state land management system under the ministry of lands and housing. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 132 6.2 e-health the government has started to partner with developed countries to get assistance on e-health. projects on e-health require a lot of financial and human capital investments. in 2008 the government of india and botswana went into partnership which resulted in botswana receiving sophisticated e-health machines from india. the machines will enable doctors in india to consult and diagnose patients in botswana without having to travel (bopa 2008).with the current issues affecting health sector, audits cannot be left out of the health industry. 6.3 eeducation a lot of efforts have been channeled towards e-learning. there is a national e-learning committee tasked with formulating and promotion of e-learning in botswana. the ministry of education is trying to encourage its partners to look at e-learning as one of the possible teaching modes in botswana.the university of botswana just completed a strategy on digital scholarship which focuses on embracing digital scholarship. the university went further and is working on strategy for e-learning which will be a great driver in the area of e-learning. there are a number of institutions which have adopted e-learning, for example bocodol, niit and others. 6.4 e-business internet access and web presence are growing rapidly in botswana and this say the same about commercial sites across banks, tour companies, insurance firms, airlines and others. most businesses are providing their employees with internet and email access at their desks, homes and mobile devices. a lot of e-business in botswana involves the banking industry. majority of banks in botswana see e-business as an opportunity and competitive edge.fnb in botswana was the first to launch mobile and internet banking and banks such as barclays followed(monitor 2010).banks generally offer the following e-services; electronic fund transfer(eft),electronic banking (ebk),automatic bank teller (atm) and others. other businesses too, have adopted e-business. businesses the world over are practicing different forms of e-business like electronic data interchange(edi),electronic advertising, electronic consulting, electronic mail, electronic research, electronic conferencing, computerized inventory system(cis) ,electronic order processing(eop) and others. there is also a lot of international trade due to globalization thus a lot of online transactions. 7. challenges it auditing is faced with many challenges, such as human capital, policy, education and others. the starting point is who is to do it audit? the public expects finance auditors to undertake it audit. certified public accountants are increasingly being asked to solve information technology problems for clients and prospective clients, according to the 2010 top technology initiatives survey by the american institute of certified public accountants. even within the audit profession, the challenge is huge as to who owns it auditing and line of asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 133 management. it and finance auditors each feel they should own the new specialism of auditing. the line of management is another burning issue, finance managers feel the reporting should be with them while it managers feel otherwise. both groups overwhelmingly agree that is audit is becoming more important. however, financial auditors describe the current and future relationship between the two practices differently. financial auditors are more likely to indicate that the financial audit will continue to dominate the is audit. is auditors see a growing is dominance over the financial audit (vendrzyk &bagranoff, 2003). during the past decade, is audit has changed from being a small support piece of the financial audit to being a driving force in the overall public audit (bagranoff & vendrzyk, 2000). since it auditing is new in botswana and elsewhere in africa, there is still a vacuum in terms of professional and tertiary education. there are professional courses such as cisa and cism which are common and available at different learning institutions but in botswana the opposite is true thus a major challenge. tertiary institutions in botswana do not have a well structured programme, at certificate or degree level or even a specialization in it auditing. it auditing as area of research is still an untapped in botswana. this is another challenge; there is no literature either scholarly or otherwise on this topic. this is a major setback contributing to the slow growth of this discipline. areas of specialization such as purchasing and supply, ccna, mcse and others were quick to break into the market but it auditing is still struggling. companies are still reluctant or have not been convinced by it auditing. the low level of adoption is seen somehow with students too. students, however, were ambivalent in their opinions concerning two aspects of a career in auditing. these were reflected in their responses to statements concerning whether or not they would like the life beyond the job and the perceived time and effort needed to prepare for an occupation in this field( yavas & arsan,1996). technology assumes the role of a double sided sword when dealing with issues of it auditing, challenge and driver. it auditing involves a lot of technology as enabler. there are many technologies used for finance and it auditing, and they keep changing. it is a challenge for it auditor to keep up with the changing technology. the other challenge faced by it auditing is perception. “when we start an audit they look so unhappy to see us. hey, we are doing our job as internal auditors; the other teams do not have any right to treat us badly” said by ravi an internal audit manager. auditors are perceived as opinionated, argumentative, autocratic, bureaucratic, insensitive, callous, political, critical, impolite, or bully. unfortunately, it auditors are painted with the same brush thus a challenge for them. 8. successes the success of auditing in botswana is still to be documented .this is due to the fact that it auditing is a new discipline. most of the success can be traced to the benefits, most companies are enjoying the benefits of good it auditing such as a good system which is a product of well planned and audited system. companies across the world have done a lot of asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 134 it audits and these have helped them to exist. a number of banks in botswana have managed to identify fraudulent activities and dealt with them accordingly.fnb have put controls in place and in use to mitigate the risks associated with online services and these have worked.(fnb website) stanbic bank too has upped its game, they have introduced mastercard securecode as control to improve security, and this was a result of through it auditing.(stanbic website) botswana police pr officer christopher mbulawa said that the police service works with interpol on matters of cross-border crime. "where something may be going on that we do not yet know of, interpol are our eyes internationally. they contact us in cases where criminals are involved in international schemes”. botswana through interpol they have managed to do audits and identify and investigate certain crimes perpetrated using computers (mmegi, 2010). internationally too, i t auditing has been successful: the founder of indian outsourcing giant satyam appeared in court in a billion-dollar corporate fraud case dubbed “india’s enron. as a result of auditing it was found that in january 2009 he had falsified profits plunging the indian business world into turmoil (hyderabad, india (afp 2010)). 9. implications it auditing adoption is an indication of some form of readiness of a business or country to take part in global trade. from the point of view of it and business ,the importance of global trade needs to be emphasized .the rapid growth of it has forced a lot of countries to attain some measure of it auditing. countries look at it auditing as away and enabler of global trade, where all businesses regardless of geographical location can share and utilize information. adoption of it auditing will educate the business community on how it audit can add value to an organization. botswana as a developing country, the government and community appreciate it and this has brought problems. it audits if done well, will identify, and assess design of controls and then test the effectiveness of the controls .a company or country that has attained a certain level on fore-mentioned areas will be better placed to carry out business with less risk. audits are needed for assurance and internal controls. as organizations make huge investments in technology, it auditing can provide the assurance that huge losses are not just around the corner. organisations in botswana are to benefit a lot from it audits. when planned and executed based on best practices will cover risks associated with confidentiality, integrity and availability of information technology infrastructure and resources. there are also risks related to the effectiveness, efficiency and reliability of it (computers and technology 2010).most companies in botswana still miss the fact that it risk is business risk. threats and vulnerabilities in it operations can directly affect an entire organization. with the recent cases involving fraud and cyber crime, international organizations and governments are looking at ways to curb these ills. there are standards, regulations and asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 135 policies governing the way companies do business. for companies to trade, they have to meet regulatory or compliance requirements before they can trade. scandals such as the enron’s, aig and others have driven the surfacing of it auditing. nowadays a lot of us and international requirements such as sarbanes oxley are gaining ground. it auditors provide the assurance that such requirements are met. one area that is neglected is communication. communication can break or make a company. it auditing facilitates communication between business and technology management. as auditors carry out their procedures, such as observing, interviewing and testing result in valuable information in written reports and oral presentations and managers can pick a lot of information from there (computers and technology 2010).the reverse communication from senior management to the technology professionals is also critical. it auditing is major tool for it governance. the objectives of it governance which are it is aligned with the business, it enables the business and maximizes benefits, it resources are used responsibly, it risks are managed appropriately. it auditors are involved in getting assurance that each of these objectives is realized. 10. the way forward auditing in general has received mixed reviews in light of last year's series of corporate failures. although internal auditors have not been specifically implicated in any of the recent financial-reporting incidents, these events have nonetheless put somewhat of a damper on our reputation in the minds of clients and the general public. and, although more and more people are beginning to appreciate the value of internal auditing in helping to prevent future enrons and maintain good governance, the profession could still benefit from -and is perhaps long overdue for -an image makeover. (williams, 2003) the government has a major role in enabling environment for it auditing adoption in botswana. the policies of the country must be in line with the new challenges such as cybercrimes and others. unless laws advocate for it auditing, this important area will be unnoticed .the government ministries and departments should be seen as leaders in adoption of it auditing. management support is critical especially for projects requiring considered amount of budget and affecting some operational processes(vasarhelyi and kuenkaikaew, 2009)adoptions such as technology, bpr projects and auditing need top management support .for it auditing to be adopted and have impact on the business, top management should support the initiative. if there is no support, it auditing will be viewed as an enemy by the organization. companies and government top management should come to the party and play a role. it is also necessary that the auditor has access to the systems and data of each auditee (handscombe 2007). such access requires management approval. major issue to be addressed is the employee skill set. it auditing adoption is slow because of not at par skills of employees. this new specialization needs certain skills or combination of two or more existing skills. employees are finding it tough to adapt and training is highly needed. the current crop is made of two extremes: general/finance auditors and it guys. for asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e8 www.macrothink.org/ajfa 136 easy it auditing adoption, employees who have business and it skills are needed. private sector too should assist the government. it auditing if not done well or not at all can haunt the organization for several years. private sector should take part in adoption of it auditing. the sector can educate and improve employee skill sets. solo efforts by the government will not make enough impact. professional (bia, iia and others) and learning institutions should do the cultivating role, they should produce students who are capable to handle the demands of it auditing. universities should review their curriculums to accommodate the new specialism. programmes such as business information systems offered by the university of botswana should have options for students to pursue it auditing as a specialization. professional institutions should encourage their members to take professional courses which are tailored to it auditing such as cisa qualifications. 11. conclusions the adoption level of it auditing across the world and in botswana is encouraging. few companies have adopted this new specialization, they have put policies and frameworks but there are still not enough. for areas like auditing, companies have to go all out to make sure they adopt it auditing in full and not just certain parts. big auditing companies in botswana, like ernest and young, kpmg and others have recently set new units which will be responsible for it auditing. majority of these units are small and without experienced personnel, this impact negatively on the growth of it auditing. auditing companies must seriously consider it auditing and allocate it enough resources such as experts in the area and technology resources. the institute of internal auditors should change some of its policies and frameworks to reflect the new field. there should be advocacy for adoption of it auditing by professional bodies references bagranoff, n., vendrzyk, v. 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(2003).association for integrity in accounting enters the discussion of accounting reforms. the cpa journal, 73(4), 14 yavas, u, & arsan,n. (1996). image of auditing as a field of study and a career among college students, managerial auditing journal, 11(5), 41 – 44. http://dx.doi.org/10.1108/02686909610120523 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 3012-11548-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 365 determinants of commercial bank profitability: south asian evidence shrimal perera monash university, caulfield east, victoria 3145 australia michael skully monash university, caulfield east, victoria 3145 australia zahida chaudhry monash university, caulfield east, victoria 3145 australia received: jan 7, 2013 accepted: march 19, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3012 url: http://dx.doi.org/10.5296/ajfa.v5i1.3012 abstract this study investigates the bank-specific and other determinants of commercial bank profitability in selected south asian countries (bangladesh, india, pakistan and sri lanka). the single-equation, dynamic panel data procedure employed accommodates explicit measures of production efficiency, industry competition, profit persistence and country-specific differences in governance. the findings reveal profit persistence in south asian banking markets. even though increasing competition exerts negative pressure on bank profitability, high industry concentration still allows these banks to earn higher profits. the well-capitalised banks and those with relatively more efficient production processes are the more profitable. south asian banks also seem to experience economies of scale as bank size is positively associated with profitability. the results also indicate that slack legal systems in these countries (leading to inferior contract enforcement) positively affect profits as banks probably require higher risk premiums on their loan contracts. keywords: bank profitability, competition, profit persistence, south asia, banking asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 366 1. introduction south asian financial markets are in transition as deregulation and liberalization measures stimulate and facilitate greater competition, improve operational transparency, streamline regulatory policies and achieve higher efficiency levels (central bank of sri lanka 2009; bangladesh bank 2009). in addition, the south asian association for regional cooperation (saarc) and its south asian free trade agreement (safta) seeks more cross-border trade and competition in financial services. this objective is reinforced further by a range of bilateral trade agreements affording even greater access between south asian financial markets. while these regional efforts concentrated mainly on the local to local access, international players are also gaining greater access through the general agreement on trade in services (gats). the gats require its members ensure ‘level playing fields’ in financial services by removing discriminatory policies against foreign banks, thus further exposing the ‘protected’ south asian domestic banks to new competitive dynamics and banking strategies. moreover, south asian governments must also respond to other regulatory changes within the increasingly ‘globalizing’ financial markets. these include the basel accord capital adequacy requirements, international accounting and auditing standards and practices, and self regulation and market discipline etc. such level of change within the region offers a rich basis for inquiry into the competitive dynamics, efficiency and profitability of south asian banking systems. some prior studies have examined the factors affecting competitive dynamics and bank production efficiency in isolation ignoring their impact on bank earnings and profitability (see, perera, skully and wickremanayake 2006 and perera, skully and wickremanayake 2007). they provide no direct insights, however, into the determinants of south asian bank profitability given changes in bank competition and efficiency. thus, we are motivated to investigate these determinants as only sound and profitable banking sectors can endure negative shocks and contribute to stability of financial systems and economic growth. specifically, the following research question is addressed: what bank-specific and external factors drive south asian bank profitability? our sample comprises of 119 domestic commercial banks in four selected south asian countries (bangladesh, india, pakistan and sri lanka) over 1992–2007 with 1,539 bank-year observations. we utilise a single-equation, dynamic panel data procedure which accommodates explicit measures of production efficiency, industry competition, profit persistence and country-specific differences in governance. we contribute to the literature in several ways. as far as it could be ascertained, this is the first study to accommodate possible profit persistence (given the high level of concentration in south asian banking markets) and for cross-country differences in corruption and rule of law. our model also includes an industry competition measure derived from bank-specific revenue behaviour (panzar-rosse h statistic) to control for competitive dynamics. finally, we utilise an explicit measure of management efficiency in the form of data envelopment analysis (dea) efficiency scores in our analyses. this approach provides more reliable asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 367 management efficiency estimates than the expense ratios of prior bank profitability studies. 2. literature review 2.1 bank-specific determinants the prior bank profitability literature employs bank size, ownership status, bank risk, capital level, and expense management as bank-specific determinants. bank size is generally found to relate positively to profitability (kosmidou 2008). this supports the argument that large banks typically benefit from scale and scope economies and have greater product and loan diversification leading to lower risk profiles. hence, their required rate of return becomes lower which reduces their costs and generates higher profits. large banks may also be able to exert market power through stronger brand image or implicit regulatory (too-big-to-fail) protection. abnormal profits obtained through the exercise of market power in wholesale or capital markets may also contribute to a positive size–profitability relationship (goddard, molyneux and wilson 2004). in contrast, if bank size is a function of ‘empire building’ by managers and/or government-sponsored funding (especially in developing countries like those in south asia), then the resulting diseconomies should lead to a negative association between bank size and profitability. thus, no a priori expectation is formed with regard to bank size in the south asian context. ownership status is primarily concerned with whether a bank is governmentor privately owned. generally, privately-owned firms generate relatively higher profits (see for example, kosmidou, pasiouras and tsaklanganos 2007). this is consistent with the view that government-owned banks may have other than simply profit considerations. it is especially true in developing countries (like those in south asia), where loan distribution is influenced by government directed credit programmes, interest rate ceilings and branching restrictions. thus, we expect the privately-owned south asian banks to be relatively more profitable than their government-owned counterparts. bank risk is conceptualised in the literature using proxies for credit risk and liquidity risk. the former is generally negatively related to profitability since financial institutions exposed to more high-risk loans accumulate more non-performing loans (miller and noulas 1997). with liquidity, since liquid assets have lower risk and generate lower returns, these holdings earn less than could be otherwise gained from higher risk, less liquid assets. in this way, higher level of liquid holdings reduces profits (molyneux and thornton 1992). thus, we expect south asian banks will show a negative relationship between credit risk and bank profitability and a positive relationship between liquidity risk and bank profitability. bank capital level is another important determinant of bank profitability. the well-capitalised banks should attract deposits at lower cost thereby increasing their profitability. this association is reported by several studies (see molyneux and thornton 1992; demirguc-kunt and huizinga 1999; athanasoglou, brissimis and delis 2008). thus, a positive relationship is expected between south asian banks’ capital level and profitability. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 368 the expense management ratios, as proxies for management quality, have also been used in bank profitability studies. athanasoglou, brissimis and delis (2008) separate the total cost of banks (net of interest payments) into operating cost and other expenses (including taxes, depreciation etc.). they argue that only operating expenses are an outcome of bank management. the ratio of these expenses to total assets should be expected to be negatively related to profitability, since their better management may increase efficiency and therefore raise profits. this applies in particular to banking markets (like those in south asia) where personnel expenses are affected by relatively low productivity and the excess capacity of the larger publicly-owned banks. hence, a positive relationship is expected between management efficiency and bank profitability in south asia. 2.2 industry-specific determinants the market structure (and the number and size distribution of competitors) also influences bank profitability. for example, when competition is weak in concentrated markets, firms may acquire monopoly profits by using their market power to charge higher loan prices and offer lower deposit rates. so increased concentration is not the result of managerial efficiency, but rather reflects increasing deviations from competitive market structures, which lead to monopolistic profits. consequently, concentration should be positively related to bank profitability. studies that examine this relationship reach inconsistent results. for example, on the one hand, gilbert’s (1984) review identifies 27 prior studies that provide evidence that banks in highly concentrated markets tend to collude and earn monopoly profits. on the other hand, kosmidou (2008) finds industry concentration to be statistically significant but negatively related to bank profits. their implication is that increased industry concentration leads to slack operational efficiency and so reduced profitability. due to the contradictory evidence, no a priori expectation is formed with regard to the relationship between bank market concentration and profitability. 2.3 country-specific determinants in addition to these bank specific variables, the literature also has identified other factors important in this relationship such as macro-economic variables and the corruption and rule of law indicators. the macro-economic variables employed (the inflation rate, the long-term interest rate and/or the growth rate of money supply) were found to have a positive relationship with bank profitability (molyneux and thornton 1992). with regard to the corruption and rule of law, banks operating in environments characterised by high levels of law and order and corruption controls earned lower interest margins possibly reflecting lower risk premiums required on bank lending (demirguc-kunt and huizinga 1999). in the south asian context, the expected relationships between macroeconomic variables and bank profitability and law and order/corruption controls and profitability should be consistent with the existing evidence. 3. data and method this study utilises unconsolidated, bank-specific annual data of 119 domestic commercial banks operating in four south asian countries (bangladesh, india pakistan, sri lanka). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 369 unconsolidated data is preferred over the consolidated data as the latter includes revenue and costs from non-bank subsidiaries of bank holding companies. sample and sample period are constrained by the data availability. for example, other south asian countries bhutan, maldives and nepal are excluded due to data limitations. other types of banks, such as investment banks, saving banks, cooperatives banks and non-bank financial intermediaries (insurance companies, mortgage houses etc.) are excluded as their regulatory requirements differ from those for commercial banks. the primary source of bank-specific annual data is the bankscope database. data for corruption control and law and order are obtained from the governance indicators published in a world bank’s policy research paper by kaufmann, kraay and mastruzzi (2007). these aggregate indicators are based on hundreds of specific and disaggregated individual variables measuring various dimensions of governance, taken from 33 data sources provided by 30 different organizations. the data reflect the views on governance of public sector, private sector and ngo experts, as well as thousands of citizen and firm survey respondents worldwide. as explained later in this section, competition indicators (the h statistics and the herfindahl-hirschman index (hhi) values) and bank-specific efficiency measures (based on data envelopment analysis (dea)) are computed by the authors. with regard to sampling procedure, a comprehensive list of 198 licensed commercial banks was initially obtained from the central bank annual reports of bangladesh, india, pakistan and sri lanka. (a summary of the sampling procedure is given in table 1). these were then searched in the bankscope database for bank-specific information. due to data limitations, 70 foreign bank subsidiaries and branches and 8 domestic commercial banks (5 bangladeshi, 3 pakistani and 1 indian) were eliminated resulting in 119 banks. this represents the overall domestic banking markets of the four countries with 94 percent coverage. of the 119 bank final sample, there are 29 bangladeshi, 58 indian, 21 pakistani and 11 sri lankan banks. the high proportion of indian banks reflects the large number of domestic banks in india. table 1. sampling procedure and sample size description no. licensed commercial banks in bangladesh, india, pakistan and sri lanka (july 2008) exclude: foreign subsidiaries and branches (annual statements not published) 198 70 total number of domestic commercial banks exclude: banks not covered in the bankscope database 128 9 final sample (number of banks) total bank-year observations over 1992-2007 119 1,539 the sample’s coverage of each banking market (based on ratio of total assets of sample banks to total assets of the banking sector) is shown in table 2 and varies from a low of 60 percent in pakistan to a high of 83 percent in sri lanka. in terms of ownership, 69 percent of the sample is private-owned and 31 percent is government-owned. there are 76 listed and 44 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 370 non-listed banks in the sample. with regard to number of observations, the final sample consists of 1,539 bank-year observations over 1992-2007. table 2. domicile of sample banks and composition bangladesh india pakistan sri lanka no. of sample banks relative to total domestic banks (%) 85.3 98.3 87.5 100 of sample banks state-owned 4 27 3 2 private-owned 25 31 18 9 listed 15 39 16 6 non-listed 14 19 5 5 share of assets (%)a 70 69 60 83 a ratio of total assets of sample banks to total assets of the banking sector. sources: bankscope data base, annual reports from respective central banks this study specifies a single-equation dynamic panel model which controls for competitive dynamics in the south asian banking markets and country-specific differences in regulatory and governance structures. the generalized method of moments (gmm) estimators help to account for possible correlations among independent variables (baltagi 2001; athanasoglou, brissimis and delis 2008). the general model used takes the following form: = c + + + + + , ε = v + u , (1) where i denotes banks, t time, j countries, x’ bank-specific factors, y industry structure, zm macroeconomic factors and d a vector of time dummies. π is the profitability of bank, ε is the disturbance, with ν the unobserved bank-specific effect and u the idiosyncratic error. this is a one-way error component regression model, where νi ~ iin(0, σ2 ν ) and independent of iin(0, σ2 ν ). bank profits show a tendency to persist over time reflecting impediments to market competition, informational opacity and/or sensitivity to regional/macroeconomic shocks to the extent that these are serially correlated (berger et al. 2000). hence, a dynamic specification of equation 1 is utilised by including a lagged dependent variable among the regressors to account for profit persistency as follows: = c + , + + + + + , (2) where πi¸t-1 is the one-period lagged profitability and δ is the speed of adjustment to equilibrium. if δ takes a value close to 0, it means that industry has high speed of adjustment to equilibrium while a value of δ close to 1 implies very slow adjustment to equilibrium. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 371 for empirical investigation, equation (2) is expanded as follows: = c + , + + + + + ++ + + ∑ + , (3) where subscript roaa denotes bank profitability, eq bank equity capital, risk bank liquidity ratio, eff technical efficiency, tassets bank size, comp industry competition, rol rule of law, corr control of corruption and tax represents tax rate. these variable definitions, summarised in table 3, are now each discussed separately. table 3. variable definitions variables definitions supporting literature roaa the return on average total assets pasiouras and kosmidou (2007); athanasoglou, brissimis and delis (2008) eq equity per dollar of total assets molyneux and thornton (1992); pasiouras and kosmidou (2007); athanasoglou, brissimis and delis (2008) risk loans per dollar of deposits and short-term funds pasiouras and kosmidou (2007); kosmidou (2008) eff dea technical efficiency scores charnes et al., (1978); nakane and weintraub (2005); yi-hsing et al., 2007 comp h statistic / herfindahl-hirschman index (hhi) panzar and rosse (1987); bikker and haaf (2002) rol the rule of law index kaufmann, kraay and mastruzzi (2007) corr the control of corruption index kaufmann, kraay and mastruzzi (2007) tax tax paid on profit before tax demirguc-kunt and huizinga (1999) with regard to the independent variable, i.e., roaa, we employ average value of assets rather than end-year values in order to avoid possible use of window dressing techniques as profits are a flow variable generated during the year. the use of average assets values is found to be more reliable measure of profitability as it captures any differences that occurred in assets during the fiscal year (athanasoglou, brissimis and delis 2008). the ratio of equity to total assets (eq in equation 3) is used as the proxy for a bank’s capital strength. banks with higher capital-assets ratios have low levels of leverage and therefore, less risk. this reduces cost of capital for the bank and increases its profitability. hence, a positive coefficient for eq variable is expected. the ratio of loans to deposits and short term funding (risk in equation 3) is used as the proxy for banking risk (pasiouras and kosmidou 2007 and kosmidou 2008). in fact, this ratio captures both credit risk and liquidity risk and affects profitability in multiple ways. for asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 372 example, higher values for loans to deposits and short term funding ratio signify (1) more funds invested in earning assets and higher expected profitability, (2) lower holdings of liquid assets and lower expected profitability due to increased costs of purchased funds as an alternative, and (3) lower profitability due to increased credit risk and loan losses. thus, no a priori expectation is made about the sign of the risk variable. management efficiency (represented by eff in equation 3) is measured using bank-specific technical efficiency scores computed using nonparametric data envelopment analysis (dea). our approach is consistent with berger and humphrey (1997) who profess that frontier-based efficiency scores provide more reliable management efficiency measures. moreover, the expense ratios used in prior bank profitability studies suffer bias due to accounting adjustments. in the dea algorithms, consistent with the intermediation approach, banks are viewed as combining deposits and equity capital to generate net total loans and other earning assets. with regard to input-output orientation, we recognise that profit maximisation requires a bank to produce the maximum output given the level of inputs employed (i.e., be technically efficient). since, profitability improves when banks become more efficient a positive coefficient for eff variable is expected (berger, hancock and humphrey 1993). bank size (tassets) is utilised in equation 3 to control for scale effects. insofar large banks exert market power through stronger brand image or implicit regulatory (too-big-to-fail) protection a positive coefficient for tassets variable is expected. in contrast, a negative coefficient is expected if bank size is a function of ‘empire building’ by managers and/or government-sponsored funding programmes. bank competition (represented by comp in equation 3) is measured using the h-statistics derived from the non-structural panzar and rosse (pr) model (panzar and rosse 1987). this approach recognises that competition could be present in markets characterised by relatively high degree of concentration. using the pr model, the competitive indicator, h statistic, can be defined as the sum of elasticities of the reduced-form revenues with respect to input prices (indexed by k). market power is assessed by the extent to which a change in input prices ( wki) is reflected in the revenues earned by bank i ( ri ). thus h statistic is defined as: = ∗ ∗ (4) panzar and rosse (1987) establish that h statistic is an increasing function of the demand elasticity, e, and hence there is a negative relationship between the level of market power exercised by the firms and the value of h. in other words, higher h values represent more competitive markets and lack or market power at firm level and vice versa. this proposition highlights the explanatory power of h as an indicator of level of competition. following bikker and haaf (2002) procedure, h statistics for the sample countries are obtained and employed in equation 3 as the proxy for industry competition. since higher values of the h statistic represents greater competition levels a negative coefficient for comp variable is expected. to verify the robustness, we also utilise herfindahl-hirschman index (hhi) as an alternative asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 373 measure of bank competition (represented by comp in equation 3). the hhi is a measure of the size of firms in relationship to the industry and an indicator of the amount of competition among them. it is defined as the sum of the squares of the market shares of each individual firm (i.e., the average market share) weighted by market share and expressed as: = (5) here is square of the market share of each firm “i”. value for hhi can range from 0 to 1 moving from a very large amount of very small firms to a single monopolistic producer, i.e., if a market is closer to being a monopoly and the market's concentration is higher (and the lower its competition) the value is closer to one. similarly, if there is large number of small firms competing, each would have nearly zero percent market share, and the hhi would be close to zero indicating nearly perfect competition. hence, decreases in the herfindahl index generally indicate a loss of pricing power and an increase in competition, whereas increases imply the opposite (bikker and haaf 2002). to the extent increasing competition exerts downward pressure on profitability a negative coefficient is expected for hhi. in addition to bank-specific factors and industry competition, other differences across countries may also need to be considered. in particular, corruption and law and order in developing countries (e.g. south asian countries) may be important in determining bank profitability. for example, not only international investments are affected by a country’s state of law and order, but domestic businesses also suffer if state fails to enforce the contracts due to corruption. thus, we utilize two governance indicators calculated by kaufmann, kraay and mastruzzi (2007) and published by the world bank: the rule of law index (rol) and the control of corruption index (corr). these indicators are reported on a scale of -2.5 to +2.5 with higher values indicating good quality rule of law/corruption controls. as the prevalence of rule of law and effective corruption controls ensures a conducive environment and quality of contract enforcement, positive coefficients are expected for rol and corr variables. furthermore, following demirguc-kunt and huizinga (1999) we utilise bank-specific tax rate (tax variable in equation 3) to control for differing tax regimes and treatments among sample firms. taxes are expected to increase bank revenue insofar a bank is able to shift its tax bill forward to its depositors and lenders. this is supported by the common observation that bank-stock investors need to receive a net of company tax return that is independent of the company tax. this relationship is tested by demirguc-kunt and huizinga (1999) and it is found that corporate tax is positively associated with bank profitability. hence, a positive coefficient for tax variable is expected. finally, this study uses annual cross-section and time series pooled data as this helps to remove biases caused by aggregating heterogeneous individual banks. this approach also provides more reliable regression estimates due to the larger sample size and helps to control for any unobserved heterogeneity / omitted variable problems. in a strictly time series or cross section approach, these may be absorbed into the usual error term and can cause problems in estimation (baltagi 2001). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 374 4. results 4.1 summary statistics of the data set and econometric issues the summary statistics for the data set are given in table 4. not surprisingly, the tassets shows the largest variation and highlights the wider dispersion of bank size in the sample. similarly, bank competition (represented by comp) measured in terms of the h statistic varies considerably over the sample period possibly signifying the effect of deregulation and financial liberalization measures taken by the south asian governments. the average level of competition (h statistic = 0.7314) is consistent with the findings of perera, skully and wickremanayake (2006) who report h statistics for the same four banking market over 1995-2003. the efficiency ratio (eff variable) implies that on average south asian banks could have increased their output by approximately 10 percent given the respective input levels. perera, skully and wickremanayake (2007) report a possible efficiency improvement ratio of 12 percent for the same banking markets over 1997-2004. table 4. summary statistics of the data set variable mean maximum minimum std. dev. roaa 0.0097 0.1024 -0.1820 0.0178 comp 0.7314 1.2047 0.1300 .3567 eq 0.0593 0.9931 -0.0679 0.0774 corr -0.5600 -0.1300 -1.3200 0.3285 risk 0.5830 3.2972 0.0609 0.1816 rol -0.2414 0.2900 -0.9500 0.4649 tax 0.2725 0.5274 -3.1900 6.4933 tassets us$3.3m us$1300m us$0.3m us$8.6m eff 0.9370 1.0000 0.1914 0.0910 roaa the return on average total assets; comp – h statistics; eq equity per dollar of total assets; corr the control of corruption index; risk loans per dollar of deposits and short-term funds; rol the rule of law index; tax tax paid on profit before tax; tassets – total assets; eff dea technical efficiency scores. the risk profile of the sample banks (risk) is also diverse with the average ratio of loans to deposits and short-term funding of 58 percent but with a minimum of just 6 percent. this is in line with the eq variable measuring equity capitalization as the ratio of total equity to total assets with a maximum value of 99 percent. the rule of law index and the control of corruption index (which varies between -2.5 and +2.5) show the lowest variation and signifies little improvement over the sample period. with regard to the methodology, our relatively larger time period t, (t=15), may lead to issues regarding non-stationarity of the panel. this is evaluated by using fisher test and null hypothesis of non-stationarity is rejected at the 5 percent level. maddala and wu (1999) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 375 suggest the use of the fisher test, which is based on combining the p-values of the test statistic for a unit root in each bank. the advantage of this test is that not only it performs better than other tests for unit roots in panel data but also it can work with unbalanced panels. prior to obtaining empirical results, we also established whether the difference in coefficients between fixed effects (fe) and random effects (re) is systematic or not. hausman test is used for this purpose and as the test statistic indicates, differences are found to be systematic providing evidence in favour the fe model (x2 (9) = 35). with regard to extracting consistent and efficient estimates, we used all available lagged values of the dependent variable plus lagged values of the exogenous regressors as instruments (arellano and bond 1991). the use of the arellano and bond estimator has been criticized sometimes when applied to panels with very small time periods. the reason suggested is that under such conditions this estimator is inefficient if the instruments used are weak (arellano and bover 1995). in this study however, the t is 15, which is arguably large enough to avoid such problems. consequently, the model can be safely estimated using the gmm estimator in the arellano and bond paradigm. the sargan test indicates that there is no evidence of over-identifying restrictions, model is correctly specified and instruments are valid (x2 (106) = 274.61). although the equations indicate the presence of negative first-order autocorrelation (z=-13.79, p-value=0.0001) this does not imply that the estimates are inconsistent. estimates are considered inconsistent if second order autocorrelation is present (arellano and bond, 1991), but this case is rejected by the test for ar (2) errors (z=1.52, p-value=0.13). finally, because the time frame of this study is fairly large (t = 15) and due to the developments and regulatory changes in the south asian banking markets, time effects can be present in the error component of the model. this issue is addressed by testing for each year and using a vector of dummies to capture time-varying effects. 4.2 discussion of findings overall, the coefficients’ signs and statistical significance are consistent and there is broad stability across model 1 and model 2. this indicates the relative soundness of model fitting and the reliability of the estimates obtained. the main results are now discussed in the same order as presented in table 5. the highly significant coefficient for the lagged profitability variable (roaa(-1)) confirms the dynamic character of the model specification. its coefficients take values of 0.2352 in model 1 and 0.1564 in model 2 which reveal that speed of adjustment is slow and that profits seem to persist to a moderate extent. athanasoglou, brissimis and delis (2008) reported similar findings. the equity capital level (eq), as anticipated, is found to be significantly and positively associated with bank profitability. these results substantiate the fact that well-capitalised banks can source deposits and other funding at low cost and thereby increase their profits. similar results are presented by pasiouras and kosmidou (2007) and athanasoglou, brissimis and delis (2008). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 376 table 5. gmm estimates panel a: regression results model 1 (with the h-statistic) model 2 (with the hhi) variables (proxy) coefficient p-values coefficient p-values lag profitability (roaa(-1)) 0.2352 0.0061** 0.1564 0.0278** equity capital level (eq) 0.0704 0.0078** 0.0385 0.0767* risk profile (risk) -0.0045 0.0805* -0.0032 0.1069 efficiency of bank production (eff) 0.0081 0.0462* 0.0143 0.0443** scale effects (tassets) 0.0000 0.0564* 0.0000 0.0432** degree of competition (comp) -0.0018 0.0777* 0.9517 0.0378** rule of law (rol) -0.0092 0.0409** -0.0102 0.0770* control of corruption (corr) -0.0163 0.0002*** -0.0119 0.0148** tax (tax) -0.0001 0.0278** -0.0001 0.0257** panel b: diagnostics equilibrium test (wald test for h=0) bangladesh h = 0.2912 (p-value = 0.4878); india h = 0.8897 (p-value = 0.3048); pakistan h = 0.7988 (p-value = 0.4675); sri lanka h = 0.2176 (p-value = 0.5975) sargan test x2 (106) = 274.61 hausman test x2 (9) = 35 ar(1) z=-13.79 (p-value 0.0001) ar(2) z=1.52 (p-value = 0.13) ***, ** and * signify statistical significance at 1, 5 and 10 percent respectively. consistent with prior evidence, the ratio of total loans to deposits and short-term funds (risk variable in equation 3) is negatively associated with bank profitability (weakly significant at 10 percent level in model 1). this indicates that higher levels of loans to deposits and short-term funds exert downward pressure on bank profitability due to higher levels of non-performing assets and increased liquidity costs. likewise, the efficiency of bank production (eff variable in equation 3) is found to be significantly positively related to bank profitability. this is in line with conventional wisdom that improved efficiency and productivity growth positively affect bank profits. with regard to scale effects (tassets in equation 3), bank size is found to be positively related to profitability. this positive association indicates that as south asian banks increase their size, their profitability also increases perhaps due to increased economies of scale. moreover, larger banks can achieve greater product and loan diversification and so lower their risk profiles. hence, required rate of return becomes lower which reduces their costs, generating higher profits. similarly, large banks may also be able to exert greater market power through stronger brand image or implicit regulatory (too-big-to-fail) protection. abnormal profits obtained through its exercise in wholesale or capital markets may also contribute to a positive size–profitability relationship. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 377 the level of competition (comp in equation 3) is proxied by the h statistic (in model 1) and the hhi (in model 2). a basic assumption of the pr model used to compute the h statistics is that firm level revenue behaviour is consistent with market equilibrium conditions. to that end, following bikker and haaf (2002), an equilibrium test was conducted before estimating equation 3 to determine, for each country, whether or not the equilibrium assumption of the pr model is violated. the test statistics, reported in panel b of table 5, are not statistically significant at 90 percent level. this indicates that input prices in each banking market are not correlated with industry returns: meaning, the equilibrium assumption of the pr model holds and the computed h statistics can be interpreted rationally. as anticipated, increasing competition among south asian banks (captured by higher values for the h statistic, in model 1) exerts negative pressure on bank profitability (table 5, panel a). this is so because increasingly banks compete on price and incur expenses to counter competitors’ strategic moves. interestingly, in model 2, higher values of the hhi are associated with higher profitability. this means that those south asian banks operating in relatively concentrated markets (characterised by higher hhi values) extract economic rents and higher profits. overall, the received wisdom is that even though increasing competition (arguably driven by on-going deregulation and liberalisation of the financial services industries) exerts negative pressure on bank profitability in these south asian countries, high levels of industry concentration still allows ‘large’ banks to earn higher profits. this observation is consistent with the proposition that competition can prevail even in highly concentrated markets. moreover, the higher profits earned by these banks (despite increasing competition) may reflect the practice of product differentiation as found by perera, skully and wickremanayake (2007). in the south asian banking markets low quality rule of law (represented by rol in equation 3)) and lack of effective corruption control (represented by corr in equation 3) are found to be significantly influencing bank profitability. the results indicate that slack legal systems in the south asian countries (leading to inferior contract enforcement) positively affect bank profits as banks probably require higher risk premiums on their loan contracts. moreover, arguably, banks may exploit lack of effective corruption controls to create and maintain ‘profitable’ relationships which otherwise would not have existed. the result for tax variable is not consistent with expectations as the tax rate is found to have significantly negative impact on bank profitability. this indicates that south asian banks must bear most of their tax costs and are unable to pass these onto their customers. the vector of time dummies utilised to account for time-varying omitted influences reveal that during 1997-1999 asian financial crisis period bank profitability declined. this is consistent with the decline in earning asset growth and incline in substantial provision for non-performing assets during that period. we also experimented with three other macroeconomic variables: long-term interest rate, inflation rate and real output growth. these three variables were found to be highly correlated with each other and the bank size variable included in equation 3. we acknowledge that bank size is more relevant in controlling for uneven distribution in firm size in the sample and asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 378 hence included. it is argued that the inclusion of the vector of time dummies can capture, partially at least, time-varying effects of economic life cycle. 5. conclusion this paper investigated the bank-specific and external determinants of south asian bank profitability. the sample consisted of 119 commercial banks with 1,539 bank-year observations. a single-equation, dynamic panel data procedure was employed to accommodate explicit measures of production efficiency, industry competition, profit persistence and country-specific differences in governance. the findings reveal that well-capitalised low risk banks and those with relatively more efficient production processes are more profitable. south asian banks also seem to experience economies of scale as bank size is positively associated with profitability. with regard to competition, even though increasing competition (arguably driven by on-going deregulation and liberalisation of the financial services industries) exerts negative pressure on bank profitability, high levels of industry concentration still allows banks to earn higher profits. this observation is consistent with the proposition that competition can prevail even in highly concentrated markets. moreover, the higher profits earned by these banks (despite increasing competition) may also be due to the practice of product differentiation. the results also indicate that slack legal systems in the south asian countries (leading to inferior contract enforcement) positively affect bank profits as banks probably require higher risk premiums on their loan contracts. moreover, arguably, banks may be able to exploit lack of effective corruption controls to create and maintain ‘profitable’ relationships which otherwise might not have existed. the findings have important implications to regulators, bankers and bank shareholders. for regulators, their policy formulation and implementation can be streamlined by directing scarce regulatory resources to focus on external factors that restrict profitable and stable banking systems (such as mergers and acquisitions that increase industry concentration). at the same time, regulators and authorities should scrutinize banking practices in these countries as there is a positive association between low quality rule of law/corruption controls and bank profitability. for bankers, the findings should help to identify the key drivers (both internal and external) to achieve stable profits which in turn lead to sustainability and stability at the firm level. this is important due to the increased competition through globalization of banking and foreign bank entry into the south asian financial markets. for shareholders, it helps to assess how varying bank characteristics can alter the quality of their returns and control for those factors that can adversely affect the bank profits. this study, however, suffers from some limitations. with regard to sample composition, as almost all foreign-owned banks operating in south asia publish only their world-wide consolidated reports, it is not possible to include foreign-owned banks even as a control sample. due to resource constraints and data limitations, we could also not include some other bank-specific and country-specific factors that might also impact on bank profitability (e.g. off balance sheet activities, a composite measure of deregulation and financial liberalisation over the years etc.). moreover, annual bank-specific data is used as higher asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 379 frequency data (e.g. weekly or monthly data) was not available. finally, due to lack of detailed information on different bank products, it could not be identified whether the use of different products (or product mixes) might affect bank profitability. references arellano, m., & bover, o. 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(2007). cost efficiency in south asian banking: the impact of bank size, state ownership and stock exchange listings. international review of finance, 7, 35-60. http://dx.doi.org/10.1111/j.1468-2443.2007.00067.x microsoft word 2320-9096-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 277 capital flight and nigeria economic growth ajayi, l.b. department of banking and finance faculty of management sciences ekiti state university, ado-ekiti, nigeria e-mail: boblaw2006@yahoo.com received: august 30, 2012 accepted: october 27, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.2320 url: http://dx.doi.org/10.5296/ajfa.v4i2.2320 abstract this paper provides evidence on the negative impact of the assessment of capital flight on economic growth of nigeria for 40 years (1970-2009). it provides a comprehensive analysis of capital flight and its resultant impact on domestic investment and the growth rate of the economy. the study used cointegration and error correction mechanism (ecm) as its main estimation techniques. it was discovered that capital flight and its assessments are significant factors for explaining economic trends in nigeria. it was also discovered that capital flight have negative impact on the economy. consequently, it is recommended that funds from foreign sources in form of loans, gifts, grants and aids should be judiciously used for economic development of nigeria. it also recommended fiscal discipline, serious and commitment on the part of government and its functionaries. above all, government should provide enabling environment for business to thrive thereby encouraging foreign direct investment and discouraging capital flight. keywords: capital flight, gross domestic product, residual approach, cointegration, error correction model asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 278 introduction there exists no generally acceptable definition of the term “capital flight” most of the times, this term are related to capital which is shifted out of developing countries. lesser and williamson (1987) defines capital flight as illegal conveyance of capital aboard which stays unrecorded in the national accounts of developing countries. ndikumana and boyce (2003) also defined capital flight as residents’ capital outflows, excluding recorded investment abroad. however, if capital shifts out of the developed country it is usually revered to as capital outflow. investors from developed countries are seen as responding to investment opportunities while investors from developing countries are said to be escaping the high risk they perceived at home (ajayi 1997). the huge amount of capital flight experienced by the less developed countries (ldc) and their effects on the national economy have attracted the attention of many economists in recent years. capital flight has been regarded as a major factor contributing to the foreign debt problem and inhibiting development effects in the third world, codington (1986). causes of capital flight according to ajayi (2005) include varying risk perception, exchange rate misalignment, financial sector constraints and repression, fiscal deficits, weak institutions, macroeconomic policy distortions, corruption and extraordinary access to government funds among others. the economic arguments against capital flight from developing countries are not only convincing but are also too strong to be ignored. according to deppler and williamson (1991), capital flight is said to lead to a net loss in the total resources which are available to an economy for the purpose of investing and growth. while some analysts view it as a symptom of a sick society characterized by break down of social cohesion, reduction in growth potentials, erosion of tax base, failure to recover from debt problems, and a redistribution of wealth from poorer to richer social groups, others consider the very use of the word capital flight as unnecessarily pejorative description of natural, economically rational responses to the portfolio choices that have confronted wealthy residents of some debtor countries in recent years, ali and benard (2011). it is against this background that this study is set to critically provide a comprehensive analysis of capital flight and the resultant impact on domestic investment and nigeria economic growth. literature review and theoretical framework by it very nature, it is difficult to measure capital flight. the difficulties involved notwithstanding; a number of capital flight estimates have been made over the last several years. the preponderant of these studies cover a number of countries including argentina, brazil, chile, korea, mexico, peru, the philippines and venezuela. a recent study covers argentina, bolivia, chile, columbia, ecuador, gabon jamaica, mexico, nigeria, peru, the philippines, venezuela and yugoslavia. these various studies differ from one another in term of the methodological approaches of measurement, country coverage and life span. the most significant of these studies which have made impact on capital flight estimates include the studies by dooley et al, (1986) world bank (1985). these approaches of capital flight estimate including others are briefly discussed below. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 279 a. the residual process of capital flight estimate the residual approach was developed by the world bank, (1985) and erbe (1985). it was further modified by morgan guaranty trust (1986). in the world bank (1985) and erbe (1985) version of the residual approach, capital flight is calculated as the difference between sources and uses of capital inflows. the source of capital inflows are increases in external debt and foreign direct investment. these capital inflows are used to finance either current account deficits or increase in official reserves. the inflows that finance neither current account deficits nor increases in reserve constitute capital flight. in essence, capital flight in the world bank (1985) version of the residual approach is measure as: f(wb) = ebebt + g + f-n (1) where: g is foreign direct investment; f is current account balance and n is increase is reserves. positive value of kf-wb represents capital flight while negative value is capital re-flows or the reserve capital flight. morgan trust (1986) adjusted the world bank (1985) measure for changes in foreign assets held by domestic agents other than the banking system. according to morgan trust (1986) capital flight is measured as: kf(morg) = edebt + g + f – n1 (2) where: kf (morg) is the morgan trust (1986) measure of capital flight; 1 is increase in foreign assets of the domestic banking system; g, f and n are as defined above. as usual in residual measures of capital flight, negative values of kf-m or g are capital reflows while positive values are capital flight. b. dooley process of estimating capital flight the dooley method defines capital flight as illegall capital outflows, or all capital outflows based on the desire to place assets beyond the control of domestic authorities. following this concept of capital flight, the dooley method considers all outflows that do not receive register interest payment as illegal capital outflows. the dooley measure incorporates the net errors and omissions, as well as the difference between the world bank data on the annual change in the stock of external debt and debt flows as reported in the balance of payments statistics. in its simplest form, capital flight magnitude is measure as the excess of total capital outflows over the stock of registered interest receipt external assets. the total capital outflow is computed as: cot = debt t + fitt cadt frst xt – yt (3) where: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 280 co denotes total capital outflows; yt is net errors and omissions, and xt represents the different the world bank and imf debt statistics. the stock of total external assets (stk) is computed as: stkt = (1+rw)rt (4) where: rw stands for internationally realistic interest rate, and rt is the registered receipts. from equations 2 and 3 the dooley measure of capital flight (cfd) is calculate as: cfd t = cot stkt (5) there exists a wide literature with respect of capital flight with diverse empirical evidence; some of which are also discussed in this paper. cuddington (1986) estimates the economic determinants of resident’s capital outflow of four countries (argentina, mexico, uruguay and venezuela). his empirical finding differed from country to country. in mexico, capital flight was highly related with over valuation of the exchange rate, while in venezuela, there were overvaluation and foreign interest rates in argentina and uruguay if lagged effective exchange rate and error of the model were related to capital flight. conesa (1987) had similar results except that it had 16 annual observations while cuddington (1986) had 91. conesa (1987) had growth as an additional explanatory factor and did not attempt to estimate over valuation of the real or effective exchange rates but used level of government borrowing in his study of seven developing countries (argentina, mexico, brazil, chile, peru, venezuela and philippines). doley, et al. (1986) discovered that capital flight is significantly related to domestic inflation, financial repression and a measure of country risk premium. khern and hague (1987) estimated capital flight from foursub-saharan, nigeria, sudan, tanzania and uganda) from 1976 to 1989, using their estimates capital flight may seem small compares to latina american countries but the burden as a percentage of gpd is higher by 61% of subsaharan compared to 22% for latin american. also, by their calculation, murinde et al, (1996) discovered that nigeria experienced the biggest capital flight over the period representing 60% of the combined total of the four countries in the sample of their econometric analysis of the determinant of capital flight which indicated that the most explanatory variables is public external borrowing. the results implied that capital flight and external debt are closely dependent. in his study of three countries (cote d’ ivore, nigeria and morocco) ojo (1992) opined that nigeria had the largest capital flight of about 35-billion and emphasized the importance of domestic economic environment including policy related variables as government budget defect and changes in external debt. ajayi (1995) discovered in his study that cumulative capital flight in the period of 1980 to 1991 averaged 40% of external debt to run 18 countries sampled. the ratio was as high as 94% for nigeria, 74% for kenya and 60% for sudan. he also discovered that countries that exhibited the greatest capital flight often are the most highly indebted and referred to them as “twin problems”. ajayi (1992) estimated capital flight from nigeria in 1972 to 1989 drawing attention to the role of trade taking asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 281 (misinvoicing) in the country’s oil sector and to the link between capital flight, corruption and governance failure. he concluded that most of the capital flight from nigeria is recorded in the bop and debt statistics and that is not unexplained by economics factor but also political factor or uncertainty. onwioduokit (2007) in his studies stated that the major determinant of capital flight from nigeria are domestic inflation, availability of foreign exchange reserve, comparative growth rate of the economy and parallel market premium. a study on econometric analysis of capital flight in nigeria by ayadi (2008) investigates the determinants of huge capital flight (with its constraints on economic growth) in nigeria so as to make meaningful policy contributions on strategies of minimizing capital flight and its attendant impacts. his study investigates the linear determinants of capital flight in nigeria utilizing the ordinary least squares (ols) and the error correction method (ecm). the study found among other things, the validity of the portfolio theory which postulates how risk-averse investors can build portfolios in order to optimize or maximize expected returns given a level of market risk. this is confirmed in the international realm as private sector engaged in international arbitrage. capital flight is caused by the interest rates deferential both in the short and in the long run. in addition, exchange rate depreciation significantly increases capital flight in nigeria. output growth which measures the domestic opportunity cost of flight in nigeria is negative and significant in the short-run indicating that non performance of domestic resources can trigger capital flight. boyrie (2011) in his study of the determinants of capital flight and capital movement through trade mispricing in african countries attempts to accomplish two things. first, it tries to establish the determinants of capital flight and capital movement through trade misinvoicing from selected african countries in order to ascertain whether the same factors could explain both types of capital movement. second, it attempts to determine whether granger causation exists between capital movement through trade misinvoicing and capital flight. data for selected countries were combined into geographical, economic, and monetary regions using 21 explanatory variables, the results showed that variables that explain capital flight do not always explain capital movement and vice versa. the independent variables tended to explain the dependent variables in a few cases, implying that the reason for capital flight and capital movement was other than for investment purposes. overall causality was found to exist between the dependent variables, mostly in the form of feedback. yet, the relationship was mostly transitory with a long-term relationship existing in only few cases. ali and walters (2011) investigated the causes of capital flight from sub-sahqran africa. the study drawing on insights from portfolio theory, presents empirical evidence that links capital flight to the domestic investment climate. using a panel data set for 37 african countries over the 1980-2005 period, the study discovered that once account is taken of the region’s structural and institutional features, private capital outflows from africa are explained by policy distortions along with the relative riskiness and poor potability of investments. in addition, the study discovered evidence that the type and composition of resource flows to the region are important for capital flight: foreign aid generally discourages capital flight while short term borrowing and fdi contribute to it. the findings of the paper are robust to endogeneity, outliers, sub-samples, and to different econometric methods. the poor results of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 282 empirical studies on capital flight from african may not be unconnected to the use of estimated statistics of capital flight as a dependent variable. attempts to empirically determine the factors that affects an estimated statistics on capital flight is suspect and is bound to produces spurious results, as none of the methods of estimation discussed can capture the very nature and character of the developing countries including nigeria. the relative under developed nature of statistical gathering as well as the very nature of the applied concept of capital flight makes the adoption of any model developed for the industrial economies for the purpose of measuring capital flight in the developing country like nigeria, irrelevant. methodology based on the theoretical and literature reviewed above, we adopt the residual approach to capital flight by adopting the world bank (1985) and erbe (1985). this is because it encompasses macro-economic variables that determine the economic growth of nigeria. this variables are the volatility in external debt ( exdebt) and external reserve, current account balance (cab) and direct foreign investment (dfi). all these variables are capital flight estimate according to world bank (1985) and erbe (1985). this study used cointegration and error correction mechanism (ecm) as its estimation techniques with data over the period of 1970 2009. therefore, we determine the effect of these macro-economic variables on nigeria economic growth introducing gross domestic product (gdp) as the dependent variable. the model is functionally specified as follows: gdp= f(δexdebt, dfi,cab,δres, µ) (6) where: gdp= gross domestic product; δexdebt= change in external debt; dfi= direct foreign investment; δres= change in external reserves; cab= current account balance = functional notation; µ= stochastic error term. the estimation technique of the above model in explicit form and by loglinearizing thus becomes: lgdp= α0 + α1 lδexdebt + α2 ldfi + α3 cab + α4 lδres+ µ (7) where: log= natural logarithm; α0 is the intercept of the relationship in the model while α1, α2, α3 are the coefficients of the independent variables and µ is the disturbance error term. the ‘apriori’ expectations of the model are that: δgdp/δexdebt <o; δgdp/δdfi >0; δgdp/δres ><0; δgdp/δcab ><0; the test for stationarity is done using the augmented dickey-fuller (adf) unit root test. this is done at various levels of stationarity. the adf statistics must be greater than the mackinnon critical value before the variable can be adjudged stationary. the test for the long run relationship is done using the johansen co-integration test. the long run relationship is determined by the trace statistics. the study used secondary data that are obtained from the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 283 central bank of nigeria (cbn), federal office of statistics (fos) and other sources that are relevant to the study. empirical results since the study used time series data, the first step is to establish the stationarity or otherwise of the variables. to ascertain this, the visual plot of the variables is usually the first step. the graphs below shows that the variables exhibit varying degrees of fluctuations thereafter, a unit root test was carried out by using the adf methodology. 8 10 12 14 16 18 70 75 80 85 90 95 00 05 lgdp 0 2 4 6 8 10 12 14 16 70 75 80 85 90 95 00 05 ldebt 6 7 8 9 10 11 12 13 14 70 75 80 85 90 95 00 05 ldfi 2 4 6 8 10 12 14 16 70 75 80 85 90 95 00 05 lca 2 4 6 8 10 12 14 16 70 75 80 85 90 95 00 05 les figure 1. graphical representation of time series data source: e-view statistical software, version 7 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 284 table 1. summary of adf unit root test variables adf test statistics mackinnon critical vale @ 5% no of the time differences remark gdp -5.312332 -2.9411 i(1) stationary δexdebt -8.300316 -2.9411 i(1) stationary dfi -9.563759 -2.9411 i(1) stationary cab -11.60126 -2.9411 i(1) stationary δres -6.471667 -2.9458 i(1) stationary source: extracted from e-view 7. the results of unit root test above indicated that the variables used in the study are integrated of order i (1) respectively. this means that the variables are stationary at their respective first difference cointegration test and error correction model having established stationary of the variables, we determine the existence of a long-run equilibrium relationship among the variables in the model. to realize this, the study employed the johansen cointegration technique. the cointegration results of the variables are presented below: table 2. johansen cointegration test hypothesized no of (ecs) elgen value trance statistics or likehood ratio 5% critical value. 1% critical value. none * at most 1 at most 2 at most 3 at most 4 0.590082 0.440374 0.223149 0.137789 0.009747 71.54793 37.65963 15.60113 60.05883 0.372203 68.52 47.21 29.68 15.41 3.76 76.07 54.46 35.65 20.04 6.65 source: extracted from e-view 7. the cointegration equation is presented linearly as below: gdp = -1.003544 0.116930exdebt 0.890854dfi + 0.1494422cab 0.368442res from the table above, it shows that there exist a long-run equilibrium relationship in model 6 because the likelihood ratio (71.54793) is greater than 5 percent critical value (68.52) at none hypothesized no of ecs (none*). furthermore, the long run cointegration equation shows that exdebt is negatively related to gdp in the long run. so also is dfi and res with the constant parameter negatively related to lgdp. however the lcab remained positive in the long run. all the variable stands significant. having established the long run equilibrium asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 285 relationship among the variables in the model, we switch to the short-run error correction model. error correction model the error correction model measures the speed of adjustment to equilibrium. the error correction model (ecm) is significant if it has a negative sign in either over parameterized or parsimonious ecm. this implies that the present value of the dependent variable adjust rapidly to changes in the independent variable. a higher percentage of ecm indicates a feedback of that value or an adjustment of that value from the previous period disequilibrium of the present level of depend variable and the present and past level of the independent variables. the over parameterized ecm is being made by leading and lagging each variables while the parsimonous ecm consider the variables that adjust rapidly to equilibrium between the leading and the lagged variables. the tables below shows the result of both overparameterised and parsimonious ecm conducted on the specified parameters. table 3. overparameterised ecm variable coefficient std. error t-statistics probability d(gdp(-1)2) -0.3721222 0.174548 -2.143952 0.0412 d(exdebt,2) 0.022078 0.011212 1.969158 0.593 d(exdebt(-1)2) 0.014935 0.012166 1.227351 0.2302 d(dfi1,2) 0.112763 0.047860 2.356130 0.0260 d(dfi(-1)2) 0.001820 0.039370 -0.046231 0.9635 d(cab,2) 0.072545 0.019333 3.752335 0.0008 d(cab(-1,)2) 0.035226 0.024685 2.237263 0.0337 d(res,2) 0.029270 0.018965 1.54326 0.1344 d(res(-1)2) 1.010114 0.015052 0.671900 0.5074 ecm (-1) -0.240563 0.089417 -2.690338 0.0121 source: extracted from e-view 7. r2 = 0.66619, dw = 1.671511 table 4. parsimonious ecm variable coefficient std. error t-statistics probability d(exdebt,2) -0.012886 0.011821 -1.090022 0.2838 d(dfi1,2) -0.014984 0.043259 -0.34369 0.7313 d(cab,2) 0.011442 0.020147 0.567905 0.5741 d(cab (1),2) 0.062094 0.020620 3.156873 0.0035 ecm (-1) 0.010082 0.039370 -0.046231 0.9635 source: extracted from the computer output. r2 = 0.460923, dw = 2.617338 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 286 the table above shows the over parameterized ecm (ecm1) and parsimonious ecm (ecm2) of model 6. the negative sign of ecm value in both model (ecm 1 and 2) shows that the ecm is significant. this implies that the present value of lgdp adjust rapidly to changes in exdebt, dfi, cab and res. the ecm value of 0.240563 shows a feedbacks of about 24.05% from the previous period disequilibrium of the present level of gdp in the determination of causality between the past level of gdp and the present and past level of exdebt, dfi, cab, and res. the coefficient of multiple determinations denoted as r2 shows that 66.67% variation in gdp can be explained by exdebt, dfi, cab, and res while the remaining 33.33% is being included by the stochastic error term. the durbin watson statistics of 1.67 shows that the presence of autocorrelation in the model is inconclusive as the durbin watson statistics falls under the positive side of the inconclusive region. the results of the short run ecm is in contrast to the long run cointegrating equation. this is because all the variables and their lagged values are positively related to gdp. this study does not pretend to considers exhaustively all the potential factors determining economic growth and development as regards to capital flight. however, the models developed and the estimation techniques employed in this study are intended to reveal how capital flight has been able to affect the gross domestic product (gdp) and balance of payment (bop) since capital flight is detrimental to development of any economy as also revealed by the empirical results or this study, this is consistent with the findings of ajayi (1992) and on woduket (2007). though ajayi (1992) did not employ cointegrating analytical technique to estimate his data, the ‘apriori’ expectation still holds. discussion and findings the motive behind external debt is to provide basic infrastructural facilities that boost economic growth and development of a nation nigeria is not an exception. judicious use of external debt can also lead to influx of fereign investors, increase in external reserve and boost economic growth and development. unfortunately, this is not so in nigeria as revealed by the empirical findings of this study. external debt reduces gross domestic product, degree of openness, gross capital formation i.e domestic investment, and external reserve. findings also shows that the interest being paid on foreign debt is now higher that the principal itself. the negative relationship between external debt and economic development in the long run implies that increase in external borrowing by the nigerian government fails to transform into increase in the level of economic development. this is a indication that the borrowed funds were diverted to other uses that do not translate to economic development. previous studies revealed that most of these funds were diverted by corrupt government functionaries to their private use other countries. (paul collier et al 2004). ideally external borrowings and aids are expected to induce and attract foreign private capital thereby improve the domestic economy. increase external borrowing is expected to induce domestic investors to retain greater proportion of their wealth within the economy, but in a situation where increase debt results in greater proportion of private wealth to be held outside the country, the domestic economy cannot develop. although, direct foreign investment and change in external reserve are positively related to gross domestic product in the short-run, the long-run increasing trend in external debt makes government to finance foreign debt from external reserve hence, a asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 287 decrease in external reserve. this has a multiplier effect on the economy as foreign investors are not encourage by increase in foreign debt servicing and those already in the country chooses to repatriate profit to their parent country. all these will cause a current account balance deficit in the long run which also reduce gross domestic product. foreign direct investment and gross domestic product are among the largest sources of external finance from developing countries including nigeria. the positive and negative relationship observes in the model formulated in models 6 and 7 indicated that foreign direct investment could have both adverse and beneficial effect on the economy. for instance, foreign direct investment inflows into an economy may facilitate capital flight or cause a reduction in capital flight. if the returns from foreign direct investment are repatriated into foreign countries, it is detrimental, but if the returns on foreign direct investment are reinvested in the local economy, there will be improvement in the gross domestic product. conclusion and recommendations a number of conclusions can be drawn from this study. the first is that there is no generally accepted definition of capital flight, hence the use of several concepts in this study. secondly, a significant proportion of capital flight can be estimated from recorded data in the balance of payment and debt statistic. the implication is that, the reliability of the measure is dependent on the accuracy of the items in the balance of payment statistics and debt data. significant amount of capital flight in relation to external debt took place over the years covered by this study. trade faking has been discovered as an important vehicle of effecting capital flight. thirdly, domestic macro economics policy distortion is the culprit in the capital flight episode. of significance in the area of policy errors are lack of opportunities for profitable investments within the domestic economy. the attractive incentives offered by the foreign sector cannot be left out. lastly, the present level of the economy cannot only be explained or judged by the current level of capital flight but also the previous level of capital that fled the economy as evident by our findings. however, this may seem uncachievable as the hub of capital flown out of nigeria is unrecorded. on this note, policymakers and the relevant authorities should pay more attention than ever to the issue of capital flight in order to stem its counter productive effects on economics growth. the study recommends a fiscal discipline so that deficit as a proportion of the gross domestic product is kept in check because this is crucial to the maintenance of macro economic stability and appropriation of interest rate. this should be high enough to attract funds but not too high to stifle investment initiatives. in addition, an integrated and unified tariff structure would be useful, as it will reduce the rewards of trade faking. the issue of the existence of and how to deal with corruption is certainly more difficult to prescribe. it is part of the general problem of capital flight; one can only say that there is a need for change of attitude on the part of those who hold public offices that have access to foreign funds directly or indirectly through the contracts they awarded. this attitudinal change involves the seriousness and commitment on the part of government and its functionaries. the study also recommended that government officials should place their public duties ahead of their personal gain, by so doing the economy will experience a boost as enough funds will be asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 288 available to execute developmental project such as power generation and opening of new vibrant sectors. of paramount importance is the provision of enabling environment for business to thrive. it is mores important to make the domestic economy more attractive for the investors by creating a wider menu of domestic financial assets on which domestic capital can be assessed and invested at lower rate comparable to foreign financial instruments. if the policy packages discussed are pursued rightly and with consistency it should be possible to hope for the repatriation of capital flight from nigeria for investment and funds from foreign sources in form of loans, gifts, grants and aids should be judiciously used to facilitate economic growth and development of nigeria. references ajayi, i. s. (1992). an economic analysis of capital flight from nigeria. world bank, working paper 993. ajayi s. ibi. (1995). capital flight and external debt in nigeria. research paper 35, nairobi. ajayi i. s. (1997). an analysis of external debt and capital flight in the severely indebted low-income countries in sub-saharan africa. international monetary fund, working paper 97/68. ali, & benard walter. (2011). on the causes of capital flight from sub-saharan africa. university of manchester; f20, e6, g11, 055 ayadi. (2008). econometric analysis of capital flight in developing countries. 8th global conference & economics. 978-09742114-5-9 boyce, j. k., & l. ndikumana. (2001). is africa a net creditor? new estimates of capital flight from severely indebted sub-saharan african countries, 19701996. journal of development studies, 38(2). http://dx.doi.org/10.1080/00220380412331322261 conesa, e.r. (1987). the causes of capital flight in latin america. interamerican development bank washington d.c cuddington (1986). capital flight estimate issue and explanation princeton studies on international finance 58 princeton de boyrie, m. (2011). money laundering and income tax evasion: the determination of optimal audits and inspections to detect abnormal prices in international trade. journal of financial crime, 12, 123–130. http://dx.doi.org/10.1108/13590790510624972 doley m.p. (et al). (1986). country specific risk premium, capital flight and net investment incomes payment in selected development countries. international monetary fund. mimo washington d.c. khern m., & hague (1987). capital flight from development countries. finance and development, 24 (1). lesser, & williamson. (1987). capital flight and third world debt. journals of international business studies, 19 (3). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 289 morgan guaranty trust company. (1986). ldc capital flight. world financial markets, 13-15. murinde. (et al). (1996). nigeria seek to help tracing billion took by former military leader classes 23rd july 5. onwioduokit e. a. (2007). capital flight from nigeria: an empirical reexaminations. west african monetary institute accra. ojo oladeji o. (1992). an empirical investigation of capital flight in selected african countries. african development bank economics research papers abidjan. world bank. (1985). capital flight and the third world debt. institute of international economics, washington d.c. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 118 a case study of voluntary disclosure by chinese enterprises desmond c.y. yuen (corresponding author) faculty of business administration, university of macau avenida padre tomás pereira, taipa, macau, china tel: (853) 8397-4752 e-mail: desmondy@umac.mo ming liu faculty of business administration, university of macau avenida padre tomás pereira, taipa, macau, china tel: (853) 8397-4162 e-mail: mliu@umac.mo xu zhang faculty of business administration, university of macau avenida padre tomás pereira, taipa, macau, china tel: (853) 8397-4186 e-mail: xuzhang@umac.mo chan lu faculty of business administration, university of macau avenida padre tomás pereira, taipa, macau, china tel: (853) 8397-8500 e-mail: luchan@umac.mo mailto:desmondy@umac.mo mailto:mliu@umac.mo mailto:xuzhang@umac.mo mailto:luchan@umac.mo asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 119 abstract this study examines the impact of ownership features, corporate governance mechanisms, and firm-specific characteristics on the voluntary disclosure provided by publicly-listed companies on the shanghai stock exchange in china. the ownership structure features and corporate governance mechanisms include (1) concentration of ownership; (2) ownership by state and state-related institutions; (3) individual ownership; (4) the chief executive officer is also the chairman of the board of directors; (5) board independence, and (6) the existence of an audit committee. the firm-specific characteristics are (1) firm size; (2) leverage; (3) profitability, and; (4) type of industry. with the use of a relative disclosure index for measuring the voluntary disclosure level, our results indicate that individual ownership, the existence of an audit committee, firm size, and leverage, including board structure and functioning, employee information, director‟s remuneration, the presence of an audit committee, related party transactions, and stakeholders‟ interests, are significantly related to the extent of voluntary disclosure. this study provides empirical evidence for chinese policy makers and regulators to improve corporate governance mechanisms and transparency of publicly-listed companies. the findings also contribute to an understanding of disclosure behavior among former wholly state-owned enterprises during the privatization process in china. keywords: voluntary disclosure, corporate governance, audit committee, disclosure index, firm-specific characteristic jel classifications: m40, m41, m48 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 120 1. introduction the effective functioning of capital markets depends on how information is shared among the participants (ho, 2003). in recent years, the quality of information disclosure in companies‟ annual reports has attracted considerable interest among scholars. some companies disclose the information that is stipulated by local governance regulations, but there may be costs and benefits for disclosing additional financial information. by increasing the amount of information that companies release to the public, companies can lower their capital costs, gain investor confidence, and improve the marketability of shares (meek et al., 1995; kristandl and bontis, 2007). according to a study by ho and wong (2001), the asian financial crisis not only resulted from a loss of investor confidence but also from a lack of effective corporate governance and transparency in many of asia‟s financial markets and individual firms in the late 1990s. the failures of chinese companies, including hongguang, yorkpoint, yinguangxia, chaoda, daqing lianyi, citic, zhengbaiwen, and euro-asia agriculture, are examples of the results of operating under a weak corporate governance structure and a lack of transparency. the 2008 global financial crisis has led investors to pay more attention to additional disclosure of company information. haw et al. (2000) note that firms listed on the two chinese domestic stock exchanges, i.e., shanghai and shenzhen, disclose little information to the public. as a result, this study will investigate how the ownership structure and corporate governance mechanisms affect the level of voluntary disclosure of information by chinese companies. compared to mature stock exchange markets in the developed countries, such as the united states and the united kingdom, there are some unique features of the chinese market. since the 1980s china has been rapidly undergoing change from a traditional planned economy to a market economy. the privatization of state-owned enterprises (soe) has transferred a portion of state-owned shares to other types of owners, including a, b, and h owners. privatization encourages the injection of private capital into the soes. but it also transfers public assets to private agents who do not necessarily use the assets in effective ways (stiglitz, 1997). the chinese economic environment is different from that in the developed countries; the market economy is still at a developing stage and state ownership plays a leading, or even a controlling role in the public listing of companies. these unique characteristics lead to differences in corporate governance and the extent of disclosure of information by chinese publicly-listed companies. the state‟s loss of control can result in ownership takeovers by individuals. newman (2000) notes that takeovers are common; however, a rapid change of ownership may not improve firm transparency. in the cases of privatization in eastern europe and the former soviet union, many companies failed due to the lack of control and the expropriation of minority ownership. because of agency effects, majority owners may reap personal benefits. as a result of the rapid changes in the stock market structure, chinese regulatory bodies have published a list of laws and regulations for companies to eliminate the possibility of providing false information and to encourage voluntary disclosure so as to enhance their international reputations. eventually, these policies will prepare the companies to list on foreign stock exchanges. the characteristics of corporate governance and the existence of an audit committee may affect the level of voluntary disclosure. using an opacity asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 121 index to indicate company‟ transparency, kurtzman et al. (2004) show that the level of voluntary disclosure is affected by the legal system, government economic policy, accounting standards and governance rules, the regulatory structure of the financial system, and the business environment. if a company operates in an unstable environment, these high risk factors become part of its operational costs, thus making it difficult to predict the future. it will also slow down the company growth rate and performance. other empirical studies have found that firms that have boards with a higher proportion of inside directors result in less management of earnings (chtourou et al., 2001; klein, 2002; peasnell et al., 2001; xie et al., 2001) and exhibit greater reporting conservatism (beekes, pope, and young, 2002). hence, it is hypothesized that a higher level of voluntary disclosure will lead to better performance and voluntary disclosure is a key way to improve investor confidence. the main objective of this study is to test a set of corporate governance, ownership structure, and company characteristics that may affect voluntary disclosure practices. these characteristics include board structure and functioning, employee information, remuneration for the director, the presence of an audit committee, related party transactions, ownership information, and stakeholder interests. the variables include ownership concentration, government ownership, and related institutional ownership, individual ownership, dual roles of the ceo on the board of directors, the independence of the board of directors, and the existence of an audit committee. the characteristics of the ownership structure may affect the level of voluntary disclosure of information. the chinese government has encouraged an increase in transparency so as to increase investor confidence in both the government and related institutional enterprises. one of the selling strategies for a company to increase the number of tradable shares to individual investors is to increase transparent reporting of information by enhancing the monitoring system through the creation of an audit committee, for the ceo not to play a dual role by also serving on the board of directors, and to improve the independence of the board directors. a well-governed firm will disclose more information to investors and creditors to enhance transparency and hence to improve company performance (kurtzman et al., 2009). diagram 1 indicates the framework of this study. control variables: firm size, leverage, profitability, industry type ownership concentration government ownership & legal entity percentage of tradable share ceo-is-top dir independent of board audit committee the extent of voluntary disclosure h1 (-) h2 (+) h3 (+) h4 (-) h5 (+) h6 (+) http://www.sciencedirect.com/science?_ob=articleurl&_udi=b6w4p-4kr3jh2-1&_user=818225&_coverdate=12%2f31%2f2006&_rdoc=1&_fmt=full&_orig=search&_cdi=6548&_sort=d&_docanchor=&view=c&_searchstrid=1100032481&_rerunorigin=google&_acct=c000044339&_version=1&_urlversion=0&_userid=818225&md5=3529e17d2dbc60331de58b73004d52b3#bib12 http://www.sciencedirect.com/science?_ob=articleurl&_udi=b6w4p-4kr3jh2-1&_user=818225&_coverdate=12%2f31%2f2006&_rdoc=1&_fmt=full&_orig=search&_cdi=6548&_sort=d&_docanchor=&view=c&_searchstrid=1100032481&_rerunorigin=google&_acct=c000044339&_version=1&_urlversion=0&_userid=818225&md5=3529e17d2dbc60331de58b73004d52b3#bib35 http://www.sciencedirect.com/science?_ob=articleurl&_udi=b6w4p-4kr3jh2-1&_user=818225&_coverdate=12%2f31%2f2006&_rdoc=1&_fmt=full&_orig=search&_cdi=6548&_sort=d&_docanchor=&view=c&_searchstrid=1100032481&_rerunorigin=google&_acct=c000044339&_version=1&_urlversion=0&_userid=818225&md5=3529e17d2dbc60331de58b73004d52b3#bib50 http://www.sciencedirect.com/science?_ob=articleurl&_udi=b6w4p-4kr3jh2-1&_user=818225&_coverdate=12%2f31%2f2006&_rdoc=1&_fmt=full&_orig=search&_cdi=6548&_sort=d&_docanchor=&view=c&_searchstrid=1100032481&_rerunorigin=google&_acct=c000044339&_version=1&_urlversion=0&_userid=818225&md5=3529e17d2dbc60331de58b73004d52b3#bib56 http://www.sciencedirect.com/science?_ob=articleurl&_udi=b6w4p-4kr3jh2-1&_user=818225&_coverdate=12%2f31%2f2006&_rdoc=1&_fmt=full&_orig=search&_cdi=6548&_sort=d&_docanchor=&view=c&_searchstrid=1100032481&_rerunorigin=google&_acct=c000044339&_version=1&_urlversion=0&_userid=818225&md5=3529e17d2dbc60331de58b73004d52b3#bib56 http://www.sciencedirect.com/science?_ob=articleurl&_udi=b6w4p-4kr3jh2-1&_user=818225&_coverdate=12%2f31%2f2006&_rdoc=1&_fmt=full&_orig=search&_cdi=6548&_sort=d&_docanchor=&view=c&_searchstrid=1100032481&_rerunorigin=google&_acct=c000044339&_version=1&_urlversion=0&_userid=818225&md5=3529e17d2dbc60331de58b73004d52b3#bib5 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 122 diagram 1 research framework it is expected that this study will make several contributions. first, prior studies do not test the relationship between corporate governance and voluntary disclosure using chinese financial and accounting data from the shanghai stock exchange. this study attempts to provide empirical evidence for chinese regulatory bodies and listed companies of the effectiveness of implementing voluntary monitoring systems. second, prior studies (ho and wong, 2001) do not test the impact of a change in ownership structure on voluntary disclosure in china, thus leaving a research gap in the literature. third, this study provides companies with evidence to further understand the most significant information that outside users seek to obtain from annual reports. a questionnaire containing 51 voluntary disclosure items was sent to financial analysts at the bank of china. they were asked to score each item according to its importance. the results reveal 34 “most-important” items. this provides evidence for policy makers and regulators to encourage companies to provide more voluntary disclosures in their financial reports. section 2 introduces the literature on disclosure in china and presents the research framework and design. section 3 discusses selection of the sample and formulation of the hypotheses. section 4 presents the results of the multiple regression models. the final section summarizes the results and discusses the implications and limitations of the study. 2. mandatory vs. voluntary disclosure both mandatory and voluntary disclosures are effective ways to release information to shareholders. a mandatory disclosure is a basic market demand for readers of the financial report; the readers must have access to this basic information as required by various laws and regulatory bodies in order to make company assessments. this requirement protects investors, and it also has indirect impacts on the corporate governance structure. a mandatory disclosure may help promote corporate governance by contributing to the effective exercise of shareholder franchises, by assisting shareholder enforcement of management fiduciary duties, and by raising managerial consciousness. casabona (2005) notes that global investors and creditors make their decisions based on information published in various non-financial, financial, and economic reports issued by listed companies. investors and creditors also review the profitability, financial conditions, and non-financial conditions, such as employee information, the director‟s remuneration, and internal share transactions, before making investment decisions. hence, voluntary disclosure, highly encouraged in chinese companies, is an extension of the disclosure of the basic information that annual reports must contain, reflecting the economic realities of an entity in a meaningful, transparent, and comparable manner (wong, 2008). studies of voluntary disclosure have been conducted in many developed countries (malone et al., 1993; ling and lundholm, 1996; ferguson et al., 2002). in order to protect the interests of public investors and other market participants, an effective regulatory system of corporate disclosure is required. with the development of the securities market in china, many regulations relating to the public disclosure of information by listed companies have been promulgated. the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 123 specific regulations governing information disclosure of publicly-listed firms in china include provisional rules on the issuance of stocks and transaction management released by the state council in april 1993. standards governing the content and format of public disclosures by listed firms were promulgated in 1994 (and revised in 1998, 1999, 2001, 2002, 2003, 2004, and 2005). notices on enhancing the quality of the disclosure of financial information by listed companies were released in 1999. implementation guidelines (provisional) on information disclosure by companies making public stock offerings have been issued by the china securities regulatory commission (csrc). table 1 shows the specific accounting standards issued by the ministry of finance (mof) and the listing rules in 2000 governing the shanghai and shenzhen stock exchanges. according to the regulations of the csrc, a publicly-listed firm should publish the information in its entirety or schematic form in a csrc-authorized national publication. in 1999 companies were concurrently required to publish summary printed annual reports and full reports on the internet. the code of corporate governance released in 2001 further specifies that a publicly-listed company should provide the necessary information to its creditors so that the shareholders will have a better understanding of the company‟s operational and financial positions. table 1. regulation governing financial disclosures by listed companies in china sources items effective date standing committee, national people‟s congress -the securities law -the company law 1 july 1999 1 july 1994 state securities committee, state council -the provisional regulations on stock issuance and trading -provisional measures on prohibition of falsification in securities transactions 22 april 1993 15 august 1993 china securities supervisory commission -detailed rules on information disclosures by publicly-listed companies -rules on the content and format of disclosure (nos. 1-7) 10 june 1993 since 1995 ministry of finance -accounting standards for business enterprises -accounting system for stock companies (amended 1994 and 1998) -practical (detailed) accounting standards (thus far, nine standards have been implemented) 1 july 1993 1 july 1992 since 1997-1998 shanghai stock exchange -guidelines on information disclosures by listed companies -guidelines on the operations of listed companies since 1990 since 1995 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 124 shenzhen stock exchange -rules on information disclosure by listed companies since 1993 3. the sample and the survey two types of shares are issued on the shanghai stock exchange (shse) and the shenzhen stock exchange: a-shares and b-shares. a-shares are mainly for domestic-market investors. b-shares are for international market investors. obviously, there are more companies issuing a-shares than b-shares. according to the csrc, in 2003 there were 1,146 companies issuing a-shares and only 111 companies issuing b-shares. because the a-share market accurately represents the situation in the chinese securities market, this study selected a sample from the a-share market of the shse. selection of the sample was based on the following criteria: 1. the percentage of selected sample firms is similar to that in the whole population; 2. the financial and insurance sectors are excluded from the final sample because such companies have different capital structures; 3. companies with abnormal financial performance are excluded; and 4. industries with less than five companies are eliminated. the study randomly selected 200 companies from the shanghai a-share market for the research sample. the industrial breakdown of the selected firms is presented in table 2. the study has determined that there is no difference between the level of voluntary disclosure of manufacturing firms and non-manufacturing firms (p > 0.05). therefore, the high proportion of manufacturing firms in the sample will not affect our interpretations of the results. table 2. industry breakdown of selected firms (n = 200) industry type number percentage mining 10 5% manufacturing 118 59% utilities 14 7% transportation and warehousing 18 9% information technology 16 8% wholesale and retail trade 12 6% real estate 12 6% 200 100% 3.1 corporate governance characteristics this study focuses on the relationship between the extent of voluntary disclosure and corporate governance. it examines corporate governance from the perspective of the ownership structure, including (1) ownership concentration; (2) state-owned or related ownership; and (3) individual ownership. the controls for the directors and the audit committee include: (1) the independence of the non-executive directors; (2) the ceo as the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 125 top director; and (3) the existence of an audit committee. there are also controls for firm-specific characteristics, including (1) firm size; (2) leverage; (3) profitability; and (4) industry. most of the data were collected from annual reports, which can be found on the web site of the shse. other data were collected from the china stock market and accounting research database (csmar). the following includes information on the details and measurement of the data collection of the variables: (i) ownership concentration may expose higher potential agency problems (jensen and meckling, 1976). ownership and management may generate benefits from entrepreneurial activities, such as the physical appointments of the office, pension funds, and personal benefits. under a high (low) concentrated ownership structure, the managers‟ compensation is negatively (positively) related to company performance (jiang et al., 2009; ahman and picur, 1997). the diverging interests between management and outside shareholders create an agency problem. in other words, firms with concentrated shareholdings should have greater control over minority shareholders. it is more efficient to monitor the compensation of managers in companies with a low level of ownership concentration. controlling owners are likely to be less dependent on transparency and information disclosure (erik and anete, 2005), and they can obtain information directly from informal channels. hence, a company with a centralized ownership structure will be reluctant to disclose additional information. therefore, it is expected that there is a negative relationship between voluntary disclosure and ownership concentration. the following hypothesis is proposed: h1: there is a negative relationship between the extent of voluntary disclosure and ownership concentration. (ii) government ownership, including ownership by government-related institutions (legal entities), of publicly-listed companies is a feature of the chinese market. some of the shares can only be transferred to domestic institutions with the approval of the csrc. most of the publicly-listed companies were originally held by soes and their shares are still controlled by the central or local governments. when they go public, the soes must transfer a high percentage of the shares to government bodies in order to preserve the socialist structure of the economy. there has been no prior research on voluntary disclosure and government ownership in the chinese context. but eng and mak (2003) find that a company with significant government ownership in singapore is associated with an increased propensity to disclose information. the government may have to consider the comprehensive development of the industry and the society. jiang (2009), conducting a study of new zealand companies, reaches a similar result -a governmentand management-controlled ownership structure has a considerably higher propensity to disclose more information. agency costs are high in state-owned companies because of the conflicting objectives between the pure profit goals of commercial enterprises and goals related to national interests (wong, 2008). h2: there is a positive relationship between the extent of voluntary disclosure and government ownership. (iii) michael et al. (2002) find that firms with more tradable shares disclose significantly asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 126 more strategic and financial information. listed companies are required to meet listing requirements and to increase the level of transparency. lauterbach and vaninsky (1999) examine the effect of ownership structure on firm performance. they find that owner-managed firms are less efficient in generating net income and in disclosing information than firms managed by non-owners. this result suggests dispersed ownership and non-owner managers enhance firm performance and company transparency. the chinese government requires that these companies disclose additional information before they can issue more shares to the public, thus allowing local investors to learn more about the firms‟ financial situation. the chinese government can press publicly-listed firms to disclose more information by means of regulations and laws. from the company perspective, it must provide more information to potential investors in order to increase the attractiveness of its shares on the stock market (meek et al., 1995). therefore, the following hypothesis is proposed: h3: there is a positive relationship between the extent of voluntary disclosure and the percentage of tradable shares. (iv) the controlling power of the director means that the ceo is the key person in the company and he/she may also be the chairman or vice chairman of the board of directors (ceo duality). chia et al. (2008) and cheng and courtenay (2006), in conducting empirical research in the united states, indicate that there is no significant relationship between ceo duality and company performance. recently, an increased number of u.s. companies have converted from a dual to a non-dual ceo structure. but chia et al. (2008) do not find any significant relationship between a non-dual structure and company performance. however, regulatory bodies and investors prefer a separation of the role of the ceo and chairman of the board of director. if such a dual role exists, the ceo may fail to play a monitoring role in the company. as noted by bai (2003), the board of directors has a significant impact on company performance. the ceo‟s control of the board is expected to have a negative impact on company performance due to his/her excessive compensation. under such conditions, a dual role is expected to contribute to ineffective monitoring. at the initial stage of a public offering, state owners prefer to retain a certain level of control and to assign the ceo to the board. this further indicates that with a change in ownership structure, firms may use inside directors to indirectly influence the company. this study provides empirical evidence of the relationship between corporate governance and its impact on the level of disclosure. the appointment of an independent board is one method to ensure alignment of the interests of the managers and owners. hence, ceo-is-top-dir is expected to have a negative impact on a company‟s voluntary disclosure. the fourth hypothesis can be presented as follows: h4: there is a negative relationship between the extent of voluntary disclosure and the existence of ceo-is-top-dir. (v) the percentage of outside (independent) executive members on the board of directors to the total number of directors appointed by the controlling shareholders represents the monitoring capacity of the company. it is expected that a high ratio shows that outside directors play a significant role in the company‟s monitoring system (fama and jensen, 1993; asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 127 rosenstein and wyatt, 1990). cheng and courtenay (2006) examine the association between board monitoring and the level of voluntary disclosure. they find that firms with a higher proportion of independent directors on the board are associated with higher levels of voluntary disclosure. although board size and ceo duality are not associated with voluntary disclosure, boards with a majority of independent directors have significantly higher levels of voluntary disclosure than firms with more balanced boards. the presence of an external governance mechanism, the regulatory environment, enhances the strength of the association between the proportion of independent directors and the level of voluntary disclosure. a company is expected to produce more voluntary disclosure when on the board there is a higher percentage of independent non-executive directors, who reduce the possibility of withholding information. therefore, independent non-executive directors on the board have a positive relation with voluntary disclosure and performance. good governance should protect and secure adequate returns for minority shareholders. according to bai et al. (2003), a well-structured governance structure can be established by an independent board through transparent disclosure and by an effective legal environment which will reduce the tendency for dysfunctional behavior by the controlling shareholders. according to agency theory, the controlling shareholders may seek personal benefits rather than overall company success. the controlling shareholders may appoint the principal officers of the company. hence, it is hypothesized that: h5: high voluntary disclosure is expected when a company has a high percentage of independent non-executive directors on its board. (vi) an audit committee can assist management boards and individual directors in the sharing of internal responsibilities. dezoort and salterio (2001) discuss the composition, functions, responsibilities, resources, and impacts of an audit committee on the corporate governance experience. to effectively fulfill its oversight functions, the audit committee should be independent, competent, financially literate, adequately resourced, and properly compensated. forker (1992) argues that the existence of an audit committee improves the internal control system, thus it is one of the most effective monitoring mechanisms to improve the quality of disclosure. generally, the duties of an audit committee include overseeing the quality of the financial information that is reported. the committee ensures that the management board is well informed about company decisions regarding accounting policies, practices, and disclosures. it also reviews the scope and outcomes of internal and external audits, and it oversees the financial reporting process (wallace and zinkin, 2005). the effectiveness of an audit committee is dependent on several factors. the earlier literature (klein, 2002; davidson et al., 2005) indicates that there is a relation between the independence of the audit committee and the effectiveness of corporate governance. according to wallace and zinkin (2005), the audit committee is likely to perform effectively when it is composed of a small group of between three and six members. chtourou et al. (2001) and xie et al. (2001) find that the committee is more effective when it participates in additional monitoring activities. the audit committee is an important mechanism to increase company transparency and to encourage management to disclose more information. we thus expect to find a positive relationship between the existence of an audit committee and the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 128 extent of voluntary disclosure. the following hypothesis is suggested: h6: a positive relationship is expected between the extent of voluntary disclosure and the existence of an audit committee. 3.2 measurement of voluntary disclosure 3.2.1 relative disclosure index there are three components to develop a measurement of voluntary disclosure by using the importance-adjusted relative disclosure index (rdi): (1) the items for voluntary disclosure; (2) the relative importance of disclosing an item of information; and (3) the extent of the actual disclosure of these items. (1) items for voluntary disclosure the first step is to establish a voluntary corporate governance disclosure checklist. the checklist is developed with reference to several important corporate governance principles and recommendations by organizations, including the organisation for economic co-operation and development (oecd), the australian stock exchange (asx), the hong kong securities exchange (hkse), and the csrc. after reviewing the principles of these organizations, the principles were integrated into 120 items of corporate governance-related information and grouped in seven categories: 1) board structure and functioning; 2) employee-related issues; 3) director remuneration; 4) audit committee; 5) related party transactions; 6) controlling shareholders‟ interests; and 7) stakeholder interests. all 120 disclosure items were checked to determine whether they are mandatory or voluntary items. in china, the 2002 code of corporate governance for listed companies and the no. 2 format and content of publicly-listed companies (revised in 2005) are the main mandatory disclosures required by the csrc. after checking against these mandatory disclosure requirements, six categories and 51 items remained on the checklist; the remainder of the items were eliminated. the items are indicated in table 3. table 3. checklist of voluntary disclosure items voluntary disclosure items board structure and functioning 1 educational qualifications (academic and professional) 2 the skills and expertise relevant to the position of director held by each director holding the position at the time of the annual report 3 directors‟ interests in competing businesses 4 statement of directors‟ responsibilities regarding the financial statements 5 statement indicating whether any bankruptcy has been filed by the company, its executive officers, or members of the board of directors within the previous ten years 6 the qualifications of the company secretary 7 the qualifications of the accountant asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 129 8 the full name and qualifications of the appointed compliance officer employees 9 details on the amount of employee remuneration, and remuneration policies, bonuses, and share option schemes 10 amount spent on training 11 nature of training 12 policy regarding training 13 categories of employees undergoing training 14 number of employees trained 15 welfare information (general) 16 safety policy 17 data on accidents 18 cost of safety measures 19 redundancy information (general) 20 equal opportunity policy statement 21 recruitment problems and related policies 22 corporate culture development directors’ remuneration 23 how and by whom are the fees and other benefits of the non-executive directors determined 24 analysis of the directors‟ remuneration – performance-based compensation 25 analysis of the directors‟ remuneration – non-performance-based compensation 26 the role and functions of the remuneration committee 27 number of meetings per year 28 the names of the members of the remuneration committee 29 attendance by committee members at committee meetings 30 work undertaken by the remuneration committee during the year 31 significant issues addressed during the year 32 the existence and terms of any schemes for retirement benefits other than statutory superannuation, for non-executive directors audit committee 33 details on the names and qualifications of those appointed to the audit committee 34 the role and function of the audit committee 35 number of committee meetings asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 130 36 attendance at committee meetings 37 statement of independence 38 report on completed work related party transactions 39 directors‟ current accounts/loans to officers 40 directors‟ interests in significant contracts 41 a statement of the interests of each director and ceo of the company in equity or debt securities of the company or any associated corporation (class and number of such securities) 42 the details of any right to subscribe to equity or debt securities of the company granted to any director or ceo of the company or to the spouse or the children under the age of 18 of any such director or chief executive and the exercise of any such right stakeholder interests 43 company‟s acknowledgment of its wider social responsibilities, including environmental protection 44 company‟s human resource policies, internal management structure, and workplace development initiatives 45 commentary on the quality of the company‟s key relationships with investors, employees, customers, creditors, suppliers, and other significant parties 46 company‟s contributions to the community 47 social policy and value-added information 48 environmental protection programs – qualitative 49 environmental protection programs – quantitative 50 charitable donations and activities 51 community programs (general) (2) the relative importance of disclosing an item of information after the checklist was established, a questionnaire containing 51 voluntary disclosure items were developed (refer to table 4). because this study focuses on a-shares that are traded domestically, local analysts were selected to determine the need of domestic investors for disclosure items. with the help of a senior-level manager of the bank of china international, china (boc) ltd., questionnaires were sent to 100 internal financial analysts, 71 of whom responded via e-mail. thus, the response rate was 71 percent. among these 71 respondents, 5 refused to complete the questionnaire due to personal reasons or lack of time. therefore, the remaining 66 respondents were used to develop the importance-adjusted relative disclosure index. the boc analysts were asked to rate the importance of each item on a 7-point scale. after the questionnaires were returned, the average importance score of every voluntary disclosure item was calculated. the items with a minimum mean score of 4 remained on the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 131 checklist and the others were eliminated. the mean scores of 34 voluntary disclosure items were above 4. table 4 lists all the voluntary disclosure items and their average scores. the 34 voluntary disclosure items were then used to develop the importance-adjusted rdi. table 4. disclosure frequencies on the voluntary disclosure index disclosure items percentage of total responding companies (n=66) average score educational qualifications (academic and professional) 28% 4.6 skills and expertise relevant to the position of director held by each director in position at the time of the annual report 68% 5.5 directors‟ interests in competing businesses 5% 6.4 statement of directors‟ responsibilities regarding the financial statements 100% 5.8 qualifications of the accountant 16% 5.6 details on the amount of employee remuneration, remuneration policies, bonuses, and share option schemes 10% 4.6 nature of training 3% 4 training policy 5% 4 categories of employees trained 1% 4.1 safety policy 3% 4.5 data on accidents 1% 4 recruitment problems and related policies 6% 4 corporate culture development 6% 4.8 how and by whom are the fees and the other benefits of the non-executive directors determined 95% 5.6 analysis of the directors‟ performance-based remuneration compensation 91% 5.1 the role and functions of the remuneration committee 8% 5.3 number of meetings per year 4% 4.1 the names of the members of the remuneration committee 4% 4.5 attendance by committee members at committee meetings 3% 4.6 work undertaken by the remuneration committee during the year 4% 4.8 significant issues addressed during the year 1% 5 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 132 details on the names and qualifications of those appointed to the audit committee 4% 5.5 the role and functions of the audit committee 5% 5.9 number of committee meetings 4% 4.8 attendance at committee meetings 3% 4.8 statement on independence 3% 5.8 report on work accomplished 1% 6 directors‟ current accounts/loans to officers 0% 5.9 directors‟ interests in significant contracts 0% 6 a statement of the interests of each director and ceo of the company in the equity or debt securities of the company or any associated corporation (class and number of such securities) 99% 6 details on any right to subscribe to equity or debt securities of the company granted to any director or ceo of the company or to the spouse or the children under the age of 18 of any such director or chief executive and on the exercise of any such right 3% 4.9 company‟s acknowledgment of its wider social responsibilities, including environmental protection 8% 4.8 commentary on the quality of the company‟s key relationships with investors, employees, customers, creditors, suppliers, and other significant parties 43% 5.1 environmental protection programs – qualitative 4% 4 average score 5.01 (3) the extent of actual disclosure of these items this process involved checking the annual reports of each company against the importance-adjusted relative disclosure items on the checklist. the total number of items for each company sample is disclosed. the actual disclosure of each company is reported in table 4. the rdi of each sample company is computed as the ratio of the absolute disclosure score to the maximum possible disclosure score (ho and wong, 2001). the maximum possible disclosure score is the total number of items that the company disclosed in its annual report. the items considered irrelevant to the companies will not be disclosed. for example, because not all companies in the sample have an audit committee, such companies are not required to disclose the audit committee item. 4. measurement of the independent variables all the data were collected from the chinese stock market and accounting research database (csmar) and they were verified by the annual reports of the respective companies. the ownership of the 10 largest shareholders measures the ownership concentration, but some firms may have fewer than 10 shareholders (haniffa and cooke, 2002). therefore, ownership concentration is measured in terms of a percentage. this variable is denoted as asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 133 “top10” the proportion of shares held by the government and related government institutions is published in the annual reports of the publicly-listed companies. in the chinese market, government ownership includes the shares held directly by the government and the legal-entity shares that may be controlled by various government levels. these data can be retrieved from the companies‟ annual reports. they are measured in the form of a percentage to indicate how many shares the government holds. this variable is denoted as “pg.” the proportion of individual shares (only a-shares) can also be collected from the annual reports of the listed companies. this variable is denoted as “ts.” all the information about the directors of the publicly-listed companies is listed in their annual reports, including information about executive directors and independent non-executive directors. the proportion of independent non-executive directors (inds) to the total number of directors is the number of independent non-executive directors on the board divided by the total number of directors on the board. the ceo-is-top-dir (cd) means that the same person is board chairman and ceo of the firm. the names of the board chairman and the ceo are available in the annual reports. the study codes a dummy variable that is equal to 1 if the board chairman and the ceo are the same, and 0 otherwise. data on the existence of an audit committee (ac) use dummy variables to indicate its existence or non-existence, coded “1” or “0” respectively. 4.1 measurement of the control variables a regression model is used to test the relation between corporate governance and the voluntary disclosure items as stated in h1-h6 (see table 7). first, it is necessary to control for company size. hence, the natural logarithmic total sales lns as a control variable limits the possible size effects. second, long-term debt/equity is used to control for possible leverage effects (rajan and zingales, 1995). third, profitability (profit) is measured by the return on equity. an average of three years of data was used to calculate profitability. last, the industry type of every publicly-listed company can be found on the web site of the shse. table 2 indicates that there are seven industrial categories in this study. 4.2 descriptive statistics and bivariate analysis table 5 shows the distribution of the dependent variable (rdi) and the mean of 0.2139. the range is between 0.107 and 0.7058. there is a large variation in the voluntary disclosure practices revealed in the annual reports of the chinese publicly-listed companies. the disclosure frequency on the voluntary disclosure index and the average score were rated by financial analysts of the bank of china. only 5 items are disclosed in more than 50 percent of the sample and 25 items are disclosed in less than 10 percent of the sample. no sample company disclosed the “directors‟ current accounts/loans to officers and the directors‟ interests in significant contracts,” which have the highest scores as rated by the financial analysts. the average score of all the voluntary disclosure items is 5.01, which is lower than the score reported in the study by ho and wong (2001) (their average score is 5.31). these results imply that publicly-listed companies in the chinese market voluntarily disclose less information than the companies in ho and wong‟s hong kong sample. the low average score based on the analysts‟ ratings also indicates that they do not regard the annual reports as the most important source from which to obtain company information. the most important items obtained from the analysts are (1) the directors‟ interests in competing businesses; (2) the report on the completed work of the audit committee; (3) the directors‟ interests in asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 134 significant contracts; (4) the statement of the interests (class and number of securities) of each director; and (5) the ceo‟s interests in the equity or debt securities of the company or any associated corporation. the mean of the shares held by the top 10 shareholders is 66.95 percent (within a range of 35.5 percent to 90.59 percent). the mean ratio of shares held by the government is 33.39 percent (within a range of 0 percent to 76.51 percent). this result is consistent with the previous literature that shows that the ownership structure of publicly-listed companies on the chinese stock market is highly concentrated and controlled by the state because these companies were originally soes. the mean ratio of independent non-executive directors is 34.55 percent (within a range of 20 percent to 44.44 percent). the descriptive statistics do not apply to the audit committee or the dominant personality variables because they are presented in the form of nominal variables. table 5. summary statistics of the continuous variables (n = 200) mean min. max. std. dev. dependent variables rdi extent of voluntary disclosures 0.214 0.107 0.706 0.095 independent variables top10 the shares held by the top 10 shareholders 0.670 0.355 0.906 0.097 pg the shares held by the government 0.340 0.000 0.765 0.239 inds the ratio of independent non-executive directors 0.345 0.200 0.444 0.041 lsize firm size (measured by log of total assets) 9.382 8.661 11.154 0.456 lev leverage ratio (total liabilities to total equity) 0.496 0.138 0.802 0.154 prf profitability (measured by roe) 0.086 -0.299 0.443 0.084 ts tradable shares 0.291 0.029 0.519 0.095 this study includes several nominal variables in the independent variables. the summary statistics of these variables are listed in table 6. among the publicly-listed firms, 52 percent have an established audit committee. the percentage of publicly-listed firms in which the ceo and the chairman of board is the same person is 17 percent. this means more companies are designed to establish audit committees and fewer companies have the management and ownership mix as reported by ho and wong (2000) (23.5 percent and 29 percent respectively). table 6. summary statistics of the nominal independent variables (n = 200) percentage of firms in the sample ac the existence of an audit committee 52 cd the existence of ceo duality 17 it industry types: mining 5 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 135 manufacturing 59 utilities 7 transportation and warehousing 9 information technology 8 wholesale and retail trade 6 real estate 6 table 7 shows the correlation matrix of all the dependent and independent variables. it is found that there are five variables that have a significant positive relationship with the rdi, including firm size, profitability, government and related institutions, percentage of independent directors on the board, and percentage of tradable shares held by individuals. in contrast, the existence and leverage of an audit committee has a negative and significant sign to predict the rdi. the presence of the bivariate relationship further encourages interpretation of the results by multivariate analysis. all of the variables were put into multiple regressions to test their relationship with the dependent variable (rdi). a multicollinearity problem may exist in the multiple regression model and may affect the interpretations of the results. therefore, a variance inflation factor (vif) was employed to test the presence of multicollinearity effects. the vifs of all the independent variables are below 2, meaning that there is no multicollinearity in this multiple regression model. table 8 shows the multiple regression results of the relationship between corporate governance and other specific characteristics on the extent of voluntary disclosure. table 7. correlation analysis rdi pg inds lsize lev prf top10 ts rdi 1.000 pg 0.219*** 1.000 inds 0.185** -0.048 1.000 lsize 0.324*** 0.292*** 0.161** 1.000 lev -0.192*** -0.029 0.061 0.206*** 1.000 prf 0.159** 0.081 -0.057 0.212*** -0.013 1.000 top10 0.042 0.413*** -0.046 0.180** -0.003 0.021 1.000 ts 0.130* -0.215*** 0.130* -0.174** -0.113 0.155** -0.602*** 1.000 *significant at the 10% level, **significant at the 5% level, and***significant at the 1% level. n = 200 table 8. multiple regression results of the relationship between corporate governance and other specific characteristics on the extent of voluntary disclosure r² = 0.374 adjusted r² = 0.313 f significance = 0.000 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 136 durbin watson test = 1.991 n = 198 explanatory variable coefficient std error beta t-values significance constant 0.484 0.265 1.829 0.069 top10 0.001 0.001 1.179 0.240 pg 0.039 0.027 1.470 0.143 inds 0.374 0.152 2.470 0.015* lsize 0.083 0.016 5.151 0.000* lev 0.175 0.041 4.315 0.000* prf 0.144 0.078 1.854 0.066 ts 0.292 0.095 3.070 0.003* cd 0.011 0.015 0.722 0.471 ac 0.024 0.012 2.034 0.044* it1 0.186 0.193 0.961 0.338 it2 0.215 0.157 1.373 0.172 it3 0.171 0.125 1.366 0.174 it4 0.061 0.091 0.671 0.504 it5 0.103 0.059 1.750 0.082 it6 0.035 0.034 1.023 0.308 ﹡significant at the 5% level. top10 = the shares held by the top 10 shareholders. pg = the shares held by the government. inds = the ratio of independent non-executive directors. lsize = firm size (measured by log of total assets). lev = leverage. prf = profitability (measured by roe). ts = tradable shares. cd = the existence of ceo duality. ac = the existence of an audit committee. it1 = industry type 1. it2 = industry type 2. it3 = industry type 3. it4 = industry type 4. it5 = industry type 5. it6 = industry type 6. 4.3 results and discussion based on the results in table 8, hypothesis 1 cannot be accepted. hence, there is no relationship between voluntary disclosure and ownership concentration. hypothesis 2 refers to a positive and significant (p < 0.1) relationship between the extent of voluntary disclosure asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 137 and government or related institutional ownership. the results do not reject h2. both these results may be due to differences between the political direction of the chinese government and the operations of listed companies. the chinese government has encouraged the release of information so as to increase investor confidence and to improve china‟s international reputation. government-controlled enterprises make preparations for listing internationally by providing financial transparency and disclosing adequate information disclosures on company operations to shareholders. it is expected that internationally listed companies will adopt international standards, will disclose sufficient information, and will follow international accounting standards to fulfill the requirements for overseas listings (therefore, h2 is positive and significant). in practice, most of the large and controlling shareholders are appointed by government officials and they are reluctant to disclose information. firm managers pursue their own interests rather than the interests of the shareholders, and there may be conflicts of interest between the controlling shareholders and other shareholders. la porta et al. (1998) state that expropriation may be in the form of excessive compensation, loan guarantees, or transfer pricing between related companies. an increase in the number of tradable shares has a significant and positive impact on the level of voluntary disclosure; hence hypothesis 3 cannot be rejected. some companies may hope to increase the number of shares by selling to individual investors. but in order to attract more investors, they have to develop a good reputation. as a result, they will benefit from a lower cost of capital and they will be exposed to more investors. thus, they are aware that they may benefit from greater disclosure. the negative relationship between the extent of voluntary disclosure and the existence of ceo-is-top dir indicates that hypothesis 4 cannot be supported. this finding is inconsistent with studies by forker (1992) and chen and jeggi (1998). only 17 percent of the companies have a ceo who is also chairman of the board, compared to 70-80 percent in the united states (rechner and dalton, 1991; rhoades et al., 2001) and 54 percent in hong kong listed companies (gul and leung, 2004). the separation of ownership and management is emphasized in the transformation from state to private ownership. in recent years, state-owned companies have attempted to retain their influence over government-appointed ceos. by doing so, company transparency is reduced. but some companies have succeeded in separating the two roles. corporate transparency may be further improved by reducing the share of ceos who are also chairmen of the board. prevalent corporate governance practices in europe separate the ceo and the chairman, and only 10 percent of uk publicly-listed companies combine the two (coles et al., 2001; higgs, 2003; kang and zardkoohi, 2005). these encouraging figures indicate that the separation of the two roles may contribute to the disclosure of more information. hypothesis 5 states that companies with a higher proportion of independent nonexecutive directors to total directors will be more likely to make more voluntary disclosures. this study supports h5. it also supports the studies by fama and jensen (1993) and rosenstein and wyatt (1990). there is more voluntary disclosure when there is a higher percentage of independent non-executive directors on the board who, in turn, reduce the possibility of withholding information. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 138 hypothesis 6, stating that companies that have an audit committee are likely to have higher voluntary disclosure, is not supported. in fact, the opposite is found in a significant direction. this study does not find sufficient evidence to support forker (1992) who finds a weak relationship and ho and wong (2001) who find a positive relationship between the two variables. the implication is that many companies in china voluntarily create audit committees to provide more effective communication between the board of directors and the external auditors. the audit committees are expected to oversee corporate governance, financial reporting, the internal control structure, internal audit functions, and external audit services. in china, the existence of an audit committee serves only to ensure that the company has complied with the mandatory disclosures. the purpose of the audit committee is not to press the company to disclose more voluntary information. the members of the audit committee may be appointed by the ceo or by the board of directors in order to fulfill shareholder requirements, and this may affect their monitoring roles in terms of their independence and trust. thus, the audit committee may not increase company transparency or increase disclosure of non-mandatory information to the public. 5. implementation and limitations of the study this study examines the role of governance on issues of voluntary disclosure in china. for both chinese regulatory bodies and listed companies, it is important to identify the corporate governance mechanisms that may affect company transparency. the privatization process of soes represents a gradual transfer of operational and financial control from state assets to individual investors. the speed of the transfer should be timed with progress in developing a strong regulatory governance system. in many countries with institutional weaknesses, such as china, regulatory capacity and reliability are limited. yet this study concludes that in such environments, maintaining state control undermines the very important progress toward less direct state control. most of the shares held by the government and legal entities in china are still concentrated (about 34 percent, see table 5). this study reveals a relationship between the extent of voluntary disclosure and government ownership and ownership concentration. since the 1990s, the chinese government has introduced shareholding and publicly-listed companies have had to transfer their non-tradable shares to tradable shares, thus dispersing the ownership structure of publicly-listed companies to individual owners and potentially also affecting the level of voluntary disclosure. this study also provides information on the expectations of both the investors and the creditors with respect to disclosure items. it finds that although more than half of the publicly-listed companies have audit committees, few companies disclose any information about their audit committees or their structures. but information on the audit committee is important so as to provide objective information to the readers of the annual reports. therefore, management of publicly-listed companies should disclose more of this kind of information to fulfill the needs of the public. the regulatory body should provide some incentives to encourage companies to disclose more information. the current turmoil in financial markets presents audit committees (not only the audit committees of financial service companies) with the critical challenge of understanding how financial crises affect their risk profiles. from liquidity and access to capital, to fair value and asset impairment, and, ultimately, to the adequacy of the company‟s processes to manage these and other risks effectively, audit committees focus on the risks that companies face in the current environment. the audit committee should disclose these risks to the shareholders. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e6 www.macrothink.org/ajfa 139 after all, what are "institutions" if not governance mechanisms with some degree of autonomy from both political and private interests? the gradual creation of institutions that are partially autonomous from political power is central to the development of an optimal mode of regulatory governance. this study offers suggestions about providing maximum accountability in regulatory governance, in particular by creating an internal control system based on a rotating board, representing users, producers, and civic organizations, which is elected by a process involving frequent reporting and disclosure. there are several major limitations to this study. first, it focuses only on the market in mainland china. the regulatory and economic situations in the china market are different from those of other markets. the results of this study only reflect characteristics of the china market. therefore, future research should be extended to other markets. given the impact of chinese culture, high power distance and secrecy (ailon, 2008; hofstede 2005) may also have significant impacts on the level of disclosure. because improvements in the corporate governance mechanism may change the management culture of chinese companies, it is important to extend future studies to investigate how these issues may enhance transparency. second, the sample in this study is small, including only 200 companies of the 850 publicly-listed companies, and companies listed on the b-share market are not included. furthermore, the study only examines the 2005 annual reports of the selected companies. although the a-shares in the shanghai and shenzhen markets are quite similar, there are still some differences between them. for example, the shanghai a-share market has more financial companies and the shenzhen a-share market has more real estate companies. therefore, the data may not precisely reflect the overall situation. third, due to resource limitations, it is difficult to increase the number of respondents, i.e., questionnaires to 100 analysts and 66 respondents. our study bases the demands of users of annual reports for information on the opinions of only 66 financial analysts from the boc to develop the rdi. actually, the opinions of these 66 persons may not represent the opinions of all financial analysts in the china market. the generalizability of the findings may thus be limited. future cross-country comparative studies are suggested to investigate the use of the rdi to measure the voluntary disclosure level in different countries. fourth, our study does not include other important independent variables that may also affect the extent of voluntary disclosure. nazli and pauline (2006) present other variables that affect the voluntary disclosure level of publicly-listed companies; for example, in the malaysian securities market, companies with a higher ratio of family members on the board and a higher proportion of shares held by the executive directors disclose less voluntary information. because information about family members on the board and the proportion of shares held by the executive directors is difficult to obtain, our study does not include these two variables. if additional resources are found, such information may be included in future research. the characteristics of the ownership structure, such as firms managed by professional managers, family members, partnerships of individuals, 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(1999). property right, corporate governance and performance: an evaluation on china‟s soe (in chinese), shanghai fareast publishing house. microsoft word profit per share kkk-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 162 predicting the profit per share using financial ratios khaldoun m. al-qaisi assistant prof. of finance, faculty of business finance department amman arab university, jordan e-mail: khaldoun_21@yahoo.com received: october 21, 2011 accepted: november 21, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.1027 url: http://dx.doi.org/10.5296/ajfa.v3i1.1027 abstract the objective of this research is to test the effect of financial ratios on the accomplished profit per share. the results of this research have showed that the predictability of accomplished profit per share was reached using the financial ratio, economical ratio and commercial ratio. the use of working capital and peremptory cash ratio and rapid cash were not useful to predict the accomplished profit per share. keywords: financial ratio, economic ratio, commercial ratio, working capital, rapid cash, profit per share 1. introduction the predictability of profit per share is considered important for the investors' decisions and shareholders in different companies. if the shareholders or investors were able to predict the profit per share for companies, this indicated they will be able to make good investing decisions. a convincing long-term return reversal effect has been shown in us studies (e.g. de bondt and thaler, 1985, 1987; chopra, et. al., 1992) and in the uk market (dissanaike, 1997 and 2002, and arnold and baker, 2007). prior period extreme positive return shares (over 3 to 5 years) subsequently under perform the market, whereas those shares that perform the worst over a sequence of years then, on average, produce returns significantly greater than the market as a whole. studies from around the world have drawn similar conclusions. the phenomenon is demonstrated to be robust to various risk analyses, the influence of size and market-to-book ratio. another strand of research takes the perspective that the firm’s fundamental values are indicated by information in financial statements. share prices deviate at times from these, and only slowly gravitate toward fundamental values. thus, analysis of published financial asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 163 statements can discover values that are not reflected in share prices. several papers document the market’s inability to fully process the implications of various financial signals (e.g. foster, et. al., 1984, sloan, 1996, michaely, et. al., 1995, piotroski, 2000 and hirshleifer, et. al., 2004). multiple pieces of information available from firm’s financial statements are used to predict future excess returns (ou and penman, 1989a, 1989b, holthausen and larcker, 1992, lev and thiagarajan, 1993, abarbanell and bushee, 1997, richardson, et. al., 2003 and fairfield, et. al., 2003). linked to this ‘predictability anomaly’ may be the observation that financial analysts pay less attention to poor-performing, low-volume or small firms (mcnicholls and o’brien, 1997, and hayes, 1998). they have a bias in recommending those with a strong recent performance (stickel, 2000, jegadeesh et. al. 2004). one possible explanation for this is that, on an individual basis, the typical loser share will continue to under-perform. so, despite the documented out-performance of a loser portfolio analysts may risk ridicule and loss of credibility by recommending prior period losers as most of the these recommendations will turn out to be bad. the objective of this research is to: (1) measure and analyze the profit per share through the period 2005-2010 and (2) measure the predictability of profit per share using the profitability ratios. 2. methodology amman stock exchange market data was used for ten companies in industrial sectors for the period 2005-2010. the ratios calculated included financial profit, economical profit, commercial profit, exchange ratio, rapid cash, liquidity peremptory, working capital, and profit per share. the research tested one major hypothesis and two sub-ones as follow: the major hypothesis: there is not any statistical effect of financial ratios on real profit per share. this hypothesis testing the effect of ratios on predicting the profits gained per share in the ten industrial companies. hypothesis testing will divided to two groups. the first groups testing the effect of profit ratio on the profit per share while the other will be the testing the effect of liquidity testing on the profit gained per share for the ten companies. 3. results table 1 showed the financial ratios of the ten industrial companies for the study period. the companies' names were listed in abbreviation as c1 indicating company one up to c10 to indicate the tenth company in the industrial sector. 3.1 the effect of financial ratios on the accomplished profit per share table 2 shows linear regression of effect of financial ratios on predicting the profit per share. linear regression was used to test the effect of financial profit ratio on the accomplished profit per share. table 2 shows positive effect of financial profit ratio on predicting the profit per share accomplished. the coefficient of financial profit was 3.106 and the impact on profit per share was positive. the model was significant with significance p<0.05. the regression asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 164 coefficient was small indicating the effect of other factors that contribute in predicting the profit per share value the function of prediction is: y = 3.1068 x1 + 0.232159, where y: profit per share x: financial ratio 3.2 the effect economical profit on accomplished profit per share table 3 shows the results of testing the prediction of accomplished profit per share using economical profit. linear regression was used in this testing. the results of testing showed significant positive effect of economical ratios on the accomplished profit per share. the constant value was 1.523 indicating that the increase of accomplished per share will increase by this value if the economical ratio improved by one unit. the model was significant with f value 21.30 and significant p<0.05. the regression model for this effect was: y = 1.524 x – 0.209; where y: accomplished profit per share x: economical ratio 3.3 the effect of commercial ratio on accomplished profit per share table 4 represents the linear regression for the effect of commercial ratio on accomplished profit per share. the table provides model summary. linear regression testing shows positive effect of commercial ratio on the accomplished profit per share. the effect was significant. the improvement of commercial ratio will improve the accomplished profit per share by 5.45. the model was significant with f value 40.74 with significance p<0.05. 3.4 the effect of different ratios on accomplished profit per share table 5 represents the effect of commercial, financial and economical ratios on accomplished profit per share. the model predictability was acceptable as the regression coefficient was 0.426 indicating that these ratios can be used to predict accomplished profit per share ratio. linear regression analysis showed the positive effect of profit ratios on the accomplished profit per share. the effect was limited to the commercial ratio which shows significant effect on commercial ratio (p<0.05). this indicates that there is collinearity which affected the other factors to be included in one model to test the accomplished profit per share. in this concern, the previous regression models showed that each of the included ratio has positive effect on the accomplished profit per share. 3.5 the effect of exchange ratio and the accomplished profit per share table 6 shows the results of testing linear regression of exchange ratio on the accomplished asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 165 profit per share. the linear regression testing shows positive effect of exchange ratio on the accomplished profit per share but the relation was not significant. even though the model was not significant and the regression coefficient was small. these results indicate that the exchange ratio cannot be used to predict the accomplished profit per share. 3.6 the effect of rapid cash liquidity ratio on the accomplished profit per share table 7 shows the linear regression for the effect of liquidity ratio on the accomplished profit per share. the results of testing the effect of rapid cash on the accomplished profit per share shows low regression coefficient 0.0788. the model was not significant with p>0.05. the effect of rapid cash on accomplished profit per share was not significant. these results indicate that there is no effect for rapid cash of the company on the accomplished profit per share. 3.7 the effect of cash peremptory on the accomplished profit per share table 8 shows the effect cash peremptory ratio on the accomplished profit per share. the regression model for testing the effect of peremptory cash ratio on the accomplished profit per share was not significant (p>0.05). the regression coefficient was very low and close to zero and the effect of peremptory cash ratio coefficient was not significant. 3.8 the effect of working capital on the accomplished profit per share table 9 shows the linear regression of the effect of working capital on the accomplished profit per share. the regression model showed not significant model for the effect of working capital on the accomplished profit per share (p>0.05). the regression coefficient was close to zero indicating that there is no effect and the effect of working capital was not significant. the effect of the previous ratios (working capital, peremptory cash, and rapid cash) on accomplished profit was not significant using one model (table 10). 4. discussion predicting profit per share is considered one of the motives of financial markets. profit per share is expected to be affected by financial ratios, economical profit and commercial ratios. the effect of rapid cash, cash peremptory, and working capital was tested on profit per share. the results of this research indicated that the profit per share can be predicted using the financial ratios. the model of testing was highly significant with significant effect of financial ratios on profit per share. accordingly, the profit per share is triplicated by 3.11 the financial ratio. the results indicated that the economical ratios can be used as predictor of profit per share. the linear regression showed significant model with significant effect of economic ratios on profit per share. the predicted effect indicated that profit per share would increase by 1.5 if asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 166 the economical ratio was one. moreover, commercial ratio has a positive effect on the profit per share. the testing model was significant and the t-test of the effect of commercial ratio was significant too. the model represents direct relation between the profit per share and commercial ratio. the collinearty among financial, economical and commercial ratios makes it impossible to test the effect on profit per share using the three factors in one model. the results have shown that the effect of exchange ratio, cash peremptory and working capital was not significant, which is indicates that these ratios cannot be used for the prediction of profit per share. 5. conclusions the objective of this research is to test the effect of financial ratios on the accomplished profit per share. the predictability of profit per share is considered important for the investors' decisions and shareholders in different companies. if the shareholders or investors were able to predict the profit per share for companies, this indicated they will be able to make good investing decisions. the results of this research have showed that the predictability of accomplished profit per share was reached using the financial ratio, economical ratio and commercial ratio. the use of working capital and peremptory cash ratio and rapid cash were not useful to predict the accomplished profit per share. references abarbanell, j. s., & bushee, b.j. 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(2000). analysts incentives & financial characteristics of wall street darlings & dogs, working paper, lasalle university   asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 168 table 1. the selected financial ratios for ten industrial company from ase market for the period 2005-2010. financial profit economicl profit commercial profit exchange ratio rapid cash liquidity peremptory profit per share working capital 0.170.46 0.111.601.600.080.25 867116 2010 c1 0.170.39 0.101.701.700.100.22 1047154 2009 0.160.40 0.121.631.630.330.26 1064654 2008 0.180.61 0.141.841.840.480.30 1080073 2007 0.190.52 0.131.811.810.530.28 1135082 2006 0.180.48 0.112.112.110.790.25 1493639 2005 0.271.29 0.526.046.040.325.76 1958172 2010 c2 0.111.37 0.466.266.260.605.22 1768842 2009 0.150.83 0.284.644.640.903.20 1254892 2008 0.010.09 0.037.907.905.060.24 1334138 2007 0.100.70 0.195.945.943.982.13 1387161 2006 0.301.85 0.585.225.223.186.77 1349482 2005 0.100.30 0.122.202.200.160.19 5107758 2010 c3 0.000.01 0.011.501.500.020.01 3354754 2009 0.040.15 0.042.272.270.250.07 4126164 2008 0.050.29 0.073.083.080.660.09 4369614 2007 0.080.41 0.122.852.850.940.16 4773781 2006 0.040.21 0.072.752.750.550.08 4121221 2005 0.210.83 0.244.304.300.830.39 30697941 2010 c4 0.210.98 0.255.335.331.370.36 31846245 2009 0.151.00 0.235.635.631.530.33 30187753 2008 0.171.16 0.256.116.111.690.54 28723629 2007 0.150.92 0.225.555.551.560.44 26263388 2006 0.140.88 0.215.635.631.810.38 24008435 2005 0.260.78 0.994.034.030.872.14 15810423 2010 c5 0.080.14 0.236.726.720.000.48 16638827 2009 0.050.14 0.1816.9916.991.170.56 23628082 2008 0.070.14 0.175.365.360.000.58 20682805 2007 0.100.18 0.205.625.620.000.76 20408306 2006 0.090.13 0.194.124.120.000.57 18882061 2005 0.220.61 0.202.622.620.010.46 1638366 2010 c6 0.180.77 0.203.433.430.860.36 1547982 2009 0.161.00 0.233.743.741.140.39 1461318 2008 0.150.91 0.193.943.940.750.31 1379267 2007 0.211.12 0.233.633.630.310.40 1297689 2006 0.160.52 0.182.382.380.220.27 973290 2005 0.040.45 0.0410.0910.091.990.09 2645714 2010 c7 0.030.37 0.047.347.341.050.10 2626096 2009 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 169 0.050.28 0.046.276.271.600.09 2625787 2008 0.040.21 0.045.055.051.310.09 2569598 2007 0.070.18 0.063.303.300.920.14 2541091 2006 0.060.21 0.073.793.790.660.12 2444457 2005 0.130.81 0.264.024.021.830.18 5250280 2010 c8 0.040.78 0.224.334.332.390.14 5402303 2009 0.111.41 0.315.715.713.440.20 6119560 2008 0.080.76 0.276.306.304.070.11 7498466 2007 0.101.52 0.368.608.606.320.18 6440674 2006 0.101.51 0.338.198.195.790.17 5712068 2005 0.581.19 0.333.063.061.991.11 90458244 2010 c9 0.621.12 0.313.263.261.990.86 70144651 2009 0.200.59 0.191.841.840.740.45 24803813 2008 0.140.31 0.130.860.860.130.27 -6740163 2007 0.090.15 0.081.391.390.100.15 12704774 2006 0.030.06 0.041.841.840.330.06 23469149 2005 0.520.17 0.171.161.160.140.64 4931068 2010 c10 0.340.12 0.161.901.900.760.41 16989329 2009 0.110.11 0.123.263.261.830.14 11067259 2008 0.090.14 0.112.092.091.410.12 6432480 2007 0.100.15 0.111.851.851.130.12 5273932 2006 0.080.08 0.081.711.711.000.09 5669991 2005 table 2. linear regression of effect of financial ratios on predicting the profit per share model r r square adjusted r square std. error of the estimate 1 0.285522895 0.081523 0.065688 1.286787 model sum of squares df mean square f sig. 1 regression 8.524233 1 8.524233 5.148038 0.027009 residual 96.03766 58 1.655822 total 104.5619 59 model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 0.232159 0.260409 0.891516 0.376336 financial profit 3.106808 1.369284 0.285523 2.268929 0.027009 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 170 table 3. regression analysis for the effect of economical profit on profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.518305308 0.26864 0.256031 1.148255 anova(b) model sum of squares df mean square f sig. 1 regression 28.08955 1 28.08955 21.30435 2.22e-05 residual 76.47235 58 1.318489 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -0.20888 0.244259 -0.85517 0.395976 economical ratio 1.523797 0.330136 0.518305 4.615664 2.22e-05 table 4. linear regression for the effect of commercial ratio on accomplished profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.642375356 0.412646 0.402519 1.029017 anova(b) model sum of squares df mean square f sig. 1 regression 43.14706 1 43.14706 40.74796 3.15e-08 residual 61.41484 58 1.058877 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -0.37093 0.212423 -1.74618 0.086074 commercial ratio 5.454293 0.854448 0.642375 6.383413 3.15e-08 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 171 table 5. the regression model for the effect of financial, economical and commercial ratio on accomplished profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.652910265 0.426292 0.395557 1.034995 anova(b) model sum of squares df mean square f sig. 1 regression 44.57388 3 14.85796 13.8702 7.08e-07 residual 59.98802 56 1.071215 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -0.46517 0.246124 -1.88999 0.063939 financial ratio -0.05251 1.231587 -0.00483 -0.04264 0.966144 economical ratio 0.466316 0.406916 0.158613 1.145978 0.256678 commercial ratio 4.566233 1.19566 0.537785 3.819007 0.000338 table 6. linear regression for the effect of exchange ratio on the accomplished profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.159613777 0.025477 0.008674 1.325467 anova(b) model sum of squares df mean square f sig. 1 regression 2.663877 1 2.663877 1.51627 0.223155 residual 101.898 58 1.756862 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 0.353835 0.32025 1.104871 0.273778 exchange ratio 0.078839 0.064025 0.159614 1.231369 0.223155 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 172 table 7. the linear regression for the effect of rapid cash on the accomplished profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.159613777 0.025477 0.008674 1.325467 anova(b) model sum of squares df mean square f sig. 1 regression 2.663877 1 2.663877 1.51627 0.223155 residual 101.898 58 1.756862 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 0.353835 0.32025 1.104871 0.273778 rapid cash 0.078839 0.064025 0.159614 1.231369 0.223155 table 8. linear regression results for the effect of cash peremptory on the accomplished profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.04708566 0.002217 -0.01499 1.341191 anova(b) model sum of squares df mean square f sig. 1 regression 0.23182 1 0.23182 0.128875 0.720905 residual 104.3301 58 1.798794 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 0.630645 0.23403 2.694718 0.0092 peremptory cash 0.044652 0.124382 0.047086 0.358992 0.720905 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 173 table 9. regression coefficient for the effect of working capital on accomplished profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.037564133 0.001411 -0.01581 1.341733 anova(b) model sum of squares df mean square f sig. 1 regression 0.147544 1 0.147544 0.081957 0.775682 residual 104.4144 58 1.800247 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 0.720811 0.209318 3.443622 0.001072 working capital -3.1e-09 1.08e-08 -0.03756 -0.28628 0.775682 table 10. regression coefficient for the effect of working capital, rapid cash and peremptory cash on accomplished profit per share model summary model r r square adjusted r square std. error of the estimate 1 0.171363329 0.029365 -0.02263 1.346234 anova(b) model sum of squares df mean square f sig. 1 regression 3.070501 3 1.0235 0.564738 0.640531 residual 101.4914 56 1.812346 total 104.5619 59 coefficients(a) model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 0.398095 0.339566 1.172363 0.246015 rapid cash 0.090491 0.074531 0.183204 1.214129 0.229794 peremptory cahs -0.03698 0.142689 -0.03899 -0.25914 0.796479 working capital -4.3e-09 1.08e-08 -0.05216 -0.39459 0.694644 microsoft word 3365-13208-1-rv-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 233 information content of csi 300 index futures during extended trading hours: evidence from china yugang chen associate professor of finance, business school sun yat-sen university 135 xingang road, guangzhou, china, 510275 e-mail: chenyugang76@163.com karen jingrong lin (corresponding author) assistant professor of accounting, manning school of business university of massachusetts-lowell / sun yat-sen university 1 university avenue, lowell, ma, 01854 e-mail: jingrong_lin@uml.edu received: march 10, 2013 accepted: april 9, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3365 url: http://dx.doi.org/10.5296/ajfa.v5i1.3365 abstract china established its stock futures exchange in year 2006, but not until year 2010 did the first futures contract become publicly available for trading. the tight government as well as the composition of market participants raises the question that whether this futures market is informationally efficient. we study the information incorporation of the futures market during the extended trading hours beyond those of the underlying spot market. our analyses show that, first, spot market is the main information source of the futures market. in addition, using a t-garch model, we show that the post-closing, overnight and pre-opening returns are significantly correlated with the overnight spot market return. second, the return innovations of the futures market significantly correlate with the overnight spot market return, indicating a price discovery role of the futures market. finally, the futures market during the extended hours reflects the overnight news in the u.s. market. keywords: stock index futures, information content, price discovery, extended trading hours asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 234 1. introduction we investigate information efficiency of the futures market in an important emerging economy, china. in particular, we explore whether the csi 300 index futures traded during extended trading hours (i.e., after the spot equity market is closed or before it is open) incorporate additional information. following other markets around the world, china has adopted asynchronous opening and closing times between the spot and the futures market. we investigate the information role of the futures market by examining information incorporation of the csi 300 index futures during the non-trading hours of the underlying spot market. the capital market in china is heavily regulated with numerous unsophisticated individual traders as market participants1. thus, the equity market in china is often considered to be weakly efficient regarding information incorporation (chong, lam, & yan, 2012; gul, kim, & qiu, 2010; morck, yeung, & yu, 2000). in 2006, the chinese securities regulatory commission (csrc) established the china financial futures exchange (ffex), but it was not until year 2010 that the first futures product based on the equity market index, the csi 300 index, was publicly available for trading. the government was cautious about the risks involved in developing the financial derivatives markets in china, and investors are concerned about the market efficiency of these markets. under tight control by the government, it is unclear whether china’s futures market is informationally efficient. in this study we address three interrelated research questions. first, how are returns from different trading sessions of futures during the non-trading hours related to the overnight spot market return? second, following hiraki, maberly, and takezawa (1995) and cheng, jiang, and ng (2004), does the return innovation extracted from the futures market during the extended trading hours explain the overnight spot return? finally, is the overnight futures market effective in incorporating information from the main overseas markets such as the u.s. market? in particular, we investigate two sources of additional information: the price volatility in the u.s. market, as well as the overnight news of the u.s. market (such as interest rate news released by the federal reserve). using high-frequency trading data at the minute level during april 16, 2010 to february 28, 2011, we were able to divide the trading of futures during extended hours into three parts: post-closing trading session (15:00-15:15pm), overnight session (15:15-9:15, next day), and pre-opening trading session (9:15-9:30). our analyses generate empirical evidence as follows. first, we confirm that the underlying spot equity market is the main information source of the futures market. specifically, trading of futures contracts during a post-closing session is less active and conveys less information than it does when the spot market opens. in addition, the three trading sessions of csi 300 index futures are significantly correlated with the overnight spot csi 300 index return. second, we find significant explanatory power of the futures return innovations of the post-closing and pre-opening sessions on overnight spot returns. this suggests that post-closing and pre-opening sessions convey private information about 1 individual investors are the major force of the stock market. for example, in 2009 the aggregate value of stocks possessed by institutional investors increased to 54.62 percent. source: http://www.china.org.cn/business/news/2009-05/06/content_17732363.htm asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 235 the overnight spot market. finally, we confirm the overnight return of the futures market incorporates information from a major overseas market, in our case, the u.s. market. this result is consistent with the contagion model presented by king and wadhwani (1990). our study contributes to the existing literature in the following ways. first, we provide evidence of information efficiency of the newly incepted futures market in china, adding to the existing knowledge about futures markets in emerging economies such as hong kong and korea (cheng et al., 2004; chong et al., 2012; min & najand, 1999). second, our study sheds light on the information transfer between china’s spot and futures market, as well as that between china’s market and the u.s. market. the rest of this study is organized as follows: section 2 is a literature review and hypotheses development, section 3 introduces data and methodology, section 4 discusses empirical results, and section 5 concludes. 2. literature review and hypothesis development information content as well as information efficiency of futures market has attracted enormous academic attentions because prices of futures are usually used as measures of market expectations. an informationally efficient futures market should deliver futures prices that accurately predict prices of the spot markets in the future (e.g., bigman, goldfarb, & schechtman, 1983). based on this understanding, a voluminous literature documents the correlation between the volatility of the futures and spot market (e.g., antoniou & holmes, 1995; chang, cheng, & pinegar, 1999). however, it has been not explored that whether the newly-launched china’s futures market is informationally efficient or not. on the one hand, the highly-regulated chinese markets can generate fluctuate stock prices conditional on political swings on both the spot (morck et al., 2000) and futures markets, reducing the predictability of the futures prices to the future spot prices. the fact that the major participants of the futures markets are unsophisticated investors exacerbate the problem of futures market may lack information efficiency. on the other hand, the long-time deliberation and preparation of the finance ministry and the stringent administrative environment indicate that this market is on the attention of high-level government attentions. therefore, if informationally inefficient, the government will interfere and change the regulatory environment. we test the information efficiency of the futures market in china by asking the following research question: how are returns from different trading sessions of futures during the non-trading hours related to the overnight spot market return? hiraki et al. (1995) show that the closing returns of the previous day and the opening returns on the next day are positively correlated, indicating information across different dates transmission during trading (e.g., kyle, 1985). following this spirit, if the spot market is a good source of information for the futures market, we should observe that the post-closing, overnight and pre-closing returns of the futures market are positively correlated with the overnight spot return. we therefore form our hypothesis (written in the null form) as follows: h1a. the post-closing, overnight and pre-opening returns of the futures market are not asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 236 correlated with the overnight spot return. if csi 300 index futures convey additional information to the spot market, the 15-minute extended trading session after the spot market closes allows investors to continuously incorporate information. similarly, trading activities in the futures market during the 15-minute pre-opening session impound overnight information before the spot market opens. that is, the unexpected returns in the futures market during these two trading sessions shall be able to predict the overnight spot market returns. both foster and viswanathan (1994) and hiraki et al. (1995) find that informed traders strategically trade on their private information and trading of futures contracts during post-closing and pre-opening sessions reveals informed traders’ private information and facilitates price discovery of the spot market. however, in a country where political control is overwhelming, information arbitrageurs will be driven away thus stock prices reflects only public and common information (morck et al., 2000). china is one of such country according to morck et al. (2000). therefore, a priori, it is difficult to predict whether china’s index futures market incorporates information additional to that traded in the spot market. we use a t-garch (1,1) model (engle & ng, 1993; zakoian, 1994) to extract the returns innovation from the extended trading hours to predict the overnight spot market returns2. the second hypothesis (written in the null form) is formulated as the following: h1b. the return innovations of csi 300 index futures contracts during the extended trading hours do not correlate with the overnight spot return of the csi 300 index. one important information source for the futures market after the spot market closes will be information from the overseas market. king and wadhwani (1990) find that rational investors infer private information from trading in other markets. lin, engle, and ito (1994) find that the tokyo and new york stock exchanges have correlated overnight and daytime returns, indicating information revealed during the trading hours of one market has a global impact on the returns of the other market. following these arguments, we examine whether overnight csi300 index futures returns incorporate news from the daytime trading in the u.s. market, and our third hypothesis (written in the null form) is the following: h2. the trading of futures contracts does not reflect the overnight information arrival in the u.s. market. 3. data and methodology 3.1 extended trading hours of the spot market we obtained the high-frequency trading data at the minute level from the tinysoft database. we divide each day’s trading into fifteen-minute intervals. the normal trading hours of the spot market is 9:00-15:00 every day. the extended trading hours of futures contracts are 2 engle and ng (1993) show that, in japan’s market, the t-garch model is the best parametric model when there is asymmetric return volatility conditional on news types. (chiang & wang, 2002) used it to investigate the taiwan futures market. we therefore follow this approach because we assume that asian countries share commonalities in market microstructures. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 237 9:15-9:30am and 15:00-15:15 (3:00-3:15pm). we further decompose the return of csi 300 futures in the non-trading hours of the spot market as the following: 3.2 information captured by the futures and spot markets to test hypotheses h1a, we test the difference of the price change, return and trading volume of the csi 300 index futures during the three sessions: pre-opening of the spot market, opening of the spot market, and post-closing of the spot market. this test is more descriptive in nature. to test h1b, we run the following regression model, eq (1), in which spot market overnight return of day t (i.e., ret300,t) is regressed on the futures return during three sessions: post-closing return of day t (i.e., ret1, t), overnight return (i.e., ret2, t), and pre-opening return of day t+1 (i.e., ret3, t). we labeled all three sessions with subscript t to reflect the fact that these returns are regressed corresponding to the overnight spot market return of a particular day. , = + , + , + , + ϵ , (1) and ret300,t is calculated as follows: , = (2) where pt is the opening price of csi 300 in day t, and pt-1 is the closing price of day t-1. empirically, we use the t-garch model (zakoian, 1994) to estimate the coefficients. statistically significant coefficients β1, β2, or β3 imply that (at least partially) the futures market captures information that is incorporated into the spot market. the underlying information between the two markets is similar. additional information reflected in the futures market to test h2, we follow hiraki et al. (1995) and cheng et al. (2004), using a two stage model to extract information from the futures returns and to predict the overnight spot market return. in the first stage, a t-garch (1,1) model is used to estimate the following models to extract return innovation from the futures returns: 9:15 9:30 (information after the closing of the spot market in day t-1) (information during closing hours of both futures and spot markets) (information before the opening of stock market in day t) 15:00 15:15 total information during three non-trading sessions of stock market (ret300) ret1 ret2 ret3 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 238 ret , = c + c ret , + u h = α + α u + α d u + α h d = 1 u < 0( ) 0 u ≥ 0(good news) (3) where ht is the conditional standard deviation of the ut process , and ut captures the private information of futures traded during the post-closing session. ret , = c + c ret , + v h = β + β v + β d v + β h d = 1 v < 0( ) 0 v ≥ 0(good news) (4) where vt captures the private information of futures traded during the pre-opening session. in the second stage, we regress the overnight spot market return on the return innovation from the futures during the extended trading hours. that is, we estimate the following t-garch (1, 1) model: ret , = c + c u + c v + ε h = γ + γ ε + γ d ε + γ h d = 1 ε < 0( ) 0 ε ≥ 0(good news) (5) 4. results 4.1 descriptive statistics figure 1 depicts the csi 300 index (spot market) return volatility and volume. we calculate return volatility using two methods: the high-low (hl) method and the end-to-end (ee) method (parkinson, 1980). the extreme value variance estimator is superior to the traditional close-to-close variance estimator in providing an efficient estimate of return volatility. the return volatility by hl method is calculated as the following: = ( ∑ ln , − ln , ) . (6) where p , is csi futures’ highest price and p, is the lowest price during session i on day t, and n is the number of observations. the volatility by ee method is calculated as the following: = ( ∑ ln , − ln , ) . (7) where , is the closing price of time t and , is the closing price of time t-1. the volume is calculated as the following: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 239 = , (8) similarly, figure 2 panels (a)-(d) portray the trading of index futures of four different contracts, if01-if043. figure 1 and figure 2 show that spot and futures markets have similar pattern of return volatility. additionally, if01-if03 contracts share similar patterns of return volatility and volume, too. if04 is slightly different. we then, in the following analysis, use the if01 contract as our sample because this is the contract with the largest trading volume among the four types of contracts. figure 1. price volatility of csi300 index (spot market) this graph presents the price volatility, calculated using the high-low method (σ_hl) and end-to-end method (σ_ee) (parkinson, 1980), as well as trading volume csi 300 index (spot market). the volatility calculated using high-low method is based on the following model: = ( ∑ ln , − ln , ) . ; where p , is csi 300 index’ highest price and p, is the lowest price during session i on day t, and n is the number of observations. the extreme value variance estimator is superior to the traditional close-to-close variance estimator in providing an efficient estimate of return volatility. the end-to-end method is based on the following model: = ( ∑ ln , − ln , ) . ; 3 if01, if02, if03 and if04 are four different index futures contracts with different maturity dates: these are contracts with maturity dates in the current month, next month, the last month of the closest quarter, and the last month of the next closest quarter. for example, assuming it currently is april, if01-04 refer to contracts with maturity dates at the third friday in april, may, june, and september, respectively. if the current month is may, then if01-04 refer to contracts with maturity dates at the third friday in may, june, september, and december, respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 240 the trading volume is calculated as: = ∑ , . this graph presents the price volatility, calculated using the high-low method (σ_hl) and end-to-end method (σ_ee) (parkinson, 1980), as well as trading volume of four different contracts of the csi 300 index. all variables are defined in figure 1. (a) (b) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 241 (c) (d) figure 2. price volatility of csi 300 index futures table 1 reports descriptive statistics of the variables. by comparing ret1, ret2 and ret3, we observe that ret2 is larger than returns in the other two sessions. this indicates that overnight information usually triggers more price reactions than that in the extended trading hours. table 2 reports the pearson correlation coefficients among variables. the overnight spot return is positively and significantly related to the overnight and the pre-opening futures return. table 1. descriptive statistics of variables this table presents descriptive statistics of the csi 300 index spot market return and the returns on three trading sessions of the csi 300 index futures when the spot market is closed. specifically, ret300 is the total return of the csi 300 index during the non-trading hours of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 242 the spot market. ret300 is calculated as the difference between the closing price of day t and the opening prices of day t+1 of the csi 300 index, divided by the closing price of the csi 300 index of day t. ret1 is the return of stock index futures during 15:00-15:15, ret2 is the return of stock index futures during 15:15 9:15 (next day), and ret3 is the return of stock index futures during 9:15-9:30. variable mean std.dev median max min ret300 -0.001** a 0.008 -0.001 0.021 -0.029 ret1 0.000 0.002 0.000 0.006 -0.007 ret2 0.001** 0.007 0.001 0.030 -0.026 ret3 0.000 0.003 0.000 0.009 -0.008 t-tests: null conclusion p-value ret1= ret2 rejected 0.068 ret2= ret3 rejected 0.062 ret1= ret3 0.970 note: ***,**,* represent statistical significance at levels of 1%, 5% and 10%, respectively. at-test is performed to examine whether the mean of the variable is significantly different from 0. table 2. correlation table ret300 ret1 ret2 ret3 ret300 1 ret1 0.097 1 ret2 0.722*** -0.091 1 ret3 0.424*** -0.011 0.072 1 4.2 information captured by the futures and spot markets to test hypothesis h1, we estimate eq (1) using the t-garch model developed in zakoian (1994), and results are presented in table 3. the coefficients for ret1, ret2, and ret3 are positive and significant at the 1% level, with a z-statistic of 9.956, 27.833 and 13.620, respectively. this indicates that information reflected in spot prices is also incorporated in futures prices. entering ret1, ret2, and ret3 one by one into the regression generates similar results. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 243 table 3. information captured by futures market and spot market when spot market is closed this table presents the multiple regression results of eq (1) using tgarch (1,1) model (zakoian, 1994). ret300 is the total return of csi 300 index during the non-trading hours of the spot market. that is, ret300 is calculated as the difference between the closing price of day t and the opening price of day t+1 of the csi 300 index, divided by the closing price of the csi 300 index of day t. ret1 is the return of stock index futures during 15:00-15:15, ret2 is the return of stock index futures during 15:15 9:15 (next day), and ret3 is the return of stock index futures during 9:15-9:30. ret , = c + c ret , + c ret , + c ret , + ϵ h = δ + δ ϵ + δ d ϵ + δ h d = 1 ϵ < 0( ) 0 ϵ ≥ 0(good news) ϵ is the residual of the model. (1) (2) (3) (4) variables ret300 ret300 ret300 ret300 intercept -0.001*** -0.001** -0.001*** -0.001** (-7.017) (-2.160) (-3.676) (-1.191) ret11 0.807*** 0.862*** (9.956) (3.304) ret2 0.865*** 0.865*** (27.833) (20.643) ret3 1.005*** 1.243*** (13.620) (9.309) intercept 0.002*** -0.009** 0.006*** -0.004 (4.328) (-1.960) (6.261) (-2.549) ε 0.478*** 0.059 0.003 0.074 (3.235) (1.193) (0.039) (1.317) d ε 0.381*** -0.008 0.468*** -0.074 (2.940) (-0.457) (5.117) (-1.335) h 0.095 2.139*** -0.307** 1.513*** (1.130) (3.293) (-2.036) (3.221) n 208 208 208 208 wald chi2 882.619 10.915 426.138 86.657 log likelihood 864.150 732.515 805.790 745.170 prob > chi2 0.000 0.001 0.000 0.000 note: ***,**,* represent statistical significance at levels of 1%, 5% and 10%, respectively. z-statistics are reported in parentheses. 4.3 additional information reflected in the futures market a t-garch (1,1) model is used to estimate eq. (4) and eq. (5). table 4 reports the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 244 first-stage, in which futures return innovation (i.e. unexpected information contained in futures returns) during extended trading hours, are extracted. panel a presents the estimated coefficients for regression using the futures return during the post-closing session (ret1) as the dependent variable. the coefficient for ret2 is not significant. this indicates that the information reflected in the post-closing session (15:00-15:15) does not overlap with the information captured by ret2 during the regular trading hours (from 9:30-15:00). this result is different from that in the study by cheng et al. (2004), who found a positive relation between the returns during the post-closing session and the returns during the regular trading hours. through the t-garch model, we extract unexpected components from futures returns for the post-closing session (ut). panel b reports the estimated coefficients for regression using the pre-opening session (ret3) as the dependent variable. the coefficient for ret1,t-1 is also not significant, indicating that the information reflected in the pre-opening session (9:15 a.m. to 9:30 a.m.) does not overlap with the information captured by ret1,t-1 during the post-closing session (15:00 p.m. to 15:15 p.m.). this result is consistent with that in the study by cheng et al. (2004). through the t-garch model, we extract unexpected components from futures returns for the post-closing session (vt). table 4. tgarch (1,1) models for extracting information variables this table presents multiple regression results of eq (1) using tgarch (1,1) model (zakoian, 1994). ret1 is the return of stock index futures during 15:00-15:15, ret2 is the return of stock index futures during 15:15 9:15 (next day), and ret3 is the return of stock index futures during 9:15-9:30. panel a. extracting information of the post-closing session panel a reports the extraction of the futures return innovations of the post-closing session using the following t-garch(1,1) model: ret , = c + c ret , + u h = α + α u + α d u + α h d = 1 u < 0( ) 0 u ≥ 0(good news) where ut is the residual of our model. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 245 variable coefficient estimate z-stat. intercept c × 10 0.183 1.319 ret2 c -0.027 -1.328 intercept α 0.001 0.822 ε α -0.202 -2.231** d ε α 0.032 0.347 h α 0.762 1.739* n 208 log-likelihood 1.763 wald chi2 1019.885 prob > chi2 0.184 table 4 (cont’d) panel b. extracting information of the pre-opening session panel b reports the extraction of the futures return innovations of the pre-opening session using the following t-garch(1,1) model: ret , = c + c ret , + v h = β + β v + β d v + β h d = 1 v < 0( ) 0 v ≥ 0(good news) where vt is the residual of our model. variable coefficient estimate z-stat. intercept c × 10 -0.686 -0.274 ret1,t-1 c -0.155 -1.427 intercept β × 10 -0.457 -0.314 ε β 0.311 1.998** d ε β -0.331 -1.903* h β 1.154 1.907* n 162 log-likelihood 2.037 wald chi2 747.239 prob > chi2 0.153 note: ***,**,* represent statistical significance at levels of 1%, 5% and 10%, respectively. table 5 presents the second-stage results, in which overnight spot market returns are explained by the innovations of the futures market returns. the coefficient of ut-1 is negative asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 246 and significant at the level of 10%, suggesting that post-closing futures innovations are weakly negatively correlated with overnight spot returns. the coefficient of vt is positive and significant at the level of 1%, with a z-statistic of 5.993. this indicates that pre-opening futures unexpected information has a positive impact on spot returns, consistent with the findings in hiraki et al. (1995) and cheng et al. (2004). table 5. tgarch (1,1) model for overnight spot returns ret300 represents the overnight spot return; ut-1 is the lagged futures return innovation during the post-closing session; vt is the futures return innovation during the pre-opening session; is the residual of our model. ret , = c + c u + c v + ε h = γ + γ ε + γ d ε + γ h d = 1 ε < 0( ) 0 ε ≥ 0(good news) variable coefficient estimate z-stat. intercept c -0.002*** -3.384 u c -0.558* -1.845 v c 1.108*** 5.993 intercept γ 0.002 0.845 ε γ 0.265 1.623 d ε γ -0.390*** -2.941 h γ 0.719** 1.986 observations 162 wald chi2 36.642 log likelihood 590.724 prob > chi2 0.000 note: ***,**,* represent statistical significance at levels of 1%, 5% and 10%, respectively. 4.4 overnight information from the u.s. market reflected in futures to test hypothesis h2, we investigate the extent to which overnight u.s. market information is incorporated into the csi 300 index futures market. empirically, we use two types of news from the u.s. market to capture the highversus lownews day of trading in the u.s. market. we define days in which price volatility is high (i.e., daily price volatility ranks in the top 33%) in the u.s. market, as well as days when the federal reserve released interest rate news, as high-news days. we define days otherwise (i.e., daily price volatility ranks in the bottom 33%, and days without interest rate news) as low-news days. panel a of table 6 reports the mean and median of price change, return and trading volume of index futures during the pre-opening sessions (i.e., 9:15-9:30) in both highand lownews days, where news is defined by price volatility in the daytime trading of the u.s. market. it asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 247 shows that during high-news days, price changes and returns during the pre-opening sessions are not significantly different from those in the low-news days, while the trading volumes are significantly different. panel b reports the mean and median of price change, return and trading volume of index futures during the pre-opening sessions in both highand lownews days, where news is defined by the u.s. federal reserve interest rate news. panel b shows that the price changes in the highversus low-news days are significantly different for the pre-opening trading of index futures. combined, the price discovery process of the index futures before the spot market opens appear to be effective in reflecting overnight u.s. market news. table 6. incorporation of u.s. market overnight information for the futures market panel a. high/lownews days defined by u.s. market trading rs obs. mean median price change return volume (billion) price change return volume (billion) lowest 33% 45 0.34% 0.22% 6.707 0.24% 0.18% 6.725 highest 33% 45 0.30% 0.18% 9.029 0.25% 0.12% 8.646 high-low 0.04% 0.03% -2.322*** -0.01% 0.06% -1.921*** p 0.41 0.76 0.01 0.36 0.2 0.01 note: rs is the absolute value of the s&p500's return at last night. we divided the trading day in the sample into three groups of high, medium and low in accordance with price fluctuations of u.s. stocks in the last night. the trading day with the highest price change of u.s. stocks was used as the trading day with the most overnight information. on the contrary, the trading day with the lowest price change of u.s. stocks was used as the trading day with the least overnight information. ***,**,* represent statistical significance at levels of 1%, 5% and 10%, respectively. panel b. high/lownews days defined by u.s. fed interest rate news release note: we collected nine samples of monetary policy adjustment events from the 208 trading days and used the nine trading days with overnight monetary policy adjustments as the trading day with important overnight information. we compared the trading behavior during the first 15 minutes of the opening of the stock futures market in these nine trading days (n (2)) with the remaining 199 trading days (n (1)). ***, **,* represent statistical significance at levels of 1%, 5% and 10%, respectively. information obs. mean median price change return volume (billion) price change return volume (billion) n(1) 199 0.30% 0.19% 7.544 0.26% 0.14% 7.489 n(2) 9 0.46% 0.26% 9.206 0.44% 0.20% 8.216 n(1)n(2) -0.16%*** -0.07% -1.662 -0.18%*** -0.05% -0.727 p 0.02 0.48 0.41 0.02 0.4 0.35 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 248 5. conclusions in this paper, we study the information role of the newly launched futures market in china. in particular, we examine information incorporations of the futures market during the extended trading sessions to the underlying spot market. our findings are three-folded. first, the spot market is the main information source to the futures market, and private information incorporation of the futures market after spot market closes becomes significantly weaker. this indicates a weak informational efficiency of the futures market. second, using a t-garch(1,1) model, we test whether the return innovations in the futures market are correlated with the spot market, and we confirmed a positive relation between returns from the two market. third, we test whether futures market incorporate additional news from the overseas market (i.e., the u.s. market) and we confirm a positive answer to this research question. overall, our results show that the futures market in such a strong politically controlled economy is informationally functional, but only to a weak extent. our paper adds to the current discussion of information content of newly incepted markets such as japan, korea and hong kong. grossman (1977) point out that future market can facilitate information transfer from informed investors to uninformed investors, and our results indicate that futures market in china fulfills this information transmission role. the implications of our results are not only theoretical but also practical. for 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(2000). the information content of stock markets: why do emerging markets have synchronous stock price movements? journal of financial asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 250 economics, 58(1,2), 215-260. parkinson, m. (1980). the extreme value method for estimating the variance of the rate of return. the journal of business, 53(1), 61-65. doi: 10.2307/2352357 zakoian, j.-m. (1994). threshold heteroskedastic models. journal of economic dynamics and control, 18(5), 931-955. http://dx.doi.org/10.1016/0165-1889(94)90039-6 microsoft word 1518-5966-1-sm-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 151 do malaysian spin-offs create value? nadisah zakaria (corresponding author) salford business school, the university of salford salford greater manchester, m54wt, united kingdom e-mail: n.zakaria@edu.salford.ac.uk glen christopher arnold salford business school, the university of salford salford greater manchester, m54wt, united kingdom e-mail: g.c.arnold@salford.ac.uk received: march 15, 2012 accepted: march 25, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1518 url: http://dx.doi.org/10.5296/ajfa.v4i1.1518 abstract this paper investigates the shortand long-run share return performance of malaysian spin-off firms during the period january 1980 to april 2011. using daily and monthly data, the study examines the performance of spin-off firms against the benchmarks of malaysian all-shares indices. the results show that parent firms significantly outperformed the market during the few days surrounding the announcement date even after adjustment for size. in the long-run analysis of three years, however, and after allowing for size, this research failed to find abnormal performance for either parents or spun-off entities. overall, the results of this research allow us to plausibly argue that the market anticipates both increased value for parent shareholders and potential exploitable stock market efficiency in the short-run period but not in the long-run. keywords: spin-offs, share return performance, market efficiency, size effect, malaysia jel classification: g14 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 152 1. introduction a crucial question in corporate spin-offs is whether the action creates wealth for shareholders in the shortand long-run periods. earlier studies in other countries suggest that spin-offs generate positive abnormal returns during the few days surrounding the announcement. however, the evidence on the long-run share returns performance of firms is more mixed. the present study fills a gap in the literature by discovering how malaysian spin-off firms perform in both the shortand long-run periods. it makes several contributions. first, as there is no evidence on the influence of the firm size effect in the event of a spin-off in the malaysian capital market, the present study adds to growing body of international evidence in corporate spin-offs. second, we employ two novel market indices: malaysia all-shares equal weight index (mas-ewi) and malaysia all-shares value weight index (mas-vwi)1. both benchmarks are more comprehensive than any used in previous malaysian event studies which commonly adopt two popular market indices, namely ftse kuala lumpur composite index (klci) and ftse bursa malaysia emas index which fail to represent the broader malaysian market2. third, we use cumulative abnormal returns (cars), buy-and-hold abnormal returns (bhars) and market model as the abnormal return metrics to provide a more comprehensive analysis of share return performance, whereas previous international studies used only one of these models in their analysis. this study defines a corporate spin-off as occurring when the shares of a subsidiary are distributed on a pro-rata basis to the original shareholders of the parent firms. following the transaction, the subsidiary becomes an independent firm; therefore the parent firm has no controlling relationship with it. the former parent firm’s shareholders, however, now own two different securities: the shares from the parent and the shares from the newly spun-off firm. spin-off activity by malaysian listed firms began in the late 1980s in tandem with the development of the capital market. it gathered momentum with increasing numbers of corporate spin-offs during the bull-run period of 1993 to 1994; and also in the years following the 1997 crisis. out of 36 cases, 67% of the spin-off announcements occurred during the bear periods from 1999 to 2006. this study examines a sample of 36 spin-offs completed between january 1980 and april 2008. in a previous study which examined 85 malaysian firms, only some of which were engaged in spin-offs. yoon and ariff (2007) found a significant positive cumulative average abnormal return (caar) of +22.7% in a two-day (day -1 to day 0) event window surrounding the announcement date during the period 1986 to 2003. it is unfortunate that the study was not purely focused on spin-offs. it is also unfortunate that the authors did not study long-run share return performance and the influence of size effect. therefore the present 1 both benchmarks cover all sizes of all firms (based on the market capitalisation). 2 each of the benchmarks comprises different cohorts of firms based on their market capitalisation. the ftse bursa malaysia klci index consists of the 30 largest firms in the market, whilst the ftse bursa malaysia emas index constitutes the top 100 largest firms and 260 small capitalisation firms (as at 30th april 2011). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 153 work represents the first comprehensive study of corporate spin-offs in the malaysian capital market over the shortand long-run periods against the market benchmarks of mas-ewi and mas-vwi. indication of the size effects are seen in the different results when we switch from equal-weighted index to value-weighting (we find a reverse size effect in malaysia with large firms outperforming). our study finds that: (1) before size adjustment, there is a significant outperformance in the few days surrounding the announcement date (short-run) for parent firms; (2) before size adjustment, the overall results indicate that parents, spun-offs and combined firms significantly outperformed the mas-ewi in the three-year period, but failed to produce similar results when the mas-vwi was used as a market benchmark; (3) after size adjustment, the overall results confirm the presence of a spin-off effect for parent firms over the short-run period; and (4) after size adjustment, there is no significant abnormal performance for parents, spun-offs and combined firms in the long-run period. overall, these findings imply that spin-offs produce positive abnormal share returns in the short-run period; but fail to demonstrate abnormal performance after adjusting for size in the long-run period. the remainder of the paper is organised as follows. section 2 describes a brief literature concerning the shortand long-run share return performance of spin-off firms. section 3 explains the sample selection and data. section 4 outlines the methodologies used in the present study. section 5 presents the results for both shortand long-run share return performance of malaysian spin-off firms. section 6 concludes the paper. 2. literature review the spin-off effect has been widely studied internationally. the us studies (e.g. hite and owers, 1983; schipper and smith, 1983; miles and rosenfeld, 1983; rosenfeld, 1984; cusatis et al. 1993; desai and jain, 1999; krishnaswami and subramaniam, 1999; mcconnell et al. 2001; and chemmanur et al. 2010) generally show that investors who buy and then sell shares in the few days surrounding the spin-off announcement (short-run period) and those who hold them for three-year period following the completion date of spin-offs (long-run period) gain superior positive returns. in europe, the evidence is more mixed with three-year holding period studies (e.g. kirchmaier, 2003; veld-veld merkoulova, 2004; murray, 2008; boreiko and murgia, 2007; and dasilas et al. 2010) failing to find evidence that spin-offs create value. evidence for short-run value creation, however, is similar in spirit to that reported using the us data. although limited empirical research has been conducted outside the us and europe, the extant studies (e.g. koh et al. 2005; yoon and ariff, 2007; and uddin, 2010) demonstrate evidence consistent with the earlier works in these markets over the short-run period. however, the long-run period of, say, three years, has not been explored. the most recent study by dasilas et al. ( 2010) explores the share price behaviour of 239 spin-off announcements that took place between 2000 and 2009, in both the us and europe. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 154 they find that an investor could earn an announcement-period abnormal return of +3.47% in the three-day event window (from day -1 through day +1). they also reveal that the markets react differently in the us and european spin-offs: the us spin-offs generate a stronger positive spin-off effect than the european spin-offs, on average +4.21% compared with +1.36%. these findings are similar in spirit to those of the us and europe spin-off studies: positive and significant announcement-period abnormal returns of the order of +3.28% to +3.84%; using different time periods, methodologies and sample firms. given these facts an intriguing question is whether the conclusions drawn by previous empirical studies into spin-offs hold in the malaysian market. little attention has been given to the performance of these entities following the listing of spun-off firms in the market, reminding us that the spin-off effect over a long-run period of, say, three years, is open to debate. 3. sample selection and data both parents and spun-offs trading on the main market (merging of main board and the second board) and ace (formerly known as mesdaq) of bursa malaysia from 1st january 1980 to 30th april 2008 are identified. this enables the present study to analyse one to three years’ post spin-off performance up to april 2011. 36 malaysian parent firms conducting spin-offs have been identified. two event dates are specified for this analysis: the spin-off announcement date and the completion month of the spin-off. the announcement date is designated as the one in which the event first receives a mention in the financial press. the event month is defined as the month in which the newly spun-off firm is listed, and trading its shares begins on bursa malaysia. the identities of both parents and spun-offs are obtained from the investors digest (a monthly publication of klse or bursa malaysia) and also from bursa malaysia’s website. these sources of information is then cross-checked with the relevant press and financial announcements, for instance nexis business and news database, local english newspapers, individual firms’ websites and annual reports. combined firms are created by weighting the returns of parents and those of spun-offs by the market value of equity on the completion month of a spin-off. as a spin-off involves a pro rata distribution of the shares of a subsidiary, creating combined firms provides information about the return that an investor would have realised if he had held onto the shares of both parents and spun-offs following the completion month of a spin-off (desai and jain, 1999). in the case of daily data, defining t=0 as the announcement date, t=-20 days to t=+20 days represents the event period or observation period, and t=-220 days to t=-21 constitutes the estimation period (to apply in the market model for obtaining the value of alpha, α and beta, β). for monthly data, the event period begins with the completion month of a spin-off up to +36 months. share price data are collected from the datastream database. specifically, the data comprises individual parent and spun-off firms’ adjusted closing prices (adjusted for dividends). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 155 4. methodology to analyse short-run share return performance, we employ the market model (henceforth mm) and cumulative abnormal returns (henceforth cars). buy-and-hold abnormal returns (henceforth bhars) are used to measure the share return performance over the long-run period. fama (1998) notes that the choice of weighting scheme depends on the hypothesis of interest to the researcher. loughran and ritter (2000, p.363, note 2) state that ‘if one is trying to measure the abnormal returns on the firms undergoing some event, then each firm should be weighted equally.... [this] will produce point estimates that are relevant from the point of view of a manager, investor, or researcher attempting to predict the abnormal returns associated with a random event’. veld and veld-merkoulova (2004) claim that they prefer equal weighted portfolio returns to test whether the random event of spin-offs is associated with long-run superior performance. therefore, we adopt equal-weighted portfolio returns because spin-offs are random events that occur intermittently from january 1980 to april 2008. 4.1 market model and cumulative abnormal returns (cars) model following the market model, the daily abnormal return for security j of spin-off firms in event period t is computed as:  mtjjjtjt rrra  ˆˆˆ  (1) where, jt râ and jt r are the daily abnormal return and the daily actual return of security j in event period t, respectively. mt r is the daily market return of mas-ewi and mas-vwi in event period t. the parameters of alpha, j ̂ and beta, j̂ are the regression intercept and the slope of characteristic line, respectively; estimated for security j over the pre-event estimation period (e.g. 200 trading days) by running the ordinary least squares (ols) regression. based on the cars model, the performance of an individual security is adjusted to the performance of a market index. therefore, the daily abnormal returns of any security j is given as the difference between daily actual return and the corresponding daily return on the market index during period t, and are computed as follows: mtjtjt rrar  (2) the abnormal return for each security j (derived from the above two models) is observed for each day in the event period and averaged across n firms or securities using the following equation: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 156    n j jtt ar n aar 1 1 (3) where, t aar is the daily average abnormal return in event period t and n denotes the number of securities in the sample. finally, the  21,ttcaar is computed by summing the daily average abnormal returns t aar over days from period t1 to period t2 as follows:      2 1 2,1 t tt ttt aarcaar (4) 4.2 buy-and-hold abnormal returns (bhars) model the main justification for including bhars for long-run abnormal returns is that this approach is able to accurately simulate the effect of a spin-off event on the investor’s portfolio, because its compounding approach is more accurate than that of cars. the three-year holding period return is examined by computing the compounded monthly buy-and hold return, jtbhr for both parent and spun-off firms in time t as follows:   11 1          t t jtjt rbhr (5) where, jtr is the monthly actual return on security j in event period t. t is designated as the number of months in event period t. the buy-and-hold returns, mtbhr , for the market benchmarks, proxied by the mas-ewi and mas-vwi are:   11 1          t t mt mt rbhr (6) mtr is the corresponding monthly index level of mas-ewi and mas-vwi in event period t. the buy-and-hold abnormal returns for each security or firm in event period t are computed as: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 157                    t t mt t t jtjt rrbhar 11 1111 (7) where, jtbhar is the buy-and-hold abnormal return of security j in event period t. 4.3 statistical tests the statistical significance of the cumulative average abnormal returns is calculated following brown and warner (1980, 1985) and the parametric test-statistics for the daily cumulative average abnormal returns,  21, ttcaar from period t1 to period t2 as follows:   2 1 )(/ 2,1 taarcaart ttt   (8) where,  21 , ttcaar is the daily cumulative average abnormal return from period t1 to period t2, )( t aar is the standard deviation of daily average abnormal return and t denotes the total number of days in event period t. the test-statistic for the monthly buy and hold abnormal returns,  21 , ttbhar during the clustering period from t1 to period t2 is calculated as:   2 1 , /)(/21 tbharbhart t tt  (9) where,      2,1 ttbhar is the monthly average buy and hold abnormal return from period t1 to period t2; and )( t bhar is the standard deviation of monthly buy and hold abnormal return in event period t and t is the total number of firms in the sample. the non-parametric sign test is used to test the significance of percentage of parents, spun-offs and combined firms with positive abnormal returns in both the short-run and long-run periods. the null hypothesis for the sign test is given by the proportion of positive abnormal returns equal to 50%. note that this approach acts as a robust test for those reported results obtained from the parametric test-statistics. 5. results 5.1 short-run performance of parent firms following the spin-off announcement table 1 reports evidence of the announcement-period abnormal returns (adjusted to the market) on parent firms against the mas-ewi and mas-vwi benchmark. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 158 insert table 1 about here notably, all the abnormal return metrics (cars model and mm), demonstrate positively significant abnormal returns in the three-day event window, from day -1 through day +1. using the mas-ewi as a benchmark, spin-offs generate positively significant caars of +4.99% and +5.06% for the cars model and mm, respectively. when the abnormal returns metrics are measured against the mas-vwi, the results show that the caars for both cars model and mm are +5.40% and +5.04%, respectively. both abnormal returns are positively significant at 5% level. these results are aligned with the findings reported by the non-parametric sign test. this approach is used as a robust test to analyse the significance of the percentage of parents with positive abnormal returns 3 . it can be observed that the percentages of parent firms with positive abnormal returns over this period in both benchmarks are very strong, significant at 1% level. the presence of strongly significant positive abnormal returns for parent firms in the three-day event window (day -1 through day +1) is of considerable interest, indicating that the market anticipates considerable shareholder wealth enhancement. although the findings are slightly greater than those documented in the us (e.g. desai and jain, 1999), they are comparable to several european studies (e.g. kirchmaier, 2003; veld and veld-merkoulova, 2004; and dasilas et al. 2010). interestingly, the analysis shows that parent firms outperform both market benchmarks in the five-day event window (day +1 through day +5) following the spin-off announcement date. however, using the mas-vwi as a benchmark, only the mm is found to show a significant caar, +3.88% (at the 10% level). unfortunately, neither the cars model nor the mm posits significant results (though both methods record positive abnormal returns) when the mas-ewi is used as a market benchmark. so, we find that it is difficult to conclude on this evidence alone that there is a strongly expressed exploitable market pricing inefficiency; especially considering that transaction costs have not been deducted (see later). 5.2 long-run performance of parents, spun-offs and combined firms following the completion month of spin-offs although lyon et al. (1999, p.198) remind us that ‘analysis of long-run abnormal return is treacherous’, a number of methods are proposed4. extensive literature favours the use of the bhar method as it copes better with the effect of compounding than does car (e.g. ritter, 1991; and barber and lyon, 1997). in modern event studies, the most commonly accepted 3 evidence put forward in the literature mentions that the use of a parametric test (e.g. test statistic) in event studies is not well specified because the distribution of abnormal returns is fat tail and right-skewed. in other words, this approach tends to reject the null hypothesis of positive abnormal returns too often, thus violating the assumption of normality in abnormal returns (brown and warner, 1980). a number of papers suggest a non-parametric test (e.g. sign test) as a robust test, given that this method is well specified and more powerful in detecting no abnormal returns. also, this approach does not require as stringent an assumption on return distributions as the parametric test (cowan, 1992). note that the non-parametric test is often used in event studies and is a better choice when the sample contains thinly traded shares (cowan, 1992 and maynes and rumsey, 1993). on the other hand, uddin (2010) uses the non-parametric test to overcome the small population problem. 4 see for example barber and lyon (1997), fama (1998) and lyon et al. (1999). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 159 methodology is the bhar approach. therefore, we adopt this method to capture the effect of a spin-off event on the investor’s portfolio over the long-run period5. table 2 presents the percentage monthly buy-and-hold abnormal returns (adjusted to the market) for the full sample of parents, spun-offs and combined firms in the three-year period following the completion month of spin-offs against the mas-ewi and mas-vwi benchmarks. insert table 2 here in panel a, the result shows that the parent firms significantly outperformed (at the 10% level) the mas-ewi, on average by +19.61% in the three-year holding period following the listing of spun-off firms. the result also shows that the percentage of parent firms with positive bhars (about +69.44%) over this period is considerably strong, significant at 5% level. both results thus support the earlier findings reported by cusatis et al. (1993). when the buy-and-hold returns of parent firms are measured against the market benchmark of mas-vwi, the parent firms show a contrary result. they demonstrate a negative and significant abhar of -18.74% over the three years, indicating that in the malaysian market as a whole, large firms outperformed small firms during the study period. in panel b, the result suggests that spun-off firms significantly outperformed the mas-ewi, on average by +29.19% over the thirty-six months holding periods pursuant their listing month. it can be seen that the long-run share returns performance of the spun-off firms is better than the parent firms’ (perhaps because they are more focused on their core business than their corresponding parent firms as claimed by most malaysian spin-offs managers). this result supports the evidence documented in both european (e.g. kirchmaier, 2003) and us (e.g. cusatis et al. 1993; and desai and jain, 1999) markets. in contrast, using the mas-vwi as a benchmark, the result shows that spun-off firms insignificantly underperformed the market, on average by -12.90% over the three-year holding period following the completion month of a spin-off. in panel c, although the combined firms outperformed the mas-ewi in the three-year holding period following the completion month of a spin-off, the abhar at +16.50% is statistically insignificant. nevertheless, we find that combined firms are associated with a significant negative abhar when the mas-vwi is used as a benchmark. the abhar for combined firms over the thirty-six months holding periods is -23.48%, statistically significant at 5% level. not surprisingly, our finding is substantially different from those in the us (e.g. cusatis et al. 1993; and desai and jain, 1999) and european (e.g. kirchmaier, 2003; and veld and veld-merkoulova, 2004) studies. 5.3 index performance of the ftse bursa malaysia index series this research has already indicated that, in malaysia, large firms outperformed small firms; we now examine this in more detail. ftse asia research (june, 2009) reports that malaysian 5 to double-check the results presented by the bhar model, we analyse the long-run share return performance using the car model. by adjusting the share return of spin-off firms to the market benchmarks of the mas-ewi and mas-vwi, we find that the car approach produces results consistent with the bhar; therefore we do not report them in this paper. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 160 small capitalisation firms consistently underperformed large capitalisation firms over a 12-year period (1997-2008). we analyse the index performance of the ftse bursa malaysia index series over a 15-year period (1996-2011) as a preliminary to investigating whether the size effect subsumes the spin-off effect. the historical performance of the ftse bursa malaysia index series is shown in table 3 and figure 1. since the price index data for all index series (excluding ftse bursa malaysia kuala lumpur composite index) becomes available in datastream from 1st january 1996, this analysis therefore begins on this particular date. insert table 3 and figure 1 here the result shows that the ftse bursa malaysia klci, a large cap index, has outperformed other indices over a long-run period. over the 15-year period, the ftse bursa malaysia klci generates substantial positive cumulative returns, up to +44.01%. over the same period, the ftse bursa malaysia fledgling index records the worst share returns performance of -29.43%; followed by the ftse bursa malaysia small cap index with negative cumulative returns of -18.13%. from figure 1, it can be seen that both the ftse bursa malaysia fledgling and small cap indices outperformed the ftse bursa malaysia klci during the bull periods of 1996 (prior to the 1997 financial crisis) and 2000. nevertheless, the trend is reversed during the bear periods from 2001 to 2006. the large capitalisation firms continue to demonstrate superior performance in the subsequent years. it is important to note that the test period of one to three years’ post spin-off performances coincides with the several periods of a malaysian bear market. two-thirds of the spin-off events occurred during the period 1999 to 2006, following the 1997-98 massive decrease in malaysian share prices, disproportionately affecting small capitalisation firms. these findings thus support the results documented by nathrah (2006); using all the firms listed on the bursa malaysia during the period 1994 to 2003, she observed that a reverse size effect was seen during the bear months; while a small firm effect tended to occur during the bull months. to show the size composition of malaysian spin-off firms, this study presents the percentage of parents and spun-offs on the basis of size-ranked decile portfolios for the whole market (in table 4) with the largest market capitalisation portfolio in decile 1 and the smallest in decile 10. insert table 4 here clearly the percentage of spun-off firms is distributed fairly evenly across the deciles. on the other hand, approximately 70% of the total number of parent firms are categorised in the largest market capitalisation quintile; hence, this research needs to test if the performance of spin-off firms is a manifestation of the size effect. 5.4 size adjustment to ascertain whether there is a spin-off effect independent of a size effect, a full size adjustment analysis is conducted. following arnold and baker (2007), ‘size-adjusted asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 161 portfolio’ is created. to generate these, the completion month of a spin-off is taken. on that date, we allocate all shares in the malaysian market into decile on the basis of market capitalisation. size decile 1 consists of the largest market capitalisation firms, whilst size decile 10 includes firms with the smallest market capitalisation. this allows us to observe the returns for the size decile appropriate for the sample firm. we then have data for the returns (for each of 36 spin-off firms) over the 36 months following the spin-off completion as a result of belonging to size decile. if these returns are subtracted from the actual returns for the sample firm, we have the size-adjusted returns, and can then comment on whether the size effect subsumes the spin-off effect. a similar analysis is conducted for the few days around the spin-off announcement by forming size decile for each sample parent firm at the date of announcement and observing the average returns for the size decile that the sample firm falls into. table 5 displays the daily size-adjusted abnormal returns for parent firms during the period surrounding the announcement date. table 6 shows the percentage monthly size-adjusted abnormal returns for the full sample of parents, spun-offs and combined firms in the three-year holding period following the completion month of a spin-off. insert table 5 and 6 here after adjusting for size, the results confirm the presence of a spin-off effect for parent firms during the few days surrounding the announcement date (as shown in table 5). the size-adjusted abnormal returns (saars) in the three-day event window (day -1 through day +1) and in the five-day event window (day +1 through day +5) are recorded at +4.81% and +4.21%, respectively, indicating that the short-run outperformance of parent firms persists following the size-adjustment analysis. interestingly, the size adjustment increases the strength of evidence in favour of a pricing inefficiency. in the five days following the announcement there is a jump in returns, indicating some post-announcement drift, although the results are significant only at the 10% level. in contrast to the results obtained using market adjusted buy-and-hold abnormal returns as reported in table 2, it can be observed that there are no significant spin-off abnormal returns for parents, spun-offs and combined firms over the three-year holding period after eliminating the influence of size (as shown in table 6); thus any spin-off effect is subsumed by the size effect. 6. summary and conclusion overall, these results imply that, following an adjustment for size, spin-offs create (perhaps illusory) value in the short-run period; but there is no evidence of long-run market outperformance after allowing for size. we find that evidence for short-run value creation supports the broad consensus in the literature which indicates that spin-offs generate positive gains for shareholders during the few days surrounding the announcement date. nonetheless, evidence for the three-year period, fails to show that spin-offs create value similar in spirit to the reported findings using european data. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 162 an interesting question arises from this work: ‘what do the findings say about the efficiency of the stock market in pricing the shares?’ there is the possibility of a reasonably consistent delay in the positive reaction by investors for a few days after the spin-off announcement, which may be exploitable. a study put forth by barnes (1986) suggests that poor dissemination of new information, or a lag in the information process, generally causes a delay in market participants’ reactions. at this point, the results suggest that the action of buying and selling shares in the few days after the news concerning spin-offs has been made public would offer investors significant abnormal returns. stoll and whaley (1983), however, claim that on the basis of currently available information, a market is inefficient if it is possible for an investor to earn abnormal returns (adjusted to the market) net of all transaction costs. to avoid mistakenly concluding that the malaysian market is inefficient, and at the same time not to underestimate the transaction costs associated with the share purchases of parent firms, we need to consider the average trading costs in the order-driven malaysian share market. trading of shares on bursa malaysia involve the following costs: brokerage fees, clearing fees and stamp duty fees6. taking these costs into the calculation, an average roundtrip transaction cost in buying and selling shares on bursa malaysia is approximately +0.66% of the contract value7. madun (2008) reports that a typical transaction cost in the malaysian share market is on average nearly +1% of the contract value, comparable to the share markets of singapore (around +1%) and hong kong (around +0.6%). taking the highest estimated cost of 1%, it appears that an investor could possibly earn an abnormal return net of transaction cost of +2.88% (3.88%-1.00%) by concentrating his investment on parent firms during the five-day event window (day +1 through day +5) following the spin-off announcement date. it is apparent that by opting for such action investors would ‘beat the market’, and hence provide some evidence contradictory to the assertion of semi-strong efficiency. our findings sit alongside the view put forward in most of the literature on the malaysian market. malaysian studies (e.g. dawson, 1981; sadique and siverpulle, 2001; sharma and wongbappo, 2002; morck et al. 2000; drew and veeraraghanan, 2002; hameed and ting, 2000, ahmad and hussain, 2001; natrah, 2006; choudary et al. 2007; lim et al. 2007; and norli et al. 2010) agree that the malaysian share market is not semi-strong efficient, even though their methodology, sample size and length of period taken are significantly different from each other. 6 it should be noted the brokerage fees could change depending on the order size. for example, the minimum brokerage fees are +0.3% of contract value (retail trades valued above rm100, 000), +0.6% of contract value (retail trades below rm100, 000) and up to a maximum of +0.7% of the contract value. for simplicity, this study applies the +0.3% of contract value in the calculation. this study also takes account of the +0.001% stamp duty and +0.03% clearing fee. 7 this study calculates the roundtrip transaction cost as follows: roundtrip transaction cost = (2 * brokerage fees) + (2 * stamp duty) + (2 * clearing fees) = (2 * 0.3%) + (2 * 0.001%) + (2 * 0.03%) = +0.66% asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 163 this research is subject to some limitations. first, the present study only includes firms conducting spin-offs. other divestiture announcements including split-offs, sell-offs and equity carve-outs are excluded. second, the results of the study are based on a relatively small sample of firms over a limited period of study. considering the scarcity of this area of research in the asian region, a similar attempt should be made to discover whether spin-offs create value in other capital markets in an effort to provide an integral framework for comparative study. references ahmad, z., and hussain, s. 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(2007). corporate spin-offs, their price reactions and determinants in malaysia. international journal of banking and finance, 5, 83-112. appendices asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 167 table 1. announcement period: share returns performance of the parent firms over a short-run adjusted for mas-ewi and mas-vwi using the cars model and market model panel a: adjusted for mas-ewi panel b: adjusted for mas-vwi note: 0 denotes the announcement date of the spin-off event. asterisks indicate statistical significance at the 10% (*), 5% (**) and 1% (***) levels, using a two-tailed test. the non-parametric sign test is used to test the significant percentage of firms with positive abnormal returns. the null hypothesis for the sign test is given as the proportion of positive abnormal returns equal to 50%. a, b and c indicate significance at the 10%, 5% and 1% levels. interval (day) cars model market model caars t-stat percentage positive caars t-stat percentage positive -5 to +5 6.86% 2.15** 77.78c 6.36% 2.13** 83.33c -2 to +1 5.31% 1.92* 47.22 4.89% 1.92* 77.78c -1 to +1 5.40% 2.53** 75.00c 5.04% 2.68** 80.56c 0 2.27% 2.36** 75.00c 2.09% 2.25** 75.00c 0 to +1 5.00% 11.05*** 88.89c 4.59% 11.38*** 77.78c 0 to +3 6.16% 2.63** 86.11c 5.76% 2.71** 80.56c 0 to +5 6.34% 2.29** 80.56c 5.98% 2.39** 77.78c +1 to +5 4.07% 1.69 66.67a 3.88% 1.79* 63.89 interval (day) cars model market model caars t-stat percentage positive caars t-stat percentage positive -5 to +5 5.79% 1.92* 72.22b 6.07% 2.04** 77.78c -2 to +1 4.78% 1.85* 72.22b 4.79% 1.90* 75.00c -1 to +1 4.99% 2.65** 77.78c 5.06% 3.00*** 83.33c 0 2.13% 2.25** 72.22b 2.14% 2.27** 72.22b 0 to +1 4.57% 14.94*** 83.33c 4.49% 21.59*** 75.00c 0 to +3 5.43% 2.46** 83.33c 5.50% 2.60** 77.78c 0 to +5 5.49% 2.09** 75.00c 5.67% 2.27** 75.00c +1 to +5 3.36% 1.51 66.67a 3.53% 1.69 66.67a asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 168 table 2. long-run performance: share returns performance of the parents, spun-offs and combined firms adjusted for mas-ewi and mas-vwi using the bhar model panel a: parent firms interval (month) bhars model (mas-ewi) bhars model (mas-vwi) abhars t-stat percentage positive abhars t-stat percentage positive ex + 1 to ex + 12 5.67% 0.47 41.67 -7.25% -0.60 25.00c ex + 1 to ex + 24 1.78% 0.21 44.44 -18.46% -2.14** 30.56b ex + 1 to ex + 36 19.61% 1.82* 69.44b -18.74% -1.75* 27.78b ex + 13 to ex + 24 6.52% 0.93 55.56 0.68% 0.10 44.44 ex + 25 to ex + 36 21.57% 2.31** 69.44b 7.44% 0.85 52.78 panel b: spun-off firms interval (month) bhars model (mas-ewi) bhars model (mas-vwi) abhars t-stat percentage positive abhars t-stat percentage positive ex + 1 to ex + 12 11.24% 0.99 50.00 -2.59% -0.22 25.00c ex + 1 to ex + 24 33.08% 1.88* 52.78 12.44% 0.66 36.11 ex + 1 to ex + 36 29.19% 2.51** 61.11 -12.90% -0.98 38.89 ex + 13 to ex + 24 27.68% 2.31** 50.00 22.54% 1.72* 50.00 ex + 25 to ex + 36 16.58% 1.83* 61.11 0.15% 0.01 41.67 panel c: combined firms interval (month) bhars model (mas-ewi) bhars model (mas-vwi) abhars t-stat percentage positive abhars t-stat percentage positive ex + 1 to ex + 12 1.20% 0.12 38.89 -11.83% -1.20 13.89c ex + 1 to ex + 24 1.43% 0.20 44.44 -19.44% -2.56** 25.00c ex + 1 to ex + 36 16.50% 1.60 69.44b -23.48% -2.26** 22.22c ex + 13 to ex + 24 9.79% 1.44 58.33 3.30% 0.49 47.27 ex + 25 to ex + 36 16.13% 2.12** 72.22b 1.50% 0.21 50.00 note: ex denotes the listing month of the spun-off firms. asterisks indicate statistical significance at the 10% (*), 5% (**) and 1% (***) levels. panel a indicates the average buy-and-hold abnormal returns (abhars) for the parent firms against the market benchmarks of mas-ewi and mas-vwi. panel b presents the average buy-and-hold abnormal returns (abhars) for the spun-off firms against the mas-ewi and mas-vwi benchmarks. panel c shows the results of average buy-and-hold abnormal returns (abhars) for the combined firms against the novel benchmarks of mas-ewi and mas-vwi. the non-parametric sign test is used to test the significance percentage of firms with positive abnormal returns. the null asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 169 hypothesis for the sign test is given as the proportion of positive abnormal returns equal to 50%. a, b and c indicate significance at the 10%, 5% and 1% levels. table 3. monthly cumulative returns of the bursa malaysia index series (january 1996 – january 2011) indices ftse bursa malaysia klci ftse bursa malaysia emas index ftse bursa malaysia mid 70 index ftse bursa malaysia small cap index ftse bursa malaysia fledgling index number of constituents 30 100 70 260 431 market capitalisation (rm) 485,666.50 690,859.41 137,745.02 67,447.92 18,958.84 1 month (%) from 1996 2.75 2.60 3.08 0.30 4.16 3 month (%) from 1996 12.71 13.45 14.34 19.04 40.15 6 month (%) from 1996 1.21 1.33 2.19 3.59 18.27 12 month (%) from 1996 15.28 18.87 26.66 19.66 27.46 36 month (%) from 1996 -43.96 -47.88 -55.87 -55.43 -52.95 60 month (%) from 1996 -31.05 -37.88 -52.91 -57.40 -53.07 120 month (%) from 1996 -13.40 -27.34 -40.66 -64.36 -55.79 132 month (%) from 1996 12.69 -2.41 -14.22 -48.10 -44.22 144 month (%) from 1996 32.01 17.37 -2.42 -28.86 -37.18 156 month (%) from 1996 -16.20 -27.99 -42.54 -58.42 -58.28 168 month (%) from 1996 19.30 5.44 -13.01 -33.22 -39.37 180 month (%) from 1996 44.01 30.12 17.25 -18.13 -29.43 note: 1. price index data for ftse bursa malaysia emas, ftse bursa malaysia mid 70, ftse bursa malaysia small cap and ftse bursa malaysia fledgling indices became officially available in datastream on 1st january 1996. 2. ftse bursa malaysia klci comprises the 30 largest firms in the ftse bursa malaysia emas index by full market capitalisation. 3. ftse bursa malaysia emas comprises the constituent of the ftse bursa malaysia top 100 index (constituting ftse bursa malaysia mid 70 index and ftse bursa malaysia klci) and ftse bursa malaysia small cap index. 4. ftse bursa malaysia mid 70 index comprises 70 medium size firms in the ftse bursa malaysia emas index by full market capitalisation. 5. ftse bursa malaysia small cap index comprises those eligible firms within the top 98% of the bursa malaysia main market excluding constituents of the ftse bursa malaysia klci and ftse bursa malaysia mid 70 index. 6. ftse bursa malaysia fledgling index comprises the main market firms that meet stated eligibility requirements but are not in the top 98% by full market capitalisation and are not constituents of the ftse bursa malaysia emas index. (source: number of constituents, market capitalisations (in ringgit malaysia) and the features of ftse bursa malaysia index series are obtained from the website of bursa malaysia, as at 30/04/2011) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 170 table 4. percentage of parents and spun-offs on the basis of size-ranked deciles size deciles percentage of parent firms percentage of spun-off firms 1 (largest market capitalisation) 31.43% 17.14% 2 40.00% 8.57% 3 11.43% 17.14% 4 8.57% 5.71% 5 2.86% 11.43% 6 2.86% 5.71% 7 2.86% 11.43% 8 0% 5.71% 9 0% 14.29% 10 (smallest market capitalisation) 0% 2.86% note: size deciles are created using the market capitalisations on the completion month of spin-offs. table 5. size adjusted announcement period: share returns performance of the parent firms interval (day) size-adjusted abnormal return (cars approach) saars t-stat percentage positive -5 to +5 6.70% 2.15** 80.56c -2 to +1 5.16% 2.10** 77.78c -1 to +1 4.81% 2.13** 83.33c 0 2.25% 2.23** 77.78c 0 to +1 4.70% 22.57*** 91.67c 0 to +3 6.70% 3.50*** 83.33c 0 to +5 6.45% 2.45** 77.78c +1 to +5 4.21% 1.86* 63.89 note: 0 denotes the announcement date of the spin-off event. asterisks indicate statistical significance at the 10% (*), 5% (**) and 1% (***) levels, using the two-tailed test. the non-parametric sign test is used to test the significance percentage of firms with positive abnormal returns. the null hypothesis for the sign test is given as the proportion of positive abnormal returns equal to 50%. a, b and c indicate significance at the 10%, 5% and 1% levels. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 171 table 6. size adjusted long-run performance: share returns performance of the parents, spun-offs and combined firms panel a: parent firms interval (month) size adjusted abnormal returns (bhars approach) saars t-stat percentage positive ex + 1 to ex + 12 -1.01% -0.11 27.78b ex + 1 to ex + 24 -4.19% -0.63 36.11 ex + 1 to ex + 36 -8.09% -0.87 41.67 ex + 13 to ex + 24 3.15% 0.55 50.00 ex + 25 to ex + 36 -0.68% -0.09 33.33a panel b: spun-off firms interval (month) size adjusted abnormal returns (bhars approach) saars t-stat percentage positive ex + 1 to ex + 12 2.24% 0.25 36.11 ex + 1 to ex + 24 8.90% 0.86 41.67 ex + 1 to ex + 36 5.58% 0.48 41.67 ex + 13 to ex + 24 11.06% 1.68 55.56 ex + 25 to ex + 36 4.70% 0.61 44.44 panel c: combined firms interval (month) size adjusted abnormal returns (bhars approach) saars t-stat percentage positive ex + 1 to ex + 12 -4.35% -0.56 19.44c ex + 1 to ex + 24 -6.22% -1.02 38.89 ex + 1 to ex + 36 -9.24% -1.01 38.89 ex + 13 to ex + 24 3.33% 0.62 50.00 ex + 25 to ex + 36 -1.81% -0.26 38.89 note: ex denotes the listing month of the spun-off firms. asterisks indicate statistical significance at the 10% (*), 5% (**) and 1% (***) levels. panel a indicates the size-adjusted abnormal returns (saars) for the parent firms adjusted for the size-control portfolio returns. panel b presents the size-adjusted abnormal returns (saars) for the spun-off firms adjusted for the size-control portfolio returns. panel c shows the results of size-adjusted abnormal returns (saars) for the combined firms adjusted for the size-control portfolio returns. the non-parametric sign test is used to test the significance percentage of firms with positive abnormal returns. the null hypothesis for the sign test is given as the proportion of positive abnormal returns equal to 50%. a, b and c indicate significance at the 10%, 5% and 1% levels. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 172 figure 1. long-run return performances of ftse bursa malaysia index series   microsoft word 6070-21864-1-sm _1_-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 45 shareholder types, corporate governance and firm performance: an anecdote from indian corporate sector dr namita rajput associate prof. in commerce sri aurobindo college, usms, ggs university of delhi, india e-mail: namitarajput27@gmail.com ms bharti ( corresponding author) assistant professor in management indraprastha university, india e-mail: bharti.1119@gmail.com received: august 5, 2014 accepted: nov.11, 2014 published: june 1, 2015 doi:10.5296/ajfa.v7i1.6070 url: http://dx.doi.org/10.5296/ajfa.v7i1.6070 abstract the issues regarding corporate governance have received major attention owing to their apparent importance for the economic health of companies especially after plethora of corporate scams and debacles in the recent times. high ethical values can reduce costs to achieve a high corporate governance standard and make it more sustainable. improving corporate governance is an issue of critical importance to india today and for future developments. the indian government has realized that good corporate governance is necessary to improve corporate competitiveness and to attract foreign investors. it is believed that with better corporate governance, listed firms can reduce agency costs, become more competitive in global markets, and fulfill their social responsibilities. there are no conclusive evidences so far in the literature in proving the linkages between shareholder types and firm performance, hence the present study will add and address the glaring knowledge gap in indian literature. the typical shareholder types among listed companies in india are asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 46 institutions, government, managers, foreigners and diverse shareholders. using panel regression, the relationships between shareholder types and financial performance as measured by tobin’s q, roa, roe were tested taking a sample of bse100 companies excluding banking and insurance companies. the analysis of the result shows significant positive influence of foreign institutional investors and family ownership on roe whereas government and retail shareholder affect roe negatively. also, the corporate governance index has a significantly negative impact on roe. however, the relationship of cgi with roa and tobin's q was not found to be significant. keywords: corporate governance, shareholder types; firm performance, agency cost, corporate governance index asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 47 1. introduction in some ways corporate governance is not a new concept; responsibility in the handling of money and conduct of business and commerce has always been important. in the last century or so, with the increasing complexity and power of corporations, it has come to the fore emphatically. a decisive beginning was made in this direction when after the introduction of liberal-market reforms, the indian corporate sector, led by cii, drew up a voluntary code of corporate governance (cg). further developments from there vacillated between making cg voluntary or mandatory. by the year 2000, the same had been incorporated as a necessity in the clause 49 of the listing agreement administered by the market regulator sebi as per the recommendations of the birla committee that specifically placed an emphasis on independent directors. the committee also recognized the importance of audit committees and made many specific recommendations regarding the function and constitution of board audit committees. it was followed by the naresh chandra committee report with major stress on independent oversight of board and audit, and improvements in disclosures (financial as well as non-financial). in the subsequent years, two more committees were constituted under the leadership of mr narayan murthy and mr j j irani, with the explicit aim of bringing in best practices from around the world to create a well regulated environment that promotes entrepreneurship. in 2009, the satyam fiasco shook the indian industry, bringing home the point that proper governance is indispensable to further growth and development. since then efforts to create a framework have gained urgency. the ministry of corporate affairs (mca) came out with guidelines in 2009. in its present form, clause 49, called ‘corporate governance’, contains eight sections dealing with the board of directors, audit committee, remuneration of directors, board procedure, management, shareholders, report on corporate governance, and compliance. firms that do not comply with clause 49 can be de-listed and face financial penalties. now, the companies act, 2013 which has been enacted recently, has further strengthened the cg norms. there are four major sources of forces directly shaping a company’s corporate governance: (1) individual ethics and corporate cultures, (2) internal ownership/control and incentive mechanisms, (3) market and external monitoring mechanisms, and (4) laws and regulations and their enforcement. clearly, corporate governance is also affected by a firm’s institutional environments and its own attributes. high ethical values can reduce costs to achieve a high corporate governance standard and make it more sustainable. this relies on companies setting ethical guidelines and good communication channels with all levels of staff so that the same corporate values are attained by every member of the organization. corporate culture does begin with the personal values of the top management. unfortunately, one fundamental concern in india is the low ethical standard in business and the lack of proper corporate culture. improving corporate governance is an issue of critical importance to india today and for future developments. the indian government has realized that good corporate governance is necessary to improve corporate competitiveness and to attract international capital. it is believed that with better corporate governance, listed firms can reduce agency costs, become more competitive in global markets, and fulfill their social responsibilities. empirical evidence presented in this study underlines the importance of ownership structure asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 48 in terms of the types of shareholders and the corporate governance index on financial performance of the company. different financial performance measures are used by researchers and the indicators include profitability, efficiency, leverage and liquidity. the selection of performance measures depends on the research objectives. three measures of performance, as supported in the finance and accounting literature were chosen for the purpose of analysis, namely roa, roe and tobin's q as proxy for firm performance. our research studies the effect of twelve variables on firm performance as measured by roe. these independent variables are retail shareholding, institutional shareholders, government ownership, family shareholding, fii shareholding, corporate shareholding and corporate governance index. also, control variables such as firm's size, proxy by total assets, firm's age since its inception and leverage proxy by debt equity ratio are considered as exogenous variables. we have also included advertising expenses and board size of the sample firms. table 1. variables studied variables used definition symbol used return on equity net profit as a percentage of shareholder's equity roe return on assets net profit as a percentage of total assets roa tobin's q market value of equity plus book value of debt and preference share capital divided by total assets tobin's q retail shareholding percentage of shares held by individuals rsh institutional shareholding percentage of shares held by institutions iish government shareholding percentage of shares held by government gsh family shareholding percentage of shares held by family fsh fii shareholding percentage of shares held by foreign institutional investors fiish corporate shareholding percentage of shares held by corporate bodies, excluding those already covered csh size firm size in terms of total assets owned s advertising expenses includes sum of advertising, marketing and distribution expenses advt corporate governance index includes the corporate governance parameters like duality, number of directors ,proportion of non-executive directors, proportion of independent directors, number of board meetings held, average attendance of audit committee meetings, average attendance of board meeting, number of audit committee meetings, number of remuneration meetings ,number of nomination committee meetings , proportion of independent directors in nomination committee, profile of directors, minutes of different meetings, whistle blowing policy, related party disclosure cgi asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 49 board size number of directors on board bs age number of years between observation year and year of incorporation age debt equity ratio (leverage) ratio of long term debt to equity debt to achieve the objective of the study, the paper is divided into following sections, section i ,i.e. the present section gives the insights of corporate governance and its various parameters, followed by section ii which gives a brief review of literature. section iii presents research objectives and hypothesis followed by section iv which deals with data and methodological issues. section v entails the analysis and interpretation of empirical results which are divided into two parts, 5.1, gives the relationship between shareholder types and roe and 5.2 analyses the relationship between cgi and financial performance. it is followed by the summary, conclusion and implications of the research contained in section vi followed by references. 2. review of literature the following section gives the brief snapshot of review of literature done in india and across the globe. the connection between ownership structure and performance has been the subject of an important and ongoing debate in the corporate finance literature. the debate goes back to the berle and means (1932) thesis, which suggests that an inverse correlation should be observed between the diffuseness of shareholdings and firm performance. their view has been challenged by demsetz (1983), who argues that the ownership structure of a corporation should be thought of as an endogenous outcome of decisions that reflect the influence of shareholders and of trading on the market for shares. a burgeoning empirical research shows that share ownership and its structure can be important sources of incentives for managers, boards of directors and outside shareholders (milgrom and roberts, 1992). in developing economies, ownership is also heavily concentrated (blasi and shleifer, 1996; claessens et al., 1996; claessens, 1997; xu and wang, 1997; la porta et al., 1998; yee, 1998; wiwattanakantang, 1999; yeh, et al., 2001; and joh, 2003). there is evidence of pyramiding and family control of businesses in asian countries, particularly india (bertrand et al., 2002). it is believed that this is a result of the ineffectiveness of the legal system in protecting property rights. mcconnell and servaes (1990) provide evidence on the relation between the distribution of equity ownership and corporate value. for the sample cross sectional relation between tobin's q and equity ownership is found where the value of the firm is taken to be the function of distribution of equity ownership amongst corporate insiders, individual shareholders, block shareholders and institutional investors. in the analysis, tobin's q ratio is regressed against various measures of ownership to gauge their impact on the value of the firm. the results show that there is a strong evidence of a curvilinear relationship between insider ownership and q, i.e value of q first increases as insider ownership increases and then declines on further increase in insider ownership of equity. block shareholders have no asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 50 significant relationship with the value of the firm and lastly institutional investors have a significant positive influence on the firm value. shleifer and vishny (1997) have focused on the subject of corporate governance from the perspective of agency problem, sometimes referred to as the separation of ownership and control. the basic question of corporate governance is to find out how investors get the managers to give them back their invested money. the paper discusses the role of concentration of ownership as an approach to corporate governance and takes into account ownership by small investors and concentrated ownership; i.e. by large shareholders) which reduces agency costs and thereby improves corporate governance and firm performance. the paper also discusses the negative impact of state ownership on firm performance. thomsen, pedersen (1998) examine the impact of ownership structure on company economic performance in the largest companies from 12 european nations. ownership structure is measured by the identity and share of the largest owner. performance is measured by return on assets, market to book values and sales growth controlling for industry. five categories of shareholders have been identified: banks, other financial companies (institutional investors), other non-financial companies, personal/family and government. the authors find evidence of a bell-shaped (first increasing and then decreasing) effect of ownership share on assets returns and market-to-book values of equity. companies whose largest owner is a financial institution have higher market-to book values than companies in which the largest owner is a family, another company or the government. the effects on asset returns are qualitatively identical, but weaker and insignificant except for a negative effect of government ownership. in contrast, companies whose largest owner is a family or another company have significantly higher sales growth. xu xiaonian, wang yan (1997) investigate whether ownership structure has significant effects on the performance of publicly-listed companies in china, and in what ways if it does. these companies are typically owned by five groups of agents: the state, legal persons (domestic institutions), tradable a-share holders (mostly individuals), employees, and foreign investors. the data set includes all shse and szse listed companies for 1993, 1994 and 1995. the authors have employed three accounting ratios to measure the firm's performance, the market-to-book value ratio (mbr), roe, and roa. the paper concludes that the firm's performance is positively correlated with legal persons(institutional shareholders). in contrast, the fraction of equity owned by individual shareholders, has a significant negative effect on the market-to-book ratios, consequently individual shareholders have a negative relation with the firm's performance. also the authors conclude a negative relationship between the shares owned by the state and firm performance. in the paper, the influence of individual shareholders to firm's profitability is insignificant, if not completely irrelevant. in many cases, the relationship between equity held by individual investors and firm performance is significant but negative, indicating that the market values individual private ownership downward. claessens, djankov, fan and lang (1999) have studied the relationship between the concentration of cash flow rights and control rights and the type of block ownership on one hand and corporate valuation on the other hand in east asian corporations for the year 1996. the analysis is based on newly-assembled data for publicly-traded corporations (including both financial institutions and non-financial institutions) in hong kong, indonesia, japan, asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 51 korea, malaysia, the philippines, singapore, taiwan, and thailand. in the majority of cases, the principal shareholders are themselves corporate entities, not-for-profit foundations, or financial institutions. the paper documents the relation between ultimate ownership and market valuation, differentiating between control from cash-flow rights. it is found that higher cash-flow rights are associated with higher market valuation, but higher control rights are associated with lower market valuation, especially when cash-flow rights are low and control rights are high. this suggests expropriation of minority shareholders by controlling shareholders. the authors conclude that family control is an important factor behind the negative relation between control rights and market valuation. in contrast, no evidence of expropriation for state control and control by widely-held corporations is found. finally, the relation between control by financial institutions and market valuation is negative. repei, (2000) has analyzed a sample of 318 companies for 1997 – 1998 years. the sample comprises companies from all regions of ukraine. it covers 15 sectors including fast moving service and finance. the author has formulated hypothesis to test if corporate performance varies according to the shareholder structure where the performance of the firm is taken as a function of ownership type. the corporate ownership is divided into five main categories with respect to dominant shareholder type. these are insider, home outsider, foreign outsider, individual and state. the author concludes that private ownership lead to higher performance than state one. further, outside owners provide much better governance of assets, while private individuals are very ineffective owners due to "free-riding" problem. the state demonstrates failure in enterprise restructuring because of economically harmful political objectives. the effect of insider ownership is ambiguous. kumar (2004) examined empirically the relationship between the ownership structure and firm performance using a panel of indian corporate firms over 1994-2000 and found that foreign shareholding pattern did not influence the firm performance significantly. ongore o. vincent , k’obonyo o. peter, ogutu martin, (2011 ), analyzed forty-two firms in kenya. the methodology adopted was calculation of pearson’s product moment correlation and logistic regression. the results of ownership identity were analyzed based on five elements: government; foreign; institution; diverse; and manager (insider). the study found a significant positive relationship between insider ownership and firm performance. there is a significant negative relationship between government ownership and firm performance. regarding the relationship between ownership by institutions and firm performance, the study found a significant positive relationship. also the research concluded a significant positive relationship between diverse ownership and firm performance. lastly the author posits a positive relationship between foreign ownership and firm performance. to sum up, the existing literature points towards a significant and positive impact that foreign ownership brings to the firm. also, the government as a stakeholder is of little benefit in enhancing the firm performance. further, private individuals and retail owners are mostly ineffective in increasing the financial performance. there is a paucity of studies revealing the impact of shareholder types, corporate governance on financial performance, this study is a modest attempt in this direction. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 52 3. research objectives and hypothesis in the research, we have attempted to examine the relationship between firm performance and shareholding pattern or ownership structure. total of 76 companies have been included from bse 100, excluding banking and financial sector companies. following are the objectives of the research: 1. to study effects of ownership structure (shareholding pattern) on performance of a firm in india. 2. to study the effect of corporate governance measured by corporate governance index on financial performance of a firm. 4. data and methodological issues for our research, we have taken daily data files from bse 100 index. the time period of the study is from 01st april 2007 to 31st march 2014. the data sources were the annual reports of the companies, corporate database (prowess) maintained by the cmie, the center for monitoring the indian economy, and the reports filed by companies with the bse as part of the listing requirements. for the analysis, we took the 100 companies. we kept out all the banking and financial services companies since they are governed by the banking regulation act; hence these companies were different from those governed by the companies act. these sample selection criteria’s resulted in a final sample size of 76 companies. key variables to examine the effect of ownership structure on corporate governance and performance, the following variables were used: measurement of corporate performance two measures of performance, as supported in the finance and accounting literature were chosen for the purpose of analysis. tobin’s q: tobin and brainard (1968) and tobin (1969) designed a measurement of corporate performance, which is equal to the ratio of market value of equity and debt divided by the replacement costs of total assets. the notion is that replacement costs are a logical measure of the alternative-use values of the assets. hence, unless assets used by firms are able to create at least as much value as the cost of reproducing them, the assets would be better employed elsewhere. companies displaying tobin’s q greater than unity are considered to be using scarce resources effectively, while those with tobin’s q less than unity as using resources poorly. tobin’s q has been computed as [mv of common stock + bv of preference stock + bv of borrowings + bv of cl)/ bv of total assets as denoted by fa + inv + ca] with all values computed at the year end. return on assets (roa). the accounting variable chosen was calculated as the ratio of net profit to assets. total assets include value of fixed assets, investments, and current assets. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 53 return on equity (roe): we measure return on equity capital as the ratio of net profit to equity capital. equity capital is the total outstanding paid up equity capital of the firm as at the end of the accounting period. shares issued but not paid-up or pending allotments do not form part of equity capital. this includes bonus equity shares issued, if any, by the firm in the past. roe = net profit/ equity capital ownership and governance variables the ownership structure and corporate governance mechanisms can influence company performance. the ownership and governance measures were analyzed as independent variables. ownership structure. the distribution of ownership among different categories of owners provides useful information about the corporate governance structure of a company. the shareholding has been classified according to a standard taxonomy of investors’ categories and definitions as provided under clause 35 (appendix iii) and 40a of the listing agreement (appendix iv). for the cross-sectional and pooled panel regression analysis the study considers only six major groups of ownership viz., retail shareholders, family ownership, foreign institutional investors, domestic institutional investors, government, corporate. h1: there is a significant relationship between the ownership by n retail investor and return on equity. h2: there is a significant relationship between the ownership by n institutional investor and return on equity. h3: there is a significant relationship between the ownership by government and return on equity. h4: there is a significant relationship between the ownership by family and return on equity. h5: there is a significant relationship between the ownership by fii and return on equity. h6: there is a significant relationship between the ownership by n corporate and return on equity board size: there is a view that larger boards are better for corporate performance because they have a range of expertise to help make better decisions and are harder for a powerful ceo to dominate. however, recent thinking has leaned towards smaller boards. board size has been measured as the total number of directors on the board. h5: there is a significant relationship between board size and return on equity. control variables in order to control for the other possible determinants of performance not captured by the ownership variables, some observed company characteristics have been included as control variables. the control variables used in the study have been selected with reference to those employed in earlier studies. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 54 age: age of the company has an ambiguous effect a priori on company performance. it is argued that due to the effects of the learning curve and survival bias older firms are likely to be more efficient than younger ones. thus, a better performance should be expected. however, older companies are prone to inertia, and rigidities in adaptability, which may lead to lower performance. age has been measured as the number of years for which the company has been in existence since incorporation to the date of observation. size: a vast amount of literature has investigated the relation between size and performance of firms. band (1981) and reinganum (1981) documented that small firms have higher returns than large firms, even after adjusting for risk via the capital asset pricing model (capm). lang and stulz (1994) reported significant negative correlation between size and tobin’s q. firm size can be measured in different ways, using total assets as a proxy of firm size. gilson (1997) used the natural log of total assets as a proxy of firm size. the literature also shows that alternative measures of size, based on annual sales or total asset values, do not materially affect the inferences. this has been measured by the natural logarithm of total assets of firms. debt-equity: theories on the role of debt provide us with a complementary corporate governance mechanism that monitors the management (jensen, 1989; and thomsen and pedersen, 2000). following regression equation for our research has been formulated: we have used pooled panel regression model. the data are usually collected over time and over the same individuals and then a regression is run over these two dimensions. the regression has been applied on the entire sample in total. 5. analysis and interpretations of empirical results 5.1 relationship between shareholder types and roe asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 55 table 2. result of pooled panel regression dependent variables independent variables roe coefficients pvalue intercept 92.77196 0.0819 retail shareholding -0.240335 0.3653 institutional investors shareholding 0.069376 0.4072 government -0.105731 0.0171 family shareholding 0.807634 0.0054 fii shareholding 0.385009 0.0009 corporate shareholding -0.045606 0.361 size -16.8298 0.018 log advertising 2.064538 0.0134 cgi -15.82816 0.001 board size 1.383278 0.0831 age 0.154378 0.2059 debt-equity -1.9976 0.4354 r squared 0.20886 the table is a snapshot of the regression results on an aggregate basis. the calculations show that retail shareholding has a negative relationship with financial performance as measured by roe, though not significant. individual shareholders are ineffective due to "free riding" problem (repei, 2000). the hypothesis that there is a significant relationship between the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 56 ownership by retail investor and return on equity is therefore rejected. the presence of institutional shareholders in a company has a positive but insignificant effect on the firm performance as seen in the results. the institutional investors help in reducing the information asymmetry associated with ownership and control. also they have access to information that helps in decision making (shleifer and vishny, 1986). we therefore reject the hypothesis that institutional shareholders have a significant impact on roe. the impact of government ownership on the firm performance is significant at 5% and is negatively related as governments are likely to pay special attention to political goals, many of which may be negatively correlated with the roe (pedersen and thomsen, 1998). in fact the rationale for government ownership in welfare economics is nonprofit making ( arrow, 1969, shephard, 1989). accordingly we accept that there exists a significant relationship between the ownership by government and return on equity. we accept the hypothesis that family ownership has a positive and significant impact on the financial performance of the company. here the incentive alignment argument is applied to explain the positive effect especially when family members also act as managers. the conflicts between principal and agent are reduced (anderson & reeb (2003), górriz & fumás (2005). another widely applied argument is the long-term orientation of the family owner. while other owner types focus on profit maximization in the short term, family owners have a long term commitment to the firm and are willing to invest in the capacities that will create competitive advantages which require large investment in the beginning. the fii ownership contributes positively to roe and the effect is significant at 5% level. we therefore accept the hypothesis. researchers (aydin, sayim and yalama, 2007) have inference that on an average multinational corporations have performed better than the domestically owned firms. there are two main reasons. firstly, the foreign owners are more likely to have the ability to monitor managers and give them performance based incentives and avoid behaviors that undermine the wealth creation motivation of the firm owners. the second reason is the transfer of new technology and globally tested management practices to the firm, which help in enhancing the efficiency by decreasing operating expenses and generating savings for the firm (ongore, k'obonyo and ogutu, 2011).the presence of corporate ownership has a negative impact on roe, though insignificant. however, the size (proxy by amount of assets) should have a positive effect on roe as more assets provide the company with cushion to raise capital easily. however the factor has a negative and significant correlation with firm performance. the firm size has an ambiguous effect on the firm performance. it is argued that as the size increases, efficiency reduces as control by top managers over strategic and operational activities decreases. advertising expenses of the firm yield positive and significant relationship with roe at 5%. this can be attributed to the fact that the firm gets more visibility in the market and its products are sold easily. joshi and hanssens, 2010 posit that advertising spending has a positive effect on the market capitalization of the firm and a negative impact on the valuation of the competitor of comparable size. the corporate governance index, cgi, has a significantly negative impact on the firm performance. this is mainly because of negative and significant impact of ceo duality, audit committee size, board meetings and presence of non-executive directors who may not have total commitment to the cause of the company because of other commitments which limits their contribution. according to baysinger and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 57 heskisson, 1990, non-executive directors are limited in scope and understanding when it comes to complexities involving decision making because of their temporal position. the results show that size has a significant and positive effect in increasing the roe at 10% significance level. the result is consistent with several studies that are in favor of a large board size as greater knowledge of the various administrators can improve performance (coles et al., 2008 and linck, et al., 2008).the experience of the firm proxy by age shows a positive relationship although insignificant in improving performance . older firms gain experience based economies of scale; they enjoy superior performance (kumar, 2004). high debt in a company leads to increased cost of capital along with risk of financial distress. this effect the roe significantly negative at 5%. to sum up, we accept that foreign institutional investors, government and family have a significant impact on the roe whereas corporate, retail and institutional investors have no significant effect on the financial performance as measured by roe. also, the control variables namely debt and size have significantly negative impact on roe. also cgi variable has negative impact on financial performance of the firm. r-squared value is 20.88% for roe. 5.2 relationship between cgi and financial performance in this section, we have applied panel pooled regression to study the relationship between cgi and financial performance. the results are as follows: table 3. result of pooled panel regression of cgi with firm performance dependent variables independent variables roe roa tobin's q coefficients pvalue coefficients pvalue coefficients pvalue intercept 55.32801 0 5.401542 0.0027 318.8497 0.7902 size -3.016807 0.5315 -0.29831 0.0602 -1.93122 0.00855 log advertising -1.481781 0.0134 0.158925 0.6541 0.778071 0.8937 cgi -11.10036 0.0263 -1.26706 0.09 -570.323 0.2546 board size 1.383278 0.3227 0.733712 0.0365 -29.3817 0.3692 age -0.068426 0.1665 0.055125 0.4564 0.005942 0.3136 debt-equity -4.860119 0.4042 -1.0162 0.2445 -0.2973 0.9568 r squared 0.054072 0.027122 0.178171 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 58 analysis of the results shows that the corporate governance index (cgi) has a significantly negative impact on roe. roa is negatively correlated to cgi, although the relationship is insignificant at 5% significance level. cgi is negatively related to financial performance of the firm as measured by tobin's q, although the relationship is insignificant r squared for the analysis is 5.40%., 2.71%, 17.8% 5. summary, conclusions and implications this paper investigates the effect of ownership structure on firm performance with sample from india. to conclude, the research questions are answered with evidence from non-financial listed companies on bse. the nature of ownership identity in india and its effect on firm performance was analyzed using pooled panel regression. it is found that family/foundation owned firms have better financial performance and firms with government ownership show significantly negative financial performance. foreign institution owned firms show a positive relationship with performance. arguments are combined to explain the results: management entrenchment argument for dispersed ownership; incentive alignment argument and long-term orientation argument for family ownership; institutional myopia argument and cost-efficiency of monitoring argument for institution ownership; information asymmetry of bureaucracy argument and dual-role argument for government ownership. the effect of owner identity on firm performance exists and varies among different types of owner, because the different owner has its own preference on firm strategic goals and varies in incentive and capability to deal with agency problems. some of the control variables had a significant effect on the corporate performance. the control variables like leverage had a negative impact while age had a positive effect on performance. corporate governance index had a significantly negative impact on roe. the reason could be that the components of cgi are negatively related to the firm performance. also, although the relationship between cgi and roe, roa and tobin's q is observed to be negative, but the impact of cgi is significant only in case of roe. implications of the study • the findings underline that family ownership is dominant followed by institutional investors. the individuals are insignificant investor type. since board derives its power from dominant shareholders, disciplining them is not feasible resulting in the ineffectiveness of the board. there thus exists a dual challenge of resolving conflict between not only the shareholders and management but also between dominant shareholders and minority shareholders. shleifer and vishny (1986) argue that large shareholders have a strong incentive to monitor managers because of their significant economic stakes. • sound functioning corporate governance mechanisms are of crucial importance for both local companies and foreign investors so as to tap tremendous opportunities for investment and growth which the indian economy provides. • there is a significant negative relationship between government ownership and firm performance. government ownership contributes to generally poor performance of firms, due to excessive bureaucracy, nepotism, political expediency. the current study has confirmed asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 59 this long-held position. therefore the government should infuse private sector-like management systems and progress the divestiture program to attract more private individuals and institutions to co-own the public sector undertakings. • in line with the above, the private players should have a stake in the projects launched by the government to make them more efficient, thereby improving the performance. • there is a positive and significant relationship between foreign ownership and firm performance. foreign owned companies have access to management systems whose efficacy has been tested in many contexts. the massive resource base and bail-out plans for fledgling affiliates are other factors that enhance performance of foreign owned firms. • the debate on corporate governance pertains to board composition especially board size and independence. the introduction of independent directors is an important arrangement in monitoring the effectiveness of board of directors. it is therefore imperative to improve effectiveness of independent directors in monitoring managers especially to strengthen their independence. a major problem, however, is the limited 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(1998). a study on relationship between ownership and return in malaysia. mba thesis, university of malaya, kuala lumpur. yeh, y.h., t.s. lee, and t. woidtke (2001). family control and corporate governance: evidence from taiwan. international review of finance, 2, 21-48. http://dx.doi.org/10.1111/1468-2443.00014 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. microsoft word 1660-6596-2-rv _1_-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 345 macro effect of global financial crisis on nigerian economy oke, michael ojo. department of banking and finance faculty of management sciences ekiti state university, ado ekiti, nigeria e-mail: okemike2001@yahoo.com ajayi, lawrence boboye department of banking and finance faculty of management sciences ekiti state university, ado ekiti, nigeria e-mail: boblaw2006@yahoo.com received: april 18, 2012 accepted: may 15, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1660 url: http://dx.doi.org/10.5296/ajfa.v4i1.1660 abstract this study examined the macro effect of the global financial crisis on nigerian economy using key economic variables. it adopted the error correction mechanism (ecm) technique to analyse the time series data from secondary sources. the study used gross domestic product (gdp) as the dependent variable, as well as, a measure of economic growth while the other key variables such as the inflation rate (inf), money supply (ms) and foreign direct investment (fdi) represent the explanatory variables. the results revealed a positive relationship between gdp and fdi as well as ms, while a negative relationship was found between gdp and inflation. the study recommended among others; that to reduce or eliminate completely the negative effect of the global financial crisis, the government and the monetary authority must formulate and implement policies that will reduce inflation, diversify the economy as well as encouraging local and foreign investors. keywords: globalization, financial crisis, investors, capital market shocks, error correction model asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 346 1. introduction globalization is a process of integrating economic decision making such as the consumption, investment and savings process all across the world. it is a process of creating a global market place in which increasingly all nations are forced to participate. globalization can easily transfer the happenings in one economy to another (abdul, 2009). the key elements of the process of globalization include the interconnection of sovereign states through trade and capital flows; harmonization of the economic rules that govern relationship between these sovereign states; creating structures to support and facilitate dependence and interconnection and creation of a global market place. one of the major adverse effect of globalization is the recent economic and financial crisis which started in the united states in september 2008 and has rattled the financial markets and of both the developed and developing economies around the globe. this crisis was as a result of the bursting of the united states housing bubble which peaked in approximately 2005-2006. high default rates on subprime and adjustable rate mortgages began to increase quickly thereafter. an increase in loan packaging, marketing and incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief that they would be able to quickly refinance at more favourable terms (blanchard, 2009). however, interest rates began to rise and housing prices started to drop moderately between 2005 and 2007 in many parts of the u.s., refinancing became more difficult. defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and adjustable rate mortgages interest rates reset higher. consequently, housing prices declined, major global financial institutions that has borrowed and invested heavily in subprime mortgage reported significant losses. falling price also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. this created a serious financial crisis which spread to other part of the world including nigeria. this crisis continues to drain wealth from consumers and erodes the financial strength of banking institutions in the global economies. since the world is linked inextricably by globalization, financial crisis has continued to dominate global discussions on global economy and every economy is trying to formulate strategies to mitigate the impact of the financial crisis on domestic and global economy. the risk of global recession has heightened significantly and volatility of commodity prices which is the mainstay of most developing countries like nigeria has increased further. if this situation continues to deteriorate, developing countries could be in jeopardy (adewale, 2009). given the above mentioned situations, there is the need to investigate the effect of the global financial crises on the nigerian economy and to recommend probable ways to reduce the effect. 2. literature and theoretical review 2.1 the global financial crisis and the nigerian economy the reasons for this crisis are varied and complex, but largely, it can be distributed to a number of factors in both the housing and credit markets which developed over an extended asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 347 period of time. some of these include: the inability of homeowner to make their mortgage payments, poor judgment by the borrower and /lender, speculation and over building during the boom period, risky mortgage products, high personal and corporate debt levels, financial innovation that distributed and concealed default risks, central bank policies and regulation. the impact of the crisis on the nigerian economy has different implications for the capital market, the banking sector, foreign exchange and the balance of payments, as well as the real sector. market capitalization fell by 45.8% in 2008, a sharp reversal of growth from 2007, when the market grew by 74.4% (okereke-onyiuke, 2009). the crude oil price (bonny light) declined precipitously from u.s. and 147 percent per barrel in july 2008 to $47 per barrel in january 2009, prompting the government to seek other sources of financing for the 2009 fiscal year, as it could not rely on earnings from crude oil exports. eventually, there was a huge budget cut at all tiers of government and social spending, such as on education, health and other millennium development goals was deeply affected. the nigerian currency, the naira, has also been depreciating against the u.s. dollar and this has implications for foreign reserves, which dropped from $67 billion in june 2008 to $53 in december 2008 and to about $34billion in 2011. the all share index and the market capitalization of the 233 listed equities capture activities and performance on the nigerian stock exchange (nse). the index has been growing over the years from a value of 12,137 in 2002 to 66, 371 in march 2008, with a market capitalization of 4998 trillion because of the melt down. by the end of the first week of march 2009, values had declined to 21,893 points, with a market capitalization of 4900 trillion. this value had further declined to 21, 608 points, with a market capitalization of 4836 trillion, by the end of the second week of march 2009. this reveals that between march 2008 and march 2009, the all share index had lost a total share of 67%, while market capitalization had lost 62% of its value (okonjo-iweala, 2009). there are concerns regarding how rapidly the global financial crisis penetrated the nigerian capital market, especially given that there is hardly any thriving domestic mortgage market. the decline of indicators of activities on the nse before the escalation of the crisis on the global scene in july 2008 became a source of concern for many. however, the emerging facts reveal that the crisis may have been made evidence in the capital market through various channels (soludo, 2009). foreign portfolio investment withdrawals and withholdings in order to service financial problems at the foreign investors home as well as prospects of reduced fdi are bound to affect investor confidence in the economic health of nigeria. evidence on foreign portfolio withdrawals shows that the total financial inflows to nigeria between 2007 and 2008 increased by 21%, while that between 2008 and 2009 reduced by 38.6%. the adoption of a public-private partnership (ppp) policy platform to implement huge investment plans such as oil and gas (liquefied natural gas – lng-project), power plants, railways, housing and roads, therefore exposed the country more to fdi uncertainties and vagaries. the credit crunch experienced by lending institutions, affect business that requires short and long term fund including banks’ lending to corporate organizations as well as inter-bank short-term lending. in a country like nigeria, where mortgages and credit card purchases are not well developed, this credit crunch became manifest in weakened risk assets of banks that had given out loans to some investors to invest in other financial instruments (particular secondary market purchase and initial public offerings (ipos), in the hope of making quick asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 348 returns through a quick turnaround of their portfolio. this was what was termed otherwise ‘margin lending’. this may also be termed nigeria’s own version of the ‘subprime problem’, resulting in an exploding domestic stock market and stock prices and astounding returns to both the spectaculars and providers of the margin funds (the banks). other factors that have had a serious impact on the stock market are what can be called the ‘intensifiers’. these include policy interpretations by the market, which may have been induced by the slow government initial stand on the economy. this also includes interpretation of announcements, proclamations and rumors by the market. examples include the proposed recapitalization plan of the stock market players (stock broking firms) as well as rumors on the termination of margin lending by banks. 2.2 theoretical framework many scholars have given various theories to explain economic crisis or global financial crisis. kaldor, in 1940 built a model of trade cycle based on the keynesian terminology of savings and investment. he showed that trade cycle is the result of pressure that push the economy towards the equality of anticipated, expected, or planned (ex-ante) saving and investment. kaldor shows the stability and instability conditions in the form of linear diagrams, through the cycle is only possible when investment and savings are non-linear. the forces that bring about lower turning point are not so certain at the higher level. a boom left to it is certain to come to an end but depression might get into a position of stationeries and remain there until external changes (the discovery of new markets) come to rescue. thus the cycle in this model are not necessarily symmetrical, as a matter of fact, they depend on the slopes of investment and savings curves and the rate at which they shift in each phase of the cycle. marxist theory of trade cycle based on market capitalism is intrinsically prone to crisis. in marx’s view, profit is the major engine or the market-economy, but business (capacity) profitability has the tendency to fall, that recurrently creates crisis in which mass unemployment occurs, business fail, the remaining capital is centralized and concentrated, profitability is recovered. in the long run, these crises tend to be more severe and the system eventually fails. thus marx viewed capitalism as a system that cannot be put under societal condition. the chamberlain oligopoly model proposed a stable duopoly solution recognizing mutual dependence between the two sellers or nations. he asserts that each seller act so as to render his profit a maximum. in order to do this, he will take account of his total influence upon the price, indirectly as well as directly. when a seller remains passive to changes in price or output of his rival, it is a direct influence. on the other hand, when a seller reacts to the price or output changes of his rivals and changes his own price or output, the influence is indirect. according to chamberlain; when interdependence is recognized between sellers, both direct and indirect influences of a change in the price or output of a seller leads to a stable industry equilibrium with monopoly price and output. 2.3 review of empirical studies bogunjoko (1997)) examines the impact of financial crisis on nigeria, which makes nigerians to face an uncertain economic situation both in the near and far future as a result of the oxidizing global and domestic financial crisis. the findings show that the capital market asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 349 is in ratters, banks are struggling, the sole dependency on oil continues to bedevil the nation, and our foreign reserve situation remains an enigma wrapped in a mystery. he concludes by calling for an urgent need to adjust government’s expenditure and upcoming budget accordingly. okonjo-iweala (2009) examines the impact of such crisis on oil price. which she saw as the biggest component of external shock that has hit nigeria in which she suggest two challenges faced by policy makers, which are; how to respond to the down cycle of oil prices and how to ensure that the economy emerges stronger and more diversified after the crisis ends. she concluded by saying that fiscal and exchange rate/monetary policy are the vehicles that will sustain the economy’s growth and quest for diversification. ajakaiye and fakiyesi (2009) used computable general equilibrium (cge) methodology to examine the impact of global financial crisis. the study examined that the nigerian economy is affected by the current global financial crisis which is transmitted via the fall in the prices of crude oil exported to the international market. their result of the research shows that negative oil price shock has negative impact both in the short and medium term growth of the economy, based on their findings, the oil price shock have had a stagflation effect on the nigerian economy; the showdown in the rate of economy growth and increase in the domestic price level. also, they reduce the level of domestic investment and worsened the government account and income position. besides, the shocks have increased the level of poverty and worsened household welfare over the period of august 2008 to january 2009 and are expected to worsen them in 2010. avgouleas (2008) enumerated the causes of the crisis as: breakdown in underwriting standards for subprime mortgages; flaws in credit rating agencies assessment of subprime residential mortgage backed securities (rmbs) and other complex structured credit products especially, collaterized debt obligations (cdos) and other asset-backed securities (abs); risk management weakness at some large u.s. and european financial institutions and regulatory policies including capital and disclosure requirements that failed to mitigate risk management weakness. 3. methodology in order to effectively realize the objectives of the study, this study adopts the model of rusuhuzwa and baracako (2009). in their study, they investigated the impact of global financial crisis showing private capital inflows and economic growth in rwanda and burundi using foreign direct investment (fdi) upon real gdp growth. fdi is an important variable in any study on global financial crisis because the inflows of foreign capital or international financial assets have the tendency to import inflation from home country to the host country as a result exposes the host country to global financial crisis. however, the model was modified to suit the nigerian environment as follows: gdp = (inf, ms, fdi, ε) …………………………… (1) where: asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 350 gdp= gross domestic product, inf=inflation, ms=money supply, fdi= foreign direct investment, ε=stochastic variable, =functional relationship. specifying the model in explicit form by log-linearising, it becomes: log (gdp) = xo + x1 log (inf) + x2 log (ms) + x3 log (fdi) + ε……. (2) where: log=natural logarithm, xo =intercept of the relationship in the model; x1=co-efficient of inflation, x2=co-efficient of money supply, x3=co-efficient of foreign direct investment specifying the model in a time series form, we have; log (gdp)t = xo + x1 log (inf)t + x2 log (ms)t + x3 log (fdi)t + ε….. (3) specifying the model in a general error correlation model (ecm) gives thus; log (gdp) = xo + ni log (inf) t-1 + ni x2log(ms) t-1 + ni x3 log(fdi) t-1 + ni ecm t-1 +  t……………………………..(4) where t-1 = means that the variables where lagged by one period ni = 0 ecm t-1 = error correlation term  t =white noise residual once co-integration is established alongside its extent and form, the next step is to proceed to the error correction mechanism. the augmented dickey-fuller (adf) unit root test will be employed to the stationarity of data and order of integration. johansen co-integration test will reveal whether long-run relationship exist among the variables and examines the long-run effect of the macroeconomic variables on the endogenous variable while the error correction mechanism (ecm) shows the adjustment process and indicates how the disequilibrium of the previous period shocks adjusts into the long-run equilibrium in the current period on gdp. a priori expectations are determined by the principles of economic theory and refer to sign and size of the parameters of economic relationship. inflation is expected to have a negative relationship with the gross domestic product because an increase in inflation will have a negative effect on crisis on gross domestic product (gdp). thus, gdp / inf <0, money supply is expected to be positively related with the gross domestic product because an increase in money supply will have a positive effect on gross domestic product (gdp). thus, gdp / ms >0, foreign direct investment is expected to be positively related with the gross domestic product because an increase in foreign direct investment will have a positive effect on gross domestic product (gdp). hence, gdp / fdi >0. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 351 data on the selected economic and financial indicators in nigeria were sourced from secondary sources such as the review of cbn (central bank of nigeria) statistical bulletin, central bank of nigeria annual report, economic reports, publications of the nigeria institute of economic and social research (niser), federal office of statistics annual abstract and other write-ups gotten from various economic journals. 4. analysis and findings 4.1 unit root test there is need to know the status of the variables used in the study. to realize this, the unit root test is carried out to know if the data of the variables are stationary with respect to time. the table below shows the results of the stationary test for all variables used. the stationary level is considered after comparing the adf against the mackinnon critical value at 5% level. table 1. result of stationary test at level variables adf test statistical value mackinnon critical value (5%) nos of time difference remark ldgp 1.21399 3.0521 1(0) non-stationary lms 2.726451 3.0521 1(0) non-stationary linf 1.898187 3.0521 1(0) non-stationary lfdi 1.722632 3.0521 1(0) non-stationary source: author’s computation. from the table above, the absolute value of mackinnon critical value at 5% are greater than the adf test statistical value in all the variables. hence, the null hypothesis of the presence of unit root at 1% is accepted since there is non-stationary of the variables at level differences of the time series variables. there is need to carry out the test at first difference to see if there will be stationarity of the variables. the table below shows the result of first difference asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 352 table 2. result of stationary test at first difference variables adf test statistical value mackinnon critical value (5%) nos of time difference remark ldgp 4.041385 3.0659 1(1) stationary lms 1.317554 3.0659 1(1) non-stationar y linf 3.196039 3.0659 1(1) stationary lfdi 3.411465 3.0659 1(1) stationary source: author’s computation. the above table shows that the dependent variable (lgdp) and the independent variables (linf) and (lfdi) are stationary at first difference while the independent variable (lms) is non stationary at first difference because the result shows that the adf statistics value of lms is still less than the mackinnon critical value at 5%. however, this is not so in the case of lgdp, linf and lfdi. there is need to carry out further test of second difference with respect to lms as shown in the table below table 3. result of stationary test at first difference variables adf test statistical value mackinnon critical value (5%) number of time difference remark lms 1.317554 3.0659 1(2) stationary source: author’s computation. the table above shows that the variable (lms) is stationary at its second difference. that is, adf statistics value of the variable is greater than the mackinnon critical values which means the variable is stationary at the second difference. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 353 table 4. summary of the order of stationary variables order of stationary ldgp 1(1) lms 1(1) linf 1(1) lfdi 1(2) source: extracted from tables 4.2 and 4.3. the table below shows the result of the adf test equation on each of the variables with their different levels of stationary and lagged period. also shown is their corresponding co-efficient of multiple determinations (r2). the variable in each of the multiple are regressed together expressing one as dependent variable (i.e. lgdp) and others as independent variables. the test of significance is also conducted for each of the equation. table 5. the adf test equation variables co-efficient standard error t-statistics prob. value r2 d[lgdp(-1)] d[lgdp(-1)2] c -1.754102 0.298668 0.449434 0.434035 0.263790 0.231293 -4.041385 1.132218 1.943141 0.0014 0.2780 0.0740 0.705657 d[lms(-1),2] d[lgdp(-1),3] c -1.740934 0.156279 0.049194 0.479318 0.279757 0.042394 -3.630593 0.558622 -1.160389 0.0034 0.5867 0.2685 0.761387 d[linf(-1)] d[lgdp(-1),2] c -0.938974 0.058498 -0.126097 0.293793 0.235271 0.144408 -3.196039 0.248642 -0.873202 0.0070 0.8075 0.3984 0.534039 d[lfdi(-1)] d[lgdp(-1),2] c -1.578858 0.115915 0.351342 0.462809 0.274899 0.243382 -3.411465 0.421665 1.443582 0.0046 0.6802 0.1725 0.712733 source: author’s computation. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 354 4.2 co-integration test the test for co-integration was performed using johansen maximum likelihood estimation approach. under this approach, trace test statistics was used on testing whether a long run relationship exist among the variables. table 6. result of the johansen co-integration test hypothesized number of (ces) eigen value trace statistics or likelihood ratio 5% critical value 1% critical value none ** 0.755691 53.84015 47.21 54.46 at most 1* 0.560198 29.88166 29.68 35.65 at most 2* 0.501416 15.91733 15.41 20.04 at most 3* 0.213632 4.085615 3.76 6.65 *(**) denotes rejection of hypothesis at 5% (1%) significance level. l.r test indicates 4 co-integration equations at 5% significance level. source: author’s computation. the co-integration equation is specified as follows gdp = -0.143321ms + 0.814827inf – 0.066983fdi – 14.56459 (0.18220) (0.30721) (0.37823) note: standard error statistics are stated in parenthesis. the result in the above table shows the existence of co-integration or long-run relationship among gross domestic product (gdp), money supply (ms), inflation rate (inf) and foreign direct investment (fdi). the condition for co-integration among the variables is that the critical value at 5% must be less than the likelihood ratio. considering the table, the critical value at 5% is less than the likelihood ratio at none hypothesized (i.e. the first column). hence, the hypothesis of no co-integration has been rejected at 5% significance level. furthermore, the condition for the long-run model among the four (4) co-integration equations is that the equation with the highest log-likelihood (at absolute term) is chosen to be the long-run model. having established the long-run relationship among the variables through the use of johansen co-integration test, the next step is to switch to the error correction model. the unit root test was also conducted on the error correction term with its adf test statistics as (4.491639) and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 355 critical value at 5% (-3.0659) at first difference. this shows that the error correction term is stationary at first difference. an over parameterized error correction model is estimated by setting the lag length long enough in order to ensure that the dynamics of the model have not been constrained by a too short length. the table below presents the over-parameterized error correction model. table 7. over-parameterized model (ecm1) variables co-efficient standard error t-statistics prob. value d[lgdp(-1),2] -0.148802 0.190948 -0.779281 0.4582 d[lms,2] -0.252517 1.175748 -0.214771 0.8353 d[lms(-1),2] 0.458036 0.967108 0.473614 0.6484 d[linf,2] 0.132275 0.235532 0.561601 0.5898 d[linf(-1),2] -0.106823 0.197278 0.541485 0.6029 d[lfdi,2] 0.028158 0.191885 0.146743 0.8870 d[lfdi(-1),2] 0.475977 0.352978 1.348459 0.2144 ecm (-1) -0.786531 0.415267 -1.894039 0.0948 r2 = 0.93, durbin watson statistics = 1.918 source: author’s computation. the table above shows the over parameterized over correction of global financial crisis and nigeria’s economic development. the ecm is negative as theory predicts, and the value indicates that about 79% error corrections take place in the model. also, the r2 is 0.93 or 93% with the durbin watson of 1.918. it could be deduced from the results that all the probabilities for the variables are greater than 10%. therefore, there is no need to go further to the parsimonious error correction model (ecm2). from the over-parameterized model result above, it can be seen that the co-efficient of money supply, foreign direct investment and inflation rate are in conformity with the ‘a priori’ expectations. there is a positive relationship between gross domestic product, money supply and foreign direct investment with the co-efficient of money supply and foreign direct investment at 0.4580 and 0.4760 respectively, this implies that a unit increase in both ms and fdi will increase gross domestic product by 0.4580 and 0.4760 respectively. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 356 again, the co-efficient of inflation rate is negative in conformity with our ‘a priori’ expectations. this means that there is a negative relationship between gdp and inf. the co-efficient of inf is 0.106823, meaning a unit increase in inf will lead to 0.106823 unit decrease in gdp. more so, the ecm otherwise known as the speed of adjustment is significant with the appropriate sign i.e. negative sign in conformity with the ‘a priori’ expectation. this means that the present value of gdp adjust to changes in money supply (ms), inflation rate (inf), and foreign direct investment (fdi). the large value of the error correction variable given as 78.65% indicates a feedback of that value or the adjustment of that value from the previous period disequilibrium of the present level of gdp in the determination of the causality between the past level of gdp and the present and past level of ms, inf and fdi. the co-efficient of determination (r2) shows the percentage total of variation in the dependent variable explained by the independent variable. the r2 from the model stands at 0.93 or 93%. this means that over 93% of the variation in the present state of gross domestic product is being explained by the past values of gdp and the present and past values of ms, inf, and fdi while 7% of the variation in the present value of gdp is being explained by the stochastic error term. the standard error test is carried out for the significance of the parameters. the standard error test measures the statistical reliability or significance of the co-efficient estimates. it is carried out by comparing the standard error value of the parameters and the co-efficient of the variables divided by 2. table 8. the standard error test variables co-efficient co-efficient 2 s.e h0 h1 remark lms 0.458036 0.229018 0.927108 accept reject insignificant linf 0.106823 0.0534 0.197278 accept reject insignificant lfdi 0.445977 0.2380 0.352978 accept reject insignificant source: author’s computation from the above standard error test, it can be seen that all the variables in the model are statistically insignificant. this means that the null hypothesis is accepted while the alternative hypothesis is rejected. the f-test shows the overall or aggregate significance of the model. the aim is to find out whether all the explanatory variables put together do actually have any significant influence on the dependent variable. it is carried out by comparing the f-calculated and f-tabulated. this follows an f-distribution value with k-1 and n-k degree of freedom at 95% confidence level. therefore with v1 = k-1 = 4-1 3, v2 = n-k = 19-4 = 15. therefore, f-tabulated = 3.24 fcalculated = 20.648 (obtained from computer output). since the f calculated is asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 357 greater than the ftabulated, the null hypothesis is rejected while the alternative hypothesis is accepted. this shows the overall significance of the model. 5. conclusion and recommendations the accepted alternative hypothesis in this study has empirically confirmed that the global financial crisis strongly affect the nigerian economy because of uncertainty in foreign direct investment and money supply that could create uncertainty in the level of investment which retards economic growth in. this is evidenced by the bearish trend in the capital market, the problem in the banking sector, the decline in commodity prices especially crude oil, the reduction in foreign direct investment and the decline in remittance from abroad are all result of the global financial crisis. hence, it can be asserted that economic recession or crisis adversely affects the economic growth and development. it slows down the economy, investors are discouraged, producers do not have access to external fund to produce, consumers lack necessary money due to unemployment and therefore they cannot afford to buy the available goods in the market. however, several policy measures have been put in place by the monetary authority in nigeria (cbn), federal government and other regulatory authorities in order to cushion the adverse effect of the crisis. however, more still needs to be done in this direction. given the various adverse implication of the global financial crisis has evidenced in this study, it is appropriate to suggest some solutions that could solve or reduce the effects. first, there should be adequate facilities for the remittance of profit, dividend and interest so that the foreign investors will be sure of repatriating their profit back to their various countries. second, there should be special awareness and training programmes for nigerians on the importance of investment in order to promote economic growth and development. third, political stability should be enhance encourage foreign investors because frequent changes in government may come with different policies and ideas which may not be to the advantage of the investors. fourth, the regulatory authorities and policy maker in nigeria should try as much as possible to bring down the cost of investment (interest rate) so as to encourage both the foreign and local investors to invest in nigeria. fifth, overdependence on imported raw materials should be curbed by encouraging local substitutes because inflation could be imported into the country through the importation of raw materials in time of crisis. sixth, to avoid any problem from future global financial crisis, there is an urgent need for nigeria to diversify its export market and seventh, there is an urgent need for the nigerian government to diversify the economy away from being a monoculture of oil and gas to embark on deep and systematic reform of financial institutions to engender stability and robust policies. references aluko, m.e. (2008). capital market, foreign reserves vs. global financial meltdown in nigeria. zest international, 1(6). adewale, d. (2009). global economic crisis: nigeria and national strategy. journal of nigerians in america, 40(2), 145-167 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 358 ajaikaiye and fakiyesi (2009). global financial crisis, discussion series nigeria. united kingdom. overseas development institute (odi). 111 westminster bridge road london se1 7jd.paper 8 avgouleas, e. (2008). financial regulation, behaviour finance, and the financial credit crisis in search of a new regulatory models. url http://papers.ssrn.com (november) bogunjoko, j .o. (1997). monetary dimension of the nigeria economic crisis: empirical evidence from a co-integrated paradigm. national center for economics management and administration (ncema), nigeria journal of economics and social studies, 39(2), 145-167 blanchard, olivier. (2009). the crisis: basic mechanisms, and appropriate policies, imf working paper, wp/09/80 crotty, j. (2008). structural causes of the global financial crisis: a critical assessment of the new financial architecture, political economy research institute (peri) working paper, no. 180. ibrahim, m .h., & aziz, h. (2003). macroeconomic variables and the malaysian equity market: a view through rolling subsamples. journal of economic studies, 30(1), 6-27. http://dx.doi.org/10.1108/01443580310455241 mukherjee, t. k., & naka, a. (1995). dynamic relations between macroeconomic variables and the japanese stock market: an application of a vector error-correction model. journal of finance research, 18(2), 223-237. okereke-onyiuke, n. (2009). a review of market performance in 2008 and the outlook in 2009. the nigerian stock exchange. okonjo-iweala, n. (2009). the global financial crisis: impact and implication for nigeria, distinguished lecture delivered at african university of science and technology. abuja; march 16 okonjo-iweala, n (2009). the nigerian stock exchange market performance in 2008 and outlook for 2009. zenith economic quarterly, 4(1), january, 12-20 soludo, c. (2009). global financial and economic crisis. how vulnerable is nigeria? a paper presentation by governor of central bank of nigeria on january, available on www.cenbank.or/uut/speches/2009. ross s. a. (1976). the arbitrage theory of capital asset pricing. journal of economic theory, 13, 341-360. http://dx.doi.org/10.1016/0022-0531(76)90046-6 rusuhuzwa, t. k., & baracako, j. (2009). ‘the global financial crisis showing private capital inflows and economic growth in rwanda and burundi. african economic conference, addis ababa. microsoft word 2165-8496-1-rv-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 289 futures trading and its impact on volatility of indian stock market namita rajput e-mail: namitarajput27@gmail.com ruhi kakkar e-mail: ruhi.kakkar@gmail.com geetanjali batra e-mail: ms.geetanjali.batra@gmail.com received: july 29, 2012 accepted: december 14, 2012 published: june 1, 2013 doi:10.5296/ajfa.v5i1.2165 url: http://dx.doi.org/10.5296/ajfa.v5i1.2165 abstract derivative products like futures and options are important instruments of price discovery, portfolio diversification and risk hedging. this paper studies the impact of introduction of index futures on spot market volatility on s&p cnx nifty using bi-variate e-garch technique. the evidence of this model shows that the volatility spillover between spot and futures markets is uni-directional from spot to futures and spot market dominates the futures market in terms of return and volatility. the volatility persistence and clustering is found to be significant and bidirectional at 5 % level of significance. at the practical level, a better understanding of the mean and variance dynamics of the spot and futures market can improve risk management and investment decisions of the market agents. the findings have implications for policy makers, hedgers and investors. the research contributes to literature for emerging markets such as india. keywords: derivatives, index futures, stock markets, volatility, arch-garch, spillover jel classification: g1, g13, g14, g15, g18, c32 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 290 introduction the liberalization and integration of financial markets globally has created new investment opportunities, which in turn require the development of new instruments that are more proficient to deal with the increased risks. investors who are actively engaged in industrial and emerging markets need to hedge their risks from these internal as well as cross-border transactions. agents in liberalized market economies who are exposed to volatile stock prices and interest rate changes entail suitable hedging products to pact with them. with the advent of liberalisation and economic expansion in these emerging economies demands that corporations should discover better ways to manage financial and commodity risks. the most wanted instruments that allow market participants to manage risk in the modern securities trading are known as derivatives which are a new advent in developing countries compared to developed countries. the main reason behind the derivatives trading is that derivatives reduce the risk by providing an additional way to invest with lesser trading cost and it facilitates the investors to extend their settlement through the future contracts. it provides extra liquidity in the stock market. they represent contracts whose payoff at expiration is determined by the price of the underlying asset—a currency, an interest rate, a commodity, or a stock. derivatives are traded in organized stock exchanges or over the counter by derivatives dealers. the impact of derivatives trading on stock market volatility has received considerable attention in india, particularly after the stock market crash of 2001. derivative products like futures and options have become important instruments of price discovery, portfolio diversification and risk hedging. in the last decade, many rising and transition economies have started introducing derivative contracts. derivatives markets have been in existence by many accounts even longer than that for securities. however, it has been their growth in the past 30 years that has made them a significant segment of the financial markets. from a proscribed economy, india has moved towards a world where there are daily prices fluctuations. need of the derivatives was felt in india post liberalization because derivative trading provides various benefits such as risk management, price discovery, operational advantage, market efficiency and opportunity to speculate.the recent gain in momentum in recent years is mainly because of liberalization procedure and efforts of rbi in creating currency forward market. derivatives are an integral part of liberalization process to manage risk. nse gauging the market requirements initiated the process of setting up derivative markets in india. in july 1999, derivatives trading commenced in india. the introduction of derivatives segment from the early 2000s onwards has led both to interactions between the spot and futures markets, and to an interest by regulators in controlling any possible harmful influences of this new trading segment. it is expected that the futures prices can reflect additional information, over and above that already reflected in the spot price, given the leverage benefits and so can serve as a leading indicator for the spot price. in response to this need, derivative markets for stock risks trading arose, and their use has become extensive. there are many instruments traded in these markets which include financial instruments such as futures and forward contracts, options, swaps, and physical instruments like inventories. future contracts are among the most important of these instruments, and provide significant information about cash and storage markets. price discovery, hedging, financing, liquidity, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 291 price stabilization, encouraging competition, increasing efficiency, inherent leverage, low transaction costs, and lack of short sale restrictions as well as fulfilling desires of speculators are some of the prime economic functions of the futures market. price discovery and risk transfer are considered to be two major contributions of futures market towards the organization of economic activity (garbade and silber, 1983). price discovery refers to the use of future prices for pricing cash market transactions. this implies that futures price serves as market’s expectations of subsequent spot price. understanding the influence of one market on the other and the role of each market segment in price discovery is the central question in market microstructure design and is very important to academia and regulators. price of the derivative is derived from the underlying asset, any change in price of the underlying asset leads to change in the value of the asset. derivatives facilitate investment and arbitrage strategies that straddle market segments. it helps to increase asset substitutability, both domestically and internationally. derivatives help to improve liquidity. it helps to facilitate the creation of pay off characteristics at a lower cost that would result from the acquisition of underlying assets. derivative markets help increase savings and investment in the long run. the derivative market performs a number of economic functions. some of them are given below:  the prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. thus derivatives help in discovery of future as well as current prices.  an important subsidiary benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.  derivatives markets help boost savings and investment in the long run. transfer of risk enables market participants to expand their volume of activity. the issue pertaining to the impact of index futures on the volatility of the underlying spot market has increasingly received the attention of researchers and policy makers alike. this is primarily due to the destabilizing perception surrounding index futures in the context of several stock market crashes, such as us market crash of 1987, the us flash crash in 2010, and the indian stock market crash in 2008. researchers have tried to find a pattern in stock return movements or factors determining these movements. volatility is a very important area of interest for regulators and market participants who prefer less volatility to more volatility. a meaningful interpretation of volatility will give significant information and will act as a measure to know as to how far the current prices of an asset deviates from its average past prices. at a fundamental level, volatility specifies the strength or the confidence behind a price move. instinctively, it can be argued that the measurement issues of volatility can also be useful to comprehend the market assimilation, co-movement and spillover effect. the existence of volatility spillover between the two markets specifies that the volatility of returns in one market has an important effect on the volatility of returns in the other market. kavussanos and visvikis (2004) note, market agents can use the volatility transmitting asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 292 market in order to cover the risk exposure that they challenge. considerable amount of research work has been conducted in the field of volatility and its spillover, the results of which are mixed. for modeling volatility the work done by pre-eminence of bollerslev (1986), engle (1982), bollerslev and engle (1986) is noteworthy. therefore, it has become necessary, from time to time, to conduct empirical studies to measure the impact of financial derivatives, on volatility spillover to spot market and vice-versa. generally, volatility is considered as a measurement of risk in the stock market return and a lot of discussions have taken place about the nature of stock return volatility. therefore, understanding factors that affect stock return volatility is an imperative task in many ways. issues like price discovery and volatility spillover have been extensively researched for mature markets. the work is very limited for emerging markets in general and india in particular. in this backdrop, an attempt has been made to revisit the debate on volatility spillover in indian stock market. it covers fairly longer study period compared to prior research of the subject. the study attempts to address the following questions: is there a volatility spillover from futures market to spot market and vice-versa? the remainder of the paper is organized as follows. section one gives review of literature and the relevance of study. section two contains description of data and the methodology employed along with the empirical tests carried out. section iii exhibits analysis and interpretation of the data through a variety of tables into which relevant details have been compressed and summarized under appropriate heads and presented in the tables. section iv provides brief summary, conclusion of the main findings, policy implications. review of literature cox (1976) opine that the introduction of futures markets led to increase in informational efficiency, as futures are relatively inexpensive, have low margin requirements and low transaction costs. figlewski (1978) suggests that the new traders in the gnma market add noise to gnma securities trading because of the introduction of futures trading. cox, 1976; stein, 1987; ross, 1989, chan et al.,1991 conclude that index futures enable investors to trade large volumes at lower transaction costs, improve risk sharing and reduce volatility. figlewski (1981) examines impact of futures trading on government national mortgage association (gnma) market volatility. he concludes that the volatility of the gnma security market is related to several factors, including futures trading. the amount of outstanding gnma lowers cash market volatility and futures trading increases gnma security volatility. stein (1987) developed a model to determine prices by the interaction between hedger and informed speculators. his model demonstrates that futures markets reduce volatility and act as essential tool for risk management. kawaller et al. (1987) conclude that movements in the index futures market led to movements in the spot market. edwards (1988) examines the volatility effects of the introduction of share futures on percentage daily changes in the level of the s&p 500 index from 1972 to 1987. he concludes that that there is no rise in volatility subsequent to the introduction of index futures. in fact, he reported that volatility in the stock market decreased after futures trading began, although he does not directly attribute the decrease to futures trading. harris (1989) examines the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 293 impact of s&p 500 index futures and options trading on the volatility of the firms' shares that comprise the s&p 500. he reports no significant difference in the volatility of the s&p 500 stocks as compared to a control sample of 500 matching shares in the period 1975 to1983 before the start of trade in index options and futures. however, after 1983, he reported statistically significant increase in the volatilities of firms in the s&p 500 index. he suggests that the change in volatility is not significant "economically" and that other factors could be responsible for the increase. becketti and roberts (1990) opine that futures contract is an agreement to exchange in future. it does not necessarily involve an exchange of assets in the future; the buyers and sellers of the index settle their positions by taking offsetting positions. close to cessation, futures traders may close their positions by taking a position opposite to the initial one, by physical delivery, or by paying the difference between the futures price and the spot price of the underlying asset. hodgson et al., (1991) study the impact of all ordinaries share index (aoi) futures on the associated australian stock exchanges over the all ordinaries share index. they analyse data for a period of six years from 1981 to 1987. standard deviation of daily and weekly returns is estimated to measure the change in volatilities of the underlying index. the results indicate that the introduction of futures and options trading has not affected the long-term volatility, which reinforces the findings of the previous u.s. studies. froot and perold (1991) develop a model to demonstrate that futures markets cause an increase in the market depth due to the presence of more market makers in the futures segment than in the cash market and the more rapid dissemination of information. abhyankar (1995) concludes that lower transaction cost is the main reason for traders who have market wide information to use the futures market. pericli and koutmos (1997) analyse the impact of the us s&p 500 index futures on spot market volatility. their results show that index futures do not increase spot market volatility. dennis and sim (1999) examine share price volatility with the introduction of individual share futures on the sydney futures exchange by employing garch model. they conclude that the impact of futures trading on cash market volatility is not significant as compared to the impact of cash market trading. gulen and mayhew (2000) examine stock market volatility before and after the introduction of index futures in 25 countries. they find that index futures had no significant effect on the spot markets in all the countries excluding us and japan. they also find that spot volatility was independent of changes in futures trading in 18 countries, and that spot volatility is negatively influenced by uninformed futures volume in austria and the uk. bologna and cavallo (2002) examine the effect of the introduction of stock index futures on the volatility of the italian spot market, and find a reduction in spot market volatility and enhanced market efficiency. they conclude that increased impact of recent news and a reduced effect of the uncertainty originating from the old news were the main reasons for this phenomenon. chiang and wang (2002) investigate the impact of taiwan index futures trading on spot price volatility using gjr garch model and conclude that the trading of taiex futures had a major impact on spot price volatility, while the trading of msci taiwan did not. they conclude that the increase in asymmetric response behaviour following the beginning of the trading of two index futures reflects the fact that a major proportion of the investors in tse asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 294 are non-institutional investors who are generally un-informed and are prone to over react to the bad news. the introduction of the taiex futures trading improves the efficiency of information transmission from futures to spot markets. raju and karande (2003) find a reduction in spot market volatility after the introduction of index futures. golaka c nath (2003) investigates behaviour of stock market volatility after introduction of derivatives by employing garch model. using a sample of 20 stocks taken randomly from the nifty, he observes that for most of the stocks, the volatility comes down in the post derivative period while for only few stocks in the sample the volatility in the post derivatives remains same or increases marginally. thenmozhi and thomas (2004) conclude that there is a reduction in volatility in the underlying stock market and increased market efficiency following the launch of nifty-linked futures. pok and poshakwale (2004) study the impact of the futures trading on spot market volatility. they used data from both the underlying and non-underlying stocks of malaysian stock market. they used garch to test time varying volatility and volatility clustering in data. they conclude that the initiation of futures trading increases spot market volatility and the flow of information to the spot market. the underlying stocks respond more to recent news whereas the non-underlying stocks respond to old news. antoniou et al. (2005) examined the relationship between index futures and their underlying markets. vipul (2006) investigate the effect of futures trading on volatility in nifty and in individual stocks using data for the period from 1998 to 2004. using garch model to capture volatility clustering phenomena in the data, he concludes that introduction of derivatives trading does not destabilize the stock market. schwert (1990), backetti and roberts (1990), darrat and rahman (1995), kamara et al. (1992), perieli and koutmos (1997), spyrou (2005), and alexakis (2007) also confirmed the stabilisation theory. suhasini subramanian (2012), analyse contrasting theoretical approaches and empirical evidence relating to the impact of index futures on volatility and noise trading. data base and methodology index futures on s&p cnx nifty were permitted for trading on national stock exchange (nse) on 12th june, 2000. for the purpose of the current study on price discovery, index futures on s&p cnx nifty. daily closing values of index futures and s&p cnx nifty have been taken from june, 2000 till march 2012. returns ( rt) have been calculated as log of ratio of present day’s price to previous day’s price (i.e. rt = ln (pt /pt-1)). data relating to the price series have been obtained from website of nse (www.nseindia.com). given the nature of the problem and the quantum of data, we first study the data properties from an econometric perspective and find unit root of the two series futures and spot. further, to quantify and study volatility spillover, we use bivariate egarch framework which is covered in the next section. the regression analysis would yield efficient and time invariant estimates provided that the variables are stationary over time. however, many financial and macroeconomic time series behave like random walk. the time series stationarity of sample price series has been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 295 (1988) test of stationarity has also been performed for the series. the error correction model takes into account the lag terms in the technical equation that invites the short run adjustment towards the long run. this is the advantage of the error correction model in evaluating price discovery. the presence of error correction dynamics in a particular system confirms the price discovery process that enables the market to converge towards equilibrium. in addition, the model shows not only the degree of disequilibrium from one period that is corrected in the next, but also the relative magnitude of adjustment that occurs in both markets in achieving equilibrium. moreover, cointegration analysis delivers the message saying how two markets (such as futures and spot commodity markets) reveal pricing information that are identified through the price difference between the respective markets. the implication of cointegration is that the commodities in two separate markets respond disproportionately to the pricing information in the short run, but they converge to equilibrium in the long run under the condition that both markets are innovative and efficient. in other words, the root cause of disproportionate response to the market information is that a particular market is not dynamic in terms of accessing the new flow of information and adopting better technology. therefore, there is a consensus that price change in one market (futures or spot commodity market) generates price change in the other market (spot or commodity futures) with a view to bring a long run equilibrium relation is : ttt sf   (1) equation (1) can be expressed as in the residual form as: ệ ftst  ệ t (2) in the above equations ft and st are futures and spot prices of a commodity in the respective market at time t. both α and β are intercept and coefficient terms, where as ệt is estimated white noise disturbance term. the main advantage of cointegration is that each series can be represented by an error correction model which includes last period’s equilibrium error with adding intercept term as well as lagged values of first difference of each variable. therefore, casual relationship can be gauged by examining the statistical significance and relative magnitude of the error correction coefficient and coefficient on lagged variable. hence, the error correction model is: fttftftfft syfef    11 ^ 1 (3) sttftftsst fyses    11 ^ 1 (4) in the above two equations, the first part et1 ^ is the equilibrium error which measures how the dependent variable in one equation adjusts to the previous period’s deviation that arises from long run equilibrium. the remaining part of the equation is lagged first difference which asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 296 represents the short run effect of previous period’s change in price on current period’s deviation. the coefficients of the equilibrium error, αf and αs signify the speed of adjustment coefficients in future and spot commodity markets that claim significant implication in an error correction model. at least one coefficient must be non zero for the model to be an error correction model (ecm). the coefficient acts as an evidence of direction of casual relation and reveals the speed at which discrepancy from equilibrium is corrected or minimized. if, αf is statistically insignificant, the current period’s change in future prices does not respond to last period’s deviation from long run equilibrium. if both, αf and βf are statistically insignificant; the spot price does not granger cause futures price. the justification of estimating ecm is to know which sample markets play a crucial role in price discovery process. error correction terms (ects) also known as meanreverting price process, provide some insights into the adjustment process of spot and future prices towards long run equilibrium. this implies that once the price relationship of spot and futures market deviates away from the long-run coinetgrated equilibrium, both markets will make adjustments to re-establish the equilibrium condition during the next period. bi-variate egarch model and volatility spillover in this section, we evaluate if there is any volatility spillover between future and spot market for the sample series. volatility spillover reveals that future trading could intensify volatility in the underlying spot market due to the larger trading program and the speculative nature of the future trading. the volatility spillovers hypothesis involves testing for the lead-lag relations between volatilities in the futures and spot markets. clearly, reliable tests require common good measure of volatilities. bollerslev’s (1986) generalize autoregressive conditional heteroscedasticity (garch) model cannot be used due to certain regularities where it assumes that positive and error terms have a symmetric effect on the volatility. in other words, good news (market advances) and bad news (market retreats) have the same effect on the volatility in this model. this implies that the leverage effect (price rise and fall) is neutralized in this model. the second regularity is that all coefficients need to be positive to ensure that the conditional variance is never negative (i.e. measure of risk). to overcome these weaknesses of the garch model in handling financial time series, nelson’s (1991) exponential garch (egarch) model is used in order to capture the asymmetric impacts of shocks or innovations on volatilities and to avoid imposing non-negativity restrictions on the values of garch parameters. there are many studies in which symmetries in stock return are documented [e.g., nelson (1991), koutmos and booth (1995), koutmos and tucker (1996), engle and ng (1993), and glosten et al. (1993)]. in this study, the estimation process is concentrated on the direct spillover between futures and spot markets volatility. the empirical analysis reported here is based on two-stage estimation. the first step is to apply vecm and the second step is to use the residuals of vecm in the bivariate egarch model. this two step approach (the first step for the vecm and the second step for the bivariate egarch model is asymptotically equivalent to a joint estimation for the vecm and egarch models (greene, 1997). estimating these two models simultaneously in one step is not practical because of the large number of parameters involved. our ec-egarch model allows the conditional volatilities and covariance to asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 297 adjust to deviations from long-run price disequilibria, whereas traditional egarch models do not. as such, the model facilitates the testing of both short run and long run volatility spillovers hypotheses. the ec-egarch model may further prove useful for portfolio managers in formulating optimal hedging strategies. some studies e.g., yang, bessler, and leatham (2001) emphasize the need to incorporate any existing cointegration between spot and futures prices into hedging decisions, while others such as lien and lou (1994) underscore the importance of garch effects in such decisions. we use the following egarch model )()()()ln( 1 2 1 2 1 22   tftfstffft fsefe  (5) )()()()ln( 1 2 1 2 1 22   tftsftssst sfese  (6) the unrelated residuals eft and est are obtained from the equations (3) and (4). this two step approach (the first step for the vecm and the second step for the bivariate egarch model is asymptotically equivalent to a joint estimation for the vecm and egarch models (greene, 1997). before estimating the egarch model, it is necessary to check the model adequacy by performing the diagnostic tests that involve serial correlation, normally distributed error and goodness of fit measures. hence we check the model adequacy test by testing auto correlation lm test, normality test and var stability condition test (ar roots). analysis and interpretation of results the results of stationarity tests are given in table 1. it confirms non stationarity of stock price data; hence we repeat stationarity tests on return series (estimated as first difference of log prices) which are also provided in table 1. the table describes the sample price series that have been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron (1988) test of stationarity has also been performed for the price series and then both the test are performed on return series. panel a and panel b report results of stock prices respectively. the sample return series exhibit stationarity thus conforming that both spot and future stock prices are integrated to the first order. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 298 table 1. stationarity test for sample series priceseries inference on return series integration i (i) adf test phillips-perron test adf test phillips-perron test t-statistics t-statistics t-statistics t-statistics nifty (a)future prices -1.09 -0.51 -41.98 ** -41.98 ** (b) spot prices 1.12 -1.38 -41.35 ** -41.32 ** the table describes the sample price series that have been tested using augmented dickey fuller (adf) 1981. the adf test uses the existence of a unit root as the null hypothesis. to double check the robustness of the results, phillips and perron (1988) test of stationarity has also been performed for the price series and then both the test are performed on return series also as shown in panel-a (price series) and panel b (return series) are integrated to i(1). all tests are performed using 5%level of significance (**). before estimating the egarch model, it is necessary to check the model adequacy by performing the diagnostic tests that involve serial correlation, normally distributed error and goodness of fit measures. all diagnostic tests are primarily carried on the standardized residuals via ols and it is found that all are significant at 5% level. the diagnostic statistics with respect to egarch model are reported in table 2. table 2. var adequacy test nifty var adequacy test critical values lags future price & spot price 1 stability (modulus values of roots of characteristics polynomials) 0.94, 0.89, 0.24, 0.08 (stable) 2* 2 normality chi-square values 4.81 (jarque-bera) p val (0.09)( normal) 2* 3 serial correlation lm-test 18.55( p val 0.08) (no serial correlation) 2* the coefficients of βsf and βfs are very important and reveal volatility spill over from the spot to future or future to spot. the results of volatility spillover relationships between futures and spot market for sample series are established using bivariate e-garch model. the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 299 coefficient βsf indicates the volatility spillover from futures to spot and βfs means reverse direction. the coefficients βss and βff show the volatility clustering, while the coefficients λs and λf measure the degree of volatility persistence. the residuals of the model are tested for additional arch effects using arch lm test. the results of volatility spillover from spot to future are significant as p-value of coefficient of βfs is < 0.05 at 5 % level of significance, it is not true in the reverse direction i.e. p-value of βsf is > 0.05 i.e. no significant spillover is observed from future to spot see table 3 panel (a) &panel (b) respectively. this means innovations of spot markets have asymmetric influence to the variance of futures markets, and there is a uni-directional volatility spillover, from spot market to future market, or in simple words we can say that an innovation originating in spot market influences the volatility of the futures market. volatility persistence is tested for sample series to test the effect of shocks, which is an indicator of market efficiency. it means persistence of volatility that today’s volatility is due to information that arrived today and will affect tomorrow’s volatility and volatility of days to come. γf and γs measure the persistence of volatility in spot and futures market. the smaller the absolute value of the coefficient, the less persistent volatility is after a shock. volatility persistence is significant for both spot and future prices for sample series, as p (value) is coming less than 0.05 at 5 % level of significance with significant coefficients of λs and λf which is a measure the degree of volatility persistence. volatility estimation is important for several reasons and for different people in the market pricing of securities is supposed to be dependent on volatility of each asset. market prices tend to exhibit periods of high and low volatility. this sort of behaviour is called volatility clustering. volatility clustering is tested for sample series, which means “large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes.” a quantitative manifestation of this fact is that, while returns themselves are uncorrelated, absolute returns |rt| or their squares display a positive, significant and slowly decaying autocorrelation function: corr (|rt|,|rt+τ |) > 0 for τ ranging from a few minutes to a several weeks. a significantly positive and asymmetrical influence of innovation is observed i.e. the market-specific volatility clustering coefficients are all positively significant at 5% level in the future and spot markets. of course, we can understand the efficiency degree in spot-futures market from one side according to the magnitude of correlative coefficients. therefore, the bivariate egarch model indicates that past innovations in futures significantly influence spot volatility. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 300 table 3.volatility relationship dependent variable – future panel a: coefficient std. error z-statistic prob. a. βff (volatility clustering) sqrresidfuture(-1) -0.0 0.0 -2.01 0.0** b. βfs (volatility spillover) sqrresidspot(-1) 0.0 0.0 2.27 0.0** c. λf (volatility persistence) varfuture(-1) 0.94 0.0 210.71 0.0** volatility relationships dependent variable –spot panel b coefficient std. error z-statistic prob. a. βss (volatility clustering) sqrresidspot(-1) 0.01 0.00 1.31 0.0** b. βsf (volatility spillover) sqrresidfuture(-1) -0.0 0.01 -1.01 0.3 c. λs(volatility persistence) varspot(-1) 0.9 0.00 191.71 0.0** the table describes volatility spillover (βsf and βfs) volatility persistence (λf and λs) and volatility clustering (βff and βss) from the spot to future or future to spot respectively. volatility spillover is observed from spot to future and not vice versa. volatility persistence is significant for both spot and future prices for all commodities and indices, the market-specific volatility clustering coefficients βff and βss are all positively significant at 5% level in the future and spot markets. conclusion in a perfectly functioning world, every bit of information should be replicated concurrently in the both spot market and its futures markets. however, in actuality, information can be disseminated in one market first and then send out to other markets owing to market imperfections. the study investigates how much of the volatility in one market can be explained by volatility innovations in the other market and how fast these movements transfer between these markets. thus, the lead-lag relationship in returns and volatilities between spot and futures markets is of interest to academicians, practitioners, and regulators. if volatility spillovers exist from one market to the other, then the volatility transmitting market may be used by market agents, who need to cover the risk exposure that they face, as a very asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 301 important vehicle of price discovery. for example, the information about instantaneous impact and lagged effects of shocks between spot and futures prices may be used in decision making regarding hedging activities (wahab and lashgari, 1993). a deep understanding of the dynamic relation of spot and futures prices and its relation to the basis provides these “agents” the ability to use hedging in a more skilled mode. furthermore, if a return analysis is questionable, volatility spillovers provide an alternative measure of information transmission (chan, chan and karolyi, 1991). owing to these grounds, research committed to the relationship between futures and spot returns (first moments) has been capacious (chan and karolyi, 1991; chan, 1992), with this interest growing to examining higher moment dependencies (time-varying spillovers) between markets (ng and pirrong, 1996; and koutmos and tucker, 1996). the literature relating to volatility in stock futures market has mainly been confined to developed economies. stock markets in emerging economies like india have been growing exponentially. empirical studies on the subject show that the introduction of derivatives contracts improves the liquidity and reduces informational asymmetries in the market. the present study evaluates volatility spillover effects for fairly large period in indian stock market to bridge the important gap in the literature in a comprehensive way. we cover nifty indices and the study period is from june 2003-march 2012.we find that spot and futures a unidirectional volatility spillover is observed from spot to futures and not vice-versa. whenever there is high volatility in stock market that will affect futures market. the findings of the study suggest that the nifty spot are more important indicators of stock movements which is in contrary to the studies done by kawaller, koch and koch (1987), stoll and whaley (1990) , chan (1992) and ghosh (1993) which reported dominant role of s&p 500 futures. in studies like chan, chan and karolyi (1991), arshanapali and doukas (1994), wang and wang (2001), mukherjee and mishra (2004) bidirectional spillover (cross market spillover) is observed in both the markets. an investor who is trading in futures market should always watch out for volatility in the stock market. from regulators point of view, whenever there is unexpected volatility in spot market; regulator should take necessary steps to curb the volatility. otherwise the excess volatility in the spot market will spillover to futures market thereby making the futures market unstable. spot market reacts to information faster than futures market and serves as a price discovery vehicle for futures market. the possible reasons 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(2001). futures trading activity and commodity cash price volatility. journal of business finance & accounting, 32(1) & (2). microsoft word 3592-13574-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 355 impact of gender upon the perception and auditor's job satisfaction nasrollah takhtaei accounting department islamic azad university, dezful branch, dezful, iran e-mail: nasrollah_takhtaei@yahoo.com leila abbasi dezfully accounting department islamic azad university, dezful branch, dezful, iran e-mail: leilaabbasi2003@yahoo.com received: april 28, 2013 accepted: may 24, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3592 url: http://dx.doi.org/10.5296/ajfa.v5i1.3592 abstract the purpose of the present research is to investigate the effects of gender upon the level of job satisfaction of auditing professionals as well as examine if gender leads to differences in their perceptions of work related attributes such as advancement opportunities and relations with supervisors. questionnaires have been applied as a means to collect required data to test the hypotheses. the dependent variable is gender and independent variable consists of 9 factors including job fulfillment, treatment with supervisors, promotion and advancement opportunities, supervisors, gender discrimination, employee relations with coworkers, workload volume, fringe and benefits, and amount of compensation. the results indicate that there is a significant relationship between gender and all factors regarding independent variable except advancement and promotion opportunities. the results also show that there are differences between male and female auditors in treatment by peers and supervisors and gender discrimination. the results point out the effects of gender on 9 factors of the level of job satisfaction in audit firms. keywords: auditing, job satisfaction, gender, job attitude asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 356 1. introduction there are gender differences among accountants in their attitudes towards their careers. male were found to be more satisfied with their jobs than female, with most (82%) male being satisfied or very satisfied compared with just over half (57%) of females. females were significantly less satisfied than male with aspects of their careers included: the opportunity for development of skills, the flexibility and control they had over their working hours, interpersonal relationship with other staff (morley, bellamy, jackson, & o'neill, 2002). a large wage gap has been observed between male and female public accounting professionals (cao, lynn, & horn, 1998). female may find it more difficult than male to balance their dual family and professional responsibilities and may experience greater inter-role stress (parent, deangelis, & myers, 1989). females place less emphasis on status, financial reward and position, and greater emphasis on achieving personal goals and gaining recognition from others (dann, 1995). job satisfaction represents the tendency and feeling which individuals have regarding their job (mosadeghrad, 2003). from view point of robbins (2001), job satisfaction is attitude and positive perception (positive feelings) of individuals concerning their job. a person with a high job satisfaction is a person who generally likes their job considerably and they has been able to afford their needs through their job and consequently has positive feelings with regard to it. the organization cannot improve job incentive of employees and cannot increase job satisfaction except for it recognize necessities which are important for individuals. necessity is a state of disequilibrium or endogenous deficiencies that smooth away an area for strengthening or pressure on behavioral action. deficiency or inadequacy could have a variety of causes. nevertheless, the existence of necessity creates individuals incentive so as to do actions which could return the equilibrium and feels satisfaction. with the recognition of needs in a scientific manner, a positive step can be taken with the aim of meeting needs and giving job satisfaction. alvani (2001) points out that dissatisfaction of organization employees is presented in the form of low return, low profitability, and unrealized goals. in fact, job satisfaction provides conditions which have a positive effect on return with meeting his or her needs thus understanding necessities in organization has priority and using incentive factors of increasing merely salary does not increase employees' job satisfaction. job satisfaction has a multiple dimensions and complexity concept which has a relationship with the factors including body, social, and spiritual. it means that not only one reason does not provide job satisfaction but also combination of a variety of different factors cause to feel job satisfaction. the importance of auditors' job in presentation of audit's report is clear for everybody which leads to attesting to financial statements. auditing occupation circumstances are often stressful. stress has a negative influence on employees inversely and could lead to dissatisfaction and finally could lead to employees leave their job. one of the most important cases of dissatisfaction of inexperienced auditors of work circumstances in audit firms is time limitations for doing favorable duties (albrecht, brown, & field, 1981; collins & killough, 1989; mehrani & mahdis, 2003). almer and single (2007) say that flexible works arrangements help retain, but perhaps not advance, female. one of the most important issues is auditors' job satisfaction in audit firms because, the area of increasing auditors' productivity can be provided through improvement of their job satisfaction and in this manner, audit firms will be successful in asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 357 getting their goals. based on aforementioned discussion, the following questions are raised so as to examine auditors' job satisfaction in audit firms: could it be possible to prevent auditor’s turnover with increasing their job satisfaction? could directors prevent from auditors' exit from audit profession with recognizing factors affecting on auditor's job satisfaction? could investigation of variables affecting job satisfaction prevent from auditors who may get involved in other jobs? the response to this question and investigation of factors affecting on level of auditors' satisfaction could lead to recognize conditions that provide more proper circumstances for auditors finally and will follow an increasing in job satisfaction for auditors and will decrease auditors' turnover (moyes, williams, & koch, 2006). the result of this awareness leads to maintain skillful employees and hence leads to the survival of the firm and it would be possible to ensure that great contract will happen. belkaoui (1989) highlights the extent of the auditors' job satisfaction could lead to successful and unsuccessful of audit firms in achieving their goals. 2. background and hypotheses development job satisfaction is affected by a variety of social reasons and has different levels. factors affecting job satisfaction in organization is in relation with variables such as age, training level, gender, working environment, work experience years, individual skills, job skills, education levels, managerial methods of organization and these variables have been investigated by researchers in different groups and organizations. in this study, the effect of gender on auditors' job attitude has been investigated. job characteristics investigated including 9 factors such as job fulfillment, treatment by peers and supervisors, promotion and advancement opportunities, supervisors, gender discrimination, employee relations with coworkers, amount of compensation, fringe benefits and amount of workload that are based on spector's (1985) perspective and has presented in report regarding job satisfaction survey and moyes, et al., (2006) has applied these proxies in his study and these factors have been presented as indicators of job's satisfaction and attitude in most of the contexts of management science and organizational and incentives psychology. do auditors of male and female have different perspectives in relation to their job? are social and working conditions of men and female are the same? do job satisfaction factors have the same definitions from the male and female perspectives? does female have possibility of advancement the same as male? in the study carried out by taylor (1999) in australia, the effect of gender on job satisfaction levels has been indicated and study carried out by larkin (1990) resulted in that gender does not have any effect on level of auditors' job satisfaction. ang et al., (1993) confirm that alone gender does not have an influence on level of auditors' job satisfaction in another study. gregson (1990) rejects the effect of gender on job satisfaction of auditors working in audit firms in u.s directly or even indirectly. albrecht, et al., (1981) concluded that working environments of audit firms are more satisfied for male using investigating 27 proxies of job satisfaction. furthermore, existing evidence with regard to job satisfaction of male and female is not satisfied in the opinion of many researchers and it could not be included that even if job level were fixed, female based on their gender characteristics compared with male are more satisfied and even if there were any difference, there are not asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 358 enough confidence concerning its concept (abraham, 1997). in other words, other studies also have emphasized on effect of gender and attitude difference of male and female in relation to job characteristics. for example, oskamp and costanzo (1993) point out those females give priority to have satisfied colleagues more than males whereas males give priority to consultative opportunities with others and their effects on important decisions more than females. therefore, it seems that a variety of different jobs, satisfy males and females with different degree. on the other hand, females feel more satisfaction in situations that are less competitive and are more cooperative (lussier, meskimen, & kinskey, 1997) .although the promotion degree and job security of males and females were the same based on ranking factors creating job satisfaction by beutell and brenner (1986), the rank 3 and 4 were given to the respect and gracious circumstances females by in the next process despite the fact that these ranks for males were gaining more revenue and attaining higher executive responsibilities. professional auditors are main and principal employees of audit firms in order to continue their working and survival. audit firms spend a great deal of money so that employ and educate their auditors. in recent years, females' presence in working circumstances has intensified strongly which has been dominated by males for years. whereas most of them consistent with males’ requirements. inattention to differences in attitude between males and females lead to auditor's female's dissatisfaction and giving up their audit's firms. auditor females exit from firms' high positions has a great negative influence on the other auditor’s females at the same level and even at lower organizational levels which we simply cannot neglect from its importance (mosadeghrad, 2003). in addition, it is required to spend a lot of time for training replacement newcomer employee entry to do their job and also putting organization's trust in newcomer and however newcomer's confidence in organization. confidence and recognizing senior employees for directors and supervisor is vital that it take a long time with regard to newcomer auditors (morley, et al., 2002). generally, with measurement of auditors' satisfaction degree for keeping on working with related audit firms could predict continuing being colleague or resignation. in other studies, the way of relationship between auditors' job satisfaction and their incentive for continuing being colleague with audit firms has been examined. studies carried out in the area of behaviors science point out that being high in auditors' job satisfaction resulted in increasing their incentive for continuing being colleague with organization (arnold & feldman, 1982; porter & steers, 1973). this relationship has been meaningful in the studies carried out by auditors (dole & schroeder, 2001; harrell & stahl, 1984; rhode, sorensen, & lawler iii, 1977). identifying basic factors of auditors' job satisfaction in audit firms and also employers and directors awareness with regard to attitudinal differences of males and females could help them in keeping their auditors and providing proper environmental conditions. according to above-mentioned and prior research, present study hypotheses are as follows: h1: there is a significant relationship between gender and job's attitude measured by nine variables including job fulfillment, treatment by peers and supervisors, promotion and advancement opportunities, relationship with supervisors, feeling of gender discrimination, employee relations with coworkers, amount of workload, fringe benefits, and amount of compensation. h2: there is a different in job's attitude between males and females. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 359 3. research methodology following the moyes, et al., (2006), as with other studies in order to investigate the existence of difference in attitude of auditor's males and females, moyes's (2006) questionnaire has been applied in this study. questionnaire mentioned includes 48 questions that 17 questions regarding job fulfillment, 5 questions regarding treatment by peers and supervisors, 3 questions regarding promotion and advancement opportunities, 3 questions regarding supervisors, 7 questions regarding gender discrimination, 5 questions regarding employee relations with coworkers, 3 questions regarding fringe benefits and amount of workload and 2 questions regarding amount of compensation. in the questionnaire mentioned, we have used likert's scale and degrees of privileging from highly agree, agree, disagree, and highly disagree has been priced. the degree of questionnaire reliability was calculated by use of coefficient of cronbach's alpha which calculated coefficient 0.831 indicating high correlation of questions. in this study, 300 questionnaires were distributed that based on received responses, some of the questionnaires were not useable and thus 269 out of 300 valid questionnaires were completed and extracted. the selection of variables is based on theoretical perspective of study carried out by (moyes, et al., 2006). in order to test the hypotheses and to investigate the relationship between gender and level of job satisfaction, chi-square and in order to investigate the existence of job's attitude difference between males and females, independent sample test has been used. since number of research data is more than 30, hence being normality of variables distribution is acceptable. 3.1 dependent variable job satisfaction is defined as dependent variable that is measured using 9 proxies including; 1) job fulfillment, 2) treatment by peers and supervisors, 3) promotion and advancement opportunities, 4) supervisors, 5) gender discrimination, 6) employee relations with coworkers, 7) amount of compensation, 8) fringe benefits, and 9) amount of workload. 3.2 independent variable: gender 4. empirical results to investigate whether there is a statistically significant relationship between gender and job's attitude measured by nine variables including job fulfillment, treatment by peers and supervisors, promotion and advancement opportunities, relationship with supervisors, feeling of gender discrimination, employee relations with coworkers, amount of workload, fringe benefits, and amount of compensation or not, a chi-square statistic was used. table 1 shows the chi-square results and indicates that there is as significant relationship between gender and eight variables of job's attitude composing job fulfillment (χ2 = 37.736, p<0.001), treatment by peers and supervisors (χ2 = 31.659, p<0.001), relationship with supervisors (χ2 = 28.819, p<0.001), feeling of gender discrimination (χ2= 25.326, p<0.001), relations with other colleagues (χ2= 26.696, p<0.001), amount of workload (χ2= 74.865, p<0.001), fringe benefits (χ2= 11.438, p<0.001), and amount of compensation (χ2= 29.655, p<0.001), and hence statistically the relationship between gender and eight aforementioned variables is significant, but there is no relationship between gender and promotion and advancement opportunities asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 360 (χ2= 15.719, p>0.001). table 1. chi-square analysis of job's attitude of auditors of male and female variables χ 2 p-value there is a significant relationship between gender and job fulfillment. 37.736 0.000 there is a significant relationship between gender and treatment by peers and supervisors. 31.659 0.000 there is not a significant relationship between gender and promotion and advancement opportunities. 15.719 0.008 there is significant relationship between gender and relationship with supervisors. 28.819 0.000 there is significant relationship between gender and feeling of gender discrimination. 25.326 0.000 there is significant relationship between gender and employee relations with coworkers. 26.696 0.000 there is significant relationship between respondent's gender and amount of workload. 74.865 0.000 there is a significant relationship between gender and fringe benefits. 11.438 0.000 there is significant relationship between gender and amount of compensation. 29.655 0.000 to investigate if there is a different in job's attitude between auditor's males and females or not, an independent sample test was applied. table 2 shows the independent sample test results and indicates that job's attitude of males were significantly different from females in reference to variables comprising treatment by peers and supervisors (p<0.05 and equals to 0.00) and gender discrimination (p<0.05 and equals to 0.00). inspection of the two group means indicates that the average treatment by peers and supervisors for male (11.30) and average gender discrimination for male (17.74) is higher than average treatment by peers and supervisors for female (10.14) and average gender discrimination for females (17.04). the differences between two means are 1.16 and 0.70 respectively. males did not differ significantly from females on variables comprising job fulfillment (p=0.31), promotion and advancement opportunities (0.37), relationship with supervisors (0.48), employee relations with coworkers (0.41), amount of workload (0.64), fringe benefits (0.13), and amount of compensation (0.65). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 361 table 2. comparison job's attitude of auditors of male and female variables n mean sd t df p job fulfillment 1.03 235 0.31 male 165 44.21 2.4 female 72 43.86 2.48 treatment by peers and supervisors 5.71 256 0.00 male 177 11.3 1.59 female 81 10.14 1.36 promotion and advancement opportunities -0.89 267 0.38 male 180 8.27 1.25 female 89 8.4 0.9 supervisors 0.71 267 0.48 male 180 7.98 1.15 female 89 7.89 0.78 gender discrimination 3.65 245 0.00 male 173 17.74 1.57 female 74 17.04 0.78 employee relations with coworkers 0.83 257 0.41 male 178 13.62 1.04 female 81 13.51 1.09 amount of workload 1.86 267 0.06 male 180 7.46 1.25 female 89 7.15 1.35 fringe benefits -1.51 267 0.13 male 180 8.04 0.59 female 89 8.17 0.73 amount of compensation -1.85 267 0.07 male 180 5.37 0.8 female 89 5.54 0.5 5. conclusion 1. there is a significant relationship between respondent's gender and job fulfillment. 2. there is a significant relationship between respondent's gender and treatment by peers and supervisors. 3. there is not a significant relationship between respondent's gender and promotion and advancement opportunities. 4. there is significant relationship between respondent's gender and relationship with supervisors. 5. there is significant relationship between respondent's gender and feeling of gender discrimination. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 362 6. there is significant relationship between respondent's gender and employee relations with coworkers. 7. there is significant relationship between respondent's gender and amount of workload. 8. there is a significant relationship between respondent's gender and fringe benefits. 9. there is significant relationship between respondent's gender and amount of compensation. 10. there is an attitude difference between male and females with regard to treatment by peers and supervisors and gender discrimination. in the examination of relationship between gender and 9 variables which cover job's attitude of individuals, it can be seen that there is no significant relationship between gender and variable namely promotion and advancement opportunities. it is seemed very optimistic that we think that promotion and advancement opportunities is the same for males and females in jobs particularly audit engagements with special working conditions and characteristics and in regard to fringe benefits similarly is done the same. it could be said that many factors can be interfered in this area including whether herself own females are attempting to promote their jobs or based on the historical and traditional role that females are expected to do from their birth by society, conservatism would be continued by them and playing role as a low-ranking employee is good and sufficient for them. there are certain duties for females that they are required to do consistent with formation of gender's identity and social learning. in this attitude, the main duties of females consist of paying attention to children and conduct their home affairs and hence occupation and earning revenue are defined as a second preference for females. this attitude is very much intensifier among their own females than males. many of the females feel that they are indebted and owed to their families and this attitude causes to feel that the time that they must be accessible to their husbands and children are spending on administrative center and occupation. this attitude is result from social learning and formation of gender's identity and duties of every gender. there are less female's employee than male that enter in challenges of changes and 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(1999). managing job satisfaction: data aimed at helping an accounting firm retain its talented professional staff. australian cpa, 69, 46-47. microsoft word 2558-10001-2-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 301 valuation of a holding company: the case of sk c&c ipo seoungpil ahn (corresponding author) sogang business school, sogang university pa706, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: spahn@sogang.ac.kr gwangheon hong sogang business school, sogang university pa711, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: ghong@sogang.ac.kr doseong kim sogang business school, sogang university ma311, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: doseong@sogang.ac.kr young-seok park sogang business school, sogang university pa811, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: yspark@sogang.ac.kr received: oct. 25, 2012 accepted: november 6, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.2558 url: http://dx.doi.org/10.5296/ajfa.v4i2.2558 abstract we examine the ipo of sk c&c. facing the recent regulation change to improve corporate governance structure, korean conglomerates resolve the issue of cross-holdings across asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 302 affiliated companies. the establishment of a holding company and the ipo of sk c&c streamline the ownership structure of sk group. our analysis shows that the issue price of sk c&c is set at substantial discount. given that the priority of sk group was to improve corporate governance structure, it appears that managers of sk c&c are less interested in selling their shares at the highest possible price. the ipo of sk c&c achieved the intended goal of dismantling cross-holdings and streamlining ownership structure of sk group. this drives higher market valuation for shareholders of sk c&c and affiliated companies in sk group as well. keywords: ipo; valuation; holding company; ownership structure; governance structure jel classification: g30, g32, g34 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 303 1. introduction on november 3, 2009, sk group (“sk”, hereafter) has announced the initial public offering (ipo) of sk c&c that would complete a holding company structure for sk. through the ipo of sk c&c, sk group, one of the biggest korean conglomerates known as chaebul, resolves cross-holdings across its core subsidiaries and transforms into a formal holding company structure. the completion of this transition is targeted for the early next year. the transition of sk to a holding company has been planned since july of 2007 when president choi unveiled the plan emphasizing “…. to meet with expectations from the market and policy makers and to expedite on global management, corporate governance structure of sk shall be improved to meet the global standard”. as he argues, resolving cross-holdings among subsidiary companies has important implication for the company’s market valuation. the uk’s cadbury report in 1992 and the us sarbanes-oxley act of 2002 require significant improvement in corporate governance practices. these rules are followed by similar regulations in other countries including korea in the effort to increase transparency and effectiveness of corporate governance structure within a company. in academia, many scholars including gompers, ishii, and metrick (2003), boone, field, karpoff, and raheja (2007), and yermack (1996) document that corporate governance structure has an important impact on firm value. fundamental weaknesses in governance may have crippling consequences for a company’s future growth perspectives and hence constrain firm value. we show how the ipo is related to the corporate governance reform. using the ipo of sk c&c, we illustrate the importance of corporate governance for the firm’s decision makings. the ipo of sk c&c enhances transparency of the sk group, improves corporate governance structure, and thus eliminates the value discount associated with its poor governance structure. fundamental analysis on the value of sk c&c shows that the ipo price of sk c&c is set at a significantly discounted value. contrary to the average ipo performance as reported in ritter (1991), we find a significant out-performance of sk c&c in the two years after the ipo. we also explain other consideration factors that lead to the discount in the ipo price. this research contributes to the literature in three significant ways. first, while prior academic studies are mostly focused on the average performance of ipos and sort out factors that are common for the ipo firms, we focus on an individual ipo and extract some unnoticed reasons for the ipo: the issue of corporate governance can be another important factor that affects the ipo decision. second, we demonstrate that the corporate governance driven ipo of sk c&c outperforms the market in two-years after the ipo, which deviates from the typical pattern of ipo underperformance. finally, this study can be used in graduate programs to examine various circumstantial factors to be considers in the ipo and provide practical view on the ipo pricing. the reminder of the paper is organized as follows. in section 2, we discuss background information on sk c&c ipo. section 3 shows financial data and explains our methodology to compute fundamental value of sk c&c stocks. section 4 reports the results of our analysis and additional factors to be considers. section 5 concludes. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 304 2. background information on sk c&c ipo 2.1. the plan for ipo and ownership structure change sk c&c will be listed in korean stock exchange on nov. 11, 2009 and the subscription by institutions and public investors starts from 3rd and 4th of november, 2009. the issue price is set to be 30,000 korean won (krw) per share. sk plans to sell 18 million shares of sk c&c to investors, which represents 36% of total shares of sk c&c. before ipo, the stakes of sk c&c are held by president choi (44.5% of stakes), sk telecom co. (30.0% or, 14.5 million shares) and sk network co. (15.0% or 7.5 million shares). in the process of ipo, both sk telecom and sk network will tender their entire stakes (22.5m shares) in sk c&c and from these shares, 18 million shares will be sold to outside investors. the remaining shares of these two companies will either keep as investment stocks or be sold to other institutional investors in block deals after six month of lock-up period. an insider at woori investment securities, a leading underwriter, says “initially we targeted for 1.5m shares. after receiving the intentions from 150 or so domestic and international institutions to oversubscribe by more than krw2,000 billion, we decide to increase the number of shares selling”. through the ipo of sk c&c, sk telecom and sk network can raise krw540 billion (about us$500 million) to be used for the investment to strengthen their global positions. the transition to a holding company has a special meaning for sk. in 1970’s, sk has completed vertical integration from the oil to fable thorough the acquisition of korean oil company (yu-kong, currently sk energy co.). following new business venture in telecommunication industry through the acquisition of korean mobile telecomm (currently, sk telecom) in 1990’s, this will be an opportunity for sk preparing another big jump. sk can completely resolve cross-holding issue that has prevented sk from becoming a holding company according to the regulation of korea fair-trade commission. the commission sets forth the regulation that prohibits cross-holdings among subsidiaries and encourages vertical integration of ownership structure for a business group in korea, chaebul. the link of cross-holdings for sk network will break once and for all through the sales of sk network’s entire stake at the time of sk c&c’s ipo. in the case of sk telecom, the remaining stakes will be sold by april of 2010. currently, fair trade act prohibits a holding company from owning a financial subsidiary, but this law will be abandoned soon since the amendment is under the way in the congress. graph 1 summarizes the planned ownership restructuring of sk group after the ipo of sk c&c. 2.2. corporate governance and the vision for global sk the optimal corporate governance structure for an individual corporation is far from simple regulations such as having smaller board, higher proportion of outside directors, or higher ownership by managers. coles, daniel, and naveen (2008), chi and lee (2010), rose (2009), duchin, matsusaka, and ozbas (2010) argue that the optimal governance structure depends on firm characteristics such as firm size, growth opportunities, leverage, and the complexity asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 305 of the operations. klein (1998), bhagat and black (2001), and boone et al. (2007) also find that the effectiveness of board monitoring is conditional on firm characteristics. other research show that the impact of certain governance structure depended on outside environment as well. for example, cremers and nair (2005) contend that internal governance mechanism such as insider ownership interacts with external governance mechanisms such as industry competition and institutional holdings. considering these argument, sk group shall find the right governance system that fits for the company’s characteristics. the transition to a holding company structure and the adoption of independent directors are the solution of sk group to improve its governance structure. sk pursues “big leaps” on the ground of a stable holding company structure through new business ventures and enforcement on global businesses. an insider of the company says “debates on corporate governance structure will inevitably cause unnecessary costs, direct and indirect, to the company” and “clear governance structure via the holding company as a control tower can intensify the business capability of the group”. recent merger of sk network with sheraton workhill and the inclusion of sk construction as a subsidiary is a part of the internal restructuring plan to be aligned with the new governance system. mr, kyun oh-yong, a vice president in sk brand management division, argues “clear governance structure will enhance reputation of the company which will create a synergy effect with the global business strategies in sk” and “a transition to a holding company will definitely become a big opportunity for sk”. this emphasis on corporate governance came only after the painful lesson by president choi. previously, sk global has been involved with fraud in accounting. regulator has been investigated the stock exchange between workhill and sk holdings and a secret deal between sk and jp morgan. president choi has been convicted for these misdemeanors. as of august 15, 2008, president choi has been released. since then he accepts more than 50% of outside directors in the board to ensure internal monitoring. currently, there are no legal actions taken against the management of sk c&c and sk group. 3. data and methodology we separately analyze the value of main business of sk c&c and the value of share holdings in subsidiary companies. we then sum these two parts’ values to compute the equity value of sk c&c and per share value. 3.1. the value of sk c&c it business main business of sk c&c is an information technology (it) service. the company has founded in april 1991. sk c&c envisions “global u-service leader” in the digital convergence areas. in particular, the company has business areas in it strategic consulting, it outsourcing, system integration (si), and solutions for ubiquitous environment. system integration includes planning, development, construction, and operation of an information system customized for each customer. in 2008 and 2009, si services represented about 65% of sk c&c’s sales revenues followed by 33% of sales in operation system management asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 306 services and the remaining 2% is from other businesses. the majority of revenues in 2008 is generated in the domestic market (almost 98% of sales). from table 1, the market for it service business in korea is expected to grow at average 5.6% for the next three years and the market shares for the top three players are likely to remain similar over the period. sk c&c has its strength in financial sectors and there could be higher market growth due to early introduction of new international financial reporting standards (ifrs) accounting rules by financial companies in korea. in year 2009, sk c&c expects krw230 billion (about us$200 million) sales in the financial services sector, which is a substantial increase from krw180 billion (about us$150 million) in 2008. the company has actively implemented globalization plan since year 2007. the proportion of international business represents 2.1 percent in 2007 and expected to grow to 5.1 percent by 2009. mr. oh, a financial analyst at ktb investment securities, forecasted that the proportion of global sales is expected to increase up to 12.1 percent by the end of 2013 and then 20 percent in the much longer run. the company is expected to achieve global sales of krw100 billion (about us$90 million) by 2010 through the establishment of a global network in china, india, and the united states. sk c&c has constructed mobile banking service systems in singapore, philippines, china, thailand, and malaysia. an insider of the company mentioned “we will focus on mobile financial market in the us as well as emerging markets”. in sk c&c, the operating income krw 50 billion till 2003 and jumped to krw90-100 billion in recent years. table 2 illustrates the recent improvement of accounting performance. it is however possible that sk c&c charged higher rates for the services provided to sk’s subsidiaries to inflate the operating margin and net income. it is well known that a firm manages earnings for years before ipos. if the recent operating performance is inflated, we need to adjust the forecast downward. the globalized si firms are expected to grow much faster: earnings growth rate of 13.4% as shown in table 3. much of this growth expectation can be achieved from emerging capital markets including china, india, and south american countries. if sk c&c is successful in its globalization plan, the company can tap on the higher growth potential, which is above the domestic growth rate estimate. we use relative valuation approach to estimate the value of it business of sk c&c. in relative valuation, pe of other companies can be used to determine ipo price of sk c&c. in the ipo process, pe multiple approach is widely used to back up the estimated intrinsic value with discounted cash flow approach. panel b of table 2 is pe ratios for comparable firms in korea, the us, and india. although samsung sdi and lg cns are not traded in the public market, their target pe is estimated along with pes of two other listed korean firms. ssangyong i&c and shinsegae i&c are listed firms, but their size in sales and assets are far below those of sk c&c and thus they may be not suitable for making direct comparison with sk c&c. industry average pe multiple for the global it firms is 19.62 as shown in panel a of table 3. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 307 3.2. the value of share holdings sk c&c holds shares of sk holdings, which is a holding company itself of other subsidiaries of sk group. thus, there is a double layer of holding companies. the question is whether the stake in sk holdings should be discounted or not. the reason is that the stakes of sk holdings in other subsidiaries are already discounted in sk holdings’ valuation. therefore, it seems inappropriate to apply double discount on sk c&c’s stake on sk. for instance, currently market price of sk holdings is around krw 9,200 per share (us$8) and this value is already 60% discounted from sk holdings’ net asset value. in 2004 when sovereign asset management engaged in the share competition with president choi, the share price went up to krw 120,000 (us$100) and over krw 250,000 (us$220) in 2007. it thus appears that the current price of sk holdings is already substantially discounted. from table 3, usual discount for holding companies in korea ranges from 30% to 60% from their net asset value. the observed discount on holding companies is attributable to possible appropriation of minority shareholders’ interests. the following argument presents some of this concern as addressed in fitch’s report on industrial investment holding companies (iihc).i iihcs are defined as groups where a parent company controls subsidiaries’ operations with a majority ownership that exceeds 50% and associated companies with ownership ranges between 20%and 50%. because the parent company is not able to directly extract cash flows from subsidiaries and associated companies, majority of cash flows of the parent firm consists of non-operational cash flows in the form of brand royalty and dividends, inter-company loan interest, and/or management fees. thus, this practice causes complexity in valuing the parent firm. equity investors therefore concern about the governance issues caused by the complexity. specifically, they concern that a main shareholder (managers of parent firm) do not necessarily act for the best interests of minority shareholders who have less complete information about the overall group. as a result, publicly listed iihcs tend to trade at a discount, often by 20%-30% or more. in korea, the holding company discount is more substantial than 30%. table 4 illustrates holding company discount. the discount ranges from 28.10% to 59.70%. higher the discount reflects higher risk of deprivation of minority shareholder interests. 3.3. other majority share holdings sk c&c also hold one-hundred percent ownerships in two private companies: sk lubricants and infosec. sk lubricants has been established in 1968 and has been expanding lubricants business since the introduction of zic brand in 1995. infosec is a cyber-security service provider established in 2000. the book value of assets of these two companies is krw0.663billion. in addition, sk c&c has 32.50% of share ownership in sk e&s. sk e&s is a private utility company that provides gas services and operates lng power plant. the book value of asset of sk e&s is krw 0.961 billion with ebit of krw52 million as of 12/31/2009. the market value of these private companies may be estimated through multiple approach by referring to the industry benchmark. nonetheless, since the market value of these share holdings is small compared to the operating value of sk c&c, book value of assets might be used instead for the sake of brevity. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 308 4. valuation results 4.1. fundamental value of sk c&c based on the net income number in year 2008 (krw 145.7 billion) and industry pe multiples, we estimate the value of it business of sk c&c. from table 3, current per of global information services industry is 19.62. thus, total market value of it business of sk c&c is krw 2,858.63 billion (=19.62krw145.7 billion, or about us$130 million). with korean industry average per of 12.5, the number is krw 1,821.25 billion (about us$1.6 billion). we thus predict that the value of it business of sk c&c ranges between the two estimates. next, our baseline valuation for share holdings is estimated based on the 31.8% ownership of sk c&c on sk holdings and the market capitalization of sk holdings. the market capitalization of sk holdings is krw 4,320 billion at the end of september, 2009. thus, the baseline estimated value of ownership stake in sk holdings is krw 1,373.76 billion. note however that the market capitalization of sk holdings is substantially discounted from its net asset value of ownership in other subsidiary companies. from table 4, the net asset value of sk holdings is krw 9,299 billion. we apply the 30% of the holding company discount to compute the intrinsic value of the share holdings. with this number, the estimated ownership value for sk holdings is krw 2,070 billion (=krw9,299b(1-30%)31.8%). this assumes that sk c&c improves its corporate governance system and thereby the excess discount for the korean holding company will be resolved in the long-run. the value of holdings in sk lubricants, infosec, and sk e&s is estimated with their book value, krw 1.624 billion (= krw 0.663 billion + krw0.961 billion). again, this may underestimate the true value of these three companies, but we consider that these companies’ value is relatively small and thus the marginal effect of any bias on the final valuation of sk c&c would be minimal finally, summing all these parts’ value together, our estimation for the total equity value of sk c&c ranges from krw 3,196.634 billion (=krw 1,821.25b + krw 1,373.76b + krw 1.624b) to krw 4,930.254 billion (=krw 2,858.63b + krw 2,070b + krw 1.624b): equity value of sk c&c = business value of it services + ownership value in sk holdings + majority holdings in other subsidiaries using the number of shares outstanding (50 million shares), we compute the per share value of sk c&c to be in the range between krw 63,932 (=krw 3,196.634b/ 50m share) and krw 98,605 (=krw 4,930.254b/ 50m share). the intrinsic value range is two to three times higher than the ipo price of krw 30,000. considering ipo underpricing by maximum 30%, the result indicates that the ipo price of sk c&c is significantly underpriced at the time of the issuance. in the next section, we consider several factors that may have influence on the observed underpricing. 4.2. other consideration factors asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 309 there are several factors we further consider to have a finite adjustment on the final valuation. first, we compute the operating assets value for it business of sk c&c separately. it means that there is no need to further adjust for the consolidated debt. that is, if the initial valuation is for cash flows from consolidated assets, then consolidated debt shall be subtracted. second, there is possible merger between sk c&c and sk holdings. current ownership structure is awkward in a sense that there is a double layer of holding companies. sk holdings is a pure holding company with less of operating assets and most of its income consists of brand royalty corrected from subsidiaries. president choi and his family hold about 20% stakes in sk holdings and 50% in sk c&c, respectively. the market capitalization of sk holdings is krw 4,320 billion at the end of september, 2009. the merger between sk holdings and sk c&c might dilute the share ownership of president choi. president choi has an incentive to increase the equity value of sk c&c’s operating assets to maintain his ownership in the merged firm to at least 50%. this intention for future merger will increase the stock price of sk c&c relative to that of sk holdings. third, following the employee stock plan in sk c&c, employees of sk c&c are entitled to subscribe ipo shares at the issue price of krw 30,000. employees can buy shares at the issue price and thus these shares are considered as benefits to employees. forth, as shown in the table 5, the market timing of sk c&c’s ipo is during bear market. the stock market performance of recent ipos is poor and subsequently some of ipos scheduled in october are postponed for later date. this suggests the offer price of sk c&c is less likely to be overpriced. the implementation of global visions and clean the governance structure is foremost priority of sk group and, therefore, the discount of issue price is less of concern for the company, especially when the company launches its long-term strategic plan. finally, we trace the stock market performance of sk c&c since the ipo. given the substantial discount in the ipo price, we expect that the company would not underperform. this would be a different pattern from the typical long-run underperformance of ipo stocks as reported in ritter (1991). for the past three years since the ipo, sk c&c has been traded in the range of krw35,650 to krw163,500. as reported in graph 2, the stock price continues to increase from krw35,650, which is the opening price on the first day of trading. the two-year holding period return for sk c&c is 163.50%, outperforming the market average return of 21.80% in the korean stock market index (kospi). the result confirms that our valuation correctly estimates the intrinsic value of sk c&c. 5. conclusion and summary we examine the valuation of a holding company. the ipo of sk c&c provides unique test settings to examine various issues related to the ipo. this study illustrates multiple factors of ipo decision making that are often ignored in large sample tests. the key factor for the ipo of sk c&c is regulatory changes to improve corporate governance structure for sk group. unique practice for korean conglomerates is cross-holdings using resources of subsidiary companies. this severely weakens transparency of korean conglomerates which often creates criticism by public investors and media. the establishment of a holding company and the ipo of sk c&c clarify the ownership structure of sk group and thus improve the transparency of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 310 the entire affiliated companies in sk group. our analysis shows that sk set the issue price at substantial discount. the post-issuance of the ipo confirms the underpricing and show a different pattern from the typical ipos. it appears that managers of sk c&c are less interested in selling their shares at the highest possible price, which is typical incentive of managers to initiate ipos. given that the priority of sk group was to improve corporate governance structure, the ipo of sk c&c achieved the intended goal of dismantling cross-holdings and streamlining ownership structure of sk group. this drives higher market valuation for shareholders of sk c&c and affiliated companies in sk group as well. references bhagat, s., & black, b. (2001). the non-correlation between board independence and long-term firm performance, journal of corporation law, 27, 231-274. boone, a., field, l., karpoff, j., & raheja, c. (2007). the determinants of corporate board size and composition: an empirical analysis, journal of financial economics, 85, 66-101. chi, j., & lee, d. (2010). the conditional nature of the value of corporate governance, journal of banking and finance, 34, 350-361. coles, j., daniel, n., & naveen, l. (2008). boards: does one size fit all?, journal of financial economics, 87, 329-356. cremers, k., & nair, v. (2005). governance mechanism and equity prices, journal of finance, 60, 2859-2894. damodaran, a. (2006). damodaran on valuation (2nd ed.), john wiley & sons inc., new york: new jersey. pmcid:1635410 duchin, r., matsusaka, j. & ozbas, o. (2010). when are outside directors effective?, journal of financial economics, 96, 195-214. http://dx.doi.org/10.1016/j.jfineco.2009.12.004 fitch ratings (2008), global corporate finance criteria report. gompers, p., ishii, j., & metrick, a. (2003). corporate governance and equity prices, quarterly journal of economics, 118, 107-155. http://dx.doi.org/10.1162/00335530360535162 klein, a. (1998). firm performance and board committee structure, journal of law and economics, 41, 275–303. http://dx.doi.org/10.1086/467391 ritter, j. (1991). the long-run performance of initial public offerings, journal of finance, 46, 3-27. http://dx.doi.org/10.1111/j.1540-6261.1991.tb03743.x rose, m. (2009). heterogeneous impacts of staggered boards by ownership concentration, journal of corporate finance, 15, 113-128. http://dx.doi.org/10.1016/j.jcorpfin.2008.09.008 yermack, d. (1996). higher market valuation of companies with a small board of directors, journal of financial economics, 40, 185-211. http://dx.doi.org/10.1016/0304-405x(95)00844-5 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 311 appendix graph 1. ownership structure of sk group graph 2. weekly price chart for sk c&c (2009/11/01-2012/10/01) president choi sk telecom sk c&c sk holdings sk networks skc sk energy sk gas sk e&csk e&ssk shipping sk-pow er sk securities 30 (to be sold) 15 (to be sold) 44.5 31.8 7 722.4 17 7 10.1 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 312 table 1. expected sales growth forecasts for it service market in korea (in krw billion) 2007 2008 2009e 2010e 2011e 2012e average growth rate consulting / si 2,493.50 2,736.80 2,849.40 3,049.00 3,197.40 3,325.50 5.90% outsourcing 2,012.70 2,214.50 2,343.90 2,493.80 2,643.90 2,796.20 6.80% support & training 1,058.70 1,097.80 1,120.60 1,148.90 1,173.00 1,196.10 2.50% it services in total 5,564.90 6,049.10 6,313.90 6,691.70 7,014.30 7,317.80 5.60% source: estimates from idc, sk c&c, and solomon investment securities co. table 2. historical income statement of sk c&c sources: bloomberg, fn guide (in krw100 million) 2006 2007 2008 2009.6 sales (net) 11,079 11,609 12,752 5,216 cost of goods sold 7,055 7,652 8,099 gross sales margin 4,024 3,958 4,653 5,216 selling, general, & admin. expense 2,891 3,162 3,761 4,684 ebit 1,134 796 892 533 ebitda 1,539 1,118 1,232 706 non-operating income(expense) 1,558 1,959 441 944 ebt 2,692 2,755 1,333 1,476 corporate tax 754 796 -125 347 net income 1,938 1,959 1,458 1,129 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 313 table 3. industry growth estimates and pe ratios a. average pe multiple for the global information services firms source: damodaran (2006) online (http://pages.stern.nyu.edu/~adamodr/) b. pe for comparable companies company country target pe industry average pe (local) country average pe samsung sds korea 15.2 12.5 10 lg cns korea 30.1 ssangyong i&c korea 15.4 shinsegae i&c korea 7.1 eds corporation usa 12.5 13.8 13.8 wipro limited india 16.5 16.1 13.6 infosys india 17 sources: bloomberg, fn guide table 4. comparison of six largest holding companies in korea (in krw100 million, if not otherwise indicated) lg sk holdings gs doosan hanhwa cj market value of cross holdings 140,290 98,810 41,210 31,150 44,780 21,550 net asset value* 163,290 92,990 46,110 36,750 38,780 22,980 net assets value per share (in krw) 92,367 226,876 48,698 158,448 55,750 82,351 stock price on nov. 5th, 2009 (krw) 66,400 91,400 28,450 74,300 38,400 47,250 discount** 28.10% 59.70% 41.60% 53.10% 31.10% 42.60% *: net asset value = market value of cross holdings in subsidiaries + real estate +brand royalty net borrowings **: discount = (net asset value per share stock price)/net asset value per share sources: daewoo securities co., shinhan finance & investment, 2009 table 5. performance of recent ipos company bidding date (mm.dd) offer price (krw) ipo date current price (krw) changes i&c technologies 9.24 16,000 10.6 11,500 -28.13% neowizbugs 9.25 9,000 10.6 6,680 -25.78% dongyang life insurance 9.3 17,000 10.8 15,000 -11.76% hans bio-med 9.3 5,500 10.9 5,970 8.55% jinro 10.9 41,000 10.19 43,000 4.88% sources: fn guide i fitch ratings, global corporate finance criteria report, may 22, 2008. industry name number of firms price/current eps price/trailing eps price/forward pe expected growth payout ratio information services 29 19.62 22.31 21.14 13.37% 38.17% asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 25 information quantitiy and order in students’ tax research judgments alexander m.g. gelardi associate professor university of st. thomas 1 received: april 11 2009 accepted: june 30, 2010 abstract the belief adjustment model predicts recency effects for complex information encoded in a step-by-step process. however, the literature indicates that the recency effect may not carry-over to larger numbers of pieces of information. this may be a problem with the amount of information now available through the internet. tax research tasks can have a number of pieces of information (cues). how tax students process information has not been studied extensively. this study extended prior work by investigating the effect of series of four, eight, and twelve cues on tax decisions made by undergraduate tax students. it was found that there was a strong overall recency order effect. however, the recency order effect seemed to be driven by the longer cue series, rather than by the shorter cue series. this is contrary to the predictions of the belief adjustment model. keywords: accounting recency tax judgments belief adjustment model jel classifications: h24, h29, h34, c12, c21, c91, m41 1 opus college of business, university of st. thomas, 1000 lasalle avenue, tmh#443 minneapolis, mn, 55403-4710 phone: 651-962-4402 fax: 651-962-4710 email: amgelardi@stthomas.edu asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 26 1. introduction students are required to carry out some research task in many of their tax courses. they research some area of tax law and make a judgement based on the findings. several different sources of authority may be consulted: tax services and electronic data bases may be used. searches on the internet have expanded ability to find potential sources of information. the amount of information available can be extremely large. information from these media sources is, by necessity, obtained sequentially and can contain conflicting messages. prior studies have found that the order in which information is presented and processed can affect judgments in sequential information processing tasks (see hogarth and einhorn 1992 for a review). however, some uncertainty exists whether this order effect can be generalized to legal tax research contexts. studies using experiments in accounting contexts to examine order effects may not typify tax decision making because these studies tended to use balanced information sets of two or four pieces of information (cues) in the experimental tasks. to prepare students to carry out legal tax research in practice, the students are often presented with more than four pieces of information. this is designed to correspond to a typical legal tax research task, where a tax advisor is likely to obtain a number of pieces of information, as well as to consult different sources of authority. this study extends prior research by examining order effects in tax research decisions of students. the experiment tested for order effects in tax judgments using information sets of four, eight and twelve pieces of information. the results of this study show that order effects do exist in a legal tax research setting, especially where the number of pieces of information is large. this would indicate that there is the possibility that tax judgments are systemically biased. therefore, the tax research tasks should be designed so that information is given in a mixed order, as opposed to a more "helpful" order. also, students should be trained not to group the results of their research, using tax authorities (cases, revenue rulings etc.), into lists that support a certain position and that do not support that position (to carry out more detailed research with those authorities). the rest of this paper is organized in the following manner. the next section briefly outlines some theoretical aspects of belief revision in decision making. prior empirical studies using the model in accounting contexts are outlined. the hypotheses tested in this study are then specified in the following section. the experiments conducted are described. the data analysis and the experimental results are presented. a discussion of the findings and the limitations of the study precede the summary section. 2. theoretical framework several authors have found that human beings do not follow the bayesian model when adjusting their beliefs but are influenced by normatively irrelevant factors (e.g., kahneman and tversky, 1972, 1979; hogarth, 1987; markowitz, 1952]. one such factor that has been empirically observed is an order effect. that is, the order in which information is received by the decision maker can affect the decision made (see hogarth and einhorn, 1992 for an extensive review). this paper uses the belief adjustment model (hogarth and einhorn, 1992) as its theoretical base. in the belief adjustment model, hogarth and einhorn (1992) examine the effects of evidence on a decision maker's revision of his belief. they consider some task variables predicted to have an effect on the outcomes. specifically, they consider the complexity of the actual subject matter, the number of asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 27 information cues that have to be considered, the encoding reference background and the response mode used to elicit the judgments. two types of response modes are considered. one is whether the belief is adjusted after each piece of evidence is received (step by step ["sbs"]). the other is whether belief is adjusted after looking at all the pieces of evidence (end of sequence ["eos"]). the encoding reference backgrounds are either the hypothesis being considered ("evaluation") or the current anchor ("estimation"). the belief adjustment model the model is based on the premise that persons formulate an opinion on the first piece of evidence they see (or, alternatively, have a prior belief) and then adjust from this belief with any new evidence obtained. in effect, this is the sequential anchor-and-adjustment strategy specified by tversky and kahneman (1974). the model also looks at processes involved where only one decision is being made. the model is not intended to cover situations in which several decisions or hypotheses are interdependent [cf., robinson and hastie, 1985]. further, this model is concerned with the updating of a hypothesis, not the construction of a hypothesis over time. construction of a hypothesis, as in the pennington and hastie (1986) experiments, can give results not predicted by the belief adjustment model. the basic form of the model is: sk = sk-1 + wk[s(xk)-r] (1) where sk = degree of belief in some hypothesis after evaluating k pieces of evidence (o ≤ sk ≤ 1). sk-1 = anchor or prior belief. initial belief is so. wk = an adjustment weight for the k th piece of evidence. s(xk) = subjective evaluation of the k th piece of evidence. r = background reference point against which the impact of the k th piece of evidence is being evaluated. the difference between the evaluation of the k th piece of evidence and some reference background is the representation of the encoding process. this is shown as [s(xk)-r] in equation 1. hogarth and einhorn envisage two types of encoding modes and related backgrounds against which the k th piece of evidence is evaluated. these types of encoding modes can be labelled as evaluation or estimation. in the evaluation mode, the reference background is the hypothesis being considered. evaluation involves deciding whether or not the hypothesis is true. the current belief can be expressed by some value on a continuum that the hypothesis is true or false. in this case, evidence that supports the hypothesis always increases one's belief in the hypothesis, whereas disconfirming evidence always decreases the belief. thus, the evidence is seen as being bipolar. the background reference point is stable. the evidence is considered to be positive or negative with respect to the hypothesis, thus it gives -1 ≤ s(xk) ≤ 1 and r=0. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 28 substituting r=0 in equation 1 gives sk = sk-1 + wks(xk). (2) in the estimation mode, the background against which the new piece of evidence is evaluated is the belief held at that time, the current anchor. if the strength of the new piece of evidence is greater than the anchor, the belief will increase. if the strength of the new piece of evidence is less than that of the current anchor, the belief will decrease. the same piece of evidence can be regarded as positive or negative depending on the current belief. thus, the evidence can be seen as being unipolar. the background reference point is dynamic. the evidence is considered to be positive or negative with respect to the current belief, giving 0 ≤ s(xk) ≤ 1 and r=sk-1. substituting r=sk-1 in equation 1 gives sk = sk-1 + wk[s(xk)-sk-1]. (3) rearranging the terms, equation 3 becomes sk = (1-wk)sk-1 + wks(xk). (4) this is the averaging form of the model. the evaluation mode with the stable background is similar to anderson's (1981) additive model; the estimation mode with the dynamic background is similar to anderson's averaging model. hogarth and einhorn (1992) give a further illustration of the difference between the evaluation and the estimation encoding modes. suppose that one is required to update a neutral belief and that two pieces of evidence are received sequentially. also, suppose that these items are both positive, although one is weak and the other is strong. if assessed on a bipolar evaluation scale, the evidence may have values of +0.8 and +0.2. if assessed on a unipolar estimation scale both pieces of evidence would have values of greater than 0.5, say 0.9 and 0.6, under the assumption that the current belief is 0.5 (i.e., neutrality on the unipolar scale). in the evaluation mode, both pieces of evidence would increase the belief because they are both encoded as positive. it does not matter in which order the pieces of evidence are received. however, the encoding process is different in the estimation mode. if the pieces of evidence were received in a weak-strong order, then, because 0.6 is greater than 0.5 and 0.9 is greater than the average of 0.6 and 0.5, both pieces of evidence would result in an upward belief adjustment. if the evidence were received in a strong-weak order, the strong piece of evidence would increase the belief because 0.9 is greater than 0.5; however, the weak piece of evidence would decrease the belief because 0.6 is less than the average of 0.9 and 0.5. to give a tax example, consider the case of whether an item of income should be regarded as capital or ordinary income. in the evaluation mode, one would classify any new evidence as supporting the capital treatment (positive) or not (negative). in the estimation mode, the new piece of evidence is evaluated with regard to the current anchor. if one holds a very strong opinion that the item is capital but the new evidence only weakly supports that view, the new piece of evidence would be encoded as negative. after the evidence is encoded, it is processed. a series of pieces of evidence can be processed in several ways. the usual ways are a) "step by step" (sbs) and b) "end of sequence" (eos). when a asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 29 person uses the sbs process, he updates or changes his prior belief with each piece of new evidence. when a person uses an eos process, he updates his prior belief only after he has seen all the evidence. at first sight, these are similar to the response modes. the main difference is that the processes are those that are actually used for decision-making strategies, whereas the response modes are the required methods for responding in the experimental situation. it is possible that, when one is required to use an eos response mode, one in fact uses an sbs process and reports only the final updated belief. this may be the case when the evidence series is long or complex (hogarth and einhorn, 1992). the model shows that new evidence has an adjustment weight, wk. the adjustment weight has to be sensitive to the fact that the impact of the evidence (s(xk)-r) is either negative or positive, and also to the level of the prior anchor, sk-1. when the evidence is negative or neutral (i.e., s(xk) ≤ r), then the weight, wk, is proportional to the prior anchor. this indicates that if the prior belief is low, then evidence deemed negative can only reduce one's belief further by a small amount. whereas, if the prior belief is high, then negative evidence can reduce that belief to a greater extent. thus, wk = αsk-1 when s(xk) ≤ r. (5a) the term α is the decision maker's sensitivity to negative evidence. where the new evidence is positive (i.e., s(xk) > r), similar arguments to those above would indicate that the weight, wk, is inversely proportional to the strength of the anchor. thus, wk = β(1-sk-1) when s(xk) > r. (5b) the term β is the decision maker's sensitivity to positive evidence. different individuals may have different sensitivities to negative or positive evidence. a high (low) α indicates a high (low) sensitivity to negative evidence. similarly, a high (low) β indicates a high (low) sensitivity to positive evidence. thus, low α and β would indicate low sensitivity to new evidence, whereas high α and β show high sensitivity to new data. a skeptic would have a relatively high α and low β, and an advocate would have a relatively high β and low α. the relative strengths of α and β can dampen the order effects. step by step process. after each piece of evidence is received, the decision-maker updates his belief. he then uses that new belief as the anchor for the adjustment he makes after observing the next piece of evidence. thus, equations 5a and 5b are placed into equation 1 to obtain: sk = sk-1 + αsk-1 [s(xk)-r] when s(xk) ≤ r. (6a) sk = sk-1 + β[1-sk-1][s(xk)-r] when s(xk) > r. (6b) the belief held after k pieces of evidence have been processed is a function of the following: a) the initial belief, b) the sequence in which the evidence was observed, c) the process by which the evidence was encoded, and d) the individuals' sensitivity to the direction of the evidence (positive or negative). the sensitivity weights also indicate that the belief adjustment to new consistent evidence follows the "law of diminishing returns." that is, as more, say, positive evidence is received, the amount of belief asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 30 revision will be less and less. this concept follows from the proportionality of the adjustment weight, wk, to the prior anchor. end of sequence process. in the eos process, the decision-maker updates his belief only after seeing all the evidence. there is only one belief change. sk = so + wk [s(xi,...,xk)-r]. (7) s(xi,...,xk) is some function, possibly the weighted average, of the evaluations of each piece of evidence. it is assumed that the scale value of the evidence does not vary with its position (i.e., first, third, etc.) in the sequential series. the model is based on the premise that persons formulate an opinion on the first piece of evidence they see (or, alternatively, have a prior belief) and then adjust from this belief with any new evidence obtained. in effect, this is the sequential anchor-and-adjustment strategy specified by tversky and kahneman (1974). this study examines a small subset of the model's predictions. it is considered that in a professional task the encoding reference background is evaluation and the response mode is sbs (asare and messier, 1991). most tax research tasks are likely to be complex (as defined by hogarth and einhorn (1992) and may be either short or long. order effect predictions the belief adjustment model makes a number of order effect predictions. the order effects depend on the type of processing used (sbs or eos), the reference background (r=sk-1 or r=0), the complexity of the task, and the length of the series of cues. under the sbs response mode, the model predicts a recency effect where r = sk-1, in all cases. when r=0, the model predicts no order effects where the evidence is consistent (all negative or positive). if the evidence is mixed, then a recency effect is predicted, unless either α or β is approximately zero. where a negative piece of evidence is followed by a positive one (+), the positive evidence is given more weight than if it had preceded the negative evidence. similarly, where a negative item of evidence follows a positive one (+ -) the negative evidence is given more weight than if it had preceded the positive evidence. thus, the recency effect gives a non-equivalence in the final belief. if the belief adjustments were graphed, then there would be a fish-tail effect (see figure 1). asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 31 figure 1 for a long series, the prediction is a primacy effect for consistent evidence in the evaluation encoding mode (r=0) and a force toward primacy for all other cases. force toward primacy means that there is a recency effect that diminishes as the series becomes longer and eventually turns into a primacy effect. under the eos response mode, the situation is more complex. if the task is simple, the model predicts a primacy effect, whether the encoding mode is evaluation or estimation, for both consistent and mixed evidence. where the task is complex, the model makes several predictions: recency effects for both mixed and consistent evidence in the estimation mode, and for mixed evidence in the evaluation mode, but no order effect for consistent evidence in the evaluation mode. based on previous studies, hogarth and einhorn (1992) define a long series as twenty or more cues. a short series is defined to be less than twelve cues. in most of those studies, the long series cues tended to be cognitively simple items such as adjectives. in all cases, there is a primacy or force toward primacy effect for long evidence series. this is similar to the concept of "attention decrement" set out by cues belief 0 1 2 80 70 60 50 40 30 20 ++ -+ fish tail effect asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 32 anderson (1981). hogarth and einhorn (1992) state that the reason for primacy is that persons may tire if they have to process too many items of evidence and also may become less sensitive to new information as the incremental value of that evidence is small. there may, however, be a third factor working in conjunction with these two. although an anchoring and adjustment heuristic may be used, it is possible that where information is received over a short period of time, prior pieces of information can influence the decision. if this is so, then the more pieces of information obtained the less influence some of the "middle" pieces of information will have (murdock, 1962). thus, the earlier pieces of information may have relatively greater influence, giving a force toward primacy. part of the complexity of predictions under the eos response mode come about from the fact that the eos response mode can elicit either eos or sbs processing strategies. the sbs strategy is expected to be used where the task involves a long evidence series or is cognitively complex (hogarth and einhorn, 1992). the model predicts recency for sbs response mode and primacy for eos response mode, in short simple tasks. if the task is cognitively complex, then recency is predicted for mixed evidence in both response modes. there is a force toward primacy for long tasks in all cases. in a tax context, it is suggested that the encoding mode will be evaluation, and so the background would be the hypothesis (i.e., r=0). this seems reasonable because most tax judgments tend to be on a dichotomous scale (cf., asare and messier, 1991). for example, one would have to decide whether or not a client is resident in country a for tax purposes, or whether a person is an employee or a self-employed contractor. the evidence in such judgments is bipolar. prior experimental evidence in accounting prior research using the belief adjustment model in accounting has concentrated on using professionals, especially auditors, as subjects. the predictions of the model may be important in accounting decisions, as it is suggested that many judgments in accounting are formed from processing sequential information (gibbins, 1984; knechel and messier, 1990). researchers using the belief adjustments model in a tax setting include christian and reneau (1989) who conducted four experiments using both undergraduate students and professional tax advisors. they examined both consistent evidence and mixed evidence. in the mixed evidence experiments, they found significant order effects for both the students and the tax professionals. christian and reneau (1989), further, found that the tax professionals revised their beliefs by a greater amount for positive evidence than for negative evidence. the students revised their beliefs by approximately the same amount for both directions of the cues. this would suggest that tax professionals have higher sensitivity for positive evidence than for negative evidence (i.e. opposite results to those found with auditors) and consistent with the advocacy role. this idea that tax professionals are more sensitive to positive pieces of information is supported by johnson (1993), who found that tax professionals use a confirmatory process in belief adjustment. the assumption is that tax professionals initial belief supports that client’s view. ashton and ashton (1988) examined an earlier version of the model in an auditing environment using professionals. they found results that were predicted by the model for both consistent evidence (no order effect) and mixed evidence (recency effect), under the sbs response mode. the authors also manipulated initial anchors (0.20, 0.50, 0.80 on a scale of 0 1.00). the changes from the anchors showed that the asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 33 larger anchors were more hurt by negative evidence than were smaller anchors, which supported the model's prediction. it has also been found that inexperienced auditors were affected by different anchors, whereas experienced auditors were not so affected (butler, 1986). because the subjects in the ashton and ashton (1988) experiments were reasonably inexperienced (the mean of the length of experience was less than three years), experience may be a factor where an a priori anchor is provided for the subjects. as tax students could be regarded as being similar to inexperienced professionals, tax students could be subject to the recency effect bias. ashton and ashton (1988) also examined mixed evidence and found that there was no order by anchor interaction, which was predicted by the model. they also found that there was a strong interaction effect between type of response mode (sbs or eos) and the direction of the evidence. the belief adjustments were less marked in the eos mode, than in the sbs mode, for both positive and negative evidence. the scenarios in the ashton and ashton (1988) experiments were fairly simple. tubbs et al. (1990) used more complex audit situations. they found that there was no recency effect for consistent evidence, but there was a recency effect for mixed evidence. butt and campbell (1989) examined a mixed series of ten cues with subjects being given high prior beliefs or low prior beliefs. they found no recency effect for subjects with high prior beliefs and a marginally significant (p = 0.073) recency effect for subjects with low prior beliefs. hogarth and einhorn (1992) state that they consider butt and campbell's series of ten pieces of information could be regarded as being similar to a long series. this is contrary to their own prior statement that a series of twelve pieces of information is classified as a short series hogarth and einhorn (1990). christian and reneau (1989) conducted four experiments using both undergraduate students and professional tax advisors, in a tax setting. they examined both consistent evidence and mixed evidence. in the mixed evidence experiments, they found significant order effects for both the students and the tax professionals. christian and reneau, further, found that the tax professionals revised their beliefs by a greater amount for positive evidence than for negative evidence. the students revised their beliefs by approximately the same amount for both directions of the cues. this would suggest that tax professionals have higher sensitivity for positive evidence than for negative evidence (i.e. opposite results to those found with auditors) and consistent with the advocacy role. this idea that tax professionals are more sensitive to positive pieces of information is supported by johnson (1993), who found that tax professionals use a confirmatory process in belief adjustment. the assumption is that tax professionals initial belief supports that client’s view. some studies in the accounting field have tended to support the model's recency predictions using mixed evidence in a sbs mode (e.g., messier, 1992; asare, 1992). these studies used either professional auditors or students. however, other studies have had mixed results (messier and tubbs, 1994; butt and campbell, 1989). also, legal tax research judgements often do involve different numbers of cues. only series of two or four cues have been examined in prior studies in a tax context (christian and reneau, 1989; pei et al., 1990, 1992). thus, it is useful to examine further how beliefs are updated in tax research judgments. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 34 hypotheses the belief adjustment model predicts a recency effect in sequential belief. as detailed above, this is one of the model’s main predictions. the recency effect has been supported by prior studies in accounting as shown above (messier, 1992; asare, 1992; ashton and ashton, 1988). the model also predicts a recency effect for complex cues as well as mixed cues. tax information is regarded as being complex (christian and reneau, 1989). thus, the first hypothesis is: h i: a recency order effect will be observed when processing items of information in updating belief. most previous studies in accounting contexts (either tax or auditing) have generally used four items of mixed information. for longer series, hogarth and einhorn (1992) predict no recency effect and this is supported by butt and campbell (1989). this leads to the hypothesis that as the number of cues increases the recency effect will decrease. longer series of cues have not been studied in a tax context. the model indicates that the recency prediction may not be valid for the longer series of cues. thus, the second hypothesis is: h ii: the recency order effect in updating beliefs will be less marked as the number of items of information increases. these hypotheses assume a sbs processing mode. 3. methodology a laboratory-type experiment was conducted. the experiment was designed to involve complex tasks, and both were designed to force the subjects to use the sbs processing mode. a 2 x 3 analysis of variance (anova) design was used. subjects the subjects were 173 students enrolled in an undergraduate tax course. as can be seen from table 1, the mean age of the students was 26. they were generally full-time students (86%) and only 10% had had any practical tax experience. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 35 table 1: demographic data number 173 gender: %male 47 average age 26 class: %junior 19 %senior 76 %graduate 5 full/part-time: %full time 83 overall gpa (undergraduate) 3.18 accounting gpa (undergraduate) 3.04 business gpa 3.18 accounting courses 6 business courses 10 tax experience: %with 10 years 1.3 design the participants were given a booklet containing an introductory letter, the experimental instrument and a post-test questionnaire. the experimental task required the participant to decide whether an individual taxpayer could be regarded as a "dealer" or "investor" in real property. this specific task was chosen as it is often decided by taking into account the facts and circumstances of the taxpayer's situation. the subject matter of the task has well-defined criteria from which it was possible to obtain information sets of different lengths. the criteria are such that they could be constructed into positive or negative cues. although this is a typical tax research task, it is unlikely that it is one about which the students would have had strong priors. this subject matter has been used in other studies (e.g., roark and reneau, 1989; pei et al., 1990, 1992). the cues used in this study were based on the set of cues developed by taylor (1980) from the relevant case law. the cues were ranked and scaled as to their importance in an "investor dealer" decision by a group of experienced tax ph.d. students and tax faculty at a major state university. 2 the cues were constructed from the results of this exercise. the positive and negative cues were made approximately equal in strength. the cues regarded to be the most important were in each cue level, as these are more likely to be influential in the decision making process. the less important cues were added for the longer cue levels. this was done as it is expected that the more important cues would be used first in any summary of facts. (this may give a slight bias against the prediction of recency). the cues were designed to be unambiguously positive or negative. the initial belief was anchored at 50 percent. this was accomplished by indicating, before the cues were seen, that there was a 50:50 chance of either 2 the ph.d. students had had experience as tax managers, just prior to entering the ph. d. program. two were advising some private clients. the tax faculty were generally less experienced. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 36 treatment. the instrument presented the client facts and the results of the staff member's "research." the subjects were asked to make a series of sequential decisions as new client facts were received. in order to force the subjects to encode the information in a sbs process, each new client fact was presented on a new page. the decisions were requested on a 100 point scale placed at the bottom of each page. the subjects were asked to mark on the scale what they believed to be the probability that the "client" would be regarded as a "dealer" or an "investor" in real property. the experiment was designed as a 2 x 3 anova (analysis of variance). a between-subjects design was chosen because there was a major concern for the possibility of a carry-over effect in a cognitively complex sequential processing task. there was also a concern that, in a within-subject design, the subjects might have been able to guess the hypotheses (pany and reckers, 1987). the subjects were randomly assigned to one of six (2x3) conditions. they were given as much time as they needed to discount time pressure as a variable. independent variables there were two independent variables: order ("order"), and the number of cues ("load"). the order factor had two levels: a) positive cues followed by negative ones (level 1) and b) negative cues followed by positive ones (level 2). 3 the load factor had three levels: a) four cues, b) eight cues, and c) twelve cues. these cue lengths were chosen to bracket seven (miller, 1956), and because it was considered unlikely that a client's facts would have many more than twelve separate items of information for any single legal tax research task. dependent variable the dependent variable was the change in belief from the manipulated anchor. that is, the belief after all items of information have been received less the initial anchor of 50%. 4. data analysis hypothesis i the analysis was conducted using a 2x3 anova. the results of the analysis are shown in table 2. 3 there is often some concern that the serial position of the cues could affect judgments. therefore, the cues within each directional series were presented in two different orders so that any serial effects could be observed. it should be noted that the model assumes that there is no serial effect. a serial effect was tested for, but was not found. this confirmed pei et al. (1992) who also did not find a serial effect. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 37 table 2 anova table for two-way analysis source df ss f value p value model 5 9831.94 3.11 0.0104 error 167 105740.00 source df ss iii f value p value order (o) 1 5009.57 7.91 0.0055 load (l) 2 2396.56 1.89 0.1539 l * o 2 2655.61 2.10 0.1260 because the results show that there is no interaction, it is permissible to look at the main effects. there is a significant main effect for order (p = 0.006). the overall means of the two levels of the factor indicate that there is a recency effect. therefore, the evidence is again consistent with the predictions of hypothesis i. hypothesis ii hypothesis ii stated that the recency effect is expected to diminish as the number of cues in the series increases. two-way anova results. the analysis was conducted using the same 2x3 anova model used to test hypothesis i. if the results were consistent with the prediction of hypothesis ii, one would expect to see a significant load by order interaction. the results are reported in table 4. the results show that the load by order interactions are not significant in either case. thus, the evidence is not consistent with the prediction of hypothesis ii. from a practical viewpoint, it was considered important to obtain further insight into the effect of increasing the load levels. therefore, multiple pairwise comparisons were analyzed. 4 this analysis showed that the mean of the twelve cue load factor in order level 1 (+ -) was significantly different from the mean of the twelve cue load level in order level 2 (+) and from the mean of the eight cue load level in order level 2 (+). no other pairwise comparisons were significant. the multiple pairwise comparisons suggest that there may be a difference in the order effects among the different load factor levels but not in the pattern predicted by hypothesis ii. the table above and the figures below (figures 2-4) show that as the number of cues increase the “fish-tail” effect (recency bias) becomes more pronounced. the four cue series results show no recency effect, whereas the twelve cues series shows a significant recency effect (the eight cue series shows a moderate recency effect). looking at the figures, it can be seen that for the four cue series there is no “fish-tail” effect – the beliefs after the fourth cue are almost the same for the two orders (positive – negative; and negative – positive). figure 3 has a slight “fish-tail”, the lines for the two orders cross 4 scheffé's method was used. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 38 just before the final cue. figure 4 shows a substantial “fish-tail” effect, the crossover of order lines is before the tenth cue. figure 2 four cue series cues belief 0 1 2 3 4 100 90 80 70 60 50 40 30 20 10 0 ++ + --++ asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 39 figure 3 eight cue series cues belief 0 1 2 3 4 5 6 7 8 100 90 80 70 60 50 40 30 20 10 0 + ----++++ ++++--- asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 40 figure 4 twelve cue series one-way anova results. as a result of the analysis reported in the previous subsection, it was considered appropriate to partition the data by load factor levels and to analyze the partitioned datasets in three separate one-way anovas. the results are shown in table 3. cues belief 0 1 2 3 4 5 6 7 8 9 10 11 12 100 90 80 70 60 50 40 30 20 10 0 +++++-----+ ------++++++ asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 41 table 3 anova tables for one-way analysis four cue load source df ss f value p value model 1 26.67 0.05 0.8262 error 58 31800.73 eight cue load source df ss f value p value model 1 1564.57 2.42 0.1254 error 54 34868.86 twelve cue load source df ss f value p value model 1 5927.17 8.34 0.0055 error 55 39070.41 these results indicate that there is a highly insignificant difference in the cell means for the four cue load level (p = 0.826), a mildly insignificant difference in the cell means for the eight cue load level (p = 0.125) and a highly significant difference in the cell means for the twelve cue load level (p = 0.006). this suggests that there is a strong order effect at the twelve cue load level. inspection of the cell means shows that they are consistent with a recency effect. since, as stated above, the weaker cues were added for the longer series, the fact that a recency effect was found in the longer series indicates the strength of the recency bias. summary. hypothesis ii predicted a significant load by order interaction in the two-way anova. none was found. thus, the evidence is not consistent with the prediction of hypothesis ii. however, the multiple pairwise comparisons indicate that there were differential order effects among the load levels. based on analyses using one-way anovas, the results indicate that the strength of the asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 42 recency effect increases as the number of cues in the series increases. the twelve cues load series being significant, whereas the four cues load series is insignificant. this is opposite to the prediction of hypothesis ii. 5. discussion and limitations discussion from the analysis section above it can be seen that a strong recency order effect was found. this is consistent with the predictions of the belief adjustment model. however, the multiple pairwise comparisons in the two-way anova and the one-way anova results of the individual load levels suggest that the strong recency order effects may be driven mainly by the longer cue load level. the strength of the recency order effect in the twelve cue load factor level may indicate that hogarth and einhorn (1992) were justified in stating that a series of twelve cues could be regarded as a short series. if this is the case, then the butt and campbell (1989) study does not support the model. further, hogarth and einhorn's (1992) statement that butt and campbell's series of ten cues was more like a long series may not be justified. considering that most of the prior studies have found strong recency effects, the lack of a significant effect for the four cue load factor level is surprising. however, the insignificant results found in this study for the four cue load level are not inconsistent with the results previously found for inexperienced tax managers (pei et al., 1992). thus, it is possible that inexperienced tax decision makers, such as students, are cautious when they have a small number of cues available and so are able to show more consistent evaluations. as the number of cues increases, the bias that the model predicts may become influential. further research is needed to establish the demarkation between a short and a long series. the strong recency order effect found in the longer cue series should be of interest to the tax profession. as stated earlier, tax advisors, typically, are likely to use more than a small number of cues in their judgments. in these cases, the recency order effect may result in a systemic bias in their judgments. it would be of benefit to tax advisors if they are made aware of this potential bias, so that they may be able to undertake measures designed to prevent the bias from occurring. appropriate measures could include the mixing of evidence of different directions before it is analyzed. this would be possible where the advisor uses an electronic database (or a hard copy tax service) to search for, say, relevant court cases. the database usually provides the researcher with a brief summary of the findings of the case. this enables the researcher to judge whether that particular case supports or contradicts his intended position. limitations the experiments were carried out together in a laboratory setting. this is a different environment to the one in which students would normally carry out their research. the subjects were undergraduate students taking a tax course at a major western public university. although there is no evidence that these students' cognitive processes would be different from those of other students, generalization to all tax students may be limited. thus, there are some serious concerns about the external validity of this experiment. the subjects were given the different instruments at the same time. they were told that the instruments were designed to take different amount of time to complete and that they should expect that some would be finished before others. however, it is possible that some subjects with the longer asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 43 instruments may have rushed their tasks and did not give considered responses. future research should be able to look at different techniques to mitigate the order biases found in this research to ascertain which techniques are efficient and under what conditions such techniques do counter the order bias potential in tax decisions. further research could include using mixed positive and negative cue alternatively to ascertain whether this would mitigate the recency bias. 6. summary the belief adjustment model predicts recency effects for complex information encoded in a step-by-step process. prior studies using the model in a tax context have examined balanced information sets of two or four cues and have generally used professionals. generally, these studies found a recency effect. however, psychology literature indicates that the recency effect may not carry-over to long series of cues. this study extended prior work by looking at students and different number of cues. it investigated the effect of series of four, eight, and twelve cues on tax research decisions. an experiment was carried out. the subjects were 173 undergraduate students enrolled in tax courses at a major u.s. state university. it was found that there was a strong overall recency order effect. however, the recency order effect was driven by the longer cue series, rather than by the shorter cue series. this is contrary to the predictions of the belief adjustment model. students under taking tax research generally use a fairly large number of items of information in their judgments. thus, the finding of a strong recency order effect in the longer series should be of interest to tax educators. tax educators should be able to teach students to avoid the possibility of succumbing to order biases during tax research tasks. this training then should carry over to the time when the students become professionals. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 44 references anderson, n.h. 1981. foundations of 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effects. auditing: a journal of practice and theory 7, 39-53. pei, b.k.w., reckers, p.m.j., wyndelts, r.w., 1992. tax professionals' belief revision: the effect of information presentation sequence, client preference and domain experience. decision science. 23, 175-199. pei, b.k.w., reckers, p.m.j., wyndelts, r.w., 1990, the influence of alternative information on professional tax judgments. journal of economic psychology 11, 119-146. pennington, n., & hastie, r. 1986. evidence evaluation in complex decision making. journal of personality and social psychology, 51, 242-258. robinson, l.b., & hastie, r. 1985. revision of beliefs when a hypothesis is eliminated from consideration. journal of experimental psychology: human perception and performance, 11, 443-456. roark, s.j., reneau, h.j., 1989. an experimental test of factors affecting tax advisor's information acquisition and recommendations. unpublished manuscript, arizona state university. taylor, r.l., 1980. dealers and investors in real estate. journal of real estate taxation, 7, 395-403. tubbs, r.m., messier, w.f, knechel, w.r., 1990. recency effects in the auditor's belief revision process. the accounting review, 65, 452-460. tversky, a., kahneman d.,1974. judgment under uncertainty: heuristics and biases. science 185, 1124-1131. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e2 www.macrothink.org/ajfa 46 copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 5 decisionmaking-writer2-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa decision-making based on human resource accounting information and its evaluation method fariborz avazzadehfath research scholar, dos in commerce, university of mysore, india e-mail: favazzadeh2010@gmail.com dr. h.raiashekar, m.com, ph.d associate professor, dos in commerce, university of mysore, india e-mail: rajashekar1@yahoo.co.in received: august 17, 2011 accepted: november 23, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.883 url: http://dx.doi.org/10.5296/ajfa.v3i1.883 abstract skillful and specialized human resources are of vital importance for an organization just like its physical properties and investments. managers of the organizations spend a lot of money for training and educating their workers and employees in order to increase the efficiency of the organization under their control, but human resources accounting system which should be used for human resources information processing have not been used practically by any organization in iran. this paper explores firstly, whether investment decisions are affected by human resource accounting information disclosed in the financial statements or not? secondly it explores as to what factors can interfere in this effect? thirdly it examines which evaluation method of human resource is the most appropriate method consistent with iranian companies in terms of qualitative characteristics of accounting information? the results indicate that human resource accounting (hra) information disclosure in financial statements is relevant and affect on the optimal investment decisions. furthermore, other results state that the most effective and appropriate evaluating method of human resource consistent with current status of iranian companies and institutions is the original cost method (historical cost). keywords: cost of human resource, decision-making, evaluating methods of hr, human resources accounting (hra). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa 1. introduction accounting has special position and plays an important role in economic, trade and manufacturing currents (tomassini, et al. 1977). it is a man-made art and its principles and procedures have been evolved over a long period to aid business in reporting for the management and public. of the four factors of production, viz., man, money, material and land, the last three of them are amenable to conventional accounting, but the first one, i.e., the human resource has not been subject to such accounting (carme, barcons et. al 1995). over the last two decades the idea of accounting for human resources is gaining active consideration. so, hra is not a new issue in economics. economists consider human capital as a production factor, and they explore different ways of measuring its investment in education, health, and other areas. accountants have recognized the value of human assets for at least 70 years. research into true hra began in the 1960s by rensis likert (bowers, 1973). likert defends long-term planning by strong pressure on human resources' qualitative variables, resulting in greater benefits in the long run. looking at different proposals (conner, 1991), the resource theory considers human resources in a more explicit way. this theory considers that the competitive position of a firm depends on its specific and not duplicated assets. the most specific (and not duplicated) asset that an enterprise has is its personnel. it takes advantage of their interdependent knowledge. that would explain why some firms are more productive than others. with the same technology, a solid human resource team makes all the difference (archel, 1995). hra has attracted a considerable amount of interest in a comparatively short period of time. although many works on behavioral and organizational aspects of accounting have been conducted, but research, writings, enthusiasms as well as criticisms and disappointments have greatly flourished in hra area (topomy deb, 2009). business enterprises often proclaim that their labor force is their most important asset, while at the same time they fail to recognize it in managerial planning, decision-making and in published annual reports. hra attempts, in most cases, have been directed to an internal, management control perspective. however, the potential usefulness of hra information would seem to be even greater for the external decision-makers than for the company's management (jan bratton, 2003). there are two reasons for including human resources in accounting (ripoll and labatut, 1994). first, people are a valuable resource to a firm so long as they perform services that can be quantified. the firm need not own a person for him to be considered a resource. second, the value of a person as a resource depends on how he is employed. so management style will also influence the human resource value. the present paper focuses on hra information in aspects usefulness, decisionmaking, valuation and related issues. 2. human resource accounting in aspects reporting and decision-making the american accounting association (1970) defines hra as "the human resources identification and measuring process and also its communication to the interested parties." the immediate impact of human resource costs on reported profits may lead to decisions that are influenced by tax considerations toward reporting larger or smaller profits for a period. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa for example, a manager trying hard to minimize tax payments, will look with great favor on human resource investment that is expensed than on physical resource investment to get a short run tax advantage, while a manager already conscious of the embarrassing aspects of a declining profit trend may favor physical resource investment over human resource investment so as to postpone the impact upon reported profits. hra could avoid this unintended and unjustified bias. it may be suggested further that hra is in itself a way of communicating to the people of an organization that their role is considered valuable and that managers are going to be evaluated, at least in part, on the basis of their contribution to the development of the human resource under their control. if this communication is effective, it will most certainly affect decisions and behavior. the assessment of human resource conditions is likely to encourage managers to take long run view of their decisions (bino catasus, 2009). the impact of human resource investments as well as other decisions and management styles are now represented as a human resource condition precedent to the ultimate productivity or effectiveness of the organization. hra is not useful to the management alone in achieving its economic goals. it could also be the source of important information for investment decision purposes. the inclusion of appropriate human resource data in published financial statements would, in all likelihood, make such statements for more meaningful in predicting future performance which is, of course, the principal concern of investors (jawahar lal, 2009). when managers go through the process of hra measurement treating human resources as capital assets, they are more likely to make decisions that treat the company's employees as long-term investments of the company. flamholtz (1976) describes the hra paradigm in terms of the "psycho-technical systems" (pts) approach to organizational measurement. according to the pts approach, the two functions of measurement are: first, process functions in the process of measurement and second, numerical information from the numbers themselves. whereas one role of hra is to provide numerical measures, an even more important role is the measurement process itself. the hra measurement process as a dual function attempts to increase recognition that human capital is paramount to the organization's short and long-term productivity and growth. when managers go through the process of measuring human resources, they are more likely to focus on the human side of the organization and are more likely to consider human resources as valuable organizational resources who should be managed as such (sullen, 2007). 3. literature review during the two last decades, several advocates of hra, including herman & mitchell (2008) ,flamholtz et al. (2003), pekin ogan (1988), chris dawson (1994), flamholtz (2004), lev & schwartz (1971), elias (1972), hendricks (1976) and others have suggested that hra could benefit external users of financial statements. external decision makers must know the changes in human assets in order to evaluate properly assets and income. the conventional accounting profit may be misstated and the asset base distorted, if the condition of human assets changes during the period, (flamholtz, 1999). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa herman theeke, john b. mitchell (2008) discussed how reporting under a human resource liability paradigm fits into the traditional accounting framework of contingent liabilities; examine the financial effects of such reporting on market valuation and internal planning; and explore measurement of human resource liabilities. from reviews of financial effects of human resource liability reporting the research logically extends those results to support the proposed paradigm. the paper provides support for the feasibility and need to adopt a human resource liability paradigm for valuing, reporting and managing human resources. flamholtz et al. (2003) utilized the hra measure of expected realizable value, and found that employees' participation in a management development program increased the value of the individuals to the firm. in addition the authors noted that the hra measures provided upper level management with an alternative accounting system to measure the cost and value of people to an organization. thus hra represented both a paradigm or way of viewing human resource decisions, and the set of measures for quantifying the effects of human resource management strategies upon the cost and value of people as organizational resources. chris dawson (1994) indicated relationship between two prescriptive models of hra the replacement cost model (rcm) and the stochastic rewards valuation model (srvm). investigates not only the operationalization of the two models, but also the reasoning used by managers in determining or arriving at the data. goes on to discuss the general benefits and limitations of simulation methodologies and how they relate to prescriptive and descriptive approaches to the study of management. pekin ogan(1988) reported the results of a field experiment designed to assess the impact of hra information on layoff decisions made by managers. the findings of this study indicates that hra information does make a difference in personnel layoff decisions and enables managers to increase their level of confidence regarding decisions of this sort. tomassini (1977) provided to a sample comprising of accounting students, traditional financial information and information containing human resources accounting. hra information led to remarkable differences in decision-making. hendricks (1976) performed a study using accounting and finance students as subjects. his simulated investors made two stock investment/capital allocation decisions, one with and one without human resource cost data. in this research, hra had a meaningful impact on adopted decisions statistically. schwan (1976) considered the effects of human resource cost measures on banker decision-making. he found that the inclusion of hra data in published financial statements resulted in, one, significantly different ratings of management's preparedness to meet future challenges and opportunities and, two, statistically different predictions of a firm's net income. acland (1976) selected a sample comprising of 500 financial analysts and provided financial reports for some of them and reports containing behavioral indexes to some other analysts so that they can make decisions about investments in one or two companies. insertion of behavioral indexes caused that some analysts would make decision differently from those asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa who had only financial information. this difference was visible in the analysts who had received hra information with behavioral indexes. research was performed about relative impact of disclosure of hra monetary information versus non-monetary information. flamholtz (1976) asked official accountants to select between two persons for occupying a position. he gave three kinds of information to the accountants, traditional information about function, non monetary information about hra and monetary information about it. this information was given about three cases a, b and c respectively to the accountants. in contrary to flamholtz's expectation, non-monetary information had impact on decisions. nabil elias (1972) provided 2 groups of financial reports (one, traditional report and another, reports containing hra information) in his research to the sample including accounting students, financial analysts and accountants. research results showed that hra information had meaningful impact on decisions statistically, although the relationship between hra information and the adopted decisions was not strong. 4. hypotheses development the main purpose of the research is to study the impact of provision of hra information on investment decisions in order to improve the quality of financial decisions made by the groups inside and outside an organization through entering hra information in total decision making traditional variables. so, the following hypotheses have developed: hypothesis 1: the presentation of hra information has information increasing content. hypothesis 2: there is significant relationship between individual’s background and experience and impact of hra information on decision-making. hypothesis 3: there is significant relationship between individual's personal viewpoints about assessment of hr and impact of hra information on decision-making. hypothesis 4: there is significant difference between the evaluating methods of hra with respect to the qualitative characteristics of accounting information. 5. materials and methodology in this paper the services, investment and manufacturing companies decision makers of tehran stock exchange, were selected as the statistical population in 2009 to do the research by making use of the views and opinions of this expert group. hence, the research statistical unit is an investment, services and manufacturing active company and member of tse, while the resource of the collection data are following: 1investment experts and analysts and financial managers working in listed companies in tse. 2managers and experts of auditing institutions of tehran. the authors selected 68 companies of tehran stock exchange as sample size by using random sampling technique. furthermore, we distributed 238 questionnaires between investment experts and analysts and financial managers and experts of auditing companies asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa due to unlimited statistical population, but questionnaires received from respondents was 162. this research in terms of methodology is a descriptive/correlation research.the tools being used in this research is questionnaire.the responses to structured questionnaire collated by using spss software in the significant level (α=5%), and the relevant statistical methods like mean value, standard deviation, correlation coefficient, t-test, ftest, chi-square ( 2) and compare means test have adopted to arrive at meaningful conclusions. 6. the questionnaire design the authors have used systematic or closed questionnaire for collecting data. in this case, we have prepared two questionnaires. in the first questionnaire, the financial statements of two hypothetical companies without providing of hra information were prepared and presented to the members of statistical population and they were asked to allocate rials 50,000,000 in the above-mentioned companies as investment which is called the first behavior. in the second questionnaire, the financial statements containing hra information were distributed among the same members of the population two weeks after collecting the first questionnaire and they were asked to do the same investment again which is called the second behavior. it should be mentioned that the second questionnaire includes 9 questions for measuring the experience variable and 11 questions for measuring individuals' personal viewpoints and finally, with regard to the fourth hypothesis of this paper, a questionnaire including 7 questions has been designed which refers to the degree of possessing primary and secondary characteristics of accounting information for each evaluating method. 7. research variables 7.1 dependant variable the dependant variable of this research is the investment decisionmaking. the concept of decision making is selection of shares of a company among shares of some different companies on the basis of financial statements information. 7.2 independent variables 7.2.1 the presentation of hra information this variable was measured through the presentation of financial statements of two hypothetical companies working in the same industry, the same size and are equal in the number of ordinary shares with equal prices. 7.2.2 background and experience of individuals age, degree of education, number of years of business experience, the type of occupation, experience of evaluating stocks, number of years of managerial experience, the number of studied articles & participated seminars relating to hra, number of personal stock transactions, number of courses completed in accounting and finance. 7.2.3 the individuals' personal viewpoints about hra asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa this variable measured by 11 questions about hra as follows: 1) companies that disclose more hr information, transaction their shares will be done more easily. 2) if the corporations disclose higher hr information in annual reports, the optimal investment decisions will increase by users' groups. 3) hra information reporting will be good marketing to recruit good people. 4) hra information reporting will help investors for performance measurement of managers and entire business unit. 5) if companies disclose hra information properly, the employees will be sure are supported by the company. 6) although the organizations can indicate the employees as asset in balance sheet, they are not owners of the persons. 7) evaluation of human resources leads to behavioral reaction as asset which marks efficiency of the organizations problematic. 8) real status of human resources is evaluated better through discussion with managers until financial statements are referred in this regard. 9) in case of evaluation of internal human resources, it is not necessary to evaluate external human resources such as goodwill resulting from presence of the customers. 10) decreasing or increasing in investment on human resources is disclosed through their submission in the financial statements in better way. 11) presentation of human resources value in financial statements is contrary the generally accepted accounting principles. 7.2.4 the most appropriate evaluating method of human resource in this section questions related to the selection of the most appropriate method of applicability have been designed based on theory of accounting measurement. these methods include historical cost, replacement cost, opportunity cost, stochastic method with rewards, estimated feature cost and estimated feature benefits. qualitative characteristics include objectivity, reliability, relevancy, punctuality, impartiality, cost-effectiveness, adaptability with the current systems of accounting. 8. hypotheses testing and findings of the research with regard to the questions mentioned in the questionnaires and based on the results of the information analysis, the research findings can be summarized as follows: 8.1 hypothesis 1 as said before, we have used two questionnaires related to the balance sheet and income statement of two hypothetical companies before and after provision of hra information to asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa survey of the first hypothesis. after examination, mean, standard deviation and standard error of allocated amount of each hypothetical company (a & b) is summarized in the table 1 & 2. table 1. first behavior: mean amount allocated in company a & b )percentage % st. error st. deviation mean company 83.2 % 63765.2 724564 8,435,130 a 16.8 % 63765.2 724564 41,564,870 b table 2. second behavior: mean amount allocated in company a & b )percentage % st. error st. deviation mean company 70.9% 63765.2 724564 35,456.118 a 29.1 % 63765.2 724564 14,543,882 b as per table 1 the mean amount allocated in company a was rls. 8,435,130 in first behavior and rls. 35,456.118 in second behavior. furthermore, the mean amount allocated in company b was rls. 41,564,870 in first behavior and rls.14,543,882 in second behavior. in addition, to examine the first hypothesis of this study, t-test was used. as shown in table 3, the criticalt value is equal to 2.864 and calculated-t value is equal to 16.425 that can be concluded the calculated-t is more than critical-t and it is placed in the h1 area. so, the first hypothesis is confirmed and we can say the hra information has impact on decision-making to traditional accounting information, table 3. decision-making based on hra between 2 groups sig. degree of freedom t calculated t critical value 0.032 161 16.425 2.864 8.2 hypothesis 2 the second hypothesis of this study to survey individuals' background and experience and the impact of hra information on the investors' decision-making. this hypothesis was examined by using the f-test. the results of the hypothesis test indicate that the critical-f value with degree of freedom 9 and 152 and the alpha level of 5% is equal to 1.98. with regard to that the calculated-f value is equal to 69.7 %, so, we can conclude that the calculated f is placed in the h0 area and it is less than critical-f value. therefore, the second hypothesis is rejected. table 4 shows the result briefly. table 4. the impact of background and experience on decision-making) critical f calculated f degree of freedom resource 1.98 0.6971 9 regression 152 residuals the correlation coefficient between the difference score and age was 0.348 and the correlation between the difference score and experience was 0.636. both correlations were asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa significantly different from zero at the 0.05 level. the correlation between age and business experience was 0.821. because the difference score was related to both age and experience and because age and experience were highly correlated, two partial correlations were computed. first, a low partial correlation of 0.098 was calculated for the difference score and age, controlling for experience. second, a partial correlation of0.286 was computed for the difference score and experience, controlling for age. this coefficient was significant at the 0.05 level. the two partial correlations indicate that experience rather than age is more important in explaining variation in the dependent variable, the difference score. thus, the business experience may be a possible cause of decision differences when hra information is added to traditional accounting information. 8.3 hypothesis 3 the third hypothesis of the study to examine the relationship between individuals' personal viewpoints and the impact of hra information on decision-making. chi-square test was used to examine this hypothesis. as shown in the table 4 the critical value of chisquare with 10 degree of freedom in alpha level 0.05 is equal to 11.63. calculated chi-square value is equal to 39.48 and we can conclude that the calculated chi-square is more than critical value of chi-square and it is placed in h1 area, so the third hypothesis is accepted. the results are summarized in table 5. table 5. the impact of individuals' viewpoints on decision-making) sig. degree of freedom calculated chi-square critical chi-square 0.026 10 39.48 11.63 furthermore, to test hypothesis 3, the difference score was correlated with the responses to each of the eleven hra viewpoints. the correlation coefficients and level of significance of each using a one-tailed test are shown in table 6. the results of correlations between difference score individuals' personal viewpoints about hra as follows: table 6. correlation coefficient (r) questions n correlation coefficient (r) sig. 1 162 0.50 0.020 2 162 -0.65 0.030 3 162 0.41 0.328 4 162 -0.21 0.087 5 162 0.59 0.123 6 162 -0.34 0.046 7 162 0.66 0.456 8 162 0.38 0.034 9 162 -0.66 0.031 10 162 0.73 0.025 11 162 0.17 0.427 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa 8.4 hypothesis 4 the fourth hypothesis of the study examined that the most appropriate method for assessing of hra information based on qualitative characteristics. to examine this hypothesis was used compare means test. the results of questionnaire analysis indicate that there is significant difference among evaluation methods of hr in terms of applicable statistically. furthermore, the results state that historical cost method has more consistent with qualitative characteristics of accounting information in the iranian context. so, the fourth hypothesis is confirmed. the results survey of six evaluation methods of hra as follows: table 7. compare between evaluation methods of hr estimated future benefit estimated future cost stochastic rewards opportunity cost replacement cost historical cost evaluation methods 1.4244 2.1460 1.1323 1.8789 2.1222 2.4553 means 9. conclusion with considering to the results of the study, lack of hra information disclosure in financial statements and notes of financial statements will lead to obliquity of users. as study results show, the use of hra information in financial statements has incremental impact on individuals' decision-making process in order to stock investment statistically. hra information can play a crucial role in internal managerial decision-making, and its measures can be used to show that investments in a company's human resources may result in long-term profit for the company. there are several studies, which have found a significant association between hra information and decision-making. the major findings of the study confirm results of herman & mitchell (2008), flamholtz et al. (2003), pekin ogan (1988), chris dawson (1994), flamholtz (2004), lev & schwartz (1971), elias (1972), hendricks (1976). furthermore, the results indicate that background and experience of individuals' variables no has impact on decision-making based on hra information. in the researcher's opinion one of the factors causing this difference could be due to different cultures. other results states that there is significant relationship between the individuals' viewpoints about the evaluation of human resources and the impact of hra information on the investment decisions. so, we can state that hra is relevant and accountants can clarify it in management accounting information and disclose in notes of financial statements or they can provide it in financial statement (such as balance sheet or income statement) in order to better understanding. the last discussion of the paper had examined the most appropriate of evaluation method of hr based on viewpoints of experts and by using qualitative characteristics of accounting information. results of the survey indicate that historical cost method, also called the original cost, is the most applicable method in current status of iranian companies. in this method human resource cost (hrc) includes the acquiring, recruit, training and development costs. this method has greater acceptability by tax agencies and it is more common than other methods in the accounting operations of assessment assets. concerning the findings asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e14 www.macrothink.org/ajfa mentioned abovewe found that the inclusion of hra data in published financial statements resulted in, one, significantly different ratings of analysts’ preparedness to meet future challenges and opportunities in iranian context and, two, statistically different evaluating of a firm's position in terms of external users. references american accounting association. 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(2009). human resource development: theory and practice. ane books pvt.ltd, pp 470-480. microsoft word 4533-16740-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 329 internationalization and capital structure: evidence from malaysian manufacturing firms mohamed albaity, phd (corresponding author) department of banking and finance faculty of business and accountancy university of malaya malaysia email: m_baity@um.edu.my arison ho sel chuan faculty of business and accountancy university of malaya malaysia received: nov. 10, 2013 accepted: december 16, 2013 published: december 16, 2013 doi:10.5296/ajfa.v5i2.4533 url: http://dx.doi.org/10.5296/ajfa.v5i2.4533 abstract this paper attempts to examine the determinants of capital structure for internationalized manufacturing firms that are listed on bursa malaysia. firm-related characteristic variables namely internationalization, firm size, profitability, company growth and tangibility over period 2007-2011 are tested their relationship with debt ratio of firms by using panel data fixed effects model. the results showed that firm size and tangibility are significantly positively related with debt ratio while internationalization, profitability and company growth are significantly inversely related with debt ratio. the findings indicate that the static trade-off theory, pecking-order theory and agency theory are pertinent in malaysia situation. keywords: internationalization, capital structure, panel data, profitability, malaysia, manufacturing firms asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 330 introduction in view of the cost and risk involved in debt and equity financing respectively, it is crucial for the managers to choose a suitable capital structure policy for their company, as the financial leverage is one of important factors that will impact the performance of the company. some empirical studies in malaysia (suto, 2003) showed that the capital structure of the firm is negatively related to the performance of companies in different industries in malaysia. these results imply to us that proper management of the capital structure will generate better returns to the company. therefore, it will be valuable to managers to know the factors that may impact the capital structure of a firm so that they can control the determinants of the capital structure to maximize firm’s profit. however, the previous studies about capital structure still focus on the relationship of firm-related characteristics on capital structure. many studies have provided empirical evidence that firm-related characteristics such as profitability, tangibility, firm growth, firm size and etc. are important determinants on capital structure (booth et al, 2001 and ooi, 1999). even though studies have found these characteristics to have significant effects on a firm’s capital structure, they explain only a small portion of across-firm variations. other, yet unidentified, factors apparently are at play. one area that remains unexplored is the effect of strategic variables on capital structure (harris and raviv, 1991). international diversification plays a key role in the strategic behavior of large firms (hitt et al 1994) and is important in improving the financial performance of multinational firms (hull and lee, 1999). internationalization has also been shown to be an important determinant of capital structure (burgman, 1996). with the globalization and liberalization of economy, many firms choose to invest oversea. the purposes of going abroad are to capture new markets, achieve economy of scales by selling existing products to new customers, spreading the business risk or political risk from one sole country to other safer countries and gaining new technological know-how and management skills if firms from emerging countries invest in developed countries. therefore, internationalization seems to be one strategic movement for the firms to maximize its value. furthermore, many studies regarding capital structure of internationalized firms are mainly focused on developed countries like united kingdom and united states, while evidence in developing countries like malaysia is very little (hitt et al. 1997 and thomas and eden, 2004). the recent financial crisis had a very big impact on the firms in malaysia. manufacturing sector suffers the most in the financial crisis. during the peak of the financial crisis, malaysia’s export decreased by 27.7 % in january 2009 and it was the biggest reduction in the country history since year 1982 (malaysia’s external trade statistics, january 2009). malaysia is an export-based country. most of the manufactured products are exported oversea. therefore, manufacturing sector plays an important role in malaysia’s economy. during this financial crisis, many manufacturing companies lost their assets and their share value depreciated. some companies have undergone capital restructuring. and unlucky ones even ran into bankruptcy. rationale of the study malaysia has introduced the third industrial plan (imp3) in 2006. imp3 starting from 2006 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 331 to 2020 focuses on policies and strategies that help realizes the vision 2020 which is for malaysia to become a developed country. the plan leverages upon the strengths and capabilities of manufacturing sector to enhance its competitiveness and resilience in the global platform. with exercise of several free trade agreements (ftas) with asean, china and japan, reduction of tariff will potentially create better and bigger regional markets that favor and attract the malaysian manufacturing firms to penetrate into that new markets. firms may need to extra fund to run their international diversification. however, the potential benefits come along with the challenges from the competitiveness of other ftas member countries. firms with weak management in international investment may encounter failure and result in difficulties in debt repayment. thus, this study with the most recent data of the internationalized firms in manufacturing sector will be able to test and confirm the determinants of these firms’ capital structure and the findings might provide the managers in the relevant sectors who wish to employ international diversification strategies with valuable insights in capital structure decisions making process. therefore this study is focused on examining the determinants influencing the capital structure of public listed manufacturing firms in malaysia as well as to investigate the influence of internationalization on the leverage of public listed manufacturing firms in malaysia. the rest of this paper is organized as follows: next section is literature review which summarizes the determinants of capital structure and internationalization strategy empirical studies. section three focuses on the methodology used, hypotheses and variables of the study. the results and analysis of this study is discussed in section four. lastly, part five concludes the study also highlight areas for future study. literature review despite the many researches done, there is a surprising lack of consensus even about many basic empirical facts, such as the determinants of capital structure. thus, as was the case with leverage measures, there also exist problems of finding, defining and measuring the determinants of capital structure. as harris and raviv (1991) showed in their review article, the motives and circumstances that could determine capital structure choices seem nearly uncountable. generally, the factors that determine capital structure choices observed in the previous study can be categorized into macroeconomic factors such as profitability and firm size, industry specific factors, management control factors and legal factors. booth et al (2001) investigated the relationship between debt measures and a set of independent macroeconomic variables, firm specific and institutional variables. some interesting generalizations emerge from the regression results. the findings indicate that the three proxies used for debt were negatively related to market capitalization and long-term market while gdp and liabilities were positively related to debt. the high growth rate and high inflation have opposite effect on book to market ratio. in addition, the more developed the equity market is the lower the appetite of firms for debt financing. similarly, the highly developed the debt market the higher the level of debts. furthermore, higher taxes lead to higher debt ratio in the countries under study. ooi (1999) examined the capital structure determinants of 83 property companies in uk asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 332 growth rate, profitability, and tax rate were statistically insignificant. the result indicates that firms with higher tangible assets employ higher debt. in addition, property companies with high property developments tend to be highly leveraged. firm size was found to be negatively related to debt. property firms substitute debt financing with equity financing when stock market is performing well and the opposite is true. on the other hand, panno (2003) examined whether capital structure theories from the developed market are applicable to kenyan firms. using several variables to study these firms found the following. debt ratio was negatively related to size and profitability but was positively related to tangible asset. debt ratio relationship with age depends on the proxy used for age however the result were not statistically significant. the most important variable in explaining debt levels were profitability, asset structure and size. mohd, perry and rimbey (1998) examine the effect of the agency costs and ownership concentration on the capital structure of the firm. using several variables for the period from 1972 to 1989 the findings are as follow. they found negative relationship between institutional and the level of debt. this result accompanied with no significant effect from outside shareholders on the level of debt lead to the conclusion that institutional investor act as a monitoring authority on the firm. some of the studies that have been conducted in malaysia on the subject of capital structure are studies by mohamad (1995) and kester and mansor (1994). kester and mansor (1994) conducted a survey among the chief executive officers of companies that are listed on bursa malaysia in order to find out their view on capital structure policy. though the majority of executives in malaysia expressed a preference for similar financing hierarchy as us companies, the results of the survey reveal that they ranked new ordinary shares through right issues ahead of debt. in view of the debt market development in malaysia, the result may not be as surprising as the debt market in malaysia is still undeveloped internationalization chkir and cosset (2001) using us companies examined the relationship between multinational companies capital structure. they found that the level of debt acquired by these firms increase as diversification of risk increases. similarly, kwok and reeb (2000) using “upstream-downstream” hypothesis, which indicate the level of risk exposure by going international, studied the relationship between level of diversification and the level of debt. using data from 32 countries they found that diversification is negatively related to the level of debt in developed markets. however they found that international diversification is positively related to leverage financing in emerging markets. in concluding they indicate that firms in emerging markets reduce risk by going overseas (upstream), while in developed markets firms increase risk by going international (downstream). on other hand, low and chen (2004) using the same “upstream-downstream” hypothesis on asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 333 232 firms in 30 countries confirm the results by kwok and reeb (2000) for the us firms. however, they obtained insignificant results between diversification and leverage for the other markets. thomas (2006) using mexican data studied the relationship between company performance and international diversification. he found that firms experienced negative relationship due to their newness in the international market however, with time the relationship was reversed. these firms managed to exploit the international diversification and earned higher returns. this is relevant to emerging market since most of them are inexperienced in the global market and going to be exposed to new environment. therefore firms from the emerging markets will be able to increase their performance with time. aggarwal and kyaw (2010) used data from almost 4000 firms for 10 years to study the relationship between international diversification and firm performance measured by dividend payout ratio. the findings indicate that firms exposed to international markets have lower level of debt than domestic firms while the international firm’s payout is higher than domestic firms. they indicate that international diversification helps firms reduce their risk and level of debt and increase their payout. similarly, in confirming aggarwal and kyaw (2010) lin and hung (2012) compared the capital structure of electronic firms for domestic as well as international firms in taiwan for 10 years. they found those leverage and dividend payouts are negatively related for international firms while the opposite is true for domestic firms. following the study of singh et al (2003), thomas (2006), kwok and ramirez (2010) and aggarwal and kyaw (2010), the proxy used for internationalization here is the foreign sales over total sales ratio in all malaysian manufacturing firms. data and methodology secondary data will be used to measure the debt ratio and the determinants of capital structure. all the data are collected from database datastream5 and bloomberg for the companies listed in bursa malaysia under manufacturing sectors. the criteria for the companies are as follow. first, the companies must contain complete financial information for the period 5 years (2007-2011). second, the companies must have debt financing in their capital structure. third, the companies must have positive equity because a negative market-to-book equity ratio would not be meaningful to indicate a company’s growth opportunity. after eliminating the outliers, the final sample size is 311 companies with a total of 1486 observations. hypothesis development capital structure, which is defined as total debt to total assets at book value. in this study, our dependent variable capital structure will be measured by total debt over total assets ratio. we use this measure because it provides information to a firm’s policy for both short-term and long term debt. international diversification leads to a lower volatility of earnings as the mnc has cash flows asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 334 in imperfectly correlated markets. this leads to a reduction in bankruptcy risk and enables the mnc to utilize more leverage in its capital structure (shapiro, 1992). thus, the diversification hypothesis predicts a positive relationship between international diversification and financial leverage. empirical evidence, however, is inconsistent with this assumption. burgman (1996) and chen et al. (1997) find a negative relationship between international diversification and leverage. one possible explanation for this is that “the effect of higher agency costs of debt for mncs, as a result of international capital and labor market imperfections and complexity of international operations exceeds the possible benefits of international diversification and leads to lower debt ratios for mncs” (chkir and cosset, 2001). kwok and reeb (2000) propose that the relationship between international diversification and capital structure is dependent on the relative risk of the mnc home country and target country. according to this hypothesis, the capital structure of mncs can differ between developed countries based and emerging countries based firms. they provide empirical evidence that international diversification is negatively related to leverage for us based firms and positively related to leverage for emerging market-based firms. based on isa (international standard of accounting) and gaap (generally accepted accounting principles), frequently the amount of at least 10 percent foreign sales mentioned as a base for effective internationalization. hence, all the malaysian manufacturing firms that have equal or more than 10 percent foreign sales are considered as internationalized firms (dummy =1 ), while the malaysian manufacturing firms with less than 10 percent foreign sales are domestic firms (dummy = 0). h1: internationalization is negatively related to debt ratio size is considered to be the first important characteristic of firm. the trade-off theory proposes that the larger a firm is, more needs have to be diversified and this is the reason for it to apply more leverage in its capital structure. this theory also proposes that larger firms can reduce bankruptcy costs by diversifying their businesses. therefore, it can be said that there is a positive relationship between the size of firm and leverage. many empirical studies have shown a mixed result. for example, rajan and zingales (1995) reported a positive relationship between firm’s size and leverage in the us, uk, japan and canada, while the result of their study in france show a negative relationship. thus, we hypothesize that: h2: firm size is positively related to debt ratio. profitability is considered as another important characteristic of firms that can affect capital structure. based on the pecking order theory, companies prefer to be financed by their internal resources. retained earnings are the first option, then debt is considered as the next option and finally the new equity will be the last resort. as a result, firms with high level of profitability should have the low level of debt. therefore, according to the pecking order theory, there is a negative relationship between profitability and leverage. in contrast, the trade-off theory depicts a positive relationship between profitability and leverage because the theory states that profitable companies can use more debt to take advantages of the tax-shield. empirical evidences from previous studies seem to be in line with the pecking order theory. the results of most studies show negative relationship between profitability and asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 335 leverage. for instance, the results of studies by cassar and holmes (2003) affirm a negative relationship between profitability and leverage. however, the finding of petersen and rajan (1994) is inconsistent with pecking-order theory because they reported a positive relationship between profitability and leverage. from the perspective of pecking-order theory, larger firms tend to internalize their retained earnings first for further investment rather than borrowing. thus, we hypothesize that: h3: profitability is negatively related to debt ratio higher growth leads to more investments opportunities which increase the cost of borrowing which leads to internalized funds rather than debt. moreover, firms experiencing high growth rates prefer not to increase its level of debt because their cash flow might not sustain servicing the debt when needed. for this reason, the relationship between company growth rate and borrowing should be negative. growth is defined as the market-to-book ratio. thus, we hypothesize that: h4: company growth is negatively related to debt ratio bevean and danbolt (2001) showed that tangibility is positively correlated to total and long-term debt ratios respectively but inversely related to short-term debt ratio. from a trade-off perspective, firms with a lot of fixed assets find it easier to issue bonds or get loan from banks because the fixed assets of the company will be able to serve as collateral for the borrowing and reduces the default risk for the lenders. under the pecking-order theory, the greater the value of the tangible assets, the smaller the asymmetric information, therefore, it is expected that the collateral value might be positively related to the debt ratio. many previous empirical studies supported this hypothesis. for instance, rajan and zingales (1995) supported this hypothesis in industrialized countries. suto (2003) also supported this hypothesis in malaysia. thus, we hypothesize that: h5: tangibility is positively related to debt ratio. testing the earlier hypothesis is done using the following model dratioi,t = β0 + β1 intli,t + β2 sizei,t + β3 profiti,t + β4 growthi,t + β5 tangi,t + εi,t where dratio represents debt ratio, intl represents internationalization, size represents firm size, profit represents profitability, growth represents company growth and tang represents tangibility. β0 is constant, β1, β2, β3, β4, and β5 are coefficients of the independent variables, i is the cross section identifier, t is the time identifier and ε represents error term. results and findings this section presents the results and finding of the research. the research attempts to explain the determinants of capital structure of internationalized firms in manufacturing sector that are listed in bursa malaysia over the 2007-2011 period. this study employed cross sectional panel data. we used pooled ordinary least squares (ols) regression to estimate the coefficient of the independent variables and the fixed effect model approach to examine the effect of independent variables on debt ratio on the basis of cross sectional variation. the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 336 results of the relationship between debt ratios with the independent variables namely internationalization, firm size, profitability, company growth and tangibility are as follows. table 1.1 summary of descriptive statistics dratio growth intl profit size tang mean 0.228 1.087 0.254 0.0472 12.23 0.354 median 0.202 0.78 0.134 0.058 12.099 0.344 std. dev. 0.185 1.358 0.298 0.134 1.270 0.180 skewness 1.710 7.527 0.995 -5.463 0.626 0.290 kurtosis 13.69 88.57 2.815 79.24 3.829 2.825 table 1.1 demonstrates the descriptive findings for both dependent and independent variables. it can be seen that on average the manufacturing firms in malaysia have 22.8 percent of debt in their capital structure. this indicates that malaysian manufacturing firms employ very low level of debt in their capital structure. besides, tangible or fixed assets account 35.4 percent on average in the firms’ total assets. in term of internationalization, on average the manufacturing firms in malaysia establish stable international diversification by achieving 25.4 percent of foreign sale over their total sale. this confirms that malaysia is an export-based nation and manufacturing firms contributed most major role in malaysia’s export. table 1.2 correlation matrix dratio growth intl profit size tang dratio 1 growth -0.10365 1 intl -0.06997 -0.00203 1 profit -0.16267 0.22334 -0.06191 1 size 0.146603 0.153085 -0.05992 0.294231 1 tang 0.22406 -0.06053 -0.04501 -0.04459 0.02162 1 table 1.2 presents the correlation matrix for the sample companies. it shows that company growth and profitability have negative correlation with debt ratio. the negative correlation between debt ratio and profitability affirms the pecking-order theory that firms tend to internalize retained earnings first for further investment and debt financing would serve as second option. company growth has negative correlation with tangible assets and debt ratio. this implies that when the firms’ growth increases, they do not favor in investing in tangible assets but tend to invest in riskier intangible projects. this increases the cost of borrowing and default risk for the debtors, thus results in lower level of debt ratio. the most striking finding in this correlation matrix is that internationalization has negative correlation with the major firm characteristics namely company growth, profitability, firm size, tangibility and debt ratio. although malaysia is an export-based country but the recent financial crisis has damaged the manufacturing sector harshly. firms that have foreign operation or business suffer shrink in term of profitability, growth and firm size from this financial crisis. from asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 337 another perspective, this also indicates that malaysian manufacturing firms encounter huge competitiveness from other rivalry countries in the global platform. the competition is predicted to be more aggressive when the ftas are implemented fully in future. table 1.3 multiple regression results pooled regression fixed effect regression variables coefficient tstatistic prob coefficient tstatistic prob intl -0.013 -3.28 0.00 -0.025 -2.42 0.01 growth -0.011 -3.21 0.00 -0.012 -2.29 0.02 profit -0.273 -4.05 0.00 -0.086 -2.91 0.00 size 0.031 26.02 0.00 0.031 2.28 0.02 tang 0.209 11.42 0.00 0.137 2.54 0.01 c -0.195 -8.61 0.00 -0.167 -0.93 0.35 r2 0.12 0.79 hausman test (χ2) 20.57* adj r2 0.12 0.75 f-statistic 39.95 14.80* * significant at 1%. white cross-section standard errors & covariance was used table 1.3 summarizes the comparison of multiple regression results between pooled ols model and fixed effects model. both models confirm and support all the research hypotheses significantly at 0.05 level. however, the r-squared value (r2 = 0.79) under fixed effects model is much higher than the value of r-squared (r2=0.12) under pooled ols. the hausman test with its associated probability (p=0.001) also reveals that the results under fixed effects model have better explanatory power compared to results under pooled ols. discussion and conclusion internationalization empirical results show that research hypothesis 1 is supported, thus, internationalization is negatively related to the debt ratio. the findings are consistent with the studies done by burgman (1996), low and chen (2004), aggarwal and kyaw (2010) and lin and hung (2012). burgman (1996) and low and chen (2004) investigated and revealed that the negative relationship between internationalization and debt ratio is mainly attributed to us firms. according to “upstream-downstream” hypothesis (kwok and reeb, 2000), firms from developed countries increase their risk when they go abroad (downstreamthey go to riskier markets) and this leads to a lower debt capacity. meanwhile, the leverage of firms from emerging markets increases when they could spread the risk by going international (upstreamthey go to safer markets). however, the “upstream-downstream” hypothesis cannot fit well in malaysia situation since malaysia is an emerging country. the negative relationship in this study can be explained through pecking-order theory. firms from emerging countries can achieve economies of scale, access to new market and spread the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 338 business risk when they pursue strategy of international diversification. given these advantages, internationalized firms have greatly increased their foreign sales and profitability. as pecking-order theory predicts, profitable firms would first internalize the retained earnings for future investment rather than borrowing debt. thus, leverage of these firms would decrease. it is supported by the studies by aggarwal and kyaw (2010) and lin and hung (2012) as their research results indicated that internationalized firms generate greater profitability and have lower debt ratio compared to domestic firms. the inverse relationship between internationalization and debt ratio is also consistent with the implications of agency theory. malaysia is an export-based country. most of the listed manufacturing firms enter foreign markets through exporting goods abroad. agency cost of debt increases when creditors often find themselves difficult to monitor the selling activities oversea due to the complexity of foreign operation. therefore, creditors become less willing to lend funds to the exporting firms. chen and yu (2011) presented findings that are consistent with this agency theory when their investigation showed that exporting firms have lower debt ratio meanwhile firms with fdi abroad have higher leverage. firm size the empirical findings supported research hypothesis 2, thus, firm size is positively related to the debt ratio. the findings are consistent with the studies of krishnan and moyer (1997), titman and wessels (1998), hall et al (2000), suto (2003) and sheikh and wang (2011). the result confirms the static trade-off theory that postulates larger firms should operate at higher leverage level in order to take the benefits of tax shield on debt interest payment. besides, a large and multi product company is more stable therefore the business risk is low compare to a small and single product company. as a result, the possibility to bankrupt for larger companies are low and they can sustain a higher level of debt. incidentally, large companies will be able to enjoy economies of scales in issuing long-term debt, and have a strong negotiating power with lenders. thus, larger firms tend to have higher debt ratio. profitability the empirical results supported the research hypothesis 3, thus, profitability is negatively related to the debt ratio. the findings are in line with studies by ross (1977), rajan and zingales (1998), suto (2003), panno (2003), chen (2004), chakraborty (2010), chen and yu (2011) and sheikh and wang (2011). the results are as expected by the pecking-order theory. according to pecking-order theory, managers will prefer internally generated funds to external financing when they cannot credibly convey inside information to outsiders. first, managers will choose internal finance. secondly, managers will choose to borrow when their investment cannot be met by internal finance. the managers will only issue the equity as the least preferred choice when the options of borrowing were exhausted. furthermore, as mentioned earlier, debt financing is obligated to a fixed interest payment regardless of the company’s performance. thus, in the short run, profitability is negatively correlated with leverage. company growth the empirical results supported the research hypothesis 4, thus, company growth is negatively related to the debt ratio. the findings are consistent with studies of titman and asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 339 wessels (1998) and eldomiaty (2008). the inverse relationship between company growth and debt ratio is in line with assumptions of agency theory. most often, higher growth opportunities provide incentives to invest. the high investment increases the cost of borrowing and lead to smaller pool of debt funds. thus, growth firms tend to use internalized funds or equity rather than debt. moreover, firms experiencing high growth rates prefer not to increase its level of debt because their cash flow might not sustain servicing the debt when needed. tangibility the empirical results supported the research hypothesis 5, thus, tangibility is positively related to the debt ratio. the findings are in line with many previous studies such as rajan and zingales (1995), bevean and danbolt (2001), suto (2003), pandey (2007) and chakraborty (2010). the positive relationship between tangibility and debt ratio can be explained by the static trade-off theory and pecking-order theory. from a static trade-off perspective, firms with a lot of fixed assets find it easier to issue bonds or get loan from banks because the fixed assets of the company will be able to serve as collateral for the borrowing and reduces the default risk for the lenders. under the pecking-order theory, the greater the value of the tangible assets, the smaller the asymmetric information, therefore, it is expected that the collateral value might be positively related to the debt ratio. conclusion and implications the empirical evidence from this study showed that internationalized manufacturing firms have lower debt ratio than the domestic manufacturing firms. this documented important implications to the internationalized firm managers, policy makers, investors and academic researchers who are interested in international finance. for example, the internationalized firm managers and policy makers should encourage the company to engage on international diversification. according to pecking-order theory, companies that pursue international diversification can spread the business risk from one solely market to other regional markets. besides, the results of this study showed that internationalized firms are likely to have lower leverage. thus, the firms are considered less risky as the firms do not much obligation in paying the debt interest payment. this is even risk-reducing as the firms are less borne to the bankruptcy costs when facing financial crisis. in the view of equity investors, the stock of internationalized firms is preferred than the stock of domestic firms. as explained above, internationalized firms have lower debt; the reduced bankruptcy costs and less debt interest payment obligation make the firms less risky and more financially stable. vice versa, the debt investors should invest by lending the fund in the domestic firms. the agency problem such as monitoring costs can be mitigated as the debt investors can assess these domestic firms without extra monitoring costs compared to internationalized firms. therefore, this study portrayed the consistent results that domestic firms have higher debt ratio. future research may extend this study in more details by adopting more independent variables. it is suggested to include other definitions of capital structure such as short-term debt ratio and long-term debt ratio. the decomposition of capital structure can give clearer insights in the relationships of the determinants with the capital structure. besides, financial data should asian 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(1997). bankruptcy cost: some evidence. journal of finance, 32(2), 337-347. http://dx.doi.org/10.2307/2326766 microsoft word 1579-6365-2-rv-writer3-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 75 the percent-change extension to the dupont identity david eagle dept. of management, eastern washington university 668 n. riverpoint blvd., spokane, wa 99202-1677, usa tel: 1-509-828-1229 e-mail: deagle@ewu.edu arsen djatej (corresponding author) dept. of accounting information systems, eastern washington university 668 n. riverpoint blvd., spokane, wa 99202-1677, usa tel: 1-509-828-1250 e-mail: adjatej@ewu.edu received: april 1, 2012 accepted: july 23, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1579 url: http://dx.doi.org/10.5296/ajfa.v4i2.1579 abstract from the dupont identity, this paper derives a formula relating the percent changes in the return on equity (roe) to the percent changes in the dupont components. this formula is useful in determining the primary reasons why the roe changed from one period to the next. while the periodic percent change relationship is nonlinear, a simple and intuitive additive formula is an approximation, albeit at times a poor approximation. we also convert the periodic percent changes in the roe and its dupont components into their equivalent instantaneous rates of change. these instantaneous rates of changes in the dupont components do precisely sum to the instantaneous rate of change in the roe, providing a method for analysts to both intuitively and accurately present their analysis. keywords: dupont identity, time-series analysis, return on equity asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 76 1. introduction the dupont identity is a widely cited and extensively used relationship between the return on equity (roe), the profit margin (pm), the total asset turnover rate (tat), and the equity multiplier (em). sometimes analysts use the dupont identity to compare and interpret differences in these ratios among different firms (i.e., cross-sectional analysis). analysts also at times use the dupont identity to analyze and interpret the changes of these ratios for a particular firm over time (i.e., time-series analysis). the existing literature on the dupont identity includes various extensions to the dupont identity that enhance the information revealed for cross-sectional analysis. however, we found no literature that improves the dupont identity’s use for time-series analysis. to help facilitate the “time-series” type of comparisons, we extend the dupont identity to a relationship which relates the rate of change in the roe to the rate of change in each of its components. the new relationship should be more useful than the dupont identity itself to explain why the roe changes from one time period to the next. this paper presents both the theoretical relationship and a simple additive approximation between the percent changes in the dupont identity components and the percent change in the roe. many analysts and their audiences will find the simplicity of the additive approximation more intuitive than the exact theoretical relationship. however, at times the impreciseness of the approximation can lead to incorrect results. to enable analysts to maintain precision while using the intuitively-appealing simple sum, we convert the periodic percent changes of the dupont components to equivalent instantaneous percent changes. the sum of these instantaneous percent changes in the components does exactly equal the instantaneous percent change in the roe. while some may find the formulas for the instantaneous percent changes daunting, we present them in a computer spreadsheet which enables analysts to quickly and easily make the conversions. the next section presents a short literature review of the dupont identity. section 3 then presents and explains our extension to the dupont identity. while this extension has a simple and intuitive additive approximation, that approximation can at time be misleading. section 4 shows how we can convert the periodical rates of change to equivalent instantaneous rates of change where these instantaneous rates do exactly sum to instantaneous the rate of change in the roe. 2. literature review instead of “dupont identity,” the literature sometimes uses the labels “dupont equation,” “dupont analysis,” or “dupont model.” several articles in the literature use the definition of dupont identity in their analysis. for example, van voorhis et al. (1981) discuss how the dupont identity can be useful to small businesses. mishra et al. (2008) apply the dupont identity to the agricultural economy in the u.s. solliman (2007) empirically finds the information contained in the dupont identity’s components is useful in determining the value of firms; he also finds that changes in the dupont component ratios do have effects on investors’ valuation of the firm. dehning and stratopoulos (2002) empirically use the dupont component ratios to study information-technology firms to determine their comparative asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 77 advantages in terms of profitability and efficiency. blumenthal (1998) discusses the advantages and disadvantages of the dupont identity compared to other methods of analysis. other researchers utilize the dupont identity to supplement other methods of analysis. for example, feroz et al. (2003) do “data envelopment analysis” based on the dupont identity by converting the dupont component ratios to technical-efficiency equivalents. feroz et al. then empirically demonstrate that the data envelopment analysis does add informational value relative to just using the dupont ratios by themselves. other analysts have extended the dupont identity in various ways. these extensions break the dupont components down into subcomponents. bruns et al. (2008) extend the dupont identity to include the spreads between the return on net assets and the cost of debt to try to better deal with the effect of financial leverage. colin (1997) discusses how the profit margin can be further broken down into three subcomponents: (i) an operating profit margin, (ii) an interest factor, and (ii) a tax factor. callahan et al. (2007) is the most comprehensive discussion of the dupont identity and many of its extensions. while there have been several additions to the dupont identity for cross-sectional analysis, none of these extensions have improved the use of the dupont identity for time-series analysis. our paper fills this gap by providing what we refer to as a “growth-rate extension to the dupont identity.” 3. growth-rate extension to dupont identity the dupont identity as presented in parrino et al. (2012) is as follows where the t subscript represents the period for each variable: roet = pmt tatt emt (1) where roe sales incomenet  , pm sales incomenet  , tat assets sales , and em equiity assets . the equity multiplier (em) also equals one plus the debt-to-equity ratio. to convert the dupont identity to a relationship involving changes of these variables, define e, p, a, and m to be the growth rates in the roe, pm, tat, and em respectively. therefore, the following equations relate each variable at time t to its value at time t-1: roet = (1+e) roet-1 (2) pmt = (1+p) pmt-1 (3) tatt = (1+a) tatt-1 (4) emt = (1+m) emt-1 (5) equations (2), (3), (4), and (5) are standard application of growth rates where xt = (1+g) xt-1 where g is the growth rate of a generic variable x. also, note that this form is the same as for compound interest because the interest rate is the growth rate of the accumulated value on an account paying compound interest. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 78 if we substitute (2), (3), (4), and (5) into the dupont identity (1), we get: (1+e) roet-1 = (1+p) pmt-1 (1+a) tatt-1 (1+m) emt-1 by the associative law of multiplication, we can rearrange the terms to read: (1+e) roet-1 = (1+p) (1+a) (1+m) pmt-1 tatt-1 emt-1 since the dupont identity (1) applied to time t-1 states that roet-1 = pmt-1 tatt-1 emt-1., the term roet-1 exists on both sides of the equation. by dividing both sides by roet-1, we simply the above equation to the following: (1+e) = (1+p) (1+a) (1+m) (6) we call equation (6) the “growth rate version of the dupont identity.” a linear approximation to (6) that may be more intuitive for many is: e  p + a + m (7) while (7) may be more intuitive for some, (6) is the exact relationship; (7) is not exact.1 table 1. dupont identity example 1 time profit margin total asset turnover equity multiplier roe 2008 5.00% 1.2 2.2 13.20% 2009 5.50% 0.8 2.2 9.68% periodic % increase +10.00% -33.33% 0.00% -26.67% instantaneous % increase +9.53% -40.55% 0.00% -31.02% for an example to apply (6) and (7), assume the ratios presented in table 1. in this case between 2008 and 2009, the pm increased, but the tat decreased, while the em stayed the same. since an increase in the pm causes roe to increase and a decrease in the tat causes the roe to decrease, we have opposite pressures on the roe to change. equations (6) and (7) help explain why the roe decreased in this case. while the pm increased by 10%, the tat decreased by over 30%, which dominated the pm effect. for the reader’s information, we computed the growth rates in pm, tat, em, and roe as 1 equation (7) does hold with equality for instantaneous growth rates. however, if we apply (7) to periodic growth rates, then (7) only approximately holds. later in this paper, we show how one can convert the periodic growth rates to equivalent instantaneous growth rates where (7) holds exactly. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 79 follows: %00.10 %00.5 %00.5%50.5 1 1      t tt pm pmpm p %33.33 2.1 2.18.0 1 1      t tt tat tattat a %00.0 2.2 2.22.2 1 1      t tt em emem m %67.26 %20.13 %20.13%68.9 1 1      t tt roe roeroe e it is important to note that the above formulas are implied by equations (2), (3), (4), and (5). computing the percent increase in this manner is consistent with the concept of growth rate whereas other definitions of percent increase are not consistent with the concept of a growth rate.2 table 2. dupont identity example 2 time profit margin total asset turnover equity multiplier roe 2008 5.00% 0.90 1.2 5.40% 2009 4.50% 1.08 1.3 6.32% % increase -10.00% +20.00% +8.33% +17.00% instantaneous % increase -10.54% +18.23% +8.00% +15.70% if we apply the approximation (7), we would conclude that the roe decreased by approximately 23.33% (=10%-33.33%). however, if we apply (6), we get: %)67.261(7333.016667.010.1%)01(%)33.331(%)00.101(  2 for a generic variable x, a couple of other definitions of % increases are t tt x xx 1 and 2/)( 1 1     tt tt xx xx . (see financial times – lexiton, 2012). these are often used in computing returns. however, neither of these gives the true growth rate. hence, we argue that the true % increase is given by 1 1   t tt x xx . asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 80 which is consistent with the actual decrease in roe by 26.67%. table 2 presents a second example where all three components change, but in different directions. in this case, the approximation formula (7) indicates that the roe should increase by 18.33% (=-10.00%+20.00%+8.33%), whereas the precise increase in roe is 17.00%. to explain why the roe rose despite a 10% decrease in the profit margin, we note that the combined effect of the 20% and 8.33% respective increases in the tat and the em was greater than the 10% decrease in the profit margin. table 3. dupont identity example 3 time profit margin total asset turnover equity multiplier roe 2008 5.00% 0.90 1.3 5.85% 2009 4.85% 1.00 1.2 5.82% % increase -3.00% +11.11% -7.69% -0.51% instantaneous % increase -3.05% +10.54% -8.00% -0.51% next, consider the example in table 3. in this example, equation (7) results with a positive 0.42% approximate increase in roe, even though the roe actually decreased by 0.51%. while formula (6) precisely leads to the 0.51% roe, many would find a simple sum such as (7) to be more intuitive. in a later section, this paper provides a description of how to convert the periodical percent increases to equivalent instantaneous percent increases, so that (7) holds with equality. table 3 presents those instantaneous percentage increases for example 3. when we add those instantaneous percentage increases, -3.04%+10.53%-8.00%, we get the exact -0.51% change in the roe. table 4. dupont identity example 4 time profit margin total asset turnover equity multiplier roe 2008 10.00% 1.28 1.2 15.36% 2009 9.00 1.30 1.4 16.38% % increase -10.00% +1.56% +16.67% +6.64% instantaneous % increase -10.54% +1.55% +15.42% +6.43% table 4 presents an example where the growth rate formula (6) or its approximation (7) is more useful than the dupont identity itself for determining the real reason behind a roe increase. in this example, the roe increased by 6.64% between 2008 and 2009. under normal circumstances, we usually would consider an increase in the roe to be a good result. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 81 in this case, however, the pm decreased by 10%, the tat increased by 1.56%, and the equity multiplier (em) increased by 16.67%. we then conclude that the reason the roe increased was primarily related to the increase of the equity multiplier iby 16.67%. had the pm decreased by 10% and tat increased by 1.56%, with no change in the equity multiplier, then the roe would have decreased by an approximate 8.44% according to (7) or an exact 8.59% according to (6). the sharp increase in the equity multiplier is an indicator of increased leverage, an increase in the use of debt to fund the company. while increased debt does usually increase expected return, increased debt also increases risk (ross et al., 2006, pp. 538-40).3 one should not consider an increase in roe due to the increase in the equity multiplier (em) to be a good thing. a sharp analyst should note that the only positive development, a 1.56% increase in tat is quite small compared to the 10% decrease in the pm. as a result, despite the roe increasing, a good analyst would conclude that the fundamentals of the components indicate that the firm is doing worse in 2009 than it did in 2008. 4. converting periodic rates of change to instantaneous rates of change many analysts and especially their respective audiences will find the approximation formula (7) to be more intuitive than the exact relationship (6). for example, bremster (1995, p. 8) states that forensic accountants and forensic economists need “to present testimony in an understandable fashion for the jury.”4 however, bremster continues, the “opposing attorney’s goal is to diminish the jury’s confidence in the expert’s opinion.” as spizman and weinstein (2008) warn, the opposing attorney could diminish a forensic accountant’s or forensic economist’s testimony that used an approximation rather than the precise relationship by stating, “’i wonder what other little overestimating errors you have made?’” the ideal would be to present one’s results in a manner that is both understandable and precise. this section explains why (7) is only an approximation for periodic rates of change. we then find that (7) actually holds with equality when we deal with equivalent instantaneous rates of change instead of periodic rates of change. we then develop the equations for a computerized spreadsheet that analysts can use to convert periodic rates of change to their equivalent instantaneous rates of change. note that the extension (6) to the dupont identity applies to any equation where one variable equals other variables multiplied together. consider a simpler situation where z=xy where x, y, and z are three generic variables. then (1 + z) = (1 + x)(1 + y) (8) where z, x, and y are the annual percentage increases in variables z, x, and y, respectively. consider the specific situation where x = +30% and y = -30%. then (1+z) = (1+30%)(1-30%), which equals .91, which means that z = -9.1% or z declines by 9.1%. clearly, this 3 the widely-held view that increased leverage increases expected return does not take into account the real options. on the hand, according to guthrie (2011), the relationship may no longer be monotonic when the real option of abandoning projects is taken into account. 4 as waldrup et al. (2004, p. 1) note, the need for forensic accountants is more acute after the enron and other accounting scandals. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 82 exemplifies that z is not the sum of 30% and -30%. in particular, the 30% decrease had a larger impact than did the 30% increase. we can use instantaneous rates of changes as a way to show the differences of the impacts between the 30% increase and the 30% decrease. let x~ be the instantaneous rate of change that is equivalent to the periodic rate of change x. by equivalent, we mean that the effect over one period is the same, i.e., )~exp()1( xx  , where exp(.) is the exponential function.5 taking the natural logarithms of both sides gives: )1ln(~ xx  (9) equation (9) is how we convert a periodic rate of change to its equivalent instantaneous rate of change. applying (9) to the 30% increase gives %24.26)3.1ln(%)301ln(~ x . however, applying (9) to the 30% decrease gives %67.35)7.0ln(%)301ln(~ x . this demonstrates that the instantaneous rate of decline of the 30% drop is greater in absolute value than the instantaneous rate of increase corresponding to the 30% increase. this confirms our earlier statement that the 30% drop has a greater impact than the 30% increase. it turns out that converting the periodic rates of change to instantaneous rates of change will result in (7) holding precisely for the instantaneous rates of change. we do this conversion below by first repeating (6) and then replacing (1+e) with )~exp(e , (1+p) with )~exp( p , (1+g) with )~exp(g and (1+m) with )~exp(m : (1+e) = (1+p) (1+a) (1+m) (6) )~exp()~exp()~exp()~exp( mgpe  which can be simplified to: )~~~exp()~exp( mgpe  (10) taking the natural logarithm of both sides of (10) gives: mgpe ~~~~  (11) 5 it is well known that with an instantaneous interest rate r~ , the principal and interest at the end of a period equals the beginning principal times the factor )~exp(r . similarly, with an instantaneous growth rate x~ , the value of the variable at the end of the period equals the beginning value times the factor )~exp(x . asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 83 note that (11) is the same as (7) except that (11) holds with equality and (11) concerns the equivalent instantaneous rates of change rather than the periodic rates of change. in summary, by converting the periodic rates of change to their equivalent instantaneous rates, we then meet our objective of being able to discuss the relationship of these rates as a sum rather than using the less intuitive equation (6). furthermore, for those who find the conversion to equivalent instantaneous rates of change to be complicated, table 5 provides the formulas for a computerized spreadsheet that can easily make those conversions for the analyst. for examples using the equivalent instantaneous rates of change, see tables 1, 2, 3, and 4. in particular, for example 4, the instantaneous rates of change for the pm, tat, and em are -10.54%, +1.55%, and +15.42%. the sum of these equal 6.43%, which equals the equivalent instantaneous rate of change for roe. 5. conclusion previous academic inquiries has extended the dupont identity to reveal more information for cross-sectional analysis. this paper leads the effort to extend the dupont identity to better serve those who use the identity for time-series analysis. our research presents a growth rate extension to the dupont identity that enables one to determine precisely why the roe changes as it does by looking at the percentage increases or decreases in the pm, tat, and em. while we only extended the conventional presentation of the dupont identity to percent changes in its components, our extension methodology could also be applied to some more complex versions of the dupont identity that are described in the previous literature as long as the components are multiplied together. we encourage other researchers to pursue such applications of our methodology in future research. this paper presents an approximation formula (7) that will be more intuitive to many in the analyst’s audience than the precise equation (6) we derive. however, the imprecision of (7) could lead to some incorrect conclusions in some circumstances. also, in the case of expert testimony in front of a jury or a judge, forensic accountants and forensic economists need to present their analysis in a relatively intuitive approach, but also need to maintain precision to table 5. spreadsheet formulas for conversion to equivalent instantaneous % increases b c d e f 2 year roe pm tat em 3 2008 =d3*e3*f3 0.1 1.28 1.2 4 2009 =d4*e4*f4 0.09 1.3 1.4 5 gross % increase =c4/c3 =d4/d3 =e4/e3 =f4/f3 6 net % increase =c5-1 =d5-1 =e5-1 =f5-1 7 instantaneous % increase =exp(c5) =exp(d5) =exp(e5) =exp(f5) avoid being discredited by the opposing attorney. to meet both needs, we show how an asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 84 analyst can convert the periodic percent changes to their equivalent instantaneous percent changes so that these equivalent instantaneous percent changes do precisely add up to the instantaneous percent change in the return on equity. references blumenthal, r. g. (1998). tis the gift to be simple. cfo magazine (january issue), retrieved from http://www.cfo.com/article.cfm/2990236. bremster, w. (1995). forensic accounting and fraud. american management association, retrieved from http://www.flexstudy.com/catalog/schpdf.cfm?coursenum=95063 burns; d. c., sale, t. j., & stephan, j.a. (2008). a better way to gauge profitability: systematic ratio analysis using the advanced dupont model. journal of accountancy, 206(#2), 38-42. callahan, k. r., stetz, g. s., & brooks, l. m. (2007). project management accounting: budgeting, tracking, and reporting costs and profitability. hoboken, new jersey usa: john wiley & sons. colin, f. (1997). investment basics: xxxiv. the du pont identity. investment analysts journal, 44, 71-73. dehning, b., & stratopoulos, t. (2002). dupont analysis of an it-enabled competitive advantage. international journal of accounting information systems, 3, 165-176. http://dx.doi.org/10.1016/s1467-0895(02)00032-5 feroz, e. h., kim, s., & raab, r. l. (2003). financial statement analysis: a data envelopment analysis approach. journal of operational research society, 54, 48-58m. http://dx.doi.org/10.1057/palgrave.jors.2601475 financial times – lexiton. (2012). return on equity roe. retrieved march 20, 2012, from http://lexicon.ft.com/term?term=return-on-equity--roe firer, c. (1997). the du pont identity. investment analysts journal, 44, 71-73. guthrie, g. (2011). a note on operating leverage and expected rates of return. finance research letters, 8(2), 88–100. http://dx.doi.org/10.1016/j.frl.2010.10.004 mishra, a. k., harris, j. m., erickson, k., & hallahan, c. (2008). what drives agricultural profitability in the u.s.: application of the dupont expansion method. paper presented at the american agricultural economics association annual meeting, orlando, fl, july 27-29, 2008, retrieved march 15, 2012, from http://ageconsearch.umn.edu/bitstream/6413/2/sp08mi30.pdf parrino, r., kidwell, d., & bates t. (2012). fundamentals of corporate finance (2nd ed.). hobenken, nj usa: john wiley & sons ross, s., westerfield, r. w., & jordan, b. d. (2006). fundamentals of corporate finance (7th ed.). new york, ny usa:mcgraw-hill/irwin asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 85 soliman, m. t. (2007). the use of dupont analysis by market participants. retrieved from http://ssrn.com/abstract=1101981. spizman, l., & weinstein, m.a. (2008). a note on utilizing the geometric mean: when, why and how the forensic economist should employ the geometric mean. journal of legal economics, 15(1), 43-55. van voorhis, k. r. (1981). the dupont model revisited: a simplified application to small business. journal of small business management, 19(2), 45-51. waldrup, b., capriotti, k., & anderson, s.c. (2004). forensic accounting techniques: a defensible investigatory process for litigation purposes. journal of forensic accounting, 5, 1-16. copyright disclaimer copyright reserved by the authors. this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). compliance with the interim financial reporting standard in malaysia asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 53 the reliability of corporate quarterly financial reports in malaysia: post-masb 26 evidence ku nor izah ku ismail (corresponding author) college of business, university of utara malaysia 06010 sintok, kedah, malaysia tel: +604-9283906 e-mail: norizah@uum.edu.my shamsul nahar abdullah department of accounting and finance faculty of management and economics university of malaysia terengganu,21030 kuala terengganu, terengganu, malaysia tel: +609-6683137 e-mail: snahar@umt.edu.my abstract this study examines the reliability of the quarterly reports of malaysian listed companies after the malaysian accounting standard board (masb) issued a standard on interim reporting, masb 26 interim reporting in 2002. masb 26 requires companies to adopt the discrete method in reporting most of the transactions. in particular, this study focuses on the reporting of exceptional items (eis) in the quarterly reports, and is an extension of the study conducted in 2001 by ku ismail and chandler (2005). this paper argues that the reports are more likely to be reliable if the discrete method is practiced. if the discrete method is applied, companies are less likely to defer the reporting of eis to the final quarter, and thus, the incidence of eis in all the four quarters is equally likely (i.e. not being lumped in the fourth quarter as a tool to “settle-up”). an examination of the 2003 quarterly reports of 91 companies reveals that half of the incidence of eis is reported in the final quarter. the percentage is not significantly lower than those of the previous study. this indicates that masb 26 fails to enhance the reliability of the quarterly reports as far as the eis are concerned. in addition, this study indicates that the eis reported in the fourth quarter are more likely to be negative than positive. further, we find that companies that defer the recognition of eis are more likely to be those listed on the second board rather than on the main board of bursa malaysia. with the recent convergence of accounting standards whereby many countries have adopted frss in totality, including a standard on interim reporting, the present research findings act as a basis for similar research in other emerging economies. keywords: quarterly reports, masb 26, reliability of interim reports, earnings management, exceptional items. jel classification: m41 mailto:norizah@uum.edu.my mailto:norizah@uum.edu.my asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 54 1. introduction various stock exchanges around the world, including bursa malaysia (previously known as the kuala lumpur stock exchange) have required interim financial reporting to ensure users receive more timely information. interim financial reports help to reduce uncertainties, enhance investors‟ confidence, and improve users‟ decisions. in recent years, a number of stock exchanges have required more frequent reporting by imposing quarterly reports instead of half-yearly reports. a similar trend is also observed in malaysia with bursa malaysia having required all listed companies to issue quarterly reports since 1999. this was one of the measures taken following the asian financial crisis of 1997/1998 in an effort to reduce uncertainty and restore investors‟ confidence through timelier information. in the unites states of america (us), requirements to issue quarterly reports were introduced in 1970 when companies were required by the securities and exchange commission (sec) to publish quarterly income reports on form 10q. following that, in 1973, the american institute of certified public accountants (aicpa) issued accounting principles board (apb) opinion 28 (interim financial reporting). numerous empirical studies have since been carried out which show that quarterly reports are useful to users; for example, they have been found to improve earnings forecasts (fortin et al., 1997; allen et al., 1999) and are associated with adjustments in stock prices (kiger, 1972; foster, 1977; balsam et al., 2002). however, cases of accounting irregularities, such as those that involved enron, worldcom and tyco international, cast doubt on the ability of quarterly reports in enabling the detection of fraudulent accounting practices at the earliest stage possible. studies have also shown that companies manage their quarterly reports, thus rendering them unreliable (e.g. givoly and ronen, 1981; kinney and trezevant, 1997; nigrini, 2005). it is generally believed that the use of the integral method rather than the discrete method of reporting, in addition to the fact that quarterly reports are not independently audited, provides more opportunities for companies to manage quarterly earnings in the us. even though the use of the integral method is appropriate in some cases, the method requires a lot more judgment and estimates compared to the discrete method. thus, the tendency for earnings management is more likely under the integral method than under the discrete method. although apb opinion 28 adopts both the discrete and integral methods (depending on the type of transactions), the latter is more dominant. the integral method, as recommended in the us, regards a quarterly report as one of the reporting cycles in the full financial year reporting cycle. bartsch (1989), for instance, notes that: “under this perspective, deferrals, accruals and estimates reported in each interim statement reflect the accountant‟s belief of what is likely to transpire relative to the results of operations for the entire year. essentially, interim-period allocations are components of interim accounting reports prepared by the integral method”. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 55 as opposed to the integral method, the discrete method treats each interim period as an accounting period distinct from the annual cycle. under this method, deferrals, accruals and estimates at the end of each interim period should be determined by the principles that apply to the annual periods. the transactions reported in the interim period should reflect the economic activity of that particular quarter independent of the other quarters, rather than outcomes based on forecasts of the operations of the forthcoming year. the discrete view rests on the premise that when an annual period is both a discrete accounting period and a segment of the total life of an enterprise, the interim period should likewise be considered as both a discrete accounting period and a fraction of an annual period (malaysian accounting standards board (masb) [1] , 2000). taken together, the sum of the interim figures must equal the annual figures, as reported in the full year‟s financial statements. in applying the integral approach, apb 28 requires a specific cost that benefits more than one interim period, such as a major annual repair, to be appropriately apportioned and charged to each interim period. in another example, an inventory loss from a market price decline is not to be recognized at interim dates if the decline is expected to be restored before the end of the fiscal year. under the discrete approach (as adopted by masb 26, for example), the cost that benefits more than one interim period is not to be anticipated or deferred. instead, the expense is fully recognized in the period in which it is incurred. as for inventory loss from a market price decline, masb 26 requires recognition of the loss at the interim date. the above examples show that the use of judgment and estimation in determining the amount to be charged to a particular interim period is particularly prevalent under the integral method. thus, the integral method is subject to more earnings manipulation. given the nature of the integral method, hussey and woolfe (1994) contend that errors and manipulation would be more likely to occur, resulting in unreliable information in individual interim reports. in addition, because underor over-allocations are more likely to occur under the integral approach, this could cause distortion of results in subsequent interim periods. thus, given this nature, information in the quarterly reports prepared using the discrete method is argued to be more reliable than that prepared using the integral approach. based on this assertion, the malaysian accounting standards board‟s standard 26 (masb 26 interim financial reporting, which was subsequently renamed as financial reporting standard (frs) 134) requires the use of the discrete method rather than the integral method in reporting most items. one approach to determine the reliability of the quarterly reports is by observing the reporting of exceptional items (eis; often referred to as unusual or infrequent items, but not both) that affect the income statement (see for example ku ismail and chandler, 2005; and kinney and trezevant, 1997). masb 26 requires companies to disclose among others, “the nature and amount of items affecting assets, liabilities, equity, net income or flows that are unusual because of their nature, risk and incidence” (masb 26, paragraph 16). these items are often referred to as exceptional items. for the purpose of this study, we restrict our asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 56 definition of exceptional items to those that affect the net income. they include, among others, the write-down of inventories or its reversal, recognition of a loss from the impairment of assets or its reversal, loss or gain on disposal of investments and property, plant and equipment, and the reversal of any provisions for the costs of restructuring. we argue that companies are less likely to adopt the discrete method if eis are deferred to the final quarter. it is argued that the quarterly reports are more likely to be unreliable if companies defer the reporting of eis to the fourth quarter. hence, deferment is more likely to occur when a company reports more exceptional items in the fourth quarter than in any other quarter. the deferment of eis to the final quarter is intended to smooth the quarterly earnings of the previous three quarters if the eis in the fourth quarters are negative than if the eis in the fourth quarter is positive. in the malaysian context, ku ismail and chandler (2005) are skeptical about the reliability of the quarterly reports. this is because they find more exceptional items being recognized in the fourth quarter than in any other quarters. this led the authors to believe that companies purposely defer the recognition of eis to the final quarter of the year. therefore, they postulate that managers use eis to manage quarterly reports. this prediction seems to be supported as they found that the eis reported in the fourth quarter are more likely to be negative. this indicates that quarterly earnings of the other three quarters are likely being overstated and management delays bad news by overstating interim earnings through the postponement of the release of unfavorable news to the final quarter. the above study was conducted in 2001 when masb 26 was at its draft stage. companies then had the choice of adopting either the integral or the discrete method of reporting. therefore, the practice of deferring of eis to the final quarter and the pervasiveness of negative adjustments in the fourth quarters found by ku ismail and chandler (2005) was not surprising. masb 26 was issued as a standard by the masb in 2002 and was made effective on 1 july 2002. the standard requires companies to adopt the discrete method in reporting most of their transactions rather than the integral method of reporting. compliance with masb 26, specifically with the application of the discrete method, would enhance the reliability of the quarterly reports. given that companies are now required to observe masb 26 (now frs 134) which adopts the discrete view of reporting, this paper seeks to revisit the study by ku ismail and chandler (2005). first, this study seeks to determine if the reliability of the quarterly reports is enhanced after the issuance of masb 26, as far as the reporting of eis is concerned. there will be reasons to believe that the reliability of the quarterly reports is enhanced if the practice of deferring the reporting of eis to the final quarter is significantly reduced. second, this study will observe if the reports of the first three quarterly reports are overstated. in other words, it will observe if companies defer the reporting of negative eis to the final quarter. in addition, this study investigates whether the pattern of a firm‟s ownership explains the decision to defer the reporting of eis to the final quarter. the motivation to examine this variable is due to the fact that the ownership pattern of malaysian firms is unique compared asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 57 to the ownership patterns of firms in developed countries. the shareholdings of companies in malaysia tend to be closely-held rather than widely dispersed. we base on management entrenchment theory, information argument and agency theory in explaining the association between the reliability of quarterly reports and ownership structure. management entrenchment theory (see for example, wetson, 1979) argues that high management interest is more likely to be associated with unreliable financial information because the controlling owner of the firm decides on the accounting policies and the amount of disclosure. consistent with management entrenchment, information argument believes that concentration of ownership enables companies to limit the amount of disclosure to the public. this is done to protect the information from being known to competitors or to avoid unwanted political or social scrutiny (fan and wong, 2002). agency theory, on the other hand, argues that low management interest leads to greater manipulation of accounts due to the misalignment of the interests of management and owners (warfield et al., 1995). finally, company characteristics, which have been examined previously in voluntary disclosure-based studies (namely size, profitability, leverage and listing status of a company), are also included to determine if they influence the practice of reporting eis in quarterly reports. the remainder of this paper is organized as follows. in the next section, this paper provides a review of relevant studies. following that we present the research methods and hypothesis development. the findings of the study will be presented next. finally, we will provide our conclusions. 2. previous studies 2.1 earnings management and interim reporting the ambiguity of accounting standards and the adoption of the integral method (as opposed to the discrete method), among others, contribute to the potential for abuse in the reporting of interim information (mendelhall et al., 1988; doran, 1995; national commission on fraudulent financial reporting, 1987). for instance, interim reporting failures in the us contributed greatly to the dot.com bubble of 1999/2000. the discretion available and the application of the integral method as proposed in apb opinion 28 often lead to the practice of earnings management among firms in the us, in which the fourth quarter "settling-up" effect is often observed. a fourth quarter “settling-up” occurs when management has under or over-estimated the interim earnings and subsequently makes use of the fourth quarter to absorb the corrections or misstatements made in the previous three quarters. a number of studies have examined the extent of earnings management in interim reports. givoly (1974), as cited by givoly and ronen (1981), observes that the standard deviation of the fourth quarter‟s income of us companies significantly exceeds that of the first three quarters. the findings thus suggest that not all quarterly data are equally reliable and it is argued that managers make year-end accounting adjustments in an attempt to smooth annual income numbers. the finding is supported by givoly and ronen (1981) and fried et al. (1987). the latter find large write-offs are observed in the fourth quarter. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 58 subsequent research studies by kinney and mcdaniel (1989) and doran (1995) reveal that earnings originally reported in the first three quarters are overstated. this is especially the case for companies that are relatively small, less profitable, highly geared, laggard in growth, and given qualified audit opinions (kinney and mcdaniel, 1989). in other words, financially weak firms are more likely to window dress their quarterly reports than their financially strong counterparts. doran (1995) supports the notion that management may have incentives to overstate interim earnings by delaying bad news and, where the integral method is adopted, they may make optimistic full year estimates for interim reporting purposes. in canada, fortin et al. (1997) reveal that fourth quarter net income accounts for the highest percentage of the annual net income. this suggests that management makes major adjustments in the fourth quarter. the authors thus conclude that adjustments are made because either their estimates are not accurate or that they purposely manage the interim income such that the annual income looks more favorable. however, it is often difficult to equate motive and intent with actions. in some cases, preparers may be overly optimistic rather than having the intent to deceive. kinney and trezevant (1997) provide additional evidence that „special items‟ are used to manage earnings and more of these items are recognized in the fourth quarter than in any other quarter. this finding provides support for the notion that earnings reported in the fourth quarter differ significantly from earnings reported in earlier quarters. considering that there is evidence that special items are used to manage income, the results imply that earnings reported in the fourth quarter might be subjected to more manipulation than earnings reported in other quarters. as discusses earlier, the same evidence was found in respect to malaysia by ku ismail and chandler (2005). 2.2 ownership structure and financial reporting the issue of ownership structure emerges with the issuance of shares to the public who may hold insignificant amounts of shares in a firm. if many shareholders hold shares and there is no ultimate shareholder with controlling power, the ownership pattern is said to be widely dispersed. on the other hand, when there is an ultimate shareholder with controlling power and the shares are held by few shareholders, the ownership is argued to be closely-held. interest in the pattern of ownership arises because of the separation of control and decisions, with management dominating the latter role. the pattern of companies‟ shareholdings in malaysia is argued to be closely-held (fatimah, 2001; abdullah and mohd-nasir, 2004). abdullah and mohd-nasir (2004) show that the top 20 shareholders of the bursa malaysia main board companies account for, on average, 73 percent of a firm‟s traded shares. in an earlier study, abdullah (2002) reveals that the average shareholding of a firm‟s largest shareholder was about 37 percent in the year before the 1997 asian financial crisis. this ownership pattern could lead to the interests of controlling shareholders being pursued aggressively at the expense of the non-controlling shareholders. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 59 to ensure that the interests of a firm‟s non-controlling shareholders are protected, a sufficient number of independent representations on the board are required. to this end, the malaysian code on corporate governance (finance committee on corporate governance, 2001) stipulates that when a company has a significant shareholder on the board, in addition to requiring the company to have one-third of the board members being independent, the board should include a sufficient number of directors that can fairly represent the investment of shareholders other than the significant shareholder. management interest and the quality of earnings are related as shown, for instance, by warfield et al. (1995). they find that the extent of shareholding by management positively influences the informativeness of earnings, as indicated by the earnings response coefficient (erc). their argument is that when the level of management ownership is low, contracts would be written to constrain management‟s opportunistic behaviors. since the contracts rely on the accounting numbers, the accounting numbers which are purported to constrain management‟s opportunistic behaviors are capable of being manipulated. this is because management still has the discretion in choosing accounting methods which in turn would reduce earnings informativeness. however, in a study in malaysia by abdullah (1999), such evidence is not supported where the erc is found to be insignificant. subsequent studies in malaysia (abdullah, 2002; abdullah et al., 2004) also fail to document evidence on the impact of the extent of management interest on the level of accounting disclosure and the choice of accounting methods for goodwill, respectively. in examining earnings informativeness of companies from seven countries in east asia, including malaysia, fan and wong (2002) contend that the power of the controlling shareholders in these countries is even more profound where the controlling owners can exert more power than their equity shareholdings due to the complicated ownership structure arising from cross-holdings. consistent with their contention, they document that the informativeness of earnings is reduced with the increase in ownership concentration. they argue that concentration of ownership leads to agency conflicts between controlling owners and outside shareholders. this results in the controlling owners being perceived by the public to report accounting information for their own purposes rather than for the information of other users. this perception causes other outside shareholders to lose confidence in the reported earnings. 3. hypothesis 3.1 reliability of the quarterly reports quarterly reports are argued to be unreliable when companies delay the reporting of accounting items to the final quarter or use the final quarter as a “settling-up” period. “settling-up” can be detected by examining the reporting of eis in each of the four quarterly reports. the incidence of „settling up‟ is expected to be present if the incidence of eis reported in the fourth quarter is greater than that reported in any other quarters. in this respect, asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 60 for each company under study, the proportion of the incidence of eis in each quarter to the total incidence of eis reported in all quarters is calculated. the incidence of reporting negative eis are also observed. if more negative adjustments rather than positive adjustments are made at the end of the year, there is an indication that earnings of the earlier quarters are more likely to be overstated than understated. based on the belief that companies are more likely to adopt the discrete method of reporting after the issuance of masb 26, we hypothesize that companies tend not to delay the reporting of eis to the fourth quarter. in addition, we hypothesize that the first three quarterly reports are not overstated. we thus form our hypotheses as follows: h1: the incidence of eis reported in each of the four quarters is equally likely, and h2: the incidence of negative and positive eis reported in the fourth quarter is equally likely. subsequently, the current findings would be compared with that of ku ismail and chandler (2005) to determine if the reliability of the quarterly reports improves after the implementation of masb 26. a substantial reduction in the proportion of eis being recognized in the final quarter implies that the reliability of the quarterly reports improves after the issuance of masb 26. 3.2 eis and ownership structure the relationship between the reliability of quarterly reports and ownership structure could be explained from the perspectives of management entrenchment theory, information argument and agency theory. management entrenchment theory (weston, 1979; morck et al., 1988; fan and wong, 2002) argues that high management interest leads to high likelihood of unreliable financial information. the controlling owner of the firm effectively decides “… the accounting reporting policies” (fan and wong, 2002: 403) which could lead to low quality accounting information. this incentive is primarily driven by the controlling owner‟s motive to hold up the firm‟s non-controlling shareholders (fan and wong, 2002). thus, the manipulation is achieved by deferring the disclosure of the eis to mislead the firm‟s non-controlling shareholders. the non-controlling shareholders do not have access to the information about the firm other than the published information, i.e. quarterly reports. likewise, information argument also sees the influence of a firm‟s controlling shareholders on the flow and the amount of information to be made available to the public (i.e. the non-controlling shareholders). the concentration of ownership enables companies to limit the amount of disclosure to the public (fan and wong, 2002), especially of proprietary-type information. this is done to protect the information from being known to competitors or to avoid unwanted political or social scrutiny (fan and wong, 2002). agency theory, on the other hand, would predict the relationship between the deferment of eis and management interest to be negative (jensen and meckling, 1976). this is due to the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 61 misalignment of the interests of management and owners. agency theory argues that in order to align the interests of management who often hold negligible shares in the firm, contracts are written, such as bonus plans and debt covenants. these contracts, which rely on the accounting numbers, are written to constrain the anticipated opportunistic behaviors of managers. due to flexibility, managers have a wide discretion in applying the accounting standards. thus, despite the presence of contracts, low management interest often leads to the manipulation of accounts because management has the flexibility in choosing the set of accounting policies (warfield et al., 1995). managers also have such flexibility when preparing quarterly reports; thus the flexibility leads to the quarterly reports being less informative (warfield et al., 1995). in order to effectively mitigate agency problem, it is argued that managers should hold significant amount of shares so that their interest and those of other shareholders converge. the higher the management interest, the more informative will be the accounting information because of less manipulation. the relationship, nevertheless, is not monotonic the relationship between firm value and management ownership is positive at the lower levels and negative at higher levels (e.g. morck et al., 1988; mcconnell and servaes, 1990). therefore, agency theory is in conflict with management entrenchment theory and information argument. further, the evidence provided by fan and wong (2002), in which malaysian companies are included in their sample, reveals that the informativeness of earnings is significantly lower when voting rights (i.e. control) of the ultimate shareholder are high. this evidence appears to be consistent with management entrenchment theory and the information argument, but inconsistent with agency theory. previous studies in malaysia (e.g. abdullah et al., 2002) also fail to confirm the importance of agency theory in explaining management‟s income smoothing incentives. the ownership pattern in malaysia, which is closely held, as opposed to a widely-dispersed ownership pattern in the us and where agency theory was first developed, contributes to evidence not supporting agency theory. based on the evidence of fan and wong (2002), and in line with information theory and management entrenchment theory, this study hypothesizes that the concentration of ownership by management is positively associated with the deferment of eis to the final quarter. concentration of ownership is observed from two perspectives – management interest and family ownership. management interest is measured by the percentage of shares owned by management. as for family ownership, companies are classified into family controlled and non-family controlled. the classification is achieved by examining the composition of the board of directors. if the family of the substantial shareholder dominates the board of directors, the firm is said to be family-controlled [2] . a firm is deemed to be dominated by the family of a substantial shareholder if the family represents at least thirty percent of the board of directors. a value of “1” is given if the firm is family-controlled and a value of “0” if it is not family-controlled. based on the above discussion, the following hypotheses are tested: h3: companies with higher concentration of ownership by management are more likely to defer eis to the final quarter. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 62 h4: family-controlled firms are more likely to defer the reporting of eis to the final quarter. 3.3 eis and other firm characteristics we further predict that the deferment of eis to the final quarter is associated with size, profitability, leverage and board listing status of a company. ettredge et al. (1994) provide evidence that size is negatively associated with the extent of adjustments made in the fourth quarter, and kinney and mcdaniel (1989) show that size of a company is negatively associated with the number of errors found in the quarterly reports. reports of smaller firms are argued to contain more errors than are those of larger firms. kinney and mcdaniel (1989) offer two reasons why smaller companies are expected to have more errors. first, larger firms are more likely to have internal audit teams whose activities might reduce the incidence of errors in quarterly reports. smaller firms, on the other hand, would be more likely to depend on external auditors for error detection. second, size has often been associated with the quality of internal control of a firm. larger firms are expected to have better internal controls than smaller firms. kinney and mcdaniel (1989) contend that financially troubled firms are more likely to “window dress” in an attempt to hide their financial problems. they hypothesize and find that profitability of a company is negatively associated with the number of errors found in the quarterly reports. in addition, they also conjecture that leverage is positively related to the number of errors. this is because the higher the ratio of debt to total assets, the higher the risk of failure. kinney and mcdaniel (1989) provide evidence to support their contention. additionally, one distinctive feature of the bursa malaysia is that it has two boards: the main board and the second board. companies in the two boards are differentiated by the number of shares being traded on the exchange. both main board and second board companies are subjected to the same listing requirements imposed by the bursa malaysia. however, given the exposure in the capital markets by the number of shares traded, the main board firms are predicted to be followed more closely by analysts than the second board firms. trading of shares of the second board firms is usually less active than for the main board firms. because the main board companies are more likely to be scrutinized by analysts, and any manipulation is more likely to be detected, we expect that they are less likely to manipulate their quarterly reports compared to those of the second board. thus, the deferment of eis is more likely among the second board companies than those of the main board firms. hence, the hypotheses are as follows: h5: smaller companies are more likely to defer the reporting of eis to the final quarter. h6: less profitable companies are more likely to defer the reporting of eis to the final quarter. h7: higher leveraged companies are more likely to defer the reporting of eis to the final quarter. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 63 h8: second board companies are more likely to defer the reporting of eis to the final quarter. we measure firm size by the total assets of a company, a measure used in a large number of studies (for example hossain and adams, 1995; schadewitz and blevins, 1998). although there are various measures of profitability (such as return on assets, eps and net income), this study measures profitability by the profit margin of a company, that is, the ratio of net income to sales. various measures of leverage have been adopted in the literature, depending on the objective of the analysis (rajan and zingales, 1995). leverage could be measured in terms of book value (for example, the ratio of the book value of total liabilities to book value of total assets, or the ratio of book value of debt to book value of equity) or market value (for example, the ratio of market value of debt to market value of equity). this study measures leverage in terms of the ratio of debt to total assets, as employed by courtis (1979) and chow and wong-boren (1987). 4. research methods 4.1 sample and data analysis sample companies for this study were those listed on the bursa malaysia as of 31 december 2002 with financial year-ends falling on 31 december. companies with other year-ends were not included to avoid non-uniformity and seasonality problems. companies listed under the finance, trust and closed-end fund categories were also excluded from the sample because they have to comply with additional requirements with respect to financial reporting. we finally had 410 companies in the sampling frame. quarterly reports for the year 2003 of these 410 companies were subsequently scrutinized for the reporting of eis. out of these, only 91 companies (22 percent) reported eis in at least one of the 2003 quarterly reports, and are thus included as sample firms in this study. of the 91 companies, 69 were listed on the main board and 22 were traded on the second board. this study adopts the method employed by kinney and trezevant (1997), ettredge et al. (2000) and ku ismail and chandler (2005). to examine the reliability of the quarterly reports, first the incidence of exceptional items reported in each of the four quarterly reports is observed. although some of the eis reported in the final quarter are genuine, the quarterly reports of a company are more likely to be unreliable (or less likely to adopt the discrete method) if more exceptional items are found in the final quarter than in any of the first three quarterly reports. this is because we expect that a company which reports more eis in the final quarter has a greater tendency to purposely defer the reporting of eis compared to a company that has an equal or a lesser incidence of eis in the final quarter. deferment is less likely if the eis are equally reported in each of the four quarterly reports. although the asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 64 relationship between deferment and the choice of reporting approach could not be justified in this study, based on previous literature we believe that companies that defer are less likely to adopt the discrete approach of reporting as required by masb 26 in recording most of the eis. second, we also expect that a report is less likely to be reliable if the first three quarterly earnings are likely to be overstated or if there is a tendency for companies to delay bad news. a company is more likely to overstate its first three quarterly earnings if more negative eis are reported in the final quarter than in the first three quarters. to test the hypotheses related to management ownership and other firm characteristics, the following logistic regression model is used: defer = α + β1fmown + β2mgown + β3size+ β4profit + β5lev + β6board + ε (1) where, defer = „1‟ if the incidence of 4 th quarter ei is greater than in any other quarters, otherwise „0‟, mgown = percentage of management ownership, fmown = percentage of family ownership, size = size of a company, measured by natural log of total assets, profit = profitability, measured by profit margin, lev = leverage, measured by ratio of debt to total assets, board = „1‟ if listed on the main board of bursa malaysia, and „0‟ if listed on the second board, and ε = error term. 5. results and discussion table 1 presents the reporting of eis in the quarterly reports. in comparing the pattern of reporting between preand post-masb 26, table 1 also reproduces the findings from ku ismail and chandler (2005). it is shown that 44 out of 91 companies (i.e. 48.4 percent) reported more incidence of eis in the fourth quarter than in any other individual quarters and 34 of these companies (37.4 percent) report greater incidence of eis in the final quarter than in the first three quarterly reports combined. in an earlier study by ku ismail and chandler (2005), the incidence rates were 56.1 percent and 42.1 percent, respectively. hence, the present results imply that the tendency for companies to defer the reporting of eis to the final quarter has decreased following the implementation of masb 26. however, the chi-square results shown in table 2 reveal that the percentage drop is not significant. this implies that the implementation of masb 26 has not been able to ensure the use of the discrete method. thus, this evidence casts doubt on the ability of masb 26 to enhance the reliability of the quarterly reports, as far as the reporting of eis is concerned. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 65 table 1. reporting of eis in the quarterly reports yes no ku ismail and chandler (2005) yes no freq % freq % freq % freq % companies reporting incidence of eis in the 4 th quarter more than in any other quarter 44 48.4 47 51.6 64 56.1 50 43.9 companies reporting incidence of eis in the 4 th quarter more than in the first three quarters combined 34 37.4 57 62.6 48 42.1 66 57.9 table 2. incidences of eis in the 4 th quarter: preand post-masb 26 periods present study (post-masb26) ku ismail and chandler (2005) (pre-masb26) sub-totals companies reporting incidence of eis in the 4 th quarter more than in any other quarter 48.4% 56.1% 104.5% 48.6% * 55.8% * companies reporting incidence of eis in the 4 th quarter more than in the first three quarters combined 37.4% 42.1% 79.5% 37.1% * 42.4% * sub-totals 85.8% 48.2% 184% * expected value χ2 = 0.00698, the critical value is χ2=3.84 (d.f = 1, α=0.05) table 3 reports the overall mean proportion of the incidence of eis reported in each quarter. in the first quarter, the lowest proportion (10.98 percent) of eis was reported and the value increased as the quarters moved towards year-end, with the fourth quarter reporting the highest proportion (50.02 percent). results of paired t-tests on the equality of means shown in table 3 indicate that the proportion of the incidence of eis reported in the fourth quarter is significantly higher than for each of the other quarters. the finding is consistent with that of ku ismail and chandler (2005) see the last column of table 3 for comparison. this suggests asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 66 that the tendency for companies to defer the reporting of eis to the final quarter still prevails even after the issuance of masb 26, which reinforces the findings in table 1. table 3. proportion of the incidence of eis in each quarter eis difference with mean of 4 th quarter ku ismail and chandler (2005) mean (percent) std. deviation t-value sig. (2-tailed) mean (percent) 1 st quarter 10.98 0.1999 -7.649 0.000*** 10.40 2 nd quarter 19.16 0.2866 -5.014 0.000*** 16.96 3 rd quarter 19.83 0.2747 -5.137 0.000*** 22.11 4 th quarter 50.02 0.3737 50.53 ***significant at the 0.01 level the signs of the eis reported in each quarter, that is, whether they are positive or negative in nature, are reported in table 4. the results in table 4 show that during the fourth quarter, the number of negative eis (67.1 percent) outnumbers positive eis (32.9 percent) significantly. because our evidence shows that more negative adjustments rather than positive adjustments are made at the end of the year, this provides an indication that earnings of the earlier quarters are more likely to be overstated than understated. the findings fail to support our hypothesis (h2) that earnings of the first three quarters are not likely to be overstated. the findings are consistent with those of doran (1995) and ku ismail and chandler (2005) who reveal that quarterly earnings for the first three quarters are overstated. thus, the notion that management may overstate interim earnings by delaying the release of negative information until the final quarter still occurs despite the move made by the masb to require the application of the discrete method. thus, the reliability of earnings in the quarterly reports is questionable. although the actual motivation as to why companies delay the reporting of eis to the final quarter is not addressed in this study, there are reasons to believe that managers make use of eis in the quarterly reports as a tool to manage earnings. results may also imply that companies are either ignorant or lacks the knowledge on how to apply the discrete method in reporting eis. in ensuring that the discrete method is fully complied with, serious efforts should be taken by the regulators to provide management and preparers with a better understanding of the method. it may take some time for companies to fully apply the method. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 67 table 4. the signs of eis reported in each quarter negative freq. (%) positive freq. (%) total freq. (%) chi-square (sig.) 1 st quarter 19 (59.4) 13 (40.6) 32 (100) 0.289 2 nd quarter 19 (44.2) 24 (55.8) 43 (100) 0.355 3 rd quarter 26 (59.1) 18 (40.9) 44 (100) 0.228 4 th quarter 47 (67.1) 23 (32.9) 70 (100) 0.004*** total 111 (58.7) 78 (41.3) 189 (100) *** significant at the 0.01 level table 5 presents the descriptive statistics of the variables used in the regression model. the results presented in table 5 confirm the pattern of firm ownerships in malaysia, which are closely-held (e.g. fatimah, 2001; abdullah and mohd-nasir, 2004). for instance, the average managerial ownership is 30 percent and family ownership is 17 percent. it is a relatively common practice in asian countries, especially in malaysia, to appoint family members as top management of companies. table 5. descriptive statistics variables min. max. mean std. deviation defer .0000 1.0000 .48 .502 mgown .0000 .8500 .30647 .24286 fmown .0000 .5714 .16814 .18996 size 10.11 17.2400 13.1294 1.32320 profit -3.05 15.7200 .0681 1.75431 lev .0000 1.1400 .2652 .24651 board .0000 .0000 .76 .431 table 6 presents results from correlation analysis. it is shown that two correlation coefficients are deemed to be high – those for management and family ownerships (0.430), and organisation size and listing board (0.508). however, according to cooper and schindler (1998), high correlations are acceptable so long as they are not greater than 0.8. based on this argument, the high correlation coefficients (i.e. 0.430 and 0.508) as shown in table 6 are within the acceptable range and therefore do not affect the explanatory power of these independent variables (i.e. mgown, fmown, board, and size) on the dependent variable. asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 68 table 6. correlation analysis mgown fmown size profit lev board defer -.054 -.040 -.105 -.093 .055 -.275*** (.609) (.709) (.330) (.389) (.612) (.008) mgown .430*** -.147 -.125 .008 -.056 (.000) (.170) (.246) (.944) (.598) fmown -.187 -.065 -.040 -.111 (.081) (.545) (.708) (.295) size -.168 .110 .508*** (.118) (.306) (.000) profit -.163 .090 (.130) (.403) lev -.301*** (.004) ***significant at the 0.01 level (2-tailed). table 6 also shows that board listing is significantly associated with the deferment of eis. second board companies are more likely to defer the reporting of eis compared to the main board companies. other variables seem not to influence the reporting of eis. results from logistic regression analysis are presented in table 7. consistent with the findings from the univariate analysis, the regression results reveal that second board companies are more likely to defer the reporting of eis to the fourth quarter than those of the main board. this is consistent with our prediction that main board companies, which are more likely to be followed by analysts, are less likely to manage earnings, as compared to firms on the second board. the incentive for not managing quarterly earnings through the deferment of eis by the main board firms is expected to be attributable to the firms‟ desire to avoid negative publicity from analysts. table 7. logistic regression results variables b s.e. wald df sig. exp(b) mgown -.260 1.066 .060 1 .807 .771 fmown -.541 1.357 .159 1 .690 .582 lnasset .071 .214 .110 1 .740 1.074 margin -.117 .193 .365 1 .546 .890 lev -.583 1.038 .316 1 .574 .558 board -1.632 .698 5.461 1 .019* .196 constant .540 2.608 .043 1 .836 1.716 asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 69 * significant at the 0.05 level cox & snell r square = 0.095 nagelkerke r square = 0.127 in sum, our findings provide no evidence to support the hypotheses that the tendency to defer the recognition of eis to the fourth quarter is associated with ownership structure, size, profitability, or leverage of a company. these findings thus fail to support the earlier evidence by ettredge et al. (1994), kinney and mcdaniel (1989), and fan and wong (2002). however, the findings are not surprising as inconsistent findings have been documented in an earlier study by abdullah et al. (2002) who failed to find evidence of an association between the incidence of income smoothing (through ei disclosures) and management interests, firm size, and leverage. similar findings were also produced by abdullah et al. (2004) when investigating income manipulation through goodwill, and by abdullah and mohd-nasir (2004) in a study on accrual management. thus, earnings management may not be significantly motivated by the firm‟s size, leverage and management ownership. 6. conclusion the issue of the reliability of quarterly reports arises because firms are not required to have them audited by independent auditors, and in some countries (for example the u.s) the integral method is preferred over the discrete method. thus, earnings could be managed to suit management‟s objectives. in malaysia, masb 26 requires the use of the discrete method in reporting most of the items in the quarterly reports. extending the study by ku ismail and chandler (2005), this study aims at determining whether the reliability of the quarterly reports improved following the issuance of masb 26. this is accomplished by examining the reporting of eis in the quarterly reports. we predict that if the discrete method is employed, the incidence of eis is equally likely in all quarters and the quarterly reports are said to be reliable. in other words, if masb 26 is observed as far as the use of the discrete method is concerned, it is predicted that companies would be less likely to defer the reporting of eis to the final quarter. this study reveals that almost half of the sampled companies reported eis in the fourth quarter of 2003 than in any other earlier quarters of that year. even though the number of occurrences has declined from that of the 2001 survey by ku ismail and chandler (2005), the decline is not significant. similar to the previous study, the proportion of the incidence of eis being reported in the fourth quarter is significantly higher than for each of the earlier three quarters of the year. this may indicate that the discrete method has not been fully practiced by companies and masb 26 has not been able to ensure the reliability of the quarterly reports as far as eis are concerned. it is also observed that negative eis significantly outnumber positive eis in the fourth quarter. therefore, there is a tendency that management apparently delays the reporting of bad news or overstates the first three quarterly earnings. our findings further reveal that bursa malaysia second board companies are more likely to engage in fourth quarter “settling-up” compared to the main board companies. this implies that the former are less likely to adopt the discrete method, and the quarterly reports of these asian journal of finance & accounting issn 1946-052x 2009, vol. 1, no. 2: e3 www.macrothink.org/ajfa 70 companies are therefore less likely to be reliable. however, there is no evidence of association between the reliability of the quarterly reports and management ownership, size, profitability and leverage of a company. the findings of this study bring to light the issue of the reliability of quarterly financial reports. the issue should be of interest to researchers, financial reporting regulators, users and preparers of the reports. the main objective of quarterly reports is to provide users with reliable and timelier information. however, manipulation of quarterly reports via ei adjustments in the fourth quarter by some companies defeats the purpose of quarterly reports. thus, to help enhance the quality and usefulness of quarterly reports, companies should take the initiative to observe masb 26 (now frs 134) more closely, and at the same time, the monitoring mechanisms of the regulatory bodies should be strengthened. investors should treat quarterly earnings with caution because the latter may be overstated as negative eis are more likely to be deferred to the final quarter. this study opens up avenues for future research on quarterly reporting, not only in malaysia, but also in other emerging economies. based on our findings, deferment of eis to the final quarter, particularly negative eis, does exist. thus, this could lead to quarterly reports being less reliable and less useful. further research could be carried out to determine whether this is indeed the case. this could be achieved, perhaps, by using methods other than ei adjustments. with the recent divergence of global accounting standards whereby many countries have adopted frss in totality, including a standard on interim reporting, the present research findings act as a basis for similar research in other emerging economies. this would facilitate comparisons of evidence among emerging economies whose legal and cultural environments are similar to malaysia. notes 1 with effect from 1 january 2006, accounting standards in malaysia are referred to as financial reporting standards (frss). the standard on interim reporting is subsequently known as frs 134. since the contents of frs134 are similar to masb 26, the effective date of frs 134 was brought back to 1 july 2002, which was the effective date for masb 26. 2 in the directors‟ profile section of the annual reports, the names of directors 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(1979). the tender takeover, mergers and acquisition, 74-82. microsoft word 2027-7953-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 218 long memory property in return and volatility: evidence from the indian stock markets joshi prashant maheshchandra professor, uka tarsadia university maliba campus, gopal vidyanagar, bardoli, india e-mail: joshiprashantm@gmail.com received: july 1, 2012 accepted: august 27, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.2027 url: http://dx.doi.org/10.5296/ajfa.v4i2.2027 abstract the paper examines the existence of long memory in the indian stock market using arfima, figarch models. the data set consists of daily return of bse and nse stock indices and long memory tests are carried out both for the returns and volatilities of these series. the results of arfima model suggests the absence of long memory in return series of the indian stock market. the results of figarch model indicate strong evidence of long memory in conditional variance of the stock indices. the long memory property of the bse market is revealed to be stronger than nse. keywords: arfima, garch, long memory, figarch jel classification: c22, c50 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 219 1. introduction long memory dynamics are important pointers for identifying presence of nonlinear relations in conditional mean and variance of financial time series. the modelling of stock market volatility has been a considerable field of research after the introduction of arch and garch classes of models by engle(1982) and bollerslev(1986). it has been found that stock market volatility is time varying and exhibits positive serial correlation (volatility clustering).this implies that changes in volatility are non-random. however, these models do not account for long memory in volatility. the long memory is often found in conditional mean and variance of a financial time series at the same time. slow mean-reverting at hyperbolic rate decay in autocorrelation functions of return and volatility is defined as long memory in return and volatility. based on this idea, the empirical works of baillie, han and kwon(2002) and beine, laurent and lecourt (2003) have focussed on analysing dual long memory property in conditional mean and variance. the empirical findings act as evidence for presence of long memory in return and volatility of returns. mendes and kolev(2006) found that the presence of long memory in conditional variance hid its true dependence structure. madlebrot(1971) implied that the perfect arbitrage was not possible when returns displayed a long-range dependence. the derivative pricing models become ineffective in the presence of long-range dependence. hence, the presence of long memory has important theoretical and practical implications. the study of long memory property in return and volatility of stock markets of india has received little attention. in the light of this background, the primary aim of this paper is to investigate the dual long memory property in the returns and volatility of stock markets of india using arfima-figarch model. the rest of the paper is organized as follows. section 2 presents a brief review of previous work on long memory property in return and volatility. section 3 discusses arfima-garch model. section 4 provides the statistical properties of data and the estimation results of the arfima-figarch models. section 5 summarizes. 2. literature review modelling long memory properties in stock market return and volatility has become an interesting research area in recent years. the existence of long memory in returns and volatility suggests the presence of dependencies among observations. kasman, kasman and torun(2009) found that long memory in these series were related with the high autocorrelation function which decays hyperbolically and finally died out. in contrast, if correlation between distant observations is negligible, the series possesses short memory and exhibits exponential decaying observations. granger and joyeux(1980) and hosking(1981) found that fractionally integrated series could capture long memory property and proposed fractionally integrated autoregressive moving average (arfima) model. it is characterized by hyperbolic decaying of autocorrelation function. lo (1991), jacobson(1996), crato and lima(1994) and tolvi(2003) used arfima model to investigate the presence of long memory in stock market returns. besides numerous asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 220 studies examine long memory in stock return, ding and granger(1996), lobato and savin(1998), comte and renaut(1998) and andreano(2005) investigated the long memory in volatility. they showed that the autocorrelation function of the squared daily return decayed very slowly. baillie et al.(1996) developed fractionally integrated generalized conditional heteroscedasticity(figarch) model to allow for fractionally integrated process of conditional variance. korkmaz, cevik and ozatae(2009) detected long memory property in volatility of returns in istanbul stock exchange of turkey. jeffery and thupayagale (2008) found the evidences of long memory in volatility for south aftica and zimbabwe, whereas no such evidence was found in botswana. kang and yoon (2007) suggest that arfima-figarch model can provide a useful way of examining the relationship between conditional mean and variance of a process exhibiting the long memory property. moreover, kasman et. al (2009) found that these models offer greater flexibility to analyze long memory property in return and volatility with fractionally differencing process. kumar( 2004) analyzed the long memory property of indian stock markets of national stock exchange(nse) and bombay stock exchange(bse) by examining trade volume series using arfima-garch models during 1995 to 2003. the study found that the the trade volume series exhibited strong evidence of long memory. the study has made no attempt to investigate long memory property in return and volatility of indian stock indices. there has been no comprehensive study of long memory in return and volatility in india, which is one of the fasted growing emerging stock markets. hence, the present paper is devoted to this issue in two premier indian stock exchanges namely nse and bse. 3. methodology 3.1 arfima-figarch model granger and joyeux (1980) and hosking (1981) introduced arfima to test long memory property in the asset returns. the purpose of this model to consider fractionally integrated process i(d) in the conditional mean. the arfima ),,( sn  model can be expressed as follows: tt lyll   )()()1)((  (1) ttt z   , )1,0(~ nzt (2) where t is independent and identically distributed with variance 2 and l denotes the lag operator and replacing with difference operator (1-l) of an arima process with the fractional difference operator )1( l , where  denotes the degree of fractional integration. the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 221 differencing parameter  need not be an integer, but the integer value of  leads to a traditional arma models. if 5.00   , all autocorrelations are positive implying long memory while they are negative if 05.0   . the negative values indicate that the process exhibits negative dependence between distant observation suggesting anti-persistence. the process is said to be stationary when 0 . for 1 , the process follows a unit root process. n nllll  .....1)( 2 21  and s sllll   .....1)( 2 21 are the autoregressive (ar) and moving-average (ma) polynomials. the extension of the arfima representation in squared errors ( 2 ) is figarch model of baillie et al. the figarch (p,d,q) can be expressed as follows: t d lll  )](1[)1)(( 2  (3) 22 tttv   is mean zero serially uncorrelated error, 2 t is the squared error of the garch process. the }{ tv process is integrated as the “innovations” for the conditional variance ( 2 t ). if d=0, the figarch (p, d, q) process reduces to a garch (p,q) process and if d=1, the figarch process becomes an integrated garch process. rearranging the terms in eq.(3), one can write the figarch model as follows: .])1)((1[)](1[ 22 t d t lll   (4) the conditional variance equation of 2 t is obtained by: 22 )1()(1[ )(1)](1[ t d t l l l l                 (5) that is 22 )()]1(1[ tt l       (6) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 222 where ....)( 2 21 lll   baillie et al. (1996) mention that the impact of a shock on conditional variance of figarch(p,d,q) processes decrease at a hyperbolic rate when .10  d hence, the long term dynamic is taken into account by the fractional integrated parameter d and the short dynamic is captured through traditional garch model parameters. baillie et al (1996) through simulations demonstrated that quasi maximum likelihood (qmle) estimation method performs better in case of high frequency financial data. therefore, we use qmle method to estimate the results of arfima-figarch model. 3.2 the adjusted pearson goodness-of-fit test the adjusted pearson goodness-of-fit test can access the relevance of various estimated distributions like normal and skewed student-t distribution. it compares the empirical distribution with theoretical innovations. palm and vlaar(1997) classify the residuals in cells corresponding to their magnitude to implement the test. the pearson goodness-of-fit statistics for a given number of cells denoted g is given as follows: i g i ii en enn gp     1 2)( )( (7) where in is the number of observations in cell i, and ien is the expected number of observations. under the null hypothesis of a correct distribution, p(g) statistics is distributed as )1(2 g . since there is no consensus on the proper choice of g in literature, we set g equal to 60 for our sample size. 4. empirical results 4.1 preliminary analysis of data we consider daily returns of two most popular and widely quoted stock indices-bombay stock exchange and national stock exchange of india. the bombay stock exchange is the oldest stock exchange in asia. the bse sensitivity index(sensex) is launched in 1986. it comprises 30 shares and its base year is 1978-79. the major criteria for selection of a scrip in the bse sensex is large market capitalization. besides this criteria, other criteria like number of trades, average value of shares traded per day as a percentage of total number of outstanding shares are considered for inclusion in sensex. another index which has become popular in a short span of time is the s&p cnx nifty of national stock exchange of india. the national stock exchange began equity trading in november 1994. nse introduced this index to reflect the market movements more accurately, provide for managers with a benchmark for measuring portfolio performance. the s&pcnx nifty launched comprises of 50 scrips which are selected on the basis of low impact cost, high liquidity and market capitalization. the dataset consists of daily asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 223 closing prices starting from january 2, 2008 to august 10, 2011 covering 890 observations. the period is the most recent. the economy has also been affected by global financial crisis at different point in time during the period, leading to some fluctuations in the stock prices. this study which uses the data set covering the crisis period is, therefore, relevant and instructive for the analysis. the daily stock returns are defined as logarithmic difference of the daily closing price of respective indices. the descriptive statistics of these two indices are reported in table 1. table 1. descriptive statistics of sample return series descriptive statistics bse nse mean -0.0002 -0.0001 standard deviation 0.0203 0.0199 skewness 0.2873 0.1705 kurtosis 9.6177 11.0789 jarque-bera 1632.57 2419.23 q(20) 32.07 35.77 qs(20) 279.94 195.76 all the return series reveal that they do not correspond with normal distribution assumption. jarque-bera statistics suggest that there are significant departures from normality. we examine the null hypothesis of white noise using the box-pierce statistics of the return residuals(q(20) and squared return residuals qs((20)). from the results, we certainly reject the null hypothesis of white noise. it also indicates that the series are autocorrelated. 4.2 unit root tests before investigating the long memory in return and volatility, we check the series for a presence of unit root. we have employed three unit root tests--adf(augmented dickey fuller), pp(philips-peron) and kpss(kwiatkowski, phillips, schmidt and shin) to determine if the individual return series are stationary or not. three tests differ in the null hypothesis. the null hypothesis of the adf and pp test is that a time series contains unit root while kpss test has the null hypothesis of stationarity. the empirical results of all the three tests are presented in table 2. table 2. unit test results test bse nse adf -27.65(0.000)* -28.32(0.00) pp -27.61(0.000)* -28.33(0.00) kpss 0.264** 0.274 notes: * mackinnon's 1% critical value is -3.435 for adf and pp tests. ** a kpss critical value is 0.739 at 1% significant level. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 224 large negative values for adf and pp tests for both return series reject the null hypothesis of a unit root at the 1% significant level. additionally, the statistics of the kpss test indicate that return series are stationary. thus both the series are stationary and suitable for subsequent long memory tests in this study. 4.3 estimation results of arfima models we estimate different orders of arfima models of (n,s) and compare the performance of the arfima models to determine the adequate orders in detecting long memory property in return series. following cheung(1993), we consider all possible combinations for the arma(n,s) with maximum n=0,1,2 and s=0,1,2. the results of the models are reported in table 3. the results indicate that the long memory parameter  and coefficients of all ar and ma are insignificant in all cases. it clearly suggests that there is no evidence of long memory in both bse and nse return series. it is consistent with weak-form market efficiency. model selection criteria select arfima (0,0,0) model. we, therefore, consider arma (0,0) model with garch class of models to analyze long memory in volatility of return series. the diagnostic statistics in table 3 indicate that the significant departure from normality with large excess kurtosis and skewness. the j-b statistics also suggest that the residuals appear to be leptokurtic. in addition, arch statistics are highly significant implying the presence of arch effects in the standardized residuals. it, therefore, implies that we need garch models to capture long memory property in the indian stock market. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 225 table 3. estimation of arfima models for (a) bse and (b) nse (n, ,s) (0, ,0) (0, ,1) (0.  ,2) (1, ,0) (1, ,1) (1, ,2) (2, ,0) (2, ,1) (2, ,2) (a)  -0.02 (0.769) -0.02 (0.78) -0.02 (0.77) -0.01 (0.79) -0.02 (0.76) -0.02 (0.76) -0.02 (0.77) -0.01 (0.81) -0.02 (0.78) 1 0.07 (0.17) -0.37 (0.67) 0.76 (0.00) 0.08 (0.201) 0.57 (0.08) 0.07 (0.9) 2 -0.033 (0.41) -0.02 (0.19) -0.32 (0.93)  0.00 (0.98) 0.00 (0.98) 0.00 (0.97) 0.00 (0.89) 0.00 (0.98) 0.00 (0.97) 0.00 (0.98) 0.00 (0.96) 1 0.06 (0.21) -0.02 (0.77) 0.36 (0.77) -0.66 (0.00) -0.04 (0.06) -0.00 (0.99) 2 -0.03 (0.12) -0.06 (0.13) -0.00 (0.99) ln(l) -1889.73 -1887.23 -1886.89 -1887.31 -1888.74 -1887.91 -1886.86 -1888.93 -1886.86 aic 4.231 4.25 4.254 4.259 4.269 4.265 4.38 4.28 4.27 skewness 0.287** 0.31** 0.29** 0.31** 0.28** 0.33** 0.29** 0.34** 0.29** excess kurtosis 6.62* 6.47* 6.45* 6.44* 6.63* 6.36* 6.46 6.02* 6.45* j-b 1632.6* 503.7* 505.2* 500* 525.78* 486.95* 504.56* 448.87* 506.78* q(20) 523.86* 1561.6* 1556.1* 1550.3* 1638.9* 1513.4* 1550.4* 1357.8* 1551.1* arch(5) 13.63* 13.76* 13.58* 13.82* 13.64* 14.03* 13.60* 14.61* 13.56* (b)  -0.01 (0.82) -0.014 (0.84) -0.014 (0.83) -0.01 (0.84) -0.00 (0.84) -0.02 (0.85) -0.01 (0.82) -0.014 (0.8) -0.02 (0.98) 1 0.05 (0.36) -0.19 (0.94) 0.05 (0.96) 0.049 (0.41) 0.05 (0.96) 0.049 (0.96) 2 -0.011 (0.77) -0.01 (0.89) -0.011 (0.96)  0.00 (0.97) 0.00 (0.98) 0.00 (0.87) 0.00 (0.95) 0.00 (0.96) 0.01 (0.97) 0.00 (0.98) 0.00 (0.98) 0.00 (0.98) 1 0.04 (0.39) 0.05 (0.42) 0.21 (0.93) 0.00 (0.98) 0.00 (0.99) -0.00 (0.98) 2 -0.01 (0.85) -0.01 (0.91) -0.00 (0.97) ln(l) -1875.6* -1874.5* -1874.5* -1874.4* -1895* -1894.49* -1874.4* -1874.5* -1874.0* aic 4.24 4.23 4.233 4.231 4.234 4.235 4.23 4.234 4.237 skewness 0.17** 0.19** 0.18** 0.20** 0.17** 0.18** 0.18** 0.19** 0.18** asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 226 excess kurtosis 8.08* 7.91* 7.90 7.89* 8.02* 8.90* 7.89* 8.90* 7.89* j-b 2419.2* 2321* 2314.6 2307.1* 2383.8* 2313.3* 2312.1* 2313.6* 2312.4* q(20) 703.82 682.07 681.6* 678.77* 696.2* 681.3* 681.53* 681.6* 882.1* arch(5) 10.65* 10.84* 10.79* 10.89* 10.67* 10.78* 10.79* 10.77* 10.76* notes: qmle standard errors are reported in the parentheses below corresponding parameter estimates. ln(l) is the value of the maximized gaussian likelihood and aic is the akaike informatin criteria. the q(20) is the ljung box test statistics with 20 degree of freedom based on the standardized residuals. the arch(5) denotes the arch test statistic with lag 5. the skewness and kurtosis are also based on standardized residuals. * and ** denote significance levels at 1% and 5% respectively. 4.3 estimation results of figarch models we compare the performance of garch, igarch and figarch models in modelling a long memory volatility process and determine its best fitting order. we used arfima (0,0,0) model in mean equation. the results of the models are presented in table 4. the model selection criteria based on aic and ljung-box q statistics. the model which has lowest aic and passes q-test simultaneously is used. the model selection criteria suggest figarch(1,1,1) model in both the stock market of india. the sum of estimates of 1 and 1 is close to one for all the indices, indicating that the volatility is highly persistence. in particular, the estimates of 1 in garch model are very high, suggesting a strong autoregressive component in the conditional variance process. the long run memory parameter d is statistically significant in the indian stock markets implying prevalent of long memory in volatility. comparing the degree of parameter d between the bse and nse stock markets, the long memory property in nse market is less than that in its counterpart. the reasons might be related to market microstructure. nse has been providing investors’ better platform to adopt broader investment strategy and gather information through better usage of information technology. the results also indicate that the 1 estimates are lower in the figarch than those of garch models. these results are in line with the findings of baillie et al.(1996) who show that there is an upward bias in garch estimates in the presence of long memory due to the fact that garch model does not take into account the long memory component of the volatility process. examining the distributional property, the standardized residuals exhibit excess kurtosis and skewness. this justifies the use of skewed student-t distribution. the statistically insignificant value of p(60) test suggest the relevance of the student-t distribution for the bse and nse returns. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 227 table 4. estimation results of garch models (a) bse and (b) nse (p,d,q) garch (1,0,1) igarch (1,1,1) figarch (1,d,0) figarch (1,d,1) (a)  0.046 (0.33) 0.047 (0.33) 0.065 (0.21) 0.047 (0.30)  0.028 (0.09) 0.026 (0.07) 0.044 (0.72) 0.031 (0.33) 1 0.889 (0.00) 0.889 (0.00) 0.787 (0.00) 0.712 (0.00) d 1 0.854 (0.00) 0.702 (0.00) 1 0.107 (0.00) 0.111 (0.00) 0.07 (0.31) ln(l) -1694.45 -1694.5 -1704.5 -1688.91 aic 3.828 3.826 3.848 3.817 q(20) 19.15 (0.51) 19.11 (0.51) 20.249 (0.44) 20.173 (0.44) qs(20) 8.017 (0.978) 8.152 (0.976) 8.578 (0.979) 8.328 (0.973) arch(5) 0.587 (0.709) 0.601 (0.699) 0.561 (0.730) 0.544 (0.742) skewness 0.15** 0.15** 0.12 0.14** excess kurtosis 2.14* 2.13* 2.22* 2.11* p(60) 44.57 (0.83) 54.30 (0.50) 61.73 (0.24) 60.51 (0.22) (b)  0.057 (0.25) 0.058 (0.24) 0.068 (0.13) 0.059 (0.23)  0.031 (0.07) 0.028 (0.07) 0.059 (0.12) 0.034 (0.32) 1 0.888 (0.00) 0.888 (0.00) 0.693 (0.036) 0.649 (0.00) d 1 0.743 (0.04) 0.650 (0.00) 1 0.108 (0.00) 0.112 (0.00) 0.109 (0.21) ln(l) -1685.75 -1685.81 -1684.66 -1683.86 aic 3.808 3.806 3.805 3.704 q(20) 17.45 (0.56) 18.35 (0.56) 19.84 (0.47) 19.11 (0.51) asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 228 qs(20) 5.80 (0.99) 5.96 (0.98) 6.48 (0.99) 5.91 (0.99) arch(5) 0.338 (0.89) 0.348 (0.88) 0.416 (0.84) 0.323 (0.123) skewness 0.17* 0.17* 0.16* 0.18* excess kurtosis 3.40* 3.43* 3.64* 3.41* p(60) 54.29 (0.46) 47.81 (0.74) 63.08 (0.18) 71.73 (0.13) notes: p(60) is the pearson goodness-of-fit statistic for 60 cells. the arch(5) and p(60) tests are computed on the standardized residuals. * and ** indicate rejection at 1% and 5% significance level, respectively. 5. conclusions the study examined the long memory property in the indian stock markets. the results of arfima model indicate that there is no existence of long memory property in the stock returns. the absence of long memory in asset returns supports the weak form market efficiency hypothesis. we investigate the long memory property in conditional variance series of indian stock markets. the arma-garch(1,0,1), arma-igarch(1,1,1), arma-figarch (1,d,0) and arma-figarch(1,d,1) were estimated. the estimation results indicate that arma-figarch (1,d,1) model better explains long memory property in conditional variance of return series. the results suggest that there is a prevalence of long memory property in volatility of indian stock markets. therefore, long memory models such as figarch are recommended for volatility forecasting. in addition, the long memory property of the bse market is revealed to be much stronger than nse. it could be said that nse might be having better process of market development and greater participation of competing investors than bse which could lead to better informational efficiency in volatility in comparison to bse. the evidence of long memory in volatility, however, shows that uncertainty or risk is an important determinant of the behaviour of daily stock data in the indian stock markets. high frequency data at minute frequency would be useful in understanding the dynamics of the markets. diebold and inoue (2001) detected the linkage between regime switching and long memory property. therefore, non linear models like regime switching might provide valuable insight over the dynamics of stock return, which could be an area for future research. references andreano, m. s. 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(2001). long memory and regime switching. journal of econometrics, 131-159. http://dx.doi.org/10.1016/s0304-4076(01)00073-2 microsoft word 4783-17548-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 110 is good governance a driver of family firm performance? jonathan bauweraerts university of mons warocqué school of economics and management accounting and management department, belgium e-mail: jonathan.bauweraerts@umons.ac.be olivier colot university of mons warocqué school of economics and management accounting and management department, belgium e-mail: olivier.colot@umons.ac.be received: dec. 17, 2013 accepted: march 4, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.4783 url: http://dx.doi.org/10.5296/ajfa.v6i1.4783 abstract in an economic context characterized by instability, corporate governance is a real challenge to the current managerial era. indeed, many financial scandals have recently erupted, encouraging the establishment of high quality governance practices in order to obtain stakeholders’ confidence through effective communication and transparency. however, family firms present specific organizational structures with intrinsic characteristics and a particular mode of operation. due to these characteristics, family firms exhibit specific governance practices which can affect performance. this paper investigates the relationship between governance structures and family firms’ performance so as to determine if governance is a driver of value creation or a mechanism enabling family businesses to retain stakeholders’ confidence. using a governance score, our results show that family governance practices are negatively linked with firm’s performance while classic governance practices do not play a significant role. it suggests that the implementation of formal family governance mechanisms creates a superfluous cost that hampers performance. our findings also asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 111 demonstrate that family firms with the lowest levels of performance display the higher governance scores, thus suggesting that family firms try to improve the image perceived by stakeholders. these results seem to confirm the convergence between economic and socioemotional objectives when the continuity of the organization is in danger. keywords: family firms, corporate governance, performance, stakeholders, socioemotional goals asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 112 introduction in recent years, economic news was marked by numerous financial scandals so that corporate governance has received high attention from academics and practitioners. thereby, the supervision of managers’ actions and decisions has become a necessity in an unstable economic environment characterized by many irregularities. the implementation of efficient governance structures thus constitutes a major challenge in the current managerial era. this challenge becomes more complex and interesting when the research object is family businesses. indeed, these organizations are full of specificities that make them a unique setting to analyze good practices of governance. due to their specific characteristics, family firms usually outperform their non-family peers. explanations are given either by a contractual approach based on agency theory (jensen and meckling, 1976; demsetz, 1983), or a relational approach based on altruism (schulze et al., 2001) and trust (allouche and amann, 1998), or an approach based on human resource management (colot, dupont, and volral, 2008). despite these empirical arguments, few empirical studies have tried to compare large family firms performance in belgium since previous research has mainly focused on smes (colot and croquet, 2005; colot and bughin, 2008; huybrechts et al., 2008). as a result, large family firms’ performance has not been linked with governance practices in the belgian institutional setting despite their potential to contribute to value creation (gombers et al., 2003; drobetz et al., 2003). indeed, even though little attention has been paid to the influence of governance on listed family firms performance in belgium, gompers et al. (2003) reveal that good governance practices are positively associated with firm’s performance. in the same vein, drobetz et al. (2003) have shown that german firms displaying the highest governance scores are the best performers. besides, mckinsey (2002) argues that institutional investors are willing to pay a premium comprised between 12% and 14% for firms in which good governance practices are implemented. in that sense, amir (2007) found that investment strategies oriented toward companies with good governance practices generates an abnormal return of 8.5%. based on these results, analyzing the relationship between good governance practices and performance would be particularly relevant in family businesses. indeed, the informal nature of governance and the willingness of family owners to preserve their socioemotional endowment (gomez-mejia et al., 2007; berrone et al., 2010) is likely to have an impact on the governance structure adopted by the organization and its effect on firm’s performance. accordingly, the main purpose of this research will be to investigate the relationship between good governance practices and performance on the belgian stock market (bel20). furthermore, the reverse relationship between performance and governance practices would also be investigated in this paper. in order to lead this research, a scale will be drawn up based on the belgian corporate governance code from 2009. in the next step, regressions will be run in order to compare family firms presenting the highest scores of governance and those displaying the lowest scores. the structure of this paper is as follows. a first section is a literature review analyzing the role of governance in family firms. the second section explains our methodological approach asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 113 regarding sample selection, good governance practices scale and econometric models. the results of our research are presented and discussed in a third section before concluding in a fourth section. 1. governance within family firms family firm’s performance is based on three main pillars: a permanent business project, a functional family group, and a professionalized management (lievens, 2006). indeed, family firms cannot remain healthy and evolve if they do not develop a continuous business project and spirit. they also need to be supported by a healthy and functional family in an environment guaranteeing the application of good governance practices. therefore, it seems necessary to assess the role of good governance in family businesses. due to the overlapping role of family, management, and ownership in family firms, adapted governance structures are necessary in order to enhance value creation in this type of organization. in that sense the particularities of governance systems within family businesses has been underlined by numerous scholars (melin and nordqvist, 2000; carney, 2005; miller and le breton-miller; madani and khlif, 2010). melin and nordqvist (2000) argue that governance in family firms differ from the original concept depicted by agency theory. they define corporate governance as the processes, principles, structures, and relationships that contribute to the achievement of family owners’ goals. based on this definition, corporate governance in family firms is more about the real influence of the family over the organization than the relationships between owners and managers. therefore, it means that as well factors related to structures and processes as formal and informal family influence through ownership, management, and supervision have to be taken account. according to this view, the existence of strong and longstanding relationships among family members turns the family into a natural governance mechanism. in such a context, family ties and the multiple roles of family members in the organization enable family structures to efficiently control the behaviors of family agents. another point of view is given by neubauer and lank (1998) who have defined corporate governance as a system of structures and processes enhancing control and leadership in the company. applying this broad definition of corporate governance is relevant at two levels. firstly, family governance refers to the function of control but also to the function of leadership through the strategy-making process. secondly, family governance is composed of three principal components: the family, the board of director, and the top management. the family dimension makes the governance system a point of confrontation between family values and economic goals. accordingly, family governance has to take into account the complexity induced by the presence of family members and their roles in the entrepreneurial structures. as a result, the family system plays a significant role in the value creation process. therefore, neubauer and lank (1998) have stressed that a family who wants to stay involved through ownership and management has to implement mechanisms that enable the family to be coherent such as family meeting, family councils, family nomination committee, etc. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 114 whereas the family is an essential pillar of the governance structure adopted by family businesses, lievens (2006) underlines the degree of importance devoted to the board. indeed, although the board is a primordial element in the classic managerial governance, the overlapping of ownership and managements in family firms creates a context where the board and the management appear as equivalent actors. in such a context, corporate governance is more likely to be apparent through informal processes. in that sense, davis et al. (1997) argue that informal processes are preferred in family firms and that formal structures have to be implemented when it is impossible to complete the current and short-term governance objectives. therefore, due to less formalistic style of family governance (carney, 2005), the implementation of formal family governance can be likely to create a superfluous cost that alters performance. based on this assumption, the presence of good governance practices in family firms can be detrimental to value creation since their opportunity cost is high. despite the economic cost of these formal mechanisms, the likelihood of their implementation is high. indeed, gomez-mejia et al. (2007) underline the importance of socioemotional wealth in family firms. indeed, family firms can take decisions that are not always economically driven in order to preserve their socioemotional endowment (gomez-mejia et al., 2007; gomez-mejia et al., 2010). adopting this perspective, family principals can be tempted to adopt elaborated governance structure that can be seen as a good sign by external stakeholders. indeed, the identification of family members with the organization can lead family principals to take decisions that can improve family image (sharma and manikutty, 2005) so that the perception of the firm by stakeholders is improved. based on this reasoning, family firms are likely to comply with governance code even if it induces costs that hamper performance. since governance mechanisms in family firms can induce superfluous costs accepted by family principals, we propose the next hypothesis: h1: the presence of formal governance mechanisms in family firms will lead to lower levels of performance. 2. methodology 2.1. target population the target population of our research is the family businesses that are listed on the belgian stock market (bel20). we focus on this index because all the firms listed on the belgian stock exchange have to comply with the norms presented in the governance code 2009 or to explain why they do not meet its recommendations. in order to determine whether a firm presents a family character, we explore the numerous criteria generally adopted to define a company as a family business. among these, the most frequently used criteria are related to ownership, control, and the willingness to pass a company onto subsequent generations. in our research, a firm is defined as being a family business when a family directly and/or indirectly owns 20% of the shares. this threshold can be justified by the fact that, even if the family is not majority owner, she can exert control over the organization and influence decision-making. in that sense, laporta et al. (1999) argue that a threshold of 20% is sufficient to effectively retain control in markets asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 115 characterized by dispersed ownership. moreover, using 20% as cut-off point enables us to be in line with previous research on listed firms that used thresholds comprised between 5% and 25% (barontini and caprio, 2006 ; favero et al., 2006 ; maury, 2006 ; sraer and thesmar, 2007 ; miller et al., 2007 ; andres, 2008 ; kowalewski et al., 2010 ; sacristan-navarro et al., 2011). as a result, we finally identify eight family firms on the bel20. 2.2. the measurement of good governance in family firms in order to measure good governance in family firms, we build an analysis grid that takes into account five dimensions: structure and functioning of the board, information transparency and disclosure, compensation and nomination policies, internal control, and family factors. this grid is based on previous work related to corporate governance in family firms (davis et al., 1997; melin and nordqvist, 2000; lievens, 2006) and takes into account the specificities of the belgian governance code 2009. the analysis grid is summarized in table 1. table 1. analysis grid of corporate governance in family firms dimensions criteria structure and functioning of the board 1.1 internal regulations of the board are provided in the governance charter of the company 1.2 separation of responsabilities between the ceo and the chairman of the board 1.3 board composition based on gender diversity 1.4 at least 50% of non-executive members act in the board 1.5 at least 50% of independent members act in the board 1.6 board members meet regularly information transparancy and disclosure 2.1 the company publishes an governance charter on its website 2.2 a declaration of governance is published in a specific section of the annual report. 2.3 firm’s values are disclosed in the governance charter 2.4 strategic choices are presented in the governance charter 2.5 a list of board members is published in the declaration of governance 2.6 a list of the members of the executive committee is published in the declaration of governance 2.7 information related to ownership structure is disclosed in the governance charter 2.8 the company mentions in the declaration of governance and the governance charter whether it complies with the belgian governance code 2009 2.9 when the company does not comply with the governance code, explanations are provided in the declaration of governance (comply or explain) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 116 2.10 the number of pages dedicated to governance in the annual report is adequate 2.11 information related to governance is easily available and readable compensation and nomination policies 3.1 nomination procedures of board members are published 3.2 selection criteria related to the nomination of board members are published 3.3 presence or absence of a nomination committee 3.4 presence or absence of a compensation committee 3.5 at least three members act in the compensation committee 3.6 at least three members act in the nomination committee 3.7 a compensation report is published in a specific section of the declaration of governance 3.8 the compensation report reveals information related to the remuneration policy of the executive managers 3.9 the amount of remuneration and other benefits directly or indirectly attributed to the ceo by the company and/or its subsidiaries is published in compensation report 3.10 the global amount of remuneration and other benefits directly or indirectly attributed to the other executive managers by the company and/or its subsidiaries is published in compensation report 3.11 information regarding the part of variable compensation is disclosed internal control 4.1 the main characteristics of internal control are presented in the declaration of governance 4.2 presence or absence of an audit committee 4.3 at least three members act in the audit committee family factors 5.1 presence or absence of a family council 5.2 presence or absence of a family charter 5.3 the number of family members seating at the board is disclosed 5.4 at least a family meeting each year based on this grid, a global score as well as five dimensional scores are calculated. these measures enable us to compare family firms with high governance scores and their peers that present the lowest results in order to investigate between the relationship between good governance practices and performance within family firms listed on the bel20 and vice asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 117 versa. moreover, regressions are also run in order to measure the individual influence of each dimension of governance on performance. 2.3. regression models in order to measure the influence of each dimension of the governance grid on family firms’ performance, we propose the next model that integrates control variables commonly used in studies analysing performance (e.g. anderson and reeb, 2003, villalonga and amit, 2006): (1) perfi,t = β0 + β1 board compositioni,t + β2 transparencyi,t + β3 policiesi,t + β4 internal controli,t + β5 family factorsi,t+ β6sizei,t + β7agei,t + β8debtsi,t + β9 sales growthi,t + β10investi,t + β11crisis + εi,t dependent variables. roa and roe are indicators that measure of performance within family firms. we chose for roa because this measure of performance focuses on economic profitability without taking into account the effect of financial choices whereas roe takes into account these elements (ooghe and vanwymeersch, 2006). independent variables. board compositioni,t corresponds to the score related to the category “structure and functioning of the board”. transparencyi,t is a variable integrating the score of the category “information transparency and disclosure”. policiesi,t is related to the score of the category “compensation and nomination policies”. internal controli,t corresponds to the score of the category “internal control”. family factorsi,t integrates the influence of family governance. control variables. sizei,t is control variable for size and is determined as the natural logarithm of total assets. agei,t control for life-stage of the firm and is measured by the natural logarithm of the numbers of years since the creation of the company. debtsi,t is a control variable for the effect of the financial structure on performance and is assessed by the ratio long-term debts/total assets. sales growthi,t controls for the maturity of the firms. investmenti,t is assessed by capital expenditure divided by total assets in order to control for the effect of investment policy on performance. crisist is a dummy variable taking the value 1 after the outbreak of the financial crisis in 2007, 0 otherwise. 3. results and interpretations 3.1. descriptive statistics asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 118 table 2. governance score analysis ab inbev ackermans & van haaren bekaert colruyt d’ieteren gbl solvay ucb structure and functioning of the board 5 5 5 3 6 5 6 6 information transparency and disclosure 15 12 15 5 7 16 14 15 compensation and nomination policies 12 14 12 4 9 14 15 15 internal control 3 3 4 3 2 4 4 3 family factors 1 2 2 0 2 2 2 2 governance score 36 36 38 15 26 41 41 41 ranking 3 3 2 5 4 1 1 1 minimum 15 maximum 41 mean 34,25 descriptive statistics reported in table 2 indicate that the mean family firm presents a governance score of 69.9% (34.25 divided by 49 items). therefore, it seems that family firms listed on the bel20 comply with the governance code 2009. however, we also see that most of them meet the requirements of the code in terms of classic rules of governance whereas the rules related to family factors of governance are not really respected. thus, it seems that family firms are not inclined to disclose information and to meet the required standards regarding family governance. besides, it is interesting to see the influence of good governance practices on family firms’ performance and vice versa. in this respect, four groups are established: group a gathers together family firms displaying the highest governance score and group b brings together family businesses presenting the lowest governance scores. this comparison is proposed in table 3. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 119 table 3. influence of governance on performance (roa/roe) performance group a group b mean max min mean max min roa 7.34 21.53 0.92 6.78 15.51 1.46 roe 12.13 41.63 0.91 17.16 49.28 0.26 table 3 shows that family firms with the lowest scores of governance display the highest levels of performance. indeed, we see a small difference between the two groups in terms of roa. however, roe is significantly higher for family firms that exhibit the lowest scores of governance. these results suggest that the existence of good governance practices exerts a negative influence on performance. this observation can be explained by the cost of implementing governance practices that would be greater than the gain in terms of efficiency in family firms. indeed, since these firms are characterized by informal governance mechanisms, the adjunction of formal mechanisms can be superfluous so that performance is hampered. however, we have to be cautious with these results due to the greater dispersion of performance in the two groups. 3.2. regressions analysis the negative influence of governance on performance has to be deeper analyzed in order to understand the origins of this negative relationship. in the present sub-section, regressions are run in order to assess the influence of different governance practices on performance. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 120 table 4. the effect of governance on family firms’ performance performance roa roe constant 0.067 (0.418) -0.028 (0.723) board composition -0.031 (0.338) -0.232 (0.585) transparency -0.095 (0.304) -0.192 (0.526) policies 0.103 (0.224) 0.297 (0.388) internal control 0.019 (0.203) 0.035 (0.351) family factors -0.410 (0.403) -1.344** (0.698) crisis -0.031 (0.028) -0.060 (0.048) debts -0.138 (0.150) -0.165 (0.261) size 0.009 (0.028) 0.027 (0.049) age 0.023 (0.388) 0.079 (0.067) invest -0.000 (0.000) 0.000 (0.000) sales growth -0.001 (0.003) -0.002 (0.006) r squared 0.3061 0.6178 wald test 24.35** 64.31*** number of observations 40 40 number of firms 8 8 ***, **,*: significant at 1%, 5%, and 10% respectively. standard errors are within brackets. table 4 indicates that the implementation of family governance mechanisms exerts a negative influence on performance, with a significant negative relationship with roe (p < .05). however, our results also indicate that classic forms of governance do not have any impact on family firms’ performance. therefore, the implementation of family governance mechanisms can be seen as detrimental to firm’s performance. this observation can be asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 121 explained by the superfluous cost associated with the implementation of formal family governance mechanisms. indeed, since family governance is usually informal (davis et al., 1997), the implementation of formal mechanisms can hamper performance. this situation seems to confirm that, due to their identification with the organization, family principals are likely to adopt governance mechanisms in order to improve the perception of their image so that their socioemotional endowment is preserved even if it impedes value creation (gomez-mejia et al., 2007). however, lower performance is likely to threaten the socioemotional wealth of family principals (gomez-mejia et al., 2007). therefore, we distinguish family firms according to their levels of performance in order to see if performance can have an influence on the adoption of formal governance mechanisms in the firm. group c gathers together family firms displaying the highest levels of performance and group d brings together family businesses presenting the lowest levels of performance. this comparison is illustrated in table 5. table 5. influence of performance (roa/roe) on governance practices group c group d mean max min mean max min roa and governance score 30.75 41 15 37.75 41 36 roe and governance score 29.5 41 15 39 41 36 table 5 suggests that performance is negatively associated with the implementation of good governance practices. indeed, we see that family firms displaying the highest levels of performance are characterized by the lowest scores of governance. this situation can be explained the fact that high-performing family firms do not have an incentive to provide external investors with information related to governance. indeed, due to their higher levels of performance, they do not have to improve the perception of their image by external stakeholders. however, when their performance becomes weaker, they can be tempted to disclose more information related to corporate governance and to implement governance mechanisms in order to reassure external stakeholders. accordingly, information disclosure related to governance practices and their implementation is more economically driven than relationally oriented. as a result, it can be argued that the willingness to opportunistically preserve the image of the company can be seen as an economic objective. as such, these results confirm that economically driven decisions can be taken in order to preserve the socioemotional endowments of family owners when the continuity of the firm is threatened (gomez-mejia et al., 2007; chrisman and patel, 2012). conclusion the main purpose of this paper was to analyze the influence of corporate governance on performance in listed family firms. indeed, these organizations are characterized by several asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 122 particularities that make them a unique setting to investigate governance (melin and nordqvist, 2000). indeed, the pursuit of socioemotional goals such as the preservation of the family image is likely to affect decisions related to the implementation of governance mechanism (gomez-mejia et al., 2007). accordingly, although formal governance mechanisms could be superfluous in family firms (davis et al., 1997), family principals are likely to engage in the elaboration of formal governance practices even if it induces weaker performance. indeed, the perception of internal and external stakeholders is an important issue in family firms. our results confirm that the existence of formal governance mechanisms is negatively associated with family firms’ performance. more specifically, family governance mechanisms exert a significant negative influence on firm’s performance. based on this observation, it can be argued that family firms implement costly family governance mechanisms because decision-making is also driven by non-economic goals such as the willingness to perpetuate a good family image (berrone et al., 2010). however, we also state that low-performing family firms tend to implement more formal governance mechanisms. in such a context, the socioemotional wealth of family principals is threatened by weak performance so that decisions are more economically driven (gomez-mejia et al., 2007). consequently, it can be argued that, when socioemotional endowment is threatened, family firms are more likely to invest in the implementation of governance mechanisms in order to reassure stakeholders such as external investors. although these decisions are more economically driven, they are necessary to preserve the future of the company so that we observe a convergence between economic and non-economic goals when the socioemotional endowment is threatened (chrisman and patel, 2012). as such, our results illustrate that family firms tend to take decisions that are not always economically driven excepted when firm’s continuity is in danger. our research presents several limitations. first, our sample is small and does not enable to generalize our findings. therefore, this paper can be seen as an attempt to give new insights regarding the role of governance in family firms and to draw attention on the importance dedicated to non-economic goals. future could thus replicate our method and use our analysis grid of governance in order to see if our findings can be verified in other institutional settings. second, we do not take into account generational issues in family firms even if the can have affect the importance given to socioemotional wealth by family principals (gomez-mejia et al., 2007). accordingly, future 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(2007). performance and behavior of family firms: evidence from the french stock market. journal of the european economic association, 5, 709–751. http://dx.doi.org/10.1162/jeea.2007.5.4.709 villalonga, b., & amit, r. (2006). how do family ownership, control and management affect firm value. journal of financial economics, 80(2), 385-417. http://dx.doi.org/10.1016/j.jfineco.2004.12.005 microsoft word 1001-4110-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 1 the issue of transparency in the financial statements of commercial banks: empirical evidence after the global financial crisis yen bui flinders business school, flinders university e-mail: yen.bui@flinders.edu.au received: october 27, 2011 accepted: november 13, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.1001 url: http://dx.doi.org/10.5296/ajfa.v3i1.1001 the author would like to thank mr graham jones, professor angele cavaye and mr peter lenz for their feedbacks. special thanks go to mr philip palmer for helpful comments; and associate professor sarath delpachitra for valuable inputs, support and guidance. abstract the debate on the applicability of fair value accounting has resurfaced after the global financial crisis. this study contributes to this debate by empirically comparing the effects when the fair value changes of financial instruments disclosed in the notes are considered in the primary financial statements. the study’s sample is four major australian banks and four of the largest american banks and covers the period from 2005 to 2010. the results show that comprehensive income of the sample banks is extremely negatively affected by fair value changes. shareholders’ equity is also negatively affected, although the effects are not material. these findings indicate that, from a market value perspective, the underlying performance and risks of commercial banks are not properly reflected in the financial statements. by contrast, as a consequence of high holdings of regulatory capital, fair value changes do not trigger violations of tier 1 capital ratio and total capital ratio. similar results are found for american banks when capital injections from the troubled assets relief programme are excluded. keywords: commercial banks, fair value disclosures, comprehensive income, shareholders’ equity, regulatory capital jel classification: g01, g21, g28, m41, m49 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 2 1. introduction the debate over fair value measurement of financial instruments has been going on for more than two decades, beginning simultaneously with the savings and loans crisis of the united states in the late 1980s. it was argued that reporting the major financial instruments, which were integral to commercial banks’ core operations, at historical cost did not portray faithfully their underlying performance and risk (enria et al., 2004; hodder et al., 2006). during that period, the rapid development of derivative financial instruments following the deregulation of financial markets and the increase of off-balance sheet transactions provided further reasons for the improvement of accounting standards for financial instruments (fasb, 2008). the historical cost basis of financial reporting was believed to be out of step with the changes in the investment environment and in capital market practices, where financial instruments were evaluated and traded at market values (jwgss, 2000). it was obvious that better disclosure of these complex transactions was necessary. the statement of financial accounting standards (fas) 107, disclosures about fair value of financial instruments, was issued in 1991 by the financial accounting standards board (fasb). this standard required disclosures of fair values of all1 financial instruments, both assets and liabilities, recognised and not recognised in the balance sheet (fasb, 2008). in a similar move, in 1995 the international accounting standards committee (iasc), now named the international accounting standards board (iasb), issued international accounting standard (ias) 32, financial instruments: disclosure and presentation (iasb, 2010). since the issuance of fas 107, several significant accounting standards for financial instruments have been released. derivatives were first required to be reported at fair value in 1993 by fas 133. fair value measurement was subsequently required for trading securities (landsman, 2006). notably, the accounting standard setters from major economies attempted to introduce a comprehensive fair value accounting model for financial instruments. in 2000 the joint working group of standard setters (jwgss) proposed a framework for the fair value measurement of all financial instruments (jwgss, 2000). under this framework, all fair value changes of financial instruments were to be taken to the income statement and the balance sheet (jwgss, 2000). nevertheless, concerns by the regulators and opposition, mainly from the banking industry, have meant that, to date, the framework has not been mandated (aba, 2010; bis, 2009; jwgba, 1999; jwgba, 2000). consequently, accounting standards requiring fair value disclosures of financial instruments which are still reported at historical cost in the balance sheet remain effective (with amendments) in most jurisdictions. the global financial crisis (gfc) of 2008–09 rekindled the ongoing debates and controversy on fair value accounting among major regulators, accounting standard setters and the banking industry (laux and leuz, 2009). there has been a significant volume of literature analysing the effects of fair value accounting, with the majority of the studies focusing on the banking industry in the united states, which was at the centre of the gfc. while proponents of fair value accounting believed that fair value measurement played a very limited role () in 1 the term “all” is not technically correct as “all” does not include intangible financial instruments (see penman, 2007). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 3 the gfc, critics contended that fair value measurement significantly contributed to this financial catastrophe (barth and landsman, 2010; laux and leuz, 2010; mala and chand, 2011). both the proponents and opponents argued for and against the effects of fair value accounting under the mixed-measurement framework of historical cost and fair value. under this framework, many commercial banks still reported a significant portion of their financial instruments at historical cost (sec, 2008). the current mixed-measurement method was therefore dominated by historical cost accounting, not fair value accounting. in our study, we took a different approach, by analysing the effects of reporting all financial instruments at fair value. we incorporated all disclosed fair value changes on the financial statements for selected major commercial banks. we were interested in examining how important elements of the financial statements, such as comprehensive income and shareholders’ equity, are affected when all the financial instruments are reported at fair value. further, we also investigated the change in the regulatory capital ratio when all fair value disclosures are taken to the regulatory capital. the samples selected were the four major australian banks and the four largest american banks, according to their assets at their balance dates in 2010. our aim was to contrast two groups of major banks operating in two countries, each of which had a very different experience during the gfc. the effects of fair value measurement of all financial instruments on current accounting and prudential measures could therefore be obtained from two extreme experiences. the remainder of this paper is set out as follows. section 2 provides an overview of the banking industry during the gfc and the effects of fair value accounting. section 3 discusses the basis for the research questions. section 4 introduces the samples and basis for analysis. section 5 analyses the results. section 6 presents a summary and conclusion. 2. banking industry during the global financial crisis following the technology stock market crash and the recession of 2000–02, many commercial banks in the united states changed their marketing strategy and focused on the retail banking sector, which includes the subprime 1 mortgage sector. encouraged by government policies (e.g. community reinvestment act), subprime mortgage lending, which was almost non-existent in 1993, had, by 2003, exceeded 20% of total residential mortgage lending (ryan, 2008). when house prices were accelerating and debt markets were liquid, subprime mortgagors were able to secure new debts, and defaults were low. unfortunately, because mortgagors’ equity cushion gradually declined after origination, refinancing became difficult and finally impossible (gramlich, 2007; ryan, 2008). credit losses from subprime mortgages and the collapse of the housing market resulted in the rapid depreciation in the prices of loans and affected other investments whose values were directly or indirectly tied to house prices. these investments include residential mortgage backed securities (rmbs), collateralized debt obligations (cdos) and credit derivatives, among others (ryan, 2008). rmbs and cdo are the two subsets of asset securitizations.2 these financial instruments 1 less than highly creditworthy (ryan, 2008). 2 process of pooling and selling illiquid assets (jobst, 2006). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 4 have been a major source of financing by financial institutions since the 1990s. in 2007, the securitization market was valued at us$9.3 trillion, twice the size of the us treasury bonds (barth and landsman, 2010). it is believed that the growth of the securitization market significantly contributed to the growth of the credit market, which facilitated the housing boom. because loans were securitized, banks had a tendency to establish riskier loans. when assessing bank credit risk, credit rating agencies generally did not take into account asset securitizations (barth et al., 2010). further, when assets were pooled, the securities were rated less risky than the individual underlying assets (amel-zadeh and meeks, 2010). due to the lack of transparency in financial reporting in this area and the complexities involved in understanding and evaluating these complex instruments, investors underestimated the risks they were taking (barth and landsman, 2010). derivatives were also at the core of the gfc because they magnified the risk to which both banks and investors were exposed (barth and landsman, 2010). according to allen and carletti (2005), credit risk transfer (credit derivatives and cdo) could create problems with liquidity and increase the risk of contagion and crises in the banking and the insurance sectors. this is essentially what happened to aig and lehman brothers.3 by the end of 2009, over one hundred banks in the united states had failed (frb, 2010b). many of them were acquired, for instance, jp morgan chase’s acquisition of bear stearns and the bank of america’s purchase of merrill lynch. the number of banks facing difficulties identified by the federal deposit insurance corporation increased from 250 to 700. the total value of the troubled assets relief program (tarp) amounted to us$700 billion, of which us$400 billion was actually taken up. nevertheless, the amount, after inflation adjustment, vastly exceeded us spending in the second world war (frb, 2010b; lewis, 2009). by contrast with the united states and many other major economies, the australian banking system proved to be resilient during the gfc. unlike the extensive “rescue packages” elsewhere, there were no bank bailouts in australia (see hawtrey, 2009 for a list of countries where capital injection were provided and banks assets were purchased). australian banks remained profitable as their overseas counterparts suffered severe losses during the crisis (edey, 2009). nevertheless, in order to promote financial stability in australia, the australian government introduced the government guaranteed scheme for large deposits and wholesale funding. as at january 2010, the average daily guaranteed amount was a$166 billion. the scheme was closed to new borrowings from march 2010 (schwartz, 2011). housing loans accounted for the majority of total loans by banks in australia, where mortgage lending was more conservative in practice. housing loans were full recourse; therefore, mortgagors had a strong incentive to avoid over-commitment. low-doc and non-conforming loans were a small part of the market (8%), by comparison with the 3 aig wrote more than us$440 billion of credit default swaps, the majority of which were for debts issued by lehman brothers. when lehman brothers defaulted on its huge debts, aig did not have sufficient cash to honour its credit default swaps contracts. it was feared that, if aig had not been “rescued” by the us government, aig’s problems could spread to other financial institutions and triggered the collapse of the entire system (barth and landsman, 2010; johnson, 2009). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 5 subprime loans (over 20% of total residential lending value) in the united states (edey, 2009; ryan, 2008). another important factor was the timing of the housing cycle. the australian housing cycle peaked around 2002–03 and, in the few years that followed, the housing market moved into a period of correction, with softer house prices and lower lending. therefore, australia evaded the problems of over-pricing and over-building experienced by the united states (edey, 2009). further, because of the more conservative banking model, australian banks had less exposure to highly risky assets such derivatives and trading securities (edey, 2009). australian banks had maintained a culture of intermediation rather than evolving into one of securitization, with excessive risk-taking. while many overseas counterparts encountered liquidity issues, australian banks had a more diversified and stable funding base (hawtrey, 2009). 2.1 effects of fair value accounting proponents of fair value accounting believe that fair value measurement provides timely information to the market and increases the relevance and transparency of financial reporting (barth and landsman, 2010; mala and chand, 2011). when there is an obligation to report the market value of assets and liabilities without delay, firms are encouraged to take prompt action to repair and strengthen their balance sheets (ryan, 2008). deviations from depressed markets to avoid reporting losses and impairments could decelerate corrective measures and increase fiscal costs, such as the case of the united states’ savings and loans crisis in the 1980s (laux and leuz, 2009). opponents to fair value accounting have expressed concern that, when financial markets become irrational and depressed, reporting fair values may not be a reliable reflection of fundamental values (laux and leuz, 2009). critics have also argued that fair value accounting can lead to pro-cyclicality, causing “over-pricing during boom times and exacerbating downward pressures when prices decline in illiquid markets” (stevenson, 2011, p. 1). distressed downward spiralling sales of assets can contribute to systemic risks among banks and possible contagion4 (adrian and shin, 2008; khan, 2010). by contrast, proponents contend that it is unlikely that the current fair value reporting framework increased banks’ leverage in the boom and worsened their problems during the gfc. although distressed sales did occur5, it was not clear that these sales resulted from the application of fair value measurement (laux and leuz, 2010), a view further supported by shaffer (2010). in an examination of fourteen of the largest banks in the united states, shaffer (2010) concluded that there was little evidence of distressed selling among these banks during 2008. from a prudential perspective, opponents to fair value accounting have contended that reporting assets and liabilities at fair value contributed to capital losses and rendered banks undercapitalised. this situation forced governments to inject vast sums of taxpayer funds into 4 contagion happens when problems of one bank spread to other banks which may lead to the failure of the whole banking system (pais and stork, 2010). 5, in july 2008, merrill lynch sold its asset-backed securities collateralized debt obligations (abs cdo) portfolio with a face value of us$30.6 billion at a price of us$6.7 billion (amel-zadeh and meeks, 2010). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 6 banks (frantianni and marchionne, 2009; also see veron, 2008). fair value reporting also affected the regulatory capital requirements imposed by prudential regulators, which may have forced banks to sell assets below fundamental values6 (khan, 2010). by contrast, shaffer (2010) found that, for large american banks in 2008, capital destruction or depletion was caused by large loan losses, trading losses and dividend payments, rather than by the reporting of assets and liabilities at fair value. the impact of the current fair value measurement framework on capital was not large enough to trigger asset sales to replenish capital and created a downward “spiralling” offload of assets. barth and landman (2010) noted that the collapse of the housing market in the united states resulted in the collapse of fair values of loans. loans were generally the largest asset group held by commercial banks. however, as allowed by the standards, loans were not reported in the primary financial statements at fair value. the proportion of banks’ assets reported at fair value in the first quarter ending 31 march 2008 in a sample of 50 representative banks in the united states was only approximately 31% (sec, 2008). the majority of banks’ assets were reported at cost, or under alternative measurement systems other than at fair value. similarly, the proportion of banks’ liabilities reported at fair value may also have been minor because deposits and debts, which are major liabilities, were still reported at historical cost. recent research has focused on the effects of fair value accounting in the current mixed-measurement system. under the mixed-measurement system, banks did not report all financial instruments at fair value. therefore, a question may be asked in relation to what the effects of using fair value measurement for all financial instruments would have been during the gfc. 3. research questions from the mid-1980s, the fasb commenced working on several projects whose aim was to develop accounting standards for new financial instruments and related transactions, including disclosure standards (fasb, 2008). the first disclosure standard was issued in 1990, fas 105, disclosures of information about financial instruments with off-balance sheet risk and financial instruments with concentrations of credit risks. the second disclosure standard, fas 107, disclosures about fair value of financial instruments, was issued in 1991. subsequently, fair value measurement in the balance sheet was required for certain types of investment securities through fas 115 and for derivative financial instruments through fas 133 (landsman, 2006). under the accounting standard codification (asc) project, in 2009 the fasb issued fas 107-1 and apb7 28-1, interim disclosures about fair value of financial instruments, which was subsequently replaced with asc 825-10-50-11, financial instruments: fair value of financial instruments. asc 825-10-50-11 required disclosures of the fair values of financial instruments on a more regular basis (quarterly). in australia in 1999, the australian accounting standards boards (aasb) first introduced aasb 1033, presentation and disclosures of financial instruments, which required disclosures of net fair values of all financial instruments. the rationale behind the requirement for disclosures was that fair value information was “widely used for business 7 accounting principles board. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 7 purposes in determining an entity’s overall financial position and in making decisions about individual financial instruments” (aasb, 1999, p. 37). aasb 1033 was replaced by aasb 7, when the iasb standards were adopted in australia in 2005. similar to fas 107, aasb 7 required fair value disclosures, in a comparable manner, of financial instruments that were recognised at historical cost. that is, fair value disclosures were to be presented together with the carrying amounts reported in the balance sheet. with the introduction of fas 107, there has been a significant volume of accounting research that has concentrated on the value-relevance8 aspect of banks’ fair value disclosures. focusing on financial institutions and particularly the banking industry, these studies investigated major classes of financial instruments, including investment securities, loans and debts (see barth, 1994; barth et al., 1995; barth et al., 1996; eccher et al., 1996; yonetani and katsuo, 1998). they found significant positive correlations between fair value disclosures and market-based measures such as share prices. other researchers furthered these studies by examining the risk-relevance aspect of fair value disclosures. their results also showed a positive relationship between fair value measures and market-based risk measures (hodder et al., 2006). nevertheless, it is also observed that increasing the disclosures about the fair values of financial instruments cannot be viewed as substitutes for the recognition of financial instruments in the primary financial statements (schipper, 2007). ahmed et al. (2006) provided evidence on how investors’ valuation of derivatives differed, depending on whether these instruments were recognised or disclosed. they identified that the valuation coefficients on recognised derivatives were significant, whereas the valuation coefficients on disclosed derivatives were not significant. they concluded that fas 133, which required recognition of all free-standing derivatives, increased the transparency of the financial statements. overall, it could be concluded that fair value disclosures of financial instruments are more relevant to financial reports users than are historical cost numbers. only the fair value recognition of financial instruments in the primary financial statements, however, ensures the transparency of the financial statements (ahmed et al., 2006; landsman, 2006). due to many factors, both political and technical, the major classes of financial instruments, such as investment securities, loans, debts and deposits, continue to be reported at historical cost (see aba, 2010; benston, 2008; bies, 2005; picker et al., 2009; among others for discussions). some subclasses of these instruments are allowed to be recognised at fair value. however, because of their classification, their unrealised gains and losses may not affect reported net income (laux and leuz, 2009). with the historical cost measurement model still in place, banks have some leeway to strategically time their profits and losses. the issue has been raised in the literature (see howieson and hancock, 1995; barth, 2004; laux and leuz, 2009). timing profits or hiding losses reduces transparency of financial statements (laux and leuz, 2009). in the wake of the gfc, it has been argued that deviations from the recognition of assets and liabilities at market value (fair value) shielded bank managers from the scrutiny of 8 value-relevance research analyses “the association between a security price-based dependent variable and a set of accounting variables; if an accounting number is significantly related to the dependent variable, then it is value-relevant” (beaver, 2002, p. 459). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 8 the capital market (laux and leuz, 2009). in that context, it would be interesting to know how important elements of financial statements such as income and shareholders’ equity would change if all financial instruments were measured at fair value. thus, we firstly investigated: 3.1 how are reported comprehensive income and shareholders’ equity affected when all financial instruments are recognised at fair value in the financial statements? income is one of the key indicators that financial analysts use to evaluate the performance of an economic entity. this is because income or earnings per share, not cash flows, are the more important metrics frequently considered by investors (graham et al., 2005). although reported net income (ni) presented in the income statement is better known than comprehensive income (ci) in the statement of changes in equity, the latter, with more incorporation of fair value changes, is a more transparent measure of income. shareholders’ equity (se) is another important financial indicator. se is commonly used to evaluate the gearing level and the solvency of an entity. different gearing levels have important implications for the entity’s financial stability (brierley and bunn, 2005). fair value accounting is believed to create more volatility in financial statements for commercial banks. volatility of financial statements is of concern to entities preparing financial statements and the regulators who are in charge of the financial stability of the financial system (barth, 2004). the more instruments are recognised at fair value, the more volatile the financial statements become (boyer, 2007; novoa et al., 2009; plantin et al., 2008a, plantin et al., 2008b). according to hodder et al. (2006), ni is the least volatile measure of income. full fair value income (ffvi), when all financial instruments are recognised at fair value, is the most volatile measure. ci falls between these two measures. as a partial adoption of hodder et al.’s (2006) method, this study aims to compare these three metrics in regard to value and variation (volatility) for a new sample of banks during the gfc period. our second research question therefore examined: 3.2 how do net income, comprehensive income and full fair value income compare? fair value accounting and its effect on regulatory capital and, consequently, the financial stability of banks have been of major concern to prudential regulators (barth, 2004) and this topic also been a regular subject of academic research since the mid-1990s. a study by barth et al. (1995) suggested that american banks violate regulatory capital more frequently under fair value accounting than under historical cost accounting. in denmark, where fair value accounting was extensively used, banks’ capital ratios tended to exceed the required minimum by a large extent, at approximately 38%–50%. furthermore, it was also discovered that small danish banks violated capital ratios more frequently (bernard et al., 1995). during the gfc, critics argued that under a fair value accounting regime banks had to recognise an unjustified reduction in the fundamental economic value of assets, with a corresponding reduction in shareholders’ equity. in order to maintain solvency ratios, they were forced to raise capital during depressing capital market conditions (see frantianni and marchionne, 2009; veron, 2008). it is therefore interesting to examine how regulatory capital ratios (cr) would be affected if fair value recognition were applied to all financial instruments on the asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 9 balance sheet. we investigated: 3.3 how are tier 1 capital ratio and total capital ratio affected when all financial instruments are recognised at fair value on the balance sheet? 4. samples and basis for analysis this is a descriptive case study. the samples are the four major australian banks and the four largest american banks according to their assets at their balance dates in 2010 (see table 1). the period under study is 2005–10, inclusive. the four major australian banks held 76% of australian banking industry resident assets (apra9, 2010); the four largest american banks held 41% of the united states domestic banking assets (frb10, 2010a; frb, 2010c). the issue of transparency of the financial statements is more important for large banks than small banks, because, even without any adverse situations such as the gfc, large banks are already scrutinised by the capital market, the general public and the regulators. insert table 1 here the banks selected for this study are four australian banks and four american banks. the australian sample banks are the national australia bank (nab), commonwealth bank group (cba), westpac banking corporation (wbc) and australia & new zealand banking group (anz). the balance date for the australian banks was the 30 september, except for cba, which reported on 30 june. the american sample banks are the bank of america (bac), citigroup (ctg), jpmorgan chase (jpm) and wells fargo (wfc). their balance date was 31 december. in relation to value, commercial banks report a substantial proportion of their financial instruments at historical cost. these financial instruments include loans, deposits and debts. apart from these three major financial instruments, commercial banks also report a number of other financial instruments at historical cost. these can be investment securities or non-marketable equity investments, federal funds and securities under re-sale or re-purchase agreements. table 2 shows the proportion of loans, deposits and debts as a percentage of total assets. the balance sheet of commercial banks was skewed toward historical cost, especially on the liabilities side. insert table 2 here commercial banks were required to disclose the fair values of all financial instruments recognised at historical cost in the balance sheet. for loans, fair values were estimated by discounting principal and interest payments using internal credit risk and interest rate models. fair values of deposits were estimated by discounting contractual cash flows using current market rates for instruments with similar terms and maturities. fair values of debts were estimated by using quoted market prices or were based on current market interest rates and credit spreads for instruments with similar terms or maturities (see sample banks’ financial reports during the period 2005–10). 9 australian prudential regulation authority. 10 federal reserve board. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 10 for the purpose of this study, reported ci, se, regulatory capital, cr, values of risk-weighted assets and gross fair value disclosures of all financial instruments reported at historical cost were retrieved from the banks’ 48 financial statements and the notes to the financial statements. gross fair value disclosures were subsequently calculated net of tax11, based on the statutory tax rates. because ci, se and rc were based on after-tax profits, fair value changes were also reconstructed net of tax numbers to ensure comparability. the percentage change was calculated by dividing the fair value change after tax by ci or se. ffvi was calculated by adding the fair value change after tax to ci. the three income measures, ni, ci and ffvi, were calculated as a percentage of total average assets. percentage change = fair value change after tax / ci or se (1) ffvi = ci + fair value change after tax (2) ni/ci/ffvi = ni/ci/ffvi/[(beginning assets+ending assets)/2] (3) the mean of ni, ci and ffvi was used to determine which income type creates the highest income numbers for banks over the designated period. the standard deviation (sd) of ni, ci and ffvi was to measure the volatility level. regulatory capital was composed of shareholders’ equity, with adjustments allowed by the relevant prudential regulator. australian banks were required by apra to hold as a minimum a tier 1 capital ratio (t1cr) of 4% and a total capital ratio (tcr) of 8%. to be “adequately-capitalised” under the federal bank regulatory agency definitions, american banks had to hold a t1cr of at least 4% and a tcr of at least 8%. to be “well-capitalised”, t1cr and tcr had to be 6% and 10% respectively. the change in cr was calculated by dividing the fair value change after tax by total risk-weighted assets. the adjusted cr was computed by adding the change in cr to the reported cr. change in cr = fair value change after tax / risk-weighted assets (4) adjusted cr = reported cr + change in cr (5) there are two benchmarks used in this study. if an incorporation of a fair value change triggers a change of more than 10%, the change is considered material. if an incorporation of a fair value change triggers a violation of the cr, the change is considered significant. 5. results 5.1 effects on comprehensive income and shareholders’ equity table 3 shows the changes in a$ million dollars and in percentage in ci and in se of australian banks when fair value disclosures are taken to ci and se. the change in any single year can be very large for some of the sample banks. nab shows a reduction of a$2,157 million in ci and se in 2009. to put this number into perspective, nab’s 2009 reported ni and ci were a$4,602 million and a$3,993 million respectively. cba shows an increase of a$1,205 million in 2010. cba’s reported ni and ci in 2010 were a$3,410 11 australian company tax rate is 30% and american corporate tax rate is 35%. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 11 million and a$3,408 million respectively. insert table 3 here apart from the cba, which shows a mean increase of 6.41% in ci for the whole period of 2005–10, the other three banks experience mean decreases. the mean decrease is very material for nab (114.96%) and the effect can also be extreme for any single year. for example, nab’s ci decreases more than six times in 2009 (621.73%). nab’s ci in 2009 is a$347 million; incorporating all fair value changes effectively transforms nab’s ci into a full fair value loss of a$1,810 million. different banks experience different effects of fair value changes in different periods. in 2005, nab and wbc experienced a negative change, whereas cba experienced a positive change, and anz stayed almost unchanged. wbc experienced the highest reduction in ci (by 37.27%) in 2005, anz in 2007 (by 10.38%), cba in 2008 (by 37.96%), and nab in 2009 (by 621.73%). for wbc, anz and cba, the decreases are caused by the fair value changes of loans which are not offset by the fair value changes of deposits and debts. for nab, the decrease is caused by the fair value changes of investment securities which are not offset by the fair value changes of deposits and debts. thus, portfolio structure and quality may have played an important role in the variation of the fair values of financial instruments in any single year (see anz, 2007; cba, 2008; nab, 2009; wbc, 2005). in contrast with the effects on ci, the effects of fair value changes on se are not material, with a maximum value of 4.84% and a minimum value of negative 6.29%. table 4 shows the fair value changes in us$ million dollars and in percentage in the ci and se for the american banks. the fair value change in any single year can be extremely large. for example, bac shows a fair-valued reduction of us$24,413 million in 2008. to put this number into perspective, bac reported a net income of us$4,008 billion and a comprehensive loss of us$7,946 in that year. ctg shows a fair-valued increase of us$16,640 million in 2008. during that year, ctg reported a net loss of us$27,684 million and a comprehensive loss of us$48,219 million. insert table 4 here for the period 2005–10, bac and jpm show mean ci decreases of 76.50% and 200.26% respectively; and ctg and wfc show mean increases of 81.07% and 21.14% respectively. again, the effects can be extremely large for any single year. for example, jpm shows a reduction in ci by 12 times in 2008. this is mainly due to the fair-valued decrease of loans, which is not offset by the fair-valued decrease of debts (jpm, 2009). in contrast, ctg shows an increase of nearly six times in ci for 2008. in contrast with other american banks, ctg reduced the size of its debt portfolio significantly in 2008 by comparison with 2007 and may not have needed to obtain new funds at higher market rates. in order to measure the fair values of debts, ctg discounted cash flows using market interest rates (ctg, 2009). ctg’s old debt portfolio, when measured at fair value using higher market rates of 2008, may have asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 12 been reduced significantly. unlike australian banks, there are material effects on se for several american sample banks (maximum and minimum values are 11.75% and 16.38% respectively with a count of 5). the negative effects appear to concentrate in the gfc years of 2008–09 and to a lesser extent, in 2010. the finding is not surprising, given that the united states was at the centre of the gfc. this is in contrast to australian banks, where negative effects can be found in any year of the period 2005–10. thus, the effects on australian banks may be explained by the micro environment, where portfolio structure played a more important role. 5.2 comparison of net income, comprehensive income and full fair value income table 5 shows ni, ci and ffvi as a percentage of average total assets for the period 2005–10 for the australian sample banks. for this period the standard deviation of ffvi is consistently highest for the four banks, followed by the standard deviation of ci and then that of ni. that indicates that ffvi is the most volatile measure of income, with ni the least volatile measure. cba’s ffvi varies the most, at about three times its ni (0.37% versus 0.12%) and ci (0.37% versus 0.13%). wbc’s ffvi varies the least by comparison with its ci and ni (0.19% versus 0.17%). insert table 5 here in relation to the measure of centrality, for nab, wbc and anz, the mean ni is highest and the mean ffvi is lowest. cba has a ffvi which is marginally higher than its ni and ci. the difference between nab’s mean ffvi and ni is very large: 0.47% versus 0.81%. nab’s ffvi is almost half its ni. incorporation of all fair value disclosures has changed nab’s ci to a full fair value loss (-0.28%). wbc’s mean ffvi is also 22% lower than its ni (0.78% versus 1%). when compared with ni, which is the best-known measure of performance of commercial banks, the ffvi of three of the australian major banks is significantly lower. the exception is cba. ffvi creates more volatility in income over the six-year period for all four banks. it can be concluded that australian banks can demonstrate a more favourable picture of their underlying performance to the users of financial reports by reporting ni under the mixed-measurement regime. consistent with the findings for australian banks, american banks’ ffvi is the most volatile measure of income during the period 2005–10 (see table 6). ci is somewhere in the middle and ni is the least volatile. the average variation of jpm’s ffvi is about three times its ni (0.94% versus 0.31%) and more than double its ci (0.94% versus 0.40%). the other three banks also show noticeable differences between the standard deviation of ffvi versus that of ni, and to a lesser extent, ci. insert table 6 here the mean ffvi of bac and of wfc is materially lower than their mean ni. bac’s ffvi is about half its ni (0.37% versus 0.71%). wfc’s ffvi is about 76% of its ni (0.92% versus asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 13 1.21%). in contrast, ctg’s ffvi is about 50% higher than its ni (0.58% versus 0.38%). jpm’s ffvi is 16% higher than its ni (0.89% versus 0.77%). for all of the sample banks, the ci numbers are closer to the ni numbers. thus, only ffvi creates dramatic changes to the income of banks. incorporating fair value changes into ci exerts more negative effects on american banks than on australian banks. ci is changed into a full fair value loss for bac in 2009 (-0.37%), ctg in 2010 (-0.07%) and jpm in 2008 (-0.49%). 5.3 effects on regulatory capital table 7 shows the changes in cr of australian banks when after-tax fair value disclosures are taken to shareholders’ equity. australian banks were required by apra to hold a minimum 4% t1cr and 8% tcr. during the period 2005–10, australian banks were well capitalised, with t1cr above 6.5% and tcr above 9.5%. insert table 7 here when fair value disclosures are incorporated, cr only decreases by a maximum value of 0.63% (nab in 2009) and increases by a maximum value of 0.46% (cba in 2006). consequently, the adjusted t1cr and tcr are also above the minimum regulatory requirements. it is therefore obvious that the incorporation of all fair value disclosures into shareholders’ equity does not significantly affect t1cr and tcr for australian banks. table 8 shows the changes in cr of american banks after fair value adjustments. during the period 2005–10, american banks were well capitalised under the federal bank regulatory agency’s definitions, including during the crisis years. some banks achieved the high cr with the assistance of the troubled asset relief program (tarp), while other banks accomplished this without the tarp (to be discussed further below). however, all their t1cr and tcr were above 6% and 10% respectively. when fair value disclosures are taken to shareholders’ equity, cr decreases by a maximum value of 1.85% for bac in 2008 and wfc in 2009 and increases by a maximum value of 1.67% for ctg in 2008. the adjusted t1cr and tcr of american banks are all above the “well-capitalised” benchmarks. therefore, similar to australian banks, for american banks, the incorporation of all fair value disclosures into shareholders’ equity does not significantly affect t1cr and tcr. insert table 8 here during the gfc, the american banks bac, ctg and jpm received financial assistance from the united states government to strengthen their capital base through the tarp. bac raised approximately us$15 billion in october 2008 and us$30 billion in january 2009 through the sale of preferred stock to the united states department of treasury. ctg raised us$25 billion in october 2008 and an additional us$20 billion in december of that year. jpm and wfc both raised us$25 billion at the end of 2008. the four banks repaid tarp in 2009 (see bac, 2009; ctg, 2009; jpm, 2009; wfc, 2009). insert table 9 here asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 14 as per table 9, without us government support through tarp, the tcr and adjusted tcr of wfc fall below the well-capitalised benchmark (minimum 10%) but stay above the adequately-capitalised benchmark (minimum 8%). being much higher capitalised, the tcr and adjusted tcr of bac, ctg and jpm are not significantly affected. the tcr and adjusted tcr of bac, ctg and jpm stay above the well-capitalised benchmark without tarp funds. 5. conclusion this study shows that, when fair value changes are taken to the income statement, ci decreases materially for the majority of the sample banks in both the australian and american groups. the fair value increases in “good years” (before the gfc) do not offset the fair value decreases in “bad years” (during and after the gfc), with some banks experiencing extreme full fair value losses. similarly, se also decreases on average for the majority of the sample banks. however, the effects are not material. relatively consistent results are found when the three income measures, ni, ci and ffvi, are compared. that is, the extent by which ffvi is lower than ni is much sharper than the extent by which ffvi is higher than ni. consistent with hodder et al.’s (2006) findings, ffvi is the most volatile income measure during the six-year period, followed by ci; ni is the least volatile measure. fair value adjustments do not trigger violations of t1cr and tcr for any of the sample banks. this appears to be consistent with previous research, where small banks, not large banks, tended to violate regulatory capital ratio more frequently when fair value accounting was applied (bernard et al., 1995). the same results are found when tarp funds are removed from the capital of american banks, except for one of the sample banks. the findings have important implications. during a financial crisis, fair value measurement of all financial instruments have extreme negative effects on income for the majority of the sample banks, by comparison with the current mixed-measurement of fair value and historical cost. further, fair value measurement of all financial instruments causes much higher volatility of income year after year. given that the banks hold dominant positions in the economies in which they operate, these effects might be viewed as creating “too much noise”. the findings provide a further confirmation of the reasons for the banking industry’s success in lobbying for the mixed-measurement model. this also explains why prudential regulators have continually expressed their concern over the expansion of fair value measurement for financial instruments (see bis, 2009; frb, 2004). unfortunately, by avoiding “noise” through the application of the mixed-measurement regime, financial statements have also become less transparent. the underlying performance of commercial banks and the risks they take, as judged by market value benchmarks, have not been adequately reflected in the financial statements. on the other hand, fair value adjustments of shareholders’ equity did not trigger a violation of t1cr or tcr for the sample banks during the period 2005–10. this result is consistent during the crisis years of 2008–09, with or without tarp funds. it can therefore be concluded asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 15 that, when major banks are sufficiently capitalised, which is often the case, capital ratios will not be materially affected even if all financial instruments are measured at fair value. since this study focuses on only a very small sample, concentrating as it does on only two countries, an avenue for future 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(1998). economic policy review october, fair value accounting and regulatory capital requirements. federal reserve board of new york, new york. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 20 table 1. sample banks’ total assets in a$ billion (australian banks) and us$ billion (american banks) bank12 2005 2006 2007 2008 2009 2010 nab 423 485 565 657 654 686 cba 337 369 425 488 620 646 wbc 300 300 375 440 590 618 anz 301 336 393 471 477 532 average 340 372 439 514 585 621 bac 1,292 1,460 1,716 1,818 2,223 2265 ctg 1,494 1,884 2,188 1,939 1,857 1914 jpm 1,199 1,352 1,562 2,175 2,032 2118 wfc 482 482 575 1,310 1,296 1258 average 1,117 1,294 1,510 1,810 1,852 1,889 source: sample banks’ annual reports. table 2. loans, deposits and debts as a percentage of total assets banks loans deposits debts deposits and debts nab 56.03 48.99 13.62 62.61 cba 72.35 52.68 21.64 74.32 wbc 75.44 54.80 22.96 77.77 anz 72.23 60.77 15.84 76.62 n=24 69.01 54.31 18.52 72.83 bac 44.91 46.89 20.87 67.77 ctg 34.11 40.72 22.37 63.09 jpm 32.71 42.53 15.53 58.06 wfc 62.89 63.80 21.57 85.37 n=24 43.65 48.49 20.08 68.57 sources: sample banks’ annual reports. 12 the banks are listed in the order of the size of their total assets as at the balance dates in 2010. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 21 table 3. australian banks – effects on ci and se when all fair value disclosures are taken to the financial statements (a$ million dollars) bank description 2005 2006 2007 2008 2009 2010 mean nab change ($) -1,317 599 687 -575 -2,157 -1,131 ci (%) -32.99 10.21 18.53 -31.66 -621.73 -32.13 -114.96 se (%) -4.18 2.09 3.28 -2.50 -5.70 -2.90 -1.65 cba change ($) 779.80 990.50 -680.61 -1035.86 452.27 1205.40 ci (%) 22.88 23.52 -18.38 -37.96 20.90 27.50 6.41 se (%) 3.44 4.64 -3.98 -5.66 2.05 4.84 0.89 wbc change ($) -1063.30 -409.50 -770.00 -322.70 -891.80 -667.80 ci (%) -37.27 -13.10 -22.20 -8.29 -28.13 -10.79 -19.96 se (%) -6.29 -2.54 -4.32 -1.63 -2.44 -1.66 -3.15 anz change ($) 68.60 219.80 -401.10 -119.00 -155.40 -77.00 ci (%) 2.49 6.26 -10.38 -3.52 -8.68 -2.08 -2.65 se (%) 0.35 1.10 -1.82 -0.45 -0.48 -0.23 -0.25 n=24 ci (%) max = 27.50 min = -621.73 change > |10%| count = 18/24 change > |50%| count = 1/24 change > |100%| count = 1/24 se (%) max = 4.84 min = -6.29 change > |10%| count = 0 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 22 table 4. american banks – effects on ci and se when all fair value disclosures are taken to the financial statements, (us$ million) bank description 2005 2006 2007 2008 2009 2010 mean bac change ($) -1,604 1,645 3,479 -24,413 -19,049 163 ci (%) -13.74 7.38 14.60 -307.23 -164.88 4.90 -76.50 se (%) -1.58 1.22 2.37 -13.79 -8.23 0.07 -3.32 ctg change ($) 11,895 8,580 13,130 16,640 585 -14,755 ci (%) 53.20 42.12 523.52 -34.51 11.24 -109.16 81.07 se (%) 10.57 7.16 11.56 11.75 0.38 -8.90 5.42 jpm change ($) 1,300 1,690 585 -10,075 -4,680 130 ci (%) 16.12 11.56 3.65 -1206.59 -27.01 0.70 -200.26 se (%) 1.21 1.46 0.47 -6.04 -2.83 0.07 -0.94 wfc change ($) 1,483 629 948 -8,829 -18,736 -1,700 ci (%) 20.08 7.38 11.18 178.76 -82.92 -7.66 21.14 se (%) 3.65 1.37 1.99 -8.91 -16.38 -0.86 -3.19 n=24 ci (%) max 523.52 min -1206.59 change > |10%| count = 18/24 change > |50%| count = 8/24 change > |100%| count = 5/24 se (%) max 11.75 min -16.38 change > |10%| count = 5/24 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 23 table 5. australian banks – ni, ci and ffvi as a percentage of average total assets bank income 2005 2006 2007 2008 2009 2010 mean sd ni 1.10 1.13 1.06 0.51 0.39 0.63 0.81 0.33 nab ci 0.96 1.26 1.01 0.43 0.05 0.53 0.71 0.45 ffvi 0.64 0.97 0.84 0.29 -0.28 0.36 0.47 0.45 ni 1.06 1.12 1.13 1.06 0.86 0.90 1.02 0.12 cba ci 1.06 1.19 1.13 1.06 0.86 0.90 1.03 0.13 ffvi 1.30 1.47 1.09 0.53 0.67 1.26 1.05 0.37 ni 1.15 1.10 1.04 0.97 0.68 1.06 1.00 0.17 wbc ci 1.12 1.10 1.03 0.96 0.62 1.02 0.97 0.19 ffvi 0.70 0.96 0.80 0.88 0.44 0.91 0.78 0.19 ni 1.13 1.16 1.15 0.77 0.62 0.89 0.95 0.23 anz ci 0.99 1.10 1.06 0.78 0.38 0.73 0.84 0.27 ffvi 1.01 1.17 0.95 0.76 0.34 0.72 0.83 0.29 table 6. american banks – ni, ci and ffvi as a percentage of average total assets bank income 2005 2006 2007 2008 2009 2010 mean sd ni 1.37 1.54 0.94 0.23 0.31 -0.10 0.71 0.67 bac ci 0.97 1.62 1.50 -0.45 0.57 0.15 0.73 0.80 ffvi 0.84 1.74 1.72 -1.83 -0.37 0.15 0.37 1.37 ni 1.65 1.28 0.18 -1.34 -0.08 0.58 0.38 1.07 ctg ci 1.50 1.21 0.12 -2.34 0.27 0.72 0.25 1.37 ffvi 2.30 1.71 0.77 -1.53 0.31 -0.07 0.58 1.36 ni 0.72 1.13 1.05 0.30 0.56 0.84 0.77 0.31 jpm ci 0.68 1.15 1.10 0.04 0.82 0.90 0.78 0.40 ffvi 0.79 2.41 1.14 -0.49 0.60 0.90 0.89 0.94 ni 1.69 1.76 1.52 0.28 0.99 1.01 1.21 0.56 wfc ci 1.62 1.77 1.60 -0.52 1.77 1.15 1.23 0.89 ffvi 1.95 1.90 1.78 -1.46 0.30 1.06 0.92 1.33 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 24 table 7. australian banks – changes in tier 1 capital ratio (t1cr) and total capital ratio (tcr) when fair value disclosures are taken to shareholders’ equity bank description 2005 2006 2007 2008 2009 2010 nab t1cr 7.50 7.30 6.70 7.40 8.96 8.91 adjusted t1cr 7.07 7.49 6.89 7.23 8.33 8.58 tcr 10.50 10.80 10.00 10.90 11.48 11.36 adjusted tcr 10.04 10.99 10.19 10.73 10.85 11.03 cr +/-0.46 0.19 0.19 -0.17 -0.63 -0.33 cba t1cr 7.46 7.56 7.14 8.17 8.07 9.15 adjusted t1cr 7.87 8.02 6.86 7.67 8.23 9.56 tcr 9.75 9.66 9.76 11.58 10.42 11.49 adjusted tcr 10.16 10.12 9.48 11.08 10.58 11.90 cr +/0.41 0.46 -0.28 -0.50 0.16 0.41 wbc t1cr 7.20 6.90 6.50 7.80 8.10 9.10 adjusted t1cr 6.58 6.69 6.16 7.68 7.79 8.86 tcr 9.70 9.60 9.50 10.80 10.80 11.00 adjusted tcr 9.08 9.39 9.16 10.68 10.49 10.76 cr +/-0.62 -0.21 -0.34 -0.12 -0.31 -0.24 anz t1cr 6.90 6.80 6.70 7.70 10.60 10.10 adjusted t1cr 6.93 6.89 6.55 7.66 10.54 10.07 tcr 10.50 10.60 10.10 11.10 13.70 11.90 adjusted tcr 10.53 10.69 9.95 11.06 13.64 11.87 cr +/0.03 0.09 -0.15 -0.04 -0.06 -0.03 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e1 www.macrothink.org/ajfa 25 table 8. american banks – changes in tier 1 capital ratio (t1cr) and total capital ratio (tcr) when fair value disclosures are taken to shareholders’ equity bank description 2005 2006 2007 2008 2009 2010 bac t1cr 8.25 8.64 6.87 9.15 10.40 11.24 adjusted t1cr 8.07 8.80 7.16 7.30 9.16 11.25 tcr 11.08 11.88 11.02 13.00 14.66 15.77 adjusted tcr 10.90 12.04 11.31 11.15 13.42 15.78 cr +/-0.18 0.16 0.29 -1.85 -1.24 0.01 ctg t1cr 8.79 8.59 7.12 11.92 11.67 12.91 adjusted t1cr 10.13 9.40 8.17 13.59 11.72 11.40 tcr 12.02 11.65 10.70 15.70 15.25 16.59 adjusted tcr 13.36 12.46 11.75 17.37 15.30 15.08 cr +/1.34 0.81 1.05 1.67 0.05 -1.51 jpm t1cr 8.50 8.70 8.40 10.90 11.10 12.10 adjusted t1cr 8.65 8.88 8.46 10.09 10.71 12.11 tcr 12.00 12.30 12.60 14.80 14.80 15.50 adjusted tcr 12.15 12.48 12.66 13.99 14.41 15.51 cr +/0.15 0.18 0.06 -0.81 -0.39 0.01 wfc t1cr 8.26 8.95 7.59 7.84 9.25 11.16 adjusted t1cr 8.65 9.10 7.79 7.04 7.40 10.99 tcr 11.64 12.50 10.68 11.83 13.26 15.01 adjusted tcr 12.03 12.65 10.88 11.03 11.41 14.84 cr +/0.39 0.15 0.20 -0.80 -1.85 -0.17 table 9. american banks – total capital ratio (tcr) and adjusted total capital ratio (%) without the support of tarp, for the year 2008 bank tcr adjusted tcr bac 11.86 10.02 ctg 11.18 12.85 jpm 12.80 11.99 wfc 9.56 8.76 microsoft word 918-3765-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 56 barriers to islamic banking growthbank employees’ perspective from pakistan adnan bashir lecturer, faculty of management & administrative sciences university of gujrat, pakistan e-mail: adnan.bashir@uog.edu.pk mirza rizwan sajid lecturer, faculty of statistics university of gujrat, pakistan e-mail: mirza.rizwan@uog.edu.pk samra iqbal mphil scholar, department of economics university of gujrat, pakistan e-mail: samrabashir@yahoo.com received: september 1, 2011 accepted: november 20, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.918 url: http://dx.doi.org/10.5296/ajfa.v3i1.918 abstract the concept of islamic banking (ib) in pakistan traces its roots back to late 70s. since its inception it has had its fair share of growth. the ib industry, despite its growth during the last few years, has not fully nurtured and its share in banking industry is moderate 6.4%. this study explores the view point of bank employees of gujranwala division pakistan regarding this statistics. by using a sample of 126 respondents, comprising islamic bank employees (ibe) and conventional bank employees (cbe) to investigate the factors responsible for low market share of islamic banking in banking industry. our findings indicate that according to over all sample small network of branches, inadequate info about islamic banking services, ignorance to teachings of islam, trust deficiency towards interest free banking and location of banks as the main reason for mere rise of islamic banking. the factors change if we divide our sample in subsamples of ibe and cbe. although considerable work in this area has been done in world and pakistan is no exception to this however, the focus of majority of research asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 57 is on the customers view point. this paper explores the roots of modest share of ib from bank employees’ angle. keywords: bank employees, conventional banking, employees, financial system, islamic banking. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 58 1. introduction the concept of islamic financial system (ifs) is as old as the religion islam itself. according to moin (2008) it dates back to the life of the holy prophet muhammad (pbuh), about fifteen centuries ago when he acted as an agent for his wife business dealings. ifs has evolved over the years & the phenomenon which started off as a mere means to fulfill religious obligation has now turned into a more structured & organized way of banking in the current challenging & difficult economic climate. in the last quarter of 20th century, islamic finance industry has made significant progress globally. moreover, during the last decade or so the ifs have registered a tremendous increase of about 20 percent per annum. due to this it has become one of the fastest growing sectors of the overall financial system. the breeding seeds of this revolutionary concept of ib were sown in late 1940‘s & by 1960’s & 1970’s ib started taking a meaningful shape. according to sikand (1997) traces of first islamic bank are found in the area of mit ghamr in egypt in 1963 when first interest free islamic bank was formed & from onwards it has never looked back. in the years to come ib took more momentum & with the increasing influence of middle eastern countries on the world economy, due to their oil reserves more and more traditional western banks started establishing their own subsidiaries or partnerships practicing interest free banking in muslim countries. according to warde (2010) the decade of 1970 saw the emergence of so many islamic banks namely dubai islamic bank (1975), kuwait finance house (1977), faisal islamic bank of egypt (1977), islamic bank of sudan (1977), jordan islamic bank of finance & investment (1978), bahrain islamic bank (1978) and islamic international bank for investment. in pakistan during late 70’s serious efforts were put into action to islamize the economy and that laid the foundation for modern ib. however it took some time to flourish ib. according to awan (2009) the growth of ib in pakistan accelerated since 2002. this was the time when state bank of pakistan changed its approach to introduction of ib as a change management issue. according to state bank of pakistan (2008) the first fullfledged commercial islamic bank license was issued in 2002[1]. currently there are 6 fullfledged islamic banks and 13 conventional banks offering islamic products. although islamization of economy was started in late 70’s, still ib phenomenon has not fully borne fruit and that is reflected in its modest market share of 6.4%. this figure looks even more surprising, that about 98% people are muslims and being a conservative society religious beliefs hold a central importance and place in the overall thinking process. although a lot of work has been done in this area from customer’s point of view, but studies focusing on employees are very few. according to quagraine (2010) employees are the source of energy for the organization. their non involvement in decision making can alter the performance of the organization. this study is an effort to bridge the gap of lack of literature in this area. moreover the recommendations of this study can be used by the policy makers to devise a framework for growth of ib. 2. literature review in order to understand the real causes of lack of growth of ib in pakistan we need to discuss in detail what really matters according to employees. studies focusing on employees’ point of asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 59 view are very few; hence we will concentrate on what influences customers’ choice or decision of doing business with any particular bank. different researchers have listed numerous selection criteria & they vary across the globe. according to erol and el-bdour (1989) availability of fast and efficient services, image of bank and its reputation and confidentiality were the most important factors. they conducted a study on jordanian customers. they were of the view that religion was not the most important reason to select financial institution. sudin et al. (1994) observed the behavior of malaysian customers. they were of the opinion that provision of fast and efficient services, speed of the transaction and reputation and image of the bank were the main factors that customers consider important while choosing the financial institution hegazy (1995) carried out a research on the attitude of egyptian customers. his respondents were islamic bank customers. he reached at the result that efficiency and speed of delivering banking services were the most crucial elements in the selection of bank. gerrard and cunningham (1997) performed study on the singapore customer. they wanted to explore the awareness of customers towards the islamic banking products. their findings highlighted the need of strong advertising campaign to overcome the lack of awareness of the customer regarding the ib. a study was conducted by naser et. al (1999) on jordan banks clients. they highlighted the opening time of banks as not helpful. according to rammal and zurbruegg (2006) strong image and availability of services like atm and phone banking were the important contributors in customer selection of islamic banking products. they explored the awareness of australian muslims towards islamic banking. they pointed out that people were interested in ib products; however unawareness to these products was the biggest hurdle in this regard. dusuki and abdullah (2006) conducted a research on why do malaysian customers patronize islamic banks and they found out that the provision of offering islamic banking services should not be taken as far granted success. other factors like cost & benefits of products offered, service quality, convenience and size of the bank were equally important if not more important which influence customers’ choice. haque et. al (2009) stressed upon the importance of availability of good quality services to influence customers’ perception about islamic bank. in addition to this social culture and religion was also playing its role in this regard. they performed their research on malaysian customer choices. al-ajmi et. al (2009) after studied the attitude of bahrain clients and identified quality of customer service, friendly staff, qualified personnel, bank brand name, convenience in terms of parking space and interior design of bank as the main factor for selection of bank. rashid and hassan (2009) looked at the responses of bangladesh customers’. they arrived at asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 60 the conclusion that fast and efficient services, speed of the transaction were the most preferred factors in choosing an islamic bank. they negated the religion as basic criteria for selection of bank. abduh and omar (2010) identified the compliancy to shariah laws, knowledge of ulama council of indonesia (mui) fatwa towards interest, perceptions towards security of capital and advertisement of islamic banks as the most important variables for banks. they explored the obstacles to indonesian customers. khattak & rehman (2010) analyzed the customers’ contentment and their knowledge about islamic banking products in pakistan. their findings suggested that islamic banking products were not well known to majority of customers. in their view, branch location was playing a vital role in this regard. moreover they argued that islamic banks must offer more efficient products to their customers. mansour et. al (2010) after analyzing the uk respondents’ behavior pin pointed the cost as the main reason for choosing a bank. 3. research methodology 3.1 data a well structured questionnaire was used to collect the data from the respondents. this instrument of data collection consisted of two sections: ist section aimed to obtain socio-demographic information about the respondents and the 2nd part solicited information about the 9 possible obstacles faced by employees of islamic & conventional banks. these motives were drawn mainly from earlier studies cited above. in the 2nd part five point likert scale was used to obtain answers from respondents. the population of the study consisted of the employees of islamic and conventional banks. they were randomly selected from gujranwala division. the researcher distributed the questionnaire among a sample size of around 160 people. out of those distributed questionnaires, 126 were fully answered while the remaining 34 were either partially answered or not answered at all. researcher went to extra length to make sure that selected sample had diversification in demographic characteristics. pre testing was also done to check the validity of questionnaire. 3.2 methodology stratified random sampling was used to select the sample. it was considered that conventional and islamic bank employees might have different opinions about the barriers of ib growth. so population of bank employees was divided into two groups: conventional bank employees (cbe) and islamic bank employees (cbe). proportion allocation method was used to select the sample from these two said groups. chi-square test of homogeneity was used to see the difference among more than two categories of responses. for barriers to ib growth 5-point likert scales converted into 3-point for data analysis. strongly agree and agree considered to be one category as agree and strongly disagree and disagree as disagree. this test shows which category proportion is different from other? so on the basis of this test we can say which assumed factor is asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 61 confirmed in this research. it is important to note that we should not only focus on the p-value for the confirmation of factors. we also have to see the proportions of category which has significantly high frequency. it shows that result move towards that direction e.g. high frequency of agree with p-value < level of significance shows that factor is significant barrier for ib end vice versa. 4. empirical results out of 126 respondents 101 were male which constituted 80.2% of sample while remaining 19.8% were female respondents. with respect to age of participants, age group of 25 to 35 was the largest with a figure of 39.7%. participants of 55 years or elder were in the least quantity. according to the education of the respondents, people with graduation had lion’s share of around 49%. around 39.7% people had attained master’s qualification. these statistics show that majority of our sample was highly qualified. if we turn our attention to marital status of correspondents here married people had a figure of 63.5% as compared to 37.5% of single. the researcher found out that 29% respondents were earning 25,000 or less, 49.2% between 25,000 to 50,000.while 16.7% were earning between 50,000 and 100,000, while 6 participants were earning above 100,000. the above percentage shows that majority of the respondents were earning 50,000 or less per month. with respect to type of banking, majority of bankers in our population were employees of conventional banks. their percentages stood at 69.8% while employees of islamic banks had less proportion with 31.2%. the researcher observed that 5-10 years experience category had 25.4% while less than 3 years experience people were 24.6%. in this category least percentage of 18.3 was of respondents with 15 or more year’s experience. table 1 presents descriptive statistics of the respondents. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 62 table 1. demographic characteristics of the sample demographic categories frequency % age under 25 23 18.3 25-35 50 39.7 35-45 29 23.0 45-55 14 11.1 above 55 10 7.9 sex male 101 80.2 female 25 19.8 education matric 7 5.6 intermediate 6 4.8 graduation 61 48.4 master 50 39.7 other 2 1.6 marital status single 46 36.5 married 80 63.5 monthly income 0-10000 1 .8 10000-25000 36 28.6 25000-50000 62 49.2 50000-100000 21 16.7 above 100000 6 4.8 banking type islamic 38 30.2 conventional 88 69.8 years of experience less than 3 31 24.6 3-5 24 19.0 5-10 32 25.4 10-15 16 12.7 above 15 23 18.3 4.1 barriers to overall sample table ii shows the opinion of ibe and cbe as a whole regarding the lack of the growth of ib. in this research 77 out of 126 employees of banks (conventional and islamic both) are of the view that ignorance to teachings of islam with respect to financial transactions is a major factor for low market share of ib. the test of homogeneity of proportions resulted that this proportion is significant at 0.05 level of significance. so ignorance to teachings of islam regarding financial matters is an important factor for growth of ib system. this shows that religion is an important consideration for low market share of ib for the respondents of this asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 63 study. this is in-align with the study of haque et. al (2009) and mansour et. al (2010). these studies considered religion as important reason. when we turn our attention to trust deficiency towards interest free banking, facts and figures show that most of bank employees think that people do not trust ib regarding interest free setup. the present factor is also confirmed through test of homogeneity at 0.05 level of significance with p-value .of 000. this could be explained by the fact that pakistan is an islamic country in which majority of people has perception about banking system as interest based set up, which is not allowed in islam. so people think that any type of banking cannot be free of interest. here findings of our research are consistent with that of abduh and omar (2003). although ib is more than 30 years old, however people are not aware of its products and services. according to our study inadequate information about islamic banking products and services is important factor for lack of growth of ib. test of homogeneity at 0.05 level of significance also verifies this. in our study 84 out of 126 respondents said that it is a significant factor for low market share of ib. this view was shared by the work of gerrard and cunningham (1997) and rammal and zurbruegg (2006). experienced and skilled human resource is required for effective and efficient system. shortage of experienced and qualified staff is also significant hindrance for growth of ib according to our sample. according to this study 67 out of 136 agree with this. pvalue of 0.000 is also significant at 0.05 level of significance. here our findings were in line with that of al-ajmi et. al (2009). literature review showed that non availability of good quality customer services is also playing its part in low market share of ib. but according to our findings it is not significant factor, because majority of bank employees show their disagreement about it. it means that in pakistan ib are providing good customer services. results disagreeing with inadequate information about islamic banking service are significant. low effectiveness of services is not a hurdle for ib progress. according to results of our research, number of respondents agreeing and disagreeing to this is almost equal. the results is not significant due to proportional difference between agree and disagree but due to huge difference from neutral group. previous researches also identified high cost of ib products as main reason for its low market share. but this research also rejects this notion. the reason for this is the frequency of people for and against this is almost equal. moreover p-value is also insignificant at 0.05 level of significance. employees of banking system were of the view that small network of branches and their locations are very important hurdle in the progress of ib system. both these factors are significant at.05 level of significance. here our results also support the view point of khattak & rehman (2010). thus according to the whole group significant factors for low share of ib are asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 64 1) small network of branches 2) inadequate info about islamic banking services 3) ignorance to financial teachings of islam 4) trust deficiency towards interest free banking 5) location of banks 6) shortage of experienced and qualified staff table 2. test result of overall sample factors observed n expected n residual chi square test value with significance ignorance to financial teachings of islam disagree 32 42.0 -10.0 46.429 .000* not sure 17 42.0 -25.0 agree 77 42.0 35.0 trust deficiency towards interest free banking disagree 32 42.0 -10.0 46.429 .000* not sure 17 42.0 -25.0 agree 77 42.0 35.0 inadequate info about islamic banking services disagree 27 42.0 -15.0 64.714 .000* not sure 15 42.0 -27.0 agree 84 42.0 42.0 shortage of experienced and qualified staff disagree 44 42.0 2.0 32.333 .000* not sure 15 42.0 -27.0 agree 67 42.0 25.0 non availability of good quality customer services disagree 61 42.0 19.0 25.857 .000* not sure 16 42.0 -26.0 agree 49 42.0 7.0 low effectiveness of services disagree 54 42.0 12.0 10.905 .004* not sure 25 42.0 -17.0 agree 47 42.0 5.0 high cost of banking products and services disagree 47 42.0 5.0 2.905 .234 not sure 33 42.0 -9.0 agree 46 42.0 4.0 small network of branches disagree 21 42.0 -21.0 86.333 .000* not sure 14 42.0 -28.0 agree 91 42.0 49.0 location of banks disagree 38 42.0 -4.0 19.619 .000* not sure 24 42.0 -18.0 agree 64 42.0 22.0 * significant at .05 level of significance asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 65 4.2 factors for subsample: it was decided to divide the sample into two subsamples i.e. conventional and islamic and compare the factors responsible for growth of ib system. our sample consisted of 38 & 88 respondents respectively. table iii and table iv highlight these factors. with respect to 1st factor of ignorance to teachings of islam, total sample agreed that ignorance to teachings of islam is a big barrier for ib growth. both of our subsamples i.e. islamic and conventional bank employees in table iii and iv also come to same conclusion. however according to ibe this is more of concern as compared to cbe due to no. of respondents in favor of this are in much higher proportion in islamic than conventional. next comes the factor of trust deficiency towards interest free banking system. the overall sample confirms this as significant hurdle in the expansion of this ib. results of both subsamples also think that this is a significant factor. but like previous factor this is much more important to ibe as compared to cbe. it can be observed that ibe are giving it more weight than cbe. in this case, 30 out of 38 of ibe are in favor of this factor, however in cbe only 47 out of 88 agree with this. so it is an important factor for both but ibs employees are more strongly agree to this than cbs employees. ibe also give assign more weight to the inadequate information about islamic banking products and services as compared to cbe counterparts. this is similar to previous factor situation. in the overall sample, we can see that shortage of experienced and qualified staff is a significant factor. however in case of ibe, is not significant however cbe consider this to be an important factor. it can be said that ibe are biased because being the respondents of this study; they may not consider themselves as unqualified and inexperienced. in the next case non-availability of good and quality customer services, both types of employees show consensus that this is not a barrier to ibs. it can be observed that in both situations, disagree proportion is high. these results are significant at 0.05 level. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 66 table 3. test result of islamic banking factors observed n expected n residual chi square test value with significance ignorance to financial teachings of islam disagree 2 12.7 -10.7 40.158 .000* not sure 5 12.7 -7.7 agree 31 12.7 18.3 trust deficiency towards interest free banking disagree 7 12.7 -5.7 37.000 .000* not sure 1 12.7 -11.7 agree 30 12.7 17.3 inadequate info about islamic banking services disagree 6 12.7 -6.7 36.211 .000* not sure 2 12.7 -10.7 agree 30 12.7 17.3 shortage of experienced and qualified staff disagree 15 12.7 2.3 5.421 .067 not sure 6 12.7 -6.7 agree 17 12.7 4.3 non availability of good quality customer services disagree 21 12.7 8.3 13.000 .002* not sure 3 12.7 -9.7 agree 14 12.7 1.3 low effectiveness of services disagree 18 12.7 5.3 4.000 .135 not sure 8 12.7 -4.7 agree 12 12.7 -.7 high cost of banking products and services disagree 17 12.7 4.3 2.579 .275 not sure 12 12.7 -.7 agree 9 12.7 -3.7 small network of branches disagree 8 12.7 -4.7 25.316 .000* not sure 3 12.7 -9.7 agree 27 12.7 14.3 location of banks disagree 12 12.7 -.7 15.842 .000* not sure 3 12.7 -9.7 agree 23 12.7 10.3 * significant at .05 level of significance with respect to low effectiveness of services, ibe and cbe as whole do not see it as a problem for expansion of ib. the result of ibe subsample is in aligns with that of overall sample. moreover, p-value of .002 is not significant for cbe due to proportional difference between agree and disagree but due to huge difference from neutral group. both types of bank employees show that high cost of banking products and services is not a asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 67 barrier for ibs. in the last two factors, small network of branches and location of branches are significant barriers for promotion of ib. both types of employees are showing their consensus on these factors. these results are significant at 0.05 level. thus according to ib employees subsample following are hindrances to ib growth 1) ignorance to teachings of islam 2) inadequate info about islamic banking services 3) trust deficiency towards interest free banking 4) small network of branches 5) location of banks asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 68 table 4. test result of conventional banking factors observed n expected n residual chi square test value with significance ignorance to financial teachings of islam disagree 30 29.3 .7 19.727 .000* not sure 12 29.3 -17.3 agree 46 29.3 16.7 trust deficiency towards interest free banking disagree 25 29.3 -4.3 17.341 .000* not sure 16 29.3 -13.3 agree 47 29.3 17.7 inadequate info about islamic banking services disagree 21 29.3 -8.3 32.205 .000* not sure 13 29.3 -16.3 agree 54 29.3 24.7 shortage of experienced and qualified staff disagree 29 29.3 -.3 28.659 .000* not sure 9 29.3 -20.3 agree 50 29.3 20.7 non availability of good quality customer services disagree 40 29.3 10.7 14.068 .001* not sure 13 29.3 -16.3 agree 35 29.3 5.7 low effectiveness of services disagree 36 29.3 6.7 7.795 .002* not sure 17 29.3 -12.3 agree 35 29.3 5.7 high cost of banking products and services disagree 30 29.3 .7 4.386 .112 not sure 21 29.3 -8.3 agree 37 29.3 7.7 small network of branches disagree 13 29.3 -16.3 61.523 .000* not sure 11 29.3 -18.3 agree 64 29.3 34.7 location of banks 5 disagree 26 29.3 -3.3 7.386 .025* not sure 21 29.3 -8.3 agree 41 29.3 11.7 * significant at .05 level of significance while cb employees consider following to major hurdle to ib growth 1) small network of branches 2) inadequate info about islamic banking services asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 69 3) trust deficiency towards interest free banking 4) ignorance to financial teachings of islam 5) location of banks 5. conclusion there has been a tremendous growth in ib all over the entire world especially in muslim countries. pakistan is the second largest islamic country in the world in terms of population, boasting over 98% muslim population. although concept of ib in pakistan traces its roots back to late 70s, still share of ib is modest i.e. 6.4%. it still remains a surprise why has islamic banking not touched the heights as expected? the researcher has tried to debate on this issue as a banker. according to this study there are number of factors contributing in the slow progress of ib i.e. small network of branches, inadequate info about islamic banking services, ignorance to financial teachings of islam, trust deficiency towards interest free banking, location of banks and shortage of experienced and qualified staff. the findings of this study reveal that people have serious reservations about the truly islamic nature of ib and they don’t consider current ib according to the true teachings of islam. sbp being the regulator of all financial activities in pakistan needs to revaluate its regulatory and supervisory role. although sbp have taken several steps including establishment of its shariah board for compliance to sharia laws. however, lot of work needs to be done in this regard. the results of this research also identify the need of more work for existing islamic banks to make their products acceptable for common man. while each islamic bank has appointed shariah advisor, responsible for shariah compliance matters. but its role needs to be looked at. marketing strategies of islamic banks may be partially held responsible for low market share. existing marketing approaches need to revamp and islamic banks need to come up with new marketing ideas to attract more customers. islamic banks should try to reach more people by opening more branches and it will certainly increase public confidence on them. islamic banks need to expedite their expansion plans. in addition to this banks need to train their existing staff to deal with ib products. workshops, training sessions and seminars are good way to overcome the lack of qualified personnel. the results of this study provide some useful insight into the hurdles faced by ib industry and it will pave the way for further research in this area involving different stakeholders’ opinion and their demographic variables. references abduh, muhamad and omar, mohd. azmi. 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(2007). awareness of islamic banking products among muslims: the case of australia. journal of financial services marketing 12, 65-74. http://dx.doi.org/10.1057/palgrave.fsm.4760060 rashid, m., hassan, m. k. (2009). customer demographics affecting bank selection criteria, preference and market segmentation: study on domestic islamic banks in bangladesh. international journal of business and management 4, 131-146. sikand, y. (1997). trends in islamic banking and finance. islamic voice.11-09, available at: http://www.islamicvoice.com/september.97/isla.htm (10 december 2010). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e4 www.macrothink.org/ajfa 71 sudin, h., norafifah, a., and planisek, l. (1994). bank patronage factors of muslim and non muslim customers. int. j. bank mark 12, 32-40. http://dx.doi.org/10.1108/02652329410049599 wardey, i. (2010). islamic finance in the global economy, edinburgh university press. edinburgh, http://www.sbp.org.pk/publications/schedule_banks/index.htm (10 october 2010) microsoft word 5822-20950-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 64 is temporary trading halt mechanism for new shares on the first day of trading conducive to curbing speculations? kai shi school of economics, northeast normal university 2555 jingyue street, changchun 130117, p.r. china e-mail: shik142@nenu.edu.cn li nie graduate school of commerce and management administration hitotsubashi university, 2-1 naka, kunitachi, tokyo 186-8601, japan e-mail: brilliant.so.kai@gmail.com received: june 17, 2014 accepted: july 30, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5822 url: http://dx.doi.org/10.5296/ajfa.v6i2.5822 abstract ipo underpricing as well as speculation on the first day of trading is a worldwide phenomenon. in order to curb ipo speculation risks, shenzhen stock exchange makes an attempt to directly restrain price volatility and turnover rate through the temporary trading halt mechanism. this paper employs rubin causal model and genetic matching method to evaluate and analyze real effects of the mechanism. empirical results show that, although it lowers the first-day turnover rate, the mechanism does push up first-day returns and first-day price-to-earning ratio. in fact, it keeps the closing price stay in a relatively high level, but is helpless for curbing risks. keywords: temporary trading halt mechanism for ipos on the first day of trading, matching method, rubin causal inference asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 65 introduction in china, speculative trading about newly listed shares is a typical drinking-game in which thousands of irrational investors may ignore stock fundamentals and follow suit to participate in the hype, and the finale is being hung up for a long time and suffering great losses. according to the statistics of financial innovation laboratory of shenzhen stock exchange, 497 of 583 newly listed shares between the beginning of 2010 and the end of february 2012, especially for 33 of 34 newly listings, whose first-day returns exceed 100%, have fallen below the first-day closing price, with an average drop of 23.15% and the maximum decline even outpaces 64.4%. the loss percent of individual investors in whose account the amount is less than 100 thousand yuan reaches up to 60.75%. since the launch of small-and-medium enterprise board, especially for the beginning of ipo system reform, shenzhen stock exchange (szse) has committed to explore the effective ways of refraining speculation. during the initiation of growth enterprise market, szse made a first trial about the temporary trading halt mechanism for newly-listed shares during first-day trading, and punished 9 short-term speculative accounts, who frequently partook in the hype, by restricting free transactions. in the wake of the effects of ipo system reform gradually emerging, pricing in primary market becomes more and more reasonable; meanwhile, newly listed shares speculations in secondary market get to intensify once again. from the middle of february, 2012, the returns of 8 ipos on the first-day of trading expands significantly, with an average rise of 62.65%, and over 60% shares’ first-day returns growth outpaces 50%, including 3 shares whose rises even exceed 80%. in order to take precautions against the risk of newly listed shares on the first-day of trading as well as cooperate with ipo system reform, szse made a bold move which stressed direct executive interference on ipo shares’ first day performance and released “notice on further optimizing the temporary trading halt mechanism for newly-listed shares during first-day trading” (the notice), highlighting the role of trading halt mechanisms. although szse has rolled out a series of new supporting measures for ipo reform, analysts still insist that these probably encourage speculations and bring individual investors more risks. among copious literature relevant to ipo underpricing not many researches pay enough attention to ipos first-day risk management. ruud (1993) investigates the distribution of initial returns following ipos and find a partially unobserved left tail effect. ruud believes underwriter price support may account for the skewed distribution and challenges the presumption that ipo underpricing is deliberate. according to his logic, any ipo regulatory initiatives aimed at eliminate premium is redundant. pettway and kaneko (1996) explore the linkage between the change of ipo pricing regimes and new shares initial returns. they find that the price limits remove and auction mechanism introduction significantly reduce initial returns. thus, risk management about initial returns may rely on market-oriented reforms. krigman, shaw and womack (1999) show that ipo flipping is predictable and underwriters’ pricing errors are intentional. thus, rational pricing is the very solution to restrain the risk of first-day flipping. kao, wu and yang (2009) examine two sets of ipo regulatory initiatives, pricing regulations and penalty regulations and find pricing regulations may induce firms to manipulate pricing-period earnings thus negatively influence the post-ipo performance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 66 whereas penalty regulations prevent firms from over-optimism about earnings forecast thus have positive impacts. song, tan and yi (2014) evaluate the relative importance of ipo underpricing and overvaluation and find that overvaluation has more explanatory power on initial return. its implication lies in what the regulatory commission should do is to reduce overvaluation but not to overly depend on controlling secondary market performance. in this paper, we focus on testing the real effects of the notice which in fact sets a limitation for the price volatility of newly listed shares, and explore whether this measure lowers the risks or not. to the best of our knowledge, this is the first attempt to quantify the impacts of price control on the secondary market performance of ipos during the first day of trading. our findings not only provide guidance for deepening china’s ipo system reform, but also provide a reference for other countries. the structure of this article is as follows: section 2 briefly reviews the attempts of szse in coordination with ipo system reform; section 3 describes data and econometric methodology; section 4 explains empirical results, and section 5 makes a concluding remark. attempts in coordination with ipo system reform in china on 25th may, 2012, three shares landed on small-and-medium enterprise board which commenced the implementation of new ipo rules. the new rules bring three changes: increasing the allotment for institutional investors in off-line offering; removing the requirement for three-month lock-up; allowing new shares acquired on the first trading day to freely float. in order to propel reform, new ipo rules are also absorbed into management measures for securities issuance and underwriting amended in line with the china securities regulatory commission guidelines for further deepening ipo reform (the guidelines). in response to changes in new shares issuance management, szse releases three follow-up measures aimed at curbing first-day speculation, inducing rational pricing and maintaining orders during the first-day transaction of newly-listed shares. first, szse releases “notice on further optimizing the temporary trading halt mechanism for newly-listed shares during first-day trading”, which highlights the role of the trading halt mechanisms. in order to curb newly listed shares speculation, szse released “first-day temporary trading halt system for ipo shares” on 8th march, 2012. some positive results emerged after that. first-day closing prices of 45 ipos listed on szse since then has risen only 21.82% on average, which is obviously lower than previous. in response to the public concerns over shortened trading time for hot ipo shares on their first trading day, szse reformulated the trading halt triggering criterion based on the percent of price volatility and turnover ratio. this adjustment is part of the consistent effort to explore and optimize the existing trading halt mechanism through sound appraisal and extensive public consultation. the notice further refines the system. first, according to the measure, a new price volatility criterion of 20% above or below the opening price is set to be a trigger: (1) if price fluctuation during intraday trading reaches or exceeds 10% above or below the opening price for the first time, trading will be suspended for one hour and risk alert of possible speculation will be issued to investors. if price fluctuation during intraday trading reaches or exceeds 20% above or below the opening price for the first time, trading will be suspended until 2:57 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 67 p.m., the time that closing auction begins; (2) if turnover rate reaches or exceeds 50% during intraday trading, trading will be suspended for one hour. second, szse releases guidelines to enhance regulation over the trading of newly-listed shares. guidelines for monitoring abnormal trading behaviors in periods immediately after listing (draft) covers many new points: specifying explicit definitions of abnormal trading behaviors on first-day and subsequent trading; clarifying specific regulatory measures to enhance transparency of szse’s regulations and procedures; offering evaluation and corresponding monitoring standards for member firms’ performance in managing their clients’ behaviors in the transaction about newly-listed shares. third, szse provides further guidance for investors rationally participating in ipos and urges members to intensify the efforts of investor suitability management. by drawing on the experience of investor suitability management on the chinext market, szse emphasizes risk alerts and education and requires institution members to help raise their clients’ awareness of compliance during their participation in ipos trading as well as further enhance self-regulatory mechanism. in general, two notable measures may significantly influence the first-day transaction. first, under the new scheme, transactions about newly-listed shares will be halted for one hour if the price volatility relative to the opening price by as much as 10% during its first trading day. meanwhile, the status of trading halt until the last 3 minutes before closing will take effect if the price deviates over 20% from the opening price. second, transactions will also be halted for one hour if the turnover ratio exceeds 50% on the first day. obviously, the distinctive characteristic of temporal trading halt system is that it is a non-market intervention means. in the view of szse, it is necessary for an immature market even though not everyone believes so. however, numerous analysts insist that although being given high expectation the trading halt mechanism actually loosen the regulation about speculation due to the fact that speculators are able to manipulate trading with fewer funds under this mechanism. thus, it is helpless for risk control. data and methodology data we aim at quantifying the effect of temporary trading halt mechanism on the performance of first-day trading. data about 51 newly-listed shares upon szse during 1st january, 2012 and 11th may, 2012 (including 19 shares issued before the implementation of temporary trading halt mechanism and 32 ones issued after that) have been selected for empirical research. we focus on this period for two reasons: the primary one is to keep other impact factors invariant as far as possible meanwhile eliminating the influence of market trends, thus 1st january, 2012 has been choose as the beginning; the other is that since the end of may 2012, ipo in chinese domestic stock market has been paused temporarily waiting for further reform deepening. all data come from csmar database. in the process of policy effect assessment and comparative analysis, one of the most considerable issues is to figure out how the same share will perform during the first day of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 68 trading without temporary trading halt mechanism? it involves the comparison between observational and potential outcomes. except in the realm of science fiction, where parallel universes are sometimes imagined to be observable, it is impossible to measure causal effects at the individual level. in essence, causal inference is a missing value issue. we resort to rubin causal inference model and matching method. rubin causal inference model the rubin causal model conceptualizes causal inference in terms of potential outcomes under treatment and control, only one of which is observed for each unit (rubin 1990). a causal effect is defined as the difference between an observed outcome and its counterfactual. let yi1 denote the potential outcome for newly-listed share i if its first trading day is after the release of the notice, and yi0 denote the potential outcome for i if its opening transaction is before the release of the notice. the treatment effect for i is defined by τi = yi1 yi0. causal inference is a missing data problem because yi1 and yi0 are never both observed. in principle, if assignment to treatment is randomized, causal inference is straightforward, while, in our observational setting, covariates are almost never balanced across treatment group, in which members are newly-listed after the release of the notice and thus subject to the temporary trading halt mechanism, and control groups, in which shares are newly-listed before the release of the notice and thus independent of its regulation, because they are not ordinarily drawn from the same population. thus, a common quantity of interest is the average treatment effect for the treated (atet): ( ) ( ) ( )1 01 1 1i i i it e y t e y tτ = = = − = (1) where ti is a treatment indicator who equals to 1 when i is newly-listed after the release of the notice and 0 otherwise. equation 1 cannot be directly estimated because yi0 is not observable for the treated. thus, we assume that selection into treatment depends on observable covariates x. following rosenbaum and rubin (1983), conditional on x, treatment assignment is unconfounded ({y0, y1⊥t}|x) and there is overlap: 0<pr(t=1|x)<1. together, they constitute the property of strong ignorability of treatment assignment. for atet, the unconfoundedness assumption can be weakened to mean independence: e(yij|ti,xi)=e(yij|xi), and meanwhile the support of x for the treated be a subset of the support of x for control observations is an enough shortcutting for overlap assumption. by conditioning on observed covariates x, treatment and control groups are exchangeable. then the atet can be estimated as ( ) ( ) ( ){ }1 , 1 , 1 1i i i i i i it e e y x t e y x t tτ = = = − = = (2) where the outer expectation is taken over the distribution of xi|(ti=1) which is the distribution of baseline variables in the treated group. when estimating causal effects using observational data, it is desirable to replicate a asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 69 randomized experiment as closely as possible by obtaining treated and control groups with similar covariate distributions. this goal can often be achieved by choosing well-matched samples of the original treated and control groups, thereby reducing bias due to the covariates. the most straightforward and nonparametric way to condition on x is to exactly match on the covariates, however it usually fails in finite samples if the dimensionality of x is large. two other commonly used approaches are propensity score matching and multivariate matching based on mahalanobis distance. a significant shortcoming of them is that they may (and in practice, frequently do) make balance worse across measured potential confounders (sekhon, 2011). diamond and sekhon (2013) propose a matching algorithm, genetic matching, that maximizes the balance of observed covariates between treated and control groups. it is a generalization of propensity score and mahalanobis distance matching. the algorithm is nonparametric and does not depend on knowing or estimating the propensity score. genetic matching the idea underlying genetic matching method is that if mahalanobis distance is not optimal for achieving balance in a given dataset, one should be able to search over the space of distance metrics and find something better. if one has a good propensity score model, it should be included as one of the covariates. under this circumstance, both propensity score matching and mahalanobis matching can be considered special cases of genetic matching. genetic matching is an affinely invariant matching algorithm using the distance measure d(), in which all elements of w are zero except down the main diagonal. ( ) ( ) ( ) ( ) 1 2 1 2 1 2,i j i j i jd x x x x s ws x x− − ′′= − −    (3) where w is a k×k positive definite weight matrix and s1/2 is the cholesky decomposition of s which is the variance-covariance matrix of x. setting the non-diagonal elements of w to zero aims at enhancing computational power, and meanwhile many loss criteria can be used to choose the free elements of w. genetic matching method attempts to minimize a measure of the maximum observed discrepancy between the matched treated and control covariates at every iteration of optimization. unlike traditional matching methods, genetic matching reliably reduces both the bias and the mean squared error of the estimated causal effect even when the propensity score is incorrectly specified and the covariates are not ellipsoidally distributed (as is almost always the case in applied work) as long as the selection on observables assumption holds. evenly when the covariates are ellipsoidally distributed and the propensity score is correctly specified, in finite samples, estimates based on genetic matching have lower mean squared error than those based on the usual matching methods such as propensity score matching (diamond and sekhon, 2013). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 70 empirical results the phenomenon of high first-day returns of ipo shares in china has drawn lots of attention for a long time. dozens of news reports, specialist interviews has dedicated to this topic. high first-day return is not only a speculation phenomenon in an immature market, but also a signal which implies that there are severe problems in current new shares pricing system. the temporary trading halt mechanism is no other than a trial to curb speculative transaction. matching the key concept in determining which covariates to include in the matching process is that of strong ignorability. to satisfy the assumption, it is important to include all variables known to be related to both treatment assignment and the outcome. generally poor performance is found of methods that use a relatively small set of “predictors of convenience” (shadish, clark and steiner, 2008). including variables that are actually unassociated with the outcome can yield slight increases in variance. however, excluding a potentially important confounder can be very costly in terms of increased bias. thus, it should be liberal to include variables that may be associated with treatment assignment and/or the outcomes. meanwhile, one type of variable that should not be included in the matching process is any variable that may have been affected by the treatment of interest. in china, under the approval system, china securities regulatory commission controls the scale and pace of new share issue through checking submitted shares’ price, quantity and time to market. new share issue price is always built on price-earning ratio. reasonable price-earning ratio and issuance quantity are two key points of getting issuance approval. considering these, we decide to take five variables: expected fully diluted price earning ratio, fully diluted price earning ratio, offering qquantity, issuance quantity, circulation quantity, as covariates to do the genetic matching. the full output is included in appendix. as shown in the appendix, the smallest p value across all of the variables after matching is 0.2356 compared with the pre-matching value of 0.0998. apparently, genetic matching improve the balance across covariates. the balance is excellent for all variables. the impact of first-day temporary trading halt mechanism not that we have achieved excellent balance, we can examine our estimate of the treatment effect and its standard error. in this paper, we focus on three aspects about new shares performance: first-day market-adjusted returns, first-day turnover rate and first-day price-earning (pe) ratio. all resutls are presented in the table. first-day market-adjusted returns. the estimate of the treatment effect for the treated about the first-day market-adjusted returns (atetmareturns) is 4.79% with a abadie-imbens standard error of 0.0209. the average treatment effect about first-day market-adjusted returns (atemareturns) is 9.71% with a standard error of 0.0449. both of them are significant at 5 percent significant level. first-day turnover rate. the estimate of the treatment effect for the treated about the first-day turnover rate (atettorate) is -21.85% with a abadie-imbens standard error of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 71 0.0906. the estimate of the treatment effect about first-day turnover rate (atetorate) is -21.03% with a standard error of 0.0897. also, both the atettorate and atetorate are significant at 5 percent significant level. first-day price-earning ratio. the estimate of the treatment effect for the treated about the first-day pe ratio (atetperatio) is 10.04 with a abadie-imbens standard error of 2.6952. the estimate of the treatment effect about the first-day pe ratio (ateperatio) is 9.93 with a standard error of 2.5873. both the atettorate and atetorate are significantly different from 0 at 1 percent significant level. table 1. the real effects of temporary trading halt mechanism impact direction atet ate first-day market-adjusted returns + 4.79%** (0.0209) 9.71%** (0.0449) first-day turnover rate -21.85%** (0.0906) -21.03%** (0.0897) first-day price-earning ratio + 10.04*** (2.6952) 9.93*** (2.5873) note: numbers in the brackets are abadie-imbens standard errors. ** and *** represent being different from 0 at 5% and 1% significant level, respectively. “+” means the temporary trading halt mechanism makes the dependent variables increase and “-” means decrease. on average, szse’s first-day temporary trading halt mechanism for new shares pushes up individuals’ first-day market-adjusted returns and their first-day pe ratio whereas lower down first-day turnover rate. empirical results show that the first-day temporary trading halt mechanism for ipo shares has positive impacts on first-day returns and first-day pe ratio as well as a negative impact on first-day turnover rate, which means the initiatives that szse made about curbing ipo speculation in fact do not push up the first-day price but also limit the transaction meanwhile. concluding remarks the direct purpose of first-day temporary trading halt mechanism for ipo shares is to curb the speculative transaction that unsuccessful subscribers have high inclinations to involve in. moreover, its deeper motivation lies in coordinating with the improvement of ipo pricing mechanism as well as narrowing down the spread between primary and secondary market. it is, in essence, a transitional supporting measure. in fact, under current circumstances, the dilemma of stock market segmentation between primary and secondary market in china is still serious. ipo usually descends to the tunnel of profit transferring. restrictions about trading performance in secondary market without breaking the ice of segmentation are unable to solve the problem of ipo underpricing and first-day speculation. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 72 acknowledgement this research was financially supported by the moe research funds of philosophy and social science (11yjc790181), the jilin social science planning funds (2014b40) and the fundamental research funds for the central universities (14qnjj039). references abadie, a., & imbens, g. (2006). large sample properties of matching estimators for average treatment effects. econometrica, 74, 235-267. http://dx.doi.org/10.1111/j.1468-0262.2006.00655.x diamond, a., & sekhon, j.s. (2013). genetic matching for estimating causal effects: a general multivariate matching method for achieving balance in observational studies, review of economics and statistics, 95, 932-945. http://dx.doi.org/10.1162/rest_a_00318 jennifer l. kao, donghui wu, & zhifeng yang (2009). regulations, earnings management, and post-ipo performance: the chinese evidence. journal of banking and finance, 33, 63-76. http://dx.doi.org/10.1016/j.jbankfin.2007.03.016 judith s. ruud (1993). underwriter price support and the ipo underpricing puzzle. journal of financial economics, 34, 135-151. http://dx.doi.org/10.1016/0304-405x(93)90015-4 laurie krigman, wayne h. shaw, & kent l. womack (1999). the persistence of ipo mispricing and the predictive power of flipping. journal of finance, liv, 3, 1015-1043. richard h. pettway, & takashi kaneko. (1996). the effects of removing price limits and introducing auctions upon short-term ipo returns: the case of japanese ipos. pacific-basin finance journal, 4, 241-258. http://dx.doi.org/10.1016/0927-538x(96)00013-3 rosenbaum, p.r., & rubin, d.b. (1985). the central role of the propensity score in observational studies for causal effects. biometrika, 70, 41-45. http://dx.doi.org/10.1016/j.cjar.2013.12.001 rubin, d.b. (1990). comment: neyman (1923) and causal inference in experiments and observational studies. statistical science, vol. 5, 472-480. sekhon, j.s. (2011). multivariate and propensity score matching software with automated balance optimization: the matching package for r. journal of statistical software, 42(7). shunlin song, jinsong tan, yang yi (2004). ipo initial returns in china: underpricing or overvaluation? china journal of accounting research, 7, 31-49. http://dx.doi.org/10.1016/j.cjar.2013.12.001 william r. shadish, m. h. clark and peter m. steiner. can nonrandomized experiments yield accurate answers? a randomized experiment comparing random and nonrandom assignments. journal of the american statistical association, 103(484), 1334-1343. http://dx.doi.org/10.1198/016214508000000733 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 73 appendix the full output of matching is as follows: ***** (v1) expected fully diluted price earning ratio ***** before matching after matching mean treatment........ 23.2380 23.2380 mean control.......... 26.5210 23.2330 std mean diff......... -58.0450 0.0920 mean raw eqq diff..... 3.5811 0.9252 med raw eqq diff..... 2.1100 0.7200 max raw eqq diff..... 23.0600 3.1800 mean ecdf diff........ 0.1028 0.0443 med ecdf diff........ 0.0905 0.0400 max ecdf diff........ 0.2611 0.1600 var ratio (tr/co)..... 0.2794 0.9535 t-test p-value....... 0.2356 0.9836 ks bootstrap p-value. 0.3230 0.8510 ks naive p-value...... 0.4537 0.9062 ks statistic.......... 0.2611 0.1600 ***** (v2) fully diluted price earning ratio ***** before matching after matching mean treatment........ 30.8900 30.8900 mean control.......... 34.7260 30.3300 std mean diff......... -49.8980 7.2907 mean raw eqq diff..... 4.3337 1.4132 med raw eqq diff..... 2.3800 0.9600 max raw eqq diff..... 30.7400 5.6800 mean ecdf diff........ 0.0901 0.0457 med ecdf diff........ 0.0779 0.0400 max ecdf diff........ 0.2463 0.1600 var ratio (tr/co)..... 0.2843 0.2843 t-test p-value....... 0.1652 0.3027 ks bootstrap p-value. 0.3900 0.8500 ks naive p-value..... 0.5291 0.9062 ks statistic......... 0.2463 0.1600 ***** (v3) offering qquantity ***** before matching after matching mean treatment........ 2808.5 2808.5 mean control.......... 2500.9 2582.7 std mean diff......... 20.816 15.282 mean raw eqq diff..... 378.16 249.16 med raw eqq diff..... 200 160 max raw eqq diff..... 3400 1500 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 74 mean ecdf diff........ 0.0524 0.0515 med ecdf diff........ 0.0463 0.0400 max ecdf diff........ 0.1811 0.1600 var ratio (tr/co)..... 2.2794 1.3164 t-test p-value........ 0.0998 0.5919 ks bootstrap p-value.. .7030 0.8270 ks naive p-value...... 0.8710 0.9062 ks statistic.......... 0.1811 0.1600 ***** (v4) issuance quantity ***** before matching after matching mean treatment........ 2808.5 2808.5 mean control.......... 2500.9 2582.7 std mean diff......... 20.816 15.282 mean raw eqq diff..... 378.16 249.16 med raw eqq diff..... 200 160 max raw eqq diff..... 3400 1500 mean ecdf diff........ 0.0524 0.0515 med ecdf diff........ 0.0400 0.0463 max ecdf diff........ 0.1600 0.1811 var ratio (tr/co)..... 2.2794 1.3164 t-test p-value........ 0.0998 0.5919 ks bootstrap p-value.. 0.7030 0.8270 ks naive p-value...... 0.8710 0.9062 ks statistic.......... 0.1811 0.1600 ***** (v5) circulation quantity ***** before matching after matching mean treatment........ 2249.6 2249.6 mean control.......... 2068.4 2005.2 std mean diff......... 15.304 20.648 mean raw eqq diff..... 302.98 198.11 med raw eqq diff..... 164 128 max raw eqq diff..... 2700 1200 mean ecdf diff........ 0.0519 0.0507 med ecdf diff........ 0.0484 0.0400 max ecdf diff........ 0.1811 0.1600 var ratio (tr/co)..... 2.2602 1.3189 t-test p-value........ 0.1010 0.5911 ks bootstrap p-value.. 0.7090 0.8280 ks naive p-value...... 0.8710 0.9062 ks statistic.......... 0.1811 0.1600 before matching minimum p.value: 0.0998 after matching minimum p.value: 0.2356 microsoft word 1737-6828-2-rv (1)-writer2-new-final asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 39 outside directors, corporate governance and firm performance: empirical evidence from india naveen kumar research scholar (corresponding author) department of management studies, indian institute of technology roorkee, uttarakhand, 247667, india e-mail: naveensrivastav@gmail.com j. p. singh professor, department of management studies, indian institute of technology, roorkee, uttarakhand, 247667, india received: may 3, 2012 accepted: june 27, 2012 published: december 1, 2012 doi:10.5296/ajfa.v4i2.1737 url: http://dx.doi.org/10.5296/ajfa.v4i2.1737 abstract the current study examines the efficacy of outside directors on the corporate boards of 157 non-financial indian companies for the year 2008. the research particularly investigates if the monitoring by grey director (non-executive non-independent) and independent director influences firm performance. research finding reveals that while the proportion of grey directors on board has marginally deteriorated effect, the independent director’s proportion has an insignificant positive effect on firm value. outcome of research has significant implications for devising a board model for companies in india that have a significant ownership concentration and insider control. independent directors require greater representation on the board in lieu of other non-executive outside directors. keywords: outside directors, independent directors, corporate governance, firm performance, insider ownership asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 40 1. introduction corporate governance has become vital issue all around the world, particularly, in the aftermath of global financial crisis that teetered many economies into recession. much of the recent discussion that has taken place centers on an effective corporate governance mechanism to protect shareholder rights and their wealth. the corporate governance is an important issue of public policy debate in india because of ongoing discussions within government and various regulatory bodies to promulgate the new companies act. efficacy of sound corporate governance mechanisms in india and its regulation cannot be overemphasized, understanding the fact that investors and shareholders lost around 2.8 us billion dollars in country’s largest accounting fraud at satyam computers limited (tellis, 2009). further, external corporate governance mechanism and market forces are weak in indian capital market. therefore, it is essential to enforce proper corporate governance structure through law. assuring good corporate governance in companies through outside directors is a prominent public policy issue in india. boards comprising of outside directors monitor corporate management on the behalf of shareholders (fama and jensen, 1983). in the agency settings of emerging economies, where ownership concentration is the general norm along with weak protection of shareholder rights, composition of board with outside directors (particularly independent directors) pose a significant challenge. as such, supervision of the management by outside directors cannot be overemphasized. further, the board performs multifaceted tasks (ruigrok et al., 2006) and has direct or indirect effect on firm performance. therefore, the pertinent issue worthy of consideration is board composition with outside directors (independent and grey directors) under concentrated ownership, optimal from the perspective of maximizing shareholder value. the current study aims to enhance our understanding about various theoretical foundations on outside directors as an important corporate governance mechanism and their effect on firm in different institutional settings. the primary objective of paper is to investigate how the arrangement of outside directors affects the corporate performance of indian companies. our second objective is to propose and validate various theoretical hypotheses with the moderating effect of insider ownership and control on outside director performance. the empirical outcome of this study will help to determine the effectiveness of outside directors in the presence of dominant shareholders. it will help regulators and policy makers to determine board composition in india. 2. related literature corporate board is considered as the zenith of internal corporate governance mechanism (brennan, 2006). board of directors on behalf of shareholders is envisaged with the role of monitoring the management and protecting their rights (jensen and mecking, 1976). the monitoring by the board is important because potential cost is incurred when management may pursue its own interest at the expense of shareholders' interest (hillman and dalziel, 2003). in order to reduce the agency cost, arising from the separation of ownership and control in developed countries, the board is required to compose of a majority of outside asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 41 directors. board independence is considered crucial because outside directors considered as true monitors’ and can discipline the management and improve firm performance (fama and jensen, 1983; weishbach, 1988; duchin et al., 2010). outside directors being financially independent of management, free from potentially conflicting situations able to alleviate agency problems and curb managerial self-interest (rhodes et al., 2000). they can protect the shareholder interest, perform monitoring and control function in a better way to align firm resources for better performance. there have been several efforts to find empirical evidence on the effectiveness outside director on firm performance. the results, however, have been diverse. while several authors find that independent outside directors, protect shareholders in specific instances in which there is an agency problem (weishbach 1988; byrd and hickman, 1992; xie et al., 2003; mccabe and nowark, 2008). several researchers have found a positive relationship with the presence of outside director and firm performance. daily and dalton (1992), baysinger and butler (1985) and brickley et al. (1994) find more independent directors on the board improve economic performance of the firm. several other studies find a positive impact from appointing outside independent directors upon the board. studies find less likelihood of financial statement fraud (beasley , 1996), positive price reaction (rosenstein and wyatt , 1990 ), positive reaction to tender offer bids and poison pill adoptions ( byrd and hickman, 1992; brickley et al.,1994), better firm profitability ( ezzamel and watson, 1993) and better stock price returns ( bhagat and black, 1999) in relation to outside and independent directors. several other empirical studies, however find either no significant effect or negative effect of outside directors on firm performance. many researchers (baysinger and butler, 1985; dalton et al., 1998; dalton and daily, 1999; fernandes, 2005) do not find any relationship between board composition with representation of outside independent directors and firm performance. hermalin and weishbach (1991), meharan (1995), bathala and rao (1995), vafeas and theodoru (1998), core et al. (1999), and klien (1998) and yermack (1996) report an insignificant relation between corporate board independence and various measures of firm performance. many researchers also have reported a negative relationship between the proportion of outside directors and firm value. agrawal and knoeber (1996) and bhagat and black (2002), finds a negative relationship between the proportion of outside directors on board and firm performance. efficacy of outside directors as governance mechanism is therefore questionable in the developed counties because of presence external governance mechanism like mergers and acquisition, market for corporate control and product market competition. efficacious corporate governance mechanisms of the developed countries may not be effective in emerging markets and other countries due to its ownership structure and strength of the capital market. apart from few anglo-saxon countries, most of the companies of other countries exhibit high ownership concentration (shleifer and vishny, 1997; la porta et al., 2000; claessens et al., 2000). the typical agency problem, which arises from the separation of ownership from control in such a setting, is between the dominant shareholder and other minority shareholders. dominant shareholders have the ability (because they control the firm asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 42 with sufficiently high voting rights) and the incentive (because usually their cash flow rights are much lower than their voting rights) to expropriate other shareholders by diverting the firm’s resources to themselves (claessens et al., 2002; la porta et al., 2002). the pertinent question under case is whether board composition with a majority of independent directors will increase firm value by assuring the investors and minority shareholders that an independent board will prevent diversion of firm resources and better monitoring (dhaya et al., 2007). choi et al. (2007) in korean context finds that effect of independent directors on firm performance is strongly positive, while contributions from grey director is ambiguous. dahya et al. (2007) in their analysis of 799 firms across 22 countries find a significant positive relationship proportion of independent directors and firm performance in the presence of dominant shareholders and countries with weak protection of shareholder rights. further, their results also find a negative relationship between the higher proportion of independent directors on board and related party transactions. erickson et al. (2005) in dominant shareholder regime for canadian companies find a negative relationship between the fraction of outside directors and firm value. however, the authors suggest that independent board was able to mitigate agency problem arising out of dual class common stock. ehikioya (2009) and uadiale (2010) for nigerian companies find the positive association proportion of outside directors and firm performance. ameer et al. (2010) for malaysian companies suggest independent directors perform better than affiliated (grey) directors. yammeesri and herath (2010) for thailand companies and rashid et al. (2010) for companies in bangladesh report a positive but an insignificant relationship with presence of independent directors and firm value. 3. outside directors and corporate governance in indian context – hypothesis development india, like many other emerging asian countries has high ownership concentration, with dominance of family controlled firms along with many state controlled firms being a peculiarity of the corporate sector (chakrabarti, 2005). many companies are affiliated with a family managed business group, and show high ownership concentration with the dominant (promoter) shareholders having control of most of these firms. the agency problem in india is also that between a dominant shareholder and minority shareholder. in this paper, we put forward that the proportion of outside director on the board is a determinant of good corporate governance. they are instigated on board because of their high monitoring ability with aimed at reducing the agency cost arising out. outside directors (non-executive directors), particularly independent directors are mandated by law, in order to protect the minority shareholders, expropriation of firm resources by insiders and to increase firm profitability and its value. securities exchange board of india (sebi) first introduced outside directors as a corporate governance mechanism in the indian corporate regulatory framework in the year 2000. securities market regulator, sebi promulgated clause 49 of the listing agreement as corporate governance code for the listed companies. the sebi endeavor of introducing independent director on the corporate board was to protect the rights of minority shareholders. clause 49 of the listing agreement, in its current form necessitates that where the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 43 chairman of the board is a non-executive director, at least one-third of the board should comprise of independent directors, and in case he is an executive director ( including non executive promoter chairman), at least half of the board should comprise of independent directors. in any case, the board must have at least fifty percent of non-executive directors. empirical studies in indian context, jackling and johl ( 2009) find a significant positive relationship on firm value (tobinq) with outside directors, while other studies find no significant relationship between the presence of outside directors on the board and firm performance (ghosh, 2006; kota and tomar, 2010). however, earlier studies fail to delineate the difference between outside affiliate (grey) directors and outside non-affiliate (independent) directors. we envisage finding the impact of outside directors on firm value and proposing that: h1: proportion of non executive directors (independent and grey directors) on the board is positively related to firm value effect of insider ownership on outsider directors performance in relation to firm value efficacy of outside directors as a corporate mechanism depends upon the bargaining strength of different ownership constituents of a company (chow and kim, 2007). different countries have ownership structure unique to the strength of capital market and legal rights of shareholders. the relative strength of shareholders and their influence depends upon the typical ownership structure. high ownership concentration with a large shareholder controlling the firm is norm of the most of asian, latin american and african economies (shleifer and vishny, 1986; shleifer and vishny, 1997). in indian context, founding family members or their offspring’s, typically known as “promoters”, are generally the largest shareholders in the companies. according to the prowess database of the center for monitoring indian economy (cmie), average promoter holding in bse500 index companies for financial year 2009 is approximately 51.197 percent. promoters being dominant shareholders in indian context either occupy a management position or wield significant influence management of the company. typical agency problems arising out of ownership and control is absent, but a different type of agency cost transpires in indian companies incited through expropriation of minority shareholder rights by dominant inside shareholders. in companies with dominant shareholders, expropriation of wealth from minority shareholders may come in many ways. johnson et al., (2000) show that dominant shareholders can divert value by selling assets, goods, or services to the company through self-dealing transactions; they can obtain loans on preferential terms. bertrand et al., (2002) report a significant amount of tunneling in indian business groups occurring via non-operating part of the profits. chakrabarti (2005) further suggests the ownership structure of the indian companies is very complex with widespread tunneling, cross-holding and pyramiding effect, where promoters acquire ownership rights more than their voting rights. all this helps controlling shareholders to tunnel firm’s resources for their private benefits. the main purpose of outside directors in india is to minimize the agency cost occurring due to ownership concentration and the presence of large inside shareholders. this way, the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 44 higher is the ownership and control of promoter shareholders (dominant shareholders) on the companies, less will be the effectiveness of outside directors. controlling rights to promoters allows them, to have direct influence on the appointment of the outside directors on the board. in family controlled firms, outside directors, particularly independent directors, may not be fully committed to their monitoring role, either due impinging authority of promoters or due to their familiarity with them (chen and jaggi, 2000; leblanc and giles, 2005). cho and kim (2007) suggest that the firm performance may deteriorate due to the greater power concentration in the hands of insiders due significant agency cost arising between insiders and minority shareholders. outside directors, in such context may not act as effective monitors of management due to persistence of high information asymmetry. choi et al. (2007) in korean context, suggests that the family ownership concentration negatively affects the board independence and firm performance. ibrahim and samad (2011) for malaysian companies find that the family concentration negatively moderates firm performance. based on related literature and findings we hypothesize that: h2: insider ownership has a negative moderating effect on outside directors’ in relation to the firm value 4. research design sample and data collection the data for research pertains to firms listed on bombay stock exchange (bse) in the year 2008. initially, for study bse 200 firm, which approximately account for 72 percent of market capitalization, were taken. thereafter, 36 banking and other financial firms were eliminated, as these belong to highly regulated industry. in addition, one firm was left for incomplete financial data. initial ols regression was carried out, and six firm observations were found to have undue influence on the model. all these six firm observations were removed from final analysis to keep results robust to outlier’s effect. this resulted in a final sample of 157 firms that were taken for empirical validation of different hypothesis proposed. the financial and other data for these firms was obtained from the prowess database of centre for monitoring indian economy (cmie). the data on corporate governance variables like board size, proportion of the outside directors and board leadership for sample firms was extracted from corporate governance reports annexed to annual reports. variables market-based measure tobin’s q has been selected as the dependent variable in this study. it is considered more reliable in india as compliance with accounting standard is weak. further, market based measure discounts and factors in all parameters affecting firm performance. the explanatory variable in our study is the outside directors (proportion of non-executive directors). further, we have delineated the difference between affiliate outside directors (gray directors) and non-affiliate outside directors (independent directors) to separately find their effect on firm performance in the main model. firm value is not just contingent upon proportion of outside directors on the board, but also influenced by several firm specific factors and other governance parameters. non-inclusion asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 45 of these parameters may lead spurious relationship between outside directors and firm value. several firm specific variables like firm age (fage), firm size (fsize), leverage (lev) and previous year firm profitability (lagroa) were included in the regression model as a control variable. inclusion of these variables as removes heterogeneity related firm and account firm complexity, economies of scale and firm capital structure. further, corporate governance parameters, like insider ownership (insown), board size (bsize) and board leadership (nedchair) that previous research have suggested that affect the firm performance were also included in the regression model. all variable definitions and measurement are given in table 1. table 1. variable definitions and measurement variables abbreviation measure of variables tobinq tobinq the market value of equity plus the book value of short-term and long-term debt divided by total assets outside directors perne number of non-executive directors divided by the total number of directors on the board independent directors ( non affiliate outside directors) perind number of independent directors divided by the total number of directors on the board grey director ( affiliate outside directors) pergr number of non-executive non-independent directors divided by the total number of directors on the board firm age fage natural logarithm of the number of years since the establishment of a firm to year 2009 firm size fsize natural logarithm of total assets firm leverage lev ratio of long term debt to the total assets previous year firm profitability lagroa measured as net profit to the total asset insider ownership insown percentage of promoter or promoter group ownership in firm board size bsize total number of directors on the board of company board leadership nedchair a dummy variable, which takes a value of 1 if the chairman is non-promoter non-executive director, else 0 empirical analysis the main aim of research is to validate first hypothesis that the proportion of outside directors (also independent and grey) is positively related to firm performance. we adopted ordinary least squares (ols) regression to test this hypothesis. subsequent hypothesis asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 46 required moderating effect of insider ownership on outside directors, and for that purpose moderated regression was adopted.for insider ownership, piecewise moderated regression analysis was performed on outside directors, separately for both independent and gray directors, for the insider ownership level up to fifty percent and above fifty percent. aim of this type of analysis was to figure out, how does high ownership and absolute control (above 50 percent) to promoters influences outside directors performance in relation to firm value. 5. results and discussions the descriptive statistics of the sample companies are presented in table 2. the average percentage of outside directors (perne) is 70.9, and that of independent directors (perind) on the board of companies is 50.4 percent. this clearly reflects that the most of boards of companies are comprised of a majority of independent and non-executive directors. the promoter ownership ranges from zero to 100 percent with a mean of 54.5 percent. table 2. descriptive statistics of variables variables n minimum maximum mean std. deviation tobinq 157 0 4.19 1.284 0.825 fage 157 0.693 4.868 3.314 0.75 fsize 157 9.08 14.715 11.147 1.121 lev 157 0 67.96 24.25 19.095 lagroa 157 -3.99 70.96 12.171 9.989 insown 157 0 1 0.545 0.197 bsize 157 5 20 10.924 3.079 nedchair 157 0 1 0.159 0.367 perne 157 0.444 1 0.709 0.132 perind 157 0.2 0.857 0.504 0.107 pergr 157 0 0.625 0.205 0.146 table 3 illustrates the correlations among different explanatory, control and dependent variables that have used in the regression analysis. as shown in table 3, an interesting finding from the correlation matrix is that promoter ownership is positively related to firm size, contemplating the fact that most of the large firms in india are promoted dominated and belongs to family managed group. correlation matrix reflects a significant correlation between an outside director (perne), gray director (pergr) and independent director (perind). high correlation is quite evident from the fact that all these are endogenous in board composition. however, multicolinearity is within permissible limit (0.709) and further, as we entered all these categories of outside directors independently in the regression model, multicollinearity was not an issue. the highest variance inflation factor (vif) in the regression model (without interaction terms) was easily within the limit. however, we do the faced issue of multicollinearity, when interaction terms for testing moderation effect were asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 47 entered in the regression model. therefore, in order to remove multicollinearity, all the variables whose interaction effect to be analyzed in the regression model were mean centered. thereafter, multicollinearity was not a significant issue in the regression analyses, as none of vif approached the critical value of 10. other criteria for checking the multicollinearity is condition index, which in all regression models was always with the maximum permissible limit of 50, for the social science research. table 3. pearson correlation matrix between variables tobinq perne perind pergr bsize nedchair fage fsize lev lagroa perne -.085 perind -.023 .265** pergr -.060 .709** -.493** bsize -.072 -.136 -.195* .020 nedchair .135 .090 -.179* .212** -.097 fage -.154 -.169* -.120 -.065 .125 -.035 fsize -.235** -.149 -.022 -.118 .309** -.194* .178* lev -.311** -.106 .118 -.181* -.004 -.057 -.053 .102 lagroa .365** -.097 -.021 -.071 -.062 .024 .044 -.098 -.360** insown .140 -.046 -.052 -.004 -.016 -.038 -.042 .205** -.213** .053 ** correlation is significant at the 0.01 level , * correlation is significant at the 0.05 level the regression results are presented in table 4 and 5. the results are robust to the effect of multi-collinearity, outliers and non-linearity. squared terms of perne, perind and pergr were also included in the regression equation and no significant difference was found. the results of this regression model are not shown here. further, randomly 100 firms were selected for regression. the regression results were robust to that with no significant difference observed from main findings. the table 4 presents regression analysis performed to examine the impact of outside directors on the firm value. there is a significant negative relationship between the outside directors (without delineating the difference between grey and independent directors) and the firm value, which rejects hypothesis 1 (r=-0.852, p < 0.1). when grey (affiliate outside directors) and independent director (non-affiliate outside directors) were differentiated, there clear was a clear demarcation in the firm performance. the percentage of the grey director on board has a significant negative relationship (r=-0.749, p<0.1) with firm value, while independent directors do not have significant positive impact on firm value. promoters ownership is positively related to firm value in all models as investigated in many prior studies studied (khanna and palepu, 1999; singh and gaur, 2009). the results are consistent with other asian countries and indian studies (chow and kim, 2007; ghosh, 2006; kota and tomar, 2010) which have also not find any significant association with the presence of outside directors on the board. as some evidence of asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 48 regression results of table 4, that the grey directors mainly drive the negative impact of outside director on the value, offsetting the positive influence of independent directors. table 4. tobin’s qboard composition by outside directors independent variables ne director grey director ind director coeff p value coeff p value coeff p value (constant) 3.631 4.593* 3.066 4.647* 2.726 3.692* perne -0.0852 1.837*** pergr -0.749 -1.772*** perind 0.79 0.136 bsize 0.004 0.196 0.01 0.489 0.008 0.402 nedchair 0.209 1.29 0.25 1.512 0.197 1.181 fage -0.173 -2.152** -0.16 -1.999** -0.15 -1.852*** fsize -0.142 -2.421** -0.143 -2.435** -0.135 -2.293** lev -0.08 -2.385** -0.008 -2.436** 0.007 -2.091** lagroa -0.022 -3.431* 0.022 3.456* 0.024 3.726* insown 0.487 1.551 0.513 1.637*** 0.524 1.664*** no. of firms 157 157 157 adj r square 0.224 0.223 0.207 f change 6.639 6.6 6.052 * denotes significance 1 % level ,** denotes significance at 5 % level, *** denotes significance at 10 % level the results does not hypothesis 2. in fact, it is rejected that insider ownership has a negative moderating effect on outside director’s performance. the empirical findings of moderated regression model show very weak but positive moderating effect of promoter ownership on outside directors (table 5). on further examination, it may find that moderating effect of insider ownership is positive on grey directors but negative on independent directors. the results here may be explained and interpreted in several ways. there is weak but positive moderating effect of insider control on performance of outside grey directors. this is due to the alignment of incentives of grey directors with greater ownership by insiders. grey directors being affiliated with ownership have interests aligned with managers cum owners (promoters) and perform their advising role to good extent in devising firm strategy. this leads to a positive impact on firm value. the high ownership eliminates the typical agency problem arising from the separation of ownership and control and has a positive effect on firm value. this is evident from positive (in some models significant) association with promoter ownership with firm value in all the models and asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 49 consistent with prior studies (khanna and palepu, 1999; singh and gaur, 2009). however, this actuates high agency cost in terms of monitoring by independent directors in safeguarding minority shareholder rights. in a high informatory asymmetry environment with presence of greater ownership of promoters outside directors, both monitoring and advisory role is less efficacious (duchin et al., 2010). our findings are consistent with chow and kim (2007) findings, and their explanation of substitute governance mechanisms (redikar and seth, 1995) is also valid in indian context. the ownership concentration among a dominant shareholder (promoter) minimizes the risk of takeover, and therefore acts substitute mechanism for monitoring by independent directors. a higher proportion of independent with high insider ownership further attenuates conflict of interest between them and the management / owner that may hinder the decisions making process (singh and gaur, 2009). another perspective for explanation is ownership and control by promoters on firm allows them to have their own people on the board as an independent director. in such cases, the independent director role is more or less ceremonial and only for compliance requirement purpose. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 50 table 5. tobinqmoderating effect of insider ownership on outside director independent variables ne director independent director grey director coeff p value coeff p value coeff p value (constant) 3.532 4.35 2.738 3.688* 2.96 4.441 insown0-50* (perne,perind,pergr) 1.328 0.266 -1.798 -0.374 2.759 0.642 insown51-100* (perne,perind,pergr) 1.412 0.482 -2.007 -0.537 2.662 1.08 perne -0.829 -1.769*** perind 0.08 0.137 pergr -0.78 -1.827*** bsize 0.005 0.24 0.009 0.411 0.012 0.591 nedchair 0.213 1.303 0.185 1.095 0.248 1.486 fage -0.169 -2.059** -0.156 -1.897*** -0.161 -2.006** fsize -0.138 -2.330** -0.136 -2.286** -0.138 -2.336** lev -0.008 -2.330** -0.007 -2.018** -0.008 -2.328** lagroa 0.022 3.459* 0.023 3.668* 0.022 3.505* insown 0.505 1.579 0.541 1.694*** 0.564 1.77*** no. of firms 157 157 157 r 0.516 0.515 0.515 r square 0.266 0.265 0.265 adj r square 0.216 0.22 0.22 f change 5.296 5.88 5.88 * denotes significance 1 % level ,** denotes significance at 5 % level, *** denotes significance at 10 % level 6. conclusions this paper modestly examines efficacy of outside directors as an important corporate governance mechanism, from an agency perspective in both developed and emerging countries, also covering the extant literature that divulges their impact on the firm performance. emerging markets that are steadily integrating with the global economy are getting high recognition in corporate governance study (chow and kim, 2007). corporate boards with outside independent directors are considered as an important internal corporate mechanism in the absence of external governance mechanisms in emerging markets (singh and gaur, 2009). this paper investigates the importance of outside directors on corporate asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 2 www.macrothink.org/ajfa 51 boards of indian companies and their influence on firm value. it further examines the moderating effect of dominant shareholder on outside directors in relations to firm value. analysis of outside directors as determinant of firm performance is also carried out by delineating the difference between grey and independent directors. this aspect has been often lacking in previous studies. this study finds that the negative effect of outside directors on the firm value of indian companies is mainly due to the grey directors, where as independent directors have a positive but insignificant effect. it may be concluded that market values companies with a greater proportion of independent directors. however, the promoters who are owners and controllers of indian companies negatively impact the performance of independent directors. the results have some implications for policy makers who are trying to find a suitable board model for companies and define the role of independent directors. the study implicates that for an independent board with grey directors to be replaced by an independent director. further, a greater discussion and analysis is required so that independent directors remain independent of the 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(1996). higher market valuations of companies with a small board of directors. journal of financial economics, 40, 185-211. http://dx.doi.org/10.1016/0304-405x(95)00844-5 microsoft word 4821-17661-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 90 theoretical aspects of economic balanced scorecard analysis sergey ivanovich krylov department of accounting, analysis and audit ural federal university, russian federation e-mail: zali6770@yandex.ru received: nov. 8, 2013 accepted: january 25, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.4821 url: http://dx.doi.org/10.5296/ajfa.v6i1.4821 abstract the author proposes theoretical and methodological aspects of the applied strategic analysis (asa) as a new instrument of the balanced scorecard (bsc) comprehensive study of the organization economic activity. the asa concept has resulted from the further development of the bsc concept which defines a set of the analyzed indicators and the analysis sequence. such are the main asa objectives: comparative evaluation of the bsc data, diagnostics of the bsc data divergence and forecast of the bsc data. all the objectives are closely interrelated, as every coming problem entails from the previous one. the principle of the asa implementation, a deduction principle, is understood as a research, firstly, of the general bsc indicators, then – specific ones. the basic asa applications are as follows: analysis of financial data, analysis of customers’ data, analysis of the internal business processes data and analysis of the personnel training and development. keywords: balanced scorecard, applied strategic analysis, comparative assessment, variance diagnostics, forecast jel classification: c02, m00, m19, m41 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 91 1. introduction to enhance strategic management efficiency in difficult conditions of today market economy we need to improve its information-analytical support, to evolve theory, methodology and methods of the overall strategic economic activity aspects to the level of the financial analysis being an efficient research instrument of the financial aspects of the organization economic activity based on the financial indicators and described experience. one of the leads of further research is the development of the foundations of the applied strategic analysis (asa) concept, assuming a comprehensive research of strategic aspects of the organization economic activity based on the balanced scorecard (bsc) and considered to facilitate strategic management functions. it should be taken into consideration that the applied strategic analysis lacks any standard methods as it is applied to the balanced scorecard system special for any particular organization. hence, the asa methods are special as well for any particular organization. so it enables to discuss general aspects of the methodology rather than its universal specification. the paper treats theoretical and methodological aspects of the applied strategic analysis concept as a research instrument of the financial aspects of the organization economic activity by means of the financial indicators of the bsc as well as other aspects of the organization performance by means of other elements of the bsc such as customer, internal business-processes, training and personnel development. 2. literature review the balanced scorecard concept as an analytical instrument applied in the field of strategic management was developed by american scientists robert kaplan and david norton (1992) at the beginning of the 90s of the xx century evolving both in their works (kaplan & norton, 1996, 2001, 2003, 2004, 2005, 2006, 2008) and those of other scientists studying economics (friedag & schmidt, 2002; horvath & partners, 2004; maisel, 1992; norreklit, 2000; olve, roy & wetter, 2000; rampersad, 2003), and was multiply tested. at present bsc is considered to be one of the essential instruments of the organization management system (enterprise, firm, company, and business-unit). the main reason to develop bsc was a contradiction between contingencies aimed at setting up wide competitive opportunities and immobile accounting system (financial accounting system). balanced scorecard as a whole is implied as an aggregate of parameters featuring an overall organization performance in up-to-date market economy. it reflects a balance to be brought about between short-term and long-term goals, financial and non-financial indicators, basic and auxiliary parameters, as well as internal and external factors of the organization economic activity. the scores of the balanced system were formed depending on the outlook and strategic goals of any particular organization and have individual features. they represent a balance between asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 92 external accounting data for the owners (shareholders) and internal characteristics of the most significant business processes, innovations, training and growth that is the balance between the results of the organization performance and future growth. the system comprises a combination of objective quantity estimated data and subjective somewhat arbitrary parameters of future growth. the main goal of the balanced scorecard is to transform the company strategy into specific tangible objectives, indicators and end up with events. the bsc scores are selected so that the organization managers and employees focus on the factors to enhance the organization competitiveness, the bsc to be accessible for the employees of all levels. the ‘front-end’ employees should be well aware of the financial consequences of their decisions and actions, while top managers must be committed to the long-term financial success. three scores system group balanced scorecard: cause and effect, results attain factors and interrelation with financial data. the balanced scorecard comprises four basic interrelated elements: financial indicators, customer, internal business processes ones as well as training and personnel development indicators. the bsc scores enable to characterize comprehensively an activity of commercial, government and non-for-profit organizations, the scores being relatively few (about 25 scores in average, as a rule). the balanced scorecard is presented in table 1. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 93 table 1. balanced scorecard of the organization development bsc elements key problem strategic goal indicator target figure strategic event financial activity which goals do they have to set coming from the shareholders and investors expectations? customers which goals concerning customer mix and their demands do they have to set to attain financial goals? internal business-processes which goals concerning business-processes do they to set to attain financial and customer goals? training and personnel development which goals concerning training and personnel development do they have to set to attain financial and customer goals as well as internal business processes goals? to complete a brief description of the balanced scorecard it should be noted, that the bsc concept has matured and has been appreciated by different organizations; it has been completed yet neither in terms of theory nor practical application. 3. theory and methodology applied strategic analysis assumes a comprehensive complex research of the strategic aspects of the organization economic activity based on the balanced scorecard. asa subject implies balanced scorecard and determining factors. asa object refers to as strategic aspects of the organization economic activity. asa information support is balanced scorecard as an aggregate of parameters characterizing overall organization economic activity in up-to-date market economy: separate elements, key problems, strategic goals and their values and strategic events as well (table 1). a goal of the applied strategic analysis is to form analytical support of the strategic managerial decision taking. the asa objectives are: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 94 1. comparative assessment of the balanced scorecard. 2. diagnostics of the balanced scorecard variance. 3. balanced scorecard forecast. all of them are interrelated as each consecutive objective follows from the previous one. for example, the diagnostics is exercised on the results of the bsc elements comparative assessment while their forecast takes into account the diagnostics results. comparative assessment of the balanced scorecard elements assumes comparison of their outcome and target figures, determination of the bsc real and target figures variance and qualitative characteristics of the variance (table 2). the qualitative characteristics of the bsc real and target figures variance depends on their value (table 3). table 2. comparative assessment of the balanced scorecard balanced scorecard element target figure real figure variance qualitative variance characteristics absolute % table 3. estimation of qualitative variance characteristics of the bsc real and target figures variance value, % qualitative variance characteristics up to ± 1% from ± 1% to ± 5% from ± 5% to ± 10% from ± 10% to ± 20% ± 20% and higher fairly small essential significant large very large balanced scorecard variance diagnostics is based on the cause and effect ties combining bsc values into the general indicators balanced complex and specifying factors (results attaining factors). the general indicators as the key results indicators which are characteristic to many industries and organizations are assumed as basic parameters (for example, profitability, market share, customer satisfaction, customer base retaining, personnel competence field) applied for deferred evaluation. the results attaining factors are unique for every deferred specific business-unit evaluation indicators reflecting the strategy applied (for example, profitability financial factors, competition market segments, specific business-units goals, training and personnel development). they disclose how the general indicators are attained. moreover, at the early stages the general indicators are not sufficient to estimate implementation of the organization strategy. vice versa, the results attaining factors (for example, production cycle time or faulty products percentage) with appropriate indicators asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 95 missing enable to improve only short-term production processes and do not reflect their impact on the customer base and, consequently, on the financial results. however, some specific bsc outcome indicators (for example, customer and internal business-processes) may be assumed as factors defining factoring indicators variance of the more general element, for example, financial element). while diagnosing the bsc indicators variance we are able to find out the results attaining factors having impact on the general or outcome bsc indicators and determine the variance value. the bsc factoring model comprises the outcome financial bsc indicator as final (more general) indicators and seven levels of the defining factors: 1st level factors: factorial indicators of the bsc financial element; 2nd level factors: outcome customer indicators and some outcome indicators of the internal bsc business-processes; 3rd level factors: customer factorial indicators and some outcome indicators of the internal bsc business-processes; 4th level factors: some outcome indicators of the internal bsc business-processes and personnel development; 5th level factors: some factorial indicators of the internal bsc business-processes and personnel development; 6th level factors: some outcome indicators of the bsc training and personnel development element; 7th level factors: some factorial indicators of the bsc training and personnel development element. we can push the analogy further on the five levels of the factors defining the outcome bsc customer variance, three levels of the factors defining the outcome bsc internal business-process indicators variance, and one level of the factors defining the outcome bsc training and personnel development indicators variance (table 4). table 4. the computation results of the factors impaction the outcome bsc indicators the outcome bsc indicators absolute variance the factorial indicators impact 1st level 2nd level … 7th level … … … … … … … … … … … … the appropriate deductions are drawn from the computation results. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 96 in case of the objective conditions the balanced scorecard forecast is targeted at the primordial determination and/or correction of the target bsc indicators values and either determination of the specific ways of their attainment or the development of the events aimed at the elimination of the variance emerged between outcome and target bsc indicators values in the future. firstly, the general (outcome) indicators are forecast then the factorial bsc indicators are deducted from them. the results of the forecast bsc indicators values are presented in the form of a table (table 5). table 5. the results of the forecast bsc indicators values bsc value factual value target value variance comments absolute % the asa aspects imply proper strategy aspects, tactical aspects and operations aspects. within strategic asa aspects evaluated, diagnosed and forecast are final bsc indicators values at the time of the developed strategy functioning i.e. their strategic values. within tactical aspects of the applied strategic analysis we evaluate, diagnose and forecast interim bsc indicators values by the end of the year, i.e. their tactical values. within operations aspect of the applied strategic analysis evaluated, diagnosed and forecast are interim bsc indicators values by the end of each month, i.e. their operations values. all the asa aspects mentioned are interrelated and agreed: the results of the analysis of the operations bsc indicators values impact on their tactical values and the results of the tactical value analysis impact on the strategic ones. the instruments of the asa methods comprise a combination of methods ensuring that the analysis is carried out and its goals are attained. the basic asa method may include methods of absolute, relative and average values, comparison, grouping, graphical, table and balance methods, as well as factoring, correlation and regression analysis. the asa accomplishment principle, a deduction principle presumes, firstly, an investigation of the general bsc indicators, then specific indicators. the principle defines general sequence of the asa analysis according to the following leads: 1. analysis of financial indicators. 2. analysis of customer indicators. 3. analysis of internal business-processes indicators. 4. analysis of training and personnel development indicators. 4. results each of the basic asa leads, financial, customers, internal business-processes as well as training and personnel development is represented through the prism of its basic objectives: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 97 evaluation, diagnostics and forecast. the asa commences from the comparative evaluation of the financial indicators and is completed by the forecast of training and personnel development. in addition, assuming “intersection points” of the basic leads and the most significant objectives as some kind of elements we are able to build a matrix out of the asa elements (table 6). the author assumes that the introduced matrix (table 6) may be considered as a matrix model respectively visualizing their composition and economic contents. table 6. asa elements matrix basic asa leads the most significant asa objectives comparative evaluation (1) variance diagnostics (2) forecast (3) financial indicators analysis (1) comparative evaluation of financial indicators diagnostics of financial indicators variance financial indicators forecast customer indicators analysis (2) comparative evaluation of customer indicators diagnostics of customer indicators variance customer indicators forecast analysis of internal business-processes indicators (3) comparative evaluation of internal business-processes indicators diagnostics of internal business-processes indicators variance internal business-processes indicators forecast analysis of training and personnel development indicators (4) comparative evaluation of training and personnel development indicators diagnostics of training and personnel development indicators variance training and personnel development indicators forecast let rij (i = 1…4, j = 1…3) denote elements of the matrix then we are able to mathematically describe the asa content by means of the formulae:  = = = 4 1 3 1i j ijrr . (1) where r is a sum of the asa elements; i is an index of the basic asa leads: 1 is financial indicators analysis, 2 is customer indicators analysis, 3 is internal business-processes analysis, 4 is training and personnel development analysis; asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 98 j is an index of the basic asa objectives: 1 is a comparative evaluation of the bsc indicators, 2 diagnostics of the bsc indicators divergence, 3 is bsc indicators forecast. the author assumes that the introduced matrix (table 6) and formulae (1) may be considered as matrix and mathematical models respectively visualizing their composition and economic contents. thus, completing overall description of the applied strategic analysis concept and contents we would like to discuss each of its basic leads: financial indicators analysis, customer indicators analysis, internal business-processes analysis and training and personnel development analysis in terms of their goals, separate elements, examples of the indicators analyzed and brief description of the analysis performance. 4.1. financial indicators analysis the goal of the bsc financial indicators analysis is to form analytical support of taking strategic decisions in finance management. the basic elements of the financial indicators analysis are as follows: 1. analysis of assets and investment application efficiency. 2. analysis of financial risk. 3. analysis of cash flow. 4. analysis of earnings costs and profit. the examples of the analyzed financial indicators are presented in table 7. table 7. examples of the analyzed financial indicators element of the financial indicators analysis indicators analyzed outcome factorial 1.analysis of assets and investment application efficiency investment efficiency in operating activities in terms of net sales (or net cash flow); investment efficiency in intellectual and human capital in terms of net sales (or net cash flow); assets efficiency in terms of net income (or outcome net cash flow; net capital efficiency in terms of net income (or outcome net cash sales efficiency; net cash flow to sales earnings; net income to overall earnings; outcome net cash flow to total earnings; gross sales profit (or earnings) to average investment in operating activities; sales revenues (or cash inflow) to average investment in intellectual and human capital; earnings (total cash inflow) to total asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 99 flow) average assets; total average assets to average net capital 2. financial risk analysis root average square variance and net sales variation coefficient (or net cash flow); root average square variance and net income variation coefficient (or outcome net cash flow); effect of operating leverage; effect of financing leverage root average square variance and sales revenues variation coefficient (or net cash inflow); root average square variance and operating cost variation coefficient (or net cash outflow); root average square variance and earnings variation coefficient (or total cash inflow); root average square variance and total expenses variation coefficient (or total cash outflow); proportion of fixed costs in cost of goods sold; proportion of fixed expense in total expense 3. cash flows analysis outcome net cash flow; net cash flows from operating, investing and financing activities; net cash flows from sales of individual products; net cash flows from individual accounts; net cash flows from sales of new products; proportion of net cash flow from sales of new products in net cash flow from current activities total cash inflow and outflow; cash inflows and outflows from operating, investing and financing activities; cash inflows and outflows from production and sales of individual product range; cash inflows and outflows from production and sales to individual accounts; cash inflows and outflows from production and sales of new products 4. analysis of earnings, expense and profit net income; pre-tax income; net sales; net certain products sales; net sales from individual accounts; net sales from new products; other income; net income growth rate to pre-tax income; net sales growth rate to pre-tax total earnings; total expense; total tax expense; sales revenues; cost of goods sold; individual product range sales revenues; cost of individual goods sold; sales revenues from individual accounts; cost of goods sold by individual asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 100 income; sales revenues to cost of goods sold; proportion of every product sales within net sales; proportion of new products sales within net sales; proportion of net sales from each account within net sales; net sales gain rate from each item to net sales; net sales gain rate from new products to net sales; net sales gain rate from each account to net sales customers; price of individual product range; unit cost of individual product range; new products sales revenues; cost of new product range; other income; other expense the procedure of bsc financial indicators analysis commences from the analysis of overall organization assets and investment application and their separate items as well as the level of the accompanying financial risk logical within well-known context of risk and profitability correlation. then analyzed are cash flows generated by economic activity of the organization and by its separate divisions. the analysis is finalized by the study of earnings, expense and income from the organization economic activity including operating and other activities as well as earnings from its certain product range. 4.2. customers indicators analysis the analysis of the bsc customer indicators is aimed at making up analytical support for taking strategic sales management decisions. the basic elements of the bsc customer indicators analysis are: 1. analysis of the customer profitability level. 2. analysis of the products distribution market share. 3. analysis of the customer base mix, volume and structure. 4. analysis of the customer satisfaction level. the examples of the customer indicators analyzed are presented in table 8. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 101 table 8. examples of the customer indicators analyzed element of the customer indicators analysis indicators analyzed outcome factorial 1. analysis of the customer profitability level sales efficiency (total) sales efficiency to individual customers; sales efficiency of individual product range; sales efficiency of new products; sales efficiency of each product 2. analysis of the products distribution market share company market share individual customer market share; market share of individual products manufactured; new products market share 3. analysis of the customer base mix, volume and structure proportion of regular customers within a total number of customers; proportion of new customers within a total number of customers; proportion of transactions with regular customers within a total number of transactions; transactions with new customers within a total number of transactions; proportion of sales to regular customers within a total number of sales; proportion of sales to new customers within a total number of sales; absolute and relative growth of regular, new and total number of customers; absolute and relative growth of total, regular and new transactions, absolute and relative growth of total, regular and new sales; a number of new customers to a number of potential customers total number of customers; a number of regular customers; a number of new customers; a number of potential customers; total sales; transactions with regular customers; transactions with new customers; total sales; sales to regular customers; sales to new customers asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 102 4. analysis of the customer satisfaction level rating of the customer satisfaction level results of customers polled; a number of repeat businesses the procedure of the bsc customer indicators analysis is characterized by a rigorous sequence and commences from the analysis of the customer profitability level. later analyzed is products distribution market share of the organization. then the analysis of the customer base mix, volume and structure is performed. finally, we analyze a level of customer satisfaction. 4.3. internal business-processes indicators analysis the analysis of the internal business-processes indicators is aimed at making up analytical support for taking strategic production management decisions. the basic elements of the internal business-processes indicators analysis are: 1. analysis of the after-sales service indicators. 2. analysis of the operating process indicators. 3. analysis of the innovation process indicators. it should be noted that every element of the internal business-processes analysis such as analysis of the operation process indicators and analysis of the innovation process indicators is sizable and needs to be subdivided into particular sub-elements. the complex after-sales service indicators analysis comprises the following elements: 1. analysis of the customer invoicing rate, as well as final payment and differences settlement. 2. analysis of the due delivered goods upgrade. 3. analysis of the guaranteed maintenance and repair rate. 4. analysis of the faulty goods replacement rate (should they be delivered). the examples of the after-sales service indicators analysis for every complex element are entered into table 9. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 103 table 9. examples of the after-sales service indicators analysis element of after-sales service indicators analysis indicators analyzed outcome factorial 1. analysis of the customer invoicing rate, as well as final payment and differences settlement average rate of customer invoicing; average rate of customer accounts payable; average rate of customer differences settlement rate of individual customer invoicing; rate of payment of individual customer accounts payable; rate of individual customer difference settlement 2. analysis of the due delivered goods upgrade average rate of the delivered goods upgrade rate of the goods upgrade delivered to individual customers; cost of the delivered goods upgrade 3. analysis of the guaranteed maintenance and repair rate absolute and relative change of the time cycle; proportion of repeat application for repair and guarantee maintenance within total applications; proportion of repeat application for short notice repair and maintenance time cycle durability; total number of applications for repair and guarantee maintenance; number of repeat applications for repair and guarantee maintenance; number of applications for; short notice repair and guarantee maintenance 4. analysis of the faulty goods replacement rate (should they be delivered) average rate of faulty goods replacement rate of faulty goods replacement to individual customers the analysis of the after-sales service indicators commences from the customer invoicing rate, as well as final payment and differences settlement. later analyzed is due delivered goods upgrade. then we analyze guaranteed maintenance and repair rate and finally faulty goods replacement rate (should they be delivered). the complex operation process indicators analysis comprises the following elements: 1. analysis of products due delivery. 2. analysis of production cost. 3. analysis of the products quality compliance to customer demand. the examples of the operation process indicator analysis for each sub-element are presented in table 10. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 104 table 10. examples of the operation process indicator analysis element of operation process analysis indicators analyzed outcome factorial 1. analysis of products due delivery production cycle efficiency; alternative error of products delivery time to customers; proportion of late deliveries within total deliveries time of production cycle; time of products deliveries to customers; number of late deliveries to customers 2. analysis of production cost variance of the normal (target) production cost; variance of normal (target) values of various units production cost normal (target) production cost; factorial value of production cost; normal (target) values of various units production cost; factorial values of various units production cost 3. analysis of the products quality compliance to customer demand number of defects per a unit production million; number of faults per a unit production million number of defects per a unit production million revealed in the process of production; number of products replacement, quality and warranty claims; waste and products losses caused by defects the procedure of the operation process indicators analysis is characterized by a rigorous sequence and commences from the analysis of the products due delivery. then analyzed are total production cost and various units’ production cost. the procedure is finalized by the analysis of the products quality compliance to customer demand. the complex elements of the innovation process analysis are the following: 1. analysis of the new products development expediency. 2. analysis of the applied research and development expediency and production of the next generation product feasibility study. 3. analysis of the in-depth scientific research expediency of innovative products. 4. analysis of the cutting-edge innovative products development feasibility study. 5. analysis of the customer demand acceptable in terms of new products development as customer future value. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 105 the examples of the innovation process indicator analysis for each sub-element are presented in table 11. table 11. examples of the innovation process indicator analysis element of the innovation process analysis indicators analyzed outcome factorial 1. analysis of the new products development expediency proportion of new products immediately meeting customer demand; sales losses from undue marketing caused by initial design adjustments new products promotion rate; break-even time-period 2. analysis of the applied research and development expediency and production of the next generation product feasibility study number of the feasible next generation products manufacturing feasibility of production process 3. analysis of the in-depth scientific research expediency of innovative products number of innovative products; proportion of innovative products within sales volume; new products introduction opposite to planned or rival product in-depth research and development feasibility 4. analysis of the cutting-edge innovative products development feasibility study time of the innovative product development; extent of ferreted out customer preferences in terms of innovative products number of innovative products prototypes before the launch 5. analysis of the customer demand acceptable in terms of new products development as customer future value approximate sales of anticipated new products manufactured; approximate profit from anticipated new products sales types of customer preferences acceptable in connection with new products production feasibility; rating of each type of customer preferences acceptable in connection with new products production feasibility; pro-forma prices for anticipated new products asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 106 the procedure of the innovation process indicators analysis commences, firstly, from the analysis of the new products development expediency. secondly, the applied research and development expediency and production of the next generation product feasibility study are analyzed. the third step is to analyze in-depth scientific research expediency of innovative products and cutting-edge innovative products development feasibility study. finally, analyzed is customer demand acceptable in terms of new products development as customer future value. 4.4. training and personnel development indicators analysis the analysis of the training and personnel development indicators is aimed at making up analytical provision for taking strategic production management decisions. the basic elements of the training and personnel development indicators analysis are: 1. analysis of the employees’ motivation level, delegated authorities volume and the extent of conformity of their personal and corporate goals. 2. analysis of the extent of the information system expansion. 3. analysis of the quality of the employees training and their creative abilities development. the examples of the training and personnel development indicators analysis are presented in table 12. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 107 table 12. examples of the training and personnel development indicators analysis element of the training and personnel development analysis indicators analyzed outcome factorial 1. analysis of the employees’ motivation level, delegated authorities volume and the extent of conformity of their personal and corporate goal average number of accepted and introduced innovation per an employee; level of flaws uniformity and permanent reduction; level of cooperation between employees and organization departments number of employees; number of accepted and introduced innovations; number of defects; number of employees, whose bsc defined goal are in conformity with it 2. analysis of the extent of the information system expansion provision time of complete and authentic information to assess customer position as well as to understand and predict the demand; provision time of customer information in terms of the goods supplied proportion of employees communicating with customers direct and having access to the needed interactive information ; portion of necessary real-time data from customer feedback 3. analysis of quality of the employees training and their creative abilities development percentage of key employees turnover; proportion of qualified employees within the total personnel; labor cost at sales revenues; employees efficiency; value added per an employee; net income per an employee level of employees professional satisfaction; average time per an employee training and personnel development the procedure of the bsc training and personnel development indicators analysis commences from the analysis of the employees’ motivation level, delegated authorities volume and the extent of conformity of their personal and corporate goals. ten we analyze the extent of the information system expansion. the analysis is finalized by the analysis of the quality of the employees training and their creative abilities development. the applied strategic analysis as a new bsc research instrument of the organization economic activity defines its general contours as a new lead of scientific research and practical activity presents some kind of theoretical basis for further asa development and above all for its practical application. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 108 5. concluding remarks to complete the treatment of the applied strategic analysis we draw a number of conclusions: applied strategic analysis (asa) may be considered as a new lead of scientific research and practical application in the field of strategic organization management; asa concept emerged from the bsc concept development arising the need to transform a financial analysis of the organization activity into a broader and complex concept; asa is a bsc indicators research instrument and assumes their comparative assessment, variance diagnostics and forecast; asa comprises four basic leads: financial indicators analysis, customer indicators analysis, internal business-processes indicators analysis and training and personnel development indicators analysis; asa concept may evolve into specific methods, economic-mathematic models and software to be practically applied. the following may be considered to be basic trends of the further applied strategic analysis development: further asa development assuming its elaboration and specification in terms of certain bsc elements; asa methods development for different companies in different industries; asa spread to include current activities, being bsc derivative; economic-mathematic models and software development enabling to apply asa practically for organization management processes. references friedag, h. r., & schmidt, w. (2002). balanced scorecard: mehr als ein kennzahlensystem. berlin: haufe mediengruppe. horvath & partners. (2004). balanced scorecard umzetzen. stuttgart: schaeffer-poeschel verlag gmbh. kaplan, r. s. (2005). how the balanced scorecard complements the mckinsey 7-s model. strategy and leadership, 3(33), 41-46. http://dx.doi.org/10.1108/10878570510594442 kaplan, r. s., & norton, d. p. (2006). alignment. using the balanced scorecard to create corporate sinergies. boston: harvard business school press. kaplan, r.s., & norton, d.p. (2004). measuring the strategic readiness of intangible assets. harvard business review, 2(82), 52-63. kaplan, r. s., & norton, d., p. (1993). putting the balanced scorecard to work. harvard business review, 5(71), 134-142. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 109 kaplan, r. s., & norton, d. p. (2003). strategy maps. boston: harvard business school press. kaplan, r. s., & norton, d. p. (1992). the balanced scorecard: measures that drive performance. harvard business review, 1(70), 71-79. kaplan, r.s., & norton, d.p. (1996). the balanced scorecard: translating strategy into action. boston: harvard business school press. kaplan, r. s. & norton, d. p. (2008). the execution premium: linking strategy to operations for competitive advantage. boston: harvard business school press. kaplan, r. s., & norton, d. p. (2005) the office of strategy management. harvard business review, 10(83), 72-80. kaplan, r. s., & norton, d. p. (2001). the strategy-focused organization: how balanced scorecard companies thrive in the new competitive environment. boston: harvard business school press. kaplan, r. s., & norton, d. p. (1996). using the balanced scorecard as a strategic management system. harvard business review, 1(74), 75-85. kaplan, r.s., norton d. p., & rugelsjoen b. (2010). managing alliances with the balanced scorecard. harvard business review, 1(88), 114-120. maisel, l. s. (1992). performance management: the balanced scorecard approach, journal of cost management, 2(6), 47-52. norreklit, h. (2000). the balance on the balanced scorecard a critical analysis of some of its assumptions. management accounting research, 1(11), 65-88. http://dx.doi.org/10.1006/mare.1999.0121 olve, n.-g., roy, j., & wetter, v. (2000). performance drivers: a practical guide to using the balanced scorecard. chichester: john wiley & sons, ltd. rampersad, h. k. (2003). total performance scorecard: redefining management to achieve performance with integrity. new york, ny: butterworth heinemann. microsoft word comovement latest journal edited-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 185 co-movement and index changes evidence from the emerging indian stock market srikanth parthasarathy assistant professor bharathidasan institute of management tiruchirappalli 620014, india tel: 91-909-413-5843 e-mail: psrikanth2011@gmail.com received: august 17, 2011 accepted: december 8, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.835 url: http://dx.doi.org/10.5296/ajfa.v3i1.835 abstract this study investigates the return co-movement around the benchmark nifty index changes for the period 1999-2010 in the indian stock market. we find evidence of significant increase in co-movement between the added stocks and the nifty index subsequent to additions to the benchmark nifty index. on the contrary stocks deleted from the nifty index do not evidence decreased co-movement between the deleted stocks and the nifty index. we have employed various methodologies used by vijh(1994), barberis et al(2002) and greenwood and sosner (2002) and the results suggest that the information related views explain the nifty index changes in the emerging indian stock market. keywords: indian equity market, index changes, co-movement, information jel classification: g11, g12, g14. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 186 1. introduction the empirical investigation of stock index changes around the world has focused on two aspects: firstly, the price effect which was studied for over the past three decades had evidenced permanent increase in stock prices following addition to stock index. shiefler (1986), lynch and mendenhall (1997), wurgler and zhuravskaya (2002) have found evidence for permanent price effects following addition to s&p 500 index. greenwood (2003) evidenced similar price effects in the tokyo stock market. secondly, the return co-movement1 as measured by stock beta, between the added (deleted) stocks and the market index following addition (deletion) to (from) the market index. pioneering work on co-movement around index changes was done by vijh (1994) and later by barberis et al (2002). vijh (1994) discriminated between the price pressure hypothesis and non-synchronous trading hypothesis as the explanations for co-movement subsequent to index changes. according to mitchel et al(2004), the price pressure hypothesis asserts that prices will temporarily move away from their intrinsic values with uninformed shifts in order to compensate the liquidity providers. according to harris and gurel (1986), the price pressure hypothesis assumes that investors who accommodate demand shifts should be compensated for the transaction cost and the portfolio risk they bear when they agree to buy or sell stocks which otherwise they would not trade. the suppliers of liquidity are compensated by immediate price drops (increases) with large sales (purchases). on the other hand, according to scholes and williams (1977) trading activity around index addition might enable investors to trade the index portfolio more efficiently (non-synchronous properties). this enables bench mark index stocks to incorporate market wide information immediately compared to non-benchmark stocks which impound information with a lag. the study shows that non-synchronous trading also biases the estimated stock betas. barberis et al (2002) analyzing the s&p 500 index additions discriminated between the three co-movement views, namely category view, habitat view and finally the information diffusion or fundamental view. in the category view, the investor’s, like index traders, group assets or stocks into categories and when they move from one category to another, co-movement is generated between assets in the same category. similar explanation is the habitat view in which a group of investors for various reasons choose to trade only in a subset of assets2 and move in and move out of them together due to transaction costs, trading restrictions or lack of information. the above views posit that the increased co-movement is due to trading actions of the index funds, co-movement is generated. finally the information view relates co-movement to rapid incorporation of information in benchmark index stocks compared to other stocks because of market frictions. consequently the stocks tend to co-move with the index. overall the debate is whether the increased co-movement subsequent to index addition is due to behavioral / index trading or traditional / fundamental based reasons. 1 co-movement is defined as a pattern of positive correlation (barberis et al, 2002). dirk baur (2003) explains co-movement as a phenomenon in which an asset (price) is ‘moving with’ another asset (price) and defines co-movement as the movement of assets that is shared by all assets at time‘t’ 2 for example, some investors may trade only in the indian stocks which are included in the msci index etc. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 187 though this is well researched topic in the developed markets, there are few studies in the emerging markets like india on index changes in general and co-movement in particular. the importance of these studies in the indian stock market can be appreciated based on the fact that the indian equity market stood 13th in the world and 4th in asia in terms of both traded value ($ 1050 bn during the year) and market capitalisation ($ 645 bn at the year end)3 in 2008. the increasing international portfolio investment and participation provides a perfect platform for gathering information about the market structure, efficiency and evidence of the integration mechanism with the developed markets. the indian stock market differs from the developed markets in the following ways; the indian stock market4 is characterized by less informational efficiency, higher costs, smaller investor base and lower liquidity compared with the stock markets of developed countries. finally, unlike the developed markets, there may be drastic difference in the quality of assets between benchmark index and other index stocks. this is truer for the foreign investors’ as local factors affect pricing significantly. hence, it will be interesting to analyse whether the results evidenced in the developed markets apply to emerging markets like india. this is very important as countries like india have looked upon the developed countries for their financial sector policies. these studies will help the decision makers to appreciate the differences or similarities between the emerging and developed countries and to take informed policy decisions. the co-movement following index changes has implications for portfolio managers as they might alter the return correlation due to conventional factors like industry etc. the purpose of this study is to analyse the co-movement subsequent to nifty index changes by comparing the ‘beta’ of the added/deleted stocks before and after the addition and deletion to benchmark nifty index. the increased (decreased) co-movement may be either due to trading strategies of institutional investors post inclusion or due to fundamental reasons. this study enters the debate by positing that the nifty index additions might be accompanied by increased comovement and fundamental explanations like information diffusion view (barberis et al,2002) or the non-synchronous trading hypothesis( vijh, 1994) might explain the increased co-movement. this study contributes to ever growing index addition literature by studying the co-movement between the added (deleted) stocks and the nifty market index following addition (deletion) to (from) the nifty market index in the indian stock market. the second section details the existing literature. the third section details the nifty index selection, methodology and data. the fourth section reports and analyses the findings and the fifth section concludes. 2. review of literature 2.1 theories of co-movement the explanations for increased co-movement post index additions have revolved around two groups of explanations namely; while vijh (1994) discriminated between the price pressure 3please see http://nse-india.com/archives/us/ismr/us_ismr2009.htm for more details. 4 chakrabarti(2002) and hacibedel(2008) have discussed the differences between developed and emerging markets extensively. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 188 hypothesis and non-synchronous trading hypothesis as the explanations for co-movement subsequent to index changes, barberis et al (2002) discriminated between the three co-movement views, namely category view, habitat view and finally the information diffusion or fundamental view. according to the price pressure hypothesis, large trading volume in premier index stocks like the nifty stocks would cause price pressures because of short term demand-supply considerations. this may be due to the fact that someday ‘buy’ orders may dominate and on other days ‘sell’ orders might dominate. this also may be caused by large trades based on investment strategies following index changes etc. according to mitchel et al (2004), the price pressure hypothesis contends that prices will temporarily move away from their intrinsic values with uninformed shifts in order to compensate the liquidity providers. according to harris and gurel (1986), the price pressure hypothesis assumes that investors who accommodate demand shifts should be compensated for the transaction cost and the portfolio risk they bear when they agree to buy or sell stocks which otherwise they would not trade. the suppliers of liquidity are compensated by immediate price drops (increases) with large sales (purchases). the index funds and other institutional investors have to rebalance their portfolios immediately following the effective date of index changes due to tracking error. vijh (1991) opines that price pressure might overstate nifty stock betas and understate non-nifty stock betas. parthasarathy (2010) evidenced that the effect of price pressure is very limited at best based on the price and volume effects following nifty index additions in the indian stock market. scholes and williams (1977) contended that the trading activity around index addition might enable investors to trade the index portfolio more efficiently (non-synchronous properties). this enables bench mark index stocks like the nifty index stocks to incorporate market wide information immediately compared to non-benchmark stocks which impound information with a lag. the study shows that non-synchronous trading also biases the estimated stock betas. if the changes in co-movement are driven by the non-synchronous trading, beta increase should be evidenced only in the stocks experiencing increased volume and not for the stocks that did not experience volume increase. however, according to the price pressure all the added stocks would experience beta increase irrespective of the post inclusion volume. barberis et al (2002) discriminated between the three co-movement views, namely category view, habitat view and finally the information diffusion or fundamental view. in the category view, the investor’s, like index traders, group assets or stocks into categories and when they move from one category to another, co-movement is generated between assets in the same category. the idea is that investors choose to asset allocation rather than security analysis and hence choose the category like the index funds rather than the individual stocks. the implication is that the correlation among stocks is due to investor actions and not due to fundamental reasons. similar explanation is the habitat view in which a group of investors for various reasons choose to trade only in a subset of assets and move in and move out of them together due to transaction costs, trading restrictions or lack of information. the above views posit that the increased co-movement is due to trading actions of the index funds, co-movement is generated. the habitat view is based on the segmented market approach. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 189 there are two implications of the category and habitat views; firstly, increased co-movement in the latest period along with the growth of index funds and secondly, symmetric response to index additions and deletions with regard to co-movement. finally the information view relates co-movement to rapid incorporation of information in benchmark index stocks compared to other stocks because of market frictions. consequently the stocks tend to co-move with the index. 2.2 empirical literature the existing literature on co-movement between the added stocks and the market index following addition to the market index predominantly deals with developed markets. however there is some literature regarding co-movement and stock synchronicity in the emerging economies. the literature on the developed economies is discussed first. vijh (1994) analysed 329 stocks added to the s&p 500 index during the 1975-1989 period. he evidenced increased stock beta subsequent to index additions. he evidenced an increase of 0.211 and 0.130 in daily and weekly betas respectively. he found evidence that the increase in co-movement was predominantly due to index trading strategies rather than the reduction of non-synchronicity. though both the price pressure hypothesis and non-synchronous trading hypothesis support increased beta for s&p 500 stocks and reduced beta for nons&p 500 stocks, vijh(1994) asserts that the cross sectional implication would be different. the non-synchronous trading hypothesis expects that increase or decrease of individual stock beta depends on the before and after trading volume. it predicts that for the stocks whose trading volume, subsequent to index addition, decreases, the stock beta will decrease and vice versa. the price pressure hypothesis predicts that as the addition of a stock to the premier index always increase the covariance with the market returns and hence the stock beta of individual stocks will always increase irrespective of trading volume. the second important study regarding stock co-movement subsequent to index inclusion was by barberis et al (2002). they studied s&p 500 index inclusions and exclusions using weekly data for the period 1976-2000. they evidenced an increase of 0.11 and 0.03 in stock beta and co-efficient of determination ‘r2’ respectively. they introduced the non-s&p stock returns5 into the regression independently. the bivariate regression evidenced even starker confirmation of increased co-movement. the beta increase was 0.21 while the beta decrease for the non-s&p stocks was -0.12. barberis et al provided support in favor of behavioral views like category and habitat views rather than fundamental view for s&p 500 stock inclusion by evidencing that the results were stronger in the later period and were robust to both size and industry characteristics. greenwood and sosner (2002) studied the one time inclusion of 30 stocks to the japanese nikkei index in the year 2000. they evidenced a significant increase of 0.6 in daily stock betas subsequent to addition and a significant decrease of 0.71 subsequent to deletions. this study also supported the behavioral / trading related views for the increased co-movement. coakley and kougalis (2004) studied post inclusion co-movement in the ftse100 index on 5 total market return minus s&p 500 returns. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 190 the lines of barberis et al. the univariate regressions using the ftse100 index returns evidenced post inclusion daily beta change of 0.34 and -0.35 for inclusions and exclusions respectively. the weekly beta increase was 0.16 post inclusion. the bivariate results using the ftse100 index and nonftse100 index returns evidenced post inclusion daily beta increase of 0.51. the weekly results evidence beta increase of 0.603 for ftse stocks and -0.872 for non-ftse stocks. j.coakley et al.(2008) studied msci canada standard country index rebalancing wherein 17 stocks were added and 13 stocks were deleted in the year 2000. they evidenced an average beta increase by a factor of 1.6 for the added stocks and by a factor of –0.05 for the deleted stocks and supported the trading related views. however the evidence in favor of trade related co-movement in the developed markets is not unanimous. kasch and sarkar(2009) examining s&p 500 inclusions for the period 1989-2004 showed significant co-movement and concluded that changes in co-movement subsequent to s&p 500 additions reflect changes in the expectation about the fundamental value of added firms. claessens and yafeh(2009) studied co-movement subsequent to index additions for the period 2001-2007 in 39 developed and emerging markets around the world. they concluded that in less developed markets the increase in co-movement is due to information related problems. finally, chen et al (2004) analysed the price and volume effects of the s&p 500 index changes. they evidenced asymmetric results for additions and deletions regarding permanent price increase. he attributes this to the ‘investor awareness view’ which contends that many investors can become aware of the added stocks leading to permanent price increase. but the investors do not become unaware of the deleted stocks and hence deleted stocks may not evidence permanent price decrease post deletion. parthasarathy (2010) examined the price and volume effects of the nifty index additions in the indian stock market in the 1999-2010 period and concluded that the information related explanations explain the evidenced permanent increase in price. 3. data and background information 3.1 the nifty index the s&p cnx nifty (nifty hereafter) is the headline index on the national stock exchange (nse) maintained by the india index services and products ltd. (iisl) from 1998. it represents a portfolio of 50 large and most liquid stocks of the nse and captures 65% of the total market capitalization. the nse is the premier exchange of india in terms of market capitalisation and value traded. the main criteria of selection of stocks for the nifty index are market capitalization, float, liquidity and industry representation. the index is normally reviewed every six months and six weeks’ notice is normally given to the market after announcement before change is effected. index removal is normally effected either due to corporate actions like restructuring etc. or when market capitalisation of an index stock falls below 50% of the market capitalisation of the top most stock of the replacement pool (top nifty junior stock). normally nifty index replacements are top most stock of the nifty junior asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 191 index. nifty and nifty junior index represents two disjoint sets together representing the top 100 stocks in the indian stock market. 3.2 sample selection the sample period for this study is 1999 – 2010, coincides the starting year of index funds in india. this choice of the period will help us to discriminate between the various theories as the index funds play an important part in the price pressure hypothesis. also details regarding both announcement date (here after ad) and effective date of inclusion/exclusion (here after ed) are available only from 1998 onwards. the daily data from www.nse-india.com is used to calculate daily return and daily volume of the added stocks and nifty index. the sample consists of 41 inclusions and 30 deletions. the following stocks are not considered: stocks arising out of corporate restructuring, stocks which do not have trading history for at least 100 trading days prior to the announcement date in the case of additions and at least 70 trading days post deletion in the case of deletions. the total number of nifty index changes for the 1999-2010 period is 54. the total number of stocks available for research after the elimination is 41 in the case of additions and 30 in the case of deletions. the sample is separated into two periods namely, 1999 2006 and 2007 – 2010 as the latter period is marked by increased fund activity and participation and is more representative for the current market activity. 3.3 return and volume daily return rt is calculated as rt = ln ( pt ) ln (pt-1) (1) where pt is the stock / nifty index / nifty junior closing price at time t and pt-1 is the stock / nifty index / nifty junior closing price at time t-1. the volume effect is studied in the spirit of harris and gurel(1986) where volume ratio vr = (vit /vmt) ÷ (vi / vm) (2) where vit and vmt are the trading volumes at time ‘t’ of security i and the total nse respectively, and vi and vm are the average trading volumes of the security i and total nse for the period ad-70(70 days before announcement) through ad-10. the calculated daily vr is used to calculate the ‘vr’ for the period ed+10 to ed+70. the volume ratio6 should have a value of ‘one’ under null hypothesis. if for a stock vr>1, then post inclusion volume is more than the pre inclusion volume and vice versa. 4.4 descriptive statistics table 1 describes the growth of market capitalization, mutual funds and average trading volume from the year 1999 to 2009. the table 1 also details the number of yearly additions to the nifty index and the beta change for the added stocks after inclusion into the index. there 6 volume in this study is the number of shares traded. the stock volume is standarised using the total nse market volume. the calculation of volume ratio takes into account the capitalization changes asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 192 is a steep increase in all the variables like market capitalization, mutual funds assets and average daily trading volume except for the years 2001 and 2008 suggesting increased participation from various market players.. table 1. yearwise ed abnormal return and beta change is given for the period 1999-2010 in order to verify whether the beta change is stronger in the latest data. year number of additions beta change average assets under mutual funds in rs. millions market capitalisation in rs. millions average daily trading volume in rs. millions 1999 5 -0.219 970280 10204260 33030 2000 4 0.423 993260 6578470 53370 2001 0 0 1018220 6368610 20780 2002 6 0.167 1226600 5371330 24620 2003 3 0.088 1400930 11209760 43290 2004 4 0.049 1505370 15855850 45060 2005 2 0.515 1992480 28132010 62530 2006 2 0.182 3235970 33673500 78120 2007 6 0.37 5499360 48581220 41480 2008 3 0.057 4211170 28961940 113250 2009 6 -0.031 7944860 60091730 169590 the data is given for the period 1999-2010. the number of additions to nifty index each year. the daily pre-event regression is run for the period ad-130 to ad-11 (120 trading days). the daily post event regression is run for ed+10 to ed+130. when data for 130 days are not available, the estimation period is shortened to 90 days in case of addition and 60 days in case of deletion. the point of interest is the difference ‘βc’ which is calculated for each added/deleted stock by subtracting the pre event beta from the post event beta. the mean yearly beta is the average beta of all the added stocks in a year. the average assets under mutual funds represent assets as on 31st december of each year. the average assets under mutual funds(year end) is regressed with yearly mean beta change in order to verify whether the beta change is stronger in the latest data. the market capitalisation and average daily trading volume are given as on march 31st of the respective financial year7. 4. analysis and findings 4.1 univariate regressions the following regression was run for each of the 41 added and 30 deleted stocks using approximately six months data, both pre-announcement and post-inclusion. rit = α + β * rnifty,t + εit (3) 7 based on nse fact book 2011. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 193 where, rit is stock return, rnifty,t is the nifty index return on day ‘t’, β is the regression slope beta co-efficient and εit is a random variable with expected value of zero assumed to be uncorrelated8 with rnifty,t. for the additions, the daily pre-event regression is run for the period ad-130 to ad-11 (120 trading days). the daily post event regression is run for ed+10 to ed+130. when data for 130 days are not available, the estimation period is shortened9 to 60 days in case of addition and 60 days in case of deletion. the point of interest is the difference ‘βc’ which is calculated for each added/deleted stock by subtracting the pre event beta from the post event beta. the hypothesis that βc is significantly greater than zero is first tested cross sectionally using one-tailed t-test. the post inclusion/exclusion regression starts only from the 11th day after inclusion as the first few days after inclusion will be characterized by sudden increase in volume and volatility due to action of index funds. consequently, in order to maintain symmetry, the pre-event regression ends 10 days before the announcement date. the results of the univariate regression of added stocks are reported in table 2, panel a. according to barberis et al(2002) preposition i, for category based co-movement added (deleted) stock should experience a beta increase (decrease). the nifty index additions experience a statistically significant positive change in the betas(slope co-efficient) post inclusion. the average beta change for the complete period is 0.140. the beta change is also statistically significant in both the sub periods. the average beta change in the first and second sub period is 0.133 and 0.153 respectively. the results of the univariate regression of deleted stocks are reported in table 2, panel b. nifty deletions experience a beta increase of 0.045, though not statistically significant, instead of an expected significant beta decrease. also both the sub periods do not evidence significant beta decrease. the result for deletions is also different from the evidence in the developed markets. the lack of symmetric response to additions and deletions does not support the barberis et al (2002) ‘category view’. the results seem to support the chen et al (2004) explanation of ‘investor awareness’ as an explanation index changes in the indian stock market. 8 this assumption is valid in the nifty index changes because unlike the western equity markets, the nifty index changes do not normally feature multiple additions. there are 29 unique additions(29 different inclusion days) for the total of 41 additions. see coakley and kougalis (2004) for more information on this issue. 9 the estimation period is shortened for only two added stocks and one deleted stock. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 194 table 2. changes in co-movement measured by daily beta before and after addition of stocks to nifty index panel a results of univariate regression -additions period no. of additions average beta before inclusion average beta after inclusion increase in beta % of stocks with beta increase 1999-2010 41 1.013 1.153 βc 0.140 57% t-stat 2.131** 1999-2006 26 0.950 1.083 βc 0.133 58% t-stat 1.504* 2007-2010 15 1.125 1.278 βc 0.153 54% t-stat 1.585* panel b results of univariate regression deletions period no. of deletions average beta before deletion average beta after deletion increase in beta % of stocks with beta increase 1999-2010 30 0.793 0.838 βc 0.045 56% t-stat 0.783 1999-2006 19 0.821 0.890 βc 0.07 63% t-stat 0.947 2007-2010 11 0.745 0.747 βc 0.002 37% t-stat 0.026 the sample of addition to nifty index for the period 1999-2010 consists of 41 added stocks and 30 deleted stocks which are not involved in mergers/demerger and related events and have sufficient daily data. for each added/deleted stock the betas are estimated for both the pre-change and post-change period. pre-change betas and post-change betas are calculated using daily data for the period ad-130 to ad-10 and period ed+10 to ed+130 respectively(120 trading days) using daily log returns in univariate market model. the statistical significance is tested cross sectionally using one-tailed t-test. ***, **, * denotes statistical significance at 1%, 5% and 10% level respectively. however, if the stocks10 with substantial pre addition/deletion and post addition/deletion time series falling in the recession period jan-2008 to mar 2009 is removed, the second sub-period mean beta change for addition increases to 0.233 from 0.153 but for the deletions decreases from -0.002 to a still not significant -0.027. similarly the percentage of stocks with positive beta change increases to 70% from 54% in the case of additions. further, the recent period results after removing the recession period data are still not in line with that of the developed markets with significant beta increase for additions and small beta decrease (statistically not significant) for deletions. 10 five stocks in addition and four stocks in deletion. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 195 in order to verify that few outliers do not cause the results, the percentage of stocks with beta increase is calculated for both the additions and deletions. the percentage of stocks with positive beta change is over 50% for the complete period for not only the added stocks but also the deleted stocks. this suggests that the results are not due to a few outliers. the asymmetric results for the addition and deletion do not appear to support category based reasoning in barberis et al preposition i for the co-movement subsequent to nifty index changes. we have also used a matched sample methodology (results not showed for brevity) using firms that have not been added from the nifty junior index. this is important since stocks over this period could be showing increased co-movement with the index in general and the observed increased co-movement might have nothing to do with addition to the index. we have chosen ten random stocks representing all the major industries from the nifty junior index and have calculated ‘βc’ for these nifty junior stocks similar to the added stocks using the same ad and ed and is calculated for each by subtracting the pre event beta from the post event beta for 11 different event dates. the matched sample results evidence of ‘βc’ equal to 0.038 as against 0.140 for the added stocks. further, we ran a regression between the matched sample ‘βc’ and with that of the actual added stocks using the 11 different event dates. a significantly positive slope coefficient would suggest that the co-movement is not due to addition and may be due to increased co-movement with the index in general and the observed increased co-movement might have nothing to do with addition to the index. the regression slope co-efficient was negative (though not statistically significant) implying no correlation between the beta change of the added stocks and the matched sample stocks. this confirms that the increased co-movement is due to index addition only. in order to test for the barberis et al (2002) assertion that if the index trading strategies are the main reason for the significant co-movement, the results should be stronger in the later sub-period along with the growth of index funds. the difference between the beta changes in both the sub periods in panel a is compared using both parametric (two sample t-test) and non-parametric tests (mann whitney test). the tests unanimously suggest that the difference in beta changes between the two sub-periods is not significant at any level of significance11 suggesting that the beta change is not significantly stronger in the later period. this result does not support the index trading strategies assertion. further if the beta effect (βc) gets stronger along with the growth of index funds12, a significantly positive slope co-efficient should result when yearly beta change (table 1) is regressed with the yearly average value under mutual funds. however the regression13 slope co-efficient is found to be almost zero and is not statistically significant at any level of significance. the results of this study differ from those of barberis et al(2002) and coakley and kougalis (2004) in not supporting the index trading based co-movement as the reason for co-movement subsequent to index additions. the above results along with the univariate results for deletions do not support the 11 the results of the two sample test (1999-2006 and 2007-2010): parametric test: t-value is -0.215, p-value : 0.831. non parametric test: value is 0.293, p-value : 0.769. 12 as the data for index fund growth in the indian market is not available, the mutual fund data is used as a proxy in this study. the average assets under mutual fund as on 31, december. the source is www.amfiindia.com. 13 the d-w stat is within limits for all the regressions. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 196 no-information assertion for nifty index additions and differs from those of the developed countries. 4.2 bivariate regressions barberis et al(2002) introduced the bivariate regression in their preposition ii by introducing non-s&p 500 returns independently in the regression and stated that controlling for nons&p 500 stocks, stocks added to (deleted from) the s&p 500 index will experience a beta increase (decrease). in the nifty index additions, stocks are added from among the top market capitalization stocks of ‘nifty junior’ index but the stocks deleted from the nifty index are not included back in the nifty junior index. the following bivariate regression is run for all the added stocks, rit = α + βi,nifty * rnifty,t + βi,niftyjunior * rniftyjunior,t + εit (4) where rniftyjunior,t is the nifty junior index return on day ‘t’. barberis et al(2002), coakley and kougalis (2004) have calculated and used the non-s&p 500 and non-ftse return respectively in the bivariate regression using the total market return and total market capitalization data in their respective markets. due to paucity of such readily available data in the indian stock market and due to the fact that stocks added to nifty as a rule comes from nifty junior index, rniftyjunior,t is used in this study. also as the stocks deleted from the nifty index are not included back in the nifty junior index, similar bivariate regression would not make sense for stocks deleted14 from nifty index. according to barberis et al (2004), in the category view, the basic prediction is that, when a stock enters a bench mark index like nifty, it becomes more sensitive to that bench mark index sentiment shock. the independent variable in the univariate regression in eq(3) is not a clean measure of this sentiment shock as a substantial part of its variation might come from news about cash flows. the βi,niftyjunior variable in eq(4) can be thought of as a control for such news, making the βi,nifty in eq(4) a cleaner measure of sensitivity of such sentiment shock. alternatively, under the information diffusion view, eq(4) is a cleaner test than eq(3) of whether, after inclusion, stock i becomes more sensitive to that component of market-wide news that is incorporated more quickly into nifty index than into niftyjunior index. the results of bivariate regession are displayed in table 3. the average change in βnifty and average change in βniftyjunior for the complete period is 0.532 and –0.442 respectively and statistically significant. the results for both the sub periods are statistically very significant. the though the change in βnifty and βniftyjunior is as per the predictions of preposition ii of barberis et al(2002) and similar to the results evidenced in the developed countries, the beta change for the later sub-period is not stronger than for the earlier sub-period which suggests again that the index trading strategies may not be the primary reason for the increased co-movement subsequent to additions and differs from the results in developed markets. moreover, in the developed markets the magnitude of decrease in non s&p / non ftse beta was equal or more than the magnitude of increase in s&p / ftse beta. however, in the indian stock market the magnitude of decrease in niftyjunior beta was markedly lower than 14 for the stocks deleted from nifty index, bivariate regression was run using nifty junior index. the average change in βnifty and average change in βniftyjunior for the complete period is not statistically significant. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 197 the magnitude of increase in nifty beta in the complete period and even lower in the later period for nifty additions. it is seen from table 3 that the βnifty increase for the later period was 0.518 but the decrease in the βniftyjunior was only -0.378. table 3. results of bivariate regression panel achanges in co-movement measured by daily beta before and after addition of stocks to nifty index and before and after exclusion from the niftyjunior index period no. of additions average nifty beta before inclusion average nifty beta after inclusion increase in beta % of stocks with beta increase 1999-2010 41 0.284 0.832 βc 0.532 81% t-stat 5.183*** 1999-2006 26 0.269 0.833 βc 0.539 77% t-stat 3.787*** 2007-2010 15 0.310 0.819 βc 0.518 87% t-stat 3.660*** panel achanges in co-movement measured by daily beta before and after exclusion from the niftyjunior index(ie addition to nifty index) period no. of additions average niftyjr beta before deletion average niftyjr beta after deletion decrease in beta % of stocks with beta decrease 1999-2010 41 0.832 0.390 βc -0.442 75% t-stat -4.708*** 1999-2006 26 0.833 0.355 βc -0.479 73% t-stat -4.055*** 2007-2010 15 0.829 0.451 βc -0.378 80% t-stat -2.395** the sample of addition to nifty index for the period 1999-2010 consists of 41 added stocks which are not involved in mergers/demerger and related events and have sufficient daily data. in this bivariate regression, for each added stock the betas are estimated for both the pre-change and post-change period for both the nifty index and the niftyjunior index as top stocks from the niftyjunior index are added to the benchmark nifty index based on predetermined criteria. pre-change betas and post-change betas are calculated using daily data for the period ad-130 to ad-10 and period ed+10 to ed+130 respectively(120 trading days) using daily log returns in bivariate market model. the statistical significance is tested cross sectionally using one-tailed t-test. ***, **, * denotes statistical significance at 1%, 5% and 10% level respectively. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 198 4.3 the non-synchronous trading hypothesis according to scholes and williams (1977), index trading strategies around nifty index additions increases the trading frequency of the included stocks which enables those stocks to incorporate market wide information immediately compared to non-nifty stocks which impound information with a lag. the study shows that non-synchronous trading also biases the estimated stock betas. according to their model, betas of added stocks will increase as their trading volume moves closer to market average and not in other cases. the non synchronous trading hypothesis therefore implies that beta of added stocks will increase only if the post addition trading volume is greater than pre addition volume. heavy trading helps in the incorporation of market wide information efficiently in the nifty index stocks compared to non-nifty stocks. this is similar to the barberis et al (2004) information diffusion view15. the implication is that the added stocks which are less frequently traded pre addition should witness beta increase due to the increased trading activity of institutional investors in the added stocks. price pressure hypothesis predicts betas of added stocks will increase in all the cases. the methodology developed by vijh(1994) and later modified by coakley and kougalis (2004) is used in this study. the sample of 41 added stocks are grouped into two groups based on their trading volume. the first group consists of added stocks whose post-addition volume decreased and the second group consists of added stocks whose post-addition volume increased. all the added stocks are grouped in either one of the groups based on the above criteria. if the increased co-movement, as measured by increased beta subsequent to nifty index additions, is due to non-synchronous trading, then only the second group should evidence beta increase. if the increased co-movement as measured by increased beta subsequent to nifty index additions is due to the price pressure caused by index trading strategies, both groups should evidence beta increase. the results are tabulated in table 4. while panel a reports the beta change for stocks for which trading volume decreased post addition, panel b reports the beta change for stocks for which trading volume increased post addition. as an additional measure, panel c reports beta change ordered based on quintile change using trading volume. according to the price pressure hypothesis, beta should increase post addition in both the groups and in all the quintiles. whereas the non-synchronous trading hypothesis expects the beta increase only for second group (panel b). the beta change for the stocks for which trading volume decreased post addition decreased by 0.011 (median: 0.07) for the complete period as predicted by non-synchronous trading view and beta change for the stocks for which trading volume increased post addition is a increase of 0.267 (median: 0.272). the results for the both the sub-periods are similar to the full periods in both the panels. the results are corroborated by the median values and percentage of stocks with beta increase in both the panels. for the complete period, only 36% 15 the information diffusion view contends that the large liquid stocks impound information efficiently compared to smaller less liquid stocks and consequently priced fairly most of the time. this implies that the nifty index would lead the other secondary indices in the indian stock market. please see appendix i for the results supporting the information diffusion view in the indian stock market. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 199 of added stocks report beta increase for panel a stocks. whereas the beta increase for the panel b stocks’ is 73% of added stocks. in panel c, where stocks are arranged into three quintiles based on average trading volume, the beta increase from the lowest to highest quintile is – 0.06 (median: 0.107), 0.192 (median: 0.168) and 0.285 (median: 0.294) respectively. the above results are presented to suggest that the results are not due to outliers or stock selection. further, nonparametric, two independent sample test compared the beta change between panel a and panel b stocks rejected the equality of mean at 1% level. the results support the non-synchronous trading hypothesis in the indian stock market and are different from the results in the developed markets. table 4. testing the price pressure against the non-synchronous trading hypothesis panel a stocks for which trading volume decreased post inclusion: volume ratio(vr) is less than one period sample increase in beta average volume ratio vr % of stocks with beta increase prediction of price pressure hypothesis prediction of non-synchronous trading hypothesis mean median 1999-2010 19 -0.011 -0.070 0.53 36% increase decrease 1999 2006 10 -0.034 -0.050 0.43 40% increase decrease 2007-2010 9 0.014 -0.070 0.65 33% increase decrease panel b stocks for which trading volume increased post inclusion : volume ratio(vr) is more than one period sample increase in beta average volume ratio vr % of stocks with beta increase price pressure prediction nonsync trading prediction mean median 1999-2010 22 0.267* 0.272 2.67 73% increase increase 1999 2006 16 0.237* 0.236 2.69 66% increase increase 2007-2010 6 0.346* 0.372 2.35 83% increase increase panel c daily beta as a function of trading volume quintile of volume ratio sample increase in beta average vr % of stocks with beta increase price pressure prediction nonsync trading prediction 1999-2010 41 0.140 1.64 57% mean median lowest 14 -0.06 -0.107 0.44 30% increase decrease middle 14 0.192* 0.168 1.05 77% increase increase highest 13 0.285* 0.294 3.39 64% increase increase asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 200 the sample of addition to nifty index for the period 1999-2010 consists of 41 added stocks which are not involved in mergers and related events and have sufficient daily data. for each added stock the betas are estimated for both the pre-change and post-change period. pre-change betas and post-change betas are calculated using daily data for the period ad-130 to ad-10 and period ed+10 to ed+130 respectively(120 trading days) using daily log returns in univariate and bivariate market model. the volume effect is studied in the spirit of harris and gurel(1986) where volume ratio vr = (vit /vmt) ÷ (vi / vm) where vit and vmt are the trading volumes of security i and the total nse respectively, and vi and vm are the average trading volumes of the security i and total nse for the period ad-70 through ad-10. the calculated daily vr is used to calculate the ‘vr’ for the period ed+10 to ed+70. the volume ratio should have a value of ‘one’ under null hypothesis. if for a stock vr>1 then post inclusion volume is more than the pre inclusion volume and vice versa. the quintile ranking is based on vr. the statistical significance is tested cross sectionally using one-tailed t-test. * denotes statistical significance at 5% level. further, coakley and kougalis (2004) considered the bivariate changes and suggested that non-synchronous trading could explain the results if the ratio of absolute increase in nifty beta βi,nifty to absolute decrease in nifty junior beta βi,niftyjunior is larger for the second group in panel b compared to panel a in table 3. while the ratio for the first group (panel a) is 0.872, the ratio for the second group (panel b) is more than double at 1.672 (almost 100% increase). the above result seems to confirm that the non-synchronous trading view as the major explanation for co-movement subsequent to nifty index changes. 4.4 non-synchronous trading and auto-correlations according to greenwood and sosner (2002), pricing effects due to index trading strategies should eventually end and as a result added stocks should co-move strongly immediately after addition but later revert to reflect fundamentals. he argues that the resulting effect would be negative auto-correlations for the added stocks and vice versa for deleted stocks. coakley et al(2008) argues that if non-synchronous trading effects dominate, then the autocorrelations of the added stocks should become more positive. the variance ratio test is used to test whether the auto correlation becomes more negative for the added stocks and less negative for the deleted stocks. lo a.w. and a.c. mackinlay(1988) enunciated the powerful variance ratio test which is based on variance of returns and have good size and power properties over other tests. the authors have reviewed the overlapping variance ratio tests and have concluded that for moderate to large samples and proper choice of holding period “q”, the variance ratio test is better than many other similar tests. the test is based on the fact that the variance of the increment of a random walk is linear in the sampling interval. this statistic compares one period return with longer period returns. the variance ratio less than / more than ‘1’ represents negative / positive auto correlation respectively. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 201 table 5. autocorrelation between a stocks' current return to its past return for stocks added / deleted to/from nifty index for the 1999-2010 period using variance ratio. addition n=40 pre event post event difference mean variance ratio16 at q = 2 q = 5 q = 2 q = 5 q = 2 q = 5 period 1999-2010 1.041 1.027 1.048 1.048 0.63% 2.02% sub period 1999-2006 1.037 1.029 1.067 1.065 2.33% 3.45% sub period 2007-2010 1.049 1.024 1.026 1.020 -2.19% 0.38% deletion n=30 pre event post event difference mean variance ratio at q = 2 q = 5 q = 2 q = 5 q = 2 q = 5 period 1999-2010 1.009 1.013 1.046 1.068 3.72% 5.45% sub period 1999-2006 1.008 0.996 1.052 1.071 4.42% 7.56% sub period 2007-2010 1.011 1.041 1.036 1.062 2.50% 1.98% the sample of addition to nifty index for the period 1999-2010 consists of 40 added stocks and 30 deleted stocks which are not involved in mergers and related events and have sufficient daily data. for each added/deleted stock the autocorrelation between the current period stock returns and earlier period stock returns are estimated for both the pre-change and post-change period using daily data(daily log returns) for the period ad-130 to ad-10 and period ed+10 to ed+130 respectively(120 trading days) using variance ratio. the variance ratio of ‘1’ indicated zero auto correlation. variance ratio > 1 implies positive autocorrelation and variance ratio < 1 implies negative autocorrelation. table 5 reports the variance ratio statistic calculated for each added/deleted stock for holding periods q = 2, 5. both the pre-change and post-change periods use 120 trading days each as the variance ratio is a powerful test in moderate and large samples. the results for the included stocks show an increase in mean auto correlation contrary to the predictions of the price pressure/index trading strategies. the first order auto-correlation at holding period q=2 and week long q=5 increase by 0.63% and 2.02% respectively for the complete period. for the first sub period the results are similar to the complete period but for the second recent sub-period there is marginal reduction in the autocorrelations. 16 the median values suggest even stronger increases in the complete period and both the sub periods for the added / deleted stocks. ex. for added stocks, for the second sub period, auto correlation increases at all lags. vr was not calculated for one stock as it had only prechange period of only 60 days asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 202 the results for the deleted stocks show that the autocorrelation increases between pre and post event for complete period and both the sub periods. the first order auto correlation increases by 3.72% and weeklong auto-correlation increases by 5.45% for the complete period. though the changes between the pre change and post change auto correlations are not statistically significant17 for both the additions and deletion for all the holding periods18, the results for the additions do not support the price pressure/index trading explanations as the explanation for the co-movement subsequent to index additions. this result seen along with the other results for slow information diffusion and non-synchronous trading appears to suggest that the information related explanations rather than the trading based explanations explain the nifty index changes after addition to or deletion from the nifty index during the period 1999-2010. 5. conclusion this study set out to empirically analyse the co-movement between the added/deleted stocks and the nifty index subsequent to nifty index changes in order to discriminate between the two competing explanations: the fundamental based approach which attributes return co-movement to correlation in news about fundamentals and the friction based or the index trading strategies based approach. the results for the univariate regressions for nifty index additions evidence significant increase in co-movement post addition. however, contrary to the results in the developed markets the nifty index deletions too experience increase in co-movement (though not statistically significant). the bivariate regressions for nifty index additions evidence significant increase in co-movement post addition. but both the univariate and bivariate regressions do not evidence significant increase in co-movement in the recent second sub period compared to the first sub period. the above results along with the tests conducted using the methodologies of vijh(1994), barberis et al(2002) and greenwood and sosner (2002), in contrast to the developed markets, suggest that the information related views explain co-movement subsequent to nifty index changes better than other competing explanations. an interesting finding is that the stock pricing become less efficient when the non-nifty stocks become nifty index stocks based on the auto correlation results. this has implications for the efficient market theory. due to increased trading and visibility subsequent to index addition, pricing of added stocks should become more efficient after addition to the benchmark index. further, the lack of symmetric response to additions and deletions seem to support the chen et al (2004) explanation of ‘investor awareness’ as an explanation index changes in the indian stock market. overall, the results suggest that information related explanations explain nifty index changes better than other competing explanations. acknowledgement i thank dr. victor louis anthuvan, professor of finance, chairperson phd, loyola institute of business administration, chennai-600034, for his guidance and support throughout the study. 17 using both parametric (two sample t-test) and non-parametric tests (two paired sample comparison test).. 18 the results for q=3 and q=4 are similar to the reported results for both additions and deletions. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 203 i also thank prof. lodewijk berlage, professor emeritus, katholike university, leuven, belgium, for his valuable suggestions. references amihud, y., & mendelson, h. 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(2009). additions to market indices and the co-movement of stock returns around the world. www.cepr.org/ pubs/dps/dp7052.asp., centre for economic policy research. appendix the information diffusion view contends that the large liquid stocks impound information efficiently compared to smaller less liquid stocks and consequently priced fairly most of the time. this implies that the nifty index would lead the other secondary indices in the indian stock market. barberis et al (2004) differentiates between the category – habitat theories with that of slow information diffusion view (fundamental view) for co-movement subsequent to index changes. coakley and kougalis(2004) studying ftse 100 additions in the london asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 205 stock market evidence that the bench mark ftse 100 index leads other secondary indices up to five lags. granger causality test is used to test whether nifty index returns causes or leads the non-nifty returns or vice versa in the indian stock market. according to granger causality, if a series x granger causes or leads a series y, then past values of x should contain information to predict y above and beyond the information contained in the past values of y alone. granger causality is normally tested in the context of linear regression models. granger causality measures precedence and information content but does not indicate causality in the normal sense of the term. consider the following bivariate linear auto regressive model       p i p i tvitiitit urniftyjrrniftyrnifty 1 1 , (5)       p i p i tritiitit urniftyrniftyjrrniftyjr 1 1 , (6) where, ‘p’ is maximum number of lagged observations included in the model. rnifty, rniftyjr represents nifty return and niftyjunior return respectively. this study uses 3 lags as determined by akaike information criterion(aic) and schwarz criterion. in the equation (6), if γi coefficients are statistically significant, then including lagged values of both nifty returns series and niftyjunior returns series gives a better forecast of niftyjunior returns. in this study, bivariate regression is run for all possible combinations in the group. the reported f-statistic is the wald statistic test is used to test for joint hypothesis, γ1 = γ2 = ….. = γi = 0 (7) for each equation. the null hypothesis is that the niftyjunior returns does not granger cause or leads nifty returns in eq(5) and nifty returns does not granger cause or leads nifty junior returns(eq 6). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 206 table 5. tests for information diffusion among the nifty, niftyjunior and cnx 500 indices using granger causality tests. panel a null hypothesis: nifty returns do not granger cause/lead niftyjunior and cnx 500 returns. lag 1 lag 2 lag 3 nifty junior f-stat 4.68 1.62 2.55 p-value 0.031** 0.199 0.054* cnx 500 f-stat 3.27 2.97 1.59 p-value 0.071* 0.051* 0.190 panel b null hypothesis: niftyjunior and cnx 500 returns do not granger cause/lead nifty returns. lag 1 lag 2 lag 3 nifty junior f-stat 0.22 0.22 0.56 p-value 0.639 0.639 0.641 cnx 500 f-stat 2.47 2.13 1.47 p-value 0.116 0.119 0.220 the nifty, niftyjunior and the cnx 500 daily return series is calculated for the period between 01-01-2000 to 31-03-2010. the granger causality as to whether the nifty returns leads/granger causes both niftyjunior and cnx 500 is tested. *, **, *** represents singnificance at 10%, 5%, 1% level. the tests are conducted using three indices, namely nifty index, nifty junior index and the broad based cnx 500 index. the nifty index constitutes the top 50 large, liquid stocks. the nifty junior index19 constitutes the next 50 stocks based on market capitalization (may be regarded as a midcap index). the cnx 500 index consists of top 500 stocks in the indian stock market and includes both nifty stocks and nifty junior stocks. if slow information diffusion plays a major role in the co-movement subsequent to index additions in the indian stock market then a) nifty returns must granger cause or lead both the nifty junior and cnx 500 returns b) cnx 500 returns must granger cause or lead nifty junior returns. if that is not the case, then category/habitat views explain the co-movement subsequent to index additions. the data between 01-01-2000 and 31-03-2010 is used as data for cnx 500 is available only from the second half of the year 1999. table v presents the results of the f-test along with the corresponding significance level. the results in panel a show that the null hypothesis nifty returns do not granger cause/lead niftyjunior is rejected for lags 1 and 3 at 5% and 10% significance level respectively. similarly the null hypothesis that nifty returns do not granger cause/lead cnx 500 is rejected for lags 1 and 2 at 10% significance level. however panel b results show that the hypothesis nifty junior 19 the s&p cnx nifty and the cnx nifty junior make up the 100 most liquid stocks in india with nifty constituting the top 50 stocks and nifty junior the next 50 stocks. the maintenance of the s&p cnx nifty and the cnx nifty junior are synchronized so that the two indices will always be disjoint sets; i.e. a stock will never appear in both indices at the same time. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e12 www.macrothink.org/ajfa 207 and cnx 500 returns do not granger cause/lead nifty returns is not rejected at any level of significance. the results suggest that nifty index returns lead20 both nifty junior and cnx 500 indices between one to three days. the results suggest that the market wide information gets reflected in the nifty index stocks immediately while it gets reflected in the nifty junior index stocks after a lag of three days as would be expected from the slow diffusion view. 20 as expected, the cnx 500 returns lead nifty junior returns in all the three lags at 1% significance level. though the aic and schwarz criterion restricted the lags to 3, nifty junior index lag nifty index up to at least 8 lags. microsoft word seasonality_and_market-writer2-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 174 seasonality and market crashes in indian stock markets mihir dash1 school of business, alliance university anirban dutta genpact india pvt. ltd. mohit sabharwal adani wilmar ltd. received: september 28, 2011 accepted: november 20, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.997 url: http://dx.doi.org/10.5296/ajfa.v3i1.997 abstract the presence of seasonal effects in monthly returns has been reported in several developed and emerging stock markets. the objective of this study is to explore the interplay between the month-of-the-year effect and market crash effects on monthly returns in indian stock markets. the study uses dummy variable multiple linear regression to assess the seasonality of stock market returns and the impact of market crashes on the same. the results of the study provide evidence for a month-of-the-year effect in indian stock markets, particularly positive november, august, and december effects, and a negative march effect. further, the study suggests that the incidence of market crashes reduces the seasonal effects. keywords: seasonality, stock market returns, month-of-the-year effect, market crash effects, dummy variable regression. jel classification: g14 1 school of business, alliance university, chikkahagade cross, chandapura-anekal main road, anekal, bangalore-562106, tel: +91-9945182465, email: mihirda@rediffmail.com asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 175 introduction the efficient market hypothesis (emh) asserts that in informationally-efficient markets, the market prices of assets should be equal to their true expected values, reflecting all information available to the market participants (fama, 1965; fama et al, 1969). in particular, this would imply that stock returns follow a random walk, unpredictable, without pattern. however, several market anomalies, contradicting the emh, have been reported, such as the january effect, the monday effect, the turn-of-the-month effect, the holiday effect, the small-firm effect, announcement effects, and many others. such market anomalies are primarily due to behavioural causes (schwert, 2003). the presence of market anomalies seems to be ubiquitous, occurring in stock markets around the world, in both developed markets and emerging markets. for example, the january effect is the phenomenon in which asset prices tend to increase in the month of january; in fact, between the last trading day in december of the previous year and the fifth trading day of the new year in january. a theory explaining the january effect is that of tax-loss selling, wherein investors sell their losing positions at the end of december; these stocks are sold typically at a discount to their market value, and they are subsequently picked up by speculators, creating a buying pressure in the market (rozeff and kinney, 1976, kiem, 1983). in fact, it is reported that when the s&p500 has a net positive gain in the first five trading days of the year, there is about an 86% chance that the stock market will rise for the year, while when the first five days of january yield a net loss, there is no statistical bias of the market, up or down2. literature review there is an extensive literature documenting several forms of market anomaly, especially in the matured capital markets such as those in us and europe. in particular, the calendar anomalies such as the month-of-the-year and day-of-the-week effects have been comprehensively studied in matured as well as emerging stock markets. the following undertakes a review of some of the prominent literature on seasonality in stock returns. the pioneering work on seasonality was by watchel (1942), who was the first to report seasonality in stock returns. rozeff and kinney (1976) studied the january effect in new york exchange stocks, finding that average return for the month of january was higher than other months. keim (1983) studied the january effect, along with size effects in stock returns. he found that january returns of small firms were significantly higher than large firms, providing evidence for the tax-loss-selling hypothesis. similar effects were found by reinganum (1983) and by gultekin and gultekin (1983). brown et al. (1985) found evidence of december-january and july-august seasonal effects in the australian stock market, with the latter due to a june-july tax year. on the other hand, raj and thurston (1994) found that the january and april effects in the new zealand stock market were not statistically significant. mill and coutts (1995) found calendar effects in british stock markets. choudhary (2001) found the january effect on the uk and us stock markets, but not in the german stock market. 2 http://www.mysmp.com/stocks/january-effect.html asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 176 fountas and segredakis (2002) studied seasonal patterns in returns in several markets around the world. the main reasons they attributed for the january effect in stock returns in most of the developed stock markets were the tax loss selling hypothesis, settlement procedures, and insider trading information. another explanation for seasonal effects is window-dressing related to institutional trading; to avoid reporting to many losers in their portfolios at the end of year, institutional investors tend to sell losers in december and buy them back after the reporting date in january in order to hold their desired portfolio structure again. another interesting effect is the holiday effect, in which higher returns are exhibited around holidays, mainly in the pre-holiday period as compared to returns of the normal trading days. several studies examine this effect (lakonishok and smidt, 1988; ariel, 1990; cadsby and ratner, 1992). husain (1998) studied the ramdhan effect in the pakistan stock market, finding a significant decline in stock returns volatility in the month of ramdhan, though no significant change in the mean returns. the day-of-the-week effect in stock market returns has also been extensively reported in developed and emerging stock markets, with lower mean returns on mondays and higher mean returns on fridays (kelly, 1930; hirsch, 1968; cross, 1973; gibbons and hess, 1981; smirlock and starks, 1986; jaffe and westerfield, 1989). several studies have also examined seasonality of stock returns in indian stock markets. pandey (2002) examined seasonality in monthly returns of the bse sensex, finding evidence of the january effect. bodla and jindal (2006) also found evidence of seasonality in both indian and us markets. kumari and mahendra (2006) studied the day-of-the-week effect in the bse and the nse, finding negative returns on tuesday and relatively higher returns on monday. sah (2008) studied seasonality in s&p cnx nifty, investigating both the day-of-the-week effect and the month-of-the-year effect, finding evidence for a friday effect and monthly anomalies for july, september, december, and january. elango and al macki (2008) studied the day-of-the-week effect in the nse, finding evidence of the monday effect, with lowest daily returns on monday, and with highest daily returns on wednesday. on the other hand, elango and pandey (2008) studied the month-of-the-year effect in the nse, finding the presence of a january anomaly, with march and april having significant negative returns, and november and december showing significant positive returns. patel (2008) also studied calendar effects in monthly returns in indian stock markets, finding two distinct effects: a november-december effect, in which the mean returns for november and december were significantly higher than those in the other ten months, and a march-to-may effect, in which mean returns for the months march to may were significantly lower than those during the other nine months; and they showed that these effects were independent of each other. the literature has highlighted some widely-accepted market anomalies in both developed and emerging markets, though with some differences in different time periods and in different markets. there is, however, a gap in the literature regarding the impact of market crashes on market anomalies, particularly calendar effects. most studies tend to regard market crashes as aberrations or outliers, and remove them from consideration when investigating market anomalies. the present study examines the interplay between market crashes and the asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 177 month-of-the-year effect in indian stock markets. data and methodology the present study focuses on the monthly patterns of returns in the indian stock market, specifically the bombay stock exchange (bse). to avoid distortions due to size effects, it is appropriate to use a value-weighted index to detect the seasonal effect in stock returns. bse’s sensitivity index (sensex) is such a value-weighted share price index, including the thirty most actively traded shares on the bse, weighted by their market capitalizations (pandey, 2002). the study uses historical data covering the post-reform period, leading up to the global financial crisis in the third quarter of 2007. the data used for the study were the monthly closing sensex values in the period april 1999 to march 2007, collected from the bse website3. monthly returns were calculated as the continuously compounded monthly percentage change in the closing sensex values, using the formula: , where rt represents the monthly returns in period t, and pt represents monthly closing sensex value for period t. the market crashes considered for the study were as follows: apr’00, jul’00, oct’00, mar’01, sep’01, may’04, oct’05, may’06, and feb’07. the study tests for seasonality and market crash effects using dummy variable regression. monthly returns are taken as the dependent variable, and dummy variables for each month and each market crash are taken as the independent variables; i.e. , where the mi represent the dummy variables for each month, while the cj represent the dummy variables for each market crash. the significance of the coefficients βi and γj in the regression indicate significance of the monthly effects and the crash effects, respectively. in order to avoid the problem of spurious regression, the sensex returns series has to be tested for stationarity. this is done using the augmented dickey-fuller (adf) test for unit roots, which involves regressing the first difference of the series against a constant term, a time trend, the series lagged one period, and the differenced series at n lag lengths (elliot et al, 1996); symbolically: . if the coefficient γ is statistically significantly and negative, then the hypothesis that rt is nonstationary (specifically, having a unit root) is rejected. the adf test can be carried out with and/or without the constant and/or trend; one has to choose the appropriate lag length m. analysis and findings as a preliminary analysis, anova was performed to test for differences in mean monthly 3 www.bseindia.com asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 178 returns between different months. the results are presented in table 1 below. table 1. anova test for differences in mean monthly returns between different months descriptive statistics for monthly return month mean std. dev. january 1.8127% 4.13377% february 1.1003% 4.89012% march -3.7858% 7.31299% april -1.9988% 4.56146% may -0.8500% 12.07133% june 4.0319% 5.13898% july 0.8260% 7.45880% august 4.7709% 4.55991% september -0.4850% 8.84573% october -0.7107% 7.28869% november 7.3026% 2.91993% december 4.8462% 5.19512% overall 1.4408% 7.01023% f-stat 1.8900 p-value 0.0520 (source: primary data) duncan’s post hoc test month subset for alpha = .05 subset 1 subset 2 subset 3 march -3.7858% april -1.9988% -1.9988% may -0.8500% -0.8500% october -0.7107% -0.7107% september -0.4850% -0.4850% july 0.8260% 0.8260% 0.8260% february 1.1003% 1.1003% 1.1003% january 1.8127% 1.8127% 1.8127% june 4.0319% 4.0319% 4.0319% august 4.7709% 4.7709% december 4.8462% 4.8462% november 7.3026% p-value 0.0500 0.0900 0.0990 (source: primary data) the anova was found to be not significant, implying that there was no significant difference in mean monthly returns between different months, i.e. no seasonal effect. however, duncan’s post hoc test indicated that march returns were significantly lower than those of november, december, and august; and that november returns were significantly higher than those of march, april, may, october, and september. thus, there was found to be evidence of seasonality in monthly returns. to test for the presence of a unit root, the augmented dickey-fuller test was performed. the results are presented in table 2 below. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 179 table 2. augmented dickey-fuller test adf regression constant -2.1830 (0.2250) trend 0.0670 (0.0600) rt-1 -1.0660 (0.0010)** δrt-1 0.0800 (0.7780) δrt-2 0.1020 (0.6820) δrt-3 0.0620 (0.7700) δrt-4 -0.0410 (0.8220) δrt-5 -0.1370 (0.3610) δrt-6 -0.0140 (0.8970) statistics: r2 51.20% fcal 10.3530 p-value 0.0000** (source: primary data) the results of the adf test showed a significant negative coefficient of rt-1, indicating rejection of the hypothesis of a unit root, so that the monthly returns series can be taken to be stationary. the regression analysis of monthly returns was performed subsequently. regression with trend only yielded insignificant results (r2 = 1.60%, fcal = 1.4940, p-value = 0.2250). the results of the three dummy variable regressions performed are presented in table 3 below. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 180 table 3. dummy variable regression of monthly returns model i: trend + seasonality model ii: trend+ crashes model iii: trend + seasonality + crashes constant -5.5950 (0.0205)* 1.2310 (0.1625) -4.5640 (0.0290)* trend 0.0340 (0.0880) 0.0330 (0.0705) 0.0450 (0.0210)* january 5.6670 (0.0460)* 4.0790 (0.0720) february 4.9200 (0.0710) 4.9680 (0.0435)* april 1.9580 (0.2850) 0.9860 (0.3705) may 3.2770 (0.1640) 7.2630 (0.0.095)** june 8.1250 (0.0085)** 6.6130 (0.0100)* july 4.8850 (0.0730) 4.7720 (0.0490)* august 8.7960 (0.0050)** 7.2620 (0.0550)* september 3.5060 (0.1470) 3.8240 (0.0925) october 3.2460 (0.1655) 4.5740 (0.0645) november 11.2250 (0.0005)** 9.6590 (0.0005)** december 8.7340 (0.0050)** 7.1570 (0.0060)** 2000_crash1 -8.7520 (0.0650) -4.0820 (0.2430) 2000_crash2 -12.1280 (0.0185)* -11.2810 (0.0270)* 2000_crash3 -11.5850 (0.0230)* -10.5540 (0.0365)* 2001_crash1 -18.4060 (0.0010)** -12.8790 (0.0140)* 2001_crash2 -16.5340 (0.0025)** -14.9010 (0.0055)** 2004_crash -20.5070 (0.0005)** -22.6870 (0.0000)** 2005_crash -12.8240 (0.0135)* -12.5120 (0.0170)* 2006_crash -18.7480 (0.0010)** -21.2070 (0.0005)** 2007_crash -12.9060 (0.0135)* -13.1750 (0.0130)* statistics: r2 21.80% 42.50% 55.00% sse 3612.0690 2658.3380 2078.5340 dfsse 82 84 73 fcal 1.9060 6.1970 4.2500 p-value 0.0450* 0.0000** 0.0000** (source: primary data) due to multicollinearity of the month dummy variables, the march dummy variable was not entered into the models. thus, march can be viewed as the base month, with the constant term representing march returns, and the regression coefficients representing monthly differences from march returns. model i shows the results of the dummy variable regression of monthly returns on the trend and month dummy variables taking march as the base. the regression was found to be statistically significant, explaining 21.80% of the overall variation in monthly returns. in this model, the trend was found to be statistically insignificant; amongst the months, november, august, december, july, and january were found to have significant positive returns, while march (represented by the constant term) was found to have significant negative returns. this asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 181 more or less corresponds with the results obtained from duncan’s post hoc test. model ii shows the results of the dummy variable regression of monthly returns on the trend and market crash variables. the regression was found to be statistically significant, explaining 42.50% of the overall variation in monthly returns. in this model, the constant term and the trend were both found to be statistically insignificant, while all of the market crashes were found to be highly significant, except for the apr’00 crash. obviously, all of the crashes had a negative effect on monthly returns, the worst being the may’04 crash, followed by the may’06 crash, the mar’01 crash, the sep’01 crash, the feb’07 crash, the oct’05 crash, the jul’00 crash, the oct’00 crash, and finally the apr’00 crash. model iii shows the results of the dummy variable regression of monthly returns on the trend, month, and market crash variables. the regression was found to be statistically significant, explaining 55.00% of the overall variation in monthly returns. in this model, the trend was found to statistically significant; amongst the months, november, may, august, december, june, february, and july were found to have significant positive returns, while march (represented by the constant term) was found to have significant negative return; while all of the market crashes were found to be highly significant, except for the apr’00 crash. again, all of the crashes had a negative effect on monthly returns, the worst being the may’04 crash, followed by the may’06 crash, the sep’01 crash, the feb’07 crash, the mar’01 crash, the oct’05 crash, the jul’00 crash, the oct’00 crash, and finally the apr’00 crash. also, the month effects were found to be reduced by the inclusion of market crashes, except for february, may, september, and october; and the impact of the market crashes were found to be reduced by the inclusion of month effects, except for the may’04 crash, the may’06 crash, and the feb’07 crash. the relative significance of group effects was assessed by comparing the results of model iii with model ii and model i, in turn. the results are presented in table 4 below. table 4. test for significance of group effects variable group fcal p-value month-of-the-year effect 1.8512 0.0606 crash effect 5.9843 0.0000** (source: primary data) it was found that the combined month effects were not statistically significant in the presence of crash effects, while the combined crash effects were highly statistically significant in the presence of month effects. conclusions the results of the study provide evidence for a month-of-the-year effect in indian stock markets. in particular, there is clear indication of positive november, august, and december effects, and a negative march effect. these results are consistent with the literature, particularly patel (2008). the end-of-the-year effect (i.e. positive november and december asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e11 www.macrothink.org/ajfa 182 effects) could be a diwali effect, with a huge surge in the purchase of household goods, electronic equipments, and gold in india, usually in november. another possible contributing factor could be the rabi harvest (also called the “winter crop”), which affects commodity prices and, in turn, stock market prices. similarly, the kharif harvest (also called the “monsoon crop”) could be a contributing factor for the august effect. the results of the study also indicate a highly significant negative impact of market crashes on stock market returns, as would be expected, and that the incidence of market crashes reduces the seasonal effects. there is scope for further investigation of the interplay between market crashes and seasonality, perhaps studying mediating/moderating effects. the results of the study also provide evidence for a march effect for stock returns in india. this could be because the indian tax year ends in march, in contrast with the us tax year which ends in december. the negative march returns could be because of “tax-loss selling.” there are some limitations inherent in the study. the choice of the market crashes to include in the analysis may have a bearing on the results. the results of the study could also be affected by the choice of the research period, as the selected research period is generally considered to be a bull period. particularly, the research period excludes the global financial crisis; 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(1942). certain observations on seasonal movement in stock prices. journal of business, 15 (2), 184-193. microsoft word 7952-28624-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 58 the effect of sfas no. 131 on the diversification discount seoungpil ahn sogang business school, sogang university pa706, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: spahn@sogang.ac.kr received: july 2, 2015 accepted: august 1, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.7952 url: http://dx.doi.org/10.5296/ajfa.v7i2.7952 abstract for a sample of diversified firms, i investigate the impact of the segment reporting rule change from sfas no. 14 to sfas no. 131 in 1997. this change in segment-reporting rules to sfas no. 131 potentially allows more precise estimation of diversification discount. i probe the changes in the diversification discount before and after the reporting rule change in 1997. i find that there is a substantial increase in the diversification discount under sfas no. 131. further analysis indicates that the changes in the diversification discount are unrelated to the changes in firm value or investment efficiency. instead, the measures of diversity appear to be more associated with the changes in excess value. this indicates that excess value is not a clean measure of diversification discount. keywords: diversification; segment reporting; valuation; diversification discount; disclosure asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 59 1. introduction the issue of corporate diversification on value remains controversial and is yet not well understood despite numerous written reports. a part of the reason for the observed discount in diversified firms attributed to the errors in segment report. graham, lemmon, and wolf (2002), villalonga (2004), and whited (2001) addresses several concerns in measuring diversification discount with compustat segment reportings based on industrial segments under sfas no. 14. in june 1997, the financial accounting standards board (fasb) issued statement of financial accounting standards (sfas) no. 131, disclosure about segments of an enterprise and related information, which became effective for fiscal years starting after december 31, 1997. sfas no. 131 requires enterprises to cover data about operating segments, products and services, the geographic regions in which they work, and their major customers. this new rule replaces sfas no. 14 that requires firms to disclose a geographical analysis of foreign operations to the extent that foreign operations account for more than 10% of total operations. it is significant to mention that the fasb has given management wide latitude for interpretation of the distinction between domestic and foreign operations. likewise, there is no consistent manner of reporting the countries of foreign sales. some firms report their foreign sales for regional groups such as europe, asia, or south america, while others report for specific countries such as japan, germany, or the u.k. under sfas no. 131, segment reporting is more consistent with the organizational structure of the firm and provides more detailed information about geographic segments. this change in segment-reporting rules to sfas no. 131 may alleviates these concerns inherent in sfas no. 14 and potentially allows more accurate estimation of diversification discount. i examine the changes in the diversification discount before and after the reporting rule change in 1997. the result shows that there is a significant increase in the diversification discount under sfas no. 131. further analysis indicates that the increase in the diversification discount is not driven by the poor firm valuation in the later period, nor it is due to the decrease in the investment efficiency. rather, the increment in the diversity is associated with the observed alteration in the diversification discount. given that there is no fundamental changes in firm value and investment efficiency, the result suggests that excess value does not necessarily indicate a value loss due to the diversification per se. 2. sample selection and estimation of diversification discount 2.1 sample selection my initial sample consists of the universe of companies covered by compustat (including the research file) in both firm level and segment level at any time over the period 1992 to 2003. the data ends in year 2003 to match the sample period before and after the rule chage and also due to the data availability at my institution. i matched the firm data with the segment data. i obtain segment data from the compustat industry segment (cis) files over the period of 1992 to 1997. according to the change in the segment reporting standard from sfas no. 14 to sfas no. 131 in the end of year 1997, i use segment data from the compustat operating segment (cos) files over the period of 1998 to 2004. the initial sample of the paper is obtained from the compustat geographic segment (cgs) files for 1998. since asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 60 firms effectively adopted the new segment rule sfas 131 in 1998, i use fiscal year end 1998 for the sample. to avoid any distortion effect of really small companies in calculating the excess value, i exclude firms with sales revenue less than $20 million. i also exclude firms with any segment operating in the financial industry (sic code 6000-6999), those in other regulated utilities (sic code 4900-4999) and those that are listed as american depository receipts (adrs). i also removed firms lacking the needed information in calculating market-to-sales ratio. i define diversified firms as those firms reporting at least two segments running in different three-figure, standard industrial classification (sic) codes. i define focused firms as those firms reporting only one section. i leave out any multiple segment firms reported segments operating in the same three-digit sic codes.i therefore, by definition, diversified firms in our sample consist of pure conglomerates operating in unrelated industries. for these diversified firms, i eliminate segments entitled “corporate”, “allocation”, “inter-segment allocation”, and “others”. these segments are non-economic activities representing unallocated amount in segment sales, segment assets and segment operating profits. after elimination of the non-economic segments, i exclude diversified firms in which the sum of segment sales deviates by more than 1% from the total sales of the firm. under sfas no. 141, a firm is required to provide two additional years of back-date on segment information. if the reported segments are converted from the original data year, the back-data could be substantially different from the original segment data. therefore, i used segment data which have source year matched with data year. 2.2 estimation of diversification discount the excess value of a diversified firm is defined similar to lang and stulz (1994), rajan, servaes, and zingales (2000), and villalonga (2004). following rajan, servaes, and zingales (2001), i compute the excess value as the natural log of the tobin’s q of the firm divided by its imputed q. tobin’s is proxied by market value to sales ratio. imputed q is calculated as the sales weighted sum of the ratio of the market value of sales for single-segment firms in the same industry. specifically, the excess value of the firm is defined as follows: rsz 1 sales based excess value (ev ) d ssn j j j m v s sm v s s=      =   ×     (mv/s)d is the market value of a firm divided by sales. sj is the end-of-the-year sales of segment j and n is the number of segments. the market value of a firm is the book value of assets plus the market value of common equity minus the sum of the book value of common equity and balance sheet deferred tax. imputed values are calculated as the sales weighted asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 61 sum of the ratio of the market value to sales for single-segment firms in the same industry. thus, (mv/s)ssj is the median market-to-sales ratio of single segment firms in the same industry of j segment. i match each segment of a diversified firm with the industry median value of single segment firms. industry is defined at the 4-digit sic level provided that there are at least five single-segment firms in the industry. if there are fewer than five single-segment firms in a 4-digit sic industry, i define industry at the 3-digit sic level and then 2-digit sic level. i winsorize excess values as well as all other final variables at the 1st and 99th percentiles. i also use the excess value calculated according to berger and ofek's (1995) sales multiple approach and yield similar results. this selection process resulted in a final sample of 8,147 firm-year observations and a total of 22,632 segment-year observations. on average, the diversified firms report 2.8 segments with a median of 3.0 segments. over the entire sample period, diversified firms are trading at a discount: average (median) excess value is -0.0988 (-0.0942). the purpose of calculating excess value is to provide an unbiased estimate of the value of the conglomerate when the segments operated as if they are independent firms. i make several choices based on previous findings to minimize the possibility of biased statistics. first, i match segments with industry median instead of sales or asset weighted mean. i prefer to use industry median over weighted mean because the median is less subject to the size effect. it is possible that the mean value is driven by large and, presumably, more successful single segment firms resulting in a downward bias in the calculated excess value. in fact, when i use weighted averages instead of median value of focused firms, the resulting excess value is more negative. second, the sample of diversified firms confined to conglomerate having segments operating at least two different industries and exclude firms with multiple segments in the same industry at the three-digit sic level. third, i prefer to use segment sales instead of segment assets or net income. segment assets tend to be under-allocated across segments and segment net income is subject to earnings manipulation. 3. sfas no. 131 and the diversification discount table 1 reports our measure of excess value in each year from 1992–2003. i confirm a significant diversification discount in the overall period. the excess value of diversified firms continues to be discounted under the new segment reporting standards. the result suggests that excess value calculated under sfas no. 14 does correctly capture the discount in diversified firms. the magnitude of the diversification discount is significantly greater after the change in segment reporting standards to sfas no 131. the excess value is on average -0.05 under sfas no. 14 and it is -0.14 under sfas no. 131. the differences in the mean and median excess value in the two periods are statistically significant at the 1% significance level. the significant increase in the diversification discount after year 1998 could represent the impact of the segment reporting change, the change in characteristics of diversification, or both. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 62 table 1. excess value of diversified firms over time under sfas #14 (1992-1997) under sfas #131 (1998-2003) year n evrsz year n evrsz 1992 618 -0.0191 [-0.0390] 1998 865 -0.0050 [-0.0474] 1993 599 -0.0449b [-0.0522]a 1999 858 -0.1127a [-0.1295]a 1994 610 -0.0612a [-0.0713]a 2000 820 -0.1894a [-0.2051]a 1995 635 -0.0507b [-0.0453]a 2001 715 -0.2182a [-0.2165]a 1996 611 -0.0754a [-0.0668]a 2002 641 -0.1174a [-0.1123]a 1997 577 -0.0489b [-0.0465]b 2003 598 -0.2269a [-0.1947]a mean [median] 3,650 -0.0498a [-0.0538]a mean [median] 4,497 -0.1386a [-0.1341]a the number of diversified firms, excess value of diversified firms each year, and the percentage of discount firms. evrsz is the natural log of the ratio of the market value of total capital to sales for the firm divided by that of a sales-weighted portfolio of focused firms operating in the narrowest sic industry. a,b,c denote significance at the 1%, 5%, and 10% levels, respectively. the sample includes 8,147 firm-year observations of diversified firms between 1992 and 2003. diversified firms are defined as firms with at least two segments operating in different 3-digit sic codes. one possible explanation for the increase in the diversification discount under sfas no. 131 is that the changes in firms' environment trigger the increase of diversity leading to deeper discount.ii alternatively, sfas no. 14 under-identifies segments and the adopting sfas no. 131 corrects the under-identification problem. to find out these possibilities, i compare changes in firm value in the two stops. i use market-to-sales ratio to measure firm valuation. table 2. diversification discount and firm value around segment reporting change under sfas #14 (1992-1997) under sfas #131 (1998-2003) f [χ2] mtos 1.5957a [1.1661]a 1.8311a [1.2027]a 36.62*** [78.98]*** evrsz is the natural log of the ratio of the market value of total capital to sales for the firm divided by that of a sales-weighted portfolio of focused firms operating in the narrowest sic industry. *, **, *** denote significance at the 1%, 5%, and 10% levels, respectively. the sample includes 8,147 firm-year observations of diversified firms between 1992 and 2003. diversified firms are defined as firms with at least two segments operating in different 3-digit sic codes. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 63 table 2 indicates that the corresponding change in market-to-sales ratio is an increase from 1.6 to 1.8. this suggests that the growth in the diversification discount is not forced by lower valuation of diversified firms in the later period. to further analyze whether the change in excess value under sfas no. 131 is driven by the changes in investment efficiency, i compare investment efficiency in the two periods. i measure investment efficiency with relative value added (rva). shin and stulz (1998) argue that investment efficiency is related to the diversification discount. to compute rva, i weight firm-and-industry-adjusted segment investment by the difference between the industry median tobin’s q for that segment and the sales-weighted average q for the firm. more precisely, rva is defined as follows. 1 1 relative value added by allocation(rva) ) ss ssn n j j j j j j jj jj j i ii is (q q w s s s s total sales = =      − − − −            =   where qj is the median tobin’s q for single-segment firms operating in the same industry. is sales-weighted average q of the firm. rva thus measures the allocation efficiency of corporate resources. in table 3, rva is -0.003 on average in the period of 1992-1997 under sfas no. 14 and it is -0.0055 in the period of 1998-2003 under sfas no. the difference is statistically not significant. the outcome indicates that there are no substantial changes in investment efficiency in diversified firms in the two stops. thus, the observed increase in the diversification discount in the two periods is not driven by poor investment efficiency in the later period. this suggests that the observed change in the diversification discount under sfas no. 131 is not driven by the periodic change in a firm’s fundamental value. table 3. investment efficiency under sfas #14 (1992-1997) under sfas #131 (1998-2003) f [χ2] rva -0.0030a [-0.0003]a -0.0055a [-0.0002]a 2.46 [0.49] rva is a measure of investment efficiency. *, **, *** denote significance at the 1%, 5%, and 10% levels, respectively. the sample includes 8,147 firm-year observations of diversified firms between 1992 and 2003. diversified firms are defined as firms with at least two segments operating in different 3-digit sic codes. i next examine the diversity in the two periods. diversity is measured by the number of segments (segn), sales-based herfindahl index (herfindahl), standard deviation of segment q (std of segment q), and rajan et al.’s measure of diversity rsz diversity). rsz diversity is a resource-weighted growth opportunities among segments and it is measured by the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 64 standard deviation of sales-weighted industry median q normalized by arithmetic average of q. rajan et al. (2000) argue that if segments themselves cause the distortion of capital allocation, the measures of diversity shall be negatively associated with rva. i test the change in diversity measures in the two periods. previous literature indicates that the diversification discount is related to the measure of diversity in a way that higher diversity of a diversified firm is associated with lower firm value.iii in table 4, the mean [median] number of segments increases from 2.7 [2.0] to 2.9 [3.0] in the later period. the change is statistically significant at the 1% significance level. similarly, standard deviation of segment q and the diversity measure of rajan et al. (2000) show a significant increase in diversity in the later period. although i could not observe any significant change in herfindahl index, the overall result from table 4 suggests that diversity has increased in the later period. this indicates that the observed increase in the diversification discount is associated with the increase in the diversity in the later period. thus, the diversification discount is increased under sfas no. 131 due to the increase in the diversity measures. however, the increase in the diversification discount does not reflect the changes in fundamentals in firm value or investment efficiency. table 4. changes in diversity under sfas #14 (1992-1997) under sfas #131 (1998-2003) f [χ2] segn 2.67a [2.00]a 2.86a [3.00]a 77.71*** [78.97]*** herfindahl 0.5686a [0.5432]a 0.5659a [0.5334]a 0.50 [1.98] std of segment q 0.6033a [0.3341]a 1.0736a [0.5156]a 247.28*** [167.57]*** rsz diversity 0.3058a [0.2605]a 0.3218a [0.2713]a 9.81*** [7.35]*** segn is the number of segments in a diversified firm. herfindahl is a sales-based herfindahl index. std of segment q is the standard deviation of segment tobin’s q. rsz diversity is rajan et al.’s measure of the diversity of a diversified firm. *, **, *** denote significance at the 1%, 5%, and 10% levels, respectively. the sample includes 8,147 firm-year observations of diversified firms between 1992 and 2003. diversified firms are defined as firms with at least two segments operating in different 3-digit sic codes. 4. conclusion i examine the impact of the segment reporting rule change on the measure of diversification discount, excess value. in 1997, sfas no. 131 rules replace sfas no. 14. under sfas no. 131, a firm shall report information about operating segments, products and services, the geographic areas in which they operate, and their major customers. with detailed information on segments, this change in segment-reporting rules may allow more accurate estimation of diversification discount. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 65 the results however show that the time-series variation of mean excess value is not reflecting the changes in a firm’s fundamentals. specifically, the diversification discount is not driven by the changes in firm value nor the decrease in the investment efficiency. the measures of diversity appear to be more associated with the changes in excess value. because i count not find any evidence that firm value and investment efficiency has changed in the two periods, the observed changes in excess value are more likely to be driven by the number of reported segments, standard deviation of segment q and rajan et al (2000)’s measure of diversity. this indicates that excess value is not a clean measure of diversification discount. references berger, p., & ofek e. (1995). diversification’s effect on firm value, journal of financial economics, 37, 39-65. http://dx.doi.org/10.1016/0304-405x(94)00798-6 graham, j.r., lemmon, m.l., & wolf, j. (2002). does corporate diversification destroy value?, journal of finance, 57, 695-720. http://dx.doi.org/10.1111/1540-6261.00439 lang, l., & stulz, r.m. (1994). tobin’s q, corporate diversification, and firm value, journal of political economy, 102, 1248-80. http://dx.doi.org/10.1086/261970 rajan, r., servaes h., & zingales l. (2000). the cost of diversity: the diversification discount and inefficient investment, journal of finance, 55, 35-80. http://dx.doi.org/10.1111/0022-1082.00200 shin, h., & stulz, r. m. (1998). are internal capital markets efficient? quarterly journal of economics, 113, 531-552. http://dx.doi.org/10.1162/003355398555676 whited, t.m. (2001). is it inefficient investment that causes the diversification discount? journal of finance, 56, 1667-1692. http://dx.doi.org/10.1111/0022-1082.00385 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). i main findings of the paper are not sensitive to this definition. i find qualitatively similar results if industry is defined at either the two-digit or four-digit sic level. ii it is unclear though whether the deeper discount represents mistakes made by diversified firms, simply the result of acquisition of already discounted units, or self-selection. iii berger and ofek's (1995), lang and stulz (1994), and rajan, servaes, and zingales (2000) microsoft word 6133-22048-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 142 accounting disclosure, governance standards and innovation activities in emerging markets zhenxiang chen wuhan yangtze business university 3, huangjiawu west road, hongshan district, wuhan, hubei 430065, china e-mail: 541922306@qq.com ming li (corresponding author) wuhan yangtze business university 3, huangjiawu west road, hongshan district, wuhan, hubei 430065, china e-mail: 36010526@qq.com liang song michigan technological university 1400 townsend drive, houghton, mi 49931, united states e-mail: liangs@mtu.edu yanan xing huaxin trust co., ltd. 34 dagong st, xigang, dalian, liaoning, china, 116011 e-mail: 82272933@qq.com zhaoguo zhang huazhong university of science and technology 1037 luoyu road, wuhan, hubei 430065, china e-mail: xuehai0225@126.com asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 143 received: april 13, 2014 accepted: sep. 24, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6133 url: http://dx.doi.org/10.5296/ajfa.v6i2.6133 abstract we investigate how investor protection resulted from country-level and firm-level governance standards influence the relationship between market disciplines resulted from firm-level accounting disclosure and innovation activities. employing a sample across 14 emerging markets, evidence confirms that the effects of firm-level accounting disclosure on innovation activities are more important in a country with weaker governance standards and for firm with poor corporate governance. the results suggest that market disciplines can substitute for investor protection. keywords: accounting disclosure, governance standards, emerging markets, innovation activities asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 144 1. introduction the existing literature shows that innovation contributes to countries’ economic growth (aghion and howitt, 2006) and firms are trying to promote innovation (hoskisson et al., 2002). much of the extant research is based on the managerial conflicts (jensen and meckling, 1976; holmstrom, 1989). the existing empirical studies find that innovation is determined by several corporate factors (francis et al., 2012a; o’connor and rafferty, 2012; aghion, van reenen, and zingales, 2013). while most of the conclusion has been from u.s. firms, recent research has also investigated emerging economies (chen et. al., 2011; francis et al., 2012b; gibson, 2003; hasan and song, 2014a; klapper and love, 2004). our research further analyzes innovation in emerging countries by considering the impact of country-level and firm-level governance standards on the relationship between accounting disclosure and innovation, as measured by r&d. according to the agency theory, managers are trying to maximize their own interest by conducting less investment to research and development and investing more in safe projects. strong governance mechanisms such as investor protection and market discipline should reduce such agency problems (see o’connor and rafferty, 2012) although the literature has addressed the effects of market disciplines resulted from accounting disclosure on innovation activities, there is little evidence of whether the effects of market disciplines are more important in a country with weaker investor protection and for firms with poor corporate governance. one hypothesis is that if governance is weak, then accounting disclosure is less credible and market disciplines are less effective (hasan and song, 2014; hasan et al., 2014b). an alternative hypothesis is that if the firm is located in countries with weak legal systems and investor protections and has poor corporate governance, shareholders and owners would welcome even small improvements in market disciplines relative to other firms (klapper and love, 2004). to test our hypotheses, our firm-level accounting disclosure and corporate governance data is obtained from the survey data by credit lyonnais securities asia. we use the three country-level governance measures such as judicial efficiency, legality, and shareholder rights from la porta et al. (1998) and the international country risk guide (2000). we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also control for the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. empirically, we use r&d as our innovation measure. the key independent variables are the interaction terms between firm-level accounting disclosure and governance variables. specifically, we estimate the following equation: company-r&d = α + β1 accounting-disclosure + β2 governance variables + β3 accounting-disclosure * governance variables + β4 control variables + industry effects + year effects + ε (1) across 14 emerging markets, evidence confirms that the effects of firm-level accounting asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 145 disclosure on innovation activities are more important in a country with weaker governance standards and for firms with poor corporate governance. the results suggest that market disciplines resulted from firm-level accounting disclosure can substitute for investor protection resulted from country-level and firm-level governance standards. our analysis extends the existing research by examining how investor protection resulted from country-level and firm-level governance standards influence the relationship between market disciplines resulted from firm-level accounting disclosure and innovation activities. compared with hasan et al., (2014a), this paper discomposes the overall firm-level corporate governance into two components such as accounting disclosure and non-disclosure governance and examines the individual and interaction effects of these two components on firms’ innovation activities. in the next section, we describe the data. section 3 presents results. section 4 provides conclusions. 2. variable definition, sample, and descriptive statistics in this subsection, we present the variable definition, the sample construction and the descriptive statistics. our firm-level accounting disclosure and corporate governance data is from the survey data conducted by credit lyonnais securities asia. the variable accounting-disclosure measures the firms’ accounting disclosure level such as whether the firms have disclosed their roa in the previous years. the variable firm-governance captures non-disclosure governance level such as the board structure of the firms. we use the three country-level governance measures such as judicial efficiency, legality, and shareholder rights from la porta et al. (1998) and the international country risk guide (2000). we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also include the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. we present summary statistics in table 1. as shown in table 1, the mean value of the variable accounting-disclosure is equal to 59.01 and its standard deviation equals 21.32. the mean value of the variable firm-governance is equal to 58.02 and its standard deviation equals 22.24. the mean value of the variable log-gdp-per-capita is equal to 8.21 and its standard deviation equals 1.22. the mean value of the variable log-gdp-growth is equal to 1.61 and its standard deviation equals 0.32. the mean value of the variable log-assets is equal to 14.11 and its standard deviation equals 1.41. the mean value of the variable total-liability is equal to 22.43 and its standard deviation equals 19.53. the mean value of the variable accounting-earnings is equal to 14.91 and its standard deviation equals 23.61. the mean value of the variable company-r&d is equal to 2.71 and its standard deviation equals 1.22. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 146 table 1. summary statistics mean standard 10th 50th 90th deviation percentile percentile percentile accounting-disclosure 59.01 21.32 20 50 90 firm-governance 58.02 22.24 30 50 80 log-gdp-per-capita 8.21 1.22 6.62 8.21 10.02 log-gdp-growth 1.61 0.32 1.20 1.61 2.02 log-assets 14.11 1.41 12.44 14.11 16.01 total-liability (%) 22.43 19.53 0.30 19.21 49.42 accounting-earnings (%) 14.91 23.61 2.27 10.06 29.34 company-r&d (%) 2.71 1.22 1.50 2.51 3.58 the table reports summary statistics. our firm-level accounting disclosure and corporate governance data is from the survey data by credit lyonnais securities asia. we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also control for the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. 3. methods and results the summary statistics presented in the previous section show significant differences in innovation activities across emerging markets. we next conduct a more formal investigation, and employ the multivariate analysis to examine how investor protection resulted from country-level and firm-level governance standards influence the relationship between market disciplines resulted from firm-level accounting disclosure and innovation activities. the existing literature has shown the effects of accounting disclosure in the emerging markets. for example, hasan and song (2014) present the evidence that banks provide better loan contracting terms to firms with better disclosure standards. they also find that the influence of accounting disclosure on the loan contracts is more significant for firms with superior governance environment. hasan et al., (2014b) present the evidence that borrowers’ better disclosure standards have a significant impact on bank loan syndicates. they also find that the influence of accounting disclosure on the loan syndicates is more significant for firms with superior governance environment. hasan et al., (2014a) use a cross-section sample to present the evidence that firm-level corporate governance and country-level governance both have a significant effect on innovation activities. although the literature has addressed the effects of market disciplines resulted from accounting disclosure on innovation activities, there is little evidence of whether the effects asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 147 of market disciplines are more important in a country with weaker investor protection and for firms with poor corporate governance. one hypothesis is that if governance is weak, then accounting disclosure is less credible and market disciplines are less effective (hasan and song, 2014; hasan et al., 2014b). an alternative hypothesis is that if the firm is located in countries with weak legal systems and investor protections and has poor corporate governance, shareholders and owners would welcome even small improvements in market disciplines relative to other firms (klapper and love, 2004). we use r&d as our innovation measure. the key independent variables are the interaction terms between firm-level accounting disclosure and governance variables. specifically, we estimate the following equation: company-r&d = α + β1 accounting-disclosure + β2 judicial-efficiency + β3 accounting-disclosure * judicial-efficiency + β4 control variables + industry effects + year effects + ε (2) table 2. regression with investor protection measured by judicial-efficiency company-r&d (1) (2) accounting-disclosure 0.0036*** 0.0035*** (5.526) (5.672) judicial-efficiency 0.0182*** 0.0180*** (4.858) (4.973) accounting-disclosure * judicial-efficiency -0.0004*** -0.0005*** (-4.632) (-4.462) log-assets 0.2151*** (5.345) total-liability 0.0052 (0.341) accounting-earnings 0.0050 (0.342) control for firm-governance yes yes log-gdp-per-capita yes yes log-gdp-growth yes yes industry effect yes yes year effect yes yes observations 807 641 adjusted r-squared 0.425 0.526 the table reports coefficients and t-statistics. significance at the 10%, 5% and 1% levels is indicated by *, **, and ***, respectively. in calculating standard errors, we cluster by firm. our firm-level accounting disclosure and corporate governance data is from the survey data by credit lyonnais securities asia. we use the three country-level governance measures such as asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 148 judicial efficiency, legality, and shareholder rights from la porta et al. (1998) and the international country risk guide (2000). we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also control for the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. as shown in table 2, the coefficients of the interaction terms between accounting disclosure and judicial efficiency are always statistically significant at 1% level. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0036. the coefficient of the variable judicial-efficiency is equal to 0.0182. the coefficient of the variable accounting-disclosure * judicial-efficiency is equal to -0.0004. this finding indicates that the relation between accounting disclosure and r&d is stronger in countries with poor investor protection. when we include firm characteristics, the conclusion does not change. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0035. the coefficient of the variable judicial-efficiency is equal to 0.0180. the coefficient of the variable accounting-disclosure * judicial-efficiency is equal to -0.0005. the coefficient of the variable log-assets is equal to 0.2151. table 3. regression with investor protection measured by country-legality company-r&d (1) (2) accounting-disclosure 0.0041*** 0.0042*** (4.647) (3.746) country-legality 0.0381*** 0.0380*** (4.573) (4.489) accounting-disclosure * country-legality -0.0002*** -0.0002*** (-3.980) (-3.893) log-assets 0.2154*** (5.256) total-liability 0.0050 (0.301) accounting-earnings 0.0052 (0.302) control for firm-governance yes yes log-gdp-per-capita yes yes log-gdp-growth yes yes industry effect yes yes year effect yes yes observations 807 641 adjusted r-squared 0.421 0.520 the table reports coefficients and t-statistics. significance at the 10%, 5% and 1% levels is indicated by *, **, and ***, respectively. in calculating standard errors, we cluster by firm. our firm-level asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 149 accounting disclosure and corporate governance data is from the survey data by credit lyonnais securities asia. we use the three country-level governance measures such as judicial efficiency, legality, and shareholder rights from la porta et al. (1998) and the international country risk guide (2000). we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also control for the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. in table 3, we estimate the following equation: company-r&d = α + β1 accounting-disclosure + β2 judicial-efficiency + β3 accounting-disclosure * judicial-efficiency + β4 control variables + industry effects + year effects + ε (3) as shown in table 3, the coefficients of the interaction terms between accounting disclosure and legality are always statistically significant at 1% level. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0041. the coefficient of the variable country-legality is equal to 0.0381. the coefficient of the variable accounting-disclosure * country-legality is equal to -0.0002. this finding indicates that the relation between accounting disclosure and r&d is stronger in countries with poor investor protection. when we include firm characteristics, the conclusion does not change. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0042. the coefficient of the variable country-legality is equal to 0.0380. the coefficient of the variable accounting-disclosure * country-legality is equal to -0.0002. the coefficient of the variable log-assets is equal to 0.2154. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 150 table 4. regression with investor protection measured by shareholder-rights company-r&d (1) (2) accounting-disclosure 0.0043*** 0.0040*** (4.778) (4.457) shareholder-rights 0.0351*** 0.0360*** (3.893) (4.782) accounting-disclosure * shareholder-rights -0.0011*** -0.0010*** (-4.987) (-4.815) log-assets 0.2143*** (5.256) total-liability 0.0049 (0.300) accounting-earnings 0.0055 (0.301) control for firm-governance yes yes log-gdp-per-capita yes yes log-gdp-growth yes yes industry effect yes yes year effect yes yes observations 807 641 adjusted r-squared 0.441 0.519 the table reports coefficients and t-statistics. significance at the 10%, 5% and 1% levels is indicated by *, **, and ***, respectively. in calculating standard errors, we cluster by firm. our firm-level accounting disclosure and corporate governance data is from the survey data by credit lyonnais securities asia. we use the three country-level governance measures such as judicial efficiency, legality, and shareholder rights from la porta et al. (1998) and the international country risk guide (2000). we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also control for the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. in table 4, we estimate the following equation: company-r&d = α + β1 accounting-disclosure + β2 shareholder-rights + β3 accounting-disclosure * shareholder-rights + β4 control variables + industry effects + year effects + ε (4) as shown in table 4, the coefficients of the interaction terms between accounting disclosure and shareholder rights are always statistically significant at 1% level. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0043. the coefficient of the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 151 variable shareholder-rights is equal to 0.0351. the coefficient of the variable accounting-disclosure * shareholder-rights is equal to -0.0011. this finding indicates that the relation between accounting disclosure and r&d is stronger in countries with poor investor protection. when we include firm characteristics, the conclusion does not change. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0040. the coefficient of the variable shareholder-rights is equal to 0.0360. the coefficient of the variable accounting-disclosure * shareholder-rights is equal to -0.0010. the coefficient of the variable log-assets is equal to 0.2143. table 5. regression with investor protection measured by firm-governance company-r&d (1) (2) accounting-disclosure 0.0053*** 0.0052*** (4.799) (4.490) firm-governance 0.0050*** 0.0068*** (3.898) (4.789) accounting-disclosure * firm-governance -0.0002*** -0.0002*** (-4.944) (-4.899) log-assets 0.2112*** (5.222) total-liability 0.0044 (0.255) accounting-earnings 0.0052 (0.300) control for country-legality yes yes log-gdp-per-capita yes yes log-gdp-growth yes yes industry effect yes yes year effect yes yes observations 807 641 adjusted r-squared 0.440 0.513 the table reports coefficients and t-statistics. significance at the 10%, 5% and 1% levels is indicated by *, **, and ***, respectively. in calculating standard errors, we cluster by firm. our firm-level accounting disclosure and corporate governance data is from the survey data by credit lyonnais securities asia. we use the three country-level governance measures such as judicial efficiency, legality, and shareholder rights from la porta et al. (1998) and the international country risk guide (2000). we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also control for the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 152 in table 5, we estimate the following equation: company-r&d = α + β1 accounting-disclosure + β2 firm-governance + β3 accounting-disclosure * firm-governance + β4 control variables + industry effects + year effects + ε (5) as shown in table 5, the coefficients of the interaction terms between accounting disclosure and firm-level governance are always statistically significant at 1% level. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0053. the coefficient of the variable firm-governance is equal to 0.0050. the coefficient of the variable accounting-disclosure * firm-governance is equal to -0.0002. this finding indicates that the relation between accounting disclosure and r&d is stronger for firms with poor corporate governance. when we include firm characteristics, the conclusion does not change. specifically, the coefficient of the variable accounting-disclosure is equal to 0.0052. the coefficient of the variable firm-governance is equal to 0.0068. the coefficient of the variable accounting-disclosure * firm-governance is equal to -0.0002. the coefficient of the variable log-assets is equal to 0.2112. 4. conclusion although the literature has addressed the relationship of investor protection resulted from country-level and firm-level governance standards, market disciplines resulted from firm-level accounting disclosure and innovations, relatively limited evidence of whether market disciplines and investor protection are substitutes or compliments in determining firms’ innovation activities. this paper explores how the relationship between accounting disclosure and innovation activities differ in different legal environments and firm-level corporate governance. to test our hypotheses, our firm-level accounting disclosure and corporate governance data is obtained from the survey data by credit lyonnais securities asia. we use the three country-level governance measures such as judicial efficiency, legality, and shareholder rights from la porta et al. (1998) and the international country risk guide (2000). we obtain our dependent variable from worldscope, and define r&d as the ratio of a firm’s r&d expenditures to sales. we also control for the logarithm of firm assets, total liability, accounting earnings, gdp growth, gdp per capita. our sample period is between 2000 and 2005. our final sample includes 807 observations in fourteen emerging markets. empirically, we use r&d as our innovation measure. the key independent variables are the interaction terms between firm-level accounting disclosure and governance variables. specifically, we estimate the following equation: company-r&d = α + β1 accounting-disclosure + β2 governance variables + β3 accounting-disclosure * governance variables + β4 control variables + industry effects + year effects + ε (6) using the sample across 14 emerging markets, the paper reports that the effects of firm-level accounting disclosure on innovation activities are more important in a country with weaker asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 153 governance standards and for firms with poor corporate governance. the results suggest that firm-level market disciplines can substitute for investor protection. there are also policy implications in this research. the existing literature shows that innovation contributes to countries’ economic growth (aghion and howitt, 2006) and firms are trying to promote innovation (hoskisson et al., 2002). thus, it is an important issue to increase a country’s innovation activities for policy makers. to achieve that goal, it is better for them increase firms’ accounting disclosure level and the effects are affected by firms’ governance environment. references aghion, p., & howitt, p. 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(2012b). are firmand country-specific governance substitutes? evidence from financial contracts in emerging markets. journal of financial research, 35(3), 343-374. http://dx.doi.org/10.1111/j.1475-6803.2012.01320.x gibson, m. (2003). is corporate governance ineffective in emerging markets? journal of financial and quantitative analysis, 38(1), 231-250. http://dx.doi.org/10.2307/4126771 hasan, i., & song, l. (2014). disclosure and bank loan contracting: evidence from emerging markets. asian review of accounting, 22(1), 2-19 http://dx.doi.org/10.1108/ara-10-2013-0069 hasan, i., song, l., & raymar, s. (2014a). effects of corporate and country governance on r&d investment: evidence from emerging markets. singapore economic review, forthcoming. hasan, i., song, l., zhan, m. s., zhang p., & zhang z. g. (2014b). corporate disclosure and financing arrangements: evidence from syndicated loans in emerging markets, asian review of accounting forthcoming. holmstrom, b. 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(2004). corporate governance, investor protection, and performance in emerging markets. journal of corporate finance, 10(5), 703–728. http://dx.doi.org/10.1016/s0929-1199 (03)00046-4 la porta, r., lopez-de-silanes, f., shleifer, a., & vishny, r. w. (1998). law and finance. journal of political economy, 106(6), 1113-1155. http://dx.doi.org/10.1086/250042 o’connor, m. and rafferty, m. (2012). corporate governance and innovation. journal of financial and quantitative analysis, 47(2), 397-41. http://dx.doi.org/10.1017/s002210901200004x copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 8296-30039-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 161 how do the banking systems of vietnam, china and india fare? thanh pham thien nguyen university of economics ho chi minh city e-mail: thanh.nguyen8@griffithuni.edu.au received: sep. 14, 2015 accepted: oct. 29, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8296 url: http://dx.doi.org/10.5296/ajfa.v7i2.8296 abstract given that vietnam, china and india are among the few remaining banking systems which have central bank dependence, state dominance, regulatory restrictions and gradual reforms towards liberalisation, this study examines cost, revenue and profit efficiency and stability of these banking systems. using dea window analysis, the study found that these banking systems achieved high efficiency levels, with generally increasing efficiency from 1995 to 2011. cost efficiency was equally driven by technical and allocative efficiencies; revenue efficiency was driven by interest income efficiency more than by non-interest income efficiency; and profit efficiency was equally driven by cost and revenue efficiencies. furthermore, state banks were found to be more efficient than private banks, but this efficiency gap declined over time. compared to private banks, state banks appear to have been better at coping with the asian financial crisis (afc), but worse at facing the global financial crisis (gfc). however, banking systems of vietnam and china were slightly hit by the afc, while china and india were slightly hit by the gfc. keywords: efficiency, crises, state banks, dea window analysis jel classification: g21, g01, c61 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 162 1. introduction the banking systems of vietnam, china and india are among the few remaining regulated and state-dominated systems in asia, which started with a regulated and state-dominated system, but then moved towards a deregulated and private-dominated system by later liberalisation and privatization these countries initiated gradual reforms towards liberalization from the 1990s, but the central bank is not independent from the government. moreover, restrictions on interest rate, credit allocation, credit growth and foreign investors still exist. in these countries, state banks take up the largest market share, followed by private banks, then foreign banks. notably, india’s reforms have generally been more comprehensive and have been implemented at a faster pace than those of vietnam and china. these give rise to interesting research questions: how efficient and resilient have the regulated and state-dominated banking systems of vietnam, china and india been over the last two decades? efficiency is measured by cost, revenue and profit efficiency. data envelopment analysis (dea)with a window analysis approach introduced by charnes et al. (1984)was employed to estimate efficiency scores of individual banks. as this method uses moving average analogues, it can reduce the effects of banking technology progress over time when capturing the efficiency trend. it is also appropriate for our small-size dataset. to have a robust check of the findings on the banking-system efficiency trend and efficiency gap between state and private banks which were obtained from calculated raw efficiency scores, tobit regression is conducted in the second stage. annual data for the period 1995-2011 was utilised because it covers most of the significant changes in the three banking systems including recapitalization and privatization of state banks, financial liberalization, wto entry, regulatory changes, and the asian financial crisis (afc) in 1997 and global financial crisis (gfc) in 2007. the study found that regulated and state-dominated banking systems of vietnam, china and india achieved high efficiency levels, with generally increasing efficiency from 1995 to 2011. cost efficiency was equally driven by technical and allocative efficiencies; revenue efficiency was driven by interest income efficiency more than by non-interest income efficiency; and profit efficiency was equally driven by cost and revenue efficiencies. furthermore, state banks were found to be more efficient than private banks, but this efficiency gap declined over time. compared to private banks, state banks appear to have been better at coping with the asian financial crisis (afc), but worse at facing the global financial crisis (gfc). however, banking systems of vietnam and china were slightly hit by the afc, while china and india were slightly hit by the gfc. this study makes several contributions. firstly, although there are a large number of studies on bank efficiency either across or within countries over the last two decades, this is the first study of differences and similarities in the efficiency of banks across vietnam, china and india. secondly, this is the first study measuring bank efficiency by simultaneously considering the three most important economic aspects: cost, revenue and profit efficiencies. thirdly, this study provides a comprehensive background of these banking systems in regards to the banking structure, state dominance, regulatory restrictions and gradual reforms towards asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 163 liberalisation in recent decades. fourthly, the findings of this study will provide insights into the merits and demerits of a regulated and state-dominated banking environment; thereby, offering some lessons for other countries’ future reform agenda. lastly, this study makes advances in methodology by combining dea three-year window analysis and size-adjusted efficiency measures to characterise the banking system and banking-type efficiency. this study is organized as follows. section 2 provides a background of the regulated and state-dominated banking systems of vietnam, china and india. section 3 shows the dea window analysis and data sample used for the assessment of bank efficiency. section 4 analyses empirical findings, followed by section 5 which provides concluding remarks. 2. background of the regulated and state-dominated banking systems of vietnam, china and india the banking systems of vietnam, china and india have similarities in commercial banking such as bank-type structure, state dominance,regulatory restrictions and reforms towards liberalisation.in vietnam and india, the banking system is monitored and regulated by their central banks (state bank of vietnam and reserve bank of india, respectively), whilethere are two regulatory institutions in the banking system of china: the central bank (the people’s bank of china)and the china banking regulatory commission. in vietnam and india, moreover, commercial banks are divided into three categories based on ownership criteria: state banks (above 50% government ownership; called public banks in india), private banks (above 50% private ownership; called joint-stock banks in vietnam), and joint-venture and foreign banks (at least 49% foreign ownership). however, there is one more category china: local banks(provincial or municipal governments are major stockholders and their operation limited to one city and the surrounding area). since the 1990s the governments of vietnam, china and india have started making gradual banking reforms towards deregulation, but the governmentstill wields the power to beable to significantlyintervene in the banking system via state-owned banks and regulatory restrictions. table 1 highlights that though these banking systems are dominated by state banks, there seems to be tough competition between state and private banks, as the former gradually lost their marketshare to the latter. however, state banks were partially privatized (from1991 in india, 2005 in china and 2007 in vietnam), because they were considered to store significant non-performing loans, but to enable intervention the government still retains the controlling stake in these privatized banks. in these countries, governments hold various powers to intervene. theycan,because of central bank dependence, intervene in the operation of commercial banks, for instance, on interest rates, credit allocation, credit growth and foreign investors. the vietnamese government,for example, sets upper limits on mobilising and lending interest rates and loans distributed to securities and real estate. it encourages banks to give loans to sectors such as agricultural, rural, export production, support industries, and small and medium enterprises. it alsocontrols the credit growth of individual banks based on their performance as well as the whole banking system based on the country’s economic performance. however, in order to improve asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 164 competition the vietnamese government has reduced barriers to foreign banks;however, foreign banks were more restricted in entry, activity and opening branches than domestic state and private banks. for instance, transactions of foreign banks were limited to only foreign currency in 1991–1994. these restrictions were lifted in 1994.foreign banks could now gather local currency denominated deposits which did not exceed 20 per cent of their charter capital and from households and businesses with no existing credit relationships. from 2010, foreign banks have been allowed to operate with fewer restrictions and at level with domestic banks as per commitment to the world trade organisation (wto). further, domestic banks have been allowed to draw foreign investment up to 30%. in china, prior to 1997, the government fixed deposits and lending interest rates, and required banks to provide loans to state-owned enterprises at lower fixed interest rates than those extended to other types of enterprises. in the following years, interest rates on loans and deposits were gradually liberalized, but the central bank still set benchmark interest rates for rmb-denominated deposits and loans. that is, banks were allowed to offer interest rates within a band above and below the benchmark rates. also, the central bank stopped allocating credit quotas to individual banks but continued to set overall credit growth targets for the year. an additional observation is that the chinese government has been very conservative in allowing foreign bank entry. from 2003, for instance, foreign banks were allowed to expand rmb business from the four major cities of shanghai, shenzhen, tianjin and dalian to the rest of the country. from 2007, rmb business activity was extended from foreign enterprises and individuals to cover domestic firms and residents. quantitative restrictions on rmb liabilities were lifted, various restrictions on branch development were removed, and capital requirements were set in equality with domestic banks. from 2003,foreign investors have been permitted to hold minority stakes in a domestic bankup to 25%. the indian banking reform program can be divided into two stages: 1991-1997 and 1998 onwards. the first stage relates to structural deregulation aimed at promoting competition. this stage was characterised by the liberalisation of interest rates on deposits and lending, the removal of restrictions on entry and on private ownership, and an increase in the range of permissible activities. however, banks were not free to determine the interest rates for all loans and term deposits below inr200,000. the second stage aimed at strengthening financial stability. the whole reform process was aimed at creating a level playing field among different bank types through regulatory policies relating to interest rates, prudential norms, and reserve requirements applied uniformly across bank groups. nonetheless, priority sector credit requirements remain in place, with different targets for domestic and foreign banks (lending portion of 40% for domestic banks and 32% for foreign banks). although the targets have not changed during the reform period, the cost of this directed lending practice has been gradually reduced by expanding the definition of priority sector lending and liberalizing lending interest rates on advances over inr200,000. unlike vietnam and china, banking reform in india has not involved large scale privatization. the approach, instead, first involved recapitalization of banks from government resources to bring them up to appropriate capitalization standards. second, instead of privatization, increase in capitalization has been done through diversification of ownership to private investors up to a limit of 49%, thereby asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 165 keeping majority ownership and control with the government. also, limit on foreign investment in a domestic bank increased from 40% in 1998 to 49% in 2001. in summary, the three banking systems -vietnam, china and india are regulated and state-dominated.governments in these countriesare still able to wield significant influence over the operations of commercial banks via state banks and regulatory restrictions although theyhave implemented gradual banking reforms towards deregulationsince the 1990s. nevertheless, it appears that india’s reforms are generally more comprehensive and implemented at a faster pace than those of vietnam and china, as foreign banks’ activity and foreign stakes in a domestic bank in india are the least restricted. table 1. distribution of deposits by bank types (%) country bank type 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 vietnam state-owned banks 78.4 80.8 80.5 79.5 78.1 78.6 70.0 58.0 56.1 49.7 39.7 joint-stock banks 11.3 9.2 10.1 11.2 13.2 14.3 22.0 29.0 35.9 42.8 51.4 foreign and joint-venture banks 10.3 10.0 9.4 9.3 9.7 7.1 8.0 13.0 8.1 7.5 8.9 china equitized banks 76.8 75.1 74.3 72.7 70.6 69.5 68.5 65.7 joint-stock banks 14.3 15.4 16.1 16.7 18.2 19.0 20.0 21.0 city commercial banks 7.0 7.2 7.2 7.9 8.3 8.8 9.4 11.0 foreign and joint-venture banks 1.9 2.3 2.4 2.7 3.0 2.7 2.1 2.3 india public banks 81.7 78.1 77.7 76.5 76.9 74.4 72.9 73.5 75.8 76.6 76.9 private banks 12.8 16.7 17.6 18.5 18.6 20.1 21.3 20.9 18.8 18.3 18.6 foreign and joint-venture banks 5.5 5.2 4.7 5.0 4.5 5.5 5.8 5.7 5.4 5.2 4.5 source: authors’ calculation from central banks’ reports 3. methodology and data 3.1. methodology this study first employed dea window analysis to estimate cost, revenue and profit efficiencies of individual banks. these efficiency scores were then weighted by total funding to characterize the overall efficiency levels and trends of the banking system as well as its bank types over the period 1995-2011. this study also employed tobit regression as a robust check of the findings on the banking-system efficiency trend and efficiency gap between state and private banks, which were obtained from calculated raw efficiency scores. this study also examines the drivers of these efficiencies by breaking cost efficiency into input-oriented technical efficiency and input-allocative efficiency, and revenue efficiency into interest-revenue efficiency and non-interest revenue efficiency. this study selects inputs and outputs under intermediation approach and uses data from fitch. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 166 3.1.1. dea models and window analysis the two most widely-used frontier techniques are stochastic frontier analysis (sfa), and data envelopment analysis (dea). sfa, a parametric method, requires a large dataset to give reliable results while dea, a non-parametric technique, can provide information on the peer group. dea was selected in this study since some years of our data have less than 15 banks and information on peer group was very useful for managerial purposes. moreover, we estimated these efficiencies under variable return to scale (vrs) assumption to rule out any impact of scale inefficiency in the overall analysis, because the dataset included numeric values with a large difference in magnitude. cost/revenue/profit efficiency reflects how close a bank’s actual cost/revenue/profit is to what the best-practiced bank’s cost/revenue/profit would be. to assess the efficiency trend over the years using dea, the mean efficiencies of individual years can be estimated by forming corresponding individual frontiers or by forming only one frontier over data points of the analysis period. for the former, it is difficult to identify whether the progress or regression in efficiency over the years is a result of efficiency change or technological change. for the latter, efficiency estimates assume an unchanged production technology, an assumption that is difficult to hold in the long period. dea window analysis introduced by charnes et al. (1984) and dea malmquist index which was first suggested by malmquist (1953) can minimize the effect of production technology progress when capturing the efficiency trend over time. dea window analysis assesses the efficiency change over time by using a moving average analogue. this technique treats a dmu in one year independently of the next. dea malmquist index measures the total factor productivity change between two data points by calculating the ratio of the distance of each data point relative to a common technology. of the two, the former has the advantage of being able to increase the number of observations of the data sample, so it can improve the degree of freedom, resulting in more reliable efficiency estimates (avkiran, 2004). a rough rule of thumb to have sufficient efficiency discrimination among dmus is to have a number of dmus equal to or greater than 3 times of total number of inputs and outputs (william wager cooper et al., 2007). our study has 3 inputs and 2 outputs, so the desirable number of dmus is at least 15. since some years in our dataset have less than 15 banks, dea window analysis was selected to estimate banking efficiency levels and trends. in the banking systems of vietnam, china and india, there is a big difference in size between state and private banks as well as among private banks. unweighted efficiency average, therefore, may not necessarily be a good way to characterize the efficiency of the banking industry and its bank types, since small banks may distort these overall efficiencies and people tend to emphasize large banks. we, instead, use weighted efficiency measure introduced by zhu (2000), with the weights of individual banks for individual years calculated based on total funding criterion. efficiency estimate is expressed as a number between 0 and 1, where a bank with an estimate of less than 1 is considered inefficient. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 167 assuming that we have n banks (i =1,…, n) that use a vector of m inputs = ( , … , ) for which they pay prices = ( , … , ) to produce a vector of s outputs =( , … , ) which are sold at price = ( , … , ). dea models and window analysis to estimate bank efficiency are as follows: cost efficiency (ce) model the widely-used cost efficiency model for estimating the cost efficiency of bank j can be expressed in linear programming as follows: subject to ≥ ⩝ ≤ ⩝ = 1 ≥ 0 the solution to this model is the optimal input demand vector ∗ = ( ∗ … … , ∗ ) in the production possibility, which minimizes costs with the given input prices c, and is obtained from a linear combination of banks that produces at least as much output as bank j does, using the same or less amount of input. this hypothetical bank then would have an optimal cost ∗ = ∑ ∗ which, by definition, would be less than or equal to that of bank j ( = ∑ ). the cost efficiency of bank j (cej) is defined as follows: = ∗ = ∑ ∗∑ to examine the drivers of cost efficiency, input-oriented technical efficiency (te) of bank j, where the inputs are minimized and the outputs are kept at their current level, was initially estimated under the model introduced by banker et al. (1984):  subject to asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 168 ≥ ⩝ ≤ ⩝ = 1 ≥ 0 then, input-allocative efficiency (ae), where the cost can be minimized by combining inputs in an optimal way while unchanging the current outputs, was computed based on the formula: ae = ce/te. revenue efficiency (re) model revenue efficiency model introduced by william w cooper and seiford (2000)was employed to measure revenue efficiency for bank j as follows: subject to ≥ ⩝ ≤ ⩝ = 1 ≥ 0 the solution to this model is the optimal output supply vector ∗ = ( ∗ … … , ∗ ) in the production possibility, which maximizes revenues with the given output prices r. this hypothetical bank then would have optimal revenue ∗ = ∑ ∗ which, by definition, would be higher or equal to that of bank j ( = ∑ ). the revenue efficiency of bank j (rej) is defined as follows: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 169 = ∗ = ∑∑ ∗ to examine the drivers of revenue efficiency, we first separated the overall revenue into interest revenue and non-interest revenue, and then estimated interest-revenue efficiency and non-interest revenue efficiency. profit efficiency (pe) model the profit efficiency model developed by färe and grosskopf (1997) and färe et al. (2004)was employed to measure profit efficiency for bank j as follows: − subject to ≥ ⩝ ≤ ⩝ = 1 ≥ 0 the solution to this model is a combination of the optimal output supply vector ∗ = ∗ … … , ∗ and the optimal input demand vector ∗ = ( ∗ … … , ∗ ) in the production possibility set that maximizes the profits with the given output prices r and input prices c, and is obtained from a linear combination of banks that produces at least as much outputs as bank j does, using the same or less amount of inputs. this hypothetical bank then would have an optimal profit ∗ = ∑ ∗ − ∑ ∗ which, by definition, would be higher than or equal to the actual profit of bank j ( = ∑ − ∑ ). the profit efficiency for bank j (pej) then can be measured as follows: = ∗ = ∑ − ∑∑ ∗ − ∑ ∗ asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 170 window analysis dea window analysis proposed by charnes et al. (1984) and charnes and cooper (1984)was employed to assess the efficiency trend over the 1995-2011 period. we chose a three-year window since three years is appropriate for common frontier and moving average analogue (table 2). the principle of forming 15 windows over 1995-2011 is that when a new period is introduced into the window, the earliest year is dropped. thus, the first window includes the first three years of the analysis period—1995, 1996 and 1997. in the second window, year 1995 was excluded and year 1998 included and so on. since dea window analysis treats a dmu independently across the entire period, 15 three–year windows considerably increases the number of observations of the sample, providing a greater degree of freedom and producing a more reliable result (avkiran, 2004). as illustrated in table 2, the efficiency trend of each dmu (bank) can be evaluated over 17 years (averaging from the column view) or over 15 windows (averaging from row view).however, as we are more interested in the efficiency change over the years, we present the result of the efficiency trend by calculating from column view. table 2. 15, three-year window breakdown table over the period 1995-2011 window 1 1995 1996 1997 window 2 1996 1997 1998 window 3 1997 1998 1999 window 4 1998 1999 2000 window 5 1999 2000 2001 window 6 2000 2001 2002 window 7 2001 2002 2003 window 8 2002 2003 2004 window 9 2003 2004 2005 window 10 2004 2005 2006 window 11 2005 2006 2007 window 12 2006 2007 2008 window 13 2007 2008 2009 window 14 2008 2009 2010 window 15 2009 2010 2011 3.1.2. input-output specification to estimate efficiency scores, various input–output specifications have also been proposed under intermediation and production approach, with each likely to produce a slightly different result (drake et al., 2009; moffat & valadkhani, 2011). while all approaches have particular merits and demerits, the intermediation approach seems to be preferred as banks primarily intermediate funds between savers and investors (altunbas et al., 2001; koetter, 2006; maudos et al., 2002).accordingly, this study employs intermediation approach, which commonly specifies inputs as total funding, physical assets and the number of employees, with corresponding prices as unit interest cost of funding, unit other operating costs of physical assets, and unit price of employees. similarly, outputs include net loans and other earning assets, with corresponding prices as unit interest income of net loans and unit non–interest operating income of other earning assets. we are not able to obtain data on the number of employees, thus we respectively use personnel expenses and 1 as proxies for number of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 171 employees and the corresponding price to comply with the objectives of cost-minimisation of cost efficiency model and profit-maximisation of profit efficiency model (table 4). 3.2. data our sample is an unbalanced panel consisting of 30 vietnamese banks, 17 chinese banks and 52 indian banks over the period of 1995–2011 (table 3). the 17-year period (1995–2011) was selected because it covers most of the significant changes in the three banking systems, including recapitalization and privatization of state banks, financial liberalization, wto entry, regulatory changes, and the afc 1997 and gfc 2007. all data were obtained mainly from fitch, accounting for over 70% of all banking assets. some of the missing values were backfilled from audited annual reports. we did not include foreign banks, since their scope and location of business are much more restricted than state and private banks, their business is within the parent banks’ strategy, and some were just recently established. we also did not include city commercial banks in china, because they are only allowed to operate in one city while state and private banks operate on a national scale. thus, our dataset includes only state and private banks to ensure data homogeneity. table 3 shows that there are considerably fewer state banks than private banks in vietnam and china, but slightly more state banks than private banks in india. table 3. data sample over the period 1995-2011 country 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 vietnam total 11 13 13 14 16 16 18 19 21 23 24 29 30 30 30 30 28 state banks 4 4 4 4 5 5 5 5 5 5 5 5 5 5 5 5 5 joint-stock banks 7 9 9 10 11 11 13 14 16 18 19 24 25 25 25 25 23 china total 12 14 14 14 14 14 14 14 14 15 16 17 17 17 17 17 17 equitized banks 4 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 joint-stock banks 8 9 9 9 9 9 9 9 9 10 11 12 12 12 12 12 12 india total 50 50 50 50 51 51 52 51 50 50 51 49 49 47 47 45 44 public banks 28 28 28 28 28 28 28 28 27 27 28 28 28 27 27 26 26 private banks 22 22 22 22 23 23 24 23 23 23 23 21 21 20 20 19 18 source: fitch input and output data were adjusted by the gdp deflator, with 1994, 2000 and 2004 as the respective base years of vietnam, china and india. table 4 shows descriptive statistics of the inputs, outputs and prices used for estimating efficiencies in the banking system of vietnam, china and indiain 1996 and 2010. it can be seen that total funding, net loans and other earning assets of the whole banking system and its bank types expanded over the years. of the two bank types, private banks are much smaller in size, but expanded at a higher speed over the study period than state banks. there was also a wide dispersion in size among banks of each bank type. banks also suffered a considerable increase in costs for employees. mobilizing and lending interest rate and operating cost per unit varied from year to year. weighted data calculated for individual years based on total funding criterion is available from the corresponding author. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 172 table 4. inputs, outputs and prices in 1996 and 2010 per bank/year deflated by gdp deflator; standard deviations in brackets; x1, x2, x3, y1, y2 in million usd; c1, c2, r1, r2 in percentage input vietnam china india output 1996 2010 1996 2010 1996 2010 price all state private all state private all equitized private all equitized private all public private all public private x1 432 1259 64 1364 4175 802 78477 209575 5645 351261 911064 118010 4416 7378 645 18637 26260 8347 (595) (302) (44) (1637) (2234) (657) (125278) (132515) (3805) (411394) (326280) (75268) (7701) (9313) (534) (30662) (37236) (13593) x2 6.9 18.7 1.6 9.2 26.1 5.8 1333 3575 88 3236 9412 663 77 119 22 165 220 91 (9.2) (8.1) (1.4) (11.0) (16.6) (5.3) (2027) (1889) (76) (4528) (3724) (458) (102) (119) (26) (201) (217) (153) x3 4.0 11.9 0.5 11.8 47.9 4.6 553 1458 50 2048 5403 650 106 181 10 199 273 99 (7.2) (9.5) (0.2) (20.7) (32.5) (3.8) (797) (685) (39) (2525) (2222) (475) (222) (276) (9) (394) (495) (152) y1 332 964 51 851 3086 404 47084 126105 3183 194777 498507 68223 2336 3888 360 12653 17869 5611 (453) (222) (28) (1297) (2026) (317) (72549) (70391) (2115) (222331) (168467) (46633) (4418) (5448) (292) (21440) (26198) (9104) y2 135 400 17 491 1159 357 29730 78283 2756 176313 463926 56474 1855 3130 233 6714 8824 3867 (236) (293) (17) (458) (527) (309) (46983) (50820) (1960) (213841) (182044) (34571) (3508) (4299) (191) (11417) (13290) (7684) c1 9.2 8.6 9.5 6.3 6.3 6.4 6.3 9.0 4.8 1.5 1.3 1.6 7.8 7.5 8.3 5.6 5.5 5.7 (3.7) (2.1) (4.3) (1.1) (1.3) (1.1) (4.5) (6.9) (1.5) (0.3) (0.1) (0.3) (1.3) (0.8) (1.7) (0.7) (0.5) (0.8) c2 78.0 103.2 66.8 136.3 141.8 135.2 86.5 66.1 97.8 80.5 45.8 94.9 74.5 87.7 57.6 133.2 103.4 173.4 (41.1) (46.5) (35.6) (96.7) (36.7) (105.2) (59.8) (68.6) (55.4) (34.4) (8.8) (30.4) (53.2) (54.2) (48.0) (139.9) (88.8) (183.3) c3 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) r1 16.0 15.3 16.3 16.4 14.0 16.8 10.7 10.6 10.8 5.0 4.7 5.1 13.0 12.6 13.5 9.1 8.7 9.8 (4.5) (3.5) (5.1) (3.6) (3.0) (3.6) (2.7) (2.0) (3.1) (0.4) (0.4) (0.4) (1.3) (1.0) (1.4) (1.0) (0.6) (1.1) r2 5.0 2.9 6.0 2.9 3.1 2.9 9.0 13.8 6.4 3.0 3.4 2.9 15.8 14.8 17.2 10.4 9.5 11.5 (3.0) (1.6) (3.0) (2.8) (2.5) (2.9) (12.4) (19.8) (5.7) (0.6) (0.2) (0.7) (2.8) (1.6) (3.5) (3.8) (1.3) (5.6) x1: total funding, x2: fixed assets, x3: personnel expenses, y1: net loans, y2: other earning assets, c1: total interest expense/x1, c2: other operating expenses/x2, c3 =1, r1: interest income/y1, r2: total non-interest operating income plus dividend/y2 4. empirical results 4.1. the efficiency of the regulated and state-dominated banking system over the period 1995-2011, the three regulated and state-dominated banking systems generally achieved high efficiency levels, with an increasing trend (figures 1-3).it is believed that these efficiency achievements could be the result of the positive effect of significant regulatory reforms which have been implemented in these banking sectors from the 1990s. moreover, a number of points can be made about the results of table 5. first, the overall cost, revenue and profit efficiencies were, respectively, 0.91, 0.91 and 0.83 in vietnam, 0.94, 0.96 and 0.93 in china, and 0.90, 0.91 and 0.81 in india. it can be seen that cost efficiency is virtually as high as revenue efficiency in these three banking systems. however, the profit efficiency of banks in vietnam and india was lower than their cost and revenue efficiencies, implying that banks in vietnam and india were efficient either at asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 173 managing costs or creating revenue. the profit efficiency of banks in china was similar to their cost and revenue efficiencies, implying that if a bank in china was competent at controlling costs, it was also competent at producing revenue and vice versa. moreover, profit efficiency was equally driven by cost and revenue efficiencies. second, the mean technical and allocative efficiencies are respectively 0.95 and 0.96 in vietnam; 0.98 and 0.96 in china; and 0.94 and 0.95 in india. this implies that banks in these countries were highly efficient in utilizing deposits, personnel and physical assets to produce loans and other earning assets (technical efficiency), and combining these bank inputs in an optimal way to reduce total cost while keeping the same amount of outputs (allocative efficiency). also, cost efficiency of banks in these countries was almost equally driven by technical and allocative efficiencies. third, breaking the overall revenue into interest and non-interest revenue, we obtained the respective interest-revenue and non-interest revenue efficiencies of 0.89 and 0.56 in vietnam, 0.94 and 0.83 in china, and 0.85 and 0.82 in india, implying that bank revenue efficiency in these countries was driven by interest revenue efficiency more than non-interest revenue efficiency, but with the greatest reliance on interest revenue efficiency in vietnam, followed by china, then india. figure 1. weighted cost, revenue and profit efficiency of the vietnamese banking system 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ce re pe asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 174 figure 2. weighted cost, revenue and profit efficiency of the chinese banking system figure 3. weighted cost, revenue and profit efficiency of the indian banking system 0.20 0.40 0.60 0.80 1.00 1.20 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ce re pe 0.20 0.40 0.60 0.80 1.00 1.20 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ce re pe asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 175 table 5. the components of weighted cost, revenue and profit efficiency year vietnam china india te ae-input ce re re-i re-ii pe te ae-input ce re re-i re-ii pe te ae-input ce re re-i re-ii pe 1995 0.84 0.97 0.82 0.90 0.90 0.45 0.70 0.98 0.99 0.97 0.96 0.94 0.92 0.90 0.88 0.96 0.84 0.86 0.69 0.82 0.70 1996 0.95 0.93 0.88 0.94 0.94 0.48 0.76 0.99 0.98 0.98 0.98 0.96 0.88 0.93 0.92 0.96 0.88 0.87 0.71 0.87 0.75 1997 0.94 0.95 0.90 0.93 0.91 0.50 0.81 0.98 0.97 0.96 0.86 0.93 0.72 0.84 0.93 0.96 0.90 0.91 0.75 0.87 0.79 1998 0.90 0.96 0.86 0.90 0.90 0.49 0.66 0.99 0.95 0.94 0.97 0.93 0.69 0.94 0.92 0.97 0.89 0.91 0.76 0.86 0.76 1999 0.94 0.97 0.91 0.90 0.90 0.50 0.77 0.98 0.95 0.93 0.96 0.96 0.69 0.89 0.92 0.97 0.90 0.91 0.79 0.84 0.78 2000 0.92 0.95 0.88 0.87 0.84 0.53 0.79 0.98 0.95 0.93 0.97 0.93 0.77 0.88 0.93 0.97 0.90 0.91 0.80 0.81 0.79 2001 0.95 0.96 0.91 0.86 0.85 0.47 0.83 0.97 0.94 0.91 0.96 0.91 0.77 0.87 0.94 0.96 0.91 0.92 0.84 0.83 0.83 2002 0.97 0.97 0.94 0.95 0.94 0.43 0.88 0.96 0.95 0.91 0.95 0.90 0.78 0.91 0.94 0.97 0.91 0.92 0.84 0.84 0.84 2003 0.98 0.97 0.95 0.95 0.94 0.43 0.91 0.97 0.95 0.92 0.96 0.93 0.79 0.93 0.95 0.95 0.90 0.93 0.81 0.87 0.88 2004 0.99 0.97 0.95 0.96 0.96 0.50 0.94 1.00 0.95 0.95 0.99 0.96 0.84 0.98 0.96 0.94 0.90 0.93 0.85 0.87 0.86 2005 0.97 0.96 0.94 0.92 0.90 0.53 0.90 1.00 0.96 0.96 0.99 0.95 0.88 0.98 0.96 0.94 0.90 0.93 0.90 0.82 0.88 2006 0.96 0.96 0.92 0.90 0.87 0.60 0.86 1.00 0.97 0.97 0.99 0.96 0.88 1.00 0.96 0.94 0.90 0.94 0.94 0.83 0.87 2007 0.98 0.98 0.95 0.93 0.90 0.70 0.93 0.95 0.95 0.91 0.94 0.92 0.85 0.88 0.96 0.94 0.90 0.91 0.94 0.81 0.81 2008 0.93 0.97 0.90 0.85 0.83 0.66 0.76 0.99 0.96 0.94 0.96 0.90 0.92 0.96 0.96 0.95 0.91 0.91 0.95 0.79 0.80 2009 0.96 0.97 0.93 0.91 0.89 0.68 0.90 0.99 0.97 0.96 0.95 0.95 0.85 0.97 0.96 0.94 0.91 0.91 0.95 0.78 0.81 2010 0.97 0.96 0.91 0.92 0.90 0.79 0.90 1.00 0.97 0.96 0.99 0.97 0.91 0.98 0.96 0.94 0.91 0.90 0.96 0.74 0.81 2011 0.95 0.98 0.92 0.84 0.83 0.77 0.79 1.00 0.97 0.97 0.99 0.96 0.93 0.99 0.98 0.95 0.93 0.93 0.97 0.75 0.87 mean 0.95 0.96 0.91 0.91 0.89 0.56 0.83 0.98 0.96 0.94 0.96 0.94 0.83 0.93 0.94 0.95 0.90 0.91 0.85 0.82 0.81 te: technical efficiency; ae-input: input allocative efficiency; ce: cost efficiency; re: revenue efficiency; re-i: interest revenue efficiency; re-ii: non-interest revenue efficiency; pe: profit efficiency 4.2. the efficiency of state versus private banks we compared the performance of state against private banks by calculating the efficiency gap between them (t-test is used to test the significance of the gap and the results are all significant at 5% level). if the efficiency gap was positive, we deduced that state banks were more efficient than private banks. a number of points can be made about the results of table 6. the results highlight that the respective mean cost, revenue and profit efficiency gaps for the whole analysis period are 0.13, 0.17 and 0.24 for the vietnamese banking system; 0.07, 0.05 and 0.09 for the chinese banking system; and 0.09, 0.01 and 0.03 for the indian banking system. these results suggest that in the regulated and state-dominated banking systems, state banks were more cost, revenue and profit-efficient than private banks. this could be explained by better governance due to longer operations, and more benefits on the cost side from the government due to state-driven banking systems. for example, state banks may not pay full market rent for offices; they may pay below-market rates on deposits from government-owned non-financial firms and enjoy benefits resulting from other government protection. further reasons are lower mobilizing costs due to being thought safer and more strategically important lending projects due to bigger capacity. however, these efficiency gaps have generally declined over the analysis period. this could be explained by the gradual relaxation of subsidies of the state to state banks within the context of banking deregulation. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 176 this has enabled private banks to gain market share at the expense of state banks, and then improve their efficiency at a greater speed than state banks over the years. table 6. the efficiency of state against private banks vietnam china india year ce gap re gap pe gap ce gap re gap pe gap ce gap re gap pe gap 1995 0.01 0.13 -0.13 0.06 0.06 0.04 0.12 0.19 0.25 1996 0.14 0.22 0.20 0.09 0.06 0.12 0.11 0.09 0.17 1997 0.22 0.17 0.35 0.09 0.00 0.02 0.07 0.03 0.10 1998 0.21 0.31 0.34 0.11 0.10 0.21 0.06 0.03 0.11 1999 0.19 0.17 0.38 0.22 0.17 0.30 0.06 0.02 0.04 2000 0.18 0.20 0.34 0.20 0.15 0.26 0.08 0.02 0.05 2001 0.15 0.13 0.32 0.18 0.14 0.23 0.10 -0.03 -0.06 2002 0.16 0.21 0.30 0.07 0.05 0.10 0.13 0.01 0.09 2003 0.15 0.17 0.29 0.00 -0.01 -0.01 0.16 0.00 0.00 2004 0.12 0.17 0.27 0.05 0.02 0.06 0.20 -0.01 0.13 2005 0.12 0.15 0.24 0.04 0.01 0.05 0.15 -0.05 -0.06 2006 0.12 0.17 0.24 0.02 0.03 0.03 0.12 -0.04 -0.07 2007 0.09 0.14 0.12 -0.05 -0.02 -0.05 0.08 -0.05 -0.10 2008 0.07 0.20 0.25 0.03 0.04 0.11 0.03 -0.02 -0.08 2009 0.08 0.14 0.12 0.03 0.00 0.05 0.02 -0.02 -0.04 2010 0.12 0.08 0.17 0.00 0.00 0.02 0.08 -0.01 -0.01 2011 0.09 0.21 0.30 0.00 0.00 0.03 0.03 0.00 0.02 mean 0.13 0.17 0.24 0.07 0.05 0.09 0.09 0.01 0.03 ce: cost efficiency; re: revenue efficiency; pe: profit efficiency there were some differences, nonetheless, in the efficiency behaviour of the three regulated and state-dominated banking systems. these differences could have been partly brought about by variation in the reform programs and reform speed. at first, state banks performed better than private banks in vietnam and china in cost, revenue and profit efficiencies in each year of the analysis period, whereas state banks in india were well ahead of private banks in only cost efficiency. state banks in india operated at the same level or were surpassed by private banks in revenue and profit efficiencies from 2000. we also examined the most efficient banks and the least efficient banks in these three regulated and state-dominated banking systems. an interesting pattern emerged that the five most efficient banks comprise both state and private banks, while the five least efficient banks included only private banks. 4.3. the stability of the regulated and state-dominated banking system we created a ‘difference’ variable by subtracting the mean efficiency score of the crisis period from that of the pre-crisis period. we hypothesized that if the efficiency difference was relatively positive, the mean efficiency score of the pre-crisis period is relatively larger than that of the crisis period, implying that bank efficiency may be hit by the crisis; otherwise asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 177 banks are resilient in the crisis period. we selected 1995-1996, 1997-1999, 2004-2006 and 2007-2009 as pre-afc, afc, pre-gfc and gfc period, respectively. a number of points can be made about the results in table 7-9. first, the differences between pre-afc and afc periods in cost, revenue and profit efficiency are 0.04, 0.02 and 0.15 for vietnamese banks; 0.05, 0.05 and 0.06 for chinese banks, and -0.06, -0.09 and -0.10 for indian banks (these differences are significant at 5% level when using t-test). the results suggest that vietnamese and chinese banks appear to have been slightly hit by the afc, while indian banks appear to have been resilient throughout this crisis. second, the respective differences between pre-gfc and gfc in cost, revenue, and profit efficiencies are -0.02, 0.01 and -0.01 for the vietnamese banking system,0.00, 0.04 and 0.03 for the chinese banking system, and 0.01, 0.02 and 0.08 for the indian banking system. this implies that the vietnamese banking system appears to have been resilient in the gfc, while the chinese and indian banking systems appear to have been slightly hit by the gfc. third, the efficiency differences between pre-afc and afc periods for state banks are smaller than for private banks, while those between pre-gfc and gfc periods for state banks are larger than for private banks. this suggests that state banks were better than private banks in coping with the afc, but worse in facing the gfc. this could be because the government, as a wto commitment, has relaxed the subsidies to state banks in recent years. therefore, the efficiency deterioration of the banking system in the gfc period was mainly caused by state banks, due to the government’s relaxation of subsidies to state banks rather than the gfc impact. table 7. the effect of the afc and gfc on banks in vietnam crisis efficiency state-owned banks joint-stock banks the vietnamese banking system no. of obs pre-crisis crisis difference no. of obs pre-crisis crisis difference no. of obs pre-crisis crisis difference afc ce 4.00 0.87 0.92 -0.04 7.00 0.83 0.73 0.09 11.00 0.84 0.80 0.04 re 4.00 0.95 0.93 0.01 7.00 0.75 0.72 0.03 11.00 0.82 0.80 0.02 pe 4.00 0.77 0.80 -0.03 7.00 0.67 0.42 0.25 11.00 0.71 0.56 0.15 gfc ce 5.00 0.94 0.92 0.02 18.00 0.85 0.88 -0.03 23.00 0.87 0.89 -0.02 re 5.00 0.93 0.91 0.02 18.00 0.83 0.81 0.01 23.00 0.85 0.83 0.01 pe 5.00 0.88 0.82 0.07 18.00 0.72 0.76 -0.04 23.00 0.75 0.77 -0.01 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 178 table 8. the effect of the afc and gfc on banks in china crisis efficiency equitized banks joint-stock banks the chinese banking system no. of obs pre-crisis crisis difference no. of obs pre-crisis crisis difference no. of obs pre-crisis crisis difference afc ce 4 0.98 0.96 0.01 8 0.89 0.82 0.07 12 0.92 0.86 0.05 re 4 0.97 0.94 0.02 8 0.92 0.85 0.07 12 0.94 0.88 0.05 pe 4 0.90 0.90 0.00 8 0.81 0.72 0.09 12 0.84 0.78 0.06 gfc ce 5 0.94 0.92 0.02 10 0.92 0.93 -0.01 15 0.93 0.93 0.00 re 5 0.98 0.94 0.04 10 0.94 0.91 0.03 15 0.96 0.92 0.04 pe 5 0.99 0.95 0.03 10 0.97 0.95 0.02 15 0.98 0.95 0.03 table 9. the effect of the afc and gfc on banks in india crisis efficiency public banks private banks the indian banking system no. of obs pre-crisis crisis difference no. of obs pre-crisis crisis difference no. of obs pre-crisis crisis difference afc ce 28 0.83 0.88 -0.05 22 0.79 0.87 -0.08 50 0.81 0.88 -0.06 re 28 0.85 0.89 -0.04 22 0.75 0.90 -0.15 50 0.80 0.89 -0.09 pe 28 0.68 0.74 -0.06 22 0.67 0.73 -0.06 50 0.63 0.73 -0.10 gfc ce 26 0.91 0.89 0.02 19 0.83 0.83 0.00 45 0.87 0.86 0.01 re 26 0.91 0.87 0.03 19 0.90 0.89 0.01 45 0.91 0.88 0.02 pe 26 0.83 0.72 0.10 19 0.79 0.74 0.04 45 0.81 0.73 0.08 4.4. robust check to have a robust check of the findings on banking-system efficiency trend and efficiency gap between state and private banks in section 4.1 and 4.2, we employ tobit regression (because the dependent variable is censored at 0 and 1) where dependent variables are the efficiency scores and independent variables are bank-specific characteristics, ownership, reform and environmental factors. we used a variable ‘time’ which respectively equals 1 through to 17 for years 1995-2011 to capture the efficiency trend over the analysis period resulted from banking reforms; a dummy variable ‘sob’ which equals 1 for state banks and 0 otherwise to characterise the efficiency of state banks relative to private banks and an interaction variable ‘time x sob’ of variables ‘time’ and ‘sob’ to capture the trend of efficiency gap between state and private banks from 1995 to 2011. table 10 displays the impact of bank-specific characteristics, ownership, reform and economic performance on bank efficiency. it can be seen that the coefficients on the time trend (‘time’) are significantly positive for all three banking systems, confirming that cost, revenue and profit efficiencies of the regulated and state-dominated banking system experiences an upward trend over the period 1995-2011. moreover, the coefficients on state ownership (dummy variable ‘sob’) are all significantly positive (except that coefficient on state ownership for vietnamese banks in profit efficiency case is positive but not significant). this suggests that state banks of the regulated and state-dominated banking system are more efficient than private banks. in addition, the coefficients of interaction between time trend and state ownership (‘time x sob') are all significantly negative, confirming that the reforms towards liberalisation have narrowed the efficiency gap between state and private banks over the analysis period. in brief, these findings on the efficiency behaviour of the three regulated asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 179 and state-dominated banking systems support the results obtained by calculating raw efficiency scores in section 4.1 and 4.2. table 10 also provides information on other variables; however, we are not explaining their empirical relationship with bank efficiency as these variables were control variables in the model. table 10. tobit regression of efficiency score on other factors vietnam china india ce re pe ce re pe ce re pe number of obs 365 365 2365 289 289 289 901 901 901 cons 0.9487*** 1.2466*** 1.3944*** 1.9267*** 1.3742*** 1.9156*** 1.7362*** 1.4263*** 2.0458*** (7.95) (7.78) (4.36) (6.60) (4.60) (2.57) (25.05) (18.14) (10.60) sob 0.1408*** 0.2225*** 0.1810 0.1217*** 0.1670*** 0.3271*** 0.1303*** 0.0960*** 0.1948*** (2.91) (3.59) (1.48) (3.53) (4.82) (3.71) (9.88) (6.44) (5.47) eta 0.0011 0.0015 0.0160*** 0.0040** 0.0055*** 0.0140*** 0.0024*** 0.0040*** 0.0236*** (1.10) (1.07) (5.19) (2.14) (2.84) (2.96) (2.51) (3.57) (7.93) loans_deposit 0.0001 0.0013*** 0.0015*** 0.0009* 0.0006 -0.0001 0.00005*** 0.0001*** 0.0001 (0.58) (4.44) (2.63) (1.87) (1.27) (-0.07) (3.06) (2.66) (1.60) size -0.1451*** -0.2652*** -0.5974*** -0.2625*** -0.1202** -0.2720** -0.2220*** -0.1532*** -0.3780*** (-3.46) (-4.74) (-5.28) (-4.78) (-2.15) (-1.95) (-13.13) (-7.98) (-7.97) size square 0.0135*** 0.0236*** 0.0583*** 0.0131*** 0.0050* 0.0118* 0.0123*** 0.0092*** 0.0227*** (3.87) (5.14) (6.25) (5.04) (1.90) (1.80) (12.38) (8.11) (8.13) gdp_growth 0.0172*** 0.0106 0.0448*** 0.0105*** 0.0082*** 0.0210*** -0.0038*** -0.0045*** -0.0070** (3.14) (1.5) (3.23) (3.17) (2.52) (2.58) (-3.04) (-3.18) (-2.10) time 0.0114*** 0.0053 0.0125* 0.0076*** 0.0116*** 0.0262*** 0.0065*** 0.0080*** 0.0119*** (4.53) (1.58) (1.90) (4.05) (6.02) (5.31) (6.76) (7.33) (4.61) timexsob -0.0099*** -0.0166*** -0.0250*** -0.0169*** -0.0107*** -0.0196*** -0.0037*** -0.0078*** -0.0118*** (-2.58) (-3.41) (-2.6) (-5.68) (-3.59) (-2.58) (-3.20) (-6.08) (-3.87) ce: cost efficiency; re: revenue efficiency; pe: profit efficiency sob: dummy variable which equals 1 for state banks and 0 otherwise; eta: equity divided by total assets; loans_deposit: ratio of loans to deposits; size: natural logarithm of total assets; gdp_growth: annual gdp growth; time: respectively equals 1-17 for years 1995-2011; time x sob: interaction variable of ‘time’ and ‘sob’ to the best of our knowledge, this is the first study comparing the efficiency behaviour across the banking systems of vietnam, china and india, so we just compared our findings with the existing literature in regards to efficiency levels and trends of individual countries. it appears that for vietnamese banks, our finding is basically in line with that of vu and turnell (2010) for cost efficiency levels and trends as well as gardener et al. (2011)’s finding for more cost-efficient state banks than private banks.for chinese banks, the finding is similar to that of jiang et al. (2013) for cost and profit efficiency levels,berger et al. (2009) for cost efficiency level, and chen et al. (2005) and berger et al. (2009) for cost efficiency of state banks relative to private banks. for indian banks, the finding supports wanniarachchige and suzuki (2011)’s study for cost and revenue efficiency levels as well as gaps between state and private banks,ray and das (2010) and tabak and langsch tecles (2010)’s findings for cost and profit efficiency levels and gaps between state and private banks, andperera et al. (2007) for being resilient in the afc period. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 180 5. conclusion this study investigated the cost, revenue and profit efficiency levels and trends of banks in vietnam, china and india, explored the drivers of these efficiencies, compared the efficiency of state-owned banks against private banks, and examined the impact of afc and gfc on the efficiency of these banks over the period of 1995-2011. using the dea window analysis, the first finding was that the banking systems of vietnam, china and india achieved high efficiency levels, with increasing efficiency trends over the analysis period. cost efficiency was equally driven by technical and allocative efficiencies, while revenue efficiency was driven more by efficiency from interest income than from non-interest income, and profit efficiency was equally driven by cost and revenue efficiency. the second finding was that state banks were more efficient than private banks, but the efficiency gap has become smaller towards the end of the analysis period. the five most efficient banks, moreover, comprised both state and private banks, while the five least efficient banks were only private banks. thirdly, compared with private banks, state banks appear to have been better at coping with the afc, but worse at facing the gfc. fourthly, the vietnamese and chinese banking systems appear to have been slightly hit by the afc, while the chinese and indian banking systems experienced efficiency deterioration during the gfc period. some differences in efficiency behaviour among these regulated and state-dominated banking systems were also observed. banks in vietnam and india have been efficient in either managing costs or creating revenue, while banks in china have been good at both. the revenue efficiency of banks in vietnam was found to rely most on interest-revenue efficiency, followed by china and then india. in each year analysed, state banks in vietnam and china performed better than private banks in cost, revenue and profit efficiency, whereas state banks in india were well ahead of private banks only in cost efficiency. state banks in india operated either at the same level or were surpassed by private banks from 2000 on. these differences could be partly explained by differences in the programs and speed of banking reforms. references altunbas, y., evans, l., & molyneux, p. 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(2000). multi-factor performance measure model with an application to fortune 500 companies. european journal of operational research, 123(1), 105-124. retrieved from http://www.sciencedirect.com/science/article/pii/s037722179900096x microsoft word 4005-14966-1-sm-new-finaldoc.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 75 impact of intellectual capital on the organizational performance of islamic banking sector in malaysia dr. muhammad khalique department of business management, universiti malaysia sarawak, malaysia e-mail: drmkhalique@gmail.com dr. jamal abdul nassir bin shaari department of business management, universiti malaysia sarawak, malaysia e-mail: jamalnassir@yahoo.com prof. dr. abu hassan bin md. isa department of accounting and finance, universiti malaysia sarawak, malaysia e-mail: miahassan@feb.unimas.my noridah binti samad universiti malaysia sarawak, malaysia received: july 14, 2013 accepted: september 11, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4005 url: http://dx.doi.org/10.5296/ajfa.v5i2.4005 abstract in a contemporary business environment, intellectual capital is considered as the most critical strategic asset for the success of the organization. intellectual capital is a life blood of the high-tech and knowledge intensive organizations. banking sector is considered as a knowledge intensive segment. therefore, there is a great need to nourish the concept and applications of intellectual capital in banking sector. in malaysia, banking sector is mainly based on conventional banking sector and islamic banking sector. this study was conducted on islamic banking sector operating in kula lumpur malaysia. a total of 120 individuals were asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 76 participated in this study to examine the influence of intellectual capital on the organizational performance of islamic banking sector. pearson correlation and multiple regression analysis were used to determine the influence of intellectual capital on the performance of islamic banking sector. the results revealed that intellectual capital has significant influence on the performance of islamic banking sector in malaysia. keywords: intellectual capital, human capital, customer capital, structural capital, performance asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 77 1. introduction in a knowledge-based economy, intellectual capital has secured overwhelming attention from the researchers, academicians, practitioners and entrepreneurs. many researchers such as (ahmad sharabati, ibrahim nour, & sajid shamari, 2013; bataineh & al zoabi, 2011; bontis, keow, & richardson, 2000; de castro & sáez, 2008; de pablos, 2003; ismail, 2005; khalique, 2012; khalique, shaari, isa, & alkali, 2012; ordonez de pablos, 2004) have found that intellectual capital is appeared as the most vital asset for the success of organizations. they argued that intellectual capital is based on the soft assets or intangible assets of the organizations that will help to organizations to create value added products and services. fundamentally, intellectual capital performs a crucial rule to enhance the innovation and creativities in organizations. in an organization intellectual capital is used to create value addition features in their products and services. in competitive environment high-tech industries or knowledge based organizations mainly based on the knowledge assets which refer to intellectual capital. banking sector is considered as the knowledge intensive sector, and this sector mostly offers services orientated products to their customers. presently, banking sector plays a crucial role for development and growth of the national economy. banking sector performs as a lever to facilitate the financial transactions. competitive environment and globalization business challenges has forced to organizations to reshape into knowledge intensive organizations rather than traditional. when knowledge-intensive organizations tend to dominate in the competitive finance sector, there is a need to capitalize the organizational resources, especially intellectual capital. like other countries, in malaysia the banking sector is playing vital role for the development and growth of economy. it can also consider as the banking sector is a back of bone of economy, particularly in present time banking sector involve in every segment of our life. malaysian banking sector is based on conventional and islamic banking sector. in malaysia, these both sectors are performing on parallel lines and their significant positive contribution in the development of economics is highly recognized by the government. in previous studies, researchers mainly focused on conventional banking sector while the islamic banking sector got insignificant attention from the researchers, therefore, in this study, the researchers focused on islamic banking sector to examine the role of intellectual capital in order to enhance the organizational performance. there is no doubt that there are many other important factors that contribute to enhance the performance of organizations but in a knowledge-based economy, many researchers such as (bataineh & al zoabi, 2011; bontis et al., 2000; bueno, salmador, & rodríguez, 2004; díez, ochoa, prieto, & santidrián, 2010; khalique, 2012; khalique, shaari, & isa, 2011; ordonez de pablos, 2004) have found that intellectual capital is one of the most important and strategic assets for the success of organizations. they argued that in a competitive business environment intellectual capital is considered as the life blood of knowledge intensive organizations. in addition, they emphasis that it is indispensible for high-tech industries such as (service oriented and manufacturing orientated) to generate and capitalize their intellectual capital in order to get the competitive edge in cutthroat competition. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 78 2. intellectual capital intellectual capital is manly based on the soft assets of the organizations that contribute to enhance the performance of the organization. in a knowledge-based economy, the nature of resources has been changed. in agriculture-based economy and industrial-based economy the organizations mainly based on tangible assets but now in a knowledge-based economy, intangible assets are considered as the vital resources for the success of organizations. intellectual capital is considered as the nucleus of a knowledge-based economy. the term intellectual capital was first introduced by john kenneth galbraith in 1969 (feiwal, 1975). he understood that intellectual capital meant more than just “intellect as pure intellect” but rather incorporated a degree of “intellectual action”. intellectual capital is based on intangible assets. due to the vital contribution in the innovation, development, growth and enhancement of the organizational performance intellectual capital has secured overwhelming responses from the researchers. to understand intellectual capital in depth many researchers divided intellectual capital into different components for example (stewart, 1997) argued that intellectual capital is based on three components namely, human capital, customer capital and structural capital. intellectual capital model of mcelroy is based on human capital, structural capital and social capital (mcelroy, 2002). ismail argued that intellectual capital is based on human capital, customer capital, structural capital and spiritual capital (ismail, 2005). in 2006 (bueno, salmador, rodríguez, & de castro, 2006) argued that intellectual capital is encompasses on human capital, organizational capital/structural capital, technological capital, social capital and business capital/customer capital. to overcome the scattered opinion about the concept and applications of intellectual capital (khalique, shaari, & isa, 2011b) proposed integrated intellectual capital model (iicm). the iicm model is based on the human capital, customer capital, structural capital, social capital, technological capital and spiritual capital. however, this study is at preliminary stage therefore, the researchers used only three components namely human capital, customer capital and structural capital. human capital is considered as the lifeblood of the organization and it is the crucial source of innovation and development in the organization. human capital cannot be owned by organization but it can only be rented. human capital refers employees who work for the success of the organization. the ingredients of capital are mainly, knowledge, skills, expertise, training and development. customer capital is refers to the customer satisfaction, customer loyalty to the organization while structural capital represent the database, policies, procedures and operating rules of the organizations. 4. conceptual framework figure 1 represents the proposed conceptual framework of this study. this framework posits that there is a direct and positive relationship between intellectual capital and the organizational performance. four research hypotheses of this research are as follows: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 79 figure 1. conceptual framework hypothesis # 1 human capital has significant positive relationship with the organizational performance of islamic banks in malaysia. hypothesis # 2 customer capital has significant positive relationship with the organizational performance of islamic banks in malaysia. hypothesis # 3 structural capital has significant positive relationship with the organizational performance of islamic banks in malaysia. hypothesis # 4 intellectual capital has significant positive influence on the organizational performance of islamic banks in malaysia. 3. research methodology in this study, three components of intellectual capital namely, human capital, customer capital and structural capital are considered as independent variables while organizational performance is used as a dependent variable. to gather the required data 140 applicants were approached from four islamic bank’s headquarters in kuala lumpur. the participants were picked through convenience sampling technique. the five point likert scale research instrument was adopted from (khalique, 2012). a total of 120 individuals were participated in this study in order to understand the concept and applications of intellectual capital to enhance the organizational performance. 5. reliability of instrument reliability analysis (cronbach’s alpha) is used to examine the reliability and internal consistency of each individual item. the item loadings obtained 0.6 can be considered as reliable and acceptable (sekaran, 1992). as demonstrated in table 1, internal consistency values for each of the four constructs is fine since the alpha values for each are greater than 0.90. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 80 table 1. findings of the reliability test variable items cronbach alpha human capital 9 0.945 customer capital 8 0.920 structural capital 8 0.911 organizational performance 10 0.912 6. testing of research hypotheses pearson correlation and multiple regression were used to test the proposed research hypotheses of this study. in this research, correlation and multiple regression are widely used to examine the relationship and influence of independent variables on the dependent variable. therefore, these two techniques were used to examine the research hypotheses. table 2 showed that the correlation between the employed components of intellectual capital and organizational performance were significant positive at the p = 0.01 level (2-tailed). results illustrated that there is a significant positive relationship between human capital and organizational performance (r = 0.714, p < 0.01), customer capital and organizational performance (r = 0.727, p < 0.01) and structural capital and organizational performance (r = 0.659, p < 0.01). in addition, during further analysis it was observed that the customer capital has the strongest relationship with organizational performance of islamic banks, followed by human capital, and finally, structural capital. table 2. pearson correlation between the independent variable and dependent variable variables hc cc sc human capital (hc) customer capital (cc) 0.794 structural capital (sc) 0.657 0.664 organizational performance 0.714 0.727 0.659 note: correlation is significant at the 0.01 level (2-tailed) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 81 multiple regression was used to test the fourth research hypothesis of this study. the coefficient of determination (r2) indicates the goodness of fit for the regression model (namvar, safaralizadeh, baniameri, pourmirza, & karimzadeh, 2012). findings shows that the coefficient of determination (r2 = 0.611) of the variance in the organizational performance of the islamic banks is jointly explained by the employed three independent variables (f = 60.733; sig. = 0.001). the r2 indicated that 611% of the variance in islamic bank’s performance was explained by the contributions of human capital, customer capital and structural capital. the researchers can conclude that the regression model meets the criteria of goodness of fits to validate the regression model and the fourth research hypothesis also supported. table 3 depicts the regression model. table 3. multiple regression model summary and coefficients model unstandardized coefficients standardized coefficients t sig. b beta (β) (constant) 1.007 3.690 .000 human capital 0.238 0.283 2.840 .005 customer capital 0.303 0.336 3.357 .001 structural capital 0.243 0.250 3.096 .002 r = ( 0.781) r2 = (0.611) adj.r2= (0.601) f = (60.733) 0.001 regression-coefficient indicates the degree of each explanatory variables contribution to the variation explained in the dependent variable. all the three variables namely, human capital (β = 0.283, p = 0.005), customer capital (β = 0.336, p = 0.001) and structural capital (β = 0.250, p = 0.002) were found to be significant predictors at the significant level of 5%. the results showed that all three components of intellectual capital are significantly contributing to enhance the performance of islamic banks in malaysia. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 82 7. discussion, recommendations and future studies the findings of this study revealed that the organizational performance of islamic banks in malaysia is influenced by intellectual capital. the findings of this study also supported with the previous studies such as (abdullah & sofian, 2012; ahmad sharabati et al., 2013; bontis et al., 2000; castro & delgado-verde, 2012; díez et al., 2010; khalique, 2012; khalique et al., 2011; ngah & ibrahim, 2009; sharabati, jawad, & bontis, 2010). the findings of this study could be encouraged to the concerned authorities to explore and capitalize their intangible assets to enhance the performance of islamic banks operating in malaysia. this study will be a millstone for the potential researchers to conduct their research in high-tech or knowledge intensive industries operating in manufacture and services sector. this study will motivate to the researchers to apply the integrated intellectual capital model (iicm) in their studies to test the iicm model in different sectors of industries and countries. references abdullah, d. f., & sofian, s. 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(2004). the role of social capital in today's economy: empirical evidence and proposal of a new model of intellectual capital. journal of intellectual capital, 5(4), 556-574. http://dx.doi.org/10.1108/14691930410567013 bueno, e., salmador, m. p., rodríguez, ó., & de castro, g. m. (2006). internal logic of intellectual capital: a biological approach. journal of intellectual capital, 7(3), 394-405. http://dx.doi.org/10.1108/14691930610681474 castro, g. m. d., & delgado-verde, m. (2012). assessing knowledge assets in technology-intensive firms: proposing a model of intellectual capital. journal of centrum cathedra, 1(5), 43-59. http://dx.doi.org/10.7835/jcc-berj-2012-0066 de castro, g. m., & sáez, p. l. (2008). intellectual capital in high-tech firms: the case of spain. journal of intellectual capital, 9(1), 25-36. http://dx.doi.org/10.1108/14691930810845786 de pablos, p. o. 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(1992). research methods for business: a skill buiding approach, john wiley. new york. sharabati, a. a. a., jawad, s. n., & bontis, n. (2010). intellectual capital and business performance in the pharmaceutical sector of jordan. management decision, 48(1), 105-131. http://dx.doi.org/10.1108/00251741011014481 stewart, t. (1997). intellectual capital: the new wealth of organizations. new york: bantam doubleday dell. microsoft word empirical testing-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 107 empirical testing of capital asset pricing model on bahrain bourse dr. iqbal t.h. associate professor college of business administration & assistant to president for accreditation & quality assurance kingdom university, kingdom of bahrain, bahrain e-mail: i.hawaldar@ku.edu.bh received: august 3, 2015 accepted: oct. 1, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8356 url: http://dx.doi.org/10.5296/ajfa.v7i2.8356 abstract the study is undertaken to find out the relationship between portfolio returns and market returns and test the empirical validity of the standard capm model on bahrain bourse. the study is based on 39 companies listed in the bahrain bourse, bahrain all share index as market proxy and yield of government of bahrain securities as risk free rate of return. the study covers period from january 1, 2011 to december 31, 2014. the analysis of the results of the study revealed that many of the independent variables together with beta can explain the portfolio returns. however, the intercept test reveals that the portfolio returns are equal to the risk-free rate of return. therefore, we can conclude that the results of intercept test of standard capm proves the theory and the beta test results goes against the standard theory. keywords: capital asset pricing model, risk, portfolio, return, beta. jel: g13; g14; g 15; g18; c32; f30 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 108 1. introduction rational investors are assessing the risk-return profiles of securities before investing. therefore, it is important to understand the rate of returns and the degree of risks to be assumed. different measures have been used for assessing risks of securities. after sharpe-lintner-mossin proposed the standard form of capm, many studies have been conducted by the researchers to test the validity of capital asset pricing model. even though there are many research studies on the developed and developing countries stock market, there are no research studies on the bahrain bourse. therefore, the researcher attempted to test the validity of capital asset pricing model in the bahrain bourse. there are 47 companies listed in bahrain bourse and out of these 47 companies, for 8 companies share prices are not available. therefore, 39 companies are selected and the study is based on 39 companies, bahrain all share index as market proxy and yield of government of bahrain securities as risk free rate of return. the study covers period from january 1, 2011 to december 31, 2014. the daily closing share prices of the sample companies and bahrain all share index data were collected and used in this study. the share price and index price series have been used to construct daily return series. 2. review of literature the portfolio theory developed by markowitz (1952, 1959) provided the basis for capm. he suggested that rational investor to optimize risk and return should choose portfolio rather than individual stock. therefore, rational investor uses diversification of portfolio to optimize risk and return. according to sharpe (1964), “in equilibrium there would be a simple linear relationship between the expected returns and standard deviation of returns for efficient combination of risky assets. in effect, market presents two types of prices: the price of time or the pure interest rate and the price of risk, the additional expected returns per unit of risk. diversification enables the investor to escape from all except the risk that results from the swings in economic activitythis type of risk persists even in efficient combinations”. black et al. (1972) used regression equation to estimate alpha (α) and beta (β) for the monthly share price data of nyse from 1926 to 1964. the estimated beta was used to divide stocks into 10 portfolios. the parameters for each 5-year period were calculated and used to test the realized returns for subsequent 12 months. time series method was used to estimate α and β for 420 months data and 4 sub-periods data. they found that α and β are inversely related for all sub-periods except for the first sub-period. fama and french (1992) tested capm using stock returns data between 1941and 1990 from nyse, amexa and nasdaq. they discuss the combination of size and book-to-market equity to capture the cross-sectional variation in average stock returns associated with market beta. they concluded that the variation in beta is not related to the size and there is a flat relation between market beta and average return, even though beta is the only explanatory variable. the results do not support the sharpe-lintner-black capm model’s positive relation between average stock return and beta. they report that beta does not completely explain “cross-sectional” variation in the average returns of stocks during the study period. fama and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 109 french observe that a firms size, book-to-market ratio (be/me) absorb the role of leverage and e/p factors in stock returns. black (1993) rejected that “beta as the sole variable explaining returns on stock is dead”, and argues that this is a misstatement of the results of fama and french (1992). he argues that the result of fama and french (1992) is the effect of data mining and the announcement of death of beta seems to be premature. fama and french (1993) suggest that a firm’s book-tomarket ratio and size are in fact proxies for the firm’s loading on priced risk factors. fama and french (1996a) questioned the validity of the results of kothari et al. (1995) and argued against beta. they also showed that annual and monthly betas produce the same inferences about the beta premium. they argued that beta premium is more and cannot save the capm even though there are evidences to support that the beta alone cannot explain expected return. the review of literature shows that most of the tests of capm have been conducted on developed stock markets and are based on the basic methodology adopted by (sharpe, 1964; lintner, 1965; mossin, 1968; black et al., 1972; fama and macbeth, 1973; ross, 1976). besides testing for capm, many of the studies have firm size effect, p/e effect, dividend effect, and problems due to misspecification in the capm model. in spite of the criticism of (roll, 1977, 1981; fama and french, 1992, 1996; and davis et al., 2000) on the relevance of tests of capm, it is clear that the studies on capm have provided valuable insights to the stock returns behaviour in markets. if systematic risk and returns are linearly related and residual risk is unrelated to returns, it will have important implication for investors. iqbal (2011) reviewed 36 research articles on relevance of capm and found that there are different views on the relevance of capm. many researchers believe that capm is relevant to measure risk and return and the argument on beta death is premature whereas there is another group of researchers who criticise capm and argue that the beta is dead. singla and pastricha (2012) in their study did not find any positive relationship between the stocks’ systematic risk, beta (β) and their expected returns. they found that the stocks’ expected return is more closely related to their betas (β) in the negative return periods than in the positive return periods. 3. objectives of the study the objectives of the study are: to find out the relationship between market returns and returns on portfolio. to determine the influence of unsystematic factors on portfolio. to test the empirical validity of the standard capm model on bahrain bourse. 4. hypotheses the following hypotheses are developed based on fama and french (1992) factors model: ho: market betas are not the determinants of the cross-section of the expected portfolio returns. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 110 ho: the intercept (alpha) in the capm is not significantly different from zero. ho: the cross section regression is not a good fit in both univariate and multiple regression. ho: excess market return over the risk free rate of return (rm-rf) does not explain the cross-section of portfolio returns. the corresponding alternate hypotheses for the above null hypotheses are: h1: market betas are the determinants of the cross-section of the expected returns on portfolio. h1: the intercept (alpha) in the capm is significantly different from zero. h1: the cross section regression is a good fit in both univariate and multiple regression. h1: rm-rf explains the cross-section of portfolio returns. the intercept value is hypothesized to be zero in the capm because of the model used to test the dependent variable, excess of portfolio returns over the risk free returns (rp-rf). in other cases, the intercept is expected to be equal to the risk-free rate of return. because of the way researcher has defined the dependent variable in this study, alpha is equated to zero. this model also yields results similar to the standard form where alpha is equated to the risk-free rate of return. 5. research methodology black et al. (1972) analysed the relationship between risk and return and verified whether the relationship is linear. they found that systematic risk or beta is an important determinant of security return. 5.1 calculation of percentage returns, beta, alpha and total risk the daily returns are calculated using the following models: 1 1 1 1 100, 100it it it it it mit it it p p i ir r p i − − − − − −= × = × (1) mean return of security is given by: 1 n it t i r r n ==  (2) mean return of market m is given by: 1 n mit t m r r n ==  (3) where, asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 111 rit = return on security i during time period t; rmit = return on market index during time period t; pit = adjusted closing price of security i for time t; pit-1 = adjusted closing price of security i for time t-1; iit = adjusted closing value of market index corresponding to the period of security i for time t; iit-1 = adjusted closing value of market index corresponding to the period of security i for time t-1; n = number of observations (returns). the following market model is used to represent expected returns on security. the realized returns are used as the measure in place of expected returns. the risk measures like beta, alpha are calculated using this model. , 1,... .i i i m ir r e for i nα β= + + = (4) mean of (ei) = e (ei) = 0; variance of ei = e (ei 2) = 2 ieσ ; variance of rm = e (rm rm)2 = σm 2 (5) variance of security i is: σi 2 = βi 2 σm 2 + 2 ieσ (6) where, ri = expected return on security ‘i’; αi = intercept of a straight line or alpha coefficient of security i; βi = slope of a straight-line or beta coefficient of security i; rm = expected return on index m; ei = error term with mean zero and a standard deviation which is constant. this term captures the variations in security i that are not captured by the market index m; σm = standard deviation of market index m, σm 2 = variance of market index m. beta and alpha are calculated by using the following formulae: 1 1 1 2 2 1 1 n n n mit it mit it t t t i n n mit mit t t n r r r r beta n r r β = = = = = − = =  −          (7) ( )i it i mitalpha r rα β= = − (8) total risk of i is: 2 2 2 2 ii i m eσ β σ σ= + (9) total risk = systematic risk + unsystematic risk n = number of pairs of observations. if capm is valid, then the intercept (αi) will not be significantly different from zero (as our dependent variable is rp-rf. thus a direct test of the capm is by estimating equation (5) for a portfolio and testing to see if αi is equal to zero. the capm assumes that there is a direct relationship between the security returns and their beta. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 112 5.2 steps to calculate regression of portfolio 5.2.1 regression using size (year t-1) the methodology used by (fama and french, 1992; mohanty, 2002; connon and sehgal, 2003) has been used in this study. using size as independent variable and the difference between the individual portfolio returns and the risk-free rate of returns (rp-rf) as the dependent variable, a regression is run for the following: ( ) 112 p ttp f me pr r r eα β −− − = + + (10) if the factors model holds true then we expect αo to be closer to zero and size to capture the cross-sectional variation in average security returns. 5.2.2 regression using lnbe/me (year t-1) the methodology used by (fama and french, 1992; connon and sehgal, 2003) has been used in this study. using be/me as independent variable and rp-rf as the dependent variable, a regression is run for the following: 5.2.3 regression using eps/price (year t-1) ( ) 1 1 3 t pt p f pbe me r r r eα β − −       − = + + (11) if the factors model holds true, we expect αo to be closer to zero and book-to-market equity to capture the cross-sectional variation in portfolio returns. the methodology used by (fama and french, 1992; mohanty, 2002) has been used in this study. using price earning as an independent variable and rp-rf as the dependent variable, a regression is run for the following: ( ) 1 1 4 t pt p f pe p r r r eα β − −       − = + + (12) if the factors model holds true then we expect αo to be closer to zero and price earning to capture the cross-sectional variation in portfolio returns. 5.2.4 regression using rm-rf (year t-1) the methodology of fama and french (1992) has been used. using excess market returns over the risk free rate of return (rm-rf) as independent variable and rp-rf as the dependent variable, a regression is applied for the following: ( ) ( ) 1 1 5 ptm f pt p f r r r r r eα β − − − − = + + (13) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 113 if the factors model holds true then we expect αo to be closer to zero and rm-rf to capture the cross-sectional variation in portfolio returns. 5.2.5 multiple regression using bp, and size (year t-1) the methodology used by (banz, 1981; fama and french, 1992; connon and sehgal, 2003) has been used. using portfolio betas (phase i multiple regression in standard form of capm) and size as independent variables and rp-rf as the dependent variable, a multiple regression is applied for the following: ( ) 111 2 ttp f p me p pr r r eα β β β −− − = + + + (14) if the factors model holds true then we expect αo to be closer to zero and two variables, size and beta, combine to capture the cross-sectional variation in portfolio returns. 5.2.6 multiple regression using bp, and be/me (year t-1) the methodology of fama and french (1992) has been used. using portfolio betas and be/me as independent variables and rp-rf as the dependent variable, a multiple regression is applied for the following: ( ) 1 1 1 3 t pt p f p pbe me r r r eα β β β − −       − = + + + (15) if the factors model holds true then we expect α to be closer to zero and two variables be/me, and beta, combine to capture the cross-sectional variation in portfolio returns. 5.2.7 multiple regression using bp, and eps/price (year t-1) the methodology of fama and french (1992) has been used. using portfolio betas e p as independent variables and ( )p fr r− as the dependent variable, a multiple regression is applied for the following: ( ) 1 1 1 4 t pt p f p pe p r r r eα β β β − −       − = + + + (16) if the factors model holds true, then we expect αo to be closer to zero and the two variables, eps/price and beta, combine to capture the cross-sectional variation in portfolio returns. 5.2.8 multiple regression using bp, and rm-rf (year t-1) the methodology of fama and french (1992) has been used. using portfolio beta and excess market returns over the risk free rate of return (rm-rf) as independent variables and rp-rf as the dependent variable, a multiple regression is run for the following: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 114 ( ) ( ) 1 1 1 5 tm f pt p f p pr r r r r eα β β β − − − − = + + + (17) if the factors model holds true then we expect α to be closer to zero and two variables, ( )m fr r− and beta combine to capture the cross-sectional variation in portfolio returns. 5.2.9 multiple regression using bp, size and eps /price (year t-1) the methodology of fama and french (1992) has been used. using portfolio betas, size and e/p as independent variables and rp-rf as the dependent variable, a multiple regression is applied for the following: ( ) 11 1 1 2 4p tt pt p f p me pe p r r r r eα β β β β −− −       − = + + + + (18) if the factors model holds true then we expect αo to be closer to zero and the three variables, beta, size and price earnings, combine to explain the cross-sectional variation in portfolio returns. 6. empirical results of the study the empirical results of the study are discussed in this section. 6.1 test for alpha and the slope co-efficient of independent variables based on the results of cross-section regression the intercept and slope co-efficient values of the independent variables are tested using the t-test, and adjusted r2 values are tested using f-test at 5 percent level of significance. if the capm holds, the alpha value should not be significantly different from zero since ri-rf has been used as the dependent variable. it is expected that the α value of the regression based on these independent variables should be equal to zero and the slope co-efficient of independent variables should be equal to zero if they are not the determinants of security returns. in other way if the value of alpha is significantly different from zero it implies that the hypothesis regarding the risk-free rate of return does not hold and if the values of the slope co-efficient of the independent variables are significantly different from zero it implies that the independent variables chosen for the study determine the security returns in a significant way. the independent variable, security beta (βi), is expected to explain the variation in security returns. if the independent variable, βi, explains the variance of the dependent variable, then the slope co-efficient of βi should be significantly different from zero. therefore, the hypotheses relating to the slope co-efficient are that they are equal to zero, while the alternate hypotheses are that the slope co-efficient are significantly different from zero. the f-test significance f indicates whether the regression of null independent variable/s with the dependent variable is a good fit. if the independent variable/s cause /s the variation in the dependent variable, the regression should be a good fit and therefore the computed values of significance f should be less than the level of significance chosen in most of the period. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 115 6.1.1 analysis of the results based on percentage returns regression line has been fit by considering the percentage stock returns of the companies taken for analysis. the regression results based on percentage stock returns are obtained by forming portfolios with equal weights and market stock capitalization weights. table 1. the test for alpha and the slope co-efficient of (rm-rf) in table 1, the results indicate that in majority (76.96%) of the years, α value is not significantly different from zero and therefore, the null hypothesis is accepted. the (rm-rf) slope coefficients test shows that in all the years, the slope coefficient is not significantly different from zero. therefore, we accept the null hypothesis that (rm-rf) is not a significant determinant of portfolio returns. the f-test results indicate that in all the years p-values are more than 0.05. this indicates that the regression is a not good fit for all the years. this concludes that the independent variable (rm-rf) does not explain the variation in the dependent variable. table 2. the test for alpha and the slope co-efficient of (rm-rf) p-value α p-value (rm-rf) sig f status of p values 76.9231779 91.666777 84.62539 per n<0.05 23.0769332 8.3333443 15.39461 per n>0.05 in table 2, the results indicate that in majority (76.99%) of the years, α value is significantly different from zero and therefore, the null hypothesis is rejected. the (rm-rf) slope coefficient test shows that in majority (91.78%) of the years, the slope coefficient is significantly different from zero. therefore, we accept the alternate hypothesis that (rm-rf) is a significant determinant of portfolio returns. the f-test results indicate that in majority (84.62%) of the years p-values are less than 0.05. this indicates that the regression is a good fit for majority of the years. this leads to conclusion that the (rm-rf) explains the variation in the portfolio returns. 6.2 cross-sectional regression results of percentage returns with equally weighted portfolios: year wise analysis based on year t-1 weights table 3. the test for alpha and the slope co-efficient of beta p-value α p-value βp sig f status of p values 53.8461648 7.6923237 7.692128 % n<0.05 46.1539262 92.365692 92.31869 % n>0.05 in table 3, the results indicate that in majority (54.24%) of the years, α value is significantly different from zero and therefore, the null hypothesis is rejected. the βp slope coefficient test shows that in majority (93.22%) of the years, the slope coefficient is equal to zero. on basis of the results we accept the null hypothesis that beta of the portfolio is not a significant p-value α p-value (rm-rf) sig f status of p values 23.0779233 0 0 per n<0.05 76.9231767 100 100 per n>0.05 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 116 determinant of returns of the portfolio. the f-test results indicate that in majority (93.22%) of the years p-values are more than 0.05 and support the argument that the portfolio beta does not explain the variation in the portfolio returns. table 4. the test for alpha and the slope co-efficient of eps/price p-value α p-value eps/price sig f status of p values 53.8461478 7.6922137 7.6832308 % n<0.05 46.1865456 92.318692 92.29869 % n>0.05 the results presented in the table 4 indicate that in majority (55.91%) of the years, α value is significantly different from zero and therefore, the null hypothesis is rejected. the p-values of eps/price slope coefficients are more than the level of significance in majority (91.11%) of the years. therefore, we accept the null hypothesis that security eps/price ratio is not a significant determinant of security returns. the f-test results indicate that in majority (91.11%) of the years p-values are more than 0.05. this supports the argument that the eps/price ratio does not explain the variation in the portfolio returns. table 5. the test for alpha and the slope co-efficient of (rm-rf) p-value α p-value ((rm-rf)) sig f status of p values 23.1669229 0 0 per n<0.05 76.9229669 100 100 per n>0.05 the results presented in the table 5 indicate that in majority (77.96%) of the years, α value is not significantly different from zero and therefore, the null hypothesis is accepted. the (rm-rf) slope coefficient test shows that in all the years, the slope coefficient is not significantly different from zero. therefore, we accept the null hypothesis that (rm-rf) is a significant determinant of portfolio returns. 7. conclusion the analysis of the results of the study revealed that many of the independent variables together with beta can explain the portfolio returns. however, the intercept test reveals that it is equal to the risk-free rate of returns. therefore, we can conclude that while the intercept test of capital asset pricing model proves the theory, the beta test goes against the standard theory. references ansari, v.a. 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(2012). asset pricing in the indian capital market: a study of positive and negative return periods. journal of academic research in economics, 4(1), 90-101. microsoft word 5200-18875-2-sm-writer2-new-final.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 159 vietnamese money supply m1 and stock price behavior chu v. nguyen associate professor of economics and finance and assistant chair faeis department, college of business, university of houston-downtown 320 north main st., suite 410-c, houston, texas 77002 tel: 1-713-222-5334 e-mail: nguyenchu@uhd.edu received: feb. 26, 2014 accepted: march 18, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5200 url: http://dx.doi.org/10.5296/ajfa.v6i1.5200 abstract this study applies enders and siklos’ (2001) procedure to test for the long-run asymmetric co-integrating relationship and granger causality between vietnamese monthly money supply m1 and monthly equity index over the period july 2000 to august 2010. the empirical results suggest a long-run asymmetric co-integration relationship between the narrowly defined money supply and equity index, indicating that the countercyclical monetary policies affect investors differently in different phases of business cycles. the empirical results further suggest that vietnamese equity investors are more responsive to contractionary than expansionary monetary policy measures. thus, the vietnamese central bank countercyclical monetary policy is effective in influencing the equity markets. the empirical findings should be of special interest for the central bank in formulating and implementing its countercyclical monetary policy, for equity investors in designing their investment strategies, and corporate executives in determining their capital structures. keywords: asymmetry, co-integration, market equity index, money supply, tar model, and vietnam. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 160 1. introduction since the late 1930s, keynesian fiscal policy has played a critical role in macroeconomic management in market economies. beginning in the 1960s, changes in international economic conditions resulted in persistently large government budget deficits in economies around the world. as articulated by mishkin (1995), this fiscal policy has lost its luster due to persistent budget shortfalls, large public debts, and doubt about the political system’s ability to utilize the fiscal policy instrument in a timely and effective manner to achieve desirable stabilization outcomes. consequently, the stabilization of output and inflation has been left largely to monetary policy. clearly, monetary policy becomes more and more important as an instrument for macroeconomic policy-making and macroeconomic management. however, formulating and implementing monetary policy in a transitional economy such as the case of vietnam is very challenging. the state bank of vietnam supervisors encountered difficulties enforcing the rules and regulations. moreover, excessive loans to shareholders are a particular problem for jointstock banks as regulations limiting credit to a single borrower can be easily circumvented. the national monetary policy has been guided by, at times, conflicting policy objectives. domestically, these conflicting objectives include economic growth, price and currency stability, financing inefficient state owned enterprises through policy directed lending and financial system stability. the vietnamese banking system consists of two segments: the four dominant large state owned commercial banks, and a number of small and more dynamic foreign-owned and jointventure banks. the state owned commercial banks frequently operate on a non-commercial basis, with a culture of policy lending, which is subject to direct government interference. however, the rest of the banking system is more market-oriented. transparency in banking operations, especially in the lending decisions, is always a thorny issue. these complicate the transmission of monetary policy, which operates under a mix of direct channels (through the state owned commercial banks) and market mechanisms (through other banks) in an opaque environment. even under the increases in inflation pressure, the state bank of vietnam must continue to focus its operations on the need to meet the economic growth objectives set by the national assembly. as a result, open market operations at times have been used primarily to inject liquidity into the banking system as needed to support the state owned commercial banks' own budget shortfalls and the financing of large public infrastructure projects. one of the consequences of the above policy has been the increase in non-performing loans, mostly from the state-owned enterprises, accumulated in the financial institutions' balance sheets. even with reforms, the governmental banking decrees and legislatures modifying the national assembly's 1997-laws relating to the operations of the central bank and commercial banks, the internal and external difficulties of the vietnamese banking system are still asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 161 problematic. as recently as december 2006, the state bank of vietnam was still wrapped in a vicious circle, evidenced in the imf country report 06/421:"the state bank of vietnam revised monetary program for 2006 targets a deceleration of credit growth to 20 percent by end-2006. the team supported the authorities' aim to low credit growth and welcomed the increased caution exercised by the state owned commercial hanks in their new lending. however, given a still large amount of excess bank liquidity, there is a risk that credit growth will resurge during the remainder of the year, especially if this proves necessary to ensure the financing of strategic state owned enterprise projects. moreover, challenges may be posed by financing of strategic state owned enterprise projects. additional challenges may be posed by owned enterprise bonds and stock market-related lending. the authorities acknowledged that bank financing for many large state owned enterprise projects was likely to materialize in the corning months." the standard neoclassical paradigm of financial economics assumes that investors react to noteworthy news events by adjusting their investment portfolios because these events change the risk-return profile of securities. therefore, changes in the money supply m1 is an indicator of changes in future macroeconomic conditions such as inflation, interest rate and unemployment, sophisticated and unsophisticated investors alike will react according to their ability to access research information and reposition their portfolios. more specifically, neo-classical economists theorized that an increase in money supply strengthens the stock prices. conversely, a fall in money supply should slow down the stock prices. the post-keynesian school of economics (see wray, 1998 for the exposition of post-keynesian thinking) has long questioned the importance of the above hypothesized relationship. this school of thought posits that movements in money supply m1 reflect the shift of money from long-term saving deposits to demand deposits and vice versa as a result of the preceding changes in stock prices. for example, raises in stock prices induce investors to liquidate their long-term saving deposits to use the fund to purchase stocks and other financial assets. in this portfolio adjustment process demand deposits tend to increase, which in turn raises money m1. the trend is reversed when assets and stock prices are falling. from this logic, some post-keynesian economists argue that changes in stock prices actually cause changes in money supply m1 and not the other way around. additionally, the asymmetries in financial market instruments are neither new nor novel. they have been studied extensively and documented in the literature of the indirect financing segment of the financial industry. arak et al. (1983), goldberger (1984), forbes and mayne (1989), levine and loeb (1989), mester and saunders, (1995), dueker, (2000), and tkacz (2001) report asymmetries in the u.s. prime lending rate. thompson (2006) confirms that the asymmetries in the us prime lending-deposit rate spread. cook and hahn (1989), moazzami (1999), and sarno and thornton (2003) find asymmetries in u.s. treasury securities. frost and bowden (1999) and scholnick (1999) report asymmetries in mortgage rates in new zealand, and canada. heffernan (1997) and hofmann and mizen (2004) indicate asymmetric behavior of retail rates in the united kingdom. hannan and berger (1991), and neumark and sharpe (1992), diebold and sharpe (1992) examine various deposit rates. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 162 the rationale for incorporating the possible asymmetric adjustment process of the stock prices to the long-run equilibrium can be attributed to the seemingly opposite effects of the efficient market hypothesis and the counter-cyclical monetary policy over different phases of business cycles (thompson, 2006; nguyen et al., 2010). for instance, during the contractionary phases of business cycles, the countercyclical monetary policy would usually increase the money supply reducing market interest rates, while the information from that state of the economy would precipitate investors to resist adjusting their required rate of return on the stock market portfolio downward because their perceived market portfolio risk increases. thus, the stock prices only increase slowly. by the same logic, it may be argued that, during the expansionary phases of business cycles, investors are less likely to resist adjusting their required rate of return on the stock market portfolio downward while the central bank is expected to reduce the growth in the money supply, raising market interest rates. it is expected that stock prices would adjust downward faster when the cycles are closer to their peaks. the existence of the asymmetric response of the stock prices to the changes in the money supply will affect firms relying on equity market for funds differently than those using loans for their financial resources. thus, policymakers should be aware that counter-cyclical monetary policy may have different effects due to stock price asymmetries in their formulation of monetary policy. additionally, keeping pace with the age of globalization, the equity market has been increasingly internationalized. thus, modeling the asymmetry in the stock prices may provide a better understanding of the countercyclical monetary policy and the equity market worldwide. the above discussions imply the hypothesis of an asymmetric co-integrating relationship and granger causality between stock prices and the money supply. to formally investigate these possibilities, this study utilizes enders and siklos’ (2001) procedure to test for an asymmetric co-integrating relationship and granger causality between vietnamese stock prices and the monthly money supply m1. the remainder of this paper is organized as follows: the next section briefly discusses the vietnamese equity market and banking industry; the section that follows describes the data for this study and some descriptive statistics; the following sect1on briefly describes the methodology used in the investigation; the next section reports the empirical test results; and the final section provides some concluding remarks. 2. vietnamese equity market and banking sector vietnam's first stock exchange, known as the ho chi minh city securities trading center, was established in july 2000. by the spring of 2005, the number of companies listed on the exchange had reached 28, representing a total market capitalization of only u.s. $270 million. in march 2005, vietnam opened an over-the-counter exchange known as the hanoi securities trading center. the purpose of the second exchange was to expedite the process of equitization (partial privatization) of state-owned enterprises. although these exchanges are still very small, officials set the goal of expanding their combined market capitalization to 10 percent of gross domestic product by 2010 and gradually phasing out asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 163 restrictions on foreign ownership o f s h a r e . in september 2005, vietnam's prime minister announced that the limit on foreign share ownership would rise from 30 percent to 49 percent. actually, as indicated by table 1, at the end of 2012, the number of companies listed is 183 and the total market capitalization accounts for only 23.2 percent of gross domestic product. the vietnam stock index or vn-index is a capitalization-weighted index of all the companies listed on the ho chi minh city stock exchange. the index was created with a base index value of 100 as of july 28, 2000. prior to march 1, 2002, the market only traded on alternate days. table 1.market capitalization of listed companies as percentage of gross domestic product advanced markets 2009 2010 2011 2012 asian emerging markets 2009 2010 2011 2012 australia 136.3 127.8 86.6 84.6 bangladesh 7.9 15.6 21.0 15.1 canada 125.7 137.0 107.2 110.7 people’s rep. of china 100.3 80.1 46.3 44.2 france 75.3 75.6 56.4 69.8 india 86.4 94.4 54.2 68.6 germany 39.3 43.5 32.9 43.7 malaysia 126.6 166.3 137.2 156.9 japan 67.1 74.6 60.0 61.8 pakistan 20.5 21.6 15.5 18.9 rep. of korea 100.3 107.3 89.2 104.5 philippines 47.6 78.8 73.8 105.6 new zealand 57.6 51.4 45.1 47.7 sri lanka 19.3 40.2 32.8 28.7 singapore 160.1 170.4 125.8 150.8 thailand 52.4 87.1 77.7 104.7 united states 108.5 118.9 104.3 119.0 vietnam 21.8 19.2 14.8 23.2 average 96.7 100.7 78.6 77.1 average 53.6 67.0 52.6 62.9 source: world bank, world development indicators. market capitalization is the share price times the number of shares outstanding. listed domestic companies are domestically incorporated companies listed on the country’s stock exchange at the end of the year (2012). listed companies do not include investment companies, mutual funds, or collective investment vehicles. additionally, many regulations issued in 2006 and the officially accepted to be wto member have changed the landscape of the vietnamese equity market significantly. on may 03, 2006 the vietnam securities depository officially went into operation under decision no. 189/2005/qd-ttg signed on july 27, 2005 to increase the market performance in general, and the clearing and settlement system in particular. on june 01, 2006 the hanoi securities trading center increased the number of trading days from 3 to 5 days a week, in order to increase the market liquidity. on june 14, 2006, the ho chi minh city securities trading center increased the number of order matching phases from 2 to 3 phases a day (1st phase from 8h40 to 9h10, 2nd phase from 9h20 to 9h50, 3rd phase from 10h to 10h30) in order to meet investors’ trading demand. finally, on november 07, 2006 vietnam was passed membership to become 150th member of the world trade organization, and would officially join on january 11, 2007. that event made new opportunities and challenges in the country’s cultural and economic integration course into the globe, especially with respect to the financial aspect of the economy. as table 1 indicates, vietnamese equity market is still relatively not well developed. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 164 as to the banking industry, vietnam's banks suffer from low public confidence, regulatory and managerial weakness, and high levels of non-performing loans (npl), non-compliance with the basel capital standards and the absence of international auditing. since 1992 vietnam's banking system has consisted of a combination of state-owned, joint-stock, joint-venture and foreign banks, but the state-owned commercial banks predominate, and they suffer from high levels of npl, most of them made to state-owned enterprises. consequently, in september 2005 vietnam decided to equitize all five state-owned banks-a change from previous plans to equitize only two of them. in addition, vietnam plans to boost the transparency of its financial system by establishing a credit-rating agency and performance standards for joint-stock banks. large foreign banks are balancing their strong interest in serving multinationals in vietnam and frustration with continuing restrictions on their activities. as reported by the asian focus (2011), heavy lending to state-owned enterprises by state-owned commercial banks —notably prior to the 1997-98 asian financial crisis—has led to relatively higher levels of non-performing loans than at other financial institutions. state-owned commercial banks accounted for the largest share of lending, with 49.3% of total loans as of year-end 2010, down from 58.4% in 2007. although vietnam is a cash-based society, as reported by the asia focus (2011) rapid economic growth has contributed to rising household incomes and an increasing demand for retail banking services. credit and debit card use has become more common, with the number of cards issued doubling between 2008 and 2010 to 28.5 million. the asia focus further articulates that the number of automated teller machines (atms) in the country has also climbed dramatically, rising from 1,800 in 2005 to 11,000 as of december 2010. however, despite this growth, banking penetration rates remain relatively low. as of december 2009, the asia focus estimated that 20% of vietnam’s population had bank accounts and around half of those with accounts actively used consumer banking services. the asian focus also posits that although these figures have likely risen somewhat during 2010 given the rising trend in credit cards and atms, the vietnamese market continues to present growth opportunities for banking service providers. in transitional and developing economies such as vietnam, the conduct of the monetary policy, and hence the money supply, has been influenced by the following institutional and structural constraints. in early 1998, state owned commercial banks still accounted for 80% of deposits and their lending remained subject to political direction. state enterprises continue to receive borrowing privileges, including obtaining loans without collateral, easier access to foreign currency loans and subsidized interest rates. accounting practices rendered credit evaluations problematic and off-balance sheet liabilities, such as letters of credit, emerged as a major source of risk (imf staff country report no 98/30, 1998). 3. data this study uses data on the monthly equity market index money and the narrowest money supply m1 (in trillion) from the vietnamese central bank over the period from july 2000 to august 2010. the monthly market equity index and the narrowest money supply m1 are asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 165 expressed in natural logarithmic values. the natural logarithmic values of the monthly market equity index and the narrowest money supply m1 are denoted by tep and tms , respectively. throughout this study, tep and tms are referred to as the stock price index and the money supply. the difference between tep and tms is defined as the basis or the spread between stock price index and the money supply and is denoted by tsp . moreover, given a level of the stock price, a decrease in the money supply m1, would widen the spread between the stock price and the money supply m1: a widening of the basis. the opposite is true if the money supply m1 changes in the other direction. the descriptive statistics reveal that the mean money supply during the sample period is 5.432 percent ranging from 4.358 percent to 6.401 percent with standard deviation being 0.595, while the mean stock price is 5.790 percent, ranging from 4.605 percent to 7.024 percent with is standard deviation being also 0.595. their correlation is 72.19 percent. the logarithms of vietnamese stock price index, the narrowest money supply, and their spread july 2000 to august 2010 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 -1 0 1 2 3 4 5 6 7 8 stock price index narrowest money supply spread source: vietnamese central bank, bloomberg, and calculations by the author. figure 1 4. methodological issues and analytical framework 4.1 structural break over time, every economy would experience many business cycles caused by internal and external shocks; therefore, countercyclical monetary policy measures would be used to bring the economy back to its long-run path. consequently, the spread between stock the price index and the money supply is most likely to suffer some structure breaks. to search endogenously for the possibility of any structural break in the basis, this study utilized perron’s (1997) endogenous unit root test function with the intercept, slope, and the trend dummy, as specified by equation (1), to test the hypothesis that the spread between stock price index and the money supply has a unit root. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 166 tit k i itbt spsptddttdusp υψβδγαθμ +δ++++++= −=−  11)( (1) where t is a linear time trend; )(1 bttdu >= is a post-break constant dummy variable; )(1 bttdt >= is a post-break slope dummy variable; )1(1)( +== bb tttd is the break dummy variable; and tε are white-noise error terms. the null hypothesis of a unit root is stated as 1=β . the break date, bt , is selected based on the minimum t-statistic for testing 1=β (see perron, 1997). 4.2 threshold autoregressive (tar) model additionally, to further investigate the nature of the granger causality between the vietnamese equity index and the narrowest money supply, this study uses the threshold autoregressive (tar) model, developed by enders-siklos (2001), that allows the degree of autoregressive decay to depend on the state of the spread between the logarithm values of the vietnamese market equity and the narrowest money supply m1 or the basis, i.e. the “deepness” of cycles. the estimated tar model would empirically reveal if the basis tends to revert back to the long-run position faster when the spread is above or below the threshold. therefore, the tar model indicates whether troughs or peaks persist more when shocks or countercyclical monetary policy actions push the basis out of its long-run equilibrium path. in this model’s specification, the null hypothesis that the basis contains a unit root can be expressed as 021 == ρρ , while the hypothesis that the basis is stationary with symmetric adjustments can be stated as 21 ρρ = . the first step in the enders-siklos’ (2001) procedure is to regress the spread between the logarithms of the stock price index and the money supply, tsp , on a constant, a linear trend and an intercept dummy (with values of zero prior to the structural break date and values of one for the structural break date and thereafter), as specified by equation (2). tttt dummytrendsp εβββ +++= 320 (2) the saved residuals, tε from the estimation of equation (2), denoted by tε̂ , are then used to estimate the following tar model: tpt p i ittttt uii ˆˆˆ)1(ˆˆ 11211 +δ+−+=δ −=−−  εαερερε (3) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 167 where ),0.(..~ˆ 2σdiiut , and the lagged values of tε̂δ are meant to yield uncorrelated residuals. as defined by enders and granger (1998), the heaviside indicator function for the tar specification is given as:    < ≥ = − − τε τε 1 1 ˆ0 ˆ1 t t t if if i (4) the threshold value,τ , is endogenously determined using the chan’s (1993) procedure which obtains τ by minimizing the sum of squared residuals after sorting the estimated residuals in an ascending order, and eliminating 15 percent of the largest and smallest values. the elimination of the largest and the smallest values is to assure that the tε̂ series crosses through the threshold in the sample period. throughout this study, the included lags are selected by the statistical significances of their estimated coefficients as determined by the t-statistics. 4.3 the asymmetric error-correction model moreover, to investigate the short-run asymmetric dynamic behavior between the stock price index and the money supply m1, this study specifies and estimates the following asymmetric error-correction model. the estimation results of this model can be used to study the nature of the granger causality between the stock price index and the money supply. the empirically determined nature of the granger causality will help to empirically evaluate the neoclassical and post-keynesian hypotheses regarding the relationship between money supply m1 and the stock price index in the last decade of the vietnamese financial markets. additionally, the following tar-vec model differs from the conventional error-correction models by allowing asymmetric adjustments toward the long-run equilibrium. tit q i iit n i ittttt umsepiiep 11112110 ˆ)1(ˆ +δ+δ+−++=δ −=−=−−  γαερερα (5) tit q i iit n i ittttt umsepiims 21112110 ~~ˆ)1(~ˆ~~ +δ+δ+−++=δ −=−=−−  γαερερα (6) where ),0.(..~ 2 2,1 σdiiu t and the heaviside indicator function is set in accord with (4). this model’s specification recognizes the fact that the stock price index (i.e. the investors, because the investors collectively determine the stock prices) respond differently depending on whether the basis is widening or narrowing, i.e. contractionay or expansionary monetary policy. 5. empirical results 5.1 results of the test for structural break asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 168 the estimation results of perron’s endogenous unit root tests are summarized in exhibit 1. an analysis of the empirical results reveals that the post-break intercept dummy variable, du, is positive and is insignificant at any conventional level. also, the post-break slope dummy variable, dt, is negative and is significant at the 1 percent significant level. the time trend is negative but is insignificant at any significant level. the empirical results of these tests suggest that the spread between the logarithm values of the vietnamese market equity index and the narrowest money supply m1 or the basis followed a stationary process with a break date of october 2006, which may be attributable to the consequence of the aforementioned introductions of regulations into the equity markets earlier in the year. however, the 4.26660)1( −==αt is not sufficiently large to confirm the structural break. to definitely affirm this break, the chow’s test was carried out and the result confirms the suggested date of the structural break of basis. the confirmed structural break may be attributable to the aforementioned revision of the state bank of vietnam’s monetary program for 2006 targets a deceleration of credit growth to 20 percent by end-2006. exhibit 1perron’s endogenous unit root test, vietnamese data 2000:07 to 2010:08 notes: critical values for t-statistics in parentheses: critical values based n = 100 sample for the break-date (perron, 1997). “*” indicates significance at the 1 percent level. 5.2 results of cointegration test with asymmetric adjustment to examine whether or not the logarithmic values of the stock price index and the money supply are co-integrated when allowing for asymmetric adjustments, the spread between the logarithms of stock price index and the money supply is regressed on a constant, a linear trend and an intercept dummy with values of zero prior to october 2006 and values of one for october 2006 and thereafter. the estimation results are reported in exhibit 2. exhibit 2estimation results for equation, vietnamese data, july 2000 to august 2010 notes: “*” indicates significance at the 1 percent level. (a) as articulated by enders and siklos (2001, p. 166), in this type of model specification, tε may be contemporaneously correlated. the residuals from these estimations are used to estimate the tar model specified by equations (3) and (4). the estimation results for the tar model are reported in exhibit 3. ttbt sptddttdusp υ++−−−+= −177954.0)(16207.000639.000007.066238.010621.0 (1.86535) (3.55872*) (-0.74365) (-3.52851*) (-1.27014) (15.08646*) no. of augmented lags: =k 11 break date: october 2006 4.26660)1( −==αt tttt dummytrendsp ε++−= 5117.00110.08389.0 (10.0964*) (-6.0062*) (3.8564*) lnl = -55.4629 2r = 0.2430 dw statistic(a) = 0.1246 f (2,119) = 20.4171* asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 169 over all, the empirical results reveal that the null hypothesis of symmetry, 21 ρρ = , is soundly rejected at the 1 percent significant level based on the partial f = 8.1516, indicating statistically that adjustments around the threshold value of the basis the difference between the natural logarithmic values of the vietnamese stock price index and the money supply m1the basis are asymmetric. additionally, the calculated statistic μφ = 5.5591 indicates that the null hypothesis of no co-integration, 021 == ρρ , should also be rejected at the 1 percent significance level, confirming that the basis is stationary. with regard to the sationarity of the basis, ewing, et al. (2006) pointed out that this simple finding of stationarity is consistent with the two underlying series comprising the basis being co-integrated in the conventional, linear combination sense. exhibit 3-unit root and tests of asymmetry, vietnamese data july 2000 – august 2010 1ρ 2ρ τ 0: 210 == ρρh 210 : ρρ =h aic sic -0.6469* -0.0522 0.35107 μφ = 5.5591* f = 8.1516* -4.1191 -4.0030 q(12)=12.6100[0.3980] ln l = 81.8744 f(4,115)=6.5453* dw = 2.1125 notes: the null hypothesis of a unit root, 0: 210 == ρρh , uses the critical values from enders and siklos (2001, p. 170, table 1 for four lagged changes and n = 500). * indicates the 1 percent level of significance. the null hypothesis of symmetry, 210 : ρρ =h , uses the standard f distribution. τ is the threshold value determined via the chan (1993) method. q(12) denotes the ljung-box q-statistic with 12 lags. these test results support the long held theoretical articulation of the co-integrating relationship between stock prices and money supply. the estimation results reveal that 1ρ is significant at the 1 percent level, while 2ρ is statistically insignificant at any conventional level. in fact, the point estimates suggest that the spread tends to decay at the rate of 6469.01 =ρ for 1ˆ −tε above the threshold, 35107.0=τ , and at the rate of 0522.02 =ρ for 1ˆ −tε below the threshold. finally as mentioned above, the finding of 21 ρρ > indicates a faster convergence for positive disequilibrium than for negative disequilibrium. 1ˆ −tε > 0.35107 is indicative that the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 170 decline in the money supply, as a result of the contractionary monetary policy, has widened the difference between the stock price and the money supply. this widening of their basis initiates a downward adjustment in the stock price. this result implies that the stock price adjusts faster to the threshold value when the vietnamese central bank tightens money supply, widening the above defined basis than when the authority eases the money supply, narrowing the basis. these findings suggest that the equity investors and hence the stock prices are more responsive to contractionary monetary policy as reflected in the decline in the money supply m1. these results suggest that the monetary policy affects the vietnamese corporations and hence investors differently in different phases of the business cycles in the long run. 5.3 results of the asymmetric error-correction models exhibit 4 summarizes the estimation results for the tar-vec model specified by equations (5) and (6) using natural logarithmic values of the vietnamese stock price index and the monthly money supply m1. in the summary of the estimation results, the partial fij represents the calculated partial f-statistic with the p-value in square brackets testing the null hypothesis that all coefficients ij are equal to zero. “*” indicates the 1 percent significant level of the t-statistic. qlb (12) is the ljung-box statistic and its significance is in square brackets, testing for the first twelve of the residual autocorrelations to be jointly equal to zero. lnl is the log likelihood. the overall f-statistic with the p-value in square brackets tests the overall fitness of the model. the retained estimated coefficients iα , iγ , iα~ , and iγ~ are based on the 5 percent level of significance of the calculated t-statistics. an analysis of the overall empirical results indicates that the estimated equations (5) and (6) are absent of serial correlation and have good predicting power as evidenced by the ljung-box statistics and the overall f-statistics, respectively. as to the long-run adjustment, the statistical significances of the error correction terms and 21 ρρ > in equation (5) indicate that the stock price asymmetrically responds to negative and positive spreads. in fact, estimation results of the tar-vec reveal that stock price reverses to the long-run equilibrium faster when the vietnamese central bank tightens the money supply m1, widening the basis compared to ease monetary policy actions. with regard to the long-term money supply m1, the estimation results of equation (6) show | 2 ~ρ | < |~| 1ρ . however, both | 1 ~ρ | and |~| 2ρ are not statistically significant at any conventional level, indicating that the money supply does not respond to either the widening or the narrowing of the spread between stock price and the money supply in the long run. these empirical findings suggest that vietnamese monetary policy makers have not been sensitive to equity market in the long run. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 171 exhibit 4asymmetric error correction model, vietnamese monthly data, 2000:07-2010:08 eq. (5) independent variables overall 000]7.8268[0.0)88,11( =f ; lnl= 107.3700; )12(q =6.47201[0.8905]; 2r = 0.4314 tepδ 021191191 ===== ααααα 0201981 ==== γγγγ 1ρ 2ρ partial f11 = 9.4280[0.000] partial f12 = 8.5329[0. 000] -0.1484* -0.0138 eq. (6) independent variables overall 00]7.7152[0.0 )91,7( =f ; lnl= 230.7142; )12(q =15.5880[0.2108]; 2r = 0.3242 tmsδ 0~~~ 221712 === ααα 0~~ 1210 ==γγ 1 ~ρ 2 ~ρ partial f21 =5.1530[0.003] partial f22 = 21.2280[0.000] 0.0053 0.0102 notes: partial f-statistics for lagged values of changes in the lending rate and central bank discount rate, respectively, are reported under the specified null hypotheses. q(12) is the ljung-box q-statistic to test for serial correlation up to 12 lags. “*” indicates the 1 percent level of significance of the t-statistics. with regard to the short-run dynamic granger causality between stock price and the money supply, the partial f-statistics in equation (5) reveals is a bi-directional granger-causality from the money supply to the stock price, i.e., the stock price responds to both the its own lagged changes and the lagged changes of money supply as well. as to the empirical results for equation (6), the partial f-statistics suggest that the money supply responds not only to its own lagged changes but also to lagged changes of the stock price in the short run. over all, the tarvec estimation results seem to lend credence to the neo-classical in the long run and the keynesian views in the short run on the causality between the market stock price and the money supply in the last decade. 6. concluding remarks the standard neoclassical paradigm of financial economics assumes that investors react to noteworthy news events by adjusting their investment portfolios because these events change risk-return profile of securities. therefore, a change in the growth rate of the money supply m1 is an indicator of future macroeconomic conditions such as higher interest rate, sophisticated and unsophisticated investors alike will react according to their ability to access research information and reposition their portfolios. consequently, the stock prices will move. the post-keynesian school of economics posits that movements in money supply m1 reflect the shift of money from long-term saving deposits to demand deposits and vice versa as a result of the preceding changes in stock prices. the results of this study empirically reveal both the neoclassical and the post keynesian paradigm that there is a bidirectional granger causality between the stock price index and the narrowest defined money supply. in asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 172 fact, their granger causality is asymmetric. this asymmetric relationship indicates that the counter cyclical monetary policies affect corporations differently in different phases of business cycles. the empirical results reveal the existence of the asymmetric response of the stock prices to the changes in the money supply, which will in turn affect firms relying on equity market for funds differently than those using loans for their financial resources. thus, policymakers should be aware that countercyclical monetary policy may have different effects due to the asymmetric behavior of stock prices in their formulation of monetary policy. additionally, keeping pace with the age of globalization, the equity market has been increasingly internationalized; these findings may provide a better understanding of the countercyclical monetary policy and the equity market worldwide. more specifically, the results reveal that the stock price adjusts faster to the threshold value when the vietnamese monetary authority tightens the money supply, widening the basis than when the central bank eases the monetary policy, narrowing the basis. these findings suggest that the stock price is more responsive to contractionary monetary policy as reflected in the decline in the money supply m1. most of studies of vietnamese equity market are of micro-nature and detailed operations. the macro nature of the empirical results of this investigation would help policy makers to design and implement proper policy, investors to design their investment strategies, and corporate executives to determine their capital structures. references arak, m., englander, s., & tang, e. 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(1998). modern money. working paper no. 232, the jerome levy economics institute, september. microsoft word paper template-writer2-new asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 299 stock market reaction to good and bad political news muhammad tahir suleman school of economics and finance victoria university of wellington po box 600, wellington 6140, new zealand tel: 64-220-744981 e-mail: tahir.suleman@vuw.ac.nz received: april 24, 2012 accepted: may 8, 2012 published: june 1, 2012 doi:10.5296/ajfa.v4i1.1705 url: http://dx.doi.org/10.5296/ajfa.v4i1.1705 abstract the purpose of this study is to analyze the consequence of political news on stock market returns and hence its volatility. for this purpose we split the political news into two categories (good and bad news). we used univariate asymmetric garch model, to gauge the impact of political news on returns and volatility. our results show that good news have positive impact on the returns of the kse100 index and also decreased the volatility. on the other hand, bad political news has negative influence on the returns (decrease the returns) and increase the volatility (positive effect). further, our results also confirm that bad news has stronger effect (almost double) on the volatility than good news. most of the sectors are also affected by the good and bad news in the same way as kse100 index. we also find that the results of a few sectors (oil and gas, financial, health care) are not statistically significantly in respond to good and bad political news, indicating that this type of news does not affect the returns or volatility. our results show that the sectors which respond more towards good news has lower beta, suggesting variance moves quickly through the time. keywords: political risk, good and bad news, asymmetry, egarch asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 300 1. introduction over the past decades, researchers have identified numerous factors that can affect stock exchange returns such as economic and political factors. political risk is an important factor especially in developing countries and emerging markets. political stability index defines political risk as a probability of political events occurring that will change the prospects for profitability of a given investment. brews (1981) explain political risk as an assortment of risks associated from doing business abroad. clark (1997) refers it as stochastic element as well as the timing of the political events that cause losses. clark and tunaru (2003) explain political risk as the expected arrival rate of political events. clark and tunaru (2005) defines political events with significant negative economic and financial consequences that are felt everywhere as beside to political events whose economic and financial outcomes are limited to specific country or region. this means that political risk can arise from a large number of sources, which are often mutually dependent. authors like root (1973) and simon (1982) consider political risk as an event that causes loss. research on political risk focus that political news affect financial markets. especially stock markets respond more to new information regarding political decisions that may affect domestic and foreign policy. the reaction of the stock exchange depends on the political news, prices should increase if the news leads to upward revision of investor’s expectation and similarly it can lead to downward if the investors respond to news in opposite way (tan and gannon 2002). researcher use different ways to test political events and use them to test against stock market’s volatility. soultaanaeva (2008) use political news as proxy to view political risk and find that there is a week relationship between political risk and stock market volatility. researchers such as robock (1971) and kobrin (1979) or freshly feils and sabac (2000), concentrated on political risk as it changes the investment’s overall profitability in both ways. cutler et al. (1989) and bittlingmayer (1988) chan and wei (1996), kim and mei (2001), consider political risk with respect to stock market volatility. other papers, such as erb et al. (1995 and 1996), cosset and suret (1995), bekaert (1995), and bekaert and harvey (1997) focus on losses and test political risk with respect to stock market performance. empirical literature on stock exchange behaviour has focused on the link between stock prices and political risk, (beaulieu, cosset and essaddam 2006; fong and zhang wang and lin 2007; chan and wei 2009 ).beaulieu, cosset and essaddam (2006) investigated the short run effect of the 30 october 1995 quebec referendum on the common stock returns of quebec firms. their result shows that the uncertainty surrounding the referendum outcome had an impact on stock returns of quebec firms. they also find that the effect of the referendum varied with the political risk exposure of quebec firms, that is, the structure of assets and principally the degree of foreign involvement. regardless of its consequence, a minor empirical research has examined the importance of political risk on stock market volatility. fong and koh 2009 used the data from hong kong stock market to investigate whether political risk has induced regime shifts in stock market’s volatility. they found a strong evidence of the regime shift in conditional volatility as well as significant volatility asymmetry in high volatility periods. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 301 since the day of independence in 1947, pakistan has become a ball to play between democratically-elected and authoritarian military leaders, linked with an unstable relationship with neighbouring india. from 1988 to 1999, following zia ul haq's death, democracy though an unstable one sovereignty, power alternated between benazir bhutto and nawaz sharif, with none of them completing their full in the prime minister house. finally, in october 1999, a chief of army staff, pervez musharraf, take over the government of sharif and took over as president1 and sent him to jail and later to exile in saudi arabia for ten years. after asserting himself the chief executive, the supreme court in may 2000 authorized musharraf to hold the president office. in 2002 a parliamentary election returned civilian rule, yet the musharraf presidency was extended for another five years. although parliamentary elections were to take place in 2007, they were first postponed because of doubts of instability and later as a result of the assassination of benazir bhutto in december 2007. when the elections finally took place in february 2008, president musharraf was crushed by the ppp and pml (n). both parties formed a coalition government in march 2008 with a new prime minister in power, yusuf raza gilani. the purpose of this paper is to examine the impact of political uncertainty on stock exchange. this paper contributes to the existing literature in the following way. first, to our best knowledge, the current literature lacks the empirical evidence regarding the impact of political news on the return and the volatility at sector indices level, as all the previous research is done on the main indices. second, pakistan is an ideal laboratory to examine the impact of political events as there is a high density of political instability and involvement of army in the politics. in this paper we analysed the consequences of political news on the stock market returns and volatility. for this purpose we split the political news into two categories (good and bad news). we use the daily data from karachi stock exchange to observe the affect of political news on the stock market. furthermore, we examine the returns of different sectors to examine either they are also affected by the political news or not. additionally this also helps us to identify which sector responds more to the political news. we used univariate asymmetric garch model, to gauge the impact of political news on the returns and volatility. we specifically used egarch as it allows good news and bad news to have different impact on volatility while standard garch model does not (engle and victor 1993). our results shows, that the good news has positive impact on the returns of the kse100 index and good news also decreased the volatility. on the other hand, bad political news has negative impact on the returns (decrease the returns) and increase the volatility (positive effect). furthermore our results also confirm that bad news has more affect (almost double) on the volatility than the good news, such results are consistent with laakkonen and lanne (2008). most of the sectors are also affected by the good and bad news in the same way as kse100 index. we also found that a few sectors (oil and gas, financial, health care) are not statistical significant for good and bad political news, means these type of news do not affect the returns or volatility. we also reported the volatility asymmetry, which is negative in most of the sectors including the kse 100 which is due to the leverage effect. however the asymmetry for auto and parts is positive showing that there is no leverage effect in this. furthermore, persistence parameter beta is also reported, which is very large in most of the asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 302 selected sectors including kse 100 which indicate that variance move slowly through time. our results divulged that the sectors which response more towards good news (volatility decrease more than other such as basic material and industries) has lower beta, means variance move quickly through the time. the organization of this study is as follows. section 2 presents the formulation of hypotheses and egarch modelling of financial returns and volatility. section 3 describes the data. empirical findings are discussed in section 4. further research areas and the conclusion are presented in section 5. 2. methodology even though garch performs well at describing volatility, its underlying assumption about the behavior of the squared residuals is problematic. the model expects that the same magnitude of positive and negative shocks have the same effects on variance. this is seen in the model by squaring the previous values of shocks. by doing this the sign of the shocks is lost. to solve this problem, asymmetric, non-linear models were introduced. in this study our focus lies only on egarch model. 2.1 the egarch model nelson (1991) introduce the exponential garch which is more useful as compared to garch because it allows good news and bad news to have a different impact on volatility and it also allows big news to have greater impact on volatility. this model work in two steps, firstly it considers the means and secondly the variance. one way to define the egarch model is: log σ ω α f z βlog σ (1) | | | | (2) where, / , , are parameters for conditional variance estimation. , indicate the impact of the last period measures on the conditional variance. if the is positive that means a positive change in stock prices is associated with further positive change and vice versa. is a coefficient which measures the effect of previous period in the information set and explain the past standardized residuals influence on the current volatility. furthermore, signify the asymmetry effect the in the variance, a negative means that bad news has higher impact on volatility than the good one with the same magnitude. since egarch models the logarithmic time-varying conditional variance, the parameters are allowed to be negative. this means that the model does not require any non-negativity constraints in the parameters. the lack of non-negative restrictions makes the model more attractive than a garch and gjr. there is however a necessary constraint regarding the stationarity of the model that needs to be specified. the stationary restriction for an egarch (1, 1) model is that the beta is less than one (β < 1). in the case of symmetry, where the magnitudes of positive and negative shocks have equal impact on the variance, γ will be equal to zero. if, γ < 0 the magnitude of a negative (positive) shocks will cause the variance to increase (decrease). if, on the other hand, γ > 0 positive (negative) shocks will cause the variance to increase (decrease). asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 303 2.1 political risk and security returns with egarch after having measured the univariate return and volatility linkages, we further our analysis by measuring the effect of good news and bad news announcement for the kse 100 index and other selected sector indexes. we measure the return and volatility response to good and bad political news by adding a dummy variable in our univariate egarch model that take the value 1 on news2 days, else zero. it is important to note that we measure separately the response of each news category, i.e., our model is estimated independently for each news category. more specifically, the univariate egarch model with a dummy variable for stock market indexes is defined as follows: , , , , (3) (4) equation (3) is the return equation and (4) represent the volatility equation. where, the dummy variables are the good and bad news. 3. data and descriptive statistics the data used in this study was collected from the karachi stock exchange and thomson datastream. it consists of the kse-100 index and the eight sector indexes those are, oil and gas, financial, basic material, utilities, food and beverages, industry, health care and auto and parts. the data consists of daily closing prices, stated in local currency (rupee). for kse-100 index data ranges from january 2, 1992 to march 30, 2010 consists of 4686 observations. while, for all the sectors the data range is from july 17, 1992 to march 19, 2010 consist of 4162 observations. the software used in the study is e-views. the daily return series was generated as follow, , / (5) where, is the return on karachi stock exchange and represents the closing value of kse indexes on the day t. it is important to mention here that the series is adjusted neither for dividends nor for risk free rate. we can ignore the dividends and interest rates as it does not create any significant error when we forecast stock market volatility (nelson 1991). summary statistics for our returns series of kse-100 index, and other sectors are as given in equation (5) are shown on the next page in table 1. table 1 show that the mean value of the kse100’s return is 0.0004 and the median 0.00000. the standard deviation is about 1.62%. this is a quite high value, with respect to the mean return, indicating that the returns often deviate from the mean. the skewness in this case is nearly -0.32 which indicates a negative skewness indicating that the curve is more concentrated on the left hand side. indices usually have a weak negative skewness since the stock prices in the long range tend to increase with time. the kurtosis is around 8.62, which is way too high means the curve has a high peak. there is, thus, excess kurtosis in the index meaning that the distributions are leptokurtic. standard normal distribution should have a skewness of zero and a kurtosis of three. based on these values we conclude that the data does not follow a normal distribution. one way to confirm whether the data follows a normal distribution is to look at the jarque bera. in this case, with respect to table 1, the jb is 6243.621 with a p-value of 0, and hence the h0 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 304 hypothesis is rejected which means that the data is not normally distributed. table 1 shows details of the descriptive statistics of the selected sectors such as financials, industry, utilities etc. all mean returns are positive except of the industries.the skewness of the series indicate that more than half of the series has a negative skewness. moreover, we also reported the autocorrelation coefficients for simple and squared returns at first lag in table 1. the first order return autocorrelation coefficient displays a significantly positive serial correlation for most of the return series. in addition, coefficients measuring the serial correlation in squared returns indicate a presence of volatility clustering effects for all sectors including the kse 100 index. thus, we can use garch models to capture these characteristics of asset returns. furthere more all the series reject the h0hypothesis for jbtest confirming that these are not normal distributed. 3.1 news data political news has great impact on the pakistani stock market as it is clear when the parliament passes the 18th amendment in the evening and the next day the kse100 roses by 300 points. in this paper we use political news to test the impact of political risk on stock market volatility. we collected 186 news items in total after careful reading of more than 4000 news3. we gathered all the news which are related to politics and include i) agreements between political parties, ii) conflicts between politicians and army iii) talks and statements given by the leaders of political parties about future policies, iv) dismissal of governments before time, v) intervention of army. after collecting the political news, we sort these news into “good” and “bad” news. we classify them according to their nature and ultimate affect on the economy and response of general public. for instance, in our sample period we have two main parties4 which are always against each other. so any talk or an agreement between these two parties is considered as good news. however, when these parties try to make fake cases against each other then the news considered as bad one. the interference of army or take over on the democratic government always considered as bad news. we also included the news related to mqm (muttahida qaumi movement) as they are the key role player in the karachi city the biggest city of the pakistan. 4. empirical results we justify the selection of egarch models by utilizing the linear models on kse 100 and other selected sectors with different lags and investigate the best fit model for the data according to akaike information criterion (aic) and schwarz information criterion (sic). we find arma (1, 1) model is the best fit model in most of the series in order to capture the first movement. 4.1 impact of good political news first we test the impact of good political news on the stock returns, means how returns responds to the good news. in general, we know that good news increase the returns. the empirical results from univariate egarch model (3) & (4) are reported in tab 2. as it clear the table that good political news dummy is positive (0.007288***) and is significantly and statistically significant at 1 % for kse 100 index. moreover the results of dummy variable for sector indexes is also positive and statistically significant showing that good political news have positive effect on returns. financial, auto and parts sector show more asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 305 positive returns (0.010607*** and 0.009291** respectively) as compared with other sectors make, which make clear that they react more to positive news with respect to others. this is a good sign because whenever political parties sit together to solve the matters for public interest and it influence the market in a positive way. now, turning our concern to the volatility dynamics reveal more interesting results. table 2, also describe the coefficient of dummy in the volatility equation (4). results show that good news decrease volatility in most of the cases including kse100, basic material, utilities, food and beverages, industries and health care. good news dummy is more significant and higher in the case of basic material (0.255694**) industries (0.215425***) as compare to other sectors. however some sectors as oil and gas (0.037254), financial (0.061050) and auto and parts (0.059129) are not statistically significant with respect to good political news. table 2 also reports the volatility asymmetry, which is negative in all of the sectors including the kse 100 which is due to the leverage effect. however the asymmetry for auto and parts is positive showing that there is no leverage effect in this sector. moreover negative asymmetry implies that the variance goes up more after negative news than after positive news. furthermore, persistence parameter is also reported in table 4, which very large in most of the selected sectors including kse 100 which indicate that variance move slowly through time. from the table we also observe that the coefficient for basic material (0.589553***) and industries (0.721994) is quite low as compare to the other sectors those have coefficient more than 0.90. we conclude that the sectors which response more towards good news (volatility decrease more than other such as basic material and industries) has lower . our results also explains that good political news have no affect on the volatility of the oil and gas sectors, since the price of oil is linked to the international markets so the domestic good news did not change the volatility. similar results are found with the financial sector, describe that the coefficient for good news is not statistically significant. it is because the financial sector can be more dependent on the economic news rather than the political one. the time period required for shocks to reduce to one half of the original size defined as ln 0.50 ln is approximately 8.30 days for kse100 index and a higher one is 23.3 days for food and beverages and smallest of 1.3 days for basic material sector index. this is an indication that the shock persist is 8.30, 23.3 and 1.3 days for kse100, food and beverage and basic material sector index respectively. a shorter lasting persistence of shocks in the conditional variance implies more volatility. the extent to which negative innovations increase volatility more than positive innovation is defined as | 1 | 1 , about 1.11 times for kse100 index, 1.39 which is the maximum in all the sectors is for basic material and lowest if for 1.01 times for auto and parts sector index respectively. asymmetry effect of 1.11 means, that the negative impact is 1.11 times more than the positive impact on the kse100 index. 4.2 impact of bad political news in this part we test the impact of bad political news on the stock returns and volatility. generally speaking, bad news decreases the returns and increases the volatility. the empirical results from univariate egarch model (3) & (4) are reported in table 3. as it is perceived from the table that bad political news dummy is statistically significant at 1% and significantly negative effect (0.011564***) on the returns of the kse 100 index. we also asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 306 reported the results of the sectors with respect to bad news. financial and basic material is more negative results (0.015145*** and 0.014795*** respectively) with respect to other sectors. however, we find no significant result (0.000942) of the bad news on health care sector. concentrating on impact of news on volatility we find motivating results. table 3 also divulges the coefficient of dummy in the volatility equation (4). results show that bad news increase volatility all of the cases including kse100, basic material, utilities, food and beverages. bad news has more impact on the volatility basic material and financial sector (0.600746*** and 0.492515*** respectively) as compare to other sectors. however, we did not find significant statistic of the impact of bad political news on industries (0.039800) and health care (0.018243). table 3 also reports the volatility asymmetry, which is negative in all of the sectors including kse100 except auto and part, confirming leverage effect. moreover negative asymmetry implies that the variance goes up more after negative news than after positive news. however in case of auto and parts the asymmetry is positive implies the absence of leverage effect. furthermore, persistence parameter is very large in most of the sectors including kse 100 which indicate that the variance move slowly through time. on the other hand, for the basic material and industries is lower than the other sectors. residual autocorrelation coefficients at 10th lag for both simple and squared standardized residuals are also reported in table 3. the statistic of autocorrelation in residual and squared residual shows the absence of correlation. we also find that the magnitude of the negative political news is more than the positive political news on both return and volatility. there is no affect of bad political news on health care sector which is not surprising as pakistan is a developing country and the health care is related to basic needs of the people. so the investor think that the struggle among the political parties do not affect this sector. furthermore bad news does not influence the volatility of the industrial sector. the reason behind this is that almost 90% of the politicians are related to the industrial sector directly or indirectly. so they actually have all the inside news about the future policies. furthermore table 2 and 3 shows that the asymmetry for bad news is more than good news means bad news have more impact than good news. however the asymmetry for auto and parts is positive showing that there is no leverage effect in this sector. moreover negative asymmetry implies that the variance goes up more after negative news than after positive news. we also observed that the beta coefficient for basic material and industries is quite low as compare to the other sectors those have beta coefficient more than 0.90. we conclude that the sectors which response more towards good news (volatility decrease more than other such as basic material and industries) has lower beta. the time period required for shocks to reduce to one half of the original size defined as ln 0.50 ln is approximately 7.96 days for kse100 index, 22.88 days for food and beverages and lower one of 1.25 days for basic material sector index. this is an indication that the shock persist is 7.96, 22.88 and 1.25 days for kse100, food and beverage and basic material sector index respectively. a shorter lasting persistence of shocks in the conditional variance implies more volatility. the extent to which negative innovations increase volatility more than positive innovation is defined as | 1 | 1 , about 1.10 times for kse100 index, 1.43 which is uppermost in all the sectors is for basic material and lowest if for 0.99 times for auto and parts sector index respectively. asymmetry effect of 1.43 means, that the negative impact is 1.43 times more than the positive impact on the basic material asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 307 sector index. 5. conclusion pakistan is facing political uncertainty right from the beginning. after the death of the founder quaid-i-azam muhammad ali jinnah, there is struggle of government between the democratic parties and the military. army always tried to get benefit of enjoy the government whenever there is conflict between the democratic parties. this is the reason that more than half of the years since the independence, the government is ruled by the dictators. this study examined the impact of political uncertainty on stock exchange. we studied the effect of political news on the stock market returns and volatility. for this, we split the political news into two categories (good and bad news). . generally speaking, good news has positive effect on returns and decreases the volatility. where as bad news decreases the returns and increases the volatility. furthermore bad news increases volatility more than the good news. we used the daily data for eighteen years from karachi stock exchange to examine the affect of political news on the stock market. additionally this also helped us to identify which sector responds more to the political news. we used univariate asymmetric garch model, to gauge the impact of political news on the returns and volatility. we specifically used egarch proposed by engle and victor (1993) as it allows good news and bad news to have different impact on volatility while standard garch model does not. our results demonstrate that the good news has positive effect on the returns of the kse100 index and good news also decreased the volatility. on the other hand, bad political news has negative effect on the returns (decrease the returns) and increase the volatility (positive effect), which in the line of engle and victor (1993) results specifying that bad and good news have different impact on volatility. furthermore our results also confirm that bad news have more effect (almost double) effect on the volatility than the good news, such results are consistent with laakkonen and lanne (2008). most of the sector results are also affected by the good and bad news. .financial, auto and parts sector show more positive returns on good political news as compared with other sectors, which make clear that they react more to positive news with respect to others. same is the case with volatility the response towards good news dummy is more significant and higher in the case of basic material industries with respect to other sectors. bad political news affected more on the returns of financial and basic material. moreover, bad news has more impact on the volatility of basic material and financial sector as compare to other sectors. we also find that a small number of sectors are not statistical significant for good and bad political news, means these type of news do not affect the returns or volatility. good news has no impact on the volatility of oil and gas and financial sector. however, the influence of bad political news is also not statistically significant for the returns of health care such results are consistent with suleman (2012). furthermore, we did not find significant statistic of the impact of bad political news on industries and health care. we also reported the volatility asymmetry, which is negative in most of the sectors including the kse 100 which is due to the leverage effect. furthermore, persistence parameter beta is also reported, which is very large in most of the selected sectors including kse 100 which indicate that variance move slowly through time. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 308 this study could be extended by including more news such as, economic, military and neighboring countries. moreover, analysis can be done on the industry level. we can also examine the impact of these news on individual stock or on portfolios. furthermore we can use more countries in our data such as south asian countries and test the impact of one country’s political news on the other. for this we may employ multivariate egarch model for studying the volatility. acknowledgement author would like to thank professor johan knif , kenneth högholm, mujahid hussain, sheraz ahamad and hilal butt for useful comments and suggestions. references beaulieu, m. c, cosset, j. c. & essaddam, n. 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(2002). information effect of economic news: spi futures. international review of financial analysis, 11, 467-489. http://dx.doi.org/10.1016/s1057-5219(02)00065-0 notes note 1. pakistan political stability – harvard –belfer center for science and international affairs. note 2. this is for both good and bad news. note 3. the main sources are: the news, nation, dawn newspaper and bbc. note 4. pakistan people’s party, pakistan muslim league. asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 310 table 1. descriptive statistics kse100 oil & gas financial basic material utilities food & beverage industries health care auto & parts mean 0.0004 0.0007 0.0005 0.0005 0.0001 0.0002 8.21e0.0003 0.0004 maximum 0.1276 0.0799 0.599 0.4666 0.10 0.1418 1.6618 0.0804 0.1882 minimum 0.1321 0.0799 -0.665 0.492 0.10 0.1464 1.6239 0.0804 0.1759 std. dev. 0.0162 0.0187 0.0246 0.0203 0.0233 0.0182 0.0416 0.0176 0.0277 skewness 0.317 0.0446 -1.012 -0.4159 0.0373 0.0492 0.5875 0.3459 0.3208 kurtosis 8.6203 6.1956 198.04 139.56 6.8598 11.388 1060.9 6.7652 8.0187 jarque-bera 6243.6 1963.58 73098 35834 2863.4 13521 2.15e+ 2815.8 4918.3 probability 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 ac return 0.022 0.018 0.001 0.001 0.011 0.008 0.013 0.000 0.000 ac sq. return 0.198 0.293 0.239 0.488 0.268 0.234 0.281 0.301 0.153 observation 4686 4162 4162 4162 4162 4162 4162 4162 4162 note. the jarque-bera statistics is computed from the following equation; 6 3 4 where n is the number of observations, s the skewness and k the kurtosis. the hypotheses for the jb-test are: h0 = normal distribution h1 = no normal distribution asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 311 ac (10) residual 0.020 0.016 0.013 0.033 0.029 0.004 0.020 0.057 0.046 ac (10) squared residual 0.003 0.003 0.004 0.001 0.022 0.011 0.001 0.004 0.004 notes: this table reports the estimates from the following arma egarch model: rkse, rkse, θ εkse, dummy εkse, log , , , log , we report the estimates for arma egarch return and volatility for kse 100 index and other selected indexes. the coefficients measuring the effect of dummy variable used as a proxy for the good political news on karachi stock markets’ returns and volatilities are also reported. significant coefficients are denoted with***, **, * on 1%, 5 %, and 10 % significance level respectively. residual autocorrelation coefficients at 10th lag ac (10) for both simple and squared standardized residuals are also reported. table 2. estimation results from arma egarch with good news kse 100 oil and gas financial basic material utilities food and beverages industries health care auto and parts 0.0007** 0.001*** 0.0010** 0.001*** 0.0008** -0.000291* -0.00068** 0.0005** 0.0006** 1.0090*** 0.921*** 1.069*** 0.4353** 0.895*** 1.0213*** 0.9780*** 0.281*** -0.68*** 0.8963*** -0.86*** -0.96*** -0.380** -0.86*** -0.9333*** -0.9801*** -0.1771 0.737*** 0.0072*** 0.007*** 0.010*** 0.0063** 0.0084** 0.00599** 0.00807** 0.0038** 0.0092** 0.903*** 0.87*** 1.43*** 3.56*** 0.86*** 0.401*** 2.336*** 0.78*** 1.21*** 0.3058*** 0.267*** 0.301*** 0.416*** 0.236*** 0.2372*** 0.2952*** 0.290*** 0.265*** 0.051*** -0.03*** 0.08*** -0.16*** 0.024** 0.034*** 0.066*** 0.021** 0.003266 0.9198*** 0.915*** 0.847*** 0.589*** 0.908*** 0.9706*** 0.7219*** 0.930*** 0.856*** 0.11474* 0.037254 0.061050 0.255** 0.1102* 0.0981** 0.215*** 0.144** 0.05912 asian journal of finance & accounting issn 1946-052x 2012, vol. 4, no. 1 www.macrothink.org/ajfa 312 table 3. estimation results from arma egarch with good news kse 100 oil and gas financial basic material utilities food and beverages industries health care auto and parts 0.0005* 0.001*** 0.001*** 0.0021*** 0.001312*** 0.000164 3.98e-05 0.0006*** 0.0007* 1.030*** 0.930*** 0.969*** 0.47668** 0.868454*** 0.6183*** 0.986*** 0.59463* 0.93*** -0.908*** 0.87*** 0.86*** 0.422269*** 0.8455*** 0.707817*** 0.9840*** 0.70063** 0.994*** 0.011*** 0.01*** 0.01*** 0.014795*** 0.0120*** 0.0091*** 0.0067** 0.000942 0.01*** 0.942*** 0.89*** 1.56*** 3.719236*** 0.8751*** 0.4059*** 1.767*** 0.800*** 1.37*** 0.3107*** 0.271*** 0.321*** 0.432867*** 0.237518*** 0.233812*** 0.2542*** 0.2938*** 0.280*** 0.054*** 0.03*** 0.08*** 0.175501*** 0.0258*** 0.0343*** 0.055*** 0.0228** 0.003696 0.9165*** 0.914*** 0.833*** 0.573164*** 0.907792*** 0.970159*** 0.7924*** 0.9293*** 0.836*** 0.2578*** 0.1051** 0.492*** 0.600746*** 0.079643* 0.078952* 0.039800 0.018243 0.11452* ac (10) residual 0.020 0.016 0.013 0.032 0.029 0.021 0.015 0.057 0.046 ac (10) squared residual 0.005 0.003 0.006 0.001 0.020 0.009 0.002 0.005 0.004 notes: this table reports the estimates from the following arma egarch model: rkse, rkse, θ εkse, dummy εkse, log , , , log , we report the estimates for arma egarch return and volatility for kse 100 index and other selected indexes. the coefficients measuring the effect of dummy variable used as a proxy for the bad political news on karachi stock markets’ returns and volatilities are also reported. significant coefficients are denoted with***, **, * on 1%, 5 %, and 10 % significance level respectively. residual autocorrelation coefficients at 10th lag ac (10) for both simple and squared standardized residuals are also reported. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 239 the availability, extent and quality of sustainability reporting by malaysian listed firms: subsequent to mandatory disclosure hafizah abd-mutalib (corresponding author) senior lecturer, department of commerce sultan abdul halim mu‟adzam shah polytechnic, jitra, kedah, malaysia e-mail: hafizah.mutalib@yahoo.com che zuriana muhammad jamil associate professor, school of accountancy, college of business universiti utara malaysia, sintok, kedah, malaysia wan nordin wan-hussin professor, othman yeop abdullah graduate school of business universiti utara malaysia, sintok, kedah, malaysia received: august 9, 2014 accepted: oct. 7, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6108 url: http://dx.doi.org/10.5296/ajfa.v6i2.6108 abstract the purpose of this study is to examine the availability, extent and quality of sustainability reporting (sr) by malaysian firms subsequent to the mandatory disclosure. based on an across-industry sample of 300 firms in 2011, the results indicate that despite the mandatory disclosure, 3% of the sampled firms failed to make such reporting. furthermore, in both aspects of extent and quality, human-related sustainability engagement, which consists of the workplace and community themes are found to be the favorite themes to be reported. meanwhile, firms in the infrastructure, finance and plantation industries perform the best of extent and quality of sr, while firms in hotel industry marks the poorest in quality and lowest in extent of sr. keywords: sustainability reporting, malaysia, extent, quality mailto:hafizah.mutalib@yahoo.com asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 240 1. introduction the term “sustainability” has become one of the important idioms in the business vocabulary. the world commission on environment and development (1987), states that “sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs”, as such, the principles of sustainability is to ensure that our actions today do not limit the range of economic, social and environmental options open to future generations (elkington, 1997). sr may be interchanged with many other terms, such as corporate social responsibility (csr), which refers to the voluntary actions taken by a company to address economic, social, and environmental impacts of its business operations and the concerns of its principal stakeholders (christensen, peirce, hartman, hoffman, & carrier, 2007), or triple bottom line (tbl), a concept that expresses the idea that business firms or other organizations create value in multiple dimensions, which are in the economic, social and environmental value added (elkington, 2006). despite the various terms associated to sustainability, the ultimate focus is the same, which is to preserve the current world condition for the benefit of future generations through fulfilling the needs of not only the shareholders, but also the stakeholders as well, by complementing the financial performance with environmental and social commitments. the engagement to sustainability activities is seen as an important agenda to be considered as such engagement may result in the sustainability of not only the business firms, but also the sustainability of the environment in which they operate. the world today has witnessed the massive destructions on the environment which ends up with environmental disasters and human-related issues such as child-labour and workplace discrimination which resulted from the lack of commitments to preserve sustainability by business firms. in order to cope with such issues, sustainability engagement has become a vital plan in dealing with such matters. in malaysia, one of the commitment posed by the government towards sustainability engagement is to require such engagement to be disclosed in the annual reports by malaysian listed firms (ministry of finance, 2006). this requirement has also been gazetted in the bursa malaysia listing requirements under appendix 9c, para 29, as such, starting from the year 2007, every malaysian listed firm needs to disclose their sustainability or csr activities in their annual reports. the purpose of this study is to examine the availability, extent and quality of sr by malaysian listed firms in 2011, which marks 5 years subsequent to the mandatory disclosure. prior to the mandatory disclosure, the level of sr by malaysian firms are not extensive (teoh & thong, 1984), plus poor in quality and low in quantity (thompson & zakaria, 2004). furthermore, malaysian firms are found to concentrate on the philanthropic and public relations aspects of sustainability engagement (lu & castka, 2009), and least in environmental engagement (thompson & zakaria, 2004). the reporting also concentrates on reporting good news on sustainability commitments (haron, yahya, manasseh, & ismail, 2006; nik ahmad, sulaiman, & siswontoro, 2003; thompson & zakaria, 2004), which implies that sustainability reporting is more for improving corporate image (nik ahmad, et al., 2003). with respect to the location for reporting, there is no specific location identified, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 241 where most firms report in the chairman‟s statement and operations review (nik ahmad, et al., 2003). additionally, the nature of reporting is merely narrative or a declarative statement (haron, et al., 2006; nik ahmad, et al., 2003). one of the reasons for the poor performance of sr is due to lack of legislations and regulations on sustainability disclosure (teoh & thong, 1984; thompson & zakaria, 2004), thus it is crucial to examine if the sr requirement put forth by the malaysian government and bursa malaysia starting in the year 2007, may enhance the level of sr by malaysian listed firms. despite the numerous studies done to determine the availability of sr by malaysian firms (muhammad jamil, alwi, & mohamed, 2003; nik ahmad, et al., 2003; teoh & thong, 1984; thompson & zakaria, 2004), the results refer to the availability of sr prior to the mandatory disclosure, while studies that refer to the period subsequent to the mandatory disclosure has concentrate on large size firms (zainal, zulkifli, & saleh, 2013). prior research has also focus on certain industries, for instance, finance industry (abdul rahman, md hashim, & abu bakar, 2010; singh, yahya, amran, & nabiha, 2009), non-financial industries (haniffa & cooke, 2005; janggu, joseph, & madi, 2007; kasim, 2007; mohd ghazali, 2007), and concentrates to environmental engagement (kasim, 2007; othman & ameer, 2010; smith, yahya, & amiruddin, 2007). moreover, past researches have either use the extent measurement, whether by words (haniffa & cooke, 2005) and by sentences (abdul rahman, et al., 2010; amran & devi, 2007; janggu, et al., 2007) or quality measurement (saleh, zulkifli, & muhamad, 2010, 2011) for sr. to compliment these prior researches, the current study provides relevant input in these four contributions: (1) using a more recent data, which is the sr in the 2011 annual reports; (2) examine the availability of sr by malaysian firms subsequent to the mandatory disclosure, where limited evidence has been found; (3) across-industry sampling and analysis; and (4) measurement of sr in four focal themes, which are the environment, workplace, marketplace and community themes, using both the extent and quality measures. the rest of the paper progresses as follows. the next section reviews the related literature on sr reporting in malaysia. this is followed by the methodology, and the findings are discussed thereafter. the concluding remarks summarize the main results, highlight the study limitations and suggest avenues for future research. 2. literature review 2.1 sustainability the term “sustainability” is connected to the classic definition of “sustainable development” by world commission on environment and development (1987), which states that “sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs”. the principle of sustainability is to ensure that our actions today do not limit the range of economic, social and environmental options open to future generations (elkington, 1997). from the notion of sustainability, emerged other related terms; where among the most popular terms are tbl and csr. the former expresses the idea that business firms or other organizations create value in multiple dimensions, i.e., in economic, social and environmental dimensions asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 242 (elkington, 2006), while the latter refers to the voluntary actions taken by a company to address economic, social and environmental impacts of its business operations, and the concerns of its principal stakeholders (christensen, et al., 2007). besides tbl and csr, sustainability also refers to social responsiveness, social performance, public policy, csp, business ethics or stakeholder management (carroll, 1991; mohammed, alwi, & muhammad jamil, 2009). from the perspective of accounting, sr, which is also known as tbl or csr reporting, generally refers to a reporting framework that highlights three important areas, i.e., the economic, environmental and social performance of an organization, in addition to its financial performance (choudhuri & chakraborty, 2009). global reporting initiative (gri), a prominent organization in the field of sustainability defines sr as the practice of measuring, disclosing, and being accountable to internal and external stakeholders for organizational performance towards the goal of sustainable development (global reporting initiatives, 2011), which is synonymous with other reports used to describe the economic, environmental and social impact, and consistent with tbl and csr reporting (global reporting initiatives, 2011). another sustainability leading organization, the association of chartered certified accountants (acca), provides similar definition of sr, i.e., the reporting of the economic, environmental and social impact of organizational performance (acca, 2005). from these definitions, it may be concluded that sr denotes the reporting of the economic, environmental and social performance of an organization, which is similar to other related reports by any other name. as a medium of communication between organizations and stakeholders, sr provides information on the sustainability commitments undertaken by firms, which makes the onus of producing sr, much as financial reporting, the responsibility of the corporate boards (elkington, 2006). in the malaysian context, sr is commonly referred to as csr reporting. bursa malaysia (2008) defines csr as the firms‟ “commitment to operate in an economically, socially and environmentally sustainable manner whilst balancing the interest of diverse stakeholders”. sustainability or csr reporting must be disclosed in annual reports of malaysian listed firms starting from the year 2007 (ministry of finance, 2006), where the reporting or disclosure should be made on four focal areas, namely the environment, the workplace, the marketplace and the community (bursa malaysia, 2006). thus, from the various explanations above, sustainability may be defined as the commitments undertaken by the corporate bodies in serving the rights of the stakeholders, which covers the non-financial aspects, such as the environmental and social commitments, with the intention to preserve a sustainable future. 2.2 the development of sr in malaysia numerous studies have been done to determine the level of sr by malaysian listed firms prior and subsequent to the mandatory requirement (abdul rahman, et al., 2010; haron, et al., 2006; janggu, et al., 2007; kasim, 2007; mohammed, et al., 2009; mohd aini & sayce, 2010; muhammad jamil, et al., 2003; nik ahmad, et al., 2003; saleh, et al., 2010, 2011; smith, et al., 2007; teoh & thong, 1984; thompson & zakaria, 2004; zainal, et al., 2013). in the preliminary stage, the sr by malaysian firms is not as extensive as its real practice asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 243 (teoh & thong, 1984), and shows the sign of poor in quality and low in quantity (thompson & zakaria, 2004). these situations may be associated to several reasons. the most important cause is due to the lack of legislations and regulations on sustainability disclosure (teoh & thong, 1984; thompson & zakaria, 2004). this is also supported by the lack of education on environmental and social responsibility (ramasamy & ting, 2004) during that period. apart from that, low disclosure is also being caused by the firms‟ perception that such disclosure does not incur much tangible benefits (teoh & thong, 1984; thompson & zakaria, 2004), such as its positive consequences on financial performance (ramasamy & ting, 2004), and lack of pressure from stakeholders (thompson & zakaria, 2004). despite the poor findings in previous studies, thomson and zakaria (2004) states that the situation of sustainability awareness and reporting are improving, which is supported by subsequent research which claims that the level of awareness of csr is high when 83% of the sampled malaysian plcs disclose their social performance (muniandy & barnes, 2010). saleh, et al. (2010) claims that the level of sr among malaysian firms are improving gradually between the year 2000 – 2005, while zainal, et al. (2013), who studied the level of sr in the pre and post period of mandatory disclosure reveals that 100% of the sampled firms have some sr whether by the extent (sentences count) or quality (csr index) measurement. however, the previous findings by muniandy and barnes (2010), saleh et al. (2010) and zainal et al. (2013) have focused on the firms with large size, or to be specific, top listed firms by market capitalization, which might be the reason of the improving sign of sr among the firms. firms with large sizes tends to have high sr (amato & amato, 2007; amran & devi, 2008; galbreath, 2011) due to greater public visibility and impact on society (teoh & thong, 1984), thus, they are more likely to engage to sustainability activities as a respond to public pressures (zainal, et al., 2013). past researches also reveals that malaysian firms tend to give emphasis to human-related sr, which involves the workplace and community themes (bursa malaysia, 2008; haron, et al., 2006; janggu, et al., 2007; nik ahmad, et al., 2003; saleh, et al., 2010; thompson & zakaria, 2004), and mainly directs to employees training, welfare and benefit and donations and charity activities. environmental theme has been acknowledged as the least theme to be reported, which may be influenced by industry types. for instance, environmental reporting has been extensively reported by firms in manufacturing, plantation and industrial products sectors, but less by other industries (bursa malaysia, 2008; saleh, et al., 2010) as the activities of the firms in these types of industry may have huge impact to the environment (amran & devi, 2008). however, despite the arguments that plantations industry put priority to environmental theme, othman and ameer (2010) reveals that environmental disclosure by firms in plantation industry is still low. furthermore, abdul rahman, et al. (2010) reveals that a firm in finance sector did not have any environmental disclosure in its annual reports for 14 years, indicating that firms in finance industry tend to neglect environmental commitments, which may be due to the perception that their operation do not give huge impact to the environment. despite the findings by abdul rahman, et al. (2010), singh, et al. (2009) points out that firms in finance industry do have environmental commitments although not as extensive as their social engagements. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 244 with relations to industry types, even though finance industry do not put forth the environmental engagement (abdul rahman, et al., 2010), they tend to have high level of sr as they have the tendency to be more prudent and conscious (abdul rashid & ibrahim, 2002) besides being heavily regulated and under the purview of bank negara (central bank) (amran & devi, 2008). firms that give impact to the environment such as plantation industry also provide a high level of sr (amran & devi, 2008; saleh, et al., 2010), which is obviously concentrated to environmental commitments as this type of industry deals with issues relating to the environment. the least sr has been found in the hotel industry (haron, et al., 2006; saleh, et al., 2010), although earlier research by muhammad jamil, et al. (2003) reveals that 100% of the sampled firms in the hotel industry do have some sort of sr. 2.3 commitment to sustainability: the role of malaysian government the commitment of the malaysian government to sustainability development can be seen as encouraging. besides having sustainability agenda supplanted in three out of nine challenges in the vision 2020, which are the challenges to establish a moral and ethical community, to establish a fully caring culture and to ensure an economically just society, such agenda has also being put forward through the silver book, which objective is to promote sustainability awareness and to guide the sustainability activities and implementations among malaysian government-linked companies (glcs) and government-linked investment companies (glics) (putrajaya committee on glc high performance, 2006). in addition, to promote sustainability engagement among corporate firms, the malaysian government has imposed a mandatory disclosure of csr activities among bursa malaysia listed firms starting from the year 2007 (ministry of finance, 2006). this mandatory requirement has also been gazetted in bursa malaysia listing requirements under appendix 9c, para 29, and firms are encourage to report their csr activities based on four focal areas, namely the environment, workplace, marketplace and community. 3. methodology the population of study is the malaysian listed firms in the year 2011, with the financial year end of 31 december. by using the stratified random sampling technique, 300 firms from 11 industries (excluding the mining industry, which has a zero population during the period under study) are selected as samples. the justification for this action is due to previous findings where it is found that industry types may influence the level of sr. for instance, firms in the manufacturing, plantation and industrial sectors tend to focus more information on the environmental theme of sr as these industries are more involve in environmental impact (amran & devi, 2008; bursa malaysia, 2008), while firms in the finance industry may be more positive towards sr as they tend to be more prudent and conscious (abdul rashid & ibrahim, 2002). as such, by stratifying the listed firms in accordance to their industry before the sampling process will provide a more reliable set of samples. the details of the population and samples for this study are explained in table 1. sr activities from the sampled firms‟ annual reports are the data used for this study. the annual reports are the type of report that is obtainable, as all firms established under the company‟s act 1965 are required to produce such report; and accessible, as this type of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 245 report may be accessed through bursa malaysia website; as such other type of reports such as stand-alone sustainability reports, firms‟ csr bulletin and press releases has been ignored from this study. sr activities are captured in four focal areas, which are the environment (ev), workplace (wp), marketplace (mp) and community (cm) themes as outlined by bursa malaysia. in order to make the findings more specific, each theme is segregated into different dimensions, where the ev and wp themes contain 8 dimensions each, while the mp and cm themes, both have 7 dimensions. overall, 30 different dimensions are utilized in this study. table 1. population and sample industry population sample percentage construction (cons) 23 13 4.3 consumer product (cp) 69 39 13.0 finance (fin) 20 11 3.7 hotel (hot) 4 2 0.7 industrial product (ip) 154 86 28.7 infrastructure (inf) 4 2 0.7 mining (min) 0 0 0.0 plantation (plt) 25 14 4.7 property (prop) 44 25 8.3 real estate investment trust (reit) 11 6 2.0 technology (tech) 58 32 10.7 trading and services (ts) 126 70 23.3 total 538 300 100.0 in measuring the sr activities, this study implements 2 types of measurements, which are the quality of reporting (qual) and the extent of reporting (ext). qual seeks to evaluate the quality of disclosures by using the quality index, where the aim is to distinguish between the poor and excellent disclosure of items (hooks & van staden, 2011). for the purpose of this study, a 4-point index with the scale of 0 – 3, which has been used in previous research (hoq, saleh, zubayer, & mahmud, 2010; saleh, et al., 2010, 2011; zainal, et al., 2013) is utilized. a score of 0 denotes a non-disclosure, 1 for general qualitative disclosure, 2 for qualitative disclosure with specific explanations, and 3 for quantitative data. accordingly, the quality index is derived by computing the ratio of the total scores to the maximum score attainable, with the following formula: qualsrj = ij nj asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 246 where qualsrj = quality of csr for jth firm. nj = total number of items estimated for jth firm, with maximum score assigned. xij = the score of 3 for the ith item if quantitative data is disclosed, the score of 2 for the ith item if qualitative data with specific explanation is disclosed, the score of 1 for the ith item if general qualitative data is disclosed and the score of 0 for the ith item if there is no disclosure. by utilizing this formula, firms that achieve maximum score for each theme may have the maximum index score of 1. while qual aims to distinguish between the poor and excellent disclosure of items (hooks & van staden, 2011), the extent of reporting (ext) seeks to evaluate the disclosure in term of “how many”, thus this study adapts the number of sentences in determining the quantity of sr. this method is justified as a more reliable method; as a complete sentence makes better sense compared to counting the words (milne & adler, 1999). however, counting for sentences alone is not enough as this may omit information that may be generated from tables, pictures, graphs and charts. however, these flaws are corrected by taking 15 words in a table or the captions on the graphs, charts and pictures as equal to one sentence (hooks & van staden, 2011). 4. findings the malaysian listed firms are required to disclose their sr activities in the annual report starting from the year 2007 (ministry of finance, 2006), where this requirement has been gazetted in bursa malaysia listing requirements under appendix 9c, para 29. as the mandatory disclosure being imposed, it is being expected that 100% of the sampled firms will have such reporting. however, contrary to the expectation, several firms do not comply with this requirement, where 9 firms fail to do so, comprises of 1 firm in consumer product (cp) industry, 5 firms in industrial product (ip) industry, 2 firms in real estate investment trust (reit) industry and 1 firm in the trading and services (ts) industry. although the percentage is small, which is only 3%, this situation explains that despite having the regulation on the sr activities mandatory disclosure, still there are firms which do not take the matters of the disclosure seriously. moreover, when across-industry analysis is done, the result reveals that 33% of firms in reit industry do not incorporate sr in their annual report. table 2 depicts the result of sr availability in the annual reports of the sampled firms. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 247 table 2. sustainability reporting availability frequency percent not available 9 3.0 available 291 97 total 300 100.0 availability industry samples available % not available % construction (cons) 13 13 100 0 0 consumer product (cp) 39 38 97 1 3 finance (fin) 11 11 100 0 0 hotel (hot) 2 2 100 0 0 industrial product (ip) 86 81 94 5 6 infrastructure (inf) 2 2 100 0 0 mining (min) 0 0 100 0 0 plantation (plt) 14 14 100 0 0 property (prop) 25 25 100 0 0 real estate investment trust (reit) 6 4 67 2 33 technology (tech) 32 32 100 0 0 trading and services (ts) 70 69 99 1 1 total 300 491 9 in determining the quality and extent of disclosure (refer to table 3. descriptive statistics), the results indicate that the minimum score for qual and ext is 0, which may be explained by 3 situations. firstly, it is due to the totally lack of sr disclosure by respective firms in the year under study. secondly, the sr disclosure exists; however, the disclosure is too general to be interpreted in accordance to the four specific themes and thirty dimensions. for instance, one of the firms states that “the group will continuously explore, identify and act on social issues which are relevant” – bld plantations berhad, which do not give any picture as to which theme or dimension that this disclosure should be assigned to. thirdly, the sr disclosure exists, however, the disclosure points out that no such activities has been undertaken for the particular years, for instance, “we have not been involved or undertaken any corporate social responsibility activities or practices...” – amanah harta tanah pnb or “during the financial year, no activity was conducted by the group in relation to the corporate social responsibility” – naim indah corporation berhad. the maximum score for the quality index (qual) was 0.84 while for ext, the maximum sentences disclosed was 1,055.4 sentences. overall, the mean for qual amounted to 0.1450, while the mean for ext was 42.418 sentences. the findings indicates that in terms of quality, the disclosure may be considered as weak in quality as the average quality index score is only 0.1450 points, compared to the overall quality score of 1.00 points. however, in terms of the extent of disclosure, the sampled firms show an increasing number of sentences disclosed, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 248 with 42.418 sentences on average, compared to only 20.14 sentences in the year 2000 annual reports (nik ahmad, et al., 2003). by separate themes, the mean for quality index, qual for ev theme amounted to 0.1197, wp with 0.1617, mp with 0.0946 and cm with 0.2052. the mean ext score for ev theme showed 8.354 sentences, wp with 14.402 sentences, mp with 7.723 sentences, while cm theme with 11.938 sentences. from these findings we may observe a few points. firstly, after about 5 years of mandatory csr disclosure by malaysian listed firms, the themes that are most disclosed whether by quality or extent are the workplace and community themes. however, by comparing between the two measurements, the wp theme marks the highest extent of reporting but came second in the quality reporting, and vice versa to cm theme, which marks the best in quality and second in the extent. for the other two themes however, the findings indicate that ev theme and mp theme marks the third and last place in both measurements of csr activities disclosure. these findings explain that malaysian firms put emphasis on the “people” related sr activities, which may be viewed in both wp and cm themes, but less on the ev and mp themes, and is more likely to be the same with previous research prior to the mandatory years of sr disclosure (nik ahmad, et al., 2003; thompson & zakaria, 2004; haron, et al., 2006; janggu, joseph, & madi, 2007; bursa malaysia, 2008). although there is some reporting for each theme, the findings also reveal that the quality of reporting may be considered as poor. this may be explained by the maximum score which may be achieved by each firm in accordance to the separate themes. for instance, the maximum quality index score for each theme which may be achieved is 1, but the sampled firms just manage to achieve 0.1197 for ev, 0.1617 for wp, 0.0946 for mp and 0.2052 for cm, which shows that the firms under study may only disclose csr activities in a small number of dimensions or may be due to the disclosure of general statements for each dimensions, which results in the low quality index score. further analysis is done to determine the quality and extent of sr according to specific dimensions (refer table 4). the findings reveal that there is not much difference in results using the two measurements. for instance, in the ev theme, the most disclosed dimension, whether in term of quality or extent are the environmental conservation, environmental campaign and effective usage of energy and resources. the highest point in both measurements by the environmental conservation and environmental campaign dimensions depicts that firms prefer more or inclined to the outside csr activities, such as tree planting, river cleaning and also involving themselves with the communities such as giving environmental talk to the communities and participating in the communities‟ earth and environmental campaign such as the “earth hour”. in the wp theme, the most reported dimensions are the employee welfare and benefit, employee training and education and employee safety and health, in both measurements. employee training is positively related to organizational commitments (brammer, millington, & rayton, 2007), which explains why firms put priority to training and education, thus securing their best talents, which in the end, may give impact to firms‟ performance. by securing the employees‟ welfare, benefits, safety and health, firms may also secure their asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 249 subordinates from moving to other companies, which will be a waste in term of staff turnover, as this may involve losing skilled employees to other companies. table 3. descriptive statistics quality of reporting (qual) minimum maximum sum mean std. deviation ev 0.0 0.83 35.92 0.1197 0.1679 wp 0.0 0.83 48.50 0.1617 0.1733 mp 0.0 0.86 28.38 0.0946 0.1540 cm 0.0 0.95 61.57 0.2052 0.2065 total qual 0.0 0.84 43.50 0.1450 0.1550 extent of reporting (ext) minimum maximum sum mean std. deviation ev 0.0 221.8 2506.1 8.354 22.7810 wp 0.0 274.2 4320.7 14.402 34.4444 mp 0.0 449.7 2317.0 7.723 30.6514 cm 0.0 147.2 3581.5 11.938 21.3881 total ext 0.0 1,055.4 12,725.3 42.418 97.5773 ev = environment wp= workplace mp = marketplace cm = community qual = quality of reporting ext = extent of reporting the same situation goes with the cm theme, where both measurements marks the charity programs, donations programs and training, education and scholarship dimensions to be the best reported both in term of quality and extent. the findings indicate that firms tend to be inclined to the activities that involved the act of „giving‟ to the communities compared to other csr activities such as providing job opportunities to the local communities. in the mp theme, the result shows that the product and service quality dimension portrays to be the best of quality and extent of sr. the good disclosure for product and service quality dimension may be due to the impact that it might bring to the performance of the firm. if a firm manages to give good reputation for its products or services, the firm may achieve a long-term superior performance. therefore, firms tend to give priority to their product and services quality compared to other dimensions in the mp theme. firms also put priority to their customer services, which may be observed through the second highest disclosure in the number of sentences, as customer services, particularly the “after-sales services” may influence the customers or consumers to come back and do business again with the respective firms, which in the long-run, will also improve firms‟ performance. a more interesting finding from this study is that firms were interested in stakeholder engagement, where this dimension marks the second best disclosure in quality. again, this shows that firms nowadays are concerned to open their door to the stakeholders, as they are more open to accepting visits whether from the government officials, students and ngos, and at the same time conduct meetings with the stakeholders to understand their needs and expectations. another interesting point is that firms tend to disclose more on the certifications and award achievements related to the mp theme. this may be due to the reputation which may be asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 250 gained through such disclosure, as stakeholders may perceive that firms which are high achievers in respective areas may provide the best of product or services. further analysis is to determine if the quality and extent of csr varies according to industry type. by referring to table 5, the findings of this study revealed that the firms in infrastructure industry (inf) marked the highest in qual of sr with the quality index mean of 0.489, followed by finance industry (fin) with the mean score of 0.306 and plantation industry (plt) with 0.256. the poorest disclosure in qual is pointed to the firms in hotel industry (hot) with the quality index mean score of 0.050. with regards to the extent of csr, the result indicated the same outcome as in the quality of reporting, where the inf industry seemed to dominate the extent of reporting, with the mean of 544.2 sentences. the second in line are the firms in the fin industry with the mean of 135.05 sentences in 2011, followed by plt industry with the mean of 101.08 sentences. as for the lowest sr quantity, firms in the hot industry marks the weakest with the mean of only 6.5 sentences. by separate themes, in term of quality of reporting (qual), inf industry depicts the highest quality index score for 3 out of 4 themes covered in this study, which are the ev, wp and the mp themes, and becomes second in the mp theme after the fin industry. plt industry marks the second place with good quality and high in quantity of sr for ev theme, and third place in the other three themes (wp, mp and cm), while fin industry secures the position of firms that disclose the most excellent quality of reporting in the cm theme, second in wp and mp themes, and third in the ev theme. in term of the extent of reporting (ext), firms in inf industry depict the highest extent of sr in all 4 themes, plt industry marks the second place ev theme, while in the other three themes, fin industry performs better quality and extent of csr compared to plt. the firms in hot industry disclose the poorest level in quality and extent of sr in the ev and wp themes, plus second poorest quality in mp theme and second poorest extent in mp theme. firms in ip industry marked the poorest in quality for cm theme, while reit industry marked the lowest extent of sr for mp theme. 5. discussions and conclusions, limitations and future research the first objective of this study is to examine the availability of sr among malaysian listed firms. as the mandatory disclosure of sr being imposed on malaysian listed firms in their annual reports, it is being expected that all firms under study will exhibit some sort of sr. the results however indicate that despite having mandatory policy on such disclosure, 3% (9 firms) of the sampled firms do not have sr in their annual report, which consists of 5 firms in the industrial product, 2 firms in the reit and 1 firm in both consumer product and trading and services industry. the interesting point is that 33% of firms in the reit industry do not incorporate sr in the annual report. the situation might be due to the low level of holdings by institutional investors in the reit industry firms (newell, ting kien, & acheampong, 2002), as previous studies identified that the presence of institutional investors in a firm‟s shareholding structure may enhance sr (amran & devi, 2008; coffey & fryxell, 1991; oh & chang, 2011; said, zainuddin, & haron, 2009). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 251 table 4. descriptive statistics according to themes and dimensions qual ext min max sum mean sd min max sum mean sd environment (ev) waste management and disposal 0.00 1.00 34.67 0.116 0.242 0.00 24.7 227.4 0.758 2.614 pollution and emission control 0.00 1.00 27.33 0.091 0.233 0.00 56.3 210.3 0.701 3.726 reusing and recycling 0.00 1.00 33.67 0.112 0.227 0.00 11.0 182.5 0.608 1.503 effective usage of energy and resources 0.00 1.00 39.00 0.130 0.263 0.00 55.4 421.6 1.405 5.186 prevention and reparation program 0.00 1.00 22.67 0.076 0.213 0.00 42.3 263.0 0.877 3.973 environmental conservation 0.00 1.00 59.33 0.198 0.289 0.00 156.1 688.0 2.293 10.036 environmental campaign 0.00 1.00 40.00 0.133 0.281 0.00 45.0 335.8 1.119 4.138 certification and awards achievement 0.00 1.00 30.67 0.102 0.245 0.00 18.0 177.5 0.592 1.999 total env 0.00 0.83 35.92 0.120 0.168 0.00 221.8 2,506.1 8.354 22.781 workplace (wp) employee training and education 0.00 1.00 86.00 0.287 0.318 0.00 73.3 932.0 3.107 7.6476 employee health and safety 0.00 1.00 79.33 0.264 0.318 0.00 110.8 1086.0 3.620 10.570 employee welfare and benefits 0.00 1.00 93.33 0.311 0.342 0.00 67.3 1101.3 3.671 8.512 share options for employees 0.00 1.00 24.33 0.081 0.269 0.00 18.6 119.3 0.398 1.687 employee development and recognition 0.00 1.00 51.00 0.170 0.307 0.00 66.1 602.1 2.007 7.229 freedom of voice, communication channel 0.00 1.00 24.00 0.080 0.222 0.00 24.3 194.7 0.649 2.577 discrimination, child labour and corruption 0.00 1.00 15.33 0.051 0.184 0.00 44.3 180.8 0.603 3.656 certification and awards achievement 0.00 1.00 14.67 0.049 0.170 0.00 26.3 104.5 0.348 2.038 total wp 0.00 0.83 48.50 0.162 0.173 0.00 274.2 4,320.7 14.402 34.444 marketplace (mp) product development 0.00 1.00 22.33 0.074 0.223 0.00 53.1 253.8 0.846 4.045 product safety 0.00 1.00 6.33 0.021 0.119 0.00 61.0 96.8 0.323 3.697 product and service quality 0.00 1.00 48.00 0.160 0.289 0.00 95.4 528.3 1.761 6.605 customer services 0.00 1.00 18.67 0.062 0.204 0.00 153.8 513.7 1.712 12.499 stakeholder engagement 0.00 1.00 45.67 0.152 0.270 0.00 45.8 415.4 1.385 4.176 certification and awards achievement 0.00 1.00 41.00 0.137 0.273 0.00 38.7 424.9 1.416 5.207 customer and supplier training 0.00 1.00 16.67 0.056 0.192 0.00 9.0 84.1 0.280 1.149 total mp 0.00 0.86 28.38 0.095 0.154 0.00 449.7 2,317.0 7.723 30.651 community (cm) donations programs 0.00 1.00 98.33 0.328 0.390 0.00 50.0 623.7 2.079 5.047 job opportunity 0.00 1.00 19.33 0.064 0.203 0.00 39.8 132.2 0.441 2.565 public projects 0.00 1.00 66.33 0.221 0.3653 0.00 34.8 580.2 1.934 4.935 training, education and scholarships 0.00 1.00 80.33 0.268 0.380 0.00 83.2 751.6 2.505 7.072 charity programs 0.00 1.00 123.00 0.410 0.389 0.00 46.1 1,201.8 4.006 7.062 certification and awards achievement 0.00 1.00 9.67 0.032 0.150 0.00 24.0 65.1 0.217 1.605 sports and cultural activities 0.00 1.00 34.00 0.113 0.282 0.00 32.0 226.9 0.756 2.813 total cm 0.00 0.95 61.57 0.205 0.207 0.00 147.2 3,581.5 11.938 21.388 grand total 0.00 0.84 43.50 0.145 0.155 0.00 1,055 12,725 42.418 97.577 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 252 table 5. qual and ext across industry qual ext industry n ev wp mp cm qual total ev wp mp cm ext total construction (cons) 13 mean .093 .170 0.070 0.194 .132 5.231 8.892 3.100 10.654 27.877 sd .102 .134 0.114 0.149 .114 9.816 6.814 6.402 19.195 39.293 consumer product (cp) 39 mean .150 .173 0.120 0.238 .170 9.767 13.321 7.618 14.028 44.733 sd .162 .177 0.176 0.197 .149 19.772 33.318 16.383 20.940 84.626 finance (fin) 11 mean .182 .341 0.251 0.463 .306 12.882 53.291 29.782 39.091 135.045 sd .178 .231 0.246 0.239 .197 16.773 73.251 44.931 38.601 162.495 hotel (hot) 2 mean .021 .021 0.024 0.142 .050 .500 1.000 1.500 3.500 6.500 sd .029 .029 0.034 0.067 .039 .707 1.414 2.121 .707 4.950 industrial product (ip) 86 mean .096 .120 0.049 0.124 .098 4.316 6.319 1.814 4.564 17.013 sd .135 .116 0.102 0.147 .107 9.568 10.964 4.345 7.437 29.290 infrastructure (inf) 2 mean .521 .500 0.571 0.357 .489 109.650 139.600 229.850 65.100 544.200 sd .383 .354 0.404 0.236 .346 140.926 190.353 310.915 80.752 722.946 plantation (plt) 14 mean .260 .289 0.143 0.330 .256 33.721 37.843 11.671 17.843 101.079 sd .243 .233 0.188 0.226 .207 60.737 51.936 19.792 21.951 135.134 property (prop) 25 mean .085 .125 0.084 0.276 .140 5.200 7.460 4.636 15.020 32.316 sd .130 .165 0.136 0.253 .154 12.895 11.476 11.119 22.688 50.643 real est. inv. trust (reit) 6 mean .083 .063 0.024 0.159 .082 3.167 3.917 .500 7.250 14.833 sd .204 .153 0.040 0.194 .134 7.757 9.594 .837 10.490 26.969 technology (tech) 32 mean .065 .135 0.103 0.158 .114 2.312 9.522 4.878 6.231 22.944 sd .078 .159 0.131 0.160 .111 3.345 18.036 7.911 9.722 34.217 trading and services (ts) 70 mean .132 .180 0.101 0.221 .158 8.984 17.576 8.499 15.257 50.316 sd .202 .185 0.154 0.225 .174 18.265 37.627 21.966 25.828 95.318 total 300 mean .120 .162 0.095 0.205 .145 8.354 14.402 7.723 11.938 42.418 sd .168 .173 0.154 0.206 .155 22.781 34.444 30.651 21.388 97.577 the second objective of this study is to examine the extent and the quality of sr among malaysian listed firms. in term of quality, the results indicate that the quality sr by malaysian listed firms are still low with the quality index score of only 0.1450 compared to the overall index score of 1. however, in term of extent, the sampled firms scored a mean of 42.418 sentences. therefore, we may conclude that malaysian firms have the tendency to report, but, the content is rather limited to general information and qualitative information. with relations to the themes and dimensions reported, the results indicate that human-related sr which consists of the workplace and community themes, are the most to be reported, whether measured by extent or by the quality of reporting. the results are more or less the same with what was found in previous studies, where firms put more effort to engage in sustainability activities involving both themes (bursa malaysia, 2008; haron, et al., 2006; janggu, et al., 2007; nik ahmad, et al., 2003; saleh, et al., 2010; thompson & zakaria, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 253 2004). in the workplace theme, firms put priority to the employee welfare and benefits, followed by employee training and education and employee health and safety, while for community theme, charity programs become the most popular type of engagement, followed by donations program and training, education and scholarships. firms also show emphasis on the product and service quality dimension in the marketplace theme, and environment conservation dimension in the environment theme. the across-industry analysis reveals that firms in the infrastructure industry dominates sr the extent and quality of reporting in total, while firms in the hotel industry marks the poorest quality and lowest extent of sr. by separate themes, the firms in this industry performs highest in quantity in each theme and marks the most excellent of quality in environment, workplace and marketplace themes. these finding indicate that sr by firms in the infrastructure industry shows an improvement, as in previous studies by saleh (2009), conclude that infrastructure industry marked the second highest after plantation industry with relation to the quality of sr. the improvement in the quality and extent of sr by the firms in the infrastructure industry may be due its nature of greater exposure to risks (amran, rosli, & hassan, 2009), as such, more information may be demanded by the stakeholders, which may explain the act of disclosing the sr activities. firms in the finance industry depicts the second highest score in both quality and extent measures for total sr, highest in the quality of cm theme and in second place for quality and extent of wp and mp themes and extent of cm. this findings are consistent to previous studies, where prudent and conscious act by firms in finance industry (abdul rashid & ibrahim, 2002) and being heavily regulated and under the purview of bank negara (central bank) (amran & devi, 2008) seems the logical explanation for high level of sr. firms in the plantation industry, which receives the third highest score for quality and extent of sr marks the second highest score for ev theme by both measurements. this result indicates that firms in the plantation industry concentrate more to environmental theme of sr, which may be explained as their nature of activities which give great impact to the environment (amran & devi, 2008). the study is not without limitation. as the objective of this study is to examine the availability of sr in the annual reports subsequent to the mandatory disclosure, other types of disclosure such as stand-alone sustainability reports have been neglected. as such, future research may consider incorporating such reports to gauge the level of sr among malaysian firms. the findings from this study have also indicated that the lowest level of sr in both extent 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(2013). a longitudinal analysis of corporate social responsibility reporting (csrr) in malaysia public listed firms: pre-and-post-mandatory csrr requirement. international journal of advanced research in management and social science, 2(1). http://dx.doi.org/ http://dx.doi.org/ microsoft word 5291-19174-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 249 impact of overhead costs apportionment on selling price determination in malaysian automobile manufacturing industry kabiru isa dandago (corresponding author) visiting professor of accounting, school of accountancy, college of business universiti utara malaysia, 06010 uum sintok, kedah darrul aman, malaysia tel: 60-14-303-2297 e-mail: kidandago@gmail.com zulaikha rabitah zaidi school of accountancy, college of business, universiti utara malaysia 06010 uum sintok, kedah darul aman, malaysia e-mail: zulaikharabitahzaidi@yahoo.com received: march 15, 2014 accepted: april 28, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5291 url: http://dx.doi.org/10.5296/ajfa.v6i1.5291 abstract this study aims to examine the impact of overhead cost apportionment on selling price determination in the malaysian automobile manufacturing industry. specifically, the study looks at the treatment of overhead costs apportionment from the perspective of the profit making effort of automobile manufacturing firms. the methodology used is interview with staff of one automobile manufacturing company in malaysia taken as a case study: that is naza automotive manufacturing sdn. bhd. the findings of this study show that overhead costs apportionment has significant impact on the determination of “true and fair” selling price of an automobile manufacturing firm, especially as service centres are considered in primary apportionment before their shares are re-apportioned to production centres, using an appropriate method. this study, therefore, recommends that automobile manufacturing firms in malaysia should adopt the activity based costing method of overhead costs apportionment as it considers service centres of the company together with production centres in fair apportionment of overhead costs, taking into account the percentage of services enjoyed by the production centres from the service centres. this would allow room for fairly accurate asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 250 determination of total cost per unit of their products, which would ultimately lead to effective pricing decision. keywords: overhead costs, cost apportionment, activity based costing, selling price, automobile manufacturing industry asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 251 1. introduction there are two major types of costs involved in manufacturing firms: direct costs and indirect costs. direct costs are the costs which can be traceable physically and directly to a product or service; while the reverse applies for indirect costs. although they cannot be traced directly to the product or service itself, however, it is extremely important to ensure that indirect costs are apportioned accurately, as the amount significantly impacts on the pricing decision of a manufacturing business. manufacturing has been defined by business dictionary in the website (http://www.businessdictionary.com/definition/manufacturing.html) as “the process of converting raw materials, components, or parts into finished goods that meet a customer's expectations or specifications. manufacturing commonly employs a man-machine setup with division of labor in a large scale production”. thus, producing automobiles is a manufacturing activity since all the parts are to be combined by machine and labor; passing through a number of stages before producing the finished goods in the form of completed vehicles. overhead costs are usually closely related to the factory or production activities out of which goods are produced. but service/performance centres also incur overhead cost which cannot be directly attributed to a particular product. general overhead costs incurred in the course of the activities of production and service centres in a manufacturing firm are to be summed up for fair apportionment to all the centres, as a first step, and then the service centres’ shares re-apportioned to the production centres as a second step, using appropriate methods of primary and secondary apportionment of overhead costs. examples of overhead costs are water and electricity bills, safety and environmental costs, and insurance for the machinery and other fixed assets used in production. guy (1997: 228) explains that, “choosing the best method of overhead cost apportionment is a topic which has been dealt with many times in management accounting discourse by advocates of different methods which can be used by accountants and controllers to gauge margins and profits”. this supports the fact that the method used to apportion overhead costs plays a crucial role in influencing the pricing decision on a product and the overall performance of a firm, specifically a manufacturing firm that has to consider all costs incurred in determining the selling price per unit of its product. overhead costs apportionment is crucial for manufacturing companies from different perspective, especially for profit determination. the challenge of fairly apportioning overhead costs has become very important nowadays since overhead cost is a major player in determining the profitability level of manufacturing firms. this challenge includes adoption of the most suitable method to apportion overhead costs and how the apportionment of these costs will amount to optimum pricing decision and enhance the financial performance of the firm. traditionally, primary apportionment of overhead costs is done to all the cost centres (production and service/performance centres), using any of the numerous methods available. for fairness to be ensured, the shares of the service centres overhead costs are to be re-apportioned to the production centres or products based on the percentage services asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 252 rendered to them, using any of the secondary apportionment methods like direct method, continuous allotment method, step method, etc. as the indirect costs are fairly apportioned to production centres and ultimately to each unit produced, total cost per unit can now be determined since material and labour costs have already been traced. it is then that pricing decision could be scientifically made, taking into account the target profit to add to the total cost per unit and, of course, the acceptance of the selling price by the market. overhead costs apportionment, therefore, needs serious attention from manufacturing firms, especially those in export-oriented countries like malaysia. naza automotive manufacturing sdn. bhd. was selected for the study on treatment of overhead costs apportionment by automobile manufacturing firms in malaysia in view of the fact that the company bears all the characteristic features of firms operating in that industry. it is hoped that studying the impact of overhead costs apportionment on selling pricing decision in naza automotive manufacturing firm would throw light on how overhead costs are apportioned to all cost centres in the malaysian automotive industry. this would give room for suggestion on the most appropriate treatment of overhead costs in that industry for better pricing decision. this paper specifically examines the impact of overhead costs apportionment on selling price determination in the malaysian automotive industry. the paper is divided into five sections, with the introduction above as its section 1. section 2 reviews related literature. section 3 is about statement of the methodology used in the study. section 4 presents and discusses the results obtained, while section 5 concludes the paper. 2. literature review 2.1 conceptual/theoretical framework overhead cost is defined as indirect factory-related cost. it is a cost that is difficult to trace into the finished products. to exemplify overhead cost, the management accountancy website (http://www.managementaccountancy.com/2009/05/overhead-cost-allocation/) asks the question: is it possible to determine the costs of electricity used to produce one ‘can’ of soft drink? but each ‘can’ of soft drink deserves some share of the cost of electricity used in its production! overhead costs, therefore, need to be treated with caution and seriousness so as to avoid wrong pricing decisions. these overhead costs are also known as manufacturing overheads, factory overheads, factory burden and manufacturing support costs. to be precise, manufacturing overheads are the costs which the company incurs, other than the direct costs, for it to produce the finished products. the costs that can be included in this group of costs are handling and setting of manufacturing equipment, inspection of the products, maintenance of the machine, factory cleanliness, record keeping as well as monitoring and maintenance of the production line. mott (1991:6) states that, “the easy definition of indirect costs is to say that they are all costs which cannot be identified as direct costs! they are, therefore, costs which cannot be immediately identified with the end product going to customers, but which first must go through some intermediate channelling process”. this means that overhead cost is the cost asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 253 which can only be traced to the finished products using suitable methods of primary and secondary apportionment. according to mott (1991:8), “when a cost can be charged in total to either a cost unit or a cost centre, without first being divided into smaller parts, we say it is allocated”. costs allocation also can be defined as cost assignment, cost apportionment and cost distribution. all of these terms explain the process of taking a given common cost and dividing it between various cost objects. three steps are required to allocate costs: first, define the cost objects, second, accumulate the common costs to be assigned to the cost objects and third, choose a method for allocating common costs accumulated in step 2 to the cost objects defined in step 1 (zimmerman, 2009:314). again, zimmerman (2009:316) states that, “cost allocations are quite prevalent in manufacturing. manufacturers cannot deduct all their manufacturing costs for financial reporting and tax purposes. rather, they must trace their direct manufacturing costs and allocate their indirect manufacturing costs between units sold and units remaining in inventory”. hence, for calculating cost of goods sold, net income and cost of closing inventory, financial reporting standards require that indirect manufacturing costs are to be apportioned. cost apportionment issue also arises whenever a firm has a cost-based reimbursable contract. in this case, the firm’s revenues depend on reported costs, including allocated costs. this shows that selling price of a product depends to a large extent on the overhead costs apportioned to the product. there are several methods of allocating overhead costs to cost centres. in this study, the examination of these methods is restricted to activity-based costing (abc) method of total cost determination and traditional methods of overhead costs apportionment and total cost per unit determination. 2.1.1 traditional overhead cost apportionment method a well established method for allocating overhead costs is the traditional method. horngren, bhimani, foster and datar (1999) are of the view that the traditional approach of overhead cost apportionment often uses too few pools of indirect costs, so that cost allocations are overly broad averages. the resulting costs may lead managers to make erroneous decisions about pricing or product emphasis. this shows that traditional method does not emphasize on the need to “net” all indirect cost elements; it is concerned only with the few prominent indirect costs like depreciation, electricity charges, water bills, salary of administrative staff, etc. additionally, jamaliah and maliah (2008: 7) opined that “the traditional accounting approach for primary apportionment of overhead costs is about allocation based on labour hours or machine hours”. the limitations of this method, according to them are that “it rarely reflects the true cause and effect of the relationship between indirect costs and individual products”. scholars like bastl, grubic, templar, harrison and fan (2010) are of the view that the traditional accounting practice is mainly represented by standard costing, which often do not asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 254 fulfil inter-organisational roles well enough to be considered relevant for decision making support. other explanations regarding traditional apportionment are offered by chan and lee (2003) who state that in using the traditional costing system, the allocation basis adopted in stage two (secondary apportionment) tend to be dominated by volume-related factors, such as number of direct labour hours, direct labour dollars and number of production units. however, these apportionment methods often do not reflect reality. chan and lee(2003) are, therefore, uncomfortable with the use of traditional method of overhead cost apportionment, especially using any the methods of secondary apportionment. to them the bases used are mostly subjective and, so, unreliable. since, the traditional method is just based on the number of direct labour hours, direct labour dollars and number of production units, there is the danger that it would lead to inaccurate and unreliable calculation of the total cost that is incurred to produce a unit of product. thus, it is bound to lead a manufacturer to the determination of inaccurate and wrong selling price of the product. this would ultimately affect the overall performance of the business in the shortor long-run. 2.1.2 activity-based costing method gunasekaran, marri and yusuf (1999:287) explain that, “the ultimate goal of abc as a cost allocation system is to trace the production costs generated by the production of goods or services, as accurately as desired, to the causing activities”. this means that activities are the bases of incurring direct and indirect cost, leading to the total cost of the activities necessary for the production of a unit of product or service. synder and davenport (1997), define abc as an attempt to allocate overhead costs based on the activities that cause overhead costs to be incurred, rather than arbitrarily assigning overhead costs simply because the organisation incurs them. this method is simply about allocating overhead costs based on the activities leading to the production of goods or services. guy (1997) is of the view that abc can be useful in avoiding allocation of charges into the cost of products that are not concerned with those charges. according to jamaliah and maliah (2008), abc is a tool to help allocate overheads with a greater degree of accuracy. abc has been defined as a method of measuring cost and performance of activities and products (gunasekaran, marri and yusuf, 1999). from these explanations, it is clear that abc is considered to be relatively accurate compared to other methods of overhead cost apportionment. according to horngren, bhimani, foster and datar (1999), abc focuses on activities as the fundamental cost objects. an activity is an event, task or unit or work with a specified purpose. abc uses the cost of these activities as the basis for assigning costs (direct and indirect) to other cost objects, such as products, services or customers. this is another powerful viewpoint in support of abc method which emphasizes on allocating overhead cost to the activities that incur them in the course of producing products or services. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 255 marshall, mccartney, van rhyn, mcmanus and viele (2010: 450) are of the view that abc system has led to more accurate costing than older overhead application methods and has supported more effective management of the production, administrative and marketing functions of manufacturing firms. abc method also makes it easier for performance/service departments to ascertain their running cost, as costing is purely based on activities undertaken. mott (1991) suggests that a more valid approach is to accumulate overhead costs not on a departmental basis but on an activity basis. this approach regards activities as incurring costs and products as consuming those activities. this way, overhead cost apportionment is clearly to be consumer (the relevant product) and, so, total cost per unit and selling price determination would not pose any technical problem. using abc method of overhead cost apportionment, a company is bound to improve on its pricing decision making. this is supported by jamaliah and maliah (2008), who found that abc adoption leads to better selling pricing decisions and eventually to an enhanced bottom line for a manufacturing or service organization. other than that, abc leads to the accurate calculation of the cost of goods and services as per the finding of synder and davenport (1997) that, the primary benefit of using abc is that it ensures more accurate costing and that the related benefit of better costing is likely to be better managerial decisions. taking into account the supports abc method enjoys from scholars and practitioners, whose works are reviewed, it is clear that activity-based costing is the more preferred method for overhead cost allocation/apportionment in the existing literature. this is due to the fairly accurate results that had been argued to be obtained using abc in allocating/apportioning total cost to units produced. the expected accuracy in total cost per unit determination will lead to convincing selling price determination. 2.2 review of empirical studies there are many significant reasons for allocating manufacturing overhead costs to products. in price-setting process of manufactured products, the price should cover all the manufacturing costs, including direct and indirect costs. this indicates that overhead costs must be apportioned accurately to determine a reasonable and competitive price. furthermore, the products which are yet to be sold, that is., closing inventory should be reported on the balance sheet a part of current assets. it is the requirement of accounting principles that inventory costs are presented in the financial statements; and that closing inventory, as a the balance sheet item must include not only the direct costs, but also overhead costs. since overhead costs cannot be traceable directly in the products’ physical appearance, there should be a special method to apportion it in order to fairly determine the cost of each product produced by a reporting entity. synder and davenport (1997: 159) argue that: “there are two basic outcomes from allocating overhead cost to units produced: better economic decisions and higher level of managerial motivation”. horngren, bhimani, foster and datar (1999:135) mention four purposes for allocating indirect costs: to provide information for economic decisions, to motivate asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 256 managers and employees, to justify costs or calculate reimbursement and to measure income and assets for reporting to external parties. according to armistead, bowman and newton (1995), the perception of the need to control overhead costs in the different service and manufacturing environments may depend more on the accuracy of accounting systems to measure cost of unit of product than on the nature of the service or manufacturing. the two are, however, linked to some extent. in manufacturing companies, the accounting systems are usually designed to measure cost of unit of product, including overhead cost allocation. while there is debate about accuracy of the traditional accounting process to make overhead cost apportionment as fairly as possible, the process is at the heart of control systems in manufacturing. in pure services, as characterised by professional services, the cost of unit of product is measured, to a lesser extent, by including the overhead allocation (armistead, bowman and newton, 1995). the main control is, therefore, through utilisation of professional fee earning activity. mixed and quasi-manufacturing service might be expected to lie somewhere between the two extremes of manufacturing and pure service. all of these statements support the importance of fair apportionment of overhead costs. it is clear that overhead cost apportionment is really very important towards the determination of “true and fair” selling price of the products of manufacturing firms. a manufacturing firm should, therefore, chose the most appropriate methods of overhead cost apportionment that is suitable for its circumstances in order to arrive at a fairly accurate selling pricing decision, so as to enhance its sales as well as overall financial performance as a business. in handling costing system, a manufacturing firm should appoint a dedicated person or team to be in charge of cost centre monitoring and to discharge the responsibility of cost management, especially to accurately overhead cost apportionment to cost centres and ultimately to cost units. usually, in a manufacturing firm, the person involved in overhead costs apportionment and other cost management functions is designated cost accountant or management accountant. according to the goergetown university website (http://provost.georgetown.edu/mcfo/nav/finmanresponsibilities/costcenter/), the cost manager (cost accountant) is an individual who has been delegated the responsibility for monitoring and reconciling the cost centre status reports (ccsrs), which suggests that the person in such a position has huge responsibilities to discharge including overhead costs apportionment of a manufacturing firm. 3. statement of methodology the method of data collection used in conducting this study is interview. the interview was conducted with the chief internal auditor of naza automotive manufacturing sdn. bhd. naza, as an automotive manufacturing firm, was sampled for data collection because: (i) it is a fair sample representing all the automotive manufacturing companies in malaysia; (ii) it is a firm producing motor vehicle as a finished product which involves high overhead costs; and (iii) it takes account of all overhead costs, ranging from the costs of security guards to utilities costs. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 257 for this study, qualitative accounting data were gathered from the interview with the internal auditor; a senior management staff of naza automotive manufacturing sdn. bhd. an internal auditor, being the custodian of the internal control system of a firm, is expected to be very knowledgeable about the cost accounting system of the firm. he/she should also be very independent in commenting on the working of the system than the cost accountant who operates the system. this is the logic behind the conduct of the interview with the internal auditor. from this interview, several important issues were discovered and are discussed in section 4. 4. results and discussion an interview session was conducted with the internal auditor of naza automotive manufacturing sdn. bhd. six specific questions were asked during the interview session, particularly relating to the impact of overhead costs apportionment on the determination of selling price of the automotive manufacturing firm. from the responses in the interview, several major issues regarding the impact of overhead costs apportionment on selling price determination were identified for discussion. 4.1 about the background of naza automotive manufacturing sdn. bhd. naza automotive manufacturing sdn. bhd is a subsidiary of naza group of companies, based in seoul, south korea. it is located in gurun, kedah and was established in 1996 by the late y. bhg. tan sri dato’ seri utama sm nasimuddin sm amin. the philosophy of this company is building high value, high quality, safe and dynamic vehicles in accordance with its tagline; "the power to surprise". its employees consist of management level staff and the labour-force drawn from among the local community (malaysians). the factory was built on an area of 140 acres, consisting of assembly plant, a two-storey office, a track for testing, lots for vendors and suppliers, accommodation for staff and recreation facilities. this factory is equipped with facilities such as body welding and painting, which is fully automated, assembly and pre-delivery inspection of the units, accessories, the test and simulation that includes equipment used to assess performance, endurance and quality of each unit of vehicle. this manufacturing firm produces various types of motor vehicles through its 85 representative branches in malaysia (www.nazakia.com.my).this automotive manufacturing firm is fast becoming a competitor to local automotive manufacturers, like proton and perodua, as well as other automotive manufacturers in malaysia. it is currently common to see naza produced motor vehicles throughout the country. 4.2 method of apportioning overhead costs to products on the method used by the company to apportion overhead costs to products, below is the discussion on the internal auditor’s response: the first question is to look at the significance of choosing the method for apportioning overhead costs. this is because this method influences the costing system of a manufacturing firm. from the interview, it is found that naza, as an automotive manufacturing firm, uses asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 258 traditional method of overhead cost apportionment. the officer clearly stated that the direct overhead costs are allocated by model and according to standard hours or minutes. as for the indirect costs, the officer mentioned that they are apportioned to all the cost centres, including performance/service centres, as a first step. the service cost centres’ shares of the indirect costs are thereafter re-apportioned to the production cost centres or allocated directly to the units of vehicles produced, based on the percentage services rendered to them by the service cost centres. from this finding, it shows that naza automotive manufacturing firm uses traditional method of apportioning overhead costs and that the traditional method is still relevant to the malaysian automotive manufacturing companies, as testified by naza automotive manufacturing sdn. bhd. it also shows that it is really important for the manufacturing firms to select an appropriate method to apportion overhead costs to all departments or centres, including performance centres, and that the apportionment of overhead costs is not to be done arbitrarily. the important thing to note here is that various methods of primary and secondary apportionment of overhead costs impact differently on the selling price to be determined for the products of the company. 4.3 price-setting the respondent was also asked on how the company arrives at the price per unit of its product. below is the discussion on the response to the question: price-setting is very important since it determines the revenue or sales of a firm. it also leads to the profit performance of a manufacturing firm and helps determine whether the firm is doing well or not. as for naza automotive manufacturing company, the price set for its product comprises the total costs of material, labour, overheads and profit margin. all the costs elements are critically identified and calculated first in order to avoid losses. then, in order to make sure that the profit of the company is increasing over time, naza determines a reasonable rate for profit margin according to the quality that the company provides for its products. this is also to ensure the sustainability of the manufacturing firm. the box below illustrates how naza automotive manufacturing sdn. bhd. derives its selling prices for each of its products. the overhead cost component in the selling-price determination shows that overhead cost is really important and provides significant impact on the determination of selling-price. 4.4 roles and responsibility of costing department on the officer(s) of the company in charge of overhead costs apportionment, below is a discussion on the internal auditor’s response: the costing department is extremely important in a manufacturing firm since its major function is to deal with the core activities and business of the firm. the performance of this selling price = material + labour + overhead + profit asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 259 department will affect the performance of the firm because this is where the overhead costs apportionment process is handled and managed. as for naza automotive manufacturing sdn. bhd., the persons in charge of the overhead costs are the cost centre managers. these staffs play a crucial role in this automotive manufacturing firm since the overhead costs are controlled and operated by them. naza accords high priority to the role of these personnel since the decisions they make in allocating costs will affect pricing decision and the overall performance of the automotive manufacturing firm. 4.5 maintaining quality of the product on how naza reduces overhead costs and, at the same time, maintains the quality of its products, and how the two aspects relate to each other, we discuss the response of the internal auditor below: naza has its own system to cater for this. overhead costs can be reduced by close monitoring on the actual amount incurred by every departmental head. cost reduction programme is one of the initiatives to evaluate the items/areas that impact overhead costs. action must be taken to control the impact of, and minimise the increase in, overhead costs. examples of areas to assess are overtime, wastages and utilities, etc. quality of the product is not directly related to overhead costs. apart from trimming the size of labour force and its costs, other procedures such as increased supervision, quality control, and quality of raw materials contribute towards better quality of the products. this shows that overhead costs apportionment is very useful in fairly determining total cost per unit since it reduces the risk of unfair allocation of indirect cost to cost units, thereby reducing the cost that might be unfairly allocated to a particular product. costs reduction would lead to increased profits of individual products and this would enhance the overall performance of the company. 4.6 relationship between overhead costs apportionment and performance of the firm on whether or not effective overhead cost apportionment enhances the performance of naza as a company, it is found that: effective overhead costs allocation definitely enhances the productivity and profitability performance of the company. the respondent mentioned that effective overhead cost apportionment leads to accurate price-setting, better decision-making and higher maintenance of product quality, all of which are key elements in enhancing the performance of a manufacturing firm, like naza automotive manufacturing sdn bhd. 5. conclusion naza automotive manufacturing sdn. bhd. is one of the productive automotive manufacturing firms in malaysia and the firm shows that overhead costs apportionment is highly relevant to its selling price determination and enhancement of its overall performance. the method best suited to the company’s needs must be selected since overhead costs involve a huge amount of money towards the production of finished vehicles in the firm. the profit of the firm will be negatively affected if the overhead costs are apportioned inaccurately. the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 260 total cost per unit of the vehicle produced by the firm is affected by the method chosen for overhead costs apportionment, like wise its price setting. it is the responsibility of the costing department of an automobile manufacturing company to ensure that an appropriate method of overhead costs apportionment is adopted to do accurate apportionment that would ensure accurate selling price determination, so that the overall performance of the company could be enhanced. the recommendation that can be made to naza automotive manufacturing sdn. bhd. and other malaysian automobile firms is that they should learn to change their overhead costs apportionment system from the traditional method to the abc method in order to have accurate calculation of the total costs per unit of their products. furthermore, overhead apportionment using abc method would enhance the overall performance of the firms, as the selling prices of their products would be determined more accurately and more reliably. references armistead, c., bowman, c., & newton, j. (1995). managers' perceptions of the importance of supply, overhead and operating costs. international journal of operations & production management, 15(3), 16-28. http://dx.doi.org/10.1108/01443579510080526 bastl, m., grubic, t., templar, s., harrison, a., & fan, i. s. (2010). inter-organizational costing approaches: the inhibiting factors, the international journal of logistics management, 21(1), 65-88. http://dx.doi.org/10.1108/09574091011042188 chan, s. y., & lee, d. s. y. (2003). an empirical investigation of symptoms of obsolete costing systems and overhead cost structure. managerial auditing journal, 18(2), 81–89. http://dx.doi.org/10.1108/02686900310455065 gunasekaran, a., marri, h.b., & yusuf, y.y. (1999). application of activity-based costing: some case experiences. managerial auditing journal, 14(6), 286–293. http://dx.doi.org/10.1108/02686909910280217 guy, g. e. (1997). using improper costing methods may lead to losses. the tqm magazine, 9(3), 228–230. horngren, c. t., bhimani, a., foster, g., & datar, s. m. (1999). management and cost accounting (10th ed.). new jersey: prentice hall europe jamaliah, a. m., & maliah, s. (2008). implementation of activity based costing in malaysia: a case study of two companies. asian review of accounting, 16(1), 39–55 marshall, d. h., mccartney, j., rhyn, d. v., mcmanus, w., & viele, d. f. (2010). accounting: what the numbers mean (2nd ed). australia: mcgraw-hill australia pty ltd mott, g. (1991). management accounting for decision makers (2nd ed). london: pitman publishing. retrieved oct 11, 2012, from world wide web: http://www.managementaccountancy.com/2009/05/overhead-cost-allocation/ asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 261 retrieved oct 12, 2012, from world wide web: http://blog.accountingcoach.com/manufacturing-overhead-allocated/ retrieved oct. 20, 2012, from the world wide web: www.nazakia.com.my retrieved oct 31, 2012, from the world wide web: http://provost.georgetown.edu/mcfo/nav/finmanresponsibilities/costcenter/ retrieved nov 29, 2012, from the world wide web: http://www.businessdictionary.com/definition/manufacturing.html roslina, s. (2012, october 19). interviewed by zulaikha. gurun: naza automotive manufacturing sdn bhd (nam) snyder, h., & davenport, e. (1997). what does it really cost? allocating indirect costs. asian libraries, 6(3), 205–214. http://dx.doi.org/10.1108/10176749710368389 zimmerman, j. l. (2009). accounting for decision making and control (6th ed). new york: mcgraw-hill/irwin microsoft word 3725-14003-2-rv-new2.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 386 an application of the weak form of the efficiency hypothesis on the saudi arabia stock market after tadawul mohammed hokroh university of leicester, uk received: feb. 24, 2013 accepted: may 20, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3725 url: http://dx.doi.org/10.5296/ajfa.v5i1.3725 abstract the aim of this study is to test the efficiency of the saudi stock market (ssm) after “tadawul” (the entity responsible for operating the ssm). the weak form of the efficiency theory was applied to test the ssm efficiency. the ssm daily stock price returns index was examined using autocorrelation and the run test of randomness from january 1st 2007 to march 18th 2007 (before tadawul) and from march 19th 2007 to may 29th 2007 (after tadawul). the results suggest more investigation to be done on the ssm behavioral finance and under reaction and overreaction split to confirm the ssm “efficiency”. keywords: saudi stock market, hokroh, tadawul, efficient market hypothesis, fama asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 387 1. introduction 1.1 the efficient market hypothesis (emh) the efficient market hypothesis (emh) is a key discussion in the finance literature. dr. eugene fama pointed out that there are three forms of this theory, the strong, semi-strong and weak form. he further defined the weak-form as a market where, under analysis, firms’ historical information will be fully and quickly reflected in its present stock price. (poshakwale 1996) this is to differentiate it from the strong form which is defined as a market where, under analysis, firm’s publicly available or privately held information will be fully and quickly reflected in its present stock price. on the other hand, the semi-strong form is defined as a market where, under analysis, firm’s publicly available information will be fully and quickly reflected in its present stock price. (gili et.al. 2008) few applications of the theory were attempted in the saudi stock market (ssm). 1.2 the history of the saudi stock market (ssm) and the “tadawul” system the history of the ssm goes back to early 1934, when stocks were unofficially traded. in 1983, the official ssm was formed and gradually emerged until this date. (al-bogami 1996) “tadawul” is the name of the company responsible for operating the market effectively and efficiently, ensuring market integrity, fairness and education of customers (tadawul 2013a). the tadawul company was formed on march 19th 2007 and is assumed to bring transparency to the market, thus ensuring availability and reliability of information to all market participants (tadawul 2013b). few researchers tested the weak-form of the emh in the ssm. 2. literature review 2.1 previous work few researchers discussed the efficiency theory in the ssm (butler et.al. 1992, al-razeen 1997, khababa 1998, onour 2004, alabdulqader et.al. 2007). butler et.al. (1992) examined 35 saudi stock market returns from 1985 to 1989 and could not confirm if the ssm exhibited a weak form of efficiency. al-razeen (1997) reviewed 28 companies’ weekly share price data from 1992 to 1995 and found that the ssm has low level of efficiency. khababa (1998) examined 61 companies’ weekly share price returns from 1985 to 1997. khababa (1998) found that 72% of the autocorrelations were significant at the 5% level and 51 out of the 61 firms studied revealed evidence of predictability in their share returns and concluded inefficiency. this view was definite for onour (2004) who also signified inefficiency. onour (2004) observed the ssm’s daily returns from march 2003 until august 2004 and advised greater focus on increasing the market transparency. the most comprehensive of all studies was for al-abdulqader et.al. (2007) as it contained a good mix of firms varying in size and age. they studied 45 firms from july 1990 to august 2000 and covered six market sectors (banking, industrial, cement, services, electricity and agriculture). al-abdulqader et.al. (2007) reported improvement in efficiency and instructed that it may be due to the introduction of information technology (it). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 388 2.2 discussion although al-abdulqader et.al. (2007) proposed that it may have contributed to the improvements of the ssm efficiency, their study was not aimed at examining tadawul impact on efficiency. abdulqader et.al. (2007) study was conducted before the “tadawul” period when there was another system in place called the “electronic security information system” (esis) offered by the saudi arabian monetary agency (al-bogami 1996). according to al-bogami (1996), the esis was the first technology to be introduced in the ssm in 1990. the esis helped make the ssm more transparent and provided investors with instant bid feature but had limitations (e.g. 400 domestic and oversea bank terminals) (al-bogami 1996). as a result, it was replaced by the “tadawul” system (tadawul 2013c). opposing to previous work, this study is aimed at examining the “tadawul” effect on efficiency, an examination that has never been attempted in previous literature. accordingly, the autocorrelation and the run test of randomness are used to test for the weak-form of the emh before and after “tadawul”. 3. methodology 3.1 data collection the empirical work of this research is based on a comparison between the ssm daily stock price returns (close price) before and after tadawul. using the tadawul company’s official website data engine, i was able to obtain the ssm stock price returns from january 1st 2007 onward. accordingly, the ssm daily stock price returns index before tadawul (january 1st 2007 to march 18th 2007) and after tadawul (march 19th 2007 to may 29th 2007) were collected. the ssm daily stock price returns index includes all the daily closing price for all shares traded from 11:00 a.m. to 3:30 p.m. (tadawul 2013d). all data was collected from the tadawul company’s website (http://www.tadawul.com.sa) using the websites’ historical database search engine (tadawul 2013d). the total number of observations was 104 observations (52 before tadawul and 52 after tadawul). 3.2 autocorrelation test autocorrelation is a statistical analysis technique used to describe the degree to which one variable is related to another (levin et.al. 1998). in other words, to test the association between variable won values at different intervals of time (kashif et.al. 2010). accordingly, if there is a strong association between variables at a time series, a pattern can be predicated and as a result, the efficiency hypothesis is rejected. however, if the opposite occur, the efficiency hypothesis cannot be rejected and randomness is assumed. given measurements, y1, y2, ..., yn at time x1, x2, ..., xn, the lag k autocorrelation function is defined as: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 389 accordingly, two hypotheses are obtained; h0: data is random, there is no sequence. h1: data is not random, follow a predictable sequence. the autocorrelation was applied on the ssm daily stock price returns index from 1/1/2007 until 3/18/2007 and from 3/19/2007 until 5/29/2007. 3.3 the run test of randomness the run test of randomness is statistical test that is used to evaluate the randomness of a series of observations by analyzing the number of runs it contains. a run is defined as the consecutive appearance of one or more observations that are similar. (weiers 2008) accordingly, the run is the order of identical occurrence preceded and followed by different occurrence or by none at all (levin et.al. 1998). to illustrate this, suppose for example that a random observation table contained the following data: 2, 7, 6, 8, 9, 6, 7, 6, 6 and 4. the median of these observations is 4.5. thus, the digit (2) which is below the median (4.5) constitutes one run. the digit (4) which is also below the median will constitute another run and the middle eight digits that are all above the median make up another run. as a result, the observation table contained three runs. (weiers 2008). the run test can be calculated as follows: t – ((2n1n2/n) + 1) z = ــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ √2n1n2 (2n2n1 – n)/n2 (n-1) t is the number of runs, n1 is the number of observation of the first type, n2 is the number of observation of the second type and n is the total number of observations (n1 + n2). similier to autocorrelation, two hypothesizes are obtained: h0: data is random, there is no sequence. h1: data is not random, follow a predictable sequence. the run-test was applied on the ssm daily stock price returns index from 1/1/2007 until 3/18/2007 and from 3/19/2007 until 5/28/2007 to examine the efficiency hypothesis before and after “tadawul”. 4. results and findings 4.1 results before performing the test statistics, an overview of price returns correlation over time was captured using a simple scatter diagram. diagram 1 shows the price returns before “tadawul” while diagram 2 shows price returns after “tadawul”. the scatter plot in diagram 1 shows a asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 390 moving trend of prices inclining over time which suggest a predictable pattern. diagram 2 shows a variation of price movements but fewer patterns are observed. diagram 1. the ssm price index before tadawul diagram 2. the ssm price index after tadawul asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 391 to test h0 and h1, autocorrelation and the run test of randomness were applied on the price returns. the results of the autocorrelation test are shown in table 1 and 2 while the result of the run test of randomness is shown in table 3: table 1. (autocorrelations) series: before tadawul (1/1/2007 to 3/18/2007) lag autocorrelation (p) std. errora box-ljung statistic value df sig.b 1 .958 .135 50.502 1 .000 a. the underlying process assumed is independence. b. based on the asymptotic chi-square approximation. table 2. (autocorrelations) series: after tadawul (3/19/2007 to 5/29/2007) lag autocorrelation (p) std. errora box-ljung statistic value df sig.b 1 .864 .135 41.120 1 .000 a. the underlying process assumed is independence. b. based on the asymptotic chi-square approximation. table 3. (runs test) before tadawul after tadawul test valuea 7731.44 7636.15 cases < test value 26 26 cases >= test value 26 26 total cases 52 52 number of runs 3 4 z -6.723 -6.443 asymp. sig. (2-tailed) .000 .000 a. mean 4.2 findings although both the autocorrelation and run tests validate the correlation assumption between the ssm price returns, the strength of correlation obviously decreased after “tadawul” by 9.8% asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 392 (autocorrelation), 18.5% (box-ljung statistic) and 4.16% (run test). this decrease gives a clear indication that an alteration in the ssm efficiency has obviously occurred after the formation of “tadawul”. however it is not clear if this “efficiency improvement” is predominantly due to the “tadawul” or just a “shock” resulting from regulatory changes? to further investigate, the ssm stock price index returns from 5/30/2007 until 12/31/2007 were tested via same tests to see if the alteration of efficiency preserved or decreased over time. in addition, the ssm stock price index returns from 1/1/2008 to 12/31/2008 were also tested. the results are shown in tables 4, 5, 6 and 7. table 4. (autocorrelations) series: (5/30/2007 to 12/31/2007) lag autocorrelation (p) std. errora box-ljung statistic value df sig.b 1 .972 .082 138.885 1 .000 a. the underlying process assumed is independence. b. based on the asymptotic chi-square approximation. table 5. (runs test) series: (5/30/2007 to 12/31/2007) test valuea 7837.67 cases < test value 72 cases >= test value 72 total cases 144 number of runs 12 z -10.202 asymp. sig. (2-tailed) .000 a. mean asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 393 table 6. (autocorrelations) series: (1/1/2008 to 12/31/2008) lag autocorrelation (p) std. errora box-ljung statistic value df sig.b 1 .979 .065 228.943 1 .000 a. the underlying process assumed is independence. b. based on the asymptotic chi-square approximation. table 7. (runs test) series: (1/1/2008 to 12/31/2008) test valuea 9285.31 cases < test value 118 cases >= test value 118 total cases 236 number of runs 12 z -13.960 asymp. sig. (2-tailed) .000 a. mean the results in tables 4, 5, 6 and 7 clearly show more correction as time passes. the correlation coefficient observed has clearly increased even more than what have been noticed before “tadawul”. the reason behind that is the period of the correlation test. when the tests are applied on the selected data over a short period of time (e.g. three months), less correlation is observed, however, if the tests are applied on data selected over a longer period of time (more than three months), more correlation is observed. fama (1998) explains that there is a growing literature that relates this phenomenon to market slow adjustment to information, but he challenges this assumption by arguing that most of the studies done on long term returns will conclude inefficiency and questions if “efficiency” should be discarded? fama (1998) argue that for long term returns, if an even anomalies split between underreaction and overreaction can be observed, then they cannot be attributed to chance and are consistent with market the emh. hence, future research may consider investigating underreaction and overreaction split before and after “tadawul” to test for “efficiency”. another aspect is the rationality of the ssm participants. it is true that, the “tadawul” technology improved the dissemination of information to market participants, but it is not necessary that the ssm participants rationally perceive information dissemination. doran asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 394 et.al. (2010) found that investments objectives of finance professors are largely driven by the same behavioral factors for those amateur investors. doran et.al. (2010) found that personal confidence in the ability to beat the market is independent of opinion on market efficiency. thus, future research may look more on the behavioral finance of the ssm. without looking collectively to all of these factors (behavioral finance, underreaction and overreaction split and returns correlation), it is difficult to confirm the ssm “efficiency”. 5. conclusion the aim of this study is to test the weak form of efficiency in the ssm before and after “tadawul”. the ssm daily stock price returns index was examined from january 1st 2007 to march 18th 2007 (before tadawul) and from march 19th 2007 to may 29th 2007 (after tadawul) to investigate alterations in efficiency through autocorrelation and the run test of randomness. more investigation should be made on behavioral finance, underreaction and overreaction split. without looking collectively to all of these factors (behavioral finance, underreaction and overreaction split and returns correlation), it is difficult to confirm the ssm “efficiency” references al-abdulqader, k. a., hannah, g., & power, d. m. (2007). a test of the weak-form of the efficient markets hypothesis for the saudi stock market. journal of emerging market finance, 6(2),167-190. http://dx.doi.org/10.1177/097265270700600202 al-bogami, s. (1996). an examination of the usefulness of interim financial statements to investors in the saudi stock market. ph.d. thesis. united kingdom: university of dundee al-razeen, a.m. (1997). the weak-form efficiency of the saudi stock market. ph.d. thesis. united kingdom: university of leicester butler, k. c., & malaikah, s. j. (1992). efficiency and inefficiency in thinly traded stock markets: kuwait and saudi arabia. journal of banking and finance, 16(1), 197-210. http://dx.doi.org/10.1016/0378-4266(92)90085-e doran, j. s., peterson, d. r., & wright, c. (2010). confidence, opinions of market efficiency, and investment behavior of finance professors. journal of financial markets, 13, 174-195. http://dx.doi.org/10.1016/j.finmar.2009.09.002 fama, e. f. (1998). market efficiency, long-term returns, and behavioral finance. journal of financial economics, 49(3), 283-306. http://dx.doi.org/10.1016/s0304-405x(98)00026-9 fishman, m. j., & kathleen h. m. (1992). insider trading and the efficiency of stock prices. the rand journal of economics, 23(1),106-122. http://dx.doi.org/10.2307/2555435 gili, y., & cheng, f. l. (2008). efficient market hypothesis (emh): past, present and future. review of pacific basin financial markets and policies, 11(2), 305-329. http://dx.doi.org/10.1142/s0219091508001362 kashif, h., suleman, m. t., shah, s.z., & akash, r. s. (2010). testing the weak form of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 395 efficient market hypothesis: empirical evidence from asia-pacific markets. international research journal of finance and economics, 58, 122-132. khababa, n. (1998). behaviour of stock prices in the saudi arabian financial market: empirical research findings. journal of financial management and analysis, 11(1), 48-55. levin, r. i., & rubin, s. d. (1998). statistics for managers upper saddle river, new jersey: prentice hall onour, i. a. (2004). testing weak-form efficiency of saudi stock exchange market. ministry of economy and planning, riyadh: saudi arabia poshakwale, s. (1996). evidence on weak-form efficiency and day of the week effect in the indian stock market. finance india, 10(3), 605-616. tadawul. (2013a). our technology available online at: http://www.tadawul.com.sa/wps/portal/!ut/p/c1/04_sb8k8xllm9msszpy8xbz9cp0os3g_ a-ewie8tiwmlj2axa0_vqgnzy18q1waoh4kk7x4qzmrgaeitbbqc4gvs4gleqhdwa p6-n0d-bqp-qw5eoqdhzss6/dl2/d1/l2djqsevuut3qs9zqnb3lzzftjbdvljjndiwoe htrdbjs1eznznnndiwndc!/ (february 5, 2013) tadawul. (2013b). objectives available online at: http://www.tadawul.com.sa/wps/portal/!ut/p/c1/04_sb8k8xllm9msszpy8xbz9cp0os3g_ a-ewie8tiwmlj2axa0_vqgnzy18q1waoh4kk7x4qzmrgaeitbbqc4gvs4gleqhdwa p6-n0d-bqp-qw5eoqdhzss6/dl2/d1/l2djqsevuut3qs9zqnb3lzzftjbdvljjndiwoe htrdbjs1eznznnndiwndc!/ (february 10, 2013) tadawul. (2013c) riyad bank profile available online at: http://www.tadawul.com.sa/wps/portal/!ut/p/c1/ny9bdoiwfetp4gn-pwrk0qbi1trigvg2d dfkgoeajorxlttwgm3szuylm5cdvvm8dvl02jrfbsfipckwygi6ixg6von0z49-spyed 3obi2eezs7s2yethu2msmlpnhixezplgkm4rcqvnfcnsk2pfqji54mmi3zb9naurmi mfwss_ldx7j_xrtvncalsj653o0coofjq2nqjvxwrxj0708pevf8cqth2pxjdea_t04sxn5 s3yqel3oae/dl2/d1/l0ldu0lkq2dwukehis9jrfjbqulqrufjz3fhbutnl1lcsko0ntrrc2 x5dhdbisevn19omenwukk0mjbhmtkxmellu1e5vtjbmjbcns9hy3rpb25tdhjpb mcvy29tcgfueq!!/?symbol=1010&taborder=5 (february 10, 2013) tadawul. (2013d). historical data available online at: http://www.tadawul.com.sa/wps/portal/!ut/p/c1/lc9nd4iwdabgn9tkl3pgxslzcepcucwej 1kcm8ef_fmymxcxpre-fdiwaphln5pqgqumbnqooi4exbjmsebhqrmtkno0j2sxy5lgnp pppctdjehkpjadfctexxpzie6xrzwmpil-0exqoeczsobqr79objwo3f9n635idls6a96r h3xdlbzlvnzmobyu7k-cydaaurtyzd3c_ynw1qz54qx34vi9kq0nksgbzit42w!!/dl2/ d1/l2djqsevuut3qs9zqnb3lzzftjbdvljjndiwrze5mtbjs1nrovuyqtiwsjc!/?sym bol=1010&taborder=2 (february 10, 2013) weiers, r. m. (2008). introduction to business statistics united states: south-western cengage learning. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 92 priority sector lending by commercial banks in india: a case of barak valley jaynal ud-din ahmed department of management, north eastern hill university tura campus, chandmari-794002, west garo hills, tura, meghalaya, india e-mail: jaynaluahmed@yahoo.co.in; juahmednehu@gmail.com recieved: march 23 2009, accepted: september 19 2009 abstract the priority sector lending is mainly intended to ensure that the assistance from the banking system to those sectors of the economy which has not received adequate support of institutional finance. the attainment of the socio economic priorities of the government like growth of agriculture, promotion of small entrepreneurs and development of backward area etc is the major responsibility of commercial banks. since seventies, reserve bank of india and government of india have stipulated guidelines for priority sector lending by banks. the same was revised on april 30, 2007 and overall priority sector lending target was fixed at 40 per cent for domestic banks and 32 per cent for foreign banks. however, the banks are not able to reach the prescribed target of lending to priority sector. the small entrepreneurs and farmers are continued to be both credit and demand constraints. thus, it can be observed that the demand for funds for priority sector viz., small entrepreneurs and agricultural sector is enormous. with this backdrop, the present treatise is an attempt to diagnose the various lacunas of priority sector lending by commercial banks in the area under consideration in the context of national scenario. keywords: priority sector lending, commercial banks, credit-deposit ratio, barak valley, india jel classifications: g20, g21, o10, o14 mailto:jaynaluahmed@yahoo.co.in mailto:juahmednehu@gmail.com asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 93 1. introduction: the diversification of a large fraction of bank credit from the traditional sector to the priority sector is a remarkable feature of credit deployment in the post nationalization era. the concept of priority sector lending (psl) is mainly intended to ensure that assistance from the banking system in an increasing manner to those sectors of the economy which has not received adequate support of institutional finance. the reserve bank of india (rbi) emphasized that the priority sector comprised of agriculture (direct and indirect finance), small scale industries (ssi), small road and water transport operators, small business, professional and self-employed persons, education, housing, micro-credit, weaker sections 1 etc. rbi monitors the psl by commercial banks through periodical return received from the banks and the performance of banks is reviewed in various foray set up under the lead bank scheme (rbi, weblink, 2009) 2 . since seventies, rbi and government of india have stipulated some guidelines viz, financing in the priority sector on an increasing scale, more deployment of credit backward regions, preparation and implementation of credit plan and measures for enhancing productivity, employment and economic growth with social justice (narasimham, 1994). the banks, without insisting adequate security, have supplied advances to priority and other neglected sections of the society at a concession rate of interest. however, the banking statistics revealed that, this designated priority sector as well as neglected sections received about 15 per cent of the total bank credit at the time of bank nationalization (goi, 1991) 3 . on the later period, proportion of advances to the priority sector has increased from 15 per cent to 33.3 per cent in 1974 and further to 40 per cent in 1980. the commercial banks have achieved the target and even surpassed it in quantitative terms. but in qualitative terms, there is an apprehension among the bankers that the advances to priority sector resulted in a loss of interest income due to highly subsidized lending rates. as a result, the profitability of banks has adversely affected besides maintaining additional manpower requirements for supervision of small loans, mounting over dues, poor recovery of advances and raising volume of non performing assets (npas) (niranjana and anbumani, 2002). the narasimham committee (1991) on financial sector reform has drawn attention to the problem of low and declining profitability and stated that there is need for gradual phasing out of the directed credit programme, i.e. the stipulations that 40 per cent of all credit should go to the priority sector should be scrapped. the priority sector should be redefined and the proportion shall be fixed at 10 per cent of the aggregate credit. subsequently, the committee (1998) 4 indicated that timely and adequate availability of credit rather than its costs is very 1 weaker sections, which come under priority sector for lending purposes, hitherto included scheduled castes, scheduled tribes, small and marginal farmers, artisans and distressed urban poor indebted to non-institutional lenders. within priority sectors, domestic commercial banks have to give 10 per cent of their net lending to weaker sections, but no such specific target is set for foreign banks., weblink: http://news.indiamart.com/news-analysis/rbi-widens-priority--15730.html, ( visited on 16/05/09) 2 http://www.rbi.org.in/scripts/faqview.aspx?id=8, (accessed 15/05/09) 3 govt. of india (1991a) report of the committee on financial system, ministry of finance,, december 4 govt of india (1998) report of the committee on financial system, ministry of finance, (narasimham committee-ii), april http://news.indiamart.com/news-analysis/rbi-widens-priority--15730.html http://www.rbi.org.in/scripts/faqview.aspx?id=8 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 94 indispensable for intended beneficiaries. the impact of narasimham committee recommendations with regard to lending to priority sector has not been encouraging (majumdar, 2001). it appears that there is a growing anxiety that the process of financial sector reforms has by-passed the priority sector. in this respect, dr. y. v. reddy (february 3, 2001), deputy governor of rbi, remarked that the flow of credit to priority sector/ rural areas has not been up to the mark owing to accumulation of losses in public sector banks (psbs) on account of mounting npas. the internal working group was set up by rbi under the chairmanship of c.s. murthy to examine the need of continuance of psl prescriptions. on the basis of the recommendations of the working group, the guideline for psl were revised on april 30, 2007 and overall target was fixed at 40 per cent of net bank credit (nbc) for domestic banks (psbs and private banks) and 32 per cent for foreign banks. the target for agricultural advances fixed at 18 per cent for domestic banks and the target in case of ssi was fixed at 12 per cent for foreign banks (rbi, 2009) 5 . the psbs are not able to reach the prescribed target of lending to priority sector. the small entrepreneurs and farmers are continued to be both credit and demand constraints. it has been reported that the constraints facing by the bankers with regard to deployment of credit to priority sector are lack of viable credit products, implying lack of demand for credit etc (shete, 2002). on the other hand, there exists an informal sector which provides credit to priority sector particularly agricultural credit at higher rates of interest, which indicates that there are no demand constraints. thus, it can be observed that the demand for funds for priority sector viz., small entrepreneurs and agricultural sector is enormous. the present paper is an attempt to diagnose empirically the various lacunas of priority sector advances by commercial banks in the area under consideration in the context of national scenario. 2. review of related literature: there have been many researches and studies on priority sector lending by banks in india. a brief review of these studies is highlighted in the following paragraphs to highlight the importance of the study. joshi (1972) proposed the rbi to give clear and specific definition of the different component of priority sector as some of the bankers are not clear about the precise scope of agricultural lendings. chawala (1979) examined the dimension of credit flow to the priority sector during seventies and observed that the purpose of psl by banks is not available for which it is meant for. angadi (1983) observed the concentration of psl in general and agricultural advances in particular in some state because of rapid branch expansion, deposit mobilization, privileged cropped area, adoption of high yielding variety etc. joshi (1986) in his study identified weak fund management capacity of banks due to statutory liquidity ratio (slr), cash reserve ratio (crr) and psl. he found that the low yield rate and rising cost contributed a lot to the declining trend in profitability of banks. singh (1987) identified many exogenous and endogenous factors for the strains and stresses of banking system. the major of them being continuous increase in the slr, crr, persistent emphasis on social goals, growing incidence of industrial sickness, rapid branch expansion in the under banked areas, unfavorable change of deposit mix and growing incidence of 5 http://www.rbi.org.in/scripts/faqview.aspx?id=8, (accessed 15/05/09) http://www.rbi.org.in/scripts/faqview.aspx?id=8 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 95 financial disintermediation. muhammed yunus (1988) strongly underlined that credit without discipline is nothing but charity and charity in the name of credit will only destroy the poor, instead of helping them. he, however, stressed on the loan recovery mechanism rather than blaming the defaulters. rangarajan (1991) pointed out that improving the quality of loan assets is the true test of improved efficiency of banking system. the narasimham committee (1991) has stated the need for gradual phasing out of the directed credit programme. krishnaswamy (1992) criticized the recommendations of the committee on financial system. he pointed out the committee’s report considered only the interest of industrialist and it essentially concerned with reducing govt. regulations and improving profitability. rajagopal (1994) studied on the consequences of psl in indian banking and remarked that concessional credit should be restricted only to the poorest of the poor and to the under privileged sections of the society. commercial rate of interest should be charged from those who can afford it. patel (1996) in his paper realised that the traditional banking ethics were not compatible with the needs of economic development and that the balanced development was not possible without strengthening the hold of commercial banks in the backward and neglected areas. with a view to bring the down-trodden, hitherto neglected sector households to the mainstream, fundamental changes in the traditional banking norms were called for to move away from security based credit towards programme oriented credit. the narasimham committee (1998) 6 pointed out that the sufficient credit to priority sector is very indispensable for intended beneficiaries. kohli (1997) observed the existence of significant linkages between bank credit and investment in both agriculture and industries in india. he suggested that although directed credit programme for psl is effective in india, affirmative support to small-scale units is required. ajit (1997) examined the issue of para banking activities and suggested that bank should be allowed to undertake these activities, particularly use of capital as risk, from the experience of other countries like usa. department of banking supervision (1999) 7 studied the impact of priority sector advances on npas and found that the incidence of npas in priority sector is much higher in view of the fact that priority sector advances constitute 30-32 per cent of the gross bank credit. vyas committee (2001) 8 also observed that commercial banks seem to have shied in extending rural credit as they are dealing vast number of small accounts. niranjana and anbumani (2002) observed that there is anxiety among the bankers that the advances to priority sector resulted in a loss of interest income due to highly subsidized lending rates. in the context of enormous demand for funds for priority sector, (shete, 2002) examined priority sector advances by psbs during the post reform years and found that the psbs are not able to reach the prescribed target of lending to priority sector. 6 govt of india (1998) report of the committee on financial system, ministry of finance, (narasimham committee-ii), april 7 rbi, department of banking supervision (1999) some aspects and issues relating to npas in commercial banks, rbi bulletin, liii(7): 913-930 8 report of the expert committee on rural credit (v s vyas committee), 2001, nabard, mumbai, november 12. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 96 the world bank (2004) 9 in its report, 'sustaining india's service revolution' highlighted that government ownership of banks in india stifles competition and raises the cost of lending to the public. the world bank has blamed rbi's stiff psl norms for foreign and domestic banks for the weak financial health of commercial banks. the report has indicated that largest government ownership in the banking sector led to insufficient competition in the indian banking system and hence, led to increased cost of intermediation, lowering capital allocation efficiency and under-lending to the private sector. rbi (2005) 10 draft technical paper of internal working group identified the issues relating to necessity of psl. the working group recommended the need for psl prescriptions, the composition of priority sector which includes agriculture, ssi, small road and water transport operators, small business, professional and self-employed persons, education, housing etc. the existing system of computation of priority sector obligations in relation to nbc is based on the outstanding advances of banks. linking the priority sector obligations to outstanding advances has its shortcomings as outstanding tend to decline as a result of better recovery, write-offs, etc. moreover, a portion of outstanding comprises npas, which continue to get reflected in the achievement of banks in lending to priority sector. the disbursement during a given period is, therefore, a better indicator of banks’ lending. in order to improve the flow of credit to the priority sector and to ensure that a certain proportion of funds out of the total bank credit flows to this sector, the computation of psl obligations of banks could be linked to the total disbursements made by banks during the previous year. ahmed (2005) in a diagnosis observed that commercial banks together have gradually increased the quantum of advances to small industries but the proportion in which total bank credit in priority sector has expanded, the relative share of small sector has not grown in the same ratio during the reform regime. the weak infrastructure facilities may have prevented the greater flow of credit. the industrial campaign, awareness programmes and industrial training to the prospective entrepreneurs from the appropriate authority may be the remedy in this respect. bhati (2006) examined the lending climate for banks in emerging economies like india. the study found that due to the government policies, banks in india undertake many additional risks when they lend. this study focused on one specific aspect of lending relationship between branch manager and loan officer of bank branches in india and recommended social risk evaluation is therefore more appropriate for risk evaluation and reduction by banks in india. rikta (2006) in a policy note on institutional lending and financing policy for small sector in bangladesh examined the effectiveness of financial, fiscal, and related policies for financing the small sector. the study suggested that the financial institutions need to have the financial capacity to accept the lending risks along with access to appropriate funding which fulfill the clients' requirements. an assessment on the causes and consequences of npas of commercial banks, by rajesham and rajender (2007), concluded that a strong political will only be able to find satisfactory solution to the problem of mounting npas. narasaiah and 9 world bank (2004) indian bank profits hit by priority sector lending , 15 th june 2004, weblink: http://www.domain-b.com/finance/banks/world_bank/20040615_profits.html, (accessed on 13/05/09) 10 rbi internal working group (2005) priority sector lending, rural planning and credit department central office, rbi, mumbai, september http://www.domain-b.com/finance/banks/world_bank/20040615_profits.html asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 97 naik (2007) observed that although great strives have been made in the last decade to ensure finance for micro enterprises, rare initiative has been taken to help ssis. as a result, ssis have been constrained to seek loans for new ventures from commercial banks. sooden and kumar (2007) analyzed the priority sector lending in the post reform period and suggested for a balanced approach as development agent and sustainability of directed lendings keeping in view the quantum of npa in priority sector advances. from the above review of earlier studies it is revealed that not many studies based exclusively on the priority sector lending by banks. most of the studies relate to the institutional financing, nature and problems of psl by banks. however, the studies relating to the practices and pattern of commercial banks for psl remained un-researched in the study area. 3. priority sector lending by banks: the national scenario. 3.1. deployment of bank credit to priority sector in india the commercial banks played a significant role among the institutional sources of credit for priority sector in india. the significance of bank credit in the priority sector can be observed against the backdrop of increasing quantum of such credit to this sector. the table -1 presents total bank credit and the deployment of bank credit to priority sector in india during 1997-2006. table-1: deployment of bank credit to priority sector in india (amount rs. in crores) sl no priority sectors march 1997 march 1998 march 1999 march 2000 march 2001 march 2002 march 2003 march 2004 march 2005 march 2006 1 total bank credit 2,58,991 (100) 3,00,283 (100) 3,42,012 (100) 4,00,818 (100) 4,69,153 (100) 5,36,727 (100) 6,69,534 (100) 7,64,383 (100) 10,40,909 (100) 14,45,837 (100) 2 agriculture & allied 31442 (12.1) 34869 (11.6) 39634 (11.6) 44381 (11.1) 51922 (11.0) 60761 (11.3) 73,518 (10.9) 90,541 (11.8) 1,25,250 (12.0) 1,72,279 (11.9) 3 small scale industries 35944 (13.9) 43508 (14.5) 48483 (14.2) 52814 (13.2) 56002 (11.9) 57199 (10.6) 60,394 (9.0) 65,855 (8.6) 74,588 (7.2) 90,239 (6.2) 4 other priority sector 17494 (6.8) 21130 (7.0) 26494 (7.7) 34632 (8.6) 46490 (9.9) 57299 (10.7) 77,697 (11.6) 1,07,438 (14.0) 1,81,638 (17.4) 2,47,379 (17.1) figures in the parentheses indicate percentages to total bank credit deployed. source: reserve bank of india, report on currency and finance, various issues the outstanding bank credit of small scale sector increased from rs.35, 944 crores in march 1997 to rs. 90, 239 crores in march 2006 recording a 2.5 fold increase but the percentage share to total bank credit has declined from 13.9 per cent to 6.2 per cent. during the same period, the amount of bank advances to agriculture sector increased from rs.31, 442 crores to rs.1.72, 279 crores. there is a sudden jump of bank credit deployed to other priority sector during the period under consideration. the same has recorded an increase from rs. 17, 494 crores in march 1997 to rs.2, 47,379 crores in march 2006. it can be argued that the growth of advances to other priority sector in absolute figure has gone over the growth of bank credit asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 98 to small sector although the percentage share has remained lower throughout the period. 3.2. priority sector advances: bank group-wise comparisons. the bank group wise distribution of priority sector advances and percentage share to total bank credit in india are furnished in table-3. table -2: priority sector advances by bank groups in india (amount rs in crores) as on march public sector banks private sector banks foreign banks 1995-96 61809 (36.6) 6049 (34.3) 4439 (29.0) 1996-97 68925 (37.8) 6283 (34.0) 5019 (32.1) 1997-98 79131 (41.7) 88321 (41.2) 6139 (37.7) 1998-99 91319 (41.8) 11614 (40.9) 6940 (34.3) 1999-00 107200 (43.5) 14155 (41.4) 8270 (37.0) 2000-01 127807 (43.6) 10819 (38.7) 9699 (34.5) 2004-05 307046 (42.8) 69886 (43.6) 23843 (35.3) 2005-06 409748 (40.0) 106586 (42.8) 30439 (34.4) 2006-07 521180 (39.6) 143768(42.7) 37835 (33.4) figures in parentheses indicate percentage to total bank credit. source: rbi, statistical tables relating to banks in india. iba bulletins it is clear that in the reform years percentage share of priority sector advances of psbs has increased steadily from 36.6 in 1995-96 to 39.6 in 2006-07. further during post reform era, psbs lending in priority sector remains higher than the foreign banks. the psbs did not achieve the priority sector target of 40 per cent till march 1999. the target was first achieved in 2000 and continued till 2005-06. the priority sector lending of psbs, however, fell short of 40 per cent by 0.4 per cent in march 2007. the private sector banks were able to meet priority sector lending target of 40 per cent throughout the period from 1997-98 to 2006-07 except 2000-01. the 32 per cent target fixed for priority sector lending has been met by foreign banks over the years. this indicates that these banks, private banks in particular, lent larger quantity to the priority sector in recent years though the volume of advances are meagre than that of psbs. 3.3. level of npas in priority sector advances of banks: the issue of sustainability of priority sector depends upon how efficiently the credit is recycled in the priority sector and the issue is directly linked with the level of priority sector npas. the priority sector npas of banks are presented in table-4. the sector-wise analysis of npas of psbs revealed that priority sector added up a large proportion 46.4 per cent of total advances in march 1998 and increased to 59.5 per cent in march 2007. in the non-priority sector, the same has been decreased to 39.3 per cent in march 2007 from 50.6 per cent in march 1998. the public sector npas remain as minimum level throughout the period. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 99 table-3: npas of priority sector vis-a-vis other sectors (amount rs. in crores) year (end march) priority sector non-priority sector public sector total amount per cent amount per cent amount per cent 1998 21184 46.4 23107 50.6 1362 3.0 45653 1999 22606 43.7 27608 53.4 1496 2.9 51710 2000 23715 44.5 28524 53.5 1055 2.0 53294 2001 24156 45.4 27307 51.4 1711 3.2 53174 2002 25150 46.2 28405 52.2 903 1.7 54458 2003 24939 47.2 26781 50.7 1087 2.1 52807 2004 23841 47.5 25698 51.2 610 1.2 50149 2005 21926 48.1 23249 51.0 444 1.0 45619 2006 22374 54.1 18664 45.1 341 0.8 41378 2007 22954 59.5 15158 39.3 490 1.3 38602 b 924.82 1911.3 18.03 2854. 28 cgr 4.37 8.86 1.31 6.24 source: reserve bank of india, trend and progress of banking in india in order to study the growth scenario of sector-wise npas, linear growth rate (b) 11 and compound growth rate (cgr) 12 has been considered. the ‘cgr’ of npas in non-priority sector is comparatively higher (8.86 per cent). the ‘b’ and ‘cgr’ became negative in the public sector. this exposes that the commercial banks have not considered loan to the public sector due to further npas menace over the years. moreover, the overall ‘cgr’ of npas during 1998-2007 of psbs was 6.24 per cent while non-priority sectors cgr (8.86 per cent) overweighs the priority sector (4.37 per cent). thus the non-priority sector is also considerably adding fresh npas over the years. on the other hand, higher npas in priority sector advances have pushed up the overall proportion of npas by three to four percent. the reasons of higher proportion of npas in priority sector advances at the national level may be attributed to the directed and pre-approval nature of loans sanctioned under sponsored programmes, lack of effective follow up due to large number of small accounts, non-cost effective legal recovery measures, vitiation of the repayment culture consequent to the loan waiver schemes, willful defaulters and so on. 4. objectives of the study: the foregoing discussions relating to the priority sector advances of banks at the national level revealed that there are a number of serious issues relating to the psl which became great concern of the policy makers. now the doubts relating to the sustainability of psl may be studied in the backward area particularly to identify the real factors. in this respect, we have conducted an empirical study over twelve commercial banks operating in the study area. the major objectives are 11 for calculating linear growth rate (b), we have assumed the linear regression line y = a + bt (where y = quantum of npas corresponding to year ‘t’ origin at 1998. b 12 compound growth rate (cgr) = x 100 harmonic mean (h.m) of y b = x 100 n / 1/y asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 100 (a) to study the reasons for poor quality of priority sector lendings in the area under study. (b) to study the level of npas in priority sector advances of commercial banks. (c) to study the recovery performance of priority sector advances of banks over the years. (d) to study the determinants of psl by commercial banks over the years. 5. hypotheses framed: the following operational hypotheses have been framed to meet the objectives of the study 1. there exists an ample difference between deployment of bank credit to priority sector and development of backward region. 2. the priority sector advances have direct bearing on increasing quantum of non-performing assets of commercial banks. 3. the psl led to significant increase in the volume of overdue over the years. 4. the mounting overdue has significantly restricted the bank’s lending capacity to priority sector. 6. methodology adopted: the secondary data collected from rbi report on currency and finance, rbi bulletins, rbi annual report, regional offices of banks and lead bank office of the study area has been considered for the purpose of the study. the entire study is subjected to statistical techniques like correlation analysis, regression analysis, growth rate analysis, parametric tests etc. the extent of credit channelization has been tested with the correlation matrix analysis. linear growth rate and compound growth rate analysis have been used to assess the growth of bank credit in the area under study. a comparison of credit targets and actual achievements has been made to judge the credit performance. besides this simple tabulation, percentage analysis has also been used. the banks lending capacity has been studied with the percentage of recovery in agricultural sector. regression model has also been fitted to study the determinant of psl by identifying independent variables which are mentioned in appropriate places. 7. background of the study area: the barak valley is the southernmost region of assam composed of three districts viz, cachar, karimganj and hailakandi, covers an extensive area of 6922 sq. kms in assam 13 . the topography of the valley is heterogeneous composed of high hills, low lands called ‘beel’ and ‘hoar;’ and level plains dotted with low ranges isolated hills called ‘tillas’. the economy of the valley had been a periphery to the economic mainstream of bengal during the british rule. the partition of the country in the wake of independence and the consequent emergence of east pakistan (now bangladesh) not only had shattered the traditional cheapest and quickest lines of transport and communication but also had snapped the age old channels of trade, commerce and transactions. the post independence phase did not adequately compensate the valley for al the loss inflicted on it by partition. 13 govt. of assam (2005) statistical hand book, directorate of economics and statistics, guwahati, assam. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 101 the population of the valley was 30.10 lakhs persons as on march 2001. the valley is characterized by thickly populated area with density of 360 persons per sq. km and urban population comprises about 9 per cent of total population. the work participation rate in the valley is 8.6 per cent which is much lower than the national average 25.7 per cent. the valley is agrarian biased. about 49 per cent of the geographical area is under agriculture and 36.9 per cent are under forest 14 . the number of existing industries (factories and ssi) in the valley constituted about 8 per cent 15 of the total number of industries state assam during the period 1991-2007. the district industries centres (dics) are imparting training to the rural artisans in trade, leatherwork, tailoring, bamboo work, carpentry etc. there were only two industrial training institute (itis), one is at srikona, cachar district and another is at karimganj district catering specialized training to the entrepreneurs of the valley 16 . the valley has 7.2 per cent 17 of the road ways and 19.8 per cent 18 of the railway network of the state assam. 55 per cent of the total villages are electrified in the valley while 65 per cent in assam 19 . the institutional finance is essential for economic development of any area. but unfortunately, the rate of growth of flow of institutional finance in the valley has not shown significant rise. the valley has 12.5 per cent of the total bank offices of state assam 20 . at present, 12 psbs, 1 regional rural bank (rrbs) and 3 private banks are operating with a net work of 147 branches. as on 31.12.2007, there are 147 numbers of branches of commercial banks operating in the valley. the district cachar is bestowed with 72 branches (51psbs, 19 rrbs and 2 private banks) while the district karimganj got 52 branches (32 psbs, 17 rrbs and 3 private banks ) and 12 branches (13 public sector banks, 8 rrbs and 2 private banks) in the district of hailakandi are taking the care of banking activities. the analysis of the aforesaid indicators revealed that the valley is economically and industrially backward. the socio-economic backwardness of the valley is discerned by the symptoms like under utilization of resources, agrarian bias of population, low level of industrialization, fragility of prevailing infrastructure and high incidence of unemployment. thus, development of infrastructure like transport, communication, power, education and banking network etc is urgently needed in the direction of industrial and agricultural development for overall development of the districts under study. 8. the result and discussions: 8.1. sector-wise break up of bank credit: the socialization of bank credit has been the subject matter of psl by the banks. the attainment of the socio economic priorities of the government like growth of agriculture, 14 office of the joint director of agriculture, south assam zone, silchar 15 calculated on the basis of data obtained from directorate economics and statistics & district industries centres of the area under study 16 superintendent, industrial training institute, karimganj, assam. 17 percentage of roadways is calculated on the basis of data obtained from district transport office. 18 area manager, n.f. railway, badarpur, karimganj, assam 19 office of the electrical division, karimganj, assam 20 lead bank office, united bank of india, silchar, assam. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 102 promotion of small entrepreneurs and development of backward area etc is the major responsibility of commercial banks. table -5 presents the data on the total bank advances to the priority and non-priority sector for the period between december 1998 and december 2007 in the districts of the valley. table 4: sector-wise break-up of bank credit in barak valley (1998-2007) (amount rs in lakhs) year (end december) karimganj district cachar district hailakandi district priority sector non-prior ity sector total priority sector non-priorit y sector total priority sector non-prior ity sector total 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1693 (47.4) 2010 (55.8) 2022 (63.4) 2038 (50.8) 1875 (58.6) 2159 (60.9) 2980 (60.7) 3421 (64.0) 2653 (50.8) 3120 (57.9) 1878 (52.6) 1593 (44.2) 1167 (36.6) 1975 (49.2) 1324 (41.4) 1386 (39.1) 1873 (39.3) 2309 (36.0) 2510 (49.2) 2751 (43.1) 3571 (100) 3603 (100) 3189 (100) 4013 (100) 3199 (100) 3545 (100) 4853 (100) 5730(100) 5163 (100) 5871 (100) 3772 (57.7) 4384 (58.1) 4025 (57.0) 4987 (52.5) 5595 (49.0) 5294 (47.0) 6432 (48.9) 6890 (51.2) 7534 (48.0) 7834 (49.1) 2585 (42.3) 3161 (41.9) 4200 (43.0) 4511 (47.5) 5821 (51.0) 6060 (53.0) 6934 (51.1) 6700 (48.8) 7890 (52.0) 7908 (50.9) 6357(100) 7545(100) 8225(100) 9498(100) 11416(100) 11354(100) 13366(100) 13590 (100) 15424 (100) 15742 (100) 1780 (57.6) 1791 (56.7) 1682 (51.3) 1695 (49.8) 1945 (53.5) 2300 (49.8) 2430 (50.8) 2751 (45.6) 3230 (52.0) 3904 (56.6) 1307 (42.4) 1363 (43.3) 1595 (48.7) 1705 (50.2) 1688 (46.5) 2314 (50.2) 2393 (49.2) 3024 (54.5) 3129 (480) 3079 (43.4) 3087(100) 3154(100) 3277(100) 3400(100) 3633(100) 4614(100) 4823 (100) 5775 (100) 6359(100) 6983 (100) agr 4.0 2.2 3.3 3.4 14.7 8.0 6.1 5.6 3.8 figure in the parentheses indicate percentage to total credit of the respective district. source: lead bank office, ubi, cachar, karimganj and hailakandi districts the percentage share of priority sector advances of banks in the region is much higher than the national level during the period. the banks in the study area are able to maintain the psl prescription of 40 per cent as per revised guidelines. it is exposed from the table that the share of priority sector advances to total advances has been declined in the area under study except karimganj district while the same has increased at the national level. it has also been observed that the average annual growth (agr) of priority sector advances was 4.0 per cent, 3.1 per cent and 6.1 per cent in the karimganj, cachar and hailakandi district respectively during 1998-2007. this indicates a wide gap between deployment of bank credit to priority sector and the development of the backward regions. it is imperative to take appropriate strategy for financing priority sector like ssi, agriculture etc in the backward regions. 8.2. deployment of bank credit under annual credit plan: the banks operating in the study area, keeping in view of their aim and objectives for the economic development under the lead bank schemes, have made an effort in providing financial support to agriculture and ssi. the psl is done in the districts through annual credit plans. the sector-wise credit deployment under annual credit plan in the districts is shown in table6. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 103 table5: bank credit deployment under annual credit plan in barak valley (account in nos. and amounts rs. in thousands) year (as on march) sectors total agriculture and allied ssi and rural artisans trade and services account amount account amount account amount account amount karimganj district 1998 3884 21918 922 12778 1468 17005 6274 51001 1999 3797 18668 787 12374 1407 16736 5891 48378 2000 4132 21132 784 21285 1290 24832 6206 67249 2001 2496 24349 817 23541 1393 20800 4706 68690 2002 2560 26965 743 15833 1638 27754 4941 70602 2003 2189 26565 773 16954 1624 34393 4586 77912 2004 1444 15419 484 8771 1448 30339 3376 54529 2005 1238 15977 565 10571 1836 45026 3639 71574 2006 1453 16530 462 10923 1983 46312 3780 73765 cachar district 1998 3218 19878 916 9636 1495 16439 5629 45953 1999 2808 22530 816 6258 1490 21467 5099 54255 2000 2369 14673 624 14019 1635 31118 4628 59810 2001 2159 19609 952 20090 2022 40784 5133 80433 2002 2255 29517 648 19839 2869 65709 5772 115065 2003 2136 34412 796 24190 2965 79623 5890 135323 2004 2350 32378 1265 37584 3126 94407 6741 164369 2005 2450 33478 1528 39281 3028 83408 7006 156167 2006 2590 32598 1674 40965 3210 97502 7623 171065 hailakandi district 1998 2836 20968 823 12003 1407 11589 4319 44569 1999 3121 16312 729 10928 1218 24892 5068 52132 2000 2639 21862 613 24139 1123 23689 4106 69690 2001 2416 18674 580 21017 1359 12536 4355 52227 2002 1938 26312 728 12829 1439 18390 4105 57913 2003 1539 22392 791 15312 1408 17890 3738 55594 2004 2560 21831 865 18316 1506 27831 4931 67978 2005 1961 14326 871 15109 1458 26091 3490 55526 2006 1980 23564 901 16534 1643 27325 5424 67423 source: lead bank office, united bank of india, cachar, karimganj and hailakandi district the table reveals that agriculture is one of the single dominant sectors that absorbed major portion of the credit outstanding. in march 1998, credit outstanding for agriculture was rs 219.2 lakhs, rs 198.8 lakhs and rs. 209.7 lakhs for karimganj, cachar and hailakandi district respectively. the same has declined to rs 165.3 lakhs in march 2006 for karimganj district and increased to rs. 325.9 lakhs and rs. 235.6 lakhs for cachar and hailakandi districts in march 2006. the bank credit deployed to ssi and service sector in absolute term has been increased throughout the period in the districts. the service sector has experienced relatively more deployment of credit in terms of quantum. the growth of bank credit in different sectors may be assessed by compound growth rate (cgr) of bank credit sanctioned during the period. the results obtained are summarized in table7. the inter-sectoral growth rate analysis reveals that there is a significant decrease in respect of credit sanctioned in agriculture and allied activities (cgr = -0.43) while ssi (cgr = 2.45) and trade and service (cgr = 9.23) achieved an increasing trend in karimganj district. on the other asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 104 hand, district cachar experienced a positive growth rate of credit sanctioned in small sector (cgr = 13.08), agriculture and allied activities (cgr = 3.24) and trade and service (cgr = 11.58). it is therefore, evident from the growth rate analysis that the reform process had made a positive impact on the sectoral credit deployment. table6: cgr of bank credit deployed the inter district growth rate analysis shows that the ssi and agriculture sector received comparatively less attention then that of trade and services during the period. this may be due to the negative attitude of banks towards the proposals submitted by small entrepreneurs and the farmers. as they had bitter experience of sanctioning more loan to these sectors since the volume of overdues have mounted over the years. 8.3. recovery performance of banks in priority sector lending: the liquidity of banks largely depends on the recovery of advances. the recovery position of banks in the area is, quite unsatisfactory, presented in table-8. it has been observed that the recovery position was very much poor in almost all the sector in the area under study. in 1990, it was 14.9 per cent in agriculture and allied activities followed by 28.4 per cent in small sector and 19.9 per cent in trade and service sector for karimganj district while 16.3 per cent, 22.9 per cent and 46.9 per cent in the respective sectors for cachar district as on end june 1989. the recovery position in agriculture and allied activities is relatively discouraging to other priority sectors in three districts under consideration. district agriculture and allied ssi and rural artisans trade and service total credit karimganj cachar hailakandi 0.43 3.24 1.29 2.45 13.08 0.32 9.23 11.58 6.05 11.27 14.08 4.71 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 105 table7: sector-wise recovery position of banks in barak valley (amount rs. in lakhs) year agriculture & allied small sector & rural artisans trade & service demand recovery overdue demand recovery overdues demand recovery overdues karimganj district 31-12-90 292.3 (100) 43.8 (14.9) 248.5 (85.1) 92.3 (100) 26.3 (28.4) 66.0 (71.6) 1025.2 (100) 204.3 (19.9`) 820.9 (80.1) 30-09-96 363.2 (100) 98.2 (27.0) 265.0 (73.0) 143.0 (100) 45.2 (31.6) 97.8 (69.4) 1530.8 (100) 345.6 (22.5) 1185.2 (77.5) 30-03-99 458.8 (100) 115.8 (25.2) 343.0 (74.8) 206.3 (100) 92.6 (44.8) 113.7 (55.2) 1960.3 (100) 558.2 (28.4) 1402.1 (71.6) 30-03-05 543.2 (100) 231.1 (27.9) 320.9 (72.1) 245.7 (100) 110.8 (43.6) 134.2 (56.4) 2134.0 (100) 602.8 (27.6) 1432.0 (72.4) 30-03-08 599.1 (100) 250.0 (35.4) 349.1 (65.6) 287.4 (100) 140.2 (45.8) 147.2 (55.2) 2359.0 (100) 879.0 (29.9) 1480.0 (70.1) cachar district 30-06-89 325.6 (100) 53.3 (16.3) 272.3 (83.7) 118.3 (100) 27.7 (22.9) 90.5 (77.1) 524.6 (100) 246.3 (46.9) 278.3 (53.1) 31-12-94 638.3 (100) 113.0 (17.7) 525.3 (82.3) 299.2 (100) 45.8 (15.8) 253.4 (84.7) 853.2 (100) 424.6 (49.7) 428.6 (50.3) 31-03-98 758.6 (100) 215.6 (28.4) 543.0 (71.6) 345.2 (100) 96.2 (27.8) 249.0 (72.2) 1022.8 (100) 511.2 (49.9) 511.6 (50.1) 31-03-05 875.9 (100) 298.7 (27.9) 576.5 (72.1) 398.5 (100) 100.5 (32.1) 298.0 (67.9) 2563.9 (100) 1263.8 (48.1) 1300.1 (51.9) 30-03-08 915.8 (100) 314.7 (32.7) 601.1 (67.3) 450.5 (100) 210.2 (35.1) 240.3 (64.9) 3290.3 (100) 1687.0 (50.9) 1603.3 (49.1) hailakandi district 31-12-91 192.0 (100) 20.2 (10.5) 171.8 (89.5) 62.8 (100) 19.2 (30.5) 43.6 (69.5) 302.7 (100) 145.6 (48.1) 157.1 (55.9) 31-03-94 258.3 (100) 45.0 (17.4) 213.3 (82.6) 85.3 (100) 41.6 (48.7) 43.7 (51.3) 512.6 (100) 213.9 (41.7) 298.7 (58.3) 31-12-99 482.9 (100) 102.9 (21.3) 380.0 (78.7) 90.6 (100) 45.2 (49.8) 45.4 (50.2) 418.2 (100) 219.0 (52.3) 199.2 (47.7) 31-03-05 879.6 (100) 278.6 (25.3) 601.0 (74.7) 201.6 (100) 95.3 (47.4) 106.3 (52.3) 657.2 (100) 321.1 (49.1) 336.1 (50.9) 30-06-08 970.8 (100) 290.1 (26.5) 680.7 (73.5) 234.8 (100) 103.5 (46.0) 131.3 (54.0) 879.4 (100) 432.1 (49.8) 445.3 (50.2) figure in the parenthesis indicates percentage to total. source: lead bank statements (lbs), lead bank office, cachar, karimganj and hailakandi districts of assam the lower recovery indicates erosion of banks profitability and blocking up bank credit from developmental project of the area. the gravity of the situation will be cleared when we found rs. 250.0 lakhs (35.5 per cent) was realized against the total outstanding dues of rs. 599.1 lakhs under agriculture sector in karimganj district as on 30-03-08. while in cachar district rs. 314.7 lakhs (32.7 per cent) was realized against the total dues of rs. 915.8 lakhs in 30-03-08 and in hailakandi district rs. 290.8 lakhs (26.5 per cent) was realised against total dues of rs. 970.8 lakhs in 30.06.08. similar trend was noticed in small sector and service sector in the districts. however, the recovery position of small sector (46.0 per cent) is relatively better that agriculture (26.5 per cent) in 2008. the service sector has experienced a recovery of 49.8 per cent as on june 2008. a significant feature of banks lending is that, despite mounting over dues in each year, the agriculture and allied sectors enjoyed relatively major portion of bank credit. the asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 106 agriculturists and poor people of the area could not repay the loans because they spend their loan on consumption purposes rather than productive purposes without bothering the liability of making repayment because of illiteracy (ubi, 2008) 21 . further, in the perspective of economic development, there have been many disparities in the area in the distribution of resources. the flow of institutional loans has particularly benefited the richer section. in that content, the priority sector lending provides privileges to the poor people in order to lift their economic structure and condition. they are provided loans for buying buffaloes, cows, pigs, to buy auto-rickshaw, to rear hen, and different machines for small scale industries. indeed, they get subsidy by government on this loan. but they do not use the loan in the proper way for productive use. so, the loanee can not return loan. constant failure of monsoon, natural calamities as famine flood etc, willful default, deficiencies in lending policies are the chief reasons for non-recovery of loans. the reasons for poor recovery may also be attributed to various other factors such as lack of supervision of end use of fund owing to lack of vehicle and paucity of staffs, defective processing of loan applications, political interference’s, communication gap between banker and customer etc. the loans sanctioning authority begins to take undue advantage from such people. no effort is made for recovery of such loan. the local leaders do not encourage them to pay it back. they assure them that govt. will exempt it. consequently the loan is never recovered in future; it becomes difficult to pay it back due to heavy amount. as a result the mounting over-dues restricted the banks lending capacity. therefore, an immediate action from appropriate authority to accelerate the recovery position in all sectors is necessary. 8.4. inter-relationship between non-performing assets and priority sector advances: due to non-availability of information relating to priority sector npas in the area under study, an attempt has been made hereunder to study the relationship between npa and psl to identify with contribution of the same to total npa. for this purpose, we have calculated ‘r’ between npas per branch (a) and priority sector advances per branch (b) and non-priority sector advances per branch (c) during the period 1998-2007. the table-9 presents the position of the variables relating to npas and priority, non-priority sector advances per bank branch. the analysis reveals that the positive correlation 0.74 is statistically not significant at 1 per cent and 5 per cent level of significance at their respective degree of freedom for priority sector advances. the r value 0.65 for non-priority sector advances is significant at 5 per cent level but not at 1 per cent level of significance. this implies that with the increase of priority sector lending, there has been corresponding increase in the volume of npas. however, it can not be argued that psl is the sole factor in enhancing the volume of npas in the area under study. the non-priority sector advances are equally responsible apart from other bank specific factors like credit deposit ratio, ration of npa to advances, capital adequacy ratio etc for the present npa scenario. 21 information supplied by lead bank manager, lead bank office, united bank of india, silchar, assam during the field survey of the study. asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 107 table-8: position of priority and non-priority sector npas of commercial banks (amount rs in lakhs) year npas (rs.) priority sector advances (rs.) non-priority sector advances (rs.) npa per branch (rs.) priority sector advances per branch (rs.) non-priority sector advances per branch (rs.) 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 538.2 699.8 761.8 829.9 1154.9 1016.2 1997.5 3686.9 2976.2 5143.0 7245 8185 8310 8720 9135 9753 9980 12780 14328 16453 5135 4758 4608 6412 6644 8466 9754 9831 10895 11342 5.9 7.5 5.8 5.5 12.1 10.6 22.0 30.6 28.5 48.4 79.6 88.0 89.3 91.7 96.2 102.7 120.7 132.9 186.0 231.0 56.4 51.1 49.5 67.5 69.9 89.1 87.9 121.0 113.9 128.6 the results are summarized here under – rab = 0.742. ‘t’ value (cal) = 3.123 ‘t’ value (tab) at 8 d.f. 1 pc = 2.896 5 pc = 1.860 8.5. factors influencing priority sector lending by commercial banks: the above analysis, therefore, shows that the bank credit support to priority sector is not satisfactory. thus, it is very important to identify the factors affecting bank financing of priority sector. for this we have used regression analysis considering independent variables like percentage of overdue in priority sector, interest rate, performance of banks measured with credit-deposit (c/d) ratios, credit delivery centers, ie, branch expansion of banks and volume of business (deposit plus advance). the following multiple regression model has been employed for this purpose. yt = β1 + β2x1 + β3x2 + β4x3 + β5x4 + β6 x5 + ut where, yt is the deployment of bank credit to priority sector. x1 is the percentage of overdue in priority sector. x2 is the interest rate x3 is the performance of credit delivery institution ie. c / d ratio x4 is the bank branch expansion. x5 is the volume of business (deposit plus advances) of banks. ut is the error term. β1 is the intercept. βi ( i = 1,2,3 …….6) is the regression coefficients. the result obtained from the regression analysis is summarized in table-10. rac = 0.65 ‘t’ value (cal) = 2.404 ‘t’ value (tab) at 8 d.f. 1 pc = 2.896 5 pc = 1.860 asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 108 table 9: regression summery of independent variables independent variables ‘β’ value ‘t’ stat s e f r2 adjusted r2 intercept (β1) percentage of overdues ( β2 ) interest rate on credit( β3) credit/deposit ratio( β4) branch expansion of banks( β5) volume of business ( β6) 0.1822 0.0031 0.1983 0.0252 0.3610 1.6280 0.0006 5.1732 2.5112 -1.1201 0.0129 0.0192 0.0035 0.0093 0.0253 167.572 (000a)sig. 0.97306 0.865 the analysis relating to determinants of psl by banks shows a high degree of explanatory power (r 2 =0.973). this indicates 97 per cent variation in the bank financing of agriculture in the district is explained by independent variables. it is further confirmed by ‘f’ ratio which turned to be statistically significant. this implies that the independent variables like mounting over dues, interest rate, credit-deposit ratio, branch expansion and volume of business are the perfect determinants of dependent variable viz., priority sector advances. the β (beta) value of mounting over dues, c/d ratio, and branch expansion are positive and statistically significant. however, the β coefficient of interest rate is positive and of business volume of bank is negative, but both are not statistically significant. the aforesaid analysis indicates that two factors viz., mounting overdues and c/d ratio, out of five identified factors are the most affecting factors of deployment of bank credit to priority sector. higher recovery ensures bank to endorse higher quantum of credit to priority sector. the stumpy performance intensity of credit delivery institutions, ie, unhealthy c/d ratio, does present an impression that flow of credit to priority sector has come down substantially despite various measures undertaken. the adequacy of credit delivery centers i.e., branch expansion of banks, is also a credit supporting variable to activities relating to small business entrepreneurs and agricultures. it may be suggested that there should be proper recovery of loan amount from loanee in order to restore the performance of commercial banks in the area under study other wise banks would face liquidity crisis for recycling the fund. 9. recommendation for future research: the shrinking share of real priority sector, neglect of agriculture, falling number of accounts across the different categories of priority sector, loan recovery mechanism etc are some of the serious issues which need immediate attention of the policy makers. the overall discussion on priority sector advances by commercial banks is developed using secondary data. however, the analysis of priority sector npas in the study area viz, barak valley has not been included due to non availability of information, rather the analysis in the paper is based on the interrelationship between the quantum of npas and quantum of psl. the obtaining of such information is an imperative step for future work and, as such, would make an important contribution to this pivotal field. [acknowledgement: the author is instrumental to acknowledge the academic assistance and encouragement received from prof. sujit sikidar, department of commerce, gauhati university, guwahati, assam, india] asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 109 references: ahmed, j.u. 2005, bank financing of small scale industries: a diagnostic evaluation, ahmed (ed.) industrialization in north eastern region, mittal publications, new delhi ajit, d. 1997. para banking in india, some issue. economic and political weekly, (october 18) , xxxii (42) angadi, v.b. 1983. bank’s advances to priority sectors: an enquiry in to the causes of concentration, economic & political weekly, xviii (13):503-510, march 26 bhati, s. 2006, trust between branch managers and loan officers of indian banks, international review of business research papers, 2(4):51-58, december chawala, a.s. 1979. nationalization and growth of indian banking, deep and deep 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internal working group (2005) priority sector lending, rural planning and credit department central office, rbi, mumbai, september rbi, department of banking supervision (1999) some aspects and issues relating to npas in commercial banks, rbi bulletin, liii(7): 913-930 reddy, y. v. 2001. address at the conference of indian society of agricultural marketing at vizag (a.p.) february asian journal of finance & accounting issn 1946-052x 2010, vol. 2, no. 1: e5 www.macrothink.org/ajfa 110 report of the expert committee on rural credit (v s vyas committee), 2001, nabard, mumbai, november 12. rikta, n. n. 2006, institutional lending and financing policy for smes in bangladesh, policy note, federation of bangladesh chamber of commerce and industry, dhaka shete, n.b 2002 priority sector advances by public sector banks during the post reform period (1992-93 to 2000-01). working paper, nibm, pune, march 2002 singh, s. 1987. profitability of commercial banks in india, punjab national bank monthly review, (october) ii (ii) sooden, m and kumar, s. 2007. priority sector lending in post reform period, finance india, december, xxi(4): 1389-1404 world bank (2004) indian bank profits hit by priority sector lending , 15 th june 2004, weblink: http://www.domain-b.com/finance/banks/world_bank/20040615_profits.html, (accessed on 13/05/09) copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). http://www.domain-b.com/finance/banks/world_bank/20040615_profits.html microsoft word 4132-15391-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 244 abnormal audit fees and stock price synchronicity: iranian evidence mikaeil mansouri serenjianeh accounting department, university of kurdistan, kurdistan, iran e-mail: mmansouri64@yahoo.com nasrollah takhtaei1 accounting department, dezful branch, islamic azad university, dezful, iran e-mail: nasrollah_takhtaei@yahoo.com received: august 16, 2013 accepted: october 3, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4132 url: http://dx.doi.org/10.5296/ajfa.v5i2.4132 abstract the main objective of this research is to investigate the association between stock price synchronicity. stock price synchronicity as a criterion for stock market reaction has been the subject of this study for the first time in iran. for fulfilling the objectives of this research, the post event research method has been applied and for testing the hypothesis the data panel method has been employed. this research sample encompasses 71 accepted firms in tehran stock market from 2006 to 2010. the results of this research indicate that stock market reaction positively to abnormal audit fees. in other words, the investors tend to assume that abnormal audit fees lead to more information of firm into stock prices and this will enhance audit quality. keywords: abnormal audit fees, actual audit fees, auditor independence, normal audit fees, stock price synchronicity 1. correspondence author: phd student in accounting, department of commerce, delhi school of economics, university of delhi (india) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 245 1. introduction with increasing of resource accessible to management, number of stakeholders of firm is also increasing simultaneously that consequence of this situation is an occurrence of conflicts of interest. as a result, stakeholders to align their interests with others or to minimize the impacts of interest's conflict should endure the agency costs. the manager has been in the focus of this conflict is trying to reduce these costs with providing financial information. however due to power of management, independent auditor's professional judgment has been suggested to monitor the performance of management. in order to use audit services, fees should be paid to auditors which is determined by auditors based on their assessment from the audit risk and volume. in this study, theoretically, actual audit fee comprises two components; (1) standard audit fee, (2) abnormal audit fee. standard audit fee reflects the effort and costs of litigation risk and actual audit fee is equally fees paid to auditors. the auditor's efforts might increase with increasing fee payment that leads to quality high in auditing. as a result, market indicates a positive reaction to the high quality of information. instead, it is possible, auditors' high fees, make them economically to depend on their clients. such dependence leads to the lack of auditor independence. therefore, clients do not rely on firm's information that consequences of such procedure leads to a negative market reaction in relation to poor information quality. in this study, stock price synchronicity reflects the contact of company information (audited financial statements) with stock price which considering as a benchmark of market reaction. whatever stock price synchronicity is increased, the association between company information and stock price is decreased and leads to a negative reaction of stock market. conversely, with lower stock price synchronicity, relationship between company information and stock price increases and hence market reaction come to be positive. this study is to examine whether investors perception of an auditor's independence incentives affects the incorporation of firm-specific information into its clients stock prices through two methods. one very likely method using which auditor independence impacts stock price synchronicity is the quality of audited earnings. higher (lower) earnings quality is associated with lower (higher) stock price synchronicity. it is consistent with that high quality public information could lead to lower cost of private information (grossman & stiglitz, 1980). thus high quality public information would encourage informed investors to collect private information and/or would encourage market intermediaries to process public available information into value-relevant private information. as a consequence of more informed trading, stock price are more informed. also, kim and verrecchia (1994) support the view that high quality public disclosure can lead to an increase in trading and more information incorporated into stock prices. they argue that information provided from public disclosure may lead to different interpretation of a firm's performance. thus, market participants with informed judgments or opinions about a firm's performance are willing to bear the cost for engaging in trading on their judgment. the trading activities incorporate firm-specific information into stock prices. that is, in a market with many risky asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 246 stock, during any given time interval, information about the fundamental values of some firms might be cheap, while information about the fundamental values of some firms might be dear. trader, ceteris paribus, obtains more private information about the former and less about the latter. consequently, the stock price of the former, moving in response to informed trading, are both more active and more informative than the stock prices of the latter (art durnev, morck, & yeung, 2004). another method through which auditor independence affects price synchronicity is that auditor independence affects client firm's transparency. as argued by jin and myers (2006), hiring a credible auditing team might be a pre-commitment to convey inside information because; credible auditing may also enhance investors property right by reducing costs of monitoring and controlling the firm. jin and myers (2006) develop an analytical model to link firm opaqueness (i.e. lack of transparency) and stock price synchronicity. their analytical model assumes that insiders (e.g. managers) observe more about the firm-specific information than outside investors, which results in the information asymmetry between insiders and outsider. this information asymmetry (i.e. lack of complete transparency) enables insider to capture more (less) cash flows if the hidden firm-specific information is positive (negative). that is, insiders are required to absorb firm-specific risk and this leads to lower firm-specific risk absorbed by investors. the lower firm-specific risk shared by investors due to the lack of transparency increases the ratio of market to total risk, which means that stock prices move in a more synchronized manner with the market, i.e. stick price synchronicity. thus, market perception of auditor independence affects the stock price synchronicity through the methods of quality of audited earnings and transparency. by using the relationship between abnormal audit fees and auditor independence, the question that can be begged is that whether the company's information will provide a basis for evaluating the stock price or not. 2. hypothesis development if investors realize that this abnormal audit fees is the result of auditors’ economic dependence to their employers, auditor independence is lost and the quality of financial reporting is reduced; therefore, investors do not be sure of company information. consequently, the company’s information cannot support the company's stock price in the market. however, if investors believe the abnormal audit fee is due to other factors, apart from economic dependence, and also they believe that abnormal audit fees resulting from removing their reputation and uncertainty assessment, so it increases their efforts, they can use company’s information to evaluate the company's stock. in this study, based on the various factors in the perspective of investors in iran, it is expected that the increase in fees consider due to extraordinary auditors’ efforts. therefore, the following hypotheses are raised: main hypothesis: stock market against abnormal audit fees reacts. hypothesis 1: the market share against audit fees with a positive sign react positively. so, in the hypothesis 1, it is argued that an audit fee in the stock market with positive sign asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 247 indicates a positive reaction. according to the hypothesis 1, a reduction in audit fees reduces the effort, as a result, leading the negative reaction of the stock market to the information provided. therefore, hypothesis 2: the stock market in audit fees a positive sign indicates a positive reaction. 3. empirical procedures this study is of the positive accounting research theoretically. positive research includes a set of methods that not only express observation but also consider the relationship between observed variables. this study also is applicable from the viewpoint of objective. from the viewpoint of time period, this study is of post-event research. in post-event research, the researcher detects and investigates the relationship between factors and special conditions that exist before or have occurred using studying their results. therefore, both dependent and independent variables have occurred in the past and based on this description, this study is called empirical research or post-event research. on the other side, according to the using sample for running methods and research techniques generalizing sample findings to population, this study is considered as an induction research inferentially. it also can be considered as a correlation research because it attempts to approve the existence relationship between dependent and independent variables. 3.1 measurements of abnormal audit fees actual audit fees can be decomposed into two components: normal audit fees and abnormal audit fees. normal fees reflects auditors efforts costs and litigation risk, and are determined by factors that are common across different clients such as client size, client complexity and client-specific risk, while abnormal fees determined by factor that are idiosyncratic to contractual relationships between auditor and their clients, while are actual fees in excess of normal fees and are more likely to capture the economic bonding. 3.1.1 measurements of normal audit fees according to simunic (1980), the model of the standard audit fee variable depends on the probability of occurrence losses and bankruptcy. in this study, the risk of loss of client companies through company size, the total assets (ta) of the company, and bankruptcy of clients are tested by the z test. in addition, based on previous studies (ashbaugh, lafond, & mayhew, 2003; francis, 2006; frankel, johnson, & nelson, 2002; palmrose, 1986), if the financial year is not ending to the end of year, dummy variable is used to control for the seasons of non-work in audit. additionally, the current ratio, quick (acid) asset ratio, and also financial leverage ratio are used to control the risk of firm. the used model in this study is derived from simunic (1980) model that is defined as follows: lafee = + lta+ cata + quick + de + bankruptcy + foreign + ye + loss + ɛ where; lafee = natural log of audit fees; asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 248 lta = natural log of total assets; cata = ratio of current assets to total assets; quick = ratio of current assets (less inventories) to current liabilities; de = ratio of long term debt to total assets; bankruptcy = bankruptcy of clients are measured by the z test; foreign = proportion of total sales from foreign operations; ye = indicator variable, 1= if firm's financial year is not ended to march 20); loss = indicator variable, 1= loss in current fiscal year, "0" otherwise; ɛ = residuals 3.2 measurements of stock price synchronicity (the standard of stock market reaction) the stock price synchronicity measures how firm stock returns are closely tied to marked return is. following prior literature (art durnev et al., 2004; artyom durnev, morck, yeung, & zarowin, 2003; morck, yeung, & yu, 2000), the stock price synchronicity measure is derived from the of the following regression: , = + , + , , (1) , : monthly return of each firm , : market return in the tehran stock market the stock price synchronicity (syn) is defined as the following: , = ( ) where r is the coefficient of determination from the estimation of the above equation (1). 3.3 the model for examining the association between stick price synchronicity (the standard of stock market reaction) and abnormal audit fees the following model derived from the model of piotroski and roulstone (2004) is that the synch (the standard of stock market reaction) as the dependent variable and abfee (abnormal fees) as the independent variable. and also, in this study, lognind, big auditor, firmage and asset has been considered as a control variable. syanch = + abfee+ lognind + quality + firmage + logasset + e synch: the standard of stock market reaction as the dependent variable abfee: abnormal audit fees as the independent variable lognind: as the control variable is defined as the natural logarithm of the number of firms in asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 249 the industry. it is expected that the greater the number of firms in a particular industry, contact information, according to the characteristics of the industry, the stock price increases; thus, this leads to a lower stock price synchronicity (the information of the share price of these companies will be affected more). quality: this variable as a dummy variable takes 1 if audit firm is of high quality. quality of the audit firm has determined via website of iranian association of certified public accountants (iacpa). this variable as a dummy variable take 1 if the audit firm has is a score of a; otherwise zero. it is expected that receiving high fees by high quality audit firms, leading to lower stock price synchronicity and hence stock price data will be most affected. firmage: presence of companies in tehran stock exchange (tse) by the end year 2010 is defined as a control variable. information environment of older companies are more reliable and accurate than emerging ones and capital market uses company information rather than alarmist methods to evaluate stock prices over time. therefore, it is expected that firms with long life relates more the companies' information with their stock price in stock exchange. logasset: natural logarithm of total assets is defined as a control variable. with increasing the total assets in the financial statements, the financial statements will be of most interest and this leads to lower stock price synchronicity (stock market reaction to company information). e: residuals for firm i at time t, 4. empirical results tables 1 and 2 show the descriptive statistics of the study. according to the table 1, the central indicators such as mean, median, and indicators of dispersion, standard deviation, kurtosis and skewness have been calculated for different variables. if mean is more than median representing that there are big points among data. in these cases, the data distribution is skewness to right, for instance, the distribution in firmage is skewness to right. there is no skewness to right, just the mean and median values of some variables is close to the distribution that it indicate that variables are symmetric. almost all other variables except for the mentioned variables, particularly dependent variable, are symmetry relatively. this feature is important because the symmetry is one of the properties of normal distribution. dependent variable is observed with symmetry and skewness distribution close to the normal distribution (stretching and skewness rate in normal distribution is zero). in table 2, 17.7 % of the data is zero value for quality and 82.3 % is one value. table 1. descriptive statistics variable mean median std.dev skewness kurtosis min max synch -1.220 -1.0724 1.01852 -.769 .516 -4.31 1.02 abfee .01914 .00515 .519731 -.181 .467 -1.988 1.790 lognind 1.1373 1.1761 .36300 -1.414 1.692 .00 1.46 frinage 15.37 14.00 8.534 1.607 2.294 5 45 logasset 5.5497 5.5428 .49803 .055 .123 4.10 6.97 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 250 table 2. descriptive statistics of dummy variable quality of audit firms dichotomous no. audit firms with a score %audit firms with a score 0 63 17.7% 1 292 82.3% table 3 represents the results of the relationship between stock price synchronicity, measure of market reaction, and abnormal audit fees using multivariate regression. regression analysis shows that the determining factors in stock price synchronicity variables explain 0.257 % of variation of dependent variable. according to the table 3, it can be noted that the multiple correlation coefficient is equal to 0.257 (mr = 0.257), and the square of the coefficient of determination is equal to 0.066. so, the three variables of abfee (abnormal audit fees), logasset (log of total assets) and firmage (lifetime of the stock) explain the net rate of 0.058% of the variance in the equations in stock price synchronicity. the other variables by external factors and unknown variances which has not mentioned in this study will be explained. in this model, the most important factors that influence the other factors are the variable abnormal audit fees. t-test of the regression coefficient shows that the coefficient was significant (p<0.000) and the estimated value of stock price synchronicity is effective (table 5). therefore, the three variables of abfee, logasset, firmage have a significant impact on stock price synchronicity, but figure 6 indicates that there is no relationship between the quality of the audit firm and the logarithm of the number of firms in the industry with stock prices. the anova’s results in table 4 shows that the calculated level of significance for this statistic is equal to 0.000; it shows a significant regression in 99% (p<0.000), the negative relationship between stock price synchronicity and audit fees that represent abnormal stock market reaction is positive. so the main research hypothesis is confirmed. table 3 is the results of the relationship between stock price synchronicity, measure of market reaction) and abnormal audit fees using multivariate regression. regression analysis shows that factors that determine the stock price synchronicity variables, among all variables were entered into the regression equation, has explained approximately 0.257 % of the dependent variables stock price synchronicity. according to table 3, it can be stated that the multiple correlation coefficient is equal to 0.257 (mr=0.257), and the coefficient of determination is equal to 0.066. as a result, the three variables of abfee (abnormal fees), logasset (log of total assets) and firmage (lifetime of the stock) explain the net rate of 0.058% of the variance of stock price synchronicity in the equations, and the other variables, external factors and unknown variances that has not mentioned, will be explained. in this model, the abnormal audit fee has had the most important factor than the others. table 5 shown t-test of the regression coefficient was significant (p<0.000) and the estimated value of stock price synchronicity is effective. therefore, the three variables of abfee, logasset, firmage has a significant impact on stock price synchronicity, by contrast, table 6 shows that the quality of the audit firm and the logarithm of the number of firms in the industry, has asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 251 no relationship with stocks prices synchronicity. the anova in table 4 shows that the significance level for this test was 0.000 and it represents that regression is significant in 99% (p<0.000) the negative relationship between stock price synchronicity and unusual fees audit shows positive reaction in stock market. thus, the main hypothesis of research is proved. table 3. the multivariate regression results of stock price synchronicity variable coef. r-squared adj r-squared std. err. durbin-watson stat synch 0.257 0.066 0.058 0.988 1.89 table 4. anova analysis results of stock price synchronicity source sum of squares df mean square f-statistic sig. model 24.244 3 8.081 8.272 0.000 residual 342.922 351 0.977 total 367.166 354 table 5. independent variables coefficients that remain in model variable unstandardized coefficients standardized coefficients t-statistic sig. b std.b beta concept 0.322 0.603 0.535 0.593 abfee -0.32 0.107 -0.155 -3.007 0.003 logasset -0.319 0.106 -0.155 -3.000 0.003 firmage 0.016 0.006 0.132 2.563 0.011 table 6. statistic relating independent variables excluding from final model variable beta t-statistic sig. partial correlation abfee 0.007 0.183 0856 0.024 lognind -0.011 -0.279 0781 -0.036 the results in table 7 show a positive relationship between stock price synchronicity with abnormal audit fees. according to this table, it can be stated that the correlation coefficient is 0.146 (r = 0.146). the coefficient is 0.021 which 0.015 percent of the value of that stock price synchronicity in abnormal audit fees is associated with positive symptoms and the rest depends on other factors. adjusted coefficient of determination in this case is equal to 0.021 percent. according to watson statistic, 2.5 to 1.5, the remaining independent can be concluded. in table 8 the significance of the regression is calculated using f test. the anova shows that there is a significant difference in this statistic (p<0.000) and it means a significant relationship in regression (p<0.000). table 9 indicates that with increase of a unit in audit fees abnormal with positive sign, 0.146 of unit synchronous stock price will drop. t-test of the regression coefficients in this table shows that a significant relationship (p<0.000) and the estimated value of stock price synchronicity is effective. based on these results, it is asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 252 stated that abnormal audit fees, with signs positive, impact on stock price synchronicity negative relationship between stock price synchronicity and abnormal audit fees with positive sign indicates a positive reaction in the stock market. therefore, sub-hypothesis 1 is confirmed. table 7. the regression results of stock price synchronicity on audit fees abnormal with positive sign variable coef. r-squared adj r-squared std. err. durbin-watson stat abfee 0.146 0.021 0.015 1.06 1.8 table 8. anova analysis results of stock price synchronicity and audit fees abnormal with positive sign source sum of squares df mean square f-statistic sig. model 4.029 1 4.029 3.572 0.04 residual 183.869 163 1.128 total 187.898 164 table 9. the regression results of effects of audit fees abnormal with positive sign on stock price synchronicity (dependent variable) synch unstandardized coefficients standardized coefficients t-statistic sig. b std.b beta concept -1.06 0.157 -6.762 0.000 abfee -0.585 0.310 -0.146 -1.890 0.04 according to the table 10, it can be stated that the correlation coefficient is equal to 0.119 (r=0.119). the coefficient of determination obtained 0.014; it shows that 0.014 percent of changes in stock price synchronicity are related to abnormal audit fees, with negative sign, and the rest depends on other factors. adjusted coefficient of determination in this case is equal to 0.009 percent. due to the amount of watson statistic is between 1.5 and 2.5; the remaining independent can be concluded. according to the table 11, the anova show a significant variance for this test which is equal to 0.111, indicating that the regression is not significant. so, it can be announced that abnormal audit fees are not significantly and negatively affect the stock price synchronicity; consequently, sub-hypothesis (2) is rejected. table 10. the regression results of stock price synchronicity and audit fees abnormal with negative sign variable coef. r-squared adj r-squared std. err. durbin-watson stat abfee 0.119 0.014 0.009 0.98 1.92 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 253 table 11. anova analysis results of stock price synchronicity and audit fees abnormal with negative sign source sum of squares df mean square f-statistic sig. model 2.486 1 2.486 2.561 .111 residual 172.792 178 0.971 total 175.279 179 table 12. the regression results of effects of audit fees abnormal with negative sign on stock price synchronicity synch unstandardized coefficients standardized coefficients t-statistic sig. b std.b beta concept -1.271 0.111 11.428 0.000 abfee -0.328 0.205 -0.119 -1.6 0.111 5. summary and concluding remarks the purpose of this study is to examine the stock market reaction to abnormal audit fees of listed companies in tehran stock exchange. stock market reaction to stock price is determined by considering theoretical research, which means lower stock price synchronicity has a positive reaction in stock market and vice versa. totally, the results show that there is a significant and negative relationship between stock price synchronicity and abnormal audit fees. in other words, the stock market will react positively than abnormal audit fees. in terms of investors and users of financial statements, increase in audit fees leads to more contact information in the stock price. in order to analyze the different results from abnormal audit fees, with positive sign (additional fee real standard) and negative sign (the actual additional fee standardized) and its effect, separately, evaluated on stock price synchronicity. the results showed that there is a negative relationship between stock price synchronicity and auditing fees with positive signs. the results indicate that investors in excess of the fee paid to the auditor's stock price, leading more contact information to stock price; consequently, positive stock market reaction. also, the study shows that there is no significant relationship between stock price synchronicity and auditing fees. in fact, investors do not react to payments that are less than actual fees paying to auditors. the results are consistent with desai, desai, singhvi, and munsif (2012), srinidhi and gul (2007), krishnan, sami, and zhang (2005) and choi, kim, and zang (2006). each of these studies examined the association audit fees with audit quality and financial reporting process. these results suggest a positive association between audit fees and audit quality. on the other hand, the results are not consistent with wang (2009) results. the study carried out by wang (2009) examined whether the abnormal audit fee related the company's information to the stock price and the results showed that high audit fees lead to auditor independence; so, it decreases audit quality and increases stock price synchronicity and inconsistent results may be due to investors' perception of the relationship. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 254 5.1 research suggestions 1. the study, for the first time, investigates the abnormal audit fees and stock price synchronicity in tehran stock exchange (tse). in future research, the effect of other factors, on each of these variables, can separately be investigated. 2. in this study, only the variables of abnormal audit fees, natural logarithm of the number of firms in the industry, the size of auditing firm, the time spent in the stock market and the natural logarithm of total assets is considered. while many variables, including the ratios of corporate debt, profit, and others in stock price synchronicity are effective; so it is recommended to future researchers to use them. 3. the range of studied years is only from 2006 to 2010, while the use of a longer period of time can give more accurate results. 4. some of the variables have more than one operational definition that it can be used by other definitions. for example, non-audit fees can be used instead of audit fees financial advisory, tax, etc. 5. the research can be used in various industries separately or jointly for some industries and according to the nature of industrial activity, different results can be expected. references ashbaugh, h., lafond, r., & mayhew, b. w. 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(phd thesis), school of accounting and finance, the hong kong polytechnic university. microsoft word 8262-29909-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 138 risk anomaly: a review of literature dr. mayank joshipura professor and head of the department finance at school of business management nmims university, mumbai, india e-mail: mayank.joshipura@nmims.edu mrs. nehal joshipura assistant professor (finance), durgadevi saraf institute of management studies mumbai, india e-mail: nehal.joshipura@dsims.org.in received: sep. 4, 2015 accepted: oct. 13, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8262 url: http://dx.doi.org/10.5296/ajfa.v7i2.8262 abstract number of studies show that portfolio of low risk stocks outperforms portfolio of high risk stocks as well as the market portfolio over the full market cycle on risk adjusted basis and in some cases, absolute basis as well. this surprising contradiction to classic finance theory led by capm has held its ground over long periods of time, across different markets and different methodological choices. this review paper aims at contributing to the body of knowledge in four ways. one, it highlights and links different strands of literature on low risk anomaly that has evolved over a period of time. second, it highlights, different methodological choices that have been used. third, it classifies explanations for persistence of risk anomaly into economic and behavioral explanations and explanations that try to explain the anomaly away. fourth, it reviews the state of current research and explores potential but yet underexplored areas of research on risk anomaly. keywords: market efficiency, risk anomaly, capm, preference for lottery, limits of arbitrage, volatility effect asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 139 1. introduction finance theory suggests that there is clear and linear positive relationship between the risk and the return. one needs to assume higher risk in order to earn higher return. modern portfolio theory (markowitz, 1952) offers the framework to optimize risk return trade-off based on investors’ risk budget by allowing them to construct a portfolio that offers the highest level of expected return at the given level of volatility or alternatively allows to construct a portfolio that offers the higher expected return at given level of volatility. capital asset pricing model (capm) (sharpe, 1964) argues that while there is a positive relation between the risk and return, the reward for the additional risk is limited to the systematic risk only and not available on the total risk. the logic is that a rational investor should be able to diversify away the unsystematic risk and hence no risk premium should be associated with such risk. however, when it comes to measuring performance of any managed portfolio, the most popular measure is the sharpe ratio that measures the excess return (return of a portfolio over risk free return) to volatility, measured by standard deviation and not beta. the reason why an actively managed portfolio may not be a fully diversified is that it intends to outperform the benchmark market portfolio (a proxy for fully diversified portfolio with zero unsystematic risk) on a risk-adjusted basis. therefore they may retain unsystematic risk for the superior returns. in such cases, investors need reward not only for the systematic risk of the portfolio but for the unsystematic risk retained in the portfolio as well. however, empirical evidence showcasing superior risk adjusted performance of low volatility (lv) and minimum variance (mv) investment strategies compared to benchmark as well as high risk have raised questions about direction and degree of positive risk return relationship preached by classic finance theory. a large body of overlooked academic research reveals that risk and return within the equity markets are not correlated, or if they are, it is negative correlation. this surprising contradiction seems to be true and persisting and not varying a great deal with difference in methodological choices and markets. more recently, there are several studies that have highlighted that risk and expected return relationship is not only flat but also actually negative within the asset class such as equity if not across the asset class. this is known as “low risk anomaly”. the proposition is that “portfolio consisting of low risk stocks not only outperforms its high volatility counterpart but also market capitalization weighted benchmark portfolio over a period of full market cycle”. now the next question that immediately comes to mind is that is it possible to have portfolios, which give returns greater than high volatility (hv) portfolio and market portfolio with lesser risk? is it possible to have a portfolio, which lies above the capital market line? this is the basic premise behind ‘exploring for risk anomaly in stock markets!’ there are two ways to test and exploit risk anomaly – [a] low volatility (lv) portfolio and [b] minimum variance (mv) portfolio. many studies in developed markets report superior returns associated with low volatility portfolios over the market portfolio as well as the portfolios with higher risk. the risk being measured either by standard deviation of returns or by beta of the stock returns. here is the brief explanation of the lv and mv investment strategies – asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 140 (a) low volatility investing – this strategy sorts or ranks all the stocks by their historical volatility and/or beta and then forms a portfolio using subset of these stocks – comprising those with the lowest beta and/or volatility. (b) minimum variance investing – it relies on observations and/or estimates of correlations of individual stocks. individual stocks have higher risk, but a well-diversified portfolio when optimized for minimum risk is identified as the minimum variance portfolio. these investment strategies have been noteworthy in the sense that they have been able to deliver higher absolute returns as well as risk-adjusted returns over time. both mv and lv portfolios reduce volatility and face least drawdowns1. we organize remaining part of this paper as follows. section 2 discusses review of literature in general, section 3 discusses different methodological choices, section 4 discusses possible explanations and section 5 discusses road ahead followed by section 6 conclusion. 2. review of major literature initial evidence on “betting against beta” version of risk anomaly throwing light on flatter than expected or even inverse relationship between risk and return as predicted by capm (sharpe, 1964) traces back to 1970’s where ((black, 1972),(haugen & heins, 1975)) show flatter than expected and negative relationship between beta and expected returns. further (fama & french, 1992) report flat relationship between beta and cross section of returns in u.s. markets for 1963-1990 period. (haugen & baker, 1991) and (haugen & baker, 1996) offer initial evidence on inverse relationship between risk and return. more recent studies on risk anomaly can be classified based on choice of 1) portfolio construction methodminimum variance vs. volatility sorting 2) choice of risk measuresstandard deviation, beta, idiosyncratic risk 3) choice of portfolio construction and holding period-short vs. long we further classify various studies based on the way they attempt to explain or explain away, the risk anomaly. 1) studies attempting to explain the volatility effect either by economic reasoning or by behavioral explanation 2) studies attempting to explain away the risk anomaly. minimum variance investing or low volatility investing has been inspired by early work from haugen and baker (haugen & baker, 1991)2. for the period covering the years 1972 to 1989, the authors report that repeatedly investing into a stock portfolio constructed to expose 1drawdown is defined as peak to trough decline during a specific period in the stock price. 2acadian asset management, axa rosenberg, analytic investors llc, invesco, lgt capital management, msci barra, robeco, sei, state street global advisors, martingale asset management llc and unigestion are running minimum variance index concepts. ishare & russel have already launched etfs based on mv indices. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 141 investors to minimum risk (as measured by variance) would outperform the wilshire 5000 index (provide a higher sharpe ratio3). today, the body of research supporting the low risk anomaly studies the period from 1926 to the present. many other studies specific to u.s. markets including (chan, karceski, & lakonishok, 1999), (schawartz, 2000), (jagannathan & ma, 2003) report both higher returns and lower realized risks for the minimum variance portfolio (mvp) versus a capitalization-weighted benchmark (mwp). we discuss some of the major studies and their propositions below. clarke et al. (clarke, desilva, & thorley, 2006a) study focus on the characteristics of minimum-variance (mv) portfolios. the study reports that mv portfolios based on the 1,000 largest u.s. stocks over the period of 1968 – 2005, achieved a volatility reduction of about 25% while delivering comparable or even higher average returns than the market portfolio. this means that the mv portfolios had around 75% of the risk of the market portfolio, with returns comparable to those of the broad market. mv portfolios gave average 6.5% excess return above t-bills with a volatility of 11.7% whereas the market index gave average excess return of 5.6% with a volatility of 15.4%. blitz & vliet (blitz & vliet, 2007) report that low volatility stocks have superior risk-adjusted returns relative to the ftse world development index. the study also reports that low beta stocks have higher returns and high beta stocks have lower returns than predicted by capm. they also provide detailed analysis of the volatility anomaly and demonstrated its robustness across regions and to controls for size, value and momentum effects. they show outperformance associated with low historical volatility stocks both in terms of higher sharpe ratio and higher positive capm alpha. they attribute such sustainable outperformance to restricted borrowing as reported by (black, 1972), decentralized investment approach and behavioral biases such as preference for lotteries. further details on explanations are given in possible explanations section of this document. ang et.al. ((ang, hodrick, xing, & zhang), 2006, 2009) report evidence for inverted relationship between idiosyncratic volatility as opposed to systematic and total risk for a very short term-one month volatility measure in u.s. as well as other global markets. in another recent study by (baker & haugen, 2012) finds that from 1990 – 2011, low risk stocks have produced higher returns in every market worldwide – including emerging markets. frazzini & pedersen (frazzini & pedersen, 2010) document that low-risk securities have high risk-adjusted returns in global stock, treasury, credit and futures market. most recently, (frazzini & pedersen, 2014) report evidence for betting against beta and attributed to leverage constrained investors seeking superior returns bid up the high beta stocks that in turn results into lower expected returns on high beta stocks. 3sharpe ratio = excess return on portfolio over risk free rare divided by standard deviation of portfolio returns. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 142 choueifaty & conignard (choueifaty & coignard, 2008) argue that maximizing a diversification ratio, the weighted average of the stocks’ volatilities divided by the portfolio volatility, as an approach to achieve risk-adjusted returns is superior to those of the market cap-weighted portfolios. based on the results on the universe of u.s. and eurozone securities, they conclude that, if all of the stocks in the study’s universe possess the same volatility, then the maximum diversification portfolio is equal to the global minimum-variance portfolio. baker et. al. (baker, bradley, & wurgler, 2011) report that contrary to basic finance principles, high-beta and high-volatility stocks long underperformed low-beta and low-volatility stocks. karceski (karceski, 2002) provides behavioral explanation to low risk anomaly. according to him, mutual funds investors tend to chase returns over the time and across the funds, possibly because of an extrapolation bias. these forces make fund managers care more about outperforming in bull markets rather than underperforming in bear markets and therefore increase their demand for high beta stocks and reduce required rate of returns. baker et. al. (baker, bradley, & wurgler, 2011) & (baker, bradley, & taliaferro, 2013) provide some explanation for the presence and sustainability of low risk anomaly. according to them, the typical institutional investor’s mandate to outperform a fixed benchmark discourages arbitrage activity in high-alpha, low-beta stocks and low-alpha, high-beta stocks. they replicate (pettengill, sundaram, & mathur, 1995) study which reports higher (lower) total return associated with high beta stock in months where market report above (below) median return compared to their low beta counterparts. the results are similar. however, on capm adjusted basis, low beta stocks still outperform in bull as well as bear markets and provide evidence for presence of low risk anomaly over market cycles. soe (soe, 2012) tests the low-risk anomaly in different markets and across various market cap stocks to find that the low-volatility effect is not unique to the u.s. equity markets; it is present on a global scale. carvalho et. al. (carvalho, raul, xiao, & pierre, 2012) find that a rankings-based or quintile-based low volatility construction approach could be considered as an equal risk budget strategy that does not account for the impact of correlations between stocks. while evidence for risk anomaly is growing, some recent studies report findings in favor of classic positive risk-return relationship or dispute the methodological choices of other studies reporting flat or inverted risk-return relationship. martellini (martellini, 2008) finds that positive relationship between risk and return is intact. however, one must note that the study uses only surviving stocks and therefore systematically ignores stocks delivering significant negative returns before disappearing. (fu, 2009) claims that one should focus on expected rather than historical volatility, and reports a positive relation between risk and return by using egarch models to estimate idiosyncratic volatility. 3. methodological choices asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 143 following variations in term of methodological choices are popular to test presence of risk anomaly. • minimum variance vs. simple volatility sorting based approach • choice of measure of riskhistorical standard deviation, beta or idiosyncratic risk • choice of return measures-simple vs. compounded • choice of period for volatility estimationshort vs. long • choice of universedeveloped countries vs. emerging markets, size and liquidity of the stocks • weighing scheme: equally weighted vs. value weighted • division of portfolios-decile vs. quintiles given below are some of the examples of different methodological choices used in some of the important studies. (clarke, desilva, & thorley, 2006a), (chan, karceski, & lakonishok, 1999), (schawartz, 2000), (jagannathan & ma, 2003) use minimum variance based approach whereas (blitz & vliet, 2007), (ang, hodrick, xing, & zhang, 2006), (baker & haugen, 2012), (frazzini & pedersen, 2014) use risk measure based sorting approach. (clarke, desilva, & thorley, 2006a), (bali & cakici, 2008), (baker, bradley, & wurgler, 2011) use standard deviation or variance as risk measure, (frazzini & pedersen, 2014) use beta as risk measure. (blitz & vliet, 2007) use both standard deviation as well as beta as risk measure. (ang, hodrick, xing, & xhang, 2009) use idiosyncratic volatility as risk measure. (fu, 2009) uses volatility using egarch rather than historical volatility. (ang, hodrick, xing, & zhang, 2006), (martellini, 2008), (bali & cakici, 2008) use simple returns, whereas (blitz & vliet, 2007), (baker, bradley, & wurgler, 2011) use compounded returns. (blitz & vliet, 2007) use three year volatility of weekly returns, (baker, bradley, & wurgler, 2011) use five year volatility of monthly returns. on extremes, (martellini, 2008) use ten-year volatility of monthly returns, whereas, (ang, hodrick, xing, & xhang, 2009) and (bali & cakici, 2008) use very short term one month volatility of daily returns. (fu, 2009) does not use historical volatility at all and uses egarch estimate of daily returns volatility. most of the studies focus on u.s. markets using crsp data including (clarke, desilva, & thorley, 2006b), (ang, hodrick, xing, & zhang, 2006), (fu, 2009), (baker, bradley, & wurgler, 2011). however, there are number of studies focusing on data from other regions and emerging markets and specific size and liquidity based screen in choice of their universe. (blitz & vliet, 2007) use ftse world stocks sample with focus on large stocks with regional focus on japan and europe data, besides u.s. (baker, bradley, & wurgler, 2011) use crsp top 1000 sample besides all crsp stocks in their study. (ang, hodrick, xing, & xhang, 2009) use msci europe and asia sample in their study. (blitz, pang, & vliet, 2012) focus on asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 144 universe from emerging markets only. (martellini, 2008)chooses universe with only survivor stocks form crsp during entire period of 1975 to 2004. (blitz & vliet, 2007), (fu, 2009) use decile portfolios, (ang, hodrick, xing, & zhang, 2006), (ang, hodrick, xing, & xhang, 2009), (bali & cakici, 2008), (martellini, 2008), (baker, bradley, & wurgler, 2011), (blitz, pang, & vliet, 2012) use quintile portfolios. while (blitz & vliet, 2007), (martellini, 2008), (baker, bradley, & wurgler, 2011) use equal weighing scheme, (ang, hodrick, xing, & zhang, 2006), (ang, hodrick, xing, & xhang, 2009), (bali & cakici, 2008) use value weighing scheme and (fu, 2009) uses both. 4. possible explanations while it is difficult to explain presence of such low risk anomaly and its persistence using traditional finance theory and models such as capital asset pricing model (capm) and markowitz modern portfolio theory (mpt), there are some plausible explanations to explain such consistent outperformance of low volatility investment strategies. as we report earlier, there are two sets of explanations available. one set of explanations tries to explain evidence of low risk anomaly using economic or behavioral reasoning. whereas the other set of explanations tries to explain it away. 4.1 economic explanations following are some of the economic explanations. 1. borrowing restrictions: leverage is essential to take full advantage of attractive absolute returns of low-risk stocks. however, in practice there are several restrictions on short selling and leverage allowed for investment purpose. (black, 1972) documents borrowing restrictions applicable for both the individual as well as most of the institutional investors. black (black, 1993) argues that one should look at asset allocation between bonds and low risk equity rather that bond and market portfolio of equity. however, for that, one has to recognize low risk equity as a separate asset class.(blitz & vliet, 2007) and (baker, bradley, & wurgler, 2011) explain underpricing of low volatility stocks and overpricing of high volatility stocks due to such borrowing restrictions. 2. limits of arbitrage: (baker, bradley, & wurgler, 2011) attribute low-beta high-alpha and high-beta low-alpha scenario to the fact that most of the institutional investors are working for beating some benchmark and in order to achieve that they tend to go for high beta stocks. this is because chasing high beta stocks is an easier way to beat the benchmark rather than search for stock with alpha that is high enough to enable them to outperform the benchmark. the alternative way of doing it is by investing in low beta stocks using leverage and outperforming benchmark and benefiting from alpha as well. however, restrictions on borrowing including ‘long only’ mandate leads to elimination of possibility of exploiting arbitrage opportunity between low beta-high alpha and high beta-low alpha stock. 3. decentralized investment approach: in professional investment industry, the practice is that the chief investment officer makes the asset allocation decision and in second stage, capital is allocated to managers who buy securities within the different assets classes. binsbergen et al. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 145 (binsbergen, brandt, & koijen, 2008) attribute inefficiencies in decentralized investment management approach to profit maximizing asset managers’ search for outperformance in up market rather than in the down market. 4. short selling constraints: (hong & sraer, 2012) show that high-risk stocks have greater divergence of opinion about their payoffs making them more prone to speculative overpricing than low-risk ones. short selling constraints, does not allow arbitrageurs to correct the inflated prices of high volatility stocks immediately by going long on ignored low risk stocks and shorting high risk stocks, which in turn, leads to underperformance of high volatility stocks. 5. agents maximize option value: (baker & haugen, 2012) observe that portfolio managers are typically paid a base salary and sufficiently high bonus based on the portfolio return. this makes their compensation resembling a call option with payoff function: c + max(rp – x, 0), where rp is portfolio return, c is base salary or fee and x is the hurdle rate. this in turn results in portfolio managers seeking higher risk and focusing on outperformance during up market rather than down market and taking higher risk by tilting portfolios towards high beta stocks. 4.2 explanations based on investor’s behavior and biases there is the other set of explanations highlighting irrational behavior of not fully diversified investors and how behavioral biases influence investment decision and make investor prefer high volatility stocks with positive skewness and lottery like payoffs and thereby pushing them in to overpriced territory. 1. preference for lottery: the general assumption is that investors are risk averse and that is true under normal circumstances. a layman tends to reject a bet with 50 percent probability of winning rs.110 and 50 percent probability of losing rs.100 despite positive expected payoff associated with this bet. (kahneman & tversky, 1979) explain such behavior as “loss aversion”. however something strange happens with individuals when probability shifts. if the same individual who rejected the bet with positive expected payoff of rs.5 earlier is now offered a bet with almost certain loss of re.1 and a small chance (probability is 0.15 percent) of getting rs.5000, is willing to accept the bet despite negative expected payoff associated with it. that’s the very reason, people buy lottery! this has something to do with positive skewness of payoffs and not volatility. however, (mitton & vorkink, 2007) highlighted that high volatility individual stocks with limited liability, are also positively skewed. buying a high volatility, low priced stock is like buying a lottery high probability of losing money vs. a small chance of doubling or tripling money in short term. (kumar, 2009) shows that individual investors show clear preference for stocks with lottery like payoff measured as idiosyncratic volatility or skewness. (boyer, mitton, & vorkink, 2010) argue that volatility is a proxy for expected skewness. 2. mental accounting: (blitz & vliet, 2007) give a related mental-accounting explanation for the volatility effect, arguing that investors may make rational risk-averse choices for asset allocation decision, but when it comes to security selection within the asset class, they become risk seeking or risk neutral and show preference for high volatility investments with lottery like payoffs. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 146 3. preference for attention-grabbing stocks: (falkenstein, 1996) documents that mutual funds hold firms-in-news more. (barber & odean, 2008) also find that individual investors are net buyers of attention-grabbing stocks. boring low-volatility stocks are neglected causing the volatility effect. 4. representativeness bias: (falkenstein, 2009) argues that representativeness bias may also explain the volatility effect. as explained by (kahneman & tversky, 1983), representativeness bias is that people rely more on appealing anecdotes than on dull analysis. so it creates a logical error: stocks that had the highest returns were risky, therefore risky stocks should have higher expected returns. the widespread heuristic that ‘risk creates returns premium’ causes investors to overweight risky stocks to generate return premium. this actually negates the effect through their collective action. 5. overconfidence: people generally see themselves as better than average on nearly any subjective and socially desirable dimension. (falkenstein, 2009) argues that many people believe that they are capable of successful stock picking. thus investors may be biased towards high-risk stocks for so-called alpha discovery purposes, rooted in overconfidence. also with regard to market timing, there is an implication leading to risk anomaly. if an investor is confident about market rising, he will surely park his money into high-beta stocks to benefit most. if he senses that the market will go down, he will not invest into low-beta stocks; rather will stay away from the equities. 4.3 explanations trying to explain it away there are many studies that try to explain away risk anomaly based on arguments related to methodological choices and other known investment effects. following studies offer such findings. (bali & cakici, 2008) argue that the negative expected returns associated with high volatility stocks reported by (ang, hodrick, xing, & zhang, 2006) are due to presence of small and illiquid stocks with lottery like payoffs. removing these stocks form the sample makes the anomaly insignificant. (martellini, 2008) finds that positive relationship between risk and return is intact using long term volatility rather than short term. however, one must note that the study uses only surviving stocks and therefore systematically ignores stocks delivering significant negative returns before disappearing. (fu, 2009) claims that one should focus on expected rather than historical volatility, and reports a positive relation between risk and return by using egarch models to estimate idiosyncratic volatility. (scherer, 2011) argues that large part of excess return of minimum variance portfolio over benchmark portfolio is attributable to systematic exposure to size and value factors and volatility effect in large part a mere proxy for value effect. (poullaouec, 2010) shows that while msci mv index has outperformed msci world index by 0.5% per annum over a period of 1988 to 2010, large chunk of this outperformance comes from a period of june 2000 to june 2003, period representing the aftermath of dotcom crisis and therefore superior returns of minimum variance strategy are concentrated during extreme bearish periods. (bali, cakici, & whitelaw, 2011)further contest results of (ang, hodrick, xing, & xhang, 2009) by arguing that inverted risk-return relationship is attributable to lottery like payoffs associated with high asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 147 idiosyncratic volatility stocks and substantiate their results by developing variable max to proxy for the preference for lottery-like stocks. they try to establish that max is an independent variable and not a mere proxy for idiosyncratic volatility. 5. road ahead 5.1 critical review risk anomaly has turned out to be one of the longest standing anomalies in the history of modern finance era. it seems to be a global phenomenon and has seriously challenged classic finance theory based on positive risk return relationship. while we have some studies highlighting positive risk-return relationship recently including (martellini, 2008) and (fu, 2009), both studies suffer from survivorship bias and look ahead bias respectively. persistence of risk anomaly has led to researchers looking for explanations and there are enough and compelling economic as well as behavioral explanations to explain persistence of such anomaly. some studies try to explain the anomaly away but that part of the evidence and weak and small at the moment. in closing, it looks like that while positive risk-return relation as prescribed by capm and mpt certainly holds true as asset class level but have come across severe scrutiny within the asset class, especially equity, where the evidence is growing for low volatility with higher expected return and vice versa. the question here is that “is this anomaly going to stay here forever or market learns over a period of time to phase it out?” the answer is as long as we have market frictions such as borrowing restrictions and short selling constraints, call option like compensation structure for portfolio managers that incentivizes them to pursue higher risk and reward them more for outperformance during positive markets only and benchmarking and minimizing tracking error as key performance measure, this is going to stay. besides, emergence of behavioral finance has already established that investor behavior is far from rational both as well as institutional level and therefore preference for lottery, overconfidence, representativeness bias and limits of arbitrage are going to stay for a long, however, as professional investors learn about this, more and more investment strategies will target to benefit from this anomaly and in turn will make it less attractive. for sure, compensation structure of portfolio managers will undergo change to align it in such a manner that the portfolio managers don’t have enough incentive for preferring high beta-low alpha stocks and will reward them for outperformance during down markets as well rather than only during up markets. going forward, some of the changes may reduce the intensity of such anomaly in some of the markets but it seems to be far away. 5.2 scope for further research while there is plenty of work done in exploring and explaining (or explaining it away) risk anomaly, there is a scope for lot of work. first, many strategies that have worked well on paper or theoretically have failed in practice due to execution problems due to market microstructure effects. next phase of work may focus on evaluating potential of low volatility investment strategy vis-à-vis value weighted market portfolio in light of transaction cost, impact cost, taxes and such other microstructure issues. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 148 second, is to provide more empirical evidence on some of the behavioral explanations. except for preference for lottery where (bali, cakici, & whitelaw, 2011) have developed a clear and measurable variable to proxy for lottery-like stocks, other explanations are still more qualitative in nature. third, is to look at testing low volatility effect using implied volatility data from options markets rather than using historical volatility or using conditional volatility estimates such as egarch. the other area of work may be to look at equity mutual fund schemes rather than stocks and see whether risk anomaly can explain cross section of mutual funds’ performance. forth, is some more work to provide clear linkage between positive risk-return relationship in cross section of asset returns and flatter or negative returns within the securities of given asset class. 6. conclusion we conclude that the risk anomaly is one of the strongest and longest standing anomalies of equity markets, which, it is going to stay here for a long time. it has posed significant challenge to classic finance theory. there are several compelling reasons that explain persistence of risk anomaly. one the one hand, we have economic and market friction based explanations, whereas on the one hand, there are behavioral explanations highlighting behavioral biases 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(2012, august 1). the low volatility effect: a comprehensive look. s&p dow jones indices paper. microsoft word 4510-16663-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 289 time varying macroeconomic risk and industry stock returns: empirical evidence from india dr. t.g.saji assistant professor post graduate department of commerce and management studies government college, thrissur, kerala, 680014, india tel: 91-94-4686-9214 e-mail:sajthazhungal@gmail.com received: nov. 4, 2013 accepted: december 10, 2013 published: december 10, 2013 doi:10.5296/ajfa.v5i2.4510 url: http://dx.doi.org/10.5296/ajfa.v5i2.4510 abstract this paper searches further evidence for the relation between the time varying macroeconomic conditions and stock returns in india using monthly data during the post 2000 period. unlike other research in the area, the study uses industry level stock price data on six sectors namely banking, energy, fmcg, information technology, pharmaceuticals and automobiles. data availability and diverging business cycle sensitivity constitute the rationale behind the selection of industry groupings. empirical methodology involves a multi-factor modeling using generalized auto regressive conditional heteroskedasticity (garch) model. the results of the study proved that the expected premium on stock market investments in india was time varying and has been affected by the time varying conditional volatilities of macroeconomic factors. the impact of economic changes found different across the industries and the sectoral variations in stock returns confirm the potentials of industry allocation for the diversification of investment risks. keywords: macroeconomic variables, stock returns, garch, conditional volatilities jel classification: c22, c32, e44 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 290 1. introduction discovering the forces that impel stock returns is a major topic of discussion among academics and practitioners. the stock price movement is highly exposed to the changes in fundamentals, among which the economic factors representing real and financial sectors seems to be dominant. the rationale behind such holding is that the real value of a stock almost equal to the present value of future cash inflows from its investments. the modern financial theory considers systematic factors as the prime sources of variations in stock returns. the specific nature of an economy along with its linkage with the external world often decide the size and patterns of cash inflows to its different sectors in changing economic cycles. sometimes investment in stocks of worst industry at the expansion stage of an economy delivers better return than that the best industry in the declining stage delivers, hence a stock analyst should identify the key economic factors that influence the performance of particular sector and also its relative strength or weakness. several models explaining the relation between stock return and its determining factors are available today. the capital asset pricing model (capm) of sharpe (1964) and lintner (1965) explains the variation in stock returns as the linear function of changes in the market beta. these predictions have become the subject matter of investigation in many studies later. much of the evidence proved empirical contradictions of capm model and they strongly challenged the ability of market return as the sole factor to explain the variations in stock returns. most of these studies suggested the use of a multifactor approach to identify the extra market factors which cause price volatility in stock markets. this approach takes an assumption that the stock return are under the influence of a limited number of economic factors. the pioneer in that approach is arbitrage pricing theory (apt) developed by ross (1976). roll and ross (1980) modified apt in the form of a model capable to test its fitness. in addition to apt, a multi beta capm approach can also be used for discovering extra factors in addition to market return which contribute to stock returns volatility. in practice, risk averters in financial markets want to forecast not only returns, but also volatility during their investments. on realizing this, now a day’s consensus exists among the analysts as to the need of using conditional means and variance in financial econometric analysis. when forecasting expected returns, the investors should consider heteroskadasticity (merton, 1980). literature shows that the class of generalized auto regressive conditional heteroskedasticity (garch) successfully captures asset returns and volatility by allowing the means of asset returns to depend on their time varying variance as well as other contributory factors (butt et al. (2010). as an emerging economy, india has gained significant amount of economic growth during the post liberalization period. being a cost efficient labor rich economy, india is able to capitalize the service sector boom, especially in it and ites sector, in the global market. the economy continues to expand with service sector as its driving force. the economic expansion led to improved income distribution in the country, by this many sectors including banking, automobiles, and fmcg have benefitted much. the global financial crisis badly affected the earnings of certain sectors like pharmaceuticals; information technology etc… since their asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 291 exposure to foreign markets are relatively more. the price fluctuations in crude oil market have affected the performance of energy sector. it is worthy to remember that almost all of these economic revolutions were happened during the post 2000 period. the governance and financial innovation practices during this period have brought in creditable makeovers which in turn fuelled the growth of an equity cult in india. then indian stock market shoots up which rejuvenated confidence to domestic investment base, at the same time augment foreign investment flows in to the country. on consolidating these facts researchers need to answer certain questions. do the economic forces impact the sectoral stock returns in india symmetrically? if not, what are the economic factors critical in predicting stock return variability across the sectors? to answer these questions it is imperative to measure the stock return variations across industries under a transfigured economic frame. the rest of the paper is organized as follows: section 2 reviews related studies. section 3 describes data and methodology employed in this study. section 4 discusses the results of the analysis and section 5 concludes the paper. 2. review of literature a significant amount of empirical literature investigates the relations between the economic variables and stock returns by using multifactor asset pricing models in different country contexts. as a pioneering work in the area, chen (1983) gave an economic interpretation to statistical factors. in their popular work, chen, roll and ross (1986) use a six factor model based on monthly data for the period of 1953-1983 and found industrial production, risk premium and term structure premium as the significant determinants of stock returns in u.s market. their model failed to capture the stock returns’ relations with factors like market returns, changes in expected inflation, and unexpected inflation. later zhou (1999) confirmed the statistical significance of four out of six variables used by chen et al. (1986) in predicting u.s stock returns. mukherjee and naka (1995), wongbangpo and sharma (2002), chaudhari and smile (2004), majid and yousof (2009), gazi and hisham (2010), ibrahim (2011) and ray (2012), all of these studies have found significant positive association between stock prices and economic activities in various countries. fama and french (1993) introduced a ‘three factor model’ in the spirit of arbitrage pricing theory. they argued that the effects of size and book equity to-market equity could be explained as manifestations of risk premiums. using an arbitrage pricing type model they show that stocks with higher sensitivity on size or book-to-market factors have higher average returns. according to them risk is determined by sensitivity of a stock to three factors (1) market portfolio, (2) a portfolio that reflects relative returns of small verses large firms and, (3) a portfolio that reflects relative returns of firms with high verses low book-to market ratio firms. they argued that even though size and book to market equity ratios are not direct factors affecting returns, they perhaps might be proxies for more fundamental determinants of risk. thus they conclude that these patterns of returns are consistent with efficient market hypothesis in which expected returns depend solely on risk. bae and duvall (1996) applied multi-index capms to explore the relationships of us aerospace industry stock returns to selected market and industry variables during the period 1982 -1991. the study found that the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 292 market returns represented by the s&p 500 index and department of defense expenditures are significantly positively related to aerospace stock returns. cauchie, hoesli and isakov (2002) investigated the determinants of stock returns in a small open economy in an arbitrage pricing theory framework. the analysis is conducted with monthly data from the swiss stock market over the period 1986-2000. they used data on industrial sector indices, as well as macro-economic data and found that swiss equity returns are influenced by both global and domestic economic conditions. the results also show that the statistically determined factors yield a better representation of the determinants of stock returns than the macro-economic variables. rehman and saeedullah (2005) applied a multi-index model to relate the stock returns of pakistan cement industry firms to selected market and industry variables. they found industry variables are insignificantly related to the stock returns of cement industry but they do increase the explanatory power of the model. in indian scene, madhusoodanan (1997) conducted a study to find out the relationship between the expected return and risk by using portfolio method rather than the individual security approach. for the purpose, portfolios were formed to test their performance in the consequent period. results indicated that the risk and expected return in the indian market are not necessarily positively related. moreover in indian market, the investor rationality and risk aversion do not appear to be important. sehgal (1997) empirically tested three-parameter capital asset pricing model in indian capital market by taking monthly rates of return (adjusted for bonus, stock splits and right issues) for 80 securities included in bse national index. the evidence indicated that capm is not a suitable descriptor of asset pricing on the indian capital market for the period of the study. slope was found negative but insignificant for the total period, implying absence of any significant relationship between beta and average return. malakar and gupta (2002) took an effort to explain the major determinants of sectoral stocks in indian stock market. their sample consists of eight major cement companies india and study covered the period from 1968 to 1988. the study has found earnings per share and investment expenditure to be significant determinants of share price. mishra (2004) examined the relationship between stock market and foreign exchange markets in india using granger causality test and vector auto regression technique .they used monthly data for stock return, exchange rate, interest rate and demand for money for the period 1992 to 2002. the study found a unidirectional causality between the exchange rate and interest rate and also between the exchange rate return and demand for money. the study also suggested that there is no granger causality between the exchange rate return and stock return ahmed (2008) examined the nature of the causal relationships between stock prices and the key macro economic variables representing real and financial sector of the indian economy for the period march, 1995 to march, 2007 using quarterly data. the results of the study revealed differential causal links between aggregate macro economic variables and stock indices in the long run. however it revealed that causal pattern is similar in both markets in the short run. the study results indicate that stock prices in india lead economic activity except movement in interest rate. interest rate seems to lead the stock prices. based on capm as theoretical framework and the samples of size varying from 182 companies to 544 companies for various estimations period between april 1991 to march 2006 francy asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 293 (2008) provides empirical validity of the three factor model of fama and french(1992) in determining stock returns in india. the explanatory power of the three-factor model was found to lie between 69 per cent and 90 per cent for the various portfolios constructed which shows that the three-factor model has captured the majority of the positive returns that had been left unexplained by the capm in indian context. time variation in stock market volatility is also a matter of investigation for many researchers in different market context. errunza and hogan (1998) in their study, provide evidence for the impact of past variability of economic factors on european stock market volatility. similar study was under taken by mei and hu (2000) based on real estate stock returns of some asian countries and found that risk premium of asian property stocks influenced significantly by macroeconomic risk factors. bivariate garch m model of fang and miller (2002) measured the time varying conditional variances of stock market returns and currency depreciation in five emerging east asian markets. liow (2004) proved the expected risk premium on real estate stock in singapore were time varying and correlated to time varying conditional volatilities of macroeconomic variables. in their comprehensive study liow, ibrahim and huang (2006) extend the work of liow (2004) to some more markets, japan, hong kong and uk. even though the study confirmed the validity of previous findings, it found that the impact of macroeconomic factors on property stock returns quite different across the markets. joseph and vezos (2006) by using an egarch model tried to capture the impact of interest rate movement and exchange rate changes on us banks stock returns. the results showed that market return contributed to the variation in stock returns and its sensitivity towards both interest rate changes and exchange rate fluctuations was not much significant. butt, rehman, khan and safwan (2010) under garch m framework examined the stock returns variations to specific economic variables by applying a multi factor model. the model applied on the stock returns of firms from two industriesbanking and textile in pakistan. the study found that economic exposure is higher at industry level than the firm level stock returns. in their study, donadelli and lucchetta (2013) found equity risk premium in emerging market is higher than that in developed markets. their study also confirmed the time varying nature of emerging stock market excess returns. on reviewing the available literature it is quite evident that the research on the impact of macroeconomic performance on the stock price behavior is not scanty in indian context. but most of these studies provide a general measurement of stock return variations influenced by various economic factors. surprisingly very few published research is found concerning the causality between the economic variables and sectoral stock returns in india. moreover indian corporate sector as well as stock market received significant growth during the post financial sector reform phase (second phase) of 2000. to the best of our knowledge, no exhaustive work on the impact of macroeconomic performance on stock returns of different industrial groupings covering this period in indian context has not made so far. this paper ultimately attempts to discover which, if any, of the economic variables are of use in explaining the variability of industry stock returns in india. however this paper does not evaluate the stock return performance of a particular sector relative to that of others in terms of its sensitive change to a specific industry variable. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 294 3. data and methodology 3.1 data the researcher limits this study to selected six independent (macroeconomic) variables which once identified through literature review. along with these economic variables, market return measured by the relative change in nse nifty is also used as independent variable. industrial production index in india is compiling and publishing on monthly basis, hence it is used instead of gdp to give proxy for the domestic supply factors/national output. to gauge the money stock in the economy the most popularly used broad money supply (m3) and to give proxy for interest rate prevailing in the economy 3 months’ treasury bill (tb) rate has been used in this study. to account for inflation, the whole sale price index and to check the linkage with the external world, rs/$ exchange rate is used. to recheck the validity of some of the earlier studies finding that foreign institutional investors is the crucial factor deciding the stock price behavior in india, fii net flows to india has also included in the data frame. data selection takes into account the data availability and their accessibility within the available timeframe. most of the macroeconomic variables under study is available on monthly basis only which restrict the study to choose monthly data. required macroeconomic data were mainly obtained from rbi handbook on statistics and economic survey reports (various issues) published by government of india. the data for nifty was obtained from the website of national stock exchange. then, stock returns from six industries namely banking, energy, fmcg, information technology, pharmaceuticals and automobiles were considered based on the availability of the data. monthly closing values of the indices representing these sectors were used for ascertaining the sector wise stock returns. among these six indices, all five indices except, automobile are nse indices. since nse is not publishing any automobile sector index, the index representing automobile stock movement has taken from bombay stock exchange. realty and infrastructure indices could also not to be included as these indices have been compiled and published by stock exchanges in india since 2005 only, the inclusion of which definitely lack data consistency in comparison on time period basis. as many of the sector indices values are available from the financial year 2001-02 only, this part of analysis covered only nine years from that financial year to 2009-10. 3.2 empirical methodology the study relates the performance of six industrial stock returns in india with the macroeconomic performance of the country during the post 2000 period. it estimates five garch (generalized autoregressive conditional heteroskedasticity) equations separately to find out the sensitive relationship of each of the selected industrial stock returns with the macroeconomic performance of the country. the empirical procedure pursued in the study is detailed below: 3.2.1 unit root test time series analysis must be stationary for producing most reliable results. a data series is said to be stationary if its mean and variance are constant (non-changing) overtime and the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 295 value of co variance between time periods depends only on the distance or lag between two time periods and not on the actual time at which the covariance is computed. estimation using non-stationary data will lead to unreliable t-statistics, as the underlying time series would theoretically have infinite variances. so before initiating any type of advanced econometric techniques for the study, at first it should check the stationary property of the time series variables used in the study by performing unit root test. the study has followed the standard procedure of unit root testing by employing the augmented dicky fuller (adf) test. adf test on the variables in level and first difference is employed to check for stationary. augmented dickey fuller (adf) test adf is a parametric method for controlling higher order correlation by assuming that the series follows an ar (p) process (dickey and fuller 1979, 1981). this process is done by adding lagged difference terms of the dependent variable to the right-hand side of the regression. the augmented dickey-fuller test requires running a regression of the first difference of the series against the series lagged once lagged difference terms and a constant with a time trend such as: )1( 1 1100 −−−−−−−+δ+++=δ  = −− t m i titt yyty εγλβα where ∆ is the first difference operator, εt is an error term, and m is the number of lagged first differenced term and is determined such that εt is approaching white noise. the ho hypothesize that yt is non stationary time series (has a unit root) translates in to hoe: λ= 0. the output of the adf test consists of the t (tau) statistic on estimated coefficient of the lagged variable (λ) and the critical values for the test of a zero coefficient. if the estimated adf statistic is larger (in absolute) than its critical value then the null is rejected suggesting that the series is a stationary. the choice of optimal lag length used in the unit root tests is determined by applying akaike (aic) and schwarz (sic) information criteria. 3.2.2 garch (generalized autoregressive conditional heteroskedasticity) conventional econometric analysis takes homoskedasticity assumption or views the disturbance terms as constant over time (asteriou and hall, p. 249). but most of the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 296 financial data exhibit periods of unusually high volatility followed by more tranquil periods of low volatility. in such cases the assumption of homoskedasticity is very limiting, and in such instances it is preferable to examine patterns that allow the variance to depend upon its history. estimates a garch model (garch = generalized autoregressive conditional heteroskedasticity), either a univariate model or a multivariate model, if independent variables are selected, including the given exogenous variables. the conditional variance equation is shown below. )2( 11 2 0 −−−−−−−++=  = − = − p j jtj q i itit hh βεαα the parameter p therefore represents the generalized (or "ar") order, while q represents the regular arch (or "ma") order. if p is non-zero, q must also be non-zero otherwise the model is unidentified. however, one can estimate a regular arch model by setting q to a positive value and p to zero. the sum of p and q must be not greater than 5. 4. results and discussions 4.1 industrial stock returns – descriptive statistics table 1 presents the summary statistics for the five industrial sector indices for the period 2002-2010. minimum and maximum rate of return provided by each sector index during the period and their respective mean, standard deviation (s.d) and skewness are also reported. sd and skewness are computed for explaining the volatility and normality of the distribution respectively. lower rate volatility in the distribution of return indicates more consistency in market and lesser chance for investors to lose their money. generally value for zero skewness represents that the observed distribution is normally distributed. the skewness coefficient, in excess of unity is taken to be fairly extreme (chou 1969). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 297 table 1. industrial stock returns – descriptive statistics minimum maximum return on annual basis s.d skewness banking -26.66 44.53 28.80 10.53 0.200 energy -29.02 36.60 27.72 9.19 -0.088 fmcg -17.90 28.21 13.32 6.93 0.303 it -42.00 38.21 13.92 11.29 -0.316 pharmaceuticals -24.38 16.48 20.02 7.14 -0.534 *automobiles -26.92 31.80 23.16 9.28 -0.002 compiled from nse industry indices data *bse auto index data the statistics shows that the return generating capacity of different sector stocks are not uniform during the study period. moreover the variability of returns which is measured by both standard deviation and range (difference between maximum and minimum of returns during a period) is also much different from industry to industry. when the banking sector scrip delivered the highest return of 28.80 per cent to its investors, energy sector delivered almost same scale of return with 27.72 per cent. automobiles and pharmaceuticals were produced returns at the rate of 23 per cent and 20 per cent respectively. the performance of information technology and fmcg stocks in terms of return were far behind of other sector indices. but in risk terms the performance of fmcg sector indices outperforms other sector indices. pharmaceutical stocks also showed more consistency compared to the stocks of remaining sectors. stability in delivering returns to investors by energy sector is almost similar to that of automobiles during this period. information technology and banking sector stocks proved to be the most risky investments for investors with the standard deviations of 11.29 per cent and 10.53 per cent respectively. the variability in return from these sectors in terms of range is also considerably high compared to other sectors. here it is also very interesting to note that the return profile of the most risky stock investment among the group – information technology sector stocks is somewhat poor which further creates an impression that the return from stock investments of all sectors shall not always be commensurate with its risk profile. investment in it sector stocks in india has not been better rewarded for the level of the risk that its investors actually assumed during the period of the study. it can also be seen that frequency distribution of all the indices except energy and automobiles are not normal, but none of them showed any extreme skewness. skewness coefficient for both energy and auto sector returns almost equal to zero which one way help to say that market for these two sectors is relatively normal. when it and pharmaceutical indices showed moderate degree of negative skewness indicating the greater probability of large decreases in prices rather than rises, banking and fmcg sectors showed low degree of positive asymmetry in its distribution of returns. thus the descriptive statistics on variance and skewness contribute to different volatilities across the industrial sectors in india. consequently the base hypothesis in every efficient asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 298 capital market that the stock returns and macroeconomic performance are normally distributed may not be validated. these findings suggest that stock returns and economic time series exhibit conditional heteroskedasticity and that a garch specification is appropriate for capturing the presence of time varying volatility. 4.2 unit root test results adf test is applied on all variables that is, on both stock returns and economic factors. in adf unit root test, we test the null hypothesis that the time series has a unit root or it is non-stationary. table 2. test results for stationarity of variables variables level (with trend and intercept) first difference (with trend and intercept) test statistic p value test statistic p value energy -3.8995 0.0121** -4.6408 0.0008* information technology -2.2288 0.4729 -4.8304 0.0004* pharmaceuticals -2.5398 0.3087 -4.9389 0.0001* fmcg -2.2088 0.4840 -4.3231 0.0028** banking -3.3113 0.0643*** -3.9479 0.0103** auto -2.9681 0.1413 -2.7632 0.0824*** nifty -3.0524 0.1180 -4.3760 0.0023* exchange rate -3.4173 0.0490** -3.9084 0.0117** m3 -1.6895 0.7562 -7.3649 0.0000* wpi -2.0260 0.5865 -4.9822 0.0001* tbr -2.3104 0.4246 -10.4551 0.0000* iip -1.8458 0.6823 -6.0065 0.0001* fii -5.4718 0.0000* -7.2943 0.0000* *significant at 1 per cent level ** significant at 5 per cent level *** significant at 10 per cent level table 2 summarizes the results of adf unit root tests. on the basis of test statistics, only the banking and energy stock returns found stationary at levels with intercept and linear trend. among the independent variables all the series except foreign institutional investment net flows and exchange found non stationary at level. so it is reasonable to believe that these series are integrated of order 0, hence i(0) variable. but the remaining stock returns and macroeconomic variablestbr, wpi, and m3 are integrated of order one, i(1), as they asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 299 become stationary with intercept and trend after their first differencing. 4.3 garch results the stock performance of six sectors was analyzed at industry level. the fitted garch models estimate diverse pattern of relationship between industrials stock returns and the macroeconomic conditions in india. both arch and garch terms are statistically significant for three sectorsinformation technology, energy and fmcg; which establish the time varying characteristics of their stock returns volatility. conditional volatility of stock returns of these sectors could be the function of both the lag of the squared residuals and lagged variances. only garch term is statistically significant for the remaining sectors which provide the impression that the stock returns of banking, pharmaceuticals and automobile sectors are the functions of their lag variances. the statistically significant relationship between risk (lag variances) and returns provide the evidence for the risk premium for the risk associated with the stock returns of all sectors. table 3. macroeconomic factors and stock returns: garch results dependent variable constant nifty wpi exchange iip m3 fii(net) t bill rate arch garch rate information -1.9106*** 4.7234* -2.1437** 1.8393*** 1.8201*** -0.4334 -1.132 -2.2924** 1.8549*** 8.2768* technology -0.056 0.0000 -0.0321 -0.0659 -0.0687 -0.6647 -0.25764 -0.0218 -0.0636 0.0000 pharmaceuticals -0.1452 3.2217* -0.442 1.1025 -1.4653 0.4545 -0.9727 1.132 0.0206 9.5320*** -0.8845 -0.0013 -0.6582 -0.2703 -0.1484 -0.6495 -0.3307 -0.2576 -0.9836 -0.0508 energy 1.3086 7.1307* -0.2773 0.798 -0.3886 -2.7577* -12.4251* 0.8462 1.9534*** 2.1497** -0.1907 0.0000 -0.7816 -0.4249 -0.6976 -0.0059 0.0000 -0.3875 -0.0508 -0.0316 banking 2.6917* 0.9629 -0.7321 -1.3642 -2.5641** 0.5803 -0.3126 1.0061 0.7593 3.9674* -0.0071 -0.3356 -0.4641 -0.1725 -0.0103 -0.5617 -0.7546 -0.3144 -0.4477 0.0000 automobiles 0.5038 -3.8297* 0.1149 -1.7957*** 1.1311 0.0849 -0.6721 -1.1461 0.7617 4.8185* -0.6144 -0.0001 -0.9085 -0.0725 -0.258 -0.9324 -0.5015 -0.2518 -0.4462 0.0000 fmcg 1.0082 0.0763 -0.0541 -0.6691 -0.9006 -1.2716 -0.0035 1.8847*** 2.3365** 11.1522* -0.3133 -0.9392 -0.9569 -0.6571 -0.3678 -0.2035 -0.9972 -0.0595 -0.0194 0.0000 (figures given in parentheses indicate p value) *significant at 1 per cent level ** significant at 5 per cent level *** significant at 10 per cent level market exposure found as the most significant factor in determining stock returns in india. this is because market return has significant relationship with stock returns of the sectors other than banking and fmcg. but automobile stock returns have only negative impact by general market changes. indian banking and fmcg sectors performed relatively well even during the period of recession. when the growth of banking sector in the country is mainly due to the prudent rbi policies, the domestic market orientation insulates the fmcg sector from the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 300 economic downturns (saji, harikumar & kasim, 2013). this could be taken as the better explanation for the independence of the stock return of these two sectors from the changes in benchmark index. garch estimation results also provide evidence for the diverging nature of stock returns exposure at industry level to the changes in economic factors. wholesale price index is insignificant to stock returns of almost all sectors except that of information technology. this suggests that the rising inflation in the country often leaves the stock returns of most sectors being unaffected. however the inflationary conditions in the country pull down the performance of it sector, hence its stock returns also. the fluctuations in value of dollar against rupee are affecting the stock returns of only two sectors, information technology and automobiles. it stock return is impacted positively by the depreciation of indian rupee. indian it industry is more exposed to the export market (us and europe) for their revenues (nasscom, 2008), hence the depreciation of rupee enable it to make more earnings on dollar realizations. however the continuous depreciation of rupee is causing a negative effect on stock returns of automobile sector. indian automobile sector is depending heavily on foreign supplies for their input materials and assembling parts. the rupee depreciation definitely brings in increased cost to the sector in rupee terms. industrial production index is positively related to the it stock return and negatively related to banking returns. other sectors hold no causal relation with index of industrial production. the positive relationship between it stock returns and real output might be due to the dominant share of it industry in the total industrial production of india. the negative relationship between banking stock returns and the total production in real sector shows the diversion of investible wealth from financial sector to real sector and vice versa. money supply variable has shown insignificant relationship in almost sectors. the broad money variable holds significant bearing only on energy sector returns. fii net flows are insignificant for almost all sectors, but have shown uniform behavior to stock returns in india. this external variable holds inverse relationship with the price changes in different sectors. however such relationship is significant for energy sector only. the insignificance of impact of fii on stock returns in india imples the strength of the domestic institutional investment base of the country which seems to be vital inputs for policymakers and regulators. the interest rate is found negatively related to the stock returns of it and automobile sectors; nevertheless the impact is significant for only it sector. the lower interest rate means lower cost of capital and better corporate earnings, which influence positively on share prices of these two sectors. with the stock returns of remaining sectors, the interest rate variable is positively related. among these, except banking, all other sectors are more of defensive nature; hence rational to treat their stock returns independent of interest rate changes. the positive relationship of banking stock returns can be attributed to the nature of the industry being financial sector. the market return contributes largely to the variations in stock returns of most of the sectors. many of other economic variables also account for variations in stock returns even though the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 301 study observed their impact different across the sectors. so the inclusion of relevant economic variables along with the market return in a model definitely adds its explanatory power in estimating stock returns. this finding do up the utility of multifactor modeling in stock return estimation which earlier reported in studies like chen et al (1986) and butt et al. (2010). 5. conclusion the study investigates the relations between time varying macroeconomic conditions and industrial stock returns in india. the descriptive statistics on variance and skewness suggest that stock returns and economic time series exhibit conditional heteroskedasticity. hence the garch specification is appropriate for capturing the presence of time varying volatility in india. multivariate asymmetric garch modeling administered in the study found evidence of linkage between macroeconomic conditions and industrial stock returns. however the impact of macroeconomic forces on stock returns is different from industry to industry. we find the evidence of maximum economic shocks on the stock returns of india’s flagship industry, information technology sector. except money supply and index of industrial production, all other economic variables have strong bearing on the stock returns of information technology. when energy sector returns is impacted by money supply and foreign institutional inflows, automobile stock returns and fmcg stock returns are affected by the changes in exchange rate and interest rate respectively. the stock returns of financial services sector, banking sector, have shown negative responses to the increases in the total productivity of the country. the negative relationship between banking stock returns and the total production in real sector revealed the diversion of investible wealth form financial sector to real sector and vice versa. pharmaceutical stocks remain indifferent to the changes in the macroeconomic conditions. market return is the most significant factor which contributes to the variations in industrial stock returns in india. so we can expect the existence of risk premium at least for the market risk associated with the stock returns at industry level. moreover the stock return volatility revealed time varying properties across the industries which basically could be the outcome of both the lag of the squared residuals and lagged variances in most cases. ultimately this study rationalizes the usefulness of a multifactor model in stock return estimation process. along with the market return one has to include other economic variables also which is significant in explaining stock return variations. the nature and degree of relationship between stock returns and economic variables are different across the industries. hence the investor of a particular sector has to design a model by including those variables which have sufficient explanatory power in determining his stock returns. the vigor of this paper is to supply with different models using relevant economic variables by judging their fitness and also by substantiating the reason for the inclusion of a particular variable in an estimation model. the findings and implications of this study are limited to the post financial sector reform period 2000-2010 for india. using alternative methodologies such as cointegration, ardl etc.., incorporating longer sample period and including other macroeconomic variables that asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 302 may potentially affect stock returns might improve further analysis and significance of the study in this issue. moreover the inclusion of data about other prominent emerging markets definitely makes the study more fruitful by better generalization of the results in emerging market context. references asteriou, d., & hall, s.g. 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(1980). on estimating the expected return on the market. journal of financial economics, 8, 323-361. http://dx.doi.org/10.1016/0304-405x(80)90007-0 microsoft word 5565-20060-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 440 does the relationship between accounting disclosure and bank loan contracts vary with borrower characteristics? evidence from emerging markets dekui li school of management, wuhan yangtze business university 3, huangjiawu west road, hongshan district, wuhan, hubei 430065, china tel: 86-27-88147108 e-mail: jerryinkorea@gmail.com liang song (corresponding author) school of business and economics, michigan technological university 1400 townsend drive, houghton, mi 49931, united states tel: 1-906-487-4368 e-mail: liangs@mtu.edu zhaoguo zhang school of management, huazhong university of science and technology 1037 luoyu road, wuhan, hubei 430065, china tel: 86-2762273783 e-mail: xuehai0225@126.com received: april 30, 2014 accepted: june 23, 2014 published: june 23, 2014 doi:10.5296/ajfa.v6i1.5565 url: http://dx.doi.org/10.5296/ajfa.v6i1.5565 abstract we examine how borrower characteristics affect the relationship between accounting disclosure and bank loan contracts in emerging economies. we find that the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with smaller size, higher leverage, lower profitability, lower tangibility, less diversity, younger age, and less lending asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 441 relationship. these results suggest that the relationship between accounting disclosure and bank loan contracting terms are more pronounced for firms with higher credit risk. keywords: accounting disclosure, bank loan contracts, emerging markets asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 442 1. introduction one stream of empirical studies have demonstrated that banks provide more favorable loan contracting terms such as larger loan size, longer loan maturity, and lower loan spread for borrowers with superior disclosure rankings (e.g., armstrong et al., 2010; hasan and song, 2014; mazumdar and sengupta, 2005). another stream of academic research has shown that borrower characteristics have a significant effect on bank loan contracting process because banks take into account of borrower characteristics as risk factors to determine the loan contract (e.g., strahan, 1999). however, little attention has been paid to the interaction effects between accounting disclosure and borrower characteristics on bank loan contracts. in this paper, we try to fill this void by investigating whether the relationship between accounting disclosure and bank loan contracts vary with borrower characteristics in emerging markets. when creditors are trying to make a loan to a firm, they have to evaluate the borrower’s credit risk. however, one obstacle in this process is the information asymmetry problems between lenders and borrowers (bharath et al. 2008; diamond, 2004). borrowers’ superior accounting disclosure can alleviate this information asymmetry problem and this effect should be more significant for firms with higher risk because banks can better monitor well-disclosed borrowers (botosan, 1997; botosan and plumlee, 2002; mazumdar and sengupta, 2005). emerging economies provide a sound testing ground for this research question because there is not enough country-level investor protection compared with developed countries and banks should pay more attention to borrowers’ characteristics and their accounting disclosure levels (hasan and song, 2014). employing a sample including eleven emerging economies, we find that the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more pronounced for borrowers with smaller size, higher leverage, lower profitability, lower tangibility, less diversity, younger age, and less lending relationship. these results suggest that the relationship between accounting disclosure and bank loan contracting terms are more significant for firms with higher credit risk. our paper contributes to the existing literature by several ways. first, as mentioned before, the individual effects of accounting disclosure and borrower characteristics on bank loan contracting process have been examined extensively in the existing literature (e.g., hasan and song, 2014; mazumdar and sengupta, 2005; strahan, 1999). we add to this strand of literature by showing how accounting disclosure and borrower characteristics interact to affect bank loan contracts. thus, we provide a more comprehensive picture about the bank loan contracting process. second, the existing literature such as bae and goyal (2009) and qian and strahan (2007) have shown the influence of country-level factors on bank loan contracts. we contribute to this stream of literature by investigating how firm-level factors influence bank loan contracts. thus, we have shown more determinants of financial contracts in the syndicated loan market. finally, the existing literature has investigated the effects of accounting disclosure and corporate governance on the syndicated loan market in emerging economies (e.g., francis et asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 443 al., 2012; hasan and song, 2014). we contribute to this strand of literature by examining how borrower characteristics influence the effects of accounting disclosure on bank loan contracts. thus, we provide a more complete picture about the determinants of bank loan contracting process in emerging markets. the rest of the paper is organized as follows: section 2 describes the hypotheses about the effects of borrower characteristics on the relationship between accounting disclosure and bank loan contracting terms. section 3 presents the sample, variable construction, and summary statistics. section 4 shows the methodology and results. the last section concludes. 2. the effects of borrower characteristics the existing literature has established that the information asymmetry problems between banks and borrowers are important determinants of bank loan contracting terms. for instance, jappelli and pagano (1993) argue that lenders would like to provide more credit if borrowers have a better information environment. diamond (2004) shows that lenders reduce the loan maturity if borrowers are more opaque. freixas and rochet (1997) presents that information asymmetry problems between creditors and borrowers significantly influence the loan spread. borrowers’ accounting disclosure can reduce banks’ cost to obtain the useful information about borrowers (mazumdar and sengupta, 2005). thus, banks should provide more favorable contracting terms when borrowers have superior disclosure rankings. for example, hasan and song (2014) have shown that well-disclosed borrowers obtain a better bank loan contracts such as larger amount, longer maturity, and lower spread in emerging markets. 2.1 company size as argued in strahan (1999), larger companies are more possible to generate stable cash flows to service the future debt payment compared with small ones. in addition, larger companies are more likely to survive the financial crisis because of their established reputation in the market. thus, larger companies can obtain better bank loan contracting terms. smaller companies have more credit risk and the influence of accounting disclosure on bank loan contracting terms should be more pronounced for companies with smaller size. hypothesis 1: the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with smaller size. 2.2 company leverage companies with higher leverage are more likely to face future insolvency (strahan, 1999). in addition, these companies are more likely to have moral hazard problems. for example, higher leverage companies have incentive to change low risk assets to high risk assets after they obtain a loan from a creditor. thus, lower leverage companies can obtain better bank loan contracting terms. higher leverage companies have more credit risk and the influence of accounting disclosure on bank loan contracting terms should be more pronounced for companies with higher leverage. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 444 hypothesis 2: the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with higher leverage. 2.3 company profitability companies with higher profitability are more likely to generate future cash flow to service the future debt payment (strahan, 1999). thus, companies with higher profitability can obtain better bank loan contracting terms. companies with lower profitability are more risky and the effects of accounting disclosure on bank loan contracting terms should be more pronounced for companies with lower profitability. hypothesis 3: the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with lower profitability. 2.4 company tangibility tangible assets can reduce firms’ information asymmetry problems and can be used as collateral to obtain a loan (strahan, 1999). thus, companies with higher tangibility can obtain better bank loan contracting terms. companies with lower tangibility have more credit risk and the influence of accounting disclosure on bank loan contracting terms should be more pronounced for companies with lower tangibility. hypothesis 4: the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with lower tangibility. 2.5 company diversity diversification can reduce companies’ risk because the cash flow for the future debt repayment can be generated by several separate business lines. thus, companies with higher diversification can obtain better bank loan contracting terms. companies with lower diversification have more credit risk and the influence of accounting disclosure on bank loan contracting terms should be more pronounced for companies with lower diversification. hypothesis 5: the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with less diversity. 2.6 company maturity companies with a long history are more likely to have a good reputation in the capital market and are more competitive in their own industry. thus, companies with a long history can obtain better bank loan contracting terms. companies with a short history have more credit risk and the influence of accounting disclosure on bank loan contracting terms should be more pronounced for companies with younger age. hypothesis 6: the effects of accounting disclosure on bank loan contracting terms such as the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 445 loan size, the loan maturity, and the loan spread, are more significant for borrowers with younger age. 2.7 company lending relationship companies with a longer lending relationship are more likely to have a less information asymmetry problem because banks are more familiar with these companies (benston and smith, 1976; fama, 1985). thus, companies with a long lending history can obtain better bank loan contracting terms. companies with a short lending have more credit risk and the influence of accounting disclosure on bank loan contracting terms should be more pronounced for companies with less lending relationship. hypothesis 7: the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with less lending relationship. 3. sample, variable construction, and summary statistics 3.1 sample and variable construction our sample period is from 2000 to 2007, which exclude the u.s. financial crisis period of 2008. our sample covers 11 economies: brazil, chile, hong kong, india, south korea, malaysia, the philippines, singapore, south africa, taiwan, and thailand. our sample includes 436 loans for 103 firms. following the existing literature (e.g., francis et al., 2012; hasan and song, 2014; klapper and love, 2004), we define the variable company_disclosure as the total value of the answers to the questions in the transparency category of the 2000 survey by credit lyonnais securities asia (clsa). we construct the variable company_governance as the average value of the answers to the questions in the management discipline, independence, accountability, responsibility, and fairness categories of the 2000 clsa survey. our borrower characteristics are from the worldscope database and the company website. we define the variable company_size as the logarithm of total assets. the variable size_dummy is equal to one if a company has more than the median value of company_size and zero otherwise. we construct the variable company_leverage as total liability scaled by total assets. the variable leverage_dummy is equal to one if a company has more than the median value of company_leverage and zero otherwise. the variable company_profitability is defined as earnings scaled by total assets. the variable profitability_dummy is equal to one if a company has more than the median value of company_profitability and zero otherwise. we define the variable company_tangibility as pp&e scaled by total assets. the variable tangibility_dummy is equal to one if a company has more than the median value of company_tangibility and zero otherwise. we construct the variable company_diversification, which is equal to one if a company has more than one segment and zero otherwise. the variable diversification_dummy is equal to one if company_diversification is equal to one and zero otherwise. the variable company_maturity is defined as the number of years since their ipo. the variable asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 446 maturity_dummy is equal to one if a company has more than the median value of company_ maturity and zero otherwise. the variable company_lending_relationship is defined as the logarithm of the sum between one and the number of previous borrowing. the variable lending_relationship_dummy is equal to one if a company has more than the median value of company_lending_relationship and zero otherwise. the two country-level variables are constructed as the control variables. specifically, the variable country_investor_protection is defined as the average value of the world governance index. the variable country_gdp_growth is equal to change in gdp per capita, which is from the world development indicator database. our bank loan variables are from the dealscan database. specifically, the variable bank_loan_size is used to measure loan amount. the variable bank_loan_spread is used to measure loan maturity. the variable bank_loan_spread is used to measure loan spread. the variable bank_loan_type_dummy is a series of dummy variables for different types of loans such as term loans. the variable industry_dummy is a series of dummy variables for each industry. the variable year_dummy is a series of dummy variables for each year. 3.2 summary statistics table 1 presents the summary statistics of our variables. we report mean, standard deviation, 10th percentile, 50th percentile, and 90th percentile in the table. the average bank loan size is $ 154.10 million. the average loan maturity is 49.01 months. the mean value of loan spread is 137.01 basis points. the average gdp growth is 4.31%. all the variables have significant variations as shown in the column of standard deviation. these descriptive statistics are consistent with the results reported in the previous literature. table 1. summary statistics mean standard 10th 50th 90th deviation percentile percentile percentile company_disclosure 58.02 21.35 20.00 50.00 80.00 company_size 16.90 2.66 14.54 17.25 22.25 company_leverage 0.45 0.18 0.24 0.46 0.71 company_profitability 0.51 0.44 0.15 0.41 0.90 company_tangibility 0.48 0.25 0.10 0.51 0.74 company_ diversification 0.63 0.48 0.00 1.00 1.00 company_ maturity 11.65 4.04 4.00 10.00 16.00 company_lending_relationship 0.54 0.52 0.00 0.68 1.36 conpany_governance 53.33 14.30 24.00 54.64 81.10 country_investor_protection 64.25 15.88 40.27 62.34 87.55 country_gdp_growth (%) 4.31 1.66 2.48 4.36 6.98 bank_loan_size ($ millions) 154.10 20.33 130.10 151.23 183.99 bank_loan_maturity (months) 49.01 11.02 37.00 47.00 66.00 bank_loan_spread (basis points) 137.01 10.11 123.00 136.50 152.00 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 447 the definitions of all variables are shown in the appendix. we report mean, standard deviation, 10th percentile, 50th percentile, and 90th percentile in the table. 4. methodology and results 4.1. methodology to examine the influence of borrower characteristics on the relationship between accounting disclosure and bank loan contracting terms, we estimate the following equation: bank loan contract terms = α + β1 company_disclosure + β2 company_disclosure * borrower characteristics dummy+ β3 control variables + industry_dummy+ year_dummy+ ε (1) where bank loan contract terms include bank_loan_size, bank_loan_maturity, and bank_loan_spread. borrower characteristics dummy include size_dummy, leverage_dummy, profitability_dummy, tangibility_dummy, diversification_dummy, maturity_dummy, and lending_relationship_dummy. our control variables include company_size, company_leverage, company_profitability, company_tangibility, company_diversification, company_maturity, company_lending_relationship, company_governance, country_investor_protection, and country_gdp_growth. finally, we include industry_dummy and year_dummy. we cluster borrower-level when calculating standard errors. 4.2. results we present the results to examine the effects of company size on the relationship between accounting disclosure and bank loan contracting terms such as loan size, loan maturity, and loan spread in table 2. in column 1, the effects of accounting disclosure on the loan size are equal to (0.0021-0.0006*size_dummy). the results suggest that the effects of accounting disclosure on the loan size are more significant for borrowers with smaller size. in column 2, the effects of accounting disclosure on the loan maturity are equal to (0.0028-0.0008*size_dummy). the results suggest that the effects of accounting disclosure on the loan maturity are more significant for borrowers with smaller size. in column 3, the effects of accounting disclosure on the loan spread are equal to (-0.0018+0.0006*size_dummy). the results suggest that the effects of accounting disclosure on the loan spread are more significant for borrowers with smaller size. in summary, our results are consistent with hypothesis 1 and the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with smaller size. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 448 table 2. regressions of bank loan contracting terms on the interaction between company_disclosure and size_dummy dependent variable log_loan_size log_loan_maturity log_loan_spread (1) (2) (3) company_disclosure 0.0021*** 0.0028*** -0.0018*** (0.0003) (0.0006) (0.0002) company_disclosure* size_dummy -0.0006*** -0.0008*** 0.0006*** (0.0001) (0.0002) (0.0001) company_size 0.0038*** 0.0040*** -0.0039*** (0.0007) (0.0006) (0.0008) company_leverage -0.0555*** -0.1678*** 0.0311*** (0.0095) (0.0289) (0.0055) company_profitability 0.0149*** 0.0379*** -0.0020*** (0.0028) (0.0072) (0.0003) company_tangibility 0.0157 0.0339 -0.0827*** (0.0400) (0.0704) (0.0199) company_ diversification 0.0155*** 0.0385*** -0.0023*** (0.0029) (0.0075) (0.0005) company_ maturity 0.0020*** 0.0030*** -0.0028*** (0.0003) (0.0004) (0.0006) company_lending_relationship 0.0470*** 0.0866*** -0.0489*** (0.0161) (0.0240) (0.0106) company_governance 0.0038*** 0.0081*** -0.0039*** (0.0009) (0.0010) (0.0006) country_investor_protection 0.0025*** 0.0034*** -0.0017*** (0.0004) (0.0010) (0.0004) country_gdp_growth 0.0052 0.0110 -0.0143 (0.0056) (0.0109) (0.0096) control for bank_loan_type_dummy yes yes yes industry_dummy yes yes yes year_dummy yes yes yes obs 436 436 150 adjusted r2 0.5733 0.5790 0.6500 the definitions of all variables are shown in the appendix. we cluster at the borrower level when calculating standard errors. we report coefficients in the table and standard errors in the parentheses. we employ *, **, and *** to indicate significance at the 10%, 5%, and 1% levels respectively. we show the results to investigate the effects of company leverage on the relationship asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 449 between accounting disclosure and bank loan contracting terms such as loan size, loan maturity, and loan spread in table 3. in column 1, the effects of accounting disclosure on the loan size are equal to (0.0015+0.0005*leverage_dummy). the results suggest that the effects of accounting disclosure on the loan size are more significant for borrowers with higher leverage. in column 2, the effects of accounting disclosure on the loan maturity are equal to (0.0020+0.0007*leverage_dummy). the results suggest that the effects of accounting disclosure on the loan maturity are more significant for borrowers with higher leverage. in column 3, the effects of accounting disclosure on the loan spread are equal to (-0.0012-0.0007*leverage_dummy). the results suggest that the effects of accounting disclosure on the loan spread are more significant for borrowers with higher leverage. in summary, our results are consistent with hypothesis 2 and the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with higher leverage. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 450 table 3. regressions of bank loan contracting terms on the interaction between company_disclosure and leverage_dummy dependent variable log_loan_size log_loan_maturity log_loan_spread (1) (2) (3) company_disclosure 0.0015*** 0.0020*** -0.0012*** (0.0004) (0.0005) (0.0003) company_disclosure* leverage_dummy 0.0005*** 0.0007*** -0.0007*** (0.0001) (0.0001) (0.0001) company_size 0.0037*** 0.0041*** -0.0037*** (0.0006) (0.0007) (0.0009) company_leverage -0.0557*** -0.1670*** 0.0318*** (0.0098) (0.0283) (0.0050) company_profitability 0.0147*** 0.0370*** -0.0025*** (0.0029) (0.0079) (0.0005) company_tangibility 0.0154 0.0332 -0.0821*** (0.0401) (0.0701) (0.0190) company_ diversification 0.0150*** 0.0383*** -0.0024*** (0.0028) (0.0079) (0.0006) company_ maturity 0.0021*** 0.0031*** -0.0027*** (0.0004) (0.0005) (0.0007) company_lending_relationship 0.0471*** 0.0861*** -0.0485*** (0.0165) (0.0242) (0.0109) company_governance 0.0037*** 0.0080*** -0.0037*** (0.0008) (0.0015) (0.0007) country_investor_protection 0.0024*** 0.0033*** -0.0016*** (0.0005) (0.0011) (0.0003) country_gdp_growth 0.0051 0.0113 -0.0141 (0.0054) (0.0108) (0.0098) control for bank_loan_type_dummy yes yes yes industry_dummy yes yes yes year_dummy yes yes yes obs 436 436 150 adjusted r2 0.5734 0.5791 0.6502 the definitions of all variables are shown in the appendix. we cluster at the borrower level when calculating standard errors. we report coefficients in the table and standard errors in the parentheses. we employ *, **, and *** to indicate significance at the 10%, 5%, and 1% levels respectively. we presents the results to examine the influence of company profitability on the relationship asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 451 between accounting disclosure and bank loan contracting terms such as loan size, loan maturity, and loan spread in table 4. in column 1, the effects of accounting disclosure on the loan size are equal to (0.0022-0.0007*profitability_dummy). the results imply that the effects of accounting disclosure on the loan size are more significant for borrowers with lower profitability. in column 2, the effects of accounting disclosure on the loan maturity are equal to (0.0027-0.0007* profitability_dummy). the results suggest that the effects of accounting disclosure on the loan maturity are more significant for borrowers with lower profitability. in column 3, the effects of accounting disclosure on the loan spread are equal to (-0.0019+0.0006*profitability_dummy). the results suggest that the effects of accounting disclosure on the loan spread are more significant for borrowers with lower profitability. in summary, our results are consistent with hypothesis 3 and the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with lower profitability. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 452 table 4. regressions of bank loan contracting terms on the interaction between company_disclosure and profitability_dummy dependent variable log_loan_size log_loan_maturity log_loan_spread (1) (2) (3) company_disclosure 0.0022*** 0.0027*** -0.0019*** (0.0002) (0.0005) (0.0003) company_disclosure* profitability_dummy -0.0007*** -0.0007*** 0.0006*** (0.0001) (0.0001) (0.0001) company_size 0.0039*** 0.0041*** -0.0038*** (0.0006) (0.0005) (0.0006) company_leverage -0.0552*** -0.1673*** 0.0310*** (0.0091) (0.0280) (0.0051) company_profitability 0.0146*** 0.0375*** -0.0022*** (0.0024) (0.0070) (0.0004) company_tangibility 0.0154 0.0331 -0.0822*** (0.0401) (0.0700) (0.0193) company_ diversification 0.0152*** 0.0388*** -0.0021*** (0.0023) (0.0078) (0.0004) company_ maturity 0.0021*** 0.0032*** -0.0029*** (0.0002) (0.0004) (0.0005) company_lending_relationship 0.0472*** 0.0864*** -0.0488*** (0.0160) (0.0241) (0.0102) company_governance 0.0039*** 0.0080*** -0.0038*** (0.0008) (0.0011) (0.0007) country_investor_protection 0.0026*** 0.0035*** -0.0016*** (0.0005) (0.0009) (0.0003) country_gdp_growth 0.0051 0.0113 -0.0149 (0.0059) (0.0100) (0.0090) control for bank_loan_type_dummy yes yes yes industry_dummy yes yes yes year_dummy yes yes yes obs 436 436 150 adjusted r2 0.5731 0.5792 0.6504 the definitions of all variables are shown in the appendix. we cluster at the borrower level when calculating standard errors. we report coefficients in the table and standard errors in the parentheses. we employ *, **, and *** to indicate significance at the 10%, 5%, and 1% levels respectively. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 453 we presents the results to examine the effects of company tangibility on the relationship between accounting disclosure and bank loan contracting terms such as loan size, loan maturity, and loan spread in table 5. in column 1, the effects of accounting disclosure on the loan size are equal to (0.0021-0.0006*tangibility_dummy). the results suggest that the effects of accounting disclosure on the loan size are more significant for borrowers with lower tangibility. in column 2, the effects of accounting disclosure on the loan maturity are equal to (0.0026-0.0006*tangibility_dummy). the results suggest that the effects of accounting disclosure on the loan maturity are more significant for borrowers with lower tangibility. in column 3, the effects of accounting disclosure on the loan spread are equal to (-0.0020+0.0005*tangibility_dummy). the results suggest that the effects of accounting disclosure on the loan spread are more significant for borrowers with lower tangibility. in summary, our results are consistent with hypothesis 4 and the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with lower tangibility. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 454 table 5. regressions of bank loan contracting terms on the interaction between company_disclosure and tangibility_dummy dependent variable log_loan_size log_loan_maturity log_loan_spread (1) (2) (3) company_disclosure 0.0021*** 0.0026*** -0.0020*** (0.0003) (0.0004) (0.0004) company_disclosure* tangibility_dummy -0.0006*** -0.0006*** 0.0005*** (0.0001) (0.0001) (0.0001) company_size 0.0037*** 0.0040*** -0.0036*** (0.0005) (0.0005) (0.0005) company_leverage -0.0554*** -0.1677*** 0.0312*** (0.0090) (0.0281) (0.0052) company_profitability 0.0148*** 0.0378*** -0.0023*** (0.0026) (0.0075) (0.0005) company_tangibility 0.0150 0.0335 -0.0820*** (0.0400) (0.0709) (0.0190) company_ diversification 0.0154*** 0.0389*** -0.0023*** (0.0024) (0.0079) (0.0005) company_ maturity 0.0022*** 0.0032*** -0.0028*** (0.0003) (0.0005) (0.0006) company_lending_relationship 0.0470*** 0.0866*** -0.0489*** (0.0160) (0.0241) (0.0102) company_governance 0.0037*** 0.0087*** -0.0039*** (0.0007) (0.0012) (0.0008) country_investor_protection 0.0025*** 0.0034*** -0.0015*** (0.0004) (0.0007) (0.0002) country_gdp_growth 0.0050 0.0119 -0.0148 (0.0079) (0.0109) (0.0096) control for bank_loan_type_dummy yes yes yes industry_dummy yes yes yes year_dummy yes yes yes obs 436 436 150 adjusted r2 0.5739 0.5799 0.6509 the definitions of all variables are shown in the appendix. we cluster at the borrower level when calculating standard errors. we report coefficients in the table and standard errors in the parentheses. we employ *, **, and *** to indicate significance at the 10%, 5%, and 1% levels respectively. we show the results to examine the effects of company diversification on the relationship asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 455 between accounting disclosure and bank loan contracting terms such as loan size, loan maturity, and loan spread in table 6. in column 1, the effects of accounting disclosure on the loan size are equal to (0.0020-0.0005*diversification_dummy). the results suggest that the effects of accounting disclosure on the loan size are more significant for borrowers with lower diversification. in column 2, the effects of accounting disclosure on the loan maturity are equal to (0.0025-0.0005*diversification_dummy). the results suggest that the effects of accounting disclosure on the loan maturity are more significant for borrowers with lower diversification. in column 3, the effects of accounting disclosure on the loan spread are equal to (-0.0021+0.0004*diversification_dummy). the results suggest that the effects of accounting disclosure on the loan spread are more significant for borrowers with lower diversification. in summary, our results are consistent with hypothesis 5 and the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with lower diversification. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 456 table 6. regressions of bank loan contracting terms on the interaction between company_disclosure and diversification_dummy dependent variable log_loan_size log_loan_maturity log_loan_spread (1) (2) (3) company_disclosure 0.0020*** 0.0025*** -0.0021*** (0.0004) (0.0003) (0.0005) company_disclosure* diversification_dummy -0.0005*** -0.0005*** 0.0004*** (0.0001) (0.0001) (0.0001) company_size 0.0035*** 0.0041*** -0.0037*** (0.0004) (0.0006) (0.0004) company_leverage -0.0553*** -0.1675*** 0.0314*** (0.0096) (0.0280) (0.0050) company_profitability 0.0149*** 0.0379*** -0.0024*** (0.0025) (0.0073) (0.0004) company_tangibility 0.0151 0.0336 -0.0821*** (0.0401) (0.0710) (0.0197) company_ diversification 0.0158*** 0.0383*** -0.0022*** (0.0022) (0.0075) (0.0004) company_ maturity 0.0023*** 0.0034*** -0.0029*** (0.0004) (0.0006) (0.0007) company_lending_relationship 0.0472*** 0.0868*** -0.0485*** (0.0162) (0.0225) (0.0112) company_governance 0.0036*** 0.0085*** -0.0036*** (0.0006) (0.0015) (0.0009) country_investor_protection 0.0026*** 0.0032*** -0.0014*** (0.0005) (0.0007) (0.0003) country_gdp_growth 0.0053 0.0110 -0.0140 (0.0099) (0.0129) (0.0099) control for bank_loan_type_dummy yes yes yes industry_dummy yes yes yes year_dummy yes yes yes obs 436 436 150 adjusted r2 0.5731 0.5791 0.6501 the definitions of all variables are shown in the appendix. we cluster at the borrower level when calculating standard errors. we report coefficients in the table and standard errors in the parentheses. we employ *, **, and *** to indicate significance at the 10%, 5%, and 1% levels respectively. we presents the results to examine the effects of company maturity on the relationship asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 457 between accounting disclosure and bank loan contracting terms such as loan size, loan maturity, and loan spread in table 7. in column 1, the effects of accounting disclosure on the loan size are equal to (0.0023-0.0006*maturity_dummy). the results suggest that the effects of accounting disclosure on the loan size are more significant for borrowers with lower maturity. in column 2, the effects of accounting disclosure on the loan maturity are equal to (0.0027-0.0006*maturity_dummy). the results suggest that the effects of accounting disclosure on the loan maturity are more significant for borrowers with lower maturity. in column 3, the effects of accounting disclosure on the loan spread are equal to (-0.0023+0.0005*maturity_dummy). the results suggest that the effects of accounting disclosure on the loan spread are more significant for borrowers with lower maturity. in summary, our results are consistent with hypothesis 6 and the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with lower maturity. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 458 table 7. regressions of bank loan contracting terms on the interaction between company_disclosure and maturity_dummy dependent variable log_loan_size log_loan_maturity log_loan_spread (1) (2) (3) company_disclosure 0.0023*** 0.0027*** -0.0023*** (0.0005) (0.0004) (0.0005) company_disclosure* maturity_dummy -0.0006*** -0.0006*** 0.0005*** (0.0001) (0.0001) (0.0001) company_size 0.0037*** 0.0043*** -0.0039*** (0.0005) (0.0007) (0.0005) company_leverage -0.0555*** -0.1677*** 0.0316*** (0.0097) (0.0281) (0.0051) company_profitability 0.0148*** 0.0377*** -0.0026*** (0.0027) (0.0075) (0.0005) company_tangibility 0.0150 0.0338 -0.0823*** (0.0407) (0.0716) (0.0199) company_ diversification 0.0159*** 0.0385*** -0.0025*** (0.0024) (0.0078) (0.0004) company_ maturity 0.0025*** 0.0036*** -0.0028*** (0.0005) (0.0007) (0.0006) company_lending_relationship 0.0474*** 0.0867*** -0.0487*** (0.0164) (0.0227) (0.0114) company_governance 0.0037*** 0.0086*** -0.0037*** (0.0007) (0.0016) (0.0010) country_investor_protection 0.0024*** 0.0030*** -0.0012*** (0.0004) (0.0006) (0.0002) country_gdp_growth 0.0055 0.0112 -0.0144 (0.0090) (0.0120) (0.0090) control for bank_loan_type_dummy yes yes yes industry_dummy yes yes yes year_dummy yes yes yes obs 436 436 150 adjusted r2 0.5725 0.5788 0.6510 the definitions of all variables are shown in the appendix. we cluster at the borrower level when calculating standard errors. we report coefficients in the table and standard errors in the parentheses. we employ *, **, and *** to indicate significance at the 10%, 5%, and 1% levels respectively. we show the results to examine the effects of company previous lending relationship on the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 459 relationship between accounting disclosure and bank loan contracting terms such as loan size, loan maturity, and loan spread in table 8. in column 1, the effects of accounting disclosure on the loan size are equal to (0.0022-0.0007*lending_relationship_dummy). the results suggest that the effects of accounting disclosure on the loan size are more significant for borrowers with less lending relationship. in column 2, the effects of accounting disclosure on the loan maturity are equal to (0.0025-0.0007*lending_relationship_dummy). the results suggest that the effects of accounting disclosure on the loan maturity are more significant for borrowers with less lending relationship. in column 3, the effects of accounting disclosure on the loan spread are equal to (-0.0021+0.0006*lending_relationship_dummy). the results suggest that the effects of accounting disclosure on the loan spread are more significant for borrowers with less lending relationship. in summary, our results are consistent with hypothesis 7 and the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with less lending relationship. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 460 table 8. regressions of bank loan contracting terms on the interaction between company_disclosure and lending_relationship_dummy dependent variable log_loan_size log_loan_maturit y log_loan_sprea d (1) (2) (3) company_disclosure 0.0022*** 0.0025*** -0.0021*** (0.0004) (0.0005) (0.0005) company_disclosure* lending_relationship_dummy -0.0007*** -0.0007*** 0.0006*** (0.0001) (0.0001) (0.0001) company_size 0.0039*** 0.0041*** -0.0038*** (0.0006) (0.0008) (0.0006) company_leverage -0.0551*** -0.1671*** 0.0311*** (0.0098) (0.0282) (0.0057) company_profitability 0.0145*** 0.0375*** -0.0025*** (0.0029) (0.0077) (0.0004) company_tangibility 0.0152 0.0335 -0.0825*** (0.0402) (0.0712) (0.0195) company_ diversification 0.0156*** 0.0381*** -0.0022*** (0.0026) (0.0074) (0.0004) company_ maturity 0.0027*** 0.0038*** -0.0026*** (0.0006) (0.0008) (0.0005) company_lending_relationship 0.0476*** 0.0865*** -0.0485*** (0.0163) (0.0229) (0.0116) conpany_governance 0.0035*** 0.0084*** -0.0039*** (0.0006) (0.0018) (0.0008) country_investor_protection 0.0023*** 0.0031*** -0.0013*** (0.0005) (0.0007) (0.0003) country_gdp_growth 0.0054 0.0110 -0.0142 (0.0094) (0.0122) (0.0092) control for bank_loan_type_dummy yes yes yes industry_dummy yes yes yes year_dummy yes yes yes obs 436 436 150 adjusted r2 0.5734 0.5790 0.6519 the definitions of all variables are shown in the appendix. we cluster at the borrower level when calculating standard errors. we report coefficients in the table and standard errors in the parentheses. we employ *, **, and *** to indicate significance at the 10%, 5%, and 1% levels respectively. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 461 5. conclusion in this paper, we investigate how borrower characteristics affect the relationship between accounting disclosure and bank loan contracts in emerging economies. the evidence shows that the effects of accounting disclosure on bank loan contracting terms such as the loan size, the loan maturity, and the loan spread, are more significant for borrowers with smaller size, higher leverage, lower profitability, lower tangibility, less diversity, younger age, and less lending relationship. these results imply that the relationship between accounting disclosure and bank loan contracting terms are more pronounced for firms with higher credit risk. one caveat is that the dealscan database only includes large firms and we leave it in the future research. our results also have some policy implications for policy makers. specifically, to increase firms’ access to the capital market, it is better to increase firms’ disclosure level, which is more important for firms with higher risk. references armstrong, c. s., guay, w. r., & weber, j. p. 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(1999). borrower risk and the price and nonprice terms of bank loans. frb of new york staff report no. 90. appendix variable description company_disclosure the total value of the answers to the questions in the transparency category of the clsa survey. company_size the logarithm of total assets. size_dummy one if a company has more than the median value of company_size and zero otherwise. company_leverage total liability scaled by total assets. leverage_dummy one if a company has more than the median value of company_leverage and zero otherwise. company_profitability earnings scaled by total assets. profitability_dummy one if a company has more than the median value of company_ profitability and zero otherwise. company_tangibility pp&e scaled by total assets. tangibility_dummy one if a company has more than the median value of company_ tangibility and zero otherwise. company_ diversification one if a company has more than one segment and zero otherwise. diversification_dummy one if company_ diversification is equal to one and zero otherwise. company_ maturity the number of years since their ipo. maturity_dummy one if a company has more than the median value of company_ maturity and zero otherwise. company_lending_relationship the logarithm of (1+ the number of previous borrowing). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 463 lending_relationship_dummy one if a company has more than the median value of company_lending_relationship and zero otherwise. conpany_governance the average value of the answers to the questions in the management discipline, independence, accountability, responsibility, and fairness categories of the clsa survey. country_investor_protection the average value of the world governance index. country_gdp_growth change in gdp per capita. bank_loan_size loan amount. bank_loan_maturity loan maturity. bank_loan_spread loan spread. bank_loan_type_dummy dummy variables for each type of loan. industry_dummy dummy variables for each industry. year_dummy dummy variables for each year. copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word comparative performance-new asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 103 comparative economic performance and stock market performance: some evidence from the asia-pacific region sayeeda bano the university of waikato, hamilton, new zealand e-mail: sbano@waikato.ac.nz sriya kumarasinghe (corresponding author) department of accountancy and finance, school of business, university of otago p.o. box: 56, dunedin 9054, new zealand e-mail: sriya.kumarasinghe@otago.ac.nz yih pin tang the university of the south pacific, suva, fiji e-mail: tang_y@usp.ac.fj received: june 15, 2011 accepted: november 24, 2011 published: december 1, 2011 doi:10.5296/ajfa.v3i1.716 url: http://dx.doi.org/10.5296/ajfa.v3i1.716 an early version of this paper was presented at the 27th annual conference of euro-asia management studies association (eamsa) held in delhi, india, in november 2010. the authors wish to thank the two anonymous reviewers and the conference participants for their valuable comments. they also wish to thank the university of otago and the department of accountancy and finance for the bloomberg facility. special thanks go to mr. warren bailey, dr. shawn strother, and professor timothy crack for all their help and constructive suggestions. we also extend our thanks to the university of waikato for eamsa conference participation support and professor jose tabbada for his valuable comments. any errors and omissions are our own. abstract this study looks at interdisciplinary research in the fields of economics, finance and socioeconomic relations addressing the question whether the ranking of countries by major asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 104 economic, social, and financial performance indicators provide any guide to the rate and pattern of growth and development in the asia-pacific region. the paper also examines the extent of balanced and sustained growth in selected 14 asia-pacific countries. it analyses data on msci returns, gdp growth, and hdi to rank and correlate the overall performance of each country during the 1993-2009 period. gini index and cpi are also included to provide added insights. the results show that developing countries like india, indonesia, pakistan, and sri lanka are at the top on most of the financial and economic indicators, while japan is the lowest except on hdi, where the bottom rankings goes to india, indonesia and pakistan. overall, the results indicate no significant relationships between a country’s stock market returns and its gdp growth. nonetheless, the results suggest that for balanced and sustainable well-being, economic growth in the less-developed countries need to be matched by concomitant improvements in social welfare, income distribution, transparency and accountability. keywords: performance ranking, hdi, stock market, asia-pacific, sri lanka jel classification: f010, f040, e44, e63, f14, f15, o057, r11. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 105 1. introduction nations comprising the asia-pacific region are a diverse group with different historical backgrounds, religious beliefs and affiliations, and socio-cultural practices. they also have different levels of economic development, rates of economic growth and capital market performance. nonetheless, these nations have experienced rapid growth and rising levels of income over the past several decades. their economic growth as well as capital market performance has been aided largely by the rapid expansion of multinational enterprises and the integration of international financial markets which are characteristic of the current phase of globalisation. this in turn has resulted in significant increases in international capital inflows and outflows in the region. according to the latest indicators on economic and human development from the international monetary fund (imf), more than any other region, asia is making a stronger contribution to the global recovery from the current recession. this is in large part due to the strong domestic demand in these asian countries, which has been due to the rapid economic growth experienced by these countries in the decades prior to, as well as after, the asian financial crisis of 1997. the east asian countries have been favoured recipients of foreign direct investments (fdis), or have had high levels of foreign trade or both as a consequence of the rapid growth in their economies. another contributing factor was the significant growth in business activities between and among the neighbouring countries in the region. although there are previous studies which looked at the relationship between macro-economic variables and stock market prices (lee, boon and baharumshah, 2001; fifield, power, and sinclair, 2002; patro, wald, and wu, 2002; gunasekarage, pisedtasalasai, and power, 2004; wickramasinghe, 2011), it is our understanding that studies on stock market performance and social performance are rare or almost non-existent. having a meagre attention on social performance creates a big gap in this research field, because as countries advance economically and financially, the improvement in peoples’ welfare cannot be ignored or postponed. given the financial and economic importance of asian countries in global trade and investment, an investigation of the financial-economic performance and social performance in these countries is both necessary and timely. the aim of this paper is thus to examine the relationship between financial and economic performance on one hand, and social performance on the other. the study also attempts to explore the extent to which these countries have been able to maintain balanced and fairly sustained growth during the period 1993-2009. sri lanka is examined as a special case of a country which has managed to achieve continuous economic growth despite a long-running and destructive war with extremists. economists generally use macroeconomic indicators to evaluate a country’s economic performance, while financial analysts employ financial market data to assess its financial strength. the two indicators (macro-economic and financial) are seldom combined in one study. this paper attempts to combine economic, financial and social indicators to rank a sample of countries according to their growth and development performance. it examines the movements of stock prices and socio-economic performance to determine whether and (if asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 106 so) to what extent the two are related. by enhancing our knowledge and understanding of the co-movements and correlations of these indicators, the findings of this study intend to enhance the usability of such indicators to investors and policymakers alike. the outline of the paper is as follows. the first section reviews the recent literature on stock market and economic performance, and emphasizes the significance of social performance for people’s well-being in a country. the second section discusses the methodology and the data used for the study. the third section reports the results and analyzes their implications. the last section presents the conclusion, the limitations of the study, and possible future research. 2. literature review 2.1 macro-economy and the equity market one of the major goals of open economies is to have sustainable economic growth. development theory suggests that indices such as gdp, per capita gdp, literacy rate, poverty level, gini index (for income distribution), and level of corruption signify the level of “well-being” of a particular country. on the one hand, the economic growth and efficiency of a country largely depends on the country’s financial system, in which the stock market contributes to economic growth via productive investments. on the other hand, stock market performance is often used as a general gauge of a country’s business environment. this is so because performance in the share market reflects or is affected by such factors as rate of inflation, interest rate, levels and rates of growth of disposable incomes, trade balance, and the degree of transparency and accountability in the economy. the performance or success of an economy is often indicated by: a) economic growth, b) efficiency, c) income distribution, d) stability, and e) viability. gregory and stuart (2004) call these as “performance criteria”. in the development literature, these criteria are often subsumed under the rubric of “development”, which is much broader concept than mere economic growth. rosser and rosser (2004) came up with a more detailed set of nine criteria1 that can nevertheless also be subsumed under the five criteria proposed by gregory and stuart (2004), so our discussion focuses on the latter. economic growth refers to the level and rate of growth of output and income, total as well as per capita, and the composition of output over time. efficiency, on the other hand refers to the relationship between output and the inputs used in producing that output, and efficiency is often indicated by the presence (or absence) of economies of scale, total factor productivity, and the absence of corruption. efficiency is related to growth in the sense that efficient economies are likely to grow more rapidly than those that are not, and such economies are expected to have no or lower level of corruption. 1 nine criteria (rosser and rosser, 2004): the level of output (gdp of an economy); the growth rate of output, adjusted for population growth; per capita gdp; composition of output; static and dynamic efficiency; macroeconomic stability (inflation and employment); economic security of the individual; the degree of equity of the income and wealth distributions (gini index); the degree of freedom available to the individual and human development index (which is constructed from real per capita income, life expectancy, adult literacy rates, and education enrolment). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 107 corruption is increasingly recognized in the development literature as a major obstacle to growth and development. corruption, usually indicated by the corruption perception index, (cpi) distorts the allocation of resources by channelling them to inefficient projects, wastes scarce societal resources on the unproductive activity of “rent-seeking”, and generally increases transaction costs. although there is no one-to-one negative correlation between the level of corruption and the rate of economic growth (some corrupt countries have grown while others have stagnated), a strong case can be made that growth, income levels and income distribution could have been higher or better with lesser corruption. as economic growth, or in other words, rate of increase in output, how output is distributed among the various income groups or classes is also important. most countries have as their stated objective an equitable distribution of income, which is usually measured by the gini index. policymakers of developing countries are acutely aware of “kuznets’ inverted u-shaped curve”, according to which income distribution worsens during the early stages of industrialization, and are determined to escape the operation of this “iron law”. some countries have been more successful than others in escaping kuznets’ curve and among the more successful ones have been the east asian “tigers”, in which rapid economic growth has come hand-in-hand with a relatively equitable distribution of income. most countries have not, however, been so fortunate. stability refers to macro-economic stability, which is usually indicated by low inflation and interest rates, low levels of unemployment and underemployment, a balanced budget, and other “fundamentals” of good economic housekeeping. these are important not only in and of themselves, but also in providing a conducive environment for business. broadly defined, stability can include political stability in the sense of peaceful handover of power, and policy continuity. abrupt policy reversals or changes in the “rules of the game” such as a decision of a new government to cancel all the contracts entered into by the previous government would hinder the expected stability of the economy. viability is, in our view, more or less the same as sustainability, defined, as in environmental economics, as leaving the future generations at least as well off as the present generation. it means not depleting the capital stock but maintaining it or even adding to it. it also means not saddling future generations with unsustainable deficits and debt burdens. an increasingly important measure that captures many of the foregoing and focuses more on the human aspect is the human development index (hdi). hdi encompasses indicators of well-being such as health, nutrition, infant and maternal mortality, education, environment, security and other factors that positively contribute to the realization of the full human potential. hdi correlates well with levels of per capita income. although countries with high levels of per capita income score or rank high in hdi, the correlation would not be perfect (gregory and stuart, 2004). alvan (2009) has conducted an empirical test using 90 countries including both developing and developed nations which confirmed a negative correlation between high hdi and income inequality as well as a positive correlation between medium and low levels of hdi and income inequality. assessing how hdi correlate with market performance is a matter we investigate in this paper. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 108 when we relate stock market performance to socio-economic performance, we refer primarily to the foregoing criteria by gregory and stuart (2004). several previous studies have linked macro-economic and stock prices for evaluating developing countries’ performance. for example, the results of a previous research by pilinkus (2009) on lithuanian stock market support the hypothesised association between changes in the stock prices and measures of real economic activity. for instance, the mobilization of domestic savings through the stock market assists in capital formation, which is essential to a country’s economic growth. rapid growth attracts investment, which enhances stock market performance, which in turn fuels further growth, and so on, in a virtuous upward spiral. the converse is, of course, also possible. if, for whatever reason (lack of confidence usually being one), investments are withdrawn by the domestic or foreign investors, this will result in lower stock market performance, which will in turn lead to lower growth prospects or performance, and so on, in a downward spiral. using daily returns from 1988 to 1998, johnson and soenen (2002) investigated the degree of integration between japan’s equity market and the equity markets of twelve asian countries. the results indicated that the equity markets of australia, china, hong kong, malaysia, singapore and new zealand were highly integrated with the japanese market, especially since 1994. it should be recalled that during the said period japan experienced a stagnating economy following the 1985-1990 asset price bubble. despite this, the increased exports from other asian economies to japan, on one hand, and the greater fdi from japan to asian economies, on the other hand, increased the co-movement between the japanese stock market and the asian equity markets (johnson and soenen, 2002). while most studies on stock market and economic performance have focused on advanced economies, kyereboah-coleman and agyire-tettey (2008) did a case study on the stock exchange of ghana, a developing country, for the period 1991-2005, in order to examine the effects of macroeconomic indicators on stock market performance. the study showed that while high lending rates and inflation rates had a negative impact on the performance of ghana’s stock market, the resulting domestic currency depreciation still benefited the investors. in a more or less similar study, pilinkus (2009) investigated the association between macroeconomic variables and the lithuanian stock market index from december 1999 to march 2008. the results from this study revealed that the gdp deflator, net export, and fdi impacted on the stock market index. these study reports stimulated our interest to explore the economies in the asia-pacific region. in an empirical work on a sample of 27 countries including g72 and southeast asian economies, henry et al. (2004) used switching regression analysis to examine the relationship between stock returns and growth rates during the period 1982-2001. the authors concluded that in the organization for economic cooperation and development (oecd) and in five southeast asian countries (hong kong, korea, the philippines, singapore, and taiwan) there was a significant relationship between stock returns and economic growth. 2 g7 countries include france, germany, italy, japan, uk, usa, and canada. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 109 2.2 co-movement of economic and stock market performance two explanations have been offered for the co-movement of stock markets and economies in different countries. one is that stock markets are highly influenced by global factors, in which the macroeconomic variables are closely associated. the other explanation is that there is no correlation between market returns and fundamental market information. albuquerque and vega (2009) attempted to verify the role of news about fundamental stock market performance in cross-country correlations between the us and portugal, using variables such as daily stock market returns, order flow and real-time macroeconomic news release of gdp, unemployment rate, industrial production, industrial sales, retail sales, trade balance, the consumer price index, and production price index. the authors concluded that cross-country stock market returns were not responsive to the us macroeconomic news. however, when portuguese macroeconomic news was released the existence of different degrees of impacts on investors’ decisions was confirmed by decreasing the co-movement. comparative studies include either economic and financial variables or economic and socio-economic variables. fifield et al. (2002) investigated the predictability of stock market returns through the movements of global and local economic factors, namely, gdp, inflation, money and interest rates, world industrial production and world inflation. analyzing the data from 13 emerging stock markets over the period of 1987-1996, the authors concluded that both global and local factors were crucial in explaining stock market returns in emerging economies. using annual data of a diversified sample of 13 countries for the period 1960-2002, handa and khan (2008) tested for granger causality and reported that there was no one-way causality from financial development to economic development. according to their findings, india, argentina, germany, japan, the uk and the us had a bi-directional granger causality, while bangladesh, sri lanka, brazil, malaysia, thailand, and turkey had a uni-directional causality that ran from economic growth to financial development. using johansen’s methodology of multivariate co-integration analysis on monthly time-series data, gunasekarage (2004) examined the dynamic interrelations between macroeconomic variables and the stock market index in sri lanka. macroeconomic variables such as the money supply, the treasury bill rate (as a measure of interest rate), the consumer price index, the exchange rate and market index data for the period january 1985december 2001 were used for the study. monthly values of share price index were used to represent aggregate equity returns of the market for the 17-year period. variance decompositions analyses revealed that a major proportion of the variability in the market index was explained by the stock market’s own innovations, while only a minority was explained by macroeconomic variables. the author attributed the results obtained to the fact that the macroeconomic variables used in the study represented only a subset of variables available in studies of developed markets. a recent research on sri lanka by wickremasinghe (2011) confirmed the causal relationship between stock prices and macroeconomic variables such as the exchange rate, three months’ deposit rate, the consumer price index and gdp. in general, although there are a number of researches on financial and economic performance, we are not aware of any research to date that uses socio-economic variables along with asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 110 financial and economic data. this indicates a rather narrow view of the concept of ‘development’. when a country has high performance both economically and financially, are people in the country well-looked after? in other words, do improvements in economic and financial performance lead to improved socio-economic conditions? this paper attempts to answer the above question by using morgan stanley capital international (msci) returns, the gdp growth, and hdi to examine whether these three performance measures exhibit similar rankings. in addition to this, we attempt to determine the type of correlation between the variables for any of the sample countries. 3. data and variables 3.1 data description the sample countries included east asian countries and a few asia-pacific countries where financial, economic and socio-economic data were available for the period 1993-2009. the selected group of east asian economies were china, hong kong, indonesia, japan, malaysia, philippines, singapore, south korea (korea from here onwards) and thailand3. since india is geographically close to east asia and has experienced exceptionally high economic growth rates in recent years (making the country a popular fdi target), it was also included in the dataset. for added insights, sri lanka, pakistan, australia and new zealand were also included in the sample. all the stock market data were obtained from the bloomberg data provider. msci index, a widely adopted benchmark for cross-border equity funds licensed by morgan stanley, was selected as the main financial variable in this study. mean returns were calculated based on the yearly closing prices of the msci country indices. most of the economic and socio-economic data were obtained from the world bank and imf. corruption and gini indices have been calculated only periodically. therefore the use of such data was limited. hdi was available continuously from the year 2005 to 2009 which enabled us to analyze the correlation during that time period. 3.2 ranking approach for the ranking in a given year, each country’s msci annual returns were calculated based on the yearly closing prices between two consecutive periods. for a range of sample years, the rankings were based on the mean of the annual returns for that time period. gdp growth rates were calculated in a similar way based on the country’s annual nominal gdp expressed in local currencies. countries were then ranked from highest to lowest in each category. for the most part of the analysis, msci returns and gdp growth rates were the two major variables chosen to represent financial and economic variables, while hdi, corruption and gini coefficients were selected as the socio-economic indicators. mean ranking and correlation analysis were the statistical methods used. 3 this study can be extended to include all other countries or regions worldwide that have established equity market indexes and periodic reports on socio-economic indicators. taiwan was not included since the country’s socio-economic data were not available through imf or world bank as taiwan is not a member of these organisations. laos, myanmar, vietnam and other pacific countries were excluded due to insufficient or unavailability of data. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 111 4. results this section presents the summary statistics and performance ranking results of msci returns, gdp growth rates, and hdi. the analysis has two components: (1) an examination of performance rankings during the east asian financial crisis around 1997 and the us credit crunch/global financial crisis in 2007; and (2) performance ranking on selected financial, economic and socio-economic variables. the statistical summary is presented in table 1. for msci returns, sri lanka has the widest range of 248.25%, a standard deviation of 56.50% and a mean of 19.75%. australia has the lowest range: msci returns of 73.99%, a standard deviation of 17.24% and a mean of 8.18%. for gdp growth, indonesia has the broadest range of 41.73%, a standard deviation of 9.47% and a mean of 19.54%, which is the highest among the sample countries for the sample period. indonesia also has the highest mean msci returns during the sample period. in contrast, new zealand has been more stable with the smallest range of gdp growth at 6.94%, a standard deviation of 2.19%, and a mean of 5.42%. 4.1 performance rankings in times of crisis 4.1.1 the 1997 east asian financial crisis in the 1980s and early 1990s, the “east asian tigers” or “dragons” (hong kong, singapore, korea, and taiwan) received attention from the rest of the world for their double-digit economic growth. given their stellar economic performance, special attention is paid to compare performances with other countries in the asia-pacific during the years surrounding the 1997 crisis. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 112 table 1. summary statistics (1993-2009) msci returns gdp growth msci returns gdp growth msci returns gdp growth australia australia china china hong kong hong kong mean 8.18 6.42 6.38 16.14 6.48 3.64 maximum 34.06 9.12 80.27 35.95 55.38 8.47 minimum -39.93 1.55 -52.23 3.63 -53.16 -6.03 range 73.99 7.57 132.50 32.31 108.54 14.49 standard deviation 17.24 1.76 44.85 8.92 31.52 3.86 india india indonesia indonesia japan japan mean 19.49 13.32 23.95 19.54 0.69 -0.06 maximum 91.51 17.87 106.47 52.26 45.69 2.11 minimum -56.82 7.70 -50.76 10.53 -43.62 -6.12 range 148.33 10.17 157.23 41.73 89.31 8.22 standard deviation 41.28 3.35 48.17 9.47 22.81 2.10 korea korea malaysia malaysia new zealand new zealand mean 15.72 9.10 10.84 9.43 3.13 5.42 maximum 79.15 18.31 113.48 18.50 49.43 8.16 minimum -44.55 2.01 -51.62 -8.70 -42.35 1.22 range 123.71 16.29 165.10 27.20 91.77 6.94 standard deviation 39.23 4.83 38.35 6.85 20.31 2.19 pakistan pakistan philippines philippines singapore singapore mean 18.30 15.02 11.46 10.79 10.07 7.24 maximum 116.65 30.21 155.11 14.81 98.99 16.09 minimum -68.40 5.77 -46.77 3.64 -49.50 -3.98 range 185.05 24.44 201.88 11.17 148.49 20.07 standard deviation 51.87 5.98 48.06 2.60 37.93 6.90 sri lanka sri lanka thailand thailand mean 19.75 15.42 9.65 7.19 maximum 187.67 23.25 115.37 15.34 minimum -60.58 8.64 -51.79 -2.24 range 248.25 14.61 167.15 17.59 standard deviation 56.50 3.92 49.49 5.02 asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 113 as shown in tables 2a and 2b, all east asian countries experienced negative msci returns in 1997, with thailand registering a low -51.79%. thailand’s low ranking for the years 1996 and 1997 reflects the fact that the 1997 east asian financial crisis started or first manifested itself in thailand. by gdp growth, thailand was also ranked at the bottom three in 1997 and 1998. by contrast, countries outside the region, like pakistan and sri lanka, were ranked within the top three in 1997, in terms of the msci returns and gdp growth. indonesia had the highest gdp growth, but it had one of the lowest ranks based on msci returns. table 2a. performance rankings by msci returns (%) around the 1997 east asian financial crisis country 1996 country 1997 country 1998 china 35.16 pakistan 36.36 korea 68.51 indonesia 29.55 sri lanka 21.39 hong kong 55.38 malaysia 23.86 india 19.94 australia 10.26 philippines 17.08 australia 6.60 philippines 9.78 australia 6.22 new zealand 1.31 indonesia -2.19 new zealand 5.03 hong kong -7.62 malaysia -5.60 india -1.97 japan -15.05 japan -9.55 japan -5.47 singapore -16.98 thailand -16.06 pakistan -5.54 china -26.33 singapore -16.40 singapore -9.07 korea -34.34 india -16.42 sri lanka -11.26 indonesia -40.80 new zealand -17.81 hong kong -25.68 philippines -43.82 sri lanka -19.44 korea -32.84 malaysia -51.62 china -43.83 thailand -36.84 thailand -51.79 pakistan -56.06 source: the msci mean returns were calculated based on the msci indexes from bloomberg. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 114 table 2b. performance rankings by gdp growth around the 1997 east asian financial crisis rank country 1996 country 1997 country 1998 1 china 17.32 indonesia 17.86 indonesia 52.26 2 indonesia 17.17 sri lanka 15.90 india 14.67 3 india 15.67 pakistan 14.53 sri lanka 14.35 4 sri lanka 15.03 philippines 11.73 pakistan 10.27 5 malaysia 14.05 malaysia 11.06 philippines 9.82 6 philippines 13.96 india 10.77 china 5.97 7 pakistan 13.63 china 10.10 australia 5.48 8 korea 12.48 korea 9.48 korea 2.01 9 thailand 10.15 singapore 9.07 new zealand 1.22 10 singapore 9.70 australia 5.32 malaysia 0.51 11 australia 6.05 hong kong 5.06 japan -2.08 12 new zealand 4.86 new zealand 3.73 thailand -2.24 13 hong kong 4.19 thailand 2.64 singapore -3.12 14 japan 1.99 japan 2.11 hong kong -6.03 source: gdp growth rates were calculated based on the nominal gdp in local currencies obtained from imf. 4.1.2 the 2007 us global financial crisis the 2007 us credit crunch was triggered by a liquidity shortfall in the world’s largest economy. to a greater or lesser extent, however, the crisis also affected other countries worldwide. the rankings by the msci mean returns and nominal gdp growth during the period are reported in tables 3a and 3b, respectively. as table 3a shows, for the year 2007 new zealand, japan, sri lanka and hong kong’s msci returns were negative, ranging from -4.68% in new zealand to -53.16% in hong kong. by gdp growth, japan, new zealand and hong kong were in the bottom three in 2007, as shown in table 3b. japan remained low in terms of gdp growth ranking in the next two years. within the total sample period, japan experienced negative gdp growth in the years 1998-1999, 2001-2003, and 2008-2009, and also negative msci returns in the years 1996-1998, 2000-2002, and 2007-2008. the highest msci return in japan was 42.94% in 2005. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 115 table 3a. performance rankings by msci returns (%) around the 2007 us/global financial crisis rank country 2006 country 2007 country 2008 country 2009 1 china 78.68 china 63.54 hong kong 55.28 sri lanka 187.67 2 indonesia 55.02 indonesia 57.50 australia -39.93 india 91.51 3 sri lanka 50.26 india 52.49 korea -40.62 indonesia 90.27 4 india 46.47 pakistan 34.13 malaysia -40.77 pakistan 89.77 5 philippines 43.59 malaysia 32.68 new zealand -42.35 singapore 63.02 6 hong kong 37.83 thailand 31.33 japan -43.62 thailand 63.00 7 singapore 30.94 korea 30.80 philippines -46.77 china 58.86 8 malaysia 24.25 philippines 16.26 thailand -48.72 korea 56.63 9 australia 18.28 singapore 16.25 singapore -49.50 philippines 55.79 10 new zealand 6.26 australia 12.22 indonesia -50.76 malaysia 46.25 11 japan 6.09 new zealand -4.68 china -52.23 australia 30.84 12 korea 2.31 japan -11.33 india -56.82 new zealand 14.84 13 pakistan 0.14 sri lanka -14.20 sri lanka -60.58 japan 7.25 14 thailand -5.87 hong kong -53.16 pakistan -68.40 hong kong 6.48 in 2008, hong kong’s msci returns managed to rebound, while all the other sample countries suffered from deep plunges in their msci returns ranging from -39.93% in australia to -68.40% in pakistan. in 2008, japan was the only country in the sample which experienced negative gdp growth rates, while in 2009 several other countries like malaysia, singapore, hong kong and thailand also experienced negative nominal gdp growth, as shown in table 3b. table 3b. performance rankings by nominal gdp growth around the 2007 us/global financial crisis rank country 2006 country 2007 country 2008 country 2009 1 indonesia 20.36 sri lanka 21.78 indonesia 25.32 pakistan 24.37 2 sri lanka 19.81 china 21.41 sri lanka 23.25 indonesia 13.37 3 pakistan 17.28 indonesia 18.32 pakistan 18.10 india 11.78 4 china 15.67 singapore 15.78 china 16.85 china 11.54 5 india 15.58 india 15.50 malaysia 15.46 sri lanka 9.40 6 philippines 10.79 pakistan 13.77 india 12.66 philippines 3.64 7 singapore 10.66 malaysia 11.37 philippines 11.44 korea 3.57 8 thailand 10.52 philippines 10.24 australia 9.12 new zealand 1.68 9 malaysia 9.95 australia 9.09 new zealand 7.50 australia 1.55 10 australia 7.65 thailand 8.66 thailand 6.40 thailand -0.27 11 hong kong 7.02 korea 7.29 korea 5.28 hong kong -2.66 12 new zealand 5.65 hong kong 6.38 singapore 3.02 singapore -3.27 13 korea 5.03 new zealand 5.03 hong kong 2.15 japan -6.12 14 japan 1.12 japan 1.61 japan -2.02 malaysia -8.70 source: gdp growth rates were calculated based on the nominal gdp in local currencies obtained from imf. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 116 4.1.3 do country-specific economic, financial, and socio-economic performance indicators tell the same story in the asia-pacific region? overall, the rankings based on msci returns and gdp were not consistent for all countries in the sample, or for all the years. it was observed both the msci returns and gdp growth ranked indonesia and china at the top, while hong kong and japan were ranked at the bottom in 2007. however, sri lanka, which had msci return of -14.20% in 2007, was ranked first in terms of gdp growth (21.78%). this shows that the two indicators do not always provide consistent rankings or that they move in the same direction. this is because measures of a country’s economic growth, such as its gdp level and rate of growth and per capita income, are determined by various factors, including a country’s rate of domestic saving and investment, total factor productivity, human capital and technology, government expenditures, the country’s legal and institutional framework, income distribution, level of corruption, the exchange rate regime, and the presence (or absence) of sound financial institutions and policies. these measures of economic growth in each country seem to have varying degrees of influence in their own contexts. 4.2 rankings across variables during the sample period 1993-2009, indonesia, on average, topped the performance in terms of msci returns and gdp growth, whereas japan was ranked the lowest under both msci returns and gdp growth. in terms of human development, however, japan ranked third while indonesia ranked in the bottom three, as displayed in table 4. table 4. performance rankings by msci, gdp and hdi for 1993-2009 rank msci returns (%) (1993-2009) gdp growth (%) (1993-2009) hdi index (2005-2009) 1 indonesia 23.95 indonesia 19.54 australia 0.930 2 sri lanka 19.75 china 16.14 new zealand 0.901 3 india 19.49 sri lanka 15.42 japan 0.878 4 pakistan 18.30 pakistan 15.02 korea 0.863 5 korea 15.72 india 13.32 hong kong 0.852 6 philippines 11.46 philippines 10.79 singapore 0.835 7 malaysia 10.84 malaysia 9.43 malaysia 0.734 8 singapore 10.07 korea 9.10 china 0.637 9 thailand 9.65 singapore 7.24 sri lanka 0.645 10 australia 8.18 thailand 7.19 thailand 0.641 11 hong kong 6.48 australia 6.42 philippines 0.628 12 china 6.38 new zealand 5.42 indonesia 0.578 13 new zealand 3.13 hong kong 3.64 india 0.498 14 japan 0.69 japan -0.06 pakistan 0.478 overall, countries that have higher economic growth rates tend to have higher msci returns, although their rankings may not be the same under these two indicators. interestingly, the asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 117 sample countries with higher gdp growth, mainly from the less-developed group, tend to have lower hdi scores which implies that when a country improves its economic well-being, it tends to increase its financial wealth or vice a versa, at the cost of social well-being of people in that country. sri lanka, however, has been able to maintain a balance between financial, economic, and social development to a certain level. graph 1. gini index (2007) the gini index must, however, be interpreted with care. a lower ranking in gini index indicates lower income inequality, which is generally an economically as well as socially desirable condition. one may expect a country with a high gini index value (high income inequality) to have a lower score (lower transparency) in the cpi. the philippines had the highest gini index among the sample countries (graph 1), while japan had the lowest index which is compatible with hdi data. as expected, the philippines, a country with a high degree of income inequality, also had the low levels of transparency in the cpi. in fact, it was ranked the lowest (graphs 2). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 118 graph 2. corruption perception index (cpi) (2009) however, this pattern of high level of inequality and low corruption perception does not hold true for all the countries. for instance, while hong kong and singapore ranked high in the gini index (indicating high income inequality), their cpi rankings were also high (depicting low levels of corruption). the situation in singapore can be explained by the government’s severe penalty for corruption. generally, the countries that rank low in the cpi are developing countries while countries with higher ranks are developed countries. 4.2.1 relationship between msci returns, gdp growth, and hdi pearson and partial correlations between msci returns, nominal gdp growth, and hdi were analysed for the years 2005-2009. gini coefficient and cpi were not included due to unavailability of annual data. the results are presented in table 5. asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 119 table 5. correlations between economic, socioeconomic and stock market performance (2005-2009) country msci return and gdp msci return and hdi hdi and gdp pearson partial1 partial2 pearson partial1 partial2 pearson partial1 partial2 australia -.561 -.647 -.975 -.244 -.923 .755 -.510 .891 .883 china -.018 .981 .962 -.151 -.239 .336 -.121 -.422 .065 hong kong -.119 .966 .852 .063 -.470 .862 -.686 -.682 .469 india .117 .996* .981 -.027 .546 .762 -.696 .465 .622 indonesia -.930* -.882 .991* .029 -.535 -.637 -.290 .869 .733 japan .155 1.00** -.812 -.816* -.988 -1.00** -.540 -.987 .819 korea -.258 .451 .008 -.253 -.772 -.224 -.049 .219 .828 malaysia -.697 .972 -.458 .077 .949 .171 -.368 .996* .797 new zealand -.672 -.990* -.202 -.269 -.728 -.900 -.510 .622 -.244 pakistan .294 .310 -.633 -.049 -.520 -.300 .579 -.973 -.549 philippines -.610 .364 .240 -.140 -.867 -.846 -.642 -.780 -.721 singapore -.142 1.00** .692 .003 -.782 .940 -.552 -.794 .897 sri lanka -.965** .983 .142 .253 .951 .063 -.254 .991* .997* thailand -.517 .983 .774 .135 -.656 -.999* -.750 -.505 -.750 developed -.078 .479* .540** -.152 -.152 .034 .013 -.616** -.080 emerging -.103 .502** .343* -.130 -.236 -.305 -.544** -.524** -.485** frontier -.543 .641 .220 .119 .772* .567 -.075 .784* .767* all countries -.007 .556** .487** -.201* -.320* -.422** -.666** -.462** -.540** partial 1 controlled for gdp deflator and partial 2 controlled for consumer price index. msci classification: developed (australia, hong kong, japan, new zealand, singapore), emerging ( china, india, indonesia, korea, malaysia, philippines, thailand), frontier (pakistan, sri lanka) * significant at the 0.05 level (1-tailed). ** significant at the 0.01 level (1-tailed) the results show that indonesia and sri lanka had strongly and significantly negative correlations between msci returns and gdp growth. when controlled for inflation using the gdp deflator and the consumer price index, india, japan, china, indonesia and singapore showed perfect or near perfect positive partial correlations between msci returns and gdp growth, whereas new zealand had a strongly and significantly negative correlation between these two variables. japan and thailand were found to have significant and negative relationships in their msci returns and hdi. on the other hand, malaysia and sri lanka showed strong and positive relationships between hdi and gdp growth. when the sample was grouped under msci country classification4, developed and emerging countries in the asia pacific were found to have strongly positive correlations between msci 4 msci classification: developed (australia, hong kong, japan, new zealand, singapore), emerging ( china, india, indonesia, korea, malaysia, philippines, thailand), frontier (pakistan, sri lanka). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 120 returns and gdp growth, while the relationships were negative between hdi and gdp. frontier countries like pakistan and sri lanka had strong positive relationships between hdi and gdp growth. the results for pakistan further indicated a positive correlation between hdi and msci return. overall, the correlation analysis clearly shows a tendency towards wealth maximisation and concentration in the developed and emerging countries and more wealth distribution for social welfare in frontier or less-developed countries. 5. the case of sri lanka sri lanka, which is geographically close to india and china, the two large, developing countries with exceptionally high growth rates in recent decades, is an emerging economy according to the imf classification, has shown strong economic growth in recent years. this country has achieved a respectable rate of economic and social development despite the long-running and destructive internal war. hence, special attention is paid to sri lanka in this paper. sri lanka has a very high literacy rate of 91.3%, one of the highest in the region. however, the dependency ratio is also high at 48.3% (central bank of sri lanka annual report, 2009). each year the government of sri lanka spends a substantial portion of its national income on the social welfare programs such as free education, free public health, and both financial and non-financial assistance to the less-privileged members in the country. in the early 90's a new cohort of creative and strategically oriented entrepreneurs emerged, buoyed by an aggressive privatization program. since then the economy of sri lanka has improved considerably, in large part due to investor-friendly policy measures such as dedicated fdi zones, expansion of infrastructure, the increasing number of skilled employees, and the opening up of the capital market to foreign investment; all of which contributed to economic growth. for instance, the number of foreign companies has visibly increased. in 1995 fdi was only 0.4% of gdp, however, by 2007 it had increased to over 2%. moreover, sri lanka’s fdi is widely diversified and include: ceramics, rubber, electrical goods, gems and jewellery, information technology and business process outsourcing, education, tourism, agriculture, textile and apparel, fabricated metal, and the medical and pharmaceutical industries (central bank of sri lanka, 2008). at present, 70% of exports from sri lanka and 80% of its industrial exports are carried out by companies approved by the board of investments. as a result of the foregoing developments, sri lanka is now in a position to compete in the global market place. although the devastating boxing day tsunami in 2004 may have set back some of these efforts, the end of three decades of civil war coupled with investor-friendly policies, have resulted in a large expansion of national and international business activities in sri lanka. according to united nations development program (undp), in 2009 sri lanka’s per capita gdp was us$ 2,029 (1 us$ = slrs. 110.80 on 31 october 2010), which increased to us$4999 in the following year (undp, 2011). the performance of sri lanka’s economy depends heavily on the service sector, (claims 59% of the gdp), the industrial sector (28.6%) and the agriculture sector (12%). while tea, rubber, coconut and some agricultural crops still play a major part in sri lanka’s export profile, these commodities have been superseded by textile and clothing exports (central bank of sri lanka, 2009). asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 121 the colombo stock exchange (cse) is sri lanka’s major stock exchange and one of the most advanced stock exchanges in south asia. the cse has 232 companies representing 20 business sectors and the market capitalisation as of 31st march 2010 was slrs. 1,210.8 billion (us$ 10.91 billion). for the years 1993-2009, sri lanka had a mean msci return of 19.75%, with a wide range between -60.58% and 187.67% as presented in table 1. during the same period, sri lanka experienced a satisfactory average gdp growth of 15.42%, with a range between 8.64% and 23.25% (table 1). sri lanka was ranked one of the top two on both msci returns (21.39%) and gdp growth rate (15.90%) during the 1997 east asian crisis. for the period immediately before, during and after the 1997 financial crisis (1996-1998), sri lanka’s gdp growth rates stayed within 14.35 15.90%. although its msci returns were high (21.39%) in 1997, the values were negative for the years before (-11.26%) and after (-19.44%), as presented in table 2a. during the 2007 global financial crisis, sri lanka’s msci returns were also high and were ranked within the top three for the years 2006 and 2009, with returns of 50.26% and 187.67% in the respective years (table 3a). however, in 2007 and 2008, with its negative msci returns of -14.20% and -60.58%, respectively, sri lanka was ranked as second from the bottom. this shows that sri lanka, as well as most other open economies in the world, were adversely affected by the 2007 global financial crisis, but the data shows the stock market was able to recover itself by 2009. although the drop in sri lanka’s gdp growth from 23.25% (2008) to 9.40% (2009) may have resulted from the global financial crisis, the country maintained its rank in the top three for the gdp growth in the years 2006-2008 (table 3b). graph 3. sri lanka’s gdp growth and msci returns (1993-2009) asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 122 during the entire sample period 1993-2009, sri lanka was, on average, ranked among the top three on both msci returns and gdp growth. furthermore, the country sustained double-digit gdp growth rates except for the years 1999 and 2009. the country’s msci returns were highly variable throughout the sample years, with -60.58% in 2008 and 187.67% in 2009 (graph 3). concurrent to this, undp (2011) data on hdi shows continuous improvements in the health, safety, nutrition and education of its people suggesting sri lanka’s commitment in social welfare. among the financial indicators in 2009, sri lanka occupied top rank on msci returns. it is worthwhile to note however, there were varying numbers of companies included each year for msci calculations. according to the cse data, 231 companies with a total market capitalization of slrs 1,092.1 billion (equivalent to us$ 958 million at 1 us$ = slr 114) were listed on the cse as of 31st december 2009. the number of companies included in the msci for 2009 was only three. however, those few companies had an immense influence on the stock market in sri lanka by claiming over 80% of the total market capitalization (us$ 767 million) (msci barra). it is also interesting to note that there were no significant correlations between msci returns and hdi (table 5) in sri lanka. as a possible future study it may be worthwhile investigating the relationship between the local market index and the hdi. 6. conclusion the purpose of this study was to investigate the movements among economic, financial and socio-economic indicators, and also to see whether msci returns, gdp growth, and hdi were positively correlated. the results show that msci returns and gdp growth rates were positively associated with each other in developed and emerging economies at the expense of social welfare. however, some frontier economies had been able to maintain a balance between economic and social performance. the results also show that while most of the developing countries in the asia-pacific region such as india, indonesia and sri lanka consistently scored high on financial and economic indicators. in contrary to this, japan, an industrialized economy, ranked one of the lowest on financial and economic variables, while scoring high on hdi. there were similar rankings for certain countries in particular years, but the financial and economic variables did not always provide consistent rankings. the results also show that while most of the developing countries in the region have experienced rapid growth in total output, per capita incomes and capital markets, they may need to make further improvements in hdi by enhancing the following aspects: social welfare, income equality, employment rates, human capital, economic freedom, transparency and good governance. more advanced statistical models and methods for testing hypotheses are necessary in order to obtain stronger results which can be done in subsequent studies. there is a need to carry out more research in the fields of economics, finance and social policy issues. references albuquerque, r. and vega, c. 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(2004). comparative economics in a transforming world economy, the mit press, cambridge, massachusettes. united nations development program. (2011). international human development indicators, asian journal of finance & accounting issn 1946-052x 2011, vol. 3, no. 1: e7 www.macrothink.org/ajfa 124 http://hdr.undp.org, accessed: 7/20/2011 wickremasinghe, g. (2011). the sri lankan stock market and the macroeconomy: an empirical investigation, studies in economics and finance, 28(3): 179-195. http://dx.doi.org/10.1108/10867371111141954 microsoft word 4501-16642-1-sm _1_-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 305 audit premium, brand name reputation, and industrial specialist: an empirical study of private universities and colleges in taiwan yung-yu lai overseas chinese university, taiwan e-mail: caesar.larry@msa.hinet.net fu-hsing chang chihlee institute of technology, taiwan e-mail: cfs@mail.chihlee.edu.tw received: nov. 2, 2013 accepted: december 14, 2013 published: december 14, 2013 doi:10.5296/ajfa.v5i2.4501 url: http://dx.doi.org/10.5296/ajfa.v5i2.4501 abstract the main obstacle of audit fee research lies in fees collection. in the past, audit fees were usually collected by questionnaire survey method. this study however features itself by collecting first-hand audit fees data from the moe directly via legislators and from the announcement after cpa association public bidding. this study examines not only types of tendering procedures but also audit revenue premiums about private universities and colleges in taiwan in both brand name reputation and industry specialist perspectives. the results give support to our hypotheses. this study contributes some findings and significance. firstly, the most important significance in the study, different from prior researches in which audit fees are paid by the client, we collect the unique data that audit fees are paid by the moe. we can examine whether the effects of independent variables on audit fees are different from prior studies. secondly, prior studies give evidence to support the agency theory, while we didn’t find any research focused on real audit fees of npos applied the agency theory in taiwan. applying real audit fees, our results show that the agency theory is tenable for npos, especially the private universities and colleges. thirdly, we propose some determinants of audit fees about the private universities and colleges. finally, audit revenue premiums exist not only in profit organizations but also in npos. keywords: audit fees, audit revenue premium, types of tendering procedures, brand name reputation, industry specialist asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 306 1. introduction numerous studies have investigated audit fees for profit organizations. however, nonprofit organizations (npos), one of the three biggest organization systems in society, have not received similar attention.1 thorne et al. (2001), examined audit prices for government. they tested whether audit fees charged differently for different audit engagements using local governmental data collected from northern california. nonprofit organizations (npos) cover a wide range of entities from hospitals, foundations, churches, and schools to museums. however, due to the difficulty of collecting audit fee information, only a few studies have focused on audit fees for npos. this research has not found a study focusing on audit premiums using actual npo audit fees in taiwan, especially for private universities and colleges. 2 following a financial crisis at hualien da-han industrial and business college in 1988 and an accounting scandal at kaohsiung international business college, the ministry of education (moe) adopted strict controls over financial operations of private universities and colleges. since then, the moe has required that financial statements of universities and colleges be audited by auditing firms. the recent deregulation of founding private universities and colleges has increased public and private universities and colleges to a total number of 162 in 2006. the moe started hiring auditors to audit private universities and colleges through open tendering procedures between 2001 and 2002. the moe restricted bidder qualifications in 2003 to enhance auditors’ abilities, and adopted limited tendering procedures to choose auditors and auditing fees. the tendering procedure uniquely appoints auditors in taiwan. what factors determine audit fees of private universities and colleges? researches demonstrate that the main factors for profit organizations are client size (simunic, 1980; palmrose, 1986), client risk (simunic, 1980), client complexity (thornton and zeghal, 1994), and auditor brand name reputation (simunic, 1980; craswell et al., 1995). prior studies show that large audit firms systematically charge higher audit fees. according to the product differentiation economic theory (klein and leffler, 1981; shapiro, 1983), large audit firms investing in a brand name for better audit quality positively relates to higher audit fees in competitive markets. the demand for audit quality differentiation can be explained as agent/contract costs (simunic and stein, 1987; watts and zimmerman, 1986). most knowledge or experience of organizational management and audit are mainly obtained from profit organizations, and the mission and performance evaluation criteria of npos are different from those of profit organizations. thus, studies on managing npos will face some obvious challenges. this study focuses not only on types of tendering procedures, but also on audit revenue premiums charged for better auditor brand name reputation and auditor industry specialization. the purpose of this research is three-fold. firstly, this investigation tests not only the effects of open tendering procedures, but also the effects of limited tendering procedures on audit fees. secondly, this work examines the big 4 audit fee-premiums behavior using samples collected from non-profit (private colleges and universities) rather than profit organizations. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 307 thirdly, the current study divides the big 4 audit fee-premiums into two components in terms of npo features: brand name reputation and auditor industry specialization and different audit periods. the first component refers to the general auditor brand name premium, representing that audit revenue premium positively relates to auditor brand name. the second component is the auditor specialist premium, indicating that a positive relationship exists between audit revenue premiums and industry specialists of the big 4. the results give support to our hypotheses that: (1) cpa firms can get more revenue (audit fees) under limited tendering procedures are higher than those under open tendering procedures; (2) specialist big 4 auditors can get more revenue (audit fees) than non-specialist big 4 auditors; and (3) specialist big 4 auditors can get more revenue (audit fees) than non-specialist big 4 auditors. these findings are similar to the evidence from profit organizations and extend the literature. some findings and significance in the study include the following. firstly, the current study significantly differs from prior researches in which the client pays audit fees. this work collects unique data and shows that the moe is the responsible party for paying audit fees. this study also examines whether the effects of independent variables on audit fees are different from prior studies. secondly, prior studies give evidence to support the agency theory, while this research does not find any research that focuses on real audit fees of npos applying the agency theory in taiwan. results from applying real audit fees show that the agency theory is tenable for npos, especially for private universities and colleges. thirdly, this work proposes some determinants of audit fees concerning private universities and colleges. finally, revenue premiums exist not only in profit organizations, but also in npos. the remainder of this paper is organized into four sections. section 2 reviews related literature and develops the hypotheses. section 3 describes the sample selection and empirical design. section 4 not only shows the empirical results but also contains sensitivity analyses to determine robustness of the results to alternative specifications. section 5 provides a summary and conclusion. 2. literature review and research hypotheses 2.1 types of tendering procedures the moe, in order to promote auditor independence, encouraged private school audits by auditors assigned by the moe. as shown in table 1, during the 1997-2000 academic years, the right to appoint auditors and the responsibility to pay for audit services was left to schools or remained with the moe. the moe changed the auditor selection process to enhance bidder qualifications, following the biggest educational scandal in 2000. as a result, the moe selected auditors through tendering procedures, and was responsible for audit fees from 2001 to 2003. since such practices represented different cost expenses, this study sampled data adopted from 2001-2003 to study the effects of different tendering procedures on audit fees. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 308 table 1. audit selector and responsible party for paying audit fees academic year 3 auditor selector responsible party for paying audit fees 1992 private universities and colleges private universities and colleges 1995 private universities and colleges half of the audit fees was subsidized by the moe 1997 1.private universities and colleges, or 2.assigned by the moe 1.private universities and colleges, or 2.the moe when cpa was assigned by the moe 2001 the moe entrusted the special case to audit (open tendering procedure) the moe 2003 the moe entrusted the special case to audit (limited tendering procedure) the moe 2004 private universities and colleges private universities and colleges regulators in many countries have recently taken initiatives to enhance competition in the audit market. changes to government regulations may provide the external impetus necessary to alter the underlying competitive environment. these changes can affect audit fees. maher et al. (1992) report a decline in audit fees resulting from deregulation from 1977 to 1981 in a study of seventy-eight audits. sanders et al. (1995) find a similar decline in audit fees from 1985 to 1989 in a study of 159 municipal audits. their results support the argument that deregulation may enhance competition in the audit market and result in a decline in audit fees. that is, audit fees under regulation will be higher. hackenbrack et al. (2000) examine the price and quality effects of an unusual state-mandated market restriction that required nonprice competition and prohibited price competition among auditors. they document that municipalities covered by the statute paid higher audit fees. the moe entrusted auditors to audit the special case after examining bidder qualifications under a limited tendering procedure. this study expects that audit fees under limited tendering procedure will be higher and develops the following hypothesis: h1: ceteris paribus, audit fees under limited tendering procedures will be higher than those under open tendering procedures. 2.2 auditor brand name reputation according to the product differentiation economic theory (klein and leffler, 1981; shapior, 1983), large audit firms investing in brand name for better audit quality positively relates to higher audit fees in competitive markets. the demand for audit quality differentiation can be explained as agent/contract cost (simunic and stein, 1987; watts and zimmerman, 1986). higher audit fees might result when firms recognize an auditor to be of superior quality to other firms. if firms perceive auditors as providing different quality services, some clients asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 309 may demand, and be willing to pay more for, higher quality (hay et al., 2006). researchers have attempted to use a large number of different proxy variables to represent audit quality but the four that are most common are dummy variables for firms classified as being in the big 8/6/5/4. for example, in the us audit market, francis and simon (1987) find an auditor brand name premium. using uk data, chan et al. (1993), pong and whittington (1994), and mcmeeking et al. (2006) provide evidence supporting brand name premium. francis (1984), defond et al. (2000) find existing brand name premiums in australia, new zealand, and hong kong, respectively. craswell et al. (1995) examine audit revenue premiums received by the big 8 using a sample of 1,484 australian listed companies. on average, the big 8 brand name premium over the non-big 8 averages around 30%. klein and leffer (1981), palmrose (1986), and simunic and stein (1987) provide evidence consistent with existing brand name premiums due to better quality provided. in taiwan, wong (1999) find a brand name premium in his studies. in the meta-analysis papers which they consider, published over twenty-five years (1977-2002) and including more than twenty countries, hay et al. (2006) find that the big 8/6/5 associates with higher audit fees with 67% of all studies finding a significant positive result. as for npos, ward et al. (1994) document a big-6 audit fee premium in their sample of michigan municipalities comprising cities. in this research, the ratio of subsidiaries from government to total ordinary revenues is 13% for private universities and colleges. agency theory about private universities and colleges indicates that cpa firms monitor schools on behalf of the government. meanwhile, the ratio of tuition fees to total ordinary revenues is approximately 65% for private universities and colleges. the government also monitors schools on behalf of the students and the students’ parents. this research expects that agency theory can be applied in npos, private universities and colleges, and the following hypothesis is developed: h2: ceteris paribus, non-specialist big 4 auditors will have higher audit fees than non-big 4 auditors. 2.3 auditor industry specialist premium accounting technology is an accounting system or accounting policies businesses use for reporting economic activities. in a general sense, accounting policies mainly relate to recognizing and measuring assets, debt and income from economic activities. if accounting technology is for a specific industry, both agent and contract problems of a business and accounting solutions will contain specific industrial characteristics. for example, specific industries may require some complicated contracts such as advanced contracts, long-term lease contracts, risk portfolio management contracts and off-balance sheet arrangements. certain industries, such as the natural resources industry or the financial service industry may require specific accounting principles or financial reporting. an electronic data processing system and internal control system for the financial service industry are complicated and specific. industrial specialization has led to auditor’s specializing. this trend, however, significantly leads auditors to win a group of “specialism-based” clients. therefore, specialist audit firms provide greater assurance for industries with specific contracts or accounting asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 310 technology than those of non-specialist audit firms. many audit firms also recognize that investing in in-depth industry specific knowledge can have a valuable effect, contributing to firm brand name. apart from normal requested returns, the large audit firm seeks higher audit fees to compensate for additional costs spent on industry specialization, compared to non-specialist audit firms. alternatively, audit firms can achieve specialization by expanding market share. early researches of auditor industry specialists focused on industries with greater than thirty client firms (e.g. craswell et al., 1995). later studies (e.g. ferguson et al., 2003) estimated revenue premiums in all industries, irrespective of the number of client firms within an industry. craswell et al. (1995) examined audit revenue premiums received by the big 8 using of a sample of 1,484 australian listed companies. on average, industry specialist big 8 auditors earn a 34% premium over the non-specialist big 8. in the meta-analysis covering a twenty-five-year period, hay et al. (2006) found evidence consistent with an industry specialist premium. carson and fargher (2007) found an industry specialist premium in the australian market for audit services. industry leadership expecting a fee premium arises from expected returns for investing in specialization and from higher quality audits (craswell et al., 1995) and also from city level reputation effects (defond et al., 2000; ferguson et al., 2003). higher audit quality associates with higher audit fee levels. the current study develops the following hypothesis: h3: ceteris paribus, specialist big 4 auditors will have higher audit fees than non-specialist big 4 auditors. 3. sampling and modeling 3.1 sampling the data of this research is collected from cpa firms appointed by the moe to audit private universities and colleges for academic years 1998-2002. this research obtains information about audit fees and cpa audit firms from the moe directly via legislators. the current work also obtains audit fees information for the 2003 academic year from the announcement after cpa association public bidding. according to the regulation in ‘the must-dos list for cpa auditing, the financial statements of junior colleges and above’, article 6 regulates that service fees are limited to the audit fees on financial statements. the manually collected data contains not only the audit report, but also financial statements of private universities and colleges from each school website. table 2 lists audit fees of the moe appointed cpa firms, public bidding and limited bidding cpa firms for the 1998-2003 academic years. the current study expects data shown in the table to be more accurate than using questionnaires by previous literature. table 2 shows nine, ten, and fourteen schools between the 1998 and 2000 academic year that were audited by appointed cpas, accounting for 10% of the whole. due to the limited sample size for the 1998-2000 academic years, this investigation was unable to compare audit fee difference between academic years 1998-2000 and 2001-2003. the table obviously shows that the means of audit fees are not significantly different from each other during the academic year asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 311 2001 and 2002; however, the mean of audit fees during the 2003 academic year is significantly higher than those of the previous two academic years. table 2. audit fees of private colleges and universities by the moe appointed project cpas （expressed in new taiwan dollars） year no. of obs. min mean max sd 1998 9 300,000 388,889 700,000 151,186 1999 10 380,000 563,000 930,000 151,375 2000 14 410,000 613,714 950,000 196,656 2001 101 142,500 293,350 850,480 128,495 2002 101 142,500 292,237 830,000 126,863 2003 100* 175,000 448,936 775,000 167,036 *there are 104 private universities and colleges in 2003 academic years, with 4 schools’ audit fees unavailable. 3.2 modeling the regression model used to examine the effects of tendering procedures and brand name reputation over audit fees (h1 and h2), is specified as follows: lnaui＝a＋ 1b year03i ＋b2year02i ＋b3big4i＋ 4b lnasseti + 5b debti+ 6b int/earni＋ 7b boardi＋ 8b donatei ＋ 9b earni ＋ 10b subsidyi ＋ 11b univi+ 12b opp/tai + iε (1) where, lnau: natural log of the audit fee. year03: dummy variable, equals to one if academic year is 2003, and zero otherwise. year02: dummy variable, equals to one if academic year is 2002, and zero otherwise. big4 : dummy variable, proxy for audit quality, equals to one if audited by big 4, and zero otherwise. lnasset: natural log of total assets of private universities and colleges, proxy for size. debt: the ratio of debt to total assets, proxy for risks. int/earn: interest expenses divided by current net income/loss, proxy for risks. board: the ratio of board expenditures to current revenues, proxy for risks. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 312 donate: the ratio of personal donations to current revenues, proxy for risks. earn: the ratio of current earnings to current revenues, proxy for risks. subsidy: the ratio of subsidy to current revenues, proxy for risks. univ : equals to one if university, and zero otherwise; proxy for complexity. opp/ta: the ratio of operating funds to total assets, proxy for complexity. 3.2.1 dependent variable this study uses the natural log of the audit fee (lnau) as the dependent variable to reduce heteroskedasticity of the residual terms (pamrose, 1986; gul, 1999). 3.2.2 independent variables year03 is a dummy variable, which equals to one if academic year is 2003, and zero otherwise and tests h1. this study predicts that audit fees under limited tendering procedures will be higher than those under open tendering procedures. we predict coefficient 1b in eq (1) to be positive. big4 is a dummy variable, proxy for audit quality, which equals to one if audited by big 4, and zero otherwise and tests h2. this study predicts an existing big 4 premium. that is, we predict coefficient b3 in eq (1) to be positive. 3.2.3 control variables simunic (1980) presented a production view of the audit process and hypothesized that certain drivers associated with varying audit fees because those drivers caused an auditor to perform more (or less) work during the course of the audit. the general audit fee model is common to most studies in the literature represents audit fees as a function of client size, risk, client complexity, and quality (e.g. craswell and francis, 1999). lin (1997) aims to generate audit fee models for listed companies in taiwan. the results show that client size, audit risk, client complexity, and audit firm reputation significantly relate to audit fee variability. this study tests audit quality or audit firm reputation by hypotheses 2 and 3. a meta-analysis provides a means of understanding the body of knowledge developed over more than twenty years in audit fee research. the study of hay et al. (2006) confirms that well-established control variables for size, risk, and complexity relate to audit fees. therefore, the current work uses size, risk, and complexity as control variables. this study uses year02 to control year effects. the main control variables are stated as follows: client size the larger the clients, the greater the number of individual elements comprising the accounting systems as well as the greater the required number of formal control activities and thus the greater amount of input hours, audit efforts and audit fees required. previous asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 313 literature adopts the total asset variable to measure client size and to significantly explain audit fee variability in cross-sectional studies (simunic, 1980; francis, 1984; craswell et al., 1995). chow (1982) applies agency theory to observe motivations behind companies appointing auditors. results indicate that client size appears to be vital in explaining why managers request audit services. accordingly companies pay greater audit costs when audit efforts need to expand for large clients. results across virtually all published studies found size to be the most dominant determinant of audit fees, which is expected to have a positive relationship with fees (simunic 1980). the results of hay et al. (2006), find size measures are overwhelmingly positive and significant. likewise, audit firms charge higher audit fees for private universities and colleges perceived to be larger. therefore, this study uses a natural log of npos’ total assets (lnasset) as a proxy for client size to control the effects of client size on audit fees. client risk auditors consider auditee’s risks in determining audit fees. auditors may reduce follow-up audits to cut costs since auditors recognize npo clients (private universities and colleges) with steady and strong financial structures as having low audit risk. in contrast, the higher the assessment level of auditee’s risk, the higher the level of audit risk. a client with higher audit risk requires a greater amount of evidence to reduce audit risk, resulting in a correspondingly high audit fee. in a word, audit fees reflect the risk level of npos. financial structures of private universities and colleges differ from those of profit organizations; the current study lacks insight into the relationship between debt ratio to total assets and audit fees. however, auditors consider other measures as a proxy for auditee’s risk in deciding audit fees. this study proposes some proxy risk variables for private universities and colleges. leverage measures the risk of client failure, which potentially exposes the auditor to loss (simunic, 1980). consequently, researchers generally expect to find an association between leverage of a company and its audit fees. the first proxy this study uses for risk is the ratio of debt to total assets (debt). the second proxy for risk is the ratio of interest expenses to net income (int/earn).this research predicts a positive correlation between int/earn and the natural log of audit fees (lnau). npos achieving better performance receive more donations from the private sector and greater financial support from the government, which in turn brings about a positive image for these npos. thus, this work uses the ratio of subsidy to current revenues as a proxy for risk. in the same way, the ratio of personal donation to current revenues (donate) is also a proxy for risk. high ratio of current earnings to current revenue (earn) represents a steady financial structure of an organization that leads to lower operational risk. these measures, except for int/earn, have an entirely negative impact on risks faced by npos, showing that such measures are negatively connected with audit fees. vafeas (1999) suggest that increasing number of board meetings increases board effectiveness. an effective board of directors of npos results in sound corporate governance of the school due to reduced organization’s operational risk. all board expenditures should be debited to the board’s expense account which usually includes freight costs and operation costs. 4 it states that all operation expenditures should relate to board operation only, and does not asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 314 allow any personal spending to be recorded on the accounts. this study therefore reasonably predicts that amount the board of directors spends closely depends on how effective the board operates. a negative relationship between corporate governance of organization and audit fees is accordingly expected. the current work uses the ratio of board expenditures to current revenue (board) as a proxy for corporate governance soundness with regard to private colleges and universities. the more effective npo operations are, the better the corporate governance, hence the higher the related board expenditures. therefore, this work expects a negative correlation between board and the natural log of the audit fee (lnau). client complexity researchers typically expect that the more complex a client, the harder it is to audit and the more time is consumed (simunic, 1980; hackenbrack and knechel, 1994). the most typical indicator of complexity for profit organizations is the number of subsidiaries (hay et al., 2006). compared with profit organizations or subsidiaries, private universities and colleges have subsidiary (e.g., hospital or kindergarten) operations that require more audit services and time as typical school operations and subsidiaries are totally different. therefore, client complexity positively correlates to audit fees. a university organization is also larger and more complex compared to a college so that the universities have greater potential and more opportunities to acquire proposed projects and to develop continuous education than most colleges do. the current study also conjectures that auditors will charge a university higher audit fees than a college. as discussed above, this study uses two variables univ and opp/ta to measure client complexity. since industry experts are all big 4, the variable big4 very likely correlates with spe, leading to the problem of variance inflation, and hence the multicollinearity problem. to avoid the above biases, when examining whether audit fees of the professional big 4 are higher than those of the non-professional big 4 in the industry with professional cpa firms, this research uses only the schools audited by the big 4 to test hypothesis 3. the model is as follows: lnaui ＝ a ＋ 1b year03i ＋ b2year02i ＋ b3spei ＋ 4b lnasseti + 5b debti+ 6b int/earni＋ 7b boardi＋ 8b donatei ＋ 9b earni ＋ 10b subsidyi＋ 11b univi+ 12b opp/tai + iε (2) where, spe: professional cpa firms; equals to 1 when the ratio of audit fees over total audit fees of the schools is greater than 10%, 0 otherwise. 5 the other variables are defined the same as those in eq (1). finally, this study uses the whole sample to test again: are audit fees of the professional big 4 greater than those of the non-professional big 4 cpa firms in the industry with professional cpa firms? the current work also tests whether audit fees charged by the non-professional asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 315 big 4 contain trademark premiums not found in the non-big 4 cpa firms, i.e., when the reputation of attested cpa is higher, is the information value greater? because professional cpa firms are all big 4, therefore, the interaction term of big4 and spe is the same as spe; thus, we only employ spe. eq (3) is again used to test the hypotheses. lnaui ＝ a ＋ 1b year03i ＋ b2year02i ＋ b3 big4i ＋ b4 spei+ 5b lnasseti + 6b debti+ 7b int/earni＋ 8b boardi ＋ 9b donatei＋ 10b earni ＋ 11b subsidyi＋ 12b univi+ 13b opp/tai + iε (3) where, spe: professional cpa firms; equals to 1 when the ratio of audit fees over total audit fees of the schools is greater than 10%, 0 otherwise. the other variables are defined the same as those in eq (1). to test robustness of the results, we use 15% as the threshold to define professional cpa firms in the sensitivity test. we also use (1) the ratio of the number of audited schools over total schools and (2) the ratio of total assets of schools audited over total schools’ assets as the indicators of industry experts, and adopt 10% and 15% thresholds, separately, to do the sensitivity tests. table 3. expected empirical results independent variables eq(1) eq(2) eq(3) expected signs year03 hypothesis 1 hypothesis 1 hypothesis 1 + year02 control variable control variable control variable ? big4 hypothesis 2 -hypothesis 2 ＋ spe -hypothesis 3 hypothesis 3 ＋ lnasset control variable control variable control variable ＋ debt control variable control variable control variable ？ int/earn control variable control variable control variable ＋ board control variable control variable control variable － donate control variable control variable control variable － earn control variable control variable control variable － subsidy control variable control variable control variable － univ control variable control variable control variable ＋ opp/ta control variable control variable control variable ＋ year03:dummy variable, equals to one if academic year 2003, and zero otherwise. year02:dummy variable, equals to one if academic year 2002, and zero otherwise. big4 :dummy variable, proxy for audit quality, equals to one if audited by big 4, and zero otherwise. spe:professional cpa firms; equals to 1 when the ratio of audit fees over total audit fees of the schools is greater than 10% or 15%, 0 otherwise. lnasset :natural log of total assets of private universities and junior colleges, proxy for size. debt :the ratio of debt to total assets, proxy for risks. int/earn:interest expenses divided by current net income/loss, proxy for risks. board:the ratio of board expenditures to current revenues, proxy for risks. donate:the ratio of personal donation to current revenues, proxy for risks. earn:the ratio of current earnings to current revenues, proxy for risks. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 316 subsidy:the ratio of subsidy to current revenues, proxy for risks. univ :equals to one if university, and zero otherwise; proxy for complexity. opp/ta:the ratio of operating funds to total assets, proxy for complexity. 4. empirical results and analysis 4.1 descriptive statistics table 4 indicates the descriptive statistics of audit fees and financial data of sample schools for the 2001-2003 academic years. the average audit fee for the sample schools is nt$344,496, and the minimum of that is nt$142,500 whereas the maximum is nt$850,480. both the academic year 2002 and 2003 consists of 33% of the sample. approximately 39% of the sample schools are audited by the big 4. the biggest school had total assets equivalent to nt$14.74 billion and the smallest one had total assets about nt$430 million; however, average total assets are nt$3.52 billion. generally speaking, the ratio of debt to total assets for private universities and colleges cannot be that high and so it ranges from 1% to 73% with a mean of 14%. on average, the ratio of interest expenses to net income is 5% (maximum of 65%). as for the ratio of personal donations to current revenues, the mean is 5% (maximum of 79%). on average, the ratio of subsidy to current revenues is 13% (minimum of 3%, maximum of 35%). the average ratio of current earnings to current revenues is 28% (minimum of -26%, maximum of 70%). private universities made up 33% of the sample. as for the ratio of operating funds to total assets, the mean is 2% (maximum of 61%) 4.2 test of multicollinearity table 5 presents results of the pearson correlation analysis. among the independent variables, as table 5 indicates, there are relatively high correlations between lnasset and univ (0.692, significant at the 0.01 level), year03 and big 4 (0.561, significant at the 0.01 level), big 4 and spe(both 10% and 15%), spe(10%) and spe(15%) ,and the remaining coefficients are not higher than 0.5. this work computes the variance inflation factor (vif) to assess the susceptibility of the model to problems of multicollinearity. all the vifs of variables fell below 3.0 which suggest that multicollinearity is unlikely to be problematic. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 317 table 4. descriptive statistics（n=302;expressed in new taiwan dollars） variables mean minimum maximum std. deviation audit fees 344,496 142,500 850,480 159,459 year03 0.33 0.00 1.00 0.47 year02 0.33 0.00 1.00 0.47 big4 0.39 0.00 1.00 0.49 spe (10%) 0.31 0 1 0.46 spe (15%) 0.20 0 1 0.40 asset 3,523,678,688 429,949,870 14,740,416,907 2,689,134,236 debt 0.14 0.01 0.73 0.13 int/earn 0.05 -0.33 0.65 0.09 board 0.0029 0.00 0.02 0.0035 donate 0.05 0.00 0.79 0.11 earn 0.28 -0.26 0.70 0.12 subsidy 0.13 0.03 0.35 0.05 univ 0.33 0.00 1.00 0.47 opp/ta 0.02 0.00 0.61 0.08 audit fees:audit fees. year03:dummy variable, equals to one if academic year 2003, and zero otherwise. year02:dummy variable, equals to one if academic year 2002, and zero otherwise. big4 :dummy variable, proxy for audit quality, equals to one if audited by big 4, and zero otherwise. spe:professional cpa firms; equals to 1 when the ratio of audit fees over total audit fees of the schools is greater than 10% or 15%, 0 otherwise. asset :total assets of private universities and junior colleges, proxy for size. debt :the ratio of debt to total assets, proxy for risks. int/earn:interest expenses divided by current net income/loss, proxy for risks. board:the ratio of board expenditures to current revenues, proxy for risks. donate:the ratio of personal donation to current revenues, proxy for risks. earn:the ratio of current earnings to current revenues, proxy for risks. subsidy:the ratio of subsidy to current revenues, proxy for risks. univ :equals to one if university, and zero otherwise; proxy for complexity. opp/ta:the ratio of operating funds to total assets, proxy for complexity. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 318 table 5. pearson correlation matrices year03 year02 big4 spe (10%) spe (15%) lnasset debt int/earn board donate subsidy earn univ opp/ta year03 1 -0.499** 0.561** 0.500** 0.452** 0.072 -0.079 -0.148** 0.018 -0.022 -0.174** -0.213** 0.053 0.005 year02 1 -0.280** -0.219** -0.225** 0.019 0.009 -0.003 -0.011 -0.008 0.067 0.053 0.003 0.005 big4 1 0.839** 0.615** 0.211** -0.017 0.010 -0.174** -0.133* -0.218** -0.225** 0.209** 0.058 spe(10%) 1 0.733** 0.201** 0.000 0.016 -0.161** -0.143* -0.209** -0.204** 0.206** 0.084 spe(15%) 1 0.179** -0.091 -0.039 -0.189** -0.103 -0.223** -0.197** 0.129* -0.006 lnasset 1 -0.343** -0.177** -0.469** -0.006 -0.122* 0.063 0.692** 0.371** debt 1 0.655** 0.063 -0.075 -0.106 -0.021 -0.225** -0.149* * int/earn 1 -0.006 -0.041 -0.107 -0.071 -0.132* -0.099 board 1 -0.068 0.122* -0.194** -0.303** -0.075 donate 1 0.017 0.489** -0.038 0.075 subsidy 1 -0.114* 0.013 -0.055 earn 1 -0.016 0.239** univ 1 0.219* opp/ta 1 year03:dummy variable, equals to one if academic year 2003, and zero otherwise. year02:dummy variable, equals to one if academic year 2002, and zero otherwise. big4 :dummy variable, proxy for audit quality, equals to one if audited by big 4, and zero otherwise. spe:professional cpa firms; equals to 1 when the ratio of audit fees over total audit fees of the schools is greater than 10% or 15%, 0 otherwise. lnasset :natural log of total assets of private universities and junior colleges, proxy for size. debt :the ratio of debt to total assets, proxy for risks. int/earn:interest expenses divided by current net income/loss, proxy for risks. board:the ratio of board expenditures to current revenues, proxy for risks. donate:the ratio of personal donation to current revenues, proxy for risks. earn:the ratio of current earnings to current revenues, proxy for risks. subsidy:the ratio of subsidy to current revenues, proxy for risks. univ :equals to one if university, and zero otherwise; proxy for complexity. opp/ta:the ratio of operating funds to total assets, proxy for complexity. **correlation is significant at the 0.01 level (2-tailed). * correlation is significant at the 0.05 level (2-tailed). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 319 4.3 results of regression models as table 6 shows, of the 302 samples conducted for the 2001-2003 academic years, more than 10% of the entire sample group, defined as audit fees provided by one single audit firm, are industry specialists; and after filtration, ninety-four samples in total are cases handled by the big4 audit firms. when the threshold is increased to 15%, fifty-nine sample cases are industry specialists. table 6. cpas and types of private universities and colleges cpas specialist (10% threshold) specialist (15% threshold) universities and colleges institutes of technology total universities and colleges institutes of technology total specialist 33 61 94 19 40 59 non-specialist big 4 11 13 24 25 34 59 nonbig 4 61 123 184 61 123 184 total 105 197 302 105 197 302 because of the close relationships between these two variables, the four major audit firms (big4) and the industry specialist (spe), when the industry specialist accounts for 10% of the sampling population, the pearson coefficient is 0.839 with 1% significance level and at 15%, the pearson coefficient is 0.731 at the 1% significance level. therefore, when the regression model consists of both the big4 and spe variables simultaneously, problems of collinearality may surface. hence, when conducting the demonstration, eq (1) is used to independently test the non-industry specialist samples, and to examine whether trademark premiums exist as stated in hypothesis 2. this is followed by an independent test using eq (2) to examine the big4 samples to see whether an industry specialist premium exists in hypothesis 3. finally, eq (3) is used to test the entire sample group for existing auditor brand name and industry specialist premiums. when this research sets the specialist threshold at 10%, there are two industry specialist firms: pricewaterhousecoopers, which conducted audit services for fifty-nine schools (accounting for 29.38% of the total sample during the three-year period) and deloitte & touch, which completed audit services for thirty-five schools (not including cases before merging) during the three-year sampling period which accounts for 13.64% of the total sampling number. the percentages of audit fees accounted by the rest of the auditing firms are all below 10%. when using (1) to exam the total occupancy rate of the school and (2) to exam the percentage of total school capital that accounts for the overall total school capital of the representative auditor industry specialists, the outcomes for categorized results and categorized audit fees are the same. when proceeding with the demonstration, the sample is then separated into two groups of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 320 industry specialists and non-industry specialists; when the definition for industry specialists is set at 10%, the samples collected of industry specialists and non-industry specialists are 94 and 208, respectively. when the threshold is defined at 15%, the samples are 59 and 243. first, non-industry specialist samples were used to examine hypothesis 2. in an industry consisting of professional audit firms (specialists), the audit fees of the big4 non-specialist audit firms are higher than the non-big4 auditing firms, which demonstrate that the model is the same as eq (1). in the research conducted by francis (1984), craswell et al. (1995) and palmrose (1986), the big6 audit firms charged higher fees due to higher quality auditing services they provided. therefore when we use the scale of an auditing firm to represent its auditing quality, this work considers the scale as a variable element that affects audit fees. table 7 shows the effects of trademarks on audit fees in an industry with specialized audit firms. by eliminating the four major specialized audit firms, this study compares the four major non-specialized firms to the four non-major firms to avoid confusions created by industry specialization. because this particular test is limited to non-specialized firm samples, any differences in audit fees can be referred to trademark effects. table 7 shows, when the specialization definition is set at 10%, the four major non-specialized firms achieve the required significance level; and when the threshold is 15%, the four major non-specialized firms have a coefficient of 0.1083 at the 1% significance level. this result is the same as anticipated by hypothesis 2. in an industry with specialized auditing firms, audit fees of the big4 non-specialized audit firms are higher than those of non-big4 audit firms. the differences between the big4 and non-big4 have already eliminated the effects caused by specialization. this result can independently refer to trademark effects of the big4. other than debt and int/earn, which do not achieve significance, the other control variables are the same as anticipated and at the significance level. this section examines whether audit fees of the big4 specialized audit firms are higher than the big4 non-specializing audit firms in an industry with specialized audit firms. this study uses 118 samples extracted from the school data examined by the four major audit firms to test hypothesis 3. when using a 10% audit fee threshold to decide the industry specialists, ninety-four samples of the 118 total samples belong to industry specialists; when using 15% audit fee threshold, fifty-nine samples of the 118 total samples belong to industry specialists. table 8 shows the results. the coefficient of year03 is significantly positive, supporting hypothesis 1 that audit fees under limited tendering procedures will be higher than those under open tendering procedures. when 10% is used as a threshold for deciding industry specialists, the specialist variable (spe) does not reach the significance level. but when the threshold is set to a stricter 15%, the coefficient on the spe is 0.1689 at the 5% significance level. this proves that in an industry with specialists, limiting the samples to big4 clients controls the confusion created by trademark (big4 against non-big4) effects. there are differences between audit fees because the big4 are industry specialists. the result is consistent with hypothesis 3 that audit fees of the four major specialized audit firms are higher than the four major non-specialized audit firms. results in table 7 and table 8 demonstrate that the big 4 possesses trademark reputation and that the spe variable of audit asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 321 fee premium represents the positive return of the big 4 auditors and their investment in industry specialization. finally, in order to consolidate the results, eq (3) is used with the entire 302 samples for demonstration. when the percentage of audit fee over the industry is at the 10% and 15% thresholds to decide industry specialist, ninety-four and fifty-nine cases belong to the specialist, respectively. results in table 9 show that all variables with vifs values less than 4 have no serious variable inflation problems. the coefficient of year03 is significantly positive, supporting hypothesis 1 that audit fees under limited tendering procedures will be higher than those under open tendering procedures. when the audit fee is over the 10% threshold of the entire industry audit fees, the big4 has a variable of 0.1437 at the 1% significance level. after controlling for the four major audit firms’ influences, the industry specialist (spe) variable coefficient is 0.0985, the p-value is 0.0757, and these gave hypotheses 2 and 3 very weak supporting evidence. when a stricter threshold is applied at 15%, the coefficients of big4 and spe are 0.1526 and 0.1674, respectively, at the 1% significance level. results show support for hypotheses 2 and 3 when table 7 and table 8 are analyzed separately. after controlling for possible effects of confusion created by the trademark premium (big 4 against the non-big 4 audit firms), the difference between audit fees is due to a public expense premium when the big4 are industry specialists. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 322 table 7. brand name effect of non-specialist audit firms lnaui ＝ a ＋ 1b year03i ＋ b2year02i ＋ b3big4i ＋ 4b lnasseti + 5b debti+ 6b int/earni＋ 7b boardi＋ 8b donatei ＋ 9b earni ＋ 10b subsidyi＋ 11b univi+ 12b opp/tai + iε eq(1) specialization is set to be over 10% of market share specialization is set to be over 15% of market share variable:lna u coefficient p-value vif coefficient p-value vif intercept 7.2144 0.0000 6.4308 0.0000 year03 0.2325 0.0000 1.4449 0.2714 0.0000 1.6723 year02 -0.0600 0.0204 1.2176 -0.0528 0.0608 1.2604 big4 0.1238 0.0022 1.2499 0.1083 0.0015 1.4039 lnasset 0.2556 0.0000 2.6664 0.2903 0.0000 2.8452 debt -0.0167 0.8883 1.9432 -0.0803 0.5244 1.9700 int/earn -0.2067 0.2412 1.8794 0.0937 0.5814 1.7988 board -9.9654 0.0036 1.3835 -11.3069 0.0035 1.4340 donate -0.3598 0.0013 1.5872 -0.3616 0.0027 1.4298 earn -0.2955 0.0278 1.9701 -0.2927 0.0240 1.7020 subsidy -1.3090 0.0000 1.1680 -0.9987 0.0001 1.1074 univ 0.1432 0.0001 1.8934 0.0845 0.0257 2.0260 opp/ta 0.9353 0.0000 1.2660 0.4986 0.0024 1.3034 r-squared 0.785 0.751 adjusted r-squared 0.772 0.738 f-statistic 59.304 57.817 prob(f-statistic) 0.000 0.000 n 208 243 lnau: the natural log of the audit fee. year03:dummy variable, equals to one if academic year 2003, and zero otherwise. year02:dummy variable, equals to one if academic year 2002, and zero otherwise. big4 :dummy variable, proxy for audit quality, equals to one if audited by big 4, and zero otherwise. lnasset :natural log of total assets of private universities and junior colleges, proxy for size. debt :the ratio of debt to total assets, proxy for risks. int/earn:interest expenses divided by current net income/loss, proxy for risks. board:the ratio of board expenditures to current revenues, proxy for risks. donate:the ratio of personal donation to current revenues, proxy for risks. earn:the ratio of current earnings to current revenues, proxy for risks. subsidy:the ratio of subsidy to current revenues, proxy for risks. univ :equals to one if university, and zero otherwise; proxy for complexity. opp/ta:the ratio of operating funds to total assets, proxy for complexity. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 323 table 8. brand name premium of specialist audit firms lnaui ＝ a ＋ 1b year03i ＋ b2year02i ＋ b3spei ＋ 4b lnasseti + 5b debti+ 6b int/earni＋ 7b boardi＋ 8b donatei ＋ 9b earni ＋ 10b subsidyi＋ 11b univi+ 12b opp/tai + iε eq(2) specialization is set to be over 10% of market share specialization is set to be over 15% of market share variable:lnau coefficient p-value vif coefficient p-value vif intercept 9.5709 0.0000 9.1745 0.0000 year03 0.3545 0.0002 2.2323 0.3310 0.0003 2.2520 year02 0.0404 0.7005 1.8772 0.0441 0.6642 1.8313 spe 0.1042 0.1671 1.1046 0.1689 0.0123 1.3934 lnasset 0.1497 0.0827 3.8665 0.1619 0.0563 3.8834 debt -0.9201 0.0239 2.9264 -0.7534 0.0599 2.9682 int/earn 1.4869 0.0019 2.8510 1.4598 0.0018 2.8518 board -26.3068 0.1838 1.8105 -8.3736 0.6887 2.1223 donate -0.1461 0.7193 1.2599 -0.1502 0.7044 1.2456 earn -0.5054 0.0940 1.3960 -0.3712 0.2176 1.4573 subsidy -0.2163 0.7879 1.2402 0.0979 0.9027 1.2831 univ 0.1007 0.2639 2.4243 0.1268 0.1536 2.4465 opp/ta 0.1942 0.5740 1.3498 0.2438 0.4678 1.3271 r-squared 0.447 0.470 adjusted r-squared 0.384 0.409 f-statistic 7.075 7.748 prob(f-statistic) 0.000 0.000 n 118 118 lnau:the natural log of the audit fee. year03:dummy variable, equals to one if academic year 2003, and zero otherwise. year02:dummy variable, equals to one if academic year 2002, and zero otherwise. spe:professional cpa firms; equals to one when the ratio of audit fees over total audit fees is greater than 10% or 15%, and zero otherwise. lnasset :natural log of total assets of private universities and junior colleges, proxy for size. debt :the ratio of debt to total assets, proxy for risks. int/earn:interest expenses divided by current net income/loss, proxy for risks. board:the ratio of board expenditures to current revenues, proxy for risks. donate:the ratio of personal donation to current revenues, proxy for risks. earn:the ratio of current earnings to current revenues, proxy for risks. subsidy:the ratio of subsidy to current revenues, proxy for risks. univ :equals to one if university, and zero otherwise; proxy for complexity. opp/ta:the ratio of operating funds to total assets, proxy for complexity. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 324 table 9. results of regression model for brand name premium and industry specialist with full sample lnaui ＝ a ＋ 1b year03i ＋ b2year02i ＋ b3big4i ＋ b4spei+ 5b lnasseti + 6b debti+ 7b int/earni＋ 8b boardi ＋ 9b donatei＋ 10b earni ＋ 11b subsidyi＋ 12b univi+ 13b opp/tai + iε eq(3) specialization is set to be over 10% of market share specialization is set to be over 15% of market share variable:lnau coefficient p-value vif coefficient p-value vif intercept 7.5382 0.0000 7.5596 0.0000 year03 0.2153 0.0000 2.0267 0.2020 0.0000 2.0447 year02 -0.0408 0.2315 1.3661 -0.0356 0.2869 1.3610 big4 0.1437 0.0099 3.8622 0.1526 0.0002 2.1006 spe 0.0985 0.0757 3.4708 0.1674 0.0002 1.7438 lnasset 0.2406 0.0000 2.8276 0.2376 0.0000 2.8271 debt -0.2074 0.1717 1.9987 -0.1508 0.3131 2.0144 int/earn 0.4337 0.0356 1.8807 0.4244 0.0362 1.8810 board -14.0938 0.0028 1.4364 -12.2554 0.0086 1.4568 donate -0.3457 0.0148 1.3743 -0.3538 0.0110 1.3710 earn -0.3511 0.0160 1.6583 -0.3119 0.0297 1.6690 subsidy -0.9973 0.0010 1.1669 -0.8893 0.0030 1.1812 univ 0.0684 0.0982 2.0070 0.0772 0.0577 2.0045 opp/ta 0.5242 0.0054 1.2805 0.5796 0.0017 1.2773 r-squared 0.698 0.708 adjusted r-squared 0.684 0.695 f-statistic 51.095 53.786 prob(f-statistic) 0.000 0.000 n 302 302 lnau:the natural log of the audit fee. year03:dummy variable, equals to one if academic year 2003, and zero otherwise. year02:dummy variable, equals to one if academic year 2002, and zero otherwise. big4 :dummy variable, proxy for audit quality, equals to one if audited by big 4, and zero otherwise. spe:professional cpa firms; equals to one when the ratio of audit fees over total audit fees is greater than 10% or 15%, and zero otherwise. lnasset :natural log of total assets of private universities and junior colleges, proxy for size. debt :the ratio of debt to total assets, proxy for risks. int/earn:interest expenses divided by current net income/loss, proxy for risks. board:the ratio of board expenditures to current revenues, proxy for risks. donate:the ratio of personal donation to current revenues, proxy for risks. earn:the ratio of current earnings to current revenues, proxy for risks. subsidy:the ratio of subsidy to current revenues, proxy for risks. univ :equals to one if university, and zero otherwise; proxy for complexity. opp/ta:the ratio of operating funds to total assets, proxy for complexity. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 325 5. conclusions the main obstacle of audit fee research lies in fees collection. previous audit fees were usually collected by questionnaire survey method. this study however collects audit fee data from audited financial statements of private colleges and universities for the 2001-2003 academic years. this study examines not only types of tendering procedures, but also audit revenue premiums for private universities and colleges in taiwan according to both brand name reputation and industry specialist perspectives. the evidence gives support for our first hypothesis (h1) that audit fees under limited tendering procedures will be higher than those under open tendering procedures. by excluding industry specialist big 4, findings show a comparable result consistent with our second hypothesis (h2). the result shows that the auditor brand name reputation premium exists between non-specialist big 4 and non-big 4 while non-specialist big 4 defined as an audit firm, has industry audit fees less than 15 percent. as auditing is a high specialization industry, an increase in audit fees charged by non-specialist big 4 is expected to be naturally greater than those of non-big 4. the coefficient estimated on spe is also significant at the 0.05 level, revealing that specialist big 4 has higher audit fees than those of non-big 4. to assess robustness of the results, we reran the regression model with the full sample and the results remain consistent with those derived from subsamples. in sum, we conclude that differences in audit fee charges may attribute to revenue premiums for specialist big 4 that supports our third hypothesis (h3), providing additional evidence to sustain auditor brand name reputation premium and industry specialist effects. the findings extend the literature. this study contributes some findings and significance. firstly, the most important significance in the study, different from prior researches in which audit fees are paid by the client, we collect the unique data that audit fees are paid by the moe. we can examine whether the effects of dependent variables on audit fees are different from prior studies. secondly, prior studies give evidence to support the agency theory, while we didn’t find any research focused on real audit fees of npos applied the agency theory in taiwan. applying real audit fees, our results show that the agency theory is tenable for npos, especially the private universities and colleges. thirdly, we propose some determinants of audit fees about the private universities and colleges. finally, revenue premiums exist not only in profit organizations but also in npos. our study has several limitations. nine, ten, and fourteen schools between the academic year 1998 and 2000 were audited by appointed cpas, accounting for 10% of the whole. due to limited research data, we were unable to compare audit fee differences between academic years 1998-2000 and 2001-2003. furthermore, we were unable to collect audit fees from academic year 2004 and onward. thus, this study cannot explore the effects of different auditor selectors, the moe or private universities or colleges, on audit fees. notes 1. the three biggest organizations are profit organizations, non-profit organizations and government organizations. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 326 2. universities and colleges include universities, colleges, and institutes of technology in this study, unless otherwise stated. 3. academic years of schools are different from those of firms. for example, academic year 1992 started from august 1, 1992 and went to july 31, 1993. 4. according to article 33 of the private school law, “the positions of chairman, director, and consultant shall all be non-paid, provided that stipends may be paid for meeting attendance and transportation.” under the administrative rules governing special audit at the private junior college and higher levels, the moe specifies that the engaged auditors must pay attention to examining board’s expenditures. 5. according to article 33 of the private school law, “the positions of chairman, director, and consultant shall 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(1999). the correlation among non-audit services, cpa size, and audit fees. master’s thesis, national chung cheng university (in chinese). microsoft word 6286-22566-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 319 real estate investment in bangladesh: a pre liminary study naheem mahtab (corresponding author) school of business, independent university, bangladesh plot 16, block b, aftabuddin ahmed road, bashundhara, dhaka-1229, bangladesh e-mail: naheem@iub.edu.bd maqbool kader quraishi school of business, independent university,bangladesh plot 16, block b, aftabuddin ahmed road, bashundhara, dhaka-1229, bangladesh e-mail: quraishimk@gmail.com received: sep. 8, 2014 accepted: oct. 14, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6286 url: http://dx.doi.org/10.5296/ajfa.v6i2.6286 abstract now a day's real estate investment through bank is a common phenomenon. every single person or every house development company is used to take loans from banks or other financial institutions to complete their construction. without bank loans it not possible to complete their construction on time. income level is a very impressive influencing factor of real estate investment in our country. people don't want to spend whole amount construction cost from their own pocket that's why they are becoming dependent on loans of banks or other financial institution. financing cost includes the interest payment of loans. sometimes people are facing problem to repay the loans when any other political or natural instability stop their construction they the client of the bank are come to the defaulters list. there is a big issue in current real estate market that is low transparency of loans of financial institutions. when any financial institution provides loans to any house building company then they sometimes not disclose some terms related to loans then after some month or year the loan taking clients get some problems which is not good for the sector in bangladesh. keywords: real estate investment, financing cost, political risk, transparency, defaults asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 320 1. introduction real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. real estate has traditionally outperformed the wall street equity market. a street by street knowledge of the market makes it perfect for small savvy investors. large institutions lag behind trends. improvement of realty property as part of a real estate investment strategy is generally considered to be a sub-specialty of real estate investing called real estate development. real estate is an asset form with limited liquidity relative to other investments, it is also capital intensive (although capital may be gained through mortgage leverage) and is highly cash flow dependent. if these factors are not well understood and managed by the investor, real estate becomes a risky investment. the primary cause of investment failure for real estate is that the investor goes into negative cash flow for a period of time that is not sustainable, often forcing them to resell the property at a loss or go into insolvency. a similar practice known as flipping is another reason for failure as the nature of the investment is often associated with short term profit with less effort. once an investment property has been located, and preliminary due diligence (investigation and verification of the condition and status of the property) completed, the investor will have to negotiate a sale price and sale terms with the seller, then execute a contract for sale. most investors employ real estate agents and real estate attorneys to assist with the acquisition process, as it can be quite complex and improperly executed transactions can be very costly. during the acquisition of a property, an investor will typically make a formal offer to buy including payment of "earnest money" to the seller at the start of negotiation to reserve the investor's rights to complete the transaction if price and terms can be satisfactorily negotiated. this earnest money may or may not be refundable, and is considered to be a signal of the seriousness of the investor's intent to purchase. the terms of the offer will also usually include a number of contingencies which allow the investor time to complete due diligence, inspect the property and obtain financing among other requirements prior to final purchase. within the contingency period, the investor usually has the right to rescind the offer with no penalty and obtain a refund of earnest money deposits. once contingencies have expired, rescinding the offer will usually require forfeiture of the earnest money deposits and may involve other penalties as well. 2. statement of problem the problem statement of this research is-―to investigate customers income level how extent related to the loans and why they are talking loans, their financial cost how cover with this loan facilities viewpoint on acquisition of real estate investment through bank loans. 3. purpose of the study the purpose of this study is to know about the consumers’ income level, financing cost, property pricing and transparency of real estate market how effects the real estate investment through bank loans or any other financial organization. customer’s loan taking tendency from banks to make real estate financing can easily identify by this research. acquisition of real estate investment through bank loan research is the process by which we can easily asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 321 identify the house building organizations financial position and willingness towards bank loans. real estate investment through bank loans is an effective tool for experience higher revenues on this sector. • focusing on income level and its correlation with real estate acquisition through bank loans and discussing the expertise of buying behaviour to know customers real estate investment intension. • verifying consumers ‘dependency on loan products available for real estate acquisition and cost of loan recommendation before making the final purchase decision. • evaluating buying process which includes studying the need of transparency of information in the real estate market, cost of loan and evaluation of alternatives and acquisition behaviour of customers. • analysing the necessity of determining property prices and its influence on consumer decision making. • determining income level and the association of income with loan costs while using loans for real estate investment. • examine whether the customer belief on the available transparency of information in the real estate market is significant in relation to the loan cost of the loan used in the acquisition process of real estate in bangladesh. 4. literature review income level: the term social capital is often traced back to the work of the sociologist bourdieu (1977), but it gained popularity with the seminal work of coleman (1990) and putnam (1993). recently, guiso et al. (2008) define social capital as “good” culture—i.e., a set of beliefs and values that facilitate cooperation among the members. the authors show that social capital can be measured by both direct indicators (such as generalized trust) and indirect indicators (such as blood donations). there is a large consensus that heterogeneity is one important factor reducing the formation of social capital. usually, community heterogeneity refers to income inequality but also ethnicity, and racial heterogeneity. in the present literature review, we concentrate our attention on economic inequality. several mechanisms could explain the association between economic inequality and social capital. first, individuals might be adverse to heterogeneity. in other words, they prefer having contacts with individuals that are similar to themselves, i.e. that belong to the same socioeconomic group. in heterogeneous societies contacts between dissimilar individuals will be at a lower rate than in more homogeneous societies. repeated interactions being conducive of social capital and trust, heterogeneous societies are thus characterized by fewer contacts and, in consequence, by lower levels of cooperation and trust (see the seminal work by colman, 1990, and alesina et al, 2002 for instance). this aversion to heterogeneity can be driven by the fact that individuals from different socioeconomic groups are less likely to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 322 share common values and norms which makes it more difficult for them to predict the attitudes of others. this creates an environment not favorable to the development of social capital (knack and keefer, 1997). second, when resources are not evenly distributed, poor individuals might perceive that they are living in an unfair society where the rich tend to exploit the poor. this will lead individuals at the bottom end of the income distribution to develop distrust against richer individuals (rothstein and uslaner, 2004). uslaner and brown (2005) argue that when income inequality is high, individuals from different socioeconomic groups will have the sensation that they are not sharing the same fate, and this will hamper trust. third, inequality should relate to the level of optimism. higher level of inequality is likely to reduce the level of optimism for the future and thereby trust (uslaner and brown, 2005, rothstein and uslaner, 2005). most of the scholars interested in the relationship between social capital and income inequality have relied on trust as a proxy for social capital. the type of question used to assess the level of trust is “in general, do you think that most people can be trusted?” fewer studies focus on different dimensions of social capital such as group membership, volunteering (alesina and laferrara, 2000, costas and kahn, 2003, and uslaner and brown, 2005), informal social capital such as entertaining with friends and relatives (lancee and van de werfhorst, 2011). transparency in real estate market: according to jones lang lasalle (2006), transparent market in real estate context is a market fairly free from corruption and it has readily available information and operates in a fair and consistent manner. it has been argued that more transparent real estate markets attract greater levels of foreign investors as they become more comfortable and better informed (jones lang lasalle, 2008). this argument is supported by previous studies (jones lang lasalle, 2004, 2009; dhar and goetzmann, 2006). jones lang lasalle (2008) noted that uncertainty respecting frei laws could weaken investor confidence, caused confusion, negatively affected transparency and as a result decrease fdi into property sectors. in their comprehensive summary, sirmans and worzala (2003) concluded that international real estate investment is highly related to available market information and real estate market transparency. jones lang lasalle (2004) argued that foreign real estate investors are not keen to invest in countries where domestic investors have easier access to information and therefore a competitive advantage, since the costs and risks of property transactions are high. similarly, dhar and goetzmann (2006) documented that more complete information about the long-term performance of real estate asset class can help resolve uncertainty and affect institutional investors’ demand for different types of properties. he et al. (2009) provided evidences that foreign investors would favor those china’s provinces with a more transparent real estate markets. more specifically, they argued that provinces that transfer their land use rights through a more open and transparent way would be attractive to foreign real estate investors. in his study on transparency and real estate investment, triantafyllopoulos (2006) argued where there is no security of legal title and enforceability of property rights, domestic and international investors are not always willing to invest. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 323 triantafyllopoulos further discussed that lack of information regarding real assets may cause a country to be ignored by real estate investors when they draw up their international investment strategies. triantafyllopoulos also noted that when corruption dominates in property markets, the private marginal product of capital invested decrease because of the bribes that have to be paid, lowering the investment rate. as a result, participation of (domestic and foreign) investors in property market would decrease. falkenbach (2009) found that one of the important criteria for market selection in international real estate investment is availability of market information and performance benchmarks (transparency). with regard to general fdi, drabek and payne (2002) also concluded that a nation that takes steps to increase the degree of transparency in its policies and institutions could expect significant increases in the level of foreign investment. property prices: another hypothesis to be tested is the relationship between property prices in host countries and frei. the rationale for selecting property prices as an independent variable is that real estate can be considered as financial assets, whose price changes would affect the quantity and direction of financial movements across borders (rodrı´guez and bustillo, 2010). anumber of researchers found that heightening property prices in the host countries encourages foreign investment in real estate sectors of those countries (he et al., 2009; zhu et al., 2006). for example, in their financial model for frei in spain, rodrı´guez and bustillo (2010) found that there is a long-run and positive relationship between expectations of increasing prices for real estate assets and frei in spain. in particular, they argued that spain is attractive for real estate investment because the future return of the present investment is expected to be high. similarly, as mentioned earlier, he et al. (2009) showed that the heightening housing prices significantly stimulate the inflow of fdi in china’s real estate industry. in other words, he et al. (2009) argued that foreign investors in real estate lean towards those (china) provinces with higher average housing prices. jones lang lasalle (2009) discussed that potential for capital growth is one of the main criteria for long-term investors in mena countries’ real estate sector. in his study, bagchi-sen (1995) also found that the value of property is one of major determinants of fdi in real estate sector in the usa. on the other hand, it can be argued that an increase in property prices have opposite effect on frei. for example, in their demand model for real estate in a foreign country, rodrı´guez and bustillo (2010) showed that there is a long-run and negative relationship between property prices and frei in spain. in other words, they argued that demand for housing services abroad is (negatively) influenced by their prices, consistent with demand theory. financing cost: one of the possible determinants of frei is the financing system in the host countries. it is because foreign investors in service sectors (including real estate) rely on the host country’s financial systems to raise the capital that is required for their investment (ramasamy and yeung, 2010). therefore, a high interest rate could negatively influence the extent of fdi inflow because a large amount of funds could be raised by foreign investors asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 324 from the financial system of host countries. this argument is consistent with a number of previous studies. he et al. (2009) found that foreign investors in china’s real estate industry avoid provinces with high financing cost (or lower value for loan). this means that foreign investors favor provinces in which foreign investors are easy to borrow money from commercial banks. in their study on determinants of frei in spain, rodrı´guez and bustillo (2010) also found that frei is negatively related to the long-term interest rate. with regard to general fdi, zhao (2003) found that the relatively high costs of capital borrowing in china inhibited the flow of fdi. the expenses associated with the nonperforming loans that results can create the appearance, if not the reality, of low cost efficiency. the authors refer to this as the "bad luck" hypothesis. the second empirical link between problem loans and productive efficiency appears in studies that use supervisory examination data. a relationship between asset quality and cost is consistent with the failed bank data, and suggests that the negative relationship between problem loans and cost efficiency holds for the population of banks as a whole as well as for failing banks. third, some recent studies of bank efficiency have directly included measures of nonperforming loans in cost or production relationships. whether this procedure improves or hinders the estimation of cost efficiency depends upon the underlying reason for the relationship between costs and nonperforming loans. thus, important policy and research issues rest on identifying the underlying relationship between problem loans and measured cost efficiency: the primary cause of problem loans and bank failures determining the most important supervisory focus for promoting safety and soundness at banks deciding how to estimate the cost efficiency of financial institutions. the authors test four hypotheses bad luck, bad management, skimping, and moral hazard using granger-causality analysis. the skimping hypothesis posits that banks might achieve low costs by under-spending on loan underwriting and monitoring in the short run, and after time passes this slack results in increases in problem loans. the authors test the moral hazard hypothesis by testing whether equity capital negatively granger-causes nonperforming loans. the authors results suggest that the inter-temporal relationships between loan quality and cost efficiency run in both directions. http://ideas.repec.org/p/wop/pennin/96-01.html acquisition of real estate through bank loans: for the next several years, the commercial real estate mortgage market faces record levels of maturities. as shown in figure 1, the annual amount of commercial mortgage loan maturities has risen steadily during the last decade from $50 to $ 100 billion in 2000 through 2003 to $200 to $250 billion in 2008 and 2009. maturities are estimated to exceed $250 billion per year from 2010 through 2015 and are not forecast to decline below $200 billion per year until 2018. the level and extent of commercial mortgage maturities far exceed the level of maturities during the last major real estate downturn of the early 1990’s. the continued economic recession combined with declines in rental rates, declines in occupancy levels, other deteriorating property fundamentals and increases in capitalization rates have caused declining property values. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 325 in the context of record levels of outstanding commercial mortgage debt, these factors place considerable stress on the ability of borrowers to service debt and to refinance scheduled maturities. while some loans might be refinanced or extended, many of these maturing loans will eventually result in other resolution strategies including workouts/restructurings, bankruptcies, discounted payoffs, or foreclosures. distressed loans can be defined as loans that will follow one or more of these resolution paths. when pools of loans are involved, buyers and sellers use similar information to configure pools, determine specific assets on which to conduct diligence and develop pricing on either individual loans or on like kind loans using statistical sampling techniques and models. this article focuses on the acquisition of distressed notes and mortgages on real estate at the individual loan level and discusses the manner in which various post acquisition loan resolution strategies effect the due diligence and pricing in those acquisitions. for the purposes of this article, distressed commercial real estate debt is broadly defined to include both loans secured directly by mortgages on real property and loans secured by llc, partnership or stock interest in entities whose assets consist primarily or exclusively of real property. interests in collateralized mortgage backed securities, collateralized debt obligations, and similar structures are not covered in this article. http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer 5. conceptual framework 6. hypotheses ho1: there is no positive relationship between income level and acquisition of real estate through bank loans. ha1: there is a positive relationship between income level and acquisition of real estate through bank loans. ho2: there is no negative relationship between financing costs and acquisition of real estate through bank loans.. financing cost income level property prices transparency in real estate market acquisition of real estate through bank loans asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 326 ha2: there is a negative relationship between financing costs and acquisition of real estate through bank loans. ho3: higher level of transparency in real estate market would not attract greater amount of acquisition of real estate through bank loans. ha3: higher level of transparency in real estate market would attract greater amount of acquisition of real estate through bank loans. ho4: there is no relationship between property prices and acquisition of real estate through bank loans. ha4: there is a relationship between property prices and acquisition of real estate through bank loans. ho5: there is no relationship between the availability of bank loans and acquisition of real estate in bangladesh. ha5: there is a relationship between the availability of bank loans and acquisition of real estate in bangladesh. 7. the research design-methods and procedures research design is crucial as it acts as a blueprint for the collection, measurement and analysis of data. in this study, we selected formal research design. because this study required structured and précised way to show the relationship among different variables and to test hypotheses. under the method of data collection, we selected communication study. because we needed to communicate with different customers through questionnaire to understand their income level, financing cost, product pricing etc. which have significant impact on their acquisition of real estate investment through bank loans. our study was an experimental study. because our study was required to gather information selective samples. our study was causal explanatory as we tried to explain the relationship among different variables such as we tried to discover whether bank loans can affect customers‘financing decision. our study reflected a snapshot of one point in time. we studied on 100 customers as samples for and they did not need to be studied again for the same study. we focused on statistical study and descriptive analysis. our study was designed for testing the hypotheses quantitatively which required a good number of samples which reflected the population. our research occurred in actual environmental conditions. this option was chosen because we had to receive information from our sample on field and relationships in variables of our study were required to represent via mathematical models. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 327 participants ‘were aware of our presence and knew the reason of being selected as sample. we tried to find out their natural behavior as much as we could via questionnaire. 8. sampling 8.1 sample unit sample unit of research was based on customers who acquired real estate through the use of loans of banks or other financial institutions. in order to gather information, participants had been asked to fill up questionnaires. the population for the current research was the customers who use loans to acquire various real estate products in bangladesh. in particular, the study revealed that the sample consisted of equal number of males than females and mostly people in the work force. 8.2 sample size sample size relates to how many people to pick for the study. we picked both male and female of different ages, educational back ground and occupation. the sample size for our study was 50. 8.3 sample procedure this study utilized probability sampling technique that involved selecting participants randomly for questionnaires. two facts were considered to select the participants for the questionnaires. firstly, the sample members bought their real estate products from renowned companies were transparency of information was high and prices of the property was accurately determined according to the market rates. secondly, these customers used or are using various loan product available from various financial institutions. in our case these customers information were mainly acquired from those groups who had taken a home loan from standard bank limited. 9. instruments of research the key variables in this study were measured by a self-report questionnaire. a self-report is any method which involves asking a participant about their feelings, attitudes, and beliefs and so on. the first part of the instrument included demographic characteristics of gender, age, income, occupation and educational background. the rest of the questionnaire assessed the five variables in the research hypotheses. there were 17 questions excluding demographic questions in the questionnaire. every variable has different questions for each and our questionnaire introduces five points likert scale to our participants. we had collected the information about online marketing from different participants from different areas and also collected participant‘s photos during the survey. our likert scale has five points. the points are first one is strongly disagree, second one is disagree , third one is neutral, forth one is agree and lastly fifth one is strongly agree. our participants easily understand our rating scale and successfully completed the survey. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 328 income level and financing cost: by this variable we came to know that how online marketers ‘recommendation affects the customers buying intention and how customers are inspired by the recommendation. in this section i have five questions in our questionnaire. transparency in real estate market: this variable has three questions about how the customers believe the information which online marketers’ are providing to them. in this section i have five questions in our questionnaire. property prices: every participant gave the good response on this because everyone likes to do online shopping now a day and this variable has two questions and by these two questions we can easily come to know that the participants attitude toward the online marketing. acquisition of real estate through bank loans: four questions for online brand image reflects the participants awareness how they are choosing the branded products and the company. 10. data collection data collection was carried out in two ways: primary data and secondary data. in this research, we used both of the methods. 11. data analysis 11.1 descriptive analysis: descriptive analysis includes numbers that summarize the data with the purpose of describing what occurred in the sample. our study involved 50 random samples. frequency distributions were which have been given under table no. 1‘. in my research, there were 33 male which was 66% of total sample under survey and the other 17 were female which consisted of 34%. fourteen participants were between 51-60 years of age that was 28%. i had 3 participants above 60 years and who constituted 6 %. thirteen participants in below 30 year and the percentage was 26%. twelve participants in 41-50 years and eight participants in 30-40 years and they constituted 40%. all of my participants were service holder. from 50 participants i had 25 business men and their percentage was 50%. i had 16 service holders (private sector) and 9 service holder (public sector) who constituted 32% and 18% from total questionnaire. in my questionnaire i had found 17 participants who finished their post graduation and 10 participants were completed under graduation and combining both degrees i found 54% of our participants are well educated. thirteen participants completed diploma and ten participants only completed their hsc which i categorized by other and both group constituted 46% of total questionnaire. i had five categories for income and 17 participants were in between tk. 100000-tk. 300000 and they constituted 34% which was majority of our questionnaire. i had 12 participants whose income level was below tk. 100000 and the percentage was 24%. 7 participants were asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 329 from tk. 300001-tk. 500000 and they constituted 14%. i had also 3 participants from above tk. 700000 and 11 participants from tk. 500001-tk. 700000 both constituted 28%. table 1. frequency distribution statistics gender age annual income occupation education n valid 50 50 50 50 50 missing 0 0 0 0 0 gender frequency percent valid percent cumulative percent valid male 33 66.0 66.0 66.0 female 17 34.0 34.0 100.0 total 50 100.0 100.0 age frequency percent valid percent cumulative percent valid below 30 13 26.0 26.0 26.0 30-40 8 16.0 16.0 42.0 41-50 12 24.0 24.0 66.0 51-60 14 28.0 28.0 94.0 above 60 3 6.0 6.0 100.0 total 50 100.0 100.0 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 330 annual income frequency percent valid percent cumulative percent valid below tk. 100000 12 24.0 24.0 24.0 tk. 100000-tk. 300000 17 34.0 34.0 58.0 tk. 300001-tk. 500000 7 14.0 14.0 72.0 tk. 500001-tk. 700000 11 22.0 22.0 94.0 above tk. 700000 3 6.0 6.0 100.0 total 50 100.0 100.0 occupation frequency percent valid percent cumulative percent valid service in public sector 9 18.0 18.0 18.0 service in private sector 16 32.0 32.0 50.0 self employed (business) 25 50.0 50.0 100.0 total 50 100.0 100.0 education frequency percent valid percent cumulative percent valid post graduate 17 34.0 34.0 34.0 under graduate 10 20.0 20.0 54.0 diploma 13 26.0 26.0 80.0 others 10 20.0 20.0 100.0 total 50 100.0 100.0 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 331 cross tabulation was also done which has been shown under table 2 table 2. cross tabulation calculation case processing summary cases valid missing total n percent n percent n percent gender * age 50 100.0% 0 .0% 50 100.0% gender * age cross tabulation count age total below 30 30-40 41-50 51-60 above 60 gender male 8 3 10 10 2 33 female 5 5 2 4 1 17 total 13 8 12 14 3 50 case processing summary cases valid missing total n percent n percent n percent gender * annual income 50 100.0% 0 .0% 50 100.0% gender * occupation 50 100.0% 0 .0% 50 100.0% gender * education 50 100.0% 0 .0% 50 100.0% gender * annual income cross tabulation count annual income total below tk. 100000 tk. 100000-tk. 300000 tk. 300001-tk. 500000 tk. 500001-tk. 700000 above tk. 700000 gender male 7 12 4 8 2 33 female 5 5 3 3 1 17 total 12 17 7 11 3 50 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 332 gender * occupation cross tabulation count occupation total service in public sector service in private sector self employed (business) gender male 6 10 17 33 female 3 6 8 17 total 9 16 25 50 gender * education cross tabulation count education total post graduate under graduate diploma others gender male 9 8 10 6 33 female 8 2 3 4 17 total 17 10 13 10 50 case processing summary cases valid missing total n percent n percent n percent age * annual income 50 100.0% 0 .0% 50 100.0% age * occupation 50 100.0% 0 .0% 50 100.0% age * education 50 100.0% 0 .0% 50 100.0% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 333 age * annual income cross tabulation count annual income total below tk. 100000 tk. 100000-tk. 300000 tk. 300001-tk. 500000 tk. 500001-tk. 700000 above tk. 700000 age below 30 9 4 0 0 0 13 30-40 0 3 2 3 0 8 41-50 2 4 3 2 1 12 51-60 0 6 2 4 2 14 above 60 1 0 0 2 0 3 total 12 17 7 11 3 50 age * occupation cross tabulation count occupation total service in public sector service in private sector self employed (business) age below 30 1 9 3 13 30-40 1 1 6 8 41-50 4 2 6 12 51-60 3 2 9 14 above 60 0 2 1 3 total 9 16 25 50 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 334 age * education cross tabulation count education total post graduate under graduate diploma others age below 30 2 5 5 1 13 30-40 5 0 1 2 8 41-50 8 2 1 1 12 51-60 1 3 5 5 14 above 60 1 0 1 1 3 total 17 10 13 10 50 11.2 reliability analysis internal consistency reliability is the accuracy or precision of a measuring instrument, which is the extent of unidimensionality, that is, the detailed items (questions) measure the same thing. the internal consistency reliability was assessed by calculating cronbach‘s a value. a commonly accepted rule of thumb for describing internal consistency using cronbach's alpha (http://en.wikipedia.org/wiki/cronbach's_alpha#cite_note-cortina-8) is as follows  α ≥ 0.9 excellent  0.7 ≤ α < 0.9 good  0.6 ≤ α < 0.7 acceptable  0.5 ≤ α < 0.6 poor  α < 0.5 unacceptable in my research, i had calculated cronbach's alpha for each variable under each sample group which has been shown under table 3‘. table 3. reliability calculation income level: case processing summary n % cases valid 50 100.0 excludeda 0 .0 total 50 100.0 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 335 case processing summary n % cases valid 50 100.0 excludeda 0 .0 total 50 100.0 a. listwise deletion based on all variables in the procedure. financing cost: case processing summary n % cases valid 50 100.0 excludeda 0 .0 total 50 100.0 transparency in real estate market: case processing summary n % cases valid 50 100.0 excludeda 0 .0 total 50 100.0 a. listwise deletion based on all variables in the procedure. reliability statistics cronbach's alpha n of items .616 3 reliability statistics cronbach's alpha n of items .609 2 reliability statistics cronbach's alpha n of items .755 5 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 336 property prices: case processing summary n % cases valid 50 100.0 excludeda 0 .0 total 50 100.0 a. listwise deletion based on all variables in the procedure. acquisition of real estate through bank loans: case processing summary n % cases valid 50 100.0 excludeda 0 .0 total 50 100.0 a. listwise deletion based on all variables in the procedure. for variable income level cronbach's alpha is .616 which indicates acceptable and good internal consistency respectively for this variable. in case of variable financing cost, this result is .609 for which also indicates acceptable and good internal consistency for this variable. for variable transparency in real estate market the result is .755 which indicates good internal consistency for this variable. the cronbach‘s alpha for the variable property pricing is .798 which reflects good internal consistency for this variable. in case of variable acquisition of real estate through bank loans, this result is .659 this indicate acceptable internal consistency for this variable. 12. limitations it was impossible for us to prepare a report without limitations. there are some limitations in this research which were • data collection was restricted within dhaka city only, which might fail to represent the factual scenario of the relationship between measured variables. • sample size was 50 which were very small to represent the proposed scenario. reliability statistics cronbach's alphaa n of items .798 4 reliability statistics cronbach's alpha n of items .659 3 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 337 • i had to face time constraints and money constrains that led to get narrower outcomes. 13. significance of study bangladesh is a small but one of the most densely populated countries in the world with quite a small and poor economy. majority of its population fall in the low income bracket and therefore basic needs fulfillment is the main concern for them. one of the five basic needs is shelter and state is supposed to ensure that. but state can’t do that due to resources scarcity and this is the point in which most experts stick on for the development of the real estate sector in bangladesh. the sector is dominated by the private investors, though the government is present in the market through some housing projects. these private investors are widely treated as profit concerns, but they are working hard to meet the rising housing demand in the country too. bank loans have an increasing role for corporate activities. in most countries, bank loans are the main source of financing for small and medium-sized enterprises. even though the role of banks decreased in the last years, banks take advantage of a privileged position which allows them to provide liquidity cheaply than other intermediaries. the activity of bank lending is often influenced by the adverse selection due to the fact that corporate clients are often reluctant, in providing the complete and real information about them. as a result the information asymmetry may have a negative impact both on banks and companies. the most important effects of the financial and economic crisis on the companies are the drastic drop in demand for goods and services and a tightening in credit terms, which are severely affecting their cash flows. also, companies face financing constraints which often amplify the effects of crisis. land scarcity and the lack of social security are the two major reasons people think lie behind the development of the real estate sector in bangladesh. there are other important factors too for example price of houses, rapid growth in population, rapid urbanization, and complexities in buying lands to build houses etc. though there are varied opinions for what the sector has been developed in bangladesh, almost all the respondents and real estate experts think that the development of the real estate sector was obvious in bangladesh mainly to meet the rising demands for houses across the country. public sector’s failure to ensure the housing for the total population enhanced the development. majority of the population is not satisfied about the current practice of the sector. they think companies are mainly profits concern and don’t care about the quality of their services. references arnold, j., javorcik, b.s., & mattoo, a. (2006). the productivity effects of services liberalization evidence from the czech republic. world bank’s research program, world bank,washington, dc, mimeo. bagchi-sen, s. (1995). fdi in us producer services: a temporal analysis of foreign directinvestment in the finance, insurance and real estate sectors. regional studies, 29(2),159-170. http://dx.doi.org/10.1080/00343409512331348873 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 338 baltagi, b.h. (2005), econometric analysis of panel data, 3rd ed., willey, chichester. bardhan, a., & kroll, c. a. (2007). globalization and the real estate industry: issues,implications, opportunities. paper prepared for the sloan industry studies annualconference, cambridge, april. basu, b., & yao, j. (2009). foreign direct investment and skill formation in china.international economic journal, 23(2), 163-179. http://dx.doi.org/10.1080/10168730902901106 brown, g.r., & matysiak, g.a. (2000), real estate investment: a capital market approach. financial times/prentice-hall, singapore. busse, m., & hefeker, c. (2007). political risk, institutions and foreign direct investment.european journal of political economy, 23(2), 397-415. http://dx.doi.org/10.1016/j.ejpoleco.2006.02.003 chen, c.h. (1996). regional determinants of foreign direct investment in mainland china.journal of economic studies, 23(2), 18-30. http://dx.doi.org/10.1108/01443589610109649 chin, w., dent, p., & roberts, c. (2006). an exploratory analysis of barriers to investment andmarket maturity in southeast asian cities. journal of real estate portfolio management, 12(1), 49-58. chuang, c.c., & wang, y.h. (2009). developed stock market reaction to political change:a panel data analysis. quality and quantity, 43(6), 941-949. http://dx.doi.org/10.1007/s11135-009-9230-2 colman, & alesina et al. (1990). repeated interactions being conducive of social capital and trust, heterogeneous societies are thus characterized by fewer contacts and, in consequence, by lower levels of cooperation and trust see the seminal work by http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) cordero, j., & paus, e. (2008). foreign investment and economic development in costa rica:the unrealized potential. working group on development and environment in the americas, discussion paper no13, april. costas, & kahn. (2003). informal social capital such as entertaining with friends and relatives http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) d’arcy, e. (2009). the evolution of institutional arrangements to support theinternationalization of real estate involvements: some evidence from europe. journal ofeuropean real estate research, 2(3), 280-293. http://dx.doi.org/10.1108/17539260911000006 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 339 dhar, & goetzmann. (2006). documented that more complete information about the long-term performance of real estate asset class can help resolve uncertainty and affect institutional investors’ demand for different types of properties http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) http://ideas.repec.org/p/wop/pennin/96-01.html jones lang lasalle. (2008). it has been argued that more transparent real estate markets attract greater levels of foreign investors as they become more comfortable and better informed knack, & keefer. (1997). this creates an environment not favorable to the development of social capital http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) liao, & mei. (1999). empirically examined the relationship between institutional factors and real estate returns using data from developed and emerging market countries http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) sirmans and worzala. (2003). in their comprehensive summary, concluded that international real estate investment is highly related to available market information and real estate market transparency http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) uslaner, & brown. (2005). argue that when income inequality is high, individuals from different socioeconomic groups will have the sensation that they are not sharing the same fate, and this will hamper trust http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) uslaner, & brown. (2005). informal social capital such as entertaining with friends and relatives http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1041&context=crer (july 6, 2014) appendix appendix 1. survey question questionnaire dear respondent, the questionnaire is aimed at understanding the use of bank loans to acquire real estate property in bangladesh and the various factors that effects this acquisition process. your response will be dealt asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 340 with strict confidentiality and it will be used only for academic purpose. thank you for spending your valuable time to fill this questionnaire. 1. gender: male female 2. age: below 30 3. annual income: below tk. 100000 31-40 tk. 100000-tk. 300000 41-50 tk. 300001-tk.500000 51-60 tk. 500001-tk. 700000 above 60 above tk. 700000 4. occupation: 5. education: post graduate service in public sector under graduate service in private sector diploma self employed (business) others level of agreement regarding the following statements: please mark (√) the number which most closely responds to your thinking. please mark (√) the number which most closely responds to your thinking. income level and financing cost 1. based on your current income level did you consider a real estate investment. 1 2 3 4 5 2. do you plan to use your savings/inheritance as a source of funding for real estate investment. 1 2 3 4 5 3. did you approach any financial institutions / banks for loan purposes for real estate acquisition. 1 2 3 4 5 1= strongly disagree 2= disagree 3= neutral 4= agree 5= strongly agree asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 341 4. do you think the current financing cost of this loans provided by the financial institutions/banks are competitive. 1 2 3 4 5 5. is your income sufficient to meet the interest payments of these loans (should you consider to take one) if you think of a recent / have carried out a recent investment in real estate. 1 2 3 4 5 transparency in real estate market 6. do you consider the current real estate market of bangladesh a transparent one in terms of companies promising clients an estimating complacent timings of project. 1 2 3 4 5 7. do you consider transparency in terms of pricing of raw materials an important factor. 1 2 3 4 5 8. lack of transparency will lead to problems in relation to loan interest payment. 1 2 3 4 5 9. does this transparency create an impact on your disposable income level if you have already used financing for real estate investment. 1 2 3 4 5 10. do you think this transparency will impact your decision to invest in real estate in using financing options in future given your current income level. 1 2 3 4 5 property prices 11. do you think property price changes in bangladesh follows a fixed trend. 1 2 3 4 5 12. do you think financial institutions/banks in bangladesh should provide a fixed interest rate irrespective of property price fluctuation. 1 2 3 4 5 13. do you think property prices in bangladesh is investment friendly given your current income level. 1 2 3 4 5 14. do you think property prices in bangladesh is investment friendly given the average interest rate on average amount of loan taken by an average investors. 1 2 3 4 5 acquisition of real estate through bank loans asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 342 15. do you think that acquisition of real estate through bank loan is a common trend in bangladesh. 1 2 3 4 5 16. do you think banks in bangladesh are promoting their investment loan products in an appreciable manner to prospective investors. 1 2 3 4 5 17. do you think banks are providing a good loan protection/insurance for investors using financing for real estate investment. 1 2 3 4 5 microsoft word onb warrants ajfa-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 343 valuing the first negotiated repurchase of the tarp warrants dr. linus wilson associate professor of finance, university of louisiana at lafayette b. i. moody iii college of business, 214 hebrard boulevard, moody hall 253 p. o. box 44570, lafayette, la 70504-4570 tel: (337) 482-6209 e-mail: linuswilson@louisiana.edu website: http://www.linuswilson.com received: august 21, 2013 accepted: oct. 29, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.4160 url: http://dx.doi.org/10.5296/ajfa.v6i2.4160 abstract on may 11, 2009, old national bancorp was the first publicly traded bank to buy back its capital purchase program warrants. it paid $1.2 million, which is below the low-end of this note’s estimates of the fair market value of the warrants. this note estimates the warrants are worth between $1.5 and $6.9 million. this low negotiated price, from the perspective of taxpayers, indicates that the u.s. treasury would probably get a better price marketing the cpp warrants to third party investors. keywords: bailout, banks, banking, capital purchase program, emergency economic stabilization act, options, tarp, valuation, warrants journal of economic literature codes: g01, g13, g21, g28, g32, g38 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 344 1. introduction the emergency economic stabilization act of 2008 created the $700 billion dollar troubled asset relief program (tarp). that legislation mandated the purchase of warrants in banks which sold assets to the u.s. treasury. on october 13, 2009, u.s. treasury secretary henry paulson announced the capital purchase program (cpp) to buy warrants and preferred stock in healthy banks. the cpp preferred stock pays dividends at 5 percent per annum for the first five years and 9 percent per annum thereafter.1 by march 31, 2009, over 500 financial institutions received funds totaling nearly $200 billion dollars, according to sigtarp (2009, p. 47). closely held centra bank was the first bank to repurchase the tarp warrants. nevertheless, because centra was a privately held bank, its purchase agreement, which the bank management signed, specified that the cost of buying back the warrants would be five percent of the face value of the preferred stock investment.2 for publicly held banks, section 4.9 of the securities purchase agreement gives banks the right to repurchase the warrants at “fair market value.”3 old national bancorp (onb) was the first publicly held bank to negotiate its repurchase of the cpp warrants on may 11, 2009. old national bancorp, which is traded on the new york stock exchange under the ticker of onb, received $100 million dollars from the capital purchase program on december 12, 2008. the company had $7.9 billion in assets as of its last 10-k filing. onb was founded in evansville, indiana, in 1834. it is one of the top 100 bank holding companies in the united states in terms of assets. nevertheless, it considers itself a community bank with operations in indiana, illinois, and kentucky. with the approval of the office of the comptroller of the currency and the federal reserve, onb repurchased the preferred stock at par plus accrued dividends on march 31, 2009. on may 11, 2009, it became the first publicly traded bank to repurchase its cpp warrants, paying $1.2 million for its 813,008 cpp warrants.4 thus, it is the first example of the u.s. treasury’s ability to obtain the fair market value of the cpp warrants. this is the first paper to value the onb warrants just prior to the $1.2 million deal struck with the u.s. treasury. this paper finds that the management of onb struck a good deal for its shareholders. unfortunately for taxpayers, the deal struck is at below the author’s range of estimates for the fair market value of the onb warrants. this paper uses the methodology proposed in wilson (2009) to value the cpp warrants of onb. this paper finds that the onb warrants are worth between $1.5 million and $6.9 million. these estimates are sensitive to assumptions as to whether or not onb would have completed a qualified equity offering 1 mark landler and eric dash, october 15, 2008, “drama behind a $250 billion banking deal,” new york times, accessed online december 23, 2008 at http://www.nytimes.com/2008/10/15/business/economy/15bailout.html?. 2 damian paletta and deborah solomon, april 22, 2009, “financial firms lobby to cut cost of tarp exit,” accessed online on april 27, 2009 at http://online.wsj.com/article/sb124035639380840961.html. 3 there is a flawed design in the appraisal process outlined in the securities purchase agreement’s section 4.9. it has a split the difference resolution procedure that encourages the government, if it chooses to act in taxpayers’ interest, to hire appraisers with optimistically high valuations of the warrants. on the other hand, it encourages banks to hire appraisal firms with extremely low valuations of the warrants. this flawed resolution procedure makes the appraisal process less informative than a well designed mechanism could have produced. 4 press release, may 11, 2009, “old national bancorp repurchases warrant from u.s. treasury,” accessed online on may 11, 2009 at http://www.snl.com/irweblinkx/file.aspx?iid=100391&fid=7780588 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 345 (qeo) on or before december 31, 2009.5 they also depend on estimates of the dividend yield and the volatility of onb’s stock price over the next 9.6 years. 2. data and inputs the valuation was conducted based on the closing share price and the last option trade on may 8, 2009. friday, may 8, 2009, was the last trading day before the agreement was announced by onb on monday, may 11, 2009, in an 8-k filing, and a press release on its website. with the exception of the option price data on may 8, 2009, which was taken from www.prophet.net, all data was obtained from yahoo! finance. dividend yield was estimated by finding the average dividend yield from january 1, 2002, to may 8, 2009. the dividend paid was divided by the ex dividend day’s closing stock price. this dividend yield was compounded so that the yield was annualized. then the annualized yield was converted into a continuously compounding yield so that it would be compatible with the continuous time models of merton (1973) and black and scholes (1973). over this period the continuously compounding yield was 3.93 percent. this was used as the middle estimate for dividend yield. the high estimate of dividend yield was 1.5 times the average continuously compounded dividend yield, or 5.89 percent. the lowest estimate of dividend yield was the dividend yield based on the announced forward dividend of $0.07 per share divided by the closing share price of $14.70 on may 8, 2009. onb recently cut its dividend from $0.23 per share to $0.07 cents pre share. since dividends reduce the value of call options and warrants, the low-end valuation used the highest dividend yield, and the high-end valuation used the lowest dividend yield. the middle estimate of volatility is based on the black and scholes (1973) implied volatility of the closing price of the $17.50 call option that expires on june 19, 2009. two hundred and fifty contracts were traded on may 8, 2009. the closing call option price was $0.35, and the closing stock price was $14.70. the implied volatility was estimated at 59.72 percent. the three month t-bill rate of 0.15 percent was used as the risk-free rate in the implied volatility calculation. the low and high estimates of volatility were obtained by using the procedure of hull (2003, pp. 238-241) after adjusting the stock price for several stock dividends. stock dividends increase the number of shares outstanding. thus, the stock price should fall on the day of the stock dividend. the adjustment, in theory, should have reduced the historic volatility of the stock and more accurately reflects the volatility of the stock’s returns. the low-end estimate of volatility was 37.10 percent. it was derived from daily closing stock prices and quarterly dividends paid from january 1, 2002, to may 8, 2009. the standard deviation of the lower estimate is 0.61 percent. the high-end estimate was 72.89 percent. it 5 a qualified equity offering according to the cpp term sheet page 2 “’qualified equity offering’ shall mean the sale by the qfi [qualified financial institution] after the date of this investment of tier 1 qualifying perpetual preferred stock or common stock for cash.” source: u.s. treasury, “tarp capital purchase program senior preferred stock and warrant summary of senior preferred terms” at http://www.financialstability.gov/docs/cpp/termsheet.pdf asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 346 was based on daily closing stock prices and quarterly dividends from january 1, 2008, to may 8, 2009. the standard deviation of this volatility estimate is 2.80 percent. 2008 and 2009 have been unusually volatile years for the stock market.6 since warrants are more valuable when the volatility is higher, the low-end valuation uses the lowest volatility number, and the high-end valuation uses the highest valuation estimate. thus, 37.10, 59.72, and 72.89 percent were used as the volatility estimates in the low, middle, and high warrant valuations, respectively. the cpp warrants have an unusual provision that cancels half of the warrants if the institution issues preferred or common stock in the amount of the cpp investment prior to january 1, 2010, but no earlier than the date that the cpp funds were disbursed to the bank. thus, the expected number of warrants has been reduced by the probability that onb would have sold preferred or common stock in the amount of $100 million by december 31, 2009. the author subjectively put a fifty percent probability of such an issuance in the low-end valuation, a thirty percent probability of such an issue in the middle valuation, and a ten percent chance of such an issue in the high-end valuation. this translated into the expected number of warrants outstanding by the end of 2009 at 609,756, 691,057, and 772,358 in the low, middle, and high valuation scenarios. despite the fact the u.s. treasury owned 813,008 warrants, the expected number of warrants is less than that because of the warrant reduction provisions in the cpp term sheet. after looking through onb’s recent press releases and 8-k filings, the author was not able to find any evidence that onb had initiated any preferred or common stock offerings since receiving the cpp funds. therefore, it seems unlikely that it would have completed a qualified equity offering prior to the start of 2010. the author nevertheless cautions the reader that his estimates about warrant cancellation probabilities are highly subjective. table 1 provides many of the inputs used in the valuation in tables 2, 3, and 4. these are the number of shares outstanding, the number of warrants, the closing stock prices and the strike price of the warrants. all the valuations used a continuously compounding, risk-free rate of 3.19, percent which was based on the ten year treasury note rate reported for may 8, 2009, on yahoo! finance. 3. models and results the most preferred model adjusts for dividends and the dilution associated with warrant exercise. when warrants are exercised, the number of shares increase. on may 8, 2009, the number of shares outstanding was 66.41 million. thus, if all warrants were exercised, then the number of shares would increase by 0.81 million. galai and schneller (1978) adjust for the capital raised from warrant exercise, because the exercise price is collected by the firm. that model also adjusts for the dilution associated with the extra stock circulating. on balance, warrant exercise puts downward pressure on the stock price. galai and schneller (1978)’s methods were used to adjust the estimates generated from the option pricing model of merton (1973). merton (1973) shows how to estimate option prices for stocks which pay 6 brad hessel, april 24, 2009, “the volatility is off the charts!” the motley fool, accessed online on april 29, 2009 at http://www.fool.com/investing/general/2009/04/24/this-volatility-is-off-the-charts.aspx. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 347 continuous dividends. merton (1973) is a good estimate for a long lived call option such as warrant with almost ten years to expiration. the warrant values were solved numerically and are summarized in table 2. the per-warrant valuation is the lowest in table 2 because the dilution and dividend adjustments reduce the warrants’ value. the per-warrant values are $2.50, $5.93, and $8.88 in table 2 in the low, middle, and high scenarios, respectively. in table 3, only the model of merton (1973) is used. the warrants are adjusted downwards for dividends, but no adjustments are made for dilution. the per-warrant values in table 3 are $2.52, $3.63, $8.91. if we compare the results in table 2 and table 3, dilution only cost a few cents per-warrant. in table 4, the black and scholes (1973) model is used. it does not adjust for either dilution or dividends. thus, table 4 generates the highest values per-warrant. the per-warrant values are $6.72, $9.69, and $11.05 in the low-end, medium, and high-end valuations. this is significantly higher than the other two tables. black and scholes (1973) significantly overstates the values of the cpp warrants because that model does not adjust for dividends. since financial stocks are heavy dividend payers, any realistic valuation of their warrants must adjust for dividends. 4. conclusion this paper has valued the old national bancorp (onb) warrants which were issued as part of this bank’s brief participation in the capital purchase program (cpp). in the author’s most preferred model, the middle estimate was that the cpp onb warrants were worth $3.61 million. this is significantly higher than the $1.2 million price that the u.s. treasury sold them back to onb. the low-end and high-end estimates of the warrants value in the preferred model of galai and schneller (1978) and merton (1973), which provides the lowest estimates of the warrants’ value, in table 2 are $1.5 million and $6.9 million, respectively. therefore, the first negotiated repurchase of the cpp warrants should worry taxpayers. the u.s. treasury negotiated a price below what could be considered fair market value. u.s. taxpayers do not appear to be receiving fair market value for the risky securities that they purchased. policy makers should be troubled because wilson (2009) estimates that the cpp warrants could be worth between $5 billion and $24 billion based on may 1, 2009, closing prices. it could mean billions of dollars in lost revenue if the u.s. treasury continually negotiates deals at the low-end of or below fair market value. further, if the u.s. treasury agrees to sell the cpp warrants below fair market value, then the estimates of the subsidies involved in the cpp investments by the congressional budget office (2009) and the congressional oversight panel (2009) may be significantly underestimated. in other words, the estimated paper losses in congressional budget office (2009) and the congressional oversight panel (2009) reports may turn out to be much larger when they are locked in by poor negotiations by the u.s. treasury. many readers will not be surprised by this result. u.s. treasury officials’ incentives are not as well aligned with the interests of taxpayers as bank managers’ incentives are aligned with the interests of their shareholders. for this reason, we should probably continue to expect the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 348 u.s. treasury to negotiate a price that is below or on the low-end of the fair market value of the cpp warrants. without a major change in the structure of compensation in the federal bureaucracy, which seems nearly impossible, the best hope for taxpayers is to sell the warrants to third party investors. third party investors competing against each other will get the best price for the u.s. taxpayer. the u.s. treasury is comfortable marketing the u.s. national debt to investors all over the world. whenever possible, it should seriously consider doing the same with the cpp warrants even if this means hiring an independent brokerage firm, asset manager, or investment bank to market these securities. references black, f., & scholes, m. (1973). the pricing of options and corporate liabilities. journal of political economy, 81, 637–654. http://dx.doi.org/10.1086/260062 congressional budget office. (2009). the troubled asset relief program: report on transactions through december 31, 2008. accessed online on may 6, 2009 at http://www.subsidyscope.com/projects/bailout/documents/15/. congressional oversight panel. (2009). february 6, 2009, february oversight report: valuing treasury’s acquisitions. accessed online on may 5, 2009, at http://cop.senate.gov/reports/library/report-020609-cop.cfm. galai, d., & schneller, m. i. (1978). pricing of warrants and the valuation of the firm. journal of finance, 33, 1333-1342. http://dx.doi.org/10.1111/j.1540-6261.1978.tb03423.x hull, j. (2003). options, futures and other derivatives. 5th ed. pearson hall: upper saddle river, new jersey. sigtarp. (2009). office of the special inspector general for the troubled asset relief program, quarterly report to congress: april 21, 2009. accessed online on may 5, 2009, at http://www.sigtarp.gov/reports/congress/2009/april2009_quarterly_report_to_congress.pd. wilson, l. (2009). the goldman sachs warrants. review of business, 30, 4-32. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 349 table 1. summary statistics for old national bank corp on may 8, 2009 shares oustanding (millions) 66.41 cpp strike price $18.45 new shares after exercise (millions) 0.81 closing share price $14.70 total shares with 100 percent warrant exercise (millions) 67.22 maket cap (millions) $976.23 shares outstanding, the closing share price, and market capitalization data was obtained from yahoo! finance after the close of trading on may 8, 2009. the cpp new shares after exercise and cpp strike price are taken from sigtarp (2009, p. 219). table 2. valuation of old national warrants on may 8, 2009, adjusting for dividends with merton (1973) and dilution with galai and schneller (1978) low middle high volatility 37.10% 59.72% 72.89% dividend yield 5.89% 3.93% 1.90% probability that half warrants will be cancelled 50% 30% 10% expected number of warrants 609,756 691,057 772,358 per warrant value ($) $2.50 $5.93 $8.88 total value of warrants ($ millions) $1.52 $4.09 $6.86 the low-end volatility is the annualized historic volatility. this is obtained from calculating the daily instantaneous returns from january 1, 2009, to may 8, 2009, using the procedure outlined in hull (2003, pp. 238-241) and wilson (2009). the high-end volatility is also based on historic volatility of the stock from january 1, 2008, to may 8, 2009. the middle volatility estimate is based on the implied volatility of the $17.50 june 2009 call options traded on may 8, 2009. the middle estimate of dividend yield is based on the average dividend yield from january 1, 2002, to may 8, 2009, adjusted for continuous compounding. the low-end estimate’s dividend yield is 1.5 times the middle estimate. the high-end valuation’s dividend yield it the forward dividend yield based on the announced dividend of $.07 per share and the may 8, 2009, closing stock price of $14.70 adjusted to be an annualized continuously compounding rate. the historic option price data was obtained on www.prophet.net. the stock price data was taken from yahoo! finance. the probability that half the warrants will be cancelled is the subjective probability given by the author of the likelihood of a qualified equity offering being completed by december 31, 2009. completion of a qualified equity offering would allow the bank to cancel half the warrants. the per-warrant value is calculated with the inputs in this table and the stock price and strike price in table 1 using the merton (1973) model with the dilution adjustments proposed by galai and schneller (1978). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 350 table 3. valuation of old national warrants on may 8, 2009, adjusting for dividends with merton (1973) low middle high volatility 37.10% 59.72% 72.89% dividend yield 5.89% 3.93% 1.90% probability that half warrants will be cancelled 50% 30% 10% expected number of warrants 609,756 691,057 772,358 per warrant value ($) $2.52 $5.96 $8.91 total value of warrants ($ millions) $1.54 $4.12 $6.88 the low-end volatility is the annualized historic volatility. this is obtained from calculating the daily instantaneous returns from january 1, 2009, to may 8, 2009, using the procedure outlined in hull (2003, pp. 238-241) and wilson (2009). the high-end volatility is also based on historic volatility of the stock from january 1, 2008, to may 8, 2009. the middle volatility estimate is based on the implied volatility of the $17.50 june 2009 call options traded on may 8, 2009. the middle estimate of dividend yield is based on the average dividend yield from january 1, 2002, to may 8, 2009, adjusted for continuous compounding. the low-end estimate’s dividend yield is 1.5 times the middle estimate. the high-end valuation’s dividend yield it the forward dividend yield based on the announced dividend of $.07 per share and the may 8, 2009, closing stock price of $14.70 adjusted to be an annualized continuously compounding rate. this option price data was obtained on www.prophet.net. the stock price data was taken from yahoo! finance. the probability that half the warrants will be cancelled is the subjective probability given by the author of the likelihood of a qualified equity offering being completed by december 31, 2009. completion of a qualified equity offering would allow the bank to cancel half the warrants. the per-warrant value is calculated with the inputs in this table and the stock price and strike price in table 1 using the merton (1973) model with no dilution adjustments. table 4. valuation of old national warrants on may 8, 2009, using black scholes (1973) low middle high volatility 37.10% 59.72% 72.89% probability that half warrants will be cancelled 50% 30% 10% expected number of warrants 609,756 691,057 772,358 per warrant value ($) $6.72 $9.69 $11.05 total value of warrants ($ millions) $4.10 $6.70 $8.53 the low-end volatility is the annualized historic volatility. this is obtained from calculating the daily instantaneous returns from january 1, 2009, to may 8, 2009, using the procedure outlined in hull (2003, pp. 238-241) and wilson (2009). the high-end volatility is also based on historic volatility of the stock from january 1, 2008 to may 8, 2009. the middle volatility estimate is based on the implied volatility of the $17.50 june 2009 call options traded on may 8, 2009. the option price data was obtained on www.prophet.net. the stock price data was taken from yahoo! finance. the probability that half the warrants will be cancelled is the subjective probability given by the author of the likelihood of a qualified equity offering being completed by december 31, 2009. completion of a qualified equity offering would allow the bank to cancel half the warrants. the per-warrant value is calculated with the inputs in this table and the stock price and strike price in table 1 using the black and scholes (1973) model with no adjustments for either dilution or dividends. microsoft word 6358-22817-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 351 corporate social responsibility and financial performance: a case study of jamuna bank limited, bangladesh mohammad mazibar rahman (corresponding author) department of accounting hajee mohammad danesh science and technology university dinajpur-5200, bangladesh e-mail: mazibar.act.hstu@gmail.com md. mamunar rashid associate professor, department of accounting hajee mohammad danesh science and technology university dinajpur-5200, bangladesh e-mail: raselhstu@yahoo.com md. reiazul haque assistant professor, department of accounting hajee mohammad danesh science and technology university dinajpur-5200, bangladesh e-mail: mrhaque01@gmail.com received: sep. 26, 2014 accepted: nov. 4, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6358 url: http://dx.doi.org/10.5296/ajfa.v6i2.6358 abstract banking is a business which runs on the confidence and the trust of people that enables the bank to mobilize funds from various sources. the profitability of a bank always depends on asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 352 the efficient management of fund and exploring the genuine avenues in which its resources are invested to produce the maximum income. the purpose of the study is to discover the impact of corporate social responsibility (csr) expenditure on the profitability of jamuna bank ltd (jbl) which indicates the fundamental picture of the overall banking industry of bangladesh. jbl is one of the non-government commercial banks in bangladesh, for this study purpose csr expenditure is taken as the independent variable and profit after tax (pat) as the dependent variable. required data are collected from the annual reports of jbl and bangladesh bank csr review for the year 2007 to 2012 and analyzed using ordinary least squares (ols) model and tested the hypothesis through the student’s t test. the results show that there is no significant impact of csr on pat and therefore recommends the bank to critically evaluate its existing policy on performing csr activities to increase profitability. for academic and industry discourse it is suggested that further study should be conducted to establish the real value, in monetary terms, how much csr contribute to the organization’s profitability. keywords: csr, bangladesh bank, jbl, profitability, profit after tax asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 353 1. introduction since the 1950s, csr (bowen, 1953) along with the related notions of corporate social responsiveness, corporate social responses (strand, 1983), and corporate social performance (carroll, 1979; wood, 1991), have been the subject of many conceptualizations originating mainly from the management literature. in bangladesh, the banking sector has a glorious history of getting engaged themselves in different kinds of social activities which is formally known as csr like donations to different educational and social organizations, country beautification, patronizing cultural activities, health etc. but in some recent years there is tremendous growth in this involvement, because in the 2008 bangladesh bank guideline suggested the banks to involve in these activities in a more structured way. all banks have embraced csr in 2013 with a decision at the highest corporate level have formed separate foundations or trusts as non-profitable institutions solely devoted to the cause of charity, social welfare and other benevolent activities towards the promotion of csr objectives. the majority of banks in bangladesh has committed to specified percentages of their pretax profit/net profit each year towards csr activities. corporate social responsibility (csr) is gaining fast global acceptance as a standard to assume environmentally sustainable and socially equitable business practices. csr then is not only a topic for business, but equally a subject for government and civil society or the ngo sector. driving forces behind this evolution is pressure from various stakeholders (importers, environmentalists) while slow progress is attributed to lack of good governance, absence of strong labor unions, consumer forums and above all lack of understanding by business houses, specifically non-exporting ones, that csr is not charity but is rather an instrumental pr investment. the role of business world-wide and specifically in the developed economies has evolved from classical 'profit maximizing' approach to a 'social responsibly' approach, where businesses are not only responsible to its stockholders but also to all of its stakeholders in a broader inclusive sense. as a member of the global economy, bangladesh is also aware of the need to take positive initiatives to establish an image of environmentally and socially responsible businesses. however, these efforts were hardly recognized and labeled as csr activities since most of the financial institutions have not integrated csr in their routine operation; rather these were in the form of occasional charity or promotional activities. bangladesh bank will monitor csr adoption and csr performance of banks and financial institutions, as an additional dimension of their management performance. the banking community has responded sensibly to the call for csr and sustainable social development. this paper in basically focused on the csr activities of the jbl and how it is related to profitability and to what extent banks are eager to involve in these sorts of csr activities. banks are profit based organizations, so in this perspective they surely want to spend money in those sectors which will directly or indirectly bring money for them, so obviously there are some positive relationships between csr and bank’s profitability. the rest of the paper is structured as follows. we first present a basic framework to capture the notion of csr as a tool in maximizing profits. in section 2, we explain the literature review and data sources we use. section 3 highlights research objectives and section 4 explores the research methodology and model development. finally, in section 5 and 6, we address analysis, hypothesis testing and conclusion of csr choices. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 354 2. literature review and conceptual framework the general signaling role of csr was also studied by goyal (2006). that study however is considerably different from the relative authors as it did not consider the brand-value of firms. rather, goyal (2006) investigated the signaling role of the csr when firms considering fdi (foreign direct investment) are interested in favorable terms. some progressive companies in bangladesh voluntarily provide some information with regard to social and environmental matters (chowdhury and chowdhury, 1996). csr is one of the corporation’s responsibilities to its stakeholder and also a voluntary contribution by a corporation to sustainable development (crane and matten, 2007). in addition, the view of csr as an obligation fails to provide normative criteria to evaluate the extent to which actual business practices can or cannot be considered as socially responsible (jones, 1995). in particular, as stated by clarkson (1995), society is at "a level of analysis that is both more inclusive, more ambiguous and further the ladder of abstraction than a corporation itself". clarkson (1995) argued that businesses are not responsible to society as a whole but only toward those who directly or indirectly affect or are affected by the firm's activities. this first perspective was launched by bowen (1953), who defined csr as the obligation "to pursue those policies, to make those decisions, or to follow those lines of action which are desirable in terms of the objectives and values of our society". the view of csr as a social obligation has been advocated in later conceptualizations (carroll, 1979) and contemporary marketing studies (brown and dacin, 1997; sen and bhattacharya, 2001). as emphasized by carroll (1979), different types of social obligations can be distinguished: (a) economic obligations (be productive and economically viable), (b) legal and ethical obligations (follow the law and acknowledged values and norms), and (c) philanthropic obligations (proactively give back to society). the companies have to satisfy the divergent number of stakeholders, the credible relationship is created through csr reporting. it improves communication with the community and other stakeholders and results in competitive advantage (anand, 2002). imam (2000) has conducted a survey of csr practices in bangladesh which shows that the csr disclosure level is not adequate. the current voluntary system of social reporting has failed to achieve either the goal of organizational transparency or stakeholder engagement. instead, a fair assessment is that corporations have been able to co-opt a process designed for stakeholder accountability and turn it into a process of stakeholder management (owen et al., 2000). a growing consensus is that firms are only disclosing social and environmental information when they are faced with some type of crisis that threatens their legitimacy (deegan, 2002). khan and hossain (2003) made a short study on the environmental reporting practices in the annual reports of manufacturing companies of bangladesh. hossain et al. (2004) identified the nature of the voluntary disclosure on human resource in the annual reports in bangladesh though it is not mandatory from a regulatory authority. moir (2001) believes that the csr's big impact in business may depend on two different causes. the first reason is associated with a kind of necessary ethics and morality. as companies have the resources, it is their role to solve social problems. holmes (1976) examined this role and came to the following conclusion: "in addition to making profits, business should help to solve social problems whether or not business helps to create those problems even if there is probably no short-run or long-run profit potential" (holmes, 1976). the second reason for asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 355 csr's impact is that companies have a vested interest to apply csr. they have discovered that csr can be used to strengthen their position in the market. by working with csr, companies are getting a better reputation and achieving greater loyalty among employees (moir, 2001). martin (2002) believes that companies today face increasing demands to implement csr from consumers or market forces, partly due to globalization and increasing demands for corporate responsibility. smith (2003) also argues that various corporate scandals such as enron and worldcom have further damaged public confidence in the economy. a further reason for the requirement of csr has increased is the growing realization among the public that government sometimes fails to resolve social problems. in the light of globalization and mistrust of large companies, there is increasing pressure on executives and their companies to deliver wider social values (martin, 2002). globalization has also meant that large companies have spread their operations to countries with lower living standards than in western countries, places where there is no democracy and developed laws. in these countries, companies have an opportunity to compensate for the lack of laws by working with csr (smith, 2005). the relationship between csr and financial performance has produced mixed results with some studies concluding for a positive others negative and even others for the existence of such a relationship (mcwilliams and siegel, 2006; margoslis, elfenbein and walsh, 2007). the empirical studies conducted in developed markets on the relationship between csr and financial performance is essentially of two distinct categories (margolis and walsh, 2007). most of the prior studies found a positive relationship between csr and financial performance (simpson and kohers, 2002; graves and waddock, 1994; mcguire et al., 1988). moskowitz (1972) found a positive relationship between socially responsible business practices and corporate equity returns. policies, strategies and programmes that are associated with social activities can be used to indicate the level of csr‘s commitment of an organization. organizations too, need to meet the customer‘s demand and expectations. as to maintain good relationship and attract more customers, enterprises are taking initiatives to fulfill the demand of providing such information. employees who feel protected and appreciated will increase their productivity in production and thus, will achieve economies of scale. 3. research objectives the general objective of this study is to examine the effect of csr expenditure on jbl’s profitability. but specifically, the study also sought to achieve the following objectives: i. to find out how jbl carries its csr. ii. to investigate whether csr guarantees the strong profitability linkage. 4. methodology and model development secondary data were the chief source of information for the study. the study used the annual reports of jbl. data used include csr expenditure and pat for the period of 2007-2012. an extensive literature reviewed to understand the concept of csr and the relationship between csr and financial performance of banking business. data relating to cost/investment/expenditure for the bank on csr and pat were used to construct an ols asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 356 model of regression to which was analyzed to assess the impact as well as test the hypothesis of the study; if there is a relationship and the extent of the relationship, if any, between the independent variable (csr expenditure) and the dependent variable (pat). pearson product moment correlation coefficient (r) was used to determine the nature of relationship, coefficient of determination (r2) and adjusted r2 to conclude on the power of independent variables in explaining the variations of dependent variable. the formulated hypothesis was experienced by using the student’s t test at the 5% level of significance. 4.1 model development p t = α 0 + β 1 csr t + ἐ this study also attempted to use the pearson correlation analysis method; this is consistently in line with previous studies to understand the csr and profitability link and its relational degree and direction. 4.2 csr and pat table 1 represented the total amount of csr which jbl spent through the year of 2007 to 2012. it shows that the increasing value of csr in every year also increases the profit of the company. table 1. csr and profitability of jbl for year 2007 to 2012 sl no. year *csr (tk.) *pat (tk.) 1 2007 142,17,894 891,10,000 2 2008 14,51,338 4764,30,000 3 2009 45,76,813 9231,23,207 4 2010 170,00,000 10663,69,649 5 2011 552,00,000 13301,93,325 6 2012 290,20,000 10453,96,736 *source: bangladesh bank csr review and jbl annual report 2007-2012. 5. discussion and analysis 5.1 statement of hypothesis h 0 : there is no significant effect of csr expenditure on jbl’s profitability. h 1 : there is a significant effect of csr expenditure on jbl’s profitability. 5.2 correlation coefficient pearson product moment correlation is denoted by r. r which stands for the co-efficient of correlation is defined below as: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 357 table 2. mean value calculation of csr and pat year csr (x)/ (tk. millions) pat (y) / (tk. millions) ( − ) ( − ) ( − )( − ) 2007 14.217894 89.110000 -6.026447 -732.660486 4415.33946452624 2008 1.451338 476.430000 -18.793003 -345.3404862 14548.17939 2009 4.576813 923.123207 -15.667528 101.352721 -1587.946574 2010 17.000000 1066.369649 -3.244341 244.599163 -793.5630509 2011 55.200000 1330.193325 34.955659 508.422839 17772.25547 2012 29.020000 1045.396736 8.7756591 223.6262498 8452.883842 mean 20.244341 821.7704862 total = 28258.5379 the co-efficient of correlation is independent of the scale used if we divide the term ∑( − )( − ) by the sample standard deviation. it is also made independent of the sample size, and bounded by the values +1.00 and -1.00 if we divide by (n-1). correlation coefficient r = .( )( . )( . ) = 0.6300 coefficient of determination, r2 = 0.3969 adjusted r2 = 0.2375 the calculated value of r suggests that there is a direct relationship between csr and profitability for the jbl. however, the r2 value points that the association is not so strong. csr can only explain 23.75% of the variation in profitability. 5.3 t test for the coefficient of correlation: at the 0.05 level of significance, the decision rule state that if the computed t falls in the area between + 2.776 and -2.776 the null hypothesis can not be rejected. t = . √√ ( . ) = .. = 1.6226 p = 0.18 the computed t value is 1.6226 which falls within the critical limit. additionally, the calculated p value is higher than the predetermined level of significance. thus at the 5% level of significance, the null hypothesis that there is no significant effect of csr expenditure on jbl’s profitability can’t be rejected. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 358 5.4 liner regression analysis: p t = α 0 + β 1 csr t + ἐ where, β 1 = r ( ) β 1 = 0.6300 ( .. ) = 14.531 α 0 = 821.7705 (14.531*20.2444) = 527.599 the value of calculating r indicates that the csr and financial performance of jbl have a positive direct relationship. thus, the regression equation is p t = 527.599 + 14.531 csr t. so if jbl spent 14.218 million csr in 2007, then expected pat would be 734.209 million. the α 0 value of 527.599 is the point where the equation crosses the pat value. a literal translation is that if there was no csr made by jbl then the amount of pat estimated 527.599. 6. conclusion nowadays, the concept of csr has become more and more common in business practices and customers who expect companies to be socially responsible although the initiative may not work for all types of organization. hence designing csr scheme requires careful planning and implementation mechanism by the high level management. consequently, the study is undertaken to get an idea about the csr activities performed by jbl and its impact on profitability. taking into account the results, the study shows that there is no significant effect of csr on profitability for jbl throughout the years 2007 to 2012. as a consequence, the bank is suggested that it should be careful in designing activities concerning csr. future research in this area could proceed in a number of directions. firstly, more extensive studies are needed to explore the causal mechanisms linking csr to profitability and to determine whether or not those relationships hold consistently over time. secondly, it is also important to position the timing in the relationship, since it would be valuable to investigate and to ascertain how long it takes for the impact of csr on financial performance to be revealed. finally, the reliability of the csr data should be determined, as the sources have significant differences regarding how to evaluate the csr performance of a firm. acknowledgement this study is based on a part of my mba 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(1 16 (4), 691 formula rrelation c rson‘s produ dependent v ean of indep pendent var ean depend efficient of est for the c ner regress 1991). corp 1-718. http:/ coefficient uct momen variable (co pendent var riable (prof dent variable f determina coefficient o t = √ sion porate socia //dx.doi.org r = nt correlation orporate soc riable (corp fitability) e (profitabil ation: of correlat √√ w p t = 361 al performa g/10.5465/a = ∑( )(( ) n. cial respons porate socia lity) tion with n-2 de α 0 + β 1 csr asian ance revisi amr.1991.4 ) sibility) al responsib gree of free r t + ἐ n journal of f ited. academ 4279616 bility) edom. finance & ac issn 19 2014, vol. www.macrothi my of mana ccounting 946-052x 6, no. 2 ink.org/ajfa agement microsoft word 5910-21227-2-sm _2_-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 53 relationship between firm age and financial leverage with dividend policy mohammad tamimi accounting department, dezful branch, islamic azad university, dezful, iran e-mail: tamimi.mohammad@gmail.com nasrollah takhtaei accounting department, dezful branch, islamic azad university, dezful, iran e-mail: nasrollah_takhtaei@yahoo.com fatemeh malchi (correspondence author) department of accounting, payame noor university, i.r of iran e-mail: fatemeh.malchi@gmail.com received: july 2, 2014 accepted: july 30, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5910 url: http://dx.doi.org/10.5296/ajfa.v6i2.5910 abstract in this study, the effect of the financial leverage the age of the company on the policies of the profit distribution of the company has been investigated. in this case, two hypotheses have been developed. in the first hypothesis, the effects of the age of the company and also in second hypothesis the effects of the financial leverage on the policies of profit distribution of the company have been investigated. sample firms are the manufacturing companies accepted in tehran stock exchange (tse) over the period from 2005 to 2011. in order to determine the sample firms, systematic sampling has been used and finally 92 companies have been selected. to investigate the linear or non-linear relationship between company age and dividends, the square and the cube of the company age in empirical model of the research have been used. the results indicate a positive and significant relationship between company age and dividend ratio, but a negative and significant association between financial leverage and dividend. keywords: profit, dividend policies, financial leverage, company age asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 54 1. introduction the primary aim of financial accounting is presenting the useful information for the investors to predict the function of economic unit. the necessity to report the profit as an initial source for the investors deciding was usable well and the profit report in different ways such as presenting a basis for calculating tax, a criterion to evaluate the success of the function of the company, the level of the dividends, management of the profit distribution, management of an economic unit etc. helps the economics of the society. in addition, since the value of a company is related to the profits of the present and future, determining the profit has a significant importance (fasb, 1978). dividend policies are discussable from two very important aspects. from one viewpoint, dividend is an effective factor on the future investments of the companies; the more dividend, the less internal sources of the company in order to accomplish the investment projects and the more necessity to the financial sources out of the company, which this can affect the price of the stocks of the companies in the future. on the other hand, many of the company investors demand cash dividend. therefore, the managers (with the aim of increasing the investors property) should make an alignment in different interests of the stockholders either not to lose the profit investing opportunities, or to pay the cash profit required by the stockholders. accordingly, the decisions in distribution of profit which are taken by the managers of companies are very important and sensitive (mehrani, 2004). the stockholders need some information to determine the value of securities for deciding about buying and selling the companies' stocks. the main role of accounting is preparing the information for the users to determine the dividend politics of the companies. the investors can make better decisions about buying or selling the stocks, using the accounting information in the case of dividend policies. according to what has been mentioned above, the effect of the age of the company and financial leverage on dividend policies of the company is significant and this study has been done in this case. following this part, the literature review will be presented, then the hypotheses, methodology and the variables used in the study will be defined and finally the testing of the hypotheses and the results of the study will be presented. 2. literature review the dividend term usually refers to the cash or non-cash payments of the company income to the stockholders. the profit of the stocks may be paid as cash dividend or share dividend. cash dividend is the most usual kind of transferring the returns from companies to the stockholders. the companies do not act in the same way in distributing their cash dividend and they have different policies. these policies can be various and have a range from the payment of the minimum of the cash dividend appointed in the regulations to the payment of the whole profit of the company and even more than the annual profit as the cash profit. the leverage includes the warnings indicating the managers’ information about the investing opportunities. the theories of the investment structure express that the managers of the companies with appropriate opportunities for growth should choose a less leverage, because asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 55 if they increase their external debt, will not be able to use the advantages of their investing opportunities and therefore there will be a negative relationship between the future growth and the leverage, since the managers of the companies with high opportunity to grow will choose the low leverage. such results can be in regressions which control the growth opportunities. in economics and management, the age of the companies and institutions is divided into the steps. in the literature of these sciences, some models have been presented for the age of the companies which in the framework of these models, the companies and the institutions follow a specific policy considering every step of their economic age. these policies will be reflected in the accounting information of the companies in different ways (ghorbani, 2006). in the field of accounting, some of the researchers have paid attention to the study of the effect of the age cycle of the company on the accounting information as well (black, 1998; jenkins, kane, and velury, 2004; ahmad and javid, 2009). these researchers have expressed four steps to describe the age cycle of the company as (1) the introduction stage, (2) the growth stage, (3) the maturity stage, and (4) the decline stage. for the first time, lintner (1956) investigate the analysis of the dividend policies using both empirical and survey approaches. his study in financial literature led to introducing 15 effective variables on dividend policies such as company size, investing expenses, tendency to use external financing, share dividend, earnings persistence and ownership (lintner, 1956). wang et al. (2011) examine the dividend policies and the age cycle hypothesis in taiwanese stock exchange market. the result of their study indicated that the payment of the stocks profit in new business units with high growth ability and low profitability will lead to the more distribution of share dividend versus cash dividend. also, it indicated that in business units with low growth ability and high profitability will lead to the more distribution of cash dividend versus share dividend (wang et al., 2011). using data from a sample of 25 companies during 1999 to 2009 on the greek stock exchange, afza and mirza (2010) indicate that the dividend policies and its treatment is the most important for the investors (afza and mirza, 2010). in another study, almazan et al. (2010) also examined the effect of the financial leverage on the dividend policies in the companies of karachi. the result of their study indicated a negative and significant relationship between financial leverage and amount of divisible profit. additionally, their study showed that the changes of net income and the returns of cash dividend are effective on the dividend policies (almazan et al., 2010). the first study in the field of the age cycle of the companies in accounting area was conducted by anthony and ramesh (1992). after classifying the companies into growth, maturity and decline steps, they investigated the relationship between the function criteria such as increasing of selling and investment expenses with the price of the stock market. the purpose in their study was investigating the reaction of the market to the accounting information in different steps of the age cycle. the findings indicates that there is a significant relationship between the function criteria and the price of the stock market in different steps of the age cycle, so that the amount of the relationship of the selling growth criteria and investing expenses from introduction to decline steps has a downward movement (anthony and ramesh, 1992). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 56 stepanyan (2011) investigates the age cycle of the business unit and the type of the dividend payment. in this study three different groups of business units distributing cash including redemption of shares, cash dividend and a combination of the cash dividend and redemption of shares, are considered. redemption of shares in quick growth step is very probable and is a sign of the quality of the business unit for the investors. cash dividend payment to the stockholders increases in matured business units. the managers’ tendency also increases for expanding or preserving the size of the business units to the welfare of the stockholders. finally, using the combination of the cash dividend and redemption of shares will be in more matured business units. this study shows that the age cycle of the companies is one of the most important reasons for choosing the methods of the dividend payment (stepanyan, 2011). 2.1 hypotheses development this study aims to determine the amount of the effect of the financial leverage and the age of the company on the profit division politics which is based on afza and mirza (2010) research and according to the presented model. the special goal is to clarify whether there is a meaningful relationship between the age of the company and the financial leverage with the amount of the dividend in accepted companies in tehran stock exchange. considering what has been mentioned, the hypotheses in this study have been designed as follows and will be tested: h1: there is a significant relationship between dividend policy and company age. h2: there is a significant relationship between dividend policy and financial leverage. 3. research design this study is a kind of quasi-experimental research in the field of proving researches of accounting which will be accomplished using multivariable regression method and the econometrics patterns. the hypotheses of the study will be tested based on pooling statistical method using eviews software. considering that the iranian capital market has a large fluctuation during the research, in order to increase the reliability of the results, the research hypotheses will be tested crosssectionally. 3.1. data collection and sample selection the sample firms of this study are the companies accepted in tehran stock exchange for 7 years during the period from 2005 (2005/03/21, the beginning of fiscal year in iran) to 2011 (2012/03/20, the end of fiscal year in iran), which during this period perform as a member in securities exchange. the data is balanced using the following conditions: the samples should not be included in the sector of financial services, investing and insurance companies but manufacturing companies. the companies should be in securities exchange during the years considered in this study. their transactions shouldn’t be stopped more than three months and there should be the available data required for this study during the mentioned time and have annual year ending to the end of financial year (20xx/03/20). the considered companies should not be loss companies and also they should pay dividend at least for three years asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 57 consecutively. according to the criteria, 92 companies have been selected which their information has been collected through tehran stock exchange and tadbirpardaz database. 3.2. variables definition the variables of this research are dependent, independent and control variables which are defined as under: 3.2.1. dependent variable dividend is the payable profit to the stockholders which is acquired through dividing dividend over number of outstanding shares at annual general meeting. 3.2.2. independent variables 1. company age (age) is the number of the activity years of the company which is acquired through the difference between the current year and the year of the establishing the company (john and williams, 1985). 2. financial leverage (lev) is defined as the total debts divided by total assets of the company at the end of fiscal year. 3. additionally, control variables have been used to equalize the companies through the effective factors in this study. these variables include earnings per share and company size which according to deangelo (1981) is measured as the natural logarithm of the total assets at the end of the financial period (deangelo, 1981). the earnings per share (eps) is the part that indicate firm's periodical performance based on ownership of the shareholders. this proportion indicates the revenue of each common stock of the company and is calculated through dividing net profit by the number of the common stocks. 3.3. model specifications based on the mentioned explanations and in order to test the hypotheses, the research model is presented as follows: itititititititit sizeepslevageageagedpo εβββββββ +++++++= )()()()()()( 654 3 3 2 210 where; dpo: division payout, age: company age, lev: financial leverage, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 58 eps: earnings per share, size: company size, ɛ: error term, 4. results 4.1. descriptive statistics in order to do the current study, the collected data have been analyzed and then the results related to the descriptive statistics of the data, correlation coefficient stable, standard deviations, regression results regarding research hypothesis have been interpreted. table 1. descriptive statistics of the variables variables minimum maximum mean median std.dev dpo 0.0000 1.2354 0.3865 0.4439 0.6529 age 9.0000 54.0000 22.5438 23.4764 14.8602 age2 81.0000 2916.0000 1204.3690 1190.1600 143.9167 age3 729.0000 157464.0000 65891.7600 61439.9100 1426.5620 lev 0.3681 0.9378 0.6237 0.6139 0.6894 eps –1382.7800 7238.9300 894.2100 978.4400 28.8620 size 4.2866 7.6894 5.4139 5.3673 1.4805 notes: dpo = dividend payout; age = age of company; age2 = square of company age; age3 = cube of age company; lev = financial leverage; eps = earnings per share; size = company size 4.2. pearson correlation matrix the study of correlation is a statistical way through which the order that a variable can be related to another variable linearly can be measured. the relationship between the variables of the research has been presented in table 2. the correlation coefficient between the independent variables applied in the model should not be large, because the correlation between independent variables in a model leads to the bias in the regression results. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 59 table 2. pearson correlation matrix variables dpo age age2 age3 lev eps size dpo 1.0000 age 0.2231 1.0000 age2 –0.0656 0.2108 1.0000 age3 0.1904 0.0362 0.2472 1.0000 lev –0.1178 –0.3514 –0.0913 0.1087 1.0000 eps 0.2302 –0.0012 0.1436 0.0043 –0.0346 1.0000 size 0.3401 0.0212 –0.0264 0.0658 0.1456 0.1406 1.0000 notes: dpo = dividend payout; age = age of company; age2 = square of company age; age3 = cube of age company; lev = financial leverage; eps = earnings per share; size = company size 4.3. regression results as mentioned before, the main aim of the study is to test of the relationship between the age of the company and the proportion of the financial leverage with the dividend politics. in this case two hypotheses have been developed. following, the results of the test of the first and second hypotheses have been presented. the test of the significant coefficients is what the researcher is going to find. the results of regression model significance and coefficients significance using pool data method are presented in table 3 for 2005-2011. as it is observed in the table, f-statistic at the level of 99% confidence is significant. therefore, the model of the study is significant generally and the independent and control variables are able to explain variations in the dependent variable of the model. in addition, the determination coefficient is equal to 0.02293. this number indicates that about 23% of the changes in the dependent variable, that is the proportion of the dividend, are explained by the changes in the independent and control variables of the model and 77% of the changes are related to other factors which are not considered in this study. in addition to the determination of the coefficients significance, the direction of the effect of the coefficients on the dependent variable should be determined as well. the related statistic to determine the significance of the coefficients is t-statistic. generally, to investigate the model as a significant one, the f-statistic is also used. to test the null hypothesis, t-statistic is used. according to this if the p-value is less than 0.05, the null hypothesis will be rejected and therefore, the alternative hypothesis will be accepted. accepting the alternative hypothesis implies that there is a significant linear relationship between independent variables and dependent variable in the model. therefore, if sig (p-value) < .05, thenh0 will be rejected and otherwise h1 will be accepted. according to our multivariable model, if the coefficient of each of the independent variables (i.e., β) is positive, the related independent variables will have a direct relationship with the dependent variable which is dividend of each stock and if the coefficient is negative, there will be an inverse relationship. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 60 table 3. multivariate analysis dependent variable: dividend payout (dpo) independent variable parameter coefficient t-statistics p-value intercept β0 0.0828 4.2316 0.0017 age β1 1.1138 4.8794 0.0153 age2 β2 –0.3809 –2.0267 0.0987 age3 β3 0.0626 3.3249 0.0000 lev β4 –0.1729 –4.0928 0.0048 eps β5 1.0216 14.3269 0.0000 size β6 0.2674 2.8342 0.0413 adjusted r2 0.2293 f-statistics 6.4358 p-value (f) 0.0000 d-w 1.9276 notes: dpo = dividend payout; age = age of company; age2 = square of company age; age3 = cube of age company; lev = financial leverage; eps = earnings per share; size = company size 4.3.1. result of first hypothesis the first hypothesis of the research refers to the investigation of the relationship between the age of the company and the proportion of the dividend. in this hypothesis, the dependent variable is the proportion of the dividend and the independent variable is the age of the company. the age of the company is the duration between the year of the establishment of the company and the current year. following afza and mirza (2010), the square and cube of the age of the company is also employed. the reason is finding out the linear or non-linear relationship between the dividend and the age of the company. because the companies have age cycle and it is possible that the profits divided in the beginning of the establishment or the beginning of the entrance to the securities exchange among the stockholders be different from the amount of the division profits in maturity or growth steps or recession step. according to the results indicated in table 4, t-statistic is related to the age and its level of significance (p-value) are 4.8794, 0.0153 respectively. since the fact that the considered alpha for this study is 0.05, the result will be that the age of the company with error level of 5% has a significant relationship with the proportion of the dividend. the variable coefficient of the age is positive. therefore, the relationship between the age of the company and the dividend of the company is direct. in other words, increasing the age of the company in sample companies, the amount of the dividend of the considered companies will be increased as well. in age variable coefficient test it is observed that the resulted level of significance is more than 0.05. therefore, it can be resulted that the square of the age of the company has insignificant relationship with the proportion of the dividend. according to the acquired results of the estimation of the model, the t-statistic related to age independent variable and its level of the meaningfulness (p-value) are 3.3249 and 0.0000 respectively. these numbers indicate that the considered variable coefficient with 99% confidence level is significant. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 61 according to what has been mentioned above, the first hypothesis of the study is confirmed. the relationship between the age of the company and the proportion of the dividend is a linear relationship and the non-linear relationship (curve) is not confirmed. the reason can be explained as the sample companies of the study use the investing opportunities for increasing the profit at the beginning of the establishment or at the beginning of the entrance to the securities exchange and in the future more profits will be divided. the results of the test of this hypothesis are not consistent with the results of the afza and mirza (2010). they found a non-linear relationship between the age of the company and the dividend in pakistani companies. 4.3.2. result of second hypothesis the second hypothesis refers to the investigation of the relationship between the financial leverage and the proportion of the dividend. in this hypothesis, the dependent variable is the proportion of the dividend and the independent variable is the proportion of the financial leverage. the financial leverage measured as the ratio of debt over assets indicates the financial risk of the company. according to the results of the table 4, t-statistic is related to the financial leverage (lev) as independent variable and its level of significance (p-value) is -4.0928 and 0.00048 respectively. since the acquired level of significance is less than 0.01, it can be resulted that the ratio of the financial leverage with 99% confidence level has a significant relationship with the ratio of the dividend. the coefficient sign of financial leverage (lev) is also negative. therefore, there is an inverse relationship between the ratio of the financial leverage and the dividend of the company. in other words, as the risk and the financial leverage increase (decrease) in sample companies, the amount of the dividend decreases (increases). the results of the second hypothesis are consistent with afza and mirza (2010). 5. discussion and conclusion the main aim of the current study is to investigate the relationship between the age of the company and the ratio of financial leverage with the ratio of the dividend. thus, two hypotheses were developed. in the first hypothesis, the effect of the age of the company on the dividend politics and in the second hypothesis the effect of financial leverage on the dividend politics of the company was investigated. the sample consists of 92 listed companies on tehran stock exchange in manufacturing industry during 2005-2011.the pooled data analysis and multivariable regression method were used to test the hypotheses. in order to investigate the linear or non-linear relationship between the age of the company and the dividend, the square and the cube of the age of the company were also used in the empirical model of the study. the results of the first hypothesis were inconsistent with the results of study conducted by afza and mirza (2010). they found a non-linear relationship between the age of the company and the dividend in pakistani firms. the results of the second hypothesis indicate that the relationship between the ratio of the financial leverage and dividend of the company is negative. in other words, as the risk and the financial leverage increase (decrease), the amount of the dividend of the iranian companies decreases (increases). the results of the second hypothesis are consistent with the results of study asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 62 conducted by afza and mirza (2010). generally, the results indicate the confirmation of the first and second hypotheses of the study. in other words, there is a significant and positive relationship between the age of the company and the ratio of dividend and there is a significant and negative relationship between the ratio of the financial leverage and the dividend. the results also demonstrate a linear association between company age and dividend. references afza, talat, & mirza, hammad hassan. (2010). ownership structure and cash flows as determinants of corporate dividend policy in pakistan. international business research, 3(3). ahmad, h., & javid, attiya. (2009). dynamics and determinants of dividend policy in pakistan: evidence from karachi stock exchange non-financial listed firms. international research journal of finance and economics, 25, 148-171. almazan, andres, de motta, adolfo, titman, sheridan, & uysal, vahap. (2010). financial structure, acquisition opportunities, and firm locations. the journal of finance, 65(2), 529-563. http://dx.doi.org/10.1111/j.1540-6261.2009.01543.x anthony, joseph h., & ramesh, k. (1992). association between accounting performance measures and stock prices: a test of the life cycle hypothesis. journal of accounting and economics, 15(2-3), 203-227. http://dx.doi.org/10.1016/0165-4101(92)90018-w black, ervin l. (1998). life-cycle impacts on the incremental value-relevance of earnings and cash flow measures. journal of financial statement analysis, 4, 40-57. deangelo, linda elizabeth. (1981). auditor size and audit quality. journal of accounting and economics, 3(3), 183-199. http://dx.doi.org/10.1016/0165-4101(81)90002-1 fasb, financial accounting standard board. (1978). objective of financial reporting by bussiness enterprises statement of financial accounting concept no 1. ghorbani, arash. (2006). relationship between earnings and cash flows with firm's value in firm's life cycle framework. (m. a. dissertation), islamic azad university, mashhad branch. jenkins, david s, kane, gregory d., & velury, uma. (2004). the impact of the corporate life-cycle on the value-relevance of disaggregated earnings components. review of accounting and finance, 3(4), 5-20. http://dx.doi.org/10.1108/eb043411 john, kose, & williams, joseph. (1985). dividends, dilution, and taxes: a signalling equilibrium. the journal of finance, 40(4), 1053-1070. http://dx.doi.org/10.1111/j.1540-6261.1985.tb02363.x lintner, john. (1956). distribution of incomes of corporations among dividends, retained earnings, and taxes. american economic review, 46(2), 97-113. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 63 mehrani, kaveh. (2004). relationship between earnings per share, dividend, and investment in listed firms on tehran stock exchange iranian accounting and auditing review, 36. stepanyan, gohar g. (2011). firm life cycle and the choice of the form of payout. available at ssrn 1632834. http://dx.doi.org/10.2139/ssrn.1632834 wang, ming-hui, ke, mei-chu, liu, day-yang, & huang, yen-sheng. (2011). dividend policy and the life cycle hypothesis: evidence from taiwan. the international journal of business and finance research, 5(1), 33-52. microsoft word 5156-18688-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 262 ownership volatility and firm performance: evidence from the korean firms haksoon kim assistant professor of finance, division of economics and finance troy university montgomery campus montgomery, alabama 36103 tel: 334-832-7285 e-mail: hkim11@troy.edu received: feb. 20, 2014 accepted: march 18, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5156 url: http://dx.doi.org/10.5296/ajfa.v6i1.5156 abstract this paper investigates the relationship between ownership volatility and firm performance in korea. using the five year ownership volatility variables from 2005 till 2009, the paper shows a positive relationship between foreign ownership volatility and the firm performance of sample firms in korea. further, we perform a factor analysis out of ownership volatility variables and investigate the relationship between the common factors of ownership volatility variables and the firm performance of sample firms in korea. we find a positive relationship between the common factors and the firm performance. the paper contributes to the prior literature by investigating the role of ownership volatility on firm performance. keywords: ownership volatility, factor analysis, firm performance, corporate governance jel classification: g15; g32; g34 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 263 1. introduction it has been an established theory since berle and means (1932) that ownership structure is well distributed to minority shareholders even though managers have the control of a firm. however, many studies have shown that the concentration of ownership increased in countries like germany, japan, italy and even in the united states since 1980’s. the effect of ownership structure on corporate governance is that the increased ownership of managers leads to reduced incentive for wealth transfer and more incentives for majority shareholders than minority shareholders to monitor the managers. specifically, the increase in managerial ownership causes reduction in conflict with outside large shareholders and creates higher firm performance (berle and means, 1932; jensen and meckling, 1976). the increase in managerial ownership makes managers be in a definite position and managers sacrifice the value of outside shareholders (fama, 1980; demsetz, 1983). grossman and hart (1988) and harris and raviv (1988) perform a study on the best fitted cash flow right and control right of firms. shleifer and vishney (1986) and burkart, gromb and panunzi (1997) study the costs and benefits of majority shareholders. demsetz and lehn (1985) and morck, shleifer and vishiny (1988) show the relationship between the ownership structure of a firm and firm performance. morck, shleifer and vishiny (1988) find that the relationship between ownership and tobin’s q or accounting rate of return is nonlinear. also, they find that firms managed by family have lower tobin’s q than firms managed by others. kang and stulz (1996) tried to find the relationship between the variability of foreign investors’ ownership and investment by using the japanese firm data. this paper shows a so-called ‘home-bias’ phenomenon by investigating the ownership variability of foreign investors in japan from 1975 to 1991. the paper finds that foreign investors usually invested in large firms, and sought for the portfolio with higher volatility than the market portfolio in japan. so, they did not earn higher return but monthly return volatility was higher than that of the market portfolio in japan. la porta, lopez and shleifer (1999) investigate the corporate ownership around the world. the paper uses ownership data of large firms in 27 leading countries to identify the ultimate dominant shareholder. the paper finds that firms in countries with high level of shareholder protection are typically dominated by their family or the country they are in. stock market control by financial institutions rarely occurs in these countries. majority shareholders have more control rights than cash flow rights, and this is realized by pyramidal governance structure, participation in the management, cross shareholdings and tunneling problem. it is the opposite with berle and means (1932) who asserted the universality of the widely held corporation holderness, kroszner and sheehan (1999) show that officers and directors of public firms have tended to increase their ownership in recent years in spite of the separation of ownership and management (berle and means, 1932). but, increased managerial ownership does not necessarily mean the substitution of other corporate governance mechanisms. they argue that asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 264 lower volatility and greater hedging opportunity due to the development of the financial market seem to clearly explain the increased managerial ownership. more recently, burkart, panunzi, and shleifer (2002) and anderson and reeb (2003) find that firms more involvement of family firms lead to better financial performance. using listed companies in germany, andres (2008) finds that firms with family ownership perform better than any other type of firms within their sample. isakova and weisskopf (2014) finds that family firms outperform widely-held corporation and companies with non-family blockholders using swiss listed companies from 2003 till 2010. cornett, marcus, saunders and tehranian (2007) find that higher institutional ownership leads to better operating performance. 2. hypothesis from related literature, we can conclude that there is an effect of ownership structure on firm performance as a corporate governance mechanism. also, different countries have different ownership structure, and the effect of ownership structure on firm performance is different around the world. however, we cannot find much literature of the effect of ownership volatility on firm performance. also, we cannot find much literature of ownership volatility during financial crisis and its effect on firm performance. elyasiani and jia (2010) finds a positive relationship between firm performance and institutional ownership stability. also, li, nguyen, pham and wei (2011) find a negative relationship between large foreign ownership and stock return volatility using 31 emerging markets. however, there is no paper which addresses the effect of ownership volatility on firm performance. so, using korean data, we examine the relationship between ownership volatility and firm performance. the reason why we use korean data is because korean firms are sensitive to the trading volume of foreign investors, domestic institutions and domestic big individuals. for example, choe, chung and lee (2008) find that foreign investors, domestic institutions and domestic big individuals play dominant roles in stock price movement from 1997 till 2000. especially, the role of domestic big individuals becomes distinct in later years. more recent report by korea exchange show that firms with increased foreign and institutional ownership realize higher operating performance than that of average korean exchange firms from 2009 till 2011. so, we will focus on the ownership volatility, instead of trading volume, of these entities and its effect on firm performance in this paper. hypothesis: there is a positive relationship between ownership volatility and firm performance for korean exchange listed firms. 3. data and variable construction we collect data on a sample of firms from the korea investor’s network for disclosure system (kinds) spanning from 2005 till 2009. ownership data for controlling shareholders or second largest shareholders as well as yearly industry classifications are obtained from the ts2000 on-line database. we hand collect foreign and institutional ownership data from the korea information service website (http://www.kisinfo.com/koreanstockmarket/index.htm). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 265 after we collect the ownership data, we create the ownership volatility variables by calculating the standard deviation of ownership from 2005 till 2009 as follows. managerv= )1( 2009 2005 ___________ − − = n managermanager i i (1) institutionv= )1( 2009 2005 ___________ − − = n ninstitutioninstitutio i i (2) foreignv= )1( 2009 2005 ___________ − − = n foreignforeign i i (3) where managerv, institutionv, and foreignv represents the volatility of managerial ownership, institutional ownership and foreign ownership, respectively. also, ___________ manager , ___________ ninstitutio , and ___________ foreign represents the average value of managerial ownership, institutional ownership and foreign ownership, respectively. financial information is retrieved from fn dataguide database. they are the number of shares outstanding, market price per share, total assets, total debt and growth rate in sales. after we obtain data from the database, we construct size, leverage and growth variables as follows. tobinq= assetstotal debttotalshareaofpricemarketdingoutssharesofnumberthe +*tan at t (4) size=log(total assets) at t-1 (5) leverage=total debt/total assets at t-1 (6) growth=growth rate in sales at t-1 (7) where tobinq, log and t-1 represents the tobin’s q measure, the natural logarithm and one year before tobin’s q measure date. since we measure tobin’s q at the end of year 2009, size, leverage and growth variables are measured based on the year 2008 data. final sample consists of 703 observations after we exclude missing observations. 4. empirical results asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 266 table 1. descriptive statistics variable n mean median stdev minimum maximum tobinq 642 1.02 0.88 0.56 0.35 7.33 managerv 685 0.04 0.02 0.06 0.00 0.64 institutionv 685 0.03 0.00 0.04 0.00 0.34 foreignv 685 0.02 0.00 0.03 0.00 0.40 size 703 26.66 26.32 1.66 22.58 32.27 leverage 703 0.48 0.48 0.24 0.01 2.03 growth 688 0.15 0.12 0.36 -0.96 2.58 table 1 reports the previous five year ownership volatility and firm characteristics of korean exchange listed firm sample. the sample period is from 2005 till 2009 for ownership volatility variables. we use the year 2009 sample for tobinq. finally, the sample period for size, lever and growth is 2008. previous five year ownership volatility is highest for managerial ownership (mean=0.04, median=0.02) and lowest for foreign ownership (mean=0.02, median=0). tobin’s q is close to 1, on average, but its median value is less than 1. size, which is measured by previous year’s log of total asset, is 26.66, on average. it is translated into 378.70 billion korean won ($315.56 million using the exchange rate of 1,200 korean won/$). the median value of size is 26.32. it is translated into 269.55 billion korean won ($224.62 million using the exchange rate of 1,200 korean won/$). leverage, which is measured by previous year’s total debt-to-total assets ratio, is 0.48 or 48 percent, on average. growth, which is measured by previous year’s growth rate in sales, is 0.15 or 15 percent, on average. the median value of growth is 0.12 or 12 percent. table 2. ols regressions of ownership volatility on tobin’s q dependent tobinq intercept -0.05 -0.03 0.08 0.16 (-0.12) (-0.08) (0.19) (0.39) managerv -0.16 -0.26 (-0.41) (-0.68) institutionv 0.80 0.76 (1.53) (1.44) foreignv 1.44 1.36 (2.07)** (1.96)** size 0.04 0.04 0.03 0.03 (2.54)** (2.45)** (2.10)** (1.83)* leverage 0.12 0.12 0.13 0.15 (1.09) (1.10) (1.24) (1.35) growth 0.06 0.06 0.07 0.06 (0.83) (0.89) (0.97) (0.81) n 703 703 703 703 r-squared 0.02 0.02 0.02 0.03 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 267 we set up an ordinary least squares (ols) regression model as follows. iiii iiii egrowthleveragesize foreignvnvinstitutiomanagervtobinq ++++ +++= *** *** 654 3210 βββ ββββ (8) where subscript i represent a firm within our sample, β represents regression coefficients and e represents an error term. table 2 reports the ols regression results of ownership volatility on tobin’s q after controlling for firm characteristic variables. the dependent variable is tobin’s q. the independent variables are managerial, institutional and foreign ownership volatility after controlling for log of total assets, debt-to-assets ratio and growth rates in sales. the results partially support our hypothesis. the positive coefficient of foreign ownership volatility suggests that firms with high foreign ownership volatility tend to have higher profitability, measured by tobin’s q. we have consistently positive coefficients from this variable with or without managerial and institutional ownership volatility variables. however, we do not find any statistically significant relationship between managerial or institutional ownership volatility and tobin’s q. for control variables, we have consistent positive relationships between log of total assets and tobin’s q across all the regression results in table 2. table 3. panel a: factor pattern matrix obtained from principal component analysis factor1 factor2 managerv 0.24 -0.12 institutionv 0.34 0.006 foreignv 0.19 0.14 panel b: variance explained by each factor factor1 factor2 0.2118 0.0359 table 3 reports the factor pattern matrix and the variance explained by each factor from the principal component analysis. the analysis captures the common variation among ownership volatility variables which is not captured by individual variable. two factors have been obtained from the minimum eigenvalue criterion. from panel a, we can see the unique variance contribution of each factor on the variance of ownership volatility variables. managerv has a loading of 0.24 in factor 1 and a loading of -0.12 in factor 2. instiutionv has a loading of 0.34 in factor 1 and a loading of 0.006 in factor 2. foreignv has a loading of 0.19 in factor 1 and a loading of 0.14 in factor 2. from panel b, the first factor accounts for 21.18 percent from the total variation. the second factor accounts for 3.59 percent from the total variation. two factors account for the total of 24.77 percent of the total variation of ownership volatility variables. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 268 table 4. ols regressions of factors on tobin’s q dependent variable: tobin's q intercept factor1 factor2 size leverage growth n adjusted r2 0.19 0.09 0.24 0.03 0.15 0.06 703 0.02 (0.46) (1.66)* (1.94)** (1.86)* (1.33) (0.86) standardized coefficient estimates intercept factor1 factor2 size leverage growth 0 0.0662 0.0808 0.0778 0.0547 0.0350 the ols regression results of factors on tobin’s q are summarized in table 4. as we can see from the regression results, we find positive relationships between two factors and tobin’s q after controlling for size, leverage and growth opportunity. the results are consistent with our hypothesis. if we factor out the common variation from ownership volatility variables and run a regression of factors on tobin’s q, common variation factors increase the profitability of firms in our sample. from standardized coefficient estimates, we can find that one standard deviation change in factor1 increases tobin’s q by 6.62%. for factor 2, one standard deviation change in factor 2 increases tobin’s q by 8.08%. for control variables, one standard deviation change in size increases tobin’s q by 7.78%. factor1 and size are statistically significant within one percent significance level. factor2 is statistically significant within five percent significance level. conclusion the relationship between ownership, as one proxy of corporate governance, and firm performance has been widely discussed in corporate finance literature. however, little has been discussed about the relationship between ownership volatility and corporate governance in prior literature. using five year ownership volatility of korean firms in our sample spanning 2005 to 2009, we investigate the relationship between the volatility and the firm performance of the sample firms in 2009. consistent with our hypothesis, we find a positive relationship between foreign ownership volatility and firm performance. further, we investigate the relationship between common factors from three ownership volatility variables and firm performance. consistent with our hypothesis, we find a positive relationship between two common factors and firm performance. this paper has two contributions to the prior literature. it is the first paper to investigate the ownership volatility and its relationship with firm performance in korea using both ols regression technique and factor analysis. second, it sheds light on the role of ownership volatility on firm performance in other financial markets. references anderson,r. c., & reeb,d. m. 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(1986). large shareholders and corporate control. the journal of political economy, 94(3), 461-488. http://dx.doi.org/10.1086/261385 appendix i: definition of variables variables definition tobin q proxy for firm valuation defined as (the number of shares outstanding*market price of a share+total debt)/total assets in 2009 size the natural log of total asset in 2008 leverage total debt/total asset in 2008 growth annual growth in sales in 2008 managerv the standard deviation of five year ownership of large shareholders from 2005 to 2009 foreignv the standard deviation of five year foreign ownership from 2005 to 2009 (if the ownership is above 5%, then we assign the ownership; otherwise we assign zero) institutionv the standard deviation of five year institutional ownership from 2005 to 2009 (if the ownership is above 5%, then we assign the ownership; otherwise we assign zero) microsoft word 4336-16027-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 139 the initial going-concern of delisting firms: an application of proportional hazard model chi-chen wang department of financial management, national defense university yueh-ju lin department of accounting, kainan university yunsheng hsu (corresponding author) department of accounting, national chung-hsing university received: may 27, 2013 accepted: october 12, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4336 url: http://dx.doi.org/10.5296/ajfa.v5i2.4336 abstract this paper examines the survival period and the factors of business failure of firms who have been issued with an initial going concern opinion (igco) by auditors. empirical results show that financial variables are not significant predictors for future delisting crisis, but the corporate governance variables are especially for firms under deteriorating financial condition. important factors causing the higher rate of delisting risk include shorter listing years, lower rate of retained earnings to total assets, lower rate of market value of equity to total debts, and higher rate of pledged shares of directors’ and supervisors’ within 7.5 quarters after the igco issued, the number of delisting firms reaches its peak, consistent with the existence of self-fulfilling prophecy. the hazard delisting function first rises to a peak at the 38th quarter and then declines rapidly, showing that after the disclosure of igco, first nine years is the delisting crisis period for taiwan public firms. keywords: going concern, business failure, proportional hazard model, survival analysis, self-fulfilling prophecy asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 140 1. introduction most financial statements users apply audit opinions as an operational health checkup point to evaluate if the firm could operate normally or would fail in the future (casterlla et al., 2002). therefore, when firms are issued with an initial going-concern modified opinion by auditors, related parties may have various concerns about the igco firms. financial statements users need to evaluate the length of future survival period in the listing market for the igco firms. shareholders need to make selling decisions at an appropriate timing to avoid more losses. creditors need to evaluate whether to demand for a debt repayment. particularly when a higher credit risk is associated with borrowers, banks will consider the acceptance of future financing requests or simply demand for debt repayments. government agencies also need to determine appropriate interventions to maintain financial orders. therefore, further studies about the survival crisis for the igco firms are essentially useful to the related parties of delisting firms. when firms are issued with igco, the firms have a higher probability to occur financial crisis. in financial accounting literature, there are two issues related to igco. first, after the disclosure of an adverse igco, whether the firms would go bankruptcy or whether the audit opinion could be an early warning predicting business bankruptcy has become an important research topic. previous studies focus on the prediction powers of business bankruptcy by comparing audit opinions with statistical forecasting models. most empirical evidences show that audit opinions do not exert higher prediction powers than those statistical models’ (altman and mcgough, 1974; koh, 1991). these results cause doubts on auditors’ professional judgment, and some studies even suggest auditors to use statistical forecasting models to lower possible misjudgment in their evaluation (altman, 1982; koh and killough, 1990; levitan and knoblett, 1985). previous research simply uses a binary choice of failure or survival in the bankruptcy forecasting models in which only an accurate bankruptcy rate within the exact research period could be learned. however, because business failure is a lengthy and complicated process and even after issued with igco, some firms may still survive while others may bankrupt when time passes. however, since firms have different survival periods and some may occur bankruptcy out of a research period, analysis assuming a same time period as a comparison basis would even causes the observed data to be censored. the problem will underestimate the probability of hazard rate of bankruptcy and cause errors in the analysis by wrongfully assuming the businesses are still in normal operation but actually its future failure is unpredictable. therefore, the binary choice model does not consider the survival period of business failure in its forecasting models and thus lowers its effectiveness in future preventions and treatments. understanding the time process about how firms go bankrupt is more useful than simply knowing its probability during the research period by the choice model. the survival analysis can further measure the survival time in addition to the probability of failure. the second issue discussed in the financial accounting literature is to investigate the existence of self-fulfilling prophecy by examining if the bankruptcy probability increases during the first or second year after an igco issued. these studies, although considering the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 141 time process of business failure, merely limit their discussions to the primary effects of igco at an early stage. actually after the disclosure of igco, financial impacts to corporate operations do not occur immediately but generally prolong to the future. focusing on only one or two years after an adverse igco issued and when bankruptcy probability may not increase yet and impacts of future periods are ignored, result bias may occur in empirical inferences (louwers et al., 1999). therefore, after the disclosure of igco firms, for any point in time during the survival period, bankruptcy probability should be evaluated carefully. the survival analysis focuses on the timing issue by measuring a possible future bankruptcy risk for the igco firms when financial crisis occurs. in addition, a related issue for financial statements users is about when to make their decisions. to overcome issues in previous studies and solve for actual problems for financial statements users, the entire time process, from the issuance of igco to their delisting, should be considered for these firms in financial crisis. evaluation for the survival period before delisting and its delisting probability during the period is necessary for different users of financial statements to determine their further strategies. this main characteristic in this paper is to connect audit opinions with the dynamic process of business failure, aiming at discussing the time process for a survival period until delisting for firms issued with an igco. we discuss three related issues of an igco, which are the hazard delisting period for taiwan igco firms, the existence of self-fulfilling prophecy, and factors influencing the delisting. following previous financial crisis studies, we separate delisting factors based on corporate structures, the general, financial, operational, and shareholding structure. we construct a survival period model for financial crisis firms, covering from the time igco issued till delisting. business failure occurs when many intervening factors cause its operation to cease or even withdraw from industry. most related studies employ the choice model in the matching process of a business failure forecasting model to measure the most likely probability for survival or failure at a certain point in time. their models use a static analysis which can merely evaluate the highest hazard rate for business failure or delisting during a certain period. unfortunately, the complicated time process involved during the survival period is not investigated, for the process of either delisting from financial crisis or business failure from normal operation. thus, possible timing for prevention and treatment has lost for firms in financial crisis. for instance, when a financial warning of igco issued, possible delisting time and its probability are still unknown. then, if apply the survival analysis, delisting factors and the survival periods and probability can be estimated. this paper employs the proportional hazard models to estimate the delisting factors for taiwan public companies. our empirical results show that factors causing a higher delisting hazard rate are shorter listing time, lower rate of retained earnings to total assets, lower rate of market value of equity to total debts, and higher rate of pledge shares of directors’ and supervisors’. we discover that after the sample been issued with an igco, its delisting risk rises continuously and reaches its peak at the 38th quarter and then declines rapidly. thus we conclude that taiwan public firms have a nine-year delisting hazard period after the disclosure of an igco. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 142 in addition to the above introduction, the second section is literature review and the third section explains the design for econometric models. the fourth section describes the sample and data statistics, with the fifth section concluding our findings. 2. literature review this section aims at improving previous financial crisis studies which ignore timing factor and by employing the survival analysis model, timing factor is incorporated with two research topics into our study. in addition, we also discuss the application of survival analysis in the empirical studies focusing on the industry and financial structure. the first research topic is the comparison of prediction accuracy for corporate bankruptcy between audit opinions and statistical forecasting models. when corporate continuous operation is doubtful, auditors issue their going-concern opinions to caution public investors but not to predict bankruptcy. however, users of financial statements still consider the opinions as an early warning for business failure and regard a modified opinion as a financial checkup point (casterlla et al., 2002). a study of altman and mcgough (1974) first connects audit opinion of going-concern quality with bankruptcy prediction. they collect a sample of 34 firms one year before bankruptcy during the years of 1970 to 1973 and employ a z-score statistical forecasting model (altman, 1968) to compare accuracy in bankruptcy prediction based on audit going-concern opinions. their study finds that the statistical forecasting model has an accuracy rate of 82%, almost doubling the audit opinions’. thus they suggest auditors to apply statistical models to improve accuracy in their opinions. other related studies also have similar findings that statistical forecasting models are superior than those of audit opinions in bankruptcy prediction (altman, 1982; koh, 1991; koh and killough, 1990; levitan and knoblett, 1985). besides, a report by the cohen commission (aicpa, 1978) also concerns the issue and international federation of accountants (1989) even requires more auditors’ attention when issuing going-concern opinions. although these suggestions cast a reasonable doubt on audit opinions, they also provide an objective auxiliary tool for auditors to apply. studies in bankruptcy prediction models are developed from the univariate to multivariate models, most of which have reviewed and based their methods from altman (1968), deakin (1972), and ohlson (1980). zavgren (1983) and jones (1980) provide auditors with bankruptcy models as a professional reference. their models are a binary choice model in which only accuracy but not bankruptcy probability is provided. unfortunately, users of financial statements also concern the occurring time for bankruptcy in addition to its probability. during the survival period after an igco issued, users must evaluate associate risk and probability of bankruptcy at various times in searching for earlier strategies. however, the binary choice model does not discuss the survival period and the time process for business failure or delisting, and thus has lowered opportunities for early preventions and treatments. therefore, understanding the changing process during survival period is meaningful in actual business practices when firms are in financial and delisting crisis. the second research topic is an investigation about the existence of self-fulfilling prophecy. after an igco is issued, if bankruptcy probability increases within one or two years, the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 143 effect of self-fulfilling prophecy may exist. louwers (1999) indicated that the igco opinion accelerates business failure and thus has impacts on current and potential investors, creditors, suppliers, and customers. previous studies test the self-fulfilling prophecy by the percentage approach, calculating the ratio of bankrupt igco firms to the total igco firms. for example, in a sample of 78 igco australian firms during the years of 1980 to 1992, psaros and zhang (1994) discover that after the first or second year of igco issued, 24 firms (37.2%) declares bankruptcy. within the same research period, barnes and hooi (1987) find that only 3 (5.9%) out of a total sample of 51 igco firms occur bankruptcy within two years after igco issued. besides, altman (1982) states that about 25% igco firms are bankrupt after igco issued. in conclusion, above studies do not support the existence of self-fulfilling prophecy. on the other hand, in a sample of 157 american igco firms during the years of 1983 to 1990, nogler (1995) finds a 33% sample declares bankruptcy after the first year of igco issued and supports the effect of self-fulfilling prophecy. in addition, in a sample of 210 igco american firms during the years of 1984 to 1991, louwers (1999) states that 38 (18%) firms are bankrupt after the first year of igco issued, 17 (8%) firms after the second year. if applying the dtsa (discrete time survival analysis) modeling, it is 27% after the first year and 18% after the second year, which are similar to a 24% after the first year in the study of citron and taffer (1992) for a british igco sample. both studies support the effect of self-fulfilling prophecy. therefore, there is no conclusion about the existence of self-fulfilling prophecy for firms been issued with igco. the inconclusive finding for self-fulfilling prophecy is due to the lack of an objective standard in the measurements of percentage approach. to present the effect of self-fulfilling prophecy, there is a need to investigate objective measurements for the effect of self-fulfilling prophecy. zhang and suzanne (1997) suggest applying the length of time for survival to measure the effect. however, the self-fulfilling prophecy seems to imply that igco must be issued before bankruptcy to occur. because it is a complicate process for a normal corporation to declare bankruptcy, many factors could involve. merely applying audit opinions to determine whether the firm will bankrupt after an early stage of igco issued seems incomprehensive. besides, an igco is expected to exert its effect further to the future and other lagged effects may involve as well. therefore, changes in the time process for audit opinions to exert impacts should be investigated further. finally, previous empirical studies find that the log-logistic model in survival analysis is the most appropriate method to match firms’ survival period. through the likelihood ratio test, an appropriate matching model can be obtained. however, if a quarter of the sample data is censored and if the selected parameter model assumes a final failing rate of one, the rate could easily be overestimated. in addition, the use of weibull distribution assumption could also be used to build an early warning model for financial institutions. bandopadhyyaya and jaggia (2001), in a sample of 107 bankrupt firms during the years of 1979 to 1990, discuss the length of time and factors causing final bankruptcy after reorganization. they employ a split population duration model to perform tests and realistically consider the final bankruptcy rate not necessary equal to one. however, they do not explain the selection process of log-logistic modified model in their split population duration model. in conclusion, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 144 although the survival analysis is empirically applied to business studies, it is rarely applied to the study of audit opinions. since financial distress occurs at different points in time which is a continuous process, it is more reasonable to use the survival period model to overcome the timing issue for our study. 3. econometric models logic or probit method is generally used in the financial crisis literature which discusses the relation between the probability of financial distress and its factors. these methods imply that financial crisis occurs at the same time which simply separate the sample into occurring crisis or not. in order to distinguish different occurring time, this paper uses a periodical model to further separate the sample based on different delisting time. our models consider the survival period so that the relation between corporate operating factors and delisting can be investigated correctly. the periodical model, also called the transition model, focuses on the length of time a status condition remains or the possibility of changing status at a certain point in time. the possibility is called the hazard rate, and the higher the rate is the shorter time the status remains. this paper discusses the relation between the hazard rate and corporate operating conditions (delisting). a higher hazard rate represents a worse operating condition, in which when the possibility of changing status from un-delisting to delisting is higher, the firm is more likely to occur delisting within a shorter time period. the periodical model is applied in previous bankruptcy studies for financial institutions in which two models are generally used, the proportional hazard model and the accelerated failure time model (lane, looney and wansley, 1986; wheelock and wilson, 1994). the two models have different assumption about its baseline hazard. the baseline hazard is set respectively as the following: the proportional hazard model: )|( xth = )exp()(0 βxth , the accelerated failure model: )|( xth = )exp(),(0 βα xxth , in which )|( xth is the hazard rate, )(0 ⋅h is the baseline hazard, x is the various predictors, α and β is the coefficient for its baseline and exponential function. from the above settings, the baseline hazard is assumed not to be affected by the predictors in the proportional hazard model, but otherwise in the accelerated failure model. both models can apply parameter estimation methods, but cox (1972) in his partial-likelihood approach for the estimation of proportional hazard model, assumes no baseline hazard for any pattern of distribution. both models have different thresholds, characteristics, and applications. the following explains the use of proportional hazard model in this paper. for the random variablet , representing days after igco, follows the probability distribution of f(t|x) with an cumulative density function of f(t|x). within t days after the igco, the delisting probability could be written as: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 145 ==≤ t duxufxtfxttprob 0 )|()|()|( (1) the delisting probability after t days in the survival function of )|( xts could be written as: )|(1)|( xtfxts −= . (2) thus, the hazard rate )|( xth for delisting occurring at t days could be written as the following: )|( )|( ),|( ),|( lim)|( 0 xts xtf xtttf xtttttprob xth =≥=≥+≤≤= → δ δ δ . (3) from equation (1), (2) and (3), we can obtain the following three equations: dt xtsd xth )|(log )|( −= (4) )|()|()|( xthxtsxtf = (5) −= t duxuhxts 0 ))|(exp()|( . (6) to estimate the relation between variables and the survival period, any function set for )|( xtf , )|( xtf , )|( xth , or )|( xts must be known. this paper follows cox’s (1972) partial log-likelihood method to estimate the proportional hazards model. the hazard rate is set as the following: βxethxth )()|( 0= (7) of which x describes the structures for listing firms and β is the coefficient. different characteristics of x may cause delisting effects differently, so the sign for each corresponding coefficient could be positive or negative. the baseline hazard )(0 th is the unobserved variable effects on the hazard rate. from equation (7), we can obtain the parameter function for )|( xth but not )(0 th . therefore, the proportional hazard model is called the semi-parametric estimation method. the estimation for β is based on the partial-likelihood approach. this approach first arranges the sample in the order of the delisting and assumes n number of listing firms in the sample. thus, each t in a listing firm asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 146 satisfies  321 ttt . when at 1t , the conditional delisting probability for the first firm is as the following:  == == n t x x n t ie e xth xth l 11 11 11 1 1 )|( )|( β β β β . (8) at jt , the conditional delisting probability for the j th firm is as the following:  == == n i x x n i ii jj j i j e e xth xth l 11 )|( )|( β β β β . (9) from equation (8) and (9), we can write the partial likelihood function, pl as in the following: ∏ ∏ = = = × == n i n i n i jij i i i xy x lpl 1 1 1 ] )exp( )exp( [ δ β β . (10) in equation (10), if ij tt ≥ , then let 1=ijy and if ij tt  , then let 0=ijy . if the data is censored, then 0=iδ , and if not censored, then 1=iδ . therefore, a set of coefficients β can be obtained in which the partial likelihood function reaches its maximum value. the β set is our estimated targets. from the above, the proportional hazard model merely assumes the relation between the hazard rate and the baseline hazard. in equation (7), the hazard rate and the followed distribution in the survival period are not set. the main difference between the two models (the proportional hazards and the accelerated failure time) is in the assumption that the survival period follows a certain distribution. the model is set as the following: )exp( σεβ += xt , (11) of which t follows a certain distribution of f(t),σ is the scale parameter, and ε is the standard error term. we can write the likelihood function l as the following: ∏ ∏ = = −− =−= n t n i iiiiiiii iiii tstftftfl 1 1 11 )]([)]([)](1[)]([ δδδδ . (12) when l is maximized, β can be estimated. note that the obtained signs in both models must be opposite, because when the survival period is shorter, the hazard rate will be higher. in the accelerated failure model, the shape for hazard rate is different because it follows various distribution of t. in equation (11), non-linear relation between t and variables can be found. distribution in the standard error term ε is not the same as t’s, but a one-on-one asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 147 switching relation. table one is distributions for the survival period, the standard error term, and characteristics in its corresponding hazard rates. for these distributions, hazard rates have four different shapes, increasing, decreasing, no changing, or increasing first and then declining later. therefore, when set the distribution for survival period, a life table must be used to describe the hazard rate first. then based on the shape and characteristics in the hazard rate, a reasonable distribution for the survival period can be set, or there could be a specification error presented in the model. table 1. distributions for t,ε , and hazard rate characteristics distribution t distribution ε characteristics in )(th exponential extreme value (1 parameter) )(th is a fixed constant gamma log-gamma )(th increasing or decreasing log-logistic logistic )(th first increasing/decreasing, then the opposite log-normal normal )(th first increasing, then decreasing weibull extreme value (2 parameter) )(th first decreasing, then increasing source：allison (1995) this paper studies a total sample of 153 delisting firms after been issued with an initial going-concern opinion (igco) by auditors. research period covers from january 1, 1980 to june 30, 2006, a total of 16 years (64 quarters). table 2 is the life table for the sample, arranged by the order of occurring period of delisting (in quarter time) based on a non-parametric analysis. as shown in table 2, the igco sample have a high number of delisting firms during the quarters of 0 to 7.5 (31 firms), 7.5 to 15.0 (10 firms), 15.0 to 22.5 (29 firms), and 22.5 to 30.0 (13 firms) respectively. on the other hand, the rest of survival periods have only delisting firms of six, one, or zero. particularly, after igco issued until the 7.5th quarter, most igco firms occur delisting, showing that the effect of self-fulfilling prophecy exists in taiwan capital market for our research period. during the same period (0 to 7.5th quarter), the delisting probability continuously rises from 0.0328 to 0.1000 the highest rate, with a corresponding survival period from 30.0 to 37.5 quarters. then, the hazard rate declines rapidly, meaning the average survival period for the igco firms to occur delisting is about 38 quarters (9 years). within this period, the delisting probability is the highest, and then the hazard rate declines quickly until the quarter of 45 to 52.5, the rate rises to 0.0381 again. graph 1 is a bar chart for the hazard rate and survival period based on table 2. the distribution pattern for hazard rate is different from those of corresponding hazard rates in asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 148 table 1. therefore, we decide not to apply the accelerated failure time model and employ the proportional hazard model instead by applying the cox’s partial log-likelihood approach. table 2. life table1 survival period (quarters) sample size censored firms possible delisting firms actual delisting firms survival rate hazard rate 0.0 7.5 153 23 141 31 1.000(0.000)2 0.0328(0.006)3 7.5 15.0 99 18 90 10 0.7809(0.035) 0.0157(0.005) 15.022.5 71 17 62 29 0.6941(0.040) 0.0806(0.014) 22.530.0 25 0 25 13 0.3721(0.049) 0.0937(0.024) 30.037.5 12 2 11 6 0.1786(0.044) 0.1000(0.038) 37.545.0 4 0 4 0 0.0812(0.033) 0.0000(0.000) 45.052.5 4 0 4 1 0.0812(0.033) 0.0381(0.038) 52.560.0 3 0 3 0 0.0609(0.031) 0.0000(0.000) 60.067.5 3 0 3 0 0.0609(0.031) 0.0000(0.000) 67.575.0 3 3 1 0 0.0609(0.031) 0.0000 (0.000) source: calculation from the sample remark 1: this table is based on cutler and ederer method. 2：standard deviation is in brackets for the survival rate. 3：standard deviation is in brackets for the hazard rate. time 7.5-15.0 67.5-75.0 60.0-67.5 52.5-60.0 45.0-52.5 37.5-45.0 30.0-37.5 22.5-30.0 15.0-22.5 0-7.5 m ea n r a t e .12 .10 .08 .06 .04 .02 0.00 graph 1. hazard rate asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 149 4. data and sample statistics based on audit opinions on financial statements, excluding the unqualified opinion, this paper investigates auditors’ initial going-concern opinion (igco) on listing companies. we employ important predictors for delisting from related literature to construct a survival analysis model. corporate structures constructed in the predictors are financial information, stock prices, the pledged shares ratio of directors’ and supervisors’, and the insider shareholding ratio. sample data is derived from the quarterly modules of cumulative financial information, full delivery share, or delisting company in the taiwan economic journal (tej) databank. the research period includes 64 quarters (16 years) from january 1, 1980 to june 30, 2006 and a total sample of 153 igco firms. because a long complicated process is involved for a delisting crisis to occur, our study considers the survival period from the issuance of igco to the time of delisting (the failure event) or to research period stop date (right censored data). we take two points in time when the igco is issued and when the delisting occurs to calculate the actual survival period in quarters. during the research period for igco firms, a total final sample of 153 firms is obtained for modeling. to qualify as a delisting firm in this paper, the firm must be delisted by taiwan securities and futures bureau but not by voluntary delisting. during the research period (1980/1/1~2006/6/30), if a survival period could be measured, a completed data for an igco delisting sample firm is obtained. however, if the delisting time is after the research stop date, the igco sample firm is considered un-delisting (right censored data) and has an incomplete survival data. for this incomplete survival data (right censored), its survival period is calculated by deducting the research stop date from the igco date. these incomplete survival data can only provide partial information due to the limitation on the research period stop date. table 3 lists the selected sample numbers, in which panel a is the sample selection process for financial distress firms. the first sample selection standard is to include only those igco firms who have complete financial statements and related information. thus, four banking and securities igco firms with significant different accounting systems and 25 other igco firms with incomplete information are excluded. finally, 153 igco firms are derived as our research sample at the research stop date of june 30, 2006. panel b in table 3 lists annual sample numbers of igco firms, delisting and un-delisting. until the research stop date (2006/6/30), 68 igco firms are delisted and 85 igco firms are un-delisted. based on the sample data, since 1998, numbers of igco firms increase , and delisting occurs mostly after 1998. the main reason may due to the asian financial crisis in 1997 which overturns economic condition, leading operating difficulties and depressing stock market continuously. during the period, many adverse cases such as inappropriate corporate investments or misappropriating corporate capital by large shareholders to maintain stock prices have caused corporate bankruptcy. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 150 table 3. sample selection panel a: sample selection process # of igco firms during 1980 – 2006 182 less: banking and securities companies 4 less: incomplete data information 25 total number of final igco sample firms 153 panel b: annual sample selected year # of igco firms # of delisting firms # of un-delisting 1980 0 0 0 1981 0 0 0 1982 1 1 0 1983 0 0 0 1984 0 0 0 1985 0 0 0 1986 1 1 0 1987 2 2 0 1988 1 1 0 1989 0 0 0 1990 0 0 0 1991 2 2 0 1992 0 0 0 1993 0 0 0 1994 1 0 1 1995 3 3 0 1996 1 1 0 1997 0 0 0 1998 20 14 6 1999 14 9 5 2000 18 10 8 2001 30 10 20 2002 12 4 8 2003 9 3 6 2004 19 7 12 2005 19 0 19 2006 0 0 0 total 153 68 85 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 151 table 4 is the sample statistics for the 153 igco sample firms by industry and listing market. it is generally believed public firms listing in the otc market have smaller capital and unhealthier financial structure than those listing in the main stock market. this paper test the effect of type of listing market on delisting and find it is insignificant at a 0.05 confidence level with a correlation phi coefficient of 1.414 with p-value of 0.199. thus, empirically there is no significant correlation between delisting and listing market type in taiwan for our igco sample firms. there is no difference between listing market type for delisting igco firms. table 4. sample statistics for the igco firms delisted igco firms un-delisted igco firms main market otc market total main market otc market total # % # % # % # % # % # % cement 0 0.00 0 0.00 0 0.00 1 1.18 0 0.00 1 1.18 food 9 13.24 0 0.00 9 13.24 1 1.18 0 0.00 1 1.18 plastic 1 1.47 0 0.00 1 1.47 2 2.35 0 0.00 2 2.35 textile 5 7.35 0 0.00 5 7.35 8 9.41 0 0.00 8 9.41 machinery 2 2.94 0 0.00 2 2.94 0 0.00 0 0.00 0 0.00 appliance 1 1.47 0 0.00 1 1.47 2 2.35 0 0.00 2 2.35 bio-chem 0 0.00 0 0.00 0 0.00 1 1.18 1 1.18 2 2.35 glass 1 1.47 0 0.00 1 1.47 3 3.53 0 0.00 3 3.53 paper 0 0.00 0 0.00 0 0.00 1 1.18 0 0.00 1 1.18 steel 2 2.94 1 1.47 3 4.41 5 5.88 2 2.35 7 8.24 rubber 0 0.00 0 0.00 0 0.00 1 1.18 0 0.00 1 1.18 auto 1 1.47 0 0.00 1 1.47 1 1.18 0 0.00 1 1.18 electronics 5 7.35 7 10.29 12 17.65 13 15.29 14 16.47 27 31.76 constructing 6 8.82 4 5.88 10 14.71 9 10.59 3 3.53 12 14.12 trading 1 1.47 0 0.00 1 1.47 1 1.18 1 1.18 2 2.35 tourism 0 0.00 0 0.00 0 0.00 0 0.00 1 1.18 1 1.18 communication 0 0.00 1 1.47 1 1.47 0 0.00 0 0.00 0 0.00 software 0 0.00 0 0.00 0 0.00 0 0.00 2 2.35 2 2.35 others 2 2.94 1 1.47 3 4.41 5 5.88 3 3.53 8 9.41 managerial 17 25.00 1 1.47 18 26.47 4 4.71 0 0.00 4 4.71 total 53 77.94 15 22.06 68 100.00 58 68.24 27 31.76 85 100.00 previous studies suggest auditors to apply corporate bankruptcy models as a tool to evaluate audit opinions. due to its objective measurement and convenience in obtaining data, most asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 152 statistical models employ financial ratios as main predictors. cybinski and winnsor (2005) also advise auditors to select appropriate information to reflect client operating conditions such as the financial ratios. following previous studies (altman, 1982, 1986; chen and lee, 1993; ohlson, 1980, 1993), we classified the factors for financial distress into four corporate structures, the general, financial, operational, and ownership structure. the following explains these four corporate structures in detail. corporate general structure including firm size (size) and firm age (age). chen and lee (1980) and ohlson (1993) stated that the larger the firm size is, the less likely for financial crisis to occur. chen and lee (1993) showed that the higher the firm age, the less likely for delisting to occur. corporate financial structure could be evaluated by corporate shortand long-term solvency, and the worse the ability, the more likely financial crisis could occur. this paper employs four financial ratios to measure corporate solvency. current ratio (cacl) is current assets divided by current liabilities is current ratio. this ratio measure corporate liquidity, and the higher it is, the better short-term solvency is. ohlson (1980) empirically proves that current ratio measures liquidity which is a significant indicator for corporate bankruptcy. working capital to total assets ratio (wcta) is the difference between total short-term assets and liabilities. altman (1968) states that reducing of the firm’s net current assets and liquidity will dampen its short-term solvency and increase the likelihood of delisting. cash flows from operation to total liabilities (futl) is cash flows from operation divided by total liabilities. beaver (1966) believes that this ratio reflects the amount of total liabilities its cash flows could bear. total liabilities to total assets (tlta) is total liabilities divided by total assets. beaver (1966) and ohlson (1980) reveal that this debt ratio has a significant prediction power for business financial crisis. financial crisis generally occurs due to a declining profitability from ineffective use of corporate capital. this paper studies the effectiveness in applying corporate capital and believes that the survival period for a financial crisis is related to its operational structure. corporate operational structure explains the effectiveness in the use of capital. returns on total assets (nita) measure corporate profitability meaning the return that each dollar asset creates. studies reveal that this rate is significantly associated with corporate financial crisis and the higher the rate, the better the profitability (altman, 1968; beaver, 1996; ohlson, 1980). altman (1968) uses retained earnings to total assets ratio (reta) to measure the degree of earnings accumulated when time passes. younger or profitless firms accumulate lower earnings which can lower this ratio and raise the delisting probability. altman (1968) employs market value of equity to total liabilities (mvetl) to evaluate how the value of corporate assets declines when total debts exceed assets. if this ratio is low, a serious asset value declining problem and a solvency crisis may exist, which may thus increase the delisting probability. corporate governance studies investigate internal control mechanism. it is generally believed firms can effectively supervise and restraint managers’ behaviors and lower their privileged consumption at corporate costs, resulting increases in firm value (fama and jensen, 1983; asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 153 jensen and meckling, 1976). this line of literature focuses on the impacts of board characteristics and ownership structure on firm values. we use the pledged share ratio of directors’ and supervisors’ and insider shareholding ratio to proxy corporate ownership structure in our paper. pledged share ratio of directors’ and supervisors’ (ratio) is measured by the total pledged shares of directors’ and supervisors’ to their total shareholdings. when directors and supervisors pledge their shares, it seems that they withdraw their investments but remain ownership control. if the ratio is high, distortion in ownership structure become serious which may raise its delisting probability. insider shareholding ratio (own) is measured by the total shareholdings of insiders (managers and directors) to the total outstanding shares. beneish (1997) indicate that in larger companies, managers have lower shareholding ratios and thus less incentive to maximize firm values. laporta et al. (1999) discover that when ownership is rather concentrated, firm value will be relatively higher. this paper uses shareholdings of managers’, directors’, and supervisors’ to represent the insider shareholding ratio. table 5. predict signs for predictors of delisting probability explanatory variables* predict sign definition firm size(size) log (total assets) firm age in years (age) years after establishment current ratio (cacl) current assets/current debts working capital to total assets (wcta) (current assets – current debts)/total assets total liabilities to assets (tlta) + total debts/total assets market value of equity to total liabilities (mvetl) (market values of common and preferred shares)/total debts cash flows to total liabilities (futl) operating cash flows/total debts returns on assets (nita) income before extraordinary items/average total assets retained earnings to total assets (reta) retained earnings/total assets pledged shares % of directors’ and supervisors’ (ratio) + pledged shares of directors’ and supervisors’/their total shares insider shareholding ratio (own) shares of managers, directors, and supervisors/total outstanding shares *above predictors use quarterly data in the information of financial, stock prices, pledged share ratios of directors’ and supervisors’, and insider share holding ratio. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 154 based on the descriptive statistics in table 6, we find that the average of the igco observations is 15 quarters. because certain firms have censored data, the average survival period is thus without actual meanings. the average age is 13 quarters, but the standard deviation is quite large at 9.7087, meaning that our sample firms are not concentrated at a certain year range, which is measured from the establishment to the beginning of our research period. the current ratio has an average value of 68%, revealing a depressed short-term solvency for the igco sample. table 6. descriptive statistics and mean differences variable mean standard deviation mean differences* time 14.71241 12.04414 0.7524 age 13.18954 9.70807 -0.4873 size 14.78033 1.18690 -0.3083 cacl 0.68113 0.44511 8.9689 wcta -0.32609 0.59220 28.4319b tlta 0.89929 0.44286 -27.1754b futl -0.00229 0.02856 -0.088% reta -0.19611 0.36995 5.2631% mvetl 0.19678 0.40282 0.2623a ratio 0.25968 0.33574 -16.3824%a own 0.01040 0.03812 -0.654% a is significant at a 0.01 level, and b is significant a 0.05 level. *is the difference between the delisting firms and those remaining operation at the end of 2006. 5. empirical results information is costly and some are even limited or not obtainable when investors need useful information to make investment decisions. this paper applies both financial and no financial information to investigate delisting factors for igco firms. our study examines four models of corporate structure combinations under insufficient or sufficient information assumption. for insufficient information assumption, three structure models, the general financial, general operation, and general ownership are tested respectively. the sufficient information model has all corporate financial and non-financial structures into the model, including the general, financial, operational, and ownership structure. we discuss the relation between different corporate structures and its delisting and search for significant impact predictors for corporate delisting. table 7 includes our empirical results. according to model 1 in table 7, insignificant financial predictors for delisting are current ratio (cacl), working capital to total assets ratio asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 155 (wcta), debt ratio (tlta), and market value of equity to total debt ratio (mvetl). the result shows that ratios in financial structure are inefficient predictors for delisting. model 2 includes three ratios of returns on assets (nita), retained earnings to total assets (reta), and market value of equity to total debts (mvetl) in corporate operational structure to its impacts on delisting. among these ratios, the retained earnings to total assets (reta) ratio has a significant and negative impact on delisting. when in financial distress, corporate performance and profit decline which reduce accumulated earnings as a result. this shows that inappropriate application of corporate resources may cause its assets to function incompletely. in addition, the market value of equity to total debts ratio (mvetl) is also significant and negative. after the issuance of igco, corporate stock prices fall, market values shrink, and debt paying ability even lowers, resulted in a higher delisting probability. model 3 has two ratios in the corporate ownership structure to predict delisting, including the pledged share rate of directors’ and supervisors’ and insider shareholding ratio. among these two ratios, the insider shareholding ratio has a significant and positive effect on delisting. large ownership shareholders pledge their shares to obtain capital and make inappropriate investment decisions, causing corporate financial crisis as a result. this situation is normally observed in taiwan public companies and eventually they are desisted from the market. model 4 incorporates all four corporate structures into the model when information is sufficient to exam its impacts on delisting. the empirical results show two significant and negative impacts on delisting, the retained earnings to total assets ratio (reta) and the market value of equity to total debts ratio (mvetl). the pledged share ratio of directors’ and supervisors’ has a significant and negative impact, meaning that applying operational and non-financial ownership structure together into the model is useful in predicting corporate delisting. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 156 table 7. empirical results based on the proportional hazard model mode 1 model 2 model 3 model 4 cacl -0.315(0.276) -0.107(0.289) wtca 0.216(0.241) -0.082(0.270) tlta 0.209(0.351) 0.156(0.451) futl 1.895(3.812) 4.535(3.948) nita -24.79(48.36) -15.26(56.557) reta -0.680(0.404) * -0.747(0.416) * mvetl -0.924(0.295) *** -0.991(0.416) *** ratio 0.978(0.364) *** 0.857(0.407) ** own -1.140(3.120) -0.509(3.337) age -0.044(0.014) *** -0.049(0.014) *** -0.041(0.014) *** -0.049(0.014) *** size -0.093(0.099) -0.103(0.098) -0.027(0.097) -0.069(0.104) log-likelihood -357.224 -353.186 -354.516 -350.046 restrict log-l slope=0 -365.859 -365.859 -365.859 -365.859 standard deviation in the brackets, *, **, and ***represent significant at the level of 0.05, 0.025, and 0.01. model 1 includes corporate general and financial structure. model 2 includes corporate general and operational structure. model 3 includes corporate general and ownership structure. model 4 includes corporate general, financial, operational, & ownership structure. 6. conclusion after the issuance of an initial going-concern opinion (igco), users of financial statements concern about whether the firm will be delisted from the market, or it will depart from financial crisis and continue its operation. previous studies suggest employing the binary choice model as a tool for auditors to evaluate the issue of going-concern for the firm. the choice model is used to predict future business failure possibility, and early relevant impacts of igco. on the other hand, important issues that capital markets concern about is the occurring time for delisting, the maximum delisting probability, or the length of survival period after the opinion by igco firms. furthermore, because the binary choice model can only simply to predict the maximum delisting probability, the timing process for delisting cannot be fully understood, which may lower the prevention and treatment function in crisis forecasting models. we employ the proportional hazard model on the sample of taiwan igco delisting firms to discuss the delisting dynamic process after been issued with an igco. first, we obtain a life table from the research period data by a non-parametric analysis and learn that after 38 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 157 quarters from igco issued, the sample has a highest delisting probability during our research period. after issued with an igco, the delisting hazard period is about nine years, with a high delisting probability of 10%. this paper applies four corporate structures to measure impact factors on the delisting function and find that except for the ratios of equity to total debts and retained earnings to total assets, explanatory variables in corporate financial structure are all insignificant factors. however, the pledged share ratio of directors’ and supervisors’ in ownership structure, representing corporate governance has a significant and positive impact on delisting. generally, objective financial information can be used to measure operational performance. auditors issue the going-concern modified opinion based on their professional judgment about clients’ financial statements and relevant information. when such a modified igco is issued, unhealthy financial structure of the firm has already existed for a long time. then it would be misled by these financials to evaluate its future operational performance. by assisting with non-financial information, decisions about a delisting crisis for igco firms can be evaluated. among our results, corporate governance structure is proved to be an important index. however, our results reflect that by merely applying financial information to evaluate factors for delisting in taiwan igco sample is insufficient. more importantly, the result shows that corporate governance mechanism is related to the issue of going-concern operation. 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(2005). the efficacy of auditor’s going–concern opinions compared with a temporal and an temporal bankruptcy risk model: analyzing u.s trade and service industry failures 1974-1988. pacific accounting review, 3-36. schmidt, p., & a. d. witte. (1989). predicting criminal recidivism using split population survival time model. journal of econometrics, 40, 141-159. http://dx.doi.org/10.1016/0304-4076(89)90034-1 microsoft word 6543-23361-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 172 corporate governance and profitability of nigerian banks akinyomi oladele john (corresponding author) department of accounting and finance, mcpherson university, ogun state, nigeria e-mail: delejohn21@yahoo.com, akinyomio@gmail.com olutoye ebenezer adedayo banking and finance department, afe babalola university, ado ekiti, ekiti state, nigeria e-mail: olutoyedayo@yahoo.com received: nov. 3, 2014 accepted: may 22, 2015 published: june 10, 2015 doi:10.5296/ajfa.v7i1.6543 url: http://dx.doi.org/10.5296/ajfa.v7i1.6543 abstract the nigerian banking environment is a vibrant and challenging financial environment and is endemic with systemic governance problems, capacity constraints and defaulting in compliance and implementation of laws which has inhibited economic growth. therefore the current investigation focuses on association between organizational governance and profitability of deposits money banks in nigeria. three indicators of corporate governance mechanism (board composition, board size and directors’ interests) were incorporated in the study. relevant information was extracted from audited financial statements of the selected banks. the results of the regression analysis revealed the existence of positive but non-statistically significant association between board composition and profitability on one hand; and board size and profitability on the other hand. however, a non beneficial and non-significant association exists between directors’ interests and profitability in the nigerian banks. based on the findings of the study, the study recommends that in order to prevent distress in the banking sector, there should be a regular review of the corporate governance codes so as to reflect current social, environmental, technological and economic situations. keywords: board composition, board size, directors’ interests, profitability asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 173 1. background the nigerian banking environment is a vibrant and challenging financial environment and is endemic with systemic governance problems, capacity constraints and defaulting in compliance and implementation of laws which has inhibited economic growth (suberu & aremu, 2010). this requires enhanced investigations, and more detailed reporting of activities. the penalties of organizational collapse are very expensive for an emerging economy such as nigeria (mohammed, 2012). mmadu (2013) reported that the global economic crisis and the decline in the value of investment collections of deposit money banks particularly in nigeria are due to distorted credit management and this problem can be traced to poor corporate governance. schjoedt (2000) (as cited in mmadu, 2013) also observed that this was as a result of the association amongst the financial institutions, politicians and large-size enterprises. prior to the introduction of new prudential guidelines in nigeria, which culminated in the consolidation of the banking industry; there were about 89 active players with dull performance, cases of negligent and reckless managers and directors and the reign of ethical abuses (mmadu, 2013). bad business governance remains one of the most important causes in almost all reported cases of bank failure in nigeria. the pre-consolidation era was characterized by poor organizational governance which manifests in form of inadequate internal control mechanisms, fraudulent practices, non-compliance to limits of authority, failure in paying attention to principles of discreet lending, nonexistence of risk management procedures, and override of internal control measures (mmadu, 2013). thus, the current investigation focuses on the relevance of organizational governance on earnings in the context of the nigerian banking sector. the following hypotheses were formulated in order to achieve the set objective: hoi: there is no significant relationship between board size and bank’s financial performance. hoii: there is no significant relationship between board composition and bank’s financial performance. hoiii: there is no significant relationship between director’s interest and corporate financial performance. 2. extant literature wessels and wansbeek (2014) relate governance to the exercise of authority, direction and control. it is a concept that has a history that could be traced to chaucer, which carries with it the implication of prudence (uwuigbe, 2011). organizational governance represents a number of procedures, habits, pattern of operations, and rules that influence the manner an organization is governed (dar, naseem, rehman, & niazi, 2011). corporate governance represent methods through which organizations are being administered, a structure through which the welfare of different parties with vested interests are harmonized, showing group of interaction between a company’s administration, its board, its shareholders and other interested parties (cheema & din, 2013). it involves the interaction among the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 174 many interested parties concerned and the reasons while the corporation is being managed (dar, naseem, rehman, & niazi, 2011). organizational governance represents a noteworthy variable which establish the strength of the organization and the company’s capability to live through financial shake-ups (uwuigbe, 2011). the overall focus of organizational governance has to do with developing reliability, guaranteeing openness and responsibility (uwuigbe & fakile, 2012). the merits of good corporate governance are evidenced in its role towards financial firmness through corporate profitability improvement and boosting organizational opportunities to obtain outside funds, serving government policy goal, lowering vulnerability of the economic disaster, and reducing expenditure incurred in obtaining funds (latif, shahid, haq, waqas, & aeshad, 2013). good governance also encourages support and assurance in the banking system (mohammed, 2012). 2.1 the board of directors and its size it is the responsibility of the board of directors to guarantee that the business is enjoying maximum benefits of prevailing occasions and ensuring that the economic worth of the organization is enhanced, being successful when its ability to make choices and affect the administrators is incredibly strong (uwuigbe & fakile, 2012). the board should check the behaviours of managers for owners’ welfare, decide on crucial issues, hire set of administrative officers and oversee that organizations adhere to the rule while taking responsibility for managing and supervising (akinyomi, 2013). the board of directors uses its powers and responsibilities within the structure of legislation, main contract, regulations and policies, and represents the company in line with the authority given to it at the general meeting of shareholders (dogan & yildiz, 2013). the economic worth of an organization would further be enhanced as the board carries out its functions which include supervision of the operations of administrative officers and choosing the employees of an enterprise, appointing and monitoring the activities of an autonomous auditor to boost the worth of the company (uwuigbe, 2011). when the number of board membership goes up, there would be possibility for divergent opinions which could result in more confusion among board membership (dar, naseem, rehman & niazi, 2011; adegbemi, donald & ismail, 2012). previous studies on this concept observed that organizations select size of board to create equilibrium between the requirements for timely advice and the financial implications of maintaining large board membership (akinyomi, 2013). the board of directors performs its duties in the form that it would ensure and provide a long term and stable earnings to the company shareholders while aiming at the maximization of market facilities by the companies (dogan & yildiz, 2013). the board includes internal and external directors (akinyomi, 2013); whose role includes chief executive officers’ and organizational administrators’ regulation in order to boost the economic worth of the company (uwuigbe, 2011). 2.2 firm performance profitability is one of the major reasons for the existence of business enterprises (akinyomi asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 175 & olagunju, 2013), and business enterprises continue their operation by making profits (ayse, 2013). organizational performance has to do with the approach and method by which things of economic value existing in a corporation are prudently utilized for the achievement of the general business goal of a particular enterprise (latif, shahid, haq, waqas & aeshad, 2013; akinyomi, 2014). banks are business enterprises and as such their aim is to make profits just like any other profit making organizations. in this regard, the profitability which is an indicator of economic result of any organization indicates the success of its management, which also makes it one of the most important indicators for the investors (ayse, 2013). the current study anchors on some theoretical foundations, particularly the stakeholder and agency theories. these were selected because of their relevance to the composition of the hierarchy of corporation and the functions of the directors, with respect to reporting to the shareholders 2.3 stakeholder theory according to akinsulire (2011), there are diverse sets of individuals with vested interests in any organization. these include the ordinary and preference shareholders, providers of funds, workforce, those who supply materials used by the organization, consumers and general public. every member of these sets of individuals have to be rewarded a smallest amount as the removal of their involvement could result in the shutting down of the business (akinyomi, enahoro & olutoye, 2013). since institutions do not exist to serve their own purposes alone (agle, donaldon, freeman, jensen, mitchell, wood, 2007), the company’s continuous existence depends on meeting together its financial and non-financial goals by satisfying the different demands of the organization’s diverse interested parties (pirsch, gupter & grau, 2007). stakeholder theory could be expressed in two main enquiries (freeman,1994). these two main enquiries include inquiry on the objective of the organization and also what is the responsibility of management to the stakeholders. 2.4 agency theory there has been a focus on the agency theory with emphasis on the principal-agent problem (sami, wang & zhou, 2009); the theory which has its foundation in economic theory has become dominant in the corporate governance literature (uwuigbe, 2011). the theory asserts that most of the time, the objectives of the organizational administrator do conflict with those of the real owners of the business. this means that business owners have to connect their economic rewards with salaries and other remuneration of the organization’s administrators. the moment it becomes difficult to predict the way business administrators would behave, and then their remuneration becomes a governance issue geared towards motivating them to carry out their duties in the best interest of the owners (vo & phan, 2013). the theory agrees with the designation and absorption of leadership of members of the board and the utilization of encouraging remuneration packages, while the board monitors the managers by means of periodic reporting, evaluation and the adoption of laid down guidelines (uwuigbe, 2011). in spite of the fact that some studies on agency theory recommends that appropriate governance may possibly minimize agency expenses and boost the earnings of business asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 176 owners, some results of other investigations suggest otherwise. one likely explanation to this divergence of results may be the utilization of different indicators of organization governance (sami, wang & zhou, 2009). in organizations, owners-managers conflict happens in situation where the interest of managers contradicts that of the owners (sami, wang, & zhou, 2009). the theory presents a structure to provide explanation on the ways to ensure efficiency in supervision and motivation system in situations of partial and imperfect knowledge (sami, wang, & zhou, 2009). 2.5 empirical review there are several studies conducted in the past which focused on organizational governance (wessels & wansbeek, 2014). therefore, this review is eclectic in that it considers the investigation of corporate governance and corporate performance from several countries: denmark, china, bangladeshi, pakistan, sri lanka and of course, the united states. bennedsen, kongsted and nielsen (2007) used data comprised of the entire public companies in denmark during the period ended 1999. chief executive officer’s family characteristics were the major approach in determining the influence of size of board membership on organizational profitability. they used six thousand eight hundred and fifty companies, extracting data on chief executive officer’s family features. they re-examined the existence of any association between size of board membership and organizational profitability. the report of the ordinary least square analysis showed the presence of a high favourable association between board size and family size. it further indicated that such an association was facilitated in companies where the chief executive officer’s family members were board members. bhagat and bolton (2009) related corporate governnace to performance in the light of the sarbanes-oxley act. they separated the companies on the basis of time-frame of prior to year 2002, and the second group beginning from year 2002 upwards. this was done to reveal how the different regulations could have affected the companies’ profitability within the time periods. relevant information was extracted from risk-metrics directors and governance databases. put together, it was reported that there was variation in the association between board independence and companies’ profitability in the preand post2002 era. the study documented a negative association between board independence and profitability in the pre 2002 era. meanwhile in the post 2002 era, they found a positive association between board independence and operating performance. in china, sami, wang and zhou (2009) made their study stand out by using a compound indicators of organizational governance in investigating the effect of organizational governance on firm profitability and appraisal in china. with a theoretical foundation in the agency theory, return on assets, return on equity and tobin’s q were used as the dependent variables in their model. the outcome of the investigation supported the hypothesis that concentration of shareholders and board independence has favourable effects on organizational profitability and appraisal. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 177 kutubi (2011) gave a closer look at the board, with emphasis on its size and the independence of its directors. the study investigated the association between bank board size, independent directors and profitability of bangladeshi commercial bank after the prudential regulation issued in the country; using a sample of selected banks for the period 2005-2009. bank performance was measured with roa and roe, alongside the tobin’s q. understanding the behaviour of directors on the performance of the banking firm was the justifiable reason for the use of the effect of size, leverage and performance of loan as control variable. the outcome of the analysis indicated a statistically significant positive association between bangladeshi banks’ board size and their profitability in terms of tobin’s q, but no significant relation in terms of roe and roa. a study was conducted in pakistan on the association between organizational governance system and organizational performance indicators for a period between year 2004 and 2010 (dar, naseem, rehman & niazi, 2011). the study highlighted some failures in pakistan which were caused by lack of corporate governance. the regression analysis showed that profit margin is positively correlated with the firm’s board size. the study reported that larger board size enhances profitability of the organizations. in sri lanka, danoshana and ravivathani (2013) carried out an investigation on the association between organizational governance and profitability. data for the study were subjected to regression analysis; and the result revealed that organizational governance mechanisms of board size, how often they meet and the size of audit team have considerable effect on organizational profitability. while board size and size of audit team are favourably associated with organizational profitability; how often they meet has a negative relationship with firm performance. another investigation on organizational governance was carried out in pakistan with specific data drawn from the cement industry. the investigation considered the association between organizational governance and companies’ profitability (cheema & din, 2013). panel data covering 15 organizations operating between 2007 and 2011 in the cement sector in pakistan was used. relevant information was extracted from financial statements of the selected companies. the results showed that board size has no considerable association with profitability; meanwhile chief executive officers’ duality has effect of organizational profitability. wessels and wansbeek (2014) focused their discussion paper on the existence of noteworthy association between organizational governance arrangements and its profitability. data were obtained from business organizations in the united states of america in order to evaluate the existence of association between governance and corporate earnings. the findings of their investigation indicated the existence of noteworthy association between governance and corporate earnings. the interpretation given to the result was that it provided support that organizations decide to put into operation efficient organizational governance mechanisms considering the prevailing occasions. on the other hand, when the effect of the investment opportunity set was not accounted for, they could calculate the unconditional correlation between governance and performance. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 178 the study of uwuigbe (2011) set out to examine the correlations of relationships between financial performance of banks and each of the following: board size, existence of foreign directors, ratio of non executive directors, directors’ equity interest, and organizational governance disclosure, the investigation further inquire whether there was considerable distinction between the earnings of strong banks and those of weak commercial institutions. for ascertaining the degree of organizational governance disclosure in the banks, the investigation employed content analysis in obtaining relevant information from the financial statements of the financial institutions, while the panel data methodology was used. the regression analysis revealed the existence of noteworthy but unfavourable association between board size and profitability. the regression result for outside directors showed unfavourable association with profitability. the regression result for directors’ equity holding showed positive relationship with performance. for government disclosures, the finding showed favourable and considerable association with performance. 3. material and methods this study employed correlational research design. four banks were randomly selected from the existing twenty-two banks in nigeria as at the end of year 2013. the study was based on information obtained from annual reports of selected commercial institutions in nigeria for the period 2008-2012. the analysis was carried out using regression model. the model for the study is as follows: y= β0 + β1x1+ β2x2+ β3x3 + µ where, y= dependent variable (bank’s profitability) β0 = intercept coefficient β1 = standardized regression coefficient for each of the independent variables. x1= board size x2= board composition x3= directors’ interest µ = stochastic variable. 4. results and discussion the data analysis result is presented in table 1 below; this was immediately followed by the interpretation and discussion of the findings. table 1. regression result with roe as dependent variable variable coefficient std. error t-statistics probability board composition 0.016 0.021 0.754 0.461 board size 0.123 0.131 0.933 0.363 directors’ interests -0.634 0.653 -0.971 0.344 source: researcher’s computation (2014) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 179 the result revealed the existence of a positive relationship between board composition and profitability. however, the probability of t test of profitability is not statistically significant at 5% with p value of 0.461 which is greater than critical value of 0.05 for board composition; while the coefficient value on roe is 0.016. this connotes that there is no statistically significant relationship between board composition and profitability in the nigerian banks. return on equity will be increase by 2% if board composition changes by one. this means change in board composition will not result in high financial performance. similarly, the result revealed the existence of a positive relationship between board size and profitability. this means that the larger the board size, the more effective the board becomes in monitoring banks’ managers. however, the probability of t test of profitability is not statistically significant at 5% with p value of 0.363 which is greater than critical value of 0.05 for board size; while the coefficient value on roe is 0.123. this connotes that there is no statistically significant relationship between board size and profitability in the nigerian banks. return on equity will be increase by 12% when board size increases by one person. this means increase in board size will not result in high financial performance. however, the result revealed the existence of a negative relationship between directors’ interest and profitability. nevertheless, the probability of t test of profitability is not statistically significant at 5% with p value of 0.344 which is greater than critical value of 0.05 for directors’ interests; while the coefficient value on roe is 0.634. this connotes that there is no statistically significant relationship between directors’ interests and profitability in the nigerian banks. return on equity will be reduced by 63% when directors’ interests increase by one unit. this means increase in directors’ interests will not result in high financial performance. 5. conclusion and recommendations the current investigation focuses on the effect of organizational governance on the profitability of commercial banks in nigeria. three indicators of corporate governance mechanism (board composition, board size and directors’ interests) were incorporated in the study. data were obtained from audited annual reports of the selected banks. the results of the literature review and data analysis revealed the existence of a positive but non-significant relationship between board composition and profitability on one hand; 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(2014). what is the relation (if any) between a firm’s corporate governance arrangements and its financial performance? cesifo working paper 4599. available at ssrn:http://ssrn.com/abstract=2393995 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 6342-22749-1-sm-writer2-new2 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 487 stakeholders’ perception of the independence of public sector auditors in nigeria oyerogba ezekiel oluwagbemiga (corresponding author) department of economics, accounting and finance jomo kenyatta university of agriculture and technology, kenya tel: 23-480-6630-8115 e-mail: oyeezekiel2903@yahoo.com solomon adeoluwa zaccheaus department of economics, accounting and finance jomo kenyatta university of agriculture and technology, kenya e-mail: a.zsolomon@yahoo.com olaleye michael olugbenga department of economics, accounting and finance jomo kenyatta university of agriculture and technology, kenya e-mail: olaleyeolugbenga@yahoo.com adesinatemitopeoluwaseyi accountancy department, federal polytechnic, offa, kwara state, nigeria e-mail: sheyitope@yahoo.com received: sep. 22, 2014 accepted: nov. 20, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6342 url: http://dx.doi.org/10.5296/ ajfa.v6i2.6342 abstract this study is an endeavor to investigate the extent to which public sector audit independence was achieved and how it was achieved in nigeria. the emphases were on the three significant aspect of independence (investigative independence, reporting independence and financial independence) which were used in formulating the three hypotheses that guided the study. by asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 488 means of survey design, the study relied on primary data obtained through a well-structured questionnaire administered to a sample of 96 respondents randomly selected from the population for the study. employing both descriptive and inferential statistics for the analysis, it was observed that a high level of independence was maintained by the public sector auditors in nigeria. similarly, the results of the inferential statistic revealed that there is likelihood of quality audit assignment where investigative independence, reporting independence and financial independence of auditor general is guaranteed. it is therefore appropriate for the legislature to put in place necessary machinery to promote the independence of the auditor general at all level of governance if the objectives of providing transparent and responsible government will be achieved. keywords: audit independence, public sector organization, reporting independence, investigative independence, financial independence asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 489 1. introduction 1.1 background of the study independence has always been considered a crucial attribute of an auditor, external or internal, private or public. the national audit office (uk) public audit manual of 1988 and developed by and for commonwealth nations’ auditor generals established certain criteria for promoting the independence of public sector auditors (auditor general) (andy, 2001). the criteria among others include that the appointment and dismissal of the auditor general not to be within the prerogative of the executive, the auditor general’s salary to be a direct charge on public fund and not subject to annual appropriation, the auditor general’s right to report directly to the legislative rather than to and through the executive and to decide the nature and timing of the report, the auditor general to have the power to appoint and pay the staff in line with the civil service condition but subject to budgetary approval by the legislature or a body empowered to so by the legislature, the auditor general to have a right of access to papers and information and to obtain information and explanations, and that the audit mandate should cover all public enterprises (andy, 2001). similar provisions can be found in local regulations such as audit act of 1958, section 24 of the finance (control and management) act of 1958, the fiscal regulation of 1976, the audit standard, civil service rules and section 85(2) of the 1999 constitution of the federal republic of nigeria (omolehinwa, 2004). however, it has been recently observed by galwene, (2008) that this independence that is a panacea to the success of any auditing job is only a theoretical provisions and not being enjoyed by public sector auditors. oladipupo&izedonmi, (2013), stated that for the audit report to be publicly accepted as reflecting the true and fair view the organization position, auditors must be seen to be indeed truly independent. in addition to technical competence, auditor independence appears to be the most important factor in establishing the credibility of the audit opinion (baker, 2005). therefore, considering the significant role of audit report in improving the quality of financial statement, this study attempted to investigate the level of independence being enjoyed by the auditors at the three tiers of government in nigeria (federal, states and local governments) compare to their counterparts in the private sectors.nigeria democratic system is structured into three tiers with each government holding a separate and distinct account as allocated from the federal treasury and in addition to other revenue derived frominternally generated revenue such as taxes and levies. this in turn, has put a responsibility on the leadership and management of these tiers of government to render a stewardship report to the citizenry who have given them the mandate to manage their resource. however, for these reports to achieve its intended purpose there is a need for the provision of written reasonable assurance from independent sources that the financial statements present a true and fair view in accordance with the accounting standards (oladipupo&izedonmi, 2013). 1.2 statement of problem recent corporate scandals and legislation like the sarbanes-oxley act have spurred the public to focus on the importance of governance (nashuwa, 2005). according to john, (1995) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 490 governance is not limited to business entities: it is important to public sector entities as well. public sector entities include state and local governments, federal agencies, public utilities, hospitals, colleges and universities, pension plans, city councils, boards of trustees, legislatures, and boards of governors (doyle, 2005). governance in the public sector deserves the same attention as governance in the corporate sector. while unethical behavior in the corporate sector impacts the shareholders of a company, unethical behavior in the public sector impacts all taxpayers and citizens (muhamad&kabhari, 2006). in other words, government programs should be managed in a way which represents value for money for the taxpaying community. however, the recent scandals involving long island school districts illustrate all too well that this objective has not been achieved even in the developed societies (nashuwa, 2005). the government is obliged to account to taxpayers for its management of public funds and services. it must ensure that funds are properly raised, protected from loss, and spent with maximum efficiency and effectiveness for the purposes approved by parliament (doyle, 2005). consequently, for effective functioning of the management, there is a need for independent monitoring in form of auditing. therefore, u.s. government accountability office (gao) in 2003, recommend that public sector entities consider the benefit of strengthening the independence of auditor general. 1.3 aims and objectives of the study primarily, the study aim at investigating the extent to which public sector audit independence is achieved and how this independence is achieved in the nigeria public sector organizations. the specific objectives include: (i) to investigate the extent to which investigative independence is achieved in the public sector organizations. (ii) to investigate the extent to which reporting independence is achieved in the public sector organizations (iii) to investigate the extent to which financial independence is achieved in the public sector organizations. (iv) to determine the effect of investigative independence, reporting independence, financial independence on the quality of audit assignment in the public sector organizations. 1.4 significance of the study this study contributes to the existing body of knowledge, as well as make up for the paucity of scholarly papers in nigeria on independence of public sector auditors. also, the findings of this study will aid an efficient and effective performance of duties by the auditor generals in nigeria. regulatory authorities will also find the study helpful in policy making and implementation. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 491 1.5 research questions supporting the research objectives stated above, the following research questions were raised and will be answered during analysis. (i) to what extent does public sector auditors enjoyed investigative independence (ii) to what extent does public sector auditors enjoyed reporting independence (iii) to what extent does public sector auditors enjoyed financial independence (iv) to what extent is the audit engagement in the public sector organizations affected by investigative independence, reporting independence and financial independence 1.6 research hypotheses the following research hypotheses were formulated in null form for the study in line with the research questions and objectives. (i) there is no significant relationship between the quality of audit assignment and auditor’s investigative independence. (ii) there is no significant relationship between the quality of audit assignment and auditor’s reporting independence. (iii) there is no significant relationship between the quality of audit assignment and auditor’ 2. review of literature. 2.1 theoretical review. theoretical framework serves as a base for the interpretation of empirical results of a study. the main theory for this study is the performance theory of public sector auditing. 2.1.1 performance theory of public sector auditing after the beginning of the transitional period to market based economy, the central and eastern europe countries had to re-establish a proper auditing practice as befits a democratic institutional system. the theory for the new institutional framework was based, in the majority of the countries concerned, on the legislation and experience of western democracies. the adoption of performance auditing in the public sector is one of the more significant new additions to the traditional auditing role (financial audit). in a financial (or regularity) audit, the auditor expresses an opinion whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. in a performance audit, the auditor expresses an opinion whether, in all material respects, the administration of a particular program or entity has been carried out economically and/or efficiently and/or effectively. performance auditing is relatively a new type of audit. performance audit represents according to the intosai international audit standards1, an independent, assessment or examination of the extentto which an activity, program or public institution operates efficiently and effectively, with due regardto economy. as proposed by adriana, (2007), it is important to understand that in the present days, sufficient condition does not asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 492 mean that the public money are spent according to law provision, but they must be under the economic, efficient and effective condition too. this new type of audit has evolved to meet the need for greater information by the taxpayer and its representative, parliament, mainly regarding the efficiency and economy in the use of resources by the public managers acting on behalf of the executive. these requirements prompted audit offices to develop their own institutional capabilities and to apply the highest standard auditing procedures and techniques to ensure that decision makers can be assured that the budgetary resources and assets are utilized in an economical and effective way. in addition to that, demirag and khadagoo, (2012) stated that the robust objective setting and performance appraisal systems, which are essential prerequisites for a workable performance management system is essential in achieving the objectives of performance audit. 2.2 empirical review 2.2.1 the concept of auditor’s independence the initial concept of auditor independence was primarily of british origin, in the 19th century, where auditors doubled as book keepers (baker, 2005). aderibigbe (2005) views independence as an emotive word serving as a banner for freedom, integrity and all that is good. auditor independence according to dictionary of international accounting terms (2001) infers a state of impartiality required of auditors who should have no personal or financial involvement with a client. louwers et al. (2007) expresses independence as a mental attitude and physical appearance which portrays the auditor as being uninfluenced by others in judgment and decision. this can be sustained by avoiding financial connection that makes it appear that the wealth of the auditor depends on the outcome of the audit and management connections that makes the auditor appear as if he is involved in management decisions. as a key ingredients of audit quality gray & manson (2000) and hayes et al. (2005) described independence as a position required in other to take an unbiased viewpoint in the performance of audit tests, analysis of results and attestation in the audit report. despite all the definitions, and descriptions of auditor independence, whittington &pany (2004) concluded that auditor independence is relative and not absolute. according to tairu (2009), auditor independence comprises of programming independence, investigation independence, and reporting independence. of these three components, reporting independence is the most likely to be influenced by the directors of a client company. this is the foci of this research. the independence of auditors is seen as a means and not an end in itself (mcgrath,et al., 2001). consequently, smith (2003) opined that the prime responsibility of maintaining independence and objectivity rests with the auditor. 2.2.2 investigative independence iyawe (1997) viewed investigative independence as protecting the auditor’s ability to implement the strategies in whatever manner they consider necessary. similarly as perceived by dunn, (1996) auditors must have unlimited access to all client information. in like manner, baker, (2005), suggests that queries regarding a client’s business and accounting treatment asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 493 must be answered by the client. paul and walker, (2009) opined that the collection of audit evidence is an essential process, and cannot be restricted in any way by the client company. 2.2.3 reporting independence reporting independence was recognized by iyawe, (1997), as instrument protecting the auditor ability to choose to reveal to the public any information they believe should be disclosed. if company directors have been misleading shareholders by falsifying accounting information , they strive to prevent the auditors from reporting this .it is situation like this that auditor independent in most likely to be compromising like this that auditor independence is most likely to be compound. 2.2.4 financial independence it has been observed that the more economically dependent the auditor is on the client, the more likely the auditor is to succumb to client pressure (nelson, elliot &tarpley, 2002; trompeter, 1994). mautz and sharaf (1961) recognize the auditor‘s financial dependence on clients as a built-in-anti-independence factor. they further observe that since auditors are financially dependent on the client, their independence as regards the financial reports might be reduced. deangelo (1981) argues that future economic interest in a client reduces the auditor‘s independence towards the client. in other words, the greater the client-specific quasi-rent stream, the less likely the auditor is to report a discovered breach. 3. methodology 3.1 research design by means of survey research design, this study examined the extent that public sector audit independence is achieved the how this independence is actually achieved in nigeria. the choice of this design was due to the fact that the research perceived it as being appropriate because of his lack of control over the responses and inability to manipulate sample subject. 3.2 population of the study the population for this study consisted of the auditor general of the federation and all the staffs in the office of the auditor general of the federation and also the auditor general for the 36 states in nigeria and all the staffs in their respective offices. 3.3 sample and sampling techniques the data used for this study were collected from a sample of 105 respondents using a stratified sampling technique and simple random sampling technique. since the south west region was used as the study location, a state was regarded as a stratum and 15 respondents were randomly selected from the state auditor general office of the six states in the region and the remaining 15 respondents were selected from the office of the auditor general for the federation to arrive at the sample for the study. the adoption of this sampling technique was based on the criteria set by the researchers which include the experience of the respondent, their knowledge on the subject matter, and their reasoning ability. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 494 3.4. research instrument for data collection. the data for the study were generated by means of a well-structured questionnaire administered to 105 staff of the selected states and the federal capital territory. the reason for this instrument was that questionnaire is the most widely used instrument for data collection and because it is a quick means of obtaining the views of the respondents on a wide range of subjects. 3.5.1 validity of research instrument to enhance the validity of the research instrument draft copy of the instrument was given to 3 holders of doctor degree in accounting 2 chartered accountants and 2 retired auditor general whose constructive criticisms were taken into consideration to ensure that the questionnaire contained all the relevant dimension of the study. 3.5.2 reliability of research instrument. towards assuring the reliability of the instrument, a test and re-test method was used. the aim was to find out how consistent the instrument was in collecting the required data for analysis. the results of reliability analysis revealed a cronbach alpha 0.928 for items relating to financial independence, 0.886 for investigative independence and 0.869 for items relating to reporting independence. the psychometric tests suggest the presence of reasonable level of reliability 3.6 administration of research instrument. one hundred and five (105) copies of the questionnaire were distributed by the researcher with the help of two 2 research assistant to the respondents directly. ninety six (96) copies of the questionnaire were returned representing 91.4% of the total copies distributed, while nine (9) copies were not returned due to constraint of time representing 8.6% of the total copies distributed. 3.7 statistical tool/ analytical procedures the study adopted both descriptive and inferential statistics for the analysis of data. descriptive statistic includes the frequency and percentage while the inferential statistic focused on multiple linear regression analysis with the aid of statistical package for social science (spss) version 17.0. the general formula for the study model was as follows; y =β0 + β1x1 + β2x2 + β3x3 + μ where; y = auditor assignment x1 = investigative independence x2= reporting independence x3= financial independence asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 495 in the model, β0 = the constant term while the coefficient βii= 1….3was used to measure the sensitivity of the dependent variable (y) to unit change in the predictor variables. μ is the error term which captures the unexplained variations in the model. 4. analysis and interpretation of data 4.1 presentation of demographic data tables 1 shows that out of the 96 respondents, fifty eight (58) respond representing 60.4% were males while the remaining 38 respondents representing 39.6% were females. this shows that the male respondents were more than the female respondents. it was also revealed that 16 respondents representing 16.7% had between 1-5 years working experience, 20 respondents representing 20.8% of the total had working experience of 6-10 years, 8 respondents representing 8.3% had worked for 11-15 years, 24 respondents (25%) possessed between 16-20 years of working experience, while the remaining 28 respondents representing 29.2 of the total had worked for over 20 years in the field. it can therefore be said that majority of the respondents had worked for over 20 years. furthermore, the results on educational qualification shows that 4 respondents representing 4.2% possessed an ssce certificate, 64 respondents, representing 66.6% of the total possessed bsc / hnd qualification, 28 respondents (29.2%) of the respondents possessed msc/ mba degree as their highest academic qualification. this implies that majority of the respondents were bsc./hnd holders, meaning that a group of learned and experience staffs in the subject investigated covered were selected for the study. in like manner, it was also observed that 44 respondents (45.8%) belonged to the professional membership of ican, 12 respondents representing 12.5% of the total belonged to the professional membership of anan while the remaining 40 respondents representing 41.7% of the total did not belong to any professional institute. this implies that majority of the respondents are professionally qualified for their job. table 1. presentation of demographic data of the respondents gender male female frequency frequency 58 60.4 38 39.6 work experience 1-5 years 6-10 years 11-15 years 16-20 years 20 & above frequency % frequency % frequency % frequency % frequency % 16 16.7 20 20.8 8 8.3 24 25 28 29.2 educ. qual. ssce bsc./hnd msc./mba frequency % frequency % frequency % 4 4.2 64 66.6 28 29.2 prof. qual. ican anan others frequency % frequency % frequency % 44 45.8 12 12.5 40 41.7 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 496 4.2 presentation and analysis of data according to research questions 4.2.1 the extent to which investigative independence is achieved in the public sector organizations. information for this analysis was from the responses obtained from the respondents. for the above stated objective, five (4) questionnaire items were put forward to the respondents, the responses obtain were captured in table 2. in the nigeria public sector, investigative independence could be said to have been achieved to a reasonable level based on the opinion of the randomly selected 96 staff of the auditor general office. first, it was observed that the auditor general either at the state level or the federal level was able to determine the scope of the audit work to be carried out on the financial statement prepared by the accountant general office without any hindrance from any constituted authority. this was supported by the 78% respondents strongly agreed and agreed to the question on the extent to which auditor general was able to determine the scope of audit work in the public sector organizations. secondly, the removal of auditor general was done by the legislature and through a two third majority. infact, the result of the interview conducted revealed that before the last military government, all auditor generals in nigeria had either retired voluntarily or on reaching the retirement age. furthermore, the compliance level for the submission of annual financial statement by the office of the accountant general to the auditor general office was also commendable. although, there were cases of failure in meeting the deadline as stipulated by the regulation but annual financial statement audit was done in all the state sampled. however, there is the need for improvement on the willingness of the executive to give out relevant and appropriate information to aid an effective audit work in the public sector as only 38% of the respondents agreed and strongly agreed that auditor general was able to request information considered necessary for the discharge of his duty from the executive. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 497 table 2. the extent to which investigative independence was achieved in the public sector organizations strongly agreed agreed indifferent disagreed strongly disagreed total frequency % frequency % frequency % frequency % frequency % frequency % auditor general was able to examine the financial statement annually 51 53 24 25 1 1 18 19 2 2 96 100 auditor general was able to determine the scope of audit work 48 50 40 42 4 4 4 4 96 100 financial statement are submitted for examination promptly 18 19 43 45 7 7 28 29 96 100 auditor general was able to acquire information necessary for audit work 27 28 10 10 1 1 21 22 37 39 96 100 4.2.2 the extent to which reporting independence is achieved in the public sector organizations. reporting independence as perceived by the independence regulations in the european union (2009), protects the auditors’ ability to choose to reveal to the public and information they believe should be disclosed. in that regard, a survey was carried out to investigate the extent to which reporting independence was achieved in the nigeria public sector organizations. 69% of the respondents agreed and strongly agreed that auditor general was able to report directly to the legislature without any external interference with the editing of their reports. this implies that reporting independence has been achieved in the public sector organizations asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 498 in nigeria. in like manner, there were public account committees established by the legislature and the substantial development in the public sector auditing in the last five years was that the public account committees were able to consider and review the annual financial statement of the government as prepared by the accountant generals and the report of the auditor general. furthermore, it was observed that in the sampled states auditor general was able to appoint his staffs up to the grade level six as expressed by 83% of the respondents while senior and professional staffs were recruited and promoted by the civil service commission. it would have been more appropriate if auditor general was able to recruit staff at the other levels so that professional competency needed for the job can be a major yardstick. surprisingly, auditor general office appeared to be distinctly separated from the ministry of finance with 25% and 53% strongly agreed and agreed respectively. the high scoring of this aspect of the reporting independence will assist in preventing undue restriction and interference with audit assignment table 3. the extent to which reporting independence was achieved in the public sector organizations strongly agreed agreed indifferent disagreed strongly disagreed total frequency % frequency % frequency % frequency % frequency % frequency % auditor general was able to report directly to the legislature. 45 47 21 22 3 3 22 23 5 5 96 100 there is a public account committee at each state. 48 50 26 27 14 15 8 8 96 100 auditor general was able to appoint his staff. 48 50 32 33 2 2 14 15 96 100 auditor general office was not an extension of ministry of finance 24 25 51 53 3 3 18 19 96 100 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 499 4.2.3 the extent to which financial independence is achieved in the public sector organizations the empirical results as presented in table 4 revealed that financial independence has been achieved in the public sector organizations in nigeria. this was based on the over whelming response rate of 89% affirming that auditor general budget was approved by the legislature in the same way as the annual budget for each ministry. furthermore, as freely expressed by the respondents and supported by sec 125 of 1999 constitution, the salary and other remuneration of the auditor general was decided directly by the legislature. in the same vain auditor generals in the sample states were able to attend annual conference organized by his professional bodies. strongly agreed agreed indifferent disagreed strongly disagreed total frequency % frequency % frequency % frequency % frequency % frequency % there is a separate budget for the auditor general’s office 59 62 26 27 4 4 7 7 96 100 auditor general’s budget was determined by the legislature 31 32 48 50 2 2 15 16 96 100 auditor general was entitle to annual salary increase and fringe benefits 36 38 54 56 6 6 96 100 auditor general was able to appoint the suppliers of services 58 61 4 4 32 33 2 2 96 100 4.3 inferential results to determine the effect of investigative independence, reporting independence, financial independence on the quality of audit assignment in the public sector organizations multiple regression analysis was carried out. with r square 0.62, the combine effect of investigative independence, reporting independence, and financial independence are significant in determining the quality of audit assignment done by the public sector auditors. this implies that 62% of variation in the quality of audit work in the public sector organizations were caused by the independent variables (investigative independence, reporting independence, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 500 and financial independence) while the remaining 38% were caused by the other variables not captured in this study. consequently, the relationship between audit job and investigative independence was to be positive and significant. this was supported by the coefficient of 0.001 and tstatistics of 3.333. this implies that the likelihood of quality audit job is greater in the public sector where investigative independence is achieved. similarly, the relationship between audit job and reporting independence was significantly positive at 1% level of significance (coefficient= 0.037, tstatistic= 12.333) suggesting that auditor are able to do their job ethically where they are able to report their finding to the appropriate authority. in like manner, and as suggested by other research studies such as agambi and adekunmi, (2002), and mothaz, (2008) among others, the relationship between financial independence and audit assignment is very significant and positive. more importantly, the coefficient was 0.079 while the t-statistic was 4.638, fallen on the rejection region of the null hypothesis using 2 tail statistic at 5% level of significance. therefore, our alternative hypothesis which predicts a relationship between audit job and financial independence was not rejected. table 5. model summary indicators coefficients r-square 0.623426 adjusted r-square 0.611147 standard error 0.545653 observation 96 table 6. analysis of variance df ss ms f sig. regression 3 45.34778 15.11593 50.76939 1.89e-19 residual 92 27.39181 0.297737 total 95 72.73958 table 7. regression coefficient variables beta std. error tstatistic sig. constant 0.335 0.0216 1.552 0.000 investigative independence 0.001 0.0003 3.333 0.010 reporting independence 0.037 0.003 12.333 0.000 financial independence 0.079 0.017 4.638 0.000 5. conclusion audit independence has always been considered a crucial attribute for auditors. an auditor both in the private and public sector organization is saddled with the responsibility of ascertaining the true and fair view of the financial position of the organization being audited. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 501 however, the extent to which this will be achieved depends on the level of independence maintained by the auditor. in the light of that, this study provides empirical analysis of the audit independence maintained by the public sector auditors’ in nigeria. the primary objective guiding this study was to investigating the extent to which public sector audit independence is achieved and how this independence is achieved in the nigeria public sector organizations while the specific objectives were to investigate the extent to which investigative independence is achieved in the public sector organizations, to investigate the extent to which reporting independence is achieved in the public sector organizations, to investigate the extent to which financial independence is achieved in the public sector organizations, and also to determine the effect of investigative independence, reporting independence, financial independence on the quality of audit assignment in the public sector organizations. in order to achieve the objectives of the study, a survey research design was adopted in which primary data were collected with the aid of a well-structured questionnaire to the randomly selected 105 staff of the auditor general office in the sampled states. similarly, the study adopted descriptive and inferential statistics for data analysis with the aid of stata-64. the results of descriptive analysis revealed that both investigative independence, reporting independence and financial independence has relatively been achieved by the auditors in the public sector organizations in nigeria. it was also discovered that auditor’s independence was significantly influenced by references aderibigbe, p. 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(1994). ―the effect of partner compensation schemes and generally accepted accounting principles on auditor partner judgment. auditing, a journal of practice and theory, 13(1), 56 – 68. microsoft word 3998-14929-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 47 cross-sectional variation in stock price reaction to bond rating changes: evidence from india sanjay sehgal professor, department of financial studies south campus, university of delhi benito juarez road, dhaula kuan, delhi, india e-mail: sanjayfin15@yahoo.co.in shruti mathur (corresponding author) assistant professor, sri venkateswara college, university of delhi benito juarez road, dhaula kuan, delhi, india e-mail: shrutimathur25@gmail.com received: july 12, 2013 accepted: september 7, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.3998 url: http://dx.doi.org/10.5296/ajfa.v5i2.3998 abstract we study the cross – sectional variation in stock price reaction to bond rating changes for india. pre – event returns are significant for downgrades but not for upgrades implying that investors are able to anticipate bad news more than good news. significant post event abnormal returns are observed for rating upgrades suggesting the dominance of signalling effect. no post event abnormal returns are seen in case of downgrades owing to anticipation and early investor reaction in the pre – event period. it was found that firm chacterstics do impact the relationship between bond rating changes and stock returns. small size, low p/b, less liquid, high leverage, more intangible assets and less profitable companies tend to provide positive returns after downgrades implying wealth redistribution effect. they also generally provide positive post – upgrade returns indicating signalling effect. analysing factors that influence postrating performance one confirms negative relationship between pre and post downgrade returns as well as magnitude of rating change and post – downgrade returns. our findings shall be highly useful for policy makers, credit rating agencies, investment analysts, bankers and academicians. the research contributes to bond rating and market efficiency literature for emerging markets. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 48 keywords: bond ratings, stock price reaction, wealth redistribution and signalling effect, firm characteristics, event study analysis jel codes: g14, g24, c12, c13 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 49 1. introduction credit rating agencies play a very vital role in the financial markets by providing an opinion about the ‘quality’ or ‘creditworthiness’ of a particular debt instrument to the investors. the ratings define the default risk for the bond issue over its life. while the investors gain from this assessment, it is claimed that the firms also benefit because ratings and subsequent rating changes are an effective means of conveying confidential inside information to the investors without revealing anything to the competitors (kliger and sarig, 2000; bannier and hirsch, 2010). however, recently the rating agencies have been severely criticized. the lack of prompt response by the rating agencies during the east asian financial crisis (1997), the failures of enron (2001), worldcom (2002) and subprime mortgage crisis (2008) have put a question mark on their reliability and credibility. the issue regarding the informational content of the ratings has been debated. one school of thought believes that ratings only lower the borrowing costs but do not tell anything new (wakeman, 1990). the agency’s rating change action is based on publicly available information and lags the event. thus, the announcement of bond rating changes would not affect market prices, assuming the capital markets are efficient in semi-strong form. many studies support the premise that bond rating changes do not provide new information (pinches & singleton, 1978; creighton, gower and richards, 2007; mohindroo, 2008). on the other hand, the credit rating agencies claim to possess superior information about the company which is used by them for arriving at their ratings (goh and ederington, 1993; ederington and yawitz, 1987). therefore, any change in the ratings would affect security prices. again, the exact nature of relationship between rating changes and stock returns needs to be understood. there are two main theories which explain the impact of rating change announcements by the credit rating agency on stock prices. these are -information asymmetry and signalling hypothesis and wealth redistribution hypothesis (romero and fernández, 2007). the signalling hypothesis suggests that a rating change provides additional information to the market about total value of the firm. a rating change may be seen as a signal indicating future earnings and cash flows of the issuer. hence, a rating downgrade is associated with a decline in stock prices (hand, holthausen and leftwich, 1992; elayan, maris and young, 1996; hite and warga, 1997; barron, clare and thomas, 1997; dichev and piotrosky, 2001; choy, gray and ragunathan, 2006; gropp and richards, 2001; benjamin, 2008; avramov et al. 2009; chakravarty, chiyachantana and lee, 2009; lal and mitra, 2011) while an upgrade (or placement on a watch with positive indications) is associated with rise in stock prices (barron, clare and thomas, 1997; gropp and richards, 2001; chakravarty, chiyachantana and lee, 2009). wealth redistribution hypothesis emphasizes that there is usually a conflict between the interest of bondholders and stockholders. the limited liability may prompt the stockholders to invest in riskier options to earn higher return. such an approach increases the default risk of outstanding bonds forcing the credit rating agencies to downgrade the rating (romero and fernández, 2007). this leads to a decline in the value of bond, which is transferred from bondholders to stockholders, leading to a rise in share price. conversely, a rating upgrade will asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 50 lead to a decrease in stock prices. holthausen and leftwich (1986) and zaima and mccarthy (1988) also suggest that if equity shareholders are viewed as holding an option on the value of the firm with an exercise price equal to the par value of the firm's debt, then an increase in the variance of the firm's cash flows would redistribute the wealth from bondholders to stockholders. the higher the volatility, the more the risk and thus the option pricing model for valuation becomes more relevant. results obtained by goh and ederington (1993); bhoot (1995) and romero and fernández (2007) support wealth redistribution hypothesis. the signalling and wealth redistribution effects work in opposite direction and may fully or partly offset each other. prior literature also shows that the price responsiveness to downgrades is more pronounced than upgrades. this confirms the asymmetric nature of relationship between bond rating changes and stock returns. another notable issue is whether all the firms react in a similar manner to the information provided by the rating changes. there may be a differential response to new information in case of companies for which there is little or infrequent information compared to companies which are always in news. the former are much harder to value and arbitrage. for instance, small size, low price to book value (as a measure of relative firm distress as suggested by chan and chen (1991)), low liquidity, high asset intangibility, high leverage and low profitability firms are expected to exhibit stronger price reaction to bond rating information, owing to poor disclosures, lower investment analyst and media coverage, higher cost of trading, greater degree of uncertainty in estimating their cash flows and a greater likelihood of earnings management. dichev and piotroski (2001) and creighton, gower and richards (2007) reported stronger price reaction for small firms. avramov et al. (2009) ran cross-sectional regressions of monthly individual stock returns on credit rating and other firm characteristics including book value to market value ratio but did not find it to significantly affect the returns. cornell, landsman and shapiro (1989) found that a firm’s stock price response to bond rating variations depends on the net intangible assets of the firm. kliger and sarig (2000) show that the bond price reaction to rating change was positively affected by the firm’s leverage. in contrast, goh and ederington (1993) report that downgrades arising due to a change in the leverage of the firm did not affect the prices of stocks significantly. the actual direction of the impact on returns depends on whether earnings or leverage or both are a surprise. apart from firm characteristics, there are a number of other factors which influence the response of share prices to a bond rating change. all other things remaining the same, the market should only show price response to a surprise or unanticipated rating change. this implies that the pre – event and post – event returns should be negatively correlated. another factor which affects their relationship is the ‘importance’ of the information being conveyed by the rating change. importance refers to the intrinsic value of the information as perceived by the investors (goh and ederington, 1999). more vital the information being conveyed, the stronger is the price reaction both before and after rating change announcement implying a positive correlation between the pre – announcement and post – announcement returns (goh asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 51 and ederington, 1999). another variable shaping the response of share prices to the rating change announcements is the magnitude of rating change i.e. the number of grades or levels by which the rating is changed. cornell, landsman and shapiro (1989) and hand, holthausen and leftwich (1992) found that the number of rating grades changed on rating revision has a significant influence on returns. a related issue is whether the investors react more strongly where the change in bond rating is from investment to speculative grade in case of downgrades. holthausen and leftwich (1986); hite and warga (1997); creighton, gower and richards (2007); benjamin (2008) and lal and mitra (2011) found that downgrades resulting in change in category of bond from investment to speculative grade extract a larger price response than any other downgrades. similarly, it is expected that where the bond ratings are in the speculative grade the shareholders may respond more intensely due to higher risk of default of such bonds (goh and ederington, 1999). another factor under consideration is the influence of bad economic conditions on the post – event abnormal returns in case of rating changes (goh and ederington, 1999). the time frame in this study includes the period when the investor sentiments were negative due to the sub-prime mortgage crisis. in such times, the investors expect bad news like the announcement of downgrades. they also under react to positive news like announcement of upgrades though there is an element of surprise. moreover, the degree of risk aversion increases in recession, so the price reactions are expected to be stronger. this paper also considers the influence of all such factors on the price response of firm – characteristic based portfolios (size, p/b, trading volume, leverage, intangibility and profitability) to bond rating changes. a review of the past research shows that although a lot of studies on the changes in ratings and their relationship with stock returns have been conducted abroad; there is little research on the subject in india. the limited literature which exists concentrates more on the comparison and analysis of rating methodologies and the performance of various rating agencies (duggal, 1992; goswami and venkatesh, 1999; raghunathan and verma, 1992; bajaj, 1998; sehgal and arora, 2004; kaur and kaur, 2011). although some studies do cover the rating changes, but their impact on security prices is not examined (bajaj, 1998; sehgal & arora, 2004). only a few studies explore this relationship in the indian context (mohindroo, 2008; lal and mitra, 2011). moreover, other important areas such as the effect of firm characteristics on the relationship between bond rating changes and stock return behaviour have not been studied. the impact of factors like anticipation, magnitude of rating change, transition to, from or within speculative grade and business cycle on stock returns after rating change in the indian market is also largely unexamined. thus, a serious gap exists in the existing literature on credit rating for the indian environment. the present study attempts to fill this important research gap in bond market literature. this paper explores the relationship between bond rating change information and stock return behaviour in india. it examines whether the rating changes have any informational content. it also evaluates the cross-sectional variation in the stock return behaviour to bond rating changes for firms with different characteristics (size, p/b ratio, liquidity, leverage, intangibles and profitability). the paper inter alia investigates the relationship between pre – event and asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 52 post – event abnormal returns implying surprise or importance element in case of upgrades and downgrades and firm characteristic based portfolios. it also examines whether factors like magnitude of rating change, transition to, from or within speculative grade and business cycle influence post – event abnormal returns. the paper is divided into 5 sections including the present one. section 2 describes data and their sources, section 3 deals with methodological issues. the empirical results are discussed in section 4, while the last section provides summary and conclusions. 2. data the data about the bond rating changes was collected from the websites of the two main rating agencies in india namely – crisil and icra. a list of all the events where a company’s bonds had been upgraded or downgraded between november 2003 and february 2011 was made. this consisted of a total of 227 bond rating changes out of which 117 were downgrades and 110 were upgrades. however, these cases were checked for any contamination. the event was considered to be contaminated if any other major announcement like merger or acquisition, divestment, buyback of shares, debenture, gdr or fccb conversion or exercising of esop or esos option took place 70 days before or 35 days after the announcement of rating change. data was also considered contaminated if there was any capital structure change such as declaration of stock dividend, rights issues and stock splits within the event window or if there was an earnings announcement between ±3 days of the date of rating change (goh and ederington, 1993). it was also important to identify companies for which regular stock price data was available for the event periods. after data filtering process we finally end up with 70 valid cases of which 31 were upgrades and 39 were downgrades. for all these 70 cases of rating revision, daily closing price data was obtained from bse sensex. daily closing observations for bse 200 stock index, which was used as market proxy, were also obtained for the corresponding periods. bse 200 is a broad based value weighted (free float weighted) index which is compiled on the lines of standard and poor’s index, usa. the data for firm characteristics i.e., market capitalization, price to book value ratio, daily trading volume, debt equity ratio, net intangibles to total assets ratio and return to equity ratio was collected from thomson reuter’s datastream software. the details about measurement of each characteristic as well as the number of cases in each characteristic sorted portfolio are given in exhibit a. to classify the cases on the basis of firm characteristics, list of bse 500 companies and the above mentioned attributes was also obtained for each year end from december 2002 to december 2010. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 53 exhibit a: measurement of firm characteristics firm characteristic measurement calculation number of usable cases number of cases in each portfolio size natural log of market capitalization loge[(price) x (number of shares outstanding)] 51 cases (24 downgrades and 27 upgrades) downgrades9 large and 15 small size. upgrades19 large and 8 small size. price to book value ratio market price to book value ratio market price / book value per share 50 cases (23 downgrades and 27 upgrades) downgrades-, 4 high and 19 low p/b. upgrades12 high and 15 low p/b. trading volume7 natual log of average trading volume to total average trading volume for all companies on bse 500. loge[(average trading volume for one year preceding the date of rating change) ÷ (total average trading volume for all companies on bse 500)] 48 cases (23 downgrades and 25 upgrades) downgrades-12 high and 11 with low trading volume. upgrades12 high and 13 low trading volume. leverage debt equity ratio long-term debt / shareholders' equity. 42 cases (18 downgrades and 24 upgrades) downgrades11 high and 7 low leverage. upgrades11 high and 13 had low leverage. intangibles net intangibles to total assets ratio net intangibles / total assets 44 cases (18 downgrades and 26 upgrades) downgrades10 high and 8 as low intangibles. upgrades14 high and 12 had low intangibility. profitability return on equity pat / average net worth 44 cases (18 downgrades and 26 upgrades) downgrades5 high and 13 with low profitability. upgrades19 high and 7 had low profitability. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 54 3. methodology the study has been conducted in two parts. in the first part, the relationship between company characteristics, bond rating changes and stock returns is examined. the impact of bond rating changes is analysed separately in case of downgrades and upgrades and for each of the company characteristics. we use event study methodology, as developed by fama, et al. (1969), brown and warner (1985) and campbell, et al. (1997). the event date ‘t0’ is the date of announcement of the bond rating change. the daily closing stock prices for the period t0 – 120 days to t0 + 20 days are used for analysis in this study. this daily prices are converted into daily returns using the formula: rk, t = log e (pk, t / pk, t-1) (1) where, rk,t is the continuously compounded return on day ‘t’ for the stock ‘k’, pk, t is the closing price of the stock ‘k’ on day ‘t’, and pk, t-1 is the closing price of the stock ‘k’ on day ‘t – 1’ i.e. the previous day. daily log returns were also found for the bse 200 index for the same period. the market model developed by sharpe (1963) was used in the analysis. this model relates the return of a security to the return of the market index as given below: rk, t = α k + β k r m, t + ε k, t (2) e[ε k, t ] = 0 and var[ε k, t ] = σ2 εk . where, rk, t is the day t return on security ‘k’, r m, t is the market index (bse 200) on day ‘t’, ε k, t is the zero mean error term, and α k , β k and σ2 εk are the estimated parameters of the market model. the market model is estimated using ordinary least squares (ols) regression. the estimation window is a rolling window and consists of 100 days immediately before the day t, on which the return rk,t is to be computed. this procedure has been used to obtain dynamic values of α k and β k, which change for each day of the event window (–20 to +20 days). this enables us in obtaining more precise values of expected returns for each day of event window. the period consisting of day t0 – 120 to day t0 – 21 was used to obtain the initial estimates of α k and β k and the process is repeated by skipping one day at a time. autocorrelation was checked using durbin watson test at 1% significance level. in this study, autocorrelation was detected in 13 cases. gls estimation procedure is adopted for these cases to ensure efficiency of the estimated parameters. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 55 next, abnormal returns were calculated using the following formula: ark, t = rk, t – erk , t (3) where, ark, t is the abnormal return for security ‘k’ on day ‘t’, rk, t is the realized return of the security ‘k’ on day ‘t’, and erk , t is the fitted values derived from equation (2). the daily abnormal returns for the pre-event window, days t0 – 20 to t0 – 1 as well as the post event window, i.e. days t0 to t0 + 20 were calculated. for drawing inferences about the impact of the event, the abnormal returns so obtained were aggregated. the summation for each company was across time. cumulative abnormal returns for the stocks were defined as: = , (4) = , (5) where, cari are the pre-event cumulative abnormal returns, carj are the post-event cumulative abnormal returns, and ark,t are the abnormal returns of security ‘k’ on day ‘t’ calculated using equation 3 the abnormal returns of firms with downgrades and those with upgrades were analysed as separate portfolios. we estimate the average of abnormal returns across sample companies for each event day (i.e. t0 – 20, t0 – 19,…….,t0 + 20). these were called as average abnormal return (aar). = , ⁄ (6) where, aart is the average abnormal return for day ‘t’ , t is any day in the pre – event or post – event window (i.e. t0 – 20, t0 – 19,…….,t0 + 20) ark,t is the abnormal return of company k for day ‘t’ as calculated by equation 3. n is the number of companies (31 for upgrades and 39 for downgrades). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 56 the aars were summed for the pre-event and post-event windows to obtain caari and caarj respectively. these are given by the following equations: = , (7) = , (8) where, caari and caarj are respectively the pre-event and post event cumulative average abnormal returns, aart is the average abnormal returns for day ‘t’ as calculated by equation 6. the caars were then standardized using the equation given below: = ⁄ (9) where, scaar is the standardized cumulative average abnormal return, caar is the pre-event or post – event cumulative average abnormal return secaar is the standard error of caar calculated as: = ∗ (10) where, t is the number of days (20 for preevent and 21 for post event) σp is portfolio standard deviation given by the markowitz portfolio formula: = + (11) where, σp 2 is the portfolio variance. σk and σh are the standard deviations of abnormal returns of company ‘k’ and ‘h’ for the pre – event or post-event windows, ρkh is the correlation coefficient between the returns of securities of company k and h. xk=xh=1/n (equally weighted), asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 57 n=number of sample companies (31 for upgrades and 39 for downgrades). ρkh accounts for any cross-correlations between the securities. the correlation coefficient ρkh is taken to be 0 if there is no overlap in the event windows of the k and hth companies. the scaar values follow t-distribution and are compared to t-statistic, at 5% significance level, 2-tailed with (t-2) degrees of freedom. this helps to find significant average abnormal returns in the pre-event and post-event windows. the relationship between the bond rating changes and stock returns is also analysed for portfolios created on basis of different firm chacterstics. the characteristics considered include firm size, price to book value ratio, stock liquidity, leverage, nature of assets (intangibles) and profitability. the first step included arranging the bse 500 companies in the descending order of their respective firm characteristic value (size, p/b ratio, leverage, proportion of intangibles and profitability) at end of each year (31 december) from 2002 to 2010. the bse 500 companies were then divided into two equal parts – large and small, each year on the basis of their characteristic value. company below the median characteristic value was classified as small or low on characteristic otherwise it was classified as large or high on the characteristic1. the characteristic category of each case of bond rating change was taken as the category to which the case belonged for the year – end preceding the rating change. liquidity had to be estimated as average trading volume. the liquidity of stocks was computed for each case of rating change. the companies on bse 500 were arranged in the descending order of this ratio and divided into two equal parts high and low based on their liquidity value for each relevant date. company below the median liquidity value was classified as less liquid otherwise it was classified as highly liquid. the category of each case of rating change was taken as the category to which the case belonged on the relevant date of rating change. thereafter, upgrade and downgrade portfolios based on each characteristic were analysed separately using the caar analysis. in the second phase of research, the relationship between the stock returns and bond rating changes was analysed in light of factors like anticipation, magnitude of rating change, transition to, from or within speculative grade and impact of business cycle. the impact of these factors is also seen for the various firm characteristic based portfolios. regression model given by goh and ederington (1999) was used for analysis. the equation is given below: carj = α + β1 * cari + β2 * num_grade + β3 * business_cycle + β4* spec + β5 *fallen + εi (12) e[εi] = 0 and var[εi] = σ2 εi here, carj is 21 day post – event cumulative abnormal returns including the day of announcement2. cari is the 20 day pre – event cumulative abnormal returns3. num_grade refers to the magnitude of rating change4. it is calculated as the absolute value of difference between the numerical score of the rating after and before the rating asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 58 change. business_cycle is dummy variable for downturn of business cycle taking values either 1 or 0. in this study the period after september, 20085 was taken as the period where the business cycle took a downturn due to global economic crisis. the variable takes the value of 1 where the rating was changed after september, 2008. in all other cases where the rating underwent a change in or before september, 2008, the dummy variable is taken as 0. spec is a dummy variable taking the value of 1 for movement within speculative grade and 0 otherwise. fallen is also a dummy variable which assumes value 1 where the movement is to or from speculative grade and 0 otherwise. this model was also applied to the various firm chacteristic based portfolios to examine whether this relationship changes due to the variables including anticipation, magnitude of rating change and impact of business cycle. the other two variables (fallen and spec) were excluded owing to the lack of sufficient cases in the portfolio data. all the variables were tested for correlation with each other. wherever, a significant correlation was found the variables were suitably transformed to avoid multicollinearity problems. 4. empirical results 4.1 bond rating changes and stock returns 4.1.1 aggregate analysis according to table 1, in case of downgrades, the pre-event caar is positive and significant but post – event caar is not significant. the results indicate rating changes lag abnormal returns. the existence of lag may imply that the investors pre – empt or anticipate that the rating is about to be downgraded or there are leakages in information and therefore, the reaction exists before the announcement of downgrade. it indicates that the shareholders are able to anticipate the information through other variables related to corporate performance. the positive direction of abnormal returns shows that the wealth redistribution effect dominates and overcomes the negative earnings signal. while the abnormal returns are significantly positive pre-event, they are not significant after the rating downgrades. the investors anticipate in advance that the rating is about to be downgraded and therefore, the wealth redistribution effect is exhausted in the pre-event window leading to insignificant returns in the post – announcement period. another explanation could be that the downgrade is seen as an indication of deterioration in the financial health of the company which sends a negative signal to the shareholders. thus, in the post announcement period the positive wealth redistribution effect is cancelled by the negative earnings signal resulting in insignificant returns for the shareholders. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 59 table 1. aggregate analysis: pre-event and post-event caar * value significant at 5% level of significance in case of upgrades, (table 1), pre-event caar is not significant but post upgrade caar is found to be positive and significant. the statistical insignificance of pre – event results indicates the lack of anticipation by the shareholders in case of upgrades. it emphasizes that shareholders do not monitor good news or positive developments as closely as bad news or potentially negative developments. this confirms asymmetric investor reaction to different types of information. in case of upgrades, significantly positive abnormal returns are observed after the rating change and there is no lag or anticipation of the rating change. the positive sign in case of upgrades indicates the dominance of signalling effect i.e. the rating change is seen as an indication of future trend of company’s performance. 4.1.2 analysis on the basis of firm characteristics size based portfolios the results on the basis of company size are listed in panel a of table 2. it can be seen that the size based portfolios exhibit different return behavior in case of upgrades. while signalling effect dominates in large size portfolio, small sized portfolio does not depict a significant impact after upgrades. however, in case of downgrades, both the large and small size portfolios show dominance of wealth redistribution effect. thus, they show similar post – downgrade reaction. moreover, though theory suggests that small sized firms should respond more strongly to bond rating changes than large firms but the results obtained do not support this conjecture. this is due to the observation of strong post – event abnormal returns in case of large firms both after downgrades as well as upgrades. in case of downgrades, the large size firms demonstrate stronger response (caar = 0.064) than small size portfolio (caar = 0.039). in case of upgrades, caar is significant only in case of large sized firms. it is also observed that large size firms show anticipation both in case of upgrades and downgrades as evident from the presence of significant pre – event abnormal returns. this anticipation may be because institutional investors have exposure in large companies and these companies are continuously monitored for any developments which may have a bearing on the future cash flows. moreover, the impact of the news leading to a rating revision is not fully absorbed in the pre – event period and the effect continues after the rating change. small firm portfolio does not show anticipation in case of downgrades. the absence of significant returns in case of small companies indicates that there is no pre – emption. this is downgrades upgrades pre event post event pre event post event caar 0.024* 0.009 -0.002 0.016* scaar 3.358 1.393 -0.516 2.882 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 60 consistent with the expectations since small firms are expected to have lesser transparency and may be difficult to value and arbitrage. so credit ratings provide new information in their case. table 2. results for firm characteristic – based portfolios panel a: results for size – based portfolios downgrades upgrades pre – event post – event pre – event post – event large small large small large small large small caar 0.029* 0.016 0.064* 0.039* 0.018* -0.053* 0.031* -0.006 scaar 2.299 2.097 6.198 3.804 2.983 -5.986 4.457 -0.494 panel b: results for price to book value – based portfolios downgrades upgrades pre – event post – event pre – event post – event high low high low high low high low caar -0.062* 0.040* -0.041 0.070* 0.021* -0.022* 0.017* 0.023* scaar -3.270 5.535 -1.918 8.324 3.072 -3.093 2.248 2.536 panel c: results for stock liquidity – based portfolios downgrades upgrades pre – event post – event pre – event post – event high low high low high low high low caar 0.028* 0.009 0.035* 0.080* -0.020* 0.018* -0.049* 0.070* scaar 2.800 0.910 3.588 6.554 -2.652 2.430 -7.220 6.655 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 61 panel d: results for leverage – based portfolios downgrades upgrades pre – event post – event pre – event post – event high low high low high low high low caar 0.027* 0.004 0.081* 0.009 -0.020* 0.020* -0.041* 0.076* scaar 2.825 0.325 7.474 0.622 -2.371 3.381 -4.987 7.897 panel e: results for intangibles – based portfolios downgrades upgrades pre – event post – event pre – event post – event high low high low high low high low caar -0.027* 0.074* 0.056* 0.048* 0.017* -0.007 0.071* -0.041* scaar -2.813 5.468 4.880 3.606 2.597 -0.848 8.038 -5.141 panel f: results for profitability – based portfolios downgrades upgrades pre – event post – event pre – event post – event high low high low high low high low caar 0.010 0.021* -0.012 0.077* 0.004 0.013 -0.012 0.104* scaar 0.630 2.320 -0.861 7.113 0.640 1.310 -1.879 7.606 * value significant at 5% level of significance price to book value (p/b) based portfolios panel b of table 2 shows results of price to book value based portfolios. the firms classified on the basis of p/b ratio differ in their response to bond rating changes after downgrades. while no significant reaction is seen for high p/b firms after downgrades, for low p/b firms a strong wealth redistribution effect is observed. this may be because in high p/b firms, both the signalling and wealth redistribution effect cancel each other. alternatively, it can be said that the entire impact of the information leading to downgrades may have been absorbed in the pre – event period and, therefore, no significant caar is observed after the downgrade. on the other hand, the fundamentally weak6, low p/b companies demonstrate abnormal returns after announcement. they show significantly positive abnormal returns after downgrade. the positive impact may come from possible increase in leverage of the firms which changes the risk profile of the firm. these companies initially under react to the information leading to rating downgrade during the pre – event period and the effect asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 62 continues in the post event period as well, bringing positive abnormal returns later. in case of upgrades, however, both high as well as low p/b portfolios exhibit signalling effect after announcement. moreover, the relationship between bond rating changes and stock returns is more pronounced for low p/b firms compared to high p/b firms. this is indicated by the presence of strong abnormal returns for low p/b firms both after downgrades as well as upgrades. this is particularly evident in case of downgrades where no significant reaction is observed for high p/b firms after downgrades but for low p/b firms a strong wealth redistribution effect is seen after the announcement of rating downgrade. the value of caar in their case increases from 0.040 before to 0.070 after the announcement of downgrade. also in case of upgrades, the stock return behavior of low p/b portfolio shows a stronger response than high p/b firms. the caar value for high p/b portfolio is only 0.017 whereas in case of low p/b portfolio the caar is 0.023 after upgrade. for low p/b portfolio the sign of caar changes from negative to positive after upgrade announcement. in this case a strong positive signal on announcement of upgrade overcomes the negative wealth redistribution effect prevailing in the pre – event period. this may be because for low p/b firms there is less reliable public information. the negative abnormal returns before announcements of upgrades may be due to the wealth redistribution or because the ongoing developments may not be clear to the shareholders and the uncertainty lead to fall in prices, but the upgrade announcement sends a clear positive signal leading to positive returns after the upgrades. thus, it can be concluded that low p/b firms respond more strongly to bond rating changes than high p/b firms. all the p/b portfolios exhibit anticipation in pre –event period. in downgrades, the direction of caar is different. in high p/b firms, the signalling effect is anticipated and dominant. this is so because such companies may have better disclosures which give the shareholders a fair idea about the earnings position of these firms. in the low p/b companies there may be information problems which make anticipation of earnings difficult. however, the wealth redistribution effects are easier to anticipate. thus, these firms exhibit positively significant returns before downgrade. the direction of pre – event caar also differs in case of upgrades. for high p/b firms, a positive impact is seen on the share prices because of strong signalling effect. this observation is in line with expectation that these companies disclose information in a timely manner leading to occurrence of abnormal returns in the pre – event period. however, in low p/b firms, wealth redistribution effect offsets the positive earnings signal leading to negative caar. stock liquidity based portfolios panel c of table 2 shows results of stock liquidity based portfolios. the relationship between bond rating changes and stock returns differs for illiquid and highly liquid stocks only in case of upgrades. the results show that firms with high trading volume exhibit wealth redistribution effect in case of upgrades whereas the firms with low trading volume demonstrate signalling effect. this may be because high liquidity firms may have more transparency so earnings signal may already be reflected in share prices and wealth redistribution effect may, therefore, dominate. but less liquid stocks are more difficult asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 63 to value and therefore, the rating upgrades give a strong earnings signal in case of such firms. however, post downgrades, wealth redistribution effect is shown by both the portfolios. it is observed that the post downgrade caar for stocks with low trading volume is 0.080 which is higher as compared to caar of highly liquid stocks (0.035). so the response to bond rating downgrades is stronger in case of illiquid stocks. no significant reaction is seen before the downgrades for illiquid stocks (small trading volume). the lack of anticipation is in line with the premise that illiquid firms may have few interested investors and these firms may not be closely monitored for major changes. on the other hand, for the firms whose shares are frequently traded, positive pre – event abnormal returns are observed. this is due to the possible close watch kept by the stockholders for any material changes in the capital structure or earnings situation of these companies. liquidity, therefore, seems to be the criteria for pre empting information about the downgraded stocks. in case of upgrades, liquid as well as less liquid stocks show abnormal returns in the pre – event period. however, the direction of these returns is different. in case of less liquid (small trading volume) stocks, signalling effect is very strong and overcomes the wealth redistribution effect leading to a positive caar. on the other hand, in case of more liquid stocks, the wealth redistribution effect dominates and overcomes the signalling effect and negative abnormal returns are witnessed. financial leverage based portfoliospanel d of table 2 shows results of leverage based portfolios. the relationship between bond rating changes and stock returns differs in case of high leverage firms and low leverage firms. in case of rating downgrades, as expected, the high leverage firms show a strong response to rating change while low leverage portfolio do not show any significant caar. for high leverage firms the abnormal returns are positively significant both before and after the event because the firms which already have a high leverage are more risky and therefore any further change in leverage may be closely monitored by the shareholders. there is an increase in risk due to downgrades which prompts the investors to expect a higher return on their stocks. the downgrades occurring due to change in capital structure make the investment risky for the bondholders but may lead to transfer of wealth from bondholders to shareholders. also, these are usually the firms with information problems and therefore the wealth redistribution effect is not fully absorbed in the pre event window. the firms with low leverage show insignificant returns before as well as after the downgrade. this is because these firms are less risky and a downgrade, in particular, that which occurs in response to change in capital structure does not affect these firms very strongly. the response of the two portfolios also differs in case of upgrades. in case of upgrades, while strong wealth redistribution effect explains results for high leverage firms, signalling effect dominates the firms with low leverage. the firms with high leverage demonstrate strong wealth redistribution effect both in case of upgrades as well as downgrades. this is due to the reason that high leverage firms are more sensitive to wealth redistribution effects. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 64 intangible assets based portfolios panel e of table 2 shows results of intangibles based portfolios. the nature of response to rating upgrades is different for high and low intangibility firms. in case of upgrades, while strong signal explains results for high intangibility firms, wealth redistribution dominates the firms with low intangibility. in case of firms with higher intangibles, the value of caar increases from 0.017 to 0.071 after upgrades. this is possibly because in these firms rating upgrades provide new earnings information. the abnormal returns continue from the pre – event period to the post –event period implying that the information is not fully absorbed in the first period. the caar becomes stronger after the announcement because the announcement possibly provides clear earnings signal for such companies which are usually difficult to value and have less predictable earnings. on the other hand, the wealth redistribution appears after the announcement which leads to negative returns in case of firms with small proportion of intangibles. this may be because earnings signal is not very strong as these companies are easier to value. in case of downgrades both the portfolios demonstrate wealth redistribution effect after announcement. moreover, after downgrades, the high intangible firms react strongly (caar = 0.056) in comparison to firms with low intangibles (caar = 0.048). the firms with high component of intangibles show pre emption about earnings signal both before upgrades and downgrades but the low intangibles firms exhibit surprise in case of upgrades. profitability based portfoliospanel f of table 2 shows results of profitability based portfolios. price response is more pronounced for small profitability firms compared to large profitability firms. the results for high profitability portfolio are insignificant. for low profitability firms, a response is seen both after upgrades and downgrades. signalling effect is dominant after upgrades in low profitability firms. this may be because the investors normally do not expect firms with low profitability to be upgraded. the announcement of upgrade is seen as an improvement in the future earnings prospects of the firm. this leads to positive sentiment in the shareholders and generates significant returns. in case of downgrades, wealth redistribution effect dominates and overcomes the signal. also firms with low profitability are likely to be downgraded, thus, anticipation is seen in form of significant pre – event returns. there is no pre emption in case of upgrades. this may be because investors monitor negative market developments (leading to downgrades) more closely than good ones (which result in upgrades). thus, firm characteristics do impact the relationship between rating changes and stock returns. in case of less informationally efficient firms, wealth redistribution effect dominates in downgrades while signalling effect generally dominates in upgrades. for more informationally efficient firms, the results are not so clear. further, stock price reaction is stronger for low p/b and low profitability firms (which are expected to be informationally less efficient) viz a viz their counterparts for both rating upgrades as well as downgrades. similar conclusions however, cannot be drawn while classifying firms on other characteristics. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 65 4.2 factors affecting cross –sectional post rating change performance 4.2.1 aggregate analysis table 3 shows the results of regression between the post event car and the independent variables both in case of downgrades and upgrades. table 3. results of regression between post – event car and pre – event car, magnitude of rating change, business cycle dummy, movement within speculative grade dummy and movement from investment to speculative grade dummy downgrades upgrades** beta t beta t (constant) 0.025 0.517 0.008 0.188 cari -0.326* -2.162 0.646 1.677 num_grade -0.081* -3.392 -0.121 -1.072 business_cycle -0.031 -0.491 0.024 0.438 spec -0.007 -0.056 -0.074 -0.634 fallen 0.075 0.648 -- adjusted r square 0.337 0.138 * value significant at 5% level of significance **there were no cases of rise of rating from speculative grade to investment grade after upgrade in the sample. therefore, the variable fallen was not included in analysis of upgrades in case of downgrades, two of the variables namely the pre – event car (cari) and magnitude of rating change (num_grade) are found to significantly affect the post – event stock returns. the pre – event car negatively affects the post event car. the negative sign implies that post – event abnormal returns are high in cases where pre – event abnormal returns are low and vice – versa. thus, where the downgrade is anticipated by the investors, the post – event abnormal returns are low whereas, the abnormal returns are larger where the downgrade is a surprise. the results also show that the post – event car is negatively affected by the magnitude of rating change. this means that the more the magnitude of rating change the lower the abnormal returns after announcement. this is not in line with expectations. usually studies find a direct relationship between the two variables. a possible explanation may be that a large magnitude of rating change is easier to anticipate as compared to a small rating change. it seems that in case of downgrades, the signalling effect tends to become stronger for a larger magnitude of rating change which relatively offsets the wealth redistribution effect. this may be the reason why more the number of grades changed, the less the impact on post event returns. other variables (business_cycle, spec, fallen) were not found to be significant. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 66 in case of upgrades, none of the variables was found to be significant. 4.2.2 firm characteristic based portfolios the results of relationship of post –event stock returns with pre – event stock returns, magnitude of rating change and business cycle in case of bond rating changes for firm characteristic based portfolios are shown in table 4. significant relationship was observed in only two cases. the portfolios based on liquidity cross – sectional variation in case of upgrades. the relationship between pre – event and post – event returns was found to be significant in case of upgrades for portfolios with large trading volume. this may be because in case of firms with high liquidity of stocks, more information in the form of voluntary disclosures and transparency is expected. thus, the market is able to anticipate the rating change in advance and starts responding to this information even before actual announcement. the relationship was positive indicating importance of the information being conveyed through the upgrade. the second case where the firm characteristic based portfolio showed significant results was in case of upgrades of portfolio with small proportion of intangibles. here, a significant positive relationship was observed between business cycle and post – event returns. this implies that during a downward trend in business cycle, the firms with small proportion of intangibles give better returns after upgrade. it may be because these companies have more tangible assets whose value does not erode when the business cycle takes a downturn. further, the investors may shift from companies which have more intangibles as the value of these intangible assets gets eroded during adverse conditions making such investments more risky. thus, the firms with small proportion of intangibles become more attractive. moreover, during adverse economic conditions investors expect ratings to be downgraded whereas upgrades are less common. as a result, the investors respond more strongly to an upgrade than a downgrade (which is a common occurrence during such periods). in all other cases no significant relationship was observed between the post – event abnormal returns and independent variables. this implies that these variables do not explain cross sectional variation for the characteristic based portfolios except in the two cases mentioned above. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 67 table 4. results of regression between post – event car and pre – event car, magnitude of rating change, business cycle dummy for bond rating changes of characteristic – based portfolios@ panel a: results for size – based portfolios downgrades upgrades large small large small** beta t beta t beta t beta t constant 0.254 2.191 0.001 0.013 0.220 1.070 0.036 0.294 cari -0.523 -2.258 0.510 0.867 0.962 1.266 0.729 1.180 num_grade -0.143 -1.607 0.030 0.681 -0.174 -1.053 -- business_cycle 0.139 1.166 -0.028 -0.285 -0.027 -0.291 -0.004 -0.031 adjusted r square 0.605 0.077 0.112 0.256 panel b: results for price to book value – based portfolios downgrades upgrades high*** low high low beta t beta t beta t beta t constant -0.966 0.033 0.443 0.232 2.117 0.215 0.804 cari -3.360 -0.285 -1.025 0.737 1.704 1.106 1.401 num_grade 0.139 -0.005 -0.149 -0.187 -1.950 -0.157 -0.659 business_cycle 0.678 0.088 1.291 -0.082 -1.569 -0.029 -0.157 adjusted r square -0.136 0.046 0.173 panel c : results for stock liquidity – based portfolios downgrades upgrades high low high low beta t beta t beta t beta t constant -0.047 -0.432 0.118 0.894 0.171 1.445 0.229 0.712 cari -0.340 -1.353 0.505 0.674 0.733* 2.304 0.773 0.926 num_grade 0.009 0.142 0.025 0.451 -0.157 -1.647 -0.151 -0.587 business_cycle 0.160 2.040 -0.114 -0.796 -0.071 -1.573 -0.019 -0.135 adjusted r square 0.425 0.098 0.456 0.101 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 68 panel d: results for leverage – based portfolios downgrades upgrades high low high low** beta t beta t beta t beta t constant 0.086 1.247 -0.119 -0.754 0.192 1.320 0.052 0.405 cari -0.605 -2.067 -0.807 -1.120 0.756 2.161 0.770 0.686 num_grade -0.040 -1.283 0.541 1.412 -0.169 -1.522 -- business_cycle 0.140 1.857 0.184 0.916 -0.062 -1.094 0.011 0.077 adjusted r square 0.444 0.601 0.405 0.045 panel e: results for intangibles – based portfolios downgrades upgrades high low high** low beta t beta t beta t beta t constant 0.013 0.099 0.040 0.158 0.038 0.471 0.005 0.114 cari -0.410 -0.560 -0.660 -1.582 0.366 0.371 0.372 1.648 num_grade -0.009 -0.170 0.005 0.025 ---0.038 -0.965 business_cycle 0.079 0.609 0.082 0.635 0.053 0.443 0.132* 2.304 adjusted r square 0.106 0.476 0.038 0.808 panel f: results for profitability – based portfolios downgrades upgrades high low high low beta t beta t beta t beta t constant 0.013 0.404 0.08 0.721 0.132 0.914 0.339 0.576 cari -0.238 -4.371 -0.622 -1.492 0.565 1.679 2.059 0.926 num_grade -0.020 -1.102 -0.023 -0.509 -0.128 -1.055 -0.258 -0.594 business_cycle 0.016 0.852 0.063 0.587 -0.019 -0.355 0.059 0.214 adjusted r square 0.956 0.209 0.168 0.277 * value significant at 5% level of significance ** num_grade had constant value of 1 in the data set, therefore, it was not included in regression. *** results could not be tested because of problem of micronumerosity. @ the number of cases in each portfolio are the same as mentioned in exhibit a 5. summary and conclusions this paper analyses the cross – sectional variation in the stock price reaction to bond rating changes in indian context. the aggregate results show that downgrades are preceded by positive abnormal returns indicating that either there are leakages in information or the investors can do superior analysis. it may also indicate that rating changes by the rating agency lag the news which necessitates the rating change action and the shareholders are able to anticipate the ratings information through other variables related to corporate performance. no significant abnormal return was reported after downgrade. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 69 in case of upgrades, no pre –event abnormal returns were observed. this implies that investors were able to anticipate downgrades but not upgrades, thus, investors seem to track bad news more than good news. on post upgrades basis, there were significantly positive abnormal returns. signalling effect dominates the post – upgrade investor behaviour. this also indicates that rating upgrades have informational content. the stock price reaction to bond rating changes varies for companies with different financial characteristics. the differential response is also seen on comparing upgrades with downgrades. the firms with low p/b ratios and low profitability respond more strongly to the announcement of bond rating changes than their counterparts. results show that after the announcement of downgrade, all the companies with possible information problems namely small in size, low p/b, less liquid, high leverage, high proportion of intangibles in total assets and low profitability displayed positive significant abnormal returns. this indicates that wealth redistribution effect is dominant in case of bond rating downgrade for firms which are expected to have less transparency, information problems and earnings management. the investors and traders can thus, earn positive payoffs after downgrades of such firms. for firms which may have information problems, response differed after upgrades. while most of these portfolios showed signalling effect (low p/b, less liquid stocks, high intangibles and low profitability) and exhibited positive returns in the post event period, wealth redistribution effect was found to be strong in case of high leverage companies as shown by negative post – event returns. small sized companies had insignificant returns in the post upgrade period. for companies which are expected to have transparency and better disclosures, the post rating change results are not as strong as their counterparts. there is mixed response to downgrade announcements. in case of downgrades, the wealth redistribution effect dominates in case of only large size, highly liquid and low intangibles companies. again in case of such firms, the results after upgrade announcement support the signalling effect in only three cases (large size, high p/b, and low leverage). analysing the factors that influence post –rating performance, it is observed that pre – event car negatively affects the post event car. the negative sign implies that where the downgrade is anticipated by the investors, the post – event abnormal returns are low, whereas, the post – event abnormal returns are larger in cases where the downgrade is a surprise. the results also confirm that there is a significantly negative relationship between post – event abnormal returns and magnitude of rating change in case of downgrades which is contrary to prior research. a possible explanation could be that investors generally track troubled companies which may experience a higher magnitude of downgrade. thus, reducing the surprise element which is reflected in lower post – event abnormal returns. firm characteristics based portfolios were found to differ cross – sectionally in respect to their response in only two cases. the relationship between pre – event and post – event asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 70 returns was found to be significantly positive in case of upgrades for portfolios with large trading volume indicating importance of the information being conveyed. again in case of portfolio with small proportion of intangibles a significantly positive relationship was observed between business cycle and post – event returns for upgrades. this indicates that in companies with low intangibility the value does not get eroded to a large extent in the downturn of business cycle. the study shall be useful for regulators, rating agencies, investors, analysts, bankers and academicians. the research has implications for the regulators like sebi because the pre – emption of rating change may imply leakages of information and insider trading in case of companies undergoing rating change. the same can be examined by the regulators. the study is useful for credit rating agencies. the role of credit rating agencies as information providers seems to be over-stated in the system. this is evident from the presence of pre – announcement stock price reaction in a number of cases indicating that the investors are able to gauge the financial position of the firm from indicators other than the rating change announcements. there seems to be a need for closer monitoring of assigned ratings. the investors and traders can apply the results of the research to form profitable trading strategies. the banks and other creditors may also find the study helpful in ascertaining how their returns and risk of default varies around rating change. the study is helpful particularly where, a bond rating downgrade is leading to positive returns. assuming that the overall value of the firm remains constant it implies that the shareholders are gaining at the cost of bondholders owing to redistribution of wealth. from academic point of view study contributes to the bond rating and market efficiency literature from the emerging market’s perspective. notes 1. in case of intangibles, all companies which had no intangible assets were put in the low intangibles category irrespective of where they fell in equal division of companies during classification. 2. this study differs from the work by goh and ederington, 1999 in respect of post – event window. while the above mentioned researchers used a 2 day post event window, this study uses a longer window consisting of 21 days. this has been done due to the reason that impact of rating change is usually lagged and is spread over a longer period of time. thus, a longer window is used to understand how the impact of bond rating change continues over time. 3. the pre – event window used by goh and ederington (1999) consisted of 45 days. however, in this study the window used consists of 20 days which is consistent with the analysis done in the previous sections. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 71 4. for calculating numgrade, icra as well as crisil’s rating scale is converted into numerical form with the highest rating (crisil aaa of crisil and [icra]aaa of icra) being given a score of 20, and lowest rating (crisil d of crisil and [icra]d of icra)being given a score of 1. the approach of converting the scale of rating change has been followed by a number of researchers like barron, clare and thomas (1997); goh and ederington (1999) and avramov et al. 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(1990). the real function of bond rating agencies. in c. smith, ed: the modern theory of corporate finance, 2nd ed., mcgraw hill, new york, 391-396. pmcid:pmc1292652 zaima, j. k., & mccarthy, j. e., (1988). the impact of bond rating changes on common stocks and bonds: tests of the wealth redistribution hypothesis, the financial review, 23, 483-498. http://dx.doi.org/10.1111/j.1540-6288.1988.tb01283.x microsoft word 6694-23784-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 155 country risk modeling in indonesia: an empirical approach muhammad adnan1*, sri maemunah2, fitri ismiyanti2 & rudi purwono2 1faculty of islamic economic and business the state islamic university of ar-raniry banda aceh, indonesia 2faculty of economic and business, airlangga university, surabaya, indonesia *corresponding author: faculty of islamic economic and business, the state islamic university of ar-raniry, banda aceh indonesia. e-mail: mhd_adnan@ymail.com received: july 23, 2014 accepted: nov. 11, 2014 published: june 1, 2015 doi:10.5296/ajfa.v7i1.6694 url: http://dx.doi.org/10.5296/ajfa.v7i1.6694 abstract this study is intended to analyze the influence of internal and external risk factors considered relevant influencing the country risk. we find result of long term vecm estimation indicating that the exchange rate, the interest rate of certificate of bank indonesia (sbi) for 6 months and the world economic growth have positive and significant influence to country risk. inflation, indonesia economic growth, the fed, and msci acwi imi return have negative and significant influence to country risk. all hypotheses presented in this study are theoretically and statistically accepted, except that the hypothesis on inflation is rejected because it is in controversy with theory, although statistically it has significant influence to the country risk in indonesia. meanwhile the estimated output of vecm in a short term, the exchange rate, the interest rate of sbi for 6 months and the world economic growth have positive and significant influence to country risk. the fed and msci acwi imi return have negative and significant influence to country risk. the hypotheses testing accepted from the estimated vecm in short term are the exchange rate, the sbi interest rate in 6 months, the fed, the world economic growth and the return of msci acwi imi. keywords: country risk, country beta approach, risk factors, indonesia, vecm asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 156 1. introduction the aim of investors to make investment is to maximize the level of profits (return) without neglecting the risk factors they have to bear. return is the output obtained from investment, so that the presence of return will motivate investors to invest. in addition, investors have to be able to calculate the risk of an investment, because the risk level contains possibility of the deviation of the realization return from the expected return. preferences of investors to the risk vary, because not all investors like the risk. the traditional portfolio theory states that the risk in security is classified into two categories, namely market risk and company risk (schill, 2008). the market risk is measured by the trend of the stocks moving together, whereas the company risk is more related to certain company. the total portfolio risks borne by the investors consist of the systematic risk and non-systematic risk (ross et al. 2009, p. 292). the market risk also called systematic risk constitutes the risks related to the changes at the market as a whole. such a market change can influence variability of return of an investment. this systematic risk can be measured by using the beta (ß) coefficient. beta indicates the sensitivity of security return to the change in market return. in the context of international diversification, beta indicates sensitivity of profit level index of a certain country to the level of portfolio profit of the world market. investors can and will carry out the international diversification. this proves that the stock market of a country is integrated to the world stock markets. this study uses the term country risk, in which the country risk is a systematic risk of an international portfolio. country risk was a covariant of security return of a certain country to the security return of global market (harvey, 1991). verma and soydemir (2006) said that in the perspective of foreign investors, the country risk evaluation was urgently needed because it concerns with the cross-country investment. harvey (1991) introduced the model of country risk beta approach constituting the extension capital asset pricing model (capm) by sharpe (1964), lintner (1965), and mossin (1966) and a cornerstone in investment theory. this capm theory was a development of markowitz’s portfolio theory based on the trade-off between the risk and the return having the linear and positive nature. the capm assumed that under equilibrium conditions, expected return represent fair compensation for the degree of risk security contributed to a broad market portfolio (bruner et al., 2008). this country risk approach was a quantitative method by using the beta coefficient in which the said beta represented the time-varying parameter of a function of a number of economic and financial independent variables (verbenik et al., 2011). jagannathan and wang (1996) were in the opinion that the time-varying beta derives from the special issues at the company and the economic condition as a whole. further, teixeira et al. (2008) states that time-varying parameter was influenced by the internal and external risk factors. oetzel et al. (2001), abel and kruger (1989) stated that the macroeconomic variables constitute the most potential factor influencing the time-varying beta. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 157 some empirical studies having applied the country beta approach were harvey and zhou (1993), erb et al. (1996a, 1996b), gangemi et al. (2000), andrade and teles (2006), verma and soydemir (2006), basu et al. (2011), and the latest was verbenik et al. (2011). output of the previous research indicated that the relation between country risk and internal and external macroeconomic variables varied. this was caused by relevant macroeconomic variables between the different developed market and the emerging market. this research estimates several internal and external macroeconomic variables considered relevant influencing the country risk in indonesia, by using the econometric approach under vector error correction model (vecm) method. the remaining of the paper is organized as follow: section 2 literature study and empirical study. section 3 presents hypotheses development. section 4 describes methodology and the econometric methodology. section 5 report result and estimation. the final section is the conclusion. 2. literature study and empirical study investment conducted at the stock market is an investment full of uncertainties, because the securities sold and purchased at the stock market contains the risks and uncertain level of return. before making investment, the multinational companies or foreign investors had better consider first the political stability and macroeconomic condition of the country becoming the destination of their investment, because it has the impact on the risk level and the return to be received. harvey (1991) stated that country risk was as conditional sensitivity (or covariance) of the country return to world stock return. gangemi et al. (2000) stated that the country risk constituted the exposure function of a country to the world market. verma and soydemir (2006) added that the country risk was a risk arising as the effect of investors conducting the international investment. this is a non-systematic risk (unique risk), if it is observed from the view point of foreign investors making investment in other countries. however, when it is observed from the view point of domestic investor, this is a systematic risk. based on various definitions above, it can be concluded that the beta concept or the country risk constitutes the beta (ß) systematic risk, in which this risk appears when the investors make investment in different countries or making the international diversification. according to sharpe (1964) and lintner (1965), beta was a focal point of investment and financing decision. beta is a systematic risk parameter of a security that cannot be omitted by doing diversification. akdeniz et al. (2003) beta risk changed through time with the changes in the economic environment and the dynamics of time variation of beta differsed across industries. in addition, beta indicates the sensitivity of security return to the change of market return. under a capm equilibrium model, the beta value influences a great deal to the level of the expected profit of a security. the higher the value of beta and the market return are, the higher level of return signaled by the investors. country risk is influenced by the internal and external risk factors. this internal risk factor refers to the specific factors influencing the country risk related to the economic fundaments of a certain country, rate of exchange, such as inflation, economic growth, amount of money asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 158 in circulation (money supply), and many others. the external risk also covers all factors of global risks in which if the changes occur on such factors, they will have a domino effect to the world economic activities, such as world price increase and development of stock return from the stock market becoming the standard of the world investment and the usa’s monetary policy to the fed (ferson and harvey (1994), min (1999), grandes (2002), and teixeira (2008). several studies already been carried out to estimate the country risk by using the country beta approach method introduced by harvey (1991). harvey and zhou (1993) carried out country risk estimation in 17 (seventeen) developing countries on the effect of portfolio of the world market. erb et al. (1996a) estimated the country risks for 117 (one hundred seventeen) countries during the period of 1984 – 1995 by investigating the 5 (five) sources of risks (political, financial, economic, composite risk index and credit ratings). their finding stated that there was a relationship between country risk and the future stock return. further, erb et al. (1996b) also analyzed the country beta as a function of country credit risk in 21 (twenty one) developed markets and 26 (twenty six) emerging markets during the period of 1979-1995. the finding of their study stated that the political risk, inflation, rate of exchange, industrial portfolio and economic growth simultaneously influence the country’s credit rating. gangemi et al. (2000) analyzed the impact of macroeconomic focusing on the open economic variables to the australia’s country risk. the finding of their study indicated that only the trade weighted of exchange rate significantly influences the country beta in australia. andrade and teles (2006) analyzed the influence of macroeconomic variables to the country risk of brazil by using a time-varying parameter approach. output of their study indicated that the monetary policy of this country represented by the rate of interest significantly influenced the country risk of brazil and international reserve had a significant impact only in fixed exchange rate period. verma and soydemir (2006) investigated the local factors and the global factors influencing the country risk of latin america. output of their study indicated that those two factors had relatively different influence to the country risk of latin america. the global factor, namely the real interest and inflation of g-7 countries had negative influence to the country beta of mexico, followed by brazil and chile. money supply was a very influential local factor to the country risk of mexico and followed by chile and brazil, whereas the exchange rate only gave the influence to mexico and brazil but not to argentina and chile. basu et al. (2011) used some macroeconomic indicators and political risk to make estimation on india country risk. the output of his study indicated that the country risk of india was very much influenced by fdi inflow, rate of interest, rate of exchange, and level of unemployment. verbenik et al. (2011) estimated the country risk of new european union member states by using the local and global risk factors. output of their study was that on the fourth quarter of the year 2008, during the occurrence of economic crisis, it causes the country risk of the new eu member states increased. the beta coefficient of the new european union member states significantly was more influenced by the global risk factor rather than the domestic one. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 159 3. hypotheses development portfolio theory of markowitz states that the relationship between the risk and the return of an investment is in the same direction and positive. based on the said model, each investor is assumed that he will diversify his portfolio and will choose the portfolio on his preference upon return and risk. the capm was a simple and stable linear relationship between an asset’s systematic risk and its expected return (akdeniz et al., 2003). the beta coefficient constituting the systematic risk was influenced by the business cycle (jagannathan and wang, 1996). the less stable, the local and the global macroeconomic condition was, the bigger influence the investors would get to make investment in a certain country. some hypotheses able to be presented in this study related to the influence of internal and external macroeconomic factors to the country beta in indonesia are as follows: the change in rate of exchange to usd, either due to appreciation or depreciation will influence the activities of export and investment in a country, because at present the usd is still a currency dominating the global payment and global commercial transactions. some empirical studies conducted by min (1998), abel and krueger (1989), gangemi et al. (2000), bilson et al. (2001), jeon (2001), wdowinski (2004), verbenik et al. (2011), and also topak and muzir (2011) stated that the rate of exchange significantly influenced the country risk of a certain country. h-1: the exchange rate of rupiah to usd has positive influence to the country risk in indonesia. the interest rate is one of the monetary instruments frequently used by bank indonesia as a means of monetary control. the change of interest rate of sbi (certificate of bank indonesia) is potential to increase or decrease the investment risk at the stock market. the study by abel and krueger (1989), and verbenik et al. (2011) stated that the interest rate significantly influenced the country risk. h-2: interest rate of sbi for 6 months has positive influence to the country risk in indonesia. inflation influences the economy of a country, because the change in inflation rate illustrates the stability or the failure of the macroeconomic policy of a country. the impact of the price increase of the goods gives influence to the return received by the company or the investors. according to barro and gordon (1983), inflation had the impact to the economy of a country. the high level of inflation could reduce the level of actual income or profits of the investors. h-3: inflation has positive influence to the country risk in indonesia. the economic growth of a country is frequently used as a macroeconomic barometer to predict the investment condition in a certain country. the increase of economic growth of a country can increase the income per capita of the community so that their purchasing power increases and in the end it increases the company profitability. some studies conducted by kharas (1984), abel and krueger (1989), soussanov (2002), grandes (2002), vij and kapoor asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 160 (2007), also topak and muzir (2011) declared that the relationship between gross domestic product (gdp) and country risk was negative. h-4: indonesian economic growth has negative influence to the country risk in indonesia. the increase of the world oil price also gives pressure to the exchange rate so that it increases the demand for foreign currency from the economic doers in order to fulfill their import needs, so that the increase of oil price is a bad news for the market in general and has negative impact to the movement of stock price. the uncertainty of this world oil price makes the investors more doubtful to make investment at the stock market, so that it gives impact to the economy of the said country. the studies conducted by verma and soydemir (2006), and verbenik et al. (2011) stated that the global factor gave more influence to the country risk of the said country. h-5: the world oil price has positive influence to the country risk in indonesia. the increase of the fed decreases the stock prices in us, so that it makes the global market doers withdraw their investment from the us stock market and transfer them to some other stock markets potentially giving the profits. verma and soydemir (2006) said that the influence of the us interest rate to the country risk was negative h-6: the fed has negative influence to the country risk in indonesia. the slowing down of the economy of the advanced countries gives impact to the slower down of the economic growth of the emerging market countries. the indonesia stock market is an inseparable part of the global stock market activities, so that its development is very vulnerable to the macroeconomic condition in general. this indicates that there is a domino effect (contagion effect) of a certain country to the other countries which is able to influence the economic condition or stock market of the other countries. h-7: the world economic has positive influence to country risk in indonesia. the foreign transaction also gives a contribution in determining the stock price movement in indonesia. during the time of the increase of foreign capital inflow to indonesia, it is also a positive signal for the domestic investors and the stock market, because the foreign capital inflow into indonesia will attract the domestic investors to invest. the foreign transaction disparity between the net purchase and the net sale will be able to influence the ihsg (composite stock price index). h-8: foreign transaction value has negative influence to country risk in indonesia. the indonesian stock market through the indonesian stock exchange is the inseparable part of the global stock exchange activities. the world stock index, such as msci acwi imi constituting the benchmark of the world stock market, is expected to be able to illustrate the real condition of the world stock exchange. the high return of msci illustrates the condition of the world stock exchange which tends to be bullish, or the contrary – the low return of msci acwi imi illustrates the world stock exchange conditions having the tendency to be asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 161 bearish, so that it is surely confirmed to make investment at the stock exchange having the high risk. h-8: the return of msci acwi imi has negative influence to country risk in indonesia. 4. methodology 4.1 data and source the data applied in this study is the quarterly time series during period of 2004-2013. data are obtained from bank indonesia (bi), central bureau of statistics (bps), international financial statistics (ifs) and morgan stanley capital international (msci), and also indonesia stock exchange (idx). the description of the variables and data source is as follows: table 1. internal and external risk factors internal factor acronym description data source ihsg composite stock price index idx ntr exchange rate of rupiah to usd bi sbi interest rate of sbi (certificate of bank indonesia) in 6 months bi inf consumer price index bps grindo indonesian economic growth bps external factor acronym description data source oil the world oil price ifs fed fed fund rate ifs grdunia the world economic growth ifs fnbs foreign transaction value idx msci morgan stanley capital international all country world index investable market index (msci acwi imi) msci 4.2 empirical model this study uses the standard country beta market model to measure the indonesian country risk, as conducted by gangemi et al. (2000), andrade and teles (2006), verma and soydemir (2006), verbenik, et al. (2011), and also basu et al. (2011) employ time-varying model of beta as shown in equation: rihsg,t = α + β requity world,t + et (1) where, rihsg,t is return on indonesia stock exchange, α and β are the parameter, requity world,t is return on the global stock index and et is the random disturbance term. beta (β) is used as asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 162 the basis to measure the indonesia country risk, in which this beta is influenced by combination of the internal and external macroeconomic factors. the studies carried out by fama and french (1989), also mc-queen and roley (1993) stated that equity returns were closely related to the business cycle and such activities were influenced by macroeconomic variables. further, ferson and harvey (1991), jaganathan and wang (1996) declared that the beta risk was the time-varying, and constitutes the part of business cycle. based on the above argumentation, this study applies the time-varying model of beta as follows: βt = b0 + + ut (2) the equation of time-varying model of beta in this study is as follows: βt = b0 + b1ntrt + b2sbit + b3inft + b4grindot + b5oilt + b6fedt + b7 grduniat + b8fnbst + ut (3) the time-varying model of beta (3) cannot be estimated directly, therefore βt in equation (3) is substituted into the equation of standard country beta market model (1) so that an equation is obtained as follows: rihsgt = α + βt rmsci t + et (4) further, the βt at the equation (3) is substituted with the equation (4), so that we can obtain the time-varying beta market model applied to estimate the model of indonesia country risk. the equation model applied in this research is as follows: rihsg,t = a + (b0 + b1ntrt + b2sbit + b3inft + b4grindot + b5oil + b6fedt + b7grduniat + b8fnbst) rmsci,t, + et (5) or: rihsg,t = a + b0rmsci,t + b1ntrt *rmsci,t + b2sbit *rmsci,t + b3inft *rmsci,t + b4grindot *rmsci,t + b5oilt *rmsci,t + b6fedt *rmsci,t + b7grduniat *rmsci,t + b8fnbst *rmsci,t + et (6) 5. estimation and result this study applies the vecm model to estimate the data from variables being studied. the application of vecm model with the time series requires several tests before estimating such vecm model. the first test to do is the stationery testing, namely by using the augmented dickey-fuller (adf). the procedure of this stationery test is carried out by comparing the probability value of adf (p-value) and the critical value under the terms if adf t-statistic is bigger than critical value at α = 5%, then such a data is said to be stationery (mandala, 2005, p. 548). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 163 table 2. unit root test for stationary variabel level first difference t-statistik adf critical value 5% t-statistik adf critical value 5% return ihsg -4.268809* -2.938987 -3.836662* -1.949609 ntr*rmsci -2.606193 -2.938987 -4.454861* -1.949609 sbi*rmsci -2.144295 -2.938987 -4.092222* -1.949609 inf*rmsci -3.687200* -2.938987 -3.686735* -1.949609 grindo*rmsci -5.021868* -2.938987 -4.837831* -1.949609 oil*rmsci -4.944515* -2.938987 -4.725515* -1.949609 fed*rmsci -2.498023 -2.941145 -3.922204* -1.949609 grdunia*rmsci -6.169604* -2.938987 -5.789056* -1.949609 fnbs*rmsci -6.436192* -2.938987 -5.859868* -1.949609 return msci -4.764237* -2.938987 -4.588113* -1.949609 *denote significance level at 5% based on the output of adf test, it is observed that the variables of ntr, sbi, and fed are not stationery at a certain level, in which adf t-statistic is smaller than its critical values at the level of 5%. therefore, in order to obtain the stationery data, a differencing is carried out in the form of first difference and its result shows that all variables of adf t-statistic value is bigger than the critical value at the level of 5%. the second test is carried out after the stationery data is obtained in order to determine the proper length of lag in vecm model. there are some criteria to determine the optimal lag, namely likelihood ratio (lr), final prediction error (fpe), akaike information criteria (aic), schwarz information criteria (sic), and hannah-quinn criteria (hqc). this study applies the aic criteria with the lowest order of model to determine its optimal lag. the following is the outputs of optimum lag test: table 3. var lag order selection lag logl lr fpe aic sc hq 0 -35.22944 na 5.12e-12 2.380497 2.811441* 2.533823* 1 44.16246 112.8201 1.80e-11 3.465134 8.205515 5.151725 2 207.0754 145.7642* 2.22e-12* 0.153925* 9.203743 3.373781 * indicates lag order selected by criterion asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 164 based on the aforesaid test result, it is found out that the optimum lag in this vecm model is available at the second order of aic. this can be seen at the above table in which the value of the second order of aic is lower compared to the other criteria of optimum lag. thus, the aic criteria in the second lag fulfills the requirement to carry out further analysis, namely performing the co-integrated test. third, this johansen test is carried out by two statistics, namely trace test and maximum eigen test. under such a circumstance, if the trace test or the maximum eigen test statistic has bigger value than the critical value of 0.05, it means there is a co-integrated relationship among variables being tested. the following is the output of co-integrated test (the value of max-eigen statistic): table 4. johansen cointegration test hypothesized no. of ce(s) eigenvalue trace statistic 0.05 critical value prob.** none * 0.971036 460.0959 273.1889 0.0000 at most 1 * 0.922253 325.5110 228.2979 0.0001 at most 2 * 0.845773 228.4476 187.4701 0.0001 at most 3 * 0.744817 157.4129 150.5585 0.0193 at most 4 0.594926 105.5135 117.7082 0.2281 at most 5 0.514862 71.17338 88.80380 0.4616 at most 6 0.344143 43.68713 63.87610 0.7064 at most 7 0.297241 27.65826 42.91525 0.6425 at most 8 0.256402 14.25408 25.87211 0.6366 at most 9 0.075824 2.996411 12.51798 0.8770 *denotes rejection of the hypothesis at the 0,05 level ** mackinnon-haug-michelis (1999) p-value based on the output of co-integrated test, it is shown that the value of trace statistic and max-eigen is bigger than the critical value of 0.05, so that it can be concluded that the aforesaid data are cointegrated. this indicates that there is a long term relationship between variables applied in this research and the country risk. the co-integration of a data indicates a proper signal to apply the vecm model. estimation output of the indonesia country risk using the vecm method gets the long term and the short term coefficients. the output of the long term vecm estimation is as follows: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 165 table 5. result of vecm in the long run cointegrating eq: cointeq1 return_ihsg(-1) 1.000000 ntr*rmsci(-1) 0.005601 [ 13.7407]* sbi*rmsci(-1) 2.709230 [ 6.66158]* inf*rmsci(-1) -1.850480 [-9.46841]* grindo*rmsci(-1) -2.201963 [-6.87622]* oil*rmsci(-1) 0.011677 [ 0.75436] fed*rmsci(-1) -2.062963 [-9.52235]* grdunia*rmsci(-1) 2.449573 [ 13.2236]* fnbs*rmsci(-1) 0.086711 [ 1.49516] return msci(-1) -52.56941 [-8.82982]* @trend(04q1) -0.004838 c 0.004470 [ ] = tstatistic *denote significance level at 5% and df 31= (2,042) based on the output of long term vecm estimation, its equation can be written as follows: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 166 rihsgt = 0.004470 + 0,00560 ntr*rmsci t + 2,70923 sbi*rmscit 1,85048 inf*rmscit 2,2019 grindo*rmscit + 0,01167 oil*rmscit -2.0629 fed*rmsci it + 2.44957 grdunia*rmsci t + 0.086711 fnbs*rmscit 52.56941 rmscit (7) output of the long term vecm estimation indicates that the exchange rate of rupiah to us dollar (ntr*rmsci), the interest rate of sbi for 6 months (sbi*rmsci), the world oil price (oil*rmsci), the world economic growth (grdunia*rmsci), foreign transaction value (fnbs*rmsci) have positive influence to the country risk in indonesia. inflation variable, indonesia economic growth (grindo*rmsci), fed fund rate (fed*rmsci) and the return of msci acwi imi have negative influence to the country risk in indonesia. output of the short term vecm estimation is shown as follows: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 167 table 7. result of vecm in the short term error correction d(return ihsg) cointeq1 -0.346688 [-3.97142] d(return ihsg(-1)) -0.307200 [-1.43631] d(ntr*rmsci(-1)) 0.001606 [ 2.92200]* d(sbi*rmsci(-1)) 0.677907 [ 2.32540]* d(inf*rmsci(-1)) -0.359988 [-1.99084] d(grindo*rmsci(-1)) 0.077975 [ 0.19552] d(oil*rmsci(-1)) 0.020491 [ 1.82674] d(fed*rmsci(-1)) -0.492326 [-2.60995]* d(grdunia*rmsci(-1)) 0.477636 [ 2.17530]* d(fnbs*rmsci(-1)) -0.055585 [-0.76023] d(return msci(-1)) -20.39836 [-3.00523]* c 0.034365 [ 0.87108] [ ] = tstatistic *denote significance level at 5% and df 31= (2,042) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 168 based on the result of the said vecm estimation, the short term equation can be written as follows: δrihsgt = 0.0343 0.3466 coint.eq 0.3072δrihsgt-1 + 0.001606 δ ntr*rmscit-1 + 0.677907 δ sbi*rmscit-1 0.359988 δ inf*rmsci t-1 + 0.077975 δgrindo*rmscit-1 + 0.020491 δoil*rmscit-1 0.492326 δ fed*rmscit-1 + 0.477636 δ grdunia*rmscit-1 0.055585δ fnbs*rmsci t-1 20.39836 δrmscit-1 (8) the above equation model indicates that for the short term, the exchange rate of rupiah to us dollar (ntr*rmsci), the interest rate of sbi for 6 months (sbi*rmsci), indonesia economic growth (grindo*rmsci), the world oil price (oil*rmsci), and the world economic growth (grdunia*rmsci) have positive influence to the country risk in indonesia. inflation (inf*rmsci), fed fund rate (fed*rmsci) and foreign transaction value (fnbs*rmsci) as well as the return of msci have negative influence to the country risk in indonesia. the presence of co-integration between dependent variables and independent variables or the long term equilibrium enables to cause the occurrence of short term disequilibrium. this disequilibrium is frequently found at the economic behavior, meaning that what is needed by the economic doers is not always the same with what actually happens, so that an adjustment is required due to the said difference. the model including the adjustment for such equilibrium correction is called error correction method (ecm). according to gujarati and porter (2010, p. 459), the speed of adjustment coefficient had the value from zero until one. based on the output of short term vecm estimation, it is found out that the value of ect is –0.34668, and such value indicates that the disequilibrium is previously corrected at the current period at the amount of 0.34668 %. ect indicates how fast the disequilibrium returns back to the long term equilibrium. 6. conclusion based on the output of the long term vecm estimation, all variables of internal macro-economy significantly influence the country risk in indonesia. however, output of the short term vecm estimation indicates that only the variables of exchange rate of rupiah to us dollar and the interest rate of sbi for 6 months have positive influence to the country risk in indonesia. the internal factor having very great influence to the country risk in this study is the sbi interest rate in 6 months, namely at the amount of 2.70923%. the indonesia economic growth has negative significant to the country risk, namely at the amount of 2.2019 %. inflation has negative significant influence to the country risk at the amount of 1.8504% and the variable having the smallest but significant influence to the country risk is the exchange rate of rupiah to us dollar, namely 0.0056. according to output of the long term vecm estimation, the external factors the having significant influence to the country risk in indonesia are fed fund rate, the world economic growth, and the return of msci acwi imi. the output of short term estimation indicates that variables having significant influence to the country risk are fed fund rate and the return of msci acwi imi. the world economic growth significantly influences the country asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 169 risk for the output of short term vecm estimation. the world oil price and foreign net buying/selling insignificantly influences the country risk based on the outputs of either long term or short term vecm estimation. the return of msci acwi imi has a great influence to the country risk in indonesia, namely at the amount of 52.5694%, so that this variable influences very much to the investors in making their decision to make investment in indonesia. the variable with the smallest influence but significant to the country risk is fed fund rate, namely at the amount of 2.0629%. output of the long term or the short term vecm estimation for the msci acwi imi return has negative and significant influence to the country risk in indonesia. msci acwi imi constituting the benchmark index of global market influences the country risk. this indicates the indonesia stock market has a very close interconnection with the stock markets of other countries. the increase of msci acwi imi return causes the decrease of indonesia country risk, so that it influences the decision of investors to make investment in indonesia. references abell, j., & krueger, t. 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(2004). determinants of country beta in poland. cesifo working paper series, no. 1120. microsoft word 5290-19171-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 198 variables for modeling saccos in tanzania joseph john magali accounting school, dongbei university of finance and economics p.o box 116025, hei shi jiao, dalian, p.r china e-mail: josephmagali@yahoo.com received: march 15, 2014 accepted: april 8, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5290 url: http://dx.doi.org/10.5296/ajfa.v6i1.5290 abstract in order to publish a quality article in a journal, an author must understand how to apply the econometric skills to construct models which explain the relationship between the independent and dependent variables. this study used the literature review to examine the variables used to establish relationship between the independent and dependent variables in savings and credits cooperative societies (saccos) in tanzania. the findings reveal that currently few studies have been conducted to model saccos in tanzania and scholars mostly applied the regression models. moreover, the findings show that most scholars have empirically studied the outreach and sustainability of saccos in tanzania compared to other topics. the studies also show that most of issues have not been addressed in the research. this study recommends that financial management researchers should learn econometrics so that they might gain skills which might help them to model saccos and other mfis. moreover, topics which were not addressed in research should be given priority by the researchers in tanzania and in other countries. keywords: variables, modeling, saccos, tanzania asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 199 1. introduction 1.1 background of the study tanzania is one of the least developing countries located in eastern part of africa with a population of 44 million. liberalization of economy in tanzania took place in 1980s where the socialism policies dominated the economy since independence in 1961. majority of tanzanians (more than 80%) engage in peasant agricultural production and dwell in rural areas (nbs 2013). savings and credits cooperatives societies (saccos) have been established since 1980s after liberalization of the financial services (maghimbi 2010). wangwe (2004) asserted saccos have helped to provide the financial services to many clients who the formal financial institutions such as banks did not serve them. hence saccos have solved the problem of capital inadequacy for rural people in tanzania. qin and ndiege (2013) and bwana and mwakujonga (2013) revealed that saccos significantly contribute to gdp of tanzania. the government of tanzania promotes the establishment of saccos even to very remote areas because of their importance contribution to the country economy (wangwe, 2004). therefore the saccos increase rapidly each year because of government sensitization. the total saccos in tanzania were 5,559 in march 2013 whereas the number of members, amount of shares, savings and deposits were 1,153,248 and 463.5 billion tzs respectively (moft 2013). the government establishes various policies and regulations in order to supervise the saccos and cooperatives in tanzania. based on the history, the literatures indicate that improper management, frauds, inadequate capital, business misconduct and non performing loans (npl) are the problems facing cooperatives and saccos in tanzania (tfc 2006; bibby 2006; maghimbi 2010; magali 2014). various scholars have designed models which accommodate different variables to investigate various issues in mfis. the most famous models in mfis measure the performance, credits risk, efficiency, impacts, outreach and sustainability. scholars usually use the variables of returns of assets or equity (roa, roe) or profitability to measure performance while they use npl to measure the credits risk management. moreover, they use inputs and outputs to measure the efficiency whereas they use the livelihood variables to assess the efficiency and impacts of mfis. furthermore, authors use the average loan size, number of clients or borrowers, number of female clients to measure the outreach but they use roa, financial self sustainability (fss) or operational self sustainability (oss) to measure financial sustainability of mfis. often regression models are used to measure the relationship between independent and dependent variables for mfis when measuring performance, credits risk, efficiency, impacts, outreach and sustainability. however, in measuring efficiency data envelopment analysis (dea) model is mostly used. moreover, scholars use the logistic regression for the models which have dichotomous outcomes. some models measure the social performance of the mfis. zeller et al (2003) asserted that outreach to the poor and excluded, adaptation of the services and products to the target clients, improving social and political capital of clients and communities and social responsibility are the four major dimensions of the social performance model of mfis. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 200 in mfis modeling, one model can be applied to examine the relationship between the mfis variables in various circumstances. what is important is the possession of knowledge by the applicant of the model. most scholars apply rules based scoring, statistical method and neural network models for modeling of credits risk in mfis (sur 2008). moreover, most scholars use value at risk (var) to measure the market risks of stocks and other assets (alam and masukujjaman 2011). salari et al (2012) recommended var for measuring loans portfolio. rouk (2008) argued that credit grades model (cgm) calculate the credits risk and indicates that the loans need to be impaired. logistic regression model was used by vasanthi and raja (2006) in measuring the credits risks for state housing authorities in australia. however, haque et al (2011) applied the logistic regression model to assess the impacts of a mfi to the beneficiaries. moreover, doreitnera and pribernya (2011) designed a model to measure the probability of default in mfis by taking into consideration variables from the stock markets. likewise, some scholars use multivariate discriminant analysis (mda) to model the credits risk of default in banks (castagnolo and ferro 2014; raj and sindhu 2013; chijoriga 2011). moreover, some authors use the bayesian models to predict the credits probability of default in banks and mfis (mileris 2010; figini and giudici 2013). the list is long, however the listed examples show that scholars explain the relationship between the mfis variables by designing the new or apply the existing models. 1.2 problem statement and justification the literatures show that most scholars modeled the credits risk in banks (rouk 2008; abdou and pointon 2011; lefcaditis et al 2011; kruppa et al 2013). however, few scholars modeled the credits risk in mfis (doreitnera and pribernya 2011; kinda and achonu 2012; elías et al 2012). likewise, various empirical studies have been conducted to assess the banks and mfis performance, efficiency, outreach and sustainability. the literatures also show that saccos in tanzania are important engine for the economic growth and development. moreover, the literatures show that only few empirical studies concerned saccos are done in tanzania. likewise, most university academic staff specialized in finance or business management in tanzania don’t publish scientific papers in journals because they lack skills in saccos or mfis modeling. lack of skills in modeling the mfis and saccos variables, made the university academic staff to stay in their academic grades for long time (some for more than ten years). furthermore, many students who are doing their researches in finance or financial management especially at undergraduate and master levels in tanzania fail to structure their studies empirically because they don’t have knowledge and skills on how to model the mfis or saccos’ variables. thus they only design their studies qualitatively or descriptively. therefore, this paper describes how to use the saccos variables to construct models. the paper might be very useful to students and university academic staff who want to model saccos and other mfis. i believe that this paper will encourage many students and academic staff to conduct the empirical quantative studies by modeling the mfis variables which is a key step toward articles’ publication. 2. literature review 2.1 descriptive and qualitative studies done in saccos outside tanzania mostly scholars analysed the problems in saccos by using descriptive and qualitative asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 201 analysis. the following are some of studies which applied the descriptive and qualitative analysis. waweru (2011) investigated the cash balance management approaches for kenya saccos at nakuru region. fiorillo (2006) assessed the effects of wholesale lending to saccos in uganda. sebhatu (2011) studied the outreach and sustainability of saccos in ethiopia. sharma et al (2005) assessed the impact assessment of saccos in nepal’s hill district by using pra and descriptive analysis. matumo et al (2013) examined the impact of front office saccos’ activity on saccos’ performance in kenya. odera (2012) assessed the corporate governance problems saccos in kenya. friends consult ltd (n.d) investigated the delinquency management for the umurenge saccos in rwanda. gingrich (n.d) examined a sustainable means for microfinance delivery for community based savings and credit cooperatives in nepal while hall (2005) studied the strengths and weaknesses of koperasi citra lestari and koperasi mawar putih savings and credit cooperatives microfinance institutions at east java indonesia. chahayo et al (2013) analyzed the reasons for financial mismatch in saccos in kenya. mwangi, et al (2013) analysed the role of saccos in growth of youth entrepreneurship in kenya. mwangi and wanjau (2013) examined the role of sacco in growth of youth entrepreneurship in kenya. makori et al (2013) studied the challenges facing deposit-taking saccos’ regulatory compliance at gusii region in kenya and ondieki et al (n.d) assessed the effect of external financing on financial performance of saccos at kisii central district, kenya. the literatures show that kenyan scholars lead to study about saccos’ problems. 2.2 quantative studies done outside tanzania scholars use various models to study issues in saccos. awotide et al (n.d) used the queue model to analyse the effectiveness of cooperative societies’ in delivering credits for agricultural enterprises in southwest nigeria. the three variables were modeled to measure the effectiveness of credits delivery as follows: time rivalnumberofar earrivalrat = time rvednumberofse eservicerat = eservicerat earrivalrat ensitytraffic =int they asserted that arrival rate depicts the number of loan request per month, the service rate represents the number of application accepted while traffic intensity measures the efficiency in queue management, which is achieved when arrival rate =service rate. lagat et al (2013) studied the effects of credits risk management practices on lending portfolio among saccos in kenya by using a multiple regression model. the portfolio performance (pp) was used as a dependent variable and the independent variables were: risk identification (ri), risk assessment (raa), risk monitoring (rm) and credit risk analysis (cra). the model was specified as follows: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 202 iiiiii ecrarmraariurmpp ++++++= 543210 ββββββ where 0β =intercept and ie is the error term. moreover, onsase et al (n.d) studied the effects of performance management practices on provision of financial services for saccos in kenya by using the likert scale and the univariate regression model. the regression model was written as: y=a+bx where; y is the dependent variable, that is performance of financial services (pfs) and x, is the independent variable that is performance management practices (pmp). olando et al (2013) examined the contribution of saccos’ financial stewardship to the growth of saccos’ wealth (gsw) in kenya by using a multiple linear regression analysis. the financial stewardship was measured by loan evaluation (le), loan disbursement (ld), loan recovery (lr), loan protection (lp), default risk (ds), staff competence (sa) and innovativeness (tec). the model was constructed as: εββββββββ ++++++++= tecsadslplrldlegsw 76543210 where: =0β constant term and =− 71 ββ coefficient of the independent variables and =ε error term. onchangwa and memba (2012) investigated whether investment in saccos have effect on members’ investment culture in kenya. the univariate regression model expressed the relationship between savings and investment as follows: y= a + bx1 where: y= investment, x1= savings in saccos, a = the intercept and b =the beta coefficient. auka and mwangi (2013) examined the factors influencing saccos’ members to seek services from other financial service providers in kenya. the relationship between independent variables and dependent variable was established by the regression model as follows: epepsspmdpttpfi +++++++= 6543210 βββββββ where: fi = financial service provider, tp = type of financial product, pt = processing time of loan applications, sp =staff performance, ps = promotion strategies, pe = physical evidence, =0β intercept, β1 β6=estimated coefficients of independent and e = error term. mosongo et al (2013) investigated the relationship between the financial innovation and financial performance for saccos at nairobi county in kenya by using the descriptive and multivariate regression analysis. the dependent variable (y) was the financial performance and the independent variables were institutional (x1), process (x2) and product innovations (x3). the multivariate regression model was specified as follows: μββββ ++++= 3322110 xxxy mpiira et al (2013) studied the factors influencing households’ participation in saccos programmes in uganda using the ordered probit regression model which was presented as follows: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 203 udistricturbandiststablemaritalddep gendereducdinfoageageyks ii i p n ++++++ +++++++==   == = 1211 3 1 1098 5 1 76 3 1 543210 2^)pr( βββββ ββββββββ where pr is the probability that the household will choose to participate in the programme and sn =k represent the household status whether is a non-member or a member who save or don’t save. the independent variables of the model includes: py which determines the presence of permanent income, age of the household head, age of spouse ( 2^age ), dummy of information about the famous banks used for depositing the children school fees (dinfo), the education level of the household (educ), gender of respondent, dummy variable of children going school whether in nursery, primary, secondary or university (ddep), marital status, dummy of stable income, distance from home to the saccos office (dist), dummy of household location whether in rural or urban and district of residence whether is a base district or otherwise. ahimbisibwe (2007) studied the effects of saccos on members’ saving culture in ntungamo district in uganda. the author applied the multivariate linear regression model where saving culture was the dependent variable. the model was expressed as follows: tt tertsecprimgoschnochildincomey εβββββββ +++++++= 6443210 where: income = a dummy for income, nochild = a dummy for number of children in a family, gosch = a dummy for number of school going children, prim = a dummy for primary level of education, sec = a dummy for secondary level of education, tert = a dummy for tertiary level of education, yt = saving culture, β0 =intercept, β1 -β6 = estimated coefficients of independent variables and =tε error term. similarly, mohammed (2011) applied the regression model to examine how financing strategies and financial sustainability strategies which influenced the sustainability and outreach of saccos in uganda. the independent variable was the financing strategies of saccos which was measured by debt, equity and individual savings while the independent variables were operational self sustainability, financial self sustainability, active borrowers and average loan size. the study used the first and the second two variables to measure the financial sustainability and outreach of the saccos respectively. tesfamariam et al (2013) applied the data envelopment analysis to examine the relative efficiency of rural saccos in ethiopia where they specified total expenses and savings and loans and total income as inputs and outputs respectively. moreover, dong and featherstone (2004) studied the technical and scale efficiencies of chinese rural credit cooperatives by using a bootstrapping approach in dea and treated deposits as inputs and loans as outputs. similarly, kipesha (2012) assessed the efficiency of microfinance institutions in east africa by using dea. kipesha asserted that a simple dea model to measure the technical efficiency using input oriented approach for mfi (including cooperative mfis such as saccos) can be asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 204 constructed by assuming that there is k decision making units (dmus or mfis) which utilize n inputs to produce m outputs. kipesha (2012) argued that if inputs are denoted by xjk with j=1…n and outputs by yik with i=1…m for each dmu, the technical efficiency for dmu under inputs specification can be expressed as: kr vjxjk uiyis minte n j m i ....1 1 1 =−−−−−−=   = =  = ≥+−= m i wyifuiyrsubjecto 1 0  = ≥− n j ujxkxjr 1 0 ui and vj 0≥ where ui and vj are the weights of output and input correspondingly (kipesha, 2012). 2.3 empirical descriptive studies done in saccos from tanzania some studies in tanzania explain issues in saccos by using descriptive and qualitative analysis. piprek (2007) examined the links between saccos and crdb bank in expanding the access of financial service in rural areas. magali and qiong (2014) compared the commercial banks and rural saccos’ credits risk management. magali (2014) investigated the influence of leadership, corporate governance and regulations on credits risk management on rural saccos. kyessi and furaha (2010) examined the access of housing loans by the urban poor clients from wat-saccos in dar es salaam by using descriptive and pictorial presentation. karumuna and akyoo (2012) studied the challenges faced the kibaigwa financial services and credit cooperative society (kifisaccos) in kongwa district by using descriptive and swot analysis while bwana and mwakujonga (2013) studied the issues related with saccos’ development in kenya and tanzania by using the literature review. 2.4 empirical saccos’ studies which applied models in tanzania since 2010 tanzanian scholars are motivated to model saccos’ variables in tanzania. kushoka (2013) analysed the sustainability of an employee based saccos at dar es salaam city in tanzania by using the likert scale and linear regression model. the model was written as follows: μβ +++= 210 bxaxy where y=sustainability, 0β =intercept, x1=capital base, x2=amount of loans issued, a & b = coefficients of x1 and x2 and μ =error term. qin and ndiege (2013) assessed the role saccos in economic growth in tanzania. they applied econometric model which captures the time series data. the model was specified as: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 205 ittttttt intrinflsgdpcgdprpgdp μβββββ +++++= )()()()()( 4320 where rpgdp =real gdp per capita which was used to measure the economic growth, (cgdp) = credits divided by real gdp per capita and sgdp =savings divided by real gdp per capita. the two proxies were used to measure the financial deepening in saccos while inflation rate (infl) and real interest rate (intr) were used as controlling variables. magali (2013d) assessed the impacts of rural saccos’ loans on borrowers in tanzania by using the logit model which was expressed as:       − = i i p p logplogit 1 )( ……………..(1) where the term within the square brackets is the odd of an event occurring, i.e odd of a saccos’ borrower to perceive the impacts from using loans let: )1pr( ii xxyp === ……………….(2) then the model was written as: μβββββββ +++++++==      − 6655443322110)( 1 xxxxxxplogit p p log i i i ……(.3) pi = probability that of a borrower to realize positive impacts while (1-pi) =probability of a borrower to realize the negative impacts from using the credit from the rural saccos. the independent variables specified in the model were: improvement in health and education, buying of assets, improvement of income, improvement of crop yields, increment of business’ capital and improvement of housing structure after receiving loan from the rural saccos. similarly, girabi and mwakaje (2013) assessed the impact of rural saccos on smallholder farm productivity in iramba district, singida region tanzania. the regression model was specified as follows: uxbxbxbxbxbxbaq +++++++= 665544232211 .where: q = farm’s output (bags) a = constant bs = estimated coefficients, x1 = inputs (fertilizer, seeds, pesticides) x2 = technology (tractor, ox-plough or hand hoe); x3 = hired labour x4 = money (in tanzania shillings-tzs), x5 = land u = error term. magali (2013e) examined whether the rural saccos in tanzania are currently sustainable by using the multivariate regression model. the study measured the outreach by using the log average loan size and the model was specified as follows: μβββββ +++++= 443322110 xxxxy . the independent variables were savings and deposits to total assets, age of saccos, log of cost per borrower and oss. moreover, oss measured asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 206 the sustainability of the rural saccos and the model was written as: μββββββ ++++++= 55443322110 xxxxxy . in this model npl to equity, log of cost per borrower, age of saccos, grants to total loans and log of average loan size were regarded as independent variables. ndiege et al (2013) examined relationship between sources of funds and outreach for saccos in tanzania by using two similar regression models. the number of members (memb) and average credits (avc) were used as dependent variables for breadth and depth of outreach in the first and second model while credits per assets (crar), external source of funds (eqt), internal sources of funds (lib) and external-internal sources ratio (ler), age of saccos (year) and number of saccos (sacc) were used as independent variables. the two models were specified as follows: )1......(333221 itititititiit lercrarlblsaccoyearmemb μββββββ ++++++= )2........(333221 itititititiit lercrarlblsaccoyearavc μββββββ ++++++= temu and ishengoma (2010) used the multivariate regression model to examine effects of financial linkages on performance and sustainability of the rural saccos in tanzania by using the regression model. in the model the financial linkages was measured by a dummy variable of 1 if on a study year, a mfi received a loan from commercial banks or large mfi at least tzs 50000 per its individual member or 0 otherwise. the independent variables were membership growth, membership size, size of loan and interest income. the model was written as follows: p = a + bl + [sigma]bc + e pi = a + [sigma][[beta].sub.i][c.sub.i] + [sigma][[beta].sub.2][l.sub.i] + [.sub.i] (1), where p, c, l, and e represented the saccos' performance, controllable variables, financial linkages and error term correspondingly while [[beta].sub.1], and [[beta].sub.2] presented the controllable variables and linkages parameters. similarly, nyamsogoro (2010) used dependent variable as financial self sufficiency (fss) to assess the sustainability of rural mfis (saccos, ngos and sacas) in tanzania. the independent variables were: mfis capital structure (equity/capital), interest rates, lending type (group or individual), cost per borrower, product type, mfi size, age, number of borrowers (as a proxy for outreach), female clients, yield on gross loan portfolio, level of portfolio risk, liquidity level, staff productivity and operating model (regulated vs non regulated). average loan size was used as a proxy measure for outreach while the size of mfi was measured by total assets. difficulty in assessing data forced the author to measure the depth of outreach by assessing the relationship between number of borrowers and profitability instead of using poor clients. i include this study because 82% of the sample size was saccos and sacas while the remaining sample items were ngo mfis. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 207 the model was specified as follows: itititit itititititit itititititit itititititi matigrtmatindtagrarea educareaborrowersregutedfemalemfisizeavoutloan mfitypemfiageloangrloanindiprodtypetpborr rinstainstalindtpdolstratecapstrucfss εβββ βββββ ββββββ ββββββα +++ ++++++ ++++++ ++++++= 2ln2ln lnlnln minmincosln lglncoslnint 201918 1716151413 121110987 654321 magali (2013a) assessed the factors affecting credit default risks for rural saccos’ borrowers in tanzania by using the multivariate regression analysis where the default risk (dependent variable) was proxied by non-performing loans (npl). the model was specified by the following equation: μ+++++++++++= 10109988776655443322110 xbxbxbxbxbxbxbxbxbxbby . the specified factors which determined the default risk were: age of the respondent, education of the respondent, size of household, marital status, interest rate, received loan amount, loan maturity, value of collateral, borrowers’ experiences in years and loan activity. similarly, magali (2013b) examined the rural saccos’ variables which influence the loans default risks in tanzania by using the multivariate regression model where the loans default risk was measured by npl. the model was specified as follows μ+++++= 443322110 bxbxbxbxby . the independent variables were savings and deposits, total assets, year of schooling of the manager and the number of borrowers with outstanding loans. moreover, magali (2013c) assessed the impacts of credits risk management on profitability of rural saccos in tanzania by using the univariate regression model where the credits risk management was measured by npl ratio and profitability was measured by returns on asset (roa) and returns on equity (roe). the univariate regression model was expressed as: μβα ++= )(),( tl nplroeroap (1), by simplifying the model, it can be written as: )(),( logtl lognplroeroap βα += (2), where p represents profitability and diversity of npl and tl were reduced by introduction of base 10 logarithm. furthermore, magali and pastory (2013) assessed the technical efficiency of rural saccos in tanzania by using dea where number of members, total savings and deposits and total expenses were classified as inputs while the loans issued were classified as output while marwa and aziakpono (2013) assessed the technical and scale efficiency of saccos in tanzania by using dea where the total costs and total fixed assets were classified as inputs while the total deposits and total loans in a portfolio were used as outputs. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 208 3. discussion of the findings the findings show that kenyan scholars lead in studying saccos’ issues. the findings from tanzania, kenya and other countries show that most scholars apply the regression analysis to model the saccos’ variables. clock backward (2009) asserted that most scholars prefer to use the univariate or multivariate regression models which apply ordinary least square (ols) method because its application in computers is simple, it can handle problems of various fields, simple to analyse mathematically as opposed to other models and the results from the regression analysis can be interpreted easily even to a non-mathematician. however, the results from the multivariate regression models need to be tested against heteroscedasticity, autocorrelation and multicollinearity as proposed by gujarat and porter (2010). likewise the findings show that most scholars in tanzania examined the outreach and sustainability of the saccos while few scholars analysed the efficiency. however, efficiency studies need to be extended so as to reveal the real situation of both rural and urban saccos’ efficiencies in tanzania separately. the findings further indicate that magali (2013a &b) assessed the credits risk management in rural saccos by using npl as dependent variables with a multiple regression model. this is an innovation since majority of authors use the amount of loans repaid by borrowers with multiple regression models to assess the credits/loans repayment performance in mfis (oladeebo and oladeebo 2008; acquah and addo 2011; haque et al 2011; ojiako and ogbukwa 2012). however, studies which examined the borrowers’ loans default risk applied the logit models (tra and lensink n.d; vasanthi and raja 2006; kohansal and mansoori 2009). moreover, mensah (2013) measured loans default by counting the number of times the borrower defaulted. magali (2013b) also adopted the model from commercial banks in measuring the impacts of credits risk management on profitability of the rural saccos. scholars who assessed the impacts of credits risk management on profitability of banks include achou and tenguh (2008), haneef et al (2012), funso et al (2012) and kaaya and pastory (2013). the findings show that this is the first study to be done in rural mfi (i.e saccos) in tanzania. the findings also indicate that to the best of my knowledge, only two studies (magali and pastory 2013 and marwa and aziakpono 2013) assessed the technical efficiency of saccos in tanzania by using dea. however, only magali and pastory (2013) focused the efficiency of rural saccos in tanzania while marwa and aziakpono (2013) assessed the efficiency of both rural and urban saccos. the literatures show that most scholars are interested to the study the efficiency of banks or other mfis (misra 2006; kipesha 2012, gwahula 2012). likewise the findings indicate that impacts of loans on clients were measured by using the logistic regression model (magali 2013d). the use of logistic regression in measuring impacts of mfis is not famous by many authors .the literature show that haque et al (2011) applied the logistic regression model to investigate the impacts of a mfi in bangladesh. 4. conclusion and recommendations this study used the literature review to examine the variables used to establish relationship between the independent and dependent variables in saccos modeling. the findings reveal asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 209 that currently few studies are done in tanzania and scholars applied mostly the regression models. however, the findings show that most studies which modeled the saccos variables were conducted in kenya. the findings further revealed that most scholars have empirically studied the outreach and sustainability of saccos compared to other topics. the studies from tanzania also show that most of issues have not been addressed in the research. this article recommends that scholars to assess issues which limit the saccos’ 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(2003). measuring social performance of micro-finance institutions: a proposal social performance indicators initiative (spi). final report submitted to argidius foundation and consultative group to assist the poorest (cgap). copyright disclaimer copyright reserved by the author(s). this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 5314-19246-1-sm-new-final.docx asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 236 the effects of the financial crisis on the financial performance of malaysian companies dr. ben chin-fook yap assistant professor, universiti tun abdul razak e-mail: benyap@unirazak.edu.my dr. zulkifflee mohamed assistant professor, universiti tun abdul razak e-mail: zulkifflee@unirazak.edu.my k-rine chong assistant lecturer, universiti tun abdul razak e-mail: krine@unirazak.edu.my received: march 15, 2014 accepted: april 8, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5314 url: http://dx.doi.org/10.5296/ajfa.v6i1.5314 abstract the 2007/08 financial crisis which began in the united states was not felt in malaysia until the last quarter of 2008 where gdp stalled and then began to fall. the country has a high export to gdp ratio and in 2009 the contraction in manufacturing exports was steep. this paper investigates the effects of the crisis on the financial performance of 70 companies in the manufacturing sector over a period of 5 years from 2006 to 2010. using factor analysis, an initial set of 21 financial ratios was reduced to just six significant ratios. using this smaller set of representative ratios, the sample companies were cluster analyzed into 4 categories of poor, below average, above average and good financial performers. the results showed that there is a direct effect of the financial crisis on the financials of companies in the study where 46 companies categorized as good in 2006 fell to just 6 in 2010 while 7 companies in the poor category increased to 27 during the same period. of particular concerns would be the 15 companies that fell three clusters down from good to poor performers and 15 out of 17 companies in the average categories that dropped into the poor performing category. a key finding from this study is that when a financial or economic crisis occurs, most companies’ financials would be severely and adversely impacted and if the negative economic conditions do not improve, there would be high probabilities that many companies would face liquidity asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 237 and solvency issues that could eventually lead to collapse and bankruptcies. finally, with just 6 key financial ratios, a company’s financial performance can be tracked and analyzed over a period of time resulting in the enhancement of the quality of credit evaluations as well as the minimizing of investor risks. keywords: financial crisis, financial performance, financial ratios, factor analysis and cluster analysis jel classifications codes: g33, c39, m41 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 238 1. introduction maximizing shareholders’ equity values has been generally accepted as one of the most important objective of any business organization even though this goal may not be stated explicitly. whether the other motivations for a business entity are corporate social responsibility, environmentally friendly policies or sustainable business development, maximizing profit will still be a dominant factor in management decision makings. according to hanson and wernerfelt (1989), there are two main areas of research on the determinants of company performance and success namely, the external market environment and organizational factors. however, the performance of a company depends on many factors internal and external. external factors would include the market conditions of the country where the company is located, government policies and regulations and the country’s current stage of economic development. internal factors would include the products and services the company is offering, the financial strength of the company as well as the quality of its management team. during normal times, however, poor financial performances are more likely to be caused by falling profits or losses for several years in succession, excessive debts, insufficient working capital, managerial errors and misjudgements, though management frauds have surfaced now and then and recently involving large multinationals. an economic downturn like the 1997-98 asian financial crises resulted in dampened business confidence, poorer company financial performance and increased company bankruptcies. in a study by cirmizi, klapper and uttamchandani (2012), the 2007/2008 financial crisis affected companies around the world resulting in reduced demand for goods and services, contraction in availability of business financing and a declining flow of inter-border investment funds. there was an increase in the level of insolvency among business entities due to declining demand for goods and services and decreasing availability of external finance. another study by erkens, hung and matos (2012) stated that due to the large numbers of collapses in the financial institutions around the world, there was a freeze of global credit markets that requires widespread government interventions. shama (1978) found that consumers felt more insecure over their employment during economic slowdowns and their buying behavior changes with the changing economic conditions. companies that are affected more severely during economic crisis may be forced to liquidate and cease business, while others affected less severely may have to curtain their operations, retrenching some of their workers, asking employees to accept a smaller compensation package and finding ways and means to cut costs so as to remain competitive. the study by koksal and ozgul (2007), found that managers are asked to either delay or abandon investment projects during an economic downturn while the study by ang, leong and kotler (2000) found that businesses will encounter cash flow issues as lending institutions and suppliers are reluctant to offer favorable financial terms and customers default on their outstanding credits or they simply buy and spend less. the resulting combinations of tight financing, reduced demand and fall in exports, reduced consumer spending and consumer sentiments will contribute to tight cash flows, declining cash positions, falling profitability and losses leading to potential insolvency and bankruptcy. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 239 therefore, to be able to analyse and track companies’ financial performance closely over time and to be able to classify companies into good or poor financial performers is of utmost importance. many interested stakeholders including individuals, institutional investors and fund managers who manage large investment portfolios can enhance the market value and returns of their clients’ investments if they are able to discriminate the weak companies from the healthy ones. having sufficient knowledge and skills in financial statement analysis can be very useful. financial ratios when used and properly interpreted will enable an external party to make informed judgments about a company’s profitability, management effectiveness and financial health and its ability to sustain and compete with other players in the industry. the purpose of this study is identify a smaller set of significant and representative financial ratios using factor analysis (from an initial set of 21 commonly used ratios found in the literature), that would be most effective in classifying 70 listed manufacturing companies from the malaysian stock exchange (bursa saham malaysia) according to their financial performance. the companies are randomly selected and represent about 28% of the total number of companies that are involved in the manufacturing of industrial products. another objective of this study is to use the smaller set of representative ratios as identified, to cluster these companies into four clusters namely good financial performers, above and below average performers and the poor performers. each company’s performance are analysed and tracked over a five year period from 2006 to 2010 to see how they have moved or migrated between the clusters. finally, a comparison is made to see whether there is a direct link between company financial performance and the financial crisis that started in 2007/2008. the gross domestic product (gdp) growths as well as the export data for the five years are used as indicators of the economic conditions during each of the five years. the rest of the paper is organized as follows: section 2 reviews the relevant literature, section 3 discusses the methodology, sample sizes and variables used, section 4 presents the findings and discussions on the findings, section 5 gives the concluding remarks of the paper and finally section 6 briefly describes the limitation of the study and recommendations for future studies. 2. literature review most businesses and corporations are compelled to produce a set of financial statements annually to comply with legal and regulatory requirements. for most stakeholders, to understand and evaluate the financial performance and financial status of companies may not be easy unless they have some basic knowledge in accounting and finance. when it comes to understanding how a company has performed in the past and its likely future performance, analysing financial statements is one of the most useful tools an interested party can use. eidleman (1995) states that financial-statement analysis looks at a firm's past performance to predict its future condition. lev and sunder (1979) found that financial ratios are used extensively by both practitioners and researchers. ratio variables have also been used in studies by cleary (1999) in explaining investment decisions by companies and by ozkan (2001) in his study on the determinants of companies’ capital structure. in the area of distress and bankruptcy prediction, quite a number of statistical techniques were employed in different models using quite a wide array of ratios in their initial studies and later selecting a asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 240 few that is felt to be most effective for prediction accuracy (altman (1968), pinches (1973), and jones and hensher (2004). using a combination of financial ratios on a set of financial statements can reveal strengths and weaknesses in a company. ratios are commonly used to track a company’s financial trend over time, whether profitability is acceptable and whether cash flows and cash positions are healthy. there are so many financial ratios that can be computed from the financial data found in a set of financial statements. as many of the ratios measure similar characteristics, it would not be necessary to use all of them. it has been found that a smaller set of dominant ratios are sufficient to evaluate the financial performances of companies (taffler 1983, and koh and killough (1990). one statistical method often used as data summarization and data reduction is factor analysis. . the result of data summarization is to derive the underlying dimensions that will describe the data in a much smaller number of concepts than the original individual variables. data reduction on the other hand extends the process of data summarization. it obtains an empirical value or factor score for each factor and this value will be used instead of the original values. some past studies that have used factor analysis to reduce a larger set of financial ratios into a smaller set of representative ratios include pinches (1973), tan et al. (1997), ganalsingam and kumar (2001), öcal et al. (2007) and anupam et al. (2011). cluster analysis is a statistical technique where similar entities are identified from the characteristics the entities possess. companies are clustered in the same group where the degree of association is strong between companies in that group and association is weak between members of different clusters. this is minimizing within-cluster variation and maximizing between-cluster variation. according to sharma and wadhawan (2009), in their study on using cluster analysis on small medium enterprises, clustering is explained as a mathematical method for segregating the observed data into groups so as to maximize the similarity of observations within the same group and minimize the similarity of observations across different groups. jensen and meckling (1976), in their study on using cluster analysis to study the financial performance of business firms, said that cluster analysis is about “classifying the entities into various clusters where items "within" a cluster are deemed to be more homogeneous than items "between" clusters”. sharma and wadhawan (2009) used eleven variables and produced three clusters. the objective of their study is to cluster the successful smes based on their growth, mode and strategies. using cluster analysis, they tried to search for the common characteristics between the different types of smes. 3. research methodology 3.1 sample size in this study, financial statements from the annual reports of companies from the industrial products sector as listed in the bursa saham malaysia (malaysian stock exchange) are used in this study. the companies would be randomly selected and analyzed over a period of five years from 2006 to 2010. 3.2 selection of variables twenty-one ratios are initially selected and classified into five groups. the ratios are chosen to ensure that all the financial characteristics of the companies are not excluded. the ratios asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 241 are grouped under five main categories to illustrate and represent the companies’ short-term liquidity and cash positions, profitability performance, solvency and leverage status and the efficient utilization of the company’s assets. table 1 below shows the groupings, the financial ratios and their codes used in the study” table 1. financial ratios group 1: shortterm liquidity group 2: profitability working capital ratio quick ratio wcr qr earnings b. interest and tax/total assets ebitta working capital/sales cash flow/sales wcs cfs net profit margin net income/total assets np nita cash flow/total assets cfta net income/total debts nitd cash flow/total debts cftd retained profit/total assets rpta group 3: cash position group 5: operating asset efficiency cash/sales cs debtors turnover dt cash/total assets cta inventory turnover it cash/current liabilities ccl total assets turnover tat cash/total debts ctd group 4: solvency & leverage total debts/total assets tdta total debts/shareholders fu tdsf long term debt/total assets ltdta 3.3 factor analysis factor analysis is a statistical tool from the spss is used as a data reduction technique to reduce the initial set of 21 financial ratios into a more parsimonious and smaller set of ratios to be used for the classification of the 70 companies according to their financial performance. this statistical method examined the interrelationships among a large number of variables and then tries to explain them in accordance to their underlying characteristics called factors. according to hair et al. (2009), for factor analysis to be used effectively, there should be at least five variables, that there should be more observations than the variables and that the minimum absolute sample size should be 50 observations. in this study, the sample size is 70 companies covering a period five years giving a total of 350 observations. to determine the number of factors to extract, this study will use the latent root criterion which sets a threshold value for assessing the eigenvalues of the derived factors. this means that only factors with an eigenvalue of more than 1 will be considered as significant and will be extracted. there must be multicollinerity in the variables and this is assumed to be the case before factorizing.. the variables must be interrelated, whether strongly or not, as the analysis aims to find the underlying common characteristics among the variables. if each variable is not related to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 242 another, then each variable will be its own factor as factor analysis has no common underlying dimensions with which to create factors. therefore, tests of appropriateness will be undertaken with the test of sphericity and the measure of sampling adequacy (msa) will be utilized. the bartlett test of sphericity test the null hypothesis that the correlation matrix is an identity matrix where all the diagonal elements is 1 and the off diagonal elements is 0 and this null hypothesis must be rejected. the bartlett test must have a p-value of < 0.05 to indicate that sufficient correlations exist among the variables. the measure of sampling adequacy is measured by the kaiser-meyer-olkin (kmo) statistic. if the variables (financial ratios) are correlated or at least partially correlated, then the kmo statistic will predict that the variables used will factor well and it can also identify the variables that need to be taken out of the analysis due to lack of interrelationship. the kmo statistic varies between 0 and 1, and values closer to 1 are better. if the reading is less than 0.5 then the variable with the lowest individual kmo statistic value will be removed one at a time until the kmo overall rises above .50, as well as when each individual variable kmo is above .50. 3.4 cluster analysis after factor analysis, the smaller set of ratios is then used in another statistical technique called cluster analysis from the spss to classify the sample companies into four clusters: good, above average, below average and poor performers. companies are clustered in the same group where the degree of association is strong between companies in that group and association is weak between members of different clusters. this is minimizing within-cluster variation and maximizing between-cluster variation. for this study, the k-means clustering method will be employed. the k-means algorithm method is a partitioning clustering approach in the k-means analysis, the number of clusters (k clusters) is initially specified. each cluster will have a centroid to be called the k centroid. the characteristics of a cluster are the centroid or average values of the characteristic of the variables comprising the cluster. these centroids should be placed as far away as possible from each other as the location can affect the result. the k-means algorithm aims at minimizing an objective function, in this case a squared error function. the objective function is: = ( ) − where ( ) − is a chosen distance measure between a data point ( ) and the cluster centre , is an indicator of the distance of the n data points from their respective cluster centers. the euclidean distance method measures the straight line distance between two points. for example, if we used the squared euclidean distance to measure the similarity between two points with specified dimensional spaces, the squared distance between any two points in a p-dimensional space is given by the formula: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 243 d 2 y = (x − x )p k=1 where x is the coordinate of the ith consumer for the variable and x is the coordinate of the jth consumer for the kth variable. dy is the distance between i and j, p is the number of variables and n=1, 2, 3,…, ∞. the f statistic and significance level of each variable will be examined on the significant differences across the three clusters. here, only the significant variables will be taken into account in the interpretation and the labeling of the three clusters. profiling of the clusters will be calculated with the use of discriminate analysis. profiling is a descriptive way to understand the characteristics of each cluster and how they differ from each other. anova may be used other than discriminate analysis as mentioned above. the companies are then clustered into good financial performers, average and poor performers within each sector. each cluster depending on the characteristics of the data used will defined the class they belong to. the cluster analysis will be performed for each year to check whether companies will remain or move within each cluster in each of the five years. 4. results and findings table 2 below showed the results of the factor analysis. six variables were selected as most significant and representative from the initial set of 21 ratios. of the six ratios, two measure operating asset efficiency while one each measure cash position, profitability, solvency and short-term liquidity. each of the six ratios showed high factor loadings and the criteria for selecting the ratios is that each must have an eigenvalue of more than 1. the communalities showed how much of the variance in the variables has been accounted for by the extracted factors. for example, 91.7% of the variance in cash to current liabilities are accounted for and 95% of the variance in earnings before interest and tax are explained. for all the ratios selected after the factor analysis, the factor loadings are very high ranging from 0.849 for total assets turnover to 0.943 for earnings before interest and tax indicating that the ratios selected are good representation of the initial set of ratios. the sampling adequacy was good with the kaiser-meyer-olkin (kmo) measure showing a p-value of 0749. the bartlett’s test of shpericity showed a p-value of 0.00 indicating that the null hypothesis that the variables in the correlation matrix are uncorrelated can be rejected. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 244 table 2. selected ratios after factor analysis ratio variables codes ratio category eigen values factor loadings communalities cash to current liabilities ccl cash position 7.120 0.923 91.7% earnings before interest & tax ebitta profitability 2.742 0.943 95% total debts to shareholders’ funds tdsf solvency 2.059 -0.807 76.7% cash flow to total assets cfta short-term liquidity 1.761 0.876 82.9% total assets turnover tat efficiency 1.590 0.849 80.8% inventory turnover it efficiency 1.059 0.923 86.7% table 3 below shows the results of the cluster analysis. the sample companies are classified into four clusters and the number of companies in each cluster for each of the years 2006 to 2010 is shown to illustrate the changes in the number of companies for each cluster over the five years, table 4 below shows the gross domestic product growth over the same five years. the effect of the financial crisis that started in 2007/2008 is clearly seen from the two tables below. in 2006 there were 46 companies in the good performing cluster and the number of companies in this cluster decreases over the five years and by 2010, they total only 6 companies. for the poor cluster, the number of companies increases from 7 in 2006 to 27 in 2010. analysing the 17 companies in both the average performing cluster, it was found that 15 of those companies have actually migrated downwards to the poor performing cluster. the performance of the companies is also reflected by the gdp and exports data as shown in table 4. the worst year for these two statistics was 2009 when gdp contracted 1.7% and exports contracted 17%.. the economic data improves quite quickly in 2010 coinciding with the improved economic indicators in the united states and china where much of malaysia’s external trade are with but the financial performance of malaysian companies have not recovered to the pre-crisis level. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 245 table 3. classification of companies after cluster analysis clusters 2006 2007 2008 2009 2010 poor 7 7 4 2 27 below average 15 17 42 48 3 above average 2 1 1 1 34 good 46 45 33 19 6 total 70 70 70 70 70 table 4. gross domestic products (gdp) and exports years 2006 2007 2008 2009 2010 gdp growth % 5.9 6.3 4.6 -1.7 7.2 exports usd 187 192 210 175 202 exports growth % 10 3 9 -17 15 table 5 below shows the f-statistics and the p-values of the ratio variables used in the cluster analysis. the f values would show how well the variables discriminate in the clustering process. variables with large f values will discriminate better than those with lower f values. the significance or p-values would not be useful in the usual tests of the hypothesis that the cluster means are equal and the f tests should be used as descriptive only. however, it is quite certain that those variables with f values greater than 0.05 would cluster the companies well. in different years different variables are found to cluster well. in 2006, ccl, tdsf and cfta are significant in clustering the companies well. for 2007, the significant variables are ccl, tat and it, for 2008 the variables are ebitta, cfta and it, for 2009, there is only one significant variable which is tat while for 2010, the significant variables are ccl, tat and it. overall, for the five years, tat and it are found to be potent as a clustering variable for 4 of the 5 years while ccl is useful for 3 of the years. table 5. anova statistics 2006 2007 2008 2009 2010 f value sig. f value sig. f value sig. f value sig. f value sig. ccl 35.07 .000 23.34 .000 1.136 .351 .181 .96 41.83 .000 ebitta 0.32 .895 1.59 .175 25.97 .000 1.13 .35 1.96 .096 tdsf 3.76 .005 2.11 .075 2.01 .089 2.26 .05 1.03 .406 cfta 0.44 .815 2.02 .086 2.61 .033 0.34 .88 1.87 .111 tat 216.4 .000 2345 .000 1.136 .351 585.5 .00 222.1 .000 it 2.28 .057 4.04 .003 1069.8 .000 1.957 .09 4.12 .003 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 246 5. concluding remarks this paper investigates the effects of the 2007/2008 financial crisis on the financial performance of 70 randomly selected listed companies in the manufacturing sector in malaysia over a period of 5 years from 2006 to 2010. using factor analysis, an initial set of 21 financial ratios was reduced to just six significant ratios which represented the underlying dimensions of the 21 ratios. of the six ratios identified, two are measures of efficiency in utilization of assets (total assets turnover and inventory turnover), and one each to measure cash position (cash to current liabilities), profitability (earnings before interest and tax), short term liquidity (cash flow to total assets), and one that measures solvency (total debts to shareholders’ funds). another objective of this study is to use the smaller set of representative ratios as identified, to cluster these companies into four clusters namely good financial performers, above and below average performers and the poor performers. each company’s performance are analyzed and tracked over a five year period from 2006 to 2010 to see how they have moved or migrated between the clusters. it was found that the companies’ financial performance have all declined sharply over the five years. of 46 companies in the good performing cluster in 2006, there were only 6 in this cluster in 2010. of the 7 poor performing companies in 2006, there were 27 in 2010 and analysing the average performing companies in the average clusters in 2006, it was found that 15 of those companies have actually fall downwards into the poor cluster in 2010. the results also showed that not all ratios are significant in its clustering abilities. the ratios that stand out are total assets turnover and inventory turnover which are significant in 4 of the 5 years while cash to current liabilities is found significant in 3 out of the 5 years. a comparison is made to see whether there is a direct link between company financial performance and the financial crisis. the findings showed that there is a direct correlation between the two where the country’s gdp growth and exports have contracted gradually since the crisis started with the most severe contraction in gdp and drop in exports in 2009 at the height of the financial crisis. however, the financial performance of malaysian companies has still not recovered to the pre-crisis level even in 2010. in conclusion, the study showed that with just 6 financial ratios, a company’s financial performance can be tracked and analysed over a period of time resulting in the enhancement of the quality of credit evaluations as well as the minimizing of investor risks. finally, this paper showed that though the 2007/08 financial crisis has affected the financial performance of companies, the extent and severity of the impact has been found to be much more devastating on companies’ financials than has generally been known as media reports then suggesting that the emerging economies like malaysia will not been too badly affected as they are not exposed to the many complex financial instruments including derivatives that to a great extent contributed to the subprime crisis. 6. limitation of the study and future studies this study is limited to 70 companies in the industrial products sector 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(1997). stability of financial ratios: a study of listed companies in singapore. asian review of accounting, 5(1), 9-39. http://dx.doi.org//10.1080/00014788.1995.9729943 microsoft word 5241-18976-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 337 multifactor explanations of capm anomalies: an evidence for indian stock market dr. a. balakrishnan assistant professor, department of banking technology pondicherry university, india tel: 91-94-8958-5514 e-mail: abalki22@gmail.com received: march 5, 2014 accepted: may 28, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5241 url: http://dx.doi.org/10.5296/ajfa.v6i1.5241 abstract we evaluate the ability of alternative asset pricing models in explaining returns on various characteristic (company size and value) sorted and prior return ranked portfolios. data is employed from january, 1997 to june, 2012 for 488 companies listed on bse-500 index. we find that fama-french three factor model performs better than one factor capital asset pricing model in explaining mean excess returns on characteristic sorted portfolios. we also observe that fama-french model partly explains long term, reversal, and momentum profits. asset pricing results are found to be vibrant to the alternate versions of company size and value factors and choice of different market proxies as the ff model (in all its versions) outperforms capm. we further show that the carhart four factor model involving an additional momentum factor, does not significantly perform better than ff model for different portfolios except short term momentum profits. keywords: capm, asset pricing, momentum effect, reversal effect and company size jel codes: c12, c31, g12, and g14 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 338 1. introduction capital asset pricing model (in short capm) developed by sharpe (1964) has laid empirical foundation that securities returns have linear relationship with their market betas and returns are adequately explained by market betas. the above arguments have been violated for us stock market due to the empirical evidences against the core predictions of the capm. one of the most important arguments posing challenge to capm is firm size-return relationship. banz (1981) documents size effect1 in which company size measured by market capitalization (market price of stocks times number of shares outstanding in the market) is related with stock returns. it means the companies with small size capitalization (small stocks) provide higher returns vis-à-vis the companies of big size capitalization (big stocks). chan (1985) shows that small firms provide higher returns than big firms as the small firms are likely to be exposed to economic fluctuations such as boom and depression. keim (1982) records size related anomaly and he finds that the abnormal returns are negatively related to size i.e., big size firms provide abnormal returns than small size firms. he also tests the seasonal effect in stock returns and finds that there is january effect in stock returns and abnormal returns are heavily registered in january. friend and lang (1988) experiment the size effect and also state that size is predominantly a risk effect which is not captured by beta. chan and chen (1991) express that small size firms provide better returns than big firms as the former tend to be having less operational efficiency, higher financial leverage, and weak ability to access for external financing etc,. another challenge the one factor capm confronts is the company value effect2 which is documented by different researchers for several stock markets of which some of the main studies are highlighted here. basu (1977) documents that stocks with low p/e ratios (an indicator of company value) provide superior returns than stocks with high p/e ratios. his arguments to this include non-reflection of p/e ratio information in securities prices, market disequilibrium, and entry of tax-paying investors in to capital market to rebalance their portfolios through buying low p/e stocks. bhandari (1988) observes a linear relation between stock returns and firm’s debt-equity ratio. chan, hamao, and lakonishok (1991) demonstrate that there is a positive relation between stock returns and corporate fundamentals such as size, book equity to market equity, earnings yield, and cash flow yield. they find a significant impact in stock returns and book equity to market equity and cash flow yield. chan, karceski, and lakonishok (1998) take on an empirical work which examines the stock returns’ relation with fundamental factors, technical factors, and macroeconomic factors and they find a significant influence of fundamental factors (accounting based variables) and technical factors (prior returns) in stock returns while poor relation is observed between stocks returns and macroeconomic factors. _____________ 1 size effect means small stocks (small size companies) outperform big stocks (big size companies) by providing extra-normal returns. see banz (1981). 2 value effect means low value stocks provide higher returns vis-à-vis high value stocks. see fama-french (1993), basu (1977), bhandari (1988), and chan, hamao, and lakonishok (1991). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 339 chui and wei (1998) test the relationship between stock returns and market beta, size, and book equity to market equity for the stock markets of hong kong, korea, malaysia, taiwan, and thailand. they find a positive relation between beta and stock returns is weak while size effect is strongly pronounced across the markets. book to market equity explains the stock returns in all the markets with exception of taiwan and thailand. stattman (1980) shows that stock returns have negative relation with book equity to market equity. another challenge of capm is prior return effect3 which means past returns on stock attract the investors. debondt and thaler (1985, 1987) find new evidence that most of the investors overreact to certain unexpected news released by corporate and events happening in the company. they further show that portfolios provided higher returns in the past starts giving lower returns in the future. chan, jegadeesh and lakonishok (1996) reveal that prior returns and past earnings surprise predict large variations in stock returns and these variations are not explained by market beta, size, and book equity to market equity. barberis, shliefer and vishny (1998) find that value stocks or out of favour stocks outperform the glamour stocks by providing higher returns. moreover, they see a little evidence in favour of an argument that value stocks are fundamentally risky. daniel, hirshleifer and subrahmanyam (1998) develop a theory which proves that the investors overreact to information which are of private in nature while underreact to public information being released corporate. hence, size, value, and prior returns are typically called as asset pricing anomalies. fama-french [(ff model) (1993)] propose a model which consists of three stock market related factors such as market, company size and value. the company size is represented by market capitalization while value is quantified by price-to-book ratio. fama-french (1996) develop a multifactor model which explains most of the capm anomalies excepting momentum pattern which is outlined later. they also show that their multifactor model can also explain stock returns when alternative measures of size and value factors are used. hence, the model has piqued the interest of the researchers and practitioners. jegadeesh and titman (1993) document of short term momentum effects in stock returns which could be achieved through buying stocks that provided better returns in the past and selling stocks that fetched poor returns in the past. this strategy is described as momentum strategy. jegadeesh and titman (2001) uphold the robustness of their previous findings. however ff multifactor model (1996) fails to explain this momentum pattern in stock returns. this led to the genesis of four factor model by carhart (1997) which includes a one year momentum factor recorded by (jegadeesh and titman) in addition to the already specified fama-french factors. the four factor model suggests that common factors associated with stock returns as well as investment expenses can explain returns on mutual funds. ________________ 3 for prior returns effect see de bondt and thaler (1985, 1987) and (jegadeesh and titman, 1993, 2001), fama-french (1966) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 340 lui and zhang (2008) find that substantial part of momentum profits are explained by industrial production which is one of the macroeconomic variables. they also perceive that expected growth in industrial production is a kind of risk which can be priced by the investors. fama-french (2008) re-examine and find the emergence of new stock return anomalies such as profitability, growth, accruals, net stock issues etc., besides size, value, and momentum. they further document that these anomalies are integrated with stock returns. fama-french (2012) test the integration between stock returns and size, value, and momentum for four regions namely north america, europe, japan, and asia pacific. they conclude that there is premium for value, size, and momentum in all regions with the exception of japan. three factor fama-french model has widely been accepted by stock markets across the world. [see fama-french (1998) and chui-wei (1998)]. in indian environment, connon g and sehgal s, (2003) reveal that their findings are benign to the ff model. sehgal s and balakrishnan i (2002) find that long term returns pattern reverts after short term momentum effect is controlled. sehgal s and balakrishnan i, (2008) also find that a major part of momentum profits on indian equities are explained by fama-french model. sehgal, s, and jain, s, (2009) document a strong short term momentum pattern in stock returns in indian stock market and they also find that momentum profits could not be explained by capm and ff model. sehgal, s, and jain, s, laurence, (2013) observe a weak momentum profits on portfolios formed using long term past returns. they further show that capm and ff model do not capture the long term momentum profits. sehgal s, and balakrishnan a, (2013) reconfirm the presence of strong size and value effects. they also find that ff model is stronger than capm in explaining stock returns. this paper attempts to examine the efficiency of three factor fama-french model (ff model), and four factor carhart model for indian stock market in explaining stock returns. to evaluate the above, we perform out of sample test using data for a longer time period (1997 2012). the sample covers more recent period. hence, this study will be a useful one to check if the fama-french factors continue to be valid over time. hence one does not infer that ff factors are not the outcome of investor fancies towards company characteristics which may be defunct in due course. we also test the efficacy of ff model using its alternative construction/selection of risk factors. we also evaluate the robustness of carhart four factor model in explaining the cross sectional average stock returns. the structure of the paper is as follows. section ii presents data and their sources. section iii examines if the fama-french three factor model is superior to one factor capm in terms of explaining stock returns. section iv verifies if ff model is robust to explain the average stock returns when fama-french alternative versions/risk factors are employed. section v tests the relative strength of carhart model vis-à-vis ff model in explaining stock returns. last section sheds light summary and conclusion of the study. 2. data the sample size of the study is 488 companies which are listed on a recognized stock exchange i.e., bombay stock exchange (bse) 500. the index is broad based one. the data consists of month end adjusted share prices4 from january, 1997 to june, 2012. the data source for share asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 341 price is cmie prowess. we form stylized portfolios based on company size and value which are described as company characteristics. the size of the company is measured using three variables such as market capitalization (mc), total assets (ta), and enterprise value (ev). ev is the total book value of debt plus market capitalization. value of the company is determined by using two measures such as price-to-book (p/b) and price-to-earning (p/e) ratios. fama-french (1993, 1995) find a relative distress/value effect for the companies. the premise of relative distress (value) factor is such that the companies which have low p/b and p/e ratios are expected by the investors to provide them higher returns as these companies are characterized as low earning companies while companies of high p/b and p/e ratios are potentially high earnings making companies which tend to provide lowerr returns to the investors as these companies are possibly less risky. in line with prior research, we also use p/b and p/e ratios as the measures of company value. we again collect the data for company characteristics from cmie prowess. treasury bill (t-bill) is one of the money market instruments being issued by government. return on t-bill has zero covariance with return on market portfolio and other risk factors. the implicit yields on t-bills are the risk free returns. moreover, it is a general practice in asset pricing research in india of using implicit yields on 91 day t-bills as risk free rate in order to compute excess returns on portfolio and excess returns on market. hence, we use implicit yields on 91-day treasury bills as risk free proxy. the implicit yields on 91 day t-bills are collected from reserve bank of india’s website. the bombay stock exchange (1983-84) and national stock exchange (nse-50) popularly known as nifty are used as market proxies. 3. explanation on the cross section of average stock returns: capm versus fama-french model connon g and sehgal s (2003) perform maiden experimentation of the ff model for indian stock market and find that ff model captures the mean excess returns on portfolios which is missed out by one factor capm. we examine whether ff model continues to be a successful asset pricing tool in a longer and more recent time period i.e. 1997-2012 for indian stock market. in order to execute this, we construct portfolios based on company characteristics using single and double sort criterion, also form the portfolios based on prior returns of the sample companies. ______________ 4 the study uses only adjusted share price for estimation purpose. it means the share prices are adjusted for capitalization changes such as stock split, stock dividends, and right issues. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 342 3.1 single sorted portfolios we start the analysis by ranking sample securities on a single criterion (company characteristic) i.e. measure of company size/value and form portfolios termed as single sorted portfolios. the portfolio construction procedure is as follows. first, we rank the companies at the end of june, 1997 (period t) on the basis of market capitalization (mc). then the companies are categorized in to five portfolios, p1 (portfolio one) contains 20% of the sample stocks with smallest mc while, p5 (portfolio five) comprises of 20% of the sample stocks with largest mc. then equally weighted returns on these five portfolios from july, 1997 (t) to june, 1998 (t+1) are calculated. then ranking is revised in june, 1998 and this process is repeated till end of the study period. next we estimate the mean excess return5 on each portfolio from july, 1997 to june, 2012. the similar procedure is adopted for alternative measures of company size i.e., ta and ev. since ta is fully accounting based information while ev happens to be partly accounting based data, they are made available to the public in the month of march of every year. unlike other countries, india has financial year in which march is the closing month. hence, some companies release the financial statement and other finance related information to the investors with some delay. this may trigger a lag between financial closing date and availability of financial information so as to be used by investors for their decision making purpose. hence, the portfolios are formed with a time gap of three months from financial closing date to overcome this problem. thus portfolios are formed based on these size measures in march of year (t), while the holding period starts from july of year (t) unlike market capitalization where portfolio ranking is done in june of (period t) as information is regularly available. next the sample stocks are sorted on the basis of relative distress measures (value factor) i.e. p/b and p/e ratios. while ranking is done based upon these financial ratios in march of year (t), portfolio is constructed from july to june (t) as p/b and p/e ratios are accounting based information and therefore the time gap for portfolio formation is necessary for reason stated above. then, we run capm regressions on returns on portfolios using prominent excess return version of the market model specification. rpt – rft = a+b (rmt-rft ) + et (1) where rpt – rft = excess returns (stock return minus risk free return) on portfolio, rmt – rft = excess returns on the market factor (excess of market returns over risk free return) a = measure of abnormal returns and b = sensitivity coefficient. _________________ 5 the excess return is the security return minus risk free return for corresponding time period asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 343 equation (1) is the capm specification which is estimated to verify whether returns on portfolio are fully explained by excess returns on market portfolio. this can be decided on the basis of ‘a’ (intercept) value. if the value of ‘a’ (intercept) is indistinguishable from 0, it implies that capm explains returns on portfolio otherwise one can presume that it fails to do so. equation (2) represents three market related anomalies such as market, size, and value, proposed by fama-french (1993). equation (2) is estimated to evaluate if ff three factors have the explanatory power of returns on portfolio as capm fails to explain the portfolio return. hence, we regress the excess returns on portfolios for fama-french factors being expressed in the way of: rpt – rft = a + b (rmt – rft) + ssmbt + llmht + et (2) where, smb and lmh are the risk proxies of company size and value respectively and s and l represent the sensitivity coefficients of smb and lmh factors. smb and lmh factors are constructed by performing double sorted criterion. next we rank the sample stocks on the basis of size and value of companies. the ranking procedure follows. in the month of june of year (t), we rank the sample stocks by taking market capitalization as a measure of size. then the stocks are categorized in to two groups namely small and big. bottom 50% of the stocks are named as small (s) and top 50% of the securities are called as big (b). then the sample stocks are again classified in to three groups namely low (l), medium (m), and high (h) based on p/b ratio which is a value measure. to the above classification based on p/b ratio, we use the following breakpoints. first 33.33% of stocks from bottom are falling in the low group, next 33.33% of stocks are in the bracket of medium group, and above 66.66% of the stocks are in the high group. then from the intersection of two size and three value groups, six portfolios consisting of s/l, s/m, s/h, b/l, b/m and b/h are constructed. the s/l portfolio contains small size and low value stocks, while b/h comprises of big size and high value stocks. the smb (small minus big) portfolio means mimicking the risk factor in returns associated with mc (measure of size of the company). smb is the average returns on small stock portfolios (s/l, s/m, and s/h) reduced by average returns on big-stock (b/l, b/m, and b/h) portfolios. smb is expressed as follows: smb = (((s/l) + (s/m) + (s/h)) ((b/l) + (b/m) + (b/h)))/3 (3) lmh (low minus big) portfolio means mimicking the risk factor associated with returns related to p/b ratio (measure of value of the company). lmh is the average of the returns on high – p/b portfolios (s/h and b/h) minus average returns on low p/b portfolios (s/l and b/l). lmh is shown as under: lmh = (((s/l) + (b/l) – ((s/h) + (b/h)))/2 (4) the estimation of the lmh differs from ff model (1993) which uses hml, meant to mimick the risk factor in returns relating to value factor. hml is constructed using book equity to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 344 market equity (be/me). we estimate lmh using price-to-book ratio (p/b) which is the mirror image of be/me. hence, the interpretation of the results of value factor will be inverse to those of ff model (1993). table 1 (a) presents means excess returns on size/value based portfolios. the mean return on p1 exceeds that of p5 by about 43% on annualized basis using alternative size definitions except total assets whose mean return differential is 40%. hence at prima facie, a strong size effect is observed. the company value is defined using two measures namely p/b and p/e ratios. p1 is the portfolio with the highest relative distress firms (firms having weak fundamentals) and p5 is the portfolio with lowest relative distress firms (firms with strong fundamentals). the results for two relative distress proxies are also provided in table 1 (a). the mean return differentials between portfolios p1 and p5 are 24% and 14% for p/b and p/e respectively. this reveals a strong value effect. further, we observe the relationship between company size/value and return is monotonic in nature. the return differentials between p1 and p5 are high, thus, indicating returns could be influenced by risk factors. hence, it is imperative to check if excess returns on size and value based portfolios are captured by risk models. in table 1 (b), regression results for one factor capm are presented. it is seen that capm does not explain the excess returns on portfolios. this is confirmed from the fact that alphas (intercepts) of all p1 are distinguishable from zero. it means abnormal returns on portfolios seem bigger. further, the inability of capm to the above is also witnessed from the t-statistics of alphas which are significant at 5% level. similar results are found for alternative size/value measures. further, betas differentials between p1 and p5 seem to be little which also indicates the failure of capm to explain extra normal returns. table 1 (c) documents regression results for size/ value sorted portfolios using ff model are reported. it can be noted that small stock portfolios load heavily on size factor, while strong size effect is countered by inverse value effect thus reducing the power of ff model in explaining abnormal returns on size sorted portfolios. there is an inverse value effect found with the exception of market capitalization based classification. low p/b and p/e stocks are highly sensitive to both size and value factors compared to high p/b and p/e stocks resulting in low alpha. ff model alphas are however smaller than capm alphas. our results show that ff model explains major part of extra normal returns on single sorted portfolios compared to capm. 3.2 double sorted portfolios next we form portfolios based on two company characteristics by adopting double sorted criterion which has already been discussed in the previous sub-section. then, we construct six sets of portfolios using the standard ff model definition i.e., mc-pb as well as alternative versions of ff model (mc-pe, ta-pb, ta-pe, ev-pb, and ev-pe). these six sets are made by combining size and value measures. the mean excess returns on portfolios formed using double sort are given in table 2 (a). it is clear that the returns on all small size and value (s/l) stocks are more than that of big and growth (b/h) stocks. this indicates that indian stock market has strong influence of company asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 345 size and value effects. however, these findings are not consistent with berk’s empirical findings which prove that size effect is an outcome of endogenous identity. moreover, it is noting worth that size effect is pervasive for all three size measures (mc, ta, and ev). mc is a market based measure while latter two are non-market based measures. berk does not find size effect for non-market measures6. next, we verify if size and value effects in stock returns could be explained by asset pricing models. the regression results of capm are shown in table 2 (b). it is clearly understood that the model fails to explain average returns on s/l stocks. this is substantiated with alphas of all s/l stocks are not close to zero and t alphas are statistically significant at 5% level. table 2(c) presents the regression results of ff model. the results clearly express that ff model captures the average returns on s/l portfolio. the explanation for this is s/l portfolios load heavily on size and value factors. it is also noticed that alphas of all s/l portfolios are almost decimated. this again confirms that the ff model is a better descriptor. 3.3 prior return portfolios 3.3.1 portfolios based on long term past returns we form the portfolios based on long-term prior returns as has been done by de bondt and thaler (1985) and fama-french (1996). in the month of june of each year t, we rank the sample stocks in ascending order on the basis of their average returns during last three years (36 months) then we form five portfolios. the bottom 20% of the sample stocks are called portfolio one (p1) whereas top 20% of the sample stocks are clubbed in portfolio five (p5). p1 is found to be the loser portfolio as it provided the lowest past returns while p5 is the taken as the winner portfolio as it yielded the highest returns. then equally weighted returns on monthly basis on these five portfolios from july of year t to june of year t+1 are calculated. the portfolios are reformed in june of year t+1, on the assumption that portfolio holding period is 12 months. thus, we adopt i months/j months trading strategy, where i is the portfolio formation period and j is the portfolio holding period. table 3 (a) shows the mean returns on loser (p1) and winner (p5) portfolios. the mean excess returns on p1 and p5 are 29% and 35% respectively on annualized basis. the results suggest the presence of long term momentum pattern in stock returns. table 3 (a) also reveals of regression results for long term prior return portfolios regressed on the market factor as per capm model. the capm does not have explanatory power as alphas for p1 and p5 are statistically significant. the regression results of ff model are also reported in table 3 (a). the ff model partly captures the abnormal returns. _________________ 6 book value of assets, book value of all un-depreciated assets including plant and equipments, total annual sales, total number of employees asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 346 it is also important to check that if average returns tend to reverse when the portfolios are formed using returns for three years prior to portfolio formation. international evidence points out reversals in long term returns while a momentum pattern for such data is observed in the case of india. our long term results may be distorted due to the fact that there is a strong short term momentum in stock returns shown later where this short term (12 months) is forming part of long term data. to correct this, one year is skipped between portfolio formation and holding periods as suggested by fama-french (1996). in the month of june of year (t), we rank the sample stocks in ascending order on the basis of their average returns during last three years (36 months) then we form five portfolios. p1 and p5 are termed as loser and winner portfolio respectively. then equally weighted returns on monthly basis on these five portfolios from july of year t to june of year t+1 are calculated. the portfolios are reformed in june of year t+1, on the assumption that portfolio holding period is 12 months. we thus adopt 36 month 12 month trading strategy skipping one year between portfolio formation period and portfolio holding period. the results for these portfolios are shown in table 3 (b). one can observe that there is a weak reversal pattern in stock return after controlling the momentum effect. capm again fails to explain returns on corner7 portfolios and ff model is able to capture the abnormal returns partly. this is predominantly due to the fact that loser portfolio loads heavily on the value factor compared to winner portfolio. this supports the risk argument as the loser seems to be fundamentally weak as it contains mainly low p/b stocks. 3.3.2 portfolios based on short-term past returns we finally form portfolios based on short term past returns as suggested by jegadeesh and titman (1993). for this purpose stocks are sorted on the basis of their average excess returns in the past one year (12 months). then five portfolios are formed that equally weight the securities composition. the bottom 20% of the securities are termed as portfolio one (p1) whereas top 20% of the securities are called portfolio five (p5). according to this classification again p1 and p5 are the loser and winner portfolios respectively. then equally weighted returns on monthly basis on these five portfolios from july of year t to june of year t+1 are calculated. the portfolios are reformed in june of year t+1, on the assumption that portfolio holding period is 12 months. thus we adopt 12 month/12 month trading strategy. the results for short term past return portfolios are reported in table 3 (c). one can observe a strong momentum pattern in stock returns. capm as expected does not explain momentum returns. interestingly, the ff model partly explains abnormal returns on the winner portfolio. this is owing to the fact that p5 loads heavily on size factor. however it does not happen with value factor as p5 fails to load on value factor. thus, implying it comprises of small stocks. ______________ 7 empirical results in all tables except (table 2) are shown only for the corner portfolios. the results for intermediate portfolios though estimated, are not shown due to the paucity of space. in the case of double sorted portfolios, results are shown for all the portfolios as they are not formed on a single criterion. hence, corner portfolios do not exist. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 347 4. fama-french alternative definitions/versions section 3 of this paper discusses the ability of ff model with its standard version i.e., mc_pb in explaining returns on portfolios based on characteristic and prior return sorted portfolios. we find that substantial part of returns on portfolios based on company characteristics and half of the returns on portfolios based on prior returns are explained by standard version of the ff model (mc-pb). it tempts us to verify if ff model with its alternative versions such as mc-pe, ta-pb, ta-pe, ev-pb, and ev-pe can extend its explanatory power on portfolio returns. the erstwhile six versions/definitions including mc-pb have been constructed using three size measures (mc, ta and ev) and two value measures (p/b and p/e). we also check the robustness of our asset pricing results to the selection of market proxy by using another stock market index namely nse-50 in place of the bse-200 which has been used initially. nse-50, like bse-200 is a popular value weighted index but is comparatively narrow based. the theoretical arguments suggest that broad based index should be a better proxy for market portfolio (which is value weighted and all-inclusive). hence, we expect stronger results for bse-200 compared to nse-50 index. table 4 (a) provides the results for single sorted, double sorted, and prior return portfolios using bse-200 as a market surrogate while table 4 (b) provides similar results for nse-50. it is observed that ff model shows stronger results across the versions. the values of mean absolute alphas and adjusted r2 showing the measure of abnormal returns and goodness of fit respectively appear to be similar in all six versions. at the same time it is noting worth that capm has substantially high mean absolute alpha and significantly lower adjusted r2. hence, one can suggest that the ff model is undoubtedly superior to capm. further, these results are robust to irrespective of the market proxy used by us. therefore, the ff model is also robust to its alternative versions/risk factors and, in general, does much better job in explaining average returns compared to one factor capm. 5. carhart four factor model in the previous section we find that the ff model is not able to fully explain returns on size and value sorted portfolios. we now verify if the carhart (1997) four factor model does a better job than ff model in explaining prominent asset pricing anomalies, especially momentum. carhart’s model includes the three factors specified by ff (1993) and an additional momentum which is constructed by taking the difference between the returns on winner and loser portfolios based on short term (12 months) past returns on period to period basis. the carhart’s specification is: r pt r ft = a + b (rmt – rft) + s smb t + l lmh t + w wml t + e t (5) where wml is mimicking portfolio that proxies for momentum factor in returns. w is the sensitivity coefficient. all other terms in equation have been described earlier. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 348 we repeat our experiments for characteristic sorted as well as prior return ranked portfolios. the results for carhart model are provided in table 5. we observe that four factor model does not significantly perform better than the three factor model in explaining the abnormal returns (alphas) on size and value sorted portfolios. the four factor model also fails to explain long term momentum profits (reversals) as winner portfolio does not load on momentum factor. however, carhart model does explain one year momentum profits that are partly left unexplained by the ff model owing to the fact that winner portfolio (p5) loads heavily on the momentum factor. one possible explanation for the success of stock momentum factor could be that it proxies for industry momentum. this implies that winning stocks come from industries which perform well in the recent past while losing stocks belong to poor performing industry. to the extent differences in industry performance is a reflection of differences in industry growth potentials, industry momentum factor is fundamental in nature and its impact is felt through the stock momentum factor (see liu and zhang (2008). this may lend support to the behavioral argument that momentum profits result owing to investor under reaction to past information. 6. conclusions in this paper we experiment the established asset pricing models’ ability to explain cross section of average stock returns. sample size is 488 indian companies from 1997 to 2012. the sample companies are actively trading in the market. we perform our tests using three experimental portfolios: 1. single sort based on size and value 2. double sort based on size/value 3. prior return portfolios based on long term (36 months), reversal, and short term (12 months) momentum effects. mc, ta, and ev are used as the measures of company size while p/b and pe ratios are used as the measures of company value. empirical results confirm that stock returns are strongly influenced by size and value factors in indian stock market. it is also documented that ff model continues to be a better asset pricing tool as it explains the returns on portfolios formed on the basis of company characteristics. however, the ff model is not able to explain abnormal returns fully that is missed out by capm. these results are echoing the previous findings for the indian stock market shown by sehgal s and balakrishnan a (2013). our study covers longer time period including more recent years and suggest that the ff size and value factors have become relatively less important. more appropriately, it may imply that size and value do not proxy for any risk factors but perhaps represent investor fancy for certain firm characteristics as suggested by daniel and titman (1997) that are fading overtime the ff model is able to partly capture contrarian and momentum patterns in stock returns that are missed by capm. the results contradict with previous findings documented by sehgal and sakshi jain (2009 and 2011). we also evaluate the robustness of asset pricing results to alternative constructions/selection of the risk factors. we find that the ff model outperforms capm in all its versions involving alternative proxies of size and value factors and use of different market proxies. finally, we evaluate if the carhart four factor model which includes an additional momentum factor besides the ff factors, does a better job than ff model in explaining returns. it is shown asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 349 that the carhart model does not perform significantly better than the ff model for characteristics sorted portfolios as well as long term momentum profits. however, the four factor model does explain the momentum profits this is owing to the fact that the winner portfolio loads on the momentum factor. momentum profits do survive even in a four factor framework thus implying that continuation patterns may partly have their source in non rational investor behavior which cannot be explained by any systematic risk factor. the study contributes to the asset pricing literature especially for indian 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(1980). book values and stock returns. the chicago mba: a journal of selected papers, 4(1), 25-45. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 352 table 1. empirical results for single sorted portfolios for size sorted portfolios p1 represents small size stocks while p5 indicates big stock portfolios (based on market capitalization, total assets and enterprise value). for value sorted portfolios (based on price to book and price to earning ratios) p1 represents value stocks while p5 denotes growth stocks. panel a: mean excess returns mc p1 p5 mean 0.045 0.009 standard deviation 0.121 0.088 ta p1 p5 mean 0.047 0.014 standard deviation 0.114 0.100 ev p1 p5 mean 0.046 0.010 standard deviation 0.111 0.093 pb p1 p5 mean 0.034 0.014 standard deviation 0.121 0.090 pe p1 p5 mean 0.029 0.017 standard deviation 0.109 0.105 panel b: capm results mc a b t(a) t(b) r2 p1 0.037 1.101 6.339 15.834 0.585 p5 0.001 1.002 0.697 42.685 0.911 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 353 ta a b t(a) t(b) r2 p1 0.040 1.067 7.586 17.162 0.623 p5 0.007 1.082 2.114 29.481 0.830 ev a b t(a) t(b) r2 p1 0.038 1.068 7.700 18.139 0.649 p5 0.003 1.038 1.110 36.604 0.883 pb a b t(a) t(b) r2 p1 0.026 1.126 4.612 16.848 0.615 p5 0.007 0.979 2.411 29.758 0.833 pe a b t(a) t(b) r2 p1 0.022 1.059 4.535 18.764 0.664 p5 0.009 1.141 2.794 29.768 0.833 fama-french model results mc a b s l t(a) t(b) t(s) t(l) r2 p1 0.006 0.981 1.595 0.300 2.035 31.854 23.048 5.108 0.921 p5 0.002 0.984 -0.131 0.233 1.127 44.339 -2.637 5.524 0.923 ta a b s l t(a) t(b) t(s) t(l) r2 p1 0.013 1.008 1.496 -0.211 3.966 26.994 17.839 -2.974 0.869 p5 0.004 1.015 -0.080 0.667 1.570 39.857 -1.391 13.765 0.921 ev a b s l t(a) t(b) t(s) t(l) r2 p1 0.012 0.983 1.402 0.073 4.333 32.818 20.826 1.275 0.912 p5 0.001 1.002 -0.044 0.358 0.491 40.104 -0.779 7.528 0.912 pb a b s l t(a) t(b) t(s) t(l) r2 p1 0.001 0.982 1.054 0.800 0.438 31.057 14.837 13.285 0.916 p5 0.001 0.990 0.424 -0.316 0.336 33.403 6.375 -5.593 0.869 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 354 pe a b s l t(a) t(b) t(s) t(l) r2 p1 0.000 0.946 0.943 0.578 0.136 31.816 14.127 10.205 0.910 p5 0.001 1.127 0.480 -0.118 0.283 31.501 5.975 -1.731 0.859 table 2. empirical results for double sorted portfolios formed on alternative measures of company size and value panel a: mean excess returns mc_pb s/l s/m s/h b/l b/m b/h mean 0.037 0.028 0.028 0.016 0.011 0.011 standard deviation 0.123 0.107 0.107 0.106 0.097 0.085 mc_pe s/l s/m s/h b/l b/m b/h mean 0.034 0.029 0.032 0.017 0.012 0.009 standard deviation 0.112 0.103 0.113 0.101 0.090 0.095 ta_pb s/l s/m s/h b/l b/m b/h mean 0.040 0.027 0.018 0.024 0.015 0.011 standard deviation 0.118 0.103 0.095 0.114 0.104 0.095 ta_pe s/l s/m s/h b/l b/m b/h mean 0.039 0.025 0.022 0.020 0.017 0.011 standard deviation 0.110 0.097 0.101 0.105 0.100 0.103 ev_pb s/l s/m s/h b/l b/m b/h mean 0.038 0.029 0.024 0.019 0.011 0.010 standard deviation 0.118 0.106 0.101 0.116 0.103 0.088 ev_pe s/l s/m s/h b/l b/m b/h mean 0.035 0.029 0.028 0.017 0.013 0.009 standard deviation 0.111 0.100 0.105 0.105 0.095 0.098 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 355 panel b: capm results for double sorted portfolios mc_pb a b t(a) t(b) r2 s/l 0.029 1.146 5.074 16.742 0.612 s/m 0.021 1.049 4.511 19.260 0.676 s/h 0.021 1.103 5.014 22.665 0.743 b/l 0.008 1.111 2.161 24.722 0.774 b/m 0.003 1.083 1.192 35.010 0.873 b/h 0.004 0.940 1.554 32.219 0.854 mc_pe a b t(a) t(b) r2 s/l 0.026 1.057 5.091 17.166 0.623 s/m 0.022 0.995 4.891 18.517 0.658 s/h 0.023 1.169 5.586 23.603 0.758 b/l 0.009 1.085 2.686 28.213 0.817 b/m 0.005 0.998 1.896 34.399 0.869 b/h 0.001 1.041 0.498 30.459 0.839 ta_pb a b t(a) t(b) r2 s/l 0.032 1.082 5.748 16.230 0.597 s/m 0.019 1.015 4.441 19.605 0.683 s/h 0.011 0.995 3.206 24.648 0.773 b/l 0.016 1.127 3.379 19.865 0.689 b/m 0.007 1.125 2.196 28.338 0.819 b/h 0.003 1.069 1.262 37.668 0.889 ta_pe a b t(a) t(b) r2 s/l 0.031 1.020 6.064 16.674 0.610 s/m 0.018 0.980 4.704 21.086 0.714 s/h 0.014 1.047 3.806 23.865 0.762 b/l 0.012 1.070 2.946 22.100 0.733 b/m 0.009 1.088 2.938 29.569 0.831 b/h 0.003 1.131 1.065 31.878 0.851 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 356 ev_pb a b t(a) t(b) r2 s/l 0.030 1.080 5.336 16.109 0.593 s/m 0.021 1.034 4.692 19.242 0.675 s/h 0.017 1.038 4.458 23.142 0.751 b/l 0.011 1.178 2.408 21.714 0.726 b/m 0.003 1.136 1.093 32.809 0.858 b/h 0.003 0.965 1.349 32.654 0.857 ev_pe a b t(a) t(b) r2 s/l 0.027 1.046 5.336 17.146 0.623 s/m 0.022 0.972 5.149 18.988 0.669 s/h 0.020 1.088 5.088 23.580 0.758 b/l 0.009 1.116 2.495 26.820 0.802 b/m 0.006 1.047 2.036 32.386 0.855 b/h 0.002 1.070 0.508 30.338 0.838 panel c: fama-french model results mc_pb a b s l t(a) t(b) t(s) t(l) r2 s/l 0.002 1.002 1.217 0.718 0.750 32.805 17.734 12.336 0.925 s/m -0.002 0.962 1.160 0.216 -0.768 31.451 16.882 3.705 0.901 s/h 0.002 1.074 1.102 -0.296 0.704 32.212 14.709 -4.666 0.883 b/l 0.001 1.025 0.109 0.742 0.457 32.635 1.547 12.411 0.893 b/m 0.000 1.060 0.145 0.139 -0.175 35.008 2.133 2.407 0.882 b/h 0.001 0.954 0.225 -0.244 0.493 34.058 3.576 -4.570 0.869 mc_pe a b s l t(a) t(b) t(s) t(l) r2 s/l 0.001 0.939 1.237 0.459 0.205 31.997 18.758 8.212 0.917 s/m 0.001 0.921 1.087 0.127 0.378 25.924 13.617 1.870 0.855 s/h 0.004 1.120 1.073 -0.092 1.322 32.986 14.067 -1.417 0.890 b/l 0.002 1.021 0.151 0.523 0.899 33.642 2.222 9.056 0.890 b/m 0.001 0.977 0.144 0.122 0.457 34.371 2.252 2.245 0.878 b/h -0.001 1.041 0.150 -0.076 -0.269 30.044 1.933 -1.151 0.840 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 357 ta_pb a b s l t(a) t(b) t(s) t(l) r2 s/l 0.003 0.961 1.422 0.404 1.187 30.654 20.188 6.766 0.914 s/m 0.000 0.968 1.110 -0.131 -0.082 26.589 13.570 -1.891 0.848 s/h 0.002 1.000 0.607 -0.364 0.642 28.330 7.653 -5.411 0.832 b/l 0.000 1.006 0.598 0.821 -0.091 30.924 8.185 13.252 0.901 b/m 0.000 1.062 0.260 0.459 -0.153 33.046 3.597 7.494 0.885 b/h 0.000 1.062 0.172 -0.029 0.016 37.305 2.681 -0.542 0.891 ta_pe a b s l t(a) t(b) t(s) t(l) r2 s/l 0.005 0.922 1.313 0.243 1.758 27.260 17.275 3.776 0.885 s/m 0.002 0.939 0.934 -0.098 0.572 27.057 11.976 -1.488 0.846 s/h 0.002 1.036 0.755 -0.279 0.574 27.887 9.051 -3.942 0.835 b/l -0.002 0.974 0.539 0.618 -0.703 31.413 7.743 10.469 0.894 b/m 0.003 1.034 0.212 0.401 0.910 33.319 3.042 6.784 0.884 b/h -0.001 1.113 0.193 0.070 -0.263 31.514 2.437 1.042 0.857 ev_pb a b s l t(a) t(b) t(s) t(l) r2 s/l 0.003 0.950 1.280 0.557 0.944 28.656 17.190 8.824 0.904 s/m 0.000 0.966 1.145 0.040 -0.056 27.551 14.533 0.596 0.866 s/h 0.002 1.023 0.913 -0.333 0.691 29.881 11.865 -5.101 0.859 b/l -0.002 1.066 0.435 0.820 -0.773 31.306 5.690 12.647 0.895 b/m -0.001 1.103 0.160 0.228 -0.419 33.481 2.163 3.632 0.876 b/h 0.001 0.978 0.236 -0.241 0.223 34.455 3.703 -4.463 0.872 ev_pe a b s l t(a) t(b) t(s) t(l) r2 s/l 0.002 0.937 1.229 0.383 0.747 28.867 16.856 6.189 0.897 s/m 0.003 0.914 1.042 0.007 0.883 25.351 12.871 0.104 0.841 s/h 0.003 1.057 0.952 -0.194 1.104 30.627 12.278 -2.948 0.869 b/l -0.002 1.037 0.411 0.527 -0.878 36.292 6.402 9.685 0.909 b/m 0.001 1.021 0.176 0.157 0.446 32.640 2.504 2.636 0.869 b/h -0.001 1.067 0.156 -0.050 -0.323 29.826 1.945 -0.732 0.839 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 358 table 3. empirical results for prior returns portfolios formed on long term prior returns we adopt a 36/12 strategy. while 36 month is portfolio formation period while 12 month is the portfolio holding period. p1 includes past loser and p5 includes past winner. panel a: mean excess returns p1 p5 mean 0.024 0.029 standard deviation 0.104 0.122 capm results a b t(a) t(b) r2 p1 0.015 1.103 3.624 21.894 0.771 p5 0.018 1.344 4.289 26.583 0.833 ff model results a b s l t(a) t(b) t(s) t(l) r2 p1 -0.002 1.012 0.720 0.304 -0.471 25.958 7.955 3.580 0.874 p5 0.004 1.321 0.893 -0.229 1.132 31.490 9.169 -2.498 0.894 we adopt a 36/12/12 strategy. the portfolio formation period is 36 month. we skip 12 months between portfolio formation and holding periods. the portfolio holding period is 12 month. p1 contains past loser and p5 comprises of past winners. panel a: mean excess returns p1 p5 mean 0.031 0.030 standard deviation 0.102 0.123 capm results a b t(a) t(b) r2 p1 0.017 1.121 4.298 22.571 0.797 p5 0.014 1.399 3.277 27.414 0.853 ff model results a b s l t(a) t(b) t(s) t(l) r2 p1 0.002 0.995 0.691 0.397 0.704 29.849 9.389 5.475 0.920 p5 0.001 1.365 0.762 -0.132 0.345 30.348 7.676 -1.351 0.899 panel b: portfolios formed on short-term past returns. we adopt a 12/12 strategy. portfolio formations as well as portfolio holding period are of 12 month each. p1 consists of past loser and p5 contain past winner. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 359 mean excess returns p1 p5 mean 0.022 0.033 standard deviation 0.111 0.118 capm results a b t(a) t(b) r2 p1 0.012 1.120 2.595 20.754 0.722 p5 0.021 1.247 4.998 24.762 0.787 ff model results a b s l t(a) t(b) t(s) t(l) r2 p1 -0.004 1.044 0.698 0.336 -0.886 23.892 7.004 4.087 0.823 p5 0.006 1.213 0.901 -0.190 1.624 29.414 9.580 -2.443 0.862 table 4. empirical results for alternative construction/selection of fama-french factors in this table we show how capm and alternative versions of the fama-french model is explaining cross-section of returns on various characteristic sorted and prior returns portfolios. panel a shows the results for bse-200 when bse-200 is used as a market proxy for estimating models while panel b provides results using nse-50 as market proxy. single sorted portfolios formed on company size: comparative results for capm and alternative versions of fama-french model. panel a: market proxybse-200 is used as a market proxy for estimating capm as well as fama-french model model mean/alpha r2 market (capm) 0.015 0.755 market,smb1,lmh1(standard fama-french model – (version1) 0.004 0.880 market,smb2,lmh2 (version-2) 0.004 0.861 market,smb3,lmh3 (version-3) 0.004 0.866 market,smb4,lmh4 (version-4) 0.005 0.833 market,smb5,lmh5 (version-5) 0.004 0.874 market,smb6,lmh6 (version-6) 0.004 0.851 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 360 single sorted portfolios formed on company value: comparative results for capm and alternative versions of fama-french model. model mean/alpha r2 market (capm) 0.014 0.771 market,smb1,lmh1(standard fama-french model – (version1) 0.002 0.882 market,smb2,lmh2 (version-2) 0.001 0.868 market,smb3,lmh3 (version-3) 0.003 0.869 market,smb4,lmh4 (version-4) 0.005 0.841 market,smb5,lmh5 (version-5) 0.002 0.877 market,smb6,lmh6 (version-6) 0.002 0.856 double sorted portfolios formed on different measures of company size and value: comparative results of capm and fama-french model. model mean/alpha r2 market (capm) 0.014 0.751 market,smb1,lmh1(standard fama-french model – (version1) 0.002 0.878 market,smb2,lmh2 (version-2) 0.002 0.862 market,smb3,lmh3 (version-3) 0.003 0.865 market,smb4,lmh4 (version-4) 0.005 0.837 market,smb5,lmh5 (version-5) 0.001 0.874 market,smb6,lmh6 (version-6) 0.002 0.854 portfolios formed on long term past returns without skipping one year: comparative results for capm and fama-french model. model mean/alpha r2 market (capm) 0.015 0.820 market,smb1,lmh1(standard fama-french model – (version1) 0.002 0.906 market,smb2,lmh2 (version-2) 0.001 0.895 market,smb3,lmh3 (version-3) 0.003 0.888 market,smb4,lmh4 (version-4) 0.005 0.862 market,smb5,lmh5 (version-5) 0.001 0.893 market,smb6,lmh6 (version-6) 0.002 0.874 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 361 portfolios formed on long term past returns skipping one year between portfolio formation and holding period: comparative results for capm and fama-french model. model mean/alpha r2 market (capm) 0.014 0.825 market,smb1,lmh1(standard fama-french model – (version1) 0.001 0.917 market,smb2,lmh2 (version-2) 0.001 0.909 market,smb3,lmh3 (version-3) 0.002 0.897 market,smb4,lmh4 (version-4) 0.004 0.871 market,smb5,lmh5 (version-5) 0.002 0.902 market,smb6,lmh6 (version-6) 0.002 0.884 portfolios formed on short term past returns: comparative results for capm and fama-french model. model mean/alpha r2 market (capm) 0.014 0.767 market,smb1,lmh1(standard fama-french model – (version1) 0.003 0.861 market,smb2,lmh2 (version-2) 0.003 0.840 market,smb3,lmh3 (version-3) 0.004 0.846 market,smb4,lmh4 (version-4) 0.005 0.815 market,smb5,lmh5 (version-5) 0.003 0.857 market,smb6,lmh6 (version-6) 0.003 0.831 panel b: market proxy nse-50 single sorted portfolios formed on company size: comparative results for capm and alternative versions of fama-french model. model mean/alpha r2 market (capm) 0.017 0.689 market,smb1,lmh1(standard fama-french model – (version1) 0.004 0.840 market,smb2,lmh2 (version-2) 0.004 0.822 market,smb3,lmh3 (version-3) 0.004 0.821 market,smb4,lmh4 (version-4) 0.005 0.779 market,smb5,lmh5 (version-5) 0.004 0.829 market,smb6,lmh6 (version-6) 0.004 0.808 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 362 single sorted portfolios formed on company value: comparative results for capm and alternative versions of fama-french model. model mean/alpha r2 market (capm) 0.016 0.705 market,smb1,lmh1(standard fama-french model – (version1) 0.001 0.840 market,smb2,lmh2 (version-2) 0.001 0.827 market,smb3,lmh3 (version-3) 0.002 0.823 market,smb4,lmh4 (version-4) 0.004 0.786 market,smb5,lmh5 (version-5) 0.001 0.831 market,smb6,lmh6 (version-6) 0.002 0.812 double sorted portfolios formed on different measures of company size and value: comparative results of capm and fama-french model. model mean/alpha r2 market (capm) 0.016 0.688 market,smb1,lmh1(standard fama-french model – (version1) 0.002 0.838 market,smb2,lmh2 (version-2) 0.002 0.823 market,smb3,lmh3 (version-3) 0.002 0.821 market,smb4,lmh4 (version-4) 0.004 0.785 market,smb5,lmh5 (version-5) 0.001 0.829 market,smb6,lmh6 (version-6) 0.001 0.811 portfolios formed on long term past returns without skipping one year: comparative results for capm and fama-french model. model mean/alpha r2 market (capm) 0.017 0.736 market,smb1,lmh1(standard fama-french model – (version1) 0.002 0.849 market,smb2,lmh2 (version-2) 0.002 0.832 market,smb3,lmh3 (version-3) 0.002 0.829 market,smb4,lmh4 (version-4) 0.005 0.789 market,smb5,lmh5 (version-5) 0.001 0.836 market,smb6,lmh6 (version-6) 0.002 0.810 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 363 portfolios formed on long term past returns skipping one year between portfolio formation and holding period: comparative results for capm and fama-french model. model mean/alpha r2 market (capm) 0.017 0.737 market,smb1,lmh1(standard fama-french model – (version1) 0.001 0.862 market,smb2,lmh2 (version-2) 0.001 0.847 market,smb3,lmh3 (version-3) 0.003 0.839 market,smb4,lmh4 (version-4) 0.006 0.796 market,smb5,lmh5 (version-5) 0.002 0.847 market,smb6,lmh6 (version-6) 0.002 0.819 portfolios formed on short term past returns: comparative results for capm and fama-french model. model mean/alpha r2 market (capm) 0.016 0.705 market,smb1,lmh1(standard fama-french model – (version1) 0.003 0.822 market,smb2,lmh2 (version-2) 0.003 0.802 market,smb3,lmh3 (version-3) 0.003 0.805 market,smb4,lmh4 (version-4) 0.005 0.764 market,smb5,lmh5 (version-5) 0.003 0.815 market,smb6,lmh6 (version-6) 0.002 0.791 table 5. the carhart four factor model comprises of three factor fama-french risk factors i.e. market, size and value as well as an additional momentum factor panel a: single sorted portfolios mc a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.006 0.987 1.637 0.292 -0.004 1.861 30.041 22.337 4.505 -0.089 0.987 p5 0.003 0.994 -0.111 0.207 -0.053 1.280 41.157 -2.055 4.342 -1.538 0.920 ta a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.012 1.004 1.488 -0.177 0.083 3.449 25.183 16.731 -2.245 1.453 0.870 p5 0.004 1.023 -0.071 0.657 -0.033 1.519 36.813 -1.150 11.980 -0.836 0.918 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 364 ev a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.011 0.980 1.376 0.098 0.056 3.927 30.553 19.228 1.553 1.227 0.911 p5 0.002 1.013 -0.025 0.327 -0.056 0.705 37.278 -0.418 6.093 -1.452 0.909 pb a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.001 0.993 1.016 0.789 -0.009 0.284 29.178 13.388 11.749 -0.176 0.913 p5 0.001 0.992 0.420 -0.323 0.003 0.222 30.658 5.815 -5.053 0.067 0.864 pe a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.000 0.949 0.890 0.578 0.016 0.103 29.966 12.608 9.245 0.345 0.908 p5 0.001 1.149 0.454 -0.172 -0.077 0.419 30.364 5.381 -2.306 -1.429 0.862 panel b: double sorted portfolios mc_pb a b s l w t(a) t(b) t(s) t(l) t(w) r2 s/l 0.002 1.008 1.211 0.694 -0.030 0.685 30.459 16.400 10.621 -0.626 0.921 s/m -0.002 0.968 1.131 0.195 -0.021 -0.587 29.374 15.384 2.996 -0.447 0.897 s/h 0.003 1.084 1.103 -0.343 -0.084 1.002 30.858 14.082 -4.952 -1.673 0.885 b/l 0.002 1.030 0.101 0.708 -0.057 0.669 30.886 1.356 10.755 -1.199 0.892 b/m 0.001 1.076 0.136 0.092 -0.075 0.200 33.146 1.875 1.434 -1.613 0.881 b/h 0.001 0.954 0.208 -0.254 -0.003 0.322 31.489 3.083 -4.251 -0.063 0.866 mc_pe a b s l w t(a) t(b) t(s) t(l) t(w) r2 s/l 0.000 0.943 1.220 0.451 0.002 0.172 29.743 17.251 7.195 0.040 0.913 s/m 0.002 0.923 1.080 0.094 -0.047 0.590 23.917 12.540 1.233 -0.857 0.847 s/h 0.006 1.138 1.066 -0.157 -0.104 1.706 31.666 13.295 -2.212 -2.028 0.890 b/l 0.003 1.038 0.135 0.489 -0.069 0.980 32.323 1.891 7.714 -1.498 0.892 b/m 0.002 0.975 0.160 0.092 -0.058 0.694 31.737 2.330 1.519 -1.331 0.873 b/h 0.000 1.052 0.121 -0.119 -0.030 -0.054 28.338 1.462 -1.621 -0.559 0.839 ta_pb a b s l w t(a) t(b) t(s) t(l) t(w) r2 s/l 0.002 0.968 1.403 0.416 0.007 0.722 28.552 18.557 6.217 0.137 0.911 s/m 0.000 0.968 1.081 -0.160 -0.039 0.083 25.031 12.531 -2.102 -0.703 0.846 s/h 0.002 1.007 0.601 -0.392 -0.023 0.662 26.418 7.066 -5.216 -0.421 0.830 b/l 0.000 1.017 0.579 0.781 -0.051 0.052 29.112 7.439 11.328 -1.032 0.898 b/m 0.001 1.078 0.254 0.394 -0.107 0.432 31.778 3.357 5.890 -2.202 0.886 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 365 b/h 0.000 1.073 0.180 -0.054 -0.045 0.161 34.511 2.601 -0.886 -1.022 0.887 ta_pe a b s l w t(a) t(b) t(s) t(l) t(w) r2 s/l 0.006 0.925 1.300 0.233 -0.005 1.666 25.160 15.860 3.212 -0.097 0.879 s/m 0.002 0.946 0.945 -0.116 -0.041 0.670 25.641 11.485 -1.591 -0.770 0.847 s/h 0.002 1.042 0.718 -0.307 -0.028 0.438 26.668 8.237 -3.981 -0.494 0.838 b/l -0.002 0.981 0.505 0.609 -0.008 -0.608 29.415 6.785 9.254 -0.167 0.891 b/m 0.004 1.049 0.212 0.341 -0.104 1.291 31.528 2.861 5.193 -2.186 0.881 b/h 0.001 1.132 0.207 -0.002 -0.109 0.245 29.909 2.449 -0.032 -2.017 0.856 ev_pb a b s l w t(a) t(b) t(s) t(l) t(w) r2 s/l 0.002 0.967 1.270 0.544 -0.031 0.613 27.086 15.944 7.722 -0.608 0.901 s/m 0.001 0.974 1.117 0.002 -0.058 0.321 25.811 13.271 0.027 -1.071 0.861 s/h 0.002 1.023 0.916 -0.360 -0.024 0.733 28.630 11.490 -5.103 -0.466 0.864 b/l -0.001 1.076 0.414 0.761 -0.082 -0.415 29.988 5.170 10.744 -1.606 0.895 b/m 0.000 1.131 0.166 0.166 -0.129 -0.085 32.441 2.133 2.405 -2.588 0.879 b/h 0.001 0.981 0.222 -0.257 -0.014 0.250 31.721 3.221 -4.206 -0.323 0.868 ev_pe a b s l w t(a) t(b) t(s) t(l) t(w) r2 s/l 0.002 0.946 1.205 0.369 -0.019 0.744 26.870 15.356 5.303 -0.369 0.891 s/m 0.004 0.930 1.052 -0.033 -0.087 1.015 23.952 12.141 -0.429 -1.566 0.838 s/h 0.004 1.061 0.936 -0.227 -0.022 1.181 29.283 11.582 -3.180 -0.416 0.871 b/l -0.001 1.055 0.393 0.470 -0.089 -0.498 35.091 5.862 7.914 -2.075 0.911 b/m 0.003 1.027 0.185 0.103 -0.100 0.879 30.830 2.491 1.559 -2.111 0.867 b/h -0.001 1.086 0.130 -0.092 -0.057 -0.145 28.092 1.512 -1.204 -1.040 0.837 panel c: prior return portfolios: portfolios formed on long term past returns (36/12 strategy) a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.004 0.913 0.540 0.415 -0.325 0.685 14.229 4.391 3.714 -4.098 0.849 p5 0.002 1.292 0.865 -0.178 0.244 0.619 32.141 9.390 -2.044 4.278 0.906 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 366 portfolios formed on long-term past returns skipping one year between portfolio formation and portfolio holding periods (36/12/12 strategy) a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.002 0.997 0.692 0.396 -0.024 0.782 29.703 9.373 5.441 -0.522 0.919 p5 0.002 1.369 0.765 -0.136 -0.071 0.537 30.371 7.712 -1.387 -1.134 0.900 portfolios formed on short-term past returns (12/12 strategy). a b s l w t(a) t(b) t(s) t(l) t(w) r2 p1 0.002 1.135 0.807 0.054 -0.537 0.537 33.124 10.555 0.795 -10.970 0.898 p5 0.002 1.135 0.807 0.054 0.463 0.537 33.124 10.555 0.795 9.459 0.910 microsoft word 7008-24866-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 105 vat increase and impact on consumers’ consumption habit masoom ahmed glyndwr university, uk e-mail: masoomsonia@yahoo.com fazluz zaman business trainer and curriculum writer australian business and retail academy, sydney, australia e-mail: fazluzzaman@gmail.com munshi samaduzzaman (corresponding author) accounting lecturer, kaplan business school, sydney, australia e-mail: samaduzzaman@gmail.com received: jan. 25, 2015 accepted: feb. 26, 2015 published: june 1, 2015 doi:10.5296/ajfa.v7i1.7008 url: http://dx.doi.org/10.5296/ajfa.v7i1.7008 abstract the uk government has put new economic policy to increase the value added tax (vat) to 20%, which raise widely discussions. this case study aims to find out how increased standard vat influence customer’s satisfaction and consumption habit in north wales area. there has been lively debate between the government and the opposition party, the government has asserted that it is progressive, as those with higher incomes spend more and will therefore pay more vat. opposition claims, however, that as low earners have to spend a much bigger share of their income than high earners in order to meet their basic needs. a total of 80 respondents participated in the survey. sreliability test analysis was used to analyse the reliability of each questions in the questionnaire. data collected were analysed by using correlation analysis and t-test to determine the relationship between variables and test the hypothesis. the findings reveal that vat increase has significant impact on consumers’ consumption habit. this case study could fill the gap in the literature for consumers’ asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 106 consumption habit on vat increase. also the outcomes of this study could add to existing literature and serve as a foundation for further studies. keywords: consumers’ consumption, customer's behavior, government, influence, value added tax asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 107 1. introduction vat has imitated relationship in daily life, and even it can happen everywhere, every day which has effect on people’s daily life. according to statement of standard accounting practice (ssap, 1993) which states that “vat is a tax on the supply of goods and services which is eventually borne by the final consumer but collected at each stages of the production and distribution chain”. in the uk, vat is charged on the supply of all goods and services made in the course of a business by a taxable person, unless they are specifically exempt. all businesses must register for vat if their turnover of taxable goods and/or services is above a given threshold – which is £79,000 at present (budget, 2013). a business pays vat on its purchases known as input tax, and charges vat on its sales known as output tax, settling up with hm revenue & customs for the difference between the two (hm treasury, 2009/2010). the original form of vat started in germany in 1919. in 1937, france introduced a form of vat known as pro-duction tax, which has helped replaced with producer’s income-based tax in 1948 and consumption tax in 1954. the french vat system became a condition precedent of becoming a member of european economic community (eec) under the treaty of rome in 1957. the european community unanimously adopted vat in 1967 following the reports of the neumark and jansen committees (oladipupo and izedonmi, 2013). vat was introduced in the uk on 1 april 1973 at two rates: a standard rate of 10%, and a zero rate on selected goods and services (such as food, books, children’s clothing, and certain supplies for charities). the increase in vat from 17.5% to 20% estimated to raise £12.1bn in 2011/12, rising to £13.5bn by 2014/15 (crr, 2010). however, vat increase to 20% would cost each of the uk’s 26.2 million households an extra £1.16 per day or £520 a year, reducing spending power by an average 1.25% per annum and increasing the annual vat bill by 13.9%. increase consumer price inflation by between 0.6% and 0.8%. hit the poorest one-fifth of the population (who pay the largest proportion of their income as vat). there has been lively debate between the government and the opposition party, with opinions from economists and journalists, about whether the rise in vat is ‘progressive’ or not. the government has asserted that it is progressive, as those with higher incomes spend more and will therefore pay more vat. opposition claims, however, that as low earners have to spend a much bigger share of their income than high earners in order to meet their basic needs, the tax will actually hit them harder. 2. consumers’ satisfaction and consumption habit customer satisfaction affects many aspects of the organisation, such as revenue and sales, expenses, especially the bottom line profit peppad, (2002). customers’ behavior includes recognising what they need, where and which brand they choose and compared shopping to make financial purchasing plan (solomon, (2004). hamel (2013) thought the price of goods asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 108 and service play importance roles in customer purchasing power. if the price increase, people may reduce purchase it, however, if the price fall, people increase buying it. carty (2013) has the similar opinions that if the price increase, the customers would choose a cheaper one to instead. especially in similar goods or service, consumers often switch the products. if the prices are the same, the impact of price is not obviously. the retail industry employs 3 million people and accounts for 25% of national gdp a slowdown in the sector could lead to a further 0.5% decline in economic growth over a twelve month period (crr, 2010). labour leader ed miliband (bbc, 2010) argued that it was the "wrong tax at the wrong time", because the rise would hit families when they will be under pressure from government spending cuts. similarly, wellings (2011) stressed that the increased vat would distorted the customers’ consumption habit. there are four types of factors can influence the customer shopping behavior: social, cultural, personal and psychological factor. cultural factor include social calls which is not only depends on the income but also the wealth and occupation. age plays an import role in personal factors. with the change of age, people may have different opinions about consumption which also includes the marital status. it is very essential to consider the economic situation in personally factor. if the customers get high income or salary they would buy more products and less consider about the price, however if the people get low income or salary, they may buy cheaper products and consider much about the price (shah, 2013). key factors to be researched h1: vat increase has significant influence on change in consumers’ life style. h2: vat increase has significant influence on change in consumers’ purchasing power. h3: the annual income has significant influence customers’ buying behavior h4: age has influence on consumers’ buying behavior. 3. methodology the research methods include the survey questionnaire design, the sample and methods of data analysis. questionnaire design: the questionnaire for this study separated into two segments thus section a and b. section a consists on the demographic profile such as gender, age, marital status, income, races and employment status. section b is made up with main research questions (figure 1-appendix). figure 2 explains about scale measurements. the extent of each variable was based on five-point likert scales which scale points from 1-strongly disagree to 5-strongly agree. several researchers have used the same measurement in their paper because the reliability of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 109 likert scales tends to be good and it gives a wide choices answer to respondents (goldsmith and flynn, 2004; houque et al., 2006; changchit, 2006). figure 3 (appendix) presents reliability test for each variables in the questionnaire. overall reliability of scales adopted in this survey questionnaire was 0.835 which shows very good consistency among the scales (law and bai, 2008). however, the reliability of individual variables seems different from each other and varied from 0.884 to 0.782. then, this survey question can be reliable to examine vat increase and change in consumers’ consumption habit. collected data using questionnaire was analysed by spss (21) with related diagrams and charts to find the results. and then make correlation and hypotheses testing (t-test). 4. findings and conclusion from a total 120 questionnaires sent randomly, 80 were returned, which resulted in a response rate of 66%. brief description of descriptive statistics of the respondents can be found in table 2 (appendix). a correlation matrix constructed using the variables in the questionnaire to show the strength of relationship among the variables (table 3-appendix). correlation analysis was used to analyse the relationship between all variables. this analysis associates variables and discovers if there any variables tend to shift in the same or opposite way when it moves (saunders et al., 2007), which also can be exposed as positive or negative relationship. if positive value indicates there is positive relation between variables meanwhile, the negative value means vice versa (hair et al., 2009). on the one hand, values from 0.1 until 0.5 means there is a weak relationship, on the other hand, 0.5 to 1 means there is strong relationship between the variables. however, if the value is negative, it shows there is no direct relationship between the variables. the correlation matrix indicates that vat increase highly correlated with consumers’ consumption habit. the highest coefficient of correlation in this study was between vat increase and change in consumers’ purchasing power, which 0.36. this study also found positive correlation between vat increase and change in consumers’ life style, annual income and customers’ buying behaviour, age and customers’ buying behaviour. in other words, the results indicate that the influence variable was vat increase on consumers’ purchasing power. h1: vat increase has significant influence on change in consumers’ life style. table 4 indicates that the t-statistic is 1.34> (0.5), which means vat increase has influence on change in consumers’ life style. there were some similarities between the outcomes of this study and those of previous studies (jonker et al., 2004; carare & danniger, 2008). on the strategic implication, it can be concluded that vat payments represent 12.1% of the disposable income of the lowest household quintile (the bottom one-fifth of earners) compared to 7.4% by the average household. the vat increase hit these people hard (crr, 2010). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 110 h2: vat increase has significant influence on change in consumers’ purchasing power. table 4 indicates that the t-statistic is 1.64> 0.5 which mean vat increase has significant influence on change in consumers’ purchasing power. previous research (carare & danniger, 2008; shah, 2913) indicated that wealth and economic situation influence customers’ shopping behavior. due to the vat increase, most prices of products increase, people have to care the price and their expending. if the customers get high income or salary they would buy more products and less consider about the price, however if the people get low income or salary, they may buy cheaper products and consider much about the price. h3: the annual income has significant influence customers’ buying behavior table 4 indicates that the t-statistic is 5.42> 0.5 which mean annual income has significant influence customers’ buying behaviour. on the strategic implication, it can be concluded that every individual is faced with reviewing their own budget and spending pattern to make future decision so that they can adjust to vat increase (carare & danniger, 2008; leach, 2012). h4: age has influence on consumers’ buying behavior. table 4 indicates that the t-statistic is 3.98> 0.5 which means age has influence on consumers’ buying behaviour. there were some similarities between the outcomes of this study and previous studies (fisher, 1952; pol, 1991; swarana, 2012) which also agreed that age as influential predictors of consumers’ buying behaviour. the uk government has put new economic policy to increase the value added tax (vat) to 20%, which raise widely discussions. the research highlights the influence of vat from government, company, and customer, these three aspects. some people believe that the increase vat is good policy for the government to get more revenue, to solve economic problem. however, more people thought it has brought more pressure to the companies and customers. due to the vat increase, the company may suffer recue sales and increase income problem, and customers had to change their life style, such as consumption habit. consumers could research prices for essential products to get the best post increase prices. they can also take decision what luxuries item they still can afford, given that most luxury items are subject to vat. the study is significant in terms of managerial and theoretical contribution. this study could fill the gap in the literature on vat increase and change in consumers’ consumption habit. for further studies may provide valuable insights students of demographics such as gender, marital status, educational qualifications. additional tools such as content analysis and grounded theory could be employed. also the outcomes of this study could add to existing literature and serve as a foundation for further studies. from managerial point of view, this study could assist policy makers to set back vat at 17.5%, as the gfk consumer survey shows a considerable improvement in consumers’ confidence since december 2011. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 111 reference bbc. (2010). shoppers split over vat increase. the budget, 22 june, http://www.bbc.co.uk/news/10381844]. [electronically accessed 16/12/2013]. budget. (2013). hc 1033 march 2013 para 2.179. the threshold was increased in line with inflation for the 2013/14 year with effect from 1 april 2013, by order (si 2013/660). carare, a., & s. danninger. (2008). inflation smoothing and the modest effect of vat in germany. imf working paper, wp/08/175. carty, s. (2013). the effects of purchasing power. available form: http://ezinearticles.com/?factors-affecting-consumer-behavior&id=4602848[electronically accessed 14th jan. 2013]. changchit, c. (2006). consumer perception on online shopping. issues in information system, 4(2), 177-181. field, a. (2006). discovering statistics using spss, second edition, sage publications, london fisher, j. (1952). income, spending and saving patterns of consumer units in different age goups. studies in income and wealth, 15. goldsmith, r.e., & flynn, l.r. (2004). psychological and behavioral drivers of online clothing purchase. journal fashion marketing management, 8(1), 84-95. http://dx.doi.org/10.1108/13612020410518718 gujarati, d. n. (2011). basic econometrics. palgrave macmillan, new york. hair, j. f., black, w. c., babin, b. j., & anderson, r. e. (2009). multivariate data analysis. upper saddle river, nj: prentice hall. hamel, g. (2012). factors influencing purchasing power. available from: http://www.ehow.com/list_7150340_factors-influencing-purchasing-power.html. [electronically accessed 14th jan. 2013]. hm treasury, (2009/2010), tax benefit reference manual 2009/10 ed. p88. houque, a. sadeghzadeh, & j, khatibi, a (2006). identifying potential online sales in malaysia: a study on customer relationships online shopping. journal application business, 22(4), 119-130. joe peppard. 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(2007). research methods for business students, 4th edition, prentice hall, england. shah, a., (2013). factors affecting consumer behaviour. available from: http://www.ehow.co.uk/list_7242892_effects-purchasing-power.html[electronically accessed 14th jan. 2013]. solomon, m. r. (2004). consumer behavior. buying, having, and being (6th ed.). upper saddle river, nj: pearson prentice hall. statement of standard accounting practice. (ssap). (1993). vat decree no. 102, government printer. swarna, b. (2012). impact of gender on consumer purchase behavior. journal of commerce and management, 1(9), 10-18. the centre for retail research. (2010). vat hike to 20%: effects on retailers and consumers. http://www.retailresearch.org/vatincrease.php. wellings, r. (2011). why raising vat destroys wealth, iea4 january 2011.available from: http://www.iea.org.uk/blog/why-raising-vat-destroys-wealth appendix how does vat work? a product with a net retail value of, say, £20.00, would cost £23.50 when vat is applied asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 113 (£20.00 + [17.5% x £20.00]) and would increase to £24.00 after january 4 2011 (an increase of 2.1%). that is the theory. table 1. the main changes to the vat structure since the introduction of the tax are: the standard rate was cut to 8% on 29 july 1974. a higher rate on selected goods and services was introduced on 18 november 1974, set at 25%. initially this was applied to petrol only; it was extended to a list of other supplies from 1 may 1975. the higher rate was cut to 12.5% from 12 april 1976. the standard rate was increased to 15% on 18 june 1979; at this time, the higher rate of vat was abolished. the standard rate was increased to 17.5% from 1 april 1991. domestic supplies of fuel and power were charged vat at a reduced rate of 8% from 1 december 1993. this was cut to 5% from 1 september 1997. the standard rate was cut temporarily to 15% from 1 december 2008 to 31 december 2009. the rate was set back at 17.5% on 1 january 2010. the standard rate of vat increase from 17.5% to 20% from 4 january 2011. variables questions consumer demographic characteristics demography 1-7 consumers’ shopping intentions attitude 8-10 h1: vat increase has significant influence on change in consumers’ life style. life style 11-13 h2. vat increase has significant influence on change in consumers’ purchasing power. purchasing power 14-16 h3. the annual income has significant influence customers’ buying behavior income 17-19 h4. age has influence on consumers’ buying behavior age 20-22 figure 1. relationship between variables and hypotheses asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 114 figure 2. scale measurement component cronbach’s alpha life style .884 purchasing power .865 income .810 age .782 average .835 figure 3. adopted from spss reliability test for each variable table 2. descriptive statistics of the respondents descriptive statistics reveals that the male respondents are accounted for 66% of the total population where male and female respondents 61% and 39%. the largest group of respondents was aged between 21-30 years 41%, with 25% below 20 years, 28 % aged between 31-40 and 6% over 40 years and over. annual income for the respondents was 46% below £20000, 25% £21000-£30000 and 29% over £31000. it was found that professional, shop workers, businessmen, students participated in the study. the findings imply that majority of respondents work full time. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 115 table 3. summary of correlations among variables gender age life style purchasing power income gender pearson correlation 1 .265** -.293** -.252** -.265** sig. (2-tailed) .000 .000 .000 .000 n 80 80 80 80 80 age pearson correlation .265** 1 .087 .076 .121 sig. (2-tailed) .000 .163 .225 .054 n 80 80 80 80 80 life style pearson correlation -.293** .087 1 .770** .735** sig. (2-tailed) .000 .163 .000 .000 n 80 80 80 80 80 purchasi ng power pearson correlation -.252** .076 .770** 1 .646** sig. (2-tailed) .000 .225 .000 .000 n 80 80 80 80 80 income pearson correlation -.265** .121 .735** .646** 1 sig. (2-tailed) .000 .054 .000 .000 n 80 80 80 80 80 **. correlation is significant at the 0.01 level (2-tailed). table 4. t-test statements mean st. d. t sign. result h1: vat increase has significant influence on change in consumers’ life style 3,09 1.25 1.34 0,000 accepted h2: vat increase has significant influence on change in consumers’ purchasing power 2.63 1.28 1.64 0,000 accepted h3: the annual income has significant influence customers’ buying behavior 2.79 1.20 5.42 0,000 accepted h4: age has influence on consumers’ buying behavior 3.23 1.05 3.90 0,000 accepted microsoft word 5085-18449-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 70 determinants of internet financial disclosure in gcc countries mohamed a. k. basuony assistant professor of accounting, department of accounting school of business, american university in cairo auc avenue, p.o. box 74, new cairo, postal code: 11835, cairo, egypt tel: 20-2-2615-3259 e-mail: mohamed.basuony@aucegypt.edu ehab k. a. mohamed professor of accounting, department of accounting and finance faculty of management technology, german university in cairo new cairo, postal code: 11835, cairo, egypt tel: 20-2-2759-0764 e-mail: ehab.kamel@guc.edu.eg received: february 8, 2014 accepted: march 4, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5085 url: http://dx.doi.org/10.5296/ajfa.v6i1.5085 abstract the purpose of this paper is to examine the determinants and characteristics of voluntary internet disclosures by listed companies in saudi arabia and oman. this paper uses archival data from listed companies on tadawul stock exchange and muscat securities market. binary logistic regression analysis is used to examine the determinants of internet financial reporting. mann-whitney test is used to examine the differences in disclosure characteristics between the two countries. the results of this study reveal that firm size is the major influencing factor that impacts internet financial reporting. the results reveal that a number of disclosure characteristics that differ significantly between the two countries. the paper provides insights into corporate internet disclosures in the gcc countries that will benefit all stakeholders with an interest in corporate reporting in this important region of the world. keywords: internet, financial reporting, disclosure, saudi arabia, oman, gcc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 71 1. introduction this paper investigates and reports on the extent, nature and determinants of internet financial reporting (ifr) by companies listed on the stock exchanges in saudi arabia and oman. while ifr is fast becoming the norm in most western countries, there is little empirical evidence of the phenomenon in gulf cooperation council (gcc) countries. until recently, hard (paper) copies have been the primary means for communicating financial information to shareholders and other interested corporate stakeholders. technological advances have made the internet a useful, timely and cost-effective tool for the communication of this information to stakeholders. the internet has the potential to revolutionize financial reporting. companies can include the traditional annual reports together with additional financial and non-financial information in multiple formats (jones and xiao, 2004). questions persist as to whether corporate organizations in the gcc are availing themselves of the opportunity provided by the internet to communicate financial information to their stakeholders. while the use of the internet for the communication of financial information raises a variety of challenging issues, there is little doubt about its benefits. this paper is an important first step in gauging the extent to which such benefits are being captured in the gcc. given the increasing importance of ifr and the lack of empirical study on ifr practices in the middle east, this paper provides an important contribution to filling the gap in our knowledge of this subject. this is of particular importance in a time when there is so much interest in investment opportunities in the gcc countries where rapid economic growth is fuelled by booming oil revenues. evidence of ifr practices in various countries have been presented by a number of academic and professional studies – see, for example, craven and marston (1999) and gowthrope (2004) uk, deller et al. (1999) us, uk and germany, gowthorpe and amat (1999) – spain, hedlin (1999) – sweden, lymer et al. (1999) – international comparison, pirchegger and wagenhofer (1999) austria and germany, marston and polei (2004) – germany, trites (1999) us and canada, oyelere et al. (2003), fisher et al. (2004) and laswad et al. (2005) new zealand, marston (2003) japan, xiao et al. (2004) china, smith and peppard (2005) – ireland, khadaroo (2005) – malaysia, and chan and wickramasinghe (2006) – australia, bozcuk et al. (2009) – turkey, ismail and sobhy (2009) – egypt, mohamed et al. (2009) – oman, salawu (2009) – nigeria, mohamed (2010) – middle east. they indicate the growing use of the internet for the corporate dissemination of information, including providing annual reports on the internet, and that the extent and sophistication of ifr practices varies across countries. the objective of this paper is to study ifr practices in the gcc. the paper provides evidence of the extent and determinants of ifr in two gcc countries, namely saudi arabia and oman. the understanding of ifr practices is important for standard setting purposes. the objective of this paper is to examine internet financial reporting practices and determinants in companies listed in tadawul stock exchange (saudi arabia) and muscat securities market (oman). the rest of this paper is structured as follows. a review of relevant literature is provided in the next section. the proposed research methodology is asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 72 discussed in section 3. section four provides analyses and discussions on the extent, nature and determinants of ifr by companies listed in the two stock exchanges. summary and conclusions are presented in the final section. 2. literature review 2.1 background the internet provides a useful communication tool for corporate organizations. one of the main benefits of ifr is the potential for large savings in the cost of production and distribution of financial information. the internet allows companies to reach a much wider range of stakeholders at a relatively lower cost. the use of ifr also leads to a reduction in incidental requests from non-shareholder financial statement users (allam and lymer, 2002; sec, 2002, 2003a,b; khadaroo, 2005) . the literature also documents a number of other benefits that may accrue from ifr (baker and wallage, 2000; ettredge et al., 2001; debreceny, et al., 2002; wagenhofer, 2003; jones and xiao, 2004; boritz and no, 2005). these include more equitable information dissemination among stakeholders as a result of the improved accessibility of the information. with ifr users can choose to access information that meets their specific needs as the internet allows non-sequential access to information through the use of hyperlinks, interactivity and search facilities. ifr also presents companies with the opportunity to provide more information than is available in annual reports. the internet provides an opportunity for going beyond what is available in hard copy corporate financial statements to communicate additional financial information to users, possibly in real-time and on an interactive basis (mccafferty, 1995; louwers et al., 1996; green and spaul, 1997; trites and sheehy, 1997; trites, 1999; fasb, 2000; ettredge et al., 2002; wickramasinghe, 2006). ifr provides corporate organizations with a real opportunity to extend financial disclosure beyond the reproduction of a hard copy annual report and improve on the timeliness, scope, and interactivity of financial reporting, with multimedia, such as sound, animation and video, being used to potentially increase the understanding of information (louwers et al., 1996; ravlic, 2000; wickramasinghe and lichtenstein, 2006). these developments have a great potential impact on users (wallman, 1997; green and spaul, 1997; gowthrope and flynn, 2001). a number of ifr-related issues and challenges have been noted in the literature. it is possible that the dividing line between current financial information used by management and historical audited financial information made available to public users of financial information could be erased by online, real-time reporting (green and spaul, 1997; hodge, 2001; oyelere, 2003), with auditors being possibly required to provide opinion on such hitherto internal financial information (trites and sheehy, 1997; lymer and debreceny, 2003; khadaroo, 2005). if ifr is installed as the only mode for communicating financial information it is likely that access to such information will be restricted to only those who possess costly computer equipment and skills. hence, to ensure equitable access to financial information it will be necessary to ensure that the information being reported through corporate websites is also provided through other media of financial information disclosure (mccafferty, 1995). this could be seen as unnecessary duplication and may result in even asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 73 greater costs in the middle east where financial information is commonly disseminated in both english and arabic. additional issues and challenges for ifr include possible errors in the extraction or re-keying process, which may affect the reliability and integrity of the financial information; generally accepted accounting practice (gaap) implications of ifr; the use of the corporate websites for many diverse purposes, which may make the location of financial information difficult; and the acceptability of internet financial reports as alternatives to hard copy annual reports among users of corporate financial information (laswad et al., 2000). by far the greatest challenge faced in the ifr environment is that of ensuring the security and integrity of the financial information published on corporate websites. apart from possible errors in the publishing process, materials published on the web are susceptible to all manners of security risks. financial information could, post-publication, be knowingly or unknowingly altered by parties both external and internal to the organization. there is a real risk that critical decisions could be made by users of financial information based on inaccurate financial information gleaned from corporate websites. the extent to which these issues are dealt with is likely to determine the long-term usefulness of the internet as a medium of corporate financial information dissemination. 2.2 hypotheses development very little, if any, evidence exists on the extent and nature of ifr practices in the gcc countries. it is predicted that ifr is likely to overtake the hard-copy print form of financial information disclosure in the near future. it is therefore surprising that evidence on the variety of issues associated with this form of financial disclosure is currently not being publicly discussed. such evidence will depend on the outcome of thorough, in-depth investigation and analysis, such as is being preliminarily undertaken in the current study. therefore, considering the importance of ifr in disseminating financial information and the little research of these practices in emerging economies, the objective of this paper is to study the extent, practices and determinants of ifr in saudi arabia and oman. while those countries share a number of characteristics due to being in the same region and sharing similar cultures, they are at different stages of development, or with different business environments that may affect the attributes of internet financial disclosure. this argument leads to the first hypothesis: h1. there is a significant difference in the attributes of corporate internet disclosure between saudi arabia and oman. recent studies have provided evidence on the factors motivating the ifr behaviour of companies around the world. given the voluntary nature of ifr, these studies sought to establish the reason why companies engage in ifr and the extent of such engagement. the majority of these studies have found corporate size to be a major factor, with ifr likely to provide greater economies of scale cost savings for larger firms (ashbaugh et al., 1999; craven and marston, 1999; pirchegger and wagenhofer, 1999; debreceny et al., 2002; asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 74 ettredge et al., 2002; oyelere et al., 2003; fisher et al., 2004; chan and wickramasinghe, 2006; trabelsi, 2007). evidence on other variables examined is largely inconclusive. firm size several studies examine the relationship between firm size and voluntary disclosure (malone et al., 1993; ahmed and nicholls, 1994; raffournier, 1995; haniffa and cooke, 2002; karim et al.,2006; almilia and surabaya 2009; aly et al 2010). it is argued that stock market pressure forces large corporations to disclose more information on their websites to assist them in increasing their outside capital to enhance their performance. hence, large corporations are more able to access financial markets through disclosing more information online (bonso´n and escobar, 2002). large corporations can disclose information on the internet for lower costs as they have the resources to do so. agency theory implies that large firms exhibit higher agency costs due to the information asymmetry between market participants (jensen and meckling, 1976). to reduce these agency costs, larger firms disclose a large flow of corporate information. while, according to the political cost hypothesis, large firms attract more financial analysts putting firms under higher pressure because they are more publicly visible (boubaker et al., 2012). due to the industrial competition between companies, smaller firms tend to hide their important information (almilia and surabaya 2009, marston 2003). moreover, large companies always have a larger number of products and their distribution networks are very complex than smaller firms. thus, information disclosure is required more in large companies (marston 2003; aly et al 2010). empirical findings suggest a significant relationship between firm size and online disclosure (hossain et al., 1995; ashbaugh et al., 1999; craven and marston, 1999; pirchegger and wagenhofer, 1999; brennan and hourigan, 2000; bonso´n and escobar, 2002; debreceny et al., 2002; ettredge et al., 2002; larra´n and giner, 2002; oyelere et al., 2003; marston and polei, 2004; xiao et al., 2004; garcı´a-borbolla et al., 2005; bollen et al., 2006; sriram and laksmana, 2006; ezat and el-masry, 2008). this prompts the second research hypothesis: h2. there is a positive relationship between firm size and ifr profitability it is suggested that firm profitability can be regarded as an indicator to good management, as management tends to disclose more information when the rate of return is high. hence, profitable companies have extra financial resources to disseminate financial information voluntary and have more incentives to disclose to both the stakeholders and public that they are more profitable than their counterparts in the same industry. this can be justified by the agency theory, where managers of the highly profitable companies disseminate more information on their companies’ website to achieve personal advantages such as the marinating their positions and justifying compensations (singhvi and desai, 1971; wallace et al., 1994; haniffa and cooke, 2002). furthermore, signaling theory suggests that profitable companies have an incentive to disclose more information, to signal the firm’s profitability to investors and to raise capital at the lowest price (oyeler et al., 2003; marston and polei, 2004). however, there are mixed results with some studies revealing significant relationship asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 75 between firm profitability and internet financial disclosure (ashbaugh et al., 1999; ismail, 2002; debreceny and rahman, 2005), while other studies find no significant relationship between profitability and online financial disclosure (larra´n and giner, 2002; oyelere et al., 2003; marston and polei, 2004; xiao et al., 2004; momany and al-shorman, 2006; ezat and el-masry, 2008). thus, the third research hypothesis is: h3. there is a positive relationship between profitability and ifr leverage based on the agency theory, the agency costs of loan capital depend on the nature of claims held by outsiders. it suggests that the costs are higher for firms with proportionally more debt in the capital structure (leftwich et al. 1981). voluntary disclosure can reduce the agency costs by facilitating debt supplier’s assessment of a firm’s ability to meet its debts (jensen and meckling, 1976). thus, it is suggested that firms that are highly leveraged are more inclined to try and satisfy debt suppliers by disseminating reliable information on the website to make these creditors more confident about the ability of the companies to pay their debts. though this dissemination results in extra disclosure costs, providing reliable information to debt suppliers reduces agency costs. likewise, shareholders demand more information to assess the firm’s financial ability (ismail, 2002; larra´n and giner, 2002; oyelere et al., 2003; xiao et al., 2004). nonetheless, the literature offers inconclusive evidence on the relationship between leverage and internet financial disclosure. some studies show a significant positive relationship (mitchell et al. 1995; hossain et al. 1995; xiao et al., 2004), other studies show a significant negative relationship (meek et al., 1995), while others show an insignificant relationship (brennanand hourigan, 2000; debreceny et al., 2002; larra´n and giner, 2002; oyelere et al., 2003; bollen et al., 2006; ezat and el-masry, 2008). hence, the fourth hypothesis is: h4. firms that are highly leveraged are more inclined to practice ifr industry type according to the signalling theory, companies within the same industry tend to adopt the same level of disclosure. when a company within an industry tends not to follow the same disclosure practices, including internet disclosures, as others in the same industry, then it may be interpreted as a signal that the company is hiding bad news (craven and marston, 1999). the difference in disclosure practices between different industries may be due to different industries having different proprietary costs of disclosure and some may be more technologically advanced than others (ismail, 2002). several studies examine the relationship between the type of business activity and internet financial disclosure. the findings are mixed with some studies revealing a significant relationship between internet financial disclosure and industry type (ashbaugh et al., 1999; craven and marston, 1999; brennan and hourigan, 2000; bonso´n and escobar, 2002; garcı´a-borbolla et al., 2005; ismail, 2002; oyelere et al., 2003, ezat and el-masry, 2008, aly et al., 2010). however, others show insignificant relationship (debreceny and rahman, 2005; larra´n and giner, 2002; trabelsi and labelle, 2006). this leads us to the fifth research hypothesis: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 76 h5. there is a significant relationship between industry type and ifr audit type it is suggested that audit quality is an important factor in improving firms’ overall reporting practices. international audit firms are more likely to facilitate the diffusion of innovative practices, such as the internet financial reporting (hail, 2002; xiao et al., 2004). agency theory suggests that auditing helps mitigate agency costs due to the interest conflicts between manager and shareholders. big auditors are likely to be independent and could constrain managers to maintain more stringent disclosure standards (deangelo, 1981). large international audit firms are likely to demand high-quality disclosure. this could be explained by the signalling theory because managers that hire large auditing firms signal to the market that they are willing to provide quality disclosures (healy and palepu, 2001). the findings of some prior studies reveal a positive relationship between audit type and internet financial disclosure (ahmed and nicholls, 1994; raffournier, 1995; xiao et al., 2004; boubaker et al., 2012). though, other studies no significant relationship between audit type and disclosure (wallace et al., 1994; hossain et al., 1995; abd el salam, 1999, aly et al., 2010). therefore, the sixth research hypothesis is: h6. firms that are audited by a big 4 audit firm are more inclined to practice ifr 3. methodology the aim of this study is to investigate and document the extent and nature of ifr practices among firms listed on the gcc countries. the research methodology employed to accomplish this aim is presented in this section. the population of the study consists of firms that are publicly listed in the stock exchanges of ksa and oman. data is collected for 2011 as it is the most recent year for which company annual reports are available for the sample at the time of undertaking this research. table (1) below shows the population and samples selected for each of stock exchanges: table 1. population and samples per stock exchange ksa (tadawul) oman (msm) total all listed companies 156 126 282 unavailable data (3) (13) (16) total 153 113 266 finally, the sample of this study is 266 firms out of 282 after excluding 16 firms for those firms that have not available data. moreover, theses 266 firms are consist of 153 firms from ksa, and 113 firms from oman. table 2 below shows the sample selected for each of stock exchange in each country. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 77 table 2. sample by country country number of companies % ksa 153 57.5% oman 113 42.5% total 266 100.0% data regarding whether these companies have website or not were obtained via searching the names of these companies in internet search engines. where corporate sites are available, we moved to the next stage of the data collection process by investigating the type of information provided at these sites. four categories of information – company history/background, products/services, financial and other information – were of interest to us at this stage. the next stage of the data collection process involved querying the extent and nature of financial information provided on the corporate websites. of interest are the type of financial information that is, whether full financial statements and/or financial highlights; the format of presentation, that is whether pdf, html, other formats or a combination of these; and the volume of financial information presented. this data collection approach is similar to the one used in craven and marston (1999), deller et al (1999), oyelere et al (2003), and laswad et al (2005). the objective of this paper is to examine internet financial reporting practices and its determinants in firms listed in ksa stock exchange (tadawul), and oman stock market (msm). table (3) shows the definition and measurement of these variables. table 3. definition and measurement of variables symbol variable definition measurement dependent variables ifr internet financial reporting if ifr exists = 1; if it does not = 0 independent variables (determinants) frmsize firm size natural log of total assets roa return on assets net income / total assets lvg leverage total liabilities / total assets indtyp industry type manufacturing = 1; non-financial services = 2 2; financial services = 3 audtyp auditor type if ‘big 4’ = 1; otherwise = 0 control variables market stock market tadawul = 1; msm = 2 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 78 4. results and discussion 4.1 descriptive analysis table 4 represents the descriptive statistics using minimum, maximum, mean and standard deviation for disclosure attributes (panel a), while panel b represents descriptive statistics for determinants of corporate internet disclosure as discussed in the literature review section. table 4 : descriptive statistics min. max. mean sd panel a: eweb 0 1 0.92 0.264 aweb 0 1 0.63 0.483 investor relation 0 1 0.43 0.496 figures & graphs 0 1 0.55 0.499 email link 0 1 0.92 0.264 multimedia 0 1 0.82 0.388 format 0 1 0.58 0.495 cg report 0 1 0.20 0.397 company information 0 1 0.91 0.282 products & services information 0 1 0.91 0.287 forward looking information 0 1 0.47 0.500 general financial information 0 1 0.62 0.485 ifr 0 1 0.58 0.495 current annual report 0 1 0.52 0.500 ifryrs 0 3 1.45 1.326 panel b: roa -0.68 0.86 0.004 0.122 audit type 0 1 0.80 0.397 industry type 1 3 1.82 0.806 lvg 0.00 1.38 0.475 0.265 frmsize 14.98 26.53 20.52 2.058 the 266 companies listed on the two stock exchanges in ksa, and oman has three industrial sectors. a distribution of the 266 companies among the different industrial sectors is presented in table 5. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 79 table 5. sample distribution country manufacturing non-financial services financial services total % ksa 61 50 42 153 57.5% oman 54 35 24 113 42.5% total 115 85 66 266 % 43.2% 32% 24.8% 100.0% table 6 shows that the majority of companies (80.5%) operating in the gcc hire big 4 audit firms. the highest percentage is in ksa where about 84% of companies hire big 4 audit firms and 76% in oman. table 6. auditor type country big 4 non-big 4 total ksa 128 25 153 oman 86 27 113 total 214 52 266 % 80.5% 19.5% a classification of “websiters” and “non-websiters” by country is provided in table 7 and 8. overall, 246 companies (92.5%) have english websites, while only 168 companies (63.2%) have arabic websites. 150 companies (98%) in ksa have english website and 144 companies (94%) have arabic website. 85% of oman listed companies have english websites and 21% have arabic websites. generally, the proportion of website ownership appears good when compared with developed western countries such as the us, the uk, australia and new zealand (lymer et al., 1999; oyelere et al., 2003; chan and wickramasinghe, 2006). table 7. listed companies with or without english websites by country country with website without website total ksa 150 98% 3 2% 153 oman 96 85% 17 15% 113 total 246 92.5% 20 7.5% 266 table 8. listed companies with or without arabic websites by country country with website without website total ksa 144 94% 9 6% 153 oman 24 21% 89 79% 113 total 168 63.2% 98 36.8% 266 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 80 table 9 provides description of internet disclosure attributes. overall, all companies provide information on company, email link and product and services with (100%). on the other hand, only 21% of companies disclose corporate governance information and 46% have a section for investor relations. while 88% of companies use multimedia on their websites, only 59% use figures and graphs. the number of companies that use their website for internet financial reporting is 154 out of 246 (63%) and 57% of the companies have the current annual report (2012) disclosed. a breakdown of the overall results is shown in table 10. table 9. overall internet disclosure statistics disclosure attribute yes % no % total investor relation 114 46% 132 54% 246 cg report 52 21% 194 79% 246 email link 245 100% 1 -246 multimedia 217 88% 29 12% 246 company information 243 99% 3 1% 246 products & services information 242 98% 4 2% 246 forward looking information 126 51% 120 49% 246 figures & graphs 145 59% 101 41% 246 general financial information 166 67% 80 33% 246 ifr 154 63% 92 37% 246 current annual report 139 57% 107 43% 246 table 10. internet disclosure statistics by country variable ksa oman frequency %* frequency %** investor relation 96 64% 18 19% cg report 44 29% 8 8% email link 150 100% 95 100% multimedia 137 91% 80 83% company information 150 100% 93 97% products & services information 149 99% 93 97% forward looking information 81 54% 45 47% figures & graphs 124 83% 21 22% general financial information 117 78% 49 51% ifr 103 69% 51 53% current annual report 92 61% 47 49% * based on a total number of 150 companies with websites in ksa ** based on a total number of 96 companies with websites in oman asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 81 4.2 hypothesis testing mann-whitney test is used to test the first hypothesis. for testing the remaining five hypotheses (h2-h6), logistic regression is used to examine the determinants of ifr in the gcc countries. table 11 reveals that there are significant differences at 1% level between the corporate internet disclosure among the two gcc countries in terms of corporate governance report (z = -4.399), products and services information (z = -4.237), general financial information (z = -5.500), investor relations (z = -7.612), the use of figures and graphs (z = -10.094), internet financial reporting (z = -3.616), the disclosure of current annual report (z = -2.986), the multimedia content (z = -3.891) and email link (z = -4.462) as shown in table 11. while significant at 5% level for forward looking information (z = -2.114) .these results support the first hypothesis that there is a significant difference in the characteristics of corporate internet disclosure among the two gcc countries. table 11. mann-whitney test results variable mean rank mann-whitney ksa oman z-value sig. eweb 140.89 123.49 -3.993** 0.000 aweb 174.68 77.55 -12.157** 0.000 investor relation 159.95 97.69 -7.612** 0.000 figures & graphs 168.79 85.72 -10.094** 0.000 email link 141.76 122.31 -4.462** 0.000 multimedia 144.09 119.16 -3.891** 0.000 format 146.04 116.53 -3.616** 0.000 cg report 145.75 116.92 -4.399** 0.000 company information 142.39 121.46 -4.506** 0.000 products & services information 142.02 121.96 -4.237** 0.000 forward looking information 140.91 123.46 -2.114* 0.035 general financial information 152.21 108.17 -5.500** 0.000 ifr 146.04 116.53 -3.616** 0.000 current annual report 143.97 119.32 -2.986** 0.003 ifryrs 144.31 118.86 -2.842** 0.004 * sig. at 5% level. ** sig. at 1% level. the following equation is used to test hypotheses two to six: ifr = α + β1 roa + β2 audtyp + β3 indtyp + β4 lvg + β5 frmsize + ε using logistic regression to examine the determinants of ifr in the gcc countries (tadawul, and msm), as in the equations above. where, where, chi2 = 39.595, cox and snell r2 = 0.138. the results in table 12 show that the only factor that significantly impact internet asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 82 financial reporting in the gcc countries is firm size, where wald = 29.373 (p-value = 0.000) at 1% level. all other variables show insignificant effect on internet financial reporting in the two countries. the results are consistent with the findings of previous studies (ashbaugh et al., 1999; craven and marston, 1999; pirchegger and wagenhofer, 1999; debreceny et al., 2002; ettredge et al., 2002; oyelere et al., 2003; fisher et al., 2004; chan and wickramasinghe, 2006; trabelsi, 2007; ezat and el-masry, 2008). the results can be justified by the fact that to reduce these agency costs, larger firms disclose a large flow of corporate information (jensen and meckling, 1976). also, large companies are more likely to use information technology than small ones to improve financial reporting to meet the greater demand for information (xiao et al., 1996). the relative cost of disclosing information may also be lower than smaller ones (oyelere et al., 2003). furthermore, according to the political cost hypothesis it is argued that larger firms face more demands for information from analysts than smaller firms (mckinnon and dalimunthe, 1993; boubaker et al., 2012). table 12. logistic regression results variables dependent variable (ifr) coefficient se wald p-value roa 0.167 1.204 0.019 0.890 audtyp -0.229 0.370 0.384 0.536 intyp -0.094 0.180 0.271 0.603 lvg -0.680 0.582 1.366 0.243 frmsize 0.457 0.084 29.373** 0.000 constant -8.315 1.596 27.138** 0.000 cox and snell r2 chi-square 0.138 39.595 (df = 5) n 266 **sig. at 1% level 5. summary and conclusion this paper investigates and reports on the extent, nature and determinants of ifr practices among companies listed in tadawul and msm. as there is little empirical study on ifr practices in the middle east region this paper is an important contribution to filling the gap the literature. the paper provides insights into ifr in the middle east that will benefit all stakeholders with an interest in corporate reporting. data has been collected and analysed on 266 companies listed on the stock markets in saudi arabia and oman. while 246 of these companies maintain websites, only 154 provide internet financial reporting on their websites. the majority of these companies use the pdf format to publish financial information and some companies use the internet to provide additional financial information, in the form of financial highlights. this study reveals a good use of the internet for financial reporting purposes in saudi arabia and oman. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 83 the results show that large firms tend to disclose more financial information in order to reduce information asymmetry and also reduce agency costs. also, the more exposure large firms are subjected to leads to the firms being under higher pressure to disclose information. large corporations seem to disclose information on the internet due to the fact they can benefit from the lower cost that results from these firms having the resources to do so. additionally, the results are consistent with agency theory that large firms attempt to reduce the high agency costs associated with information asymmetry between market participants by disclosing a large flow of corporate information. furthermore, according to the political cost hypothesis, large firms attract more financial analysts putting firms under higher pressure because they are more publicly visible. the benefits to be derived from ifr in the modern era of globalisation and endemic market inter-linkages are likely to far outweigh the pecuniary costs. the current level of technological expertise and development in the arabian gulf is more than adequate for the creation, operation and maintenance of corporate websites for ifr purposes. however, perceptions about cost and technological expertise may be limiting the widespread implementation of ifr among companies in the arabian gulf. nonetheless, apart from initial set-up costs, which are relatively minor, the ongoing long-term costs of operating and maintaining corporate websites for ifr purposes are minimal. however, the results show that large firms tend to disclose more financial information in order to reduce information asymmetry and also reduce agency costs. also, the more exposure large firms are subjected to leads to the firms being under higher pressure to disclose information. perhaps the “novelty” factor is the main factor responsible for the current low uptake of ifr among companies in saudi arabia and oman. this is likely to be generalisable to other countries in the arabian gulf region, and possibly the broader middle east. if that is the case, the region is likely to witness an upsurge in ifr over the next few years and regulators and other governmental agencies, as well as other stakeholder groups will need to be prepared for this imminent development. nonetheless, there is little by way of regulatory guidance or pronouncement on ifr in saudi arabia and oman and perhaps in most countries of the middle east. this situation needs to be remedied in advance. references abd el salam, o.h. 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(1996). the impact of information technology on corporate financial reporting: a contingency perspective. british accounting review, 28(3), 203-27. http://dx.doi.org/10.1006/bare.1996.0015. xiao, j., yang, h., & chow, c. (2004). the determinants and characteristics of voluntary internet-based disclosures by listed chinese companies. journal of accounting and public policy, 23(3), 191-225. http://dx.doi.org/10.1016/j.jaccpubpol.2004.04.002. microsoft word le-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 464 an exploratory study of herd behaviour in vietnamese stock market: a new method uyen minh le phd program in business, yuan-ze university, taiwan, r.o.c. hong ngoc truong phd program in business, chung yuan christian university, taiwan, r.o.c. received: feb. 28, 2014 accepted: april 8, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5326 url: http://dx.doi.org/10.5296/ajfa.v6i1.5326 abstract this research examines the presence of herd behavior in vietnamese stock market from 2006 to 2012. based on two methods suggested by christie and huang (1995); and chang, cheng, and khorana (2000), this research work proposes a new probability approach; that is on market index return and market dispersion to capture herd behavior. this new method enables this study to detect herding in a given trading day. the study adopts daily data from a main center of vietnamese stock market. the existence of herd is found during the whole period as using the statistics methods. to be more concrete, herding days are explored via the new probability method in this work. keywords: herd behaviour, cross-sectional standard deviation, cross-sectional absolute deviation, probability approach, vietnamese stock market asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 465 1. introduction herd behavior is a popular phenomenon in financial markets and in stock markets of advanced and emerging markets. herding of participants in the financial market is defined as “the tendency to accumulate on the same side of the market”, which is a significant threat for financial market’s stability and efficiency (kremer & nautz, 2011, p. 1). in other words, it exists in most economies in the world, regardless of size. in different markets, the degree of herd behavior, nevertheless, is not the same. while herding behavior does not usually appear at a low degree in mature markets, this behavior is such a widespread phenomenon and it highly influences the so called “immature” markets. with an inappropriate long term pricing mechanism, it leads to the sudden development and/or possible collapse of the stock market (bikhchandani & sharma, 2001). it, therefore, affects other related markets in the economy. hence, capturing exactly the herd in the market is always an important objective. many analysts and experts failed to detect herd (gleason et al., 2004; demirer & kutan, 2006; ohlson, 2010). thus, a new method, which can find out herd, is an essential contribution for detecting herd behavior in particular and financial field in general. the vietnamese stock market has just been established. consequently, herding behavior does not only exist in the vietnamese stock market, but it is also a captain which leads the market. there were periods when all the market went up regardless of shares’ quality. there were also many times when the whole market went down even though it was helped by a lot of positive information from companies or the government. in other words, herd behavior has controlled most of vietnamese stock markets. hence, this study introduces methods to detect herd behavior in a stock market and apply these methods to point out herd behavior in the vietnamese stock market. 2. literature review numerous researches have studied herd behavior and most of them retained the idea of bikhchandani and sharma (2001). they argued that individuals can examine herd if they invest without knowing decisions of other investors. in vice versa, they will not make the investment when they find others’ decisions (bikhchandani & sharma, 2001). other researchers proposed a broader definition of herd behavior. they conceptualized herd behavior as “a group of investors transacting in the same way, in the same direction (buy or sell) for a given period of time” (grinblatt, titman & wermers, 1995); nofsinger & sias, 1999). so, the correlations in investors’ behaviors influence each other. however, this correlation may be observed when investors are solely affected by factors or common information (khan, hassairi, & viviani, 2011). at another side, hirshleifer and teoh (2003) perceived the difference between two types of herd behavior. they are convergence of behaviors and informational cascades situations where the trading of individual investors depends on their observation about others’ action instead of their own informational signal. therefore, when investors try to follow the market consensus, it may lead asset prices to deviate from economic fundamentals. as a result, stocks are not accurately priced. further, many studies focus on market participants' herding behavior of managers to analysts working in mutual fund and institutions. grinblatt, titman and wermers (1995) detected obvious evidence of herding activity in mutual fund markets. herd behavior appeared when fund managers flock to buy shares that can make profit. they confirmed that nearly 80 percent of mutual fund investors are momentum investors, who try to buy high return securities and sell poor return ones. welch (2000) suggested that fundamental information is less likely to lead investors to flock to the market consensus. he also implied that analysts are tempted to determine to herd because of little or no information. whereas wermers (1999) detected asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 466 evidence of little herding by mutual fund managers in trading average securities, welch found more support of herding in trades of small stocks by growth-oriented funds which have plans to get bigger. there are several empirical researches related to measures which have been developed to investigate herd behavior in financial market. lakonishok, shleifer and vishny (1992) detect herd by exploring whether number of money managers are equal in buying and selling stock or not. for example, after finding out that in the market 70 percent of money managers raised their holding, whereas just 30 percent money managers declined their holding, they concluded that herding was present. however, this measure does not concern the quantity of stocks which are bought or sold by investors. the second method proposed by christie and huang (1995) (henceforth referred as ch) which investigates the magnitude of cross-sectional dispersion of individual stock returns during large price changes. if the dispersion is small during the large price changes then they suggest that there is an evidence of herding. after that, chang, cheng and khorana (2000) (henceforth referred as cck) introduced another method to detect herd using the relationship between dispersion of market return and market return. in this method, the dispersion is represented by cross-sectional absolute deviation. hwang and salmon (2004, 2011) created and developed a model based on capital asset pricing model to detect and measure a herd’s magnitude. hwang and salmon (2004, 2011) suggested a model based on the change of stock betas from their equilibrium to measure the herd behavior level. they used cross-sectional betas of assets to measure herding. with this method, they observed herding behavior in the stock markets of the united states, united kingdom, and south korea. they found beta herding when investors believed that they know where the market is herding rather than when the market is in crisis. this model also allows us to add other variables in order to test steadiness or measure the effects of other factors. nevertheless, it is not easy to obtain expected results using hwang and salmon’s method due to insignificant coefficients. in addition, methods of christie and huang (1995) and chang et al. (2000) still have their model’s disadvantages. consequently, a new method with a probability approach to detect herding is offered. the new method will be applied to test herd behavior of vietnamese stock market. its empirical results will be taken to compare with the results in christie and huang (1995) and chang et al. (2000)’s research works. 3. method in order to comprehend these three methods as well as compare empirical results, basic principles of the methods used to detect herd are translated as follows. 3.1. method of christie and huang (1995) christie and huang (1995) or ch (1995) used the cross-sectional standard deviation (cssd) of single stock returns concerning market returns. the cssd is calculated by the formula as:  2 , , 1 1 n i t m t i t r r cssd n      (1) where cssdt is the cross-sectional standard deviation of market return at time t. ri,t is observed stock return of company i at time t. ,m tr is the cross-sectional average return of the n stock returns in the stock market at time t. n is the number of stocks in the market asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 467 portfolio. in other words, cssdt is the standard deviation of stocks’ returns at time t in the stock market when we consider the stock market is a sample. ch (1995) also stated that rational asset pricing models forecast that dispersion will go up with the absolute value of the market return. it is because individual stocks differ in their sensitivity to the market return. ch (1995) proposed that in the extreme market movements (up or down) individual investors are highly probable to follow the market consensus. they wanted to do an empirical test in order to find out whether asset return spreads during extremely bullish and bearish periods are significantly lower than in average. therefore, they estimated this difference through the following formula: l l u u t t t tcssd d d       (2) dt l and dt u are dummy variables. dt l = 1 if the market return of day t belongs to the intense lower tail of the market return distribution and of course dt l = 0 if not. dt u = 1 when the market return of day t lies in the intense upper tail of the market distribution and dt u = 0 otherwise. these variables are created to capture differences of investors’ actions between intense movement and normal conditions of the market. as the statistical coefficients of βl and βu are significantly negative, they indicate the presence of herd behavior. to define periods of extreme bull and bear market, ch (1995) used one or five per cent of the lowest and highest observations in terms of market return. 3.2. method of chang, cheng and khorana (2000) adopting the same idea with christie and huang (1995), chang, cheng and khorana (2000) also used cross-sectional dispersion to detect herd behavior and developed cck model. however, instead of cssd, chang et al. (2000) used the cross-sectional absolute deviation of returns (csad) as a measure of spread. the cross-sectional absolute deviation as a better measure of spread compared to the cssd is defined as follow: , , 1 n i t m t i t r r csad n     (3) where csadt is the cross-sectional absolute deviation of market return at time t. ri,t is observed stock return of company i at time t. ,m tr is the cross-sectional average return of stocks in the market at time t. n is the number of stocks in the market portfolio. in other words, csadt is the average of absolute differences of market return and each stock return. this measure is also applied to the ch (1995)’s method via the equation: l l u u t t t tcsad d d       (4) the consequence is the same with equation (2). βl and βu are significantly negative when they estimate coefficients. they illustrate the presence of herd behavior. 3.3. the new method finding herd in a specific day asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 468 christie and huang (1995) and chang et al. (2000) could only detect herd behavior during a period of time while this present research suggests a new simple method which can capture herd in a specific day. this new method is also based on the relation between market return and market volatility as same as ch (1995) and ckk (2000) did. nevertheless, the new method uses probability approach instead of using statistic approach like ch (1995) and ckk (2000). usually, the relationship between market return and market dispersion belongs to a particular interval. however, it will be outside this interval if there is herd behavior. therefore we can measure the probability of this relationship to detect herding. there are two ways to calculate market return. the first one is using cross-sectional average stocks returns in the market. this way is implemented in christie and huang (1995) and chang et al. (2000). another one is using market indexes. the latter is adopted in the new method as follow: , , , 1 ln m t index t m t p r p          (5) where rindex,t (or market index return) is the market return which is calculated by using market index; ln(.) is natural logarithm function; pm,t and pm,t-1 are market index at time t and (t-1), respectively. it is assumed that the market return is the market index return in this case, has a normal distribution with its own mean (µ) and variance (σ2). its distribution or “probability density function” is a bell-shaped which is symmetric with its mean at the center. this function is also known as gaussian function. it is as follows:   2 1 2 21 ; , 2 x f x e            (6) where µ is the mean or expectation (location of the peak); σ2 is the variance; σ is standard deviation; e is an irrational and transcendental constant approximately equal to 2.718; π is a mathematical constant that is the ratio of a circle’s circumference to its diameter, and is equal to 3.14 (mcclave, 2011). when the market return is a fairly stochastic process (or a random process), it follows a normal distribution with zero or rindex ~ n (0, σ2) as the mean, which can be tested with a null hypothesis h0: μrindex = 0. base on these assumptions, it is not difficult to standardize market return distribution. it means transferring market return from normal distribution (n (0, σ2)) into standard normal distribution (n (0, 1)). then, the probability (p-value) of the relationship between market returns and market dispersions in each day can be computed. the more the probability is, the more frequently it happens. the method’s principle is not hard to comprehend. if the daily market return has an up-jump over a particular upper limit and the market dispersion is relatively small, then this jump seems to be a rare event due to its tiny p-value. therefore, we can implement this logical idea to capture herd in a specific day. a daily herd will be detected through the daily market return and the daily market volatility. to be more concrete, if market return is higher (smaller) than upper (lower) limitation and market dispersion is small enough, herding is presented, or vice versa. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 469 by implementing this method, analysts can capture herd in specific days and count number of days which herd happens in a period. moreover, the method allows investors to compare herd’s effect between up and down market. this method seems to be better than the previous statistic approach methods. it eliminates disadvantages of these methods in terms of model fitness. in additions, it provides a clearer picture about herd behavior in stock markets. all of these advantages will be illustrated in detail in the results section. the raw data are the daily closed prices of stocks issued in ho chi minh city stock market and closed index of vn-index. data sample is collected from 01 january, 2006 to 30 june, 2012. 4. empirical results this section shows the result analyses of three methods. 4.1. the two models ch (1995) and cck (2000) 4.1.1. sample data the investigating presence of herd behaviour in vietnamese stock market begins by using dummy variables in regression tests which are the same as the methods of christie and huang (1995) and chang, cheng and khorana (2000) (henceforth referred as ch (1995) and cck (2000)). both of cross-sectional standard deviation (cssd) and cross-sectional absolute deviation (csad) are used as measures of dispersion. the coefficients of dummy variables interpret differences in dependent variables and cast light on the range of herd behavior via extremely bullish and bearish trading day. equation (2) and (4) are estimated by using 3% of the price movement days following the definition of extremely bullish and bearish days. table 1 shows the parameters estimated by t-statistics value and p-value pertaining to the daily data. the results of these equations suggest the same feature. this is an appearance of herd behavior in the stock market. the coefficients of βl and βu are negative and the p-values are much smaller than 0.05. it means βl and βu are significantly negative. however, when we look at the results carefully, we can see differences between the coefficients of βl and βu in cssd model (-0.0056 and -0.0075, respectively) and csad model (-0.0080 and -0.0084, respectively). only one data is considered being used for these models. so it can be said that the csad model is more sensitive than another in terms of capturing herd behavior. in addition, the r-squared (r2) in csad model is much higher than r2 in cssd model (0.107 compares to 0.056). it means that in csad model, regression line fits a set of data better than one in cssd model. table 1. estimated coefficients of christie and huang (1995)’s and chang et al. (2000)’s methods cssd csad βl βu r2 βl βu r2 coefficients -.0056*** -.0075*** .0556 -.0080*** -.0084*** .107 t-statistics -5.968 -7.904 -9.659 -10.306 note: * significant at 10%; ** significant at 5%; *** significant at 1%. csad: cross-sectional absolute deviation cssd : cross-sectional standard deviation however, in both models, the values of r2 are too small (less than 0.2). r2 is used to describe how well the data fit a model is. r2 is between 0 and 1, and the bigger r2 is, the better the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 470 data fit the model. therefore, in this case, the models do not fit the data well. it is not difficult to explain this problem. actually, herd behavior is not only a reason which leads to changes in market dispersion in extreme price movement periods. there are also fundamental factors of the market which affect the market in the same way. nevertheless, these factors are not involved in the models, so small r2 is a reason. unfortunately, it is not easy to increase r2 by adding variables into the models. this problem also caused inaccuracy of the two methods of christie and huang (1995) and chang et al. (2000) in terms of detecting herd behavior. 4.1.2. yearly periods according to the integrated results in table 2, once again we can see the advantage of csad in comparison to cssd to represent market variation because the coefficients in csad model are always higher than ones in cssd model. it means that csad is more sensitive than cssd regarding to changes in dl and du. table 2. estimated coefficients of christie and huang (1995) and chang et al. (2000) method in each year cssd csad βl βu βl βu 2006 coefficient t-value -0.0008* -0.2105 -0.0056* -1.5534 -0.0036* -1.3503 -0.0063* -2.3477 2007 coefficient t-value -0.0026* -0.9974 -0.0027* -1.0263 -0.0038* -1.7651 -0.0045* -2.0756 2008 coefficient t-value -0.0047* -1.4841 -0.0103* -3.2909 -0.0092* -3.0025 -0.0120* -3.9017 2009 coefficient t-value -0.0097* -5.2489 -0.0158* -8.5562 -0.0122* -6.7142 -0.0155* -8.5245 2010 coefficient t-value -0.0020* -1.7267 -0.0041* -3.4977 -0.0022* -1.9522 -0.0035* -3.1033 2011 coefficient t-value -0.0003* -0.2856 0.0009* 0.9160 0.0002 0.2460 0.0016 1.6492 first half of 2012 coefficient t-value -0.0015* -1.0623 -0.0047* -3.2562 -0.0008* -0.5928 -0.0053* -3.6976 note: * significant at 1%. csad: cross-sectional absolute deviation cssd : cross-sectional standard deviation the presence of herd behavior can be detected only in 2009 by using cssd measures. however, when using csad to measure the dispersion, herding is found in 2008 and 2009 at 1% significant level because both βl and βu are significantly negative at alpha is 1%. 4.2. the new method this method is based on a simple principle; however, to be reliable, the data has to satisfy some assumptions which are concerned in the previous sections. some tables and graphs for describing the data are showed in order to provide a clear picture of stock market data in vietnam. 4.2.1. descriptive analysis asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 471 descriptive statistics in table 3 illustrates essential statistics of data which include min, max, mean, median, standard deviation, kurtosis, skewness, and n (number of observation). the largest range of market returns is around 0.096 in 2006 and the smallest one is 0.070 in 2012. however, in total, the distribution of data, which is symmetric with the skewness (-0.0511), is closed to 0, and is equal to the mean (0.0002) and the median (0.0002). table 3. descriptive statistics of market index return min max mean median s.d kurt skew n 2006 -0.0497 0.0465 0.0036 0.0026 0.0202 0.1036 -0.2437 250 2007 -0.0447 0.0414 0.0008 -0.0007 0.0172 -0.0629 0.1840 248 2008 -0.0480 0.0464 -0.0043 -0.0058 0.0233 -0.6393 0.1007 248 2009 -0.0467 0.0465 0.0018 0.0018 0.0218 -0.5127 -0.0893 251 2010 -0.0402 0.0440 -0.0001 0.0005 0.0132 0.8954 -0.1276 250 2011 -0.0411 0.0336 -0.0013 -0.0013 0.0133 0.2362 -0.0116 248 2012 -0.0303 0.0393 0.0015 0.0003 0.0141 -0.0599 -0.0403 121 total -0.0497 0.0465 0.0002 0.0002 0.0184 0.1209 -0.0511 1616 besides, figure 1 also gives us a visual way to capture the total data. intuitively, market return distribution is symmetric and seems to be a normal distribution with a mean is 0. figure 1. distribution of market index return in addition, daily statistic information of stocks in the market is provided to market index returns. table 4 shows descriptive statistics of all stocks in september 2008. according to these results, differences between the highest and lowest daily stocks returns are relatively high (less than 10%). daily stocks returns distributions seem to be asymmetric because absolute skewness statistics are quite high. especially, there are three days, 19th, 22nd and 30th whereas the kurtosis was extremely high (14.2, 30.9 and 23.4) respectively. it demonstrates that there are unusual features that occurred in those days. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 472 table 4 . descriptive statistics of stocks’ returns in september 2008 year min max mean range s.d kurt skew n 20080903 -0.050 0.065 0.036 0.116 0.024 5.236 -2.456 141 20080904 -0.073 0.057 0.015 0.131 0.035 -0.930 -0.665 141 20080905 -0.077 0.066 -0.001 0.143 0.042 -1.723 -0.007 141 20080908 -0.072 0.062 -0.008 0.134 0.039 -1.489 0.370 141 20080909 -0.051 0.063 -0.006 0.115 0.037 -1.432 0.256 141 20080910 -0.052 0.048 -0.029 0.101 0.027 0.554 1.226 143 20080911 -0.075 0.053 -0.040 0.129 0.020 6.524 2.440 143 20080912 -0.074 0.042 -0.043 0.116 0.016 9.289 2.727 143 20080915 -0.063 0.064 -0.009 0.127 0.039 -1.505 0.325 143 20080916 -0.132 0.047 -0.046 0.179 0.019 8.902 1.081 143 20080917 -0.065 0.047 -0.040 0.112 0.021 7.281 2.788 143 20080918 -0.091 0.045 -0.042 0.136 0.021 7.835 2.680 144 20080919 0.001 0.094 0.046 0.094 0.009 14.202 -0.685 145 20080922 0.015 0.093 0.046 0.078 0.006 30.900 2.341 145 20080923 -0.070 0.060 -0.006 0.131 0.037 -1.458 0.157 145 20080924 -0.058 0.050 -0.024 0.108 0.027 0.398 1.128 145 20080925 -0.050 0.072 0.025 0.122 0.028 0.822 -1.307 145 20080926 -0.051 0.048 0.015 0.100 0.028 -0.580 -0.604 145 20080929 -0.051 0.048 -0.020 0.099 0.029 -0.066 0.970 145 20080930 -0.087 0.000 -0.048 0.087 0.007 23.474 1.701 145 the market index return and market dispersion are illustrated in the figure 2. in september 2008, the market return fluctuated with large ranges, while in some days market dispersion was quite small. therefore, it is not difficult to realize that there were some herding days in which market deviation was fairly small whereas return was relatively high. for instance, on 12th, 16th, 19th, 22nd and 30th, the absolute market index return was over 4 percent and the market dispersion was really small (less than 2 percent). it means, based on the new method’s principle, herd obviously happened in these days. hence, looking the figure can be a simple way to capture herd, even though it is a visual way. figure 2. market index return and market dispersion in september 2008 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 473 4.2.2. testing the null hypothesis the result of testing the null hypothesis is demonstrated in table 5. according to the p-value (0.6622) which is much higher than 0.05, the null hypothesis is not rejected. in other words, the market index return has a zero mean. the market return distribution follows the normal distribution with the mean is equal zero or rindex ~ n (0, σ2). it means the data satisfies assumptions of the method. hence, the new method is applicable to detect herd. table 5. the result of testing the null hypothesis mean of rindex std.dev of rindex n t-value p-value 0.0002 0.018 1616 0.437 0.6622 4.2.3. detecting herd results the results in table 6 show the number of herding days in the market during each year and the whole period. herd is detected in two levels of significance at alpha is 5 percent and 1 percent. the smaller alpha is, the less herding days are found. in total, the number of herding days at 5 percent of alpha is double at 1 percent of alpha. in additions, the market is fairly symmetric with number of herding days is almost the same in both up and down market. herd happened mostly in 2008 and 2009 and were not frequent since 2010, regardless of market direction. hence, the new method illustrates herd in the vietnamese stock market. a conclusion is similar to previous studies of ch (1995) and ckk (2000). however, it provides a more concrete picture about herd compare to the others. according to this result, the frequency of herd behavior is relatively high in the market. especially, the frequency of herd behavior at 5% of alpha are used to detect herding days (114 herding days in 1616 trading days). table 6 . number of herd days in the market year up market down market total α = 5% α = 1% α = 5% α = 1% α = 5% α = 1% 2006 13 8 9 5 22 13 2007 6 1 3 1 9 2 2008 13 9 24 14 37 23 2009 23 9 14 5 37 14 2010 4 1 2 1 6 2 2011 0 0 2 0 2 0 2012 1 0 0 0 1 0 total 60 28 54 26 114 54 as the result shows, herd behavior appeared frequently from 2006 to 2009. in such period, the stock market developed dramatically, and then dropped significantly. stocks’ price and the market index were much over their real value. however, since 2010, herd behavior rarely happened. investors have become more rational. stocks’ price came back to their true values without any rapid development or crash. it means that the stock market seems to operate more efficiently and stably. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 474 5. conclusion the main purpose of this research is not only proving whether herd behavior exists or not in vietnamese stock market. the fact is that herd behavior usually exists in a financial market, especially in an immature market like vietnamese stock market. people can easily realize the presence of herd cognitively. in this study, the crucial objective is introducing the new method to detect herd behavior. through empirical tests and results comparison between this new method with the two methods of ch (1995) and cck (2000), a deeper comprehension about herd is provided. therefore, this research can be deemed as an angle of new interest for researchers or potential researchers who are working or going to work in the same field, same topic or topics related to herd behavior detecting. there have been many methodologies used to detect herd behavior in the world. they used data in the past to test whether herd happened. therefore, it does not make sense for realistic researchers for it may conflict with the time framed context and reference. the present research particularly contributes to fundamental studies of herd behavior for future researches. it provides basic and moderately significant theory and empirical exploration about herd behavior detecting method. thus, this research can be noted to prove a new method which can predict herd in the near future by using daily data. the method’s object is more specific and concrete. it is a stock or a group of stocks instead of a whole market like the previous researchers did. with the new method, herd trend of individual stocks or groups of stocks can be detected in advance. such result can help investors earn profit as well as authorities prevent price bubbles in the future. references bikhchandani, s., & sharma, s. (2001). herd behavior in financial markets. imf staff papers, 47(3), 279-310. chang, e., cheng, j., & khorana, a. (2000). an examination of herd behavior in equity markets: an international perspective. journal of banking and finance, 24(10), 1651-1679. http://dx.doi.org/10.1016/s0378-4266(99)00096-5 christie, w. g., & huang, r. d. (1995). following the pied piper: do individual returns herd around the market? financial analysts journal, 51(4), 31-37. http://dx.doi.org/10.2469/faj.v51.n4.1918 demirer, r., & kutan, a. m. (2006). does herd behavior exist in chinese stock markets? international financial markets, institutions and money, 16(2), 123-142. http://dx.doi.org/10.1016/j.intfin.2005.01.002 gleason, k. c., mathur, i., & peterson, m. a. (2004). analysis of intraday herding behavior among the sector etfs. journal of empirical finance, 11(5), 681–694. http://dx.doi.org/10.1016/j.jempfin.2003.06.003 grinblatt, m., titman, s., & wermers, r. (1995). momentum investment strategies, portfolio performance, and herding: a study of mutual fund behavior. the american economic review, 85(5), 1088-1105. hirshleifer, d., & teoh, s. (2003). limited attention, information disclosure, and financial reporting. journal of accounting and economics, 36(1-3), 337-386. http://dx.doi.org/10.1016/j.jacceco.2003.10.002 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 475 hwang, s., & salmon, m. (2001). a new measure of herding and empirical evidence. warwick business school: financial econometrics reserach centre. hwang, s., & salmon, m. (2004). market stress and herding. empirical finance, 11(4), 585-616. http://dx.doi.org/10.1016/j.jempfin.2004.04.003 khan, h., hassairi, s., & viviani, j. (2011). herd behavior and market stress: the case of four european countries. international business research, 4(3), 53-67. http://dx.doi.org/10.5539/ibr.v4n3p53 kremer, s., & nautz, d. (2011). short-term herding of institutional traders: new evidence from the german stock market. 27 pages, berlin: sfb 649 economic risk. lakonishok, j., shleifer, a., & vishny, r. (1992). the impact of institutional trading on stock prices. journal of financial economics, 32(1), 23-43. http://dx.doi.org/10.1016/0304-405x(92)90023-q mcclave, j. b. (2011). statistics for business and economics. pearson education inc. nofsinger, j. r., & sias, r. (1999). herding and feedback trading by institutional and individual investors. the journal of finance, 54(6), 2263-2295. http://dx.doi.org/10.1111/0022-1082.00188 ohlson, p. (2010). herd behavior on the swedish stock exchange. master thesis, 36 pages, jönköping international business school. welch, i. (2000). herding among security analysts. journal of financial economics, 58(3), 369-396. http://dx.doi.org/10.1016/s0304-405x(00)00076-3 wermers, r. (1999). mutual fund herding and the impact on stock prices. journal of finance, 54(2), 581-622. http://dx.doi.org/10.1111/0022-1082.00118 microsoft word 4761-17484-1-sm-writer2-new-final.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 24 the measurements of firm performance’s dimensions ebrahim mohammed al-matari faculty of business and economics, ammran university yemen and othman yeop abdullah graduate school of business university utara malaysia, malaysia e-mail: ibrahim_matri@yahoo.com abdullah kaid al-swidi othman yeop abdullah graduate school of business, university utara malaysia, malaysia e-mail: swidi@uum.edu.my faudziah hanim bt fadzil othman yeop abdullah graduate school of business, university utara malaysia, malaysia e-mail: fhanim@uum.edu.my received: nov. 8, 2013 accepted: january 25, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.4761 url: http://dx.doi.org/10.5296/ajfa.v6i1.4761 abstract the main purpose of this study was to review the measurements that are related to the corporate governance. a close look at the literature of corporate governance and firm performance reveals that different measures have been used by the researchers to measure the performance. they classified those measurements into accounting-based and market-based indicators. performance measurement has great significance in effective management of an organization and in the enhancement of the processes since only measurable things is manageable. hence, the enhancement of the organizational performance requires some measurements to determine the impact of the level of organizational effectiveness upon business performance. this study can act as a reference to the researchers who are concerned with the firm performance measurements. keywords: performance, accounting-based measurement, market-based measurement asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 25 1. introduction nowadays, the performance of companies is the first to be evaluated by investors around the world as currently, the world has become smaller in a sense that businesses can be conducted anywhere. globalization facilitates business activities and high performance and in eliminating the barriers existing in corporate trade and financial investment, businesses can have a wider opportunity to grow. in addition, with the highest spread of generation in technology, people who are interested and concerned in achieving their jobs from anywhere are encouraged to look for any company around the world that shows high performance for investment. thus, the performance of the company is the most important to encourage the people to come to it. and therefore, people who are responsible for running firms must improve firm performance through new plan and procedures to update its operations and transactions during its life cycle. regarding to the importance of this subject of performance of firms, this study considers the effect of performance in the business environment in consistent to some measurement such as accounting-based measurement and market-based measurement as discussed in the coming sections. 2. firm performance definitions performance measurement refers to the process of measuring the action’s efficiency and effectiveness (neely, gregory & platts, 1995). performance measurement is the transference of the complex reality of performance in organized symbols that can be related and relayed under the same circumstances (lebas, 1995). in the current business management, performance measurement is considered to be in a more critical role compared to quantification and accounting (koufopoulos, zoumbos & argyropoulou, 2008). this is consistent with bititci, carrie and mcdevitt (1997) who described performance management as a process wherein the organization manages its performance to match its corporate and functional strategies and objectives. additionally, the firm’s value can be described as the benefits stemming from the firm’s shares by the shareholders (rouf, 2011). the company’s performance can be viewed from the financial statement reported by the company. consequently, a good performing company will reinforce management for quality disclosure (herly & sisnuhadi, 2011). 2.1 firm performance importance performance measurement is critical for effective management of any firm (demirbag, tatoglu, tekinus and zaim, 2006). the process improvement is not possible without measuring the outcomes. hence, organizational performance improvement requires measurements to identify the level to which the use of organizational resources impact business performance (gadenne and sharma, 2002; madu, aheto, kuei and winokur, 1996). the firm’s success is basically explained by its performance over a certain period of time. researchers have extended efforts to determine measures for the concept of performance as a crucial notion. finding a measurement for the performance of the firm enables the comparison of performances over different time periods. nevertheless, no specific asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 26 measurement with the ability to measure every performance aspect has been proposed to date (snow & hrebiniak, 1980). performance of a firm is significantly impacted by corporate governance and if the functions are appropriately established for the corporate governance system, it attracts investment and helps in maximizing the company’s funds, reinforcing the company’s pillars and this will result in the expected increase in firm performance. in other words, an effective corporate governance protects against probable financial challenges and facilitates remarkable growth and therefore, corporate governance plays a key role in the growth of the firm performance. currently the impact of corporate governance upon the general firm well-being has been examined (ehikioya, 2009). 2.2 firm performance measurement measurement of performance can offer significant invaluable information to allow management’s monitoring of performance, report progress, improve motivation and communication and pinpoint problems (waggoner, neely & kennerley, 1999). accordingly, it is to the firm’s best interest to evaluate its performance. nevertheless, this is a management area characterized by lack of consistency as to what constitutes organizational performance. according to cameron and whetten (1983), the importance of business performance in strategic management can be categorized into three dimensions; theoretical dimension, empirical dimension and managerial dimension. moreover, performance measurement is critical in performance management. through the measurement, people can create simplified numerical concepts from complex reality for its easy communication and action (lebas, 1995). the simplification of this complex reality is conducted through the measurement of the prerequisites of successful management. on a similar note, bititci et al. (1997) contended that performance measurement is at the core of the performance management process and it is of significance to the effective and efficient workings of performance management. in theory, the concept of performance forms the core of strategic management and empirically, most strategy studies make use of the construct of business performance in their attempt to examine various strategy content and process issues. in management, the significance of performance is clear through the many prescriptions provided for performance enhancement. research dedicated to governance structures relationship with financial performance was highly dependent on accounting-based indicators. some studies have adopted individual measurements (accounting-based or market-based measurements). although there are widely measurements of performance with many which it related to much fields but we tried to execute this measurement regarding to corporate governance. based on our reading of much article that interconnection to corporate governance that we will provide almost of measurements of firm performance form different perspective as it explains follows. the countless number of ways has been brought forward to measure financial performance and among them are: measurement of performance as the level of return on assets (roa), return on equity (roe), tobin-q, profit margin (pm), earnings per share (eps), divided asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 27 yield (dy), price-earnings ratio (pe), return on sales (ros), expense to assets (eta), cash to assets (cta), sales to assets (sts), expenses to sale (ets), abnormal returns; annual stock return, (ret), operating cash flow (ocf), return on capital employed (roce), labor productivity (lp), critical business return on asset (croa), cost of capital (coc), market value added (mva), operation profit (op), return on investment (roi), market-to-book value (mtbv), log of market capitalization, loss, growth in sales (gro), stock repurchases, sales per employee(spe), return on revenue (ror), output per staff (ops), cost per service provided (cpsp) and cost per client served (ccs), superior to cumulative abnormal returns (cars), profit per employee (ppe) and return on fixed assets (rofa) etc. most of these proposed measures have been utilized by studies regarding governance. recently, special attention has been dedicated to determining the corporate governance effectiveness through different measurement of firm performance, one that is related to the production process, namely technical efficiency (e.g. sheu & yang, 2005; bozec & dia, 2007; destefanis & sena, 2007; lin et al., 2009; & garcia-sanchez, 2010). this is because the main element of business organization is its operation function which refers to the transformation of inputs into outputs, and wherein efficiency is very significant (sheu & yang, 2005). along the same line, hill and snell (1989) contended that the advantage of making use of technical efficiency is its constitution of accurate measure and the disadvantages of other measures such as financial ratios and tobin’s q as firm performance measure; the latter two are very sensitive to the differences among accounting methods/manipulation of accounting profit (barth, la mont, lipton & spelke, 2005). in this section will categorize these measurements to two classifications such as accounting based measurement and marketing based measurement as it is explained following: 2.2.1 accounting-based measurements accounting-based measurement is generally considered as an effective indicator of the company’s profitability and the business when compared to benchmark rate of return equal to the risk adjusted weighted average cost of capital. the accounting based measurement indicators to the profitability of firms on the short term in the past years such as (roa), (roe), (ros), (pm), (roi), (ocf), (eps), (op), (gro), (roce), (eta), (cta), (sts) and others as we will offer below. the profit measure is criticized for its backward-looking element and its partial estimation of future events in terms of depreciation and amortization. the rate of profit is measured by the accountant, limited by standards established by the profession and is hence impacted by the accounting practices like the various methods employed for the assessment of tangible and intangible assets (kapopoulos & lazaretou, 2007). also, roa, as an accounting-based measurement, gauges the operating and financial performance of the firm (klapper & love, 2002). the measurement is such that the higher the roa, the effective is the use of assets to the advantage of shareholders (haniffa & asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 28 huduib, 2006). higher roa also reflects the company’s effective use of its assets in serving the economic interests of its shareholders (ibrahim & abdulsamad, 2011).). according to hutchinson and gul (2004) and mashayekhi and bazazb (2008), accounting-based performance measures present the management actions outcome and are hence preferred over market-based measures when the relationship between corporate governance and firm performance is investigated. as a result, a company showing a positive performance through roa, it indicates its achievement of prior planned high performance (nuryanah & islam, 2011). contrastingly, a negative person indicates failure of the planned high performance which requires revision of plans to enhance short-term performance. the negative performance results in investors’ (local and foreign) loss. the company therefore has to update its objectives from time to time if it is desirous of competing in the market place. the rest of the section provides extensive summaries of all accounting-based measurements tested by researchers. table 1. summary of accounting-based measurements factors authors how to measure a factor return on assets (roa) al manaseer et al., (2012),uwalomwa and olamide (2012), karaca and ekşi (2012),chari, chen and dominguez (2012), rouf (2011),swamy (2011), khatab et a., (2011), ibrahim and abdulsamad (2011),chaghadari (2011), mirantyherly and sisnuhadi (2011),heenetigala and armstrong (2011),valenti, luce and mayfield (2011), azam, usmani and abassi (2011), khan, nemati and iftikhar (2011), pandya (2011), geletkanycz and boyd (2011), junarsin (2011), bhagat, bolton and subramanian (2011), prabowo and simpson (2011), najid and abdul rahman (2011), shahab-u-din and javid (2011), fazlzadeh, hendi and mahboubi (2011), lin chang-jui (2011), chiang and lin (2011), chahine and safieddine (2011), lin, liao and chang (2011), liang, lin and huang (2011), herri (2011), ghahroudi (2011), chugh, meador and kumar (2011), reddy, locke and scrimgeour (2010), ibrahim, rehman and raoof (2010), shao (2010), pissaris, jeffus and gleason (2010), gurbuz and aybars (2010), o`connell and cramer (2010), chowdhury ( 2010), chamberlain (2010), larmou and vafeas (2010), millet-reyes and zhao (2010), evans, nagarajan and schloetzer (2010), liargovas and skandalis (2010), bøhren and strøm (2010), muravyev, talavera, bilyk and grechaniuk (2010), mandacı and gumus (2010), bauer, eichholtz and kok (2009), chidambaran, palia and zheng (2009), irina and nadezhda (2009), jackling and johl (2009), bhagat and bolton (2009), hsu, hsiao and li (2009), bauwhede (2009), singh and gaur (2009), ehikioya by net income over total assets at the end of the year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 29 (2009), bektas and kaymak (2009), hutchinson and zain (2009), omrana mohammed, bolbol and fatheldinc (2008), bhagata and bolton (2008), mashayekhi and bazazb (2008), abdullah, shah and hassan (2008), juras and hinson (2008), harjoto and jo (2008), kubo and saito (2008), chung, kim, kim and choi (2008), koufopoulos, zoumbos and argyropoulou (2008), dey (2008), ting (2008), kyereboah-coleman (2007), wei (2007), dahya and mcconnell (2007), kim and yoon (2007), filatotchev, isachenkova and mickiewicz (2007), premuroso and bhattacharya (2007), sánchez-ballesta and garcía-meca (2007), moilah and talukdar (2007), cho and kim (2007), garcia, gonzález and ortega (2006), kyereboah-coleman and biekpe (2006), tsai, hung, kuo and kuo (2006), barontini and caprio (2006), douma, george and kabir (2006), firth, fung and rui (2006), joher and ali (2005), sanda, mikailu and garba (2005), xu, zhu and lin (2005), bozec (2005), filatotchev, lien and piesse (2005), dhnadirek and tang (2003), jong, gispert, kabir and renneboog (2002). return on equity (roe) al manaseer et al., (2012),obiyo and lenee (2011),rouf (2011), swamy (2011), ibrahim and abdulsamad (2011),yasser, entebang and mansor (2011), dar, naseem, rehman and niazi (2011), chaghadari (2011), heenetigala and armstrong (2011),valenti, luce and mayfield (2011), azam, usmani and abassi (2011), khan, nemati and iftikhar (2011), pandya (2011), najid and abdul rahman (2011), shahab-u-din and javid (2011), bozcuk (2011), lin (2011), chiang and lin 2011), chahine and safieddine (2011), lin, liao and chang (2011), khan and javid (2011), herri (2011), chugh, meador and kumar (2011), ibrahim, rehman and raoof (2010), shao (2010), chamberlain (2010), larmou and vafeas (2010), uadiale (2010), liargovas and skandalis (2010), bauer, eichholtz and kok (2009), hsu, hsiao and li (2009), bauwhede (2009), singh and gaur 2009), ehikioya (2009), omrana, bolbol and fatheldinc (2008), yue, lan and jiang (2008), mashayekhi and b a z a z b (2008), o kajola (2008), abdullah, shah and hassan (2008), juras and hinson (2008), ting (2008), adjaoud, zeghal and andaleeb (2007), premuroso and bhattacharya (2007), luan and tang (2007), sánchez-ballesta and garcía-meca (2007), moilah and talukdar (2007), kyereboah-coleman and biekpe (2006), makri, lane and gomez-mejia (2006), sanda, mikailu and garba (2005), earle, kucsera and telegdy (2005), brown and caylor (2004), leng (2004). by profit after tax / total equity shares in issue return on sales geletkanycz and boyd (2011), ghahroudi (2011), bøhren and strøm (2010), muravyev, talavera, bilyk and grechaniuk (2010), by it determined by asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 30 (ros) singh and gaur (2009), filatotchev, isachenkova and mickiewicz (2007), sánchez-ballesta and garcía-meca (2007), firth, fung and rui (2006), bozec (2005). dividing net profit by sales. return on investm ent (roi) adjaoud, zeghal and andaleeb (2007). by the benefit (return) of an investment is divided by the cost of the investment. profit margin (pm) al manaseer et al., (2012), obiyo and lenee (2011),yasser, entebang and mansor (2011), dar, naseem, rehman and niazi (2011), azam, usmani and abassi (2011), junarsin (2011), jiang and peng (2011), ghahroudi (2011), reddy, locke and scrimgeour (2010), bauer, eichholtz and kok (2009), bauwhede (2009), o kajola (2008), premuroso and bhattacharya (2007), wei (2007), brown and caylor (2004). it can estimate by profit after tax / turnover. operati ng cash flow (ocf) millet-reyes and zhao (2010). it can evaluate by net income depreciation expense / total assets. earning s per share (eps) al manaseer et al., (2012), junarsin (2011), tsegba and ezi-herbert (2011), lin, liao and chang (2011), yue, lan and jiang, luan (2008), mashayekhi and b a z a z b (2008), ting (2008), adjaoud, zeghal and andaleeb (2007), filatotchev, lien and piesse (2005). it could evaluate by is net income divided by total shares. operati on profit (op) harjoto and jo. it can be calculated by operating income before depreciation to total asset growth in sales (gro) herri (2011), firth, fung and rui (2006), brown and caylor (2004). it can be calculated by dividing the difference between current sales and previous year’s sales volumes by previous year’s asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 31 sales volume. return on capital employ ed (roce) uadiale (2010), filatotchev, lien and piesse (2005). it can analyze by the profit before tax / total issued capital. expense to assets (eta) najid and abdul rahman (2011). it can be calculated by total expenses / total assets. cash to assets (cta) najid and abdul rahman (2011). it can measurement by cash / total assets sales to assets (sts) najid and abdul rahman (2011). it can calculate by total sales / total assets. expense s to sale (ets) najid and abdul rahman (2011). it can be designed by total expenses / total sales. labor product ivity (lp) muravyev, talavera, bilyk and grechaniuk (2010), fidrmuc and fidrmuc (2007) and sheu and yang (2005). it can be measured by the ratio of sales to the number of workers employed. cost of capital (coc) kim and yoon (2007). it can be calculated by interest expense + cash dividends / revenue. loss: firth, fung and rui (2006). it can calculate by the net operating loss. return on revenu e (ror) dhnadirek and tang (2003). it can measure by net profit after taxes/revenues. profit fidrmuc and fidrmuc 2007. this is factor asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 32 per employe e (ppe) can calculate by the total sales less the costs over the total number of employees return on fixed assets (rofa) fidrmuc and fidrmuc 2007. this is factor can calculate by the total sales less the total costs over the fixed assets. table 2. the account-based measurement return on assets (roa) 88 return on equity (roe) 52 return on sales (ros) 9 return on investment (roi) 1 profit margin (pm) 15 operating cash flow (ocf) 1 earnings per share (eps) 9 operation profit (op) 1 growth in sales (gro) 3 return on capital employed (roce) 1 expense to assets (eta) 1 cash to assets (cta) 1 sales to assets (sts) 1 expenses to sale (ets) 1 labor productivity (lp) 3 cost of capital (coc) 1 return on revenue (ror) 1 profit per employee (ppe) 1 return on fixed assets (rofa) 1 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 33 figure 1. the account-based measurement based on figure 1, shows the ratio of highest measure of account-based measurements examined with corporate governance. the first account-based measurement is return on assets (roa) with 46% followed by return on equity (roe) with 27% of total ratio, and profit margin (pm) with 8%. and hence, roa is uniquely measurement of the profit before tax, divided by total assets and it is easy to obtain from the firm’s annual report. 2.2.2 market-based measurements the second type of measurement is the market-based measurement which is categorized as long term like tobin’s q, (mva), (mtbv), (ret), (dy) and among others as discussed in the following paragraphs. the market-based measurement is characterized by its forward-looking aspect and its reflection of the expectations of the shareholders concerning the firm’s future performance, which has its basis on previous or current performance (wahla, shahsyed & hussain, 2012; shan & mciver ron, 2011; & ganguli & agrawal, 2009). tobin’s q refers to a traditional measure of expected long-run firm performance (bozec, dia & bozec, 2010). the employment of market value of equity may present the firm’s future growth opportunities which could stem from factors exogenous to managerial decisions and this is indicated by the companies level (shan & mciver, 2011; demsetz & villalonga, 2001). in addition, a high q ratio shows success in the a way that the firm has leveraged its investment to develop the company that is valued more in terms of its market-value compared to its book-value (kapopoulos & lazaretou, 2007). moreover, market-based expectations for firm performance may result in management incentive to modify their holdings on the basis of their expectations of the future performance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 34 of the firm (sánchez-ballesta & garcía-meca, 2007). as a result, when the company’s market-based performance is higher than the results of tobin’s q, this indicates that the company has succeeded in achieving its planned high performance (nuryanah & islam, 2011) but if it is less than tobin’s q, then the company needs to revise its plans to enhance its short-term performance. the negative performance leads to investor’s loss (local and foreign) and hence, it is important for the company to update its objectives from time to time if it is desirous of competing in the market place. now, we provide instances of studies conducted all over the world dedicated to the study of corporate governance dimensions relation with firm performance. table 3. summary of marketing-based measurements factors authors how to measure a variable tobin-q karaca and ekşi (2012),wahla, shah and hussain (2012), kang and kim (2011), ibrahim and abdulsamad (2011),herly and sisnuhadi (2011),heenetigala and armstrong (2011), shan and mciver (2011), saibaba and ansari (2011), nuryanah and islam (2011), bhagat et al., (2011), najid and abdul rahman (2011), shahab-u-din and javid (2011), bozcuk (2011), lin (2011), tsegba and ezi-herbert (2011), valenti, luce and mayfield (2011), lin, liao and chang (2011), liang, lin and huang (2011), garcı´a-meca and sa´nchez-ballesta (2011), reddy, locke and scrimgeour (2010), ghazali (2010), kota and tomar (2010), o`connell and cramer (2010), chowdhury ( 2010), larmou and vafeas (2010), millet-reyes and zhao (2010), leung and horwitz (2010), bøhren and strøm (2010), hu, tam and tan (2010), mandacı and gumus (2010), mizuno (2010), bauer, eichholtz and kok (2009), chidambaran, palia and zheng (2009), macaulay, dutta, oxner, mary and hynes (2009), irina and nadezhda (2009), jackling and johl (2009), bhagat and bolton (2009), siala, adjaoud and mamoghli (2009), shakir (2009), amran and ahmad (2009), hsu, hsiao and li (2009), switzer and tang (2009), ehikioya (2009), bektas and kaymak (2009), ganguli and agrawal (2009), lee (2009), omran, bolbol and fatheldin (2008), yue, lan and jiang, luan (2008), bhagata and bolton (2008), abdullah, shah and hassan (2008), lee, lev and yeo (2008), harjoto and jo (2008), schmid and zimmermann (2008), dey (2008), ting (2008), sing and sirmans (2008), kyereboah-coleman (2007), khanchel (2007), wei (2007), garg (2007), kapopoulos and lazaretou (2007), choi, park, and yoo (2007), mura (2007), it can calculate by the ratio of the market capitalization plus total debt divided by total asset of the company. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 35 sánchez-ballesta and garcía-meca (2007), barontini and caprio (2006), douma, george and kabir (2006), albert-roulhac and breen (2005), dwivedi and jain (2005), sanda, mikailu and garba (2005), belkhir (2005), florackis (2005), brown and caylor (2004), black, jang and kim (2003), jong, gispert, kabir and renneboog (2002), lemmon and lins (2001). market value added (mva) kula (2005) and abdullah, shah and hassan (2008). it can be calculated by it is the difference between the market value and book value of equity. market-t o-book value (mtbv) al farooque, zijl, dunstan and karim (2007), cordeiro, veliyath and romal (2007), black and kim (2007),yawson (2006), maury (2006) and fairchild and li (2005). it can be calculated by market value of equity / book value of equity. abnorma l returns; annual stock return, (ret) o`connell and cramer (2010), kim and yoon (2007), firth, fung and rui (2006), jong, gispert, kabir and renneboog (2002). it can calculate by annual abnormal returns from the market model. dividend yield (dy) obiyo, ofurum and lenee (2011), brown and caylor (2004), leng (2004). it can evaluate by the dividend per shared / price per share. price-ear nings ratio (pe) valenti, luce and mayfield (2011), ehikioya (2009), sanda, mikailu and garba (2005). it can measure by measured as the ratio of price per share to earnings per share. log of market capitaliz ation moilah and talukdar (2007). ---------- stock repurcha ses brown and caylor (2004). it can calculate by (purchases of common and preferred stock asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 36 (compustat annual item 115) – decrease in preferred stock (from previous year)) / market value of equity. superior to cumulati ve abnorma l returns (cars) braun and sharma (2007). it can calculate by the long-term abnormal stock returns. table 4. the market-based measurement tobin-q 74 market value added (mva) 2 market-to-book value (mtbv) 6 abnormal returns; annual stock return, (ret) 4 dividend yield (dy) 3 price-earnings ratio (pe) 3 log of market capitalization 1 stock repurchases 1 superior to cumulative abnormal returns (cars) 1 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 37 figure 2. the market-based measurement based on figure 2, the ratio of highest measure of market-based measurements examined with corporate governance is displayed by tobin-q with 78% followed by market-to-book value (mtbv) with 7% of total ratio. abnormal returns and annual stock return (ret) displayed 4%. this indicates that tobin`s q is widely used to measure the ratio of the market capitalization plus total debt divided by total asset of the company. this measure is fixable in obtaining the source of company from data stream. 2.2.3 others measurements some measurements cannot capitalize under either accounting or marketing measurement such as output per staff, cost per service provided and cost per client served; these factors were tested by ii, kankpang and okonkwo (2012). based on the above provision of the advantages of accounting and market based measurements, there are some distinct differences between the two. demsetz and villalonga (2001) highlighted two crucial aspects where two measures differ; first, accounting profit ratios are backwards looking measures (shan & mciver, 2011), whereas tobin’s q is described as a forward-looking measure of firm performance. in this situation, accounting profit ratios are impacted by accounting practices and they stress on management outcome. tobin’s q also presents the investors assigned value to the firm’s tangible and intangible assets on the basis of predicted revenue and streams of costs. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 38 the second difference lies in the actual measuring performance. accounting profit measures are often employed by accountants limited by accounting standards and accountability. the tobin’s q measure is frequently used by investors limited by their perceptions (acumen, optimism and pessimism). tobin’s q is favored by several economists who are better informed of the market constraints and not the accounting constraints (demsetz & villalonga, 2001). in theory, researchers revealed that the accounting based measurements like roa, roe, profit margin and others are used for the short-term performance of the firm while the market-based performance of the firm is gauged through tobin’s q as a representation of future long-term performance. therefore, the integration between the two provides a clear picture of the firm. despite the widely used aspect of the measurements, results are still inconclusive. while some found a positive relationship between corporate governance and firm performance through accounting and market-based measurement, others revealed a negative relationship between corporate governance and firm performance. 3. conclusion the current performance of companies is the first to be evaluated by investors all over the globe. currently, the world has become smaller in terms of the opportunities to conduct business anywhere around the world. globalization has facilitated business high performance as economic globalization helps people the world over. by eliminating the barriers to corporate trade and financial investments, development and growth are realized and better opportunities can be paved. performance measurement is very crucial for the organization’s effective management and enhancement of the process is impossible without outcome measurement. hence, organizational performance requires measures to identify the effect of organizational recourses upon business performance. this study is unique to offer all measures to study the relationship between corporate governance and firm performance. it is the first of its kind to conduct a review of all measures of firm performance. we dedicate our effort to conduct a review of the majority of studies studying all the measurements of firm performance with corporate governance dated from 2000 to 2012. this study suggests that future research should use a combination measure of the firm performance that both accounting and market based measures to accurately measure the firm performance. in fact, the accounting –based measure can reflect the past performance of the company while the market-based indicators help to anticipate the future performance. moreover, although there are many measurements for firm performance as we mentioned above, some have been widely used such as return on assets (roa), return on equity (roe), return on sales (ros), profit margin (pm), earnings per share (eps), tobin-q, market value added (mva) and market-to-book value (mtbv), while others are not widely used. it is, therefore, recommended that future researchers should use other measures such as operation profit (op), growth in sales (gro), return on capital employed (roce), expense to assets (eta), cash to assets (cta), cost of capital (coc), return on revenue asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 39 (ror), return on fixed assets (rofa), dividend 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(2008). financial data mining in chinese public companies: corporate performance and corporate governance in business groups. international conference on intelligent computation technology and automation, 772–776. http://dx.doi.org/10.1109/icicta.2008.343. microsoft word 8550-31028-2--writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 239 gender diversity of audit committees and audit fees: evidence from chinese listed companies rui xiang department of corporate finance & accounting business school, sichuan university chengdu, sichuan, p. r. china 610064 e-mail: xiangrui@scu.edu.cn meng qin department of corporate finance & accounting business school, sichuan university chengdu, sichuan, p. r. china 610064 e-mail: mengqin@stu.scu.edu.cn craig a peterson (corresponding author) department of finance & commercial law haworth college of business, western michigan university kalamazoo, mi 49509 e-mail: craig.peterson@wmich.edu received: nov. 9, 2015 accepted: dec. 14, 2015 published: december 14, 2015 doi:10.5296/ajfa.v7i2.8550 url: http://dx.doi.org/10.5296/ajfa.v7i2.8550 abstract this paper investigates whether women, who serve on the audit committee of the board, can have a significant impact in reducing audit fees paid by china's a-share listed companies during the period 2004 to 2007. we show that audit committees composed of both men and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 240 women pay significantly smaller audit fees. the relationship is significantly greater in non-state enterprises than that exhibited by state-owned enterprises and significantly greater in companies deemed to have weak management vis-à-vis strong management. further analysis shows that the composition of the committee is irrelevant when management is strong, regardless of whether it provides guidance for a state-owned enterprise or a strictly public company. when management is deemed weak, however, gender diversity is associated with smaller fees. keywords: corporate governance, china, audit committees, audit fees, gender diversity asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 241 1. introduction the people’s republic of china was governed as a planned economy until the 1990s when the government allowed companies to go public with multiple classes of stock. joint-equity enterprises appeared in the 1980s, and in 1990 and 1991 stock exchanges were founded in shanghai and shenzhen, marking the beginning of china’s equity market. the capital market has grown since then but corporate governance and market supervision lag developed countries (allen, qian & qian, 2005). most listed companies are state-owned and management has generally retained its official administrative posts or ranks. agency conflicts are common as corporate governance is still in its infancy. management engages in rent-seeking activities and demands personal perquisites (lin & lu, 2009). firms lack effective market supervision and investors need protection. that is not to say that the developed world’s equity markets do not struggle with similar agency problems. for instance, the sarbanes–oxley act (pub.l. 107-204, 116 stat. 745) was enacted july 30, 2002, “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.” title iii corporate responsibility, §301 public company audit committees sets forth standards including (3) independence of audit committee members. §407 mandates audit companies include at least one member who is a financial expert. similarly, the securities regulatory commission and the national economics and trade commission of the people’s republic of china jointly issued the code of corporate governance for chinese listed companies in 2002. chapter ⅲ directors and board of directors, §6 special committees of the board states(52)in listed companies, the board of directors can form audit committees based on the decision of general meetings, most of the audit committee’s members should be independent directors, and at least one member should have accounting expertise. it also lists clearly (54)the major responsibilities of audit committees. however, audit committee formation in china is voluntary, differing from developed countries such as u.s and u.k., where its formation is compulsory. furthermore, intensive government control and intervention impose additional complexity to the functioning of the audit committee of the chinese board (pan, xia & yu, 2008; zhang & wang, 2010). the preceding narrative raises questions. first, if the stated purpose of the cited legislation is to protect investors, does the audit committee of the board play a role in reducing agency costs? second, partial ownership of chinese firms means that the state potentially controls operations which also suggest that it may play an important role in corporate governance. therefore, does the nature of the firm’s ownership/management structure matter? third, both pieces of legislation ascribe importance to directors being “independent” with at least one audit committee member deemed a “financial expert”. however, nothing about the composition of the audit committee is ascribed to either piece of legislation even though there is increasing awareness throughout the business and academic communities that women directors further the board’s governance function (burke & mattis, 2000). thus, does this recognition of the importance of gender for the board and its committees extend to chinese companies? we address the question whether women, who serve on the audit committee, can play a role in reducing audit fees – our proxy for agency costs – of chinese companies. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 242 this paper uses a sample of china's a-share listed companies during the period 2004 to 2007. we use number of female members, presence of at least one female member, and percentage of female members on the audit committee as our measures for diversity. this study contributes to the literature in four ways. first, prior research on audit committees in china mainly focuses on those factors that influence the formation of audit committees and their characteristics, thus ignoring the issue of gender diversity. we study that issue in the special institutional background of china where audit committee formation is voluntary and find that diversity leads to lower audit fees, the same as ittonen, miettinen and vähämaa (2010) document using u.s. data. this finding suggests that even though differences exist in institutional and business conditions between china and the u.s., the public’s perception of the contribution that chinese business women provide is similar to that realized by american women. second, after considering the influence of ownership structure and management control on the governance function of audit committees, we show that the negative relationship between diversity and audit fees is significantly greater in non-state enterprises than that in state-owned enterprises; however, the negative relationship of diversity and audit fees exists only when management control is weak. third, our results suggest that after controlling for ownership structure and management control, there is a significantly negative relationship between diversity and audit fees in both state-owned and non-state firms when management is weak but when it is strong, gender diversity is not significantly negatively related to audit fees in either state-owned or non-state enterprises. 2. literature review and hypotheses audit fees are determined both by client demand and the supply of this service by external auditors (abbott, parker, peters & raghunandan, 2003; collier & gregory, 1996; goddard & masters, 2000; goodwin-stewart & kent, 2006). one school of thought holds that audit committees require higher quality audits, thus necessitating more audit hours expended along with greater assurances from external auditors that financial statements are stated in accordance with specified criteria (abbott,et al.2003). conversely, supply-side arguments suggest that the more effective the audit committee, the better the company’s internal controls and the more reliable the firm’s accounting systems (gul &tsui, 1997; mitra, hossain &deis, 2007; tsui, jaggi& gul,2001). the literature on audit committees mainly focuses on the characteristics (e.g. independence, expertise and activity) and association between audit committee quality, auditor independence and internal control（bedard, chtourou & courteau, 2004; carcello & neal, 2000; zhang, zhou & zhou,2007). recently, some studies find that gender diversity of audit committees plays an important role in corporate governance (gavious, segev& yosef, 2012; ittonenet al. 2010; thiruvadi & huang, 2011), but these studies are based on u.s. data and generally do not examine situations unique to emerging and transitional nations, thus their findings may not be applicable to chinese firms. the primary focus of chinese academic studies pertaining to the audit committee is which factors influence the formation (xia, 2005; xiang, 2012; xiang, gan & wang, 2010) and characteristics (wang, zhang &gao, 2008; wang, wang & wu, 2006). audit fees have been asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 243 associated with the ratio of independent to non-independent directors (li & wang, 2006). large boards pay more for auditing while state ownership and top executive duality (ceo and board chair being the same individual) are associated with lower audit fees (cai, 2007). cai also finds that non-state ownership with moderate managerial stock ownership reduces audit fees. he and liu (2015) show that companies with management deemed as having high ability, as measured by the ma score (which is partitioned from total efficiency of the firm and the manager), pay less for auditing. the purpose of this paper is to extend that research stream by investigating whether gender diverse audit committees have a significant effect on the audit feesof chinese companies, after controlling for ownership typeand management control. 2.1 gender diversity of audit committees and audit fees many authors using data from the developed world have also addressed research questions pertaining to the efficacy of the board (fondas & sassalos, 2000; huse & grethe-solberg, 2006; miller &del carmen triana, 2009; nielson &huse, 2010) and audit committee when women are members. stewart and munro (2007) argue that female representatives on audit committees demonstrate superior communication skills and are better prepared for meetings. in comparison to committees that are totally male, a woman’s presence makes members more diligent (thiruvadi, 2012) and reduces fees (ittonenet al. 2010). kuang and chen (2011) suggest that a feminine presence on the chinese corporate board is associated with demands for higher quality external auditing. as the percentage of female board members increases, there are more discussions at board meetings, the discussions are smoother and directors pay closer attention to the interests of other stakeholders and not just stockholders; thus corporate reputation improves (gao& zhang, 2011). we argue that having women on the audit committee can significantly increase the quality of financial reporting and the efficacy of internal control, thereby lowering audit fees in chinese firms like elsewhere. thus,our hypothesis is: hypothesis 1: the gender diversity of audit committees is negatively related to audit fees. 2.2 gender diversity of audit committees, ownership structure and audit fees durnev and kim (2005) argue that major shareholders with different characteristics may have different incentive mechanisms. state-owned listed companies are essentially controlled by and extensions of government with their decisions influenced by state considerations such as those related to job security, tax revenues and social stability (chen, firth, gao &rui, 2006). the non-transferability of state-owned property rights leads to large transaction costs for shareholders or management to liquidate ownership interests and thus, major shareholders of state-owned companies have increased incentive to encroach upon profits at the expense of minority shareholders. in contrast, stockholders of non-state companies in china seem more unified in striving towards the goal of maximizing shareholder wealth. state ownership is generally regarded as inefficient (boycko, shleifer &vishny, 1995; roland,2000). the government is the controlling shareholder and its intervention may lead to tunneling, which means that controlling shareholders encroach upon company assets and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 244 profits for their own benefit. in china, the government takes responsibility for the failure of state-owned companies; companies do not bear the risks. non-state companies do not have this government backstop, thus need to be more cognizant about projects undertaken and risks assumed. xia and fang (2005) find that government control, especially at county and city levels, has a negative impact on corporate value. in contrast, xu and chen(2003) document that listed non-state companies have greater corporate value, larger profits and are more flexible in operation. xu and chen also find the efficacy of corporate governance is higher – senior management subjected to more rigorous supervision within and more scrutiny from outside the company. liu, ye and liao (2014) find that women directors significantly increase financial performance in non-state firms while performance in state-owned firms is not associated with female directors. it appears that risks confronted and management motives may differ between state-owned vis-à-vis non-state organizations. how does this ownership dichotomy affect those women who serve as directors on the audit committee? we argue that due to the government intervention, the female members on a state-owned corporate audit committee may not perform their responsibilities as effectively as their female counterparts on non-state firms. hence control risks, which are an important source of audit risks, increase. our hypothesis is: hypothesis 2: the negative relationship between the gender diversity of audit committees and audit fees is greater in non-state enterprises than that realized in state-owned enterprises. 2.2 management control, gender diversity and audit fees one function of the board is to emplace mechanisms that minimize conflict between management and shareholders (jensen & meckling, 1976). although the board supposedly monitors management, managers may still pursue their own interests by affecting its composition (mizruchi, 1983; weisbach, 1988). vance (1983) argues that when management controls the board, it is in fact supervising itself which weakens the board. if the company’s chief executive officer simultaneously serves as board chair, it is harder for boards to function (lipton &lorsch, 1992). with increased management control, the power balance between the two sides weakens. increased control by management also negatively affects the independence of its audit committee (ruiz-barbadillo, biedma-lopez & gomez-aguilar, 2007). in china, the ceo is usually appointed by the controlling shareholder (the state if the company is state-owned) and oftentimes also chairs the board, thus weakening the board’s supervisory role. gender is another type of power relationship affected by the corporate environment in which it exists (scott, 1999). when management control is strong, traditional feminine characteristics such as conservatism and obedience may reduce a woman’s influence on the committee and may diminish her ability to positively affect corporate governance. we argue that with stronger management control, fewer women are appointed as audit committee members further weakening its supervisory function. this lowers the quality of financial reporting and thus, increases auditing hours and risk assessment. our hypothesis is: hypothesis 3: the negative relationship between the gender diversity of audit committees and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 245 audit fees is greater in companies where management control is weak than in companies where management control is strong. 3. research design the data herein is obtained from the csmar (china security market accounting research) database except for that pertaining to audit committees which was collected by hand for the period from 2004 to 2007. reliable data on control/ownership of listed companies is not available prior to 2004. the 2008 u.s. subprime mortgage financial crisis affected chinese companies including audit fees, thus we exclude companies beginning in 2008 and thereafter.1 we screened the sample as follows: first, we reject firms with insufficient information about their audit committees; second, we omit companies that do not have actual controllers; third, we exclude firms with insufficient financial data. we are left with 2,114 observations, including 359 (2004), 483 (2005), 526 (2006), and 746 in 2007. our sample is subdivided into the type ofcontrollers, resulting in 1,446 state-owned and 668 non-state observations. we also divide our sample according to whether the ceo simultaneously serves as chairman of the board. there are 278 observations labeled as having strong management control, i.e., the two positions of ceo and board chair are dually held by the same individual, and 1,816 observations with weak management control (no duality). we use the following model to investigate the influence of gender diversity on audit fees: afee = β0 + β1gender + β2csize + β3rec + β4inven + β5lev + β6cfo + β7loss + β8size + ε where afee is the dependent variable specified as the natural log of domestic audit fees. gender is the explanatory variable representing the audit committee’s gender diversity. as per ittonen, et al. (2010) and thiruvadi and huang (2011), we use three proxies to measure diversity: fsize denotes the number of women members; fem is a dummy variable set to 1 if there is at least one female on the audit committee; and fpct denotes the percentage of female members to total number of directors on the committee. based on prior literature (abbott,et al. 2003; ittonen, et al. 2010; mitra, et al. 2007; thiruvadi & huang, 2011), control variables are defined as follows: csize is a measure of the total number of audit committee members; rec is the ratio of fiscal year end (hereafter fye) receivables to total assets; inven is the ratio of fye inventories to total assets; lev is the asset-liability ratio specified as fye total debt to total assets; cfo denotes fye net cash flow from operations to total assets; loss is a dummy variable set to 1 if the firm has incurred a loss, 0 otherwise; size is measured as the natural log of fye assets. 4. results and discussion table 1, panel a presents descriptive statistics. the mean and median values of afee are 13.061 and 13.017, respectively; the mean values of fsize, fem and fpct are 0.46, 0.37 and 0.131, which differ from thiruvadi and huang (2011), who report 0.22, 0.20 and 0.06 for the same metrics, suggesting that the gender diversity of chinese listed companies is larger asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 246 than that of the s&p small cap 600 firms. the mean and median values of csize are 3.6 and 3.0, respectively, differing from ittonen, et al. (2010) who report 4.143 and 4.0 for s&p 500 firms, suggesting smaller sized audit committees for chinese firms. panel b shows subsamples of state-owned and non-state enterprises. the 13.103 mean value shown for the audit expense (afee) incurred by state-owned companies is significantly larger than the 12.971 shown for non-state firms (t = 5.095; p = 0.000). our metrics for female membership on the audit committee (fsize, fem, fpct) are 0.46, 0.37 and 0.125 for state-owned organizations and 0.48, 0.38 and 0.146 for publicly-owned companies. only fpct – the percentage of women serving as audit committee members – has a statistically significant difference (t = -2.144, p = 0.032). the results suggest that state-owned firms pay more for auditing and have fewer women sitting on the audit committee – a finding consistent with the hypotheses. companies differentiated by strength of management are shown in panel c. companies with strong management control report a mean value for afee of 12.999 whereas audit expense for those firms with weak management is 13.069 –a statistically significant difference (t = -1.956, p = 0.051). the numbers for the three variables representing a woman’s presence on the audit committee are not significantly different between groups. the results suggest that what strong management is willing to pay for auditing is not dependent upon the composition of the committee. table 2 presents multiple regression results. all gender coefficients are negative and significant at the 0.05 level – a finding consistent with h1 that fees decline with a woman’s presence (βfem = -0.047, p = 0.014) on the audit committee. similarly, fees decline as the number of females (βfsize = -0.034, p = 0.015) or as the ratio of female to male committee members increases (βfpct = -0.015, p = 0.013) after controlling for other variables shown to affect fees. variable afee fsize fem fpct csize rec inven lev cfo loss size mean 13.061 0.460 0.370 0.131 3.600 0.117 0.169 0.985 0.043 0.120 21.363 median 13.017 0.000 0.000 0.000 3.000 0.093 0.140 0.528 0.052 0.000 21.269 stdev 0.556 0.678 0.484 0.197 1.315 0.108 0.143 19.077 0.552 0.320 1.182 variable mean median std. mean median std. mean t-statistic afee 13.103 13.017 0.553 12.971 12.899 0.539 0.132** 5.095 fsize 0.460 0.000 0.676 0.480 0.000 0.683 -0.020 -0.829 fem 0.370 0.000 0.483 0.380 0.000 0.487 -0.010 -0.712 fpct 0.125 0.000 0.188 0.146 0.000 0.216 -0.021 -2.144 variable mean median std. mean median std. mean t-statistic afee 12.999 12.899 0.544 13.069 13.017 0.558 -0.070† -1.956 fsize 0.450 0.000 0.677 0.470 0.000 0.679 -0.020 -0.396 fem 0.350 0.000 0.476 0.380 0.000 0.485 -0.030 -1.090 fpct 0.128 0.000 0.202 0.132 0.000 0.197 -0.004 -0.337 (p= 0.10 †; p=0.05 *; p=0.01 **) table 1: descriptive statistics. panel a: sample statistics n=2114 panel b: state-owned and non-state companies strong management (n=278) weak management (n=1816) difference state-owned (n=1146) non-state-owned (n=668) difference panel c: strong and weak management control the sig corpora experien auditing receivab regress compan diversit (p = 0.0 audit fe state-ow in non-s p = 0.00 suggest support fees tha regardl interest const 6.137 0.00 6.142 0.00 6.147 0.00 (p= 0.1 3 2 1 gnificance ations (size nced a loss g declines. bles-to-asse sion results nies are sho ty and audit 035) sugge ees. this de wned firms. state enterp 07; βfem = ting that fe ts h2 that g an those in s less of ow tingly, rec tant fsize f 7† -0.034* 00 0.015 ** -0 00 0 ** 00 0 †; p=0.05 *; p= table 2: of the con e); firms tha s (loss). a there is s ets (rec) in for the seco own in tabl t fees in stat ests that the emonstrates models (4) prises. our p -0.086, p = ees decrease gender dive state-owned wnership st c, inven a fem fpct 0.047* 0.014 -0.115* 0.013 =0.01 **) gender diversit ntrol variab at are highly as net cash some indica ncreases, so ond hypothe e 3. models te-owned en e percentage that any fe ), (5) and (6 proxies for f 0.018; βfpc e when wo erse commit d companies tructure, si and cfo a csize rec i -0.006 0.158† 0.387 0.083 -0.007 0.159† 0.322 0.081 -0.01 0.158† 0.140 0.083 ty of audit comm 247 bles sugges y leveraged h flow from ation (at th o too does th esis pertain s (1), (2) an nterprises. o e of female e-effects ar 6) report tes female mem ct = -0.159, omen sit on ttees in pub s. ize and l are significa inven lev -0.092 0.003** 0.151 0.000 -0.09 0.003** 0.158 0.000 -0.089 0.003** 0.161 0.000 mittees and audit asian sts it is mo (lev); and m operations he 10% lev he cost of au ing to statend (3) test th only model e audit com rising from sts of this d mbership on p = 0.048) n their aud blicly-held lev have ant for stat cfo lo -0.078** 0.0 0.000 0 -0.078** 0.0 0.000 0 -0.078** 0.0 0.000 0 t fees: regressi n journal of f ore expens d companie s (cfo) inc vel) that as uditing. -owned ver he associati l (3), in wh mmittee mem gender dive diversity/aud n the commi are all nega dit committ companies significant e-owned fir oss size 063* 0.325* .033 0.000 062* 0.325* .036 0.000 062* 0.326* .035 0.000 ion analysis of t finance & ac issn 19 2015, vol. ajfa.macr sive to aud s that have creases, the s the propo sus publicly ion between hich fpct i mbers helps ersity are lim dit fees rela ittee (βfsize ative and sig tees. the e have small t impact o rms but no e n adj. r ** 0 ** 0 ** 0 the sample. 2114 0.43 2114 0.43 2114 0.43 ccounting 946-052x 7, no. 2 rothink.org dit large recently e cost of ortion of y-owned n gender s -0.118 s reduce mited in ationship = -0.07, gnificant, evidence ler audit on fees. ot public r2 f-value 8 207.102 8 207.051 8 207.068 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 248 companies (panel a). one plausible explanation is that receivables in state-owned firms are subject to government intervention. transactions have an added element of complexity resulting in larger bad debt ratios. other implicit guarantees also exist in state-owned companies, thus a large inventory ratio does not necessarily suggest problems with financial performance. and with official administrative posts/ranks, management has motive to reduce the risks of cash flows from operations so as to improve its political stature. loss and csize are non-state variables of interest (panel b). when firms incur losses, state-owned companies avoid ‘special treatment’, i.e., the possibility of delisting, by china’s securities regulatory commission by receiving financial subsidies whereas their non-state counterparts can protect themselves from punishment only through earnings. this increases risk and audit expense. less government intervention in publicly-owned firms may also suggest that the audit committee can more effectively advise management as committee size increases, thus reducing audit fees. table 4 shows results divided by strength of management. models (1), (2) and (3) show the association between a woman’s presence on the committee and audit expense in firms with strong management, previously defined as those companies in which the ceo and chairman of the board are the same person. a gender diverse committee does not function to reduce fees when management is strong. models (4), (5) and (6) report the relationship between gender diversity and fees in companies with weak management, i.e., the ceo and board chairman are two different individuals. negative and significant results appear in the three models (βfsize = -0.033, p = 0.022; βfem = -0.045, p = 0.027; βfpct = -0.109, p = 0.027), suggesting that fees decline when management is weak and women serve as committee members. the evidence supports h3 that gender diverse committees help to reduce audit fees in a managerial framework designated as having weak management control. size and lev remain significant regardless of sample groupings. rec is important for panel a: companies with strong management control constant fsize fem fpct csize rec inven lev cfo loss size n adj. r2 f-value 1 7.24** -0.024 -0.009 -0.071 -0.124 0.002** -0.070** 0.032 0.277** 0.000 0.531 0.694 0.718 0.527 0.000 0.000 0.682 0.000 2 7.24** -0.026 -0.009 -0.066 -0.118 0.002** -0.070** 0.032 .277** 0.000 0.640 0.670 0.738 0.550 0.000 0.000 0.688 0.000 3 7.25** -0.104 -0.011 -0.066 -0.117 0.002** -0.070** 0.032 .277** 0.000 0.414 0.609 0.737 0.550 0.032 0.000 0.683 0.000 4 5.56** -0.033* -0.007 0.281** -0.107 0.108** -0.116 0.034 0.349** 0.000 0.022 0.330 0.007 0.133 0.000 0.310 0.298 0.000 5 5.56** -0.045* -0.008 0.280** -0.107 0.108** -0.116 0.032 0.349** 0.000 0.027 0.260 0.007 0.134 0.000 0.310 0.316 0.000 6 5.57** -0.109* -0.012 0.280** -0.105 0.108** -0.118 0.033 0.350** 0.000 0.027 0.117 0.007 0.139 0.000 0.301 0.312 0.000 (p= 0.10 †; p=0.05 *; p=0.01 **) panel b: companies with weak management control table 4: regression analysis of subsamples by management control. 278 0.39 23.049 278 0.39 23.012 278 0.39 23.106 1816 0.46 193.047 1816 0.46 192.957 1816 0.46 192.968 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 249 companies with weak management control whereas cfo is significant in companies with strong management. our suspicion is that the complexity of receivable and the risk of uncollectibleare larger in firms with weak management. this exposes the auditors to increased risk. cfo is negative, which may indicate that strong management is more capable at controlling cash flows from operations, lowering audit risks. 5. further analysis in further discussion, we separate the sample first into companies with strong and weak management and then each management group into state-owned vis-à-vis publicly-owned companies in order to examine when management control varies, whether the negative relationship between gender and audit fees is affected by ownership. table 5 reports that there are no gender effects arising from a female presence on the audit committee when management control is strong regardless of ownership. as before, fees increase with the size of the firm. interestingly, a dichotomy exists for cash flow from operations. when the state shares ownership, an increase in cfo reduces auditing costs as expected. in contrast, expense increases with cfo for publicly-held corporations. one plausible explanation is that strong management pursues its own interests rather than maximize the value of cash flow from operations, increasing audit risks and incurring larger audit expenses. the previously identified positive relationship between leverage and auditing costs is again present but only for non-state companies. government implicit guarantees do not extend to publicly-held firms. thus, creditors demand higher quality and more expensive auditing as non-state enterprises increase their debt burden. table 6 shows the results of our gender investigations when management control is weak. for state-owned companies, neither the presence (fem) nor number (fsize) of females holding a committee seat is significant. however, there is a significant and negative relationship between the ratio of women to men (βfpct = -0.127, p = 0.030) and audit fees.large companies and levered firms increase expenditures for auditing. panel b reports both number of women (βfsize = -0.062, p = 0.035) and their presence (βfem = -0.069, p = 0.085) reduces fees for non-state companies. as the total number of committee members increase (csize), panel a: state-ownership constant fsize fem fpct csize rec inven lev cfo loss size n adj. r2 f-value 1 6.40** -0.008 -0.001 -0.189 -0.143 0.073 -0.087** 0.071 0.312** 0.000 0.900 0.968 0.610 0.638 0.545 0.000 0.589 0.000 2 6.42** -0.005 -0.003 -0.204 -0.141 0.074 -0.087** 0.071 .311** 0.000 0.949 0.925 0.589 0.643 0.541 0.000 0.586 0.000 3 6.40** -0.048 -0.002 -0.180 -0.143 0.072 -0.087** 0.071 .312** 0.000 0.820 0.956 0.627 0.637 0.550 0.000 0.586 0.000 4 8.15** -0.062 -0.027 0.103 0.056 0.002** 0.718* -0.003 0.235** 0.000 0.229 0.360 0.670 0.831 0.006 0.049 0.975 0.000 5 8.16** -0.084 -0.028 0.115 0.079 0.002** 0.702† -0.009 0.234** 0.000 0.276 0.345 0.634 0.768 0.006 0.054 0.933 0.000 6 8.18** -0.218 -0.034 0.116 0.070 0.002** 0.713* -0.009 0.234** 0.000 0.166 0.258 0.630 0.790 0.006 0.050 0.931 0.000 table 5: companies with strong management control. 150 0.45 16.465 150 0.45 16.462 150 0.45 16.474 panel b: public ownership 1816 0.46 193.047 1816 0.46 192.957 1816 0.46 192.968 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 250 fees decline. we suppose this is true because with more eyes watching management, audit risks and expenses decline. the combined results suggest that the female-male composition of the audit committee does not matter when management control is strong. when control is weak, it appears that women matter – audit fees decline – for both state-owned and non-state companies. 6. conclusion this paper investigates whether the supervision function and governance of audit committees have an influence on fees from the perspective of gender diversity. we use number of female members, presence of at least one female member, and percentage of female committee members as measures to examine the relationship between gender diversity and audit fees for chinese companies, taking into consideration the effects of both ownership structure and management control. the conclusion is that gender diversity is significant and negatively related to audit fees, and that such a relationship is greater in non-state enterprises than that in state-owned enterprises. furthermore, the negative relationship of gender diversity and audit fees exists only when management control is weak. in further analysis, results show that when management control is weak, gender diversity is negatively related to fees in both state-owned enterprises and non-state enterprises, and when management control is strong, gender diversity is not related to fees in either state-owned enterprises or non-state enterprises. therefore, the governance function of audit committees in china can be improved by increasing gender diversity of audit committees, reforming ownership structure systems in state-owned enterprises and weakening management control. acknowledgement data was collected and analyzed for the years 2011-12. results are similar and available upon request. panel a: state-ownership constant fsize fem fpct csize rec inven lev cfo loss size n adj. r2 f-value 1 5.32** -0.023 0.003 0.571** -0.209* 0.079† -0.128 0.032 0.358** 0.000 0.169 0.741 0.000 0.015 0.072 0.356 0.393 0.000 2 5.33** -0.036 -0.002 0.568** -0.211* 0.079† -0.128 0.032 0.357** 0.000 0.118 0.766 0.000 0.014 0.073 0.354 0.401 0.000 3 5.35** -0.127* 0.002 0.570** -0.214* 0.079† -0.134 0.030 0.357** 0.000 0.030 0.996 0.000 0.013 0.071 0.332 0.426 0.000 4 5.61** -0.062* -0.034* -0.123 -0.008 0.109** 0.042 0.085 0.354** 0.000 0.035 0.035 0.500 0.952 0.000 0.838 0.178 0.000 5 5.59** -0.069† -0.038* -0.117 -0.007 0.109** -0.049 0.079 0.356** 0.000 0.085 0.019 0.521 0.956 0.000 0.811 0.209 0.000 6 5.56** -0.114 -0.043* -0.122 -0.008 0.110** -0.055 0.084 0.357** 0.000 0.208 0.007 0.505 0.954 0.000 0.786 0.185 0.000 table 6: companies with weak management control. 1277 0.50 159.92 1277 0.50 159.05 1277 0.50 159.62 panel b: public ownership 539 0.36 39.287 539 0.36 38.992 539 0.36 38.717 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 251 references abbott, l. j., parker, s., peters, g. f., & raghunandan, k. 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(2007). audit committee quality, auditor independence, and internal control weaknesses. journal of accounting and public policy, 26, 300-327. http://dx.doi.org/10.1016/j.jaccpubpol.2007.03.001 microsoft word 7260-25876-3-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 183 non-performing loans in emerging economies case study of india dr. k sriharsha reddy assistant professor finance and accounting institute of management technology (imt-hyderabad) tel: 91-40-3046-1673 e-mail: dr.sriharshareddy9@gmail.com received: may 26, 2015 accepted: june 14, 2015 published: june 14, 2015 doi:10.5296/ajfa.v7i1.7687 url: http://dx.doi.org/10.5296/ajfa.v7i1.7687 survey no. 38, cherlaguda village, shamshabad, hyderabad 5000218, india abstract recovery of non-performing assets is considered as one of the biggest problems for the entire banking industry as the earning capacity and profitability of many banks are adversely affected by the high level of npas. in this paper an attempt is made to outline the problem of npas in indian banking system. the objectives of the paper are to observe the trends in the incidence of npas in indian banking system, to understand the problem of npas in india in comparison with select economies in the world and to outline the policy measures to curtail incidence of npas in india. it is observed that the public sector and to some extent the private banks accounts for the bulk of the npa problem during recent years due to global financial turmoil. thus, while the policies that have been implemented to address the npa problem may have been largely successful, there are further steps that can be taken by the rbi as well as by the banks themselves to tackle the problem of npas. keywords: npas, indian banks, regulatory response, global financial crisis asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 184 1. introduction a major problem being observed all over the world in the banking sector is problem of bad loans. first step of building a stable and strong financial system is to minimize non-performing loans. according to world bank (2014), non-performing loans as proportion of total loans is 24..6 % for ireland, 31.3 % for greece, 9.5 % for egypt, 6% for russia, 3.6% for south africa, 3.2% for usa, 2.9 % for brazil and 1% for china. non-performing loans have been huge concern for al the nations across the globe. since the introduction of financial sector reforms in 1992 and second phase of reforms in 1998, the recovery of non-performing assets is considered as one of the biggest problems for the entire banking industry in india. the high level of non-performing assets (npas) taints the overall portfolio but puts a burden on the income statement of banks in the form of higher provisions. the earning capacity and profitability of many banks are adversely affected by the high level of npas. though it is not possible to have zero npas, a proper understanding of npas is required to manage them, with a view to keeping them under control. to understand npas, it becomes imperative to understand the determinants of npas both from the regulatory as well as managerial angles. for the regulator, npas are crucial since they constitute the first trigger of banking crises. for the bank manager, npas reduces the bank’s profitability, as banks are not allowed to book income on npas and, at the same time, required to make provision for such accounts as per the regulator’s guidelines. moreover, managerial and financial resources of the bank are diverted towards resolution of npa problem causing lost opportunities for more productive use of resources. a bank saddled with npas might tend to become risk averse in making new loans, particularly to smes. hence an attempt is made to understand the determinants of the performance of the banks based on asset quality measured by the level of non-performing assets in a bank subsequent to the recommendations made in narasimham committee report (1998) and global financial turmoil. 2. previous research and research questions 2.1 empirical studies using static econometric models in the banking literature, the problem of npas has been revisited in several theoretical and empirical studies. rajaraman, bhaumik and bhatia (1999) explained variations in npas across indian banks through differences in operating efficiency, solvency and regional concentration. a considered view is that banks’ lending policy could have crucial influence on non-performing loans. reddy (2004) critically examined various issues pertaining to terms of credit of indian banks. in this context, it was viewed that ‘the element of power has no bearing on the illegal activity. a default is not entirely an irrational decision. rather a defaulter takes into account probabilistic assessment of various costs and benefits of his decision’. mohan (2003) emphasized on key lending terms of credit, such as maturity and interest-terms of loans to corporate sector. the indian viewpoint alluding to the concepts of ‘credit culture’ owing to reddy (2004) has an international perspective since several studies in the banking literature agree that banks’ lending policy is a major driver of non-performing loans [mcgoven (1993), bloem and gorters (2001)].the problem of npas is related to several internal factors and external factors confronting the borrowers (muniappan, 2002). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 185 the internal factors such as business (product, marketing, etc.) failure, inefficient management, strained labour relations, inappropriate technology/technical problems and external factors such as recession, non-payment in other countries, inputs/power shortage, price escalation, accidents and natural calamities. rajaraman and vasishtha (2002) in an empirical study provided an evidence of significant bivariate relationship between an operating inefficiency indicator and the problem loans of public sector banks. saurina (2002) using panel data on spanish commercial and saving banks, revealed that various macroeconomic and bank specific factors such as growth in gdp, rapid credit expansion, bank size and capital adequacy ratio influenced the non-performing loans. berger and udell (2004) suggested that the time lapse between successive loan bust periods could be a contributing factor for banks to accumulate bad loans in the future and this could be due to the high turn-over of credit officers in the banking system due to various reasons. the pro-cyclical nature of the accumulation of bad loans is due to the fact that during the bust times, the value of collateral erodes and there is an overall decline in the credit standards (gabriel et al. 2006). hu et a.l, (2004) found an inverse relationship between bank size and npls. their argument is that large banks have better risk management strategies that usually translate into more superior loan portfolios than their smaller counterparts. hu et al. (2004) also found that the banks with higher government ownership recorded lower non-performing loans. 2.2 empirical studies using dynamic econometric models at this point we must stress, that the above studies do not take into account the dynamism which influences incidence of npas. first, salas and saurina (1999b) have modelled the problem loans ratio of spanish banks in order to gauge the impact of loan growth policy on bad loans. they were interested in capturing the lag between credit expansion and the emergence of problem loans. using panel data, they compared the determinants of problem loans of spanish commercial and savings banks in the period 1985–1997, taking into account both macroeconomic and individual bank level variables. the gdp growth rate, firms, and family indebtedness, rapid past credit or branch expansion, inefficiency, portfolio composition, size, net interest margin, capital ratio, and market power are variables that explain credit risk. however, there are significant differences between commercial and savings banks, which confirm the relevance of the institutional form in the management of credit risk. their findings raise important bank supervisory policy issues: the use of bank level variables as early warning indicators, the advantages of bank mergers from different regions, and the role of banking competition and ownership in determining credit risk. das and ghosh (2007) examined the factors affecting problem loans of indian state owned banks for the period 1994-2005, considering dependent lagged variable, macro and bank specific variables influencing npas. they found that gdp growth rate at macro level and loan growth rate, operating expenses and bank size at bank level play an important role in influencing problem loans. thiagarajan et al (2011), carried out a study to predict the determinants of the credit risk in the indian commercial banking sector by using an econometric model by utilizing a panel asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 186 data at bank level for 22 public sector banks and 15 private sector banks. they have shown that the lagged non-performing assets had a strong and statistically significant positive influence on the current non-performing assets. there is a significant inverse relationship between the gdp and the credit risk for both public and private sector banks. in conclusion, the studies which are focused on factors influencing the problem loans of banks, using static or dynamic models are numerous. for this reason, the following table presents some empirical studies and the factors which are identified as responsible for the problem loans. table 1. problem loans determinants proportion of priority sector advances in advances rajaraman, bhaumik and bhatia (1999), rajaraman and vasishtha (2002), ranjan and dhal (2003), chaudhury and sensarma (2006). das and ghosh (2007), thiagarajan et al (2011) size chaudhury and sensarma (2006), salas and saurina (1999b), espinoza r and prasad a (2010), hu. j., y. li and y., chiu (2004) loan growth chaudhury and sensarma (2006), salas and saurina (1999b), espinoza r and prasad a (2010), operating expense ratio chaudhury and sensarma (2006), salas and saurina (1999b), espinoza r and prasad a (2010) gnp growth salas and saurina (1999b), fernandez de lis et al , (2000), chaudhury and sensarma (2006), roa chaudhury and sensarma (2006), car lyoha and udegbunam (1999), chaudhury and sensarma (2006) ownership effects hu. j., y. li and y., chiu, 2004, chaudhury and sensarma (2006), das and ghosh (2007) though significant research was undertaken to understand problem loans, impact of global financial crisis on problem loans in indian context is untouched. further, impact of bank-specific and macroeconomic variables along with ownership of banks on npas is revisited using latest data from 20012012. 3. indian banking industry and problem loans the indian banking system is characterized by different groups of banks categorized into stateowned or public sectors banks, domestic private banks, and foreign banks, which compete amongst each other in almost all areas of banking business. the state-owned public sector banks dominate the banking industry in terms of presence and asset size (chart 1). however, the new domestic private banks, which were set-up in 1995 subsequent to deregulation, have quickly occupied a significant position as compared to the old private banks (table 2). source: r signific occupie table 2 of marc yrs 19 g roup sbi 8 nb 20 opb 34 npb fb 13 scb 75 rs crs 58 source: r report on ban cant position ed a signific 2. no. of ba ch 980 n o. of banks % to total 31.2 0 59.1 4 4.9 ---- 3 3.8 5 100 8,238 report on ban 0 10 20 30 40 50 60 3 char nking statistic n as compar cant position anks and a 1985 n o. of banks % to total 8 32.0 20 57.8 32 4.2 --- 20 4.0 80 100 1,36,681 nking statistic 1980 1990 31.2 33.2 29 59.1 55.7 4 4.9 3.3 0 0 3.8 5. rt 1. asset s cal returns, r red to the o n as compar sset structu 1990 n o. of banks % to total 8 33. 20 55. 25 3.3 ---22 5.4 75 100 2,92,770 cal returns, rb 2000 2006 2 9.1 24 2 48.1 46 4 6.7 5.25.1 14.6 .4 7.1 6.9 sbi nb 187 structure of rbi (2000-201 old private b red to the ol ure of india 1995 % to total n o. of banks 2 8 2 7 19 5 24 5 8 1 27 7 0 86 1 5,29,87 bi (2000-201 2007 2008 2 23 23 24 47 46 4 22 22 2 9 8 8 b opb np asian f indian ban 14) deregula banks (tab ld private b an commerc 2000 % to total n o. of banks 29.5 8 53.3 19 5.8 24 1.4 8 7.1 42 100 101 6 11,52 4) 2009 2010 20 4 23 22 47 50 51 20 4 4 15 9 7 pb fb n journal of f nking ation, have le 2). regul anks (table cial bankin 200 % to total n o. of banks 29.1 8 48.1 20 6.7 19 5.1 8 7.1 29 100 84 2,604 28, 011 2012 20 21 22 1 51 51 4 5 5 15 16 1 7 7 finance & ac issn 19 2015, vol. www.macrothi quickly occ ation, have e 2). ng system a 06 2 n o.ofbanks % to total 24 6 46 2 5.2 1 14.6 7 6.9 4 100 8 ,75,520 9 13 5 16 6 ccounting 946-052x 7, no. 1 ink.org/ajfa cupied a quickly as at end 2013 n o. of banks % to total 6 22 20 51 13 5 7 16 43 6 89 100 95,73,334 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 188 our economy was deregulated and liberalized to attract foreign capital in early 1990s. since that time many financial institutions entered into india with strategic ideas. prior to 1990s our public sector banks and other banks concentrated more on social lending and had accumulated huge non performing assets. the financial statements revealed that most of the psbs profitability was affected due to mounting of poor quality assets later pronounced as non-performing assets. it was identified by narasimham committee-i (1991) and recommended prudential norms on income recognition, asset classification and provisioning on par with international standard set by bis (bank for international settlement). while it is often argued that the banking sector reforms in india were successful in enhancing efficiency and productivity of banks (sensarma 2006), one of the problems faced by indian banking is npas problem. as on march 31st 2013 the gross npas to gross advances ratio of all scbs in india was 3.4 while net npas (net of provisioning) to net advances ratio was 1.7 (table 3). npa ratios have been declining over the years for all bank groups. net npa ratio was the highest for public sector banks at end-march 2013 (1.7 per cent), followed by foreign banks, old private banks, and new private banks. furthermore, the problem of npas was more severe for domestic banks as compared to that for foreign banks because 93 per cent of the assets (table 2), 95 percent of gross advances (table 3b) and 95 percent of gross npas (table 3a) of indian banking industry are with public sector banks and domestic private banks. thus, it is extremely crucial to understand the asset quality of public and domestic private banks in india for the financial stability of the economy. moreover, because of their significant contribution to domestic industrial credit and mobilizing deposits, the issue of prudent lending and effective credit risk management is of paramount importance for these banks. table 3 source: r source: . incidence year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 report on ban chart 2. n : report on 0 1 2 3 4 5 6 7 8 9 199 of gross an % of gross scb 14.4 14.7 12.8 11.4 10.4 8.8 7.2 5.2 3.3 2.6 2.4 2.4 2.5 2.4 2.9 3.4 nking statistic npa s of sch banking st 98200020012 nd net npa npas to gro psb o 16.0 1 15.9 1 14.0 1 12.4 1 11.1 1 9.4 8 7.8 7 5.5 6 3.7 4 2.8 2 2.3 2 2.1 3 2.3 3 2.3 2 3.2 2 3.8 1 cal returns, rb heduled co tatistical re 2002200320 psb 189 as of scbs oss advances opb npb 0.9 3.5 3.1 6.2 1.3 4.2 0.9 5.1 1.0 8.9 8.9 7.6 7.6 5.0 6.0 3.6 4.3 1.7 2.4 2.7 3.2 3.0 2.5 2.1 .9 bi (2000-201 mmercial b eturns, rbi 0420052006 fb dp asian (at end-ma % of advanc fb scb 6.4 7.3 7.6 7.6 7.0 6.8 6.8 6.2 5.4 5.5 5.3 4.4 4.6 2.9 2.8 2.0 1.9 1.2 1.9 1.0 1.9 1.0 4.3 1.1 4.3 1.1 2.5 1.0 2.7 1.4 3 1.7 4) banks as per (2000-2014 62007200820 pb ascb n journal of f arch) f net npa ces psb opb 8.2 6.5 8.1 9.0 7.4 7.3 6.7 7.3 5.8 7.1 4.5 5.5 3.0 3.8 2.1 2.7 1.3 1.6 1.1 1.0 1.0 1.1 0.7 1.5 1.1 0.8 1.2 0.5 1.7 0.6 2 0.8 rcent of net 4) 00920102011 b finance & ac issn 19 2015, vol. www.macrothi as to net npb fb 2.6 2.2 4.5 2.9 2.9 2.4 3.1 1.8 4.9 1.9 4.6 1.8 2.4 1.5 1.9 0.9 0.8 0.8 0.7 1.2 1.7 1.1 1.8 0.6 0.6 0.5 0.6 0.4 1 t advances 120122013 ccounting 946-052x 7, no. 1 ink.org/ajfa asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 190 table 3a. incidence of gross npas of scbs (at end-march) gross npas in 00’ crs proportion of gross npas in total year psb pb fb scb psb pb fb ascb 2006 413.78 77.74 20.90 512.42 81% 15% 4% 100% 2007 384.25 92.39 24.52 501.16 77% 18% 5% 100% 2008 396.06 129.76 31.18 556.99 71% 23% 6% 100% 2009 440.32 168.88 72.94 682.13 65% 25% 11% 100% 2010 572.93 173.84 71.28 818.05 70% 21% 9% 100% 2011 710.80 179.72 50.65 941.17 76% 19% 5% 100% 2012 1124.89 183.15 62.92 1370.96 82% 13% 5% 100% 2013 1,558.90 199.92 79.72 1,838.54 85% 11% 4% 100% source: report on banking statistical returns, rbi (2000-2014) table 3b. incidence of gross advances of scbs (at end-march) gross advances in 00’ crs proportion of gross advances in total year psb pb fb scb psb pb fb ascb 2006 10708.72 3037.93 988.62 14735.27 73% 21% 7% 100% 2007 13737.77 3918.69 1278.67 18935.13 73% 21% 7% 100% 2008 16963.33 4723.45 1629.99 23316.78 73% 20% 7% 100% 2009 20999.38 5196.55 1697.14 27893.07 75% 19% 6% 100% 2010 25123.58 5845.76 1674.39 32643.72 77% 18% 5% 100% 2011 30598.70 7323.10 1993.21 39915.01 77% 18% 5% 100% 2012 35503.89 8804.45 2347.10 46655.44 76% 19% 5% 100% 2013 40,558.74 10,466.65 2,686.12 53,711.51 76% 19% 5% 100% source: report on banking statistical returns, rbi (2000-2014) 4. problem loansa cross country analysis to get an idea of the scale of india’s bad loans problem in comparison with the rest of the world, a comparison of incidence of npas in india with that of some selected countries across geographical regions is made (table 4). it is observed that the incidence of npas has come down significantly from 2000 till 2013 for almost all countries reported above india in the table. from 2007, gross npas have increased for some of the countries due to hard-hit recession and global financial crisis. moreover, in 2013 incidence of npas in india appears to be high in comparison to emerging economies such as china (1), thailand (2.3), malaysia (1.8), korea (0.7) and turkey (2.6). developed countries such as australia (1.4), and canada (0.6), expectedly, have the lowest levels of npas. surprisingly, problem of npas is less severe in india when compared to developed economies such as france (4.3) and emerging economies such as russia (6). the major reason for this trend can be attributed to the global financial crisis faced by the developed economies and conservative, watchful policies adopted by the rbi in india. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 191 table 4. cross-country comparison of gross non-performing loans to total loans country 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 finland 0.6 0.5 0.5 0.4 0.3 0.2 0.3 0.4 0.6 0.6 0.5 0.5 0.5 canada 1.5 1.6 1.2 0.7 0.5 0.4 0.4 0.8 1.3 1.2 0.8 0.6 0.6 sweden 1.5 1.2 1.9 1.1 0.8 0.8 0.1 0.5 0.8 0.8 0.7 0.7 0.6 china 29.8 26 20.4 13.2 8.6 7.1 6.2 2.4 1.6 1.1 1 0.9 1 singapore 8 7.7 6.7 5 3.8 2.8 1.5 1.4 2 1.4 1.1 1 0.9 venezuela, rb 7 9.2 7.7 2.8 1.2 1.1 1.2 1.9 3 3.4 1.4 1.2 0.7 argentina 13.1 18.1 17.7 10.7 5.2 3.4 2.7 2.7 3 1.8 1.2 1.5 1.7 korea, rep. 3.4 2.4 2.6 1.9 1.2 0.8 0.7 1.1 1.2 1.9 1.4 1.5 0.7 bolivia 16.2 17.7 16.7 14 11.3 8.7 5.6 4.3 3.5 2.2 1.7 1.7 1 australia 0.6 0.4 0.3 0.2 0.2 0.6 0.6 1.3 2 2.2 2 1.9 1.4 indonesia 31.9 24 6.8 4.5 7.4 6.1 4 3.2 3.3 2.5 2.1 2.1 1.5 malaysia 17.8 15.9 13.9 11.7 9.6 8.5 6.5 4.8 3.6 3.4 2.7 2.2 1.8 mexico 5.1 3.7 3.2 2.5 1.8 1.8 2.4 3 2.8 2 2.1 2.2 3.2 chile 1.6 1.8 1.6 1.2 0.9 0.8 0.8 1 2.9 2.7 2.4 2.4 2.1 israel 8.2 2.4 2.6 2.5 2.3 2 1.5 1.5 1.4 3.1 2.5 2.4 2.4 philippines 27.7 26.5 16.1 14.4 10 7.5 5.8 4.5 3.5 3.4 2.6 2.4 3 turkey 29.3 12.7 11.5 6 5 3.9 3.3 3.4 5 3.5 2.6 2.5 2.6 austria 2.3 3 3 2.7 2.6 2.7 2.2 1.9 2.3 2.8 2.7 2.7 2.9 thailand 11.5 15.7 13.5 11.9 9.1 8.1 7.9 5.7 5.3 3.9 2.9 2.7 2.3 colombia 9.7 8.7 6.8 3.3 2.7 2.7 3.2 3.9 4 2.9 2.5 3 2.8 japan 8.4 7.4 5.2 2.9 1.8 1.5 1.5 1.4 1.6 2.5 2.4 2.3 india 11.4 10.4 8.8 7.2 5.2 3.3 2.7 2.4 2.4 2.5 2.3 3 3.8 netherlands 2.3 2.4 2 1.5 1.2 1.7 3.2 2.8 2.7 3.1 3.2 brazil 5.6 4.5 4.1 2.9 3.5 3.5 3 3.1 4.2 3.1 3.5 3.6 2.9 belarus 14.9 9 3.7 2.8 3.1 2.8 1.9 1.7 4.2 3.5 4.2 3.9 4.6 united states 1.3 1.4 1.1 0.8 0.7 0.8 1.4 3 5.4 4.9 4.1 3.9 3.2 south africa 3.1 2.8 2.4 1.8 1.5 1.1 1.4 3.9 5.9 5.8 4.7 4.6 3.6 czech republic 13.7 8.1 4.9 4 3.9 3.6 2.4 2.8 4.6 5.4 5.2 5.1 5.2 russian federation 6.2 5.6 5 3.8 2.6 2.4 2.5 3.8 9.5 8.2 6.6 6.7 6 united arab emirates 15.7 15.3 14.3 12.5 8.3 6.3 2.9 2.3 4.3 5.6 6.2 7.6 8.4 poland 21.1 21.2 14.9 11 7.4 5.2 4.4 7.9 8.8 8.2 8.4 5.2 portugal 2.1 2.3 2.4 2 1.5 1.3 2.8 3.6 4.8 5.2 7.5 9 11 egypt, arab rep. 16.9 20.2 24.2 23.6 26.5 18.2 19.3 14.8 13.4 13.6 10.9 10.7 9.5 croatia 7.3 10.2 8.9 7.5 6.2 5.2 4.8 4.9 7.7 11.1 12.3 13.2 15.4 hungary 2.7 2.9 2.6 2.7 2.3 2.6 2.3 3 6.7 9.8 13.4 15.8 17.6 romania 3.3 8.3 8.1 2.6 1.8 2.6 2.8 7.9 11.9 14.3 16.8 21.6 bulgaria 3.3 2.6 3.2 2 2.2 2.2 2.1 2.5 6.4 11.9 14.9 16.9 greece 5.6 5.5 7 7 6.3 5.4 4.5 5 7.7 10.4 14.4 17.2 31.3 ireland 1 1 0.9 0.8 0.7 0.7 0.8 2.6 9 8.6 16.1 18.7 24.6 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 192 source: world bank group (2014), imf, s., & soundness, r. f. (2013) http://data.worldbank.org/indicator/fb.ast.nper.zs?order=wbapi_data_value_2013%20wbapi_data_value%20wbapi_dat a_value-last&sort=asc clearly, while india’s bad loans problem is not as severe as in several other comparable economies, there is a need to manage npas and reduce them further. the problem of npas when ignored has the potential of causing economic and financial deterioration of an economy. to tackle the problem, the regulators have initiated several policy responses, which are discussed in the next section. 5. regulatory response to npas several measures have been implemented by the rbi and the government of india to contain the level of npas. these include debt recovery tribunals (drts), corporate debt restructuring (cdr) scheme, securitization and reconstruction financial assets and enforcement of security interest (safaesi) act, and asset reconstruction companies (arcs). settlement advisory committees have also been formed at regional and head office levels of commercial banks. in order to provide an additional option to banks and to develop a healthy secondary market for npas, guidelines on sale/purchase of npas were issued in july 2005 for those institutions which are not either securitization companies or reconstruction companies. some other steps that have been taken to reduce npas are:improvement in supervisory mechanism through prompt corrective action (pca), sharing of borrower information among banks by setting up of credit information bureau of india limited(cibil) and rewarding low npa banks with freedom in dividend payments to the shareholders. with regard to the first measure mentioned, rbi initiates some structured and discretionary actions against those banks which have hit certain ‘trigger points’ on three parameters, viz. crar, net npas and roa. the two trigger points for npas are 10 per cent and 15 per cent beyond which the concerned bank has to implement measures such as a special drive to reduce npas, review its loan and credit-risk management policies, not enter new lines of business etc. with regard to the second measure mentioned above, cibil is a depository of information containing credit history of commercial and consumer borrowers that banks can use in evaluating their risks and taking their credit decisions. with regard to the last measure mentioned, rbi has granted general permission to those banks to declare dividends (subject to a cap of 40 per cent on dividend payout ratio) for the accounting year ended 31 march, 2005 onwards, which comply with: (i) crar of at least 9 per cent for preceding two years and the accounting year for which it proposes to declare dividend; and (ii) net npa ratio of less than 7 per cent. in case any bank does not meet the above crar norm, but has crar of at least 9 per cent for the accounting year for which it proposes to declare dividend, it is allowed to declare dividend, provided its net npa ratio is less than 5 per cent. thus, banks have a variety of options and legislations to take recourse in order to resolve their bad loans problem. there are also supportive supervisory mechanisms available with the rbi and incentives provided to banks for reducing the level of npas. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 193 5.1 the debt recovery tribunal act (drtact) coincident with the first phase of banking sector reforms, one of the first legislations to address the problem of npas in india was the recovery of debts due to banks and financial institutions act, 1993, which came into force on 24th june, 1993. the act recommended setting up of drts for speedy adjudication and recovery of debts (where the claim is more than rs 10 lakh) due to banks and financial institutions (fis). the act also recommended setting up debt recovery appellate tribunals (drats) to entertain appeals against any order made by a drt. alongside this, the rbi actively promoted the compromise settlements or one time settlements (ots) to encourage out-of-court settlements of bad debts. lok adalats (or people’s courts), organized by drts, help banks to settle disputes involving small loans, but the ceiling has now been raised from rs 5 lakh to rs 20 lakh. as on 31 march, 2013, there were 29 drts and one drat in india. during 2013, 8,40,691 cases involving an amount of rs 6600 crs was filed in lokadalats, out of which an amount of rs 400 crs was recovered (rbi 2012-13). in addition to the actual recovery, drts are one of the main factors behind the defaulters coming forward for ots with the banks and fis. during 2013, 13,408 cases involving an amount of rs 31000 crs was filed in drts, out of which an amount of rs 4400 crs was, recovered (rbi 2012-13). 5.2. the corporate debt reconstruction scheme (cdr) on 23 august, 2001, the rbi issued guidelines to banks and financial institutions to implement cdr system. cdr is a voluntary and non-statutory arrangement between lenders and borrowers for timely and orderly restructuring of debts which are affected by certain internal and external factors. the corporate debt restructuring (cdr) cell has restructured 638 cases having aggregate debt of rs 446156 crs between august 2001 and september 2014 and 505 cases amounting rs 367607 crs were approved (cdr performance, 2014). 5.3. the sarfaesi act and arc the sarfaesi act was passed on 21st june, 2002 to enable banks and fis to attach the assets of defaulting borrowers without having to approach the courts for recovery. the act provides for the sale of financial assets by banks and financial institutions to securitization companies (scs) and arcs. scs and arcs are institutions that acquire npas from fis and bank with the objective of recovery thereby taking up their burden of npas. the first arc, asset reconstruction company (india) limited (arcil) was also set up under the act and commenced business on 29th august, 2003. this act was later amended through the enforcement of security interest and recovery of debts (amendment) act 2004, which was passed on 29th december, 2004. the new act made it mandatory for the borrowers who appeal to drat to deposit upfront 50 percent of the amount involved in the dispute. this is expected to restrict borrowers from delaying repayments under the cover of trivial cases. recoveries under the sarfaesi act, 2002 amounted to rs 18500 crore as at end-march 2013 (table 5) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 194 table 5. npas recovered by scheduled commercial banks through various channels source: report of trends and progress of banking in india by rbi (2010-2014) 6. determinants of problem loans 6.1 priority sector advances priority sector advances is a significant feature of indian banking industry since nationalization of banks in 1969 and proportion of priority sector loans in total loans (pradv) is included as a determinant in order to account for the argument that the priority sector loans are responsible for the most number of defaults (narasimham committee report 1998). while it is also argued that it is the non-priority sector that contributes to the biggest defaults in terms of size, controlling for this variable appears sufficient to take care of the nature of the sector to which most of the loans are given as a determinant of npas (chaudhury and sensarma, 2006, rajaraman, bhaumik and bhatia) h1: the banks’ proportion of priority sector advances in total advances is positively correlated with problem loans 6.2 size one of the most discussed features of the banks influencing problem loans is size of the bank. size (size) taken as logarithm of assets acts as a control for whether bigger banks are more vulnerable to the npa problem than smaller banks (chaudhury and sensarma 2006, salas and saurina 1999, espinoza and prasad 2010, hu et al 2004, ranjan and dhal (2003)) h2: the bank size is negatively correlated with problem loans 6.3 capital adequacy capital adequacy ratio (car) is the ratio between bank’s capital and risk weighted assets. it is considered to account for the importance of capitalization in causing npas. it is expected 2010 2011 2012 2013 channels of cases referred involved (rs. crores) recovered of cases referred involved (rs. crores) recovered of cases referred involved (rs. crores) recovered of cases referred involved (rs. crores) recovered lok adal ats 778833 7235 112 616018 5254 151 4,76,073 1700 200 8,40,691 6600 400 drt s 6019 9797 3133 12872 14092 3930 13,365 24100 4100 13,408 31000 4400 sar fae si act 78366 14249 4269 118642 30604 11561 1,40,991 35300 10100 1,90,537 68100 18500 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 195 that adequately capitalized banks would exhibit lower npas (lyoha and udegbunam 1999, rajaraman, bhaumik and bhatia 1999, chaudhury and sensarma 2006) h3: the bank‘s capital adequacy is negatively correlated with problem loans 6.4 profitability profitability of the banks can be captured using return on assets ratio which is the ratio between the net profit after tax and average assets. it is argued that profitable banks will have quality orientation towards credit management and less vulnerable to problem loans (narasimham committee report 1998). return on assets (roa) is considered with an expectation that the more profitable banks would have less npas (chaudhury and sensarma 2006). h4: bank’s profitability is negatively correlated with problem loans 6.5 cost inefficiency inefficient banks performing poor screening and monitoring of borrowers will tend to have inferior portfolio quality. kwan and eisenbis (1997) demonstrate that higher levels of bank inefficiency can lead to an increase in problem loans. to capture bank level inefficiency, operating cost ratio (ocr) which is the ratio between operating expenses and total assets is considered. it is included with an expectation that npas will increase with high operating costs or low cost efficiency (chaudhury and sensarma 2006, salas and saurina 1999, espinoza and prasad 2010). h5: bank’s inefficiency is positively correlated with problem loans 6.6 credit growth a rapid credit expansion is considered as one of the most important causes of problem loans (caprio et al , 1994). growth in advances (gradv) is included to understand the aggressiveness of a bank in its lending behaviour. more aggressive banks may push riskier loans and hence end up with more npas (clair 1992). on the other hand, banks which concentrate on more lending will develop expertise in effectively managing credit risk and hence exhibit lower npas. therefore, the role of lending aggressiveness in npas is ambiguous. gradv t-1 and gradv t-2 are considered to capture the lag effects of growth rates in advances on npas ( salas and saurina 1999, espinoza r and prasad a 2010, das a. & ghosh s 2007 ). h6: bank’s credit growth is correlated with problem loans 6.7 congenial macroeconomic environment the empirical evidence tends to suggest that banks problem loans are closely related to economic activity (salas and saurina 1999, fernandez de lis et al 2000, chaudhury and sensarma 2006, das a. & ghosh s 2007). when growth slows or even turns negative, firms and households reduce their cash inflows and makes it difficult for them to repay the loans. banks anticipate that if a recession occurs, firms and households will encounter asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 196 liquidity shortages, which would raise the likelihood of delays in the fulfillment of their financial obligations (jimenez and saurina, 2006). growth in gross national product at constant prices (ggnp) is included with an assumption that when the macro-economic conditions are sound and gnp growth is higher, the level of npas would be lower. h7: growth in gross national product is negatively correlated with problem loans 7. data and econometric methodology to assess the impact and to identify the determinants of npas in indian banking we need to estimate a relationship of the following form using bank level data and macroeconomic across several years. npait = α+ βxit + εit (1) here, x represents factors, which are supposed to determine npas, i and t represents bank and year respectively and ε unexplained residual. the financial data of banks are taken from “statistical tables relating to banks” (2001-2012) published by rbi and data on macro-economic variables have been obtained from rbi website. our data set consists of 41 public and domestic private sector banks and period of study is from 2001-2012. this kind of dataset allows us to look at, a certain number of units over time, mainly through fixed or random effects models and dynamic econometric models. specifically, according to relevant econometric literature (e.g.. hsiao, 1985; hsiao, 2014; ozkan, 2001; gaud et al., 2005; wooldridge, 2006; colin and trivedi, 2005; baltagi, 1995, stavros et al 2011) in order to achieve sufficient estimates within this short run sample period (2001-2012), it is necessary to use panel dataset. foreign banks are not included in the present study as level of npas was never a problem in the case of foreign banks (table 3), proportion of assets in indian banking industry is only 7 % (table 2) and foreign banks adopt the strategy of ‘intensive banking ‘ as against the strategy of ‘extensive banking’ by public sector banks. the analysis consists of estimating different versions of the npa equation using fixed effects and random effects panel regression using stata 12. the pooled ols estimation of equation (1) may yield unsatisfactory results due to the nature of data being panel data, time series and cross sectional. therefore, fixed effects and random effects regression models were deployed. to select an appropriate model between random and fixed, the character of the individual effects is tested through hausman’s test. to find out whether the global financial crisis had any ameliorating effect on npas, a dummy variable (gfcdum) is introduced, which takes the value one from the year 2008 and zero for other years. to assess the impact of ownership on npas ownership dummies (opbdum for old private banks and npbdum for new private banks) are included in the npa equation. we begin the discussion of our analysis with the estimation results of the following versions of equations 1. nnpa = f (priadv, roa, car, gradv, size, ocr, ggnp, gfcdum, opbdum, npbdum). it is used to assess the impact of ownership along with bank specific and macroeconomic variables on npas of the banks using fixed effects panel regression model asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 197 2. nnpa = f (priadv, roa, car, gradv, size, ocr, ggnp, gfcdum, opbdum, npbdum). it is used to assess the impact of ownership along with bank specific and macroeconomic variables on npas of the banks using random effects panel regression model 8. results and discussion 8.1 descriptive statistics and correlation summary statistics for the set of variables in this study is presented in the following table table 6. summary statistics of explanatory variables variable observations mean std. dev. min max nnpa 492 2.607 2.897 0 18.37 pradv 492 34.199 6.937 4.22 56.69 roa 492 0.969 0.527 -3.38 2.43 car 492 13.203 3.91 0 56.41 gradv 451 25.708 32.737 -80.94 568.92 size (ln assets) 492 14.978 1.449 10.97 18.71 ocr 492 1.977 0.563 0.6 4.07 ggnp 492 7.24 1.883 3.99 9.75 source: author computations the volatility of variables lies within the expected range except for the variable of growth in advances (gradv) which seems to be dominated by outliers. furthermore, we note that average npa ratio of 2.6% is on higher side when compared with global standards (table 4). mean profitability of 0.97% with volatility.52 % is moderately good and capital adequacy of 13.2 % is higher than the stipulated ratio of 9% (rbi 2004). the following table indicates the matrix of correlation coefficients between npa ratio and independent variables. it is evident that there is no problem of multi-collinearity (mean vif = 1.25) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 198 table 7. correlation matrix of explanatory variables variables nnpa pradv roa car gradv size ocr ggnp nnpa 1 pradv -0.0913* 1 0.043 roa -0.3626* 0.082 1 0 0.0693 car -0.2666* 0.0423 0.2906 1 0 0.3495 0 gradv -0.1216* -0.2158 0.0715 0.0264 1 0.0097 0 0.1294 0.5767 size -0.3409* -0.2797 0.0788 -0.1426 0.1015 1 0 0 0.0806 0.0015 0.0311 ocr 0.4843* 0.203 -0.3829 -0.0895 -0.1779 -0.3973 1 0 0 0 0.0473 0.0001 0 ggnp -0.5967* 0.2037 0.0706 0.0876 0.032 0.1908 -0.2726 1 0 0 0.1176 0.0521 0.4978 0 0 note: * significant at 1%, ** significant at 5% source: author computations observing the summary results of model 1 (table 8), it is found that the coefficients of the variables considered have mixed results. pradv is negatively significantly associated with npas. this result is against the popular belief that incidence of npas is significantly due to directed lending captured by proportion of priority sector advances to total advances. due to rationalization of sub components in directed lending and deregulation of interest rates, priority sector advances are disbursed on market principles and resulting in lower npas than expected. roa is found to be negatively associated with npas indicating that highly profitable banks exhibit efficient credit management system and thus lowers npas. car is significantly negatively related to npas indicating that highly capitalized banks exhibit lower npas. growth in advances (gradv) is negatively associated with npas indicating that banks which concentrate on more lending may have developed expertise in effectively managing credit risk and hence may exhibit lower npas. the coefficient of size turns out to be negative indicating that smaller banks are vulnerable to high proportion of npas which is evident from the burgeoning npas of smaller banks in recent years. ocr is found to be positively associated with npas. in other words, inefficient banks have higher incidence of npas. coming to macroeconomic conditions, it is found that gnp growth is significantly negatively associated with npas, which would signify that the bad loans problem is less when the economy at large is doing well and the macro-economic environment is conducive for business growth. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 199 8.2. impact of ownership to estimate the impact of ownership of banks on npas, ownership dummies (opbdum for old private banks and npbdum for new private banks) are included in model 1 and 2. the results indicate that new private banks and old private banks are different from public sector banks in management of npas. management of npas is better with new private banks than old private banks. 8.3. impact of the global financial crisis to understand the impact of global financial crisis a dummy variable (gfcdum) is introduced in model 1 and 2. the global financial crisis has indeed hampered the credit activity in indian banking sector as corporates cut down their expansion plans due to recessionary conditions. it was expected that incidence of npas would have increased after global financial crisis. surprisingly, gfcdum is significantly negatively related to npas in random effects model and negatively related in fixed effects model. the cautious credit policy of the banks and meticulous supervision of rbi to cut down the high levels of npas during global financial crisis could be the reasons for the significant decline in npas after 2008. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 200 table 8. empirical results of impact of macro economic and banking variables (2001-2012) variables model 1 (fe) model 2(re) b t.s b t.s (constant) 30.29569 8.39 17.72678 7.67 priadv -.0296805 -1.49 -.0492046 -2.97* roa -.7456199 -4.01* -.7529061 -4.25* car -.0805 -3.10* -.0807964 -3.40* gradv -.0033494 -1.39 -.0053859 -2.28* size -1.449958 -5.95* -.5274061 -3.91* ocr .4623289 1.83** .5871993 2.63* ggnp -.544519 -11.19* -.5714354 -11.97* gfcdum -.2657603 -0.94 -1.136536 -5.53* opbdum 0 (omitted) -.5565324 -1.35 npbdum 0 (omitted) -.7113089 -1.51 r2 0.3544 0.5486 between = 0.1546 0.3627 within= 0.6055 0.5905 n 451 451 f(10,400) 77.11* prob > f 0.0000 number of groups 41 41 wald chi2(10) 596.70* prob > chi2 0.0000 @ hausman test chi2(8) = 28.42* prob>chi2 = 0.0004 mean vif 1.25^ note: * significant at 1%, ** significant at 10% ^ vif less than 10 indicates that there is no multi collinearity problem among explanatory variables # f-test is statistically significant, which means that the fe model is statistically significant $ wald test is statistically significant, which means that the re model is statistically significant @ hausman test is statistically significant and rejects the null hypothesis of “ho: difference in coefficients not systematic” source: authors asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 201 table 8a. expected and observed signs of independent variables with dependent variable variables nnpa statistically significant estimated signs fixed effects random effects priadv + roa car gradv size ocr + + + ggnp gfcdum + opbdum npbdum source: authors 9. conclusion and policy implications this paper reviews the problem of npas in indian banking. the magnitude of the problem, the associated prudential norms, and different policy responses undertaken to address it were discussed. an empirical analysis was undertaken to identify the determinants of npas in indian banking. finally, the impact of ownership and global financial crisis on npas were investigated. for the purpose of the empirical analysis panel data of 41 indian banks (which covers 88% of indian banking assets) for twelve years from 2001 to 2012 was considered. first, the impact of priority sector lending on npa levels is negative and significant, indicating that npa problem in india is more due to lending to non priority sectors and sensitive sectors such as personal loans and real estate loans. second, larger banks exhibit better credit risk management demonstrated by lower npas as evident from the coefficient of size (total assets) being negative and significant. third, adequately capitalized bank also appear to have lower npas as evident from the coefficient of car being negative and significant. fourth, the impact of growth in gross national product (grgnp) on npa levels is negative and significant indicating that favorable macroeconomic conditions help to lower npa levels. fifth, nature of ownership has a significant impact on npa levels. specifically, new private banks have the lowest npa levels, followed by old private banks, and public sector banks in this order. finally, policy measures initiated to tackle global financial crisis have been largely successful in achieving their objective of curtailing high npa levels. to tackle the problem of npas in indian banking system the rbi should focus on smaller banks and less profitable banks that seem to exhibit higher npas. adequate attention should also be paid to banks with low operating efficiency and low capitalization as also to macroeconomic cycles that appear to be important in determining npa levels. finally, after accounting for all the above explanations for npas, it appears that the public sector, and to some extent the old private sector, accounts for the bulk of the npa problem. thus, while the policies that have been implemented to address the npa problem may have been largely asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 202 successful, there are further steps that can be taken by the rbi as well as by the banks themselves to tackle the problem of npas. these relate to smaller banks, unprofitable banks, inefficient banks, especially during adverse macroeconomic conditions, and more so for the public and old private sector banks. these findings are of crucial importance to banks in order to improve their credit risk management and for the regulatory-supervisory authority in devising its policies, especially in view of the importance that is now being attached to the concept of risk-based supervision in order to prioritize the allocation of resources. references baltagi b.h. 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(2011). dynamic approach of capital structure of european shipping companies. international journal of economic sciences and applied research, 5(3), 33-63 thiagarajan, somanadevi, ayyappan, s., & ramachandran, a. (2011). credit risk determinants of public and private sector banks in india, european journal of economics, finance & administrative sciences, 34, 147 wooldridge, j.m. (2006). introduction to econometrics, β, athens: edition papazisi world bank group (ed.). (2014). world development indicators 2014. world bank publications. available at:http://data.worldbank.org/indicator/fb.ast.nper.zs?order=wbapi_data_value_2013%20 wbapi_data_value%20wbapi_data_value-last&sort=asc appendix 1 concept of non performing assets the concept of npas dates back to the banking sector reforms. the term nonperforming asset was coined by the narasimham committee i in 1991. it classified npas into three categories viz. a. substandard assets. b. doubtful assets and c. loss assets, based on the time period of default. in 1995, according to rbi, if the interest / installment of the principal has remained ‘past due’ for a specific period of time, it is called a npa. nonperforming asset is one where interest or repayment of installment has not been made within sevenying default has been revised from time to time, in order to align the indian accounting standards to the international standards. the changes in the time period for recognizing npas have been shown in the table 1. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 205 table 1. changing past due period for determining npas year specific period 1994 3 quarters i.e. 270 days (past due) 1995 2 quarters i.e. 180 days (past due) 2000 1 quarters i.e. 90 days (past due) 2004 1 quarters i.e. 90 days (without past due) source: compilation by authors thus, from the norm of classifying only those assets as non performing which are four quarters past due and which was applicable until 1993, rbi moved to the norm of three quarters past due in 1994 and then to two quarters (180 days) past due in 1995. in 2001, rbi reduced this further by removing the past due concept. the 90 days norm comes into force with effect from march 31, 2004. according to securtisation and reconstruction of financial assets and enforcement of security interest ordinance, 2002, non performing asset means “an asset or account of a borrower which has been classified by a bank or financial institution as substandard, doubtful or loss asset”. thus, the definition of npas was clearly spelt out in 1993. but the time period has been gradually revised from time to time, starting from 360 days default to 90 days deadline by the year 2004. assets that generate income for the bank, that is, non npas, are known as standard assets. once an asset becomes an npa, banks have to make provision for the uncollected income from these assets. the provisioning is made on the basis of the classification of assets i.e. sub-standard, doubtful, and loss assets. provisioning norms 1) loss assets should be either written off or 100 per cent of the outstanding should be provided for. 2) in case of doubtful assets, provisioning requirement is 100 per cent of the ‘unsecured portion’ and for the ‘secured portion’ the requirement ranges from 20 per cent to 100 per cent depending on the age of the npa. 3) in the case of sub-standard assets, provision of 15 per cent on total out-standing is to be made. sub-standard assets which are also ‘unsecured exposures’ require additional provisioning of 10 per cent, that is, a total of 25 per cent on the outstanding balance. in the case of standard assets, banks are required to make a general provision of a minimum of 0.4 per cent. 1 the hausman specification test compares the fixed versus random effects under the null hypothesis that the individual effects are uncorrelated with the other regressors in the model (hausman 1978). if correlated (h0 is rejected), a random effect model produces biased estimators, violating one of the gauss-markov assumptions; asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 206 so a fixed effect model is preferred. hausman's essential result is that the covariance of an efficient estimator with its difference from an inefficient estimator is zero (greene 2003). microsoft word 5884-21149-1-sm _1_-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 216 the compliance of methods of implementation of ifrs: study of the impact on the relevance of accounting information mohamed rachid ouezzani departement of management, national school of trade and management of tangier,morocco youssef alami departement of management national school of trade and management of tangier, morocco received: june 28, 2014 accepted: oct. 4, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5884 url: http://dx.doi.org/10.5296/ajfa.v6i2.5884 abstract during the last two decades, many countries have chosen to implement the ifrs for at least one category of firms. according to zeef and nobes (2010), the implementation of ifrs can be classified into four methods. thus, countries as israel and south africa have adopted the method “implementation process”, others as canada, australia and the european union have opted for the method called “standard by standard” while that switzerland applies the “optional” method; china has chosen the “not fully converged” method. the analysis of these methods of implementation of ifrs demonstrates that these latter differ in terms of degree of compliance with the ifrs as issued by the iasb. this difference of compliance with the ifrs led us to wonder if it affects the quality of accounting information through its qualitative characteristic the “relevance”. to answer this question, we use an empirical model that we apply to a sample of listed companies from six countries opting for different methods of implementation of ifrs. the significant results found demonstrates that the compliance of methods of implementation of ifrs influences positively the relevance of accounting information and that this relevance is better for the listed companies of countries which have chosen a compliant method of implementation with the ifrs as issued by the iasb. these results complement the previous studies on the relevance of accounting information following the transition to ifrs and give asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 217 new significant proves on the impact of ifrs on the relevance of accounting information. keywords: ifrs, implementation, method, compliance, impact asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 218 1. introduction the number of countries that have adopted for the ifrs is important. according to the survey of the ifrs foundation, over 115 countries require or permit the application of ifrs for at least one category of firms. the number of these countries increases every year. the european union has been a pioneer in this domain with its adoption of the regulation 1606/2002 making mandatory the application of ifrs as adopted by the union for the publication of consolidated financial statements of listed companies. the adoption of this regulation by the european union was a solution to several problems of harmonization. indeed, this union of countries includes constantly new countries adopting divergent national accounting standards. although several regulations have been adopted by the european union in the past, the accounting harmonization between the countries constituting this union remained inefficient. the implementation of ifrs by the european union was an ideal solution for this problem of accounting harmonization. following this decision of the european union, several other countries have chosen to implement the ifrs. some of these countries have started the process of implementation early while others are until now in the phase of study of project of implementation of ifrs. in fact, the introduction of ifrs requires a certain preparation and the establishment of a strategy of implementation. thus, after the studies established by the countries wishing to implement the ifrs, these latter have opted for the suitable methods of implementation. several factors may explain the choice of the method of implementation of ifrs by a country. in fact the countries that entirely trust the international standard setter have opted for an advanced method of implementation named by zeef and nobes “due process” or have chosen the sub-method “ifrs as issued by the iasb”; others countries wishing to keep some control over standards applied by their companies have opted for the sub-method “fully convergence with ifrs” or the sub-method “ifrs with deletions”; countries wishing to give their firms the choice between two or more repositories have opted for the “optional” implementation; those wanting to conserve certain accounting standards have opted for the method “not fully converged”. according to their compliance with the ifrs as issued by the iasb, these methods have been classified by zeef and nobes (2010) into 3 categories: the first category includes the methods that are “compliant”, the second contains those “possibly compliant” and the last one the methods “unlikely compliant”. this classification has prompted us to ask the following question: is that the compliance of methods of implementation of ifrs with the ifrs issued by the iasb influences the relevance of accounting information? to answer this question, we have examined the various methods of implementation of ifrs enunciated by zeef and nobes (2008, 2010) that we introduce in the first section accompanied by a review of literature of studies on the relevance of accounting information. through this literature review, we have examined the different models used by the previous studies and have chosen the model that provides the best results in terms of significance. thus, we have opted for the model of ohlson (1995). next, we have formulated the research asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 219 hypotheses that we explain in the third section. in the fourth section we present the methodology as well as the sample selected. this later is constituted by companies listed on the stock market of six countries that have chosen different methods of implementation of ifrs. the significant results found that we report in the last section shows that the compliance of methods of implementation of ifrs influencesthe relevance of accounting information. also, they demonstrate that the relevance of accounting information is better in countries opting for compliant methods of implementation of ifrs with the ifrs issued by the iasb. 2. literature review 2.1. methods of implementation of ifrs the objective of the iasb is to make of ifrs an international accounting and financial standards. this is practically realized as enunciated by gelard gilbert. indeed, this former member of the iasb made this statement on the basis of results of a study published by the ifrs foundation. based on the declarations of accounting standards authorities of 122 countries, this study has been established under the direction of pacter (2014). it shows that the ifrs are today 'mandatory or widely used in more than 115 countries around the world. according to the results found, from 122 countries, 101 require the use of ifrs for all or almost all domestic public interest entities (listed companies and financial institutions). some countries, such as australia, new zealand and hong kong have adopted the ifrs as national standards. two additional countries, indonesia and thailand, are in the process of adoption of ifrs. in addition to 101 countries, 10 countries including india, japan, switzerland and singapore allow but not require the use of ifrs. saudi arabia and uzbekistan require the ifrs only for the financial institutions. in terms of number of companies adopting the ifrs, it is very difficult to get statistics. in addition to the 8,000 listed companies of europe and the many foreign companies listed on the u.s. market that use the ifrs, the other entities which are unlisted and who have also adopted the ifrs make this operation difficult to establish. in fact, it requires making a detailed analysis by country. in terms of companies concerned by the implementation of ifrs, most of countries that have required the ifrs, have made this requirement for the listed companies (excluding some financial institutions). also, over 90% of the 101 countries that require the ifrs for listed companies require or permit these standards for most unlisted companies. concerning the ifrs for smes, the analysis of the report published by the ifrs foundation reveals that 57 out of the 122 countries require or permit the norm ifrs for smes and 16 other countries are currently considering this option. also, the content analysis of report of the ifrs foundation shows that a large part of countries that have adopted the ifrs, have made very few changes to the text produced by the iasb. these changes are often considered temporary, as is the case in europe concerning the ias 39 underlined by the former member of the iasb gilbert gelard. in addition, the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 220 report of the ifrs foundation stipulates that some countries or regions have differed the dates of application of certain standards, in particular the recent ifrs 10, ifrs 11 and the ifrs 12. in terms of methods of implementation of ifrs, zeef and nobes (2010) have established a classification of these methods for listed companies and have retained four methods of implementation. thus, according to these authors the implementation of ifrs conducted in south africa and israel is an implementation “due process”. it is the most advanced level of implementation and the most fairly close to ifrs issued by the iasb. by this method, the standards published by the process are automatically adopted by the country and applied by the firms concerned. the second method of implementation of ifrs is called “standard by standard”. this latter is divided into 3 sub-methods: the first one is called “ifrs as issued by the iasb”. it is considered as conform to ifrs issued by the iasb and consists in the adoption of ifrs published by the international normalizer after an automatic passage through the regulation. the only example given by the authors is the canada. the second sub-method is called “fully converged with ifrs”. it is adopted in australia, new zealand and honk kong and consists on making a complete convergence of national standards with ifrs. the third sub -method called “as issued by the iasb with deletions” consists on the application of standards adopted locally. it is considered by zeef and nobes as possibly conform to ifrs issued by the iasb. the third method of implementation of ifrs is adopted in switzerland and named “optional” method. it aims to provide to the companies of the country the option to adopt ifrs or to choose another accounting referential. as for the sub-method “ifrs as issued by the iasb with deletions”, this method is considered as possibly compliant with the ifrs issued by the iasb. the fourth method of implementation of ifrs is called “not fully converged”. it is considered as unlikely with the ifrs issued by the iasb. indeed, trough this method, the normalizer leaves intact some standards. china is an example of countries adopting this method. in terms of dates of implementation of ifrs, this later differs. for countries as south africa, israel and the e.u., the ifrs must be applied by the concerned companies the 1st january 2005 while that in canada the retained date is the 1st january 2011. however, for these countries, the entities were obliged to collect data according to ifrs since the opening exercise of the last year of implementation of ifrs. in china which has opted for an incomplete convergence, the date of application of the new chinese accounting standards is the 1st january 2007 with no requirement to collect data according to the new converged accounting standards since the opening exercise of the last year of the implementation. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 221 figure 1. methods of implementation of ifrs for listed companies established by zeef and nobes the figure 1 illustrates the classification established by zeff and nobes (2010) of methods of implementation of ifrs. it shows the four methods of implementation of ifrs for listed companies: “due process”, “standard by standard” with its 3 sub-methods, “optional” and the “not fully converged” implementation. it demonstrates the compliance of these methods and sub-methods of implementation with the ifrs issued by the iasb and gives some examples of adopters’ countries. 2.2. the relevance of accounting information the study of the relevance of accounting information for the determination of the continuous informational value (called utility of accounting approach) has retained the attention of several researchers in accounting since the work of fischer (1911). generally two approaches were chosen by the researchers for the treatment of this subject: the utilitarian approach and the economic approach. 2.2.1. the utilitarian approach of measure of the value the utilitarian approach considers accounting as a principal provider of financial information. this approach has been criticized for its inability to predict the economic and the financial difficulties of firms. researches that have used this approach can be classified into two categories: those measuring the results and those searching to aggregate the measure of the financial value. for the researchers using the results for the determination of the value of the company, these latter consider the accounting profits as a “proxy” of the financial value of the company. the supporters of this approach argue the idea that the accounting profit is the only relevant determinant of the value of a firm. the empirical studies analyzing the relevance of accounting information trough this approach have been significantly influenced by the studies of fisher (1911), lindhall (1933) and hicks (1946). these researches aim to determine the capacity of the accounting information to help the investors to make decisions as specified by easton et al. (1992). thus, they have evaluated the informational content of the accounting asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 222 information by the study of the reaction of financial market after the announcement of accounting income. the majority of these empirical studies have adopted the methodologies of “reaction studies” or “event studies”. other researchers have used the results for the determination of the value of the company. these latter have used another approach called the approach measuring the “true value”. this approach is centered on the methodology of “association studies”. the object of this methodology highlighted by beaver and al (1980, 1989) and collins and kothari (1989) is to reduce the margin of error of models analyzing the relationship between the accounting information and the market value. these studies dissect the value of the company into three components: the “true value” which is the perfect measurement, the “systematic error” that measures the factors that are not identified by the explanatory variables and the “random error” that represent the hazard that distorts the measure of the value. the second category of researches using the utilitarian approach to measure the global financial value has exploited the complementarity between the various determinants of the value. this approach is called “abnormal profit”. thanks to works of ohlson (1995) and feltham and ohlson (1995) this approach initiated by preinreich (1938) has been revived. the researches using this approach can be split in two typologies: the first one is called “imperfect measurement approach of the value” and the second one is named “evaluation by the abnormal earnings approach”. the objective of the approach of the imperfect measurement is to remedy to weaknesses of the informational content of accounting earnings in various contexts. it has led the accounting researchers to identify other determinants of accounting value (dumontier and raffournier, 2002). in fact, the empirical studies using this approach as highlighted by walker (1997) reject the idea of measure of the value only by the results and consider the result as a measure among others. two orientations are identified: the first one is focused on seeking the alternatives determinants of profit and is based on "comparative studies associations”. it consists in the comparison of various determinants of the accounting information with the result and the informational content of these determinants with the quality of the representation of the regression. the second orientation considers that the profit is not the only variable to explain the stock market value, but there are other determinants that allow accountants to further clarify the information content of the value. the approach of evaluation of a firm by the abnormal earnings expresses the value of a company by the amount of capital invested and the future wealth created by the entity. reflected in accounting terms, the model becomes equal to the sum of the book value of equity and the actualized abnormal earnings. the first work considering this approach is ohlson (1995) and feltham and ohlson (1995). these authors start from a logic based on the distribution of wealth to guide their analysis to the measure of the wealth created by the use of the model of abnormal earnings. bernard (1995) explains that the evaluation by the abnormal earnings approach is considered as a "mixed" approach because it includes several information from the balance sheet and the income statement. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 223 2.2.2. the economic approach of measure of the value the economic approach of the measure of the value of a firm implies that the accounting information is an economic good that is traded on a market. it supposes therefore an economic rationality. the supply and the demand of information by an economic agent are used to enable a rational choice between several possibilities. in this sense the economic agent will opt for the possibility that maximize its usefulness. at this stage of analysis, the information is fed into decision models. thus, the information is relevant if its measure of the expected utility is uppermost (salanie, 1994). if we transpose the economic logic to accountancy, the supply and the demand of accounting information are dependent on various heterogeneous behaviors of producers and users of accounting information. walker (1988) considers that the economic approach of measure of the value provides a "scientific" vision of the accounting information because it helps to solve the problems raised mainly by the followers of the positive accounting theory (jensen 1976, p 11). in terms of period and purpose, this approach can be divided into three phases: a first phase that has marked the accounting researches of the 70s and the 80s wishing to establish a theoretical basis of the value. next, a second phase has begun in the late of the 80s. its objective is to examine the influence of the alternatives on the choice of policies of evaluation of the company by borrowing the economic concepts of information. a third phase has focused on the study of the asymmetry of the information between managers / investors and investors / investors (walker 1988). 2.2.3. comparison between the approaches and choice of the appropriate model the economic approach of measure of the accounting information aims to implement a new accounting research methodology for the evaluation of a company. in the assumption of an efficiency of information and a rationality of economic agents, the economic approach offers a "theoretical basis" model for the measure of the value of a firm. indeed, this approach wants to remedy to weaknesses of the utilitarian approach. the reflections of feltham (1968) and butterworth (1972) on a possible merger between the economic approach of accounting information and the utilitarian approach via the reconciliation between the economic measure and the accounting value of the company has retained the interest of several searchers. in terms of number and importance of results, the utilitarian approach of measure of the accounting information remains the dominant approach in terms of number and results of research. in comparison with the economic approach, the empirical studies of the utilitarian approach have succeed to explain the information content of the stock prices in a fairly meaningful way. some models reached a maximum of 90% as illustrated by the table 1 below. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 224 table 1. results of some important previous studies on the relevance of accounting information author study period country sample results model used bernard (1995) 1978-1993 united states between 670 et 712 firm/year. 29%<r²<68% dividend discount model and residual income model frankel & lee (1996) 1987 – 1994 20 countries 24909 observations 70%<r²<90% residual income model gragham & king (1998) 1987 1996 6 asiatic countries 3655 observations 16%<r²<90 % residual income model dechow & al. (1999) 1976 – 1995 united states 50133 observations 8%<r²<40% residual income model abukari & mcconomy (2000) 1992 – 1996 canada 2 090 observations 53%<r²<68% dividend discount model francis & al. (2000) 1989 – 1993 united states 2 907 observations 74%<r²<90% residual income model shores & bowen (2002) 1976 – 1997 united states 222 observations 52%< r² <76 % economic determinants the table 1 below provides a synthesis of results founded by some previous researches. it shows the importance in terms of number and results of searches using the utilitarian approach compared to the economic approach. based on the results of previous researches mentioned above, our choice in terms of approach is focused on the utilitarian approach. 3. hypotheses development several researches have studied the effects of the adoption of ifrs. an important part of these studies has concerned the countries of the european union. in terms of results, several of these researches have proved that the adoption of ifrs has a positive impact on the quality of accounting information and that these standards have changed positively the constitution of several accounting and financial indicators that investors use to make decisions. these positive results have differed between the countries. taking as base the work of zeef and nobes who have proposed a classification of methods of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 225 implementation of ifrs according to their compliance with the ifrs issued by the iasb. these authors have enunciated that the methods of implementation of ifrs chosen in countries such as south-africa, israel, canada and australia are compliant, those adopted by the european union and the switzerland are possibly compliant and the method chosen in china is unlikely compliant with the ifrs issued by the iasb. taking into account several results of previous studies showing the positive effect of the implementation of ifrs on the relevance of accounting information as illustrated by morais and curto (2009) who have noted through a sample of companies listed in 14 european countries that the relevance of the value of the financial statements of these countries has increased following their transition to ifrs, chalmers et al. (2008) have found that the ifrs communicate more additional information for the investors in relation with the goodwill that the australian standards and have shown (2011) that the benefits have become more relevant following the implementation of ifrs; these results demonstrate that the effect of ifrs on the relevance of accounting information is variable from a country to another; thus, these results leads to the first hypothesis: h1: the compliance of methods of implementation of ifrs with the ifrs issued by the iasb chosen influences the relevance of accounting information. the difference of results illustrated by several studies demonstrate a better relevance of accounting information established in ifrs compared to the local accounting standards of several countries as proved by the study of auer (1996) which have established that the information in ias were moderately higher in informational content than the swiss standards, the work of bartov, goldberg and kim (2005) showing the high significant superiority of ifrs compared to the german local repository, eccher and healy (2000) which have founded that the accounting information in ifrs was slightly more relevant than chinese standards; this prompts the second research hypothesis:: h2: the relevance of accounting information for the countries opting for a compliant method of implementation of ifrs has been more improved than that of countries that have opted for methods which are not compliant. 4. methodology in the present subsections, we present the data, the model used and explain how we compute our empirical measure of the relevance. 4.1. sample selection and statistics the sample that we have chosen consists of companies listed on the stock market of six different countries. each of these latter has opted for a different method of implementation of ifrs. thus, the firms in our sample are listed on the main segment of the following markets: israel, canada, hong kong, france, switzerland and china. for the stock market data and the accounting data, they are from the data base s&p capital iq. the observation period is 13 years from 2000 to 2012. however, we have initiated a number of adjustments and eliminations in order to ensure asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 226 representativeness of the sample and avoid bias that can affect the results of our research. thus, we have: eliminated companies whose observations are not complete: information on equity, earnings, stock prices and standards adopted; eliminated the extreme observations on equity, earnings, stock market value. table 2. sample of companies selected by country implementation method / sub-method adoption process standard by standard used for as issued by the iasb fully converged countries israel canada hong kong selected companies 88 399 191 model 2 initial observations 3674 16451 7842 observations retained 3432 15561 7449 implementation method standard by standard optional not fully converged as issued by the iasb but with deletions countries united kingdom switzerland china selected companies 200 53 651 initial observations 7954 2145 21623 observations retained 7800 2067 20625 total of selected companies 1582 total of initial observations 59689 model 1 total of observations retained 56935 source: the observations are from the database s&p capital iq the table 3 below provides descriptive statistics of the sample for the variables (market value at the end of period, earning per share and book value per share) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 227 table 3. descriptive statistics of the sample by country countries n. firms average st. deviation q1 q2 q3 min. max. bef aft bef aft bef aft bef aft bef aft bef aft bef aft bef aft israel p eps bvs 88 88 88 88 88 88 7.2 0.8 6.8 8.1 2.7 8.5 2,12 3,12 3,43 2.35 3.23 3.12 0.9 0.2 0 1.10 .3 0,1 2.4 3.1 4.1 2.1 2.8 3.8 6.1 4.3 6.8 5.6 4.9 6.4 0.01 0.03 0.04 0.06 0.08 0.02 1348 547 6513 1847 614 7784 canada p eps bvs 399 399 399 399 399 399 9,8 0.7 4.1 11 1.1 7.3 4,2 3.1 2,4 3.23 3.13 2.3 0.5 0.9 0.0 0.50 .9 0.0 5.2 1.6 3.6 4.2 1.9 3.7 5.2 6.9 3.8 9.3 7.6 4.1 0.06 0.09 0.08 0.04 0.06 0.01 5479 1032 8451 4384 1971 7541 hong kong p eps bvs 191 191 191 191 191 191 24 0.5 16 29 4.1 21 2,12 1.1 2.2 2,12 1.1 2.2 1.5 0.0 1.7 1.7 0.1 1.4 2.9 3.7 4.5 3.2 4.9 4.1. 3.7 4.6 7.2 3.2 4.9 8.7 0.07 0.06 0.02 0.06 0.03 0.01 8746 1245 9784 8674 1351 9478 u.k. p eps bvs 200 200 200 200 200 200 40 0.3 2 47 0.2 2.1 1.2 2.1 1.4 1.2 2.1 1.4 0.3 1 0.2 0.0 8 0.21 .4 0.1 3.3 1.8 2.0 2.1 1.6 2.3 6.3 6.2 5.9 5.1 6.6 7.5 0.02 0.01 0.01 0.01 0.04 0.02 9745 546 7548 9614 614 7798 switzerland p eps bvs 53 53 53 53 53 53 15 0.7 11 12 0.6 10 2.12 4.12 3.12 2.12 4.12 3.12 0.11 0.1 1 0.1 0.0 1,4 3.1 4.4 4.6 4.11 5.1 3.1 5.2 9.4 7.6 5.7 8.4 6.7 0.05 0.01 0.04 0.03 0.01 0.02 8451 951 8457 9475 784 7845 china p eps bvs 651 651 651 651 651 651 1.2 0.1 0.4 1.5 0.2 3.1 2.4 0.1 0.8 2.4 0.1 0.8 0.2 0.4 0.1 0.1 0.5 0.0 3.4 4.8 6.1 3.7 5.9 6.4 6.5 7.8 6.8 5.8 7.4 6.9 0.01 0.08 0.04 0.01 0.04 0.01 7458 647 8472 9645 754 9457 source: the observations are from the database s&p capital iq 4.2. empirical model the basic model that we use to measure the relevance of accounting information is the result of work of ohlson (1995) and feltham and ohlson (1995). this model represents a current of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 228 research of the evaluation of the value of a firm. using a conventional approach of evaluation, it establishes a link between the financial statements and the market value. the approach of feltham-ohlson using accounting information for the financial evaluation simplifies the perception of this link: from the accounting data we pass directly to the value of market without the detour through the forecast dividends. this model has increased the productivity and has simplified the theoretical approach of evaluation of a firm. this model highlights the importance of the accounting information that has been overlooked or undervalued by the financials for a long time. the ohlson model represents the price at the end of the period via the earnings per share and the equity per share: model (1): pit= b0 + b1 epsit + b2 bvsit + b3 compliancet + eit model (2): pit= b0 + b1 epsit + b2 bvsit + eit with: pit : the stock market value of the firm i at the end of year t (31/12/t); epsit : the ratio of earnings per share of firm i in year t; bvsit : the ratio of equity per share related to firm i in year t; compliancet : a dichotomous variable witch takes the value 0 in the case of no compliant of the method of implementation chosen by the country to ifrs issued by the iasb and the value 1 otherwise; eit : other informational pertinence of firm i in year t thus, we use the model 1 for the study of the effect of the compliance of the method of implementation of ifrs on the relevance of accounting information. the model 2 is used for the comparison of the relevance between the countries adopting different methods of implementation of ifrs. 5. results to study the relevance of accounting information we have used the coefficient of determination r2. this coefficient shows the percentage of values explained by the proposed model. we have obtained the following results presented by model. 5.1. a significant effect of the compliance of the method of implementation of ifrs on the relevance the objective of the model 1 is to see if the compliance of the method of implementation chosen by a country influences the relevance of the accounting information. the analysis period is three years. the choice of this period is limited by the date of implementation of ifrs in canada, the only one country having chosen the method of implementation called "ifrs as issued by the iasb". indeed, since 2011, the application of ifrs is mandatory for listed companies of canada with an obligation to prepare the accounting information in ifrs for the previous year. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 229 the results founded for the model 1 are quite significant with a coefficient of determination between 73% and 78% and a f. test between 602 and 624 for the years 2010, 2011 and 2012. these results reflect the good capacity of the model to explain the value of the stock market by accounting variables eps and bvs and the dummy variable compliance. in terms of variables, the results demonstrate that the three variables eps, bvs and compliance are significant at a level of 1% for the three years studied for the model1: 2010, 2011 and 2012. thus, the compliance of the method chosen by a country with the ifrs issued by the iasb influences the relevance of accounting information. also, the analysis of coefficient b3 of the variable compliance shows that the relationship of this variable with the dependent variable is positive. in terms of relevance of accounting information of all the countries of the sample having implemented the ifrs, the analysis of the coefficient of determination shows that the accounting information established in ifrs is relevant for the ensemble of the countries and explains the stock market value of listed companies. table 4. results of model 1 m(1): pit= b0 + b1 epsit + b2 bvsit + b3 compliancet + eit 2010 2011 2012 constant b0 -15,1450 -78,1140 -64,0090 t -2,5040 -3,9123 -3,8240 sign. 0,0140 0,0000 0,0000 eps b1 0,6340 0,4240 0,3140 t 7,4510 11,5350 6,5470 sign. 0,0000 0,0000 0,0000 bvs b2 0,7470 0,5450 0,6540 t 35,9670 34,0100 38,2740 sign. 0,0000 0,0000 0,0000 compliance b3 1,4870 2,0990 1,5780 t 4,6480 4,4570 4,9780 sign. 0,0000 0,0000 0,0000 r2 0,7841 0,7490 0,7304 f 624,12 602,14 621,94 durbin watson 1,41200 1,6412 1,7170 5.2. different degrees of improvement of the relevance following the implementation of ifrs the analysis of results of the regression of model 2 shows that the degree of variation following the transition to ifrs differs from a country to another. in fact, this variation is positive and very important for the countries as the united kingdom that has opted for the method of implementation “ifrs with deletion”, hong kong adopting a “full convergence” method and israel implementing the ifrs by the “due process method”. thus, in israel, honk kong, united kingdom and switzerland, the examination of results asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 230 shows that for the years following the transition to ifrs, the r2 was high which demonstrates a very good performance. this performance has been maintained at a high level after the application of ifrs with a coefficient r2 between 49% and 91%. in comparison between the period before and after the implementation of ifrs, the results demonstrate that the implementation of ifrs has improved the relevance of accounting information in israel, honk kong, united kingdom and switzerland. in canada, the results demonstrate that the relevance of accounting information has been maintained following the implementation of ifrs. in china which has adopted a “not fully converged method” for the implementation of ifrs, the results demonstrate a decrease in relevance following the transition to ifrs. table 5. comparison of the evolution of r2 of model 2 by country country method 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 israel d.p. 48%* 39%* 34%* 41%* 39%* 41%* 36%* 84%* 69%* 74%* 67%* 89%* 86%* canada i.i. 39%* 23%* 56%* 37%* 25%* 60%* 44%* 85%* 96%* 95%* 89%* 80%* 84%* hong kong f.c. 0,2% 0,1% 3% 1% 4% 1% 3% 9% 83%* 73%* 78%* 49%* 58%* united kingdom i.d. 0,2% 0,8% 0,3% 0,4% 1,7% 92%* 94%* 91%* 92%* 63%* 84%* 72%* 70%* switzerland o.a. 46%* 41%* 57%* 43%* 49%* 34%* 46%* 37%* 91%* 85%* 80%* 75%* 77%* china n.c. 88%* 96%* 98%* 95%* 96%* 94%* 88%* 53%* 91%* 83%* 82%* 73%* 76%* d.p.: due process; i.i.: as issued by the iasb; f.c.: fully converged; * sig. 1% i.d.: ifrs with deletions; o.a.: optional adoption; i.c.: not fully converged; ---after ifrs the table 5 above illustrates the variation of coefficient of determination r2 for the two periods before and after the transition to ifrs. it indicates an improvement of r2 following the transition to ifrs in israel, hong kong, united kingdom and switzerland. a contrary result is observed in china. in canada, the relevance of accounting information for the period after the implementation of ifrs has been maintained in a high level. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 231 figure 2. evolution of r2 for the period before and after the implementation of ifrs asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 232 table 6. model results in israel (due process method– compliant) c ou nt ry year constant eps bvs f sig. f r2 d. w. b0 t sig. b1 t sig. b2 t sig. is ra el 2000 -0,07 -0,03 0,9660 7,24 10,12 0,0000 1,47 1,32 0,1960 194,21 0,0000 48% 1,24 2001 -0,51 -0,64 0,3260 14,13 14,15 0,0000 1,27 3,21 0,0020 145,24 0,0000 39% 1,83 2002 -0,23 -0,84 0,2720 5,31 5,45 0,0000 1,84 3,97 0,0010 138,30 0,0000 34% 1,74 2003 -2,56 -2,53 0,0630 14,22 6,08 0,0000 1,27 3,14 0,0050 148,27 0,0000 41% 1,84 2004 -0,09 -0,05 0,9400 -2,01 -3,54 0,0029 2,05 4,84 0,0000 145,87 0,0000 39% 1,86 2005 -1,34 -0,61 0,3830 -2,77 -1,10 0,1612 3,21 4,77 0,0000 38,36 0,0000 41% 1,24 2006 -2,13 -2,56 0,0320 4,42 2,00 0,0009 1,47 3,95 0,0010 140,12 0,0000 36% 1,43 2007 6,74 2,23 0,0290 6,06 2,86 0,0000 2,09 4,84 0,0000 1324,9 0,0000 84% 2,47 2008 0,52 1,41 0,1940 2,25 2,83 0,0056 1,74 5,36 0,0000 412,42 0,0000 69% 2,31 2009 3,14 1,12 0,0620 7,41 1,24 0,2789 3,88 7,98 0,0000 854,12 0,0000 74% 1,97 2010 3,74 2,41 0,0950 1,64 0,54 0,5421 2,14 6,45 0,0000 309,08 0,0000 67% 1,64 2011 2,41 1,12 0,0410 1,54 1,21 0,1347 1,24 6,48 0,0000 1621,9 0,0000 89% 2,07 2012 0,27 0,21 0,3410 1,23 0,59 0,5140 2,24 10,43 0,0000 1420,0 0,0000 86% 2,01 µ before 39,71% µ after 78,16% table 7. model results in canada (as issued by the iasb method– compliant) c ou nt ry year constant eps bvs f sig. f r2 d. w. b0 t sig. b1 t sig. b2 t sig. c an ad a 2000 3,68 3,47 0,0001 -8,24 -5,78 0,0000 1,34 17,24 0,0000 145,21 0,0000 39% 2,00 2001 4,51 5,21 0,0000 1,04 0,94 0,2450 0,34 4,89 0,0000 74,21 0,0000 23% 2,01 2002 2,50 6,04 0,0000 -2,96 -4,44 0,0000 0,97 18,79 0,0000 303,72 0,0000 56% 1,98 2003 3,95 3,43 0,0001 -7,96 -5,01 0,0000 1,78 14,18 0,0000 136,37 0,0000 37% 2,00 2004 6,05 6,28 0,0000 1,01 0,95 0,3410 0,27 4,57 0,0000 76,80 0,0000 25% 2,02 2005 4,80 5,89 0,0000 -1,77 -2,77 0,0060 1,30 13,07 0,0000 347,82 0,0000 60% 2,02 2006 5,23 4,64 0,0000 -1,95 -1,39 0,1640 1,30 5,73 0,0000 184,63 0,0000 44% 2,01 2007 4,90 11,76 0,0000 2,50 9,22 0,0000 0,57 18,94 0,0000 1326,80 0,0000 85% 1,87 2008 0,97 6,02 0,0000 1,46 21,96 0,0000 0,74 77,48 0,0000 5399,75 0,0000 96% 2,11 2009 2,29 10,50 0,0000 3,40 21,48 0,0000 0,68 67,83 0,0000 4275,89 0,0000 95% 1,67 2010 4,12 10,42 0,0000 0,51 1,30 0,0910 0,80 28,58 0,0000 1828,41 0,0000 89% 1,64 2011 3,15 6,66 0,0000 1,60 5,57 0,0000 0,69 41,01 0,0000 936,97 0,0000 80% 1,74 2012 5,12 12,51 0,0000 0,64 1,41 0,2145 0,97 30,54 0,0000 1478,21 0,0000 84% 1,75 µ before 80,25%* µ after 84,33% * the average before the ifrs implementation is based on the r2 of years 2006, 2007, 2008 and 2009 since the information available for the country in ifrs relates 3 years. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 233 table 8. model results in hong kong (full convergence method– compliant) c ou nt ry year constant eps bvs f sig. f r2 d. w. b0 t sig. b1 t sig. b2 t sig. h on g k on g 2000 -1,21 -0,04 0,9660 6,12 0,94 0,9560 1,64 3,45 0,0000 0,37 0,9620 0,20% 2,12 2001 -1,32 -0,94 0,3560 12,21 0,84 0,9700 2,45 2,94 0,0000 0,44 0,9951 0,10% 1,97 2002 -1,21 -0,73 0,4720 5,65 0,97 0,9701 2,89 1,95 0,000 9,41 0,3520 3% 1,84 2003 -1,64 -2,04 0,0530 31,12 0,87 0,9641 2,46 3,12 0,0050 2,06 0,0645 1% 1,34 2004 -1,24 -0,06 0,9500 -5,12 0,06 0,9993 2,31 15,88 0,0000 12,87 0,9412 4% 1,86 2005 -1,32 -0,71 0,4830 -3,12 -1,38 0,1945 3,18 7,77 0,0000 2,36 0,0631 1% 1,54 2006 -4,24 -2,24 0,0350 4,12 -2,27 0,0341 1,79 3,95 0,0010 9,12 0,3412 3% 1,63 2007 -4,12 -2,28 0,0310 4,12 -2,28 0,0340 4,12 4,33 0,0000 24,90 0,1214 9% 1,48 2008 1,65 1,36 0,1930 6,51 2,87 0,0090 2,74 3,41 0,0000 548,01 0,0000 83% 2,21 2009 3,23 1,84 0,0780 3,21 2,76 0,0060 1,56 6,97 0,0000 406,12 0,0000 73% 2,01 2010 -2,52 1,64 0,1160 2,31 2,93 0,0009 1,75 5,15 0,0000 468,10 0,0000 78% 2,07 2011 3,24 2,12 0,0460 1,45 3,64 0,0000 2,13 10,27 0,0000 142,12 0,0000 49% 2,04 2012 3,45 0,88 0,3860 2,24 4,57 0,0000 1,41 10,39 0,0000 208,45 0,0000 58% 2,34 µ before 2,66% µ after 68,2% table 9. model results in united kingdom (ifrs with deletions method – compliant) c ou nt ry year constant eps bvs f sig. f r2 d. w. b0 t sig. b1 t sig. b2 t sig. u ni te d k in gd om 2000 3,68 0,47 0,9751 -8,24 -0,24 0,9541 1,34 0,24 0,9541 0,94 0,9610 0,20% 2,24 2001 4,51 0,21 0,9845 1,04 0,65 0,9314 0,34 0,89 0,9314 1,21 0,9101 0,80% 2,13 2002 2,50 1,04 0,9101 -2,96 -0,87 0,0000 0,97 0,79 0,9145 0,98 0,9420 0,30% 1,94 2003 3,95 0,43 0,9845 -7,96 -0,78 0,0000 1,78 0,18 0,9984 1,37 0,9254 0,40% 2,02 2004 6,05 0,28 0,9812 1,01 0,54 0,0000 0,27 0,57 0,9465 1,14 0,8650 1,70% 2,21 2005 4,21 5,84 0,0000 -1,77 -2,77 0,0060 1,30 56,07 0,0000 5447,82 0,0000 92% 2,11 2006 5,12 4,64 0,0000 -1,95 -1,39 0,1640 1,30 58,73 0,0000 5674,63 0,0000 94% 2,04 2007 4,12 11,76 0,0000 2,50 9,22 0,0000 0,57 64,94 0,0000 5126,80 0,0000 91% 1,94 2008 3,32 6,02 0,0000 1,46 21,96 0,0000 0,74 77,48 0,0000 5421,75 0,0000 92% 2,10 2009 2,65 10,50 0,0000 3,40 24,48 0,0000 0,68 24,83 0,0000 517,89 0,0000 63% 1,97 2010 4,87 10,42 0,0000 0,51 4,30 0,0000 0,80 46,58 0,0000 867,41 0,0000 84% 1,91 2011 3,42 6,66 0,0000 1,60 5,57 0,0000 0,69 32,01 0,0000 496,97 0,0000 72% 1,92 2012 5,35 12,51 0,0000 0,64 6,46 0,0000 0,97 29,54 0,0000 464,21 0,0000 70% 1,97 µ before 0,68% µ after 82,25% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 234 table 10. model results in switzerland (optional method – compliant)) c ou nt ry year constant eps bvs f sig. f r2 d. w. b0 t sig. b1 t sig. b2 t sig. sw itz er la nd 2000 -1,78 -0,64 0,4124 8,17 9,19 0,0000 0,43 1,32 0,1960 282,01 0,0000 46% 2,85 2001 -1,32 -0,41 0,5560 10,16 11,04 0,0000 1,05 3,42 0,0020 235,12 0,0000 41% 1,82 2002 -1,12 -0,75 0,3640 8,39 4,39 0,0000 1,09 1,95 0,0630 458,40 0,0000 57% 1,63 2003 -1,65 2,35 0,0354 16,38 5,00 0,0000 1,54 3,12 0,0050 246,86 0,0000 43% 1,30 2004 -1,13 -0,71 0,3464 -3,07 -3,36 0,0030 2,75 15,88 0,0000 295,87 0,0000 49% 1,86 2005 -3,21 -0,44 0,5230 -2,77 -1,40 0,1600 4,12 7,77 0,0000 175,36 0,0000 34% 1,03 2006 -2,22 -2,98 0,0210 7,92 4,00 0,0010 2,82 3,95 0,0010 284,12 0,0000 46% 1,44 2007 -2,12 -2,78 0,0950 6,06 2,84 0,0090 4,03 4,33 0,0000 183,90 0,0000 37% 2,26 2008 2,21 1,23 0,1930 3,55 2,84 0,0090 1,79 3,49 0,0000 5040,6 0,0000 92% 2,32 2009 1,53 1,45 0,0780 -7,24 -1,12 0,2710 4,88 6,19 0,0000 1851,9 0,0000 85% 1,72 2010 1,12 1,98 0,1160 1,90 0,67 0,5060 2,73 5,19 0,0000 1351,1 0,0000 80% 1,91 2011 2,64 1,74 0,0460 1,63 1,50 0,1440 2,18 10,87 0,0000 1013,9 0,0000 75% 2,24 2012 1,41 0,97 0,3860 1,00 0,65 0,5210 2,01 10,43 0,0000 1492,0 0,0000 77% 2,64 µ before 44,1% µ after 81,8 table 11. model results in china (not fully converged method – not compliant) c ou nt ry year constant eps bvs f sig. f r2 d. w. b0 t sig. b1 t sig. b2 t sig. c hi na 2000 3,68 4,47 0,0000 -19,24 -5,78 0,0000 1,34 37,24 0,0000 2145,21 0,0000 88% 2,00 2001 4,51 5,21 0,0000 10,04 6,94 0,0000 0,34 64,89 0,0000 5374,21 0,0000 92% 2,01 2002 2,50 6,04 0,0000 -8,96 -4,44 0,0000 0,97 78,79 0,0000 5903,72 0,0000 94% 1,98 2003 3,95 3,43 0,0001 -17,96 -5,01 0,0000 1,78 74,18 0,0000 5136,37 0,0000 91% 2,00 2004 6,05 6,28 0,0000 1,01 4,95 0,0000 0,27 74,57 0,0000 5476,80 0,0000 93% 2,02 2005 4,80 5,89 0,0000 -1,77 -5,77 0,0000 1,30 23,07 0,0000 5347,82 0,0000 92% 2,02 2006 5,23 4,64 0,0000 -1,95 -4,39 0,0000 1,30 35,73 0,0000 1784,63 0,0000 81% 2,01 2007 4,90 11,76 0,0000 2,50 9,22 0,0000 0,57 18,94 0,0000 278,80 0,0000 53% 1,87 2008 0,97 6,02 0,0000 1,46 21,96 0,0000 0,74 77,48 0,0000 5399,75 0,0000 91% 2,11 2009 2,29 10,50 0,0000 3,40 21,48 0,0000 0,68 42,83 0,0000 4275,89 0,0000 83% 1,67 2010 4,12 10,42 0,0000 0,51 1,30 0,0910 0,80 38,58 0,0000 1768,41 0,0000 82% 1,64 2011 3,15 6,66 0,0000 1,60 5,57 0,0000 0,69 21,01 0,0000 507,97 0,0000 73% 1,74 2012 5,12 12,51 0,0000 0,64 1,41 0,2145 0,97 26,54 0,0000 530,21 0,0000 76% 1,75 µ before 90,28% µ after 76,33% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 235 6. summary and discussion the relevance is an essential characteristic of accounting information. several researchers have studied this qualitative characteristic for the determination of the effect of an accounting referential on the quality of the accounting information. in terms of standards concerned by these studies, the ifrs have been widely studied. thus, to accomplish this objective, several models have been developed. the comparison of results of these models shows a better explanatory power of model of ohlson (1995) and a large difference in the results from one country to another. this difference in results may be caused by several factors. the study of zeef and nobes (2010) on the methods of implementation of ifrs has conducted us to think that the compliance of methods of implementation of ifrs with the ifrs issued by the iasb influences the relevance of accounting information. thus, through this study we have tried to investigate the effect of the compliance of methods of implementation of ifrs on the relevance of accounting information. we have used the ohlson model to study this effect. also, we have used the classification made by zeff and nobes (2010). according these authors, the implementation of ifrs for the listed companies around the world can be decomposed according to its degree of implementation and compliance with ifrs issued by the iasb into four methods of implementation: the first method is the “due process” which is the most advanced degree of implementation; the second method is the “standard by standard” implementation; it includes three levels named “adoption of the publications of the iasb”, “full ifrs convergence” and “ifrs adoption and deletions”. the third implementation method is the “optional” adoption and the last method is the “incomplete convergence”. subsequently, two models have been used. the first model aims to study the effect of the compliance of methods of implementation on the relevance of accounting information and the second model is proposed to compare the relevance between the countries of the sample adopting different methods of implementation of ifrs. the period chosen is of 3 years (2010-2013) for the first model and of 13 years (2000-2012) for the second model. the number of countries is six. these countries have implemented the ifrs by various methods of implementation. the results show a significant effect of the compliance of the method of implementation of ifrs on the relevance of the accounting information. this effect is positive which demonstrates that the compliance is positively correlated with the relevance. also, the results demonstrate an improvement of the relevance in countries as israel which has opted for a “due process” method, honk kong which has selected a “complete convergence” method, the united kingdom which has adopted the method “ifrs with deletions” and switzerland which has selected an “optional” method for the implementation of ifrs. in canada a country which has opted for a method of implementation “ifrs as issued by the iasb”, the results demonstrate a maintain of the high relevance of accounting information for the period after the transition to ifrs. in china, a decline of the relevance of accounting information is observed following the adoption of the new chinese accounting standards which are fairly close but not fully compliant with the ifrs. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 236 these results confirm those of some studies on the relevance of accounting information which demonstrate an improvement of the relevance following the adoption of ifrs such as the studies of bartov et al. (2005) and of morais and curto (2009). the first authors have reported a greater relevance of u.s. gaap and ias compared to german standards. the second have noticed through a sample of companies listed in 14 european countries that the relevance of the value of financial statements of these countries had increased following their transition to ifrs. references amir, e., and harris, t.s., & venuti e.k. (1993). a comparison of value relevance of us versus non-usgaap accounting measures using form 20-f reconciliations, journal of accounting research supplement, 31, 230–264. http://dx.doi.org/10.2307/2491172 amir, e., harris, t.s., & venuti, e.k. (1993). a comparison of value relevance of us versus non-us-gaap accounting measures using form 20-f reconciliations, journal of accounting research supplement, 31, 230–264. http://dx.doi.org/10.2307/2491172 amir, e., & lev, b. 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(2010). commentary: has australia (or any other jurisdiction) ‘adopted’ ifrs?, australian accounting review, 20(2), 178–184. http://dx.doi.org/10.1111/j.1835-2561.2010.00089.x microsoft word 4310-15941-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 183 momentum effect: evidence from the vietnamese stock market∗ pascal alphonse professor, university of lille north of france skema business school lsmrc thu hang nguyen∗∗ phd candidate, university of lille north of france lecturer, foreign trade university, hcmc campus, vietnam received: sep. 20, 2013 accepted: october 31, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4310 url: http://dx.doi.org/10.5296/ajfa.v5i2.4310 abstract this paper focuses on the profitability of momentum strategies in the vietnamese stock market. the results assert that momentum occurs within smalland largesized stock subsamples in the period prior to the lehmann shock and does not exist in the remaining subsamples. further tests point out that the occurrence of momentum follows market gains and is consistent with the overreaction hypothesis. the phenomenon is likely to be explained by the low individualism in the vietnamese culture. evidence on high volatility, low persistence and high correlation of stock returns is also found from the study. keywords: market efficiency, momentum, vietnamese stock market, investor behavior, market state ∗ this article is a revised and expanded version of a paper entitled “momentum effect in the vietnamese stock market”, presented at 2nd annual international conference on accounting and finance (af2012), singapore and published in procedia economics and finance 2 (2012). ∗∗ corresponding author, email: nthuhang@hotmail.com asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 184 1. introduction levine (2001) asserts that a well-organized stock market promotes economic growth in developing countries by creating liquidity, improving risk diversification and corporate governance. these results explain the reasons for the establishment of vietnamese stock market. vietnam launched its first exchange in hochiminh city in 2000 and the second one in hanoi in 2005. over a decade, the vietnamese stock market has experienced significant growth. the number of listed stocks rose from two in 2000 to more than 7001 in 2012, while the total market capitalization of listed firms peaked a mark of 27.5 percent of gdp in 2007 the year of market boom and decreased to 14.8 percent in 20112. the market intensive development has raised a concern over its quality including liquidity, information disclosure and volatility. in decision no 252/ qd-ttg3, which approves initiatives to develop the stock market over the period from 2011 to 2020, the government emphasizes the key targets of improving market liquidity and information disclosure, increasing the total market capitalization up to 70 percent of gdp and enhancing the operation efficiency of trading system. this means that vietnam is aiming at a well-organized stock market in accordance with levine (2001).therefore, the question whether the market is efficient is important for both policy makers and researchers. nguyen, tran and zeckhauser (2012) reject the semi strong form efficiency of the vietnamese stock market. they discover extremely high abnormal returns of stocks prior to their split announcements, higher than their abnormal post-announcement returns, raising a concern over illegal insider trading in the market. employing autocorrelation tests, runs tests and variance-ratio tests, truong, lanjouw and lensink (2010) reject the weak-form efficiency of the market. however, as the authors examine a sample of only 5 stocks in the 2000-2004 period when the market has just been established, their results should be used with care. our study also focuses on the weak-form efficiency with a sample ranging from 67 to 267 stocks listed on the ho chi minh stock exchange (hose)-the main exchange of the vietnamese stock market4 for the period from january 2007 to june 2012. we use a sample of weekly returns to increase the number of observations. the weak-form efficiency implies that it is impossible to earn abnormal returns on the basis of past returns (fama, 1970, 1991). the two diametrically opposed anomalies often found in a weak-form inefficient market with respect to past returns for different investment horizons are reversals and momentum. prior literature shows that the former occurs in short-term for weekly returns (lehmann, 1990) or in long-term (three to five years) for monthly returns (debond & thaler, 1985), whereas the latter happens in medium-term (from several to 12 months) for weekly returns (gutierrez & kelley, 2008) or monthly returns (jegadeesh & titman, 1993). this means that both reversals and momentum may appear in weekly returns. however, gutierrez & kelley (2008) indicate that a brief reversal is present in the first two weeks after portfolio formation and easily offset by the following strong long-lasting momentum. this finding asserts that momentum, not reversals, is a dominant feature of weekly returns. motivated by these results, using a sample of weekly returns, we concentrate 1 as of 29 november, 2012, 308 listed firms on ho chi minh stock exchange (retrieved from http://www.hsx.vn/hsx_en ) and 395 on hanoi stock exchange (retrieved from http://www.hnx.vn/en ). 2 according to the world bank’s data on market capitalization of listed companies (% of gdp) (retrieved from http://data.worldbank.org/indicator/cm.mkt.lcap.gd.zs ) 3 retrieved from http://www.hsx.vn/hsx_en/modules/phapquy/phapquy.aspx 4 as announced on websites of the hochiminh stock exchange (hose) (http://www.hsx.vn/hsx_en) and the hanoi stock exchange (hnx) (http://www.hsx.vn/hsx_en), at the end of 2011, the total market capitalization of the two markets is 453,784 billion vnd and 81,889 billion vnd, respectively. this means that the hose accounts for 84 percent of the total market capitalization of the market. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 185 on the momentum effect. employing the methodology initiated by jegadeesh and titman (hereafter jt) (1993), we find the occurrence of momentum in the short-run. the evidence also indicates that winner and loser returns are lowly persistent and highly volatile, but their strong correlation creates significant momentum profits. the results from additional tests point out that momentum is confined to smalland large-sized subsamples in the period before the lehmann shock. especially, it follows short-term market gains and is consistent with the over-reaction hypothesis. this implies that after realizing market gains investors are more confident and overreact to news, which generates momentum and long-term reversals. however, the magnitude of reversals is very weak, which can be explained by the argument of chui, titman and wei (2010) on individualism. the less individualistic investors who act less like the overconfident/self-attribution biased ones tend not to make investment decisions that produce momentum profits and reversals in long-term horizons. after short-term market declines or the lehmann shock, momentum does not exist, which is similar to the finding of chui, titman and wei (2000) on the absence of momentum in asian markets for the period prior to the 1997crisis. the remainder of the paper is organized as follows: section 2 gives a brief review on momentum effect and its explanations; section 3 provides data description; section 4 illustrates methodology description; section 5 shows empirical results and section 6 concludes some findings. 2. literature review 2.1 market efficiency and momentum evidence the efficient market hypothesis suggests that market is rational and security prices fully reflect all available information (fama, 1970, 1991). however, fama emphasizes that market efficiency is not testable because it should be tested in the context of a proper pricing model. this means that if anomalies are found in empirical studies, we merely infer that either the market is inefficient or the model is implausible. put differently, it remains impossible to infer precisely the degree of market efficiency due to the joint-hypothesis problem (fama, 1991). in fact, prior literature commonly sidesteps the issue of plausible models but concentrates on the anomalies. amongst those, momentum has been debated widely since the publication of jt (1993). jt (1993) find medium-term return continuation in the us market for the period prior to 1989: the momentum strategies that long stocks with high returns over the past three to 12 months and short stocks with low returns over the same periods earn significantly positive profits. in their following research, jt (2001) report sustained momentum in the 1990s, but jt (2011) discover negative profits in 2008 and 2009. gutierrez and kelley (2008) employ a sample of weekly returns of the us market from 1983 to 2003 and find a long-lasting stream of momentum that follows a brief reversal in the initial two weeks after portfolio formation. the momentum profits are sufficient enough to offset the initial reversal, resulting in significant momentum over the full year following portfolio formation. rouwenhorst (1998) focuses on international momentum strategies over twelve european markets from 1978 to 1995 and discovers medium-term momentum across markets and within each market except for sweden. the momentum effect is examined in emerging and asian markets as well, but is reported that the magnitude is weaker than that in the us and european markets. rouwenhorst (1999) documents that momentum is present in an aggregate asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 186 sample of 20 emerging markets, but with the samples of individual markets it is significantly positive for only six markets. examining eight asian markets, chui et al. (2000) report that momentum within each country is rather weak: only the profit of hong kong market is significantly positive for the whole sample period, while the profits of hong kong, malaysia, singapore and thailand are significantly positive for the pre-crisis period. with a bigger sample of 40 countries, griffin, ji and martin (2003) confirm that momentum in asian and emerging markets is relatively weak in comparison with that in the remaining areas. 2.2 explanations for momentum effect on the assumption that stock returns follow a simple one-factor model, jt (1993) decompose the profit into three components: the cross-sectional dispersion in expected returns, the serial covariance in factor returns and the serial covariance of the idiosyncratic components of security returns. if the momentum is caused by either the first or the second component, it can be considered as compensation for bearing systematic risk and is not regarded as an indication for market inefficiency. if it is driven by the third component, it is possible to conclude that the market is inefficient. jt (1993) provide evidence suggesting that momentum may arise from the last component, implying that the delayed price reactions to firm-specific information generate the profits. this result has two interpretations: one is the under-reaction of investors to firm-specific information and the other is the over-reaction that is eventually followed by reversals. departing from jt (1993)’s argument, on the assumption that the mean returns of individual stocks are stationary, conral and kaul (1998) assert that momentum profits are mainly driven by the cross-sectional variation in mean returns, that is, momentum reflects compensation for risk. thus, the following studies such as jt (2001), gutierrez and kelley (2008) examine risk-adjusted profits under specific asset pricing models. their results show that the momentum is still statistically significant after being accounted for risk, that is, the risk-based theory is unlikely to explain the effect. hence, recent literature mainly relies on behavioral models to explain this phenomenon. there are three main hypotheses on investor behavior, which are considered to create momentum. firstly, barberis, shleifer and vishny (1998) propose that conservatism bias causes investor under-reaction to news, which generates return momentum. precisely, investors slowly change their beliefs in the face of news announcement, which creates stock abnormal returns. when the information is fully incorporated in prices, no further abnormal return exists. secondly, daniel, hirshleifer and subrahmanyam (1998) argue that investor overconfidence and biased-self attribution create momentum. the study supposes that investors tend to be overconfident about their private information and overestimate its precision. additionally, they asymmetrically react to their decision outcomes. they attribute successes to their skill and ascribe failures to external noise. hence, the investors’ confidence increases when the subsequent public information confirms their private news, which boosts the overreaction and produces momentum in stock returns. however, the momentum will eventually be reversed in the long run when the investors realize their errors. thirdly, hong and stein (1999) explain the short-term momentum and long-term reversals in asset markets as results of interaction between news watchers and momentum traders – the two types of agents in the market. the news watchers predict future returns based on their private fundamental information and do not pay attention to current or past prices, whereas the momentum traders trace profits based only on past price changes. hong and stein (1999) argue that if information spreads gradually across news watchers, that is, price under-reaction asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 187 occurs in the short run, and then momentum traders can earn profits. however, their attempts to trace profits might push up the prices above the fundamental values, and then overreaction happens and leads to fundamental reversals in the long run. although daniel et al. (1998) and hong and stein (1999) initiate from different assumptions on investor behavior, they have a similar inference on price behavior in the long run, which is a stream of overreaction followed by reversals. consequently, there are two types of price behavior inferred from the three behavioral models: under-reaction and overreaction. jt (2001) provide evidence supporting the latter. upon the jt (1993)’s argument that momentum arises from the investors’ delayed reactions to firm specific information, a number of studies have investigated the relationship between momentum and the factors relating to firm characteristics, information quality and behavioral biases. jt (2011) provide a precise review on these papers. amongst those, chordia and shivakumar (2002), chui et al. (2010), cooper, gutierrez jr. and hameed (2004), du, huang and liao (2009) have some implications relating to our results. chui et al. (2010) find that individualism is positively correlated with the degree of momentum and the magnitude of reversals tends to be higher in countries with higher individualism. chordia and shivakumar (2002) discover that momentum profits are positive only during expansionary periods and are negative or statistically insignificant during recession periods. cooper et al. (2004) find a relationship between market states and momentum magnitude, which implies that the overreaction is greater when the market is up. du et al. (2009) indicate that the poor performance of momentum in the taiwan stock market relates to the down market states. 3. data we use a sample of simple weekly returns of stocks listed on the ho chi minh stock exchange (hose) for the period between january 2007 and june 2012. the data was supplied by itrade corporationa data provider of the vietnamese stock market. although the hose had its first trading section on july 28th 2000, the sample of the period prior to 2007 is not utilized because it has not enough stocks to build portfolios. to compute the past 13-week returns on individual stocks and to measure returns on the momentum portfolios which are held up to 13 weeks, we require all selected stocks to have return history of at least 26 weeks. thus, stocks listed after january 1st 2012 are deleted from our sample. in addition, for some stocks that had been traded in the hanoi stock exchange (hnx) before being moved to the hose, only the data for the period of being traded in the hose are utilized5. the sample also excludes some stocks that had been traded in the hose before being moved to the hnx as they were small firms and did not meet the hose’s minimum capital regulation for listing6. furthermore, to avoid the effect of extremely small and/ or illiquid stocks, we treat them as follows. first, for small stocks that have prices below vnd10,0007 in any single week, their returns in that week is treated as missing. second, in a week that a stock is not traded, its return is also treated as missing. after handling the small and illiquid stocks, we again screen out stocks with the requirement of having at least 5we do not use the data in the hnx because of the differences in trading mechanisms in the two exchanges. while the hose employs two trading methods: a call auction to determine opening and closing prices, and a continuous order matching, the hnx applies only a continuous order matching method. also, the regulated daily price limit in the hose is (+/-) 5 percent, while that in the hnx is (+/-) 7 percent. therefore, the inclusion of data from the hnx may cause bias. 6 according to document no.163/ubck-pttt issued by the state security commission of vietnam on 10 february 2009, by august 2009 (retrieved from http://www.vinanet.com.vn/uy-ban-chung-khoan-nha-nuoc/300/cqbh.xhtml ) those firms who are being listed on the hose but cannot meet the minimum capital of 80 billion vietnamese dong (vnd) have to move to the hsx which applies a minimum capital of 10 billion vnd. 7 in vietnam all stocks have a face value of ten thousand vnd. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 188 26-week returns. finally, we have a sample with the number of stocks ranging from 67 (in beginning of 2007) to 267 (at the end of 2011). as the prices have already been adjusted for dividend payments and stock splits, the simple weekly return on each security is calculated using wednesday-wednesday closing prices to avoid the weekend effects. the choice of a weekly sampling interval is to gain a large number of observations while lessening the biases arising from the daily price limit8. instead of using continuously compounded returns, we choose simple returns as the simple return on a portfolio is equal to the weighted average of its component stocks’ simple returns. this characteristic does not work for the continuously compounded returns. the market index, the vn-index, calculated as the capitalization-weighted average of all stocks listed on the hose is employed as a proxy for the market portfolio. the weekly return of vn-index calculated based on wednesday-wednesday closing indices is applied as a proxy of the market return. an equivalent weekly rate of the five year-treasury bond with an assumption that there are 52 weeks in a year is adopted as a proxy for the risk-free rate9. 4. methodology we employ the methodology initiated by jt (1993) but with weekly returns to examine the profitability of momentum strategies. we rank all stocks in week t from the lowest to the highest on the basis of their average returns over past k weeks. the stocks in the highest quintile are named “winners” and those in the lowest quintile “losers”. winner and loser portfolios are formed by allocating an equal weight across all component stocks. a portfolio that buys the winner portfolio and sells the loser portfolio is formed at week t and then held for j weeks (from week t to week t+j)10. this is regarded as a winner-minus-loser (wml) portfolio. we call profit on the wml portfolio, because this is a zero-cost strategy, return is not determined. a momentum strategy is formed at week t and held for j weeks, thus, j time series of raw profits on the wml portfolios are created. wml tkr , (k = 1,…, j) are the raw profits on the wml portfolios that are formed k weeks ago. following literature, in order to increase the power of our tests, overlapping profits in a given calendar week are examined. at week t, there are j wml portfolios – one formed in week t-1, one formed in week t-2, and so on. with an assumption of no transaction cost, the overlapping profit in calendar week t can be calculated as an equally weighted average of the j overlapping portfolios’ profits in that week:  = = j k wml tk wml tj r j or 1 ,, 1 (1) 8 the regular daily price limit of the hose is (+/-) 5 percent. 9 since the data on the secondary market t-bonds’ yields are not available, we use the primary market yields by regarding the minimum among accepted yields of bond auctions conducted within a month as the rate of that month. for any month in which no auction is implemented or succeeded, the rate of the previous month is applied alternatively. we choose the five year-t bond’s yield as this bond is the most frequently issued. the data are collected from the website of hnx (http://bond.hnx.vn ) 10 although in vietnam short sales are prohibited, due to the loose management of the vietnamese securities agency, brokers can short their customers’ securities. for example, according to hoang loc, “co hay khong hoi ban khong co phieu? (“are there stockshort selling groups?”) vneconomy news on 10 september 2012 (retrieved from http://vneconomy.vn/2012090911541106p0c7/co-hay-khong-hoi-ban-khong-co-phieu.htm ); hai dang, “nhieu chieu ban khong chung khoan” (“many ways to short stocks”), tuoi tre news on 17 october 2012 (retrieved from http://tuoitre.vn/kinh-te/516266/nhieu-chieu-ban-khong-chung-khoan.html) , stock short sales are prevalent in vietnam. thus, the prohibition of short sales is not cause for concern. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 189 the overlapping returns on winner and loser portfolios in a given calendar week t can be calculated similarly. the average of overlapping profit on the wml portfolio is employed as a metric to test the momentum of the market. if the average profit is significantly positive, the momentum occurs, otherwise, it does not exist. as the number of observations in our sample is limited, the profits on wml portfolios which are formed based on stock average returns over past one, two, four, eight and thirteen weeks (k=1, 2, 4, 8 and 13) and held for the periods of one, two, four, eight and thirteen weeks (j =1, 2, 4, 8 and 13) are tested. 5. empirical results 5.1 evidence on the momentum effect table 1 presents the average raw returns and profits on the winner, loser and wml portfolios which select stocks based on their average returns over past k weeks and hold them for j weeks (k=1, 2, 4, 8 and 13, j = 1, 2, 4, 8 and 13). the results show that the profits on the wml portfolios with k=1 are significantly positive over all holding periods (j), while those on the wml portfolios with other intervals (k) are significantly positive over one, two or three holding periods. in addition, for each interval (k) the profit tends to fall for longer holding period (j), which is similar to the findings of rouwenhorst (1998). the portfolio with k=1 and j=1 earns the highest profit of 0.83 percent per week. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 190 table 1. returns and profits on winner, loser and winner-minus-loser portfolios k j 0 1 2 4 8 13 1 winners 0.0833*** (21.11) 0.0054 (1.35) 0.0038 (0.93) 0.0026 (0.62) 0.0017 (0.41) 0.0014 (0.32) losers -0.0707*** (-24.92) -0.0029 (-0.83) -0.002 (-0.54) -0.0004 (-0.09) -0.0002 (-0.06) 0.0000 (0.00) wml 0.1540*** (57.11) 0.0083*** (3.22) 0.0058*** (2.69) 0.0030* (1.76) 0.0020* (1.70) 0.0014* (1.70) 2 winners 0.0584*** (14.73) 0.0040 (1.03) 0.0033 (0.83) 0.0028 (0.67) 0.0020 (0.47) 0.0016 (0.38) losers -0.0488 *** (-16.36) -0.0022 (-0.61) -0.0014 (-0.35) -0.0003 (-0.06) -0.0004 (-0.09) -0.000 (-0.00) wml 0.1073 *** (40.69) 0.0062** (2.33) 0.0047** (2.00) 0.0031 (1.60) 0.0024 (1.60) 0.0016 (1.56) 4 winners 0.0408*** (10.91) 0.0039 (1.02) 0.0036 (0.93) 0.0032 (0.77) 0.0020 (0.47) 0.0017 (0.40) losers -0.0341*** (-11.40) -0.0006 (-0.16) -0.0007 (-0.16) -0.0005 (-0.13) -0.0001 (-0.03) 0.00005 (0.01) wml 0.0749 *** (32.14) 0.0044* (1.75) 0.0043* (1.79) 0.0037* (1.77) 0.0021 (1.18) 0.0016 (1.23) 8 winners 0.0289*** (8.01) 0.0037 (0.99) 0.0032 (0.83) 0.0025 (0.61) 0.0020 (0.46) 0.0014 (0.33) losers -0.0249*** (-7.98) -0.0010 (-0.27) -0.0006 (-0.14) -0.0004 (-0.10) -0.0001 (-0.03) 0.0005 (0.10) wml 0.0538*** (23.68) 0.0047* (1.88) 0.0040 (1.54) 0.0030 (1.23) 0.0021 (1.01) 0.0009 (0.52) 13 winners 0.0224*** (6.38) 0.0040 (1.08) 0.0033 (0.86) 0.0025 (0.62) 0.0017 (0.40) 0.0011 (0.28) losers -0.0203*** (-6.30) -0.0013 (-0.35) -0.0011 (-0.26) -0.0006 (-0.14) 0.00005 (0.01) 0.0005 (0.11) wml 0.0427*** (19.80) 0.0053** (2.13) 0.0044* (1.70) 0.0031 (1.18) 0.0016 (0.68) 0.0006 (0.32) note: t-statistics are calculated using newey-west standard errors and setting the number of lags equal to the number of overlapping weeks in each calendar week. (***), (**), (*) indicate significance at the 1%, 5% and 10% level, respectively. t-statistics are presented in parentheses. taking a look at the profits on the wml portfolios with k=1, 2, 4, 8 and 13, j=1, we find that the profits are still significant for sorting intervals longer than one week, but the portfolio with k=1 has a higher and less risky11 profit than the others. we have similar results with j=2, 8 and 13. these findings imply that one-week returns provide more substantial 11 the standard deviation of profit on the portfolio with k=1 is lower than those of the others. the information on the standard deviations of winners, loser and wml portfolios’ returns is available upon request. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 191 information than longer-horizon returns in predicting future returns. for j=4, the portfolio with k=4 gains a larger profit (0.37 percent per week) but suffers from larger risk (standard deviation of 3 percent per week) than the portfolio with k=1, of which the profit and standard deviation are 0.30 percent and 2.11 percent per week, respectively. put differently, the portfolio with k=4 has a 23 percent higher gain but bears 42 percent larger risk than the one with k=1. this means that the latter is better than the former, confirming the ability of one-week returns in predicting future returns. from a practical point of view, it is important to examine the profitability of the momentum strategies after considering transaction costs. in the vietnamese stock market, transaction costs range from 0.15 percent to 0.35 percent of trading value and decrease for larger trading value12. since momentum is considered as an arbitrage opportunity which is commonly realized by institutional investors with huge trading value, it is plausible to impose the lowest trading cost of 0.15 percent on the momentum strategies. considering the strategy with j =1, the transaction cost is imposed twice on each long and short position at the portfolio formation and disposal. furthermore, the momentum profit is the difference between returns on winner and loser portfolios, thus can be seen as return per dollar invested in the long position. consequently, for the strategy with j=1, four times of the transaction cost should be cut down from its profit. for the strategy with j=2, since the profit is determined as the overlapping average profit on two wml portfolios at a calendar week, the transaction cost is charged four times to each position during two weeks. this means that the transaction cost is imposed twice per week on each long and short position. hence, for the strategy with j=2, four times of the transaction cost should be deducted from its weekly profit. similarly, for the strategies with j= 4, 8 and 13, four times of the transaction cost should be subtracted from their weekly profit. after accounting for a transaction cost of 0.15 percent, only profits on the two strategies with k=1, 2 and j =1 still exist, whereas the profits on the remaining strategies vanish absolutely. table 1 also reports the average returns on winners and losers separately. the winner and loser returns are insignificant for all couples of k and j, raising a concern over their significance in the sorting week, that is, whether the momentum strategies are based on significant information. the first column indicates that in the sorting week (j=0), the returns on winners are significantly positive and decrease as the ranking interval is longer, while the returns on losers are significantly negative and their absolute values decrease for longer ranking intervals. this means that the momentum strategies are built on significant information. furthermore, the decrease in the absolute values of the t-statistics for longer sorting intervals confirms our previous findings that the backward interval of one week provides more substantial information than longer sorting horizons. the extremely high returns of winners in the sorting week (j=0) in comparison with their low and insignificant returns in the following weeks raise a concern whether the high returns are driven by some special corporate events such as stock issues. since the list of winners and losers varies from week to week, it is difficult to examine the relationship between stock 12 according to the trading fee tables of some big securities companies such as hsc, ssi, vcbs, acbs as in october 2012. the lowest trading cost (0.15 percent) is provided by hsc and vcbs for the trading value of more than one billion vnd (equivalently, usd 50,000). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 192 returns and stock issues for all stocks within this paper. thus, we carry out a rough test on some specific stocks of high and low frequency of being winners (losers). we sort stocks by their frequency of being winners (losers), select top ten highand low-frequency stocks and observe the events of stock issue during our sample period. the findings uncover that the high returns are not likely to be driven by the stock issuances13. for example, a mining stock, named ksh had 57 times of being a winner in its 163 observations for the period of three and a half year, but did not have any stock issue during the period. however, a real estate stock, namely ppi had two times of stock issues but suffered 22 times of being a loser relative to its 61 observations in more than two years. thus, the correlation between the high returns in sorting weeks and the stock issuances is unlikely to exist. this test also reveals that eight of the top ten-high frequency stocks being winners have higher average returns than the market average return, whereas seven of the top ten –low frequency stocks being winners have lower average returns. this means that winners can be divided into two groups: “clear winners”the stocks with high persistence of their returns and “noisy winners”the stocks with low persistence of their returns. for the losers, all top ten-high frequency stocks being losers have lower average returns than the average market return, whereas nine of top ten-low frequency stocks being losers have higher average returns. put differently, two kinds of clear and noisy losers are also found. moreover, the correlation between these two frequencies is 34.59 percent, indicating that the probability of a winner becoming a loser and vice versa is extremely high. the low persistence of winners and losers is reaffirmed by the results in table 2, which provides information on the conditional probability of a stock belonging to group i at week t, given the knowledge that it has been already sorted in group j at week t-1. table 2. transition matrix s=j, t-1 s=i, t 1 2 3 4 5 1 0.2135 0.1851 0.1805 0.1971 0.2238 2 0.1669 0.2153 0.221 0.2201 0.1768 3 0.1671 0.2078 0.2275 0.2201 0.1776 4 0.1838 0.2153 0.2079 0.2037 0.1894 5 0.2437 0.1817 0.1631 0.1708 0.2408 note: for each week from january 2007 to june 2012, stocks are ranked from the highest to the lowest based on their previous one week return (k=1) and then divided into five groups. group 1 includes the lowest-quintile stocks, i.e. the losers; group 5 consists of the highest-quintile ones, i.e. the winners and the same rules for others. the conditional probability of a stock belonging to group i at week t, given the knowledge that it has been already sorted in group j at week t-1 , i.e., prob (s=i, t|s=j, t-1) is presented in the table. 13 the detailed results are available upon request. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 193 the results indicate that only 24.08 percent of winners continue being winners and 21.35 percent of losers continue being losers in the following week. the probability of a winner falling in other groups for the subsequent week is 75.02 percent, including a 24.37 percent chance of dropping into losers. the probability of a loser moving to other groups in the subsequent week is 78.65 percent, including a 22.38 percent chance of becoming a winner. the high volatility of stock returns confirms the existence of noisy winners and losers. an additional question is why the insignificant returns of winners and losers produce significant momentum profits. the average standard deviations of returns or profits on the winner, loser and wml portfolios for all couples of k and j are 0.0536, 0.0552 and 0.0296, respectively. the average correlation between the winner and loser returns is around 0.85. as the wml portfolios are built by buying the winners and selling the losers, the highly positive correlation between winner and loser returns reduces the standard deviation of the wml profits, making the momentum profits significant in some periods. put differently, the findings confirm the portfolio diversification effect: high correlation between long and short positions produce less variance of the wml profits. nevertheless, the risk of wml profits still exists, which should be accounted for in the next section. jt (1993) argue that in order to avoid some of the bid-ask spread, price pressure and lagged reaction effects, a second set of strategies that skip one week between the portfolio formation and the holding periods should be examined. since we use closing prices determined by call-auctions, the problem of bid-ask spread is not a concern. in a nutshell, the evidence asserts that momentum occurs in the vietnamese stock market for some sorting and holding periods. after being controlled for transaction costs, only two strategies with k=1, 2 and j =1 earn significantly positive profits. the results also indicate that one-week returns provide more substantial information than longer-horizon returns in predicting future returns. furthermore, the winner and loser returns are lowly persistent and highly volatile, but their strong correlation creates significant momentum profits. 5.1 momentum profits within size-and pre-or post lehman shock-subsamples jt (1993) argue that if the momentum profits are driven by the cross-sectional dispersion in expected returns, the size-subsamples will earn lower profits than the full sample due to the less difference of expected returns within size-subsamples. additionally, if the profits are factor-related, the small-sized subsamplewhich consists of less actively traded stocks is likely to yield a higher profit than the large-sized subsample. in our sample, the average market capitalization of winners and losers shows that the winners contain large firms, while the losers include small firms14, which is different from jt(1993)’s result that the highest and lowest past return-portfolios consist of small stocks. this implies that the momentum may be limited to any particular subsample of stocks. thus, at the beginning of each year, we classify stocks into three categories of small, medium and large sizes based on their market capitalization at the previous year-end15. the profits on the wml 14 the average market capitalization of winners and losers is 2,620 billion vnd and 2,280 billion vnd, respectively, while that of the entire sample is 2,540 billion vnd. 15 market capitalization of each firm at the year-end is calculated as a product of the market price of its common stock and asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 194 portfolio built from the three categories are examined to clarify whether they are due to either the difference in expected returns or the positive serial correlation in factor returns. fama (1970, 1991) asserts that anomalies should be tested in the context of a pricing model as they may be compensation for risk. additionally, our previous section asserts that although being zero-cost portfolios, the momentum strategies are still risky. thus, we employ two commonly used modelsthe capm and the fama-french three factor model16to account for risk. furthermore, chordia and shivakumar (2002) find relationship between momentum profits and business cycle; jt (2011) report negative momentum profits in 2008 and 2009 when the market severely declined; chui et al. (2000) show insignificant momentum profits in the asian markets for the post-crisis period. our sample includes a severe market decline period since the beginning of 2008. from its high level of 800 points at the beginning of 2008, vn index has fell to about 400 points in june, recovered to around 500 points at the beginning of september, but since the lehmann shock it has again slumped to the lowest level of 234 points in february, 2009, and then has been sluggish around 400 points to the end of the sample period. besides, during the period from 27/3/2008 to 18/8/2008, to prevent market declines, the state securities commission of vietnam applied temporary daily price limits varying from (+/-)1 percent to (+/-) 3 percent instead of the regular regulation of (+/-) 5 percent. this sample period should be removed from our sample to prevent bias arising due to the administrative intervention. hence, we divide our sample into two periods: before the lehmann shock (from january 2007 to march 2008) and after the lehmann shock (from september 2008 to june 2012) to examine whether the momentum effect is limited to any particular period. as reported earlier, the strategy with k=1 and j=1 yields the highest profit, thus for brevity, the profit of this strategy constructed within sizeand preand postlehmann shock subsamples is further examined. the results are presented in table 3. observing the momentum profits by periods, we find that the raw and the risk-adjusted profits in the first period are strongly and significantly positive, while those in the second period are insignificant. this means that the momentum is confined to the period prior to the lehmann shock. our statistics17 shows that the standard deviations and the correlation of winner and looser returns in the first period are not very different from the corresponding statistics in the second period, while the difference between winner and loser returns in the first period is rather higher than that in the second period. indeed, large difference between winner and looser mean returns makes momentum significant in the first period and small difference drives the momentum insignificant in the second period. the number of outstanding stocks at that time. 16 we follow fama and french (1996) to build the smb and hml portfolios. 17 the means, standard deviations and the correlation of winner and loser returns in the first period is 0.78%, -0.82%, 6.4% (standard deviation), 5.7% (standard deviation) per week and 0.80, while those for the second period are 0.25%, 0.14%, 5.4% (standard deviation), 5.1%( standard deviation) per week and 0.83. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 195 table 3. momentum within size-, preand post-the lehmann shock subsamples periods all small medium large whole period 1/2007-6/2012 raw 0.0083*** (3.22) 0.0026 (0.83) 0.0030 (1.16) 0.0094*** (3.24) capm alpha 0.0086*** (3.25) 0.0032 (1.04) 0.0034 (1.32) 0.0097*** (3.34) ff alpha 0.0084*** (3.20) 0.0028 (0.94) 0.0032 (1.27) 0.0098*** (3.32) first period 1/20073/2008 raw 0.0161*** (2.77) 0.0156** (2.24) 0.0057 (1.12) 0.0154** (2.40) capm alpha 0.0171*** (2.82) 0.0171** (2.54) 0.0061 (1.16) 0.0168** (2.55) ff alpha 0.0154** (2.54) 0.0148* (2.06) 0.0045 (0.84) 0.0163** (2.40) second period 9/2008-6/2012 raw 0.0007 (0.30) -0.0054 (-1.59) -0.0031 (-1.33) 0.0021 (0.76) capm alpha 0.0006 (0.28) -0.0050 (-1.50) -0.0029 (-1.25) 0.0022 (0.78) ff alpha 0.0005 (0.21) -0.0052 (-1.58) -0.0029 (-1.20) 0.0023 (0.78) note: t-statistics are calculated using newey-west standard errors to test the null hypothesis that the profit or alphas are equal to zero. (***), (**), (*) indicate significance at the 1%, 5% and 10% level, respectively. t-statistics are presented in parentheses. looking at profits by sizes, we find that for the first period, the small and the large-sized subsamples have a little bit lower raw profits than the full sample. additionally, the small-sized subsample gains a little bit higher profit than the large-sized one. these results do not strongly support the argument by jt (1993) that momentum may be due to the dispersion in expected returns or the positive serial correlation in factor returns. furthermore, the risk-adjusted profits from the small and the large-sized subsamples are statistically significant. this means that momentum is limited to the small and large-sized subsamples and cannot be regarded as the compensation for risk. hence, it can be considered as delayed price reactions to information, as mentioned in jt (1993). for the second period, the raw and the risk-adjusted profits from all size-subsamples are not significant, which is in accordance with the previous finding on the absence of momentum during this period. 5.2 performance of momentum profits in the post-holding period in this section we analyze the profits in longer horizons following the holding period to examine whether the momentum is driven by either the under-reaction or the over-reaction hypothesis. due to the limitation of observation number, we focus on the profits up to six months or 26 weeks following the formation week. additionally, the profit on the strategy with k=1 and j=1 is further examined. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 196 as described earlier, 26 time series of raw profits on the wml portfolios that are formed k weeks ago (k =1,…,26) are created. following cooper et al. (2004), we regress these 26 time series of raw profits against a constant and the appropriate factors.  ++= i itikkt fr εβα (2) then, the risk-adjusted profits are calculated as: −= i itikkt adj kt frr β̂ (3) where rkt is the time series of raw profits on the wml portfolio that is formed k weeks ago. fit is the realization of factor i in week t. ikβ̂ is the estimated loadings of the time series of raw profit on the factors. the excess return of the market index over the risk free rate is used as the unique factor for the capm-adjusted profit, and the two more factors, smb and hml, are served for the fama-french-adjusted profit. the weekly average raw or risk-adjusted profits between week k1 and k2, following the formation week are calculated: )1/( 12 * ,, 2 1 21 +−=  = + kkrar k kk ktkkk (4) where 21,kkar is the average weekly profit between week k1 and k2, *r is either the raw or the risk-adjusted profit. table 4 demonstrates the weekly average profits over the first month (k1=2, k2=5), second month (k1=6, k2=9), third month (k1=10, k2=13) and the following three months (k1=14, k2=26) after the holding period. table 4 shows that for the whole and the first periods, after reaching a significantly positive rate in week 1, the raw and the risk-adjusted profits become insignificant in the subsequent months. in the second period, the raw and risk-adjusted profits are insignificant in week 1 and in all following months, confirming the absence of momentum. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 197 table 4. average weekly profit in the post holding periods week 0 week 1 week 2-5 week 6-9 week 10-13 week 14-26 whole period (1/2007-6/2012) raw profit 0.1540*** (57.11) 0.0083*** (3.22) 0.0009 (0.80) 0.0004 (0.40) 0.0007 (0.65) -0.0006 (-1.00) capm alpha 0.1547 *** (59.56) 0.0086*** (3.25) 0.0009 (0.80) 0.0004 (0.41) 0.00067 (0.60) -0.0006 (-1.11) fama-french alpha 0.1542*** (62.24) 0.0084*** (3.20) 0.0009 (0.78) 0.0007 (0.65) 0.00087 (0.86) -0.00065 (-1.30) first period (1/2007-3/2008) raw profit 0.1562*** (22.74) 0.0161*** (2.77) 0.0023 (0.91) 0.0017 (0.49) 0.0014 (0.37) -0.0013 (-1.10) capm alpha 0.1586*** (24.61) 0.0171*** (2.82) 0.0026 (1.07) 0.0021 (0.66) 0.0016 (0.43) -0.0014 (-1.19) fama-french alpha 0.1556*** (25.75) 0.0154*** (2.54) 0.0025 (1.01) 0.0037 (1.42) 0.0038 (1.40) -0.0011 (-0.72) second period (9/2008-6/2012) raw profit 0.1554*** (58.19) 0.0007 (0.30) -0.0011 (-0.94) 0.0003 (0.37) 0.0008 (0.81) -0.0006 (-0.86) capm alpha 0.1558*** (58.97) 0.0006 (0.28) -0.0011 (-0.95) 0.0003 (0.34) 0.0007 (0.77) -0.0007 (-0.90) fama-french alpha 0.1559*** (63.40) 0.0005 (0.21) -0.0012 (-1.10) 0.0000 (0.02) 0.0006 (0.65) -0.0009 (-1.35) note: (***), (**), (*) indicate significance at the 1%, 5% and 10% level, respectively. t-statistics are presented in parentheses. the results in table 3 indicate that momentum is confined to the period prior to the lehmann shock, that is, it seems to be related to market states. hence, we look closer at the relationship between momentum and market states. due to the limitation of our observation number, we define market state based on lagged eight-week market returns. the state is regarded as “up” if the lagged market-return is non-negative, and as “down” if the lagged market-return is negative. following cooper et al. (2004), we regress the time-series of weekly average raw or risk adjusted profits on an up dummy variable and a down dummy variable, with no intercept to calculate the profit following each state. the results are presented in table 5. panel a reveals that for the whole period, the raw and risk-adjusted profits following up states are significantly and strongly positive in week 1, preserve their significance in week 2-5, and become insignificant in longer horizons. on the other hand, following down states, the raw and the capm-adjusted profits except for the raw one in week 10-13 are not statistically significant in week 1 and in the subsequent months. after being controlled for the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 198 three factors, the profit is weakly significant in week 1 and insignificant in the subsequent months. table 5. momentum and market states week 0 week 1 week 2-5 week 6-9 week 10-13 week 14-26 panel a: whole period (1/2007-6/2012) average weekly profits following up markets raw profit 0.1715 *** (45.49) 0.0135*** (4.13) 0.0030** (2.20) -0.0002 (-0.15) -0.0013 (-0.88) -0.0008 (-1.12) capm alpha 0.1711*** (47.13) 0.0133*** (4.12) 0.0031** (2.30) -0.0004 (-0.33) -0.0010 (-0.67) -0.0006 (-0.81) fama-french alpha 0.1688*** (48.51) 0.0127*** (3.94) 0.0029** (2.22) 0.0007 (0.59) -0.00002 (-0.02) -0.0011 (-1.56) average weekly profits following down markets raw profit 0.1397*** (40.99) 0.0041 (1.40) -0.0007 (-0.59) 0.0009 (0.79) 0.0024* (1.80) -0.0004 (-0.62) capm alpha 0.1413*** (43.05) 0.0047 (1.59) -0.0008 (-0.66) 0.0012 (0.98) 0.0020 (1.54) -0.0007 (-1.07) fama-french alpha 0.1424*** (45.27) 0.0049* (1.69) -0.0007 (-0.61) 0.0007 (0.57) 0.0016 (1.29) -0.0003 (-0.47) panel b: first period (1/2007-3/2008) average weekly profits following up markets raw profit 0.1914*** (22.66) 0.0257*** (3.55) 0.0071** (2.19) 0.0034 (0.87) -0.0027 (-0.54) 0.0000 (0.02) capm alpha 0.1899*** (23.53) 0.0247*** (3.48) 0.007** (2.23) 0.0023 (0.61) -0.0025 (-0.52) -0.0002 (-0.09) fama-french alpha 0.1849*** (24.50) 0.0224*** (3.24) 0.0063** (2.12) 0.0067** (2.02) 0.0034 (0.80) -0.0039* (-1.88) average weekly profits following down markets raw profit 0.1280*** (16.95) 0.0085 (1.31) -0.0015 (-0.51) 0.0002 (0.07) 0.0046 (1.05) -0.0024 (-1.29) capm alpha 0.1341 *** (18.66) 0.0110* (1.73) -0.0009 (-0.31) 0.0019 (0.58) 0.0048 (1.11) -0.0023 (-1.27) fama-french alpha 0.1322 *** (19.59) 0.0099 (1.60) -0.0006 (-0.21) 0.0013 (0.44) 0.0042 (1.11) 0.0011 (0.57) panel c: second period (9/2008-6/2012) average weekly profits following up markets raw profit 0.1633*** (42.50) 0.0040 (1.28) 0.0007 (0.49) -0.0002 (-0.14) 0.0001 (0.05) -0.0014** (-2.01) capm alpha 0.1635*** (43.18) 0.0039 (1.28) 0.0009 (0.65) -0.0003 (-0.21) 0.0001 (0.09) -0.0012* (-1.69) fama-french 0.1612*** 0.0029 0.0007 -0.0007 -0.0003 -0.0013* asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 199 alpha (45.85) (0.94) (0.50) (0.59) (-0.24) (-1.85) average weekly profits following down markets raw profit 0.1485*** (41.33) -0.0022 (-0.77) -0.0026** (-2.02) 0.0008 (0.67) 0.0014 (1.18) 0.0001 (0.13) capm alpha 0.1490*** (42.08) -0.0023 (-0.79) -0.0028** (-2.21) 0.0008 (0.69) 0.0013 (1.07) -0.0002 (-0.27) fama-french alpha 0.1511*** (45.95) -0.0016 (-0.56) -0.0029* (-2.31) 0.0007 (0.58) 0.0014 (1.23) -0.0006 (-0.87) note: (***), (**), (*) indicate significance at the 1%, 5% and 10% level, respectively. t-statistics are presented in parentheses. panel b illustrates that for the first period, the raw and the capm-adjusted profits following up states are significant in week 1, sustain their significance in week 2-5 and become insignificant in longer horizons. after being accounted for the three factors, the profit prolongs its significance till week 6-9, and then weakly reverses in week 14-26, showing a sign of initial over-reaction and a price correction in stock prices. especially, the profit following up states is 2.24 per cent per week, rather higher the average profit of 1.54 per cent per week in table 4. on the other hand, following down states, the raw and the three-factor adjusted profits are insignificant in week 1 and in the subsequent months. the capm-adjusted profit is weakly significant in week 1 and become insignificant in all following months. these results show that the stream of insignificant profits following down states offset the stream following up states in table 5, generating a stream of a significant profit in week 1 and insignificant profits in the subsequent months in table 4. panel c shows that momentum does not occur in the second period following either up or down states. the raw and the risk-adjusted profits in week 14-26 following up states and those in week 2-5 following down states are significantly negative. nevertheless, these values are economically small. cooper et al. (2004) argue that these reversals may be caused by other factors instead of the price correction for the delayed overreaction. in a nutshell, table 4 and 5 indicate that momentum is related to market states: it follows market gains only in the period prior to the lehmann shock; after the market declines or in the post-lehmann shock period it does not exist. the profit stream following up states is consistent with the over-reaction hypothesis. 6. conclusion and discussions our initial results show that momentum occurs in the short-run. the most successful strategy that selects stocks based on their previous one-week returns and keeps them for one week earns 0.83 percent per week. this profit is still higher than transaction cost when a large value of trading is considered. the results from additional tests indicate that winner and loser returns are lowly persistent and highly volatile, but their strong correlation creates significant momentum profits. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 200 the results from further tests show that momentum is confined to smalland large-sized subsamples in the period before the lehmann shock. especially, it follows short-term market gains and is consistent with the over-reaction hypothesis. this implies that after realizing market gains, investors are more confident and overreact to news, which produces initial over-reaction and long-term reversals. however, the magnitude of reversals is very weak, which can be explained by the argument of chui et al. (2010) on individualism. a survey by geert hofstede indicates that vietnam is a collectivistic society with its individualism score of 2018. in addition, ngo and truong (2011) provide evidence on herding behavior, which implies the low individualism of the vietnamese investors. hence, the low individualism is likely to explain the weak reversal in the vietnamese stock market. put differently, the less individualistic investors-who act less like the overconfident/self-attribution biased ones tend not to make investment decisions that produce momentum profits and reversals in long-term horizons. similar to the findings of chui et al. (2000) in the asian markets in the pre-1997 crisis period, momentum does not exist after the lehmann shock. this is due to the small difference between winner and loser returns, which might derive from the less confidence of investors following market declines. references barberis, n., shleifer, a., & vishny, r. 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(1999). local return factors and turnover in emerging stock markets. the journal of finance, 54(4), 1439-1463. http://dx.doi.org/10.1111/0022-1082.00151 truong, d.l, lanjouw, g., & lensink, r. (2010). stock-market efficiency in thin-trading markets: the case of the vietnamese stock market. applied economics, 42, 3519-3532. http://dx.doi.org/10.1080/00036840802167350 microsoft word 5431-19585-2-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 306 the impacts of corporate governance, audit system to business failure of going-concern firms yunsheng hsu national chung hsing university taiwan, province of china chi-chen wang national defense university taiwan, province of china tzeu-chen han national penghu university taiwan, province of china received: april 7, 2014 accepted: may 22, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5431 url: http://dx.doi.org/10.5296/ajfa.v6i1.5431 abstract this study examines the companies in which auditors have first issued going concern suspect, focusing specifically on impact factors influential to the company’s survival period as well as analyzing when these companies will most likely be delisted. empirical results imply that the first five years is the critical period for delisting after the going concern suspect. the paper also indicates that the mechanism of corporate governance and audit system are also decisive factors to companies with going concern suspicion whether they will be able to continue. keywords: corporate governance, audit system, going concern suspect, business failure, survival analysis asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 307 1. introduction the purpose of the paper is to investigate the relation between auditor report with going concern suspect and business failure1, and the impacts of corporate governance and audit system. when the company has been expressed auditor reports with going concern suspect, it means that the auditors raise doubts of the company’s ongoing ability (casterlla, lewis and walker, 2001). the company is now concerned with possible business failure. the investors are anxious to find indicators to evaluate whether the company can and will survive. the literatures presented whether the function of “early warning” resides in auditors’ judgement to business failure, and to investigate whether there is “self-fulfilling prophecy” after going concern suspect. in regards to “early warning” function, the relative literatures compared the forecast ability between audit judgements and statistical forecast models on corporate failures. koh (1991) indicates that auditors’ accuracy on failure predictions were not better than statistical forecast models. levitan and knoblett (1985) and koh and killough (1990) suggested that auditor judgement should be made by utilising statistical forecast models at the same time. the literatures on early warning merely predicted corporate failure probability within the study period, but failed corporations had different time frames from when risk was first detected to the actual failure. if the same time period was chosen as comparison basis during the study, then the observed data might be censored data, thus underestimating delist risks and result in biased analytical mistakes. in addition, the forecast models did not consider the corporate survival period between first risk identified to actual failure, so this type of risk forecasting weakens the functions of risk forecast and regulation. studies on “self fulfilling prophecy” explored whether the possibility of business failure will rise further after going concern suspect has been issued, but the existence of self fulfilling prophecy itself created controversial literature conclusions (louwers, 1998). louwers, messina and richard (1999) state that the studies on self fulfilling prophecy only analyse the effect during the initial stage right after going concern suspect issued, the effect in the later periods have been neglected, resulting in biased outcomes. furthermore, users of financial reports face the problem of decision making in a specific point in time. when firms have been issued with going concern suspect by auditors, besides survival probabilities, the survival lapse of time must also be considered. to the aforementioned blind spots, the overall time period from first on going concern to delist must be examined thoroughly. this paper has also reviewed operation risk literatures and corporate governance factors and audit system that can influence corporate delist. in 1999, taiwan announced generally accepted auditing standard no.33 as well as the modified version of no. 16 bulletin. when auditors have major going concerns, this information should be disclosed according to no. 2 and no. 16 audit standard bulletins before the modification. even if the firm has already appropriately revealed this information in the financial reports, the accountant should still give qualified opinion and disclaimer of opinion reports. in 1999, after the adoption of no. 33 standard along with modified no. 16 bulletin, 1 in this study, business failure means that the companies have been delisted by law enforcement. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 308 the accountant should give modified unqualified opinion reports. when accountants have going concern suspect, they can change their reports to “modified unqualified opinion” from “qualified opinion”. with the announcement of no. 33 bulletin, it allowed the accountants to apply more graceful standards when issuing going concern suspect reports to companies (hsu, wang and liou, 2011). this study selects observations of companies that have been issued with going concern by auditors from 1988 to 2007 as observed data. empirical results indicate some of the reasons for higher delist risk rate are: companies only listed for a short period of time, low ratio of reserved earning to total asset, low ratio of share market price to total debt, high ratio of directors’ pledge, or low percentage of share holding by internal management. at the same time, when going concern has been issued, delist risk will continue to rise, it will reach the summit in 19th quarter and then gradually descends. this indicates first 5 years is the delist high risk period for a company after first going concern. split models’ final failure rate parameter is estimated at 0.834, through verification, test results are significantly other than 1. therefore it is clear that standard model is not appropriate to this study’s sample data and does not fit the assumption of companies will fail at the very end. this paper is structured as follows: introduction, literature reviews, analysis model, factors to business failure, data and sample selection, empirical results and conclusion. 2. literature review this paper will take theories from previous literatures as basis and proposes the use of survival analysis model with the incorporation of time factor, because neither of these considered the time factor. altman and mcgough (1974) compared statistical forecast model and forecast ability of the auditors, results indicated the accuracy of auditor’s forecast to corporate failure is only half of what the statistical model has forecasted. the related studies also concluded with higher accuracy on statistical models rather than the auditor’s judgements (levitan and knoblett, 1985; koh and killough, 1990; koh, 1991). these were all choice models to differentiate whether the corporate has failed, but to report users, they not only care about the probability of corporate failure, but also when this is likely to happen. from the moment auditors issue on going concern to the actual failure point, f/s users must evaluate risk in corporate failure and the probability of when this will take place at any time from that point onwards so corresponding actions can be planned. on the other hand, choice models did not signify the company’s survival lapse period from point of issuance of going concern to corporate failure, thus choice models have lower prevention and management functions for failed companies. louwers (1998) deemed that when auditors issue on going concern, the probability of corporate failure could rise due to this action, this is called self fulfilling prophecy. altmen (1982), barnes and hooi (1987) and psaros and zhang (1994) did not support the existence of self fulfilling prophecy. but nogler (1995), louwers (1998), citron and taffer (1992), and wang, lin and hsu (2013) supported self-fulfilling prophecy. it is clear that there is no unanimity in conclusion whether self-fulfilling prophecy exists. the reason for this diversification in results is self fulfilling prophecy implies companies will fail in the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 309 immediate years after the issuance of going concern suspect, but the actual process for a company to go from normal operations to company failure is much more complex. there are many influential factors to bankruptcy. it is not thoughtful thinking to judge audit rationality by merely looking at company failure after going concern has been issued, because the effect of this issuance is not only restricted to the immediate years following the issuance, but might also have a lag effect. therefore one should probe further into resulting changes reflected upon the lapse of time. besides, the measurement standard of percentage approach to evaluate self fulfilling prophecy is not quite objective, hence more objective indications should be identified. zhang and suzanne (1997) suggested adopting survival analysis model to measure with more confidence. to the factors of business failure, kesner (1987) and mcconnell and servaes (1990) indicated that equity ownership positively relates to firm performance. when accountants have going concern suspect, they can change their reports to “modified unqualified opinion” from “qualified opinion”. with the announcement of no. 33 bulletin, it allowed the accountants to apply more graceful standards when issuing going concern suspect reports to companies. the rate of company failure announced after no.33 bulletin should be lower than companies that have been issued with going concern prior to the bulletin. with this influential factor in mind, a dummy variable is set. after the announcement of no.33 bulletin is 1 and before this period is 0, to control the effect of no.33 bulletin. bandopadhyaya and jaggia (2001) used split population duration model to investigate bankrupted companies where after restructure, the time it will take for these companies to go broke again and what are the influential factors in the 2nd bankruptcy. their main concern was that re-bankrupt rate is not equal to 1, which matched the actual scenario, but they did not explain the process of choosing log-logistic correction model. one must note that researches on the above survival analysis model did not explain thoroughly the model selection process. if the model used in the above research is applied as direct quote, the analytical deviation errors are likely to happen due to different study purpose and objects. 3. analysis model due to most studies adopted the choice model to construct financial difficulty forecast models, it was limited in such a way that it only measured the corporation’s greatest possibility to fail in a specific point in time, in other words, it is a static analysis. this type of analysis only evaluated greatest risk of delist in a certain time frame. it was not able to depict the survival duration so consequently the right timing to prevent and handle financial crisis is lost. crucial factors such as delist time after financial alerts, delist risk and average survival periods are all decision making references which were not shown in choice model. therefore this study adopts survival analysis to investigate what factors affect firms’ delist and survival period as well as select a model to best fit study data. due to the fact that delist might happen after the observe period, referred to as censored data, this will create incomplete information on whether the incident happened or not. if hypothesised incident did not happen in the future, then the analysis will be biased. in order to solve this analytical deviation error, this study uses survival analysis method instead of traditional choice model. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 310 general survival analysis models assumed that companies will fail at the end, this does not coincide with the fact that most corporations have continued their operations in real life scenarios. if we chose to use the model that assumed failure at the end to set the parameters of survival analysis, then the numbers will result in over estimating final failure probability. therefore, this study used split population duration model to estimate the influential factors of companies’ delist. the annunciation of audit opinions and company failures have been linked together to create a motion process. the purpose is to investigate the influential factors and time frame from when auditors reveal their opinions to whether the companies will survive or fail at the end. investigations also include listed companies’ length of most risk to delist, the probability of delist and its influential factors. generally speaking, economic theories alone do not contribute to the fitness of study data distribution in survival analyses. if inappropriate literature models are used, it will lead to deviation errors on study results due to differences in study purposes and objects. the study data in this paper was attended straightforward to find the best fit study model. the log-logistic model, which is the distribution achieved from generalized f parameter value verification, is compared to split model, with final risk rate corrected, to obtain the difference between these two estimate parameters in the model fit confirmation process. the main purpose is to show whether split model will best fit the study data. empirical results show the risk function is upside down u shaped on both models, this means the risk of delist from going concern will increase according to time, and will gradually descend after its peak point. this paper also tests whether there are difference in study results by using split model as compared to standard model to a company’s final delist assumption. standard model assumes that companies will fail at the end, thus final fail rate is 1. split model assumes that companies will continue to operate, thus final fail rate is less than 1. this study investigates on influential factors that could affect company’s normal operations or company’s failure. in a parametric model, it is hypothesised that survival time t under independent variables x, will follows one parametric probability distribution2. following lancaster (1990), the linear regression can be expressed as: in this equation, σ is standard deviation of survival time t, ω is decided by the distribution of survival time t distribution. use mle to estimate β, σ and the related parameters. the survival analysis model assumes that all companies will eventually be delisted; in fact, this is not necessarily the case in real life. in order to solve this incident that the observed objects might not end in failure, this study uses schmidt and witte (1989)’s method, setting final delist probability value as ip , where 1ir = means the company will delist at the end, 0ir = means it will not delist at the 2commonly used probability distributions in survival analysis include: weibull, lognormal, generalized gamma, log-logistic and generalized f. σωβχ +′=tlog asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 311 final stage. furthermore, the delist probability can be affected by some other exogenous variables which can be assumed as ( )αiz ′φ . in this, iz is defined as the variable of final death rate, α is the coefficient of iz , φ is accumulative probability density function of normal distribution, therefore log likelihood function is expressed as: ( ) ( ) ( ) ( ) ( )[ ]{ } == φ+φ−+   φ= n iii n ii ii wszzwfzl 0 '' 1 ' 1log 1 loglog δδ αα σ α where '(ln ) /i i it xω β σ= − and f (wi) is decided by f (ti). finally, this study uses generalized f distribution parameters to decide on the types of survival period’s distribution3. there are four parameters in generalized f distribution, λ、m1、 m2 and p=1/σ. generalized f’s probability density function is expressed as follows: ( )( )( 1) 1 ( 1 2)( ) / ( 1, 2) (1 )m m mf t t m m k kλρ λ βρ− − += ⋅ + where ( )( 1/ 2) p k m m tλ= , and ( ) ( ) 1 ( 2 ) ( 1, 2 ) 1 2 m m m m m m β γ γ = γ + according to the special features of generalized f parameters, it is possible to find a distribution type more fit to survival data through statistical verification (lancaster, 1990). generalized f distribution’s survival function and hazard function are s (t) = b     + 1,2, 1 1 mm k and ( )( ) ( ) f th t s t= , in this equation, b is beta distribution’s accumulative probability density function. 4. factors to business failure the paper investigates the factors of business failure to going concern firms. financial crisis forecast models in literatures generally adopted financial ratios as explanatory variables (zmijewski, 1984), cybinski and carolyn (2005) showed statistical models based on financial ratios can reflect company operational status appropriately. this study followed chen and lee (1993), and differentiated the factors that will affect delist risks into corporate governance, general structure, financial structure, operation structure and also macroeconomic structure so that industry and system outlook fluctuations within the observation period can be incorporated. the corporate governance factors indicate that the higher the ownership, the more sound in 3although one can use the parameter values of generalized gamma distribution to determine which family and distribution it belonged to, but comparatively to generalized gamma, generalized f can be determinate to be log-logistic distribution or not. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 312 the functionality of the directing board due to better regulation and inspection of manager’s behaviors and decrease managers self-profit actions (fama and jenson, 1983; jensen and meckling, 1976). therefore equity could affect possibilities of companies being delisted. this study uses directors’ pledging ratio and director’s share holding ratio to evaluate share structure. kesner (1987) and mcconnell and servaes (1990) indicated that equity ownership positively relates to firm performance. when company’s directors pledge the shares that they own to the bank, this is the same as retracting capital at an early stage but still hold entitlement to the company. the higher the directors’ pledge, the more distorted the company’s financial structure will be and thus higher possibility of the company being delisted. fama and jenson (1983) and jensen and meckling (1976) both indicated that the higher the ownership, the lower the agency cost, resulting in lower chances for managers to self profit. it is expected for companies with high director’s ownership, there is lesser possibility of the company being delisted. the rate of company failure announced after no.33 bulletin should be lower than companies that have been issued with going concern prior to the bulletin. with this influential factor in mind, a dummy variable is set. after the announcement of no.33 bulletin is 1 and before this period is 0, to control the effect of no.33 bulletin. the general structure including company age and size. the years ranging from setting up or start of the company until sample study period, because companies that have set up earlier might have accumulated better profitability and operational experiences, there is lower possibility of delisting (chen and lee, 1993). ohlson (1980) and chen and lee (1993) both agreed on the fact that the larger the companies in size, the more resources will be made available, therefore lesser possibility of financial distress, and lower delist probability. the impacts of financial structure indicate that short and long term solvency can also be used to evaluate a company’s capital dispatch ability. this study adopted liquidity ratio, ratio of operation fund to total assets, and ratio of operation cash flow to total debt to evaluate the company’s short term solvency. long term solvency is evaluated by leverage. ohlson (1980) discovered measurement of liquidity ratio has a significant effect on company failure rate. deakin(1972) and ohlson (1980) agreed that when the company is continuously in a loss state, operation fund could decrease, and when ratio of operation fund to total assets is lowered, the company’s short term solvency will deteriorate and thus higher possibility of delist. beaver (1966) stated that ratio of operation cash flow to total debt could evaluate the ability of company’s yearly cash flow to carry on total debt. the lower the ratio, the weaker the ability of cash flow to repay total debt, thus higher possibility of delist due to debt. ohlson (1980) indicated leverage has significant forecast ability towards corporate financial distress. if there are any problems in capital dispatch, then there is a high possibility of debt crash, thus higher delist possibility. using operation structure to evaluate asset efficiency can indicate whether assets have been effectively utilized. it not only is the key survival factor for corporations in the competitive market but also a major influential factor for companies with going concern. this study uses the ratio of retained earnings to total assets and ratio of market value to total debt for evaluation. altman (1968) used ratio of retained earnings to total assets to evaluate the level asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 313 of company’s profit accumulative ability. the lower the ratio is, the higher chances of companies being delisted. altman (1968) regarded the ratio of market value to total debt as an evaluation to represent the decrease in company asset value. low ratios mean company market value is relatively lower than total debt, thus there is a serious decrease in company asset value, leading to higher possibility of being delisted. in the analysis of this study on companies which have been issued with going concern, 26.45% of them are electronics listed companies. in order to consider the possible effect of industry variance, the paper controls the factor of electronic/non electronic companies on companies being delisted. additionally, the period of this study is 20 years. there were numerous major prosperity fluctuations within this period, for example 1990’s stock crash, 1998’s asian financial crisis, 1999 taiwan financial crisis and 2001’s internet bubble-bursting crisis. therefore there is a need for including macroeconomic structure’s effect in the analysis. this study set the variable using seasonal prosperity indications released by council for economic planning and development. quarter indicators above 23 points is 0, where 23 points is the lowest point for green light in prosperity indication. under 22 points is 1, to regulate the effects of macroeconomics to companies’ possibility of being delisted. 5. data and sample selection the observations are companies which have been issued their first going concern suspect reports after financial reports have been audited by auditor with signing of modified unqualified opinion, qualified opinion, or adverse opinion reports. relative explanatory variables, as extracted from tej (taiwan economic journal), are also used to construct the model to investigate company delist behaviors4. the time frame of this study started from 1988 to 2007, totaling 20 years or 80 quarters. due to the fact that generally there is a lapse of time for a company to experience financial difficulty to final delist stage, so the study model considered the date upon first issuance of going concern suspect until the delist date or until the study end date (right censored data) as “survival period”. all sample companies that had first issuance of going concern along with their delist dates are recorded to get the survival period of each company, using quarter as unit of measure, and the result is 155 records. if sample company’s first issuance of going concern suspect date and delist date both fell within the study period from 1988 to 2007, then this record is called “complete data” and is identified as “delisted or failure”. if observations’ delist date happened after the study period, it is called “incomplete data” because the company’s actual survival cannot be confirmed or determined within the set date of this study. this then will be identified as “not yet delisted’’ (right censored data). the survival period of this data will be from first issuance of going concern suspect date to study end date. table 1 is the sampling process of companies with going concerns suspect, criteria are 4 in 1999, before the announcement of generally accepted auditing standard no.33, besides qualified opinion or adverse opinion reports issued by accountants, disclaimer of opinion reports are also included for signature on going concern audit reports. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 314 company which received their first issuance of going concern suspect with complete financial reports and relevant information. this will exclude banking industry which adopts significantly different set of accounting standards, and companies which do not have complete financial reports or other relative information. finally, 155 companies met the selection standard and the data were used for this study. table 1. sample selection companies which have been issued with first going concern report within the period of 1988 to 2007 187 less: companies in banking industry 5 suitable observations 182 less: companies with incomplete financial reports or other relevant information 27 final observations 155 table 2 is the life table of these observations. taking nonparametric analysis of duration data to examine, the survival rate and hazard rate can be determined. data shows that most delisted companies’ survival period are between 18.8-22.5 quarter, totaling 20 companies, with hazard rate of 0.133. for delisted companies with survival period between 22.5-26.3 quarter, their survival rate will significantly drop, averaging only 0.3607. this means, based on company survival period, 36% of national listed companies have an average survival period until 19th to 23rd quarter (approx. 5-6 years) after they received first issuance of going concern. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 315 table 2. the life table of the sample survival period after going concern suspect enter right censored companies risk set delisted companies survival rate hazard rate 0.03.8 155 2 153 12 1.0000(0.000) 0.0205(0.006) 3.87.5 141 16 125 20 0.9259(0.021) 0.0460(0.010) 7.5-11.3 105 12 93 13 0.7790(0.035) 0.0238(0.008) 11.3-15.0 80 7 76 2 0.7123(0.039) 0.0071(0.005) 15.0-18.8 71 7 67 9 0.6937(0.040) 0.0381(0.013) 18.8-22.5 55 10 50 20 0.6012(0.045) 0.1333(0.029) 22.5-26.3 25 0 25 8 0.3607(0.050) 0.1016(0.035) 26.3-30.0 17 0 17 5 0.2453(0.048) 0.0920(0.041) 30.0-33.8 12 0 12 6 0.1731(0.043) 0.1778(0.068) 33.8-37.5 6 2 5 0 0.0866(0.033) 0.0000(0.000) 37.5-41.3 4 0 4 0 0.0866(0.003) 0.0000(0.000) 41.3-45.0 4 0 4 0 0.0866(0.033) 0.0000(0.000) 45.0-48.8 4 0 4 1 0.0866(0.033) 0.0762(0.075) 48.8-52.5 3 0 3 0 0.0649(0.031) 0.0000(0.000) 52.5-56.3 3 0 3 0 0.0649(0.031) 0.0000(0.000) 56.3-60.0 3 0 3 0 0.0649(0.031) 0.0000(0.000) 60.0-63.8 3 0 3 0 0.0649(0.031) 0.0000(0.000) 63.8-67.5 3 0 3 0 0.0649(0.031) 0.0000(0.000) 67.5-71.3 3 1 2 0 0.0649(0.031) 0.0000(0.000) 71.3-75.0 2 2 1 0 0.0649(0.031) 0.0000(0.000) note: figures in parentheses are p-values as the descriptive statistical in table 3, the average survival time for sampling companies is approx. 15 quarters. however, because some companies’ data is censored, so the above average survival period does not have meaningful implications. the average age of sampling companies is 13 quarters with standard deviation of 9.708, this means sampling companies did not centralize within a specific time frame from set up to early dates of this study. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 316 table 3. descriptive statistics and mean difference test variables mean median standard deviation mean difference survival period (quarter) 14.712 13 12.044 0.752 directors’ pledging ratio 0.260 0.042 0.336 -16.382** shareholding ratio by insiders 0.010 0.028 0.038 -0.654 audit system 0.202 0 0.403 -0.063* company age (years) 13.190 11 9.708 -0.487 company size 14.780 14.731 1.187 -0.308 liquidity ratio 0.681 0.596 0.445 8.969 ratio of operation fund to total assets -0.326 -0.233 0.592 28.432* ratio of operation cash flow to total debt -0.002 0.009 0.029 -0.088 leverage 0.899 0.828 0.443 -27.175* ratio of retained earnings to total assets -0.196 -0.202 0.370 5.263 ratio of market value to total debt 0.197 0.202 0.403 0.262** industry factor 0.255 0 0.437 0.048 economic prosperity 0.556 1 0.499 0.106 note: 1. ** means significant under 0.01 confidence level, * means significant under 0.05 confidence level. 2. mean difference means the difference between delisted companies and companies still in operation in 2007. 3. survival period is the time from first issuance of going concern report to delist. listed years refer to the years the companies were set up to the year of study end date. company size is natural logarithm of total assets. liquidity ratio is the ration of liquid asset to liquid debt. operation fund is the difference between liquid assets and liquid debt, operation fund to total assets ratio is the ratio of capital fund to total assets. capital fund to total assets is the ratio of capital fund to total assets. ratio of cash flow to total debt means the ratio of cash flow from business activities to total debt. directors’ pledging ratio is the ratio of pledged shares to total shares held by directors. shareholding ratio by insiders is the ratio of directors’ shares to outside shares. industry factor used electronic industry as 1 and non electronics as 0. audit system used the standard of no.33 and the announcement year of 1999 where after this announcement, it is 1, and before this year it is 0. economic prosperity is determined by council for economic planning and development of 0 when above 23 points (lowest point in green light) and 1 for below 22 points. the average ratio of directors’ pledging is 0.260 and it is quite different for each individual company, with standard deviation of 0.336, this is greater than the average. the companies which have been delisted and companies still in operation are vastly different in ratios such as directors’ pledge, leverage, market value to total debt, and capital fund to total assets. initial asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 317 analyses indicate that insufficient liquid capital, carrying on business based on high debt, and high directors’ pledge is the main factors contributing to companies being delisted. 6. empirical results the study subjects include taiwan listed companies which have been issued going concern suspect reports. the study time period is from 1988 to 2007. for companies which did not get delisted on dec. 31, 2007, they are placed on censored data because their actual survival period cannot be determined within the study date. analytical models include the parametric, semi-parametric and non-parametric models. theoretically speaking, if after statistical verification the study data followed a specific type of distribution, it will then be easier to explain its economic implications. therefore this study first uses parametric model, if it is not a fit distribution, then semi-parametric and non-parametric models will be used. the parameters of generalized f distribution are used to test which parameter model fitted the data survival period. after distribution verification, split model is used to estimate with the addition of explanatory variables. since the survival period of delisted companies cannot be determined by economic theories, this study will use generalized f distribution to test the alternative hypotheses m1≠1 and m2≠1. test results show m1 and m2’s estimate values are 3.534 and 60.542, z-values are 1.245 and 0.172 respectively. it is clear that under significant confidence level α=0.05, m1 and m2 equals 1 are fail to reject that it obeys log-logistic distribution. therefore this study infers that data distribution is closer to log-logistic distribution. due to the fact that not all companies will be delisted after first issuance of going concern suspect, this means the probability of delist will not equal to 1. therefore this study draws the assumption that failure rate of delist companies is less than 1. by importing split-population log-logistic model (split model in short), and also log-logistic model (standard model in short), the data are ready for comparison. to understand the risk functions faced by delisted companies, the results of the two models’ estimate parameters are listed in table 4. standard and split models’ σ value is 0.436 and 0.425 respectively, both significantly greater than 0. parameter ( 1 / )γ σ= are greater than 1, which means risk rate will start from first issuance of going concern suspect (t=0), then the rate will increase incrementally as time goes on, when reaches the maximum value, it will decrease gradually. risk function is shown as upside down u shaped. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 318 table 4. estimating log-logistic model and split-population log-logistic model variables movement expectation log-logistic model split-population log-logistic model constant 0.958 (0.065) 0.908 (0.067) directors’ pledging ratio + 0.479* (0.021) -0.379* (0.026) shareholding ratio by insiders － -0.152* (0.018) -0.831** (0.005) audit system － -0.213** (0.008) -0.226** (0.003) company age (year) － -0.021** (0.008) -0.033** (0.008) company size － -0.112 (0.072) -0.251 (0.072) liquidity ratio － 0.012 (0.212) 0.011 (0.213) ratio of operation fund to total assets － -0.009 (0.209) -0.009 (0.212) ratio of operation cash flow to total debt － -1.837 (0.376) -1.322 (0.362) leverage ratio + 0.129 (0.299) 0.104 (0.298) ratio of retained earnings to total assets － -0.368* (0.046) -0.454* (0.045) ratio of market value to total debt － -0.615** (0.008) -0.746** (0.007) industry factor ？ 0.168 (0.235) 0.192 (0.161) economic prosperity + 0.135 (0.328) 0.171 (0.211) σ 0.436** (0.004) 0.425** (0.002) δ 0.834** (0.007) note: 1. ** means significant under 0.01 confidence level, * means significant under 0.05 confidence level. p value in (). 2. listed years refer to the years the companies were set up to the year of study end date. company size is natural logarithms of total assets. liquidity ratio is the ration of liquid asset to liquid debt. operation fund is the difference between liquid assets and liquid debt, operation fund to total assets ratio is the ratio of capital fund to total assets. capital fund to total assets is the ratio of capital fund to total assets. ratio of cash flow to total debt means the ratio of cash flow from business activities to total debt. directors’ pledging ratio is the ratio of pledged shares to total shares held by directors. shareholding ratio by insiders is the ratio of directors’ shares to outside shares. industry factor used electronic industry as 1 and non electronics as 0. audit system used the standard of no.33 and the announcement year of 1999 where after this announcement, it is 1, and before this year it is 0. economic prosperity is determined by council for economic planning and development of 0 when above 23 points (lowest point in green light) and 1 for below 22 points. standard model assumes that the companies will be delisted at the end, so the setting of delist probability is 1. on the other hand, split model assumes that companies will continue operations, so the final delist probability is set as smaller than 1. it is clear from table 4 that the final delist estimate value is 0.834, and after verification, the result is significantly different to 1. therefore it is confirmed that standard model does not fit the assumption of companies will be delisted at the end, furthermore, the observations of this study cannot be asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 319 addressed appropriately. in regards to hazard function of the two models, it is clear that directors’ pledging ratio and the ratio of director’s ownership to hazard function are both significant and negatively related. in studies on corporate governance, directors’ pledging ratio and directors’ ownership can both be used to evaluate company equity structure. this indicates that to financial report users, when the company’s financial numbers are generally poor, one must seek other appropriate non financial indicators to evaluate whether the company can break away from operational difficulties. in so far as this study goes, when general company financial indicators are not performing, the importance of corporate governance is accentuated. on the other hand, audit system does. the results indicate that after the release of no. 33 bulletin, accountants are more graceful to the auditee in regards to standards of identifying on going concern. companies which have been issued going concern suspect after the release of no. 33 bulletin and have been delisted show average probability of company failure, which is lower than companies which have been issued going concern suspect before the release of no.33 bulletin. the ages affect hazard function in a significant and negative relation. at the same time, it is easier to raise capital in the market and lesser chance of being delisted even after the issuance of going concern suspect. generally speaking, larger companies have more resources and can survive through the crisis when there are going concerns. however, company size does not affect significantly hazard function, this means not only small size companied can be delisted after the issuance of going concern and that the chances for bigger size companies to survive through the crisis is not lower than smaller size companies. liquidity ratio and ratio of operation capital to total assets do not have significant effect on delist hazard. leverage ratio and ratio of cash flow to total debt coefficients are not significant as well. this may due to insufficient liquidity and unsound financial structure that are a common issue in these companies with going concern suspect. the coefficient of market value to total debt ratio is significant and is relatively negative. this will explain the fact that after the market publicized the going concern reports on these companies, share prices will fall and company value will diminish daily, making it even harder to shoulder its debt, in turn, the possibility to be delisted will rise. ratio of retained earnings to total assets had significant effect on hazard function and is negatively related, this means if the company improves operational performances, earnings can be accumulated thus reducing the possibility of being delisted. furthermore, industry factor and economic prosperity cannot be confirmed to have significant effect on delist probabilities. 7. conclusion this study observes listed companies that have been issued going concern suspect reports to investigate the process from first issuance to final delist stage. when split-population duration model is used to evaluate average probability of observations delist, the result is 83.4%. when the company was firstly issued with going concern report, in the 19th quarter, the company is exposed to greatest risk of delist. thus after first issuance of going concern suspect report, delist risk of companies is highest within the first 5 years, reaching to as high asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 320 as 7% in the fifth year. in regards to the factors that affects delist, besides “the ratio of market value to total debt” and “the ratio of retained earnings 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(1984). methodological issues related to the estimation of financial distress prediction model. journal of accounting research, 22(supplement), 59-82. microsoft word 6447-23021-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 451 evaluating earnings management in taiwan’s nonprofit hospitals using cross-sectional abnormal items models zhen-jia liu1 changzhou university, school of business e-mail: 2240328588@qq.com received: oct. 10, 2014 accepted: dec. 10, 2014 published: december 10, 2014 doi:10.5296/ajfa.v6i2.6447 url: http://dx.doi.org/10.5296/ajfa.v6i2.6447 abstract the purpose of this paper is to examine whether earnings management in the non profit hospitals of taiwan and analyze the earnings management behavior. we developed and tested the standard-jones, modified-jones, bd (abnormal bad debt), wca (abnormal working capital), norr (abnormal non-operating or non-revenue generating activity expenditure), and ngsp-models (abnormal net gain on the sale of property) to estimate the amount of abnormal accrual items or abnormal real items. empirical evidence suggested that the bd, norr and ngsp models may be used to determine levels of earnings management. thus, these models are ideal for determining how taiwan’s nonprofit hospitals manage their earnings. keywords: non-profit organization, earnings management, hospitals, taiwan 1changzhou city, jiangsu providence, china asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 452 1. introduction non-profit organizations are generally perceived to not have profit maximization as their operational goal because profit is not their critical concern (tan, 2011). there are fundamental differences between nonprofit organizations and for-profit entities. for example, because nonprofit organizations do not aim to generate profit, the majority of the revenue generated goes directly to the organization’s services (silverbo, 2004). typically, nonprofit managers ensure that public funds are used efficiently and effectively (ben-ner and gui, 2003). nonprofit use of non-distribution constraint reduces the likelihood that public funds will be used for private gain (weisbrod, 1988). instead the focus is on community health needs and social capital growth (bryce, 2005). however, managers of nonprofits organizations have also been increasingly concerned about managing organizational performance (speckbacher,2003; ritchie and kolodinsky, 2003; green and griesinger,1996; bielefeld,1992; kaplan,2001; kirk & nolan, 2010; calabrese,2013; buteau et al.,2014) and have suggested that nonprofit organizations focus on financial performance indicators, such as fundraising efficiency, public support, and fiscal performance (ritchie and kolodinsky 2003) because boards typically engage in resource-related activities including fundraising and making personal financial contributions (green and griesinger, 1996) or donations(li et al.,2012; yetman & yetman,2013); cost efficiency(hughes,2013) besides it, like other types of donor-based non-profit organizations, non-profit hospitals engage in business operations to maintain organizational sustainability while delivering social welfare. thus, managers of non-profit hospitals also must consider the organization’s financial performance (tan, 2011; singh & wheeler, 2012). this includes performing credit evaluations (leone and van horn,2005), managerial assessments (leone and van horn,2005), making donation decisions (frank et al.1990; leone and van horn,2005; tan,2011), contract negotiations (leone and lawrence,2005), determining tax status (krishnan and yetman,2011; leone and van horn,2005; eldenburg et al.2011 tan,2011), the level of governmental supervision (tan,2011), regulatory scrutiny (eldenburg et al.2011; eldenburg et al. 2004), obligations to stakeholders (eldenburg et al.2011) ; fundraising (erwin, 2013) nonprofit hospitals are also reported to make accounting adjustments to avoid small losses (ballantine et al.2007; leone and van horn,2005; frank et al.1990; hoerger,1991; leone and van horn, 2005; eldenburg et al. 2011; eldenburg et al. 2004; tan, 2011), break even (ballantine et al.2007), near zero (ballantine et al.2008; chang and tuckman, 1990), achieve decreased earnings (leone and van horn, 2005; eldenburg et al. 2004), and avoid large positive net incomes (eldenburg et al.2011). additionally, many nonprofit hospitals are known to adjust discretionary accruals (leone and van horn,2005; ballantine et al. 2007; eldenburg et al. 2004; tan, 2011), manipulate real activities (eldenburg et al. 2011; hoerger, 1991; leone and van horn, 2005; krishnan and yetman, 2011) and meet earnings objectives. an important issue in nonprofit hospital financial reporting is the extent to which managers manipulate reported earnings. accrual and real activities-based measures are now widely asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 453 employed in earnings management. the most frequently used techniques for achieving this separation are the standard jones2 (leone and van horn, 2005), modified jones3 (tan, 2011), bd4 (leone and van horn, 2005), wca (ballantine et al. 2007), norr5 (eldenburg et al. 2011) and ngsp models6 (eldenburg et al. 2011). regarding earnings management in nfp hospitals in taiwan, tan (2011) investigated whether earnings management occurred in nfp hospitals using financial data manually collected from foundation hospitals in taiwan between 2006 and 2008. by examining the distribution of reported income for a sample of 45 hospitals, based on the results of 133 annual reports, tan observed that nfp hospitals tend to manage their earnings at just above zero. that study also found that hospitals that receive donations from religious and business groups tend to manage earnings to a range just above zero. by contrast, huang and liu (2011) used non-profit proprietary hospitals in taiwan and the ordinary least squares method to test their hypothesis regarding earnings management behavior (that is, discretionary accruals play an active role in earnings management). the empirical results indicated that ceo duality (ceos also serving as chairmen) is negatively related to earnings management. thus, regarding earnings management, evidence suggests that the behavior of nfp hospitals is similar to that of fp organizations. because the optimal earnings management model for nfp hospitals in taiwan remains unclear in related literature. we develop and test an optimal model is evaluated in terms of specification7 (i.e., the probability of a type i error) and power8 (i.e., the probability of a type ii error). the remainder of the paper is organized as follows. section 2 presents a brief review of the related literature. section 3 provides details of the research design and sample selection procedure and develops our alternative model for estimating optimal earnings management. section 4 presents our empirical findings. section 5 contains a summary and conclusions. 2. literature review nonprofit hospitals adjust discretionary items to meet earnings objectives. hoerger (1991) predicted and found that nonprofit hospitals minimize the variance in reported earnings because they attempt to achieve a target level of earnings that satisfies the budget constraint. this suggests that managers can increase or decrease discretionary spending near the year’s end to get closer to desired profit levels. ballantine et al. (2007) used discretionary accrual models to show that english nhs hospitals reported profit and achieved the financial break-even point. eldenburg et al. (2011) determined earnings management in nonprofit hospitals through assessing their management of accruals and use of real activities (non-revenue-generating activities) to avoid reporting earnings that fall below or well above the zero-profit benchmark. furthermore, krishnan and yetman (2011) evaluate whether 2 discretionary accruals 3 discretionary accruals 4 bad debts 5 non-operating and non-revenue-generating activity accounts expenditures 6 net gain on the sales of property 7 peasnell et al. (2000) 8 peasnell et al. (2000) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 454 nonprofit hospital managers inflate program service expenses relative to fundraising, management, and general expenses, when program service expenses are described as being dedicated to any “activity of an organization that accomplishes its exempt purpose” (internal revenue service 2010). tan (2011) suggested that managers of nonprofit hospitals used discretionary accruals (estimated using aggregate accruals models and specific accruals models) to meet the earnings target. ballantine et al. (2008), who studied public sector nhs hospital trusts in the united kingdom, and chang and tuckman (1990), who examined nonprofit organizations in the united states, found that accrual management facilitates reported earning manipulation to achieve a low or no profit result. the different objectives of earnings manipulation may result in varying degrees of specification and power of discretionary items for earnings management. 3. methods the sample for this study was obtained from the department of health, executive yuan, and nfp hospitals (totaling 43) between 2005 and 2011 (sample size = 301). this study also adopted the regression method. a regression model was employed to analyze the data variables and research model used for this study; the results are described below. 3.1 measuring discretionary accruals ( itda ) it it it it it it it itit it asset medcaid asset medcare asset netrev assetasset bd εββββ + δ + δ + δ += δ −−−−− 1 4 1 3 1 2 1 1 1 . (1)9 it it it it it itit it asset nppe asset netrev assetasset jacc εβββ ++ δ += −−−− 1 3 1 2 1 1 1 …………………………. (2)10 it it it it itit itit it asset gppe asset arsales assetasset mjacc εβββ ++ δ−δ += −−−− 1 3 1 2 1 1 1 ……………..……. (3)11 it it it it it it it it it it it itit it asset nppe asset sales asset cfo asset cfo asset cfo assetasset wc εββββββ ++ δ ++++= δ −−− + −− − −− 1 6 1 5 1 14 1 3 1 12 1 1 1 ..(4)12 it it it itititit it it lasset salesassetnopredincreasedecrease lasset expend εββββββ +δ+++++=δ 543210 … (5)13 9 leone and van horn(2005), itdabd represents the discretionary of bad debt at time t using model 1 10 leone and van horn(2005), itdaj represents the discretionary accruals of the jones model (1991) at time t using model 2 11tan(2011), itdamj represents the discretionary accruals of the modified jones model at time t using model 3 12ballantine et al.(2007), itdawc represents the discretionary of working capital at time t using model 4 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 455 ititititititit gppesaleslassetabovezerobelowzerogain εββββββ ++δ++++= −1543210 ……. (6)14 discretionary items are frequently used in prior studies as a proxy for earnings management, for which the value of for measuring earnings management was adopted. 3.2 model specification15 we evaluate model specification by examining the extent to which each of the six cross-sectional models incorrectly rejects the null hypothesis of no earnings management. this is achieved using the following simulation procedure: (a) estimate the first stage regressions for each of the six models for each hospital in year t (b) select 25 firms at random from year t and construct an indicator variable (part) defined as one if the firm has been selected and zero otherwise; (c) randomize all observations in year t and compute abnormal discretionary items (adi) for each of the six models using the coefficient estimates obtained in (a); (d) estimate the following univariate regression for each measure of abnormal discretionary items iitit partadi εβα ++= and test whether the estimated coefficient on part is significantly different from zero16. steps (a)–(d) are then repeated 100 times for each sample year. since observations at stage (b) are selected at random, they should not be characterized by any systematic earnings management activity. as such, a well specified model is not expected to reject the null hypothesis of b=0 at rates that significantly exceed the appropriate test statistic (e.g., five percent or one percent levels). 3.3 power to detect earnings management17: we assess the power of alternative cross-sectional abnormal discretionary items models by 13eldenburg et al.(2011), itdanga represents the discretionary of non-operating or non-revenue-generating activity at time t using model 5 14 eldenburg et al. (2011), itdagsp represents the discretionary of net gain on property sales at time t using model 6. 15 peasnell et al. (2000) 16a part coefficient that is significantly different from 0 indicates that the selected firm (part = 1) conducts earnings management (management involving increasing or decreasing earnings), whereas a part coefficient that is not significantly different from 0 indicates no such management. 17 peasnell et al. (2000) itε asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 456 examining their ability to detect earnings management activity when it is known to exist. this is achieved by adding a pre-determined amount of positive discretionary items to the reported accruals of a randomly selected set of firms and then examining the ability of the models to detect this artificial earnings management. the procedure is similar to that described above for testing general model specification with the exception that at stage (b), artificial earnings are added to the reported accruals for firms where part equals18. as before, steps (a)–(d) are then repeated 100 times for each sample year. however, since the observations where part equals one are now known to contain earnings management activity, we would expect a powerful model to reject the null hypothesis that b=0, in favor of the alternative that rates at b≠0 significantly exceed the specified test level (type ii errors test). all else equal, the higher the rejection frequencies associated with a particular model, the more powerful that model is deemed to be at detecting earnings management activity. 4. results 4.1 descriptive statistics table 2 shows 19 that the discretionary accruals of the modified jones model and discretionary of net gain on property sales were negative, whereas discretionary of bad debt , discretionary accruals of the jones model (1991), discretionary of working capital, and discretionary of non-operating or non-revenue-generating activity were positive. the results also showed that the discretionary accruals of the modified jones model and discretionary accruals of net gain on property sales were income-decreasing performance-adjusted discretionary items. the discretionary accruals of bad debt, discretionary accruals of the jones model (1991), discretionary accruals of working capital, and discretionary accruals of non-operating or non-revenue-generating activity show that income-increasing performance adjusted the discretionary items of nfp hospitals in taiwan. tables 3 to 8 present descriptive statistics for the discretionary item models. because the standard-jones model (table 4) and modified jones model (table 5) are equivalent at the estimation stage, their coefficients in δ rev are positive from 2005 to 2011. however, the 18as such, the parameter estimates from the first stage regressions in part (a) are not contaminated by the artificially induced earnings. as explained in footnote 15, a part coefficient that is significantly different from 0 indicates the existence of earnings management, with part = 1, whereas in firms without earnings management, part = 0. 19 chen et al. (2011) indicated that is categorized into two groups 19 : a positive denotes that income-increasing performance-adjusted discretionary items and a negative denotes that income-decreasing performance-adjusted discretionary items. itε itε itε asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 457 δ rev magnitudes are typically considerably low, ranging from a high of 0.442 in 2011 to a low of -0.086 in 2006. moreover, the adjusted r-squared statistics ranged from a maximum of 33.5% in 2006 to a minimum of 9.8% in 2009. compared to the jones model, table 5 (modified jones model) also shows that the itsalesδ itarδ coefficient, representing changes in medical revenue minus the changes in account receivables, is positive for each year. the average itsalesδ itarδ magnitude is typically higher than that of the jones model, ranging from a high of 0.551 in 2007 to a low of 0.285 in 2008. moreover, the adjusted r-squared statistics ranged from a minimum of 12.5% in 2007, to a maximum of 34.1% in 2010. thus, on average, the modified jones model (table 5) has greater explanatory power than the jones model (table 4) does. however, table 6 (working capital model) shows that the adjusted r-squared statistics ranged from a minimum of 39.5% in 2007, to a maximum of 55.8% in 2010. on average, the working capital model was more effective than the jones model and modified jones model in measuring abnormal discretionary accrual items. in addition, the 1−itcfo coefficient was negative and the 1+itcfo was positive, suggesting that when the previous year does not have sufficient cash flow, taiwan’s nonprofit hospitals may conduct earnings management to maintain cash flow. we also discovered that when the following year has sufficient cash flow, the managers of taiwan’s nonprofit hospitals also conduct earnings management to protect against temporary fluctuation. ballantine et al. (2007) show that the 1−itcfo coefficient is non-significant; it is unclear whether the iitcfo + coefficient is positive or negative. these results highlight the differences between taiwan’s and england’s hospitals. we adopted three models to measure abnormal real discretionary items (bad debt model, non-operating or non-revenue-generating model, net gain on property sales model). table 3 (bad debt model) shows that the δ rev coefficient was positive each year except 2011, which was equivalent to the jones model. the average magnitude of δ rev ranged from -0.125 in 2006, to 0.417 in 2011. moreover, the adjusted r-squared statistics ranged from 27.9% in 2011, to 52.1% in 2010. table 7 (non-operating or non-revenue-generating model) shows that the adjusted r-squared statistics ranged from 26.6% in 2005, to 36.5% in 2011. the itincrease and itnopred coefficients were positive. eldenburg et al. (2011) showed that the itincrease and itnopred coefficients were non-significant. however, table 8 (net gain on property sales model) shows that the adjusted r-squared statistics ranged from 32.1% in 2005, to 51.4% in 2007. the itbelowzero and itabovezero coefficients were positive. eldenburg et al. (2011) showed that the itbelowzero coefficient is non-significant and the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 458 itabovezero coefficient is negative. thus, in comparison to eldenburg et al. (2011), we found that managers in taiwan’s hospitals tend to differ from managers in american hospitals. 4.2 model specification results of the discretionary accruals of the jones model, the discretionary accruals of the modified jones model, the discretionary of bad debt, the discretionary of working capital, the discretionary of non-operating or non-revenue-generating activity and the discretionary of net gain on property sales model assessments are presented in table 9. type i errors from one-tailed tests are reported for both the null hypothesis that abnormal accruals are greater than or equal to zero (alternative hypothesis: income-decreasing earnings management) and the null hypothesis that abnormal accruals are less than or equal to zero (alternative hypothesis: income-increasing earnings management). recall that since the sampling procedure helps ensure that firms where part equals one are unlikely to be characterized by systematic earnings management activity, a well-specified model should not reject the null hypothesis of no earnings management at rates that significantly exceed the test level (e.g., 5% or 1%). consistent dose not with the findings reported by dechow et al.(1995), the frequency of type i errors in table 9 corresponds to the specified test levels for only four models ( the discretionary accruals of the jones model, the discretionary of bad debt, the discretionary of non-operating or non-revenue-generating activity, the discretionary of net gain on property sales) in a binomial test fails to reject the null hypothesis that the observed rejection frequencies equal the specified test levels. these findings suggest that the discretionary accruals of the jones model, the discretionary of bad debt, the discretionary of non-operating or non-revenue-generating activity, the discretionary of net gain on property sales, and cross-sectional models appear well specified when applied to a random sample of firm-years. 4.3 power to detect earnings management this section conveys the artificially induced earnings management simulation results. table 10 provides information regarding the effectiveness of alternative models used to determine earnings management. the frequency of type ii errors in table 10 corresponds to the relative power test levels for the discretionary of bad debt, the discretionary of non-operating or non-revenue-generating activity and the discretionary of net gain on property sales in a binomial test and reject the null hypothesis that the observed rejection frequencies equal the specified test levels. these findings suggest that the abnormal bad debt, the abnormal non-operating or non-revenue generating activity expenditure, the abnormal net gain on the sale of property and cross-sectional models appear well relative power when applied to a random sample of firm-years. overall, tables 8 and 9 show that the standard jones, bd (abnormal bad debt), norr (abnormal non-operating or non-revenue-generating activity expenditure),, ngsp (abnormal net gain on property sales), and cross-sectional models are well-specified; the bd (abnormal bad debt), norr (abnormal non-operating or non-revenue-generating activity asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 459 expenditure), ngsp (abnormal net gain on property sales), and cross-sectional models appear to possess high relative power. thus, discretionary items (discretionary accruals and discretionary real spending) are evaluated differently regarding specification and power in relation to nfp hospitals in taiwan. 5. conclusion previous studies have focused on researching earnings management behavior in nonprofit hospitals in the uk and the u.s. however, the operational system and environment of hospitals in taiwan are significantly different from the cases studied and cannot therefore be considered equivalent. this study used the ordinary least square method and cross-sectional estimation procedures to examine power issues relating to the measurement of abnormal accruals and abnormal real items in taiwan’s nonprofit hospitals. we also developed and tested alternative procedures, labeled the discretionary accruals of the jones model, the discretionary accruals of the modified jones model, the discretionary of bad debt, the discretionary of working capital, the discretionary of non-operating or non-revenue-generating, the discretionary of net gain on property sales. the empirical results show that discretionary accruals of the jones model, discretionary of bad debt, discretionary of non-operating or non-revenue-generating and discretionary of net gain on property sales cross-sectional models appeared well specified. however, only the discretionary of bad debt, discretionary of non-operating or non-revenue-generating and discretionary of net gain on property sales cross-sectional models appeared well relative power when applied to a random sample of firm-years. empirical solutions show that the discretionary of bad debt, discretionary of non-operating or non-revenue-generating, and discretionary of net gain on property sales are ideal for evaluating earnings management in taiwan’s nonprofit hospitals. non-profit hospitals have different goals, management, and manager enticement. all of which lead to differences in financial reports. because of the special environment, non-profit hospitals in taiwan often make complex. most of non-profit hospitals (especially medical centers or institution-owned hospitals) have positive net income and even more than other industries were. the department of health, executive yuan, and taiwan (doh) adopts the so-called revenue-increased system. it leads to burden citizen’s insurance costs. it is a serious puzzle. earnings management and the source of revenue for hospitals are possible reasons for this, as well as the possibility of an unbalanced insurance system. future studies should consider refining the measurement of the earnings management model because not all of them are equal, and it is unlikely that the consequences of engaging in earnings management are equal in all non profits hospitals. in addition, researchers should examine which magnitude is optimal for earnings management in the discretionary of bad debt, discretionary of non-operating or non-revenue-generating and discretionary of net gain on property sales models. subsequent research should keep track of these trends and analyze the degree of earnings manipulation. thus, the research will cover a complete study of earnings management in not for profit hospitals. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 460 references ballantine, j., forker, j., & greenwood, m. 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(2013). how does the incentive effect of the charitable deduction vary across charities? the accounting review, 88(3), 1069-1094. table 1. definition of variables variable definition itbdδ the change in bad debt expenses for year t the change in net revenue for year t the change in medicare revenue (revenue collected by hospitals through national medical insurance) for year t the change in medicaid revenue for year t itjacc the total accruals calculated as the change in non-cash current assets minus the change in current liabilities for year t-1 to year t and minus the depreciation expenses for year t 1−itasset the total assets in year t-1 itnppe the net property, plants, and equipment at the end of year t itmjacc the total accruals calculated as the continuing operating net profit (medical net profit) minus the cash flow from operations for year t the change in medical revenue for year t the change in account receivables for year t itgppe the gross fixed assets for year t; itnetrevδ itmedcareδ itmedcaidδ itsalesδ itarδ asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 463 the change in working capital accruals = (the change in current non-cash assets minus the change in current liabilities) for year t the cash flow from operations for year t-1 the cash flow from operations for year t the cash flow from operations for year t+1 change in non-operating or non-revenue-generating activity expenditure for t-1 to t 1 if pre-management20 income/total assets are within or above the benchmark range (income/total assets[0,0.04]) for year t, and 0 otherwise 1 if pre-management21 income/total assets exceed the benchmark range (income/total assets[0,0.04]) for year t, and 0 otherwise 1 if pre-management22 income/total assets are below the benchmark range (income/total assets[0,0.04]) for year t, and 0 otherwise itlasset log of the total assets for year t 1 if the hospitals reports a net gain on the sale of property in year t, 0 otherwise 1 if pre-managed23 income/total assets are to the left of the benchmark range (income/total assets < 0.0) for year t, 0 otherwise 1 if pre-managed24 income/total assets are to the left of the benchmark range (income/total assets 0.04) for year t, 0 otherwise 1−itgppe gross property, plants, and equipment for year t-1 20 we begin by calculating net income before spending on non-operating or non-revenue-generating activity (eldenburg et al., 2011). 21 we begin by calculating net income before spending on non-operating or non-revenue-generating activity (eldenburg et al., 2011). 22 we begin by calculating net income before spending on non-operating or non-revenue-generating activity (eldenburg et al. 2011). 23 we begin by calculating net income before net gain on property sales activity (eldenburg et al., 2011). 24 we begin by calculating net income before net gain on property sales activity (eldenburg et al.2011). itwcδ 1−itcfo itcfo 1+itcfo itexpendδ itdecrease itincrease itnopred itgain itbelowzero itabovezero ≥ asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 464 table 2. descriptive statistics—all samples variables definition max min avg itdabd the discretionary of bad debt 0.93793 -0.1292 0.09173 itdaj the discretionary accruals of the jones model (1991) 0.86116 -0.2441 0.12279 itdamj the discretionary accruals of the modified jones model 0.27624 -11.244 -0.2921 itdawc the discretionary of working capital 0.66028 -1.2059 0.003 itdanga the discretionary of non-operating or non-revenue-generating activity 0.06776 -0.0106 0.01188 itdagsp (ten million) the discretionary of net gain on property sales 6.703 -12.745 -8.179 table 3. descriptive statistics for the estimated cross section for each hospital and year combination: the discretionary of bad debt it it itt it itt it itt it t it it ta medcaid ta medcare ta netrev tata baddebt εββββ +δ+δ+δ+=δ −−−−− 1 3 1 2 1 1 1 0 1 year t0β t1β t2β t3β 2r f value 2005 -0.058 0.175* 0.457*** -0.325** 0.427 15.51 2006 -0.156 0.315** 0.477** -0.448** 0.385 14.41 2007 0.305* 0.417** -0.205 -0.483*** 0.321 15.48 2008 0.258* 0.289** 0.345** 0.153 0.352 15.21 2009 0.215* 0.307*** 0.179 -0.248** 0.285 14.41 2010 0.205*** 0.341*** -0.225 -0.283** 0.521 14.84 2011 0.458*** -0.125 0.245** -0.332* 0.279 15.66 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 465 table 4. descriptive statistics for the estimated cross section for each hospital and year combination: the discretionary accruals of the jones model year it it itt it itt it t it it ta ppe ta netrev tata acc εβββ ++δ+= −−−− 1 2 1 1 1 0 1 t0β t1β t2β 2r f value 2005 -0.061 0.032*** -0.026*** 0.242 15.645 2006 0.056 -0.086 -0.126** 0.135 11.064 2007 0.067 0.364*** 0.084 0.173 16.688 2008 -0.212** 0.051 -0.230** 0.135 15.16 2009 -0.061** 0.032 -0.026 0.098 15.645 2010 -0.056** 0.086** -0.126 0.109 11.125 2011 -0.047 0.442*** 0.054 0.155 16.147 table 5. descriptive statistics for the estimated cross section for each hospital and year combination: the discretionary accruals of the modified jones model year it it it it itit itit it ta ppe ta arsales tata acc εβββ ++δ−δ+= −−−− 1 2 1 1 1 0 1 t0β t1β t2β 2r f value 2005 -0.372*** 0.314*** -0.194** 0.313 11.235 2006 -0.233** 0.361*** -0.259** 0.258 12.347 2007 -0.191* 0.285** -0.211** 0.125 10.256 2008 -0.255** 0.551*** 0.144 0.242 12.335 2009 0.237 0.331*** -0.364** 0.231 13.578 2010 -0.342*** 0.425*** -0.321** 0.341 14.215 2011 -0.405** 0.375** -0.245* 0.159 11.243 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 466 table 6. descriptive statistics for the estimated cross section for each hospital and year combination: the discretionary of working capital year it it it it it it it it it it it itit it ta ppe ta rev ta cfo ta cfo ta cfo tata wc εββββββ ++δ++++=δ −−− + −− − −− 1 5 1 4 1 1 3 1 2 1 1 1 1 0 1 t0β t1β t2β 3β 4β 5β 2r f 2005 0.668* -1.161*** -0.865*** -0.097 0.713** -0.523 0.512 11.25 2006 0.557** -0.962*** -0.765 0.916 0.581** 0.433 0.412 10.03 2007 0.782** -0.741** 0.235 -0.095 0.642* 0.758* 0.395 12.46 2008 0.421** -0.689*** -0.125 0.126 0.359* -0.658 0.405 13.25 2009 0.325* -0.558*** 0.339 0.436** 0.451** -0.648 0.458 11.25 2010 0.741*** -0.641** -0.425 -0.256 0.745*** 0.614* 0.558 10.48 2011 0.653** -0.569** 0.432 0.256* 0.162* 0.558 0.358 11.12 table 7. descriptive statistics for the estimated cross section for each hospital and year combination: the discretionary of non-operating or non-revenue-generating activity year it it it itititit it it asset salesassetnopredincreasedecrease asset expend εββββββ + δ +++++= δ 543210 t0β t1β t2β 3β 4β 5β 2r f 2005 0.068** 0.083 0.024 -0.067 0.092** -0.019 0.266 10.1 2006 -0.056 -0.075** 0.125*** 0.069** 0.059* 0.036 0.285 10.5 2007 -0.024 -0.156* 0.085* -0.058 0.125** 0.154** 0.275 11.2 2008 -0.078 0.099 0.256*** 0.139** -0.025 0.339*** 0.295 12.3 2009 0.069 -0.275** 0.342*** 0.354*** -0.056 0.114* 0.352 13.5 2010 -0.055 -0.062* 0.156** 0.342*** -0.072 0.245*** 0.328 11.5 2011 0.048 -0.352*** -0.056 0.415*** 0.125* 0.128** 0.365 10.2 table 8. descriptive statistics for the estimated cross section for each hospital and year combination: the discretionary of net gain on property sales year ititititititit ppesalesassetabovezerobelowzerogain εββββββ ++δ++++= −1543210 t0β t1β t2β 3β 4β 5β 2r f 2005 0.659*** 0.054* -0.039 0.0115 0.085** 0.006 0.321 12.5 2006 0.528*** 0.412*** 0.504**** 0.525*** 0.426*** 0.312*** 0.558 12.3 2007 0.652*** 0.185** 0.142* -0.051 0.235** 0.215** 0.514 11.5 2008 0.248** 0.254*** 0.236** -0.014 -0.129 0.159 0.375 10.2 2009 0.445*** 0.441** 0.412** 0.262 0.321* -0.115 0.435 11.2 2010 0.512*** -0.109 0.352** 0.325** 0.243* -0.058 0.421 10.9 2011 0.345** 0.524*** 0.125 0.434** 0.159* 0.123 0.455 11.3 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 467 table 9. comparison of type i error rates for abnormal accruals estimated using the discretionary accruals of the jones model, the discretionary accruals of the modified jones model, the discretionary of bad debt, the discretionary of working capital, the discretionary of non-operating or non-revenue-generating activity, the discretionary of net gain on property sales. percentage of 700 randomly selected firm-years for which the null hypothesis of no earnings management is rejected using a one-tailed test simulations for each abnormal accrual model are performed using 100 random samples of 25 firms in each of the seven sample years (2005-2011), resulting in a total of 700 simulations per model. * significantly different from the specified test level at the 5 percent level ** significantly different from the specified test level at the 1 percent level using a two-tailed binomial test. alternative hypothesis income increasing accruals income decreasing accruals null hypothesis earnings management 0≥ earnings management 0≤ test level 5% 1% 5% 1% the discretionary accruals of the jones model 6.25% 1.25% 5.17% 1.36% the discretionary accruals of the modified jones model 4.52% 0.52% 4.22% 0.78% the discretionary of bad debt 5.25% 1.98% 5.17% 1.59% the discretionary of working capital 4.17% 0.59% 4.45% 0.88% the discretionary of non-operating or non-revenue-generating activity 5.55% 1.25% 5.21% 1.18% the discretionary of net gain on property sales 5.71% 1.43% 5.43% 1.63% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 468 table 10. comparison of type ii error rates for abnormal accruals estimated using the discretionary accruals of the jones model, the discretionary accruals of the modified jones model, the discretionary of bad debt, the discretionary of working capital, the discretionary of non-operating or non-revenue-generating activity, the discretionary of net gain on property sales. percentage of 700 randomly selected. firm-years for which the null hypothesis of no earnings management is rejected using a one-tailed test alternative hypothesis income increasing accruals income decreasing accruals null hypothesis earnings management 0≥ earnings management 0≤ test level 5% 1% 5% 1% the discretionary accruals of the jones model 5.15% 1.26% 5.28% 1.58% the discretionary accruals of the modified jones model 5.26% 1.37% 5.59% 1.76% the discretionary of bad debt 4.18% 0.58% 4.15% 0.85% the discretionary of working capital 5.17% 1.35% 5.33% 1.85% the discretionary of non-operating or non-revenue-generating activity 4.27% 0.62% 4.25% 0.77% the discretionary of net gain on property sales 4.39% 0.75% 4.05% 0.68% simulations for each abnormal accrual model are performed using 100 random samples of 25 firms in each of the seven sample years (2005-2011), resulting in a total of 700 simulations per model. * significantly different from the specified test level at the 5 percent level. ** significantly different from the specified test level at the 1 percent level microsoft word 3945-14732-1-sm-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 126 a comparison of itm and otm protective-puts and covered-calls mihir dash department of quantitative methods, school of business, alliance university chikkahagade cross, chandapura-anekal road, anekal, bangalore e-mail: mihirda@rediffmail.com ankush goel research scholar, school of business, alliance university chikkahagade cross, chandapura-anekal road, anekal, bangalore received: june 30, 2013 accepted: march 4, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.3945 url: http://dx.doi.org/10.5296/ajfa.v6i1.3945 abstract the diverse uses of derivatives arise from the skewing effect that options strategies have on the returns distribution of portfolios. in particular, it is widely believed that the performance of pure-stock portfolios can be enhanced by incorporating different options strategies, the most popular strategies being protective-put buying and covered-call writing. the present study considers these two popular options strategies, and applies them to a sample of fifty-five stocks listed in national stock exchange f&o segment, using corresponding stock options, in order to find out which of these strategies yields maximum returns, as compared to a pure-stock position. the study also compares the performance of in-the-money (itm) and out-of-the-money (otm) protective-put buying and covered-call writing. the results of the study suggest that protective-put buying performs better overall than covered-call writing, and that the mean and standard deviation of the returns distribution of the underlying stock affected the optimal strategy: buying protective-puts was optimal for stocks for which the returns distribution had relatively higher mean values and lower standard deviations, while selling covered-calls was optimal for stocks for which the returns distribution had relatively lower mean values and higher standard deviations. keywords: derivatives, options strategy, covered-call writing, protective put buying, in-the-money (itm), out-of-the money (otm) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 127 introduction derivatives, which were originally introduced as financial instruments to hedge financial risk, are now increasingly used for speculative purposes as well. the diverse uses of derivatives arise from the skewing effect that options strategies have on the returns distribution of portfolios. in particular, it is widely believed that the performance of pure-stock portfolios can be enhanced by incorporating different options strategies, the most popular strategies being covered-call writing and protective-put buying. theoretically and empirically, however, there is no clear evidence on whether this is really the case. the general framework suggested by hakanson (1978), cox (1976) and ross (1976) indicates that incorporating option strategies enhances the general efficiency of financial markets by increasing the number of investment opportunities available to investors in terms of insurance and hedging. on the other hand, options can themselves be used as short-term investment instruments, and can improve portfolio performance when used speculatively (dash et al, 2007). the present study investigates the effect of option buying and writing strategies on the returns of an (unhedged) stock position. the objective of the study was to find out the optimal strategies (i.e. that yield maximum returns), to compare the returns of covered-call and protective-put strategies, and to compare the returns of itm and otm options combinations. literature review several studies compare the performance of pure-stock positions with that of stock positions combined with options, and the performance of different option strategies. trennepohl and dukes (1981) investigated the performance of option writing and buying strategies using in-the-money (itm) and out-of-the-money (otm) options, and found that covered option writing lowers portfolio standard deviation and improves portfolio mean returns. bookstaber and clarke (1984) compared the performance of protective-put, covered-call, and pure-stock strategies, and found that call writing is better than put buying in terms of expected return and volatility, but that the former truncates the right-hand side of a distribution causing undesirable negative skewness, while put-buying truncates the left-hand side of a distribution causing desirable positive skewness. castellano and giacometti (2001) compared the performance of protective-put and covered-call strategies to the performance of holding an unhedged currency portfolio and found that the option strategies perform better than the optimal naked portfolios and the protective-put strategy performs well for different var models. isakov and morard (2001) investigated the performance of a global investment strategy that combines diversification and option strategies, in particular the covered call strategy, and found that the use of option strategies consistently improves the performance of stock portfolios, even in the presence of transaction costs. abid et al (2009) investigated the performance of option strategies, including writing otm covered-call and buying itm protective put, with that of the pure-stock investment, and found that, in general, the buying itm protective-put strategy has the best performance, followed by the writing otm covered-call strategy, both out-performing the naked stock. some studies show that the performance of option strategies with stock portfolios could depend on other factors or on market conditions. benninga and blume (1985) analyzed the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 128 optimality of portfolio insurance in complete and incomplete markets, and found that buying put option may be optimal only in an incomplete market, not in a complete market. brooks and hand (1988) examined the return characteristics of index futures contracts, and found that both the return distribution and performance evaluation depend on the risk-free rate, the dividend rate, the basis and the margins. the current study follows the approach of dash et al (2008), who have also analysed the effect of options strategies on a pure-stock position. they identified two types of optimal options strategies: one which yielded highest returns at the lowest strike price (5% below the initial stock price) and for which the returns decreased with increase in strike price; and one which yielded highest returns at the highest strike price (5% above the initial stock price) and for which the returns decreased with decrease in strike price, termed as “optimal in the first sense” and “optimal in the second sense,” respectively. the results of their study show that two were two strategies that were optimal more than 60% of the time: “hold stock, buy call” (in the first sense), and “hold stock, sell put” (in the second sense); and that these two strategies were very strongly associated with each other. in fact, the covered-call and protective-put strategies, which were so widely investigated in the literature, were optimal only to a marginal extent (0.8% of the time). further, the optimal strategies were found to be discriminated by the standard deviation, the skewness, and the kurtosis of the daily returns of the underlying stock; and the returns of the optimal strategies were found to be related to the kurtosis of the daily returns of the underlying stock. in particular, skewness and kurtosis in the daily returns of the underlying stock tended to favour to more aggressive options positions, suggesting that the optimal strategies were influenced by abnormal tail behaviour of the daily returns of the underlying stock. overall from the literature it can be concluded that option introduction improves the performance of portfolios significantly, but there are mixed results concerning whether covered-calls or protective-puts perform better. the present study addresses this question explicitly. data & methodology the present study was undertaken to analyse the effect of options strategies on a pure-stock position. to this end, two stock-option combinations were considered: buying protective-puts (i.e. holding the stock, and buying a put-option on the same stock) and selling covered-calls (i.e. holding the stock, and writing a call-option on the same stock). the sample stocks used for the study were those stock listed on the national stock exchange (nse), mumbai, india, for which the corresponding derivatives were actively traded on the national stock exchange futures & options segment, thus constituting a judgmental sample. the sample size was fifty-five such stocks. the time period considered for the study was 1st october 2007 to 27th december 2007. the option-stock combinations considered for the study were static strategies: it was assumed that, for a particular option-stock combination, the position was entered on the first day of the study period and maintained until expiration on the last day of the study period. the data used for the study consisted of the opening prices of the stocks and option premia of the stock asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 129 options at different strike prices on the first day of the study period and the closing prices of the stocks on the last day of the study period obtained from the nse archives. for each stock option, five strike prices were available initially: at par with the initial stock price, 2% below the initial stock price, 5% below the initial stock price, 2% above the initial stock price, and 5% above the initial stock price. in this context, for each stock, the option strategies were classified as either in-the-money (itm) or out-of-the-money (otm) strategies, at the time of entering into the contract. for each stock-option combination, returns were computed as the excess of the payoff from the stock-option combination over the payoff from the pure-stock position, in proportional terms. analysis & interpretation it was found that for 94.55% of the sample stocks, the stock-option combinations overall yielded higher returns as compared to a pure-stock position. in particular, buying itm protective-puts yielded higher returns as compared to a pure-stock position for 56.36% of the sample stocks; buying otm protective-puts yielded higher returns as compared to a pure-stock position for 58.18% of the sample stocks; selling otm covered-calls yielded higher returns as compared to a pure-stock position for 36.36% of the sample stocks; and selling itm covered-calls yielded higher returns as compared to a pure-stock position for 34.55% of the sample stocks. overall, it was found that buying itm protective-puts were optimal for 32.73% of the sample stocks; buying otm protective-puts were optimal for 25.45% of the sample stocks; selling otm covered-calls were optimal for 29.09% of the sample stocks; and selling itm covered-calls were optimal for 12.73% of the sample stocks. thus, buying protective-puts was optimal for 58.18% of the sample stocks, while selling covered-calls was optimal for 41.82% of the sample stocks. comparing the returns from the different options combinations, it was found that selling itm covered-calls yielded better returns than selling otm covered-calls for 45.45% of the sample stocks, and vice versa for 54.55% of the sample stocks; selling itm covered-calls yielded better returns than buying itm protective-puts for 38.18% of the sample stocks, and vice versa for 61.82% of the sample stocks; selling itm covered-calls yielded better returns than buying otm protective-puts for 40.00% of the sample stocks, and vice versa for 60.00% of the sample stocks; selling otm covered-calls yielded better returns than buying itm protective-puts for 43.64% of the sample stocks, and vice versa for 56.36% of the sample stocks; selling otm covered-calls yielded better returns than buying otm protective-puts for 43.64% of the sample stocks, and vice versa for 56.36% of the sample stocks; and buying itm protective-puts yielded better returns than initial buying otm protective-puts for 54.55% of the sample stocks, and vice versa for 45.45% of the sample stocks. in fact, two specific patterns were observed very frequently: for 29.09% of the sample stocks, buying itm protective-puts yielded higher mean returns than buying otm protective-puts, which in turn yielded higher mean returns than selling itm covered-calls, which further yielded higher mean returns than selling otm covered-calls, and for 23.64% of the sample stocks, buying otm protective-puts yielded higher mean returns than buying itm protective-puts, which in asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 130 turn yielded higher mean returns than selling otm covered-calls, which further yielded higher mean returns than selling itm covered-calls. the comparison of returns of the different stock-option combinations is presented in table 1. table 1. correlation and t-tests for differences in returns of different stock-option strategies strategy pairs mean std. dev. paired-samples correlation p-value paired-samples t-test for means p-value pair 1 sell itm covered-call -1.2955 2.3326 0.8583 0.0000 0.2479 0.8052 sell otm covered-call -1.3400 2.5823 pair 2 sell itm covered-call -1.2955 2.3326 -0.4888 0.0002 -3.6247 0.0006** buy itm protective-put 0.9482 2.9749 pair 3 sell itm covered-call -1.2955 2.3326 -0.4366 0.0009 -3.2633 0.0019** buy otm protective-put 0.5840 2.7019 pair 4 sell otm covered-call -1.3400 2.5823 -0.7148 0.0000 -3.2965 0.0017** buy itm protective-put 0.9482 2.9749 pair 5 sell otm covered-call -1.3400 2.5823 -0.5656 0.0000 -3.0517 0.0035** buy otm protective-put 0.5840 2.7019 pair 6 buy itm protective-put 0.9482 2.9749 0.9509 0.0000 2.9068 0.0053** buy otm protective-put 0.5840 2.7019 it was found that the returns from the protective-put combinations were negatively correlated to the returns from the covered-call combinations. further, overall, buying itm protective-puts yielded the highest mean returns, followed by buying otm protective-puts, selling itm covered-calls, and finally, selling otm covered-calls. in fact, the mean returns from itm protective-puts were significantly higher than those of other strategies, and the mean returns from buying protective puts were significantly higher than the mean returns from selling covered-calls. also, the mean returns from buying itm protective-puts were found to be significantly higher than the mean returns from buying otm protective-puts; while there was no significant difference in the mean returns from selling itm and otm covered-calls. in order to further investigate the different optimal strategies, the relationships between the optimal strategies and the characteristics of the returns distribution of the underlying stock were analysed. the characteristics of the returns distribution of the underlying stock for different optimal strategies are shown in table 2 and table 3. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 131 table 2. characteristics of the returns distribution of underlying stocks for different stock-option strategies buy itm protective-put buy otm protective-put sell itm covered-call sell otm covered-call overall f-test p-value mean stock returns 0.6224% 0.2118% 0.3940% 0.4287% 0.4325% 1.6087 0.0994* stdev stock returns 4.0133% 3.0578% 3.4651% 3.1631% 3.4530% 1.8584 0.0742* skewness stock returns 0.6256 0.2603 -0.2041 0.4101 0.3643 0.8871 0.2272 kurtosis stock returns 2.5243 4.4215 3.5436 1.3707 2.8014 0.6860 0.2824 table 3. characteristics of the returns distribution of underlying stocks for buying protective puts vs. selling covered-calls buy protective-puts sell covered-calls overall f-test p-value. mean stock returns 0.4428% 0.4181% 0.4325% 0.0278 0.4341 stdev stock returns 3.5953% 3.2550% 3.4530% 0.8960 0.1741 skewness stock returns 0.4658 0.2231 0.3643 0.5693 0.2269 kurtosis stock returns 3.3544 2.0320 2.8014 0.6516 0.2116 there were found to be significant differences in the mean stock returns and standard deviation of stock returns for different optimal strategies, but no significant difference in the skewness and kurtosis of stock returns for different optimal strategies. the optimal strategy of buying itm protective-puts was found to be associated with high mean returns, high standard deviation of returns, moderate positive skewness, and slight platy-kurtosis; the optimal strategy of buying otm protective-puts was found to be associated with low mean returns, moderate standard deviation of returns, slight positive skewness, and slight lepto-kurtosis; the optimal strategy of selling itm covered-calls was found to be associated with moderate mean returns, moderate standard deviation of returns, moderate negative skewness, and slight lepto-kurtosis; and the optimal strategy of selling otm covered-calls was found to be associated with moderate mean returns, moderate standard deviation of returns, moderate positive skewness, and moderate platy-kurtosis. there were found to be no significant difference in the mean stock returns, standard deviation of stock returns, skewness of stock returns, and kurtosis of stock returns between optimal buying protective-puts and optimal selling covered-calls; optimal buying protective-puts was found to be associated with higher skewness and kurtosis than optimal selling covered-calls. the results of regression analysis of optimal returns on the characteristics of the distribution of the underlying stock are shown in table 4. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 132 table 4. regression of optimal returns on the characteristics of the distribution of underlying stocks unstandardized coefficients standardized coefficients t-test p-value mean stock returns -232.9297 -0.5212 -2.4160 0.0193* stdev stock returns 80.7126 0.9729 4.0223 0.0002** skewness stock returns 0.0971 0.0386 0.2776 0.7824 kurtosis stock returns 0.0157 0.0335 0.2178 0.8284 the standard deviation of returns and the mean returns of the underlying stock were found to have significant impact on the optimal returns, while the skewness and kurtosis of returns of the underlying stock were not found to have a significant impact on the optimal returns. moreover, the optimal returns were found to be positively correlated with the standard deviation of returns of the underlying stock, other characteristics remaining constant, and negatively correlated with the mean returns of the underlying stock, other characteristics remaining constant. together, the characteristics of the returns distribution of the underlying stock explained 42.1% of the variation in optimal returns. the results of regression analysis of the optimal strategy on the characteristics of the distribution of the underlying stock are shown in table 5. table 5. regression of optimal strategy on the characteristics of the distribution of underlying stocks unstandardized coefficients standardized coefficients t-test p-value mean stock returns -30.6465 -0.3246 -1.4593 0.1506 stdev stock returns 18.1371 1.0350 4.1495 0.0001** skewness stock returns -0.0839 -0.1578 -1.1010 0.2761 kurtosis stock returns -0.0291 -0.2949 -1.8589 0.0688* the standard deviation of returns, the mean returns, and the kurtosis of returns of the underlying stock were found to have significant impact on the optimal returns, while the skewness of returns of the underlying stock was not found to have a significant impact on the optimal strategy. moreover, the optimal strategy was more likely to involve buying protective-puts for lower standard deviation of returns of the underlying stock and selling covered-calls for higher standard deviation of returns, other characteristics remaining constant; and vice versa for the other characteristics. together, the characteristics of the returns distribution of the underlying stock explained 38.4% of the variation in optimal strategy. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 133 the results of regression analysis of the optimal strategy on the dominance relations between different strategies are shown in table 6. table 6. regression of optimal strategy on the dominance relations between different strategies unstandardized coefficients standardized coefficients t-test p-value otm covered-call dominates otm protective-put 0.4000 0.4086 5.8878 0.0000** otm covered-call dominates itm protective-put 0.4000 0.4086 5.8878 0.0000** itm covered-call dominates itm protective-put 0.2000 0.1911 3.4084 0.0013** the optimal strategy was found to be significantly affected by three dominance relations: otm covered-calls dominating over otm protective-puts, otm covered-calls dominating over itm protective-puts, and itm covered-calls dominating over itm protective-puts. if all three of these relations hold, then selling covered-calls is optimal; while if none of these relations hold, buying protective-puts is optimal. the weights indicate that the first two dominance relations are twice as important as the third dominance relation in affecting the optimal strategy. together, these three dominance relations explained 98.3% of the variation in optimal strategy. the results of discriminant analysis of the optimal strategy on the characteristics of the distribution of the underlying stock are shown in table 7. table 7. discriminant analysis of optimal strategy on the characteristics of the distribution of underlying stocks canonical discriminant function standardized coefficients unstandardized coefficients mean stock returns -1.7087 -315.8150 stdev stock returns 1.7244 131.1379 skewness stock returns 0.8221 0.6990 kurtosis stock returns 0.0781 0.0130 (constant) -3.4535 values at centroids buy protective-puts 0.2321 sell covered-calls -0.3230 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 134 the standard deviation of returns and the mean returns of the underlying stock were found to have significant impact on the optimal strategy, followed by the skewness of returns and the kurtosis of returns of the underlying stock. moreover, the optimal strategy was more likely to involve selling covered-calls for lower standard deviation of returns of the underlying stock and buying protective-puts for higher standard deviation of returns, other characteristics remaining constant; and vice versa for the mean returns of the underlying stock. the discriminant function correctly classified 50.9% of the sample stocks. the results of discriminant analysis of selling itm covered-calls and selling otm covered-calls on the characteristics of the distribution of the underlying stock are shown in table 8. table 8. discriminant analysis of selling itm and otm covered-calls on the characteristics of the distribution of underlying stocks canonical discriminant function standardized coefficients unstandardized coefficients mean stock returns 1.0357 196.0300 stdev stock returns -1.9970 -157.1348 skewness stock returns 0.2940 0.2487 kurtosis stock returns 0.8668 0.1438 (constant) 4.0848 values at centroids sell otm covered-calls 0.3199 sell itm covered-calls -0.3838 the standard deviation of returns, the mean returns, and the kurtosis of returns of the underlying stock were found to have significant impact on the dominance relation between itm covered-calls and otm covered-calls, followed by the skewness of returns of the underlying stock. moreover, selling otm covered-calls was more likely to dominate selling itm covered-calls for lower standard deviation of returns of the underlying stock and vice versa for higher standard deviation of returns, other characteristics remaining constant; and vice versa for the mean returns and the kurtosis of returns of the underlying stock. the discriminant function correctly classified 63.6% of the sample stocks. the results of discriminant analysis of buying itm protective-puts and buying otm protective-puts on the characteristics of the distribution of the underlying stock are shown in table 9. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 135 table 9. discriminant analysis of buying itm and otm protective-puts on the characteristics of the distribution of underlying stocks canonical discriminant function standardized coefficients unstandardized coefficients mean stock returns 1.2305 230.9568 stdev stock returns -2.0038 -153.6011 skewness stock returns 0.1405 0.1195 kurtosis stock returns 1.3061 0.2191 (constant) 3.6477 values at centroids buy otm protective-puts 0.3540 buy itm protective-puts -0.2950 the standard deviation of returns, the kurtosis of returns, and the mean returns of the underlying stock were found to have significant impact on the dominance relation between otm protective-puts and itm protective-puts, followed by the skewness of returns of the underlying stock. moreover, buying otm protective-puts was more likely to dominate buying itm protective-puts for lower standard deviation of returns of the underlying stock and vice versa for higher standard deviation of returns, other characteristics remaining constant; and vice versa for the kurtosis of returns and mean returns of the underlying stock. the discriminant function correctly classified 58.2% of the sample stocks. discussion the results of the study showed that buying protective-puts and selling covered-calls do yield higher returns than a pure-stock position. overall, buying protective-puts yielded better returns over a pure-stock position than selling covered-calls, but with mixed results, as was observed in earlier studies. the returns from protective-put and covered-call strategies were negatively correlated, and further analysis showed that the mean and standard deviation of the returns distribution of the underlying stock affected the optimal strategy: buying protective-puts was optimal for stocks for which the returns distribution had relatively higher mean values and lower standard deviations, while selling covered-calls was optimal for stocks for which the returns distribution had relatively lower mean values and higher standard deviations. further, a similar association was found for itm and otm options strategies: buying otm protective-puts was better for stocks for which the returns distribution had relatively higher mean values and lower standard deviations, while buying itm protective-puts was better for stocks for which the returns distribution had relatively lower mean values and higher standard deviations; similarly, selling otm covered-calls was better for stocks for which the returns distribution had relatively higher mean values and lower standard deviations, while selling itm covered-calls was better for stocks for which the returns distribution had relatively lower mean values and higher standard deviations. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 136 the study suggests that the returns distribution of the underlying stock plays a central role in the optimality of options strategies. the results of present study suggest that the mean returns and the standard deviation of returns affect hedging strategies (i.e. buying protective-puts and selling covered-calls), while the results of dash et al (2008) suggest that the standard deviation, skewness, and kurtosis of returns affect more aggressive speculative strategies (“hold stock, buy call” and “hold stock, sell put”); in particular, skewness and kurtosis in the daily returns of the underlying stock tend to favour to more aggressive options positions. the results of the present study also suggest that the mean returns and the standard deviation of returns affect itm and otm strategies. the present study has some limitations. the study considers options strategies only for nse-listed stocks, but the results should be generalisable to other stock exchanges as well, particularly in other emerging economies. also, the study considers only three-month contracts, for a specific period (viz. 1st october 2007 to 27th december 2007), so that the results obtained may not be generalised to other periods. the results could be due to the overall bull run witnessed by indian stock markets in the period in question. there is scope for further research to examine the generalisability of the results of the present study; particularly whether the results continue to hold in similar conditions. a more serious limitation is that the study does not investigate the distributions of daily returns of the option-stock positions, from which even richer results may have been obtained. there is a vast scope for further research to investigate the distributions of daily returns of different option-stock positions and to relate these to the distributions of daily returns of the underlying stocks. references abid, f., mroua, m., & wong, w.-k. 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(1976). futures trading and market information. journal of political economy, 84(6), 1215-1237. http://dx.doi.org/10.1086/260509 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 137 dash, m, kavitha v., deepa, k.m., & sindhu, s. (2008). a study of optimal stock and options strategies. ssrn working paper series, abstract no. 1293203. dash, m., narendra babu, n., & kodagi, m. (2007). speculation strategies using investment in options. indian journal of finance, 1(4), 3-8. dybvig, p., & ingersoll, j. (1982). mean-variance theory in complete markets. journal of business, 55(2). 233-251. http://dx.doi.org/10.1086/296162 hakansson, n. (1978). welfare aspects of options and supershares. journal of finance, 33, 759-776. http://dx.doi.org/10.2307/2326472 isakov, d., & morard, b. (2001). improving portfolio performance with option strategies: evidence from switzerland. european financial management, 7(1), 73-91. http://dx.doi.org/10.1111/1468-036x.00145 ross, s. (1976). options and efficiency. quarterly journal of economics, 90(1), 75-89. http://dx.doi.org/10.2307/1886087 trennepohl, g., & dukes, w. (1981). an empirical test of option writing and buying strategies utilizing in-the-money and out-of-the-money contracts. journal of business finance & accounting, 8(2), 185-202. http://dx.doi.org/10.1111/j.1468-5957.1981.tb00813.x microsoft word 6429-22975-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 377 corporate governance and financial performance of bank in asian regions and recommendations ping-fu lai (brian) (corresponding author) division of business and management united international college beijing normal university hong kong baptist university po box 74107, kowloon central post office, hong kong e-mail: blai8733@gmail.com on-na choi (anna) abrs international consultancy po box 74107, kowloon central post office, hong kong received: oct. 8, 2014 accepted: nov. 17, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6429 url: http://dx.doi.org/10.5296/ajfa.v6i2.6429 abstract this research analyzes the bank’s corporate governance with financial performance relationship in asian regions. as we know, corporate governance helps to promote prosperity, financial performance and economic growth. in this research, we use multiple linear regression analysis and correlation matrix to explain the effect of explanatory variable; namely, capital (car), profitability (ptc and roaa), asset size (ta) and asset quality (npl) on a proxy variable which are the corporate governance (cg), board size (bs) and board meeting (bm). findings are that there is statistically significant relationship between car, ptc and corporate governance. ta, npl, roaa are not statistically significant relationship between corporate governance. there is also statistically significant relationship between car, ptc and board size. ta, npl and roaa are not statistically significant relationship between board sizes. besides, there is showed statistically significant relationship between ptc, ta, roaa and board meeting. car and npl are not statistically significant relationship between board meetings. additionally, this study also finds that financial performance of banks in year 2007-2008 (financial crisis) is statistically different from that of year 2011-2012. since banks faced slowdown in the us economy and financial crisis in year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 378 2007-2008. it shows that ptc and roaa are no statistically significant difference. car, ta and npl are statistically significant difference. the methods of banks use to improve corporate governance and financial performance via strengthen internal control and ensure compliance is important. it can help management to respond risk quickly and achievement of objectives. keywords: corporate governance, board sizes, board meetings, asian region’s banks, financial performance jel classification: j11, j16 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 379 1. introduction the nature of the banking business is such that the creditworthiness of banking institutions are often observed to be closely linked to the economic environment in which it operations and the systematic risk of a failure in the banking sector. according to the bank’s annual report, we can realize the bank risk management and corporate governance. risk management and corporate governance is the key factors to effect bank operation. good corporate governance indicated the board of directors and others senior management should have clear understanding about of the risks and what risk is the bank facing. there should have complete monitoring and management reporting system for the bank’s business complexity and diversity. the management should have good expertise and experience to receive timely information; they have duty to monitor bank performance. board of directors has an agency relationship with the stakeholders. they should take the responsibility to maintain shareholder’s interest, good long-term financial and operation performance. the benefits of applying good corporate governance can help to stimulates performance. bank should be institutes clear accountability and effective links between performance and rewards, which can encourage the employees to improve its performance. and it also can reduce the level of risk as perceived by investors, protecting shareholder’s rights; it can maintain a good profit (andres and vallelado 2008). the aim of this study is to find out the financial condition of credit risk ratio which is more important to represent bank’s performance; we can know the importance of corporate governance. 2. literature reviews 2.1 theoretical background corporate governance as a system, that organizations are directed and controlled. it provided a framework for pursuing and achieving organization’s goal and monitoring performance and reduces risk. management goal is maintaining the interests of the organization and its shareholders. moreover, it should be monitor effectively and encourage enterprises to use the resources correctly (cadbury report 1991). if the organizaton wants to avoid conflict of interest that it should be appointment of independent non-executive directors. based on agency perspective, it should be separation of the roles of ceo from chairman (william et al. 2003). corporate governance emphasised the directors should be accountability to the stakeholders (novikova, 2004). good corporate governance should be promoted corporate or bank’s true and fair view, transparency and accountability. it cannot have any conflict of interest. board of directors is the most important device to monitor the management and the independency of board members (abdullah, 2004). it needs take the responsibility to accountable to the stakeholders. it can help to built up positive management image. corporate governance mechanisms assure investors in corporation that they will receive adequate returns on their investments (shleifer and vishny, 1997). according to various studies, we found that there was existed many factors would effects financial performance. v. h. vroom (1964) suggested that people consciously choose asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 380 particular courses of action, based upon perceptions, attitudes, and beliefs, as a consequence of their desires to enhance pleasure and avoid pain. motivation was a key component of leadership; the leaders could create motivating environments for their followers. the incentives promoted effort and performance, and there was a lot of evidence that they often do (gibbons 1997 and lazear, 2000). contingent rewards serve as “positive rein forcers” for the desired behavior. good corporate governance could help to promote bank’s goodwill and image. it could help to motivate people have creative thinking in different aspects. recent studies researches showed that good corporate governance could help to increase valuation, high profit, sales growth and low expenditure (wolfgang, 2003). the remuneration was associated with the incentive alignment which depends on the strength of corporate governance (sun, jerry & cahan, steven f. & emanuel, david (2009).). corporate governance quality would affect executive’s compensation and bank performance, if bank could improve the corporation governance quality that it could help to increase bank performance and reduce agency problems. but it was also needed possess strong management’s leadership to promote success corporate governance. leadership style had been became an issue and topic which decided the competence. leader’s age, year of experience, educational level and genders was always taken into consideration (bass, 1990). it showed good corporate governance could help to increase expertise and strategic decision making. all board members were encouraged to examine board decisions critically. principal agent relationship in corporate governance was the necessary in theoretical. managers had responsibility to maximum shareholders interests but could not have any conflict of interest. due to ownership and control was separation, there was the relationship between the shareholders and management. agency theory was indicated agents might care their own interest then would ignore the interest of principal, so shareholders would take action to restrict their behavior, so it caused agency conflict. core et al. (2001) and murphy (1999) suggested that the sensitivity of executive compensation to firm performance had increased over times. board should be determined the company's direction and performance of interaction. internal corporate governance factors could effective interaction among a company's management, board and shareholders. it should be regular report the management situation to the boards and others stakeholders. it was argued that the executive compensation was the “smoking gun” of governance failure (monks, 2005). the executive pay might be the substitute of the outside directors (coulton and taylor, 2004). executive compensation in the form of ‘optimal contracting approach’ might play a key role in resolving the agency problem in areas where the monitoring was difficult (mangel, 1993). good corporate governance had become more important because practice needed achieve transparency and accountability requirements. banks listed in capital markets was tended to have better corporate governance practices because they were closely monitored by investors who demand that the banks should increase their transparency and disclosure (akhigbe and martin, 2008). corporate governance could help to improve company performance. the empirical researches found that corporate governance practices could have a positive impact on bank performance (gompers et al., 2003; brown and caylor, 2006; andres and vallelado, 2008; bhagat and bolton, 2008). it was most common that researchers used company age, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 381 audit firm, auditor’s quality, auditor and client relationship to do testing. corporate governance indicated increases the importance of the financial information’s transparency and monitor on the corporate reporting. since auditing quality arouse the public attention. the institutional environment had a significant impact on the functioning of corporate governance (cuervo, reese and weisbach, 2002). it was brought the characteristics of the governance and audit market. simunic’s (1980) described audit pricing model considers client characteristics such as size, complexity, profitability and client-specific risk. the variables had a significant impact on audit fees. francis and wilson (1998) and defond (1992) showed that the degree to which audit clients was confronted with agency conflicts influence their choice of audit quality. the articles also indicated the negative effect of audit committee on bank performance could be attributed to the audit committee members’ lack of expertise in helping the board in the governance of the bank. it seemed that the wider pool of knowledge and experience available to the board could help the board to identify opportunities more readily. a larger board of directors was beneficial and would increase the collection of expertise and resources accessible to a firm (dalton, daily, johnson, & ellstrand, 1999). but, jensen (1993) argued that board size increase, the efficiency of the boards would decrease due to increase in decision-making time. board size too large sometimes was not good, because it might lack of time monitor. yermack (1996) reported that a larger board was comprised of experts from various fields; however, an excessively large board would drag down the efficiency of the board and also the effectiveness of corporate governance mechanisms. the size of the boards was the important governance consideration. since many studies indicated board independency, ceo duality and board size was more relevant to corporate governance if the boards could success to discharge their fiduciary duties that it would be increased company value and shareholder wealth (abdullah, 2004). some researches indicated a negative relationship between board size and company performance (yermack, 1996). directors followed the accounting policies could make them possess better risk alert in the environment and raised the ability of evaluation. the assessment prepared by management should be contained a wide range analysis which was related to company’s profitability, collect debt and financing aspects. during credit crunch, risk should be needed to identify, classify, assessment and tackling. management had duty to evaluate the impacts and probability of happening and found ways to solve. the company might face different types of risks or difficulties in operation. therefore, management should be helped the company set policy and objective to safeguard company and respond risk. corporate governance had many testing factors such as leverage; and dividend used to test a positive or a negative influence on company’s performance. crutchley and hansen (1989) showed the evidence of dividend policy acting as a corporate monitoring vehicle. board committees was also took into consider elements, klein (1998) found that it had evidence of a positive relationship between the presence of a rcom and firm financial performance. use roe as a proxy of bank performance relevant to shareholder’s investment (siamat, 2004; berger, et al., 2005; kim and rasiah, 2010). lin and zhang (2009) deployed return on equity (roe) as an alternative measure of profitability. to solve the relationship between corporate governance and bank asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 382 performance, capital adequacy ratio was an important element to affect bank financial performance. through in-depth review of the literatures, we explored the effects of financial performance of bank had the several main variables. it seen that dividend yield was a comparable valuable to reflect whether company had ability to satisfy shareholder’s interest. since higher dividend yield had been considered desirable by many investors. many studies about bank performance were focused on branch performance in south africa (oberholzer and vander westhuizen, 2004). the measurement of bank performance in commercial banks had increased attention over the past years (seiford and zhu, 1999). size would be affected on the financial variables accord several literature (samad, 2004). it was common used financial ratios to measure organization’s performance. bank regulators measure banks which were mainly accorded bank’s liquidity, solvency or overall performance to consider their ability. measure bank performance could enhance managerial ability in setting good corporate governance practices; it could help to improve bank efficiency. traditionally accounting methods was based on the financial ratios for assessing bank performance (ncube, 2009). pi and timme (1991) showed that it had significantly positive between efficiency and the ratio of loans to total assets. meinster and elyasiani (1988) indicated that several financial ratios were selected to assess the financial performance to asset management ratios, expense and profitability and risk management ratios. oberholzer and van der westhuizen (2004) found the efficiency and profitability of banking in south africa, the results was an efficiency measure existed relationship between profitability and efficiency ratios. financial ratios could be used to identify a bank’s specific strengths and weaknesses as well as providing detailed information about bank profitability, liquidity and credit quality policies (hempel et al, 1994; dietrich, 1996). it indicated evaluate banks past performance which could help to plan for bank’s future performance (hempel et al, 1994). it was common to use ratios to measure the financial performance and compare with the past to make interpretations (oberholzer and westhuizen, 2004). the operating efficiency had an affect on the bank size. pilloff and rhoades (2002) said a positive relationship existed between the profitability and bank size. although financial statements were backward looking, they were only detailed information available on the bank’s overall activities (sinkey, 2002). it could provide information to evaluate company future whether it had ability to get reasonable returns. samad (2004) indicated that liquidity was the life and blood of a commercial bank. the objective of the banks was to reduce the bad loans and lending losses. due to outbreak of before global economic crisis, so it might be common to found research about the financial performance indicators of bank (casu et al, 2006). al-tamimi (2012) examined the relationship between corporate governance practices of uae national banks and performance level. hassan and al-mazrooei (2007) stated the uae risk management practices and techniques of the bank. dietrich and wanzenried (2011) showed that the global financial crisis was affected the profitability of swiss commercial banks during the crisis years 2007-2009. cornett, m (2009) showed the banks during the financial crisis with more illiquid asset portfolios, banks would be increased liquid assets and decreased lending. bank’s financial performance would affect asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 383 by economic crisis. so, good corporate governance could help to improve problems. sufian (2009); molyneux and seth (1998); ramlall (2009) also found an affirmative relation of bank size and examined the dependence of bank size upon economies of scale because smaller banks were less profitable than larger banks. whereas koasmidou (2008); spathis, koasmidou & doumpos (2002) found empirically a negative relation existed between bank size and profitability. bank size and financial ratios such as efficiency / profitability ratios, liquidity ratios, capital/ leverage ratios and asset quality ratios was effective tool to classify the public and private banks and these ratios was also suggested by sbp statistical bulletin to evaluate the financial performance of banks. financial measures such as return on assets (roa), interest margins (im) and capital adequacy (ca) had positive relation with customer service quality (elizabeth & elliot, 2004). raza, farhan & akram (2011) classified the investment banks in his study using return on total assets (roa) and return on owners’ equity (roe). effectiveness and efficiency was the independent factors (tarawneh, 2006). there was no boundness that efficient bank also had effectiveness always. ahmad almazari (2011) studied the financial performance of seven jordanian commercial banks. he used the roa to measure. the results of his analysis reflected a strong negative correlation between roa and bank’s size, a strong positive correlation between roa and asset management ratio, and a negative weak correlation between roa and operational efficiency. khizer ali, muhammad akhtar and hafiz ahmed (2011) conducted a comprehensive study about banks’ profitability in pakistan, where they found significant relation between asset management ratio, capital and economic growth and with roa. while they found that operating efficiency, asset management and economic growth was significant with the roe. it was common that researchers were mostly to use return of equity (roe), return of assets (roa) and earning per share (eps) to test the relationship between board characteristics (grossman, 2000). muhammad sidqui and adnan shoaib (2011) found their study “measuring performance through capital structure in pakistan” that size of the bank played a significant role in determining the profitability of the bank measured by roe. they used also the tobin’s q model as a proxy of determining banks performance while they found that tobin’s q was affected by the size of the bank, the leverage ratio and investments carried out by the bank. greenidge and grosvenor (2010) argued that the non-performing loans were an important element in the financial and banking crises. guy (2011) said that non performing loans had been widely used as a measure of asset quality among financial institutions. morrison and white (2001) pointed out that the capital adequacy ratio requirement was useful to limit the size of the group; it could avoid moral hazard problems. 3. research methodology 3.1 the importance of this study of the following points dependent variable of corporate governance, board size and board meeting can use to test the relationship between other independent variables (capital, asset size, profitability and asset asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 384 quality) to represent financial condition. financial condition ratio is absolutely can show that bank’s risk management does best or not. bank has ability to reduce non-performing loans and earn great profit. financial performance is absolutely can reflect on eps. eps increase or decrease that is absolutely represents bank profitability performance. we want to know credit risk performance do better or worst whether its can really reflect in eps. this study wants to using variables to indicate the significant indicators of the relationship between corporate governance and financial condition (credit risk). risk management needs how to reduce risk to achieve corporate governance requirements. it also gives suggestions about how to improve bank financial performance. 3.2 data collection in this analysis, the data were collected from different bank in asian regions such as hong kong and china. we would search for updated annual report of each bank. the annual reports information of bank must be available for the period from year 2007-2012. the calculation could be accorded each bank’s annual report to calculate the value or percentage. the information could be searched from www.pwc.com, http://finance.yahoo.com/ or others finance websites. 4. data finding and analysis (a) firstly, this study also wants to examine whether the financial performance of the banks in year 2007-2008 is statistically different from that of year 2011-2012. so, it will be used t-test to test the hypothesis that the means of the two periods are the same on the five variables. the following hypothesis is set h0: µ1 =µ2, where µ1 is the mean for year 2007 2008 and µ1 is the mean for year 2011-2012. the hypothesis is decided by looking at t test statistics and critical values associated with the mean. table 1. mean year 2007-2008 mean year 2011-2012 pvalue capital car 0.147 0.130 0.002 asset size ta 354441.120 237817.900 0.019 asset quality npl 0.007 0.015 3.05619e-06 profitability ptc 0.240 0.233 0.660 roaa 0.014 0.039 0.315 with regard to capital, car showed banks performed better in the year 2007-2008 compared to year 2011-2012. according to the above table, the mean of car is 0.147 in year 2007-2008 which is compared to 0.130 in year 2011-2012. the p-value is 0.002, so the difference between the performances for two periods is statistically significant because the p-value is smaller than the significant level of 5%, therefore the null hypothesis can be rejected. about the profitability, ptc and roaa showed banks performed better in the year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 385 2007-2008 compared to year 2011-2012. according to the above table, the mean of ptc is 0.240 in year 2007-2008 which is compared to 0.233 in year 2011-2012. the mean of roaa is 0.014 which is compared to 0.039 in year 2011-2012. the p-value of ptc and roaa are 0.660 and 0.315 respectively, so the difference between the performances for two periods is not statistically significant because the p-value is greater than the significant level of 5%, therefore the null hypothesis cannot be rejected. with reference to asset size, ta shows banks performed better in the year 2007-2008 compared to year 2011-2012. the p-value of ta is 0.019, so the difference between the performances for two periods is statistically significant because the p-value is smaller than the significant level of 5%, therefore the null hypothesis can be rejected. besides, npl showed banks perform worst in the year 2007-2008 compared to year 2011-2012. the mean of npl is 0.007 in year 2007-2008 which is compared to 0.015 in year 2011-2012. the p-value of npl is 3.05619e-06, so the difference between the performances for two periods is statistically significant because the p-value is smaller than the significant level of 5%, therefore the null hypothesis can be rejected. to conclusion the above results, ptc and roaa are no statistically significant difference. car, ta and npl are statistically significant difference. (b) table 2. anova: single factor summary groups count sum average variance board size (bs) 180 2620 14.55556 10.38237 board meeting (bm) 180 1266 7.033333 11.88715 anova source of variation ss df ms f p-value f crit between groups 5092.544 1 5092.544 457.3555 5.8e-66 3.867565 within groups 3986.244 358 11.13476 total 9078.789 359 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 386 table 3. t-test: two-sample assuming equal variances board size (bs) board meeting (bm) mean 14.55556 7.033333 variance 10.38237 11.88715 observations 180 180 pooled variance 11.13476 hypothesized mean difference 0 df 358 t stat 21.38587 p(t<=t) one-tail 2.9e-66 t critical one-tail 1.649121 p(t<=t) two-tail 5.8e-66 t critical two-tail 1.966613 to test whether the average size of board meeting frequency (bm) and board size (bs) was existed a significant difference. with reference to the group, according to anova, f-test statistic is 457.3555 with p-value of 5.8e-66. since the p-value is less than 0.05, we reject the null hypothesis that regression parameters are not zero at significance level 0.05. f value is greater than 2.2660. it concluded that the parameters are jointly statistically significant at significance level 0.05. the t static value is 21.386 larger than 2.179 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to the two-sample assuming equal variances, the pooled variance is 11.135, the t static 21.386 and p-value of two-tail is 5.8e-66. (c) after the review of literatures and methodology, it is decided to find the correlation of the several factors with financial performance indicators to the banks, to see those banks financial performance under corporate governance practices, guideline influence and board size and board meeting 1) capital adequacy ratio (capital), 2) total assets (asset size), 3) profit before tax to tier 1 capital (profitability), 4) non-performing loans to total assets (asset quality) and 5) return on average assets (profitability). the study consists of independent variables the bank’s financial condition with ratio analysis (capital, asset size, profitability, asset quality) also dependent variable (corporate governance), (board size) and (board meeting). the qualitative assessment of bank’s operations on cg: part 1 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 387 (a) the dependent variable of corporate governance (cg) risk management and corporate governance aspects, competent risk management and corporate governance are essential to bank's operation. the important indicators of good risk management structure and corporate governance are: board of directors and senior management should have a clear understanding about bank's risk is facing. there are comprehensive policies and identification of measurement, control and monitoring procedures for each type of risk. there are an efficient built up monitoring and management reporting system that it can have ability to cope with the complexity and different bank's operations. board of directors and senior management possesses with good professional knowledge and experience. they have ability to get update information and monitoring management performance. part 2 (b) the dependent variable of board sizes (bs) the meaning of the board size is calculated the number of directors on the boards. part 3 (c) the frequencies of board of directors meetings (bm) the frequencies of board of directors meetings may be seem as an important factor in board effectiveness. godard et al (2004) indicated that increase the number of board meetings has a positive influence on the finance performance of french companies. the quantitative assessment of bank’s financial condition or performance:  a bank's financial position, its credibility objective indicators is the strongest. it should consider four key aspects in the evaluation of a bank's financial position, which is a major factor affecting performance such as the bank's capital, asset size, profitability and asset quality. all data can find in the annual report such as balance sheet and income statement.  capital (c) the assessment of capital can be dividend into two types; one is capital adequacy and soundness of assets ratio. in this study, capital adequacy ratio will be took into consider used as capital parameters.  capital adequacy ratio (%) (car) capital adequacy ratio reflects the bank's ability to absorb unexpected losses. capital adequacy is measured by capital adequacy ratio, which is based on the bank's risk-weighted assets. banks should at least meet the minimum regulatory capital requirements. currently, the basel committee proposed minimum capital adequacy ratio of 8%. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 388  soundness of assets ratio tier 1 capital / assets (%) tier 1 amount used as indicator of the capital quality. tier 1 capital as indication of the capital quality. if the ratio is higher, bank can have better quality and reduce the risk of bank. tier 1 capital is means the core capital of the bank, it is calculated accord to basel capital accord and it included share and retained earnings normally.  asset size (as) ($) total assets (ta) it is very easy for their business or a diversified portfolio of large banks, so they are less vulnerable to specific shocks. asset size is also related to the "market position", which is commonly used in the quantitative analysis of long-term credit. if a bank's command significant market shares, it will also have significant pricing power, a broader capital base and better quality of service.  profitability (p) (%) (1) profit before tax to tier 1 capital: profit before tax / tier 1 capital (ptc) (2) return on average assets (roaa): profit before tax/ average equity typically, the high profitability will increase the bank's equity value. this means that a larger buffer to absorb fluctuations in the river before the loss occurs. high profitability is usually a positive indicator relate to the bank's financial strength. it used to analyze the bank's profitability and operating efficiency.  asset quality (aq) (%) non-performing loan (npl): non-performing loans/total loans according several overseas studies, the history showed most of the poor quality of bank assets and mismanagement caused by their failure. because of poor asset quality and credit losses adversely affect the bank's financial strength. in addition, the poor quality of assets will adversely affect the bank's financial strength. therefore, the usual high non-performing loans (npl) ratio is considered to be bank and one of the key failure warning signals. ratios calculated by dividing non-performing loans to total non-performing loans portfolio. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 389 table 4. descriptive statistics cg car ptc ta npl roaa y x1 x2 x3 x4 x5 mean 2.166666667 3.822222222 4.45 4.166667 4.14444444 4.138888889 standard error 0.027855261 0.064564412 0.058576 0.059743 0.04669208 0.069028862 median 2 4 5 4 4 4 mode 2 4 5 4 4 4 standard deviation 0.373717546 0.86622249 0.785874 0.801535 0.62643999 0.926119367 sample variance 0.139664804 0.750341403 0.617598 0.642458 0.39242706 0.857697083 kurtosis 1.268101314 -0.14449984 0.37295 0.526294 0.08041954 2.475608191 skewness 1.803921999 -0.428994274 -1.19475 -0.7716 -0.2523665 -1.390077609 range 1 4 3 4 3 4 minimum 2 1 2 1 2 1 maximum 3 5 5 5 5 5 sum 390 688 801 750 746 745 count 180 180 180 180 180 180 confidence level(95.0%) 0.054966938 0.127405306 0.115588 0.117891 0.09213774 0.136215029 descriptive statistics of the above data included sample means, maximum, minimum, standard deviation, skewness and kurtosis. the variables of car, ptc, ta, npl and roaa have negative skewness which indicated the fat tail on the left-hand side of the distribution. we measure the corporate governance of bank. as presented in table 2, the average corporate governance is 2.17; the maximum value is 3 and the minimum value is 2. about capital aspects, it used capital adequacy ratio which is showed the average 3.82. the maximum value is 5 and the minimum is 1. for the profitability, profit before tax to tier 1 capital (ptc) showed the average 4.45 and return on average assets (roaa) showed the average 4.14. the maximum value is 5. with regard to the asset quality, the non-performing loan to total loans (npl) has averaged 4.14. for asset size, measured by the total assets, the average is 4.17. the maximum value is 5. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 390 table 5. t test for independent variables car x1 ptc x2 ta x3 npl x4 roaa x5 calculated t stat 6.1838 4.3524 0.2727 0.0637 2.7438 p(t<=t) one-tail 2.06e-09 1.13e-05 0.3927 0.4746 2.9363-35 t critical one-tail 1.6534 1.6534 1.6534 1.6534 1.6534 sample t-test and f-test were used to testing. the hypothesis is set for the t-test and f-test with y to group x1 to x3. the null hypothesis is set independent variable x do not positive significantly relate to the dependent variable y. the alternative hypothesis is set independent variable x do positive significantly relate to the y. h0: μy-μx ≤ 0 and h1: μy-μx > 0. another hypothesis is set for the y to group x4 to x5. the null hypothesis is set independent variable do not negative significantly relate to the dependent variable y. the alternative hypothesis is set independent variable x do negative significantly relate to the y. according to the result of y to x1, the t static value is 6.1838 greater than t critical one tail 1.6534 and the means for car is significantly different as p value is 2.064e-09. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to the result of y to x2, the t static value is 4.3524 greater than t critical one tail 1.6534 and the means for ptc is significantly different as p value is 1.13e-05. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to the result of y to x3, the t static value is 0.2727 smaller than t critical one tail 1.6534 and the means for ta is significantly different as p-value is 0.3927. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. according to the result of y to x4, the t static value is 0.0637 smaller than t critical one tail 1.6534 and the means for npl is significantly different as p-value is 0.4746. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. according to the result of y to x5, the t static value is 2.7438 greater than t critical one tail 1.6534 and the means for roaa is significantly different as p-value is 2.9363-35. thus, the null hypothesis is rejected. there is existed statistically significant relationship. table 6. f test for independent variables car x1 ptc x2 ta x3 npl x4 roaa x5 calculated f 1.2149 0.6137 1.6371 0.4575 6.1411 p(f<=f) one-tail 0.0968 0.396 0.000525 1.2435 1.67e-30 f critical one-tail 1.2796 0.7815 1.2796 0.7815 1.2796 for the output of y to x1, the f test is 1.2149 smaller than f critical value one tail 1.2796 and the mean for the car is significantly different as p-value is 0.0968. the null hypothesis is not asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 391 rejected. there is existed not statistically significant relationship. for the output of y to x2, the f test is 0.6137 smaller than f critical value one tail 0.7815 and the mean for the ptc is significantly different as p-value is 0.3960. the null hypothesis is not rejected. there is existed not statistically significant relationship. for the output of y to x3, the f test is 1.6371 smaller than f critical value one tail 1.2796 and the mean for the ta is significantly different as p-value is 0.000525. the null hypothesis is rejected. there is existed statistically significant relationship. for the output of y to x4, the f test is 0.4575 smaller than f critical value one tail 0.7815 and the mean for the ta is significantly different as p-value is 1.2435. the null hypothesis is not rejected. there is existed not statistically significant relationship. for the output of y to x5, the f test is 6.1411 greater than f critical value one tail 1.2796 and the mean for the ta is significantly different as p-value is 1.67e-30. the null hypothesis is rejected. there is existed statistically significant relationship. table 7. y to x1 y to x2 y to x3 y to x4 y to x5 calculatedχ2 0.683 0.393 8 6.237 6.338 p-value 0.4563 0.5568 0.0035 0.0182 0.0178 degree of freedom 1 1 1 1 1 significance level 0.05 0.05 0.05 0.05 0.05 χ2 square critical value 3.563 3.563 3.563 3.563 3.563 chi-square test applied in this study, there are two groups set relying on above or below means to each variable. the average of y is 2.1667, and the means of x1 to x5 is 3.8222, 4.45, 4.167, 4.144 and 4.139 respectively. in the test, the group is defined relying on the means of y. each individual variable direction x is considered in the y situation. there are two groups formed to each variable x of above and below mean. the individual variables x values for each group of overlapping set of y variable, they will be paired in the same group. hypothesis is set. null hypothesis: the corporate governance y is not depended of independent value x individually. alternative hypothesis: the corporate governance y is depended of independent value x individually. group 1 is defined as below means and group 2 is defined as above means. there are 15 banks have set corporate governance lower than the average, and 15 banks have set upper the means. the degrees of random set (2-1)*(2-1) =1. the level of significance is set 5% and the degrees of freedom are 1. for the output y to x1, x2 statistic is 0.683 does not exceed critical value 3.563. so we can accept the null hypothesis that the y is not depended of independent x1 value. but, the p-value of two-tailed equals 0.4629. so it is not statistically significant. for the output y to x2, the x2 statistic is 0.393 and do not exceed the critical value. so we can accept null hypothesis. there is existed not statistically significant relationship. for the output y to x3, the x2 equals 8; it exceeds the critical value, so we can accept the null hypothesis. and the two-tailed p-value is 0.0035. so it is statistically significant. for the output y to x4, x2 statistic is 6.237; it exceeds the critical value, so we can reject null hypothesis. so it is statistically significant. and the two-tailed p-value is 0.0182. for the output y to x5, x2 statistic is 6.338; it exceeds the critical value, and the two-tailed asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 392 p-value is 0.0178. so we can reject null hypothesis. so it is statistically significant. the statistical method of t-test with hypothesis is used to point out the correlation between the full data of the dependent and independent variables. in the view to the variables x1 to x5, null hypothesis (h0) as independent variables x do not exist influence to the dependent variable y significantly, whereas the another hypothesis (h1) is independent variable x affect to the dependent variable y significantly. the explanatory of r2, it used to measures explain the percentage of the independent variable of the dependent variable. the correlation and regression analysis is performed on the dependent variable with cg, bs and bm which is used to test the relationship between the independent variables (capital, asset size, profitability, asset quality) with financial performance. part 1 (a) hypothesis testing of this study the following are the hypothesis of this study based on the various variables: a) corporate governance has a statistically significant effect on capital of banks. b) corporate governance has a statistically significant effect on profitability of banks. c) corporate governance has a statistically significant effect on asset size of banks. d) corporate governance has a statistically significant effect on asset quality of banks. part 2 (b) hypothesis testing of this study the following are the hypothesis of this study based on the various variables: a) board size has a statistically significant effect on capital of banks. b) board size has a statistically significant effect on profitability of banks. c) board size has a statistically significant effect on asset size of banks. d) board size has a statistically significant effect on asset quality of banks. part 3 (c) hypothesis testing of this study the following are the hypothesis of this study based on the various variables: a) board meeting has a statistically significant effect on capital of banks. b) board meeting has a statistically significant effect on profitability of banks. c) board meeting has a statistically significant effect on asset size of banks. d) board meeting has a statistically significant effect on asset quality of banks. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 393 table 8. correlation of parameters part 1 (a) cg car ptc as npl roaa y x1 x2 x3 x4 x5 cg 1 car 0.161069 1 ptc 0.313859 -0.35781 1 ta 0.167851 -0.28698 0.394668 1 npl 0.063635 0.243197 -0.28029 -0.15947 1 roaa 0.094157 -0.03869 0.236033 0.593291 -0.10218 1 the table showed correlation coefficients between the dependent and independent variable in these articles. the examination of the correlation matrix showed that there is a significant relationship between the dependent variable (cg) and the variables related to the bank’s financial performance which are car, ptc, ta, npl and roaa. it showed that the corporate governance is positive direction to car, ptc, ta, npl and roaa. part 2 (b) bs car ptc as npl roaa y x1 x2 x3 x4 x5 bs 1 car -0.29483 1 ptc 0.243626 -0.28227 1 ta -0.07259 -0.21428 0.212768 1 npl -0.00462 -0.27994 0.035715 0.278679 1 roaa 0.152637 -0.09574 0.06877 -0.00384 -0.00946 1 the examination of the correlation matrix showed that there is a significant relationship between the dependent variable (bs) and the variables related to the bank’s financial performance which are ptc and roaa. it showed that board size is negative direction to car, ta and npl. part 3 (c) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 394 bm car ptc as npl roaa y x1 x2 x3 x4 x5 bm 1 car -0.3864 1 ptc 0.32933 -0.2823 1 ta 0.29448 -0.2143 0.21277 1 npl -0.0168 -0.2799 0.03571 0.27868 1 roaa 0.34492 -0.0957 0.06877 -0.0038 -0.0095 1 the examination of the correlation matrix showed that there is a significant relationship between the dependent variable (bm) and the variables related to the bank’s financial performance which are ptc, ta and roaa. it showed that board meeting is negative direction to car and npl. table 9. linear regressions model part 1 (a) (dependant variable: cg) r2 f t stat p-value capital car 0.025943 4.7408615 2.17735 0.03077 asset size ta 0.028174 5.1603436 2.27164 0.02431 asset quality npl 0.004049 0.7237151 0.85071 0.39607 profitability ptc 0.098507 19.450331 4.41025 1.80e-05 roaa 0.008866 1.5921869 1.26182 0.20866 based on the above table, the linear regression analysis showed in the following: according to capital adequacy ratio result, r 2 is 0.0259; the regression relationship is very weak; 2.5% of the variability in the car can be explained by the linear relationship between the corporate governance and the capital. the f test is 4.740 is greater than 3.894. the t static value is 2.177 greater than 1.973 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to profit before tax to tier one capital ratio result, r 2 is 0.0985; the regression relationship is very weak; 9.8% of the variability in the ptc can be explained by the linear relationship between the corporate governance and profitability. the f test is 19.450 is greater than 3.894.the t static value is 4.410 greater than 1.973 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to total assets result, r 2 is 0.0282; the regression relationship is very weak; 2.8% of the variability in the total assets explained by the linear relationship between the corporate governance and asset size. the f test is 5.1603 is greater than 3.894. the t static value is asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 395 2.272 greater than 1.973 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to non-performing loans result, r 2 is 0.03796; the regression relationship is very weak; 0.4% of the variability in the total assets explained by the linear relationship between the corporate governance and asset size. the f test is 0.724 is greater than 3.894. the t static value is 0.851 smaller than 1.973 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. according to return on average assets result, r 2 is 0.004; the regression relationship is very weak; 0.4% of the variability in the total assets explained by the linear relationship between the corporate governance and asset size. the f test is 1.592 is greater than 3.894. the t static value is 1.261 smaller than 1.973 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. there is statistically significant relationship between car, ptc, ta, roaa and corporate governance. npl is existed not statistically significant relationship between corporate governance. part 2 (b) (dependant variable: bs) r2 f t stat p-value capital car 0.08693 16.94591 -4.11654 0.36687 asset size ta 0.00527 0.94286 -0.97101 0.33286 asset quality npl 0.00002 0.00380 -0.06166 0.95091 profitability ptc 0.05935 11.23157 3.35135 0.00098 roaa 0.02330 4.24597 2.06058 0.04080 based on the above table, the linear regression analysis showed in the following: according to capital adequacy ratio result, r 2 is 0.0869; the regression relationship is very weak; 8.69% of the variability in the car can be explained by the linear relationship between the board size and the capital. the f test is 16.946 is greater than 3.894. the t static value is -4.112 smaller than 1.973 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. according to profit before tax to tier one capital ratio result, r 2 is 0.059; the regression relationship is very weak; 5.90% of the variability in the ptc can be explained by the linear relationship between the board size and profitability. the f test is 11.23 is greater than 3.894.the t static value is 3.351 greater than 1.973 and p-value greater than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to total assets result, r 2 is 0.0053; the regression relationship is very weak; 0.53% of the variability in the total assets explained by the linear relationship between the board size and asset size. the f test is 0.00380 is smaller than 3.8942. the t static value is -0.971 smaller than 1.973 and p-value greater than the level of significance 5%. thus, the null asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 396 hypothesis is not rejected. there is existed not statistically significant relationship. according to non-performing loans result, r 2 is 0.00002; the regression relationship is very weak; 0% of the variability in the total assets explained by the linear relationship between the board size and asset size. the f test is 0.724 is smaller than 3.894. the t static value is -0.062 smaller than 1.973 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. according to return on average assets result, r 2 is 0.023; the regression relationship is very weak; 2.3% of the variability in the total assets explained by the linear relationship between the board size and asset size. the f test is 4.246 is greater than 3.8942. the t static value is 2.061 greater than 1.973 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. there is statistically significant relationship between ptc, roaa and board size. npl, car and ta are existed not statistically significant relationship between board sizes. part 3 (c) (dependant variable: bm) r2 f t stat p-value capital car 0.14931 31.2427 -5.5895 0.67687 asset size ta 0.08672 16.9019 4.1112 0.02586 asset quality npl 0.00028 16.5832 -0.224 0.85191 profitability ptc 0.10846 21.6537 4.65336 0.00139 roaa 0.11897 24.036 4.90265 0.03070 based on the above table, the linear regression analysis showed in the following: according to capital adequacy ratio result, r 2 is 0.1493; the regression relationship is very weak; 14.93% of the variability in the car can be explained by the linear relationship between the board meeting and the capital. the f test is 31.243 is greater than 3.894. the t static value is -5.590 smaller than 1.973 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. according to profit before tax to tier one capital ratio result, r 2 is 0.1085; the regression relationship is very weak; 10.85% of the variability in the ptc can be explained by the linear relationship between the board meeting and profitability. the f test is 21.654 is greater than 3.8942.the t static value is 4.653 greater than 1.973 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. according to total assets result, r 2 is 0.0867; the regression relationship is very weak; 8.67% of the variability in the total assets explained by the linear relationship between the board meeting and asset size. the f test is 16.902 is greater than 3.8942. the t static value is 4.111 greater than 1.973 and p-value smaller than the level of significance 5%. thus, the null asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 397 hypothesis is rejected. there is existed statistically significant relationship. according to non-performing loans result, r 2 is 0.00028; the regression relationship is very weak; 0.028% of the variability in the total assets explained by the linear relationship between the board meeting and asset size. the f test is 16.583 is greater than 3.894. the t static value is -0.224 smaller than 1.973 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. according to return on average assets result, r 2 is 0.1190; the regression relationship is very weak; 11.90% of the variability in the total assets explained by the linear relationship between the board meeting and asset size. the f test is 24.036 is greater than 3.8942. the t static value is 4.903 greater than 1.973 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. there is statistically significant relationship between ptc, ta, roaa and board meeting. npl and car are existed not statistically significant relationship between board meetings. multiple linear regression models multiple linear regression models are an attempt to show two or more fit the observed data plotted as a linear equation of the explanatory variables and the relationship between the dependent variable. to examine how the corporate governance, board size and board meeting to affect the bank’s financial performance of the asian banks, so we will set 3 multiple regression equation is represented by y=β0+ β1x1 + β2x2 + β3x3 +β4x4+ β5x5 where the dependent variable y is the value for the corporate governance, board size and board meeting; β is the slope means beta coefficient for the indicator individually. according to the multiple regressions, the formula for the regression testing is for part 1: corporate governance (cg) = β0 + β1 capital (car) +β2 profitability (ptc) + β3 asset size (ta) +β4 asset quality (npl) +β5 profitability (roaa) the formula for the regression testing is for part 2: board size (bs) = β0 + β1 capital (car) +β2 profitability (ptc) + β3 asset size (ta) +β4 asset quality (npl) +β5 profitability (roaa) the formula for the regression testing is for part 3: board meeting (bm) = β0 + β1 capital (car) +β2 profitability (ptc) + β3 asset size (ta) +β4 asset quality (npl) +β5 profitability (roaa) table 10. part 1 (a) (dependant variable: cg) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 398 summary output regression statistics multiple r 0.4591595 r square 0.2108274 adjusted r square 0.1881501 standard error 0.3367297 observations 180 anova df ss ms f significance f regression 5 5.27069 1.0541 9.29682 7.28e-08 residual 174 19.7293 0.1134 total 179 25 coefficients standard error t stat p-value lower 95% upper 95% cg 0.265645 0.31821 0.8348 0.40498 -0.3624 0.8937 car 0.139926 0.03249 4.3068 2.76e-05 0.0758 0.20405 ptc 0.198893 0.03702 5.3728 2.46e-07 0.12583 0.27196 ta 0.0740828 0.04249 1.7435 0.08301 -0.0098 0.15795 npl 0.0714471 0.04244 1.6833 0.09411 -0.0123 0.15522 roaa -0.029879 0.03433 -0.8703 0.38536 -0.0976 0.03789 cg =0.2656+ (0.1399) car + (0.1989) ptc + (0.0740) ta + (0.0714) npl + (0.0299) roaa according to anova, f-test statistic is 9.2968 with p-value of 7.28087e-08. since the p-value is less than 0.05, we reject the null hypothesis that regression parameters are not zero at significance level 0.05. f value is greater than 2.2660. it concluded that the parameters are jointly statistically significant at significance level 0.05. car has estimated standard error of 0.0325; the t static value is 4.3068 greater than 1.9737 and pvalue smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. ptc has estimated standard error of 0.0370; the t static value is 5.3728 greater than 1.9737 and pvalue smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. ta has estimated standard error of 0.0425; the t static value is 1.7435 smaller than 1.9737 and pvalue greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. npl has estimated standard error of 0.0424; the t static value is 1.6833 smaller than 1.9737 and pvalue greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. roaa has estimated standard error of 0.0343; the t static value is -0.8703 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 399 smaller than 1.9737 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. there is statistically significant relationship between car, ptc and corporate governance. ta, npl, roaa are not statistically significant relationship between corporate governance. part 2 (b) (dependant variable: bs) summary output regression statistics multiple r 0.39681382 r square 0.15746121 adjusted r square 0.13325032 standard error 2.99981948 observations 180 anova df ss ms f significance f regression 5 292.6329 58.52658 6.503736 1.43212e-05 residual 174 1565.812 8.998917 total 179 1858.444 coefficients standard error t stat p-value lower 95% upper 95% bs 17.8537158 1.471705 12.13131 6.16e-25 14.94902326 20.75840827 car -30.293497 8.370826 -3.61894 0.068388 -46.81492502 -13.77206853 ptc 5.56760621 2.12297 2.622555 0.009501 1.377517673 9.757694747 ta -9.95e-07 4.62e-07 -2.15515 0.062525 -1.90617e-06 -8.37734e-08 npl -15.706288 27.36175 -0.57402 0.566693 -69.70993758 38.29736063 roaa 2.53350518 1.58608 1.597338 0.112005 -0.596927018 5.663937377 bs =17.8537+ (-30.2935) car + 5.5676 ptc + (-9.95e-07) ta + (-15.7063) npl + (2.5335) roaa according to anova, f-test statistic is 6.5037 with p-value of 1.43212e-05. since the p-value is less than 0.05, we reject the null hypothesis that regression parameters are not zero at significance level 0.05. f value is greater than 2.2660. it concluded that the parameters are jointly statistically significant at significance level 0.05. car has estimated standard error of 8.3708; the t static value is -3.6189 smaller than 1.9737 and p-value greater than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. ptc has estimated standard error of 2.1229; the t static value is 2.6226 greater asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 400 than 1.9737 and pvalue smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. ta has estimated standard error of 4.62e-07; the t static value is -2.1551 smaller than 1.9737 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. npl has estimated standard error of 27.3618; the t static value is -0.5740 smaller than 1.9737 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. roaa has estimated standard error of 1.5861; the t static value is 1.5973 smaller than 1.9737 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. there is statistically significant relationship between car, ptc and board size. ta, npl, roaa are not statistically significant relationship between board sizes. part 3 (c) (dependant variable: bm) summary output regression statistics multiple r 0.595169 r square 0.354226 adjusted r square 0.335669 standard error 2.81016 observations 180 anova df ss ms f significance f regression 5 753.7225013 150.7445 19.08884 4.067e-15 residual 174 1374.077499 7.896997 total 179 2127.8 coefficients standard error t stat p-value lower 95% upper 95% bm 10.69752 1.378658734 7.759365 6.94e-13 7.9764698 13.418564 car -35.7165 7.841591247 -4.55475 9.833382 -51.1934 -20.23964 ptc 5.461584 1.988748255 2.746242 0.006662 1.5364084 9.3867592 ta 1.6e-06 4.324832654 3.692684 0.000297 7.434e-07 2.451e-06 npl -67.4449 25.63183618 -2.63129 0.08927 -118.0342 -16.85556 roaa 7.339436 1.485801915 4.939714 1.83e-06 4.4069217 10.271951 bm =10.6975+ (-35.7165) car + 5.4616 ptc + 1.6e-06 ta + (-67.4449) npl + 7.3394 roaa asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 401 according to anova, f-test statistic is 19.0888 with p-value of 4.067e-15. since the p-value is less than 0.05, we reject the null hypothesis that regression parameters are not zero at significance level 0.05. f value is greater than 2.2660. it concluded that the parameters are jointly statistically significant at significance level 0.05. car has estimated standard error of 7.8416; the t static value is -4.5548 smaller than 1.9737 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. ptc has estimated standard error of 1.9887; the t static value is 2.7462 greater than 1.9737 and pvalue smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. ta has estimated standard error of 4.3248; the t static value is 3.6927 greater than 1.9737 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. npl has estimated standard error of 25.6318; the t static value is -2.6312 smaller than 1.9737 and p-value greater than the level of significance 5%. thus, the null hypothesis is not rejected. there is existed not statistically significant relationship. roaa has estimated standard error of 1.4858; the t static value is 4.9397 greater than 1.9737 and p-value smaller than the level of significance 5%. thus, the null hypothesis is rejected. there is existed statistically significant relationship. there is statistically significant relationship between ptc, ta, roaa and board meeting. car and npl are not statistically significant relationship between board meetings. table 11. summary of outcomes (coefficient) part 1 (a) variables coefficients p-value car x 1 0.139926 2.76e-05 ptc x 2 0.198893 2.46e-07 as x 3 0.0740828 0.08301025 npl x 4 0.0714471 0.09410908 roaa x 5 -0.029879 0.38535758 *significant at 5% level the coefficient, it used to measures the level of the variability of each independent variable with the dependent variable. additional, the positive and negative sign is used to indicate the direction of the effect on the coefficient. a negative sign means that the coefficients of the independent variables are reduced from the size of the dependent variable. the term of multicollinearity is refers to the correlation among the independent variables. the coefficient of y to x1 is 0.1399 and the p-value is 2.76e-05. the coefficient of y to x 2 is 0.1989 and the p-value is 2.46e-07. the coefficient of y to x 3 is 0.1989 and the p-value is 2.46e-07. the coefficient of y to x4 is 0.0714 and the p-value is 0.094. the coefficient of y to x5 is -0.030 and the p-value is 0.3854. according to the tests, it showed that car, ptc, as and npl are positive coefficient to corporate governance. but, roaa are negative coefficient to corporate governance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 402 part 2 (b) variables coefficients p-value car x 1 -30.293497 0.068388 ptc x 2 5.56760621 0.009501 as x 3 -9.95e-07 0.062525 npl x 4 -15.706288 0.566693 roaa x 5 2.53350518 0.112005 *significant at 5% level the above table exhibited simple correlation matrix among research variables for the sake of determining the existence of any multi-co-linearity problem before the regression analysis could be carried out. it was argued that a multi-co-linearity problem existed when correlation scores are 0.8 or greater (cooper and schindler, 2003). the term of multicollinearity is refers to the correlation among the independent variables. the coefficient of y to x1 is -30.2935 and the p-value is 0.0684. the coefficient of y to x2 is 5.5676 and the p-value is 0.0095. the coefficient of y to x3 is -9.95e-07 and the p-value is 0.0625. the coefficient of y to x4 is -15.7063 and the p-value is 0.5667. the coefficient of y to x5 is 2.5335 and the p-value is 0.1120. according to the tests, it showed that ptc and roaa are positive coefficient to board size. but, car, as and npl are negative coefficient to board size. part 3 (c) variables coefficients p-value car x 1 -35.7165 9.833382 ptc x 2 5.461584 0.006662 as x 3 1.60e-06 0.000297 npl x 4 -67.4449 0.08927 roaa x 5 7.339436 1.83e-06 *significant at 5% level the coefficient of y to x1 is -35.7165 and the p-value is 9.8334. the coefficient of y to x 2 is 5.4616 and the p-value is 0.0067. the coefficient of y to x 3 is 1.60e-06 and the p-value is 0.0003. the coefficient of y to x4 is -67.4449 and the p-value is 0.0893. the coefficient of y to x5 is 7.3394 and the p-value is 1.83e-06. according to the tests, it showed that ptc, as and roaa are positive coefficient to board meeting. but, car and npl are negative coefficient to board meeting. 6. conclusions and recommendations we can know corporate governance how to effect corporate or banks. corporate governance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 403 can bring out the positive or negative influence to the banks in many situations such as goodwill and financial performance. in the study, we used various independent variables to represent bank’s performance or condition such as financial ratio. bank’s financial condition is the strongest objective indicator of creditworthiness. many financial ratios such as cost to income ratio or return on average equity can use to test capital, profitability, asset quality and asset size. but, this study mainly used capital adequacy ratio (car), total assets (ta), and non-performing loans (npl), profit before tax to tier 1 capital (ptc) and return on average assets (roaa). because we considered the above financial ratios are more significant to represent bank’s financial performance. the testing results indicated there is statistically significant relationship between car, ptc and corporate governance. ta, npl, roaa are not statistically significant relationship between corporate governance. there is statistically significant relationship between car, ptc and board size. ta, npl, roaa are not statistically significant relationship between board sizes. there is statistically significant relationship between ptc, ta, roaa and board meeting. car and npl are not statistically significant relationship between board meetings. this study wanted to examine whether the difference in performance of the banks in year 2007-2008 is statistically different from that of year 2011-2012, the t test is used to set the hypothesis. the results showed ptc and roaa are no statistically significant difference. car, as and npl are statistically significant difference. and this study showed correlation coefficients between the dependent and independent variables. the results showed that the corporate governance is positive direction to car, ptc, ta, npl and roaa. another testing of board size is indicated have negative direction to car, ta and npl. finally, it showed that board meeting is negative direction to car and npl. apart from the financial, risk, liquidity management and corporate governance will effect bank’s operations. it still has other factors such as macro economic environment. the growth rate of an economy is another key indicator to measure economy. growth of gdp is a significant factor affecting banking security. bank loan quality deterioration when the business cycle is in a downward trend. a higher growth 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(1996). higher market valuation of companies with a small board of directors. journal of financial economics, 40(2), 185-211. copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 5372-19443-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 388 is eva a superior measure of shareholder value? evidence from cnx nifty constituent firms nusrathunnisa assistant professor, school of business, alliance university, india e-mail: nusrathun@yahoo.com p. janakiramudu professor of finance, school of business, alliance university, india received: march 27, 2014 accepted: june 13, 2014 published: june 13, 2014 doi:10.5296/ajfa.v6i1.5327 url: http://dx.doi.org/10.5296/ajfa.v6i1.5327 abstract business organisations are under pressure to device measures to increase shareholder value, improve financial performance and incentivize compensation plans that motivates and encourages managers to increase shareholders wealth and contribute towards business growth. a recent innovative trade-marked version of residual income measure known as economic value-added (eva) is being experimented and implemented in many organisations. this paper attempts to empirically test if any residual income components such as net operating profit after tax (nopat), return on net assets (rona) and cash flow measure i.e., free cash flow(fcf), the predictor variables, together variable wise and year wise from 2009 to 2012 has any influence on economic value added (eva), the criterion variable in the study. to examine the influence of the said variables data of 16 sample companies from cnx it index has been taken and required financial information was sourced from cmie’s capitaline database. the descriptive statistics, correlation and multiple regression analysis has been performed using spss 20.0 version through enter method and stepwise method for every year across the sample companies. statistical results prove that nopat has highest influence on eva throughout the study period compared to other variables. also compounded annual growth rate (cagr) of eva and year on year growth rate (yoygr) of all variables has been computed. keywords: value based measure, economic value added, net operating profit after tax (nopat), return on net assets (rona), free cash flow(fcf), compounded annual growth rate (cagr), year on year growth rate (yoygr), correlation, multiple regression analysis. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 389 introduction economic value added (eva) is the best available measure for evaluating shareholders value. it is a measure of economic profit and not accounting profit. eva calculation shows the difference between the cost of capital and the return on that capital. the shareholders of the company invest with the aim of getting return and increase in the value. although business concern exists to create value for their shareholders, the corporate executives and managers do not always represent to maximize shareholder value, because of perceived conflict with other goals. shareholder value does not necessarily conflict with good conduct toward employees, customers, suppliers, the environment etc. companies tend to outperform others, suggesting that value can be delivered to shareholders only if it is first delivered to other stakeholders. value-based management strategies existed since businesses evolved. under eva approach performance measurement gains a new meaning in contrast with the traditional approach which is merely based on the simple notions of accounting profits and the relevant ratios derived from them, such as the return on equity (roe) and the return on assets (roa). the difference is that the traditional performance measurement benchmarks do not consider the cost of invested capital (equity and debt) in order to generate the profits made by a company. thus, under the traditional approach two companies that have the same roe would be considered as equally successful, whereas under the eva approach the same conclusion could not be reached if these two firms had a different cost of capital, in other words if their economic profit or residual income was different. economic value added (eva) is proved to be the best metric available because the other measures have significant drawbacks: 1. traditional income measures, including net income and earnings per share, can be easily manipulated, and they do not account for the cost of equity. 2. market-based measures, including market value added (mva), excess return and future growth value (fgv), can only be calculated for publicly-traded entities. 3. cash flow measures, including cash flow from operations (cfo) and cash flow return on investment (cfroi), include neither the cost of equity nor the cost of debt. eva is highly accurate because it includes the cost of debt financing and equity financing. it is a motivational tool deep within the organization. traditional managers understand that their companies need to control operating costs and succeed in the commercial markets. today, companies also must compete in the capital markets by keeping their cost of capital low. eva measures residual income; that is, it measures the difference between a firm’s cost of capital and return on capital. eva is expressed as either a positive or negative. to calculate eva, assign a cost to each component of your firm’s financing (equity and shortand long-term debt). the resulting weighted average cost of capital (wacc) is one of eva’s asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 390 most important components. it requires transparent, credible calculation, because there are differing ways of assigning costs to capital (in particular, to equity financing). the simplest way to calculate eva is to subtract capital charges (invested capital multiplied by the wacc) from net operating profit after taxes (nopat). eva can be increased in several ways, by: 1) increasing nopat; 2) lowering the wacc; and 3) reducing invested capital. often, companies refine their eva calculations by making accounting adjustments to overcome the inherent limitations in generally accepted accounting principles (gaap). literature review studies on eva began with the publication of the book ‘the quest for value by stewart (1991), in which the author expressed his views about the usefulness of eva as the basis of performance measurement of a company and its management at a total or a divisional level. in his empirical research he examined the informational content of eva analyzing 613 american companies comparing two periods, namely 1984–85 and 1987–88 and found a strong correlation between eva and mva, which becomes more apparent when the changes in eva and mva are considered giving an r2 of about 97%. however, for companies with a negative eva the association becomes less obvious, because of the increased probability of liquidation or acquisition, which sets a lower limit on the market value of these companies. david crowther, et.al. (1998) critiques economic value added techniques as a means of calculating changes in shareholder value, contrasting such techniques with more traditional techniques of measuring value added. it considers the merits of the respective techniques in explaining shareholder and managerial behaviour and the problems with using such techniques in considering the wider stakeholder concept of value. it concludes that this economic value added technique has merits when compared with traditional accounting measures of performance but that it does not provide the universal panacea claimed by its proponents. banerjee and jain (1999) attempted to trace out the explanatory influence of eva on shareholders; value. having adopted backward elimination method, they evidenced that, inter alia, eva was the most powerful explanatory variable on shareholders’ value. in line with this finding, farsio, degel and degner (2000) found out that shareholders’ value creation was measured primarily on the basis of eva and eva was only the factor explaining the volatility in shareholders’ value. these findings were based on the analysis of eva and stock returns of s&p 500 firms. kramer and peters (2001) empirically test the relation between capital intensity and the ability of eva to serve as an effective proxy of market value added. they find that eva is no less “at home” in the information economy than it is in traditional manufacturing businesses. however, their results indicate that in most of the industries studied, the marginal costs of using eva as a proxy for market value added are not justified by any marginal benefits. kang and kim (2002) found out significant controversy around the validity of eva as the final answer to shareholders’ value creation. they think as with any other management tool, eva should be used to guide and support corporate decisions and should be applied cautiously. this measure can be modified and adjusted in order to apply it to not-for-profit organizations. their study compares and contrasts eva to traditional performance measures. they examine the effectiveness of eva in evaluating a firm's financial performance. thus, they question whether or not eva adds any value in performance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 391 evaluation over the conventional measures. issham ismail (2006) studied if positive eva outperform negative eva in predicting company performance and either the period of study may play a vital role in explaining the variation of the stock return. their study found that neither value creator nor value destroyer had a relationship with stock return, as both models prove to be statistically insignificant. the value creators had a better relationship with earnings than value destroyers and indicated that, value creators have better earnings multiplier than value destroyers. it also indicates that, eva had a better relationship with stock return over a longer period of their study. dimitrios i. maditinos (2006) introduced the concept of economic value added in the greek context and explained on the utilization of both earnings and eva in the ase. their study relating to the period 1995-2001 provided evidence to establish eva as a superior performance measurement and incentive compensation system and claimed that it is really better to use eva than traditional accounting performance measures such as earnings, eps, roi or roe. both relative and incremental content approaches were tested. relative information content tests revealed that stock returns are more closely associated with eps than eva. anil k. sharma, et.al. (2010) presented a comprehensive literature review and a critical analysis to move towards the advances in eva. maja ilic (2010), aimed to show practical examples of the extent to which traditional assessment of the company success may differ from the business overviewed from the perspective of economic value added. amalendu bhunia (2012) examined the relationship between shareholder’s value and financial variables and tested whether value based frameworks are applicable in indian condition. by adopting linear regression, factor analysis and multiple discriminant analysis empirical results showed that effect on shareholder value creation might lead to more information and insight. h.m. van der poll (2011) determined the extent to which eva is used by south african organisations and also their investigation focused on methods used by these organisations to calculate eva and aimed to determine the south african business sectors in which it is most likely to be implemented. mehdi arab salehi (2011) examined assertions that economic value added is superior as a performance measure compared to traditional accounting measures. the investigation is performed using a panel data procedure for a sample consisting of 76 iranian listed companies in the tehran stock exchange from 2001 to 2008 and explained theoretical foundation of eva with its origination, definition, ways to make it tailored, adjustments required, scope and some other related issues. fayez salim haddad (2012) studied sample consisting of 15 banks listed in amman stock exchange (ase) during the period 2000-2009 to examine the relationship between economic value added (eva), return on assets (roa), return on equity (roe), and capital adequacy ratio as explanatory variables for stock returns. the results showed positive and significant relationship between eva and stock returns, but insignificant relationship between roa, roe, and capital adequacy ratio with stock returns. pratapsinh chauhan (2012) analysed the performance of the petroleum companies and used eva, mva, nopat, pat, market capitalization and eps data provided by cmie prowess database for the period of 10 years (2001-02 to 201011). for each of the 07 companies, we have calculated the 10-year correlation between eva of each year and each year’s mva, nopat, pat, eps and market capitalization. to test hypothesis t-test was applied. eva has been found to have significant correlation with op, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 392 nopat, eps, market capitalization and mva figures of firms and the firms have created positive eva and mva. rasool et al.(2013) identified the relationship between financing methods and economic value added (eva)and found financing through owners’ equity and maintaining stock profit (dividends policy) have a positive and meaningful relationship with economic value added. also they showed that there is a reverse and meaningful relationship between using debts and economic value added. seyed mojtaba hasani (2012) evaluated performance of 70 companies in securities bourses using traditional method with only accounting profit and one of the valuebased criteria is the economic value added criteria. the correlation results, using pearson index between two indices, the economic value added index and the index of stock market value, show that at 1% level, these two variables are correlated, and the correlation is positive. also, the results of the panel regression estimation indicate a positive and significant relationship between two indices of the economic value added and stock market. akbar parvaei1 & soran farhadi (2013) examined the main performance measures (net income (ni), residual income (ri), economic value added (eva) & free cash flow (fcf)) of firm and management to find out whether eva works better than other performance measures in terms of evaluating the firm’s performance and also examined the predictability of economic value added for future performance by employing both relevant information content and incremental information content of measures. the results showed that eva is the best measure for evaluating the performance of firm and management among other measures. objectives of the study for carrying out the study, the following specific objectives have been set for the study.  to study value based measure economic value added.  to examine the correlation between eva and nopat, fcf & rona  to know the impact of predictors on eva hypotheses formulation h0: eva does not depend on time factor. h1: eva of cnx it is not influenced by rona, fcf and nopat methodology of the study selection of sample the sample companies are derived from cnx it index comprising of 20 companies, out of which 16 companies have been selected based on the availability of data required for the study. the study period is from 2009 to 2012. the data is collected from capitaline database maintained by centre for monitoring indian economy (cmie) based on the either financial year results or calendar year results. both the periods were considered inorder to analyse the results. some companies have been eliminated due to non-availability of required information in terms of stock returns for the said period for analyzing the data. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 393 data collection for the purpose of the study, only secondary data have been used. the relevant secondary data have been collected from the capitaline database, provided by centre for monitoring indian economy (cmie). the study required variety of data; therefore websites like www.rbi.org.in, www.nic.in, www.indiastat.com have been comprehensively searched. model development to test the hypotheses and as a part of analysis, some statistical tools like descriptive statistics, anova, correlation analysis, multiple regression analysis has been used. also cagr (compounded annual growth rate) of eva, the criterion variable, and yoygr (year on year growth rate) of all variables has been computed. the following is the description of the model fit used in the study. eva = α + β1 (nopat) + β2 (fcf) + β3 (rona) + e the above model connotes residual income measure viz., economic value added (eva) as dependent variable or also known as criterion variable and net operating profit after tax (nopat), free cash flow (fcf) and return on net assets (rona) as independent variables or also known as predictor variables. eva = net operating profit after taxes (nopat) (capital invested * wacc) nopat= operating income x (1 tax rate) wacc= (ke * we) + (kd * wd) ke = cost of equity : calculated using capm model i.e., ke = rf + β (rm – rf) rf = treasury bill rate rm = market return where, rs is the return on the stock and rb is the return on a benchmark index. we = equity share capital / capital invested kd = cost of debt = interest / total debt wd = total debt / capital invested fcf= net cash flow from operating activities – net cash used in investing activities rona= operating profit / net assets along with the above connotations other co-efficients also have been incorporated, such as, ‘α’ is the intercept and ‘β1’ is the coefficient of nopat, ‘β2’ is the coefficient of fcf and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 394 ‘β3’ is the coefficient of rona which indicate the variability in the criterion variable i.e. eva from its mean value caused by predictor variables and ‘e’ is the error term. to examine the correlation between the variables karlpearson’s correlation co-efficient has been employed which facilitate to evaluate the strength of the linear relationship among the stated variables. to validate the model regression analysis is run separately for individual year from 2009 to 2012 using criterion and predictor variables of all 16 sample companies from cnx it index. it is done to test the impact of predictor variables on criterion variable independently in each year and to examine if any single predictor variable exclusively or all predictors influenced eva during the study period. in order to study the special contribution of each predictor variable to the equation, beta coefficients (β) of the un-standardized variables are taken into account. also the compounded annual growth rate (cagr) and year on year growth rate (yoygr) of eva has been computed. empirical results inorder to test the impact of all predictor variables on economic value added of the sample companies certain statistical tools were used to analyse the data. the spss 20.0 was used to ascertain the results and the output was condensed into tabular form to avoid consumption of space. some observations have been interpreted to state relevant findings. table 1. descriptive analysis variables 2009 2010 2011 2012 eva mean 676.83 742.22 687.56 837.68 s.d 1235.19 1438.74 1864.99 2678.58 nopat mean 634.37 715.94 852.95 1138.82 s.d 1277.87 1466.42 1989.25 2853.63 fcf mean 266.42 75 372.39 321.39 s.d 548.51 544.68 1238.95 923.36 rona mean 2.22 2.52 2.05 2.11 s.d 2.25 2.13 1.66 1.85 table 1 shows the descriptive statistics of all variables. according to the table, the mean statistics indicate that all variables have a positive mean and also nopat (1138.82) has largest mean in 2012 and rona (2.05) has the lowest mean in 2011 among the variables. the standard deviation of eva is the highest in 2012 compared to other stated variables throughout the study period. the standard deviation shows how much variation from the mean occurs. a low standard deviation indicates that the data points tend to be very close to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 395 the mean and a high standard deviation indicates that the data points are spread out over a large range of values. hence eva is spread amongst all the predictor variables. table 2. anova sum of squares df mean square f sig. between groups 259587.123 3 86529.041 .024 .995 within groups 2.137e8 60 3562172.176 total 2.140e8 63 to check whether there is a significant influence of time period from 2009 to 2012 on economic value added of 16 cnx it firms, one way anova is applied. the table 2 result indicates that the time period is not significant on eva at 5% level. graph showing mean values of the variables asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 396 table 3. correlation among the variables eva nopat fcf rona eva pearson correlation 1 .990** .880** .098 sig. (1-tailed) .000 .000 .220 n 64 64 64 64 nopat pearson correlation .990** 1 .894** .128 sig. (1-tailed) .000 .000 .157 n 64 64 64 64 fcf pearson correlation .880** .894** 1 .060 sig. (1-tailed) .000 .000 .320 n 64 64 64 64 rona pearson correlation .098 .128 .060 1 sig. (1-tailed) .220 .157 .320 n 64 64 64 64 **. correlation is significant at the 0.01 level (1-tailed). from the above table 3, the pearson correlation among the variables is strong and positive between eva and other predictor variables during the study period. the absolute value of the co-efficient measures how closely the variables are related. the closer it is to 1 the closer is the relationship. a correlation co-efficient over 0.8 indicates a strong correlation between the variables. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 397 table 4. summary statistics of the model pertaining to overall analysis between eva as the criterion variable and nopat, fcf, rona as predictor variable (enter method) year α r r2 adj. r2 std. error sig. f d.w 2009 36.589 0.995 0.989 0.986 54.471 363.617 2.514 2010 30.571 0.996 0.993 0.991 56.123 560.129 1.562 2011 -26.491 0.997 0.993 0.991 71.245 574.169 1.284 2012 65.585 0.995 0.989 0.986 122.679 363.499 1.596 unstandardized beta coefficients and ‘t’ statistic predictor nopat fcf rona year ‘β’ and (‘t’ value) ‘β’ and (‘t’ value) ‘β’ and (‘t’ value) 2009 1.019 (18.198)* -0.033 (-0.589) 0.029 (0.946) 2010 1.016 (28.027)* -0.748 (0.469) 0.078 (0.939) 2011 1.149 (6.632)* -0.148 (-0.864) -0.053 (-1.726) 2012 1.106 (6.400)* -0.096 (-0.556) -0.105 (-3.403)* *significance at 5% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 398 table 5. summary statistics of the model pertaining to overall analysis between eva as the criterion variable and nopat, fcf, rona as predictor variable (step method) year model α r r2 adj. r2 std. error r2 change sig. f predictors ‘β’ and (‘t’ value) d.w 2009 1 67.389 0.994 0.998 0.987 39.607 0.988 1137.469 nopat 0.994 (33.726) 2.662 2010 1 42.399 0.996 0.993 0.992 35.928 0.993 1871.594 nopat 0.996 (43.262) 1.685 2011 1 -108.635 0.996 0.991 0.991 49.144 0.991 1600.960 nopat 0.996 (40.012) 1.549 2012 1 -219.696 0.989 0.978 0.977 110.084 0.978 635.342 nopat 0.989 (25.206) 1.695 2 75.426 0.994 0.989 0.987 118.125 0.010 575.691 nopat rona 1.011 (33.732) -0.104 (-3.479) from the above tables, table 4 is divided into two parts. part 1 contains summary statistics of the model using regression analysis through enter method that disclose if the criterion variable eva depended significantly on the said predictor variables together. it is found that significance f in all the years was below 0.05 and hence it is inferred that eva of the companies depended significantly on nopat, fcf and rona and therefore reject null hypothesis. it proves that eva of cnx it firms depended on nopat, fcf and rona together throughout the study period from 2009 to 2012. part 2 contains unstandardised beta coefficients and t-values of predictor variables. it shows that the eva depended significantly depended on nopat than other predictors (fcf & rona) from 2009 to 2011. in 2012 eva depended on nopat and rona i.e., initially nopat played significant component in the dependency of eva whereas in further years even rona began influencing eva. table 5 contains the summary statistics through step-wise multiple regressions. it is noted that the r, r2, and adj. r2 values remain same in both enter and step-wise method. the fcf variable has no influence on value based measure eva through the study period as similar to enter method. the durbin watson statistic in both tables one and two in every year indicates that auto correlation among determinant variables in all the models throughout the study period was within the limits. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 399 table 6. compounded annual growth rate year 2009 2010 2011 2012 cagr 7.37% 21.54% 6.45% -1.68% table 6 and graph shows the compounded annual growth rate of eva, nopat, fcf and rona from 2009 to 2012. it reveals that the growth rate of nopat is high when compared to the growth rate of other variables. hence nopat is more influential variable than any other variable on eva. table 7. year on year growth rate variables eva nopat fcf rona 2009 2010 10% 13% -72% 14% 2011 -7% 19% 397% -19% 2012 22% 34% -14% 3% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 400 to be more specific on the growth of the study variables, apart from compounded annual growth rate as shown in the previous table and graph, year on year growth rate has also been computed and depicted in table 7 and the above graph. it reveals that there is more fluctuation in growth of fcf than other variables. the growth of eva is in line with nopat and rona. conclusion compared to conventional measures, eva is an epochal measure since it can be maximized and it is better if eva is larger. eva helps enormously the management and employees and the constituencies to see what should be real objective of the company, since it makes clear to all what profitability really is. eva as a value based measure is influenced by certain variables. in the study it is found that majorly net operating profit after taxes had major influence in the initial period and at the end of the study period return on net assets had influence on eva. this indicates that to shareholders value creation would be effected if there is minimum profit after taxes. references akbar parvaei, s. f. (2013). the ability of explaining and predicting of economic value addedversus net income (ni), residual income (ri) & free cash flow (fcf) in tehran stock exchange (tse). international journal of economics and finance, 5(2), 67-77. anil k sharma, s. k. (2010, may). economic value added (eva) literature review and relevant issues. international journal of economics and finance, 2(2), 200-221. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 401 banerjee, a. a. (1999, jan/june). economic value added and shareholder wealth: an empirical study of relationship. paradigm, 3(1), 99-135. bhunia, a. (2012, may). relationship between shareholder's value and financial variables a study of maximise shareholder value. universal journal of marketing and business research, 1(1), 006-016. chauhan, p. (2012). shareholders value creation in indian peroleum industry: an empirical analysis. international conference on business, economics, management and behavioral sciences. david crowther, m. d. (1998). evaluating corporate performance: a critique of economic value added. journal of applied accounting research, 4(2), 3-34. dimitrios i. maditinos, ž. š. (2006, november). the introduction of economic value added in the corporate world. international conference: innovation, entrepreneurship and competitiveness in balkan and black sea countries. farzad farsio, j. d. (2000). economic value added (eva) and stock returns. financier, philadelphia, 7(1-4). h m van der poll, n. b. (2011). an overview of the implementqation of economic value added performance measures in south africa. south african business review, 15(3). haddad, f. s. (2012). the relationship between economic value added and stock returns: evidence from jordanian banks. international research journal of finance and economics. hasani, s. m. (2012, july). relationship tthe economic value addedwith stock market value and profitabilityratios. interdisciplinary journal of contemporar research in ?business, 4(3), 406-415. ilic, m. (2010). economic value added as a modern perfomance indicator. perspectives of innovations, economics and business, 6(3). http://dx.doi.org/10.15208/pieb.2010.90 ismail, i. (2011, june). the ability of eva attributes in predicting company performance. african journal of business management, 5(12), 4993 5000. jungyu kang, k. k. (2002). economic value added (eva): a financial performance measure. journal of accounting and finance research, 10(1). peters, j. k. (2001). an inter industry analysis of economic value added as a proxy for market value added. journal of applied finance, 11(1), 41-49. rasool baradaran hasanzade, f. n. (2013). studying the relationship between financing methods and eva. trends in social science, 6(1), 90-99. salehi, m. a. (2011). eva or traditional accounting measures: empirical evidence from iran. international research journal of finance and economics, 65. microsoft word 6602-23518-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 64 risk conception and evaluation in taiwan financial markets yin-ching jan department of distribution management national chin-yi university of technology 57, sec. 2, chung-shan rd., taiping dist., taichung city, taiwan, r.o.c. tel: 886-4-23924505 e-mail:jan511@mail.ncut.edu.tw received: nov. 12, 2014 accepted: dec. 22, 2014 published: june 1, 2015 doi:10.5296/ajfa.v7i1.6602 url: http://dx.doi.org/10.5296/ajfa.v7i1.6602 abstract an experiment is designed to explore risk conception and evaluation of investors. a new risk measurement, which is called martingale variance, is included. the new measure uses previous return as benchmark instead of mean return to calculate variance. the results show that respondents are more care about expected loss than variance, but are indifferent between variance and loss probability. meanwhile, the respondents prefer martingale semivariance to martingale variance significantly. the weighted martingale semivariance also dominates martingale semivariance. the results can be helpful to explain the relationship between risk and return. keywords: downside risk, martingale variance, martingale semivariance asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 65 1. introduction the foundation of an asset pricing model is assumption of risk evaluation. when the assumption doesn’t conform to the risk conception and evaluation of investors, the asset pricing model wouldn’t explain the relationship between expected return and risk. the accuracy of capital asset pricing model (capm) would reside in whether investors apply beta to evaluate investing risk. the debate of capm in explaining risk/return focuses on the debate of the application of beta. therefore, to expect an asset’s return, we need to explore how investors evaluate risk in investing assets. in this paper, an experiment is designed to examine risk conception and evaluation of investors in taiwan financial markets. experimentation is an important means in studying the risk perception, risk attitude, and risk/return relationship. for example, gneezy and potters (1997) showed that the more frequently returns on investment are evaluated, the more risk averse investors will be. levy (1997) designed experiments to test capm, and showed partial support of the capm. olsen (1997a, 1997b) found that the risks perceived by professional portfolio managers were multidimensional, and the most important factor is return below target. wood and zaichkowsky (2004) applied segmentation approach to identify segments of individual investors based on investing attitudes and behaviors. siebenmorgen and weber (2004) examined the effect of different investment horizons on investors risk behavior. veld and veld-merkoulova (2008) found that most investors implicitly use more than one risk measure. for those investors who systematically perceive risk according to the same risk measure, semivariance of returns is most popular. in effect, the breakthrough results of behavior economy come from the experiment study of kahneman and tverskey (1979) and tverskey and kahneman (1981). the results show that respondents are more care about expected loss than variance, but are indifferent between variance and loss probability. when autocorrelation of time series return is taken into account, the respondents prefer martingale semivariance to martingale variance significantly. meanwhile, weighted martingale semivariance also dominates martingale semivariance. the results are contrary to the assumption of risk evaluation of existing asset pricing model, leading the failure of explanation of risk/return relationship. the remainder of the article is organized as follows. next section presents the experiment and methodology. section 3 shows the experimental results. finally, section 4 has concluding remarks. 2. methodology a questionnaire is designed to explore the risk conception and evaluation of investors. there are three parts in the questionnaire. the first part explores what kind of risk investors care about. the second investigates whether the investors will concern risk involved autocorrelation of time series return. the last wants to know some characteristics of respondents. the first part modifies the work of veld and veld-merkoulova (2008). their work designs two assets with four risk measures, which include variance, semivariance, probability of loss, asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 66 and expected value of loss. one asset has a lower risk measure compared to another asset, but has three higher risk measures than the other. when a respondent choose the asset with a lower risk measure, then we can ascertain what kind of risk the investor care about. nevertheless, their designed questions would be complex for investors. therefore, we modify their design to two assets with two risk measures. each asset has a lower risk measure and a higher risk measure compared to another asset. there are four questions in the first part. the first question is designed to identify respondent’s risk attitude. the traditional question let respondent to choose one among three options: risk-averse, risk-love, or risk-neutral. we let the respondent to have seven options. the first question is as follows: q1. suppose that you plan to invest new taiwan dollar (nt$) 100,000 of your own money. you can choose between two financial products. both products will be liquidated after one year, and the expected payoffs are nt$ 105,000 (there is rate of return of 5%). what do you choose? a: 100% chance of nt$105,000 payoff. b: 50% chance of nt$55,000 payoff, and 50% chance of nt$155,000 payoff. choose a choose b absolutely always sometime indifference sometime always absolutely a 100% risk-averter will absolutely choose asset a, while 100% risk-taker will absolutely choose asset b. the risk-neutral will be indifferent between these two assets. the second question is designed to explore the respondent’s concern about symmetric risk, which is measured by standard deviation, or downside risk, which is measured by semi standard deviation. q2. suppose that you plan to invest nt$100,000 of your own money. you can choose between two financial products. both products will be liquidated after one year, and the expected payoffs are nt$ 105,000 (there is a rate of return of 5%). what do you choose? c: 25% chance of nt$75,000 payoff, and 75% chance of nt$115,000 payoff. (the asset c has standard deviation of $17,321 and semi standard deviation of $15,000) d: 10% chance of nt$70,000 payoff, and 87.5% chance of nt$105,000 payoff, and 2.5% chance of nt$245,000 payoff. (the asset d has standard deviation of $24,749 and semi standard deviation of $11,068). we design third question to reflect respondent’s risk attitude between system risk and expected value of loss, and fourth question to reflect respondent’s risk attitude between system risk and probability of loss. q3. suppose that you plan to invest nt$100,000 of your own money. you can choose between two financial products. both products will be liquidated after one year, and the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 67 expected payoffs are nt$ 110,000 (there is a rate of return of 10%). what do you choose? e: 15% chance of nt$80,000 payoff, 40% chance of nt$92,000 payoff, and 45% chance of nt$136,000 payoff. (the asset e has standard deviation of $23,900 and expected loss of $62,000). f: 10% chance of nt$64,000 payoff, 60% chance of nt$99,000 payoff, and 30% chance of nt$147,000 payoff. (the asset e has standard deviation of $26,400 and expected loss of $42,000). q4. suppose that you plan to invest nt$100,000 of your own money. you can choose between two financial products. both products will be liquidated after one year, and the expected payoffs are nt$ 110,000 (there is a rate of return of 10%). what do you choose? g: 45% chance of nt$92,000 payoff, and 60% chance of nt$122,200 payoff. (the asset g has standard deviation of $14,700 and probability of loss of 40%). h: 10% chance of nt$20,000 payoff, and 90% chance of nt$120,000 payoff. (the asset h has standard deviation of $30,000 and probability of loss of 10%). 3. new risk measure and evaluation of investors the calculations of variance and semivariance don’t take autocorrelation of time series return into account. goyal and santa-clara (2003) include the autocorrelation feature in their risk measure. jan and wang (2012) use of martingale variance (mvar) to measure risk. the martingale variance uses previous return as benchmark, instead of average return, to compute variance. specifically, it is calculated as follows: )},()(2{ )})(())(r2{( )( )( 1 1 2 1 t 1t 22 t 1 2 1 − = − = = − −= −−− = − =   tt t t tt t t tt rrcovrvar t rerrre t rr rmvar [1] the second part of the questionnaire is designed to detect whether the investors will concern risk involved autocorrelation of time series return. i use diagram instead of numeric rate of return to reflect the time series pattern. there are three questions in this part. the first question, which is shown below, is designed to compare the traditional variance and martingale variance. we still use the likert seven point scales. q1. the following diagrams show two time-series pattern of asset’s return, whose average returns equal to zero. which asset do you think more risky? asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 68 choose a choose b absolutely always sometime indifference sometime always absolutely we see that the variance and semivariance of a and b are same. however, the martingale variance of asset b is higher than that of asset a. that is because the autocorrelation feature has been included in the calculation of martingale variance. the second question lets the respondent to choose either martingale variance or martingale semivariance. the martingale semivariance (msvar) is similar to the relative semivariance. nevertheless, the martingale semivariance, which is shown as below, applies past return as the time-varying return benchmark. t rrmin rmsvar t t tt = −− = 1 2 1)},0({ )( [2] q2. the following diagrams show two time-series pattern of asset’s return, whose average returns equal to zero. which asset do you think more risky? the time series return of asset c is growing, while asset d is downward. however, the variance, semivariance, and martingale variance of c are the same as those of d. nevertheless, the martingale semivariance of d is larger than that of c. a -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 b -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 c -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 d -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 69 the martingale semivariance can’t distinguish between the assets whose return rising firstly and then declining, and the assets whose return declining firstly and then rising. however, the investors may not be indifference between these two time series return pattern. we design third question as follows. q3. the following diagrams show two time-series pattern of asset’s return, whose average returns equal to zero. which asset do you think more risky? we can see that the assets e and f have the same measures of variance, semivariance, martingale variance, and martingale seimivariance. to separate these two return pattern by risk measure, jan (2014) propose a weighted martingale semivariance (wmsvar), which is reached by the combination of the martingale semivariance and the use of weighted average method. when we put more weights to the recent return variations, the weighted martingale semivariance of e would be larger than that of f. that is,  = −−= t t ttt rrminwrwmsvar 1 2 1 )},0({)( [3] the respondent’s characteristics are put in the final part, including gender, whether diversified investing, and benchmark setting. we also design two questions to examine internal consistency in the last two questions. the questionnaire of the respondent’s characteristics can be found in appendix. gender differences in risk propensity and strategy in financial decision-making have been well studied. see weber, blais, and betz (2002), and fellner and maciejovsky (2007) for example. their results show that females are more risk-averse than males. we want to see whether the results also exist in taiwan financial market. to improve reliability of the study, we need respondents to be familiar with risk measurement. therefore, the respondents are college students which major in finance. specifically, all of the 191 respondents come from department of finance and department of finance and insurance in national taichung university of science and technology. 4. results table 1 exhibits summary statistics for the respondents’ characteristics. there are 120 respondents are female, which is 63% of the 191 samples. most investors consider diversified portfolio when investing. only 2% of the investors don’t diversify. the most benchmark e -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 f -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 70 investor compared is market portfolio, which reaches 60%. we employ cronbach alpha to compute the internal consistency. cronbach alpha is frequently used as a measurement to estimate reliability for multi-item scales. cronbach's alpha for the last two questions reaches 0.802, which shows a reliable internal consistency. table 1. summary statistics for the respondents’ characteristics respondent’s characteristics count frequency gender male 70 36.8% female 120 63.2% diversify always consider 41 21.6% often consider 87 45.8% sometimes consider 58 30.5% never consider 4 2.1% benchmark initial investment 44 23.9% risk-free rate 25 13.6% market portfolio 111 60.3% others 4 2.2% the summary statistics and t tests for paired risk measures are shown in table 2. remember that the measurement we used is likert seven scales. a risk-neutral investor will be indifferent to these two assets, and will be measured by four. a risk-averse investor would be measured by less than four. the results show that the average of risk measure is 3.69, and is less than 4 significantly, which implies that investors are risk-averse. the second figure shows the risk measured by variance versus semivariance. the mean, which is 3.68, indicates that the respondents are more care about variance than semivariance on average, and reaches 5% significance level. it’s surprised that the result doesn’t conform to the evidences of veld and veld-merkoulova (2008). they find that semivariance of returns is most popular for those investors who systematically perceive risk according to the same risk measure. the next two figures show that respondents are more care about expected loss than variance at 1% significance level, but are indifferent between variance and loss probability. the result is similar to the work of veld and veld-merkoulova (2008) for bond investors, but is contrary to the work of duxbury and summers (2004), whose found that individuals’ perceptions of risk are linked to loss probability. all the results show that the risk perception and evaluation of taiwan investors isn’t same as other financial markets. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 71 table 2. summary statistics and t tests for paired risk measures risk attitude choice mean standard deviation t( : = ) p value risk-averse versus risk-love 3.69 1.842 -2.288 .023** variance versus semivariance 3.68 1.903 -2.238 .026** variance versus expected loss 4.58 1.834 4.268 .000*** variance versus loss probability 3.81 2.033 -1.279 .202 variance versus martingale variance 4.21 1.881 1.525 .129 martingale variance versus martingale semivariance 4.44 1.674 3.558 .000*** weighted martingale semivariance versus martingale semivariance 3.80 1.447 -1.849 .066* *, **, *** denote 10%, 5%, and 1% significance level, respectively. the last three results examine whether the investors concern risk involved autocorrelation of time series return. when we compare variance in contrast to martingale variance, the respondents prefer martingale variance to variance on average, but don’t reach significance level. the next figures present that the respondents prefer martingale semivariance to martingale variance at 1% significance level. meanwhile, weighted martingale semivariance also dominates martingale semivariance at 10% significance level. a high martingale semivariacne or weighted martingale semivariance implies that the asset’s return is declining, leading a high loss probability and expected loss. furthermore, there exists a liquidity risk when the asset’s return is declining. llorente, et. al (2002) found that the cross‐sectional variation in the relation between volume and return autocorrelation is related. the results may explain why most existing apm can’t explain the risk/return relationship in the taiwan exchange market. the low percentage in considering symmetric risk in taiwan is same as other studies on the developing market, e.g., veld and veld-merkoulova (2008). the results support downside risk studies of stevenson (2001), estrada (2003), and ang, chen, and xing (2006), among others. the results can help to explain why the downside risk measures can result in improvement in risk/return relationship. table 3 shows the risk conceptions by respondent’s gender. the results tells that male investors are more risk-seeking than female on average, but don’t reach significance level. the results are not similar to the work of weber, blais, and betz (2002), and fellner and maciejovsky (2007), who show that woman are more risk averse than man. the second result shows that male concerns semivariance, while female concerns variance. when compared variance versus expected loss, loss probability, and martingale variance, there is indifferent between female and male. the next result presents that male concerns about martingale semivariance in contrast to martingale variance as female, but is more cared about martingale semivariance than female at 5% significance level. the last result in table 3 tells that man concerns martingale semivariance, while woman concerns weighted martingale semivariance. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 72 the different reaches 5% significance level. table 3. two independent samples t tests by gender risk attitude choice gender mean standard t p value risk averse versus risk love male 3.94 1.828 1.409 0.161 female 3.54 1.849 variance versus semivariance male 4.11 2.016 2.350 .020** female 3.42 1.799 variance versus expected loss male 4.45 1.985 -0.710 0.478 female 4.65 1.750 variance versus loss probability male 3.85 2.234 0.159 0.874 female 3.80 1.920 variance versus martingale variance male 3.99 1.943 -1.193 0.235 female 4.33 1.840 martingale variance versus martingale semivariance male 4.79 1.775 2.213 .028** female 4.23 1.590 weighted martingale semi variance versus martingale semivariance male 4.10 1.499 2.185 .030** femal 3.62 1.391 ** denotes 5% significance level. 5. conclusions i design an experiment to examine risk conception and evaluation of investors. the results show that respondents are more care about expected loss than variance, but are indifferent between variance and loss probability. when autocorrelation of time series return is taken into account, the respondents prefer martingale semivariance to martingale variance significantly. meanwhile, weighted martingale semivariance also dominates martingale semivariance. the results are contrary to the assumption of risk evaluation of asset pricing model, leading the failure of explanation of risk/return relationship. i also explore the risk conceptions by respondent’s gender. the results present that male concern about martingale semivariance in contrast to martingale variance as female. the results also tell that man concerns martingale semivariance, while woman concerns weighted martingale semivariance. all of the results can be applied to the calculation of risk and the examination of the return/risk relationship. references ang, a., chen j., & xing y. 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(2004). attitudes and the trading behavior of stock market investors: a segmentation approach, journal of behavioral finance, 5, 170-179. http://dx.doi.org/10.1207/s15427579jpfm0503_5 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 75 appendix questionnaire of the respondent’s characteristics (in chinese) 1. your gender is: □ male □ female. 2. when you invest a specific asset, do you consider the relationship between the asset and your existing portfolio? □always consider □often consider □sometime consider □never consider 3. when you evaluate the performance of your portfolio, what is your benchmark? □ the initial investment □ riskfree asset □ market portfolio □ other. 4. investment always entails risks, and high risk is rewarded by high return. please indicate your risk tolerance by 1 to 5, where 1 denotes low risk tolerance and 5 denotes high risk tolerance. 5. which project you will choose among following investment opportunities: risk expected return volatility of rate of return □ very low 7.5% 5%~9% □ low 9.0% 3%~12% □ middle 10.5% 0%~21% □ high 12.5 -3%~25% □ very high 13.5% -9%~32% microsoft word 6000-21575-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 75 disclosure quality and corporate governance: evidence from iran fatemeh soheilyfar accounting department, dezful branch, islamic azad university, dezful, iran e-mail: nasimsoheilyfar@yahoo.com mohammad tamimi accounting department, dezful branch, islamic azad university, dezful, iran e-mail: tamimi.mohammad@gmail.com mohammad ramezan ahmadi accounting department, shahid chamran university, ahvaz, iran e-mail: ahmadi-m@scu.ac.ir nasrollah takhtaei (corresponding author) accounting department, dezful branch, islamic azad university, dezful, iran e-mail: nasrollah_takhtaei@yahoo.com received: july 20, 2014 accepted: august 13, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6000 url: http://dx.doi.org/10.5296/ajfa.v6i2.6000 abstract this study explores the relationship between disclosure quality and corporate governance in tehran stock exchange (tse). in this study, the mechanisms of corporate governance are consist of internal audit, ownership concentration, ceo duality, board independence, board size, board chairman independence, and chairman tenure. on the other hand, the measure of disclosure quality calculated by the stock exchange organization (seo) has been used as a proxy for disclosure quality. using a sample of 83 accepted firms on tehran stock exchange (tse) over the period from 2005 to 2010, the results reveal that there is a significant and positive relationship disclosure quality and each of independent variables such as internal audit, ownership concentration, ceo duality, board independence, and chairman independence, but no association between disclosure quality and each of board size and chairman tenure. keywords: disclosure quality, corporate governance, informational asymmetry asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 76 1. introduction considering the process of the disclosure of the information, the investors deal with informational asymmetry. this problem arises when one of the two parties to a deal has more information than the other (graham, koski, & loewenstein, 2006). the role of the responsible individuals of the information disclosure is indicated in the corporate governance which includes monitoring and the procedures to make sure that not only the firm management does not have incentive to make their own profits but also they attempt to increase the interests of the investors and the firm value (kanagaretnam, lobo, & whalen, 2007). the appropriate application of the corporate governance mechanisms is a basic step to use optimum resources, increasing the responsibility, transparency, regarding the justice and the rights of the parties who have interests in the firm (jalali, 2008). the high level of disclosure quality is useful for the firm because it has the potential to decrease the cost of capital (botosan, 1997; diamond & verrecchia, 1991; lev, 1992), meaning that it may lead to decreasing the expense of the debt (sengupta, 1998) and increasing the stock price (healy, hutton, & palepu, 1999; lang & lundholm, 2000; welker, 1995). however, if the given information by the managers is not completed, the firms will not get all of the advantages. considering the motivations of managing for information disclosure, it is possible that the information disclosure be distorted (donnelly & mulcahy, 2008). the low level of information disclosure causes inappropriate allocation of the resources in the stock market, since it causes that the investors make economic decisions based on wrong information (cerbioni & parbonetti, 2007). the current study investigates if the corporate governance mechanisms influence on the information disclosure quality. 2. literature review klein (1998) investigates about the role of the non-independent directors and independent directors, in undertaking the duties of the decision management and decision control, and she required some documents in the case of the value of the presence of non-independent directors in control committees such as the audit committee and supervisory committee to the financial reporting quality (nikoomaram & badavar nahandi, 2009). lakhal (2005) examines the relationship between the voluntary disclosure of the french firms’ managers and the mechanisms of corporate governance. the results show that if the ownership structure is pretty dispersed and has more non-independent managers on board, the level of voluntary disclosure will be increased. the duality in managing director’s duties will probably decrease the level of the voluntary disclosure of the information. there is a small relationship among the number of the board independent members and making decision about voluntary disclosure and board size and voluntary disclosure. the results of the research indicate a negative relationship between board size and voluntary disclosure which is not what they expected. the relationship between the firm characteristics, the corporate governance rules and the level of voluntary disclosure in spain was explored by babío arcay and muiño vázquez (2005). the results of the study show that the ratio of independent directors on the board of directors, the existence of the audit committee in the firm and the cooperation of the board of directors in the firm investment and also offering the stock option plans to the managers as the fee, are related to the disclosure. cheng and courtenay (2006) analyze the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 77 relationship between the ratio of independent directors on the board of directors, the board size and also the duality of the managing director’s duties with voluntary disclosure. the results indicate that the ratio of the independent directors is directly related to the level of voluntary disclosure and also the board size and the duality of the managing director’s duties are not related to the voluntary disclosure. akhtaruddin, hossain, hossain, and yao (2009) investigate the relationship between corporate governance and voluntary disclosure of information in annual reports. the results demonstrate that there is a positive association between the board size and the voluntary disclosure of the information and also between the number of the independent managers and voluntary disclosure of information. nevertheless, the level of the voluntary disclosure has a negative relationship with family control, but there is no relationship between the ratio of the audit committee members to total number of directors on the board and voluntary disclosure of information. sajadi, zaranejad, and jafari (2009) investigate the non-financial characteristics effectiveness to the quality of the financial reporting in accepted firms on tehran stock exchange. the results reveal that the size of the firm, the age of the firm and the type of the industry have a positive and significant relationship and the ownership structure has a negative relationship with the financial reporting quality, but type of audit firm is not significantly associated with financial reporting quality. khodadadi, khazami, and aflatooni (2010) explore “the effect of corporate governance structure on the extent of voluntary disclosure in iran”. in their study, the corporate governance mechanisms were the ratio of the independent directors on the board of directors, the percentage of the institutional investors and the duality of the managing director and the chairman of board of directors’ duties. using a sample of 106 accepted firms on tehran stock exchange (tse) during period from 2001 to 2005, the results indicate that there is a significant relationship between the ratio of the independent directors and duality in the managing director’s duties with the level of voluntary disclosure. in addition, the results document a significant association between the percentage of the institutional investors and the level of voluntary disclosure of information. using a sample of accepted firms on tehran stock exchange over the period from 2002 to 2009, khoshbakht and mohammadzadeh salteh (2011) investigate the relationship between the corporate governance mechanisms and the discretionary disclosure of information. in their study, the corporate governance mechanisms include the percentage of the board independent members, the ownership concentration, institutional ownership, free floating stocks and the type of the firm auditor. the results reveal that the relationship between the percentage of the independent directors on board and institutional ownership with the level of the discretionary disclosure of information in the firms is significant, but they report no significant relationship between three mechanisms of the corporate governance such as ownership concentration, free floating stocks and the type of the firm auditor and the level of the discretionary disclosure of information. aburaya (2012) examines the relationship between the corporate governance and the environmental disclosure quality of the firm. the results designate that there is significant association between the environmental disclosure quality of the big firms and the mechanisms of corporate governance. the results also report a negative and association asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 78 between ceo duality and environmental disclosure quality, indicating that holding position of the managing director and board chairman by the same person reduce environmental disclosure quality, but a positive and significant association board meetings and environmental disclosure quality, suggesting that the more the number of board meetings, the more the quality of environmental disclosure. in a similar way, katmun (2012) investigates the effective factors on disclosure quality. the results show that there is a significant positive relationship between each of audit committee, number of board meetings, board independence and disclosure quality. 2.1. research hypotheses according to the abovementioned literature, seven hypotheses are developed as follows: h1: there is a significant relationship between internal audit unit and disclosure quality. h2: there is a significant relationship between ownership concentration and disclosure quality. h3: there is a significant relationship between ceo duality and disclosure quality. h4: there is a significant relationship between board independence and disclosure quality. h5: there is a significant relationship between board size and disclosure quality. h6: there is a significant relationship between board chairman independence and disclosure quality. h7: there is a significant relationship between chairman tenure and disclosure quality. 3. research methodology this research is a type of correlational and regression analysis and hence will investigate the correlation between dependent variable and independent variables. since the data are of cross-section and time-series type, the panel data models (fixed or random effects) are used to test the hypotheses. 3.1. sample selection and data sources the sample consists of 83 accepted firms on the tehran stock exchange (tse) during the period from 2005 to 2010 (5 fiscal years), and accordingly 498 firm-year observations are used. data required to test the hypotheses are collected using data sources such as compact disks (cds) issued by tehran stock exchange organization, tadbirpardaz database and other sites of stock exchange organization. 3.2. variables definition 3.2.1. measuring dependent variable 1. disclosure quality (dq) is the dependent variable in this study. to measure this variable, the annual report under title "ranking firms by disclosure quality score" is employed in which each firm is given a score by tehran stock exchange organization (tseo) annually. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 79 3.2.2. measuring independent variables 1. internal audit (ia): to measure this variable, a dummy variable is used where internal audit (ia) set to "1" if firm has internal audit unit and zero "0" otherwise. 2. ownership concentration (owncon): ownership concentration is measured as the ratio of common shares owned by concentrated shareholders over total shares outstanding by firms. 3. ceo duality (ceod): a dummy variable is used to measure the ceo duality where ceo duality equals "1" if chief executive director is not board chairman and zero "0" otherwise. 4. board independence (bodind): this variable is measured as the number of independent directors on board divided by total number of board of directors. 5. board size (bods): board size is defined as the number of total number of board of directors who may be independent or non-independent directors. 6. board chairman independence (bodci): board chairman independence (bodci) is measured by a dummy variable where board chairman independence (bodci) set to "1" if the chairman of the board is a non-executive director and zero "0" otherwise. 7. chairman tenure (chairten): chairman tenure is measured as the number of years the chairman had held that position in a given firm. 3.2.3. measuring control variables 1. financial leverage (lev): financial leverage as a control variable is measured as the total debts liabilities over total assets. 2. firm size (fsize): firm size is the control variable which is measured by the natural logarithm of total assets of the firm at the end of the fiscal year. 3.3. model specification dq = β1 + β2 (ia) + β3 (owncon) + β4 (ceod) + β5 (bodind) + β6 (bods) + β7 (bodci) + β8 (chairten) + β9 (lev) + β10 (fsize) + ε where: dq = disclosure quality iau = internal audit owncon = ownership concentration ceod = ceo duality bodind = board independence bods = board size bodci = board chairman independence chairten = chairman tenure lev = financial leverage asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 80 fsize = firm size 4. empirical results 4.1. descriptive statistics usually the most useful and first step in organizing data is ordering data based on a logical criterion and then acquiring the central indexes and distribution. totally, by appropriate using of descriptive (statistics) methods, the characteristics of one group of the information can be expressed exactly. descriptive statistics is always used for determining and expressing the characteristics of research information. therefore, in this section descriptive statistics of variables in research will be investigated, which is presented in table 1. the numbers present a general statue of the research data distribution. the most significant central index is mean which indicates the balance point and the center of distribution and also is a good index to show the centrality of the data. median is another central index which shows the statue of population. in general, distribution parameters are criteria to determine the level of distribution of each other or distribution to the mean. the range indicates the range of the largest number and smallest number. one of the most important distribution parameters is standard deviation. among the research variables, ownership concentration and board tenure has the highest and the lowest distribution respectively. the level of asymmetry of the frequency graph is called skewness. if skewness coefficient is 0, the population will completely be symmetric and if the coefficient is positive, skewness will be towards the right side and if the coefficient is negative, skewness will be towards the left side of the graph. the size of the firm has the most asymmetry and disclosure quality has the less asymmetry to the normal distribution. table 1. descriptive statistics variables dq iau owncon ceod bodind bods bodci chairten lev fsize mean 50.10 0.55 0.436 0.85 0.61 5.18 0.77 3.71 0.73 5.86 median 50 1.00 0.41 1.00 0.60 5.00 1.00 2.00 0.77 5.80 maximum 98 1.00 0.89 1.00 1.00 10.00 1.00 20.00 3.33 8.64 minimum −13 0.00 0.12 0.00 0.00 3.00 0.00 1.00 0.01 2.80 st.dev 25.9 0.497 0.19 0.36 0.22 0.62 0.49 3.78 0.29 0.65 skewness −0.16 −0.22 0.38 −1.84 −0.39 3.16 −1.30 2.09 1.72 0.42 observations 498 498 498 498 498 498 498 498 498 498 note: dq = disclosure quality; ia= internal audit; owncon = ownership concentration; ceod = ceo duality; bodind = board independence; bods = board size; bodci = board chairman independence; chairten = chairman tenure; lev = financial leverage; fsize = firm size asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 81 4.2. pearson correlation to determine the level of the relationship among the variables, pearson correlation coefficient has been used. correlation coefficient is a statistical way to measure the level that a variable can be related to another variable linearly. the correlation coefficient should not be high among the variables of model. gujarati (2003) argues that as a thumb of rule, correlation coefficient more than 0.8 is regarded as high correlation and hence indicates a serious problem of multicollinearity. since the high correlation among the independent variables in a model, may lead to spoiling the results of regression. when the significance coefficient of a variable is less than 5% (sig<5%), h0 will be rejected and h1 will be cofirmed and significance of the two variables will be acceptable otherwise it will be unacceptable. as it is seen in the table, the level of correlation among the research variables indicates a significant correlation among the most of the variables, and therefore the results indicate that there is no multicollinearity between our variables. table 2. pearson correlation matrix dq iau owncon ceod bodind bods bodci chairten lev fsize dq 1.00 iau 0.29* 1.00 owncon 0.10* −0.12 1.00 ceod 0.32* 0.02* 0.02 1.00 bodind 0.33* 0.17* 0.14* 0.57* 1.00 bods −0.02 0.00 0.04 −0.07 −0.02 1.00 bodci 0.23* 0.08 0.15* 0.65* 0.59* −0.04 1.00 chairten 0.00 −0.07 0.04* −0.08 −0.03 0.09 0.00 1.00 lev 0.03 −0.16* −0.03 0.16* 0.10* −0.04 −0.04 0.10* 1.00 fsize −0.04 −0.07 0.36* 0.06 0.08 0.21* 0.12* −0.17* 0.09 1.00 note: dq = disclosure quality; iau= internal audit unit; owncon = ownership concentration; ceod = ceo duality; bodind = board independence; bods = board size; bodci = board chairman independence; chairten = chairman tenure; lev = leverage; fsize = firm size 4.3. regression results and discussion according to the results of hausman-test, the most suitable estimation method for all models is random effects. therefore all models are run based on random effects estimation method. in model1, (f=21.33) statistics, indicates the significance of regression model1 that since p-value<5%, and hence regression model1 is significant. r2 = 29% also indicates the level of the relationship of the independent variables with disclosure quality (dependent variable). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 82 internal audit unit independent variable is significant and indicates a positive and significant relationship between internal audit unit and disclosure quality as 15.91%. therefore, the first hypothesis is not rejected since our results support it. the control variables in this model are not significant as well. in model2, (f=14.87) statistics, indicates the significance of regression model2 that since p-value<5%, regression model is significant. r2 = 22% also indicates the level of the relationship of the independent variables with disclosure quality (dependent variable). ownership concentration independent variable is significant and indicates a positive and significant relationship between ownership concentration and disclosure quality as 20.13%. therefore, the second hypothesis is not rejected since our results support it. the size of the firm as control variable is significant as well and it is equal to −6.34. in model3, (f=18.30) statistics, indicates the significance of regression model3 that since p-value<5%, regression model3 is significant. r2 = 26% also indicates the level of the relationship of the independent variables with disclosure quality (dependent variable). ceo duality as an independent variable is significant and indicates a positive and significant relationship between ceo duality and disclosure quality as 18.77%. therefore, the third hypothesis is not rejected since our results support it. the size of the firm as control variable is significant as well and it is equal to −2.36. in model4, (f=19) statistics, indicates the significance of regression model4 that since p-value<5%, regression model4 is significant. r2 = 27% also indicates the level of the relationship of the independent and control variables with disclosure quality (dependent variable). board independence as an independent variable is significant and indicates a positive and significant relationship between board independence and disclosure quality as 30.29%. therefore, the fourth hypothesis is not rejected since our results support it. the size of the firm as control variable is significant as well and it is equal to −4.61. in model5, (f=13.52) statistics, indicates the significance of regression model5 that since p-value<5%, regression model5 is significant. r2 = 21% also indicates the level of the relationship of the independent variables with disclosure quality (dependent variable). board size as an independent variable is not significant (p-value = 0.34). therefore, fifth hypothesis is rejected because our result does not support it. the size of the firm as control variable is significant as well and it is equal to −4.41. in model6, (f=15.44) statistics, indicates the significance of regression model6 that since p-value<5%, regression model6 is significant. r2 = 23% also indicates the level of the relationship of the independent variables with disclosure quality (dependent variable). board chairman independence as an independent variable is significant and indicates a positive and significant relationship between board chairman independence and disclosure quality as 10.26%. therefore, the sixth hypothesis is not rejected since our results support it. the size of the firm as control variable is significant as well and it is equal to −4.7. in model7, (f=13.41) statistics, indicates the significance of regression model7 that since p-value<5%, regression model7 is significant. r2 = 21% also indicates the level of the relationship of the independent variables with disclosure quality (dependent variable). the chairman tenure as an independent variable is not significant (p-value =0.6). therefore, seventh hypothesis is rejected because our result does not support it. the size of the firm as control variable is significant as well and it is equal to −3.8. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 83 table 3. multivariate analysis 5. conclusion more and better disclosure of information is one of the effective and important characteristics and factors in investors' economic decisions and also one of the appropriate characteristics in competitive markets. the firms with stronger systems of corporate governance and appropriate monitoring may have more ability to impact on the firm management in order to disclose more and better information. the mentioned firms have the better qualitative indexes of the market and their stocks prices are less influenced by the deals and the possibility for dealing in these firms is at a low level based on confidential information, that is, the asymmetry of information is less and these firms lead to the efficiency of the capital market (khoshbakht & mohammadzadeh salteh, 2011). in this research, the association between corporate governance and disclosure quality has been investigated. using a sample of 83 listed firms on tehran stocks exchange (tse) during period from 2005 to 2010, the results indicate that there is a significant and direct relationship between disclosure quality and explanatory variables such as internal audit, ownership concentration, ceo duality, board independent variables model1 model2 model3 model4 model5 model6 model7 constant 56.33 (0.000) 77.07 (0.000) 61.12 (0.000) 60 (0.000) 66.02 (0.000) 69.55 (0.000) 71.63 (0.000) internal audit 15.91* (0.000) − − − − − − − − − − − concentration − 20.13* (0.000) − − − − − ceo duality − − 18.77* (0.000) − − − − board independence − − − 30.29* (0.000) − − − board size − − − − 1.81 (0.34) − − board chairman independence − − − − − 10.26* (0.000) − chairman tenure − − − − − − 0.16 (0.6) financial leverage 5.02 (0.2) 1.375 (0.7) -0.7 (0.47) -1.49 (0.7) 0.74 (0.8) 0.26 (0.94) 0.29 (0.9) firm size −1.74 (0.08) −6.34* (0.00) −2.36* (0.01) −4.61* (0.01) −4.41* (0.02) −4.7* (0.01) −3.8* (0.04) f 21.33 (0.00) 14.87 (0.00) 18.30 (0.00) 19 (0.00) 13.52 (0.00) 15.44 (0.00) 13.41 (0.00) r2 29% 22% 26% 27% 21% 23% 21% no of observations 498 498 498 498 498 498 498 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 84 independence, and board chairman independence. however, our findings reveal that disclosure quality is not significantly associated with board size and chairman tenure of the board. reference aburaya, r. 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(1998). corporate disclosure quality and the cost of debt. the accounting review, 73(4), 459-474. doi: 10.2307/248186 welker, m. (1995). disclosure policy, information asymmetry, and liquidity in equity markets. contemporary accounting research, 11(2), 801-827. http://dx.doi.org/10.1111/j.1911-3846.1995.tb00467.x microsoft word 6751-28624-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 23 beta estimation in indian stock markets some issues mihir dash professor and head, department of quantitative methods school of business, alliance university, chikkahagade cross, chandapura-anekal road, anekal, bangalore tel: 91-994-518-2465 e-mail: mihirda@rediffmail.com received: dec. 8, 2015 accepted: august 1, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.6751 url: http://dx.doi.org/10.5296/ajfa.v7i2.6751 abstract this study examines the reliability of the ols beta estimates in indian stock markets by considering the residual characteristics of the market model regressions. the statistics used include the coefficient of determination (r2), the f-test for significance of the regression coefficient, the durbin-watson test for serial autocorrelation, the residual autocorrelation function, the kolmogorov-smirnov and shapiro-wilk tests for normality of the residuals, the presence of outliers, and white’s test for heteroskedasticity. the results of the study indicate some serious issues afflicting beta estimation in indian stock markets, including: non-normality of stock returns and of residuals, extreme standardized residual values, heteroskedasticity, residual autocorrelation, and low r2. thus, the simple market model is likely to result in biased estimates for beta in indian stock markets. keywords: beta, indian stock markets, non-normality, extreme values, heteroskedasticity, residual autocorrelation. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 24 introduction the concept of beta is at the heart of the capital asset pricing model (capm) of treynor (1961), sharpe (1964), lintner (1965) and mossin (1966). beta is a measure of an asset’s systematic risk, representing the component of the asset’s total risk that is undiversifiable through portfolio formation. thus, beta is the portion of the asset’s total risk that is associated with overall movements in the market or economy in general. in other words, beta measures the sensitivity of the asset’s returns to movements in the market. beta plays an important role in many financial applications such as estimating the cost of capital, applying various valuation models, and determining portfolio strategies. it is also used extensively in financial research, for applications such as determining relative risk, testing asset pricing models, testing trading strategies, and conducting event studies. the capm assigns beta a central role in asset pricing. it is based on the principle that the relevant risk measure in holding a given security is the systematic risk, or beta, because all other sources of risk can be diversified away. this yields a linear relationship in equilibrium between the expected return of the asset and its beta. a common approach to estimating beta is to apply the standard market model estimated under the ordinary least squares (ols) technique. this was strongly advocated by fama and macbeth (1973), who interpreted the capm as implying a basic linear relationship between stock returns and market betas which should completely explain the cross-section of returns at a specific point in time. they proposed a two-pass methodology for empirically testing the capm. in the first pass, betas are estimated from a time-series regression of stock or portfolio returns on market returns, using a stock market index as a proxy for the market portfolio. in the second pass, the relationship between mean returns and betas is tested cross-sectionally across stocks or portfolios. this study examines some issues in beta estimation in indian stock markets, specifically those that arise from the time series nature of the market model regressions. literature review the fama-macbeth (1973) methodology has been accepted as a standard procedure for testing the capm, and other factor models are often tested through a similar procedure: a regression model is proposed for the stock returns, and the theoretical implications are tested as hypotheses on the parameters of the regression model. however, the fama-macbeth methodology has been the subject of much criticism that has led to many attempts at improvement. roll (1977) argued that that capm was logically equivalent to the assertion that the market portfolio was mean-variance efficient (i.e. that the capm was just a tautology), and, more seriously, that the market portfolio was in fact unobservable (i.e. the stock market index is not an appropriate model for the market portfolio). another major setback to the fama-macbeth methodology came from a series of papers by fama and french (e.g. fama and french, 1992) which asserted that beta by itself is not sufficient for explaining expected return in particular, the empirical anomalies of the size effect, wherein small stocks outperform large stocks (fama and french, 1992), and the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 25 book-to-market effect, wherein stocks with high book-to-market equity ratios outperform stocks with low book-to-market ratios (fama and french, 1992). further, fama and french (1992) demonstrated that the cross-sectional relationship between systematic risk and return was not significant once firm size and book-to-market ratio were included as explanatory variables. on the other hand, using alternative econometric techniques, amihud et al (1992) reclaimed beta as the valid measure of risk in asset pricing, overturning fama and french’s results. another source of difficulty in the estimation of beta is the problem of time-varying betas and the stability of betas. the capm assumes that the beta coefficient is constant through time. blume (1971) found that portfolio betas tend to regress toward the mean over time, and found low correlations of ols betas through time, concluding that the estimate of an individual firm’s beta has low predictive power for decision making in the current period. vasicek (1973) argued that ols beta estimates were biased in the sense that the more the sample estimate deviates from an unconditional expectation, the greater the chance that the estimate results from sampling error. using bayesian techniques, he proposed an unbiased beta estimate. gray et al (2009) argued that ols beta estimates with r2 less than 10% were unreliable, were likely to be significantly lower than the true beta, and were expected to vary considerably over time. they recommended the use of the vasicek correction technique especially for low r2/beta estimates. a basic principle of the capm involves the separation of estimating beta risk from its pricing. the capm assumes that one can define and measure systematic risk irrespective of risk aversion, which affects only the equilibrium pricing of individual assets. however, this separation is valid only under the restrictive assumption of two-factor separating distributions or alternatively, if the utility function is quadratic. an additional issue that complicates the problem of estimating beta is that one cannot separate the issue of risk aversion from the statistical loss function used in the estimation. risk aversion signifies the asymmetric treatment of deviations from the regression of stock returns on market returns; on the other hand, statistical theory implies the equal treatment of observations. the clash between financial and statistical theories complicates the estimation procedure. shalit and yitzaki (2002) found that ols estimators of beta coefficients of stocks and portfolios were highly sensitive to observations of extremes in market index returns, and that this sensitivity was rooted in the inconsistency of the quadratic loss function in financial theory. they proposed to introduce considerations of risk aversion into the estimation procedure using alternative estimators derived from gini measures of variability to improve the reliability of beta estimators. another difficulty in the fama-macbeth methodology is the assumption of constant variance/volatility. there is a vast literature incorporating arch and garch models in the market model in order to improve the beta estimates (e.g. armitage and brzeszczynski, 2011). this methodology tends to result in lower beta estimates than ols, and is significantly so for large-cap stocks. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 26 methodology the objective of the study is to examine some issues in beta estimation in indian capital markets. the data for the study consisted of daily closing prices of all the stocks comprising the cnx nifty in india’s national stock exchange (nse) as on 01/04/2014. the study period selected was april 1, 2013 march 31, 2014. the rates of return of each of the stocks and the index have been calculated using the log-returns formula , = ln ( , ,⁄ ), where si,t and si,t-1 represent the closing prices of the stock/index at time t and t-1, respectively, correcting suitably for dividends, stock-splits/bonus share issues, and share buy-backs. the beta coefficients βi were then calculated using the market model as follows: , = + , + , , where rm,t denotes the rate of return on the cnx nifty, and αi and βi are the regression parameters to be estimated. the study examines the reliability of the ols beta estimates by considering the residual characteristics of the market model regressions. the statistics used include the coefficient of determination (r2), the f-test for significance of the regression coefficient, the durbin-watson test for serial autocorrelation, the residual autocorrelation function, the kolmogorov-smirnov and shapiro-wilk tests for normality of the residuals, the presence of outliers, and white’s test for heteroskedasticity. findings the descriptive statistics and normality tests for each of the stocks and the index are presented in table 1 below. the scatterplot of mean returns against standard deviation of returns is presented in figure 1. table 1. descriptive statistics and normality tests min. max. mean std. dev. k.-s. test p-value s.-w. test p-value nifty -4.17% 3.74% 0.07% 1.14% 0.0647 0.0128 0.9797 0.0012 acc -6.61% 6.07% 0.08% 1.74% 0.0572 0.0457 0.9836 0.0054 ambuja cement -11.17% 7.73% 0.06% 2.06% 0.0500 0.2000 0.9638 0.0000 asian paints -7.79% 7.27% 0.04% 1.80% 0.0801 0.0006 0.9619 0.0000 axis bank -9.90% 14.60% 0.05% 2.71% 0.0578 0.0412 0.9605 0.0000 bajaj auto -4.72% 5.40% 0.06% 1.57% 0.0445 0.2000 0.9913 0.1437 bank of baroda -8.93% 10.08% 0.03% 2.82% 0.0668 0.0086 0.9811 0.0020 bharati airtel -6.39% 7.55% 0.03% 2.21% 0.0727 0.0027 0.9865 0.0181 bhel -21.38% 8.64% 0.04% 3.11% 0.0831 0.0002 0.9005 0.0000 bpcl -8.94% 7.22% 0.08% 2.45% 0.0602 0.0282 0.9774 0.0005 cairn -4.95% 5.21% 0.08% 1.50% 0.0912 0.0000 0.9666 0.0000 cipla -8.19% 4.76% 0.00% 1.47% 0.0467 0.2000 0.9566 0.0000 coal india -10.68% 6.73% -0.03% 2.00% 0.0555 0.0591 0.9698 0.0000 dlf -12.34% 9.25% -0.11% 3.27% 0.0696 0.0051 0.9824 0.0034 dr reddy's -4.40% 4.67% 0.15% 1.51% 0.0511 0.2000 0.9923 0.2168 gail -6.77% 4.81% 0.07% 1.68% 0.0546 0.0670 0.9903 0.0933 grasim -4.89% 6.17% 0.01% 1.59% 0.0772 0.0010 0.9723 0.0001 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 27 hcl tech -6.96% 4.76% 0.22% 1.87% 0.0547 0.0662 0.9796 0.0011 hdfc bank -8.43% 7.75% 0.07% 1.88% 0.0770 0.0011 0.9643 0.0000 hdfc -8.12% 6.34% 0.03% 2.00% 0.0667 0.0088 0.9784 0.0007 hero moto co -6.51% 7.14% 0.15% 1.71% 0.0668 0.0086 0.9841 0.0068 hindalco -7.89% 10.86% 0.17% 2.61% 0.0588 0.0352 0.9841 0.0068 hindunilvr -4.46% 16.03% 0.10% 1.85% 0.1430 0.0000 0.7726 0.0000 icici bank -5.58% 8.88% 0.07% 2.29% 0.0694 0.0053 0.9819 0.0028 idfc -18.05% 7.54% -0.06% 2.86% 0.0649 0.0124 0.9387 0.0000 indusind bank -8.96% 8.01% 0.09% 2.80% 0.0568 0.0482 0.9814 0.0023 infy -23.90% 10.36% 0.05% 2.17% 0.1631 0.0000 0.6242 0.0000 itc -6.35% 5.98% 0.05% 1.65% 0.0646 0.0130 0.9778 0.0006 jindal steel -16.70% 8.85% -0.07% 2.77% 0.0850 0.0002 0.9231 0.0000 kotak bank -6.07% 8.43% 0.07% 2.06% 0.0613 0.0234 0.9741 0.0002 l&t -7.74% 6.80% 0.12% 2.19% 0.0491 0.2000 0.9897 0.0760 lupin -6.91% 5.01% 0.16% 1.66% 0.0482 0.2000 0.9870 0.0229 m&m -4.89% 5.50% 0.05% 1.82% 0.0378 0.2000 0.9966 0.8719 maruti -8.35% 7.75% 0.17% 2.00% 0.0979 0.0000 0.9417 0.0000 mc dowell's -7.68% 12.53% 0.13% 2.36% 0.0784 0.0007 0.9610 0.0000 nmdc -5.39% 6.72% 0.01% 2.08% 0.0595 0.0313 0.9877 0.0302 ntpc -12.49% 4.08% -0.07% 2.01% 0.0872 0.0001 0.8831 0.0000 ongc -6.20% 7.29% 0.01% 2.15% 0.0357 0.2000 0.9942 0.4436 pnb -7.70% 8.95% 0.01% 2.70% 0.0561 0.0542 0.9860 0.0147 powergrid -11.86% 4.36% 0.00% 1.62% 0.0796 0.0006 0.9090 0.0000 reliance -6.49% 5.55% 0.07% 1.73% 0.0572 0.0451 0.9866 0.0187 sbi -8.17% 9.20% -0.03% 2.01% 0.0475 0.2000 0.9701 0.0000 sslt -9.43% 15.16% 0.08% 2.85% 0.0892 0.0001 0.9153 0.0000 sun pharma -5.33% 6.88% 0.13% 1.88% 0.0498 0.2000 0.9876 0.0304 tata motors -6.17% 9.54% 0.16% 2.17% 0.0744 0.0019 0.9731 0.0001 tata power -16.25% 7.55% -0.05% 2.38% 0.0752 0.0016 0.9266 0.0000 tata steel -6.58% 9.95% 0.09% 2.55% 0.0324 0.2000 0.9920 0.1895 tcs -6.02% 5.50% 0.12% 1.74% 0.0682 0.0067 0.9835 0.0052 tech mahindra -5.00% 7.23% 0.21% 1.89% 0.0779 0.0008 0.9854 0.0115 ultratech cem -6.03% 6.44% 0.06% 1.87% 0.0677 0.0073 0.9705 0.0000 wipro -13.10% 6.61% 0.09% 1.92% 0.0728 0.0026 0.9016 0.0000 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 28 figure 1. scatterplot of mean returns against std. dev. of returns it was found that for 86% of the stocks there was evidence of non-normality of stock returns. several of the stocks were found to have extreme high or low values: 22% of the stocks had extreme low values, less than –10%, while 14% had extreme high values, greater than 10%; only one stock had both. the alpha and beta coefficients and the r2 and f-tests for each of the stocks are presented in table 2 below. the scatterplot of r2 against beta is presented in figure 2. table 2. alpha, beta, and r2 estimates alpha beta r2 f-test p-value acc 0.01% 0.9312 37.59% 149.9877 0.0000 ambuja cement 0.00% 0.9570 28.29% 98.2113 0.0000 asian paints -0.99% 1.8202 2.01% 5.1175 0.0245 axis bank -0.07% 1.7198 52.73% 277.7967 0.0000 bajaj auto 0.01% 0.7786 32.28% 118.7110 0.0000 bank of baroda -0.08% 1.6126 42.80% 186.2975 0.0000 bharati airtel -0.04% 1.1414 34.89% 133.4347 0.0000 bhel -0.05% 1.4068 26.76% 90.9917 0.0000 bpcl 0.00% 1.1923 30.91% 111.4191 0.0000 cairn 0.05% 0.4034 9.41% 25.8499 0.0000 cipla -0.03% 0.4662 13.16% 37.721 0.0000 coal india -0.07% 0.6777 14.98% 43.8562 0.0000 dlf -0.23% 1.8358 41.18% 174.3381 0.0000 dr reddy's 0.12% 0.4706 12.63% 36.0039 0.0000 gail 0.02% 0.6881 22.01% 70.2795 0.0000 grasim -0.05% 0.8500 37.52% 149.5210 0.0000 hcl tech 0.20% 0.3311 4.11% 10.6774 0.0012 hdfc bank -0.01% 1.2835 61.15% 391.8962 0.0000 hdfc -0.06% 1.2895 54.49% 298.1168 0.0000 hero moto co 0.11% 0.7151 22.79% 73.5100 0.0000 hindalco 0.10% 1.1976 27.46% 94.2824 0.0000 -0.20% 0.00% 0.20% 0.40% 0.00% 1.00% 2.00% 3.00% 4.00%m ea n re tu rn s std. dev. of returns risk-return plot asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 29 hindunilvr 0.06% 0.6034 13.85% 40.0187 0.0000 icici bank -0.03% 1.5551 60.47% 380.8840 0.0000 idfc -0.18% 1.6917 45.62% 208.8486 0.0000 indusind bank -0.03% 1.7564 51.49% 264.3086 0.0000 infy 0.02% 0.4808 6.41% 17.0474 0.0000 itc -0.01% 0.9037 39.07% 159.6459 0.0000 jindal steel -0.14% 1.0821 19.95% 62.046 0.0000 kotak bank -0.01% 1.3026 52.25% 272.4680 0.0000 l&t -0.11% 1.2135 18.06% 54.8935 0.0000 lupin 0.13% 0.3816 6.87% 18.3633 0.0000 m&m 0.00% 0.8377 27.82% 95.9851 0.0000 maruti 0.11% 0.8736 24.92% 82.6438 0.0000 mc dowell's 0.08% 0.7311 12.59% 35.8573 0.0000 nmdc -0.05% 0.9214 25.65% 85.9156 0.0000 ntpc -0.12% 0.7368 17.59% 53.1617 0.0000 ongc -0.07% 1.2108 41.53% 176.8890 0.0000 pnb -0.09% 1.6546 49.13% 240.4387 0.0000 powergrid -0.04% 0.5981 17.83% 54.0205 0.0000 reliance 0.00% 1.0776 50.96% 258.7953 0.0000 sbi -0.11% 1.1460 42.39% 183.1974 0.0000 sslt 0.00% 1.1260 20.35% 63.6088 0.0000 sun pharma -0.19% 0.8164 4.01% 10.3980 0.0014 tata motors 0.09% 1.0154 28.50% 99.2331 0.0000 tata power -0.12% 0.9904 22.61% 72.7396 0.0000 tata steel 0.01% 1.2605 31.83% 116.2524 0.0000 tcs 0.09% 0.5046 10.95% 30.6227 0.0000 tech mahindra 0.19% 0.2729 2.72% 6.9742 0.0088 ultratech cem 0.00% 0.9221 31.74% 115.7820 0.0000 wipro 0.07% 0.2601 2.40% 6.1218 0.0140 figure 2. scatterplot of r2 against beta 0.00% 20.00% 40.00% 60.00% 80.00% 0.0000 0.5000 1.0000 1.5000 2.0000 r2 beta r2 vs. beta asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 30 it was found that 16% of the stocks had low r2 (lower than 10%). there was found to be significant positive correlation between beta and r2 (r = 0.7071, tcal = 6.9283, p-value = 0.0000**). two of the stocks (sun pharma and asian paints) had exceptionally low r2 though their betas were relatively high (0.8164 and 1.8202, respectively). however, the ols regressions were found to be significant for all stocks. the residual autocorrelations of the market model regressions for each of the stocks are presented in table 3 below. table 3. residual autocorrelations of the market model regressions d.-w. ρ1 ρ2 ρ3 ρ4 ρ5 ρ6 ρ7 ρ8 ρ9 ρ10 acc 1.8538 0.0661 0.1023 -0.0409 0.0465 0.0361 0.0645 0.1258 0.0435 -0.0050 -0.0108 ambuja cement 2.0297 -0.0158 0.0565 0.0225 -0.0406 -0.1110 -0.0175 0.0014 -0.0449 -0.0616 -0.0624 asian paints 2.0262 -0.0131 -0.0028 -0.0312 0.0011 0.0248 0.0182 -0.0034 -0.0149 -0.0089 -0.0077 axis bank 2.0378 -0.0191 0.0429 0.1473 -0.0465 0.0887 -0.0468 -0.0086 -0.1095 -0.0388 -0.1077 bajaj auto 1.9470 0.0228 -0.0498 -0.0751 -0.1476 -0.0386 0.0739 -0.0090 0.0425 0.0027 -0.0890 bank of baroda 1.9594 0.0189 -0.1243 -0.0529 -0.1246 0.0267 0.0598 -0.0906 -0.0416 0.0975 0.0332 bharati airtel 2.3003 -0.1502 0.0684 -0.1340 0.1009 -0.0018 0.0355 -0.0236 0.0362 -0.0291 -0.0137 bhel 1.8147 0.0895 0.0090 -0.0740 -0.0792 0.0009 -0.0185 0.1315 -0.0061 0.0607 -0.0629 bpcl 2.0247 -0.0126 -0.0264 -0.0086 -0.0620 0.1362 -0.1300 -0.0889 -0.0204 -0.0431 -0.0375 cairn 2.3249 -0.1840 0.0083 -0.0699 -0.1055 0.0841 -0.0086 0.0985 -0.0620 -0.0467 -0.0371 cipla 2.0410 -0.0231 0.0095 0.0476 0.0323 0.0269 -0.0747 -0.0918 -0.0468 -0.0528 -0.1310 coal india 1.9484 0.0241 -0.0220 -0.0057 -0.0358 0.0038 -0.0033 -0.0748 -0.0042 -0.0757 -0.0540 dlf 1.6875 0.1401 -0.0211 0.0921 -0.0914 -0.0290 -0.1271 -0.1740 -0.0816 -0.0663 -0.1281 dr reddy's 1.9176 0.0256 -0.0956 0.0328 0.0006 0.0041 -0.1258 -0.1511 0.0083 -0.0538 -0.0715 gail 2.0480 -0.0264 0.0068 -0.0189 -0.1431 -0.0510 0.0423 -0.0628 -0.0117 -0.0816 -0.0494 grasim 2.0328 -0.0177 -0.0149 -0.0343 -0.1033 0.0394 0.0409 -0.0079 0.1523 -0.0552 0.0223 hcl tech 2.0062 -0.0049 -0.0898 -0.0098 0.0634 -0.0244 -0.0998 0.0798 0.1268 -0.0410 -0.1608 hdfc bank 2.4162 -0.2091 -0.0072 0.0438 -0.1031 -0.0006 -0.1230 0.0227 -0.0782 -0.0176 0.0759 hdfc 2.2038 -0.1030 -0.0284 -0.0549 -0.0145 0.0007 -0.0069 -0.0700 0.0149 -0.0869 -0.0969 hero moto co 2.1282 -0.0654 -0.1253 0.0059 -0.0481 -0.1558 0.0421 0.1107 -0.0544 0.0707 0.1126 hindalco 2.0324 -0.0404 0.0459 -0.0035 -0.0340 0.0105 -0.1502 0.0890 0.0443 0.0896 -0.0397 hindunilvr 1.7971 0.1007 -0.0747 -0.0246 -0.0135 -0.0115 -0.0313 -0.0233 -0.0439 -0.0357 0.0271 icici bank 2.0706 -0.0369 -0.0152 0.0127 -0.0239 -0.0164 0.0229 -0.0156 0.0586 -0.1086 -0.0254 idfc 1.8602 0.0657 -0.0714 0.1598 -0.0904 -0.0387 0.0779 -0.1229 -0.0584 0.1083 -0.1211 indusind bank 2.1508 -0.0776 -0.0835 0.0197 -0.0978 0.0802 -0.1453 -0.1067 0.1272 0.0745 -0.0573 infy 2.1383 -0.0706 -0.0017 0.0700 0.0591 0.1080 0.0656 0.0285 -0.0026 -0.0272 0.0098 itc 2.0920 -0.0508 -0.0007 -0.0276 -0.0817 0.0448 0.0175 -0.0105 -0.0866 0.1014 -0.0275 jindal steel 2.1122 -0.0627 -0.0030 -0.0396 0.0543 -0.0394 -0.1143 0.1090 0.1888 -0.0256 -0.0502 kotak bank 2.1393 -0.0701 -0.0342 -0.0247 -0.1532 0.0946 -0.0604 0.0206 -0.0442 0.0222 -0.0112 l&t 2.0037 -0.0032 -0.0490 0.0289 0.0286 0.0078 0.0136 0.1607 -0.0062 0.0228 0.0317 lupin 1.8738 0.0609 -0.1382 -0.1091 0.0150 -0.0405 0.0316 0.0391 -0.0046 -0.0827 -0.0155 m&m 2.1978 -0.1006 -0.1129 -0.0799 0.1170 -0.0625 -0.0070 0.0435 -0.0507 0.1439 -0.0727 maruti 1.9736 0.0109 -0.0012 0.0007 -0.0642 -0.0117 0.0799 0.0020 -0.0364 -0.0388 0.1286 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 31 mc dowell's 2.1554 -0.0782 0.0345 0.0323 -0.0695 -0.0723 -0.0548 -0.0072 -0.0266 0.0146 0.0158 nmdc 2.0818 -0.0429 0.0954 -0.1067 -0.0032 0.0266 0.0137 0.1475 0.0163 0.1084 -0.1030 ntpc 2.2317 -0.1168 -0.0443 0.0914 -0.0363 -0.0729 0.0004 0.0310 -0.0040 0.0289 -0.1007 ongc 2.2388 -0.1290 0.0231 -0.0040 -0.2021 0.0178 -0.0543 -0.0106 0.0301 0.0163 0.0045 pnb 1.8764 0.0612 -0.0054 0.0446 0.0137 0.0107 -0.0631 -0.0229 0.0496 0.0326 0.0185 powergrid 2.5453 -0.2779 0.0490 0.0161 -0.1289 0.0659 0.0195 -0.0782 -0.0345 0.0773 -0.0553 reliance 1.9676 0.0132 -0.1284 -0.0856 -0.1189 0.0202 0.0648 0.0914 -0.0471 -0.0902 0.0013 sbi 1.9260 0.0362 -0.0596 0.0475 -0.0204 -0.0268 -0.0338 -0.0235 0.0634 -0.0126 -0.0034 sslt 2.3609 -0.1860 0.1698 0.0285 0.0078 0.1317 -0.1389 0.1545 -0.0913 0.0548 -0.0504 sun pharma 2.1546 -0.0778 0.0500 -0.0668 0.0340 -0.0199 0.0421 0.0440 0.0542 -0.1011 -0.0136 tata motors 2.0597 -0.0319 -0.0982 -0.1257 0.0305 -0.0142 -0.0685 0.0221 -0.0167 0.1033 -0.0724 tata power 2.2050 -0.1041 -0.0259 -0.0759 0.0285 0.0064 0.0614 -0.0965 -0.0362 0.0151 0.1249 tata steel 1.7729 0.1094 0.0755 0.0647 0.0537 0.0688 0.1213 0.0343 0.1092 0.1392 0.0269 tcs 2.0692 -0.0375 0.0746 0.0290 -0.0119 0.0933 0.0030 -0.0613 0.0143 -0.0585 -0.1063 tech mahindra 1.9124 0.0402 0.0539 -0.0815 -0.0489 0.0357 -0.0137 -0.0120 0.0199 -0.1038 -0.0225 ultratech cem 1.9731 0.0107 -0.0670 0.0671 -0.0439 -0.0360 -0.0435 -0.0415 0.1136 -0.0847 -0.0354 wipro 1.9055 0.0442 -0.0711 0.1201 0.0469 0.0521 -0.0312 -0.0210 0.1069 -0.0399 0.0653 it was found that 6% of the stocks showed evidence of significant negative autocorrelation based on the durbin-watson test, while none of the stocks showed evidence of significant positive autocorrelation. in fact, 24% of the stocks had some significant autocorrelations among the first ten lags. the residual statistics and normality and heteroskedasticity tests for each of the stocks are presented in table 4 below. table 4. residual statistics and normality and heteroskedasticity tests std. dev. skew kurt zmin zmax k.-s. test p-value s.-w. test p-value white's test p-value acc 0.0137 0.0733 0.6925 -3.5672 3.3295 0.0578 0.0412 0.9912 0.1394 2.8087 0.0938 ambuja cement 0.0174 -0.3420 3.8595 -5.6311 2.7980 0.0875 0.0001 0.9525 0.0000 6.2680 0.0123 asian paints 0.0180 -0.1340 2.8259 -2.7821 2.8656 0.0454 0.2000 0.9927 0.2615 1.5405 0.2145 axis bank 0.0186 0.4829 3.2154 -2.7019 5.4459 0.0540 0.0737 0.9687 0.0000 6.3525 0.0117 bajaj auto 0.0129 0.2032 0.5036 -3.0958 3.4795 0.0416 0.2000 0.9947 0.5306 0.4093 0.5223 bank of baroda 0.0213 0.0078 2.4312 -3.8648 4.1879 0.0605 0.0269 0.9716 0.0001 6.1512 0.0131 bharati airtel 0.0178 0.5887 1.6106 -3.1853 4.1073 0.0854 0.0001 0.9681 0.0000 0.0698 0.7917 bhel 0.0266 -2.0146 17.2109 -8.0731 3.4284 0.0957 0.0000 0.8613 0.0000 0.2108 0.6461 bpcl 0.0204 -0.0738 2.5380 -4.0472 3.7492 0.0651 0.0119 0.9666 0.0000 1.3646 0.2428 cairn 0.0143 0.3527 1.1739 -2.9680 3.6065 0.0678 0.0072 0.9817 0.0025 2.2525 0.1334 cipla 0.0137 -0.4019 3.8679 -5.4832 3.2084 0.0447 0.2000 0.9592 0.0000 0.0008 0.9778 coal india 0.0185 -0.6363 3.1164 -5.4014 2.7174 0.0556 0.0578 0.9692 0.0000 1.0774 0.2993 dlf 0.0251 -0.0529 1.3639 -3.5720 3.1972 0.0966 0.0000 0.9730 0.0001 0.3541 0.5518 dr reddy's 0.0141 0.0819 0.7655 -3.3126 3.2833 0.0576 0.0430 0.9905 0.1022 2.0088 0.1564 gail 0.0148 0.1611 0.3509 -2.6455 3.1686 0.0525 0.0901 0.9938 0.3954 9.1273 0.0025 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 32 grasim 0.0125 0.2512 0.2720 -2.4014 3.4937 0.0477 0.2000 0.9924 0.2265 10.2249 0.0014 hcl tech 0.0183 -0.2811 0.8096 -3.7830 2.3185 0.0460 0.2000 0.9845 0.0079 0.1611 0.6882 hdfc bank 0.0117 0.2686 1.9268 -3.3323 3.7504 0.0679 0.0070 0.9710 0.0001 7.5996 0.0058 hdfc 0.0135 -0.0141 1.2632 -3.5938 3.9206 0.0461 0.2000 0.9885 0.0424 5.5521 0.0185 hero moto co 0.0150 0.5555 1.1088 -2.5683 3.5778 0.0682 0.0067 0.9788 0.0008 27.1377 0.0000 hindalco 0.0222 0.5057 1.3897 -3.3866 3.7658 0.0580 0.0399 0.9778 0.0006 0.7008 0.4025 hindunilvr 0.0172 3.8272 30.4120 -1.9923 9.1053 0.1303 0.0000 0.7490 0.0000 0.3505 0.5538 icici bank 0.0144 0.2283 0.6945 -3.2072 3.3567 0.0395 0.2000 0.9926 0.2447 22.5816 0.0000 idfc 0.0211 -0.7620 5.1630 -5.6417 3.0945 0.0690 0.0057 0.9403 0.0000 18.8409 0.0000 indusind bank 0.0195 0.1365 2.9888 -3.7831 4.8500 0.0729 0.0025 0.9666 0.0000 10.9973 0.0009 infy 0.0210 -5.3840 63.3411 -11.0983 4.6292 0.1584 0.0000 0.6154 0.0000 0.7048 0.4012 itc 0.0129 -0.0827 0.2374 -2.6438 2.8625 0.0442 0.2000 0.9930 0.2920 6.2811 0.0122 jindal steel 0.0248 -1.1293 7.0689 -6.0035 3.2584 0.0907 0.0000 0.9050 0.0000 0.9768 0.3230 kotak bank 0.0142 -0.0724 3.2281 -4.8525 3.7761 0.0806 0.0005 0.9558 0.0000 2.6623 0.1028 l&t 0.0219 -0.2022 0.9498 -5.3665 3.8292 0.0450 0.2000 0.9575 0.0000 4.3677 0.0366 lupin 0.0161 -0.0139 1.2075 -4.276 3.011 0.0673 0.0079 0.9832 0.0046 3.9682 0.0464 m&m 0.0154 -0.0376 0.1367 -2.9639 2.7087 0.0221 0.2000 0.9975 0.9633 0.2614 0.6092 maruti 0.0173 0.4893 5.1001 -4.7925 4.1648 0.0893 0.0000 0.9111 0.0000 1.4322 0.2314 mc dowell's 0.0220 0.6869 3.3617 -2.9982 5.3226 0.0587 0.0357 0.9633 0.0000 0.6679 0.4138 nmdc 0.0179 0.1312 0.6324 -3.0472 3.2230 0.0337 0.2000 0.9918 0.1742 5.5012 0.0190 ntpc 0.0182 -2.3650 14.8010 -6.9757 2.2636 0.0829 0.0003 0.8475 0.0000 0.5660 0.4518 ongc 0.0164 -0.0110 0.8519 -3.6946 3.0168 0.0353 0.2000 0.9918 0.1786 2.0447 0.1527 pnb 0.0192 0.4303 1.4268 -3.0087 3.8328 0.0562 0.0530 0.9793 0.0010 1.1350 0.2867 powergrid 0.0147 -1.6908 13.3918 -7.6778 2.5746 0.0712 0.0037 0.8947 0.0000 1.1051 0.2931 reliance 0.0121 -0.0360 0.7018 -3.2697 3.3981 0.0430 0.2000 0.9916 0.1625 0.8659 0.3521 sbi 0.0153 0.2533 2.1688 -3.6875 4.1153 0.0748 0.0017 0.9701 0.0000 15.8772 0.0001 sslt 0.0255 1.5525 7.1099 -2.8971 6.0481 0.1055 0.0000 0.8972 0.0000 3.2542 0.0712 sun pharma 0.0188 0.1792 0.9728 -2.8899 3.8340 0.0358 0.2000 0.9907 0.1166 0.8332 0.3613 tata motors 0.0184 0.4410 1.3365 -2.4453 4.5692 0.0606 0.0262 0.9818 0.0026 3.0262 0.0819 tata power 0.0209 -0.7095 7.3327 -6.4863 3.8506 0.0755 0.0015 0.9310 0.0000 6.9100 0.0086 tata steel 0.0211 0.6447 0.7982 -2.5012 3.5238 0.0729 0.0026 0.9746 0.0002 0.0793 0.7782 tcs 0.0164 0.0900 1.0986 -3.4261 3.0793 0.0545 0.0681 0.9820 0.0028 1.5097 0.2192 tech mahindra 0.0186 0.3555 0.6084 -2.8716 3.5994 0.0778 0.0009 0.9828 0.0040 1.2722 0.2594 ultratech cem 0.0155 -0.0924 1.9602 -3.7019 4.1448 0.0469 0.2000 0.9763 0.0003 4.1578 0.0414 wipro 0.0190 -1.4881 10.0602 -6.8139 3.5709 0.0781 0.0008 0.8982 0.0000 0.4415 0.5064 it was found that for 78% of the stocks there was evidence of non-normality of residuals. for 12% of the stocks the residual distribution was negatively skewed with skewness less than –1, while for 4% of the stocks the residual distribution was positively skewed, with skewness greater than +1. all of the stocks showed leptokurtic residual distributions, with 68% of stocks having residual kurtosis greater than +1. further, 70% of the stocks showed extreme low standardized residual values, less than –3, of which 50% were less than –3.5, and 84% of the stocks showed extreme high standardized residual values, greater than +3, of which 52% asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 33 were greater than +3.5. also, for 36% of the stocks there was evidence of heteroskedasticity in residual variance. discussion the results of the study highlight some of the serious issues afflicting beta estimation in indian stock markets. non-normality of stock returns was highly prevalent, as was non-normality of the market model regression residuals, the latter particularly tending to be highly leptokurtic, with extreme high and low standardized values. this implies that the standard errors of the ols estimates are biased. thus, ols beta estimation may not be efficient; weighted least squares (wls) beta estimation may be more suitable. also, the extreme values should be investigated further to identify any market events/forces that can systematically explain them. the results of the study provide some evidence of heteroskedasticity in the market model regression residual variance, again implying biasedness of the standard errors of the ols estimates. wls beta estimation may again provide a remedy. also, arch or garch modeling may give better beta estimates (e.g. armitage and brzeszczynski, 2011). the results of the study also indicate some prevalence of residual autocorrelation. this would suggest that an auto-regressive model may be more appropriate in place of the simple regression model. this may further be combined with generalized least squares (gls) estimation. the results of the study further indicate some prevalence of low explanatory power (e.g. gray et al, 2009). this would imply that ols beta estimates with r2 less than 10% are unreliable, for which the vasicek correction technique may provide better estimates. however, a possible cause for the low explanatory power of the market model could be as suggested by fama and french (1992) that other determinants may need to be included in the model. alternatively, more advanced econometric techniques such as filters may need to be employed to improve explanatory power. there are several limitations inherent in the study. the sample stocks used for the analysis were the constituents of cnx nifty, and were thus all highly traded large-cap stocks. thus, the sample was small and unrepresentative. the mid-cap and small-cap stocks may exhibit quite different results. similarly, thinly-traded stocks may be expected to exhibit quite different behavior. further studies would need to examine these issues in beta estimation for a wider sample of stocks, and would need to compare the results of ols beta estimation with other approaches such as wls, auto-regressive gls, arch/garch, and so on. references amihud, y., christensen, b.j., & mendelson, h. (1992). further evidence on the risk-return relationship. working paper, new york university. armitage, s., & brzeszczynski, j. (2011). heteroscedasticity and interval effects in estimating beta: uk evidence. applied financial economics, 21(20), 1525-1538. http://dx.doi.org/10.2139/ssrn.1100573 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 34 blume, m. (1971). on the assessment of risk. journal of finance, 26, 1-10. http://dx.doi.org/10.1111/j.1540-6261.1971.tb00584.x fama, e.f., & french, k.r. (1992). the cross-section of expected stock returns. journal of finance, 47(2), 427-465. http://dx.doi.org/10.1111/j.1540-6261.1992.tb04398.x fama, e.f., & macbeth, j.d. (1973). risk, return, and equilibrium: empirical tests. journal of political economy, 81(3), 607–636. http://dx.doi.org/10.1086/260061 gray, s., hall, j., klease, d., & mccrystal, a. (2009). bias, stability, and predictive ability in the measurement of systematic risk. accounting research journal, 22(3), 220-236. http://dx.doi.org/10.1108/10309610911005563 lintner, j. (1965). the valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. review of economics and statistics, 47(1), 13–37. http://dx.doi.org/10.2307/1924119 mossin, j. (1966). equilibrium in a capital asset market. econometrica, 34(4), 768-83. http://dx.doi.org/10.2307/1910098 roll, r. (1977). a critique of the asset pricing theory's tests part i: on past and potential testability of the theory. journal of financial economics, 4(2), 129–176. http://dx.doi.org/10.1016/0304-405x(77)90009-5 shalit, h., & ve yitzaki, s. (2002). estimating beta. review of quantitative finance and accounting, 18, 95–118. http://dx.doi.org/10.1023/a:1014594617251 sharpe, w.f. (1964). capital asset prices: a theory of market equilibrium under conditions of risk. journal of finance, 19(3), 425-42. http://dx.doi.org/10.2307/2977928 treynor, j.l. (1961). market value, time, and risk. unpublished manuscript dated 8/8/61, no. 95-209; published as toward a theory of market value of risky assets in robert korajczyk (ed.), asset pricing and portfolio performance (1999), london: risk books. http://dx.doi.org/10.1007/978-0-387-77439-8_13 vasicek, o. (1973). a note on using cross-sectional information in bayesian estimation of security betas. journal of finance, 28, 1233-1239. http://dx.doi.org/10.1111/j.1540-6261.1973.tb01452.x microsoft word 5901-21204-1-sm _1_-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 124 the effective factors in abnormal error of earnings forecast-in case of iran hamid rasekhi supreme audit curt of mashhad, iran alireza azarberahman (corresponding author) dept. of accounting, islamic azad university-mashhad, iran tel: +98-915-119-1929 e-mail: a_berahman@yahoo.com jalal azarberahman supreme audit curt of mashhad, iran received: july 3, 2014 accepted: august 5, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5901 url: http://dx.doi.org/10.5296/ ajfa.v6i2.5901 abstract purpose: the main purpose of this research is to examine the effective factors in abnormal error of earnings forecast. design/methodology/approach: this research is an applied research, and its design is semi-empirical, which is done by the method of post-event (past information). the statistical population of the research includes all companies listed in tehran stock exchange (tse), and its period is four years, from 2010 to 2013. to examine the hypotheses, correlation analysis, and variance analysis test are used. findings: the results of this research indicate there is a meaningful relationship between the type of industry, and the effective factors in abnormal error of earnings forecast. the mining, chemical materials, petrochemical and pharmaceutical industries have high abnormal error of earnings forecast, while metal industries, agriculture, and animal husbandry have low abnormal error of earnings forecast. also we find in this research that there is a meaningful relation between the firm size, and the firm age in stock exchange. finally, simultaneous effect of the three factors on abnormal error of earnings forecast was examined. keywords: earning per share, abnormal error of earnings forecast, firm size, firm age, industry type, forecasted earning per share asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 125 1. introduction decision makers need useful and helpful information for making a correct and exact decision. to do so, required financial information should be available for them by financial reports of firms. most of users emphasize on items they perceive as the most relevant information. information on earning per share is a scale considered as the most relevant by most users. direct and indirect observations confirm that reported earning per share and forecasted earning per share have direct effect on the stock market price, and investors want this information. american financial accounting standards board (fasb) states that the main purpose of financial reporting for business enterprises is to satisfy the informational needs of external users, i.e., affording the information to people who have not the necessary power to order the firm for their required information, so should use the information that the managers afford for them. the management of business enterprise is bound to provide them with the information such as forecasted earning per share, as an estimation of the firm's future perspective. the correct decision making make the investor to reach his/her expectations from the investing, and the firm can attract the trust of the user by providing the correct information. the researches indicate that forecasts about the earning per share have information content (ball & brown-1968, beaver-1968). but if the management does not provide the investors by such information, they should do it themselves, or ask for the help of financial analysts. the accuracy of earning forecast depends on the type of information resources. the resource which leads to less mistakes, i.e., its forecast is closer to the reality, would be more accurate. many studies have performed to compare the accuracy of earning forecasts by managers, or by analysts with time series models (ruland-1978, emhof-1978). the results indicate that the managers' or analysts' forecasts are more accurate than time series models, but in long term it would be inversed. doing such researches confirms the importance of the issue. according to article 5 of regulations on disclosure of information by the companies registered in the tehran stock exchange, the firms are bound to publish the earning per share forecast every three months to the public, at most 20 days after the end of three months period. this research tries to introduce some of the factors may be effective in reducing the error of earning forecasts to the investors in order to help them choose the firms with more accurate earning forecast when buying the stocks of firms. 1.1 review of the regulations on earning forecast majority shareholders have access to much information, and even expect to receive the information out of access of minority shareholders. minority shareholders should be relied on agents. u.s. securities and exchange commission (sec) permanently encourages the companies to disclose more information for the welfare of minority shareholders. in early 1973, the securities and exchange commission announced that for the first time the companies registered in the stock exchange would have the permission to disclose the earning forecasts. the next plan was proposed in 1975. in this plan, the companies were obliged to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 126 publish the forecasts information along with financial reports. these obligations cause the management information to be almost equal to information the public has. in april 1976 the proposal of the securities and exchange commission war removed for the large resistance. in the lack of earning forecast disclosure by managements, the minority shareholders always rely on the professional analysts. tehran stock exchange considered as the main and most important center in iran for capital exchange and established in 1966 is bound to give this information to the organization: a. the annual audited financial statements and reports, and the summary of annual statement of the agent activity which is confirmed by reliable auditor of the stock exchange at most four months after the end of financial year. b. any kind of change in announced conditions to the organization for the license. c. other documents and information requested by the organization, and all the reports mentioned in the enacted regulations in the context of pertinent rules. this process continued till 1979, and after that the stock exchange was almost suspended. from 1991 to 1996 the monthly statistics for production and sale, sale forecast, annual sale, and the real statistics for production and sale of the previous year were considered as the basis for pricing and the useful information for the investors' decision makings. in 1997, according to a circular, tehran stock exchange bound the companies to announce also the real quarterly earning per share, and annual estimated earning per share. in 2000, tehran stock exchange bound the companies to publish the analyzed midterm six-month information in standard forms, because of the importance of midterm financial reports in the users' decision makings for regulating the methods of making reports, and increasing the reliability. it is obvious that presenting information in this framework, the announcement of monthly statistics for production and sale by companies was cancelled. presenting the information on earning per share forecast was continued. paragraph c of article 5 of the regulations on disclosure of information by the companies registered in the tehran stock exchange in 2002 bound the companies to publish the earning per share forecast every three months, at most 20 days after the end of three months period. 2. research literature 2.1 information content of earning: in 1960s, the accounting researches were directed to positive theories. positive theories help the explanation of accounting phenomena. since we need fundamental theories of behavioral or economic sciences to explain and forecast in positive accounting researches, the financial economy theory is a base for actions and reactions in capital market. this branch of research is the base for accounting researches which examine the relation of price and accounting information. ball and brown (1968) were the first ones who used these researches. they examined the relation between annual earnings and annual abnormal return rate, and found that the earnings have information content, i.e. the changes in stock prices for a given period depend on the unexpected earnings of that period. this reflects the presence of different information resources which help the market in earnings forecast. beaver (1968) in a separate research confirmed the information content of earnings. the results of his study showed that asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 127 announcement of earnings makes abnormal changes in return. patell (1976) examined the evaluation of information content of earnings forecast with the impact of announcing forecasted earnings on price of stocks. the sample of patell included 258 firms among 336 firms for the period of 1963 to 1969. the results of the research reflected the reality that the announcement of forecasts would be followed by modification in stocks prices, so the forecasted earnings have information content. jahankhani and saffarian (2003) studied the information content of estimated earnings. in this research, the price changes of 27 companies were collected in the period of 1995 to 1997. the information on four weeks before and after the announcement of estimated earnings was studied. the results showed that the estimated earnings per share had information content, and made the price and volume of transactions to change in tse. however, since the announcement of estimated earnings per share is an effective factor in the investors and shareholders' decision makings about buying and selling of shares, the earnings forecast per share should have the minimum deviation from its real value. but unfortunately, for the lack of proper policies in tehran stock exchange, there were large disturbance in forecast figures, especially before 1997. 2.2 comparison of the accuracy in earnings forecast due the resources present it: kreg and malkiel (1968) studied the earnings forecast for 5 investment companies for five years, and concluded that the accuracy of the forecasts of analysts is better than time series models. richard (1976) collected the analysts' forecasts about earnings per share of 92 companies in new york stock exchange during 1972-1976, and classified them in 5 classes due to industry type (banking, construction, chemicals, pharmaceutics, and electronics). the results showed that the relative error of analysts' forecasts was 24.1%, while relative error of time series models is 38.9%. therefore, the analysts' forecasts are more accurate. moreover, the relative error of forecasts was least for banking industry, and most for electronics industry. ruland (1978) compared the managers' and analysts' forecasts, and both of them with time series models for four years. the findings indicated that managers' forecasts were more accurate than analysts'. but the difference is not significance. moreover, he found that analysts' forecast, if announce before managers', is less accurate compared with when announce after managers' forecasts. hamid khaleghi moghaddam (1999) studied the accuracy of earnings forecasts announced by managers in 45 firms of tehran stock exchange. in this research, the relation of four variables of share prices, firm size, firm age, and the degree of financial leverage with accuracy of earnings forecast was examined by simple and multi-variable regressions. the results showed that 39% of the accuracy of earnings forecast was about the changes in share prices, and 44% of it was about the firm size. it also showed that firm age and degree of financial leverage have no impact on determining accuracy of earnings. 2.3 accuracy of earnings forecast in primary issue of stocks: firth (1998) studied the accuracy of earnings forecast in primary issues of shares in singapore stock market. in this research 116 primary issues in singapore stock were analyzed between 1977-1992. according to findings, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 128 there was a positive relation between managers' earnings forecasts and shares evaluation in their primary issue. lonkain and firth (2005) in another study surveyed the accuracy of earnings forecast in primary issues of shares in thailand stock market, and its relation with shares evaluation from 1991 to 1997. the results showed that the forecasts are in an optimistic way, that is the forecasted earnings are more than real earnings. however, the earnings forecasted by managers are more accurate than time series models in a meaningful manner. so, forecasting of earnings in primary issues has information content. bahramian (2006) evaluated the accuracy of forecasted earnings per share in the companies were offered their shares for the first time in tehran stock market, and companies increased their capital in stock market. the period of this study was 2000-2002, and included 81 companies. seven variables including firm size, period, firm age, type of activity, degree of financial leverage, the auditor opinion, and macroeconomic conditions were identified in determining accuracy of earnings forecast. the results showed that the error of earnings forecast has direct relation with the period of forecast, and fluctuations in stock index, and there were no meaningful relation with firm size, firm age, degree of financial leverage, auditor opinion and industry type. 3. research methodology 3.1 research method, statistical population, and sampling method in this research, we used the correlation type method, and studied the relations between independent and dependent variables by statistical methods such as regression and correlation test. this research is also, considered as post-event (using past data). the statistical population of this research includes firms were active in tehran stock market from 2010 to 2013. then, firms were active just in one or two years of this period are included too. to make the data homogenous, firms were selected according to following items: 1. the firms listed in tehran stock exchange have different end dates for their financial years (march 20, june 20, july 21, september 21, october 21, november 20 and december 20). this difference is because of the difference in the activities and production cycles. the homogeneity of sample firms in end date of financial year is important, especially on the time of offering the earnings forecast per share, and their comparison capability. most firms in tehran stock exchange have the march 20 as their end date of financial year, so we selected these firms. 2. the firms which are member of financial intermediaries, holdings, and banks are firms whose performance is depended on the activities of other firms, and are distinct from other firms clearly. so the accuracy of earnings forecast in these firms is different from other firms. therefore, we excluded these firms from our study. 3. several firms have not announced the earnings forecast per share despite the obligation of the regulations on disclosure of information by the companies listed in the tehran stock exchange, or their earnings forecast are not available. we excluded these firms. then, the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 129 sample of our study encompasses the firms had announced their earnings forecast for at least one year in the period of this study. 4. the firms their transactions were completely ceased during the period of this study were excluded. considering the limitations mentioned above, the statistical population in 2010, 2011, 2012, and 2013 were respectively 130, 127, 154, and 160. the firms under our research are shown in table 1, according to industry type. table 1. firms according to industry type type of industry no. in 2010 no. in 2011 no. in 2012 no. in 2013 1 mining and related products 26 31 37 39 2 agriculture, animal husbandry, and related industries 21 14 19 22 3 chemical, petrochemical, and pharmaceutical substances and related products 38 35 36 37 4 machinery, equipments, and electric devices 35 35 42 42 5 basic metals and related products 10 12 20 20 total 130 127 154 160 3.2 hypotheses of the research studying the literature review, we formulated the following hypotheses: the first hypothesis: = there is not a meaningful relation between the industry type and abnormal error of earnings forecast. : = there is a meaningful relation between the industry type and abnormal error of earnings forecast. : the test statistic for examining the first hypothesis is variance analysis. if the f-value were close to one, it can be concluded that there is no meaningful difference among the average of samples. if there were large difference among the average of samples, the numerator would become larger, and the f-value would be more than one, so there would be a meaningful difference among the averages of samples. the second hypothesis: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 130 = there is not a meaningful relation between firm size and abnormal error of earnings forecast. : = there is a meaningful relation between firm size and abnormal error of earnings forecast. : the third hypothesis: = there is not a meaningful relation between firm age and abnormal error of earnings forecast. : = there is a meaningful relation between firm age and abnormal error of earnings forecast. : the statistic test for examining the second and third hypotheses is employing t distribution (t-student) with the degree of freedom of n-2. since the purpose of this research is to study the distribution of the characteristics of statistical population, the employed research method is descriptive longitudinal survey. in longitudinal surveys, data are collected during the time, or in other words, in different times, so we can find the changes due time, and the relations of variables through the time. after collecting data, we used the variance analysis test, and t test, in the confidence level of 95% (significance level of 5%). the statistic level acquired would confirm or reject the relations between independent and dependent variables by confirming or rejecting the hypotheses. 1.3 variables of research independent variables of this research are: (1) firm age, (2) industry type, (3) firm size. to evaluate the firm age variable, we considered the time the firm has been accepted in tse. then, the firms were divided into three groups: (a) firms with the age of less than 5 years, (b) firms with the age of 5-10 years, and (c) firms with the age of more than 10 years. the firms were selected among (a) mining and related products, (b) agriculture, animal husbandry, and related industries, (c) chemical, petrochemical, and pharmaceutical substances and related products, (d) machinery, equipments, and electric devices, and (e) basic metals and related products. the firm size variable was also measured according to net sales of firms. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 131 the dependant variable is abnormal error of earnings forecast, which is obtained due the following: normal level of eps = abnormal error of earnings forecast = forecasted eps – normal eps 4. results of testing the research hypotheses examining the first hypothesis: for examining the first hypothesis, we used the variance test to indicate the difference in the extent of abnormal error of earnings forecast among different industries, and single averages comparison test for comparing industries. these analyses are shown in figures 2 and 3. table 2. variance analysis source sum of squares f.d deviations average f-value p-value among groups 26.42 4 6.61 3.52 0.008 within groups 31.1062 566 1.88 total 1088.73 570 for doing variance analysis test, first the data were normalized. to normalize the data, we used the fourth root. as shown in above table, according to probability value and level of test, it can be stated that the null hypothesis, i.e., there is not meaningful relation between the type of industry and the extent of abnormal error of earnings forecast would be rejected. in other words, it can be stated with the probability of 95% that there is a meaningful relation between the type of industry and the extent of abnormal error of earnings forecast. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 132 table 3. single averages test mining and related products agriculture, animal husbandry, and related industries chemical, petrochemical, and pharmaceutical substances and related products machinery, equipments, and electric devices basic metals and related products mining and related products 0.010 0.852 0.024 0.016 agriculture, animal husbandry, and related industries 0.010 0.014 0.460 0.998 chemical, petrochemical, and pharmaceutical substances and related products 0.852 0.014 0.034 0.022 machinery, equipments, and electric devices 0.024 0.460 0.034 0.489 basic metals and related products 0.016 0.998 0.022 0.489 to determine the best industry we used single averages test. as we see in table 3, there is a meaningful difference in the 5% level of significance between some industries. so, we can classify the industries into two categories: a. the industries with relatively low abnormal error of earnings forecast including: (1) basic metals and related products, (2) agriculture, animal husbandry, and related industries, and (3) machinery, equipments, and electric devices, and b. the industries with relatively high abnormal error of earnings forecast including: (1) mining and related products, and (2) chemical, petrochemical, and pharmaceutical substances and related products. examining the second hypothesis: in examining the second hypothesis, we used pearson's correlation coefficient test, and simple linear regression after the conversions related to normalization. to normalize the data on abnormal error of earnings forecast, we used the fourth root of the numbers, and to normalize the values of firm size, the best conversion is logarithm. figures 4 and 5 show the data on abnormal error of earnings forecast and firm size before and after normalization. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 133 figure 5: data after normalization figure 1. data before normalization the following figure shows the correlation between the firm size and abnormal error of earnings forecast, after removing irrelevant values. figure 6: the relationship between the company's dimension and the abnormal error of profit prediction over the different years abnormal error of earnings forecast asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 134 t h e fo u rt h r oo t of t h e p ro fi t' s ab no rm al e rr or square root of logarithm of the firm size figure 2. according to the linear regression equation in 2010, the more the firm size, the more the abnormal error of earnings forecast decreases; whereas in years of 2011, 2012 and 2013 the more the firm size, the more the abnormal error of earnings forecast increase too. table 4. : the firm size correlation coefficient of the logarithm square root and the fourth root of the earnings abnormal error year firm size correlation coefficient of the logarithm square root and the fourth root of the earnings abnormal error p-value 2010 -0.0142 0.875 2011 0.0644 0.481 2012 0.0145 0.859 2013 0.0298 0.714 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 135 table 5. pearson's correlation coefficient pearson's correlation coefficient log of the square root of firm size p-value 4th root of abnormal error of earnings 0.0007 0.987 overall, the firm size has no impact on abnormal error of earnings. table 6. variance analysis for the second hypothesis regression statistics 0.001 correlation coefficient 0.000 corrected determination coefficient -0.002 standard error 1.273779 no. of observations 551 variance analysis: f.d sum of squares average of squares f-value p-value regression 1 0.000455 0.000455 0.00028 0.986652 error 549 890.7596 1.622513 total 550 890.76 according to the probability value in correlation coefficient, and also the table of variance analysis related to regression line, and its comparison with level of test, it can be said that the null hypothesis, or the hypothesis that “there is no relation between firm size and the extent of abnormal error of earnings” would not be rejected. examining the third hypothesis: to examine the third hypothesis, the test of pearson's correlation coefficient, and simple linear regression were used after the conversions related to normalization. also, for a better result, the irrelevant values were removed. the table 10 shows the correlation between firm age and abnormal error of earnings forecast. according to regression lines, in 2010 with increase in firm age, the abnormal error of earnings forecast has increased, but in 2011, 2012, and 2013, with increase in firm age, the abnormal error of earnings forecast has decreased. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 136 f ir m a ge abnormal error of earnings forecast figure 3. the association between firm age and abnormal error of earnings forecast 2010-2013 table 7. correlation coefficient for logarithm of the square root of firm age, and fourth root of abnormal error of earnings. year firm age correlation coefficient of the logarithm square root and the fourth root of the profit's abnormal error p-value 2010 -0.0142 0.875 2011 0.0644 0.481 2012 0.0145 0.859 2013 0.0298 0.714 according to the above table, in overall the firm age has no impact on abnormal error of earnings forecast. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 137 table 8. pearson's correlation coefficient the square root of log of firm age p-value fourth root of abnormal error of earnings 0.0087 0.837 table 9. variance analysis for the third hypothesis regression statistics 0.009 correlation coefficient 0.000 corrected determination coefficient -0.002 standard error 1.278 no. of observations 561 variance analysis: f.d sum of squares average of squares f-value p-value regression 1 0.069068 0.069068 0.04232 0.837086 error 559 912.3087 1.632037 total 560 912.3778 according to the probability value in correlation coefficient, and also the table of variance analysis relevant to regression line and its comparison with level of test, it can be said that the null hypothesis or the hypothesis that "there is not relation between the firm age and the extent of abnormal error of earnings forecast" would not be rejected. since the hypotheses on the presence of a meaningful relation between firm size and firm age, and the abnormal error of earnings forecast was not confirmed, we want to examine the effect of all three factors together, under the title of glm model. general linear model (glm) and the mutual effects of two-factors statistics of general linear model: correlation coefficient 0.187485 square of multiple correlation coefficient 0.035151 square of modified multiple correlation coefficient 0.008595 no. of observations 561 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 138 variance analysis: f.d sum of squares average of squares f-value p-value model 15 32.07055 2.138037 1.323663 0.182411 error 545 880.3072 1.615243 total 560 912.3778 examine of factors: sum of squares f.d average of squares f-statistic p-value constant 0.033603 1 0.033603 0.020804 0.885368 industry type 3.274268 4 0.818567 0.506776 0.730783 firm size 2.756227 1 2.756227 1.706386 0.192006 firm age 2.212053 1 2.212053 1.369487 0.242412 industry type*firm size 3.676743 4 0.919186 0.56907 0.685196 industry type*firm age 1.602081 4 0.40052 0.247963 0.910891 firm size*firm age 2.257542 1 2.257542 1.397649 0.237633 general linear models are the models similar to regression models. in these models, in addition to independent quantitative variables, classified variables can be used too. in this research, we examined a general linear model with three variables (two quantitative and one qualitative factor) and mutual effects of every two factors. to analyze these models, we used a method entitled covariance analysis. according to probability value, a model with above variables is not a good model, and a model with less factors should be employed. the difference between determination coefficient and modified determination coefficient is a proof for this claim. general linear model (glm) with two-factor mutual effects after removing unnecessary factors statistics of general linear model correlation coefficient 0.170275 square of multiple correlation coefficient 0.028994 square of modified multiple correlation coefficient 0.018477 number of observations 561 covariance analysis: sum of squares f.d average of squares f-statistic p-value model 26.45308 7 3.779011 2.363149 0.021917 error 885.9247 554 1.599142 total 912.3778 561 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 139 examine of factors: sum of squares d.f average of squares f-statistic p-value firm size 1474.358 1 1474.358 921.9682 0.000 firm age 27.88639 1 27.88639 17.43834 0.000 industry type*firm age 24.37733 4 6.094332 3.811001 0.005 firm size*firm age 27.73935 1 27.73935 17.34639 0.000 after removing unnecessary variables and constant value in the previous model, the following model would be resulted: y= where: = the firm size; = the firm age; ( ) = the firm size × firm age; and ( ) is industry type × firm age. according to the model, the firm size and firm age factors, which are present in the model independently and simultaneously, have impact on abnormal error of earnings, but industry type exert its effect just through the firm age. 5. conclusion summary of the results of hypothesis examinations is shown in bellow: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 140 hypotheses year correlation meaningfulness of relation the first hypothesis industry type and abnormal error of earnings forecast confirmed the second hypothesis firm size and abnormal error of earnings forecast not confirmed firm size and abnormal error of earnings forecast 2010 reversed not confirmed firm size and abnormal error of earnings forecast 2011 direct not confirmed firm size and abnormal error of earnings forecast 2012 direct not confirmed firm size and abnormal error of earnings forecast 2013 direct not confirmed the third hypothesis firm age and abnormal error of earnings forecast not confirmed firm age and abnormal error of earnings forecast 2010 direct not confirmed firm age and abnormal error of earnings forecast 2011 reversed not confirmed firm age and abnormal error of earnings forecast 2012 reversed not confirmed firm age and abnormal error of earnings forecast 2013 reversed not confirmed the results of this research indicate there is a meaningful relationship between the type of industry, and the effective factors in abnormal error of earnings forecast. the mining, chemical materials, petrochemical and pharmaceutical industries have high abnormal error of earnings forecast, while metal industries, agriculture, and animal husbandry have low abnormal error of earnings forecast. also we find in this research that there is a meaningful relation between the firm size, and the firm age in stock exchange. references bahramian.m. (2007). inaccuracy of forecasting earnings of the companies in the new issuing of shares and increase of capital, master thesis, allame tabatabaei university. ball.r.j., & brown. (1968). an empirical evaluation of accounting income numbers. journal of accounting research, 103-26. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 141 beaver.w.h. (1968). the information content of annual earnings announcement. journal of accounting research, 67-92. h.khaleghi moghaddam. (1999). the accuracy of profit forecasts of firms, phd dissertation, tehran university. j.m.patell. (1976). corporate forecasts of earnings per share and stock price behavior: empirical tests. journal of accounting research, 246-76. jahankhani.a., & saffarian.a. (2003). the stock market reaction to the announcement estimated earnings per share in tse, financial researches, no. 16. m.firth. (1998). ipo profit forecasts and their role in signaling firm value and explaining post-listing returns. applied financial economics, 29-39. r.lonkain, & m.firth. (2005). the accuracy of ipo earning forecasts in thailand and their relationships with stock market valuation. accounting and business research, 256-69 w.ruland. (1978). the accuracy of forecasts by management and financial analysts. the accounting review, 2(2), 440. microsoft word 3637-13710-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 344 zodiac calendar and market returns alex meisami judd leighton school of business and economics indiana university south bend e-mail: ameisami@iusb.edu received: may 5, 2013 accepted: may 22, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3637 url: http://dx.doi.org/10.5296/ajfa.v5i1.3637 abstract throughout history, chinese zodiac astrology has significantly influenced the way people in that area think, feel, or make daily decisions. in the zodiac calendar, each year is marked by one of twelve symbolic animals and each animal is associated with its own specific traits. previous literature suggests investors’ mood, attitude, and behavior are influenced by natural events such as cloudy or sunny weather, or lunar cycles. cultural events such as holidays or religious feasts are also shown to have impact on investing decisions. in this paper we study the stock market returns in different lunar years in the zodiac calendar. we find that hang seng’s mean returns are higher in rat years and both mean and median returns are lower in snake years. these results are statistically significant despite a small sample size. for s&p 500, only snake and rooster years show lower, statistically significant, holding period return. results are inconclusive for other animal-years or other categorizations in the zodiac astrology. keywords: zodiac calendar, hang seng, s&p 500, stock market returns, market efficiency asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 345 1. introduction previous literature studies the effect of cyclical and natural events on stock returns. yuan, zheng, and zhu (2006) review the impact of lunar phases on stock market returns and determine there is a decline in return of 3% to 5% per annum on a seven day window around a full moon, as opposed to days near a new moon. hirshleifer and shumway (2003) find a significant correlation between sunshine and stock market returns. in the same vein, saunders (1993) shows that market returns on cloudy days are lower than the sunny days. other studies document how mood and behavior of individuals affect stock market returns. mehran, meisami, and busenbark (2012) find that joyous (solemn) mood and demeanor of different jewish holidays has a positive (negative) effect on the stock market returns. according the wall street journal, in 2013 a number chinese couples rushed to get married before the lunar year dragon ended and the lunar year snake began. this haste was reinforced as the coming year was also a "blind year" (it did not embrace the first day of spring). in this paper we study market returns in different zodiac years. we hypothesize the market returns vary in each zodiac year based on demeanor and characteristics attributed to that year. we believe this is important since throughout history the zodiac calendar plays a noteworthy role in how chinese and, to a lesser extent, others make important decisions. section 2 presents a brief summary of the meaning behind the years in zodiac calendar. in section 3, we highlight some of the relevant literature. we present our data, methods, and findings in section 4 and conclude in section 5. 2. zodiac calendar mythology plays a significant role in the chinese culture. chinese zodiac calendar is created and influenced by this mythology. the zodiac calendar consists of different classes of diverse categories each with different interpretation. the simplest category divides things of this world in two: yin and yang. the two represent traditional way of understanding the world from zodiac point of view. in brief, yin represents darkness, cold, shrinking, and fragile. yang, on the other hand, represents light, upward, enlarging, lively, hot, and strong. in addition, there are five main zodiac elements: earth, fire, metal, water, and wood. these five elements are related to five main planets in the solar system. according to the zodiac philosophy, all the natural phenomena around us are a direct result of interaction between these five elements. for instance, wood causes fire, water causes wood, water conquers fire, and fire conquers metal. these five elements could also represent direction, color, season, body parts, senses, and tastes. in addition to the elements, there are twelve animals in the zodiac calendar: rat, ox, tiger, rabbit, dragon, snake, horse, sheep, monkey, rooster, dog and boar. why were these particular animals included? ancient myth states these exclusive twelve animals where included because they accepted an invitation. hence, they were rewarded their own signs on the zodiac calendar. table 1 summarizes what each of these animals signify. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 346 table 1. what does each zodiac animal symbolize? rat sociable, shrewd, charismatic, intense, tenacious ox dependable, calm, ambitious, born leader, hardworking, logical tiger rebellious, unpredictable, sincere, generous, daring, impulsive rabbit kind, gracious, good friend, shy, elegant, reserved dragon strong, proud, eccentric, intellectual, passionate snake deep thinker, creative, prudent, purposeful, wise horse popular, earthly, magnetic, cheerful, agile, magnetic sheep righteous, gentle, compassionate, mothering, peaceful monkey inventor, problem solver, polite, sociable, competitive rooster scientific, organized, decisive, conservative, alert, zealous, practical dog intelligent, honest, loyal, attractive, straightforward, moralistic boar patient, trusting, thoughtful, understanding, sturdy each animal, which represents one year in a 12-year cycle in the chinese lunar calendar, is described in details by using the precise knowledge of astronomy that existed at the time. finally, there is chinese feng shui that is related to the zodiac through the five elements. in short, the chinese zodiac employs the positioning of celestials along with the interaction of the five elements, yin and yang, the twelve animals and the ten heavenly stems. there are two heavenly stems for each of the five elements, a yin and a yang. 3. literature review ariel (1990) and sullivan, timmermann, and white (2001) study the connection between holidays and stock market returns. they find on the days immediately preceding an american holiday, the returns are about 0.38% greater in an equal-weighted index and even greater in a value-weighted index. ariel concludes that increased stock returns, near american holidays, is caused neither by other previously researched effects– such as the january-effect or weekend-effect– nor by market specialists since positive returns on these days occur well prior to the market close, and there is miniscule evidence of a discernable ask/bid component. to explain this, he hypothesizes that short sellers may desire to close risky positions prior to the holiday; nevertheless, this is determined to be somewhat inconclusive. analysis as to if the mood of the american holiday had an impact on the returns is not presented by these authors. investors’ mood (not specific to holidays) and its impact on stock market returns is studied by hirshleifer and shumway (2003). by reviewing market returns on sunny days – days widely linked with good moods – they are able to show sunshine is correlated with increased stock market returns. by observing traders’ behavior, they find that investors would marginally benefit from trading on sunny days. however, after including transaction costs and controlling for additional variables, their findings are uncertain concerning the extent to which sunshine-based trading is beneficial. hirschliefer and shumway (2003) provide evidence that investors are subject to various conscious and subconscious mood biases when asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 347 making investment decisions, suggesting that investors should be cognizant of their moods when trading stocks. similarly, an analysis of stock market returns based on lunar phases is documented by yuan, zheng, and zhu (2006). the authors review lunar phases and stock market returns and determine a 3-5 percent deduction in return, per annum, on a seven day window around the full moon relative to return in the same window surrounding the new moon. 4. data, methodology, and empirical results we used yahoo finance to extract the s&p 500 (s&p hereafter) adjusted daily closing index returns for the period 1950-2011. we used bloomberg to download hang seng index (hsi hereafter) values. our data range for hsi is 1964-2013; there is no data available before 1964. next, we merged this data with zodiac calendar data for the same period. the zodiac calendar is based on lunar phases therefore it rotates through the gregorian calendar. our first task was to detect the start and the end date for each zodiac year in the gregorian calendar. second, we kept the s&p values for the first 10 days and the last 10 days of each zodiac year. third, we calculated the average price for the first 10 trading days and the last 10 trading days of the each zodiac year. finally, we calculated the holding period return (hpr) for each zodiac year as: hpr = [(average price for the last 10 trading days of the zodiac lunar year)/ (average pricefor the first 10 trading days of the zodiac lunar year)] -1. (1) our final sample includes 62 zodiac years from 1/3/1950 to 2/22/2011. for hsi we use a slightly different methodology. hsi has missing values around the chinese new year making it less useful to use the previous method to calculate the hpr. in this case, we calculate the average index value for the first and last month of the lunar calendar. then the hpr is simply calculated as: hpr hang seng= (average index value in the last month of the zodiac lunar calendar/ average index value in the first month of the zodiac lunar calendar)-1. (2) in table 2 we calculate the hprs separately for yin and yang years. as mentioned before, in the chinese zodiac calendar, yin is interpreted as dark, inactive, sliding, cold, shrinking, and weak; yang is interpreted as active, clear, rising, hot, and sturdy. for hsi, there are 24 yin and 24 yang years in our sample. mean (median) hpr is 19.98% (16.42%) for the yin years and 24.73% (18.55%) for the yang years. for s&p there are 31 yin and 31 yang years. mean (median) hpr is 7.81% (8.75%) for the yin and 8.19% (10.43%) for the yang years. previous studies show positive relation between stock returns and feeling good; consistently, yang years seem to have higher mean (median) returns. the difference, as indicated by the t-test, is not significant. we also calculate the p-value using the wilcoxon-mann-whitney test for medians; once again, there is no significant difference between the medians. although statistically insignificant, the mean median difference between yin and yang years returns are higher for the hsi compared to s&p. overall, the results are somewhat consistent with the notion that the yang years, that are associated with good feelings, lead to higher market returns. also, the results indicate that the hsi investors care more about the meanings of the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 348 yin and yang years as opposed to the s&p investors, consistent with the view that local culture and norms have a more significant impact on their own local index than on foreign indices. table 2. yin, yang, and overall return statistics panel a. hang seng mean median stdev occurrence all 22.41% 18.13% 57.26% 48 yin 19.98% 16.42% 70.30% 24 yang 24.73% 18.55% 40.95% 24 diff. t & pvalues (0.7798) (0.8828) panel b. s&p 500 mean median stdev occurrence all 8.00% 9.89% 14.79% 62 yin 7.81% 8.75% 14.13% 31 yang 8.19% 10.43% 15.66% 31 diff. t & pvalues (0.9207) (0.2249) table 3 presents the market mean and median returns in years concurrent with each of the five zodiac years earth, fire, metal, water, and wood. the f and p-values are the result of the anov test performed to evaluate the difference between the means of each group. for hsi there are 10 observations for earth, fire, and metal, 9 observations for water, and 8 observations for wood. the mean (median) hpr is equal to 44.09% (18.63%) for water. earth has the largest median. in the chinese culture, it is believed that individuals born in earth and water lunar-years are more likely to respond to circumstances. for s&p (panel b) there are 13 observations for earth and metal and 12 observations for fire, water, and wood. we do not find similar results for s&p; however, overlooking the statistical significance, the wood years show the largest mean and median returns. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 349 table 3. five zodiac elements and market returns panel a: hang seng five elements mean median stdev occurrence earth 32.86% 40.33% 39.64% 10 fire 6.03% 4.47% 23.50% 10 metal 16.50% 18.40% 32.65% 10 water 44.09% 18.98% 113.62% 9 wood 12.81% 19.27% 37.38% 8 f-value (0.67) p-value (0.6141) panel b: s&p 500 five elements mean median stdev occurrence earth 9.56% 12.67% 18.39% 13 fire 4.17% 0.75% 12.22% 12 metal 6.92% 9.47% 11.64% 13 water 6.08% 7.66% 16.09% 12 wood 13.24% 13.63% 15.31% 12 f-value (0.67) p-value (0.6180) according to the chinese zodiac philosophy, each of the five elements can manifest in a yin or yang form. this leads to 10 groups. these 10 groups are called heavenly stems. table 4 shows the hprs for these ten groups. the f and p-values are the result of the anova test performed to evaluate the difference between the means of each group. excluding yin earth and yang metal with 7 observations, the other 8 groups have 6 observations each. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 350 table 4. ten heavenly stems and market returns panel a: hang seng heavenly stem mean median stdev occurrence yin earth 47.22% 46.76% 35.49% 5 yin fire -8.89% -9.18% 17.09% 5 yin metal 7.43% -10.08% 37.60% 5 yin water 20.27% 28.62% 67.56% 4 yin wood 37.43% 39.55% 22.07% 4 yang earth 18.51% 27.64% 41.96% 5 yang fire 20.95% 18.13% 19.84% 5 yang metal 25.56% 22.22% 27.94% 5 yang water 63.14% 18.98% 146.20% 5 yang wood -11.81% -14.10% 34.01% 4 f-value (0.74) p-value (0.6662) panel b: s&p 500 heavenly stem mean median stdev occurrence yin earth 9.33% 12.67% 12.81% 7 yin fire -0.22% -4.78% 11.73% 6 yin metal 2.09% 9.11% 13.15% 6 yin water 9.03% 9.45% 17.47% 6 yin wood 18.59% 19.30% 11.17% 6 yang earth 9.84% 12.60% 24.79% 6 yang fire 8.56% 7.42% 12.03% 6 yang metal 11.06% 10.43% 9.14% 7 yang water 3.13% 6.42% 15.61% 6 yang wood 7.90% 8.29% 17.95% 6 f-value (0.75) p-value (0.6608) for hang seng, once again earth and water stand out, especially yang water (in line with what we saw in table 3) and yin earth. yang water has the highest mean (63.14%) but a mediocre median; yin earth however, has the second largest mean (47.22%) and the largest median (46.76%). yin wood also stands out with the mean (median) of 37.4% (39.55%). yin wood has the highest mean and median (18.59% and 19.30%) for s&p also. this is followed by yang metal with mean of 11.06% and median of 10.43%. at first glance, other groups have considerably lower mean and medians. however, the f and p-values form the anova test do not suggest significant difference between the average hprs of these 10 groups. this low power of the test is most likely due to the small sample size. the sample size problem is more sever for hsi. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 351 in table 5 we calculate hprs for each of the 12 animals. each animal represents one zodiac year (see table 1 for the significance of each animal in the zodiac calendar). for hsi the rat year has the highest mean (81.30%). the snake year has the lowest mean return of negative 15.79%. interestingly, year 2013 faced a transition from the dragon to the snake lunar year. according to the wall street journal, many individuals in hong kong hurried to get married before the snake arrives. 1 panel b shows that the snake year has a negative return even for s&p. sheep has the highest mean (18.97%) and median (17.54%) hpr. again, possibly because of the small sample size, the f and p-values do not show statistical significance. table 5. twelve zodiac animals and market returns panel a: hang seng year mean median stdev occurrence rat 81.30% 22.89% 163.14% 4 ox -6.43% -2.01% 52.89% 4 tiger 3.96% 8.08% 38.66% 4 rabbit 27.77% 24.92% 47.36% 4 dragon 15.44% 17.02% 17.18% 4 snake -15.79% -10.13% 13.41% 3 horse 7.40% 7.75% 20.55% 4 sheep 36.20% 41.62% 37.64% 4 monkey 41.40% 45.22% 33.82% 4 rooster 34.94% 28.77% 44.66% 4 dog -1.11% -1.89% 36.21% 4 boar 34.26% 34.28% 22.71% 4 f-value (0.78) p-value (0.6557) panel b: s&p 500 year mean median stdev occurrence rat 3.74% 10.43% 23.17% 5 ox 9.72% 13.18% 15.96% 6 tiger 10.41% 19.47% 18.89% 6 rabbit 10.75% 12.67% 11.58% 5 dragon 5.38% 7.66% 7.32% 5 snake -1.69% 0.84% 13.18% 5 horse 5.60% 8.64% 21.19% 5 1 “jacky choi, who is in his mid-30s, hurried to get married just before the lunar new year-in part because he wanted to avoid having a wedding during the year of the snake.” the year of the snake draws hisses—and yawns. by te-ping chen and fiona law. walls street journalfebruary 7, 2013. http://online.wsj.com/article/sb10001424127887324590904578288182480182760.html asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 352 sheep 18.97% 17.54% 10.63% 5 monkey 7.41% 5.19% 5.63% 5 rooster -2.68% -4.84% 9.25% 5 dog 16.19% 14.00% 13.81% 5 boar 11.44% 8.75% 15.31% 5 f-value (0.94) p-value (0.5135) next, we define a dummy variable for each zodiac animal. for example, a zodiac year is assigned the value 1 if it falls in the rat year, and 0 otherwise. then, by using the following ols regression, we investigate if hsi holding period returns are affected by a specific animal-year. hpr hang seng= α+ β (animal_year_dummy) (3) results are presented in table 6. rat year coefficient is significant at 5% level (p-value is .0299); however the test fails to show similar results for the snake or other animal-years. table 6. ols regression of year-dummies over hang seng returns parameter std. estimate error t-value rat intercept 0.17 0.08 2.02 rat-dummy 0.64** 0.29 2.24 r2 0.1005 f-value 5.03 p-value 0.0299 snake intercept 0.25 0.09 2.91 snake-dummy -0.41 0.34 -1.2 r2 0.0310 f-value 1.44 p-value 0.2366 to control for major macroeconomic factors such as gdp and unemployment rate we also tried the following regression for hsi. hpr hang seng= α + β (animal_year_dummy) + γ (annual % change in gdp)+ ג(annual % change in unemployment rate) (4) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 353 the ols results for both rat and snake dummies indicate that the annual % change in unemployment rate explains most of variation in returns (at 1% significant level). the gdp and the dummy (rat and snake) coefficients are not significant. for brevity, tabulated results are not reported here. to further investigate, in table 7, we test the significance of the difference between the means (t-test) and the medians (wilcoxon–mann–whitney test) of a one animal year versus the rest. we repeat this process for each of the 12 animals. table 7 presents the results only for the rat and the snake years. table 7. return comparison rat, snake versus others rat mean n yes 0.8130 4 no 0.1693 43 mean difference 0.6437 p-value 0.0299 median one-sided p-value 0.4824 two-sided p-value 0.9649 snake mean n yes -0.1579 3 no 0.2501 44 mean difference -0.408 p-value 0.0061 median one-sided p-value 0.0415 two-sided p-value 0.0830 based on the univariate analysis shown in table 7, rat has significantly higher mean and snake year significantly lower mean and median compared to the rest of the animal years. other years are not presented as no statistical significance was observed. when we repeat this analysis for s&p, only snake and rooster years show lower hprs than the rest. the statistical significance is 10% (5%) for snake (rooster). rooster also shows significantly lower median hprs. results are not reported here. 5. summary previous studies show how mood, character, attitude, and daily experience of individuals affect stock market returns. in the same vein, it is documented that holidays, religious feasts, and cultural beliefs affects stock market returns. since ancient times, chinese zodiac culture and astrology has affected the way people in asian and occasionally in western societies make minor or major decisions. each zodiac year is distinguished by a symbolic animal or an asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 354 element. in this paper we investigate whether or not the hsi returns were affected by the demeanor of a specific zodiac year –animal or element. when data is broken by the animal symbols, the rat year shows the highest gain and the snake year displays the biggest lose consistent with common belief in the chinese culture. we do not find statistical significance for the remaining animal-years. for s&p, both snake and rooster show lower holding period returns. we also document that the yang years show higher returns for both hsi and s&p. water and earth years and more specifically, yang water and yin earth years display relatively higher returns. even though the results suggest a difference, the statistical tests come short of finding definitive difference in returns, possibly due to small sample size. references ariel, r.a. (1990). high stock returns before holidays: existence and evidence on possible causes. journal of finance, 45, 1611-1626. http://dx.doi.org/10.1111/j.1540-6261.1990.tb03731.x hirshleifer, d., & shumway, t. (2003). good day sunshine: stock returns and the weather. journal of finance, 58, 1009-1032. http://dx.doi.org/10.1111/1540-6261.00556 mehran, j., meisami, a., & busenbark, j.r. (2012). l'chaim: jewish holidays and stock market returns. managerial finance, 38, 641-652. http://dx.doi.org/10.1108/03074351211233104 saunders, e.m. (1993). stock prices and wall street weather. the american economic review, 83, 1337-1345. sullivan, r., timmermann, a., & white, h. (2001). dangers of data mining: the case of calendar effects in stock returns. journal of econometrics, 105, 249-286. http://dx.doi.org/10.1016/s0304-4076(01)00077-x yuan, k., zheng, l., & zhu, q. (2006). are investors moonstruck? lunar phases and stock returns. journal of empirical finance, 13, 1-23. http://dx.doi.org/10.1016/j.jempfin.2005.06.001 microsoft word evaluation of return-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 407 evaluation of return mean and stock surplus return mean with two approaches of traditional risk and downside risk dr. ebrahim abbasi associate professor, alzahra university, iran faculty of economic and social sciences, alzahra university, tehran, iran e-mail: abbasiebrahim2000@yahoo.com hanieh sadat hoseini department of accounting, islamic azad university kalaleh, iran e-mail: hosseini.k.s@gmail.com amir mohammadzadeh (corresponding author) department of insurance & financial management, university of tehran, iran e-mail: amir.mohammad@alumni.ut.ac.ir. received: july 22, 2013 accepted: nov. 23, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6010 url: http://dx.doi.org/10.5296/ajfa.v6i2.6010 abstract this study aims to compare performance of indexes of traditional risk (variance and traditional beta) and indexes of downside risk (semi-variance and downsize beta) to evaluate risk and better evaluation of return and stock surplus return in tehran stock exchange market. the statistical sample contains 60 firms from 2005 to 2009 with panel data pattern. to test the comparison between the two indexes of traditional and downside risk, linear regression has been used. the results show that downside risk evaluates stock return mean better than traditional risk does. in addition, downside risk evaluates stock surplus return better than traditional risk. keywords: d-capm, downside risk, downside beta, semi-variance, traditional beta asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 408 1. introduction investment, as an economical decision, has always had two components of risk and return, and interchanging of these two brings about investment various blends. investors seek to maximize their own income from investment, and on the other hand, they encounter uncertainty on financial markets, the latter makes access to investment earnings uncertain. in other words, all investment decisions happen based on relationships of risk and return. risk and return have direct relationship with each other. dictionary defines investment risk as potential loss of investment which can be calculated. financial and arithmetic amount of risk equals probability distribution of each investment. weston and bigam believe that risk of an asset is the result of probable changes of future return of that asset. as assets return distribution is not normal and there is skewdness in returns distribution, variance cannot be used. therefore, in postmodern theory of portfolio, return semi-variance has been used as risk index for the following reasons: first, investors do not hate appropriate (positive) changes of return, but they only hate downside (negative) changes. second, in both situations of symmetric and asymmetric return distribution, semi-variance can indicate the concept of risk as much as variance does. this study is different from previous studies at time period, using panel data, testing second hypothesis model, and also the fact that stock return is monthly. the structure of this study includes theoretical considerations, and research literature, research hypotheses, research method, statistical analysis, and hypothesis testing, conclusion and suggestions for further studies. 2. theoretical considerations and research literature there are two viewpoints for definition of risk: first viewpoint: risk as any possible fluctuations in future returns, and second viewpoint: risk as any possible negative future fluctuations (raí, r., saídi, a, 2004). according to these two viewpoints, modern and postmodern theories of portfolio have been shaped. modern theory of portfolio deals with evaluating risk from first viewpoint, based on which the company risk is divided into systematic (unavoidable or market risk) and non-systematic (avoidable or exclusive risk) risk. from this viewpoint, evaluation index of systematic risk is (β) and evaluation criterion of risk is variance. based on postmodern theory which views risk as potential loss (possibility of negative fluctuations), appropriate changes (increasing financial assets return rate) is not considered as risk, and the observations which are lower than return mean rate are considered as risk. capital assets pricing model (capm) has been modeled based on the fact that investors invest with variance-mean chart. this behavior chart in capm reflects a balance in which investors maximize an appropriate function which depends on two parameters of return and variance u=f(µ,ᵹ2). this model based on different hypotheses, tries to explain investors ‘behaviors in assets pricing. its main idea is that an asset price should be in a way that expected return makes up for investors ‘risk. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 409 capm has developed by markwitz. one of the underlying concepts of capm is that market situations are symmetric, and there is an interface between risk and return in a way that whenever a high risk is accepted by investor, a high return is expected. the idea that market is symmetric is not true in the model of d-capm2 which is an advanced version of capm, it means that accepting more risk which is expected to bring about more return, does not necessarily bring about more return. conditions of market symmetry are derived from the factors that not only affect risk, but influence assets expected return rate. hence, there is no interface between risk and return. the most important cause of producing d-capm is that negative risk viewpoint, and semi-variance index is not considered as downside risk. because in conditions of asymmetric market, investors run away just from falling and negative change. in addition, semi-variance is obtained from blending information which has been derived from variance and skewdness (asymmetry). in these conditions, when capm is mediated, the factors which have been applied in such as systematic risk (β) should also be mediated, and downside beta should be replaced with that. semi-variance and semi-standard deviation have been presented as downside risk with two papers by markwitz and ry. a criterion which deals with only deviations lower than mean. markwitz offered two different bases for obtaining semi-variance: 1. below-mean semi-variance rate which is total of deviation from return mean rate. 2. target-mean semi-variance rate which is total of deviation from goal return rate. (qurik,j.p. r.saposnik, 1962). theoretically analyzed that semi-variance is better than variance. (mao,james c.t,1970). proved that for investors, only downside is of high importance, and prefer semi-variance, and provided a strong, fundamental, practical theory to search on semi-variance under goal rate. (hogan,w.,&warren,j,1974), extracted a portfolio optimization arithmetic algorithm for expected return and semi-variance under goal rate (es index), and developing their own model, they offered es-capm which is a asset (β) sensitivity index to market fluctuations. this new index is called downside beta. (harlow,v.&rao,r, 1989). developed a form of pricing model based on downside risk chart, and all previous models are a form of this model. through an experimental research, they concluded that assets return mean is an appropriate index of goal rate. (bawa,v.&lindenberg,e, 1977). offered lpm-capm which prices semi-variance in mediated conditions. (estrada,j, 2002). and (estrada,j, 2004). and (harvey,c.r, 2002). tested downside risk indexes in mediated and non-mediated conditions. they suggested that downside risk indexes determine the conditions of developing markets better. strada developed the model of d-capm which can present a good estimate of expected return in asymmetric market. (ang ,a.chen,j.xing,y, 2002). used three types of beta, strada beta, hugan beta, and bava beta. in these betas, skewdness has been included differently and they studied whether downside beta or downside skewdness are useful for explaining temporary return or not. they measured downside beta with conditional falling correlations and with market changes and concluded that all three models of capm based on downside risk, show a positive risk, but only strada was significant. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 410 (hawang,s.pedersen,c, 2004). showed that downside beta presents a more suitable estimate for expected return rate in asymmetric market than capm beta. (estrada,j, 2007). showed downside risk indexes, based on experimental data, are more reliable than traditional indexes of risk. he used return data in his study. in these studies, downside beta explains 45% of temporary return changes of the sample (including both new-born market and developed market).however, 55% of temporary return changes of the sample dealing with new-born market can be explained by downside beta. (don u. a. galagedera, 2007). showed that the relationship between traditional and downside beta is effected by parameters such as standard deviation, skewdness, and the effect of mentioned parameters on extracted relationships in an downside chart is significant in terms of importance. the results showed that if asset return distribution is not normal, beva and ledinberg beta is a better index of systematic risk compared to other risk indexes. in addition, in markets which return distribution has more skewdness, downside beta is a suitable index of systematic risk. the results of the study showed that in new-born markets there is no standard model having higher acceptability power, and it should be warned to the people who work in new-born markets. (qaiser, a.a,usman.m,shahid.s,k,saeed, 2011). analyzed the stages of providing capm and concluded that d-capm which is based on downside risk, is a fast alternative for capm which has all features of capm. based on the ample evidence from all markets particularly new-born markets, it seems d-capm can improve problems of assets pricing. having analyzed variance and semi-variance at the level of assets return for indexes of 44 countries, (steven l.beach,2011). concluded that ratio of obtained risk for return in d-capm (56%) is more than capm (42%). it is a strong reason for the fact that semi-variance and downside beta better shows countries’ surplus return. (raí r., khosravi, a, 2007). studied capital assets pricing model (capm) performance by replacing three types of downside risk (bava-lindenberg beta, harlo-rao beta, strada beta) with traditional beta index. they concluded that using bava-lindenberg beta and harlo-rao beta as systematic index in capital asset pricing model does not make any significant difference in estimating expected return, and has the same performance as traditional beta does. but strada beta instead of traditional beta in estimating expected return works significantly better in explanation power. (saídi, a., safdaripour, a, 2008). compares normal indexes of risk (beta, sharp ratio, and trino index), and downside risk indexes (beta, sharp ratio, and mediated trino index). they concluded that mediated beta indexes, and mediated trino index determines stock surplus return significantly better than equivalent normal indexes. 3. research hypotheses 1. downside risk evaluates stock return mean better than traditional risk does. 2. downside risk evaluates stock surplus return mean better than traditional risk does. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 411 4. research methodology statistical population of the research contains all non-financial companies accepted in tehran stock exchange market from 2005 to 2009. required data was extracted by corpus and monthly return by tadbirpardaz software. the number of studied sample in this study is 60 companies which have been selected through criteria filtering technique and with regard to the following criteria: omission of the companies which their stocks have been supplied for the first time during the studied period. omission of the companies with transaction breaks over 2 months among the companies passing through the first filter. the type of studied company is non-financial and therefore financial institutes and banks have not inserted in the sample. to purify data, first, by using collected data, variables have been calculated for each of the studied companies and years. all purification operation has been done by the excel software, and by eviews software, hypotheses have been tested. in this research, blended data made statistical power of coefficients increase, and linearity among variables decrease, and estimations are done by increasing degree of freedom. research variables include variance, semi variance, traditional beta, and downside beta as independent variables, and return mean and stock return mean as dependent variables. variance: is an index of risk which return distribution statistically determines a share around its expected amount which is obtained as follows: ri : monthly return of company stock µi: monthly return mean of company stock semi variance: is an index of risk which considers only downside deviations (lower mean) of return. to obtain semi variance, strada index is used as follows: traditional beta: is an index of return changeability of an asset or an investment compared to market which measures an asset risk in terms of its effects on a group of assets. if the relationship between stock return rate and market return is proved, β can be obtained through the following relationship: ri:monthly return of company stock µi: monthly return mean of company stock (1) (2) (3) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 412 downside beta: it measures company return compared to market return only in periods when market return is lower than mean or riskless return amount or investment minimum acceptable return. to obtain this index, strada index [10] is used as follows: stock return: return is earning which a share brings about for its owner in certain time period. to obtain it, the following relationship is used: 0 01 p pdprit −+= ri : is the return of the company i, d: dividend, extra stock, and priority of stock purchase, p1: stock price at the end of period, p0: price at the beginning of the period surplus return: the models, based on the theory of efficient market including capm, believe that no stock has mediated return based on more risk as market return does. surplus return means getting return more than market after doing mediations relevant to risk of investment risk function. ( ) ifm ex i rrr β−= ri ex: surplus returns of company stock i, ri: riskless return 5. research hypotheses results to analyze data, first descriptive data is presented in table 1. table1. descriptive data of research meanmedianmaximminimumnumber of observations return mean 022/0 009/0 197/0 036/0 60 surplus return mean 123/0 083/0 132/2 614/0 60 traditional beta 126/0 082/0 697/0 170/2 60 downsize beta 151/0 111/0 656/0 017/0 60 variance 223/0029/0509/2000/0 60 semivariance018/0011/0090/0002/0 60 (4) (5) (6) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 413 to test normality of data, first jark-bera test has been used. since dependent variables were not normally distributed (prob≤0.05), to have normality of dependent variables in regression procedure, johnson convert has been used in minitab (figures 2,1), which causes probability of stock return mean variable to reach to 0.674, and probability of stock surplus return mean variable to increase to 0.574. 0.20.10.0-0.1 99.9 99 90 50 10 1 0.1 pe rc en t 40-4 99.9 99 90 50 10 1 0.1 pe rc en t 1.21.00.80.60.40.2 0.60 0.45 0.30 0.15 0.00 z v alue pva lu e fo r a d te st 0.38 ref p p -v a lue for b est f it: 0.674995 z for b est f it: 0.38 b est t ransform ation t y pe: s u t ransform ation function equa ls -0 .828447 + 0.803854 * a sinh( ( x + 0.00769948 ) / 0 .0110674 ) p r o ba b ility p lo t fo r o r ig ina l d a ta p r o ba b ility p lo t fo r t r a n sfo r m e d d a ta se le ct a t r a n sfo r m a tio n (p -value = 0.005 means <= 0.005) johnson transformation for mr figure 1. examining normality of return mean 7.55.02.50.0 99.9 99 90 50 10 1 0.1 pe rc en t n 345 a d 26.313 p-v a lue < 0.005 2024 99.9 99 90 50 10 1 0.1 pe rc en t n 345 a d 0.298 p-v a lue 0.587 1.21.00.80.60.40.2 0.60 0.45 0.30 0.15 0.00 z v a lue pva lu e fo r a d te st 0.83 r ef p p -v a lu e fo r b e st f it: 0 .5 8 7 3 5 9 z fo r b e s t f it: 0 .8 3 b e s t t ra n s fo rm a tio n t y p e : s u t ra n s fo rm a tio n fu n ct io n e q u a ls -2 .1 7 2 5 4 + 0 .9 8 9 5 5 7 * a s in h ( ( x 0 .7 7 9 6 2 7 ) / 0 .0 9 5 3 6 1 3 ) p r o b a b i l i t y p lo t f o r o r ig in a l d a t a p r o b a b i l i t y p lo t f o r t r a n s f o r m e d d a t a s e le c t a t r a n s f o r m a t io n (p v a lu e = 0.005 m ean s < = 0.005) j o hns o n t r a ns fo r m a tio n fo r q figure 2. examining normality of surplus return mean after normalizing variables, for research variables to be independent from each other, correlation matrix has been used. the results of these matrixes showed that correlation coefficients among each couple of variables are lower than 0.50 which correlation between variables does not lead to sever linearity. in addition, because all estimated coefficients are significant and separable, it shows the fact that movement among variables is not sever. then validity of dependent and independent variables has been studied. validity of the research variables means and 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beta and nal risk in size beta (4. t relationshi ze risk. n stock retu imr σ -0.27(0. 1.37(0.0 0.6 0.6 254 0.00 2.8 1.8 n 1.0 0.5 dourbin-wa ranzh coeffi he test of 0.05. the nu riables that erted two by high (28.8) 68) is high c erted, risk t 415 hows that a hness of r2 d variance i evaluating 83) is high ip between urn mean an rvαα += 10 0.04 .000*) 0.7 003*) 3 1 1 .9 00 8 9 9 7 atson test t icient which normality o umbers of s t is variance y two, it ca ) compared compared to traditional c asian ll processed 2semivarian indicates do stock retur compared t downsize ri nd risk varia iiv ε+ 4(0.000*) 7(0.000*) 0.57 0.55 117.16 0.000 2.63 2.18 3.75 0.153 that statistic h its value s of error se tatistic t are e and semi an be observ d to varianc o traditiona criteria are n n journal of f d regressio nce (73%), ownsize ris rn mean. t to traditiona isk and stoc ables -0.66(0.000 38.36(0.00 0.73 0.72 281.53 0.000 2.85 2.09 2.51 0.28 c should be should be lo entences wh e in regressi variance, tr ved that reg ce coefficie al beta coeff not signific finance & ac issn 19 2014, vol. www.macrothi on models ar and downs k high exp that semi v al beta and v ck return me -0.69( 0*) 4.83(0 2*) 0. 0. 258 0.0 2. 2. 1. 0. between 1. ower than k hose probab ion table. raditional b garding the ent (0.38), a ficient (0.27 cant. that d ccounting 946-052x 6, no. 2 ink.org/ajfa re at the size beta planation variance variance ean, and (0.000*) 0.008*) .72 .71 8.54 000 .73 .08 .07 .58 5 to 2.5, k of two bility of beta, and fact that and that 7), when downsize asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 416 risk coefficients are positive and high (semi variance, downsize risk) indicates that downsize has more significant relationship with stock return mean. table 4. two-variable results between stock and risk variables ii rvrvmr εααα +++= 22110 21 / rvrv dββ / 21 / rvrv  2/σ 0.7 (0.000*) -0.58(0.000*) 0 α 0.27 (0.001*) 0.38 (0.000*) 1 α 4.68(0.000*) 28.8(0.000*) 2 α 0.72 0.63 r2 0.71 0.61 adj.r2 259.35 281.05 f_ statistic 0.000 0.000 prob(f-s) 2.85 2.85 lm(statistic) 1.88 2.09 durbin-watson 8.71 6.63 jarque-bera 0.18 0.11 prob(j-b) mr: return mean, d.w: dourbin-watson test that statistic should be between 1.5 to 2.5, lm: value of statistic of lagranzh coefficient which its value should be lower than k of two tables (3.62), jarque-bera: the test of normality of error sentences whose probability of statistic should be more than 0.05. the numbers of statistic t are in regression table. in table 5, all presented variables are inserted in a common multiple regression. the estimated model has determining coefficient of 73% which means independent variables high explanation power. here, only downsize risk criteria keep their significance. in this situation, regression remains significant. regarding the fact that beta and variance variables are not significant, it can be concluded that these criteria are not appropriate to calculate risk. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 417 table 5. the results of four variable test between stock return mean and risk variables ii rvrvmr εααα +++= 22110 21 / rvrv dββ / 21 / rvrv  2/σ 0.7 (0.000*) -0.58(0.000*) 0 α 0.27 (0.001*) 0.38 (0.000*) 1 α 4.68(0.000*) 28.8(0.000*) 2 α 0.72 0.63 r2 0.71 0.61 adj.r2 259.35 281.05 f_ statistic 0.000 0.000 prob(f-s) 2.85 2.85 lm(statistic) 1.88 2.09 durbin-watson 8.71 6.63 jarque-bera 0.18 0.11 prob(j-b) mr: return mean, d.w: dourbin-watson test that statistic should be between 1.5 to 2.5, lm: value of statistic of lagranzh coefficient which its value should be lower than k of two tables (3.86), jarque-bera: the test of normality of error sentences whose probability of statistic should be more than 0.05. the numbers of statistic t are in regression table. the second hypothesis results the second hypothesis: downside risk evaluates stock surplus return mean better than traditional risk does. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 418 table 6. f-test, hasman and fixed effects fixed effect test hasman test )prob( f-test )estimated statistic f( variable 0.000 0.007 2.63 σβ / 0.000 0.002 2.76  2/β 0.000 0.001 2.12 σβ /d 0.000 0.001 2.56  2/dβ value of table f )3.62( table 7. the results of surplus return mean and risk variables iim ex i rvmr 210 αβαα ++= + iε  2 σ irv -0.63 (0.000*) 0.26(0.000*) 0 α 0.18 (0.000*) 0.16 (0.014*) 1 α 35.44 (0.000*) 1.41(0.007*) 2 α 0.52 0.47 r2 0.51 0.47 adj.r2 1572.18 252.10 f_ statistic 0.000 0.000 prob(f-s) 2.63 2.52 lm(statistic) 2.24 1.88 durbin-watson 1.05 2.32 jarque-bera 0.59 0.31 prob(j-b) mr: return mean, d.w: dourbin-watson test that statistic should be between 1.5 to 2.5, lm: value of statistic of lagranzh coefficient which its value should be lower than k of two tables (3.62), jarque-bera: the test of normality of error sentences whose probability of statistic should be more than 0.05. the numbers of statistic t are in regression table. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 419 table 8. the results of surplus return mean and risk variables i d imm ex i rvmr 10 λβλλ ++= + iε  2 σ irv 0.71 (0.000*) -0.39(0.000*) 0 α 1.73 (0.001*) 1.38 (0.014*) 1 α 26.42 (0.003*) 1.008(0.007*) 2α 0.63 0.68 r2 0.63 0.67 adj.r2 285.17 1583.36 f_ statistic 0.001 0.000 prob(f-s) 2.86 2.76 lm(statistic) 1.89 1.89 durbin-watson 4.32 4.51 jarque-bera 0.11 0.10 prob(j-b) mr: return mean, d.w: dourbin-watson test that statistic should be between 1.5 to 2.5, lm: value of statistic of lagranzh coefficient which its value should be lower than k of two tables (3.62), jarque-bera: the test of normality of error sentences whose probability of statistic should be more than 0.05. the numbers of statistic t are in regression table. the obtained results from model estimation are significant at the level of 95%. regression results are showed at tables 7, 8. semi variance and downsize beta coefficients in both models are variance and traditional beta coefficients. it means that downsize risk better shows stock surplus return changes. in addition, the results indicate that if any of the variables of downsize risk is inserted in the model, they will have higher determining coefficients. the highness of the obtained r2 by traditional beta and semi variance (52%) compared to variance and traditional beta (47%), and downsize beta and variance (63%), downsize beta and semi variance (68%) has higher explanation power than variance and traditional beta (47%) for downsize risk to traditional risk in evaluating stock surplus return mean. statistic f indicates the whole regression significance. discussion and conclusion using the models based on variance mean behavior for explaining tehran stock exchange companies is not appropriate. because in most parts of market, normality of return can not be used. therefore, inappropriate risk indexes (semi variance and downsize beta) have been used in evaluating return mean, and surplus return mean, and it was proved that they are better asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 420 than risk traditional indexes. the direct and linear relationship between return and risk various indexes has been proved. the results show that downsize indexes have higher explanation power than traditional indexes for return and surplus return. therefore, analysts and activators of investment market can focus on downsize and falling risks to evaluate their predictions, and obtain more satisfactory results. the results of this research, in the first hypothesis, are in line with quiric and saposnik (1962), estrada (2002, 2007), harvey (2002), and pederson and howang (2002), and don (2007). the results of the second hypothesis prove the researches done by stivenbech (2011), and saídi and safdaripour (2008). suggestions for further research 1. using downsize risk criteria to evaluate appropriateness of investment projects 2. evaluating performance of common funds investment basket through downsize risk approach 3. evaluating downsize risk criteria in financial institutes and investment companies 4. semi variance analysis under target rate at the level of companies return. references ang, a., chen, j., & xing, y. (2002). downside correlation and expected stock returns,efa 2002 berlin meetings presented paper: usc finance & business econ. bawa, v., & lindenberg, e. (1977). capital market equilibrium in mean –lower partial moment farmwork. journal of financial economics, 5, 189-200. don u. a. galagedera. (2007). an alternative perspective on the relationship between downside beta and capm beta. emerging market review, 8, 4-19 estrada, j. (2002). systematic risk in emerging market: the d-capm. emerging markets review, 4, 365-379. http://dx.doi.org/10.1016/s1566-0141(02)00042-0 estrada, j. (2004). mean-semi variance behavior: an alternative behavioral model. journal of emerging market finance, 3, 231-248 estrada, j. (2007). mean –semi variance behavior: downside risk and capital asset pricing. international review of economics and finance, 16, 169-185. http://dx.doi.org/10.1016/j.iref.2005.03.003 harlow,v., & rao, r. (1989). asset pricing in a generalized mean-lower partial moment framework: theory and evidence. journal of financial and quantitative analysis, 24, 285-311. harvey, c. r. (2002). drivers of expected returns international market. emerging market quarterly, 32-48. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 421 hawang, s., & pedersen, c. (2004). asymmetric risk measures when modeling emerging markets equities: evidence for regional timing effects. emerging markets review, 5, 109-128. hogan,w., & warren, j. (1974). toward the development of equilibrium capital market model based on semi variance. journal of financial and quantitative analysis, 9, 1-11. http://dx.doi.org/10.2307/2329964 mao, james c.t. (1970). models of capital budgeting e-v vs. e-s. journal of financial and quantitative analysis, 5(5), 657-676. markowitz, h. (1952). portfolio selection. journal of finance, 46, 469-477. qaiser, a. a, usman. m., shahid. s, k., & saeed. (2011) from regularbeta capm to downside-beta capm. european journal of social sciences, 21(2), 189-203. qurik, j. p., & r. saposnik. (1962). admissibility and measurable utility functions. review of economics studies. http://dx.doi.org/10.2307/2295819 raí r., & khosravi, a. (2007). explaining capm with downsize risk approach in tehran stock exchange. journal human and social sciences, 26. raí, r., & saídi, a. (2004). the basics of financial engineering and risk management, samt publication, management faculty of university of tehran. roy,a.d.(1952). safety first and the holding of assets. econometrics, 20(3), 431-449. saídi, a., & safdaripour, a. (2008). comparative evaluation of downsize risk indexes performance, and normal risk criteria performance in predicting stock surplus return mean in tehran stock exchange. quarterly of stock exchange, 4, 7-33. steven l. beach. (2011). semi variance decomposition of countrylevel returns. international review of economics and finance, 17 34-20 . weston, j. f., & brigham e.f. (1970). essentials of managerial finance, 3. microsoft word 6464-23081-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 76 determinants of value creation of gcc firms an application of pls sem model rajesh kumar b associate professor, finance institute of management technology, dubai academic city dubai, uae e-mail: rajesh@imtdubai.ac.ae received: oct. 17, 2014 accepted: dec 30, 2014 published:june 1, 2015 doi:10.5296/ajfa.v7i1.6464 url: http://dx.doi.org/10.5296/ajfa.v7i1.6464 abstract value creation for a firm is a function of identifying and managing value drivers. this study aims to understand the drivers of value creation for gcc listed firms. the paper proposes a model for value creation through the application of partial least square structural equation modeling (pls-sem).the model proposes value creation of a firm as a function of critical drivers like size of firm, dividend policy, investment policy, capital structure and risk characteristics. higher the leverage for the firm, lesser will be the value creation for the firm. investors are skeptical about whether firms with high leverage would create value. firm size is negatively related to value creation. keywords: value creation, pls sem, path diagram, bootstrapping, reflective measurement models, heterotrait-monotrait ratio, blind folding. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 77 1. introduction the determinants of value creation can be categorized in terms of growth, size, efficiency, capital structure and profitability drivers. value creation for a firm is a function of identifying and managing value drivers which have the greatest impact on value creation. a focused approach would enable management to transform the goals of value creation into specific actions. value driver analysis is an important tool in strategic planning analysis. organizations which create long term value in terms of shareholder wealth are expected to create value for all stakeholders. from the perspective of economist’s value viewpoint, value is created when revenues exceed all costs. value is created when management generates revenues over and above the economic costs incurred to generate revenues. the costs come from sources like employee wages and benefits, material, supplies, economic depreciation of physical assets, taxes and opportunity cost of capital. shareholders expect management to generate value over and above the costs of resources consumed which includes the cost of using capital. shareholders require an adequate level of return for the risk they take in. stock prices reflect investors’ expectations about future cash flows. wealth for shareholders will be created only if firms undertake investment decisions which have a positive net present value. value creation is used in the perspective of value derived from accounting based information. wealth creation is based on stock market information. shareholders’ wealth maximization is theoretically logical and operationally feasible normative goal for guiding the financial decision making. from the shareholders’ point of view, the wealth created by a company through its actions is reflected in the market value of the company’s shares. profitability and growth are basically considered as the major determinants of firm value. corporate strategies can be assessed on the basis of their expected effect on profitability, growth and firm value. the value based planning models suggests that management of a firm aims to create shareholder wealth by maximizing market value of the equity thereby creating excess value over the book value of the firm. a firm’s management must focus on strategies that creates excess value attributed to market value (mv) compared to the book value (bv) of equity. a firm’s management creates value for shareholders if mv>bv, destroys value if mv<bv and maintains value if mv=bv. many researchers have focused on establishing the linkage between the strategic position of a company and its financial performance. identifying and selecting strategies that create value for shareholders is a major challenge facing management in the modern era. the identification of financial factors which have the highest impact on value creation in a business can facilitate establishment of criteria for appropriate strategy selection in that direction. the ability of a firm to create value by distributing cash flows to its stakeholders depend on its ability for cash generation from its operating activities and access of additional funds through external financing. the two basic sources of external financing are debt and equity financing. a company’s ability to borrow today is based on projections of its future cash flow generation. the shareholder returns basically depends on prices, costs, investments, volume of products sold and riskiness of firms in an industry. the variables representing these factors can be asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 78 considered as determinants of shareholder value. working capital and fixed capital investment are the two components of investment value drivers. management’s investment choices and financial policy are also value drivers in the context of riskiness of cash flows for the company. scale economies for firms in purchasing, manufacturing, distribution and research can generate value drivers in operating margin, working capital investment and fixed capital investment. the link between value chains and value drivers as reflected by sales growth rate, operating profit margin, income tax rate, working capital investment, fixed capital investment and cost of capital are basic building blocks of shareholder value creation. total risk is the combination of business risk and financial risk. business risk is the uncertainty inherent in the business operations. financial risk arises for shareholders on account of the increased leverage due to additional debt in the capital structure. the financial leverage increases would lead to increased variability of cash flows since fixed interest payment is bound to increase. hence shareholders expect higher returns for highly leveraged firms. strategies which increase business risk can increase systematic risk which is measured by betacoefficient. investors expect higher rate of return as the systematic risk of the firm increases. earnings is considered an important variable which affects the market value of equity shares. the investment decisions aimed at expansion of scale of operations ultimately is focused on earnings generation. hence earnings enhancement could affect market value of a company. many studies have considered measures of market value of equity in excess of book value like tobin q, market to book value, price to earnings ratio or price to sales ratio as the variable representing value created in a firm. studies have also highlighted the positive contribution of research and development (r&d) investments to economic growth, productivity and profitability. 2. objective of the study the basic objective of the paper is to examine the determinants of value creation in terms of drivers.in other words study aims to understand the drivers of value creation for gcc listed firms. 3. review of literature the study by sam ben et al (2002) uses random probit model estimation procedure to estimate the determinants of value creation among companies listed in tunisia stock exchange. the study finds that probability of creating future value is significantly correlated with profitability. the study also finds that value creation is affected by industry patterns, size and nature of property. the linkage between strategic position of a company and its financial performance have been advocated by studies of de bodinat (1978), pene (1983), degos et al (1988) etc. the study by rappaport (1987) suggests the determinants of value creation as growth rate, operating profit margin, income tax rate, working capital investment, fixed capital investment, cost of capital and value growth duration. caby et al (1996) based on a sample of french companies find that the determinants of value creation are variables based on profitability, activity, financial policy, investment policy and dividend policy. the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 79 study by varaiya (1987) highlights the significance of return on equity (roe) as a signal of profitable investment. the results of this study indicate that profitability and growth do influence shareholder value and the market to book value of equity ratio, tobin‘s q ratio are theoretically and empirically equivalent measures of value creation. the studies by ross (1977); bhattacharya (1979), hakansson (1982), miller et al (1985) suggests that dividend payment signals the market about the higher cash flow generation potential of firms. the choice of debt level is a signal of firm quality (leland 1977, ross 1977, myers 1977). rappaport (1986) suggests that profitability is an important determinant of value creation. profitability improvement can result from economies of scale, cost reducing linkages with suppliers and channels. banz (1981) advocates size effects (measured by market capitalization) as a significant determinant of average returns provided by market beta. this study finds that average returns on small size ( low market capitalization) stocks are too high given their beta estimates and average returns on large size (high market capitalization) stocks are low. bhandari (1988) documents positive relationship between leverage and average returns. studies by stattman (1980) and rosenberg et al (1985) finds that average returns on stocks are positively related to the ratio of firm’s book value of equity to market value of equity. the study by chan et al (1991) finds that the ratio of book value to market value of equity is a significant determinant in explaining the cross section of average returns on japanese stocks. chen et al (1991) postulate that the earning prospects of firms are associated with a risk factor in returns. firms with low stock prices and high ratio of book to market equity which are characterized having poor prospects by market are considered risky and have higher expected stock returns than firms with strong prospects. basu (1983) suggests that the earning-price ratios (e/p) is a variable that explain the cross section of average returns on us stocks which includes size and market beta variables. the studies by black et al (1972) and fama et al (1976) find positive relation between average stock returns and beta. the study by fama and french (1992) suggests that size (measured by market value of equity) and book to market equity are important determinants which reflect powerful characterization of the cross section of average stock returns during the period 1963-1990. the main results of the fama and french (1992) study indicates that for the 1963-1990 period, size and book to market equity capture the cross sectional variation in average stock returns associated with size, e/p, book to market equity and leverage. it can be stated that if the stocks are priced rationally, systematic differences in average returns can be attributed to differences in risk. in the perspective of rational pricing, the variables size measured by the total market capitalization (price multiplied by number of shares) and be/me can be considered as proxy variables to sensitivity to common risk factors in returns. fama and french (1995) study the behavior of stock prices in relation to size and book to market equity (be/me), which reflects the behavior of earnings. specifically the study explores whether the behavior of stock prices in relation to size and book to market equity is consistent with the behavior of earnings. in the context of rational pricing, the study indicates that high be/me signals persistent poor earnings and low be/me signals strong earnings. a low stock price relative to book value (high be/me) signals sustained lower earnings on asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 80 book equity. in summary low be/me (high stock price relative to book value) is typical of firms with high average returns on capital (growth stocks), whereas high be/me is typical of firms that are relatively distressed. fama and french (1995) also suggest that size is related to profitability. controlling for be/me, small stocks tend to have lower earnings on book equity than do big stocks. penmann (1991) suggests that low book to market equity firms remain more profitable than high be/me firms. firms with higher required equity returns will have higher book to market ratios. this prediction is consistent with the positive relation between average stock return and be/me observed by fama and french (1992, 1995). fama and french (1995) predicts that high be/me should be associated with a persistently low ratio of earnings to book equity, while low be/me should be persistently associated with strong earnings to book value of equity. in other words low be/me stocks are on average more profitable than high be/me stocks. debt equity ratio (der) is used as a variable to explain the expected common stock returns. an increase in debt equity ratio of a firm increases the risk of its common equity. cross sectionally the common equity of a firm with higher debt equity ratio always have higher risk since the firm level risk may vary, der is expected to be positively correlated to the risks of common equity across firms (bhandari 1988).beta is based on a market proxy and calculated for a period. the financial leverage hypothesis suggests that increase in debt is a signal to the market that the firm’s prospects have improved. the dividend payout hypothesis suggests that value creation is a function of the dividend payout of companies. higher the dividend payout more is the value creation for the company. ross (1977) suggests that companies that increase dividend payout signal to the market that it has the potential to generate future cash flows to meet future dividends. the value of a company is expected to increase on account of dividend payment as it signals to the market that the firm is expected to have higher cash flows. the profitability hypothesis suggests that higher the profits generated by firms, greater would be the value creation. the study by gamba and triantis (2008) develop a model that endogenizes dynamic financing, investment and cash retention/payout policies in order to analyze the financial flexibility on firm value. the study demonstrate that value of financing flexibility depends on the costs of external financing, the level of corporate and personal tax, the firm’s growth potential. michael et al (2001) suggests integration of entrepreneurial and strategic thinking for value creation in entrepreneurial firms. the paper by amhud (2002) shows that over time, expected market illiquidity positively affects ex ante stock excess return, suggesting that expected stock excess return partly represents an illiquidity premium. severine et al (2004) examines the determinants of stock returns in a small open economy using an apt framework and finds that statistical factors yield a better representation of the determinants of stock returns than macroeconomic variables. boyer et al (2007) find that the return of canadian energy stock is positively associated with the canadian stock market return, with appreciations of crude oil and natural gas prices, with growth in internal cash flows and proven reserves, and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 81 negatively with interest rates. the study by fang l et al (2009) find that stocks with no media coverage earn higher returns than stocks with high media coverage even after controlling for well-known risk factors. 4. methodology 4.1 model discussion the proposed model for value creation is framed with respect to latent constructs as given in the diagrammatic design below. it is assumed that value creation is a function of critical variables of size of the firm, dividend policy of the firm, investment decisions, capital structure and risk characteristics of the firm. it is hypothesized that investment decisions would lead to growth which in turn would lead to profitability and results in value creation. figure 1. initial path diagram for value creation the relationship between the constructs is based on the direction of arrows. the latent constructs of dividend policy (divpo), firm size, growth, investment decision (investdeci), risk, capital structure are designed with reflective indicators. the final latent construct of value creation is designed with formative indicators of average stock returns, earnings to book value of equity and ratio of market value to book value of the firm. the description of the reflective and formative indicators is provided in the table below. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 82 table 1. reflective and formative indicator definitions variables definitions mvt / bvt market value of firm / book value of firm in year t lnsa natural log of average revenue in t-1 to t-3 dividend payout (dpo) total dividends / total earnings in t-1 to t-3 lnta natural log of total assets in t-1 to t-3 lev(leverage) total debt / total equity in t-1 to t-3 lnme natural log of market equity in t-1 return on equity (roe) net income / total equity in t-1 to t-3 return on assets (roa) net income / total assets in t-1 to t-3 capex / ta capital expenditure / total assets in t-1 to t-3 wc / ta working capital / total assets in t-1 to t-3 sg sales growth rate in t-1 to t-3 eg earnings growth rate in t-1 to t-3 earnings / price (e/p) total earnings / market capitalization in t-1 to t-3. market capitalization is price multiplied by number of shares. return average monthly returns in july of year t to june of year t+1. beta measures the systematic risk of the stock. beta is found out by regressing stock returns for a stock on respective market indices returns based on one year of data. beta is calculated for one year period t-1. div yield dividend per share / market price per share in t-1 to t-3. et / bet-1 total earnings in t / book value of equity in t-1 the formative indicator variables of market value of firm to book value of firm, average stock returns and earnings were based on the year 2012. one of the formative indicator for final latent construct of value creation was et / bet-1 where et was in the year 2012 and. bet-1 was based in the previous year, the average accounting data for the year’s t-1 to t-3 is matched with the average monthly returns for july of year t to june of year t+1. the values for variables of size, dividend payout, profitability are average values for period t-1 to t-3 (2009-2011). the financial data was collected from the balance sheets of the firms. the stock market data was collected from the seven stock exchange websites. 4.2 sample selection for the empirical modelling part, we selected eight companies with highest average market capitalization from saudi tadawul, and seven companies each from other six stock markets -dubai financial markets, abu dhabi securities exchange, muscat securities market, qatar exchange and kuwait stock exchange the average market capitalization was based on five years during the period 2009-2013. the value of average market capitalization was calculated asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 83 in us dollars. all financial variables in terms of value were converted to us dollars based on the exchange rate of us dollar vis a vis gcc currencies1. table 2. sample segregation sector number of companies banking 22 industrial 6 telecommunication & it 5 investment and financials 5 petrochemical and energy utilities 3 real estate and construction 3 consumer services 3 insurance 2 transport 1 total 50 the following table gives the descriptive statistics for 50 sample companies based on five yearly average values.the table below e gives the descriptive statistics of the sample firms involved in the empirical study. the descriptive statistics of variables like total assets, revenues, cash flows and net profit are given in the table. the average, mean, standard deviation, the maximum value and minimum value of the sample statistics are given. the descriptive statistics are for 50 sample companies based on five yearly average values. the average total assets and revenues of the sample firms amounted to $23.65 billion and $3.2 billion respectively. the standard deviations for the total assets and revenues were 28.59 and 6.47 respectively. hence the variability in asset size and revenues were higher in the sample firms. the analysis for the maximum and minimum value for assets and revenues suggests huge difference in values. the sample firms had an average cash flow and net profit of $8.7 billion and $0.416 billion respectively. the standard deviation for cash flow and net profit were $46.82 billion and $0.521 billion respectively. table 3. descriptive statistics (values in millions of dollars) variables average standard deviation maximum minimum total assets 23656.39 28599.43 140216.56 463.45 revenues 3200.91 6472.93 42266.60 31.68 cash flow 8703.81 46824.72 330799.50 -68.47 net profit 416.06 521.15 2111.88 -413.85 11usd=3.67aed; 3.75 saudi riyal; 3.64 qatari riyal; 0.28 kuwaiti dinar; 0.38 bahrani dinar ; 0.38 omani rial. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 84 the following table provides the cross sectional statistics of the reflective and formative indicators. thecross-sectional statistics are for averages, standard deviation, maximum and minimum values for the sample firms. the variables indicate growth, earnings, leverage, profitability and risk measures. size is measured by book value of total assets and market value of equity. risk is measured by beta. table 4. cross sectional variable statistics variables average standard deviation maximum minimum mv / bv 1.05 0.50 2.36 0.15 log (sales) 6.90 1.74 10.58 0.0000 earnings growth 1.80 9.53 66.70 -4.6800 log (total assets) 9.09 1.91 12.02 0.0000 dividend payout 0.38 0.35 1.70 0.0000 leverage 3.61 3.12 12.91 0.0000 roe 1.60 8.6 46.8 -8.3 roa -0.27 2.14 0.17 -15.16 capex/ta 0.0040 0.06 0.26 0.0000 wc/ta -0.28 0.68 1.06 -4.3 sales growth 0.12 0.28 1.23 -0.23 e/p 0.98 1.67 6.1200 -1.32 return -0.0009 0.0322 0.12 -0.11 beta 0.94 0.61 2.64 0.0000 ln (me) 9.3 1.5705 11.74 4.3 ln bv/mv 0.08 0.56 1.86 -0.85 dividend yield 0.09 0.40 2.75 0.0000 the partial least squares structural equations modeling (pls-sem) was used to test the determinants of value creation in the gcc firms. the structural equation modelling procedure can be done in two ways, namely covariance based structural equation modeling (cb-sem) and partial least squares modeling (pls-sem). recently, there is an increased use of pls-sem rather than cb-sem due to both theoretical and methodological reasons (hair et al., 2012).partial least square modeling is used to tackle many multi equation econometric models. since pls also reflects the sum of the diagonal in the covariance matrix, it is also suited for prediction. basically a path model is a diagram that connects variables/constructs based on theory and logic to visually display the hypothesis that will be tested. structural asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 85 equation models are based on an analysis of correlation or covariance. pls-sem is more preferable than cb-sem in case of small samples and when the focus is on prediction and theory development. with respect to methodological reasons,cb-sem models require larger sample size and normal data for better goodness of fit indices in comparison with pls-sem. 5. results and discussion in pls sem, the significance of factor loadings are assessed by the bootstrapping procedure with minimum samples of 5000 and the number of cases equivalent to sample size (n=50). bootstrapping is a non-parametric procedure which can be applied to test whether coefficients such as outer weights, outer loadings and path coefficients are significant by estimating standard errors for the estimates. in bootstrapping, the subsamples are created with observations randomly drawn from the original data set (with replacement). through the process of bootstrapping, reflective and formative indicators which were not significantly loading with their respective loadings or not meeting the criteria were removed from the model. for the reflective indicators, outer loading relevance testing is carried out based on the following criteria. if the outer loading is less than 0.40, the reflective indicator is deleted. if the outer loading is less than 0.40 but greater than 0.40, then the impact of indicator deletion on ave and composite reliability is analyzed. if the deletion increases the measures above the threshold, then the reflective indicator is deleted. if the measures already meets the threshold, then the reflective indicator is retained. if the outer loading is greater than 0.70, then the reflective indicator is retained. the reflective indicators of dividend yield (divyield), lnta, lnsa and eg were removed from their respective constructs. 5.1 validity assessment of reflective measurement models the pls sem algorithm converged. the assessment of reflective measurement model is done through indicator reliability, internal consistency reliability, convergent liability and discriminant validity. it is required that at least 50 per cent of each indicator’s variance must be accounted for by the underlying construct.the indicator reliabilities for reflective measures are analyzed by examining the outer loadings. indicator reliability is also known as indicator communality. reflective indicators of e/p for latent construct profitability, roe for profitability and wc/ta are found to be statistically significant. loadings of value one indicate that the latent construct had only one reflective indicator. for example the only reflective indicator for the latent construct risk is beta. the indicator reliability loading of e/p and wc/ta were above 0.70. for the latent construct profitability, e/p indicator has a higher loading than roe. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 86 table 5. outer loadings of indicator reliabilities loadings for originals sample mean p values beta <risk 1 1 capex/ta <investdeci 0.488 0.465 0.28 dpo <divpo 1 1 e/p <profitability 0.809 0.658 0.002 lev <capital structure 1 1 lnme <firmsize 1 1 roe <profitability 0.602 0.707 0.002 sg <growth 1 1 wc/ta <investdeci 0.889 0.728 0.017 the internal consistency reliability of reflective measures is analyzed through composite reliability and cronbach’s alpha. table 6. composite reliability values p values capital structure 1 divpo 1 firmsize 1 growth 1 investdeci 0.661 0.002 profitability 0.67 0 risk 1 composite reliability values of greater than 0.6 are generally acceptable. the p values are statistically significant for the latent construct of investdeci and profitability. the reflective indicators of investdeci (investment decisions) are capex/ta (ratio of capital expenditure to total assets) and wc/ta (ratio of working capital to total assets). the reflective measures of profitability are the ratio of earnings to price and return on equity. all the reflective measures have composite reliability. it has to be noted that other than the above discussed constructs, all the rest have value one since they are represented by only one reflective measure. the cronbach’s alpha measure for the majority of the construct was above 0.7. the cronbach’s alpha can be considered as the lower bound and the composite reliability as the upper bound of the true internal consistency reliability. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 87 table 7. average variance extracted (ave) original sample sample mean p values capital structure 1 1 divpo 1 1 firmsize 1 1 growth 1 1 investdeci 0.514 0.543 0 profitability 0.509 0.519 0 risk 1 1 the average variance extracted (ave) is the measure of convergent validity. ave is the grand mean value of the squared loadings of all indicators associated with the construct. each construct should account for atleast 50 per cent of the assigned indicators’ variance. it is also referred to as construct communality. all the construct satisfy the convergent validity criterion. discriminant validity discriminant validity is tested by means of assessment like fornell larcker, cross loadings and the heterotrait -monotrait ratio (htmt) table 8. fornell larcker measure capital structure divpo firmsize growth investdeci profitability capital structure 1 divpo -0.198 1 firmsize 0.053 0.081 1 growth 0.041 -0.313 -0.131 1 investdeci -0.462 -0.128 0.063 0.187 0.717 profitability -0.068 0.148 0.017 -0.53 -0.164 0.713 risk -0.251 0.325 0.319 -0.111 0.033 -0.019 value creation -0.404 0.159 -0.259 -0.096 0.146 0.107 the fornell larcker criterion suggests that the square root of ave must be greater than the correlation of the construct with all other constructs including the formative measures in the structural model. this criterion is satisfied in this case. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 88 table 9. cross loadings capital structure divpo firmsize growth investdeci profitability risk value creation beta -0.251 0.325 0.319 -0.111 0.033 -0.019 1 0.145 capex/ta -0.438 0.145 0.107 0.088 0.488 0.003 0.308 0.023 dpo -0.198 1 0.081 -0.313 -0.128 0.148 0.325 0.159 e t / be (t-1) -0.187 0.045 -0.297 -0.023 0.162 0.137 -0.013 0.649 e/p 0.054 0.158 -0.039 -0.428 -0.2 0.809 0.001 0.099 lev 1 -0.198 0.053 0.041 -0.462 -0.068 -0.251 -0.404 lnme 0.053 0.081 1 -0.131 0.063 0.017 0.319 -0.259 roe -0.19 0.037 0.083 -0.32 -0.008 0.602 -0.034 0.049 return -0.384 0.174 -0.107 -0.108 0.065 0.034 0.2 0.805 sg 0.041 -0.313 -0.131 1 0.187 -0.53 -0.111 -0.096 wc/ta -0.298 -0.223 0.016 0.167 0.889 -0.19 -0.124 0.155 according to cross loading criteria, each indicator must load highest on the construct on which it is the indicator measure both in terms of reflective and formative measures. table 10. discriminant validity assessment through heterotrait -monotrait ratio (htmt) capital structure divpo firmsize growth investdeci profitability risk capital structure divpo -0.198 firmsize 0.053 0.081 growth 0.041 -0.313 -0.131 investdeci -2.013 -0.212 0.337 0.698 profitability -0.504 0.722 0.161 -2.778 -2.557 risk -0.251 0.325 0.319 -0.111 0.501 -0.122 htmt is the average heterotrait -heteromethod correlations relative to the average monotrait -heteromethod correlations. monotrait -heteromethod correlations represent correlations of indicators measuring the same construct.heterotrait -heteromethod correlations are correlations of indicators across constructs measuring different phenomena. htmt values close to 1 indicate lack of discriminant validity. the threshold value is considered close to 0.85. the constructs in the study satisfy the discriminant validity assessment on the basis of htmt. 5.2 validity assessment of formative measurement models the validity assessment of formative measurement models consists of assessingthe collinearity issues and assessment of significance and relevance of the formative indicators. collinearity issues occurs when two or more indicators of a construct are highly correlated. collinearity assessment is done through the analysis of vif. if there are no critical levels of collinearity ( ie vif<5), then the analysis enters the next stage. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 89 table 11. vif values vif beta 1.000 capex/ta 1.001 dpo 1.000 e t / be (t-1) 1.005 e/p 1.000 lev 1.000 lnme 1.000 roe 1.000 return 1.005 sg 1.000 wc/ta 1.001 the table shows that all vif values are less than 5. the next stage consists of assessing the relevance of the formative indicators in the following manner. the outer weight is assessed to be significant or not. if the outer weight is significant, then the operation is continued with the interpretation of the outer weight’s absolute and relative size. if the outer weight is not significant then the formative indicator’s outer loading is analyzed. if the outer loading is less than 0.5, then the significance of the formative indicator’s outer loading is tested. if the outer loading is less than 0.5 and not significant, then the formative indicator is deleted. if the outer loading is less than 0.5 but is significant, then the removal of the indicator may be considered. if the outer loading is greater than 0.5, then the indicator is retained even if it is not significant. the processing resulted in the removal of the formative indicator variable mv/bv. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 90 figure 2. the final path diagram for value creation model 5.3 assessment of the structural model the assessment of the structural model consists of five steps.firstly the structural model is assessed for collinearity issues. the vif values are found to be less than 5. hence structurally the model has no collinearity issues. the second step consists of assessing the significance and relevance of the structural model relationships. this process involves testing the significance and relevance of path coefficients. the path coefficients vary between -1 to +1. the type of effects is divided into direct effect, indirect effect and total effect. the third step involves determination of coefficient of determination r square. it is a measure of the model’s predictive accuracy. the fourth step involves measurement of effect sizes by means of f square. the fifth step involves estimation of q square value to find the predictive relevance through blindfolding. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 91 table 12. path coefficients original sample sample mean t statistics p values capital structure -> value creation -0.337 -0.310 2.195 0.029 divpo -> value creation 0.060 0.058 0.371 0.711 firmsize -> value creation -0.291 -0.257 1.166 0.244 growth -> profitability -0.530 -0.633 3.185 0.002 investdeci -> growth 0.187 0.245 1.194 0.233 profitability -> value creation 0.083 0.066 0.747 0.456 risk -> value creation 0.136 0.136 1.012 0.312 capital structure variable of leverage is negatively related to value creation. the path coefficient is -0.337 for capital structure with statistical significance at 5% level of significance. hence it can be assumed that higher the leverage for the firm, lesser will be the value creation for the firm. this result signifies that with respect to stock market valuation, investors are skeptical about whether firms with high leverage would create value. firm size is negatively related to value creation. the path coefficient has a value of -0.291 but without statistical significance. growth is negatively related to profitability with statistical significance. investment decisions are positively related to growth. hence firms which focus more on investment decisions like capital expenditures and working capital tend to create more value for the firm. profitable firms tend to create more value for firms. riskier the firm, higher the value creation. the results are not statistically significant. table 13. r square r square growth 0.035 profitability 0.281 value creation 0.250 r square is a measure of the model’s predictive accuracy. it represents the amount of variance in the endogenous constructs explained by all of the exogenous constructs linked to it. the r square value for value creation is 0.25. thus all the exogenous variables accounts for 25 per cent of variation in the endogenous construct value creation. f square measures the size effects. it assesses how strongly one exogenous construct contributes to explaining a certain endogenous construct in terms of r square. growth to profitability construct have strong effect and rest of the constructs has weak effects. blindfolding is an iterative procedure in which different parts of data matrix are omitted. the estimates based on the reduced datasets are used to predict the omitted parts. the prediction error is used as an indicator of predictive relevance. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 92 table 14. results of blind folding sso sse 1-sse/sso capital structure 50 50 divpo 50 50 firmsize 50 50 growth 50 50.186 -0.004 investdeci 100 100 profitability 100 91.426 0.086 risk 50 50 value creation 100 97.732 0.023 the q2 square value as given in the last column signify weak effect. 6. conclusion this paper proposes a theoretical model for value creation. value creation is analyzed through path diagram through pls sem algorithm. value creation for a firm is a function of its capital structure, investment decisions, size, growth, profitability and risk measures. the study finds that leverage is inversely related to value creation.investors are skeptical about whether firms with high leverage would create value. firm size is negatively related to value creation. references amihud, y. 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(1987). the relationship between growth, profitability and firm value. strategic management journal, 8, 487-497. http://dx.doi.org/10.1002/smj.4250080507 microsoft word 3687-13892-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 396 the global financial crisis and the role of ownership structure on cost of capital salman afkhami rad department of finance, waikato management school, the university of waikato hamilton, new zealand tel: 64-7838-4466 e-mail: sa177@waikato.ac.nz professor stuart locke dean of finance department, waikato management school, the university of waikato hamilton, new zealand tel: 64-7838-4466 e-mail: smlocke@waikato.ac.nz dr. krishna reddy lecturer at finance department, waikato management school, the university of waikato hamilton, new zealand tel: 64-7838-4466 e-mail: krishna@waikato.ac.nz received: may 12, 2013 accepted: may 30, 2013 published: june 17, 2013 doi:10.5296/ajfa.v5i1.3687 url: http://dx.doi.org/10.5296/ajfa.v5i1.3687 abstract this paper explores the relationship between ownership structure and cost of capital. prior studies have established links between ownership structure, firm performance and cost of capital but their results are mixed and inconclusive. as ownership structure is one of the important issues faced by corporates, especially in listed companies, the objective of this study is to explore the relationship between ownership structure and cost of capital in listed companies. in addition, the role ownership structure plays is regarded as important; the expectation of managers and shareholders is to determine the optimal ownership structure that protects companies in normal and in crisis situations as well. therefore, this study asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 397 explores the role ownership structure plays in determining the cost of capital during and after the financial crisis period. after employing the panel regression method, we report a negative relationship between the ownership structure and cost of capital during a global financial crisis. keywords: global financial crisis, ownership structure, cost of equity capital asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 398 introduction global financial markets regardless of their distance or openness, exogenously were affected by the global financial crisis in 2007 (bedford, 2008). the effect of the crisis on cost of capital was different across countries. the world bank (2010), reports that cost of risk in high-income countries fell more sharply during the crisis compared to other countries. interest rates in developing countries fell substantially during the financial crisis, countries in east asia and the pacific region were also affected but developing countries in europe and central asia were not. a global financial crisis affects economies in different ways, such as international assets, international liabilities and international financial leverage (bedford, 2008). exposure to prior crises and market malfunctions provide some guidance as to how companies could equip themselves in order to face these situations. berle and means (1932) were the primary researchers to start talking about establishment of a more powerful company. establishing a powerful company that has the ability to protect its shareholders’ wealth is still a challenging issue in academic environments and practical environments (chareonwong, 2011; margaritis, 2010). berle and means (1932) believe that a diffused ownership structure in a modern corporation allows managers to take control of the company and care less about shareholder wealth. while berle and means point out the divergence of interests between managers and owners as the source of problems, further studies in recent years mention separation of ownership and control as being a problem and part of a wider debate about corporate governance (chen, 2009; international corporate governance network, 2009). as insiders, managers and directors of a company have control over almost all parts of a company, so it is more probable they will be interested in maximizing their own interests which is sometimes in line with owners’ utility and sometimes not. thus, in dealing with corporate governance debates the main issue is to find the mechanisms that utilize the managers’ behaviour in value-maximising decisions. through these mechanisms, owners are able to monitor managers’ actions to ensure they are in line with maximising company value. mechanisms for utilizing manager behaviour consist of different strategies, such as characteristics of ownership and characteristics for controlling and running the company. the interests of company insiders (managers and directors) and outsiders (investors and shareholders) are highly related to their own benefits. although moral issues might satisfy insiders to do their best in maximising company value, investors cannot convince themselves to rely on that. thus, exploring a mechanism for monitoring insiders’ behaviour by investors and aligning the interests of insiders and investors seems to be significant. ownership structure can address these questions by increasing the monitoring power of investors through block ownership and aligning interests through insider ownership (margaritis, 2010; mcconnell, 2008). bayrakdaroglu, ersoya and citak (2012) believe that block ownership is significantly related to a firm’s performance but find little evidence of effectiveness for insider ownership. although ownership structure plays a significant role in normal business situations, an important issue that companies need to face is whether the same ownership structure can asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 399 survive in companies in difficult and crisis situations. in order to address this question, the global financial crisis of 2007 provides a stunning opportunity. the new zealand market is a commodity-based economy with relatively small sized companies and affected by its geographical distance to export markets. in comparison, singapore is a highly international economy with larger companies and an open economy. therefore, it is appropriate to consider these two different countries and how company ownership structure influences the cost of capital during a financial crisis. although there are different ownership structures in these two countries, such as higher insider ownership in new zealand (12%) compared to relatively lower insider ownership in singapore (3%) and lower block ownership in new zealand (49%) compared to higher block ownership in singapore (72%), these can be the result of different economy and governance mechanisms and assessing these companies in two different countries will help academics and practitioners to better analyse company and economy situations. literature review conflicts of interest between managers and shareholders have long been studied regarding issues of ownership and performance; the main studies were by berle and means (1932) and jensen and meckling (1976). investigations on the relationship between ownership structure and performance of firms go back to (1932) when berle and means released the results of their study of us firms. they document that in firms where lots of small shareholders have the ownership of a firm and control of that business is in hands of insider managers, there is a tendency for under performance. following their study, in (1976) a more classical owner-manager agency problem was developed by jensen and meckling. they document that aligning the interests of managers and shareholders is possible by having managers hold shares in that firm. managers who hold shares in a firm do not have enough incentive to expropriate shareholders’ wealth and nor do they engage in external activities that damage company profit. mehran (1995) in his study on the us market reports a positive linear relationship between managerial ownership and firm performance. in line with these studies, shleifer and vishny (1986) indicate that large equity holders have strong incentives to monitor manager performance and that consequently mitigates agency conflicts. prowse (1994) also indicates that concentrated ownership in companies will mitigate agency problems and agency costs. demsetz (1983) believes that there is a negative relationship between managerial ownership and companies’ financial performance because of the entrenchment effect. thus, demsetz documents a negative linear relationship between managerial ownership and financial performance. ang, cole and lin (2000) document a negative relationship between proportions of shares owned by managers and financial performance in the us market. in subsequent years, researchers document no statistical significant relationship between ownership structure and firm performance (al farooque, 2007; demsetz, 2001). followed by demsetz in 1983, stulz (1988) and morck et al (1988) document a combined effect of incentive alignment and entrenchment to report the relationship between insider ownership and firm performance. block holders have strong incentives to monitor and discipline management in order to mitigate agency conflicts (shleifer, 1986, 1997). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 400 entrenchment effect determines whether firm value would be maximised by the presence of large external shareholders (claessens, 2003; villalonga, 2006). in this regard, family firms are a special class of large shareholders with unique incentive structures. for example, some factors such as concerns over family and firm reputation can mitigate the agency cost (anderson, 2003). minority shareholders’ expropriation may still happen in firms with controlling family shareholders (villalonga, 2006). reddy et al (2008) find a negative relationship between insider ownership and financial performance in new zealand small cap companies. morck, shleifer and vishny (1988) present two conflicting effects for insider ownership: (1) an alignment effect, (2) an entrenchment effect. alignment effect refers to the positive effect of increasing insider ownership and firm performance by aligning the financial interests of insiders and firm. entrenchment effect is when the likelihood of replacement through a proxy fight or takeover declines as insider ownership increases and provides more incentives for managers to pursue their own goals. entrenchment effect shows that expropriation of minority shareholders will occur when managers fail to align managers and shareholder interests by giving shares to managers (johnson, boone and breach 2000, shleifer and vishny 1997). grossman and hart (1982) document the strong incentive of external block owners to control the opportunistic behaviour of management. aside from the positive role block owners have on firm performance because of strong monitoring incentives and voting control, some issues also exist that prevent block owners doing their best for the firm. cable and yasuki (1985) document a positive relationship between ownership concentration and firm performance in japanese firms except keiretsus which is one kind of japanese company, while prowse (1992) finds no significant relationship between ownership concentration and financial performance of japanese firms either keiretsus or non-keiretsus. in contrast, mcconnell and servaes (1990) and thomsen and pedersen (2000) show a positive relation between performance and ownership concentration. mudambi and nicosia (1998) in the uk and lehmann and weigand (2000) in germany indicate a negative linear relationship between ownership concentration and firm performance. they believe that expropriation behaviour of block owners negatively affects firm performance, because block owners try to have benefits on minority shareholders’ costs. one of the outcomes of this behaviour is that minority shareholders reduce their ownership. gedajlovic and shapiro (1998) in us and miguel, pindado and la torre (2004) in spain predict a quadratic relationship between performance and ownership concentration. they assume that at primary levels of ownership concentration, the positive effect of block owner monitoring leads to an increase in firm performance and improve cost of capital. but in high levels of block ownership the expropriation effect (entrenchment effect) negatively affects their performance and consequently causes a decrease in firm value (claessens, 2003). mahrt-smith (2005) concludes that predicting the effect of ownership structure on firm performance will be difficult unless one controls the firm’s capital structure choice. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 401 some other studies document a non-linear relationship between ownership concentration and firm performance. they find a cubic relationship which is an up/down/up relationship between performance and ownership concentration (gugler, 2004; short, 1999). gugler, mueller and yurtoglu (2004) show that with primary levels of block ownership there is a positive relationship between block ownership and firm performance because of block owners’ incentives to monitor managers and their performance. but after a specific level of ownership expropriation, behaviour of block ownership (entrenchment effect) influences their performance and negatively affects firm performance. this happens because their ownership is not up to a level that makes them highly concerned about firm performance and nor is it up to a level where they can have their effect cheaply. in high levels of block ownership there is a positive relationship between block ownership and performance. in this situation they have more incentive to monitor firm performance because their wealth is highly tied with firm performance so they accept the costs of monitoring in order to protect their wealth. gugler, mueller and yurtoglu (2008) document an unclear effect of insider ownership on firm performance. they believe on both positive role of alignment effect and negative role of entrenchment effect. while prior studies document mixed and inconclusive results on the role of ownership structure, firm performance and cost of capital, it is still challenging to know whether or not this pool of research can address the primary question. the primary question in this field is to know whether ownership structure affects the performance of the firms and if the answer is yes, how does ownership structure affect firms. although the characteristics of capital markets and the characteristics of each economy require different strategies and guidelines, an empirical study on this issue can clarify different dimensions and aspects of ownership structure. the financial crisis in 2007 provides a unique situation to check the efficiency of academic and practical guidelines on required ownership structure in firms. if research finds that firms in different economies, which implement different ownership structure guidelines, successfully pass through a financial crisis, then it is possible to conclude that the suggested ownership structures are efficient. new zealand as a commodity-based economy with a unique geographical situation and singapore as a highly international economy can reflect the idea of various effects of ownership structure in crisis situation in different markets. method and data description this study includes two null hypotheses which are reported below: h0: does insider ownership negatively affect cost of capital during global financial crisis h0: does block ownership negatively affect cost of capital during global financial crisis this study employs regression models in order to address the above hypotheses. panel regression model and ordinary least square (ols) methods of estimation are employed in this study. as mentioned in the previous section, some studies report a linear relationship between ownership structure (reddy, 2008), performance and cost of capital while others report a square relationship and yet others report a cubic relationship (gugler, 2008). thus in order to asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 402 track the correct relationship between ownership structure and cost of capital, three potential equations are employed. a. a linear equation to check linear relationship (cost of capital) it = αi + α2i (ownership structure) it + α3ifirm size it + α4i leverage it + α5gdpt b. a square equation to check square relationship (cost of capital) it = αi + α2i (ownership structure) it + α3i (ownership structure) it ^ 2 + α4ifirm size it + α5i leverage it + α6gdpt c. a cube equation to check cubic relationship (cost of capital) it = αi + α2i (ownership structure) it + α3i (ownership structure) it ^2 + α4i (ownership structure) it + α5ifirm size it + α6i leverage it + α7gdpt where ownership structure represents insider ownership or block ownership. firm size, leverage and gdp are employed as control variables. insider ownership considers the percentage of the company owned by company managers. although different definitions exist when estimating block ownership in companies, the most popular method is to calculate the percentage of shares owned by the top five big shareholders. this study also employs the percentage of shares owned by the top five shareholders. these three equations will be used to check the potential relationship between ownership structure (insider ownership and block ownership) and cost of capital. a dummy variable is employed to track the effect of the global financial crisis. these dummy variables will target 2008 individually, and 2009 and 2010 together, to track the role of ownership structure on cost of capital during and after the global financial crisis. different models of calculating cost of capital have been developed in prior studies. among these methods, weighted average cost of capital captures the effect of cost of equity and cost of debt together. weighted average cost of capital (wacc) is obtained from modigliani and miller (1958, 1963) and miles and ezzell (1980) studies. ross, westerfield and jaffe (1996) argue that wacc is the most widely used method of calculating cost of capital in the real world so far. basic definition of wacc, which is the cost of capital coming from both equity and debt, make it one of the fundamental concepts in corporate finance (farber, 2006). wacc equation for a firm which is using common share (equity) and bond (debt) financing is as below: wacc = r = wdrd (1-t) + were where rd represents the market rate on the firm’s outstanding debt as cost of debt and re represents cost of equity which is frequently calculated by capm method. wd is the weights of debt and we is the weights of equity and t is tax. the most challenging part of this equation is the method of estimating cost of equity. the primary method of calculating cost of equity was implemented by sharpe (1964) and lintner (1965). they believe that fluctuation of market price can reflect the behaviour of a company’s price completely. so they document the fluctuation of company price as the side effect of fluctuation of market price. they called asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 403 their model capital asset pricing model (capm). capm was the unique method of estimating cost of equity since fama and french (1992) revealed the result of their study and introduced two other explanatory variables for explaining market price behaviour. their fama-french three factor model, which includes firm size and book-to-market equity of companies, was the popular method of calculating cost of equity while jegadeesh and titman (1993) and fama and french (1993) revealed their comments about the effectiveness of another factor (momentum factor) on fluctuation of companies. their momentum effect was the return of diversified portfolio of winners minus losers. although negative and positive comments exist in employing each method, most recent studies suggest the momentum model is a better model for estimating cost of equity (fama, 2004; tien, 2010). data data from large listed companies on the new zealand stock exchange (nzx) and singapore exchange market (sgx) during 2006 to 2010 are employed in this study. large listed companies in new zealand and singapore are collected through nzx 50 and sti constituent respectively. the thomson one banker database and datastream are employed to extract the data for weighted average cost of capital and firm size in new zealand’s listed companies and singapore’s listed companies during 2006 to 2010. the ownership information of companies consists of insider ownership and block ownership collected from the annual reports of each listed company. some companies are omitted from the sample because of unreported or insufficient data or unreported annual reports. the nature and characteristics of the new zealand market, which make it more unique, cause more elimination. it is obvious that in small markets like new zealand, not all the companies have transactions every day. thus, it is expectable to lose a higher number of companies in new zealand. descriptive statistics of this study are reported in table 1 as below: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 404 table 1. descriptive statistics insider own. (nz) block own. (nz) firm size (nz) leverage (nz) gdp (nz) insider own. (sing.) block own. (sing) firm size (sing.) leverage (sing.) gdp (sing.) mean 8.21 48.68 13.25 2.27 1.02 1.88 71.87 15.80 2.54 6.64 median 1.1 48.26 13.23 0.93 1.3 0.13 75.37 15.78 0.87 8.80 maximum 65.00 89.02 15.99 51.29 2.7 27.8 93.23 17.97 32.20 14.80 minimum 0.00 0.41 8.57 0.12 -2.1 0.00 39.39 12.09 -2.8 -1.00 std. dev. 13.8 20.44 1.26 6.21 1.78 6.2 14.47 1.00 4.11 5.66 skewness 2.21 0.02 -0.48 5.89 -0.75 3.49 -0.52 -0.58 3.67 0.00 kurtosis 8.11 2.44 3.58 38.64 2.24 13.59 2.07 4.59 22.50 1.68 observations 195 195 195 195 195 135 135 135 135 135 as discussed in the previous section, the new zealand market is a relatively small market. the average firm size of new zealand’s large listed firms is smaller than firm size of singapore’s large listed firms. block ownership in new zealand’s large listed companies is 49 per cent while in singapore 72 per cent of firm ownership belongs to the top five shareholders. although block ownership in singapore is significantly higher than new zealand, percentage of shares owned by managers of companies in new zealand is 8.21 per cent which is much higher than 1.88 per cent in singapore. thus, it is expectable to track different roles for ownership structure on cost of capital in new zealand and singapore. high standard deviation and difference between mean and median of some variables show that the distributions of these variables are not normal. along with high standard deviation, skewness of variables, which is reported in descriptive statistics shows that variables have tails on their right or left hand side. high kurtosis distribution, which report in some variables, shows that the distribution of these variables has a sharper peak and longer fat tails. dealing with unbalanced data requires some consideration. exclusion of outliers in case of presence of fat tails may lead to depriving the estimations of some effective variables. in order to prevent excluding important variables in fat tails the grubbs test is implemented in this study. the difference between true outliers and outliers in fat tails that contain important asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 405 information is detectable through the grubbs test. implementation of this test reveals two real outliers in insider ownership variables. these variables are corrected by reconsidering the databases. thus, presence of high standard deviation beside skewness and kurtosis distribution of data in this study does not lead to exclusion of data because the grubbs test reveals the importance of data in fat tails. endogeneity, heteroskedasticity and correlation of variables have been checked and a weighted coefficient covariance method is employed to track all three. this happens in insider ownership of the singapore market. empirical results empirical results of this study document a cubic relationship between block ownership and cost of capital in new zealand, whereas the relationship between block ownership and cost of capital in singapore is squared. the cube relationship in new zealand is like a down/up/down relationship, the squared relationship in singapore is like up/down relationship. in new zealand, an increase in block ownership up to 18.52 per cent causes cost of capital to decline, while increasing block ownership between 18.52 per cent and 60.86 per cent causes cost of capital to increase. however, increasing block ownership over 60.86 per cent leads to a decline in the cost of capital again. this means that at low levels of block ownership leads to interest alignment between the shareholders and the management. however, when block ownership increases between 18.52% and 60.86%, it leads to an entrenchment effect causing cost of capital to increase. at higher levels of block ownership, the interest alignment effect causes cost of capital to decline again. the relationship between block ownership and cost of capital in singapore is an up/down relationship where an increase in block ownership up to 67.43 per cent increases the cost of capital and block ownership over 67.43 per cent causes cost of capital to decline. this means that block ownership up to 67.43% has a negative effect on cost of capital in singapore because of the entrenchment and expropriation behaviour. however, the block ownership over 67.43% leads to an interest alignment causing cost of capital to decline. however, empirical results provide a different picture when we consider year-dummy variables for 2008 and for 2009 -2010. the results for the year-dummy for 2008 show a negative relationship between block ownership and cost of capital and the year-dummies for 2009 and 2010 document a positive relationship in new zealand. in singapore the year-dummy variable for 2008 show a statistically significantly positive relationship while the year dummy variable for after-2008 show a positive but statistically insignificant relationship. the results show that, block owners negatively affected cost of capital in new zealand during 2008 and in the years after 2008, the role of block ownership on cost of capital is positive because of expropriation behaviour. our results show that block ownership in the singapore market positively affects cost of capital during and after a financial crisis while this effect is statistically significant in 2008 but not after 2008. this indicates that high level of block ownership has been ineffective in singapore after the financial crisis period. however, during financial crisis period a high asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 406 block ownership has had a negative effect cost of capital. the average level of block ownership in new zealand and singapore are 49% and 72% respectively. our empirical results documents a cube relationship between insider ownership and cost of capital in new zealand and a linear relationship between insider ownership and cost of capital in singapore. the cube relationship in new zealand is like an up/down/up relationship while in singapore, the linear relationship shows a negative relationship. in new zealand, an increase in insider ownership up to 13.16 per cent causes an increase in cost of capital while increasing the insider ownership between 13.16 per cent and 50.63 per cent leads to an increase in the cost of capital. however, increasing insider ownership in new zealand over 50.63 per cent leads to an increase in the cost of capital again. our results indicate that at low level of insider ownership, leads to value-destroying decisions. insider ownership between 13.16% and 50.63%, negatively affects cost of capital because of the interest alignment of the principals and the agents. insider ownership over 50.63% positively affects the cost of capital because of the entrenchment effect and the expropriation behaviour of insiders. the relationship between insider ownership and cost of capital in singapore is negative which indicates that an increase in insider ownership decreases the cost of capital. this means that higher levels of insider ownership tend to better align the interests of insiders and firm. as the average level of insider ownership in singapore is 1.88%, which is not relatively high, a higher level of insider ownership makes the insiders more concerned about maximising firm value. the empirical results relating to the year-dummy variables for 2008 and the period 2009 2010 reveal different results for the insider ownership. while the year dummy for 2008 show a negative relationship between insider ownership and cost of capital, the year dummies for 2009 and 2010 document a positive relationship in both, new zealand and singapore. insider ownership positively affects cost of capital in singapore but this effect is not statistically significant. the average level of insider ownership in new zealand is 8.21our results show that there is a positive effect of insider ownership on cost of capital in years after 2008 but have a negative effect cost of capital e during 2008. this indicates that the current level of insider ownership has a positive effect on companies in new zealand. in singapore, our results show that insider ownership has a positive effect on cost of capital of companies during and after a financial crisis. this indicates that the insider ownership structure in singapore is not at optimal and has a negative effect on the cost of capital in singapore. estimations of this study are reported in appendix a and b. conclusion this paper investigates the effect of ownership structure on cost of capital during and after the 2007 global financial crisis in new zealand and singapore’s large listed companies. although the results of prior studies about the effect of ownership structure on firms were mixed and inconclusive, this study finds interesting results regarding the ownership-performance relationship. despite the ordinary effect of ownership structure on cost of capital (which depends on the pattern of their relationship between ownership and cost asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 407 of capital and the position of a firm’s ownership), the role of ownership structure on cost of capital affects the cost of capital differently during a crisis and after the crisis. our results show that block ownership in new zealand has a cubic relationship with cost of capital. we also report that the block ownership in new zealand has had a negative effect on cost of capital during financial crisis which reflects on the effectiveness of block ownership in monitoring managerial decisions during the financial crisis period. however, the effect of block ownership of cost of capital becomes ineffective after the financial crisis period. however, block ownership in singapore has a positive effect on cost of capital during and after a financial crisis, thus indicates that block owners in singapore were not interested in monitoring managerial decisions in the companies they own. the empirical results for insider ownership in new zealand are very for the block ownership. there is cubic relationship between insider ownership and cost of capital in new zealand. our results show that during a financial crisis, insider ownership has had a negative effect on the cost of capital. however, our results show that the insider ownership in singapore has had a negative relationship with cost of capital. our results indicate that insider ownership level in singapore is not at an optimal level. in summary, our results indicate that of the current ownership structure has helped companies in new zealand assists protection from the effect of the global financial crisis.. the level of insider ownership and relatively high level of block ownership in singapore reflects the view that ownership structure is singapore is not at an optimal level. references al farooque, o., zijl, t. v., dunstan, k., karim, akm. 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(2006). how do family ownership, control and management affect firm value? journal of financial economics, 80, 385-417. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 411 appendix a. estimating the effect of ownership structure on cost of capital (during and after global financial crisis) in new zealand block ownership and cost of capital in new zealand in 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 195 variable coefficient std. error t-statistic prob. c 8.271672 0.604399 13.68578 0.0000 large -8.650723 3.597196 -2.404852 0.0172 large^2 30.15846 10.41633 2.895307 0.0042 large^3 -25.26902 8.050133 -3.138956 0.0020 ln(size) -0.067641 0.060706 -1.114225 0.2666 leverage -0.203825 0.023540 -8.658570 0.0000 gdp -0.006295 0.028042 -0.224500 0.8226 dummy(2008) -0.518033 0.051671 -10.02569 0.0000 r-squared 0.282452 mean dependent var 6.540259 adjusted r-squared 0.255592 s.d. dependent var 2.526082 s.e. of regression 2.179480 akaike info criterion 4.436210 sum squared resid 888.2747 schwarz criterion 4.570487 log likelihood -424.5305 hannan-quinn criter. 4.490577 f-statistic 10.51570 durbin-watson stat 0.604093 prob(f-statistic) 0.000000 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 412 block ownership and cost of capital in new zealand after 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 195 variable coefficient std. error t-statistic prob. c 7.928905 0.723338 10.96154 0.0000 large -8.842967 3.622949 -2.440820 0.0156 large^2 30.73964 10.48238 2.932507 0.0038 large^3 -25.64114 8.109621 -3.161817 0.0018 ln(size) -0.086868 0.067592 -1.285189 0.2003 leverage -0.203664 0.023504 -8.665246 0.0000 gdp 0.166648 0.045054 3.698848 0.0003 dummy(2009,2010) 0.785978 0.181020 4.341929 0.0000 r-squared 0.282723 mean dependent var 6.540259 adjusted r-squared 0.255873 s.d. dependent var 2.526082 s.e. of regression 2.179068 akaike info criterion 4.435832 sum squared resid 887.9394 schwarz criterion 4.570109 log likelihood -424.4936 hannan-quinn criter. 4.490199 f-statistic 10.52976 durbin-watson stat 0.603153 prob(f-statistic) 0.000000 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 413 insider ownership and cost of capital in new zealand in 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 195 variable coefficient std. error t-statistic prob. c 5.355533 0.954685 5.609738 0.0000 insider 22.52175 4.500250 5.004556 0.0000 insider^2 -107.4656 19.84272 -5.415872 0.0000 insider^3 112.3925 21.78575 5.158990 0.0000 ln(size) 0.106050 0.064117 1.654008 0.0998 leverage -0.191965 0.021828 -8.794347 0.0000 gdp 0.010362 0.022427 0.462038 0.6446 dummy(2008) -0.602786 0.038690 -15.57982 0.0000 r-squared 0.281860 mean dependent var 6.540259 adjusted r-squared 0.254978 s.d. dependent var 2.526082 s.e. of regression 2.180379 akaike info criterion 4.437035 sum squared resid 889.0078 schwarz criterion 4.571312 log likelihood -424.6109 hannan-quinn criter. 4.491402 f-statistic 10.48500 durbin-watson stat 0.625110 prob(f-statistic) 0.000000 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 414 insider ownership and cost of capital in new zealand after 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 195 variable coefficient std. error t-statistic prob. c 5.184484 1.033446 5.016695 0.0000 insider 21.05293 4.693327 4.485716 0.0000 insider^2 -100.8021 20.61161 -4.890551 0.0000 insider^3 105.3194 22.57381 4.665556 0.0000 ln(size) 0.078334 0.070363 1.113289 0.2670 leverage -0.192830 0.021996 -8.766701 0.0000 gdp 0.166066 0.070954 2.340460 0.0203 dummy(2009,2010) 0.720070 0.286800 2.510706 0.0129 r-squared 0.278719 mean dependent var 6.540259 adjusted r-squared 0.251719 s.d. dependent var 2.526082 s.e. of regression 2.185143 akaike info criterion 4.441400 sum squared resid 892.8969 schwarz criterion 4.575677 log likelihood -425.0365 hannan-quinn criter. 4.495767 f-statistic 10.32297 durbin-watson stat 0.631963 prob(f-statistic) 0.000000 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 415 appendix b. estimating the effect of ownership structure on cost of capital (during and after global financial crisis) in singapore block ownership and cost of capital in singapore in 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 135 variable coefficient std. error t-statistic prob. c -17.82472 10.79626 -1.651009 0.1012 large 53.24728 9.692092 5.493889 0.0000 large^2 -39.50699 8.265752 -4.779600 0.0000 ln(size) 0.379981 0.537943 0.706359 0.4812 leverage -0.347037 0.073370 -4.729977 0.0000 gdp 0.014721 0.031444 0.468163 0.6405 dummy(2008) 0.262951 0.147332 1.784751 0.0767 r-squared 0.256644 mean dependent var 4.493068 adjusted r-squared 0.221799 s.d. dependent var 3.146991 s.e. of regression 2.776140 akaike info criterion 4.930459 sum squared resid 986.4902 schwarz criterion 5.081103 log likelihood -325.8060 hannan-quinn criter. 4.991677 f-statistic 7.365336 durbin-watson stat 1.171419 prob(f-statistic) 0.000001 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 416 block ownership and cost of capital in singapore after 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 135 variable coefficient std. error t-statistic prob. c -18.09396 10.45832 -1.730102 0.0860 large 53.08459 9.539455 5.564741 0.0000 large^2 -39.33503 8.116761 -4.846149 0.0000 ln(size) 0.400300 0.511353 0.782824 0.4352 leverage -0.346919 0.072503 -4.784910 0.0000 gdp 0.005620 0.026438 0.212562 0.8320 dummy(2009,2010) 0.213434 0.351499 0.607212 0.5448 r-squared 0.256896 mean dependent var 4.493068 adjusted r-squared 0.222063 s.d. dependent var 3.146991 s.e. of regression 2.775669 akaike info criterion 4.930120 sum squared resid 986.1556 schwarz criterion 5.080764 log likelihood -325.7831 hannan-quinn criter. 4.991338 f-statistic 7.375074 durbin-watson stat 1.166240 prob(f-statistic) 0.000001 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 417 insider ownership and cost of capital in singapore in 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 135 cross-section weights (pcse) standard errors & covariance (d.f. corrected) variable coefficient std. error t-statistic prob. c -3.375147 7.243710 -0.465942 0.6420 insider -5.483263 3.026795 -1.811574 0.0724 ln(size) 0.552969 0.468364 1.180641 0.2399 leverage -0.319168 0.057806 -5.521405 0.0000 gdp 0.000975 0.051646 0.018881 0.9850 dummy(2008) 0.175073 0.712934 0.245568 0.8064 r-squared 0.212498 mean dependent var 4.493068 adjusted r-squared 0.181975 s.d. dependent var 3.146991 s.e. of regression 2.846288 akaike info criterion 4.973335 sum squared resid 1045.075 schwarz criterion 5.102458 log likelihood -329.7001 hannan-quinn criter. 5.025807 f-statistic 6.961822 durbin-watson stat 1.179121 prob(f-statistic) 0.000009 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 418 insider ownership and cost of capital in singapore after 2008 dependent variable: wacc method: pooled least squares total pool (balanced) observations: 135 cross-section weights (pcse) standard errors & covariance (d.f. corrected) variable coefficient std. error t-statistic prob. c -3.585075 7.064813 -0.507455 0.6127 insider -5.544249 2.865991 -1.934496 0.0552 ln(size) 0.564831 0.448205 1.260206 0.2099 leverage -0.319479 0.056642 -5.640284 0.0000 gdp -0.005433 0.044486 -0.122130 0.9030 dummy(2009,2010) 0.254901 0.487671 0.522690 0.6021 r-squared 0.213703 mean dependent var 4.493068 adjusted r-squared 0.183226 s.d. dependent var 3.146991 s.e. of regression 2.844110 akaike info criterion 4.971804 sum squared resid 1043.476 schwarz criterion 5.100927 log likelihood -329.5968 hannan-quinn criter. 5.024276 f-statistic 7.012025 durbin-watson stat 1.177156 prob(f-statistic) 0.000008 microsoft word 8175-29553-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 78 retail investors’ responsibilities in stock market imperfection in bangladesh: an empirical study protap kumar ghosh assistant professor, business administration discipline khulna university, khulna-9208, bangladesh e-mail: pkghosh1982@gmail.com sutap kumar ghosh assistant professor, finance and banking department islamic university, khustia, bangladesh e-mail: ansutap@gmail.com received: august 19, 2015 accepted: sep. 29, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8175 url: http://dx.doi.org/10.5296/ajfa.v7i2.8175 abstract because of frequent price instability, stock market in bangladesh represents itself an imperfect one over times. the retail investors claim that these frequent price fluctuation in the market is due to price manipulation, presence of syndicate and improper control by regulatory bodies and so on. but this study has found that a great portion of retail investors are very micro investors and reluctant in using relevant information in stock trading and furthermore ridiculously influenced by others investors and brokerage house personnel. most of them consider only trend of past prices and market index. majority of our respondents never considered net asset per share although it might give an idea about market value per share. so, the whole responsibilities of this price volatility and market imperfection can’t be shifted to third parties solely; retail investor themselves are responsible to some extent due to their irrational behavior and high expectation from stock trading. stock market perfection in bangladesh is quite impossible without enhancing awareness among retail investors and ensuring their rational behavior in stock trading. keywords: stock market, market imperfection, retail investors, factor analysis, investors responsibilities asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 79 1. introduction there are two stock exchanges in bangladesh; one is dhaka stock exchange and another one is chittagong stock exchange. since their establishment, during the last two decades these two markets experienced two big crashes in 1996 and 2011. about 35million people lost their entire investment in 2011. even after these two big crashes, bangladesh stock market cannot represent itself stable over times. the market index has been fluctuating frequently without any foreseeable change in relevant factors. the retail investors have been claiming that this unstable situation is a product of price manipulation, insider trading; lack of adequate control, lack of suitable policies and intervention by regulatory bodies, presence of syndicate so on. several research studies were conducted by (chowdhury & abdullah, 2011; haque & faruquee. , 2013 ; ghosh, p. k., bose, t. k. & shahriar, m, 2012) and supported the claim of the retail investors. but retail investors cannot blame that this instability in the stock market is just only for the lack of proper polices and intervention by the regulatory bodies in bangladesh. retail investors should not rebuff their responsibilities in market imperfection because whenever making investment decision, by considering relevant factors and using proper valuation technique to some extent they can reduce their investment risk as well as price manipulation of the stock market and can play an active role in the process of building perfect capital market. the objectives of this study are: 1. to represent the important variables that are considered by the retail investors in stock trading. 2. to develop the core factors that influence the retail investors in making investment decision and to show its relative importance. 3. to represent the overall usages of these variables to denote their responsibilities in market imperfection and lastly to draw their attention in order to making them rational in stock trading. 2. literature review wide fluctuation in stock prices has become a common phenomenon in dhaka stock exchange (dse); even it was also seen during last few couple of years. weak market regulation, limited number of good ipos, lack of accounting knowledge of the investor and presence of syndicate (chowdhury & abdullah , 2011), corruption in regulatory organization, margin loan, direct listing, insider trading, bookbuilding method, unskilled investors and intervention of bangladesh bank, faulty listing method, ipo overpricing, small number of new listing, revaluation of asset before company’s listing, high premium on issuance of right share, stock split, stock price manipulation, investors’ high expectation and irrational behavior (haque, & faruquee , 2013) cause undue increase in market index and ultimately result in great fall in stock market. ghosh, bose and shahriar (2012) also concluded that price manipulation, insider trading, faulty financial statement, improper dividend policy and lack of appropriate policy by central bank hampered smooth operation in bangladesh capital market. stock markets are expected to accelerate economic growth by providing a boost to domestic savings and increasing the quantity and the quality of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 80 investment (yartey, 2008). bangladesh bank (central bank of bangladesh) and securities and exchange commission took some initiatives during last few years to stabilize the stock market in bangladesh but still now the market is unstable. different scholars in different countries tried to identify the determinants of stock prices. most of them tried to recognize a link among accounting information as well as macroeconomic elements of the country and stock price movement. in a study by kumar & hundal (1986) on asian share market found a positive link of earning per share, dividend per share, net asset per share and leverage ratios on stock price. a positive link between earning per share and market value of stock was also found by malhotra (1987); baskin, (1989) ; tuli, nishi & mittal, r.k. ( 2001). in australia, book value was more significant than earnings of the organization in equity valuation (ohlson, 1995). in a study by bayezid & tanbir (2010) found that announcement of dividend has a significant impact on stock price movement. piotroski. & roulstone (2004) concluded that market prices of the stock depends on demand-supply forces of a particular security in the stock market . several researchers also concluded that accounting reporting influenced the market value of corporate stock (svensson & larsson, 2009; al-shubiri, 2010; sharma, 2011; andriantomo & yudianti , 2013 ; bhatt & sumangula, 2012 ; halonen, pavlovic and persson , 2013). besides accounting information, some macro and micro economic factors also affect market value of shares (al-shubiri , 2010). gross domestic products, interest rates, current account, and employment have an impact on stock prices movement (kurihara, 2006). exchange rate, money supply, consumer prices and industrial production have strong relationship with stock prices (ibrahim, 1999; dimitrios, 2003). all the above review of past literature tried to link between secondary data and stock price movement. the context and demographic features of the retail investors in bangladesh are different from that of developed and other developing countries. so, this study has been designed based on primary data incorporating the responses of the retail investors to identify the factors that are considered by them and the level of usages of those factors so that their responsibilities in capital market imperfection can be detected and eventually they can be aware in stock trading. 3. methodology this section is divided into four parts; variables selection, questionnaire development, sampling & data collection and data analysis. 3.1 variables selection the initial base of our variable selection was intensive review of past relevant literatures. firstly, we tried to find out the determinants of stock prices though review of past literatures and then went for interviewing retail investors at four different brokerage houses in khulna to have a tentative idea about the variables they consider while making investment decision. from this pilot survey and review of past literatures, we finally developed 5 demographic variables to provide an idea about the demographic nature of the respondents and 26 ordinal asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 81 variables to conduct our statistical analysis to reach our research findings. 3.2 questionnaire development this study was mainly a descriptive one and questions were close-ended in nature. in the first part of the questionnaire, 5 variables were designed in order to obtaining demographic information of the respondents so that it can represent tentative demographic features of bangladeshi retail investors. in the second part of the questionnaire, 26 variables were designed to collect the opinion of the retail investors on how they used these selected variables in their decision making. a 4 point scale was used for the last 26 variables, where 1 denoted “never used”, 2 denoted “rarely used”, 3 denoted “frequently used” and finally 4 denoted “always used”. 3.3 sampling & data collection this study was mainly based on primary data. the population of this study was all the retail investors in khulna and dhaka cities. to collect our required data, 180 respondents were selected randomly from different brokerage houses in khulna and dhaka. the questionnaires were supplied to the respondents accordingly and the reason behind using random sampling was to ensure our research findings bias free. after collecting and checking the completeness of these filled in questionnaires, 150 responses were finally selected for analysis. 3.4 data analysis before using the statistical tools, we tested the reliability of our questionnaire and the value of cronbach's alpha (α) was 0.894 that represented high reliability of the questionnaire. to find the core factors that influenced the retail investors’ buying decisions, factor analysis was done and the value of kaiser-meyer-olkin test was 0.825 which indicated sampling adequacy (adequacy of variables) to run factor analysis. bartlett's test of sphericity represents that the value of chi-square (χ2) is 2.083 as well as the associated p-value is 0.000 that indicate multivariate normality of set of distributions that means the data set will not produce an identity matrix. the variables having more than 0.500 loading in rotated component matrix were included into a particular factor. after conducting factor analysis, descriptive statistical analysis by frequency distribution were done to represent level of usages of each variable while making investment decision by the retail investors in order to showing their contribution in capital market imperfection. 4. analysis and findings: this section was divided into four parts. first part involved demographic analysis of the respondent. 2nd part involved relative importance of the selected variables using mean score; third part held factor analysis to identify key factors that influence investors’ buying decision and its relative importance in decision making. the final part of this section included descriptive analysis of the variable in order to showing the level of usages of the variables aggregated under different factors. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 82 4.1 demographic profile of the respondents demographic findings of our respondents represented that most of our retail investors were male and their age limit were between 25 to 40 years. we found that education level of 32% of our respondents was hsc & below and it represented that having this education level, those retail investors might not have the sophisticated stock valuation skill. mainly service holders and businessmen were the dominant investors in bangladeshi stock market. if we analyze the amount of investment of the respondents, we saw that most of the respondents were micro investors having investment below bdt 500,000 (where $1 = bdt 80 approximately). as respondents were selected randomly, it might represent an approximate scenario of our retail investors. table 1. demographic features of the respondent demographic features classes frequency percentage gender male 133 88.7 female 17 11.3 age lowest to 25 18 12.0 25 to 40 99 66.0 40 & above 33 22.0 educational level hsc & below 48 32.0 graduate 44 29.3 post graduate 58 38.7 profession service holder 54 36.0 business 74 49.3 others 22 14.7 investment (in bdt) below 500,000 96 64.0 500,000 to 1,000,000 33 22.0 1,000,000 to 1,500,000 7 4.7 above 1,500,000 14 9.3 4.2 relative importance of the selected variables the table two holds relative importance of the variables to the respondents in decision making process. we saw that out of 26 variables only 5 variables crossed the frequently used level having mean score more than 3.00. the variables “fluctuation in market index”, “past prices of the stock”, “reputation of the company”, “dividend declaration” and “earning per share” were seen most frequently used variables in stock trading. then the next 8 variables cross rarely used level in our four point scale. out of them, the mean score of the variable “political stability” was very much close to the frequently used level that indicated it relative importance in stock trading. other two variables “release of new products or services” and “dividend payout ratio” were seen important to the respondent as mode value of these two variables was 4. the rest of the variables remained below rarely used level in four point scale .it was also seen that from one to eight ranked variables had mode value 4 that meant asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 83 major group of the respondents always used these variables. the rest of the variables, except “recommendation from other investors” whose mode value was two, had mode value one that meant greater part of the respondents didn’t use those variables. table 2. ranking of the variables based on mean score rank name of the variables mean std. deviation mode 1 fluctuations in market index 3.56 .790 4 2 past price of the stock 3.56 .790 4 3 reputation of the company 3.49 .766 4 4 dividend declaration 3.41 .796 4 5 earnings per share 3.31 1.068 4 6 political stability 2.83 1.096 4 7 release of new products or services 2.67 1.150 4 8 dividend payout ratio 2.62 1.197 4 9 changes in govt. policies 2.49 1.273 1 10 net asset per share 2.37 1.383 1 11 debt-equity ratio 2.10 1.151 1 12 return on asset ratio 2.03 1.184 1 13 recommendation from other investors 2.01 .867 2 14 return on equity ratio 1.97 1.144 1 15 sec intervention 1.91 1.061 1 16 recommendations from brokerage house 1.91 .907 1 17 gdp 1.81 1.109 1 18 insider information 1.73 .974 1 19 global financial aspect 1.66 .858 1 20 margin loan facilities 1.66 .954 1 21 free cash flow 1.65 1.017 1 22 expert opinion 1.63 .886 1 23 rate of interest 1.62 .981 1 24 cash reinvestment ratio 1.53 1.008 1 25 rate of inflation 1.50 .880 1 26 currency exchange rate fluctuation 1.48 .888 1 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 84 4.3 factors affecting investors’ trading decision factor analysis was done to construct the core factors that influenced the retail investors in stock trading and eventually seven factors had been extracted. only the variable “sec intervention” had been excluded from seven factors generated in table three. from appendix-2, the name of factors and the loading of respective variables under those factors are summarized in table three. table 3. loading of the variables under seven components through factor analysis factor s name of the variables loading name of the factors 1 return on asset ratio .838 overall financial position return on equity ratio .834 free cash flow .759 cash reinvestment ratio .758 debt-equity ratio .725 net asset per share .679 dividend payout ratio .601 2 rate of inflation .852 macroeconomic elements currency exchange rate fluctuation .739 gdp .696 global financial aspect .673 changes in govt. policies .588 3 past price of the stock .844 stock performance & company reputation reputation of the company .757 dividend declaration .720 fluctuations in market index .649 release of new products or services .582 4 expert opinion .716 political environment & private information political stability .681 insider information .545 5 recommendations from brokerage house .888 others’ recommendation recommendation from other investors .821 6 rate of interest .806 margin loan facilitiesmargin loan facilities .789 7 earnings per share .710 earnings per share although “earning per share” is a part of overall financial performance, it was separated as individual factor than other financial performance indicators of the company. if we see the grand mean of each factor in table-4, we find that the factors “stock performance & company asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 85 reputation” in the market was given most priority in stock trading having highest grand mean score 3.34 and the “ earning per share” was given second priority having mean value 3.31. in the same way other factors “political environment & private information”, “overall financial position”, “others’ recommendation”, “macroeconomic elements” and lastly “margin loan facilities” got third , fourth, fifth , sixth and seventh rank respectively based on its grand mean score but all the grand means were very much close to rarely used or below rarely used level. it should be noted here that although seven factors are identified here, not all factors are used by the respondents evenly. 4.4 level of usages of the variables by the investors table four holds the grand means of all the factors along with detail frequency distribution of usages of the variables aggregated under each factor. only two factors “stock performance & company reputation” and “earnings per share” passed frequently used level in four point scales. but no one variable under these two factors was seen always usages by 100% respondents while making investment decision. price of a particular stock should be based on financial position of the relevant company and so many researchers tried to link between financial performance indicators and stock price movement. but more unexpectedly the grand mean of the factor “overall financial position” was only 2.04 that was very close to rarely used level and the variable “net asset per share” was seen always usages by only 37.3% respondents . the review of past literature has proved that macroeconomic factors and stock price movement are closely linked but the variables aggregated under this factor disclosed that investors were not very much concern for macroeconomic elements in stock trading. a great number of investors never considered the variables under this factor in investment decision. it was identified that the rest of the variables, aggregated under the remaining factors, were not widely used by the retail investors in stock trading as well. table 4. descriptive statistics of the factors constructed factor name of the variables never used rarely used frequently used always used mean s.d. 1 dividend payout ratio 27.3% 15.3% 25.3% 32.1% 2.62 1.197 net asset per share 46% 8.7% 8% 37.3% 2.37 1.383 debt-equity ratio 49.1% 19.3% 19.3% 17.3% 2.10 1.151 return on asset ratio 49.3% 16.7% 15.3% 18.7% 2.03 1.184 return on equity ratio 50% 20% 13.3% 16.7% 1.97 1.144 free cash flow 64% 17.3% 8% 10.7% 1.65 1.017 cash reinvestment ratio 74.7% 7.3% 8% 10% 1.53 1.008 grand mean of the factor “overall financial position” 2.04 0.932 changes in govt. policies 36.7% 9.3% 22.7% 31.3% 2.49 1.273 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 86 2 gdp 60% 12% 15.3% 12.7% 1.81 1.109 global financial aspect 55.3% 27.3% 13.3% 4.1% 1.66 0.858 rate of inflation 70% 16% 8% 6% 1.50 0.880 currency exchange rate fluctuation 72% 14.6% 6.7% 6.7% 1.48 0.888 grand mean of the factor “macroeconomic elements” 1.79 .782 3 past price of the stock 4% 6.6% 18.7% 70.7% 3.56 0.790 fluctuations in market index 4.7% 4.6% 20.7% 70% 3.56 0.790 reputation of the company 3.3% 6.7% 27.3% 62.7% 3.49 0.766 dividend declaration 3.3% 9.4% 30% 57.3% 3.41 0.796 release of new products or services 20% 27.3% 18% 34.7% 2.67 1.150 grand mean of the factor “stock performance & company reputation” 3.34 0.645 4 political stability 15.3% 23.1% 24.3% 37.3% 2.83 1.096 insider information 55.3% 24.7% 11.3% 8.7% 1.73 0.974 expert opinion 59.3% 24% 11.3% 5.3% 1.63 0.886 grand mean of the factor “political environment & private information” 2.06 0.727 5 recommendation from other investors 33.3% 35.3% 28% 3.4% 2.01 0.867 recommendations from brokerage house 39.3% 37.3% 16.7% 6.7% 1.91 0.907 grand mean of the factor “others’ recommendation” 1.96 0.789 6 margin loan facilities 60% 22% 10% 8% 1.66 0.954 rate of interest 64.7% 18% 8% 9.3% 1.62 0.981 grand mean of the factor “margin loan facilities” 1.64 0.871 7 earnings per share 13.3 % 6.1% 17.3% 63.3% 3.31 1.068 5. conclusion and implication: bangladesh stock market represents itself as an imperfect one because of wide fluctuation in volume of stock trading and market index. it has been claimed that this imperfection in the stock market is an artifact of price manipulation, insider trading, presence of syndicate, lack asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 87 of adequate control, lack of suitable policies and intervention by regulatory bodies. it was found in this study that a great percentage of the total respondents were more or less influenced by the other investors and brokerage house personnel. moreover, they didn’t consider financial performance of the relevant companies in stock trading. they mostly considered the past prices of the stock and changes in market index but didn’t try to identify the causes of these changes analyzing financial performance of the listed organizations. furthermore, 32% of the respondents were under hsc or below education level and eventually most of them should not have sophisticated stock valuation knowledge but only 5.30% of total respondents always used expert opinion in stock trading. “net asset per share” which is known as book value per share and to some extent gives an idea about the value of a particular stock but inversely 46% of total respondents never used this variable in decision making. macroeconomic environment of a country affect stock price movement in a country but unfortunately majority of our investors disinclined in considering this factor while making investment decision. moreover, a certain portion of the retail investors always try to collect information in advance from insider personals of the relevant company. so, all the responsibilities of price instability cannot be shifted to third parties; retail investors themselves are responsible to some extent because of their irrational behavior in stock trading. although some of the factors are beyond the control of the retail investors, to some extent they can reduce this price instability by enhancing their awareness and share valuation skills and behaving rationally in the stock trading. references al-shubiri, f. 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(1995). earnings, book values and dividends in equity valuation. contemporary accounting research, 11(2), 661-687. http://dx.doi.org/10.1111/j.1911-3846.1995.tb00461.x piotroski, j. d., & roulstone, d.t. (2004). the influence of analysts, institutional investors, and insiders on the incorporation of market, industry and firm-specific information into stock prices. accounting review, 79(4), 1119-1151. http://dx.doi.org/10.2308/accr.2004.79.4.1119 sharma, s. (2011). determinants of equity share prices in india. journal of arts science and commerce, 2(4), 51-60. svensson, e. & larsson, a. (2009). value relevance of accounting informationa swedish perspective. gothenburg: school of economics and commercial law at gothenburg university. tuli, nishi, & mittal, r.k. (2001). determinants of price-earnings ratios. finance india, 15(4), 1235-1250. yartey, c. a. (2008). the determinants of stock market development in emerging economies: is south africa different? working paper, international monetary fund. http://dx.doi.org/10.5089/9781451868944.001 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 89 appendixes appendix 1. test of sampling adequacy kmo and bartlett's test kaiser-meyer-olkin measure of sampling adequacy. .825 bartlett's test of sphericity approx. chi-square 2.083e3 df 325 sig. .000 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 90 appendix 2. rotated component matrix of factor analysis rotated component matrix a component 1 2 3 4 5 6 7 earnings per share .320 .112 .250 .049 -.048 -.058 .710 return on equity ratio .834 .213 .123 .038 -.046 .014 .104 return on asset ratio .838 .144 .155 .153 -.081 .038 .093 net asset per share .679 .076 .115 .239 -.096 .128 .347 debt-equity ratio .725 .097 .092 .195 -.169 .151 .275 dividend payout ratio .601 .096 .312 .200 -.056 .131 .383 free cash flow .759 .143 .202 -.020 .079 .245 -.133 cash reinvestment ratio .758 .258 .219 .011 .115 .039 -.221 reputation of the company .132 .018 .757 -.050 .034 .015 -.002 dividend declaration .224 .090 .720 .086 -.067 .080 .231 past price of the stock .077 .022 .844 -.070 -.082 .071 .217 release of new products or services .341 .057 .582 .093 .066 .172 -.194 fluctuations in market index .137 .105 .649 .227 -.258 -.078 -.032 sec intervention .340 .383 .236 .381 .006 .075 -.378 rate of inflation .176 .852 .015 -.005 .002 .008 .067 gdp .366 .696 .028 -.035 .003 .196 .253 currency exchange rate fluctuation .173 .739 -.069 .040 -.033 .292 -.103 changes in govt. policies .224 .588 .153 .332 -.131 .288 .109 margin loan facilities .133 .195 .129 .009 .057 .789 .014 rate of interest .175 .359 .057 .151 -.042 .806 -.065 global financial aspect .005 .673 .216 .259 -.118 .049 -.054 expert opinion .203 .189 -.052 .716 .369 .007 .054 recommendation from other investors -.062 -.125 -.114 .067 .821 -.011 -.063 recommendations from brokerage house -.050 -.022 -.044 .026 .888 .041 -.007 political stability .070 .316 .326 .681 -.190 .054 -.014 insider information .306 -.219 -.187 .545 .113 .403 .125 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 91 component 1 2 3 4 5 6 7 earnings per share .320 .112 .250 .049 -.048 -.058 .710 return on equity ratio .834 .213 .123 .038 -.046 .014 .104 return on asset ratio .838 .144 .155 .153 -.081 .038 .093 net asset per share .679 .076 .115 .239 -.096 .128 .347 debt-equity ratio .725 .097 .092 .195 -.169 .151 .275 dividend payout ratio .601 .096 .312 .200 -.056 .131 .383 free cash flow .759 .143 .202 -.020 .079 .245 -.133 cash reinvestment ratio .758 .258 .219 .011 .115 .039 -.221 reputation of the company .132 .018 .757 -.050 .034 .015 -.002 dividend declaration .224 .090 .720 .086 -.067 .080 .231 past price of the stock .077 .022 .844 -.070 -.082 .071 .217 release of new products or services .341 .057 .582 .093 .066 .172 -.194 fluctuations in market index .137 .105 .649 .227 -.258 -.078 -.032 sec intervention .340 .383 .236 .381 .006 .075 -.378 rate of inflation .176 .852 .015 -.005 .002 .008 .067 gdp .366 .696 .028 -.035 .003 .196 .253 currency exchange rate fluctuation .173 .739 -.069 .040 -.033 .292 -.103 changes in govt. policies .224 .588 .153 .332 -.131 .288 .109 margin loan facilities .133 .195 .129 .009 .057 .789 .014 rate of interest .175 .359 .057 .151 -.042 .806 -.065 global financial aspect .005 .673 .216 .259 -.118 .049 -.054 expert opinion .203 .189 -.052 .716 .369 .007 .054 recommendation from other investors -.062 -.125 -.114 .067 .821 -.011 -.063 recommendations from brokerage house -.050 -.022 -.044 .026 .888 .041 -.007 political stability .070 .316 .326 .681 -.190 .054 -.014 insider information .306 -.219 -.187 .545 .113 .403 .125 extraction method: principal component analysis. rotation method: varimax with kaiser normalization. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 92 component 1 2 3 4 5 6 7 earnings per share .320 .112 .250 .049 -.048 -.058 .710 return on equity ratio .834 .213 .123 .038 -.046 .014 .104 return on asset ratio .838 .144 .155 .153 -.081 .038 .093 net asset per share .679 .076 .115 .239 -.096 .128 .347 debt-equity ratio .725 .097 .092 .195 -.169 .151 .275 dividend payout ratio .601 .096 .312 .200 -.056 .131 .383 free cash flow .759 .143 .202 -.020 .079 .245 -.133 cash reinvestment ratio .758 .258 .219 .011 .115 .039 -.221 reputation of the company .132 .018 .757 -.050 .034 .015 -.002 dividend declaration .224 .090 .720 .086 -.067 .080 .231 past price of the stock .077 .022 .844 -.070 -.082 .071 .217 release of new products or services .341 .057 .582 .093 .066 .172 -.194 fluctuations in market index .137 .105 .649 .227 -.258 -.078 -.032 sec intervention .340 .383 .236 .381 .006 .075 -.378 rate of inflation .176 .852 .015 -.005 .002 .008 .067 gdp .366 .696 .028 -.035 .003 .196 .253 currency exchange rate fluctuation .173 .739 -.069 .040 -.033 .292 -.103 changes in govt. policies .224 .588 .153 .332 -.131 .288 .109 margin loan facilities .133 .195 .129 .009 .057 .789 .014 rate of interest .175 .359 .057 .151 -.042 .806 -.065 global financial aspect .005 .673 .216 .259 -.118 .049 -.054 expert opinion .203 .189 -.052 .716 .369 .007 .054 recommendation from other investors -.062 -.125 -.114 .067 .821 -.011 -.063 recommendations from brokerage house -.050 -.022 -.044 .026 .888 .041 -.007 political stability .070 .316 .326 .681 -.190 .054 -.014 insider information .306 -.219 -.187 .545 .113 .403 .125 a. rotation converged in 9 iterations. microsoft word 5065-18389-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 138 value added tax and inflation: a graphical and statistical analysis alexander m. g. gelardi department of accounting, university of st. thomas tmh443, 1000 lasalle ave., minneapolis, mn 55403 united states tel: 1-651-962-4420 e-mail:amgelardi@stthomas.edu received: feb. 5, 2014 accepted: march 15, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5065 url: http://dx.doi.org/10.5296/ajfa.v6i1.5065 abstract the us has been considering introducing a national consumption tax federally. this would be in addition to the states’ sales taxes. since a consumption tax would be an added cost to the consumer, it would be expected that inflation would be increased. this paper uses graphs and statistical methods to ascertain whether inflation in the uk and canada was affected by the introduction or change in rate of the value added tax (or goods and services tax). it was found that the introduction of a vat in the uk showed no significant effect on the rate of change of cpi, whereas the introduction of gst in canada did have a significant increase in the rate of cpi. it was also found that when the tax rates were changed substantially, inflation was affected; however, modest changes in the tax rate did not affect inflation. keywords: value added tax, inflation, consumer price index, consumption tax, united kingdom, canada, united states asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 139 1. introduction the united states has debated establishing some kind of consumption tax a national sales tax or national value added tax (vat) for many years, even introducing legislation; for example the fair tax act 2013 (h.r. 25) and national retail sales tax act of 1997 (h.r.1325). although these bills have not become law the debate continues. some states, however, have some modified version of a vat michigan has the ‘single business tax’ and new hampshire has the ‘business enterprise tax’. the u.s. treasury has also looked into introducing a vat type tax to replace the corporate tax (u.s. treasury, 2007). as a more comprehensive tax reform, graetz has proposed that most taxpayers would be removed from paying income tax but there would a national vat instead (graetz, 2010). consumption taxes are indirect taxes. they can be single stage (e.g., sales tax) or multi-stage (value-added tax). the first major country to have a value-added tax (vat) was france in 1954. since then, at least 125 countries (including all the european union countries) have adopted a vat, under a variety of different names. a common alternative name is the goods and services tax (gst), used in a number of countries including canada. vat and gst are multi-stage consumption taxes with credits. with the us considering enacting a vat style national consumption tax, possibly a multi-stage one, this paper looks at the possible impact on consumer price index that such a tax may have. two countries with similar economies and common law legal structures, namely the united kingdom (uk) and canada, will be analyzed. the paper will look at two aspects, the introduction of a value added tax on consumer price index and the change of rate of the vat on consumer price index. the united kingdom introduced its value added tax in april1973 at the rate of 10% as part of the uk’s entry into the european economic community. the vat superseded the purchase tax, a hidden tax charged at various rates. over the years the rate of vat changed a number of times. between1975 and 1979, there was a “higher rate” on luxury goods. luxury goods included domestic electrical appliances, radios, tvs and hi-fi equipment, furs and jewellery. the uk has changed the rate of its vat several times over the years. canada introduced its goods and services tax in january 1991 at the rate of 7%. the rate remained stable for about 15 years. when introduced, the gst replaced the manufacturers' sales tax (mst), a hidden tax charged on manufacturers at a 13.5% rate. the mst was a single-stage sales tax. this tax was generally applied to the manufacturer’s sales price if the good was manufactured in canada or, if the good was imported, to the customs value of the good. like the us, but unlike the uk, canada has a federal system of government. the provinces (except alberta) also charge a sales tax in addition to the federal gst (at rates between 7% and 10%).1 the three territories do not charge their own sales tax. 1 some provinces, mainly in the maritimes and ontario, harmonize their sales tax with the gst, this is called the harmonized sales tax (hst). british columbia had also harmonized in 2010, but in a referendum in august 2011, the citizens of bc voted to return to the provincial sales tax regime. this change was put into effective in april, 2013. on asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 140 thus, the federal consumption tax is in addition to the provincial sales tax. to the consumer, the sum of the two taxes is the burden that is payable. if the us were to introduce a national consumption tax, it would be more like canada. most us states (45 out of the 50) have their own sales tax (counties and municipalities can also have their own sales taxes, even in some cases where there is no general state sales tax). this would mean that any national consumption tax in the us would be in addition to the state and local sales taxes. this paper is organized as follows: after this introduction there is the literature review followed by the section setting out the research questions. the methodology section is next, followed by the graphical and statistical results and comments. the paper ends with the conclusion. 2. literature review a number of studies have examined whether the u.s. should introduce a national sales tax or a national valued-added tax (metcalf, 1995; mikesell, 1997, 2003; zodrow, 1999; gale, 2005; the president’s advisory panel, 2005). a national value-added tax is still a matter of debate schenk, 2011). in 2005 the president’s advisory panel recommended against a national consumption tax, mainly due to the administrative costs and possible regressivity. there is a common perception that a national consumption tax would be regressive (gale, houser & sholtz, 1996). further, it has been suggested that if the burden of a national sales tax falls more heavily on the lower income taxpayers, then the volume of retail sales may decrease (feenberg, mitrusi & poterba, 1997). however, it is not necessarily the case that a national sales tax cannot be progressive (metcalf, 1997). in fact, the vat system in the dominican republic has been found to be progressive (jenkins, jenkins & kuo, 2006). caspersen & metcalf (1995) state that a value-added tax in the u.s. could be only mildly regressive or even progressive. it has been found that the introduction of vat in the uk in 1973 had only small distributional effects (whalley, 1975). few studies have examined the impact on inflation due to the introduction of a national retail consumption tax. the office for national statistics (in the uk) estimated that the consumer price index increased by 0.76% in january 2011 on the increase of vat from 17.5% to 20%. the reduction of the rate of vat in december 2008, was found to have a very limited drop in the cpi (pike, lewis & turner, 2009). they estimated that the cpi for december 2008 dropped by 0.5%, but by february had risen again to levels higher than november 2008. esenwein and gravelle (2004) in a congressional research service paper stated that the introduction of a consumption tax would likely give a one-time price inflation to avoid an economic contraction. however, this is not certain. it has been found that retail prices rise by the amount of the retail sales tax when looking at states in some circumstances only (poterba, 1996). extending this to the introduction of a vat, it has been suggested that such an introduction may lead to a one-time increase in prices, but there is little empirical evidence of any long-term increase (gale & harris, 2011). thus, there is uncertainty as to the effect of introducing a national consumption tax on inflation. the inflationary effects of changes in the rate of vat are also uncertain. in germany, it was found that increasing the vat rate from 16% to 19% had a price effect, in contrast to small prior changes where there was no effect that date, prince edward island introduced hst in the province. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 141 (deutsche bundesbank, 2008) it has been suggested that when a consumption tax replaces an income tax, individuals tend to save more initially and to consume less, possibly leading to retailers lowering prices. later, however, consumption eventually overtakes that of the original path, and there is higher consumption and a greater capital stock. (fullerton, shoven & whalley, 1983). this study examines inflationary effect of both at the introduction of a national consumption tax and at the times the tax rate is changed. some insight for the us can be obtained by observing changes in the consumer price indices in the uk and canada, countries which have similar economies to the us. 3. research questions the goal of this project is to establish whether the introduction of a national value-added tax in the united states is likely to increase inflation. this study will analyze the effect of the introduction of a national value added tax (on goods and/or services) on the consumer price index of the country in question. one of the main arguments forwarded against introducing a national vat or sales tax in the united states is that it would create a substantial increase in prices of every-day goods. this is inflation would increase due to the new tax. as a number of countries with advanced economies (similar to united states) have introduced national value-added taxes in the last 30 years or so, it is important to ascertain the validity of the argument by analyzing how the new taxes affected inflation in those counties. this study is designed to extend prior research by investigating the following questions: a) did the introduction of a national value-added tax increase the cpi in the countries where such a tax was introduced. b) if there was an increase in cpi, was it an one-time increase or was it sustained over a period of time? 4. methodology many factors influence the rate of inflation. one measure that is often used is the price of consumer goods as reported by the consumer price index. to look at the possible effect of the introduction, and rate changes, of a vat on inflation, it is necessary to observe the change in cpi (from the same period in the prior year) as close to the change as possible. otherwise, it would be difficult to make the case that it was the change that caused or impacted the change in behavior. the organization of economic co-operation and development (oecd, 1960-2008) does have data on cpi on a monthly basis for the us, uk and canada. data from the oecd, main economic indicators are used in all the graphs and the statistical analysis. the graphs show the percentage change in cpi in the month from the same month in the prior year. for example, the percentage change for april 1973 is the change in cpi rate in april 1973 from cpi rate of april 1972, as a percentage. this would account for any variation in cpi rate due to seasonality. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 142 as changes in the rate of inflation is subject to many factors other than consumption taxes, the graphs will show the three months before the introduction (or rate change), the month of the introduction or rate change and the three months after. that is, there will be seven months observed in each graph. this study will use an interrupted time-series analysis with the us and the other countries as controls. each country can be used as a control as the introduction of the new tax occurred at different dates for each country. the model will be the standard interrupted time-series model: y = a + b1x1 +e. (1) where y = dummy variables for the dates that vat was introduced or rate changed. x1 = percentage change (from the prior year) in cpi in uk, us and canada. as mentioned above, the uk introduced vat in april 1973 and canada introduced gst in january 1991. both events had been publicized in advance. this was also generally the case for the changes in the vat (or gst) rates. the public knew in advance that the rate change would occur. sometimes, the advance notice was some months; for example, the new labour party government in the uk announced in its november 1974 budget that it would introduce the higher rate tax on luxuries from april 1975. other times the advance notice was very short. the new conservative party government in the uk, in its mid june 1979 budget, announced the increase of the vat rates to 15% (from both the 8% standard rate and the 12.5% higher rate) to be effective about a week later. in the analysis this study, the us changes in cpi rates were used as a control. also, the change in cpi rate in canada and the united kingdom were also used as controls where there was no change in those countries (but the other country introduced the tax or had a rate change). for example, when the uk introduced vat in april 1973, canada did not and so both canada and the us were used as controls. similarly, when canada introduced gst in january 1991, both the uk and the us were used as controls. these added controls would strengthen the analysis. 5. results 5.1 introduction of a vat system 5.1.1 april 1973: uk introduces vat at 10% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 143 figure 1. uk introduces vat april 1973: cpi change from same month prior year tables 1a&b. uk introduces vat april 1973: cpi and statistics jan 1973 feb 1973 mar 1973 apr 1973 may 1973 jun 1973 jul 1973 uk 8.1 8.1 8.9 8.7 9.5 9.4 9.4 us 3.3 3.7 4.6 5.0 5.4 6.2 5.8 can 5.3 6.2 6.2 6.6 7.0 8.4 7.4 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) .972 5.995 .162 .882 uk -.303 .826 -.352 -.367 .738 us .868 .854 1.687 1.017 .384 can -.285 .554 -.520 -.514 .643 r2 = 0.772 there is little evidence that the introduction of vat in the united kingdom had an effect on the country’s inflation rate. although the graph shows that there was a modest increase, this was no different from the control countries of canada and the us, and was statistically insignificant. part of the reason for this could be that the vat replace the existing purchase tax. however, this can be contrasted with the change of cpi in canada when that country introduced its goods and services tax, below. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 144 5.1.2. january 1991 canada introduces gst at 7% figure 2. canada introduces gst january 1991: cpi change from same month prior year tables 2a&b. canada introduces gst january 1991: cpi and statistics oct 1990 nov 1990 dec 1990 jan 1991 feb 1991 mar 1991 apr 1991 can 4.8 5.1 5.0 7.0 6.3 6.3 6.3 uk 10.9 9.8 9.3 9.0 8.9 8.3 6.4 us 6.3 6.3 6.1 5.7 5.4 5.0 4.8 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) .485 .685 .708 .530 uk .097 .046 .251 2.089 .128 us -.551 .119 -.647 -4.613 .019 can .401 .054 .625 7.466 .005 r2 = 0.991 when canada introduced of the goods and services tax (gst) in january 1991, the change in the rate of cpi (from the prior year) increased from 5.0% to 7.0%. this increase was statistically significant. the cpi in the control countries, the us and the uk, decreased at this time. the goods and services tax replaced the manufacturer’s sales tax (mst), which was first introduced in 1924. thus, the results for canada are different from those of the uk, when it introduced its vat, above. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 145 5.2 changes in the rate of vat: uk 5.2.1 july 1974 uk decreases vat to 8% figure 3. uk decreases vat to 8% july 1974: cpi change from same month prior year tables 3a&b. uk decreases vat to 8% july 1974: cpi and statistics apr 1974 may 1974 jun 1974 jul 1974 aug 1974 sep 1974 oct 1974 uk 15.3 15.9 16.5 17.3 16.4 17.0 17.4 us 10.3 10.6 10.9 11.7 10.7 12.2 12.1 can 9.9 11.5 11.4 11.3 10.7 11.1 11.8 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -8.188 3.648 -2.244 .111 uk .880 .518 1.215 1.699 .188 us -.012 .426 -.018 -.029 .979 can -.510 .320 -.597 -1.594 .209 r2 = 0.794 when the uk lowered the rate of vat to 8%, there was an increase in the rate of cpi (from the previous year) to july and then a decrease in the month following the change. this decrease was not sustained. overall the graph shows a trend of increasing rates of inflation. it is possible that the effect of the change was manifested for the month following the change. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 146 this seems to be logical as prices would have dropped after the change. however, statistically the results are insignificant. 5.2.2 may 1975 uk introduces higher rate of 25% for luxury goods figure 4. uk introduces higher rate of 25% for luxury goods may 1975: cpi change from same month prior year tables 4a&b. uk introduces higher rate of 25% for luxury goods may 1975: cpi and statistics feb 1975 mar 1975 apr 1975 may 1975 jun 1975 jul 1975 aug 1975 uk 19.9 20.9 21.5 25.0 25.9 26.4 27.0 us 11.3 10.1 10.0 9.6 9.1 9.8 8.6 can 11.5 11.0 11.3 10.3 10.2 11.2 10.8 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -4.026 .863 -4.662 .019 uk .219 .014 1.203 16.083 .001 us .301 .053 .478 5.718 .011 can -.327 .059 -.292 -5.497 .012 r2 = 0.997 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 147 there was a significant increase in the rate of inflation (form 21.5% to 25.0%), when the uk introduced a higher rate of vat on “luxury goods”. it would seem that this increase was sustained over the following few months. the price of these luxury goods would have risen substantially. luxury goods would have included such consumer goods as domestic electrical appliances, radios, tvs and hi-fi equipment, furs and jewellery. repairs to these items would also have been subject to the higher rate tax. thus, the introduction of a higher rate on luxury goods seems to have had a material effect on inflation, causing an immediate and sustained increase. the control countries, us and canada, showed fairly stable cpi rates over this time period. 5.2.3 april 1976 uk decreases higher rate to 12.5% figure 5. uk decreases higher rate to 12.5% april 1976: cpi change from same month prior year tables 5a&b. uk decreases higher rate to 12.5% april 1976: cpi and statistics jan 1976 feb 1976 mar 1976 apr 1976 may 1976 jun 1976 jul 1976 uk 22.9 23.2 21.1 19.3 15.5 13.7 13.1 us 6.6 6.2 6.2 6.2 6.1 6.1 5.4 can 9.7 9.6 9.6 8.4 8.4 7.9 6.8 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 148 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) .600 2.285 .263 .810 uk -.022 .073 -.177 -.305 .781 us .973 .634 .656 1.533 .223 can -.647 .400 -1.270 -1.617 .204 r2 = 0.881 when the rate of vat on “luxury goods” was lowered to 12.5%, the cpi rate decreased. although, this trend that started two months before the change, it continued after the change at an accelerated rate. since the rate had been dropping prior to the change in vat rate and continued to drop after the change, it cannot be claimed that the change had any differential effect. this is borne out by the insignificant statistics. 5.2.4 june 1979: uk increase vat to 15% for all goods figure 6. uk increase vat to 15% for all goods june 1979: cpi change from same month prior year tables 6a&b. uk increase vat to 15% for all goods june 1979: cpi and statistics apr 1979 may 1979 jun 1979 jul 1979 aug 1979 sep 1979 oct 1979 uk 10.0 10.3 11.2 15.6 15.8 16.4 17.4 us 10.5 10.7 10.8 11.3 12.0 12.2 12.1 can 9.9 9.2 8.9 8.5 8.5 9.5 9.1 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 149 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -.645 2.293 -.281 .797 uk .178 .065 1.058 2.754 .070 us -.076 .274 -.102 -.278 .799 can -.042 .140 -.041 -.300 .784 r2 = 0.958 the increase in the general rate of vat from 10% to 15% showed a significant increase in the rate of inflation. cpi increased from 11.2% to 15.5% from june to july. this increase from the prior year was retained after the change came into effect. the control countries did not show the same increase and were statistically insignificant. 5.2.5 april 1991 uk increases vat to 17.5% figure 7. uk increases vat to 17.5% april 1991: cpi change from same month prior year. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 150 tables 7a&b. uk increases vat to 17.5% april 1991: cpi and statistics jan 1991 feb 1991 mar 1991 apr 1991 may 1991 jun 1991 jul 1991 uk 9.0 8.9 8.3 6.4 5.8 5.9 5.5 us 5.7 5.4 5.0 4.8 4.9 4.8 4.5 can 7.0 6.3 6.3 6.3 6.1 6.2 5.8 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 1.499 1.258 1.191 .319 uk -.405 .073 -1.172 -5.533 .012 us .187 .414 .140 .452 .682 can .162 .354 .104 .458 .678 r2 = 0.967 in 1991 when the uk increased its rate of vat again by a modest amount to 17.5%, the rate of cpi decreased by a statistically significant amount from 8.3% to 6.4%. this is counter to what would have been expected. it would seem that other factors influenced this decreased. again, the control countries did not have any statistically significant changes in there cpis. 1.2.1. december 2008 : uk decreased vat to 15% figure 8. uk decreased vat to 15% december 2008: cpi change from same month prior year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 151 tables 8a&b. uk decreased vat to 15% december 2008: cpi and statistics sep 2008 oct 2008 nov 2008 dec 2008 jan 2009 feb 2009 mar 2009 uk 5.2 4.4 4.1 3.2 3.0 3.1 2.9 can 3.4 2.6 2.0 1.2 0.9 1.3 1.2 us 5.0 3.7 1.1 0.1 -0.4 -0.1 -0.4 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 3.888 1.722 2.258 .109 uk -.979 .747 -1.633 -1.311 .281 us .158 .290 .642 .545 .623 can .057 .984 .098 .058 .958 r2 = 0.864 the decrease of vat in the uk from 17.5% to 15% in december 2008, shows a decrease in the rate of inflation from 4.1% to 3.2%. in the following months the cpi was fairly stable. it would appear that the decrease in vat had a small impact on inflation that was sustained. however, the observed decrease is not statistically significant. the us and canada both had decreases in their cpi at that time. 5.2.6 january 2010: uk increases vat to 17.5% figure 9. uk increases vat to 17.5% january 2010: cpi change from same month prior year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 152 tables 9a&b. uk increases vat to 17.5% january 2010: cpi and statistics oct 2009 nov 2009 dec 2009 jan 2010 feb 2010 mar 2010 apr 2010 uk 1.5 1.9 2.8 3.5 3.0 3.4 3.7 us -0.2 1.8 2.7 2.6 2.1 2.3 2.2 can 0.1 1.0 1.3 1.9 1.6 1.4 1.8 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -.829 .470 -1.766 .176 uk .469 .332 .733 1.409 .253 us -.479 .243 -.883 -1.970 .143 can .768 .627 .878 1.224 .308 r2 = 0.882 the increase of vat in the uk from 15% to 17.5% in january 2010, shows an increase in the rate of inflation from 2.8% to 3.5%. however, this increase is not statistically significant. the trend at the time of change of the vat rate was generally an increase (with a small drop from january to february). both canada and the us also had increases in their rate of inflation over the same period, thus one cannot conclude that the increase in vat was influential in causing the increase in inflation in the uk. 5.2.7 january 2011: uk increases vat to 20% figure 10. uk increases vat to 20% january 2011: cpi change from same month prior year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 153 tables 10a&b. uk increases vat to 20% january 2011: cpi and statistics. oct 2010 nov 2010 dec 2010 jan 2011 feb 2011 mar 2011 apr 2011 uk 3.1 3.2 3.7 4.0 4.3 4.1 4.5 can 2.4 2.0 2.4 2.3 2.2 3.3 3.3 us 1.2 1.1 1.5 1.6 2.1 2.7 3.2 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -3.235 3.192 -1.013 .385 uk .979 .793 .980 1.235 .305 us -.115 .910 -.171 -.127 .907 can .103 .840 .101 .123 .910 r2 = 0.795 the increase of vat in the uk from 17.5% to 20% in january 2011, shows a small increase in the rate of inflation from 3.7% to 4.0%. however, this increase is not statistically significant. the control countries showed differing changes in rate of inflation over the same period; the us cpi increased slightly from 1.5% to 1.6% and canada’s cpi decreased from 2.4% to 2.3%. thus, again, one cannot conclude that the increase in vat was influential in causing the increase in inflation in the uk. 5.3 changes in the rate of vat: canada 5.3.1 july 2006 canada decreases gst to 6% figure 11. canada decreases gst to 6% july 2006: cpi change from same month prior year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 154 tables 11a&b. canada decreases gst to 6% july 2006: cpi and statistics apr 2006 may 2006 jun 2006 jul 2006 aug 2006 sep 2006 oct 2006 can 2.4 2.8 2.6 2.3 2.1 0.7 0.9 uk 2.6 2.9 3.3 3.3 3.4 3.6 3.7 us 3.5 4.2 4.2 4.1 3.8 2.1 1.3 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) -1.245 2.696 -.462 .676 uk .625 .706 .462 .886 .441 us .316 .481 .689 .658 .558 can -.645 .799 -1.004 -.808 .478 r2 = 0.697 when canada decreased its rate of gst to 6%, there was not significant change in the rate of cpi from june to july. there was a large decrease in cpi two months later, from august to september (from 2.1% to 0.7%). however, one of the control countries, the us, also had a fairly large decrease (from 3.8% to 2.1%) at the same time. thus, it is not possible to maintain that the decrease in gst caused the change in the rate of inflation. 5.3.2 january 2008: canada reduces gst to 5% figure 12. canada decreases gst to 5% january 2008: cpi change from same month prior year asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 155 tables 12a&b. canada decreases gst to 5% january 2008: cpi and statistics oct 2007 nov 2007 dec 2007 jan 2008 feb 2008 mar 2008 apr 2008 can 2.5 2.4 2.4 2.2 1.8 1.4 1.7 us 3.5 4.4 4.1 4.3 -1.9 3.9 4.0 uk -3.8 -3.9 -4.2 2.3 2.5 2.4 2.9 statistical results model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) .576 .186 3.097 .053 uk .155 .011 1.009 14.003 .001 us 4.056e-5 .010 .000 .004 .997 can .017 .090 .013 .189 .862 r2 = 0.680 the rate of change of cpi in canada slightly decreased when the rate of gst dropped. however this was part of a general trend of decreasing cpi. the decrease in cpi was not statistically significant. this decrease is continues into the following months. the control countries had very volatile changes. the uk had a highly significant increase that was sustained, whereas the us had a one month drop that was recovered in the following month. 6. conclusion this paper described the changes in the consumer price index at the time of introduction of a national multi-stage consumption tax in the uk and canada and at the time of any rate changes in those countries. the us was used for control purposes, as was the other country with a vat style tax where there was no change at that time. at the introduction and each change in rate, the analysis show a graph of the change in cpi from the prior year (on an monthly basis) and the results of the statistical analysis. the results for the introduction of a vat system are conflicting. the introduction of a vat in the uk showed no significant effect on the rate of change of cpi, whereas the introduction of gst in canada did have a significant increase in the rate of cpi. an explanation of the result for the uk is that it could have been driven by the fact that the vat replaced a fairly hidden consumption tax, the purchase tax. however this explanation is not supported by the results from canada, where the gst replaced the mst. in the uk, most of the rate changes seem to have had little effect on inflation. a major exception to this was evidenced most strongly in the new higher rate of 25% for luxuries in may 1975. there was also a significant increase in the rate of cpi in july 1979 when the standard vat rate was increased to 15% (from 8%). at the same time the higher tax on asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 156 luxuries was abolished, effectively raising the rate for those luxury goods from 12.5%. therefore, all goods and services subject to vat had an increase and this impacted inflation. these two changes (both of which related to luxury goods, either totally or partially) are the changes that had a effect on inflation. the uk made a number of changes to the vat rate over the years. these changes in the vat rate, either increasing or decreasing, seem not to have had a major impact on inflation in the uk. any changes in the rate of cpi that were observed were generally part of a continuing trend. using the us and canada as controls, strengthens the assertions made. an anomaly was observed when the vat rate was increased to 17.5% in april 1979. at this time, the rate of cpi decreased in contrast to the expectation that it would have increased. however, since the rate of cpi was the change from the prior year (for the same months), the substantial increase in cpi a year before due to the higher rate (25%) in luxury goods may have had an influence on the observed results. in canada, the gst rate decreased in july 2006, dropping to 6% from 7%, and again in january 2008 dropping from 6% to 5%. neither of these decreases had an impact on inflation in canada. part of the reason could be that the decreases were modest especially considering that many of the provinces had their own provincial sales tax. the results from both the uk and canada indicate that a major change in vat rates would have an inflationary impact, whereas a minor change would not. the question arises of how this paper may shed some light on what may occur if the us decides to implement a national multi-stage consumption tax. the assumption would be that any such national vatlike tax would be in addition to, and not instead of, the federal income tax. both canada and the uk added their national consumption taxes to their existing income taxes. both countries also replaced hidden higher level consumption taxes (purchase tax in the uk and mst in canada). if the us introduced a vat-like system it would not be replacing an existing national consumption tax. thus, this would be a major change in the us tax system and thus would likely have an inflationary impact. references caspersen, e., & metcalf, g. e. (1995). is a value added tax progressive? annual versus lifetime incidence measures. nber working paper no. w4387. retrieved from http://ssrn.com/abstract=406043 deutsche bundesbank. (2008). price and volume effects of vat increase on january 2007. monthly report, april, p. 29-46. esenwein, g. a., & gravelle, j. g. (2004). the flat tax, value-added tax and national retail sales tax: an overview of issues. crs report for congress:rl32603. washington, dc: library of congress. feenberg, d. r., mitrusi, a., & poterba, j. m. (1997). distributional effects of adopting a national retail sales tax. nber working paper no. w5885. retrieved from http://ssrn.com/abstract=225667 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 157 fullerton d., shoven j. b., & whalley j. (1983). replacing the u.s. income tax with a progressive consumption tax: a sequenced general equilibrium approach. journal of public economics, 20(1), 3-23. http://dx.doi.org/10.1016/0047-2727(83)90018-x gale, w.g.& harris, b. a vat for the united states: part of the solution. in the vat reader. washington dc: tax analysts. gale, w., houser, s., & scholz, j. k. (1996). distributional effects of fundamental tax reform, in h. aaron and w. gale (eds.), economic effects of fundamental tax reform. washington: brookings institution. gale, w. g. (2005). the national retail sales: what would the rate have to be?. tax notes. 889-911. graetz, m. j. (2010) 100 million unnecessary returns. new haven: yale university press, (revised edition). jenkins, g. p., jenkins, h., & kuo, c-y. (2006). is the value added tax naturally progressive? 2006 queens university working paper. http://dx.doi.org/10.2139/ssrn.89677. metcalf, g.e. 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(1960-2012). main economic indicators. paris: organization of economic co-operation and development. pike, r., lewis, m. & turner d.(2009). impact of vat reduction on the consumer price indices. economic and labour market review, 3(8), 17-22. http://dx.doi.org/10.1057/elmr.2009.139 poterba, j. m. (1997). retail price reactions to changes in state and local sales taxes. national tax journal, 49(2), 149-65. schenk, a. (2011). prior u.s flirtations with vat. in the vat reader. washington dc: tax analysts. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 158 the president’s advisory panel. (2005). simple, fair & pro-growth: proposal to fix america’s tax system. report of the president’s advisory panel on federal tax reform. mack, c., chairman. united states treasury, office of tax policy. (2007). approaches to improve the competitiveness of the u.s. business tax system for the 21st century. washington dc: u. s. department of the treasury. whalley, j. (1975). a general equilibrium assessment of the 1973 united kingdom tax reform. economica, 42(166), 139-161. http://dx.doi.org/10.2307/2553589 zodrow, g. r. (1999). the sales tax, the vat and taxes in-between – or is the only good nrst a ‘vat in drag’? national tax journal, 52(3), 429-442. copyright disclaimer copyright reserved by the author. this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 5518-19888-3-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 367 the relation between auditor switching and self-fulfilling prophecy effect: the bivariate probit model yueh-ju lin dept. of accounting, kainan university, taiwan e-mail: judylin@mail.knu.edu.tw received: april 23, 2014 accepted: june 12, 2014 published: june 12, 2014 doi:10.5296/ajfa.v6i1.5518 url: http://dx.doi.org/10.5296/ajfa.v6i1.5518 abstract this study investigates the adverse effects of auditor initial going-concern qualified opinion (igcq) on the stock and audit market employing the bivariate probit model on taiwanese public firms. results show that (1) unobservable interference factors may be responsible for the adverse market effects, (2) interaction exists between the stock and audit markets, (3) the probability of auditor switching is higher if the client is delisted from the market or influenced endogenously, (4) the self-fulfilling prophecy effect is not supported in the taiwanese stock market; (5) one year after an igcq is issued, the client is more likely to switch auditors. keywords: going-concern, self-fulfilling prophecy effect, auditor switching, bivariate probit model, audit and stock market interaction jel classification: g33, g34, m41, m42 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 368 1. introduction the stock and audit markets are both in the same open economic environment. complicated causes or reciprocal effects may influence their interests mutually. therefore, understanding a market’s characteristics and its interaction with others is necessary to discuss market organization behaviors. audited financial information influences external related parties’ financial and credit decisions (minnis, 2011; smolarski et al., 2011). stock prices of public firms will be affected if auditors air opinions of their going-concern uncertainties, or, worse, if they are delisted from the stock market. generally, the audit market is decided by its demand and supply. however, an auditor switching may occur due to negative audit opinions issued or substantial operational changes of business. therefore, an inseparable relation exists between stock and audit market when any changes incur to the public firms. the issuance of initial going-concern qualified opinion (igcq) for audited clients is a complicated and difficult process after auditors carefully review management plans for solving going-concern uncertainties and evaluate their feasibility based on the generally accepted auditing standards (gaas) (bruynseels et al., 2011; citron and taffler, 1992). a disclosed igcq causing client bankruptcy is called “the self-fulfilling prophecy effect”. clients in financial hardship often switch auditors after an igcq (menon and schwartz, 1985; tucker et al., 2003; vanstraelen, 2003). thus, this study intends to answer two questions. first, does the self-fulfilling prophecy effect exist? the evidence has been inconsistent (citron and taffler, 1992, 2001; george et al., 1996; guiral, 2011; louwers et al., 1999; mutchler, 1984; tucker and matsumura, 1998;). disclosed igcqs accompany complex and unobservable factors. the inconsistent evidence may also vary due to different definitions of financial hardship or bankruptcy in the capital market. bankruptcy is a legal process claiming a debtor’s insolvency and specifying a series of steps to liquidation. countries’ different laws define and recognize bankruptcy differently. prior studies have discussed the different impacts of debtoror creditor-oriented corporate bankruptcy systems (charitou et al., 2007; franken, 2004; franks et al., 1996). under united states code title 11 bankruptcy law, in chapter seven for liquidation and chapter eleven for reorganization, the insolvency codes are primarily debtor-oriented. legal bankruptcy procedures might force the bankrupt company to discontinue operations. however, creditor-oriented codes in british, germany, australia, and new zealand make liquidation a normally adopted tactic for insolvent companies. unfortunately, for companies in creditor-oriented countries, liquidation costs always exceed bankruptcy costs, which put their shareholders and other interested parties in relatively disadvantaged positions (carver, 2012). hence, a bankruptcy prediction model to evaluate the effect of igcq may be inappropriate when companies are regulated by the creditor-oriented codes (kuruppu et al., 2003). in the u.s., when public companies experience financial hardships like bankruptcy, the security exchange commission (sec) may order the company shares to stop margin trading or even delist. stocks may therefore experience lower liquidity and trading volume, and their prices may plummet. investors will have lost essentially all their investments, making future bankruptcy evaluation meaningless. because of the definitions of corporate bankruptcy is asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 369 varied in countries, it would be biased to interpret research results when evaluating the impacts of possible bankruptcy on stock investors. besides, it is still unclear if public firms, subject to trading restrictions such as stop margin trading, trading suspension, or delisting, should be treated as bankruptable in current taiwanese corporate law. as a result, this study uses delisting of taiwanese public firms as the sample to represent firms in financial hardship, not firms in bankruptcy. the second research question concerns auditor switching to promote understanding about competition and expertise involved in the audit market. the sec requires public companies to disclose auditor switching in the hope that auditors can perform their service independently without considering client preferences. reasons for auditor switching should also be reported, such as changes in management, additional audit service needed, dissatisfaction or disagreement with the overall audit report, or conflicts in audit fees (addams and davis, 1994; cassell et al., 2012; chang et al., 2010; defond, 1992; feng, 2013; menon and schwartz, 1985; menon and williams, 1991;schwartz and soo, 1996; thevenot and hall, 2011). menon and schwartz (1985) study the possibility of auditor switching for firms in trouble and the influence of the capital market on the demand for audit service. their research concludes that financial hardship has a high correlation with auditor switching. unfortunately, their research focuses on a certain particular sample, which could cause selection bias. in addition, the research applies the univariate test on only one explanatory variable of firms in financial trouble for auditor switching, ignoring other possible variables. client decisions in the audit market may cause reactions in the stock market. a disclosed igcq may precipitate corporate delisting or bankruptcy. delisting may lead to auditor switching as well. previous research merely discusses the effects of audit decisions on audit or stock market, but neglects the possibility of an interaction between different market behaviors within the same economic environment, or excludes other unobservable interference factors. therefore, this study aims to examine the possible adverse effects of an igcq, with five main topics: (1) whether other unobserved factors influence the audit and stock markets at once. (2) whether companies in financial hardship are more likely to switch auditors (re-examined considering sample selection bias). (3) whether delisting influences auditor switching. that is, if there exists an endogenous problem between auditor switching and delisting. (4) whether disclosed igcqs cause delisting: that is, whether the self-fulfilling prophecy effect exists in taiwanese stock market. (5) whether auditor switching follows disclosure of igcqs immediately. this study includes a literature review on the self-fulfilling prophecy effect and auditor switching, research design to explain variables measured, specification of the bivariate probit model and empirical model, research results and analysis, sensitivity analysis for the empirical model, and a conclusion. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 370 2. literature review after the issuance of an igcq, the client may go bankrupt or switch auditors. either of these circumstances would harm the cpa firm, directly or indirectly. client bankruptcy may damage its reputation and thus drive away future clients or current ones, leading to losses of audit and non-audit revenues. the following is a review of studies of the self-fulfilling prophecy effect and auditor switching. 2.1 the self-fulfilling prophecy effect the main role that an auditor plays is to disclose information of the client, not to evaluate the risks associated with the client (islam, 2013). however, an igcq can expedite a client’s failure, exerting a bad influence on current and potential investors, creditors, suppliers, and consumers (carcello and vanstraelen, 2009). when this early warning leads to client bankruptcy, it is called the self-fulfilling prophecy effect (mutchler, 1984). from direct interviews, mutchler (1984) found that auditors generally consider potential impacts on clients in an igcq. however, most did not believe in the self-fulfilling prophecy effect. tucker and matsumura (1998) based on game theory, correlated the predicted variable and reactive factor. their models show that when the opinion pattern is self-fulfilling in the predicted variable, auditors are less likely to issue an igcq although their results do not conform to economists’ prediction. that may due to their overall risk aversion. moreover, there is no consensus in research about the self-fulfilling prophecy effect. citron and taffler (1992) sampled 86 british companies that received igcqs and controlled for company size, year, industry category, and financial conditions, intending to distinguish igcqs’ impacts. they found that one year after the igcq was issued, 21 out of the 86 sample companies were bankrupt. surprisingly, of a matched control group of 86 companies that did not receive igcqs, 22 declared bankruptcy. they found no evidence of the self-fulfilling prophecy effect. louwers et al. (1999) found no proof of it either. however, nogler (1995), using a sample of 157 american companies that received igcqs from 1983-1990, found that 33% of them were bankrupt later and 30% experienced an organizational restructure such as mergers, liquidation, or dissolution, supporting the idea of the self-fulfilling prophecy effect. in addition, george et al. (1996) also indicated the existence of self-fulfilling prophecy effect. therefore, before any further discussion about this topic, it is necessary to investigate variations in others’ research methods and their data collecting processes. however, citron and taffler (2001) proposed the degree of financial distress that drives both client bankruptcy and the auditor’s going concern disclosure rather than the disclosure itself that causes client failure. based on motivated reasoning and belief-adjustment model, guiral et al. (2011) proved the self-fulfilling prophecy that auditors’ expectations affected their attitudes toward the evidence in the going concern setting from a laboratory experiment. on the other hand, louwers et al. (1999) provided three critical problems with verifying the self-fulfilling prophecy effect. first, it is hard to clarify whether the qualified audit opinion can be an indicator for financial hardships. second, if it is, it is uncertain whether it causes bankruptcy or reflects other factors that cause bankruptcy. third, due to limits on information, auditors may not able to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 371 thoroughly evaluate foreseeable impacts on the client’s future operations after the igcq is issued. it is impossible for auditors to issue different opinions when going-concern uncertainties exist, and yet if they do, the client may still go bankrupt. this study applies the following methods to overcome these limitations and those cited by citron and taffler (1992). for the sample design, we further divide companies into two sub-sample groups, delisting and non-delisting. the igcq variable is included in the model to verify its predictive power of delisting when controlling other factors. in addition, this study also examines if the audit opinion, independently or concurrently with other unobserved variables, affects client delisting. 2.2 auditor switching previous studies have tested audit fees, auditor’s active reactions toward clients, corporate mergers and acquisitions, manager changes, effects of corporate governance, lack of beneficial reactions, stock market reaction, management’s disagreement with audit reports, and corporate financial hardships as possible reasons for auditor switching (addams and davis, 1994; asthana et al., 2010; cassell et al., 2012; chang et al., 2010; chen et al., 2010; lopez et al., 2011; menon and schwartz, 1985; schwartz and soo, 1996; stunda, 2012; yanan et al., 2013). other issues relating to auditor switching are initial public offering (menon and williams, 1991), agent conflict and relative size (defond, 1992), adverse internal control audit opinion (thevenot and hall, 2011), the effect of december fiscal year-end (feng, 2013). certain studies have shown that when clients received igcqs, auditor switching obviously is more likely to occur (citron and taffler, 1992; krishnan and stephens, 1995; lennox, 2000; tucker et al., 2003; vanstraelen, 2003). menon and schwartz (1985), however, did not discover that relation. auditors become more conservative in their going-concern judgments and the resulting audit opinion decision (anderson, 2011; stunda and pacini, 2013). in addition, empirically supports that when an audit report is changeable, auditor switching is easy (lennox, 2000). a belgian study discovers that the threat of switching can effectively remove an auditor’s autonomy (vanstraelen, 2003). most auditor switching studies have adopted statistical independence tests and applied univariate tests on two variables. however, a contradiction about research methods is found in the studies of menon and schwartz (1985). three factors may have led to their dissenting results: particular and different sample sets, unobserved variables, and occasional intervening variables. this study focuses on the association of auditor switching and delisting from the taiwanese stock market. we also investigate unobserved variables to clarify the existence of additional causal relationships. 3. research design table 1a describes research variables and table 1b describes the testing models as shown. according to citiron and taffler’s corporate bankruptcy model (1992, 2001), we uses a dummy dependent variable to represent whether the firm incurs delisting (delist, binary). a dummy variable for auditor switching (switch, binary) is the same as in menon and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 372 schwartz (1985) and vanstraelen (2003). our empirical model includes five control variables. the age variable (age, years) comes from chen and lee (1993) who use the age of the market listing period to predict the probability of bankruptcy. a longer listing period enables firms to accumulate greater profitability and smoother operation. thus, we predict the longer age is, the lower the possibility of delisting. the second control variable represents a client’s reported loss (loss, binary). when a company reports a loss, it signals its financial condition is weak and more likely to fail. the third control variable represents audit report quality. users generally incorporate such quality into their investment or credit decisions. we include a dummy variable by a “big four” cpa firm audit (b4, binary) to proxy audit quality as in the krishnan (1994) model. the fourth control variable is the firm size (size, nature log of total assets). citiron and taffler (1992, 2001) and haskins and williams (1990) agree that larger companies are less likely to fail because they have longer history and more resources to support their operation. banks and interested parties prefer to support larger firms that have more to lose in costs and unfavorable news if they fail. therefore, we expect that the larger the company, the less likely delisting is. the fifth control variable represents the degree of financial hardship (finance) by adopting a z-score composite financial hardship index according to the model of altman (1968) and cititron and taffler (2001). if the z-score is lower, the company is in more serious financial hardship and more likely to fail. the z-linear index is based on a series of financial ratios of the following: zi = 0.012x1 + 0.014 x2 + 0.033 x3 + 0.0064 x4 + 0.999 x5, where x1 = [(current asset current liabilities)/total assets], x2 = [retained earnings/total assets], x3 =[income before interests and taxes/total assets], x4 = [the market value of total equity/total liabilities], and x5 = [sales revenues/total assets]. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 373 table 1a. research variable definition variable definition delist whether the client is delisted from the stock market age the years of market delisting igcq whether the client is issued with an initial going-concern qualified audit opinion rgcq whether the client is issued with a repeated going-concern qualified audit opinion igcqy1 the client incurs auditor switching one year after igcq igcqy2 the client incurs auditor switching two years after igcq igcqy3 the client incurs auditor switching three years after igcq loss the client reporting loss during the sample period b4 the client audited by a big four cpa firm size the market value of the client switch whether the client incur audit switching finance a z-score composite index, the degree of financial hardships of the client (the lower z-score, the worse its financials) table 1b: the testing models model equations statistical method a (10), (11) bivariate probit model b (12), (13) recursive simultaneous equation c (14), (15) recursive simultaneous equation d (16) delisting (delist) model for comparison with model a e (17) switching (switch) model for comparison with model a to understand causes for auditor switching, we also employ the five control variables in the switching model according to prior studies (krishnan, 1994; menon and schwartz, 1985). however, client size inhibits auditor switching (haskins and williams, 1990; krishnan, 1994) since smaller firms grow rapidly in general and tend to switch to bigger cpa firms unlike larger firms, who are deterred by higher switching costs. sample selection bias occurs when the sample is not selected randomly but only from clients issued with igcq. to overcome the bias, we apply the bivariate probit method, which can reveal unobservable factors affecting delisting and auditor switching. the research model is designed as follows: 11 ' 11 εβ +=∗ xy (1) 22 ' 2 * 2 εβ += xy (2) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 374 where y1 * is the latent propensity for client delisting and a vector x1 ’ is the observed variables affecting y1 *. in addition, let y2 * be the latent propensity for the client to switch auditors and vector x2 ’ be the observed variables influencing y2 *. yi * is unobservable and relates to the binary explanatory variable, based on the following: 11 =y , if 01 ∗y ; 01 =y , if 01 ≤∗y and (3) 12 =y , if 02 ∗y ; 02 =y , if 02 ≤∗y (4) where y1=1 when the client is delisted and y2=1 when the auditors are switched. the error term ),( 21 εε is supposed to be a standard bivariate normal distribution, ),( 21 εεf ~n       1 1 ρ ρ , 0)()( 21 == εε ee , 1)()( 21 == εε vv , ρεε =),cov( 21 . equations (1) and (2) have the same related error terms with random disturbances for both latent propensities of delisting and auditor switching. therefore, both possibilities of delisting and auditor switching could be written into the following: );,();,( ),()1,1( 221121212 221121 2 1 ρββρφ xxfdzdzzz xxxxpyyp x x  ∞− ∞− == ===  (5) where f has a correlation coefficient of ρ which has a bivariate standard normal distribution function. the maximum likelihood method estimates the parameters in the model, with a function as the following: { = = n i l 1 21 ),,(ln ρββ )1();,(ln 21221121 yyxxfyy ii −+× ρββ + [ ] })(ln)1();,(ln 1112211 βφρββφ iii xyxx −−+ (6) where φ is a standard normal distribution function. we also investigate if delisting and auditor switching interact concurrently within the same economic environment. the recursive bivariate probit model, called the recursive simultaneous equations model, verifies the relation as in the following (greene, 2003; maddala, 1983): )0(1, * 1111 ' 11 yyxy =+=∗ εβ (7) )0(1, * 222122 ' 2 * 2 yyyxy =++= εγβ (8) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 375 where y1=1, when the client is delisted, is also the dependent variable in equation (7) and y2=1, when the client switches auditors, is the independent variable in equation (8) which also includes the endogenous variable of y1. the dependent variables are those included in the vectors of x1 ’ and x2 ’ in equation (7) and (8). the error term 21,εε in equations (7) and (8) is a standard bivariate normal distribution with a correlation coefficient of ρ . ),( 21 εεf ~n       1 1 ρ ρ , 0)()( 21 == εε ee , 1)()( 21 == εε vv , ρεε =),cov( 21 (9) to discuss how a repeated opinion influences delisting and auditor switching, we further distinguish between ordinary igcqs and repeated going-concern qualified opinions (hereafter rgcq) in equation (10). because of the time lapse between igcq and client bankruptcy, other factors or even an rgcq affecting bankruptcy may complicate the self-fulfilling prophecy effect. if the rgcq is proven insignificant, the qualified opinion itself may not be a substantial factor in delisting. in addition, according to menon and schwartz (1985) and vanstraelen (2003), we wait three years after the igcq to discover auditor switching in taiwan. empirically this study assumes auditor switching may be occur one year after igcq (hereafter igcqy1), two years after (igcqy2), and three years after (igcqy3). in our study, the sample is divided into audit clients with and without igcq so we can compare the two sub-sample groups. therefore, whether we should attribute auditor switching to the igcq or simply to the client’s original financial hardships could be clear, since previous studies suggest firms in financial hardship are more likely to switch auditors. the empirical model is below (11): ),,4,,,,( financesizeblossagergcqigcqfdelist = (10) ),,4,,1( financesizebageigcqyfswitch = (11) we also need to verify whether delisting and auditor switching are mutually causally related. since the two events are binary variables, the recursive bivariate probit model is appropriate to test them. thus, in equation (12), auditor switching is an endogenous variable in the bankruptcy model to explain delisting. in addition, equations (12) and (13) also use the bivariate probit model to test if the two events are subject to other vital unobservable factors called unspecified variables. similarly, in equation (15) for auditor switching model, another endogenous variable for delisting is used to test its effect on auditor switching as stated in the following recursive bivariate probit model to estimate equation (14) and (15). ),,4,,,,,( financesizeblossagergcqigcqswitchfdelist = (12) ),,4,,1( financesizebageigcqyfswitch = (13) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 376 ),,4,,,,( financesizeblossagergcqigcqfdelist = (14) ),,4,,1,( financesizebageigcqydelistfswitch = (15) for comparison with the bivariate prodbit model in equations (10-15), equation (16) and (17) are added to determine delisting and audit switching respectively. ),,4,,,,( financesizeblossagergcqigcqfdelist = (16) ),,4,,3,2,1( financesizebageigcqyigcqyigcqyfswitch = (17) 4. sample design and empirical results the sample design divides taiwanese public firms into three sub-sample groups based on previous studies (citron and taffler, 1992, 2001; louwers et al., 1999). the first group includes 34 public firms receiving igcqs from 1987 to 2010 but continued operation until the end of research. the second group includes 167 already delisted companies who received igcqs during the same period. the third group is the control group with a total of 557 public companies being in operation who may receive igcos during the sample period. only public firms with complete information are included into the entire sample. criteria used to match samples are sample period, industry classification, and company size. all sample data was obtained from the market observation post system of the taiwan stock exchange and from the taiwan economic journal. table 2a&2b provide sub-sample firm distribution by audit opinion (igcq: 26.5% vs. non-igcq: 73.5%), delisting (yes: 71.0% vs. no: 29.0%) and auditor switching (yes: 20.1% vs. no: 79.9%) to examine the self-fulfilling prophecy effect in taiwan. to verify model stability, firms were further divided into sub-sample groups of delisting and auditor switching. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 377 table 2a.: sub-sample firm numbers by audit opinion and market delisting if igcq firms if market delisting firms no� yes� total yes¶ 34 167 201 (26.5%) no 504 53 557 (73.5%) total 538 (71.0%) 220 (29.0%) 758 (100.0%)§ table 2b: sub-sample firm numbers by audit opinion and auditor switching if igcq firms if auditor switching firms no yes total yes 49 152 201 (26.5%) no 557 0 557 (73.5%) total 606 (79.9%) 152 (20.1%) 758 (100.0%) � not occurring market delisting or auditor switching until sampling time in 2010. � occurring market delisting or auditor switching during the period of 1987-2010. ¶ if firms issued with igcq during 1987-2010. § total sample includes 758 public firms and a sub-sample of 557 (73.5%) non-igcq firms is the controlling sample, matching with 201 igcq firms (26.5%) based on the year, industry, and companies size. table 3 states the descriptive statistics for the research variables. delisted firms consist of 29% of the entire sample, with a ratio of 1:2.5 to non-delisted firms. the ratio is not 1:1 to avoid overestimating the sample of delisted firms. auditor-switching firms consist of 20% of the sample. among igcq firms, there are 167 delisting firms, 34 non-delisting firms and 152 auditor switching firms. of the entire sample firms, 26.5% are igcq firms and 15.4% are rgcq firms. there are 11.1% igcq firms incurring auditor switching one year after the igcq. among the igcq firms, 44.9% of delisting firms also have auditor switching but only 26.4% of non-delisting firms have switching. about 10% of igcq firms have auditor switching in the next year after the igcq of which delisting firms are twice likely to switch auditors than those non-delisting ones. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 378 table 3. descriptive statistics of research variables variable mean median std. dev. max min age (years) 14.972� 12 9.504 48 1 (18.411) � (16) (9.198) (47) (6) [18.916] ¶ [17] [10.183] [48] [4] size 14.733 14.698 1.390 18.73 7.28 (nature log, (15.465) (15.94) (1.702) (18.732) (12.65) total assets) [14.871] [14.947] [1.373] [18.057] [7.282] finance 1.626 0.975 4.453 73.71 -0.10 (0.758) (0.65) (0.607) (3.095) (0) [1.094] [0.848] [1.217] [12.676] [0] � numbers without any bracket are for the total 557 sample � numbers in parentheses ( ) are for the sub-sample 34 igcq but non-delisting firms ¶ numbers in square brackets [ ] are for the sub-sample 167 igcq but delisting firms table 4 is a correlation matrix for the delisting firms, auditor switching firms, the predicted and control variables. there is positive correlation (0.751) between delisting and switching auditors. positive correlations are also found for the delisting firms with the igcq firms (0.855) but with rgcq firms (0.601), as well as for the auditor switching firms with the igcq firms (0.834) but with the rgcq (0.634). thus, many igcq firms may experience delisting and/or auditor switching soon after their igcq but not before the rgcq. the correlation between igcq and auditors switching at one year later is 0.684, revealing the auditor switching generally occurs within one year of the igcq. however, there is insignificant correlation between the degree of financial hardships (low finance index) and delisting. that may be due to the time required for serious financial hardships to develop and actually lead to delisting. the significant negative correlation (-0.79) between igcq and finance confirms that firms in financial hardships (lower finance) are generally those clients with igcq. as to the appropriateness of the bivariate probit model, first, the chi-square x2 test is applied to three sets of simultaneous equations of the bivariate probit model and the recursive models of b and c. all the models employed are significant at less than 1% level, indicating the probit and recursive simultaneous equations models are appropriate methods. based on the correlation coefficient matrix in table 4, a positive significant correlation (0.751 at < 1%) is asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 379 found between delisting and auditor switching, supporting the joint model estimation. table 4. the correlation coefficient matrix delist igcq igcq loss size finance variable age rgcq y1 y2 y3 b4 switch delist 1 age .22** 1 igcq .88** .44** 1 rgcq .60** .17** .71** 1 igcqy1 .57** .15** .58** .47** 1 igcqy2 .31** .04 .38** .30** -.08* 1 igcqy3 .19** .04 .17** .13** -.03 -.02 1 loss .48** .17** .56** .40** .34** .24** .12** 1 b4 -.08* -.23** -.08* -.05 .01 -.04 .02 .02 1 size .05 .21** .10** .10** .01 .05 .01 .12** .06 1 switch .75** .22** .83** .63** .68** .42** .20** .52** .01 .10** 1 finance -.008 -.07 -.79** -.51* -.05 .01 .04 .007 .06 -.02 -.03 1 *** significant at 1% level, ** at 5%, and * at 10%. in table 5, the bivariate probit model shows the estimated correlation coefficients, ρ , of 0.752, 0.797, and 0.763 are all significantly different from zero at 1% level for model a, b, and c respectively. that reveals both delisting and auditor switching are subject to the impacts of unobservable factors within the model such as cycles in economic and changes in financial system. based on these significant correlations, both models of delisting and auditor switching should be estimated jointly in empirical testing by two equations according to their asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 380 correlations. based on the empirical results from the three sets of a, b, and c bivariate simultaneous equations, the igcq does not affect delisting significantly, neither does the rgcq influence the delisting significantly, even when the financial hardships variable is controlled for in the model. however, our results agree with those of citron and taffler (2001). in conclusion, we cannot support the self-fulfilling prophecy effect in the taiwanese stock market because the time lapse between igcq and delisting interferes with the result. in addition, by excluding igcqs and financial hardships, unobservable factors in other markets in the same economic environment may contribute to delisting, confirmable by significant estimated correlation coefficients ρ in the bivariate probit models. from the b model, the auditor switching variable (switch) has a significant impact on delisting (delist). the c model shows that clients in financial hardships tend to switch auditors, which verifies menon and schwartz (1985)’s assertion that delisting leads to auditor switching. other changes in the stock market would also influence the demand for audit services. based on the estimation results of the a, b, and e model, factors influencing auditor switching are all significant. one year after the igcq (igcqy1), companies are most likely to switch auditors. model c also reveals that delisting raises the probability of auditor switching significantly. model e studies individual behaviors in the audit market and finds auditor switching likely in igcqy1 and igcqy2 but not igcqy3. although the audit market is highly regulated, auditors are subject to replacement with short notice by unsatisfied clients. model d only considers factors causing client delisting when its financial conditions are controlled. empirical results confirm our hypothesis that the correlation between audit and stock market may interfere with the explanation of delisting. indeed, igcq and financial hardships do not cause delisting but other market correlations in the same economic environment may be. model d also supports previous findings (citron and taffler, 1992) that corporate bankruptcy is not related to financial hardship. however, differences in variable measurements and definitions should be handled with more attention. in this study, the degree of financial hardship is measured at one year before the igcq issued, because delisting generally occurs after an igcq. earlier financial hardships are attributable to igcq but not necessarily to delisting as stated in citron and taffler (1992) findings. therefore, we conclude that early financial hardships should not be the main cause for client delisting. notice that we proxy bankruptcy by delisting which is different from previous measurements for corporate failure. delisting in general causes company shares to lose liquidity but it does not necessarily lead to bankruptcy immediately. consequently, any interpretation should be made with caution for there are different meanings among variables employed. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 381 table 5. results of bivariate probit model model a b c d e variable delist (sd) switch delist switch delist switch delist switch constant -238 (28710) -2.84*** (.28) -4.08 (92.07) -2.81** (.28) -3.99 (93.26) -3.45** (.36) -151.6 (2.2×105) -3.38** (.35) delist 2.27** (.17) switch 1.44*** (.19) igcq 241 (28710) 5.73 (92.54) 5.51 (93.44) 154.8 (1.5×105) rgcq -.22 (.22) -.25 (.16) -.20 (.22) -.22 (.22) igcqy1 3.12*** (.35) 3.06** (.34) 1.66** (.38) 3.62** (.37) igcqy2 3.14** (.4) igcqy3 8.57 (1.4×105) age .005 (.01) .027** (.09) .01 (.01) .02** (.009) .001* (.01) .022* (.01) .004 (.001) .03** (.01) loss -.25 (.44) -1.15*** (.33) -.33 (.47) -.28 (.30) b4 .07 (.24) .11 (.17) -.05 (.20) .15 (.16) .001 (.25) .28 (.19) .08 (.23) .32 (.21) size -.15** (.08) .001 (.004) -.002 (.05) .001 (.004) -.001 (.03) .001 (.02) -.14* (.07) .001 (.002) finance .05 (.10) .08 (.05) .20 (.18) .08 (.05) .42 (.16) .03 (.11) .21 (.16) .20 (0.16) ρ .752**(.17) 0.797** (.21) 0.763** (170.95) ln l -252 -253 -178 -86 -92 *** is at 1% significant level, ** is at 5% and * is at 10%. 5. sensitivity test a sub-sample is used to test the validity of empirical results for the original model, and then the entire sample is tested on different liner models again to compare the results with previous evidence obtained. detailed robust test results are as below. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 382 (1) sub-sample testing for this test, only a sub-sample for firms with the igcq is included and further divided into delisting and non-delisting, as a result, a total of 201 igcq firms are obtained. by applying the a, b, c, and d models to estimate variables, table 6 shows no significant differences among the models. table 6. sub-sample testing results of bivariate probit model model a b c d e variable delist switch delist switch delist switch delist switch constant 3.53*** (1.21) -1.44*** (.41) 3.78** (1.2) -.415 (1.02) 3.07** (1.46) -1.44** (.42) 2.97*** (1.2) -2.57** (.56) delist 1.41** (.82) switch 1.06* (.78) igcqy1 1.9*** (.41) 1.71*** (.54) 1.95*** (.42) 2.65*** (.42) igcqy2 2.16*** (.47) igcqy3 8.12 (3.8x105) age .004 (.014) .027** (.012) .004 (.014) .026** (.009) .001* (.015) .026** (.012) .003 (.001) .044** (.016) loss -.24 (.43) -.17 (.416) -.489 (.43) -.305 (.369) b4 .06 .64** .086 .59** .122 .664*** .095 .426*** (.24) (.25) (.246) (.26) (.323) (.257) (.095) (.325) size -.16** (.08) .001 (.002) -.186** (.082) .001 (.002) -.152 (.09) .001 (.003) -.141* (.077) .001 (.0001) finance -.05 (.27) -.029 (.28) -.003 (.269) -.031 (.277) .04 (.284) -.117 (.447) .294* (.177) -.043 (.26) ρ .604*(.187) 0.626*(.454) 0.614* (.531) ln l -163 -162 -161 -86 -45 *** is at 1% significant level, ** is at 5% and * is at 10%. (2) testing on different models to check the robustness of the bivariate probit model, the b and c recursive simultaneous equations are tested and compared with the other three models. table 7 is the result comparison for the five models’ testing, including their estimated coefficients and degrees of fitness. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 383 table 7. different model testing results of sensitivity tests model sure b c probit probit variable delist switch delist switch delist switch delist switch constant .089*** (.026) -.095*** (.026) -4.08 (92.07) -2.81** (.28) -3.99 (93.26) -3.45** (.36) -177.4 (1.9×105) -3.43*** (.35) delist 1.01*** (5.6x105) 2.27** (.17) switch .994*** (5x105) 1.44*** (.19) .355** (.615) igcq 1.2x10-6 (6x10-5) 5.73 (92.54) 5.51 (93.44) 181.3 (1.9×105) rgcq 9.8x10-8 (4x10-5) -.25 (.16) -.20 (.22) -.25 (.22) igcqy1 -6.4×10-11 (2.9×10-7) 3.06** (.34) 1.66** (.38) 2.41** (.36) age .006 (.001) .006 (.001) .014 (.011) .026** (.009) .001* (.014) .022* (.011) .026 (.011) .027** (.009) loss -.001 (.02) -1.15*** (.33) -.33 (.47) -.31 (.37) b4 .083 (.21) .084*** (.02) .05 (.20) .15 (.16) .001 (.25) .28 (.19) .003 (.23) .32*** (.24) size -.001* (.0012) .001 (.0001) .002 (.058) .001 (.004) -.001 (.03) .001 (.029) .170** (.081) .001 (.001) finance -.09 (.54) .08 (.05) .20 (.18) .08 (.05) .42 (.16) .03 (.11) .3 (.40) .14 (.48) ρ 0.797* (0.21) 0.763* *(170) ln l -116 -121 -253 -178 -86 -115 *** is at 1% significant level, ** is at 5% and * is at 10%. the sure model is applied by a linear sur (linear seemingly unrelated) model, similar to the bivariate probit model. same coefficient directions and significant levels in key variables are derived from the models of sure, b, and c (the recursive simultaneous equations). in addition, if employed separately by the probit models, only the significant levels exert very small changes but the coefficient directions remain the same as those of model b and c in general. therefore, according to these sensitivity tests, we conclude that the bivariate probit model is robust by applying different model estimation methods. therefore, the empirical evidence from the bivariate probit model is highly valid and trustworthy. 6. conclusions when gaas are followed, an igcq does not make a client’s delisting its auditor’s responsibility. the main purpose of this paper is not to discuss who should account for the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 384 delisting but to measure adverse impacts on the stock and audit market after the igcq issued, including delisting and auditor switching. however, if the stock and audit markets interact, delisting and auditor switching are themselves correlated. we investigated if delisting and auditor switching are subjected to unobservable factors simultaneously, in addition to the self-fulfilling prophecy effect in taiwanese stock market when there is an igcq to precipitate client delisting. on the other hand, we also discussed if the demand for audit service would be affected by an igcq and if so, when auditor switching would occur. we proved empirically there are unobserved interfering factors affecting client delisting and auditor switching after an igcq issued. while auditor switching influences client delisting, delisting itself also directly affects auditor switching, proving the two adverse effects by the igcq are not independent. since delisting and auditor switching interact within the stock and audit market, conclusions based on the assumption that relevant markets function independently are biased. moreover, we do not find evidence of the self-fulfilling prophecy effect in the taiwanese stock market and other vital unobserved variables, because neither the igcq nor rgcq has a significant impact on client delisting. however, we empirically prove that delisting significantly causes auditor switching to occur one year after an igcq is issued. the main purpose of this study is to provide all related parties in the stock and audit market and regulatory agencies with useful information. for auditors, when clients are delisted and are likely to switch auditors afterward, cpa firms may face a reduction of audit engagements. in addition, clients associated with more audit risks should face higher risk premiums, or firms should transfer and consider risks in certain additional ways. share investors should evaluate how the igcq may affect stock prices based on all relevant information. this study provides non-financial information about the possibility of auditor switching, a useful index for predicting future delisting of an igcq firm. for regulatory agencies, prior signals of financial hardships or unusual auditor switching should be used to prevent adverse effects on financial markets. references addams, h., & davis, b. 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(2003). going-concern opinions, auditor switching, and the self-fulfilling prophecy effect examined in the regulatory context of belgium. journal of accounting, auditing and finance, 18(2), 231-253. yanan, z., wen, c., & jinzheng, r. (2013). auditor switching by corporate governance: empirical analysis from the listed company in china. journal of modern accounting and auditing, 9(2), 230-238. microsoft word 5486-19763-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 271 stock returns and fundamentals in the australian market noor muhammad (corresponding author) the university of waikato, hamilton, new zealand e-mail: uighor@yahoo.com frank scrimgeour the university of waikato, hamilton new zealand received: april 16, 2014 accepted: may 15, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5486 url: http://dx.doi.org/10.5296/ajfa.v6i1.5486 abstract this study compares 10 widely used financial performance measures of stock return in the australian stock market. the five financial measures are calculated on information provided in publicly available financial reports (accounting based financial measures) and the other five are calculated using market information as one of the key variable (market based financial performance). the sample includes companies from all major industries from 2001 to 2010. the panel data analysis shows that market based financial performance measures can better explain stock price variance compare to accounting based measures of financial performance. it has significance for researchers and practitioners seeking to select measures that can empirically explain the performance of company. it has also importance for shareholders tracking performance of companies in order to make profitable investments. keywords: accounting based performance, market based performance, stock price, investment asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 272 1. introduction each measure of corporate performance is very important for a range of stakeholders. it is not only used by internal stakeholders for decision making but also by external stakeholders including creditors and competitors. performance evaluation is normally looked at in the context of published financial statements but in reality performance measures have broader scope and implications. corporate performance is perceived in different ways such as return, production efficiency and financial growth. a number of studies over a long period have emphasized the usefulness of financial fundamentals (chen & shimerda, 1981). financial ratios allow shareholders to compare different information in a meaningful way in order to make investment decisions (singh & schmidgall, 2002). ratio analysis provides information that summarizes the strengths and weaknesses of different corporations from return, liquidity and growth perspectives. when evaluating firm performance, the most common fundamentals/ratios are related to profitability and returns. these financial ratios are based on publicly published financial statements and known as accounting-based financial performance (afp). these performance measures offer significant financial information to both shareholders and researchers to assess different corporations and compare their standing within an industry over the years (gallizo & salvador, 2003). many traditional financial performance measures are reported in the literature. however, these measures are grouped on the basis of the nature of their information. financial markets have become more competitive in recent years which make efficient uses of resources a vital and challenging issue. diversification in form of products and markets often increases corporation income and enhance their value (he, 2012; olibe, ehie, & strawser, 2012; pandya & rao, 1998). a successful corporation requires excellent performance measurement tools that are suitable and aligned with a value maximization objective. conventional accounting based financial performance measures have been criticized for providing ineffective guidance when making strategic decisions. these shortcomings are addressed by market based financial measures. market price based financial measures have attracted increasing attention as alternatives to measure value for firms (sandoval, 2001). international strategy research and behavioural finance theories show that firm financial performance is substantially influenced by contextual phenomenon (tong, alessandri, reuer, & chintakananda, 2008) and it varies in different market and sectors. for example, stating the purpose of earning per share, accounting standards1 argue that it provides information on comparisons between different entities in the same reporting period and between different reporting periods for the same entity but following this fundamental principle empirical studies found confounding results. nikolai and bazley (2010) consider earning per share (eps) as a helpful measure to evaluate return over investment and risk taken by a firm. whereas, cudia and manaligod (2011) refute this claim and consider that eps fails to effectively compare financial performance between 1 international financial reporting standards (ifrs) 33 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 273 companies. jordan, clark, and smith (2007) also pointed out some pitfalls of this measure of performance. they suggest that eps may be used for large companies but it should be avoided for small listed companies’ analysis as it is poor measure for firms of different size and thus is not useful for intercompany comparison. the motivation of this study is to empirically identify appropriate financial performance evaluation tools from a range of available tools for asx 200 companies. it also compares whether accounting based financial measure or market based financial measures better explain variance in stock prices. this is an important area to be researched as ratios are often used for financial performance evaluation intuitively without considering their theoretical and statistical properties. in the next section, we cover historical background and development of ratio analysis. section 3 and section 4 discusses accounting based ratios and market based ratios respectively. section 5 covers methodology used for this research followed by results and discussion in section 6. the last section concludes the study. 2. background the word ratio is originally taken from the latin verb reri, to think; past participle, ratus (smith, 1925, p. 478). thus, ratio in latin means calculation, relation or reason. in other words ratio is the relationship of one amount to another. theoretically, when one term (numerator) is divided by another term (denominator), the resultant number is called the ratio of the first term to the second term. it is difficult to establish the first use of ratio but some greek writers like nichomachus used it in arithmetic, eudoxus used it in geometry and theon used it in music (smith, 1925, pp. 477-478). it is believed that the babylonians had some concept of ratio in 2200 b.c. (bell, 1945, p. 41). the science of ratio analysis can also be found in the elements of euclid’s approximately 300 b.c.(anjum, 2010; horrigan, 1968). however, modern ratios and their use started in the late nineteenth century in the united states when corporations were growing and had great impact on different stakeholders. creditors were concerned for the stability of firms whereas shareholders were interested in profitability. during the late nineteenth century, the flow and volume of financial information increased significantly. in this period credit analysis dominated as creditors were very keen to access financial statements to conduct credit analysis (horrigan, 1968). the most common practice of this time was the comparison of current assets with current liabilities (current ratio) (anjum, 2010; horrigan, 1968). in the first two decades of the twentieth century several financial ratios emerged. some were used with an absolute criterion2 while others were to address the need for inter-company comparisons (horrigan, 1968). wall (1919) probably conducted the first formal study by analysing 981 firms using 7 different financial ratios. he categorized these firms in different geographic locations and different sectors. he found great variation in performances between different sectors and geographic locations. despite wall’s fuzzy method, variability of 2 for lending purposes a current ratio of 2:1 was used as a judgement criterion (horrigan, 1968, p. 285) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 274 involved factors and trouble in collecting comparable financial data, it still has historical importance as a pioneer in the use of ratios (anjum, 2010; horrigan, 1968). about the same time, the du pont company came up with the du pont pyramid. the top of this matrix is return on investment and the base consists of profit margin and capital turnover ratios. this system encouraged the development of a logical order of ratio and financial performance (horrigan, 1968). after the wall (1919) study, two schools of thoughts emerged in next decade. one viewed ratios as fundamental measures of the business enterprise (bliss, 1923) and on the contrary the other school of thought viewed it as artificial measure of business enterprise (gilman, 1925). bliss (1923) presented ratios in a coherent fashion and considered them as “indicators of the status of fundamental relationship within a business” (p.34). on the other hand, gilman (1925) criticised ratios for using inconsistent and incomparable accounting data in computation. in ratio calculations both numerators and denominators vary over time, therefore, ratios are artificial measures of financial performance that distract analyst attention from a broader view of the company. after passing of legislation 3 in the united states regarding the content, quality and consistency of financial information, the science of analysing financial performance became more sophisticated and effective (horrigan, 1968). small and medium business enterprises also started to publish work on ratio analysis. analysts were keen to look at the predictive power of ratio analysis with new dimensions. for example, sorter, becker, archibald, and beaver (1964) investigated the relationship of a financial ratio to a psychological model of the corporate personality and found that conservative firms maintain higher cash and solvency. after the invention of modern statistical analysis and electronic data processing tools, studies regarding empirical effectiveness of ratio analysis also increased (salmi & martikainen, 1994). one of the important topics that is discussed in financial performance evaluation research is the distributional properties of ratios. a number of studies support the view that the majority of financial ratios are not normally distributed (deakin, 1976; ezzamel & mar-molinero, 1990; ezzamel, mar-molinero, & beech, 1987). deakin (1976), in his study rejected normal distribution assumption for the majority of studied ratios. he further claimed that normality can only be achieved by transformation of data. however, he was not sure that what kind of data transformation can produce the best results. ezzamel and mar-molinero (1990) conducted a study to examine the cross-sectional and inter-temporal distribution properties of financial ratios in united kingdom listed companies. they conducted several tests and concluded that the assumption of normality is rejected. transformation of raw data did not improve the normality assumption for their sample. however, if transformation is necessary then the cubic root seems to be a better alternative to the natural logarithm and square root. 3 the security act of 1933 and securities and exchange act of 1934 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 275 lev and sunder (1979) studied methodological issues pertaining to ratio analysis. particular attention was given to the conditions under which a ratio can achieve its intended objective. they concluded that both practitioners and researchers use ratios because of convenience and tradition rather than careful methodological investigation. the objective of their study was “to encourage the user of financial ratios to examine carefully the adequacy of using ratios in their analysis.” (p.209). salmi and martikainen (1994) reviewed financial ratio analysis research. on account of their classification of financial ratios, they categorised them in four sets: pragmatic empiricism4, a deductive approach5, an inductive approach6 and a combination of deductive and inductive approaches and called the confirmatory approach7. their review of the literature revealed that financial ratios can be reduced to only 4-7 indispensable ratios but empirical evidence is divided on this issue. this study relies on the confirmatory approach. 3. accounting-based financial performance measures in this study, five accounting measures are determined as the sub-criteria of the afp main-criterion to evaluate companies in asx 200. these measures are return on assets (roa), return on equity (roe), earning per share (eps), free cash flows (fcf) and pay-out ratio (por). these sub-criteria are briefly explained in the following. 3.1 return on assets (roa) this financial statement measure is comparing corporation profitability in a given year to the corporation’s average total assets. the return on assets ratio is expressed in the form of a percentage. this accounting measure of profitability has significant importance because it shows the effective and efficient use of firm total assets to generate earnings. alternatively, return on assets shows the amount of profit a firm generates for each unit of investment in assets (palepu et al., 2010). there is slightly variation in formulation of this measure in the literature. we adopt the palepu et al. (2010) measure of roa: = ( ) palepu and colleague used earning before the interest and taxes as the numerator as opposed to moyer, mcguigan, and kretlow (1992) who used net income. as the purpose of return on an asset does not account for whether assets are financed through equity or debt. the net income measure is adjusted for the interest expense as well as other items such as taxation. to remove the effect of financing choice, ebit is a better choice (palepu et al., 2010). return on asset formulation shows that investors favour a higher ratio because it is a proxy for the performance of a company. roa also shows the efficiency of management in using firm 4 “a subjective classification of financial ratios based on the practical experience or views of the authors” (salmi & martikainen, 1994) 5 using earlier work, deliberation, logic, reasons or even visual approximation to form a relationship (salmi & martikainen, 1994) 6 a method that has emphasis on empirical evidences rather than theoretical foundation (salmi & martikainen, 1994). 7 an approach that hypothesize priori relationship and investigate it empirically (salmi & martikainen, 1994). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 276 assets to generate earnings. similarly, roa is a helpful measure in comparing a company’s performance with its competitors. 3.2 return on equity (roe) return on equity is also referred to as return on common shareholder equity (roce). the primary factor that distinguishes roe and roa is the company debt financing. in other words financial leverage changes roa and roe. in the absence of company liabilities, total assets and shareholders’ equity will be the same and hence roe and roa would also be the same. financial leverage gives rise to a roe greater than roa due to the comparatively cheaper cost of debt financing. return on equity is a comprehensive indicator of a firm performance because it measures the percentage of profit earned on common stockholders’ investment in the firm. roe is also useful for comparing the profitability of a firm with rivals in their industry. it is the most significant and widely used financial ratio in manufacturing companies. theoretically, if a company is motivated to maximize the wealth of its stockholders, it should be trying to maximize roe. the most common method of roe calculation is as follows (livingstone & grossman, 2002; palepu et al., 2010): = ℎ ℎ ℎ ℎ only the stockholder’s equity appears in the denominator, for this reason the numerator needs to be adjusted for the payment attributed to preferred shareholders. if the firm has not issued preferred share equity of any other priority capital then no adjustment is required. in measuring the denominator palepu et al. (2010) suggest that average common shareholder equity should be used to ensure measurement unit consistency, and to compensate for any rapid growth or major changes in shareholders’ equity. higher roe show efficient management of the equity base and also the better return to its investors. in the long run, the value of the firm’s equity is determined by the relationship between its roe and its cost of equity capital. in other words, firms that are expected to generate roe in excess of the cost of equity capital should have a higher market value compared to book value, and vice versa (palepu et al., 2010). a comparison of roe with the cost of capital is useful not only for contemplating the value of the firm but also in considering the path of future profitability. the generation of a consistently higher profit will attract more competition in the absence of significant entry barriers. that is why roe tends to decline towards the cost of equity over time because of competitive forces. thus, the cost of equity capital can be used as a benchmark for the roe that would be observed in a long run competitive equilibrium. 3.3 earnings per share (eps) an absolute measure of income does not show the real performance of companies. therefore, shareholders are interested in how income is changing relative to other factors such as company size (cudia & manaligod, 2011). earnings per share is an important measure of a company’s financial performance. it evaluates economic strength relative to firm size. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 277 according to williams (2000), earning per share is an important ratio to analyse the historical operating performance of a firm and help to form an opinion about its potential. eps is used as an important variable in determining a share market price. a market reacts and makes adjustments to firm earning expectations (jordan et al., 2007). this ratio determines the relationship between firm profitability and size. therefore, the majority of studies used the number of ordinary shares outstanding as a proxy to measure firm size. if the number of ordinary shares in the market has changes in a given period because of share buyback then a weighted average of the quantity of shares is used (yalcin, bayrakdaroglu, & kahraman, 2012). = ℎ ℎ ℎ eps is very important to most stakeholders. shareholders are using this information to evaluate the return on their capital. this ratio ignores the capital make up. for example, a company with less equity may have the same eps as a company that has more equity in their capital. despite its weakness, eps is often considered as the single most important measure of a company’s profitability (yalcin et al., 2012). 3.4 free cash flows and dividend pay-out ratio one way to increase the value of a firm is by limiting the cash out the flows in form of dividend payments. this is because investors may prefer dividend payments only if acceptable capital investment opportunities do not exist. it is widely accepted that profitable capital opportunities increase firm value and internal financing (retained earnings) is the cheapest mode to finance such profitable projects. issuing new shares results in floatation cost and therefore is less attractive compared to internal financing. thus, the dividend should only be paid when free cash flows are more than the new capital budget requirements. the free cash flow hypothesis favours dividend payments in the absence of new investment opportunities. in other words if a firm cannot generate a return equal to the internal rate of return then it is better to pay retained earnings in the form of dividends. investors react differently to identical changes in dividend by similar firms. some investors may consider reduction in dividend as a signal for new profitable opportunities. these investors consider that a firm may be interested to accumulate cashflows by reducing dividend payments and thus increases its value. on the other hand, some investors consider reduction in dividend as a negative signal. because they think that reduced dividend is not in their best interest as it may increase agency problems. thus the free cash flows and dividend pay-out ratio may be used as an indication of firm investment opportunities. = − where ncf is net cash flow and ocf is operating cash flow. operating activities represent the net cash receipts and disbursements resulting from the operations of the company. it is the sum of funds from operations, funds from/used for other operating activities and extraordinary items. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 278 the dividend pay-out ratio is formulated as follows = where por is dividend pay-out ratio, d is dividend per share, and eps is earning per share. 4. market-based financial performance measures in this study, five market measures are selected as the sub-criteria of the mfp main-criterion to evaluate asx 200 listed companies. these measures are determined as price earnings ratio (pe), tobin’s q (tbq), market to book value ratio (m2b), market value added (mva) and cash flow return on investment (cfroi). these sub-criteria measures are briefly explained in the following. 4.1 price earnings ratio (p/e) the price earning measure shows the amount an investor is willing to pay per unit of earnings announced in the income statement. shareholders look at several factors before making investment decisions in favour of a particular company. despite the range of available tools, the price earnings ratio is the most powerful measure of financial performance (kumar & warne, 2009). it is calculated by dividing the current market price per share of stock by earning per share (truong, 2009): = ℎ ℎ annual earnings available to common shareholder are reported in the income statement, the number of shares outstanding in reported in the statement of financial position and the market price per share of stock is can be obtained from secondary market such as stock exchange. 4.2 tobin’s q (tbq) this market based performance ratio was first developed by tobin8 in 1969. it measures the market value of a firm relative to the replacement cost of its assets. in other words, it is the intangible assets market worth in the form of tangible assets (chung & pruitt, 1994). a tbq value above one shows that a firm’s assets could be purchased more cheaply than the firm itself and the market is overvaluing the company, while tbq ratios less than one indicate that market is undervalued in the company. tobin’s q plays an important role in explaining diverse corporate financial phenomenon such as investment strategies9 contribution to firm value (jose et al., 1986), common equity structure and its relationship with corporate value (mcconnell & servaes, 1990), acquiring firm investment opportunities that lead to the different method of payments in corporate acquisitions (martin, 1996) and time series patterns of excellence (jose, lancaster, & stevens, 2011) . 8 the tobin q metric is named after the economist and nobel winner james tobin. 9 investment strategies are referred to research & development, promotion and diversification in multiproduct companies (jose, nichols, & stevens, 1986) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 279 despite tobin’s q leading role in several corporate financial areas, managers do not commonly use this powerful tool in practical financial decision analysis. part of this reluctance is probably because of the abstract and multi-dimensional nature of q and top management unfamiliarity with q (chung & pruitt, 1994). unlike other financial performance variables q data is not directly available on popular databases. therefore, it can be calculated by applying lindenberg and ross (1981) algorithm. this procedure is so difficult and lengthy that even a dedicated analyst would rarely try to attempt it (chung & pruitt, 1994). hence a simple approximation of q developed by perfect and wiles (1994) can be used. = + + where mva is the product of a firm’s share price and the number of common stock outstanding, ps is product of firm’s preferred stock price and number of preferred stock outstanding. the simplified procedure involved in the calculation of q shows a compromise between analytical precision and calculation efforts. the true measure of any such simplification technique is its degree of accuracy when compared with values obtained from following the theoretically more correct model (chung & pruitt, 1994). however, perfect and wiles (1994) found 0.9856 observed correlation between simplified q with lindenberg and ross (1981) q through empirical investigation of 62 firms. thus simple estimation of q continues to be a useful measure of financial performance (chung & pruitt, 1994). 4.3 market to book ratio (m2b) finance and economic practitioners are continuously searching for variables that can explain the variance and predict stock returns. the market to book ratio became a strong candidate after fama and french (1992) results showed that the market to book ratio of individual stocks has the ability to explain cross sectional variation in stock returns. the formulation of this formula is as follows: = this ratio is used by practitioners and academia to analyse whether a stock price is undervalued or overvalued. if a stock is undervalued, the price is expected to rise. if it is overvalued, the price is expected to fall. in other words, this ratio looks at the worth that market places on the book value of a firm. 4.4 market value added (mva) the way in which shareholder wealth is increased is by maximizing the difference between firm total market value and the amount of capital that investors have supplied to it. this difference is called mva (gapenski, 1996). market value added is the aggregate measure of wealth created by the management in addition to the shareholder investment (kramer & asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 280 peters, 2001). although shareholder investment is recorded historically and is subject to inflation, still mva is the measure that captures all dynamics of the firm performance (ehrbar & hamel, 1997). mva efficiently quantifies the share market’s assessment of the net present value of a firm’s past and expected capital investment projects (lehn & makhija, 1996). theoretically mva at any point in time is the present value of respective yearly economic value added (eva). grant (1996) shows that if the firm's expected eva is growing at some constant growth rate, g, each year forever, then the firm's market value-added can be expressed in a constant growth model. = − where mva is current market value added, eva1 is company current eva outlook, r is cost of capital and g is growth rate in eva. as mva is known for the firm performance in the long term and it is derived from market-generated number therefore, kramer and peters (2001) calculated mva by subtracting the total capital employed in a company from the sum of the total market value of the company. = − the total market value of firm is equal to the sum of market value of equity and market value of debt. mva is the total excess value produced by the firm after paying dividends to its shareholder. in other words, mva reflects the cumulative wealth created for shareholders over the existence of the company beyond the capital employed (yook & mccabe, 2001). from a practitioner’s perspective, mva captures the market’s assessment of how effectively a company managers have used the scare resources under its control in addition to how well management has positioned the company (cheng, tsao, tsai, & tu, 2007). if mva is negative, then the market does not believe in the company’s capacity to create value and the employed capital is eroded. on the contrary, a positive value proves that the company is very attractive on the market, because it can reward its shareholders (yalcin et al., 2012). overall, mva is an effective performance tool that evaluates the quality of strategic decisions and signals about the strategic change (lehn & makhija, 1996). therefore, it is reasonable to use mva as a proxy for the measurement of owner wealth maximization. 4.5 cash flow return on investment (cfroi) this performance measure is the close rival of economic value added in corporate performance evaluation comparison. it was first used in the 1970s by callard, madden & associates and later advanced by holt value associates, which was acquired by credit suisse in 2002 (thomas & gup, 2009). cash flow return on investment (cfroi) is defined as the sustainable cash flows that a company generates in a given year as percentage of the cash invested in the company asset (erasmus & lambrechts, 2006). cfroi is similar to accounting roi, but it is calculated by dividing discounted future cash flows by total capital assets. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 281 cfroi is conceptually a simple model and is not restricted to accounting standards. the discounted cashflows represents future risk as it uses adjusted discount rate and are easily comparable with other firms, strategic business units and even product lines (dzama, 2003; erasmus & lambrechts, 2006). the cfroi model gets around accounting distortions and enables comparison among different firms and industries (dzama, 2003; young & o'byrne, 2001). = ℎ − where cash flow is gross operation cash flow, economic depreciation is the cost of depreciable assets consumed during a year, expressed in terms of opportunity cost of the original investment. according to martin and petty (2000) economic depreciation = (1 + ) − 1 where wacc is weighted average cost of capital and t is asset life. cfroi indicates whether the company has earned returns superior to its cost of capital and thus created value for its shareholders. in this sense, it shows an important similarity to eva. both measures assume that management creates value by earning returns on invested capital greater than the cost of capital. for the owners of the company or shareholders, high cfroi is an advantage because less money has to be invested to generate future growth. 5. methodology to decide whether afp or mfp can explain variance in share prices, this study selected asx 200 listed companies from 2001 to 2010. the majority of australian companies use december as year-end for their reporting year. some of the listed companies also report voluntary semi-annual financial statements to their stakeholders. we do not use these financial reports because of their tentative type of information. we used consolidated financial reports of parents companies as in forecasting context parent company accounting information is most relevant and have more influence on stock prices (darrough & harris, 1991). we dropped companies with insufficient financial data and retained only those companies that have at least four consecutive years data. in our final sample we ended up with 164 companies from ten different sectors as shown in table 1. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 282 table 1. sample composition industry name code number of companies basic materials 1 43 consumer goods 2 07 consumer services 3 22 financials 4 32 health care 5 08 industrials 6 26 oil & gas 7 14 technology 8 02 telecommunications 9 03 utilities 10 07 total 164 the information required to calculate accounting and market based financial measures are downloaded from datastream database. the dependent variable, stock return is calculated as change in year-end price divided by last year price. all prices are adjusted for dividend and taken from datastream database. correlation coefficients among dependant and independent variables are shown in table 2. we estimated five different models for each of the accounting as well as market based measures of financial performance: (1) a simple ols model (model_1), (2) cross-sectional fixed model (model_2), (3) cross-sectional random model (model_3), (4) cross-sectional and years fixed model (model_4), and (5) cross-sectional and years random model (model_5). a simple model for accounting based information is as follows. = + + + + + + + where adjretit is the dividend adjusted stock return, roa is return on assets, roe is return on equity, eps is earning per share, fcf is free cashflows, por is dividend pay-out ratio, size is the log of total assets, i=1,2,…,m cross sectional unit (companies) for periods t=1,2,…..,t. ɛ is error term with assumption of ɛit ~n(0,σ2 ɛ). a similar linear model is also estimated for market based related performance measures. = + 2 + + 2 + + + + where adjretit is the dividend adjusted stock return, p2e is price to earnings ratio, tbq is tobin’s q, m2b is market to book ratio, mva is market value added, cfroi is cash flow return on investment, size is the log of total assets, i=1,2,…,m cross sectional unit (companies) for periods t=1,2,…..,t. ɛ is error term with assumption of ɛit ~n(0,σ2 ɛ). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 283 table 2. correlation matrix ad. return roa roe eps fcf por p2e tq m2b mva cfroi ad.return 1 roa 0.001 1 roe -0.008 -0.043* 1 eps -0.006 0.048 0.118* 1 fcf -0.046* 0.008 0.025 0.300** 1 por -0.157*** 0.043 0.088*** 0.205*** 0.095*** 1 p2e -0.002 0.004 0.015 0.037 0.014 0.143*** 1 tq -0.001 -0.75*** 0.0585** -0.047* -0.014 -0687*** -0.105*** 1 m2b 0.013 0.007 -0.026 0.002 -0.002 -0.011 0.263*** 0.437*** 1 mva 0.035 -0.001 0.012 0.143*** 0.152*** -0.0828*** 0.0088 0.0138 0.011 1 cfroi -0.011 0.010 0.0786*** 0.158*** 0.445*** 0.244*** 0.0244 -0.014 -0.002 -0.0701*** 1 notes: (1) * denotes significance at 10% (p<0.10), ** denotes significance at 5% (p<0.05), *** denotes significance at 1% the assumption that observations are independent of from one another is very important in regression analysis. if it does not prevail, then the standard error of the estimate could be affected and the inferences that we make will be invalid. if this is the case, then our model 2 or model 3 transformations may work better as it allows the impact of unobserved and time invariant factors that are specific to each firm. model 1 in our study does not take into account differences across time and firms. it also assumes that coefficients are constant and has no effects and ignore the effects of such differences across firms and time using ols. as this is very restrictive assumption hence, we allow the impact of time invariant factors that specific to firm (model 2 & model 3) and across firms and time (model 4 and model 5). another important assumption in regression analysis is regarding the normality of residuals to ensure that the results of t-tests and f-test are valid and reliable. in this study we conducted shapiro-wilk w test for normality. the null hypothesis is that the distribution is normal. we reject the null hypothesis as the p-value is less than the cut-off point of 5%. this result is aligned with existing literature (deakin, 1976; ezzamel & mar-molinero, 1990; ezzamel et al., 1987). however, to overcome this problem we ran bootstrap 2000 times to see whether the results of our models estimates are consistent. we found that the t-test value is stable and not changed significantly. since panel data analysis is used it is possible that observations contain intra-firm correlations. to avoid the effect of these correlations, the models used in this study provide results using robust standard errors cluster by company. if two or more variables are in linear combination with one another it causes biased coefficient instability. the standard error of coefficients is also inflate. to check whether there is any relationship among independent variables we performed variance inflation asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 284 factor (vif) tests. all variables had vif values less than 10 which is considered to be satisfactory using the conventional rule of thumb (o’brien, 2007). 6. results and discussion table 3 and table 4 shows results of accounting based financial measures and market based financial measures respectively. evidence shown in model 4 in both accounting and market based financial measures meets expectations. starting from table 3, return on assets (roa) is positively statistically significant at 1% level in the last four models and at 5% in model 1, providing evidence that higher return on assets will result in higher stock rate of return. we also note that roa is the only accounting based measure that is positively statistically significant in model 4 and 5 from a range of measures including its close counterpart measure roe. it is pointing to the notion that stockholders are more concerned with the overall profitability of the firm compared to the return on their equity portion. table 3. accounting based financial measures model_1 model_2 model_3 model_4 model_5 roa 0.7100** 1.0519*** 0.8444*** 0.9272*** 0.7771*** (2.47) (3.34) (2.99) (3.95) (3.04) roe 0.1282 0.0278 0.0857 0.0452 0.0159 (0.81) (0.27) (0.65) (0.73) (0.15) eps 0.0504** 0.0532** 0.0501** 0.0252 0.025 (2.06) (2.02) (2.1) (0.99) (1.12) lnfcf -0.0193 -0.0155 -0.012 0.0256 0.0075 (-0.86) (-0.43) (-0.46) (0.71) (0.32) por -0.0031*** -0.0007 -0.0027*** -0.0016** -0.0031*** (-3.79) (-0.8) (-3.37) (-2.07) (-4.11) size -0.0309 0.0241 -0.0335 0.0366 -0.0465** (-1.52) (0.66) (-1.56) (0.89) (-2.23) constant 0.9657*** -0.0292 0.8995*** -0.5915 0.8430*** (6.46) (-0.05) (4.8) (-0.91) (4.86) n 1115 1115 1115 1115 1115 r2 0.1804 0.1519 0.2608 vce robust cluster robust cluster robust firm effect no yes yes yes yes year effect no no no yes yes notes: (1) * denotes significance at 10% (p<0.10), ** denotes significance at 5% (p<0.05), *** denotes significance at 1% (p<0.01); (2) number in parenthesis below each coefficient show t-statistics similarly, pay-out ratio (por) is negatively statistically significant at 1% in model 1, model 3, model 5 and 5% in model 4. pay-out ratio (por) is insignificant only in model 2. it means that the stock rate of return decreases as the firm start paying its earning in the form of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 285 dividends. stockholders are interested to reinvest earnings in the company rather to receive earning in the form of dividends. earning per share (eps) is statistically significant in the first three models but after controlling for time variant effects, earning per share (eps) turn statistically insignificant in model 4 and model 5. it shows that eps is a time variant ratio. stockholders may appreciate higher eps in some years but in other years it may not be fully reflected in stock rate of return. reported earnings that are used in formulation of eps are quite sensitive to standards imposed by accounting bodies. we know that australia adopted international accounting standards during our study period thus australian investors may not have paid much attention to the change in this ratio over the years. overall, model 4 and model 5 (fixed effects and random effects controlling for both firm effects and years) are showing consistent and similar results in favour of return on asset (roa) and pay-out ratio (por). to decide which model give best results, we run the hausman test to decide between fixed or random effects. the null hypothesis is that the preferred model is random effect over the fixed effect. for the accounting based performance measure models we fail to reject the null hypothesis at 5% significance level. therefore, the preferred model is random effects. whereas, for the market based performance measures we rejected the null hypothesis meaning that the preferred model is fixed effects. analysing market based financial measures in table 4; we note that only market to book ratio (m2b) is consistently significant throughout five models. apart from model 1 which is significant at the 10% level, in the remaining four models m2b is strongly significant at the 1% level. these results are similar to fama and french (1992) results that market to book ratio of individual stocks has the ability to explain cross sectional variation in stock returns. we find these results in the australian market and thus market to book ratio (m2b) becomes one of the strong market based financial performance candidates to explain variance in stock prices. overall model 2 (fixed effect model controlling for firm effect) and model 4 (fixed effect model controlling for firm effect and years) meet expectations. the hausman test is also in favour of fixed effect models. four out of five market based measures; price to earning (p2e), tobin’s q (tq), market to book (m2b) and cashflow return on investment (cfroi) are statistically significant in both model 2 and model 4. on other hand, the random effects model 3 and model 5 are showing only market to book (m2b) to be strongly statistically significant at the 1% level. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 286 table 4. market based financial measures model_1 model_2 model_3 model_4 model_5 p2e -0.0007 0.0020** 0.0008 0.0019** 0.0007 (-0.76) (1.98) (0.88) (2.13) (0.9) lntq 0.2293 0.9171* 0.5277 0.9573** 0.5124 (1.1) (1.96) (1.48) (2.07) (1.52) m2b 0.0090* 0.0115*** 0.0100*** 0.0121*** 0.0090*** (1.91) (2.9) (3.03) (2.8) (2.61) lnmva 0.0733 0.0539 0.0837 0.0508 0.0388 (1.57) (0.63) (1.27) (0.65) (0.63) cfroi 0.306 0.8978** 0.6227 0.8725** 0.6187 (0.74) (2.08) (1.43) (2.02) (1.53) size -0.0947* 0.2493 -0.02 0.3504** -0.0177 (-1.96) (1.56) (-0.26) (2) (-0.25) constant 0.6571** -4.1076*** -0.5907 -5.3027*** -0.3126 (2.45) (-2.63) (-1.07) (-2.91) (-0.63) n 873 873 873 873 873 r2 0.1373 0.2283 0.1779 vce robust cluster robust cluster robust firm effect no yes yes yes yes year effect no no no yes yes notes: (1) * denotes significance at 10% (p<0.10), ** denotes significance at 5% (p<0.05), *** denotes significance at 1% (p<0.01); (2) number in parenthesis below each coefficient show t-statistics after analysing accounting and market based financial performance measures, we found that market based financial measures are performing better than accounting based financial measures in explaining stock returns. two accounting ratios (return on asset (roa) and pay-out ratio (por)) and four market based ratios (price to earnings (p2e), tobin q (tq), market to book (m2b) and cashflow return on investment (cfroi)) appear to be suitable candidates to explain stock return. 7. conclusions this study identifies suitable financial performance evaluation ratios from a range of available ratios for asx 200 listed companies. a sequence of specification tests, panel regressions including both company and year fixed effects was selected as a reference model. after analysing and comparing 5 ratios from each of the sub-groups namely accounting based financial measure and market based financial measure, we find that price to earnings (p2e), tobin q (tq), market to book (m2b) and cashflow return on investment (cfroi) from market based financial measures can better explain variance in stock prices. this makes a better group of performance evaluation measures over the rival approach where only return on asset (roa) and pay-out ratio (por) can explain stock return. this adds empirical evidence to the extant literature from an australian market perspective. it reveals the inside story of the market participants that they pay more attention to market based measures over asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 287 accounting based measures. these results are not only important from an academic research point of view but also to practitioners who rely on market based measures. given the strong relations of market financial performance measures and stock returns, future studies should focus on ratio and performance measures that are related to financial risk and their impact on market rate of return. more attention is required to investigate the motivation for behaviour that is inclined towards the market based measure. market participants trust of accounting numbers and the effectiveness of financial reporting standards also requires attention from future researchers. references anjum, s. 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(2001). eva and value-based management: a practical guide to implementation. martinsburg: mcgraw-hill. microsoft word 6341-22748-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 301 the impact of treasurer’s experience and knowledge on the effectiveness of the administration and preparation of the accountability reporting system in north sumatera azhar maksum*, rustam hamid, & iskandar muda faculty of economics and business, university of north sumatera jl. dr. t.mansur, no.9, kampus usu, medan, 20155, north sumatera, indonesia *corresponding author, e-mail: azhar.maksum@yahoo.com received: sep. 22, 2013 accepted: oct. 29, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6341 url: http://dx.doi.org/10.5296/ajfa.v6i2.6341 abstract this study aims to determine the role of treasurer’s experience and knowledge on permendagri (minister regulation) no. 55/2008 to create the effectiveness of administration and preparation of the accountability reporting system. this study is an explanatory survey using primary data. the scope of the study includes the new expanded regional governments, namely; the districts of batubara, padang lawas, south labuhan batu and north labuhan batu. the effectiveness of the administration and preparation of the accountability reporting system is used as a dependent variable and both treasurer’s experience and knowledge are the independent variables. the study population comprises of 310 people where 115 people are selected as the sample using the purposive random sampling method. the study founds that the experience variable does not affect the effectiveness of the administration and preparation of the accountability reporting system; meanwhile, the knowledge variable has an effect on the effectiveness of the administration and preparation of the accountability reporting system. keywords: effectiveness of the administration and preparation of the accountability reporting system, experience and knowledge. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 302 1. introduction the efforts to improve the presentation of the regional financial report’s submission are increasingly being discussed. this is related to the importance of the governance reform, thus the efforts towards achieving good governance and authoritative have continously been emphasized. unfortunately, the efforts to reform the financial reporting presentation seems to not have been fully implemented yet by the regional governments as well as the task force units within the regional government. a change in the regional government’s accounting approach of single entry into double entry is a fairly revolutionary change. on the other hand, the publication of financial statements by regional governments through newspapers or the internet does not seem to be a common thing for most regions. the government realizes this matter, including the efforts made by issuing the regulation of the ministry of the internal affairs, especially related to treasury and governance administration. it is marked by the creation of permendagri no.55/2008 on the procedures of treasurer’s administration and accountability report preparation. all the treasurers (concentrating on receipts and spending) are at the forefront of the implementation of this regulation. a treasurer of task force units which are based on the current regulation is obliged to submit the financial reports 2 months upon the year-end closing of accounts. if the performance is good, then the regional government treasurers’ efforts to obtain the opinion of financial statements by the audit board with qualified predicate are not difficult to realize. it is necessary to study the main obstacle of not achieving the qualified predicate from several new expanded districts. thus, this study is intended to look at the effectiveness of the adminisration and the preparation of the accountability reporting system of regional task force units. a study by avazzadehfath et al. (2011) states that the skilled human resources constitute an important factor for an organization. a lot of organizations are always seeking to improve the efficiency of the organizations by sending their employees for training, on a given cost. their study in iran has found that the existing system especially for the organization’s accounting information system related to the activities of the human resource cycle, will process the data and convert them into practical information. it also finds that the investment decisions are influenced by the presence of the human resource accounting cycle and disclosed in the financial statements. thus, this concludes that the human resource accounting system which is integrated with the financial reporting cycle contributes to the production of relevant decisions contained in effective reports. meanwhile, the findings by meyta et al. (2013) which examine the fiscal management perspective based on permendagri no. 59/2007 in the financial management board and the regional asset in sorong city have concluded that the processes of planning, preparation, implementation, administration, reporting and accountability of budgets in sorong city have not been fully carried out in accordance with the regulations because of the fact that some changes in the new regulations have not been implemented where they still refer to the old regulation of permendagri no. 13/2006. this constraint occurs due to the lack of human resources that are reliable and competent in their fields as well as the fact that changes in the regulations have made the financial management cycle failed to run the way it should. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 303 kengatharan and kengatharan (2014) state that human behavior in the aspects of reporting and accountability is a fairly new field. this field is based on the aspect of psychology, in which it tries to understand the emotions and cognitive errors that influence the behavior of individuals. in this context, the behavior becomes an integral part of the decision, because it affects the performance execution. moreover, pangkong et al. (2013) examine the factors that affect the ability of the regional government’s financial statements in biak numfor district of papua province. the study proves that partially, the human resource quality affects the ability to prepare the regional government’s financial statements in numfor biak while the variables of regulatory understanding, commitment and set of supports have no effect. next, kim (2005) examines the individual-level factors and organizational performance of government oganizations in korea. he explains that the achievement of public sector organizations is determined by their performance on the individuals, thereby providing effective accountability reports. the effectiveness is determined by demographic variables such as age, work experience, gender, education level and occupation of personnel, whereby all of these factors significantly influence the performance of individuals in korea. given the arguments above, this study aims to analyze the extent of experience and knowledge of task force units’ treasurers on the permendagri no55/2008 towards the effectiveness on the administration and preparation of the accountability reporting system in the north sumatera province. 2. literature review 2.1. theoretical review 2.1.1. the theory of goal setting the theory of goal setting is part of the motivation theory proposed by edwin locke in the late 1960s (melati, 2011) in wibowo (2013). this theory asserts that an individual's intention to achieve a goal is a major source of work motivation. an individual with a difficult, more specific and challenging goal will result in higher performance than those with vague objectives such as easy goals that have no specification or purpose at all (melati, 2011). locke (1990) in melati (2011) reveals that there are two categories of actions which are directed by goals, namely: (a) non-conscious directed goal (b) conscious directed goal or purposeful actions. the underlying premise of this theory is the second category of conscious goal, where it unravels the useful ideas to encourage individuals to act (latham, 2004 in melati, 2011). meanwhile, a theory of goal setting assumes that there is a direct relationship between the definition of specific objectives and measurable performance; if the person (managers/officers) know what would exactly be the objectives that they need to achieve, then they will be more motivated to exert efforts that can improve their performance (locke & latham, 2002 in melati, 2011). the aim of having a challenge is usually implemented in the output, with a specific level to be achieved (locke & latham, 1990 in wibowo (2013). 2.1.2. the achievement motivation theory according to samsudin (2005) in haryanto (2013), motivation serves as a process that influences or as an external push against a person or working group that makes him want to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 304 implement something which has been set. motivation is a condition or energy that drives employees’ self-directed state that will lead them to achieve organizational goals. meanwhile, siegel and marconi (1989), carlos (2013) in wibowo (2013) mention that a motivation is the key to start, control, maintain and direct the behaviors. it is also regarded as a driving force of one's heart, which means that he has the willingness to obtain the success and achieve the goals. moreover, robbins and judge (2007), carlos (2013) in wibowo (2013) have posited that the motivation is a process that describes the intensity, direction and persistence of an individual to achieve his goal. on the other hand, general motivation is associated with any effort to achieve the goal. the three main elements in this definition are the intensity, direction and persistence related to the extent of how hard one works, or attempts at something. a high intensity to produce satisfactory work performance should be associated with a favorable direction. persistence is a measure of how long a person can maintain his business. 2.1.3. characteristics of administration information quality and financial accountability report the characteristics of the accounting information system comprise of elements as follows (hall, 2007): 1. relevant. this refers to the information that needs to be known to deliver new insights. the reports that are used temporarily and are later on irrelevant are to be eliminated. 2. the right time. the age of information is a critical factor in determining its usefulness. information should not be older than the period of time that it enables the action to be supported. 3. accurate. information should be free of errors that is material by nature. the material errors occur when the amount of information is inaccurate, thus the decision makers tend to make poor decisions or fail to make necessary decisions. 4. completeness. there is no part of information that is essentially needed in decision making or the execution of a task is missing. incomplete information can cause difficulties and has an impact to a great element of uncertainty. 5. summary. information must be aggregated to fit the user's needs. concise information and the summary of relevant data show deviations from the areas of the normal level, which is standard or planned as a form of information that is much needed by the users. 2.1.4. experience an experience refers to the administration and reporting accountability both in terms of the length of time, the number of assignments as well as the kinds of tasks that are handled (nilawati, 2009). another definition states that an experience is a learning process and an extension of the potential development of behaviors in both formal and non-formal education or could be defined as a process that brings a person to a pattern of higher behavior. according to nilawati (2009), the length of treasurer’s service and experience in holding a position will render them acknowledged as a person who is responsible for the basic activities in the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 305 organization’s daily operations. the longer duration that the treasurers are holding the position, the better their work performance. 2.1.5. the knowledge of permendagri (ministry of internal affair’s regulation) no. 55/2008 in relation to the administration and accountability reporting system aligned with the orderly administration and accountability of the budget implementation, it needs to prepare and submit the administration procedures and accountability reports for the treasurers. the regulation of the ministry of the internal affairs no.55/2008 is a refinement of the regulation of the ministry of internal affairs no.13/2006 on the regional financial management guidelines. this permendagri was launched in order to control everything related to treasury with the expectations to achieve goals. the regulation will then bring improvement to the regional governance policy and its financial management. according to halim (2007) in pangkong et al. (2013), the government accounting standards (sap) work as a guideline for the preparation and reporting of budget realization, to both central and regional governments, with the goal of uniformity, synchronization and harmonization of all kinds of reports. based on the government regulation no. 58/2005 on the regional financial management, the regional government has the authority to develop policies and procedures for the accounting and financial management system in accordance with the regional government’s accounting standards. above all, the regional government may prepare its financial statements in the form of the budget realization report, balance sheet, cash flow statement and notes to the financial statements in accordance with the government accounting standards, accounting policies and financial management systems and procedures, so as to produce transparent and accountable financial statements (halim et al., 2010). the regulation that relates to the treasury mentioned must at least be understood by those who carry it out. 2.2. review of previous research the matric results of the previous studies are related to the topic of this research as illustrated in table 1. below: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 306 table 1. review on previous research author/year title variables findings of research nilawati, ivon (2009) a study on delay of spending accountability report delay by the task force units (skpd) in central lampung of 2008. the research is conducted descriptively not using the dependent and dependent variables. the submission activity of spending accountability report in central lampung region is not running accordingly based on the applicable regulations and has frequent timing inaccuracy in it’s submission. the possible constraints are due to; (i) the presence of policy in spending accountability activities in central lampung is considered inappropriate and inconsistent with permendagri 13/2006, and (ii) the lack of ability on task force units in these activities, among others, due to the low quality of human resources and lack of socialization and training about the rules of the spending accountability activities in central lampung region. muda, iskandar., rasdianto, & muhammad safri lubis. (2014) implementation of the cash revenue system: a case study in the local government task forces’ units of north sumatera province, indonesia case studies related to regional financial management will be easy, fast and accurate when its computerized with the help of the regional financial management application software. with a reliable it support, then the rules of financial accountability to be a contributing factor to realize the adequacy of disclosure and can create the effectiveness of internal control systems. wibowo, dedye priyo (2013) an analysis of factors affecting the reconciliation timeliness on sai data by the task force units (a study in the task force units in malang treasury office) budget ceiling, the amount of spending, assets, education, experience, training, number of repairs, up to date applications of authorized budget accounting systems (sakpa) and the use of electronic reconciliation. the formed factors, thus a panel data analysis resulted that the human resource capacity significantly affect the timeliness of sai data reconciliation rahman, aulia et al. (2012) the effect of competence, training and agency accounting system on the competence, training and agency accounting systems and quality on competence, training and the agencies’ accounting systems simultaneously affect the quality of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 307 quality of financial reporting accountability on deconcentration fund (a study on task force units of aceh government in managing deconcentration funds) accountability of financial statements financial reporting accountability deconcentration on the task force units of aceh government. aliyah, siti and aida nahar (2012) the influence of regional financial statements and accessibility of regional financial statements on transparency and financial management accountability in jepara regency presentation of regional financial statements (x1) and accessibility of regional financial report (x2) and transparency and management accountability of regional financial (y) presentation of the regional financial statements has a positive and significant effect on the accountability reports that can be read and understood. presentation of a complete financial statements in accordance with the standard accounting administration and easily accessible to all respective parties is enable to control and supervise the financial management appropriately. 2.3. conceptual framework the conceptual framework of this study is formulated as follows: figure 1. conceptual framework 2.4. hypothesis the hypothesis of this study is established as follows: 1. the experience and knowledge of task force units’ treasurers on permendagri no.55/2008 affect the effectiveness of the administration and preparation of the accountability reporting system. 2. the administration and accountability report system in accordance with permendagri no.55/2008 has effectively been done or otherwise. treasurer’s knowledge (x2) the effectiveness of administration and preparation accountability reporting system of regional task force units (y) treasurer’s experience (x1) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 308 3. methodology this study uses an explanatory, survey-type of research that aims to explain a relationnship of a phenomenon using primary data. meanwhile, the collection of data uses questionnaires that consist of; a number of demographic variables and other questions related to the researches’ variables. meanwhile, the population of this study has included all the treasurers (receipt and spending) on the new expanded regional governments, namely: batu bara, padang lawas, south labuhan batu and north labuhan batu districts in which, as many as 168 people with a sample of 115 people had been derived from the purposive random sampling. 3.1 operational of definitions and measurement of research variables the variables consist of independent variables and dependent variable which are defined in the following table: table 2. operational of definitions and measurement of variables variable operational of definitions measurement scale dependent the effectiveness of administration and preparation accountability reporting system of regional task force units (y) accuracy and relevancy of presentation of the treasurer’s accountability for the task force units’ financial statements and support of regional government financial statements. a. effectiveness of financial statements prepared by the task force units onsists of budget realization report, balance sheet and notes to financial statements. b. relevancy in receipts and spending. c. timely receipts and spending d. accurate receipts and spending e. complete receipts and spending. f. the task force units’ financial statements prepared not later than 2 months after the fiscal year ends and regional government financial reports prepared at least 3 (three) months after the fiscal year ends. interval independent variable experience (x1) experience of treasurer’s tenure of service. formal and non-formal education tenure of service socialization, training and workshop interval treasurer’s knowledge (x2) knowledge and understanding of the treasurer on accountability system according permendagri no.55/2008 administrative accountability system functional responsibility preparation accountability report system recording of cash receipts and interval asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 309 spendings system the cash receipts and spendings through treasurer bank account system the cash receipts and spendings through treasurer’s receipts bank account of cash general regional system the receipts through cash account of general regional system the receipt of cash deposit system 3.2 hypothesis test to test the proposed hypothesis, the multiple regression test with a mathematical form works as follows: y = a +b1x1+ b2x2 +e where: y = the effectiveness of administration and preparation accountability reporting system x1 = experience x2 = knowledge and understanding a = constant b = regression coefficient e = error the confirmatory factor analysis for the indicator model will generate a coefficient called the loading standard or lambda value (λ). the lambda values are used to assess the appropriateness of the instruments in the form of a factor. meanwhile, the analysis using sem warppls requires several fit indices to measure the accuracy of the proposed model. there are some suitability indices and the cut-off values in testing the acceptance or rejection of a model (feasibility test model) among others; the effect size, output combined loadings and cross loadings, output pattern loading and cross loading, output indicator weight, output latent variable coefficient, q squared (stoner-geisser coefficient), full collinearity test, output correlations among latent variables, output block vif, output correlation among indicators and output indirect and total effect if needed (kock, 2013). 4. findings and discussion 4.1 description of data there were 115 questionnaires distributed to respondents in batubara district (20 respondents), padang lawas district (25 respondents), south labuhan batu district (32 respondents), and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 310 north labuhan batu district (27 respondents). the detail of this distribution is illustrated in the following table: table 3. distribution of questionnaires particular total percentage distributed questionnaires 115 100% returned questionnaires 93 80.87% unreturned questionnaires 22 19.13% questionnaires analysized in the research 93 80.87% source: data output (2014) 4.2 analysis on the test of qualitative data 4.2.1 validity test from the 142 distributed questionnaires, the output’s combined loadings and cross loading are used as the indicators of the convergent validity, which is part of the measurement model in sem-pls (kock, 2013). the output is expected to show the constructs on the column and the indicators on the row which have obtained the results as follows: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 311 table 4. output combined loadings and cross-loading ********************* * indicator weights * ********************* pb_x1 peng_b_ x2 esppl_y se p value vif p1 0.000 0.000 0.000 0.074 <0.001 1.446 p2 0.000 0.000 0.000 0.022 <0.001 1.416 p3 0.000 0.000 0.000 0.041 <0.001 1.448 pp1 0.000 0.132 0.000 0.042 <0.001 1.966 pp2 0.000 0.160 0.000 0.036 <0.001 2.623 pp3 0.000 0.183 0.000 0.036 <0.001 4.327 pp4 0.000 0.187 0.000 0.032 <0.001 4.314 pp5 0.000 0.166 0.000 0.034 <0.001 2.162 pp6 0.000 0.170 0.000 0.034 <0.001 2.571 pp7 0.000 0.163 0.000 0.036 <0.001 3.031 pp8 0.000 0.167 0.000 0.038 <0.001 2.867 ef1 0.000 0.000 0.097 0.028 <0.001 1.489 ef2 0.000 0.000 0.126 0.034 <0.001 3.181 ef3 0.000 0.000 0.127 0.023 <0.001 3.374 ef4 0.000 0.000 0.118 0.031 <0.001 2.118 ef5 0.000 0.000 0.141 0.031 <0.001 3.573 ef6 0.000 0.000 0.139 0.025 <0.001 3.217 ef7 0.000 0.000 0.130 0.028 <0.001 2.313 ef8 0.000 0.000 0.126 0.028 <0.001 2.267 ef9 0.000 0.000 0.140 0.031 <0.001 6.957 ef10 0.000 0.000 0.142 0.040 <0.001 7.150 note: p values < 0.05 and vifs < 2.5 are desirable for formative indicators. source: data output warppls 3.0. (2014). based on the results above, it indicates that the outer model qualifies for the convergent validity of the reflective constructs, except for the indicator of p2 where it has found an insignificant p-value. thus, it needs to make an elimination of p2. meanwhile, the loading value above 0.70 and significant p-value of > 0.05 indicate that the outer model has fulfilled the convergent validity of the reflective constructs (hair et al., 2013). this construct test qualifies the requirement of the convergent validity and loading into another construct to be lower than that into the earlier construct. 4.2.2. reliability test based on the output of warppls, the reliability test is as follows: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 312 cronbach's alpha coefficients -------------------------- pb_x1 peng_b_x2 esppl_y 0.704 0.886 0.924 based on the reliability test on the 2 constructs, it obtains the cronbach’s alpha above 60%, thus all the questions are proven reliable. 4.3. goodness of fit model test the indicators of the model fit are based on three indicators; the average path coefficient (apc), the average r-squared (ars) and the average variance inflation factor (avif). the p value is given to both indicators of apc and ars that is computed by the resampling estimation and bonferroni-like correction (sholihin & ratmono, 2013). the results show: model fit indices and p values ----------------------------- apc=0.250, p<0.001 ars=0.167, p=0.044 avif=1.059, good if < 5 source: result test of warppls, 2014. thus, both the apc and the ars values are significant at the alpha level of below 5% and the avif value is below the value of 5, indicating that the model is fit. 4.4. classical assumption test testing the classical assumptions are done to determine that the regression models are acceptable econometrically. they are the normality, multicollinearity and heteroscedasticity tests. 4.4.1. normality test based on the test results for normality using the kolmogorov smirnov test and by looking at the graph, it is concluded that the residuals are normally distributed. if the probability value asymp. sig (2-tailed) on the kolmogorov smirnov test is greater than 0.05, it can be stated that the data are normally distributed, otherwise if the probability asymp. sig (2-tailed) is less than 0.05, thus the data are not normally distributed (ghozali, 2009). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 313 figure 2. normal p-plot of regression standardized residual source: data output spss figure 3. histogram by looking at the graphs displayed in figure 2, it can be concluded that the data spread around the diagonal line, and follow the direction of its diagonal line. this shows that the data residuals are normally distributed. similarly, with the results of the histogram graph in figure 3, it shows that the data residuals are normally distributed which can be seen from the picture in a bell form that is almost perfect (symmetrical). 4.4.2. multicollinearity test based on the results of the correlation test between the independent variables by looking at the value of the vif, it is concluded that the multicollinearity problem does not occur. this is supported by the full collon value. the vif is relatively small; not greater than 3.3 (kock, 2013). the results indicate that the independent variables do not occur in multicollinearity, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 314 whereby the avif results are all smaller than 5, justifying that the model is qualified for the classical assumption in the regression analysis. table 5. multicollinearity test result full collinearity vifs --------------------- pb_x1 peng_b_ esppl_y 1.080 1.164 1.188 source: result output of warppls 3.0. (2014) 4.4.3. heteroscedasticity test the test result has concluded that the heteroscedasticity did not occur in the regression model. it can be seen from the scatterplot in which the points are spread randomly or that they do not form a specific pattern clearly, and scattered both above and below 0 on the y axis (ghozali, 2009). figure 4. scatterplots graph 4.5 hypothesis test several hypotheses proposed in this study are as follows: 1. the experience and knowledge of treasurers’ task force units on permendagri no.55/2008 affect the effectiveness of the administration and preparation of the accountability reporting system. 2. the effectiveness of the administration and preparation of the accountability reporting system in accordance with permendagri no.55/2008 has been running effectively. the results of testing on the first hypothesis are unacceptable. to test the coefficient on individual partial regression of each independent variables can be seen in the following figure: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 315 figure 5. result output of warppls 3.0. from the structural equation modeling of the figure 5, the t-test statistic is obtained as follows: 1. the experience variable (x1) with a beta value of 0.16 and the p-value with 0.10 probability level. thus, it can be concluded that p = 0.17> α = 0.05, and we accept h0 and reject ha, whereby experience does not affect the effectiveness of the administration and preparation of the accountability reporting system. 2. the treasurer’s knowledge variable of task force units on permendagri no.55/2008 (x2) with a beta value of 0.34 and the p-value with a probability level of <0.01. it can be concluded that p = 0.01 <α = 0.05, and h0 is rejected and ha accepted, whereby the knowledge of treasurers’ task force units on permendagri no.55/2008 affects the effectiveness of the administration and preparation of the accountability reporting system. with the above elaboration, the multiple regression is formulated based on the path coefficient as follows: y = 0,164 x1 + 0,337 x2 + e the multiple regression model is interpreted as: 1. the experience variable (x1) does not affect the effectiveness of the administration and preparation of the accountability reporting system with the coefficient value of 0.164, meaning that each additional unit on the value of the experience variable score will raise the value of one unit of creation effectiveness of the administration and preparation of the accountability reporting system for 1.64 units. 2. the treasurer’s knowledge variable of task force units on permendagri no.55/2008 (x2) affects the effectiveness of the administration and preparation of the accountability reporting system with the coefficient value of 0.337, meaning that each additional unit of the value of the treasurer’s knowledge variable score, will raise the value of one unit of creation effectiveness of the administration and preparation of the accountability reporting system by 3.37 units. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 316 4.6 the result test of determinant coefficient (r2) the determinant coefficient is used to test the goodness-fit of the regression model that is seen from the value of r square. r square is the means for the endogenous construct. for a set of latent predictor variables on the criterion variable, an indicator of q-squares or any other terms called the stoner-geisser coefficient (sholihin & ratmono, 2013, p. 72) are used. determining the effect of variables; treasurer’s experience and knowledge on the effectiveness of the administration and preparation of the accountability reporting system can be seen on the greater value of q-squares coefficient on the results output of warppls 3.0. table 6. r-square coefficient no pb_x1 peng_b x2 esppl_y 1 0.174 source: result output of warppls, 2014. based on the calculation above, the q-squared coefficient value is 0.174. this means that 17.4% of the variables; treasurer’s experience and knowledge on permendagri no. 55/2008 on the effectiveness of the administration and preparation of the accountability reporting system can be explained by both independent variables, while the remaining 82.6% is explained by other factors outside the model. the estimated models show a good predictive validity of 17.4%. for the second problem related to the implementation on the effectiveness of the administration and preparation of the accountability reporting system in accordance with permendagri no.55/2008, it can be viewed from the respondents’ scores found in the variable of the effectiveness of the administration and preparation of the accountability reporting system (y), where there are 10 items of questions that have to achieve the maximum answer values of 50. the tabulation results of 93 respondents indicate the maximum response that reached 49 points and the lowest minimum that reached 22 points. the average response value reached 36.58 with a standard deviation of an average of 6.03. thus, the intensity of the average respondents’ responses was close to ‘strongly agreed’, which means lower effectiveness because it only reached 36.58%. 4.7 discussion the hypothesis that the variables of treasurer’s experience and knowledge of task force units on permendagri no.55/2008 affect the effectiveness of the administration and preparation of the accountability reporting system is acceptable. the results of this study contradict (inconsistent) the results found by pangkong et al. (2013) showing that experience is the dominant factor which determines the effectiveness of the administration and preparation of the accountability reporting system. without an experience, then all tasks done are unable to determine the direction. the higher the experience, the greater the determination of the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 317 effectiveness underlying the administration and the preparation accountability reporting system. regulations can be applied in such a way and can be run based on the experience of implementing the activities. meanwhile, the activities of data processes, collection, recording and summarizing alongside the financial reporting responsibilities within the framework of the implementation on each of the task force units have been well-performed, based on the understanding of the treasurers. the understanding covers the use of certain documents as the basis of recording among others; payment for the certificate, using credit notes and legal receipts and filling in the certificate of deposit. 5. conclusion and recommendation the conclusions of this research are: 1. the experience variable does not affect the effectiveness of the administration and preparation of the accountability reporting system. the results are inconsistent with the findings found by pangkong et al. (2013). 2. the treasurer’s knowledge of the task force units on permendagri no. 55/2008 affects the effectiveness of the administration and preparation of the accountability reporting system. these contradict the results established by pangkong et al. (2013). meanwhile, the suggestions of this study for further activities are: 1. in the future, it is necessary to acknowledge that experience is not a factor that determines the success of accountability reporting, while other factors such as the commitment of the head of task force units and the policies of accounting and internal control that are applied to the treasurers of task force units used to be a critical success factor. 2. moreover, concerning the knowledge on the permendagri no. 55/2008, it needs to be strengthened in the form of training and technical assistance as a reinforcement that can benefit the receipt and spending treasurers. references aliyah, s., & aida n. 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(2013). analisis faktor-faktor yang mempengaruhi waktu penyelesaian rekonsiliasi data sai satuan kerja (studi pada satuan kerja di wilayah kerja kppn malang). jurnal on line universitas brawijaya malang. microsoft word 5212-18906-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 175 the impact of information asymmetry and client credit on lending performance taiwan’s evidence cheng-li huang department of accounting, tamkang university, taiwan tel: (886-2)-26-215-656ext:3368 e-mail: chengli@mail.tku.edu.tw bih-yun kuo department of accounting, shih chien university, tamkanguniversity, taiwan tel: (886-2)-25-381-111ext:8215 e-mail: tatskuo@mail.usc.edu.tw received: feb. 28, 2014 accepted: april 8, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5212 url: http://dx.doi.org/10.5296/ajfa.v6i1.5212 abstract using panel data from taiwan, this paper examines the impact of information asymmetry and client credit on lending performance. banks without huge losses from bad debts and from credit card lending are categorized as high lending performance banks, whereas banks with heavy losses from bad debts and from credit card lending are categorized as low lending performance banks. firms are also divided into micro and small businesses (msbs) and medium and large businesses (mlbs). logit regression is used to identify the determinants of lending performance, including the levels of information asymmetry and client credit records. the empirical results show that: (1) mlbs with good information transparency tend to establish relationships with banks that are characterized by huge losses from bad debts and from credit card lending. (2) small foreign firms, as well as mlbs with high profitability, cash and r&d expenditure ratios prefer having relationships with banks with good lending performance and low credit risk. (3) mlbs and msbs with poor credit records prefer having relationships with banks that have good lending performance and low credit risk. keywords: information asymmetry, client credit record, lending performance, micro and small business, medium and large business asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 176 1. introduction during the period from 1997 to 2008, the asian financial crisis (1997), the credit card storm (october 2005), the subprime mortgage (august 2007) and the fannie mae and freddie mac events (july 2008) continually impacted taiwan’s financial markets. faced with these severe disasters, taiwan responded by enacting its first and second financial reforms. the banking management system accompanied this change. this study uses the database managed by the joint credit information center to perform its empirical tests. we divided banks into those with or without huge losses from bad debts and heavy losses from credit card lending. we also divided firms into msbs and mlbs. information asymmetries with respect to the quality of the borrower’s assets and the accuracy of its credit risk estimates may raise the costs of credit risk management faced by bank credit officers. the situations are somewhat different according to the scale or the transparency level of the firms involved. the more opaque a firm is, the more that it is characterized by information asymmetry (myers and majluf, 1984; lummer and mcconnell, 1989; kuo and chen, 2012). to reduce the information asymmetry, the credit officer will ask borrowers to provide audited financial statements for the last three years when handling applications for loans. however, this requirement only applies to medium and large businesses (hereafter mlbs) where the capital or amount borrowed exceeds nt$30 million in taiwan, and does not apply to micro and small businesses (hereafter msbs). therefore, in the cases where msbs apply for loans, banks cannot check their financial position through their audited financial statements. in practice, banks can only use public information that can be accessed from the database of the joint credit information center (jcic) to evaluate the firm’s credit quality. among the available items, the most commonly used are the “credit records of borrowers” and “credit score of the chairperson” (kuo and chen, 2012). from the perspective of the lending management, banks require borrowers to file audited financial statements for the last three years. banks verify the past credit records of the firms and the credit score of the chairperson1 by checking the information provided by jcic. therefore, it is important for banks to understand that when they use the information supplied by jcic they will exhibit improved lending performance. our purpose in this paper is to examine the impact of information asymmetry and client credit on lending performance. we extend the previous empirical work in several ways. first, for business confidentiality, prior research only includes the data from mlbs, but this study includes information from both mlbs and msbs. we find that the loan behaviors of the two exhibit significant differences. second, this study focuses on the business of corporate and retail finance in order to observe the impact of the factors related to lending performance. third, the samples used also include clients who had been rejected by banks due to default or due to the fact that their credit scores were below the standard required but have now been approved for the loan process. we recognize that this approach can completely and comprehensively impact the factors influencing lending performance. it is important to distinguish between whether the lending performance improved with the enhanced lending system and whether the improvement in lending performance was simply due to a changing operating environment. regulators and researchers are particularly interested in the lending performance of banks and market conditions have changed asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 177 significantly for banks as the financial system in taiwan has undergone drastic change. therefore, the sample period selected in this study covers a time period in which the financial marketplace has undergone serious economic and financial environmental change. during this period, the taiwan banking industry had experienced two major financial events, one being related to corporate finance and the other to retail finance. in accordance with financial statistics monthly, issued by the central bank of republic of china, we classify our samples into an empirical group (with more than nt$50 billion of accumulated bad debts written off in the five years prior to 2008, referred to as “wobd” hereafter) and the control group2 (without nt$50 billion in bad debts written off in the five years prior to 2008, referred to as without “wobd” hereafter). we refer to the retail finance events as a credit card storm, and also divide the samples into an empirical group (with heavy credit card losses, hereafter referred to as “hccl”) and a control group3 (without heavy credit card losses, hereafter referred to as without “hccl”). in taiwan, mlbs have more flexibility in raising capital. they can borrow from banks issuing commercial paper, straight bonds or convertible bonds4. however, msbs can only borrow from banks. therefore, we divide the borrowers into msbs and mlbs5 while performing the statistical analysis and carrying out the tests. we look at the impact of information asymmetry and client credit on lending performance for different sizes of firms. furthermore, we are of the opinion that lending performance may differ by type of banks due to different risks from corporate and retail finance. thus, we divide the banks into banks with and without heavy losses from corporate or retail finance. in a nutshell, our samples are classified as consisting of borrowers obtaining finance from banks with “wobd” or without “wobd” and borrowers obtaining finance from banks with “hccl” or without “hccl”. to clarify the direct and indirect impacts of the differences in corporate and retail finance, we deliberately verify the impacts of the events individually6. all banks are simply divided into banks “with” and “without” “wobd” and “hccl”, to reflect the level of lending performance and credit risk. the empirical work is summarized as follows: (1) by comparing the information asymmetry and client credit7 for banks with and without “wobd” through the use of the t-statistics test and the non-parametric wilcoxon rank-sum test, we examine whether there are significant differences for these two types of banks. (2) by comparing the information asymmetry and client credit for banks with and without “hccl” using the t-statistics test and the non-parametric wilcoxon rank-sum test, we examine whether there are significant differences between these two types of banks. (3) we then segment the samples into high-performance and low-performance banks based on “wobd”. banks with “wobd” are categorized as banks with low-performance and high credit risk, whereas banks without “wobd are categorized as having high-performance and low credit risk. the logistic regression models each have a set of independent variables, including information asymmetry and client credit. using the logit model, we investigate whether the borrowers’ information asymmetry and credit records contain statistically significant differences among the banks with and without “wobd”. (4) finally, we regard banks with “hccl” as the banks with low-performance and high credit risk (the value of the dependent variable in the empirical asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 178 model equals 1). by contrast, we regard banks without “hccl” as those banks with high-performance and low credit risk (the value of the dependent variable equals 0). using a logit model, we investigate whether the borrowers’ information asymmetries and credit records are characterized by statistically significant differences between the banks with and those without “hccl”. 2. literature review and hypothesis development 2.1 literature review myers and majluf (1984) indicated that firms that have been in existence for only a short time and firms that are small in size tend to be characterized by severe information asymmetry, and therefore banks are reluctant to lend to them. these firms thus face severe financing difficulties. lummer and mcconnell (1989), however, found that creditor banks are still willing to lend to borrowers with asymmetric information. this conveys a positive message to the external investors, thereby reducing the information asymmetry condition. agarwal and eiston (2001) indicated that firms with better operating structures would like to borrow from banks with a better credit quality in order to receive a better appraisal from the enterprise’s external investors. kuo and chen (2012) found that the asymmetries between the borrowing customers and creditor banks may differ depending on the respective sizes of the firm. the smaller the scale of the opaque firms, the more severe is the information asymmetry. in respect of the research and switching costs, diamond (1989), boot and thakor (1994) and petersen and rajan (1994) all found that banks will charge a lower price to reflect the reduction in research costs. when borrowers are aware of the high costs of switching banks, they will be strongly motivated to continue dealing with the original bank and will pay less attention to the changes in the bank’s credit risk. in practice, msbs in taiwan actually distort their financial statements through a variety of methods. therefore, banks cannot accurately evaluate the credit risk of borrowers by examining their financial characteristics purely based on their financial statements. therefore, within the banking industry8, in addition to the financial data, they also resort to non-financial measures to evaluate the lending case. ruan and jing (2003) used samples consisting of medium-sized and small and medium enterprises (smes) and found that by combining financial information with non-financial information they could achieve the best lending performance. li (2005) included all the variables for credit rating in the logistic regression model and built models of financial indicators, non-financial indicators and integrated indicators. his results suggest that the most accurate prediction rate provided by these three empirical models was that of the integrated indicators’ model, especially when it came to predicting the default rate of the firms, followed by the empirical model for the financial indicators. the worst model was that which only used non-financial indicators. from the perspective of the variables used to describe lending management, zhang et al. (2006) found that if the empirical model included a dummy variable to distinguish the borrower’s industry, the model’s accuracy was generally better than it was without that dummy. in the empirical tests for sme lending cases, zeng et al. (2009) found that the financial information provided the ability to distinguish between defaulting corporations and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 179 normal corporations. ruan and jiang (2004) conducted a study on the default predictions for privately-held companies that did not file audited financial statements, and found that the credit rating, the frequency of inquiries, the rate of utilization of the amount of credit and the payment record significantly increased the ability of banks to discriminate between the various applications for loans. 2.2 hypothesis development according to taiwan’s lending practices, when applying for bank loans, mlbs should provide audited financial statements for the past three years, and inquiries should be made through jcic to ascertain the credit score of the chairperson and whether or not the mlbs and msbs have had bad credit records in the past. however, as to whether these practices can enhance the lending performance and reduce the credit risk is a matter worth systematic investigation. past empirical studies have been more focused on how the ownership type, scale and transaction frequency have impacted the banking relationship. to our knowledge, there are no studies using “wobd” and “hccl” that have sought to reflect bank lending performance and further explore how the information asymmetry and credit records of the borrowers impact lending performance. based on our understanding, banks that belong to the “wobd” category are always large in scale and banks that belong to the “hccl” category are mixed, including large and small banks. most of the “hccl” banks are newly-established banks. therefore, we refer to the following relevant articles in developing our hypotheses: “careless lenders and bad borrowers, “(shen and wang, 2002), “the top one and non-top one financing bank–viewpoints of lending behavior,” (chen and lai, 2003). berger et al. (2008) referred to the five relationships motivation theory9 which also provided us with the inspiration to predict the positive or negative directions of our results. the following four hypotheses are presented and discussed: hypothesis 1: firms with more transparent information are more likely to have their loan applications approved, regardless of whether the lending performance of the bank is good or bad. according to the past research literature, large banks have advantages with hard information; however, small banks make the most of soft information to develop new clients. banks with “wobd” often happen to be large banks, but “hccl” occurs in any kind of bank. regardless of the scale or the lending performance of the banks, they all prefer to lend to enterprises with more transparent information. the preference level may be associated with the lending type, scale and performance.10 another possible reason why banks have a different attitude towards credit risk is the dramatic change in the competitive banking environment11 in taiwan. because of this, in addition to using the measures of scale and length of time in existence to reflect the level of information asymmetry, we also include a measure referred to as “before or after the approval of the policy for the establishment of new banks”. to sum up, firms with more capital and assets, that have been in existence for a longer period of time, and that received their loans “before or after the approval of the policy for the establishment of new banks” will be deemed to be more transparent and with less shortage of information asymmetry. such firms and their loan applications are welcomed by asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 180 any kind of bank. if banks with and without “wobd” contain significant differences in information transparency, this may indicate that banks without “wobd” place more emphasis on information transparency. the same inferences apply to banks without “hccl”. hypothesis 2: it is easier for borrowers with a better credit history to establish relationships with banks, regardless of the bank’s lending performance. however, whether or not a bank with low performance will reduce its contact with borrowers with a bad credit history to avoid incurring a high non-performing loan (hereafter npl) ratio has yet to be verified. the same question applies to banks with a low performance, but that have had previous relationships with borrowers with a bad credit history. banks with high lending performance prefer to do business with firms whose chairperson has a good credit score. this is not usually the case for banks with low lending performance. according to the efficient frontier in portfolio theory, banks should pursue the highest rate of return within the specified risk appetite. banks should choose the optimal client and assume a reasonable amount of credit risk, but not always look for the best borrower12. if a potential client has had a bad credit record in the past, it is right for a bank to deal with such a case in a prudent manner. different banks deal with such cases in different ways. while some banks may abandon this type of business to avoid a high npl ratio, other banks are attracted by a high loan spread, all of which depends on the firm’s situation and lending performance. from the perspective of the borrower, as long as the borrower can raise sufficient funds to meet its debt capacity and loan interest rates are still low, then the borrower will be more willing to make contact with any kind of bank, without considering whether its lending performance is good or bad. many studies on the taiwan economy have shown that, unless policy-related subsidies or government relief measures are in place when banks face such loan applications from borrowers, the banks will normally ask firms to provide collateral. they will also look to see if the chairperson’s credit score is above the threshold criteria, and will require a guarantee from the chairperson13. hypothesis 3: borrowers that are publicly-held firms, or belong to conglomerates, and have lower industry concentration risk are more attractive to any kind of banks. large foreign companies are commonly multi-national, have good reputations and have a need to raise funds, and so they are more willing to build a relationship with any kind of bank. small foreign companies in taiwan would rather choose a steady relationship with one bank that has a good lending performance within this over-banking environment. the fifth motivation theory regarding the banking relationship discussed in berger et al. (2008) and kuo and chen (2012) emphasizes the importance of the cost and benefit of monitoring. therefore, banks with good lending performance (without “wobd” and “hccl”) prefer having relationships with listed and otc companies rather than with publicly-held companies. however, they would also prefer having relationships with publicly-held companies than with privately-held companies. they usually adopt the same approach with msbs. banks still prefer having relationships with corporations to relationships with proprietorships, partnerships or limited companies. it must also be understood that companies that are publicly-held respond differently to a bank’s credit risk asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 181 and performance, and vice versa. if a borrower is a member of a conglomerate and belongs to a high-tech or traditional industry, it needs to be asked whether this will affect the preferences of banks. it actually depends on whether the risk associated with the secured or unsecured loan related to the borrower or affiliated company exceeds the risk limits and industry concentration risk approved by the bank. according to the first and second motivation theories of banking relationships, if the borrower’s predetermined scale of debt is greater than the risk appetite of the bank, then it will be rejected, and the borrower will then deal with another bank. however, it cannot be determined for certain whether the borrower will determine its banking preference according to a bank’s lending performance. in this paper, we also use the marginal value generated from the empirical models of “wobd” and “hccl” to predict the sensitivity to lending performance. previous studies indicate that foreign enterprises prefer relationships with foreign banks. there are no obvious conclusions as to whether foreign enterprises will change their behavior based on a foreign bank’s credit risk. we will conduct empirical tests in this paper, too. hypothesis 4: mlbs with higher financial leverage induce higher financial risk. to fulfill their cash needs, mlbs with higher financial leverage tend to build relationships with banks regardless of the bank’s lending performance. when the r&d expenditure to total capital ratio, profitability ratio and cash ratio (measured by the ratio of cash and cash equivalents to sales) are enhanced, due to the fact that funding pressure is reduced, these mlbs will tend to build relationships with banks with low credit risk and better lending performance. according to the viewpoints of brick-palia (2007), the lower financial leverage ratio, higher profitability ratio, and cash ratio will lead to lower loan spreads. this means that when banks perceive that certain clients have a low credit risk, they will be more willing to use lower interest rates to establish a relationship with them. when the clients’ financial indicators, as mentioned above, reflect the expected level, banks with different lending performances will be eager to provide sufficient funds to meet their needs and to establish relationships with them. however, whether the motives for building relationships contain significant differences is still uncertain. it is thus good to show that clients are running their businesses soundly when the ratio of r&d expenditures increases, because this implies that the clients use long-term debt or funds to support their need for long-term intellectual capital. it is quite common for banks with different lending performances to be keen to meet their borrowers’ financing needs, but it is worth deeply examining whether the lending motivation is different. 3. research design 3.1 data sources in taiwan, the joint credit information center (jcic) is a unique organization that is constantly collecting the credit information data of both individuals and enterprises. these data are collected from financial institutions on a long-term basis. the factors that influence the credit risk of enterprise borrowers are more complicated than those that influence the credit risk of individual borrowers. it is for this reason that this study focuses on examining samples of enterprise borrowers and ignores the issues of individual borrowers. our data sources are the jcic database established in 2007. to effectively reflect the credit records asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 182 and credit scores of the businesses and their chairpersons, we use the population14 information on the enterprises followed by jcic. in addition, to grasp the real picture of the lending performance in the case of firms with and without “wobd” and “hccl”, we purposely choose the empirical period 2006-2008, a time period that followed the two important financial events referred to earlier. our observations are focused on the new loan cases of the creditor banks15. in considering the principle of materiality and the representativeness of the data, the relationship banks should be in the list of the top 20 banks, as measured by the amounts lent to the clients. as mentioned before, we use data from jcic to investigate the information asymmetry and credit records of borrowers associated with banks with different lending performances. the samples used in this study consist of borrowing firms16 and their lending banks. we define the borrowing firms as msbs (a total of 122,759 firms) where their capital and amounts borrowed are less than nt$30 million at the same time. when either of the capital and amounts borrowed exceed nt$30 million, we define the borrowing firms as mlbs (a total of 31,314 firms). moreover, we divide the mlbs17 into three kinds of organizations, “listed or over-the-counter (otc)” (1,174 firms), “publicly held but not listed or otc” (966 firms) and “privately-held with audited financial statements” (15,908 firms).18 the msbs contained in the database of the jcic are privately-held businesses that do not file audited financial statements with the lending banks. we further divide those businesses into “proprietorships, partnerships and limited companies” (89,295 firms) and “corporation” (33,464 firms). we divide the borrowers’ industries into the following four categories19: electronic manufacturing industry (msbs 2,530, mlbs 2,265), non-electronic manufacturing industry (msbs 31,590, mlbs 10,203), wholesale and retail business (msbs 56,794, mlbs 8,107) and other industries (mainly consisting of construction, real estate and investment industries (msbs 31,845, mlbs 10,739). we use wobd and hccl to distinguish banks with high or low credit risk and operating performance. among banks with “wobd”, we have selected 57,948 msbs and 10,023 mlbs. among banks without “wobd”, we have selected 75,619 msbs and 5,691 mlbs. among banks with “hccl”, we have selected 35,369 msbs and 5,343 mlbs, and among banks without “hccl”, we have selected 98,198 msbs and 10,371 mlbs. there are 513 listed, 404 otc, 133 emerging stock and 166 companies publicly-held but not included in the former three markets, giving a total of 1,210 companies used in this study. 3.2 operational definition of variables in order to explore whether the lending performance was impacted by information asymmetry and credit records, we grouped the factors into four dimensions and nineteen independent variables as follows: (1) level of asymmetric information (the dimension symbol is info). info includes the size of the borrowers. (the sizes of msbs and mlbs are measured by capital registered and total assets, respectively. we take the natural logarithm of capital registered and total assets as the proxy for firm size. the variables’ symbols are info_01 and info_02, respectively.) the second variable of info is existing length, measured by months (the variable is info_03). the third variable of info is when the borrowing firm was founded. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 183 (before or after the deregulation to allow the establishment of new banks, the variable is info_04. which is a dummy variable and we denote the value as 1 when the borrower was found before 1993 otherwise the value is 0.) (2) organization and industry type of the borrowers (the dimension symbol is com). in mlb sample, we use two dummy variables (com_01 and com_02) to distinguish between listed, otc, publicly-held and privately-held companies. if the company belongs to listed firms, the dummy variable com_01 equal 1, otherwise the value is 0. if the company belongs to otc firms, the dummy variable com_02 equal 1, otherwise the value is 0. in the msb sample, we use the dummy variable com_03 to distinguish between corporations, proprietorships, partnerships and limited companies. when the msb belongs to corporation the dummy variable equal 1, otherwise the value is 0. we use com_04 to distinguish whether or not the borrowing company belongs to a conglomerate if yes the dummy variable equals 1, otherwise the value is 0. we then use the dummy variables com_05 and com_06 to distinguish between foreign, state-owned or domestic companies. if the borrower belongs to foreign firms, the dummy variable com_05 equals 1, otherwise the value is 0. if the borrower belongs to state-owned the dummy variable com_06 equals 1, otherwise the value is 0. we also use the dummy variables com_07, com_08, com_09 to distinguish four kinds of industry: electronic manufacturing, non-electronic manufacturing, wholesale and retail, and others (including the construction, real estate, and investment industries). if the borrower belongs to electronic manufacturing, the dummy variable com_07 equals 1, otherwise the value is 0. if the borrower belongs to non-electronic manufacturing, the dummy variable com_08 equals 1, otherwise the value is 0. if the borrower belongs to wholesale and retail, the dummy variable com_09 equals 1, otherwise the value is 0. (3) financial characteristics of the borrowers (the dimension symbol is fin). given that mlbs should file audited financial statements with the lending banks, in our empirical model, only mlbs are included in the dimension of financial variables. the financial variables of the borrowers include the financial leverage ratio (measured by total liabilities over total equities (%), fin_01), the r&d expenditure ratio (measured by total r&d expenses over total equities (%), fin_02), the profitability ratio20 (measured by ebit over sales (%), fin_03), and the cash ratio (measured by cash-in-hand and cash equivalent over sales (%), fin_04). (4) credit records of borrowers (the dimension symbol is credit). this refers to whether the borrowers have faced the situation where their loans are overdue, they have defaulted, have incurred bad debts or not sufficient fund (nsf) (credit_01). we also measure the credit rating score21 of the chairperson of the borrowing firm (the symbol is credit_02). (the relevant magnitudes are obtained from the database of jcic window j10.) as mentioned before, we use with or without wobd and with or without hccl to measure the lending performances of the sample banks. (the dimension symbol is status, and the two dependent variables are status_01 and status_02.) if the bank has written off over nt$50 billion of bad debts within the last 5 years, the dependent dummy variable status_01 equals 1, otherwise the dummy variable’s value is 0. the same principles and procedures are applied to hccl. when a bank has experienced heavy credit card loss, the dependent dummy variable status_02 equals 1, otherwise the dummy variable’s value is 0. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 184 table 1. summary of dimensions and variables dimensions attributes variable symbols lending performance dependent dummy variables status_01, status_02 info (level of asymmetric information ) size info_01 for msbs, info_02 for mlbs existing length info_03 company established before or after 1993 info_04 com (organization and industry types of the borrowers) organization types com_01, com_02 for mlbs com_03 for msbs conglomerate com_04 ownership com_05, com_06 industry classification com_07,com_08 com_09 fin (financial characteristics of the borrowers) financial leverage fin_01 r&d ratio fin_02 profitability ratio fin_03 cash ratio fin_04 credit (credit records of borrowers) borrower with or without bad credit record in the past credit_01 credit score of chairperson credit_02 3.3 empirical model we use logit regression to identify the determinants of lending performance. we examine how the information asymmetry and client credit records of the msbs and mlbs impact the lending performance. according to the respective impacts of corporate finance and retail finance, we divide the credit risk and performance into two types: one is impacted by corporate finance referred to as with or without “wobd”, the other is impacted by retail finance, and is referred to as with or without “hccl”. we develop a separate model to perform the empirical testing. when using the with or without “wobd” model, the sample borrowers are selected from the corresponding banks. if the sample firms borrow from the bank with “wobd”, the value of the dependent variable of the empirical logit model is 1, otherwise it is 022. the same principles apply to with or without “hccl” model. if the sample data are from a bank with “hccl”, the value of the dependent variable of the empirical logit model is 1, otherwise it is 0. this study not only considers the difference in lending performance but also considers a firm’s scale, because the attributes of the msbs and mlbs that exist are obviously different (kuo and chen, 2012.). because of this, we develop two models to be applied for msbs and mlbs. the empirical logit models are demonstrated as formulas (1) and (2). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 185 ln[p (status)x/(1-p(status)x)]= 0β + iinfo m i i =1 β + j n j jcom =1 γ + = p l l lcredit 1 ϕ (1) ln[p(status) z/(1-p(status)z)]= 0β + iinfo m i i =1 β + j n j jcom =1 γ + k o k k fin =1 φ + = p l l lcredit 1 ϕ (2) formula (1) depicts the factors impacting the lending performance in relation to msbs, while formula (2) also depicts the factors impacting the lending performance in regard to mlbs. both formulas include the dimensions of info (level of information asymmetry), com (organization and industry types) and credit (credit records of borrowers), but only formula (2) for mlbs includes the dimension of fin (financial characteristic of borrowers). the variables are described in table 1. 4. empirical results we will summarize the empirical testing process over the next three subsections. first, we use the t-test and non-parametric wilcoxon rank-sum test to verify whether the mean and median are significantly different from the perspectives of information asymmetry and client credit in banks with and without “wobd” and “hccl”. as mentioned earlier, we divide borrowers into msbs and mlbs and discuss each one separately. in the second and third sections, we discuss how the borrowers with their own advantage or situation build relationships with banks with different levels of credit risk and lending performance. to be specific, we regard banks with “wobd” and “hccl” as banks with low performance and high credit risk. our control sample consists of banks without “wobd” and “hccl” and with high performance and low credit risk. we use a logit model to investigate whether the borrowers' information asymmetry and credit records contain statistically significant differences between banks with and without “wobd” and “hccl”. 4.1 whether or not the borrowers are significantly different 4.1.1 comparisons among msbs table 2 displays the findings that banks with “wobd” and “hccl” prefer dealing with msbs that are relatively large in scale. the average capital ranges between nt$0.028 billion and nt$0.033 billion, which is significantly higher than the controlled samples23 with between nt$0.017 billion and nt$0.018 billion at the 1% level. compared with factors for the length of time in existence (in months) and the year of establishment, we find that banks with “wobd” prefer building relationships with msbs characterized by longer lengths of time in existence. banks with “hccl” show no significant differences in this respect. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 186 compared with the median of existing length, banks with “wobd” have existed for an average of 158 months, which is significantly longer than for banks without “wobd”, for which the average is 140 months. the former generally had more clients and a more sustained borrower-lender relationship before the new bank policy to approve the establishment of new banks was introduced. the ratio is significantly higher than the latter at the 1% level. compared to sole proprietorships, partnerships and limited companies, banks with “wobd” engage in more lending business with corporations. the ratio is 34%, which is significantly higher than the 30% for the control sample. banks with “hccl” prefer relationships with clients that are sole proprietorships, partnerships or limited companies than with corporate types of organizations. the ratio is 29%, which is significantly lower than that for banks without “hccl” (32%). as to whether msbs that belong to conglomerates can decrease or increase the risks posed to the creditor banks with different lending performances presents a severe challenge to the banks’ ability to manage credit. the empirical results show that the ratios of the clients belonging to conglomerates that build relationships with banks with “wobd and hccl” are 0.4% and 0.5%, respectively, which are significantly higher than those for the control samples with 0.3% and 0.3% at the 1% level. this indicates that lending to companies belonging to a conglomerate does not ensure that the quality of credit is reliable (for banks with “wobd”). if banks lend to a subsidiary of a conglomerate, they will be concerned about the efficiency or performance of any related business unit related to that conglomerate, because the whole conglomerate may be affected. another empirical result shows that banks without “wobd and hccl” will tend to lend to small foreign companies, for which the ratios are 0.3% and 0.3%, significantly higher than those for the control samples of 0.1% and 0.1%. the implication is that small foreign companies pose less credit risk, and so it is reasonable to promote business lending to them. lending in the cases of banks with “wobd and hccl”, which carry poor credit records are up to 22% and 26%, which were significantly higher than the control samples of 17% and 17%. this explains why these banks have a higher credit risk. when comparing from the aspect of the credit score of the chairperson, the empirical results are quite similar in that cases of lending by banks with “wobd and hccl” have an average credit ratings of 509.72 and 473.63, respectively, which is significantly lower than the 541.45 and 548.28 for the control samples. 4.1.2 comparison among mlbs from the results of table 2, we found that the lending behaviors of banks with different lending performances were quite similar, including in terms of asset size, the length of time in existence and the company’s year of establishment. this means that banks with “wobd and hccl” prefer building relationships with large-scale companies, whose average total assets are between nt$1,536 million and nt$2,481 million. these averages are significantly larger than those for the control samples where the average total assets were between nt$526 and nt$495 million at the 1% level. from the perspective of the length of time in existence and the company’s year of establishment in the case of the mlbs, banks with “hccl” were significantly smaller than banks without “hccl” at the 5% level. variables related to banks with “wobd” were significantly larger those for than banks without “wobd” at the 1% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 187 level. from the perspective of the type of organization, banks with “wobd and hccl” preferred building relationships with publicly-held or otc firms (8% and 12%), which were significantly higher than those for the control samples (4% and 4%) at the 1% level. for clients belonging to conglomerates (13% and 19%), the ratios were significantly higher than for the control samples (7% and 7%) at the 1% level. as to the comparison of the financial variables, we found that clients of banks with “wobd” had a significantly higher financial leverage ratio (the mean was 246.13%) than the control samples (230.44%) at the 1% level. the median rose to 200.59%. this seems to indicate that banks with “wobd” accept lending business from mlbs with a higher financial leverage ratio which will lead to higher credit risk. the means of the mlbs of banks with “hccl” are 0.98% and 5.31% based on the ratios of r&d expenditures and profitability, which are significantly higher than the corresponding 0.58% and 4.08% for the control samples at the 1% level. the cash ratio of 9.89% is significantly lower than the 11.83% for the control samples at the same level. this reveals that when compared to the r&d expenditures and profitability ratios, the cash ratio can better reflect the quality of credit risk. from the perspective of the past credit records of banks with different lending performances, there is no significant difference between the experimental and control samples. the credit score of the chairperson of mlbs of banks with “wobd and hccl” (the average scores are 644.32 and 628.96, and the medians are 656 and 639) is significantly lower than for the control samples (the average scores are 657.81 and 659.91, and the medians are 673 and 674) at the 1% level. this seems to reflect the fact that banks with low lending performance ignore the fact that the credit score of the chairperson can serve as a signal of credit risk. 4.2. the logit model distinguished by with or without “wobd” events in this study, we measure a bank’s lending performance according to whether it encounters the events of “wobd” and “hccl.” therefore, we divide the relationship banks into those with “wobd” and those with “hccl.” for purposes of comparison, we also choose the clients of banks without “wobd” and “hccl” as the control samples24. with respect to the borrowers, “wobd” results from corporate financial failure and impacts the financing needs directly, while “hccl” results from retail financing failure, which only impacts financing needs indirectly. however, each circumstance will increase the credit risk of banks. if bad experiences accrue at the same time, the credit risk will increase dramatically. to clarify the different responses from the direct and indirect impacts, we test both events individually, and simply divide the banks into those with or without “wobd” or “hccl”. banks with “wobd” and “hccl” are characterized by high credit risk and low lending performance. banks without “wobd” and “hccl” are characterized by low credit risk and high lending performance. to avoid confused perceptions of lending behavior, we exclude the samples of borrowers who maintain relationships with banks with both high and low credit risks. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 188 table 2. comparison of msbs and mlbs from different perspectives d im ensions impact variables borrowers: msbs borrowers: mlbs “wobd” events “hccl” events “wobd” events “hccl” events y n y n y n y n samples 57,948 75,619 35,369 98,198 10,023 5,691 5,343 10,371 info info_01 or info_02 m 0.28*** 0.17 0.33*** 0.18 5.26 24.81*** 4.95 4.95 m 0.05*** 0.05 0.05*** 0.05 1.33 2.37*** 1.4 1.4 info_03 m 172.99*** 156.57 152*** 167.98 204.88 217.52** 222.95 222.95 m 158*** 140 134*** 154 189 199*** 209 209 info_04 m 0.46*** 0.4 0.37*** 0.44 0.56 0.6*** 0.63 0.63 m 0*** 0 0*** 0 1 1*** 1 1 fin fin_01 m 230.44 236.36** 242.55 242.55 m 179.07 194.23 192.10 192.10 fin_02 m 0.69 0.98*** 0.58 0.58 m 0 0*** 0 0 fin_03 m 4.59 5.31*** 4.08 4.08 m 2.84 3.24*** 2.68 2.68 fin_04 m 13.46 9.89*** 11.83 11.83 m 6.97 5.39*** 6.16 6.16 c redit credit_01 m 0.22*** 0.17 0.26*** 0.17 0.004 0.004 0.003 0.003 m 0*** 0 0*** 0 0 0 0 0 credit_02 m 509.72*** 541.45 473.63*** 548.28 657.81 628.96*** 659.91 659.91 m 624*** 640 580*** 647 673 639*** 674 674 note 1: the symbols y and n indicate that the events occur and do not occur. the mean (m) and ymedian (m) of the variables in each dimension are examined by t and the wilcoxon rank sum tests. ***, ** and * indicate significance at the 0.01, 0.05 and 0.1 levels, respectively. note 2: for simplicity, table 2 does not present the descriptive statistics of the dummy variable com_01-com_09 in dimension com. the empirical findings in table 3 indicate that enterprises featured by “large size and a long period of time in existence” have good information transparency and tend to25 build relationships with banks with “wobd”. the coefficients of the regression model for msbs are 0.18 and 0.001, and for mlbs are 0.30 and 0.009, respectively. although “large size and a long period of time in existence” are symbols of good information transparency, they are not an assurance of less operating risk. therefore banks should deal with loan applications more prudently, especially during times of recession. if banks do not have a sound risk limiting system, nor a facilities ratings system to manage industry concentration risk and they blindly adopt the lending business practices of borrowers with highly transparent information, they may suffer considerable losses in the near future. this phenomenon has become even more severe due to the lending market facing intense competition after the announcement of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 189 the policy to approve the establishment of new banks. banks with high credit risk purposely expand and extend their conditions and criteria of lending to attract new and opaque companies (the coefficient is -0.04). from the perspective of the organization type and industry of the enterprise, compared to private enterprises, foreign companies prefer establishing relationship with low credit risk bank (the coefficient is -1.02). compared to sole proprietorships, partnerships and limited companies, it seems that corporations prefer building relationships with low credit risk banks (the coefficient is -0.04). compared to the construction and real estate industry, it seems that firms within the electronic and the non-electronic manufacturing industries and wholesale industries (the coefficients are 0.11, 0.06 and 0.24, respectively) prefer to build relationships with high credit risk bank. compared to privately-held companies, it seems that publicly-held companies (the coefficient is 0.28, and the odds ratio is 1.32) prefer to build relationships with high credit risk banks. compared to publicly-held companies, it seems that listed and otc firms (the coefficient is 0.33, and the odds ratio is 1.4) prefer to establish relationships with high credit risk banks. this implies that such banks do not have a comprehensive understanding of the industrial environment. although higher public offerings will accompany those companies with more transparency, they do not guarantee better profitability. hence, it is beneficial to remain alert when dealing with clients in such situations to reduce risk and enhance performance. from the perspective of the borrower’s financial variables, large clients with high profitability ratios, cash ratios and r&d expenditure ratios prefer building relationships with banks with low credit risk (the coefficients are -0.004, -0.009 and -0.025, respectively). only companies with high financial leverage ratios select or are accepted by banks with high credit risk (the coefficient is 0.0005). however, it is not worthwhile adopting such lending business at the expense of increasing credit risk. both msbs and mlbs with poor credit records prefer building relationships with low credit risk banks (the coefficient in large companies is -2.12, which is significant at the 1% level). if the credit score of the borrower’s chairperson is increasing, it will tend to access finance from low credit risk banks. the coefficients of the msbs and mlbs are -0.0006 and -0.0035, respectively. this perhaps reflects the fact that banks with low credit risk have low liquidity risk. therefore, they should be concerned about the prospects of such a company and only with caution agree to meet the financing demands of the company. it is critical to only proceed if the bank receives assurances from the chairperson or directors or supervisors. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 190 table 3. using logit model to distinguish credit risk by “wobd” event dimensions status_01 msbs odd ratio mlbs odd ratio intercept 0.283*** 2.2194*** info info_01 0.1801*** 1.197 info_02 0.2966*** 1.345 info_03 0.00105*** 1.001 0.0009*** 1.001 info_04 -0.0417** 0.959 0.1412** 1.152 com com_01 0.2787** 1.321 com_02 0.3326*** 1.395 com_03 -0.0429*** 0.958 com_04 -0.1043 0.901 -0.0962 0.908 com_05 -1.0232*** 0.359 -0.9261 0.396 com_06 0.0492 1.05 8.5285 >999.999 com_07 0.1149*** 1.122 0.0115 1.012 com_08 0.0553*** 1.057 0.0737 1.077 com_09 0.2391*** 1.27 0.4329*** 1.542 fin fin_01 0.00054*** 1.001 fin_02 -0.0247*** 0.976 fin_03 -0.00422*** 0.996 fin_04 -0.00934*** 0.991 credit credit_01 -0.00755 0.992 -2.1188*** 0.12 credit_02 -0.00056*** 0.999 -0.00348*** 0.997 note 1: ***, ** and * denote significance at the 0.01, 0.05 and 0.1 levels, respectively. note 2: the likelihood ratio (chi-square value) of the logit model for msbs is 2,348.45, and the likelihood ratio (chi-square value) of the logit model for mlbs is 936.47, which shows that the model had good fit at the 1% level. 4.3. the logit model distinguished by with or without “hccl” events “hccl” arises due to the failure of the retail financing business. although the clients differ from the clients in the case of corporate finance, “hccl” is still an indicator of credit risk management. when banks experience “hccl” and maintain high npl ratios, they still have the capacity to finance clients with information asymmetry and poor credit. this is worth carefully exploring. in this section we focus on investigating how “hccl” banks with high credit risk affect the borrowers’ funding needs. the empirical findings in table 4 show that both msbs and mlbs that are larger scale prefer building relationships with banks that are categorized as being with “hccl” (the coefficients are 0.066 and 0.397, respectively, and the odds ratio of the latter reaches as high as 1.487). companies that have been in existence for a shorter period of time are more opaque, and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 191 therefore creditors need to be careful to grasp the overall picture of potential operating risk. banks with “hccl” are more willing to deal with such enterprises (the coefficients of msbs and mlbs are -0.0004 and -0.0011, respectively). banks with “hccl” are more eager to deal with msbs established after the policy to approve the establishment of new banks was introduced (the coefficient is -0.193). there is no doubt that the npl ratio remains high. banks with “hccl” do not wish to deal with corporations among the msbs (the coefficient compared to the sole proprietorships, partnerships, and limited companies is -0.181). this is similar to banks with “wobd” as mentioned in the previous section. only the msbs belonging to a conglomerate (the coefficient is 0.467, and the odds ratio is 1.595) can ignore the credit risk of its lending banks, for the conglomerate can back up its member businesses internally with funding needs. however, the conglomerates with poor internal controls may deliberately deal with banks with high credit risk, act in collusion and empty the assets of the enterprise on purpose. compared to the privately-held firms, small foreign enterprises are more likely to refuse to deal with banks with “hccl” (the coefficient is -0.899). most of the “hccl” banks are newly established. it is understood that they actively promote retail finance and intend to expand the market of privately-held companies. for this reason, it is understood that more risk management is needed. the empirical results also indicate that in comparing listed companies with publicly-held companies and publicly-held companies with privately-held companies, the former prefer building relationships with banks with “hccl” (the coefficients are 0.391 and 0.563, and the odd ratios are 1.48 and 1.71, respectively). there are no differences in ownership types, regardless of their being stated-owned or privately-owned or even foreign banks. mlbs with high cash and r&d expenditure ratios regularly deal with banks without “hccl” (the coefficients are -0.007 and -0.031). these findings fully reflect the fact that banks with “wobd and hccl” have a shortage of knowledge in terms of analyzing financial statements. mlbs with high financial leverage regularly and positively deal with “hccl” banks (the coefficient is 0.0003). this implies that those banks that perform poorly in the management of retail finance will perform poorly in the management of corporate finance, too. mlbs with high or low profitability keep maintain the same attitude in dealing with banks with or without “hccl”. companies with poor credit records, regardless of whether they are msbs or mlbs, will tend to build relationships with low credit risk banks without “hccl”. compared to msbs, the intentions of mlbs are 4 times higher (the coefficients are -0.696 and -2.682, respectively, and the odds ratios are about 7 times). when the chairperson’s credit rating improves, the borrower will tend to access finance from low credit risk banks without “hccl” (the coefficients are -0.002 and -0.006, respectively). this also indicates that if a borrower takes action to improve its credit rating, banks without “hccl” are sufficiently flexible to accept such loan applications. to sum up, “hccl” banks are not only short on knowledge as to how to analyze the borrower’s financial statements, but are also inflexible in terms of adjusting their lending policy to accept clients with a poor credit record. this can result in the loss of potential clients with improved credit ratings. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 192 table 4. using logit model to distinguish credit risk by “hccl” events dimensions status_02 msbs odds ratio mlbs odds ratio intercept 0.7085*** 3.0584*** info info_01 0.0657*** 1.068 info_02 0.3966 *** 1.487 info_03 -0.00042*** 1 -0.00114*** 0.999 info_04 -0.1927 *** 0.825 0.0523 1.054 com_01 0.3908 *** 1.478 com_02 0.5363 *** 1.71 com_03 -0.181 *** 0.834 com_04 0.4668 *** 1.595 0.082 1.086 com com_05 -0.8986*** 0.407 0.0633 1.065 com_06 0.5598 1.75 9.6137 >999.999 com_07 0.1518*** 1.164 0.0798 1.083 com_08 -0.0451** 0.956 -0.0616 0.94 com_09 0.00679 1.007 0.1427*** 1.153 fin_01 0.00029 *** 1 fin fin_02 -0.0307 *** 0.97 fin_03 -0.00116 0.999 fin_04 -0.00706 *** 0.993 credit_01 -0.6958*** 0.499 -2.6842 *** 0.068 credit credit_02 -0.00223*** 0.998 -0.00595 *** 0.994 note 1: ***, ** and * denote significance at the 0.01, 0.05 and 0.1 levels, respectively. note 2: the likelihood ratio (chi-square value) of the logit model for msbs is 2,878.19, and the likelihood ratio (chi-square value) of the logit model for mlbs is 1,704.57, which reflects good model fit at the 1% level. 5. conclusions using logit regression models, we explored whether banks with different lending performances placed different levels of emphasis on information asymmetry and client credit records. the empirical results show that: (1) mlbs with good information transparency tend to establish relationships with “word” and “hccl” banks. these results reveal that borrowers characterized by good information transparency and large size tend to establish multiple relationships, regardless of whether the banks are characterized by high or low lending performance. banks with “hccl” tend to build relationships with borrowers that have been in existence for short periods of time, especially following the approval of the policy for the establishment of new banks. this indicates that over-banking exists in taiwan. (2) small foreign firms, as well as mlbs with high profitability ratios, cash ratios and r&d expenditure ratios prefer building relationships with high lending performance and low credit risk banks. owing to the problem of over-banking, the borrowers with high financial leverage ratios are still adopted by banks with low lending performance. (3) msbs and mlbs with asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 193 poor credit records prefer having relationships with banks with high lending performance and low credit risk. moreover, in the case of where the chairperson’s credit score is increased, it is found that banks with high lending performance are sufficiently flexible in taking into consideration soft information instead of just hard information. this creates a policy that is not only beneficial to the lender, but is also beneficial to the borrowers. according to a survey from taiwan, it was found that the msbs that received loans from banks accounted for only 4% of the total in 2006 and the amount financed was less than one million. therefore, if the accounting association in taiwan makes an effort to introduce the ifrs for smes to these msbs and helps them prepare financial statements periodically, it will help reduce the likelihood of information asymmetry and the probability of such firms receiving loans from banks. moreover, banks can enhance their lending performance by expanding their lending activities to thousands of msbs. it is really a four-way win policy for the government, banks, accounting associations and firms, and it is worth coordinating related units to introduce these improved policies or regulations. although the empirical results indicate that client credit records are a very important source of information for lending activity, it is recognized that many clients cannot provide all the needed financial statements. this study confirms the prior research findings that integrated financial and non-financial indicators in the prediction defaulting model will result more accurate prediction rates. moreover, we suggest the future research can refer to the method presented by jacobson and roszbach (2003), using bivariate probit regression model to solve the sampling selection bias to explore what factors significantly impact the lending performance of banks and default of borrowers and how it work. notes 1. it is a requirement of the banking association that a lending bank check a firm’s credit record in the jcic before approving each loan case. in this paper, we define “bad credit record in the past” as referring to those firms that have a record of default, not sufficient funds (nsf) or bad debts. although checking the credit score records of the chairperson is not essential, most banks do so. banks especially do this in the case of borrowers with a poor credit record and a relatively high risk of default. banks will ask for collateral and the chairperson’s credit score above a certain threshold, even with a guarantee. therefore, the information regarding the “credit score of the chairperson” released by the jcic is essential in practice. 2. according to financial statistics monthly, issued by the central bank, at the end of 2008 there were 7 banks that were identified as having written off bad debts amounting to over nt$50 billion. however, we cannot provide detailed information about these banks or financial holding companies, for confidentiality reasons. these 7 banks are regarded as the control sample. 3. according to the report on the debt negotiation in retail finance issued by the bankers’ association, there are 8 banks that are characterized by heavy losses from credit card loans. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 194 however, we cannot provide detailed information about these banks or financial holding companies, for confidentiality reasons. these 8 banks are regarded as the control sample. 4. in taiwan, publicly-held companies are permitted to issue straight bonds, but only listed and over-the-counter (otc) companies are allowed to issue convertible bonds. 5. concerning to the operating definitions of msbs and mlbs, please refer to sections 3.1 and 3.2. 6. if the bank’s top executives are unable to examine the failure of operating strategies in corporate finance in depth, and they rush to expand their credit card and cash card-based “retail finance business”, this will result in their incurring huge losses for the second time. when the issuing bank and the cardholder lack risk awareness and an appropriate management mechanism, it will be more of a challenge for them to deal with both the direct and indirect impacts of credit risk. 7. in this study, “client credit” includes the aforementioned credit history, the type of organization, the industry category and financial attributes (this dimension is used only in the mlbs-related empirical model). 8. as mentioned earlier, this study focuses on exploring whether banks that focus more attention on their loan policy will be rewarded with a better lending performance. the loan policy mentioned here includes collecting relevant financial information (i.e., financial attributes) and non-financial information (especially public credit history). 9. according to berger et al. (2008) and kuo and chen (2010), the reason for the multiple lender-borrower relationships is contained in five motives: (1) a bank cannot supply all funds needed, but dealing with numbers of banks can solve the problem. (2) the borrower can solve the hold-up problem through multiple banking relationships. (3) the borrower wants to protect itself against a premature withdrawal of credit or other services due to the distress of their banking relationship so that they can maintain their own creditworthiness. (4) to avoid the loss of relationship banking due to the tightness of credit policy. (5) to focus on the costs and benefits of the bank in relation to supervision. 10. these factors may affect the bank’s loanable funds and some factors may be subject to restrictions in the laws and regulations and not just result from information transparency. for example, the amount that banks lend to individual enterprises must not exceed 5% of its net worth even if the enterprise has good credit quality and information transparency, unless it is for syndicated loans. 11. for example, after the policy for approving the establishment of new private banks was approved, there resulted the phenomenon of over-banking. this caused banks to relax credit conditions to attract customers. after 2008, the financial tsunami and the european debt crisis resulted in banks adopting a more conservative attitude in dealing with loan applications. 12. because selecting the best client can only earn the bank normal returns and it is unable to generate excess returns. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 195 13. hypothesis 2 aims at exploring how borrowers with different credit records build banking relationships with banks possessing different levels of credit risk. the prior research literature discussed “the relationship between the borrower’s financial performance and banking relationships.” it also explored “the relationship between the borrower’s credit quality and the operating performance of banks (especially foreign and domestic banks or state-owned or private banks).” there is no mention of the issue of how borrowers with different credit records build banking relationships with banks possessing different degrees of credit risk. therefore, we provide the inference based on the principles of lending management and portfolio theory. 14. taiwan approved the registration of more than 1.5 million enterprises, but only about 140,000 enterprises borrowed from banks. because of this, the population here is composed of the data contained in the credit database of the joint credit center in 2007, which did not indicate the total numbers of enterprises registered throughout the country. moreover, the results from 2006-2008 are quite similar, so that we only discuss the results for 2007. 15. in lending practice, banks generally require enterprises that apply for loans to provide financial statements for the past three years. therefore, if the empirical period periods described by creditor banks extend from 2006 to 2008, then the corresponding empirical periods for the borrowers extend from 2003 to 2008. 16. in this study, the sample did not exclude “policy loans”. we found that the state-owned banks are the most willing to promote loans with the government. since the sample characterized by this attribute still accounts for less than 1% of the overall sample, it does not affect the reliability and validity of the empirical results. 17. this classification method is based on the first edition of the joint credit information center’s credit scoring models. the corporation act was revised in 2001. at that time, the competent authority, based on the principles of corporate autonomy, deleted the regulation that capital exceed nt$500 million. in this study, we still include this category of information content. 18. according to the classification criteria of mlbs, either a capital or a borrowing amount of more than nt$30 million will qualify. in our populations, there are 13,266 observations that belong to mlbs. these are categorized as “non-publicly held & no financial statements,” and therefore we exclude them form our empirical test, because of “no financial statements, no financial variables.” 19. it is mentioned here that the industry classification of borrowers can also be used in the criteria under the taiwan stock exchange and the otc exchange center. due to the significance of and differences in the information, the content is not obvious. we thus use the classification criteria of the credit-scoring models provided by the joint credit information center. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 196 20. in addition to the four variables above, we also considered the rate of return on total assets and the debt ratio during the process of developing our empirical models. however, due to the possibility of multicollinearity with the profitability ratio and financial leverage ratio, we finally abandoned them. 21. brick-palia (2007) regarded the collateral provided by the company as inside collateral, and the collateral or personal guarantee provided by top management as outside collateral. in this study, we use the borrowing firms as our sample, and because each firm has a number of secured and unsecured loans, we do not use the method of brick-palia, which took the variable of collateral into consideration. instead, we use the credit record of the enterprise in the past (credit_01) and the credit score of the chairperson (credit_02). 22. the value of the dependent variable only has the meaning of “classification”, and has absolutely nothing to do with the numerical value. 23. the control samples refer to msbs that build relationships with banks without “wobd” and “hccl”. 24. to be specific, for the borrowers of banks with “wobd”, the control samples are defined as the borrowers of banks without “wobd”. when the research object is the borrowers of banks with “hccl”, the control samples are defined as the borrowers of banks without “hccl”. 25. according to the dependent variables in formulas (1) and (2), which refer to the ratios of event occurrences relative to their not occurring, we take the natural logarithms. for simplicity, we simply use tendencies and preferences in favor of measuring the variables, and hope it will not result in a misunderstanding on the part of the reader. references agarwal, r., & eiston, j. a. 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(2009). an analysis of corporate crisis warning-a logit modeling empirical test with financial indicators. bank of taiwan quarterly, 60(2), 154-186. microsoft word 4893-17926-1-sm-writer2-new-final.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 1 the influence of behavioral factors in making investment decisions and performance: study on investors of colombo stock exchange, sri lanka lingesiya kengatharan (corresponding author) dept. of financial management, university of jaffna, sri lanka tel: 94-21-205-2075 e-mail:lingesiya@yahoo.com navaneethakrishnan kengatharan dept. of human resource management, university of jaffna, sri lanka tel: 94-21-205-2075 e-mail:nkenga@gmail.com received: nov. 8, 2013 accepted: january 25, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.4893 url: http://dx.doi.org/10.5296/ajfa.v6i1.4893 abstract the main objective of this study is exploring the behavioral factors influencing individual investors’ decisions at the colombo stock exchange. furthermore, the relations between these factors and investment performance are also examined. as there are limited studies about behavioral finance in sri lanka, this study is expected to contribute significantly to the development of this field in sri lanka. the study begins with the existing theories in behavioral finance, based on which, hypotheses are proposed. then, these hypotheses are tested through the questionnaires distributed to individual investors at the colombo stock exchange. the collected data are analyzed by using spss. the result shows that there are four behavioral factors affecting the investment decisions of individual investors at the colombo stock exchange which are herding, heuristics, prospect and market. most of the variables from all factors have moderate impacts whereas anchoring variable from heuristic factor has high influence and choice of stock variable from herding factor has low influence on investment decision. this study also tries to find out the influence of behavioral factors on investment performance. among the behavioral factors mentioned above, only three variables are found to influence the investment performance: choice of stock has negative influence which is from herding asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 2 factor. over confidence from heuristics factor has negative influence on investment performance. anchoring from heuristics factor has positive influence on investment performance. all other variables which are volume of stock, buying and selling and speed of herding variables of herding factor, loss aversion and regret aversion variables of prospect factor and market information and customer preference variables of market factor do not have influence on investment performance. keywords: behavioral finance, behavioral factors influencing investors’ decisions, investment performance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 3 1. introduction decision-making is a complex process which includes analysis of several factors and following various steps. investors’ decisions are derived from complex models of finance. these models include those based on expected risk and return associated with an investment, and risk-based asset pricing models like capm (capital asset pricing model). but decisions should never be made only by relying on the personal resources and complex models, which do not consider the situational factors. situational factors are extended not only to the problem faced by the decision maker, but also to the environment. so, in order to make appropriate decision, one needs to analyze the variables of the problem by mediating them applying cognitive psychology. professional managers are now expected to play a role in: “challenging conventional assumptions of doing business, identifying risks, and seizing opportunities; integrating sustainability issues into strategy, operations, and reporting; redefining success in the context of achieving sustainable value creation; establishing appropriate performance goals and targets; encouraging and rewarding the right behaviors; and ensuring that the necessary information, analysis, and insights are available to support decision making” (ifac, 2011, p.6). decision making can be defined as the process of choosing a particular alternative from a number of alternatives. it is an activity that follows after proper evaluation of all the alternatives. hence, decision makers need to keep themselves up-to-date by obtaining information/knowledge from diversified fields so that they can accomplish the tasks they have to work upon. 1.1problem statement the decisions of investors on stock market play an important role in determining the market trend, which then affects the economy. to understand and provide an appropriate explanation for the investors’ decisions, it is important to explore which behavioral factors influencing the decisions of investors at the colombo stock exchange (cse) and how these factors influence their investment performance. it will be useful for investors to understand common behaviors, from which justify their reactions for better returns. security organizations may also use this information for better understanding about investors to forecast more accurately and give better recommendations. thus, stock price will reflect its true value and colombo stock market becomes the yardstick of the economy’s wealth and helps enterprises to raise capital for production and expansion. to get the research objectives, some questions are raised during the study. the study is done through answering these following questions: 1. what are the behavioral variables influencing individual investment decision makers at the cse and which factors do they belong to? 2. at which impact levels (if any) do the behavioral factors influence the individual investment decisions at the cse? asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 4 3. at which impact levels (if any) do the behavioral factors influence the investment performance of investors at the cse? 1.2 significance of the study sri lanka is an emerging economy in asia with different ethnicity and many cultural (sinhalese, tamil, muslims and burgers) characteristics similar to other asian countries. this research will provide an overview of behavioral finance in asia when comparing with western culture based on empirical findings and the importance of behavioral finance in asia in general and in sri lanka in particular. present study focuses on individual investors within the border of sri lanka. in 2012, sri lankan economy recorded an impressive growth of 7.2 per cent. it shows burgeoning growth after ended 30 years lasting civil war in may 2009 and moves to a higher sustainable growth path. all key sectors of the economy demonstrated a commendable performance in 2012, underpinned by the peaceful domestic environment, improved investor confidence, favorable macroeconomic conditions, and gradual recovery of the global economy from one of the deepest recessions in history (central bank of sri lanka , 2012). sole proprietorship, partnership, companies and small business have been directly and indirectly contributing to economic growth and its sustainability. in boosting economic condition, all the business entities will flourish. sri lanka is an island located very close to india, having a length of 435 km and width of 225 km and thus generating total area is 65610 sq km. sri lankan population is 20,451,826 and was a peaceful country before its devastating civil war in july 23, 1983. however, very recently, civil war came to end on 18 may 2009 and consequently widespread development has been taking place. sri lankan past 30 years war has seriously affected three generations of this country. anyone can find ample of examples all over the country and many are still suffering from the loss of lives, limbs and material due to the war, no matter what race or religion they belonged to. terrorism had been the major cause that hindered sri lanka achieving its development goals. however the government has allocated billions of rupees to develop the once war-torn north and east in par with the development taking place in the rest of the country. improved economic performance, gdp growth, peace, and stability in sri lanka has led the imf to change sri lanka’s status from “poverty reduction and growth trust” to “middle income emerging market,” an important landmark as the island nation makes its way down the path of development and reaps the benefits of peace. the improvement in status is expected to further open up international capital markets for the country and bring attention from investors targeting emerging markets with strong projected growth. not only local demand for business investment but also foreign heightened interest on investment escalated due to the strategic location of sri lanka: close to india and the east-west international sea route. for example, central bank of sri lanka said foreign direct investment (fdi) has reached a peak of usd 1.07 billion by december 2011, and the government expects it to rise to usd 1.75 in the year 2012. sri lanka is recognized as the most liberalized economy in south asia, foreign investment is a crucial element representing asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 5 sri lankan economic growth. the reasons behind for increasing capital investment are underpinned by peaceful domestic environment, improved investor confidence, favorable macroeconomic conditions, and increased capacity utilization together with expansion of economic activity (central bank of sri lanka, 2011). therefore, nowadays, investment decisions play a vital role than ever before. thus, this research has been designed to investigate the influence of behavioral factors in investment decisions and performance as emerging market in sri lanka. main purpose of the study, in post war situation, how investors are behaving in making their investment decisions and how such behaviors influencing investors’ performance. additionally, no studies have been carried out in sri lanka and thus, studying in unsearched area would be great contribution to existing literature. 2. theoretical review for behavioral factors impact the process of investors’ decision-making even though finance has been studied for thousands of years, behavioral finance that considers human behavior in the financial world is a fairly new field. behavioral finance theories, which are based on psychology, trying to understand how emotions and cognitive errors influence behavior of individual investors. in the present scenario, behavioral finance is becoming an integral part of the decision, since it heavily influences the performance of investors. they can be improved by recognizing the prejudices and errors of judgment that all of us are sensitive their performance. according to ritter (2003, p.429), behavioral finance is based on psychology which suggests that human decision processes are subject to several cognitive illusions. these illusions are divided into two groups: illusions caused by heuristic decision process and illusions rooted from the adoption of mental frames grouped in the prospect theory (waweru et al., 2008, p.27). these two categories as well as the herding and market factors are also presented as the following. 2.1heuristic theory heuristics are defined as the rules of thumb, which makes decision making easier, especially in complex and uncertain environments (ritter, 2003, p.431) by reducing the complexity of assessing probabilities and predicting values to simpler judgments (kahneman & tversky, 1974, p.1124). in general, these heuristics are quite useful, particularly when time is limited (waweru et al., 2008, p.27), but sometimes they lead to biases (kahneman & tversky, 1974, p.1124; ritter, 2003, p.431). kahneman & tversky seem to be ones of the first writers studying the factors belonging to heuristics when introducing three factors namely representativeness, availability bias, and anchoring (kahneman & tversky, 1974, p.1124-1131). waweru et al. also list two factors named gambler’s fallacy and overconfidence into heuristic theory (waweru et al., 2008, p.27). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 6 2.2prospect theory expected utility theory (eut) and prospect theory are considered as two approaches to decision-making from different perspectives. prospect theory focuses on subjective decision-making influenced by the investors’ value system, whereas eut concentrates on investors’ rational expectations (filbeck, hatfield & horvath, 2005, p.170-171). eut is the normative model of rational choice and descriptive model of economic behavior, which dominates the analysis of decision making under risk. nonetheless, this theory is criticized for failing to explain why people are attracted to both insurance and gambling. people tend to under-weigh probable outcomes compared with certain ones and people response differently to the similar situations depending on the context of losses or gains in which they are presented (kahneman & tversky, 1979, p.263). prospect theory describes some states of mind affecting an individual’s decision-making processes including regret aversion, loss aversion and mental accounting (waweru et al., 2003, p.28). 2.3market factors debondt &thaler (1995, p.396) state that financial markets can be affected by investors’ behaviors in the way of behavioral finance. if the perspectives of behavioral finance are correct, it is believed that the investors may have overor under-reaction to price changes or news; extrapolation of past trends into the future; a lack of attention to fundamentals underlying a stock; the focus on popular stocks and seasonal price cycles. these market factors, in turns, influence the decision making of investors in the stock market. waweru et al. (2008, p.36) identifies the factors of market that have impact on investors’ decision making: price changes, market information, past trends of stocks, customer preference, over-reaction to price changes, and fundamentals of underlying stocks. 2.4herding effect herding effect in financial market is identified as tendency of investors’ behaviors to follow the others’ actions. practitioners usually consider carefully the existence of herding, due to the fact that investors rely on collective information more than private information can result the price deviation of the securities from fundamental value; therefore, many good chances for investment at the present can be impacted. academic researchers also pay their attention to herding; because its impacts on stock price changes can influence the attributes of risk and return models and this has impacts on the viewpoints of asset pricing theories (tan, chiang, mason & nelling, 2008, p.61). in the perspective of behavior, herding can cause some emotional biases, including conformity, congruity and cognitive conflict, the home bias and gossip. investors may prefer herding if they believe that herding can help them to extract useful and reliable information. whereas, the performances of financial professionals, for example, fund managers, or financial analysts, are usually evaluated by subjectively periodic assessment on a relative base and the comparison to their peers. in this case, herding can contribute to the evaluation of professional performance because low-ability ones may mimic the behavior of their high-ability peers in order to develop their professional reputation (kallinterakis, munir & markovic, 2010, p.306). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 7 in the security market, herding investors base their investment decisions on the masses’ decisions of buying or selling stocks. in contrast, informed and rational investors usually ignore following the flow of masses, and this makes the market efficient.herding, in the opposite, causes a state of inefficient market, which is usually recognized by speculative bubbles. in general, herding investors act the same ways as prehistoric men who had a little knowledge and information of the surrounding environment and gathered in groups to support each other and get safety (caparrelli et al., 2004, p.223). there are several elements that impact the herding behavior of an investor, for example: overconfidence, volume of investment, and so on. waweru et al. (2008, p.37) identify stock investment decisions that an investor can be impacted by the others: buying, selling, choice of stock, length of time to hold stock, and volume of stock to trade. waweru et al. conclude that buying and selling decisions of an investor are significantly impacted by others’ decisions, and herding behavior helps investors to have a sense of regret aversion for their decisions. for other decisions: choice of stock, length of time to hold stock, and volume of stock to trade, investors seem to be less impacted by herding behavior. however, these conclusions are given to the case of institutional investors; thus, the result can be different in the case of individual investors because, as mentioned above, individuals tend to herd in their investment more than institutional investors. therefore, this research will explore the influences of herding on individual investment decision making at the cse to assess the impact level of this factor on their decisions. 3. data and methodology population of the study was individual investors of cse. cross-sectional design is employed in this study. study fits the nature of this study to describe a common trend of investors’ behaviors rather than one specific case, and the data in this study has not been collected in stages but carried out in a single time period. the cross-sectional design allows collecting quantitative data and data synthesized from the questionnaires sent to individual investors of cse. the data collected from questionnaires provide the basic understandings about the factors affecting investors’ decisions .questionnaires are sent to respondents using stratified random sampling. initially, convenience sampling was chosen as it is the best technique to get the highest rate of response when sending to friends and relatives. in addition, it would help to save time and money. nevertheless, convenience sampling is one type of non-probability sampling, which cannot provide representative sample, thus the result cannot be generalized for the whole population (bryman & bell, 2007, p.198) while the target is to find out the financial behaviors of the whole population of individual investors. in contrast, stratified random sampling allows us to stratifying the population by a criterion of the brokerage market share, and then choose random sample or systematic sample from each strata (bryman & bell, 2007, p.187). stratified sampling ensures that the sample is distributed in the same way as the population (bryman & bell, 2007, p.187). the number of questionnaires sent to each security company through branch managers of cse. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 8 3.1design of measurements and questionnaire the questionnaire is divided into three parts: personal information, behavioral factors influencing investment decisions, and investment performance. the 6-point likert scales, which are rating scales widely used for asking respondents’ opinions and attitudes (fisher, 2010, p.214), are utilized to ask the individual investors to evaluate the degrees of their agreement with the impacts of behavioral factors on their investment decision as well as with the statements of investment performance. the 6 points in the scale are respectively from 1 to 6: strongly disagree, disagree, no opinion, agree, and strongly agree. behavioral factors influencing the investors’ decision-making are divided into four groups: heuristic, prospect, market, and herding effect, which are presented in the table .1.0 table 1. behavioral factors influencing the investment decision making theory behavioral variables heuristic theory representativeness overconfidence anchoring gambler’s fallacy availability bias prospect theory loss aversion regret aversion mental accounting market price changes market information past trends of stocks fundamentals of underlying stocks customer preference over-reaction to price changes herding effect buying and selling decisions of other investors choice of stock to trade of other investors volume of stock to trade of other investors speed of herding source: waweru et al., 2008 these groups reflect a total picture of almost behavioral factors can impact the investors’ decisions at the stock exchanges. therefore, they can be used in order to recognize the behaviors of individual or even institutional investors in security trading, regardless of the stock market types: frontier, emerging or developed. thus, hypotheses are proposed as below: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 9 hypothesis h1: the behavioral variables that influence the investment decisions of individuals at the colombo stock exchange are grouped in four factors as the reviewed theories: heuristics, prospect, market, and herding. this hypothesis is tested by exploratory factor analysis to identify which dimensions the behavioral variables belong to. hypothesis h2: the behavioral factors have influence on the investment decisions of individual investors at the colombo stock exchange at high levels. this hypothesis is tested by synthesizing the respondents’ evaluations of influence degrees of behavioral factors on investment decisions. hypothesis h3: the behavioral factors have positive influence on the investment performance of individual investors at the colombo stock exchange. this hypothesis is tested by using multiple regression analysis that presents the correlation indexes among the behavioral factors and investment performance. figure 1. conceptual framework of the study h1 h2 h3 heuristic variables: representativeness, overconfidence, anchoring, gambler’s fallacy, availability herding variables: impacts of other investors’ decisions (buying, selling, choice of trading stocks, volume of trading stocks, speed of herding) market variables: price changes, market information, past trends of stocks, fundamentals of underlying stocks, customer preference, over-reaction to price changes. prospect variables: loss aversion, regret aversion, mental accounting investment decisions investment performance of individual investors return rate and satisfactory level of investment decisions behavioral factors asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 10 4. data process and analysis the collected data are processed and analyzed by spss. at first, the data are cleaned by removing the questionnaire with poor quality such as including too many missing values or bias ratings. then, statistical techniques, which are used for the data to achieve the research objectives, include descriptive statistics, factor analysis, and multiple regression analysis. to establish reliability and validity of the questionnaire, questionnaire was pre-tested with a 30 sample of investors and finalized before it was utilized for the survey. the cronbach’s alpha was used to measure of reliability random errors. the reliability coefficient of all indicators of industrial performance was 0.843 which indicated the high reliability. table 2. demographic summary of survey responses title category number % gender male 86 67.2% female 42 32.8% age 18-25 41 32% 26-35 34 26.6% 36-45 34 26.6% 46-55 02 1.6 % over 55 17 13.3 % marital status single 58 45.3 % married 70 54.7% divorced educational qualification high school & lower 20 15.6% undergraduate 44 34.4% bachelor 18 14.1% masters 14 10.9% phd others 32 25% years of experience under 5 years 74 57.8% 5-10 years 8 6.3% over 10 years 46 35.9% average monthly 10,000-20,000 48 37.5% 20,000-30,000 32 25% 30,000-40,000 38 29.7% 40,000-50,000 6 4.7% 50,000-60,000 over 60,000 4 3.1% asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 11 amount of investment under 25,000 39 30.5% 25,000-50,000 26 20.3% 50,000-75,000 75,000-100,000 12 9.4% 100,000-150,000 19 14.8% 150,000-200,000 12 9.4% 200,000-300,000 12 9.4% 300,000-400,000 8 6.3% over 400,000 source: survey data the demographic summary of the results reflected in table 2. the sample was consisted of 86 male (67.2%) and 42 female (32.8%) investors. age distribution in the sample is categorized as 18-25, 26-35,36-45, 46-55, and over 55. age range between 18-25 is highly represented in the sample which was 32% of the sample of young group. age ranges between 46-55 and above 55 was less represented in the sample which were 1.6 % and 13.3% respectively. respondents proportion was 26.6% consisted 26-35 and 36-45years of age range. in terms of marital status, 54.7 % of investors (n= 70) were married and 45.3 % of business operators were not married (n= 58). education level of the investors were categorized into six groups such as high school & lower, undergraduate, bachelor, master, phd degree holders and other qualification. highest percentage of the respondents was 34.4% belonged to undergraduate. second higher percentage of respondents was 25 % belonged to other education qualification 15.6 % belonged to high school and 14.1 % belonged to bachelor degree. among the educational qualification, small percentage of respondents was 10.9 % consisted of master degree. years of experience in their respected field of the sample is categorized as under 5 years, 5-10, and over 10 years. 57.8 % of sample was under 5 years of experience, 46 % of sample was over 10 years of experience, and rest was within 5-10 years of experience in their stock market field. average monthly income of the participants categorized six groups as stated in the table 1. 48 % of the respondents fall into 10,000-20,000 income level and very small percentage of sample 4% falls into over 60,000 income group. as indicated in the table 1, 30.5% of the respondents’ investments were under 25,000 and very small % of the respondents (6.3 %) was into the 300,000-400,000 investment group. factor analysis of behavioral variables influencing the individual investment decisions and the variables of investment performance the 23 questions of the questionnaire are designed to explore the levels of behavioral variables’ influence on the individual investment decisions at the cse. whereas, three asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 12 questions are created to identify the evaluation of investors about their own investment performance. the exploratory factor analysis (efa) is used for the behavioral variables and investment performance to identify the factors which these variables belong to. the requirements of factor analysis are satisfied to reduce the variables. after some rounds of removing the unsuitable variables, the analysis results that the remaining variables are grouped into five factors (four factors of behavioral variables and one factor of investment performance). here bartlett’s test of sphericity and the kaiser-meyer-olkin measure of sampling adequacy (george & mallery, 2003) are used. a measure of sampling adequacy of 0.630 with a value of bartlett’s test of sphericity (1546.465) with a high significant level (p <0.000), indicates the suitability of factor analysis and the results is presented in table 3 table 3. kmo and bartlett’s test kaiser-meyer-olkin measure of sampling adequacy. 0.630 bartlett's test of sphericity approx. chi-square 1546.465 df 351 sig. 0.000 source: survey data factor loadings of the items on a factor are greater than 0.5 (with the sample size is 100) ensure that efa has a practical significance to the analyzed data (hair et al., 1998, p.111). eigen value greater than one suggests that the five factors explain a sizable variation contained in the data. since these five factors have eigen values greater than one, which together explains a variance of 52.791%; therefore, the factors confirmed the factorial validity. the table 4 and 5 represents these results. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 13 table 4. factor analysis for behavioral variables and investment performance factors variable factor loadings factor 1 factor 2 factor 3 factor 4 factor 5 heading other investors’ decisions of choosing stock types have impact on your investment decisions 0.755 other investors’ decisions of the stock volume have impact on your investment decisions 0.817 other investors’ decisions of buying and selling stocks have impact on your investment decisions 0.823 you usually react quickly to the changes of other investors’ decisions and follow their reactions to the stock market 0.854 heuristics you believe that your skills and knowledge of stock market can help you to outperform the market. 0.799 you rely on your previous experiences in the market for your next investment 0.740 you forecast the changes in stock prices in the future based on the recent stock prices 0.737 investment performance the return rate of your recent stock investment meets your expectation 0.903 your rate of return is equal to or higher than the average return rate of the market. 0.874 you feel satisfied with your investment decisions in the last year (including selling, buying, choosing stocks, and deciding the stock volumes). 0.911 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 14 prospect after a prior gain, you are more risk seeking than usual. 0.802 after a prior loss, you become more risk averse 0.727 you avoid selling shares that have decreased in value and readily sell shares that have increased in value. 0.666 market you have the over-reaction to price changes of stocks 0.758 you analyze the companies’ customer preference before you invest in their stocks 0.759 cronbach’s alpha 0.851 0.732 0.897 0.618 0.7 extraction method: principal component analysis. rotation method: varimax with kaiser normalization. table 5. total variance explained for factors herding heuristic investment performance prospect market (factor 1) (factor 2) (factor 3) (factor 4) (factor 5) eigen value 4.108 3.582 2.832 2.107 1.625 proportion of variance explained (%) 15.214 13.267 10.488 7.805 6.018 cumulative variance explained (%) 15.214 28.481 38.969 46.774 52.791 source: survey data as shown in the table 5 the variables of herding, heuristics, investment performance, prospect, and market are grouped into related factor. some of the variables’ factor loadings have been removed from the analysis as their factor loadings are less than 0.5. the result illustrates that the behavioral variables that influence the investment decisions of individuals at the cse are grouped in four factors as the reviewed theories: herding, heuristics, prospect, and market, and as a result h1 is supported. as such, there are four behavioral factors that influence the investment decisions of individual investors at the cse. in the herding factor, all four original variables from the questionnaire are kept after the factor analysis. only three of eight original items of heuristics are kept by factor analysis, two of six original items of market and three of six original items asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 15 of prospect are accepted by factor analysis. all three original variables investment performance are accepted by factor analysis and all belong to one dimension. the internal consistency of the items used to measure each factor was calculated using cronbach’s alpha, which is the procedure of choice for investigating the internal consistency of items using likert-type scale (walsh & betz, 1995). cronbach’s alpha for each factor: factor 1(herding), factor 2 (heuristics), factor 3(investment performance), factor 4(prospect) and factor 5 (market) were 0.851, 0.732, 0.897, 0.618 and 0.7 respectively. since the marginally acceptable reliability should be above 0.60 (gliner & morgan, 2000), this study’s all measures are above 0.60 which demonstrates reliability. therefore the results of reliability analysis confirmed that consistency is at an acceptable level for each factor. impact levels of behavioral factors on the individual investment decisions and scores of investment performance the impact levels of behavioral variables on the investment decisions are identified by calculating the values of sample mean of each variable. because 6-point scales are used to measure the impact levels of these variables, the mean values of these variables can decide their impact levels on the investment decision making as the following rules: • mean values are less than 2 shows that the variables have very low impacts • mean values are from 2 to 3 shows that the variables have low impacts • mean values are from 3 to 4 shows that the variables have moderate impacts • mean values are from 4 to 5 shows that the variables have high impacts • mean values are more 5 shows that the variables have very high impacts table 6. impacts of herding variables on the investment decision making factor variables mean st.deviation herding other investors’ decisions of choosing stock types have impact on your investment decisions 2.98 0.827 other investors’ decisions of the stock volume have impact on your investment decisions 3.31 0.801 other investors’ decisions of buying and selling stocks have impact on your investment decisions 3.06 0.821 you usually react quickly to the changes of other investors’ decisions and follow their reactions to the stock market 3.16 0.846 source: survey data choice of stock, volume of stock, buying and selling and speed of herding are the variables of herding that influence the individual’s investment decision at cse. the results are shown in the table 6. choice of stock variable of herding factor (m=2.98) has a low impact on asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 16 individual investment decision. and all other three variables of herding factor which are volume of stock, buying and selling and speed of herding have a moderate impact on individual investment decision making as per the result in table 6. table 7. impacts of heuristics variables on the investment decision making factor variables mean st.deviation heuristics you believe that your skills and knowledge of stock market can help you to outperform the market. 3.73 0.646 you rely on your previous experiences in the market for your next investment 4.16 0.443 you forecast the changes in stock prices in the future based on the recent stock prices 3.75 0.640 source: survey data over confidence and anchoring are the variables of heuristics factor. results are shown in the table 1.6. overconfidence (m=3.73) has a moderate impact on individual investment decision making. anchoring: investors rely on their previous experiences in the market for their next investment (m=4.16) has a high impact on their investment decision making. anchoring: investors forecast the changes in stock prices in the future based on the recent stock prices (m=3.75) has a moderate impact on their investment decision table 8. impacts of prospect variables on the investment decision making factor variables mean st.deviation prospect after a prior gain, you are more risk seeking than usual. 3.93 0.734 after a prior loss, you become more risk averse 3.72 0.468 you avoid selling shares that have decreased in value and readily sell shares that have increased in value. 3.99 0.568 source: survey data loss aversion and regret aversion are the variables of prospect factor. those variables have a moderate impact on investment decision making. results are presented in the above table 8. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 17 table 9. impacts of market variables on the investment decision making factor variables mean st.deviation market you have the over-reaction to price changes of stocks 3.60 0.523 you analyze the companies’ customer preference before you invest in their stocks 3.75 0.615 source: survey data market information and customer preferences are the variables of market factor. according to the result shown in the table 1.8, those two variables have a moderate impact on investment decision making. in total, most of the behavioral variables of four factors: herding, herding, prospect, and market have moderate impacts on individual investors’ decision making at cse. there is a one item of heuristics factor which is anchoring: investors rely on their previous experiences in the market for their next investment (m=4.16) has a high impact on their investment decision making. and there is one item from herding factor which is choice of stock having low impacts (m= 2.98 ) on investors’ decisions. these findings do not support the hypothesis h2 that proposes that all factors of behavior finance have high impacts on individuals’ investment decisions at cse. influences of behavioral factors on the individual investment performance in order to test the influence of behavioral factors on the individual investment performance hypothesis three has been divided into four parts as follows hypothesis h3.1: variables of herding have a positive influence on investment performance hypothesis h3.2: variables of heuristics have a positive influence on investment performance hypothesis h3.3: variables of prospect have a positive influence on investment performance hypothesis h3.4: variables of market have a positive influence on investment performance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 18 table 10. results of multiple regression analysis with investment performance as dependent variable and dimensions of herding factor as predictor variables model independent variables unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 9.878 .931 10.613 0.000 choice of stocks -1.297 .334 -.458 -3.885 0.000 volume of stocks .663 .342 .236 1.940 0.055 buying and selling .496 .340 .171 1.459 0.147 speed of herding .070 .334 .025 .208 0.835 r2 = 0.113 f = 3.934 p = 0.005 source: survey data the finding of the analysis demonstrates that one dimension of herding factor that choice of stock has negative significant influence on investment performance. other three dimensions which are volume of stocks, buying and selling, speed of herding have positive impact on investment performance but those are not statistically significant. all for dimensions of herding factor emerged as predictors of investment performance explains together (r2= .113) 11.3% percent of the total variance in investment performance. as the model reveals the remaining 88.7% of variability is not explained. an analysis of variance (anova) indicates that f= 3.934, p < 0.01, the model is significant. the results illustrate that herding factor dimensions do not have positive significant influence on investment performance. therefore hypothesis h3.1 is not supported with the findings as dimensions (variables) of herding factor do not have positive significant influence on investment performance. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 19 table 11. results of multiple regression analysis with investment performance as dependent variable and dimensions of heuristics factor as predictor variables model independent variables unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 8.408 1.745 4.818 0.000 overconfidence -1.278 .402 -.356 -3.179 0.002 anchoring .773 .286 .302 2.704 0.008 r2 = 0.080 f = 5.428 p = 0.005 source: survey data heuristics factor is composited within the combinations of variables of over confidence and anchoring. the impact of variables of herding factor on investment performance of the individual investors are illustrated in table 1.10. according to the result presented in table 11 overconfidence has negative (b= -.356, p= 0.002) significant influence on investment performance whereas anchoring has positive (b=.302,p=0.008) significant influence on investment performance. value of the coefficient of determination of dimensions of herding, which is; (r2) is 0.080, whilst this result implies that 8% percent of the total variance in investment performance, can be explained by all dimensions of heuristics. as the model reveals the remaining 92% of the variability is not explained. an analysis of variance (anova), indicates that; f= 5.428, p < 0.01, that the model is significant. hypothesis (h3.2) states that, variables of heuristics have a positive impact on investment performance. the results illustrate that overconfidence variable of heuristics factor has negative significant impact on performance whereas anchoring has positive impact on investment performance and as a result h3.2 is not supported. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 20 table 12. results of multiple regression analysis with investment performance as dependent variable and dimensions of prospect factor as predictor variables model independent variables unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 8.557 1.817 4.710 0.000 loss aversion -.068 .208 -.031 -.324 .746 regret aversion .426 .386 .104 1.103 .272 r2 = 0.10 f =.610 p = .545 source: survey data prospect factor is composited within the combinations of variables of loss aversion and regret aversion. the influence of variables of prospect factor on investment performance of the individual investors are illustrated in table 1.11. according to the result presented in table 1.11, those two variables (loss aversion: b= -.031, p= 0.746; regret aversion = .104, p=.272) do not have significant positive influence on investment performance hypothesis (h3.3) states that, variables of prospect have a positive impact on investment performance. the results illustrate that variables of prospect factor do not have positive significant influence on investment performance as a result h3.3 is not supported. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 21 table 13. results of multiple regression analysis with investment performance as dependent variable and dimensions of market factor as predictor variables model independent variables unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 8.105 1.551 5.227 0.000 market information .386 .472 .087 .818 .415 customer preferences .066 .401 .017 .164 .870 r2 = 0.10 f =.600 p = .550 source: survey data market factor is composited within the combinations of variables of market information and customer preference. the influence of variables of market factor on investment performance is illustrated in table 1.12. according to the result presented in table 13, those two variables (market information: b= .087, p= 0.415; customer preference = .017, p=.870) do not have significant positive influence on investment performance hypothesis (h3.4) states that, variables of market have a positive influence on investment performance. the results illustrate that variables of market factor do not have positive significant influence on investment performance as a result h3.4 is not supported. 5. conclusion the study is concluded by giving all the answers for the research questions raised in the introduction. this means the research objectives are done and the hypotheses are tested. the following part gives the conclusions for the study by presenting the main points to answer the research questions: what are the behavioral variables influencing individual investors’ decisions at the colombo stock exchange and which factors do they belong to? asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 22 there are four behavioral factors that impact the investment decisions of individual investors at the cse: herding, heuristics, prospect and market. the herding factor includes four behavioral variables: choice of trading stocks, volume of trading stocks, buying and selling, and speed of herding). heuristics factor consists two behavioral variables: over confidence and anchoring. the prospect factor possesses two variables: loss aversion, and regret aversion. the market factor consists of two variables: market information, and customer preferences. findings suggest that the hypothesis h1 is supported. at which impact levels do the behavioral factors influence the individual investors’ decisions at the colombo stock exchange? most of the mentioned behavioral variables of four factors: herding (volume of stocks, buying and selling and speed of herding), heuristics (over confidence), prospect (loss aversion and regret aversion, and market (market information and customer preferences) have moderate impacts on individual investors’ decision making at cse. there is one item from herding (choice of stocks) having low impacts on investors’ decisions: there is one variable from heuristics (anchoring) having high impacts on investors’ decision. these findings do not support the hypothesis h2, which proposes that all factors of behavior finance have high impacts on individuals’ investment at cse. at which impact levels do the behavioral factors influence the investment performance of individual investors at the colombo stock exchange? herding: choice of trading stocks have negative significant influence on investment performance; and other three variables of herding volume of trading stocks; buying and selling; and speed of herding do not have impact on performance. heuristics: overconfidence has negative significant influence of investment performance whereas anchoring has positive significant influence on investment performance. prospect: loss aversion and regret aversion do not have significant influence on investment performance. market: market information and customer preferences do not have influence on investment performance. the results do not support the hypothesis h3 that mentions that all behavioral factors have positive impacts on the investment performance. references bryman, a. & bell, e (2011). business research methods, 3rd edn., oxford university press. bryman, a. & bell, e. (2007) business research methods, 2nd edn., oxford university press. caparrelli, f.d., arcangelis, a.m & cassuto, a. (2004). herding in the italian stock market: a case of behavioral finance. journal of behavioral finance, 5(4), 222–230. http://dx.doi.org/10.1207/s15427579jpfm0504_5 central bank of sri lanka (2011) annual report, colombo, sri lanka: available at www.cbsl.lk (accessed:15.05.2012) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 23 central bank of sri lanka (2012) annual report, colombo, sri lanka: available at www.cbsl.lk (accessed:14.09.2013) debondt, w. f. m. & thaler, r. h. (1995). financial decision-making in markets and firms: a behavioral perspective. handbooks in operations research and management science, 9(13), 385-410. http://dx.doi.org/10.1016/s0927-0507(05)80057-x filbeck, g., hatfield, p. & horvath, p. (2005). risk aversion and personality type. journal of behavioral finance, 6(4), 170–180. http://dx.doi.org/10.1207/s15427579jpfm0604_1 fisher, c. (2010). researching and writing a dissertation, an essential guide for business students. 3rd edn., pearson eduction limited. george, d., & mallery, p. (2003). spss for windows step by step: a simple guide and reference. 11.0 update (4th ed.). boston: allyn & bacon gliner,j.a., & morgan, g.a. (2000).research methods in applied settings: an integrated approach to design & analysis.morwah, nj: lawrence erlbaum hair, j. f., black, b., babin, b., andersion, r. e. & tatham, r. l. (1998). multivariate data analysis. prentice-hall, international, inc. international federation of accountants (ifac) (2011) ‘sustainability framework 2.0: professional accountants as integrators’ (march 2011). kahneman, d. & tversky, a. (1974). judgment under uncertainty: heuristics and biases, science, 85(4157), 1124-1131. kahneman, d. & tversky, a. (1979). prospect theory: an analysis of decision-making under risk’. econometrica, 47(2), 263–291. kallinterakis, v., munir, n. & markovic, m. r. (2010). herd behavior, illiquidity, and extreme market states: evidence from banja luka. journal of emerging market finance, 9, (3), 305–324. . http://dx.doi.org/ 10.1177/097265271000900303 ritter, j. r. (2003). behavioral finance. pacific-basin finance journal, 11(4), 429-437. tan, l., chiang, t. c., mason, j. r. & nelling, e. (2008). herding behavior in chinese stock markets: an examination of a and b shares. pacific-basin finance journal, 16(1-2), 61–77. http://dx.doi.org/10.1016/j.pacfin.2007.04.004 walsh, w. b., & betz, n. e. (1995). tests and assessment. (3rd ed.). englewood cliffs, n.j.: prentice hall. waweru, n., m., munyoki, e., & uliana, e. (2008). the effects of behavioral factors in investment decision-making: a survey of institutional investors operating at the nairobi stock exchange. international journal of business and emerging markets, 1(1), 24-41. http://dx.doi.org/10.1504/ijbem.2008.019243 microsoft word 8539-31006-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 255 the impact of audit quality features on enhancing earnings quality: the evidence of listed manufacturing firms at amman stock exchange dr. mohammad abdallah almomani dept. of accounting, jadara university po box 733, irbid 21110 jordan tel: 962-2-720-1222 e-mail: momani@jadara.edu.jo received: nov. 8, 2015 accepted: dec. 20, 2015 published: december 20, 2015 doi:10.5296/ajfa.v7i2.8539 url: http://dx.doi.org/10.5296/ajfa.v7i2.8539 abstract the study aims at investigating the impact of external audit quality features on enhancing the quality of accounting profits of the listed manufacturing firms at amman stock exchange (ase), where continuity of profit has been used as proxy variable to express the quality of earnings. indicators of quality of audit, audit office size, auditors' fees, period of customer's retention, type of auditor's opinion, and the specialization in client's industry, were used to measure audit quality. a sample of 45 firms had been selected, and data covering the period 2009-2013 had been collected from these firms, where 225 observations were used in the analysis. the study finds that the earnings of listed manufacturing firms at amman stock exchange are with good quality, and that there is a linear relationship between external audit quality and the quality of reported earnings. auditors' fees have most important significant effect on earnings quality, followed by auditors' opinion, where others factors has no significant effect on earnings quality. based on these findings, the study raises several questions about the reliability of audit quality properties by stakeholders in firms, especially investors, when they check the quality of earnings, whenever they need to take a decision. the study recommends further researches regarding the issue by using other metrics to measure earnings quality, and through the addition of other properties to the quality of the audit, such as linked audit offices with auditing global offices, degree of qualification employees, and the opened lawsuits against audit office. keywords: audit quality, earnings quality, earnings continuity, audit quality properties. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 256 1. introduction as a result of failures occurred to business organizations and the subsequent collapse and bankruptcy of large and multinational firms, such as enron, worldcom, and other firms, and based on the clear relationship of these collapses with manipulating the accounts of these firms, doubts emerged among users of financial information regarding the credibility of this announced information, where they depend on, in decision making. this incredibility and unreliability raise many questions, including the managements of these firms, and the effectiveness of accounting standards, and the applied procedures in firms. auditors' responsibility and credibility, audit process, and audit quality, became questionable directly next to these collapses. because of increasing number of collapsed firms, and losses incurred by investors and creditors, the issue of earnings quality became the focus of different interested groups of people. the issue of earnings quality stems its importance from the quality of reported earnings by business organizations in the financial and investments decisions that investors, creditors, and other users depend on, in taking decisions. earnings quality is used in performance evaluation of firms, and in determining the fair value of these firms. moreover earnings quality is important in future estimations and contracting.(easa, 2008). earnings quality is strongly associated with quality of financial reports, where this quality of earnings can be achieved when firms adhere to the legal, professional, and control standards. business organizations are required to issue reliable, free of errors, and misstatement information, to provide a good base for the evaluation of current operating performance of firms, and to be appropriate for the estimation of its future operating performance, and for the determinations of the fair value of firms (dechow and schrand, 2004). penman (2003), demonstrated that earnings quality is associated with accounting profits, realized cash flows, so quality of earnings is achieved when the reported income reflects the actual profits, where future expected profits can be accurately estimated. nowadays, auditors encounter several types of pressure by users of accounting information in order to improve the quality of audit, because of several financial problems exist in periodic financial reports. audit profession is required these days to concentrate on efficient and qualified work force, to provide audit services with high quality, and to be able to reveal any incorrect practices that managements take to affect the accounting measurement. audit report is considered one among the most important inputs for the decision making process. in addition, audit quality is a primary requirement for different groups of users. actually, audit quality is difficult because of its difference in nature, to provide trust with audit reports and financial statements (scott and pitman, 2005). audit quality means that audit profession has the ability to detect the significant errors, and limits information inconsistency between managements and shareholders, so it can protect the behalves of shareholders. audit profession is expected to provide highly efficient services and to keep the trust of its services in minds of interested people (eisa, 2008). both issues of earnings quality and audit quality are among the hot topics in academic and professional environments (krishnah, 2003). managements of business organizations take asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 257 different decisions that may affect income, exploiting the high degree of flexibility accounting methods, policies, and procedures alternatives, that available in accounting standards. as a result, these effects of management interventions are reflected in the reported income, and led to a situation where income does not represent the actual situation, especially when managements' awards depend on the reported income. earnings quality means that the reported income is actual and not overstated or manipulated, and at the same time reflects the actual economic events occurred in the entity during the accounting period (bellovary et al, 2005). an independent auditor plays an important role in limiting the interventions of management in the measurement processes, so this increases information consistency available to both managers and users, through providing reasonable assurance that the financial statements reflects the actual financial position and results of operation, and these statement are prepared based on gaap or ifrs ((watts and zimmerman. 1986). i believe that, when association exists between audit quality and quality of financial information, and since these statements had been audited by professional, qualified, and independent auditors, the financial information is assumed to be of high quality, and this is the base to enhance trust among different interested parties with the firm. therefore, this study investigates the effect of audit quality features on enhancing the quality of financial information. based on this discussion, the problem of the study can be well presented through the following questions: 1. are audit offices that contracted to audit the financial statements of listed manufacturing firms in amman stock exchange (ase) highly qualified? 2. do earnings reported by listed manufacturing firms in ase have a good quality? 3. do the features of audit quality play a role in enhancing the reported earnings by the listed manufacturing firms in ase? the study objects for investigating whether the characteristics of audit quality have an impact of improving the quality of reported earnings quality by the industrial listed firms in amman stock exchange. this objective can be better expressed through the following sub-objectives: 1. to determine the qualities of auditors who engaged in auditing the financial statements of listed manufacturing firms in amman stock exchange. 2. to identify the effect of audit qualities on enhancing earnings quality of listed manufacturing firms in amman stock exchange. this study is important because it investigates a topic that recently became on focus of accounting literature, next to firm's scandals and firm's collapses. this topic is actually earnings quality and audit quality. experts and professional people interpreted the firm collapses by the manipulation practices that exercised over those firms by its managements, where these managements exploit the large level of flexibility that available in accounting standards, where more than one accounting method can be used to account for each item of the financial statements. as a result the announced information of collapsing firms did not reflect the actual economic events occurred during accounting periods, so the financial positions and results of operations of those firms were overstated. in addition, audit firms that engaged in auditing the financial statements had been blamed, and as a result, several asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 258 lawsuits were opened in courts against these auditing firms, especially because audit firms did not report that the collapsed firms are unable to continue as a going concern entities. next, audit quality became the most important element of competition among audit firms and offices. the findings of the study will be beneficial and important for different parties including, shareholders, managements, creditors, and other interested users, because audit quality helps shareholders in selecting the most qualified auditors who will be able to detect any errors, faults, and misstatements in the financial statements. managements of firms will be also more interested with the role of auditors in creating and maintaining trust with the financial statements of their firms, and will find enough justification for audit fees in minds of shareholders, creditors, investors, and other interested groups of people. in addition, audit quality has a positive role in limiting the negative effects for managements' interventions with accounting measurement, because audit quality objects for issuing professional opinion with fairness and credibility of financial statements, which at the end, enhances trust with these auditors. quality of earnings is also associated with the reported earnings of firms, because it represents an important aspect in the assessment of financial position, and in estimating future earnings, in addition to its importance in the decision making process among users of financial statements. 2. literature review 2.1 audit quality the audit process is considered a key important element in the structure of financial statements because it tests whether the financial information is in an independent and objective form, in order to increase the credibility of this information. the most important factor of audit quality is the ability of an auditor to detect errors and other significant misstatements and reducing the level of accounting information inconsistency between shareholders and management. audited financial statements by highly qualified auditors have less probability to include errors and faults (eisa, 2008). the outputs of audit process depend on a group of inputs such as, auditors' experience, auditors' educational background, in addition to the efforts made by auditors, especially when a positive relationship between auditors' performance and their learning background, had been mentioned (libby & luft, 1993). the assessment of audit process is seen as multidimensional because of different parties requiring this process; including users of financial statements where they need to increase their trust in financial statement and to depend in these statements on decision making. auditors themselves are also a part because they need to achieve higher audit quality and to support their competition position in the profession. a third part is organizations which ask auditors to improve audit quality to develop the profession of auditing and to support public confidence with this profession. firms under engagement look for high audit quality because auditors' reports have important reflections and may affect share prices (al nawayseh, 2008). audit quality is defined as "auditors' possibility to detect errors and to report deviations in the accounting system of the client" (deangelo, 1981). davidson & neu define audit quality as asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 259 ''auditor's ability to detect and exclude errors and significant violations in the reported net income". audit quality expresses the ability of external auditors to collect high quality evidence to support their professional neutral opinions. (hamdan & abuujailah, 2012). the importance of audit quality is associated with the output of audit process, which is actually the audit report, where several parts depend on this report in their economic decisions. as a result, audit quality achieves the behalves of all beneficiary parts of audit process. the first beneficiary part is the auditor, because he can improve and enhance his reputation and strengthen his competitive position. management can also determine its weaknesses, and it will be eligible to avoid these weaknesses, because these weaknesses affect the firm's market price. investors and creditors are interested with audit quality because it affects their decisions. among interested groups by audit quality is governmental agencies because governmental bodies are looking to protect the economic activity and to protect all interested parties with audit process. (tayer and glezen, 1994). within the literature of auditing, several prior researches investigated the indicators that can be used in audit quality measurement. al jabr, (2011) used the indicator of large audit offices to measure audit quality. fan and wong, (2005) shows that contracting with large audit offices, was used as a mean to reduce problems occurring between the firm's management and shareholders. in 2007, the international federation of accounting (ifa) issued a working paper regarding the factors affecting audit quality. examples of factors mentioned in this working paper, are leaders' responsibility towards audit quality, ethical requirements, terms of clients' acceptance, efficiency of human skills, and tasks performance subject to the professional standards. altowaigeri and alnafa'abi, (2008) showed that these factors are affecting client's decision regarding audit office selection. they determined that these factors include auditor's fees, audit office reputation, prior experience with the client, objectivity of testing and evaluating the client's financial statements, protecting the secrecy of the client's information, audit office independency, audit service quality, and experience of auditors. eisa, (2008) used several features to present audit quality level, such as audit office size, auditors' fees, client's retention period, client's importance, audit office reputation, number of times the audit office was subject to legal accountability, and client's performance control, while office size was used to measure audit quality (krishnah, 2003). ahmed (2012) used audit fees, audit office size, client's retention period, association with international audit fees and professional qualification of audit office employees, as features of audit quality. the features of audit quality that used by hamdan, (2012) include audit office size, audit fees, client's retention period, audit office specialization with the industry of the client, and association between audit office and the international offices of auditing. a study carried out by altamimi, (2013) shows the necessity of the existence of organizational, behavioral, and personal factors, in addition to the scientific basics for audit profession to achieve audit quality, while lennox (1999) showed that large audit offices are shown in its accurate form, and in its report regarding financial report. alnawayseh (2006) found an effect of audit fees on audit quality. in addition, hamdan and abuujalah, (2012) found no significant effect of audit quality features including audit fees, office size, and auditor's continuity on limiting of earnings management. aljaber, (2012) found no effect of the auditor whether the auditor is working in asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 260 a large audit office or in a specialized office. balsam et al. (2003), showed that firms that audited by specialized audit offices has stronger coefficient of response towards earnings, and less accrual elements, when compared by non-specialized firms. based on the above findings of prior researches, i conclude that there are several common shared features used by different researchers for audit quality. examples of common shared features are audit office size, audit fees, despite no common agreement about some other features. therefore, i see that some features of audit quality, such as professional rehabilitation, legal accountability, protection of client's information secrecy, and objectivity of financial statements test as important features, and these features can be summarized in the audit report, because audit report is a summary of all what an auditor finds. in addition, audit report represents a written confirmation by the auditor that the audit standards and governmental legislation had been followed; in addition to that audit report is a reference for responsibility identification. 2.2 earnings quality earnings quality is one among the important issues nowadays in the minds of investors and accounting standard setters, especially next to financial scandals occurred by the staring of the current century, where users' trust in financial reports declined, if not missed. no common agreement yet is available for the definition of the term earnings quality among academics, researchers, and other interested people, because of the differences in objectives and decisions made by users of accounting information. dechow and schrand, (2004) defined earnings quality as "the level of available and accurate information for the purpose of current and future operating performance evaluation", while schipper and vincent, (2003) showed that earnings quality is "the reduction in the differences between the accounting reported income and economic income". ghosh and moom, (2010) demonstrated that earnings quality is the ability of earnings to be used in forecasting to predict future cash flows. moreover, bellovary et al., (2005) stated that earnings quality is achieved when the reported earnings reflect the actual performance, and can be used in predicting future earnings, so earnings quality is represented by the continuity of earnings. based on the above mentioned definitions and descriptions for the term of earnings quality, it is apparent that earnings quality stems its importance from the accounting income which is considered as the most important resource of accounting information for investors, creditors, and other users of accounting information through the different accounting reports. as a result, different features or elements for earnings quality can be concluded, including its usefulness for future profits estimation, close for economic profits, continuity, and its freedom from earnings management. earnings quality is important for users of accounting reports, since it enables them to take good decisions, evaluate manager's performance, evaluate the financial position of the firm, and estimate the future expected earnings. prior researches mentioned different measures for the determination of earnings quality level. these measures differ from one research to another because users of financial statements are also different. as a result, opinions towards earnings management are not identical, which leads to different measures among researchers for earnings management. mahdi et al., (2012) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 261 demonstrated three methods that represent three dimensions for earnings quality management. the first method focuses on profit function, based on the idea that managers prefer profits continuity, because they perceive that investors prefer a stable increase in profits, so the method is based on profits volatility. leuz et al., (2003) measured profit volatility through the computations of profits standard deviation and dividing the result on cash flows standard deviation. using this method, as the ratio is lower as earnings quality is better. the second method for measuring earnings quality had been recommended by barton and simko, (2002) where it based on surprising profits. surprising profits is computed by dividing operating assets by net sales. under this method, as the ratio is lower, as earnings quality is better. the third method is based on the ratio of cash flows to income from operations, where penman, (2001) used this method in measuring earnings quality. several recommendations for the interpretations of earnings quality are available; among these is the use of earnings continuity as indicator for quality. sloan, (1996) showed that earnings quality means cash flows continuity at a higher rate of accruals continuity. richardson et al. (2005) developed a model for the measurement of future profits continuity. other prior researches used accruals method for measuring earnings quality using the absolute value of discretionary accruals. to compute discretionary accruals jones method (1991), which adjusted by dechow et al. (1995) can be used. this method is the most common used method for earnings management measurement, and also can be used for measuring earnings quality. 3. prior researches the most important literature regarding audit quality features and earnings quality is presented here in this section. several related researches are available in western countries, but few were done in arabic states. despite that too much prior researches had been incurred in western countries, but the topic needs more and more investigations, especially in arab countries. guo, (2014), investigated a sample consisting of 4,476 clients who have the incentives and the ability to use the discretionary accruals to affect earnings to be closer to predictions. the study found a negative relationship between the abnormal level of audit fees and the use of discretionary accruals. in addition, the study shows a positive relationship between abnormal level of audit fees and audit quality. in other words, the study shows that those clients who pay high audit fees, have no desire to increase the discretionary accruals, in order to present more closed actual profits to the previously estimated profits. mushtaha, (2014) investigated the relationship between audit turnover ratio and audit quality, and its reflection on auditor's opinion. the study had been prepared based on a sample consisting of 38 listed firms in palestine stock exchange, along the period 2006-2007. the study demonstrates an existence of a positive relationship between auditors' turnover and audit quality. in addition, it shows that the length of contracting period between the auditor and the client contributes in exercising the phenomenon of earnings management, and in the issuance of standard unqualified audit report. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 262 one important study that carried out by perotti and wagenhofer, (2014) for the purpose of investigating the way that earnings quality measures are used to satisfy the key objective of announcing financial statements, in order to improve investors' decision, where additional returns are determined to be the difference between actual and expected future returns. the authors recommended two measures for measuring earnings quality. the first recommended measure by the authors depends on share prices, where high earnings firms are expected to have lower share prices than other firms. within this measure, 6 measures were studied herewith this study including, continuity, predictability, two income smoothing measures, discretionary accruals, and earnings quality. the second measure depends on earnings response coefficient and the appropriate value as independent factors, while additional returns as a dependent factor. the authors used descriptive statistics including the mean and the standard deviation, in addition to t-test and regression method in data analysis and hypotheses testing. the study had been prepared based on a sample of nonfinancial us firms over the period 1988-2007. the most important conclusion is that, all measures, except income smoothing, are negatively associated with the extra absolute returns, which generally means that income smoothing is the feature of appropriate earnings and, accrual measures generate the largest dispersion in absolute extra returns, followed by those measures depending on market. this finding supports the idea that accruals measures are the most important measures for earnings quality in the accounting literature. the objective li'etal's, (2014) study, was to investigate the effect of financial situation on earnings quality, and to study the relationship between the features of accounting profits, and financial situation of listed firms in china securities exchange. the sample of the study consisted of firms issuing additional shares over the period 2005-2007. simple linear regression and correlation matrix were used in testing the hypotheses, while descriptive statistics such as, the mean and the standard deviation, were used in data analysis. the study finds that accruals quality and the possibility of estimating future profits are widely different among financially stable and bankrupting firms. the role of audit quality as an instrument for corporate governance in enhancing earnings quality of the egyptian manufacturing shareholding firms had been carefully investigated by sameh, (2013). data from 60 manufacturing firms covering the period 2005-2010 had been collected and used in the analysis. multiple linear regression method was used in data analysis and hypotheses testing. the study reveals that an acceptable level of earnings quality in the industrial shareholding firms of egypt is existed, in addition to the existence of acceptable level of audit quality. the study also demonstrates the existence of significant positive effect of audit quality on reducing the total accruals, which leads to earnings quality improvement. the objective of a study that carried out by ahmed, (2012) was to investigate the impact of audit quality on earnings quality, and its reflections for cash dividends in manufacturing shareholding firms of egypt. the analysis was based on data collected from 50 manufacturing firms. the most important findings of the study is that, a positive effect of audit fees, audit office size, international association between audit office and international asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 263 audit offices, auditors' professional qualification is existed on earnings quality. the study finds a significant positive effect of earnings quality on cash dividends. wuchum et al. (2011) carried out a study to investigate whether a correlation is available between audit quality and the actual practice of earnings management, because of high incentives available through accrual management. the study had been based on a sample consisting of 925 firms over the period 2001-2008. the main conclusion of the study is that a correlation exists between auditor experience with client's industry, auditor's fees, and period length of clients' retention from one hand, and the practices of earnings management on the other hand. the objective of a study that carried out by mahmoud et al. (2011) was to investigate the features of earnings management and the performance of shareholding listed companies in malaysia stock exchange. the study attempted to investigate whether earnings quality of malaysian listed firms are correlated with performance. the study has structured based on three features for earnings quality, where these variables represent the three independent variables of the study. these variables include the predictive value, feedback value, and timeliness. a sample of 285 firms was used along the period 2000-2007. the main conclusion of the study is that there is a significant positive correlation between feedback value, and timeliness in one side, and the rate of return on total assets. moreover, the study shows that a positive weak correlation exists between the predictive value and return on assets. in addition, the study shows that there is a negative correlation between feedback value and tobin;s –q as a measure for companies performance, and a positive correlation is existed between earnings quality and firm's performance. eisa, (2008) carried out one related study in egypt, where the purpose was to determine the effect of audit quality on the processes of earnings management. the data used in the analysis of the study was gathered from 74 audit office managers. the study revealed the existence of a positive relationship between audit office size, audit office reputation, auditors' performance, and auditor's experience with the client's industry, in one side, and audit quality in the other side, while a negative relationship the study reveals between audit quality and earnings management behavior, which means that performing audit process at high quality, will be reflected at a positive form on the quality of the announced financial statements. al nawayseh, (2006) studied audit quality, where the purpose was to identify the factors affecting audit quality. the sample of the study consisted of 62 auditors in jordan. the study finds that the factors associated with audit team have the strongest effect on audit quality. several factors associated with audit team had been taken in consideration in this study such as, knowledge with accounting standards, commitment to audit standards, interest with training and continuous education, and the experience of audit team. audit office size, and diversification of services that auditors provide to clients, had been found with no effect on audit quality. tendeloo, (2005) tested whether a relationship exists between audit quality and earnings management of selected business organizations of 6 european countries. a sample consists of 120 firms was used in the study. the study demonstrates that high audit quality limits the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 264 managements' practices of earnings management, and these practices are rare in countries where investors' protection laws are valid. the objective of the study of hodge, (2003) was to investigate investors images regarding earnings quality, auditors' independence, and benefits of audited financial information. opinions of 414 individual investors were surveyed regarding their perception of earnings quality and independency of auditors, along the period (1990-2000). the conclusions of the study revealed the doubts honesty of security exchange commission regarding the contradiction between earnings quality and auditors independency over the last 10 years ago. the study also shows that lower perception to earnings quality impose investors to make more accurate tests for financial statements, and more focus on making more analysis for financial information. moreover, the conflict of financial statement reliability is due for conflict in auditors' independency. . based on the above mentioned related prior researches regarding the effect of audit quality on earnings quality, the effect of audit quality features on enhancing earnings quality of listed manufacturing firms at ase, had been investigated here in this study. the study is made next to the occurrence of many events that may affect the going concern of many firms, such as the global financial crisis occurred on 2008 and its effects on firms. in addition, the study comes next to enforcing jordanian shareholding firms to apply the principles of corporate governance by the starting of 2009. the study is distinguished from prior researches through its measurement of the joint effect of audit quality features, in an individual and grouping forms, in enhancing earnings quality, where this test had not been used in any of prior researches. 4. hypotheses of the study based on the survey made of the related literature and prior researches of audit quality and earnings quality, the hypotheses are as follows: ho1: there is no statistical significance of audit quality existence for audit offices that perform audit services of listed manufacturing firms in ase. ho2: there is no statistical significance for the existence of quality of the reported earnings by listed manufacturing firms in ase. ho3: there is no statistical significance of audit quality features in enhancing the quality of earning quality of listed manufacturing firms in ase. in order to be tested, this hypothesis is divided into 5 sub-hypotheses as follows. ho31: audit office size does not contribute in enhancing the quality of reported earnings of the no listed manufacturing firms in ase. ho32: client's retention period by audit offices has no contribution in enhancing the quality of earnings of the listed manufacturing firms in ase. ho33: the type of an auditor's opinion has no effect in enhancing the quality of earnings of listed manufacturing firms in ase. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 265 ho34: an auditor's experience with the client's industry does not contribute in enhancing the quality of the reported earnings by the listed manufacturing firms in ase. ho35: an auditor's fee has no contribution in enhancing the quality of reported earnings by the listed manufacturing firms in ase. 5. methodology the population of the study includes all manufacturing listed firms in ase. number of listed manufacturing firms in ase is 68 firms, by the end of 2013. a portion of needed data for the measurement of the study variables requires the availability of data one year before the period of the study, which is extended over the period 2009-2013. number of observations that were subject to analysis is 225, attributed to 45 listed manufacturing firms in ase for 5 year period, so this composes 67 percent from the total population of the study. actually, two terms should be available in a firm in order to be included in the sample. first, all needed data regarding the firm should be available; whereas the second is that the firm was not stopped or merged with other entity during the period of the study. based on the literature, one method for measuring earnings quality is through the continuity of these earnings, because quality of earnings increases when these earnings has the characteristic of continuity, which means that current earnings can be used for the estimation of future earnings, where earnings continuity means the association of future earnings with current earnings. earnings continuity is used in the study as a proxy variable to represent quality of earnings. in the study, the methodology that followed by france et al., (2004), sloan et al., (2010, and aljaber, (2012 for the measurement of this variable, using autoregressive model of order one, as follows. e , = α , + α e , + ε , (1) where: e,i,t; net current income e,i,t+1: net expected future annual income for the year t+1. current net income is divided in this model by total assets for tipping purposes, so next period income is divided by total assets. when the coefficient α1 is closed to 1, it means that earnings are of high continuity, and thereafter, these earnings are of high quality. the study based on office size, audit fees, client's retention period, audit report type, and auditor's specialization in client's industry, as indicators for audit quality. all of these indicators are used as independent variables in the study. the following model is used to analyze between audit quality features and earnings quality. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 266 , = + , + 4 , + , + , + , + , + , ∗ 4 , + , ∗ , + , ∗ , + , ∗ , +( , ∗ , ) + ( , ∗ 4 , ∗ , ∗ , ∗ , ∗ , ) + , (2) where: ei,t+1: net future income for the year t+1, which represents the continuity of earnings, and considered a proxy variable for earnings quality for firm i in year t. big4i,t: represents the size of audit office when the firm accounts are audited by the largest 4 audit offices in jordan. it is a fictitious variable where it is given 1 when it is audited by the largest 4, and 0 when it is audited by other non-large audit offices. reti,t: client's retention period by audit office, when the clients is maintained by audit office for three continuous years or more. it is also a fictitious variable, where it is given 1 when the client is retained for 3 years, and 0 when it is audited for less than 3 years. aopi,t: auditor's opinion in the financial statements in the last year directly before the year engagement. it is also a fictitious variable where it is given 1 when the auditor's opinion is standard unqualified opinion and 0 when there is a departure from standard unqualified audit report. spsi,t: auditor's specialization with the client's industry. it is a fictitious variable where it is given 1 when the auditor is specialized in client's report and 0 when the audit office is not specialized with client's industry. feesi,t: amount of audit fees measured by jordanian dinar for firm i in year t. b: constant b1, b2,..b3: coefficients of independent variables. ei,t: random error. 6. results and analysis to examine whether data is appropriate for analysis and measurement, and by the end will lead to achieve the objectives of the study, several tests had been made such as normal distribution test, multicollinearity test, and correlation. table (1) shows the used tests to be sure that the data is appropriate. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 267 table 1. test of data validity and study model variable autocorrelation autocorrelation tolerance vif durbin watson 4 , 0.868 1.151 , 0.603 1.657 , 0.973 1.028 , 0.927 1.079 , 0.988 1.012 , 0.686 1.459 1.650 with regard to normal distribution, since most variables were fictitious, these variables are not required to be subject to normal distribution. in addition, since the sample size composes about 67 percent from the total population of the study, therefore, the model will be useful and valid. tolerance coefficient is computed for each variable, to test the overlapping among variables, thereafter, the variance inflation factor (vif) had been used. since vif for all variables is not more than 5, no overlapping is available among variables, so this means that the model is highly appropriate for interpreting the effect of independent variables on the dependent one. regarding autocorrelation, durbin watson test (d-w) had been used, and its value is 1.65, so this is a good indicator that autocorrelation problem is not existed among variables. in occasion, the optimal value of (d-w) test is between 1.5 and 2.5. 6.1 descriptive statistics table (2) shows the descriptive statistics of current annual earnings (referred as ei,t), and future annual earnings (refereed as (ei,t), divided by the total assets of all included firms in the sample, for each year and all years. the table shows that the total average of current net income to total assets is 0.0229, whereas the total average of future income to total assets equals 0.024. this means that the sample firms achieved a positive return on its assets, and the accounting profits close to be permanent, which means that these profits are characterized with its continuity, so this refers that profits are with good quality. results demonstrate that the total standard deviation for current profits average is 0.15352 along the years of the study, whereas the standard deviation of future average is 0.17051. this means that the there is a little bit difference between them. table 2. descriptive statistics for accounting earnings along the period 2009-2013 year , ∗ , ∗ min. max. mean std. min. max. mean std. 2009 -0.17 0.5 0.0337 0.11579 -0.30 1.69 0.0588 0.26104 2010 -0.30 1.69 0.0588 0.26104 -0.44 0.2 0.0079 0.09918 2011 -0.44 0.2 0.0079 0.09918 -0.32 0.29 0.0086 0.11153 2012 -0.32 0.29 0.0086 0.11153 -0.44 0.31 0.0056 0.11824 2013 -0.44 0.31 0.0056 0.11824 -0.34 1.19 0.0402 0.20313 all years -0.44 1.69 0.0229 0.15352 -0.44 1.69 0.0242 0.17051 *where: , (current earning), , + (future earning) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 268 table (3) shows the descriptive statistics of the independent variables. based on information appears in the table, it is notable that large audit offices made auditing of 38.2 percent of the total listed manufacturing firms in asee, and this phenomenon is increasing from year to year. in addition, the table shows that client's retention period ratio is 92 percent, where this means that the client deals with the same audit office for more than 3 years. this means that clients trust audit offices, and audit office provides all needed tasks at a reasonable form. in occasion, the regulations identify the length that the client can continue with the same audit office to be in maximum, 4 years. moreover, the table shows that 59.1 percent of audit offices that engaged in auditing listed manufacturing firm are specialized with the clients industry, which may lead to more audit quality. the largest ratio of audit office specialization with client's industry is 62.2 percent, and this occurred in 2010. this may be attributed for the desire of listed manufacturing firm, where these firms prefer a specialized audit office to engage in auditing its financial statements, especially next to the global financial crises, where the corporate governance regulations of jordan issued next to the crises and became valid since the starting of 2009. results also demonstrate that the average of audit fees is jd13,474. moreover, the results show that 92.4 percent of issued related opinions were standard unqualified audit reports. the highest ratio was 95.6 percent, and attributed to year 2009. this means that the impact of the last year auditor's opinion is a key factor in client's trust with audit quality, so this leads the auditor to make more efforts in the road of limiting management interventions to affect accounting earnings, so an auditor's opinion reflects the actual economic events occurred in the firm. in this case, an audit office enhances clients’ trust with audit office, and maintains the reputation of these offices. table 3. descriptive statistics of independent variables year audit size (big4) retentionperiod auditor opinion specialty in clients industry auditing fees fre. % fre. % fre. % fre. % min. max. mean std. 2009 14 31.1 39 86.7 43 95.6 26 57.8 4000 98400 12940 17281 2010 17 37.8 41 91.1 41 91.1 28 62.2 4000 98400 13077 17820 2011 19 42.2 44 97.8 42 93.3 27 60 4000 92600 13279 17159 2012 18 40 43 95.6 41 91.1 26 57.8 4000 103800 13522 18452 2013 18 40 40 88.9 41 91.1 26 57.8 4000 106140 14550 20450 all years 86 38.2 207 92 208 92.4 133 59.1 4000 106140 13474 18117 6.2 hypotheses testing the hypotheses of the study object for examining earnings quality of listed manufacturing firms at ase along the period 2009-2013, and for determining the impact of audit quality features on enhancing the quality of accounting profits. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 269 6.2.1 testing the first hypothesis the first hypothesis had developed to test whether audit offices that perform audit services for listing manufacturing firms in ase have audit quality. the hypothesis is presented again as follows. ho1: there is no statistical significance of audit quality for audit offices that perform audit services of listed manufacturing firms in ase. features of audit quality including, office size, auditors' retention with clients period, type of audit report, audit office specialization with client's industry, and audit fees, have been tested in the first hypothesis. binomial distribution had been used in testing the first hypothesis. table 4. first hypothesis test variables observed prop. sig.-value (2tailed) big size (big 4) 88.2% 0.000 retention (ret) 92% 0.000 auditor opinion (aop) 92.4% 0.000 specialty in clients industry (sps) 59.1% 0.008 fees* 20% 0.000 *for the purpose of this test, audit fees had converted into dual value, where number 1 is used when audit fees are overage of these fees, whereas 0 is given when the audit fees are below the average of these audit fees, in order to insure consistency in measurement. the table shows that all audit quality features for audit offices are significant. because the coefficient of significance is below 0.05, the null hypothesis is rejected, whereas the alternative, which states that audit offices which audited the financial statements of listed manufacturing firms at ase, is accepted, 6.2.2 testing the second hypothesis the second hypothesis had developed to test whether the reported earnings of listed firms in ase are of good quality. ho2: there is no statistical significance for the quality of the reported earnings by listed manufacturing firms in ase. continuity of reported earnings of listed firms in ase is used to determine whether these earnings are of high quality. the model used for this purpose is available in table (5). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 270 table 5. test of the second hypothesis , = + , + , model t r adjusted r f-test sig. constant , 0.015 0.411 5.954 0.137 0.133 35.451 0.000* a. predictors: (constant), et b. dependent variable: +1 *significant at the 5% level. results appearing in table (5) demonstrate that the computed coefficient of significance equals zero. when this computed coefficient of significance is compared with the predetermined one, which equals 0.05 (1-0.95), it is apparent the computed one is less than its corresponding one. therefore, the null hypothesis is rejected, where its alternative one is accepted. this result means that there is a quality for the reported accounting profits by listed manufacturing firms in ase, because these earnings are characterized with its continuity, and the earnings of year (ei,t) have a clear contribution in interpreting profit variance of the next year (ei,t+1). in more details, b value was positive for the year t, and equals 0.411, which refers to continuity of profits in year (t+1), and each jd 0.411 in earnings of year t leads to increase in the earnings of year (t+1) with jd1. results also show that adjusted r2 equals 0.133, which means that earnings of year ei,t interprets 13.3 percent in the variance of earnings of year ei,t+1, and this is a good indicator for the existence of linear relationship , and there are other variables affect the continuity of earnings. this result is in agreement with (sameh, 2013), and (hamdan and abu hajeelah, 2012). 6.2.3 testing the third hypothesis the third hypothesis had developed to test whether audit quality features affect and enhance the quality of earnings of listed manufacturing firms in ase. the hypothesis is again presented, in its null form, as follows. ho3: there is no statistical significance of audit quality features in enhancing the quality of earning quality of listed manufacturing firms in amman stock exchange. multiple linear regression method had been used in testing the third hypothesis. table (6) shows the results of the study model asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 271 table 6. effect of the overall audit quality features on enhancing earnings quality , = + , + big4 , + ret , + aop , + sps , + fees ,+ , ∗ big4 , + , ∗ ret , + , ∗ aop , + , ∗ sps ,+ ( , ∗ fees , ) + ( , ∗ big4 , ∗ ret , ∗ aop , ∗ sps , ∗ fees , ) + , variable unstandardized coefficient standardized coefficient (beta) (t) sig. constant -0.056 -1.077 0.283 0.069 0.036 0.081 0.936 -0.029 0.082 -1.270 0.206 retention ( , ) 0.024 0.038 0.6 0.549 auditor opinion ( p , ) 0.019 0.029 0.474 0.636 specialty in clients industry ( , ) 0.012 0.034 -0.512 0.609 0.00000373 0.397 4.863 0.000* , * 4 , 0.397 0.314 1.357 0.176 , * , . 0.096 0.85 -0.218 0.827 , * , . 0.313 0.276 -0.561 0.575 , * , 0.134 0.116 0.374 0.709 , *fees 0.0000783 5.584 2.536 0.012* 0.0000799 5.695 -2.682 0.008* 0.266 0.225 f 6.413 sig. 0.000 a. predictors:(constant) , ,big4 , ,ret , ,aop , ,sps , ,fees , , , *big4 , , , *ret , t, , *aop , , , *sps , , , *fees, , ∗ big4 , ∗ ret , ∗ aop , ∗ sps , ∗ fees , . b. dependent variable: c. significant at the level ≤ 5%. information appears in table (6) demonstrate an existence of a linear relationship between the features of audit quality and quality of earnings. the computed f-value equals 6.413, with a computed coefficient of significance of zero. when the coefficient of significance is compared with the predetermined corresponding one, which equals 0.05, it is apparent that computed one is lower than the predetermined. therefore, and based on this result, the null hypothesis is rejected; while it's alternative one is accepted. this result means that audit quality features have an effect on quality of earnings, and plays a role in enhancing the quality of these earnings. this means that there is an effect of at least one feature among the features, and its contribution in interpreting the variance of the dependent variable. moreover, because α of ei,t, equals 0.069, which means that earnings of ei,t will have the characteristic asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 272 of continuity for the year ei,t+1. results reveal that the coefficient of determination (r2) equals 22.5 percent, where this refers that audit quality features interpret 22.5 percent in the variance of audit quality. this is considered as indicator for the existence of linear relationship between the features of audit quality and quality of earnings, and other variables, the study did not take with consideration, affect the continuity of earnings. to determine which features of audit quality have the most significant effect on enhancing the quality of earnings, beta coefficient had been used. table (6) shows that the features that have the most significant effect on earnings quality is the interaction variable that includes all features together, where beta coefficient equals -5.695, followed by the interaction between audit fees and the earning of the last year, where beta coefficient equals -5.584, then audit fees where beta coefficient equals 0.397. in addition, results indicate that the coefficient of significance for these features is below 0.05, which means that each of these features has a significant effect on enhancing the quality of earnings, while insignificant effect is found for the remaining features of audit quality. i can conclude that the overall interaction among the features of audit quality as a whole leads to an enhancing of quality of earnings, through the effect of these features on limiting the practices of earnings management that firm's managements may exercise, and through limiting these managements interventions in measurement, the disclosed financial information reflect, in a better form, the events that occurred during the accounting period. this result is in agreement with findings of hamdan and abuajeelah, (2012) where individual effect of these features is unavailable. results also are in agreement with al jaber, (2012) where no significant effect of large audit offices that specialized with a client's industry on enhancing the quality of firms reported earnings. 6.2.3.1 testing subhypotheses table 7 shows the results of tests used for the individual effect of each feature of audit quality in enhancing the quality of reported earnings. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 273 table 7. results of subhypotheses testing the impact of the big4 on enhancing earnings equality model(1) , = + , + 4 , + ( , ∗ 4 , ) + , coefficient r adj. r f-statistic sig. coefficient value t-test sig. 0.475 3.248 0.001* 0.001 0.053 0.957 -0.083 -0.5 0.618 0.138 0.126 11.807 0.000 expected sign + + + the impact of the clint retention period on enhancing earnings equality model(2) , = + , + ret , + ( , ∗ ret , ) + , coefficient r adj. r f-statistic sig. coefficient value t-test sig. 0.713 2.082 0.038* 0.016 0.398 0.691 -0.318 -0.908 0.365 0.141 0.130 12.135 0.000 expected sign + the impact of the auditor opinion on enhancing earnings equality model(3) , = + , + , + ( , ∗ , ) + , coefficient r adj. r f-statistic sig. coefficient value t-test sig. 1.364 2.69 0.008* 0.025 0.625 0.533 -0.975 -1.906 0.050* 0.155 0.143 13.480 0.000 expected sign + the impact of the specialty in clients industry on enhancing earnings equality model(4) , = + , + sps , + ( , ∗ sps , ) + , coefficient r adj. r f-statistic sig. coefficient value t-test sig. 0.644 2.568 0.011* 0.005 0.219 0.827 -0.252 -0.966 0.335 0.141 0.129 12.074 0.000 expected sign + +/+/ the impact of the auditors fees on enhancing earnings equality model(5) , = + , + fees , + ( , ∗ fees , ) + , coefficient r adj. r f-statistic sig. coefficient value t-test sig. 0.532 4.578 0.000* -0.00000 33 4.578 0.000* -0.00000 49 -2.934 0.004* 0.217 0.206 20.431 0.000 expected sign + + + a. dependent variable: b. significant at the 5% level. the first subhypothesis text is again presented, in its null form, as follows: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 274 ho31: audit office size does not contribute in enhancing the quality of reported earnings of the listed manufacturing firms in ase. the results of multiple linear regression method for model (1) are shown in table 7. based on the information appears in the table, a linear relationship exists between audit office size and quality of earnings, since f value equals 11.807, with zero coefficient of significance. because the computed coefficient of significance is less than the predetermined one, which equals 0.05, the null hypothesis is rejected, whereas the alternative one, which refers to the existence of an effect of audit office size on the quality of reported earnings, is accepted. the results also show that the value of the related coefficient of determination (adjusted r2) equals 0.126, which means that 12.6 percent of change in the quality of earnings, can be attributed to the audit office size., where this is a good indicator for the existence of a linear relationship between audit office size and earnings quality, and earnings quality is affected by other factors, in addition to audit office size. in addition, results demonstrate that the coefficient of the independent variable (audit office size) is significant and positive and equals 0.475. moreover, the table shows that the computed t-value equals 3.284, with a computed coefficient of significance of less than 0.05, which also refers the predictive value of current earnings in predicting future earnings. this result is in agreement with the findings of al jaber (2012), and clinch et al. (2010). the table also shows that the coefficient of the variable big4i.t is positive, and equals 1.34, but it has no significance. the coefficient of ei,t * big4i,t is also appears negative and equals -0.083 with no significance in the table. based on the findings, i believe that investors and stakeholders don't perceive that earnings of firms audited by other than large 4 offices has longer continuity, when compared with earnings of firms that audited by large 4 audit offices. i also believe that investors and other stakeholders do not give higher evaluation weight for firms audited by the largest 4 audit offices. the second subhypothesis had developed to measure the contribution of the client's retention period by audit office in enhancing the quality of earnings of listed manufacturing firms in ase. the test of the second subhypothesis is again presented, in its null form, as follows. ho32: client's retention period by audit offices has no contribution in enhancing quality of earnings of the listed manufacturing firms in amman stock exchange. information appears in table (7) shows the results of multiple linear regressions for model number 2, which shows the effect of clients' retention period on enhancing the quality of earnings of listed manufacturing firms in ase. results reveal the existence of a significant linear relationship between clients' retention period and quality of reported earnings, where f-value equals 12.135, and zero coefficient of significance. it is notable that the computed coefficient of significance, which equals zero, is less than the predetermined one, which equals 0.05. the value of the computed coefficient of significance is of statistical significance. because the computed level of significance is less than the corresponding predetermined one, the null hypothesis is rejected, while the alternative on is accepted. this means that a client's retention period contributes in enhancing the quality of earnings. the coefficient of determination equals 0.141, which means that client's retention period can interpret 0.141 of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 275 the change taking place in the quality of earnings. in other words, 14.1 percent of change occurring in the quality of earnings is attributed to change in a client's retention period, and other than this variable affecting the quality of reported earnings. in the table, the coefficient of the dependent variable (ei,t) appears positive with a value of 0.713. this coefficient is a statistical significance, where t-value is 2.082 at 5 percent level of significance. all of these refer to the continuity of earnings. the table also reveals a value of 0.016 for the independent variable of client's retention, and it is insignificant. the table also reveals -0.0318 value for the coefficient of the variable ei,t * reti,t. this coefficient has no statistical significance. based on the results, i believe that a client's retention period for a long period of time, will lead auditors to create special relation with the client, and routine auditing procedures will be followed by the auditor, which result in an auditor inability to detect management practices of earnings management. these results mean that investors and other interested groups of people with the firm, are more interested with auditing results in audit offices that retain its clients for more than 3 years, and they give a higher weight for results of audit office that retain clients for less than 3 years. this result is in agreement with the findings of hamdan and abu hajeelah, (2012), and eisa, (2008). the third subhypothesis had developed to investigate whether the quality of retained earnings by the listed manufacturing firms in ase is affected and enhanced by auditor's opinion. the hypothesis is represented again, in its null form, as follows. ho33: the type of an auditor's opinion has no effect in enhancing the quality of earnings of listed manufacturing firms in ase. table (7) shows the results of multiple linear regression method for model 3, which shows the effect of an auditor's opinion for the most recent period of engagement, on the quality of reported earnings by the listed manufacturing firms in ase. the results demonstrate the existence of a significant linear relationship between an auditor's report for the most recent period, and the quality of earnings. regarding this relationship, the results show 13.48 f value, at zero computed coefficient of significance. because the computed coefficient of significance, which equals zero, is less than the predetermined one, which equals 0.05 percent, the null hypothesis is rejected, and instead, the alternative one, which refers that reported earnings is affected by an auditor's opinion. results also demonstrate that the coefficient of determination is 14.3 percent, which means that about 13.64 of change taking place in reported earnings is due to change in an auditor's opinion, while other factors, the study did not take into consideration, affecting the quality of earnings. the coefficient of the dependent variable (ei,t) is 1.364, while t value equals 2.69, under 5 percent coefficient of significance. this means that current earnings have a predictive value in estimating future earnings. the table also shows that the coefficient of ei,t + aopi,t equals -0.975. this means that interested people, investors, and other stakeholders' opinions, consider auditor's opinion and its effect on the earnings of the current period, and given higher weight to refer to the continuity of earnings. the fourth hypothesis was developed to measure the effect of an auditor's specialization with a client's industry. the hypothesis is restated again as follows. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 276 ho34: an auditor's experience with the client's industry does not contribute in enhancing the quality of the reported earnings by the listed manufacturing firms in ase. results shown in table (7) refers to the multiple linear regression analysis, where model number 4 shows the effect of auditors specialization in the industry of a client on enhancing the quality of earnings of the listed manufacturing firms at ase. the results show that a linear relationship exists between the auditor specialization with a client's industry and quality of reported earnings, where the results show 12.074 with zero coefficient of significance regarding this relation. because the computed coefficient of significance, which equals zero, is less than the computed one, which equals 0.05, the null hypothesis is rejected, while the alternative one is accepted. this result means that an auditor's specialization with a client's industry leads to an enhancement in the quality of reported earnings by the listed manufacturing firms in ase. this means that the independent variables can interpret about 12,9 percent of enhancement occurring for quality of earnings. actually this is considered as a good indicator for the continuity of profits of these firms, and an indicator for the linear relationship between them, taking with consideration that other outside consideration variables affecting the quality of earnings. the positive coefficient of the dependent variable (e,i,t) equals 0.644 and has a statistical significance, where t-value is 2.568 with less than 0.05 coefficient of significance. this actually refers to the continuity of earnings. this result is in agreement with the related findings of al jaber, (2012). the insignificant coefficient of ei,t * spsi,t is -0.252, which means that investors and other users do not care whether an auditor is specialized or non-specialized with the client's industry. in other words, the result means that investors and other users do not give the earnings that audited by a specialized auditor with the industry more weight than earnings that audited by a non-specialized auditors. the fifth subhypothesis had developed to investigate whether the quality of retained earnings of listed manufacturing firms in ase is affected by audit fees. the hypothesis is represented again, in its null form, as follows. ho35: an auditor's fee has no contribution in enhancing the quality of reported earnings by the listed manufacturing firms in ase. table 7 shows the results of multiple linear regressions including model number 5, which shows the effect of audit fees on the quality of reported earnings by ase. the results demonstrate that a linear relationship is available between audit fees and reported earnings quality, where f-value is 20.431, with a coefficient of significance of zero. comparing the computed coefficient of significance, which equals zero, with the predetermined one, which equals 0.05, it is clear that the computed one is less than the predetermined. because the computed coefficient of significance is less than the predetermined one, the 5th null hypothesis is rejected, and its alternative is accepted. results show that the coefficient of determination (adjusted r2) equals 0.217, which means that 21.7 percent of change taking place in the quality of earnings is due to the dependent variables, which approves the existence of linear relationship between the dependent and the independent variables, while other variables affecting the dependent variables, the study did not take them with consideration. the positive coefficient of the dependent variable (ei,t) equals 0.532, and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 277 involves a statistical significance, with t-value of 4.578, under 5 percent level of significance. this means that the quality of the reported earnings has the characteristic of continuity. at the same time, the negative coefficient of the independent variable (feesi,t) equals -0.000033, and has a statistical significance. the table also demonstrates that the coefficient of ei,t * feesi,t is negative and equals -.0000049, and has a statistical significance. it is supposed that it should be with a positive signal, but because it has a negative signal, it means that auditors may ignore some irregularities or violations that practiced by managements of firms. i see that investors and other interested groups of people perceive that the fees of auditors lead to enhancement in earnings quality, because when auditors receive enough and satisfied fees, they will make more efforts in order to reduce the practices of earnings management, and those investors and users give higher weight for audit fees and link it with the continuity of earnings. 7. conclusions and findings the main objective of the study is to investigate the effect of audit quality features on enhancing the quality of reported earnings by the listed manufacturing firms at ase along the period 2009-2013. based on the data analysis and hypotheses testing, the study finds that the earnings of listed manufacturing firms in ase involve the characteristic of its continuity, so these earnings are with good quality based on the measures followed by the study. in addition, the study shows that a linear regression relationship exists between the features of audit quality and the quality of reported earnings, where the strongest significant effect is attributed to audit fees, followed by an auditor's opinion regarding the fairness of financial statements for the most recent period, in enhancing the quality of reported earnings. the study also finds that the proportion of specialized audit firms with the client's industry is 59.1 percent. other features of audit have no significant effect. one conclusion this study reaches is that the interaction among the features of audit quality has a significant effect in enhancing the quality of reported earnings. one important finding of the study is that the majority of listed manufacturing firms at ase continue with the same 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(2005). earnings management and audit quality in europe: evidence from the private client segment market. european accounting review, 71(3), 289-315. watts, r. l., and zimmerman, j. l (1986). positive accounting theory, englewood ciffs, n.j, prentice-hall, inc. wuchun, c., ling, l., & mikhail, p. (2011). is enhanced audit quality associated with greater real earning management?. accounting horizons, 25(2), 315-335. microsoft word 4326-15990-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 220 efficiency and productivity of commercial banks in nepal: a malmquist index approach biwesh neupane research and investment department, kriti captial & investments ltd. mathuri sadan, ravibhawan, kathmandu, nepal tel: 977-01-427-6786, 977-01-428-1776 e-mail: biwesh@kriticapital.com.np received: sep. 26, 2013 accepted: november 13, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4326 url: http://dx.doi.org/10.5296/ajfa.v5i2.4326 abstract this study investigates the change in efficiency and productivity of banking industry during the period of 2007/08 to 2011/12 and analyzes the effects of various indicators on the efficiency of the twenty two commercial banks in nepal. malmquist index is used as to measure the efficiency and productivity where as tobit regression is used as to analyze the determinants of efficiency. overall, the results show that the productivity change of commercial banks in nepal has improved over the sample period and that the increase in productivity change in nepalese commercial banks is due to the technical progress rather than efficiency components. it also reports that the decline in efficiency change is due to decline in both pure efficiency change and scale efficiency change. the tobit regression model found positive relationship between debt to equity ratio and efficiency as well as between capital adequacy and efficiency. further, profitable banks with lower leverage and higher capital adequacy ratio are found to be more efficient and bank loans seem to be more highly valued than alternative bank outputs i.e., investments and securities. keywords: efficiency, productivity, commercial banks, nepal, malmquist index, technical efficiency, scale efficiency asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 221 1. introduction banking and finance sector is one of the important pillar for the economic development of any country. commercial banks, one of the major components of banking system, have to be efficient as it links the various economic activities such as agriculture, trade, industry, energy and service with the economic development. banks need to be efficient not only for the greater goal of economic growth but also for survival against its competitors. with the growth in banking activities, the efficiency has been the growing concern of commercial banks in order to remain competitive. due to the importance of the financial sector and its impact to the whole economy, financial sector development study and efficiency analysis is necessary. the efficiency of financial institutions has been widely and extensively studied in the last few decades. for financial institutions, efficiency implies improved profitability, greater amount of funds channeled in, better prices and services quality for consumers and greater safety in terms of improved capital buffer in absorbing risk (berger et al. 1993). the mostly used measures for evaluating banks in nepalese context include various financial ratio measures, which provide the tools for managing information in order to analyze the financial condition and performance of a bank. the most commonly used financial ratios, such as return on shareholders’ equity (roe), return on assets (roa), profit margin (pm), net interest margin (nim), cash reserve ratio (crr) and earnings per share (eps), are used to characterize the performance of banks and are also presented in the annual reports of banks. the fundamental limitation of traditional ratio analysis is that the choice of a single ratio does not provide enough information about the various dimensions of the performance of a bank. the aim of this paper is to evaluate efficiency of commercial banks in nepal. in general there are two basic approaches that estimate efficiency, the parametric and the non-parametric ones. the parametric methods require explicit assumptions about the function that convert inputs into outputs and about the distribution of the error terms. on the other hand the non parametric methods (including data envelopment analysis (dea) and malmquist index (mi)) do not require functional form. it requires only the necessary data, inputs and outputs. due to the advantages of non parametric methods, in recent years mi has gained researchers’ and managers’ interest. the method is used to estimate the relative efficiency of homogenous decision making units such as hospitals, public institutions, banks, financial institutions, schools, farms etc. in this paper, we make use of malmquist index (mi) to analyze the efficiency of commercial banks in nepal during the period 2007/08 to 2011/12 and also perform tobit regression model to analyze the effects of various indicators on the efficiency of the commercial banks in nepal. the sample includes twenty two established commercial banks in nepal. using mi index first the efficiency measures under constant return to scale and variable return to scale assumption is reported. the efficiency suggested that 5 out of 22 banks were consistently efficient under both assumptions. 4 out of 22 banks were least efficient under both assumptions. then, the malmquist productivity change and its two components for four years are reported. it showed that the positive productivity change was due to technical asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 222 progress rather than efficiency change. the tobit regression model found positive relationship between profitability, leverage, and capital fund to risk weighted assets and efficiency. in nepalese banking sector profitable bank with high low leverage and higher risk weighted are found to be more efficient and bank loans seem to be more highly valued than alternative bank outputs i.e., investment and securities. the remainder of the paper is organized as follows. section 2 introduces the banking sector in nepal and section 3 reviews the related literature. section 4 presents sample data and methodology used for the paper. in section 5, empirical evidence is presented and conclusion is presented in section 6. 2. banking sector in nepal banking sector has undergone tremendous changes and revolution over a period of more than seven decades. the whim of commercial bank started with the establishment of nepal bank limited (nbl) in 1937, first commercial bank of nepal and nepal rastra bank (nrb), the central bank, nearly after two decades in 1956. the establishment of nbl and nrb is considered to be two major milestones in nepalese banking sector (maskay & subedi, 2009). third important milestone is the replacement of nrb act 1955 by current nepal rastra bank act 2005 (maskay & subedi, 2009). a decade after the establishment of nrb, rastriya banijya bank (rbb), a commercial bank under the ownership of the then his majesty’s government of nepal (hmg/n) was established. with the adoption of financial sector liberalization, characterized by liberalization and deregulation of the interest rates, relaxation of entry barriers for domestic and foreign banks, restructuring of public sector commercial banks and withdrawal of central bank control over their portfolio management, new commercial banks from private sector entered into the playground. consequently, the third commercial bank in nepal, or the first foreign joint venture bank, was set up as nepal arab bank ltd (now called as nabil bank ltd) in 1984. table 1 shows the growth of financial institutions in terms of number of different financial institutions. table 2 presents the first 10 commercial banks established in nepal. table 1. growth of financial institutions in nepal types of financial institutions 1995 2000 2005 2006 2007 2008 2009 2010 2011 2012 commercial banks 10 13 17 18 20 25 26 27 31 32 development banks 3 7 26 28 38 58 63 79 87 88 finance companies 21 45 60 70 74 78 77 79 79 69 micro-finance/development banks 4 7 11 11 12 12 15 18 21 24 savings and credit co-operatives 6 19 20 19 17 16 16 15 16 16 ngos (financial intermediaries) 7 47 47 47 46 45 45 38 36 total 44 98 181 193 208 235 242 263 272 265 source: nepal rastra bank (2012) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 223 table 2. first 10 commercial banks established in nepal s.n. name of commercial banks date of operation (a.d.) 1. nepal bank limited 1937/11/15 2. rastriya banijya bank 1966/01/23 3. nabil bank limited 1984/07/16 4. nepal investment bank limited 1986/02/27 5. standard chartered bank nepal limited 1987/01/30 6. himalayan bank limited 1993/01/18 7. nepal sbi bank limited 1993/07/07 8. nepal bangladesh bank limited 1993/06/05 9. everest bank limited 1994/10/18 10. bank of kathmandu limited 1995/03/12 source: nepal rastra bank (2012) many prominent authors agree to the fact that banks and financial institutions such as development banks, co-operatives, finance companies, merchant banks, and insurance companies directly and indirectly affect the economic development and are established all over the world to mobilize savings and invest into economy either directly and indirectly for production and generation of income and employment. with liberalization and increasing competition, the banking sector registered impressive achievement in terms of branch expansion, deposits, credit, and investment as shown in table 3. table 3. growth of commercial bank in terms of branches, deposits, credit and investment years as of july number of bank branches in units total deposits in million rs. total credit in million rs. total investment in million rs. 2001 430 181,767.00 109,121.20 25,446.50 2002 413 185,144.70 113,174.60 34,209.80 2003 447 203,879.30 124,522.40 45,386.30 2004 423 233,811.20 140,031.40 49,668.60 2005 422 232,409.80 163,718.80 60,181.10 2006 437 291,245.50 176,820.30 82,173.70 2007 440 337,497.20 231,829.50 93,530.80 2008 555 426,080.30 302,912.40 108,954.80 2009 752 563,604.40 398,143.00 130,856.90 2010 987 630,880.84 469,279.84 134,041.09 2011 1245 687,587.89 528,023.14 149,557.36 2012 1423 867,978.25 622,575.49 181,272.66 source: nepal rastra bank (2012) nepal’s commercial bank sector has grown at a rate of 15.29% with respect to deposits, 15.50% with respect to credit and 10.72% with respect to investments indicating increase in liquidity over the period of five years from 2007/08 to 2011/12. the commercial bank’s share of total asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 224 deposits and total credit has also grown over the year as shown in table 4. even though, the commercial bank sector witnessed decline in share of deposits and credit in 2010 and 2011, the commercial bank holds overwhelming share in the market. as a percentage of gdp, the banking sector has improved from around 52% to around 56% in deposits and from around 37% to around 40% in credit from year 2008 to 2012. table 4. share of commercial banks in terms of deposits and credit years as of july deposits credit amount % of share % of gdp amount % of share % of gdp 2008 426,080.30 83.7% 51.91% 302913.40 78.3% 36.90% 2009 563,604.40 83.5% 58.71% 398143.00 77.8% 41.47% 2010 630,880.84 80.1% 53.88% 469279.84 75.2% 39.89% 2011 687,587.89 78.7% 51.09% 528023.14 73.5% 39.24% 2012 867,978.25 80.6% 55.70% 622575.49 77.1% 39.96% source: nepal rastra bank (2012) 3. literature review in 1953, sten malmquist, a swedish economist and statistician first derived a quantity index for use in consumption analysis in trabajos de estadistica (malmquist, 1953). later caves et al. (1982) adapted malmquist's idea for production analysis and they named the productivity changes index after sten malmquist. the application of data envelopment analysis based on malmquist total factor productivity index is widely used in the comparison of countries and aggregate comparisons of productivity between countries (fare et al. 1994; yörük & zaim, 2005) as well as various economic sectors such as agriculture (tauer, 1998; mao & koo, 1996; coelli & rao, 2005), airlines (alam & sickles, 1995; gillen & lall, 1997; barros & weber, 2008), telecommunications industry (uri, 2002; calabrese et al. 2001), universities (avkiran, 2001), and energy sector (price & weyman-jones, 1996). berg et al. (1992) presented the first application of the malmquist index to measure productivity growth in the norwegian banking system in the pre and post deregulation era (1980-89), using the value added approach. their analysis showed that the productivity exhibited a lackluster performance in the pre-deregulation era, however, the productivity increased remarkably in the post-deregulation era suggesting that deregulation led to more competitive environment, especially for larger banks. likewise, using a generalized malmquist productivity index, grifell-tatje & lowell (1997) analyzed the sources of productivity change in spanish banking over the period 1986-1993 and found that the commercial banks had a lower rate of productivity growth compared to saving banks, but a higher rate of potential productivity growth. drake (2001) studied efficiency and productivity changes in the main uk banks over the period 1984 to 1995 and suggested that bank scale inefficiencies were a more severe problem than x-efficiencies. drake’s malmquist productivity indices suggested that, on the whole, uk banks exhibited positive productivity growth over the period. sathye (2002) also used malmquist index to analyze productivity changes from 1995-1999 in a panel of 17 australian asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 225 banks to assess the effects of deregulation and the reforms introduced by the wallis report of 1997. sathye (2002) found a decline of 3.1 per cent in technical efficiency over the period and of 3.5 per cent in the total factor productivity index, although annual productivity grew by 1.3 per cent. likewise, neal (2004) measured x-efficiency and productivity change of australian banks for the period of 1995-1999. the findings displayed that overall efficiency had a declining trend until 1997 but rose in 1998 as well as 1999, and allocative efficiency of banks was higher than technical efficiency. handful of research has also been devoted to investigate the efficiency of banks in asian countries. bhattacharyya et al. (1997) examined the productive efficiency of indian commercial banks during 1986-1991 and found a marginal increase in overall average performance after 1987 and the average efficiency of publicly owned banks is much higher than in the privately owned or foreign owned banks. galagedera & edirisuriya (2005) used data envelopment analysis and malmquist index in a sample of indian commercial banks over the period of 1995-2002 and found no significant growth in productivity during the sample period. he found that there has been no growth in productivity in private sector banks where as the public sector banks appeared to demonstrate a modest positive change through 1995-2002. sinha & chatterjee (2008) tried to make a comparison of fund based operating performance and total factor productivity growth of selected indian commercial banks for the five year period 2000-01 to 2004-05 using data envelopment analysis and mamlquist total factor productivity index. the findings displayed that the mean technical efficiency of the in-sample private and foreign banks is somewhat higher than the in-sample public sector banks. however, in-sample public sector commercial banks exhibited higher malmquist index than the in-sample private sector banks. likewise, rezvanian et al. (2008) also used malmquist index to examine the effects of the ownership on efficiency, efficiency change, technological progress, and productivity growth of the indian banking industry over the period of 1998-2003 they found that foreign banks were operating significantly more efficient than privately owned and publicly owned banks. chen et al. (2005) employed a non parametric technique to examine the change in the efficiency of 43 chinese banks between 1993 and 2000 in response to the 1995 banking deregulation. they report that the efficiency of banks has declined from 1997 to 2000, indicating that the 1995 banking deregulation has had a positive impact on banking efficiency only in the beginning year of its implementation. jeanneney et al. (2006) measured total productivity changes and its component of chinese banks from 1993 to 2001 and found increment in total factor productivity. they reported productivity growth can be attributed mostly attributed to technical progress, rather than to improvement in efficiency. ali rizvi (2001) analyzed 37 scheduled commercial banks 18 domestic and 19 foreign operating in pakistan and concluded that both efficiency and productivity have declined in the post-reforms period of 1993-98. ahmed et al. (2009) measured the efficiency of 20 domestic commercial banks of pakistan under intermediation approach and also reported decline in technical efficiency during pre-reform, phase i and phase ii period of reforms. they found that banking reforms has shown a decline trend in efficiency (with a decrease of 8.2 percent). in nepalese context, malmquist index has been used in few sectors such as energy (jha et al., asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 226 2007), and agriculture (suhariyanto & thirtle, 2001). with regards to efficiency of banking sector in nepal, thagunna & poudel (2013) used data envelopment analysis to measure and analyze efficiency levels of banks in nepal during 2007-08 and 2010-11. the study reveals that efficiency level is relatively stable and has increased overall. they found that found that both the ownership type and the asset size of a bank don’t affect its efficiency. 4. data and methodology 4.1 sample data currently, there are 32 commercial banks operating in nepal (including agriculture development bank). the sample period for the study is between 2007/08 to 2011/12; hence, 7 banks that have started operation since 2009 have been excluded from the sample because of lack of comprehensive data. out of 25 commercial banks, the sample also excludes rastriya banijya bank (rbb) and nepal bank limited (nbl) because of its huge assets size which may distort the result. likewise, agriculture development bank (adbl) has also been excluded from the sample because of its ability to provide more loans than its deposits. for instance, adbl provided on average 13% more than its deposits from the year 2007/08 to 2011/12. hence, the sample comprises of a balanced panel of 22 established commercial banks from 2007/08 to 2001/12. out of 22 sample banks, 6 commercial banks namely nabil bank limited, standard chartered bank nepal limited, himalayan bank limited, nepal sbi bank limited, nepal bangladesh bank limited, and everest bank limited are joint venture bank. the list of sample commercial banks along with codes and other details are provided in table 5. table 5. sample commercial banks s.n. name of bank code joint venture with foreign share (%)* 1. nabil bank limited nabil nb international, ireland 50% 2. nepal investment bank limited nibl 3. standard chartered bank nepal limited scbn standard chartered grind lays bank ltd., australia and uk 75% 4. himalayan bank limited hbl habib bank ltd., pakistan 20% 5. nepal sbi bank limited nsbi state bank of india, india 55.05% 6. nepal bangladesh bank limited nbbl bank asia limited, bangladesh ific bank, bangladesh 22.95% 7. everest bank limited ebl punjab national bank, india 20% 8. bank of kathmandu limited bok 9. nepal credit and commerce bank limited nccb 10. nic bank limited** nicb 11. lumbini bank limited lbl 12. machhapuchchhre bank limited mbl 13. kumari bank limited kbl 14. laxmi bank limited laxl 15. sidhhartha bank limited sbl asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 227 16. global ime bank limited*** gobl 17. citizens international bank limited cbl 18. prime bank limited pbl 19. bank of asia nepal limited** boa 20. sunrise bank limited sbl 21. grand bank limited**** gbl 22. nmb bank limited nmb *as of july 2012 ** nic bank limited and bank of asia merged and became nic asia limited in april 2013 ***global bank limited merged with ime financial institution and lord buddha finance limited and became global ime bank limited in june 2012 **** previously known as development credit bank limited (dcbl). the data required for the analysis were collected from annual banking and financing statistics published each year in july by nrb and information regarding labor was collected from the annual report published by each commercial bank for the concerned year. 4.2 methodology the aim of this paper is to investigate efficiency of selected commercial banks in nepal using the nonparametric approach. this study adopts the generalized output-oriented malmquist index, developed by fare et al. (1989) has been used to measure the contributions from the progress in technology (technical change) and improvement in efficiency (efficiency change) to the growth of productivity in nepalese commercial bank industries. the malmquist indexes are constructed using the data envelopment analysis (dea) and estimated using a program developed by coelli (1996), called deap version 2.1. forsund (1991) derived the decomposition of the simple version of the malmquist productivity index into technical change and efficiency change. fare et al. (1989) showed that the output-based malmquist productivity index between time periods t and (t + 1) can be decomposed into two components, as: mk t+1 yt+1,xt+1,yt,xt = dk t (yt+1,xt+1) dk t (yt,xt) × dk t+1(yt+1,xt+1) dk t+1(yt,xt) 1 2 (1) where m represents the productivity of the most recent production point (xt+1,yt+1) relative to the earlier production point (xt,yt) of bank k. d’s are output distance functions. following fare et al. (1989), an equivalent way of writing the equation (1) is as follows: mk t+1 yt+1,xt+1,yt,xt = dk t+1(yt+1,xt+1) dk t (yt,xt) × dk t (yt+1,xt+1) dk t+1(yt+1,xt+1) × dk t (yt,xt) dk t+1(yt,xt) 1 2 (2) or, m=effch×techch where, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 228 technical efficiency change (effch) = dk t+1(yt+1,xt+1) dk t (yt,xt) (3) technical change (techch) = dk t (yt+1,xt+1) dk t+1(yt+1,xt+1) × dk t (yt,xt) dk t+1(yt,xt) 1 2 (4) essentially, the former investigates how well the production process converts input into outputs (catching up to the frontier) and the latter reflects improvement in technology. according to fare, et al. (1994) an improvement in performance over time is associated with a malmquist index greater than unity and deterioration in performance over time is associated with a malmquist index less than unity. likewise, technical efficiency value greater than one indicates improvement in efficiency component and is considered to be evidence of catching up (to the frontier) and values of the technical change component greater than one are considered being evidence of technological progress. now, assume that there are k=1, 2,….,k financial institutions and that each varying amounts of n=1,2,…n different inputs xt k,n to produce m=1,2,…,m outputs yt k,n at each time period t=1,2,…t. thus, the reference technology under constant returns to scale (crs) at each time period t from the data can be defined as: gt= xt,yt :ym t ≤ zk t yk,m t k k=1 m=1,…..., m (5) zk t yk,m t k k=1 ≤xn t n=1,……, n zk t ≥0 k=1,……, k where zk t refers to weight on each specific cross-sectional observation. following afriat (1972), the assumption of crs may be relaxed to allow variable returns to scale (vrs) by adding the following restrictions: zk t k k=1 =1 vrs (6) fare et al. (1994) used an enhanced decomposition of the malmquist index by decomposing the efficiency change component calculated relative to the crs technology into a pure efficiency component (calculated relative to the vrs technology) and a scale efficiency-change component which captures changes in the deviation between the vrs and crs technology. the subset of pure efficiency change measures the relative ability of operators to converts inputs into outputs while scale efficiency measures to what extent the operators can take advantage of returns to scale by altering its size towards optimal scale. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 229 thus, technical efficiency change (effch) = pech × sech where, pure technical efficiency change pech = dv t+1 xk t+1,yk t+1 dv t xk t ,yk t (7) scale efficiency change sech = dc t+1 xk t+1,yk t+1 dv t+1 xk t+1,yk t+1 dc t xk t ,yk t dv t xk t ,yk t (8) the subscript ‘v’ and ‘c’ denotes vrs and crs technologies, respectively. pech greater than unity indicates increase in pure technical efficiency, while less than unity indicates a decrease and equal to unity indicates no change in pure technical efficiency. similarly, sech greater than unity indicates that the most efficient scale is increasing overtime, so the scale efficiency is improving, while sech less than unity implies the opposite and equal to unity implies no change. to construct the malmquist index for adjacent periods, it is needed to calculate four different distance functions – dt(yt, xt), dt(yt+1, xt+1), dt+1(yt, xt), dt+1(yt+1, xt+1) . this paper uses data envelopment analysis program (deap v. 2.1) developed by coelli (1996). with the help of fare et al.’s (1994) approach and deap 2.1, it is thus possible to provide five efficiency indices for each firm and a measure of technical progress over time. these are (i) productivity change (tfpch), (ii) technological change (techch), (iii) efficiency change (effch), (iv) pure technical efficiency change (pech), and (v) scale efficiency change (sech). 4.3 choice of proxies for output and input the choice of input variables and output variables to measure the efficiency of commercial banks has been a debatable issue. different literature supports different views regarding the input and output specifications. the choice depends on two different approaches used in banking studies namely, production approach and intermediation approach. production approach considers banks as producers of loan services and deposits accounts using capital and labor as inputs. under this approach, output is best measured by the number and type of transactions or documents processed over a given time period (berger & humphrey, 1997). however, such data are typically not available. the intermediation approach considers banks as financial intermediaries that convert deposits and purchased funds into loans and financial investments. this approach treats loans as outputs, while deposits and other liabilities are treated as inputs. this study also uses intermediation approach, which is mostly commonly used approach. the study specifies three output and three input variables. first output variable is loans and advances which include loans to private sectors, financial institutions and government organizations. second output variable is total investments which include investments in asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 230 government securities, bonds, government and other non-financial institutions, non-residents, shares and other investments. third output variable is interest income which includes interest incomes from loans and advances, on investments, agency balance, call deposits, and others. likewise, first input variable is total deposits which include foreign and domestic currency current, savings and fixed deposits along with call deposits and others. second input variable is labor which include average employee per branch and third input variable is capital expenses which include fixed assets and other assets (such as accrued interests, staff loans, sundry debtors, and cash in transit). table 6 presents the descriptive statistics about the input and output variables of 22 sample commercial banks during the year 2007/08 to 2011/12. table 6. descriptive statistics of output and input variables year output variables input variables total loans and advances total investment total interest income total deposits labor total capital expenses 2007/08 223,494 72,783 19,408 294,084 24 21,711 2008/09 302,261 93,761 29,106 407,508 18 26,308 2009/10 353,953 108,557 43,029 470,847 14 28,887 2010/11 390,377 113,762 55,888 500,978 14 35,145 2011/12 440,019 125,064 62,003 609,698 13 46,038 mean 342,021 102,785 41,887 456,623 17 31,618 standard deviation 83,238 20,198 17,823 116,654 5 9,410 maximum 440,019 125,064 62,003 609,698 24 46,038 minimum 223,494 72,783 19,408 294,084 13 21,711 nibl ranks highest in terms of total loans and advances, total interest income and total deposits whereas scbn ranks highest in terms of total investments and has highest number of employees per branch. nabil has highest capital expenses and is behind nibl in terms of total loans and advances, total interest income and total deposits. lbl ranks lowest in terms of total loans and advances, total investments and total deposits. 5. empirical results table 7 reports the measures of efficiency for the 22 commercial banks from 2007/08 to 2011/12 under constant returns to scale (crs) and variable returns to scale (vrs) assumption. the value of unity represents the industry frontier, thus the firm with lower value than unity is more inefficient compared to values closer than one. values of unity imply that the firm is on the industry frontier in the associated year where as value less than unity imply that firm is below the frontier or technically inefficient. it can be seen that nabil, ebl, nsbi, lbl, and pbl are consistently efficient under both crs and vrs; however, in addition, nibl and nicb are consistently efficient under vrs. nccb, nbbl, mbl and laxbl seem to be least efficient bank under both crs and vrs. however, the efficiency of nccb has slightly improved compared to other least efficient banks. the efficiency of nbbl, mbl and lbl both has declined over the year under both asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 231 crs and vrs. gobl, sbl and cbl seem to be improving its performance over the years, gobl witnessing greater growth in efficiency but sbl is more efficient. nmb lost its efficiency in between but recovered efficiency strongly during the adverse period. surprisingly, the efficiency of hbl, bok and kbl has declined slightly over the period but are still efficient compared to other banks. gbl, scbn, and gbl are in the industry frontier till 2010/11 but witnessed slight decline in efficiency in the year 2011/12. table 7. efficiency of commercial banks, 2007-08 to 2011/12 (crs) bank code crs vrs 2007/08 2008/09 2009/10 2010/11 2011/12 2007/08 2008/09 2009/10 2010/11 2011/12 nabil 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 nibl 0.951 1.000 1.000 0.984 0.946 1.000 1.000 1.000 1.000 1.000 scbn 1.000 1.000 1.000 1.000 0.963 1.000 1.000 1.000 1.000 0.970 hbl 1.000 0.901 0.974 0.931 0.911 1.000 0.983 0.989 0.956 0.995 nsbi 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 nbbl 0.828 0.972 0.974 0.930 0.836 0.835 0.988 0.988 0.936 0.872 ebl 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 bok 1.000 0.965 0.973 0.956 0.981 1.000 0.981 0.973 0.968 0.984 nccb 0.882 0.867 0.849 0.891 0.939 0.951 0.895 0.861 0.891 0.955 nicb 1.000 1.000 1.000 1.000 0.982 1.000 1.000 1.000 1.000 1.000 lbl 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 mbl 0.880 0.931 0.942 0.972 0.814 0.899 0.954 0.942 0.982 0.826 kbl 1.000 1.000 0.993 0.991 0.890 1.000 1.000 1.000 1.000 0.910 laxbl 0.977 0.955 0.907 0.903 0.858 0.980 1.000 0.942 0.945 0.864 sbl 1.000 0.929 1.000 1.000 0.995 1.000 0.938 1.000 1.000 1.000 gobl 0.767 0.933 0.901 1.000 0.907 0.782 0.948 0.908 1.000 0.927 cbl 0.950 0.840 0.979 1.000 0.916 1.000 0.988 1.000 1.000 1.000 pbl 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 boa 1.000 1.000 1.000 1.000 0.982 1.000 1.000 1.000 1.000 0.983 sbl 0.953 0.813 0.966 1.000 1.000 0.953 0.834 1.000 1.000 1.000 gbl 1.000 1.000 1.000 1.000 0.970 1.000 1.000 1.000 1.000 0.978 nmb 1.000 0.836 0.907 0.982 1.000 1.000 1.000 0.950 1.000 1.000 mean 0.963 0.952 0.971 0.979 0.950 0.973 0.978 0.980 0.985 0.967 the mean is the geometric mean of the efficiency in the particular year. the mean shows that the efficiency has increased till 2010/11, however, 2011/12 witnessed decline in the efficiency. in fact, the efficiency is lowest in 2011/12 compared to other years. this shows that the performance of commercial banks was not satisfactory compared to previous years in 2012 which can be attributed to various externalities such as adverse political situation, liquidity crunch, tight regulatory measures by nrb among others. it can also be seen that 7 out of 22 commercial banks were in industry frontier (crs) in 2011/12 compared to 13 out of 22 in 2010/11 (crs). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 232 table 8 reports the malmquist productivity changes (tfpch) over two years and table 9 and table 10 presents the two components of productivity change. the table shows that on average nsbi witnessed 22.6% growth in its productivity over 5 years. the highest growth achievers were ebl, nibl, nabil, sbl, lbl and cbl, all with double digit growth. nicb, gbl and nmb witnessed decline in productivity. overall, the mean growth rate of the industry is around 5.6% for the year 2007/08 to 2011/12; however, the productivity change has declined largely in the year 2011/12. the productivity change can be further decomposed into technical change and efficiency change as shown in table 9 and table 10 respectively. table 8. bank’s relative malmquist productivity change (tfpch) between time period t and t+1, 2007/08 to 20011/12 bank code 2007/08 2008/09 2008/09-2009/10 2009/10-2010/11 2010/11-2011/12 mean nabil 1.225 1.236 1.193 1.084 1.1845 nibl 1.253 1.208 1.073 0.939 1.1183 scbn 1.161 1.111 0.855 0.935 1.0155 hbl 0.995 1.154 1.030 0.953 1.0330 nsbi 1.542 1.109 1.122 1.130 1.2258 nbbl 1.355 1.040 0.987 0.814 1.0490 ebl 1.222 1.394 1.213 0.987 1.2040 bok 1.140 1.168 1.039 0.964 1.0778 nccb 1.033 1.002 1.090 0.939 1.0160 nicb 0.960 0.987 1.020 0.881 0.9620 lbl 1.152 1.629 0.684 0.918 1.0958 mbl 1.090 1.095 1.097 0.860 1.0355 kbl 1.223 1.219 1.033 0.869 1.0860 laxbl 1.056 1.057 1.024 0.870 1.0018 sbl 1.012 1.335 1.129 0.965 1.1103 gobl 1.220 1.094 1.133 0.836 1.0708 cbl 1.064 1.448 1.070 0.885 1.1168 pbl 1.084 1.211 1.271 0.738 1.0760 boa 1.226 1.119 0.989 0.893 1.0568 sbl 0.812 1.295 1.103 0.985 1.0488 gbl 0.861 0.995 1.052 0.839 0.9368 nmb 0.637 1.071 1.098 0.882 0.9220 mean 1.088 1.171 1.052 0.913 1.0560 table 9 presents the index values of technical change (regress/progress) as measured by average shifts in the best practice frontier. the table shows that only nabil, nsbi and mbl experienced technical progress from 2007/08 to 2010/12 while others experienced both technical progress and regress in some years. nicb, gbl and nmb witnessed technical regress where as nsbi recorded highest technical progress followed by ebl, nabil, nibl, cbl, sbl, laxbl, and lbl (with double digit technical progress). 4 out of 22 (in 2007/08-09), 3 out of 22 (2008/09-10), 2 out of 22 (in 2009/10-11), and 19 out of 22 (in asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 233 2010/11-12) witnessed technical regress. overall, the geometric mean suggests that the industry saw technical progress with technical change of 5.8%; however, there was technical regress in the year 2011/12. table 9. bank’s relative technical change (techch) between time period t and t+1, 2007/08 to 20011/12 bank code 2007/08 2008/09 2008/09-2009/10 2009/10-2010/11 2010/11-2011/12 mean nabil 1.225 1.236 1.193 1.084 1.185 nibl 1.191 1.208 1.090 0.978 1.117 scbn 1.161 1.111 0.855 0.971 1.025 hbl 1.104 1.067 1.077 0.974 1.056 nsbi 1.542 1.109 1.122 1.130 1.226 nbbl 1.154 1.038 1.033 0.906 1.033 ebl 1.222 1.394 1.213 0.987 1.204 bok 1.181 1.158 1.058 0.939 1.084 nccb 1.051 1.024 1.038 0.890 1.001 nicb 0.960 0.987 1.020 0.897 0.966 lbl 1.152 1.629 0.684 0.918 1.096 mbl 1.029 1.082 1.063 1.027 1.050 kbl 1.223 1.227 1.036 0.967 1.113 laxbl 1.081 1.112 1.028 0.916 1.034 sbl 1.090 1.240 1.129 0.969 1.107 gobl 1.004 1.133 1.021 0.922 1.020 cbl 1.202 1.242 1.048 0.966 1.115 pbl 1.084 1.211 1.271 0.738 1.076 boa 1.226 1.119 0.989 0.909 1.061 sbl 0.953 1.089 1.066 0.985 1.023 gbl 0.861 0.995 1.052 0.865 0.943 nmb 0.762 0.988 1.014 0.867 0.908 mean 1.101 1.147 1.043 0.942 1.058 table 10 reveals the change in efficiency for each individual bank during the five years. nabil, nsbi, ebl, lbl, and pbl are found to be efficient among other banks (same bank were also found to be efficient throughout the period as shown in table 7). 13 out of 22 banks witnessed decline in relative efficiency. overall, gobl experienced greater change in relative efficiency followed by sbl and nccb. overall, the mean shows decline in the overall relative technical efficiency of the bank. comparing table 7 to table 9, we can see that the change in productivity change was greater due to technical change rather than efficiency change. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 234 table 10. bank’s relative efficiency (effch) between time period t and t+1, 2007/08 to 20011/12 bank code 2007/08 2008/09 2008/09-2009/10 2009/10-2010/11 2010/11-2011/12 nabil 1.000 1.000 1.000 1.000 nibl 1.051 1.000 0.984 0.961 scbn 1.000 1.000 1.000 0.963 hbl 0.901 1.081 0.956 0.978 nsbi 1.000 1.000 1.000 1.000 nbbl 1.174 1.002 0.955 0.898 ebl 1.000 1.000 1.000 1.000 bok 0.965 1.008 0.982 1.027 nccb 0.983 0.979 1.049 1.055 nicb 1.000 1.000 1.000 0.982 lbl 1.000 1.000 1.000 1.000 mbl 1.059 1.011 1.032 0.838 kbl 1.000 0.993 0.998 0.898 laxbl 0.977 0.950 0.997 0.950 sbl 0.929 1.077 1.000 0.995 gobl 1.216 0.966 1.110 0.907 cbl 0.885 1.166 1.021 0.916 pbl 1.000 1.000 1.000 1.000 boa 1.000 1.000 1.000 0.982 sbl 0.853 1.189 1.035 1.000 gbl 1.000 1.000 1.000 0.970 nmb 0.836 1.084 1.083 1.018 mean 0.989 1.021 1.009 0.969 table 11 shows the decomposition of efficiency into pure technical efficiency change (pech) and scale efficiency change (sech). the table indicates mixed results in different year. the efficiency could be attributed more to the pure technical efficiency change in the year 2007/08-09 and 2009/10-11 where as the efficiency change to the scale efficiency change in the year 2008/09-10 to 2010/11-12. nabil, nsbi, ebl, lbl and pbl show no change in pure technical efficiency as well as scale efficiency throughout the sample period. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 235 table 11. changes in efficiency components (pure technical efficiency change and scale efficiency change) by banks between time period t and t + 1, 2007/08 to 20011/12 bank code 2007/08 2008/09 2008/09-2009/10 2009/10-2010/11 2010/11-2011/12 pech sech pech sech pech sech pech sech nabil 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 nibl 1.000 1.051 1.000 1.000 1.000 0.984 1.000 0.961 scbn 1.000 1.000 1.000 1.000 1.000 1.000 0.970 0.993 hbl 0.983 0.917 1.006 1.074 0.967 0.989 1.041 0.939 nsbi 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 nbbl 1.182 0.993 1.001 1.001 0.947 1.008 0.932 0.964 ebl 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 bok 0.981 0.985 0.993 1.016 0.995 0.987 1.016 1.010 nccb 0.941 1.044 0.961 1.018 1.035 1.014 1.072 0.984 nicb 1.000 1.000 1.000 1.000 1.000 1.000 1.000 0.982 laxbl 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 mbl 1.062 0.997 0.987 1.024 1.042 0.990 0.841 0.996 kbl 1.000 1.000 1.000 0.993 1.000 0.998 0.910 0.987 lbl 1.021 0.958 0.942 1.008 1.003 0.993 0.915 1.038 sbl 0.938 0.990 1.066 1.010 1.000 1.000 1.000 0.995 gobl 1.213 1.002 0.957 1.009 1.102 1.008 0.927 0.979 cbl 0.988 0.895 1.012 1.152 1.000 1.021 1.000 0.916 pbl 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 boa 1.000 1.000 1.000 1.000 1.000 1.000 0.983 1.000 sbl 0.875 0.974 1.199 0.992 1.000 1.035 1.000 1.000 gbl 1.000 1.000 1.000 1.000 1.000 1.000 0.978 0.991 nmb 1.000 0.836 0.950 1.142 1.053 1.028 1.000 1.018 mean 1.006 0.983 1.002 1.019 1.006 1.002 0.980 0.988 table 12 summarizes the malmquist productivity index of 22 commercial banks in nepal between 2007/08-2011/12. on average, nsbi records highest growth in productivity change which is fully due to technical change rather than efficiency change. nmb bank reports the lower growth in productivity change which can be again fully attributed to technical regress (-9.8%). overall the change in productivity of is mainly due to technical progress (5.5%) but efficiency change contributed negatively (-0.03%) to the total productivity change. furthermore, the decline in efficiency change is due to decline in both pure efficiency change and scale efficiency change. unlike omar et al. (2006), who concluded that an increase in productivity change (tfpch) in malaysia's commercial banks industry is due to the innovation in efficiency components rather than the improvement in technical aspect, it can be concluded that the increase in productivity change in nepalese commercial banks industry is due to the technical progress rather than efficiency components. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 236 table 12. summary of malmquist productivity index of bank means, 2007/08 to 20011/12 bank code tfpch effch techch pech sech nabil 1.183 1.000 1.183 1.000 1.000 nibl 1.111 0.999 1.113 1.000 0.999 scbn 1.008 0.991 1.017 0.992 0.998 hbl 1.030 0.977 1.055 0.999 0.978 nsbi 1.214 1.000 1.214 1.000 1.000 nbbl 1.032 1.002 1.029 1.011 0.991 ebl 1.195 1.000 1.195 1.000 1.000 bok 1.075 0.995 1.080 0.996 0.999 nccb 1.014 1.016 0.999 1.001 1.015 nicb 0.961 0.996 0.965 1.000 0.996 lbl 1.042 1.000 1.042 1.000 1.000 mbl 1.030 0.981 1.050 0.979 1.002 kbl 1.075 0.971 1.107 0.977 0.995 laxbl 0.999 0.968 1.031 0.969 0.999 sbl 1.101 0.999 1.103 1.000 0.999 gobl 1.060 1.043 1.017 1.043 0.999 cbl 1.099 0.991 1.109 1.000 0.991 pbl 1.053 1.000 1.053 1.000 1.000 boa 1.049 0.996 1.054 0.996 1.000 sbl 1.034 1.012 1.022 1.012 1.000 gbl 0.932 0.992 0.940 0.995 0.998 nmb 0.902 1.000 0.902 1.000 1.000 mean 1.052 0.997 1.055 0.999 0.998 note: tfch – total productivity change, effch – efficiency change, techchtechnology change, pech pure efficiency change, sechscale efficiency change regression analysis of efficiency scores and determinants of efficiency with the objective to analyze the determinants of bank efficiency, regression analysis is conducted. since the efficiency score of malmquist index ranges from 0 to 1, tobit regression model has been used. the efficiency score based on crs as well as vrs is used as dependent variables where as structure of the bank (joint venture or not), leverage ratio (d/e ratio), log of net profit, loans/assets, ratio of non-performing loans, risk weighted assets, age, and size is used as regressors. the values are taken for the year 2011/12. the regression model can be expressed as: yk *=β1+β2struck+β3levk+β4lnpk+β5loak+β6nplk+β7rwak+β8agek+β9sizek+ jt (9)ℰ = asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 237 in the equation (7), y* is the latent variable which is efficiency based on crs and vrs, is the coefficient, struck is the dummy variable which takes the value 0 if the bank is foreign joint venture and 1 if not, levk is the leverage ratio, lnpk is the log of the net profit, loak is the percentage of loan to total assets, nplk is the percentage of non-performing loans, rwak is the percentage of capital fund to risk weighted assets, agek is the number of years bank is in operation, and sizek (used as control variable) is the log of assets for each bank k. ℰ is the disturbance term, with capturing the unobserved bank specific effects and is the idiosyncratic error and is independently identically distributed (i.i.d), ek~n(0,σ2). commercial banks with foreign joint venture are expected to be more efficient than other commercial banks; hence, the coefficient of struc is expected to be negative. the lev ratio (defined as debt by equity ratio) is used as to measure the leverage of commercial banks. the variable is expected to take a positive sign and associated with higher efficiency as banks with appropriate leverage ratio can earn better from the debt portion. deposits have been taken as proxy for debt and paid up capital (with reserves and retained earnings) has been used as proxy for equity. log of net profit (lnp) is used as to measure the relationship between the efficiency and profitability. it is expected to have positive relation with the efficiency. loa is used as a proxy for liquidity risk; hence, one would expect to have positive relationship between liquidity and performance (bourke, 1989). non-performing loan as a percentage of total loans (npl) is used as a proxy of credit risk. the coefficient of non-performing loans is expected to be negative as bad loans have regressive impact on bank’s profitability. capital fund to risk weighted assets (rwa) is used as a proxy of bank’s exposure to potential losses. the coefficient of rwa is also expected to be positive as bank with higher capital fund to rwa are able to withstand higher potential losses but it may also yield negative coefficient since greater capital fund to rwa gives up financial leverage which may yield to lower interest margins and return on equity. likewise, age is used as a proxy for management expertise as greater year of operation means better understanding of competition, market condition and higher goodwill. it is generally expected that commercial banks become more efficient with higher years of operation. finally, size as a log of assets is used as control variable in the analysis. the coefficient of size may be positive if banks are able to achieve economies of scale, however, the coefficient of size may also be negative if the banks has higher risks due to higher diversification of assets. the result of tobit regression is presented in table 13. the table reveals that the coefficient of age of the commercial banks and strc as a dummy variable for foreign joint venture is in unexpected direction and the coefficient is also not significant. it is surprising result considering the fact that the foreign joint venture and old banks are considered to be more efficient. likewise, the coefficient of npl is positive but also insignificant under both crs and vrs technology which is similar to the results reported by sufian (2012). the result is close to what is called skimping hypothesis. berger and de young (1997) suggests that under the skimping hypothesis, a bank maximizing the long run profits may rationally choose to have lower costs in the short run by skimping on the resources devoted to loans underwriting and monitoring, but bear the consequences of greater loans performance problem. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 238 table 13. results of tobit regression on efficiency scores on bank indicators dependent variable ecrs evrs strc 0.059455 0.048424 (0.03684) (0.03224) lnp 0.029532** 0.034178* (0.01200) (0.01050) lev 0.02147* 0.014698** (0.00793) (0.00694) loa 0.014417 0.042285 (0.10680) (0.09345) npl 1.940538 1.866904 (1.46838) (1.28487) rwa 2.075036* 1.753671* (0.70222) (0.61446) age -0.00206 -0.002516 (0.00216) (0.00189) size -0.007891 0.049682 (0.09615) (0.08413) constant 0.259095 0.086801 (0.45584) (0.39887) * significant at 1% level ** significant at 5% level as expected rwa exhibits positive relationship with efficiency (the coefficient is significant at 1 percent level). this result suggests that the banks (with adequate capital fund to cover risky assets) are performing efficiently as they are able to withstand any financial shocks to their balance sheet. lnp is in the expected direction with significant positive correlation. the relationship between efficiency and profitability is positive which suggests that profitable banks are somewhat efficient. likewise, lev as a ratio of debt to equity is also in the expected direction. the coefficient of lev is positive and significant (at 1% for ecrs and at 5% for evrs). lower capital ratios in banking implies higher leverage and risk, hence, the results show that better capitalized banks exhibit better efficiency and productivity. the comparative analysis of lev and lnp suggests that firm with greater leverage is able to attract more deposits at lower cost which in turn reflect in higher and better loans. higher loans result in greater interest income which improves the profitability of the bank. likewise, the coefficient of loa is positive (but not significant in both cases) which suggests that there is negative relationship between bank’s efficiency and the level of liquid assets held by the bank. as the higher loa denotes lower liquidity, the result implies that the less (more) liquid banks tend to exhibit higher (lower) efficiency levels (sufian, 2012). thus, it can be seen that banks with higher loan-to-assets ratio tends to be more productive which shows that bank loans seem are more highly valued than alternative bank outputs i.e., investment and securities. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 239 size as a log of assets has been used as control variable. the coefficient of size is negative for ecrs which shows that marginal cost savings can be achieved by increasing the size of the banking firm, especially in developing markets. the result supports the findings of spathis et. al. (2002), and kosmindu (2008). eichengreen and gibson (2001) suggested that the effect of a growing bank’s size on performance may be positive up to a certain limit. beyond this point the effect of size could be negative due to bureaucratic and other reasons. however, the coefficient of size is positive for evrs which suggests that bigger banks are able to achieve efficiency under variable returns to scale assumptions. finally, regression diagnostic tests such as redundant variable test, wald-coefficient restrictions test and jarque-bera test has been performed to validate the results of the tobit regression. the redundant variable and wald test rejects the hypothesis that significant variables (lnp, lev and rwa) are redundant with likelihood ratio of 10.17 (significant at 5% level). likewise, residual diagnostics test was conducted to determine whether the residuals are normally distributed or not. jarque-bera stat was not significant at 5% level; hence, it is found that the population residual is normally distributed. 6. conclusion the paper attempts to analyze the efficiency of commercial banks in nepal during the period 2007/08 to 2011/12. the efficiency and productivity estimates are computed using mi. deap v 2.1 developed by coelli (1996) has been used to calculate all the indices. the mi allows isolating efforts to catch up to the frontier (efficiency change) from shifts in the frontier (technological change) and also explains the main sources of efficiency change: either improvements in management practices (pure technical efficiency change) or improvements towards optimal size (scale efficiency change). furthermore, tobit regression model has been used to analyze the determinants of efficiency. the finds from mi suggest that the productivity change of commercial banks in nepal has improved over the sample period and that the increase in productivity change in nepalese commercial banks industry is due to the technical progress rather than efficiency components. furthermore, decomposition of the efficiency change index into its mutually exhaustive pure technical and scale efficiency components suggest that the decline in efficiency change is due to decline in both pure efficiency change and scale efficiency change. the tobit regression model produced some interesting results in the analysis. the effect of age, structure as a dummy variable for foreign joint venture, loan to assets ratio, non performing loans and log of assets is found to be insignificant for the efficiency. as expected, capital fund to risk weighted assets is found to be positively related with efficiency as banks are able to withstand any shocks in their balance sheet. the relationship between efficiency and profitability is positive which suggests that profitable banks are somewhat efficient. the coefficient of leverage as a ratio of debt to equity is positive and significant. lower capital ratios in banking implies higher leverage and risk, hence, the results show that better capitalized banks exhibit better efficiency and productivity. thus, profitable bank with high low leverage and higher risk weighted are found to be more efficient in nepalese banking sector and bank loans seem to be more highly valued than alternative bank outputs i.e., asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 240 investment and securities. the empirical findings from this study suggest that the nepalese commercial banks are not able to catch up to the frontier because of inefficient management practices and deterioration from the optimal size. therefore, commercial banks need to focus more on management efficiency. likewise, decline in scale efficiency suggests that banks could have been too small to reap the benefits of economies of scale. therefore, from the policy making perspective, mergers, particularly among the small banking groups should be encouraged (sufian, 2012). this could entail the small banking groups to reap the benefits of economies of scale. references afriat, s. n. 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(2005). productivity growth in oecd countries: a comparison with malmquist indices. journal of comparative economics, 33, 401-420. http://dx.doi.org/10.1016/j.jce.2005.03.011 microsoft word 9248-33908-1-sm-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 127 the effects of agency costs and insiders’ shareholdings on financing choices chia-ying liu department of business administration, asia university, taiwan shiu-chen huang king steel machinery co., ltd., taiwan shieh-liang chen department of business administration, asia university, taiwan e-mail: peterchen@asia.edu.tw received: feb. 20, 2016 accepted: march 22, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.9248 url: http://dx.doi.org/10.5296/ajfa.v8i1.9248 abstract this paper investigates the effects of debt agency cost and equity agency cost of current and prior periods on the financing choices of long-term debts, seasoned equity offering, and private equity financings. it also examines the effects of the shareholdings of insiders on the association between both debt and equity agency costs and the choice of financing methods. the findings show that both prior and current debt agency costs are positively related to seasoned equity offerings of current period, and both prior and current debt agency costs are positively related to private equity financing of current period regardless of whether the models consider the factor of insiders’ shareholdings. as for equity agency cost, the document indicate that both current and prior equity agency costs are negatively related to current seasoned equity offerings, however, only prior equity agency costs are negatively related to current seasoned equity offerings under considering shareholdings of insiders. moreover, the shareholdings of insiders would affect the positive association between the corporate debt agency cost and seasoned equity offerings and the positive association between the corporate equity agency cost and debt financing. keywords: debt agency cost, equity agency cost, seasoned equity offering, long-term debts, private equity, insider’s shareholdings asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 128 1. introduction a firm should concern factors when making financing decisions, but the choice of financing methods depends on whether it can maximize the corporate benefits. the act of financing not only enables a firm to obtain sufficient capital, but also maximizes corporate benefits, and facilitates the implementation of follow-up policies. myers and majluf (1984) suggested that most firms issue bonds to gain capital, so as to receive more investment opportunities with greater value. however, compared with the investors, the managers of firms have clearer knowledge over the internal operation of firms. in case of information asymmetry, a firm could gain more capital through different financing channels.1 according to jensen and meekling (1976), the agency cost is attributable to the acts of managers motivated by self-interest in order to pursue personal gains in case of the separation of ownership and operation rights. this is detrimental to the overall corporate benefits, increases the corporate debt and equity agency costs, causes poor corporate operation performance, and results in loss of shareholder value under the separation of ownership and operation rights (fama and jensen, 1983b). both the academia and practitioner concern about how to improve corporate governance. divergence exists in taiwan regarding the study of governance structure. by reference to the corporate governance mechanism, this paper discusses the correlation between the agency cost and financing decisions as well as the impact of number of shares held by insiders on the correlation between agency cost and financing decisions. when a firm is in need of capital, capital can be obtained through issuance of new shares or debt. in case of issuance of new shares, due to increase of external shareholders, surplus is incurred, the book value is diluted, and the agency issues are incurred. nevertheless, receiving capital through debt elevates the credit risks of firms, and results in increased agency cost to shareholders and creditors. the employment of financial leverage could decide what financing method is to use, which further affects the corporate value. the corporate debt methods are merely debt from financial institutions or issuance of corporate bonds. the reasons for debt from banks and issuance of corporate bonds lie in the characters of industries and tendency to gain trust of banks or bondholders, so financing from banks or bondholders could be gained smoothly. on the other hand, either the financing method of debt or issuance of new shares incurs cost for financing. since the rate of returns required by debt is lower than that of issuing new shares, the majority of firms believe that debt financing could reduce the total capital cost, which further elevates the corporate value of firms. comparatively speaking, the debt agency cost is lower. another source of capital is private equity financing. lee and kocher (2001) pointed out that firms that engage in private equity financing are those of small scale, high growth, financial difficulty and lacking external capital. moreover, the private equity acts are not easily affected by market mispricing. due to high interest rates of debt or other factors that incapacitate firms to borrow money from financial institutions, firms would turn to the private equity financing. cronqvist and nilsson (2005) argued that firms whose information is not transparent might select private equity due to cost factors. 1 myers and majluf (1984) proposed that as the debt risks are lower than increment of cash, under the substantial investment theories, the firms intend to obtain investment opportunities with growth capacity and engage in financing. therefore, the external financing of firms tend to be financing by debt, while firms need capital injection due to investment opportunities, if they have run out of debt capacity, firms are not likely to issue securities, as the risks are high and such investment opportunities might be abandoned. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 129 the stakeholders are based on a contractual relation. besides the shareholders and the creditors, there are still issues regarding large and small shareholders, while shareholders and creditors or managers would incur the agency issues for the pursuit of personal gains. from the debt relation view, when a firm has a high leverage, it is more likely to have a conflict for corporate dividend between the creditors and the shareholders (ahmed et al. 2002). as the investment risks of creditors increase with the long-term debt ratio, the creditors may request for higher returns for the sake of personal interests, which in turn increases the debt cost of firms. from the viewpoints of equity cost, when the equity held by the shareholders of firms is enough to effectively control the decision-making rights of firms, the controlling shareholders may be motivated to continue maintenance of the equity. consequently, when the shareholdings of controlling shareholders are high, the returns of stock are also high, which further increases the equity cost of firms. if the conflicts of interests for stakeholders among agency relations are high, the required returns by creditors and shareholders are also higher, which burdens the agents with relatively higher capital cost and increasingly higher derived agency cost. the agency issues are reflected in the equity agency cost and debt agency cost. this paper attempts to understand the agency cost for different financing methods, and the roles played by debt agency cost and equity agency cost in financing decision-making. the proportion of shares held by the insiders imposes impact on the agency cost. although many studies have explored the corporate governance, agency cost and corporate value, few have focused on how the shareholdings of insiders impact the relationship between agency cost and financing decision-making. this is the motivation of this study. as there are diversified financial tools, the financing decision-making methods in the financial polices pay more attention to the selection than in the past. the public offering firms issue securities in the market, the equity disperse degree increases along with the issuance extent of equity. due to market transaction, the stakeholders change frequently. for the purpose of smooth operation, professional managers are recruited to formulate and implement decision-making on behalf of firms. for this reason, while firms intend to engage in financing acts, the decision-making ability and shareholding conditions of managers should be considered, as managers are an important factor that affects whether firms implement various financing decision-making. on the other hand, with regard to capital structure, while in need of capital, firms could gain capital through issuance of new shares or debt. gaining capital through debt would elevate the credit risks of firms, which results in increase in agency cost to shareholders and creditors. hence, the balance point must be obtained among various costs, which decides the corporate capital structure, namely, the trade-off theory proposed by myers (1984). according to previous empirical results (hessel and norman, 1992; wahal and mcconnell, 2000), shareholding by major shareholders and debt policies could effectively reduce agency problems. these tools are interactional with decision-making regarding investment, debt, dividend, and corporate risks and value. when the shares held by the insiders increase, the managers may dedicate to the r&d, advertising or hr cost after considering the long-term competitiveness and their wealth, so as to increase the corporate value. the change in shareholdings of managers also affects the correlation of agency cost and corporate financing decision-making. this paper first discusses whether firms tend to choose seasoned equity offering for financing while the debt agency costs of prior and current periods are high. second, it discusses whether firms tend to choose private equity method for financing, while the debt agency cost asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 130 of prior and current periods are high. third, it discusses the whether the shareholdings by the insiders would affect the relationship between the debt agency cost and the seasoned equity offerings financing, and whether the shareholdings of insiders would affect the relationship between the equity agency cost and the debt financing of firms. lastly, it discusses whether the shareholdings by the insiders would affect the relationship between the agency cost and private equity financing of firms. the contributions of this study are as follows. most past studies on financing acts focus on both seasoned equity offerings and debt financings, rarely relating to private equity financing; however, either the market timing theory or precautionary motive theory is related to the private equity. thus, this paper integrates the agency cost and financing decision-making into the financing method of private equity. second, according to previous literatures, firms with relatively higher investment opportunities have higher debt agency cost; hence, the debt agency cost is measured by the market to book ratio of equity. according to singh and davidson ⅲ (2003), and tsai, shao and yang (2008), the equity agency cost is measured by selling and administrative expenses ratio and the total asset turnover. the second contribution of this study is to simultaneously consider the debt and equity agency costs. the remainder of this paper is organized as follows: section 2 presents the literature review. section 3 explains the empirical methodology, including research design, research periods, sampling criteria and variable definitions, and proposing the empirical models. section 4 summarizes the empirical result, and the conclusions are given in section 5. 2. literature review and hypothesis development according to mcknight and weir (2009), as for the measurement method of agency cost, the debt agency cost is measured by the market ot book ratio of equity. the definition of equity agency cost is limited to the improper control and management (including prerogative consumption) over discretionary expenses and inefficient operation by managers. according to ang, cole, and lin (2000), the selling and administrative expenses ratio and asset turnover are employed to measure the equity agency cost. john and senbet (1998) discuss how firms resolve agency problems via control mechanism in terms of capital structure. besides the equity agency problems, debt agency problems and social agency problems impose impact on the operation performance. thus, when the impact on corporate performance by agency problem is studied, debt agency problem is an important factor to be considered for agency cost. berger, ofek, and yermack (1997), and john and senbet (1998) point out that since shareholders assume limited responsibilities, the creditors only receive returns of fixed benefits. as a result of the debt agency problem, creditors transfer the debt agency cost to the shareholders through increase of debt limits, and the managers may be forced to forsake the profitable investment plans due to increase of debt cost, which results in economic inefficiency. frank and goyal (2003) indicate that when firms intend to invest, if the needed capital cannot be supplied internally, firms would engage in external financing acts, which are categorized into issuance of stocks and debts. marchica and mura (2010) argue that if the firms have extra debt capacity, it is easier for them to obtain external financing, and the future investment expenditure is significant. in other words, proper debt enables firms to keep sound financial elasticity and the investment returns of firms in the future are greater. malmendier, tate, and yan (2011) suggest that internal capital is preferred to be used to support the capital demand of the firms as managers may overestimate the future cash flow of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 131 firms, and believe that the financing cost of external financing particularly equity financing is high, thus overestimating their own capabilities. moreover, when firms need external financing, they still prefer debt to issuance of equity. in case of debt, managers tend to be conservative over debt financing. malmendier, tate, and yan (2011) find that managers mostly employ risk-free debt or long-term debt for financing. as a result, the debt in the decision-making of the financing referred to in this study means long-term debt. equity agency cost affects firms whether to employ the financing method of seasoned equity offerings, and debt agency cost affects whether to finance through debt from banks or issuance of bonds. therefore, when discussing the agency cost, both equity agency cost and the debt agency cost should be analyzed, so as to have an overall view over the agency problems and issues. for this reason, when discussing the impact of agency cost on debt or equity financing decision-making, this study analyzes the equity agency cost and the debt agency cost simultaneously. from the views of insufficient investment, myers (1977) argues that in order to avoid sole enjoyment of investment’s returns by creditors, the shareholders of debt firms tend to select sub-optimal investment plans that results in insufficient issues or under-investment, while the creditors would require relatively lower bond price when undertaking bonds in order to protect their own interest, which makes firms confront the debt agency cost of underestimated bond price. since firms bear these debt agency cost, the capital cost of debt increases and decreases the willingness of debt, for this reason, we expected that there is a negatively association between debt agency cost and debt ratio. myers (1984) and myers and majluf (1984) propose that the information asymmetry between the managers and the investors may impact the financing acts of firms. the investors render lower share price in case of equity financing by firms, or request higher return, which leads to adverse selection and causes obstruction in financing. jensen (1986) proposes that the debt of firms could refrain from the over-investment acts of managers, and in case of external financing, the creditors are also liable for supervision on firms, which increases the corporate value. cronqvist and nilsson (2005) indicate that firms whose information is not transparent tend to finance through private equity due to consideration in cost factors and rights of control. when the information asymmetry between firms and investors is high, firms chooses the private equity for financing. lee and kocher (2001) argue that the firms engaging in private equity are mostly small in scale, high in growth, difficult in finance, and lacking external capital. moreover, the financing motivation and features of both private equity firms and public offering firms are not easily vulnerable to the mispricing of market. it can be seen that financing motivation and features of private equity firms and public offering firms have significant disparity. financing by private equity is the act of private equity firms who have strong demand over external capital. this study deduces that the higher the agency cost of corporate equity and debt is, the more likely the firms tend to select private equity for financing. based on the above, this study proposes the following hypotheses: h1a: when the debt agency cost is high, the firms are more likely to select financing by seasoned equity offerings. h1b: when the equity agency cost is high, the firms are more likely to select debt financing. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 132 h1c: when the agency cost is high, the firms are more likely to select private equity for financing. jensen and mecking (1976) point out that when the shareholdings of managers increase, the interests of managers and shareholders are more likely to be consistent, the motivation for prerogative consumption is slim. thus, when the shareholdings of managers are high, the corporate performance is better. rosenstein and wyatt (1997) suggest that when the insiders have professional knowledge of corporate operation, they are more likely to formulate decisions than the externals in a more effective manner. however, the increase of the shareholding of insiders is more likely to hurt the interests of outside shareholders. ang, cole, and lin (2000) indicate that after the listed firms raise funds in the market, the ownership is decentralized, the shareholdings of managers reduces as well, less capital contribution or low shareholding level may become the issue. the interests of managers that control the rights of management of firms apparently deviate from the corporate interests, or even infringe the interests of small and medium shareholders. ang, cole, and lin (2000) found that when firms are managed by external parties, the agency cost is relatively high. second, the agency cost of firms and the shareholdings of managers are negatively correlated. when the shares held by the non-managers increase, the agency cost increases as well. jensen and meckling (1976) argue that shareholdings of managers and the agency cost are negatively correlated, namely, when the shareholdings of managers is low, their debt agency cost and equity agency cost are higher. this paper discusses whether the shareholding of insiders would affect the correlation between the agency cost and the corporate financing selection. this study predicts that if the shareholding ratio by insiders is high, even though the equity agency cost is high due to pursuit of personal interests, the equity financing method may be employed; on the contrary, if the shareholding of insiders is high, even though the debt agency cost is high due to pursuit of personal interests, the debt financing method may be employed. based on the above, this study proposes the following hypotheses: h2a: shareholdings of insiders affect the positive correlation between the corporate debt agency cost and the financing choice of seasoned equity offerings. h2b: shareholdings of insiders affect the positive correlation between the corporate equity agency cost and the financing choice of debts. h2c: shareholdings of insiders affect the relationship between the corporate agency cost and the financing choice of private equity. 3. research design 3.1 the data our initial data is drawn from the taiwan economic journal (tej) database for the 2006-2012 periods. to calculate the turnover of assets, the source data for this variable cover the 2005-2012 period. our final sample consists of 5,759 firm-year observations. the sample is limited to publicly traded companies listed on the taiwan stock exchange (tse) and over-the-counter (otc), excluded state-owned enterprise, financial service and insurance companies from the original sample because they have unique operating characteristics and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 133 are governed by specific regulations. moreover, we deleted observations without complete financial data or discontinuous data or invalid data. the electronics industry is the most heavily covered industry, more than half of the total sample. followed by chemical, biotech and medical care industries and then electronic appliances & machinery industries, accounted for 6.64% 6.45% of the total samples, respectively. 3.2 empirical model this study adopts logistic models to examine hypotheses 1a, 1b, and 1c. for h1a and h1b, we investigate the association between agency costs of lag-one period, seasoned equity offering financing, and debt financing. we employ agency costs of lag-one period to analyze the impact of debt financing in order to avoid the problem of endogeneity. these specifications are as follows: itititititit eroaaasaeagencyadagencyaaseodebt +++++= −− 4312110 (1) itititititit eroaaasaoagencyadagencyaaseodebt +++++= −− 4312110 (2) similarly, h1c examines the relationship between agency costs of lag-one period and private equity financing. to avoid endogeneity, we introduce agency costs of lag-one period to analyze the effects on private equity financing choice. we rely on the following regressions: itititititit eroaaasaeagencyadagencyaaprids +++++= −− 4312110 (3) itititititit eroaaasaoagencyadagencyaaprids +++++= −− 4312110 (4) where seodebt: a dummy variable for equity which equal to 1 if firms make seasoned equity offering and 0 if firm raise capital via banking, issuing bonds, or private equity financing. prids: a dummy variable for private equity which equal to 1 if firms use private equity financing and 0 if firm raise capital via banking, issuing bonds, or seasoned equity offering. debtseo: a dummy variable for debts which equal to 1 if firms raise capital via banking and issuing bonds and 0 if firms make seasoned equity offering or private equity financing. dagency: debt agency costs, measured by market-to-book ratio of equity (mb). firms with higher mb represent higher the growth opportunities, whereas the higher debt agency costs then the lower long-term debt. eagency: equity agency costs, measured by the sample’s operating expense (selling and administrative expenses) ratio minus the median of operating expense ratios of all firms in an industry. oagency: equity agency costs, measured by the sample’s turnover of assets minus the median of turnover of assets of all firms in an industry. as: the natural log of total assets, controlled for the firm’s size. roa: return on total assets, indicating that firm’s profitability and managers use total assets to create profits for their shareholders. in addition, we also examine the relationship between current period’s agency costs, seasoned equity offering, and private equity financing. the models are as follows: itititititit eroaaasaeagencyadagencyaaseodebt +++++= 43210 (5) itititititit eroaaasaeagencyadagencyaaprids +++++= 43210 (6) as the above model, the measure our proxies for debt agency costs that adopts market to book ratio (mb), measured with the market value of equity divided by the book value of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 134 equity. additionally, following singh and davidson (2003) and tsai et al. (2008), our equity agency costs are measured by both turnover of assets and operating expenses ratio. this study uses the sum of the cumulative shareholdings ratio held by executives, directors and supervisors, and blockholders to measure the shareholdings of insiders. to further test the relationship between shareholdings of insiders and firm’s financing choices as well as test the effects of the interaction term between shareholdings of insiders and agency costs on the financing choice. to validate hypotheses 2a and 2b and control for endogeneity, we adopt prior shareholdings of insiders, prior equity agency costs, and prior debt agency costs to analyze their impact on financing choices. two regression models are presented in the following: (7) 76115 1141312110 ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaseodebt ++++ ++++= −− −−−−− (8) 76115 1141312110 ititititit itititititit eroaaasainsidesoagencya insidesdagencyainsidesaoagencyadagencyaaseodebt ++++ ++++= −− −−−−− we rely on the following model to examine h2c, that shareholdings of insiders affect the relations between agency costs and private equity financing. as mentioned above, to avoid endogeneity problems, we introduce lag-one period’s shareholdings of insiders and lag-one period’s agency costs to analyze their effects on private equity financing choice. two specifications are as follows: (9) 76115 1141312110 ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaprids ++++ ++++= −− −−−−− (10) 76115 1141312110 ititititit itititititit eroaaasainsidesoagencya insidesdagencyainsidesaoagencyadagencyaaprids ++++ ++++= −− −−−−− moreover, we further explore the relationship between shareholdings of insiders, agency costs and financing choices in the current period. the two research models are presented in the following: (11) 765 43210 ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaseodebt ++++ ++++= (12) 765 43210 ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaprids ++++ ++++= where insides: shareholdings of insiders, which is the sum of the cumulative shareholdings ratio held by insiders (executives, directors and supervisors, and blockholders). dagency*insides: the interaction term between debt agency costs and shareholdings of insiders. eagency*insides: the interaction term between equity agency costs and shareholdings of insiders, which equity agency costs is measured by the firm’s operating asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 135 expense ratio minus the median of operating expense ratios of all firms in an industry. oagency*insides: the interaction term between equity agency costs and shareholdings of insiders, which equity agency costs is measured by the firm’s assets turnover minus the median of assets turnovers of all firms in an industry. the definitions of other variables are as the same as equation (1). 3.3 variable definitions debt agency cost (dagency) prior literature concerning firms with higher investment opportunities usually have higher debt agency costs, thereby reduces the cost of debt financing. as r&d expenses and advertising expenses can be viewed as a proxy for firm’s investment opportunities, denotes that r&d expenses and advertising expenses are inversely related to the long-term debt. in this study, we use market-to-book ratio (mb) as a measure of agency costs of debt, calculated with the market value of equity divided by the book value of equity. the companies with higher mb exhibit higher the growth opportunities, have higher agency costs of debt, and then lower long-term debt. equity agency cost (oagency, eagency) ang, cole, and lin (2000) measure agency costs of the firm that use two alternative efficiency ratios: the operating expense ratio, which is operating expense scaled by net sales, and the turnover of assets, which is net sales divided by total assets. the asset turnover is a measure of how effectively the firm’s management deploys its assets. higher turnover of asset is associated with greater efficiency for asset management, indicating that managers can generate higher cash flows and increase sales. in turn, lower turnover of asset indicates that managers invest in less efficiency activities. to control the impact of industry effects, we use oagency as a proxy for agency costs, measured by the sample firm’s asset turnover minus the median of asset turnovers of sample firms in an industry. moreover, the measurement of equity agency costs (eagency) is measured by the sample firm’s selling and administrative expense (operating expense) ratio minus the median of operating expense ratio of sample firms in an industry. companies with higher agency cost exhibit greater the volatility of return on assets, higher operating expense ratio, and lower asset turnover ratio. seasoned equity offering financing choice (seodebtit) we apply logistic regression analysis to assess the company’s financing choice, seodebtit as measures of making seasoned equity offering. seodebtit is a dummy variable that is equal to one if firms make seasoned equity offering and zero if firms raise the fund via banking, issuing bonds, or private equity financing. private equity financing choice (pridsit) we apply logistic regression analysis to assess the company’s financing choices, prids as measures of using private equity. prids is a dummy variable that is equal to one if firms make private equity financing and zero if firm raise the fund via banking, issuing bonds, or seasoned equity offering. shareholdings of insiders (insides) total shares held by insider of a firm. this study measures insiders is according to taiwanese securities and futures bureau, financial supervisory commission’s brochures, contain executives, directors and supervisors, and blockholders. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 136 4. the results 4.1 descriptive statistics the descriptive statistics for each variable in regression models of this study are shown in table 1. the findings show that the mean of debtseoit is 0.9413, implying that under lack of funds, the firm prefers to engage in debt financing, rather than in seasoned equity offerings. this is consistent with the traditional financing pecking order theory. the mean of seodebtit is 0.2012, indicating that the company will be less seasoned equity offerings to finance. the mean of pridsit is 0.0803, which represents the company’s financing decisions do not tend to private equity (private placement) but debt or seasoned equity offerings for financing. cronqvist and nilsson (2005) find that, no matter what the agency cost financing decisions, the firm with opaque information tend to choose private equity financing due to cost factors. however, lee and kocher (2001) find that the firm with private placement will has a smaller firm size, high growth, and better financial position than the firm with seasoned equity offerings. in addition to stock’s market-to-book ratio (mb), the firm’s selling and administrative expenses minus the industry’s median of selling and administrative expenses, and the firm’s turnover of assets minus the industry’s median of turnover of assets to measure equity agency cost, we also use the sum of ratios of insider ownership (insidesit-1) to measure shareholdings of insiders. the maximum and minimum values of insidesit-1 are 99.9500 and 7.8000, respectively, and with a standard deviation of 17.0849, show that corporate insiders shareholding ratios insidesit-1 has a great difference among the sample firms. the possible reason of its mean of 44.0689 is that most of companies are family or group type in taiwan. moreover, the untabulated results of correlation analysis show that correlation coefficients at all between two variables are less than 0.65, implying that there is no multicollinearity among these variables. table 1. descriptive statistics mean std. dev. minimum maximum dagency 1.5688 2.6768 0.0700 119.6300 eagency 0.1171 0.6078 -1.1500 6.5600 oagency 3.6663 25.3511 -29.8800 762.1200 insides 44.0689 17.0849 7.8000 99.9500 as 6.7771 0.6495 5.0330 9.3106 roa 6.4258 8.3334 -71.9400 51.5600 seodebt 0.2012 0.4009 0.0000 1.0000 prids 0.0803 0.2717 0.0000 1.0000 number of total observations is 5319. variables definition: seodebt is an equity dummy variable, which sets to 1 if the firm chooses seasoned equity offering financing and set to 0 if the firm chooses bank debt, issuing bond, or issuing private equity financings. prids is a private equity dummy variable, which sets to 1 if the firm chooses private equity and set to 0 if the firm chooses bank debt, issuing bond, and seasoned equity offering financings. dagency is the debt agency cost, which is measured by market to book ratio of equity. eagency is the equity agency cost, which is measured by the firm’s selling and administrative expenses ratio minus the industry median of selling and administrative expenses ratios of all firms in an industry. oagency is is the equity agency cost, which is measured by the firm’s turnover of assets minus the industry median of turnovers of assets of all asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 137 firms in an industry. insides is the shareholdings of insiders, which is the sum of managers’ shareholdings, directors and supervisors’ shareholdings, and blockholders’ shareholdings. as is the nature log of total assets, which controls firm size. roa is return of assets, which represents the operation performance of a firm. 4.2 prior agency cost and seasoned equity offerings model 1 of table 2 use logistic regression to analyze the association between previous period’s agency costs and seasoned equity offerings, which dagencyit-1 proxies for the debt agency costs and is measured by equity’s market to book ratio. the findings show that dagencyit-1 is significantly positively related to seasoned equity offerings dummy variable, implying that the firm with higher previous period’s debt agency cost, it tends to choose seasoned equity offering in current period. the empirical results are consistent with our expectations that agency costs are endogenous, that is, the current period’s financing decisions is affect by the prior period’s debt agency cost. a higher mb means the company has higher growth opportunity, and its debt agency cost is higher, so that the company’s long-term debt is lower. the empirical result supports hypothesis 1a. as kim and weisbach (2008), a higher mb company is more likely to choose equity financing than a lower mb company. on the other hand, mode 1 in table 2 uses eagencyit-1 represents the previous period’s equity agency cost, which is measured by the previous period’s selling and administrative expenses minus the industry’s median of selling and administrative expenses. the findings show that the period’s equity agent cost is significantly negatively correlated to seasoned equity offerings, indicating that the sample companies’ previous period’s equity agency costs are higher, their possibilities of engaging in seasoned equity offerings are lower. when higher equity agency costs, operating expense ratio is higher. the empirical results support the hypothesis inference 1b, and agency costs have are endogenous as expectations, that is, when the previous period’s equity agency cost of the company is higher, the company will tend to choose debt financing in current period. model 2 in table 2 uses oagencyit-1 measure the company’s equity agency cost, which is measured by previous period’s turnover of assets minus the industry’s median of turnover of assets. the findings show that the company’s previous period’s debt agency cost is higher, the more inclined to choose seasoned equity offerings financing in the current period. therefore, it is consistent with the results those in the model 1 of table 2, and empirical results fit for the agency cost of this study is expected to have endogenous, that the current period’s financing decisions is affect by the previous period’s debt agency cost. on the other hand, turnover of asset is used to measure efficiency of a firm. if the turnover rate is higher, indicating that managers have better capabilities of asset management, allows assets to generate higher cash flows and sales volume, therefore the lower agency cost of equity. the findings of model 2 show that the previous period’s equity agency cost oagencyit-1 is positively correlated with the seasoned equity offerings. this means that the higher equity agency costs (the lower turnover of assets), the company is more likely to choose debt financing. our results are consistent with myers and majluf (1984), and the empirical results support the hypothesis 1b, that the company’s equity agency costs is higher, would tend to choose the debt financing. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 138 table 2. prior agency cost and seasoned equity offering choice itititititit eroaaasaeagencyadagencyaaseodebt +++++= −− 4312110 itititititit eroaaasaoagencyadagencyaaseodebt +++++= −− 4312110 seodebt model 1 (eagencyit-1) model 2 (oagencyit-1) variable coef. z value (p>|z|) coef. z value (p value) dagencyit-1 0.2578 9.1900 (0.0000) 0.2414 8.7300 (0.0000) eagencyit-1 -0.1763 -2.8500 (0.0040) oagencyit-1 0.0085 4.1700 (0.0000) as -0.1816 -3.1700 (0.0010) -0.1285 -2.2100 (0.0270) roa -0.0337 -7.8300 (0.0000) -0.0314 -7.2700 (0.0000) cons. -0.3454 -0.8900 (0.3720) -0.7442 -1.8800 (0.0600) number of obs. 5319 5319 lr chi2(5) 181.06 199.04 prob > chi2 0.0000 0.0000 pseudo r2 0.0339 0.0373 variables definition: seodebt is an equity dummy variable, which sets to 1 if the firm chooses seasoned equity offering financing and set to 0 if the firm chooses bank debt, issuing bond, or issuing private equity financings. dagency is the debt agency cost, which is measured by market to book ratio of equity. eagency is the equity agency cost, which is measured by the firm’s selling and administrative expenses ratio minus the industry median of selling and administrative expenses ratios of all firms in an industry. oagency is the equity agency cost, which is measured by the firm’s turnover of assets minus the industry median of turnovers of assets of all firms in an industry. as is the nature log of total assets, which controls firm size. roa is return of assets, which represents the operation performance of a firm. 4.3 prior agency cost and private equity model 1 in table 3 uses dagencyit-1 to measure the debt agency costs, which is equity’s market to book ratio. the findings show that dagencyit-1 is significantly positively correlated with private equity financing dummy variable (pridsit), implying that the prior period’s debt agency costs are higher, the company tends to choose private equity financing in current period, that is, the prior period’s growth opportunity is higher (debt agency costs is higher), the company is more likely to choose private equity, and its long-term debt is lower. the empirical result is consistent with our expectation, debt agency costs have endogenous, that the current financing decision is influenced by the previous agency cost of debt. the empirical result supports hypothesis 1c. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 139 the model 1 in table 3 show, the company’s previous equity agency cost (eagencyit-1) is negatively related to private equity financing (pridsit). this means that when the company’s ratio of selling and administrative expenses is higher, its equity agency cost is higher, and then the company is unlikely to use private equity financing. this result supports the hypothesis 1c. at the same time, the empirical results are also consistent with expectations, which the current private equity financing decision is affected by the previous period’s equity agency cost. the model 2 of table 3 use dagencyit-1 to measure the debt agency cost. model 2 uses logistic regression to explore the association between previous period’s agency costs and the private equity. the empirical results show, prior period’s debt agency costs dagencyit-1 is positively and significantly related to private equity financing in current period. in addition, higher turnover of assets indicates asset management capabilities of managers are higher, and then they can create more cash flows and sales, so the equity agency cost is lower. the results of model 2 in table 3 show that the previous period’s equity agency cost oagencyit-1 is positively correlated with private equity financing, implying that the higher of the previous cash flows and sales of company, its equity agency costs is lower, so that manager is more likely to choose private equity to finance. in contrast, when the manager invests in inefficient productivity, company’s equity agency cost is higher and it does not tend to choose private equity. the empirical result supports hypothesis 1c. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 140 table 3. prior agency cost and private equity choice itititititit eroaaasaeagencyadagencyaaprids +++++= −− 4312110 itititititit eroaaasaoagencyadagencyaaprids +++++= −− 4312110 prids model 1 (eagencyit-1) model 2 (oagencyit-1) variable coef. z value (p>|z|) coef. z value (p value) dagencyit-1 0.1188 3.0800 (0.0020) 0.0854 2.2800 (0.0230) eagencyit-1 -0.7074 -5.8400 (0.0000) oagencyit-1 0.0086 3.6500 (0.0000) as -0.5871 -5.9100 (0.0000) -0.5204 -5.1600 (0.0000) roa -0.0887 -13.6700 (0.0000) -0.0879 -13.5400 (0.0000) cons. 1.6273 2.4600 (0.0140) 1.1681 1.7400 (0.0820) number of obs. 5319 5319 lr chi2(5) 445.57 425.91 prob > chi2 0.0000 0.0000 pseudo r2 0.1499 0.1433 variables definition: prids is a private equity dummy variable, which sets to 1 if the firm chooses private equity and set to 0 if the firm chooses bank debt, issuing bond, and seasoned equity offering financings. dagency is the debt agency cost, which is measured by market to book ratio of equity. eagency is the equity agency cost, which is measured by the firm’s selling and administrative expenses ratio minus the industry median of selling and administrative expenses ratios of all firms in an industry. oagency is the equity agency cost, which is measured by the firm’s turnover of assets minus the industry median of turnovers of assets of all firms in an industry. as is the nature log of total assets, which controls firm size. roa is return of assets, which represents the operation performance of a firm. 4.4 current period’s agency cost, seasoned equity offerings, and private equity model 1 in table 4 uses dagencyit to measure debt agency costs (market to book ratio). the findings show that dagencyit and seasoned equity offerings dummy variable (seodebtit) have significantly and positively correlation, current debt agency cost is higher, the company tends to choose seasoned equity offerings. the empirical result supports hypothesis 1a. overall, from the results of tables 2 and 4, whether the previous or the current periods’ debt agent costs are positively correlated with the choice of seasoned equity offerings in current period. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 141 model 1 of table 4 uses eagencyit show the company’s current equity agency costs, which is the firm’s current period’s selling and administrative expenses minus industry median of selling and administrative expenses. when the equity agency costs higher, the larger the ratio of operating expenses is. the findings show that the current period’s equity agency costs and the financing choice of seasoned equity offerings is significantly negatively correlation, means that the higher equity agency cost of current period, the company is unlikely to choose seasoned equity offerings. the empirical result supports hypothesis 1b. overall, from the results of tables 2 and 4, either the previous period or the current equity agency costs are negatively related to current seasoned equity offerings. in addition, model 2 in table 4 examines the association between agency costs in the current period and the private equity financing. the findings show that private equity financing is positively related to dagencyit dummy variable (pridsit), showing a higher current debt agency costs, the company tend to conduct private equity financing. the empirical result supports hypothesis 1c. overall, both previous period and current period debt agency costs are positively correlated with the current period’s private equity financing. table 4 also shows that equity agency cost eagencyit is negatively related to private equity financing (pridsit). this means that when ratio of selling and administrative expenses is higher, equity agency cost is higher, so the companies do not tend to use private equity financing. the empirical result supports hypothesis 1c. integrated mentioned above, both previous or current periods’ equity agency costs are negatively correlated with the current period’s private equity financing, so that equity agency cost is higher, the company does not tend to be more interest in fund-raising of equity. table 4. current agency cost, seasoned equity offering and private equity choices itititititit eroaaasaeagencyadagencyaaseodebt +++++= 43210 itititititit eroaaasaeagencyadagencyaaprids +++++= 43210 model 1 (independent variable: seodebt) model 2 (independent variable: prids) variable coef. zvalue (p>|z|) coef. z value (p value) dagencyit 0.2344 8.0100 (0.0000) 0.1537 4.2000 (0.0000) eagencyit -0.1275 -2.0900 (0.0370) -0.5477 -4.7500 (0.0000) as -0.1911 -3.3300 (0.0010) -0.6103 -6.1000 (0.0000) roa -0.0287 -6.6000 (0.0000) -0.0829 -12.8800 (0.0000) cons. -0.2671 -0.6900 (0.4930) 1.7119 2.5900 (0.0100) number of obs. 5319 5319 lr chi2(5) 159.11 430.33 prob>chi2 0.0000 0.0000 pseudo r2 0.0298 0.1447 variables definition: seodebt is an equity dummy variable, which sets to 1 if the firm chooses seasoned equity offering financing and set to 0 if the firm chooses bank debt, issuing bond, or issuing private asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 142 equity financings. prids is a private equity dummy variable, which sets to 1 if the firm chooses private equity and set to 0 if the firm chooses bank debt, issuing bond, and seasoned equity offering financings. dagency is the debt agency cost, which is measured by market to book ratio of equity. eagency is the equity agency cost, which is measured by the firm’s selling and administrative expenses ratio minus the industry median of selling and administrative expenses ratios of all firms in an industry. as is the nature log of total assets, which controls firm size. roa is return of assets, which represents the operation performance of a firm. 4.5 shareholdings of insiders, prior agency cost, and seasoned equity offerings model 1 in table 5 examines the effect of insiders’ shareholdings on the relationship between prior agency cost and seasoned equity offerings. the finding show that under considering shareholdings of insiders, the firm with higher prior debt agency cost dagencyit-1 tends to engage in seasoned equity offerings financing, and this result is consistent with our expectation. the higher mb implies the higher growth opportunity of a firm, so that the firm has higher agency cost and lower debt financing. our result supports hypothesis h1a. in model 1 of table 5, we also adopt eagencyit-1 to measure prior equity agency cost. the finding show that under considering shareholdings of insiders, prior equity agency cost of a firm is negatively related to seasoned equity offerings financing, implying that the firm with higher prior equity agency cost does not tend to engage in seasoned equity offerings rather debt financing, so the result is consistent with our expectation and supports hypothesis 1b. however, the result in model 1 of table 5 shows that the interaction term between insiders’ shareholdings and prior debt agency cost is unrelated to current seasoned equity offering financing. this result implies that when higher insiders’ shareholdings, the firm with higher debt agency cost does not has higher possibility of engaging in seasoned equity offerings, which supports hypothesis h2a. the possible reason is that most of large firms are family or group types in taiwan. moreover, the interaction term between insiders’ shareholdings and prior equity agency cost eagencyit-1 is positively related to current seasoned equity offering financing, which supports hypothesis h2b. from model 2 of table 5, we find that under considering shareholdings of insiders, the firm with higher prior debt agency cost dagencyit-1 tends to engage in seasoned equity offerings financing, and this result supports hypothesis h1a. moreover, the turnover of assets implies assets utilization, the firm with higher turnover of assets has lower equity agency cost oagencyit-1. the result shows that oagencyit-1 is unrelated to seasoned equity offerings, so that our result does not support hypothesis h1b. the result in model 2 of table 5 shows that the interaction term between insiders’ shareholdings and prior debt agency cost is also unrelated to current seasoned equity offering financing. this result also supports hypothesis h2a. the possible reason is that most of large firms are family or group types in taiwan. moreover, the interaction term between insiders’ shareholdings and prior equity agency cost oagencyit-1 is unrelated to current seasoned equity offering financing, which supports hypothesis h2b. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 143 table 5. insiders’ shareholdings, prior agency cost and seasoned equity offering choice ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaseodebt ++++ ++++= −− −−−−− 76115 1141312110 ititititit itititititit eroaaasainsidesoagencya insidesdagencyainsidesaoagencyadagencyaaseodebt ++++ ++++= −− −−−−− 76115 1141312110 seodebt model 1 (eagency it-1) model 2 (oagency it-1) variable coef. z value (p>|z|) coef. z value (p value) dagencyit-1 0.2983 3.6300 (0.0000) 0.2457 3.0200 (0.0020) eagencyit-1 -0.5346 -3.2300 (0.0010) oagencyit-1 0.0089 1.6000 (0.1100) insidesit-1 0.0038 1.2000 (0.2310) 0.0033 1.0300 (0.3030) dagencyit-1insidesit-1 -0.0009 -0.6000 (0.5490) -0.0002 -0.1200 (0.9030) eagencyit-1insidesit-1 0.0083 2.4000 (0.0160) oagencyit-1insidesit-1 -0.0000 -0.0900 (0.9260) as -0.1574 -2.7000 (0.0070) -0.1138 -1.9300 (0.0540) roa -0.0351 -8.0600 (0.0000) -0.0321 -7.3600 (0.0000) cons. -0.6723 -1.5400 (0.1250) -0.9822 -2.2100 (0.0270) number of obs. 5319 5319 lr chi2(5) 188.74 201.12 prob > chi2 0.0000 0.0000 pseudo r2 0.0353 0.0377 variables definition: seodebt is an equity dummy variable, which sets to 1 if the firm chooses seasoned equity offering financing and set to 0 if the firm chooses bank debt, issuing bond, or issuing private equity financings. dagency is the debt agency cost, which is measured by market to book ratio of equity. eagency is the equity agency cost, which is measured by the firm’s selling and administrative expenses ratio minus the industry median of selling and administrative expenses ratios of all firms in an industry. oagency is is the equity agency cost, which is measured by the firm’s turnover of assets minus the industry median of turnovers of assets of all firms in an industry. insides is the shareholdings of insiders, which is the sum of managers’ shareholdings, directors and supervisors’ shareholdings, and blockholders’ shareholdings. as is the nature log of total assets, which controls firm size. roa is return of assets, which represents the operation performance of a firm. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 144 4.6 shareholdings of insiders, prior agency cost, and private equity financing model 1 in table 6 examines the effect of insiders’ shareholdings on the relationship between prior agency cost and private equity financing. the finding show that under considering shareholdings of insiders, the firm with higher prior debt agency cost dagencyit-1 tends to engage in private equity financing, and this result is consistent with our expectation and supports hypothesis h1c. in model 1 of table 6, we also adopt eagencyit-1 to measure prior equity agency cost. the finding show that under considering shareholdings of insiders, prior equity agency cost of a firm is negatively related to private equity financing, implying that the firm with higher prior equity agency cost does not tend to engage in private equity financing, so the result supports hypothesis 1c. however, the result in model 1 of table 6 shows that the interaction term between insiders’ shareholdings and prior debt agency cost is unrelated to current private equity financing, which supports hypothesis h2c. the possible reason is that most of large firms are family or group types in taiwan. moreover, the interaction term between insiders’ shareholdings and prior equity agency cost eagencyit-1 is unrelated to current private equity financing, which supports hypothesis h2c. from model 2 of table 6, we find that under considering shareholdings of insiders, the prior debt agency cost dagencyit-1 is unrelated to private equity financing, and this result does not support hypothesis h1c. moreover, when using turnover of assets to measure prior equity agency cost oagencyit-1. the result shows that prior equity agency cost is unrelated to private equity financing, so that the result also does not support hypothesis h1c. the result in model 2 of table 6 shows that the interaction term between prior period’s insiders’ shareholdings and prior period’s debt agency cost is unrelated to current period’s private equity financing. this result still does not support hypothesis h2c. moreover, the interaction term between prior period’s insiders’ shareholdings and prior period’s equity agency cost oagencyit-1 is unrelated to current period’s private equity financing, which still does not supports hypothesis h2c. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 145 table 6. insiders’ shareholdings, prior agency cost and private equity choice ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaprids ++++ ++++= −− −−−−− 76115 1141312110 ititititit itititititit eroaaasainsidesoagencya insidesdagencyainsidesaoagencyadagencyaaprids ++++ ++++= −− −−−−− 76115 1141312110 prids model 1 (eagencyit-1) model 2 (oagencyit-1) variables coef. z value (p>|z|) coef. z value (p value) dagencyit-1 0.2037 1.6300 (0.1040) 0.1137 0.9500 (0.3410) eagencyit-1 -1.0971 -3.4000 (0.0010) oagencyit-1 0.0095 1.4600 (0.1460) insidesit-1 -0.0013 -0.2600 (0.7910) -0.0036 -0.7700 (0.4400) dagencyit-1×insidesit-1 -0.0016 -0.6800 (0.4950) -0.0005 -0.2100 (0.8340) eagencyit-1×insidesit-1 0.0091 1.3200 (0.1860) oagencyit-1×insidesit-1 -0.0000 -0.1300 (0.8950) as -0.6024 -5.9000 (0.0000) -0.5454 -5.2600 (0.0000) roa -0.6886 -13.4600 (0.0000) -0.0867 -13.2200 (0.0000) cons. 1.7594 2.3700 (0.0180) 1.4758 1.9600 (0.0500) number of obs. 5319 5319 lr chi2(5) 449.27 427.74 prob > chi2 0.0000 0.0000 pseudo r2 0.1511 0.1439 variables definition: prids is a private equity dummy variable, which sets to 1 if the firm chooses private equity and set to 0 if the firm chooses bank debt, issuing bond, and seasoned equity offering financings. dagency is the debt agency cost, which is measured by market to book ratio of equity. eagency is the equity agency cost, which is measured by the firm’s selling and administrative expenses ratio minus the industry median of selling and administrative expenses ratios of all firms in an industry. oagency is is the equity agency cost, which is measured by the firm’s turnover of assets minus the industry median of turnovers of assets of all firms in an industry. insides is the shareholdings of insiders, which is the sum of managers’ shareholdings, directors and supervisors’ shareholdings, and blockholders’ shareholdings. as is the nature log of total assets, which controls firm size. roa is return of assets, which represents the operation performance of a firm. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 146 4.7 shareholdings of insiders, current agency cost and seasoned equity offerings model 1 in table 7 examines the effect of insiders’ shareholdings on the relationship between current period’s agency cost and seasoned equity offering. the finding show that under considering shareholdings of insiders, the firm with higher current period’s debt agency cost dagencyit tends to engage in private equity financing in current period, and this result supports hypothesis h1a. overall, both prior and current periods’ debt agency costs are positively related to seasoned equity offerings, implying that the firm with higher debt agency cost tends to conduct current period’s seasoned equity offerings, our results support hypothesis h1a. however, when using eagencyit to measure equity agency cost, we find that current equity agency cost is unrelated to current seasoned equity offerings, so our result do not support hypothesis 1b. model 1 of table 7 shows that the interaction term between current insiders’ shareholdings and current debt agency cost is negatively related to current seasoned equity offering financing. this result implies that when higher insiders’ shareholdings, the firm with higher debt agency cost does not has higher possibility of engaging in seasoned equity offerings, which supports hypothesis h2a. moreover, the interaction term between current insiders’ shareholdings and current equity agency cost eagencyit is unrelated to current seasoned equity offering financing, which also does not supports hypothesis h2b. on the other hand, in model 2 of table 7, the result shows that under considering shareholdings of insiders, the firm with higher current period’s debt agency cost dagencyit tends to engage in private equity financing in current period, and this result supports hypothesis h1c. overall, both prior and current periods’ debt agency costs are positively related to private equity financing, implying that the firm with higher current debt agency cost tends to conduct private equity financing in current period, our results support hypothesis h1c. model 2 in table 7 show that under considering shareholdings of insiders, the firm with higher current period’s equity agency cost eagencyit does not tend to engage in private equity financing in current period, and this result supports hypothesis h1c. the result in model 2 of table 7 shows that the interaction term between current insiders’ shareholdings and current debt agency cost is unrelated to current private equity financing. meanwhile, the interaction term between current insiders’ shareholdings and current equity agency cost eagencyit is also unrelated to current private equity financing. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 147 table 7. insiders’ shareholdings, current agency cost and financing choice ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaseodebt ++++ ++++= 765 43210 ititititit itititititit eroaaasainsideseagencya insidesdagencyainsidesaeagencyadagencyaaprids ++++ ++++= 765 43210 model 1 (independent variable: seodebt) model 2 (independent variable: prids) variables coef. z value (p>|z|) coef. z value (p value) dagency 0.4684 6.0000 (0.0000) 0.2463 2.2000 (0.0280) eagency -0.1124 -0.7100 (0.4780) -0.9971 -3.1600 (0.0020) insides -0.0059 -1.9800 (0.0480) 0.0132 3.1500 (0.0020) dagencyit×insidesit -0.0044 -3.4000 (0.0010) -0.0018 -1.0500 (0.2920) eagencyit×insidesit -0.0005 -0.1400 (0.8860) 0.0100 1.5900 (0.1130) as -0.1859 -3.1900 (0.0010) -0.5360 -5.3200 (0.0000) roa -0.0308 -6.9700 (0.0010) -0.0855 -13.0500 (0.0000) cons. -0.5960 -1.3600 (0.1750) 0.6266 0.8500 (0.3970) number of obs. 5319 5319 lr chi2(5) 169.22 442.48 prob > chi2 0.0000 0.0000 pseudo r2 0.0317 0.1488 variables definition: seodebt is an equity dummy variable, which sets to 1 if the firm chooses seasoned equity offering financing and set to 0 if the firm chooses bank debt, issuing bond, or issuing private equity financings. prids is a private equity dummy variable, which sets to 1 if the firm chooses private equity and set to 0 if the firm chooses bank debt, issuing bond, and seasoned equity offering financings. dagency is the debt agency cost, which is measured by market to book ratio of equity. eagency is the equity agency cost, which is measured by the firm’s selling and administrative expenses ratio minus the industry median of selling and administrative expenses ratios of all firms in an industry. insides is the shareholdings of insiders, which is the sum of managers’ shareholdings, directors and supervisors’ shareholdings, and blockholders’ shareholdings. as is the nature log of total assets, which controls firm size. roa is return of assets, which represents the operation performance of a firm. 5. conclusions this paper examines whether firms tend to choose seasoned equity offering for financing when the debt agency costs of prior and current periods are high, and whether firms tend to choose private equity method for financing when the debt agency cost of prior and current periods are high. next, we explore whether the shareholdings of insiders would affect the relationship between debt agency cost and seasoned equity offerings, and whether the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 148 shareholdings of insiders would affect the relationship between equity agency cost and debt financings. we also examine whether the shareholdings of insiders would affect the relationship between agency cost and private equity financing of firms. the findings show that both prior and current periods’ debt agency costs are positively related to seasoned equity offerings, implying that the firm with higher debt agency cost tends to conduct current period’s seasoned equity offerings. next, both prior and current periods’ debt agency costs are positively related to private equity financing, implying that the firm with higher current debt agency cost tends to conduct private equity financing in current period. as for equity agency cost, we also find the relationship that both current and prior periods’ equity agency costs are negatively related to seasoned equity offerings, implying that the firm with higher equity agency cost tends to conduct debt offerings in current period. under considering shareholdings of insiders, the evidences document that both prior and current periods’ debt agency costs are positively related to seasoned equity offerings, and both prior and current periods’ debt agency costs are positively related to private equity financing, implying that the firm with higher current debt agency cost tends to conduct private equity financing in current period. however, we only find that prior periods’ equity agency costs are negatively related to seasoned equity offerings. however, the interaction term between insiders’ shareholdings and prior debt agency cost is unrelated to current seasoned equity offering financing, implying that the insiders’ shareholdings would affect the relationship between debt agency cost does and the choice of seasoned equity offering. moreover, the interaction term between insiders’ shareholdings and prior equity agency cost is positively related to current seasoned equity offering financing. moreover, the interaction term between insiders’ shareholdings and prior debt agency cost is also unrelated to current seasoned equity offering financing, and the interaction term between insiders’ shareholdings and prior equity agency cost is unrelated to current seasoned equity offering financing. moreover, the interaction term between insiders’ shareholdings and prior debt agency cost is unrelated to current private equity financing, and the interaction term between insiders’ shareholdings and prior equity agency cost is unrelated to current private equity financing. as for private equity financing, the interaction term between prior insiders’ shareholdings and prior debt agency cost is unrelated to current private equity, and the interaction term between prior insiders’ shareholdings and prior equity agency cost is unrelated to current private 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(1990). on the efficiency of internal and external corporate control mechanisms. academy of management review, 15, 421-458. li, x., tuna, a. i., & vasvari, f. p. (2013). corporate governance and restrictions in debt contracts. working paper. zantout, z. (1994). external capital market control, corporate restructuring, and firm performance during the 1980s. journal of business finance and accounting, 21, 37-64. http://dx.doi.org/10.1111/j.1468-5957.1994.tb00304.x microsoft word 4830-17681-2-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 423 a study on options pricing using garch and black-scholes-merton model zohra bi department of finance, school of business, alliance university, bangalore, india e-mail: zohrayousuf@gmail.com abdullah yousuf department of hr, jain university, bangalore, india e-mail: yousufaroma@gmail.com mihir dash department of quantitative methods, school of business alliance university, bangalore, india e-mail: mihir@alliance.edu.in received: dec. 24, 2013 accepted: june 17, 2014 published: june 17, 2014 doi:10.5296/ajfa.v6i1.4830 url: http://dx.doi.org/10.5296/ajfa.v6i1.4830 abstract options are instruments which have the special property of limiting the downside risk, while not limiting the upside potential, thus their use in hedging. the share of the options market in the indian capital market has increased to 64% in just over a decade. the trading turnover of options in the fy11 was rs. 193,95,710 crore, and the trading volume generated by options market was almost two times that of the volume generated in the cash market and futures market put together. so trading and pricing of stock option have occupied an important place in the indian derivatives market. volatility is a critical factor influencing the option pricing; however, it is an extremely difficult factor to forecast. hence the crucial problem lies with the accurate estimation of volatility. the estimated volatility can be used to determine future prices of the stock or the stock option. empirical research has shown that using historical volatility in different option pricing models leads to pricing biases. the garch (1, 1) model can be a solution for this asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 424 problem. the present study applies the garch (1, 1) model to estimate the volatility, and applies this estimated volatility to calculate option prices with the help of black-scholes-merton model. keywords: garch model, black-scholes-merton model, option prices, volatility asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 425 1. introduction an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price called the strike price. the buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. in return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. so the loss for an option buyer is limited to the premium paid, whereas the loss for an option seller is unlimited. many options are created in standardized form and traded on an options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank. the price of an option derives from the difference between the reference price and the value of the underlying asset plus a premium based on the time remaining until the expiration of the option. there are two types of options: call options and put options. a call option conveys the right to buy the underlying asset at a specific price, while a put option conveys the right to sell the underlying asset at a specific price. option contracts have the following specifications: the type (call or put), the quantity and class of the underlying asset, the strike/exercise price (i.e. the price at which the underlying transaction will occur upon exercise of the option), the expiration date (the last date the option can be exercised), and the settlement terms (for instance, whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount). also, there are two option styles: european style options can be exercised only on the expiry date, while american style options can be exercised any time before the expiry date. the black-scholes-merton model (1973) is the most widely-used model of determining option prices. the model expresses the prices of european call and put options on a non-dividend-paying stock in terms of five parameters: the spot price of the underlying stock, the exercise price at which the transaction will be executed, the expiration period after which the option can be exercised, the risk-free rate of return, and the volatility of returns of the underlying stock. volatility is a critical factor influencing the option pricing; however, it is an extremely difficult factor to forecast. hence the crucial problem lies with the accurate estimation of volatility. the estimated volatility can be used to determine future prices of the stock or the stock option, and thus an investor can use arbitrage strategies accordingly to benefit from the model. 2. literature review there is a vast literature on options pricing using the garch-black-scholes-merton model. some of the relevant literature is reviewed in the following. adesi et al (2007) proposed a method for pricing options based on garch models with filtered historical innovations. they found that their model outperformed other garch pricing models and black-scholes models empirically for s&p 500 index options. their model was validated by empirically obtaining decreasing state price densities per unit probability. also, their model explained implied volatility smiles by the negative asymmetry of the filtered asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 426 historical innovations. the study also provides empirical evidence and quantifies the deterioration of the delta hedging in the presence of large volatility shocks. cristofferson et al (2004) extended their results in the presence of conditional skewness. siu et al (2004) proposed a method for pricing derivatives under the garch assumption for underlying assets in the context of a dynamic version of gerber-shiu's option-pricing model. instead of adopting the notion of local risk-neutral valuation relationship (lrnvr) they employ the concept of conditional esscher transforms to identify a martingale measure under the incomplete market setting. under the conditional normality assumption for the stock innovation, the pricing result is consistent with that of duan. in line with the gerber-shiu's option pricing model, they also justify the pricing result within the dynamic framework of utility maximization problems which makes the economic intuition of the pricing result more appealing. numerical results for the comparison of the model with the black-scholes-merton option pricing model are also presented. dash et al (2012) applied the garch options pricing model for options traded on the national stock exchange, india. they used the garch(1, 1) model to obtain volatility projections, and calculated option prices using these volatility projections in the black-scholes-merton model. they found that the implied volatilities (for both calls and puts) were overestimated, and that call and put option prices were predominantly overvalued, and, further, that put options were more overpriced than call options. they also found that the overestimation of volatility and overvaluation of options prices increased with higher market capitalization and moderate/higher trading volume of the underlying stocks. duan (1995) introduced the garch option pricing model, linking econometric models with the options pricing literature. heston and nandi (2000) developed a closed-form option valuation formula for a spot asset whose variance follows a garch (p, q)-process that can be correlated with the returns of the spot asset. they found empirically for s&p500 index options that their model had lower valuation errors than the black-scholes-merton model with implied volatilities. they argued that the garch model was able to simultaneously capture the correlation of volatility with spot returns and the path dependence in volatility. hao and yang (2011) presented a scenario-based risk measure for a portfolio of european-style derivative securities over a fixed time horizon under the regime-switching black-scholes economy. the study derived a closed-form expression for the risk measure for vanilla european options and barrier options, and this approach can be applied to some other exotic options. the results of the study provide some guidelines and insights for portfolios containing different kinds of derivatives. jacobs and christofferson (2004) compared a range of garch models with different lags, using option prices and returns. they found that, in contrast to the returns-based objective function, using an option price-based objective function favored a more parsimonious model. jacobs et al (2004) suggested that index option prices differ systematically from those predicted by the black-scholes-merton model. in particular, out-of-the-money put prices and in-the-money call prices were higher than predicted by the black-scholes-merton model. they suggested an analytic option pricing formula consistent with the stock return dynamic, viz. an inverse gaussian garch model, which performed better than the usual bsm model for out-of-the-money puts on the s&p 500 index. singh et al (2011) empirically investigated the forecasting performance of closed-form discrete time garch option pricing model with benchmark black-scholes and its version practitioner black-scholes model for pricing s&p asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 427 cnx nifty 50 index option of india, relative to market price using error metrics, moneyness-maturity-wise. they found that the practitioner black-scholes model outperforms the other two models, and reduced the price bias between model and market. varma (2002) evaluated the volatility pricing of the index options with the help of the black-scholes-merton option pricing formula and the garch (1, 1) model and has found severe mispricing in indian index options. he has also established the significant difference in volatility smiles for call and put options. lehar et al (2002) examined the performance of two extensions of the black-scholes-merton framework, the garch and the stochastic volatility option pricing model. they found empirically for ftse 100 option prices that garch dominated over the stochastic volatility and the black-scholes-merton model. however, they found significant errors in the prediction of the market risk from hypothetical derivative positions in all the models. 3. methodology the objective of the present study is to analyse systematic mispricing of stock and index options on the nse using the garch model and the black-scholes-merton options pricing model. to analyses the stock options ten companies from ten different sectors, closing stock prices were obtained from the national stock exchange1 for the period of 1-may-2012 to 30-apr-2013 were taken to calculate the volatility using the garch(1,1) model for 30-,60-, and 90-day periods. the volatility values thus obtained were used in the black-scholes-merton model to calculate the call and put prices for the stocks. 3.1. garch (generalized autoregressive conditional hetroscedasticity) model the generalized autoregressive conditional heteroscedasticity (garch) models were propounded by engle (1982) and bollerslev (1986). the distinctive feature of these models is that they recognize that volatilities and correlations are not constant: i.e. volatility clustering and excess kurtosis. the garch models are discrete-time models, attempting to track changes in the correlation and volatility over time. the garch model is used to estimate volatility for a variety of financial time series: stock returns, interest rates, and foreign exchange rates. garch models have been applied in various fields such as asset allocation, risk management, and portfolio management, and option pricing. the garch (p, q) model is formulated as: , where p is the order of the garch (lagged volatility) terms, and q is the order of the arch (lagged squared-error) terms. in the academic literature, the garch (1, 1) process seems to be perceived as a realistic data generating process for financial returns. an intuitively appealing interpretation of the garch (1, l) model is easy to understand. the garch forecast variance is a weighted asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 428 average of three different variance forecasts. one is a constant variance that corresponds to the long-run average. the second is the forecast that was made in the previous period. the third is the new information that was not available when the previous forecast was made. this could be viewed as a variance forecast based on one period of information. the weights on these three forecasts determine how fast the variance changes with new information and how fast it reverts to its long-run mean. volatility and risk both terms are used interchangeably today. if one decides to approach the difficult problem of forecast evaluation, the first consideration is: which volatility is being forecast? for option pricing, portfolio optimization and risk management one needs a forecast of the volatility that governs the underlying price process until some future risk horizon. future volatility is an extremely difficult thing to forecast because the actual realization of the future process volatility will be influenced by events that happen in the future, e.g. large market movements at any time before the risk horizon. thus the real problem is that of prediction of volatility. the predicted volatility can be used to determine future prices of the stock or the stock option, and thus an investor can use arbitrage strategies accordingly to benefit from the model. the garch (1, 1) model is represented as , where γ represents the weight of long run variance; vl represents the long-run variance, α the weight of periodic returns, and β the weight of variance. the parameters α, β and ω are estimated by using the maximum likelihood method, maximizing the log-likelihood function , subject to the constraint α + β < 1. once the values of α, β and ω are obtained, γ = 1 – α – β, and vl is calculated as ω/γ. the annualized volatility is calculated as 251*vl. this volatility is then used to calculate the option prices. 3.2. the black-scholes-merton model the black scholes-merton model (1973) is one of the most important concepts in modern financial theory. the bsm model gives the formulae for european call and put options on a non-dividend-paying stock as follows: where s represents the spot price of stock, x represents the exercise price of the option, r is the annual risk-free rate of return, t is the time to expiry of the option, and is the annual asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 429 volatility of the stock. in the analysis, for each option, the exercise price was taken at par with the spot price on 1-jan-2013; the times to expiry considered were 30-, 60-, and 90-days; and the risk-free rate considered was 7.27% p.a. the volatility used was the long-run volatility estimated by the garch model. the market values of the options were compared with the estimated values using the paired-samples wilcoxon test. the %age difference between the market values and the estimated garch-bsm prices were calculated to assess the extent of mispricing. also, the extent of mispricing for 30-, 60-, and 90-day call and put options were compared using the paired-samples wilcoxon test. 4. analysis 4.1 call option: table 1. comparison of call option values calculated using black-scholes and the market option value for 30, 60 & 90 day expiry companies call option black-scholes option value market value 30 day 60 day 90 day 30 day 60 day 90 day ambuja cements limited 4.23 11.59 16.17 7.6 19.45 19.45 bharti airtel 13.1 15.51 29.2 18.65 26 38.5 cipla limited 12.6 20.96 28.05 17.3 35.2 35.2 dlf limited 11.19 13.59 14.35 18.6 29 15.55 hero motocorp limited 106.18 130.69 133.8 354.25 214.45 134.4 hindustan petroleum corporation limited 24.07 22.78 17.73 23.8 38 15 hindustan unilever limited 15.68 30.67 26.05 19.35 89.2 29 infosys limited 98.18 119.48 167.6 102.15 5 138.1 state bank of india 52.56 63.85 100.96 92.3 150 145.3 sun tv network limited 21.62 28.98 27.41 32.5 23.95 40.5 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 430 table 2. average difference in three different stock call options for different time period of expiry companies percentage difference 30 day 60 day 90 day ambuja cements limited 0.443421 0.404113 0.168638 bharti airtel 0.297587 0.403462 0.241558 cipla limited 0.271676 0.404545 0.203125 dlf limited 0.398387 0.531379 0.07717 hero motocorp limited 0.700268 0.390581 0.004464 hindustan petroleum corporation limited -0.01134 0.400526 -0.182 hindustan unilever limited 0.189664 0.656166 0.101724 infosys limited 0.038864 -22.896 -0.21361 state bank of india 0.430553 0.574333 0.305162 sun tv network limited 0.334769 -0.21002 0.32321 average difference in call option prices varies based on time effect of 30, 60 & 90 days. there is only a minute difference in the option prices and the above table also shows that the stock call option with 30 days to expiry has a difference which is minimum between the model and market values. 4.2 put option: table 3. comparison of put option values calculated using black-scholes and the market option value for 30, 60 & 90 day expiry companies put option black-scholes option value market value 30 day 60 day 90 day 30 day 60 day 90 day ambuja cements limited 16.2 9.7 8.37 17.4 14.25 14.8 bharti airtel 8 10.99 17.66 16.6 25 25 cipla limited 8.69 8.48 21.27 15.8 19.5 30.35 dlf limited 9.66 12.21 9.23 17 51.5 21.1 hero motocorp limited 92.63 72.79 83.57 119.6 62.05 120.95 hindustan petroleum corporation ltd. 15.75 18.76 11.29 18.85 71.05 18.5 hindustan unilever limited 6.68 13.94 14.11 15.7 6.35 29.55 infosys limited 57.91 88.86 113.41 76.8 453.75 94.85 state bank of india 17.44 44.99 51.38 68.15 128.7 128.7 sun tv network limited 19.3 21.11 17.74 30.95 80.5 39.8 table 4. average difference in three different stock put options for different time period of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 431 expiry companies percentage difference 30 day 60 day 90 day ambuja cements limited 0.069 0.3193 0.4345 bharti airtel 0.5181 0.5604 0.2936 cipla limited 0.45 0.5651 0.2992 dlf limited 0.4318 0.7629 0.5626 hero motocorp limited 0.2255 -0.1731 0.3091 hindustan petroleum corporation limited 0.1645 0.736 0.3897 hindustan unilever limited 0.5745 -1.1953 0.5225 infosys limited 0.246 0.8042 -0.1957 state bank of india 0.7441 0.6504 0.6008 sun tv network limited 0.3764 0.7378 0.5543 average difference in put option prices varies based on time effect of 30, 60 & 90 days. there is only a minute difference in the option prices and the above table also shows that the stock call option with 30 days to expiry has a difference which is minimum between the model and market values. 4.3 paired t-test table 5. spss output of paired sample t-test to compare the model and market prices of thirty day call option price t-test paired samples statistics mean n std. deviation std. error mean pair 1 thirtydaybsm thirtydaymv 35.9410 68.6500 10 10 37.304 50 105.602 34 11.796 72 33.394 39 paired samples correlations n correlation sig. pair 1 thirtydaybsm & thirtydaymv 10 0.849 0.002 paired samples test asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 432 paired differences 95% confidence interval of the difference pair 1 thirtyday bsm thirtyday mv mean std. deviation std. error mean lower upper t df sig. (2-tailed) 32.709 00 76.511 47 24.195 05 87.442 01 22.024 01 -1.352 9 0.209 paired sample t-test is done to check whether the numerical difference between the actual and the expected thirty day call option price of stock option which is significant in this case. the spss result show that the p value is greater than 0.05. so we can accept the null hypothesis that there is no significant difference between the actual and expected call option prices of stock option. table 6. spss output of paired sample t-test to compare the model and market prices of sixty day call option price t-test paired samples statistics mean n std. deviation std. error mean pair 1 sixtydaybsm sixtydaymv 45.8100 63.0250 10 10 44.403 36 68.232 35 14.041 57 21.576 96 paired samples correlations n correlation sig. pair 1 sixtydaybsm & sixtydaymv 10 0.564 0.089 paired samples test paired differences 95% confidence interval of the difference pair 1 sixtydaybsm sixtydaymv mean std.deviation std.error mean lower upper t df sig. (2-tailed) 17.21500 56.641 61 17.911 65 57.733 96 23.303 96 -961 9 0.362 paired sample t-test is done to check whether the numerical difference between the actual and the expected sixty day call option price of stock option which is significant in this case. the spss result show that the p value is greater than 0.05. so we can accept the null hypothesis that there is no significant difference between the actual and expected call option asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 433 prices of stock option. table 7. spss output of paired sample t-test to compare the model and market prices of ninety day call option price t-test paired samples statistics mean n std. deviation std. error mean pair 1 ninetydaybsm ninetydaymv 56.1320 61.1000 10 10 56.300 98 54.734 31 17.803 93 17.308 51 paired samples correlations n correlation sig. pair 1 ninetydaybsm & ninetydaymv 10 0.948 0.000 paired samples test paired differences 95% confidence interval of the difference pai r 1 ninetydaybs m ninetydaym v mean std.deviati on std.error mean lower upper t d f sig. (2-tailed) -4.968 00 18.034 38 5.702 97 -17.869 02 7.933 02 -87 1 9 0.406 paired sample t-test is done to check whether the numerical difference between the actual and the expected ninety day call option price of stock option which is significant in this case. the spss result show that the p value is greater than 0.05. so we can accept the null hypothesis that there is no significant difference between the actual and expected call option prices of stock option. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 434 table 8. spss output of paired sample t-test to compare the model and market prices of thirty day put option price t-test paired samples statistics mean n std. deviation std. error mean pair 1 thirtydaybsm thirtydaymv 25.2260 39.6850 10 10 27.958 25 36.170 13 8.841 18 11.438 00 paired samples correlations n correlation sig. pair 1 thirtydaybsm & thirtydaymv 10 0.925 0.000 paired samples test paired differences 95% confidence interval of the difference pair 1 thirtydaybsm thirtydaymv mean std.deviation std.error mean lower upper t df sig. (2-tailed) -14.459 00 14.800 94 4.680 47 -25.046 96 -3.871 04 -3.089 9 0.013 paired sample t-test is done to check whether the numerical difference between the actual and the expected thirty day put option price of stock option which is significant in this case. the spss result shows that the p value is less than 0.05. so we can reject the null hypothesis that there is a significant difference between the actual and expected call option prices of stock option. table 9. spss output of paired sample t-test to compare the model and market prices of sixty day put option price t-test paired samples statistics mean n std. deviation std. error mean pair 1 sixtydaybsm sixtydaymv 30.1830 91.2650 10 10 28.937 11 132.681 40 9.150 72 41.957 54 paired samples correlations n correlation sig. pair 1 sixtydaybsm & sixtydaymv 10 0.793 0.006 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 435 paired samples test paired differences 95% confidence interval of the difference pair 1 sixtydaybsm sixtydaymv mean std.deviation std.error mean lower upper t df sig. (2-tailed) 61.082 00 111.134 79 35.143 91 -140.583 18.419 04 -1.738 9 0.116 paired sample t-test is done to check whether the numerical difference between the actual and the expected sixty day put option price of stock option which is significant in this case. the spss result show that the p value is greater than 0.05. so we can accept the null hypothesis that there is no significant difference between the actual and expected put option prices of stock option. table 10. spss output of paired sample t-test to compare the model and market prices of ninety day put option price t-test paired samples statistics mean n std. deviation std. error mean pair 1 ninetydaybsm ninetydaymv 34.8030 52.3600 10 10 36.414 27 44.451 33 11.515 20 14.056 74 paired samples correlations n correlation sig. pair 1 ninetydaybsm & ninetydaymv 10 0.823 0.003 paired samples test paired differences 95% confidence interval of the difference pair 1 ninetydaybsm ninetydaymv mean std.deviation std.error mean lower upper t df sig. (2-tailed) -17.557 00 25.239 35 7.981 38 -35.61214 498 14 -2.200 9 0.55 paired sample t-test is done to check whether the numerical difference between the actual and the expected ninety day put option price of stock option which is significant in this case. the spss result show that the p value is greater than 0.05. so we can accept the null asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 436 hypothesis that there is no significant difference between the actual and expected put option prices of stock option. 4.4. multiple regressions table 11. spss output of multiple regression for stock call options: regression variables entered/ removed ᵇ model variables entered variables removed method 1 maturity, stock, price, volatility, strike price ᵃ enter a. all reserved variables entered b. dependent variable: option price model summary model r r square adjusted r square std. error of the estimate 1 0.971ᵃ 0.943 0.934 11.73665 a. predictors: ( constant), maturity, stock price, volatility, strike price anovaᵇ model sum of squares df mean square f sig. 1 regression 57392.765 4 14348.191 104.162 0.000ᵃ residual 3443.722 25 137.749 total 60836.487 29 a. predictors: ( constant ), maturity, stock price, volatility, strike price b. dependent variable: option price multiple regression is done to find out the independent variables on which call option prices of the stock option depends upon. the independent variables considered are strike price, spot price, volatility and maturity time. the results of the spss output show there is dependency of call option prices of the stock option on all the variables except the maturity time as r square value is high and the p values are less than 0.05 in all the cases except maturity time. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 437 table 12. spss output of multiple regression for stock put options: regression variables entered/ removed ᵇ model variables entered variables removed method 1 maturity, stock, price, volatility, strike price ᵃ enter a. all reserved variables entered b. dependent variable: option price model summary model r r square adjusted r square std. error of the estimate 1 0.966ᵃ 0.932 0.922 8.5351 a. predictors: ( constant), maturity, stock price, volatility, strike price anovaᵇ model sum of squares df mean square f sig. 1 regression 25142.779 4 14348.191 86.286 0.000ᵃ residual 1821.177 25 72.847 total 26963.957 29 a. predictors: ( constant ), maturity, stock price, volatility, strike price b. dependent variable: option price coefficientsᵃ unstandardized coefficients standardized coefficients model 1 ( constant) b std. error beta t sig. -28.825 5.624 -5.125 0 stock price -0.742 0.08 -22.412 -9.277 0 strike price 0.755 0.079 23.187 9.611 0 volatility 307.237 54.425 0.436 5.645 0 maturity -72.704 32.503 -0.163 -2.237 0.034 multiple regression is done to find out the independent variables on which call option prices of the stock option depends upon. the independent variables considered are strike price, spot price, volatility and maturity time. the results of the spss output show there is dependency of put option prices of the stock option on all the variables as r square value is high and the p asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 438 values are less than 0.05 in all the cases. 5. discussion the findings of the study suggest that options are significantly overpriced. however, an interesting possibility suggested by the findings is that this overpricing decreases with expiration period. also, the findings suggest that put overpricing is significantly higher than call overpricing, as suggested by dash et al (2012), particularly for longer expiration periods. the study has several limitations. the sample size used for the analysis is small, and the selected stocks are all large-cap stocks; so that it is not clear whether the results of the study extend to mediumand small-cap stocks. another difficulty is that of trading volume, which may also affect overpricing, as suggested by dash et al (2012). finally, another limitation that may bias the results of the study is the choice of research period; it is not clear whether the results extend to other periods, particularly under high volatility. there is great scope for applying garch option pricing models to examine several other interesting properties of options, including implied volatility, volatility smiles, and the time-variability of options properties (e.g. greeks). references adesi g.b, engle. r.f and mancini.l. (2008). a garch option pricing model with filtered historical simulation. review of financial studies. bakshi.g, c. cao, & z. chen. (1997). empirical performance of alternative option pricing models. journal of finance, 52, 2003-2049. http://dx.doi.org/10.1111/j.1540-6261.1997.tb02749.x black.f., & m.scholes. ( 1973). the valuation of option and corporate liabilities, journal of political economy, 81,637-654. http://dx.doi.org/10.1086/260062 christoffwerson.p., & k. jacobs. (2004). which garch model for option valuation. journal of management science, 50,1204-1221. http://dx.doi.org/10.1287/mnsc.1040.0276 dash.m, dagha.j.k., sharma.p., & singhal.r. (2012). an application of garch models in detecting systematic bias in option pricing and determining arbitage in options. journal of centrum cathedra, 5(1),91-101. http://dx.doi.org/10.7835/jcc-berj-2012-0069 duan.j. (1995). the garch option pricing model. mathematical finance, 5(1),13-32. e.ghysels, & chernov.m. (2000). a study towards a unified approach to the joint estimation of objective and risk neutral measues for the purpose of option valuation. journal of financial economic, 56,407-458. http://dx.doi.org/10.1016/s0304-405x(00)00046-5 hao. f., & yang, h. (2011). coherent risk measure for derivatives under black-scholes economy with regime switching. journal of managerial finance, 37(11),1011-1024. http://dx.doi.org/10.1108/03074351111167910 heston.s.l. (1993). a close form solution for option with stochastic volatility with asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 439 application to bond and currency options. review of financial studies, 6, 327-343. http://dx.doi.org/10.1093/rfs/6.2.327 jackwerth, & buraschi. a. (2001). the price of a smile: hedgeing and spanning in option market, 14,495-527. jacobs.c., & christofferson.p. (2004). which garch model for option valuation. jounal of management sciences, 50,1204-1221. http://dx.doi.org/10.1287/mnsc.1040.0276 jacobs.c, heston, s.l., & christofferson. p.. a. (2004). a garch option pricing model with filtered historical simulation. http://dx.doi.org/10.1287/mnsc.1040.0276 lehar.a, scheicher.m., & schittenkopt.c. (2002). garch vs. stochastic volatilityoption pricing and risk management. journal of banking & finance, 26(2/3), 323-346. http://dx.doi.org/10.1016/s0378-4266(01)00225-4 m.scholes, & black.f. (1973). valuation of options and corporate liabilities. journal of political economy, 81,637-654. http://dx.doi.org/10.1086/260062 nandi.s., & heston. s. l. (2000). a close form garch option valuation model. review of financial studies, 13(3). http://dx.doi.org/10.1093/rfs/13.3.585 ross.s.a. cox. j.c. (1976). the valuation of options for alternative stochastic processes. journal of financial economics, 3, 145-166. http://dx.doi.org/10.1016/0304-405x(76)90023-4 singh.v.p, ahmed.n, and pachori.p.(2011). empirical analysis of garch and practitioner black-scholes model for pricing s& p nifty 50 index options of india. decision, 38(2),51-67. siu.t.k. tong. h and yang.h. (2004). on pricing derivatives under garch models: a dynamic gerber-shiu's approach. north american actuarial journal, 8, 17-31. varma.j.r. (2002). mispricing of volatility in the indian index option market. iim, ahmedabad, working paper series no: 2002-04-01. microsoft word 7260-25876-3-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 135 costs and benefits of foreign direct investment to azerbaijan’s economy: the case of oil sector gulkhanim mammadova department of management, fatih university e-mail: m_ati@live.ru ali coskun phd, associate professor, department of management, fatih university istanbul, turkey e-mail: alicoskun@fatih.edu.tr received: march 17, 2015 accepted: may 24, 2015 published: june 1, 2015 doi:10.5296/ajfa.v7i1.7260 url: http://dx.doi.org/10.5296/ajfa.v7i1.7260 abstract azerbaijan is a young republic with a developing economy. despite the efforts of government programs and development of non-oil sectors in recent years, the oil sector is still the most important sector of the economy. improvement in the oil sector is the main source of the developments in azerbaijan’s economy. in this study, we present the role of the oil sector in azerbaijan’s economy, investigate the foreign direct investment in azerbaijan oil sector and analyze the costs and benefits of foreign direct investment in oil industry to the azerbaijan’s economy. after a broad literature review, it is found that foreign direct investment in azerbaijan oil sector results in some minor costs to economy such as crowding out, negative wage spillover, profit repatriation and dual economy effect. on the other hand, foreign direct investment in azerbaijan oil sector has great benefits for the economy, especially in terms of significant developments at macroeconomic indicators such as rapid increase in gdp. adding to economic growth, human capital contribution, competition level, technology transfer and management and governance practices are some other benefits of foreign direct investment in azerbaijan oil sector in azerbaijan’s economy. keywords: foreign direct investment, fdi, azerbaijan, oil sector, cost and benefit analysis jel code classification: f21, o11, p33 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 136 1. introduction the republic of azerbaijan is a young country founded after the collapse of the soviet union in 1991. after gaining independence, the country faced some important issues such as economic shortage and political conflicts with neighbors. although the country has established a democratic political structure and solved most of the political problems, the country continues to have economic difficulties. in order to solve economic problems, governments focused on rich oil reserves in the country. azerbaijan has started to produce and export oil, signed important agreements and developed pipeline projects. especially after the beginning of 2000s, the country experienced a great deal of economic development. the government introduced programs to develop both oil and non-oil sectors. however, it must be admitted that the oil sector is still vital for azerbaijan economy. public services such as education, military, infrastructure etc. are financed by income from oil exports. because it depends on oil exports, the country strived to have a great deal of reserves. the rich oil reserves attracted foreign investors to the country. with the contributions of the foreign direct investment in azerbaijan oil sector, economic indicators of the country improved as well. in the study, the costs and benefits of foreign direct investment in oil sector on the azerbaijan economy are investigated. 2. azerbaijan oil sector after gaining independence in 1991, azerbaijan has tried hard to apply liberalization and free market economy. there have been various reforms for transitioning the economy to free market economy. establishing new economic system, it was unavoidable to use natural sources in the caspian sea, with the country having to focus on the oil and natural gas underneath. governors made several steps for using natural sources in order to reach economic targets (aras & suleymanov, 2012). proven recoverable oil reserves of azerbaijan at the end of 2011 reported to be 7 billion barrels (world energy council, 2013). in 2012, there was a production of 930,000 barrels per day (bbl/d). azerbaijan consumed 85,000 bbl/d of that amount. in 2012, azerbaijan was one of the top 20 oil exporters in the world. azerbaijan has a long history of oil production and a great significance in the development of oil sector in today`s world (u.s. energy information administration, 2013). table 1 shows amount of oil and gas sector in azerbaijan economy. it is seen as a fact that the oil industry has vital importance for the azerbaijan economy. the sector has great influence on the economy, especially after political stabilization in the country and oil contracts signed. all statistical data shows that azerbaijan’s economy started to develop with the beginning of the 2000s. from 2003 to 2009, as azerbaijan started to seriously develop its oil and gas sector, gdp growth averaged 16% a year due to strong investment in this sector. strong oil and gas production gains, high international oil prices and sharply higher public spending propelled growth to an average of 27% a year between 2003 and 2009. oil revenues even increased more than predicted due to the spike in oil prices in world markets between 2005 and 2008, leading the country’s currency reserves to reach 18 billion usd by the end of 2008 twice its foreign debt. the oil sector accounted for 42% of value added (of gdp), 90.7% of total gross asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 137 exports and 83.9% of total foreign investment in 2009 (world bank, 2012). table 1. gdp production in the section of oil and non-oil of economy (volume of gdp, at current prices, million manats) years total gdp oil-gas sector percentage 2000 4,718.1 1,371.0 29.1% 2001 5,315.6 1,668.2 31.4% 2002 6,062.5 1,882.3 31.0% 2003 7,146.5 2,149.1 30.1% 2004 8,530.2 2,672.0 31.3% 2005 12,522.5 5,520.9 44.1% 2006 18,746.2 10,091.8 53.8% 2007 28,360.5 15,914.2 56.1% 2008 40,137.2 22,251.3 55.4% 2009 35,601.5 16,065.5 45.1% 2010 42,465.0 20,409.5 48.1% 2011 52,082.0 25,829.9 49.6% 2012 54,743.7 24,487.3 44.7% 2013 57,708.2 24,035.1 41.6% source: the state statistical committee of the republic of azerbaijan (2014a). as it’s seen in table 2, the oil-related products have the highest share in exports. the general policy of azerbaijan about the oil sector is selling oil, earning money and using that money for social and economic development of the country. all data gathered throughout the study also showed that azerbaijan made great social and economic development thanks to oil profits. in other words, azerbaijan is using oil policy in a good manner. all those facts make government to support foreign investment in oil sector. table 2. exports of main commodities in 2013 commodities quantity value (thousand usd) crude petroleum. thsd. tons 24,855 20,244,052 diesel fuel. thsd. tons 1,084 865,353 sugar. thsd. tons 2,493 243,642 kerosene. tons 252,920 233,300 fresh fruits. tons 173,239 173,311 vegetable oil. tons 36,992 110,009 rough aluminum. tons 54,304 81,882 polymers of ethylene, in primary forms. tons 65,572 75,810 natural gas. mln. cubic meter 3,035 70,980 black oil fuel. thsd. tons 228 60,127 fresh vegetables. tons 65,518 55,595 other items 391,839 source: the state statistical committee of the republic of azerbaijan (2014b). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 138 3. foreign direct investment in azerbaijan in general, foreign direct investment (fdi) is desired by most developing countries, and governments prepare economic programs for fostering foreign direct investment in their country. fdi provides an improvement opportunity for business and economy as a whole. fdi is one of the driving forces in the integration of developing countries into the globalization process. (ilgun & coskun, 2009) the interest to the fdi is especially competitive among emerging and newly established countries, such as those of the former soviet union (festervand, 2011). azerbaijan is one of these countries, with the rich oil reserves that attract the foreign investors to the country. according to the state statistical committee of the republic of azerbaijan (2014c), there is a great increase in the amount of foreign direct investment in azerbaijan. while the total amount of foreign direct investment was 1,092 million usd in 2001, the amount exceeded 10,000 million usd in 2013. figure 1 shows the growth in total amount of foreign investment in azerbaijan in the last two decades. 0 5000 10000 15000 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 figure 1. total amount of foreign investment in azerbaijan source: prepared with the data gathered from national statistics center of azerbaijan western public and foreign investors see azerbaijan as a predictable and responsible partner. azerbaijan has become a good destination for investors as a result of support of azerbaijan government. after restoration of its independence in 1991, azerbaijan tried hard to take part in the international community, and there has been an active policy of the country. that situation was supported with increasing socioeconomic indicators (information digest, 2007: 72). it is an accepted fact that foreign direct investment plays a crucial role for economic development of a country. for that reason, countries try hard to attract foreign direct investment. azerbaijan has a successful foreign direct investment policy with low inflation rates and other economic indicators. adding contracts signed with other companies and countries, azerbaijan oil has become a good investment direction for investors (pashayev, 2013). several reasons may be claimed for increase in amount of foreign investment in azerbaijan. all in all, it is known that there is not a discriminative regime in azerbaijan for foreign investors. it is easy to make investment in azerbaijan. privatization and banking are asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 139 open sectors for investors (information digest, 2007). it must also be admitted that there are some problems faced during foreign investment as well. for example, there is a serious problem about bureaucracy in azerbaijan. moreover, corruption is also a problem seen in azerbaijan. nowadays, there are some measures to be taken and azerbaijan government has a great anti-corruption campaign (rosenblum, 2011). despite government of azerbaijan’s desires to see foreign direct investment in country, some people in the government do not consider it as a key factor for development. laws have always supported foreign direct investment in the country; however, there are some problems. for example, predatory behavior of politically connected elites, corruption, weak legal institutions and complex government bureaucracy makes it difficult to make investments (bureau of economic and business affairs, 2013). other problems faced by investors are tax rates and access to finance. three out of four entrepreneurs experience difficulties while seeking financing. the limited availability of credit funding, restrictive conditions, high interest rates and expensive processing of payments make loans unattractive for entrepreneurs. lack of financing to invest in new technologies and equipment makes local entrepreneurs less competitive in terms of quality than international suppliers (ciarreta & nassirov, 2012: 4). 4. foreign direct investment in azerbaijan oil sector foreign direct investment has always been important for the last decade for azerbaijan economy. foreign direct investment, especially seen at hydrocarbons, is a vital contribution of economic growth of the country with the support of public investment. oil sector has an important role in foreign direct investment in the country. it can be claimed that the decrease in investment in oil sector may have resulted in decrease in foreign direct investment in country (center for energy economics 2003: 2). an important portion of the foreign direct investment in the country focuses on oil sector. foreign direct investment in the country is mainly motivated by resource-seeking industries. global oil industry is an important investor in azerbaijan. despite the fact that oil sector is the attraction point of foreign direct investment, it is impossible to claim that oil sector is the sole factor of this situation. it will be beneficial to mention again that there is a good climate in the country for investors supported by government programs (frayne, 2012: 4). table 3 shows foreign direct investment in azerbaijan in last two decades. according to primary data during 2013, the country received 10.5 billion usd foreign investments from foreign countries and their companies, with 46.8% of them directed to the oil sector (the state statistical committee of the republic of azerbaijan, 2014c). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 140 table 3. foreign direct investment in azerbaijan economy (million usd) total foreign direct investment financial credits oil industry companies with joint and foreign investment 1995 375.1 220.4 139.8 14.9 2000 927.0 262.9 546.1 118.0 2005 4,893.2 698.4 3,799.9 230.5 2006 5,052.8 983.5 3,422.3 368.4 2007 6,674.3 1,576.6 4,003.3 439.1 2008 6,847.4 2,357.9 3,350.7 494.1 2009 5,468.6 1,438.3 2,412.7 624.4 2010 8,247.8 3,405.9 2,955.3 659.6 2011 8,673.90 3,692.50 3,407.80 886.0 2012 10,314.0 3,135.5 4,287.8 1,094.5 2013 10,540.9 2,655.8 4,935.2 1,041.0 source: the state statistical committee of the republic of azerbaijan (2014c). the steady real exchange rate appreciation is another potentially hampering factor for export-oriented fdi in the non-oil sector of the economy. if this real exchange rate appreciation continues at such a pace, it is bound to have a negative impact on the export competitiveness of services and manufacturing in the non-oil sector of the economy. this would be a classical example of the so called “dutch disease” and might constitute an obstacle for future fdi into services and manufacturing that aims at building a regional/global export platform in azerbaijan (günther & jinda, 2009: 10). foreign direct investment remains tightly concentrated in the oil and gas sector, and the attraction of fdi to the non-oil sector remains one of the country’s most pressing tasks. however, this is not facilitated by elements of the dutch disease, such as appreciation of the national currency or pervasive corruption (bertelsmann stiftung, 2012: 7). the government has worked hard to reduce the impact of dutch disease, setting up the state oil fund of azerbaijan to preserve macroeconomic stability and retain oil wealth for future generations. it has also implemented a series of national poverty reduction programs and increased public expenditure in infrastructure development, education and healthcare (international labour organization, 2012: 1). 5. cost and benefits of foreign direct investment in azerbaijan oil market foreign direct investment in azerbaijan oil sector has great benefits for the economy, especially in terms of significant developments at macroeconomic indicators such as rapid increase at gdp. adding to economic growth, human capital contribution, competition level, technology transfer and management and governance practices are some other benefits of foreign direct investment in azerbaijan oil sector in azerbaijan economy. on the other hand, it is found that foreign direct investment in azerbaijan oil sector results in some minor costs to economy such as crowding out, negative wage spillover, profit repatriation and dual economy effect. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 141 5.1. benefits of foreign direct investment in oil sector as an oil exporting country, azerbaijan has benefited from the oil boom over the past years, and the government gained huge amounts of oil income and wealth. these huge numbers are seen in export rates and government revenues as 92% and 74%, respectively. due to the decline of oil prices in 2008, azerbaijan revenues fell down by 35% in 2009. to cover for this economic deficiency, the government increased the amount of the yearly transfer from the petrol fund to the government budget around 2 billion usd and was able to overcome economic crises (quliyev, 2014). oil sector is an attraction point of azerbaijan in terms of foreign direct investment. despite some bureaucratic obstructions, unhealthy investment area and infrastructure constraints, foreign direct investment in oil sector continued to grow (economic intelligence unit, 2012). on the other hand, many investors and authorities from azerbaijan claim that azerbaijan there is a quality infrastructure, political stability, plenty of resources, azerbaijan`s hospitality and being crossroads of europe and asia and all those make it easy to invest in azerbaijan. economic indicators make azerbaijan authorities right as there has been a gradual increase at foreign direct investment in oil sector (azam, 2010 and 2012). 5.1.1. foreign direct investment and economic growth there is a positive relationship between economic growth and foreign direct investment. that relationship is important for both developing and developed countries. economic growth of host country is directly affected by fdi. new job opportunities, inflow of technology, managerial know-how, marketing skills and many other aspects are developed in host country thanks to experiences of foreign investors (gürsoy, sekreter & kalyoncu, 2013: 519).. not only stabilization macroeconomic development, but also huge flows of foreign direct investment are elements triggering growth in azerbaijan economy. according to hübner (2011), there is a positive correlation in azerbaijan between foreign direct investment and economic growth. the author expresses that there is a huge inflow of foreign direct investment to azerbaijan oil sector. moreover, that amount of huge flow results in being a catalyst for many other sectors. for example, finance, transportation, construction and many other sectors are directly affected from foreign direct investment to azerbaijan oil sector. investment promoting agencies and government in azerbaijan are proud of declaring that they paced a great development in terms of economic growth. they also express pride about their success of attracting foreign direct investment. it is seen that the sharp economic growth in azerbaijan economy in the first decade of 21st century is affected from the amount of foreign direct investment in oil sector (hübner, 2011: 3). gürsoy et al. (2013) studied the relationship between foreign direct investment and gpd. this study investigates the causality between fdi and gdp by using granger causality test for azerbaijan, kyrgyz republic, kazakhstan, tajikistan, turkmenistan, and uzbekistan over the period 1997–2010. the adf unit root test results indicated that kyrgyz republic, kazakhstan, tajikistan, and uzbekistan have different orders of integration. therefore, johansen cointegration test is applied to azerbaijan and turkmenistan. after finding a asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 142 long-run cointegration relationship, the authors investigate causal relationship using grager causality test. it is found that fdi granger causes gdp in the case of azerbaijan. therefore, in the case of azerbaijan, unidirectional causality exists (gürsoy, et al., 2013: 523). during 2009, there was an optimistic economic growth at azerbaijan economy. the reason for that optimistic prediction was smooth performances in the oil sector. in spite of the global financial crisis and low global oil price, azerbaijan’s economy saw relatively significant growth. both 2008 and 2009 were years of success in azerbaijan’s economy. one of the main reasons for this success was investment in the oil sector. there was a great decrease in many other sectors. there was a decrease of 3.5 percent in agriculture sector as a result of expensive inputs, water storage in agriculture areas, low credit facility and focusing on wheat production solely. moreover, there was a decrease at oil export as well. both oil export and oil machinery import decreased in that term. on the other hand, there was a great governmental support and state oil fund made a high degree of public investment (azam, 2012). investment in the oil sector in azerbaijan affects many aspect of economy. for example, foreign direct investment in the oil sector makes oil export rates higher. that has resulted in high development of the reserves of azerbaijan, especially after 2006. the importance of oil export for reserves can be understood by observing amount of reserves in 2006 and 2008. in 2006, there was a great increase at reserves of the country. there was an increase of 51.4 percent at reserves in 2008 and it reached 6.5 billion usd. however, decline of oil export resulted in a decrease of reserves. there was a decrease of 15.7 percent in 2009 and reserves decreased to 5.18 billion usd. moreover, there is an amount of 14.2 billion usd in the state oil fund, meaning no problem about liquidity. at the beginning of 2013, the reserves in azerbaijan reached 29.1 billion usd and 22.7 billion usd of that amount belongs to state oil fund (deik, 2013: 16). 5.1.2. human capital contribution human capital contribution is one of the important benefits of foreign direct investment to azerbaijan. fdi makes a significant contribution to the host country about human capital. operations of foreign investors in the country provide benefit to the country both by decreasing the unemployment and increasing the number of experienced workers. in azerbaijan oil sector foreign investors are giant international companies with high level of experience and they transfer their experience to the national staff, resulting in well trained staff. work environment, wages and benefits of foreign investors make oil sector more attractive to work. fdi companies make regular training programs to their employees and transfer the experience to the staff via that way. despite the education level and high literacy level, azerbaijan faces well-trained staff in different business areas. there is a need for engineers with a high level of skill and technologically advanced in different fields of business life. foreign investment is a good tool in azerbaijan for training people. at the same time, azerbaijan is a country where companies spent less than in all other transition countries on research & development (r&d). therefore, per-capita foreign direct investment should be coupled with policies designed to facilitate the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 143 transfer of knowledge and technology between firms. the government could also set incentive schemes for companies to invest more in its staff (education and vocational training) and in r&d (hübner, 2011: 4). in 2006, azerbaijan government prepared its “state program on study of azerbaijani youth in abroad in the years of 2007–2015” (ministry of education of azerbaijan republic, 2009). up to 2015, azerbaijan government aimed to send 5,000 students abroad per year. in the program’s last five years, it is seen that only 1,228 students were sent abroad per year. there is still a need to send 3,772 students to abroad in accordance with the program targets (economic research centre, 2010; begin group, 2014). at that point, it must be mentioned that there is not the expected amount of students going abroad directly for oil sector. the main countries hosting those students are germany, russia, great britain and turkey. according to the statistics of the years 2010–2011, 40.8% of 2,055 of azerbaijani students have studied in turkey, 24.7% in russia, 6.6% in great britain, 5.4% in germany (begin group, 2014). considering the oil sector, bp has a role of supporting human capital in azerbaijan with the community investment program (cip) starting from 2002. one of cip’s projects was the sangachal terminal expansion program, aimed to enhance the capabilities of the local workforce. at the end of 2013, the number of national employees increased by 3,216 (85%) were bp’s professional staff. bp signed cooperation agreements with the state oil company of the republic of azerbaijan (socar) to work together to nationalize bp’s staff. the aim of this cooperation is to develop professionals specializing in petroleum disciplines. bp and its co-ventures help fund a lot of educational programs, aimed at training workers in the skills and capabilities that oil industry will need in the future. bp and its co-ventures have been supporting students with oil and gas scholarships since 2002. this program gives azerbaijan students a chance to continue undergraduate and graduate studies in engineering and geosciences at universities in turkey and azerbaijan (bp, 2013). on the other hand, yildirim and tosuner (2014) examined fdi and level of education methodology for 1991–2011 in azerbaijan, uzbekistan, kazakhstan, and kyrgyz republic and could not find evidence that fdi supported the level of education in these republics. but they also pointed out the contribution of the multinational companies (mnc) to the human capital. mncs generally promote tertiary education through sponsorship scholarship to talented/gifted students, which they need for a qualified future workforce (yildirim & tosuner, 2014). 5.1.3. competition level competition level has significant importance for development of a country. productivity, innovation, lower prices and many other factors make an economy strong. foreign direct investment supports all those aspects in an economy. foreign direct investment contributes to both factor productivity and income growth in host countries, beyond what domestic investment normally would trigger. it is more difficult, however, to assess the magnitude of this impact, not least because large foreign direct investment inflows to developing countries often coincide with unusually high growth rates triggered by unrelated factors (oecd, 2002: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 144 9). in azerbaijan, the main foreign direct investment sector is still oil. it takes nearly two-thirds of total foreign direct investment. it is seen that there is an increasingly competitive environment in the oil sector. especially bp, a united kingdom energy company, makes investments in the shafaq-asiman gas field and that investment has triggered many other investments from other giant companies (oecd, 2002: 192). governments have some duties to develop foreign investment in order to increase competition level. the banking sector is a good starting point for this. in azerbaijan, to establish a more competitive environment, the government should support a national banking system. it should actively promote mergers and acquisitions among banks, especially with the participation of foreign investors. if such reforms are successful, access to finance for entrepreneurs at all levels (in general and especially in the form of better loan conditions) would improve (hübner, 2011: 4). after increases in foreign direct investment, not only the banking sector but some other sectors would face competition. for example, the agriculture sector needs competitive environment. increasing foreign direct investment is expected to increase competitive level at agriculture industry (oecd, 2002: 192). 5.1.4. management and governance practices and technology transfer globalization and regionalization are two important processes characterizing the present state of world development. azerbaijan has been confronting them with great effort. using its important geographical location and well-educated workforce, azerbaijan has tried hard to renew the silk road and europe-caucasus-asia transport corridor (traceca) located in baku sponsored by european union. the country is aware of the fact that management and governance practices contributes to an economy’s great experience and new management and governance perspectives. azerbaijan is ready to play a connecting role in realization of prospective transregional projects, encouraged by international organizations. cooperation within the framework of international organizations constitutes one of the most significant guidelines of azerbaijan’s foreign economic policy. azerbaijan is a member of more than twenty international economic organizations and has observer status at the world trade organization (oecd, 2001: 3). in azerbaijan, increasing foreign direct investment forces local companies to develop their technology and transfer technology from investing companies. to compete with more qualitative foreign goods at the domestic market, local companies have to apply better technologies. this is impossible without fdi and cooperation with leading mnes on equity and non-equity basis. local companies acquiring advanced technologies and joint ventures can replace import needs more effective manner. this is also could be justification and necessary step for further export oriented manufacturing (pashayev, 2013). according to hübner (2011), in a diversified environment, foreign direct investment can contribute to broad know-how and technology transfer, inclusion into the global economy, and the development of the financial sector as one of the preconditions for further economic stimulation. it usually contributes to wealth and job creation. and it can have an impact on asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 145 educational levels and increase skills among the working population through training and investments in research and development (hübner, 2011: 3). in azerbaijan, increasing fdi has led to some developments and projects in terms of technology transfer. some of those projects are as follows (dobrinsky, 2012): • world intellectual property organization (wipo) was requested to organize by the state committee on standardization, metrology and patents of the republic of azerbaijan in cooperation with the committee a regional seminar on technology transfer issues. • the center for technology transfer has been established at the azerbaijan state university of economics. • azdres energy efficiency improvement project. • sumgait technologies solar park. • demonstration project of hydroelectric power plant. 5.2. costs foreign direct investment in oil sector on economy 5.2.1. crowding out for a long time, it has been a significant debate whether foreign direct investments damage the economy of the host country by crowding out domestic investment. there may be several factors influencing the ability of domestic investors during their competition with foreign rivals. first, it is difficult for domestic investors to compete with foreign investors without a high level of technology and efficient operation (acar, eris & tekce, 2013:2). foreign investors in oil sector are giant companies operating globally with giant budgets and technology know-how. in general, fdi does crowd out domestic investors, especially in the short term. arbitrage and fdi take advantage of government incentives and tend to concentrate on traditional rather than high-tech industries. because private enterprises often concentrate in traditional industries, fdi can cause crowding. in private enterprises engaged in centralized and highly competitive manufacturing applications, this kind of crowding out was obvious (wu, sun & yu, 2012: 1). weak financial intermediation hits domestic enterprises much harder than it does multinational enterprises (mnes). in some cases, it may lead to a scarcity of financial resources that precludes them from seizing the business opportunities arising from the foreign presence (oecd, 2002: 10). farla, de crombrugghe, and verspagen (2013) prepared a study about this crowding-out effect in some countries including azerbaijan. the end of the study showed that effects of fdi vary during different situations. in general, it is difficult for domestic investors to struggle with giant companies. on the other hand, clemens (2008) argues that the crowding out effect in the oil sector of the azerbaijan economy is not important. a higher capital inflow from abroad is an external asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 146 increase in capital stock with no influence on the consumption and saving decision. thus, the level of capital rises, but the steady-state value does not change (clemens, 2008: 23). according to lerman and sedik (2010), foreign direct investment in the oil sector is not crowding out other sectors. however, those sectors do not perform as well as the oil sector. one of the main reasons for that can be seen as the amount of people working in oil sector and other sectors. comparing with many other oil-producing countries, azerbaijan does not employ as many people as others (lerman and sedik, 2010: 58). 5.2.2. negative wage spillover negative wage spillover is another important problem caused by foreign investors. as described above, giant companies in oil sector have giant budgets and they are able to work with qualified staff as a result of high salaries. because of this, domestic firms hire lower-quality staff. this situation results in many undesirable situations in productivity and operations (lipsey and sjöholm, 2004: 3). on wage spillovers, görg and greenaway (2001) reported that panel data showed negative spillovers, but cross-sectional data showed positive ones. the same paper found, with respect to productivity spillovers from foreign-owned to domestically owned firms, only limited evidence in support of positive spillover. most work fails to find positive spillovers, with some even reporting negative spillovers (görg and greenaway, 2001). azerbaijan has recently started to be discussed about negative wage spillover effects of foreign direct investment. however, this situation may be discussed in two ways. while negative wage spillover is harmful for domestic investors, it is good for people working in the country (pamukcu and taymaz, 2009: 3). 5.2.3. profit repatriation profit repatriation has always been an important topic for investors during foreign investment choices. companies always want to be able to take their money back home for several reasons. for example, they want to be able to take their money back home when there is any kind of instability in the host country. to attract foreign investors, countries are to make some measures about that topic. the conclusion offers an interesting idea for developing countries that seeks to attract fdi inflow and always allows free repatriation. this kind of point must be taken into account by policy makers. however, fdi may result in other benefits such as technology spillover or employment generation (markusen, 1984). foreign investors generally focus on investment opportunities. for example, changes in macro and micro economic indicators among the countries change investment plans and applications. companies are eager to have alternatives in various situations. while an economic situation in a country may make an investor invest in that country; better opportunities in another country may attract the investor more. under those circumstances, investors want freedom (lundan, 2006: 42). azerbaijan government gives investors a guarantee of free profit repatriation (hlb, 2011). according to world bank (2014), azerbaijan has a deficit in net income from abroad, asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 147 essentially because of profit repatriation by foreign oil companies. oiland gas-related fdi inflows narrowed the deficit on the capital account by 5% in the third quarter of 2013 compared with the same period in 2012. the ongoing investments to halt the decline in oil production, along with new investments in the shah deniz gas field, increased fdi inflows (world bank, 2014: 36). 5.2.4. dual economy effect for some countries, it may be unavoidable to face a so-called dual economy during foreign direct investment inflows. especially in an underdeveloped economy, when host sectors show great development as a result of fdi, the dual economy effect arises. however, fdi does not affect the general growth of the country (stanisic, 2008: 30). because azerbaijan has been a good investment direction for investors in terms of its oil sector, it may be expected to see a dual economy effect. the country is a good market for investors because of its economic and politic stability. up to recent years, it has been observed that a dual economy effect was active in the country because of investment in oil and construction sectors. even today, despite the increase of non-oil sector, there is a lack of employment, tax, and export at other sectors (eso, 2013). for the time being, it would be highly doubtful to assume that azerbaijan could survive at its current economic level without reliance on the oil and gas industry. while no changes are needed immediately, the country cannot count on the fossil fuel sector in the mid-to long-term perspective (hübner, 2011: 3). 5.2.5. other costs of foreign direct investments another negative consequence of fdi is seen at problems seen at balance of payment. according to accoley (2003), the impact of fdi on trade, i.e., exports and imports, is ambiguous. a horizontal fdi, for instance, theoretically induces a decrease in the host country’s imports and, ceteris paribus, an improvement of its trade balance. this prediction may not hold true if the inputs used by the foreign-owned firm are imported from abroad. furthermore, an fdi consisting of selling in the host country goods manufactured abroad, i.e., a vertical integration forward, will increase the home country’s imports. an fdi aiming at extracting minerals or producing component parts may positively impact the host country’s visible balance (accoley, 2003: 19). there are some other negative effects of foreign direct investments (accoley, 2003: 21): • foreign direct investment may result in some unexpected problems that are hard to measure. for example, political, social, structural and environmental disorders may be observed in the country. • the great majority of countries want to preserve their cultural properties. fdi activities of giant firms may result in active participation in mass media, changing the cultural properties of the society. • fdi in manufacturing and mining sectors in developing countries can be the source of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 148 negative externalities affecting the local environment, e.g., pollution of air and rivers. 6. suggestions to reach targets and achieve better economic results in both other sectors and the oil sector, the azerbaijan government should take some steps. first, it must develop the benefits of fdi in oil sector. secondly, it must try hard to get rid of that fdi’s costs. as mentioned, azerbaijan has a list of incentives for foreign investors. those incentives must be enhanced and problems must be solved. for example, foreign investors need more support in human capital. they also want to rely on economic and politic condition of the country. azerbaijan may take steps to explain that it has a stable economy. moreover, there may be organizations in different forums and countries to provide better information for potential investors. another important point to be discussed is competition level. competition in a sector provides great benefits. according to a study of european commission (2012), benefits of competition can be listed as follows: • low prices for all: the simplest way for a company to gain a high market share is to offer a better price. in a competitive market, prices are pushed down. • better quality: competition also encourages businesses to improve the quality of goods and services they sell – to attract more customers and expand market share. • more choice: in a competitive market, businesses will try to make their products different from the rest. • innovation: to deliver this choice, and produce better products, businesses need to be innovative – in their product concepts, design, production techniques, and services. • better competitors in global markets: competition makes companies stronger. all those reasons demonstrate that azerbaijan must get rid of hegemony of some well-known firms. government must promote all companies in the sector regardless of their nationality. in other words, both foreign investors and national investors must be supported. azerbaijan must also minimize the costs of foreign direct investment. as described above, an important cost of foreign direct investment on oil sector in azerbaijan is crowding out. in general, it is seen that foreign direct investments crowd out domestic investors, especially in the short term. arbitrage and foreign direct investment took advantage of government incentives and tended to concentrate in traditional rather than high-tech industries. because private enterprises often concentrate in traditional industries, foreign direct investment can cause crowding. in private enterprises engaged in centralized and highly competitive manufacturing applications, this kind of crowding out was obvious (wu, sun & li, 2012: 1). to minimize it, small firms in the country must be supported, especially if their capital and know-how capacity is low. therefore, the government may need to support regional investors in terms of money and experienced workers. for example, some experienced workers may be asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 149 encouraged to work in regional firms by the government itself. this is also important to minimize negative wage spillover. in fact, azerbaijan must take some steps to address its dual economy and profit repatriation. it is not difficult to solve problems caused by those factors. however, both academics and politicians must think about their effects. the following remedies may be suggested for azerbaijan: • better advertisement, • apprenticeship in multinational oil firms, • supporting competition, • investing not only capital but also technology, • supporting national firms in terms of crowding out (via encouraging skilled workers to work in regional firms), • supporting regional firms in terms of wages. 7. conclusion this study demonstrates some important points about fdi and its effect on the azerbaijan economy considering foreign direct investment seen in oil sector. first of all, fdi is an activity having great contributions for host country. it is usual to see that a country getting the attention of foreign investors and getting high amount of foreign direct investment is likely to develop in a short period of time. that kind of development is supported by high inflow seen during foreign direct investment processes, decreased levels of unemployment, increased export rates, and increased revenues. azerbaijan has had a sharp increase of economic indicators. there is significant development at inflation rates, gross domestic product, reserves, and employment rates. although the country was an oil dependent economy fifteen years ago, there is an increase at non-oil sectors as well. agriculture, tourism, construction, trade, service, transport, communication and financial service are some of the sectors in azerbaijan having high levels of development especially in the last decade. thanks to the development of non-oil sectors and especially the oil sector, there is a gradual increase of export rates. as a result of buying technological machinery, there is also an increase at import level. however, high levels of export of crude oil and gas makes export rates higher than import level. there are a great deal of reserves in the country. moreover, reviewing the literature shows that academicians, economics and many organizations estimate that azerbaijan economy will continue to develop in the future. by the year 2020, people estimate that azerbaijan will be one of the most important economies in the world. there may be several reasons for economic development in azerbaijan. however, an indicator shows similar trends with statistical data about the development of azerbaijan economy. it is the amount of foreign direct investment seen in the country. the azerbaijan economy started to develop especially after the beginning of 2000s. the amount of fdi in the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 150 country increased at the same time. moreover, fdi in azerbaijan mainly focuses on the oil sector. the more fdi in the oil sector mean the more developed macroeconomic indicators in the country. consequently, it is easy to claim that foreign direct investment in oil sector has positive effects on azerbaijan economy. since there is a positive correlation between foreign direct investment and economic growth, azerbaijan must promote fdi in the oil sector. as described previously, foreign direct investment in azerbaijan oil not only has positive effects on macroeconomic indicators, it also has effect on many other aspects of economy. for example, human capital contributions, competition level, management and governance practices and technology transfers are other benefits of foreign direct investment in azerbaijan oil sector on azerbaijan economy. on the other hand, there are also some problems faced as a result of foreign direct investment in oil sector. crowding out, negative wage spillover, profit repatriation and dual economy effect are costs of foreign direct investment in azerbaijan oil sector to azerbaijan economy. all in all, it is easy to say that foreign direct investment in oil sector has great benefits for the azerbaijan economy. another important point is technology transfer. as an important benefit of foreign direct investment, azerbaijan must try hard to benefit from investors’ expertise, capability and technology, and transmit them within the country. azerbaijan is a developing country. all developing countries face some similar problems. one of those problems is an unskilled workforce. thanks to foreign direct investment in the oil sector, azerbaijan is developing young, skilled workers. those people work in multinational firms and gain a great deal of experience thanks to those firms. as a result, those people may work further at other companies and even for the government. azerbaijan can use that advantage in a good way. firstly, azerbaijan universities must pay more attention to facilities concerning the oil sector. secondly, those students must work in multinational firms as apprentices for a long time before graduating from university. thanks to working in those firms, they will be able to learn many things about the business. that situation results in good benefits both for investors and azerbaijan itself. lastly, there is a shortage of studies about negative effects of fdi in azerbaijan economy. the previously mentioned costs of fdi to the azerbaijan economy or oil industry must be studied in great detail and suggestions must be prepared to get rid of or diminish these costs. references acar, s., eriş, b., & tekçe, m. 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(2014) the effects of fdi on human capital stock in central asian turkic republics, eurasian journal of business and economics, 7(14), 51-60. http://dx.doi.org/10.17015/ejbe.2014.014.03 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 8493-30786-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 1 the approaching lease accounting regulations and its impact on cost of capital, "a practical case study" shahir el-qawaqneh (corresponding author) faculty of economics &muamalat university sains islam malaysia, malaysia,71800 tel: 60-16-796-301 e-mail: selkawakneh@gmail.com dr. nurhidayahbintilaili faculty of economics &muamalat, university sains islam malaysia, malaysia,71800 tel: 60-12-233-1203e-mail: hidayah@usim.edu.my drkhairil f. bin khairi faculty of economics & muamalat university sains islam malaysia, malaysia,71800 tel: 60-17-260-1814e-mail: khairil@usim.edu.my received: oct.27, 2015 accepted: nov23, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8493 url: http://dx.doi.org/10.5296/ajfa.v7i2.8493 abstract we examine how the approaching international lease accounting regulations influence credit rating of particular airfreight company, we capitalize all of still effective operation lease agreements commencing in 2002 and expired on 2026. in particular we use actual operation lease data, not only the disclosed with off-balance sheet. our results suggest that, on average, capitalization of over 12 months term operation leases, dramatically alter capital structure. results either reports a positive impact on weighted average cost of capital wacc, credit rating is a financial risk assessment measurement used by credit holders, investors, and analysis, our results is consistent with the lease accounting standard sitters point of view; asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 2 investors and credit holders have the right to obtain a full transparent picture about firms lease activities in benefit of all parties. we also find some evidence that the positive change in wacc is related to the increasing portion of capitalized lease liability accompanied with an escalating decreeing in conventional debt, in certain conditions, this result suggests that financial lease has the advantage over conventional debt. keywords:lease accounting reform, capitalization, financial risk, cost of capital, credit rating asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 3 1. introduction the relationship between contractual hidden obligations such like operating leases and equity risk has been an issue of attention for long time. higher of equity capital return and higher of debt return may be required by investors and lenders to compensate for unrecorded liabilities and uncompleted or hidden information. a new lease accounting model is expected within the end of 2015, the new upcoming regulations came with a notion of lease information transparency. investors, lenders, and analysis have the right to get complete transparent information about firms lease activities, therefore the new upcoming lease accounting regulations committed lessees to capitalize all above 12 months term uncancellable lease obligations. lessors and lessees should report useful information about the cash flows arising from leasing contracts, more transparency on leverage financing would enhance comparability. han hoogervorst, the chairman of iasb, and leslie seidman, the chairman of fasb stressed that developing of an improved lease accounting standard is vital, investors have the right to determine the hidden leverage from leasing, the proposed lease accounting standard is to address the inadequacies of current lease accounting heffes (2013).lease accounting reform would manipulate all financial statements, and consequently stir investors to consider operation lease capitalization’s impact on their risk assessment. in particular, lender should consider the lease accounting’s new rules in their lessees’ credit worthiness assessments while the credibility analysts should also consider the change. this research paper is an extension of prior work, it contribute to the ongoing international debate concerning the approaching proposed lease accounting standard and its economic consequences, it is recommended byhan (2010) and de villiers and middelberg (2013). de villires recommended a case study research design that could be used to ensure a more accurate estimation of operating lease capitalization impact on a specific company, asmall sample will ensure that the lease contracts could be investigated on a lease-by lease basis in order to determine the exact remaining lease term, remaining minimum lease payments, and any other items that should be included in the calculation of the present value of the lease payments. han (2010) recommended a research design that investigates the exact cost of debt in association with equity capital to outline more wide-ranging representation of the overall impact of the operation leases. secondly, to our knowledge, no previous studies have empirically documented evidence on lease accounting reform impacts on jordan airfreight sector cost of capital, either, no previous study has imperially simulated real operational lease contracts capitalization on lease-by-lease bases.therefore, in order to answer the question of “how could the upcoming lease accounting regulations influence airfreight firms cost of capital which heavily depend on operational lease?in a forward looking approach, we examine the financial structure of a company with 90% operational leased fleet.weapply the upcoming lease accounting regulations to the royal jordanian airlines financial statements over the period (2002-2014).we capitalize thirty real operational lease contracts on lease-by-lease bases. the remainder of this paper is organized as follows: section 2 is a prior research review. section 3 discusses methodology and data. empirical analysis and results in section 3.conclusion in asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 4 section 4. 2. previous research four studies have specifically examined whether operating lease obligations are included in the market assessment of equity risk (beattie, goodacre, & thomson, 2000a,2000b; ely, 1995); imhoff jr, lipe, and wright (1993). in the first study, imhoff jr et al. (1993) extended their research by examining the airline and grocery industries. in the study, a sample of 52 grocers and 29 airlines with data available range from 1984-1990 were selected. they found that the total debt increased by 40% with regard to the median recognized liabilities for both industries. further, they confirmed that the reported level of debt was associated with equity risk (measured as the standard deviation in stock returns). having replicated this basic result then added a variable for the present value of operating leases, they found that it further explain the variation in equity risk. interestingly, the magnitudes of the effects on equity risk were similar for both debt and operating leases. this result suggests again that leases (operating leases) behave like debt in their effect on equity risk. theories in finance and accounting provide linkage between lease and the cost of equity. modigliani and miller (1958, as cited in (han, 2010) added the cost of equity capital as an increasing function of financial leverage where, if the unrecognized obligation from operating lease is treated as on-balance sheet debt, it should consequently increase the cost of equity han (2010). practically, that means investors and shareholders will require an increase in investment return. prior research found evidences that sophisticated debt holders assess off-balance sheet leases as equivalent to other debt financing (wilkins and zimmer, 1983; standard & poor's corporate ratings criteria, 2008; altamuro et al., 2008; as cited in han (2010)). however, there are other mixed evidences on whether or how share market investors assess the operational lease risk. as indicated, not all users are able to take a firm theoretical position on the scientific content of the information presented in the financial statements musvoto and gouws (2012). a number of previous studies provide evidences that off-balance sheet operational lease behaves like debt in the effect on equity risk and may alter the capital structure. for example, (beattie et al., 2000a; bowman, 1980; ely, 1995; imhoff jr et al., 1993) found a positive relation between equity risk and the capitalized off-balance sheet operational lease. aside from that, most extant findings support the value relevance of capitalized operating leases, even though, it is not clear yet whether equity investors treat the off-balance sheet leases as equivalent to those recognized in the financial statement. also, there were a number of studies attempting to capitalize operation lease in an ex-ante method (beattie, edwards, & goodacre, 1998; bostwick, fahnestock, & o'keefe, 2013; branswijck, longueville, & everaert, 2011; de villiers & middelberg, 2013; duke, hsieh, & su, 2009; ely, 1995; fitó, moya, & orgaz, 2013; grossman & grossman, 2010; imhoff, lipe, & wright, 1991; kilpatrick & wilburn, 2011; lückerath-rovers & eindhoven, 2007), and in these studies, financial ratios change measurements were based on estimations including asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 5 lease term, the remaining lease term, discount rate and depreciation method. however the estimation can be lousy and lacking accuracy (han, 2010). capitalization impact on credit risk can differ from that on equity risk, and debt holders and shareholders are most likely to perceive risk differently, and their conclusions drawn from accounting information are also different. shareholders may have higher equity risk for the reason of hidden information; they have no legitimate access to operation lease term and interest rate. it should be noted that the off-balance sheet notes just provide information about the present value of lease obligations for the next four years, and a lump sum amount for the next years. also, shareholders have limited information about lease contracts provisions and their content while debt holders may enforce access to hidden information in contracts’ provision text. in contrast,altamuro, johnston, pandit, and zhang (2012) claim that the effect on credit risk is more than the equity risk, given that leases represent a future cash flow commitment and can impact creditor’s claims in liquidation. however, liquidation is the odd case. additionally,jesswein (2008) used the altman’s discriminate analysis model and z-score, particularly to examine the capitalization impact on individual company creditability. meanwhile, schneider, mccarthy, and cotton (2012) suggested a modified copy of standard and poor's’ credit rating to examine whether the operational lease amounts reported in the footnotes are significant (relevant) contributor in credit rating determination. usually, capital consist of two sources, owners' equity and debt, both sides; owners and debt holders expected return depend on the risk margin they are taking, therefore their analysis is company specific, therefore, one of their financial analysis tools to compare and evaluate companies is the weighted average cost of capital wacc. present study in financial risk assessment is similar to the most recent study in this area ofzhao (2013)he performed his study in the usa setting, in light of the american financial reporting rule fr-67, the “tabular disclosure of contractual obligations".zhao’s study focused on five types of off-balance sheet (hidden) obligations (purchase obligations, long term debt, operational lease, capital lease obligations, and other long term liabilities) and the researcher (zhao) hypothesized that tabular disclosures can provide additional information about company risk, and influence the assessment of credit risk by credit rating agencies, public bond holders, and private loan lenders. zhao found that all four credit risk measures (i.e., credit ratings, negative credit watch, bond spreads, and the number of covenants in private loan contracts) significantly increase with off-balance sheet obligations when the firms report the tabular disclosures of contractual obligations for the first time. further, zhao’s results also suggest that the three major debt-market participants view purchase obligations as at least as relevant as operating leases and other types of off-balance sheet obligations in explaining the firms’ credit risk. lease accounting reform should stir lenders’ desire to assess its effect on lessees’ credibility. similarly, it would stir credit analysts to examine capitalization impact on company creditworthiness rank, and to compare the current lease accounting standard with the proposed lease recognition rules, either a combination of financial ratios can be used in asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 6 assessing credibility, for example, interest coverage (ic), and fixed charge coverage ratios (fccr) that are used in the company’s specific capability to generate income and cash to meet debt liabilities. additionally, some other ratios (d/a, d/e, ltd/e) are used by creditors to assess firms' credibility. han (2010) and most of prior researchers used leverages ratios change as an indicator of operational lease portion in cost of capital but leverage ratios change doesn't show and compare the financial structure. we use the adjusted wacc model to include the capitalized amounts of operational leases. we select schneider et al. (2012) suggested model, which it is a modified version of standards and poor's' weighted average cost of capital, owing to the fact that it has never been practicallytested, we perform his study in the jordanian setting, in practical study method to explore capitalized operational leases significant and relevancein credit rating. 3. data and methodology the weighted average cost of capital (wacc) is a typical model usually used by decision makers; financial analysis, investors, and lenders to explore the firm's financial structure. the upcoming lease accounting committed lessees to capitalize all above 12 months uncancellable operation lease agreements, that means a sort of new source of capitalis added to the financial structure, capitalized amounts and the lessees incremental borrowing rate are a new determinant factors added to the equation,the approaching regulations treat leases similar to normal conventional debt with only two deference's, the interest rates, and residual value terms. therefore, in order to examine the new regulations impact on cost of capital, we apply this regulation to the rj financial statements of the previous 13 years(2002-2014). then we compare the results before applying this regulation and after. table 1 reports the descriptive data of 30 actual aircraft operation leases.capitalization process started with computing the amounts of unrecorded liabilities which its exactly the monthly lease payments present value, we use exact lease payments at the beginning of the month, lease term measured in months, present value computed at individual lease contract commencing date base on its exact interest rate. the unrecorded lease liability is amortized over lease term, and lease asset is either depreciated in a straight line method over lease term, we avoid depreciating leased assets over its useful life because the upcoming lease regulations allow asset depreciation over its useful life only if the useful life of the underlying asset if shorter than lease term, in our case the minimum aircraft useful life is about 20 years and maximum lease agreement term is 12 years. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 7 table 1.the descriptive data of 30 actual aircraft operation leases wacc = (weight of equity*cost of equity +weight of debt * cost of debt)) wacc = × + + × (1 − ) × + … … … … … … … … . … (1) operation lease capitalization results in a different capital structure. the company’s capital consists of debt, recorded financial lease, owners' equity, plus the capitalized amount of operation lease. so, to guarantee more accuracy we adjust the unrecorded lease liabilities by the recorded short term lease liabilities, the unrecorded owners' equity either adjusted by the tax savings. thus, the adjusted waccconsists of three parts, equity, debt, and the capitalized a/c type qty end-date l.term monthly. rent yearly rent total rent pv of future payments 1 a-340-212 1 2002-07-18 2014-12-31 150 270,000 3240000 40380164 30383546 2 a-340-212 1 2002-08-09 2014-12-31 149 270,000 3240000 40184877 30049311 3 a-340-212 1 2003-05-29 2014-12-31 139 244,242 2930904 33998486 25837738 4 a-340-212 1 2003-07-29 2014-12-31 137 244,240 2930880 33508390 25561740 5 a-319-132 1 2008-03-13 2018-03-13 9335 184,310 2211720 1720596970 17449097 6 a-319-132 1 2008-10-30 2018-10-30 120 324,175 3890100 38922316 30690416 7 a-319-132 1 2009-02-20 2019-02-20 120 354,846 4258152 42604852 33594178 8 a-319-132 1 2009-03-14 2019-03-14 120 359,490 4313880 43162438 34033827 9 a320-232 1 2006-11-17 2018-11-17 144 209,233 2510796 30150189 22716255 10 a320-232 1 2011-04-29 2019-04-29 96 230,513 2766156 22144405 18283704 11 a320-232 1 2011-09-21 2017-09-21 72 283,088 283,088 20400944 17591280 12 a320-232 1 2011-10-19 2019-10-19 96 232,000 2784000 22287255 18399886 13 a320-232 1 2012-05-24 2018-05-24 72 284050 3408600 20460939 17746451 14 a320-232 1 2012-11-20 2018-11-20 72 288,700 3464400 20795892 18041551 15 a321-231 1 2008-04-09 2014-04-09 72 479,781 5757372 34560006 29914729 16 a321-231 1 2008-05-20 2014-05-20 72 482,940 5795280 34787557 30796624 17 a321-231 1 2012-04-16 2020-04-16 96 364850 4378200 35049590 30076718 18 a321-231 1 2012-06-15 2020-06-15 96 365690 4388280 35130285 29005230 19 emj195 1 2006-11-30 2014-11-30 96 230122 2761464 22106843 18387901 20 emj195 1 2007-02-03 2015-02-03 96 281409.5 3376914 27033816 22288196 21 emj195 1 2007-07-01 2015-07-01 96 240820 2889840 23134555 19242725 22 emj175 1 2010-11-11 2018-11-11 96 231700 2780400 22258435 18514298 23 a330-223 1 2010-05-21 2014-12-31 55 601466 7217592 33319569 29760179 24 a330-223 1 2010-05-21 2015-01-31 56 601570 7218840 33938437 30248391 25 a330-223 1 2011-08-01 2017-01-31 66 663,072 7956858 43817218 38549055 26 b787-baa 1 2014-08-27 2026-08-26 144 837,380 10048560 120637781 90913697 27 b787-bab 1 2014-09-30 2026-09-30 144 954,500 11454000 137542142 103629391 28 b787-baf 1 2014-10-01 2026-10-01 144 954,500 11454000 137542142 103629391 29 b787-bac 1 2014-11-19 2026-11-19 144 991,368 11896410 142854699 107631779 30 b787-bae 1 2014-11-20 2026-11-20 144 973,430 11681160 140269930 105684672 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 8 operation lease (unrecorded liabilities) as follow: . wacc = × + + + × (1 − ) × + + + × (1 − ) × + + (2) where: is the lessee’s incremental borrowing rate, it differs overs the past 13 years it, range between (4%5%). in our computations we select a more conservative approach, thus, we use the highest rate (5%). for the purpose of equity rate of return (re) computation we use the capital asset pricing model (capm). cost of equity = risk free rate + (company beta × market risk premium). we compute the average interest rate on jordan government treasury bonds over the period (2010-2015), bonds information retrieved from amman stock exchange web site (www.ase.com.jo/bonds_table/all). risk free rate average 5.5%. we either use the international airfreight sector mean beta as a company beta, lee and hooy (2012) investigated a sample of 462 companies of the airlines sector in north america, europe and asia, their study results an airfreight sector beta mean of (0.77). also we compensate moodys' computed total equity premium for the market risk premium. moodys' ratings is a trusted international financial and economical rating agency. ( ) = 5.5% + ( 0.77 ∗(12.5% − 5.5%)) = 10.89%.for the purpose of owners' equity (e) computation we use the average yearly market price multiplied by the average shares issued as follow: e = shares market price * shares issued. (after tax return) on debit computed as follow: = (1 − ) ∗ ….(3). we select interest rate in a conservative approach; (0.022%) is the least annual interest, local lenders charge the royal jordanian airlines in 2013. = (1 − 0.20) ∗ 0.022 = 0.018. table 2 reports a comparison between wacc and the after capitalization adjusted wacc. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 9 table 2. comparison of wacc before and after operation lease capitalization over 13 years tax: t beta total equity risk risk free return on equity (1-t) return on debt return on lease rd 0.200 0.770 12.5 5.5 10.89 0.8 0.022 0.050 0.0176 recorded owners' equity roe 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 35432000 29622000 58892000 82600000 88735000 109098000 85736000 106591000 116246000 58124000 59424000 19566000 -15855000 td (total debt) 91176000 70011000 69724000 58560000 48773000 55680000 75435000 79552000 72861000 97362000 142556000 198195000 148120000 total 126608000 99633000 128616000 141160000 137508000 164778000 161171000 186143000 189107000 155486000 201980000 217761000 132265000 d/(d+e) 72.01% 70.27% 54.21% 41.48% 35.47% 33.79% 46.80% 42.74% 38.53% 62.62% 70.58% 91.01% 111.99% e/(d+e) 27.99% 29.73% 45.79% 58.52% 64.53% 66.21% 53.20% 57.26% 61.47% 37.38% 29.42% 8.99% -11.99% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 adj.td (total debt) 72495000 29273000 61556000 50103000 40631000 53295000 70617000 74421000 67397000 91543000 136366000 191650000 141092000 aoeb 53692000 68122370 62752643 85175819 89882245 102196045 79025919 96036980 103120422 43203399 43866124 5898008 -24962643 net url (col) 58621992 104550269 97283347 89316606 121499086 148037524 234643813 267065022 299582100 332665231 352774154 267659065 685448704 total 184808992 201945639 221591990 224595425 252012331 303528569 384286731 437523002 470099522 467411629 533006278 465207073 801578061 ad.d/(d+e+col) 0.392 0.145 0.278 0.223 0.161 0.176 0.184 0.170 0.143 0.196 0.256 0.412 0.176 ad.e/(d+e+col) 0.291 0.337 0.283 0.379 0.357 0.337 0.206 0.220 0.219 0.092 0.082 0.013 -0.031 url(col)/e+d+col) 0.317 0.518 0.439 0.398 0.482 0.488 0.611 0.610 0.637 0.712 0.662 0.575 0.855 change in total debt 31% 51% 42% 37% 45% 46% 58% 57% 60% 67% 62% 53% 83% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 (e/(e+d))*re 3.048 3.238 4.986 6.372 7.027 7.210 5.793 6.236 6.694 4.071 3.204 0.978 -1.305 rd*(1-t) 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 d/(e+d)*rd*(1-t) 0.013 0.012 0.010 0.007 0.006 0.006 0.008 0.008 0.007 0.011 0.012 0.016 0.020 wacc 3.060 3.250 4.996 6.380 7.034 7.216 5.801 6.243 6.701 4.082 3.216 0.994 -1.286 (e/(e+d+col))*re 3.164 3.674 3.084 4.130 3.884 3.667 2.239 2.390 2.389 1.007 0.896 0.138 -0.339 rd*(1-t) 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 0.018 (d/(e+d+col))*rd*(1-t) 0.007 0.003 0.005 0.004 0.003 0.003 0.003 0.003 0.003 0.003 0.005 0.007 0.003 (rl*(1-t) 0.040 0.040 0.040 0.040 0.040 0.040 0.040 0.040 0.040 0.040 0.040 0.040 0.040 (l/(e+d+col))*rl*(1-t) 0.013 0.021 0.018 0.016 0.019 0.020 0.024 0.024 0.025 0.028 0.026 0.023 0.034 ad.wacc 3.183 3.697 3.106 4.150 3.906 3.689 2.267 2.418 2.417 1.038 0.927 0.168 -0.302 adj.waccwacc 0.123 0.447 -1.890 -2.230 -3.128 -3.527 -3.534 -3.826 -4.284 0.032 0.031 0.030 0.037 4. results figure 1 show rj capital structure over the period 2002-2014. equity percentage exceed debt percentage during (2004-2010), this is related to share prices improvement, the period (2010-2014)shows increase in debt percentage and at the same time a decrease in share prices, share prices escalating decrease because of the international financial crises consequences, either related to the negative financial results. table 2 reveal that owners' equity before capitalization shows higher portion over (2005-2010), either figure 2 shows highest wacc before capitalization for the same period (2005-2010), our computations is based on (10.89%) return on equity which it is either higher than 0.022% return on debt is also another reason for this result. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 10 figure 1.capital structure before capitalization table 3 reports the unrecorded lease assets, liabilities and owners' equity. capitalization process resulted in an increase on lease liabilities, this result is consistent with (beattie et al., 2000a, 2000b; ely, 1995); imhoff jr et al. (1993), increase in liability resulted in an increase in total debt, they reported 40% total debt increase, our results reveal with(31%83%) increase in total debt over the period (2002-2014). table 3 either reports a negative impact in equity, this result monopolize the rj capital structure. table 3. the capitalized (unrecorded) assets, liabilities and owners' equity uroe 2002 2 58551825 58200992 -350833 2003 4 104235803 102312639 -1923164 2004 4 96885982 92975990 -3909992 2005 4 89164214 83639341 -5524873 2006 6 121443518 114708247 -6735271 2007 8 147809282 138954486 -8854797 2008 12 234403305 223319648 -11083658 2009 14 266298221 251380002 -14918219 2010 17 298970207 280992522 -17977685 2011 20 332204911 311925629 -20279282 2012 25 352529389 331026278 -21503110 2013 25 267874085 247446073 -20428012 2014 22 686164099 669313061 -16851038 figure 2 shows the after capitalization capital structure.capitalization of all rj operational lease agreements resulted in a positive change in the royal jordanian airlines ad.wacc. figure 2 reports a comparison between wacc and the after capitalization adj.wacc. our results seems consistent with jesswein (2008) results, he reported 20% after operation lease capitalization drop in z-score credit rating model. -50.00% 0.00% 50.00% 100.00% 150.00% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 rj capital structure before capitaliztion d/(d+e) e/(d+e) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 11 figure 2. wacc before capitalization and ad.wacc after capitalization figure 3 shows that this positive change in wacc is due to three reasons; 1) capital structure change, capitalized operation lease (col) percentage increased from 31% in 2002 to 85% in 2014. 2) this is accompanied by a decreasing percentage of debt compared to total capital 3) the negative impact on owners' equity resulted from operation lease capitalization. the year 2014 shows a negative owner equity percentage due to the fact that losses exceeds its recorded equity. the positive change in wacc as credit rating measurement tool is consistent with zhao (2013) results, he hypothesized that "tabular disclosures" can provide additional information about company risk, and influence the assessment of credit risk by credit rating agencies, public bond holders, and private loan lenders, we either provide additional practical evidences on the upcoming lease accounting regulations usefulness, applying these regulations to firmsrelay heavily on long term operation lease resulted in a positive change in rj credit rating, even with 5% financial lease interest, which its higher than .022% return on debt and with 10.89% return on equity. 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 wacc 3.060 3.250 4.996 6.380 7.034 7.216 5.801 6.243 6.701 4.082 3.216 0.994 -1.286 ad.wacc 3.183 3.697 3.106 4.150 3.906 3.689 2.267 2.418 2.417 1.038 0.927 0.168 -0.302 3. 06 0 3. 25 0 4. 99 6 6. 38 0 7. 03 4 7. 21 6 5. 80 1 6. 24 3 6. 70 1 4. 08 2 3. 21 6 0. 99 4 -1 .2 86 3. 18 3 3. 69 7 3. 10 6 4. 15 0 3. 90 6 3. 68 9 2. 26 7 2. 41 8 2. 41 7 1. 03 8 0. 92 7 0. 16 8 -0 .3 02 -2.000 -1.000 0.000 1.000 2.000 3.000 4.000 5.000 6.000 7.000 8.000 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 12 figure 3.capital structure after capitalization 5. conclusion in light of thelease accounting reform upcoming regulations, we have reviewed some of possible impacts of operation lease capitalization on capital structure, financial risk, equity risk, and cost of capital measurement. taking in account the credit rating crucial role in investors and lenders credit providing,providing evidence lease accounting reform is an issue since the sixties of last century, many of these attempts have been insufficient owing to the fact of hidden information about operation lease activities. due to the nature of data and information we have used, we believe that we have provided a practically accurate evidence on some of operation lease capitalization economic consequences, particularly on capital structure and wacc which it is being used in credit rating. results indicate that operation lease capitalization has a positive impact on credit rating wacc, which isconsistent with the boards (iasb &fasb) believe, investors and credit holder's right to obtain a full transparent picture about firms lease activities in benefit of all parties. acknowledgement the research is financed by jadara university, irbid, jordan references altamuro, jennifer lynne m., johnston, rick m., pandit, shailendra, & zhang, haiwen. 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(3589788), city university of new york, ann arbor. retrieved from http://search.proquest.com/docview/1430900274?accountid=33993 microsoft word 6268-22532-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 362 impact of cashless banking on banks’ profitability (evidence from nigeria) alagh jacinta itah accounting department, bingham university, new karu, nasarawa state, nigeria e-mail: jacinta.itah@gmail.com emeka e. ene (ph. d, fca) (corresponding author) accounting department, bingham university, new karu, nasarawa state, nigeria e-mail: eneelemeka@yahoo.com received: sep. 4, 2014 accepted: oct. 17, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6268 url: http://dx.doi.org/10.5296/ajfa.v6i2.6268 abstract the quest for global relevance and sustainable development had led to wide exploitation of the benefits of cashless banking in payments system of nigerian banks. the study examines the impact of cashless banking on the profitability of banks in nigeria. the study used proxies for cashless banking such as automated teller machine (atm), point of sale (pos), and web based transaction (wbt) to examine its impact on the aggregate return on equity (roe) of deposit money banks in nigeria, through an ordinary least square (ols) multiple regression method of analysis. the result showed that atm and pos are positively related to roe, while wbt related negatively to roe. this is as a result of high rates of bank charges on online deposits and as a result, most customers do not patronize the product. non-usage of the wbt for online deposits had created a negative impact on profitability of nigerian banks. recommendations were made among which are that banks should provide a sufficient standby generators that could be used in case of electricity failure, provide adequate ict infrastructure and management framework, and enlighten the public on the importance of using ict banking products. keywords: cashless banking, point of sale, automated teller machine, web based transaction, profitability, payment system asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 363 1. introduction the importance of managing the economy efficiently cannot be over emphasized. the monetary authorities, by controlling the supply of money, maintain price stability and influence economic activities especially when combined with appropriate fiscal measures. the banking system remains the major channel for monetary control by the central bank of nigeria (cbn) and the monetary authorities in general. unfortunately, it is estimated that about 65% of the cash in circulation in the nigerian economy is outside of the banking system, thus severely limiting the impact of the cbn’s efforts at price and economic stabilization (cbn 2011). consequently, the amount of money in the form of deposits available to banks for the creation of more money is reduced. the profitability of the banks, which to a large extent depends on the amount of money at their disposal for lending, is therefore affected by the large size of this informal sector. apart from the above mentioned, the breakthrough in information communication technology (ict) has revolutionized human society in terms of communication, efficiency in processes, general exchange of information, and in the exchange of goods and services. within seconds, businesses are carried out online across different geographical location making it impossible for physical cash to be used as a medium of such exchanges. indeed, the world has become a global village and the economic competiveness depends largely on the effectiveness of economic agents to adopt technologies for their activities and service delivery. particularly, the banking institutions as major players in the process of financial intermediation, and important economic agents in the payment system, must be strongly equipped with the relevant information technology that would encourage trade, commerce and industry while promoting globalization by easing global access to fund without any barrier. customers in recent time demand more than the traditional role of safe-keeping their money. they require their banks to meet financial obligations for e-transaction almost on real time basis. but in reality, not all nigerians have access to e-banking services. according to (microfinance information exchange, 2012) in (thisday, 2013), nigeria and the democratic republic of congo have the largest gaps between populations living in poverty and those with access to financial services–80 million in nigeria and 48 million in the congo. the central bank of nigeria (cbn) in collaboration with the bankers committee, introduced the cashless policy designed to provide mobile payment services that aim to breakdown traditional barriers hindering the financial inclusion of millions of nigerians, secure and make convenient financial services to urban, semi-urban and rural areas across the country. however, implementing the cashless policy requires that the banks make huge investments on ict and other technologies that would enhance the proper implementation of the cashless system. for banks that barely survived recapitalization, and several others forced into a merger and acquisition, this policy may affect their performances positively or negatively depending on asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 364 the strength of the individual banks. therefore, this study seeks to analyze the impact of this policy on nigerian banks in relation to their profitability. to ease understanding, the paper is structured as follows: section one is the introduction; section two focuses on theoretical underpinning, and empirical literature, while section three addresses methodology and data analysis of the study. section four summarizes and concludes the study. 2. theoretical framework and literature review 2.1 theoretical framework in examining the implications of cash-less system, it is necessary to review how conventional money has evolved over time. money performs a number of roles in economic activity; it is a unit of account, store of value, medium of exchange and means of deferred payment. also, money has evolved over the centuries to minimize the friction of transaction costs that are involved in mediating exchange. in fact, the process can be observed from the development of the very first monetary products. for instance, conducting economic transactions in barter economies involved high transaction costs as considerable time and effort was required in finding suitable partner. subsequently, another facet in the evolution of money was the need for durability and divisibility. hence, the advent of study money (notes and coins) made the process less costly by allowing people specialize in production based on their strengths and by enabling the monetary authorities to mint coins in convenient denominations, thereby creating divisibility (baddeley, 2004). the theory of money has its roots in the 16th century during which classical economists such as jean boldin at that time sought to know the cause of the increases in french prices. he concluded that, among other factors, increases in gold and silver which served as currencies were responsible for the rise in the demand for french-made goods and, hence, french prices, thus linking movements in prices to movements in money stock. by the 1690s, the quantity theory of money was further advanced by john locke to examine the effects of money on trade, the role of interest rate and demand for money in the economy (omanukwue, 2010). in particular, the role of money as a medium of exchange to facilitate trade transactions was born. economists at the time inferred that the quantum of money needed for such transactions would depend on the velocity of money in circulation and the relationship between the demand and supply of money such that where there was excess demand over supply interest rates rose and vice versa (cantillon, 1755; locke 1692 as cited in ajuzie, et al, 2008). the theory of money has been described by different school of thought in their different opinions. for example, the modern classical schools of thought who are also called the monetarist are concerned with the explanation for the changes in price level. to them, a stable and equilibrating relation exists between the adjustments in the quantity of money and the price level. in other words, they refute any form of monetary influence on real output both in the short-and long-run. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 365 for the less stringent monetarist, they agree that money influences output in the short-run, but only prices in the long-run. nevertheless, irrespective of the path of adjustment, the monetarist all seem to concur that in order to reduce or curtail inflationary growth, money growth should be less than or equal to the growth in output. the quantity theory of money is hinged on the irvin fisher equation of exchange that states that the quantum of money multiplied by the velocity of money is equal to the price level multiplied by the amount of goods sold. it is often replicated as mv= pq, m is defined as the quantity of money, v is the velocity of money (the number of times in a year that a currency goes around to generate a currency worth of income), p represents the price level and q is the quantity of real goods sold (real output). by definition, this equation is true. it becomes a theory based on the assumptions surrounding it. the introduction of the modern banking system has to a great extent brought about the gradual elimination of cash based economy in most countries. in nigeria for instance, most banks have adopted this cashless policy to form and gain a strong competitive ground over other banks. there have been several arguments for and against the use of ict in the banking system. the arguments for the use of ict in the banking system are as follows; (humphrey et al, 2001) supports the fact that the introduction and use of electronic payment instruments holds the promise of broad benefit to both business and consumers in the form of reduced costs, greater convenience and more secure, reliable means of payment and settlement for a potentially vast range of goods and services offered worldwide over the internet or other electronic networks. one such benefit is that electronic payments enable bank customers to handle their daily financial transactions without having to visit their local bank branch. electronic payments products could save merchants time and expense in handling cash (appiah and agyemang, 2006). according to (cobb, 2005), “electronic payments can thus lower transaction costs stimulate higher consumption and gdp, increase government efficiency, boost financial intermediation and improve financial transparency”. she further added that “governments play a critically important role in creating an environment in which these benefits can be achieved in a way that is consistent with their own economic development plans”. however, experts in the financial sector have stressed that unless something radically innovative, functional and savvy is introduced, which accounts for attitudes as well as the huge un-banked population, the country's dream of building a functionally cashless society in the shortest possible time could be elusive (ackorlie, 2009). 2.2 review of related empirical literature summary of related empirical literature which was reviewed to provide evidence of studies on related areas is presented in table 1. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 366 table 1. summary of empirical literature s / n o topic au th or y e a r objective methodology finding/conclusio n 1. an appraisal of cashless economy policy in developme nt of nigerian economy. oko ye, p.v. c. and r. ezej iofo r 2 0 1 3 to examine the significant benefits and essential elements of a cashless economy, and to check the extent to which it can enhance the growth of financial stability in the country. the data collected was subjected to face validity test, and was tested with anova and chi – square (x2) technique was used to test the hypotheses the nigerian economy is in exciting but challenging times, the proper foundations have to be established as the cbn courageously transform the modes of operation of the nigeria economy”. 2. the impact of cashless banking in nigeria, its challenges, benefits and policy implications odi or, e. s. and fadi ya . b. b 2 0 1 3 to analyze the positive and negative policy implications of cash-less banking for the nigerian economy, with a view to exposing the possible benefits and challenges posed on economy. the data employed in the study was from secondary sources using descriptive analysis with the aid of graphs, tables, charts and trend analysis of cash system in nigeria the development of e-money could lead to the decline in currency demand; also the consistent usage of e-channels in financial transactions would lead to network congestion. and finally, the cashless banking system would imply the existence of increase in competition between financial and non-financial institutions such as telecommunication companies. 3. the impact of electronic banking in nigeria banking system olor unse , g 2 0 1 0 to examine the impact of electronic banking in nigeria banking system on how different channels could enhance the delivery of consumers and retails products the primary data were collected through the use of questionnaire while the secondary data were data collected from cbn electronic banking guideline, annual report of unity bank plc. the study used both descriptive and inferential statistics in analyzing the data. the electronic banking system in nigeria has made banking transaction to be easier by bringing services closer to its customers. 4. the effect of cashless banking on siya nbol a, t 2 0 1 to discuss the various aspects of cashless banking channels, to a descriptive research design was adopted with data gathered through questionnaire administered to dynamism in financial system is manifested by the nature and quality of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 367 nigerian economy. 3 know where the real e-banking should be, the problems facing cashless banking, its advantages and disadvantages to nigerians respondents. non-parametric tool of chi square was employed to analyze the data. payment products paraded in the system”. literatures reviewed provide indications that several studies have been conducted in related areas of our study. however the focus of previous studies has been on the history and importance of cashless system to nigerian economy and its banking system using different methods of analysis. this study on assessment of impact of cashless policies of cbn in 2012 on banks’ profitability provides a robust basis for argument in favor or otherwise of the cashless economic theory. this research seeks to find out whether or not there has been increase in banks’ profitability in the cashless system resultant from the changes made by cbn. noteworthy, was the stopping of charges on customers using their atm. the fee (which was n100) served as a source of income to these banks. but this was stopped by cbn. can we say for instance that this has an adverse effect on banks profitability? also, banks use to charge their customers a fine of n10.00 for services rendered to them which was a source of income to the banks. the cbn however reduced this amount to n3.00. can it be said that this policy has impacted positively or negatively on the profitability of these banks? these are grey areas which were not captured by previous related studies in nigeria. this research therefore seeks to find out the profitability of banks through the return on investment on these cashless products and their daily usage 2.3 an over view of payment system in nigeria the payment system plays a very crucial role in any economy. the banking system is the channel through which financial resources flow from one segment of the economy to another. it therefore represents the major foundation of the modern market economy (cbn, 2011). in today’s world, many people across the globe make payments electronically rather than in person or cash. it can then be said that the recent financial system is the product of centuries of innovation. this financial system started as a barter economy and has moved through various incarnations in response to limitations inherent in the evolving systems. ajayi, s.i and ojo, o.o. (2006). changes will definitely continue to occur in response to social and technological advancements. this has led to a shift from the old cash handling system to cashless society, which is in vogue worldwide. to this end, the world has witnessed an upsurge of electronic payment instruments meant to facilitate trade and simplify payments. before the introduction of electronic payment into the nigerian banking system, customers had to walk into banking halls to carry out transactions of all kinds. they had to queue up and spend hours waiting to talk to a teller and/or make their transactions. the inconveniences asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 368 caused by these long queues discouraged most customers who sometimes renegade from the queues in annoyance. there was need for a change. for many years, bankers, it experts, entrepreneurs and others had advocated for the replacement of physical cash and the introduction of a more flexible, efficient and cost effective retail payment solution (baddeley, m. (2004). nigerian banks are making huge investments in technology to upgrade their infrastructure in order to provide new electronic information based services. such services as online retail banking, point of sale terminals (pos), make it possible for individuals and corporate bodies to take advantage of new technologies at reasonable costs. before the emergence of a modern banking system, banking operations were manually done. the manual system which involved posting of transactions from one ledger to another without the aid of computer systems accounted for inefficiency in settlement of transactions. computations done manually led to miscalculation due to human errors, and resulted in extension of closing hours when account were not balanced on time. the introduction of cashless system is therefore meant to ameliorate the sluggish nature of banking transactions. vassiliou (2004) defines a cashless payment as a form of financial exchange that takes place between the buyer and seller facilitated by means of electronic communication. according to (cobb, 2004), the value of electronic payment goes way beyond the immediate convenience and safety of cards to a greater sphere of contributing to overall economic development. undoubtedly the last three decades have witnessed major advancement in payment technologies. today, nigeria electronic payment (e-payment)landscape is on a new threshold with banks, switching and transaction companies, vendors of automated teller machine (atms), point of sale (pos) and third party companies all jostling to expand the scope of market .for instance according to cbn reports; the volume and value of electronic card (e-card) transactions has increased significantly from 195,525,568 and n1,072.9 billion in 2010 to 355,252,401 and n1,671.4 billion, in 2011 reflecting an increase of 81.5 and 55.8 per cent, respectively. the increase was attributed to enhanced public confidence in electronic card payments in addition, data on various e-payment channels from another cbn reports indicated that atms remained the most patronized, accounting for 97.8 per cent, followed by web payments, 1.0 per cent, point-of-sale (pos) terminals, and mobile payments, 0.6 per cent each. similarly, in value terms, atms accounted for 93.4 per cent, web 3.5 per cent, pos 1.9 per cent and mobile payments, 1.2 per cent. the number of atms stood at 9,640, while the volume and value of transactions amounted to 347,569,999 and n1, 561.75 billion, at end-december 2011, respectively. these figures reflected increases of 86.7 and 63.7 per cent respectively over the volume and value of 186,153,142 and n954.04 billion, at end-december 2010. the volume and value of mobile payments increased by 215.6 and 185.8 per cent from 1,156,553 and n6.7 billion to 3,649,374 and n19.0 billion, respectively, at end-december 2011.the table below shows the market share in the e-payment market in nigeria between 2008 to 2011 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 369 a report by financial research and consulting firm; celent in india indicates that the value of retail e-payments in india is expected to reach between us$150 billion to us$180 billion by the end of 2010 (thesis-delali kumaga). “more than two thirds of all non-cash transactions payments in the united states are made electronically, with the biggest increase in electronic payments occurring between 2003 and 2006 according to a us central bank (thesis-delali kumaga). the central bank’s non-cash payments study found that about 19 billion dollar of more electronic payments was made in 2006 than 2003”. basically, the cashless banking system cannot be discussed explicitly without looking at the theory of money. money is the ‘brain box’ behind every successful transaction and the economy as a whole. 3. methodology the research employs ordinary least square (ols) method of log-linear multiple regression analysis to examine the effectiveness of cashless banking policies on return on assets of banks. before carrying out the regression analysis, stationary test using adf test was carried out on each of the variables to avoid spurious regression results. the estimation is conducted using the econometric computer software package, e-views version 7.0 data used for this study were obtained basically from secondary sources. the data was collected from nigerian banks’ annual financial reports and various issues of fact books from central bank of nigerian. the relevant variables comprise net profits, return on equity (roe), number of atm devices and volume of transaction on e-banking services of banks. quarterly series spanning 2006:q1 to 2013:q4 are adopted. this is to ensure enough data points to cater for loss of degree of freedom. this period is believed to be long enough to capture the long-run relationship among the return on asset on the cashless banking and in order to establish their impact on the profitability of the bank. 3.1 model specification the econometric model to consider in this study takes atm, pos, and wbt as the explanatory variable and roe as dependent variable respectively. these variables are used at constant prices. this is used to obtain a reliable parameter estimates in the time series regression. following from the theoretical propositions explored in the theoretical framework, for the successful examination of the impact of atm, pos, and wbt on the nigerian bank performance, the following models needed to test the set hypotheses can be explicitly specified: ( , , ) 1roe f atm pos wbt= − − − − − − − − − − − − − − specifying equation (1) in an exponential regression model, we have; 31 2 2troe atm pos wbt eβ μβ βα= − − − − − − − − − − − asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 370 in this form, the coefficients 1 2 3, ,β β β can be directly estimated by applying log-linear regression techniques via logarithmic transformation; and those coefficients will be the elasticity. taking natural logs of both sides of the equation, we have: 31 2log log log log log 3troe atm pos wbtα β β β μ= + + + + − − − − − − − − − we then differentiate partially with respect to the log of each variable to obtain elasticity of roe and a priori sign expectation of equation (4); 1 log 0 4 log t t t t atmroe roe atm atm roe β   ∂ ∂= = > − − − − − − − − − − − −  ∂ ∂   2 log 0 5 log t t t t posroe roe pos pos roe β   ∂ ∂= = > − − − − − − − − − − − −  ∂ ∂   3 log 0 6 log t t t t wbtroe roe wbt wbt roe β   ∂ ∂= = > − − − − − − − − − − − −  ∂ ∂   4. discussion and analysis 4.1 data presentation table 2 presents data collected from cbn annual activity report and statistical bulletin (2012). these data include the daily usage of atms, poss, wbts, and also, the return on equity of money deposit banks ranging on a quarterly series spanning from 2006 to 2012. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 371 table 2. atm usages, pos usages, wbt usages and roe, 2006 (quarter) 2012 (quarter) year quarters atm usages (in volume) pos usages (in volume) wbt usages (in volume) return of equity (in millions) 2006 1st quarter 1,633,957.00 5,138.00 49,219.00 47,198.40 2nd quarter 1,974,065.00 14,633.00 51,563.00 109,037.00 3rd quarter 2,156,055.00 24,689.00 52,673.00 122,587.20 4th quarter 1,974,065.00 39,733.00 52,573.00 172,538.30 2007 1st quarter 1,924,744.00 39,847.00 53,411.00 188,511.10 2nd quarter 2,840,723.00 51,311.00 168,126.00 302,380.00 3rd quarter 2,799,713.00 151,324.00 177,876.00 474,404.10 4th quarter 6,230,723.00 226,564.00 179,826.00 924,105.00 2008 1st quarter 7,762,869.00 239,997.00 274,193.00 305,028.50 2nd quarter 11,192,073.00 295,379.00 311,770.00 398,210.00 3rd quarter 18,449,864.35 295,904.90 271,036.00 437,658.60 4th quarter 22,728,804.12 363,319.22 284,467.00 481,295.50 2009 1st quarter 26,103,483.00 251,785.00 413,677.00 463,238.70 2nd quarter 29,947,212.00 238,387.00 474,180.00 1,358,276.10 3rd quarter 25,725,223.00 210,017.00 500,032.00 930,748.00 4th quarter 27,385,728.00 218,067.00 567,360.00 1,506,845.90 2010 1st quarter 7,762,869.00 253,484.00 331,787.00 1,265,643.40 2nd quarter 11,192,073.00 237,435.00 353,120.00 1,296,356.90 3rd quarter 18,449,864.34 256,637.00 414,390.00 2,247,039.90 4th quarter 22,728,804.12 324,870.00 501,789.00 2,766,880.30 2011 1st quarter 79,612,004.00 383,541.00 670,187.00 3,047,856.30 2nd quarter 85,143,051.00 425,574.00 532,849.00 3,753,277.80 3rd quarter 87,537,528.00 590,646.00 289,326.00 4,515,117.60 4th quarter 95,277,416.00 700,912.00 439,993.00 7,172,932.10 2012 1st quarter 86,689,804.00 118,620.00 374,409.00 10,981,693.60 2nd quarter 91,802,445.00 485,173.00 723,755.00 15,919,559.80 3rd quarter 94,995,190.00 767,858.00 456,286.00 17,522,858.20 4th quarter 102,000,317.00 1,183,394.00 722,014.00 17,331,559.00 sources: cbn annual activity report, (2012); cbn statistical bulletin (2012) the summary statistics for the variables: roe, atm, pos, and wbt are as shown in table 3. the mean for roe, atm, pos, and wbt are different. this indicates that the variables exhibit significant variation in terms of magnitude, suggesting that estimation in levels will not introduce some bias in the results. the jarque-bera statistics for two of the variables (roe and pos) are significant; hence we reject the null hypothesis and conclude that the two series are normally distributed (or have a normal distribution). however, those of atm and wbt were found not to be significant (or abnormally distributed). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 372 table 3. descriptive statistics roe atm pos wbt mean 3430101. 34786452 299794.3 346138.8 median 1098196. 20589334 245891.0 342453.5 maximum 17522858 1.02e+08 1183394. 723755.0 minimum 47198.40 1633957.0 5138.000 49219.00 std. dev. 5341535. 37000918 261088.0 202559.6 skewness 1.849943 0.809455 1.608112 0.122442 kurtosis 4.996807 1.914819 6.006682 2.207571 jarque-bera 20.62245 4.431565 22.61494 0.802563 probability 0.000033 0.109068 0.000012 0.669461 sum 96042837 9.74e+08 8394239. 9691887. sum sq. dev. 7.70e+14 3.70e+16 1.84e+12 1.11e+12 observations 28 28 28 28 source: author’s computation, 2014 (eview-7.0) 4.2 model estimation and interpretation re-stating our regression model (see equation 3), we have: 1 2 3log log log log log 7troe atm pos wbtα β β β μ= + + + + − − − − − − − − − the regression result is presented in table 4. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 373 table 4. regression analysis result dependent variable: roe method: least squares date: 06/06/14 time: 11:12 sample: 2006q1 2012q4 included observations: 28 variable coefficient std. error t-statistic prob. c -1130697.0 1170672.0 -0.965853 0.3438 atm 0.091220 0.027361 3.333989 0.0028 pos 5.973324 3.713643 1.608481 0.1208 wbt -1.164840 4.204962 -0.277015 0.7841 r-squared 0.719006 mean dependent var 3430101.0 adjusted r-squared 0.683882 s.d. dependent var 5341535.0 s.e. of regression 3003244.0 akaike info criterion 32.79985 sum squared resid 2.16e+14 schwarz criterion 32.99016 log likelihood -455.1979 hannan-quinn criter. 32.85803 f-statistic 20.47038 durbin-watson stat 0.523129 prob(f-statistic) 0.000001 4.3 discussion of results the regression model result in table 4.4 indicates that the r2 (r-squared) approximately 71.90percent, and this shows a very good fit, meaning that there is a strong relationship between the variables used. thus, it shows that 71.90 percent (71.90%) changes or variation in roe is explained by atm, pos and ibt, leaving 28.1 percent (29.1%) changes or variations in roe to the (white noise) error term. the goodness of fit result thus shows that there is a strong positive impact of cashless banks profitability. the f-statistics which measures the overall significance of the model shows that we cannot reject the alternative hypothesis. the f-statistics shows that the model is statistically significant, and as such, we state that cashless banking has a significant influence on banks profitability in nigeria from the above result it was observed that atm and pos are positively related to roe, while wbt related negatively with roe. the atm was also found to be statistically significant. this is because, with the introduction of cashless banking policy, a lot of transactions has been made with the use of atm, and has contributed positively with the performance of banks in the country. an easy cash withdrawal promotes trading activities within the banking sector and had improved the roe of the commercial banks in the country. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 374 even though pos was found to be positively related with roe, it was however found to be statistically insignificant. this is because proper awareness has not been created on the use of pos. most customers still rely on counter withdrawals and cash payments rather than use pos for all of such purposes. finally, the wbt was found to be negatively related to roe of banks and also not statistically insignificant. this is as a result of high rates of bank charges on online deposits and as a result, customers do not patronize the product. non-usage of the wbt for online deposits had created a negative impact on roe of the banks. 5. summary and conclusion this study reveals that the introduction of electronic banking in nigeria has a strong influence on the development of the payment system in particular and the banking system in general. however, the introduction of the system, involves commitment of huge amount of financial resources on computer technology and telecommunication facilities, computer technology is a primary requirement for the proper functioning of electronic banking. the major problems hindering the effective operation of cashless banking in nigeria are infrastructural deficiencies such as erratic power supply, lack of government support and high charge on payment terminals (pos, atms) e.t.c. these problems are only peculiar to nigeria as it is known that in developed countries issues like power failure or failure links are not in existence. however, the introduction of electronic banking system has also contributed significantly to bank income by way of fee or changes gotten from these services. the c.b.n, other financial authorities and banks have a role to play in enhancing the system through effective banking and momentary policies, efficiency and stability are also ensured and promoted. furthermore, to sustain the electronic payment system, certain strategic measures must be taken to reduce negative effects of the problems identified as obstacles to the smooth functioning of the system. from the data collected and analyzed, it is safe to conclude that ict is indeed a worthy venture to the banking sector, the government and even to customers. it is therefore only right that these beneficiaries join forces to ensure that e-banking stays for good in our country nigeria. some pertinent recommendations that would enhance ict in the nigerian banking sector are: (i) the banks should have proper and sufficient standby generators in case of power failure. this is to help cover the deficiency of power failure. (ii) in smooth functioning of the payment system the government have the major role to play, in aspect of financing the payment system which require a lot of capital to maintain and also in the aspect of creating awareness of these electronic products and their benefits to the public. (iii) skilled manpower and computer wizard should be employed by every bank, in other to stop, prevent fraudulent personal and hackers from having access and manipulating the banks’ data and stealing money from the bank accounts of individuals. references abubakar, m., gatawa, n. m. & birnin-kebbi, h. s. (2013). impact of information andcommunication technology on banks performance: a study of selected commercialbanks in nigeria (2001-2011). european scientific journal, 9(7), 213-238. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 375 ackorlie, c (2009). business and financial times. banking survey. ajayi m. 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(2000). monetary policy in a world without money. international finance, 3(229-260). http://dx.doi.org/10.1111/1468-2362.00050 worku. g. (2010). electronic banking in ethiopia – practices, opportunities and challenges. journal of internet banking & commerce, 12(2). microsoft word 10763-39715-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 136 ceo overconfidence and fair value reporting-the moderating effect of corporate governance hui-wen hsu1 department of public finance, feng chia university no. 100, wenhwa rd., seatwen, taichung city 407, taiwan tel: 886-4-2451-7250 ext.4322 e-mail: hwhsu@fcu.edu.tw received: jan. 22, 2017 accepted: february 25, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10763 url: https://doi.org/10.5296/ajfa.v9i1.10763 abstract this project examines whether ceo overconfidence affects firm's fair value reporting. moreover, prior literature indicates effective corporate governance mechanisms ameliorate the adverse impact of ceo overconfidence. thus, this paper further investigates whether effective corporate governance will mitigate the association between ceo overconfidence and level 3 fair values. using a us sample drawn from 2008 to 2011, the results of this paper show that firms with higher ceo overconfidence report more level 3 fair values and gains from level 3 fair values. the results also indicates that the positive relationship between higher ceo overconfidence and level 3 fair values reporting is attenuated for firms with high corporate governance. keywords: ceo overconfidence, fair value reporting, and corporate governance, sfas no. 157, level 3 fair values. 1 the author acknowledges the financial support of ministry of science and technology, r.o.c. (project number most 104-2410-h-035-016-). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 137 1. introduction current accounting principles around the world, including the u.s.a.’s generally accepted accounting principles (gaap) and international financial reporting standards (ifrss), are highly reliant on the fair value principle. fair value information is favored due to its greater relevance (barlev and haddad, 2003) and the assistance that it provides in encouraging prompt corrective actions (laux and leuz, 2009). however, fair value information has some reliability issues given its greater estimation error and its elicited managerial incentive of manipulation (e.g., dechow et al., 2010)2. given the ongoing debate as to whether fair values can be measured with sufficient reliability and whether they can be opportunistically manipulated, the financial accounting standards board (fasb) issued sfas no. 157, which became effective for fiscal years beginning after november 15, 2007. sfas no. 157 offers a uniform definition of fair value, develops a framework for measuring this, and expands disclosure about fair value measurements. one of the requirements of sfas no. 157 is the mandatory disclosure of the fair value estimates based on a three-level hierarchy, which is of particular interest to the current study. specifically, fas no. 157 requires firms to report the fair value of their assets and liabilities, and it prioritizes the inputs to valuation techniques into three levels. (1) level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. (2) level 2 inputs are indirectly observable inputs from quoted prices of comparable items in active markets, identical items in inactive markets, or other market-related information. (3) level 3 inputs are unobservable inputs or firm-generated inputs. level 3 inputs generate mark-to-model valuations that are largely undisciplined by market information. due to the high subjectivity of level 3 inputs, sfas no. 157 requires expanded disclosures for level 3 fair values3. many studies center on the fair value estimates presented under the three-level fair value hierarchy and demonstrate the usefulness of these estimates in valuing firms and accessing risk from perspectives of external users (e.g., kolev, 2008; song et al., 2010; riedl and serafeim, 2011). however, the relation between ceo overconfidence and fair value reporting is unclear and has received less attention in the literature. prior research indicates that ceo overconfidence affects corporate investment (malmendier and tate, 2008), financing, dividend policies (malmendier and tate, 2008; cordeiro, 2009; deshmukh, goel, and howe, 2013; malmendier, tate, and yan, 2011; hirshleifer, low, and teoh, 2012), the likelihood of an accounting and auditing enforcement release (schrand and zechman, 2012), and the likelihood of issuing overly optimistic management earnings forecasts (hribar and yang, 2016; libby and rennekamp, 2012). this study extends this line of research by investigating the effects of managerial overconfidence on fair value reporting. 2as suggested by dechow et al. (2010), fair values may not be measured with sufficient reliability, but they provide ample opportunity to manipulate earnings. 3 fas no. 157 requires expanded disclosures for level 3 fair values because of their higher subjectivity. firms are required to provide reconciliation about the beginning and ending balances of level 3 assets and liabilities. to do so, they are required to separately present changes attributable to (i) total realized and unrealized gains or losses for the period, (ii) purchases, sales, issuances and net settlements of level 3 assets and liabilities, and (iii) transfers in and/or out of level 3 fair values. the quantitative disclosures take the form of a reconciliation table. the appendix provides an example of fas no. 157 fair value measurement disclosures from a yearly report filed by the pnc financial services group, inc. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 138 because level 3 fair assets are risky assets (riedl and serafeim, 2011), i expect the high overconfident ceos are more likely to keep level 3 fair assets because they overestimate the returns to their investment projects (malmendier and tate, 2005). therefore, the first objective in this paper is to determine whether there exists a positive relationship between ceo overconfidence and level 3 fair assets. hsieh et al. (2014) indicate that overconfident ceos will seek to achieve their unrealistically high expectations and will be more likely to engage in managing earnings. since level 3 fair values is subject to the highest level of managerial discretion and provide management with discretion to determine the gains from level 3 fair values (chong et al. 2012). thus, the second purpose of this paper is to examine whether high overconfident ceo are more likely to manage earnings through gains from level 3 fair values. moreover, prior literature indicates effective corporate governance mechanisms ameliorate the adverse impact of ceo overconfidence (goel and thakor, 2008; heaton, 2002). for example, goel and thakor (2008) indicate that board fires the ceo if she is too overconfident. therefore, the third objective is to investigate whether effective corporate governance will mitigate the positive association between high ceo overconfidence and level 3 fair values. the fourth objective is to examine whether effective corporate governance will mitigate the positive association between high ceo overconfidence and gains from level 3 fair values. using a us sample drawn from 2008 to 2011, the results of this paper show that firms with higher ceo overconfidence report more level 3 fair values and gains from level 3 fair values. the results also indicates that the positive relationship between higher ceo overconfidence and level 3 fair values reporting is attenuated for firms with high corporate governance. this paper contributes to the literature by demonstrating that ceo overconfidence significantly affects fair value reporting. to our knowledge, prior work has not demonstrated the presence of these effects. in related work, malmendier and tate (2005) show that overconfidence affects their investment projects. this paper extends and complements their work. this study also extends the literature by investigating whether earnings management is associated with an individual characteristic of the ceo, termed “overconfidence” by prior finance research (malmendier and tate, 2005). second, my study contributes to the literature by examining directly the association between the strength of corporate governance and managerial fair value reporting behavior. the remainder of the paper is organized as follows. section 2 presents the discussion of the previous literature and develops the hypotheses. section 3 presents the research design and variable definitions. 2. literature review and hypothesis development 2.1 the relationship between ceo overconfidence and level 3 fair values according to prior literature, overconfidence is the tendency of individuals to overestimate their knowledge, abilities and the precision of their information, leading to expectations of more desirable outcomes than a realistic evaluation would suggest (bhandari and deaves, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 139 2006). overconfident ceos have unrealistically high expectations of their company’s future performance (hackbarth, 2003; wong, 2008; baker, ruback, and wurgler, 2007), issue more optimistic earnings forecasts (hilary and hsu, 2011; hribar and yang, 2016; libby and rennekamp, 2012), have a belief that they can ensure that high performance is achieved (malmendier and tate, 2005), overvalue their firm’s projects (heaton, 2002), pay less dividends (cordeiro, 2009; deshmukh et al., 2013), underestimate the impact of negative events on his/her firm’s cash flows (heaton, 2002; malmendier and tate, 2005), and are more likely to have financial misstatements that are later the subject of sec enforcement actions (schrand and zechman, 2012). in summary, prior literature documents that overconfidence affects corporate investment, financing, dividend policies, accounting choices, and firm performance. as we know, the managers are the key decision-makers presiding over investment, financing, and operating decisions. there are two decisions that managers must make with respect to level 3 instruments (kohlbeck and valencia, 2014). first, the management must decide whether level 3 classification is appropriate. second, the management must decide what inputs should be used in place of observable inputs once it has been determined that level 3 classification is appropriate. sfas 157 encourages the use of level 3 valuations when quoted market values do not originate from orderly markets, but the standard does not make clear the characteristics that identify an unorderly market, leaving managers considerable discretion over when and which financial instruments to use level 3 methods on. since level 3 fair values are less observable, making it more difficult compared to level 1 fair values for investors to link their performance to managerial decisions, reducing the efficiency of these activities. thus, the decision to keep level 3 fair values can be considered an investment in a risky project. for example, altamuro and zhang (2013) indicate that level 3 fair values better reflect the firms' risk characteristics. because overconfident managers may overestimate the returns to their investment projects (malmendier and tate, 2005), this study expects that the ceos may choose to classify more items as level 3 instruments when they are overconfident. accordingly, the first hypothesis is as follows: h1: firms with higher ceo overconfidence is more likely to report level 3 fair values. 2.2 the relationship between ceo overconfidence and gains from level 3 fair values prior literature indicates that gains/losses from fair values may become a tool for earnings management. for example, barth et al. (1998) indicate that the managers have greater subjectivity in reporting fair values and may use their private information to credibly report fair values. therefore, managers may manipulate inputs for fair values for their own interests (aboody et al. 2006; bartov et al. 2007). fiechter and meyer (2011) provide evidences that banks with pre-managed net income below the 10th percentile have higher discretionary level 3 unrealized losses than the control group. the evidence is consistent with big bath behavior with respect to losses of level 3 fair values. dechow et al. (2010) find that reported gains on retained interests of securitized receivables are higher for firms with low pre-securitization earnings and negative earnings changes. valencia (2011) indicates that managers' decisions to exercise opportunistic behavior with respect to level 3 instruments asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 140 may involve the use of discretion regarding the fair-value estimates they make at each reporting period. in summary, the findings of extant literature documented that managers use their discretion on fair values to manage earnings. from the viewpoint of ceo overconfidence, hsieh et al. (2014) indicate that overconfident ceos will seek to achieve their unrealistically high expectations and will be more likely to engage in managing earnings. since level 3 fair values is subject to the highest level of managerial discretion, this is expected to be an avenue for earnings management (chong et al. 2012). therefore, overconfident ceo can use the discretion allowed in level 3 fair values to boost earnings because gains on level 3 fair values increase reported earnings. according to above discussion, this paper develops the second hypothesis: h2: firms with higher ceo overconfidence is more likely to report gains from level 3 fair values. 2.3 the relationship between ceo overconfidence and fair value reporting-the moderating effect of corporate governance larcker et al. (2007) indicate that the corporate governance refers to the set of mechanisms that influence the decisions made by managers when there is a separation of ownership and control. prior literature has examined the effects of a variety of corporate governance mechanisms on managerial decision-making or constrain executive behavior (morck et al., 1988; byrd and hickman, 1992; brickley et al., 1994; yermack, 1996; core et al., 1999; klein, 2002; and gompers et al., 2003). for example, baysinger et al. (1991) find that the percentage of inside directors on a board and the percentage of institutional ownership are positively associated with r&d spending. chen and chung (2009) examines the impact of corporate governance on the cash-holding policies of firms with different investment opportunities. they find ceo ownership and board independence affect the cash holdings in listed new economy and old economy firms differently. conyon and florou (2004) find that stock compensation of outside directors and executives positively affects investment in fixed capital during the ceo’s final year. to summarize, the above literature indicates corporate governance will monitor the managerial behavior. for firms with more strong corporate governance mechanisms, information asymmetry problems associated with fair values may be lower, leading to less severe moral hazard problems, and therefore higher value relevance of these disclosures. for example, song et al. (2010) provide evidences that support the relevance of fair value measurements under fas no. 157, but weaker corporate governance mechanisms may reduce the relevance of these measures. thus, corporate governance may also affect the managerial fair value reporting. prior literature indicates effective corporate governance mechanisms ameliorate the adverse impact of ceo overconfidence (goel and thakor, 2008; liu and taffler, 2008; heaton, 2002). goel and thakor (2008) indicate that board fires the ceo if she is too overconfident. therefore, i expect the corporate governance will mitigate the positive association between ceo overconfidence and level 3 fair values. in addition, i expect effective corporate asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 141 governance will mitigate the positive association between ceo overconfidence and gains from level 3 fair values. therefore, the third and fourth hypotheses are formulated: h3: the positive relationship between high ceo overconfidence and level 3 fair values is attenuated for firms with high corporate governance. h4: the positive relationship between high ceo overconfidence and gains from level 3 fair values is attenuated for firms with high corporate governance. 3. research design 3.1 regression models and variable definitions 3.1.1 test of hypothesis 1 in hypothesis 1, it is expected that high ceo overconfidence is positively associated with level 3 fair values. following chong et al. (2012), the basic equation is developed as follows: i,t 0 1 , 2 , 3 , 4 , 5 , 6 , 7 , 8 , level3 _ _ + (1) i t i t i t i t i t i t i t i t hi over hi gindex size lev roa ocf afll pfll α α α α α α α α α ε = + + + + + + + + where, level3 = the net assets at level 3 input divided by the net assets at fair value. hi_over = the variable equals one if the ceo overconfidence score of the firm is above the median score for the sample, and zero otherwise. hi_gindex = the variable equals one if the corporate governance score of the firm is above the median score for the sample, and zero otherwise. size = the logarithm of total assets. lev = the ratio of total liability to total assets. roa = the net income divided by the total assets. ocf = the operating cash flows scaled by the total assets. afll = the allowance for loan loss scaled by the total assets. pfll = the provision for loan loss scaled by the net income. the variable of interest in this hypothesis is hi_over. if firms with higher ceo overconfidence is more likely to use more level 3 fair values, the coefficient on α1 will be significantly positive. 3.1.2 test of hypothesis 2 in hypothesis 2, it is expected that ceo overconfidence is positively associated with gains from level 3 fair values. following chong et al. (2012), the basic equation is developed as follows: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 142 i,t 0 1 , 2 , 3 , 4 , 5 , 6 , 7 , 8 , level3_gain _ _ + (2) i t i t i t i t i t i t i t i t hi over hi gindex size lev roa ocf afll pfll β β β β β β β β β ε = + + + + + + + + where, level3_gain = the gains from level 3 fair assets scaled by the net assets at fair value. hi_over = the variable equals one if the ceo overconfidence score of the firm is above the median score for the sample, and zero otherwise. hi_gindex = the variable equals one if the corporate governance score of the firm is above the median score for the sample, and zero otherwise. size = the logarithm of total assets. lev = the ratio of total liability to total assets. roa = the net income divided by the total assets. ocf = the operating cash flows scaled by the total assets. afll = the allowance for loan loss scaled by the total assets. pfll = the provision for loan loss scaled by the net income. the variable of interest in this hypothesis is hi_over. if firms with higher ceo overconfidence is more likely to report more gains from level 3 fair values, the coefficient on β1 will be significantly positive. 3.1.2 test of hypothesis 3 in hypothesis 3, it is expected that the positive relationship between high ceo overconfidence and level 3 fair values is weaker for firms with stronger corporate governance. modifying equation (1), equation (2) is as follows: i,t 0 1 , 2 , 3 , , 4 , 5 , 6 , 7 , 8 , 9 , level3 _ _ _ _ + (3) i t i t i t i t i t i t i t i t i t i t hi over hi gindex hi gindex hi over lgta lev roa ocf afll pfll γ γ γ γ γ γ γ γ γ γ ε = + + + × + + + + + + where, level3 = the net assets at level 3 input divided by the net assets at fair value. hi_over = the variable equals one if the ceo overconfidence score of the firm is above the median score for the sample, and zero otherwise. hi_gindex = the variable equals one if the corporate governance score of the firm is above the median score for the sample, and zero otherwise. lgta = the logarithm of total assets. lev = the ratio of total liability to total assets. roa = the net income divided by the total assets. ocf = the operating cash flows scaled by the total assets. afll = the allowance for loan loss scaled by the total assets. pfll = the provision for loan loss scaled by the net income. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 143 the variable of interest in this hypothesis is _ _hi gindex hi over× . if strong corporate governance causes overconfident ceo to use less level 3 fair values, the coefficient on γ3 will be significantly negative. 3.1.2 test of hypothesis 4 in hypothesis 4, it is expected that the positive relationship between ceo overconfidence and gains from level 3 fair values is weaker for firms with stronger corporate governance. modifying equation (2), equation (4) is as follows: i,t 0 1 , 2 , 3 , , 4 , 5 , 6 , 7 , 8 , 9 , level3_gain _ _ _ _ + (4) i t i t i t i t i t i t i t i t i t i t hi over hi gindex hi gindex hi over size lev roa ocf afll pfll λ λ λ λ λ λ λ λ λ λ ε = + + + × + + + + + + where, level3_gain = the gains from level 3 fair assets scaled by the net assets at fair value. hi_over = the variable equals one if the ceo overconfidence score of the firm is above the median score for the sample, and zero otherwise. hi_gindex = the variable equals one if the corporate governance score of the firm is above the median score for the sample, and zero otherwise. size = the logarithm of total assets. lev = the ratio of total liability to total assets. roa = the net income divided by the total assets. ocf = the operating cash flows scaled by the total assets. afll = the allowance for loan loss scaled by the total assets. pfll = the provision for loan loss scaled by the net income. the variable of interest in this hypothesis is _ _hi gindex hi over× . if strong corporate governance causes overconfident ceo to report less gains from level 3 fair values, the coefficient on λ3 will be significantly negative. 3.2 variable definitions 3.2.1 dependent variables for hypothesis 1 and hypothesis 3 following chong et al. (2012), this paper computes level 3 fair values (level3) as the net assets at level 3 input divided by the net assets at fair value. 3.2.2 dependent variables for hypothesis 2 and hypothesis 4 following valencia (2011), this paper proxies the gains from level 3 fair values (level3_gain) as the gains from level 3 fair assets scaled by the net assets at fair value. 3.2.3 independent variableshigh ceo overconfidence (hi_over) this paper follows prior literature (ahmed and duellman, 2013; malmendier and tate, 2005; malmendier and tate, 2008) in that it considers three proxies for ceo overconfidence: the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 144 net purchases by the ceo (purchase), firm's capital expenditures (capex), and the amount of excess investment in assets (overinvest). these proxies measure the ceos’ stock purchases and their investment decisions. the three variables are explained as following: the first measure of overconfidence is the net purchases by the ceo (malmendier and tate, 2005). purchase is set equal to one if the ceo’s net purchases (purchases−sales) are in the top quintile of the distribution of net purchases by all ceo and those purchases increase their ownership in the firm by 10% during the fiscal year, otherwise zero (campbell et al., 2011). the second proxy for overconfidence is firm's capital expenditures (capex). capex is a dichotomous variable set equal to one if the capital expenditures deflated by lagged total assets in a given year is greater than the median level of capital expenditures to lagged total assets for the firm’s fama-french industry in that year, otherwise zero (ben-david et al., 2010; malmendier and tate, 2005). following schrand and zechman (2012), the third proxy for overconfidence is the amount of excess investment in assets from the residual of a regression of total asset growth on sales growth run by industry-year (overinvest). overinvest equal to one if the residual from the excess investment regression is greater than zero, otherwise zero. the three measures are converted to percentile scores from which an index, ceo_over, is then constructed to capture the combined effect of these factors. ceo_over equals the average of these three percentile values. the variable of high ceo overconfidence (hi_over) equals one if the ceo overconfidence score (ceo_over) of the firm is above the median score for the sample, and zero otherwise. 3.2.4 independent variables-high corporate governance (hi_cg) this paper considers four proxies for corporate governance score (cg_score) as following: bd_ind is the proportion of independent directors on the board (bradbury et al., 2006; chen et al., 2007; osma, 2008; visvanathan, 2008; garven, 2009; shiue, lin, & liu, 2009). the ceo/chair duality (nodual), which is a dummy variable that equals one if the ceo does not serve as the board chair, and zero otherwise (davidson et al., 2005; bradbury et al., 2006). the average tenure of board members (bd_ten), measured as the average years of service of board members (garven, 2009; shiue et al., 2009). outside directorships (bd_dir), measured as the average number of outside directorships held by board members (garven, 2009). the four measures are converted to percentile scores from which an index, cg_score, is then constructed to capture the combined effect of these factors. cg_score equals the average of these four percentile values. the variable of high corporate governance (hi_cg) equals one if the corporate governance score (cg_score) of the firm is above the median score for the sample, and zero otherwise. 3.2.5 control variables this paper also includes a number of additional control variables that have been documented in prior literature. firm size (size), which is the logarithm of total assets and is expected to be positively associated with level 3 fair values (beatty et al., 2002). firm leverage (lev) is the ratio of total liability to total assets (fiechter and meyer, 2011). this paper controls the banks' asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 145 leverage due to the fact that a bank's capital structure can affect its structure of fair value assets to meet covenants’ requirements. in addition, jensen and meckling (1976) conclude high-leverage banks will have stronger incentives to undertake riskier projects (ex: more level 3 inputs). firm performance (roa) is the net income divided by the total assets. roa is expected to be negatively associated with level 3 fair values because the managers have a greater incentive to engage level 3 inputs for firms with poor performance (chong et al., 2012). firm cash flow (ocf) is the operating cash flows scaled by the total assets and is expected to be negatively associated with level 3 fair values because firms with less cash flow from operation to use more level 3 input (chong et al., 2012). allowance for loan loss (afll), which is the allowance for loan loss scaled by the total assets. loan loss provision (pfll), which is the provision for loan loss scaled by the net income and is expected to be positively associated with level 3 fair values (moyer, 1990; clinch and magliolo, 1993; valencia, 2011). 3.3 sample selection and data sources this paper focuses on the banking industry,4 where firms have significant amounts of fair value assets and liabilities (song et al., 2010; riedl and serafeim, 2011) from 2008 to 2011. the gains from level 3 fair values disclosed in the form 10-k are hand collected individually. to be included in the sample, firms must provide the fair value hierarchy disclosure for the fiscal years beginning after november 15, 2007. although the firms disclose level 3 fair value information (as shown in appendix), there are some in the sample that report no level 3 fair values, and thus, the value for level 3 fair values may be zero. however, the zero value for the context is meaningful. in addition, other financial data, annual stock returns, ceo overconfidence, and corporate governance data are obtained from compustat, the center for research in security prices (crsp), execucomp, and riskmetrics, respectively. the following restrictions on the sample are imposed: (1) observations that could not be matched with crsp, (2) observations with insufficient compustat, execucomp and riskmetrics data and (3) outliers. according to kleinbaum, kupper and muller (1988), a studentized residual greater than 3.0 is highly indicative of an outlier. 4. empirical results 4.1 descriptive statistics table 1 presents descriptive statistics for the variables. the mean and median of level 3 fair assets (level3) are 0.048 and 0.012, respectively. the results show, on average, 4.8 percent of the assets use level 3 fair value. the mean of gains from level 3 fair assets (level3_gain) is 0.001. for the ceo overconfidence variables, 3.5% ceo’s net purchase (purchase) are in the top quintile of the distribution of net purchases by all ceo and those purchases increase their ownership in the firm by 10% during the fiscal year. 49.5% firm's capital expenditures (capex) in a given year is greater than the median level of capital expenditures for the firm’s fama-french industry in that year. 36% firms have overinvestment (over_invest). table 1 also provides the descriptive statistics for 4sic codes 6020, 6035 and 6036. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 146 corporate governance variables. on average, 76.9% firms have independent directors on the board (bd_ind), 42.4% ceo does not serve as the board chair (nodual), the average service years of board members (bod_ten) are 11.237 years, the average number of outside directorships held by board members(bd_dir) are 0.368 seats. finally, table 1 also provides the descriptive statistics on the control variables. the means and medians of all control variables are not skewed. table 1. descriptive statistics variables n std mean min q1 q2 q3 max level3 283 0.103 0.048 -0.080 0.000 0.012 0.058 1.281 level3_gain 283 0.002 0.001 0.000 0.000 0.000 0.000 0.021 purchase 283 0.185 0.035 0.000 0.000 0.000 0.000 1.000 capex 283 0.501 0.495 0.000 0.000 0.000 1.000 1.000 overinvest 283 0.481 0.360 0.000 0.000 0.000 1.000 1.000 hi_over 283 0.474 0.661 0.000 0.000 1.000 1.000 1.000 bd_ind 283 0.118 0.769 0.333 0.667 0.800 0.857 1.000 nodual 283 0.495 0.424 0.000 0.000 0.000 1.000 1.000 bod_ten 283 3.665 11.237 3.000 8.727 11.182 13.222 24.333 bd_dir 283 0.454 0.368 0.000 0.000 0.167 0.667 2.000 hi_cg 283 0.501 0.498 0.000 0.000 0.000 1.000 1.000 size 283 1.476 9.647 7.731 8.618 9.365 9.997 14.633 lev 283 0.030 0.889 0.743 0.877 0.892 0.907 0.977 roa 283 0.015 0.002 -0.069 0.001 0.007 0.009 0.037 ocf 283 0.018 0.016 -0.101 0.010 0.015 0.021 0.137 afll 283 0.008 0.013 0.000 0.008 0.011 0.017 0.050 pfll 283 5.184 0.526 -21.297 0.037 0.372 1.198 63.647 note: 1. n=283. 2. variable definitions: level3 is measured as the net assets at level 3 input divided by the total fair value net assets. level3_gain is measured as the gains from level 3 fair assets scaled by the total fair value net assets. purchase is set equal to one if the ceo’s net purchases are in the top quintile of the distribution of net purchases by all ceo and those purchases increase their ownership in the firm by 10% during the fiscal year, otherwise zero. capex is a dichotomous variable set equal to one if the capital expenditures deflated by lagged total assets in a given year is greater than the median level of capital expenditures to lagged total assets for the firm’s fama-french industry in that year, otherwise zero. overinvest equal to one if the residual from the excess investment regression is greater than zero, otherwise zero. hi_over equals one if the ceo overconfidence score of the firm is above the median score for the sample, and zero otherwise. bd_ind is the proportion of independent directors on the board. nodual is a dummy variable that equals one if the ceo does not serve as the board chair, and zero otherwise. bd_ten is measured as the average years of service of board members. bd_dir is measured as the average number of outside directorships held by board members. hi_cg equals one if the corporate governance score of the firm is above the median score for the sample, and zero otherwise. size is the logarithm of total assets. lev is the ratio of total liability to total assets. roa is the net income divided by the total assets. ocf is the operating cash flows scaled by the total assets. afll is the allowance for loan loss scaled by the total assets. pfll is the provision for loan loss scaled by the net income. 4.2 correlation analyses table 2 shows the correlations analyses among variables. the simple correlations between level3 and level3_gain are 0.073, indicating low correlations between level 3 fair values and gains from level 3 fair values. overall, the correlations among other variables are relatively small, indicating that multi-collinearity does not appear to be a problem in the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 147 regression model. to check for the potential of multi-collinearity, this study also adopts the variance inflation factor (vif) in all tests. table 2. correlation analysis level3 level3_gain hi_over hi_cg size lev roa ocf afll pfll level3 1.000 level3_gain 0.073 1.000 hi_over 0.052 0.084 1.000 hi_cg 0.162 *** 0.089 0.027 1.000 size 0.262 *** 0.313 *** -0.014 0.228 *** 1.000 lev 0.218 *** 0.028 -0.038 -0.079 0.051 1.000 roa -0.241 *** 0.043 0.151 ** 0.033 0.015 -0.261 *** 1.000 ocf -0.048 0.122 ** -0.138 ** 0.011 0.114 * 0.005 -0.058 1.000 afll 0.204 *** 0.082 -0.245 *** 0.097 0.067 0.162 *** -0.559 *** 0.272 *** 1.000 pfll 0.002 0.014 -0.021 -0.014 0.113 * -0.026 0.131 ** -0.060 -0.091 1.000 note: 1. pearson correlations are reported in the lower diagonal. 2. n=283. 3. see table 1 for variable definitions. 4. ***, **, and * indicate significance at the 1%, 5%, and 10% level, respectively. 4.3 regression analyses the results for hypothesis one in this study are shown in column 1 of table 3. hypothesis 1 states that firms with higher ceo overconfidence are more likely to report level 3 fair values. column 1 shows that hi_over is significantly positive related to level 3 fair values (level3). thus, hypothesis 1 is supported. this result suggests that high overconfident ceos are more likely to keep level 3 fair assets because they overestimate the returns to their investment projects (malmendier and tate, 2005). regarding the control variables, size is significantly positive indicating that large banks have incentives to use level 3 inputs to value their assets. roa and ocf are significantly negative indicating that a lower return on asset (roa) and operating cash flow (ocf) are associated with a significantly higher level 3 fair values, consisting with chong et al. (2010)'s finding. the results for hypothesis two in this study are shown in column 2 of table 3. hypothesis two states that firms with higher ceo overconfidence is more likely to report gains from level 3 fair values. column 2 shows that hi_over is significantly positive related to gains from level 3 fair values (level3_gain). thus, the second hypothesis is supported. the result suggests that overconfident ceo can use the discretion allowed in level 3 fair values to boost earnings and thus report more gains from level 3 fair values. regarding the control variables, size and roa are significantly positive. the result indicates that firms with higher firm size and good performance report more gains from level 3 fair values. hypothesis three states that the positive relationship between high ceo overconfidence and level 3 fair values is attenuated for firms with high corporate governance. the results for hypothesis three in this study are shown in column 3 of table 3. the result shows that the interaction term hi_cg×hi_over, which captures the differential impact for firms with higher corporate governance, is significantly negative. the result indicates that effective asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 148 corporate governance mechanisms ameliorate the adverse impact of ceo overconfidence (goel and thakor, 2008; liu and taffler, 2008; heaton, 2002). therefore, hypothesis 3 is get supported. the results for hypothesis four in this study are shown in column 4 of table 3. hypothesis four states that the positive relationship between high ceo overconfidence and gains from level 3 fair values is attenuated for firms with high corporate governance. column 4 shows that the interaction term hi_cg×hi_over is significantly negative. the result indicates that the effectiveness of corporate governance can decrease overconfident ceo's managerial earnings behavior in level 3 fair values to boost earnings. thus, hypothesis 4 is supported. table 3. regression results dependent variable predicted sign level3 level3_gain level3 level3_gain intercept ? -0.629 *** -0.007 -0.591 *** -0.005 (-3.580 ) (-1.590 ) (-3.370 ) (-1.320 ) hi_over + 0.021 ** 0.001 ** 0.045 *** 0.001 *** (1.710 ) (1.940 ) (2.850 ) (3.090 ) hi_cg ? 0.024 ** 0.0003 0.057 *** 0.001 ** (2.020 ) (0.070 ) (3.130 ) (1.940 ) hi_over×hi_cg -0.053 ** -0.001 *** (-2.380 ) (-2.520 ) size + 0.016 *** 0.001 *** 0.015 *** 0.000 *** (4.130 ) (5.000 ) (3.800 ) (4.570 ) lev + 0.545 *** 0.002 0.497 ** 0.001 (2.790 ) (0.400 ) (2.550 ) (0.120 ) roa -1.181 ** 0.016 * -1.086 ** 0.019 * (-2.450 ) (1.430 ) (-2.260 ) (1.640 ) ocf -0.609 ** 0.010 -0.720 ** 0.007 (-1.790 ) (1.280 ) (-2.120 ) (0.860 ) afll + 1.497 * 0.037 * 1.660 ** 0.042 ** (1.560 ) (1.640 ) (1.740 ) (1.860 ) pfll + 0.0002 -0.000006 0.0004 -0.000002 (0.160 ) (-0.240 ) (0.370 ) (-0.080 ) adj. r2 0.164 0.101 0.178 0.118 note: 1. n=283. 2. see table 1 for variable definitions. 3. ***, **, and * indicate significance at the 1%, 5%, and 10% level, respectively; one-tailed for all coefficients except for those without predicted signs. 4. if the white test statistics reveals the heterogeneity problem, the t-values are calculated based on the heteroskedasticity-consistent covariance matrix following white (1980). 5.vifs are all smaller than 10. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 149 5. summary and conclusion this paper provides evidence how ceo overconfidence and corporate governance affect managerial fair value reporting behavior. using a us sample drawn from 2008 to 2011, the results of this paper show that firms with higher ceo overconfidence report more level 3 fair values and gains from level 3 fair values. the results also indicates that the positive relationship between higher ceo overconfidence and level 3 fair values reporting is attenuated for firms with high corporate governance. this paper contributes to the literature by demonstrating that ceo overconfidence significantly affects fair value reporting. to our knowledge, prior work has not demonstrated the presence of these effects. in addition, this study also extends the literature by investigating whether earnings management is associated with an individual characteristic of the ceo, termed “overconfidence” by prior finance research (malmendier and tate, 2005). second, my study contributes to the literature by examining directly the association between the strength of corporate governance and managerial fair value reporting behavior. references aboody, d., barth, m. e., & kasznik, r. 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(1996). higher valuation of companies with a small board of directors. journal of financial economics, 40(2), 185-212. http://dx.doi.org/10.1016/0304-405x(95)00844-5 microsoft word 7802-28020-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 207 perceptions towards codes of behaviour: a study of caos, cfos and other employees in bahrain amal abdel wakil department of accounting, college of business administration university of bahrain, p.o. box 32038, kingdom of bahrain e-mail: amabdelwakil@uob.edu.bh farkhanda shamim department of economics and finance, college of business administration university of bahrain, p.o. box 32038, kingdom of bahrain e-mail: fshamim@uob.edu.bh received: may 3, 2015 accepted: june 14, 2015 published: june 14, 2015 doi:10.5296/ajfa.v7i1.7802 url: http://dx.doi.org/10.5296/ajfa.v7i1.7802 abstract the objective of this study is to investigate the factors that affect chief accounting officers (caos), chief financial officers (cfos) and other employees’ perception of codes of behavior in their organizations in the kingdom of bahrain and whether an ethical work environment is influenced by factors such as the establishment of a code of behavior, corporate ethics committee, and/or policy empowerment. the paper is interpretive in nature for which data is collected using survey questionnaires. the findings validate components of an effective code of behavior similar to those identified in the literature which include: implementation of codes of behavior, checking on compliance by internal audit committees, achievement of their goals, follow-up on complaints and confidential channels for reporting ethics violations. also, results show that the organizations under study generally comply with the values in their codes of behavior. however, the results indicate that the ethical work environment as it currently exists in the kingdom of bahrain lacks three aspects. first, setting of a code of behavior seems to be a mixed responsibility between legal departments and outside councils, with minimal participation from the employees. second, the responsibility to check ethics complaints does not necessarily rest with the ethics committee. third, lack of a robust mechanism that increases accountants’ and financiers’ awareness of the importance of coe. keywords: accounting ethics, code of ethics, code of conduct, work environment, kingdom of bahrain asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 208 1. introduction to minimize business and accounting fraud in any organization, there is a need to promote ethical behavior. ethical deficiency in the accounting profession leads to big disasters in the business world such as enron, worldcom and global crossing among others. however, it is challenging to balance between private interests and public interests and to avoid accounting fraud (yen, 2010). due to the galloping increase in the number of accounting fraud cases worldwide, corporate codes of behavior – also referred to as corporate codes of ethics or corporate codes of conduct (o'dwyer and madden, 2006) – have recently gained legislative momentum and value at both the international and national levels. at the international level, for example, the sarbanes-oxley (sox) act of 2002, which became public law 107-204 in 2002, is issued with the primary goal of protection of investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws. section (406) of the sox act directed the securities and exchange commission (sec) to issue rules requiring an issuer of financial reports to disclose whether it had adopted a code of ethics (coe) for its senior financial officers, including its principal financial officer or principal accounting officer. another example is the 2006 draft issued by the international federation of accountants (ifac) as guidance to help companies develop and implement a code of conduct. at the national level, the central bank of bahrain (cbb), which is the sole regulator for the financial sector in the kingdom of bahrain, requires that an audit committee be formed and preferably there be at least one qualified accountant in the committee. among the responsibilities of the committee is to review and supervise the operation of the financial institutions’ code of conduct. (cbb rulebook, volume 1, 2007). the main differences among the sox act, sec release and cbb rulebook related to enhancement of corporate governance are summarized in the appendix. for there to be an effective ethical work environment, the implementation of several steps should occur. the coe of the international federation of accountants (ifac), american institute of certified public accountants (aicpa), institute of internal auditors (iia), institute of management accountants (ima) and edp auditors association set the ethical requirements for professional accountants and provide a conceptual framework and concrete guidelines for all professional accountants to ensure conformity with the five fundamental principles of professional ethics. these principles are integrity, objectivity, professional competence, confidentiality, and professional behavior. the first step towards effective ethical work environment is the establishment of a code of conduct, a corporate ethics committee, and a policy empowering the internal audit group to verify compliance with the code as part of its responsibility. the second step is continuous training in dealing with ethical dilemmas. the third and most significant step is a willingness to accept responsibility for one’s behavior. in light of the above, this paper discusses the existence of corporate codes of behavior in the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 209 workplace in the kingdom of bahrain; and if they exist, how are they developed and perceived by the accountants and other employees in the organizations? the paper is interpretative in nature since it attempts to address an issue identified by muel kaptein et. al (2008) that for companies a business code is not an instrument that stands in isolation of others and it could even be said that in and of itself it is meaningless: the process of developing and implementing the code is pivotal. how codes of behavior are received and interpreted may be influenced, to some extent, by the existence of an ethical culture in the business, professionalism and a distinct corporate philosophy. schlegelmilch and houston (1989) believe that all three exist in british businesses. the same environment may currently exist in the kingdom of bahrain; or if not, may be promoted in businesses in operation. the specific research questions dealt with in this paper are as follow: 1. does an ethical work environment exist in the kingdom’s business institutions through the establishment of a code of behavior, corporate ethics committee, and/or policy empowerment within organizations? 2. what are the weaknesses and the potential problem areas in the kingdom’s business institutions’ ethics environment? 3. what are the important components of an effective code of behavior for the kingdom’s business institutions? 4. to what extent has there been compliance to the values in codes of behavior in the kingdom’s business institutions? 5. to what extent code of conducts are important for the accounting and financial officers? the remainder of this paper is organized as follows. section 2 presents prior international research on ethical codes, followed by section 3 to describe data and the research methods employed in the study, whereas section 4 details research findings. section 5 concludes the study. 2. literature review in the last decade of the 20th century, research on business ethics was receiving greater attention (dunfee and werhane, 1997). first descriptive study on the ethical behavior of managers was published in 1961 (baumhart, 1961). the globalization of business and a corresponding increase in ethical conflicts faced by multinational firms such as nestle, union carbide, enron, worldcom etc. have spurred research interest in international business ethics. many studies attempted to define a corporate code of behaviour such as pitt and groskaufmanis (1990) defined it as “any written statement of ethics, law, or policy (or some combination thereof), delineating the obligations of one or more classes of corporate employees". asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 210 codes of behavior are of two types; namely, codes of ethics (coe) and codes of conduct (coc). the former (value-based code) outlines principles to guide action while the later (rules-based code) specifies principles to be obeyed (robin et al., 1989; farrell and cobbin, 1996). in the mid-1970s, the usa was the first major country in the world to experience an extensive movement among large business enterprises in the utilization of coe in their operations. in a study covering several countries such as the us, canada, europe, japan and australia, berenbeim (1988) found that companies’ coe were less prevalent outside the us and canada. beside utilization of coe in business operations it seems that there appears to be a need to understand how the code is 'received' and interpreted by those whose behavior and attitudes it is presumably intended to influence" cassell et al. (1997). the first authoritative research produced was from a study by cressey and moore (1983) which, among other things, sought to discover corporate executives’ views on what it meant to act ethically. hite et al. (1988) examined the content of 67 ethics codes among fortune 500 corporations. their findings indicated frequent misuse of funds and improper accounting, conflicts of interest, political contributions and confidential information. lefebvre and singh (1992) observed that it was only recently that specific studies had been undertaken to investigate the content of corporate codes of ethics in north america. in contrast to the usa research findings, schlegelmilch and houston (1989) studied, among other things, the respondents' attitudes towards coe in the uk. they observed that little research had been conducted in the uk on business ethics in general and corporate codes of ethics in particular. this was due to the fact that at that time codes of ethics were not as widely used in the uk. coe was viewed as too general and too broad to be reliable or of any use. fisher (2001) studied managers' perceptions of ethical codes and concluded that, in various ways, both coe and coc contribute to a loss of personal ethical responsibility on the part of employees. in particular, coe undermined or challenged personal integrity, and coc restricted and limited the development of wider loyalties. similar studies were conducted in europe. for example, langlois and schegelmilch (1990) surveyed corporate codes in france, germany and the uk. the codes tended to have "conduct" in their names rather than "ethics". their findings suggested that there could be difficulties encountered in developing codes for multinational corporations. in australia, research into corporate codes has been sparse. kaye (1992) findings indicated that very few of the firms had coe. wood (2000) reported that the australian corporate codes were not distinctly australian. in south america, the study by yuri et.al. (2012) of shape and content of ethic codes in colombian oil industry indicated that the codes are grouped into three blocks according to their structure: codes of conduct of multinational companies; codes of conduct of local companies with international ambitions; codes of conduct of small local companies. they concluded that codes of global companies are extensive and legalistic. codes of local companies with international ambitions are short and legalistic while codes of small local asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 211 companies are short and missionary. virtually all codes have their roots in the utilitarian ethics. al-khatib et al. (2001) studied business ethics in three arab gulf states; namely, saudi arabia, oman and kuwait. the findings report that ethical judgments and behaviors are influenced by “an employee’s ethical ideology”. as such, an employee who is idealistic is expected to exhibit less unethical behavior and vice versa. to sum up, the literature surveyed so far indicates that there is a substantial presence of corporate codes in many countries such as the us, uk, canada and australia. however, more recent research has indicated that there is a gap between the existence of explicit ethical codes and the attitudes and behavior of the organizations (simon webley and andrea werner 2008; lawrence 2006; mcnulty 2006). 3. data and research methodology data is collected from a random sample of organizations operating in bahrain. to minimize sampling bias, organizations are chosen carefully to cover various types of organizations such as those which are listed in the bahrain stock exchange and which are not; local and international organizations; banks and non-banking firms; and small, medium and large sized companies. a questionnaire is developed incorporating variables identified in the literature as factors that influence the perception of employees towards cob. the questionnaires are distributed by hand and collected from 207 respondents, which constitute the population under study. to minimize any bias in the responses, the questionnaire targets respondents holding different positions in the organization. table 1 provides background information about the respondents and their organizations. 3.1 demographics table 1 summarizes the general characteristics of the respondents. it is observed that most of the respondents (49.27%) are from the banking sector, followed by service sector (21.26%). this is expected since the kingdom of bahrain is known as an international financial market. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 212 table 1. profile of the sample frequency (%) sectors banking 102 (49.3%) investment 24 (11.6%) insurance 15 (7.3%) service 44 (21.3%) industrial 22 (10.6%) location of the firm local 53 (25.7%) international 153 (74.3%) stock market listed in stock market 96 (47.3%) not listed in stock market 107 (52.7%) size of the organization (measured by # of employees) l < 100 63 (36.4%) 100 < l < 500 77 (44.5%) l > 500 33 (19.1%) position chief executive officer 16 (7.8%) chief financial officer 23 (11.2%) chief administrative officer 11 (5.3%) chief accounting officer 19 (9.2%) furthermore, 74.27% of the respondents are from organizations that have branches outside the kingdom of bahrain, while 47.29% are from organizations listed on the local stock exchange. the fact that the majority of the respondents are from international organizations may have an impact on the results since codes of behavior are more developed and expected to be practiced. also, 65.70% of the respondents are from relatively large organizations with more than one hundred employees. finally, most of the respondents occupied positions other than senior ones. the category “other” (66.5%) included human resource employees and auditors. 4. results and discussion the respondents are asked to express their opinion on twenty three statements on business ethical behaviors on a five-point scale: 1 (never) to 5 (always). the collected data is analyzed first using descriptive statistics (frequency and percentages). then analysis of variance is conducted with nature of business as the only factor and the responses to the twenty three statements on coe perspectives as dependent variables to test the null hypotheses that there are no differences in the employees’ perception on ethical values in various organization in the kingdom of bahrain. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 213 4.1 descriptive analysis a perusal of table 2 shows that 52.66% of the respondents believe that their organizations have not adopted a coe, while a majority (68.60%) of them has adopted coc. this indicates that organizations operating in the kingdom of bahrain are more sensitive to the importance of coc which is rule-based code than coe which is value-based code. furthermore, these findings concur with the findings of farrell and cobbin (2000) in which most of their respondents adopted a rule-based code. table 2. type, existence and reasons of code of behavior no (percent) yes (percent) type of code of behavior: code of ethics (coe) 109 (52.66%) 98 (47.36%) code of conduct (coc) 65 (31.40%) 142 (68.60%) none 201 (97.10%) 6 ( 2.90%) existence of code of behavior for the board of directors 172 (85.57%) 29 (14.43%) chief executive officers 178 (88.56%) 23 (11.44%) chief financial officer 172 (85.57%) 29 (14.43%) chief administrative officers 183 (91.04%) 18 (8.96%) chief accounting officer 176(87.56%) 25(12.44%) all employees 28 (13.93%) 173(86.07%) reasons for setting a code of behavior prevent misconduct 77(38.31) 124(61.69) avoid crisis 93(46.27) 108(53.73) good behavior 98(49.00) 102(51.00) guide employees 90(44.78) 111(55.22) protect public 134(66.67) 67(33.33) protect consumers’ and suppliers’ interests 112(55.72) 89(44.28) control conduct 97(48.26) 104(51.74) others 188(93.53) 13(6.47) it seems that most of the organizations have adopted an overall code of behavior for their employees (86.07%); that is, a code of ethics together with a code of conduct. few respondents indicated that a code of behavior had been adopted for top management such as board of directors, chief executive officers, etc. (table 2). this result may indicate that organizations focus on the existence of cob for lower level management rather than top management. furthermore, most of the respondents believe that, to a lesser extent, setting a cob protects the public and it controls behaviors. table 3 shows that most of the codes of behavior (42.39%) had been initiated as late as 2000, indicating the recent awareness of the organizations regarding this matter. the results in table asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 214 3 further highlight that a majority of the respondents (94.5%) perceive that the code of behavior should be set for all employees so as to prevent misconduct, avoid crisis, encourage good behavior, guide employees and protect consumers and suppliers’ interests. table 3. date of initiating code of behavior and its need number of respondents (%) date of initiating code of behavior 2000-2010 39 (42.4%) 1990-1999 20 (21.7%) 1980-1989 20 (21.7%) 1970-1979 13 (14.1%) need for code of behavior yes for all employees 189 (94.5%) yes for chief accounting and finance officers only 7 (3.5%) no need 4 (2%) 4.1.1 evaluation of ethical work environment considering the importance of a strong foundation of ethics, the study investigated the existence of the ethics environment in the organizations under study. this was accomplished by studying and analyzing (tables 4, 5) factors identified in the literature as components of ethics environment. the strengths and weaknesses of the ethics environment are deduced therein. table 4 shows that most of the respondents (63.45%) indicated that an ethics committee/officer exists in their organizations and most of these committees (93.72%) have at least one financial expert as a member. this result is in line with the recent legislatives at both national and international levels, as outlined at the beginning of this study. furthermore, table 4 reveals one of the weaknesses of the ethics environment under study. the setting of the code of behavior seems to be a mixed responsibility between legal departments and outside councils, with minimal participation from the employees (15.92%). this may be a drawback or a cause for potential problem for the organization. it may be better for the organization to establish a code of behavior where the rules are set by the ruled and hence may promote more positive behavior from the employees towards the code of behavior within their organizations. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 215 table 4. components of ethics environment no yes existence of ethics committee/officer 72 (36.6%) 125 (63.5%) existence of one financial expert 12 (6.3%) 179 (93.7%) setting of code of behavior legal department 117(58.21) 84(41.79) outside counsel 143(71.14) 58(28.86) board of directors 135(67.16) 66(32.84) employee participation 169(84.08) 32(15.92) chief executive officers 142(70.65) 59(29.35) others 152(75.62) 49(24.38) global code of behavior 61 (30.8%) 137 (69.2%) finally, the fact that the code of behavior is global strengthens the ethics environment 69.19% since it is available in more than one language. a further weakness deduced from the results of table 5 is that the responsibility to check ethics complaints does not lie with the ethics committee (25.89%). on a more positive note, most of the respondents (70.16%) indicated that the main responsibility for updating the code of behavior lies with the internal parties who may be better acquainted with the ethics environment. table 5. components of ethics environment (continued) number of respondents (%) responsibility to check on complaints ethics committee 51 (25.9%) internal auditor 40 (20.3%) other 106 (53.8%) responsibility to update code of behavior external auditors 18 (9.4%) other external parties 11 (5.8%) internal parties 134 (70.2%) 4.1.2 components of an effective code of behavior cassell et al. (1997) stated that “there appears to be a need to understand how the code is ‘received’ and interpreted by those whose behavior and attitudes it is presumably intended to influence”. whether an employee is receptive to a code of behavior or not depends on the boundaries that employee is ready to accept for any ethic-related code. in other words, should codes of behavior set by an organization apply to work only or be extended to cover the personal life as well. to understand the boundaries set by the respondents in this study, a question was addressed regarding the monitoring of the employees’ behavior during and after office hours. it is revealed that more than 50 percent of the respondents believe that the code of behavior should monitor their behavior during work asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 216 only and not in their personal lives. given the boundaries set by the respondents for code of behavior developed by their organizations, tables 6 and 7 attempted to audit the organization’s ethics environment and then identify the important components of an effective code of behavior respectively. table 6. employees’ general perceptions about codes of behavior variable frequently when needed sometimes rarely never implemented 123(62.44) 52(26.40) 15(7.61) 3(1.52) 4(2.03) training to deal with dilemmas 57(28.79) 72(36.36) 35(17.68) 16(8.08) 18(9.09) internal audit committee checks on compliance 80(42.11) 65(34.21) 21(11.05) 15(7.89) 9(4.74) updating 51(26.02) 101(51.53) 19(9.70) 17(8.67) 8(4.08) ethical behavior rewarded 45(23.44) 17(8.85) 62(32.29) 36(18.75) 32(16.67) accessible to external parties 33(17.55) 47(25.00) 18(9.57) 23(12.24) 67(35.64) disclosure policies coordinated with audit committee 57(31.32) 61(33.52) 43(23.63) 12(6.59) 9(4.94) goals achieved 85(45.45) 31(16.58) 56(29.95) 10(5.35) 5(2.67) follow up on complaints 90(46.88) 59(30.73) 20(10.41) 13(6.77) 10(5.21) confidentiality of violations 96(50.79) 51(26.98) 23(12.17) 13(6.88) 6(3.18) detections of violations 38(21.23) 32(17.88) 49(27.37) 47(26.26) 13(7.26) clark (2004) proposed performing an audit of a company’s ethics environment and suggested some guidelines to do so. table 6 contains information based on some of clark’s suggestions. the findings indicate that, of the eleven variables studied, it seems that respondents believe that five of them exist in their organizations’ codes of behavior. they include: implementation of codes of behavior, checking on compliance by an internal audit committee, achievement of their goals, follow-up on complaints and confidential channels for reporting ethics’ violations. the key components of an effective code of behavior program that integrates positive values throughout an organization have been identified by messmer (2003). these components were also investigated in this study. it seems that messmer’s respondents attached high importance to all components (table 7). this is evident since 74.24% of the respondents were in agreement that leaders should set the examples for the other employees in the organization by following codes of behavior. the consistent application to all employees was also strongly supported (70.35%) in this study. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 217 table 7. importance attached by employees to effective coe program components variable strongly agree agree neutral disagree strongly disagree leaders set the example 147(74.24) 32(16.16) 16(8.08) 2(1.01) 1(0.51) ethics as core value 141(71.57) 45(22.84) 8(4.06) 2(1.02) 1(0.51) all participate in setting code of behavior 86(43.65) 59(29.95) 27(13.71) 18(9.14) 7(3.55) application of code of behavior consistently to all employees 140(70.35) 40(20.10) 9(4.53) 5(2.51) 5(2.51) employees feel safe to share concerns 115(57.79) 62(31.16) 11(5.53) 6(3.01) 5(2.51) 4.1.3 compliance to codes of behavior in general, organizations’ compliance with codes of behavior including accounting ethics is perceived by respondents to be frequently adhered to integrity, confidentiality, independence, technical standards, professionalism, public interest and conflict of interest (table 8). table 8. employees perception about compliance to codes of behavior values frequently when needed sometimes rarely never integrity 150(76.14) 28(14.21) 14(7.11) 2(1.02) 3(1.52) confidentiality 159(80.30) 26(13.13) 8(4.04) 4(2.02) 1(0.51) independence 142(73.20) 36(18.56) 10(5.15) 5(2.58) 1(0.52) technical standards 136(69.74) 38(19.49) 14(7.18) 5(2.56) 2(1.03) professionalism 148(76.68) 23(11.92) 12(6.22) 6(3.11) 4(2.07) public interest 139(71.65) 33(17.01) 13(6.70) 5(2.58) 4(2.06) conflict of interest 131(66.84) 35(17.86) 14(7.14) 12(6.12) 4(2.04) 4.2 statistical analysis the data is further analyzed based on the following characteristics of the companies/employees. • local versus international ownership • caos and cfos versus other employees • banking versus non-banking sector • listed versus non-listed companies • small versus medium versus large companies comparisons between means are analyzed with analysis of variance which tests the hypothesis that the group means of the dependent variable are equal. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 218 4.2.1 local versus international ownership there are 53 firms owned by bahrainis and 153 internationally owned firms operated in bahrain. table 9. comparisons of perceptions by local versus international companies variables mean groups t-value local international are coe implemented? 4.54 4.43 0.81 do your employees get training in how to deal with coe dilemmas? 3.27 3.80 2.70* does the internal audit committee check on compliance with coe? 3.78 4.08 1.57 how often are the coe updated? 3.67 3.93 1.55 is ethical behavior rewarded? 2.69 3.15 2.05** is there access to coe by external parties via financial reports, internet etc.? 2.09 3.01 3.60* are all ethics policies related to disclosure coordinated with the audit committee? 3.48 3.90 2.21** do you think that the existing coe achieve their goals? 3.66 4.08 2.28** is there a follow-up on any filed complaints related to coe? 3.71 4.20 2.58* do confidential channels exist for reporting ethics violations? 3.72 4.29 3.18* how often are coe violations detected? 3.13 3.22 0.42 in your opinion, does your organization comply with the following values in coe: integrity 4.71 4.59 0.86 confidentiality 4.73 4.70 0.34 independence 4.67 4.59 0.59 technical standards 4.56 4.53 0.21 professionalism 4.60 4.57 0.15 public interest 4.49 4.55 0.39 conflict of interest 4.42 4.41 0.05 how do you perceive the importance of the following: leaders set the example 4.73 4.59 1.24 ethics is a core value 4.80 4.58 2.03** everyone participates in setting coe 4.04 4.00 0.22 coe is applied consistently to all employees 4.56 4.52 0.27 employees feel safe to share concerns 4.46 4.36 0.63 * significant at 0.01 ** significant at 0.05 *** significant at 0.01 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 219 table 9 shows that several variables emerged as significantly different at the 0.01, 0.05 and 0.1 levels between local and international organizations. it appeared that international organizations provided training to their employees in how to deal with coe dilemmas more than their local counterparts (t= 2.7, p<0.01). this is expected since the international organizations have broader exposure to the issue of ethics in the work environment and hence may well be aware of the importance of training to their employees in this respect. the employees in international organizations who have been trained on how to deal with coe dilemmas may also be aware of the importance of any violations of coe. this is depicted in the variable the employees in the international organizations indicated awareness of the existence of a follow-up procedure on any filed complaints related to coe (t=2.58, p<0.01). to further understand the previous findings, the study investigated the set-up of the ethics policies and the parties involved in developing them. the results indicated that international organizations may have developed effective coe more than local organizations because they have developed ethics policies that are coordinated with their audit committees (t=2.21, p<0.05). finally, in comparison with international organizations, employees in local organizations perceived ethics as a core value (t=2.03, p<0.05). this result may support the argument that codes of behavior may be unnecessary and that an ethical culture, a distinct corporate philosophy and professionalism are deeply valued in the bahraini business environment that can be promoted without a formal code of ethics. 4.2.2 caos and cfos versus other employees the results of the comparison between accountants’ perception towards key components of an effective coe vis-à-vis other employees were generally insignificant. as such, it may be deduced that irrespective of the employee’s specialization, all employees carry the same perception towards coe in their respective organizations. however, because of the recent scandals involving the accounting profession and hence the sensitivity of the accountant position in the organization, then organizations in bahrain may need to develop a more robust mechanism that would increase the awareness of accountants in particular towards the importance of coe. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 220 table 10. comparisons of perceptions by accountants versus other employees variable mean groups t-valueothers caos & cfos are coe implemented? 4.78 4.41 2.01** do your employees get training in how to deal with coe dilemmas? 4.19 3.79 1.51 does the internal audit committee check on compliance with coe? 4.28 4.16 0.44 how often are the coe updated? 4.00 3.82 0.74 is ethical behavior rewarded? 3.08 3.00 0.21 is there access to coe by external parties via financial reports, internet etc.? 2.60 2.53 0.20 are all ethics policies related to disclosure coordinated with the audit committee? 3.92 3.59 1.23 do you think that the existing coe achieve their goals? 4.28 3.82 1.57 is there a follow-up on any filed complaints related to coe? 4.44 4.00 1.44 do confidential channels exist for reporting ethics violations? 4.26 3.97 1.01 how often are coe violations detected? 3.30 3.00 0.91 in your opinion, does your organization comply with the following values in coe: integrity 4.67 4.68 0.05 confidentiality 4.63 4.84 1.39 independence 4.67 4.72 0.37 technical standards 4.70 4.50 1.12 professionalism 4.63 4.61 0.08 public interest 4.67 4.51 0.72 conflict of interest 4.59 4.51 0.35 how do you perceive the importance of the following: leaders set the example 4.89 4.54 2.10** ethics is a core value 4.74 4.53 1.36 everyone participates in setting coe 4.30 3.87 1.47 coe is applied consistently to all employees 4.59 4.46 0.60 employees feel safe to share concerns 4.52 4.38 0.63 * significant at 0.01 ** significant at 0.05 *** significant at 0.1 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 221 4.2.3 banking versus non-banking sector as reported in table 1, 50% of the respondents work in the banking sector which is a dominant industry in bahrain. many variables in table 11 appear different between banking and non-banking firms at the 1%, 5% and 10% levels of significance. it is found that as compared to the non-banking sector, the banks in bahrain act more responsibly in the implementation of code of ethics. they provide training to their employees about coe and internal audit committee keeps an eye on the compliance with coe. the findings are statistically significant at 1% level. it is also observed that the banks’ employees are confident that coe violations are detected promptly and the existing coe achieve their goals (significant at 5% and 10% level respectively). interestingly, the respondents are confident that in their banks coe values such as integrity, confidentiality, technical standards, professionalism, public interest and conflict of interest prevail (statistically significant at 1% and 5% levels). furthermore, employees see ethics as core value of coe and they have no reservations in the implementation of coe to all employees and if they have any concern in this regard, they can freely give their opinions. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 222 table 11. comparisons of perceptions by banking versus non-banking sector variable mean groups t-value banking non-bank ing are coe implemented? 4.65 4.25 3.3* do your employees get training in how to deal with coe dilemmas? 3.92 3.42 2.95* does the internal audit committee check on compliance with coe? 4.29 3.68 3.85* how often are the coe updated? 3.94 3.79 1.05 is ethical behavior rewarded? 2.95 3.13 0.91 is there access to coe by external parties via financial reports, internet etc.? 2.76 2.78 0.09 are all ethics policies related to disclosure coordinated with the audit committee? 3.86 3.72 0.87 do you think that the existing coe achieve their goals? 4.10 3.82 1.76*** is there a follow-up on any filed complaints related to coe? 4.02 4.13 0.66 do confidential channels exist for reporting ethics violations? 4.09 4.21 0.75 how often are coe violations detected? 3.38 3.00 2.08** in your opinion, does your organization comply with the following values in coe: integrity 4.83 4.40 3.87* confidentiality 4.84 4.56 2.99* independence 4.65 4.57 0.73 technical standards 4.67 4.41 2.22** professionalism 4.74 4.41 2.57** public interest 4.74 4.32 3.38* conflict of interest 4.71 4.09 4.56* how do you perceive the importance of the following: leaders set the example 4.71 4.54 1.61 ethics is a core value 4.75 4.52 2.49** everyone participates in setting coe 4.06 3.96 0.63 coe is applied consistently to all employees 4.74 4.31 3.45* employees feel safe to share concerns 4.60 4.16 3.54* * significant at 0.01 ** significant at 0.05 *** significant at 0.1 4.2.4 listed versus non-listed companies there are 96 participating companies which are listed in the stock market, making 52.7% data asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 223 generated from non-listed companies. many of the findings are significant (table 12). table 12. comparisons of perceptions by listed versus non-listed companies variable mean groups t-value not-listed listed are coe implemented? 4.48 4.41 0.59 do your employees get training in how to deal with coe dilemmas? 3.86 3.43 2.44** does the internal audit committee check on compliance with coe? 4.02 3.98 0.26 how often are the coe updated? 3.92 3.80 0.81 is ethical behavior rewarded? 3.36 2.71 3.34* is there access to coe by external parties via financial reports, internet etc.? 2.94 2.56 1.65*** are all ethics policies related to disclosure coordinated with the audit committee? 3.77 3.79 0.08 do you think that the existing coe achieve their goals? 4.09 3.87 1.36 is there a follow-up on any filed complaints related to coe? 4.16 3.99 1.03 do confidential channels exist for reporting ethics violations? 4.22 4.12 0.66 how often are coe violations detected? 3.40 2.96 2.32** in your opinion, does your organization comply with the following values in coe: integrity 4.67 4.55 1.04 confidentiality 4.74 4.66 0.72 independence 4.64 4.58 0.49 technical standards 4.59 4.48 0.89 professionalism 4.62 4.52 0.71 public interest 4.57 4.48 0.71 conflict of interest 4.40 4.40 0.01 how do you perceive the importance of the following: leaders set the example 4.60 4.63 0.29 ethics is a core value 4.70 4.56 1.48 everyone participates in setting coe 4.07 3.92 0.89 coe is applied consistently to all employees 4.56 4.49 0.50 employees feel safe to share concerns 4.42 4.34 0.59 * significant at 0.01 ** significant at 0.05 *** significant at 0.1 nonetheless, we observe that non-listed companies are more aware of the importance of coe asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 224 and listed companies are aware but to a lesser extent. non-listed firms reward good behaviors, detect coe violations and train their employees to deal with coe dilemma. 4.2.5 small, medium and large companies in our analysis, we divide companies with respect to their number of employees. large firms employ more than 500 skilled and unskilled workers, medium size firms have between 100 and 500 employees while the small firms are hiring around 100 employees. the number of respondents from various types of firms are reported in table 1. when compared, their means are significantly different from each other for various variables. we observe that small and medium sized firms are applying coe more than the larger firms (table 13). this observation is in line with the findings that listed companies are not significantly implementing, training or detecting coe in their organizations. (table 12). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 225 table 13. comparisons of perceptions by small, medium and large companies variable mean groups t-value l<100 100>l<500 l>500 are coe implemented? 4.71 4.43 4.09 2.35* do your employees get training in how to deal with coe dilemmas? 3.83 3.88 3.00 2.63* does the internal audit committee check on compliance with coe? 4.19 3.94 3.58 1.76** how often are the coe updated? 3.93 3.97 3.31 2.30** is ethical behavior rewarded? 2.91 3.17 2.82 0.98 is there access to coe by external parties via financial reports, internet etc.? 2.71 2.93 2.55 0.82 are all ethics policies related to disclosure coordinated with the audit committee? 3.88 4.00 3.17 2.49* do you think that the existing coe achieve their goals? 3.85 4.23 3.47 2.32* is there a follow-up on any filed complaints related to coe? 3.81 4.26 4.32 1.88** do confidential channels exist for reporting ethics violations? 3.78 4.42 4.19 2.34* how often are coe violations detected? 3.17 3.30 3.03 0.68 in your opinion, does your organization comply with the following values in coe: integrity 4.81 4.58 4.50 1.46 confidentiality 4.75 4.65 4.82 0.83 independence 4.61 4.59 4.64 0.22 technical standards 4.57 4.65 4.27 1.52*** professionalism 4.74 4.61 4.24 1.81** public interest 4.62 4.59 4.39 0.87 conflict of interest 4.53 4.48 4.12 1.39 how do you perceive the importance of the following: leaders set the example 4.66 4.58 4.79 0.98 ethics is a core value 4.84 4.63 4.61 1.57*** everyone participates in setting coe 3.88 4.07 4.30 1.25 coe is applied consistently to all employees 4.68 4.66 4.12 2.30** employees feel safe to share concerns 4.44 4.45 4.06 1.53*** * significant at 0.01 ** significant at 0.05 *** significant at 0.1 5. summary and conclusions the main objective of this study is to investigate the perceptions of employees related to asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 226 codes of behavior and accounting ethics in the kingdom of bahrain. in particular, the study focused on four main issues. first, an examination was conducted as to whether an ethical work environment exists through the establishment of: a code of behavior, corporate ethics committee, and policy empowerment. the existence of an ethical work environment was validated by the results of the study. three main weaknesses in the ethics environment of some organizations were identified: (1) setting of the code of behavior seems to be a mixed responsibility between legal departments and outside councils, with minimal participation from the employees, (2) the responsibility to check ethics complaints does not lie with the ethics committee and (3) lack of a robust mechanism that enhances financiers’ and accountants’ awareness about the importance of accounting ethics. additionally, some important components of an effective code of behavior were identified such as implementation of codes of behavior, checking on compliance by an internal audit committee, achievement of their goals, follow-up on complaints and confidential channels for reporting ethics violations. finally, results revealed that the organizations under study generally comply with the values in their codes of behavior. overall, the results indicate that international organizations operating in bahrain, banks and relatively smaller firms may to a great extent, be in line with what has been identified as factors essential for the existence of an effective ethical work environment. it is pointed out that the use of questionnaires may limit the generalization ability of the results and replication of the study or use of different methodologies may enhance the results. this study may set the foundation for further research in this area in the kingdom of bahrain. in particular, a follow-up may be conducted to investigate the sustainability of coe in an ever-changing financial environment and whether more rigorous coe should be developed to enhance the importance of its existence within the organization. additionally, factors identified by other researches such as the degree of idealism in employees (al khatib et. al 2002) should also be considered. references al-khatib, j.a., robertson c.j., stanton a. & vitell s.j. 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(2008). corporate codes of ethics: necessary but not sufficient. business ethics: a european review, 17(4). http://dx.doi.org/10.1111/j.1467-8608.2008.00543.x wood, g. (2000). a cross cultural comparison of the contents of codes of ethics: usa, canada and australia. journal of business ethics, 25(4), 287-98. http://dx.doi.org/10.1023/a:1006034209956 yen, v.h. (2010). accounting ethics and its important role for reduction of accounting fraud: an empirical study in hanoi. bs thesis, help university college, hanoi. retrieved from http://dl.is.vnu.edu.vn/bitstream/123456789/223/1/vu%20hai%20yen.pdf asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 229 appendix comparative analysis of information related to code of behaviour the main differences between the sox act, sec release and cbb circular related to enhancement of corporate governance are summarized below. requirement sox act (section 406) sec cbb adopt code of behaviour for?? principal financial officer or principal accounting officer principal executive officers and senior financial officers board of directors, senior management and employees implementation date 30th july 2002 fiscal year ending on or after 15th july 2003 1st january 2005 suggested content not addressed in section (406). details are not specified. the decision as to specific provisions of each issuer's coe should be made by the issuer itself. • commitment to the code • commitment to the law and best practice standards. • employment practices e.g. health and safety • how the company deals with disputes and complaints from clients and polices the code • confidentiality disclosure not addressed in section (406). annual report, form 8-k or on its internet website. communicated throughout the organization. audit committee not addressed in section (406). • at least one audit committee financial expert. • the name of the expert must be disclosed. • preferably, there should be at least one qualified accountant in the committee. • among committee's responsibilities is to review and supervise the operation of the coe. microsoft word 2013-05-06-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 334 the impact of internal control quality on cfo turnover ya-fang wang (corresponding author) department of accounting, providence university taichung city, taiwan e-mail: yfwang2@pu.edu.tw yu-ting huang ph. d. program in business, chung yuan christian university chung li city, taiwan e-mail: g10104602@cycu.edu.tw received: may 8, 2013 accepted: may 16, 2013 published: june 1, 2013 doi:10.5296/ajfa.v5i1.3641 url: http://dx.doi.org/10.5296/ajfa.v5i1.3641 abstract accurate financial reports are crucial for regulators, auditors, and investors to understand the condition of a company. cfo turnover and internal financial controls play a large role in determining the quality of financial reporting. we investigated the association between cfo turnover and internal controls and found that companies with deficient internal controls are more likely to terminate their cfos following financial restatements. companies with deficient internal controls are also likely to have lower earnings quality. in this study, we further investigated how companies experiencing cfo turnover with weak internal controls can subsequently change controls to impact earnings quality. keywords: internal control, cfo turnover, earnings quality, restatement asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 335 1. introduction the sarbanes-oxley act (sox) aims to make major improvements to governance and financial reporting. a primary emphasis of the sox is monitoring the role of cfos in financial reporting, because they bear primary responsibility for the accuracy, documentation and submission of all financial reports. they also serve as the internal control structure to the sec. cfos thus play the first line of defense in monitoring the internal controls of financial reporting to ensure financial reporting quality, and the sox imposes stringent civil and criminal penalties on negligent cfos. companies may terminate their cfo after accounting restatements to rebuild the internal controls of financial reporting. this raises the question of whether or not cfo turnover is more likely in companies with failures in internal controls of financial reporting, as these failures indicate negligence on the part of the cfos. the purpose of this study is to examine company financial restatements to determine the relationship between cfo turnover and the internal controls of financial reporting for the company. we then examine the relationship between the earnings quality of companies with recently terminated cfos and their internal control quality. changes in internal control include upgrades or downgrades and may make various impacts on earnings quality. our results provide evidence that companies of deficient internal controls are more likely to terminate their cfos following financial restatements. such companies also have lower earnings qualities at the time of cfo turnover. this study focuses on specific cfo turnover cases and further considers a variety of internal control changes to examine the association between earnings quality and changes in internal control. empirical results show that downgraded internal controls are associated with lower earnings quality, and vice versa. our study contributes to three important streams of research. first, it extends previous research into company internal controls. second, this study contributes to literature on the association between changes in internal controls and earnings quality. finally, this study provides important public policy implications, indicating that cfo turnover is an important signal of deficient internal controls, and such a signal implies that earnings quality is likely to be negatively impacted. the remainder of this study is organized as follows: section 2 presents a literature review. section 3 describes the cfo turnover sample selection process and research design. section 4 reports the empirical results. conclusions are discussed in section 5. 2. literature review as the cfo has primary responsibility for a company’s financial reporting quality, cfo turnover has generally received much attention from regulators as well as the public. in this section, we examine the literature to identify two topics of cfo turnover that are most relevant to this study. 2.1. internal control quality and cfo turnover the quality of financial reporting is directly related to internal controls, which lies under the responsibility of the cfo. prior studies find that financial statements may need to be restated asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 336 due to errors resulting from deficient internal controls (plumlee and yohn 2010; nagarajan and carey 2008; ashbaugh-skaife et al. 2007; grothe et al. 2007a; grothe et al. 2007b; hammersley et al. 2008; li and wang 2006). however, not every restatement resulted from deficient internal controls. previous research has demonstrated that companies restating their earnings also have higher executive turnover (burks 2010; collins et al. 2009; hennes et al. 2008; arthaud-day et al. 2006; and desai et al. 2006), as well as higher director turnover (srinivasan 2005). however, no systematic evidence exists on the relationship between internal control quality and cfo turnover. this raises the question of whether cfo turnover following restatements may be more likely in companies with failures in internal financial reporting controls, which indicate negligent cfos. 2.2. internal control quality and earnings quality as related to cfo turnover much of the research on internal controls focuses on the consequences of control failures (plumlee and yohn 2010; hammersley et al. 2008; nagarajan and carey 2008; li and wang 2006). few studies have investigated whether companies improve performance after these failures, which incur high costs and public criticism. companies with failures in internal controls may have strong incentives to improve financial reporting quality and restore market confidence. furthermore, prior research does not properly consider how changes in internal control systems contribute to control failures. internal control deficiencies may be beneficial when they result from an upgrade in internal controls. for example, companies that move from weak to high-quality internal controls may have initial failures, but corporate performance ultimately improves. it is generally acknowledged that companies that experience cfo turnover due to deficiencies in internal controls should prioritize improving future performance in internal control and earnings quality to restore financial statement credibility. however, there is little empirical research indicating that such companies actually improve. this study examines companies following internal control failure and related cfo turnover to determine whether earnings quality or internal controls improve following the acknowledgment of failure. we argue that failures in internal controls may actually offer an opportunity for companies to improve company performance through subsequent changes in internal controls. 3. research design to test our research questions, we collected publicly listed companies in u.s. on an annual basis between november 2004 and december 2005, using probit and regression models. the following subsections reveal sources of research data and introduce our research model in detail. 3.1. data sources first, we read proxy statements (form def-14a) as well as press releases to identify cfo turnover of restating companies. if the proxy statement was not available, we searched for 10-ks and 8-ks. since we were specifically studying restating companies, we defined cfo turnover as a cfo leaving a company following restatements. we do not consider it turnover if a manager leaves due to a company merger or acquisition. after identifying companies asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 337 with cfo turnovers, we searched each firm’s sec file (e.g., 10-k, 10-k/a, etc.) from november 2004 through december 2005 for disclosure of any weaknesses in internal control. in the reports, we searched for the term “did not maintain effective internal control,” a common indication of deficient controls used in audit reports. we hand-collected information on corporate governance (e.g., board size and audit committee independence) from the appointing companies’ proxy statements (form def-14a). finally, we obtained accounting data from standard and poor’s compustat annual industrial, research, and full coverage files. 3.2 model specification－internal control quality vs. cfo turnover we constructed a research model to investigate whether cfo turnovers following restatements are associated with internal control weaknesses. the research model (1) is as follows: )1(,76543210 tiiboardboardsizebignlossgrowthicwturn   where turn equals 1 if the cfo leaves the company following the restatement, else 0; icw equals 1 if a company has weak internal controls, else 0; growth equals one-year percentage increase in sales; loss equals 1 if operating income is less than zero, else 0; bign equals 1 if the company’s auditor is a big n firm, else 0; size equals the natural log of total assets; board equals number of directors on the board; and iboard equals the number of independent directors on the board divided by the total board size. 3.3. model specification－internal control quality vs. earnings quality in cases of cfo turnover, we use equation (2) to estimate the association between internal control weaknesses and earnings quality. our da variable as a measure of earnings quality is the performance matched discretionary accrual (kothari et al. 2005). this figure is obtained by matching the two-digit sic code of the company with the year and current return on assets. further, equation (3) estimates the association between the changes of internal control quality and earnings quality. models (2) and (3) are as follows: )2(,76543210 tiiboardboardsizebignlossgrowthicwda   )3( /// ,7 6543210 tiiboard boardsizebignlossgrowthicbbicggdownupda     where up equals 1 if the company improved their internal controls, else 0; down equals 1 if the company’s internal control has become weak, else 0; icgg equals 1 if the company continues to maintain high-quality internal controls, else 0; icbb equals 1 if the company asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 338 continues to report weak internal controls, else 0. 4. results and analysis table 1 presents the descriptive statistics for all variables used in our research models, partitioned by two subsamples: cases of companies with internal control weaknesses (n = 114), and cases without internal control weaknesses (n = 174). as such, comparing two subsamples provides evidence as to whether or not cfo turnover following restatements is more likely to be associated with internal control weaknesses. the means (medians) of turn and loss reported in the subsample with internal control weaknesses (icw) are at the 0.01 level for both tests, which is significantly larger than those reported in the subsample with no internal control weaknesses. in addition, the means (medians) of bign and size reported in the icw subsample are at least at the 0.10 level for both, which is significantly smaller than those reported in the subsample without weaknesses. univariate comparisons indicate that companies of internal control weaknesses have high cfo turnover (turn), suffer more losses (loss), hire small auditors (bign), and are smaller in size (size) than companies without internal control weaknesses. overall, our findings suggest that cfo turnover of restating companies is likely to be associated with internal control weaknesses. table 1. descriptive statistics internal control weaknesses (n=114) no internal control weaknesses (n=174) t-test1 wilcoxon variables mean median mean median turn 0.561 1.000 0.356 0.000 3.491*** 3.425*** da 0.205 0.010 -0.252 0.000 1.205 0.061 growth 0.123 0.083 0.129 0.105 -0.204 -1.021 loss 0.421 0.000 0.201 0.000 4.134*** 4.022*** bign 0.825 1.000 0.902 1.000 -1.934* -1.925* size 6.613 6.481 6.899 7.064 -2.140** -2.227** board 8.281 8.000 8.598 9.000 -1.186 -0.996 iboard 0.785 0.820 0.782 0.810 0.153 0.132 1 asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels. table 2 represents the pearson and spearman correlations for the test and control variables used in the research models. results show that turn is positively correlated with icw (0.202), implying that companies with internal control weaknesses are more likely to terminate their cfo. as depicted in this table, most explanatory variables are not significantly correlated to each other. we also estimate variance inflation factors (vifs) to test for possible multicollinearity while considering all independent and control variables. none of the vifs is greater than 1.8, indicating no presence of multicollinearity in our study. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 339 table 2. correlation matrix variables turn da icw growt h loss bign size board iboard turn 0.006 0.202* -0.143* 0.196* 0.025 -0.066 -0.052 0.108 da -0.033 0.004 0.024 -0.034 0.050 0.057 0.015 0.047 icw 0.202* 0.071 -0.060 0.237* -0.114 -0.131* -0.059 0.008 growth -0.086 0.045 -0.012 -0.180* -0.081 -0.081 -0.171* 0.051 loss 0.196* -0.047 0.237* -0.096 -0.168* -0.175* -0.110 0.155* bign 0.025 0.033 -0.114 -0.029 -0.168* 0.408* 0.254* -0.095 size -0.061 0.126* -0.126* -0.010 -0.165* 0.388* 0.579* -0.182* board -0.068 0.023 -0.070 -0.120* -0.094 0.255* 0.599* -0.228* iboard 0.111 0.073 0.009 0.091 0.153* -0.104 -0.130* -0.221* 1 pearson correlations in the lower diagonal and spearman correlations in the upper diagonal. * indicates significance at the 5 percent level. panel a of table 3 provides a breakdown of internal control quality and cfo turnover. as depicted in panel a, the highest percentage of cfo turnover is present in the icw subsample (22.22%), confirming that companies with deficient internal controls have a higher probability of cfo turnover. we further document the results of cfo turnover regressed on internal control quality, with results demonstrated in panel b of table 3. as predicted, the coefficient on icw is 0.466 (significant at p < 0.01), suggesting once again that companies with deficient internal controls are more likely to terminate their cfos following financial restatements. the coefficients on control variables (salegrw, loss, iboard) indicate that companies with better sales growth, fewer losses, and stronger corporate governance are associated with lower cfo turnover rates. as discussed above, we find that companies of deficient internal controls are associated with higher rates of cfo termination. this lead to an exploration of the relationship between the earnings quality and internal control quality of companies with terminated cfos, since earnings quality is the primary responsibility of cfos. column (1) of table 4 indicates that the coefficient of icw is significantly positive. the coefficient of icw in column (2) is also significantly positive, while the coefficient of icw in column (3) is positive, but not significant. these findings are consistent with our conjecture that companies of deficient internal controls have lower earnings quality in scenarios when cfos are terminated due to financial restatements. table 4 shows empirical evidence for the relationship between earnings quality and internal control quality of companies with terminated cfos. we considered a variety of internal control changes asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 340 table 3. internal control weakness and cfo turnover panel a：classification table internal control weaknesses no internal control weaknesses total no cfo turnover 50(17.36%) 112(38.89%) 162(56.25%) turnover 64(22.22%) 62(21.53%) 126(43.75%) total 114(39.58%) 174(60.42%) 288 panel b：result of probit analyses variables pred. sign coef. z-value1 constant -0.996 -1.75* icw ＋ 0.466 2.90*** growth － -0.483 -1.46* loss ＋ 0.413 2.32** bign ? 0.388 1.59 size ? -0.012 -0.22 board ＋ -0.029 -0.68 iboard ＋ 0.738 1.55* pseudo r2 6.51% nobs. 288 1 asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively. one-tailed for directional expectations, two-tailed for others. table 4. internal control weakness and earnings quality of cfo turnover (1) (2) (3) total sample cfo turnover no cfo turnover variables pred. sign coef. t-value1 coef. t-value coef. t-value constan t -2.988 -1.24 -3.840 -0.80 -2.663 -1.26 icw ＋ 0.657 1.55* 1.146 1.49* 0.244 0.72 growth ＋ 0.366 0.55 0.598 0.39 0.237 0.34 loss － -0.414 -0.66 -0.586 -0.55 -0.142 -0.28 bign － -0.094 -0.15 -0.472 -0.45 0.104 0.12 size ? 0.320 1.73* 0.284 0.92 0.373 1.59 board － -0.081 -0.59 -0.161 -0.68 -0.042 -0.31 iboard － 1.651 1.02 3.813 1.04 0.361 0.30 adj. r2 3.86% 6.13% 5.93% nobs. 288 126 162 1 asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively. one-tailed for directional expectations, two-tailed for others. (upgrades or downgrades) in our analyses, which may also make various impacts on earnings quality. table 5 presents the regression results. consistent with our expectations, the coefficients of icw in columns (2) and (4) are significantly positive, suggesting that companies with internal control weaknesses that continued to have weak controls instead of upgrading are associated with lower earnings quality. on the contrary, the coefficient of icw asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 341 in column (3) is significantly negative, suggesting that companies that maintain high-quality internal controls are associated with higher earnings quality. however, the coefficient of icw in column (1) showing companies that upgraded internal control measures is positive, but not significant, which is inconsistent with our expectations. a possible reason underlying this finding is that companies that upgraded internal control may need a period of adjustment to improve their earnings quality. overall, these results confirm our expectations that even after cfo termination, internal control changes can make a heavy impact on earnings quality. table 5. internal control changes (upgrade/downgrade) and earnings quality of cfo turnover (1) (2) (3) (4) variables pred. sign coef. t-value1 coef. t-value coef. t-value coef. t-value constant -3.240 -0.70 -3.252 -0.70 -2.620 -0.61 -3.913 -0.81* up － 0.349 0.56 down ＋ 1.224 1.89** icgg － -1.203 -1.58* icbb ＋ 1.158 1.30* growth ＋ 0.883 0.53 0.900 0.54 0.601 0.39 0.842 0.53 loss － -0.362 -0.36 -0.316 -0.31 -0.576 -0.54 -0.545 -0.51 bign － -0.568 -0.51 -0.562 -0.51 -0.482 -0.46 -0.394 -0.38 size ? 0.271 0.88 0.272 0.90 0.293 0.94 0.252 0.89 board － -0.155 -0.63 -0.162 -0.64 -0.167 -0.71 -0.148 -0.61 iboard － 3.689 1.01 3.825 1.03 3.723 1.03 4.276 1.11 adj. r2 4.15% 4.15% 6.36% 5.61% nobs. 126 126 126 126 1 asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively. one-tailed for directional expectations, two-tailed for others. 5. conclusions this paper provides empirical evidence regarding the relationship between internal controls and cfo turnover based on a sample of 288 restating companies from 2004 to 2005. overall, evidence shows that companies with deficient internal controls are more likely to terminate their cfos following financial restatements. cfo turnover observations further indicate that even after cfo termination, subsequent changes in internal controls have an impact on earnings quality. downgraded internal controls are associated with lower earnings quality, while improved internal controls are associated with higher earnings quality. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 1 www.macrothink.org/ajfa 342 one major limitation of our study is that the sample period was only two years, due to manual collection of data on internal controls and cfo turnover via reading proxy statements. future research can explore whether and how restating companies with initial weak internal controls can improve their reputations by signaling improved financial reporting quality in the post-restatement era. we know that prior research uses various measures of corporate reputation, but america’s most admired companies list is by far the most widely used measure (highhouse et al. 2009; riahi-belkaoui 2001; flanagan and o’shaughnessy 2005; fombrun and shanley 1990). researchers can use america’s most admired companies list as a proxy for corporate reputation. references arthaud-day, m. l., certo, s. t., dalton, c.m., & dalton, d. r. 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(2005). performance matched discretionary accrual measures. journal of accounting and economics, 39, 163-197. http://dx.doi.org/10.1016/j.jacceco.2004.11.002 li, c., & wang, q. (2006). sox 404 assessments and financial reporting errors. working paper, university of pittsburgh and iowa state university. nagarajan, r., & carey, p. (2008). effectiveness of internal control over financial reporting and financial statement restatements: the role of management. working paper, monash university australia. plumlee, m. a., & yohn, t. l. (2010). an analysis of the underlying causes attributed to restatements. accounting horizons, 24, 41-64. http://dx.doi.org/10.2308/acch.2010.24.1.41 riahi-belkaoui, a. (2001). contextual accrual and cash flow based valuation models: impact of multinationality and corporate reputation. advances in financial planning and forecasting 10: 25-35. srinivasan, s. (2005). consequences of financial reporting failure for outside directors: evidence from accounting restatements and audit committee members. journal of accounting research, 43, 291-334. http://dx.doi.org/10.1111/j.1475-679x.2005.00172.x microsoft word 6244-23011-1-sp-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 469 determinants of operational efficiency in asian banking: a two-stage banking model analysis jonchi shyu dept. of business administration, national taiwan university of science and technology 43, sec. 4, keelung rd., da’an dist., taipei 106, taiwan e-mail: jonchi.shyu@msa.hinet.net jia-chi lin dept. of fashion administration & management, st. john’s university 499, section 4, tam-king road, tamsui, taipei 25135, taiwan e-mail: serena@mail.sju.edu.tw chen-kuang wu dept. of business administration national taiwan university of science and technology 43, sec. 4, keelung rd., da’an dist., taipei 106, taiwan e-mail: wch322@ms16.hinet.net received: august 30, 2014 accepted: dec. 21, 2014 published: december 21, 2014 doi:10.5296/ajfa.v6i2.6244 url: http://dx.doi.org/10.5296/ajfa.v6i2.6244 abstract this paper applies a two-stage banking model to analyze the operational efficiency of 137 asian banks. tobit regression model is also used to investigate the effect under the different operating environment and the characteristics of banks on banking efficiency. the empirical results show that technical inefficiency in the production stage for all the asian banks is caused by pure technical inefficiency. in the intermediary stage, the banks’ technical inefficiencies in china, taiwan, and south korea are mainly caused by pure technical inefficiency, whereas in hong kong, malaysia, thailand, singapore and philippines, it is caused by scale inefficiency. from the policy perspective, this study can help asian banks asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 470 recognize whether their competition edges lie in acting more as a producer or an intermediary. the findings can also provide important references for banks in asian countries to deliberate upon the capacities and niche in order to improve their competitive position in the financial market. keywords: two-stage banking model, dea, tobit regression analysis, asian banks, operational efficiency asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 471 1. introduction in recent years, there has been an increasing interest in the study of banking efficiency in asian countries (e.g. lim and randhawa, 2005; ahmad et al., 2010; ngo, 2012; neupane, 2013; sharma and dalip, 2014). banks, through financial intermediary and credit creation functions, settle capital supply and demand among different industries to help boost industrial development and capital preservation. therefore, banking performance is closely related to the overall economic development of a country. understanding the factors that affect banking performance can help banks to assess the adequacy of their current resource management and to allocate and apply resources more efficient, thereby greatly help the economic development of the countries in which they operate. the financial environments in asian countries become more open due to of globalization and many international banks tend to utilize their competitive strength in the asian banking sectors when entering the asian market. asian banks, meanwhile, face a more competitive environment. they need to strengthen efficiency in areas wherein they already have an edge and to make up for their weaknesses in other areas. for example, they could use fewer resources to draw deposits in the production stage to make up for inefficiency in the intermediary stage (denizer et al., 2007). asian banks also need to determine whether being a production unit or an intermediary can achieve better efficiency to meet their operating targets. relevant methods include increasing market share, introducing new financial products, and organizational downsizing (denizer et al., 2000, 2007). the banking efficiency literature has been dominated by studies in the u.s. and european countries. berger and humphrey (1997) survey 130 efficiency studies of financial institutions, of which very few address the application in asian countries. in this paper, a two-stage banking model approach (production and intermediation stage) is proposed for the efficiency evaluation for asian banking firms. data envelopment analysis (dea) techniques are used to measure the efficiency of asian banks. the empirical findings in this study can help asian banks recognize whether their competitive edges lie in acting more as a producer or an intermediary, and how to improve their efficiency in the production stage and intermediary stage. 2. banking efficiency in asian countries 2.1 evaluation of banking efficiency in extant studies on bank performance, some scholars consider banks as production units (benston, 1965; ferrier et al., 1990; shaffnit et al., 1997; zenios et al., 1999), some view banks as intermediaries (maudos and pastor, 2003; casu et al., 2003), and some believe that banks play both roles (denizer et al., 2000; athanassopoulos and giokas, 2000). benston (1965) first introduced the production approach that views financial institutions as providers of services for account holders. in this approach, outputs include all types of trading accounts and other services provided by banks, and inputs include employees, issued capital, and related costs. elyasiani and mehdian (1990a, 1990b) and mester (1987) studied bank operating performance via the intermediary approach, outputs are viewed as the earning assets of banks, whereas deposits, capital, and labor are viewed as inputs. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 472 the most important source of a bank’s profit is interest incomes, which depends on the amount of corporate and consumer loans. therefore, a bank’s “selling ability” is important in the intermediation stage. if a bank’s loanable funds are viewed as a product, the unit price of the product is interest rate on loans, and the revenue is interest incomes. in addition, the main source for a bank’s loanable funds is the deposits drawn from capital owners. therefore, deposits can be viewed as the “material” to create loans as a product in the production stage. the unit price of the material is interest rate on deposits, and its production cost is interest costs. the above arguments illustrate that the production and intermediation stages are two sides of the same coin. denizer et al. (2000) was the first to connect bank production function with intermediary function, arguing that all banks have these two functions and that these functions are complementary. in their study of the banking industry in turkey from 1970 to 1994, denizer et al. (2000) define the bank inputs in the production stage as the banks’ tangible assets, salary expenses, and interest costs, whereas the outputs are the deposits and related commission income. in the intermediation stage, the inputs are the deposits and operating costs (salary expenses are not included), whereas the outputs are the loans, related interest income, and commission income. the authors found that banking efficiency values for the two stages did not rise after the turkish government implemented financial liberalization programs. the main reason for this phenomenon was that the country did not have a stable macroeconomic environment during the sample period. in addition, scale inefficiency was the main cause of low technical efficiency. denizer et al. (2007) further applied the production and intermediary approaches to evaluate the factors that affecting banking efficiency in turkey and found that both the gdp growth rate and the inflation rate (calculated using gdp deflators) were negatively correlated with the efficiency values for the two stages. during the sample period, the inflation rate fluctuated greatly, rising from 9% in the 1970s to 85% in the 1980s, before falling to an average of 65% in the 1990s. moreover, the gdp growth rates fluctuated wildly ranging from a low of -6% to a high of 11%. such extreme fluctuations would increase uncertainty and risks for the banks. meanwhile, high growth rates would induce banks to expand their loans and investment products, which would lower the overall quality of the banks’ assets (keeton, 1999). hence, a successful financial reform program has to first build a stable economic and financial environment. after the 1997 asian financial crisis, many countries reformed their banks by closing universal banks, transferring bank assets to healthier banks, setting up core banking billing systems (the it systems that dealt with business, accounting, and bills), transferring non-performing assets to government institutions or asset management companies, and adding new assets into banks for reorganization (williams and nguyen, 2005). they also adopted international standards of banking supervision and regulation to build a healthy financial environment such as laws regarding capital adequacy ratios, loan levels, and loan loss reserves (lindgren et al., 2000). 2.2 cross-country analysis of bank efficiency in lim and randhawa’ (2005) comparison of banking efficiency in hong kong and singapore, which was based on banks playing the two roles with equal importance. the study assessed the overall efficiency through the average efficiency values for the production and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 473 intermediation stages. according to the empirical results, banking efficiency value for singapore was higher in the production stage than that for hong kong. the main reason for this finding was that the hong kong monetary authority raised the interbank overnight rate (soaring to 300% on october 23, 1997) to prevent speculators from attacking the hong kong dollar, which in turn led to a rise in capital costs. the 1997 financial crisis also made deposits in hong kong banks very unstable and caused the deposit growth rate to decline. the banks competed with one another, and increased their capital costs to gain deposits. however, the interest rate in singapore was more stable than in hong kong. in this way, singapore maintained a stable efficiency value in the production stage. nevertheless, hong kong had a higher efficiency value in the intermediation stage mainly because singapore had tremendously high capital adequacy ratio, reserve ratio, minimum liquid asset (18% of gross debt), and minimum cash balance (3% of gross debt) requirements, in addition to conservative loan strategies. this economic scenario applies that, if the singaporean government wishes to improve the performance of the banks as intermediaries, they need to loosen their regulations and create a more competitive environment, providing banks with motivation for more investment and loan activities. sufian (2009) assessed the factors determining banking efficiency in thailand and malaysia via tobit regression analysis. in malaysia banking sector, the author finds that in the operating approach, the scale of deposits to be positively correlated with efficiency and that the higher the market share a bank has, the more efficient it is. meanwhile, the ratio of loans to total assets in the intermediary approach was found to be positively correlated with efficiency values. in contrast, the factor negatively correlated with efficiency is asset size, which means that the current asset size for banks in malaysia is not sufficient for cost minimization. notably, the ratio of loan loss reserves to total loans shows a positive correlation in the operating approach. this result can be explained by the skimping hypothesis of berger and deyoung (1997), which posits that an efficient bank usually tightens its costs in a short-term period to achieve long-term profits. this action will not only lower the costs of monitoring loans but also bring a high possibility of non-performing loans. therefore, more reserves for non-performing loans are required. the ratio of non-interest expenses to total assets is negatively correlated with efficiency values in the value-added and operating approaches, but positively correlated with efficiency values in the intermediary approach. this result shows that malaysia’s bank may need to input more non-interest expenses to be a highly efficient intermediary.1 in the thailand banking sector, the factor positively correlated with efficiency is the ratio of equity to assets, which shows significant positive correlation with all the approaches. therefore, the lower the leverage of the thailand’s bank, the more efficient it is. asset size has a significant positive relation to the value-added approach, which shows the existence of economy of scale. one factor that has a negative relationship with efficiency is the natural log of gdp in the value-added approach. this negative relationship may be due to the great 1 sathye (2001) claimed that high salaries and management expenses may lead to managers being more professional, thereby facilitating higher efficiency values. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 474 fluctuation in the gdp growth rate in thailand during the sample period, which resulted in less demand for financial services and caused the default rate for loans to increase.2 as for the relation between market concentration ratio and efficiency, berger and humphrey (1997) indicated that (through a consolidation of 130 earlier studies of banking efficiency) market concentration ratio may be either positively or negatively correlated with banking efficiency. a positive correlation may be due to two possible reasons. first, the higher the market share of a firm, the more market power it has to negotiate prices and gain more returns. second, in an efficient market structure, an efficient firm is able to produce outputs with low costs and thus gain higher returns. in contrast, the reason for a negative correlation is that the higher the market concentration ratio, the better a firm is able to negotiate prices. this allows big firms to lose their impetus for cost minimization and leads to rising costs and lower efficiency. this phenomenon is essentially the “quiet life hypothesis” proposed by hicks (1935). al-muharrami and matthews (2009) evaluated the performance of the arab gulf cooperation council (gcc) banking industry in the context of the market power hypotheses in the period of 1993 to 2002. the empirical results do not find any support for the hick’s “quit life” version of the market power hypothesis. instead, gcc banks behaviour are consistent with the tradition structure-conduct-performance (scp) hypothesis where market structure helps to explain performance. based on the above studies, we can conclude that the roa, asset size, loan loss reserves to total loans, non-interest expenses to total assets, equity to total assets, market concentration rate, and gdp growth rate have a significant effect on bank efficiency. however, do these factors have different effects on bank efficiency in the asian banking industry? what are their effects on the production and intermediation stages? the answers to the above questions can provide better insights for asian banks to enhance their efficiency and optimize their resource allocation. they can also be of future reference for other international banks when entering the asian market. 3. methodology and variable selection banking industries is one of the most complex financial services sector. a single-point evaluation cannot overall reflect the financial industries' multi-function ability (paradi et al., 2011). using dea approach to evaluate the operational efficiency of multiinput and multi-output can provide directions for improvement to inefficiency (zhu, 2000). additionally, sexton and lewis (2003) and abad et al. (2004) proposed that the superiority of two-stage dea that represent the real operational process of firm in different stage of efficiency. hence, this study followed the methodology used by denizer et al. (2000, 2007) to measure the efficiency of commercial banks in the production and intermediation stages in taiwan, china, hong kong, singapore, south korea, philippines, thailand and malaysia. 2 pasiouras (2008) measured the efficiency of 715 commercial banks in 2003 in 95 countries and found that gdp growth rates to be significantly negatively correlated with efficiency values in the intermediary approach. this explains how, although high gdp growth rates signify an increasing demand for banking services, banks may also face less pressure to control costs, leading to decreased efficiency. however, gdp and banking efficiency may also be positively correlated because a high gdp indicates that the country’s economic environment is relatively strong. in this situation, the banking sector will do well to develop business and lower operating costs. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 475 the ccr model proposed by charnes, cooper, and rhodes (1978), under the assumption of constant returns to scale (crs), measures the technical efficiency (te) value of decision-making units (dmus). the ccr dual model can be computed by min k θ －ε       +  = = +− m 1i 1 rkik ss s r (1) st. 0s x ikkij n 1j j ＝+− = ikxθλ , i＝1…,m rkrkrj n 1j j ysy ＝+ = −λ , r＝1…,s jλ , + rks , iks ≥ 0 , j＝1…,n where rjy is the rth output in the jth dmu, ijx is the ith input in the jth dmu, + rks is the slack variable of the rth output in the kth dmu, and iks is the slack variable of the ith input in the kth dmu. here, λ represents the weight of the linear combination of the reference set; ε is one minimal positive number called the non-archimedean small number; and θ is the relative technical efficiency. as for equation (1), the condition for a relatively efficient dmu is θ＝1 and is ＝ + rs ＝0. under these conditions, the dmu is on an efficient frontier. for inefficient dmus, the input and output for evaluation on the production frontier can be calculated as ij n 1j jx = λ and ij n 1j jy = λ , while the constraint of equation (1) indicates − = − ikikij n 1j j sx xθλ ＝ for input and + = + rkrkrj n 1j j syy＝λ for output. thus, an inefficient dmu can achieve optimal efficiency by reducing ikxδ input or increasing rkyδ output, where ikxδ ＝ ikx －（ −− ikik sxkθ ）, i＝1,…,m (2) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 476 rkyδ ＝（ ++ rkrk sy ）－ rky = + rks , r＝1,…,s (3) the traditional ccr model uses the crs assumption to measure the efficiency of dmus. however, not all dmus are under the operation of optimal scale, and operating inefficiency may be caused by the scale of dmus, not by technical inefficiency. due to this drawback, banker et al. (1984) has proposed a revised model (the bcc model) that changes the crs assumption to the variable returns to scale assumption. under the variable returns to scale assumption, the technical efficiency in crs (tecrs) is calculated as the product of pure technical efficiency (pte) and scale efficiency (se). thus, causes for technical inefficiency include pure technical inefficiency and inefficiency from dmus not operating in the optimal scale. tecrs＝tevrs×se, and tevrs＝pte (4) the present study measured banking technical efficiency via dea and analyzed the effect of the operating environment and the characteristics of banks on banking efficiency through the tobit regression model. tobit analysis is a limited dependent variable model. when the dependent variable to be analyzed is truncated or censored, the concept of ordinary least square is not appropriate to calculate the regression coefficient. under this condition, the tobit model, which follows the idea of maximum likelihood estimation, is the more appropriate tool to estimate the regression coefficient. the general formula for the tobit model is as follows: (5) where is the variable matrix of the ith independent variable for the sample bank j, and is the sample dependent variable to describe the ith dependent variable of the sample bank j. is the residual value from the regression. in the tobit regression model, each bank’s technical efficiency is applied as a dependent variable. the efficiency value is a constant between 0 and 1. when the efficiency value is equal to 1, the bank is relatively efficient compared to other banks. this study examines commercial banks in asian banking sector from 2004 to 2008, including 29 banks in china, 19 in hong kong, 14 in south korea, 19 in malaysia, 10 in the philippines, 14 in thailand, 28 in taiwan, and 4 in singapore. the bank’s financial statements were obtained from the bankscope database; banks without complete required information were not included, thus yielding the final sample of 137 banks in this study. denizer et al. (2007) suggested that using the ratio of interest costs and interest incomes instead of the ratio of costs for deposits and loans in each stage. the weight is defined such that interest income per unit represents one unit of transaction in the intermediation stage. moreover, one unit of interest cost equals the transaction per unit in the production stage. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 477 therefore, the measure of the weight in the production stage is given as: weight = interest costs / (interest costs ＋ interest incomes). the weight in the intermediation stage is calculated as: weight = interest incomes / (interest costs ＋ interest incomes). the definitions of input and output variables in the two stages are as follows: the input variables in the production stage are (1) total resources owned by the bank (including physical and financial capital) × the weight in the production stage = (fixed assets + equity capital) × [interest costs / (interest costs + interest incomes)]; (2) non-interest operating expenses × the weight in the production stage; and (3) interest costs. the output variables in the production stage are (1) non-interest incomes and (2) total deposits. the input variables in the intermediation stage are (1) total resources owned by the bank (including physical and financial capital) × the weight in the intermediary stage = (fixed assets + equity capital) × [interest incomes / (interest costs + interest incomes)]; (2) non-interest operating expenses × the weight in the intermediation stage; and (3) total deposits. the output variables in the intermediation stage are (1) total loans and (2) banking service incomes (including interest, commission, and fees). the factors that affect banking efficiency in the tobit regression model are the following: roa (return on assets) is defined as pre-tax net profit / total assets and is used to evaluate the effect of profitability on efficiency; lnta (the natural log of total assets) evaluates the effect of a bank’s scale on efficiency; llp/loan (loan loss reserves / loans) measures the effect of a bank’s loan quality on efficiency [llp/loan is classified as a factor affecting bank efficiency in the intermediation stage only]; nie/ta (non-interest expenses / total assets) evaluates the effect of operating costs on efficiency. e/ta (shareholders equity / total assets) measures the effect of leverage on efficiency; gdp growth rate: evaluates the effect of economic conditions on bank efficiency. the data for this variable come from the world bank database; mcc (market concentration ratio): the total assets of the top three banks in a country divided by the total assets in the country’s banking sector (beck et al., 2006). 4. empirical results 4.1 operational efficiency in asian banking as seen from table 1, the average technical efficiency over five years in the production stage is 0.6940 in china, 0.7649 in taiwan, 0.8007 in south korea, 0.5170 in hong kong, 0.6589 in thailand, 0.7516 in malaysia, 0.7813 in the philippines and 0.8907 in singapore. on the other hand, the average technical efficiency over five years in the intermediation stage is 0.8284 in china, 0.8846 in taiwan, 0.7036 in south korea, 0.7841 in hong kong, 0.6429 in thailand, 0.7792 in malaysia, 0.8362 in the philippines and 0.8458 in singapore. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 478 table 1. efficiency value of two-stages banking model country year production stage intermediation stage te pte se te pte se china 2008 2007 2006 2005 2004 04~08 0.6500 0.6952 0.6890 0.7072 0.7288 0.6940 0.7300 0.7653 0.7684 0.7800 0.7921 0.7672 0.8963 0.9138 0.8963 0.9066 0.9164 0.9059 0.8347 0.8286 0.8410 0.8249 0.8130 0.8284 0.8960 0.8889 0.8877 0.8708 0.8819 0.8850 0.9339 0.9352 0.9496 0.9501 0.9255 0.9389 taiwan 2008 2007 2006 2005 2004 04~08 0.6953 0.6870 0.7458 0.8218 0.8747 0.7649 0.7443 0.7298 0.7932 0.8790 0.9436 0.8180 0.9266 0.93883 0.9430 0.9364 0.9211 0.9331 0.8931 0.9020 0.8959 0.8783 0.8538 0.8846 0.9229 0.9372 0.9307 0.9041 0.8848 0.9159 0.9682 0.9637 0.9637 0.9724 0.9678 0.9671 south korea 2008 0.7990 0.8388 0.9572 0.8039 0.8786 0.9174 2007 2006 2005 2004 04~08 0.7591 0.7627 0.8200 0.8629 0.8007 0.7961 0.8055 0.8721 0.9194 0.8464 0.9590 0.9274 0.9199 0.9267 0.9381 0.7353 0.6830 0.6206 0.6753 0.7036 0.8154 0.7498 0.7051 0.7585 0.7815 0.9112 0.9220 0.8965 0.9025 0.9099 hong kong 2008 2007 2006 2005 2004 04~08 0.5167 0.4824 0.4147 0.4541 0.7172 0.5170 0.5623 0.5353 0.4737 0.5074 0.7904 0.5738 0.9454 0.9227 0.9001 0.9206 0.9186 0.9215 0.7639 0.8941 0.8659 0.7371 0.6598 0.7841 0.8816 0.9706 0.9557 0.8822 0.8743 0.9218 0.9084 0.8475 0.8042 0.8359 0.8989 0.8776 thailand 2008 2007 2006 2005 2004 04~08 0.613 0.508 0.542 0.812 0.819 0.659 0.7023 0.5705 0.6232 0.8539 0.8924 0.7285 0.8882 0.9007 0.8890 0.9429 0.9115 0.9065 0.6437 0.6902 0.7321 0.5867 0.5620 0.6429 0.8232 0.7946 0.8796 0.7909 0.9143 0.8042 0.7302 0.8153 0.7173 0.8064 0.8129 0.8023 malaysia 2008 0.7495 0.8018 0.9380 0.8236 0.9067 0.9072 2007 0.7359 0.7945 0.9246 0.8166 0.9179 0.8913 2006 0.7556 0.8245 0.9177 0.7767 0.8839 0.8849 2005 0.7297 0.7851 0.9218 0.7450 0.8890 0.8439 2004 0.7871 0.8392 0.9251 0.7340 0.8908 0.8270 04~08 0.7516 0.8090 0.9254 0.7792 0.8976 0.8709 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 479 philippines 2008 0.8710 0.9330 0.9301 0.8585 0.9488 0.9035 2007 0.8447 0.9171 0.9165 0.7963 0.9269 0.8601 2006 0.8265 0.9014 0.9131 0.7961 0.9007 0.8890 2005 0.6904 0.8264 0.8350 0.8637 0.9645 0.8947 2004 0.6739 0.8115 0.8357 0.8666 0.9230 0.9371 04~08 0.7813 0.8778 0.8861 0.8362 0.9328 0.8969 singapore 2008 0.9116 0.9809 0.9295 0.8415 0.9347 0.8768 2007 0.7995 0.8927 0.9030 0.8761 0.9691 0.8948 2006 0.8584 0.8969 0.9529 0.9054 1.0000 0.9054 2005 0.8889 0.9470 0.9377 0.8431 0.9500 0.8866 2004 0.9951 1.0000 0.9951 0.7630 0.8427 0.9047 04~08 0.8907 0.9435 0.9437 0.8458 0.9393 0.8937 note: the te、pte and se efficiency value are bounded between 0 and 1. using the wilcoxon signed-rank test, table 2 shows that the country wherein te in the production stage is significantly higher than that in the intermediation stage is south korea. in contrast, the countries wherein the te in the intermediation stage is significantly higher than that in the production stage are china, hong kong, and taiwan. table 2. the wilcoxon signed-rank test of difference on te between the production and intermediation stage country z statistic p value (two-tailed) negative or positive for the rating basis china -5.96 0.00* － hong kong -6.90 0.00* － singapore -0.62 0.53* ＋ south korea -3.17 0.00* ＋ malaysia -1.50 0.13* ＋ philippines -1.32 0.18* － thailand -0.45 0.64* ＋ taiwan -6.42 0.00* － note: * indicates significant at 5% level. low technical efficiency may be caused by an unsuitable operational scale; however, management cannot control this problem in the short term. this kind of inefficiency requires scale adjustment in the long run. in contrast, pure technical inefficiency is under the control of managers and needs to be improved immediately. thus, pure technical inefficiency is seperated from technical efficiency to disclose how much of technical inefficiency is come from pure technical inefficiency. this information can provide managers with a reference for improving their operational decisions and resources allocation. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 480 by comparing pte and se, on average, we can see that technical inefficiency in the production stage in all the countries is caused by pure technical inefficiency. in the intermediation stage, the technical inefficiencies in china, taiwan, and south korea are mainly caused by pure technical inefficiency, whereas in hong kong, malaysia, thailand, singapore and the philippines, it is caused by scale inefficiency. when technical inefficiency is caused by low pure technical inefficiency, the banks should strive to improve management skills and resource allocations to enhance their efficiency. if scale inefficiency is the main reason for technical inefficiency, banks should examine whether they are currently operating on an increasing or decreasing returns to scale. if they are in the stage of increasing returns to scale, these banks should increase inputs/outputs to enlarge their scale. in contrast, if they are operate at decreasing returns to scale, the banks should decrease inputs/outputs to the point of crs as their optimal operating scale. 4.2 factors affecting asian banking efficiency the present study uses te as the dependent variable in the production and intermediation stages and economic environments and the banks’ characters as explanatory variables to examine the factors affecting asian banking efficiency through tobit regression analysis. base on table 3, the factors that affect banking efficiency in each stage are the following: roa shows a positive relationship with efficiency values in hong kong, malaysia, the philippines and taiwan in the production stage; and in both the production and intermediation stages in thailand. this result indicates that the higher the ability banks can generate profit from assets, the higher their efficiency. in the production stage, concerning the impact of bank size, lnta has positive effect on efficiency values in china, south korea, the philippines and taiwan banks. the finding is consistent with the study of chen and yang (2011) on chinese and taiwan banks. the authors demonstrate that scale efficiency change is the key factor to inducing the productivity growth for the banks of china and taiwan. in the intermediation stage, lnta has positive effect on efficiency values in south korea banks; however, it is negatively related to the efficiency values in the philippines and thailand banks. for the banks in the philippines, lnta has positive effect on efficiency values in the production stage, but is negatively effect bank efficiency in the intermediation stage. this result shows that the banks in the philippines need to rearrange their assets allocation between two stages. in the intermediation stage, the llp/tl ratio is positively related to the efficiency values in hong kong and thailand banks. this result confirms that berger and deyoung’s skimping hypothesis exist in hong kong and thailand banks. in the production stage, nie/ta is positively related to bank efficiency values in the philippines, but is negatively related in china and malaysia. in the intermediation stage, the variable is positively related to the bank efficiency values in singapore, but is negatively related to bank efficiency values in the philippines and thailand. the findings that nie/ta is negatively related to efficiency value suggest that those banks need to increase non-interest operating costs (i.e., management expenses) to enhance their technical efficiency. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 481 e/ta being negatively related to efficiency means that the more the leverage a bank has, the lower the efficiency and vice versa. in the production stage, e/ta is positively related to bank efficiency values in china, but is negatively related in malaysia, singapore, thailand, and taiwan. in the intermediation stage, e/ta is positively related to bank efficiency values in hong kong and the philippines, but is negatively related in singapore and thailand. mcc represents the relation between market structure and efficiency. in the production stage, mcc is positively related to bank efficiency values in hong kong, the philippines, singapore and thailand, whereas it is negatively related in south korea and taiwan. in the intermediation stage, the variable is positively related to efficiency values in south korea and taiwan, but is negatively related in singapore and thailand. the coefficient of mcc has completely different results in the two stages in singapore, thailand, south korea and taiwan, indicating that the banks in singapore and thailand overlook their operating efficiency in the intermediation stage, and banks in south korea and taiwan need to increase (reduce) consolidation in the intermediation (production) stage to improve efficiency. table 3. tobit regression analysis for asian banks in production and intermediation stages dependent: te production stage intermediation stage china coefficient t-statistic p>|t| coefficient t-statistic p>|t| roa(pretax) -0.0482*** -1.50 0.14 -0.0274*** -0.95 0.35 lnta 0.0245*** 2.58 0.01 0.0008*** 0.10 0.92 llp/tl 0.0277*** 1.36 0.18 nie/ta -0.3206*** -5.48 0.00 0.0614*** 1.24 0.22 e/ta 0.0069*** 2.47 0.02 0.0015*** 0.59 0.56 gdp growth 0.0140*** 1.19 0.24 0.0017*** 0.16 0.87 mcc 0.0282*** 1.65 0.10 -0.0067*** -0.46 0.65 intercept -1.6031*** -1.12 0.26 1.1993*** 0.97 0.33 hong kong roa(pretax) 0.1493*** 4.94 0.00 0.0149*** 0.55 0.59 lnta 0.0167*** 0.88 0.38 -0.0089*** -0.47 0.64 llp/tl 0.1360*** 1.71 0.09 nie/ta 0.0392*** 0.96 0.34 -0.0181*** -0.42 0.68 e/ta 0.0066*** 0.85 0.40 0.0153*** 2.02 0.05 gdp growth -0.0227*** -1.74 0.09 0.0428*** 3.13 0.00 mcc 0.5519*** 2.04 0.05 0.2225*** 0.82 0.42 intercept -39.5322** -2.03 0.05 -15.4345** -0.79 0.43 south korea roa(pretax) 0.0749 0.95 0.35 -0.0240*** -0.44 0.66 lnta 0.0121 0.58 0.56 0.0363*** 2.74 0.01 llp/tl -0.0242*** -0.65 0.52 nie/ta 0.0504 1.37 0.17 0.0089*** 0.71 0.48 e/ta 0.0168 0.50 0.62 -0.0899*** -4.31 0.00 gdp growth 0.0197 1.05 0.30 -0.0076*** -0.60 0.55 mcc -0.0167* -1.91 0.06 0.0217*** 3.64 0.00 intercept 0.9739 1.56 0.13 -0.6684*** -1.77 0.08 malaysia coefficient t-statistic p>|t| coefficient t-statistic p>|t| roa(pretax) 0.1032*** 4.49 0.00 0.0441*** 1.21 0.23 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 482 lnta 0.0221*** 0.98 0.33 0.0230*** 0.88 0.38 llp/tl 0.0261*** 1.21 0.23 nie/ta -0.1338*** -2.74 0.01 0.0104*** 0.21 0.83 e/ta -0.0089*** -2.64 0.01 -0.0010*** -0.23 0.82 gdp growth 0.0080*** 0.87 0.39 -0.0033*** -0.34 0.74 mcc -0.0074*** -1.43 0.16 0.0078*** 1.43 0.16 intercept 0.7609*** 1.85 0.07 0.0169*** 0.03 0.97 philippines roa(pretax) 0.0883*** 3.23 0.00 -0.0195*** -0.66 0.52 lnta 0.1435*** 5.70 0.00 -0.1430*** -6.48 0.00 llp/tl -0.0167*** -0.83 0.41 nie/ta 0.1379*** 3.24 0.00 -0.1411*** -3.52 0.00 e/ta 0.0043*** 0.80 0.43 0.0151*** 2.59 0.01 gdp growth -0.0389*** -1.58 0.12 0.0076*** 0.34 0.73 mcc 0.0090*** 3.51 0.00 0.0030*** 1.22 0.23 intercept -2.4247*** -3.47 0.00 3.5976*** 5.74 0.00 singapore roa(pretax) 0.0687*** 2.10 0.06 -0.0144*** -0.30 0.77 lnta -0.0287*** -1.49 0.16 0.0074*** 0.31 0.77 llp/tl -0.0626*** -0.98 0.36 nie/ta 0.1559*** 1.60 0.13 0.3825*** 4.22 0.00 e/ta -0.0191*** -2.24 0.04 -0.0396** -2.76 0.03 gdp growth 0.0101*** 1.17 0.26 -0.0182*** -4.24 0.00 mcc 0.0242*** 3.01 0.01 -0.0193*** -4.63 0.00 intercept -0.9020*** -1.14 0.28 2.8610*** 3.53 0.01 thailand roa(pretax) 0.0527*** 2.37 0.02 0.0456*** 2.95 0.01 lnta -0.0156*** -0.55 0.59 -0.0774*** -4.37 0.00 llp/tl 0.0312*** 2.19 0.03 nie/ta -0.0316*** -0.83 0.41 -0.1249*** -5.52 0.00 e/ta -0.0195*** -3.36 0.00 -0.0256*** -5.02 0.00 gdp growth 0.0250*** 1.36 0.18 -0.0031*** -0.28 0.78 mcc 0.0631*** 2.82 0.01 -0.0298*** -2.17 0.03 intercept -1.9853*** -1.56 0.12 4.0275*** 4.98 0.00 taiwan roa(pretax) 0.0544*** 6.24 0.00 -0.0085*** -1.11 0.27 lnta 0.0498*** 3.43 0.00 -0.0018*** -0.23 0.82 llp/tl -0.0023*** -0.44 0.66 nie/ta 0.0162*** 0.91 0.36 -0.0101*** -1.05 0.30 e/ta -0.0069*** -5.07 0.00 -0.0006*** -0.49 0.63 gdp growth -0.0057*** -1.03 0.31 0.0019*** 0.64 0.52 mcc -0.0450*** -4.52 0.00 0.0097*** 1.73 0.09 intercept 1.0612*** 2.70 0.01 0.6714*** 3.12 0.00 note: * indicates significant at 10% level,
 ** indicates significant at 5% level, *** indicates significant at 1% level. in the production stage, the gdp growth rate is negatively related to efficiency values in hong kong. in the intermediation stage, the variable is positively related to efficiency values asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 483 in hong kong, but is negatively related in singapore. the negative relationship of gdp growth rate with efficiency values in the production stage in hong kong may be the consequence of funds moving toward real estate and stocks during the sample period combined with relatively fewer deposit incentives. between 1999 and 2003, the average m1/m2 in hong kong was 7.97%; however, from 2004 to 2008, it became 10.34%, which means that funds were gradually being withdrawn from bank deposits. although gdp growth rates increased, the ability of banks to draw deposits decreased, thereby lowering the efficiency values in the production stage. this variable is negatively related to efficiency values in singapore banks in the intermediation stage. although the banks in singapore enjoy high gdp growth rates,3they may face less pressure to control their operation costs, leading to dropping of efficiency values (pasiouras,2008). 5. conclusion nearly all extant banking efficiency studies are limited to the use of either intermediary or production approaches to examine the performance of the banking industry. using only one approach, however, cannot provide a comprehensive evaluation of banking efficiency. in practice, a bank has to consider the mutual effects of the two aspects. this study find that south korea has a higher te in the production stage than in the intermediation stage from 2004 to 2008, whereas china, hong kong, and taiwan have higher te in the intermediation stage. banks with a significantly higher te in the production (intermediation) stage than in the intermediation (production) stage demonstrate strengths in production (intermediary) capability. therefore, when local banks in south korea facing foreign competition, they could to take advantage of their strength in the production stage to overcome the challenge. similarly, local banks in china, hong kong, taiwan need to exploit their advantages as intermediary to compete with foreign banks. additionally, most asian banks need to enhance their management skills in production stage in order to generate higher production efficiency. banks in china, taiwan and south korean have to strength their management abilities as an intermediary to enhance operating efficiency. however, banks in hong kong, malaysia, thailand, singapore and the philippines could increase the scale of banks to improve operating efficiency in intermediation stage. by looking at the factors that affect te, the banks in the philippines could transfer some management resources from the intermediation stage to the production stage toward obtaining a higher efficiency. banks in hong kong and thailand, in the meantime, should ensure the quality of loans in the future. if banks in china wish to improve te in the production stage, they need to lower their operating costs and debt ratios. banks in south korean and taiwan, in contrast, can improve efficiency in the intermediation stage through bank consolidation. moreover, particularly noteworthy is the fact that banks in singapore and thailand seem to have a “quiet life” attitude, in which they should pay more attention to operating costs in the intermediation stage. 3 the gdp growth rates of singapore from 2004 to 2008 were 14.15%, 8.6%, 9.85%, 13.78%, and 2.31%, respectively. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 484 references abad, c., s.a. thore, & j. laffarge. 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(2000). multi-factor performance measure model with an application to fortune 500 companies. european journal of operational research, 123(1), 105-124. http://dx.doi.org/10.1016/s0377-2217(99)00096-x microsoft word 4328-16005-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 256 market reaction to bonus announcement in post global financial crisis era: evidence from india mayank joshipura mayank joshipura is professor (finance) at school of business management nmims university, mumbai, india nusrathunnisa school of business, alliance university, bangalore, india received: sep. 26, 2013 accepted: november 18, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4328 url: http://dx.doi.org/10.5296/ajfa.v5i2.4328 abstract this study examines the stock price reaction contiguous with bonus announcement surrounding its announcement and effective day in post global financial crisis period. sample of 74 bonus announcements from the constituents of indian cnx 500 companies that announced bonus have been used for the period between 2008 through 2012. the standard event study methodology has been used. according to semi-strong form of efficient market hypothesis any information content associated with bonus announcement must be reflected in form of abnormal return on announcement day itself. however, several studies, report positive abnormal returns associated with bonus surrounding announcement as well as effective days. this study reports statistically significant positive abnormal return surrounding announcement as well as effective day and it is consistent with earlier studies. keywords: bonus announcement, market efficiency, event study, stock dividend, market reaction jel classification: g14 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 257 1. introduction the relationship between bonus issues and stock prices has been the subject of empirical discussion in finance literature. under the bonus issue, new shares are issued free of cost to the existing investors by capitalising the reserves, accumulated profits or retained earnings. bonus issue of 1:1 by a company leads to doubling of number of shares and share capital without changing face value of a share. according to semi-strong form of efficient market hypothesis, if there is any information content associated with bonus announcement it should get reflected on announcement day itself in form of abnormal returns. no abnormal returns should be present on or around ex-date because, the ex-date of bonus issue is known in advance and therefore should not contain any new information. however, several studies, both in developed and developing markets, report significant positive abnormal returns on and surrounding announcement and effective days. there are several hypotheses put forward to explain such effect. however, global financial crisis hit the world economy badly and the entire world is still to find “new normal”. in that context is it important to study that whether global financial crisis really altered market reaction to bonus announcement in any manner. the firms announcing stock dividend in tight liquidity markets like the ones seen post global financial crisis may be perceived as looking at growth opportunities for themselves at times where others were struggling to keep their head out of water and finding it hard even to utilize existing capacity. bonus announcement may well be seen as a signal of the firm’s confidence in ability to exploit growth opportunities in difficult times considering the fact that many firms used their reserves to keep paying cash dividends in times when profits were not enough and in many cases were not existent. announcing stock dividend definitely reduces firm’s ability to deep into its reserve to pay cash dividend in difficult times and therefore such announcement in difficult times may certainly speak for itself and firm’s confidence about its future. however, it may turn out to be a double edged sword if things don’t go as per plan. the current study examines the stock price reaction contiguous with bonus announcement surrounding its announcement and effective day in post global financial crisis period to see how market looks at such action by a firm and adds new findings to the existing literature by examining whether indian stock market is semistrong efficient or not. the study attempts to answer this empirical question of informational content of stock dividend announcements using standard event analysis methodology. the paper from hereon is divided into following sections. section ii discusses review of literature, section iii elaborates on methodology, section iv focuses and discussion of results and section v is conclusion. 2. review of literature numerous empirical studies have found that announcement of bonus issues / stock splits are associated with significant stock price reactions upon announcement. many exigent hypotheses have been proposed in the literature to explain this market behaviour. signaling hypothesis and liquidity hypothesis have emerged as the two leading explanations for this market behaviour. ball, brown and finn (1977) investigated stock price reaction around the announcement of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 258 ‘stock capitalisation changes’ (bonus stock issues, stock splits and rights issues) in australia for the period between 1960 and 1969 inclusive using monthly data and found 20.2% abnormal return for 13 months up to including the month of bonus issue announcements. foster and vickrey (1978) examined daily returns around announcement and determined whether stock dividend announcements cause investors to change their expectations concerning future firm prospects. in their examination of the information content for 82 stock dividend announcements, they found significant positive abnormal returns around announcement dates. woolridge (1983) examines the daily returns around 317 stock dividend announcements controlled for earnings announcements and cash dividend payments and found that stock dividend announcements are interpreted by investors as positive signals from managers about the future business operations. grinblatt, masulis and titman (1984) examined stock splits and stock dividends under the traditional signaling model and suggested that it can be considered as a costly signal. in case of stock dividends, the reduction in retained earnings will restrict the firm’s stability to pay cash dividends if the firm does not anticipate increased earnings. doran and nachtmann (1988) using a sample of 879 firms which issued stock dividends between 1971 and 1982 reports that bonus announcements led to upward revision of earnings expectations that is similar to attention getting hypothesis. ghosh and woolridge (1988); banker, das, and datar (1993) investigate the cash substitution hypothesis and find negative stock price reaction to dividends cuts and omissions could be offset by an announcement of stock dividend as a substitute. lijleblom (1989) examines the signaling hypothesis of stock dividend and stock splits for stocks listed on the stockholm stock exchange (sse).the problem of simultaneous announcements of other information is present in 90% of the cases at (sse).the contaminating effects of earnings and dividend announcements are controlled by using a control group of otherwise similar stocks but which do not split or distribute a stock dividend. they find significantly high price reactions for the stock dividend/split group than the control group which is interpreted as support for the signaling hypothesis in the presence of contaminating announcements. mcnichols and dravid (1990) provide further evidence to support the signaling hypothesis and reported positively significant abnormal returns on the day of stock dividend announcement. further they find that both small stock dividend factor sample (less than 10%) and large stock dividend factor sample show statistically significant abnormal returns on the announcement day. masse et al. (1997) examined the announcement day impact of stock splits, reverse splits and stock dividends of toronto stock exchange from 1975–94. abnormal returns are derived using the mean adjusted returns model, the market adjusted returns model and the simple ordinary least square market model. for the stock dividends, abnormal returns are positive from day 0 to day 2 and on day 0 and day 1 average abnormal return are statistically significant at 1% level. in a nutshell, there are several hypotheses put forward to explain the positive abnormal returns associated with bonus announcements. mohanty (1999) found that firms which issued bonus shares, have either maintained the payout at the pre-bonus level or only decreased it marginally thereby increasing the payout to shareholders. papaioannou et al. (2000) found no significant abnormal returns on and around announcement period as in greece it is compulsory requirements imposed upon firms to satisfy the legal requirements a however their research environment is quite different from other markets, stock dividends in greece are not initiated by firms but they are compulsory requirements imposed upon firms to satisfy legal requirements and any stock dividend announcement should get the approval asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 259 from the shareholders along with the terms of the distribution. balachandran et al. (2004) observed positive and statistically significant abnormal returns for the announcement day to the following day and found that abnormal returns or contaminated events outperform the uncontaminated events on day 0. however difference of abnormal returns is not statistically significant. given below is a summary of main hypothesis floated around to explain market reaction to bonus announcement. signaling hypothesis (grinblatt et al. (1984); mcnichols & dravid (1990); masse et al. (1997)) that suggests that ‘the bonus announcement conveys new information to the market in instances where managers have asymmetric information’. cash substitution hypothesis: while signaling hypothesis received massive support, (ghosh & woolridge (1988); banker, das, and datar (1993) float cash substitution hypothesis which suggests that the firm can conserve cash by issuing bonus as a substitute of cash dividend without facing adverse reaction from market due to lowering or omitting cash dividend. attention getting hypothesis: grinblatt et al. (1984); doran and nachtmann (1988) attribute positive abnormal returns associated with announcement of bonus to attention getting hypothesis suggesting that bonus announcement draws market attention and further leads to demand for the stock of the firm announcing stock dividend. liquidity hypothesis: lakonishok and lev (1987) investigate that stock dividend announcements intends to improve liquidity by creating additional stocks and that should lead to more trading and greater ownership dispersion in a firm. studies on bonus announcements in indian markets offer interesting findings. obaidullah (1992) reports positive wealth effect associated with bonus issue. he also finds evidence for semi-strong form of emh for indian markets. rao (1994) reports significant positive price effect just after announcement and finds evidence of semi strong form of market efficiency in indian markets. mishra (2005) reports positive abnormal return on and around announcement day associated with bonus announcement but does not find any significant abnormal return on effective day. he reports -0.10% return on effective day which also provides significant support to singling hypothesis and evidence of semi strong form of market efficiency from indian markets. joshipura (2009) also reports positive abnormal returns on and around announcement of bonus and nothing around ex-date. he further reports negative abnormal returns in relatively longer post effective day window. ray (2011) reports no price effect associated with bonus announcements on or around announcement or ex-date. 3. methodology a. sample & data source the study constituted 74 bonus issues by constituent companies listed on cnx nifty 500 from the period 2008 to 2012. bonus announcement information is collected from the capitaline database. adjusted daily closing price data for each company over the period of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 260 130 trading days before to and 10 trading days after the ex-date are used for the study. b. measuring price effect the approach used to achieve above-mentioned objective is known as “event study” which is a standard approach in the area of financial economics ever since it has been published by fama et al (1969). an event study is designed to examine market reaction of any event under observation using abnormal return criteria. for this study, we have divided data into various windows. choice of length for event and estimation windows has remained as contentious issue among scholars over the years. windows for the present study are defined as given below. event windows: ad-10 to ad+10 and ed-10 to ed+10: event window ad-10 to ad+10 is used to check any leakage prior to formal announcement of index changes. absence of abnormal return on the announcement and not before or after that can be interpreted as evidence for semi-strong form of emh if there is any information content associated with such announcement. ed-10 to ed+10 days is used as effective window. ideally, no abnormal return should be present on or around ex-date but presence of any such return may be evidence against semi-strong form of emh or requires logical explanation it is not the case. the first step in this process of determining price or wealth effect is to calculate abnormal return. to perform the analysis, first the equilibrium model for the normal stock return, that is the expected return if the event did not happen, must be specified. second, we need to identify the event date and the event window that is the period over which the security returns will be examined. the model is estimated outside this window, by choosing period of ad-30 to ad-130 days which is the standard practice in most such studies. the forecast errors over the event window measure the abnormal performance of returns associated with the event. the normal model most widely used in the event-studies is the market model which can be expressed as (1) where, ri,t is the return on security i on day t rm,t is the return on a market index on day t α i is market model constant βi is a parameter that measures the sensitivity of ri to the benchmark market index ξi,t is a random error term of market model ols regression with expected value of zero. the event dates are the announcement date (ad), the day when bonus is announced and effective day (ed), the day on which stock goes ex-bonus. market model is estimated using r ri t i i m t i t, , ,= + +α β ξ 2 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 261 estimation window and abnormal returns for every day during event windows are calculated as below. (2) in order to draw overall inferences for the event of interest, the abnormal return observations measured across securities. the following measures of abnormal performance are used: • cumulative abnormal return (car): cumulative sum of stock it’s prediction error (abnormal returns) over the window (t1, t2) = 2 1 ,, t t titi arcar (3) • mean abnormal return (mar): an average of abnormal returns across the n firms on a day t.  = = n i tit ar n mar 1 , 1 (4) • mean cumulative abnormal return (mcar): average of the cumulative abnormal returns across observations (firms); it is a measure of the abnormal performance over the event period, (5) c. testing for statistical significance the cross-sectional t-test using cross-sectional variance is performed for both mar and car. the sample equation for calculation of cross sectional variance for mar is given below. (6) a nonparametric generalized sign test based on sign of abnormal return is also employed. the hypothesis is abnormal returns are independent across securities and that the expected proportion of positive abnormal returns under the null hypothesis is 0.5. the test statistic is computed as where n is the sample size and n+ is the number of cases where the abnormal return is positive. this test is conducted to add robustness of the study. ar r ri t i t i i m t, , ,= − −α β mcar n cart i t i n = =  1 1 , s n ar mar n it t i n 2 2 1 1 1 = − −=  ( ) θ = − + [ . ] . ~ ( , ) n n n n0 5 0 5 0 1 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 262 4. results and discussion table 1. mean abnormal returns within announcement window days t-stat mar positive (out of 74) z-score ad -10 0.31 0.04% 35 -0.46 ad -9 2.73 0.32% 39 0.46 ad -8 1.67 0.19% 40 0.7 ad -7 0.76 0.09% 33 -0.93 ad -6 1 0.12% 37 0 ad -5 -0.36 -0.04% 34 -0.7 ad -4 0.43 0.05% 42 1.16 ad -3 2.77 0.32% 41 0.93 ad -2 2.12 0.25% 44 1.63 ad -1 2.16 0.25% 46 2.09 ad 4.34 0.50% 50 3.02 ad +1 0.81 0.09% 35 -0.46 ad +2 -2.98 -0.35% 27 -2.32 ad +3 0.53 0.06% 36 -0.23 ad +4 -0.26 -0.03% 35 -0.46 ad +5 -0.96 -0.11% 28 -2.09 ad +6 -0.07 -0.01% 39 0.46 ad +7 -1.57 -0.18% 33 -0.93 ad +8 -0.6 -0.07% 37 0 ad +9 -0.62 -0.07% 35 -0.46 ad +10 -0.11 -0.01% 35 -0.46 table 1 reports the mean abnormal returns (mar) during the announcement window. it is interesting to notice that the mar is positive and statistically significant with value of 0.32% on ad-3. however, only 41 out of 71 firms have positive abnormal returns for ad-3 and it is not significant on non-parametric sign test. . ad-2 is the day when market gets the sniff of bonus announcements and statistically significant positive abnormal return of 0.25% with. positive abnormal returns for 44 out of 74 firms that is statistically significant on sign test as well. abnormal returns becoming more and more significant with higher values and more number of firms are observed with positive abnormal returns. 0.25% of mar is observed on ad-1 with 46 out of 74 firms with positive abnormal returns. presence of positive abnormal returns just prior to announcement day is probably indicating some leakage of information or some early signals for market participants on potential bonus announcement. however, the largest mar of 0.5% is observed on the announcement day with 50 out of 74 firms having positive abnormal return and that is highly significant t and z value however, significant positive mar is not seen anywhere in the remaining length of announcement window (ad+1 to ad+10). in fact, statically significant negative mar of 0.35% is observed and that is significant with 47 out of 74 firms with negative abnormal returns. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 263 table 2. mean cumulative abnormal returns within announcement window days t-stat mcar positive (out of 74) z-score ad -10 0.38 0.04% 35 -0.46 ad -9 2.05 0.35% 40 0.7 ad -8 2.39 0.55% 41 0.93 ad -7 2.41 0.64% 41 0.93 ad -6 2.65 0.75% 42 1.16 ad -5 2.42 0.71% 37 0 ad -4 2.44 0.76% 39 0.46 ad -3 3.02 1.08% 45 1.86 ad -2 3.5 1.33% 47 2.32 ad -1 4.03 1.58% 50 3.02 ad 5.08 2.08% 54 3.95 ad +1 4.79 2.18% 55 4.18 ad +2 3.87 1.83% 50 3.02 ad +3 4.06 1.89% 47 2.32 ad +4 3.82 1.86% 46 2.09 ad +5 3.65 1.75% 46 2.09 ad +6 3.65 1.74% 48 2.56 ad +7 3.29 1.56% 48 2.56 ad +8 3.13 1.49% 46 2.09 ad +9 2.98 1.42% 46 2.09 ad +10 2.99 1.41% 44 1.63 table 2 reports mean cumulative abnormal return (mcar) within the announcement window. mcar also shows similar trend to mar values and is significant both with t and z statistics from ad-2 and reaches its pick on ad+1 with mcar of 2.18% with 55 out of 74 firms reporting positive mcar and that is highly significant both using parametric t-test and non-parametric sign test. while mcar remains statistically significant for the remaining length of announcement window post announcement day (ad+1 to ad+10), it fizzles out at a steady pace with mcar of 1.41% on ad+10 and only 44 out of 74 firms with positive mcar value compared to 2.18% mcar with 55 firms with positive mcar value on ad+1. this indicates that bonus announcement shows positive market reaction in anticipation of such announcement before one or two days of such announcement with significant positive response on the bonus announcement day itself-the way it should be if markets are efficient in its semi strong form and bonus announcement is perceived as a positive information about the stock. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 264 table 3. mean abnormal returns within effective window days t-stat mar positive (out of 74) z-score ed -10 -0.68 -0.08% 34 -0.59 ed -9 -1.92 -0.22% 27 -2.22 ed -8 1.59 0.19% 40 0.82 ed -7 0.99 0.12% 39 0.59 ed -6 2.74 0.32% 45 1.99 ed -5 2.54 0.30% 46 2.22 ed -4 2.01 0.24% 43 1.52 ed -3 0.59 0.07% 41 1.05 ed -2 -0.22 -0.03% 35 -0.35 ed -1 0.35 0.04% 34 -0.59 ed 4.95 0.58% 46 2.22 ed +1 0.1 0.01% 30 -1.52 ed +2 -2.79 -0.33% 22 -3.39 ed +3 -1.29 -0.15% 27 -2.22 ed +4 -1.89 -0.22% 24 -2.93 ed +5 -0.14 -0.02% 31 -1.29 ed +6 -3.74 -0.44% 24 -2.93 ed +7 -1.95 -0.23% 29 -1.76 ed +8 -2.95 -0.35% 23 -3.16 ed +9 -3.5 -0.41% 22 -3.39 ed +10 -1.67 -0.20% 32 -1.05 table 3 reports mean abnormal returns (mar) surrounding ex-bonus date. while there is no significant positive abnormal return observed within effective window prior to ex-bonus date, highly significant positive abnormal return of with mar of 0.58% is observed in 46 out of 74 firms and that can be attributed to the split like effect where investors may perceive that stock as more affordable and cheap and that might have created some demand. it is more evident due to the fact that between ed+ 1 to ed+10 there are several days on which significant mar is seen and that means the positive market reaction seen on the ex-day was just temporary and reversed in a very short period of time. if such positive reaction is due to improvement in liquidity or more permanent positive shift in demand such positive abnormal returns would have sustained. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 265 table 4. mean cumulative abnormal returns within effective window days t-stat mcar positive (out of 74) z-score ed-10 -0.72 -0.08% 34 -0.59 ed -9 -1.97 -0.30% 31 -1.29 ed -8 -0.65 -0.12% 35 -0.35 ed -7 -0.01 0.00% 35 -0.35 ed -6 1.21 0.32% 43 1.52 ed -5 2.11 0.62% 49 2.93 ed -4 2.77 0.85% 51 3.39 ed -3 2.76 0.92% 48 2.69 ed -2 2.13 0.89% 48 2.69 ed -1 2.23 0.93% 46 2.22 ed 3.77 1.51% 50 3.16 ed +1 3.73 1.53% 48 2.69 ed +2 2.76 1.20% 41 1.05 ed +3 2.32 1.05% 40 0.82 ed +4 1.92 0.83% 41 1.05 ed +5 1.75 0.81% 38 0.35 ed +6 0.87 0.37% 36 -0.12 ed +7 0.33 0.15% 35 -0.35 ed +8 -0.44 -0.20% 32 -1.05 ed +9 -1.31 -0.61% 29 -1.76 ed +10 -1.65 -0.81% 27 -2.22 table 4 reports mean cumulative abnormal returns surrounding ex-bonus date. mcar turns significant positive from ed-5 and remains till ed+5 with ed+1 report highest mcar of 1.53%. mcar remains statically significant and positive till ed+5 but it declines continuously from ed+1 high levels. mcar is 0.81% on ed+5 that is statistically significant but at a level that is much below 1.53% observed on ed+1. mcar keeps on declining from thereon and finally ends with negative 0.81% mcar on last day of effective window that is ed+10, a complete reversal of trend. 5. conclusion in this paper, we analyse market reaction surrounding announcement and ex-bonus days in post global financial crisis era in indian markets. our results show that bonus announcement leads to some buzz in the market and it reacts positively to such announcements. if, market is efficient in its semi-strong form, such positive reaction associated with bonus announcement should be restricted on announcement day only, however, we can see that market gets some hint of such potential announcement at least two days before but the biggest positive market reaction is observed on announcement day itself and not on any of the following day in the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 266 announcement window. that indicates that bonus announcement do carry positive information content and that is getting reflected just before and immediately on its announcement and that provides support for information content and some evidence of indian stock market is efficient in its semi-strong form. while, bonus announcement does not change anything substantially, capitalization of reserve is probably considered as a positive sign by the market as that indicates that the firm announcing bonus is confident of serving higher capital base for distributing future dividends and also the fact that it may not need reserves to deep into for distributing cash dividends especially in bad times. positive market reaction is observed on the ex-bonus date but fizzles out immediately after that and results in reversals by the end of effective window that indicates that such reaction is only on account of some overreaction on the ex-day and that reverses itself soon after. overall, our study concludes that bonus announcement does carry positive information content and that leads to positive market reaction on its announcement and such reaction is not following through beyond announcement day and that endorse that indian stock market is efficient in its semi-strong form. besides, positive market reaction on ex-bonus day is just overreaction by market participants and it reverses itself immediately thereafter. the results are consistent with other studies in indian markets by mishra (2005) and joshipura (2009), where they reported significant positive price effect on announcement day itself. however, the results of this study are different from those studies on ex-day returns-those studies did not report any positive price effect on ex-day, in fact mishra (2005) reports negative return on ex-day whereas, present study reports positive return on the ex-bonus day. however, such positive returns reverse immediately and hence not significant by any means. results of present study are not consistent with ray (2011) as he reports no price reaction surrounding announcement as well as effective date. to summarize, results of the present study support signaling hypothesis and provides evidence that indian markets are efficient its semi strong form with small leakage of information pertaining to the bonus announcement just prior to formal announcement. references balachandran.b, f. a. 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(1983). stock dividends as signals. journal of financial research, 6(1), 1-12. microsoft word 6021-21654-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 1 mutual fund size and investible decisions of variable life insurance nan-yu wang associate professor, department of business and tourism planning ta hwa university of science and technology, hsinchu, taiwan e-mail: nanyu@tust.edu.tw sen-sung chen department of risk management and insurance, feng-chia university, taichang, taiwan e-mail: chenss@fcu.edu.tw chih-jen huang department of finance, providence university e-mail: cjh@gm.pu.edu.tw cheng-hsin yen department of risk management and insurance, feng-chia university, taichang, taiwan e-mail: d9657462@gmail.com received: july 23, 2014 accepted: august 15, 2014 published:june 1, 2015 doi:10.5296/ajfa.v7i1.6021 url: http://dx.doi.org/10.5296/ajfa.v7i1.6021 abstract we tested the relationship between flow-return and flow-fund characteristics relationship under different fund sizes by using quantile regression. we found that insured investors’ purchase-performance is better than non-insured investors. we found that the relationship between fund inflows and fund performance was stronger among the insured investors of both large-scale and small-scale funds than it was among the noninsured investors. in addition, deferred compensation rates also influenced the purchases and redemptions of the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 2 insured investors of large-scale funds. the relationship with performance was enhanced as purchase amounts increased. keywords: mutual funds, fund performance, fund size, investment behavior, quantile regression asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 3 1. introduction large-scale funds can achieve the effects of economies of scale; that is, size can reduce management costs and increase profits, causing large-scale funds to generate fund flows greater than those of small-scale funds. huang, wei, and hong (2007) stated that economies of scale increase fund visibility, which provides services and reduces barriers to investment because when funds are linked with large fund families, they attract an increased amount of net flow. the relationship between performance and flow also intensifies. jank and michael (2013) found that fund family scale influences the relationship between flow and performance; that is, large-scale fund families are accompanied by relatively high redemption and subscription rates. sirri and tufano (1998) used fund portfolio size and hypothesized that large-scale funds have higher visibility and brand awareness than small-scale funds do. this study examined whether large-scale funds grow at a large rate and exhibit superior performance. li and lai (2009) stated that fund scale influences investment performance. high total value of net assets in a fund results in a great probability of economies of scale. this can save transaction costs for the fund. in addition, the managers of large-scale funds are highly likely to possess sufficient funding for establishing superior portfolios. chiu (2011) presented relatively weak evidence that indicated that large scales and high turnover rates in funds were associated with superior fund performance. as funds increase in size, their likelihood to attract professional talent and enjoy economies of scale increases, which can reduce transaction costs and relatively increase fund performance. shu et al. (2002) indicated that fund flows and performance during the previous period are positively correlated in large-scale funds. large-scale funds with excellent investor redemption performance exhibited more prominently positive correlations compared with large-scale funds with dismal redemption performance. these results indicate that the investors of large-scale funds prefer to purchase funds for short-term profit and sell funds that do achieve short-term profit. in addition, the fund inflows and outflows of large-scale fund investors respond to past returns. this indicates that investors strive to duplicate previous performance. however, investors of small-scale funds behave differently. the fund outflows of small-scale fund investors do not respond to past performance. however, when recent fund performance improves, investors redeem a small number of shares from the fund. this indicates that investors do not seek short-term returns but instead hold funds with superior performance. a number of scholars have also held that large-scale funds do not exhibit a strong relationship between fund performance and flow. banz (1981) and reinganum (1981) were the first to propose size effects. they found that small-scale investment portfolios have risk-adjusted returns that are significantly higher than those of large-scale investment portfolios. zheng (1999) indicated that small-scale funds that use flow information have the chance to achieve positive excess returns. pollet and wilson (2008) indicated that small-scale funds are more likely to achieve excess returns than large-scale funds are. kao, chen, tang, and tsao (2005) used simulation analysis to investigate the correctness of mutual fund performance indicators and to test equity funds in the taiwanese fund market. they found that because the taiwanese fund market is small, funds should focus on small caps as investment targets, and the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 4 subsequent scale effects will result in enhanced investment performance. chen, hung, and lee (2001) found a negative correlation between fund scale and performance. however, they also indicated that the scale of asset management companies is positively associated with performance. this implies that managers find large-scale funds to have decreased operating flexibility, leading to inefficiency, which results in unsatisfactory performance. therefore, in this study, we used fund scale to analyze the fund subscription and redemption behavior of investors. we further explored fund flow and fund performance by dividing funds into large-scale and small-scale funds. in this study, we used the tej database to seek explanatory variables for exploring whether the characteristics of multiple groups of domestic stock funds resulted in various investment behaviors because of varying levels of risk. we divided investors into overall stock fund investors (group a), insured investors (group b), and noninsured investors (group c). this paper is divided into five sections. in addition to the introduction, we define variable definitions and introduce the research sample, research period and range, and our methodology. we then explore the responses of various groups of domestic stock fund investors with investment-linked insurance policies toward varying levels of fund risk. finally, we present our conclusion. 2. variable definitions & research purposes we used net inflows and net outflows as dependent variables. the in low , is equal purchase , divided by total net assets , and out low , is equal redemption , divided by total net assets , . in low , expresses the inflow of fund i during month t. out low , expresses the outflow of fund i during month t. ℎ , is the subscription amount of fund i during month t. , is the redemption amount of fund i during month t. total net assets , is the fund assets of fund i during month t – 1. the calculation for this was . = ln (net asset value of fund i during period t). according to the research background and motivation, the research purposes of this study are as follows: (a) to explore the relationship between fund inflows and the relationship between flow-return and flow-fund characteristics relationship under different fund sizes; (b) to explore the relationship between fund outflows and the relationship between flow-return and flow-fund characteristics relationship under different fund sizes. 3. methodology 3.1 quantile regression quantile regression (qr) is a type of regression analysis used in econometrics. whereas the ordinary least squares (ols) results in estimates that approximate the conditional mean of the response variable given certain values of the predictor variables, qr aims at estimating either the conditional median or other quantiles of the response variable (koenker and bassett, 1978). qr is also known as percentile regression because it can be used to estimate the percentile of the independent variable y based on the dependent variable x. based on the given percentiles, the estimated parameter values of various groups can be obtained. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 5 the qr estimates are more robust against outliers in the response measurements. however, the main attraction of qr goes beyond that. in practice we often prefer using different measures of central tendency and statistical dispersion to obtain a more comprehensive analysis of the relationship between variables. koenker and bassett (1982) concluded that qr possesses robustness because under given regression parameters, the signs of the residuals remain unchanged during estimation, suppressing the influence on estimated values when extrema occur in the samples. lee and saltoglu (2001) considered the primary advantage of qr to be its ability to yield superior statistics using empirical quantiles. the concept of qr proposed by koenker and bassett (1978) was based on least absolute deviation (lad). an increasing number of scholars have recently adopted qr models to analyze financial data. chen and huang (2011) used qr to examine the relationship between fund governance and performance. the explained variable was defined as , which can include fund flow, inflow, outflow, and fund performance, was defined as the vectors of the explanatory variables, and t was defined as the number of sample observations (kuan, 2003). in a linear model for a given weight of (0 < < 1), the objective function of the th quantile regression is estimated to be the weighted average absolute error. ; = ∑ − ′ + 1 − ∑ − ′: ′: ′ .when is smaller (greater) than 0.5, the weight of the positive error of the objective function is smaller (greater), whereas that of the negative error is comparatively greater (smaller). therefore, this quantile is located in the left (right) portion of the distribution. when = 0.5, the weights of the positive and negative errors are equal. consequently, the equation is essentially identical to the objective function of the least absolute error method, and the estimated regression model is a 0.5 quantile (i.e., median) regression. the first-order condition for minimizing (1) is ∑ − 1 ′ = 0. where is the indicator function for incident a, and the optimal solution is the function of the th quantile regression in the distribution under condition . 3.2 sample description we use the database for tej and life insurance companies in taiwan. the research period was from january 1, 2001 to december 31, 2012. the data frequency is monthly data. the sample contained 143 months-worth of data. the variables are the names, fund sizes, jensen’s alphas, fund turnover rates, fund risks, and fund expense ratios for all of the domestic equity funds in taiwan. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 6 4. results 4.1 descriptive statistics table 1 indicates that fund sizes shrank after 2008. although the number of funds without investment-linked insurance policies decreased, their scale increased substantially. despite the financial tsunami, they did not shrink substantially. table1. descriptive statistics for fund size year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 a 1323.41 1432.28 1316.82 1466.73 1500.6 1607.94 2439 2377.38 2114.04 2139.56 2056.55 1886.14 b 1504.22 1548.52 1405.31 1480.94 1409.47 1485.93 2319.49 2253.63 1985.33 2003.02 1794.72 1619.77 c 460.01 639.24 655.39 1369.53 2335.04 4151.1 6091.45 5531.89 4143.24 4251.04 6206.27 6486.85 note: we obtained our samples from the tej database. the sample data were from january 1, 2001 to december 31, 2012. group a comprised overall domestic stock fund investors, group b comprised insured investors, and group c comprised noninsured investors. variable definition: fund size is the net asset value per month during the study period, we get the log value of net asset value for mutual fund. the unit is million. 4.2 statistical analysis to analyze the influence of various fund sizes on flow and performance, we separately performed quantile regression analysis on the large-scale and small-scale funds. fund scale is a common research topic. zheng (1999) indicated that small-scale funds that use flow information have the chance to achieve positive excess returns. pollet and wilson (2008) indicated that small-scale funds are more likely to achieve excess returns than large-scale funds are. in this study, we used a quantile regression model to cut fund flows into 10 equal quantiles and observed the relationships between quantiles, subscriptions, redemptions, and other fund characteristics. tables 2 and 3 show the relationships between flows and performance in largeand small-scale funds. 4.2.1 the relationship between fund inflows and performance in large-scale funds table 2 shows group b’s quantile regression analysis, which indicates a positive association between fund inflows and fund performance in large-scale funds. in addition, quantiles 0.1 to 0.9 were significant at a 1% level of significance. this indicates that fund inflows and performance had an intense and sensitive relationship for the insured investors. performance was excellent when subscription amounts were high. these results are consistent with those of shu et al. (2002) and jank and michael (2013). shu et al. (2002) found that the inflows and outflows of large-scale fund investors respond to past returns. this indicates that investors seek to duplicate previous performance. the quantile estimation results for group c indicate that none of the quantile results were significant for fund inflows. this indicates that the investors of group c did not seek to duplicate past fund performance. these results differ from those of group b. the quantile results for both group b and group c indicate a positive association between fund inflows and fund expense ratios. in addition, this relationship was statistically asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 7 significant with weak fund inflows and typical fund inflows. this indicates that both insured and noninsured investors preferred to purchase funds with high subscription expense ratios. although sirri and tufano (1998), barber et al. (2005), and jank and michael (2013) did not analyze funds classified by size, they all found that high expense ratios promote high subscription rates in funds. although this finding initially appears to be contrary to common sense, this positive association can be interpreted as a cause of expense ratios that act as a proxy variable for marketing expenses. thus, high expenses increase the visibility of a fund and encourage more people to purchase the fund. in the quantile regression for group b, quantiles 0.1 to 0.9 were not significant. this indicates that investors did not consider risk when purchasing large-scale funds. the quantile regression for group c revealed a significant and positive association during ordinary fund inflows and strong fund inflows. this indicates that high fund risk was associated with high fund inflows. this is consistent with the results of jank and michael (2013). although investors redeem funds that are at high risk, after adjusting for risk in performance, fund risk and fund inflows are positively correlated. this indicates that although risk-averse investors redeem funds when fund risks increase, risk-loving investors replace them. fund inflows and turnover were positively correlated for group b. in addition, quantiles 0.1 to 0.9 were statistically significant. this indicates that turnover rates increased when the insured investors actively purchased funds. the analysis for group c indicates that although fund inflows and turnover were positively correlated, this correlation was not significant under any of the conditional quantiles. thus, insured investors influenced fund turnover when purchasing funds more than noninsured investors did. 4.2.2 the relationship between fund inflows and performance in small-scale funds table 2 shows the quantile regression estimation results for group b. quantiles 0.1 to 0.9 were significant, with fund inflows positively correlated with performance. this indicates that when purchasing small funds, the protected investors purchased substantial amounts when performance was excellent. the quantile results for group c indicate that the fund inflows and performance of small-scale funds were significantly positively correlated when fund inflows were strong. this indicates that investors purchased vigorously when performance was strong. zheng (1999) indicated that small funds can use flow information to earn positive excess returns. the quantile regression results for group b and group c were not significant under any of the conditional quantiles. these results are consistent with those of fu et al. (2010). although fu et al. did not analyze fund size, they found that fund risk was not significant when subscription and redemption rates were response variables. this indicates that investors do not thoroughly consider risk factors when purchasing and redeeming funds with advertisements. thus, fund advertisements alter the risk attitudes of investors. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 8 table 2. fund inflows and operating characteristics sensitivity of fund size for group b and c. inflows large group b large group c small group b small group c quantiles estimated coefficients t value estimated coefficients t value estimated coefficients t value estimated coefficients t value jensen 0.1 0.012*** 3.98 0.0030.78 0.013*** 3.67 0.0020.77 0.2 0.018*** 4.99 0.0010.19 0.016*** 6.35 0.01** 2.20 0.3 0.022*** 5.45 0.0030.73 0.016*** 4.66 0.0051.02 0.4 0.022*** 5.96 0.0040.90 0.018*** 3.97 0.0091.49 0.5 0.022*** 5.20 0.0091.64 0.024*** 5.10 0.013** 2.13 0.6 0.026*** 5.04 0.0121.44 0.028*** 6.05 0.016*** 2.81 0.7 0.033*** 6.10 0.0120.94 0.031*** 6.87 0.017** 2.53 0.8 0.037*** 7.26 0.010.64 0.032*** 4.01 0.023*** 2.77 0.9 0.04*** 4.49 -0.009-0.21 0.038*** 4.34 0.0211.37 exp. 0.1 0.113*** 3.51 0.0290.32 0.05* 1.90 0.0330.90 0.2 0.089*** 3.04 0.2** 2.45 0.083*** 3.22 0.0731.51 0.3 0.106*** 3.04 0.179** 2.58 0.079*** 2.68 0.0911.57 0.4 0.117*** 2.92 0.163** 2.15 0.094** 2.60 0.1071.42 0.5 0.159*** 2.88 0.169* 1.86 0.101** 2.00 0.0580.79 0.6 0.221*** 2.73 0.229* 1.94 0.1051.56 0.1071.58 0.7 0.141.55 0.1390.77 0.0610.68 0.1081.20 0.8 0.0920.94 0.1660.62 0.110.81 0.1140.70 0.9 0.10.63 0.5240.99 0.2221.39 0.2860.75 risk 0.1 0.000 -0.94 0.0011.59 0.000 0.12 0.000 -0.02 0.2 0.000 -0.79 0.000 0.58 0.000 -1.13 0.000 -0.14 0.3 0.000 -1.01 0.0011.64 0.000 -0.96 0.000 -0.16 0.4 0.000 -0.68 0.001** 2.05 0.000 -1.35 0.000 -0.01 0.5 0.000 -0.73 0.001*** 3.04 0.000 -1.27 0.000 0.98 0.6 0.000 -1.00 0.001** 2.43 0.000 -0.59 0.000 1.15 0.7 0.000 -0.49 0.002** 2.52 0.000 0.52 0.0011.56 0.8 0.000 -0.91 0.003** 2.33 0.000 0.36 0.001* 1.83 0.9 0.000 -0.44 0.0041.05 0.000 -0.13 0.0010.86 turnover 0.1 0.001** 2.49 0.000 0.74 0.001*** 3.73 0*** 3.51 0.2 0.001*** 3.59 0.000 0.45 0.001*** 3.78 0.001*** 2.92 0.3 0.001*** 3.75 0.000 0.24 0.001*** 3.97 0.001*** 3.63 0.4 0.001*** 3.75 0.000 -0.06 0.001*** 4.28 0.001*** 3.63 0.5 0.001*** 3.01 -0.001-1.19 0.001*** 4.23 0.001*** 3.85 0.6 0.001** 2.53 -0.001-1.24 0.001*** 4.16 0.001*** 2.85 0.7 0.002*** 2.82 -0.001-0.71 0.001*** 2.88 0.001** 2.26 0.8 0.003*** 4.59 -0.001-0.54 0.001* 1.75 0.001** 2.36 0.9 0.003*** 3.78 0.000 -0.09 0.002* 1.71 0.0011.31 r-square 0.192 0.006 0.168 0.119 note: we obtained our samples from the tej database. the sample data were from january 1, 2001 to december 31, 2012. group a comprised overall domestic stock fund investors, group b comprised insured investors, and group c comprised noninsured investors. the variables include jensen, exp., risk, and turnover. the significance levels of 10%, 5%, and 1% are signified by *, **, and ***. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 9 4.2.3. the relationship between fund outflows and performance in large-scale funds table 3 indicates that the fund outflows and fund performance of group b were positively correlated. in addition, quantiles 0.1 to 0.9 were statistically significant. this indicates that investors did not redeem funds only when performance was unsatisfactory. when performance was strong, the investors of large-scale funds also took profits from the funds. these results are consistent with those of ippolito (1992), jank and michael (2013), and shu et al. (2002). shu et al. (2002) stated that the majority of large-scale fund investors are small investors. large-scale fund investors prefer to purchase funds for short-term profit and sell funds after obtaining this short-term profit. they also found that the fund inflows and outflows of large-scale fund investors respond to previous returns, which indicates that investors seek to duplicate past performance. fund outflows and fund performance were positively correlated in group c. this was significant for typical fund outflows (quantiles 0.4 to 0.6). in contrast to group b, in which fund inflows responded strongly to performance, when the large-scale fund investors of group c redeemed funds, the strength of fund inflows did not influence fund performance. fund outflows and fund risk were positively associated in group b. however, this was statistically significant only at times of weak fund outflows. in addition, the relationship between fund risk and fund outflows did not change substantially. the relationship between fund outflows and fund risk in group c was not significant under any of the conditional quantiles. fu et al. (2010) held that investors do not thoroughly consider risk factors when purchasing and redeeming funds with advertisements because fund advertisements alter investors’ attitudes toward risk. although we did not analyze fund advertisements, the majority of sales of investment-linked insurance policies is communicated to consumers through high-volume dm or channel marketing tactics. therefore, our results for group b and group c are consistent with those of fu et al. (2010). the results for group b indicate a positive association between fund outflows and fund turnover. this was statistically significant for quantiles 0.1 to 0.9. however, fund turnover did not change when fund outflows increased. fund outflows and fund turnover were positively correlated for group c. however, this correlation was not significant under any of the conditional quantiles. this indicates that fund turnover does not influence fund outflows. 4.2.4. the relationship between fund outflows and performance in small-scale funds table 3 indicates that the regression results for group b show a significant and positive correlation for quantiles 0.1 to 0.9. this indicates that when insured investors redeemed funds, they not only redeemed funds with unsatisfactory performance, but they also took profit from funds with superior performance. the redemption amounts of group c were significant for quantiles 0.2 to 0.9 under every conditional distribution. this indicates that fund investors tended to redeem funds with strong performance vigorously. quantiles 0.1 to 0.9 were statistically significant for the fund outflows and fund expense ratios of group b. this indicates that the insured investors of small-scale funds preferred funds with high expenses ratios when redeeming funds. the fund outflows and fund expense ratios of group c were statistically significant at quantiles 0.2 to 0.9. this indicates that investors preferred to asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 10 redeem funds with high expense ratios when redeeming funds. these results are identical to those of group b, indicating that regardless of whether investors were insured, their redemptions influenced fund expense ratios. in group b, fund outflows and fund turnover were statistically significant for quantiles 0.1 and 0.3 to 0.8. increased turnover was associated with increased fund outflows. this indicates that insured investors vigorously converted their portfolios of investment targets. in group c, fund outflows and fund turnover were statistically significant only when fund outflows were weak (quantiles 0.1 to 0.3). in addition, increases in fund outflow did not influence the sensitivity of flows and turnover. table 3. fund outflows and operating characteristics sensitivity of fund size for group b and c. outflows large group b large group c small group b small group c quantiles estimated coefficients t value estimated coefficients t value estimated coefficients t value estimated coefficients t value jensen 0.1 0.009* 1.95 0.0020.54 0.012*** 3.19 0.0081.31 0.2 0.016*** 2.77 0.0061.49 0.014*** 2.63 0.009* 1.69 0.3 0.019*** 4.26 0.01** 2.11 0.019*** 3.46 0.012** 2.35 0.4 0.022*** 4.91 0.014** 2.44 0.023*** 4.33 0.014** 2.10 0.5 0.028*** 6.31 0.013* 1.96 0.027*** 4.70 0.017** 2.02 0.6 0.028*** 7.14 0.015** 2.14 0.025*** 3.51 0.022** 2.10 0.7 0.029*** 6.81 0.018** 2.14 0.034*** 4.44 0.023** 2.08 0.8 0.032*** 5.16 0.0191.32 0.039*** 6.28 0.033*** 2.96 0.9 0.045*** 5.44 0.020.86 0.034*** 3.87 0.044*** 4.25 exp. 0.1 0.173*** 4.82 0.1221.46 0.156*** 6.69 0.1121.42 0.2 0.173*** 4.22 0.239** 2.60 0.18*** 4.86 0.235*** 2.74 0.3 0.204*** 4.90 0.282*** 3.14 0.254*** 4.96 0.309*** 3.89 0.4 0.225*** 4.07 0.376*** 4.39 0.274*** 4.90 0.325*** 3.81 0.5 0.228*** 3.07 0.414*** 4.11 0.216*** 3.04 0.485*** 5.31 0.6 0.265*** 2.65 0.451*** 3.50 0.263*** 2.88 0.574*** 5.16 0.7 0.274** 2.14 0.4*** 2.62 0.266** 2.57 0.729*** 6.26 0.8 0.395*** 3.07 0.565*** 2.68 0.328** 2.35 0.623*** 4.10 0.9 0.372*** 2.72 0.66* 1.77 0.494** 2.57 0.695*** 4.12 risk 0.1 -0.001** -2.18 0.000 0.83 0.000 -1.33 0.000 -0.19 0.2 -0.001* -1.83 0.000 0.72 0.000 -0.65 -0.001-1.44 0.3 -0.001-1.42 0.000 0.72 -0.001-1.20 -0.001-1.45 0.4 0.000 -0.93 0.000 0.50 -0.001-1.24 0.000 -0.47 0.5 0.000 -0.80 0.000 0.83 0.000 -0.35 -0.001-1.56 0.6 0.000 -0.51 0.0010.93 0.000 -0.67 -0.001** -2.10 0.7 0.000 -0.57 0.0011.51 -0.001-1.10 -0.001** -2.20 0.8 -0.001-1.17 0.0011.15 0.000 -0.45 -0.001-1.45 0.9 -0.001-1.52 0.0021.65 0.000 -0.39 0.000 0.26 turnover 0.1 0.001** 2.28 0.000 0.32 0.001** 2.49 0.000* 1.88 0.2 0.001** 2.24 0.000 -0.60 0.000 1.64 0.001*** 3.02 0.3 0.001** 2.33 0.000 -0.52 0.001* 1.69 0.000* 1.92 0.4 0.001** 1.98 0.000 -0.76 0.001** 1.99 0.000 1.38 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 11 0.5 0.001*** 2.67 0.000 -0.60 0.001** 2.38 0.000 1.25 0.6 0.001** 2.19 -0.001-0.65 0.001** 2.26 0.0011.49 0.7 0.001** 2.58 0.000 -0.19 0.002*** 3.28 0.000 0.52 0.8 0.001* 1.67 -0.001-0.60 0.001** 2.16 0.002** 2.00 0.9 0.002** 2.03 0.000 0.16 0.0011.17 0.0011.63 r-square 0.168 0.044 0.125 0.059 note: we obtained our samples from the tej database. the sample data were from january 1, 2001 to december 31, 2012. group a comprised overall domestic stock fund investors, group b comprised insured investors, and group c comprised noninsured investors. the variables include jensen, exp., risk, and turnover. the significance levels of 10%, 5%, and 1% are signified by *, **, and ***. 5. conclusion the relationship between insured investors and fund scale was also stronger than the relationship between noninsured investors and fund scale. this is consistent with the results of huang et al. (2007) and jank and michael (2013), who held that the size of fund families influences the relationship between fund flows and funds. when such relationship is linked with large-scale fund families, an increased number of net flows are attracted. because fund size clearly has a varied influence on the relationship between flows and performance, we categorized the samples to analyze whether fund inflows and fund outflows varied in different fund types among different groups of investors. we found that the relationship between fund inflows and fund performance was stronger among the insured investors of both large-scale and small-scale funds than it was among the noninsured investors. in addition, deferred compensation rates also influenced the purchases and redemptions of the insured investors of large-scale funds. the relationship with performance was enhanced as purchase amounts increased. shu et al. (2002) held that the majority of large-scale fund investors are small investors, investors who prefer to purchase funds and sell them quickly for profit to realize short-term gains. the empirical results of this study also indicate that both insured and noninsured investors of large-scale funds preferred to purchase funds with high expense ratios and turnover. expense ratios include advertising expenses. thus, high expense ratios may increase the visibility of funds and encourage an increased number of people to purchase funds. these results are consistent with those of jank and michael (2013). references banz, r. w. (1981). the relationship between return and market value of common stocks. journal of financial economics, 9(1), 3-18. http://dx.doi.org/10.1016/0304-405x(81)90018-0 barber, b. m., odean, t., and lu, z. 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(2005). performance measures for mutual funds: a simulation approach. sun yat-sen management review, 13(3), 667-694. koenker, r. and bassett, g. (1978). regression quantiles. econometrica, 46, 33-50. http://dx.doi.org/10.2307/1913643 koenker, r. and bassett, g. (1982). tests of linear hypotheses and l1 estimation, econometrica, 50, 1577-1584. http://dx.doi.org/10.2307/1913398 kuan, c. m. (2003). an introduction to quantile regression, lecture notes, institute of economics, academia sinica, http://www.sinica.edu.tw/~ckuan, (oct.5, 2006). li, c. a. and lai, h. c. (2009). the effect of the frequency of mutual fund portfolio disclosure on fund managers’ behavior. review of securities and futures markets, 21(3), 143-178. pollet, j. m. and wilson, m. (2008). how does size affect mutual fund behavior? the journal of finance, 63(6), 2941-2969. http://dx.doi.org/10.1111/j.1540-6261.2008.01417.x reinganum, m. r. (1981). a new empirical perspective on the capm. journal of financial and quantitative analysis, 16(4), 439-462. http://dx.doi.org/10.2307/2330365 shu, p. g., yeh, y. h., and yamada, t. (2002). the behavior of taiwan mutual fund asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 13 investors—performance and fund flows. pacific-basin finance journal, 10(5), 583-600. http://dx.doi.org/10.1016/s0927-538x(02)00070-7 sirri, e. r. and tufano, p. (1998). costly search and mutual fund flows. the journal of finance, 53(5), 1589-1622. http://dx.doi.org/10.1111/0022-1082.00066 zheng, l. (1999). is money smart? a study of mutual fund investors’ fund selection ability, journal of finance, 54, 901-933. http://dx.doi.org/10.1111/0022-1082.00131 microsoft word 6693-23783-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 422 determinants of disclosure quality: empirical evidence from iran nasrollahtakhtaei1 accounting department, islamic azad university, dezful branch, dezful, iran e-mail: nasrollah_takhtaei@yahoo.com zahra mousavi accounting department, islamic azad university, andimeshk branch, andimeshk, iran e-mail: zmousavi62@gmail.com mohammad tamimi assistant professor, accounting department islamic azad university, dezful branch, dezful, iran e-mail: tamimi.mohammad@gmail.com iman farahbakhsh accounting department, islamic azad university, dezful branch, dezful, iran e-mail: if9087@yahoo.com received: oct. 2, 2014 accepted: nov. 4, 2014 published: november 4, 2014 doi:10.5296/ajfa.v6i2.6693 url: http://dx.doi.org/10.5296/ajfa.v6i2.6693 abstract in this study, we investigate whether quick assets ratio, current assets ratio, roe, roa, and financial leverage ratioas information disclosure quality determinants are related to information disclosure quality. based on 240 iranian firm-year observations over the period 1. correspondence author: department of accounting, islamic azad university, dezful branch, dezful, iran asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 423 from 2006 to 2008, we find that quick assets ratio is negatively and significantly associated with information disclosure quality, however current assets ratio, return on equity (roe), return on assets (roa), and financial leverage ratio are positively and significantly associated with disclosure quality. keywords: information disclosure quality, quick assets ratio, current assets ratio, roe, roa, financial leverage asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 424 1. introduction after financial scandals of some reputation, huge corporations such as enron and worldcom that was followed decrease in common confidence in relation to the information and reports issued by these corporations, the more quality and more information was needed and has been resulted in more demand regarding more transparency, informativeness and reporting concerning corporations(mashayekhi, 2007). more disclosure and transparency will result in long-run investments in behave of investors, more easily accessible to new capital, the least finance cost, more responsible and effective management and finally stocks higher price and considerable interests of shareholders(bushman & smith, 2001). research shows that corporation financial characteristics can affect their information disclosure quality. therefore, this study aims to examine information disclosure quality effect on corporation's performance and capital structure. so, path and level of this effect is determined using correlation test, linear regression, and hence coefficients significance is tested.in this regard, theory fundamentals, literature review including theory fundamentals definitions, viewpoint and hypotheses relating to the subject and research experiment background, and the results of various researchers are presented. in research method section, research type, variables, population, sample selection and method used for the analysis are introduced and in the following section will have findings. finally, the conclusion and suggestions will be presented.according to theory agency, when corporation's leverage level is higher, monitoring cost will be increased. therefore, it is expected to be disclosing more information in order to decrease such a cost. also, it is expected to be positive in the existence of such relationship.as a rule, it is expected to be disclosed more information in annual reports by corporations that total liabilities are higher in balance sheet(ahmed & nicholls, 1994). for instance, a corporation with high ratio of liability to owners' equity (showing the corporation's financial leverage), more obligations have for the presenting information so that prepare creditor's needs and therefore may prepare more details in accounts and annual reports in order to prepare these needs than corporations with low high ratio of liability to owners' equity(saghafi & malekiyan, 1997). 2. theoretical framework and literature review in protecting shareholder value, agency theory and signalling theory assume that a complete, accurate and reliable disclosure should be provided to reduce information asymmetry, solve agency problems and reduce agency cost. from agency theory perspective, disclosure is one of the monitoring agents that aims to mitigate the agency cost in the principal-agent relationship(hope & thomas, 2008; jensen & meckling, 1976).given that the principal-agent relationship leads to an agency problem, information asymmetry and conflict of interest, managers have incentives to provide a low quality of disclosure.using signalling theory, the authors justify this positive association by the fact that corporate managers of highly profitable companies are more likely to report more information to increase investors’ confidence and consequently to raise their compensation and to raise capital at the lowest cost (marston & polei, 2004). agency theory also suggests that corporate managers of profitable companies have incentive to report more information to increase their compensation(abd-elsalam, 1999). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 425 disclosure quality is difficult to measure because it is not directly observable (lee, petroni, & shen, 2006).disclosure is defined as information released by a firm which may be financial or non-financial; qualitative or quantitative; mandatory or voluntary; disseminated through formal or informal channels(gibbins, richardson, & waterhouse, 1990).this definition of disclosure is broad and vague. however,previous studies define disclosure quality with various different keywords in practice. for example,gray and skogsvik (2004)explain that “voluntary disclosure supposedly provides information which goes beyond the requirements inherent in company law and the prevailing accounting standards” and “completeness, accuracy and reliability” is defined as disclosure quality bysinghvi and desai (1971)andbrown and hillegeist(2003)define quality of disclosure as “the precision, timeliness, and quantity of information provided”. as stated bykent, routledge, and stewart (2010), “more extensive disclosures are likely to bemore informative than brief disclosures and are, therefore, an indicator of greatertransparency”. the quality of firm disclosure and firm financial and non-financial characteristics has become a subject of much interest in recent years and has attracted the interest of many major accounting journals.in a meta-analysis study, ahmed and courtis(1999)provide empiricalevidence that the association between corporate disclosure and profitability is differentand provides contradictory results.for example, they find that some studies(e.g., singhvi & desai, 1971; r. s. o. wallace, naser, & mora, 1994)show asignificant and positive association, while others (e.g., mcnally, eng, & hasseldine, 1982; raffournier, 1995)find no such anassociation. however,a statistically significant and negative association between the two variables have been found by wallace and naser(1996).evidence from the previous empirical literature suggests that information asymmetrycan be reduced by increased disclosure(brown & hillegeist, 2003; coller & yohn, 1997; glosten & milgrom, 1985; petersen & plenborg, 2006; welker, 1995). for example, glosten and milgrom(1985) have modeled the relationship between corporate disclosure and information asymmetry. their model shows that information asymmetry decreases as the level of corporate disclosure increases. welker (1995) providing empirical evidence indicates that information asymmetry is reduced as the level of disclosure isincreased.using a sample of 19 tunisian firms during the year 1999-2008, riahi and arab (2011) provide empirical evidence that disclosures that are associated with financial decisions and performance are beneficial in reducing managers’ incentives to manipulate earnings. they find that disclosure transparency and disclosure of financial information shows statistically significant relationship. 3. methodology 3.1. research design akerlof (1970)stated that a well–run firm (with higher profitability and higher growth rates) would want to distinguish itself from lemon. it means that if the company is performing well its superiority can be signaled(ross, 1977), information asymmetry between investors and managers reduced and agency costs reduced(jensen & meckling, 1976) through increased disclosure. different profitability and growth measures used have given contradicting signs for its association with disclosure quality(laidroo, 2009). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 426 h1: there is a significant relationship between information disclosure quality and quick assets ratio. h2: there is a significant relationship between information disclosure quality and current assets ratio. h3: there is a significant relationship between information disclosure quality and return on equity. disclosure quality can also contribute to solve monitoring problems between creditors and shareholders and managers. leverage may help reducing agency costs in relationship between owners and managers, since it engage managers to maximize the firms value and even to transfer wealth from creditors to shareholders(kelly, 1983). thus, an increase in disclosure quality should be used to give more confidence to creditors and reduce debt agency cost(michaïlesco, 1999). thus: h4: there is a significant relationship between information disclosure quality and return on assets. h5: there is a significant relationship between information disclosure quality and financial leverage ratio. in line with previous studies, coefficient of determination and the regression coefficients are used to evaluate the relation between information disclosure quality and certain financial characteristics of listed firms on tehran stock exchange. it is not possible to use time series in this research, so, considering the conditions in the study period, panel analyzing is used. panel analysis is a combination of cross-sectional and time series. the panel balanced data model is applied in this research. the variables area combination of time series data and cross-sectional data for each sample firm, the covered time period is balanced and this is why we use panel data. the total framework of the panel statistical model is as follows: = + ʹ + = μ + = 1,2, … , = 1,2, … , (1) = dependent variable = independent variables = sampling observations (number of companies) t= number of time series observations , = parameters of the model the regression equation is estimated by generalized least square (gls) regression method on the cross-section weights framework and also by using the cross-section fixed effects. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 427 3.2. sample selection the population of the study is accepted companies on the tehran stock exchange (tse) over the period from 2006 to 2008. these companies were selected without sampling and according to the following criteria including:1)the corporations must not be included in industries such as investment, holding, banking, and financial,2) in order to compare the corporations, firms' fiscal year must end on 20th march (fiscal year end in iran),3)the data and information concerning corporations must be available,4) firm's stocks have to be traded continuously on the tehran stock exchange (tse) and it does not stop more than one month.according to these criteria, 80 companies out of the total accepted corporations in tehran stock exchange (tse) were selected. the same procedure is applied for the years from 2006 to 2008 with a total of 240 companies out of the total population are chosen. 3.3. data collection in this study, we used the data collection using library method. in order to calculate the variables investigated, data needed that are related to the corporations' financial statements have been used from a variety resources such as rahavard database, tadbirpardaz database, tehran stock exchange website and related compact disc (cd).for this reason, information regarding disclosure quality (discquality) was collected first. then data related financial ratios from financial statements accompanied notes were collect which entered into excel and finally the hypotheses were tested and analyzed usingeviews 7. 3.4. variable definitions this section provides details of the measurement of my interest variables. table 1. variable definitions variable name definitions dependent discquality disclosure quality, measured by score assigned to the listed companies on tse by tehran stock exchange. independent quick quick assets ratio, measured by (current assets inventories) divided by current liabilities current current assets ratio, measured by current assets divided by current liabilities roe return on equity, measured as net income divided by book equity (shareholder'sequity) roa return on assets, measured by as net income divided by total assets lev financial leverage ratio, measured by long-term liabilities divided by book equity asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 428 3.5. clasical assumption testing 3.5.1. normality testing the purpose of normality testing is to know that all data of independent and dependent variables have normal distribution. in this research, normality test is used based on jarque-bera test. would be accepted if the probability value of jarque-bera test is higher than 5%( = 0.05), it means that all data have normal distribution. would be rejected if probability value of jarque-bera test is smaller than 5% ( = 0.05), it means that all data have not normal distribution. 3.5.2. multicollinearity testing multicollinearity is a condition in which one or more independent variables are in a linear contribution with other independent variables. it means that one or more independent variables correlate with other independent variables. using correlation coefficients is one of the ways for identification of the multicollinearity. it means that the existence large correlation coefficients between variables explanatory indicate the existence of multicollinearity. in the other words, multicollinearity testing can be analyzed from coefficient of correlation. this coefficient is criterion to measure the linear correlation between the two variables and do not use to describe the nonlinear relationship. this quantity is between the -1 and +1values. 3.5.3. autocorrelation testing when the residuals are correlated with each other over time, we are having autocorrelation problem. in this research, autocorrelation is tested usingdurbin-watson test. if durbin-watson (d-w) statistic value is between 1.5 and 2.5 values, it means that there is not a first order autocorrelation in the model. but if d-w statistic value is smaller than 1.5 or it is higher than 2.5, it means that there is a first order autocorrelation in the model. 3.5.4. heteroscedasticity testing heteroscedasticity occurs when variance disturbance is not consistent from one to another time at all observations. it can affect the estimates coefficient of regression, under-estimation, over-estimation or misleading. heteroscedasticity testing uses a baltagimethod, in which if the probability value is higher than 5% ( = 0.05), there is no heteroscedasticiy.according to baltagi(2008), this may be a restrictive assumption for data panels, where cross-sectional units may often be of different size and sequence, and exhibit different variations. 3.6. hypothesis testing in this research, there is one dependent variable correlated to five independent variables. therefore, this research will be analyzed based on multiple linear regression,with the following equation: = + + + + + + explanation: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 429 = discquality a = value of if , , , , = 0 , , , , = coefficients of regression = quick = current = roe = roa = lev e = residual value 3.6.1. first hypothesis testing first hypothesis is tested with f-test with the following formula: = ( − 1)⁄1 − ( − )⁄ explanation: f = f value resulting from the calculation( ) = coefficient of determination k = number of variables n = number of observations the criteria of testing are as the following: : = = = = = 0 (quick assets ratio (quick), current assets ratio (current), return on equity (roe), return on assets (roa) and financial leverage (lev) do not affect the disclosure quality (discquality) simultaneously) : = = = = ≠ 0 (quick assets ratio (quick), current assets ratio (current), return on equity (roe), return on assets (roa) and financial leverage (lev) affect the disclosure quality (discquality) simultaneously) therefore, would be accepted if is smaller than (critical value) or when the probability value is higher than 5%( = 0.05), and would be rejected if is higher than critical value or when the probability value is smaller than 5%( = 0.05). 3.6.2. second hypothesis testing second hypothesis is tested by t-test with the following formula: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 430 t = bs explanation: t = t value that is resulted from the calculation b = coefficient of regression s = standard error of regression coefficient the criteria of testing are as follows: h : , , , , = 0(quick assets ratio (quick), current assets ratio (current), return on equity (roe), return on assets (roa) and financial leverage (lev) do not affect the disclosure quality (discquality) simultaneously) h : , , , , ≠ 0(quick assets ratio (quick), current assets ratio (current), return on equity (roe), return on assets (roa) and financial leverage (lev) affect the disclosure quality (discquality) simultaneously) then, would be accepted if is smaller than critical value or when the probability value is higher than 5%( = 0.05), and would be rejected if is higher than critical value or when the probability value is smaller than 5% ( = 0.05). 4. empirical results 4. 1. descriptive statisticsof variables descriptive statistics of variables are presented in table 2. table 2. descriptive statistics discq quick current roe roa lev mean 54.13333 0.729042 1.252083 0.380542 0.157250 0.567458 median 57.00000 0.680000 1.235000 0.340000 0.120000 0.600000 maximam 100.0000 3.790000 3.790000 4.540000 2.070000 0.860000 minimum 2.000000 0.040000 0.240000 0.010000 0.010000 0.170000 std. dev. 23.43474 0.466427 0.547433 0.358651 0.168996 0.141722 skewness -0.254428 2.839173 1.408893 7.273606 6.939207 -0.385093 kurtosis 2.323912 17.45742 7.582596 79.04151 73.36717 2.303434 table 2shows that the average of disclosure quality (discquality) for the corporations during period investigated, is 54.13. additionally, we can see that score 2 as the least number of disclosure quality (discquality) is very unfavorable for a corporation. the most important point in this table is high variance of disclosure quality. the fifthrow of table related to the standard deviation of variables is evident to this claim.also, the mean of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 431 disclosure quality (discquality), quick assets ratio (quick), current assets ratio (current), return on equity (roe), return on assets (roa) and financial leverage (lev) are 54.13, 0.72, 1.25, 0.38, 0.15 and 0.56 respectively. comparing the coefficient of variations ( . .) of independent and dependent variables, indicative the amount of dispersion. it means that whatever the amount of dispersion of a variable is less, stability of that variable is further. out of all the independent variables, roa has the greatest amount of dispersion (1.075) and lev has the lowest amount of dispersion (0.25). the difference between mean and median for the current assets ratio is lower than other variables, namely current assets ratio is more normal than other variables. 4.2. statistical test result of classical assumption testing 4.2.1. normality this research uses the analysis of jarque-beratest for normality testing. the result of normality test in table 3, shows that the probability value of jarque-bera test is 0.06, which is higher than 5%( = 0.05). this indicates that all data have normal distribution. table 3. the result of normality testing 4.2.2. multicollinearity testing in this study, multicollinearity testing is analyzed from coefficient of correlation. correlation matrix between variables is displayed in table 4. according to the results, there is a little correlation between variables, suggesting absence of multicollinearity. 0 5 10 15 20 25 30 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 series: standardized residuals sample 1 240 observations 240 mean -2.37e-16 median 3.302942 maximum 47.58480 minimum -55.42007 std. dev. 21.62584 skewness -0.301360 kurtosis 2.551261 jarque-bera 5.646381 probability 0.059416 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 432 table 4. correlation matrix quick current roe roa lev quick 1.000000 current 0.261052 1.000000 roe 0.041951 -0.002674 1.000000 roa 0.178049 0.207485 0.213563 1.000000 lev -0.214620 -0.296758 -0.017367 -0.255052 1.000000 variables definition:quick: quick assets ratio is measured as the(current assets – inventories) divided by current liabilities, current: current assets ratio is measured as the current assets divided by current liabilities, roe: return on equity is measured as the net income divided by book equity (shareholder'sequity), roa: return on assets is measured as net income divided by total assets, lev: financial leverage ratio is measured as the long-term liabilities divided by book equity. 4.2.3. autocorrelation testing in this research, autocorrelation testing is used based on durbin-watson test.result of d-w test is displayed in table 6.it indicates clearly that the durbin-watson (dw) statistic value 2.13 which is between 1.5 and 2.5 values. this indicates that there is not a first order autocorrelation in the model. 4.2.4. heteroscedasticity testing in this research, baltagimethod is used totestheteroscedasticity. the results of this testing is displayed in table 5.it indicates clearly that prob-fismore than0.05 in table 5 (0.77), suggesting no heteroscedasticity. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 433 table 5. heteroscedasticity testing arch test: f-statistic 0.072768 probability 0.774822 obs*r-squared 0.073278 probability 0.774081 test equation: dependent variable: resid^2 method: least squares sample: 2 240 included observations: 239 after adjustments variablecoefficient std.error t-statistic prob c resid^2 (-1) r-squared adjusted r-squared s.e. of regression sum squared resid log likelihood durbin-watson stat 4236.642 -0.014578 0.000212 -0.002557 24112.86 2.18e+11 -4028.877 2.000088 1352.667 3.177022 0.052565 -0.271705 mean dependent var s.d. dependent var akaike info criterion schwarz criterion f-statistic prob(f-statistic) 0.0015 0.7748 4174.250 24070.42 22.10484 22.11703 0.072768 0.774822 4.3. statistical test result of hypothesis testing the output of multiple regression analysis is presented in the following table. table 6. the result of model estimation dependent variable: discquality method: panel egls (cross-section weights) date: 07/28/13 time: 00:56 sample: 20062008 periods included: 3 cross-sections included: 80 total panel (balanced) observations: 240 linear estimation after one-stop weighting matrix variable coefficient std. error t-statistic prob. c 42.49675 4.294507 9.895605 0.0000 quick-11.51075 4.759896 -2.418278 0.0168 current 11.63819 4.769645 2.440054 0.0158 roe 3.246751 1.597618 2.0322450.0438 roa1.346525 0.501365 2.685718 0.0080 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 434 lev7.811384 3.720894 2.099329 0.0374 effects specification cross-section fixed (dummy variables) weighted statistics r-squared 0.659178 mean dependent var126.2772 adjusted r-squared 0.647322 s.d. dependent var493.3059 s.e. of regression 16.98649 sum squared resid44723.81 f-statistic 222.5695 durbin-watson stat 2.138466 prob(f-statistic) 0.000000 unweighted statistics r-squared 0.994312 mean dependent var 54.13333 sum squared resid 55373.58 durbin-watson stat 2.865979 based on table 6, the regression equation is as follows: discquality=42.49675-11.51075*quick+11.638189*current+3.246751*roe+1.34 6525*roa+7.811384*lev+ [cx=f] 4.3.1. first hypothesis testing first hypothesis states that quick assets ratio (quick), current assets ratio (current), return on equity (roe), return on assets (roa) and financial leverage (lev) affect the disclosure quality (discquality) simultaneously. from the result of f-test, it is known that the calculation of f results in (222.569) with the probability value of (0.000) in which smaller than 5%( = 0.05). this value is compared with the value on the f table (critical value), i.e., 2.21. since (222.569) is higher than that of critical value (2.21), and also the probability value of (0.000) is smaller than 5%( = 0.05), the firsthypothesis in this research is accepted. this indicates that our model is significant jointly with all variables investigated. 4.3.2. second hypothesis testing second hypothesis states thatquick assets ratio (quick), current assets ratio (current), return on equity (roe), return on assets (roa) and financial leverage (lev) affect the disclosure quality (discquality) simultaneously. from the output of the regression, the result shows that: 4.3.2.1.value of t-test for variable of quick assets ratio (quick)is 2.41higher than critical value (1.96), and the probability value of 0.016 is smaller than 5% ( = 0.05). it means that quick assets ratio (quick)affectssignificantly disclosure quality (discquality) partially. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 435 4.3.2.2.value of t-test for variable of current assets ratio (current)is 2.44higher than critical value (1.96), and the probability value of 0.015 is smaller than 5% ( = 0.05). it means that current assets ratio (current)affects significantly disclosure quality (discquality) partially. 4.3.2.3.value of t-test for variable of return on equity (roe) is2.03 higher than critical value (1.96), and the probability value of 0.043is smaller than 5%( = 0.05). it means that return on equity (roe) affects significantly disclosure quality (discquality) partially. 4.3.2.4.value of t-test for variable of return on assets (roa) is2.685higher than critical value (1.96), and the probability value of 0.008 is smaller than5% ( = 0.05). it means that return on assets (roa) affects significantly disclosure quality (discquality) partially. 4.3.2.5. value of t-test for variable of financial leverage (lev) is2.09 higher than critical value (1.96), and the probability value of 0.037 is smaller than 5%( = 0.05). it means that financial leverage (lev) affects disclosure quality (discquality) partially. according table6, and show that approximately 65% of disclosure quality variations is explained by the independent variables. the result of f-test shows that is rejected at the 5% level and so the whole model is significant. the result of t-test shows that is rejected at the 5 level for independent variables, meaning that the coefficient sof these variables are significant. durbin watson (d-w) statistic value (2.13) indicates that there is no first order autocorrelation in the model because the equation is estimated based on the weighted cross-section framework. furthermore, heteroskedascity test indicates that the residuals variance is constant and jarque-bera test for normality testing indicates that residuals have been distributed normally. 5. conclusion the main purpose of this study is to investigate the relationship between information disclosure quality with quick assets ratio, current assets ratio, return on equity (roe), return on assets (roa), and financial leverage ratio. for this reason, 80 corporations out of total corporations in tehran stock exchange were selected and analyzed during the period from 2006 to 2008.the results show that there is positive and significant relationship between information disclosure quality and current assets ratio, return on equity (roe), return on assets (roa), and financial leverage ratio. the existence of positive and significant association of information disclosure quality with current assets ratio, return on equity (roe), return on assets (roa), and financial leverage ratio indicates that corporations with higher current assets ratio, return on equity (roe), return on assets (roa), and financial leverage ratio have higher and appropriate information disclosure quality and vice versa. the results also show that there is positive and significant relationship between information disclosure quality and quick assets ratio. the existence of negative and significant association of information disclosure quality with quick assets ratio indicates that corporations with higher quick assets ratio have lower information disclosure quality and vice versa. our investigation has remarkable 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(1996). firm-specific determinants of the comprehensiveness of mandatory disclosure in the corporate annual reports of firms listed on the stock exchange of hong kong. journal of accounting and public policy, 14(4), 311-368. http://dx.doi.org/10.1016/0278-4254(95)00042-9 wallace, r. s. o., naser, k., & mora, a. (1994). the relationship between the comprehensiveness of corporate annual reports and firm characteristics in spain. accounting and business research, 25(97), 41-53. http://dx.doi.org/10.1080/00014788.1994.9729927 welker, m. (1995). disclosure policy, information asymmetry, and liquidity in equity markets. contemporary accounting research, 11(2), 801-827. http://dx.doi.org/10.1111/j.1911-3846.1995.tb00467.x microsoft word 8404-30453-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 183 the vital role of gender diversity on corporate outcomes: the need for empirical studies concerning frontier markets hauwa daniyan bagudu department of banking and finance the federal polytechnic bida, niger state tel: 23-480-6244-1337 e-mail: hauwadaniya@yahoo.com badru, olayemi bazeet (corresponding author) school of economics, finance and banking (sefb) and othman yeop abdullah graduate school of business (oyagsb), universiti utara malaysia, sintok, kedah, malaysia tel: 60-14-726-5986 e-mail: bazeetolayemi@gmail.com. abdulmumini baba alfa department of economics ibrahim badamasi babangida university lapai, niger state tel: 23-470-1192-5695 e-mail: balfa80@gmail.com received: oct 8, 2015 accepted: nov. 23, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8404 url: http://dx.doi.org/10.5296/ajfa.v7i2.8404 abstract the purpose of the study is to review empirical studies related to gender diversity on corporate outcomes and suggest the need for more empirical research on gender diversity in frontier markets. several empirical studies have identified the need for a critical mass of female directors and executives in corporate firms. this review further justifies the clamour for more female representation on boards globally. nigeria is a country that has very weak corporate governance compared to the united states (us) and other developed countries. therefore, the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 184 present study suggests that more empirical studies in this area should be carried out and widely explored. it is hoped that capital market regulatory authority can consider the need for 35% women in public institutions and corporate settings. in other words, there is an urgent need for the implementation of this policy as this would have implications for women’s development and career planning. keywords: gender diversity, corporate governance, corporate outcomes, needs, nigeria asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 185 1. introduction the board of directors is expected to act in the best interests of shareholders by advising, monitoring, managing and ensuring that the management is responsible for their actions and decisions. the board takes appropriate action to reduce the agency problems that may likely exist between the shareholders and the management. as such, the structure of the board is an important corporate governance mechanism for a company’s financial success and the society in which it operates (gamba & goldstein, 2009; johnson, schnatterly, & hill, 2012; rose, 2007; thiruvadi & huang, 2011). the large number of corporate scandals and failures as well as crisis around the world over the last decade, such as enron, worldcom, healthsouth corporation, global crossing and the 2007/2008 financial crisis, have raised substantial concern about the effectiveness of the corporate governance system. this is because the events have adversely affected the global economy and diminished investors’ confidence on the reliability of financial information provided by companies. as a result, capital market regulators and academic researchers from different fields, like accounting, finance and management, are of the opinion that these events could have been prevented if a considerable number of women ran the affairs of the companies (ferreira, 2015; sherwin, 2014; seierstad, warner-søderholm, torchia, & huse, 2015). for instance, liu, wei, and xie (2014) reported that christine lagarde (imf managing director) viewed that the lehman brothers’ corporate scandal could have been averted if lehman brothers had been lehman sisters! moreover, a considerable number of scholars have suggested that gender diversity matters for company level outcomes, board cognition, dynamics and decision-making tasks (johnson et al., 2012; thiruvadi & huang, 2011). this is due to the fact that women listen more to corporate executives, act diligently, are risk averse, do not engage in herd-like behaviour and are more cautions when deciding on corporate decisions (liu et al., 2014; sherwin, 2014; thiruvadi & huang, 2011). in terms of corporate financing decisions, female directors are known to be very cautious and determined to equip the company they manage with sufficient resources that can improve its growth and survival (adams & funk, 2012; capezio & mavisakalyan, 2015; huang & kisgen, 2013; levi et al., 2014). similarly, some other scholars have suggested that the presence of female directors on the board of directors strengthens corporate governance through effective monitoring and creating a more transparent and informative environment that can enhance public confidence (terjesen et al., 2015; thiruvadi & huang, 2011; upadhyay & zeng, 2014). all these suggest that a diverse board may be likely to affect corporate outcomes. on this basis, this study reviews relevant literature on how gender diversity is related to corporate outcomes. this study further suggests the need for more empirical evidence concerning the impact of gender diversity on various corporate outcomes. this is because existing literature on gender diversity has been conducted in mature markets, like the united states (us) and europeans markets, with little empirical studies in asia and africa, particularly nigeria. campbell and minguez-vera (2008) illustrated that gender composition of the board can serve as a very important internal control mechanism, especially in countries where the external control asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 186 mechanism is less developed. therefore, considering the inadequacy of a regulatory infrastructure for the implementation of corporate governance mechanisms, as well as a series of corporate failures in financial and non-financial sectors in nigeria, it is felt that gender diversity can serve as a crucial factor for the implementation of good corporate governance practices in nigeria (edward, angaye, & gwilliam, 2008). however, in nigeria, the corporate governance mechanism does not include a code on gender diversity. on this note, the study suggests that more gender-related studies should be conducted on various corporate outcomes. the remainder of the paper is organized as follows: section 2 discusses the global trend of gender diversity, followed by the section 2.1 on gender policy issue in nigeria. then section 3 focuses on theoretical discussion, while section 4 presents empirical studies on gender diversity on various corporate outcomes, and finally section 5 concludes the study. 2. gender diversity trend gender diversity is an area of corporate governance research that has taken centre stage in the global arena to enrich corporate life and to empower the economy. board gender diversity is an important corporate governance mechanism that affects a company’s financial outcomes (terjesen et al., 2015), besides enhancing board governance and monitoring effectiveness (capezio & mavisakalyan, 2015). for example, mohan (2014) claimed that female chief executive officers (ceos) serve mostly in innovative and team-building industries that require collaborative behaviour. in addition, schwartz-ziv (2013) asserted that a higher number of women in attendance at corporate board meetings increase the length of discussion in meetings. as such, a gender-balanced board is more active as members possess a wide and diverse set of skills. owing to the importance of gender diversity globally, various policy initiatives on gender balance on corporate boards have been carried out by regulators in different countries, such as the us, the european union, australasian and asian (vietnam, malaysia, and china) countries (goergen & renneboog, 2014; nguyen, locke, & reddy, 2015). in countries like the us, the united kingdom (uk), australia and germany, public listed companies are mandatorily required to report in proxy statement whether the nominating committee considers gender diversity when nominating board members (capezio & mavisakalyan, 2015; reguera-alvarado, de fuentes, & laffarga, 2015). meanwhile, other countries, such as norway, spain, france, netherlands and italy, legally require at least 40% of the board members to be female (reguera-alvarado et al., 2015), while in malaysia, it is 30% female members on the board. this initiative has seen an increase in the number of women, both in the government and corporate entities. for example, ferreira and gyourko (2014) documented that unlike the 1970s, where only 2% of women participated and won in local government elections, the percentage increased to more than 15% in 2005. similarly, farrell and hersch (2005) documented that the percentage of board seats held by women increased from 6% to 12% between 1990 and 1999; while it was 87% for a sample of 300 unregulated fortune 1,000 companies in 1999. huang and kisgen (2013) showed an increase in the number of female top executives in the us in 1994 from 3.0% of women chief finance officers (cfos) and 0.5% of women ceos to 7.5% of women cfos and 1.5% of women ceos in 2005. in addition, compared to 0.2% of female ceos on fortune 500 companies in asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 187 1992, mohan (2014) reported that over 5% of standard & poor’s (s&p) 1,500 companies and 4% of the fortune 500 were led by women ceos. similarly, masta and miller (2011) noted that 6% of women are in the top executive rank of us companies. reguera-alvarado et al. (2015) revealed that the increase in the number of female directors was over 98%, using a sample of 125 public listed companies on the madrid stock exchange between 2005 and 2009. nevertheless, the increase in the number of female representation is still very low. this is worth noting as almost half of the world’s population comprise women and they control about 80% of the household spending decisions (shervin, 2014). 2.1 issues related to gender policy in nigeria as of january 2015, nigeria has a population size of 51,199,237 males and 49,451, 476 females at above 15 years of age (macdonald, wong, & sheldon, 2015). despite the huge population, it is disheartening to know that nigerian women are under-represented in both democratic and corporate governance. for instance, only 7% of seats are held by women in the national parliament (world bank report, 2014) and 28% of ministerial positions are filled by women (inter-parliamentary union & un women, 2014). this is in spite of the various commitments undertaken by the government at international, regional and national levels. examples of such commitments include the 35% women’s affirmative action on government organisation. the country also saw the review of the national gender policy and its strategic implementation in july 2014, the endorsement of the beijing declaration and platform for action (bdpa) that provides for affirmative action policy, nigerian economic empowerment and development strategy (needs) and goal 3 of the millennium development goals (mdg) on gender equality and women’s empowerment (choji, 2014). the mdg goal 3 is intended at achieving gender equality and women’s empowerment to foster the attainment of other mdgs. for example, achieving environmental sustainability, which is also one of the mdg goals, helps to identify the roles that gender play in the depletion and pollution of natural resources as well as the environment, particularly, the constraints and the competition in the access to and the use of natural resources. nonetheless, developmental policies in nigeria have been gender-biased because 70% of nigerians living below the national poverty line are women and this makes women more vulnerable to poverty than men (pwanagba, 2013). consequently, a high percentage of employment of women is restricted to low income-generating activities, which are concentrated within the lower levels of the unregulated and informal sector; while men are employed in the informal sectors that are located at the upper levels, or in other words, higher income-generating activities (cida nigeria & gsaa, 2006). as in other male dominated societies, the social inter-relations and activities of nigerian women and men are governed by patriarchal systems of socialization and cultural practices that favour the interests of men above those of women. however, regardless of gender related policies, gender diversity on corporate boards is still limited. in addition, the impact of gender diversity on the corporate board, including its effects on corporate outcomes, is not well understood in nigeria. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 188 3. theoretical discussion quite a number of theoretical models have addressed the impact of gender-based diversity on various corporate outcomes. among these theoretical models are the agency theory, resource dependence theory, upper echelon theory and the critical mass theory. according to the agency theory, boards of directors play an important role for the mitigation of principal to agent problems through their monitoring function (fama & jensen, 1983; jensen & meckling, 1976). their monitoring function helps to enhance the optimistic behaviour of the management and align the interests of shareholders with that of the principal, which subsequently affect the performance of the company (fama & jensen, 1983; hermalin & weisbach, 2003). however, some aspects of the board that serve as effective monitoring mechanisms, are dependent on the extent to which the board is diverse in terms of gender diversity, or the presence of female representation on the board. this is because gender diversity enhances the effectiveness of the board of directors and adds value to the company in a tangible manner (adams, haan, terjesen, & ees, 2015; langevoort, 2011). gender diversity also facilitates creativity as well as enhances the functioning and the efficiency of both the board and its committees (adams et al., 2015). on the other hand, the critical mass theory views that it is not only the presence of female representation on board that matters; what matters most is the number or the proportion of women on the board (kanter, 1977). the theory suggests that a meaningful impact of gender diversity on company performance or on improving the value for shareholders can only be felt when the percentage of women is 35%, which signals the critical mass of women on the board. in contrast, schwartz-ziv (2013) argued that the board is most active when the board has a dual critical mass (gender-balance), i.e., when the board comprises, for instance, three men and three women. this is what is meant by ‘dual critical mass’. meanwhile, the resource dependence theory by pfeffer (1972); and pfeffer and salancik (1978), which has its roots in sociological literature, proposes that the success and the survival of a company is dependent on the resources available in its external environment. the board of directors is the primary connector between a company and its external environment in obtaining the resources needed for the company’s success and survival. these crucial resources can be improved through an increase in size and diversity of the board (pfeffer, 1972; pfeffer & salancik, 1978). a diverse board provides more alternative solutions to problems due to different beliefs, experiences and perspectives of those on the board (hillman, shropshire, & cannella, 2007). for instance, women have the potential to link a company to different constituencies and they are more committed than men. they also can create a better link between the company and the customers than men, which subsequently improves the sales of the company. moreover, women serve as a role model for individuals within the company and as a mentor for aspiring women employees. women also evaluate resource dependence differently from men and have been found to offer positive and unique contributions to the company (peterson & philpot, 2007). lastly, the upper echelon theory, which was developed by hambrick and mason (1984), suggests that corporate outcomes are largely influenced by top management characteristics. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 189 an important measure of the role of the top management team (tmt) is gender diversity (krishnan & park, 2005; krishnan, 2009). according to the upper echelon theory, diversity in the tmt of companies may have positive impact on corporate outcomes because women possess certain unique personal characteristics compared to men. for instance, women’s leadership style encourages more effective communication, deliberation and broader discussion that can enhance board effectiveness; in addition, women are known to be stricter in their monitoring function (adams & ferreira, 2009). in a nutshell, the aforementioned theories have provided a clear relationship between gender diversity and various corporate outcomes that boards and corporate executives can adopt in managing a company. 4. literature review it has been widely acknowledged that gender-based differences play a significant role, not only in leadership styles, but also in communication skills, risk behaviour and various decision-making tasks of the board. these differences have potential implications for corporate governance effectiveness, financing decisions and financial performance. given these differences, several studies have examined if these gender-based differences have a meaningful impact on various corporate outcomes. in general, one of the most common corporate outcomes is the company’s financial performance, as several studies have considered this as a significant measure of a company’s success. some examples of such measures include, return on equity, return on assets, return on sales, return on invested capital, net profit margin and tobin’s q, among others. these outcomes, however, may be largely affected by agency problems, i.e., a situation whereby managers may act against the best interests of shareholders in making corporate decisions. carrying out actions against the interests of the shareholders may derail the performance of the company, as well as the value for the shareholders. one way to prevent this is by enhancing the monitoring capacity of the corporate board (fama & jensen, 1983), including higher female representation on the board. prior empirical studies have indicated that female representation on the corporate board enhances the monitoring function of the board by ensuring that the management acts in the best interests of shareholders (adams & ferreira, 2009; campbell & minguez-vera, 2008). although a gender-diverse board is beneficial, it also has some cost implications (adams et al., 2015; nguyen et al., 2015). the benefit has to do with the positive effect on performance, which improves the value for shareholders, while the cost is vice versa. several empirical studies have revealed a positive relationship between a gender-diverse board and company performance. for example, joy, carter, wagner, and narayanan (2007) discovered a strong and positive relationship between the proportion of female directors on the corporate board and the company’s financial performance among a sample of fortune 500 companies. they indicated that companies with higher number of women on board have stronger financial performance than companies with lesser number of women on board. similar results were also reported by carter, simkins, and simpson (2003); carter, d'souza, simkins, and simpson (2007); and campbell and minguez-vera (2008), for a sample of fortune 500 and 1,000 companies, as well as spanish companies. in addition, schwartz-ziv (2013); and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 190 joecks, pull, and vetter (2013) found that the presence of a critical mass, i.e., when at least three or more women directors (30%) are on board, is associated with better performance for a sample of israeli government business companies (gbc) and german companies. additionally, a comprehensive study of 3,876 multinational public listed companies from 45 countries by terjesen, couto, and francisco (2015) documented that boards with greater proportion of female directors display better financial performance. similarly, arena, cirillo, mussolino, pulcinelli, saggese, and sarto (2015) found that critical mass, rather than the simple presence of female directors, has incremental benefits on company performance among a sample of 211 european union public listed companies in the construction industry from 28 different countries. reguera-alvarado et al. (2015) identified that the increase in the number women on the board positively affected the financial performance of 125 public listed companies on the madrid stock exchange over the period of 2005 to 2009. they concluded that compulsory legislation of female representation on corporate boards is a signal of good corporate governance. in transitional economies, such as hong kong, south korea, malaysia, singapore and vietnam, nguyen et al. (2015); and low, roberts, and whiting (2015), revealed that gender diversity has a significant and positive impact on company performance. nguyen et al. (2015) found that the performance is stronger when there is an increase in the number of female directors on the board. results also showed that as soon as the increase reaches a break-even point of 20%, the positive effect ceases. in contrast, low, roberts, and whiting (2015) discovered that the positive relationship between increased number of female directors on the board and company performance in five asian countries diminishes in countries with higher rate of female empowerment and economic participation. besides, by employing a panel of over 2,000 chinese listed companies from 1999 to 2011, liu, wei, and xie (2014) found that gender diversity has a positive influence on company performance. in particular, female executives indicate stronger positive influence on company performance than female independent directors. therefore, they concluded that the need for women on corporate boards is more than just for the monitoring role. furthermore, they discovered that boards with three or more female directors show stronger positive impact on company performance than those with two or fewer female directors. in fact, other studies (e.g., krishnan & park, 2005; smith, smith, & verner, 2006) have also documented that female representation and their proportion on the tmt are positively associated with company performance. while krishnan and park (2005) used a sample of fortune 500 companies, smith et al. (2006) covered a sample of 2,500 danish companies over the period of 1993 to 2001. gender diversity has been found to be not only sensitive to shareholders, but also to other stakeholders of the company. gupta, lam, sami, and zhou (2014) found that a gender-diverse board enhances the dimensions of social, environmental and governance aspects of a company, and not just financial performance. furthermore, although women are known to contribute to improving board performance (farrell and hersch, 2005; schwartz-ziv, 2013), what goes on in the board meetings may be different from what goes on in the equities market. using a panel data of 400 large us companies from 1997 to 2006, dobbin and jung (2011) found that block holders react asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 191 positively to board diversity. therefore, they proposed that gender diversity may influence performance not through the monitoring capabilities or board efficacy, but rather by activating bias on the part of institutional investors. based on this argument, the results show that gender bias, i.e., the appointment of female directors, negatively affects stock price. on the contrary, talijaard, ward, and muller (2014) presented that a gender-diverse board had a positive impact on share price performance for a sample of 40 largest companies on the johannesburg stock exchange between the periods of 2000 to 2013. apart from that, gender diversity can also result in an increase in cost of decisionmaking, as well as the likelihood of faction and conflict within the team, which may affect the financial performance of a company (adams et al., 2015). darmadi (2013) found that the presence of female top executives is negatively related to performance measurement for a sample of indonesian companies. however, the author states that the generalizability of the result may be difficult because the focus of the study was only a single year. joecks, pull, and vetter (2013) revealed that the presence of female directors on the board had a significant and negative impact on company performance among a sample of 151 german companies over the period of 2000 to 2005. in addition, adams and ferreira (2009) determined that a negative relationship exists between board gender diversity and company performance in the us, partially attributed to the over-monitoring role by female directors. besides, ahern and dittmar (2012) found that imposing a quota of 40% of female directors on boards in norwegian public listed companies resulted in lower firm value. therefore, they attributed their findings to the fact that this law forces firms to comply with the female quota. khalife and chalouhi (2013); and alowaihan (2004) determined that the causes for the gross revenue of female-owned companies to be lower than that of male-owned companies in kuwait and lebanon are due to liability of market newness suffered by female executives and lack of business experience. nevertheless, other studies have documented that gender diversity is unrelated to a company’s financial performance (gallego-álvarez, garcía-sánchez, & rodríguez-dominguez, 2010; rose, 2007). it should also be noted that it is not only gender diversity that matters, but also the quality of women on the corporate board. for instance, pucheta-martınez and bel-oms (2014) discovered that the presence of independent female directors with academic degrees on the nomination and compensation committees reduces the gender wage gap. this suggests that future studies should also consider the quality of women on the board of directors. furthermore, literature on psychology indicates that women have better communication skills and tend to perform better in terms of problem-solving and decision making (dallas, 2002; schubert, 2006). in line with this claim, one would expect that female ceos exhibit better performance than male ceos or chairmen. for example, peni (2012) determined that companies with female ceos/chair outperform male-led companies, which is an indication that the presence of female ceos/chair has a significantly positive impact on a company’s financial performance. in fact, some of the behavioural characteristics of women, such as their risk averseness and conservatism on certain issues, can affect the company’s legitimacy, corporate bank capital ratio and default risk. moreover, empirical evidence from the us retail industry and s&p’s 1,500 companies has revealed that the presence of women on the tmt asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 192 and board, as well as female ceos, is negatively associated with legal and company risks (bao, fainshmidt, nair, & vracheva 2014; faccio, marchica, & mura, 2015; peltomaki, swidler, & vahama, 2015). similarly, palvia, vahama, and vahama (2014) justified the conservativeness and the risk-averse nature among women directors. they found that us commercial banks with female ceos hold a more conservative level of capital after controlling for bank asset risk and other attributes. consequently, women also tend to try as much as possible to stay out of trouble. adhikari, agrawal, and malm (2015) used hand-collected data on corporate lawsuits to examine the effect of women on the tmt pertaining to corporate litigation. they asserted that companies with higher percentage of women on the tmt attract fewer lawsuits, especially in the area of product, environmental and medical liability, labour and contract. in another related study, palvia et al. (2014) also discovered that gender diversity is relevant when a company is faced with financial distress or during a crisis because smaller banks with female ceo/chairpersons are less likely to fail. similarly, strom, espallier, and mersland (2014) found that micro-finance institutions managed by female ceos and chairpersons displayed better performance than their male counterparts. moreover, with plant-level us data, tate and yang (2014) revealed that companies managed by female ceos cultivate more women-friendly culture, which increases the outcome of ceos and results in smaller wage gaps between the genders. in addition, the increase in the number of women on the corporate board influences various corporate decisions, such as fewer employee layoffs, higher labour cost and lower profit. this also has led to replacement of ceos during poor financial performance (schwartz-ziv, 2013). in corporate finance literature, mergers and acquisitions are also a crucial corporate decision where gender-related behavioural traits may be very important in the board room because male executives are likely to be more overconfident than female executives (huang & kisgen, 2013; levi et al., 2014). besides, empirical evidence by huang and kisgen (2013) on us companies has documented that male executives are relatively overconfident compared to female executives, especially when concerning decisions related to acquisition and debt issues. in particular, they identified that men executives undertake more acquisition and debt issues than female executives. in fact, companies managed by female executives grow more slowly and are less likely to make acquisitions. however, announcement returns on acquisition and debt issues made by female executives are higher than that of male executives. in addition, earnings forecasts made by female executives have significantly wider bands than male executives. levi et al. (2014) examined the impact of the presence of women on corporate boards pertaining to acquisitions, as well as the financial terms of acquisition in terms of bid premium paid. they found that companies with more women directors are less acquisitive than companies with fewer women directors, the economic interpretation being that the presence of women on the board reduces acquisition frequency by 8%. in addition, bidders with women directors on the acquisition board are negatively associated with the size of bid premium. further details show that they are also associated with lower bid premium at 15% compared to bidders with exclusively men directors. these justify that women directors asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 193 have less confidence in the precision of their estimation on acquisition and their expected value of acquisitions. in addition, the structure of a company’s capital is another important financing decision. faccio, marchica, and mura (2015) asserted that companies managed by female ceos are associated with less volatile earnings, lower leverage, and higher chance of survival, compared to companies managed by male ceos. additionally, harris (2014) examined the relationship between corporate leverage and gender diversity for a sample of fortune 500 us public listed companies over the period of 2012 to 2013. the author classified the sample into companies with no women on board and companies with 25% of women directors on board. the results indicated that gender diversity for a company with 25% of women on board has a direct significantly negative relationship with corporate leverage, as well as a moderating effect between board age and size on corporate leverage. in addition, it is well-acknowledged that men and women behave somewhat differently in terms of decision making, cognitive functioning and ethical behaviour, which may have important implications on financial reporting quality (peni & vahamaa, 2010). furthermore, women are known to be less corrupt and more dedicated to their duties (gender report, 2012). thus, gender diversity creates a more transparent and informative environment because women tend to be more concerned with interpersonal relationships and rules conformity. for instance, thiruvadi and huang (2011) suggested that the presence of female directors on the audit committee can affect management decisions and audit quality. empirical evidence presented by capezio and mavisakalyan (2015), after examining the relationship between proportion of women on the corporate board and cases of fraud among 128 australian listed companies, revealed that higher percentage of women representation on corporate boards reduces the probability of fraud. since women are known to be strict and ethically-oriented, a gender-diverse board can also help in reducing earnings management practices. a study by arun, almahrog, and aribi (2015) showed that uk companies with higher number of independent female directors on the corporate board, have reduced earnings management practices. on top of that, kyaw, olugbode, and petracci (2015) also presented similar result among european countries with high gender equality. in addition, thiruvadi and huang (2011) found that the presence of female directors is associated with income decreasing earnings management among a sample of 320 s&p small cap companies. similarly, niskanen, karjalainen, karjalainen, and niskanen (2012) documented differences in cosmetic earnings management between companies audited by male auditors and female auditors among private small and medium enterprises (smes) in finland. they found that companies audited by male auditors engage in more cosmetic earnings management compared to those audited by female auditors. also, ittonen, vähämaa, and vähämaa (2013) investigated finnish and swedish listed companies and revealed that companies with female audit engagement partners are associated with small abnormal accruals. peni and vahamaa (2010) also showed that companies with cfos are associated with income decreasing discretionary accruals, which indicate that female executives engage in conservative earnings management strategies. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 194 in contrast, they did not find any relationship between ceos’ gender and earnings management practices. another study by upadhyay and zeng (2014) that employed the herfindahl index for gender and ethnic diversities on board to examine their impact on corporate opacity measured as share turnover, analysts forecast error and bid-and-ask spread, found that gender and ethnic diversities are negatively associated with corporate opacity. however, the use of herfindahl index is somewhat confusing because it considers a board with higher proportion of ethnic and women directors as a less diverse group. in contrast, ye, zhang, and rezaee’s (2010) study that covered chinese companies showed that the gender of top executive members is unrelated to earnings quality, proxied by earnings persistence, accuracy of current earnings in forecasting future cash flows, absolute magnitude of discretionary accruals and association between earnings and stock returns. a study by hili and affes (2012) on 70 french companies listed on the sbf 120 index indicated that gender diversity is unrelated to earnings persistence. this review further confirms that gender diversity has multifaceted roles on various corporate outcomes, such as both financial and non-financial performances of a company, corporate risk taking, financial reporting quality, improved audit quality and committee activities. 5. conclusion this review demonstrates that gender diversity matters for various corporate outcomes, such as financial performance, market reaction, survival, corporate risk taking, corporate financing decisions and financial reporting quality. however, the detailed comprehension on the association between gender-based diversity and these corporate outcomes still remains unclear. in fact, empirical evidence on this aspect has been entirely skewed to developed countries with only a few studies in transitional economies, leaving the frontier markets unexplored. however, most frontier markets are immature and are characterised by a less developed external corporate governance mechanism. in fact, the results from a frontier market, like nigeria, is worth studying, especially in considering the differences in culture, language, economic development, legal system and personal values, as well as the importance of female directors and executives on the corporate board. indeed, there is a need to conduct more empirical studies on this area. moreover, the results from this frontier market can also enhance other empirical results from the developed market. this is because women are well-known to be friendlier than men, better in monitoring, exhibit more frequency in board meetings, are more conservative, less 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(2004). characteristics of women and men corporate inside directors in the us. corporate governance: an international review, 12(3), 337-342. http://ssrn.com/abstract=557315 microsoft word 8318-30109-1-sm _1_-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 120 ceo succession, investor expectations, and real earnings management chaur-shiuh young department of accountancy and graduate institute of finance & banking national cheng kung university no.1 university rd., tainan city 701, taiwan tel: 886-6-275-7575 #53445 e-mail: actycs@mail.ncku.edu.tw yueh-ju lin (corresponding author) department of accounting, kainan university no. 1 kainan rd., luzhu, taoyuan 33857, taiwan tel: 886-3-341-2500#1661 e-mail: judylin@mail.knu.edu.tw fei-liang chien department of accounting, kainan university no. 1 kainan rd., luzhu, taoyuan 33857, taiwan tel: 886-3-341-2500#4901 e-mail: acctvera@gmail.com chia-hui chen dept. of accounting, national dong hwa university no.1 sec.2, da hsueh rd., shoufeng, hualien, 97401 tel: 886-3-863-3088 e-mail:chchen@mail.ndhu.edu.tw received: sep. 8, 2015 accepted: oct. 11, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8318 url: http://dx.doi.org/10.5296/ajfa.v7i2.8318 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 121 abstract recently, u.s. firms are switching ceo at the fastest pace and these events often cause severe stock market volatility on the uncertainty of the firm’s future performance. this study investigates whether inverse market reaction on ceo succession will induce earnings management of new ceos in order to protect their reputational and career prospects. from a sample of 2,418 firm-years during the post-sox period of 2003 to 2012 by applying the regression analysis, we investigate two associations of real earnings management (rem) with ceo successions and with its market reaction respectively. our results suggest new ceos are more careful when manipulate earnings through rem activities. however, rem is negatively associated with market expectations on ceo successions, implying new ceos may utilize rem to reverse the first bad impressions held by investors. we provide a new perspective with regard to market reactions to ceo successions, by examining how and why new ceos may choose to manipulate earnings. keywords: ceo succession, ceo impression management, market reaction, abnormal return, real operating activities manipulation, earnings management jel classification: g14, m12, m40, m41 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 122 1. introduction on october 8, 2011 the wall street journal stated that the average tenure of a fortune 500 ceo was 10 years in 2000, eight years in 2010, but only 4.6 years in 2011. when a firm changes its chief executive officer (ceo), who is mainly responsible for the firm's operating strategies, investment decisions, and resources allocations, thus the level of uncertainty is raised. prior studies show that changing the ceo can significantly impact the stock price and operations of a firm, due to the unknown aspects of “human capital” and the signalling of uncertainty with regard to the company’s strategies (furtado and karan 1990; clayton et al. 2005).the issue of ceo successions, and their related effects, is thus an issue that deserves more research. a series of financial accounting studies that examine the relation between ceo succession and the quality of financial statements find that new ceos may engage in earnings management through manipulation discretionary accruals. based on the idea of “taking a big bath”, these works find that new ceos tend to lower earnings in the transition year, as these can be blamed on the departing ceos, and then take advantage of accruals reversals to improve performance in the next year, thus enhancing their own reputations (e.g. pourciau 1993; godfrey et al. 2003). a survey carried out by graham et al. (2005) shows that the goal of establishing and maintaining a good reputation may significantly affect the financial reporting decisions that ceos make. furthermore based on the “rent extraction” perspective, francis et al. (2008) find that highly reputed ceos have stronger motivations to manipulate earnings in order to maintain their professional images, which may result in lower quality reporting of earnings. in contrast, ali and zhang (2013) suggest that as ceo tenure becomes longer, ceos prefer to recognize negative news in a timely manner and to reduce the amount of discretionary accruals in order to protect their reputation. cao et al. (2012), extending the concept of reputation to the entire company, show that reputational concerns can motivate highly reputed firms to maintain good financial reporting quality. overall, although tenure, career reputation, or the idea of taking big bath may be the reasons to impact new ceos earnings management decisions, undoubtedly, ceos on their successions may possess the motivation of earnings management. however, these studies only focus on accruals management (hereafter aem), and neglect real earnings management (hereafter rem). rem means managing a firm’s real operating activities to meet or beat earnings benchmarks, and this approach is more likely to impact the firm’s cash flows and future performance than the use of aem to achieve this. due to the high litigation risk in the post-sox (sarbanes-oxley act) period, managers now use rem more often than aem to manipulate earnings (graham et al. 2005; cohen et al. 2008). our first research purpose is thus to explore whether firms with ceo successions have more incentives to engage in rem than those without ceo successions. prior studies indicate that a ceo’s public image is established based on market perceptions of their abilities (e.g. holmstrom 1999; milbourn 2003). any unexpected equity volatility due to new ceo may represent investors’ perceptions or valuations of the new ceo’s abilities. a positive market perception (reaction) can motivate managers to manage earnings to match investors’ expectations, so as to build or retain their reputations and career prospects. however, the incoming ceos if face with negative market reactions have stronger motivations to prove the market their capabilities through aggressive earnings management to asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 123 reverse investors’ negative beliefs (clayton et al. 2005). it is thus an empirical issue as to how market expectations affect a new ceo’s earnings management behaviors. this work matches one non-succession observation for each succession observation and finds that compared to non-succession firms, ceo succession firms are negatively related with rem, indicating the new ceo is likely to carefully use rem as a way to enhance earnings. however, we also find that when new ceos are faced with negative cumulative abnormal returns (cars), they are more likely to engage in rem than those with positive cars, since they are under more pressure to reverse the negative perceptions that the market has of them. these findings are also supported by the additional test of change models, which is a way to exclude the issues of inherent earnings management and self-selection bias from our results. our evidence offers varied insights from previous studies by proving the increasing market volatility can influence the new ceo’s accounting policies in order to protect their reputations and job prospects. we offer evidence with regard to how the market’s perceptions of new ceos’ capabilities affect their real earnings management behavior. the rest of this paper is organized as follows. section 2 presents a review of the literature and hypotheses development, while section 3 provides our research design and empirical models. section 4 presents the empirical results of this work, and section 5 then gives the conclusions. 2. literature reviews and hypotheses development 2.1 earnings management and ceo succession the prior literature indicates that new ceos have greater incentives to manipulate discretionary accruals, since they face pressure to convince the board and investors that they are able to improve future earnings. according to davidson iii et al. (2004), the first impression new ceos establish can have significant effects on their career prospects and firms’ future performance. ali and zhang (2013) note that a short tenured ceo may engage in aggressive financial reporting choices in order to establish a good reputation at an early stage of their career. therefore, ceos have an incentive to inflate reported earnings at the beginning of their tenure. similarly, francis et al. (2008) and seybert (2010) provide empirical and experimental evidence to support the view that ceos’ reputational concerns significantly affect their financial reporting decisions. on the other hand, most prior studies support the idea of “taking a big bath”, that new ceos tend to decrease earnings in the year of their succession to impute the bad performance to the pervious managers and to lower the benchmark for performance in the subsequent year. then, the new ceo may be able to significantly improve results, and thus impress stakeholders (pourciau 1993; godfrey et al. 2003). taken together, these results indicate that ceo succession may impact financial reporting quality, although in exactly what ways remains an open question. 2.2 management behavior with regard to manipulating real operating activities according to healy and wahlen (1999), roychowdhury (2006) defines it as “departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations.” in short, rem is when ceos manipulate real operating activities to meet short-term earnings targets. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 124 managers may engage in earnings management to meet benchmarks in an effort to enhance the firm’s credibility and reputation with stakeholders (burgstahler and dichev 1997; bartov et al. 2002). the survey in graham et al. (2005) finds that 74.1 percent of managers try to meet earnings benchmarks to provide evidence of future growth prospects. managers tend to engage more of rem than aem because of the fear of accounting fraud stigma attached after sox or litigation associated with aem (cohen and zarowin 2010; cohen et al 2008; gunny 2010; roychowdhury 2006; taylor and xu 2010; zang 2012). as managers prefer applying rem to manage short-term earnings, which is harder to be detected (cohen et al. 2008; cohen and zarowin 2010; zang 2012), rem may influence a firm’s cash flows and future performance by altering operating activities. however, concerning reputation and career prospective, whether the ceo successor manages earnings through altering real operation activities remains uncertain. therefore, we test the following non-directional hypothesis, stated in its null form, to examine this issue: h1: ceo successions are not associated with real earnings management. 2.3 market reactions to ceo successions a market reaction means a news or a relevant economic release which may induce a strong directional move in stock markets. through these reactions, the investor’s perception of that event will be observed. prior studies have documented the relationship between market reactions and ceo changes. for example, beatty and zajac (1987) suggest that ceo turnover leads to uncertainties about firm strategy, which can have adverse impacts on investors’ perceptions of the company. huson et al. (2004) and demerjian et al. (2011) find positive market reactions when a poorly performing ceo is replaced by an outside manager, since investors feel that this may improve future performance. similarly, holmstrom (1999) and milbourn (2003) state that a ceo’s reputation is based on the market perceptions of their abilities. that is, a significant reaction to ceo succession may signal (1) expectation with regard to the firm’s future operations and (2) concerns about the successor’s abilities (clayton et al. 2005). moreover, one question that arises in this context is whether the market reaction to a new ceo induces the incentive of earnings management by manipulating real operating activities of the new manager? a survey in graham et al. (2005) indicates that ceos are concerned about stock price losses, which may significantly damage both their reputations and job prospects. the survey further states that managers often choose to sacrifice the long term economic value of their firms to avoid more severe firm value damaged by market reactions to missing the earnings expectations of analysts and investors. some studies also document that when managers face increased capital market pressure, they may sacrifice the long term value of a firm to achieve short term earnings benchmarks (bhojrai and libby 2005; zhao et al. 2012). in this study, we postulate that when positive market reactions occur in response to ceo succession, investors judge the new ceo is competent. thus, in order to protect their reputations, these welcomed ceos by market tend not to apply rem which may damage a firm’s future operating performance. in contrast, when negative market reactions occur in asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 125 response to ceo succession, the new ceo is more likely to aggressively enhance earnings in order to immediately rebuild investors’ confidence (clayton et al. 2005). that is, ceo successors suffer negative market reactions may engage in higher level of rem. accordingly, the second hypothesis is thus as follows: h2: the degree of real earnings management is more pronounced for successor ceos who face greater pressure with regard to satisfying the expectation of investors. 3. methodology and data 3.1 regression model to investigate the impact of hiring a new ceo on a firm’s use of rem, we match one non-succession observation for each succession observation based on the same industry, same year, and nearest total assets. equation (1) is used to test hypothesis one, based on roychowdhury (2006) and gunny (2010). remi,t= β0 + β1 suci,t + β2 dai,t + β3 lnati,t +β4 mbi,t + β5 roai,t + β6 levi,t + β7 big4i,t + β8 litigationi,t + εi,t (1) second, we use succession observations to detect how market reactions to ceo successions impact the degree of rem. the hypothesis two is examined by equation (2) which is shown as follows. remi,t = γ0 + γ1 cari,t + γ2 dai,t + γ3 lnati,t + γ4 mbi,t + γ5 roai,t + γ6levi,t +γ7 big4i,t + γ8 litigationi,t + μi,t (2) the next section presents the definitions of the variables and their predicted signs. 3.2 variable definitions 3.2.1 dependent variables: proxies for real earnings management (rem) following dechow et al. (1998) and roychowdhury (2006), we use abnormal cash flows from operations (ab_cfo), abnormal production costs (ab_prod), and abnormal discretionary expenditures (ab_disexp) as measurements of rem. first, lower ab_cfo is achieved through sales manipulation, by offering sales discounts or lenient credit terms to boost sales and temporary increase earnings. second, engaging in overproduction, a lower of operating cash flow and cost of goods sold (cogs) is implied. third, reducing discretionary expenditures in sales and administration, r&d and advertisement can avoid losses and inflate earnings, and when paid in cash, operating cash outflows is lowered. when firms manage earnings upward, it is more likely to result in abnormally low cash flows from operations and discretionary expenditures, and abnormally high production costs. the normal level of cfo is estimated through equation (3) based on the model, which is a linear function of sales and changes in sales, estimated for each year and industry through a cross-sectional regression. note that ab_cfo is multiplied by -1, so that a higher value indicates a higher degree of upward sales manipulation. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 126 , , , 0 1 2 3 , , -1 , -1 , -1 , -1 1i t i t i t i t i t i t i t i t cfo sales sales a a a a α α α α ε δ = + + + + (3) where for fiscal year t and firm i, cfoi,t is cash flow from operations in year t; ai,t-1 is total assets at the beginning of year t; salesi,t is the sales during year t; and ∆salesi,t is change in sales in year t, defined as salesi,t－salesi,t-1. second, we define overproduction as ab_prod, estimated by subtracting the normal level of production costs from the actual production costs. the normal level of production costs (prod), as shown in equation (4), is the sum of cogs and change in inventory (∆inv) during the year. cogs is a linear function of the contemporaneous sales, as shown in equation (5), and the change in inventory is also a linear function of the contemporaneous and lagged changes in sales, as shown in equation (6). , , , , -1 , , , -1 0 1 2 3 4 , , -1 , -1 , -1 , -1 1 i t i t i t i t i t i t i t i t i t i t i t i t prod cogs inv a sales sales sales a a a a α α α α α ε = + δ δ δ = + + + + + (4) given , , 0 1 2 , , -1 , -1 , -1 1i t i t i t i t i t i t cogs sales a a a α α α ε= + + + (5) and , , , -1 0 1 2 3 , , -1 , -1 , -1 , -1 1i t i t i t i t i t i t i t i t inv sales sales a a a a α α α α ε δ δ δ = + + + + (6) where for fiscal year t and firm i, prodi,t is the production costs in period t; defined as the sum of cogs and the change in inventory; cogsi,t is costs of goods sold during year t; ∆invi,t is the change in inventory in year t; and ∆salesi,t is change in sales in year t. the third form of rem is ab_disexp, which is estimated by subtracting the normal level of discretionary expenditures (disexp) from the actual ones. the normal level of discretionary expenditures is predicted through equation (7), which is a linear function of lagged sales, estimated for each year and industry through cross-sectional regression. abnormally low discretionary expenditures indicate a reduction in this spending. we multiply ab_disexp by -1, so that a higher value represents a greater reduction in discretionary expenditures. , , -1 0 1 2 , , -1 , -1 , -1 1i t i t i t i t i t i t disexp sales a a a α α α ε= + + + (7) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 127 where for fiscal year t and firm i, disexpi,t is the discretionary expenditures in period t; defined as the sum of advertising, r&d, and selling, general and administrative (sg&a) expenses; and salesi,t-1 is sales in the beginning of year t. finally, in order to capture the effects of rem through all these three variables in a comprehensive measure, we compute an aggregated variable (sum_rem) representing the sum of the standardized variables ab_cfo, ab_prod, and ab_disexp. and the higher value of sum_rem represents relatively higher level of rem. 3.2.2 independent variables as equation (1) is applied to test hypothesis one, we use an indicator variable (suc) to proxy ceo succession. suc equals 1 if the firm has experienced a ceo succession in year t, and 0 otherwise. according to the inference of hypothesis one, we do not state any predicted signs with regard to the associations between ceo succession and rem. as prior studies indicate that a ceo’s reputation is established by market perceptions of their abilities (e.g. holmstrom 1999; milbourn 2003), we assume that market reaction to a ceo succession reflects investor perception of the reputation of the new manager. referring to brown and warner (1980), we use the market adjusted return to measure the market reaction by car for a three-day window period, starting one day prior to the succession. the proxy we use is the simple sum of the abnormal return, given by the difference between the firm’s return and that of a market portfolio, over the three-day window (-1,1), since beaver (1968) documents that most market reactions occur during this period. for the test of hypothesis two in equation (2), we predict that the market reaction to the succession is an explanatory variable that will negatively affect the level of rem (γ1<0). that is, the more market pressure (negative market reaction) the new ceo suffers, the grater the incentive to carry out rem. furthermore, we divide the cars into two groups, positive and negative, and then we apply the wald coefficient test to examine the differences between these. when we estimate equation (2) using these two groups of cars, we use the absolute value of cars (car*) to integrate the predicted direction, and thus a positive relation between absolute value of cars and rem is predicted, specifically in the negative cars group. if the coefficient of car in the group with negative cars (car<0) is significantly greater than that in the group with positive cars (car>0), then hypothesis two is supported. 3.2.3 control variables as prior studies have demonstrated that firms generally manipulate earnings using rem and aem simultaneously (roychowdhury 2006; cohen and zarowin 2010; gunny 2010; zang 2012), we incorporate discretionary accruals (da) to represent aem in the regression and predict a positive relation between rem and aem. to estimate aem, a performance-matched modified-jones model (1991) is applied and roa is also included as the application of accruals to manage earnings is affected by firm performance (kothari et al 2005) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 128 because of the systematic variations in growth opportunities and size effects on rem (roychowdhury 2006), both market-to-book value ratio (mb) and firm size (lnat) estimated by the logarithm of total assets at the beginning of the year are included in the model. in addition, roa, measured as income before extraordinary items scaled by lagged total assets, is also controlled in our regression (e.g. roychowdhury 2006; gunny 2010; zang 2012). we do not predict signs on the associations between these three variables and rem, as in roychowdhury (2006). we also control for the leverage (lev) since a high ratio of debt to equity generally implied earnings manipulation (watt and zimmerman 1986). lev is the ratio of total liabilities to total assets. finally, big4 is a dummy variable that equals 1 if the firm engaged one of the largest four audit firms, and 0 otherwise. firms audited by big four auditors may choose rem instead of aem when managing earnings, since after sox, aem is easier to detect and relatively costly than rem (chi et al. 2011; zang 2012). firms in high litigation risk industries (litigation) are also more likely to be noticed and detected by the public and regulators if manage earnings through aem (cohen and zarowin 2010; zang 2012). litigation is a dummy variable that equals 1 if the firm is in sic codes 2833-2836, 3570-3577, 3600-3674, 7371-7379, and 8731-8734, and 0 otherwise. 3.3 data and sample selection we collect the ceo changes, financial and stock price related data from the execucomp, compustat, and crsp databases, respectively. the initial sample from execucomp with ceo changes is 2,418 firm-years for the period of 2003 to 2012. the sampling period starts in 2003 to avoid the influence of sox, based on cohen et al. (2008), who suggest that firms have engaged in more rem after sox. we exclude financial firms (sic codes 6000 to 6500), firms in regulated industries (sic does 4400 to 5000), and public administration and other firms (sic codes 9000 to 10000), because the rem models applied in this work are not suitable for these industries. after deleting observations with missing data and outliers whose absolute value of studentized residual from the regression is greater than two, we match one non-succession observation for each succession observation based on the same industry, year, and nearest total assets, leading to a final sample of 2,339 firm-years for testing hypothesis one. the sample used to test hypothesis two is based on the initial 1,241 firm-year sample before excluding outliers for testing hypothesis one, and after eliminating outliers (using the same method as with h1) we obtain a final sample of 1,178 firm-years. 4. empirical analysis 4.1 descriptive statistics table 1 provides the descriptive statistics of the research variables used in the analysis. compared to non-succession firms, firms in the succession sample tend to have significantly lower means and medians for most rem proxies. these results show that firms with new ceos are less likely to engage in rem than those that do no change their ceos. the mean (median) of the car at a three-day window around the ceo succession is 0.0015 (0.0003), indicating that on average the market believes that the new ceo will be able to improve the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 129 firm’s performance. the succession group has a lower mean and median in the performance measure (roa) than the non-succession control group. the significantly lower performance in ceo succession firms indicates that firms with poor performance tend to replace ceos in order to turn around current operations. we do not find any significant differences between the succession and non-succession samples with regard to the other variables, indicating that the sample matching process is valid and there is no significant difference between the testing and control groups. in table 1, since we examine the differences between the variables for the testing and control groups, we use the sample for h1 to present the descriptive statistics. there are no significant differences in the results when we use the sample (1,178) for h2 (untabulated). table 1. descriptive statistics succession sample (n=1,166) non-succession sample (n=1,173) difference tests variables 2 mean median standard deviation mean median standard deviation mean median t-statistics z-statistics sum_rem -0.0309 -0.0066 0.3053 0.0177 0.0201 0.3076 -3.83 *** -3.46 *** ab_cfo1 -0.0403 -0.0349 0.0912 -0.0412 -0.0371 0.0895 0.25 0.19 ab_prod -0.0343 -0.0282 0.1488 -0.0124 -0.0106 0.1519 -3.52 *** -3.21 *** ab_disexp1 0.0437 0.0535 0.1681 0.0713 0.0775 0.1633 -4.04 *** -3.90 *** da -0.0169 -0.0142 0.0535 -0.0094 -0.0081 0.0549 -3.37 *** -3.40 *** car 0.0015 0.0003 0.0599 lnat 7.2447 7.1144 1.6687 7.2448 7.1263 1.6802 -0.00 -0.11 mb 2.9688 2.1113 2.8020 2.8625 2.0769 2.6242 0.95 0.73 roa 0.0247 0.0446 0.1242 0.0393 0.0504 0.1057 -3.06 *** -2.19 ** lev 0.4849 0.4868 0.1982 0.4852 0.4897 0.2046 -0.04 -0.20 big4 0.9160 1.0000 0.2776 0.8977 1.0000 0.3032 1.52 1.52 litigation 0.2702 0.0000 0.4442 0.2472 0.0000 0.4316 1.27 1.27 1 we multiply the abnormal levels of cash flow from operations and the abnormal levels of discretionary expenditures by -1, so that the higher values of these two variables represent higher rem. 2 sum_rem: the aggregation of ab_cfo, ab_prod, and ab_disexp; ab_cfo: the abnormal level of cash flow from operations; ab_prod: the abnormal level of production costs; ab_disexp: the abnormal level of discretionary expenditures; suc: a dummy variable that equals 1 indicating ceo succession, and 0 otherwise; car: cumulative abnormal return over the three-day window (-1,1); da: the discretionary accruals estimated using the “performance-matched” modified-jones model; mb: the ratio of market value of equity to book value of equity; lnat: the logarithm of the market value of equity at the beginning of the year; roa: income before extraordinary items scaled by lagged total assets; lev: the ratio of total liabilities to total assets; big4: a dummy variable that equals 1 if the firm engaged one of the largest four audit firms, and 0 otherwise; litigation: a dummy variable that equals 1 if the firm is in sic codes 2833-2836, 3570-3577, 3600-3674, 7371-7379, and 8731-8734, and 0 otherwise. 4.2 multivariate results 4.2.1 results for the relation between real earnings management and ceo successions (h1) table 2 presents the regression results for testing hypothesis one, which examines the impact of hiring a new ceo on a firm’s level of rem. all the models fit well with the adjusted r2 values between 11% and 49% (significant at 1% level). except for the positive but marginally significant relation with abnormal cash flow (ab_cfo) (p-value<0.1), ceo succession (suc) is negatively and significantly related to sum_rem, ab_prod, and ab_disexp (all p-value<0.01). the coefficients of sum_rem, ab_cfo, ab_prod, and ab_disexp asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 130 are -0.033, 0.005, -0.016, and -0.021, respectively. according to roychowdhury (2006), the positive relation between suc and ab_cfo may be induced by the mixed effects of various real earnings manipulation methods on the level of cash flow from operations. the negative relations between ceo succession and most rem proxies indicate that incoming ceos are less likely to manipulate earnings in ways that impact real operating activities. with regard to the control variables, the coefficients of da are positive and significant for all rem proxies, implying that managers may use both aem and rem at the same time. all coefficients of mb and roa are negative and significant for all rem proxies, implying that firms with higher growth rates and better performance may not need to manage earnings in this way. lnat is negative and significant for ab_cfo, ab_prod, and ab_disexp, but marginally significant for sum_rem. this result indicates that when firms are larger, they are less likely to engage in rem. litigation is negatively and significantly related to sum_rem, ab_cfo, and ab_prod, but positively and significantly related to ab_disexp. the results imply that firms in high litigation industries are less likely to manage earnings using either rem or aem. consistent with the prior literature, lev is positively and significantly related to all rem proxies, implying that high leverage firms tend to use rem to avoid debt covenant violations (roychowdhury 2006; matsuura 2008). big4 is positively related with most rem proxies, indicating that firms audited by one of the big-four auditors shift from using aem to rem. finally, consistent with the results of the correlation tests, the vifs for independent variables show that vifs are all smaller than 2.3, suggesting that multicollinearity is not an issue. we also use the nearest sales to match one non-succession observation for each succession observation, and the results are consistent. table 2. results for the relation between real earnings management and ceo succession at the succession year variables predicted sign dependent variable (n=2,339) sum_rem ab_cfo1 ab_prod ab_disexp1 intercept ? -0.001 0.009 0.014 -0.024 (-0.02 ) (0.91 ) (0.75 ) (-1.12 ) suc ? -0.033 *** 0.005 * -0.016 *** -0.021 *** (-3.07 ) (1.88 ) (-3.02 ) (-3.29 ) da + 1.581 *** 0.773 *** 0.539 *** 0.270 *** (14.61 ) (25.74 ) (9.55 ) (4.15 ) lnat ? -0.007 * -0.010 *** -0.008 *** 0.011 *** (-1.75 ) (-9.46 ) (-3.73 ) (4.65 ) mb ? -0.042 *** -0.006 *** -0.020 *** -0.017 *** (-16.95 ) (-8.55 ) (-15.18 ) (-10.34 ) roa ? -0.137 *** -0.188 *** -0.108 *** 0.159 *** (-2.58 ) (-10.10 ) (-3.60 ) (4.46 ) lev + 0.392 *** 0.110 *** 0.180 *** 0.102 *** (12.63 ) (12.5 ) (11.25 ) (5.18 ) big4 + 0.016 0.012 ** 0.015 * -0.011 (0.79 ) (2.12 ) (1.44 ) (-0.85 ) litigation + -0.056 *** -0.026 *** -0.049 *** 0.019 *** (-4.39 ) (-7.29 ) (-7.19 ) (2.40 ) year dummy yes yes yes yes model f value 61.21 *** 132.08 *** 48.50 *** 18.26 *** adj. r2 30.45 % 48.80 % 25.67 % 11.15 % asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 131 1 the abnormal levels of cash flow from operations and discretionary expenditures are multiplied by -1, so that higher values of these suggest higher degrees of rem. 2 *, **, *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively (a one-tailed test for the coefficients with predicted signs, and a two-tailed test otherwise). 3an analysis of the variance inflationary factors (vifs) for each model reveals that vifs are all smaller than 2.3, suggesting that multicollinearity is not an issue. 4variable definitions are shown in table 1. 4.2.2 results for the relation between real earnings management and the market reaction on ceo succession (h2) table 3 shows the results of the tests of hypothesis two. the explanatory powers of the models are all significant at a level of 1%, with adjusted r2 values between 10% and 53%. in panel a, it shows the results for the aggregated value of three individual rem variables (sum_rem). we first use equation (2) to examine the relationship between car and sum_rem. the coefficient on car in the full sample is negative (-0.398) and significant at the 1% level, suggesting that the new ceo who face greater pressure from the market (negative market reaction) are more likely to engage in rem. next, we further divide car into two groups: positive car (car>0) and negative car (car<0). since car* in these two subgroups proxies the absolute value of car, firms with positive coefficients of car* indicate that firms are more likely to undertake real activities management. in column 2, the coefficient for the absolute value of negative car is positive (0.430) and significant at the 5% level. conversely, in column 3, the coefficient for the absolute value of positive car is negative (-0.769) and significant at the 1% level. by using wald coefficient test to analyze the coefficient difference of car* between these two sub-samples, the result shows that ceo succession firms with negative car are more likely to engage in rem, as measured by sum_rem, than ceo succession firms with positive car, significant at the 1% level (f-value=3.66). these results thus support hypothesis two. similarly, panel b to d of table 3 shows the results for three separate proxies of rem. for brevity, we only summarize the results about the main variable. the results show that the coefficient of car in the full sample is negatively and significantly (p-value<0.05 at least) related to overproduction (ab_prod) and abnormal discretionary expenditures (ab_disexp). most coefficients of car* for the car<0 group (car>0 group) are significant and positive (negative). and the wald coefficient test to examine the differences in coefficients between these two groups shows that ceo succession firms with negative car are more likely to engage in rem, as measured by ab_cfo, ab_prod, and ab_disexp, than those with positive car. hypothesis two is also supported by these findings. finally, the results regarding to control variables in table 3 are qualitatively the same as those reported in table 2. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 132 table 3. results for the level of real earnings management at the succession year panel a: the results for the aggregation of real earnings management variables predicted sign dependent variable: sum_rem full sample sub sample difference in coef. car<0 car>0 (wald test f value) intercept ? -0.103 ** -0.050 -0.141 * 0.091 (-2.09 ) (-0.68 ) (-1.79 ) (0.85 ) car -0.398 *** (-3.15 ) car* + 0.430 ** -0.769 *** 1.199 *** (2.08 ) (-3.03 ) (3.66 ) da + 1.572 *** 1.855 *** 1.334 *** 0.521 (10.45 ) (8.35 ) (5.73 ) (1.62 ) lnat ? 0.002 0.002 -0.001 0.003 (0.29 ) (0.23 ) (-0.12 ) (0.24 ) mb ? -0.040 *** -0.043 *** -0.038 *** -0.005 (-12.96 ) (-8.80 ) (-8.42 ) (-0.81 ) roa ? -0.203 *** -0.202 ** -0.219 ** 0.017 (-3.04 ) (-2.10 ) (-2.07 ) (0.12 ) lev + 0.371 *** 0.312 *** 0.448 *** -0.136 (7.65 ) (4.84 ) (6.48 ) (-1.44 ) big4 + 0.035 0.040 0.030 0.010 (1.20 ) (1.11 ) (0.63 ) (0.17 ) litigation + -0.066 *** -0.053 ** -0.076 *** 0.023 (-3.65 ) (-2.13 ) (-2.89 ) (0.66 ) n 1,178 582 596 year dummy yes yes yes model f value 28.29 *** 16.16 *** 13.83 *** adj. r2 28.27 % 30.72 % 26.82 % panel b: the results for abnormal levels of cash flow from operations1 car -0.020 (-0.64 ) car* + 0.144 *** -0.041 0.185 *** (2.65 ) (-0.76 ) (2.42 ) panel c: the results for abnormal levels of production costs car -0.200 *** (-3.23 ) car* + 0.245 ** -0.428 *** 0.673 *** (2.28 ) (-3.66 ) (4.24 ) panel d: the results for abnormal levels of discretionary expenses1 car -0.179 ** (-2.28 ) car* + 0.041 -0.300 ** 0.341 * (0.29 ) (-1.90 ) (1.62 ) 1 the abnormal levels of cash flow from operations and discretionary expenditures are multiplied by -1, so that higher values of these suggest higher degrees of rem. 2 *, **, *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively (a one-tailed test for the coefficients with a predicted sign, and a two-tailed test otherwise). 3an analysis of the variance inflationary factors (vif) for each model reveals that vifs are all smaller than 2.3, suggesting that multicollinearity is not an issue. 4car*: the absolute value of car; other variable definitions are shown in table 1. 4.3 additional tests-results investigated by change models in order to exclude the possibility that firms may engage in rem no matter whether they replace their ceos or not, we conduct the change model of equation (1) to examine hypothesis one again (geiger and north 2006). we also conduct the change model of equation (2) to examine hypothesis two to control for any potential selection bias (e.g. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 133 carcello et al. 2010). that is, to control for the possibility that a ceo with a better public reputation may choose to work at firms with good financial reporting quality. referring to geiger and north (2006), we include rem at t-1 in the change models since firms may manage earnings continuously. table 4 shows the related results. similar to the results in tables 2, from the period immediately prior to the succession (t-1) to the new ceo succession (t), firms with new ceos (suc) are negatively and significantly associated with most rem proxies, except for the marginally significant relation with δab_cfo. regarding hypothesis two, car in the full sample is still negatively and significantly related with most rem proxies. using the change model with the subsamples, we test the differences between the positive and negative car groups. consistent with tables 3, most of the results indicate that in order to improve market perceptions of their performance and establish better reputations, new ceos with negative car on their succession are more likely to engage in rem than those with positive car on their succession. briefly, hypothesis one and two are thus supported by the change model analyses. table 4. results for the change models panel a: the results for h1(n=2,223) variables dependent variable δsum_rem δab_cfo δab_prod δab_disexp suc -0.022 *** -0.003 * -0.009 *** -0.010 *** (-3.97 ) (-1.64 ) (-3.03 ) (-3.03 ) panel b: the results for h2-full sample (n=1,137) car -0.149 *** -0.011 -0.074 ** -0.062 ** (-2.53 ) (-0.50 ) (-2.24 ) (-1.91 ) panel c: the results for h2-the difference between two subsamples (n=1,137) difference in coef. (wald test f value) car* 0.345 ** 0.065 0.226 *** 0.055 (2.27 ) (1.14 ) (2.66 ) (0.65 ) 1 *, **, *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively (a one-tailed test for the coefficients with a predicted sign, and a two-tailed test otherwise). 2 an analysis of the variance inflationary factors (vifs) for each model reveals that vifs are all smaller than 3.0, suggesting that multicollinearity is not an issue. 3 δab_cfo: the change in the abnormal level of cash flow from operations; δab_prod: the change in the abnormal level of production costs; δab_disexp: the change in the abnormal level of discretionary expenditures; δsum_rem: the aggregation of δab_cfo, δab_prod, and δab_disexp; other variable definitions are shown in table 1. 5. conclusion during the past decade average ceo tenure has rapidly become shorter, and markets may react more negatively when there is greater uncertainty with regard to future performance because of this. the prior literature finds that new ceos are more likely to engage in discretionary accruals earnings management, a fact that is explained by the idea of “taking a big bath” or impression management theory. due to the greater litigation risk in the post-sox period, firms are now more likely to manipulate earnings by rem instead of discretionary accruals earnings management. different to aem, rem is an earnings management approach that influences a firm’s cash flows and future performance, which is a concern may impact asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 134 the decisions of new ceos with regard to manipulating earnings. therefore, our research is to investigate the relation between ceo succession and rem in the post-sox era and whether market reaction on ceo succession can motivate the new ceo to engage in rem for reputation and career concern. our findings indicate that the incoming ceo is less likely to manipulate real activities for earnings management in their first year of employment, but if they are faced with lower market expectations (car<0) on succession, then the new ceo tends to engage in rem in order to boost current earnings and enhance how the market sees their abilities. our empirical results remain unchanged when the test is examined by change models. overall, we provide a new perspective with regard to market reactions to ceo successions, by examining how and why new ceos may choose to manipulates earnings. references ali a., & zhang, w. 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(2007). financial reporting after the sarbanes-oxley act: conservative or less earn ings management? research in accounting regulation, 20, 187-192. http://dx.doi.org/10.1016/s1052-0457(07)00210-x microsoft word 8410-30482-1-sm _1_-writer2-new-final asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 38 strict and uniform shariah screening methodologies in selected asian countries in comparison with the united states umayal kasi (corresponding author) university putra malaysia putra business school, university putra malaysia, selangor, malaysia e-mail: umayal86@yahoo.co.in dr. junaina muhammad professor and senior lecturer of banking and finance, university putra malaysia, department of accounting and finance, faculty of economics and management, university putra malaysia, selangor, malaysia e-mail: junaina2012@gmail.com received: nov. 5, 2015 accepted: dec. 9, 2015 published: june 1, 2016 doi:10.5296/ajfa.v8i1.8410 url: http://dx.doi.org/10.5296/ajfa.v8i1.8410 abstract this paper focuses mainly on the shariah screening methodologies for shariah-compliant firms. this paper compares the shariah screening methodologies which are used in selected asian countries and the united states, a ‘powerhouse’ nation. in order to include the analysis of the new benchmark introduced in malaysia as part of this study, the timeline used in this paper is from november 2013 until november 2014. it can be found that there are similarities and differences between the various shariah screening methodologies in all the 5 countries, in terms of feasibility, duration, economic viability and fund requirements. it also appears that the shariah screening methodologies implied in the united states is far more stringent than those implied in the selected asian countries. on the whole, the results point towards the possibility of generalising the implementation of strict and uniform shariah screening methodologies within all the country-specific shariah indices amongst muslim nations, globally. keywords: asian countries, new benchmark, screening methodologies, shariah financing, united states asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 39 1. introduction the term ‘shariah’ is arabic in nature and literally means “the way” or “a path to a watering place”, “a clear path to be followed” and more precisely, “the way which leads to a source” (international shariah research academy for islamic finance, 2011). it is generally known as islamic law, in english. ‘shariah’ actually means ‘the path to the origins of life’ (trakic and tajuddin, 2012). technically, the term ‘shariah’ refers to prophet muhammad who knew the whole of the islamic system. this has been mentioned in the quran. it also reflects the prophet’s traditional way of living, called ‘sunnah’ (trakic and tajuddin, 2012). according to securities commission malaysia (2015), a growing number of muslim population which represents almost 20% of the world population and an increasing demand for shariah-compliant investment products which provide stability and lower risk have attracted more listed companies to opt for shariah-compliant status through the screening process of inclusion-exclusion exercise. in malaysia, the establishment of islamic capital market together with the introduction of the shariah index (si) in the year 1999 has further developed a good image of the shariah-compliant stocks offered by bursa malaysia. in order to meet the demand from international muslim investors, bursa malaysia joins forces with financial times stock exchange(ftse) to form a new ftse bursa malaysia (fbm) shariah index in the year 2007. malaysia is not the only country that offers islamic capital market products but also developed countries, such as the united states (securities commission malaysia, 2015). thus, a study on screening methodologies among capital markets which offer shariah-compliant stocks is a priority, in order to meet not only the shariah requirements but also the expectations of investors who are concerned about their beliefs and the quality of the shariah-compliant stocks’ investment. generally, there are three significant principles of shariah financing and investing, i.e., and these characteristics set it apart from conventional financing,such as the prohibition of interest, profit and loss sharing and ‘gharrar’. firstly, prohibition of interest is called as ‘riba’, which is the most salient islamic principle. ‘riba’ actually means “an increase, growth or accretion” in arabic (international financial law review, 2005). in shariah terms, ‘riba’ means “the premium that the borrower must pay to the lender along with the principal amount, as a condition for the loan or for an extension in its’ maturity”, which is called as interest, in current times (international financial law review, 2005). secondly, profit and loss sharing is a concept in shariah financing, whereby partners involved, share profits and losses, in terms of their share of capital and effort. hence, investors who practice this concept, gain due to their effort and bear the risk when investing (international financial law review, 2005). thirdly, transactions that contain the element of ‘gharrar’ is strictly prohibited. ‘gharrar’ means uncertainty and speculation. in essence, all parties involved in shariah financing must realise the elements of the various islamic financing methods and its consequences. an example of such a transaction involving ‘gharrar’ is a consensus to sell lost goods (international financial law review, 2005). thus, the aforementioned principles of shariah financing, all point towards the direction of shariah screening methodologies, which greatly contributes to the differentiation of what is asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 40 shariah-compliant and what is otherwise known as non-shariah compliant. country-specific shariah screening methodologies will be analysed since each country selected in this study observes different screening methodologies. the objective of this study is to examine the current trends of shariah screening methodologies practised in selected asian countries and the united states, by comparing and contrasting them. this study also particularly investigates the extent of stringent shariah compliance methods practised in these nations. hence, this study is significant, in that it fills the research gap, by investigating the possibilities of generalising the implementation of strict and uniform shariah screening methodologies, amongst these nations and globally. this paper stems from the need to have more research evidence with regards to shariah screening methodologies in selected asian countries and the united states and to gather the similarities and differences of shariah screening methodologies, for better comprehension. hence, the objective of this paper is to compare and analyse the shariah screening methodologies, in terms of similarities and differences. in addition, this paper examines how shariah screening methodologies impact financing and investing activities of a firm. this paper also discusses how shariah screening methodologies greatly contribute to the extent of what is shariah-compliant and what is non-shariah compliant in a firm. therefore, this paper contributes to the existing literature of shariah financing in several ways. firstly, the asian countries selected in this paper – malaysia, hong kong, singapore and indonesia are either pioneers, top islamic hubs in the world (malaysia and indonesia) or advanced and developed countries (hong kong and singapore). the selection of these four countries is comprehensive in its’ own way, especially the selection of united states in this paper, as it is a powerhouse nation of the world. secondly, this paper will analyse the revamped business activity benchmarks and the new financial benchmarks introduced by the securities commission malaysia in november 2013, as part of the selected countries to be studied in this paper. thirdly, the impact of these revamped business activity benchmarks and new financial benchmarks as well as other shariah screening methodologies belonging to other selected countries on financing and investing activities of a firm will be analysed and the extent of their contribution to the shariah-compliant and non-shariah compliant elements for a firm. this paper is organised as follows. section 2 provides a brief background information on shariah financing in the selected countries for this study. section 3 describes the research methods, sample and the methodology used in this study. section 4 examines and analyses the various shariah screening methodologies that are observed and practiced by all five countries. section 5 presents the analysis of findings as well as the discussion of the results. section 6 provides suggestions for further research, while section 7 presents the conclusion of this paper. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 41 2. background information on shariah financing 2.1 country-specific 2.1.1 malaysia the new screening methodology introduced in the year 2013 is an effort to be on par globally (zainuddin et al., 2014). however, sani and othman (2013) showed an evidence that based on morgan stanley capital international (msci) islamic index screening method, the number of shariah-compliant status firms is lower (39%) than using the new shariah advisory council (sac) screening method (77%). this evidence is further supported by najib et al. (2014) which can conclude that the differences in screening methodologies between bursa malaysia and dow jones islamic index (djii) can be attributed to the flexibility factor. another study by hussin et al. (2015) also support the fact that the new screening method inbursa malaysia is not as strict as dow jones islamic world index (djim), morgan stanley compliance islamic (msci) index, financial times stock exchange (ftse) shariah index and standard and poor’s (s&p) shariah index. yazi et al. (2015) examined a likely impact of the announcement of the new decision to purchase, retain or sell shariah-compliant or non-shariah compliant stocks. the authors found that the new shariah screening methodology indicates that when a stock is included in the list of shariah-compliant securities, the inclusion has a positive effect to the value of the stock. similarly, when a stock is excluded from the list of shariah-compliant securities, the exclusion has a negative effect on the stock price. therefore, according to zin et al. (2011), the islamic finance concept began in the 1970’s, wherein basic financial solutions such as savings and financing were offered. even then, these products were ensured to be shariah-compliant and the public were able to comprehend them easily. in the 1980’s, the demand for islamic financial products through project finance was high. in the 1990’s, ijarah and equity were introduced and in the year 2000’s, islamic products like sukuk, structured and alternative assets, liquidity and management tools were further introduced. in malaysia, the kuala lumpur stock exchange (klse) (which is now known as bursa malaysia, since the year 2004), launched the shariah index (si) on april 17, 1999. this index enables the involvement of equity investments which are shariah-compliant. this means that shariah-compliant equities must comply with shariah law. in order for securities to be shariah-compliant, they must be approved by the sac of the securities commission of malaysia (scm) (sadeghi, 2008). the number of shariah-compliant securities listed on the klse as well as bursa malaysiais depictedin figure 1 (trends depicted in the form of bar graph), as well as, in figures 2 to 7 (trends depicted in the form of line chart), all of which, can be seen as follows: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 42 figure 1. number of shariah-compliant securities listed on the klse as well as bursa malaysia (bar graph) notes: the horizontal axis represents year. : the abbreviations in the table above represent: sc – number of shariah-compliant securities nsc – number of non-shariah compliant securities ts – total securities % sc – percentage of shariah-compliant securities (%) % nsc – percentage of non-shariah compliant securities : in the year 1999, the stock exchange in malaysia was known as kuala lumpur stock exchange (klse) (securities commission malaysia, 1999). : since the year 2004, klse was and is now known as bursa malaysia. : the data above is based on the then klse and the current bursa malaysia. : the new shariah screening methodologies were introduced on 29 november 2013. : the data above is adapted and modified from securities commission malaysia (1999-2014). : the data above is published by securities commission malaysia on particular dates, as below: 1999 – september 2000 – 27 october 2001 – 26 october 2002 – 25 october 2003 – 31 october 2004 – 29 october 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 sc 271 604 638 684 722 787 857 886 853 855 846 846 839 817 653 673 nsc 0 185 169 176 167 160 154 143 138 125 113 115 107 106 261 232 ts 0 789 807 860 889 947 1011 1029 991 980 959 961 946 923 914 905 % sc 0 77 79 80 81 83 85 86 86 87 88 88 89 89 71 74 % nsc 0 23 21 20 19 17 15 14 14 13 12 12 11 11 29 26 0 200 400 600 800 1000 1200 n um be r a nd p er ce nt ag e o f s ec ur iti es number of shariah-compliant securities listed on the klse as well as bursa malaysia (bar graph) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 43 2005 – 28 october 2006 – 27 october 2007 – 30 november 2008 – 28 november 2009 – 30 november 2010 – 26 november 2011 – 25 november 2012 – 30 november 2013 – 29 november 2014 – 28 november source: adapted and modified from securities commission malaysia (1999-2014). figure 2. number of shariah-compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) notes: the horizontal axis represents year. : the abbreviation in the table above represents: sc – number of shariah-compliant securities source: adapted and modified from securities commission malaysia (1999-2014). 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 sc 271 604 638 684 722 787 857 886 853 855 846 846 839 817 653 673 0 100 200 300 400 500 600 700 800 900 1000 nu m be r o f s ha ri ah -c om pl ia nt se cu ri tie s number of shariah-compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 44 figure 3. number of non-shariah compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) notes: the horizontal axis represents year. : the abbreviation in the table above represents: nsc – number of non-shariah compliant securities source: adapted and modified from securities commission malaysia (1999-2014). 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 nsc 0 185 169 176 167 160 154 143 138 125 113 115 107 106 261 232 0 50 100 150 200 250 300 n um be r o f n on -s ha ri ah c om pl ia nt se cu ri tie s number of non-shariah compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 45 figure 4. total securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) notes: the horizontal axis represents year. : the abbreviation in the table above represents: ts – total securities source: adapted and modified from securities commission malaysia (1999-2014). 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 ts 0 789 807 860 889 947 101 102 991 980 959 961 946 923 914 905 0 200 400 600 800 1000 1200 to ta l s ec ur iti es total securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 46 figure 5. percentage of shariah-compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) notes: the horizontal axis represents year. : the abbreviation in the table above represents: % sc – percentage of shariah-compliant securities (%) source: adapted and modified from securities commission malaysia (1999-2014). 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 % sc 0 77 79 80 81 83 85 86 86 87 88 88 89 89 71 74 0 10 20 30 40 50 60 70 80 90 100 pe rc en ta ge o f s ha ri ah -c om pl ia nt se cu ri tie s ( % ) percentage of shariah-compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 47 figure 6. percentage of non-shariah compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) notes: the horizontal axis represents year. : the abbreviation in the table above represents: % nsc – percentage of non-shariah compliant securities source: adapted and modified from securities commission malaysia (1999-2014). 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 % nsc 0 23 21 20 19 17 15 14 14 13 12 12 11 11 29 26 0 5 10 15 20 25 30 35 pe rc en ta ge o f n on -s ha ri ah c om pl ia nt s ec ur iti es (% ) percentage of non-shariah compliant securities listed on the klse as well as bursa malaysia over a timeline of 16 years (line chart) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 48 figure 7. number of shariah-compliant securities listed on the klse as well as bursa malaysia (combined line chart) notes: the horizontal axis represents year. : the abbreviations in the table above represent: sc – number of shariah-compliant securities nsc – number of non-shariah compliant securities ts – total securities % sc – percentage of shariah-compliant securities (%) % nsc – percentage of non-shariah compliant securities : in the year 1999, the stock exchange in malaysia was known as kuala lumpur stock exchange (klse) (securities commission malaysia, 1999). : since the year 2004, klse was and is now known as bursa malaysia. : the data above is based on the then klse and the current bursa malaysia. : the new shariah screening methodologies were introduced on 29 november 2013. : the data above is adapted and modified from securities commission malaysia (1999-2014). : the data above is published by securities commission malaysia on particular dates, as below: 1999 – september 2000 – 27 october 2001 – 26 october 2002 – 25 october 2003 – 31 october 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 sc 271 604 638 684 722 787 857 886 853 855 846 846 839 817 653 673 nsc 0 185 169 176 167 160 154 143 138 125 113 115 107 106 261 232 ts 0 789 807 860 889 947 101 102 991 980 959 961 946 923 914 905 % sc 0 77 79 80 81 83 85 86 86 87 88 88 89 89 71 74 % nsc 0 23 21 20 19 17 15 14 14 13 12 12 11 11 29 26 0 200 400 600 800 1000 1200 n um be r a nd p er ce nt ag e o f s ec ur iti es number of shariah-compliant securities listed on the klse as well as bursa malaysia (combined line chart) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 49 2004 – 29 october 2005 – 28 october 2006 – 27 october 2007 – 30 november 2008 – 28 november 2009 – 30 november 2010 – 26 november 2011 – 25 november 2012 – 30 november 2013 – 29 november 2014 – 28 november source: adapted and modified from securities commission malaysia (1999-2014). the similarities and the differences of the statistics, which are illustrated in figure 1, as can be seen above, between the years 2013 and 2014 (as this is the range of the focus area) will be discussed in the analysis section of section 5. based on the combined line chart in figure 7, as above, there was a drastic increase in the number of shariah-compliant (sc) securities between the year 1999 and the year 2000, gradually increasing over the years, followed by a slight fall in the number of sc securities, between the year 2012 and the year 2013, during which the new shariah screening methodologies were introduced on 29 november 2013. a slight increase in the number of sc securities can be observed, following this new methodology, in the year 2014. a drastic increase in the number of non-shariah compliant (nsc) securities can be observed between the year 1999 and the year 2000, then, a declining trend in the number of nsc securities over the years follows suit, with a slight increase in the number of nsc securities between the year 2012 and the year 2013 and then, a slight fall in the number of securities, in the year 2014. there was a sharp increase in the number of total securities (ts) between the year 1999 and the year 2000, followed by a gradual increase until the year 2006 and a gradual decrease from the year 2007 until the year 2014. the percentage of shariah-compliant (% sc) securities, increased drastically from 0% in the year 1999 to 77% in the year 2000. this trend is followed by an almost constant increase in the percentage of sc (% sc) securities, whereby 1% to 2% increase can be observed over the years and then, there was a slight decrease in the percentage of sc (% sc) securities between the year 2012 and the year 2013 and a slight increase in the year 2014. a slight increase in the percentage of non-shariah compliant (% nsc) securities can be observed, between the year 1999 and the year 2000, followed by a decline in the percentage of nsc (% nsc) securities over the years and then, a slight increase in the percentage of nsc (% nsc) securities between the year 2012 and the year 2013, with a slight decrease in the year 2014. 2.1.2 hong kong previously, zamzamir et al. (2014) studied the performance of 12 global islamic indices and their respective conventional counterparts between 1st january 1999 until 31st october 2011. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 50 of the 12, hong kong was also part of their study. they found that overall, (inclusive of hong kong), islamic indices in all the 12 nations outperformed their respective conventional counterparts. meanwhile, lemmon and nguyen (2015) explained the hong kong financial market scenario by investigating if a yield effect takes place in the hong kong market, whereby taxes on either dividend income or capital gain are not present. they found that there is a strong dividend yield effect within the hong kong financial market and that the yield effect can be explained by non-tax reasons. hence, the hong kong islamic index was initiated in the year 2007, since that time, the demand for islamic investment was on the rise. this index represents the performance of shariah compliant firms from both hong kong and china (hong kong islamic index, 2007).the number of shariah-compliant firms listed on the hong kong islamic indices can be seen in table 1as follows: table 1. number of shariah-compliant firms listed on the hong kong islamic indices shariah index year / date number of shariah-compliant firms hong kong islamic index(a) 2007 78 ftse all-world series ftse shariah hong kong index(b) 31 december 2014 37 notes: (a) in the year 2007, 78 shariah-compliant firms were listed on this index (hong kong islamic index, 2007). (b) in terms of the ftse all-world series, the ftse shariah hong kong index was launched on 29 october 2007 and as of 31 december 2014, there were 37 hong kong shariah-compliant firms listed on this index, for the whole year of 2014 (ftse factsheet, 2014, p.2and 3). source: adapted and modified from hong kong islamic index (2007) and ftse factsheet (2014, p.2 and 3). according to moiseiwitsch (2014), as of the second half of the year 2014, the government of hong kong raised a total of us $ 1 billion in sukuk issuance. 2.1.3 singapore prior studies on islamic finance and islamic banking in singapore include gerrard and cunningham (1997) as well as khan and bashar (2008). gerrard and cunningham (1997) found that at that time of the year, both muslims (comprising a minority) and non-muslims in singapore were not aware of the islamic banking trend. one of the most significant finding was that non-muslims preferred to be paid higher interest as compared to the muslims, thus indicating that the twodistinct groups perceived the islamic banking trend differently. meanwhile, by the year 2008, khan and bashar (2008) found that singapore was a relatively new market player, at that time. in keeping with the global trend, singapore reviewed its’ regulatory framework and tax structure and eventually launched many shariah-compliant financial products then. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 51 hence, khan and bashar (2008) pointed out that malaysia’s largest bank, called maybank, initiated islamic banking in july 2001, in singapore, by establishing singapore unit trusts ethical growth fund which is shariah-compliant. the two main reasons that have encouraged singapore’s islamic banking initiative are that singapore’s neighbouring countries have successfully initiated islamic banking into their financial services sector, much earlier and that the singaporean government allowed commercial banks to establish an islamic banking function, subject to feasibility (gerrard and cunningham, 1997). the ftse sgx asia shariah 100 index was launched on 20th february 2006 in singapore.this index consists of a combination of 50 of the largest japanese shariah-compliant firms and50 of the largest shariah-compliant firms from singapore, taiwan, korea and hong kong (ftse factsheet, 2014). the number of shariah-compliant firms listed on this index can be seen in table 2as follows: table 2. number of singaporean shariah-compliant firms listed on the ftse sgx asia shariah100 index shariah index date number of shariah-compliant firms ftse sgx asia shariah 100 index* 31 december 2014 5 note: *a) as of 31 december 2014, there were five singaporean shariah-compliant firms listed on this index, for the whole year of 2014 (ftsefactsheet, 2014). source: adapted and modified from ftse factsheet (2014, p.2). 2.1.4 indonesia prior studies on shariah financing in indonesia were undertaken by abduh and omar (2012) and setiawan and oktariza (2013). abduh and omar (2012) used cointegration and autoregression to study the role of islamic banks’ financing in indonesia towards the nation’s economic performance and found that both of these had a bi-directional relationship, in terms of short-run and long-run timelines. in addition, setiawan and oktariza (2013) used multiple regression analysis as well as significant tests and ratios, such as, t-test, mann whitney u-test, sharpe ratio, treynor ratio and jensen’s alpha, to study two issues. firstly, they studied for a possible significant difference in risk and returns between shariah and conventional stocks of selected public companies listed on the indonesia stock exchange (idx), for the years 2009 until 2011. secondly, they studied for possible significant relationships between stock returns and financial ratios belonging to both selected shariah and conventional stocks. they found that by using multiple regression analysis, financial ratios indeed had a significant relationship with both returns from shariah and conventional stocks. the tests showed that there was no evidence of significant statistical differences between shariah and conventional stocks, in terms of cumulative returns, standard deviation and beta. in addition, the ratios indicated that risk-adjusted return of both stocks’ portfolio was undertaken likewise. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 52 therefore, the jakarta islamic index was initiated on 3 july 2000 by the jakarta stock exchange. later on, this index was renamed as the indonesia shariah stock index, which wasinitiated on 12 may 2011 by the indonesia stock exchange (indonesia stock exchange, 2014). the number of shariah-compliant firms listed on the indonesia shariah stock index can be seen in table 3as follows: table 3. number of shariah-compliant firms listed on the indonesia shariah stock index shariah index date number of shariah-compliant firms jakarta stock exchange(a) 3 july 2000 30 indonesia shariah stock index(b) 8 november 2013 293 1 december 2014 310 notes: (a) in the year 2000, there were only 30 shariah-compliant securities listed on the jakarta stock exchange. (b) as of 8 november 2013, there were 293 shariah-compliant firms listed on the indonesia shariah stockindex (indonesia stock exchange, 2013). as of 1 december 2014, there were 310 shariah-compliant firms listed on the indonesia shariah stock index (indonesia stock exchange, 2014). 2.1.5 the united states several earlier studies have been undertaken with regards to the dow jones islamic market us index. ghauri et al.’s (2015) study focused on standardising the islamic market indices as well as the shariah principles. they studied the differences of four various islamic market indices, whereby halal business and debt ratio were found to be common amongst all the four indices, by using qualitative research methods. they found that various islamic market indices practise their preferred criteria for selecting a particular company. in addition, different islamic market index has its own rules and regulations pertaining to the shariah board and that a shariah board of islamic market ratifies a particular company as shariah-compliant based on certain criterias. as an example, the dow jones islamic market index ratifies a particular company because that company fulfills the criteria of the dow jones islamic market index. in addition, jouaber-snoussi et al. (2012) studied the difference in performance of a large group of dow jones islamic indexes, in terms of several benchmarks. they also distinguish exceptional events as the 100 lowest and 100 highest conventional world indexes, in terms of daily returns as well as differences in performance of the islamic indexes, in terms of geographical areas and activity sectors. they found that islamic indexes portray different characteristics as compared to the conventional benchmarks and that islamic screening indicates notable differences, in the context of risk and excess return. they also found that the lowest and highest prices do not escalate the differences between islamic and conventional indexes. moreover, hassan et al. (2005) compared the performances of a mixed portfolio, comprising of islamic screened stocks and conventional benchmark stocks, in terms of both shariah and financial criteria. they found that when islamic ethical screens are practised, they are not asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 53 necessarily indicating an adverse impact on investment performance. farooq and reza (2014) studied the impact of technical analysis on dow jones islamic market us index and compared with three significant market indices, namely, dow jones industrial average, s&p 500 index and nasdaq 100. they compared these with similar analysis on conventional indices and also compared technical analysis with fundamental analysis, in terms of prominent or significant return. they found from that comparison, the dow jones islamic market us index can be improved, when technical analysis is undertaken. khamlichi et al. (2014) examined the efficiency of islamic indices and if they could be diversified when compared with the conventional benchmarks. they also analysed if diversification was possible by studying if indices are cointegrated or not. they further studied the level of weak-form efficiency by testing the random walk hypothesis by using variance ratio tests. they studied these in the context of islamic and four main indices. they found that islamic indices are equally efficient to that of their conventional counterparts. in addition, long-run diversification is possible since it was found that the dow jones islamic indices and the s&p islamic indices are not related through cointegration, in terms of their respective benchmarks. therefore, the dow jones islamic market us index was initiated on 24 may 1999 by s&p dow jones at the new york stock exchange (s&p dow jones indices, 2015). this index is the most visible and their shariah-compliant methodologies are greatly used, globally. the shariah screening methodologies implied by the dow jones islamic market us index is more stringent, in terms of the financing aspect. the dow jones islamic market us index undertakes shariah-compliant screening on firms’ income statement and balance sheet (najib et al., 2014). the number of shariah-compliant firms listed on the new york stock exchange can be seen in table 4as follows: table 4. number of shariah-compliant firms listed on the new york stock exchange shariah index date number of shariah-compliant firms the dow jones islamic market us index(a) 31 december 2013 490 31 december 2014 556 note: (a) as of 31 december 2013, there were 490 shariah-compliant firms listed on thenew york stock exchange (s&p dow jones indices shariah quantitative analysis, 2013). as of 31december 2014, there were 556 shariah-compliant firms listed on the new yorkstock exchange (s&p dow jones indices shariah quantitative analysis, 2014). 3. research method this study is exploratory and descriptive in nature. it analyses, compares and contrasts only the shariah screening methodologies used by the shariah advisory board for screening shariah securities in the countries selected for this study. this sort of screening enables securities to be categorised as shariah-compliant and shariah non-compliant, in order for shariah-compliant securities to be listed on the indices belonging to the countries selected. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 54 3.1 sample the sample size for this study is five countries that have established their respective shariah indices, namely, malaysia, hong kong, singapore, indonesia and the united states. the first four asian countries have been selected based on two criterias, i.e. pioneers and advanced, developed countries. the united states has been selected since it is also a pioneer, an advanced, developed economy and a powerhouse nation. the indices (belonging to the main board) that are being studied in this paper are bursa malaysia shariah index (belonging to malaysia), hong kong islamic index (hong kong), ftse sgx asia shariah 100 index (singapore), indonesia shariah stock index (indonesia) and dow jones islamic market us index (the united states) can be seen in table 5 as follows: table 5. shariah indices used in this study countries region developed/ emerging markets stock exchange shariah indices malaysia asian emerging bursa malaysia bursa malaysia shariah index hong kong asian developed hong kong stock exchange ftse all-world series hong kong islamic index ftse shariah hong kong index singapore asian developed singapore exchange ftse sgx asia shariah 100 index indonesia asian emerging indonesia stock exchange indonesia shariah stock index the united states american developed new york stock exchange dow jones islamic market us index the chosen timeline of this study is recent, that is, from november 2013 until november 2014, in order to accommodate the analysis of the new benchmark which was introduced in november 2013, in malaysia. 3.2 methodology the data on the respective shariah screening methodologies as well as lists of shariah-compliant securities have been obtained from their respective websites and published reports as well as documents by their respective governments. these sources are categorised as secondary sources, which are mainly used for data collection in this paper. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 55 4. shariah screening methodologies 4.1 country-specific 4.1.1 malaysia in malaysia, the shariah advisory council (sac) of the securities commission malaysia (scm) classifies, approves and publishes the updated list of shariah-compliant securities, twice a year, in may and in november. the sac uses a two-tier quantitative approach, which are the revamped business activity benchmarks and the financial ratio benchmarks, in order to classify the status of the securities, whether shariah-compliant or non-shariah compliant. securities that pertain within these benchmarks are classified as shariah-compliant (securities commission malaysia, 2014). according to hussin et al. (2015), the two-tier quantitative benchmarks enable more shariah-compliant firms to be listed on bursa malaysia. this encourages more muslim investors to engage in the equity market. the sac outlines the revamped business activity benchmarks whereby “the contribution of shariah non-compliant activities to the group revenue and group profit before taxation of the company will be computed and compared against the relevant business activity benchmarks” (securities commission malaysia, 2014, p.11). the business activity benchmarks are outlined as follows: table 6(a). business activity benchmarks applicable to businesses or activities business activity benchmark applicable to five-percent benchmark conventional banking conventional insurance gambling liquor and liquor-related activities pork and pork-related activities non-halal food and beverages shariah non-compliant entertainment tobacco and tobacco-related activities interest income* from conventional accountsand instruments (including interest incomeawarded arisingfrom a court judgement orarbitrator and dividendsfromshariah non-compliant investments) other activities deemed non-compliantaccording to shariah notes: *a) interest income will be compared against the group revenue while dividends will be compared against the group profit before taxation. b) for the above-mentioned businesses or activities, the contribution of shariah non-compliant businesses or activities to the grouprevenue or group profit before taxation of the company must be less than five percent. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 56 source: adapted and modified from securities commission malaysia, 2014, p.11. table 6(b). business activity benchmarks applicable to businesses or activities business activity benchmark applicable to 20-percent benchmark hotel and resort operations share trading stockbroking business rental received from shariah non-compliant activities other activities deemed non-compliantaccording to shariah note: a) for the above-mentioned businesses or activities, the contribution of shariah non-compliant businesses or activities to the group revenue or group profit before taxation of the company must be less than 20 percent. source: adapted and modified from securities commission malaysia, 2014, p.12. meanwhile, the sac outlines the financial ratio benchmarks as follows: table 7. financial ratio benchmarks and their descriptions financial ratio benchmarks descriptions cash over total assets cash only includes cash placed in conventional accounts and instruments, whereas cash placed in islamic accounts and instruments is excluded from the calculation (must be less than 33%) debt over total assets debt only includes interest-bearing debt whereas islamic financing or sukuk is excluded from the calculation (must be less than 33%) note: a) each ratio, which is intended to measure ‘riba’ and ‘riba’-based elements within a company’s statements of financial position, must be less than 33%. source: adapted and modified from securities commission malaysia, 2014, p.13. moreover, the sac also considers the qualitative aspect which includes public perception or image of the firm’s activities from the islamic perspective, in addition to the aforementioned two-tier quantitative benchmarks (securities commission malaysia, 2014). in addition, al-mamun et al. (2014) state that the islamic banking system in malaysia is based on shariah guidelines in general, while conventional banking is based on interest rate. the shariah elements of banking through norms, values and laws comprise the islamic way of living. the concept of ‘riba’ is practised through shariah-compliant banking and financial system. since the islamic banking system in malaysia is based on risk-sharing and profit, riba is prohibited. this system is different to that of traditional banking and the financial system which is based on interest. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 57 4.1.2 hong kong the hong kong islamic index shariah board comprise of the shariah advisory council (sac) of the arab chamber of commerce and industry. the sac uses the shariah compliance methodology in line with the shariah guidelines. this methodology includes strict business activity screening, accounting-based screens and financial ratio screening based on total assets (hong kong islamic index, 2007). the sac reviews this index on a monthly basis. the sac outlines the business activity screening as follows: table 8. business activity screens applicable to businesses or activities business activity screens applicable to shariah sector-based screens advertising and media (newspapers areallowed, sub-industries are analysedindividually) alcohol financials gambling pork tobacco trading of gold and silver as cash on adeferred basis weapon manufacturing and supply source: adapted and modified from hong kong islamic index (2007). the sac reviews each firm’s audited annual report, in order to ensure that the firm is not engaged in any of the non-shariah compliant activities such as the above, during the selection process. firms that engage in any of the non-shariah compliant activities will be excluded from the hong kong islamic index (hong kong islamic index, 2007). after having screened these firms for non-shariah compliant business activities, the remaining firms are examined for compliance in financial ratios (accounting-based screens), which is illustrated as follows: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 58 table 9. accounting-based screens and their measurements accounting-based screens measurements i) leverage compliance debt<33% market value of equity (12 month average) accounting-based screens measurements ii) cash compliance (in terms of cash holdings) accounts receivables <49% market value of equity (12 month average) market value of equity (12 month average)< 33% iii) revenue share from non compliant activities (in certain cases, revenues from non-compliant activities are permissible, if they comply with this threshold) non-permissible income other than interest income <5% revenue iv) dividend purification ratio (for purification purposes) dividend x non-permissible revenue total revenue source: adapted and modified from hong kong islamic index (2007). in addition, those remaining firms that have also been screened for non-shariah compliant business activities are also examined for compliance in financial ratios screens, whereby those firms that do not comply with this screening are excluded from the hong kong islamic index (hong kong islamic index, 2007). the financial ratio screens are illustrated as below: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 59 table 10. financial ratio screens and their measurements financial ratio screens measurements financial ratios i)total debt divided by trailing 12-monthaverage market capitalisation ii) the sum of company’s cash and interest-bearing securities divided by the trailing 12-month average market capitalisation iii) accounts receivable divided by the trailing12-month average market capitalisation source: adapted and modified from hong kong islamic index (2007). lai (2012) points out that many foreign firms prefer to list on the hong kong stock exchange (hkse) and the type of firms listed on this board mainly consists of “information and knowledge-intensive industries such as banking, insurance, telecommunications and computer technology” (p.1286). meanwhile, enright et al. (1997) and meyer (2002) (both in lai, 2012) state that many foreign firms prefer to list on the hkse because of “hong kong’s well-developed legal system with its’ reputation for investor protection, high financial reporting standards and prudent regulatory system is well-established and internationally recognised” (p.1287). 4.1.3 singapore the ftse sgx asia shariah 100 index is the first index in the series to be launched. this index is a collaboration between ftse (financial times stock exchange) group and the singapore exchange (sgx). the screening for this index is independently done by yasaar ltd., which is an organization comprising of global network of expert shariah scholars (ftse factsheet, 2014). the screening methodology comprises of two methods, which include business activity screening and financial ratios screening, which are illustrated as follows: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 60 table 11. types of screening applicable to businesses or activities and their descriptionsand measurements types of screening applicable to / measurements i) business activity screening conventional finance (non-islamic banking, finance and insurance, etc.) alcohol pork-related products and non-halal food production, packaging and processing or any other activity related to pork and non-halal food entertainment (casinos and gambling) tobacco, weapons, arms and defence manufacturing ii) financial ratios screening debt is less than 33.333% of total assets cash and interest bearing items are less than33.333% of total assets accounts receivable and cash are less than50% of total assets total interest and non-compliant activities income should not exceed 5% of total revenue notes: a) in the initial screening process, firms involved in any of the aforementioned activities in part (i), will be categorised as non-shariah compliant. b) the remaining firms are then further screened on a financial basis, as in part (ii) above and only if firms meet the financial ratio screening as in part (ii) above, will be categorised as shariah-compliant. source: adapted and modified from ftse factsheet (2014). in addition, triyanta (2011) states that ‘murabahah’, ‘ijarah’ and ‘musharakah’ are greatly facilitated in singapore’s financial legal framework. moreover, the monetary authority of singapore (mas) consented for banks to be involved in non-financial activities, like commodity trading, in order to assist with ‘murabahah’ transactions for clients’ investments. before this, banks were prohibited from being involved in non-financial activities like trading, which is not usually linked with banking and finance (asmani, 2006) (in khan and bashar, 2008). since the concept of shariah compliance is widely understood and accepted in singapore, the mas is a representative of the islamic financial services board (ifsb). mas consolidated with ifsb and was viewed as a representative in december 2003 and was fully representing ifsb in april 2005. at present, mas engages “in the islamic money market taskforce, the supervisory review process working group and of the special issues in capital adequacy working group” (khan and bashar, 2008, p.5). 4.1.4 indonesia the shariah securities list is issued periodically by bapepam-lk twice a year, that is, at the end of may and november. bapepam-lk screens securities using two methods and they are asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 61 business screening and financial screening. securities are categorised as shariah-compliant if they are issued by “the issuer who declares that its business activities as well as its business management are conducted based on the shariah principles in the capital market as clearly stated in its article of association” and “the issuer who does not declares that its business activities as well as its business management are conducted based on the shariah principles in the capital market”, subject to the issuer fulfilling the criterias as in part (i) and (ii) below (indonesia financial services authority, 2012). the two types of screening are outlined as follows: table 12. types of screening applicable to businesses or activities and their descriptionsand measurements types of screening applicable to / measurements i) business screening gambling trading with non-deliverance of goods or service trading with counterfeit offering/demand conventional banks conventional leasing companies trading of risk that contain uncertainty (gharar) and/or gambling (maisir), e.g conventional insurance producing, distributing, trading and/or providing products orservices that are forbidden because of its’ contents; [productsor services that are forbidden not because of its’ contents butbecause they are stated forbidden by the national shariahboard-mui and/or products or services that can degradeone’s morals and are purposeless doing transactions that contain bribe substance ii) financial screening total interest-based debts in comparison with total assets < 45% non-permissible contribution income to revenue < 10% notes: a) firms are classified as shariah-compliant if their business activities do not conflict with shariah principles in the capital market whereas firms are classified as shariah non-compliant if their business activities conflict with shariah principles inthe capital market as in part (i) above. source: adapted and modified from indonesia financial services authority (2012). in addition, pepinsky (2013) states that indonesia is a suitable country for studying public choices for islamic finance since it is a vast and diverse open majority in terms of muslim democracy and financially (juoro, 2008) (in pepinsky, 2013). although indonesia has a vast and diverse traditional financial system, a handful of local and international banks offer shariah-compliant financial products through special “shariah windows” or “shariah offices” in recent times. there are also some banks in indonesia that offer only shariah-compliant products, in whole. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 62 moreover, according to shaban et al. (2014), islamic banks in indonesia prefer ‘murabahah’ contracts when they lend to small businesses. the authors illustrate a ‘murabahah’ contract scenario, whereby “the ‘murabahah’ contract (‘biaa’) or sale constitutes a bank buying an asset on behalf of the client and selling it to the client at a mark-up price. the main criterion that may assist islamic banks to expand or diversify their loan portfolio towards small businesses lending is that the bank maintains the ownership of the asset (‘collateral-by-contract’) until the terms of the contract come to an end. this eases the collateral obstacle faced by small businesses when they seek lending from an islamic bank. this is because, in the case of a ‘murabahah’ contract, the small business client does not need to provide any collateral in advance, in contrast with conventional banks where the collateral is usually an essential pre-condition for borrowing” (p.s40). 4.1.5 the united states the dow jones is lamic market index shariah supervisory board uses two methods to screen securities for shariah compliance in order to be included in the dow jones islamic market indices and they are industry screens and financial ratio screens (s&p dow jones indices, 2015). the two types of screening are outlined as follows: table 13. types of screening applicable to businesses or activities and their descriptions and measurements types of screening applicable to / measurements i) industry screens alcohol pork-related products conventional financial services entertainment tobacco weapons and defence ii) financial ratio screens total debt divided by trailing 24-month average market capitalisation the sum of a company’s cash and interest-bearing securities divided by trailing 24-month average market capitalisation accounts receivables divided by trailing 24-month average market capitalisation note: a) all of the measurements in part (ii) above must be less than 33%. adapted and modified from s&p dow jones indices (2015). in addition, penzer et al. (2009) states that there are three types of islamic structures that are frequently analysed in the united states and they are “the ‘ijara’ (lease financing), the ‘murabaha’ (cost-plus financing) and the ‘sukuk’ (islamic bonds)”. the most preferred shariah-compliant financing structure in the united states is the ‘ijara-murabaha’ acquisition financing structure, so that the islamic equity sponsors can enter the united states’financial asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 63 markets. moreover, taylor (2002) states that in order for islamic banking institutions to comply with shariah principles, such banks work hand-in-hand with the board of religious advisors who monitor possible financial transactions. this supervisory board facilitates guidance on religious laws for bankers of such institutions. the banker consults the shariah board and a ‘fatwa’ or statement of guidance facilitating islamic law is provided in return. these ‘fatwas’ have been ensured to be assembled and to serve as an indicator in order to facilitate consistency in the developing stages of islamic banking. 5. analysis 5.1 findings and discussion of results 5.1.1 malaysia as per the background information in section 2, for malaysia, statistics of the shariah-compliant securities listed on the bursa malaysia shariah index was mentioned. when the new benchmarks were introduced in november 2013, in malaysia, there were 653 shariah-compliant securities listed on this index. one year after its’ introduction, the number of shariah-compliant securities increased to 673. the increase of 20 more securities indicates that more firms want to be shariah-compliant as the risks involved are low. more firms want to be listed on this index as shariah-compliant so that more investors will invest in these firms as they portray a good, positive image and comply with the guidelines and benchmarks set by the shariah advisory council (sac) of securities commission malaysia (scm). the new benchmarks also indicate that the shariah screening methodologies imposed currently are stringent than before. by doing this, malaysia is able to be on par with countries such as the united states, in terms of rigid shariah screening methodologies, as the united states has been imposing rigorous shariah screening methodologies for a long time. another reason for malaysia to do so is because malaysia is the top islamic financial hub in the world and so, the nation has to update, in terms of practising the latest shariah screening methodologies to be on par with countries such as the united states. the aforementioned reasons explain for the 3% increase, that is, from 71% of shariah-compliant firms listed on this index in the year 2013 to 74% of shariah-compliant firms listed on this index in the year 2014. subsequently, the number of non-shariah compliant securities listed on this index decreased from 261 in the year 2013 to 232 in the year 2014. the reasons for a decrease of 29 securities were that firms had become prudent, as the need to become shariah-compliant is crucial in order to survive in a competitive business environment on a global level after the introduction of the new benchmarks. thus, in addition, firms have to ensure that their business activities comply with both the business activity benchmarks and the financial ratio benchmarks set by the sac of scm, so that these firms will be classified as shariah-compliant and that more investors will invest in these firms, as they portray a good, positive image when they do so. therefore, the aforementioned reasons explain for the 3% decrease, that is, from 29% of non-shariah compliant firms were listed on this index in the year 2013 to 26% of non-shariah compliant firms were listed on this index in the year 2014. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 64 however, the total number of securities (both categories of securities – shariah-compliant and non-shariah compliant securities) listed on this index are 914 in the year 2013 and 905 in the year 2014, thus indicating a decrease of 9 securities. the likely reasons for this decrease include elimination of non-shariah compliant firms from this index, the particular firm may have been taken over, the firm could have merged with other firms, acquisitions by other firms, the firm is inexistent due to bankruptcy etc. as per the shariah screening methodologies in section 4, when comparing with the united states, malaysia implies business activity benchmarks and financial ratio benchmarks whereas the united states implies industry screens and financial ratio screens. in terms of financing aspect, malaysia recently (in november 2013) revamped the business activity benchmarks, comprising of 5%and 20% benchmarks and introduced the new financial ratio benchmarks, consisting of cash over total assets and debt over total assets ratios. meanwhile, in the united states, in terms of financing aspect, prohibited elements are screened industrially. in terms of investing aspect, screening in terms of financial ratios is practised, whereby total debt, the sum of a company’s cash and interest-bearing securities and accounts receivables must be less than 33%. screening in terms of this investing aspect is not practised in malaysia (recommendations can be seen in section 6). 5.1.2 hong kong in hong kong, in terms of financing aspect, two types of business activity screens are implied, namely, shariah sector-based screens and accounting-based screens. in terms of investing aspect, financial ratio screens are practised, whereby total debt, the sum of a company’s cash and interest-bearing securities and accounts receivables must follow the 12-month average market capitalisation. when comparing with the united states, where industry screens are implied in the united states, in terms of the financing aspect, both hong kong and the united states practise financial ratio screens, in terms of investing aspect, whereby both the measurements are almost similar. 5.1.3 singapore in terms of financing aspect, business activity screening is implied to screen out prohibited elements in singapore. this screening methodology is close in comparison with that of the united states’ practise, within this same aspect. however, in terms of investing aspect, thefinancial ratio screening in singapore differs from that implied in the united states, whereby debt, cash and interest-bearing items must be less than 33.333%, accounts receivable and cash less than 50% and total interest and non-compliant activities income less than 5%. in addition to the above, singapore practises asset-based debt screening, within the investing aspect, in terms of debt ratio limits. 5.1.4 indonesia in indonesia, as per the background information in section 2, statistics of the shariah-compliant firms listed on the indonesia shariah stock index was mentioned. as of 8 november 2013, there were 293 shariah-compliant firms listed on this index. within a year, as of 1 december 2014, there were 310 shariah-compliant firms listed on this index. the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 65 increase of 17 more firms indicates that many more firms are interested to be classified as shariah-compliant as now they realise the risks involved are low. there is a rising need in the firms to be shariah-compliant, as the nation strives to be at the top, in terms of being one of the leading islamic financial hubs in the world. as such these firms anticipate listing on the index as shariah-compliant and to portray a good, positive image while complying to the guidelines and benchmarks set by bapepam-lk, to attract many more investors to invest. in terms of financing aspect, business activities that do not conflict with shariah principles are implied to screen for prohibited elements in indonesia. when comparing with the united states, industry screens are implied in this country, in terms of the financing aspect. whereas, both indonesia and the united states practice financial ratio screens, in terms of investing aspect, however, the measurements differ in indonesia, whereby, total interest-based debts in comparison with total assets must be less than 45% and non-permissible contribution income to revenue must be less than 10%. 5.1.5 the united states in the united states, as per the background information in section 2, statistics of the shariah-compliant firms listed on the dow jones islamic market us index was mentioned. as of 31 december 2013, there were 490 shariah-compliant firms listed on this index. within a year, as of 31 december 2014, there were 556 shariah-compliant firms listed on this index. the increase of 66 firms indicates that more firms are prudent regarding their business activities and want to ensure that they comply with the shariah guidelines set by the dow jones islamic market index shariah supervisoryboard. this is also evidence that more firms are keen to be classified as shariah-compliant as once again the risks involved are low. more firms realise too the rising need to be shariah-compliant, as the nation strives and retains its’ top position, in terms of being one of the leading islamic financial hubs in the world. in addition, more firms want to be listed on this index as shariah-compliant because once again, only when firms portray a good, positive image and comply with the guidelines and benchmarks set by this shariah supervisory board, will more investors invest in these firms. an important point to note here is that the united states is the only pioneering nation, by far, to have introduced, undertaken and retained the current shariah screening methodologies, namely, industry screens and financial ratio screens, for the past 15 years, ever since the nation introduced and launched its’ shariah index, which is the dow jones islamic market us index. interestingly, the united states is also the only nation to impose rigorous shariah screening methodologies right from the outset, until the present day, for the past 15 years. hence, in terms of financing aspect, industry screens are practised to screen for prohibited elements and in terms of investing aspect, financial ratio screens are implied, whereby total debt, the sum of a company’s cash and interest-bearing securities and accounts receivables must be less than 33%. therefore, a summarised comparison analysis, for the various shariah screening methodologies, for all the five countries selected for this study is presented in table 14 as follows: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 66 table 14. comparison analysis – a summary countries operation (screening methodologies) financing investing malaysia business activity benchmarks five-percent benchmark -20-percent benchmark financial ratio benchmarks cash over total assets debt over total assets hong kong business activities screens shariah sector based screens accounting-based screens financial ratio screens total debt, the sum of a company’s cash and interest bearing securities and accounts singapore countries business activity screening prohibited elements financial ratios screening debt, cash and interest-bearing items must be less than 33.333% accounts receivable and cash must be less than 50% total interest and non-compliant activities income must be less than 5% operation (screening methodologies) financing investing asset based debt screening debt ratio limits asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 67 indonesia business activities that do not conflict with shariah principles prohibited elements investment ratios total interest-based debts in comparison with total assets must be less than 45% non-permissible contributionincome must be less than 10% the united states industry screens prohibited elements financial ratio screens total debt, the sum of a company’s cash and interest bearing securities and accounts receivables must be less than 33% in addition, based on the detailed analysis from table 6(a) until table 14, a descriptive analysis on the similarities and the differences of the screening methodologies, for the selected five countries, is presented in table 15 as below: table 15. a detailed descriptive analysis – similarities and differences of shariah screening methodologies similarities of shariah screening methodologies differences of shariah screening methodologies financial ratio based screening, in terms of financial ratios, are observed and practised in malaysia, hong kong (accounting-based screens) and singapore. financial ratio based screening, in terms of financial ratios, are not observed and practiced in the united states and indonesia. instead, financial ratio screens are observed in the united states and investment ratios are observed in indonesia. similarities of shariah screening methodologies differences of shariah screening methodologies meanwhile, financial ratio based screening, in terms of investment ratios, are observed and practised in the united states, indonesia meanwhile, financial ratio based screening, in terms of investment ratios, are not observed and practised in malaysia and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 68 and hong kong. singapore. instead, financial ratio benchmarks are observed in malaysia and asset-based debt screening is observed in singapore. both types of financial ratio based screening, financial ratios and investment are observed and practised simultaneously in hong kong and singapore. both types of financial ratio based screening, financial ratios and investment are not observed and practised simultaneously in malaysia, the united states and indonesia. the shariah index in malaysia, hong kong, singapore, indonesia and the united states was launched in different years, in 1995 (unofficially), 2007, 2006, 2000 and 1999, respectively. malaysia and the united states were the pioneer countries in officially launching the shariah index, in the years 1995 (unofficially) and 1999 respectively, before the year 2000 onwards. hong kong was the most recent country (based on the sample selection) to have officially launched the islamic index, in the year 2007. the financial ratio of 33% is similarly observed and practised in malaysia, hong kong (accounting-based screens), singapore and the united states. the financial ratio of 33% is not similarly observed and practised in indonesia. both hong kong (financial ratio screens) and singapore (asset-based debt screening) observed and practices 12-month trailing market capitalisation, within their screening methodologies. the united states (financial ratio screens) observes and practices 24-month trailing market capitalisation, within their screening methodologies, unlike hong kong and singapore, which observes and practices 12-month trailing market capitalisation. the screening methodologies, in terms of the elements prohibited, tolerable limit and the financial ratio based screening vary in countries like malaysia, hong kong, singapore, indonesia and the united states. similarities of shariah screening methodologies differences of shariah screening methodologies elements prohibited/tolerable limit for all five countries, are about the same/similar, in terms of the business activity malaysia is the only country that observes and practices percentages of elements prohibited/tolerable limit, within the business asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 69 6. suggestions for further research there are several suggestions that can be put forward based on the analysis of findings and the discussion stemming from this paper for future researchers to undertake further research in this area. firstly, future researchers can employ a longer research timeline, perhaps, 5, 10 or 15 years to include the previous shariah screening methodologies practised by malaysia, prior to november 2013 and compare and contrast both the methodologies together with those that are practised in other nations. secondly, future researchers can analyse many other countries in this area and explore various shariah screening methodologies and compare and contrast. thirdly, future researchers can examine the aspect of shariah indiceson its own in numerous countries and compare and contrast them, thus resulting in a different outcome altogether. fourthly, future researchers can investigate the reasons why malaysia only recently imposed financial benchmarks as part of its’ shariah screening methodology as opposed to from the outset of the initiation of the bursa malaysia shariah index in the year 1999, like that of the united states. finally, future researchers can investigate the rationale as to why, not all countries practise investment ratios as part of their shariah screening benchmarks/screening. activity benchmarks, in terms of their screening methodologies. financial ratio based screening is similarly observed in all five countries, with malaysia being the recent country to practise this type of screening since november 2013. it can be observed here that malaysia, being the global leader in shariah financing, has followed suit, other countries that have implemented this type of screening, within their screening methodologies, in order to be on par with the rest of the world. yasaar ltd. (under financial times stock exchange, ftse) is the organisation that undertakes independent screening for ascertaining the shariah compliance of constituents within the index for singapore. the number and percentage of firms that comply with shariah principles vary in all the five countries. within the financial screening methodologies, hong kong is the only country that observes and practises accounting-based screens and singapore is the only country that observes and practises asset-based debt screening, amongst the five countries. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 70 methodology further to examining the benefits of implementing the said methodology, had all these countries practiced as such. 7. conclusion from the research based on this study above, it is evident as to why there are similarities as well as differences between the various shariah screening methodologies in all five 5 countries. the selected asian countries, either pioneers, top islamic hubs in the world (like malaysia and singapore) or advanced and developed countries (like hong kong and singapore) are all working towards implementing and subsequently, practising more stringent shariah screening methodologies to be on par with each other. in comparison, the united states, being a powerhouse nation of the world, has imposed strict shariah screening methodologies from the outset of the initiation of the dow jones islamic market index in the year 1999. the possible reasons for the similarities and differences between the various shariah screening methodologies are feasibility of implementing a particular screening methodology, thus integrating with the current practice, the duration needed for shariah advisory board to impose another or new screening methodology and also the time span needed for firms to then implement it as such, the economic viability for imposing a particular screening methodology, the funds required to do the same for some nations etc. nonetheless, it should be noted here that the existing practise is that only the shariah supervisory board belonging to each of the five countries have the power to determine the shariah screening methodologies to be used by their respective shariah indices. hence, the shariah screening methodologies will differ from country to country. according to dusuki (2009), “indeed ‘maqasid al-shariah’ (objectives of shariah) allows flexibility, dynamism and creativity in social policy” (p.4). zandi et al. (2014) states that these three aspects are necessary to facilitate further developments since various time frames require different rules in order to accommodate people’s needs. jamal et al. (2010) in zandi etal. (2014) states that “the determination of its’ comprehensive objectives have given a signal to change shariah solutions from time to time. however, the changes must be approved by shariah scholars” (p.271). hence, this indicates that the ‘shariah’ element itself, which is islamic-based, is indeed, flexible, in order to address the aforementioned country-specific differences, within its’ unique environment, which is rather advantageous. however, it is likely to benefit all the muslim countries, to generalise the implementation of strict and uniform shariah indices, in order to enhance understanding, interaction and economic co-operation amongst muslim nations, on a global level. acknowledgement this research paper is made possible through the help and support of my main supervisor, professor dr. junaina muhammad, of university putra malaysia whom i sincerely thank, who kindly offered me invaluable advise on methodology, data gathering and analyses. moreover, i sincerely thank my husband mr. muthuraman annamalai and my parents, who provided me with advise, inspiration and financial support. the outcome of this research paper would not be possible if not for all of them. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 71 references abduh, m. and omar, m.a. 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(2011). products of islamic finance: a shariah compliance advancement. australian journal of basic and applied sciences, 5(12), 479-484. http://ajbasweb.com/old/ajbas_december_2011.html copyright disclaimer copyright for this article is retained by the authors, with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 7598-27226-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 230 exploring the relationship between market value and accounting numbers of firms in pakistan salmanriaz (corresponding author) phd scholar, xidian university po. box 338 no. 2, south taibai road, xi’an 710071, china e-mail: grtslmn@hotmail.com yanping liu professor of finance, chief financial officer, xidian university po. box 338 no. 2, south taibai road, xi’an 710071, china e-mail: liuyp@xidian.edu.cn sajjadhussain khan school of accountancy and finance, the university of lahore 1 km raiwind road off, lahore pakistan received: may 3, 2015 accepted: june 14, 2015 published: june 14, 2015 doi:10.5296/ajfa.v7i1.7598 url: http://dx.doi.org/10.5296/ajfa.v7i1.7598 abstract this study examines the relationship between accounting numbers and market prices for the pakistani cement industry. the study covers a time span of nine years from 2005-2014. we study the influence of book value of share, breakup value of share, earning per share, gearing ratio and dividend to equity ratio on market value of share. after applying different econometric techniques we found that book value of share and earnings per share have statistically significant influence on the market price of share. keywords: market price per share, book value of share, gearing ratio and earnings per share asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 231 1. introduction it is well understood among the accounting professional that the main purpose of the accounting is to facilitate the decision making. the innovative work done by the ball and brown (1968) highlighted the role of accounting information in capital markets. this is now very important research area in accounting literature.an essential preference of this kind of research has become identified which classify the value importance of accounting numbers, financial statements are generally used by stakeholders to judge the economic worth of firms on the assumption that accounting number have a assured relationship with the equity market value. the study does not assume that shareholder use only accounting data in their savings options. they suppose that if accounting information is excellent summary that evaluates of the dealings included in security prices, after that they were value related because their exercise might give a value of the firm that is close to its market value. thus association of this studies test whether accounting numbers provide a good summary measure of the value relevant events that have been incorporated in stock prices during the reporting period. this area is very important with regard to capital markets because accounting information is thought to facilitate the prediction of firm’s future cash flows and to help investors predict the future security’s risk and returns. this is the reason a huge body of literature grown up in last three decades as (kothari, 2003; richard &tinaikar, 2003). there are three approaches (industry, finance and accounting and capital market research) theory and are available in the existing literature to value a firm. in literature there are few studies available on the financial analyst approach because of the proprietary nature of the information. on the other hand finance and accounting theory has been widely examined in the empirical literature. this approach value a firm as the present value of the expected dividends.ohlson (1995) suggested theoretical structure on the relationship between the market value of common equity and accounting variables. this paper has been followed by many researchers who re-examined the relationship between firm value and accounting numbers using fundamental analysis. bar-yousef et al. (1996) conducted the first empirical study to examine the time series relationship between market value, dividends, earnings and book value. presently a number of studies have adopted ohlson model (ahmed et al, 2000; ballester et al, 1999; callen& morel, 2000; lee et al, 1999 and morl, 1999). the motivation of this study is to enhance the understanding of the relationship between market and accounting values in the context of pakistan capital markets. given the inconclusive regarding the relationship between market and book values , it is an open question as to whether the disclosure of accounting information affects share price or whether it is irrelevant to the behavior of stock prices .the main research question is at the level of firm what is the relationship between market value and accounting numbers based on the information drawn from cement sectors firms listed onkarachi stock exchange of pakistan. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 232 the study investigates this question through an examination collected from a variety of resources. cement industry is a major indicator of economic growth and revival of any country. this industry gives the growth and improvement of infrastructure of a country. in pakistan, positive macroeconomic indicators and governments intention of spending more on social and infrastructure development has increased the requirement for cement many folds.there are total number of units are 22. the cement industry in pakistan has become a long way since independence when country had a less than half a million tons per annum production capacity. by now it has exceeded 10 million tons per annum as a effect of establishment of new industrialized facilities and expansion by existing units. privatization and effective price decontrol in 1991-92 heralded a new era in which the industry has reached a level where surplus production after meeting local demand is expected in 1997. the study consist of three sections, following sections describes the review of literature. section three explains the data and final section includes discussion on results and conclusion. 2. review of literature the current approach to capital market research (cmr) in the accounting literature began with the work of ball and brown (1968). that research was the one of the first effort systematically explore the relationship between the market value and accounting numbers of firms with the exact statistical method. ball and brown tested the hypotheses that how abnormal returns on the stock market related with the announcement of the preliminary annual earnings per share number which was the first annual eps figure announced to the stock exchange. they took 261 firm listed on new york stock exchange over the time span of 1957 to 1965.they argued that the earning numbers were useful in the earnings forester error, or earning innovation was extensively related to the abnormal returns. seetharaman & rudolph, (2010) examined the role of declaration of earning per share (eps) on the stock prices and argued that earning per share have significant influence on stock returns. graham and king, (2000) used ohlson model to examined the relationship between market values and book values, they concluded that accounting practices have significant influence on sock returns. willet & peare, (2000) studied the relationship between market values and accounting numbers for short term and long term. they document that in short run book values and market differs but have relationship in long run. omura (2005) provided the evidence that net assets have significant relevance for market values in the japanese stock markets. clout (2007) studied the australian firms and empirically reported that there is an equilibrium correlation relationship between market values and accounting numbers. williams (2000) attempted an effort to test whether accounting numbers are capable to predict distress in high technology industry and empirically document that accounting numbers are still predictive in high technology firms. there is a strong relationship between accounting numbers and market values of 59 firms listed on jakarta stock exchange (jsx) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 233 reported by suwardi (2004). earnings have significant weight in the firm valuation ( see pervits et al. 1994). kadri& mohammed (2007) examined the relationship between book value, earnings and market prices. they empirically found that there is significant relationship exists in the accounting numbers and market price. petkova and zhang, (2005) support empirically fama-french argument that market to book value ratio is a determinant of stock returns. similarly raj and ramesh (1992) the effect of book ration in japanese stock market. they found that stocks with higher market to book value ratio have earned low returns and stocks with lover book value to market ratio earned higher stock returns in japanese stock market. ball et al. (1993) studied us market; they took the data for the time span f 1950-1988. they document that changes in the earnings have systematic economic determinants that are associated with the securities return variation. vafeas et al. (1998) for cyprus stock market document that earnings level and changes in earnings level does matter for the explanation of stock returns in emerging stock markets. lamont (1998) investigated the relationship between earnings and expected returns. he argued that both dividends and earnings have ability to predict the returns and earnings having information because they are correlated with business conditions. 3. methodology & variable construction this study is an effort to explore the relationship between market values and accounting number for the cement industry of pakistan. there are 22 cement companies listed on karachi stock exchange, we took the data of 17 companies because rest of them did not provide enough information. the study covers a time span of 2005 to 2014. at that time many events happened as many firms get merged, delisted etc. we took the data of daily prices from the karachi stock market and data of accounting returns came from annual report. we used market prices and market returns as dependent variable while book value per share, earnings per share (eps), gearing ratio, dividend to equity ratio, and breakup value of shares are taken as independent variables. to measure the suggested relationship, we firstly checked the significance of individual variable by using the simple regression. after that we include only significant variables in our final model and reject all insignificant ones. following are the models 1. =∝ + ………………………………………………..1 2. =∝ + ………………………………………………2 3. =∝ + …………………………………………………….3 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 234 4. =∝ + . . …………………………………………………4 5. =∝ + ……………………………………………………5 where bv=book value per share (bv), calculated by bv= net assets/ total outstanding shares brv= breakup value of shares eps= earnings per share (eps), is calculated by eps= net earnings / number of outstanding shares gr= gearing ratio,is calculated by gr= borrowing (all long-term debts + normal overdraft) / net assets (or shareholders' funds) de= dividend to equity ratio 4. results and discussion asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 235 table1. simple regression results model summary model r r square adjusted r square std. error of the estimate 1 .478a 0.229 0.224 26.49714 2 .587a 0.344 0.34 24.42881 3 .332a 0.11 0.105 28.45839 4 .082a 0.007 0 30.07098 5 .287a 0.083 0.077 28.89903 a. predictors: (constant), book value coefficients model un-standadized coefficients standadized coefficients t sig. b std.error beta 1 constant book value 15.573 2.796 5.569 0 0.195 0.029 0.478 6.759 0 2 constant break value 18.395 2.222 1.278 0.3 0.422 0.047 0.587 0.996 0.23 3 constant eps 27.808 2.279 12.204 0 1.325 0.303 0.332 4.371 0 4 constant gr 27.857 2.408 11.57 0 0.009 0.009 0.082 1.02 0.309 5 constant de 24.298 2.506 9.695 0 1.338 0.359 3.724 0.724 0.16 a dependent variable : yearly average market price anova model sum of squares df mean square f sig. 1 regression 32074.14 1 32074.15 45.683 0 residual 108123.131 154 702.098 total 140197.271 155 3 regression 15475.77 1 15475.77 19.109 .000a residual 124721.5 154 809.88 total 140197.271 155 the above posed tables describe the linear regression results of the suggested models. anova table indicating that model 1 and model 3 are overall significant at alpha 1% 5% and 10%. model summary disseminates the information of adjusted r-squares of model. this summary shows that model 1 adjusted r-square is 22.2 percent while for the model 3, asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 236 is 10.5%. we discuss only the significant model and excluded all the insignificant models. coefficient table displays that book value have significant positive influence on the market prices of the cement industry of pakistan. model 3 that states that earning per share is contributing positively in the market price, the coefficient of earning per share in coefficient table gave us the expected relationship, that earning per share is positively contributing in the market prices that is consistent with the prior studies as (seetharaman& rudolph, 2010). after checking the significance of the individual variable we test the influence of all significant variables together with the help of linear regression analysis. from the above results we conclude that book values and earnings per share are only two variables that influence market price significantly, so in the coming results we checked their impact together. we develop following model mp= + β b.v bv βeps eps………………………………………6 where mp = market price bv= book value eps= earnings per share table 2. regression analysis reveals following results model r r square adjusted r square std.error .650a 0.422 0.415 23.01061 model sum of squares df mean square f sig. regression 59185.6 2 29592.8 55.889 .000a residual 81011.67 153 529.488 total 140197.3 155 coefficients model un-standadized coefficients standadized coefficients t sig. b std.error beta (constant) 13.096 2.453 5.339 0 book value 0.232 0.026 0.571 9.086 0 earnings per share 1.792 0.25 0.449 7.156 0 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 237 the summary of the model represents that overall model is healthy with the adjusted r-square 0.41 percent. overall model is significant at even at 1%. model represent that there is a significant relationship between market value and accounting numbers of firms evident with (0.233, 0.000) which is consistent with the same line as (willett &peare, 2000) and graham and king (2000). meanwhile earning per share could be used to predict the market price explained by (1.792, 0.000) in the coefficient table. 5. conclusion this study is an effort to investigate the relationship between the market value and accounting numbers of cement firms. investors always try to predict the market prices to maximize their returns. many researchers, practitioner and investors have tried to predict the market prices with different methods and variables. but even though extensive body of literature in this issue is available, but still unsolved issue and requires more research. that’s why we try to contribute in this issue in pakistani case. firstly we suggested five variables that could be helpful in predicting the market prices. at the first stage three of them found insignificant and we excluded that variables. in the final stage, we found that accounting numbers have positive influence on the market prices that has been argued many researchers in the existing literature. we also find this relationship in pakistani market. secondly we conclude that earning per share is statistically has significant influence on the market prices. these both variables are highly influence on market prices in the pakistan scenario. also this study has some limitations. firstly this study scope is limited to the pakistani stock market and could not be generalized. second issue is this due to certain reasons this study only discusses the cement industry of the pakistan, although it is rich industry we could not say these things for other sectors with surety. this study could be helpful for investor for predicting the prices and researches to extend this idea to the rest of sectors of the economy. references ball, r., & brown, p. (1968). an empirical evaluation of accounting income and numbers. journal of accounting research, autumn, 159-177. http://dx.doi.org/10.2307/2490232 ball, r., kothari, s. p., & watts, r. l. (1993).economic determinants of the relation between earnings changes and stock returns. accounting review, 622-638. bartholdy, j., peare, p., & willett, r. j. (2000). a theoretical and empirical analysis of the relationship between market and book values. clout, v. j. (2007). investigating the relationship between market values and accounting numbers for 30 selected australian listed companies (doctoral dissertation, school of accountancy, faculty of business, queensland university of technology). lamont, o. (1992). earnings and expected returns. journal of finance, 5, 1563-1587. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 238 omura, t. (2005). the relationship between market value and book value for five selected japanese firms. petkova.r.,& zhang. l. (2005). is value riskier than growth? journal of financial economics 78(1), 187-202. http://dx.doi.org/10.1016/j.jfineco.2004.12.001 previts, g. j., bricker, r. j., robinson, t. r., & young, s. j. (1994). a content analysis of sell-side financial analyst company reports. accounting horizons, 8, 55-55. raj, h., & ramesh, p. r. (1992). price/book value ratios and equity returns on the tokyo stock exchange: empirical evidence of an anomalous regularities. the financial review, 27(4). suwardi, e. (2004). exploring the relationship between market values and accounting numbers of firms listed in an emerging market (doctoral dissertation, queensland university of technology). vafeas, n., trigeorgis., l., and georgiou., x. (1998). the usefulness of earnings in explaining stock returns in an emerging market: the case of cyprus. european accounting review, 7(1), 105-126. http://dx.doi.org/10.1080/096381898336600 zulkifli, m., & kadri, m. h. (2008). relationship between market value and book value of malaysian firms under pre and post frs. http://dx.doi.org/10.2139/ssrn.1440771 microsoft word 3740-14051-2-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 1 the determinants of capital structure: an empirical study of new zealand-listed firms fitriya fauzi (corresponding author) the university of muhammadiyah palembang, indonesia jl. a. yani 13 ulu palembang 30263 sumatera selatan indonesia tel: 62-711-513-022 e-mail: fitriya@umpalembang.ac.id abdul basyith the university of muhammadiyah palembang, indonesia jl. a. yani 13 ulu palembang 30263 sumatera selatan indonesia tel: 62-711-513-022 e-mail: basyith@umpalembang.ac.id muhammad idris the university of muhammadiyah palembang, indonesia jl. a. yani 13 ulu palembang 30263 sumatera selatan indonesia tel: 62-711-513-022 e-mail: idris@umpalembang.ac.id received: may 21, 2013 accepted: july 25, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.3740 url: http://dx.doi.org/10.5296/ajfa.v5i2.3740 abstract this paper investigates capital structure determinants of new zealand-listed firms. this study is an extension from previous studies conducted by boyle and eckhold (1997) and, wellalage & locke (2012). boyle and eckhold and, wellalage and locke examine capital structure choices in new zealand, especially the debt choices of nz’s corporate firms. using a balanced-panel of 79 new zealand-listed firms, this study employs a balanced panel method, using dynamic-panel instrumental variable-generalised methods of moments (iv-gmm) as it corrects heteroskedasticity and endogeneity problems which might result in an unbiased and inconsistent estimation. all variables, apart from non-debt tax shields and profitability exhibit a significant impact on total debt. overall, these variables confirm the trade-off theory, asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 2 even though the coefficient for non-debt tax shield confirms the pecking-order theory. the empirical evidence is less conclusive than that of previous studies in other countries, particularly australia where capital structure confirms the pecking-order theory. overall, the trade-off theory is more appropriate in explaining new zealand listed firms’ capital structure. in addition, it appears that the capital structure theories applied to each study are contradictory, even though the result is in line with boyle and eckhold and, wellalage and locke which find that those firms’ specific characteristics play a significant role in determining the firm’s debt level. however, the contradictory results may be due to the different methods, time frames and scope of the samples used. keywords: capital structure, dynamic-panel iv-gmm, new zealand-listed firms jel classification: g32 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 3 1. introduction after the seminal work of modigliani and miller (1963), numerous studies have been done to explore to what extent the capital structure theory can be applied to different circumstances. those studies were conducted under different assumptions which fit in to the particular situation. trade-off theory, pecking-order theory, agency-theory and some other theories are empirical evidences that challenge modigliani and miller’ capital structure studies (m &m). further, the empirical relevance of the trade-off theory,pecking-order theory, agency-theory and some other theories has often been questioned. some research has been conducted to investigate this theory,but the results from various contexts are mixed and inconclusive. the different results may be caused by different firm size, the maturity of the respective capital market, and the country being used as a sample. the impact of firm characteristics on a firm’s financing choices has been extensively studied across firms and countries; for example, rajan and zingales (1995), arvin and francis (1999), goyal and frank (2003) studied us firms, while deesomsak, paudyal and pescetto (2004), and kabir and jong (2008) studied asia pacific firms, and some from other developed and developing countries. at an aggregate level, firm leverage is similar across the developed countries, and any differences that exist are not easily explained by institutional differences (rajan & zingales, 1995). most firms had a convergence in their capital structure toward industry average (arvin & francis, 1999), thus the factors identified by previous cross sectional studies in the united states to be related to leverage seem similarly related in other countries as well. however, the findings of those studies seem to be obsolete, as now some studies find that the capital structure decision of firms is influenced by the environment in which they operate.as well as firm specific factors identified in the extant literature, the capital structure decisions are not only the product of a firm’s own characteristics, but also the result of the corporate governance, legal framework and institutional environment of the countries in which the firm operates (deesomsak, paudyal & pescetto, 2004). firm specific determinants of leverage differ across countries and there is an indirect impact, because country specific factors also influence the roles of firm specific determinants of leverage (kabir & jong, 2008). the evidence indicates that different theories apply for different circumstances and periods, therefore an investigation of capital structure choices and its determinant continues to be an important subject. apparently, few studies have been conducted to investigate the capital structure choices in new zealand firms, and therefore it is necessary to conduct ongoing investigation in the pattern of capital structures. at present there are two common types of financing that can be utilised by new zealand firms; first, equity financing; and second, debt financing. these two financing methods have their own advantages compared to one another. firms may raise equity and debt financing through capital markets (the new zealand stock exchange), which was established in 2002. the new zealand stock exchange (nzx) opens more opportunities for new zealand firms to access funding sources. the main financial markets in new zealand relate to debt asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 4 instruments, equities, and managed funds. debt security markets operate at both wholesale and retail levels, which vary by type of instrument, issuer, buyer, maturity and level of risk. according to statistics new zealand (2004), the majority of new zealand firms’ financing was raised from debt financing, particularly short-term financing. the reasons why short-term financing was preferred over long-term debt financing are; first, new zealand firms were dominated by small and medium enterprises, and second, the majority of new zealand firms were in the primary sector, thus giving a different characteristic in contributing to their economic growth.though new zealand is considered a developed market, nz’s businesscharacteristics differ from those developed countries, and thus may result in the different financing choices. vos and nyamori (1997) conducted a survey research of new zealand firms’ capital structure, and they found that there were several reasons why firms choose debt as source of financing; a debt carries lower cost; it is more convenient and flexible to deal with; the debt requirement fits with their circumstances; it is a corporate policy to adjust their capital structure, and it is available all the time. further, a recent study by artemesia and mcculloch (2007) concluded that the cost structure and the net interest margins of new zealand banks are low, therefore enterprises prefer short-term financing. moreover, minimising the cost of borrowing is consistent with the pecking-order theory, as confirmed by boyle and eckhold (1997) and, wellalage and locke (2012). 2. literature review the trade-off theory is derived from the models based on taxes and agency costs. modigliani and miller (1963), deangelo and masulis(1980) and jensen and meckling (1976) suggest the firm has an optimal capital structure by offsetting the advantages of debt and the cost of debt. therefore, trade off theory refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. it states that there is an advantage to financing with debt; the tax benefits of debt, and tax benefits to be had; but there is also a cost to financing with debt; the costs of financial distress including bankruptcy costs, and agency costs. this theory suggests that there is a positive relationship between debt level and firm performance. moreover, the implication of this trade off theory is that firms have target leverage and they adjust their leverage toward the target over time. the trade-off theory has been tested by researchers in developed markets, most focusing on how the determinant factors affect capital structure choice. graham and harvey (2001) surveyed 392 chief financial officers (cfos) about the cost of capital, capital budgeting, and capital structure. they found moderate support that firms follow the trade-off theory and pecking order theory; but mixed or little evidence that signalling, transaction costs, underinvestment costs, asset substitution, bargaining with employees, free cash flow considerations and product market concerns affect capital structure choice. in addition, brounen, de jong, and koedijk (2006) also surveyed 313 cfos on capital structure, focusing onthe uk, the netherlands, germany and france. they also found that the trade-off theory is confirmed by the importance of target debt ratio in general in these four countries but also specifically by tax effects and bankruptcy costs; and they concluded strong similarities in the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 5 capital structure among the four european countries, and also with the us when comparing capital structure policies. the pecking-order theory was developed by myers and majluf (1984). myers and majluf (1984) considered that firms must issue common stock to raise cash to undertake a valuable investment opportunity. management is assumed to know more about the firm’s value than potential investors, and investors sometimes interpret the firm’s actions irrationally. an equilibrium mode1 of issue-investment decision has been developed under these assumptions. the model shows that firms may refuse to issue stock, and therefore may pass up valuable investment opportunities. the model suggests explanations for several aspects of corporate financing behaviour, including the tendency to rely on internal sources of funds, and to prefer debt to equity if external financing is required. titman and wessels (1988) tested various models which explain capital structure choices, by including all hypotheses jointly in the empirical tests; and their results suggest greater confidence in the pecking order than in the target adjustment model. likewise, sunder and myers (1994) re-examined some aspects of the empirical literature on capital structure and found a similar result. boyle and eckhold (1997) examined capital structure choice and financial market liberalisation in new zealand, especially the debt choices of nz’s corporate firms, but found that most existing theories were of little value in explaining the debt choices of nz corporate firms. most of the explained variation in long term debt choices can be attributed to differences in firms’ earning power. for short term debt, the data indicated that dividend policy and ability to utilise tax shields were statistically significant, but these variables explain little of the observed variation in debt ratios. this finding is consistent with evidence from other countries across preand post-reform periods. overall, the results are remarkably similar to those of titman and wessels (1988) and bennett and donnelly (1993) for us and uk data, respectively. wellalage and locke (2012) investigated the capital structure of new zealand’s large listed companies for the period 2003 to 2010 using quantile regressions. they included corporate governance variables (e.g., foreign share ownership, managerial ownership and non-executive directors on the board) in determining capital structure. wellalage and locke found that firm-specific characteristics play a significant role in determining a firm’s leverage levels rather than corporate governance variables. in addition, they found that new zealand firms fit into the pecking-order theory. nevertheless, this study sheds some light on new zealand’s capital structure choices and is necessary for the regulators in stimulating the enterprises to be more active in the debt market activities. though theoretical and empirical studies have shown that profitability, tangibility, firm size, non-debt tax shields, growth, managerial ownership, and some others factors impact on capital structure (titman & wessels, 1988; harris & raviv, 1992; rajan & zingales, 1995; shyam-sunder & myers, 1999; kabir & jong, 2008; wellalage & locke, 2011), this empirical evidence of firms’ specific factors are inconclusive, as different countries show a differentresult. in addition, deesomsak, paudyal and pescetto (2004) suggest that capital structure decisions are not only the product of a firm’s own characteristics, but also the result asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 6 of the corporate governance, legal framework and institutional environment of the countries in which the firm operates. profitability plays a significant role in determining how much debt is utilised by firms. according to the trade-off theory, profitable firms tend to utilise more debt compared to unprofitable ones, to avoid higher tax payment, but firms also have to offset the benefit of and the risk of utilising debt. in contrast, the pecking-order theory suggests that profitable firms tend to utilise less debt compared to unprofitable ones, because profitable firms have more earnings and they prefer to utilise internal financing rather than external financing. the study of rajan and zingales (1995) found that profitability is negatively correlated with leverage. further, the negative influence of profitability on leverage should become stronger as firm size increases. similarly, deesomsak, paudyal and pescetto (2004) found a negative relationship between profitability and leverage; but this finding is statistically insignificant for all countries. the negative relationship is consistent with the predictions of the pecking order theory, indicating that firms prefer to use internal sources of funding when profits are high; but this has not been proved because the results are statistically insignificant. in addition, kabir and jong (2008) also found a negative relationship between profitability and leverage in 25 countries, of which more than half are developed markets. most secured-debt requires collateral, as it guarantees the bondholders, and tangible assets are likely to have an impact on the borrowing decisions because they are less subject to informational asymmetries, and have a greater value than intangible assets, as in the case of bankruptcy (gaud, jan, hoesli & bender, 2005). thus, the higher the tangible assets proportion, the greater the chance of obtaining debt financing (titman & wessels, 1988; harris & raviv, 1992; rajan & zingales, 1995; gaud et al., 2005). according to the trade-off theory, larger firms with higher assets tangibility tend to have more leverage and pay higher dividends. a dividend payment is one form of tacit information that managers convey to the market, thus indicating that firms have higher growth prospects, and referred to as a signalling; and it is assumed that signalling has a positive relationship with leverage. further, some empirical studies suggest that the performance of each firm may differ according to their size, because larger firms have greater economies of scale in the transaction costs associated with long term debt, which may influence the results and inferences (ramaswamy, 2001; goyal & frank, 2003; coleman, 2007; jermias, 2008; ebaid, 2009). in addition, larger firms have less potential for bankruptcy costs; therefore, firm size should be positively related to borrowing capacity (rajan & zingales, 1995; krishnan & moyer, 1997; padron et al., 2005).in addition, harris & raviv (1992) and booth et al. (2001) imply that higher leverage can be expected to be associated with larger firm value; higher debt level relative to expected income; and lower probability of reorganization following default. however, titman & wessels (1988) and wald (1999) assert that larger firms with less asymmetric information prefer to use less debt, suggesting a negative relationship between firm size and leverage. because of asymmetric information, smaller firms are likely to bear higher costs in debt financing (graham, 2000; padron et al, 2005). the tax deduction for depreciation and investment tax credits is called non-debt tax shields (ndts). deangelo and masulis (1980) argue that non-debt tax shields are substitutes for the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 7 tax benefits of debt financing; and firms with larger non-debt tax shields have low debt. however, many studies argue that larger firms tend to be more diversified and hence are less likely to go bankrupt; so they tend to utilise debt to have the benefit of tax-shields. debt usage will reduce the taxable income, and thus firms favour having more debt, as this increase the amount of cash obtained (bradley et al., 1984). on the other hand, the presence of non-debt tax shields reduces the optimal advantage of debt, because a higher level of non-debt tax shields results in less reliance on the tax-deductible aspect of debt which leads to a negative relationship with debt. wiwattanakantang (1999) and, de miguel and pindado (2001) found an inverse relationship between non-debt tax shield and debt. empirical studies find that firms with higher growth tend to have more debt as they expect to expand their business scale; and debt financing is considered as a preferable option as it carries lower cost; however, high-growth firms having an outstanding debt with higher opportunities on profitable investments will forgo these investments as it only affects debt holders rather than shareholders; therefore, growth is expected to have negative relationships with debt (myers, 1977). further, titman and wessels (1988), rajan and zingales (1995), harris and raviv (1992), ghosh and cai (2000), booth et al (2001) and padron et al. (2005) found that firms with higher growth should utilise equity financing resulting in a negative relationship with leverage. jensen and meckling (1976 and 1986) suggest that leverage minimises the total agency costs resulting from the conflicts of interest between shareholders and managers, and conflicts between shareholders and debt holders, therefore it is expected that leverage has a correlation with ownership (including managerial ownership). leland and pyle (1977) and berger et al (1997) found that leverage is positively correlated with the extent of managerial shareholdings. on the other hand, it is assumed that higher inside ownership tends to have less debt, because they prefer to use internal financing to avoid the agency problem with debt holders; therefore negative relationships between leverage and managerial ownership are expected. friend and hasbrouck (1988) tested director’s shareholdings as a determinant of a firm’s capital structure, and they found significant negative relationship between ownership and debt. likewise, wiwattanakantang (1999) found that ownership structure affects financial structure. further, seifert and gonenc (2008) explain that in the us and the uk, ownership is dispersed, and managers and insiders have superior information compared to outside shareholders. in japan and germany, the asymmetric information issues are caused more due to the quality of information provided to investors and the legal rights afforded to these outside investors. however, empirical studies provide mixed results on how ownership structure impacts on capital structure. a series of specific hypothesis in determining the capital structure choice is provided as follows: h1 : tangibility is positively associated with leverage h2 : non-debt tax shields are negatively associated with leverage h3 : profitability is negatively associated with leverage asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 8 h4 : growth is negatively associated with leverage h5 : signalling is positively associated with leverage h6 : firm size is positively associated with leverage h7 : managerial ownership is negatively associated with leverage the empirical relevance of the capital structure theory has often been questioned. some research has been conducted to investigate this theory and the results from various contexts are mixed and inconclusive. the evidence does indicate there are likely to be differences attributable to firm size, country and the maturity of the respective capital market. 3. research methodology 3.1 sample set this study uses data from the annual report of new zealand-listed firms for the period of 2007-2011 collected from nzx deep archive. those firms with any missing observations for any variable in the model during the research period are dropped, and thus a balanced panel data of 79 new zealand-listed firms were observed from 147. though only 79 firms were included, the sample may do well in capturing aggregate leverage in the country because the listed firms can represent the whole industry in new zealand. table 3.1 presents descriptive statistics for the sample data. the mean value of leverage/total debt (td) is 0.45, with a range of 0 to 0.99, suggesting that all firms have leverage close to the average leverage of industry. further, the mean value for total long-term debt (tltd) is lower than that for total short-term debt (tstd); indicating firms have more short-term debt. two considerable reasons for utilising more short-term debt are the majority of small & medium enterprises for new zealand’s business, and the majority of agriculture industry’s domination. according to statistics new zealand (2004), new zealand’s firms utilised debt rather than equity financing which account for 72% total debt compared to australian firms which utilised only 25% of debt financing in 2003 (welch, 2003). in addition, the reason that short-term debt financing seems to dominate the capital structure in new zealand may be due to either the bank interest rate in new zealand is quite low compared with other financing choices or the firm specific characteristics of each firm in determining their capital structure. further, the average total debt utilised by new zealand firms accounts for 45% which is close to the range of the average total debt for most developed countries in the 1990s; 50 to 60% (rajan & zingales, 1995). comparing two different periods might be absurd; therefore, based on recent studies by bessler, drobetz and gruninger (2011), the average total debt for all firms over the world is 25%; for non-us firms it is 26%; for us firms it is 23%; for common law countries it is 25%; and for civil law countries it is 27%. it seems now that new zealand’s firms utilised debt financing above the average. further, the mean value for tangibility is 0.44, suggesting that the majority of firms have moderate fixed assets, hence they are useful for raising debt financing by using them as collateral. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 9 table 3.2 presents correlation matrix for all variables in the model. the highest correlation is between non-debt tax shields and profitability at 0.79. this suggests that firms with higher level of debt tend to maximise non-debt tax shields resulted in higher profitability tend to maximise. none of the correlations among explanatory variables are above 0.79, indicating a low likelihood of multicollinearity issues arising in the ols regressions. table 1. descriptive statistics variable obs. mean std. dev. leverage/total debt (td) 395 0.4537 0.2642 total long-term debt (tltd) 395 0.1986 0.1862 total short-term debt (tstd) 395 0.8014 0.1862 tangibility (tang) 395 0.4397 0.3259 ndts 395 4.6304 22.5214 profitability 395 5.1427 60.5113 growth 395 1.1198 1.3446 signalling 395 1.0028 20.2749 ownership (iownp) 395 0.1537 0.2455 firm size 395 5.3363 1.1819 industry_primary 395 0.1519 0.3594 industry_energy 395 0.0759 0.2653 industry_goods 395 0.1772 0.3823 industry_property 395 0.0633 0.2438 industry_service 395 0.4177 0.4938 industry_investment 395 0.1013 0.3021 table 2. correlation matrix td tltd tstd tangibility ndts profitability growth signalling iownp firm size td 1.0000 tltd 0.4134 1.0000 tstd -0.4134 -1.0000 1.0000 tangibility -0.1619 0.1469 -0.1469 1.0000 ndts -0.1808 -0.1983 0.1983 -0.0077 1.0000 profitability -0.1298 -0.0530 0.0530 -0.0684 0.7904 1.0000 growth -0.0513 -0.0108 0.0108 0.1139 -0.0227 -0.0106 1.0000 signalling 0.0880 0.1184 -0.1184 -0.0564 -0.0096 -0.0017 0.0196 1.0000 iownp -0.0282 -0.1350 0.1350 -0.1340 -0.0583 -0.0531 0.1701 0.0191 1.0000 firm size -0.0850 0.1825 -0.1825 0.2974 0.1739 0.1139 0.0139 -0.0258 -0.1637 1.0000 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 10 3.2 variables variables are largely adopted from previous study, thus this study uses three leverage proxies as the dependent variableswhich are total debt, long-term debt and short term debt. the explanatory variables include tangibility, non-debt tax shields (ndts), profitability, growth, signalling, managerial ownership and firm size, while industry dummy serves as a control variable variables (titman & wessels, 1988; rajan & zingales, 1995; shyam-sunder & myers, 1999). variables are defined as follow: leverage is measured as ratio of total debt over total assets; tangibility is measured as ratio of total fixed assets over total assets; non-debt tax shield is measured as ratio of total depreciation over total assets; profitability is measured as ratio of earnings before interest, tax and depreciation over total assets; growth is measured as book to market ratio; signalling is measured as ratio of dividend payment over total assets; managerial ownership is measured as percentage of the inside ownership’s equity; firm size is measured as the log of total assets (titman & wessels, 1988; rajan & zingales, 1995; shyam-sunder & myers, 1999; gaud et al., 2005; padron et al., 2005). 3.3 method this study uses panel data which allows the unobservable heterogeneity for each observation in the sample to be eliminated and multicollinearity among variables to be alleviated. maddala and lahiri (2009) specify problems that might be present in the regression model, such as heteroskedasticity, multicollinearity and endogeneity problems. those problems cause inconsistency of the ols estimates. dang (2005) examined the performance of two influential but contradicting theories of capital structure, known as the trade off and pecking order theories, using a partial adjustment model, and an error correction model as a generalised specification of the partial adjustment process. this framework allowed him to nest the cash flow deficit variable necessary to examine the pecking order theory. the empirical models are estimated by the anderson and hsiao iv and the arellano and bond gmm methods, which are argued to yield consistent estimates for dynamic panel data. as can be seen in the table 3.2 most cross-correlation for the independent variables are fairly small, thus, giving less cause for concern about the multicollinearity problem. further, the arellano-bond test for zero autocorrelation in first difference errors results -14.5681 (p-value 0.1169) confirms no serial correlation in the original error as desired. the breusch-pagan test for heteroskedasticity results 7.43 (p-value 0.006) indicates that variances among the explanatory variables are not constant. to estimate the leverage, this equation is the first point to begin, the model is as follows: = + ′ +⋯+ ′ + (1) = + + (2) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 11 = 1,… , ; = 1,… , where denotes the unobservable individual effect, denotes the unobservable time effect, and is the remainder stochastic disturbance term. when using the ordinary least squares (ols) to estimate , one assumes that ′ is orthogonal with of equation (1), but this may not be true, and thus the estimated may be biased with endogeneity. therefore, the instrumental variable (iv), denoted as , approach may be used to solve the endogeneity; while the changes in the new iv are associated with changes in but do not lead to changes in (except indirectly via ). therefore, the equation which includes endogeneity is specified as follows (cameron & trivedi, 2010); = ′ + ′ +⋯+ ′ + , = 1,… , (3) the regression errors are assumed to be uncorrelated with ′ and ′ but correlated with ′ , and this correlation leads to an inconsistent estimation. to obtain a consistent estimation, a reduced-form model is appropriate; = ′ +⋯+ ′ + (4) = | = 0 (5) most previous studies on the capital structure determinants treat tangibility, non-debt tax shields, growth and managerial ownership as endogenous variable determinants (agrawal and knoeber, 1996; dessi& robertson, 2003; maghyereh, 2005; coricelli, driffield, pal & roland, 2011), thus the durbin-wu-hausman test for endogeneity is necessary, and the result confirms that tangibility, non-debt tax shields, growth and managerial ownership are indeed endogenous. therefore, this study employs dynamic-panel iv-gmm (instrumental variable-generalised methods of moments) which provides consistent estimates by utilising instruments that have been obtained from the orthogonality condition between the regressors and the error terms. the analysis includes the sargan test for over-identification restrictions to test the validity of instruments used in the model, which will confirm that the parameters of the model are estimated using optimal gmm. it is worth mentioning the possibility that some of the regressors may be correlated with the past and current values of the idiosyncratic component of disturbances. the model for dynamic-panel gmm is (cameron & trivedi, 2010); = + , + ⋯+ , + ′ + , = + 1,… . . , (6) the assumption is that are serially uncorrelated. an important aspect of the dynamic panel estimator is its using the firm’s history as instruments for explanatory variables. the regression model is specified as follows (titman & wessels, 1988; rajan & zingales, 1995; shyam-sunder & myers, 1999): asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 12 = + + + + ℎ + +ℎ + + (7) 4. findings table 4.1, table 4.2 and table 4.3 present the regression results for total debt, long-term debt and short-term debt, respectively. each table provides four different methods, which are ols robust, 2sls, gmm and dynamic-gmm. in, addition, instrument in the dynamic-iv gmm is significant in the level of two-lagged for total debt and long-term debt, while for short-term debt the lagged instrument is significant in one-lagged. more specifically, the wald (joint) test provides evidence that supports the joint significance of all the regressors in the model. furthermore, the sargan test confirms the validity of the instruments used. as mentioned in the method section, this study uses dynamic-gmm, but there is no harm if we compare the regression results that confirmed efficient and unbiased estimators. the coefficients of tangibility, growth, signalling, managerial ownership and firm size are significant for the total debt equation (table 4.1; dynamic-iv gmm, reg.2). it can be concluded that firms’ specific factors play a significant impact in explaining new zealand listed-firms’ capital structure. the different results were obtained for long-term debt and short-term debt. for long-term debt, only growth coefficient is significant (table 4.2; dynamic-iv gmm, reg.2), while for short-term debt, only coefficients for tangibility, profitability, managerial ownership and firm size are significant (table 4.3; dynamic-iv gmm, reg.1). the tangibility coefficients for total debt and short-term debt are positive and significant, which confirm that higher assets’ tangibility is associated with higher leverage. this result is supported also by the survey of statistics new zealand (2004), that more than 70% of new zealand firms utilise debt financing, particularly short-term debt, in which the majority source of the short-term debt financing is banks. the significant result for tangibility in explaining short-term debt confirms that collateral is of importance for banks to secure the debt. the growth coefficients for total debt, long-term debt and short-term debt are positive and significant which contradict the notion of negative association between growth and leverage. this result indicates that higher growth-firms tend to have more debt, as they expect to expand their business scale, and a debt financing is preferable as it carries lower cost. the result is contradictory to titman and wessels (1988), rajan and zingales (1995), harris and raviv (1992), ghosh and cai (2000) and booth et al (2001) with a negative relationship between growth and leverage. the signalling coefficient is positive and significant for total debt which confirms that larger firms paying higher dividends tend to have more debt, as they want to convey the information to investor about the future prospects of the firm. the managerial ownership coefficients are positive and significant for total debt and short-term debt, which confirms that leverage minimises the total agency costs resulting from the conflicts of interest between shareholders and managers; and conflicts between asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 13 shareholders and debt holders (jensen & meckling, 1976 & 1986). further, this result supports the finding of leland and pyle (1977) and berger et al (1997) studies which found that leverage is positively correlated with the extent of managerial shareholdings. the firm size coefficient for total debt is negative and significant, while positive and significant for short-term debt. for total debt, the result is in line with harris and raviv (1992) and rajan and zingales (1995). while, the positive coefficient for short-term debt suggests that larger firms with higher assets’ tangibility utilise more leverage (short-term debt) to gain the tax benefits of debt, as larger firms have less risk of bankruptcy. finally, only short-term debt yields negative and significant coefficient for profitability confirming the pecking-order theory. however, this study is unable to generate that the pecking-order theory fits to new zealand listed-firms, as the majority of the firms’ specific factors support the trade-off theory. in addition, the bank interest rate in new zealand is quite low compared with other financing choices and this may explain why short-term financing is preferred. hence, not only firms’ specific factors are of importance but also the business environment characteristic in new zealand are of substantialin explaining new zealand listed-firms’ capital structure. further research is necessary as the firms’ behaviour changes over time, using wider scope of sample and periods. the estimated coefficients for those four models (ols robust, 2sls, iv-gmm and dynamic-iv gmm) are considerably different. the different results are affected by the differencing used for iv, in which simple dynamic panel models suffer from a weak instrument problem when the dynamic panel autoregressive coefficient approaches unity, as the estimator depends on time span. if the time span is small; the estimators are asymptotically random, and if time span is large; the un-weighted gmm estimator may be inconsistent and the efficient two step estimator may be biased. because of the small time span for this study, the estimated coefficients for dynamic-iv gmm yielded higher estimated coefficients and higher standard errors compared to the rest of the model. the consistent estimators yielded by dynamic gmm were because the gmm procedure can use moment conditions based on the level equations together with the usual arellano and bond type orthogonality conditions (blundell & bond, 1998), and direct maximum likelihood estimation based on the differenced data under assumed normality for the idiosyncratic errors (hsiao et al., 2002). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 14 table 3. summary of four different estimators of total debt equation variables ols robust 2sls iv-gmm dynamic-iv gmm reg. 1 reg. 2 reg. 1 reg. 2 reg. 1 reg. 2 reg. 1 reg. 2 l1. 0.0912 0.1065 (0.1300) (0.1243) l2. -0.7153*** (0.2346) constant 0.07463*** 0.7398*** 0.6877*** 0.6450** 0.5684*** 0.4396*** 0.3762 1.4958*** (-0.1385) (0.2117) (0.1097) (0.2822) (0.1024) (0.1360) (0.4800) (0.3761) tangiblity -0.0764 -0.1000 -0.2108** -2740*** -0.1590 -0.2249* -0.6580*** 0.3989** (0.0699) (0.0750) (0.1001) (0.1149) (0.1018) (0.1183) (0.2580) (0.1910) ndts -0.0011 -0.0011 -0.0016 -0.0017 -0.0030 -0.0030 -0.0020 -0.0003 (0.0010) (0.0010) (0.0016) (0.0016) (0.0020) (0.0020) (0.0032) (0.0026) profitability -0.0001 -0.0002 -0.0001 -0.0001 0.0002 0.0003 -0.0001 0.0001 (0.0004) (0.0004) (0.0005) (0.0005) (0.0006) (0.0006) (0.0010) -0.0007 growth 0.0020 -0.0018 0.0379 0.0312 -0.2182 0.0215 -0.0837 -0.0386* (0.0200) (0.0205) (0.0245) (0.0265) (0.0269) (0.0284) (0.0344) (0.0416) signalling 0.0000 0.0001*** -0.0005 -0.0005 -0.0011* -0.0012** -0.0001 0.0057*** (0.000) (0.0000) (0.0012) (0.0012) (0.0006) (0.0006) (0.0003) (0.0019) iownp -0.0806 -0.0769 -0.0999 -0.0976 -0.0999 -0.1050 0.1382 -0.9356*** (0.0939) (0.0942) (0.1107) (0.1119) (0.0900) (0.0901) (0.1487) (0.3198) firm size -0.0442* -0.0463 -0.0207 -0.0175 -0.0019 0.0027 0.0636 -0.1543** (0.0264) (0.0297) (0.0215) (0.0232) (0.0203) (0.0222) (0.0950) (0.0685) industry_primary 0.0436 0.0620 0.1409 (0.1040) (0.2478) (0.0980) industry_energy 0.1265 0.1171 (0.1604)* (0.0835) (0.2547) (0.0891) industry_goods 0.0562 0.0826 0.1740** (0.0924) (0.2483) (0.0788) industry_property -0.0666 -0.0832 (omitted) (0.1009) (0.2616) industry_service 0.0324 0.0800 0.1577* (0.0842) (0.2418) (0.0926) industry_investment -0.0762 -0.0589 0.0328 (0.1426) (0.2587) (0.1256) groups 79 79 78 78 78 78 78 75 r-squared 0.0402 0.0662 0.0741 0.1069 0.0766 0.1096 wald-chi2 41.54 239.50 18.33 21.09 65.74 88.79 26.57 70.82 prob.chi2 0.0000 0.000 0.0000 0.0712 0.0000 0.0000 0.0008 0.0000 arellano bond test -1.5094 -1.5681 prob.chi2 0.1312 0.1169 sargan test 15.3490 13.9363 prob.chi2 0.2861 0.3048 standard errors in parentheses are for coefficients. *sig. at 10%level, **sig. at 5% level, and ***sig. at 1% level asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 15 table 4. summary of four different estimators of total long-term debt equation variables ols robust 2sls iv-gmm dynamic-iv gmm reg. 1 reg. 2 reg. 1 reg. 2 reg. 1 reg. 2 reg. 1 reg. 2 l1. 0.0316 -0.0292 (0.1048) (0.1051) l2. -0.9093*** (0.2082) constant 0.0767 -0.2233*** 0.0825 -0.2112 0.0425 (omitted) 0.1080 0.3829*** (0.0691) (0.0860) (0.0718) (0.1826) (0.0701) (0.4208) (0.1543) tangiblity 0.0479 0.0734* 0.0534 0.1034 0.0751 0.1225** -0.2113 0.1028 (0.0413) (0.0434) (0.0609) (0.0685) (0.0587) (0.0556) (0.2837) (0.1439) ndts -0.0026*** -0.0025*** -0.0031*** -0.0031*** -0.0042*** -0.0041** 0.0014 -0.0004 (0.0009) (0.0009) (0.0010) (0.0010) (0.0018) (0.0020) (0.0030) (0.0027) profitability 0.0008*** 0.0009*** 0.0009*** 0.0010*** 0.0010** 0.0011** 0.0002 0.0002 (0.0002) (0.0002) (0.0003) (0.0003) (0.0005) (0.0006) (0.0009) (0.0007) growth 0.0001 0.0039 -0.0081 -0.0020 -0.0151 -0.0067 -0.0309*** -0.0571*** (0.0132) (0.0136) (0.0165) (0.0178) (0.0172) (0.0185) (0.0345) (0.0290) signalling 0.0005*** 0.0005*** -0.0007 -0.0007 -0.0010*** -0.0010*** -0.0001 0.0017 (0.0000) (0.0005) (0.0010) (0.0009) (0.0001) (0.0001) (0.0002) (0.0018) iownp -0.0806 -0.0822 -0.0790 -0.0746 -0.0658 -0.0646 0.5537*** 0.0300 (0.0504) (0.0516) (0.0673) (0.0670) (0.0569) (0.0536) (0.1530) (0.2949) firm size 0.0228* 0.0223* 0.0224 0.0185 0.0249** 0.01417 0.0189) -0.0122 (0.0138) (0.0135) (0.0138) (0.0147) (0.01480) (0.0127) (0.0893) (0.0370) industry_primary 0.2981*** 0.2822* 0.0874 (0.0397) (0.1591) (0.0707) industry_energy 0.2672*** 0.2958* 0.1039 (0.0547) (0.1628) (0.0733) industry_goods 0.2854*** 0.2913* 0.0963 (0.0444) (0.1595) (0.07156) industry_property 0.4038*** 0.4255*** 0.2432*** (0.0685) (0.1675) (0.0981) industry_service 0.2820*** 0.2746* 0.0802 (0.0358) (0.1555) (0.0681) industry_investment 0.3051*** 0.3137** 0.1022 (0.0830) (0.1660) (0.0781) groups 79 79 78 78 78 78 78 75 r-squared 0.1432 0.1893 0.14130 0.19480 0.14590 0.18410 wald-chi2 1945.93 38565.11 17.58 25.76 172 466.44 121.99 488.71 prob.chi2 0.0000 0.0000 0.0140 0.0183 0.000 0.0000 0.0000 0.0000 arellano bond test -0.4263 -0.0208 prob.chi2 0.6699 0.9835 sargan test 12.5497 22.5939** prob.chi2 0.4832 0.0319 standard errors in parentheses are for coefficients. *sig. at 10%level, **sig. at 5% level, and ***sig. at 1% level asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 16 table 5. summary of four different estimators of total short-term debt equation variables ols robust 2sls iv-gmm dynamic-iv gmm reg. 1 reg. 2 reg. 1 reg. 2 reg. 1 reg. 2 reg. 1 reg. 2 l1. -0.1800 0.2450* (0.1173) (0.1418) l2. 0.0574 (0.1287) constant 0.9234*** 1.2233*** 0.9175*** 1.2112*** 0.9575*** (omitted) 0.7309*** 0.3280 (-0.0691) (0.0860) (0.0718) (0.1826) (0.0701) (0.2390) (0.3045) tangiblity -0.0479 -0.0734* -0.0534 -0.1034 -0.0751 -0.0933 -0.4393*** -0.2917** (0.0413) (0.0434) (0.0608) (0.0685) (0.0587) (0.0628) (0.1852) (0.1435) ndts 0.0026*** 0.0025*** 0.0031*** 0.0031*** 0.0042*** 0.0041* 0.0060 0.0055** (0.0009) (0.0009) (0.0010) (0.0010) (0.0018) (0.0022) (0.0038) (0.0026) profitability -0.0008*** -0.0009*** -0.0009*** -0.0010*** -0.0010** -0.0003 -0.0020** -0.0018*** (0.0002) (0.0002) (0.0003) (0.0003) (0.0005) (0.0007) (0.0010) (0.0007) growth -0.0066 -0.0039 0.0081 0.0020 0.0151 0.0067 -0.0134 0.0033 (0.0185) (0.0135) (0.0165) (0.0178) (0.0172) (0.0185) (0.0211) (0.0246) signalling -0.0005*** -0.0005*** 0.0007 0.0007 0.0010*** 0.0009*** 0.0001 -0.0010 (0.0000) (0.0000) (0.0010) (0.0010) (0.0001) (0.0001) (0.0001) (0.0014) iownp 0.0806 0.0822 0.0790 0.0746 0.0658 0.0847 -0.5138*** 0.0028 (0.0504) (0.0516) (0.0673) (0.0670) (0.0569) (0.0604) (0.1452) (0.2358) firm size -0.0228* -0.0223* -0.0224 -0.0185 -0.0284** 0.0170 0.0891** 0.0663 (0.0138) (0.0135) (0.0138) (0.0147) (0.0148) (0.0325) (0.0423) (0.0442) industry_primary -0.2981*** -0.2822* 0.7320*** (0.0396) (0.1591) (0.1871) industry_energy -0.2672*** -0.2958* 0.6567*** (0.0546) (0.1628) (0.2196) industry_goods -0.2854*** -0.2913* 0.7317*** (0.0444) (0.1595) (0.1775) industry_property -0.4037*** -0.4255*** 0.5630*** (0.0685) (0.1675) (0.2197) industry_service -0.2820*** -0.2746* 0.7330*** (0.0358) (0.1555) (0.1884) industry_investment -0.3051*** -0.3137** 0.7555*** (0.0830) (0.1660) (0.1598) groups 79 79 78 78 78 78 78 75 r-squared 0.1432 0.1893 0.1413 0.1948 0.14590 0.18410 wald-chi2 1945.93 38565.11 17.58 25.76 172 3392.35 208.14 1223.57 prob.chi2 0.0000 0.000 0.0140 0.0183 0.0000 0.000 0.0000 0.0000 arellano bond test 0.8324 -0.8725 prob.chi2 0.4052 0.3829 sargan test 13.6350 13.2600 prob.chi2 0.4000 0.3504 standard errors in parentheses are for coefficients. *sig. at 10%level, **sig. at 5% level, and ***sig. at 1% level asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 17 5. conclusions in the last five decades, there has been considerable theoretical emphasis on the capital structure determinants as they apply to corporate finance. this paper is an attempt to empirically test for the capital structure determinants in the new zealand context in which this study examines a recent dataset of new zealand listed-firms. using dynamic-panel iv gmm, this study demonstrates that controlling for endogeneity and dynamic nature in the capital structure equation slightly increases the estimated coefficients (table 4.1, table 4.2 and table 4.3). therefore, ols estimates are upward-biased, but the bias is not so large as to be concern. additionally, this study demonstrates that using valid or non-weak instruments (firms’ history in lagged-value), leads to precise estimates of the capital structure determinants. further, the dynamic analysis of this study shows that capital structure is persistent over time. the dynamic-iv gmm regression reveals that tangibility, growth, signalling, managerial ownership and firm size exhibit a significant impact on total debt. those variables confirm the trade-off theory but firm size supports the pecking-order theory. in addition, non-debt tax shield and profitability have no significant impact on total debt; though the coefficient for non-debt tax shield confirms the pecking-order theory and the coefficient for profitability confirms the trade-off theory. this evidence is less conclusive than studies in other countries, particularly australia which confirm the pecking-order theory in their capital structure. overall, the trade-off theory is more appropriate in explaining new zealand listed firms’ capital structure. in addition, though the result is in line with boyle and eckhold and wellalage and locke which finds that those firms’ specific characteristics play a significant role in determining a firm’s debt level; but the capital structure theory applied is contradictory, in which the pecking-order style is adopted by new zealand-listed firms. however, the contradictory results are restricted to different methods, time frame and scope of the sample used. references agrawal, a., & knoeber, c. r. 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(1999). an empirical study on the determinants of the capital structure of thai firms. pacific-basin finance journal, 7(3-4), 371-403. http://dx.doi.org/10.1016/s0927-538x(99)00007-4 microsoft word 5246-18989-2-rv-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 103 intellectual capital performance of indonesian banking sector: a modified vaic (m-vaic) perspective ihyaul ulum (corresponding author) university of muhammadiyah malang, indonesia e-mail: mas_ulum@yahoo.com imam ghozali professor in accounting, diponegoro university, indonesia agus purwanto accounting department, diponegoro university, indonesia received: april 20, 2014 accepted: sep. 21, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5246 url: http://dx.doi.org/10.5296/ajfa.v6i2.5246 abstract the paper seeks to estimate and analize the modified vaic (m-vaic) for measuring the value-based performance of the indonesian banking sector for year of 2009-2012. m-vaic is a comprehensive model to measure intellectual capital performance (icp) based on value added intellectual coefficient (vaic™). the findings of this study indicate that the value of m–vaic of indonesian banking sector has a rather long range, which is between -21.41 until 5.20. based on m-vaic scores, performance of ic is classified into four, namely top performers, good performers, performers common, and bad performers. the results show that the ranking of three of the four state banks are on the top performers category. m-vaic can be used to measure the icp all of industries, not only banks. this is also reinforced by the results of the regression that indicate that the value added (va) is a function of capital employed and the ic. keywords: intellectual capital performance (icp), m-vaic, vaic, indonesian banking sector asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 104 introduction despite of the increasing recognition of the importance of intellectual capital (ic) in driving firm values and competitive advantages, accounting standards which regulate about ic is still limited. in indonesia, implicitly ic has been recognized and discussed in the statement of financial accounting standards (psak) 19 (ikatan akuntan indonesia, 2012) on intangible assets which is the adoption of international accounting standard (ias) 38. in the standard, ic is not stated explicitly, but the components of ic (eg. goodwill) described how the accounting treatment. however, psak 19 does not regulate all of ic's components. even, according to this standard, goodwill that generated internally should not be recognized as goodwill. in this regard, psak 22 on business combination which is the adoption of ifrs 3 states that goodwill arising from the acquisition is no longer be amortized but should be subject to an impairment test each year by way of testing which described in psak 48 on impairment of assets. psak 19 states that an intangible asset is recognized if, and only if: 1) most likely the company will obtain future economic benefits from these assets, and 2) the cost of the asset can be measured reliably. this requirement is difficult to meet, so the intellectual capital to date can not be reported in the financial statements. this condition makes it difficult for the (potential) investors to be able to perform the analysis and assessment of the prospects of the company in the future based on the potential intellectual capital owned. the limited provisions of ic accounting standards encourage the experts to make a measurement and reporting of ic models. the model which is very popular in many countries is value added intellectual coefficient (vaic™) developed by pulic (1998). vaic™ does not measure ic it self, but it measures the impact of ic management (ulum, 2009b; ulum, ghozali, & chariri, 2008). the assumption is, if a company has a good ic, and also managed well, there will be a good impact for the company. the impact was then measured by pulic with vaic™, thus vaic™ is more properly called as intellectual capital performance (icp) measurement which is by mavridis (2004), kamath (2007) and ulum (2009a) called as busssines performance indicator (bpi). pulic (ibec, 2003) state that two key resources in creating company’s value added are capital employed and ic. ic consists of human capital and structual capital. therefore pulic then build his vaic model consisting of three components, i.e. hce (human capital efficiency), sce (structural capital efficiency), and cee (capital empoyed efficiency). this paper offers additional component in calculating vaic, namely rce (relational capital efficiency). according to brinker (1998), stewart (1997), and draper (1998), ic consist of three component, i.e. human capital, structural capital, customer/relational capital. on the other hand, sveiby (1998) used the term of external structure, internal structure, and individual competence for all three components of ic. thereby, the vaic formulation added into four dimensions, hce, sce, rce, and cee are then called as m-vaic model. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 105 firer and williams (2003) classify bank sector as one of highly incentive ic sectors. hence, this paper evaluates the business performance of the indonesian banking sector for year of 2009-2012. financial reports of the banks for the relevant years, were used to obtain the data. literature review in indonesia, research on ic in banking sector for example has been done by ulum (2009a), widarjo (2011), and santoso (2011). two last reviewed studies examined the effect of ic to company performance, while the first only measures the performance of ic based on the original formula of vaic™. relatively, it is also done by basuki and kusumawardhani (2012) and sugiarti (2012). in a somewhat different perspective, razafindrambinina and kariodimedjo (2011) analyzed the relationship of ic and corporate social responsibility disclosure. later, ulum (2013) proposed the performance measurement model for islamic banking in indonesia, which is constructed based on the vaic™ model and labeled as ib-vaic. brooking (1996) stated that the ic is the term given to a combination of intangible assets of markets, intellectual property, employees, and infrastructure that enables enterprises to be able to function. this definition clearly implied that ic is not just about human resources/human capital. human capital is only one component of ic. table 1 summarizes some of the constructs and definitions of ic offered by scholars: table 1. constructs and definitions of ic scholars constructs definition of ic bontis (1996) human capital structural capital relational capital ic may provide a new resource-base for an organization to compete and win roos and roos (1997) human capital structural capital ic is the sum of the “hidden” assets of the company, such as brands, trademarks and patents and also includes all assets that are not shown in the financial statements. ic is a company’s the most important source of sustainable competitive advantages stewart (1997) human capital structural capital customer capital ic is knowledge, information, intellectual property and experience; it is a collective brainpower or useful knowledge edvinsson and malone (1997) human capital structural capital customer capital ic refers to the difference between a company’s market value and book value sveiby (1998) personnel competence internal structure external ic is knowledge that can be converted into asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 106 structure value bontis (1999) human capital structural capital relational capital ic is the effective use of knowledge as opposed to information andriessen and stem (2004) human resources organizational resources relational resources ic is all intangible resources that are available to an organization, that give a relative advantage, and which in combination are able to produce future benefits youndt et al. (2004) human capital organizational capital social capital ic is the sum of all knowledge that an organization is able to leverage in the process of conducting business to gain competitive advantage source: wang (2008) ic valuation and measurement method there were several studies to investigate the valuation and measurement method of ic. andriessen (2004) reviewed 25 methods for the valuation and measurement of intangibles. table 2 summarizes the name of ic valuation and measurement method based on andriessen’s study and additional research. table 2. ic valuation and measurement method no. name of method inventor/pioneer year 1. balanced scorecard robert s. kaplan and david p. norton 1992 2. calculated intangible value thomas a. stewart david h. luthy 1997 1998 3. citation-weighted patent bronwyn h. hall, adam b. jaffe, and manuel trajtenberg 2001 4. holistic value approach göran roos, j. roos, nicola c. dragonetti, and leif edvinsson 1997 5. intellectual capital audit annie brooking 1996 6. intellectual capital–index göran roos 1997 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 107 7. inclusive value methodology philip k. m'pherson and stephan pike 2001 8. intangible asset monitor karl erick sveiby 1997 9. intangibles scoreboard baruch lev 1999 10. intellectual capital benchmarking system josé maria viedma 1999, 2001 11. intellectual capital dynamic value ahmed bounfour 2002 12. intellectual capital statements jan mouritsen 2001 13. ivaluing factor ken standfield 2001 14. market-to-book ratio thomas a. stewart 1997 15. skandia navigator leif edvinsson and michael s. malone 1997 16. sullivan’s work patrick h. sullivan 1998, 2000 17. value-added intellectual coefficient (vaic) ante pulic 1997 18. value chain scoreboard/ value chain blueprint baruch lev 2001, 2003 19. extended vaic jamal a. nazari and irene m. herremans 2007 20. ib-vaic ihyaul ulum 2013 source: this study value added intellectual coefficient (vaic™) vaic™ model was developed by pulic in 1997 that is designed to provide information about the value creation efficiency of tangible and intangible assets of the company. vaic™ is an instrument for measuring the performance of the company's intellectual capital. this approach is relatively easy and very possible to do, because it is constructed from the accounts in the financial statements (balance sheet, profit and loss). pulic (ibec, 2003) states that there are two key resources to create added value in the enterprise: capital employed and ic. ic consists of human capital and structual capital. value added is the output minus the input of a firm. output is sales revenue; input is everything that comes from outside the company. figure 1 illustrates the distribution of two key resources in question by pulic (andriessen, 2004). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 108 figure 1. two key resources to create added value in the enterprise this model begins with the company's ability to create value added (va). value added is the most objective indicator to assess the success of the business and demonstrate the ability of the company in the creation of value (value creation). va is calculated as the difference between output and input. output (out) represents the revenue and includes all products and services sold in the market, while the input (in) covers the entire load used in obtaining revenue. it is important in this model is that the burden of employees (labor expenses) are not included in in. because of its active role in the process of value creation, intellectual potential (which is represented by labor expenses) is not counted as an expense (cost) and are not included in the in component. therefore, a key aspect of the model is to treat labor pulic as entity creation of value (value creating entity). va is influenced by the efficiency of the human capital (hc) and structural capital (sc). other relationships of va is capital employed (ce), which in this case is labeled with cee. cee is an indicator for the va created by one unit of physical capital. pulic (1998) assumed that if 1 unit of ce produced greater returns than any other company, it means the company better utilize its ce. thus, a better utilization of ce is part of the company’s ic. the next relationship is va and hc. 'human capital efficiency' (hce) shows how much the va can be produced with funds expended for labor. relationship between va and hc indicate the ability of hc to create value in the company. consistent with the views of other writers ic, pulic argued that the total salary and wage costs are an indicator of the company hc. the third relationship is ‘structural capital efficiency’ (sce), which shows the contribution of structural capital (sc) in value creation. sce measured the amount of sc required to produce 1 rupiah from va and is an indication of how successful the sc in value creation (tan, plowman, & hancock, 2007). sc is not an independent measure as hc, it is dependent on value creation (pulic, 2000c). that is, the greater the contribution of hc in value creation, the smaller the contribution of the sc in the case. pulic further stated that sc is va minus hc, this model has been verified through empirical research on traditional industrial sectors (pulic, 2000b). source: andriessen (2004) capital employed intellectual capital physical capital financial capital human capital structural capital asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 109 the advantage of vaic™ method is because the required data is relatively easily obtained from various sources and types of companies. the data required to calculate the various ratios are financial figures that are generally available standard of corporate financial statements (tan et al., 2007). the other alternative of ic measurements only limited on financial indicators and unique non-financial perspective that only to supplement a company's individual profile. these indicators, especially indicators of non-financial, are not available or not recorded by other companies. consequently, the ability to implement the measurements consistently with a large and diversified sample is limited (firer & williams, 2003). vaic has been used in studies in several countries in a variety of research designs. for example, vaic used to measure the ic performance of a company (kamath, 2007; mavridis, 2004; ulum, 2009a); the influence of vaic on firm’s performance is also widely studied (kamal, mat, rahim, husin, & ismail, 2011; khanqah, khosroshahi, & ghanavati, 2012; shiri, mousavi, pourreza, & ahmadi, 2012; sydler, haefliger, & pruksa, 2013); antecedent factors of vaic also been widely studied (al-musalli & ismail, 2012; el-bannany, 2008; saleh, rahman, & hassan, 2009). modified vaic (m-vaic) m-vaic is a comprehensive measure of ic based on vaic™ model. it is started with calculating va by using the formula proposed by pulic (2000a): va = op + ec + d + a where op is operating profit, ec is employee costs, d is depreciation, and a is amortisation. according to pulic (2004), vaic™ is the sum of intellectual capital efficiency (ice) and capital employed efficiency (cee), while ice is hce (human capital efficiency) plus sce (structural capital efficiency). the formula to calculate hce is as follows: hce = va/hc(pulic, 2000a) • hce = human capital efficiency: ratio of va to hc. • va = value added • hc = human capital: total salaries and wages. sce = sc/va(pulic, 2000a) • sce = structural capital efficiency: ratio of sc to va • sc = structural capital : va-hc while in this m-vaic, i add the third component of ic, i.e. rce (relational capital efficiency). rce illustrate the efficiency of investment in relational aspect. in this context, relational capital is proxied by marketing costs. rce = rc/va(this study) • rce = relational capital efficiency: ratio of rc to va asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 110 • rc = relational capital: marketing costs (nazari & herremans, 2007) pulic (2004) argued that to have a broad overview of the efficiency of all resources, it is important to take the financial capital and physical capital (capital employed) as one of the considerations. the efficiency of capital employed calculated by: cee = va/ce(pulic, 2000a) • cee = capital employed efficiency: ratio of va to ce • ce = capital employed: book value of total assets. thus, the complete formula of m-vaic is: m-vaic = ice + cee ice = hce + sce + rce m-vaic = hce + sce + rce + cee figure 2. the formulation of m-vaic indonesian bank banks are special and therefore must run business based on prudential principles. the functions of banks in indonesia are basically as financial intermediary that take deposits from surplus units and channel financing to deficit units. according to indonesian banking law, indonesian banking institutions are typically classified into commercial and rural banks. commercial banks differ with rural banks in the sense that the latter do not involve directly in source: modified from laing, dunn, and hughes-lucas (2010) value added overall i di efficiency indicators capital employed (ce) hce sce m-vaic rce intellectual capital ice cee structural capital (sc) relational capital (rc) human capital (hc) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 111 payment system and have restricted operational area. in term of operational definition, bank in indonesia are classified into non-syariah and syariah-based principles commercial banks. source: www.bi.go.id figure 3. recapitulation of banking institutions in indonesia in view of providing a wider banking services alternative to indonesian economy, the development of islamic banking in indonesia is implemented under dual banking system in compliance with the indonesian banking architecture (api). islamic banking and conventional banking systems jointly and synergically support a wider public fund mobilization in the framework of fostering financing capability of national economic sectors. the characteristic of islamic banking operation is based on partnership and mutual benefits principle provides an alternative banking system with mutual benefits both for the public and the bank. this system will give priorities to aspects related to fairness in transaction and ethical investment by underlining the values of togetherness and partnership in production, and by avoiding any speculative activity in financial transaction. by providing various products and banking services supported by variative financial scheme,.islamic banking will be a credible alternative that can be benefited by all of indonesian people without exception. commercial banks (120) state banks (4) private nation banks (116) state islamic banking unit (1) rural cedit banks (1837) rural credit banks (1683) islamic rural credit banks (154) gov. regional banks (26) private nation banks (79) islamic commercial banks (11) grb. islamic banking unit (14) islamic banking unit (8) composition of indonesian banking system asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 112 method data were drawn from financial reports of indonesian banks for the year of 2012. a review was conducted of the international literature on intellectual capital with specific reference to literature that reviews measurement techniques and tools, and the m-vaic method is applied in order to analyze the data. the result of calculating m-vaic then used to make a rank of bussiness performance indicator (bpi) of indonesian banking sector. the phases in calculating bpi using m-vaic method: phase i: calculating value added (va) va = op + ec +d + a (pulic, 2000a) phase ii: calculating the efficiency of ic (ice) • ice = hce + sce + rce(this study) • hce = va/hc(pulic, 2000a) • sce = sc/va(pulic, 2000a) • rce = rc/va(this study) phase iii: calculating the efficiency of capital employed (cee) cee = va/ce(pulic, 2000a) phase iv: deriving of m-vaic • m-vaic = ice + cee (this study) • m-vaic = hce + sce + rce + cee(this study) note about abbreviation: m-vaic : modified vaic ice: intellectual capital efficiency hce : human capital efficiency sce: structural capital efficiency rce: relational capital efficiency cee: capital employed efficiency va: value added hc: human capital; all the expenses on compensation and development of employees sc: structural capital; va hc rc: relational capital; marketing cost asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 113 ce: capital employed; book value of total assets. op: operating profit ec: employee costs d: depreciation a: amortisation phase v: since the value added (va) in any organization is a function of capital employed and the ic, the four regression are run using va as the dependent variable and hc, sc, rc, and ce as an independent variables. phase vi: make a ranking for indonesian bank based on intellectual capital performace measured with m-vaic. findings and discussion table 3 presents the mean values of each of the components forming the m-vaic, namely hc, sc, rc, ce, and va. during the four years observation, the data in table 3 show a consistent increase each year. total assets of the company (ce) have the most significant improvement compared with the other four components. table 3. mean of hc, sc, rc, ce, and va (in million rupiah) 2009 2010 2011 2012 hc 1,109,297.10 1,277,234.00 1,391,169.61 1,678,457.31 sc 1,421,147.10 2,054,545.61 2,535,499.39 2,935,841.19 rc 108,830.00 139,112.45 139,545.13 150,988.00 ce 6,537,039.31 7,989,524.81 11,549,977.53 13,729,594.02 va 2,530,444.21 3,331,779.61 3,926,669.00 4,614,298.51 note: hc: human capital; sc: structural capital ; rc: relational capital ; ce: capital employed; va: value added table 4 presents the mean value of the information hce, sce, rce, cee, and m-vaic. during the study period, the efficiency of each m-vaic components is fluctuated. consequently, scores of m-vaic also looked up and down from year to year. in 2010 and 2012, m-vaic scores are on 2.7 points, while in 2009 and 2010 only in the range of 2.2 2.3. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 114 table 4. mean of hce, sce, rce, cee, and m-vaiv category 2009 2010 2011 2012 hce 1.50 1.92 2.14 2.03 sce 0.38 0.48 -0.41 0.37 rce 0.06 0.05 0.16 0.07 cee 0.39 0.29 0.32 0.30 m-vaic 2.33 2.74 2.21 2.78 note: hce: human capital efficiency; sce: structural capital efficiency; rce: relational capital efficiency; cee: capital employed efficiency; m-vaic: modified value added intellectual coefficient. to prove that the va is a function of each of the components forming the performance of ics in the formula m-vaic, four regressions is done by placing the va as the dependent variable and each of the components (hc, sc, rc, ce) as the independent variable. this test refers to kamath (2007) who did the same way when measured the performance of ic banking in india using the vaictm model. table 5 shows that the value of r2 of the entire test is at a high enough rate (0.836-0.994) except for testing the rc and va. this means the contribution of these components is more than 80%. special to the rc, the value of r2 is in the range between 0.461-0.665. this figure is relatively smaller than other components because the number of investment in the relational capital aspects which is proxied by the marketing costs are not too large (on average between 108.830 to 150.988 million rupiah). the regression results which shown in table 5 confirms that the variables used in this study can be relied upon to draw conclusions. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 115 table 5. regression results 2009 2010 2011 2012 hc and va slope 2.562 2.907 2.114 3.261 intercept -311551.387 -380829.883 -329355.552 -859565.637 t 23.999 27.288 19.431 29.178 r2 0.955 0.963 0.929 0.966 sc and va slope 1.569 1.481 0.935 1.412 intercept 301354.319 289155.236 240661.261 468795.379 t 40.369 55.120 31.477 69.331 r2 0.984 0.991 0.972 0.994 rc and va slope 16553.859 22.371 16.996 27.402 intercept 231170.231 219756.018 239350.650 476871.412 t 4.809 7.593 6.545 6.843 r2 0.461 0.665 0.596 0.610 ce and va slope 0.421 0.477 0.202 0.314 intercept -219627.668 -482427.308 275045.377 304271.679 t 18.364 18.273 12.175 14.944 r2 0.926 0.920 0.836 0.882 note: regressions was carried out to prove that the value added (va) is a function of capital employed and ic. regressions are run using the va as the dependent variable, while hc, sc, rc, and ce as the independent variables. based on m-vaic scores, the performance of ic state banks in indonesia looked better than the private national banks. during the four years of observation, the banks owned by asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 116 government are always in the top ten best performance of ic based on m-vaic. in the category of private national banks, there are two banks that having excellent performance, namely bank pan indonesia (pnbn) and bank central asia (bbca). table 6 show top ten of icp based on m-vaic. table 6. the top ten of m-vaic score no. 2009 2010 2011 2012 1. pnbn pnbn pnbn pnbn 2. bbca bmri bbca bbca 3. bmri bbca bmri bbri 4. bbri bbri bvic bmri 5. bbni bvic bswd bswd 6. bdmn mega bbri bbni 7. btpn bswd bbkp btpn 8. baek bbni bnga mega 9. nisp bdmn btpn bdmn 10. bbtn bnga bbni bjtm note: bank codes based on the code that formally used in the indonesia stock exchange. the list of abbreviations code of banks is presented in the appendix at the end of the paper. each bank’s result are sorted on the basis of m-vaic performance and classified to four category as follows: 1) top performers –m-vaic score of above 3.50 2) good performers –m-vaic score of between 2.5 and 3.49 3) common performers –m-vaic score of between 1.5 and 2.49 4) bad performers –m-vaic score of below 1.5. table 7 and 8 present list of banks included in the the category of top performers and bad performers. in the group of banks with the best performance of ic, banks that are very asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 117 popular in indonesia seemed quite dominate in the top rankings, e.g. bank central asia (bbca), bank mandiri (bmri), and bank rakyat indonesia (bbri). on the other hand, in the group of banks with bad performers category is dominated by private national banks. three of the four state banks in indonesia can enter the top performers in the group, namely bmri, bbri, and bbni. three of the four state banks in indonesia, including the top performers in the group, namely bmri, bbri, and bbni. this finding is interesting because there has been an assumption that the state-owned banks have difficulties to compete with other companies because of the high bureaucracy, political pressure from many parties, high social obligations, a huge work force, poor image, and low efficiency (kamath, 2007). this research proves that the state banks can compete and even has a very good performance of ic. table 7. banks with ‘top performers’ in the survey no. 2009 2010 2011 2012 1. pnbn pnbn pnbn pnbn 2. bbca bmri bbca bbca 3. bmri bbca bmri bbri 4. bbri bbri bvic bmri 5. bvic bswd bswd 6. mega bbri bbni 7. bswd bbkp btpn 8. bnga mega 9. btpn 10. bbni note: bank codes based on the code that formally used in the indonesia stock exchange. the list of abbreviations code of banks is presented in the appendix at the end of the paper. the prominent bank during the observation is bank pan indonesia (pnbn), or known as panin bank. for four years in a row, the icp of panin bank is at the top beating other banks. pnbn was founded in 1971 and has had 496 branches in 2012. their advantage is the ability asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 118 to manage their employees very well. high scor of m-vaic largely contributed from hce scores that is an efficiency of human capital. panin bank managed to exploit the employees’s capabilities in a medium investment. this appears to be linear with the development strategy of employees (human capital) which states: “embrace and enhance corporate culture to fully recognize individual achievements and continue motivating our staff towards better customer service and higher productivity” (bank panin, 2012, p. 3). table 8. banks with ‘bad performers’ in the survey no. 2009 2010 2011 2012 1. inpc babp bksw beks 2. bksw bksw beks inpc 3. babp agro babp babp 4. agro beks bksw 5. bnii 6. beks note: bank codes based on the code that formally used in the indonesia stock exchange. the list of abbreviations code of banks is presented in the appendix at the end of the paper. in the list of banks in the group bad performers, there are three private banks that consistently came in last, the bank's indonesia (beks), bank kesawan (bksw), and bank icb bumiputera (babp). the three banks for four years of observation have a score of m-vaic under 1.50, even minus (-). in 2012, the total amount of capital employed (ce) three banks only 1.9% of bank mandiri (bmri). similarly, the total score of value added (va) three banks is only 2.16% of bank rakyat indonesia (bbri). with relatively limited capital, these banks are quite difficult to develop a network. this can be seen from the number of beks branch offices in 2012 that only 48, babp 16, and bksw only 14 branch offices. in fact, beks for three consecutive years (2009-2011) suffered the loss, while bksw also suffered losses in 2012. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 119 concluding remarks the term ic emphasizes a combination of intellect and capital to show the importance of knowledge (serenko & bontis, 2013). over the past few years, the company concentrate its management activities on tangible and financial assets (bellora & guenther, 2013), but recently they began to spread attention to the issue of intangible assets such as human capital and innovation capital (lev, 2001; oecd, 2010). in this context, the use of m-vaic becomes quite relevant to measure the performance of ic. the use of m-vaic to measure the icp of indonesia banking is the first study that has been done. the addition of rce as a third components in the vaic method is believed to further increase the power of this method in measuring and predicting the icp. this is proven by regression results showing that va is a function of the hc, sc, rc, and ce with r2 values that are highly significant (0.836-0.994) except for testing the rc and va. this means that these components contribute more than 80%. based on the score of m-vaic known that three of the four state banks are on the top performers category, namely bmri, bbri, and bbni. this finding is interesting because there has been an assumption that the state-owned banks have difficulties to compete with other companies because of the high bureaucracy, political pressure from many parties, high social obligations, a huge work force, poor image, and low efficiency (kamath, 2007). this research proves that the state banks can compete and even has a very good performance of ic thus, it can be concluded that the m-vaic can be used to measure the performance of ic companies, not only banks. this paper can be used as a benchmark to measure the performance of the company from the aspect of innovation, their ability to manage the ce and ic that they have to win the competition. future studies could develop study based on this paper not just on the banking sector, because the m-vaic can be implemented across all industry sectors. references al-musalli, m. a. k., & ismail, k. n. i. k. 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(2011). pengaruh modal intelektual dan pengungkapan modal intelektual pada nilai perusahaan. jurnal akuntansi dan keuangan indonesia. apendix: the list of abbreviations code of banks no code nama of bank 1 agro bank rakyat indonesia agro niaga tbk 2 babp bank icb bumi putra tbk 3 baca bank capital indonesia tbk 4 baek bank ekonomi raharja tbk 5 bbca bank central asia tbk 6 bbkp bank bukopin tbk 7 bbni bank negara indonesia (persero)tbk 8 bbnp bank nusantara parahyangan tbk 9 bbri bank rakyat indonesia (persero)tbk 10 bbtn bank tabungan negara (persero) tbk 11 bcic bank mutiara tbk 12 bdmn bank danamon indonesia tbk 13 beks bank pundi indonesia tbk 14 bjbr bank jabar banten tbk 15 bjtm bank pembangunan daerah jawa timur (tbk) 16 bksw bank kesawan tbk asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 123 17 bmri bank mandiri (persero) tbk 18 bnba bank bumi arta tbk 19 bnga bank cimb niaga tbk 20 bnii bank internasional indonesia tbk 21 bnli bank permata tbk 22 bsim bank sinar mas tbk 23 bswd bank swadesi tbk 24 btpn bank tabungan pensiunan nasional tbk 25 bvic bank victoria international tbk 26 inpc bank artha graha international tbk 27 maya bank mayapada international tbk 28 mcor bank windu kentjana international tbk 29 mega bank mega tbk 30 nisp bank nisp ocbc tbk 31 pnbn bank pan indonesia tbk 32 sdra bank himpunan saudara 1906 tbk microsoft word 6489-23194-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 13 does ownership identity of blockholders matter: an empirical analysis of publicly listed companies in new zealand krishna reddy, sazali abidin, wei he & paresha sinha department of finance waikato management school, university of waikato received: july23, 2014 accepted: nov.11, 2014 published: june 1, 2015 doi:10.5296/ajfa.v7i1.6489 url: http://dx.doi.org/10.5296/ajfa.v7i1.6489 abstract purpose – this study explores the nature of the relationships between ownership concentration, ownership identity, and financial performance in publicly listed companies in new zealand. this study also investigates whether the ownership-performance nexus changes during the financial crisis period. design/method/approach –panel data for the publicly listed companies for the period 2003 to 2009 obtained from nzx deep archive and the dynamic panel generalized method of moments (gmm) regression analysis was used to test the influence of ownership concentration, ownership identity on financial performance measured by tobin’s qandreturn on assets (roa). findings –our findings support the view that ownership concentration affects financial performance. results show that a higher ownership concentration leads to a lower market-based performance (measured by tobin’s q) and higher accounting-based performance (measured by roa). we also found evidence of owner identity having an impact on financial performance of the publicly listed companies in new zealand. more “detached” level owners (institutional investors) have positive effect on market-based performance but negative effect on accounting-based performance. whereas, more “involved” level owners (corporate investors) have negative effect on market-based performance. our evidence shows that the effect ownership identity have had on the financial performance declined during the financial crisis period due to the fact that different types of owners reduced their ownership concentration levels, thus resulting in a reduction in their social influence and expertise powers. originality/value –our findings contribute to our understanding regarding the nature of the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 14 relationships between ownership concentration, ownership identity, and financial performance. our findings support the view that the identity of the shareholder(s) do matter in terms of company financial performance. we also report that corporate holdings are the most common type of investor holding in the new zealand context. keywords: ownership concentration, ownership identity, financial performance, herfindahl index, involvement, detached gel classification: g01, g32 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 15 introduction the relationships between ownership concentration, ownership identity, and financial performance in publicly listed companies are important concerns for decision makers who are aiming to maximize firm performance. in particular as argued by jensen and meckling (1976), ross (1973) and eisenhardt (1989) the existence of information asymmetry and the divergence of interest between owners (principals) and managers (agents) is known to result in problems that adversely impacts performance and it has been suggested that the main reasons for agency problems are the different ownership structure and different roles people have in organisations. in this regard, prior researchers have investigated: (i) the nature of agency problem existing between the principal and the agent; and (ii) whether such problems can be mitigated by giving agents some proportion of ownership in the organisation they manage. two different theoretical positions have been proposed namely the convergence-of-interest hypothesis and the entrenchment hypothesis. arguably, the research findings remain inconclusive regarding the level of ownership that principals should relinquish to the agents in order to motivate them to act on their behalf. . one group of researchers reported a positive linear relationship between some low levels of insider ownership and financial performance (elayan et al., 2003; mehran, 1995; welch, 2003; kim et al., 1988; oswald and jahera jr., 1991; hossain et al., 2001), thus providing support to the convergence-of-interest hypothesis. another group of researchers have reported the relationship between insider ownership and company financial performance is non-monotonic (chen et al., , 1993; griffith, 1999; mcconnell and servaes, 1990; morck et al., 1988; short and keasey, 1999), thus, supporting convergence-of-interest hypothesis at some low levels of insider ownership and an entrenchment hypothesis at higher levels. these findings provide support to the view that the relationship between insider ownership and financial performance is non-linear. however, a third group of researchers (demsetz, 1983; demsetz and lehn, 1985; demsetz and villalonga, 2001)claim that insider ownership is endogenously determined and therefore, cannot be a determinant of company financial performance. for this reason, any observed correlation of ownership and financial performance is likely to be spurious. in fact, the relationship between insider ownership and financial performance might arise due to some company characteristics that are unobservable to the econometrician. the conflicting findings reported regarding the insider ownership-financial performance nexus suggest that the debate relating to the precise functional form of the insider ownership is far from over. it also suggests that nature of the ownership structure may be country specific and therefore, findings may vary depending on the country’s institutional and regulatory structures. for example, demetz and lehn (1985) propose that greater the instability of a firm’s environment the more difficult it is for outsiders to monitor managers, and the greater are the benefits of inside ownership. in addition, researchers have reported conflicting findings regarding the role of blockholders in mitigating agency problems. some researchers have reported that blockholders have potential to influence monitoring mechanisms (dodd and warner, 1983) while others asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 16 (claessens et al., 2000; faccio and lang, 2002; dyck and zingales, 2004) argue that principal-principal agency problem exists between the block shareholders and the minority shareholders as well. shleifer and vishny (1997)and gugler (1999)have reported evidence of blockholders receiving private benefits at an expense of the minority shareholders. according to claessens et al. (2000), blockholders receive private benefits through pyramidal business structures and cross-holdings across different companies. research findings reported for the insider and block ownership suggest that the degree of control (the per cent of shares held by an investor) is an important determinant of the ownership-performance relationship(cubbin and leech, 1983). arguably, researchers investigating ownership-performance relationship have assumed that shareholders’ are homogenous. this assumption has been challenged by many, including kang and sorensen (1999), who argue that shareholders are not always homogenous when they have different identities. in fact, some shareholders through their identity obtain powers that enable them to control companies in a manner that lead to extracting private benefits. the level of ownership and shareholder identity give shareholder’s three bases for shareholder power, that is: formal authority, social influence, and expertise(kang and sorensen, 1999). shareholders’ obtain formal authority by being a shareowner. however, shareholders’ through their identity can also influence decision making processes by engaging in social activities (social influence) or having expertise knowledge (expertise). this indicate that the ownership-performance relationship may be different when shareholders have different identities, hold different proportion of shares in companies, and have expertise that company needs(short, 1994). for example, boone, colombage and gunasekarage (2011) reported that companies that have blockholders that are financial institutions have performed better compared to their peers. this finding suggests that besides degree of control (ownership concentration), location of control (identity of the shareholder) is also an important determinant of the ownership-performance nexus. since prior research focused mainly on the ownership-performance relationship, the role shareholder identity (type of shareholder) play is less understood. this research is an attempt to fill the gap in the literature. therefore, this research investigates the nature of the relationship between the proportion of ownership, shareholder identity, and financial performance of publicly listed companies in new zealand and whether the ownership-performance relationship changes during the financial crisis period. we address three noble questions in our study: (i) do the proportion of shares held by the shareholders’ matter in terms of the financial performance of publicly listed companies? (ii) does the identity of the shareholder matter in terms of financial performance? (iii) does the relationship between ownership-performance changes during the financial crisis period? 2. literature review 2.1 insider and outsider shareholders equity and influence on company performance agency-theoretic literature assumes that shareholders are homogenous and their influence on company financial performance is directly proportional to the percentage of equity they hold asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 17 (shleifer and vishny, 1986).for example, by virtue of being a shareowner, all shareholders have some formal authority or legal right (weber, 2008) such as the power to vote on ratification regarding appointment of the board of directors and the right to approve major business decisions (clark, 1986). if the proportion of shares held by a shareholder is large, the shareholder can obtain some active role in the company as well which helps in monitoring the agent who possesses information advantage over the principal because he or she is more directly involved in the day to day running of the business (subramaniam, 2006). in this regard, a number of researchers (herman, 1981; larner, 1971; sorensen, 1996; mceachern, 1975) have compared the performance of the owner-controlled companies and manager-controlled companies and reported that owner-controlled companies perform better. according to jensen and meckling(1976), manager-controlled companies have agency problems which can be mitigated by giving agents shares in the company. study undertaken by morck, shleifer and vishny(1988) show that the insider holdings between 0 and 5 percent increases performance (interest-alignment hypothesis), between 5 and 24 percent decreases performance (entrenchment hypothesis), and insider ownership above 25 percent increases performance (interest-alignment hypothesis). a study undertaken in the us by gugler, mueller and yurtoglu (2010) show that companies’ tobin’s q initially rose with an increase in the insider ownership but fell when the insider ownership exceeded 60 percent. however, ben-amar and andre (2006) argue that mitigation of agency costs by giving insiders’ shares is possible only in countries where ownership dispersion exists. in countries where blockholding is a norm, studies show that principal-principal agency problems exist in addition to the principal-agent agency problem (rydqvist, 1987; levy, 1982; horner, 1988; zingales, 1994). 2.2 shareholder ownership dimensions and its influence on company performance the nature of influence shareholders can have in companies also depends on their ownership dimension. in this regard, mintzberg (1983) provides two dimensions of ownership, that is, concentration and involvement. concentration refers to whether the company is closely-held or wildly-held and involvement measures whether the type of ownership has the ability to influence the decision-making power of the company. mintzberg (1983) categorises corporate ownership into four different types: (i) dispersed-detached; (ii) dispersed-involved; (iii) concentrated-detached; and (iv) concentrated-involved. according to mintzberg (1983), the more involved and more concentrated owners will have greater influence on decision-making processes. for example, large blockholders and institutional investors can appoint a representative (nominee) on the board (greater influence) and/or have a regular meeting with the board and the ceo (become involved), which provides opportunity to monitor managerial decisions. different ownership concentration gives different levels of power, that is: formal authority, social influence, and expertise. arguably, the level of power that shareholders have in companies determines their nature of involvement. therefore, it is argued that monitoring by different types of shareholders would lead to different outcomes. for example, nickel, nicolitsas and dryden (1997) investigated the relationship between different types of outside asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 18 ownership and company productivity after controlling for the product market competition, financial market pressure, and shareholder control. they report that the dominant external shareholders have no effect on company performance, except when the dominant external shareholder is a financial institution. chaganti and damanpour (1991) investigated the effect of institutional investors on 40 pairs of manufacturing companies in 40 industries and reported that presence of higher proportion of institutional investor leads to relatively higher roes. harris and robinson (2003), report that presence of foreign owners in companies in the uk manufacturing industry leads to an improvement in the productivity. gursoy and aydogan (2002), reported that compared to family-owned companies, government-owned companies have lower accounting-based returns but higher market-based returns in turkish listed companies. sun, tong and tong (2002), report that the relationship between government ownership and companies’ financial performance follow an inverted u-shape pattern in china. rosen and quarrey (1987), studied employee participation in decision-making processes when employees have ownerships in companies and report that it enhances company performance. the findings reported above provide support to the view that ownership concentration level play an important role in regard to how companies perform, managed and controlled. however, it is not clear whether shareholders will behave in a similar way during the financial crisis period. 2.3shareholder identity and influence on company performance prior studies investigating ownership-performance relationship have mainly focused on the conventional separation of ownership and control concept, that is, whether insider ownership and/or blockholding lead to better financial performance. they have assumed that all shareholders’ have homogeneous goal. this assumption has been challenged by kang and sorensen (1999)who argue that shareholders are not always homogenous as they have not only different ownership concentrations but also identities. for example, inside owners and block owners can be either institutional investors, corporate investors, government investors, individual investors, and employee stock ownership plans (boone et al., 2011). identities of block owners such as family, government or corporate may have objectives that differ substantially from shareholder maximization (thomsen & pedersen, 2003). similarly, corporate shareholders focus on both the short-term and long-term performance and therefore, play an active role at the strategic and operational level decisions of the company. on the other hand, institutional investors seek long-term returns and do not pay much attention to companies’ short-term decision making processes. therefore, corporate shareholders have higher involvement compared to the institutional shareholders. different types of shareholders also have different behavioral characteristics which allow them to have different level of involvement and therefore, have different level of influence on companies. through their involvement and influence, different shareholders achieve different outcomes from companies in which they invest. according to kang and sorensen (1999), the nature of social interactions between shareholders and management is an important way shareholders’ influence the decision making processes. in particular, the identity of shareholder has potential to influence decision making processes in companies. from the corporate governance point of view, the type of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 19 interpersonal relationships can significantly affect the resource allocation decisions in firms (pfeffer, 1992). for example, the employee shareholders are able to influence decision-making processes through social interactions and their long-term relationship creates powerful reputational effect (anderson and reeb, 2004) which allow them to form a closer bond between the management and the board. it is argued that a higher level of involvement by employees have potential to reduce agency costs (jensen and meckling, 1976) on one hand, but on the other, closer relationship between employees allows managers with opportunities to extract private benefits of control (fama and jensen, 1983a). in addition, a closer relationship with the board/management provides some employees with opportunities to extract private benefit, such as obtaining appointment at management positions and/or other perquisites as well. on the other hand, foreign shareholders are geographically located outside the country, which make it difficult for them to get closer to the directors and influence decision making processes, thus giving rise to higher monitoring costs. although this is a detached ownership structure, their experience and expertise are highly regarded and they have a tendency to influence decision making by providing their expertise. on the other hand, block holders and institutional investors through social interactions with ceos are able to appoint more outside directors or independent directors on the board, and ceos which as a result, are more likely to negotiate golden parachute deals into their contracts(wade et al., 1990). zajac and westphal (1995; 1996)argue that the demographic background of the directors may also provide a source of political power which shareholders can exploit by building relationships which in turn allows them to influence the decision making processes. similarly, large shareholders’ who have superior knowledge about the industry in which the company belongs to, which allows them to provide expertise to the management regarding critical environmental forces facing the company, have different influence on decision -making. this power is specific to the shareholder(s) and knowledgeable shareholders are the intangible assets of the companies. since all these types of shareholders want to maximise company value, shareholder expertise contributes positively towards this goal(kang and sorensen, 1999). however, the government/state ownership is an involvement ownership type that has a different influence on decision making because governments have power not only from the corporate law and property rights point of view, but from state policy setting, implementation and reputation point of view as well. the conflict of interest between the government and other shareholders often arises because the state is more interested in political/social outcomes compared to the goals of the other shareholders who are more interested in the financial returns. indeed, according to boycko, shleifer and vishny (1996), the agency problem in government-owned companies arises from political issues rather than managerial issues. based on the above viewpoint, weargue that both ownership concentration and identity provides different levels of formal authority, social influence and expertise power. thus different shareholders have varying opportunity to motivate and monitor managerial behavior and influence decision making processes will do so based on their goals. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 20 3. new zealand environment identity of the owner (i.e. employee, corporate) and the ownership structure (block holding) of the publicly listed companies in new zealand make this investigation interesting. new zealand has a small and open economy, a mature capital market and small number of companies listed compared to the larger economies of australia, the usa and the uk. the size of the companies in new zealand is much smaller which provides an environment which is significantly different from the larger economies where most of the prior studies have been undertaken. the existence of a small capital market makes market for corporate control irrelevant and therefore, investors rely on alternative governance mechanisms such as blockholding to mitigate agency costs(boone et al., 2011). for this reason, blockholding has remained an important feature of new zealand listed companies ownership structure. the evidence shows that blockholding in new zealand has relatively remained unchanged overtime. for example, hossain, provost and rao (2001) reported blockholding of 76 per cent (20 largest shareholders) for the period 1991/97 and reddy, locke and scrimgeour (2010) reported blockholding of 65 per cent for the large companies in 1999/2007. table 1reports the ownership concentration of the publicly listed companies in new zealand. between 2003 and 2009, the largest shareholder held on an average 34.49% of the shares. the highest proportion of shares held by the largest shareholder was 35.31% in 2005. the second largest shareholder held on an average10% of the shares and the highest proportion held by second largest shareholder was 10.83% in 2008. the average percentage of the shareholding held by the third and fourth largest shareholder is 5.47% and 3.5%, respectively. the fifth largest shareholder controlled on an average 2.57% of the shares. the sum of the average top five shareholding (column 7, table 1) are higher than 50% in all the years between 2003 and 2009, thus suggesting that five largest shareholders have the majority control of the companies. in new zealand, shareholding greater than 5% is constituted to be blockholding (new zealand securities commission, 2006) and it is interesting to note that the top five shareholders in new zealand are mostly blockholders. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 21 table 1. % of shares controlled by the top 5 shareholders year top1 top2 top3 top4 top5 total 2003 34.32% (0.229) 9.97% (0.068) 6.47% (0.061) 4.85% (0.067) 3.01% (0.062) 58.62% 2004 34.90% (0.228) 9.52% (0.067) 5.25% (0.045) 3.01% (0.022) 2.32% (0.019) 54.99% 2005 35.31% (0.244) 9.41% (0.072) 5.38% (0.048) 3.17% (0.022) 2.30% (0.018) 55.56% 2006 35.07% (0.243) 10.21% (0.074) 5.19% (0.046) 3.32% (0.023) 2.32% (0.017) 56.10% 2007 34.86% (0.241) 10.33% (0.071) 5.05% (0.031) 3.21% (0.0210 2.48% (0.018) 55.93% 2008 32.95% (0.247) 10.83% (0.072) 5.17% (0.032) 3.30% (0.020) 2.67% (0.019) 54.91% 2009 34.02% (0.246) 10.23% (0.070) 5.79% (0.038) 3.63% (0.023) 2.91% (0.022) 56.58% average 34.49% 10.07% 5.47% 3.50% 2.57% 56.10% (note: % of shares held by each owner identity type is equal to total shares held by each owner identity type divided by total shares outstanding. standard deviations is reported in brackets) table 2and chart 1 provide an international comparison of different shareholdings and ownership identities in australia, new zealand, the uk, and the us. data for australia, the uk and the us was obtained from asx200, ftse100 and s&p500, respectively. new zealand data includes 80 companies listed in nzx in 2010. the mean proportion of corporate holding in new zealand is 16.38%, and the average employee holding is 18.44%. the proportion of shares held by both corporate and employees are much higher in new zealand compared to australia, the uk and the us. the second highest corporate holding is in australia (9.42%) and the second highest employee holding is in the uk (3.82%). the mean proportion of foreign holding in new zealand is 6.67%, which is similar to australia of 6.76% but lower than the uk (11.97%) but much higher than the us (0.83%). government holding in these four countries is very low. in new zealand, government holding is the highest at 2.46%, and in the us is the lowest at 0.1%. however, new zealand and the uk have the lowest proportion of institutional holding which is 4.06% and 3.53%, respectively. institutional holding in new zealand and the uk are less than half of that in australia (8.41%) and the us (9.04%). data for the pension fund holding in new zealand was not available; however, in other three countries it is very low. results reported in table 2 indicate that the “involvement” ownership type (corporate and employee) is much more popular in new zealand than in the other three countries. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 22 table 2. a comparison of ownership of common stock au uk us nz ch 9.46% (15.35) 5.09% (14.68) 0.86% (5.66) 16.38% (23.72) eh 3.67% (10.83) 3.82% (12.490 1.37% (4.97) 18.44% (24.86) fh 6.76% (12.78) 11.97% (17.52) 0.83% (4.38) 6.67% (16.70) gh 0.42% (3.67) 1.55% (8.26) 0.10% (1.15) 2.46% (12.76) ih 8.41% (10.83) 3.53% (5.34) 9.08% (8.22) 4.06% (7.05) pension fund 0.07% (0.92) 0.24% (1.94) 0.13% (2.28) 0.00% (0.00) total strategic held 22.24% (19.15) 15.02% 19.85) 11.73% (10.81) 41.43% (26.62) no of companies 199 102 500 81 (note: ownership variables in table 2 are : ch-percentage by corporate holding; eh-percentage by employee holding; fh-percentage by foreign holding; gh-percentage by government holding; ih-percentage by investment company holding; pension fund-percentage by pension fund holding; total strategic held = total percentage of all these identified owners. standard deviations is reported in brackets) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 23 chart 1. a comparison of ownership of common stock % in 2010 table 3reports the percent of shares held by each ownership type in different sectors in nzx in 2010. the institutional investors have the most balanced portfolio as they have invested in all six sectors1. the highest holding is in the energy sector (6.75%) and the lowest is in the investment companies (2.18%). however, government hold shares only in the services sector in new zealand(5.85%). foreign investors tends to invest more in the investment sector (17.73%) and least in the property sector (2.25%), which is not surprising as the information pertaining to the economy and investment sector are more readily available compared to the others sectors. employees own largest proportion of shares in the services sector (24.53%), followed by goods sector (22.47%), and investment sector (19.45%). a plausible reason for employees investing highly in these three sectors is that the motivation is highly connected to the companies’ profits. corporate holding is highest in the energy sector (43%). moreover, corporate holding is higher than 10% in all six sectors which indicate that corporate ownership type is the most popular and important type of ownership in new zealand. 1 the six sectors are energy, goods, investment, primary, property and services. 9.46 3.67 6.76 0.42 8.41 0.07 5.09 3.82 11.97 1.55 3.53 0.24 0.86 1.37 0.83 0.10 9.08 0.13 16.38 18.44 6.67 2.46 4.06 0.00 ch eh fh gh ih pension fund au uk us nz asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 24 table 3. ownership structure by sector in 2010 ih gh fh eh ch no. energy 6.75% (0.135) 0.00% (0.000) 6.75% (0.135) 5.00% (0.063) 43.00% (0.390) 4 goods 4.33% (0.063) 0.00% (0.000) 3.93% (0.085) 22.47% (0.282) 13.00% (0.153) 15 investment 2.18% (0.072) 0.00% (0.000) 17.73% (0.346) 19.45% (0.277) 14.09% (0.298) 11 primary 3.33% (0.060) 0.00% (0.000) 4.17% (0.063) 0.50% (0.017) 18.08% (0.2210 12 property 6.50% (0.0820 0.00% (0.000) 2.25% (0.0450 0.00% (0.000) 12.50% (0.084) 4 services 4.32% (0.070) 5.85% (0.193) 5.88% (0.142) 24.53% (0.239) 15.82% (0.242) 34 (note: ownership information was obtained from the nzx deep archive for the year 2010. numbers of companies included in the sample are given in column 7. standard deviations is reported in brackets) table 4reports the ownership percent by owner identity and size of companies based on companies total assets. total assets of the companies are divided in four segments: large, medium1, medium2, and small. large refers to companies that have total assets greater than and equal to $1 billion; medium1 refers to companies that have total assets greater than equal to $200 million and less than $1billion, medium2 refers to companies that have total assets greater than equal to $50million and less than $200million; and small refers to companies that have total assets less than $50 million. results reported in table 4 show that different owner types have different interests in different size companies. the basic consensus is that smaller size companies have greater risks and ownership patterns of institutional investors show that their investment declines as the company size gets smaller. institutional investors hold 9.64% shares in large companies, but it dramatically declines to mere 1.21% in small size companies. this is not surprising as institutional investors are known for seeking long-term returns and have low risk-bearing capability. the most striking result is that government holding in large companies in new zealand is nil compared to other countries. this is mainly because government-owned companies are not publicly listed in new zealand. another plausible reason is that new zealand government invests only in the services sector (ports) in new zealand which is only medium sized. foreign holdings are highly concentrated both in large companies (10.09%) and small size companies (10.86%). it is interesting to note that there are two distinctly different types of foreign investors existing in new zealand, that is, one seeking long-run returns and low risk, and other seeking risky investments. it is interesting to note that employee holding declines as the company size gets larger, which ranges from 30.59% in small companies to 0.64% in large companies. this is not surprising as investors need a lot more funds to hold block shares in larger companies. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 25 table 4. ownership structure by firm size in 2010 ih gh fh eh ch no. large 9.64% (0.096) 0.00% (0.000) 10.09% (0.108) 0.64% (0.021) 22.91).3 01) 11 medium1 5.05% (0.051) 2.57% (0.118) 1.14% (0.0360 10.86% (0.208) 16.05% (0.229) 21 medium 2 4.32% (0.043) 4.16% (0.1810 4.74% (0.082) 15.21% (0.252) 13.32% (0.190) 19 small 1.21% (0.012) 2.28% (0.123) 10.86% (0.256) 30.59% (0.239) 16.72% (0.254) 29 note: the data for the company’s total assets was obtained from the nzx deep achieve, for 2010. companies total assets was divided into four segments, that is: largecompanies with totals assets greater than equal to $1billion; medium1 companies having totals assets greater than equal to $200million and less than 1billion; medium2 companies with total assets greater than equal to $50 million and less than $200 million; and small companies with total assets less than $50 million . standard deviations are reported in brackets. chart2reports the time series comparison of ownership percent and identity of the 40 nzx listed companies for the period 2003 to 2009.according to chart2, institutional holding, employee holding, and corporate holding declined between the period 2003 and 2004, but foreign holding increased a little during the same period following similar trend to that of the real gdp growth rate (rgdp) of new zealand. after 2004, foreign holding, employee holding (small firms) and corporate holding followed similar trend to that of the rgdp, they all declined in 2005 and rebounded back a little in 2006. per cent of shares held by all investors declined in 2007, even though the rgdp increased slightly. a plausible reason could be that investors expected the worst possible outcome from the financial crisis and therefore, maintained lower level of interest in controlling publicly listed companies in new zealand. even though new zealand economy experienced major setback since 2008, the results reported in chart2 show that investors did increase their level of investment simply to regain control which they had lost earlier. above findings suggest that investors not only focused on the recent economic environment but their confidence level of future situation also played an important role in determining investment options. furthermore, ownership by institutional investors (large firms) remained fairly constant over the period suggesting they were seeking long-run returns, and short-term effects have had less effect on their investment patterns in comparison to employee and corporate type investors. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 26 chart2. ownership structure in time series note: rgdp is the gdp nature growth rate of new zealand, which in the secondary y-axis. ownership data include 40 nzx listed companies data and method data for this research was collated from datastream and nzx deep archive. to maintain exactitude, a balanced panel data was developed to observe both the time and cross sectional effects. unfortunately, the average life-cycle of the listed companies in new zealand in the past 11 years (1999 to 2009) has been approximately five years, which means there are a number of companies with missing data. after removing companies that did not survive the sampling period, a balanced panel of 40 companies was obtained, thus containing 280 company-year observations. in addition, 80 company’s data for 2010 was also used to obtain descriptive statistics which provide most recent statistical information regarding ownership structures of publicly listed companies during the financial crisis period in new zealand. 4.1 dependent variables similar to gugler, mueller and yurtoglu (2008), kang and stulz (1996), morck, et al.(1988), and reddy et al.(2010), this study uses tobin’s q as a dependent variable. in addition, this -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 2002 2003 2004 2005 2006 2007 2008 2009 2010 % ho ld in g year ih fh eh ch rgdp asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 27 study also uses return on assets (roa) as a dependent variable similar to demsetz and villalonga (2001) and finch and shivadasani (2006). 4.2 independent variables the independent and control variables used in this study is similar to that used by demsetz and lehn (1985) and xu and wang (1992).we use two variables as proxy for ownership concentration (con), that is, top5 and h1. our statistical analysis relies heavily on the cumulative percentage of shares held by the five largest shareholders (top5) and the approximation of the herfindahl index (hi). top5 = numbler of shares held by ive largest shareholders ℎ ∗ 100% hi = (% of shares held by largest shareholder)+ (% of shares held by second largest shareholder) + ⋯+ (% of shares held by ifth largest shareholder) similar to demsetz and lehn (1985), we have taken a logistic transformation of top5 and h1 to convert an bounded variable into an unbounded one. therefore, lt5 is determined as ln(top5) and lh1 as ln(h1) prior researches have measured ownership levels either by aggregating the per cent of shares held by the largest shareholder or top-20 shareholders. no study to date (to our knowledge) has considered the per cent of shares held by the top-5 shareholders as well as the identity of the top-5 shareholders. blockholders in publicly listed companies in new zealand tends to be insiders and as they have different identities (such as, institutions, corporates, etc.), suggests that they may play an important role in new zealand context. therefore, we follow and also have extended the method used by xu and wang’s(1999). we use five variables as proxies for the ownership identity (own), that is: eh is the percent of shares held by the employees, fh is the per cent of shares held by foreign investors (who is not a new zealand citizen and not a new zealand resident), ch is the per cent of shares held by corporate investors (non-financial companies), and ih is the per cent of shares held by investment companies or institutional investors (institutions, banks or other financial companies). government and pension funds were ignored either because their shareholding is minute or insufficient information was provided. the formula that determines proportion of each type of ownership is as follows: total number of outstanding shares hold by each identitytotal number of shares outstanding to determine the effect of financial crisis on performance, two time dummy variables were created. before is equal to “1” if the year is before 2007, otherwise “0” and after is equal to “1” if the year is after 2007, otherwise “0”. to control for the size effect we use the natural log of total assets (size) as the proxy for size. leverage (lev) of the company is measured by the ratio of total liabilities to total assets, and the firm level risk (fmrisk) is measured as the standard deviation of the firm’s daily stock price. oprisk is the standard asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 28 deviation of past five years of the firm’s roa and mshare is the proportion of the firm’s revenue to the total revenue of the sectors. a summary of dependent and control variables used in this study and their method of measurement is provided in table 5. table 5. a summary of dependent and control variables used dependent variables tobin’s q ((stock price * no. of shares outstanding) + long term debt + short term debt)/total assets roa net income/ total assets control variables ownership concentration (con): top5 no. of shares held top five shareholders/total shares outstanding ownership concentration (con): h1 (% of shares held by largest shareholder)2 + (% of shares held by second largest shareholder)2 + … + (% of shares held by fifth largest shareholder)2 ownership identity (own): eh (no. of shares held by employees)/total shares outstanding ownership identity (own): fh (no. of shares held by foreign investors)/total shares outstanding ownership identity (own): ch (no. of shares held by corporate investors)/total shares outstanding ownership identity (own): ih (no. of shares held by institutional investors)/total shares outstanding after dummy equal to “1” if year is after 2007, otherwise “0” before dummy equal to “1” if year is before 2007, otherwise “0” lev long term liabilities/total assets size natural log of total assets fmrisk standard deviation of the firm’s daily stock returns for the year oprisk standard deviation the firm’s past five year return on assets mshare proportion of the total revenue of the firm to total revenue of the sector to which firm belongs to. 4.3 model this study examines the nature of the relationship between firm performance (per) and ownership variables and tests whether the relationship is significant. two dependent variables (q, roa) and two main types of independent variables (con, own) are used to estimate the model using ordinary least squares (ols) regression. the regressions models used are as follows: asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 29 where per either equals tobin’s q or roa; con equals top5 and h1; own equals eh, fh, ch, ih; i denote a cross-sectional observation; t denotetime and ε is theerror term. we use tobin’s q as the dependent variable, ownership identity as independent variable and two time period variables, that is, before and after. the ols regression model used is as follows: where time either equals before or after. 5. empirical result 5.1 descriptive statistics table 6 provides a summary of the descriptive statistics for the dependent and control variables used in this study. the average (median) tobin’s q is 2.06 (1.25) indicating companies did create values for the shareholders’ and the company has good expectations for future performance. the average (median) roa is -0.02 (0.05) and the minimum is -4.32. the negative values for roa indicate that companies have not utilized fixed assets of the companies in an efficient manner to generate enough revenue. since median of roa is lower (0.05%), it indicates that majority of the publicly listed companies have experienced a very low financial performance during the period of the global financial crisis. the mean (median)of hi is 0.2 (0.13) and the mean (median) proportion of shares held by five largest shareholders (top5) is 0.56 (0.56), which is considered to be very high indicting more than half of the shares are controlled by five largest shareholders. the maximumtop5 is 98% and the minimum is 12%, indicating that companies in new zealand are closely-held rather than widely-held. the mean of ih is 0.03, fh and ch both have mean of 0.06, whereas mean of eh is the highest at 0.09. these results indicate that employee investors hold the largest proportion of shares in new zealand market, and the institutions hold the smallest. the mean of lev is 0.44 which is not considered to be high, but the maximum is greater than 1 thus indicating total liabilities in the companies are greater than the total assets. the mean of size is 5.31 with the median of 5.41. the mean of fmrisk is 0.33 with the median of 0.25.the mean of oprisk is 0.31 with the median of 0.02, thus suggesting that market risk and operational risk of firms are not significantly different. the mean of mshare is 0.01, thus suggesting that firms share of the market is small. 1.................εconβ mshareβopriskβ fmriskβsizeβlevβtimeβαper it16 it15it14it13it1211it101it ++ ++++++= 2.................εownβ mshareβopriskβfmriskβsizeβlevβtimeβαper it26 it25it24it23it2221it202it ++ ++++++= 3................εmshareβ opriskβownβfmriskβsizeβlevβαq it35 it34it34it33it32it313it ++ ++++++= time asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 30 the results reported in table 6 show that 17.5% of companies belong to primary industry, 37.5% services, 12.5% investment, 7.5% energy, 17.5% goods, 5% property, and 2.5% are companies which are also listed in overseas stock exchanges. table 6. descriptive statistics mean median kurtosis skewness range min max no. q 2.06 1.25 18.02 3.64 21.76 -0.25 21.51 280 mb 2.52 1.78 26.10 4.36 27.62 -2.82 24.81 280 roa -0.02 0.05 75.12 -7.45 4.69 -4.32 0.37 280 roe 0.01 0.09 52.62 -0.67 13.19 -6.44 6.75 280 hi 0.20 0.13 -0.18 1.00 0.68 0.00 0.68 280 top5 0.56 0.56 -1.09 -0.02 0.86 0.12 0.98 280 ih 0.03 0.00 16.82 3.74 0.55 0.00 0.55 280 fh 0.06 0.00 6.53 2.50 0.70 0.00 0.70 280 eh 0.09 0.00 5.02 2.40 0.80 0.00 0.80 280 ch 0.06 0.00 7.01 2.77 0.78 0.00 0.78 280 lev 0.44 0.43 0.11 0.40 1.32 0.00 1.32 280 size 5.31 5.41 -0.01 -0.62 4.25 2.66 6.92 280 fmrisk 0.33 0.25 47.96 5.10 4.33 0.01 4.33 280 oprisk 0.13 0.02 16.34 3.37 1.99 -0.07 1.92 280 mshare 0.01 0.00 4.34 0.00 0.03 0.00 0.03 280 5.2 correlation test table 7 report the pairwise correlation matrix for the independent variables. the correlation between lt5 and lh1 is the highest at 0.86, which is not surprising as the top five shareholders also have most concentrated shareholding as well. apart from this result, the rest of correlation coefficient ranges between 0.35 (between lev and size and between fh and ih) and 0.002 (lt5 and fmrisk). we also conducted the pairwise correlation between the dependent variables (q and roa) and blockholders identity variables (hi, eh, fh, ch) and found the correlations coefficient to be between 0.14 and 0.001.2 these results re-confirm the view that there are no multicollinearity issues in the data. 2 results are not reported but can be obtained from the authors if required. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 31 table 7. pairwise correlation of the independent variables size is the natural logarithm of the total assets. lev is the ratio of long term debt to total assets. fmrisk is the standard deviation of the firm’s daily stock returns. oprisk is the standard deviation of the firm’s past five year roa. mshare is the proportion of the firm’s revenue to the total revenue of the firms’ in the sector. ih1 is the natural logarithm of the herfindahl index. lt5 is the natural logarithm of the proportion of shares held by top5 five shareholders. ih is the proportion of shares held by institutional investors. fh is the proportion of shares held by foreign investors who are not institutions and/or corporates. eh is the proportion of shares held by employees and ch is the proportion of shares held by corporate investors. size lev fmrisk oprisk mshare lh1 lt5 ih fh eh ch size lev 0.347*** (0.000) fmrisk 0.315*** (0.000) 0.093 (0.119) oprisk -0.439*** (0.000) -0.179** (0.003) -0.020*** (0.000) mshare 0.328*** (0.000) 0.138† (0.021) 0.313*** (0.000) -0.110† (0.067) lh1 0.091 (0.127) -0.262*** (0.000) -0.058 (0.337) -0.111† (0.065) -0.016 (0.796) lt5 0.089 (0.136) -0.257*** (0.000) 0.002 (0.979) -0.077 (0.197) -0.024 (0.688) 0.861*** (0.000) ih 0.226 (0.000) 0.128** (0.032) 0.171** (0.004) 0.034 (0.566) 0.314*** (0.000) -0.160** (0.007) -0.128** (0.033 fh -0.007 (0.912) 0.099† (0.099) -0.010 (0.871) 0.020 (0.734) 0.114† (0.056) 0.056 (0.351) 0.038 (0.530) 0.351*** (0.000) eh -0.143** (0.016) 0.110† (0.067) -0.090 (0.134) 0.067 (0.262) -0.033 (0.585) -0.001 (0.989) 0.066 (0.269) -0.103† (0.086) -0.105† (0.079) ch -0.048 (0.422) -0.099 (0.134) -0.018 (0.758) 0.072 (0.231) -0.079 (0.190) 0.289*** (0.000) 0.247*** (0.000) -0.109† (0.069) 0.240*** (0.000) -0.076 (0.205) *** denote significance at 1% level, ** denote significance at 5% level, † denote significance at 10% level. table 8 report the results of the breusch-pagan/cook-weisberg test for heteroskedasticity. these results confirm our findings reported above that there are no heteroskedasticity issues in the data. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 32 table 8. breusch-pagan/cook-weisberg test for heteroskedasticity ho: constant variance tobin’s q mb roa roe chi2 (p-values) 247.91 (0.000) 262.81 (0.000) 622.65 (0.000) 187.33 (0.000) 5.3 ols regression of performance to ownership concentration (con) table 9reports the ols and fixed-effects3regression results for equation 1.dependent variables are tobin’s q and roa and the independent variables are listed in column 1 of table 9with corresponding t-statistics reported in brackets. according to wintoki, linck and netter (2012), unobservable heterogeneity is a source of endogeneity that affects both performance and explanatory variables. a potential solution is the fixed-effects or within estimation. columns 2 to 5 provide the regression results when tobin’s qis used as the dependent variable and con is determined by either lhi or top5, respectively. both time and size have a negative coefficient and is statistically significant at 1% level, indicating that the size of the publicly listed companies is not at an optimal level and also company performance is adversely affected by the financial crisis. the coefficient of fmrisk is positive and statistically significant at 1% level, thus indicate that listed companies that experienced high volatility in stock prices contributed positively towards performance measured by tobin’s q. since the coefficient of lt5 is negative and statistically significant at 10% level, this indicates that the monitoring provided by top five shareholders to some extent sheltered the companies from adverse financial effects. columns 6to 9 provide the regression results when roa is used as the dependent variable and con is determined by either lhi or top5, respectively. the coefficient of both con variables is positive and is statistically significant at 5% and 10% levels, respectively. this suggests that a higher ownership concentration levels lead to a higher accounting-based performance measured by roa. since coefficient of size is positive and statistically significant at 1% level, it indicates that the large companies in new zealand have better accounting performance compared to small. in summary, results reported in table 9show that companies that have a higher level of ownership concentration will tend to have lower tobin’s q and higher roa but companies that are large will tend to have lower tobin’s q but higher accounting based performance. higher concentrated owner (blockholders) has more formal authority and they tend to hold enough shares to obtain active roles in the companies. based on the ownership concentration of the blockholders, their opinion tends to have a significant effect on the managers’ activities. with blockholders in such an influential space, it is likely that the rights of the minority shareholders could be comprised. 3 the hausman test results (not reported) but shows that fixed effects results are more efficient. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 33 table 9. q is the proportion of ((stock price * no. of share outstanding) + l/t debt + s/t debt) to total assets. roa is the proportion of net income to total assets. time ranges from 2003 to 2009. size is the natural logarithm of the total assets. lev is the ratio of long term debt to total assets. fmrisk is the standard deviation of the firm’s daily stock returns. oprisk is the standard deviation of the firm’s past five year roa.ih1 is the natural logarithm of the herfindahl index. lt5 is the natural logarithm of the proportion of shares held by top5 five shareholders. mshare is the proportion of the firm’s revenue to the total revenue of the firms’ in the sector. static model q roa ols fixed effects ols fixed effects ols fixed effects ols fixed effects constant 4.58*** (4.99) 6.46*** (9.40) 4.82*** (5.72) 6.48*** (9.40) -0.68*** (-5.43) -1.06** (-1.98) -0.77*** (-6.60) -1.06** (-2.00) time -0.97*** (-3.27) -0.95*** (-3.16) 0.02 (-0.59) -0.03 (-0.67) lev 0.04 (0.051) 0.51** (2.74) -0.15 (-0.21) 0.51** (2.73) 0.01 (0.11) -0.09 (-0.64) 0.01 (0.030 -0.09 (-0.60) size -0.53*** (-2.99) -1.08*** (-8.06) -0.50** (-2.84) -1.07*** (-8.06) 0.13** (5.62) 0.23** (2.24) 0.14*** (5.62) 0.23** (2.19) fm risk 1.34*** (3.19) -0.04 (-0.47) 1.35**** (3.23) -0.04 (-0.47) 0.09 (1.53) 0.02 (0.41) 0.09 (1.93) 0.02 (0.33) oprisk -0.27** (-2.12) -0.51** (-2.53) -0.27** (-2.12) -0.51** (-2.53) -0.73*** (-10.79) -0.76*** (-4.87) -0.73*** (-10.89) -0.75*** (-4.77) mshare 11.17 (1.37) 12.79 (0.97) 11.17 (1.37) 12.79 (0.97) -4.02 (-0.93) -19.85 (-1.78) -3.83 (-0.88) -15.89 (-0.87) lh1 -0.07 (-1.16) -0.03 (-0.34) 0.35** (2.28) 0.29** (2.01) lt5 -0.14† (-1.91) -0.16† (-1.94) 0.29† (1.94) 0.25† (1.88) f stats (p value) 6.83*** (0.000) 11.07*** (0.000) 6.82*** (0.000) 11.08*** (0.000) 33.27*** (0.000) 7.17*** (0.000) 33.45*** (0.000) 7.38*** (0.000) r2 (adj. r2) 0.12 (0.10) 0.22 (0.05) 0.13 (0.11) 0.22 (0.05) 0.42 (0.41) 0.16 (0.37) 0.42 (0.41) 0.16 (0.37) n 280 t statistics in parenthesis, † denote significance at the 10% level, **denote significance at 5% level, *** denote significance at 1% level asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 34 5.4 ols regression results for performance and ownership identity table10 reports the ols regression results for the performance and ownership identity for equation 2. the dependent variables used are tobin’s q and roa and the independent variables include four owner identity variables (own), that is, institutional holding (ih), foreign holding (fh), employee holding (eh), and corporate holding (ch). table 10 columns2 to 3 report the results of tobin’s q as dependent as the dependent variable. the coefficient of ih is positive and statistically significant at 5% level, indicates that holding by institutional investors leads to an improved financial performance measured by tobin’s q. however, coefficients of eh and ch are negative, thus indicate that holding by employees and corporate investors leads to negative returns. results for the size, time and fmrisk are similar to that reported in table 9. table 10 columns 4 and 5 report the results of roa as dependent variable. the coefficient of ih is negative and statistically significant at 5% level; indicate that institutional holding has a negative effect on roa. the coefficient of ch is positive and statistically significant at 5% level; suggest that corporate investors have a positive effect on accounting-based performance. in summary, results show that higher institutional holding increases performance measured by tobin’s q and decreases accounting-based performance measured by roa. the plausible reason could be that less “involvement” owners have less power and have less interest in controlling decision-making processes, therefore, pay less attention on day-to-day operations of the companies but focus more on the long-term growth. for example, institutional investors focus on the future returns or long run returns which is reflected by tobin’s q. on the other hand, corporate holding has a negative effect on tobin’s q but a positive effect on accounting-based measure, reflecting corporate investors’ short term focus. table 10. q is the proportion of ((stock price * no. of share outstanding) + l/t debt + s/t debt) to total assets. roa is the proportion of net income to total assets. time ranges from 2003 to 2009. size is the natural logarithm of the total assets. lev is the ratio of long term debt to total assets. fmrisk is the standard deviation of the firm’s daily stock returns. oprisk is the standard deviation of the firm’s past five year roa. mshare is the proportion of the firm’s revenue to the total revenue of the firms’ in the sector. ih is the proportion of shares held by institutional investors, fh is the proportion of the shares held by foreign investors, eh is the proportion of the shares held by employees and ch is the proportion of the shares held by corporates. static model q roa ols fixed effects ols fixed effects asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 35 constant 2.00*** (8.73) 2.09*** (5.86) -0.30** (-2.34) -0.30** (-2.29) lev 0.24 (1.64) 0.44** (2.68) -0.08 (-1.02) -0.08 (-0.99) size -0.21*** (-5.06) -0.24*** (-3.54) 0.06** (2.64) 0.06** (2.57) fmrisk 0.33*** (3.64) 0.04 (0.50) 0.08 (1.49) 0.07 (1.40) oprisk -0.20 (-1.60) -0.05 (-0.27) -0.74*** (-10.49) -0.74*** (-10.30) mshare 7.56 (0.93) 9.11 (0.87) -3.32 (-0.740 -3.62 (-0.77) ih 1.16** (2.27) 0.71† (1.85 -0.59** (-1.98) -0.16† (-1.90) fh 0.01 (-0.03) 0.12 (0.38) 0.09 (0.55) 0.11 (0.63) eh -0.40** (-2.29) -0.14 (-0.72) 0.03 (0.32) 0.04 (0.37) ch -1.64† (-1.71) -0.17 (-0.86) 0.27** (2.29) 0.26** (2.20) f stats (p-value) 5.01*** (0.000) 6.76*** (0.000) 14.03*** (0.000) 19.00 (0.000) r2 adj. r2 0.22 (0.18) 0.31 (0.05) 0.44 (0.42) 0.16 (0.44) n 280 t statistics in parenthesis, † denote significance at the 10% level, **denote significance at 5% level, *** denote significance at 1% level asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 36 5.5 ols regression results for performance and ownership identity during financial crisis tables 11, columns 2 to 9report the ols regression results for equation 3 using tobin’sq as dependent variable and ownership identity (own) in different time period as the independent variable, that is, before or after financial crisis. in columns 2 to 5 in table 11, coefficients of two ownership identity variables ih and fh are positive and statistically significant at 5% levels, respectively. this result indicates that in post financial crisis period both institutional and foreign holding resulted in positive performance. however, the coefficient of ch is negative and is statistically significant at 5% level indicate that corporate holding has a negative effect on the financial performance measured by tobin’s q. in columns 6 to 9 in table 11, coefficient of ih is positive and statistically significant at a 5% level, indicate that institutional holders invested in larger companies that could sustain short-term shocks such as those arising from the global financial crisis. results suggest that their less “involved” holdings had a positive performance measured by tobin’s q. on the other hand, the results suggest that more “involved” investors (employee corporate) who tend to pay much attention to short-term performance but did not due to the crisis and therefore, experienced more negative performance. the results reported in table 11 show that during the financial crisis the effects of ownership identity on performance declined and all different types of shareholders reduced their shareholding proportion and therefore, lost some power of control. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 37 table 11. q is the proportion of ((stock price * no. of share outstanding) + l/t debt + s/t debt) to total assets. roa is the proportion of net income to total assets. time ranges from 2003 to 2009. size is the natural logarithm of the total assets. lev is the ratio of long term debt to total assets. fmrisk is the standard deviation of the firm’s daily stock returns. oprisk is the standard deviation of the firm’s past five year roa. mhare is the proportion of the firm’s revenue to the total revenue of the firms’ in the sector. ih is the proportion of shares held by institutional investors, fh is the proportion of the shares held by foreign investors, eh is the proportion of the shares held by employees and ch is the proportion of the shares held by corporates. 2003 2006 2007 2009 q q q q q q q q constant 4.14*** (4.73) 3.88*** (4.39) 4.08*** (0.000) 4.07*** (4.63) 5.21*** (6.16) 4.86*** (5.72) 5.10*** (5.89) 5.07*** (5.99) lev 0.18 (0.26 0.20 (0.29) 0.38 (0.54) 0.16 (0.23) 0.18 (0.26) 0.20 (0.29) 0.38 (0.54) 0.16 (0.23) size -0.62*** (-3.60) -0.56*** (-3.22) -0.59*** (-3.38) -0.56*** (-3.28) -0.63*** (-3.60) -0.56*** (-3.22) -0.59*** (-3.38) -0.56*** (-3.28) fmrisk 1.24** (2.97) 1.36*** (3.26) 1.33*** (3.20) 1.35*** (3.26) 1.24** (2.97) 1.36*** (3.26) 1.34*** (3.20) 1.36*** (3.26) oprisk -0.23† (-1.87) -0.19 (-1.51) -0.18 (-1.45) -0.18 (-1.43) -0.32 (-1.64) -0.14 (-1.23) -0.34 (-1.56) -0.15 (-1.05) mshare 4.34 (0.85) 5.20 (1.39) 2.49 (1.58) 1.55 (1.44) 3.23 (0.76) 4.34 (1.40) 3.23 (0.98) 3.34 (1.01) ih 5.17*** (2.41) 5.15*** (2.41) fh 0.92** (2.09) 0.68 (0.53) eh -0.81 (-1.03) -1.63 (-1.61) ch -2.59** (-1.76) 0.20 (1.06) f stats (p-value) 7.36*** (0.000) 6.14*** (0.000) 6.31*** (0.000) 6.72*** (0.000) 7.36*** (0.000) 6.14*** (0.000) 6.31*** (0.000) 6.72*** (0.000) r2 adj. r2 0.12 (0.10) 0.10 (0.08) 0.10 (0.09) 0.11 (0.09) 0.12 (0.10) 0.12 (0.08) 0.11 (0.09) 0.11 (0.09) n 121 159 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 38 t statistics in parenthesis, † denote significance at the 10% level, **denote significance at 5% level, *** denote significance at 1% level 5.7 robustness check according to wintoki, linck and netter (2012), the empirical finance attempting to explain the causes and the effects of financial decisions often has serious issues with endogeneity. according to roberts and whited (2011), endogeneity leads to biased and inconsistent parameter estimates that make reliable inference virtually impossible. wintoki, linck and netter (2012), used gmm estimator to control for the dynamic nature of the performance-governance relationship suggested by theorists, while accounting for other sources of endogeneity in corporate finance research. therefore, to check whether our ols and fixed effects regression estimates are robust, we have also undertaken the analysis using dynamic panel estimation. results of our dynamic panel estimation are reported in table 12. since the hansen-j test p-values are all high, thus suggest that all the instruments are valid and cannot be rejected at any conventional levels of significance. table 12. q is the proportion of ((stock price * no. of share outstanding) + l/t debt + s/t debt) to total assets. roa is the proportion of net income to total assets. time ranges from 2003 to 2009. size is the natural logarithm of the total assets. lev is the ratio of long term debt to total assets. fmrisk is the standard deviation of the firm’s daily stock returns. oprisk is the standard deviation of the firm’s past five year roa. mhare is the proportion of the firm’s revenue to the total revenue of the firms’ in the sector. ih is the proportion of shares held by institutional investors, fh is the proportion of the shares held by foreign investors, eh is the proportion of the shares held by employees and ch is the proportion of the shares held by corporates. system gmm q q roa roa l.q 1.17† (1.97) 0.79** (2.07) l.roa -0.68† (`-1.80) -0.52† (-1.98) lev 0.84 (1.64) 0.57 (1.36) -0.19 (-0.72) -0.08 (-0.47) size -0.12 (-1.17) -0.13 (-1.41) 0.08** (2.13) 0.07** (2.20) fmrisk -0.13 (-0.37) 0.02 (0.06) 0.04 (1.03) 0.05 (1.34) oprisk 0.13 (0.51) 0.07 (0.37) -1.48 (-1.25) -1.06 (-0.79) mshare 4.39 (1.35) 4.34 (0.94) -4.56 (-1.37) -4.32 (-1.02) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 39 hi 0.48 (0.95) 0.10 (0.50) lt5 0.28 (0.60) -0.03 (-0.07) f stats (p-value) 7.01*** (0.000) 6.88*** (0.000) 6.07*** (0.000) 6.07*** (0.000) firm-fixed effects yes yes yes yes year effects yes yes yes yes no. of obs. 280 280 280 280 no of instruments 15 20 20 20 no. of clusters 40 40 40 40 arellano-bond test for ar(1) in first differences (p-value) 0.15 0.07 0.71 0.04 arellano-bond test for ar(2) in first differences (p-value) 0.42 0.41 0.28 0.33 hansen-j test of over-identification (p-value) 0.89 0.46 0.51 0.83 t statistics in parenthesis, † denote significance at the 10% level, **denote significance at 5% level, ***denote significance at 1% level 6. conclusion this study investigates the nature of the relationship between ownership, identity and financial performance of publicly listed companies in new zealand and whether the relationship between ownership-performance changes during the financial crisis (2007 to 2009). in regard to the 3 question addressed, we report our findings as follows: 1. our findings support the view that ownership concentration affects performance. however, our results for new zealand are quite different to that reported for turkey (gursoy and aydogan, 2002)and china(xu and wang, 1999). results show that a higher ownership concentration in listed companies in new zealand leads to a lower market-based performance (tobin’s q) and higher accounting-based performance (roa). a plausible reason could be that higher ownership concentration has more formal authority and therefore, blockholding gives enough power to obtain some active roles in the company. the power blockholders’ have in these companies tends to be very high and therefore, their opinions tends to matter in regard to the managerial decision-making. our results show that blockholders have tended to pay more attention to accounting-based performance rather than market-based performance. this is not surprising as the capital market activities were affected globally, investors barely made any decent gains from share price appreciation. therefore, investors during the financial crisis have relied on profits from the operational activities to boost their earnings by the way of getting higher dividends payouts. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 40 2. we report that the owner identity do have an effect on the financial performance of publicly listed companies in new zealand. more “detached” level owners (institutional investors) have a positive effect on market-based performance but negative effect on accounting-based performance. whereas, more “involved” level owners (employee &corporate investors) have a negative effect on market-based performance. our findings support the view that institutional ownership increases tobin’s q and decreases roa, whereas corporate holding decreases tobin’s q. this result indicate that the “detached” owners have positive effect on market performance but negative effect on accounting performance whereas, “involved” level owners have negative effects on market performance. this finding indicates that the “detached” level owners have less power in seeking the short-run profit and therefore, focus less interest on operational matters but more on long-term growth of the company. 3. our results show that the relationship between owner identity and financial performance changes during the financial crisis. in new zealand context, less “involved” shareholding leads to higher performance. our evidence shows that the effect of owner identity declined during the financial crisis period due to the fact that different types of owners reduced their ownership concentration levels, thus reducing their social influence and expertise powers. our results reported in table 1 show that the largest shareholder hold34.49% of the shares and five largest shareholders hold in excess of 50% (on an average basis) of the shares. these results indicate that the top five shareholders have absolute control of the publicly listed companies in new zealand. our results also show that the average proportion of corporate and employee holding in new zealand is much higher compared to that of australia, the uk and the us; thus confirming the view that the “involvement” ownership type (corporate holding) is more popular in new zealand context. our results also show that there are two different kinds of foreign investor existing in new zealand market, that is, one seeking long-run returns and low risk and other seeking more risky investments opportunities. finally, we caution readers regarding generalizing the 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(1994). the value of the voting right: a study of the milan stock exchange. review of financial studies, 1, 125-148.http://dx.doi.org/10.1093/rfs/7.1.12 microsoft word 5159-18694-1-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 216 the role of corporate governance in the link between management accounting system and firm performance david han-min wang department of accounting, feng chia university, taichung, taiwan e-mail: hmwang@fcu.edu.tw quang linh huynh (corresponding author) faculty of economics & laws, tra vinh university, tra vinh, vietnam e-mail: quanglinhhuynh@gmail.com received: feb. 21, 2014 accepted: april 12, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5159 url: http://dx.doi.org/10.5296/ajfa.v6i1.5159 abstract this research attempts to explore the causal relationships among corporate governance structure, the adoption of management accounting systems and firm performance by applying the directed acyclic graph model. especially, it discusses and uses sobel’s procedure and the interaction factor to investigate the mediating and moderating roles of corporate governance structure in the association between the adoption of management accounting systems and firm performance, which have been missed in prior studies. the findings reveal statistical evidence on the mediating and moderating roles of corporate governance structure in the influence of adopting management accounting systems in business on firm performance. this research is useful to business managers in their decisions on the adoption of management accounting systems that should fit the corporate governance structure of their firm, which will help them to attain competitive advantages as well as better firm performance. keywords: corporate governance, management accounting system, firm performance, directed acyclic graph model jel classification: c51, g34, l25, m41 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 217 1. introduction agency problems related to corporate governance structure, which arise from the separation between ownership and management, have been discussed a lot in the management literature (jensen and meckling 1976). much previous research refers to corporate governance structure as controlling mechanisms to alleviate the agency problems, namely the proportion of outside directors and supervisors in the boards as well as chief executive officer (ceo) duality (brown and caylor 2004; edwards and clough 2005; kyereboah-coleman 2007; bhagat and bolton 2008). good corporate governance structure will help firms to diminish the conflicts of interests among managers and owners, which results in the reduction in agency costs. this will therefore create competitive advantages for the firms, which brings about sustainable economic development as well as improved firm performance (cadbury 1992). corporate governance structure is applied in this research as the composition of outside directors and outside supervisors as well as the leadership separation of chairman and ceo, which is modified from the prior research (brown and caylor 2004; edwards and clough 2005; kyereboah-coleman 2007; bhagat and bolton 2008). a number of studies have suggested the causal relationships between and among corporate governance structure, the adoption of management accounting systems and firm performance (kaplan and norton 2006; seal 2006; nicholson and kiel 2007; kaymak and bektas 2008; salvato and melin 2008; christine et al. 2011). furthermore, based on the research of baron and kenny (1986), the above suggestions allow us to argue that corporate governance structure may play a mediating role in the influence of adopting management accounting systems in business on firm performance. these above suggestions also enable us to expect that corporate governance structure may moderate the causal linkage from the adoption of management accounting systems to firm performance. nonetheless, the mediating and moderating roles of corporate governance structure in the relationship between the adoption of management accounting systems and firm performance have not been statistically investigated. in this paper, we discuss the mediating and moderating roles and then examine how and whether corporate governance structure statistically mediates or/and moderates the effect of adopting management accounting systems on firm performance by applying sobel’s procedure and the interaction factor analysis. in addition, we employ both the regression analysis and the directed acyclic graph (dag) model to study the causal relationships among corporate governance structure, the adoption of management accounting systems and firm performance. the dag model that is often applied to tell the difference between actual cause and spurious cause in a set of data clearly differentiates direct cause from indirect cause (wang 2010). furthermore, wang (2010) also contends that the difference between actual cause and spurious cause is reflected clearer with the dag model than with the structural equation modelling proceduresem. in this research, we try to make some contributions to the literature as well as to the practice. to the literature, this research is the first to provide statistical evidence on the mediating and moderating roles of corporate governance structure, which offers better understanding of the importance that corporate governance structure plays in the link between the adoption of management accounting systems and firm performance. furthermore, it is also the first to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 218 utilize the advanced model of dag, which offers better understanding of the interrelationships, to discover the causal relationships. to the practice, the findings provide business managers an insight into the relationships that exist among corporate governance structure, the adoption of management accounting systems and firm performance. the results reveal that adopting management accounting systems in business affects corporate governance structure as well as firm performance. moreover, corporate governance structure both affects firm performance and plays the mediating and moderating roles in the association between the adoption of management accounting systems and firm performance. the findings are helpful to managers in choosing suitable management accounting systems to their corporate governance structure, which yields greater firm performance. this research will be organized as follows. the subsequent section “literature review” will develop hypotheses. next, the research methodology will show the way to collect the data and to measure the variables in the research model as well as how the data is analyzed. then, the empirical results will explain the findings obtained from the data analyses. finally, the conclusions are offered. 2. literature review corporate governance structure, the adoption of management accounting systems and firm performance are three main variables mentioned in this research. the relationships between and among these variables are more complicated than simple bivariate ones. the detail of these associations will be explained in this section. cadbury (1992) considers corporate governance structure as a monitoring mechanism to lessen the extent of agency problems owing to the separation between ownership and management as well as the greater composition of outside directors in the board, which thus enhances firm performance, while mayer (1997) regards corporate governance structure as “ways of bringing the interests of shareholders and managers into line and ensuring that firms are run for the benefit of shareholders. corporate governance structure is often concerned with composition and function of firm boards. following the previous studies (brown and caylor 2004; edwards and clough 2005; kyereboah-coleman 2007; bhagat and bolton 2008), we refer to corporate governance structure as compositions of boards of directors and supervisors as well as chief executive officer (ceo) duality that is known as the situation that the posts of chairman and ceo are taken by one person. another variable discussed in this research is the adoption of management accounting systems in business. management accounting system is a management means applied to offer necessary financial or nonfinancial information for making business decisions. it is regarded by kaplan (1983) as a part of management techniques and its role is to provide important information for management planning so as to improve firm performance. kaplan (1983) and lucas (1997) suggest that traditional management accounting systems, such as traditional budgeting, cost volume profit analysis, and variance analysis, which focus on concerns internal to the firm and are financially oriented, are no more considered as a supportive means to provide sufficient information for planning and management in the current ever-changing business environment. lucas (1997) stresses that, other than these traditional management accounting asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 219 systems, firms should also relate their management tools to more advanced management systemsfor example activity based costing, total quality management and balanced scorecardthat meet the requirements of customers as well as other stakeholders, so will achieve competitive advantages. grounded on these above perspectives, we define the adoption level of management accounting systems for this study as the degree to which a firm chooses and implements the management accounting systems, composed of both the above-mentioned traditional and advanced techniques for managing business. in regard to firm performance, this variable is evaluated on a firm's overall outcomes over a given period of time. the assessment of firm performance is often based on both financial performance and nonfinancial performance. financial performance is measured using traditional indices such as return on asset and return on equity (droge et al. 2003); whereas nonfinancial performance is evaluated on the indices of innovativeness, quality, and customer satisfaction (hudson et al. 2001; kaplan and norton 2007). furthermore, these indices of financial performance and nonfinancial performance have also been applied in the research of wang and huynh (2013) and huynh and lin (2013). in this research, we measure both financial performance and nonfinancial performance as the proxy for firm performance. management accounting systems are suggested by kaplan and nagel (2004) to enhance the effectiveness of corporate governance structure, because it provides the directory board with necessary information for business management, the treatment of which needs better corporate governance structure. in other words, the adoption of management accounting systems in business will shape the corporate governance structure of firms, in which higher adoption levels of management accounting systems may lead to better corporate governance structure. furthermore, information from management accounting systems helps corporate boards in offering useful suggestion to the ceo, so that the ceo can better fulfill their managerial job (kaplan and norton 2006). therefore, it is supposed that management accounting systems generate effective corporate governance, because a higher adoption level of management accounting systems requires better corporate governance structure existing a better mechanism for dealing with inportant information obtained from management accounting systems. moreover, the research on management accounting systems and corporate governance structure by seal (2006) implicates that techniques derived from management accounting can be adapted to embed better corporate governance structure, since good corporate governance structure is formed by supportive information from management accounting systems. additionally, sam et al. (2012), in the study on managers’ decision in adopting management accounting systems in business and the characteristics of ceos, propose a relationship between the adoption of management accounting systems and ceos characteristic. consequently, we can infer the suggestion that management accounting tools can shape and enhance corporate governance structure. based on the above arguments, we can formulate the following hypothesis. h1: corporate governance structure may be enhanced by the adoption of management accounting systems in business asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 220 white and ingrassia (1992) argue that when the positions of both chairperson and ceo fall into a person, the firm can suffer an agency cost if this manager pursues his own interest at a cost of other shareholders. in addition, the studies of nicholson and kiel (2007) and kaymak and bektas (2008) highlight the boards, which include independent directors, will counter an agency problem, as these boards can supervise any self-interested actions by managers. this may lessen agency costs, and as a result bring about improved firm performance. moreover, independent directors are taken on by their outstanding qualifications, expertise and experience; hence they may effectively affect business decisions, which eventually results in benefits to the firm. independent directors are also argued by beasley (1996) and bebenroth and donghao (2007) to play a unique monitoring role in the firm, which will diminish agency costs, and so enhance firm performance. a firm will suffer worse performance, if its board cannot monitor and dismiss an underperforming ceo. accordingly, the chairperson and ceo positions should be occupied by different individuals, so that the power of control is decentralized and thus agency costs are mitigated. the above discussions allow us to posit that a good structure of corporate governance may be a driving force of improved firm performance as stated by the hypothesis below. h2: good corporate governance structure likely improves firm performance management accounting systems are aimed to facilitate decision-making by collecting, processing and communicating information that helps managers to plan, organize, manage and assess business processes as well as firm strategy and performance. mia and clarke (1999) suggest a positive relationship between the adoption of management accounting systems and business performance. they claim that the higher use of management accounting information will help managers to enhance their business performance. moreover, williams and seaman (2002) provide evidence on the role of management accounting systems in enhancing business performance. in a research on management accounting by ajibolade et al. (2010), a positive relationship between the adoption of management accounting systems and firm performance is determined. additionally, wan (2011) provides evidence that the use of e-accounting positively impacts on business performance. a number of studies have confirmed the influence of e-commerce, information system, accounting information system as well as information technology on firm performance (chong 1996; choe 2003; ismail 2007; yulius 2010; schulz et al. 2010). these tools are similar to management accounting systems, in which they are all expected to augment firm performance. overall, these previous findings lead us to suggest the hypothesis below for the management accounting context. h3: the adoption of management accounting systems may improve firm performance baron and kenny (1986) suggest that the causal relationships between and among variables in a research model are often not as simple as a simple bivariate association between a predicting variable and a predicted variable. rather, the connection between two variables in a research model is sometimes mediated by a third element. baron and kenny (1986) introduce a procedure to examine the third variable intervening role in the influence of the explanatory variable on the explained variable. this procedure requires three conditions to determine whether the interfering impact occurs. first, an explanatory variable significantly asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 221 affect an explained variable. second, it also simultaneously imposes a statistically significant impact on a third variable. third, the third variable, in turn, is the predictor of the explained variable. the third variable can be suggested to mediate the relationship between the independent variable and the dependent variable, if the three above conditions are met. as earlier discussed, hypothesis 1 (h1) indicates that the adoption of management accounting systems enhances corporate governance structure, which in turn leads to improved firm performance as stated by hypothesis 2 (h2); whereas hypothesis 3 (h3) suggests the effect of adopting management accounting systems in business on firm performance. in agreement with baron and kenny (1986), these hypotheses let us come to the hypothesis below. h4: corporate governance structure may intervene in the relationship between the adoption of management accounting systems and firm performance. furthermore, on the one hand, good corporate governance structure may result in improved firm performance (as stated in hypothesis 2), on the other hand it is also given to affect the adoption of management accounting systems in business. a study by salvato and melin (2008) points out that the empowerment of firm management to outside independent directors with their outstanding qualifications, expertise and experience will lead to a high degree of formalization. the outside independent directors have to report their jobs to their shareholders; hence they need formal management tools to effectively control business activities (cromie et al. 1995). in addition, christine et al. (2011), in their research on “corporate governance and management accounting in family firms”, find it essential to establish a separate unit in charge of management accounting, where formal management accounting tools should be employed for formalized management systems. they also imply that professionalization possessed by outside independent directors is related with the adoption of more sophisticated management systems. agrawal and chadha (2005) find that the probability of restatement is significantly lower in firms whose boards or supervisory committees include outside independent financial experts, but higher in firms where ceos hold the firm’s major shares. their findings are consistent with the argument that outside independent directors adopt formalized management systems which create more faithful earnings reports. accordingly, we can suggest that corporate governance structure impacts on the adoption of management accounting systems. the above discussions allow us to argue that the relationship between the adoption of management accounting systems and firm performance can be influenced by corporate governance structure. as such, corporate governance structure may moderate the effect of adopting management accounting systems in business on firm performance (proposition1 or p1). however, there is a lack of evidence on this moderating relationship in the existing management literature; hence we would like to undertake a tentative investigation on the moderating role of corporate governance structure in the relationship between the adoption of management accounting systems in business and firm performance. in addition to the three main variables “corporate governance structure”, “the adoption of management accounting systems” and “firm performance” mentioned above, we also consider two other variables that are deemed by previous research to affect “corporate governance structure” and “the adoption of management accounting systems”, namely environmental uncertainty and firm characteristics. we treat these two variables as asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 222 controlling variables; hence our results are more reliable. the effects of environmental uncertainty and firm characteristics on “corporate governance structure” and “the adoption of management accounting systems” are discussed below. haldma and lääts (2002) indicate that environmental factors affect managers’ decision on the adoption of management accounting system. in addition, masrek (2009) finds out the relationship between environmental uncertainty and the utilization of information systems. environmental uncertainty is also reported by ashill and jobber (2010) to influence the use of marketing information systems, while ibadin and imoisili (2010) provide evidence on the relationship between environmental uncertainty and the design of management accounting system. in addition, a study of jusoh (2010) reveals that the level of environmental uncertainty is considerably related to the use of financial and internal performance measures. grounded on the above arguments we suggest that environmental uncertainty determines the adoption of management accounting system (proposition2 or p2). soltani (2005) in his research of “factors affecting corporate governance and audit committees in selected countries” discusses the effects of factors on the effectiveness of corporate governance and the audit committee. he proposes that environmental factors have relationship with the current corporate governance. heinrich et al. (2007) suggest four environmental variables namely (1) pressure from majority shareholders, (2) pressure from outside minority shareholders, (3) pressure from internationalization/ globalization and (4) pressure from the state legal regulation are likely to influence corporate governance. furthermore, a study of altunoglu (2012) reveals that environmental variables put influence on corporate governance practices. when business environments considerably fluctuate, firms’ boards try to build good corporate governance to cope with environmental uncertainty. hence, we offer a suggestion that environmental uncertainty affects corporate governance (proposition3 or p3). firm characteristics are asserted by haldma and lääts (2002) as the determinants of the use of the control system. al-omiri and drury (2007) determine that the level of accounting system sophistication will differ significantly across firm characteristics. following them, abdel-kader and luther (2008) reveal that firm characteristics impact on the use of management accounting practices. furthermore, firm attributes are suggested by masrek (2009) as variables explaining the utilization of information systems in business. these arguments are consistent with the contingency theory of management accounting which implies that companies with different characteristics may choose and use the most appropriate management accounting systems to their firm characteristics. therefore, it is supposed that firm characteristics have an impact on the adoption of management accounting system (proposition4 or p4). demsetz and lehn (1985) find evidence that firm characteristics significantly explain the variation in ownership structure as a corporate governance variable. similarly, firm-specific factors are indicated by soltani (2005) to affect firms’ current corporate governance. further, the research on effects of factors on corporate governance practices by altunoglu (2012) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 223 implicates that organizational factors are drivers of corporate governance practices. hence we hypothesize that firm characteristics determines corporate governance (proposition5 or p5). figure 1. research model the above-discussed hypotheses and propositions enable us to build a research model given in figure 1 stating that while corporate governance structure is related to firm performance, it is affected by the adoption level of management accounting systems in business, which in turn also leads to better firm performance. furthermore, corporate governance structure is stated to play both the mediating and moderating roles in the link between the adoption level of management accounting systems in business and firm performance. in addition, environmental uncertainty and firm characteristics also affect corporate governance structure as well as the adoption level of management accounting systems. 3. research methodology this research used a population of the publicly listed firms in the two vietnamese stock exchanges, which was totally consisted of 705 firms (397 in ha noi stock exchange and 308 in ho chi minh stock exchange). before collecting the data for the research analyses, we conducted a pilot test for variable measurements with 20 managers involved in management accounting to ensure that our variable measurements are valid and appropriate for the study (donna et al. 2011). in addition to information available in their statements and reports, we sent the initial emails to solicit responses from main informants with experience in management accounting. then, we conducted the questionnaire with a relevant manager for each targeted firm. the questionnaires were delivered to 475 firms by email and face-to-face interviewed with managers in the 230 others. having gathered the responses, we removed those without necessarily sufficient information. our final sample consists of the 331 responses with adequately required information. the data was collected, based on the measurements of the variables as described as follows. corporate governance structure (cgs) is referred to as the majority of outside directors (cgs1) and outside supervisors (cgs2) that are coded as 1 if the proportion of outside directors/supervisors is more than 50% and otherwise as 0, as well as the leadership separation of chairman and ceo (cgs3) that is coded as 0.combined leadership or 1.separate leadership (brown and caylor 2004; asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 224 edwards and clough 2005; kyereboah-coleman 2007; bhagat and bolton 2008). adoption of management accounting systems (mas) is evaluated by using a five-point scale. the measurement ranges from 1.never considering, 2.decided not to introduce, 3.favored to introduce, 4.intended to introduce, to 5.under implementation of mas, adapted from cinquini et al. (2008). the six dimensions that are traditional budgeting (mas1), cost volume profit analysis (mas2), variance analysis (mas3), activity based costing (mas4), total quality management (mas5) and balanced scorecard (mas6), are employed for the factor “mas”. these six dimensions are suggested by the prior studies (lucas 1997; hyvonen 2005; al-omiri and drury 2007). firm performance (fpf) is based on both financial performance and non-financial performance. for the financial performance proxy, we use the two items that are return on assetfpf1 and return on equityfpf2, which are modified from droge et al. (2003). for the non-financial performance proxy, we employ the three items, namely innovativenessfpf3, quality in products or servicesfpf4, and customer satisfactionfpf5, which are adapted from hudson et al. (2001), and kaplan and norton (2007). the items are assessed by using a five-point scale from no growth, a little growth, average growth, fast growth to very fast growth. the items of our sample firms’ performance were compared to the industry average over the last year. furthermore, we also offer the measurements for the other two variables environmental uncertainty and firm characteristics. environmental uncertainty (eun) encompasses the five items; namely government policies (eun1), economy (eun2), resources and services used by the company (eun3), product market and demand (eun4) and competition (eun5); accepted from miller (1993), werner et al. (1996), and brouthers et al. (2002). these items are measured with a five-point scale ranging from 1.always predicted; 2.easily predicted; 3.a little difficult to be predicted; 4.quite difficult to be predicted; and 5.very difficult to be predicted, adapted from chenhall and morris (1986) and jusoh (2010). firm characteristics (chf) is constituted by the three variables which are firm size, firm type and firm interdependence. firm size (chf1) is measured with three states: 1.small if the total capital is less than vnd 10 billion for service sector or less than vnd 20 billion for other sectors, 2.medium if it is from vnd 10 billion to under vnd 50 billion for service sector or from vnd 20 billion to under vnd 100 billion for other sectors, and 3.large for the others, modified from nguyen (2009). firm type (chf2) is measured with a three-point scale that includes three levels with 1.manufacturing sector, 2.manufacturing-service sector and 3.service sector, modified from taha et al. (2011) and brouthers et al. (2002). firm interdependence or the relationship between sub-units within the company (chf3) is measured with a three-point scale that includes three descriptions of intra-unit work flow integration: 1.pooled interdependence, 2.sequential interdependence, and 3.reciprocal interdependence, adapted from chenhall and morris (1986), and ibadin and imoisili (2010). after obtaining the data, we employ the reliability and confirmatory factor analyses to determine the validity and reliability of the scales. the correlations among the variables are then calculated to test whether the problem of multicollinearity exists in our data. next, we carry out regression analyses and the directed acyclic graph model to investigate the causal relationships. then, we apply the procedure suggested by sobel (1982) to test the statistical significance for the intermediate role of corporate governance structure in the effects of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 225 adopting management accounting systems in business on firm performance. finally, we will employ the interaction variable analysis to examine the moderating role of corporate governance structure in the relationship between the adoption of management accounting systems and firm performance. 4. empirical results to examine the properties of measurement scales and the items making up the scales, we carry out the reliability analysis, which is a technique calculating a number of commonly used measures of scale reliability and offering information on the correlations between separate items in the scale. the item-total correlation of ‘mas6balanced scorecard’ is 0.336 (untabulated) smaller than 0.5, the preferable level suggested by nunnally (1978), hence this item is taken away from our data. eventually, the 21 other items (of the 3 main variables: 3 items for cgs, 5 items for mas, 5 items for fpf, 5 items for eun and 3 items for chf) obtain the good outcomes for the reliability, which is shown in table 1. table 1. outcomes from reliability analysis table 1 reveals that all the 21 remaining items take their own item-total correlations larger than 0.5. the variable “the majority of outside directorscgs1” and “the majority of outside supervisorscgs2” receive the lowest item-total correlation of 0.583; whereas the variable “activity based costingmas4” achieves the highest value of 0.771. all of them pass the 0.5 limit suggested by nunnally (1978). in addition, all the cronbach’s alphas exceed the smallest level of 0.7, stipulated by nunnally (1978). accordingly, they are reasonably retained for next analyses. next, we would like to test whether the measures of a factor are consistent with the theoretical notions implied from previous analytic research by performing the confirmatory asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 226 factor analysis. the purpose of confirmatory factor analysis is to test if the data fits a hypothesized measurement model. if the fit is poor, it can be because of some items measuring multiple factors or/and some items within a factor are more correlated to each other than to others; as a result, the model will be rejected or/and necessarily reconsidered. the confirmatory factor analysis yields the results exhibited in tables 2, 3 and 4. table 2. indicators for goodness of fit the first criterion to assess the hypothesized measurement model is the goodness of fit to the model. the indicators for evaluating the goodness of fit are provided in table 2. χ2/df of 2.443 belongs to the range of 2 – 3, the preferable limit proposed by koufaris and hampton-sosa (2002). all the indicators ifi, tli, and cfi exceed 0.9, passing the smallest level suggested by hair et al. (2009). rmsea (root mean square error of approximation) obtains the value of 0.066 smaller than the 0.08 level offered by hair et al. (2009). overall, those indices imply that our hypothesized measurement model satisfies the goodness of fit to the data. factor loadings, average variance extracted (ave) and construct reliability (cr) are specifically considered in order to evaluate convergent validity, in which ave = ∑ n and cr = ∑∑ ∑ ; where: li denotes the standardized factor loading of item i, n represents the number of items, and e is the error variance. as can seen in table 3, all the factor loadings directly obtained from the confirmatory factor analysis are above 0.5 as the acceptable limit recommended by hair et al. (2009), in which the correlation of fpf2 to fpf is the lowest at 0.651, while the factor loading of mas4 to mas is the highest at 0.834. additionally, except for the correlations (fpf1 to fpf, mas1 to mas, cgs1 to cgs, eun1 to eun and chf1 to chf) having not obtained pvalue, because they are constrained to 1, all the other factor loadings are statistically significant at the 0.01 level. in addition, having aves bigger than 0.507 and crs more than 0.791 (as shown in table 4) has statistically satisfied the smallest levels of 0.5 and 0.6 suggested by hair et al. (2009). these results suggest adequate convergent validity for our measurement model. table 4 also indicates that all the average variance extracted estimates (ave) are larger than the corresponding squared inter-construct correlation estimates (sic), which implies that our measurement model satisfies discriminant validity (hair et al. 2009). furthermore, the interconstruct correlations (ic) are all below 0.8, the largest level stipulated by kennedy (1992), which suggests that the problem of multicollinearity does not occur for our model. the above findings reveal that the retained variables in our model are adequately reliable for further analyses. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 227 table 3. factor loadings table 4. matrix of ave, cr, ic and sis the causal relationships in our research are explored with regression analyses that generate the results presented in table 5. it is shown that the adoption of management accounting systems will support corporate governance structure at the 0.01 significance level. the variable the adoption of management accounting systems accounts for 19.6% of the variation in corporate governance structure. the results also indicate that good corporate governance structure will result in improved performance for the firm. the statistical evidence on the relationship between the adoption of management accounting systems and firm performance is statistically supported by our findings at the 0.01 significance level. in addition, adopting management accounting systems in business is also found out to improve firm performance at the significance level of 0.01, in which the adoption of management accounting systems by itself explains 29.9% of variance in firm performance. however, the explanation increases to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 228 39.3%, when corporate governance structure is entered into the model together with the adoption of management accounting systems to consider firm performance. the inclusion of corporate governance structure will reduce the effect of adopting management accounting systems on firm performance from 0.455 down to 0.329. furthermore, environmental uncertainty and firm characteristics statistically affect corporate governance structure at the 0.01 significance level. they together with the adoption of management accounting systems in business jointly explain 26.7% of variation in corporate governance structure. overall, our hypotheses h1, h2 and h3 as well as propositions p3 and p5 are statistically supported, which is consistent with previous research that adopting management accounting systems in business will improve firm performance as well as lead to better corporate governance structure, which in turn also brings about improved performance for the firm. corporate governance structure is also driven by external and internal factors such as environmental uncertainty and firm characteristics. table 5. regression results furthermore, to assess the robustness of the results obtained from the regression analyses, we carry out the directed acyclic graph (dag) model to explore the causal relationships among corporate governance structure, the adoption of management accounting systems and firm performance with the control variables “environmental uncertainty” and “firm characteristics”. the software tetrad iv, which is one of the remarkable programs for evaluating causal models, is applied to undertake the dag analysis. the dag model, which can be employed to differentiate actual cause from spurious cause in a set of data, clearly distinguishes direct cause from indirect cause (wang 2010). the results obtained from the dag analysis are presented in figure 2 and table 6. the outcomes of figure 2 and table 6 reveal that adopting management accounting systems in business will enhance corporate governance structure as well as improve firm performance with the coefficients of 0.140 and 0.329 at the 0.01 significance level respectively; whereas good corporate governance structure results in better firm performance with the coefficient of 0.544 at the 0.01 significance level. in addition, environmental uncertainty and firm characteristics are discovered to influence both the adoption of management accounting systems and corporate governance structure at the 0.01 significance level. the findings from the dag analysis are consistent with those from the regression analyses, in which our hypotheses h1, h2 and h3 as well as propositions p3 and p5 are statistically supported at the significance level of 0.01. consequently, the resultswhich statistically support our hypotheses h1, h2 and h3 that corporate governance structure is a determinant of firm performance, but is boosted by the adoption of management accounting asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 229 systems in business, which is in turn also a causality of firm performanceare robust across both the procedures (regression and dag analyses). additionally, propositions p2 and p4 are also statistically supported at the 0.01 level of significance, in which environmental uncertainty and firm characteristics are the drivers leading to the adoption of management accounting systems. figure 2. research model table 6. results from the dag analysis next, the mediating role of corporate governance structure in the effect of adopting management accounting systems on firm performance is examined with a method produced by sobel (1982), which utilizes a t-test to investigate the statistical significance for the indirect effect of the mediating variable by testing the null hypothesis that there is no the indirect impact of the mediating variable on the relationship between the independent variable and the dependent variable, in which t-statistics is a ratio of the indirect coefficient to its standard error ( = ). table 5 implies that the addition of corporate governance structure in the relationship between the adoption of management accounting systems and firm performance asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 230 will lessen the effect of adopting management accounting systems on firm performance from 0.455 to 0.329 at the 0.01 significance level; hence we can suggest that corporate governance structure may play a mediating role in the influence of adopting management accounting systems on firm performance. also based on table 5, sobel’s procedure yields the results given in table 7. the finding offers statistical evidence on the mediating effect of corporate governance structure. the association between the adoption of management accounting systems and firm performance is intervened in by corporate governance structure at the 0.01 significance level with t-statistics of 5.587. accordingly, our hypothesis h4 is statistically supported. when included in the linkage between the adoption of management accounting systems and firm performance, corporate governance structure will diminish this relationship. table 7. results for testing the mediating effect to explore “our proposition1” that corporate governance structure may moderate the effect of adopting management accounting systems in business on firm performance, we use the interactive component “cgs*mas” and test whether it affects firm performance (fpf). the results are provided in table 8. the results illustrate that the factor “cgs*mas” statistically impacts on firm performance at the 0.01 significance level with the coefficient of 0.125. the component “cgs*mas” and the variable “the adoption of management accounting systems mas” explain 38.4% of the variation in firm performance. the findings implies that an improvement in corporate governance structure by 1 unit will increase the influence of adopting management accounting systems in business against firm performance by 0.125 unit. consequently, corporate governance structure is statistically evidenced to moderate the linkage between the adoption of management accounting systems in business and firm performance. rather, better corporate governance structure in a firm will boost the relationship between the adoption of management accounting systems and firm performance. table 8. results for testing the moderating effect in summary, the findings reveal that the adoption of management accounting systems in business will enhance corporate governance structure that in turn leads to improved firm performance. a higher adoption level of management accounting systems also results in more improved firm performance. more importantly, corporate governance structure is statistcially evidenced as both a mediator and a moderator in the relationship between the adoption of management accounting systems and firm performance. these findings are consistent with the previous research as above discussed. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 231 5. conclusions prior studies have investigated the causal relationships among corporate governance structure, the adoption of management accounting systems and firm performance. however, none of them have discussed and explored the mediating and moderating roles of corporate governance structure in the association between the adoption of management accounting systems and firm performance, although corporate governance structure plays an important role in the linkage between the adoption of management accounting systems and firm performance by mediating and moderating mechanisms. this study discusses and examines the mediating and moderating role that corporate governance structure takes in affecting the relationship between the adoption of management accounting systems in business and firm performance. it also re-specifies the causal links among corporate governance structure, the adoption of management accounting systems and firm performance. furthermore, this research takes into account the two controlling variables “environmental uncertainty” and “firm characteristics” when investigating the causal relationships among corporate governance structure, the adoption of management accounting systems and firm performance, and consequently our findings are more reliable. the regression analyses offer statistical evidence on the causal relationships. while the adoption of management accounting systems determines corporate governance structure as well as firm performance, good corporate governance structure leads to improved firm performance. this research also performs the robustness test for the results obtained from the regression analyses by undertaking the dag analysis, which produces the similar results to those of the regression analyses, in which corporate governance structure is statistically evidenced as a causation of firm performance, but is affected by the adoption of management accounting systems that is also a cause of firm performance. the findings for the causal relationships are consistent and robust across both the regression analyses and the dag analysis. more importantly, this paper employs sobel’s procedure to investigate the mediating effect of corporate governance structure and the interaction factor “cgs*mas” to examine the moderating influence of corporate governance structure. the findings from these analyses reveal that corporate governance structure both mediates and moderates the causal relationship between the adoption of management accounting systems in business and firm performance. this paper makes some contributions to the literature by providing new statistical evidence on the mediating and moderating roles of corporate governance structure in the influence of adopting management accounting systems in business on firm performance. when investigating the factors related to firm performance including corporate governance structure and the adoption of management accounting systems, researchers should take the mediating and moderating role of corporate governance structure in the relationship between the adoption of management accounting systems and firm performance into account. this paper also offers business managers with better understanding of the complicated associations among corporate governance structure, the adoption of management accounting systems and firm performance. hence, they can make better decisions on the choice of management accounting systems that match with the corporate governance structure of their firm, which will help them to achieve competitive advantages as well as better firm performance. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 232 although, we make some valuable contributions to the literature as well as to the practice, this research still suffers some limitations. the first limitation is that our data is based on one single informant from each firm; consequently there may be a problem of response bias. future research should employ a multi-informant research design to overcome this potential selection bias. another limitation is that this research is conducted in vietnam as a southeast asian country, but our findings are expected for use in other countries. business environments among economies may be different, therefore one should generalize our findings with care. moreover, in addition to the two factors affecting corporate governance structure and adoption of management accounting systems that are environmental uncertainty and firm characteristics, which has been above mentioned; corporate governance structure and adoption of management accounting systems may be driven by other factors such as firm structure or firm culture. future studies can include these factors into the research model in order to examine the relationships discussed in this research. hence, the 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(2010). usefulness of management accounting systems information and market competition on strategic business unit output. jurnal bisnis dan akuntansi, 12(3), 145-160 microsoft word 5505-19833-1sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 19 the impact of credit rating, ownership and relationships on loan spreads-taiwan’s evidence cheng-li huang department of accounting tamkang university, taiwan tel: (886-2)-26-215-656 ext: 3368 e-mail: chengli@mail.tku.edu.tw bih-yun kuo department of accounting shih chien university, tamkang university, taiwan tel: (886-2)-25-381-111 ext: 8215 e-mail: tatskuo@mail.usc.edu.tw received: april 20, 2014 accepted: july 30, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5505 url: http://dx.doi.org/10.5296/ajfa.v6i2.5505 abstract using panel data from taiwan, this paper performed empirical test to explore how the credit status and relationship have impacted loan spreads. our findings are as follows : (1) private financial holding companies and private non-financial holding companies grant loan spreads that are significantly lower than those of state-owned banks. foreign banks grant loan spreads that are significantly higher than those of state-owned banks, and only foreign bank loan spreads are significantly higher than those of state-owned banks when borrowers are considered to be high risk. (2) banks reduce their loan spreads only for high credit risk borrowers with obvious improvements in credit ratings, but this does not apply to general borrowers even when the credit rating condition is improved. furthermore, creditor banks unreasonably increase their loan spreads, when the borrowing companies have their credit ratings upgraded. (3) empirical findings show that the biggest and main creditor banks exhibit significantly lower loan spreads, and were also willing to give high credit risk customers lower lending spreads, which imply that taiwan’s banks emphasis “banking relationship” while lending. (4) however, robust test over the past decade shows that the banks will raise the lending spreads while the borrower’s risk increasing and reduce the lending spreads while the borrower’s credit rating upgraded. keywords: credit rating, banking relationships, ownerships, lending performance, loan spreads asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 20 1. introduction at the end of 2006, the basel committee on banking supervision of the bank of international settlements started to require all international banks, to calculate the capital to risk (weighted) assets ratio or the capital adequacy ratio through the use of a standardized approach as well as an internal ratings-based approach, so that the borrower’s credit rating is incorporated into the determination of the risk weights of loan assets. since businesses with lower credit ratings have higher risk weights, a larger provision for self-capital is required, which results in not only the higher credit risk, but also a higher cost of capital. therefore, banks place emphasis on the clients’ credit status in terms of high or low, as well as an upgrade or downgrade of the credit rating. if a bank faces a loan applicant with a poor, downgraded credit rating or a renewal contract with a worse credit condition beyond the credit threshold, it can consider whether to increase the loan spread1 before rejecting or accepting the application. over the past decade, taiwan’s financial system has encountered the following significant changes: the approval of 15 new banks, through the pronouncement or amendment of the six financial laws2 and private placement system to facilitate the first and second financial reforms. the first financial reform promoted the “258” policy3, which caused many banks to recognize more than 50 billion in bad debt losses4 due to the failure of corporate finance. during the second financial reform, there was a major credit card crisis, and many banks experienced the failure of retail finance to recognize the huge credit card losses5. the continuous negative impacts on the market not only affected bank profitability, but also increased the liquidity risk, thereby further affecting the credit capacity. in addition, over-banking and idle cash have existed in taiwan’s banking market for a long time. as to whether lending attitudes or the methods resulting in the losses mentioned earlier can effectively reduce the bank’s credit risk and increase the interest revenue, or whether, due to the dramatic competitive environment, moral hazard and adverse selections will emerge, are all concerns of the financial authorities and the public at large. as mentioned above, taiwan’s lending market is highly competitive, and to prudently select clients and achieve the goal of a successful lending business in such a financial environment is the greatest concern of all banks. in order to clarify whether the banks in taiwan possess great lending ability, we have designed our research as follows. according to whether banks have written off huge amounts of bad debts (wobd hereafter) or experienced heavily credit card debt losses (hccl hereafter), we choose their clients as experimental (wobd and hccl have occurred) and the control sample (wobd and hccl have not occurred), respectively6 this is in order to understand how banks with different performances deal with clients with high or low credit ratings as well as upgraded or downgraded credit ratings. we define banks with wobd or hccl as having low performance and those with the opposite as having high performance. in general, creditor banks have more clients with better credit ratings, result in lower loan spreads on average. on the other hand, creditor banks have more clients with worse credit ratings, result in higher loan spreads on average. we can only speculate that individual banks respond to different loan application cases differently, but we cannot directly conclude that the lending behavior gives rise to serious problems of “moral asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 21 hazard and adverse selection.” so as not to distort the inferences of the empirical results, we add the dimension of the banking relationship to further observe whether the loan spreads applied to sample banks are reasonable and valid7. a financial environment characterized by over-banking and too much idle cash in taiwan’s banking market results in companies often maintaining multiple relationships and more so than in other countries (berger et al., 2008). the empirical findings of kuo and chen (2012) indicate that publicly-held companies in taiwan deal with 2.86 banks on average, with the utilization rate of the credit availability and collateral loans ratio being 69% (median) and 36% (mean), respectively. although the utilization rate of the credit availability is less than 70% and more than half of the loans are unsecured by nature, the credit indicators still exhibit high credit risk. however the financial environment is favorable to borrowers, and so these firms, regardless of their credit status and banking relationships, still have opportunities to obtain loans at bargain prices from banks. would such circumstances, however, change in cases where there is different ownership and lending performance? it is worth examining this issue more deeply8. micro and small enterprises in taiwan seldom publicly announce information about credit ratings or upgrades or downgrades. enterprises belonging to this category frequently deal with the biggest creditor bank and rarely deal with the main banks or non-main banks9. due to considerations of representativeness, we exclude samples of micro and small enterprises, and only listed, otc and emerging companies are included. another consideration concerns the failure of corporate and retail finance during the period under study. as to corporate finance, we divide the samples into firms borrowing from banks with or without wobd. as for retail finance, we divide the samples into firms borrowing from banks with or without hccl10. if a bank belongs to wobd or hccl, we regard it as bank with poor lending performance and high credit risk. if banks suffer the failure of both corporate and retail finance, it might be reasonable to suggest that abnormal11 lending behavior may exist. in order to avoid confusion in empirical analysis (the samples are only affected by wobd or hccl individually or are affected by both wobd and hccl simultaneously), we deliberately conduct empirical tests according to each event, respectively12. furthermore, we also simply divide the banks into those with or without wobd and hccl to distinguish between the banks with low risk and better lending performance and the banks with high risk and poor lending performance. our empirical results indicate that private financial holding companies and private non-financial holding companies grant loan spreads that are significantly lower than those of state-owned banks. foreign banks grant loan spreads that are significantly higher than those of state-owned banks, and only foreign bank loan spreads are significantly higher than those of state-owned banks when borrowers are considered to be high risk. banks reduce their loan spreads only for high credit risk borrowers with obvious improvements in credit ratings, but this does not apply to general borrowers even when the credit rating condition is improved. we also find that the biggest and main creditor banks exhibit significantly lower loan spreads, and willing to give high credit risk customers lower lending spreads, which imply that taiwan’s banks emphasis “banking relationship” while lending. the rest of our paper is organized as follows: in section 2, we introduce literatures and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 22 hypotheses. the data sources and model development are explained in section 3. in section 4, we show and analyze the empirical results. finally, the conclusions are drawn. 2. literature and hypotheses after allowing for the establishment of new banks, the taiwanese banking market has often been criticized for its small scale and over-banking. these shortcomings make banks suffer dramatically from price competition in lending business. therefore, if one wants to check whether the loan spreads are reasonable, one should be concerned with both the credit system and competitive environment. the credit system is often set in accordance with the principle of the five-p’s: people (who borrow), purpose (for what), payment (resource to payoff), protection (the safety of the lending asset) and prospect (the profitability of the fund). according to these indexes, banks set their own credit system and credit regulation for their credit officers to follow their policy and write credit reports to describe each client’s credit state and relationships for determining the approval or rejection of the loan application. since the financial environment is changeable, banks should consider their own situation in light of market realities in order to set a reasonable loan spread. we refer to the prior literature related to our study in three parts. first, we introduce banking relationships between banks and clients, and then discuss how the credit risk of banks and clients impacts the loan decision. finally, we discuss the impact of the ownership type on lending business. 2.1 banking relationships three methods are used to measure the borrower-lender relationships. first, we focus on single or multiple relationships, where the borrower chooses to deal with at least one bank (domestic or foreign bank). the research point concerns the factors impacting the behavior of choosing a single or multiple relationships. second, we focus on the number and duration of the relationship banks. if the borrower deals with many banks which display a preference for multiple relationships, the longer duration signals the better the borrower-lender relationships. third, we measure the relationships with loan spreads and credit availability. the lower the loan spread and the more credit availability is a sign of better borrower-lender relationships. our research focuses on how the borrower deals with banks with different ownership and lending performance, and is related to the first and the third13 methods. banking relationships are influenced by bank size. large banks with excellent technological ability and better management systems specialize in using “hard information” to make standardized loans, while small banks specialize in using “soft information” and developing relationships to make non-standardized loans14 (stein, 2002; carter david a. et al. 2005). the credit officers of small banks prefer making the most of vital information which they obtain from the closer relationships, and the soft information is often regarded as a critical instrument in comprehending the detailed information of the borrowers. with respect to a single relationship, when the borrower experiences an unfavorable outcome, the bank will immediately tighten the credit availability to reduce the lending scale or increase the interest rate and will dominate all situations in response to the advantage of its monopolistic position. even if the borrower is in a normal situation, the relationship bank will still charge a higher interest rate (berger-udell, 2002). cole et al. (2004) indicated that large banks will lay asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 23 emphasis on the financial ratios of the borrower and will ignore the opaque firms that are small size in terms of assets while lending. sharpe (1990) indicated that a borrower with good credit quality can use its operating advantage to improve the debt capacity and obtain a lower loan spread. this is so, provided that, in the case of long-term debt, the borrower is unwilling to pay an interest rate that is higher than that in the same industry. peterson-rajan (1995) suggested that as the relationship bank has the market power (private financial holding bank in this study), when the borrower faces a difficult time accompanied by low credit quality, the relationship bank still can provide what the borrower needs to reflect its excellent ability for assuming credit risk. however, the conclusions regarding the impact of the extension of credit availability and market power on banking relationships are still inconsistent (i.e., the concentration risk of the financial industry and the establishment and banishment of the entrance barrier). peterson-rajan (1995) and cetorelli-gambera (2001) found that when banks increase their market power, they will increase the credit availability for the relationship borrower. however, the findings of black-strahan (2002) and berger et al. (2004) present opposite conclusions. boot-thakor (1994) and petersen-rajan (1995) concluded that the duration and numbers of borrower-lender relationships or business types and whether the creditor bank is the biggest or main bank are the ideal index of banking relationships. the closer relationships result in lower loan spreads and less requirements regarding collateral. greenbaum et al. (1989), sharpe (1990) and rajan (1992) found that banks with better borrower-lender relationships by contrast more strictly claimed the contract content. however, elsas-krahnen (1998), harhoff-korting (1998) and machauer-weber (2000) pointed out that banking relationships had nothing to do with the contract content. djankov et al. (2005) found that the new arrangement of financing contracts between the main creditor banks and borrowers increased the borrower’s stock price and generated cumulated abnormal returns (car) that were significantly larger than 0. 2.2 how does the credit risk of borrower and lender affect lending decisions? prior research claimed that the loan spreads mainly reflect the bank’s cost of capital and the credit risk of the borrowers. santos-winton (2008) found that companies only borrow from banks if they can afford higher borrowing rates than companies borrowing from banks and issuing bonds simultaneously. if the above two types of financing occurred during the recession period, the loan spreads will become more apparent, and the former will even encounter the embarrassment of a hold-up. gorton-kahn (1996) found that banks sometimes give borrowers with poor operating conditions relatively low borrowing rates, the intention being to prevent borrowers with bad credit from bearing high financing costs and accelerating their bankruptcy. in addition to cost of capital and the credit risk of the borrowers, some scholars indicated that factors impacting the loan spread include banking relationship but the empirical results are inconsistent. berger-udell (1995) indicated that the better the banking relationships, the lower the loan spread. elsas-krahnen (1998) and machauer-weber (2000) found banking relationships had nothing to do with loan spreads. degryse-cayseele (2000) reached the opposite conclusion whereby the better the banking relationships are, the higher the loan rate. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 24 since the basel committee promoted the risk management system recently, attention has been drawn to the factors impacting the loan spread, including the borrower’s credit quality, risk level, as well as the financial position of the creditor banks. hubbard et al (2002) found that banks with worse financial substance15 often charge borrowers a higher loan rate. by being sensitive to the worse financial position of the relationship banks, the borrowers always keep sufficient working capital to avoid the lack of investment funds. coleman et al. (2002)’s empirical findings indicated that banks with higher operating risk16 charged higher loan rates and offered relatively short-term debt to their borrowers. on the other hand, banks with excellent capital management ability would like to provide long-term debt with a higher loan rate. with regard to competition and market power, boot-thakor (2000) found that banks would maintain a free-rider mentality in order to reduce their huge investment in the monitoring technology and lessen their expenses for supervision which are consistent with the findings of broecker (1990) and sharp (1990): the more competitive the banking industry, the worse the quality of the loan portfolio. 2.3 the impact of bank ownership types on lending business berger et al. (2008) used data from india to verify the impact of bank ownership types on lending businesses, while other studies seemed to focus on the comparison of lending performance. deyoung-nolle (1996) and berger et al. (2000) found that the performance of foreign banks was worse than that of local private banks in developed countries. if data for developing countries are used instead, the efficiency value (bonin et al., 2005) and competitiveness (claessens-laeven, 2004) of foreign banks were higher than local banks. claessens et al. (2001) indicated that the more foreign banks there are in korea, the worse the profitability and net interest margin vis-à-vis local banks. when the analysis is extended to compare whether banks could sufficiently provide or make available the amount that the borrowers need, the empirical results are inconsistent. detragianche et al. (2006) indicated that foreign banks adopted a conservative attitude with respect to the financing demands of the borrowers, especially for those enterprises with worse disclosure regarding their financial information. esty (2004) used countries with sound regulations and laws and creditor interests with more concentrations and smaller shareholding percentages from the government to conduct research, and the results showed that foreign banks provided higher financing amounts and availability in such countries. mian (2006) pointed out that foreign banks which set up branches in countries with similar cultures and shorter geographical distances with the parent company would be most able to provide capital to local companies. peria-mody (2004) used the latin american financial market to explore the differences in entering a new market between setting up branches and merging with local banks, and the empirical results indicated that the loan spreads in the former were lower than those in the latter. the findings for giannetti-onegena (2009) indicated that big firms and foreign businesses intended to deal with foreign banks. small firms preferred having relationships with local private banks. the new customers were not all big enterprises and foreign businesses. de la torre et al. (2008) found that more large banks and foreign banks use “credit scoring criteria” to evaluate the opaque smes. although the scales of foreign banks are very small in the host country, with the support of the multinational parent company they asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 25 still conduct the lending business of large institutions. in the prior literature, we found that the performance of the state-owned banks in developing countries was worse with low efficiency values and high non-performing loan ratios. state-owned banks with high market shares had three negative characteristics: the credit availability provided to borrowers is not sufficient, the lending role is weakened gradually in the process of financial development, and lending plays an supplementary role in retarding economic growth (la porta et al. (2002), barth et al. (2004), beck et al. (2004)). sometimes, state-owned banks that are required to grant credit or offer subsidies to borrowers with poor physical substance for political reasons, completely ignore the borrowers’ credit quality (cole 2004) or lend most of the funds to large enterprises only, and completely neglect the financial needs of the smes (francisco-kumar, 2004). the founding objective of the state-owned banks may result in lower efficiency and higher non-performing loan ratios, especially in terms of offering subsidies to the loan applicant with negative net present value or providing lower interest rates to the enterprises experiencing financial difficulty. sometimes, state-owned banks are criticized for their poor governance mechanism and improper management, and not for lack of policy fairness and justice. 2.4 hypotheses development prior studies focus on how the ownership, scale and relationships impact the banking relationship. to our knowledge, there are few studies investigating the impact of loan spreads through the lending performance and credit risk of the banks. according to the reports of newspapers and magazines, most of the banks with wobd are domestic and featured by their large size. banks with hccl include both large and small banks and many are newly-established banks. concerning the hypotheses of loan spreads we take “careless lenders and bad borrowers” (shen and wang, 2002) and “the top one and non-top one financing bank–viewpoints of lending behavior,” (chen and lai, 2003) for reference. we also refer to the five relationships motivation theory17 and the governance mechanism presented by berger et al. (2008) as a basis to conclude how the related factors impact loan spreads. here we describe the four research hypotheses as follows: hypothesis 1: from the perspective of lending performance, banks with “wobd” or “hccl” will require higher loan spreads; when facing borrowing enterprises with poor credit rating and high credit risk, the intention will be stronger. according to the empirical findings of hubbard et al. (2002) and coleman et al. (2002), the worse the financial substance of the banks, the higher the interest rate they will charge the borrowers. therefore, in measuring the lending performance by the features of “wobd” or “hccl”, we predict that banks with higher credit risk and poor performance will charge higher loan spreads to reflect the higher cost of capital. as for borrowers with bad credit quality, banks will charge higher loan spreads to reflect the higher risk they are assuming. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 26 hypothesis 2: different ownership type banks will require different loan spreads. however, when facing borrowing firms with high credit risk, all banks will require higher loan spreads regardless of the ownership type. prior research lays emphasis on a comparison of the overall operating performance of different ownership types of banks, ignoring the item of loan spreads. for example, the performance of foreign banks in developed countries is not as good as that of local private banks, for foreign banks in developing countries have higher efficiency values and competitiveness than banks in the host countries. some scholars claim that a study of the loan spreads should take the factors of information asymmetry, credit records, collateral, and credit availability into consideration (chaplinsky-haushalter (2010)). therefore, in addition to observing ownership types, we also consider the interaction of ownership and credit risk to further observe how different ownership banks respond to loan spreads about different credit risk firms. hypothesis 3: as closer relationships exist between banks and firms, banks are willing to give borrowers lower loan spreads, and even the borrowers that have high credit risk banks are still able to obtain them. in accordance with securities and financial regulations and the review system, the highest credit review and decision unit is the bank’s board of directors, it has the greatest authority to determine the loan rate, credit availability and risk limit. to fairly express the top decision-makers’ determination, we divide the creditor bank into three kinds by the total borrowing amount or debt capacity of the enterprise, in terms of the largest, main or non-main creditor bank to describe their relationship level. however, the prior literature concerning the banking relationships and loan spreads gives rise to inconsistent conclusions. berger-udell (1995) stated that the closer the relationships, the lower the loan spreads; some scholars have argued that banking relationships do nothing about loan spreads. (elsas-krahnen, 1998; machauer-weber, 2000); degryse-cayseele (2000) indicated that the closer the relationships, the higher the loan spreads. overbanking causes the taiwan banking market to be competitive, and whether or not relationship lending is advantageous or disadvantageous for the borrower in such an environment is worth examining carefully. furthermore, we are also concerned with whether the loan spreads exhibit significant differences in terms of borrowers with different credit risks. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 27 hypothesis 4: banks are willing to grant lower loan spreads to firms with rising credit ratings and require higher loan spreads for borrowers with descending credit ratings. if the borrowing company belongs to the high risk group but has improved its credit rating in recent years, banks will normally charge lower loan spreads to reflect the improvement in the credit quality while renewing the loan agreement. according to the findings of tang (2009), a company with a rising credit rating generally receives lower loan spreads. based on the “risk add and subtract yard system” applied in practice, firms with worse credit ratings add more yards and receive higher borrowing spreads. if the credit rating of the borrowers is obviously ascending or descending during the past three years, in response to the regulation of review mechanism, the lending bank will undertake evaluating procedures every three or six months to adjust the rate for reflecting changes in credit quality. therefore, if companies with high credit risk upgrade their credit rating, the lending bank will lower loan spreads to reflect that the borrower’s credit quality had been improved. 3. data and methodology 3.1 data sources the main data sources are the long-term and short-term borrowings data18 of the publicly-held companies contained in the database of the taiwan economic journal together with the financial statements of these companies and financial data kept by relationship creditor banks. if part of the sample is missing any data, we will search for it from the market observation post system (mops) or banking website. for materiality considerations, observations in this study possess two characteristics: (1) the largest borrowing amount of the sample company in the current year; (2) the relationship creditor bank must be on the list of the top 20 creditor banks. according to the statistics, the average firms’ borrowing amount from the largest creditor banks is nt$765 million; from the second largest creditor banks it is nt$389 million on average; the median from the 20th is nt$100 million. as mentioned before, we aim to understand after the first and second financial reforms the impact of the wobd and hccl events, and how the banks have set their loan spreads in response to the borrowers’ credit state and banking relationship. therefore, our empirical periods purposely select the period 2006-200819, and include 513 listed companies, 404 otc companies, 133 emerging market companies and 160 companies that are publicly-held but not belonging to the former three. due to bank credit officers requiring the borrower to provide financial statements for the past three years as an important basis for credit ratings, therefore the corresponding empirical periods are 2003-2008 for borrowers. 3.2 variable definitions and model development with regard to the factors impacting the loan spreads, in addition to lending performance and credit risk (measured by with or without wobd and hccl), we include ownership types and relationship levels. among the influential factors which are relevant to the borrower’s asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 28 credit quality are the borrower’s credit rating (measured by the tcri figure) and the credit state (which focuses on the changes in the credit rating in terms of an upgrade or downgrade 3 years before the loan). we classify the control variables of the empirical model into two kinds: (1) those related to the scale (natural logarithm of total assets) of the creditor bank (the dimension symbol is the bank) and cost-to-revenue ratio (measured by operating expenses to the operating revenue ratio). (2) those related to the scale, debt ratio and profitability (measured by the pretax income to operating revenue ratio) of the borrower firms (the dimension symbol is the firm). to be consistent with practical convention, these variables are calculated by the arithmetic average of the past three years. after 2000, the passage of the six financial laws and private placement system led to the derivation of related innovations accompanied by mergers and reorganization, which resulted in significant changes in the substantial or controlling shareholders. in order to understand whether the loan spreads are affected, we adopt the method of xie (2008) divide the ownership (dimensions symbol ownership) into four types: state-owned, private financial holding, private non-financial holding and foreign banks, and denote it by the dummy variables of hold, non-hold and fore. in addition, we take the concept from chen & lai (2003) and divide the banking relationships (dimensions symbol relation_type) into three levels: the largest creditor banks, the main banks (loan amounts ranked no. 2 to no. 4) and non-main banks (loan amounts ranked no. 5 to no. 20), and denote it by the dummy variables of largest and main. we use the tcri system20 to evaluate the borrower's credit rating, which is developed by the taiwan economic journal (tej), regarding tcri< 4 as the low credit risk firms and tcri> 7 as the high credit risk firms. to effectively distinguish the level of credit risk, we delete tcri =5 and tcri =6. then we define the borrower’s credit state (dimensions symbol tcri_state) as being one of three kinds. if the sample company’s credit rating 3 years before the loan application appears to be rising in 2 and above 2 years, we will regard it as the upgrade state. if the sample company’s credit rating 3 years before the loan application appears to be descending in 2 and above 2 years, we will regard it as the downgrade state. other sample companies are treated as being in the normal state. we use upgrade and downgrade to denote the credit state. since the relevant dimensions may affect loan spreads under different firms’ credit ratings, we therefore include the interaction of the main dimensions with the credit state in our examination. we summarize the definitions and measurement methods of all variables in table 1. for clarity we only display the basic model for loan spreads, and the related derived models are listed in the relevant columns of table 5-7. in equation (1), the i, j and t denote bank i, firm j and year t respectively, and the other variables are defined in table 1. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 29 table 1. summary of variables dependent variables dimensions variable name variable symbol variable definition loan spreads to firms loan spreads r loan spreads of banks less the prime interest rate independent variables dimensions variable name variable symbol variable definition expected direction firms’ credit rating (symbol tcri) firm with low or high credit risk tcri dummy variable, among the previous three years, 2 and above 2 years credit rating tcri≧7, denote as tcri=1; among the previous three years, 2 and above 2 years credit rating tcri≦4 denote as tcri=0 ＋ lending performance of bank (symbol status) writing off bad debt or not bad_debt dummy variable, with or without writing off bad debt over 50 billion in recent 5 years with=1 without=0 ＋ bad_debt* tcri interaction of bad_debtit and tcrijt ＋ heavy credit card loss or not card_debt dummy variable, with or without heavy credit card loss with=1 without=0 ＋ card_debt* tcri interaction of card_debtit and tcrijt ＋ ownership type (symbol ownership) private financial holding bank hold dummy variable, private financial holding bank=1, otherwise=0 ＋/－ hold*tcri interaction of hold and tcri ＋/－ private non-financial holding bank non-hold dummy variable, private but not financial holding bank=1, otherwise=0 ＋/－ non-hold* tcri interaction item of non-hold and tcri ＋/－ foreign bank fore dummy variable, foreign bank=1, otherwise=0 ＋/－ fore *tcri interaction of fore and tcri ＋/－ relationships (symbol relation_type) the largest creditor bank largest dummy variable, denoting bank providing the largest amount loaned as largest=1 otherwise=0 － largest* tcri interaction of largest and tcri － asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 30 main bank main dummy variable, denoting bank providing the amount loaned ranking from 2 to 4 as main=1 otherwise=0 － main * tcri interaction of main and tcri － credit state of borrower (symbol tcri_state) ascending credit state upgrade dummy variable, we regard upgrade if among the previous three years, in 2 or more than 2 years the current year’s credit rating is lower than that in the preceding year. upgrade=1, otherwise=0. － upgrade* tcri interaction of upgrade and tcri － descending credit state downgrade dummy variable, we regard downgrade if among the previous three years, in 2 or more than 2 years the current year’s credit rating is higher than that in the preceding year. downgrade = 1, otherwise = 0. ＋ downgrade* tcri interaction of downgrade and tcri ＋ borrower's characteristics (symbol firm) firm’s scale size1 natural logarithm of total assets － debt ratio leverage total liabilities/total assets (%) ＋ profitability ratio ros pretax income / net operating revenue － characteristics of creditor bank (symbol bank) scale of bank size2 natural logarithm of total assets － cost to revenue ratio cost_income operating expense/net operating revenue (%) ＋ note: “+” and “-” indicate that the variable coefficients are expected to be positive and negative; “+/-” indicates that the direction of the variable coefficient is uncertain. 4. empirical analysis and results the empirical analysis procedures of this study are summarized in the following four parts. first, we use the t test and the nonparametric wilcoxon rank sum methods to verify whether the mean or median of the banks with or without “wobd” and “hccl”, banks with four different types of ownership, and companies with high or low credit risk exhibit significant statistical differences in their characteristics. then, we select publicly-held borrowing companies as empirical and control samples from banks with or without “wobd” to test the impact of clients’ credit status and relationships on loan spreads under the regression model. we divide our clients with banks with or without wobd as experimental samples and controlling samples and use the ordinary least squares empirical model to examine the factors impacting the loan spreads. the impacting factors include the financial attributes of banks and borrowing companies. in addition, we take the lending performance, ownership, banking relationship and the credit state (upgrade or downgrade) into consideration. as for asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 31 understanding whether the loan policy-making process is just, we use the tcri index to show the credit risk level21 of borrowing companies. moreover, in this study we also include the interaction items of different credit systems and lending behavior to further explore the factors impacting the loan spread. in the third section, we apply the same method as in the second section except that the sample bank groups are changed to banks with or without “hccl”. in the fourth section, we perform the robustness test by extending the empirical period to 2010 and discuss certain important variables in detail. 4.1 descriptive statistics as mentioned earlier, we shall determine the creditor banks first, then select the borrowing companies which are publicly-held from related banks as empirical and control samples. since our samples are from creditor banks and borrowing companies, therefore we introduce the summary statistics of each index individually. with regard to the samples of creditor banks, we discuss this by dividing the banks into those with and without “wobd”, with and without “hccl”, as well as four different types of ownership. as to the characteristics of the banks, we use six indexes, namely, those of total assets, the cost-to-revenue ratio, the return on assets, the return on equity, the pretax income ratio and the gross profit ratio. moreover, we divide the borrowing companies into high and low credit risk companies by the credit ratings of tcri and discussing the characteristics in terms of total assets, the pretax income ratio, debt ratio, tcri rating, loan rate and loan spreads. we use the t test and nonparametric methods to verify whether there exist significant differences among banks with or without “wobd” and “hccl” as well as among borrowing companies with high and low credit risk based on the mean and median for each index for the four different types of ownership22. table 2 shows the results of the 126 observations for creditor banks. during the empirical period there are 21 observations for 7 banks with “wobd”23 and 105 observations for 35 banks without “wobd”. furthermore, there are 21 observations from 7 banks with “hccl”24 and 105 observations from 35 banks without “hccl”, but for m&a reasons, therefore the final number of observations is 104. based on a comparison of banks with or without “wobd”, the mean and median of total assets in banks with “wobd” are nt$1,646 billion and nt$1,574 billion, respectively, which is significantly higher than nt$1223.1 billion and nt$1102.5 billion for banks without “wobd” at the 1% level. it is worth mentioning that although banks with “wobd” signal poor performance in the past five years, due to the advantages of their large scale, excellent human resources and adaptability, the operating performance of the subsequent three years are significant higher than banks without “wobd”. we show the detailed figures for the five indexes as follows: banks with “wobd” are obviously better than banks without “wobd”, the cost revenue ratio ranges from 27.21% to 34.52%, roa from 0.26% to 0.05%, roe from 4.82% to -1.74%, the pretax income ratio ranges from 11.00% to 0.38%, and the gross profit ratio from 34.07% to 28.09%. we stated that banks with “hccl” signal poor performance in retail finance. panel b in table 2 shows that banks with “hccl” are characterized by their smallness of the scale of their assets, poor performance (measured by their cost-to-revenue ratio) and profitability. the mean and median of the total assets of the banks with “hccl” (nt$957.6 billion and nt$857.3 billion) are significantly lower than for asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 32 banks without “hccl” (nt$1452.5 billion and nt$1589.7 billion). overall, the operating efficiency and profitability of banks with “hccl” are lower than for banks without “hccl”. this is displayed by the medians of the following five indexes: the cost-to-revenue ratio ranges from 31.29% to 25.74%, roa from 0.1% to 0.42%, roe from 1.68% to 7.79%, the pretax income ratio from 4.28% to 16.53% and the gross profit ratio from 34.48% to 35.63%. table 3 presents a comparison of the four different types of ownership for banks from the perspective of total assets, operating efficiency and profitability. the empirical results indicate that the total assets scale ratings are as follows: the state-owned banks (mean nt$2582.3 billion), private financial holding companies (mean nt$1355.0 billion), private non-financial holding companies (mean nt$439.0 billion) and foreign banks (mean nt$2872 billion). in terms of the cost revenue ratio displaying the operating efficiency, the worst is state-owned banks (median 52.57%) followed by foreign banks (median 38.22%), private non-financial holding companies (median 30.35%) and private financial holding companies, which have the best operating efficiency (median 25.74%). from the perspective of profitability, we find that state-owned and private holding banks are little different, the means of roa and roe range from 0.37% to 0.30% and 9.33% to 3.00%, respectively, and are significantly higher than for private non-financial holding banks and foreign banks for which the means range from -0.54% to -0.65% and -10.11% to -14.77%. table 4 summarizes the descriptive statistics of the borrowing companies’ characteristics, which include 36,024 observations from 2003 to 2008. distinguished by their credit risk, companies with tcri ≧ 7 are regarded as high credit risk companies, with a total of 16,187 observations, while tcri ≦ 4 are regarded as low credit risk companies, with a total 4,643 observations. from the observations we find that most publicly-held companies are with high credit risk, which is featured by the disadvantages in terms of the small scale of assets, poor profitability, a high debt ratio and loan spreads. compared to companies with high credit risk, companies with low credit risk display the advantages in the following indexes: total assets ranging from 113.906 billion to 4.879 billion; a pretax income ratio from 10.91% to -1.95%; a debt ratio from 41.40% to 53.41%; a borrowing interest rate from 2.909% to 3.534%, and a borrowing spread from -1.429% to -0.734%. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 33 table 2. description statistics by lending performance sample mean median std. min. max. panel a with(wi) or without(wo) “wobd” wi total assets (10 billion) 21 164.6*** 157.40*** 50.99 82.29 248.7 cost-to-revenue ratio (%) 21 27.21*** 25.74*** 3.63 22.80 34.47 roa (%) 21 0.26*** 0.42*** 0.72 -2.36 0.82 roe (%) 21 4.82 *** 10.01*** 13.74 -46.08 13.98 pretax income ratio (%) 21 11.00*** 16.53*** 20.26 -55.59 33.38 gross profit ratio (%) 21 34.07*** 35.63*** 16.77 -23.17 53.79 w o total assets (10 billion) 105 122.31 110.25 89.74 0.16 359.41 cost-to-revenue ratio (%) 105 34.52 26.89 23.05 10.32 267.43 roa (%) 105 0.05 0.17 1.34 -6.67 5.86 roe (%) 105 -1.74 2.33 19.01 -113.05 14.7 pretax income ratio (%) 105 0.38 5.75 30.74 -188.84 72.3 gross profit ratio (%) 105 28.09 35.3 27.41 -160.86 91.21 panel b with(wi) or without(wo) “hccl” w i total assets (10 billion) 21 95.76*** 85.73*** 39.63 16.45 158.61 cost-to-revenue ratio (%) 21 31.36*** 31.29*** 3.91 24.57 62.41 roa (%) 21 -0.30*** 0.1*** 1.15 -6.67 0.82 roe (%) 21 -5.74*** 1.68*** 18.87 -70.06 12.8 pretax income ratio (%) 21 -6.94*** 4.28*** 26.51 -132.63 18.79 gross profit ratio (%) 21 25.34*** 34.48*** 25.53 -62.74 53.79 w o total assets (10 billion) 104 145.25 158.97 85.28 0.16 359.41 cost-to-revenue ratio (%) 104 32.22 25.74 21.09 10.32 267.43 roa (%) 104 0.27 0.42 1.11 -5.55 5.86 roe (%) 104 2.80 7.79 16.52 -113.05 14.7 pretax income ratio (%) 104 8.01 16.53 27.15 -188.84 72.3 gross profit ratio (%) 104 31.95 35.63 23.44 -160.86 91.21 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 34 table 3. descriptive statistics by ownership of banks 欄 1 sample mean median std. min. max. state-owned banks total assets (10 billion) 8 258.23 242.15 57.56 184.84 359.41 cost-to-revenue ratio (%) 8 41.13 52.57 17.01 22.80 64.09 roa (%) 8 0.37 0.41 0.05 0.31 0.42 roe (%) 8 9.33 9.73 1.70 7.18 11.30 pretax income ratio (%) 8 14.84 16.52 2.29 11.71 16.53 gross profit ratio (%) 8 32.32 31.54 2.08 30.19 35.15 private financial holding companies total assets (10 billion) 42 135.50 148.74 48.20 22.67 205.05 cost-to-revenue ratio (%) 42 27.66 25.74 17.87 10.32 267.43 roa (%) 42 0.30 0.49 1.09 -5.17 5.86 roe (%) 42 3.00 8.13 15.96 -108.02 13.98 pretax income ratio (%) 42 8.77 16.55 24.25 -121.92 72.30 gross profit ratio (%) 42 34.14 37.60 20.36 -87.34 91.21 private non-financial holding companies total assets (10 billion) 34 43.90 30.97 39.61 0.16 116.21 cost-to-revenue ratio (%) 34 36.15 30.35 21.26 15.36 122.44 roa (%) 34 -0.54 0.01 1.38 -6.67 1.77 roe (%) 34 -10.11 0.24 21.56 -113.05 14.70 pretax income ratio (%) 34 -14.70 0.72 37.03 -188.84 35.90 gross profit ratio (%) 34 15.85 24.76 35.84 -160.86 56.49 foreign-owned banks total assets (10 billion) 17 28.72 28.44 20.26 0.76 63.64 cost-to-revenue ratio (%) 17 46.07 38.22 15.54 29.95 94.82 roa (%) 17 -0.65 -0.69 0.61 -1.26 0.00 roe (%) 17 -14.77 -15.55 13.80 -28.53 0.06 pretax income ratio (%) 17 -18.81 -19.07 14.53 -33.32 -3.95 gross profit ratio (%) 17 18.50 17.72 17.21 1.34 36.76 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 35 table 4. descriptive statistics by credit risk of borrowing companies sample mean median std. min. max. total sample total assets (10 billion) 36,024 214.26 36.92 1,107.47 1.47 15,545.37 pretax income ratio (%) 36,024 3.74 3.73 13.81 -99.53 98.79 debt ratio 36,024 48.60 48.41 13.82 3.91 97.4 tcri credit rating 36,024 6.27 6 1.53 1 9 borrowing interest rate (%) 21,613 3.235 2.890 1.292 0.020 10.050 borrowing spread (%) 21,613 -1.050 -1.401 1.382 -5.563 6.127 sample with tcri≧7 total assets (10 billion) 16,187 48.79*** 22.49*** 111.28 1.47 2180.60 pretax income ratio (%) 16,187 -1.95*** 0.85*** 14.18 -99.53 98.79 debt ratio 16,187 53.41*** 53.80*** 13.91 3.91 97.40 borrowing interest rate (%) 9,082 3.534*** 3.257*** 1.267 0.020 10.050 borrowing spread (%) 9,082 -0.734*** -1.010*** 1.345 -5.028 6.127 sample with tcri≦4 total assets (10 billion) 4,643 1,139.06 266.93 2,842.43 10.28 15,545.37 pretax income ratio (%) 4,643 10.91 8.06 13.32 -28.06 98.20 debt ratio 4,643 41.40 40.06 11.05 8.44 70.67 borrowing interest rate (%) 2,950 2.909 2.540 1.335 0.020 9.100 borrowing spread (%) 2,950 -1.429 -1.770 1.422 -5.563 5.466 4.2 factors impacting the loan spreads banks with or without “wobd” this section aims to focus on banks with or without “wobd”, and from those banks we select the relationship borrowers as samples to explore the factors impacting the loan spreads. by distinguishing these factors from the aspects of creditor banks and borrowing companies, for the former we emphasize lending performance25, ownership type and relationships, and for the latter we focus on credit risk ratings and ratings upgrade or downgrade statuses. the empirical results are shown in table 5. model (1) in table 5 simply verifies the impact of related dimensions on loan spreads. model (2) includes the interaction items of credit risk of the borrowing companies (measured by a dummy variable) with each dimension verifying whether the level of credit risk impacts the loan spreads. furthermore, model (3) includes the upgrade and downgrade credit status of borrowing companies to verify how they affect the loan spreads. the results of model (1) in table 5 indicate that for borrowing companies with a high credit risk level, the creditor banks will charge higher loan spreads. the loan spreads for banks with wobd are obviously higher than for banks without wobd, a finding that is consistent with the empirical results of coleman et al. (2002). the loan spreads of private financial holding institutions and private non-financial holding banks are significantly lower than those for state-owned banks, which means that after the m&a involving the financial institution, the private financial holding institutions make the most of lowering their interest rates to attract borrowers. the loan spreads of private financial holding institutions are significantly lower asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 36 than those of the non-financial holding banks which imply that the private financial holding institutions create scale and scope economies by means of expanding the territory and receive more competition advantages in their lending business. the foreign banks seem to be conservative in the taiwan banking industry for, perhaps out of consideration for the cost of capital, they always required higher loan spreads. the relationship level presents no significant influence on loan spreads which is inconsistent with the finding of chen and lai (2003): “the relationship level will affect the loan spreads”26. the results of empirical model (2) in table 5 indicate that companies borrowing from banks with wobd receive higher loan spreads than companies borrowing from banks without wobd. however, there is no significant difference in loan spreads between borrowing companies dealing with banks with or without wobd, which suggests that banks with wobd did not require higher loan spreads from borrowing companies with high credit risk which somehow reveals that banks are unable to take advantage of the borrowers. although companies borrowing from private financial holding institutions and private non-financial holding banks receive lower loan spreads than state-owned banks, there is no difference in the case of borrowing companies with high credit risk, which is consistent with the findings of panetta et al. (2009): “after the m&a of taiwan financial institutions, the information advantage of the taiwan financial market disappears and banks post-m&a did not possess the ability to take advantage of borrowers.” as for the borrowers with a high level of credit risk, the banks did not ask for an extra risk premium, which may explain why for post-m&a taiwan financial institutions, banks have increased their risk tolerance, and therefore did not respond to the interest rate. empirical model (2) presents the results indicating that the loan spreads of foreign banks are significantly higher than those of state-owned banks when facing borrowing companies with high credit risk, which implies that the pricing strategies of foreign banks can reasonably respond to the credit quality of the borrowing companies and pay more attention to the information presented in the financial statements, which is consistent with the findings of berger-udell (2001): banks that are large in size, foreign banks and banks facing a financial crisis tend to engage in transactional lending27. the results of empirical model (3) in table 5 indicate that in the case of borrowing companies with upgraded credit ratings, banks adversely increase the loan spreads. with regard to the high-risk borrowing companies, if they can upgrade their credit rating 3 years before financing, the bank will lower the loan spreads, revealing that the lending price only responds to high-risk borrowing companies when their credit quality improves. for common borrowers, banks do not adjust the interest rate for them even if their credit qualities have improved. with respect to the characteristics of the borrowing companies, we find that for borrowing companies that are small in size and have high debt ratios, banks will often grant them higher loan spreads. from the characteristics of the banks, we find that the banks that are large in size and characterized by low efficiency will often give borrowers higher loan spreads. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 37 table 5. the impact of the customer’s credit state and relationships on loan spreadssampling with or without “wobd” dimensions independent variables loan spreads (1) loan spreads (2) loan spreads (3) intercept -0.9139 -0.7889 -0.8547 (0.0278)** (0.0610)* (0.0420)** tcri tcri 0.4123 0.3814 0.4131 (<.0001)*** (<.0001)*** (<.0001)*** status bad_debtit 0.1480 0.1871 0.1856 (<.0001)*** (<.0001)*** (<.0001)*** bad_debtit*tcrijt -0.0504 -0.0442 (0.4170) (0.4784) ownership holdit -0.3380 -0.4167 -0.4086 (<.0001)*** (<.0001)*** (<.0001)*** holdit*tcrijt 0.1005 0.0928 (0.1103) (0.1419) nonholdit -0.1870 -0.2709 -0.2623 (0.0049)*** (0.0047)*** (0.0062)*** nonholdit*tcrijt 0.1037 0.0843 (0.3036) (0.4047) foreit 0.2597 0.0638 0.0717 (0.0013)*** (0.4941) (0.4422) foreit * tcrijt 0.4968 0.4970 (0.0010)*** (0.0009)*** relation_type largestit 0.0199 0.1047 0.1153 (0.6426) (0.0945)* (0.0661)* largestit*tcrijt -0.1278 -0.1226 (0.1209) (0.1403) mainit 0.0260 0.0648 0.0680 (0.4651) (0.1957) (0.1760) mainit * tcrijt -0.0746 -0.0663 (0.2796) (0.3385) trci_state upgradejt 0.6157 (0.0012)*** upgradejt* tcrijt -0.9321 (<.0001)*** downgradejt -0.0047 (0.9653) downgradejt* tcrijt -0.0635 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 38 dimensions independent variables loan spreads (1) loan spreads (2) loan spreads (3) (0.6093) firm size1 -0.0961 -0.0984 -0.0962 (<.0001)*** (<.0001)*** (<.0001)*** leverage 0.0069 0.0067 0.0072 (<.0001)*** (<.0001)*** (<.0001)*** ros -0.0085 -0.0087 -0.0086 (<.0001)*** (<.0001)*** (<.0001)*** bank size2 0.0241 0.0223 0.0217 (0.1429) (0.1763) (0.1876) cost_income 0.1903 0.1757 0.1909 (0.0169)** (0.0298)** (0.0183)** adj.r2 0.1977 0.1999 0.2041 fvalue 109.8 74.264 62.314 samples 4447 4447 4447 notes 1：*** significant at the 1% level,** significant at the 5% level,* significant at the 10% level, and the empirical period is 2008. notes 2: residual heterogeneity has been adjusted by using the white heteroskedasticity robustness test. 4.3 factors impacting the loan spreads banks with or without “hccl” the results of model (1) in table 6 show that borrowing companies with high credit risk often receive higher loan spreads. banks with hccl will require higher loan spreads which are consistent with the conclusions of “the companies that borrow from the banks with wobd will receive higher loan spreads,” which also reveal that banks that are heavily impacted by retail and corporate finance will ask the borrower to pay a higher interest rate. model (1) also indicates that the private financial holding institutions and private non-financial holding institutions will grant lower loan spreads than state-owned banks. the largest and main banks with closer relationships will grant borrowing companies lower loan spreads, and the largest banks will grant lower loan spreads28 than the main banks which is consistent with the findings of berger-udell (1995) that the borrowing companies which have closer relationships with the creditor banks can receive lower loan spreads. model (2) includes all interaction items related to the borrowing companies’ credit risk with each dimension, and the results show that companies borrowing from banks with hccl receive higher loan spreads than companies borrowing from banks without hccl. however, if we only verify borrowing companies with high credit risk, the adverse results indicate that banks with hccl will grant lower loan spreads than banks without hccl. therefore we refer the heavy losses to banks with hccl to their ignoring the strict review of the identification, financial position and solvency of the borrowers while issuing the card debt and simultaneously as banks are regarded as having high credit risk. the findings indicate that banks with hccl failed to learn their lessons from past experiences and still granted lower loan spreads to high credit risk borrowing companies in their corporate finance business. private financial holding institutions and private non-financial holding institutions asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 39 grant lower loan spreads than state-owned banks. however, if we focus on a comparison of the borrowing companies with high credit risk, there is no statistically significant difference, which implies that the m&a of financial institutions does not work in terms of increasing the ability to sift borrowers. through model (2) we find that the largest banks grant lower loan spreads to borrowing companies, especially the borrowing companies with high credit risk, which we still found granted excellent loan spreads to borrowers with closer relationships. the findings indicate that the fact that the largest and main banks grant lower loan spreads to borrowers with high credit risk are consistent with the prediction of chen and lai (2003): when banks build intimate relationships with borrowers, they deeply understand the profitability of the borrowing companies, if they envision the true performance potential of the enterprises, they will be delighted to grant lower loan spreads. another possible reason is that the loan spreads based on relationship lending do not truly reflect the credit risk of the borrowers. finally, the evidence shows that the borrowing companies had raised the credit rating in at least two years during the past three years, and that the creditor banks had adversely increased the loan spreads, which obviously indicates that banks in taiwan are reluctant to implement the review system even in such a dramatically competitive lending market characterized by significant information asymmetry. if we include the interaction of both high credit risk and the upgrading state in the model, we will find that high-credit risk borrowing companies with an upgraded state can receive lower loan spreads, which is consistent with the results of model (3) in table 5, and indicates that creditor banks will positively reflect the price of risk while the high credit risk borrowing companies will significantly increase their credit ratings. table 6. the impact of the customer’s credit state and relationships on loan spreads sampling with and without hccl dimensions independent variables loan spreads (1) loan spreads (2) loan spreads (3) intercept 0.8570 0.6754 0.6368 (0.0239)** (0.0798)* (0.0993)* tcri tcri 0.1179 0.3204 0.3636 (0.0094)*** (0.0002)*** (<.0001)*** status card_debtit 0.2433 0.4577 0.4645 (<.0001)*** (<.0001)*** (<.0001)*** card_debtit*tcrijt -0.2840 -0.2905 (0.0251)** (0.0214)** ownership holdit -0.4595 -0.3888 -0.3798 (<.0001)*** (<.0001)*** (<.0001)*** holdit*tcrijt -0.0932 -0.1040 (0.1841) (0.1375) nonholdit -0.4352 -0.3290 -0.3322 (<.0001)*** (0.0008)*** (0.0006)*** asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 40 dimensions independent variables loan spreads (1) loan spreads (2) loan spreads (3) nonholdit*tcrijt -0.1299 -0.1305 (0.1940) (0.1884) foreit 0.0713 0.1400 0.1583 (0.3369) (0.1963) (0.1439) foreit * tcrijt -0.0721 -0.0939 (0.6091) (0.5052) relation_type largestit -0.2669 -0.1479 -0.1276 (<.0001)*** (0.0360)** (0.0734)* largestit*tcrijt -0.1678 -0.1861 (0.0406)** (0.0246)** mainit -0.1716 -0.0685 -0.0559 (<.0001)*** (0.2552) (0.3524) mainit * tcrijt -0.1471 -0.1585 (0.0376)** (0.0252)** trci-state upgradejt 1.5386 (<.0001) *** upgradejt* tcrijt -1.6456 (<.0001)*** downgradejt -0.0670 (0.6823) downgradejt* tcrijt 0.0497 (0.7714) firm size1 -0.1487 -0.1475 -0.1455 (<.0001)*** (<.0001)*** (<.0001)*** leverage 0.0057 0.0057 0.0057 (<.0001)*** (<.0001)*** (<.0001)*** ros -0.0147 -0.0150 -0.0149 (<.0001)*** (<.0001)*** (<.0001)*** bank size2 0.0310 0.0321 0.0308 (0.0345)** (0.0290)** (0.0357)** cost_income 0.0404 0.0386 0.0364 (0.5022) (0.5241) (0.5471) adj.r2 0.0955 0.0979 fvalue 81.470 68.23 samples 12032 12032 note 1: the empirical period is 2006-2008, and the remaining signs or empirical methods are the same as in table 5. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 41 4.4 robustness test measuring the relationships based on financing ratios for different types of bank ownership since dividing the creditor banks into those characterized by high and low credit risk to observe the lending behavior and examine the factors impacting loan spreads may lack generality and validity, we perform a robustness test. first, we do not deliberately select the samples off borrowing companies from the high or low credit risk creditor banks, but on the contrary we randomly select the samples of borrower from listed, otc and emerging companies for the period 2000-2010, and have a total of 4,381 observations. the total assets of these companies amount to 16.094 billion on average and the average credit rating is higher than level 6 based on tcri29. then, according to the concept presented by kuo and chen (2012), we measure the relationships based on the ratio of the financing amount to the total assets of each sample borrower instead of using the biggest creditor, the main creditor and non-main creditor to distinguish the relationships30. by dividing the creditor banks based on the ownership, we find that most (i.e., 2,253) of the sample companies borrow from state-owned banks, followed by private financial holding banks (1,160), private non-financial holding banks (i.e., 784), and finally foreign banks (with only 221 observations). moreover, we find that the sample of borrowers that obtained loans from foreign banks were characterized by the best credit ratings and the largest scale of assets, and therefore the banks granted lower loan spreads. in addition, the sample of borrowers that obtained loans from the private non-financial holding banks was characterized by the worst credit ratings and profitability ratios. in addition, in taking into consideration the existence of big differences among listed, otc and emerging companies in terms of issuing conditions, we add two dummy variables to denote the organizational types in this section. while focusing on the lending practices and environment in taiwan, we find that it is easier for borrower with their larger scale of operations to obtain unsecured borrowing and, therefore, in the empirical model in table 7 we include a dummy variable to denote whether the sampled borrowers provided collateral. to sum up, the differences between table 7 and tables 5 and 6 are that in table 7 we did not use lending performance (with or without wobd or hccl) to denote whether the credit risk of creditor banks was high or low. furthermore, we added two dummy variables to describe the organizational types and a dummy variable to denote whether the sampled borrowers provided collateral. moreover, we used the financing ratio among the creditor banks to measure the relationships instead of using the greatest creditor bank, main creditor bank and non-main creditor bank. for comparison purposes, the three empirical models in tables 5, 6 and 7 are similar. empirical model (1) is regarded as the basic model of loan spreads which include the characteristics of factors impacting borrowing companies and creditor banks, ownership types, relationships, the upgrading and downgrading of credit ratings, organizational types and whether the borrower provides collateral. in addition to the factors impacting borrowing companies and creditor banks in model (1), models (2) and (3) use the tcri index to distinguish high from low credit risk, and also include the interaction items of each dimension to further examine the factors impacting the loan spreads. according to the results of empirical models (1), (2) and (3) in table 7, the loan spreads of asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 42 private financial holding banks and private non-financial holding banks are significantly lower than those of state-owned banks (in model (1) the coefficient values are -0.0078 and -0.0095), and only the foreign banks are an exception. if we compare the same dimensions in tables 5 and 7, we find that the results of table 7 are substantially consistent with tables 5 and 6, which indicates that in the dramatically competitive financial environment characterized by overbanking, banks have developed a low-loan-spreads strategy, which has led to the results of wobd and hccl and has even caused the occurrence of problematic banks that adversely affect the financial development of the country. in recent years, about half of the private banks have operated successfully and sustained their normal lending performance. therefore the results of tables 5 and 6 suggest that only foreign banks increase their loan spreads while facing borrowers with high credit risk (the coefficient values in tables 5 are 0.4968 and 0.4970), regardless of whether private banks belong to financial holding companies; when facing borrowers with high credit risk their loan spreads continue to remain unchanged. however, in table 7, we find that private financial holding banks will increase their loan spreads while facing borrowers with high credit risk (model (2) in table 7 shows a coefficient of 0.0189). private non-financial holding banks will significantly increase their loan spreads when facing borrowers with high credit risk (models (2) and (3) in table 7 reveals coefficients of 0.0216 and 0.01 with statistical significance at the 5% and 10% levels). the foreign banks adversely reduce their loan spreads when facing borrowers with high risk over the past decade (the coefficient is -0.0122). as mentioned earlier, only the results of table 6 indicate that closer relationships can reduce the interest burden of the borrowers; the largest and main banks still significantly reduce their loan spreads when facing borrowers with high credit risk. however, after verifying the past ten years of data for the borrowers, model (1) in table 7 reveals that only state-owned banks with closer relationships will tend to lower their loan spreads (the coefficient is -0.0028); the remaining three types of banks increase their loan spreads adversely (the coefficient values are 0.0014, 0.0017 and 0.0099, respectively). we also find that only non-financial holding companies that maintain closer relationships with borrowers are willing to reduce their loan spreads when facing borrowers with high credit risk. we recall the results of tables 5 and 6, which indicate that banks will reasonably increase their loan spreads while the borrowers’ credit risk rises even higher. however, table 5 indicates that when the high credit risk borrowers see their credit ratings upgraded, the banks would like to lower the loan spreads (the coefficient is -0.9321). according to the results of table 7, only model (2) indicates that the creditor banks will increase their loan spreads (the coefficient is 0.0237), when the credit risk of the borrowers has been rising during the past ten years. if the borrowing companies increase their credit ratings, the creditor banks will obviously reduce their loan spreads (the coefficient is -0.0165), but when facing high credit risk borrowers with upgraded credit ratings, the loan spreads will adversely abnormally increase (the coefficient is 0.0237). moreover the results in table 7 indicate that the loan spreads extended to listed firms and otc-listed companies are lower than those extended to emerging companies. in general, the larger the scale of banks and firms, the lower the loan spreads that are given and taken31. with regard to the debt and profitability ratios, the expected positive or negative directions are asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 43 confirmed in tables 5 to 7. the following conditions are unexpected: the cost-to-revenue ratio and loan spreads displayed are significantly negatively associated (the coefficient is -0.0328); the borrowers with collateral adversely receive higher loan spreads (the coefficient values are 0.0103 and 0.0064, respectively). table 7. the impact of the customer’s credit status and relationships on loan spreads--measuring relationships by the financing ratio of different ownership types dimensions independent variables loan spreads (1) loan spreads (2) loan spreads (3) intercept -0.0032 0.0849*** 0.1272*** ownership holdit -0.0078*** -0.0222** -0.0075 holdit*tcrijt 0.0189** 0.0094 nonholdit -0.0095*** -0.0218** -0.0145** nonholdit*tcrijt 0.0216** 0.0100* foreit -0.0122*** 0.0023 0.0164 foreit * tcrijt -0.0093 -0.0038 relation_type (measured by financing ratio of different ownership types) from private financial holding banks (symbol hold-rit) 0.0014*** 0.0017 0.0034 hold-rit*tcrijt -0.0002 -0.0038 from private non-financial holding banks (symbol nonhold-rit) 0.0017*** 0.0172*** 0.0179*** nonhold-rit*tcrijt -0.0229*** -0.0154*** from foreign banks (symbol fore-rit) 0.0099*** 0.0243 -0.0191 fore-rit*tcrijt -0.0357 0.0088 from state-owned banks (symbol state-ownedit) -0.0028*** 0.0067 0.0068** state-ownedit *tcrijt -0.0073 -0.0050 tcri_state tcrijt 0.0040 0.0237*** 0.0035 upgradejt -0.0165*** upgradejt* tcrijt 0.0142** downgradejt 0.0106 downgradejt* tcrijt -0.0094 organization types listed -0.0021*** -0.0055*** -0.0065*** otc -0.0034*** -0.0053*** -0.0027*** asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 44 firm size1 -0.0035*** -0.0013** -0.0006** leverage 0.0301*** 0.0237*** 0.0166*** ros -0.0110*** -0.0031*** -0.0047*** with or without collateral collateral 0.0015 0.0103*** 0.0064*** bank size2 0.0008** -0.0049*** -0.0067*** cost_income -0.008*** -0.0031 -0.0328*** adj.r2 33.01% 33.95% 34.31% fvalue 41.70 34.45 31.32 samples 2,148 2,148 2,148 note 1: for simplicity, we omitted the p value of each independent variable, ***, ** and * represent the 1%, 5% and 10% significance levels, respectively. the empirical data cover the period 2000-2010. note 2: when there is heteroskedasticity in the residuals of the empirical model, the white heteroskedasticity robustness method is used to make the adjustment. 5. conclusions over the past decade, the asian financial crisis (1997), the occurrence of huge bad debts in the banking industry (2002-2004), credit card debt events (october 2005), the subprime mortgage (august 2007) and the fannie mae and freddie mac event (july 2008) successively impacted taiwan’s financial markets. the taiwan government responded by implementing the first and second “financial reforms,” and the related procedures resulted in major and dramatic changes to the operating status of the banking system as a whole. this study has systematically performed empirical tests in order to understand how the credit status and relationships have impacted the loan spreads. the findings of this paper are as follows: (1) private financial holding companies and private non-financial holding companies grant loan spreads that are significantly lower than those of state-owned banks. foreign banks grant loan spreads that are significantly higher than those of state-owned banks, and only foreign bank loan spreads are significantly higher than those of state-owned banks when borrowers are considered to be high risk. (2) tables 5 and 6 reveal that banks reduce their loan spreads only for high credit risk borrowers with obvious improvements in credit ratings, but this does not apply to general borrowers even when the credit rating condition is improved. however, during the past decade the adverse results shown in table 7 indicate that the creditor banks reduce their loan spreads, when the borrowing companies have their credit ratings upgraded, but even if the high credit risk borrowing companies have their credit ratings upgraded, the creditor banks will adversely increase the loan spreads. (3) empirical findings show that the biggest and main creditor banks exhibit significantly lower loan spreads, and were also willing to give high credit risk customers lower lending spreads, which imply that taiwan’s banks emphasis “banking relationship” while lending. and only state-owned banks grant lower loan spreads to borrowers with which they have closer relationships, while the remaining three types of banks in terms of ownership adversely increase their loan spreads. only private non-financial holding companies have their loan spreads reduced while facing high credit risk borrowers with closer relationships. these findings contribute some points in relationship lending and impacting factors on loan spreads. (4) using data for the past decade, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 45 table 7 shows that only state-owned banks grant lower loan spreads to borrowers with which they have closer relationships, while the remaining three types of banks in terms of ownership adversely increase their loan spreads. only private non-financial holding companies have their loan spreads reduced while facing high credit risk borrowers with closer relationships. furthermore, taiwan’s bank ask higher loan spreads for otc and listed company’s clients with collateral, it may relate to the common practice of unsecured loan to such enterprises with bargain interest rate. notes 1. many studies indicate that reducing the credit availability is an instrument that can be used in response, but considering the multiple relationships existing in taiwan and the utilization rate of the credit availability being on average lower than 70%, the index cannot be properly reflected in the credit behavior. we have therefore omitted the index in this study. 2. the amendment and promulgation of the six financial laws relate to the following events: the “banking law” amendment (november 1, 2000 announcement), the “financial institutions merger act” (december 13, 2000 announcement), the “financial holding company law” (july 9, 2001 announcement and enactment on november 1 of the same year.), the “financial asset securitization act” (june 20, 2002 approved), the “financial supervisory commission organization act” (established july 1, 2004), and the “financial restructuring fund ordinance” (approved june 22, 2005). 3.the “258” policy requires all banks to reduce the npl ratio to below 5% and to increase the capital adequacy ratio to above 8% within two years. 4. according to “financial statistics monthly” issued by the central bank at the end of 2008, we can simply classify the accumulated bad debts written off during the last five years as follows: banks or financial holding companies with accumulated bad debts written off of more than nt$50 billion (7). however, to avoid trouble from related parties, we do not mention the detailed information of the banks or financial holding companies. further information is available from the authors upon request. while we do not believe this affects our research, we sincerely welcome any comments. 5. “the bankers’ association of the republic of china” announced that 8 banks experienced heavily losses during the credit card debt crisis, while the others did not encounter big losses during the credit card debt crisis. however, to avoid trouble from related parties, we do not mention the detailed information about the banks or financial holding companies. further information is available from the authors upon request. while we do not believe this affects our research, we sincerely welcome any comments. 6. specifically, the samples verified in this study consist of borrowers selected from banks with wobd and hccl. the control samples are made up of borrowers selected from banks without wobd and hccl. 7. lending cases with rational efficiency simply mean that the worse the borrower’s credit rating, the higher the lending rate should be. if the borrowers upgrade (downgrade) their credit rating the stipulations of the review system should decrease (increase) on the loan spreads. however, if the level of intimacy in the banking relationship is taken into asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 46 consideration, since it is unclear whether the loan spreads will maintain their reasonable positive and negative association, the creditor banks are faced with a problem of moral crisis and adverse selection. 8. the empirical results of kuo and chen (2012) indicate that on average there are 1.51 relationship banks for a micro-small enterprise, and the credit availability usage ratio and collateral ratio are 62% and 46%, respectively. 9. when the total annual loan amount is ranked in the second to fourth largest to the borrowing company, we denote such creditor banks as the main banks, and the other creditor banks of the borrowing company as the non-main banks. 10. whether the bank is characterized by wobd or not is directly related to the lending ability and risk consciousness of the bank and is displayed in the corporate performance of the creditor banks. as to whether the bank experienced hccl or not has an indirect impact on the loanable funds and reputation of the creditor bank and is related to the retail performance. 11. to put it simply, abnormal refers to lending irrationally. for example, granting a high credit risk borrower with lower loan spreads. 12. the challenge of credit risk will be more serious for the creditor bank when facing a depressed financial environment if the top executives cannot envision the overall operating strategy and quickly transfer to the retail financing of cash and credit card lending. a lack of risk consciousness and the management mechanism of the card holder and issuer led to a second huge loss and impacted the bank both directly and indirectly simultaneously. 13. in this study we use the classification methods of the tej, dividing the credit risk of borrowing companies into three levels:tcri ≤ 4 for those categorized by low credit risk, and tcri ≥ 7, which is considered high credit risks. in between the companies are regarded as moderate, and not discussed. 14. we exclude the factor of credit availability in the empirical model. the reason can be found by referring to note 1. 15. as for the transactional lending, customers simply fill out their data regarding salary income, operating income and other fixed items. through the help of a computer, the whole transaction or application process can be completed, which is known as lending based on hard information. common examples are credit card lending, short-term financing collateral with accounts receivable, notes receivable and inventory. relationship lending always uses soft information as the basis for approval or not. for example, they emphasize the value of borrowers’ vision, business philosophy, and positive or negative gossip or evaluation. they can also accept collateral from top managers or act as a guarantor personally, which is known as outside collateral, and is different from the inside collateral which provides company assets as collateral. 16. hubbard et al. (2002) measured the bank's risk based on the ratio of self-capital to total assets: the lower the ratio, the higher the risk of capital. 17.coleman et al. (2002) used the capital adequacy ratio, the ratio of cash to total assets, and the loans to deposits ratio as a proxy for bank risk. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 47 18. although companies borrow from financial institutions, including life insurance companies and the securities, bills and leasing industry, since the bank loans are still the most common kind of loans, our sample therefore only includes borrowers from the banking industry and does not contain data on loans from any other industries. 19. in considering the reliability and validity, we extend the empirical periods from 2008 to 2010, while conducting the robustness tests to observe possible changes in related factors. 20. according to the topics of credit ratings (76) issued by the tej, when tcri is above level 6 the default probability will obviously increase. therefore, it is reasonable to define a borrower with a tcri level of 7 to 9 as the high credit risk in this study. 21. according to the viewpoints of berger et al. (2008) there are five motives of multiple banking relationships: (1) only one relationship bank is unable to meet all the funding requirements, so through multiple banking relationships is satisfied the shortage of funds. (2) multiple banking relationships can mitigate the hold-up problem of a single banking relationship. (3) multiple banking relationships can avoid the worry of repayment or early termination. (4) to avoid the relationship bank getting lost in the loose credit policies. (5) focusing on the monitoring costs and benefits of the bank. 22. four different ownership types of bank are verified by the f test and wilcoxon rank sum method respectively in order to know whether the mean or median of each factor exhibits a significant difference. due to the significant differences in the just number of samples for the four ownership types of banks and the subsequent test that focuses on comparing those three types with state-owned types individually, we therefore omit the difference test in table 3. 23. according to “financial statistics monthly” issued by the central bank at the end of 2008, we can simply classify the accumulated bad debts written off during the last five years as follows: bank or financial holding company with accumulated bad debts written off of more than nt$50 billion or not. however, to avoid trouble from related parties, we do not mention the detailed information of the bank or financial holding company. for more information, please contact the authors. the omission of such information does not affect this research, and we sincerely welcome any comments. 24. “the bankers’ association of the republic of china” declared that there were 8 banks that experienced heavy losses as a result of the credit card debt crisis, and the others did not encounter a big loss during the period of the credit card debt crisis. however, to avoid offending the related parties, we do not mention the detailed information of the bank or financial holding company. if you need more information, welcome to write to us. the omission of such information does not affect this research, and we sincerely welcome any comments. 25. there are three banks that meet the criteria of wobd and hccl at the same time while we distinguish the risk type of the creditor bank based on the lending performance mentioned before. to avoid the confusion, we purposely delete the borrowing companies (publicly-held) from these three sample banks while empirical testing the impact of the characteristic of with or without wobd and hccl on loan spreads. 26. we use an alternative proxy to measure the level of intimacy of the banking relationship which is the ratio of the company's total borrowings to total assets. the empirical model (1) in table 5 is not significant, but in model (2), the ratio of the company's total borrowings to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 48 total assets is negatively associated with the loan spreads, the coefficient value is -0.5637 (the p value is 0.0311). the coefficient value is -0.5207 (the p value is 0.0474) for that variable in model (3) and the coefficient values for the interaction with the credit risk are -0.5637 (the p value is 0.0311), 0.5546 (the p value is 0.0508) in model (2) and in model (3), which suggests that the higher level of intimacy of the banking relationship deserves lower borrowing costs, but for the borrower with high credit risk the borrowing costs will increase. 27. transactional lending focuses more on public and objective information such as financial statements, assets, operating ability and credit ratings and pays less attention to banking relationships. 28. model (1) in tables 5 and 6 display a finding concerning the impact of the level of intimacy of banking relationships on loan spreads, the former one being insignificant but the latter one being significant. the possible reason may be attributed to the empirical period of model (1) in table 5 only containing 2008, while the empirical period of model (1) in table 6 covers 2006 to 2008. the banking industry was pervasively affected by the financial crisis in 2008, and the more conservative lending policy was more focused on the credit ratings and financial statements while tending to ignore the banking relationships. 29. by comparing the total assets of the sample borrowers we found that the maximum of the total assets was 212.091 billion and the minimum was 0.050 billion, with the standard deviation reaching up to 60.377 billion. as to the credit rating for tcri, this was found to display a standard deviation of 1.75. 30.we used the original method to perform the robustness test, which measures the level of intimacy of the banking relationships by dividing the creditor banks into the biggest, main and non-main. for space considerations and because there was nothing special in the empirical test, we have omitted this discussion from the article. 31. the empirical results differ from “the advantage of small banks” presented by berger-udell (2002), which indicated that the agent problem is not serious since the small banks have simple organizational structures. references barth, j. r., caprio, g., & levine, r. 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(2008). legal considerations on merger control over financial holding companies in taiwan. fair trade quarterly, 16(3), 1-20. microsoft word 9721-36732-1-ed-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 70 the internal rate of return model for life insurance policies prof. mihir dash department of quantitative methods school of business, alliance university chikkahagade cross, anekal, bangalore, india-562106 tel: 91-995-182-465 e-mail: mihirda@rediffmail.com received: june 20, 2016 accepted: sep. 10, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.9721 url: http://dx.doi.org/10.5296/ajfa.v8i2.9721 abstract life insurance policies are no longer seen solely as a means of insuring life. due to many new features introduced by life insurers, they are seen in the new light of serving savings and even investment purposes besides the basic purpose of insuring life. the present study discusses the rates of return given by different types of policies, and the effect of mortality on these rates of return across age, sum assured, and maturity period in each type of policy studied. the findings indicate that different types of policies give different rates of return and that mortality does have an effect on the rates of return. endowment plans have higher rate of return with mortality incorporated, while for unit-linked investment plans, the rate of return is higher when it is treated purely as an investment instrument. the study also revealed that the unadjusted and mortality-adjusted rates of return follow a linear relationship that is very similar to the capital asset pricing model. the study opens a further scope of research by extending the methodology to include other relevant risk factors besides mortality, and for different types of policies across companies. keywords: life insurance policies, rate of return, mortality, sensitivity, endowment plans, unit-linked investment plans, capital asset pricing model. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 71 introduction the life insurance market has over time become more dynamic. in the current scenario, life insurance is no longer seen solely as a means of insuring life. due to many changes and new features introduced by life insurers, life insurance policies are being seen in the new light of serving the purpose of savings and even investment besides the basic purpose it serves of insuring life. in any life insurance contract, the rate of return forms an integral element both for the investor and for the life insurer. it is in the interest of both the parties to get some favourable returns from their contract. a life insurance contract involves many contingencies and risks, mortality being one of the major ones among them. the effect that mortality will have on rates of return is therefore an area of great interest in a life insurance contract. it is therefore of relevance to study the rates of return under two conditions: firstly, when the life insurance policies are treated purely as investment instruments, and, secondly, when the probabilities of mortality are incorporated in computing the rates of return. it also becomes an area of interest to study how much these rates of return are sensitive to mortality. insurance pricing has a very long history, and discounted cash flow models, along with the internal rate of return approach, are at the heart of most insurance pricing models. teufel et al (2001) reviews these models in their discussion of the principles of insurance and the risks faced by life insurers. they have listed mortality as one of the major risks and they have called it the “bedrock in the growth and development of the life insurance industry.” according to the article, the various factors that enter into the pricing process of insurance policies are: the probability of mortality, the time value of money, the benefits promised, the expenses, and the possible contingencies/ scenarios. the article also discusses risk spreading activities and investment portfolio management. feldblum (1992) discussed how financial models which consider the time value of money, surplus commitments and investment income are increasingly being used in insurance ratemaking. he showed how an internal rate of return model can be used to price insurance policies and discusses the framework of the irr model. he also discussed how insurance transactions may be examined from two points of view as follows: between the policyholder and the insurer (wherein the policyholder pays premiums to purchase an insurance contract, obligating the insurer to compensate the policyholder for incurred losses), and between the equity provider and the insurer (wherein equity providers invest funds in an insurance company, and this investment is expected to provide a return, whether of capital accumulation or dividends). the author then explains how these two viewpoints are interrelated. the present study also uses a discounted cash flow model, along with an internal rate of return approach, but does not focus on pricing issues as such. instead, the study envisages the rate of return as a characteristic which can be used to understand life insurance policies and to make comparisons between different types of life insurance policies. the present study discusses the different rates of return given by different types of policies and how the probability of mortality has an effect on these rates of return across different ages for asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 72 different levels of sum assured and maturity periods. the study compares the unadjusted and mortality-adjusted rates of return in all the different categories, and analyses the relationship between the mortality-adjusted rate of return and the unadjusted rate of return. the study also analyses the degree of sensitivity of the rates of return to mortality, and proposes a model for the relationship between the mortality-adjusted rate of return and the unadjusted rate of return. data and methodology the data for the study covers three life insurance policies of kotak mahindra old mutual life insurance limited, viz. the capital multiplier plan, the money back plan, and the flexi-plan assuming 8% and 10% growth. the study was conducted at five different levels of sum assured of rs. 1 lakh, rs. 2 lakhs, rs. 3 lakhs, rs. 4 lakhs, and rs. 5 lakhs, with three different maturity periods of 15 years, 20 years, and 25 years. the premia and maturity values of these policies were collected using premium calculators provided by the company. the mortality rates used in the study were collected from lic mortality tables. the study involved the calculation of the unadjusted rate of return and mortality-adjusted rate of return. in both the cases, the net present value (npv) was formulated, and the internal rate of return (irr), at which the npv is zero, was then calculated. the npv formulation differs in the two cases, which may be explained as follows. calculation of the unadjusted rate of return: in the formulation of npv for the unadjusted rate of return, the effect of mortality is ignored, and hence life insurance policies are treated purely as investment instruments. the underlying assumption here is that in each case, the individual survives until the maturity of the policy. therefore, taking the discount factor into account, the calculation of npv takes the form of the present value of annuity. the formula may be expressed as follows: nj n j r mv rr pnpv )1()1( 11. 1 + +      + −−=  = , (1) where p denotes the premium, mv the maturity value, r the rate of return, and n the maturity period. the unadjusted rate of return is then calculated by equating the npv to zero. calculation of the mortality-adjusted rate of return: in the formulation of npv for mortality-adjusted rate of return, the effect of mortality is taken into account. mortality-adjusted rate of return basically means irr with probabilities of mortality incorporated in the npv formula. the underlying assumption here is that life is uncertain and hence, mortality constitutes an important element of life insurance policies. the formula used for the expected net present value may be expressed as follows, for a person aged k at the time of entering into the contract: )( 1 )()( 1 . )1( . )1( . )1( )( k j n j j jk nn k j n j j q r mv p r mvp r pnpve  == + + + + + −= , (2) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 73 where p denotes the premium, mv the maturity value, mvj the maturity value in year j, pj (k) the probability that a person aged k will survive for another j years, and qj (k) the probability that a person aged k will survive j-1 years but not j years, )(k jp = 121 −+++ ×××× jkkkk pppp  = ∏ − = + 1 0 j i ikp , (3) )(k jq = )1(....... 121 −+−++ −×× jkjkkk pppp = ( )1 2 0 1 −+ − = + −     ∏ jk j i ik pp , (4) and where ip is the probability that a person aged i will survive for age i+1 (i.e. the age-specific survival rate). the mortality-adjusted rate of return is the calculated by equating the enpv to zero. this is applicable for all the types of policies chosen for the study, except for the money back plan. a distinguishing feature of the money back plan is that there are payouts every five years till the maturity date. taking this into consideration, the payouts are deducted (keeping the discount factor in mind) while calculating both the unadjusted and mortality-adjusted rates of return. findings the unadjusted and mortality-adjusted rates of return were calculated for each type of policy for different maturity periods of 15 years, 20 years and 25 years and at different levels of sum assured of rs. 1 lakh, rs.2 lakhs, rs. 3 lakhs, rs. 4 lakhs and rs. 5 lakhs across different ages. a comparison was then made separately for unadjusted rate of return and mortality-adjusted rate of return in terms of sum assured, in terms of the products, and finally in terms of maturity period. finally, for each type of policy, a comparison is made between the unadjusted rate of return and mortality-adjusted rate of return. i. by sum assured the series of graphs which follow present a comparison of the rates of return for each policy at different maturity periods in terms of the sum assured: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 74 unadjusted rate of return for capital multiplier with rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age 15 yr. maturity 20 yr. maturity 25 yr. maturity adjusted rate of return for capital multiplier with rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age 15 yr. maturity 20 yr. maturity 25 yr. maturity the unadjusted and adjusted irr curves for the capital multiplier plan are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. the irr curves slope downwards, indicating that the rates of return gradually decrease at an increasing rate with age. further, it is observed that higher maturity periods give higher rates of return, and that the adjusted rates of return are higher than the unadjusted rates of return. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 75 adjusted rate of return for money back with rs. 1 lakh assured -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age 15 yr. maturity 20 yr. maturity 25 yr. maturity the unadjusted and adjusted irr curves for the money back plan are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. the irr curves slope downwards, the slope being much steeper than in the case of the capital multiplier plan, indicating that the rates of return decrease at a faster rate with age than in the case of the capital multiplier plan. also, in case of the money back plan, the rates of return become negative at certain ages. further, it is observed that lower maturity periods give higher rates of return, and that the adjusted rates of return are higher than the unadjusted rates of return. finally, the rate of decrease of the adjusted rates of return is lower than that of the unadjusted rates of return. unadjusted rate of return for money back with rs. 1 lakh assured -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age 15 yr. maturity 20 yr. maturity 25 yr. maturity asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 76 unadjusted rate of return for flexi-plan (assuming 8% growth),rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age 15 yr. maturity 20 yr. maturity 25 yr. maturity adjusted rate of return for flexi-plan (assuming 8% growth),rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age 15 yr. maturity 20 yr. maturity 25 yr. maturity the unadjusted irr curves for the flexi-plan (assuming 8% growth) are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. it is observed that higher maturity periods give higher unadjusted rates of return, and that the rate of decrease of the unadjusted rates of return decreases with maturity period. for this policy, the adjusted irr curves do not follow the same pattern as those of the unadjusted irr curves. the adjusted irr curves at 15, 20 and 25 year maturity periods start at different levels, gradually decrease and then coincide at a later stage, indicating that the rate of decrease of the adjusted rate of return increases with maturity period. also, the adjusted rates of return are observed to be lower than the unadjusted rates of return, indicating that the flexi-plan is more of an investment plan than the previous plans. finally, the rate of decrease of adjusted rates of return is higher than that of unadjusted rates of return. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 77 unadjusted rate of return for flexi-plan (assuming 10% growth),rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age 15 yr. maturity 20 yr. maturity 25 yr. maturity adjusted rate of return for flexi-plan (assuming 10% growth),rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age 15 yr. maturity 20 yr. maturity 25 yr. maturity the irr curves for the flexi-plan (assuming 10% growth) are observed to follow similar patterns as those of the flexi-plan (assuming 8% growth). the unadjusted and adjusted rates of return for the former are all uniformly higher than for the latter. ii. by product the series of graphs which follow present a comparison of the rates of return at different levels of sum assured and at different maturities in terms of the products: unadjusted rate of return for 15 yr. maturity, rs. 1 lakh assured -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age capital multiplier plan money back plan flexi-plan (assuming 8% growth) flexi-plan (assuming 10% growth) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 78 unadjusted rate of return for 20 yr. maturity,rs. 1 lakh assured -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 age capital multiplier plan money back plan flexi-plan (assuming 8% growth) flexi-plan (assuming 10% growth) unadjusted rate of return for 25 yr. maturity,rs. 1 lakh assured -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age capital multiplier plan money back plan flexi-plan (assuming 8% growth) flexi-plan (assuming 10% growrh) adjusted rate of return for 15 yr. maturity,rs. 1 lakh assured -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age capital multiplier plan money back plan flexi-plan (assuming 8% growth) flexi-plan (assuming 10% growth) adjusted rate of return for 20 yr. maturity,rs. 1 lakh assured -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 age capital multiplier plan money back plan flexi-plan (assuming 8% growth) flexi-plan (assuming 10% growth) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 79 adjusted rate of return for 25 yr. maturity,rs. 1 lakh assured -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age capital multiplier plan money back plan flexi-plan (assuming 8% growth) flexi-plan (assuming 10% growth) the unadjusted and adjusted irr curves are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods, the only difference being that for the flexi-plan (both cases), adjusted irr curves have a much steeper slope than in the case of unadjusted irr, indicating that the rate of decrease of the rates of return is higher for the adjusted rates of return than for the unadjusted rates of return. the flexi-plan (assuming 10% growth) is observed to have the highest rate of return, followed by the capital multiplier plan and then the flexi-plan (assuming 8% growth), while money back plan is observed to have the lowest rate of return. the irr curves of the flexi-plan (assuming 8% growth) and flexi-plan (assuming 10% growth) are parallel to each other, indicating that plans of the same type show a similar pattern: their irr curves are constant almost throughout, with only a slight rate of decrease before the maximum age. the capital multiplier plan has a gradual slope, indicating that the rate of return gradually decreases with age. the money back plan has the steepest slope. the rate of decrease of the rates of return in this case is fast, and the rates of return become negative at certain ages. iii. by maturity period the series of graphs which follow present a comparison of the rates of return for each policy at different levels of sum assured in terms of the maturity periods: unadjusted rate of return for capital multiplier plan with 15 yr. maturity 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 80 unadjusted rate of return for capital multiplier plan with 20 yr. maturity 5.80% 6.00% 6.20% 6.40% 6.60% 6.80% 7.00% 7.20% 7.40% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured unadjusted rate of return for capital multiplier plan with 25 yr. maturity 6.60% 6.70% 6.80% 6.90% 7.00% 7.10% 7.20% 7.30% 7.40% 7.50% 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured adjusted rate of return for capital multiplier plan with 15 yr. maturity 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 81 adjusted rate of return for capital multiplier plan with 20 yr. maturity 6.00% 6.20% 6.40% 6.60% 6.80% 7.00% 7.20% 7.40% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 age rs. 1 lakh assured rs.2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured adjusted rate of return for capital multiplier plan with 25 yr. maturity 6.60% 6.70% 6.80% 6.90% 7.00% 7.10% 7.20% 7.30% 7.40% 7.50% 7.60% 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 age rs. 1 lakh assured rs. 2 lakh assured rs.3 lakh assured rs. 4 lakh assured rs. 5 lakh assured as noted before, the unadjusted and adjusted irr curves for the capital multiplier plan are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. it is observed that the irr curves all coincide together, indicating that the rate of decrease of rates of return with age at different levels of sum assured is more or less uniform in all the cases. also, the irr curves at 20 and 25 year maturity periods have a steeper slope, indicating that the rate of decrease in rates of return with age increases with maturity period. unadjusted rate of return for money back plan with 15 yr. maturity -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 82 adjusted rate of return for money back plan with 15 yr. maturity -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured as noted before, the unadjusted and adjusted irr curves for the money back plan are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. for this policy, higher levels of sum assured are observed to give higher rates of return. the rates of returns are observed to decrease with age. the rate of decrease of rates of return with age is fast in all the cases, and hence the irr curves in each case have a steep slope, becoming negative at certain ages. the irr curves are almost parallel to each other, indicating that at different levels of sum assured the rates of return decrease at a uniform rate. unadjusted rate of return for flexi-plan (assuming 8% growth) with 15 yr. maturity 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured unadjusted rate of return for flexi-plan (assuming 8% growth) with 20 yr. maturity 5.10% 5.20% 5.30% 5.40% 5.50% 5.60% 5.70% 5.80% 5.90% 6.00% 6.10% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs.5 lakh assured asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 83 unadjusted rate of return for flexi-plan (assuming 8% growth) with 25 yr. maturity 5.70% 5.80% 5.90% 6.00% 6.10% 6.20% 6.30% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age rs.1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured adjusted rate of return for flexi-plan (assuming 8% growth) with 15 yr. maturity 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured adjusted rate of return for flexi-plan (assuming 8% growth) with 20 yr. maturity 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs.5 lakh assured adjusted rate of return for flexi-plan (assuming 8% growth) with 25 yr. maturity 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs 5 lakh assured asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 84 unadjusted rate of return for flexi-plan (assuming 10% growth) with 15 yr. maturity 6.00% 6.20% 6.40% 6.60% 6.80% 7.00% 7.20% 7.40% 7.60% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs 4 lakh assured rs. 5 lakh assured adjusted rate of return for flexi-plan (assuming 10% growth) with 15 yr. maturity 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age rs. 1 lakh assured rs. 2 lakh assured rs. 3 lakh assured rs. 4 lakh assured rs. 5 lakh assured as noted before, the unadjusted and adjusted irr curves for the flexi-plan (assuming 8% growth) are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. it is observed that higher levels of sum assured give higher returns. the unadjusted irr curves are almost parallel to each other, indicating that at different levels of sum assured, the rate of decrease of unadjusted rate of return with age follows a uniform pattern. also, the unadjusted irr curves at 20 and 25 year maturity periods have a steeper slope, indicating that the rate of decrease in unadjusted rate of return increases with maturity period. on the other hand, the adjusted irr curves coincide together, indicating that at different levels of sum assured the differences between the adjusted rates of return are very small. a similar pattern is observed for the flex-plan (assuming 10% growth), with even steeper slope. iv. by adjusted/ unadjusted rates the series of graphs which follow present a comparison of the adjusted and unadjusted rates of return for each policy at different levels of sum assured and at different maturity periods: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 85 unadjusted and adjusted rate of return for capital multiplier plan with 15 yr. maturity,rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 age unadjusted adjusted unadjusted and adjusted rate of return for capital multiplier plan with 20 yr. maturity,rs.1 lakh assured 5.80% 6.00% 6.20% 6.40% 6.60% 6.80% 7.00% 7.20% 7.40% 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 age unadjusted adjusted unadjusted and adjusted rate of return for capital multiplier plan with 25 yr. maturity,rs. 1 lakh assured 6.60% 6.70% 6.80% 6.90% 7.00% 7.10% 7.20% 7.30% 7.40% 7.50% 7.60% 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 age unadjusted adjusted again, the unadjusted and adjusted irr curves for the capital multiplier plan are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. it is observed that the adjusted rates of return are always higher than the unadjusted rates of return. however, in the case of 15 year maturity period, the difference between adjusted and unadjusted rates of return increases with age, while the difference between the adjusted and unadjusted rates of return is more in case of 20 year maturity period, remaining constant with age, and in the case of 25 year maturity period, the difference between the adjusted and unadjusted rates of return decreases with age. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 86 unadjusted and adjusted rate of return for money back plan with 15 yr. maturity,rs. 1 lakh assured -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age unadjusted adjusted again, the unadjusted and adjusted irr curves for the money back plan are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. it is observed that the adjusted rates of return are always higher than the unadjusted rates of return. in this case, however, the unadjusted and adjusted irr curves are steeply downward sloping, and become negative at certain ages. the difference between adjusted and unadjusted rates of return rapidly increases with age. unadjusted and adjusted rate of return for flexi-plan (assuming 8% growth),15 yr. maturity,rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age unadjusted adjusted unadjusted and adjusted rate of return for flexi-plan (assuming 10% growth),15 yr. maturity,rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 age unadjusted adjusted asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 87 again, the unadjusted and adjusted irr curves for the flexi-plan are observed to follow similar patterns, at different levels of sum assured, and across different maturity periods. it is observed that the adjusted rates of return are always lower than the unadjusted rates of return, in contrast to the capital multiplier plan and the money back plan, indicating that the flexi-plan is more of an investment plan. the difference between the adjusted and unadjusted rates of return rapidly increases beyond a certain age. v. relationship between rates of return another type of comparison was made of the difference between adjusted and unadjusted rates of return for each policy, in which the probability of not surviving until the end of a particular contact (dependent on the maturity period; for example, for a 15 year maturity period, the probability of not surviving until the end of the 15th year of the contract) was taken into consideration. in this case, both the unadjusted and adjusted rates of return were plotted against the probability of not surviving until the end of the particular contract, across different ages. the comparison for each type of policy is presented in the following series of graphs: unadjusted and adjusted rate of return for capital multiplier plan with 15 yr. maturity,rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 probability of not surviving until 15 year maturity unadjusted adjusted unadjusted and adjusted rate of return for money back plan with 15 yr. maturity,rs. 1 lakh assured -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 probability of not surviving until 15 year maturity unadjusted adjusted asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 88 unadjusted and adjusted rate of return for flexi-plan (assuming 8% growth),15 yr. maturity,rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 probability of not surviving until 15 year maturity unadjusted adjusted unadjusted and adjusted rate of return for flexi-plan (assuming 10% growth),15 yr. maturity,rs. 1 lakh assured 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 probability of not surviving until 15 year maturity unadjusted adjusted in all the cases, it was found that the unadjusted and adjusted rates of return follow a linear relationship. using linear regression analysis, it was found that the mortality-adjusted rates of return and the unadjusted rates of return follow a relationship that is analogous to the capital asset pricing model (capm). this relationship can be expressed as follows: )( ,, . k nnknk xuarrmarr β+= (5) where nkmarr , denotes the mortality adjusted rate of return, nkuarr . the unadjusted rate of return, )(k nx = )1( )(k np− is the probability of a person aged k not surviving until maturity n, and β is the degree of responsiveness or sensitivity. the regression coefficient β could be interpreted as the increase in the discrepancy between unadjusted and mortality-adjusted rates of return with 1% increase in probability of not surviving until maturity. the unadjusted rate of return represents a “risk-free” rate of return, as individuals are assumed to survive until the end of the maturity period. mortality asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 89 represents a “systematic risk” which cannot be avoided, since it is influenced by external factors. the β values were computed at each level of maturity period and at each level of sum assured to find out how the degree of sensitivity varied with these factors. by taking the probability of not surviving until maturity as an independent factor and the adjustment term (mortality adjusted rate of return less unadjusted rate of return) to be a dependent factor, the relationship between them is analysed. in each case, they show a statistically significant linear relationship. linear regression analysis through the origin gives the following β values for each of the policies, as shown in tables 1-4: table 1. β values for the capital multiplier plan 1 lakh 2 lakhs 3 lakhs 4 lakhs 5 lakhs 15 yrs 2.380 2.360 2.359 2.414 2.434 20 yrs 1.227 1.215 1.213 1.215 1.239 25 yrs 0.444 0.444 0.444 0.443 0.444 table 2: β values for the money back plan 1 lakh 2 lakhs 3 lakhs 4 lakhs 5 lakhs 15 yrs 4.809 4.961 5.074 5.132 5.168 20 yrs 3.440 3.500 3.602 3.656 3.689 25 yrs 1.620 1.633 1.706 1.750 1.778 table 3. β values for the flexi-plan (assuming 8% growth) 1 lakh 2 lakhs 3 lakhs 4 lakhs 5 lakhs 15 yrs -3.165 -3.190 -3.214 -3.212 -3.233 20 yrs -3.009 -3.009 -3.028 -3.038 -3.043 25 yrs -2.974 -2.974 -2.980 -2.988 -2.993 table 4. β values for the flexi-plan (assuming 10% growth) 1 lakh 2 lakhs 3 lakhs 4 lakhs 5 lakhs 15 yrs -3.677 -3.700 -3.722 -3.733 -3.740 20 yrs -3.413 -3.413 -3.430 -3.438 -3.443 25 yrs -3.298 -3.298 -3.304 -3.310 -3.314 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 90 it is observed that, in almost all the cases, at each level of maturity period, the degree of sensitivity increases as the level of sum assured increases, and that the degree of sensitivity is higher at lower maturity periods, i.e. the sensitivity decreases as maturity period increases. further, the money back plan shows the highest degree of sensitivity and the capital multiplier plan shows the lowest degree of sensitivity. in fact, the β values for the capital multiplier plan show an anomalous trend with the level of sum assured. finally, the flexi-plan (assuming 10% growth) shows a higher degree of sensitivity than the flexi-plan (assuming 8% growth). finally, in order to understand how the degree of sensitivity varied with the level of sum assured and the maturity period for each policy, a second-stage regression was performed for the β values on the level of sum assured and the maturity. the results of the second-stage regression are shown in tables 5-8: table 5. β regression for the capital multiplier plan coefficient t stat p-value intercept 5.2244 35.7489 0.0000 sum assured 0.0000 0.3241 0.7514 maturity -0.1946 -29.5201 0.0000 anova df ss ms f significance f regression 2 9.4645 4.7323 435.7720 0.0000 residual 12 0.1303 0.0109 total 14 9.5949 regression statistics multiple r 99.32% r square 98.64% adjusted r square 98.42% asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 91 table 6. β regression for the money back plan coefficient t stat p-value intercept 9.8997 59.0512 0.0000 sum assured 0.0000 3.0178 0.0107 maturity -0.3331 -44.0623 0.0000 anova df ss ms f significance f regression 2 27.8757 13.9379 975.2989 0.0000 residual 12 0.1715 0.0143 total 14 28.0472 regression statistics multiple r 99.69% r square 99.39% adjusted r square 99.29% table 7. β regression for the flexi-plan (assuming 8% growth) coefficients t stat p-value intercept -3.4813 -68.4262 0.0000 sum assured 0.0000 -1.5450 0.1483 maturity 0.0221 9.6318 0.0000 anova df ss ms f significance f regression 2 0.1252 0.0626 47.5795 0.0000 residual 12 0.0158 0.0013 total 14 0.1410 regression statistics multiple r 94.23% r square 88.80% adjusted r square 86.94% asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 92 table 8. β regression for the flexi-plan (assuming 10% growth) coefficient t stat p-value intercept -4.2726 -68.9861 0.0000 sum assured 0.0000 -1.1906 0.2568 maturity 0.0410 14.6644 0.0000 anova df ss ms f significance f regression 2 0.4222 0.2111 108.2311 0.0000 residual 12 0.0234 0.0020 total 14 0.4456 regression statistics multiple r 97.34% r square 94.75% adjusted r square 93.87% for the capital multiplier plan, it was found that the level of sum assured has no statistically significant effect on the degree of sensitivity, while the maturity period has a statistically significant negative effect on the degree of sensitivity. for the money back plan, however, it was found that the level of sum assured has a statistically significant positive effect on the degree of sensitivity, while the maturity period has a statistically significant negative effect on the degree of sensitivity. finally, for the flexi-plan(s), it was found that the level of sum assured has no statistically significant effect on the degree of sensitivity, while the maturity period has a statistically significant positive effect on the degree of sensitivity. all the regressions are statistically significant, explaining about 90% or more of the variation in the degree of sensitivity. discussion the primary objective of the study was to analyse and compare the pattern of adjusted and unadjusted rates of return for different types of policies. from these comparisons, the following were the key findings: • for each type of policy, in each type of comparison made for unadjusted rates of return, the irr curves follow similar patterns. • for each type of policy, in each type of comparison made for mortality-adjusted rates of return, the irr curves follow similar patterns. • in the comparison based on sum assured made separately for unadjusted and adjusted rates of return for each specific policy, it was found that, for the capital multiplier plan and money back plan, the unadjusted and mortality-adjusted rates of return follow similar patterns, while for the flexi-plan they do not follow similar patterns. for other types of comparisons, the unadjusted and adjusted rates of return follow similar patterns. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 93 • higher maturity periods tend to give higher rates of return in the case of capital multiplier plan and the flexi-plan, but the reverse is true in the case of the money back plan. • for each type of policy, higher levels of sum assured tend to give higher levels of rates of return. • in the comparisons between unadjusted and mortality-adjusted rates of return, the adjusted rates of return are higher than unadjusted rates of return in the case of capital multiplier plan and money back plan, but, in the case of flexi-plan, the unadjusted rates of return are higher. • it was found that the difference between unadjusted and mortality-adjusted rates of return follow a linear relationship against the probability of not surviving until the end of the contact that is very similar to the capital asset pricing model. this linear relationship introduces a natural notion of the sensitivity of the rates of return to mortality. it was found that the money back plan showed the highest degree of sensitivity. • it was found that the linear relationship could be extended to include the effects of the level of sum assured and the maturity period on the sensitivity, specific to a (type of) policy. as a result of the above analyses, it is possible to propose a model for the relationship between the adjusted and unadjusted rates of return, specific to a policy (or type of policy), as follows: (6) where nkmarr , is the mortality adjusted rate of return, nkuarr . is the unadjusted rate of return, )(k nx = )1( )(k np− is the probability of a person aged k not surviving until maturity n, jβ ’s are the degrees of responsiveness or sensitivity, and sa is the level of sum assured. it is to be noted that the model above only specifies a relationship between the adjusted and unadjusted rates of return, and does not specify a model for unadjusted rates of return. as earlier results had suggested, the adjusted and unadjusted rates of return follow a linear relationship with the probability of not surviving until the end of the contract, mediated by the parameters of the level of sum assured and the maturity period. a similar linear regression analysis would yield a model for unadjusted rates of return in terms of these same variables. however, this is beyond the scope of the present study, and would be an interesting direction for further research. the study does suffer from a few limitations. firstly, only three life insurance policies were considered in the analysis and that too from only one life insurance company, viz. kotak mahindra old mutual life insurance limited. a more extensive study of a larger number and different types of policies would be required to confirm the generalisability of the results. )( 210,, )..( k nnknk xnsauarrmarr βββ +++= asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 94 another limitation of the study is the reliance on lic mortality tables, which are known to be somewhat outdated, though they are used by practically all life insurance companies even to date. moreover, the mortality rates used are generalised rates and there is always a possibility that these rates may differ for different categories of individuals. such considerations may be incorporated in the methodology in a straightforward manner to yield richer results. finally, a point to be noted here is that the study took into consideration mortality risk only. life insurance contracts may involve many other risks besides the major risk of mortality. as such, the methodology used in the study did not take into account other risk factors. the study opens a further scope of research to include other risk factors which may be relevant in addition to the risk of mortality. references brealey, r.a., & myers, s.c. (1996). principles of corporate finance (5th ed.) mcgraw-hill. feldblum, s. (1992). pricing insurance policies: the internal rate of return model. study note, casualty actuarial society. available at: www.casact.org/library/studynotes/feldblum9.pdf myers, s.c., & cohn, r.a. (1987). a discounted cash flow approach to property-liability insurance rate regulation. fair rate of return in property-liability insurance, klower-nijhoff. http://dx.doi.org/10.1007/978-94-015-7753-3_3 teufel, p., tongson, t.j., & rech, j.e. (2001). insurance risk 101, technical report, american academy of actuaries, washington d.c. microsoft word 5485-19759-2-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 323 prediction of the moving direction of google inc. stock price using support vector classification and regression liu pan department of business english, gannan normal university economic & technological development zone, ganzhou 341000, china e-mail: panliu18@gmail.com xuan liu (corresponding author) department of electrical and computer engineering, johns hopkins university 3400 n. charles st, baltimore, md, usa. tel: 1-90-6487-1634 e-mail: xuliu@mtu.edu received: april 16, 2014 accepted: may 18, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.5485 url: http://dx.doi.org/10.5296/ajfa.v6i1.5485 abstract forecasting the short-term trend of a stock market has long been a big challenging task. parameters of stock markets, including open/close prices, daily-high/low prices and trading volumes, were frequently used in previous studies to forecast the stock market. basing on the fact that the moving direction of these parameters have certain inertia within short-term period, we here explored the potential application of the moving trends of these parameters within 4 different time periods (5, 15, 30 and 45 trading days respectively) for forecasting the movement direction of stock price of google inc. by using support vector classification (svc) and support vector regression (svr). we found that among the 4 different time periods tested, the moving trend within 30 days has the best accuracy on the prediction of the stock price of google inc., and using svc and svr combination improved the prediction performance. these results indicated that moving trends of stock transaction data within a certain time period have good inertia and are thus useful for forecasting the moving direction of stock price. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 324 keywords: financial forecasting, stock price prediction, trend prediction, technical analysis, support vector machine, support vector classification, support vector regression asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 325 1. introduction analysis of stock market, including the stock price forecasting, has long been an intriguing topic for both investigators and researchers. fundamental analysis and technical analysis are the two main stock analysis strategies used to forecast the future stock price movements (murphy, 1999; turner, 2007). fundamental analysis attempts to predict the price of a particular stock by studying the company fundamentals such as revenues, annual growth rates, and potential competitors (murphy, 1999). technical analysis, on the other hand, is solely based on the study of stock market's historical data or pattern, including price, volume action and technical indicators (turner, 2007). both approaches have their own pros and cons. generally, fundamental analysis is favored for longer time frames, while technical analysis is considered as a better style for short-term trading. forecasting the short-term trend of a stock market is still a big challenging task nowadays. this is because that stock market is noisy, chaotic, nonparametric and non-linear in nature, and many external entities like politics, human psychology/behavior, liquid money and related news influence the direction of the stock market (abu-mostafa and atiya, 1996). recently, a lot of interesting work has been carrying on in the area of applying machine learning algorithms, including support vector machine (svm), for analyzing price patterns and predicting stock prices and index changes (yang et al., 2002; grosan and abraham, 2006; chen et al., 2006; sapankevych and sankar, 2009; kao et al., 2013; kazem et al., 2013; zhi-gang et al., 2013). the advantage of svm is that it is able to reach the global optimum and is resistant to the undertraining or overtraining problems (yoo et al., 2005; chen et al., 2006; sapankevych and sankar, 2009). this machine learning method has been successfully used for stock return predictions in several financial areas (yang et al., 2002; chen et al., 2006; sapankevych and sankar, 2009; kao et al., 2013; kazem et al., 2013). parameters of stock markets, including open/close prices, daily-high/low prices and trading volumes, were frequently used in previous studies to forecast the stock market (lildholdt, 2002; fiess and macdonald, 2002; corwin and schultz, 2012; fuertes and olmo, 2013). considering that the moving trends of these parameters may have certain inertia within short-term period, we hypothesized that the moving direction of these parameters would be better than the original parameters themselves for predicting the short-term stock price. to test this hypothesis, in this study we explored the potential application of the moving trends of these stock parameters to forecast the movement direction of stock price of google inc. by using support vector classification (svc) and support vector regression (svr), two main svm application forms. the remaining sections of this report are organized as following: section 2 provides a brief overview of the svm algorithms; section 3 describes the experiment design; section 4 reports and discusses the experiment results; section 5 summarizes the whole report. 2. methodology 2.1 the basic ideas of svc and svr svms, a set of supervised learning algorithms developed by vapnik and his co-workers, are characterized by usage of kernels, absence of local minima, sparseness of the solution and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 326 capacity control obtained by acting on the margin or on number of support vectors (vapnik, 1995). according to the purposes, svms can be divided into svc, svr, and ranking svm. svc performs classification by finding the hyperplane that maximizes the margin between the two classes in highor infinite-dimensional space. svr is extended from svm and performs regression in the high-dimension feature space using insensitive loss. both svc and svr are widely used in various areas and continue to be two of the most successful machine learning algorithms. an overview of the basic ideas of svc and svr was described in detail in reference (yoo et al., 2005). briefly, for a two-class classification problem, we can assume that we have a set of input data points xi ∈ rd(i = 1,2,...,n) along with each point’s classification yi, where yi can take on one of two possible values: -1 or 1. the linear support vector machine is defined as the following optimization problem: min w 12 wt ·w + c l  i=1 ξi s.t. yi(wt ·xi + b) ≥ 1 − ξ, ξi ≥ 0 i = 1...l where ξi is the error for a given training point xi, w is the margin, b is the offset for the hyperplane, and c is a constant representing the emphasis that is to be placed on minimizing the error. the solution to this problem results in the following classifier for the prediction of f(x) in the new sample x: f(x) = sign( l  i=1 yiαi ·k(x,xi)+b) where αi is the parameter coefficient, and k(x,xi) is kernel function. for svr, it is formulated as minimization of the following functional: min w, b 12 wt ·w + c l  i=1 (ξi + ξi *) s.t.      yi − (wt ·xi + b) ≤ ε + ξi (wt · xi + b) − yi ≤ ε + ξi * ξi,ξi * ≥ 0, i=1..l where ε is the parameter epsilon and the couple (xi, yi) the training set. slack variables ξ and ξ* were used to allow some errors to deal with noise in the training data. once trained, the svr will generate predictions using the following formula: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 327 f(x) ≡ l  i=1 (αi − αi *)·k(x, xi) + b 2.2 kernel and optimization of kernel parameters epsilon-svr in libsvm package, which is developed by chang et al (2011) and is currently one of the most widely used svm, was employed for stock price prediction in this study. libsvm supports four basic kernel functions (hsu et al., 2005; chang and lin, 2011)： (1) linear kernel: k(x, y) = x·y (2) polynomial kernel: k(x,y) = (γ·x·y + coef0)degree (2) radial basis function (rbf) kernel: k(x,y) = exp (-γ·||x y||2) (3) sigmoid kernel: k(x,y) = tanh (γ ·x·y +coef0) we chose rbf kernel in our study because of the following factors: 1) rbf kernel has fewer numerical difficulties and can handle the nonlinear models (hsu et al., 2005); 2) the linear kernel can be regard as a special case of rbf kernel; 3) the polynomial kernel has more hyperparameters than the rbf kernel; 4) the sigmoid kernel behaves like rbf for certain parameters (hsu et al., 2005). the svm performance depends on a good setting of two parameters c and γ (hsu et al., 2005; chang and lin, 2011). basing on 3-fold cross-validation error, we obtained the best values of parameters c and γ for svc and svr using grid search method. 3. experiment design we chose the internet search giant google inc (stock symbol: goog) for this study basing on two reasons: 1) its transaction data is simpler than other stocks since this company has no divide-paying and stock-splitting/combining records; 2) the company has very high volume of outstanding shares and high stock price, making it difficult for the stock price being manipulated. we obtained the transaction data and historical prices of google inc. from the date of its initial public offering (aug 19, 2004) to dec 31, 2013 from yahoo finance (http://finance.yahoo.com). the original dataset contains 6 attributes: date, open price, high price, low price, close price, volumes and adjusted close price. the adjusted close prices are the same as the close price of google inc. as the company has never paid divides and the its stock shares have never been split or combined. figure 1 shows the overall moving trend of the close prices for google inc. traded on the nasdaq exchange from 2004 to 2013. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 328 figure 1. the overall moving trend of original (left y-axis) and scaled (right y-axis) close price for google inc. for the year of 2004 to 2013 to examine within which time period the moving trend will be better for prediction of the stock direction, in this study we analyzed the prediction accuracy of the moving trends of goog transaction data within 4 different time periods, including periods of 5, 15, 30 and 45 trading days, respectively. the svm classifiers generated basing on the 4 moving trends are named correspondingly as classifiers 1, 2, 3 and 4, respectively. the moving trend of the transaction data within a time period is defined as the slope (value b) in the regression formula y= a + bx that is produced by simple linear regression analysis, in which x is the number of trading day (from 1 to 5 for classifier 1, 1 to 15 for classifier 2, 1 to 30 for classifier 3 and 1 to 45 for classifier 4), and y is the corresponding data (open price, high price, low price, close price or volume) at the corresponding trading date. the obtained slopes of the open prices, high prices, low prices, close prices and volumes of goog within 5 (classifier 1), 15 (classifier 2), 30 (classifier 3) or 45 (classifier 4) training days were then used as five input features for svm to predict the slopes of close price of goog in the next 5th, 15th, 30th or 45th days, respectively. the predicted slope of goog close price >0 represents the stock price rose up during that period, while slope <0 means price falling down. to check the prediction accuracy, the predicted results were compared with the actual data (called indicator). the slope values of the close price of goog were directly used as indicators in svr analysis. in svc analysis, a boolean value (1 or -1) that was transformed from the slope values of the close price was used as indicators. boolean value ‘1’ means the corresponding slope value >0, while ‘-1’ means the corresponding slope <0. all the datasets were split into two parts for both svc and svr prediction in this study: training set (accounting for about 2/3 of the data) and test set (the rest 1/3 of the data). as large attribute values might cause numerical problems and greater numeric ranges dominating those in smaller numeric ranges (hsu et al., 2005), we scaled all the data to the range from 1 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 329 to 2 using mapminmax function of matlab before applying svm analysis. figure 1 shows that scaled close prices have the exactly same pattern as that of the original close prices. the best values for parameter c and γ that were obtained by grid search method for each of the svr perdition classifier are shown in table 1. 4. results and discussions 4.1 prediction of moving direction of goog price using svc svc analysis gave out a probability value ranging from 0 to 1 for each instance (e.g. moving direction in one trading period). the probability value closing to 1 means that the chance for goog stock price rising up is very high, closing to 0 means the great chance of price falling down, while close to 0.5 represents the chance of price rising-up is similar to that of falling down. figure 2 shows the correlation between the predicted probability values and actual moving trend (slope) across all the instances analyzed. among the 4 classifiers, the predicted pattern in classifier 3 (slopes within 30 trading days) is the most closest to the actual moving trend and has the highest pearson’s correlation coefficients (pearson’s r) in both training and test datasets. table 1. svm parameters and prediction accuracies for different classifiers tested classifier trading days svm best c best γ predicted accuracy training set test set 1 5 svc 2 16 64.33% (193/300) 50.59%(86/170) svr 2 8 65.67% (197/300) 50.59% (86/170) 2 15 svc 0.031 0.031 62.00% (62/100) 53.57% (30/56) svr 0.313 1 61.00% (61/100) 48.21% (27/56) 3 30 svc 90.510 0.707 74.00% (37/50) 62.96% (17/27) svr 12.126 0.218 68.00% (34/50) 59.26% (16/27) 4 45 svc 5.657 32 93.33% (28/30) 42.86% (9/21) svr 1 5.278 70.00% (21/30) 52.83% (11/21) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 330 figure 2. the correlation between the predicted possibility values and actual moving trend (slope) across all the instances (moving direction in one trading period) analyzed by svc. (a) classifier 1 (5d). (b) classifier 2 (15d). (c) classifier 3 (30d). (d) classifier 4 (45d). the svc classifier automatically classified the instances with a probability value >0.5 into the group with price rising up (e.g. slope>0), while the rest into the group with price falling down (slope<0). the prediction accuracies of svc analysis for different classifiers are listed in table 1. among the 4 classifiers tested, svc analysis using classifier 3 achieved the highest accuracy (62.96%) for the test dataset. this number means that if we use this classifier to guide our investment in goog stock, we will get gains for 63 times while get losses for 37 in 100 trading times. theoretically, this gain/loss ratio will bring about considerable returns in short-term stock trading. the prediction accuracies for the other 3 classifiers are all close to 50% for test dataset and therefore are not practical in stock trading. when we used more stringent cut-off values for the svc classifiers to make classification, we obtained higher prediction accuracies for the classifiers 2 and 3, especially the latter (table 2). for example, the accuracy is 100% for the test dataset if instances with probability values >0.7 are classified into the price-rising up group and instances with values <0.4 into the price-falling down group for classifier 3 (figure 3). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 331 figure 3. the prediction accuracies when using more stringent cut-off values for the svc classifier 3 to make classification 4.2 prediction of moving direction of goog price using svr svr analysis gave out a predicted slope value for each instance. figure 4 shows the correlation between the predicted and actual slope values across all the instances analyzed. like the svc results, the predicted slope pattern in classifier 3 is the most closing to the actual pattern and has the highest pearson’s r in both the training and test datasets. while for the other 3 classifiers, the patterns between predicted and actual slopes are similar only in the training dataset. if we only consider whether the predicted moving direction by svr is the same as the actual one (e.g., the predicted and actual slopes are both >0 or <0), we can also obtain the prediction accuracy data through the svr analysis (table 1). similar to the svc analysis, classifier 3 achieved the highest accuracy (59.26%) while the other 3 classifiers showed accuracies around 50% for the test dataset. we also tried to use more stringent cut-off values for the classification basing on the svr results. again, higher prediction accuracies were achieved for the classifiers 2 and 3, especially the latter (table 3). for example, the accuracy is 100% for the test dataset if instances with predicted slope values > 1 are classified into the price-rising up group and instances with values < -0.2 into the price-falling down group for classifier 3 (figure 5). 0 10 20 30 40 50 60 70 80 90 100 training set test set no cut-off value >0.6 or <0.4 >0.63 or <0.4 >0.65 or <0.4 >0.67 or <0.4 >0.7 or <0.4 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 332 figure 4. the correlation between the predicted and actual slope values across all the instances analyzed by svr. (a) classifier 1. (b) classifier 2. (c) classifier 3. (d) classifier 4 figure 5. the prediction accuracies when using more stringent cut-off values for the classifier 3 basing on the svr results 0 10 20 30 40 50 60 70 80 90 100 training set test set no cut-off value >0.2 or <-0.05 >0.4 or <-0.05 >0.5 or <-0.1 >0.7 or <-0.2 >1 or <-0.2 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 333 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 334 4.3 prediction of moving direction of goog price using svc and svr combination figure 6 shows that combined use of svc and svr improves the prediction accuracy of the moving trend of goog stock price for classifier 2 and 3, especially the latter. we tested combinations at two levels. one is the combination of the classification results obtained when using the second cut-off value for svc and svr. the other one is the combination of the results when using the third cut-off vale for svc and svr. the principle for this combination is that only the instance classified into same group basing on svc and svr results are counted, and then the prediction accuracy are calculated basing on the percentage of instances being correctly classified by svc and svr. figure 6. combined using svc and svr improves the prediction accuracy for the moving trend of goog stock price. columns represent the prediction accuracy for the test sets. (a) combined analysis of the prediction results that were obtained using the second cut-off vale for svc (>0.61 or <0.4) and svr (>0.4 or <-0.4). (b) combined results that were obtained using the third cut-off vale for svc (>0.62 or <0.4) and svr (>0.6 or <-0.6). 5. summary using the stock of google inc. as an example, in this study we tested the potential application of the moving trends of the stock transaction data in the forecasting the movement direction of stock price with svc and svr methods. our results indicate that the moving trends of transaction data within 30 trading days have the best prediction accuracy of the stock price in both methods, and combination of these two methods improves the prediction performance. the moving trends within short period are apt to be affected by various random events, which may explain our findings that moving trends within ≤15 trading days failed to well predict the moving direction of the stock price. however, this does not mean that moving trends >15 trading days will always be good for stock price prediction, as we also found that the trends within 45 trading days had the similar prediction performance as that within 15 trading days. prediction using the trends within >45 trading days (such as 60 and 75 trading days) failed to improve the performance either (data not shown). these results indicated that moving trends asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 335 of stock transaction data within a certain time period have good inertia and are thus useful for forecasting the moving direction of stock price. references abu-mostafa, y. s., & atiya, a. f. 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(2005). proceedings of the 2005 international conference on computational intelligence for modelling, control and automation, and international conference on intelligent agents, web technologies and internet commerce (cimca-iawtic'05). zhi-gang, wang, chi-she, wang, qing-xia, ma, & yong, hu. (2013). the securities market month k line forecast based on svc. information science and management engineering (set), 46, 235-243. http://dx.doi.org/10.2495/isme20130311 microsoft word 10288-37979-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 228 post-merger integration approaches: case analysis of the one. vip macedonia merger dushica stevchevska-srbinoska, phd university american college skopje boulevard iii makedonska brigada 60, skopje, macedonia tel: 389-2-246-3156 e-mail: dusica@uacs.edu.mk edi smokvarski, mba university american college skopje boulevard iii makedonska brigada 60, skopje, macedonia tel: 389-2-246-3156 e-mail: smokvarski@uacs.edu.mk received: nov. 7, 2016 accepted: dec. 20, 2016 published: december 20, 2016 doi:10.5296/ajfa.v8i2.10288 url: http://dx.doi.org/10.5296/ajfa.v8i2.10288 abstract selecting the best integration approach is a meticulous and sensitive process that can mold the completion of the merger and/or acquisition transaction. in this paper, i discuss that implementing the proper integration approach leads to mitigating or increasing impending risks when going into major company restructuring events. if proper selection and execution takes place, and all related processes and expectations of the parties involved are duly taken into account, successful post-merger integration can be concluded in the republic of macedonia in spite of numerous difficulties. one of the greatest risk factors certainly lies in the satisfaction or dissatisfaction of the work force which is of vital meaning for the operational excellence of every entity. three different integration approaches absorption, symbiosis, and preservation are observed through literature overview and particular transactions. additionally, i study the example of the integration approach adopted by one. vip doo skopje following the merger of vip operator dooel skopje and one in 2015, accentuating that multiple factors can increase or deteriorate the chances of integration success. keywords: integration process, integration approach, merger and acquisition, macedonian market asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 229 1. introduction organizational design is the process that enables managers to select and manage the individual dimensions and components of the organizational culture for the purpose of attaining the organization goals. organizational structure is the formal system of tasks and relationships that leads to control, coordination, and motivation of employees while enabling their cooperation. the manager’s task is to create an organizational structure and culture that: 1. encourage employees to work in a dedicated manner and to provide support for each other 2. enable people and groups to cooperate effectively (popovski, 2001). structure and culture have a vast impact on the: 1. team work and cooperation, 2. inter-group and inter-departmental relations. 3. behavior, 4. motivation, 5. results, structure and culture design and evolution influence the behavior of individuals and groups within every organization. once the desired behavior, attitude and goals of the organization members are settled, one can design the structure and proceed with developing cultural values and norms that will set the grounds to acquire the desired attitudes, comportment and goals. organizations base these decisions on the design of potential conditions they needs to face, which have to be considered upon planning. the three basicconditions that have influence on the design of structure and culture of the organization are: • organization surroundings • technology adopted and used by the organization, and • strategic direction of the company (walter, 2004). the above-stated represents basis for further differentiation of the organizations. differentiation is the process of creating groups of individuals and responsibilities for the purpose of producing goods and services. on the other hand, function represents group of people who work together and execute the same or similar type of tasks and occupy similar positions within the organization. as companies develop, work effort gets further classified into more individual functions, which requires further differentiation into more departments/units. department is a group of functions created for the purpose of enabling the enterprise to produce and offer its goods and services to customers. when developing the organizational structure, management needs to differentiate and group the organizational activities according to function and division for the purpose of attaining the enterprise goals. in general, most authors categorize all enterprises according to the following three asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 230 organizational structures which vary based on the relations that bridge the organizational functions and units: 1. functional structure 2. unit structure: according to product/service, market and geographic location, and 3. matrix (divisional) organizational structure. table 1. types of organizational structure advantages weaknesses functional structure simple communication between specialists timely decision making learning organization team work eases the evaluation of employees across all levels difficulties upon servicing the needs for all products that are offered on the market complicated coordination complicated support for all (geographic) regions not suitable for older, complex organizations unit structure ease of communication improved focus on various services, products, or consumers adapted management and solution of problems ease of team work clear connection between results and rewards modelled services high operational and management costs poor inter-departmental communication/frequent conflicts matrix structure support for fast product development great communication and cooperation between team members innovation and creativity role ambiguity stressful work conditions limited promotion opportunities source: lajoux, 2006 the functional structure comprehends activity structuring according to functions such as production, procurement, marketing, finance, sales, etc. the segment structure goes for activity grouping based on market presence, i.e. markets that the enterprise serves or geographic location covered. the matrix structure is complex and based on activity structuring according to functions and projects, where communication is both horizontal and vertical. • integration: mechanisms for improved coordination asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 231 the more grand and the more complex an entity is, the larger its hierarchy. complex organizations are comprised of multiple layers of hierarchy, while lean organizations have merely few. integration issues amongst hierarchy levels arise when a given entity becomes more complex. these issues are followed by communication difficulties and problems in decision-making processes (kpmg, 2011). also, it takes more time to deliver messages up and down the hierarchy tree, which slows down the decision-making processes. information messages lose core tone or are filtered in a way that managers interpret these messages according to their personal interest (davis, 2000). these problems deteriorate the quality of decision making even further. in order to reduce communication and decision-making difficulties which follow the growth process of every entity, especially in mergers and acquisitions, it is indispensable to take several steps such as: • decentralization • mutual adaptation • teams • personal contact. all these actions enable analysis of communication problems across multiple points without transferring minor details and messages to top management. at the same time, delegating major work duties to lower echelons can increase motivation and challenge employees, which is very essential in major restructuring projects such as mergers and acquisitions. 2. integration approaches three integration approaches are identified and analyzed by numerous researchers. their implementation is dependent on the strategic intentions behind every merger and/or acquisition event (pearson m, 1998). strategic interdependence: organizational low high autonomy: low preservation symbiosis high holding absorption figure 1. integration approaches source: haspeslagh, p., and jemison d., 1991 the absorption approach is normally preferred in mergers and acquisitions within the same industrial segment and is based on the need for economy of scope and operating efficiency due to similarity of operations. it is applied in order to reinforce or expand market presence, asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 232 such as presented in the case study in the following chapter of this paper. absorption calls for timely resolution of cultural difficulties. symbiosis is primarily applied in transactions between industrial segments where cultural differences can be quite striking. eventually, high integration is needed within certain functional areas for the purpose of gaining merger and acquisition benefits, such as cross-sales and sales network merger. symbiosis is applied in transactions where larger market presence is indispensable but the cultural differences are too grand to remove them within a short period. this is why the slow symbiotic approach is more adequate. the preservation approach focuses on transactions in a new industry/segment for the aim of transferring specific skills or knowledge to the acquiring entity or to the other transaction participant(s). in most cases, the cultural differences between the two entities are big driven by operations in different industrial segments. therefore, the merging entities are encouraged to continue operating individually with a high degree of autonomy. also, the preservation approach may be applied when the acquirer is interested in entering a new sub-segment within the same industrial branch or in entering a new geographic region (country). hence, the acquired entity remains, more or less, untouched in the aftermath of the transaction. finally, the holding structure comprehends sharing of particular risks, financial transfers and management. integration is not in the scope of these organizations as functions and departments do not merge in practice. hence, holding approach will not be evaluated in this paper in further details. the desired integration level of individual operating segments following a given merger/acquisition transaction may differ to the overall integration. that said preservation may aim at high integration across several domains such as it systems, data processing, accounting and internal audit. the remaining areas may be unaffected or may be slightly adjusted to the operations of the acquiring entity. since absorption and symbiosis ask for high integration, albeit at a different pace, most of the operations should be encompassed in a similar manner. nevertheless, exceptions to the rule exist, especially when it comes to symbiotic acquisitions where some domains are excluded from the integration efforts. such is the example of the acquisition of transped komerc doo skopje (macedonia) by viator &vektor logistika from slovenia where management decided to integrate all functions but the retail brands and specific products. on the other hand, having in mind the high autonomy granted by the preservation approach, one could expect that integration will not be applied across most operations. nonetheless, the acquirer may embark on rather insistent integration of several functional domains for the purpose of establishing a greater financial and operational control. this was the case of the 2006 acquisition of on.net macedonia conducted by one macedonia (former cosmofon), where high integration was pursued for it, accounting, and audit systems. branding was rapidly integrated as well. only a select set of operations, such as differentiated customer offer in part of the fixed communications segment, preserved their uniformity. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 233 management often handles several diverse integration timelines and priorities that touch upon multiple operation domains: • reporting responsibilities • accounting/auditfunction • it systems • human resource procedures and compensation/benefit plans • customer contacts • product lines and product logistics services • branding and marketing. speed and communication remain core aspects in every merger and acquisition integration. the decision-making process needs to be timely in order to minimize uncertainties and integration fatigue faced by employees and customers (atkinson et al., 2015). 3. case study – integration approach in one.vip merger company and transaction summary: this paper will illustrate the importance of the acumen reached upon integrating through the example of one.vip doo following the merger event of vip operator dooel skopje, macedonian subsidiary of the telekom austria group established in 2007, and one in q4 2015, telekom slovenije’s subsidiary established in 2003 as cosmofon.(telekom austria group newsroom, 2015).prior to merging, one occupied the third position in the macedonian mobile communications market, with sim market share of more than 26% at the end of q3 2015 (approximately 600k subscribers). in 2014, one achieved total revenues and ebitda of approximately 75.7 mn eur and 10.6 mn eur respectively. vip operator on the other hand, had mobile market share of 27% prior to the transaction, with 2014 revenues somewhat below 60mneur, and ebitda similar to one. the main driver behind the merger was to create a new enterprise with improved competitiveness and investment strength. in the essence, one.vip was expected to generate benefits and quality to various customer segments, while encouraging competition on product, price and quality of services. following the transaction approval by the macedonian commission for protection of competition, 55% of the new entity’s ownership remained in the hands of telekom austria group, with telekom austria retaining sole control over one.vip. call and put options for the exit of telekom slovenije group were foreseen within three years following the transaction. core condition to the merger approval was to enable mvno access to a third entrantin order to ensure competitiveness of products and prices on the macedonian telecommunications market. integration activities: leadership structure: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 234 • it was initially decided to retain nikola ljushev (ceo of vip operator dooel skopje) in the position of ceo of the new entity one.vip doo skopje. the cmo and cfo at the time were dismissed from their positions and reassigned to the holding headquarters. • nonetheless, ljushev was degraded shortly after to the position of managing director as top management functions for one.vip were extended to another operator from the telekom austria group – vipnet croatia.this top management restructuring took by surprise the employees of one.vip as ljushev had occupied the ceo position almost from the beginning of operations of vip operator dooel skopje in 2007 when the entity was incorporated in the macedonian market as a greenfield investment. communication: • failure in communicating the devotion to the reinforcement of their market presence in the republic of macedonia: most of the one.vip employees were not persuaded in the coherence of the one.vip market strategy. in fact, there was a common misunderstanding that one.vip is primarily focused on delivering communications products based solely on the technology that vip operator dooel skopje had to offer before the merger, while ignoring the in-house developed services and systems of one. this misunderstanding was further reflected to their consumers. furthermore, the situation led to losing most of the key talents of both merging entities, essentially starting with one, which burdened the hiring and retaining process. human resources: • human resource substitution: cca. 200 employees were fired or left the new company following one year of the merger transaction. the core explanation offered was overlap of duties, job functions, and similarity of operations of the merging entities. the genuine corporate motive was cost savings and effectuation of merger synergies. • selection process: the publicly acclaimed version was that retained employees were selected on the basis of merit and talent. however, selection was rather individual and based ratheron the opinion of middle management/supervisors and involved personal bias. • poor communication: although the entity aimed for a transparent selection process, the communication efforts via e-mail, intranet publications and meetings with senior management were insufficient. part of the staff claimed that they were fired due to not having signed a contract for permanent employment prior to the merger, which made it easy to dismiss them when contract period expired. • preference for retaining the management of vip operator dooel skopje: prior to merging, one middle management were offered attractive compensation packages to motivate them to leave the company. those who stayed were offered lower level positions and were degraded several scales down the organizational ladder, with the exception of few that managed to retain their department management position in the new entity. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 235 • attempt to prevent employee loss: aware of employee disappointment, one.vip tried to explain that the merger transaction was successfully completed and that in due course business will continue to run as usual. yet, employees were unhappy with the new work environment whereby they were required to work long hours and were not offered any financial compensation for the additional work effort and stress on the work place. communication failed, and one.vip continued to lose key talent to competition and to other industries. • neutralizing cultural differences: the two main cultural conflicts that impeded onstaff motivation were the more rigid decision-making processes based on financial weight of projects and market decisions in vip operator dooel as opposed to propulsive pricing processes and customer sales subordination culture in one, i.e. austrian vs. greek style organizational culture1. implemented integration level high degree of integration technology and information systems • it was decided to retain vip operator’s customer support, billing and collection, and finance systems. regarding the telecommunication network, the assets were merged in a way that the best items were tested and selected (i.e. base stations with highest area and population coverage). frequency range also was merged based on best/most used frequencies selection, with regulator (i.e. macedonian agency for electronic communications) permit to sell redundant frequency lots to the sole mobile communications competitor, t-mobile macedonia. 1 cosmote greece was the founder of one, former cosmofon macedonia. understandably, the initial owner had left their cultural landmark on the organizational structure and processes of the entity. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 236 table 2. ranking of the one.vip post-merger integration effectiveness domain ranking outcome employee retention one year into the merger (fall 2016), one.vip continued losing key talents technical system ? on-going integration as of research date sharing of knowledge loss of key talents, lack of knowledge codification for in-house developed systems and products customer retention as of fall 2016, one.vip continued experiencing drop in subscriber base and customer dissatisfaction sales network (direct, indirect, key account) ? many indirect master dealer contracts were discontinued due to preferred provider selection; shops were closed to reduce sales costs, sales people were laid off, which increased dissatisfaction and uncertainty about future. nonetheless, the sales network capilarilty was higher than before the merger. cross-selling ? customer dissatisfaction increased as technical problems due to system mergers came to surface, which made upselling and cross-selling difficult economy of scope ?/difficulty in stabilizing prices on the communications market and negative customer reaction to higher prices following the merger. difficulties in realizing expected merger synergies in the form of higher income per subscriber and lower subsidies in order to prevent negative customer reaction. given the absence of a clear leadership structure, stable communication channels, and determination to reinforce employee motivation, the one-year post-merger period proved to have damaging impact on the human relations which pointed to an inefficient integration process. as the merged entity is stepping into the second post-transaction year, integration is still on-going and final outcomes are yet to be seen and analyzed. 4. conclusion a wide spectrum of participants is directly and indirectly involved in every merger and acquisition transaction. these parties impact and are impacted by major restructuring events asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 237 such as mergers and acquisition, and the influence is reciprocal. figure 2. participants in the merger and acquisition integration process employees, customers, vendors, government bodies and agencies, private investors, the communities/geographic regions where these entities operate and cooperate with, along with market competitors are important factors to the merger success, as well as for the longevity and success of the new entity. ergo, managers must unequivocably dedicate their full attention to: • preserving and growing the current customer portfolio • georgraphic presence, especially when it comes to serving larger markets • economy of scale in revenue generating activities, full utilization of the available sales channels and their expansion, in particular through cross-selling • economy od scope in cost managememt along with operating efficiency • evaluation of the equity and liability structure • supply of products/services and brands • human resources, knowledge codification, and knowledge transfer • technology and infrastructure postmerger integration employees customers suppliers government bodiesowners community competitors asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 238 given the theoretical research and case study conducted using the available data from the one.vip merger integration, it is evident that the integration process must be aligned with the pre-set acquisition goals. implemeting the wrong approach or the right approach in the wrong manner may provoke negativeconsequences since all entities and enterpreneurial operations depend on the quality and adequacy of the human factor which is highly mobile. acknowledgement the research is supported by uacs skopje. references atkinson, s., & gary, m.s. (2015). creating value in the merger and acquisition integration process, proceedings of the 33rd international conference of the system dynamics society cambridge, massachusetts, usa -july 19-23, 2015, system dynamics society, cambridge, massachusetts, usa, presented at international conference of the system dynamics society, cambridge, massachusetts, usa. davis, steven. (2000). bank mergers: lessons for the future, london: macmillan press. https://doi.org/10.1057/9780230509399 haspeslagh, p., & jemison, d. (1991). managing acquisitions. new york: free press. kpmg. (2011). “post merger people integration”, full text available on: https://www.kpmg.com/in/en/issuesandinsights/articlespublications/documents/post%20m erger%20people%20integration.pdf. lajoux, a. reed. (2006). the art of m&a integration. a guide to merging resources, processes and reponsibilities, the mcgraw-hill companies, inc. popovski, vasil. (2001). the influence of the organizational structure on company operations, ekonomski institut skopje. telekom austria group newsroom. (2015). “macedonian competition authority approves merger of vip operator with one.” full text available on: http://www.telekomaustria.com/en/newsroom/2015-7-8-macedonian-competition-authority-a pproves-merger-of-vip-operator-with-one.1. walter, ingo. (2004). mergers and acquisitions in banking and finance. what works, what fails, and why, new york: oxford university press inc. copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 6556-23397-2-rv-writer2-new2 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 96 literature review on corporate governance structure and performance in non-financial firms in bangladesh munshi samaduzzaman (corresponding author) accounting lecturer, kaplan business school, sydney, australia e-mail: samaduzzaman@gmail.com fazluz zaman business trainer and curriculum writer uow college, university of wollongong, australia e-mail: fazluzzaman@gmail.com zahurul quazi coordinator, vocational education and training uow college, university of wollongong, australia e-mail: zahurulquazi@yahoo.com.au received: november 4, 2014 accepted: jan. 3, 2015 published: june 1, 2015 doi:10.5296/ajfa.v7i1.6556 url: http://dx.doi.org/10.5296/ajfa.v7i1.6556 abstract the need for the mechanism of corporate governance arises due to conflicts of interest between different stakeholders. different stakeholders have different views and goals, as well as incomplete knowledge of each other’s preferences. the whole world has seen the corporate scandals of big companies such as enron, tyco, worldcom, satyam computer services, etc. these collapses have brought into question the effectiveness of the corporate governance mechanism applied by organizations as part of regulating their affairs and books of accounts. this article discusses in detail the meaning and definition of corporate governance, examines corporate governance practices in bangladesh, investigates bangladesh’s corporate governance guidelines 2012 and performs a critical literature review on corporate governance structure and performance inside non-financial firms in bangladesh. keywords: audit committee, board of directors, corporate governance, directors, executives, stakeholders, securities and exchange commission asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 97 1. introduction according to hess (1996), corporate governance (cg) is the process of administration and control of the firm’s human resources and capital in the firm’s owner’s interest. sternberg (1998) defines corporate governance as a way to ensure that corporate agents, assets and actions are directed towards reaching the objectives of the corporation which is expanded by its shareholders. the centre of european policy studies (ceps, 1995) indicates, in describing corporate governance, that it acts as a whole system of processes, rights and controls that is expanded externally and internally over the entity of business management with the aim of protecting stakeholders’ interests. shleifer and vishny (1997) refer to corporate governance as being a way in which the corporation’s financial suppliers ensure that they will receive an investment return. according to o’donovan (2003), corporate governance is an internal system that includes processes, policies and people that serve the requirements of shareholders as well as other stakeholders by controlling and directing activities by the firm’s management with good business objectivity, savvy and integrity. sound corporate governance is related to external marketplace legislation and to a commitment to adding a healthy board culture that protects processes and policies. in other words, corporate governance is defined as the moral, ethical and legal corporation values that safeguard stakeholders’ interests. classens (2003) argues that corporate governance definitions, although widely varied, can be categorized into two sets. the first set of definitions deals with a behavioural pattern set that comprises the corporation’s actual behaviour, namely, its efficiency, financial structure, performance, growth and treatment of shareholders and other stakeholders. the second set of definitions deals with the normative framework. corporate governance is based on rules under which companies operate including judicial systems, financial markets, legal systems and labour or factor markets. according to blair (1995), corporate governance is the whole set of cultural, institutional and legal arrangements that identify what public-trading corporations can perform, who controls corporations, how the control is being exercised and how the activities, risks and returns are allocated. saidi (2004) points out that corporate governance is the system by which firms can be controlled and directed, and adds that the responsibility for corporate governance lies with the shareholders, board of directors (bod) and the management. these groups also act as principal players in the corporate governance process. other than the shareholders, management and board of directors, other stakeholders included in the process are suppliers, regulators, employees, creditors, the environment, customers and the community at large. likewise, according to gillibrand (2004), the corporate governance structure deals with procedures and rules that are used for making decisions on corporate affairs. corporate governance provides the structure through which the objectives of the firm can be framed and by which the performance of these objectives can be monitored and achieved. corporate governance is the system of operating, structuring and controlling a firm with a view to reaching long-term strategic goals that fulfill the expectations of creditors, shareholders, suppliers and customers, while operating in compliance with regulatory and legal asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 98 requirements. thus, corporate governance is defined as the set of rules and regulations that are framed to protect corporate values and shareholders’ interests. 2. corporate governance in bangladesh according to jahangir (2008),corporate governance practices among bangladeshi companies are just emerging. the establishment of a corporate governance framework relies on the principles of justice, fairness and open access. the model of control-based governance which is applied within listed companies in bangladesh is damaging to investors’ confidence and also hurts stock market development. in bangladesh, many listed firms, with the exception of multinational corporations and a few large firms, are managed, owned and controlled by family members and their peers. policy decisions usually made by board members are made by company owners who dispose of the firm’s executive functions, leaving no scope for the isolation of board independence and ownership. ahmed and yusuf (2005) point out that the current corporate governance system in bangladesh does not facilitate sufficient economic, institutional and legal motivation for stakeholders to enforce and encourage corporate governance practices. all corporate governance systems revolve around four principles: responsibility, fairness, transparency and accountability. the specific challenges associated with these principles rely on the corporate sector’s ownership and structure. in bangladesh, family members manage the structure of the corporation. this practice hinders the levels of accountability, fairness and transparency. the provision and enforcement of processes and bankruptcy laws are inadequate. no country can have good corporate governance standards if it has poor processes and bankruptcy laws. securitization processes and inefficient foreclosures have become major issues in bangladesh. most bangladeshi firms have a pessimistic approach in order to attract foreign investment. the outcome is a lack of drive from the international investor community for better corporate governance and, thus, investor penetration levels of bangladeshi firms in foreign investment stock exchanges will be very low (hossain, 2005). for effective corporate governance in bangladesh and a family-based management style, ahmed, alam, jafarand zaman (2008) recommend that the following significant measures must be undertaken. members of the board have to be elected from all shareholder groups in the proportion of their shareholding. for the chairmanship, the maximum term must be mentioned and rotated among the directors. the board must appoint the top five managers encompassing the chief executive officer (ceo) who must remain on the board. auditors have an essential role in ensuring compliance with bangladesh’s corporate governance guidelines. all investors rely on the integrity of the auditor who must provide investors with some assurance that the investments have credibility. accounting has changed from cash accounting to accrual accounting: accounting estimates, in part, are also included, playing a critical role in estimating firms’ profits, especially for more complex businesses in economies related to knowledge. organizations must frame a code of conduct for their executives and directors that is based on responsibility and ethical decision making. they also have to clarify and publicly represent the responsibilities and roles of the management and board. firms must create purposeful and stronger boards, improve the timing, accuracy and scope of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 99 financial reporting and concentrate on the interests and rights of minority shareholders. tough accounting standards, proper security and corporate laws, efficient judicial systems and effective regulators together can ensure the foundations of good corporate governance. 3.bangladesh corporate governance guidelines 2012 on 3 july 2012, the bangladesh securities and exchange commission (bsec) released the revised corporate governance guidelines for bangladesh. in these guidelines, under board effectiveness, the following revisions were made: separation between the roles of ceo and chairman is required; at least one-fifth of the independent directors must be present at meetings; and the independent director requirements must meet extra criteria including specific qualifications criteria. in addition, the revisions stated that: the firm must not enter into any illegal or fraudulent transactions or any transactions that violate the firm’s code of conduct; independent directors must be nominated by the board of directors and shareholders must approve the nomination at the annual general meeting; the post of independent director should not be vacant for more than 90 days; the code of conduct applies to all members of the board as does annual compliance; and the normal tenure of the independent director is three years which can be extended for only one term. in relation to audit committee (ac) affairs, the following guidelines were revised: the chairman of the audit committee shall be an independent director; ten (10) specific roles of the audit committee must be identified with professional qualifications needed for all members; one independent director is required at meetings to satisfy the audit committee’s quorum; and the audit committee’s chairman must be present at the annual general meeting. in addition, the revised guidelines state that: the company secretary may also act as the audit committee secretary and that the audit committee must report any material identification to the bsec after the expiry of every six-month period from the date of its first report to the board of directors or after reporting to the board three times when it must be reported to the bsec earlier. in terms of auditor independence, the revised guidelines state that neither any partner nor any employee of the external auditing firm can hold any shares in the client company during the audit assignment term. in relation to governance of a subsidiary firm, the revised guidelines are as follows: the subsidiary firm’s board composition must be the same as the holding firm; the holding firm may appoint one of its independent directors to act as a subsidiary firm director; and the board meeting minutes of the subsidiary firm can be presented to the holding firm’s board meeting for review. in addition, the revised guidelines are that: the holding firm’s board meeting minutes may state that the board has already reviewed the subsidiary firm’s affairs and that the audit committee of the holding firm may review the subsidiary firm’s financial statements encompassing any investment made by the subsidiary firm. in relation to additional statements by the board of directors, the revised guidelines are as follows: the outlook and possible future developments in the respective industry have to be specified; product-wise or segment-wise performance has to be specified; and various risks faced by the organization and related issues must be mentioned. in addition, discussion in the additional statements is to include: the cost of products sold; net profit margin and gross profit margin of the firm; the continuity of any extraordinary loss or gain; remuneration to board members; a statement of all transactions related to any party encompassing the basis of party asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 100 transactions; and the application of funds increased from rights issues, public issues or through other instruments (biswas, 2012). 4. critical literature review on corporate governance structure and performance in non-financial firms in bangladesh rouf (2010) carried out an investigation to determine the characteristics of linkages between corporate governance attributes and their influence on voluntary disclosure as presented in the annual reports of listed firms in bangladesh. for this analysis, data were collected from the sample of 120 non-financial firms listed on the dhaka stock exchange (dse) in 2008. the corporate governance factors that were examined included: board size; independent non-executive directors as members of the board; structure of the board leadership; board audit committee; percentage of equity owned by insiders in relation to the firm’s overall equity; and the firm’s profitability. ordinary least squares (ols) regression was used in this analysis to determine the relationship between voluntary disclosure and explanatory variables. it was also used to assess the impact of each and every variable presented in the disclosure data with this linked to the index of aggregate disclosure and used to test the proposed hypotheses. the un-weighted relative disclosure index measured voluntary disclosure in rouf’s (2010) study with the study also using pearson’s correlation analysis. in the findings, a positive relationship was observed between board size and voluntary disclosure; between the board having an audit committee and voluntary disclosure; and between the structure of board leadership and voluntary disclosure. negative associations were observed between voluntary disclosure and the proportion of independent directors, net profitability and the ownership structure. thus, in the study’s conclusions, a positive relationship was found between board size, board audit committee, board leadership structure and voluntary disclosure. voluntary disclosure had a negative relationship with the ownership structure and net profitability. siddiqui (2012) conducted a study to analyse the determinants of the capital structure of non-financial institutions in bangladesh. the source of the data was the bangladesh bank database which collects information regarding bangladesh’s non-financial institutions with 24 of the listed non-financial institutions selected for this study. feasible generalized least squares (fgls) regression was used to gauge the explanatory variables’ effects on the dependent variables. the fgls regression technique was used to estimate the variance–covariance matrix. as cross-sectional time series panel data were used for this analysis, the data may have had the problem of heteroscedasticity. however, fgls regression automatically corrects the problem of heteroscedasticity if it exists among the variables. eight factors were identified, namely: liquidity ratio; growth rate; debt service coverage; tangibility ratio; operating leverage; profitability ratio; firm age; and firm size, and their debt ratio relationships were studied. it was observed that leverage ratios of all these factors increased with a rise in firm size and growth rate. operating leverage, debt service coverage and age were also observed as being negatively associated with three debt ratios, namely,the short-term ratio, total-term ratio and long-term ratio. in terms of ratios for liquidity, profitability and tangibility, mixed results were found. firm age was not significant for all three cases. long-term debt ratio was maximized with an increase in tangibility and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 101 liquidity ratios, while total-term and short-term debt ratios declined with an increase in tangibility and liquidity ratios. rashid, lodh, de zoysa and rudkin (2010) carried out a study to determine the influence of board composition, with regard to the representation of external independent directors, on companies’ economic performance in bangladesh. data were collected from 90 non-financial firms listed on the dhaka stock exchange (dse) during the period from 2005 to 2009. a regression model was used to determine the relationship between board composition and firm performance. no significant relationship was found to exist between board composition in terms of representation from external independent directors and firm performance. this result implied that the external independent director cannot add potential economic value to the bangladesh firm. the size of the board was observed to have a negative and significant influence on firm performance under accounting based on the performance measures. this implied that information asymmetries exist between external independent directors and other directors. in the findings, it was also noted that external independent directors from bangladesh companies were unable to ensure that checks and balances were in place in the accounts and in the activities of management. board size was found to have a negative influence on firm performance under the return on assets (roa) measure. it was concluded that, while introducing independent directors will have advantages for greater transparency, in the emerging economy such as in bangladesh, due to the presence of cultural and institutional difference, it will not add potential economic value to the company. from the policy point of view, the findings of rashid et al.’s (2010) research will be helpful in providing extra insight to regulators in harmonizing the practices of corporate governance in bangladesh with international corporate governance best practices. sufian and zahan (2013) examined the relationship between ownership structure and corporate social responsibility disclosure(csrd) in bangladesh. data were collected from 254 firms listed on the dhaka stock exchange (dse). of these firms, the categories of financial institution, real estate, bank, insurance, travel and leisure, and mutual fund were excluded from the sample data. firms usually disclose corporate social responsibility (csr) information in many ways, namely, published articles or advertisements which explain the firm’s activities; annual reports; corporate websites; leaflets or booklets; interim and quarterly reports addressing the firm’s social activities; special announcements; employee reports; environmental reports; and press reports. data were collected from these sources and analysed using ols regression to determine the relationship between corporate structure variables and corporate social responsibility disclosure (csrd). to assess the degree of disclosure made by listed firms in bangladesh, a sophisticated statistical measure, namely, multivariate regression was used to analyse the collected data with the help of statistical package for the social sciences (spss) software. the coefficient of board size was observed to be negatively associated with corporate social responsibility disclosure (csrd). the coefficients of the number of external shareholders, ownership concentration and foreign ownership were positively correlated with corporate social responsibility disclosure (csrd). the relationship between concentrated ownership and csrd was also found to be positive. companies with a higher concentration of ownership disclosed less csr information than asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 102 companies with a lower ownership concentration. it was concluded that no significant relationship existed between csrd and other ownership structure variables such as foreign ownership, number of shareholders and size of the board. rouf (2012) later examined the relationship between profitability, that is, financial performance and the level of corporate governance disclosure (cgd)by listed non-financial firms in bangladesh. data were collected from the 2007 annual reports of the 94 listed firms selected for this study. the ols method and multiple regression analysis were used to estimate corporate governance disclosure. independent variables such as board audit committee, profitability, size of the firm and ownership structure were examined. corporate governance disclosure was measured using 40 items of information performance and financial performance, that is, profitability which was measured by return on assets (roa).the unweighted approach, which is mainly used for measuring corporate governance disclosure, was used as this approach is most appropriate when no significance is provided to any specific user groups. after the establishment of the disclosure index, a scoring sheet was developed to obtain the extent of the disclosures of corporate governance. the firm’s positive profitability was identified as being correlated to cgd which was positively associated with the return on equity and the board audit committee. corporate governance disclosure (cgd) was also observed as being negatively associated with the ownership structure. despite the positive correlation between cgd and total sales and total assets, they did not have a significant relationship. thus, it was concluded that the disclosure level of corporate governance was positively associated with the size of the firm. corporate governance disclosure (cgd) was also positively and significantly associated with profitability, that is, financial performance. this research by rouf (2012) provided empirical evidence to regulators and policy makers in south asia. 5. conclusion corporate governance is an internal system which includes policies, people and processes that serve the needs of shareholders and other stakeholders by controlling and directing the activities of management with good business savvy, objectivity and integrity. corporate governance is referred to as the set of policies, regulations and rules which is framed to safeguard the values of corporate shareholders’ interests. it is important in ensuring that responsibility and accountability must be incorporated into each and every part of the company or organization. present corporate governance practice in bangladesh does not provide sufficient legal, economic and institutional motivation for stakeholders to boost and enforce the new corporate governance practices. all current systems of corporate governance practice are centred on the four principles of transparency, fairness, responsibility and accountability. the specific challenges related to these principles depend on the ownership structure in the respective corporate sector. in bangladesh, the corporate governance structure is mostly managed and owned by family members with this practice hindering the level of fairness, transparency and accountability. bankruptcy laws and other such processes are not appropriate in terms of provision and enforcement. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 103 references ahmed, h. l., alam, m. j., jafar, s. a. & zaman, s. s. (2008). a conceptual review on corporate governance and its effect on firm’s performance: bangladesh perspective, aiub business and economics working paper series. ahmed, m. u. & yusuf, m. a. (2005). corporate governance: bangladesh perspective. cost and management, 33(6),18-26. bangladesh securities and exchange commission (bsec).(2012).corporate governance guidelines. retrieved 15 september 2014 from: http://www.secbd.org/notification%20on%20cg-07.8.12-amended.pdf biswas, k. (2012). corporate governance guidelines in bangladesh: some observations. cost and management, 5-9. blair, m.m. (1995).ownership and control: rethinking corporate governance for the 21st century. brookings institute, washington, dc. centre of european policy studies (ceps).(1995).cited in shleifer, a and vishny, r. (1997), a survey of corporate governance. journal of finance, 52, 737-783. http://dx.doi.org/10.1111/j.1540-6261.1997.tb04820.x classens, s. (2003). corporate governance and development, focus 1, global corporate governance forum, world bank, washington. gillibrand, m. (2004). corporate management essential for industrialization. the bangladesh observer, bangladesh. hess, g. (1996). zum stand der diskussion in den vereinigten staaten. in feddersen, d., hommelhoff, p. and schneider, u. h. (eds.). corporate governance. otto schmidt-verlag, köln. hossain, m. (2005). why shareholders’ activism is still an illusion in bangladesh. the financial express, dhaka. jahangir, a. (2008). financial disclosure in developing countries with special reference to bangladesh. doctoral dissertation, university of ghent, belgium. o’donovan. g. (2003). change management – a board culture of corporate governance. mondaq business briefing. rashid, a. lodh, s., de zoysa, a. & rudkin, k. (2010). board composition and firm performance: evidence from bangladesh. australasian accounting business and finance journal, research online, 4(1), 76-95. rouf, a. (2010). corporate characteristics, governance attributes and the extent of voluntary disclosure in bangladesh. asian journal of management research, 166-183. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 104 rouf, a. (2012). the financial performance and corporate governance disclosure: a study in the annual reports of listed companies of bangladesh. pakistan journal of commerce and social sciences, 6(1), 1-11. saidi, n. (2004).corporate governance and business ethics. launching ceremony of rdcl‘s [lebanese businessmen association] ‘code of business ethics’. beirut, lebanon. shleifer, a. &vishny, r. (1997). a survey of corporate governance. journal of finance, 52, 737-783. http://dx.doi.org/10.1111/j.1540-6261.1997.tb04820.x siddiqui, s. (2012). capital structure determinants of non-financial institutions in bangladesh. world review of business research, 2, 60-78. sternberg, e. (1998).corporate governance: accountability in the marketplace, institute of economic affairs, london. sufian, a. & zahan, m. (2013), ownership structure and corporate social responsibility disclosure in bangladesh. international journal of economics and financial issues, 3(4), 901-909. microsoft word 3666-13814-1-sm-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 203 the volatility of market risk in viet nam listed consumer good, wholesale and retail company groups during and after the financial crisis dinh tran ngoc huy banking university, hcmc – gsim, intl. university of japan, japan e-mail: dtnhuy2010@gmail.com received: may 25, 2013 accepted: july 25, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.3759 url: http://dx.doi.org/10.5296/ajfa.v5i2.3759 abstract the viet nam economy and especially, the stock exchange has been influenced by the global crisis during the period 2007-201. for specific industries, such as consumer good and wholesale/retail industries, the risk re-analysis and estimation for the listed firms in these industries become necessary. first, by using quantitative and analytical methods to estimate asset and equity beta of three (3) groups of sub-trading listed companies in viet nam material, consumer good, wholesale and retail industries with a proper traditional model, we found out that the beta values, in general, for most companies are acceptable, excluding a few cases. there are 72% of listed firms with lower risk, among total 229 firms, whose beta values lower than (<) 1. second, through comparison of beta values among three (3) above industries, we recognized there are still 26% of total listed firms in the above group companies with beta values higher than (>) 1and have stock returns fluctuating more than the market index. finally, this paper generates some outcomes that could provides both internal and external investors, financial institutions, companies and government more evidence in establishing their policies in investments and in governance. keywords: equity beta, financial structure, financial crisis, risk, asset beta, consumer good industry jel classification: g010, g100, g390 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 204 1. introduction risk evaluation can be estimated by using various research methods. here, we perform a market risk analysis based on asset and equity beta of 229 listed companies in the category of materials, consumer goods, and wholesale/retail firms. this paper emphasizes on analyzing un-diversifiable risk in the above industry in one of emerging markets: vietnam stock market during the financial crisis 2007-2011. after the previous published article on estimated beta for listed construction company groups, we will compare the estimated beta results of listed viet nam consumer goods companies to those in its supply chain activities such as materials, wholesale and retail companies to make a comparative analysis and risk evaluation after financial crisis impacts. no research, so far, has been done on the same topic. this paper is organized as follow. the research issues and literature review will be covered in next sessions 2 and 3, for a short summary. then, methodology and conceptual theories are introduced in session 4 and 5. session 6 describes the data in empirical analysis. session 7 presents empirical results and findings. then, session 8 gives analysis of risk. lastly, session 9 will conclude with some policy suggestions. this paper also provides readers with references, exhibits and relevant web sources. 2. research issues we mention a couple of issues on the estimating of beta for listed computer and electrical companies in viet nam stock exchange as following: hypothesis/issue 1: among the three (3) companies groups, under the financial crisis impact and high inflation, the beta or risk level of listed companies in wholesale/retail industries will relatively higher than those in the rest two (2) industries. hypothesis/issue 2: because viet nam is an emerging and immature financial market and the stock market still in the recovering stage, there will be a large disperse distribution in beta values estimated in the consumer goods and wholesale/retail industries. hypothesis/issue 3: with the above reasons, the mean of equity and asset beta values of these listed wholesale and retail companies tend to impose a high risk level, i.e., beta should higher than (>) 1. 3. literature review fama, eugene f., and french, kenneth r., (2004) also indicated in the three factor model that “value” and “size” are significant components which can affect stock returns. they also mentioned that a stock’s return not only depends on a market beta, but also on market capitalization beta. the market beta is used in the three factor model, developed by fama and french, which is the successor to the capm model by sharpe, treynor and lintner. as luis e. peirero (2010) pointed, the task of estimating cost of equity in emerging markets is more difficult because of problems such as collecting data in short periods. then, velez-pareja (2011) referred to the lack of inadequate information on the stock market in emerging countries may undermine beta and relevant formulas. marcin, mariusz, marek, and karol (2012) mentioned that the reliability and fitness of calculated betas are relevant to the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 205 valuation and investment of investors in merging markets. and xiaowei kang (2012) found that combining weighted or alternative beta strategies can gain significant traction in investment community and reduce risk. next, pablo fernandez (2013) also stated that industry betas are very unstable. finally, a portfolio beta can be calculated by taking market capitalization of each stock in the portfolio and then, average beta of each company security. 4. conceptual theories determinants of equity and asset beta in financial markets, systematic risk relates to the overall risk of the whole market, is affected by some factors such as: interest rate fluctuations or economic crisis, can not be avoided by diversification, and is measured by a financial metric, beta which is also called systemic risk. billio, getmansky, lo, and pelizon (2010) defined systemic risk as any circumstance that threatens the stability of or public confidence in the financial system. additionally, the european central bank (2010) mentioned it as a risk of financial instability with so widespread. several factors affecting beta include, but not limit to, the volatility of expected return of a single stock, or the volatility of the expected return of the entire stock market index. generally, beta values may vary from 0 to 2 with a few values < 0 in some specific cases and most values fall within a range from 0 to 1. in special cases, beta values can be higher than (>) 2, which means that the stock returns fall or rise doubling the values of the market returns. they are called higher-beta stocks and become riskier with the potential for higher return. and firms with beta > 1 will have the movement of stock price higher than the market benchmark. then, beta can affects the outcomes of valuation of listed firms under cost of capital and capm model. 5. methodology the period 2007-2011 is the time highlighting impacts from financial crisis. therefore, we use the data from the stock exchange market in viet nam (hose and hnx) during the four or five years to estimate systemic risk results. firstly, we use the market stock price of 229 listed companies in the materials, consumer goods, wholesale/retail industries in viet nam stock exchange market to calculate the variability in monthly stock price in the same period; secondly, we estimate the equity beta for these three (3) listed groups of companies and make a comparison. thirdly, from the equity beta values of these listed companies, we perform a comparative analysis between equity and asset beta values of these 3 companies groups in viet nam. finally, we use the results to suggest policy for both these enterprises, financial services institutions and relevant organizations. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 206 the below table gives us the number of material, wholesale and retail firms used in the research of estimating beta: market listed material companies (1) listed consumer good companies (2) listed wholesale and retail companies (3) note (4) viet nam 55 70 3 estimating by traditional method 44 51 6 estimating by comparative method total 99 121 9 total firms in groups: 229 (note: the above data is at the december 12th, 2012, from viet nam stock exchange) 6. general data analysis there is a sample of 229 firms in 3 categories of industries: materials, consumer goods, wholesale and retail companies groups, and the mean of equity beta is valued at 0,715 while that of asset beta is about 0,352. these data are acceptable values during the crisis. furthermore, the sample variance of asset beta is quite low (0,0896) which is a good number, while that of equity beta is a little bit higher (0,2476). this shows us that the effectiveness of using financial leverage has decreased the systemic risk for the whole industry. however, the max and min values of beta are still somewhat large. max equity beta value is up to 2,089 that is a little bit high, compared to max asset beta value is just 1,162 that is acceptable. looking at the table 2 (below), we can see there is 26%, or 60 listed firms still have beta values larger than (>) 1, whereas there is 72% or 166 firms whose beta values lower than (<) 1 and higher than (>) 0. value of equity beta varies in a range from 2,089 (max) to -1,712 (min) and that of asset beta varies in a range from 1,162 (max) to -1,377 (min). some companies still has larger risk exposure than most of the others. there are 3 listed companies whose betas are lower than (<) 0, which means the stock return moves in a opposite direction to the market index. next, asset beta max value is 1,162 and min value is -1,377 which show us that if beta of debt is assumed to be zero (0), the company’s financial leverage contributes to a decrease in the market risk level. lastly, we can see the relatively high difference between max equity and max asset beta values, which is about 0,9268, whereas there is a smaller difference between equity and asset beta variance values which is just 0,158; so, there is certain impact on systemic risk of certain firms in term of using leverage while it indicates for most of firms that financial leverage can enable them to reduce market risk . and there is not quite big effect from financial leverage asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 207 on the gap between company’s beta variance values. table 1. estimating beta results for three (3) viet nam listed consumer good, wholesale and retail companies groups (as of dec 2012) (source: viet nam stock exchange data) statistic results equity beta asset beta (assume debt beta = 0) difference max 2,089 1,162 0,9268 min -1,712 -1,377 -0,3354 mean 0,715 0,352 0,3631 var 0,2476 0,0896 0,1580 note: sample size : 229 table 2. the number of companies in research sample with different beta values and financial leverage equity beta no. of firms financial leverage (average) ratio <0 3 68,41% 1% 0<beta<1 166 50,13% 72% beta > 1 60 51,03% 26% total 229 51,9% 100% 7. empirical research findings and discussion a-material listed companies group during the crisis 2007-2011, the market for these companies still exists, but has certain difficulties. the rising inflation and rising lending interest rates and higher opportunity costs makes input materials or production costs increasing. so, the market for these firms has been affected because selling prices increase. the table 3 below shows us the research of 99 listed firms in this category during the above period. in general, the mean of equity beta and asset beta are 0,747 and 0,371, accordingly. these values are good numbers in term of indicating a low and acceptable un-diversifiable risk. the market demand for such products as steel, plastic,… is still high. besides, the variance of equity and asset beta of the sample group equals to 0,303 and 0,1246 accordingly which are higher than the variance of the entire sample equity and asset beta of 0,2476 and 0,0896. the effect from financial leverage makes these beta values fluctuate a little bit more from the sample beta mean. we might note that equity beta values of 99 firms in this material category are a little higher than those of firms in the rest two (2) groups. this might be considered as one characteristic of these industries. among three (3) industries, the systemic risk of material group companies is a bit higher than those of the rest two groups. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 208 besides, the estimated equity beta mean is 0,626 and sample variance is 0,1749, which is not supporting our 2nd research hypothesis or issue that there would be a large disperse distribution in beta values estimated in this industry as well as our 3rd research hypothesis or issue that the mean of equity and asset beta values of these listed companies tend to impose a high risk level or beta should higher than (>) 1. table 3. estimating beta results for viet nam listed material companies (as of dec 2012) (source: viet nam stock exchange data) order no. company stock code equity beta asset beta (assume debt beta = 0) note 1 com 0,604 0,473 2 aaa 0,403 0,186 vid as comparable 3 alv 0,890 0,618 mmc as comparable 4 amc 0,781 0,450 cpc as comparable 5 app 0,799 0,474 cpc as comparable 6 bgm 0,719 0,672 gta as comparable 7 bkc 1,339 0,928 8 bmc 1,433 1,036 9 bmj -1,712 -1,377 10 brc 0,835 0,587 tpp as comparable 11 bvg 0,197 0,053 com as comparable 12 bvn 0,531 0,163 bmc as comparable 13 cap 0,543 0,205 cpc as comparable 14 cmi 0,875 0,384 kkc as comparable 15 cpc 1,211 0,937 16 ctm 0,350 0,178 dtt as comparable 17 czc 0,090 0,028 hvt as comparable 18 dag 0,435 0,134 dhc as comparable 19 dhc 1,170 0,461 20 dhm 0,432 0,240 hgm as comparable 21 dlg 0,055 0,014 sqc as comparable 22 dns 0,076 0,025 bvg as comparable 23 dny 0,063 0,018 sqc as comparable 24 dpm 0,785 0,686 25 dpr 1,043 0,808 26 dtl 0,027 0,011 dlg as comparable 27 dtt 0,605 0,517 28 ger 0,746 0,419 mmc as comparable 29 gta 0,757 0,569 30 hai 0,823 0,456 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 209 31 hap 1,280 1,018 32 hgm 0,691 0,535 33 hla 1,833 0,339 34 hlc 0,397 0,045 35 hmc 1,227 0,348 36 hpg 0,969 0,424 37 hpp 0,627 0,268 kmt as comparable 38 hrc 0,971 0,750 39 hsg 1,821 0,587 40 hsi 0,748 0,154 41 hvc 0,314 0,083 hrc as comparable 42 hvt 0,238 0,105 43 khb 0,550 0,486 dtt as comparable 44 kkc 1,717 0,860 45 kmt 1,259 0,386 46 ksa 0,859 0,530 kmt as comparable 47 ksb 1,103 0,705 48 ksh 1,766 1,162 49 kss 2,089 1,049 50 ktb 0,485 0,366 com as comparable 51 las 0,478 0,185 dpr as comparable 52 lcm 0,542 0,531 khb as comparable 53 max 0,066 0,044 czc as comparable 54 mdc 0,546 0,126 55 mdf 0,067 0,057 dns as comparable 56 mhl 0,482 0,252 57 mic 1,417 0,902 58 mih 0,068 0,016 hvt as comparable 59 mim 0,425 0,196 app as comparable 60 mmc 1,183 0,990 61 nbc 1,129 0,273 62 nkg 0,007 0,002 dtl as comparable 63 nsp 0,811 0,719 alv as comparable 64 nvc 0,353 0,050 65 phr 0,471 0,268 66 pht 0,912 0,477 67 plc 1,338 0,448 68 pom 0,111 0,038 tis as comparable 69 ptk 1,368 0,986 ksh as comparable 70 rdp 0,827 0,303 71 sha 0,810 0,314 ksh as comparable 72 shi 1,550 0,476 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 210 73 smc 1,142 0,266 74 spc 0,062 0,015 vca as comparable 75 sqc 0,174 0,148 76 ssm 1,402 0,710 77 tc6 0,678 0,127 78 tcs 0,900 0,152 79 tdn 0,587 0,127 80 tds 0,398 0,146 pht as comparable 81 tht 0,927 0,294 82 tis 0,268 0,075 dpm as comparable 83 tlh 0,320 0,151 tdn as comparable 84 tnb 0,072 0,054 czc as comparable 85 tnc 0,949 0,846 86 tnt 1,085 0,781 ssm as comparable 87 tpc 1,062 0,531 88 tpp 1,100 0,321 89 trc 1,185 0,917 90 tsc 0,928 0,204 91 ttf 1,576 0,392 92 tvd 0,235 0,037 trc as comparable 93 vca 0,212 0,044 rdp as comparable 94 vdt 0,665 0,326 mmc as comparable 95 vfg 0,350 0,181 96 vgs 1,907 0,820 97 vid 0,757 0,272 98 vis 1,289 0,500 99 vkp 0,877 0,131 noted: raw data, not adjusted table 4. statistical results for vietnam listed material companies statistic results equity beta asset beta (assume debt beta = 0) difference max 2,089 1,162 0,9268 min -1,712 -1,377 -0,3354 mean 0,747 0,371 0,3752 var 0,3030 0,1246 0,1785 note: sample size : 99 bconsumer good listed companies group in an emerging market such as viet nam, the market for consumer goods firms is definitely asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 211 established and potential because of the public need for such necessary vital products and though it may be affected by impacts from the financial crisis. the table 5 below shows us the equity and asset beta mean of 121 listed consumer good companies, with values of 0,694 and 0,336, accordingly. this result, which means the risk is low and acceptable although the equity beta value is higher than that of the wholesale/retail firms, but the asset beta mean is a little lower. this partly, maintains the investor confidence of business operation of the whole industry and partly, indicates the good effect from using financial leverage. besides, the variance of beta values among these 121 firms is normal, from 0,2142 to 0,0659 for equity and asset beta, accordingly, whereas there are some special cases with beta higher than (>) 2. please refer to exhibit 2 for more information. table 5. statistical results for vietnam listed consumer good companies statistic results equity beta asset beta (assume debt beta = 0) difference max 2,056 1,151 0,9046 min -0,648 -0,085 -0,5624 mean 0,694 0,336 0,3579 var 0,2142 0,0659 0,1484 note: sample size : 121 cwholesale and retail listed companies group among 3 groups, this is the group with the smallest number of listed firms (sample size = 9) and with the lowest equity beta value of about 0,653. however, the asset beta mean of about 0,352 is a little higher than those of consumer good and material industries. the using of leverage has influenced these firms’ risk a bit more than the other two. different from firms in the other industries, 9 listed wholesale/retail firms has lower equity and asset beta var values, estimated at 0,1069 and 0,0307, which implies there is a more concentration in market risks among firms in this industry. the equity and asset beta values are distributed in a smaller range, from 0,391 to 1,273, and from 0,126 to 0,64 which are acceptable, compared to those of 2 previous groups, esp., asset beta values are quite low, indicating the effectiveness of using financial leverage. please refer to exhibit 3 for more information. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 212 table 6. statistical results for vietnam listed wholesale and retail companies statistic results equity beta asset beta (assume debt beta = 0) difference max 1,273 0,640 0,6334 min 0,391 0,126 0,2657 mean 0,653 0,352 0,3002 var 0,1069 0,0307 0,0761 note: sample size : 9 comparison among 3 groups of consumer good, wholesale and retail companies in the below chart, we can see among the 3 groups, equity beta value of the wholesale/retail group is the lowest (0,65) while asset beta value of the consumer good group is the lowest (0,34). assuming debt beta is 0, financial leverage has helped many listed firms in these industries lower the un-diversifiable risk. additionally, we see the asset beta mean values of all 3 groups have not big difference and acceptable. therefore, it also rejects our 3rd hypothesis that the mean values of equity/asset beta of all 3 groups impose higher risks. next, we can recognize from the chart that, the risk in the wholesale/retail industries lower than that in the other 2 industries. so, it rejects our 1st hypothesis. last but not least, from the calculated results, variance of asset beta in the consumer good and wholesale/retail industries are low while that of equity beta in these industries. in number, equity beta var is from 0,11 -0,3 and asset beta var is from 0,03-0,12 which is not big. this also rejects our 2nd hypothesis. finally, if we compare beta values of three (3) above industries to those of computer and electrical group companies, we see the asset beta mean values in the consumer good and wholesale/retail industries are a little bit lower (see exhibit 4). 0,75 0,37 0,30 0,12 0,69 0,34 0,21 0,07 0,65 0,35 0,11 0,03 0,00 0,10 0,20 0,30 0,40 0,50 0,60 0,70 0,80 equity beta mean asset beta mean equity beta var asset beta var material consumer good wholesale and retail chart 1. statistical results of three (3) groups of 229 listed vn consumer good, wholesale and retail firms during/after the crisis period 2007-2011 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 213 8. risk analysis the consumer good and material industries have certain negative impacts from unexpected increasing price in the materials, selling prices and increasing lending interest rates which are affected by the high inflation of 23% in 2008; although the inflation and interest rates decrease in later years but the prices can not decrease in a short time; so, they create risks in this period. besides, these firms have to face other kinds of risks from competition as there are more and more similar provided goods or products for consumers. these risks can affect the performance and net cash flow of these companies. 9. conclusion and policy suggestion material industry even though beta mean values are fine, this is the industry which has both the highest equity/asset beta mean values and the highest asset /equity beta var (see chart 1). during the crisis, this industry has higher market risk and beta values of firms in the group are more fluctuated. after increasing rates period (see exhibit 1), financial services industries, the government and central banks have certain efforts and proper policies to support businesses and internal investors, and stabilize inflation. consumer good industry generally speaking, this is the industry which has middle values of equity beta mean and var, among 3 groups. the using of financial leverage can be a reason to reduce market risk, from 0,69 (equity beta mean) to 0,34 (asset beta mean). the market is established. wholesale/retail industry through our comparative analysis on asset beta values, this is the industry which has the lower market risk exposure than that of the other two (2) above industries when we consider values of equity beta mean, or asset/equity beta var. also the beta variance shows a small dispersion and smaller than, esp., material and consumer good firms. in general, our empirical findings state that they are not in favor of our 1st and 2nd and 3rd hypotheses or research issues. in summary, though viet nam is an emerging market with imperfect financial system, the beta values estimated are at acceptable level with 72% firms in the research sample while just a few companies’ beta values are risky (about 26% firms). additionally, it indicates the higher the using of financial leverage, the lower the beta values. in reality, there are 72% of computer and electrical firms (166 among 229 firms) which has 0<beta<1 in this research sample. if used effectively, using leverage can be good for risk management. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 214 furthermore, if we compare these data and values to those of construction and real estate firms, and to those of computer and electrical companies in our previous research (see exhibit 4 and 5), we might see that in here, the asset beta mean can be a little bit lower while the impacts from the crisis happens on the overall market. so, the leverage becomes more meaningful and the crisis might have less influence on the firms in the above research. finally, this paper suggests implications for further research and policy suggestion for the viet nam government and relevant organizations, economists and investors from current market conditions. references adb and viet nam fact sheet, 2010 ang, a., & chen, j. (2007). capm over the long run: 1926-2001. journal of empirical finance. baker, kent h., singleton, clay j., & veit, theodore e. (2011). survey research in corporate finance: bridging the gap between theory and practice, oxford university press. bessembinder, hendrik, & zhang, feng. (2010). firm characteristics and long run stock returns after corporate events. journal of financial economics. eugene, fama f., & french, kenneth r. (2004). the capital asset pricing model: theory and evidence, journal of economic perspectives. fernandez, pablo. (2008). levered and unlevered beta, ssrn working paper series. http://www.hsx.vn/hsx/ http://www.ifc.org/ifcext/mekongpsdf.nsf/content/psdp22 http://www.mofa.gov.vn/vi/ huy, dinh t.n. (2012). estimating beta of viet nam listed construction companies groups during the crisis. journal of integration and development kashyap, anil k., & zingales, luigi. (2010). the 2007-8 financial crisis: lessons from corporate finance. journal of financial economics. pereiro, luis e. (2010). the beta dilemma in emerging markets. journal of applied corporate finance. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 215 exhibit exhibit 1 . interest rates, inflation, gdp growth and macroeconomics factors (source: viet nam commercial banks and economic statistical bureau) year basic rates lending rates deposit rates inflation gdp usd/vnd rate 2012 n/a 12% 15% 9% 6,81% 5,03% 20.828 2011 9% 18%-22% 13%-14% 18% 5,89% 20.670 2010 8%-9% 19%-20% 13%-14% 11,75% (estimated at dec 2010) 6,5% (expected) 19.495 2009 7% 9%-12% 9%-10% 6,88% 5,2% 17.000 2008 8,75%-14% 19%-21% 15%-16,5% 22% 6,23% 17.700 2007 8,25% 12%-15% 9%-11% 12,63% 8,44% 16.132 2006 8,25% 6,6% 8,17% 2005 7,8% 8,4% note approximately (2007: required reserves ratio at sbv is changed from 5% to 10%) (2009: special supporting interest rate is 4%) exhibit 2. estimating beta results for viet nam listed consumer good companies (as of dec 2012) (source: viet nam stock exchange data) order no. company stock code equity beta asset beta (assume debt beta = 0) note 1 aam 0,650 0,569 2 abt 0,852 0,660 3 acl 1,115 0,383 4 agc 1,020 0,051 5 agd 0,545 0,201 6 agf 0,881 0,365 7 agm 0,444 0,148 acl as comparable 8 anv 1,108 0,809 9 asa 0,637 0,369 nps as comparable 10 asm 0,856 0,348 11 ata 1,573 0,341 12 avf 0,255 0,060 agf as comparable 13 bas 1,200 0,545 14 bbc 1,236 0,895 acl as comparable 15 bhs 0,957 0,435 16 blf 0,903 0,177 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 216 17 cad 1,384 -0,023 18 can 0,505 0,234 19 cfc -0,150 -0,085 20 clc 0,579 0,202 21 clp 0,223 0,071 clc as comparable 22 cmc 1,530 1,151 23 cmx 0,091 0,015 agm as comparable 24 csm 1,803 0,553 25 dbc 0,994 0,371 26 dbf 0,147 0,076 clp as comparable, f.s 2010 27 dcs 1,492 1,018 28 dnf 0,441 0,105 dcs as comparable 29 dqc 1,089 0,479 30 drc 1,823 1,093 31 eve 0,079 0,066 cmx as comparable 32 fba 0,493 0,355 asa as comparable 33 fbt 0,477 0,156 34 fdg 0,233 0,045 bhs as comparable 35 fmc 0,878 0,232 36 gdt 0,562 0,418 37 gfc 0,131 0,015 fmc as comparable 38 ggg 1,410 0,341 39 gil 0,783 0,415 40 glt 0,687 0,483 41 gmc 1,033 0,434 42 had 1,020 0,813 43 hat 0,827 0,659 nps as comparable 44 hax 1,115 0,410 45 hdm 0,534 0,086 46 hfx -0,648 0,275 nps as comparable 47 hhc 1,023 0,612 48 hlg 0,762 0,226 49 hnm 0,840 0,522 50 htl 0,734 0,482 had as comparable 51 hvg 0,626 0,225 52 icf 0,916 0,414 53 ifs 0,889 0,375 csm as comparable 54 kdc 0,477 0,337 hvg as comparable 55 kmr 0,670 0,474 fmc as comparable 56 ksc 0,420 0,340 fba as comparable 57 ksd 0,265 0,106 gdt as comparable asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 217 58 kts 0,387 0,241 gdt as comparable 59 laf 1,248 0,558 60 lix 0,346 0,220 61 lss 1,327 0,917 62 mcf 0,094 0,027 ksd as comparable 63 mef 0,325 0,143 sj1 as comparable 64 mpc 1,140 0,326 65 msn 1,503 0,841 66 net 0,357 0,246 fbt as comparable 67 ngc 0,687 0,113 68 nhs 0,381 0,190 kmr as comparable 69 nps 0,984 0,427 70 nsc 0,910 0,578 71 nst 0,887 0,264 72 pid 0,316 0,220 ksc as comparable 73 pnj 0,643 0,262 74 psl 0,259 0,193 mef as comparable 75 ptb 0,122 0,032 nhs as comparable 76 ptg 0,391 0,194 ngc as comparable 77 ral 0,883 0,306 78 s33 0,267 0,068 abt as comparable 79 saf 0,888 0,524 80 sav 0,820 0,406 81 sbt 0,855 0,716 82 scd 0,738 0,546 83 sec 0,738 0,295 84 sgc 0,596 0,448 85 shv 0,199 0,043 sec as comparable 86 sj1 0,635 0,408 87 sls 0,179 0,077 net as comparable 88 smb 0,143 0,048 net as comparable 89 spd 0,174 0,033 sec as comparable 90 src 2,056 0,753 91 ssc 0,959 0,727 92 ssf 0,157 0,067 pid as comparable 93 svc 1,301 0,401 94 tac 1,076 0,393 95 tcm 1,302 0,462 96 tet 0,346 0,296 ptg as comparable 97 thb 0,976 0,608 98 thv 0,301 0,056 svc as comparable 99 tlg 0,632 0,326 tac as comparable asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 218 100 tmt 0,388 0,200 101 tmw 0,293 0,115 sj1 as comparable 102 tna 1,066 0,378 103 tng 1,135 0,310 104 tri 1,014 0,111 105 ts4 1,592 0,614 106 ttg 0,429 0,358 fba as comparable 107 vcf 0,996 0,840 tng as comparable 108 vdl 0,810 0,534 109 vdn 0,034 0,003 tmw as comparable 110 vhc 1,103 0,584 111 vhf 0,157 0,060 lix as comparable 112 via 0,387 0,337 ttg as comparable 113 vkc 0,122 0,047 s33 as comparable 114 vkd 0,095 0,051 ssf as comparable 115 vlf 0,100 0,031 s33 as comparable 116 vnh 0,547 0,256 tri as comparable 117 vnm 0,475 0,369 118 vtf 0,517 0,231 vcf as comparable 119 vti 0,023 0,003 vhf as comparable 120 vtl 0,620 0,211 121 wsb 0,127 0,097 vhf as comparable exhibit 3. estimating beta results for viet nam listed wholesale and retail companies (as of dec 2012) (source: viet nam stock exchange data) order no. company stock code equity beta asset beta (assume debt beta = 0) note 1 hhs 0,728 0,479 pit as comparable 2 imt 0,399 0,386 th1 as comparable 3 th1 0,409 0,160 4 bsc 0,420 0,342 fba as comparable 5 pet 1,273 0,351 6 btt 0,829 0,640 pit as comparable 7 cmv 0,391 0,126 pit as comparable 8 pit 1,012 0,514 9 vt1 0,411 0,175 btt as comparable asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 219 exhibit 4. statistical results of four (4) groups of 64 listed vn computer and electrical firms during/after the crisis period 2007-2011 0,63 0,33 0,17 0,07 0,72 0,44 0,21 0,13 0,75 0,44 0,11 0,09 0,67 0,46 0,29 0,21 0,00 0,10 0,20 0,30 0,40 0,50 0,60 0,70 0,80 equity beta mean asset beta mean equity beta var asset beta var electrical and electronic software hardware comm/telecom exhibit 5. statistical results of three (3) groups of 103 listed construction firms during crisis period 0,66 0,439 0,0511 0,1317 0,0697 0,891 0,663 0,0936 0,0506 0,864 0,45 0,1163 0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1 equity beta mean asset beta mean equity beta var asset beta var material construction real estate exhibit6. vni index and other stock market index during crisis 2006-2010 0 1000 2000 3000 4000 5000 6000 7000 th g1 -0 6 th g4 -0 6 th g7 -0 6 th g1 006 th g1 -0 7 th g4 -0 7 th g7 -0 7 th g1 007 th g1 -0 8 th g4 -0 8 th g7 -0 8 th g1 008 th g1 -0 9 th g4 -0 9 th g7 -0 9 th g1 009 th g1 -1 0 th g4 -1 0 th g7 -1 0 vn index s&p 500 sse index nikkei 225 (/0') tsec (/0') kospi cnt (/00') microsoft word 4121-15366-1-sm-writer2-new-final.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 127 triple bottom line reporting: an assessment of sustainability in banking industry in nigeria oluwagbuyi olusola luke department of accountancy, school of business studies the federal polytechnic, ado-ekiti, ekiti state, nigeria adaramola anthony olugbenga (corresponding author) department of banking and finance, faculty of management sciences ekiti state university, ado-ekiti, ekiti state, nigeria e-mail: gbengaadaramolaunad@yahoo.com received: may 14, 2013 accepted: september 27, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4121 url: http://dx.doi.org/10.5296/ajfa.v5i2.4121 abstract triple bottom-line reporting is an emerging issue in accounting profession in nigeria that aims at assessing and enhancing corporate performance with regards to sustainability. it widens the scope of traditional reporting which emphasises financial profitability. it considers the contributions of a corporate organisation towards the environmental and social sustainability thereby giving more attention to stake holders than shareholders. the primary objective of this study is to investigate whether triple bottom line reporting contributes significantly to sustainability of banking firms in nigeria. in our analysis of data, the descriptive statistical analysis was used to evaluate the study. 400 questionnaires were administered on the senior and management members of staff in the 22 banks in nigeria after re-consolidation. the data were analysed using chi-square statistical techniques. also, annual reports of the 22 banks spanning from 2009-2011 were examined. the findings show that emphasis is still on financial profitability of the banking industry in nigeria. the study hereby recommends that for sustainability to be enhanced in banking industry in nigeria, adequate attention should be given to the environmental and social sustainability to complement financial profitability. keywords: triple bottom line reporting, sustainability, environment and social value, dimensional measurement reporting asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 128 1. introduction group 100 (2003) submitted that the trend towards greater transparency and accountability in public reporting and communication is reflected in an organisation’s effort towards more comprehensive disclosure of corporate performance to include the environmental, social and economic dimensions of an entity’s activities. this trend is a shift from the traditional objective of maximisation of the wealth of the shareholders to ensuring that stakeholders are adequately cared for in the scheme of corporate planning, execution and appraisal. the traditional goal of a business centres on economic performance. however with the current global trend of social sustainability, the senior management must endorse and be committed to environmental and social obligations; even though these may have major resources implications to corporate goals and results. triple bottom line reporting is hinged on improved relationship among stakeholders; especially employees, customers and investors. it is believed that the adoption of triple bottom line reporting in banking firms in nigeria will lead to the enhancement of their reputations and brands. among other things, it will also guarantee an adequate social responsibility, improved access to investors, reduction in risk profile, identification of cost savings potential, increased scope of innovation, identification of stakeholders’ needs with management focus and creation of an opportunity for stakeholders’ dialogue. the aggregation of the afore mentioned variables has been widely believed will engender a robust banking operation in an economy. it is against this backdrop that this paper seeks to assess the sustainability of banking industry in nigeria if the triple bottom line standard is adopted. 2. literature review tilt (2007) posited that sustainability accounting (also known as social accounting, social and environmental accounting, corporate social reporting, corporate social responsibility reporting or non-financial reporting) was originated about 20 years ago and is considered a sub category of financial accounting that focuses on the disclosure of non-financial information about a firm’s performance to external parties such as capital holders, creditors and other stakeholders. this is the report of activities of a firm that have direct impact not only on the economic performance, but also on the business environment and the society at large. sustainability accounting in contrast with financial accounting is used for internal decision making and the creation of new policies that have effect on the organisations performance of economical, ecological and social (known as the triple bottom line or triple – p’s, people, planet, profit) level. global reporting initiative was established with the goal to provide guidelines to organisations’ reporting on sustainability. it states that ‘reporting on economic, environmental and social performance by all organisations should be seen as a routine and be made comparable to financial reporting’ (http://www.globalreporting.org). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 129 el kington (1988) opined that the triple line reporting focuses corporations not just on the economic value they add, but also on the environmental and social value, frame work for measuring and reporting corporate performance against economic, social and environmental parameters. tavis (2004) submitted that sustainability is driven by the desire to improve an organisation’s measure of progress across an integrated social, environmental and economic platform. he stated further that sustainability has emerged as a guiding principle and value-laden construct that integrates issues of the environment with issues of development and society, while the concept has become a “principle” bench mark, its application has promoted wide debate and often confusion. it is often interpreted in sectoral (development, agriculture, fisheries, industry etc.) and dimensional (environment, social, economic) contexts at varying scales (local, national and international). this led to the conclusion of meadows (1989) that the consequence of this is that sustainability can mean different things to different players but that the highest level of management should be guided by a common set of principles and objectives. tavis (2004) also submitted that inherent in sustainability is the assumption that development must meet the ongoing needs of current and future generations, including the inequalities in the distribution of goods and services. this requires societal orientation, resources conservation, development with ecological limits, environmental protection and restoration. it also requires good governance, transparency, democracy and participation. decision making must take an integrated approach that includes social, economic and environmental issues with reference to its basis as a social construct that applies to human society and culture. tavis therefore concluded by saying that ultimately sustainability is about doing things better and improving our environment, our society and economies. suggett and goodsir (2000) identified several generic characteristics of triple bottom line initiative to include accountability, transparency, integrated planning and management commitment to stakeholders’ engagement and multi dimensional measurement reporting. fred (2006) claimed that triple bottom line theory claims to be a reporting mechanism is designed to encourage businesses to give closer attention to the whole impact of their commercial activities rather than just their financial performance. it is probably the best known among non-financial reporting formats to have been given serious attention over recent years. it is defined by the mc-grand hill book publishing organisation as “a calculation of corporate, economic, environmental and social performance” elkington (1977) opined that the triple bottom line reporting implies that businesses should give parity of treatment to these three dimensions of business impact without giving unique weight to their financial result. it focuses on non-financial reporting rather than just the economic value of business activities. brundland (1987) defined sustainability as “development which meets the needs of the present without compromising the ability of future generations to meet their own needs. in its 2002 reporting guidelines, the global reporting initiative (gri) emphasized the need to develop techniques that enhance the ability of business to report more consistently and more asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 130 comprehensively on the economic, environmental and social dimensions of their activities, products and services. the gri’s objective is to enhance the quality of sustainability reporting. today, the triple bottom line reporting is the format most commonly chosen by businesses for the purpose of reporting. the speed at which triple bottom line reporting has been adopted by the business community is quite remarkable. its geographical spread is equally impressive. business support, however does rest on at least one de factor proviso. that is triple bottom line reporting should not be interpreted to mean that companies are not expected to maximise returns across the three dimensions of performance but rather that financial performance is recognised as the primary consideration in assessing business success (group 100, 2003) according to price waterhouse coopers (pwc) “management barometer” survey of 14 different advanced economies, 68% of large corporations in western europe and 41% in the united states were reporting on the triple line in the second quarter of 2002 (pwc, 2002) price waterhouse cooper commented: ‘with the current breakdown of confidence in financial reporting, large companies are facing increasing demands and expectations from stakeholders, and corporate organisations are being held more accountable for their performance and actions’. the triple bottom line reporting approach is a proactive step in providing shareholders with increased transparency and broader framework for decision making. it is a great way for companies to disclose meaningfully their non-financial results. kpmg conducted an international survey of what they call “corporate sustainability reporting” every three years. although sustainability reporting is not quite the same as triple bottom line reporting, reports of most firms always include an environmental component, which is one of the features of triple bottom lines. for kpmg survey of 2002, the most recent available, we learn that environmental, social or sustainability report from 2000 companies were assessed; these included the top half of the fortune 500 group and the top 100 companies in 19 countries. according to kpmg, the result of the survey demonstrates that this kind of reporting is becoming mainstream business and no longer restricted to sectors with high environmental impact in western countries but also in non-industrial sectors and other region (kpmg, 2002). the report documented a 29% increase in the number of companies from the fortune 500 sample publishing report in 2002, compared with 1999. it goes to state that the survey of top companies across 19 countries showed that japanese companies reported most (72%) followed by the uk (49%) and that within the united states and western europe as a whole 30-40 percent of companies report. these companies represent a huge corporate commitment to triple bottom line reporting. in addition, there is no doubt that the spate of corporate scandal experienced around the world has raised interest in triple bottom line reporting especially in the united states and europe. triple bottom line reporting is also gaining popularity in africa. this is obvious in south africa, where the second report on governance standards by king (2002) gave a direct boost to triple bottom line reporting. the king report explicitly stated that corporate citizenship was becoming an established fact in business life and that there was a need for companies to asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 131 report on their continuing sustainability in terms of environmental responsibilities, including their interpretation of, and response to social responsibility. fred (2006) however concluded that triple bottom line reporting places more responsibilities towards the stakeholders rather than shareholders. conceptually, it brings to an end the myopic view of shareholders as the driver of business policy. instead triple bottom line reporting integrates stakeholders’ interests into business policy and the interests which each organization must strive to meet. buffin (2004) said: ‘there is no question that our society has become less paternalistic and more individualistic. individual good seems to be taking precedence over the common good. there’s more change and uncertainty. jobs are for now, not for life. and in the suburbs and the regions, too many people are feeling excluded. with this sense of powerlessness, frustration is growing and what’s more, people are making their feelings known. they are saying to companies; look at it through our eyes; add empathy to your corporate strategies. to those of us in leadership roles they are saying – we expect more’. scheiwiller (2005) opined that few can disagree with the first part of this statement. however, there are evidences in support of the latter part of the statement. for example, he asserted that a group of europe’s investors controlling us $900 billion in assets have written to 20 of the world’s top pharmaceutical companies outlining the steps they believe the firms could take reduce the risks to the industry’s reputation from crisis. it is in view of the needed support from our multinational companies that this paper examines the concept of triple bottom line reporting as a reliable compliment to the concept of sustainability in banking industry in nigeria. it critically assesses the approach of banking industry in nigeria towards triple bottom line reporting. 3. method and materials both primary and secondary methods of data collections were adopted. for the primary data collection: the research designed used for the study was descriptive research of the survey type. the population comprised of the members of staff of the 20 banks in nigeria after re-consolidation namely: access bank, guarantee trust bank, wema bank, mainstreet bank, first bank, union bank, united bank of africa, skye bank, eco bank, enterprise bank, diamond bank, keystone bank, zenith bank, unity bank, sterling bank, ibtc bank, fcmb bank, fidelity bank, standard chartered bank and citi bank. in the course of the study, average of twenty (20) questionnaires were distributed in each of the banks to the top ranking officers, not less than senior managers. the total was four hundred (400) to all twenty banks with the help of research assistants. 400 were returned by the respondents. secondary data were also collected through the collection of annual report of these banks from 2009-2011. these enabled us to access the corporate obligation to triple bottom line reporting standard. 3.1 research questions i. do adequate water ways and erosion control have any significant relationship with the sustainability of banking industry? asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 132 ii. can ensuring of weed control and contribution to access road have any relationship with sustainability of banking industry? iii. can solid waste control and management have any significant relationship with environment in which a bank operates? iv. does pollution as a result of emission from generators and other electronic machines have any significant relationship with the sustainability of the banking industry? v. does contribution towards adequate security of the community in which a bank operates have any relationship with its sustainability? vi. can employee and their family welfare significantly affect the productivity and overall result of the banking industry? vii. does work force stability have any significant relationship with the result of the operations within the banking industry? viii. does provision of facilities such as employment of disabled and the less privileged who are qualified have any significant relationship with corporate sustainability? ix. do provision of scholarship awards in the community, donations to community, sponsorship of talents in games and sports have any significant relationship with the goodwill of the banking industry? 3.2 research hypotheses i. adequate waste water ways and erosion control have no significant relationship with the sustainability of banking industry. ii. ensuring weeds control and contribution to access road have no significant relationship with sustainability of banking industry. iii. solid waste control and management have no significant relationship with environment in which a bank operates. iv. pollution as a result of emission from generators and other electronic machines has no significant relationship with the sustainability of the banking industry. v. contribution towards adequate security of the community in which a bank operates has no significant relationship with its sustainability. vi. employees and their family welfare do not significantly affect the productivity and overall result of the industry. vii. stability in the workers’ turnover has no significant relationship with the result of the operation in the banking industry. viii. employment of disables and less privileged who are qualified has no significant relationship with corporate sustainability of the banking industry. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 133 ix. scholarship award in the community, donations to community, sponsorship of talents in games and sports have no significant relationship with the goodwill of the banking industry. 4. results and discussion research hypothesis 1: adequate wastage ways and erosion controls have no significant effect on the sustainability of banking industry. chisquare (x2) result diff x2 calculated x2 table value level of significance 4 8.18 7.18 5% source: authors’ computation x2 calculated value 8.18 while x2 critical value is 7.81. our analysis fails to accept the null hypothesis. therefore, the research hypothesis stating that adequate waste ways and erosion control have significant effect on sustainability of banking industry is accepted research hypothesis 2: weeds control and participation in access road construction have no effect on the sustainability of banking industry. chi square (x2) result diff x2 calculated x table value level of significance 4 14.2 7.81 0.05 source: authors’ computation x2 calculated value is 14.2 while x2 critical value is 7.81. this confirms that the alternative hypothesis is accepted indicating that needs control and participating in access road construction have significant effect on the sustainability of baking industry in nigeria. research hypothesis 3: solid waste management and control has no significant relationship with the environment in which banks operate. chi – square x2 result diff x2 calculated x2 table value level of significance 4 58.16 7.81 0.05 source: authors’ computation the alternative hypothesis stating that solid waste management and control has significant effect on the environment in which banks operate is accepted since x2 calculated value of 58.16 is greater than x2 table value of 7.81. research hypothesis 4: pollution as a result of emission from power generators and other electronic machines has no relationship with the sustainability of the banking industry asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 134 chi-square x2 result diff x2 calculated x2 table value level of significance 4 4.14 7.81 0.05 source: authors’ computation the x2 calculated it 4.14 while x2 critical value is 7.81. our analysis here fails to reject the null hypothesis. this implies that pollution as a result of emission from power generators and electronic machines has no significant effect on sustainability of the banking industry in nigeria. research hypothesis 5: adequate security of the community in which a bank operates has no relationship with its sustainability. chi-square x2 result diff x2 calculated x2 table value level of significance 4 155.9 7.81 0.05 source: authors’ computation since x2 calculated value as 155.9 which is greater than x2 table value which is 7.81, therefore the alternative hypothesis indicating that adequate security of the community in which a bank operates has a significant effect on its sustainability is accepted. research hypothesis 6: health care for employees and their families has no significant effect on effectiveness, efficiency and overall result of the banks. chi-square x2 result diff x2 calculated x2 table value level of significance 4 49.22 7.81 0.05 source: authors’ computation since x2 calculated value as 49.22 and x2 table value as 7.81, the alternative hypothesis stating that health care for employees and their families has a significant effect on effectiveness, efficiency and overall result of the banks is accepted. research hypothesis 7: work force stability has no significant effect on the result of operations in the banking industry. chi-square x2 result diff x2 calculated value x2 table value level of significance 4 97.46 7.81 0.05 source: authors’ computations asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 135 the alternative hypothesis stating that work force stability has a significant effect on the result of operations in the banking industry is accepted since x2 calculated value is greater than x2 critical value. research hypothesis 8: banks’ social responsibility such as scholarship awards to students in the communities, donations to communities and sponsorship of talents in games and sports has no significant effect on the goodwill of the industry. chi-square x2 result diff x2 calculated value x2 table value level of significance 4 25.26 7.81 0.05 source: authors’ computation x2 calculated value is 25.26 while, x2 table value is 7.81. therefore, the research hypothesis stating that banks’ social responsibility such as scholarship awards to students in the communities, donations to communities and sponsorship of talents in games and sports has no significant effect on the goodwill of the industry is accepted. research hypothesis 9: employment of physically challenged persons and the less privileged who are qualified has no significant effect on corporate sustainability of the industry. chi-square x2 result diff x2 calculated value x2 table value level of significance 4 13.52 7.81 0.05 source: authors’ computation since x2 calculated value is 13.52 which is greater than x2 critical value of 7.81. therefore, the alternative hypothesis stating that employment of physically challenged persons and the less privileged who are qualified has a significant effect on corporate sustainability of the banking industry is accepted. 4.1 discussion of findings a critical analysis of the study triple bottom line reporting: an assessment of sustainability in banking industry in nigeria revealed the following facts: adequate participation in the management of wastage ways and erosion control can have positive impact on the sustainability of baking industry in nigeria. furthermore, the study discovered that environmental need control and construction of access road as a social responsibility is positively significant to the sustainability of banking industry in nigeria. also, it is explicitly revealed that effective participation in the security of the community in which a bank operates can positively enhance the sustainability of the banking industry in nigeria. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 136 equally, the study all allows us to discover that adequate and sufficient health care for the employees and their family members can engender effectiveness, efficiency and sustainability of the banking sector. findings also revealed that work force stability is an indispensable strategy for sustainability of banking industry in nigeria. finally, the study revealed that discharging corporate social responsibility such as scholarship awards for the children of high intelligent quotient, talented children in games and spirits, employment of physically challenged and less privileged persons who are qualified can have positive result in sustainability of the banking industry in nigeria. 5. summary, conclusion and recommendations 5.1 summary of findings evaluation of triple bottom time reporting in relation to the sustainability in banking industry in nigeria shows that if nigeria banking sector can adopt the triple bottom line reporting. it will enhance the sustainability of the industry since it will affect all the stakeholders positively rather than the current traditional reporting which hinged more on financial reporting alone. triple bottom line reporting takes into consideration the concept of fairness and objectivity. it embraces the factors that can affect environment, employees and finance. this hybrid approach to reporting enables corporate organizations to be conscious of their social, financial and environmental responsibilities. corporate organizations as entities cannot live in isolation. they have to be fully aware that they affect their environment in a way. triple bottom line reporting allows the corporate organizations to understand that as a subset of the large organizations, they must be ready to contribute to the wellbeing of the society. elkington (1988) opined that the triple bottom line reporting focuses corporations not just on the economic value they add, but also on the environment and social values they add or destroy. at its narrowest, the term triple bottom line reporting is used as a frame work for measuring and reporting corporate performance against economic, social and environmental parameters. it also enhances transparency. 5.2 conclusion considering all the discoveries in this study, we can assert the fact that triple bottom line reporting will show three balance sheets which will show the statement of affairs in relation to economic activities of the reported organizations. also it will qualitatively analyze how organizational activities affect the environment in which the an organization operates possibly in terms of infrastructure, provision of good health facilities, involvement in funding of the educational sector. this is in line with the comments of price waterhouse cooper (2002) as a result of the current breakdown of confidence in financial reporting. large companies are facing increasing demands and expectation from stakeholders and corporate organization are being more held accountable for their performance and actions. also the stability of the work force and welfare has to be clearly reported. the development programmes that enhance the quality of the workers force. the care for the family of the asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 137 employees and all the on-the-job and retirement facilities including the turnover of the work force has to be reported. finally, we conclude that adoption of triple bottom will facilitate sense of belonging to all stakeholders which will enhance sustainability to the banking industry in nigeria. 5.3 recommendations a) since triple bottom line is a trend towards transparency and accountability, the central bank of nigeria should include it in its policy and make it compulsory for all banks. b) the central bank of nigeria should mandate all the banks to itemize and analyze their financial reports to reflect how the stakeholders are affected by the activities of the year. c) the central bank of nigeria should make a policy that include non-share holders in the annual general meetings and allow to participate in the issues that affect their environment. d) triple bottom line reporting should be included in the curriculum of relevant courses and professional bodies e) finally the generic characteristics of triple bottom line initiative should include integrated planning and management commitment to stakeholders engagement and mull dimensional measurement reporting. references brundland, g. (1987). our common future: the world commission on environmental and development. oxford university press u.k buffin, f. (2004). business takes on a social role sydney: the australian financial review nov 19. p.10, australia. el kington, j. (1988). cannibals with forks; the sustainability ability and social science, round table proceedings, capstone publishing u.k el kington j. (1977). cannibals with forks; the triple bottom line of 21st century business oxford capstone publishing u.k fred, r (2006). the challenge of tbl; a responsibility of whom? business and society review 11:1, 1-14 blackwell publishing, 350 main street, maiden ma 02148 u.s.a and 9600 carsington road oxford ox42dq u.k. global reporting initiative. (2002). sustainability reporting guidelines http://www.globalreporting.org. accessed jan 18, 2005 group 100, (2003). an association of australian senior fiancé executives from national business enterprise; sustainability guide to triple bottom line reporting sydney; group of 100 incorporated australia. h.//www.globalreporting.org asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 138 kpmg (2002). kpmg international survey of corporate sustainability reporting 2002. kpmg global sustainability service june 24 de meern nether lands. meadows d. (1989). indicators and information sustainable development sustainable institute v.t.u.s.a mervyn king. (2002). second report on governance standards in south africa, retrieved from: www.ecgi.org/codes/documents/executive_summary.pdf on august 8, price waterhouse coopers. (2002). “management barometer” price waterhouse coopers bsi global research, september 26 http://www.barometersurveys.com /production /bar survensfl, accessed january 25, 2005. scheiwiller t. (2005). corporate responsibility in pharmaceutical industry. price water house coopers news letter http://www.pwc.com/extweb/pwc publications nsf accessed january 25, 2005. suggett d., & goodsir b. (2000). triple bottom line measurement and reporting in australia, allen consulting group, canberra. tavis, p. (2004). triple bottom line reporting, a tool for measuring, communicating and facilitating change in local government a paper for the effective sustainability education conference 2004. sinth sydney city council australia tilt c.a. (2007). corporate responsibility accounting and accountants. idowu samuel o, leafilho water (eds). perspective of corporate social responsibility d0110.10071/978-3-6x2-02630-02, springer verlag berlin heidelberg 2009. microsoft word 7243-25837-2-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 1 drivers of firm’s value: panel data evidence from indian manufacturing industry ranjittiwari fellow, nifm iilm graduate school of management greater noida, india – 201306 brajesh kumar national institute of financial management faridabad, india – 121001 received: march15, 2015 accepted: june14, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.7243 url: http://dx.doi.org/10.5296/ajfa.v7i2.7243 abstract the purpose of this paper is to classify the value drivers into broad categories and then identify the major drivers of firm’s value for indian manufacturing industry and also work out the sectorial sensitivity of value drivers. to achieve the objectives of the study we first derive the value driver’s model next we use panel regression with different model specifications to empirically analyse the major drivers of firm’s value.ourstudy reveals that sales, net margin, book value, dividend per share, beta and earnings per share are the six major financial drivers of value. all the strategic drivers when included in the model have significant relation with value without disturbing the r-square of the model. thus, it is clear that apart from generic financial drivers, firms need to put more attention on strategic choices they make, because it is the strategic choice that will give firms an edge over others in developing economies like india. further, we also observesector specific priorities of the value drivers.this paper provides academicians and practitioners with an overview of the applicability of value drivers for indian manufacturing industry. further, the study will fill the gap in literature by adding value drivers’ evidence from one of the fastest growing economies in the world and will benefit researchers in arriving at common consensus for value drivers in emerging economies. keywords:drivers, firm value, manufacturing, panel data analysis, india. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 2 1. introduction investment funds are limited and to attract them, the firm has to submit itself to the scrutiny of the people whose money it is using.in this scenario, the firm’s that can create value1 for their shareholder and stakeholders2 are now most preferred. if the management of the firm can identify the unique drivers that have higher influence on market valuethen it will eventually increase shareholder value by managing those drivers. this is in line with argument that the managers first priority is to maximise3 the shareholder value (see, rappaport (1986), black et al. (2001), chandra (2011) among others). in the next section, we further dwell on this issue in more detail. given the importance of the issue, many researchers have tried to identify the value drivers. however there is no unanimous approach towards these drivers as well as their classification. moreover, the empirical literature on developing economies is very scant4. this has fuelled our interest to study the drivers of firm’s value in an emerging economy context which are growing at high speed (see, footnote 5) and are able to attract foreign investment because of huge untapped market and low cost labour. in line with the above discussion, the objectives of this study is to first classify the drivers into broad categories and then identify the major drivers of firm value for indian manufacturing industry and also work out the sectorial sensitivity of value drivers. more specifically, we try to develop an understanding as to which are the key drivers the companies should concentrate on that will improve performance and hence create value. to our knowledge, this is among the few studies that provide large scale evidence on value drivers of firms’ in developing economies. this paper will provideacademicians and practitioners with an overviewof the applicability of value drivers for indian manufacturing industry that may lead to increased profitability. further, the study will fill the gap in literature by adding value drivers’ evidence from one of the fastest5 growing economies in the world. while doing driver analysis we will concentrate on historic facts and empirically examine the relationship between value and potential drivers (see, section 3 for details).rest of the study isorganised as follows: section 2 provides brief review of literature, section 3 provides derivation of value drivers’ model, section 4 and 5 briefs data and methodology used for the study, section 6 provides empirical results and finally section 7 provides concluding remarks. 1we define value as change in stock prices of firms over a period. 2corporate success in creating shareholder value benefits all parties, not only shareholders. economic surpluses make everyone better off. it is difficult to imagine a business where you can satisfy shareholders without taking care of customers, employees and others. in the pursuit of economic value creation, management must concern itself with all aspects of company operations, including product quality, personnel training, know-how, company image, and reputation. hence, the pursuit of economic value is consistent with the interest of all parties. failure to which may lead to reduction in shareholder value in long run (see, rappaport, 1998; black et al., 2001; and morin et al., 2004). 3much of the theory of corporate finance is based on the assumptions that since managers are hired by shareholders they should strive to maximise the value of firm or shareholder value. 4the review of studies in section 2 reveals that majority of the studies are conducted with respect to developed nations and we are using those drivers as a proxy for measuring and/or managing performance of companies in developing nations, even after knowing the fact that the level of market efficiency and structure is different. hence we need studies that can bring forward the story of emerging nations. this study is a way forward in this direction that takes up the case of india. 5see, trade and development report 2013 and world investment report 2014. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 3 2. review of literature for the purpose of firm’s valuation, it is very essential to identify the key drivers of value because these drivers can either increase or decreasethe value depending upon the tendencies of their changes (see, kazlauskiene and christauskas (2008)).several studies (both quantitative and qualitative) have investigated the drivers influencing firm value to have a better understanding of these drivers. chugh and meador (1984) did a survey of 2000 members of financial analysts’ federation and indicate that analysts consistently emphasise the long term over the short term. the study revealed that expected changes in eps, expected return on equity, and prospects for the relevant industry were considered to be the most essentialvariables over the long term whereas industry prospects, expected changes in eps and general economic conditions were given high importance in the short term. ruhland cowen (1990) focused on the methods of creating shareholder value using an internal financial planning and control system. they stated that since return on investment, return on equity, and earnings per share figures can be manipulated by management,thereforethese variables fail to sufficiently measure a firm’s performance. they alternatively suggestedfive drivers that are likely to affect cash flows namely: operating profit margins, working capital investment, sales growth rates, fixed capital investments, and cost of capital. following similar lines mills and print (1995), scarlet (1997), rappaport (1998) and black, wright and davies (2001) in their books point out seven value drivers namely: change in sale, margin of activity profit, tax rate, working capital, expenses of capital, costs of capital, and period of competitive advantage. in addition to the above mentioned drivers, turner (1998) presented the eighth driver i.e. return on capital. kaplan and norton (1996) have divided value drivers into four categories: financial, purchasers, internal business process, and innovations which leads to the determination of seven value drives namely return on capital employed, account receivables, operating expenses, customer satisfaction, lower rework, employee morale and employee suggestion. l.e.k. consulting (1998) executive insights have classified value drivers into three broad categories: growth drivers, efficiency drivers and financial drivers. further, they suggested that by focusing on these value drivers, management can prioritise the specific activities that will affect performance in each area.cheremnikh(2000) as cited in kazlauskiene and christauskas (2008) in his study on improving company’s value for the purpose of business management classified value drivers into three broad groups with two levels each namely internal and external value drivers, quantitative and qualitative value drivers, and financial and non-financial value drivers.ittner and larcker (2001) using value based management perspective tried to identify the factors influencing the performance of firms. they, based on perceived importance presented the following categories of value drivers: financial, purchasers, employees, operational, quality, alliances, supply, environment, innovations, and society. they further examined the relative importance of these value drivers under four different strategic dimensions of firms namely: flexibility, innovation, market stability, and book to market ratio and suggested that different strategies attract different drivers. akalu (2002) suggested that it is extremely important to know the strength of value drivers to understand their influence in the process of free cash flow generation. he have considered net asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 4 sales, operating cost, interest expenses, income taxes, fixed cost of investments, replacement cost of investment and working capital investment as initial value drivers in the model. however income tax, investment cost and working capital are the three major drivers of value. xavier and vinolas(2003) suggested a fresh corporate valuation method “financial and economic value added,” or feva that integrates the eva, dcf, and mm approaches. the feva approach divides the sources of corporate value into eight value drivers (capital invested, current operating eva, franchise factor from new investments, tax shield on existing debt, tax shield from growth opportunities, bankruptcy cost of current debt, bankruptcy cost of new debt, current debt) and precisely identifies the contribution of each driver. kim (2004) proposed a model to empirically identify the critical strategic factors for value-based management. since “value” is abstract in its nature, managers of the firms need to know more solid and clear target measures that derive the value of their firm. the proposed model uses common financial factors and their variations as input variables to produce the market value added (mva). further to capture a dynamic relationship between input and output variables the model uses an artificial intelligence technique that is non-parametric by nature. findings of the study reveal that the model is able to identify a set of strategic drivers that are linked directly to the mva of companies involved. specifically, cost of capital and size of capital are the two most important factors creating value. morin and jarrell (2004) have prescribed a value based management framework putting it all together the strategic, financial and corporate governance issues to determine the value drivers for companies. finally consolidating all the three issues they have classified value drivers in two levels. level one constitutes of cash flows and cost of capital and level two constitutes of return, growth rate and capital that determines cash flow and risk that determines cost of capital.kakati (2005) has tried to identify the factors that have an influence on stock valuation process. he found that though stocks response to some common factors, they appear to response to specific factors like price earnings ratio, return on net worth, earnings per share, growth in sales, dividend per share and analysts forecast i.e. to say that financial factors influence the stock valuation process but other non-financial, industrial and economic factors have little influence. moreover he argued that the use of large number of factors in the model does not lead to better performance of stocks. hence, what is important is the reliable sources of information, better forecasting and accuracy of valuation techniques.gross (2006) in his study have identified the business mix, the branch structure, the cost efficiency and the risk capabilities as potential value drivers. further they examined their impact on value creation. they suggested that the cost efficiency and the risk capabilities are the two essential drivers of shareholder value whereas the empirical evidence on the business mix and the branch structure is ambiguous. kraai (2006) suggested that business environment at present is not just about survival; it’s about focusing on and creating sustainable value. kraai in his review suggested that over 26 value drivers have been identified but typically no more than 10 are critical in any business. the ten most common value drivers are: management depth, customer diversity, owner involvement, competition, customer satisfaction, human capital, financial history, operating efficiencies, recurring revenue and professional sense. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 5 damodaran (2006) in his study have given stress on individual characteristics of firm’s i.e. cash flows, expected growth rate and discount rate to be the most important drivers of value in any firm. he also suggested that since equity valuation through multiples approach is the most common approach among analysts hence, the fundamental drivers of equity multiples approach will be of great use in creating and/or managing value of the firm’s. the fundamental drivers of three widely used multiples (p/e, p/b and p/s multiple) among analysts where expected growth rate, pay-out ratio, risk, return on equity and net margin.kazlauskiene and christauskas (2008) suggested that the classification of value driver is subject to the disintegration of firm’s value established by the method of discounted cash flows, because all the drivers that have an impact on firm’s value are reflected in the rates of free cash flows and discount rate. they have classified the drivers into five levels and suggested to establish the impact of drivers on firm’s value through an integral method of economic factor analysis. boyd (2010) based on his past experience of advising professionals in the field of valuation have identified six key value drivers that are common to most businesses that includes: management team, operating system, customer base, facilities and equipment’s, growth strategy and financial controls. he suggested that concentrating on developing and enhancing each of these value drivers will create value for the firm. chandra (2011) has conceptualised the important levers that are available to a company for managing and creating value in a ‘value octagon’ that includes strategy and business model, capital allocation, strategic financial decisions, organisational architecture, cost management, corporate risk management, mergers/acquisitions/restructuring, and corporate governance. in a recent study chang and hughes(2012) concentrated on the innovative skills of small and medium enterprisesas a driving factor that will have a positive impact on firm’s performance. they suggested that firm’s performance is linked to innovation, which in a way is linked to other driving forces such as organisationalstructure and leadership style. al-hares, abu-ghazaleh and haddad (2012) empirically investigated the value relevance of earnings, book value and dividends in an emerging capital market and reported that book value and earnings are two major factors that are playing an important role in improving value. their results are consistent with ohlson (1995). taking into account the value influencing drivers mentioned by the authors analysing firm valuation issues, it is noticed that no consensus so far has been reached regarding the major driving forces behind firm value. we also miss a uniform approach towards these drivers as well as their classification. moreover, the empirical literature on developing economies is very scant. hence, it is of great interest to determine the value driver’s model for indian firms. doing so will enable the management to translate the broad objective of creating value into some specific actions more likely to deliver that value. 3. derivation of value driver’s model value drivers are the factors that may influence the value creation of a firm (e.g. profitability, management quality, customer satisfaction, macro-economic factors etc). the value drivers have been broadly classified into two dimensions(see, griaznova and fedotova (1998), cheremnikh (2000), ripol-saragosi (2001) and gross (2006)). the first dimension is based asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 6 on the internal and external aspects. internal value drivers are factors relating to the inherent performance of a firm, whereas external drivers are factors relating to the macro-economic environment. the second dimension takes the qualitative and quantitative aspects of value drivers. quantitative value drivers are factors concerned with the collection and analysis of data in numeric form, whereas qualitativevalue drivers,on the other hand, refers to descriptions based on some quality or characteristic of the firm. qualitative value drivers do have a significant impact on firm’s value but unfortunately, information on these qualitative drivers is typically not available and if available, its impact on value is difficult to measure because of its non-quantifiable nature (see, gross (2006)). for clarity of presentation, the two dimensions can be represented in atabular form as follows: figure 1.types of value drivers source: own modified graphic the top-left quadrant of the fig 1, represents the internal qualitative (e.g. firm specific attributes like management quality, corporate governance) aspects. similarly, the top-right quadrant gives the internal quantitative (e.g. financial indicators) attributes. likewise, the bottom-left and the bottom-right represent the external qualitative (e.g. credit rating, consumer behaviour) and external quantitative (e.g. macro-economic factors) aspects, respectively. since, we choose model decomposition 6 process to arrive at the value drivers, our modelrimthat we choose based on superiority of residual income model over other valuation models 7 is more suited for internal-quantitative attributes;hence, we only incorporate 6because models are used to estimate the intrinsic values therefore it is of utmost interest to dig out the drivers responsible for increase or decrease in value estimated with the help of these models. 7because under residual income model value is recognized early since a major portion of the stock’s intrinsic value is constructed immediately in the form of current book value and terminal values are less sensitive. moreover residual income models are based on economic profitability of a firm rather than just its accounting profitability. major studies on valuation internal-qualitative external-qualitative external-quantitative internal-quantitative qualitative quantitative int ern al ext ern al asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 7 internal-quantitative factors in our analysis. moreover, rim model is better fitted in our study as it is more informative than other value estimate models. we take this approach further and considered it for the derivation of value drivers. we construct a value metrics framework (see, figure 2), to derive the potential drivers of firm value. first, we approximate the value of a firm with our estimated intrinsic value.next, we link this value estimate to the financial indicators of the firm directly linked to the model that is used to arrive at the intrinsic value.for the estimation of the intrinsic value, we have used different financial indicators8 of the firmdirectly linked to the model and name the indicators as ‘level i financial indicator’(see, figure 2). these ‘level i financial indicator’are again a function of multiple factors9 (see, figure 3). we define the multiple factors as ‘level ii financial indicator’(see, figure 2). both the ‘level i financial indicator’and ‘level ii financial indicator’ are our financial value drivers. but as we know, market value of a firm is also dependent on other factors that have an impact on firm’s value. these factors may not be directly associated to the model; e.g. the strategic choices of companies for their growth and development,managing investor perception etc. we call them indirect financial indicators or ‘strategic value drivers’. the four probable strategic drivers of value are assumed to be pay-out ratio, investments into r&d, investments into advertisement (brand image), and participation of foreign promoters in the organisational structure of the firm (see, walter (1963), chaganti and damanpour (1991), salomo and strecker (2009) among others).we therefore classify value drivers into two broad categories namely financial value drivers and strategic value drivers (see, figure 4). further, we anticipate that market values of firms are correlated to the probable drivers of value. therefore to measure the impact of the identified value drivers, we formulate the regression model as illustrated in equation 1.a brief description of the identified value drivers are presented in table 1. table 1.brief description of the identified value drivers drivers description proxy variable used sales revenue income from sales of goods and services, minus the cost associated with things like returned or undeliverable merchandise in the normal operations of a company in a specified period. we expect that high revenue growth will lead to higher value. sales (s) of models also reveal the superiority of rim over other models (see, bernard (1995), penman and sougiannis (1998), frankel and lee (1995; 1996), francis, olsson, and oswald (2000), gross (2006), subrahmanyan and venkatachalam (2007), imam, chan and ali-shah (2013)). 8we have considered return on equity, growth, cost of equity, and book value amongthe financial indicators. 9level ii financial indicators are arrived at by decomposing level i financial indicators. for example, return on equity can be derived from change in sales, change in operating expense, change in tax rate and change in net margin. similarly, change in sales and change in capital expenditure can be used as proxy for growth of the firm. cost of equity can be analysed by three drivers: market return, risk free return and beta. book value is arrivedat by lagged book value, earnings per share and dividend per share (see, rappaport (1998); lee et al. (1999) and black and wright (2001)).however, level ii financial indicators reported in figure 2 only reports the unique drivers of decomposed level i financial indicators. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 8 operating cost operating costs include both fixed costs and variable costs. so any increase in cost will be a reduction in value. but cost may also rise to achieve higher production activities. so we measure the operational efficiency by intensity of operating cost. we expect that high intensity of cost will lead to lower value. oc / sales (ioc) tax rate total tax liability stated as a percentage of the taxable income. high tax rate will therefore reduce earnings available for equity shareholders that will lead to lower value. total tax / pbt (tr) net margin net margin is a measure of firm’s profitability, hence will lead to higher market value for the stocks. net profit / net sales (nm) capital expenditure funds used by a company to acquire or upgrade physical assets creating future benefits. capital expenditure will though reduce free cash flows of the business but will work as an agent of cash flow generation in future. hence, lagged value of net change in fixed assets is used. net change in fixed assets (capex) book value the value at which an asset is carried on a balance sheet. it is the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated. therefore higher (lower) estimates of book value may lead to higher (lower) market value. bv earnings per share the portion of a company’s profit allocated to each outstanding share of common stock. earnings per share serve as an indicator of a company’s profitability. eps dividend per share the portion of companies’ profit that is distributed among shareholders. market reacts positively to announcements of dividend increases, and negatively to announcements of dividend decreases or no dividend. dps beta it is a measure of systematic risk, of a security in comparison to the market as a whole. therefore it is expected that stocks with higher beta will form the basis of higher discount rate and hence lower value. beta pay-out ratio pay-out ratio plays an important role in emerging economies because company’s decision on whether it will pay high percentage of profits as dividends or will retain them for future expansion is a critical decision to be made because high pay-out ratio is perceived as low level of investments opportunities available to firms and vice-versa in the market and hence will lead to lower/higher market value. por ownership structure by ownership structure we mean the participation of foreign promoters. we expect that high concentration of foreign promoters will have significant positive influence on firm value. the underlying rational is that apart from easy money, foreign promoters will bring new technologies and human expertise with them, which will in a way help firms in developing economies to grow and survive in the competitive world. foreign promoters (fp) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 9 investments into r&d investments into r&d is viewed as the future of firms performance because to survive in this competitive market it is expected that firms come up with new innovative products and services, and that is only possible if firms are continuously investing into r&d. we expect the market value of firms with high investments into r&d be higher than firms with low or no investments. r&d / sales (rdi) investments into advertisement investments into advertisement are a measure of brand image. the firms with high brand value are perceived to have better future prospects because of the trust created by them over years. we expect the market value of firms with high investments into advertisement be higher than firms with low investments. advertisement / sales (ai) source: own compiled figure 2.model derivation process source: own graphic asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 10 figure 3. derivation of level ii value drivers source: own graphic sales roe operating cost tax rate sales growth capital expenditure market return coe risk free rate beta bv_l bv eps dps net margin asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 11 figure 4. classification of value drivers source: own graphic 4. data sources all the variables used in this study were obtainedfrom the prowess data base of centre for monitoring indian economy (cmie). it provides data on more than 27000 indian companies both listed and unlisted. we have taken all 3756bse (bombay stock exchange) listed manufacturing companies from prowess data base for the period from march 2002 to march 2012. the study further analyses the sectorial sensitivity of value drivers for the seven sub-sectors of manufacturing industry (as per cmie)namely chemical, machinery, metal, non-metallic, transport, textile and food & beverages sector. 4.1. sample selection we start withall the 3756 bse listed manufacturing sector companies for 11 years.out of these 3756 companies, we further filter it on the basis of availability of positive book value, iv financial value drivers strategic value drivers firm specific indicators sales operating cost tax rate net margin capex book value eps dps beta pay-out ratio foreign promoters research &developme nt advertiseme nt intensity asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 12 adjusted closing price andfirms with minimum two years of data. this resulted in our final sample size reduced to 1372 firms. the breakup of these firms into different segment has been depicted in the table 2.to obviate the effect of extreme outliers on our results, we winsorize the data by 2.5 percent top and bottom. descriptive statistics of the variables are reported in table 4. table 2. final selection of companies sub-sectors considered firms for the study selected firms for the study chemical 1073 417 machinery 558 228 metal 500 161 non-metallic 292 100 transport 173 102 textile 585 202 food & beverages 575 162 total manufacturing 3756 1372 source: own computed 5. methodology this part of our analysis aims to assess the impact of drivers on firm’s value. for this purpose, we construct the value driver’s model (see, equation 1) and estimate it with pooled ols regression,the fixed effects model (fe)andthe random effects model (re). the best model specification is identified amongst these three models to study our objective.we use f-test, lm-test and hausman test to identify the best model specification. further, we also conduct f-test to see the joint insignificance of coefficients i.e. to suggest that the models are well specified. , = + , + , + , + , + , + , + , + ,+ , + , + , + , + , + , 1 where: y is market value10 (mv); islogarithm of sales (s); isintensity of operating cost (ioc); istax rate (tr); is net margin (nm); islogarithm capex; isbv_l; iseps; isdps; isbeta; is pay-out ratio (por); isadvertisement intensity11 (ai_d); isr&d intensity12 (rdi_d); is ownership structure13 (fp_d), is constant, 10market price per share is the proxy for market value. 11ai_d is a dummy variable which takes the value of 1 if the firms are investing more than 10 percent of sales towards advertisement, otherwise its 0. 12rdi_dis a dummy variable which takes the value of 1 if the firms are investing more than 2 percent of sales towards research & development, otherwise its 0. 13fp_d is a dummy variable which takes the value of 1 if the firms have more than 10 percent foreign promoters in their asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 13 to are coefficients. 6. empirical results in this section, we discuss the influence of value drivers on firm’s value to have a critical understanding of the major drivers of value. to do this, we first need to identify the best model specification. the pooled regression model assumes homogeneity of the parameters, abstracting from heteroscedasticity and autocorrelation. the omission of firm and time-variant variables in the pooled regression model might lead to a bias in the resulting estimates. so, we relax the restrictive assumption of parameter homogeneity and run fixed effects model to gain further insights into the hypothesized relationship. further, to reap the benefits of increased accuracy in absence of effect endogeneity, we also run random effects model. to identify the best fit among panel ols, fe and re we apply the standard diagnostic tests i.e. we perform f-test to choose between panel ols and fe, breusch and pagan lm test to choose between panel ols and re, and hausman test to choose between fe and re (see, reyna(2010)). the diagnostic reveals that both fe and re are better than ols. now we need to determine the appropriate panel data model i.e. fixed effects or random effects model using hausman test. the test suggests that fixed-effects model is better than random effects (see, table 5 for discussion). test results of fixed-effects model represented in table 3, suggests that the coefficients for s, nm, bv_l, eps, dps, beta, por, ai_d and fp_d were statistically significant at 1 percent level whereas ioc and rdi_d are statistically significant at 10 percent level. but the model does not yield any significant relation with tr and capex.the high of 0.82 implies that the independent variables explain a large portion of the variation of the dependent variable. the f-statistic is 33.52, which rejects the null hypothesis of joint insignificance of coefficients and therefore suggests that the regression model is well-specified. finally based on above results we conclude that sales, net margin, book value, dividend per share, beta and earnings per shareare the six major financial driversof valuein indian manufacturing industry. the sign and the magnitude of the estimates are on the expected lines.net sales is positively linked with the value of firm indicating that growth in the revenue of firm, increases profitability hence pushes the value northwards. the significant coefficients of net margin, book value, earnings per share, and dividend per share are positively linked to value. these variables are indicators of better performance of the company that translates into increased value of the firm. the highly significant and positive coefficient of beta suggest that investor’s factor-in for the high risk associated with the manufacturing segment in-lieu of higher return, which increases the market value of the firms in rising markets because of huge cash flows. though beta increases the discount rate but the increase in cash flows is disproportionate to the change in discount rate and that forms the basis of higher market value. the results also highlight that during the study period there has been no substantial investment in plant and machinery by the manufacturing segment. this can be corroborated with the fact that no significant relation is established between capital expenditure and market value. the model is also not able to establish any significant organisational structure, otherwise its 0. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 14 relationship between intensity of operating expense and market value at 5% level. but its significance at 10% level leaves the caution behind that any mismanagement in operating expenses could lead to decline in value. as far as strategic drivers are concerned, we find that pay-out ratio is inversely related to value at 5 percent level of significance. hence, we conclude that firms in emerging economies like india should concentrate more on profitable investment opportunities meaning retention should be given more priority. the other three strategic driver’s i.e. ai, fp and rdi have significant positive relation with value. therefore, the firms that are concentrating on these strategic drivers can command a premium for their stock over those who have ignored these strategic choices in their business model (see, table 3).the striking aspect that can be noticed from the results is the significant relation of all the strategic drivers with value without impacting the r-square of the model. hence, any increase/decrease in the parameters of strategic drivers, will lead to the increase/decrease in value of the firm. from this we can safely conclude that strategic driversassume higher importance than the financial drivers. table 3.panel multivariate regression of value drivers (manufacturing) sample size, 2002 – 2012, n = 1372 statistic panel ols fixed effects random effects coefficient t-statistic coefficient t-statistic coefficient t-statistic 15.9518*** 1.8073 34.3041* 3.9337 26.4282* 3.2004 s 0.0226* 13.3013 0.0488* 21.7871 0.0411* 21.2439 ioc -0.1746*** -1.9422 -0.1431*** -1.6909 -0.1748** -2.1816 tr 0.6855* 3.5364 -0.1337 -0.5297 0.3508 1.6393 nm 0.2318** 2.1081 0.4933* 5.4108 0.4913* 5.5602 capex -0.0032* -7.5978 0.0002 0.3907 -0.0016* -3.3452 bv_l 0.5691* 31.4471 0.1810* 9.0008 0.3335* 18.4765 eps 2.4374* 21.8194 1.8913* 20.5153 2.0425* 22.8353 dps 7.3140* 21.4683 2.3939* 7.7672 3.3593* 11.3898 beta -2.0580 -0.8811 9.7303* 4.3203 7.2048* 3.4027 por -0.2596* -4.9431 -0.1595* -3.4221 -0.1399* -3.1296 ai_d 47.7922* 11.1402 17.6007* 3.4975 29.1270* 6.3979 rdi_d 52.9834* 9.4085 10.3664*** 1.6694 24.0900* 4.2141 fp_d 51.2832* 18.5931 13.4908* 2.7404 39.5871* 10.4299 r square 0.5553 0.8204 0.3101 model significance 0.0000 0.0000 0.0000 ***, **, * indicates statistically significance at the 10, 5, and 1 percent level, respectively. source: own calculated asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 15 table 4. descriptive statistics of value drivers (sample size, 2002 – 2012, n = 1372) manufacturing mv bv_l sales ioc tr nm nfa eps dps beta por ai rdi fp mean 86.8196 63.7898 4996.0850 97.9537 7.8953 3.1899 1878.9320 8.6913 1.8560 0.8709 21.8000 2.4504 0.1362 5.6946 median 28.5300 37.0400 1307.2000 97.1413 7.4100 3.5372 402.8000 3.5900 0.1050 0.8800 13.4200 1.2424 0.0000 0.0000 std. dev. 145.7314 71.9397 9814.5890 13.5494 5.9692 11.4701 3899.8730 15.3716 4.1249 0.4178 21.7807 3.1266 0.4091 15.6627 chemical mean 89.3566 61.4960 5307.7880 97.7225 8.5474 3.6330 1955.1320 9.1713 2.1704 0.8380 20.8325 2.9891 0.3645 24.8509 median 27.8800 33.5150 1138.8000 97.9263 8.5400 3.9837 330.9000 3.5050 0.0743 0.8400 15.2100 1.4844 0.0000 15.3800 std. dev. 151.8675 68.6722 10888.2200 12.0275 5.2448 12.4923 3932.3770 14.7583 4.5411 0.3853 23.2298 3.6830 0.9999 25.2932 machinery mean 115.4072 65.5919 3377.7940 99.4421 9.0314 0.9848 779.9281 9.9962 2.3068 0.9402 21.1195 2.6721 0.2200 34.6534 median 35.7400 35.4450 972.3500 97.9116 9.0800 4.3926 241.6000 3.7050 0.0551 0.9500 16.1800 1.5606 0.0000 32.6700 std. dev. 210.1164 75.4256 6048.1450 14.0025 5.5293 20.7219 1544.5250 17.5999 5.3001 0.3970 23.2926 3.0733 0.8398 29.9351 metal mean 65.2109 62.4528 9746.3500 97.8790 8.9962 4.3605 5120.6510 8.9778 1.2474 0.9947 12.6861 0.9220 0.0230 13.9965 median 29.3000 40.6450 2060.7000 98.6483 9.0350 3.2330 503.8000 4.3500 0.0000 1.0200 8.0600 0.4202 0.0000 7.1000 std. dev. 88.7264 70.9987 21344.5600 11.1162 5.3487 8.5181 14238.3600 15.1323 2.4852 0.3681 16.4624 5.5769 0.1309 17.6176 nm mean 87.4536 73.4621 6576.7970 97.0414 8.8070 4.1087 3043.3450 10.0889 1.9129 0.8573 18.2055 2.2028 0.0313 24.2762 median 30.0000 45.6100 1662.7500 96.4068 8.3100 4.3984 652.9000 4.3600 0.3856 0.9000 13.6100 1.7018 0.0000 14.4700 std. dev. 153.1103 82.7258 12288.1200 12.8434 7.0902 11.3236 6122.0690 16.8516 3.9471 0.3484 20.8221 13.9046 0.3033 25.8834 textile mean 45.4812 56.2804 2658.5880 92.9952 3.5002 1.1564 1505.5460 4.8407 0.9759 0.8306 16.1721 2.1948 0.0324 18.6374 median 16.9300 32.7300 1168.6000 92.6488 1.7300 2.3822 557.5000 1.9400 0.0000 0.8600 8.3800 1.4123 0.0000 7.4500 std. dev. 70.8351 65.2350 4095.8630 10.8065 4.1634 10.5993 2687.0800 12.4172 2.6648 0.3734 22.0857 3.6785 0.1919 21.7961 transport mean 135.9646 78.2868 8666.8070 101.5599 12.0384 4.9435 2367.7840 11.6721 2.7899 0.8479 24.7233 2.1367 0.2417 28.9103 median 67.3500 50.8600 1921.2000 101.3582 12.5700 4.4120 596.0000 7.4200 1.2847 0.8400 22.6300 1.1526 0.0000 26.0000 std. dev. 181.9484 79.0656 22306.7500 10.7232 4.9225 6.1551 5502.2830 14.9917 4.9539 0.3307 21.2497 2.5322 0.5283 20.7276 fb mean 97.9842 62.3320 4498.4170 102.4053 7.6360 3.1930 1649.0040 7.5307 1.9623 0.8013 17.8301 3.2983 0.0635 30.5292 median 28.0000 38.6650 1730.6000 97.0244 2.8600 2.2232 477.4000 3.2700 0.0000 0.7950 9.5500 1.0441 0.0000 25.3450 std. dev. 187.4804 70.2418 6981.1860 27.2735 12.1186 10.7098 2958.7410 16.8878 6.1109 0.3892 23.5783 6.6445 0.4588 27.6203 source: own calculated asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 16 table 5.diagnostic tests to identify best method in determining value drivers f-test for fixed effects ( : parameter homogeneity => fixed effects model is misspecified) statistic ols & fe f-statistic 10.9400 p-value 0.0000 breusch and pagan lm test for random effects ( : the variances across entities is zero) statistic ols & re chi-statistic 1012.9000 p-value 0.0000 hausman test statistic ( : regressors are not correlated with c => random effects) statistic fe & re chi-statistic 1724.3900 p-value 0.0000 source: own calculated note on diagnostic test results of table 5: the diagnostic test results in table 5 for panel regression methods used in table 3 reveals that in case of panel-ols and fe, fe comes out to be a better model, in case of panel-ols and re, re comes out to be a better model and in case of fe and re, fe comes out to be the better model as p-values of all the diagnostic tests were less than 0.05. from here we choose fe to be the best model for our study. 6.1. sectorial sensitivity of value drivers after analysing the value drivers for the manufacturing sector, it is of interest to study about the drivers for different sub-sector of manufacturing industry. because there is a possibility that drivers may not be constant across sectors. therefore, this sensitivity analysis will give us a clear idea as to which are the key drivers one should concentrate onwhen analysing sectors. taking the notion further that fixed effects model is better than panel ols and random effects model, for the ease of exposition we only report the results of fixed effects model in table 6. in the chemical industry;sales, net margin, earnings per share, dividend per share, book value and tax rate are the six major drivers of value. the capital expenditure for chemical industry is coming out to be significant at 10 percent level, suggesting that there are some levels of expansion/capacity overhauling in this sector.among the strategic drivers only the advertising i.e. image building is coming out to be significant. this suggests that chemical sector has invested significant amount in improving its brand image. this is also substantiated by the fact that the pay-out ratio is not significant for chemical industry, suggesting that there is high-degree of retention of profit, which is channelized into image building. the research and development driver is not significant, which coincides with the fact that the level of investment is r&d is actually very decimal (only 0.5 percent to sale in comparison to 4 percent in the global context14). 14 report on indian chemical industry, xiith five year plan (planning commission of india). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 17 in case of machinery; sales, earning per share, dividend per share, book value and beta are the five main financial drivers. among the strategic drivers, r&d and foreign promoters are positively linked with the value of the firm. in the metal industry; sales, intensity of operating expenses, capital expenditure, earning per share and beta are the five main drivers of value. the r&d is the only strategic driver that has a significant role in the determination of value for metal industry. the negative coefficient of the r&d suggests that most probably the effort towards strengthening r&d is a recent one, which is yet to translate into output. the insignificance of dividend per share can be attributed to the fact that profits have been channelized into expansion and r&d. the non-metal industry bears a similar picture as that of the metal industry. the financial drivers are almost similar except beta which is not significant. however, among the strategic drivers the foreign promoters have a significant relationship with the value of firm. pay-out ratio has inversely significant relation with value meaning that high pay-outs may lead to decline in value. the textile industry depicts a different picture from the perspective of financial drivers. earnings per share, dividend per share, beta, and book value are the four main financial drivers of value. r&d is the strategic driver of value. quite surprisingly, the sales is not the driver of value. this is the only segment where sales is not playing a role in the value determination. this is also supported by the net margin driver, which is also insignificant for textile. one possible explanation for this could be that during the study period, the textile industry has seen a sharp drop in its growth. moreover, in cotton industry exports were banned for few years15. moving on to the transport segment, it is noticed that the results on the similar lines with that of manufacturing segment for the financial drivers. the main financial drivers for this segment are sales, net margin, earnings per share, dividend per share, beta, and book value. however, one of the most significant aspects of this segment is the complete lack of strategic drivers. one plausible explanation for this could be the structural weakness in this segment in terms of high capacity additions and intensifying competition. there is also limited inflow of fdi into this sector, forcing companies to curtail their spending on r&d and the eminent competition with global players play a substantial role in companies trying to manage their financials rather than the strategic drivers. as expected, in the food and beverage industry the major strategic driver is the image building i.e. advertising. among the financial drivers; sales, net margin, earnings per share, and book value have a significant relationship with the value of the firm. from the sectorial analysis, it is observed that each sector has its unique characteristics, hence, the financial drivers and strategic drivers differ from sector to sector except sales and earnings per share that are common drivers of value across all sectors. therefore, the 15 the government banned export of raw cotton at the start of 2011, halting all export of cotton from india. hence cotton prices started falling due to the slowdown in demand. to arrest the fall and boost, the government allowed additional exports of 170 million kg in mid-2011. however prices kept declining due to a lull in demand, both in global and domestic market (crisil textile report, 2012). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 18 managers of the firm’s should possess a fair idea of these drivers relevant to the specific sectors, so that they can work on these drivers to enhance value. table6. panel multivariate regression of value drivers (sectors) sample size, 2002 – 2012, n = 1372 statistic chemical machinery metal non-metal textile transport fb coefficient t-statistic coefficient t-statistic coefficient t-statistic coefficient t-statistic coefficient t-statistic coefficient t-statistic coefficient t-statistic 46.1840* 2.7509 -55.6814* -1.8094 78.9218* 3.2740 57.2864* 2.0681 22.9443*** 1.7679 -128.0440*** -1.7281 47.2656*** 1.6791 s 0.0472* 12.5637 0.0129* 10.5598 0.0138* 5.6596 0.0310* 5.9832 0.0063 0.8197 0.0367* 5.9956 0.0535* 5.0841 ioc 0.0551 0.3304 -0.1630 -0.5858 -0.7939* -3.2312 -0.4207** -1.6341 -0.0688 -0.5049 0.8673 1.1244 -0.3006 -1.2334 tr -2.7376* -6.0575 3.9126* 4.6766 1.0545*** 1.7735 1.8773** 1.9893 0.0473 0.1336 -0.0723 -0.0553 -0.4788 -0.4784 nm 0.6783* 4.5808 -0.2325 -1.2709 0.0798 0.2571 0.1137 0.3826 0.1058 0.8465 3.8482* 4.7830 1.1405* 2.6271 capex 0.0019** 1.8576 0.0086 1.4502 0.0022* 5.2206 0.0044* 3.0564 0.0013 1.1166 -0.0010 -0.5559 0.0021 0.8486 bv_l 0.2111* 5.6143 0.4066* 5.5546 0.0246 0.6664 0.0580 1.0776 0.0993* 2.8617 0.4266* 5.1899 0.2403* 2.6134 eps 1.8363* 9.6400 3.6650* 11.5474 1.4485* 6.5549 1.8802* 7.0006 1.4853* 10.7187 1.9096* 3.5545 2.3263* 6.7259 dps 1.8648* 3.5400 4.2147* 5.3078 0.4888 0.3977 1.6422*** 1.8823 1.8900* 3.6017 2.5080** 2.0155 -0.4942 -0.5684 beta -3.4704 -0.7974 17.6255** 1.9643 12.6804** 2.3963 3.4833 0.3529 14.3854* 4.2312 73.3566* 4.8353 14.6716 1.1867 por -0.0601 -0.7211 -0.3182** -1.9985 0.0427 0.3160 -0.5801* -3.7228 -0.0004 -0.0076 -0.2320 -0.9743 0.2214 1.1650 ai_d 25.3622* 3.4515 15.8100 0.9040 13.0563 0.4233 -1.2348 -0.0850 -11.1945 -1.4021 -33.1229 -0.9667 48.6364** 2.2104 rdi_d -9.0686 -1.1084 49.2971* 2.7514 -129.2330* -3.3121 -0.2328 -0.0155 38.3721* 1.9538 17.8360 0.6864 -20.4603 -0.2837 fp_d 1.0992 0.1354 58.3351* 3.5846 1.9386 0.1991 51.2832* 18.5931 1.0042 0.1352 24.0841 1.1014 27.9474 0.6733 r square 0.5986 0.6552 0.4495 0.4513 0.5929 0.5411 0.6587 model significance 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 ***, **, * indicates statistically significance at the 10, 5, and 1 percent level, respectively. source: own calculated 7. conclusion we set out to examine the major drivers of value in indian manufacturing industry. to achieve the set objectives, we first derive the probable drivers of value by creating a value metric framework. further, we create an econometric model to analyse the sensitivity of these probable drivers of value. our results suggest that sales, net margin, book value, dividend per share, beta and earnings per share are the six major financial drives. interestingly all the probable strategic drivers (pay-out policy, brand image, investments into r&d and foreign promoters holding in organisational structure) when included in the model have significant relation with value, with no impact on r-square. hence, it can be safely argued that apart from generic financial drivers, firms need to put more stress on strategic choices they make, because it is the strategic choice that will give firms an edge over others in developing economies like india. moreover, these drivers vary from sector to sector except sales and earnings per share that are constant across all sectors (see table 6). therefore, firms in asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 www.macrothink.org/ajfa 19 emerging economies like india should concentrate on these specific financial and strategic value drivers (relevant to that particular sector) that will have the greatest impact on value. focusing on these value drivers will enable management to translate the broad objective of creating value into some explicit actions more likely to deliver that value, this will make the destinations i.e. emerging economies remain attractive for investment. moreover, the empirical results of the study produce different set of drivers compared to the set of drivers prescribed by previous studies (ruhl and cowen (1990), mills and print (1995), scarlet (1997), rappaport (1998), turner (1998), akalu (2002), gross (2006), damodaran (2006) among others). the research results can be used in practice when making decisions on organizations’ value enhancement as well as assessing the influence of the changes upon the organization’s value in the organization’s environment. the created model of value drivers can be applied when analysing the sensitivity of organizations’ value for different drivers in other developing countries too. but since the level of economic, political and social development is different it may lead to biased decision making. we therefore encourage researchers to come up with similar studies in developing economies that may help firms understand the dynamics of value drivers. these studies will further benefit researchers in arriving at common consensus forvaluedrivers in emerging economies. references akalu, m.m. 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(1963). dividend policy: its influence on the value of the enterprise. journal of finance,18(2), 280-291. http://dx.doi.org/10.1111/j.1540-6261.1963.tb00724.x xavier, a., & p. vinolas (2003). feva: a financial and economic approach to valuation. financial analysts journal, 59(2), 80-87.http://dx.doi.org/10.2469/faj.v59.n2.2516 microsoft word 6072-21997-2-rv-writer2-new-final.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 155 does shariah compliant stocks perform better than the conventional stocks? a comparative study of stocks listed on the australian stock exchange krishna reddy & mingli fu department of finance waikato management school, university of waikato received: august 11, 2014 accepted: sep. 26, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6072 url: http://dx.doi.org/10.5296/ajfa.v6i2.6072 abstract a rapid growth of islamic finance in the past decades has motivated many investors to focus on islamic stocks rather than conventional stocks. the argument whether the performance of shariah compliant stocks are better compared to the conventional stocks still remains an open question. therefore, this research examines whether there are differences in performance between the shariah compliant stocks and the conventional stocks listed on the australian stock exchange (asx) for the period 2001-2013. our findings show that there is a statistically significant difference in performance of the islamic and conventional stocks listed on the asx in terms of risk, otherwise the performance of the islamic stocks tends to be similar to the conventional stocks. in addition, we report a statistically significant relationship between the returns of shariah compliant and conventional stocks. keywords: beta, global financial crisis, jensen’s alpha, islamic finance, risk, sharpe ratio, treynor ratio asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 156 1. introduction the first islamic index was established in the dow jones market in december 1995 to enable islamic fund managers to list businesses in the capital markets. since its establishment, investment in islamic stocks has experienced remarkable growth. at the end of 2002, there were 105 islamic equity funds worth approximately us$5 billion with 48 percent located in the middle east, 30 percent in europe and north america, and 22 percent in asia (falaika, 2002). consequently, various capital markets and financial institutions around the world now have established their own islamic indices. for example, the kuala lumpur stock exchange shari’ah index (klsesi) introduced by bursa malaysia (the malaysian stock exchange) is considered to be an important mechanism of promoting the accomplishment of the islamic capital markets plan. according to walkshäusl and lobe (2012), shariah-complaint assets are in access of $939 billion worldwide and over 600 islamic funds are available, thus investors are shifting their assets from actively managed mutual funds to passive index-based investments. islamic investment is based on shariah principles, that is, it prohibit activities with elements of usury (riba), gambling (maisir), and ambiguity (gharar) and also prohibit activities like producing products or delivering services which are against islamic teaching such as pornography, producing/selling alcohol, casino etc (securities commission announcement, 2002). therefore, all islamic financial products listed in the islamic index need to have shari’ah compliance and there are different additional criteria that are sometimes used in screening the permissible companies as well. since many stocks performed poorly during the global financial crisis (hereafter gfc) period, many researchers have argued whether the gfc has had less impact on the shariah complaint stocks compared to the conventional stocks. some researchers (abbes, 2012) have also argued that the difference in performance between the two types of stocks should be minimal and some have argued that conventional stocks should outperform the islamic stocks (mcgowan & junaina, 2010). however, only limited research has been undertaken to date that relate to conventional and islamic stocks using comparative areas of sectorial/industry, market capitalisation, price earnings ratio, market to book value ratio, debt to equity, and returns. therefore, we extend the literature on the debate and undertake a comparative performance analysis of the conventional and islamic stocks. in addition, we also investigate whether the conventional and islamic stocks have performed differently during three different periods, that is, before, during and after the gfc period. we have collated data from the australian stock exchange (asx) for the period 2001-2013 to investigate whether investors in shariah products earn a higher rate of return compared to the conventional stocks. we have used australia as a case study because it has a large and open economy and data is readily available for both investment types. although australia is not an islamic country the trend shows that investors are seeking alternative types of investment that are either ethical or have potential to hedge against risk. therefore, our study has potential to benefit the regulators, fund managers, investment analysts, and general investors in terms of gaining better understanding of the similarities and differences between the conventional and islamic stocks, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 157 and how their performance deviates during different economic situations. the findings of our study will provide investors some valuable guidelines regarding optimal investment choices between conventional and islamic stocks. moreover, our findings of the test relating to whether the islamic stocks have more reliance compared to the conventional stocks when a stock exchange experiences a declining trend will provide an improved understanding to the debate. section 2 provides a brief background of shariah and section 3 provides a brief review of the literature. section 4 presents the data and the method used in this research and section 5 presents results and discussions. section 6 presents the conclusion for this study. 2. background of shariah stocks islamic investment principles emphasise ethical investing (known as shariah-compliant investments) that complies with the principles of shariah, which is the islamic law that governs every facet of muslim’s life. investments in financial instruments with fixed income, such as, preferred stocks, bonds and some derivatives (e.g. options) are unacceptable as they promise a fixed rate of return and grant no voting rights (walkshäusl and lobe, 2012). furthermore, islamic investors are not permitted to purchase stocks of companies whose main business activities are alcohol, gambling, conventional financial services, entertainment, pork-related products, tobacco, and weapons (islamic finance & investment, 2014). moreover, some financial ratios has also been used to screen companies. for example, hussein and omran (2005) reported that when the level of the debt in companies are over one third of market capitalisation, they are not shariah compliant stocks. a purification process need to be carried out to eliminate or clean the portfolio of interest income or other impermissible revenue sources. according to abdelsalam, duygun, matallín-sáez and tortosa-ausina (2014), one way of cleansing impermissible income is to donate it to charities and to non-government organisations. 3. literature review recent literature has investigated the relationship between the islamic and conventional financial markets in regard to the returns and their variability, and have also analysed the correlative performance of those markets during the gfc. indices of different regions have been used to evaluate these markets, such as, dow jones indices or ftse indices (ahdi, et al., 2013). wilson (2004), nisar (2007), keigher and bauer (2000), and derigs and marzban (2008) have presented standard rules to examine or screen whether a specific company based on shariah law is halal (lawful) or haram (unlawful). some researchers argue investment in islamic stocks leads to avoidance of speculation and unnecessary risk taking (obaidullah, 2001; naughton and naughton, 2000). dewi and ferdian (2010), argue that islamic finance is free of interest, gambling and ambiguity, therefore can help resolve the financial crisis issues. according to ahmed (2009), financial crisis arises because financial organisations charge interest and engage in risky investments and therefore, obeying islamic financial requirements can help avoid financial crises. usmani (1999), argue that it is difficult to find companies that strictly comply with shariah based principles. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 158 however, a number of studies have compared the performance of conventional indexes and islamic indexes in terms of equity investment (siddiqui, 2000, 2002; ahmad and mustafa, 2002; mamat, 2002). for example, forte and miglietta (2007) were the first to examine whether the islamic mutual fund belongs to the socially responsible mutual funds (sri) group or are fundamentally different. their findings suggest that there are significant differences between islamic investments and both traditional and sri indices in regard to their profile and portfolio. sri funds tends to perform well and have better reputation, and have lower cost due to lower turnover rate. although there are similarities between the islamic and sri funds, the main difference is that the islamic funds are non-interest bearing investments (osamah, hooi & anis, 2014, p. 30). some researchers have also compared the differences in risk and return between the islamic investment instruments and the conventional investments. for example, hayat and kraeussl (2011) compared the performance of the islamic equity funds (iefs) and the conventional equity funds and reported that the traditional equity benchmarks outperform iefs. furthermore, the underperformance of iefs increased during the recent financial crisis period. based on the capm model, hussein (2004) reported that both the islamic index and the ftse all-world index performed well during the entire period (july 1996 to august 2003). they report that the returns on the islamic index are statistically abnormally higher in the bull market period (july 1996 to march 2000) even though it underperformed the conventional index in the bear market period (april to august 2003). hakim and rashidian (2004) applied the co-integration and causality tests and reported that no correlation exists between the islamic index and the wilshire 5000 index or the three-month treasury bills. their finding also show that the wilshire 5000 or the three-month treasury bill is not the reason for the results experienced for the islamic index. the implication of their results are that the factors are independent from the broad market or interest rates turns to affect the islamic index (osamah, hooi & anis, 2014, p. 31). however, later researchers have reported evidence of correlation between conventional market indices between north american, european union, far east, and pacific markets compared to the islamic index returns (dania and malhotra, 2013). they argue that the price of islamic and conventional securities corresponds to macroeconomic elements. the findings of their research show that common factors affect the equity price of islamic and conventional bonds and that the gap resulting from different islamic and conventional financial practices tends to be minimal (krasicka &nowak, 2012, p. 1). an evaluation of the risk performance of the jakarta islamic stock index (jaskisl) and the conventional jakarta composite index (jci) using garch models show that islamic stock index is safer than traditional stocks (sukmana and kholid, 2012). based on a comparison of the investment performance of the islamic ethical portfolios and traditional benchmark portfolios, results show that the returns are not substantially negatively affected by the use of islamic ethical screens (hassan et al., 2005; hoepner et al., 2011, 847). hoepner et al. (2011) examined the financial performance and the style of investment of 265 islamic equity mutual funds in 20 countries. they reported that the type of islamic fund investment is to some extend related to the growth of stocks and that the mainstream muslim asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 159 economics funds exhibit an obvious preference for small ccorporations with low capitalisation that are referred to as small cap (hoepner, 2011, p. 831). they also reported that the islamic indices had a pattern of investing in small-cap companies compared to conventional counterparts who invest more in large corporations that are likely to be operating in sector-bands (hoepner et al., 2011, p. 847). in summary, there is no consensus in the literature regarding the directional relationship between islamic stock market and conventional stock markets. 4. data and method the weekly stock prices and financial ratios were collated for companies listed on the australian stock exchange (asx) for the period 2001-2013 from asx official website, morningstar and datastream databases. fifty shariah stocks and fifty conventional stocks was used to build a portfolio. all the chosen stocks were ranked according to their market capitalisation. the rebalancing of the portfolio was done on a weekly basis. companies were selected to be shariah compliance if the income derived by company are not from the sale of alcohol, tobacco, pork, pornography, gambling and military equipment. also, not engaged in short selling and the use of leverage is within the required level, that is, below one third of their market capitalisation. companies selected for this research belong to the following industry: industrial metal & minerals, gold, building materials, aluminium, coal, steel, oil & gas e&p, utilities regulated electric, engineering & construction, utilities-regulated gas, telecom services, medical care, utilities-independent power producers, copper & gas refining & marketing. the weekly return (rt) is determined by ln (pt/pt-1) where pt is the change in the weekly stock price for the period t and pt-1 is the price of stock in the period t-1. standard deviation and beta efficiency are the proxies for the total risk and is also used to estimate the volatility of the investment. to examine whether the differences are significant between the average return, standard deviation and the beta of the shariah and conventional stocks, the mann whitney u-test and independent samples t-test is used. the testable null hypotheses are stated as follows: h1: shariah stocks’ returns are not significantly different from the returns of the conventional stocks. h2: shariah stocks are not significantly riskier than the conventional stocks. 4.1 risk-adjusted return measurement if risk is positively associated with the returns, then portfolio performance need to include both, returns risk. according to the capital market theory, the risk adjusted return incorporates risk in computing the returns and it is assumed that investors are holding diversified portfolios. three popular ratios that are used as performance measures include: sharpe ratio, treynor ratio and jensen’s alpha. the sharpe ratio can be computed as follows: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 160       −= p rfri sp σ where sp is the sharpe ratio, ri equals the t period portfolio return, rf is the return on australian three months treasury bills during t period (proxy for the risk-free rate), and the standard deviation of the portfolio is σp. the higher the sharp ratio, the better the performance and vice versa. there are some similarities between treynor ratio and sharpe ratio except treynor uses beta to measure risk instead of standard deviation. the formula for calculating the treynor ratio is as follows:       −= p rfri tp β where tp is the treynor ratio and βp is portfolio beta. alpha is the excess return of the portfolio in the formula of jensen ratio. a higher alpha ratio indicates that the portfolio has a good risk-adjusted returns and vice versa (pareto, 2008). the formula for calculating jensen’s alpha is as follows: )()( rfrmrfrjj −−−= βα where α is jensen’s alpha, rj is the average portfolio returns over t period, rm is the average market return over t period. 4.2 multiple regression analysis in order to estimate the relationship of shariah and conventional returns to the chosen variables, the correlation of the stock returns and financial ratios are examined by the multiple regression analysis. the formula is shown as follows: rt = β0 + β1 x1 + β2 x2+ β3 x3 + β4 x4+ β5x5+ β6 x6 + ε where: rt is the yearly return of the stock; x1 is the debt to equity ratio (der) = total debt/ total equity; x2 is the earnings per share ratio (eps) = earnings available for common stockholders/numbers of shares of common stock outstanding; x3 is the price earnings ratio (p/e ratio) = market price per share of common stock/ eps; x4 is the net profit margin (npm) = earnings available for common stock/ sales; x5 is the return on equity (roe) = earnings available for common stock / common stock equity; x6 is the price to book value asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 161 (pbv) = market price per share of common stocks/ book value per share of common stocks; ε is the random error term. in this model, the linear regression least squares method is used with 10% significance level. we propose our further five hypotheses as follows: h4: stock returns are not significantly related to debt to equity ratio (der). h5: stock returns are not significantly related to earnings per share (eps). h6: stock returns are not significantly related to net profit margin (npm). h7: stock returns are not significantly related to return on equity (roe). h8: stock returns are not significantly related to price to book value (pbv). 5. results and discussion the islamic portfolio contains 50 shariah compliant stocks which are selected based on shariah law and are ranked according to their market capitalisation. the conventional stocks has the same number of stocks and is also chosen based on their market capitalisation ranking in the asx100. companies that own both shariah compliant stocks and conventional stocks are not selected. 5.1 difference in mean results for data that are normally distributed, we use the independent sample t-test; for data that is not normally distributed, we have used the non-parametric mann whitney u-test. table 1 reports the mean, standard deviation and beta of two types of stocks including the missing values and outliers. table 1. return, standard deviation and beta comparison of shariah and conventional stocks based on all the value measures sample size mean islamic portfolio conventional portfolio total islamic portfolio returns conventional portfolio returns mean difference weekly return on the stocks 83 42 41 0.004 -0.006 0.010 (0.847) risk (σ) 100 50 50 0.062 0.043 0.018*** (3.746) beta (β) 100 50 50 0.864 0.808 0.056 (0.668) asterisks indicate significance at 10% (*) 5% (**) and 1% (***) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 162 results reported in table 1 show that there are differences in the returns and risk between the shariah compliant stocks and conventional stocks. for example, the mean value of weekly returns of shariah stocks is greater than that of the conventional stocks (0.004> -0.006) but the difference is not statistically significant. the stability of securities are estimated by standard deviation. table 1 shows that standard deviation of the islamic stocks (0.062) is higher than that of conventional stocks (0.043) and the difference is statistically significant at 1% level. our results suggest that islamic stocks are less stable than conventional stocks. similarly, results for beta suggest that islamic stocks are more sensitive to the market compared to the conventional stocks, that is, beta for shariah stocks are greater than the beta of the conventional stocks (0.864> 0.808). however, the difference for beta is not statistically significant. the plausible reason could be that shariah compliant companies have smaller market capitalisation compared to the conventional stocks (hoepner, 2011, p. 831). results reported in table 2 are similar to that reported in table 1, but exclude outliers and missing values and therefore provide a robustness test for table 1. in addition, wilcoxon rank-sum analysis is also undertaken but results are not reported. the two-sample wilcoxon rank-sum (mann whitney u-test) test provide the same findings. the results reported in table 2 confirms our findings reported in table 1, that shariah compliance stocks are more risky. table 2. return, standard deviation and beta comparison of shariah and conventional stocks excluding missing values and outliers measures sample size mean islamic portfolio conventional portfolio total islamic portfolio returns conventional portfolio returns mean difference weekly return on the stocks 75 35 40 0.006 -0.005 0.010 (0.907) risk (σ) 75 35 40 0.059 0.043 0.016*** (3.338) beta (β) 75 35 40 0.865 0.817 0.048 (0.516) asterisks indicate significance at 10% (*) 5% (**) and 1% (***) in summary, results reported in tables 1 and 2 show that shariah compliant stocks are riskier than conventional stocks. our results relating to returns suggest that the screening criteria used to select shariah compliant stocks do not affect the performance of the shariah stocks. however, setiawan and oktariza (2013) argue that conventional portfolio is more risky than islamic stocks in malaysia. a plausible reason for the differences in our results could be that the islamic market in australia is less diversified compared to malaysia. furthermore, albaity and ahmad (2008) reported that the conventional index in malaysia minimally asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 163 outperforms the shariah stocks index. however, our results show that there is no significant difference in returns between shariah stocks and conventional stocks in australia 5.2 risk adjusted return performance result risk-adjusted return is used to provide a comprehensive analysis of the risk and returns for both, shariah and conventional stocks portfolio for the period 2001 to 2013. table 3 reports sharpe ratio, treynor ratio and jensen’s alpha for shariah and conventional stock portfolios, and compares their performance during the three different periods, that is, before, during and after the global financial crisis. the results reported in table 3 show that the performance of shariah and conventional stocks are similar. although the average value of islamic and conventional portfolio is negative during the sampling period, it shows that the sharpe, treynor and jensen ratios of islamic portfolio are greater than that of the conventional portfolios. this indicates that the islamic portfolio is performing better compared to the conventional portfolio, and is more diversified as the sharp ratio has a negative relationship between risk and return. specifically, the value of sharp ratio for shariah stocks (-0.467) is higher than the value for conventional stocks (-0.821). the treynor and jensen ratios of the two types of portfolio are not substantially different. a plausible reason could be that the weekly returns of both islamic and conventional stocks are mostly negative. table 3.1. risk-adjusted return performance of shariah and conventional stocks year sharpe ratio treynor ratio jensen's alpha islamic portfolio conventional portfolio islamic portfolio conventional portfolio islamic portfolio conventional portfolio economic situation 2001 -0.314 -0.656 -0.041 -0.035 -0.008 0.004 before crisis 2002 -0.480 -0.828 -0.093 -0.051 -0.021 -0.012 2003 -0.422 -0.706 -0.082 -0.083 -0.016 -0.020 2004 -0.503 -1.010 -0.026 -0.041 0.004 -0.007 2005 -0.554 -1.078 -0.064 -0.061 -0.012 -0.013 2006 -0.472 -1.050 -0.032 -0.047 0.002 -0.009 2007 -0.548 -0.976 -0.037 -0.044 0.000 -0.006 during crisis 2008 -0.553 -0.684 -0.053 -0.060 -0.004 -0.010 2009 -0.165 -0.317 -0.017 -0.020 0.003 0.000 after crisis 2010 -0.498 -0.998 -0.028 -0.041 0.004 -0.008 2011 -0.695 -0.775 -0.038 -0.046 -0.001 -0.008 2012 -0.397 -0.892 -0.024 -0.029 0.002 -0.003 2013 -0.472 -0.700 -0.031 -0.025 -0.007 -0.002 average -0.467 -0.821 -0.044 -0.045 -0.004 -0.007 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 164 table 4 reports the results of the performance of the two type of portfolios for different economic situations. before the gfc period, shariah stocks had a higher sharpe ratio but it is not much different from the treynor or jensen’s alpha compared to the conventional stocks. however, during the gfc period the performance of both portfolios were worse than their performance before the gfc period and islamic stocks tends to have larger ratios compared to the conventional stocks. the difference of the mean for the two types of stocks is not large. moreover, the results for the after gfc period show that both islamic and conventional stocks have recovered and show a slight increase. islamic stocks continue to perform better than conventional stocks. our results confirm the results reported by natarajan and dharani (2012) for india. however, our results are different to those reported by rahmayanti (2003) and hussein and omran (2005) that compared to a conventional portfolio, the performance of shariah portfolio is relatively dissimilar within the same period. table 4. risk adjusted return performance for shariah and conventional portfolio before, during and after the crisis economic situation average sharpe ratio average treynor ratio average jensen's alpha islamic portfolio conventional portfolio mean difference islamic portfolio conventional portfolio mean difference islamic portfolio conventional portfolio mean difference before crisis -0.458 -0.888 0.430 -0.056 -0.053 -0.003 -0.008 -0.009 0.00107 during crisis -0.55027 -0.82995 0.280 -0.04481 -0.05195 0.007 -0.0019 -0.0079 0.00600 after crisis -0.44534 -0.73634 0.291 -0.02762 -0.03240 0.005 0.00018 -0.00408 0.00426 5.3 multiple regression analysis result ordinary least square (ols) regression is used to investigate whether the dependent variable (stocks returns) are relate to the financial ratios (independent variables) measured by: debt to equity ratio (der), net profit margin (npm), return on equity (roe), earning per share (eps), price earnings ratio (pe) and price to book value (pbv). results reported in table 5 show that the returns of islamic and conventional stocks are affected by different independent variables stated above. among all the financial ratios, the coefficients of der, npm and roe are statistically significant for the shariah stock returns and the coefficients of der and roe are statistically significant for the conventional stocks. the coefficient of der is negative and is statistically significant, suggest that leverage has a negative effect on stock returns for both types of stocks. the coefficient of roe is positive for the shariah portfolio and negative for the conventional portfolio, thus suggest that higher asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 165 roe leads to higher returns for shariah portfolio and lower returns for conventional portfolios. npm has a negative coefficient for the shariah stock returns, thus suggest that high npm leads to lower returns. however, our results are contrary to that reported by martani et al. (2009), that npm has a positive relationship with the stock returns. however, the coefficient of npm for conventional stocks is larger than the shariah stocks, thus suggest that islamic stocks are better performing than the conventional stocks. the coefficient of pbv is positive for the shariah portfolio and negative for the conventional and both are not statistically significant. our results suggest that shariah portfolio is performing better than conventional stocks. however, martani et al. (2009) reported that pbv has a positive coefficient with types of stock returns. the results for pe is not statistically significant for both type of portfolios. table 5. ols regression model results islamic portfolio conventional portfolio b (t) b (t) intercept 14.771 (0.895) -2.927 (-0.158) der -0.039* (-1.824) -0.020* (-1.920) eps 0.000 (0.003) -0.491 (-0.315) pe -0.051 (-1.000) -0.001 (-0.125) npm -0.006* (-1.930) -0.010 (-0.263) roe 0.305** (2.538) -0.079*** (-2.933) pbv 0.005 (0.166) -0.022 (-1.268) year dummies yes yes industry dummies yes yes f statistic 4.865*** 11.246*** r-squared 0.338 0.532 no. of obs 325 466 asterisks indicate significance at 10% (*), 5% (**), and 1% (***). 6. conclusion this study examined the performance of the shariah stocks and the conventional stocks listed on the asx for the period 2001 to 2013. the mann whitney u-test and independent samples t-test shows a statistically significant difference in risk, with the islamic stocks being more risky. our results are similar to that reported in other countries (hoepner, 2011), which shows that islamic companies tends to be smaller and are relative undiversified. however, our results for beta and weekly returns are not statistically significantly different for both islamic asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 166 and conventional stocks. the investigation of portfolios of two types of stocks using risk-adjusted returns show that these two portfolios behave in a similar way and the sharpe ratio shows the islamic portfolio had a higher adjusted returns than the conventional stocks. the relationship between the financial ratios and the stock returns was examined using ols regression. our results show that der and roe have a statistically significantly positive relationship with the returns of both shariah and conventional portfolios and npm has a statistically significantly negative relationship with islamic portfolio returns. our results suggest that performance of shariah stocks tends to be better higher compared the conventional portfolio returns. our results suggest that roe has the most impact highest impact on both stock returns. references abdelsalam, o., duygun, m., matallín-sáez, j. c., & tortosa-ausina, e. 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(ed.), islamic asset management: forming the future for shari’ah-compliant investment strategies. euromoney institutional investor plc, london. microsoft word 3896-14595-1-rv-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 22 national budget and debt as measures of public sector performance: empirical evidence from nigeria onalo ugbede, mohd lizam & ahmad kaseri faculty of technology management universiti tun hussein onn malaysia, 86400 batu pahat, johor, malaysia e-mail: ugbesonas@yahoo.com or ugbedeonalo@yahoo.com received: june 24, 2013 accepted: august 14, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.3896 url: http://dx.doi.org/10.5296/ajfa.v5i2.3896 abstract changing the bureaucratic culture of public sector into one that stresses client service and achievement of results, require public sector to clearly define its objectives and priorities as well as assessing its performance against well-defined benchmarks. the objective of this study is to empirically investigate the relationship between national budget and debt as measures of public sector performance. the data for the study were basically secondary data about nigeria government as an emerging economy for the period 1960-2010. the data so collected were subjected to regression analysis, with budget performance as the independent variable and domestic, external and national debt as dependent variables. augmented dickey-fuller tests equation was employed to perform unit root tests for stationary and cointegration tests. the findings show that there is significant relationship between budget performance and domestic, external and national debt and these are appropriate and adequate in measuring public sector. the results also indicate that the poorer the budget performance the more the burden of national debt and its attendant cost, resulting into poor public sector performance and national underdevelopment. it is recommended that government should as a matter of transparent accountability prepare budget on accrual basis and put in place structures and mechanisms that will ensure the enactment of federal law making provisions for the amount that the government can borrow and the debt ceiling, which can only be increased with a vote by national assembly. keywords: public sector, performance measurement, budget performance, national debt, surplus budget, deficit budget asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 23 1. introduction the concept of performance encompasses the efficiency of a project or activity—the ability to undertake an activity at the minimum cost possible. it also includes effectiveness—whether the objectives set for the activity are being achieved (mackay, 1998). performance measurement is the comparison between plans and actuals and it is a valuable exercise which provides an opportunity and a framework for asking fundamental questions such as: what are we trying to achieve? what does “success” look like? how will we know if or when we have achieved it? in response to the global financial crisis, in 2009, ifac recommended to g20 that governments, like companies, need timely and accurate financial information to monitor and manage their performance. traditionally, companies’ performances are measured using details on their profit and loss account, including the balance sheet. contrary, government performance is evaluated based on key fiscal and monetary indicators and objectives, which include general economic growth, price stability and inflation rate, employment of resources, income redistribution, gross domestic product (gdp), per capita income, standard of living, exchange rate, employment rate, and debt burden among others. the public sectors of different countries are shaped by many factors, but they share common challenges. those challenges make public sector performance management more complex than it is in the private sector. the generally simpler environment of the private sector and its efficient evolution of best practice allow companies to benefit from tools and insights that are the envy of managers in the public sector (louise, 2011). in the same vein, it can be assumed that performance is also a dynamic concept that varies across geographical as well as scholarly “schools of thought”. meaning that, what is defined as performance and its crucial elements changes and differs depending on time and space. thus, though it is the most popular concepts in current public management theory and practice, public sector performance is an ambiguous, multi-dimensional, and complex concept (lukas and john, 2009). obviously, performance in the public domain is an elusive concept (stewart & walsh, 1994) and therefore difficult to define and measure (lukas & john, 2009) because “stakeholders often disagree about which elements of performance are most important, and some elements are difficult to measure [… and because] tinkering with agency performance also has strong political implications” brewer & selden (2000). though no public sector can afford to overlook the importance of clearly defining its objectives and priorities as well as assessing performance against well-defined benchmarks, there exist many types of public sector performance evaluation tools including on-going monitoring and performance information; project and program evaluation—ex ante, on-going/formative and ex post/summative; performance (or value-for-money) audits; financial auditing among others. for the fact that measurement findings can be an important input for government decision-making and prioritization, particularly in the budget process, budget performance can equally be employed as an appropriate base to measure the performance of public sector (mackay, 1998). therefore, with the new public management (npm) movement in general and for the fact that since the late 1 980s, performance asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 24 measurement, in particular, have been offered as approaches to help governments reduce their annual budgetary deficits, lower their accumulated debt and improve service delivery (ipac), this study seek to investigate the relationship between national budget performance and national debt as measures of public sector performance of an emerging economy like nigeria. this study is divided into the following sections. section one is the introduction. section two discusses related literatures on public sector, performance measurement, usefulness of public sector performance measurement results, the budget as a performance indicator, budget performance, national debt and budget performance, constraints of performance measurement of public sector and nigeria country profile. section three focuses on the methodology. section four is centred on data presentation, analysis, interpretation of results and lessons for past and present nigerian administration. section five is all about conclusions and possible recommendations. 2. review of related literature 2.1 public sector the importance of the public sector is an indisputable social and economic reality throughout the world (messaoud, 1999). this is because only the public sector can effectively and efficiently carry out certain functions and indeed only national governments can assume the responsibilities that affects the state as a whole (natural resources management and environment department, 2003). the public sector sometimes referred to as the state sector or the government sector, is a part of the state that deals with either the production, ownership, sale, provision, delivery and allocation of goods and services by and for the government or its citizens, whether national, regional or local/municipal (mayhew, 2009). examples of public sector activity among others include delivering social security, administering urban planning and organizing national defence. messaoud (1999) defines public sector as all market and non-market activities which at each institutional level are controlled and mainly financed by public authority. it is composed of a general government sector and a public corporation sector. it is the part of the economy concerned with providing basic government services. consistent with sna 93, he further diagrammatically gave the decomposition of public sector as presented below. thus, the general government is made up of all the government units, social security funds and non-profit non-market public or private institutions which are controlled and mainly financed by public authority. on the other hand, the public corporation sector comprises all of the intuitional units which produce for the market and are controlled and mainly financed by public authority. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 25 source: messaoud (1999) it is impossible to discuss the ‘global’ public sector, as there are so many variations in the scope and shape of public sectors in the 196 countries of the world (louise, 2011). the public sector in any country is shaped by a combination of various factors, including its economic performance, political philosophy, extent of involvement of external agencies (e.g. aid agencies) and demand from its population for services and infrastructure. however, in most countries the public sector includes such services as the police, military, public roads, public transit, primary education and health care for the poor. it is worthy to note that though the major source of revenue to the public sector is taxation, the public sector might provide services that non-payer cannot be excluded from (such as street lighting), services which benefit all of society rather than just the individual who uses the services (such as public education), and service that encourage equal opportunity. 2.2 what is performance measurement? the institute of public administration of canada (ipac) posits that performance measurement is an on-going process of ascertaining how well, or how poorly, a government program is being provided. it involves the continuous collection of data on progress made towards achieving the program’s pre-established objectives. performance indicators, or measures, are developed as standards for assessing the extent to which these objectives are achieved. public sector central level, federal state level (or regional level) & local level institutions controlled and mainly financed by public authority general government sector govern ment units social securit y funds non-profit non-market institutions public corporation sector non-market institutions market institutions asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 26 to understand clearly the concept of performance measurements ipac deemed it necessary to distinguish performance measurement from several related concepts. first, the terms performance measurement and performance management are often used interchangeably. however, performance management is a broader term that includes not only performance measurement but also the determination of the appropriate level of performance, the reporting of performance information, and the use of that information to assess the actual level of performance against the desired level. second performance measurement is often confused with program evaluation, which is an indepth study conducted on a periodic, rather than an on-going, basis to determine, in the light of current conditions, whether the objectives of a program are still appropriate, whether it is properly designed, and whether it is achieving adequate results. performance measures are a valuable input into a program evaluation. finally, performance measurement is sometimes mistaken for performance evaluation (or performance appraisal), which is a concept associated with human resource management that refers to the systematic collection and analysis of data on the performance of an employee over time. 2.3 why measure performance? ipac affirmed that the current focus on performance measurement in the public sector has been significantly influenced by the new public management (npm) movement, which, following private sector practice, places heavy emphasis on managing for results. behn (2003) identified eight purposes for which public managers have for measuring performance as tabulated below: table 1. eight purposes that public managers have for measuring performance the purpose the public manager's question that the performance measure can help answer evaluate how well is my public agency performing? control how can i ensure that my subordinates are doing the right thing? budget on what programs, people, or projects should my agency spend the public's money? motivate how can i motivate line staff, middle managers, non-profit and for-profit collaborators, stakeholders, and citizens to do the things necessary to improve performance? promote how can i convince political superiors, legislators, stakeholders, journalists, and citizens that my agency is doing a good job? celebrate what accomplishments are worthy of the important organizational ritual of celebrating success? learn why is what working or not working? improve what exactly should who do differently to improve performance? source: behn (2003) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 27 thus, consistent with the organisation for economic co-operation and development (oecd), measuring government performance has long been recognised as necessary for improving the effectiveness and efficiency of the public sector. 2.3.1 the budget as a performance indicator the main financial document that reflects the state policy regarding the set up and the use of public resources is the budget (attila, 2010). a budget is also a forecast of expenditures and revenue for a specific period of time; usually one year. as a planning document a budget enables business, government, private organizations and households to set the priorities and monitor progress toward selected goals (abdullahi, 2011). to david (2007) the budget itself is a financial document, but in fact it is much more than that. it is a financial document that reflects program planning and service priorities in financial terms and also, ideally, in terms of performance expectations. budget can be used as a benchmark, as a control system, that allows managers to compare actual performance with estimated or desired performance (silva & jayamaha, 2012). following david (2007) a good set of performance measures is a vital tool for building accountability and support of planning/budgeting efforts. true accountability means more than just assuring the public that revenues are properly collected and reported and that expenditures are made in accordance with prescribed procedures. accountability includes these important assurances but also entails assurances to the public that government resources are being spent wisely as well as legally and that services of good quality are being produced efficiently. therefore because the budget is the financial interface between the internal environment and the exterior environment of the entity (attila, 2010), its performance in terms of its transparent implementation and execution, can be employed in judging the performance of the public sector. 2.3.2 budget performance operationally, in the words of kcl (2012) budget performance is defined as a comparison between estimated revenues and expenditures and actual revenues and expenditures resulting into either a deficit (where aggregate expenditures of the government is greater or more than its total revenues collected within a given period), a surplus (where government expenditures is less than its revenues) or an equilibrium/balanced budget (where total revenues of the government equal the total expenditures). a confirmation from sheriffdeen (2012) indicate that while a surplus budget occurs when the proposed expenditure is less than the expected revenue, implying some saving at the end of the budget year, deficit budget is a situation in which the expected revenue is lower than the proposed expenditure, to be financed from accumulated savings or borrowings. better still, balanced budget means equality between estimated revenue and proposed expenditure. the approach of defining budget performance in terms of deficit, surplus and balanced budget was adopted by sahaj (2001) and the national bank of slovakia in measuring public sector budgetary performance results of the slovak republic for the year 2001 with efforts geared toward ensuring the steady progress of the state in implementing various reform measures of the government directed at gradually lowering or eliminating over the long term the deficit in the public sector budgetary performance. graphically, these situations are depicted below: asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 28 graphical presentation of deficit, surplus and balanced budget balanced budget e budget surplus government expenditure budget deficit g o v er n m en t e x p en d it u re a n d r ev en u e national income d source: kalyan city life archive (2012) at the point e, budget is balanced. to the left of point e the government budget is in deficit and to the right of point e, the budget is in surplus. anwar & chunli (2007) giving reasons for the above levels of performance affirmed that when revenues are over estimated and expenditures underestimated, sharp expenditure cuts must be made later when executing the budget. on the revenue side, overestimation can come not only from technical factors, such as bad appraisal of the impact of a change in tax policy or of increased tax expenditures, but often also from the desire of politicians or ministries to keep in the budget an excessive number of programs while downplaying the difficulties of financing them. similarly, on the expenditure side while underestimation can come from unrealistic assessments of the cost of unfunded liabilities (for example, benefits granted outside the budget) or of permanent obligations, underestimation can also be a deliberate tactic to launch new programs, with the intention of requesting increased appropriation later, during budget execution. unfortunately, governments are commonly reluctant to abandon an expenditure program after it has been started, forgetting that one should never throw good money after bad. when combined with bureaucratic and political momentum as well as vested interests, this natural reluctance leads to continuing an expenditure program even when a broad consensus exist that it is ineffective and wasteful. no technical improvement can by itself resolve institutional and asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 29 political problems of this nature. it is that much more important, therefore, to put in place robust gate keeping mechanisms to prevent bad projects and programs from getting started in the first place. by the time they are in the budget pipeline, it is usually too late to stop them. an overoptimistic budget also leads to accumulation of government payment arrears, which create their own inefficiencies and destroy government credibility. budget performance evaluation permits a smooth implementation of priority programs and prevents disruption of program management during budget execution. political interference, corruption, administrative weakness and lack of needed information often lead to unrealistic budget which can never be executed well. therefore, clear signals on the amount of expenditure compatible with financial constraints should be given to spending agencies at the start of the budget preparation process. 2.3.3 usefulness of public sector performance evaluation results consistent with mackay (1998) developing national measurement capacities is a means for ensuring that measurement findings are available to assist countries in three areas. first, measurement findings can be an important input for government decision making and prioritization, particularly in the budget process. second, measurement assists managers by revealing the performance of on-going activities at the project, program or sector levels—it is therefore a management tool which leads to learning and improvement in the future (i.e., results-based management). similarly, measurement results can also be used to assess the performance of organizations and institutional reform processes. third, measurement data contribute to accountability mechanisms, whereby managers and governments can be held accountable for the performance of their activities. public sector performance measurement results are equally inputs of public sector communications function which enables the effective flow of information and ideas within internal and external publics to facilitate participation, service delivery and informed decision-making and to build accountability and trust in government (new zealand government, 2010). david (2007) also affirmed that good sets of performance measures have multiple uses including accountability/communication, support of planning/budgeting efforts, catalyst for improved operations, program evaluation, reallocation of resources, directing operations, contract monitoring and benchmarking. 2.4 national debt and budget performance national debt will arise where the actual expenditure exceeds actual revenue and it becomes necessary to source for means of financing the excessive expenditure. to meet the budgetary objections it is imperative to draw from savings set aside or to borrow from outside sources (ndan 2009). dalton in kcl (2012) confirming this, asserts that "if over a period of time expenditure exceeds revenue, the budget is said to be unbalanced". deficit budget is one where the estimated government expenditure is more than expected revenue. government estimated revenue is less than government’s proposed expenditure. such deficit amount is generally covered through public borrowings or withdrawing resources from the accumulated reserve surplus. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 30 thus, a deficit budget is a liability to the government as it creates a burden of debt or it reduces the stock of reserves of the government. budget deficit and its attendant debt burden are giant evils that most government fights against. while to sahaj (2001) and the national bank of slovakia, “reform of the management of public finances is concerned with ensuring the steady progress of the state in implementing various reform measures of the government directed at gradually lowering or eliminating over the long term the deficit in the public sector budgetary performance”, damian (2011) affirmed that if the interest payments on the national debt are not made, the us would be in default, potentially causing catastrophic economic consequences for the us and the wider world as well. today’s sovereign debt crisis highlights some of the consequences of poor financial management and weak financial reporting in the public sector (ball, 2009). judging from the united states perspective, the federal government can pay for expenditures only if congress has approved the expenditure. if the total expenditure exceeds the revenues collected there is a budget deficit, and the only way that the shortfall can be paid for is for the government, through the department of the treasury, to borrow the shortfall amount by the issue of debt instruments. under federal law, the amount that the government can borrow is limited by the debt ceiling, which can only be increased with a vote by congress. in compliance with the provisions of the federal law, the treasury lamented that "failing to increase the debt limit would . . . cause the government to default on its legal obligations – an unprecedented event in american history". these legal obligations include paying social security and medicare benefits, military salaries, interest on the debt, and many other items. these legal and formal procedures are normally faulted in developing countries like nigeria thereby leaving the country with high level of debt burden. anwar & chunli (2007) equally posits that the summary indicator of a country’s fiscal position used commonly is the overall balance on a cash basis, defined as the difference between actual collected revenues plus grants (cash or in kind) and actual expenditure payments. the cash deficit is by definition equal to the government borrowing requirements (from domestic or foreign sources) and is thus integrally linked to the money supply and inflation targets and prospects. the overall deficit is obviously a major policy target and is used for international comparisons as well. how the deficit is financed (debt implication) also requires attention: the same level of fiscal deficit can be manageable or not, depending on whether it is financed in cost-effective and non-inflationary ways. 2.5 constraints of performance measurement of public sector some features of the public sector serve to make effective performance measurement harder in the public sector. cima identified the following features of the public sector as responsible in complicating performance measurement of the public sector. • the lack of a predominant profit motive to simplify resource allocation. private sector organisations can relatively easily determine where to invest effort and resource to maximise overall results. although many public sector organisations have revenue generating or even profit making elements, their predominant objective is to deliver services to achieve certain asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 31 outcomes. those services must be delivered to users who may not wish to receive them, or who may not value them. • politics, which affect almost everything from the very nature of the public sector to governance arrangements and the frequency and philosophy behind reform efforts. • complicated delivery chains and multiple stakeholders which make it more difficult to manage activities. public sector bodies often use other bodies or stakeholders to help them deliver services. for example, funding for a service might be decided at national level and then devolved to local bodies, which might use third sector organisations to deliver services. • unclear cause and effect relationships – public sector objectives such as increasing literacy, or reducing street crime, are affected by many different issues cutting across different programmes and organisations. the effect of changing any single factor cannot be easily isolated. • delayed impacts – achievement or progress towards many public sector objectives, particularly those which are preventative, may not be observable for many years or even decades. • attitudes towards accountability and transparency. many countries struggle with corruption, nepotism, poor governance or a lack of openness. even policy makers in countries without these problems may resist scrutiny of popular or politically motivated, rather than evidence-based decisions. equally according to ipac the barriers to effective performance measurement fall into several categories, which include: methodological barriers, financial barriers, government barriers and political and public service barriers. 2.6 nigeria country profile nigeria, the study area covers an area of 923,768sq km (356,669sq mile). it is bounded by cameroon to the east, chad to the northeast, niger to the north, benin to the west, and gulf of guinea on the atlantic ocean to the south (ofem, 2012). going by the most recent national census held in 2006, nigeria has a population of over 140 million inhabitants out of which about 48% live in urban centres. it is the most populated country in africa and accounts for more than 25 percent of the population of sub-saharan africa. nigeria is administratively divided into 36 states and the federal capital territory. nigeria practice democracy in federalism. the states are further divided into 774 local government areas. between it and the republic of south africa they account for more than 50 percent of sub-saharan africa gdp. nigeria as a member of organization of petroleum exporting countries produces an average of 2.3 million barrels of oil per day and it is reckoned to be the sixth largest oil producer in the world. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 32 table 2. nigeria key macroeconomic indications (growth rates): the variance level variable/year 2006 2007 2008 2009 2010 inflation actual 8.55 6.56 15.06 13.93 11.80 target 9.00 9.00 9.00 9.00 11.20 variance 0.45 2.44 -6.06 -4.93 -0.6 real gdp actual 6.03 6.45 5.98 6.96 7.87 target 7.00 10.00 7.50 5.00 6.10 variance -0.97 -3.55 -1.52 1.96 1.77 m1 actual 32.18 37.63 56.07 2.41 11.05 target 32.20 22.40 variance -29.79 -11.35 source: sheriffdeen (2012) 3. methodology the objective of this study is to investigate the relationship between budget performance and national debt as measures of public sector performance. the period of study spans from 1960 – 2010. the data collected are subjected to regression analysis labeling budget performance as the independent variable and national debt (including domestic and external debt) as the dependent variables. the augmented dickey-fuller tests equation was employed to perform unit root tests for stationary and cointegration tests. a comparative descriptive analysis of cross country ratio of debt to gdp is equally provided. 4. data presentation, analysis and interpretation in analyzing the data three equations were formulated having budget performance as the independent variables in the three equations and domestic debt, external debt and total national debt as the dependent variables in these equations. thus these three equations are named domestic debt (dd), external debt (ex) and total debt (td) models. 4.1 regression analysis for domestic debt the regression equation is domestic debt = 177280.9 – 4.0715 surp/deficit dependent variable: dd method: least squares date: 07/19/13 time: 16:45 sample: 1961 2010 included observations: 50 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 33 variable coefficient std. error t-statistic prob. c 177280.9 70778.52 2.504727 0.0157 bp -4.071474 0.332018 -12.26282 0.0000 r-squared 0.758036 mean dependent var 508840.8 adjusted r-squared 0.752995 s.d. dependent var 930638.3 s.e. of regression 462523.3 akaike info criterion 28.96596 sum squared resid 1.03e+13 schwarz criterion 29.04244 log likelihood -722.1490 hannan-quinn criter. 28.99508 f-statistic 150.3767 durbin-watson stat 0.706773 prob(f-statistic) 0.000000 the estimated coefficient b1, the intercept in our domestic debt model is recorded as the coefficient on the variable c in this study. c is the term for constant in a regression model. results show b1 = 177280.9. the estimated value of the slope coefficient on the variable annual budget performance (x) is b2 = -4.0715. the interpretation of b2 is: for every n4.0715 budget deficit this study estimates that there is about a n100 increase in domestic debt, holding all other factors. -2,000,000 -1,000,000 0 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 bp dd figure 1. domestic debt model graph 4.2 regression analysis for external debt the regression equation is external debt = 493244.5 – 2.0719 surp/deficit asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 34 dependent variable: ed method: least squares date: 07/19/13 time: 16:46 sample: 1961 2010 included observations: 50 variable coefficient std. error t-statistic prob. c 493244.5 181195.1 2.722174 0.0090 bp -2.071900 0.849975 -2.437599 0.0185 r-squared 0.110154 mean dependent var 661969.3 adjusted r-squared 0.091615 s.d. dependent var 1242349. s.e. of regression 1184073. akaike info criterion 30.84600 sum squared resid 6.73e+13 schwarz criterion 30.92248 log likelihood -769.1499 hannan-quinn criter. 30.87512 f-statistic 5.941891 durbin-watson stat 0.245478 prob(f-statistic) 0.018540 equally, results show b1 = 493244.5. the estimated value of the slope coefficient on the variable annual budget performance (x) is b2 = -2.0719. the interpretation of b2 is: each time government expenditure exceeds revenues by n2.0719 (budget deficit of n-2.0719) this study estimates that there is a consequential effect of about n100 increase in external debt, holding all other factors. -2,000,000 -1,000,000 0 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 bp ed figure 2. external debt model graph asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 35 4.3 regression analysis for total national debt the regression equation is total national debt = 669311 – 6.145 surp/deficit dependent variable: td method: least squares date: 07/19/13 time: 16:46 sample: 1961 2010 included observations: 50 variable coefficientstd. error t-statistic prob. c 669311.0 209085.5 3.201136 0.0024 bp -6.145025 0.980808 -6.265270 0.0000 r-squared 0.449880 mean dependent var 1169730. adjusted r-squared 0.438419 s.d. dependent var 1823264. s.e. of regression 1366331. akaike info criterion 31.13233 sum squared resid 8.96e+13 schwarz criterion 31.20882 log likelihood -776.3084 hannan-quinn criter. 31.16146 f-statistic 39.25361 durbin-watson stat 0.324590 prob(f-statistic) 0.000000 finally, analysis show b1 = 669311. the estimated value of the slope coefficient on the variable annual budget performance (x) is b2 = -6.145. the interpretation of b2 is: for every budget deficit of n-6.145 this study estimates that there is every likely hood that total debt will increase to about n100, all things being equal. -2,000,000 -1,000,000 0 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000 6,000,000 7,000,000 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 bp td figure 3. total debt model graph asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 36 in summary, results show that much easier and quicker for budget deficit to give rise to external debt than domestic and total debt. while a deficit of n2 will give rise to external debt of n100, budget deficit must get hit n4 and n6 in order to generate respectively domestic and total debt of n100. in all, the costs of adverse budget performance outweigh its benefits. n2 to n6 budget deficit resulting to debt of n100 is by all judgement not rational, outrageous and extremely costly. therefore it is recommended that government operates within the provisions of the budget to avoid budget deficit and its attendant costs. 4.4 descriptive statistics bp dd ed td mean -81434.85 508840.8 661969.3 1169730. median -3633.300 28193.90 29376.50 57570.40 maximum 32049.40 4551822. 4890270. 6260595. minimum -1105440. 53.30000 49.80000 103.1000 std. dev. 199009.6 930638.3 1242349. 1823264. skewness -3.840032 2.496145 2.193500 1.468938 kurtosis 18.42139 9.629519 6.618014 3.802311 jarque-bera 618.3390 143.4864 67.36623 19.32253 probability 0.000000 0.000000 0.000000 0.000064 sum -4071742. 25442040 33098467 58486507 sum sq. dev. 1.94e+12 4.24e+13 7.56e+13 1.63e+14 observations 50 50 50 50 the surface observation of data collected for this study evidenced that the nation’s debt keep increasing as the nation’s actual expenditure outweighs revenue (deficit) though not proportionately suggesting that there is a significant negative relationship between budget performance in the form of surplus, deficit or balance budget and domestic, external and national debt. the above present the descriptive statistics for all the variables including budget performance (bp), domestic (dd), eternal (ed) and total (td) debt. the descriptive statistics for all the dependent variables mean median, maximum and minimum exhibit positive results. on the other hand the mean and median for budget performance is negative implying that the performance of the nigeria budget has consistently being in deficit particularly since 1981 till date resulting into geometric increase in total national debt and its attendant burden and that a negative relationship exist between budget performance and domestic, external and total debt. 4.5 cross country debt to gdp as economic progress indicator (%) for more than a half century, the most widely accepted measure of a country’s economic progress has been changes in its gross domestic product (gdp). the gdp has maintained a firm position as a dominant economic indicator. indeed, most economists in business and government, teachers of economics at various levels of education, and journalists, policy asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 37 makers and politicians (regardless of their political preferences) continue to give much importance to gdp and calling for unconditional gdp growth (jeroen, 2009). gdp is an estimate of market throughput, adding together the value of all final goods and services that are produced and traded for money within a given period of time. it is typically measured by adding together a nation’s personal consumption expenditures (payments by households for goods and services), government expenditures (public spending on the provision of goods and services, infrastructure, debt payments, etc.), net exports (the value of a country’s exports minus the value of imports), and net capital formation (the increase in value of a nation’s total stock of monetized capital goods) (costanza, hart, posner & talberth, 2009). in summary, jeroen (2009) affirmed that gross domestic product (gdp) is the monetary, market value of all final goods and services produced in a country over a period of a year. due to the fact that gdp is a fundamental universal economic indicator and the real gdp per capita (corrected for inflation) is generally used as the core indicator in judging the position of the economy of a country over time or relative to that of other countries (jeroen, 2009), this study establishes a relationship in the form of the ratio between total debt and gdp for some countries. this ratio measures the portion of a nation’s gdp attributable to debt or how much of a nation’s gdp that can provide coverage for her total debt. the result of the analysis of data for period 2000 2010 is presented below: australia austria belgium canada chile czech_rep_ mean 7.745455 61.42727 93.74545 33.67273 9.563636 23.06364 median 7.500000 60.90000 94.90000 35.70000 9.200000 23.20000 maximum 11.40000 65.80000 99.50000 40.90000 15.70000 36.60000 minimum 4.900000 57.80000 85.30000 25.20000 4.100000 13.20000 std. dev. 2.234441 2.299605 4.685160 5.181716 4.232794 7.292636 skewness 0.369526 0.570895 -0.449502 -0.195987 0.162414 0.392131 kurtosis 1.899267 2.784052 2.058818 1.767808 1.498793 2.285764 jarque-bera 0.805663 0.618895 0.776431 0.766306 1.081270 0.515717 probability 0.668425 0.733852 0.678266 0.681708 0.582378 0.772705 sum 85.20000 675.7000 1031.200 370.4000 105.2000 253.7000 sum sq. dev. 49.92727 52.88182 219.5073 268.5018 179.1655 531.8255 observations 11 11 11 11 11 11 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 38 denmark estonia finland france germany greece mean 42.23636 2.663636 39.34545 53.60000 40.02727 113.8727 median 39.60000 2.900000 41.30000 52.10000 39.60000 109.7000 maximum 54.80000 3.600000 48.00000 67.40000 44.40000 147.8000 minimum 27.80000 1.300000 29.50000 47.40000 36.50000 105.7000 std. dev. 9.220767 0.797838 5.618071 5.804653 2.535780 12.64002 skewness -0.098987 -0.382685 -0.395605 1.403094 0.539173 2.054162 kurtosis 1.629325 1.763231 2.280921 4.076940 2.400279 5.889990 jarque-bera 0.879058 0.969553 0.523916 4.140811 0.697811 11.56392 probability 0.644340 0.615835 0.769543 0.126135 0.705460 0.003083 sum 464.6000 29.30000 432.8000 589.6000 440.3000 1252.600 sum sq. dev. 850.2255 6.365455 315.6273 336.9400 64.30182 1597.702 observations 11 11 11 11 11 11 hungary iceland ireland isreal italy korea mean 60.54545 40.92727 31.38182 85.39091 100.3182 25.18182 median 58.10000 33.80000 27.90000 83.40000 98.10000 27.60000 maximum 73.90000 87.50000 60.70000 97.80000 109.0000 32.60000 minimum 50.40000 19.40000 19.80000 74.70000 95.60000 16.70000 std. dev. 7.908143 22.70036 12.32167 8.973233 4.535597 6.143748 skewness 0.576880 1.291691 1.419763 0.148276 0.794156 -0.279550 kurtosis 2.045054 3.221162 4.003810 1.464425 2.250193 1.456844 jarque-bera 1.028081 3.081271 4.157334 1.121052 1.413934 1.234716 probability 0.598074 0.214245 0.125097 0.570909 0.493138 0.539368 sum 666.0000 450.2000 345.2000 939.3000 1103.500 277.0000 sum sq. dev. 625.3873 5153.062 1518.236 805.1891 205.7164 377.4564 observations 11 11 11 11 11 11 luxembour mexico netherland newzealand nigeria norway mean 4.100000 22.56364 44.10000 25.76364 42.85455 18.53636 median 2.700000 21.20000 43.00000 26.40000 29.00000 18.40000 maximum 12.60000 28.10000 51.80000 32.10000 88.70000 26.40000 minimum 0.800000 20.30000 37.60000 20.30000 11.60000 11.70000 std. dev. 3.875306 2.835233 4.582794 4.269256 32.00376 4.838858 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 39 skewness 1.184075 1.169848 0.450761 0.057874 0.335441 0.276811 kurtosis 3.017364 2.770231 2.061520 1.514452 1.399990 2.233659 jarque-bera 2.570534 2.533194 0.776182 1.017615 1.379636 0.409647 probability 0.276577 0.281789 0.678351 0.601212 0.501667 0.814791 sum 45.10000 248.2000 485.1000 283.4000 471.4000 203.9000 sum sq. dev. 150.1800 80.38545 210.0200 182.2655 10242.41 234.1455 observations 11 11 11 11 11 11 poland portugal slovak_rep_ spain sweeden switzerland mean 43.20000 65.29091 32.53636 40.99091 43.53636 24.98182 median 44.70000 66.20000 33.70000 40.70000 46.20000 25.20000 maximum 49.70000 88.00000 39.10000 51.70000 56.90000 28.30000 minimum 35.80000 52.10000 23.90000 30.00000 33.80000 20.20000 std. dev. 4.198571 10.76777 4.980617 7.194644 6.991033 3.038361 skewness -0.550736 0.789402 -0.383416 -0.025881 0.221513 -0.299018 kurtosis 2.551968 2.889988 1.939694 1.761064 2.280705 1.718225 jarque-bera 0.648072 1.147999 0.784795 0.704753 0.327093 0.916939 probability 0.723224 0.563268 0.675435 0.703016 0.849127 0.632251 sum 475.2000 718.2000 357.9000 450.9000 478.9000 274.8000 sum sq. dev. 176.2800 1159.449 248.0655 517.6291 488.7455 92.31636 observations 11 11 11 11 11 11 turkey u_k usa mean 51.43636 50.00909 39.39091 median 46.40000 42.70000 36.00000 maximum 74.10000 85.50000 61.30000 minimum 38.20000 38.70000 32.40000 std. dev. 12.45546 16.42592 9.314124 skewness 0.662118 1.316526 1.607802 kurtosis 2.066522 3.139504 4.047307 jarque-bera 1.203116 3.186530 5.241943 probability 0.547957 0.203261 0.072732 sum 565.8000 550.1000 433.3000 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 40 sum sq. dev. 1551.385 2698.109 867.5291 observations 11 11 11 these data can equally be employed to assess government risk which entails identifying and evaluating events (i.e., possible risks and opportunities) that could affect the achievement of government overall socio-economic objectives, positively or negatively. when a government carries high debt burden for example greece, such situation is highly likely to intersect with a government’s objectives—or can be predicted to do so—it become a risk. the above assertion is consistent with pricewaterhousecoopers (2008) that risk as “the possibility that an event will occur and adversely affect the achievement of objectives. therefore following pricewaterhousecoopers (2008) risk map this study classified these countries into low, medium and highly debt burdened countries. countries with mean of debt to gdp ratio of less than 10% are classified as low debt burdened countries, 10-50% medium debt burdened countries and greater than 50% high debt burdened countries. by this classification, australia, chile, estonia and luxembourg are low debt burdened countries. canada, czech republic, denmark, finland, germany, iceland, ireland, korea, mexico, netherlands, new zealand, nigeria, norway, poland, slovak republic, spain, sweden, switzerland and usa are within the category of medium debt burdened countries. finally, austria, belgium, france, greece, hungary, israel, italy, portugal, turkey and u.k are highly debt burdened. estonia has the lowest mean of debt to gdp ratio of 2.66% and greece exhibit the highest ratio of 113.87%. this is indicative that averagely, the gdp of greece is not adequate to provide coverage for her debt burden. the negative but catastrophic burden of debt is evidenced by the current economic crisis greece as the highest debt burdened country is experiencing. though nigeria by this classification falls within the class of medium debt burdened nation with a mean of debt to gdp of 42.85% and median of 29% there is every need to be courteous and on the watch out as her path of budget performance in terms of deficit that leads to the three forms of debt burden from the above analysis is quite slippery. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 41 0 40 80 120 160 200 00 01 02 03 04 05 06 07 08 09 10 australia austria belgium canada chile czech rep. denmark estonia finland france germany greece hungary iceland ireland isreal italy japan 0 10 20 30 40 50 60 70 80 90 00 01 02 03 04 05 06 07 08 09 10 korea luxembour mexico netherland newzealand nigeria norway poland portugal slovak rep. slovenia spain sweeden switzerland turkey u.k usa figure 4 and 5. cross-country debt to gdp(%) graph asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 42 4.6 unit root tests for stationary this study test whether the time series is stationary or nonstationary in order to avoid the danger of obtaining apparently significant regression results from unrelated data when nonstationary series are used in regression analysis. such regressions are said to be spurious. thus this study perform unit root tests for stationary for all the variables (bp, dd, ed and td) using the augmented dickey-fuller tests equation. since calculated dickey-fuller tests statistics for budget performance (0.338072), domestic debt (3.672291), external debt (-2.526719) and total debt (-0.883949) are all greater than 5% critical value of (-2.923780), this study did not reject the null of nonstationary. in other words, the variables budget performance (bp), domestic debt (dd), external debt (ed) and total debt (td) are nonstationary series. 4.7 conintegration tests to tests whether the nonstationary variables bp, dd, ed and td are cointegrated, this study equally examined separately the properties of the three regression residuals (dd = 177280.9 – 4.0715 bp, ed = 493244.5 – 2.0719 bp and td = 669311 – 6.145 bp). since calculated dickey-fuller tests statistics for dd = 177280.9 – 4.0715 bp (-2.938060), ed = 493244.5 – 2.0719 bp (-2.327642) and td = 669311 – 6.145 bp (-2.047329) are all less than 5% critical value for regression-based cointegration tests of (3.37), this study reject the null of no integration. in other words, the variables in the three regressions are cointegrated. 4.8 model explanatory powers goodness of fit (i.e., r2) provides an indication of the variation in the dependent variable being explained by the independent variable(s) in a regression model (jordan, waldron & clark, 2007). it is often used as a measure of the comparative predictive and explanatory abilities among models (e.g., see dechow, hutton, kim & sloan, 2011; jordan, waldron & clark, 2007; greenburg, johnson & ramesh, 1986; murdoch & krause, 1989; mcbeth, 1993). generally, the higher the r2, the greater is the predictive and explanatory power of a model. using r2 as a gauge of explanatory power, the equation investigating the relationship between budget performance and domestic debt possesses superior explanatory ability with r2 of 76% over both equations investigating the relationship between budget performance and external and total national debt respectively possessing r2s of 11% and 45%. following jordan, waldron & clark (2007), lorek & willinger (1996), cheung & krishnan (1997) and neter & wasserman (1974) models with higher r2s may not necessarily be the best predictors. this is because even a model with a high r2 may have a mean square error that is too large for inferences to be drawn when accurate predictions are needed (neter & wasserman, 1974, p. 229). jordan, waldron & clark (2007) and akresh & wallace (1982) state that predictive ability is best examined not only by evaluating a model’s r but also by analyzing the size of the residuals or error terms resulting from the model’s predictions. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 43 4.9 implications for past and appeal to present nigeria administrations this paper discovers that between 1960 and 1980, the nigerian government experience 13 years of surplus budget and 7 years of deficit budget. the frequency of budget deficit was lower compared to its corresponding surplus budget. from 1981 till 2010, except in 1995, nigeria budget has been in deficit. this result is consistent with sheriffdeen (2012) and abdullahi & angus (2012) who respectively affirmed that preparation and presentation of the budget by the president of nigeria has become more of a fanfare in recent time than a serious business it was up to the mid-1980s and that many a time government budgets in developing countries like nigeria is nothing but addition of figures only to be read to the ears of the public and departure from budget items amount to disastrous development, conflicts, scandals and corruption of administration. this study equally provide evidence of the failure of past and present nigerian administrations’ deliberate refusal to execute and implement government programs and activities within the ambit of the provisions of the budget. this position is equally cemented in the light of the assertion of sheriffdeen (2012) that though virtually all countries around the world engage in deficit budgeting, the nigerian case is a mystery and difficult to explain even by experts. this is because the nigerian budget is prepared based on u.s $ 75 per barrel of oil and x number of barrel per day. at the end of the year, the variables turn out to be better than expectations, that is, the oil output remain greater than the estimates and the price of crude oil would average about $100 per barrel with no corresponding growth in the country’s reserves, yet we claim to have budget deficit. to this end, our cry is nigeria government “don’t let our future dry up”. 5. conclusions and recommendations consistent with ipac, public sector performance measurement is imperative as it can bring substantial benefits to governments in the form of greater efficiency, effectiveness and accountability, but there are substantial obstacles to its successful implementation. because the budget is a financial document that reflects program planning and service priorities in financial terms and also, ideally, in terms of performance expectations and can be used as a benchmark, as a control system, that allows managers to compare actual performance with estimated or desired performance, investigating the relationship between its performance and national debt is appropriate and adequate in measuring the performance of public sector. there exist a negative relationship between budget performance and debt burden. meaning that the more the budget goes into deficit the more the debt burden of a nation and vice versa. national debt and its attendant costs are liabilities to the government which are capable of putting a nation in a state of perpetual economic slavery and hopelessness for the generation unborn. from the above findings, the following recommendations are made. first, in agreement with abdullahi & angus (2012), it is recommended that the budget document which is a plan of activities should be followed item after item in its implementation and execution. in addition, following ball (2009) nigeria government should as a matter of transparent accountability asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 44 prepare budget on accrual basis and put in place structures and mechanisms that will ensure the enactment of federal law making provisions for the amount that the government can borrow and the debt ceiling, which can only be increased with a vote by national assembly. references abdullahi, a. m., & angus, o. u. 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(2012). budgetary process and organizational performance of apparel industry in sri lanka. journal of emerging trends in economics and management sciences (jetem) 3(4), 354-360 the institute of public administration of canada (ipac): performance measurement. leadership matters topical briefs. the organisation for economic co-operation and development (oecd: government at a glance 2011, oecd. us department of the treasury. (2011). get the facts: raising the debt limit. retrieved from http://www.treasury.gov/press-centre/news/pages/debt-limit.aspx microsoft word 10274-37919-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 194 determinants of bank profitability in ghana: new evidence daniel anarfi faculty of economics, mendel university in brno, czech republic e-mail: anarfidaniel@ymail.com emmanuel joel aikins abakah school of business, university of adelaide, australia e-mail: ejabakah@gmail.com eunice boateng all african students union (asu) ghana e-mail: eunniceboateng@gmail.com received: nov.7, 2016 accepted: nov. 29, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.10274 url: http://dx.doi.org/10.5296/ajfa.v8i2.10274 abstract this study examines the determinants of profitability in the ghanaian banking industry for an eight (8) year period of 2007 to 2014. using a sample from 9 local banks and 12 foreign banks in ghana, the study combines bank-specific determinants and macroeconomic variables to access bank profitability with return on assets (roa) as the dependent variable. the hausman specification test was performed on a panel regression to determine the appropriate model for this study. the estimation results shows that, bank size and deposits are not significant and does not impact profitability. however, loans, capital and overheads were found to be significant and impacts on profitability. the study concludes that banks in ghana should be technological in their operations to reduce staff cost since the overhead was highly significant and impacts negatively on roa. keywords: bank profitability, determinants, return on assets asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 195 1. introduction the objective of this study is to investigate the determinants banks profitability for the period of 2007-2014. today banks have a key role in all countries and their policies and strategies affect economic development unemployment, prices, national income, etc. (goodhart, 2016). several banking empirical literature provides evidence to back the claim that banking operations is predominantly fundamental to the economic wellbeing of most countries in the world (ayadi et al., 2015; naceur & ghazouani, 2007; shahbaz & lean, 2012; van nieuwerburgh et al., 2006). haghighat and nasiri (2004) also confirms this claim that any activity which requires investments and financial resources requires the involvement of banks and financial institutions. one important role which both bank financial institutions and non-bank financial institutions plays in an economy is that, when there is a support of efficient money and capital markets in the financial system, it enhances the overall growth of the economy (lee & heshmati, 2009). traditionally, the primary role of financial institutions is to provide financial intermediation by collecting and mobilizing resources to finance business and development projects that are essential for economic development (nwaeze, michael & nwabekee, 2014). an efficient financial system is an important factor for the efficient financial intermediation which leads to sustainable private sector investment and the promotion of entrepreneurship (yaron et., 1998). as such, an understanding of the determinants of the profitability of financial institutions such as the banks is essential and crucial to the stability of the economy. lartey et al., (2013) defines bank profitability as the ability of a bank to generate revenue in excess of cost, in relation to the bank’s capital base. in this study, an attempt is made to investigate some key determinants of profitability and the extent to which they impact on profitability of banks. the analysis will adopt a fixed and random effect model with data pooled from annual financial statements of 21 banks over the period 2007-2014.the rest of the paper is organized as follows; the next section describes the data and the econometric methodology, followed by presentation of analyses and the empirical results. the last section concludes and offers some policy recommendations. 2. data and methodology this study used a strongly balanced panel of 21 banks operating in the ghanaian banking industry. the 21 banks consist of 9 local banks and 12 foreign banks. we use the bank’s annual and macroeconomics data in ghana for an 8 year period of 2007 – 2014 yielding a total of 127 year bank observations. the bank’s annual data was obtained from their annual income statements and balance sheets as well as ratios from the ghana banking survey which is published annually by pricewaterhousecoopers (pwc) ghana while the macroeconomics data was obtained from the world bank database and the bank of ghana database. for estimation purposes, we propose the following general linear model: = + ∑ + + (1) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 196 where is the return on assets of bank at time ; is the regression constant; denote the denote vectors of bank-specific and the macroeconomic determinants; is the unobserved bank-specific effect, and is the error term. dependent variable we carried out an empirical analyse to test the relationship that exist between dependent and the independent variables. the dependent variable used in this study is the return on asset (roa) and is the proxy for measuring the bank’s profitability. according to obamuyi (2013), the return on assets (roa) is a financial ratio used to measure the relationship of earnings to total assets. the roa is preferred to the use of return on equity (roe) or net interest margin because it assesses how efficiently the banks manages its revenues and expenses from operations, and also reflects the ability of the management to generate profits by using the available financial and real assets (obamuyi, 2013; jahan, 2012). also the roa as a measurement for bank profitability shows bank management’s efficiency in managing its capitals to acquire assets and make earnings from it (jamal & karim, 2012). other authors who have used the roa as a measure of profitability in several disciplines include babalola (2012) flamini et al., (2009); oladele et al., (2012); arias (2011). explanatory variables two categories of explanatory variables (bank-specific variables and macro-economic variables) were used to determine the bank profitability in the ghanaian banking industry. bank-specific determinants basically the bank specific determinants are the internal factors that are used to measure the profitability of banks. the following bank-specific determinants were considered for the purpose of this paper: • asset size: most literature have considered total assets of the banks as a proxy for bank size and is represented by natural logarithm of total asset (log a) (anbar & anper, 2011). • bank loan: the ratio of bank’s loans to total assets was also used as part of the explanatory variables. the traditional banking practice among ghanaian banks is accepting deposits and transforming them into loans. interest is charge on these loans which serves as their principal source of income. • bank deposits: the ratio of total deposits to total assets which is another liquidity indicator but is considered as a liability. thisis the main source of banks funding and isalso the lowest cost of funds. the more deposits are transformed into loans, the higher the interest margin and profit. therefore deposits have positive an impact on profitability of the banks. • capital: this is the ratio of the bank’s equity capital to total assets. according to berger (1995), there is a positive relationship between the level of capital and the profitability of the banks and when the level of capital is high, the bank can have excess funds to give out as loans after meeting the requirement of the regulator. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 197 • overhead: we again use the ratio of overhead to total assets to capture the variations of cost in the ghanaian banking industry. this is the various components of wages and salaries provided to employees and is expected to have a negative effect on profitability. macro-economic determinants three macro-economic variables were used in this paper. the first is the gdp per capital growth. there is an extant literature to show that gdp has a positive impact on performance of banks (naceur, 2003). also, gdp reflects the upswings and downswing in the business industry. moreover, exchange rate exr and interest rate –itr were the other two macro-economic variables used in this study. the panel nature of the data sample allows the application of fixed-effects (fe), random effect (re) methods on the variables (anarfi & boateng, 2016). the hausman specification test was conducted to compare the two categories of specifications and to determine the appropriate model for the study. table 1. description of the variables used in the regression models variable description hypothesized relationship with profitability dependent roa the return on average total assets of bank at time na independent bank-specific determinants size the natural logarithm of the accounting value of bank at time +/loan a measure of liquidity which is calculated as total loans/total assets + deposit calculated as total deposits/total assets +/capital calculated as total capital/total assets +/overhead calculated as total overheads/total assets. the various components of wages and salaries provided to employees macro-economic determinants gdp gross domestic product +/exr official exchange rate (ghs per us$, period average) +/itr the rate charged by banks on loans to banks +/source: author’s estimations asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 198 3. empirical results the results of the study are presented in this section. the results presented include the descriptive statistics, correlation matrix and econometric results which is relevant for the study. 3.1 descriptive statistics table 2 below indicates the mean values, standard deviation, the minimum and maximum values for each variable in the study. table 2. descriptive statistics variable mean std. dev. min max roa 2.395333 3.197508 -20.6 8.5 size 20.055 1.725792 11 22.46 loan 58.01205 13.20192 15 89 dep 70.92169 20.04782 0 139 cap 16.11102 13.67277 0 96 overhead 8.171429 3.669714 1 25 gdp 7.61125 3.135672 3.99 14.05 exr 1.5625 0.447365 0.94 2.4 itr 15.8125 2.641044 12.5 21 source: authors’ estimations table 2 above shows the basic descriptive statistics of the variables used for this study. for each variable, the table shows the mean, standard deviation, minimum and maximum value. on average, banks considered in our sample have a return on assets roa of 2.4% for the 8 year period from 2007 to 2014. the standard deviation of roa is 3.19% with a minimum and maximum values are -20.6% and 8.5%, respectively. when the mean of bank size (size) is 20.05%, minimum value is 11% and maximum value is22.46% with a standard deviation of 1.72%. again the table shows that, on average the banks give 58.01% loans and advances/assets to its customers. the minimum and maximum value of loans which the banks can give out is 11% and 89% respectively which can deviate by 13.20%. averages of deposits/assets (dep) and capital/assets (cap) are approximately71% and 16%, respectively. the bank cost which is represented by the overheads to total assets also recorded an average of 8.17%, where the highest it can reach is 25%. on the other hand, the table also shows the mean of macroeconomic variables over the period considered for this study. on the average the growth rate of gdp is approximately 7% (minimum 3.99% and maximum of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 199 14.05%). when the mean of real exchange rate is1.5%, real interest rate has a 15.8% mean value for 2007-2014 periods. 3.2 correlation analysis the table below explains the correlation of the profitability variable (roa)with that of the factors which influences profitability in the ghanaian banking industry. table 3. correlation matrix roa size loan dep cap over gdp exr itr roa 1.0000 size 0.4430* 1.0000 0.0000 loan -0.0313 -0.1111 1.0000 0.6905 0.1581 dep -0.0338 0.1347 0.0003 1.0000 0.6677 0.0864 0.9967 cap 0.0961 -0.4220* -0.1892* -0.3918* 1.0000 0.221 0.0000 0.0146 0.0000 over. -0.5723* -0.2099* 0.0758 0.0089 -0.0929 1.0000 0.0000 0.0135 0.3732 0.9165 0.2749 gdp -0.1275 -0.0680 -0.1499 0.0288 -0.0591 0.0508 1.0000 0.1028 0.3869 0.0538 0.7125 0.4491 0.5512 exr -0.2464* -0.4557* 0.1857* -0.0873 -0.0244 0.0700 -0.1299 1.0000 0.0014 0.0000 0.0166 0.2635 0.7549 0.4112 0.0933 itr 0.1184 0.1820* 0.0608 0.0367 -0.0546 0.028 -0.2816* -0.3828* 1.0000 0.1298 0.0197 0.4365 0.6387 0.4845 0.7423 0.0002 0.0000 source: authors’ estimations the above table shows the correlation analysis between the dependant variable and the independent variables. with our micro level variables, firm sze and overheads are significantly impacting on roa. the correlation between size and roa is positively correlated indicating that when the total asset of firms increases, its profits also increase. this result is consistent with the results of antwi-asare & addison (2000) who studied the financial sector reforms have influenced bank performance in ghana. this result also refutes the results of mensah-mawutor & awah (2015); tetteh (2014) that the roa is negatively correlated with bank size among ghanaian banks. bank overheads also have a negative correlation with roa as expected. however this result is not in agreement with the results of naceur (2003) whose results indicated a positive correlation between overheads and roa among banks. the results also shows that bank loans and bank deposits correlates negatively with roa and is consistent with the findings of anbar & alper (2011). consistent with the findings of naceur (2003), our findings was indicated bank capital correlates positively with roa among ghanaian banks. the results of our macro-level variables asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 200 indicated that roa has a negative relationship with gdp growth and exchange rate while is positively correlated with interest rate. 3.3 empirical results from panel data analysis table 4 below shows two different but related models of the empirical results of this study to establish the factors that determines profitability in the ghanaian banking industry in relation to our sample. the fixed effect model was first run and we assume that unobserved effects are correlated with the factors of profitability. we then run the random effects model where the initial assumptions of correlation are reversed on the same covariates. the hausman specification test was therefore used to determine and select one model that best suits the scenario for our sample. table 4 below also shows the parameters of estimation and standard errors obtained from the fixed effects model and the random effects model and the between effects model with roa as the dependent variable. we first begin the regression analysis with the fe model which we observed that size (natural log. of total assets) and deposits to total assets are not significant and impacting on profitability among our firm-level variables. loans to total assets are highly significant and impacts on profitability positively. this positive relationship indicates that the banks are able to generate more profits when they give out more loans to customers through the interest they charge. capital to total assets is also significant and impacts positively on roa and this indicate that as banks are able to hold more capital in their reserve, it increases their capital adequacy ratio which makes them liquid and profitable. lastly on the firm-level variables, overhead to total assets is highly significant and impacts negatively on the profitability variable. this indicates that as the operational cost of the banks increases, their profit also decreases. all our macro-level variables were insignificant except exchange rate which has a negative impact on roa. for the re model the research observes same results as the fe model in terms of our loan, deposits, capital and overhead variables. the only difference was the bank size which under the re model was highly significant and impacts positively on roa. this means that according to the re model bank size measured as natural log. of total assets is very important and highly determines profit in the ghanaian banking industry. the results however showed no significance and impact of our macro-level variables on roa under the re model. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 201 table 4. regression models variables femodel (roa) remodel(roa) size 0.194 (0.234) 0.791*** (0.182) loan 0.0612** (0.0227) 0.0440* (0.0183) dep. -0.0121 (0.0231) 0.00404 (0.0116) cap. 0.0964* (0.0383) 0.0625* (0.0249) over. -0.316*** (0.0683) -0.424*** (0.0588) gdp -0.0619 (0.0677) -0.0300 (0.0768) exr -1.635* (0.709) -0.340 (0.686) itr 0.0515 (0.0957) 0.0412 (0.111) _cons -0.792 (6.487) -13.73* (5.476) r-sq 0.397 aic 576.0 bic 602.3 f 8.878 n 137 137 standard errors in parentheses * p<0.05, ** p<0.01, *** p<0.00 source: authors’ estimations the hausman specification test was performed on the fixed and random effect model which calculated a chi2 of 31.15 (p>chi2=0.0001). chi2(8) = (b-b)'[(v_b-v_b)^(-1)](b-b) = 31.15 prob>chi2 = 0.0001 (v_b-v_b is not positive definite) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 202 with this result we confidently accept the result of the fixed effect model as the appropriate result for this study. 4. conclusion and recommendation this study investigates the factors of bank-specific characteristics and macroeconomic indicators on bank’s profitability in the ghanaian banking industry for the 2007-2014 periods. the bank specific variables used in this study include the size of the bank loans, deposit and overheads whilst the macroeconomic variables used were gdp growth, interest rate and exchange rate. the results from the fixed effect regression models indicated that bank loans and capital impacts positively on the profitability of ghanaian banks. also the banks should reduce their overhead cost to gain more profit since the results showed a highly negative significance on profitability. bank size and bank deposit did not have any impact on profitability. the results further showed that with the macroeconomic indicators, only exchange rate was found to be impacting negatively on profitability. references anarfi, d., & boateng, k. a. 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(1998). promoting efficient rural financial intermediation. the world bank research observer, 13(2), 147-170. https://doi.org/10.1093/wbro/13.2.147 microsoft word 5591-20141-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 439 efficiency of foreign banks operating in india: dea analysis dr namita rajput associate professor, sri aurobindo college, university of delhi e-mail: namitarajput27@gmail.com kamna chopra (corresponding author) assistant professor, sri aurobindo college, university of delhi e-mail: kamnachopra31@yahoo.com shelly oberoi research scholar, annamalai university e-mail: shellyoberoi83@gmail.com received: may 6, 2014 accepted: july 27, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5591 url: http://dx.doi.org/10.5296/ajfa.v6i2.5591 abstract indian financial sector has observed various modifications in the policies and prudential norms to raise the banking standards in india to the international strength. various financial reforms have taken place in 1991 which improved flexibility and operational autonomy in the banking sector. in 1992, on the recommendation of narasimham committee, a series of developments were instigated. in 1993-94, the approval was accepted for the entry of new private banks and foreign banks in indian banking sector. after the post reform era, the operations of foreign banks (fbs) received a considerable boost. the reserve bank of india liberalized its policy for foreign banks implying new opportunities for growth and different representations in india. the present study makes an attempt to measure and compare the efficiency scores of public sector banks (psbs), private sector banks and fbs operating in india during 2008-2013 using frontier based non-parametric technique, i.e., dea, the result demonstrates that the efficiency of fbs has shown continuous improvement in comparison with psbs and private banks following the route of deregulation with modest drifts. keywords: dea, efficiency, foreign banks, indian financial sector, npas asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 440 introduction indian financial sector has incessantly faced the rapid change in the banking system. before reform period, indian banking industry was neither perfect nor flexible. in order to create more diversified, efficient and elastic banking system, in 1992, government of india (goi) commenced inclusive banking reforms. one of the chief objectives of financial reforms was to promote flexibility, operational autonomy and to make them competitive by raising the banking standards in india to the international best practices (reddy, 2002). each and every facet of the banking industry, be it non-performing asset management, customer service, risk management, human resource development, etc has to undergo the process of transformation to line up with international standards (muniappan, 2003). the broad framework of reform plan was drafted by the committee on the financial system under the supervision of narasimham (1991), whilst the explicit shape to the plan was provided by the committee on the banking sector reforms (narasimham, 1998). consequently, the indian banking sector, which was principally controlled by the government, was liberalized. as an outcome, in 1993, the government allowed new private sector to enter the banking sector and additionally the foreign banks from 1994. since then, large number of fbs showed their interest in opening their respective branches in india to gain the noteworthy benefits of liberalized regime of indian financial system. foreign banks have brought the newest technology and new banking practices to india which has helped the domestic banks to improve their performance and provide better customer services. foreign banks in india captured a large customer base due to their speedy and well-organized working style and better customer service. prior to 90s, foreign banks effortlessly distinguished themselves vis-a-vis public sector banks. they adopted technology to their advantage to generate and often sustain lead in premium services like integrated cash management, 24-hour phone banking, and internet banking, securitisation, forex and interest rate derivatives trading, risk management and know your customer (kyc) software solutions. for instance, the first automated teller machine (atm) in the country was set up in 1987 by hsbc. this focus on innovation helped foreign banks build gainful businesses with a reasonably high share of investment and income. in 20012-13, 43 fbs were operated in india. top position is acquired by fbs in total number of banks in all three bank groups of indian scheduled commercial banking system, i.e., 26 banks of public sector banks and 20 banks of private sector banks. in 2008-09, the reserve bank of india announced a new rule for foreign banks in india by permitting them to grow in an unfettered way as in 1997, india had committed to the world trade organization (wto) to give 12 new branch licenses to foreign banks every year, including new entrants and the existing players. at present foreign banks in india are legalized to set up their local subsidiaries. after the entry of foreign banks in india, the indian banking sector has become more competitive and proficient. in asia pacific zone, india is considered to be most leading investment market due to the growth of indian economy and the assortment of income streams and product lines which give them the sturdiness to grow(neeraj swaroop,2011). as of march 2013, there are 43 foreign banks from 26 countries operating as branches and 46 banks from 22 countries operating as representative offices. standard chartered bank, the oldest foreign bank that came to india 150 years ago is now operating with 101 branches followed by hsbc with 50 branches. citibank has 42 branches and abn amro bank which is now known by royal asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 441 bank of scotland n.v has 24 branches. the other banks that have a double digit branch existence are deutsche bank (18) & dbs bank (12).considering the current scenario, an assessment of performance and efficiency level is needed about the working of fbs. this paper is an attempt to offer insights with respect to functioning and profitability of fbs in india and will also plot the efficiency level in post-liberalized regime. in the above backdrop, the focus of the paper is to compare the efficiency of the foreign owned banks with psbs and private banks operating in india and also to determine how the efficiency of fbs have improved in the recent time period. the paper is organized as follows. section 1 i.e. the present section gives the insights of indian banking industry and entry of fbs in india followed by section 2 which gives a review of the existing literature in the areas of efficiency measurement of foreign banks in the indian context. research objectives are exposed in section 3. section 4 identifies database and methodology used. interpretation of the results and analysis of this paper are summarized in section 5. conclusion will be the part of section 6. references used in the study will be a part of the last section. review of literature performance refers to financial performance of banks which is measured by appropriate accounting ratios, for example, the return on assets (roa). efficiency refers to cost efficiency, that is, the capability to produce a given level of output at the lowest cost. to construct the conceptual framework for this paper, we put light on the literature on psbs, foreign banks and private banks. galalet al. (1994), and la porta and lopezdesilanes (1997) uphold the view that performance can be improved through privatization. however, recent studies in transition economies, for example, by carlin and landesman (1997), frydman et al. (1998), and jones and mygind (1999) instituted that post privatization performance of the firms was poor. the rbi (2003) affirmed that “as regards the linkage between ownership and performance, international evidence suggests that ownership has limited impact on economic efficiency.” researches that hold this point include those of tulkens (1993), altunbus, evans and molynenx, (2000) and denizer, tarimcilar and dinc (2000). barr &siems, (1994) study scrutinize that banks are more efficient with high efficiency scores and are more competent to carry on as compare to banks which have low efficiency scores. mohan (2005) concluded that an efficient financial system contributes to resource generation, intermediation and allocation and hence contributes to economic growth and risk mitigation process. according to roma mitra, shankar ravi (2008), for increasing the economic level of a country, a stable and efficient banking sector is a prerequisite. this study tries to represent and assess the efficiency of 50 indian banks. the inefficiency can be evaluated and quantified for every evaluated unit. to estimate and compare efficiency of the banking sector in india is the objective of this paper. the analysis inculcates the verification or rejection of the hypothesis whether the banking sector fulfils its intermediation function sufficiently to compete with the global players and evaluates the performance of banking sectors in india. the results are insightful to the financial policy planner as it identifies priority areas for different banks leading to improvement in their performance. in an evaluation of the financial performance of indian private sector banks said that private sector banks play a key role in development of indian economy. the economic reforms totally have changed the banking sector. rbi asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 442 allowed new banks to be started in the private sector as per the recommendations of narasimham committee. there was the domination of indian banking industry by public sector banks. but now the situations have changed new generation banks with use of technology and professional management has gained a rational position in the banking industry. brijesh k. saho, anandeep singh (2007), this paper attempts to scrutinize, the performance trends of the indian commercial banks for the period: 1997-98 2004-2005. our broad empirical findings are pinpointing in many ways. first, there is a signal of an affirmative gesture about the effect of the reform process on the performance of the indian banking sector by the increasing average annual trends in technical efficiency for all ownership groups. second, the higher cost efficiency accrual of private banks over nationalized banks indicate that nationalized banks, though old, do not reflect their learning experience in their cost minimizing behavior due to x-inefficiency factors arising from government ownership. this finding also highlights the possible stronger disciplining role played by the capital market indicating a strong link between market for corporate control and efficiency of private enterprise assumed by property right hypothesis. and, finally, concerning the scale elasticity behavior, the technology and market-based results differ significantly supporting the empirical distinction between returns to scale and economies of scale, often used interchangeably in the literature. vradi, vijay, mauluri, nagarjuna (2006), in his study on´” measurement of efficiency of banks in india” concluded that in modern world performance of banking is more important to stable the economy in order to see the efficiency of indian banks. we have seen the fore indicators i.e. profitability, productivity, assets quality and financial management for all banks such as public sector, private sector banks in india for the period 1999-2000 to 2002-2003. there is an adoption of development envelopment analysis for measuring the efficiency of banks leading to a conclusion that public sectors banks are more efficient then other banks in india. petya koeva (july 2003), in his study on “the performance of indian banks” concluded that during financial liberalization period new empirical evidence has been seen due to the impact of financial liberalization on the performance of indian commercial banks. the analysis focuses on examination of the behavior and determinants of bank intermediation costs and profitability during the liberalization period has been focused by the analysis. the empirical results suggest that ownership type has a major effect on some performance indicators and that the observed augment in competition during financial liberalization has been related with lower intermediation costs and a profitability of the indian banks. research objectives foreign banks have a progressive position in indian banking system after financial reforms. in this paper, we will examine the improved performance of fbs through the efficiency measurement. the rationale of this paper is to compare the efficiency of foreign banks with psbs and private banks operating in india over the study period (2008-2013). the noteworthy insights are attained by empirical exploration which could be useful for the management of indian financial & non-financial counterparts. this paper will offer useful information to regulators and policy makers. we can postulate the research objectives as follows: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 443  to analyze the overall performance of fbs operating in india (as a group) in comparison with psbs and private banks.  to gauge the efficiency of each bank towards the elements of efficiency and overall performance. to achieve the above objectives following empirical hypotheses are formulated: hypothesis 1: efficiency of foreign banks (as a group) has improved during the recent time period from 2008-2009 to 2012-2013 in comparison with psbs and private banks. hypothesis 2: efficiency measures have resulted in higher efficiency level of each individual banking unit of foreign sector banks. data and methodology 4.1. database the study has measured the efficiency level of all fbs operating in india during the last eight years from 2008-2009 to 2012-2013. the focal point of the paper is to assess the efficiency scores of the banks using dea analysis. while there are 43 fbs that are working currently in india but due to the limitation of incomplete data of twelve banks, the paper excluded such banks from the sample. those banks are australia and newzealand banking group, commonwealth bank of australia, credit suisse ag, first rand bank, industrial and commercial bank of china, national australia bank, rebobank international, sber bank, sumitomo mitsui banking corporation, united overseas bank, westpac banking corporation, and woori bank. in this study, the sample size of 31 fbs is taken which is adequately large to take care of the constrictions imposed by the requirement of the dea model. 4.2. methodology data envelopment analysis (dea) is a non-parametric linear programming based data analysis methodology introduced by charnes, cooper, and rhodes in 1978, today called the ccr model. building on the ideas of farrell (1957), the seminal work “measuring the efficiency of decision making units” by charnes et al. (1978) applies linear programming to estimate an empirical production technology frontier for the first time. since then, there have been a large number of books and articles written on dea or applying dea on various sets of problems. other than comparing efficiency across dmus within an organization, dea has also been used to compare efficiency across firms. there are several types of dea with the most basic being ccr, however there are also dea which address varying returns to scale, either crs (constant returns to scale) or vrs (variable return to scale). the main developments of dea in the 1970s and 1980s are documented by seiford & thrall (1990).it assumes constant returns to scale and an orientation. the study suggests the fact that banks use certain inputs to produce certain outputs. thus, the efficiency of the banks will be measured with respect to how efficiently they are able to utilize their inputs. efficiency is measured by the ratio of weighted outputs to weighted inputs. the study suggests the fact that banks use certain inputs to produce certain outputs. the ratio has the following form: asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 444 u1 y1 + u2 y2 + …….unyn, v1x1 +v2x2 +…...vnxn, where u, v are the weights for the outputs, (y1…yn) and inputs x (x1……..xn), respectively assume that for each of the n firms there are data on k inputs and m outputs and represented by the column vectors xi and yi respectively for the ith firm. this may be expressed as (u’ yi/ v’ xi), where u is an mx1 vector of output weights and v is a kx1 vector of input weights. to arrive at the optimal weights, we define the following linear programming problem as: max u,v ( u’ yi/ v’ xj), (1) subject to u’yj / v’xj � 1, j = 1, 2 ... n, u, v � 0 (1) solving (1) will involve finding values for u and v such that the efficiency measure for each firm is maximized. a notable difficulty with this particular model formulation is that it can have an infinite number of solutions. thus, an additional constraint is added, v’xi = 1 so that this problem can be avoided. the new model, known as the transformation model, thus becomes: max �, v (�’ yi), (2) subject to, v’ xi = 1 �’ yj – v’ xj � 0, j= 1, 2 ...n, �, v � 0 (2) to reflect the transformation, u has been replaced by � and v has been replaced by v. this form in equation (2) is known as the multiplier form of the dea linear programming problem. using duality in linear programming, one can derive an equivalent envelopment form of this problem: min �, ��, (3) subject to, -yi +y � � 0 � xi x � � 0 (3) � � 0, where � is a scalar and � is a nx1 vector of constants the value obtained for will be the efficiency for the jth decision making unit (dmu). the linear programming problem would be solved for each dmu taken in the study. � = 1 will identify the technically efficient dmu and all other dmus would have � < 1, implying that the efficiency scores of all other dmu will be measured relative to the technically efficient units that have a score of � = 1. in this study each bank under observation will be treated as a asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 445 dmu. a separate frontier will emphasize the changes taking place in the macro economy and the supervisory policies of rbi. dea gives us the relative efficiency measure of the dmus. dea results are sampled specific. they don’t reflect the absolute efficiency measures. this means that the best performing dmu out of the group will be shown as 100 percent efficient. the rest of the dmus will be benchmarked against this one. another expressing way of this is to say that an efficient unit doesn’t necessarily produce the maximum output viable for a given level of input (miller & noulas, 1996). in this paper, we have taken an intermediation approach. hence, deposits, investments, operating expenses and number of employees are used as inputs whereas return on assets (roa), interest income and non-interest income together as net profits are taken as outputs. interpretation of results hypothesis 1: efficiency of foreign banks (as a group) has improved during the recent time period from 2005-2006 to 2009-2013 in comparison with psbs and private banks. foreign banks showed an increasing pattern of efficiency as it is shown in graph (see figure 1 and figure 2), i.e., dea efficiency score and net profits and return on assets (roa) with respective figures. in 2008-09, dea efficiency score of fbs was 1, and then it showed a slight dip in the dea scores 2009-2010. then in 2010-2011 fbs had 100% efficiency level as the score was 1 but in 20112012, it showed a declining trend in efficiency scores, it was 0.93.the sudden dip in the efficiency scores was mainly due to the global financial crisis and increase in the npas of the foreign banks in that year. then in 2012-13 fbs have recovered and shown 100% efficiency level. on the other hand, in 2008-09, the efficiency scores of public sector banks was 0.97, and after that it showed a continuous downward trend till 2010-11. after 2010-2011, public sector banks had 100% efficiency. this was mainly due to the radial changes in accounting, deregulation of interest rates, close follow-up of non-performing assets, introduction of prudential norms, voluntary retirement of old generation staff, concern for customer care as a part of reform process have made the management of psbs to generate surpluses and make them self-sufficient. with these developments and advanced information technology in the psbs has geared up to achieve the performance.similar trend is seen in private banks as of psbs, in 2009-10 and 2010-11, the efficiency scores of private banks have shown a declining trend. in 2011-12 and 2012-13, the efficiency score of private banks have increased mainly due to certain reforms. these results are consistent with findings of another study considering a temporal trend carried out by rajput & gupta (2010) which reported that the efficiency of fbs increased for the study period of 2005-2010 in relation to psbs and private banks, leading to a conclusion of acceptance of our hypothesis. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 446 figure 1. trends of net profits of psbs, private sector banks and foreign banks figure 2. trends of efficiency scores of psbs, private sector banks and foreign banks hypothesis 2: efficiency measures have resulted in higher efficiency level of each individual banking unit of foreign sector banks. the analysis exhibit mixed results for individual banking unit of foreign sector banks. there are four banks (bank internasional indonesia, bank of nova scotia, credit agricol bank and krung thai bank) which are 100% efficient throughout the assessment years (table i & ii). antwerp bank verified the highest efficiency level, 1, in all the years with only a fluctuation in 2010-2011. three banks (jp morgan bank, jsc vtb bank and mashreq bank) exhibit 100% efficiency except in the year 2011-12.in 2012-13, out of 31 foreign banks 9 banks are asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 447 100% efficient. the number of efficient foreign banks has increased over the assessment years, 7 out of 31fbs confirmed the escalating level of efficiency. hence, our hypothesis is accepted for 9 foreign banks which showed increasing trend in the efficiency and rejected in remaining 22 banks with the inverse picture exhibited in the results. summary and conclusion with india rising as a major information technology service provider in the 21st century, many global banks have entered in india; primarily to take advantage of the low-cost technology and available manpower. some foreign banks also created centres of excellence that provided services at the higher end of the value chain. foreign banks have made substantial contribution to the indian banking sector over the years by bringing capital and global best practices as well as grooming talent. foreign banks has shown an increasing trend of efficiency through their efficient working style and better customer service except in 2009-10 which was mainly due to the global financial crisis. over the last five years, there is persistent increase in the net profits of psbs and private banks in comparison with foreign banks but as far as efficiency scores are concerned foreign banks has shown substantial improvement. indian banks need to improve their technological orientation, to continue their efforts to reduce the percentage of npas in order to augment their profitable efficiency in the near future. at the same time, they should stay in the game for impending acquisition opportunities as and when they appear in the near term. our result exhibits that in case of foreign banks the efficiency has been tremendous and consistent throughout the period of 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(1991). report of the committee on the financial system, government of india narasimham, m. (1998). report of the committee on banking sector reforms, government of india. neeraj swaroop (2011). stan chart's regional chief executive for india and south asia, rbi. rajput & gupta (2010). efficiency, productivity and soundness of the banking sector in india: data envelopment analysis. bvimr, management edge, december issue 2011. reddy (2002). rbi and banking sector reforms. reserve bank of india monthly bulletin (december), 99-1008. roma mitra debnath, ravi shankar (2008). measuring performance of indian banks: an application data envelopment analysis. sahoo et al. (2007). productive performance evaluation of the banking sector in india using data envelopment analysis. international journal of operations research, 4(2), 63-79. tulkens, h (1993). on fdh efficiency analysis: some methodological issues and applications to retail banking. journal of productivity analysis, 4(1), 183-210. http://dx.doi.org/10.1007/bf01073473 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 449 appendix table i: net profits and efficiency scores of foreign banks (as a group) year net profits efficiency scores 2008-09 452160 1 2009-10 363410 0.847199824 2010-11 395049 1 2011-12 468925 0.939770526 2012-13 534613 1 source: rbi publication, a profile of banks table ii. dea efficiency scores of foreign banks (individual) no name of the bank 2008-09 2009-10 2010-11 2011-12 2012-13 1 ab bank 1 1 0.601172 1 0.699619 2 abu dhabi bank 0.458207 0.496351 0.54963 0.720938 0.951938 3 american express 0.773916 0.902884 0.439515 0.751628 1 4 antwerp diamond bank 1 1 0.857509 1 1 5 bank internasional indonesia 1 1 1 1 1 6 bank of america 0.651736 0.82944 1 0.782573 0.948063 7 bank of bahrain and kuwait 0.280476 0.629936 0.527522 0.63218 0.699172 8 bank of ceylon 1 0.796349 0.777925 0.997031 0.937036 9 bank of nova scotia 1 1 1 1 1 10 bank of tokyo and mitsubishi 0.873156 0.553055 1 0.761446 0.802786 11 barclays bank 0.478877 0.695733 0.755045 0.425205 0.775214 12 bnp paribas 0.576987 0.793923 0.829472 0.659577 0.866426 13 china trust commercial bank 0.782612 1 0.626425 0.904947 0.492183 14 citibank 0.502283 0.812547 0.714478 1 0.615562 15 credit agricol 1 1 1 1 1 16 dbs bank 0.651035 0.682199 0.565053 0.594942 0.68051 17 deutsche bank 0.475781 0.801458 0.852679 0.746494 0.70769 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 450 18 hongkong and shanghai bank 0.472976 0.579553 0.535199 0.466043 0.498516 19 hsbs bank oman 0.290802 0.661437 0.569308 1 1 20 jp morgan chase bank 1 0.358754 1 0.975539 1 21 jsc vtb bank 1 0.788584 1 0.883756 1 22 krung thai bank 1 1 1 1 1 23 mashreq bank 0.735466 1 1 0.940777 1 24 mizuho corporation bank 0.475165 0.713082 0.958932 1 0.891328 25 royal bank of scotland 0.548023 0.842036 0.650288 0.569072 0.52036 26 shinhan bank 0.544028 1 0.895405 1 0.89409 27 societe generale 0.493528 0.351455 0.630969 0.550888 0.693161 28 sonali bank 0.597904 0.527954 0.26438 0.797799 1 29 standard chartered bank 0.509163 0.939145 0.716881 0.674554 0.699164 30 state bank of mauritius 0.689526 1 0.65126 0.89717 1 31 ubs ag 0.603175 0.561402 0.878827 0.641769 1 source: rbi publication, a profile of banks microsoft word 7033-24961-3-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 117 material flow cost accounting system for decision making: the case of taiwan sme in the metal processing industry shen-ho chang department of accounting and centre for environmental accounting research, feng chia university no. 100, wenhwa rd., seatwen, taichung, taiwan 40724 e-mail: shchang@fcu.edu.tw an-an chiu (corresponding author) bachelor’s program of international business administration, feng chia university no. 100, wenhwa rd., seatwen, taichung, taiwan 40724 e-mail: ananchiu2009@gmail.com chin ling chu department of international logistics and marketing management, tatung institute of commerce and technology and ph.d. program in business, feng chia university no. 100, wenhwa rd., seatwen, taichung, taiwan 40724 e-mail: chinling@ms2.ttc.edu.tw teng-shih wang ph.d. program in business, feng chia university no. 100, wenhwa rd., seatwen, taichung, taiwan 40724 e-mail: t.swang0617@gmail.com asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 118 teng-shih wang administrator, division of finance, taoyuan metro corporation, taiwan no.251, sec. 4, linghang n. rd., taoyuan city 337, taiwan e-mail: t.swang0617@gmail.com sung-i hsieh budget, accounting and statistics department, taitung county government, taiwan and ph.d. program in business, feng chia university no. 100, wenhwa rd., seatwen, taichung, taiwan 40724 e-mail: aa0110913@gmail.com received: jan. 31, 2015 accepted: march 22, 2015 published: june 1, 2015 doi:10.5296/ajfa.v7i1.7033 url: http://dx.doi.org/10.5296/ajfa.v7i1.7033 abstract the purpose of this paper is to examine the implementation of a material flow cost accounting system (mfca) and to provide meaningful results for managers to make decision. a case study and the depth interview were employed for smalland medium-size enterprises in the metal processing industry to collect the information for further analysis. the result shows that the implementation of the material flow cost accounting system can mitigate the probability of dysfunctional decision making, particularly for investment decisions, assist managers in directly filtering out energy or material waste, and enhance the accuracy of product cost evaluations. this paper concludes that the material flow cost accounting system is not only a management tool, which helps managers achieve cost reductions, but also a mechanism, which realize corporate social responsibility. the results of this investigation support the proposition that implementation of environmental collaboration and monitoring practices by supply chain partners are both environmentally necessary and good business. the paper provides manufacturing managers with a structured approach to improving both environmental and organizational performance through environmental collaboration and monitoring with customers and suppliers keywords: material flow cost accounting system, corporate social responsibility, decision making asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 119 1. introduction environmental problems caused by economic growth have become worse and, as a result, the disclosure of social and environmental information has been increasing in popularity and acceptance among business entities, academics, and practitioners (djajadikerta and trireksani, 2012). as both internal and external pressures build to force corporations to adopt and maintain environmentally friendly processes and to produce environmentally friendly products and services, manufacturers must consider implementing the information system to improve the business performance and the economic viability of the corporations , as well as the environmental performance of the corporations (elliot, 2011; green et al., 2012). material flow cost accounting is essential instrument in a management approach know as flow management (strobel, 2001). the aim of flow management is to improve the management of production companies by overcoming compartmental thinking and instead to see one’s organization as a system that channels and transforms flows of materials and information from beginning to end. flow management, with the goal of having a company that is profitable and environmentally sound governments around the world have committed themselves to environmental protection to prevent further environmental deterioration and solve existing environmental problems. since 2002, the taiwanese government has motivated the study of environmental accounting plans and assisted in the trial of these plans. in addition, the government has promoted the introduction and implementation of environmental accounting systems, in particular the implementation of a material flow cost accounting system. in 2013, innolux was awarded the first iso14051 material flow cost accounting (mfca) certificate in the world for identifying, through the implementation of mfca, the waste accrued during manufacturing processes and improving operating processes to increase corporate profits. innolux has validated that the mfca is not only a decision-making tool, but also an instrument to assist corporations in undertaking their social responsibilities. in comparison with large enterprises like innolux, smalland medium-size enterprises have their own reasons to implement mfca. as 97% of the corporations in taiwan are smalland medium-size, they have limited resources to engage in environmental protection activities. however, the enhancement of environmental performance can be significant if these corporations are guided to establish and implement mcfa. other than inputting additional resources to comply with increasingly strict environmental laws, smalland medium-size enterprises compete for their profit in this competitive market either by increasing revenues or by reducing costs. it is easier and less risk to reduce a dollar of cost than to increase a dollar of revenue. therefore, locating and improving operational weaknesses and, thereby, enhancing financial and environmental performance after establishing mfca is an important topic for smalland medium-size enterprises. the introduction of mfca to companies has indeed achieved simultaneous benefits of economic gains and environmental sustainability (sulong et al., 2014). this paper proposes a case study of the smalland medium-size enterprise in the metal processing industry that adopts mfca to assist managers to make decisions and reduce costs and environmental impact. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 120 the metal processing industry1, including hand tools, nuts, bolts, screws and other metal manufacturing and surface treatments, is indispensable to taiwan’s supply chain. the manufacturing of bolts and screws requires wire rod treatment, which involves the utilization of greater resources, such as power and material loss, and environmental pollution. the treatment includes a few processes: continuous drawing of wire rods, as well as spheroidizing and phosphating wire rods. the rusty part of wire rods is eliminated and the rest of the wire rods are initially processed during the drawing process. the spheroidizing process enhances the stiffness and toughness of the wire rods by using heat treatment that consumes large amounts of electricity and generates considerable amounts of heat waste. the phosphating process involves cleaning impurities off the surface of the wire rods and soaking them in materials that form a protective membrane2 that prevents rusting. this process consumes a large amount of water and produces sewage. the continuous drawing process cleans chemical powder off the surface of the wire rods, and consumes large amounts of electricity. to conclude, the consumption of electricity and water resources increases the cost of products and causes heavy metal contamination, which results in heavy fines. fakoya and van der poll (2013) note that material flow cost accounting can identify the material losses that traditional standard cost accounting cannot recognize, such as, waste or non-product outputs. under the traditional cost accounting, activity-based costing or time-oriented activity-based costing systems, wastes are viewed as no value because they are considered irrelevant to the value chain. the importance of waste is ignored as one of the outputs of operational processes. however, in mfca, the value of waste is not an allowance for product costs. instead, it should be assessed with the same valuation as the product such as using physical information as the basis of cost calculation. product costs (positive product costs) or losses (negative product costs) are calculated on the same basis (nakajima, 2004, 2009). mfca can identify and analyze the value of waste, which assists organizations to know the role of waste in the value chain (möller and prox, 2008). by implementing and analyzing mcfa, this study discovers that waste in water resources is the main improvement decision that the case company needs to make. three additional problems including output of defective goods, residue recovery, and the heat waste are caused by the phosphating process. apart from waste in water resources, we find that the materials used in defective goods can be reused to make new products and sold to customers at the original price. managers may think that the additional costs of remaking defective goods are insignificant. however, this study shows that, the negative costs incurred at the end of the operation are greater than the defective goods produced at the front operation. moreover, the company can dry the residue using waste heat recycled from the manufacturing process 1 according to data from mii-it is, the gross outputs of metal products in taiwan in 2010 and 2011 are ntd 673,500,000 and ntd 754,300,000, respectively, among which bolts and screws account for ntd 109,800,000 and ntd 144,800,000, respectively. 2 there are nine processes involved in the phosphating process: material requisition, phosphating, water rinsing (1), oxalic acid neutralization, coating, water rinsing (2), water rinsing (3), lubrication, drying/inbound. first, wire rods are delivered to the entrance of the phosphating area (material requisition process) according to work orders. they are soaked in hydrochloric acid heated by fuel oil to remove the oxide film (phosphating process) and are washed with clean water (water rinsing 1). after that, they are processed with oxalic acid neutralization in order to make sure that the film is even when formed. the next step is coating, which involves soaking the wire rods in phosphate. after cleaning the precipitation on the surface using water (water rinsing process 2) and water rinsing process asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 121 before the residue is recovered, to greatly reduce the cost of residue recovery management. hence, managers may make dysfunctional decisions if these decisions are made based on intuition. with the use and assessment of quantitative information, this paper suggests that the case company should consider setting up inspection checkpoints and using waste heat rather than water reclamation for drying residue. 2. literature review material flow analysis assesses the effectiveness of material use to identify the waste produced from certain resources and materials (european communities, 2001). brunne and rechberger (2005) define material flow analysis as a systematic assessment conducted on material flow and stocks within a system range, and defined time and space exigencies. material flow analysis connects material source, path and final location. due to the law of conservation of matter, material flow analysis can be controlled by comparing the analysis results of input, stock and output of material flow in operation. hence, material flow analysis discusses the flows and stocks of materials. material flow analysis can also be an assisting tool for decision making in resources management, waste management and environmental management. however, while material flow analysis only focuses on the research and analysis of physical units, monetary information is an important factor of management decision making. since material flow analysis lacks monetary information, while traditional cost accounting only focuses on currency information, bernd wagner of the university of augsburg in germany propose “material flow cost accounting” and “flow cost accounting” to solve the above problems. hargroves and smith (2012) note that not only can mfca provide physical information concerning material flow analysis, but also combine physical information with monetary information. managers can clearly define ineffective production during the production process. additional benefits include the material balance concept in material analysis, a new perspective on activity-based costing systems, cost accumulation and the calculation of positive/negative outputs. nakajima (2004) indicates that the production process in traditional cost accounting is a consumption process of economic values because the economic values of the consumed resources are added to the products, i.e. the products take on the costs of resources used. as a result, if a firm adopts the traditional cost accounting, then we can ignore important losses and obtain the product’s costs. on the contrary, mfca is a calculation method based on the concept of material balance, which allows the positive and negative product costs in each manufacturing process to be presented. hence, managers are aware of material loss costs and low efficiency (nakajima, 2004; iso 14051, 2011). the most important advantage of mfca is the transparency of costs to organizations. iso 14051 (2011) proposes that enterprises may ignore the importance of waste because it can be recycled and reused. in the past, waste from spoilage was not valued because it only needed to be remade as new finished goods and sold to downstream companies at the same price. according to mfca, spoilage should be treated as a negative product and the cost of remaking spoiled products should be considered a negative cost. hence, mfca can present asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 122 these costs to management to assist them understanding the cost of spoilage. mfca assists managers to value waste and endeavor to reduce waste, which helps to improve the efficiency of production and reduce costs (onishi, kokubu and nakajima, 2009). as per the material flow cost accounting guidelines of japan (jmeti, 2007), the main purposes of mcfa are to reduce the costs and environmental impacts caused by corporate activities and to serve as a decision-making tool for corporations and managers. in fact, mcfa extends the main concept of material flow analysis and material flow accounting, namely “material balance”, which means that input is equal to output. in mcfa, input includes all the resources needed for the manufacturing process; including primary raw materials, secondary raw materials, materials, direct labor, indirect labor, water, electricity, machinery, etc. output is classified as positive product output3 and negative product output. positive products are semi-finished goods in process, or finished goods; negative products are waste resources or recycled materials. in order to convert production into monetary units, input costs must be equal to product costs. this means that the total input costs are equal to positive product costs plus negative product costs (jmeti, 2007). 3. methodology and sampling 3.1 methodology this paper uses a case study and depth interviews following fakoya and van der poll (2013). chetty (1996) indicates that exploratory research is the most common method used for case studies. the main purpose of this study is to use mfca to assist managers in decision making to save costs. we believe that the case study method can further distinguish between the methods and steps involved in implementing an mfca system and the influence of the information generated from the system on managers’ daily decision making. in addition, in-depth interviews are employed in this study to gather information. stacks (2010) points out that in-depth interviews can provide researchers with detailed backgrounds and assist researchers to understand both the researcher’s and corporate managers’ opinions of events. considering that material flow cost accounting is established in the corporation’s operational processes, this study believes that depth interviews assist in understanding the background, operational processes and current problems encountered by the case company. 3.2 selection of case company and explanations the purpose of this paper is to discuss whether smallor medium-size enterprises in taiwan are able to implement mcfa, and whether the results calculated by this system can present the product’s costs or potential improvements more accurately to assist managers in making decisions. moreover, we aim to establish feasible standard operating procedures for implementing mfca in smalland medium-size enterprises. this paper selects a case company based on the following criteria: 1. small and medium enterprises: according to the statistics, 97% of enterprises in taiwan are smallor medium-size which shows that these enterprises hold a considerable position in 3 “positive product output” and “negative product output” are the terms of jmeti. according to ifac (2005), products are classified as “product output” and “non-product output”, but the meanings for both are similar. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 123 the taiwanese economy. this study chooses to implement the system in a smallor medium-size enterprise and expects that our results are applicable for most smalland medium-size enterprises. 2. industry: nakajima (2006) indicates that mfca is more suitable for the processing industry and in particular for the manufacturing process of parts of materials and the assembly process. hence, this study chose the processing industry, which has higher productivity and implementing benefits. our case company is a medium-sized metal processing company. in the past, the organization mainly used standard manufacturing costing, the cost control tool. however, the manager still did not understand the actual cost of a product and thought that he or she could not effectively use water resources, which is a heavy burden on the company’s finance. hence, the company urgently needs to improve its recycling of water resources. the working hours for the batch production line are eight hours per day. the major raw materials of the company are wire rods. these are produced as finished products through four processes: the drawing process, spheroidizing process, phosphating process and continuous drawing process (as shown in fig. 1). wire rods become semi-finished goods after the drawing process. these semi-finished goods then go through the spheroidizing process and the phosphating process. wire rods are completed as finished goods during the continuous drawing process. figure 1. complete operating processes of the case company the case company employed a traditional cost accounting system to calculate costs and understand its past performance. however, the weakness of the traditional cost accounting system is that it only uses the single basis without taking into consideration either environmental costs or benefits. after an in-depth interview with the general manager, we discovered that the primary source of waste is the running water used during the phosphating process. although some of this water can be reclaimed and reused, the rest of it must be emitted to the sewage treatment plant in the industrial area through the company’s sewage treatment equipment. given this, management believes that it can save a lot on costs if water can be recycled more effectively. however, from the point of view of mfca, the recycling of water is not the only waste produced by the company. there are other inevitable losses which are considered as waste, such as the input of losses of resources in the drawing process and continuous drawing process for remaking products. furthermore, materials and energy are necessary for the production and maintenance of operations. if we can reduce product inputs and the wasting of resources caused by remaking products, this would result in great benefits to the company. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 124 given this, this paper, using mfca, recalculates product costs among operating processes, discusses water waste and discovers the greatest sources of waste as well as potential improvements. 4. analysis of effectiveness of implementing material flow cost accounting there are seven steps involved in establishing mfca including planning, collection and compiling of data, material flow cost accounting calculation, confirming improvements, planning improvement projects, executing improvements and assessing improvement effects (jmeti, 2007). chen and ko (2005) indicate that the development of an accounting system includes planning, analysis, design, execution, and feedback. hence, this paper establishes and analyzes mfca in three major steps: planning, execution, and improvements and feedback. 4.1 planning based on jmeti (2007), planning covers four phases: determining goals4 , determining quantity centers5 , determining the analysis for each period and determining the methods. table 1 shows the summary of the planning steps: 4 this means analyzing which goal is the most appropriate and has top priority in order to establish material flow cost accounting. a goal can be a product, a production line or even the important or major production process of a series of related products. 5 this is primarily determined by analyzing goals and handling future situations. iso 14051 defines a quantity center as a selected single process or a set of processes to quantify physical and currency unit inputs and outputs. hence, each process can be treated as a quantity center, such as material requisition, cutting, cleaning, inspection, packing, delivery and storage areas. a quantity centre is normally determined by waste processes, so quantity centers are normally more that process centers. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 125 table 1. planning-case company phases step case company planning determine goals 1. the nature of the case company is mass production. all products go through the same manufacturing processes. so we decided to use the manufacturing processes as our goal, which includes the drawing process, spheroidizing process, phosphating process and continuous drawing process. determine quantity center 1. before determining the quantity center, it is necessary for researchers to understand the manufacturing processes of the case company. this can be done by collecting the operating procedures standard. in this paper, we adequately comprehend this information via the process control enactment. 2. although four operating centers in the case company can be further classified into different groups (e.g. phosphating process can be divided into smaller operations), considering that this is the first time to establish mfca, information, including information about cost benefits, is not easily gathered6, and so we expect to establish four operating centers as quantity centers. we will determine the sub-operations if more precise information is required after the initial implementation and understanding of the positive/negative cost overview of the company. if this is the case, then we either execute again or the case company itself will establish quantity centers based on smaller operations. determine analysis model and period 1. it is the first time for the case company to establish material flow accounting of environmental management accounting, so the analysis period should not be too long, in order to reduce the difficulty of initial implementation and the risk of failure. when nitto denko co., ltd. established mfca for the first time, the analysis period was a month. hence, this paper expects that the analysis period is a month with a three-month range from oct 2010 to dec 2010. determine method of collecting data 1. to reduce the difficulty for initial establishment and enhance benefits, we expect to be provided with accounting information by the case company. 2. if we lack the necessary data for establishing material flow cost accounting, then we will ask the case company to collect these data again. 4.2 execution according to jmeti (2007), execution covers two stages: the collecting and compiling of data and the calculation of material flow cost accounting. material flow cost accounting 6 we have discussed this with the management who are involved in material flow cost accounting. the costs and quantity data of the company were recorded at the process level. if we divide the phosphating process into smaller processes, then all of the information has to be recollected, which might not be cost effective. given this, we set up a quantity center at the process level in order to reduce implementation costs. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 126 builds quantity centers by processes and obtains cost information by physical quantity as the basis of the calculation. this calculation method facilitates the combination of both costs and benefits. the differences with general accounting systems include the requirements of costing information of raw materials, labor, manufacturing costs and the physical information of raw materials. physical information can be difficult to collect because a company may not have this information or because it is not willing to disclose relevant information. as a result, this is believed to be the most difficult step in the mfca. this paper overcomes this problem by communicating and coordinating with the manager in the case company. data collection is used to quantify the quantities of input and output against each quantity center based on material balance, and to collect the relevant costs for each quantity center, including material costs, energy costs, system costs and waste treatment costs. material costs can be direct, but energy costs and system costs are amortized into quantity centers and then amortized into positive or negative products from each quantity center. with regard to the amortization of energy costs and system costs, both jmeti (2007) and iso 14051 (2011) indicate that amortization can be based on the positive/negative proportion of materials. the second stage of calculation depends on the information gathered and the concept of material balance used in mfca theory. this stage can be divided into three stages: a complete calculation of physical quantity units7 ; a complete calculation of currency quantity units; and completing the input/output relationship of positive products among quantity centers by inter-process integration8 , adjustment and completion of the costing table as shown in table 2. we can learn from table 2 that the total cost of positive products in the drawing process center, spheroidizing process center, phosphating process center and continuous drawing process center are 25,138,480, 25,138,480, 25,049,479 and 25,113,300, respectively. while the total cost of negative products in these process centers are 614,176, 35,060, 355,293 and 140,788, respectively. we can then determine that negative materials total costs are generated mostly in the drawing process center and the phosphating process center. in addition, there are waste management costs which are not listed in table 2. these costs are generated from the management of sewage from the phosphating process center. the sewage treatment equipment in the company has already exceeded its service life, and there is no depreciation cost whatsoever. the waste management costs will only include current sewage treatment charges and residue disposal charges with an actual amount of $68,320 (non-standard output) on average within 3 months. the contract price for residue disposal is $55,000 per month, but the management of the company mentioned that the treatment company is willing to handle this process for free if the residue is dry enough. 7 this paper consults the method suggested by jmeti (2007) to convert all inconsistent units into kilograms. the conversion method is to multiply kilogram with density. 8 the application of inter-process integration factors can solve the problem of values transferred out not matching with values transferred in, which is affected by the beginning inventory and the end inventory. jmeti (2007) suggests calculating inter-process integration factors by the positive standard output of the last quantity center and multiplying this by costs and inter-process integration factors. doing this allows us to obtain the values transferred in which match the values transferred out from the previous quantity center. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 127 table 2. costing table of input/ output after balanced adjustment (standard output is 1,000,000 kg) drawing spheroidizing phosphating continuous drawing current new input materials cost 25,752,656 35,060 266,291 204,609 system cost 317,373 136,267 266,004 199,475 energy cost 172,512 547,144 105,552 54,241 brought down materials cost 0 25,138,480 25,138,480 25,049,479 system cost 0 310,145 442,999 684,619 energy cost 0 168,579 710,256 787,754 total input costs materials cost 25,752,656 25,173,540 25,404,772 25,254,088 system cost 317,373 446,411 709,002 884,094 energy cost 172,512 715,723 815,808 841,995 positive costs materials cost 25,138,480 25,138,480 25,049,479 25,113,300 system cost 310,145 442,999 684,619 879,237 energy cost 168,579 710,256 787,754 837,385 negative costs materials cost 614,176 35,060 355,293 140,788 system cost 7,229 3,413 24,383 4,857 energy cost 3,933 5,467 28,054 4,610 a. the above disclosed amount is based on the new taiwan dollar. the conversion rate for the us dollar is 1:30. 4.3 improvements and feedback the last step is improvements and feedback. the direction for improvement is primarily determined by analyzing positive and negative products. the analysis can be carried out based on physical information or monetary information, and the operating processes will be re-assessed according to the analysis results in order to determine the most urgently needed improvements in the operating processes. we will carry out mfca after improvements are made, in order to understand the results and benefits of the improvements. after calculating by mfca, improvements and feedbacks are the most important factor. our analysis results are summarized below. 4.3.1 water resources that companies are concerned with the waste of water resources is not as bad as was expected in either the positive or negative costs after calculation and analysis of water resources. moreover, the costs are lower than expected, with an actual total cost of around $75,7119 per month, while the actual average negative cost is around $2,60810 , as shown in table 3. 9 this value is the mean for three months 10 this value is the mean for three months. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 128 table 3. water resources costs for the phosphating process center october november december water resources costs $79,347.62 $75,017.31 $72,767.63 negative proportions in the phosphating process center 0.0377 0.0327 0.0327 negative costs for water resources $2,991.41 $2,453.07 $2,379.5 inter-process integration factors 0.396869332 0.424951704 0.399282138 negative costs for generating 1,000,000kg of water resources $1,187.20 $1,042.44 $950.09 total negative costs for generating 1,000,000kg of water resources (in the phosphating process center) $397,060 $400,736 $425,394 proportion of total negative costs for water resources in the total negative costs 0.00299 0.0026 0.00223 a. the above disclosed amount is based on the new taiwan dollar. the conversion rate for the us dollar is 1:30. in fact, the rate of water reclamation of the case company reaches almost 70%, so there is little room for improvement with limited benefits. the benefits could be even greater if it is no longer necessary to handle the sewage through the company’s sewage treatment equipment, instead sending these emissions to the sewage treatment plant. in terms of environmental protection and mfca, it is possible to achieve the goals in terms of both economy and environmental protection by making the best of ones resources. in order to provide the authorities with investment decisions concerning water conservation, we assume that the recyclability rate can reach 90% with certain reclamation equipment. in other words, only 10% of the original water resources are wasted. provided that the life of the equipment is 10 years with a discount rate of 6%, 8% and 10%, the results are shown in table 4 below. under a discount rate of 10% (8%, 6%), it is worth investing if the investment costs are under $851,030 ($929,352, $1,019,378). that is, if investment costs are lower than investment cost limitations in the three situations, then such an investment can reduce costs and be environmental friendly11. we assessed that the reverse osmosis (ro) technique can increase the recyclability of water with an establishment charge of around $600,000 in total. this conforms to the investment limitation set out in this paper, and so we suggest that the company establish a water reclamation system. 11 this analysis only focuses on the expenses of water resources without considering the costs saved in the sewage treatment of company and industrial areas, or the income tax saved in depreciation. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 129 table 4. investment costs limitation for water resources 6% discount rate 8% discount rate 10% discount rate amount saved for water resources (year)12 $138,501 $138,501 $138,501 10 years, present value of annuity 7.3601 6.7101 6.1446 investment costs limitation $1,019,378 $929,352 $851,030 a. the above disclosed amount is based on the new taiwan dollar. the conversion rate for the us dollar is 1:30. 4.3.2 analysis of negative costs this paper discovers that the drawing process center, phosphating process center and continuous drawing process center generate most of the company’s waste. table 5 presents the data on relevant negative costs13. the material negative costs for each quantity center reach 80% of the total negative costs. the drawing process center has the greatest material negative costs in terms of wastage, and the continuous drawing process center comes in second. in terms of materials, the phosphating process center has the greatest negative costs. the case company should initiate improvements in the drawing process center or the continuous drawing process center in order to reduce material costs, because this will bring greater benefits, instead of making decisions based on subjective judgments. the reason why negative costs exist in the drawing process center and the continuous drawing process center is defective products. these products account for a high proportion of the negative costs, so reducing defective products should be considered a viable starting point. the case company should pay attention to the reasons for defective products and set up checkpoints in the spheroidizing process center in order to prevent these products from entering the phosphating process center and the continuous drawing process center, which increases the remaking costs. the large amount of material costs used in the phosphating process center may not be improved in the short term because it is restricted by the operating process and the scale of existing equipment. if plant expansion is required in the future, the company can consider the equipment type and scale of the phosphating process center when purchasing, in order to enhance the utilization of materials and thereby reduce negative costs. 12 the water emissions originally made up 30% of total usage. assume that the utilization of water resources increases and that the emissions rate is reduced to 10%. this would equal the saved costs multiplied by the unit costs without considering water reclamation by equipment (except for the weekly water change of the third sink in the phosphating process). the calculation values are the saved water costs in october, november and december. 13 waste disposal costs are not included. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 130 table 5. table of material negative costs (standard output is 1,000,000 kg) 4.3.3 analysis of relative indices although it is simple to understand the room for improvements in terms of total amounts, relative indices are also crucial. relative indices provide comparisons among companies and months, and also indicate critical points which absolute indices do not. table 6 shows the accumulated costs of each process center, which allows us to understand the significance and severity of remake costs. after processing in the drawing process center, the case company immediately performs an inspection. defective products are remade in the drawing process center. raw materials can be recycled and reinvested, so that positive costs of finished goods per kilogram will increase from $25.5915 to $26.069714. this means a cost increase of 1.87%. before delivering the products to customers (i.e. after manufacturing in the continuous drawing process center), the company performs another inspection to judge whether the products meet customers’ requirements. defective products caused by stiffness, toughness, hardness and consistency will be remade in the drawing process center and then recast in the spheroidizing process center. these products need to be cleaned in the phosphating process center and processed again in the continuous drawing process center. the cost of positive products per kilogram increases from $26.8299 to $28.5465, with a cost increase of 6.4%. in terms of material processing, the system costs and energy costs of disqualified goods are double those of finished goods after deducting raw material costs. table 6. table of accumulated costs of positive products costs in process centers (per kg) drawing spheroidizing phosphating continuous drawing material costs $25.113315 $25.1133 $25.1133 $25.1133 system costs $0.3098 $0.4425 $0.6863 $0.8792 energy costs $0.1684 $0.7095 $0.7897 $0.8374 total costs $25.5915 $26.2654 $26.5893 $26.8299 a. the above disclosed amount is based on the new taiwan dollar. the conversion rate for the us dollar is 1:30. the above analysis indicates that the continuous drawing process center has serious remake 14 26.0697=25.5915+0.3098+0.1684 15 refers to raw material costs. other materials are transferred to negative products. drawing spheroidizing phosphating continuous drawing material negative costs (a) $614,176 $35,060 $355,293 $140,788 total negative costs (b) $625,337 $43,940 $407,730 $150,256 proportion (a/b) 0.9821 0.7982 0.8710 0.9372 a. the above disclosed amount is based on the new taiwan dollar. the conversion rate for the us dollar is 1:30. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 131 problems in terms of defective products. if the company can identify defective products at an earlier stage and remake them immediately, then it should reduce the remake costs of these products. hence, this paper suggests that setting up checkpoints after the spheroidizing process center can contribute to discovering and resolving problems in a timely manner and preventing the doubling of system costs and energy costs in the phosphating process center and the continuous drawing process center. besides, there are two further points to consider when setting up checkpoints: 1. compare the establishment costs and expected benefits of checkpoints to determine its feasibility. 2. maintain system efficiency. however, in terms of cost benefits, without considering extra expenditure, the company may move the inspection of products’ stiffness, toughness, hardness and consistency in the continuous drawing process center forward to the spheroidizing process center in order to solve problems. the company can further decide if there are any improvements, such as update of techniques and elimination of old equipment, which can reduce the quantity of defective products to zero. this can actually help the case company to mitigate certain costs. last but not least, mfca can be seen as a judgment tool for an improvement approach. the company should implement the improvements and verify whether the results are as expected, by carrying out mfca so as to enhance productivity and save costs. until then, a complete cycle of mfca is finished. aside from an analysis of costs for positive units, it is also important to analyze the total amount of positive costs. since inter-process integration factors are applied, the basic calculation for the continuous drawing process center each month is 1,000,000 kg. a cost comparison for each month is very useful. as shown in table 7, the positive unit cost is around $26.8 each month. this cost can be combined with a standard costing system when the study period is longer, in order to carry out cost control or an analysis of cost variance. in other words, we will know if there is a tremendous increase or decrease in positive costs for particular units in a certain month, so that the manager can react quickly to reduce potential losses. table 7. comparison of positive unit costs in each month (unit: per kg) oct nov dec total cost $26,855,216 $26,857,170 $26,777,378 theoretical yield 1,000,000 1,000,000 1,000,000 cost per unit $26.8552 $26.8572 $26.7774 a. the above disclosed amount is based on the new taiwan dollar. the conversion rate for the us dollar is 1:30. b. total cost= material cost + system cost + energy cost 4.3.4 waste heat and residue recovery management a considerable amount of waste heat is generated in the spheroidizing process center without being recycling or reused. the residue generated in the phosphating process center can be asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 132 handled through a drying process in order to reduce disposal fees. this paper suggests that the company should purchase waste heat recovery equipment in order to handle the drying process of residue. the equipment costs around $1,500,000 to $2,000,000 whereas the contract price for residue disposal is $55,000 per month. based on a cost recovery method, it only takes around 3 years to recover the cost of purchasing waste heat recovery equipment (without considering the income tax saved due to depreciation of equipment) with a relatively high return on investment. 5. conclusion and suggestions corporate environmental responsibility should be first considered as the pivotal activity in implementing an environmentally oriented strategy in business, and thereby, as the source of competitive advantage (lee, 2012; ulubeyli, 2013). mfca has gained more attention recently because it not only values physical information, but also combines physical and monetary data to calculate costs on a consistent basis. with the management and control of waste and defective products, the system discloses relevant physical and monetary information for managerial decision making. the main purpose of this paper is to prove the feasibility and usefulness of mfca. this paper uses a smallor medium-size enterprise in the metal processing industry as our object of study. this study has shown that the establishment of mfca, and the analysis of costs and waste and information generated by mfca, can assist senior managers to mitigate the probability of dysfunctional decision making. for corporations, traditional costing systems or activity-based costing systems emphasize amortizing manufacturing overhead. since direct raw materials and direct labor are directly attributed to the cost objects, management believes that losses are normal; however, this can be avoided from the mfca perspective. moreover, mfca attaches importance to physical information which has previously been ignored by management. before implementing mfca, the case company believed that the waste came from water resources, which allowed for more room for improvement. according to the implementation results, the waste of water and materials, as well as sewage treatment, are indeed key areas for improvement. furthermore, the case company did not set up any information about defective products nor any appropriate control on these products because the manager thought that they could be remade. the results have proved that unit product costs increased by 100% for remaking defective products, without considering raw material costs. hence, the case company should improve the usage and waste of materials. this paper also suggests setting up checkpoints in the spheroidizing process center in order to immediately discover any defective products and thereby avoid ineffective inputs. the checkpoints can be moved from the continuous drawing process center in order to save extra costs and solve the problems encountered by the company. we also suggest upgrading techniques and eliminating old equipment in the phosphating process center in order to reduce negative costs if technology allows. key success factors for the implementation are the collection of data and communication with the staff. the degree of data collection is closely related to the costs because enterprises may refuse or be unable to establish mfca for cost benefitrelated issues. we needed the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 1 www.macrothink.org/ajfa 133 support of the accountants to provide the data needed. we were also supported by the operators, accountants, general manager and vice general manager during implementation. we looked for solutions to problems identified during discussions with management. the implementation might have failed if we did not have the support of management and the data provided by the accountants. the implementation of mfca also proved that it is both feasible and useful. the system highlights the significance of direct raw materials and materials that are normally ignored; at the same time, it helps management to find out which processes need improvements to avoid dysfunctional decisions. moreover, products and wastage are discussed on the same basis, so that wastage will not be ignored because it is thought to have no value. in the past, there was no direct connection between physical and monetary data because they were only linked in an indirect way. with mfca, which calculates monetary data on the basis of physical data, both data can be directly linked so that the information provided is more accurate and helpful to management in decision making and output control. finally, the case company can divide their major operations (e.g. the phosphating process center) to create a detailed quantity center in order to explore the utilization of materials, waste management or water resources costs if more detailed information is needed in the future. further studies can pay attention to the assessment of environmental management accounting tools instead of only to the discussion of mfca, although it is the most significant. we suggest that future studies carry out case analyses and research to explore the strengths and weaknesses of each tool and its applicability. the application of mfca may be suitable in taiwan because most industries are manufacturing industries or oem. future studies can discuss whether the establishment steps proposed in this paper are suitable for other process manufacturing industries or other industries in general. references brunner, p.h. & rechberger., h. (2005). practical handbook of material flow analysis, lewis publishers. chen, c.t. & ko, c.f. (2005). accounting information systems (fifth). shinlou, taiwan. chetty, s. (1996). the case study method for research in small-and medium-sized firms. international small business journal, 15(1), 73-85. http://dx.doi.org/10.1177/0266242696151005 djajadikerta, h. g. & trireksani, t. (2012). corporate social and environmental disclosure by indonesian listed companies on their corporate web sites, journal of applied accounting research, 13(1), 21-36. http://dx.doi.org/10.1108/09675421211231899 elliot, s. (2011). transdisciplinary perspectives on environmental sustainability: a resource base and framework for it-enabled business transformation. mis quarterly, 35(1), 197-236. european communities (2001). economy-wide material flow accounts and derived indicators -a methodological guide. fakoya, m.b. & van der poll, h.m. 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(2012). the pivotal roles of corporate environment responsibility. industrial management & data systems, 112(3), 466-483. http://dx.doi.org/10.1108/02635571211210077 leo´n-soriano, r., mun˜oz-torres, m. & chalmeta-rosalen, r. (2010). methodology for sustainability strategic planning and management. industrial management & data systems, 110(2), 249-68. http://dx.doi.org/10.1108/02635571011020331 meti ministry of economy, trade and industry, (2007). guide for material flow cost accounting (ver.1). environmental industries office, environmental policy division industrial science and technology policy and environment bureau, japan. möller, a. & prox, m. (2008). from material flow cost accounting to mfa and lca, proceedings of the 8th international conference on ecobalance, tokyo. nakajima, m. (2004). on the differences between material flow cost accounting and traditional cost accounting. kansai university review of business and commerce, 6, 1-20. nakajima, m. (2006). the new management accounting field established by material flow cost accounting (mfca). kansai university review of business and commerce, 8, 1-22. nakajima, m. (2009). evolution of material flow cost accounting (mfca): characteristics on development of mfca companies and significance of relevance of mfca. kansai university review of business and commerce, 11, 27-4.6 onishi, y., kokubu, k. & nakajima, m. (2009). implementing material flow cost accounting in a pharmaceutical company. in: schaltegger, s., bennett, m., burritt, r.l., jasch, c. (eds.), environmental management accounting for cleaner production. springer, netherlands, pp.395-409. serdar ulubeyli, (2013). drivers of environmental performance of cement plants. industrial management & data systems, 113(8), 1222-1244. http://dx.doi.org/10.1108/imds-01-2013-0007 stacks, d.w. (2010), primer of public relations research, second ed. the guilford press, new york. sulong, f., sulaiman, m., & norhayati, m. a. (2014). material flow cost accounting (mfca) enablers and barriers: the case of a malaysian small and medium-sized enterprise (sme). journal of cleaner production, http://dx.doi.org/10.1016/j.jclepro.2014.08.038 microsoft word 8606-31233-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 227 corporate governance and bank competition empirical study on the jordanian commercial banks listed in amman stock exchange over the period (2001-2014) dr abdulrahman hashem assistant professor, department of banking and finance al isra private university mr. fadi ayoub lecturer, department of banking and finance al isra private university dr. haitham bani ata assistant professor, department of administration and finance university college of ajloun balqa’ applied university received: nov. 5, 2015 accepted: dec. 9, 2015 published: december 9, 2015 doi:10.5296/ajfa.v7i2.8606 url: http://dx.doi.org/10.5296/ajfa.v7i2.8606 abstract the purpose of this paper is to identify the effect of corporate governance implementation on the commercial banks’ competition in jordan. bank competition is tested by using panzar and rosse h statistics model and the researchers applied it on the collected data into two periods of time (2001-2007 and 2008-2014), taking into consideration that corporate governance was first implemented in the jordanian banking sector on 31/12/2007. the researchers used mann-whitney test to compare the results of both time phases. the results showed insignificant effect of corporate governance on bank competition that can be linked to certain reasons including the immaturity of corporate governance’s implementation in the jordanian banking sector, the socio political upheavals that affected jordan, and the differentiation of bank services between banks led to a more monopolistic behavior. this paper urges other researchers and practitioners to take their role into updating and modifying corporate asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 228 governance to positively enhance bank competition taking into account the political turbulences in the neighboring countries and the movement of cash across the region and passing the country. keywords: bank competition, panzar and rosse h statistics, monopoly, monopolistic competition, corporate governance asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 229 1. introduction the major collapses of high profile companies in leading countries, have produced a need to create general systems, processes and practices to control and direct any firm or institution. consequently, corporate governance was launched in early 2002 to retrieve the shareholders’ trust against self-interest directors and managers. many scholars tried to limit the reasons despite the fact of its well-known reasons. according to becht and others: “why has corporate governance become such a prominent topic in the past two decades or so and not before? we have identified, in no particular order, the following reasons: i) the worldwide wave of privatization of the past two decades; ii) pension fund reform and the growth of private savings; iii) the takeover wave of the 1980s; iv) deregulation and the integration of capital markets; v) the 1998 east asia crisis, which has put the spotlight on corporate governance in emerging markets; vi) a series of recent usa scandals and corporate failures that built up but did not surface during the bull market of the late 1990s” (becht et al, 2002) in the beginning of the 21st century, the financial crises had put the developed countries in a time race to apply corporate governance on the banking industry to maintain its financial and managerial stability. this is when basel committee had launched principles to help protect banking discipline. it is well known that the role of the banking sector is essential in well working economies, where financial systems have a tendency to advance around it, trying to achieve economies of scale to balance the expenses of gathering and preparing data outlined to lessen uncertainty and encouraging a productive distribution of financial resources. banks tend to work as quality controllers of capital looking for fruitful ventures, guaranteeing higher returns and speeding up yield growth. however, a competitive banking system must be maintained to ensure the integrity of banks’ role in monetary intermediation to channel funds into investments that will result in higher economic growth rates and increase of shareholders’ wealth. since the beginning, the jordanian economy is still facing different challenges and difficulties due to numerous socio-political-economic factors including the political upheavals in the region, rising unemployment rates and major dependency on the remittances from the gulf countries. the growth of banks and its important role in stabilizing the national economy is not only due to their financial performance, but also to the willingness amongst the industry leaders to focus on continuous alterations in the stakeholder concerns. the central bank of jordan (cbj) is the key player in enhancing corporate governance. in 2004, the cbj issued the bank director’s handbook of corporate governance, and continued its efforts to enhance corporate governance in the jordanian banking system by issuing new instructions that are in line with the principles of the basel committee on banking supervision, the organization for economic cooperation and development (oecd), and the financial stability board to address loopholes exposed by the global financial crisis in financial institutions' governance. on the other hand, bank competition was and still one of the hot topics to be discussed and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 230 tested. one of the most important models, that were basically developed to quantitatively assess the competitive conditions in the banking sector, is the panzar rosse approach. panzar rosse h statistics model gauges the degree of banking contestability in terms of the variations between banks’ pricing strategies in response to changes in their input costs. in this study, the researchers intend to study the degree of competition before and after implementing corporate governance in the jordanian commercial banks between 2001-2014, by using panzar – rosse h statistics model in order to answer the main question whether corporate governance affect the degree of bank competition in the jordanian commercial banking sector or not? 1.1 corporate governance definition: there are several definitions of corporate governance but one of the most comprehensive definitions that the researchers find adequate is the following statement “corporate governance refers to a set of rules and incentives by which the management of a company is directed and controlled. good corporate governance maximizes the profitability and long-term value of the firm for shareholders", (khumani et al., 1998). 1.2 research objective: the objective of this experimental research is centered on determining the effect of corporate governance on the degree of competition of the jordanian commercial banks. the result will be highly important in recognizing the effect of corporate governance on bank competition and its role in reducing the gap between banks and unifying the base of processes and standards. what distinguishes this study from others is the use of panzar and rosse h statistics in determining the degree of competition in the absence and presence of corporate governance. 2. literature review: the researchers aim to identify two groups of previous literatures. the first group is focused on bank competition review (panzar and rosse approach): panzar and rosse (1977) panzar and rosse (1987) had issued certain models to measure the degree of competition. h statistics computes the percentage change in a bank’s equilibrium revenues caused by one percent change in the entire bank’s input prices. one of the first uses of the rosse-panzar system to banking sector was a multiple cross sectional studies by shaffer (1982), which inspected the competitive situation for a sample of unit banks in new york by evaluating a bank revenue equation in which total revenue is tested by variables like interest revenue, the unit prices of labor, capital, bank funds, and other variables affecting the long-run equilibrium bank revenues. shaffer used a regression relating the return on bank assets to bank input prices. his results found h ranging from .32 to .36 for the competitiveness test. nathan and neave (1989) used the same equation to test competition in canadian banks, trust companies, and mortgage companies between 1982-1984. the results showed perfect competition in the year 1982 as the value of h = 1.058, however in 1983 and 1984 they found asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 231 h =0.680 and 0.729, respectively which indicates monopolistic competition. lloyd-williams et al, (1991), tested panzar and rosse formula on a sample of 72 japanese commercial banks from1982 to 1988. they found that the 1986 values of h range between -0.004 and -0.006, which are both significantly different from zero and unity. they are, therefore, unable to reject the monopoly or hypothetical variations short-run oligopoly hypotheses for japanese commercial banks. however, for 1988 the values of h range between 0.245 and 0.423, suggesting monopolistic competition. bikker and haff (2002) examined panzar and rosse approach on banking industry in 23 countries. in order to distinguish competitive behavior on local, national and international markets, for each country, three sub-samples were taken: small or local banks, medium-sized banks and large or international banks. for all 23 countries showed monopolistic competition mamatzakis et al (2005) measured the degree of concentration and competition in banking sector in the south eastern european region over the period 1998-2002. they separately applied pr on two dependent variables which are interest revenue and total operating revenue. the results showed monopolistic competition with a significant regular improvement in terms of competition. hashem (2006) studied the commercial banks in jordan in the period of 1997-2004. pr approach was applied and showed monopolistic competition where h statistics = .654. this study recommended large banks to split into smaller ones in order to enhance the competitiveness. fayoumi et al (2012) studied bank competition in mainly six middle eastern and north african (mena) countries for the period from 1998 to 2007. the results reveal that the banking market structure can be characterized as monopolistic competition. one of the recommendations of this study was to enforce and enhance the role of corporate governance in the banking sector. since berle and means (1932) indicated on the importance of separating ownership and control in modern corporate structure, most literature concentrated on the well known agency problem between shareholders and managers without much of focus on common corporate governance codes to be applied inside corporations and banks. the second group is this study’s literature is focused on linking competition to corporate governance. one of the first studies that linked competition and corporate governance is the study of allen, gale (1999). they examined the us, uk, france, germany and japan markets and their results showed that in us and uk markets, the threat of take-over ensures that managers act in the shareholders’ interest. while in france, germany and japan markets, it’s suggested that the banks and other institutions should act as monitors. however they argued that neither system is effective as competition between firms may be more effective in ensuring that the resources are used efficiently. ciancanelli, gonzalez (2000) aimed to demonstrate the limitations of the assumption saying that banks conform to the concept of the firm used in agency theory. they aimed also to asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 232 propose an alternative conceptual framework more suitable to its analysis. they argued that commercial banks are distinguished by a more complex structure of information asymmetry arising from the presence of regulation. their study showed that regulation limits the power of markets to discipline the bank, its owners and its managers and they argued that regulation must be seen as an external force, which alters the parameters of governance in banks. crespi et.al (2004) examined two issues in the corporate governance applied in spanish banks. the two main questions are: does poor economic performance activate governance interventions that favor the removal of executive directors and the merger of non-performing banks? and does the relationship between governance intervention and economic performance vary with the ownership form of the bank? the results of this study found a negative relationship between performance and governance intervention for banks, however the results changed for each form of ownership and each type of intervention. product-market competition compensates for those weaker internal governance mechanisms and non-performing banks are not totally protected from disappearing. levin (2004) discussed two special characteristics of banks that make them special in practice: low transparency than other industries and greater government regulation. the results showed that it is important to strengthen the ability and incentives of private investors to exert governance over banks rather than relying excessively on government regulators. price et al (2011) studied the relation between compliance with the code of ‘best’ corporate practice and performance. the code was developed to offer information to market participants regarding the governance strength of firms trading on the mexican stock exchange. there results indicated that compliance generally not linked with improved performance, suggesting that monitoring alone is not enough to bring about fundamental changes. chaudhry (2012) examined the interaction of product market competition with corporate governance variables affects the performance of a corporation in the indian market. this study importantly concluded that: greater competition tends to show up in greater variations in standards of firms-level governance both within countries and among countries. firms operating in a competitive environment need to display superior corporate governance quality in comparison to their peers in order to gain access to resources and to enhance their credibility. also, it is the tendency to increase relative corporate governance scores that drives the observed divergence. 3. hypothesis of the study: this study shall test the following main null hypothesis: h01: there is no effect of corporate governance on the degree of competition in the jordanian commercial banking sector in the period 2001-2014 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 233 4. research methodology: this research studies the effect of corporate governance application and the degree of bank competition. panzar and rosse h statistics model was applied on the sample comprised of 13 commercial banks operated in the period between 2001 and 2014, and linked it to corporate governance application which effectively took place on 31/12/2007 according to the central bank of jordan. (code of corporate governance) the followed methodology applied panzar and rosse h statistics model on the sample by calculating the h statistics (i.e., the level of competition) every year from the year 2001 until 2014. the researchers divided the study into two phases: the first one is from 2001 – 2007 to show the degree of competition before implementing corporate governance, while the second phase took the period from 2008 – 2014 and tested the degree of competition after implementing corporate governance. the panzar and rosse (pr) model is as follows: ln trass it = a + h1 ln pl it + h2 ln pk it + h3 ln pf it+ e ln ass it + f ln ln ass it + g ln cap ass it + k ln ibtdep it………………………………………………………...(1) for t=1,…..,t where t is the number of periods observed (6 years), and i=1,….. , i, where i is the total number of banks (13 banks). where: the dependent variable: trass: total interest revenue per jordanian dinar (jd) of assets. the independent variables: pl: is the personnel expenses per jordanian dinar of assets (proxy for unit price of labor), pk: is the operating expenses per jordanian dinar of fixed assets (proxy for unit price of capital), pf: is the ratio of annual interest expenses to total funds (unit price of funds). the control variables: ass: is the bank assets, (bank's size) ln ass: is the loans to assets ratio, cap ass: is the total capital (equity) to assets ratio, and ibtdep: is the interbank deposits to total deposits. that is, the ratio of the bank's deposits in other banks to the total deposits in the bank. ln: is the natural logarithm, was applied after applying the pr model onto both phases, the researchers shall compare the h statistics results for each year to determine whether corporate governance affected the degree of asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 234 competition or not by using mann whitney test figure 1. variables relationship diagram source: by the researchers under the pr framework, the h statistic is equal the sum of the elasticities of the revenue with respect to the three input prices: h = h 1 + h 2 +h 3 results are interpreted as follows: 5. results: h01: there is no effect of corporate governance on the degree of competition in the jordanian commercial banking sector in the period 2001-2014 pl: (personnel expenses per jd of assets) pk: (operating expenses per jd of fixed assets) pf: (ratio of annual interest expenses to total funds) trass: (total interest revenue per jd of assets) ass: (bank assets) cap ass: (total capital to assets ratio) ln ass: (loan to assets ratio) ibtdep: (interbank deposits to total deposits) dependent variable control variables independent variable h = 1 perfect competition 0 < h < 1 monopolistic competition h ≤ 0 monopoly (or perfectly collusive behavior). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 235 this study used the mann-whitney test using spss package, to analyze the data collected from the bank annual reports from 2001-2014 provided by jordan securities commission (jsc). table 1. degrees of competition according to pr h statistics year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 h stat. 0.344 0.532 1.083 0.345 0.45 1.391 0.113 4.668 -0.159 -5.241 -1.816 0.352 0.616 0.477 after applying the regression model of pr h statistics on each year in the sample, the researchers reached to the above degrees of competition (the sum of h1, h2 and h3). mann-whitney test is used to test above hypothesis and it is found that wilcoxon w = 47.000 is not significant at 0.05 level so that there is no effect of corporate governance on the degree of competition in the jordanian commercial banking sector over the period 2001-2014. table 2. variables descriptive analysis n mean rank sum of ranks h .00 7 8.29 58.00 1.00 7 6.71 47.00 total 14 table 3. hypothesis test h mann-whitney u 19.000 wilcoxon w 47.000 z -.703 asymp. sig. (2-tailed) .482 exact sig. [2*(1-tailed sig.)] .535a asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 236 figure 2. variables relationship chart. above chart reflects the differences in pr h statistics and are not related to applying corporate governance 6. conclusions: this paper examines the effect of corporate governance on the degree of competition in the commercial banking sector in jordan. this paper used panzar and rosse model to test h statistics that indicates the degree of competition in each year in this study. the degree of competition was compared between two phases: the first one is before implementing corporate governance (between 2001-2007) and the second one is after implementing corporate governance (2008-2014). the results showed some more consistency in the first phase as the maximum level of competition that exceeded 1 to achieve perfect competition, but also declined to as low as 0.113 (monopolistic competition). on the other hand, the second phase witnessed great variations in the results as the minimum level of competition was -5.241, which indicates perfect monopoly and the maximum was 4.668. the aim of this result is to show if there is an effect of corporate governance on the degree of competition. this should lead us to a question, whether corporate governance is doing its job in enhancing the competition between commercial banks? apparently, the current version of corporate governance is not playing the expected role that is expected from it. this may be linked to certain reasons: corporate governance application is still considered immature. although the central bank of jordan claims that the starting date of corporate governance was in early 2008, the real implementation in practice would have taken few years after 2008. the financial services provided by banks are sometimes monopolized. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 237 reference to hashem (2006) study, one of his recommendations was about splitting banks to reduce assets’ sizes because of the negative relationship between total bank assets and total interest revenue. since corporate governance codes add more discipline on market entrance, which may negatively affect the competition and drive it toward monopoly such as in our case here. corporate governance regulated the market and added more discipline to banks internal procedures. this added more pressure on banks to rearrange its procedures to operate in a safer environment. this resulted by gaining the trust of investors, shareholders, and depositors. this gave advantage to certain banks to enhance their position in the market and increase their share in the market. the socio-political upheavals including the syrian war (refugees problem), had led to increase the challenge between banks in terms of deposits and loaning benefits the differentiation of bank services and products between banks, added a possible significant affect on attracting deposits and loan applications, therefore more monopolistic behavior.. 7. recommendations the researchers recommend the following: enhance corporate governance awareness in the banking industry. future research can compute the competition level in presence of foreign banks as well as the islamic banks. exploring the corporate governance layers that affect the bank competition and modify according to the actual need of the banking sector. references al-fayoumi, n., & abuzayed, b. (2010). competitive conditions in mena banking markets. allen, f., & gale, d. (1999). corporate governance and competition. university of pennsylvania. becht, m., bolton, p., roell, a., 2002. corporate governance and control. ecgi-finance working paper, 2. bikker, j.a., haaf, k. (2002) measures of competition and concentration in the banking industry: a review of the literature (electronic version). economic & financial modeling, 9, 53-98. central bank of jordan. (2007). corporate governance code for banks in jordan. chaudhry, y. (2012). corporate governance in india. journal of resources, energy and development, 9(1), 52-53. ciancanelli, p., & reyes-gonzalez, j. a. (2000). corporate governance in banking: a asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 238 conceptual framework. available at ssrn 253714. http://dx.doi.org/10.2139/ssrn.253714 crespı́, r., garcı́a-cestona, m. a., & salas, v. (2004). governance mechanisms in spanish banks. does ownership matter?. journal of banking & finance, 28(10), 2311-2330. http://dx.doi.org/10.1016/j.jbankfin.2003.09.005 hashem, a. (2006). competitive conditions in the jordanian banking sector: empirical study. (unpublished master's thesis). university of jordan, jordan. levine, r. (2004). the corporate governance of banks: a concise discussion of concepts and evidence (vol. 3404). world bank publications. http://dx.doi.org/10.1596/1813-9450-3404 lloyd-williams, d.m., molyneux, p., & thornton, j. (1991). competition and contestability in the japanese commercial banking market. (electronic version). institute of european finance research papers in banking and finance, 16. mamatzakis, e., staikouras, c., & koutsomanoli-fillipaki, n. (2005). competition and concentration in the banking sector of the south eastern european region (electronic version). emerging markets review, 6, 192-209. http://dx.doi.org/10.1016/j.ememar.2005.03.003 mccraw, t. k. (1990). berle and means. price, r., román, f. j., & rountree, b. (2011). the impact of governance reform on performance and transparency. journal of financial economics, 99(1), 76-96. http://dx.doi.org/10.1016/j.jfineco.2010.08.005 panzar, j.c., & rosse, j.n. (1987). testing for monopoly equilibrium (electronic version). journal of industrial economics, 35, 443–456. http://dx.doi.org/10.2307/2098582 rosse, j.n., & panzar, j.c. (1977). chamberlin vs robinson: an empirical study for monopoly rents. (electronic version). bell laboratories economic discussion paper shaffer, s. (1982). a non-structural test for competition in financial markets, proceedings of a conference on bank structure and competition. federal reserve bank of chicago, usa, pp. 225–243. stone, a., k. hurly, and r. khumani. (1998). business environment and corporate governance: strengthening incentives for private sector performance, the world bank/imf annual meetings. copyright disclaimer copyright for this article is retained by the authors, with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 11492-42293-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 1 a literature review on ohlson (1995) pooja kumari research scholar, indian institute of technology, kharagpur (india) e-mail: pooja.kumari@vgsom.iitkgp.ernet.in chandra sekharmishra associate professor, indian institute of technology, kharagpur (india) e-mail: csmishra@vgsom.iitkgp.ernet.in received: july3, 2017 accepted: august2, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11492 url: https://doi.org/10.5296/ajfa.v9i2.11492 abstract this paper presents the review of the literature focussed on ohlson, j.a., 1995. (earnings, book values and dividends in security valuation. contemporary accounting research 11, 661—687). firstly an overview then theoretical and empiricalresearch directly related to this work are presented, based on articles cited this work. further, some bibliometric facts about the study are added. the bibliometric analysis is based on twelve reputed journals of accounting: journal of accounting research, journal of accounting and economics, the accounting review, contemporary accounting research, review of accounting studies, journal of business finance and accounting, accounting horizons, the european accounting review, journal of accounting auditing and finance, accounting and business research, a journal of accounting, finance and business studies and the international journal of accounting. our findings of bibliometric facts come up with most influenced author, university and country by ohlson (1995) and followed by keyword analysis. keywords: ohlson (1995); theoretical review, empirical review; bibliometric facts, keyword analysis asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 2 1. introduction the active investor is usually interested in reported financial statements and their analysis to evaluation the fundamental value or the exact worth of the firm. on the other side, according to international accounting standard board (1989), the primary aim of financial reporting is to offer relevant accounting information to the participants of thecapital market. so that they can use it for investment decision-making. basically, ohlson (1995) given a firm valuation concept linking these two sides. in this paper, we have reviewed the literature revolves around the landmark study of ohlson (ohlson, j.a., 1995. earnings, book values, and dividends in security valuation. contemporary accounting research 11, 661—687) which comes under the area of capital market-based accounting research (kothari, 2001). this work got immediate recognition with avery high number of citation. according to google scholar till date, the number of citation of this study is around 5000 and according to scopus, it’s around 1300. the top accounting and financial journals are paying attention to this study. even in previous bibliometric studies, this study is found among most cited work in the field of financial accounting andcome into sight with multiple topics or methods (chan & liano, 2009; dunbar & weber, 2014). the approach we adopted for this review involves a study of the literature using ohlson (1995) as a base study. we have reviewed previous literaturebased on assumptions, theory, and results ofohlson (1995). then, we have discussed the theoretical and empirical evaluation, criticism and appraisal of this study so far. thereafter, we have investigated some bibliometric facts about o’95 to verify qualitative findings. the primary objective of this review is to construct an academically valuable work for doctoral students, researchers, and academicians. this study extends the previous comprehensive explanation and discussion by lundholm (1995) and lo & lys (2000).becausein their studiesthey haveprovided basic concept and doubts about ohlson (1995) in-depth. the most of the papers reviewed in this study are from last two decades. in accumulation to contribute the detailed review of research on ohlson(1995) (hereafter o’95).we have discussed the origin of important ideas and development. basically, we havediscussed the theoretical studies on development and addition in o’95. since validation of a theory is incomplete without empirical analysis. therefore, we included some studies based on empirical analysis also. theaim of thisstudy is to provide hostile explanations for the findings from the literature. this study leads towards unresolved questions and direction for further research. basically, o’95 belongs to the area of capital market-based accounting research (cmbar). this areastudies the relation between accounting information and capital market (kothari, 2001). this area of research was embarked by ball & brown (1968) and beaver (1968). they found anassociation between abnormal return and stock prices in the months before and after the dates of earning announcement and unexpected increment in the trade volume of securities during the week of earnings announcements.thereafter numerous theoretical and empirical research work has been carried out to investigate this relation from different prespectives (beaver & dukes, 1972; foster, 1977; bathke & lorek,1984; asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 3 lev, 1989; livnet & zerowin, 1990; lev & thiagarajan, 1993). then o’95 found mathematical validation of this relation with some assumptions and recognized as a seminal work. however, continuously this work has been criticized as well as supported by different authors. even a number of expansion and improvements were proposed in the original model (feltham&ohlson, 1995, 1996; ohlson, 1999, 2005, 2009; ohlson & juettner-nauroth, 2005). we have consciously decided to emphasis on o’95 model because two reasons. first, it is extensively used valuationmodel in thecapitalmarket-based accounting literature. second its high rate of citation. the outline of the review is as follows: section 2 consist theoretical background of o’95andpresents basic assumptions and the model.the subsections of this section are focussed towardstheoretical literature on every assumption and addition ino’95. section 3 presents empirical studies based on o’95. section 4 provides some bibliometric facts about o’95. section 5 consist summary, limitations, and conclusions. 2. theoretical background and summary of o’95 model the o’95 study is famous by the name of residual income valuation model andconnected firm valuation with residual income. although ohlson (1995), bernard (1995) & biddle et al. (1997) concluded that the idea of residual income valuationemerged long back, buto’95deserve acknowledgment for successful structured and rigorous presentation of residual income valuation model (kothari, 2001). early financial valuation theories state that the value of the firm’s equity is the present value of all future dividends, or free cash flows to equity, which defines themarket value of thefirm and helps in decision making. o’95 determined the market value of thefirm in association with accounting values. there were three central assumptions in o’95i.e. first assumptions considered an economy with risk neutrality, homogenous beliefs of individual and non-stochastic interest rates, which results in no inter-temporal arbitrage price. second assumptions consideredclean surplus relation (hereafter csr) among book value, income, and dividend. the third assumption referred as linear information dynamics (hereafter lid). according to thefirstassumption, themarket value of the firm is equaled to the present value of all expected future dividend (pved), with the given consideration of non-stochastic interest rates, risk neutrality, and homogeneous beliefs. this assumption leads towards dividend discount model (ddm) for valuation of equity. mv = ∑ ( )( )∞ (1) where mv = market value of equity at date t;e(d ) = expected dividend received at date t+i; r =discount rate assumed to be constant. the second assumption imposes the csr as present year book value equals to previous year book value plus earnings minus dividends. and this relationship is expressed as follow: b = b + x − d (2) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 4 where b = book value of equity at date t; x = earnings for period t;d = dividends paid at date t. further, in this assumption the right-hand side is primitive in order that dividend hasa negative effect onpresent year book value but has no effect on present earnings. normalearnings of the firm can be defined as the multiplication of previous year-end book value and cost of capital of the firm. then after deducting this normal earning from actual earning of current year results as abnormal earning of the firm. x ≡ x − rb (3) where x = abnormal earnings for the period t. a simple algebraic calculation with eq. 2 & 3 yields with this expression: d = x + (1 + r)b − b (4) and then from this expression, the value of dividend replace with d in eq 1. this ultimately results with residual income valuation (hereafter riv). mv = b + ∑ ( )∞ (5) this model implies that the value of the firm is equals to the sum of thebook value of equity and the present value of expected abnormal earnings. the particular fact of o’95model is that it will not be affected by the choices of accounting as in lundholm (1995). the third and the most important assumption is linear information dynamics, which explains the time series behavior of abnormal earnings. lid establishes a linkage between firm’s intrinsic value and current information. according to o’95 lid is the time series behavior of abnormal earnings can be express as follows: x = ω x + v + ε (6) v = γv + ε (7) where:x = abnormal earnings for the period t; v = other information; ω = persistence parameter of abnormal earnings ( 0 ≤ ω < 1) ; γ = persistence parameter of other information (0 ≤ γ < 1) ; ε , ε = error terms. in above expression, o’95 assumed that abnormal earnings follow persistent and autoregression, a first-degree ar (1) process. and there is another variable i.e. other information, which also affects future abnormal earnings. then, o’95 combine riv with lid and come up with the given valuation function: mv = b + α x + β v (8) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 5 where α = ω ω &β = ( ω )( γ) next, we discuss the literature or comments given by different authors with reference to o’95. it consists assumptions, concepts, and results of o’95 being questioned or supported by furtherliterature. 2.1 assumption 1: risk neutrality, non-stochastic interest rates, andhomogeneous beliefs since the work of o’95investigated how equities can be price based on accounting data. this literature assumes risk neutral investors to keep the things simple and to avoid the issue of pricing risk.sorisk-free rate was considered as adiscounting factor. but because of this assumption, the model lacks the theoretical foundation in case of stochastic interest rate (feltham &ohlson, 1999). then a general theoretical version of the model was given by feltham and ohlson (1999). in risk formula, they incorporated stochastic interest rate to calculate discount factor and satisfies the claims of modern finance theory. further ang& liu (2001) extended feltham & ohlson (1999) and have given an affine model integrates stochastic interest rates and risk aversive investors which yielda non-linear association between book value and market value. gode & ohlson (2004) assimilatedo’95 valuation framework with time-varying interest rates. they have assumed risk neutral market and did not include any risk adjustment. however, lyle et al. (2013) extended feltham and ohlson (1999) and considered dynamic expectations for systematic risk in the market. they have suggested to include firm fundamental variables and unobservable covariance in the cost of capital. whereas, know (2001) considered asymmetrically informed investors and found that accounting values are associated with market values. even in an empirical study, kirkulak & balsari (2009) concluded that inflation-adjusted rates can create different risk assessment for the firm but inflation adjusted rates were not proofed to be the substitute, it can only be the complementary to historical cost rates. 2.2 assumption 2: clean surplus relationship (csr) this assumption described clean surplus relation is an accounting system in whichcurrent year book value is equal to previous year book value plus earnings minus dividend, and capital contribution is considered as a negative dividend. dividend payment affects current book value negatively but not current earnings o’95. this assumption was the only constraint on the accounting system in o’95.brief & peasnell (1996) reviewed the supporting and opposing literature of csr for income recognition. supporting literaturesuggests that income should not include non-persistent items because these items do not have predictive ability, for example, increase or decrease in shareholders’ equity.stark (1997) concluded that in csrclean surplus earnings have a central role in firm valuation and forecasting of clean surplus earnings, only if the valuation coefficient of book value and dividend are equal. in this condition combined information of book value and dividend is adequate for valuation, instead of separate information. csr is required to get riv from pved.with given csr, riv model is equivalent to ddm. rejecting riv model means putting question on ddm. so riv model cannot be asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 6 eliminated,and same is with its assumptions of pved and csrbecause there is no specific direction given in riv model for the calculation of endless series of expected abnormal earnings. however riv modelneed impossible data requirement for empirical testing (lo & lys, 2000). ohlson & juettner-nauroth (2005) expressed the role of earnings per share in equity valuation without assuming csr. they replaced book value with next period capitalized earnings and entail only successive abnormal earnings growth to estimatefirm valuation. further, the model given by ohlson & juettner-nauroth (2005) have found comparatively more consistent in the markets where clean surplus deviations are wide-ranging, but the estimated value of the firm may differ from the actual market value because of various different assumptions of csr in two model (lai, 2015).in addition to csr deviation, ohlson (2005) and ohlson & gao (2006) concluded that in o’95 book value shows negative bias in thelinewith conservatism. however, ohlson & juettner-nauroth (2005) model exempted book value, which is more consistent. because possibly in one particular way forecasted earnings are not steadily biased. further, skogsvik & juettner-nauroth (2013) also concluded that ohlson & juettner-nauroth (2005) model is more reliable than o’95 model under some restrictions of positive expected conservatism bias. in spite of benefits of dropping the csr assumptions and including conservatism bias of book value in that place, penman (2005) concluded that measuring value after dropping book value can cause loss of information given in balance sheet. balance sheet information’s helps to increase the precision of forecasting of earnings. furthermore, in ohlson & juettner-nauroth (2005) model, the value of the firm is fixed with forecasted capitalized future earnings, which comprises transitory earnings and results to greater forecasting error in future earnings. moreover (lo & lys, 2000) calculated the difference between comprehensive income and reported income in csr and concluded that the actual difference is dirty surplus. usual examples of dirty surplus flows are minimum pension liability adjustment, profit& loss on securities available for sale, currency conversion and profit and loss on revaluation of theasset. the practice and study of dirty surplus accounting are growing from years even examined in a temporary manner, basically coming up as a debatable accounting topic (barker, 2004).o’95 is eye catching because it relates firm value with accounting data. but how far it is true that o’95 really needs accounting in horse sense of the name? the answer would be no for the real existing accounting system. yes, csr which satisfies accounting system can do this. but satisfying csr will not result in the accounting system for which a common accountant think of (lo & lys, 2000).frankel & lee (1998) reframed csr in expressions of comprehensive income i.e. change in equity book value less capital contribution, especially for dirty surplus items. so it is concluded that what o’95 required articulation between book value and earnings within csr. 2.2 assumption 3: linear information dynamics lidmodeling is the biggest contribution of o’95 model (dechow, 1999). lid propose the time-series performance of abnormal earnings and the other information variable through two asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 7 equations given above. eq. 6 consist first information dynamics in which structure of ar (1) process for abnormal earnings is attractive, easy to understand, parsimonious and constant with empirical observations. this micro look discloses some implied assumptions (lo & lys, 2000). eq. 7 consist second information dynamics in which structure of ar (1) process for other information’s is simple and elusive (lo & lys, 2000). but o’95 have not provided much discussion on this information dynamics. the implication of lid equations consist some boundaries: abnormal earnings follow first-degreeautoregressioni.e. ar(1) process; with one lag other information starts to be integrated into earnings; and then gradually the effect of other information follows an ar (1) process. further leccadito & veltri (2014) applied regime switching model instead of ar (1) for abnormal earnings to assess thenon-linear relationship between financial variables and concludes that regime-switching model is able to give improved predictive ability over ar (1) process. o’95 show that the value of the equity can be symbolized as a linear function of book value and earnings. however, various studies questioned on this linearrelation (burgstahler & dichev, 1997; zhang, 2000; biddle et al., 2001) and indicated that linear valuation function is not grabbing the full effect of book value and earnings on equity value. burgstahler & dichev (1997) found that the effect depends upon the level of these variables, also found that non-linear and convex valuation function. further, zhang (2000) extendedo’95 by including endogenous investment decision and concluded that with endogenous investment decision equity value is shown to be non-linear in book value and equity. hao et al. (2011) tested their results empirically and shows how earnings and book value of equity are needful for investment growth valuation in non-linear relation. biddle et al. (2001) proposed an investment dynamics into o’95 model, under which capital investment is followed by profitability and found that the future abnormal earnings will be non-linear rather than alinear function of current abnormal earnings. whereas, ashton et al. (2003) proved this non-linear relation with adaptation and recursion value of equity. according to yee (2000), theunconditionalexpectation of abnormal earnings, other information, and disturbance termmakes abnormal earnings unconditionally zero.this results to, zero unconditional goodwill so that firm can earn only average cost of capital and expected net present value will be zero. thus, this model does not use for selection of project. the way to solve this is to allow for a constant term to make it with positive expected abnormal earnings. myers (1999) calculated intrinsic value of firms on the basis of present accounting data and future estimated lid parameters of o’95model based on annual past time-series data and concludes that in this way intrinsic value does not describe stock price superior tobook value of equity. using myers (1999) approach callen & morel (2001), revised lid hypothesis and includes ar (2) structure in abnormal earnings and found that the intrinsic value on the revised structure basis is not superior tointrinsic value based on the ar (1) structure. dechow et al. (1999) and myers (1999) were weak in estimation of thecost of capital to calculate abnormal earnings (morel, 2003) and corrected this drawback by estimating risk premium and firm level persistence parameters, which allows them to changecross-sectional wise cost of capital. she also examined the predictive ability of o’95 by risk premium and earnings asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 8 persistence parameters from both earnings dynamics and valuation equation and concluded that both are not consistent with o’95. many studies discussed conservatism with lid (feltham &ohlson, 1995; myers, 1999; ashton & wang, 2013; clubb, 2013; skogsvik & juettner-nauroth, 2013). from valuation model approach feltham & ohlson, (1995) asserted analytically that future cash flow of firm cannot be altered through conservative accounting policies, and ultimately does not affect the market value of the equity. further, ashton & wang (2013) found a link between linear unobserved and unbiased accounting system given in om and conservatively biased reporting system. whereas, skogsvik & juettner-nauroth (2013) examined how information dynamics can force o’95 to bring conservatively biased accounting numbers in model and conclude that the linear dynamics of abnormal earnings are associated with the time series behavior of conservative biases. clubb (2013) investigated that dividend displacement is visible in linear abnormal earnings dynamics when forecast dividend is associated with apositive coefficient. lid is the exact innovation of o’95 where abnormal earnings and other information variable track an autoregressive process with mean-revert to zero. this innovation is actually worthyfor theanalytic purpose, but it raises a general question of why abnormal earnings and other information variables are expected to mean-revert to zero (gregory et al., 2005). 3. empirical studies based on o’95 in order to check the validity of o’95 model number of empirical studies have been done on different markets and from different aspects. here in this section, we have focused on most discussed empirical studies in theprevious literature. the empirical testing and ability of o’95 model have been analyzed through two different links i.e. valuation links and predictive link. valuation link is used to assess the fundamental value of the firm by the use of valuation function (eq. 8). predictive linkassesses the forecasting capacity of the model to predict future abnormal earnings (eq 6&7) (giner & lniguez, 2006). o’95 is a landmark study in accounting research not only because it associate accounting numbers with stock prices in a systematic manner but it also widely accepted in empirical studies (collins et al., 1999; morel, 2003; barth et al., 2005;). according to callen & morel (2001), three prominent reasons appear behind it. first, the alternative modelsare not emphasizing on primitive accounting information. second through csr assumption, o’95 brings income statement into the picture of firm valuation. third in o’95 the value of the firm is derived from actual accounting variables i.e. book value and earnings, over which empirical research have a reasonable advantage. on the other hand,researchershave also found some loopholes in empirical testing of o’95 in both cross-sectional (dechow et al., 1999) and time-series (myers, 1999) model. partly their studies rejected the model as an inadequate explanation of stock prices. their conclusions raised different limitations of o’95 such as various assumptions of o’95 and the other information variable. in anempiricalaspect, the major limitation of o’95 is its “other information” a scalar variable in both predictive as well as valuation link (dechow et al. 1999). “other information” causes asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 9 loss of concreteness because this variable is unspecified.many researchershave dropped this variable for empirical testing (callen & morel, 2001; ota, 2002). this grounds to theempirical content of model. although “other information” is not directly recognizable, one can assume it by its expected influence ohlson (2001). whereas, some researchers have taken analyst forecast as a base to define “other information” variable (dechow et al., 1999; mccrae & nilsson, 2001; gregory et al., 2005; giner and iniguez, 2006; choi et al., 2006). table1. prior empirical studies tested validity of o’95 author country sample link other information methodology myers (1999) usa 1975-1996 predictive & valuation order backlog time-series dechow et al. (1999) usa 1976-1995 predictive & valuation based on analyst forecast cross-sectional barth et al. (1999) usa 1987–1996 predictive & valuation ignored time-series mccrae & nilsson (2001) sweden 1987-1997 predictive & valuation based on analyst forecast cross-sectional canel& morel (2001) usa 1969-1996 predictive & valuation ignored time-series ota (2002) japan 1964-1996 predictive & valuation ignored time-series gregory et al. (2005) uk 1976–2000 predictive & valuation based on analyst forecast cross-sectional barth et al. (2005) usa 1987–2001 predictive & valuation fitted value based on valuation function. cross-sectional giner and iniguez (2006) spain 1992-1999 predictive & valuation based on analyst forecast pooled cross-section/ time-series regression choi et al. (2006) usa 1950-1995 predictive & valuation based on analyst forecast pooled cross-section/time-series regression leccadito&veltri (2014) usa 1980–2011 predictive & valuation ignored time-series table 1 consists the key features of the prior empirical literature which verify the success of o’95 model. most of the studies have been done inthe usa. both predictive and valuation link have been analyzed in these studies by using respective valuation functions. on the subject of valuation link, empirical studies show that stock prices are undervalued in all the markets. in many empirical studies the inclusion of “other information” variableprovides more accurate results(myers, 1999; dechow et al., 1999; mccrae & nilsson, 2001; gregory et al., 2005; barth et al., 2005; giner & iniguez, 2006; choi et al., 2006). however in some studies, the “other information” variable was dropped for thesake of simplicity (barth et al., 1999;canel& morel, 2001; ota 2002;leccadito&veltri, 2014). for methodology, no clear priority has been given in theliterature. myers (1999), barth et al. (1999), canel & morel (2001), ota (2002), and leccadito & veltri (2014) have tested the model on time series data basis and dechow et al. (1999), mccrae & nilsson (2001), gregory et al. (2005), and barth et al. (2005) used cross-sectional data for testing. whereas giner &i niguez (2006) and choi et al. (2006) used pooled time-series cross-sectional regressions. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 10 these empirical studies were precise to empirical testing of o’95. apart from these studies number of other studies has been done to find value relevance of accounting information in different markets with o’95 model (collins et al., 1997; francis & shipper, 1999;brown et al., 1999; lev &zarowin, 1999; kim &kross, 2005; ballas, &hevas, 2005; balachandran & mohanram, 2011; shrivastava, 2014). 4. bibliometric facts about o’95 as we have discussed earlier o’95 is one of the most cited work in accounting literature from last two decades. in this section, we will discuss some bibliometric facts about o’95. we have consideredcitation-based analysis to recognize the diversified influence of o’95 in accounting research. we have identified various subsequent accounting or non-accounting research work influenced by o’95. this work will provide a foundation for future research in order to connect o’95 with different sub-fields and helps to find research gaps and questions. it will provide afactual base to find the web of links between o’95 and other sub-fields so that one can think of different angles to analyze these links. generally, bibliometric studies provide a language for academic communication because these studies suggest what should be read by students and researchers and how to structure research work. so this study is planned to provide a worthy guide to ph.d. scholars and researchers want to work on this specific field of accounting literature. our process is based on articles in which o’95 was cited in following twelve journals from 1995 to 2015: journal of accounting research (jar), journal of accounting and economics (jae), the accounting review (tar), contemporary accounting research (car), review of accounting studies (ras), journal of business finance and accounting (jbfa), accounting horizons (ah), the european accounting review (tear), journal of accounting auditing and finance (jaaf), accounting and business research (abr), a journal of accounting, finance and business studies(abacus) and the international journal of accounting (tija). we refer these articles as “citing papers”. this process results intotal 449 citing papers. we prepared individual author, university affiliation to authors, and country list to identified most indulgedindividual author, university affiliation to authors, and country worked on o’95 model. then we have prepared the list of all keywords in cited papers and divided those keywords under different subfields. this process results in various beneficial features. first, it helps to identify various subfields of accounting influenced by o’95, such as firm valuation, earning management, value relevance of accounting information, etc. second, it is not limited to journal articles, conference papers, notes and speeches are also included. finally by grouping keywords in different subfields of accounting research, we provide a base to connect various subfields with one another through o’95. the main benefit of citation based study is quantitative parameters to measure the impact of a particular work on successive research. however, citations are not the perfect parameter to measure theimpact of particular work. because citation could be affected by self-citation or criticism of that particular work. citations are also affected by planned actions by authors like authors may try to cite the work of renowned researchers. brown & gardner (1985) discussed asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 11 these issues and concluded that while citation-based studies are not perfect but can be a beneficial tool to measure theimpact of published work. citation-based studies havean extended history (garfield, 1972, 1979). in accounting also, we have some examples of this kind of studies (bonner et al., 2006; chan et al., 2009; oler et al., 2010; dunbar & weber, 2014). some studies identified most influential journals (chen et al., 2009; bonner et al., 2006), development in accounting research (oler et al., 2010), andmost influential authors in different fields of accounting research (dunbar & weber, 2014) through citation-based studies. even dunbar & weber (2014) concluded that o’95 is one of the most influential study in thefinancial topical area. 4.1 sample selection we have selected following twelve journals: jar, jae, tar, car, ras, jbfa, ah, tear, jaaf, abr, abacus, tija. we selected jar, jae, tar, car and ras because they usually count as the top journal of accounting (bonner et al., 2006, chen et al., 2009; oler et al., 2010). to confirm that we are taking sufficient sample of citing papers,we added some prestigious and specialized journals in financialtopical area i.e. jbfa, ah, tear, jaaf, abr, abacus, and tija. because, according to dunbar & weber (2014), o’95 also comes under financial topical area. we have collected articles from these twelve journals from 1995 to 2015 through scopus and web of sciences. then we have selected the articles in which o’95 was cited from all twelve journals. this process results with 449 citing papers with given number of citing papers (fig. 1) from specific journals. figure 1. journal-wise number of citing papers note:, journal of business finance and accounting (jbfa), review of accounting studies (ras), the accounting review (tar), contemporary accounting research (car), journal of accounting and economics (jae), journal of accounting research (jar), accounting and business research (abr), the international journal of accounting (tija), a journal of accounting, finance and business studies (abacus), journal of accounting auditing and finance (jaaf), accounting horizons (ah), and the european accounting review (tear). thereafter we compiled the list of individual authors, university, country and keywords of these 449 citing papers. finally, we have used this dataset to decide most influenced 76 68 62 39 39 37 30 26 23 18 17 14 0 10 20 30 40 50 60 70 80 n o. o f c iti ng p ap er s name of journals asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 12 individualauthors, university affiliation of author’s, and country by o’95. we have grouped keywords under specific subfields to know the most influenced subfield of thefinancial topical area by o’95. 4.2 descriptive statistics figure2 summarize a year-wise number of citing papers, cited o’95. the average rate of citation over the period is 21.38 per year. figure 2.year-wise number of citing papers table 2. shows the 5 mostinfluenced individual author, university and country byo’95 in descending order. for every paper, we have counted one for every author in that paper. we escaped ohlson, j.a. from the list because of self-citation issue. university and country list shows which university andcountryare working most on o’95 based work. table 2. authors, universities, and country with the corresponding number of citing papers. author no. of citing papers university no. of citing papers country no. of citing papers landsman, w.r. 14 stanford university &lancaster university 24 usa 258 barth, m.e. 12 the university of north carolina 21 uk 77 penman, s.h. &sougiannis, t. 10 new york university 20 canada 36 beaver, w.h. 9 university of toronto 14 australia 29 wang, p. 8 hong kong university of science and technology 11 hong kong 20 landsman, w.r. is most influenced author by o’95. he cited o’95 in his 14 papers followed by barth, m.e. with 12 papers and penman, s.h. &sougiannis, t. with 10 papers each. asthe university list is concern, it constitutes the given authors comes under specific affiliated university. sostanford university & lancaster university are the universities working most in o’95 based work with 24 numbers of citing papers. followed by the university of north carolina and new york university with 21 and 20 numbers of citing papers respectively. as far as the country list is concern, it constitutes the given affiliated university comes under 20 15 34 22 25 23 24 17 30 24 2830 27 20 23 18 27 18 11 11 20 5 10 15 20 25 30 35 40 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 n o. o f c iti ng p ap er s years asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 13 specific country. so united states is working most on o’95 based work with 258 citation papers, followed by uk and canada with 77 and 36 citing papers respectively. in keywords analysis,a total count of 647 keywords has been identified. then we identified the number of repetition of every keyword, which results with 147 different keywords. then we grouped different keywords under 25 different subfields given in table 2 with number of keywords count under a specific subfield. table 3. subfields with the corresponding number of keywords count subfields number of keywords count valuation 86 earnings management 61 value relevance 53 residual income model 42 forecasting 39 cost of capital 31 financial reporting & analysis 30 capital markets 28 corporate governance 23 linear information dynamics 22 intangible assets 22 accruals & cash flow 22 conservatism 20 ifrs 20 stock risk, return, and price 19 information content 18 clean/dirty surplus 15 disclosure 12 fair value 12 book value 12 profitability 11 growth 10 dividend 9 tax 6 interest rates 4 others 20 total 647 table 3, the keywords analysis provides an overview that how the use of o’95 is diversified in different subfields. the most affected subfield is valuation followed by earnings management and value relevance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 14 4.3. results and discussion descriptive statistical results shown in theprevious section emerged with some observations. first, the keywords section highlights the diversified use of o’95 in various subfields. the several list comprises the level of influence of o’95 on individual authors work, university, and country. many of these subfields are connected by researchers with o’95 for theoretical contributions that are related to thefinancial topical area. while other subfields are useful for empirical contribution in this area. new researchersshould be conscious that it is necessary to widen their horizon of financial topical research area in different subfields. second, the citing papers list is dominated by jbfa, ras, tar, car and jae. which is similar to previous findings, usually being considered in top journals of accounting (glover et al. 2012). third, precisely universities of us and ukare highly passionate to work on improvement and development in o’95. 5. summary and conclusion in this paper, we first reviewed the theoretical and empirical studies based on o’95. we have discussed theoretical improvements associated with each assumption of o’95and empirical testing of the model for far. we observed that o’95encompassed the literature on valuation of firm through accounting information. the acceptance of the model can be justified by successive theoretical studies discussed on o’95. linear information dynamics is observed one of the major input of o’95 and this dynamics have potentials to future research for more accurate prediction of abnormal earnings. whereas, csr and“other information” variable are the major limitations of the model. even from theempirical point of view, the model lacked its validity because of required practical possibility of csr in accounting and undefined “other information” variable. future research is needed to fix this variable in order to make this model more robust for valuation purpose.finally, we conclude that the research on o’95 is moving towards robustness, and more extensions are required to fix some more issues like conservatism, clean surplus, other information, etc. the success of o’95 can also be verified by bibliometric facts of o’95 like average rate of citation in reputed journals of accounting research. as far as the bibliometric analysis is concerned about o’95through citing papers analysis we find thatlandsman, w.r., stanford university & lancaster university, and united states are at the top among individual authors, university, and country list in respective categories. and through keywords count analysis we find the diversified involvement and use of o’95 in various subfields. valuation, earning management, and value relevance are the most affected subfield by o’95. the primary limitation of this study is that the bibliometric facts are limited to citing papers of given twelve journals.the scope to extend our work for future research isthrough comparison of alternative valuation model with respect to theoretical, empirical, and bibliometric facts. asian journal of finance & accounting 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(2000). accounting information, capital investment decisions, and equity valuation: theory and empirical implications. journal of accounting research, 38(2), 271-295. https://doi.org/10.2307/2672934 microsoft word 9319-34144-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 168 review of the relationship between board attributes and firm performance mohammed mahmud kakanda tunku puteri intan safinaz school of accountancy universiti utara malaysia, sintok, kedah, darul-aman tel: 60-11-3393-8302 e-mail: manga4m@gmail.com basariah salim tunku puteri intan safinaz school of accountancy universiti utara malaysia, sintok, kedah, darul-aman tel: 60-19-470-0474 e-mail: basa1189@uum.edu.my sitraselvi chandren tunku puteri intan safinaz school of accountancy universiti utara malaysia, sintok, kedah, darul-aman tel: 60-4-928-7328 e-mail: sitraselvi@uum.edu.my received: march 1, 2016 accepted: april 30, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.9319 url: http://dx.doi.org/10.5296/ajfa.v8i1.9319 abstract corporate governance over the years has become an issue of global concern due to the 2008 economic crisis and several financial scandals and corporate failures. this has drawn the attention of policy makers, researchers, investors and regulatory institutions. moreover, the most significant mechanism of corporate governance is board of directors. therefore, the purpose of this paper is to review previous studies that examine the relationship between board attributes and firm performance, and to identify possible literature gaps. for the purpose of this review, related materials were being gathered from emerald management e-journals and research gate database. the paper synthesizes empirical findings on the relationship between selected dimensions of board attributes and firm performance. the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 169 paper identifies shortcoming of past studies and concluded by offering some avenues for future researches in this promising area of empirical research. keywords: corporate governance, board attributes, firm performance, board size, board composition, board meeting asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 170 1. introduction can board of directors attributes influence firm’s financial performance? a justifiable response to this question is through scanning the results of previous empirical studies on the subject matter. however, corporate governance over the years has become an issue of global concern due to the 2008 economic crisis and several financial scandals and corporate failures (e.g., enron, worldcom, lehman brothers, parmalat e.t.c) (jones, li & cannella, jr, 2015; shahwan, 2014; fallatah & dickins, 2012; benjamin, 2009; dalton, hitt, certo & dalton, 2007; kyereboah-coleman, 2007). therefore, this has drawn the attention of policy makers, researchers, investors and regulatory institutions. the attention increase in research on corporate governance was committed to members of corporate boards’ influence on relevant organizational outcomes (carpenter & westphal, 2001). members of board of directors in both public and private companies are vested with large number of responsibilities. these responsibilities include an ethical duty to represent the interests of funds providers (investors/shareholders) and to monitor the financial stability and performance of the organization (ethics resource center, 2002). in past decades, “boards’ influence on firm performance has normally been analyzed using variables linked to their formal composition and structure, but such analyses have usually failed to identify any substantive relationship between these factors and firm performance” (dalton & dalton, 2011). moreover, the relationship between boards of directors’ attributes and firm performance is conundrum, as it remains unresolved in the academic literature (rebeiz, 2015). owing to this, empirical researches on the subject matter have been inconclusive and fragmented as accounted by ontological, methodological and behavioural complexities. concisely, rebeiz (2015) opined that ‘ontological complexities’ barricaded researchers’ consensus on boards’ attributes and firm performance due to the complexity of an organization’s legal, economic and social systems which plays an inter-influence role between the organization and the external environment. to ‘methodological complexities’, positivists uses market or accounting indices in determining firm performance, where by both metrics suffer from measurement setbacks. the accounting metrics are based on historical values from financial statements, while market metrics are based on future expectations influenced by forces of demand and supply in the market. whereas, ‘behavioural complexities’ is on the basis that directors’ independence is being influenced by existing culture in the board room and information control by the chief executive officer (ceo) which hinders independent judgement by board members (rebeiz, 2005; aram & cowen 1983). previous studies on the relationship between boards’ attributes and firm performance have measured performance as either using accounting based performance measures like return on assets (roa), return on equity (roe), net profit margin (npm), dividend per share (dps), and earnings per share (eps) (e.g., amba, 2013; latif et al., 2013; marn & romuald, 2012; yasser, entebang & mansor, 2011; vance, 1978). in addition, market-based measures like tobin’s q (e.g., kyereboah-coleman, 2007; nicholson & kiel, 2003; vafeas, 1999). while asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 171 board of directors attributes is measured using different constructs like; board composition, board characteristics, board process, and board structure that are based on agency theory model (zahra & pearce ii, 1989). hence, this study aimed at reviewing the findings of previous studies that examined the relationship between corporate board of directors’ attributes and firm performance, and to identify possible gaps in literature. the paper is divided into four sections. the first part is the introduction, which gives an in-look of the contents, then followed by materials/methods used. the third section provides the review of related literatures on some board attribute mechanisms and firm performance, while the last section is conclusion. to achieve a comprehensive view of how boards’ attributes relates to firms’ financial performance, a broadly search was initiated within the academic literature in accounting and finance; and business management and strategy obtained from emerald management e-journals and research gate database. however, the review was not base on time-period, but based on the keywords used for the title. in addition, not only those articles that involve empirical examination of how boards’ attributes relates or impacts on financial performance in review of related literature is considered. 2. board of directors’ attributes corporate board of directors play numerous and integral roles in organizations. they are mainly saddle with the responsibility of (1) providing of oversight, advice, and counsel to chief executive officers (ceos), and (2) monitoring and if necessary disciplining ceos (finkelstein & mooney, 2003). based on agency theory, executives (agents) possess significant freedoms and powers to manage shareholders (principals’) resources. it is believing that the executives have some objectives that may be conflicting with that of the owners (principals), hence, ignoring shareholders’ wealth maximization objective (masson, 1971). in this regard, it is being expected that board of directors are to perform painstaking function of monitoring and rewarding top executives to ensure the attainment of shareholders’ wealth maximization (zahra & pearce ii, 1989). consequently, for board of directors to perform their functions effectively, some attributes must be in place. however, boards of directors attributes are also referring to as board mechanisms. the classification of boards is under four different theoretical perspectives: (1) legalistic perspective, (2) class hegemony, (3) resource dependence, and (4) agency theory (zahra & pearce ii, 1989). in this review, board attributes have been approached based on agency theory as explained earlier. board attributes under the agency theory includes board composition, board characteristics, board process and board structure. the explanations to these are comprehensively in the subsequent paragraphs. board composition connotes the number and mixture of different director types, for instance, executive and non-executive directors, independent and non-independent directors. to zahra and pearce ii (1989), board composition involves both the size (number of directors that serve on the board) and director types (widely recognized dichotomy between inside and outside directors). however, some stream of researchers (e.g., tauringana, 2015; marn & asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 172 romuald, 2012; barisua, tobira & lenee, 2012; yasser, entebang & abu mansur, 2011), refer to board composition as the number of non-executive directors on the board of a company. in essence, this review has treated board size and board composition as separate and independent attributes. on the other hand, board characteristics denotes the distinguishing features of persons serving on a board. these features are directors’ background (age, level of education and expertise) and personality (hambrick, 1987, mueller, 1981). board structure as asserted by zahra and pearce ii (1989) refers to the dimensions or specifications of the board’s organization that include: (1) number and type of committees, (2) committee membership and leadership, and (3) flow of information among the committees. whereas board process involve the series of approaches taken by the board in making decisions. it includes dimensions like; frequency and number of meetings, formality of board proceedings, self-evaluation of board, ceo-board relation and level of agreement among directors on prevailing issues (mueller, 1979). consequently, this review is not restricted to the constructs of board attributes in totality, but to selected dimensions of the attributes like board size, board composition and board meetings. the review of theses dimensions is in relation to firm performance under independent headings. 3. firm performance corporate performance is an essential requirement for an organization’s survival and growth(kakanda, bello, & abba, 2016). corporate performance relates to the process by which limited resources at organization’s disposal are utilize effectively and efficiently in attaining the general objective of the enterprise for both present and future opportunities (marn & romuald, 2012; yasser, entebang & abu mansor, 2011). however, berger & patti (2002) are of the view that “a firm’s financial performance, in the view of the shareholder is measured by how ‘better off’ the shareholder is at the end of a period, than he was at the beginning. also, this can be determined using ratios derived from financial statements; mainly the balance sheet and income statement, or using data on stock market prices”. here, ‘better off’ means the increase in value of shareholders from the beginning to the end of a given accounting period (kakanda, et al., 2016). coherently, since agency theory argues that agency relationships should be the most stressing point when studying and analyzing corporate governance. therefore, it is assuming that contribution of board of directors to organizational performance occurs by reducing agency cost arising from non-consensus of interest between the executives and the established organizational goals and procedures (mizruchi, 1983). in essence, it is of the expectation that boards will enhance the financial performance of their organizations by maximizing shareholders’ wealth. 3.1 board size and firm performance: board size is the magnitude of board of directors of a company. it is the total number of directors serving on the board of a company (ogege & boloupremo, 2014; vafeas, 1999). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 173 however, board size is view as the most crucial dimension of board attributes. this is because there are conflicting views in literature regarding board size. to the proponents of agency theory, it is assuming that a smaller board size is adequate and effective, because it has minimised monitoring duties, which encourage efficiency, coordination and communication. while an increase in board size causes delay in decision-making, coordination and communication; creates more conflict of interest (between executives and owners) and demoralized majority of members, hence affecting firm performance (abdurrouf, 2011; nanka-bruce, 2011; yermack, 1996; jensen, 1993). conversely, it was also argued that as board size increases, the position of the directors are improved which gives them more right to exercise their power in governing the organization, as the ceo dominance on the board is reduced and become more difficult (zahra & pearce ii, 1989). therefore, this leads to a positive relation between board size and firm performance. moreover, lipton and lorsch (1992) reported that number of board members of a company should be between seven and eight. this assertion is also consistent with the opinion of jensen (1993). in this effect, boards that have eight or less members stand a chance to maintain better focus, participation, good interaction and meaningful debate (firsteberg & malkiel, 1994). however, a required number of board members depend on industry-specific and size of firms; for instance, banking industry is found to have board size that is larger than that of manufacturing industry (adams & mehran, 2003). subsequently, some studies report that larger boards are assume to have directors with heterogeneous educational and industrial background and skill that will help to enhance actions of the firm, hence, improving performance (pfeffer, 1987; herman, 1981; bacon, 1973). gill and obradovich (2012) whose study aimed at examining the impact of corporate governance and financial-leverage on the value of american firms, found that larger board size larger board size negatively affects the value of american firms. other stream of studies that found negative relationship between board size and firm performance include ali and nasir (2014), ibrahim and abdul samed (2011), lin (2011), juras and hinson (2008), and yawson (2006) among others. on the other hand, yasser et al. (2011) found a significant positive relationship between board size and performance measured by return on equity (roe) and profit margin (pm). concurrently, al-matari, al-swidi and faudziah (2014) found board size to be positively but insignificantly related to financial performance (measured by roa) of listed muscat security market (msm) in oman. in the same vein, the finding of marn and romuald (2012) indicates that board size has significant effect on performance of listed malaysian firm. earnings per share (eps) measure the performance here. moreover, larger board size is being found to improve the monitoring role as well enhances economic performance (maharaj, 2008; joh, 2003). based on the above review, the first hypothesis in this review is develope as: h1: board size has positive relationship with firm performance asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 174 3.2 board composition and firm performance: board composition is the number of non-executive directors on board of a company. it is the ratio of non-executive directors to total directors (barisua et al., 2012; marn & romuald, 2012; yasser et al., 2011). it has been presumed that boards with significant outside directors will effectively perform their duty and have better decisions than board that is dominated by inside directors. fama and jensen (1983), spencer (1983), and jones and goldberg (1982), argued that non-executive directors’ representation on the board increases: board independence, directors’ objectivity and enhances directors’ expertise. on the contrary, other studies suggested that non-executive directors do not have the required time, knowledge, skill and expertise to carry out their work effectively (geneen, 1984; vance, 1983). however, some group of empirical studies has found that increasing number of outside directors will influence performance. for instance, barisua et al. (2012) has found that board of directors’ composition is positive and significantly related to performance (eps) of publicly traded deposit money banks in nigeria. connelly and limpaphayom (2004) found that board composition has positive relation with profitability of life insurance firms in thailand (connelly & limpaphayom, 2004). other studies that belong to this group are abdurrouf (2011), nanka-bruce (2011), saibaba and ansari, (2011), bhagat and bolton (2009), juras and hinson (2008) among others. in contrast, other studies found a negative relationship between board composition and firm performance. for example, marn and romuald (2012) found that board composition has no significant positive effect on the performance (eps) of malaysian listed firms. in addition, the study by barisua et al. (2012) has found board composition to be negative and significantly related to performance (net profit margin) of deposit money banks in nigeria. the likes of these studies are bhagat and bolton (2008), bozec (2005), connelly and limpaphayom (2004), agrawal and knoeber (1996), and yermack (1996). despite the conflicting findings on board composition and firm performance, yet this review hypothesized: h2: board composition has positive relationship with firm performance 3.3 board meeting and firm performance: board meeting refers to the gathering of directors on the board to discuss issues regarding the company. it is measured as the number of meetings during a year by a company board of directors (al-matari et al., 2014; chechet, yancy jnr & akanet, 2013; vafeas, 1999). board meetings play a significant role to the success of a company. in addition, board meetings serve as an important avenue for effective decision making of a company. board of directors hold meetings on behalf of the company to discuss issues of the past, present and future that is related to the company, and resolutions passed during board meetings. therefore, the more the number of board meetings, the better for a company, because the boards will have more and better chances of making various decisions (khan & javid, 2011; pearce & zahra, 1992). however, vafeas (1999) whose study aimed at examining the relationship between board meeting frequency and firm performance found that boards that meet more frequently are asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 175 valued less by the market, a finding that seems to be determined by share price declines followed by higher meeting frequencies. whereas mangena and pike (2005) found that, there is a significant positive relationship between the frequency of board meetings and performance of companies listed on the floor of zimbabwe stock exchange. again, there is a positive relationship between the disclosures of the frequency of board meetings and firm performance (brown & caylor, 2004). in this effect, attending board meetings by members ought to produce important resources to directors in enhancing the adequacy of the board (said, omar, & abdullah, 2012). additionally, some empirical studies that found boards meeting to be positively related to performance are but not limited to liang, xu and jiraporn (2013), gavrea and stegerean (2012), kang and kim (2011) and khan and javid (2011), brown and caylor (2004). equally important, jensen (1993) opines that: “daily tasks those continue most of the board’s meeting time and hence this limits the chances for external directors to conduct a meaningful oversight over management”. jensen further stressed that board should not be over active as activity of board represents a reaction to adverse performance. in regards to this, some empirical studies that found a negative relationship between board meeting and performance are; danoshana and ravivathani (2014), garcia-sanchez (2010), and kamardin (2009) among others. therefore, this review hypothesized that: h3: board meeting has positive relationship with firm performance 4. conclusion the aim of this study was to review previous studies on board of directors’ attributes and firm performance and to identify possible literature gaps. the review is based on causal-effect relationship between board dimensions such as board size, board composition and board meeting and firm financial performance. albeit, there are stream of studies on board attributes and firm performance, yet the results are still conflicting which make research in the area to be inconclusive. nevertheless, this does not render the findings of previous studies invalid. more importantly, the existing research studies have reflected limitations that accentuate the problem that is associated with the following: (1) in scanning the direct relationship between dimensions of boards attribute and firm performance, the relationship might be influence indirectly by other factors like social, economic and political that might be the strength, weakness, opportunities, and threats (swot) posed by the market within which the business operates. the relationship can also be influence by the different roles played by boards to arrive at strategic outcomes which later influence performance (zahra & pearce ii, 1989). this is an avenue for future researchers to use mediations or moderations in examining relationship between board attributes and firm performance. (2) methodological complexities and the use of historic data is another limitation in studies of board attribute and firm performance (rebeiz, 2015). this problem can be lessening through integrating deductive analysis with interpretive reasoning. this will help future researchers to asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 176 have more result that is reliable since analyses from both secondary and primary data source will be complementing each other in result interpretations. hence, improve research findings from data analyses with more accuracy and precision. (3) the use of archival data from different sectors on a stock exchange can also affect the outcome of a study. different sectors are characterized by different industry standard, different accounting policies, size and periods of operation. future researchers can use companies with homogenous characteristics or make comparative analysis between firms from available sectors. in addition, conflicting results from studies in different countries might be due to economic and political differences among nations. acknowledgement the research is financed by othman yeop abdullah (oya) graduateschool of business, university utara malaysia (uum) sintok. thanks to associate professor ahmed bawa bello and dr. mohammed abba, modibbo adama university of technology, yola. references abdurrouf, m. a. 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(1989). boards of directors and corporate financial performance: a review and integrative model, journal of management, 15(2), 291-334. http://dx.doi.org/10.1177/014920638901500208 microsoft word 5695-20512-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 1 determinants of readability of financial reports of u.s.-listed asian companies gaurav kumar associate professor of accounting university of arkansas at little rock tel: 501-569-3051 e-mail: gkumar@ualr.edu received: may 27, 2014 accepted: july 27, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5695 url: http://dx.doi.org/10.5296/ajfa.v6i2.5695 abstract in this paper, i investigate the impact of secrecy, ownership dispersion and profitability on the readability of annual reports of u.s.–listed asian companies. this is perhaps the first paper to examine the effect on readability of cross-listed asian companies. i use a measure of secrecy developed in hope at al. (2008) to study its effect on readability. the sample of this paper consists of all 68 asian companies from nine countries listed on nyse/nasdaq, that are registered and reporting with the sec. the univariate and multivariate analyses show that companies whose domestic culture is more secretive are providing less readable financial statements. this result is robust to sensitivity tests. this is an interesting and important result in line with the efforts being made to have convergence in the international accounting area. this is despite the fact that a large number of these companies are using ifrs and u.s. gaap to prepare their financial statements. the results also show that companies with higher ownership dispersion are providing more readable annual reports. the results fail to reject the hypothesis related to the effect of profitability. finally, the results show that larger sample companies are providing more difficult to read financial statements. these results have important implications for international investors and global standard-setting bodies. keywords: readability, secrecy, ownership dispersion, u.s.-listed asian companies asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 2 1. introduction and motivation public companies are required to provide an annual report to their investors. research has long argued that the disclosures provided in these reports are complex and use “incomprehensible language” (pashalian and crissy, 1952). the securities and exchange commission (sec) has made consistent efforts to make these disclosures more readable in the united states (u.s.). one of these efforts is the plain english disclosure rules adopted by the sec on january 22, 1998. according to li (2008), the primary argument for this regulation is that firms could use vague language and format in disclosure to hide adverse information, and average investors may be unable to understand these disclosures leading to capital market inefficiency. there has been little research in this area on cross-listed companies. cross-listed companies provide an excellent opportunity to examine readability of annual reports because these companies tend to borrow a global culture while retaining characteristics of domestic culture (zarzeski, 1996). there has been extensive research that examines the effect of culture on accounting disclosures. this paper extends the literature by examining the effect of cultural framework on the readability of annual reports by u.s. – listed asian companies. research has shown that accounting disclosures in asian stock markets are low in both quality and quantity as compared to the u.s. (sami and zhou, 2008). when companies from these countries cross-list on a developed market like u.s., the disclosure behavior of these firms attract more attention and therefore, affect the quantity and quality of firms’ disclosures. therefore, i use u.s.–listed asian companies because prior research has argued that annual report disclosures made by cross-listed companies will be more extensive than those of domestic-only listed companies, and also because foreign-listed companies tend to borrow a global culture (zarzeski, 1996). moreover, the importance of asian companies cannot be overstated in the present time. india and china are the fastest growing economies in the world and japan is the second largest economy after the u.s. gray (1988) uses the hofstede’s (1980) cultural framework and defines secrecy versus transparency as a preference for confidentiality and the restriction of disclosure of information about the business only to those who are closely involved with the business. hope at al. (2008) use this definition of secrecy and study its effects on auditor choice. this paper uses the measure of secretiveness developed in hope at al. (2008) and studies its effects on the readability of annual reports of u.s.–listed companies. in addition, i examine the effect of ownership dispersion on readability of annual reports because agency theory argues that as ownership structure gets more dispersed, agency costs increase due to increased probability of conflicts of interest between owners. therefore, higher ownership dispersion will lead the companies to issue more readable annual reports to reduce those conflicts. finally, i examine the effect of profitability on the readability of u.s.–listed asian companies because li (2008) reports that companies that have bad news write excessively long sentences with unnecessary big words thereby making these reports difficult to read. i use flesch reading ease (fre) score to measure the readability of annual reports and use ols regression to examine the effect of secrecy, ownership dispersion, and profitability. the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 3 results of this paper show that companies whose domestic culture is more secretive are providing less readable annual reports. in addition, this paper reports that companies with higher ownership dispersion are providing more readable annual reports. this study did not find any effects of profitability on the readability of annual reports. these results have important implications for the international accounting literature because many of these companies are using ifrs or u.s. gaap to prepare their financial statements and in spite of using these global standards the domestic culture has an effect on the readability of their annual reports. therefore, investors of these companies must take this into consideration while perusing the annual reports of these companies. in addition, the global standard-setting bodies should consider the effects of culture on financial statements while issuing new standards. this paper is organized as follows. the next section reviews the literature on this subject and explores the determinants of readability and readability measures. section 3 derives the hypotheses and describes the research design of this study. section 4 explains the sample selection process and provides descriptive analyses and the results of regression analysis. the last section concludes and provides the contributions and limitations of this research. 2. literature review and hypotheses development this section reviews the literature on readability of annual reports, readability measures, and culture. 2.1 sec and readability although the sec has been working to improve the readability of annual reports since it was established in 1934. in the last 15 years, the sec has taken an active role in emphasizing the importance of clearly presenting information in sec filings. first, the sec issued “a plain english handbook” in 1998, that encouraged the use of plain english in the designing of all prospectuses in registered public offerings. this handbook provided practical tips to improve the readability of disclosures in the annual reports such as write in short sentences, use definite, everyday language avoid the use of jargon, and double negatives, etc. in 2003, the sec reiterated the importance of readable annual reports and issued the following guidance on overall presentation of the md&a section (sec, 2003): md&a, like other disclosure, should be presented in clear and understandable language. we understand that complex companies and situations require disclosure of complex matters and we are not in any way seeking over-simplification or "dumbing down" of md&a. however, we believe that companies can improve the clarity and understandability of their md&a by using language that is clearer and less convoluted. md&a readability can be viewed as a form of voluntary disclosure and large amount of research has examined the voluntary disclosures of domestic and foreign companies (such as botosan, 1997, healy and palepu, 2001, cahan et al., 2005, kumar et al., 2008). however, very few studies have investigated the readability of annual reports of companies. the first asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 4 research on readability of annual reports was first published in 1952. over the last six decades or do, annual report readability has been examined in the context of australian companies (lewis et al., 1986; parker, 1982; pound, 1981), canada (courtis, 1986), the uk (jones, 1988), and the u.s. (pashalian and crissy, 1952; smith and smith, 1971; li, 2008). in general, findings have revealed the readability of annual reports to be at a level of difficult to very difficult, and beyond the comprehension skills of about 90 percent of the adult population and about 40 percent of the investor population (courtis, 1995). 2.2 measures of readability readability assessment research has developed several methods for measuring readability. some of the most popular methods for assessing readability include the cloze procedure, the gunning’s fox index, the flesch-kincaid grade level, and the flesch reading ease (fre) formula. the cloze procedure was one of the early methods developed for assessing readability. the method for this procedure makes it arguably the most difficult method to use for researchers since it requires the use of individual readers. critics of this method argue that it better assesses the reader’s ability rather than the readability of the passage. while the cloze approach is associated with understandability of the material, the other three procedures examine the syntactical complexity of the text. examining the syntactical complexity of the text allows the researcher to determine the readability of text independent of reader intelligence. the gunning’s fog index (gunning, 1952) is one of the methods that focuses on the syntactical complexity of the passage and requires that the researcher count words containing three or more syllables, referred to as “hard words.” the formula determines the grade level of the passage based on a formula using the percentage of “hard words” and the average sentence length. another formula that asserts to assess grade level is the flesch-kincaid grade level. this score indicates the minimum level of education required in order to understand the subject material. similar to the gunning’s fog index, the fre index uses the average sentence length, but then uses the average number of syllables per word to calculate a score.1 the fre index calculates how easy it is to read a passage and assigns a score from one to 100, where higher scores indicate greater ease in reading and a score of 64 is considered “plain english” while any score less than 60 is considered difficult reading material (flesch 1948, 1949). table 1 presents a description of the reading ease score calculated by the fre formula. although the fre index is widely used by accounting researchers to assess readability, criticism includes the fact that “attributes such as syntax, style, format, graphic design, logic, conceptual density, human interest, organization and reinforcement are not considered” (courtis 1998, p. 460). despite criticisms, according to crosier (2004), fre is the formula 1 the formula for the flesch reading ease score is: 206.835 (1.015 x <asl>) (84.6 x <asw>), where <asl> is the average sentence length (number of words/number of sentences) and <asw> average number of syllables per word (number of syllables/number of words) (microsoft.com). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 5 used most often in research, and its validity as a measure of readability has been established. the irs has also used the fre index to evaluate tax forms and instruction booklets. in a review article, jones and shoemaker (1994) identified thirty-two empirically based, readability studies in accounting research (limited to english speaking countries). they found that researchers used a flesch-based test in 26 of the 32 studies and only 11 of the 32 studies used more than one test of readability. more recently, chiang, et al. (2008) found that the readability scores obtained using the flesh reading ease, flesch-kincaid grade level index, gunning’s fog index, and the smog procedure were highly correlated (p< 0.0001) indicating consistency among the four measures. this consistency implies that a researcher need only use one of these four methods and expect reliable results (chiang et al. 2008). therefore, because of its extensive use in research and ease in calculating, i have selected the fre score as calculated in microsoft word to evaluate the readability of annual reports of sample companies. 2.3 culture and readability hofstede (1980) defines culture as ‘the collective programming of the mind which distinguishes the members of one human group from another’ and gray’s (1988) theory explains how culture affects the development of businesses and their institutions, including accounting systems. gray’s model defines four accounting values which are linked to hofstede’s societal values. these accounting values are “professionalism, uniformity, conservatism, and secrecy”. gray (1988, p. 8) describes the secrecy versus transparency as a “a preference for confidentiality and the restriction of disclosure of information about the business only to those who are closely involved with its management and financing as opposed to a more transparent, open, and publicly accountable approach.” gray (1988) states that secrecy is positively correlated with uncertainty avoidance and power distance and negatively correlated with individualism. hofstede (1980) states that individualism represents the degree of separateness within a society and a preference for a loosely knit social framework in society in which individuals are supposed to take care of themselves. power distance denotes the dispersion of authority in a society. in a society with a high power distance, for example, there is less dispersion of and less questioning of authority figures and vice-versa. the cultural dimension of uncertainty avoidance signifies the degree to which a society can accept uncertainty and ambiguity. hope et al. (2008) argue that uncertainty-avoiding societies are expected to be more secretive so as to avoid potential conflict with outsiders. when power distance is large, managers are expected to hide and not disclose information to preserve power inequalities. in addition, individualistic societies are expected to be less secretive than collectivist societies, where people share the common beliefs and possibly information. 3. hypotheses development agency theory (jensen and meckling, 1976) predicts that due to the information asymmetry between a principal (owner) and an agent (manager), there is a moral hazard problem – the possibility that an agent will exploit the principal’s assets for his self-interest. this theory asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 6 predicts that both agents and principals recognize that it can be beneficial to reduce this information asymmetry by providing accounting disclosures. however, hope et al., (2008) argue that even for managers with an incentive to share information for reducing information asymmetry, their cultural tendency to be secretive might conflict with such incentives. therefore, it can be argued that companies that want to reduce information asymmetry will provide their annual reports in a clearly readable format. however, companies from countries whose culture inherently secretive will try to hide information by burying it in complex language. warner (2003) shows that all asian countries have a distinct cultural framework and in many cases a form of management with local characteristics. more importantly, warner (2003) reports that in asia, country-specific cultures have resulted in an observable set of highly identifiable institutions leading to different management styles in all countries. therefore, this paper tests the following hypothesis (stated in alternative form): h1: u.s.–listed asian companies with low/ (high) secrecy are likely to provide more/(less) readable annual reports in the u.s. another argument that follows from agency theory is that as the ownership structure more dispersed, the agency costs increase due to increased probability of conflicts of interest between owners (fama and jensen, 1983). therefore, to counter this effect, the firms that have high ownership dispersion will likely issue more readable annual reports. oliveira et al. (2006) and kumar (2013) examines the effect of ownership dispersion on the voluntary disclosures and reports that firms with higher ownership dispersion provide higher voluntary disclosures of intangible assets. therefore, this study posits the following hypothesis (stated in alternative form): h2: u.s.-listed asian companies with higher/ (lower) ownership dispersion will provide more/ (less) readable annual reports. incomplete revelation hypothesis (irh) implies that managers can reduce the market response to bad news by making bad news more costly to analyze (bloomfield, 2002). li (2008) tests this hypothesis and reports that managers make bad news costly by writing excessively long annual reports with unnecessary big words and long sentences. an alternative explanation of these results is that losses and bad news are simply more difficult to describe. another reason is that managers might write longer and complex annual reports to protect themselves from litigation when they report poor performance (bloomfield, 2008). the sec handbook on plain english recognizes that legalese can be complex to read. therefore, this paper tests the following hypothesis (stated in alternative form): h3: u.s.–listed asian companies with higher/ (lower) profitability are likely to provide more / (less) readable annual reports in the u.s. 4. sample selection and analyses the sample for this study consists of all u.s.–listed asian companies in the year 2010. although there are hundreds of asian companies that are listed in the u.s. that have issued asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 7 adrs (american depository receipts), however, i choose to use only those companies that are registered and reporting with the sec. this is because these companies are subject to increased disclosure requirements. this leads to 85 companies from nine asian countries (see table 2). however, 17 of these companies are listed on over-the-counter (otc) debt and stock exchanges.2 there are significant differences in the disclosure rules for companies listed on otc exchanges versus those listed on national stock exchanges such as the nyse and nasdaq. therefore, this paper focuses on the 68 asian companies listed on the nyse/nasdaq from nine countries. 4.1 dependent variable an ordinary least squares (ols) model is used to test the hypotheses. the dependent variable in the ols regression model is the flesch reading ease (fre) score as calculated in microsoft word based on readability of the management discussion and analysis (md&a) section of the sample companies’ form 20-f annual report. this study measures the readability of the md&a section because of the opportunity offered by this section as a communication medium for voluntary disclosure, as its contents are not affected significantly by the accounting regulations. moreover, in the md&a section, companies provide disclosures on the current trends, and potential impact of the events or uncertainties that are reasonably likely to have material effects on a company’s financial condition (iosco, 2003). the fre score has been extensively used in prior research to measure readability and its reliability has been tested as well (chiang et al., 2008). a potential limitation to this method is a lower score (indicating more difficult reading) when used with highly technical material. the score uses the average number of syllables per word and technical terms may inflate this calculation. this limitation can be overcome by assessing material that is similar in nature (such as material on the same topic) and by using the score to assess relative readability rather than absolute readability (flory et al. 1992). therefore, this paper uses this score to test the readability of similar documents i.e., annual reports of u.s.–listed asian companies. 4.2 independent variables the primary variable of interest for the first hypothesis is secrecy. according to gray (1988), uncertainty avoidance and power distance are positively associated with secrecy and individualism is negatively related with secrecy. countries with high uncertainty avoidance tend to provide minimal disclosures to avoid conflict and competition and to preserve security of interests. high power distance societies are likely to be characterized by the hiding of information to preserve power inequalities, leading to more secrecy. secrecy is consistent with a preference for collectivism. individualistic societies express greater concern for those closely involved with the firm rather than for external parties. therefore, i measure this variable as the sum of uncertainty avoidance and power distance scores less the individualism score (similar to hope et al, 2008). table 3 shows the computation of this variable. 2 the number of u.s.– listed asian companies on the otc is 17 out of 85 companies (20%). the number of all foreign otc companies on the u.s. stock exchanges is 256 out of 970 companies (26.4%). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 8 to test the second hypothesis, i measure the ownership concentration as the percentage of shares owned by the three most important and known shareholders to be used as an independent variable (ownership concentration) 3 . the third hypothesis predicts that companies that are profitable will provide more readable annual reports. therefore, i measure the profitability as net income scaled by total assets of a firm and use that as an independent variable. 4.3 control variables the following variables are used as control variables in the regression: 1. size: various studies have shown firm size is a determinant for accounting disclosures and size is also used as a proxy variable for omitted variables (botosan, 1997; hossain et al. 1995). this paper uses natural log of total assets measured in millions of dollars as firmsize to explain the readability of annual reports. in general, it is expected that a larger firm will have more complex operations and will provide longer and complex annual reports. 2. foreign sales: i use foreign sales percentage (fsales%) as a proxy for complexity of operations. in general, higher foreign sales will lead to longer annual reports and difficult to read annual reports. in addition, this variable acts as a control variable for the domestic culture as it is expected that a larger foreign sales will mitigate the effect of domestic culture (secrecy in home country) since that means that the firm is more exposed to foreign culture norms and behaviors (hope et al., 2008) 3. debt ratio: debt ratio is measured as total liabilities divided by total assets. in general, companies that have higher proportion of debt are expected to provide less readable annual statements. 4.4 descriptive analyses table 4 shows the results of descriptive analyses. the minimum fre score for the sample companies is 3.90 and the maximum is 21. recall that a higher fre score indicates reading ease and that a score of 64 is considered “plain english”. therefore, none of the sample companies are providing annual reports that can be described as easy to read. there is a large variability in the rest of the variables as well. the sample companies come from cultures that have varying levels of secrecy in their home countries (the scores range from 62 to 127). a higher value indicates more of that particular trait. table 5 shows the scores of dependent variable and the three control variables by country. companies from india and taiwan have the highest fre scores indicating easiest to read financial statements among all the sample countries. apart from countries that have a very small number of companies listed in the u.s., companies from hong kong and china have the lowest fre scores indicating difficult to read financial statements among all the sample 3 similar to oliveira et al. (2006) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 9 countries. the largest sample companies are from japan and the smallest come from singapore. companies from china are heavily dependent upon debt (median debtratio = 0.74) and sample companies from taiwan have the lowest debtratio after singapore4 indicating higher reliance on equity capital. table 6 provides the pearson correlation coefficients among the regression variables. secrecy is negatively correlated with fre (-0.244), as hypothesized. this result provides bivariate support for the prediction that less secretive companies provide annual reports with higher readability scores. firm size is also negatively correlated with fre indicating that bigger companies provide difficult to read annual reports. debt ratio is positively correlated with firm size indicating that bigger companies have more debt and negatively related with fre. while some of these results are consistent with the hypotheses in this paper, they should be interpreted with caution since they do not control for differences in other variables. 4.5 regression analysis and hypothesis testing table 7 provides the results of regression analysis. out of the three control variables, only the coefficient for firmsize is marginally significant (p= 0.080) and the rest of the coefficients on the control variables are not significant. the coefficient on firmsize is negative, indicating larger companies have lower fre scores and therefore less readable financial statements. this result is in line with expectations as larger companies usually have complex operations. the first hypothesis predicts that companies whose domestic culture is more secretive will provide difficult to read financial statements. the variable of primary interest for the first hypothesis is secrecy and the results show that the coefficient on this variable is negative and statistically significant, providing support for h1. the second hypothesis predicts that companies with higher ownership dispersion will provide more readable financial statements; however, the coefficient on this variable is not statistically significant. therefore, these results fail to reject the second hypothesis. the third hypothesis predicts that companies with higher profitability will provide more readable annual reports; however, the coefficient on this variable is not statistically significant. therefore, these results fail to reject the third hypothesis as well. 4.6 sensitivity analyses i do three sensitivity tests to investigate the robustness of the results reported. first, i devise a second measure of secrecy based on the alternative definition in gray (1988). gray (1988) also hypothesizes a somewhat weaker link between secrecy and masculinity. he argues that in more caring societies where more emphasis is given to the quality of life, people will tend to be more open especially for socially related information. in particular, the alternative secrecy variable is the sum of uncertainty avoidance and power distance scores less individualism and masculinity scores. i repeat the above tests using the alternative measure of secrecy. there are no significant differences between results for this alternative measure of secrecy and therefore those results are not reported. 4 singapore has only one company listed in the u.s. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 10 as discussed above, i derive the readability numbers by using fre index method. as an alternative to using the resulting raw composite measure of these scores, i repeat these analyses using the ranks of readability scores. one concern is that it is hard to interpret, in an economically quantifiable way, what the difference in these composite scores represents. for example, is the difference between 18 and 12 twice as great as the difference between 15 and 12, at least in terms of the effect of culture on the variable of interest? these results are essentially similar to the ones reported with raw fre scores and therefore are not reported separately. lastly, oliveira et al. (2006) argue that different industries have different characteristics relative to market competition, the type of private information, and the threat of entry of new firms into the market. these factors provide incentives for companies belonging to the same industry to disclose more information than firms in another industry. therefore, this paper introduces a dummy variable for industry (1 if non-financial industry, 0 otherwise) and includes that variable in the regression analysis. table 8 provides those results. the results with respect to firm size and secrecy do not change. firm size is statistically significant in this regression. the coefficient on ownership concentration is negative and statistically significant. this indicates that companies that have higher ownership dispersion are providing more readable annual reports providing support for h2. the coefficient on the dummy variable, industry, is also statistically significant. 5. conclusions and recommendations this paper examined the following issues: 1) the effect of domestic culture, i.e. secrecy; 2) the effect of agency theory, i.e., ownership dispersion; and 3) the effect of profitability, on the readability of annual reports of u.s. – listed asian companies. the analyses show that companies whose domestic culture is more secretive are providing less readable financial statements. this result is robust to sensitivity analyses and holds after controlling for size, profitability, complexity of operations, debt ratio and ownership concentration. this is an interesting and important result in line with the efforts being made to have convergence in the international accounting area. this is despite the fact that a large number of these companies are using ifrs and u.s. gaap to prepare their financial statements. regarding the second hypothesis, the results in the sensitivity analyses support the finding that companies with higher ownership dispersion are providing more readable annual reports. with respect to the third issue, the results failed to reject the hypothesis related to the effect of profitability. the results also show that larger sample companies are providing difficult to read annual reports. as with all research, there are some limitations of this study. the sample size of 68 companies is unevenly distributed among nine countries. second, the fre measure of readability has been criticized in the literature because it does not consider attributes such as syntax, style, format, graphic design, logic, conceptual density, human interest, organization and reinforcement. however, its widespread use and studies showing that the reliability of this score is at least equal to the other readability measures provides support for this test. moreover, prior research argues that these limitations can be overcome if this test is used to analyze similar documents. third, the culture scores from hofstede (2001) were developed asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 11 before 1980. it is possible that the cultural characteristics of asian countries may have changed since then. an important contribution of this study is that this is perhaps the first paper to analyze the readability of annual reports of u.s. – listed asian companies in the u.s. these companies provide an important avenue of international accounting research because they come from different forms of culture and it is interesting to examine the effect of culture on their annual statements. previous research has argued that when firms get cross-listed, their characteristics change when they borrow global culture. this paper provides evidence that the annual reports of u.s.–listed asian companies exhibit some effects of their domestic culture even after they are listed globally. this result has important implications for the purpose of international accounting convergence and can prove useful for standard setters and policy makers across the world. finally, u.s.–listed asian companies are an under-explored area in the international accounting research. these companies have their origin in those asian countries, which stand at the forefront of economic growth at present (for example, india and china are two of the fastest growing economies and china is the second largest economy after the u.s.). therefore, it is important for researchers to obtain empirical evidence on the disclosure practices of these companies. future research in this area may compare the readability of annual reports by u.s.–listed asian companies with matched home country companies. another research question that can be examined is the effect of cross listing on u.s.–listed asian companies. lastly, the hypotheses tested in this study can be examined in the context of other countries. table 1. flesch reading ease score this table shows the ease of readability associated with different ranges of flesch scores. flesch score 0-30 30-50 50-60 60-70 70-80 80-90 90-100 readability very difficult difficult fairly difficult standard fairly easy easy very easy (flesch, r. 1949, p. 149) asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 12 table 2. sample companies this table provides the number of companies from each asian country that are listed in the u.s., the number of otc companies (excluded from the sample) and the number of companies included in the sample for this paper. country number of companies listed in u.s. number of otc companies/data unavailable included in sample china 11 0 11 hong kong 5 0 5 india 13 1 12 indonesia 2 0 2 japan 27 6 21 philippines 2 1 1 singapore 5 4 1 south korea 14 5 9 taiwan 6 0 6 total 85 17 68 table 3. culture scores for asian countries these scores were developed by hofstede (1980) in a multidimensional scaling of work-related surveys of 160,000 ibm employees over 64 countries. secrecy is computed based on the model in gray (1988). a higher value indicates more of that particular cultural trait. countries uncertainty avoidance (ua) power distance (pd) individualism / collectivism (indiv) secrecy (ua+pd-indiv) 1. china 30 80 20 90 2. hong kong 29 68 25 72 3. india 40 77 48 69 4. indonesia 48 78 14 112 5. japan 92 54 46 100 6. philippines 44 94 32 106 7. singapore 8 74 20 62 8. south korea 85 60 18 127 9. taiwan 69 58 17 110 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 13 table 4. descriptive statistics this table provides the descriptive statistics for the dependent and independent variables that are used in this research. variables minimum maximum mean median standard deviation flesch reading ease score 3.90 21 12.35 16.50 3.89 firmsize 18.06 28.40 23.56 22.26 2.25 debt ratio 0.13 0.98 0.53 0.54 0.25 income/assets -0.72 0.27 0.04 0.13 0.13 fsales% 0 0.99 0.33 0.41 0.36 secrecy 62 127 95.19 100 18.89 oc 0.06 0.93 0.41 0.44 0.25 flesch reading ease score: readability output from ms-word of the md& a section of the form 20-f annual report; firm size = natural log of total sales of the firms (in millions of u.s. dollars); debt ratio = total debt divided by total assets (in millions of u.s. dollars); income/assets = net income of the company divided by total assets; fsales% = foreign sales divided by total sales as reported in the form 20-f annual report; secrecy = computed as uncertainty avoidance + power distance – individualism scores from hofstede (1980); oc = ownership concentration = the percentage of shares owned by the three most important and known shareholders. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 14 table 5. country readability statistics this table provides the mean and median readability scores of companies within asian countries. please see table 4 for variable definitions. country n flesch reading ease mean (median) firmsize mean (median) fsales% mean (median) debtratio mean (median) china 11 11.74 (10.4) 23.93 (23.44) 0.06 (0) 0.69 (0.74) hong kong 5 11.64 (11.9) 22.45 (24.26) 0 (0) 0.48 (0.49) india 12 14.76 (14.5) 22.31 (22.60) 0.46 (0.43) 0.45 (0.44) indonesia 2 4 (4) 22.84 (22.84) 0 (0) 0.54 (0.54) japan 21 12.54 (13.1) 24.49 (25.14) 0.54 (0.52) 0.43 (0.43) philippines 1 7.2 (7.2) 22.48 (22.48) 0 (0) 0.65 (0.65) singapore 1 12.3 (12.3) 19.40 (19.40) 0.94 (0.94) 0.19 (0.19) south korea 9 10.78 (10.7) 24.28 (24.81) 0.32 (0) 0.62 (0.56) taiwan 6 14.65 (14.55) 23.11 (23.23) 0.62 (0.65) 0.32 (0.23) table 6. bivariate correlations this table provides the bivariate correlations (pearson) between the variables used in the regression analysis. please see table 4 for variable definitions. * indicates significance at 0.05 level. firm size fre secrecy foreign sales % oc income/assets fre -0.205* secrecy 0.303* -0.244* foreign sales % -0.185 0.140 0.023 oc -0.134 -0.093* 0.293* -0.495* income/assets 0.402 -0.116 0.026 0.089 -0.043 debt ratio 0.574* -0.192* 0.139* -0.345* 0.111 -0.204* asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 15 table 7. regression results this table provides regression results for the overall sample. please see table 4 for variable definitions. dependent variable: flesch reading ease score exp. sign std. beta t p-value intercept 1.50 1.496 0.141 firm size -0.221 1.783 0.080 secrecy -0.262 2.432 0.018 foreign sales% 0.054 0.463 0.645 oc 0.086 0.700 0.487 income/assets + -0.068 -0.661 0.512 debt ratio 0.007 0.054 0.958 model summary adj r2 f p-value 0.476 7.254 0.000 table 8. regression results this table provides regression results for the overall sample with industry as a dummy variable (1 for non-financial, 0 otherwise). please see table 4 for variable definitions. dependent variable: flesch reading ease score exp. sign std. beta t p-value intercept 1.69 1.597 0.115 firm size -0.044 -1.947 0.056 secrecy -0.259 -2.071 0.043 foreign sales% 0.090 0.716 0.477 oc -0.242 -1.947 -0.056 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(1996). spontaneous harmonization effects of culture and market forces on accounting disclosure practices. accounting horizons, 10(1), 18-37. microsoft word 5975-21466-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 195 changing bank income structure: evidence from large uk banks? kalsoom jaffar (corresponding author) department of law, economics, accounting and risk glasgow caledonian university, united kingdom lasbela university of agriculture, water and marine sciences, uthal pakistan e-mail: kalsoom.jaffar@gcu.ac.uk kumbirai mabwe department of law, economics, accounting and risk, glasgow caledonian university, united kingdom e-mail: kumbirai.mabwe@gcu.ac.uk dr. robert webb associate professor in banking nottingham university business school, united kingdom e-mail: robert.webb@nottingham.ac.uk received: july 15, 2014 accepted: oct. 3, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.5975 url: http://dx.doi.org/10.5296/ajfa.v6i2.5975 abstract the uk banking industry has steadily moved from the traditional role of financial intermediation and is increasingly relying on non-traditional business activities that generate fee income, dealings profit and other types of noninterest income. using the dataset of large british banks for the period 1986-2012, this study investigates the changes in the bank income structure as a result of the 1986 deregulation and tease out the effect that these changes have had in relation to systemic risk. on a micro analysis, larger banks are more able to sustain high levels of noninterest income. among the banks lloyds and hsbc stand out as asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 196 the major players in noninterest income generation. at aggregate level while interest income reflects a stable trend, we find a significant upward but slightly volatile trend in noninterest income for the period 1999-2008 before a sharp downturn induced by the financial crisis. this paper argues that in terms of financial stability, the banks’ greater reliance on noninterest income particularly commission income is associated with higher systemic risk. this study has shown that there is a positive correlation between interest income and non-interest income for the five banks. keywords: interest income, non-interest income, traditional banking, deregulation diversification, risk, bank stability, correlation jel codes: g2, g21, and g24 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 197 introduction traditionally the business of banking has been to accept deposits from customers and use these deposits to fund loans that they kept on their balance sheets until maturity. however due financial regulation that took place in the eighties, the uk banking system faced major changes in the form of increased competition, concentration and restructuring. in the context of these changes which had an impact on both the bank balance sheet and the income statements and in response to these changes, banks widened the range of products that banks offer to their customers. with regard to these changes, although the interest margin banks earn by intermediating between depositors and borrowers continues to be a source of profits for most banks, they also earn substantial amounts of noninterest income by charging their customers fees in exchange for a variety of financial services (deyoung and rice, 2004). while these changing trends may be indicating this as a new development, banks have traditionally undertaken these activities even before the 1986 deregulation (smith and wood, 2003). however, the radical deregulation reform that became known as ‘big bang’ marked the beginning of fundamental changes for the uk banking industry by removing numerous restrictions on financial service providers. in relation to these changes, while uk banks have been shifting away from lending activities and towards broader financial services for decades, the 1986 deregulation opened the way for full financial integration by explicitly allowing financial banks to engage in a host of new activities. in the context of the changing banking environment, banks generate substantial amounts of non-interest income from non-traditional activities such as investment banking, securities brokerage, insurance agency and underwriting (kwast, 1989; uppal, 2011). however, engaging in other "non-traditional" financial activities does not only give a promise for greater profitability, but also increases the industry’s vulnerability to systemic risk. as indicated by davies and tuori (2000) the debates on the changes in the nature of financial intermediation have been mostly based on theoretical and anecdotal bases rather than empirical evidence. while several studies have examined a similar question for us commercial banks and europe, this is the first paper to empirically examine the changing income trends in uk banks. by way interest income and noninterest income trends analysis for 5 large uk banks for the period 1986-2012, this paper explores the banks’ shift from the traditional banking activities to the non-traditional banking activities using 1986 as the base year as it is after the implementation of reforms that the transformation in the bank income structure became more apparent. this article is organized as follows. section 2 presents a brief account of related studies while section 3 presents data and methodology. in section 4 and 4.1 an empirical analysis of the interest income and noninterest income trends of all the 5 banks is presented. section 4.2 analyses the individual bank trends and compare them to the general view while section 5 presents the correlation results between interest and non-interest income. finally section 6 summarizes our findings and their implications before presenting a conclusion. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 198 related studies over the past two decades there has been a substantial increase in studies investigating the combination of traditional and non-traditional banking activities. despite the increase, earlier work on the decline of traditional banking has taken various approaches. the existing literature which is mostly based on us and in some cases on a broad set of european banks have predominantly focused on potential diversification benefits as the main reason why banks engage in a broader scope of activities. however, these studies have provided mixed results. while eisemann (1976), brewer (1989) and stiroh (2002), boyd et al, (1980) kwast (1989) and gallo et al, (2002) have indicated substantial benefits from diversification into non-bank activities, others have focused on the implications for stability and regulatory policy (see edwards and mishkin, 1995, lui, 2012). another cluster of research has however reported no benefits or even an increase in risk when banks combine traditional and non-traditional activities( see stiroh and rumble,2006; boyd and graham, 1986). boyd and graham (1986) found that expansion by bank holding companies into non-traditional; banking activities increased the risk of failures during less stringent policy periods in the 1970s. in the same context demsetz and strahan (1995) also indicate that no risk reduction was observed as banks tended to move to riskier activities to lower their capital ratios. deyoung and roland (2001) in their study on non-interest income and financial performance at us commercial banks found that fee-based activities increase the volatility of bank revenues. these findings are also similar to the work of stiroh (2004) and stiroh and rumble (2006) who not only show that non-interest income is more volatile but argue that it is also increasingly correlated with interest income. these findings imply lower diversification benefits which stiroh (2004) and stiroh and rumble (2006) have argued could be due to possible cross selling of different products to the same customers. smith and wood (2003) examine the variability of interest and non-interest income, and the correlation between these two variables, for the banking systems of eu countries for the period 1994-1998 and in the process arguing that non-interest income reduces bank risk via diversification. they found the increased importance of non-interest income to stabilise profits in the european banking industry in those years. further, canals (1993) found that the increased revenues obtained from new business units have significantly contributed to improving bank performance. focusing on the impact of non-interest income on bank profitability, saunders and walters (1994) argue that fee-based income stabilises profitability. this was also supported uppal (2011) who argues that after reforms banks have start to enter the financial market with almost daily innovative products/services to capture maximum market share and then earn maximum profits. uppal (2011) argue that the combination of banking, insurance and securities activities may lead to a more stable profit stream since the revenues stemming from different products in a conglomerate organisation are usually imperfectly correlated. in another strand of research, mester (1992) found that mixing traditional banking activities of originating and monitoring loans with non-traditional activities of loan selling and buying products does not only lead to economies of scale but also diseconomies of scope. further, asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 199 researchers kwast (1989), mishkin (1999), chow and surti, (2011) and hale and santos (2009) argued that the shift from traditional banking to non-traditional banking where banks borrow short, lend long and hold on to loans as an investment has been reshaped by increased competition and innovation after the deregulation of banking in 1986. deregulation which aimed to increase competition and profitability of banks dramatically changed characteristics of the bank balance sheet, from the types of assets bank hold to how they fund themselves to the source of bank income. bord and santos (2012) provide an account of how banks adopted the originate-to-distribute model in their corporate lending business and provide evidence of the effect that this shift has had on the growth of nonbank financial intermediation. thus, the originate-to-distribute model has changed the credit intermediation as these functions now occur less on bank balance sheets and more in capital markets. as the profitability of traditional banking activities has, for a wide variety of reasons, come under pressure in recent years, fee-earning activities have greatly increased their contribution to bank profits. further, lepetit et al, (2007) indicated that as a result of deregulation and the adoption of universal banking principles commercial banks can compete on a wider range of market segments. additionally, hale and santos (2009) are of the view that banks no longer hold the loans they generate and originate as investment but sell these loans to brokers to get liquidity and increased fee income. however, these in turn pool banks to issue securities which are distributed to a range of investors with a different set of risk characteristics. thus, with the shift to noninterest income came a different set of risk characteristics that pose a threat to financial stability as was witnessed in the 2007-2010 financial crisis (griffiths, 2011). an alternative way of viewing the banks’ shift to non-traditional banking activities is by looking at the size of the banks’ balance sheet in relation to the balance sheets of other financial intermediaries (edwards and mishkin, 1995). in this context, a reduction in balance sheet size is observed. however, as argued by boyd and gertler (1994) and later by edwards and mishkin (1995) the reduction in bank balance sheet size of the banking industry is not an indication of a decline in banking industry but an increase in off-balance-activities. this is in support of kaufman and mote (1994) and smith and wood (2003) who argue that the banking industry is not actually declining in any meaningful economic sense; rather, the nature of its intermediation activity is changing and is now dominated by the originate-to-distribute model. a further issue to consider in relation to changing bank income structure is the issue of measurement. the measurement of the shift from traditional banking activities to non traditional banking activities is not clear cut. edwards and mishkin (1995) argue that the standard measures of profitability such as pre-tax rates of return on assets and equity do not provide a clear trend in bank profitability as overall bank profitability includes increasingly important non-traditional business of banks. this paper build on edwards and mishkin’s (1995) study and davies and tuori’s (2000) argument that the income structure is considered to be a particularly fruitful area to look for indications of changes in the nature of the banking industry. we use the crude measure of profitability where we single out noninterest income from total earnings since much of this income comes from non-traditional activities. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 200 from a bank safety and stability perspective, numerous studies have investigated the implications that the adoption of universal banks have on bank risk, the safety and soundness of the banking system as well as the implications for the supervisory authorities (see: de young and roland, 2001; stiroh and ruble, 2004). stiroh and rumble (2006) argue that when banks move into fee income earning activities, sometimes the diversification gains are more than offset by the costs of increased exposure to volatile activities and this represent the dark side of diversification and this has implications for supervisors, managers, investors and borrowers. however the authors argue that in the us banks are now aware of the limitations of the expansion into non-traditional banking activities and are reverting back to the core banking competencies and in the process avoiding products that adversely affect their bottom line. while much work has been done on the decline of traditional banking and the analysis of interest income and noninterest income in the us, this is the first study in the uk to examine the interest income and noninterest income trends that covers the periods since the 1986 deregulation as well as the recent financial crisis. we also follow edwards and mishkin’s approach although several important features differentiate the current paper from earlier work analysing the trend from a different viewpoint. we use large uk bank financial statement data from 1986 up to 2012. we notice a significant shift from interest income to non-interest income beginning from as early as 1999 for some banks. we conduct a correlation analysis which enables us to capture the correlation between interest income and non-interest income for the period of our study and focus on the risk implications for the regulators and the banking industry at large. data, methodology, and sample the empirical analysis uses data on revenue sources for uk bank and bank holding companies (bhcs). this section defines the key variables in the analysis and provides some discussion of their relevance and importance. the current study focuses on five major british banks namely, hsbc, royal bank of scotland, lloyds, barclays, and natwest. we utilise data from annual reports including balance sheet and income statement. our choice of these banks is based on the fact that they play an essential role in the economy of the uk and contribute a huge percentage in the gdp of the country. the sample data is from 1986 to 2012 with 19861 as our starting point as it was dubbed as “big bang” when the deregulation of financial markets allowed banks to expand their activities in order to increase competition, innovation and profitability. our main focus is to critically analyse the changes in interest and non-interest income thereby providing an account of the changes in the income structure in the banks as a result of the deregulation and tease out the contribution that these changes have had to bank performance and systemic risk compared to a period when banks only focused on traditional banking interest income activities. 1 rbs and natwest only started reporting noninterest income in 1994 and 1992 respectively asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 201 empirical results broad overview the main aim of this study is to investigate the changing bank income structure with particular emphasis on interest income and noninterest income for the 5 large uk banks. although the data indicate that uk banks increasingly shifted from traditional banking from as early as1986, we find this trend more significant from 1999. in 1986, the first year of our sample, the banks’ non-interest income was £2265 million. however, in 2007, non-interest income had risen to £9548 million. by 2008 however as a result of the financial crisis, non-interest income had fallen to £5659 million. the interest and non-interest income trends for the period 1986-2012 are shown in figure (1) below. figure 1. interest and noninterest income of uk banks from 1986-2012 as shown in figure (1) the noninterest income for the period 1986-1988 increased due to deregulation of banking sector by the thatcher government to increase competition and profitability as banks which were not reporting the noninterest income started reporting the income from 1986. as davies and tuori (2000) highlighted, noninterest income is associated with more volatile bank returns which is observed in 1989 when the banking sector faced a downturn hence the noninterest income fell by 50% in 1991. the trends indicate that banks significantly diverted attention towards diversifying and investing in non-interest generating activities over the period as illustrated by figure (2) which shows the proportion of interest and non-interest income operating profit of banks. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 202 figure 2. proportion of interest income and non-interest income in operating income on an individual bank basis lloyds stands out when compared to other banks. hsbc and rbs show an upward movement however natwest and barclays shows a stable upward movement from 1986-2012 as shown in figure (3) appendix a. in contrast, a significantly stable trend was observed in the banks’ interest income. the interest income for lloyds was lower compare to the noninterest income trend as seen above in figure (3 & 4) in appendix. rbs shows completely different troughs although compare to hsbc as these two banks display similar trends in non-interest income. the results are in support of brunnermeier et al, (2012) who indicated that banks with high interest income contribute more to systemic risk than banks with lower interest income. our analysis reveals a similar trend as banks with higher noninterest income such as lloyds had major losses during the financial crisis 2007-2008. banks, after the deregulation act in 1986, moved from their traditional role where short term funds and lending occurred on bank balance sheet and loans were held on to as an investment. this meant that the systemic risk that were impossible to diversify were hedged by the liquid assets but in originate to distribute model of banking banks started to sell those loans and then securitized in asset backed securities, and might even re-securitised and these were held off-balance sheet. the main argument by bord and santos (2012) is when banks became more involved in originate to distribute model which allowed credit risk to be sliced, diced and dispersed but allowed them to earn fee income however, that exposed banks to systemic risk. non-interest income increased by only 8.37% in 1999 however a 39% increase in 2001 is observed, this is when non-interest income became a major source of income for banking sector. moreover, in 2003 the noninterest income increased by 48% as compare to 2001. the noninterest income followed an increasing trend up to 2007 as compare to interest income which was increasing but at a decreasing rate. thus we observe that noninterest income increasingly became the major source of income for banks. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 203 following the increasing trend up to 2007 the results of the analysis show a significant downturn in the non-interest income consequent of the 2007-2010 financial crisis. the noninterest income fell by 41% from £9548 million in 2007 to £5659 million in 2008. in contrast, the interest income increased by 18% from 2007-2008 but decreased by 9.5% from 2008-2009. this justifies ecp (2000) argument that non-interest income does not seem to be less volatile than interest income. the selected bank non-interest income is predominantly securities income and other income where the income from securities is more volatile than fee and commission income. the reason behind the decrease in interest income was due to the fact that the mortgage products were rapidly being pulled from the market due to losses on loans bad debts being written off which reduced the interest earned on the mortgage. the volatile nature of non-interest income pushed it to fall rapidly during this time. as indicated by literature above some of the changes in bank income structure were due to technological changes as well as financial processes. due to the 2007-2010, financial crisis consumer confidence fell to a record low and in the process reduced consumer demand for loans which ultimately reduced banks interest income as from 2008. as highlighted by edwards and mishkin (1995) and later by bord and santos (2012) the increase in originate to distribute function of banks and declining role of banking in traditional financial intermediations is based on comparison of the bank balance sheet size relative to other financial intermediaries. however, as argued by boyd and gertler (1994) the decline in the share of total financial intermediary assets does not indicate that the banking industry is in decline but a switch to the non-traditional banking activities. interest income and noninterest income trends for individual banks traditionally, fee income or non-interest income was a small part of the earnings stream of most banks. however, the earning stream in banks is affected by changes in other factors such as interest receivable, payable and expenses, the effect of these are discussed in relation to lloyds (see: figure (3) in appendix). the non-interest income in lloyds was greater than interest income in 1986 and remained higher until 1988 where interest non-income was £687.5 million and interest income was £192.6 million (appendix figure 5). the decline of interest income is not unique to lloyds, but was due to the banks being hard hit by the recession from 1988-1992. moreover, a drop in both interest and noninterest income can be seen from 1989-1994 when the banking sector was in turmoil during the ltcm crisis. a major event in the shift from traditional activities for lloyds bank is noticeable with the increase in noninterest income that follows the merger with abbey life in 1988. this brought about a slight increase in both interest income and noninterest. in 2000 the bank acquired scottish widows (a mutual life assurance company). this made lloyds the second largest uk provider of life assurance and pensions. scottish widows contributed an income of £403m as of march 2000.consequent of the purchase the group fee income increased to 46% of total income compared to 40% of 1999.in the same year the bank purchased chartered trust from standard chartered to form the lloyds tsb asset finance division which provides motor, retail and personal insurance under the name black horse. consequently income contribution from insurance and investments rose to 34% of total income. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 204 hence the upward trend in noninterest income continues to be noticeable. in 2004 the noninterest income was 75% higher than interest income. this increase in noninterest income was due to an increase of £26 million in fee and commission receivable which relate to a wide range of services provided throughout the group. as a result of the investment in scottish widows and the operations of black horse the bank witnessed a significant increase in noninterest income for the period 2000-2004. this was backed by a strong growth in income from insurance broking, card services and other short term investment. the interest income comparatively is showing a stable trend over the period however, as hale and santos (2009) argued the noninterest income is more stable than interest income and fee based activities reduce bank risk via diversification. the increase in non interest income is also due to increased bank investment on other financial instruments rather than just making loan to customers. for lloyds in relation to the changes on the balance sheet flowing through to the income statement the results of this study show that with a decrease in the percentage of loan to customers as a proportion of total assets came an increase in the noninterest income for the bank. this trend is observed for the period from 1996-2007. however, a totally different trend is observed during the 2007-2010 financial crisis when the percentage of loan decreases due to reduced demand of loans. thus the interest and noninterest income both declined due to low demand of loans and other marketable securities and the bank writing off loan losses. with regard to the relationship between increase in non-interest income and bank profitability of particular significance is hsbc where the increased revenue obtained from ‘new’ hsbc businesses increased the profitability of the bank. as illustrated by figure (7) (appendix). the bank started with a balanced mix of interest and noninterest income from 1988 where the interest income was £1721 million and noninterest income was £1137 million. although non-interest earning activities slightly decreased during 1991-1996 when the banking system in the uk was facing a downturn hsbc’s interest income in the 1987 reflects a high level of average assets and the interest margin of the bank was slightly higher than 1986 due to improved interest spread and increased proportion of mortgage loans. despite the flat tariff structure in the uk in 1987, hsbc’s noninterest income increased by 12.5% due to growth in banking commissions. hsbc continued to expand the insurance and trust business which leads to increased commission income. interest income in 1991 grew by £1757 million as compared to £1643 million in 1990 while noninterest income increased by 5% from 1990-1991. these results are in support of gallo, apilado and kolari (1996) found that the high proportion of mutual assets of banks holding companies over the period of 1987-1994 was associated with increased profitability and reduced risk for bank holding companies. dealing profits increased due to increased securities trading profit. the trading profit, fee income and commission increased with growth in first direct, cards and griffin factors. the noninterest income in 1997 was 8% higher than interest income which decreased to 4% in 1998.after 1998 hsbc’s fee income grew from £1275 million to £1488 million in 1999 reflecting strong wealth management activities. in 2001, the interest income increased to asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 205 £3325 million from £2716 million in 2000 due to growth in personal and commercial current account saving and lending in the uk banking. the noninterest income in 2000 was also increasing due to strong growth in global safe custody fee, higher current account and overdraft fee and increased corporate banking fee. noninterest income in hsbc uk banking was driven by an increase of 16% in life, pension and investment income and 7% increase in general insurance income. hsbc derived an increasing share of their profit from off-balance sheet activities such as fee income, commission, insurance and other trading activities. as a share of total bank income, the noninterest income increased from 42%, in 1990 to 48% in 1991. a declining trend can be observed in bank’s interest income and the declining trend in profitability of bank’s traditional business becomes evident with the noninterest income stable over the period until it takes a slight downturn from 89% to 69% observed in 2008-2009. the decline in interest income was attributable to lower yield on excess liquidity and customer lending partly offset by reduction is cost of funds on customer accounts. when compared to lloyds and hsbc, natwest shows a different story with noninterest income in natwest higher than interest income from 1992 through to 2000 as shown in figure (9) (appendix). the income trend for natwest is stable as compare to that of hsbc and lloyds. this may be due to what mishkin (1999) labelled as financial innovation and deregulation that created attractive alternatives for both depositors and lenders and banks as well. after the deregulation period natwest doubled the share of their income from off-balance sheet, noninterest income activities. however, the bank only started to report the interest income and noninterest income in their financial reports from 1993. however, a review of the banks’ annual statements and augmentation2 with other information shows that the interest income of the bank accounted for 62% of total income in 1988 and the steady increase in income is not only from increased volume of business but effective management of interest rate exposure during the period when interest rates have fluctuate significantly. in the same breadth noninterest income grew by 68% since 1984 and kept pace with the increase in interest income over the same period. in 1990 interest income increased by 3% while noninterest income rose by 9% despite the downturn in economic activities in major markets of the group. commission income which is the main component of noninterest income rose by 16%. although the investment banking business of natwest was affected by the deterioration in world stock markets and the uk economy in 1993 noninterest income of the bank benefited from the launch of national westminster life assurance (natwest life) and increased popularity of card and electronic payment system. in the same breadth the interest income increased due to increase in home loans in 1993 subsequently, fall in 1994 due to subdued loan demand. overall, interest and noninterest income trends were largely stable over the period of 1995-2005 however a significant decrease can be observed in 2008-2009 when the noninterest income falls from £5397million to £3197million. 2 augmentation with the directors reports asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 206 generally, for the period of 1986-2012, noninterest income in natwest was 51% of total income which is higher than interest income which constituted only49%. the increase in noninterest income is due to increased engagement in unlimited derivatives activities, and other debt and equity securities as shown in figure (10) in appendix. the asset side of natwest balance sheet shows that the bank invested a significant amount of funds in debt securities other investing assets include derivatives, equity securities, and dealing assets as shown above in figure (10) in appendix. for natwest the results of the research are in support of edwards and mishkin (1995) reported that banks have increased their participation in derivatives markets dramatically in the last few years. they further argue that these derivatives are held by large banks primarily to facilitate their dealings and trading operations. this increased participation of banks in derivatives markets has been a concern for both regulators and legislators because derivative will enable banks to take more risk than is prudent. researchers (kashia, rajang and stein, 2002, mishkin, 1999) argue that such activities are riskier than traditional banking activities and could threaten the stability of the entire banking system. further, as argued by edward and mishkin (1995) derivative are often complex instruments and need sophisticated risk control system to measure and track the potential exposure of bank. barclays shows a totally different trend due to its huge involvement in investment banking operations. figure (11) in appendix shows the interest and noninterest income trend of barclays over the period of 1986-2012. as from 1986, there was a strong performance from central retail services division interest income has steadily increased since 1982 by an average annual rate of 11%. the non-interest income increased from £1785 to £2966 in 1988 which was an increase of 42% where money transmission and lending fee made important contributions. the interest income increased to £3420 million in 1989 due to stronger balance sheet growth, increase in interest rate earning assets to 12% in 1987 as compare to 7% in 1986. it can also be argued that this increase was due to falling interest rates in both 1987 and 1986. furthermore, the interest income increased in 1987 and 1988 by 11% and 8% respectively due to growth in lending in the domestic uk banking. the interest income came under pressure in the second half of 1988 due to increase in interest rates. noninterest income improved by 15% in 1988 however, the contribution of noninterest income was 38% of total income compared to 37% in 1987. for noninterest income, commission in particular increased by 12% in 1989. however, a drop in both interest income and noninterest income is observed in 1994 due to 2% reduction in gross fees and commission due to decline in lending fee because of lower volumes. interest income in 1998 increased as compare to noninterest income due to maintained overall deposits and lending levels. however, a stable interest and noninterest income trend is observed till 2012 with a slight drop in noninterest income in 2005. barclay’s investment banking arm was considered as a primary source of increase in noninterest income due to increased commodity products and improved performance. however, interest income remained constant in 2011-2012 notwithstanding the group facing a decline in interest margin due to reduced benefits from group structural interest rate and hedging activities. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 207 rbs follows a slightly different trend when it comes to interest and noninterest income from 1994-2012 as shown in the figure (12) in appendix (the figureure shows the data from 1994 because rbs started reporting non-interest income in 1994). the interest income and noninterest income steadily increased over the period of 1994-2000. an increase in noninterest income is evident in 2003 where noninterest income is 19% higher than interest income which further became equal to noninterest income in 2005. from 2001-2007 non-interest income is significantly higher than interest income. a significant fall in noninterest income is observed in 2008 where noninterest income fell from £11191m in 2007 to £2348m in 2008 due to the financial turmoil all over the world, the demand for marketable securities reduced and due to increased mortgage default commission fee reduced. total income of the bank increased by 3% in 2007 where interest income increased by 7% but commission payable increased by 5% to £1469m. the reason behind the decline in noninterest income was due to a 55% decrease in trading activities due to write-down reflecting the weaknesses in us housing market. the interest income fell by 7% to £11298m due to run off balances, high risk segment in no core and exit of higher margin. additionally this is due to the fact that compared to other banks rbs was highly exposed to the housing market due to the nature of its operations. the noninterest income decreased to £10508m from £11593m in 2010.the noninterest income of the bank also decreased in the first quarter of 2012 which reflects lower gains in non-core income as investors’ confidence waned and lower international client activities. these results are in line with the kpmg (2012) uk banking performance report which indicates that this decrease in rbs’s noninterest income can also be due to decreased card transaction volume and the impact of exit of certain businesses from insurance businesses. overall, as indicated in literature and as discussed above, the increased importance of fee income at commercial banking companies is a direct result of structural changes such as industry deregulation. however the impact of new information technologies and financial innovation cannot be disregarded. the relationship between interest income and non-interest income is explore in more detail in the next section. correlation analysis: in this section we examine the correlation between interest income and non-interest income in uk banks after deregulation from 1986-2012 to investigate the effect of the banks shift towards non-traditional banking activities which have resulted in significant increase in noninterest income. the first table present the descriptive statistics while table 2 presents the results of the regression. table 1. summary statistics variable mean std. deviation interest income 3545619382.716 1987398802.739 non-interest income 3851142777.778 2190002242.222 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 208 the correlation between interest and non-interest income is displayed in table (2) below table 2. correlation matrix (pearson) variables interest income non-interest income interest income 1 0.941 non-interest income 0.941 1 figure 13. correlation between interest and non-interest income the results of this study indicate that for the uk banks interest income and non-interest income are highly positive correlated. the correlation indicates that a unit increase in interest income increases the non-interest income by 0.941 units. this high correlation between selected variables shows that the major uk banks are shifting predominantly from interest income to non-interest income. the non-interest income is increasing and at the same time interest income is increasing at a decreasing rate. it is difficult to explain these results but a possible explanation may be that banks may be changing the way they conduct traditional banking activities consequent of the increased competition from other nonbanking institutions, building societies and finance house after deregulation which increases interest income. in this context to meet this competition banking sector was required to be re-oriented to be in tune with global market and consumer demands. hence in order to meet the challenges of competition from non-banking financial institutions, banks have started to restructure their business and in the name of innovative products started selling the loans by packaging them through securitisation which ultimately adds to non-interest income. this supports the views shared by uppal (2011). the non-interest income is composed of many possible income streams such as fee income, commission and the returns on trading assets which could increase even if banks are focusing more on traditional role of borrowing and lending. our results are in support of deyoung and asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 209 rice (2004) who suggested that banks earn non-interest income by producing both traditional banking services and non-traditional financial services. in relation to diversification and the lower diversification benefits our results are in support of stiroh (2004) and stiroh and rumble (2006) who argue that argued the correlation between interest and non-interest income could be due to possible cross selling of different products to the same customers. we argue that with regard to uk banking universal banking principles does not only reflect diversification into non-traditional banking activities but also a shift in the way banks earns money from their traditional banking activities. our results show that banks derive non-interest income not only from traditional charges such as checking and cash management but from new sources such as cash withdrawal, bank account management and insurance provision on banking products, online bill payment and underwriting. these results are in line with deyoung and rice (2004:35) who also found ‘‘payment services-one of the most traditional of all banking servicesremain the single largest source of non-interest income at most us banking companies’’. the evidence from this study suggest that banks are earning non-interest income from both traditional banking activities and new non-traditional banking business. hence, there is a positive correlation between interest income and non-interest income. final remarks and conclusion the objective of this study was to analyse the risk implications of the uk banks’ shift towards non-traditional banking activities. on the basis of the chosen parameters the study concludes that interest income though increasing: it is increasing at a decreasing rate and non-interest income is rising since (the big bang) deregulation in 1986.what became evident from this research is that banks do more than intermediate between depositors and borrowers: they are not limiting themselves to simply earning net interest margins but they have moved to be ‘stylized general financial supermarkets’ with the adoption of universal banking principles as evidenced by the remarkable increase in non-interest income. significant increases in non-interest income were not only made possible by deregulation in 1986 but as argued by deyoung and rice (2004) for some banks increases in non-interest income were also made possible by advances in information technology, communication channels and financial processes. our study of the change in banks’ focus from traditional activities to non-traditional activities yields a number of significant findings. firstly, the present study, makes several noteworthy contributions to the literature. on the data side, we examine the consolidated bank holding company (bhc), rather than the subsidiary bank. secondly, the correlation proved that banks are fulfilling the requirements of regulators to focus on traditional banking by generating interest income however, the positive association between interest and non-interest income proves that banks are still more interested in generating diversified income streams rather than focusing on traditional banking methods of income generation. further, the results of the study indicate non-interest income is much more volatile than interest income from our global view point and for each individual bank. we also found that interest income increases while non-interest income also increases as evidenced by the results of the regression. possible explanation for these results is: uk banks shifting the way they asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 210 make money from traditional banking activities. another possible explanation for these results is that uk banks subsequent to the financial crisis and the government rushing them to lend are still generation a substantial amount of non-interest income by using non-traditional methods to produce traditional banking. these thoughts are also shared by deyoung and rice (2004) who argue that in the traditional banking model loan servicing fees and securitisation do not exist, as banks originate these loans in their own portfolios and service these loans themselves. we extend the work of deyoung and rice (2004) and argue that banks should not be using their loan books to generate non-interest income from customer deposits as this exposes banks to systemic risk. our argument is based on boyd and graham (1986) who earlier on ( even before deregulation) found that banks’ increased activity in non-traditional banking activities increased the risk of failures during less stringent policy periods in the 1970s. the trends documented in this article have important implications for banks and the regulators. banks’ increasing diversification to non-traditional activities has implications for financial stability and exposes the industry to systemic risk. while banks may respond to their shrinking intermediary role and diminished profitability by taking greater risk, if this goes unrestrained, it could undermine the stability of the banking system. the financial crisis provided some evidence that banks have in fact increased their risk-taking, either through riskier strategies in their traditional business lines or by seeking out new and more risky activities which left the whole banking industry exposed to greater systematic risk. in the process, this scenario has contributed to the growth of financial intermediation outside the banking system, including a larger role for unregulated “shadow banking” institutions (piciu et al., 2011). a constructive regulatory approach by the regulator has been to adopt a system of structured bank capital requirements together with early corrective action by regulators. however this only works if bank risk exposures have been measured accurately and capital requirements be set high enough to deter excessive risk-taking and for the regulator to adapt their policies to the new financial environment. this strategy, we believe, can successfully keep in check excessive risk-taking by banks while providing the flexibility for both banks arid regulators to restructure the banking system in order to achieve greater long-term stability. in the uk this is developing in the form of independent commission of banking’s report key recommendation: ring-fencing retail operations. based on our results, we support this contention in the perspective of the uk banking industry and argue the loan portfolio and the investment portfolio should be kept separate. these arguments form the basis of future research. 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(1999). financial consolidation: dangers and opportunities. journal of banking & finance, 23(2), 675-691. http://dx.doi.org/10.1016/s0378-4266(98)00084-3 piciu, g. c., chitiga, g., mihaila, n., & trica, c. (2011). the decline of traditional banking activities. eirp proceedings, 6. smith, r., staikouras, c., & wood, g. (2003). non-interest income and total income stability (p. 37). bank of england. saunders, a., & walter, i. (1994). universal banking in the united states: what could we gain? what could we lose?. oup catalogue. uppal, r. k. (2011). fee-based activities in indian banks. international journal of research in it & management, 1(1). vickers, j. (2011a). interim report: consultation on reform options. in: banking ico (ed.). vickers, j. (september 2011). the independent commission on banking final report recommendations. appendix figureure 3. noninterest income british banks from 1986-2012 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 213 figure 4. interest income of british banks from 1986-2012 figure 5. lloyds interest and non-interest income from 1986-2012 figure 6. percentage of loans from total assets in lloyds from 1992-2012 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 214 figure 7. interest and noninterest income in hsbc figure 8. share of noninterest income in total income in hsbc from 1988-2012 figure 9. the interest and noninterest income of natwest from 1986-2012 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 215 figure 10. the share of derivatives, debt and equity securities in natwest from 1993-2006 figure 11. interest and noninterest income in barclays 1986-2012 figure 12. interest and noninterest income of rbs from 1994-2012 microsoft word 4117-15337-1-sm-writer2-new-final.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 101 can corporate governance mitigate the adverse impact of investor sentiment on corporate investment decisions? evidence from taiwan wei-ju chen department of accounting tamkang university, taiwan tel: (886-2)-26-215-656 ext: 3365 e-mail: weiju@mail.tku.edu.tw received: august 23, 2013 accepted: september 25, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4117 url: http://dx.doi.org/10.5296/ajfa.v5i2.4117 i gratefully acknowledge the financial support from national science council of taiwan. the author thanks the anonymous referee for helpful comments. the author also thanks ying-ying chu for help in collecting the data and ju-lan tsai for research assistance. abstract this paper explores whether investor sentiment has an adverse impact on corporate investment decisions and whether such impact, if present, can be effectively mitigated by sound corporate governance mechanisms. the sample comprises listed firms in taiwan between 2003 and 2010. empirical results indicate that investor sentiment is significantly and positively related to amount of new investment and over-investment. investor sentiment has an adverse impact on corporate investment decisions. further test for the moderating effect of corporate governance confirms that corporate governance mechanisms can mitigate such adverse impact of investor sentiment on corporate investment decisions. the empirical results support the argument of previous literature that corporate governance has both incentive and monitoring effects on managers’ decision-making. due to the agency problem, managers’ investment decisions may be affected by investor sentiment and deviate from the goal of maximizing firm value. therefore, firms should reinforce their corporate governance mechanisms to minimize the adverse impact of investor sentiment. keywords: corporate governance; board of director mechanisms; agency theory; investor sentiment; investment decision asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 102 1. introduction classical financial theory assumes that investors are rational. the efficient market hypothesis suggests that share prices reflect all the information of a firm. however, recent studies show that investors are actually not rational and will be driven by emotional factors to make wrong investment decisions (e.g., cornelli, goldreich, & ljungqvist, 2006; de long, shleifer, summers, & waldmann, 1990; dorn, 2009; shleifer & vishny, 1997). the presence of sentimental investors makes a firm’s share price deviate from its fundamentals. in other words, a firm’s share price is determined by not only its fundamentals but also investor sentiment. it has been documented in many studies that investor sentiment also has an impact on manager decisions (baker, stein, & wurgler, 2003; baker & wurgler, 2004; dong, hirshleifer, & teoh, 2007; gilchrist, himmelberg, & huberman, 2005; polk & sapienza, 2009). therefore, this paper will explore whether investor sentiment has an adverse impact on corporate investment decisions and further examine whether such impact, if present, can be mitigated by sound corporate governance mechanisms. making investment decisions is an important activity in firm management. for sustainable operations, firms need to constantly expand and innovate their facilities and products. investment decisions concern the allocation and use of resources and funds, usually in a large amount. a wrong decision can pose a serious threat to the survival of the firm. hence, careful assessment of investment decisions is of high importance to firms. however, recent studies (e.g., baker et al., 2003; dong et al., 2007) have found that managers do not always make investment decisions in the interest of shareholders. the empirical finding in baker et al. (2003) shows that the irrational element of stock prices may affect corporate investment through an equity financing channel. through this equity financing channel, mispricing caused by investor sentiment has a positive effect on investment level, particularly among highly equity-dependent firms. in addition to the equity financing channel, investor sentiment can also affect investment decisions through a catering channel (grundy & li, 2010; kau, linck, & rubin, 2008; morck, shleifer, vishny, shapiro, & poterba, 1990; polk & sapienza, 2009). managers may increase firm investment to cater to the optimistic (pessimistic) sentiment of investors (mcconnell & muscarella, 1985). in doing so, they can achieve a quick boost of the firm’s stock price and earn higher salary or compensation for themselves. managers operate the firm for firm owners. hired by the firm, they are supposed to pursue maximum interest of shareholders. however, due to the agency problem, some managers may shirk or act in their own best interests (jensen & meckling, 1976). no matter through which channel investor sentiment motivate managers to make decisions that lead to over-investment or under-investment, such decisions are detrimental to firm value. previous research has obtained abundant evidence that sound corporate governance mechanisms can mitigate the agency problem and further increase firm performance and shareholder wealth (e.g., agrawal & knoeber, 1996; core, guay, & rusticus, 2006; cremers & nair, 2005). based on this perspective, this paper will examine whether corporate governance mechanisms can induce or force managers to act toward maximization of firm value regardless of investor sentiment. the main contributions of this paper are as follows: first, many studies have shown that asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 103 mispricing caused by investor sentiment affects managers’ investment decisions. this paper further examines whether corporate governance can moderate the relation between investor sentiment and investment decisions. second, previous research of the impact of investor sentiment on investment decisions uses investment level as the main dependent variable. this paper employs the over-investment (under-investment) model introduced by richardson (2006) to estimate the amount of over-investment and test whether investor sentiment has an adverse impact on investment decisions. third, based on baker & wurgler’s (2006) methodology, this paper develops a composite index of investor sentiment through principal component analysis. four proxy variables, including stock turnover, number of ipos, consumer confidence index (cci), and discretionary accruals are considered in the analysis. this composite index can better represent investor sentiment as it contains not only the market-wide and firm-level investor sentiment index but also the direct and indirect investor sentiment index. fourth, due to the diversity and interchangeability of corporate governance mechanisms (bathala & rao, 1995), the quality of a firm’s corporate governance cannot be judged simply by the effectiveness of a single mechanism. this paper follows the method used by bushman, chen, engel, and smith (2004) and young and wu (2009) to integrate various corporate governance variables into a composite index of corporate governance. with this index, this paper further examines whether corporate governance mechanisms can mitigate the adverse impact of investor sentiment on investment decisions. our empirical results indicate that investor sentiment has an impact on corporate investment level. firms tend to invest more when investors are more optimistic. investment decisions that fluctuate with investor sentiment will result in abnormal firm investment. managers are likely to over-invest when they increase their firm’s investment under the influence of investor sentiment (no matter through the equity financing channel or through the catering channel). excessive investment of resources into projects with little benefit for the firm will cause a persisting decline of firm value. as to the moderating effect of corporate governance, empirical evidence shows that increase of investment level and over-investment induced by the optimism of investors can be mitigated in the presence of effective corporate governance mechanisms. in other words, sound corporate governance mechanisms can offer positive incentives and constraints to managers to avoid the agency problem. 2. theoretical background and hypotheses 2.1 investor sentiment and investment decisions investor sentiment affects stock prices, causing a deviation of stock prices from fundamentals (baker & wurgler, 2006, 2007; baker, wurgler, & yuan, 2012; lemmon & portniaguina, 2006; shleifer & vishny, 1997). when investors are optimistic, they may overlook negative information and overreact to positive information, resulting in overvaluation of stock prices. conversely, when investors are pessimistic, they may overlook positive information and overreact to negative information, resulting in undervaluation of stock prices. investor sentiment causes mispricing, which in turn affects a firm’s investment level through two main channels, namely the equity financing channel and the catering channel. keynes (1936) argues that stock prices contain an important element of irrationality. this asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 104 element influences a firm’s financing decisions and further investment decisions. many studies have studied the equity financing channel through which managers’ investment decisions are affected (blanchard, rhee, & summers, 1993; bosworth, hymans, & modigliani, 1975; fischer & merton, 1984; morck et al., 1990; stein, 1996). stein (1996), for instance, proposes a model of equity financing channel in which mispricing of a firm’s stock causes changes in the financing conditions for the firm. the cost of equity financing for the firm is lower when its stock is overpriced. according to the market timing theory, managers will issue stocks to get finance. they increase the firm’s investment after gaining sufficient finance for investment. if they invest without careful assessment, they may waste resources on projects with a negative net present value (npv), which is a phenomenon called over-investment. if the firm’s stock price is under-estimated, the cost of equity financing will be higher for the firm. in this case, managers will not issue stocks. they may reduce their firm’s investment and even drop projects with a positive npv, which is a phenomenon called under-investment. therefore, mispricing is positively related to investment level and over-investment. this relation is particularly evident among highly equity-dependent firms. baker et al. (2003) use empirical data to test stein’s (1996) model. their findings reveal that investment level is positively related to the element of irrationality, and this relation is especially strong among highly equity-dependent firms. based on baker et al.’s (2003) research design, chang, tam, tan, and wong (2007) draw upon a large panel of australian firms to investigate if mispricing caused by investor sentiment has an impact on investment level. their finding supports that investor sentiment affects corporate investment through the equity financing channel. dong et al. (2007) also find that capital expenditure and research and development expenditure increase with mispricing among overvalued firms. the equity financing channel hypothesis states that investor sentiment affects firm investment through the market timing for equity offerings. the effect of investor sentiment on firm investment is indirect. according to this hypothesis, firms with a huge amount of internal funds or a high debt capacity do not need to obtain finance for investment from the equity market. in other words, their investment decisions are not susceptible to fluctuation of stock prices. in addition to the equity financing channel, many studies have found that investor sentiment also affects firm investment through the catering channel (grundy & li, 2010; kau et al., 2008; morck et al., 1990; polk & sapienza, 2009). they state that mispricing affects investment decisions when managers have an incentive to cater to the optimistic (or pessimistic) sentiment of investors, even in the absence of high equity dependence. due to information asymmetry, potential investors value a firm based on their observation of the firm’s investment behavior (chan, martin, & kensinger, 1990; chung, wright, & charoenwong, 1998; mcconnell & muscarella, 1985; trueman, 1986). according to the catering theory, when investors are optimistic but managers refuse to invest in projects favored by the investors, the investors may sell their shares, causing a slump of the firm’s stock price. therefore, managers will choose to increase (decrease) investment to cater to the optimistic (pessimistic) sentiment of investors to maximize the firm’s share price in a short time and earn higher salary or compensation for themselves. however, over-investment and under-investment are likely to occur when managers overly cater to investor sentiment. polk and sapienza (2009) use discretionary accruals as a proxy for mispricing caused by investor asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 105 sentiment to test if corporate investment caters to investor sentiment. their empirical finding suggests a significant and positive relation between corporate investment and discretionary accruals. grundy and li (2010) also empirically confirm that managers seeking to maximize short-term shareholder value may increase corporate investment that caters to investor sentiment. besides, if there is a high level of investor optimism, a higher share of ownership may provide managers with an incentive to over-invest. based on the above theories and discussions, this paper proposes the following hypotheses: hypothesis 1: a higher level of investor optimism leads to more new investment. hypothesis 2: a higher level of investor optimism leads to more over-investment. 2.2 investor sentiment, corporate governance mechanisms, and investment decisions jensen and meckling (1976) propose the agency theory, suggesting that due to separation of ownership and management, managers may put aside the interest of shareholders while seeking their own interest. investment expenditure is an important corporate decision and usually involves a huge amount of money. however, the agency problem may occur when managers make investment decisions that do not best serve the interest of shareholders but their own interest. jensen (1986) puts forth the “over-investment” problem, a problem that occurs when managers do not seek maximization of shareholder wealth but personal interests, such as social reputation, higher reward or more compensation, through continuous firm expansion. if the free cash flow is large, managers are also more likely to invest in negative npv projects. such investment, called over-investment, will further decrease the firm’s value and harm the interest of shareholders. the incentives and monitoring mechanisms of corporate governance can mitigate the agency problem. theoretically, corporate governance has a positive effect on firm value and the quality of managerial decision-making. however, the extant empirical research has mixed conclusions about the impact of corporate governance on the quality of managers’ investment decisions. the finding of masulis, wang, and xie (2007) suggests that firms with better corporate governance are more efficient in acquisition. huang, huang, and chang (2011) point out that corporate governance offer monitoring mechanisms which can ensure that managers make better investment decisions and avoid the over-investment problem. both harford, mansi, and maxwell (2008) and richardson (2006) reveal that firms with poor corporate governance tend to have greater industry-adjusted investment. bertrand and mullainathan (2003) and giroud and mueller (2010) find that poor corporate governance results in under-investment. however, richardson (2006) argues that only a small portion of corporate governance mechanisms can effectively mitigate over-investment. mispricing caused by investor sentiment can cause an increase in firm investment or even over-investment through the equity financing channel or the catering channel. according to the agency theory, sound corporate governance mechanisms offer incentives and monitoring effects that can lead and force managers to make decisions in pursuit of higher firm value. assume that investors have a high degree of optimism, and managers obtain a large cash flow due to market timing. firms with better corporate governance mechanisms may be able to asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 106 motivate and compel their managers to make proper investment decisions and avoid over-investment in negative npv projects. moreover, they can also motivate and compel their managers not to over-invest only to cater to investor sentiment. based on the above discussions, this paper proposes the following hypotheses: hypothesis 3: in the presence of better corporate governance mechanisms, the effect of investor sentiment on new investment is smaller. hypothesis 4: in the presence of better corporate governance mechanisms, the effect of investor sentiment on over-investment (under-investment) is smaller. 3. data and methodology 3.1 data and sample selection this paper draws on a sample comprising publicly listed firms in taiwan from 2003 to 2010. firms in the financial industry and firms with missing variables are excluded from the sample. the final sample includes 7745 firm-year observations. the values of consumer confidence index (cci) are obtained from the monthly survey conducted by the research center for taiwan economic development, national central university. the data of other variables of investor sentiment, corporate governance, and investment decision (including basic firm data, stock price, stock trading volume, ipo data, ownership structure, board composition, and financial reports) are obtained from taiwan economic journal (tej). 3.2 empirical model the proposed hypotheses are tested using the following regression models. in equation (1), the independent variable is investor sentiment (senti), and the dependent variable is new investment (invest). this equation is intended to examine the relation between investor sentiment and new investment level. in equation (2), the independent variable is investor sentiment (senti), and the dependent variable is over-investment (under-investment) (overinvest). this equation examines the relation between investor sentiment and over-investment. both equation (3) and equation (4) contain an interaction term of investor sentiment and corporate governance (senti*cgi) to test the relation of investor sentiment to investment level and over-investment under different levels of corporate governance. the selection and measurement of each variable is explained as follows. the operational definition of all the variables is provided in table 1. , = + , + , + , + , + , (1) , = + , + , + , + , + , (2) , = + , + , + , ∗ , + , + , + , + , (3) , = + , + , + , ∗ , + , + , + , + , (4) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 107 3.3 variables definitions and measurement 3.3.1 investment variables in this paper, the dependent variables include new investment (invest) and over-investment (overinvest). according to richardson (2006) and strong and meyer (1990), total investment expenditure is the sum of all outlays on capital expenditure, acquisitions, and research and development less receipts from the sale of property, plant, and equipment. total investment expenditure can be broken down into required investment expenditure to maintain assets in place (for which amortization and depreciation can be used as the proxy) and investment expenditure on new projects. hence, new investment (invest) is total investment expenditure minus amortization and depreciation expense. to estimate the amount of over-investment, this paper employs the method introduced by richardson (2006). the expected level of new investment is estimated using equation (5). the fitted value from the regression is the estimate of the expected level of new investment. and the residual from the regression is the estimate of over-investment. the residual can be negative or positive. positive (negative) values denote over-investment (under-investment). , = + , + , + , + ( ) , + ( ) , + , + , +∑ c + ∑ + , (5) 3.3.2 investor sentiment variables to examine whether an individual firm’s investment decisions are affected by investor sentiment, we need to capture firm-specific investor sentiment. based on the methodology of previous research (e.g., baker & wurgler, 2006; polk & sapienza, 2009), this paper uses individual stock turnover (turn) and discretionary accruals (daccr) as proxies of investor sentiment at the firm level. in addition, number of ipos (nipo) and consumer confidence index (cci) are used as proxies for investor sentiment at the market level. each investor sentiment proxy is likely to include a sentiment component as well as some idiosyncratic, non-sentiment-related components. following baker and wurgler (2006), this paper performs principal component analysis to isolate the common components. the development of each proxy variable for investor sentiment and how we build a composite index of investor sentiment (senti) is explained as follows. in this paper, we use four proxy variables of investor sentiment, including turn, daccr, nipo, and cci. first of all, we estimate the first principal component of the four proxies and their lags. this gives us a first-stage index with eight loadings, one for each of the current and lagged proxies. we then compute the correlation between the first-stage index and the current and lagged values of each of the proxies. finally, we define senti as the first principal component of the correlation matrix of four variables—each respective proxy’s lead or lag, whichever has the higher correlation with the first-stage index. this procedure produces a composite index of investor sentiment as follows. the first principal component explains 43.94% of the sample variance. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 108 senti t=0.7057 nipot-1+0.0674 daccr t-1+0.0400 turn t-1+0.7041 cci t-1 stock turnover (turn). baker and stein (2004) indicate that turnover can serve as a proxy for investor sentiment. when irrational investors are optimistic, they participate in the market and thus increase the turnover. following this idea, baker and wurgler (2006) include the market turnover variable in their composite sentiment index to test the relationship between investor sentiment and the cross-section of stock returns. in this paper, we use stock turnover as a proxy for the sentiment of irrational investors. high turnover denotes that investors are optimistic about the firm, and low turnover denotes that investors are pessimistic about the firm. discretionary accruals (daccr). the optimism of investors causes overpricing of a stock. sloan (1996) and teoh, welch, and wong (1998) find that firms with higher discretionary accruals have lower abnormal returns in the long run and therefore infer that the current stock prices of these firms are overpriced. chi and gupta (2009) and polk and sapienza (2009) also use discretionary accruals as a proxy for sentiment-induced mispricing. based on these studies, we also view discretionary accruals as one of the proxies for investor sentiment. high (low) discretionary accruals indicate the current stock prices are overpriced (underpriced) and investors are optimistic (pessimistic). we estimate discretionary accruals using the method introduced by polk and sapienza (2009). number of ipos (nipo). the ipo market is often viewed as sensitive to investor sentiment. according to the market timing theory, managers offer ipos when stock trading is highly active and their stock prices are overpriced (baker & wurgler, 2002; lucas & mcdonald, 1990). it can be inferred that investors are more optimistic when the number of ipos is greater. consumer confidence index (cci). the research center for taiwan economic development, national central university, surveys consumer confidence index (cci) on a monthly basis. unlike the other three indices which evaluate investment sentiment based on indirect data, cci directly measures the degree to which investors are optimistic about the future. cci is a direct index of investor sentiment. we use this index as a proxy for investor sentiment. cci considers six factors, including consumers’ confidence for investment in the next six months, timing of buying durables, household economic conditions, domestic price level, domestic employment opportunities, and the economic climate. the values of this index fall between 0~200. values above 100 denote investors are optimistic, and values below 100 denote investors are pessimistic. higher cci indicates higher investor optimism (qiu & welch, 2004). 3.3.3 corporate governance variables bathala and rao (1995) point out that many mechanisms of corporate governance can be substituted for one another, so a firm’s corporate governance cannot be measured by the effectiveness of only one of the mechanisms. in order to take into account a wider spectrum of variables of corporate governance, we adopt the method used by bushman et al. (2004), cheng, gul, tong, and tsui (2008), and young and wu (2009). this method is to combine asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 109 various corporate governance variables into one composite variable to assess the quality of corporate governance. we first select four variables related to board composition to measure the monitoring effects of corporate governance, including the efficiency and independence of monitoring. in addition, we select three variables concerning ownership structure to measure the incentive effects of corporate governance, including the incentive for board monitoring and the incentive for the controlling shareholder to reduce expropriation. finally, we combine these seven variables into one composite corporate governance index (cgi). the variables in each of the two constructs are explained as follows: board composition. four variables of board composition are considered, including board size (bodsize), chairman duality (duality), ratio of outside directors (outbod), and presence of independent directors or supervisors (ind). jensen (1993) and yermack (1996) have noted that when the board size is too large, incongruence of opinions and conflict of interest are likely to occur and further slash the effectiveness of board monitoring. we sort all the total numbers of directors on the board in descending order and compute the percentile of each value. at last, each percentile is converted into a bodsize value between 0~1. in taiwan, 76% of listed firms are family firms, and 66.45% are fully controlled by the largest family shareholder (yeh, 1999). because family members hold decisive shares, agency problem is likely to occur between controlling shareholders and minority shareholders in family firms. if the director of the board is simultaneously served by a family member or the ultimate controller, the independence and monitoring effect of the board may be compromised. the board can better supervise the manager without chairman duality. therefore, we set duality as a dummy variable. the value is 1 if the chairman is not served by a family member or the ultimate controller; the value is 0 if otherwise. fama (1980), firstenberg and malkiel (1980), and weisbach (1988) have mentioned that a higher ratio of outside directors on the board increases the supervisory power of the board and is positive for firm value. beasley (1996) finds a negative relation between increase in the number of outside directors and occurrence of financial statement error and fraud. this finding suggests that the presence of more outside directors can help increase the reliability of accounting information. in this paper, we calculate the ratio of outside directors in each firm and sort all the values into ascending order, so that we can convert each of them into a percentile value of outbod between 0~1. sivaramakrishnan and yu (2008) indicate that firms with more independent directors have better corporate governance. we set the presence of independent directors (ind) as a dummy variable, which is coded 1 if independent directors or supervisors are present on the board and 0 if otherwise. finally, we sum the values of the four variables, namely bodsize, duality, outbod, and ind to form a composite board composition index (cg-bod). the value of this variable ranges between 0 and 4. higher values indicate higher effectiveness of the board. ownership structure. three variables of ownership structure are considered, including ratio of shares held by board members (bshold), deviation of control rights and cash flow rights (dev), and equity pledge ratio of directors and supervisors (pledge). dechow, sloan, and sweeney (1996) and jensen and meckling (1976) suggest that when directors or supervisors hold a high ratio of shares of the firm, they will be more motivated by a high correlation asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 110 between their financial risk and the firm’s performance to monitor the management. in this paper, we sort all the ratios of board ownership in ascending order to compute the percentile for each firm, so that the value can be further converted into a bshold value between 0~1. deviation of control rights and cash flow rights (dev) is the difference between control rights and cash flow rights of the ultimate controller. it can be used to measure the quality of a firm’s corporate governance (claessens, djankov, & lang, 2000; la porta, lopez-de-silanes, shleifer, & vishny, 2002). if dev is large, controlling shareholders can control the firm with a small cash flow and there may be a stronger incentive for them to embezzle the firm’s assets and expropriate minority shareholders. therefore, a larger dev leads to worse corporate governance. we sort all the values of difference between control rights and cash flow rights in descending order and compute their percentiles, so that each value can be transformed into a dev value between 0~1. values closer to 1 indicate better corporate governance. according to kao, chiou, and chen (2004) and yeh, lee, and woidtke (2001), a higher equity pledge ratio of the board suggests that directors and supervisors are highly involved in the stock market and have collateralized their holdings in exchange for cash. there will be a smaller incentive for the directors and supervisors to manage the firm properly, and ethical crisis is likely to occur. therefore, higher pledge results in worse corporate governance. we sort all the pledge ratios in descending order and compute the percentile of each ratio to obtain a pledge value between 0~1 for each firm. values closer to 1 indicate better corporate governance. we sum the values of bshold, dev, and pledge to get a composite ownership structure index (cg-own). the values will range between 0~3, and the greater the value, the better the corporate governance. finally, we add up the board composition index (cg-bod) and the ownership structure index (cg-own) to form a composite corporate governance index (cgi). this index ranges from 0 to 7. this index denotes the strength of corporate governance mechanisms, so the higher the index, the better the corporate governance. 3.3.4 control variables the control variables in this study include cash flow (cf), investment opportunity (q), and firm size (size). both grundy and li (2010) and richardson (2006) have found a positive relation between cash holdings and investment expenditure. hence, cash flow should be controlled. besides, firms tend to invest more when they can have more investment opportunities. most previous studies use tobin’s q as a proxy for investment opportunity (chen, ho, lee, & yeo, 2000; polk & sapienza, 2009; richardson, 2006). tobin’s q is the ratio between the market value and replacement value of the total assets. as replacement value of firm assets is not accessible, we use the book value of firm assets instead (chung & pruitt, 1994). finally, firm size is controlled, and the total assets at the beginning of the year is used as a proxy for firm size. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 111 table 1. variables description variable symbol variable description and definition variables in the primary model: new investment invest the sum of all outlays on capital expenditure, acquisitions and research and development less receipts from the sale of property, plant and equipment minus amortization and depreciation expense over investment overinvest the residual from regression (5) sentiment indexes senti the first principal component of the correlation matrix of turnt-1, daccrt-1, ccit-1 and nipot-1. corporate governance composite indexes cgi the sum of bodsize, duality, outbod, ind, bshold, dev and pledge. cash flow cf the sum of income before extraordinary items and depreciation and amortization tobin’s q q the market value of total assets deflated by the book value of total assets firm size size total assets measured at the start of the year. variables in the over-investment model: growth growth change of prime operating revenue divided by prime operating revenue at the beginning leverage leverage the sum of the book value of short term and long term debt deflated by the sum of the book value of total debt and the book value of equity. cash cash the balance of cash and short term investments deflated by total assets. firm age ln(age) logarithm of the number of years since incorporation. firm size ln(size) logarithm of total assets. stock return stock return the market-adjusted stock returns. investor sentiment variables turnover ratios turn the ratio of trading volume to outstanding shares of the firm. discretionary accruals daccr daccr , = accr , − normalaccr , accr , = ∆ncca , − ∆cl , − dep, normalaccr , = ∑ accr ,∑ sales , sales , where: △ncca is the change in noncash current assets. △cl is the change in current liabilities minus the change in debt included in current liabilities and minus the change in income taxes payable. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 112 table 1. variables description (continued) variable symbol variable description and definition dep is depreciation and amortization expense. sales is net sales of firms. consumer confidence index cci cci is calculated based on the survey results provided by the research center for taiwan economic development, national central university. the number of ipos nipo the number of ipos in year t. corporate governance variables board size bodsize all the total numbers of directors on the board are sorted in descending order before computing the percentiles. each percentile is converted into a value between 0~1. chairman internalization duality a dummy variable which is coded one if the chairman is not served by the ultimate controller or a family member and zero if otherwise. the percentage of outside directors outbod all the ratios of outside directors are sorted in ascending order before computing the percentiles. each percentile is converted into a value between 0~1. presence of independent directors or supervisors ind a dummy variable which is coded one if the board has independent director(s) or supervisor(s) and zero if otherwise. the composite board composition index cg-bod the sum of bodsize, duality, outbod and ind. board ownership ratio bshold all the ratios of shares held by board members to shares outstanding are sorted in ascending order before computing the percentiles. each percentile is converted into a value between 0~1. the deviation of control rights and cash flow rights dev all the differences between control rights and cash flow rights of the ultimate controller are sorted in descending order before computing the percentiles. each percentile is converted into a value between 0~1. equity pledge ratio of the board pledge all the pledge ratios are sorted in descending order before computing the percentiles. each percentile is converted into a value between 0~1. the composite ownership structure index cg-own the sum of bshold, dev and pledge. this table provides description and definition of the variables. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 113 4. empirical results and analysis 4.1 descriptive statistics the descriptive statistics for the main variables are presented in table 2. panel a shows the average new investment is $636 million, and the abnormal investment ranges between $-151,749 million~$368,091 million. panel b shows the data of proxies for investor sentiment. the mean turnover (turn) is 211.44%, and the mean value of discretionary accruals (daccr) is $-67.13 million. the difference between the minimum and the maximum of each variable is large, suggesting that investor sentiment varies greatly from firm to firm. at the market level, cci values fall between 54.49~78.53, and the number of ipos (nipo) ranges between 34.00~124.00. the principal component analysis shows that the mean of the composite investor sentiment index (senti) is 0, with a standard deviation of 1.33. overall, cci values fall between 0~100, and the mean value of discretionary accruals is negative, suggesting that investors are slightly pessimistic during the sample period. panel c presents the data of variables of corporate governance. the mean composite board composition index (cg_bod) is 1.69 (on a scale of 0 to 4). among the elements of this index, the mean board size (bodsize) is 6.83, the mean duality is 0.19, meaning only 19% of the firms do not have the chairman duality problem. in other words, most sample firms are run by a manager who is also the controlling shareholder or a family member of the controlling shareholder and likely to have the agency problem. the mean ratio of outside directors is 34%, which is not high. besides, 43% of the firms have independent directors and supervisors. the mean composite ownership structure index (cg_own) is 1.66 (on a scale of 0 to 3). among the elements of this index, the mean ownership ratio (bshold) and pledge ratio (pledge) of board members are 23.38% and 9.48% respectively. the maximum deviation of control rights and cash flow rights (dev) reaches as high as 90.62%. the sum of the composite board composition index (cg_bod) and the composite ownership structure index (cg_own) is the composite corporate governance index (cgi). the theoretical range of this value is between 0~7. the worse firm in the sample has 0.41 on this index, and the best has 6.64. 4.2 investor sentiment and new investment table 3 examines how investor sentiment is related to new investment with sentiment indexes as independent variables, new investment as dependent variable, and cash flow, investment opportunity, and firm size as control variables. the data employed in this research are panel data. as shown in equation (1)~(4), we conduct ols with year dummies controlled, fixed effect regression with and without time effect, and random effect regression respectively to increase the robustness of the results. empirical results indicate that sentiment indexes are positively related to new investment at 1% significance level. therefore, hypothesis 1 is supported. that is, higher optimism of investors leads to more new investment. due to the consideration of equity financing cost or the incentive to cater to investor sentiment (baker et al., 2003; polk & sapienza, 2009), managers may increase their firm’s new investment when investors are optimistic about their firm. among the control variables, cash flow (cf) is significantly and positive related to new investment in the fixed effect regression model. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 114 tobin’s q is also significantly and positively related to new investment. as mentioned earlier, managers invest more to increase firm value when they spot good investment opportunities for the firm. total assets and new investment are significantly and positively related. new investment also increases relatively with firm size. table 2. descriptive statistics mean std. dev. minimum median maximum panel a: investment variables and control variables invest (million) 636 6,948 -111,834 52 381,619 overinvest (million) 0 6,643 -151,749 -139 368,091 cf (million) 1,730 9,041 -26,494 211 229,476 size (million) 17,799 585,940 32 3,827 1,380,532 q 0.73 0.74 -0.63 0.55 11.82 panel b: investor sentiment variables turn (%) 211.44 194.17 0.07 154.57 1581.29 daccr (million) -67.13 3,116.94 -94,772.25 -10.35 41,446.21 cci 68.04 8.48 54.49 68.75 78.53 nipo (number of ipo firms) 62.96 28.82 34.00 52.00 124.00 senti 0.00 1.33 -3.57 -0.41 2.51 panel c: corporate governance variables cg_bod 1.69 0.79 0.00 1.80 3.95 bodsize (number of seats) 6.83 2.33 2.00 7.00 27.00 bodsize (0-1) 0.62 0.30 0.00 0.56 1.00 duality 0.19 0.39 0.00 0.00 1.00 outbod (%) 34.08 21.23 0.00 37.50 100.00 outbod (0-1) 0.45 0.29 0.00 0.47 1.00 ind 0.43 0.50 0.00 0.00 1.00 cg_own 1.66 0.60 0.18 1.72 2.99 bshold (%) 23.38 13.83 0.00 19.97 94.95 bshold (0-1) 0.45 0.28 0.00 0.42 1.00 dev (%) 5.29 9.31 0.00 1.31 90.62 dev (0-1) 0.54 0.32 0.00 0.52 1.00 pledge (%) 9.48 18.16 0.00 0.00 100.00 pledge (0-1) 0.68 0.41 0.00 1.00 1.00 cgi 3.35 1.07 0.41 3.39 6.64 n 7,745 this table presents summary statistics for the dependent and independent variables. variable description is specified in table 1. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 115 table 3. investor sentiment and new investment (1) (2) (3) (4) ols fixed effects random effects senti t 2870.72*** 303.97*** 4328.99*** 237.05*** (3.09) (5.96) (4.80) (4.81) cf t 0.02 0.04* 0.02 0.00 (1.50) (1.78) (0.93) (0.15) q t-1 233.90** 455.24*** 350.03** 366.39*** (2.37) (3.32) (2.34) (3.09) sizet 0.05*** 0.08*** 0.08*** 0.07*** (23.07) (20.90) (21.09) (22.65) intercept -6,644.27*** -1,172.87*** -10,009.71*** -702.89*** (-3.35) (-8.89) (-5.21) (-3.73) year dummies yes no yes n 7,745 7,745 7,745 7,745 r2 0.18 0.09 0.09 the table examines how investor sentiment is related to new investment. the dependent variable is new investment (invest). the independent variables include sentiment index (sentit), cash flow (cft), tobin’s q (qt-1)) and firm size (sizet). detailed definitions of the variables are given in table 1. t-statistics (for ols and fixed effects models) or z-statistics (for random effects model) are reported below the estimated coefficients. the symbols ***, **, and * denote statistical significance at 1 percent, 5 percent, and 10 percent levels respectively. 4.3 investor sentiment and over-investment table 4 examines the relation between investor sentiment and over-investment through four models, including ols with year dummies controlled, fixed effect regressions with and without time effect, and random effect regression. the empirical findings indicate that the higher the sentiment index, the larger the over-investment. for instance, in the fixed effect model with time effect, an increase of sentiment index by 1 causes an increase in over-investment by $7,537 million. if investors are overly optimistic, managers may increase firm investment due to market timing or an incentive to cater to investor sentiment. the increased investment is likely to become over-investment. conversely, if investors are overly pessimistic, under-investment is likely to occur. the results offer support for hypothesis 2, that is, higher investor optimism leads to more over-investment. among the control variables, tobin’s q is significantly and positively related to abnormal investment in some models, implying that over-investment is more likely to occur when there are more investment opportunities. besides, firm size is positively related to over-investment. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 116 table 4. investor sentiment and over-investment (1) (2) (3) (4) ols fixed effects random effects senti t 4,114.26*** 231.68*** 7,537.18*** 153.44*** (4.34) (4.35) (8.02) (2.99) cf t 0.02 0.01 -0.02 -0.02 (1.43) (0.50) (-0.98) (-0.90) q t-1 -2.34 293.71** 274.96* 170.03 (-0.02) (2.05) (1.76) (1.39) sizet 0.03*** 0.06*** 0.07*** 0.05*** (12.76) (16.26) (17.17) (16.12) intercept -9,167.71*** -1,376.87*** -16,811.22*** -830.12*** (-4.53) (-9.99) (-8.39) (-4.44) year dummies yes no yes n 7,745 7,745 7,745 7,745 r2 0.07 0.05 0.06 the table examines how investor sentiment is related to over-investment. the dependent variable is over-investment (overinvest). the independent variables include sentiment index (sentit), cash flow (cft), tobin’s q (qt-1)) and firm size (sizet). detailed definitions of the variables are given in table 1. t-statistics (for ols and fixed effects models) or z-statistics (for random effects model) are reported below the estimated coefficients. the symbols ***, **, and * denote statistical significance at 1 percent, 5 percent, and 10 percent levels respectively. 4.4 investor sentiment, corporate governance, and investment decisions in order to examine whether corporate governance can mitigate the impact of investor sentiment on investment decisions, we include the interaction term between corporate governance indexes and sentiment indexes in the regression equations. table 5 shows whether board composition moderates the relationship between investor sentiment and investment decisions. the empirical results of equation (1)-(4) indicate that the interaction term between board composition (cg_bod) and investor sentiment (senti) is significantly and negatively related to new investment (invest). in other words, the higher the board composition index, the less that investor sentiment will positively affect new investment. firms with a better board structure can more effectively monitor managers’ decision-making and reduce the adverse impact of investor sentiment on their investment decisions. on the other hand, the results of model (5)-(8) indicate that the interaction term between board composition (cg_bod) and investor sentiment (senti) is also significantly and negatively related to over-investment (overinvest). in other words, if there is a high level of investor optimism, the better the board composition, the more effectively that the board can monitor managers and prevent them from over-investing only to cater to investor sentiment or because of the availability of free cash flow. the board plays a central role in corporate governance. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 117 the board is responsible for monitoring managerial performance, preventing conflict of interests, and ensuring compliance of firm operations with various laws. if the board has a better composition, it can exert its monitoring function more independently and efficiently. as a result, the impact of investor sentiment that causes inefficient allocation of resources and harms the interest of shareholders can be effectively mitigated. table 6 includes the interaction term between ownership structure (cg_own) and sentiment indexes (senti) to examine whether ownership structure moderates the relationship between investor sentiment and investment decisions. the results of equation (1) ~ (4) indicate that the interaction term of cg_own and senti is significantly and negatively related to new investment (invest). the results of equation (5) ~ (8) indicate that the interaction term of cg_own and senti is also significantly and negatively related to over-investment (overinvest). in other words, better ownership structure can mitigate the impact of investor sentiment on new investment and over-investment. the ownership structure index (cg_own) measures the incentive effects of corporate governance mechanisms. higher board ownership ratios indicate a higher alignment of board interest to shareholder interest, and there is a stronger incentive for the board to monitor managerial decisions. a high pledge ratio of the board means that board members have collateralized most of their shares in exchange for cash. thus, there is a weak incentive for them to monitor managerial decisions. besides, equity collateralization will deepen the connection between the personal finance of board members and the firm’s stock price, offering an incentive for board members to encourage firm investment that results in a stock price increase. finally, higher deviation between control rights and cash flow rights (dev) offer an incentive for the controlling shareholder to expropriate minority investors. such incentive can be reduced if dev is low. therefore, the quality of ownership structure concerns the incentives for monitoring and expropriation. our empirical evidence confirms that the better the ownership structure, the more effectively that managers’ investment decisions can be monitored, and the smaller the incentive for expropriation will be. better ownership structure can help mitigate the adverse impact of investor sentiment on investment that concerns the long-term value of the firm. finally, based on the board structure index (cg_bod) and the ownership structure index (cg_own), we analyze whether the overall quality of corporate governance (cgi) can moderate the relation between investor sentiment and investment decisions. as shown in table 7, the interaction term between senti and cgi is significantly and negatively related to both new investment (invest) and over-investment (overinvest). in other words, the higher the composite corporate governance index (cgi), the more that the impact of investor sentiment on new investment and over-investment can be mitigated. the results in table 5~ 7 supports hypothesis 3 and hypothesis 4, which assert that better corporate governance mechanisms can mitigate the impact of investor sentiment on new investment and over-investment (under-investment) respectively. to sum up, investor sentiment influences a firm’s investment level, even to the extent of over-investment or under-investment; the effect of investor sentiment can be mitigated if better corporate governance mechanisms are present. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 118 table 5. investor sentiment and investment decisions – the moderating effect of board composition (1) (2) (3) (4) (5) (6) (7) (8) dependent variable =invest dependent variable =overinvest ols fixed effects random effects ols fixed effects random effects senti t 3,166.65*** 710.12*** 4,579.49*** 686.74*** 4,401.99*** 667.62*** 7,781.53*** 629.64*** (3.40) (5.94) (5.06) (5.95) (4.63) (5.35) (8.25) (5.24) cg_bodt 276.44*** -298.07 -317.08 223.90 375.42*** -283.19 -234.85 303.96** (2.95) (-1.51) (-1.60) (1.53) (3.93) (-1.37) (-1.14) (2.05) cg_bodt*senti t -275.91*** -260.76*** -281.50*** -283.46*** -269.38*** -279.92*** -264.02*** -298.45*** (-3.91) (-3.75) (-3.99) (-4.27) (-3.74) (-3.86) (-3.59) (-4.32) cft 0.02 0.04* 0.02 0.00 0.01 0.01 -0.02 -0.02 (1.24) (1.78) (0.96) (0.01) (1.09) (0.50) (-0.96) (-1.06) qt-1 184.50* 474.14*** 372.10** 361.63*** -66.44 314.07** 295.76* 158.48 (1.85) (3.46) (2.49) (3.05) (-0.65) (2.19) (1.90) (1.30) sizet 0.05*** 0.08*** 0.08*** 0.07*** 0.03*** 0.07*** 0.07*** 0.05*** (23.27) (21.25) (21.45) (22.93) (13.19) (16.63) (17.47) (16.44) intercept -6,834.13*** -754.07** -9,300.54*** -1,174.27*** -9,486.07*** -988.45*** -16,265.97*** -1,440.42*** (-3.44) (-2.12) (-4.75) (-3.70) (-4.68) (-2.66) (-7.98) (-4.52) year dummies yes no yes yes no yes n 7,745 7,745 7,745 7,745 7,745 7,745 7,745 7,745 r2 0.18 0.09 0.10 0.07 0.05 0.06 this table examines whether board composition moderates the effect of investor sentiment on new investment and over-investment. the independent variables include sentiment indexes(sentit), board composition indexes (cg_bodt ), cash flow (cft), tobin’s q (qt-1), firm size (sizet) and the interaction term of board composition indexes and sentiment indexes (cg_bodt * sentit). detailed definitions of the variables are given in table 1. t-statistics (for ols and fixed effects models) or z-statistics (for random effects model) are reported below the estimated coefficients. the symbols ***, **, and * denote statistical significance at 1 percent, 5 percent, and 10 percent levels respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 119 table 6. investor sentiment and investment decisions – the moderating effect of ownership structure (1) (2) (3) (4) (5) (6) (7) (8) dependent variable =invest dependent variable =overinvest ols fixed effects random ols fixed effects random senti t 3,256.86*** 1,229.41*** 4,764.68*** 972.77*** 4,840.38*** 1,113.92*** 7,930.40*** 824.72*** (3.47) (8.06) (5.28) (6.58) (5.06) (6.99) (8.43) (5.36) cg_ownt 245.84** 213.56 208.82 229.05 681.13*** 390.95 395.48* 522.44*** (2.00) (0.93) (0.91) (1.25) (5.44) (1.63) (1.65) (2.79) cg_ownt*senti t -194.26** -563.27*** -538.62*** -448.26*** -155.54* -537.80*** -482.45*** -409.35*** (-2.15) (-6.44) (-6.15) (-5.29) (-1.69) (-5.89) (-5.28) (-4.64) cft 0.02 0.04* 0.02 0.00 0.01 0.01 -0.02 -0.02 (1.35) (1.67) (0.92) (0.00) (0.96) (0.39) (-1.00) (-1.07) qt-1 235.73** 437.51*** 339.48** 357.42*** -4.75 273.91* 262.13* 158.84 (2.39) (3.20) (2.28) (3.02) (-0.05) (1.91) (1.69) (1.31) sizet 0.05*** 0.08*** 0.08*** 0.07*** 0.03*** 0.07*** 0.07*** 0.05*** (23.05) (21.50) (21.61) (22.99) (13.62) (16.86) (17.66) (16.61) intercept -7,207.59*** -1,567.97*** -9,466.07*** -1,115.76*** -11,300.38*** -2,066.27*** -16,679.46*** -1,738.95*** (-3.54) (-3.86) (-4.83) (-3.06) (-5.46) (-4.87) (-8.16) (-4.72) year dummies yes no yes yes no yes n 7,745 7,745 7,745 7,745 7,745 7,745 7,745 7,745 r2 0.18 0.09 0.10 0.07 0.06 0.07 this table examines whether ownership structure moderates the effect of investor sentiment on new investment and over-investment. the independent variables include sentiment indexes (sentit), ownership structure indexes (cg-own t ), cash flow (cft), tobin’s q (qt-1), firm size (sizet) and the interaction term of ownership structure indexes and sentiment indexes(cg-own t * sentit). detailed definitions of the variables are given in table 1. t-statistics (for ols and fixed effects models) or z-statistics (for random effects model) are reported below the estimated coefficients. the symbols ***, **, and * denote statistical significance at 1 percent, 5 percent, and 10 percent levels respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 120 table 7. investor sentiment and investment decisions –the moderating effect of corporate governance (1) (2) (3) (4) (5) (6) (7) (8) dependent variable =invest dependent variable =overinvest ols fixed effects random ols fixed effects random effects senti t 3,498.15*** 1,335.07*** 4,931.71*** 1,199.68*** 4,879.97*** 1,275.33*** 8,112.15*** 1,116.57*** (3.74) (7.92) (5.45) (7.40) (5.12) (7.24) (8.60) (6.62) cgit 243.14*** -13.57 -28.39 236.80** 436.97*** 63.50 84.40 379.12*** (3.50) (-0.09) (-0.20) (2.18) (6.17) (0.42) (0.56) (3.44) cgit*senti t -212.33*** -321.98*** -326.08*** -298.01*** -199.00*** -326.10*** -301.22*** -296.74*** (-4.17) (-6.41) (-6.42) (-6.21) (-3.84) (-6.21) (-5.69) (-5.94) cft 0.02 0.04* 0.02 -0.00 0.01 0.01 -0.03 -0.02 (1.12) (1.70) (0.93) (-0.09) (0.76) (0.40) (-1.00) (-1.19) qt-1 193.52* 471.18*** 372.25** 355.64*** -73.29 308.82** 293.86* 147.65 (1.95) (3.44) (2.50) (3.00) (-0.73) (2.16) (1.89) (1.21) sizet 0.05*** 0.08*** 0.08*** 0.07*** 0.03*** 0.07*** 0.07*** 0.05*** (23.34) (21.60) (21.74) (23.23) (13.83) (16.94) (17.73) (16.85) intercept -7,355.65*** -1,244.53** -9,244.85*** -1,622.35*** -10,824.03*** -1,706.78*** -16,505.24*** -2,233.97*** (-3.66) (-2.47) (-4.65) (-3.86) (-5.28) (-3.25) (-7.97) (-5.27) year dummies yes no yes yes no yes n 7,745 7,745 7,745 7,745 7,745 7,745 7,745 7,745 r2 0.18 0.09 0.10 0.07 0.06 0.07 this table examines whether corporate governance mechanisms moderate the effect of investor sentiment on new investment and over-investment. the independent variables include sentiment indexes (sentit), corporate governance composite indexes (cgit ), cash flow (cft), tobin’s q (qt-1), firm size (sizet) and the interaction term of corporate governance composite indexes and sentiment indexes (cgit * sentit). detailed definitions of the variables are given in table 1. t-statistics (for ols and fixed effects models) or z-statistics (for random effects model) are reported below the estimated coefficients. the symbols ***, **, and * denote statistical significance at 1 percent, 5 percent, and 10 percent levels respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 121 5. conclusions the contemporary research of behavioral finance suggests that managerial decision-making is influenced by investor sentiment. the fluctuation of investor sentiment can affect a firm’s investment levels through the equity financing channel or the catering channel. investment decisions that are not made through careful assessment for optimal investment are disadvantageous to firm value and shareholder interest. the purpose of this paper is to investigate the impact of investor sentiment on investment decisions, including the amount of new investment and over-investment, and further examine whether corporate governance can mitigate this impact. empirical results show that higher investor optimism leads to more new investment and over-investment, supporting the argument that investor sentiment has an adverse impact on investment decisions. previous research has documented that such adverse impact mainly stems from the agency problem. generally, a manager's performance is evaluated primarily by the firm’s stock price. their concern of personal performance, salary or compensation may drive them to seek maximization of the firm’s stock price within a short time (grundy & li, 2010). therefore, when investors are optimistic, managers may make decisions that can cause a short-term boost of the firm’s price to cater to investor sentiment. however, such decisions are likely to result in over-investment. on the other hand, when investors are optimistic, the cost of equity financing can be lower. managers are likely to obtain more finance than needed. the excessive cash flow will reduce the efficiency of firm management and investment, causing over-investment (harford, 1999; jensen, 1986; opler, pinkowitz, stulz, & williamson, 1999, 2001). all these problems can affect a firm’s resource allocation and jeopardize the interest of the firm and shareholders. finally, the empirical evidence confirms that corporate governance can mitigate the adverse impact of investor sentiment on investment decisions. in the presence of sound corporate governance mechanisms, the impact of investor sentiment on new investment and over-investment is smaller. sound corporate governance mechanisms can motivate board members to perform their monitoring function, reduce controlling shareholders’ expropriation intention, and supervisor firm decisions effectively and independently. in the presence of sound corporate governance mechanisms, managers will be less likely to be motivated by self-interest to overly cater to investor sentiment or by market timing considerations to acquire too much cash flow that results in a waste of resources or over-investment. in order to increase firm value, firms should reinforce their corporate governance mechanisms, strengthen the monitoring function of the board, and improve the effectiveness of their ownership structure to inhibit self-serving or opportunistic behavior of managers and mitigate the 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(2009). the determinants and effects on earnings informativeness of asset impairments: the role of corporate governance. international journal of accounting studies, 48, 67-114. microsoft word 11537-42531-1-sm-writer3-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 254 the impact of “offer for sale” by existing shareholders in an ipo on initial aftermarket performance norliza che-yahya faculty of business and management universiti teknologi mara, puncak alam campus, malaysia e-mail: norliza9911@puncakalam.uitm.edu.my ahmad husni mohd rashid faculty of business and management universiti teknologi mara, puncak alam campus, malaysia e-mail: ahmadhusni@salam.uitm.edu.my ibrahim a. rahman faculty of business and management universiti teknologi mara, puncak alam campus, malaysia e-mail: ibrahim014@salam.uitm.edu.my siti norbaya mohd rashid faculty of business and management universiti teknologi mara, puncak alam campus, malaysia e-mail: norbaya@uitm.edu.my received: july 12, 2017 accepted: october 11, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11537 url: https://doi.org/10.5296/ajfa.v9i2.11537 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 255 abstract this study examines the impact of “offer for sale” by existing shareholders in an ipo on initial aftermarket performance. the “offer for sale” is measured by the proportion of shares offered to public from the sale of the existing shareholdings against the total number of shares offered during ipo. the “offer for sale” activity suggests that proceed from the shares sold to investors at an ipo would go into the pocket of the existing shareholders. that is, the proceed does not actually meet the goals of the ipo which is to raise fund. the new investors expect new cash inflows for the firm to finance new projects and to secure its sustainable growth. ipo firms that go public mainly through “offer for sale” activity are expected to receive less demand during the ipo from the potential investors. in other words, the investors prefer to invest more in ipo firms that offer entirely newly issued shares rather than those that offer a combination of “public issue” and “offer for sale”. firms which their shares are offered through “offer for sale” activity are predicted to produce poor initial aftermarket performance relative to firms which their shares are newly issued. employing a sample of 419 malaysian ipos issued from january 2000 to december 2015, regression results of this study reveal that firms which their shares are offered highly through “offer for sale” report poor initial aftermarket performance. keywords: offer for sale, initial aftermarket performance, malaysian ipo market asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 256 introduction malaysian economic performance has shown tremendous growth since malaysia become independence in 1957. at an average of gdp 6 % growth per year from 1970s to 2005, the economy sustained rapid growth of 8 % annually. the creation of funds is needed to support the growth, and malaysia is so accustomed to build the economy and trade from the flow of capitals across the globe. private sector activity remained the key driver of growth expanding at a very fast pace. private investment grew mainly driven by continuous capital spending especially in the services and manufacturing sector. as private sector continues to grow, companies will be focusing on need to raise funds in order to complement the government and businesses. most business fails because they lack the cash to get through the early stages of their existences. capital is crucial at the start of the company life as it enables the business to turn ideas to reality. the seed capital may be used to hire key staff, purchase inventory or market the company and its ideas. all these require cash and for these the reasons companies raise investment strategizing the future growth chart for the companies. the question that will be raised is, what the companies sell that attracted investors to lend money to the company? raising funds through ipos is a very popular ways to raise funds for a company. ipos is where a private company going public by selling its share to the public in an initial public offering. the public offerings will be done thru an investment bank appointed by the company. it will go through a complex process in trying to determine the marketability and saleability of the shares offered. the advantages of issuing ipos is that the company may grow its business without taking any debt financing that will avoid the company from paying interest and required to service interest payment. with the money on the coffer from the selling of stock, company will also be able to give better compensation to their manager, owner and founder of the company. once it become a public company, additional business will be made easier and especially if the company become more successful. what will companies’ sell that will attract the investor to purchase the shares. companies finance their investment opportunities in the form of real assets, inventory and capital expenses. the proceed of the ipos will provide cash flow for the companies that can be used to finance new positive npv projects that can be lead to further growth for the company (garfinkel,1993). this can be translated into the appreciation of shares in the futures. however, companies sometimes can exploit investors’ lack of knowledge towards the market by overvaluing their shares, hoping that they will get more cash flow. however, studies have shown that overvalued shares will experience poor long run performance (kavita wadhwa, v. naggi reddy, abhinav gopal, abdulkadir mohamed, 2016). investor chooses initial public offering for many reasons. besides having good multiples, evaluating through the prospectus, will allow investor to analyse the ipo stock more meticulously and thoroughly as to compare with buying stock under secondary market. the price that is being offered and the funds collected indeed reflect the performance and expected future growth of the companies. the expectation of investor is always that the cash flow from the ipo is to be plough back to the company so that they will be used it to create asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 257 growth. however some ipos do not offer entirely new shares but also a proportion of it comes from the shares of the existing shareholders. what if the total ipo raised is not being used for the future growth of the company? ipos that are issued and raised together with the “offer for sale” as part of the ipo but the offer for sale would be used to distribute cash to the existing shareholders. what would the perception of the investors in this type of ipo? would they perceive that shareholders have lack of confidence to the future plan of the company or the price offered is above their valuation price. would the negative perception to the selling of ipo shares, lower the demand of the ipo shares price in the initial aftermarket performances. can it have an influence on the price aftermarket performance? we would like to do a research on the premises that the portion of the ipos goes back to the shareholders will carry an impact to the ipos sales. the remaining sections of this paper is organized as follows; section 2 reviews relevant literature. section 3 describes the data and methodology used in this study. section 4 presents and discusses the empirical results while section 5 concludes the findings. literature review ipo initial aftermarket performance worldwide a lot of investors loves a good ipo story, whether it’s a company that soared after its initial offering or one that have overinflated in the early excitement. mayur & kumar (2013) founds that indian firm who go public want to raise capital for their growth and expansion, diversify the risk of initial owners and capital structure rebalancing, bring down their cost of capital, increase the liquidity of their shares, avoid excessive monitoring or large shareholders and to seek publicity. younger, riskier, transparent, more profitable, experiencing higher sales growth and size of the company will become larger are the impact to those companies who go public. however, there are cost in becoming public which are information asymmetry and adverse selection cost, experience loss of confidentiality, and bear initial and subsequent expenses. investors are actively into flipping activity which continue until subsequent week in the malaysia ipo market. stock market regulator need to do something since extreme flipping activity might detrimental the secondary ipo market. abdul rahim, sapian, yong, & auzairy (2013) found that extreme flipping activity will create synthetic pressure on the ipo price that garb for speculative activities. while study done by islam, m. s., & munira s. (2004) found that ipo flipping is certain in the initial aftermarket. bangladesh market is stimulus by institutional investors and issue size. it helps investor in predicting the liquidity and price of ipo stock in the immediate aftermarket. as to limit the proportion of institutional investor preferable to do flipping activity, sec as regulatory authority may consider to convincing the issuer to allocate lower proportion of new issues. mohd rashid, abdul rahim, hadori, & tanha (2013) examines the variability in initial return, ipo volumes, and market conditions of the ipo listed in bursa malaysia during the period from january 2000 to december 2010. initial return and market condition may give a signal of the ipo volume as it also influence the decison of the company to go public. ipos asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 258 are risky in the long run and also for the first few weeks after the listing. besides initial return and market condition, companies also study on market volatility before they make decision to go public as it has positive relationship with ipo volume. studied done by sahoo & rajib (2010) on 92 indian ipos issued during the period of 2002 to 2006, it shows that indian ipos are underpriced on the listing day as compared to market index besides during the initial year of trading but may gain positive market-adjusted return thereafter. underperformance of the ipos are due to initial day return, offer size, leverage at ipo date, ex-ante uncertantity and timing of issue. traditionally, jegadeesh, weinstein & welch (1993) found that ipo underpricing and the probability and size of subsequent seasoned offerings has a positive relationship. those firms are likely to issue seasoned equity within three years of their ipos in a large amount when they experience relatively larger ipo-date returns. abdul rahim et. al (2012) studied the winner’s curse hypothesis in a sample of 384 ipos listed on bursa malaysia from 1999 to 2008. when the ipos are overpriced, investors are more likely to gain more in their subscription. investors are advisable to gather all available information that may influence the ipos performance before making decision to subscribe any ipos. besides that, during the participation of institutional investors in the ipos, uninformed investors are willingly to pay high offer price and accept lower initial returns since they are confidence on the performance of the ipos. but, to make the non-private placement ipos are fully subscribed, uninformed investors need to be persuade with larger initial returns during the absence of informed investors. offer for sale and hypothesis a longer lockup period may give a signal to venture capital (vc) and the reputation of underwriter backing (j.d. arthurs et al., 2009). underpricing can be avoided when the lockup period is longer. however, during a longer lockup period, managers with sizeable ownership may resort to risky decisions since they afraid a certain loss of wealth. but, managers may become risk averse and avoid making risky decisions during shorter lockup period. mohd rashid, abdul-rahim, & yong (2014) examines the issue of lock-up provisions (ratio and period) in ipos and their relationship with initial returns using a dataset from bursa malaysia spanning the period from january. examines whether the lock-up ratio and lock-up period affect the initial returns, using a sample of 384 ipos listed on bursa malaysia between 2000 and 2012. the results of the cross-sectional multiple regression show that the lock-up period is significantly positive in explaining ipo initial returns, but the lock-up ratio is not. the findings provide new insights for testing the signaling content of lock-up provisions, particularly in a setting characterized by high information asymmetry, lock-up ratios and lock-up periods are predicted to have a positive influence on the initial returns of ipos based on the risk-signaling hypothesis. study on moderating effect of information asymmetry on the relationship between parameters of lockup provision and flipping activity of malaysian ipos has been done by abdul-rahim & che yahya (2015). lock-up provision is to promote committment among the major asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 259 shareholders as not to sell their shares after the process of the ipo but also it provide signal on the initial return. this study founds that the lockup provision has a greater influence on flipping activity in higher than lower information asymmetry companies. both lockup ratio and lockup period have significantly negative impacts on flipping activities. the results imply that investors have a greater tendency to flip during the post-2008 revision period when major shareholders are perceived to be less strongly accounted for their firms‟ performance. the results also show that information asymmetry moderates the negative relationship between lockup provision and flipping activity, specifically, in regards to lockup period. research methodology sample size and procedures the population of this study is all ipos listed on bursa malaysia from january 2000 to december 2015. there were 540 ipos listed during this period. the final sample of this study consists of 419 ipos, which is 77.59 per cent of the total population. this study starts the sample period in 2000 to reduce the noise from the 1997/98 asian financial crisis on the analysis. the sample period ends in 2015 as that is the latest coverage year the analysis could achieve as some information (e.g., proportion of lock-up shares) need to be validated with information provided by ipo issuer in its first annual report a year after the listing. all rare type ipos (i.e., restricted offer for sale, restricted public issue, restricted for sale to eligible employees, special and restricted issue to bumiputra investors, tender offer and special issue) and ipos with missing value were omitted. similarly, ipos issued by financial and insurance firms due to differences in the regulatory structure of the industry (schaub et al., 2003). data for this study were sourced from prospectuses of the ipo issuers, the website of bursa malaysia and the database of datastream. variables definition and analytical methods initial return the independent variable of this study, initial return (return), is measured as the percentage change in price, between the closing price on the first day of trading and the offer price. to reduce market interference and noise on the return of a stock, this study re-measure initial return using the percentage change in opening price on the first day of trading and the offer price (mohd rashid et al., 2014; 2016; yong, 2010). as suggested in yong (2010). the opening price is more able to capture the first reaction of investors upon the listing of an ipo. the measure is shown as follows: 100x p ppreturn i ii offer offeropen iopen      = − (1a) 100x p ppreturn i ii offer offerclo iclose      = − (1b) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 260 where, popeni = opening price on the first trading day for the ith issuer, pcloi = closing price on the first trading day for the ith issuer, and pofferi = offer price for the ith issuer. offer for sale the main independent variable of this study, offer for sale (ofsale), is defined as the selling down one or more shareholdings of a firm by existing shareholders during ipo (espinasse, 2011) and is measured by the ratio of total number of shares offered or sold by existing shareholders to total shares offered in an ipo (bildic & yilmaz, 2008). the measure is shown as follows: iii noshinofsaofsale /= (2) where, nofsai = offer for sale of the ith issuer, and noshii = total number of shares offered for the ith issuer. control variables the control variables of this study comprises of demand of ipo (demand) which is measured by subscription ratio. the initial return is expected to be significantly positively related to return because investors perceive that the highly demanded ipos indicate the value of the shares at the early listing days as well as the quality of the issuing firms (abdul rahim et al., 2013; islam & munira 2004). accordingly, investors are more likely join the pool to subscribe for the shares. the demand-supply theory would suggest that the higher demand will result in higher ipo price. next, supply of ipo (supply) is measured as the natural log of the total number of shares offered for an ipo multiplied by its offer price (ln (noshi x pofferi)) (bayley, lee, & walter, 2006; chong, ali, & ahmad, 2009). larger offer size indicates a larger supply of the ipo that ceteris paribus, more subscription applications will be fulfilled during allotment stage and less will be demanded during the first few trading days (sapian, abdul rahim, & yong, 2012). this argument leads to the expectation that larger issue will result in lower initial return. market condition (mkt) signifies the overall performance of the stock market. market condition is measured by the average one week returns of ftse bursa malaysia emas index. a positive preaverage market return suggests that the investors are optimistic and confident about the present market outlook which in turn affects positively on their attitude toward initial return of the new issues (chong et al., 2009; ritter & welch, 2002). therefore, a asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 261 positive relationship between mkt and retutn is expected. next control variable of this study, investors’ sentiment reflected by heurestic representative, is measured by the average returns on the opening trading day of the three most recent new issues listed prior to an ipo. unlike the overall stock market condition (mkt), heuristic representative signifies the investor sentiment in a smaller scope i.e., how investors evaluate an ipo (winner or loser) and/or a market (bull or bear) based on what has happened in the most recent period. positive (negative) mean initial returns of the three most recently issued ipos tend to elicit optimistic (pessimistic) sentiment among the investors (bayley et al., 2006; chong et al., 2011). similarly, this suggests that the optimism among market players, which allows for higher prices (or initial return). underwriters’ reputation (undrep) usually reflects the credibility of investment banks in pricing, selling and certifying an ipo. a credible investment bank is supposed to have the experiences and expertise that are necessary to estimate the true value and quality of the issuing company. therefore, the use of a reputable underwriter is expected to reduce the severity of information asymmetry between the insiders and the outside investors (yung & zender 2010) such that increase the confidence of investors in investing in some firms. with that concept in mind, this study expect a positive relationship between undrep and initial return. this study measures the underwriter reputation using its market shares on a particular year. specifically, the market shares of underwriter is percentage of the total amount of shares underwritten by the underwriter against the total amount of shares underwritten by all underwriters in the specific listing year. as suggested by fang (2005), the market share is a preferable indicator as it naturally reflects the ‘brand name’ and the ‘goodwill’ of an underwriter. institutional investors are perceived to be informationally opaque that they should only invest in companies with good prospects of future cash flows (aggarwal, 2003; gounopoulos, 2006). this study argues that the involvement of institutional investors is an ipo could be interpreted as a signal of quality of the issuing companies. measuring the institutional investors’ involvement using the proportion of ipos offered to the institutional investors against the total number of shares offered, this study expects a positive relationship between institutional investors’ involvement and initial return. next is lock-up provision’s (lock-up ratio). lock-up ratio (lockup) is defined as the percentage of shares locked by promoters. lock-up provision has been implemented on a mandatory basis on major shareholders (i.e., promoters) of ipo issuers in malaysia since 3 may 1999. in detail, the malaysian capital market regulator, the securities commission (sc) has set a minimum percentage (e.g., 45 per cent of the total shares outstanding) that need to be retained by the promoters for a certain length of time upon the listing of the shares. while there is an argument that the mandatory ruling will cause lock-up provision to be irrelevant to investors because it becomes a norm to all ipos, this study argues that the case is different in malaysia. this is because promoters of most ipo issuers in malaysia voluntarily lock more shares than mandated by the sc. this study observes there are promoters of ipo issue who voluntarily lock-up 84 per cent of their shares despite the 45 per cent requirement. the voluntary act in the practice of the lock-up provision carries an important signal (arthurs et asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 262 al., 2009; hakim, lypny, & bharbra, 2012) because it reflects the behaviour of the firms. based on signalling theory, lock-up ratio could reflect quality of the ipos (mohan & chen, 2001; wan-hussin, 2005). a higher lock-up ratio infers that affected shareholders agree to retain their shareholdings in the firms despite the high initial return in the immediate aftermarket. hence, the investors will be more confident in the ipo issuer (arthurs et al., 2009; georgen et al., 2006; islam and munira, 2004). subsequently, the higher is the lock-up ratio, the higher is the initial return. the list of control variables, predicted sign and relevant literature supporting employment and prediction on sign of these control variables are summarised in table 1. table 1. summary of control variables and expected sign no. control variable exp. sign. (return) past studies 1. demand of ipo (demand) +ve abdul rahim et al., 2013, islam and munira (2004) 2. supply of ipo (supply) -ve bayley et al. (2006), chong et al. (2009), tran et al. (2007), sapian et al. (2012) 3. stock market condition (mktlook) +ve chong et al. (2009), ritter and welch (2002) 4. investors sentiment (heurep) +ve bayley et al. (2006), chong et al. (2011) 5. underwriter reputation (undrep) +ve fang (2005), yung & zender (2010) 6. institutional investors’ involvement (insvol) +ve aggarwal (2003), gounopoulos (2006) 7. lock-up ratio (lurat) +ve islam and munira (2004), mohan and chen (2001), wan-hussin (2005) note: +ve indicates an expectation on the positive relationship while -ve indicates an expectation on the negative relationship. estimation models the following multiple regression equations are applied to examine the influence of offer-for-sale on initial return using two measurements; εcvofsaleβαireturn j jjiiopen +++=  = 7 1 1)( β (3a) εcvofsaleβαireturn j jjiiclose +++=  = 7 1 1)( β (3b) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 263 where, α is the regression intercept, β is the estimated coefficient of the respective predictor variable, cvi,j is the control variables from j = 1,…, 8 for the ith ipo, while the remaining variables are as defined in earlier section and ε is the error term. empirical results and discussion preliminary results table 2 presents the descriptive statistics of 419 malaysian ipos, listed from 2000 to 2015. the average return (opening price) is 0.28 percent from a minimum of -0.68 percent to a maximum of 4.04 percent. while the avarage return (closing price) is 0.29 percent ranging from -0.68 percent to 3.60 percent. for explanatory variables, mean of offer for sale ratio is 0.25 percent which ranges from a minium of nil to a maximum of 1.00 percent. table 2. profile of sample ipos, 2000 – 2015 items mean median min. max. std. dev. return (open price) (%) 0.28 0.15 -0.68 4.04 0.55 return (close price) (%) 0.29 0.15 -0.68 3.60 0.48 offer for sale (%) 0.25 0.00 0.00 1.00 0.31 osr 31.00 14.72 -0.89 377.95 47.54 offer size (rm) 1.76e+0 8 19560000 2400000 1.25e+10 9.14e+ 08 mean klci (%) 0.01 0.04 -1.56 1.07 0.36 heu. rep (investor sentiment) (%) 0.30 0.16 -0.38 3.17 0.43 underwriter mkt share 7.80 2.70 0.00 90.80 11.78 inst. investor involvement (%) 0.45 0.53 0.00 1.00 0.33 lock-up shares (%) 0.56 0.55 0.00 0.84 0.10 note: sample size, n = 419 for the period from january 2000 to december 2015. initial return (return) is measured as the percentage change in price, between the closing price on the first day of trading and the offer price. . popeni is an opening price on the first trading day (see. eq. 1a), while pcloi is a closing price on the first trading day (see. eq. 1b). both price is used to calculate initial return (return). table 3 presents correlations among independent variables which are below 0.90 cut-off point (aeteriou & hall, 2007) for any severe threat of multicollinearity. an exception is the 0.268 correlation between underwriter market share and institutional investor involvement, two parameters of initial return, which indicate the possibility of high correlation between two main independent variables. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 264 table 3. correlation matrix variables 1 2 3 4 5 6 7 8 9 10 1. returnopen 1 0.804 -0.201 0.315 -0.192 0.90 0.211 0.063 0.025 -0.140 2. returnclose 1 -0.208 0.427 -0.222 0.129 0.277 0.046 0.060 -0.060 3. ofsale 1 -0.223 0.384 -0.001 -0.063 0.022 -0.255 0.016 4. demand 1 -0.250 -0.002 0.178 -0.103 0.221 -0.097 5. supply 1 -0.031 -0.032 0.243 -0.274 0.054 6. mktlook 1 0.106 -0.049 0.053 -0.031 7. heurep 1 0.159 -0.131 -0.117 8. undrep 1 -0.268 0.028 9. insvol 1 0.026 10. lurat 1 notes: abbreviations returnopen = return using percentage change in opening price on the first day of trading and the offer price; returnclose = return using percentage change in closing price on the first day of trading and the offer price; ofsale = offer for sale; demand = demanf of ipo; supply = supply of ipo; mktlook = stock market condition; heurep = investors sentiment; undrep = underwriter reputation; insvol = institutional investors’ involvement; lurat = lock-up ratio; and the numbers in column headings correspond with the number of variables in row. main empirical results the main results of this study are presented in table 4 using two model specifications. model a reports regression result when the initial return is using percentage change in opening price on the first day trading and the offer price while model b presents initial return is using percentage change in closing price on the first day trading and the offer price. to begin with, the two models in table 4 satisfy all ols assumptions relating to heteroskedaticity (white’s general test) and model specification (ramsey’ test). in regard to autocorrelation, the durbin-watson d statistics in model a and model b record values of less than 2, indicating the potential existence of autocorrelation. hence, the newey-west is employed to correct for the threat of autocorrelation. overall, model a produces an adjusted r-squared of 24.88 percent which is higher than an adjusted r-squared of 15.45 percent in model b. the two figures indicate that collectively, all explanatory variables tested in this study are able to explain at least the 24.88 percent and 15.45 percent of the variations in ipo initial returns (offer to open price) and ipo initial return (offer to close price), accordingly. the f-statistics verufy the goodness-of-fits of both of the models are satisfactory (p < 0.01). in terms of the factors that have significnt coefficient in both models, only lock up shares do not have significant relationship. refering to table 4, a negative coeffficient sign for offer for sale in shown in both model a and model b. for demand, also positive coefficient sign is found in both models. the result implies that when there is a high demand on the ipos, it will influence a positive return of the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 265 ipos and it is in line with the prediction. while supply has a negative coefficient sign in both models it indicates that when there are too many supply number of ipos, it will reduce amount of initial return of the ipos. market outlook also have a positive coefficient since when the market condition is stable, the ipo will also perform good since investors prefer to invest on the ipo. similarly important is the finding on the positive significant relationship for investment sentiment for both models. this is due to the when majority of the investors have a confidence towards the potential of the ipo, it will create demand which lead to increase in price of the ipo and initial return. underwriter reputation also proven as one of the factor that may influence the ipo after market performance. when the underwriter has a good reputation in underwritting the prospectus, it might attract a lot of potential investors to invest on the ipo since the prospectus provide good information on the potential of company in the future. however, institutional investors investment have a negative coefficient sign in both models. when the institutional investors invest in a big amount on the ipo, there is a prediction that at any time they might sell the stocks which lead to big impact towards the after market performance especially to the company. some of the investors might worried when there are big percentage of institutional investors investment on the ipo. meanwhile, the consistency between results and prediction is also found in both models for lock-up period. the positive coefficient sign suggest that the longer the lock-up period might give a good signal on the ipo after market performance. the longer the period of the lock-up, the longer the time period that the promoters would remain committed to their companies. in that sense, the longer the lock-up period will affect the shareholders’ interest continues to be aligned with those of other shareholders. new and unaffected shareholders will be more willing to retain shares rather than to sell their ipos immediately upon listing. in short,lock-up period will encourages the shareholders to remain in the company for a longer term rather than the signal that reflect the confidence of investors on the company which can help to increase the ipo initial returns. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 266 table 4. regression resutls on the influence of offer for sales on ipo after market performance model a: opening price model b: closeing price variables exp. sign (return) initial return (offer to open price) initial return )offer to close price) coefficient t-statistics coefficient t-statistics main variable returnopen returnclose ofsale -0.108 -1.991* -0.167 -2.586* control variables demand + 0.004 4.309* -0.280 4.704* supply -0.043 -3.340* -0.123 -3.124* mktlook + 0.151 2.580* 0.023 1.697* heurep + 0.197 2.151* -0.005 1.650* undrep + 0.003 1.820* -0.030 1.808* insvol + -0.006 -2.900* -0.035 -3.180* lurat + 0.0017 0.100 0.011 -1.183 r² 0.2631 0.1707 adjusted r² 0.2488 0.1545 f-statistics 18.303 10.5477 p-value (f-stats) 0.0000 0.0000 durbin-watson 1.660 1.7435 vif range ramsey test: f-test statistics 0.2866 0.776 p-value 0.5927 0.378 notes: sample size (n) =419. asteriks * indicate significant at 10%. conclusion and discussion this study examines the impact of offer for sale on the ipo after market performance. using a final sample of 419 ipos listed in bursa malaysia for the period from january 2000 to december 2015, this study contributes to the ipo literature by emphasizing on the role of the offer for sale as signalling of the performance of the ipo after market. the finding of this study shows that offer for sale is positively and significantly related to ipo after market performance. meanwhile, this study finds no significant relationship between lock-up shares although positive sign for lock-up shares on initial return is consistent to the prediction. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 267 acknowledgement the authors would like to acknowledge that this paper is part of a research project funded by research acculturation grant scheme (rags) awarded by universiti teknologi mara (uitm) and ministry of higher education, malaysia and (rags/1/2015/ss01/uitm/02/1). references abdul rahim, r., che embi, n. a., & yong, o. 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(2010). moral hazard, information asymmetry and ipo lockups. journal of corporate finance, 16(3), 320-332. https://doi.org/10.1016/j.jcorpfin.2009.12.004 microsoft word 8148-29454-1-sm _1_-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 23 the role of deductive and inductive reasoning in accounting research and standard setting hasan zalaghi assistant professor, accounting department, buali sina university, hamedan, iran e-mail: zalaghi@basu.ac.ir mahdi khazaei (corresponding author) accounting department, buali sina university, hamedan, iran e-mail: m.khazaei92@basu.ac.ir received: nov. 5, 2015 accepted: dec. 9, 2015 published: june 1, 2016 doi:10.5296/ajfa.v8i1.8148 url: http://dx.doi.org/10.5296/ajfa.v8i1.8148 abstract accounting has been offered as an academic discipline in universities and higher education institutions for more than a century. for the first time in history, the american institute of accountants (aia) puts forth efforts to compile the generally accepted accounting principles back in 1939. since then, we have witnessed more efforts in setting accounting standards along with an expansion of the accounting theory and academic research studies. all of the mentioned efforts are signs of the fact that accounting is going through a change, from a profession into a field of science. however, one cannot claim accounting as a scientific field without justification, reasoning, and argumentation. thereby, in this article while studying the deductive and inductive reasoning, we will elaborate their role in developing the accounting theory, setting the accounting standards, and accounting research. what has been expected from the accounting theory is to enable the standard setting authorities to deduce standards. considering the impact of accounting theory on standard setting, the main aim of this study is to explore the role of deductive and inductive reasoning in the development of accounting theory and setting accounting standards. furthermore, regarding the fact that accounting research is the joint connection between accounting theory and standards, the role of these reasoning approaches on the integrity of this connection is studied. this non-empirical research is based on reviewing of the existing literature. keywords: deductive reasoning, inductive reasoning, accounting theory, accounting standards. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 24 1. introduction the significance of this article stems from the necessity of making the infrastructures of accounting knowledge more scientific. the infrastructures would be the basis of assumptions, principles, and concepts of accounting knowledge. only via making these infrastructures scientific, one can promote the status of accounting among other sciences. in addition, without any justification, reasoning, and argumentation, one cannot have scientific claims. the theory of accounting should ultimately enable the standards setters to deduce the standards. considering the impact of accounting theory on standard setting, this article aims at analyzing the point that whether the type of reasoning applied in developing accounting theory and setting accounting standards is a deductive or inductive one. also, considering the fact that accounting research is the joining point of accounting theory and standards, the role of deductive and inductive reasoning in the integrity of this connection is studied. deductive reasoning constitutes a valid reasoning by which it is impossible to accept the premises but reject the conclusion. the deductive approach in constructing the theory of accounting starts with specifying the objective. as soon as the objective is specified, the definitions and assumptions should be clarified. next, the researcher will develop a logical structure based on the definitions and assumptions in order to reach the objective. this methodology is usually moving from the general to the specific, since the researcher needs to develop a logical structure to achieve the objectives which are based on the definitions and assumptions. the validity of any theory that deduced from this process is extremely dependent on the ability of the researcher in identifying the various components of accounting process and their interrelations in a logical way. induction is a reasoning method by which a law or a general principle would be inferred via observing specific cases. the inductive approach emphasizes on observation and deriving conclusions through observation. it generally moves from specific to general, since the researcher generalizes his limited observations of specific circumstances to general conditions. in accounting, the inductive approach begins by observing the financial information of the companies and progresses towards constructing accounting generalizations and principles out of those observations and re-occurring relations. in deductive approach, in order to achieve a consensus, the structure of logical reasoning needs to be quite formal. however, in inductive approach, the accounting practice can turn into accounting principles. accounting standard setters, extracted the conceptual framework via the best practices which in turn have been identified based on the assumed objectives of financial reporting. at the same time, attention was paid to the conceptual integrity, because the framework has been developed descriptively, although the objective was to make an imperative framework for providing guidelines to set and interpret accounting standards (krivogorsky, 2011). in accounting research, applying the inductive approach is usually intertwined with qualitative methods of collecting and analyzing the data, while the deductive approach is usually related to quantitative methods (neuman, 1997). in inductive approach, there is no theory at the beginning of the research, and theories develop and evolve as a result of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 25 research (babbie, 2014). as far as theorizing is concerned, the method of reasoning is of great importance. the early theorists’ preference was to apply the inductive approach based on the observations of real practices. but, gradually, the theory of financial accounting was affected by economic thinking and the deductive approach became the dominant approach. regarding standard setting, while there are various merits and demerits of both approaches of reasoning, the main difference between them is the point that the inductive approach suggests applying old solutions to new problems, while the deductive approach has a tendency to apply new solutions to old problems (graham and carmichael, 2012). the article is structured as follows: first the deductive and inductive approaches in accounting are introduced and then the role of these approaches in accounting research, advancing the theory of accounting, and setting the accounting standards is discussed consecutively. finally, the discussion and conclusion will be presented. 2. inductive approach inductive approach begins with specific observations and the conclusions are generalized. in inductive approach, after selecting a number of observations correctly, one can generalize the conclusion to all or groups of similar conditions and situations. these generalizations need to be tested, some of which might be verified and some rejected. accordingly, all of the principles which are derived based on inductive reasoning are theoretically falsifiable. in the induction process, the researcher as an observer, should honestly, without any prejudgments and biases, and with an impartial mind, register what they observe. then these observations form a basis on which theories and laws are constructed which make up the scientific knowledge. inductive researchers also believe that one can logically generalize the observations into general and inclusive rules and the scientific assumptions get verified and ratified (godfrey and hudson, 2010). according to the inductive approach, at the end of research and as a result of observations, theories are constructed. the inductive approach includes looking for a pattern based on the observations and developing a theory for those patterns through hypotheses (bernard, 2011). in inductive research, no theory is applied at the beginning of the research and the researcher enjoys complete freedom in terms of determining the course of research. particularly, there is no assumption at the early stages of research and the researcher is not sure about the kind and the nature of findings as research is not finished yet. in inductive reasoning the researcher uses the observations in order to construct an abstract or to describe the circumstances being studied. (lodico et al., 2010). the main advantage of the inductive method is that there is no necessity for any pre-fabricated framework or model. obviously, while principles are generalized they should be verified through a logical method (deductive approach). the inductive approach towards science has been criticized concerning some aspects. the main issue of the inductive method can be the researchers' being influenced by their limited knowledge of the relations and the data of the research (saghafi, 2014). some claim that induction as a principle is falsifiable because it is based on human observations. kant, the german philosopher, defined a different philosophy that addressed the ontological issues for the first time and questioned the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 26 correspondence theory of truth. no scientist or philosopher living before kant had doubted that truth is the correspondence between objective concept and reality (external subject). nevertheless, kant believed observation to be an interpretive activity, i.e. we interpret our experience or observation of the world within our cultural and individual frameworks. this means that the world as represented by science has originated from the realities outside of our existence to some extent, however a part of it has originated from our classifications of the world. this approach towards science means that empirical observation is falsifiable; since it depends on cultural and social context along with the researcher's knowledge and expectations and these factors are not reliable basis for scientific laws (godfrey& hodgson, 2010). in accounting, the induction process begins with the observation of accounting data of the reporting units such as sales, purchases, financial ratios, cash flow, debts, capital, and many other data than can be reached via accounting information system. the observations of financial data of a number of companies are meticulously studied and their similar characteristics are found by one's mind. if the data have repetitive relationships, then some principles can be formed and in some cases new thoughts can be induced. if the observations are not influenced by current principles and actions, more innovative thoughts can be induced. for example, based on historical data, the cash to sales ratio of several companies belonged to the same industry might suggest a certain trend. based on this ratio, we can predict the future cash revenues. this idea is falsifiable. in other words, the macroeconomic factors such as inflation rate, the volume of the liquidity, the interest rate of bonds, and gdp might affect the trend of the cash to sales ratio in the industry and the future revenue collection might not be predictable based on the past trend of sales (saghafi, 2014). in accounting, we may observe the changes in share prices simultaneously with the changes in measurement system in the firm. however, another factors (such as a decrease in interest rates) can also justify these changes in share prices. another criticism leveled at induction is the ambiguity of some of its terms. in order to test a theory, what do the terms "sufficiently big" or "diverse conditions" mean? another problem of applying the inductive approach in accounting is the difference between the raw data of companies. if the relations between the data are also different, it would be very difficult to deduce the results. even if an inductive and a deductive reasoning get the same result, the deductive one has more descriptive power and is preferred accordingly (godfrey& hodgson, 2010). 3. deductive approach the deductive approach constitutes developing of an assumption based on the existing theories and forming a research plan to test the assumption (wilson, 2010). the deductive approach can be explained using the assumption driven from theory. in other words, the deductive approach includes deducing the results from the premises. when a deductive method is applied for a research project, the author formulates a set of hypotheses that need to be tested and next, using a relevant methodology, tests the hypothesis. deductive reasoning has specific characteristics that needs be understood. if the premises of deductive reasoning are accepted, then, the conclusion must necessarily be accepted. in a deductive reasoning, the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 27 contents of the result are implicitly stated in the premises, making such argument a non-ampliative one. if new premises are added to the argument, then the conclusion must still follow. a deductive argument is either valid or invalid and there is no degree of validity. there is no choice or decision in applying such argument and no judgment is necessary for getting the result and conclusion. beiske (2007) suggests that the deductive research approach studies a certain theory and tests to see if that theory applies under intended circumstances or not. deductive approach follows the course of logic precisely. argumentation begins with a theory and leads to a new assumption. this assumption, is tested via comparison with the observations and finally it would be accepted or rejected (sneider & larner, 2009). in addition, deductive argument can be described as a general to specific (top-down) reasoning process (pelissier, 2008). while the inductive approach is quite opposite. in other words, the deductive approach includes formulating assumptions and testing them via research process, while inductive studies have nothing to do with assumptions. an accounting theory based on deductive methodology can be shown as follows. figure 1. an accounting theory based on deductive methodology1 the first stage of forming an accounting theory by using a deductive approach is specifying the basic concepts of accounting (two main concepts are the concepts of proprietary and the entity of the reporting unit). the next stage that is somehow dependent on the first one, is stating the objectives of accounting. following the objectives, the postulates would be clarified which are dependent on the previous stage. then, the principles, rules, and procedures are drawn from the established principles using the deductive reasoning. the rules 1 1 source: iselin, e. r., (1971), “the objectives of accounting in an accounting theory, based on deductive methodology”, university of queensland press, st. lucia, queensland, volume 2 (1) production induction of laws induction of principles limiting via conditions production of results basic concepts logical extraction abstracted from context based on psychology and sociology asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 28 and procedures can be practically used for creating the result. these results are used as a test of the fundamental theory (iselin, 1971). in deductive approach, the research method does not depend on the current accounting system under any conditions. accordingly, the obtained theory does not inherit any of the weaknesses and shortages of the current accounting system. furthermore, based on this approach, the assumptions of a theory would be clearly specified. thus, they can be studied meticulously. as a result, if there is any disagreement over the results, the argument would be quickly directed towards the main causes of disagreements. some of the criticisms about the deductive approach can be due to misunderstanding. expecting a theory to necessarily be practical is not a right expectation. if a theory can present a framework for describing and developing new thoughts and practices, that theory is a useful one. in most cases, the technological application of the existing knowledge is not possible. the technology of providing, selecting and reporting information might not be that high to be able to operationalize the procedures obtained from the deductive approach (saghafi, 2014). 4. the role of inductive and deductive reasoning in accounting research the databases have made it easy for researchers to explore relationships among different data and get generalisable results using statistics knowledge. therefore, most of the research projects are conducted using inductive argumentation. obviously, the researchers have a suitable understanding and mastery of research topic and related variables, that is, they use deductive approach at the beginning of the project, and then deducing the results. since the deductive approach requires a perfect understanding of accounting and related sciences such as economics, finance, psychology, sociology and a close familiarity with the accepted social values, so mostly research groups are capable to conduct research using the deductive methodology. as a result, most of accounting dissertations have been done applying inductive approach. rarely do the researchers apply the deductive approach for their dissertations (saghafi, 2014). similar to the descriptive and prescriptive approaches, a precise analysis of the contrasts between deductive and inductive approaches suggest that this contrast cannot be useful. the most important problem is the fact that while distinguishing inductive theorizing from deductive one is correct, it does not mean that there are two different theories accordingly. the inductive and deductive theorizing are two complementary stages of constructing any theory, in a way that induction precedes deduction. while developing the theories, the researchers usually act inductively. in order to understand and explain the phenomena, they make the necessary observations, collect the evidence, and then test them. other researchers with an interest in a similar topic might present different explanations based on the same evidence which leads to debates, more research and complementary explanations. almost always, the objective is to present a common and agreed upon understanding of the concerning issue. the main method which has caused progress is testing the assumption. this is where deduction takes action. having a possible explanation allows the progress of testable assumptions, this means if the current theory is free from any fault, then under certain conditions, specific outputs can be expected. these results have been excavated from the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 29 intended theory using deductive method. the result of such a testing of an assumption can contribute to providing explanations which finally lead to either supporting or rejecting the tested assumption (roslender, 1992). amongst the progressive accounting research studies, one can refer to the work of paton & littleton (1940) titled "an introduction to corporate accounting standards". the project reflects both analytical thinking of paton and inductive approach of littleton and was a quasi-codification of accounting principles that instead of generalizing from practice, had developed deductively (mattessich, 2008). 5. the role of inductive and deductive reasoning in developing accounting theory reasoning style is of great significance for theorizing. developing a theory of accounting was initially based on induction, i.e. forming ideas or theories through observation. from 1920s to 1960s, the accounting theories were commonly based on the observation of what the accountants did in practice, that is, they were formed based on the induction process. this contrasts the method which forms theories based on deductive reasoning which relies on using logic instead of observation. referring to using observations in developing generalizable theories (inductive reasoning) after observing what accountants do in practice, the common practice turns into accounting doctrines or conventions (e.g. conservatism doctrine). the significant theories of this period of time include paton (1992), hatfield (1927), paton and littleton (1940) and canning (1929). researches based on inductive approach were under a lot of criticism. in 1960s and 1970s, although some of the researchers in accounting continued to use inductive approach, a different approach gained ground. this approach was looking for prescribing specific accounting practices, therefore it was not derived from the existing accounting practices. in other words, the theories of financial accounting were not formed based on observing the accounting practices, rather most of the theories developed at that time were based on extending arguments whereby the researcher believed the accountants should follow. instead of applying inductive arguments, these theories were based on deductive arguments. at this period, inflation prevailed in most of the countries of the world and as a result, most of relevant research and theories were trying to display the limitations of historical cost accounting and to develop better approaches for evaluating the properties at the time of fast changing prices. since the mid-1970s till the late 1970s, considerable developments occurred in terms of a shift of focus of accounting research and theories. at that time, a huge volume of accounting research was conducted with the aim of explaining and predicting the accounting procedures instead of prescribing particular viewpoints. this was, in fact, another step taken by most of accounting researchers towards predictive research and away from prescriptive research. however, there are still many researchers who do prescriptive research (deegan, 2011). the development of financial accounting theory started in the late 1930s and was a reaction to public criticism of financial accounting. first the aaa was established with 20 propositions regarding costs, values, income, and capital and surplus (aaa, 1936). this was not a comprehensive financial accounting theory, it was merely a theoretical review of some of the specific accounting practices using a deductive approach. this statement strengthened asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 30 the conservatism and historical cost accounting principles and supported a comprehensive concept of income. later on, paton and littleton extended the 1936 statement of aaa (paton & littleton, 1940). it can be claimed as the first institutional attempt to develop a theory of accounting and it is certainly the first conceptual framework of accounting standards. the statement enjoyed an inductive approach towards accounting theory and provided an explanatory framework for accounting based on historical cost. notions such as entity, going concern, historical cost, and the conformity of these concepts was explained in chapters of the statement on costs, income, benefit, and surplus by paton and littleton. nevertheless, the professionals and academicians were not convinced by paton and littleton's entity concept. the significance of their study is manifested in the fact that most of its basic and fundamental ideas are still present in the conceptual framework and standards of modern day accounting. littleton (1953) believed that theory and practice are a single subject in financial accounting. there is no surprise to see that in the structure of accounting theory, he tries to defend the historical cost accounting via inductive approach towards theory. the book puts emphasis on the view of general objectives for financial reporting with the aim of stewardship, and applied inductive approach for theorizing and presented an accounting theory within the framework of objectives, concepts, and principles. it also provided a considerable comfort and ease for the professionals in the field who were dependent on an income-centered financial reporting system based on historical cost. however, littleton's work can be approached from a different angle as well. this conforms to the philosophy of next theoretical view, the positive accounting theory. the theory takes the role of theorists as observers and embarks on explaining and predicting real procedures instead of prescribing alternative procedures (watts and zimmerman, 1986). the early theorists preferred to use an inductive approach based on the observation of real practices. nevertheless, gradually the financial accounting theory was influenced by economic thinking and due to the significance of the concepts of profit in economic theory, the accounting theory put its focus on the fiscal year profits and the relevant problems. chambers (1966) emphasized on a reporting system based on the net market value in which the financial position was taken as the core and profit as a derivative. his theory was stemming from pricing experiences, management education, concerns regarding inductive reasoning by previous theorists, weaknesses in methodology of previous theories, and increasing evidence of unreliability of reported figures. chambers presented a deductive theory of accounting using ideas from a range of disciplines including communications, economics, management, mathematics, measurement, organizational behavior, and philosophy. chambers' first project was presented back in 1955 consisted of four fundamental principles, including: units, logical management, financial statements, and accounting as a service. he developed these ideas in various papers using a prescriptive thinking and a deductive approach. the importance of chambers' work in the history of financial accounting relates to his methodology in theorizing. chambers' deductive work was a direct challenge to paton and littleton's inductive and pragmatic approach. his heritage can be seen in later theories of accounting, and also in practice. increasing attention to financial position and using net realizable value in order to actualize the fair value accounting are manifestations of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 31 chambers' efforts (lee, 2009). other classic theorists of accounting theory in the 1960s included edwards and bell (1961), monitz (1961), sprouse and moonitz (1962), mattessich (1964), graddy (1965), ijiri (1967), and sterling (1970). each of them has brought up a formal theoretical structure and has followed deductive and normative prescription approach. in the mid twentieth century, inductive approach was replaced by deductive approach. in the early years of financial accounting theory, inductive approach’s objective was that practical usages becoming the subject of future theories. sometimes in recent decades, deductive arguments have been involved in changing accounting practices, e.g. currents costs accounting in early 1980s and cash flow accounting since 1980s. those participated in this field included professionals and academicians who first used inductive approach and later deductive one, and then returned to the inductive approach (lee, 2009). the inductive theories of accounting have been formed through observation and generalization of the observations and measurements. this view is probably the oldest technique of theory construction in accounting. the accounting procedures that have been formed empirically or even accidentally are observed, the observations are generalized, and finally, these generalizations are documented as accounting theory. riahi-belkaoui (2004) mentions that the theorists such as hatfield, gilman, littleton, paton, and ijiri can be considered as inductive theorists. the history explained here, introduced two kinds of theories and theorists, the first referring to individual efforts for explaining and predicting how the profession of accounting works. these replaced from inductive studies on pragmatic procedures, to imperative prescriptions that became competitive and finally put aside as non-practical, and along with empirical observations of what is done in practice. the result of such a theory was lack of success in challenging the problems related to the conventional practice. the second kind of theory and theoretician related to the basic conceptual framework that supported the conventional practice (lee, 2009). deegan & unerman (2006) stated that there is no universal agreement on how accounting theories should be developed. accounting theories were developed applying a combination of deductive and inductive arguments. hendriksen (1982) stated that all theories need to have elements of both deductive and inductive arguments. while the deductive approach begins with extensive and general aims and presumptions and ends with specific methods and rules, the inductive approach, on the other hand, follows a totally adverse model: the generalized results are taken from detailed observations and measurements. it is notable that the data that are chosen for observations to be used in inductive reasoning, are selected by deductive reasoning, therefore the development of theory is an iterative process (vorster, 2007). 6. the role of inductive and deductive reasoning in developing accounting standards standard setters introduced the accounting theory through conceptual framework and standards. what is expected from the theory of accounting is to enable the standard setters to deduce standards. developing accounting theory and the project of developing the conceptual asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 32 framework need identifying something that can be used for deducing the standards. following the global stock market crisis of 1929, the us government tended towards increasing the regulation of financial markets. later in 1934, sec was established to monitor the financial market. in the meantime, the need arose for a deductive accounting theory. the vast economic and social damages caused by the collapse of the market forced aaa to publish a tentative statement of accounting principles underlying corporate financial statements (1936). this was the first step in the deductive approach towards the accounting theory that happened in line with a change of approach in 1933 to support investors and creditors (sutton, 2011). with the revision of 1957, titled accounting and reporting standards for corporate financial statements, the efforts of aaa in developing an accounting framework, which were originally based on inductive approach, gradually changed to a deductive one (riahi-belkaoui, 1981). in 1957–1964, some questioned the suitability of the inductive approach for extracting accounting standards and opted for a more deductive and conceptual approach. a disagreement has always been existed between the aicpa and aaa in this regard. aaa supported deductive approach. this point displays the differences over the standard setting methods. in inductive approach, standard setters tend to set standards with a firefighting approach which leads to incompatible standards. however, deductive approach needs a more conceptual view as a basis from which deduction can be extracted. in the 1960s, the failure of inductive approach of standard setting which held sway in those days, made the deductive approach more tangible (gore, 1992). moonitz (1961) in ars no. 1, titled “the basic postulates of accounting” stated that they have reached to the conclusion and in order to develop fundamental assumptions and principles of accounting, emphasis should be put on deductive argument (dennis, 2014). ars no. 7 titled inventory of generally accepted accounting principles for business enterprises (1965), was written by paul grady. this research followed the conservative views of hatfield and moore (1938), and paton and littleton (1940). the study applied inductive approach and specified ten concepts. later on, grady presented the generally accepted principles of accounting precisely and as a set of goals, emphasizing the performance of accounting (chatfield, 1996). a statement of basic accounting theory (asobat) was published a year later. asobat (1966) can be considered as a significant turning point (young, 2006). it rejected previous opinions, including grady's report (1965). grady's report challenged paton and littleton's idea. paton and littleton (1940) had used a thoroughly inductive approach in their dissertation (mattessich, 1995). asobat (1966) considered accounting as a financial reporting system (sutton, 2011). chambers (1966) suggested that rule setting is a deductive process. having assumed the principles through logical deduction, one can get the rules. chambers believed that paton's (1992) book titled “the theory of accounting” for the first time pointed to the topic of deductive extraction of a set of rules out of a set of postulates. littleton's (1953) book titled “the structure of accounting theory” was formed based on the idea that as far as there are supporting explanations, the rules seem to have been extracted asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 33 deductively (chambers, 1966). prior to 1970s, the american and british accountants' procedure for achieving consistency in financial accounting was to use an inductive approach based on logical justification of what has happened in practice. however, this method was criticized because only problems were dealt with when they arose. this led to overlapping and contradiction. then, they followed the deductive approach based on theoretical postulates. however, this approach was also criticized because it was unrealistic. this led to the creation of demand for a conceptual framework for providing a set of integrated principles of financial reporting (collis et al, 2012). the important decision in the conceptual framework project was for the framework to be based on a deductive approach. as it was mentioned before, this deductive approach had already been used, the most famous cases were in ars no. 3 in 1962 and trueblood study group in a report titled "objectives of financial statements" in 1973. the opposite approach had also been already used, the most famous cases were in apb no. 4 (1970) titled "basic concepts and accounting principles underlying financial statements of business enterprises" (graham and carmichael, 2012). regardless of various merits and flaws of both approaches, the main difference between them is that the inductive approach suggests using old solutions for solving modern problems, while the deductive approach tends towards applying new solutions for solving old problems. therefore, the resolve of fasb for using a deductive framework, has increased the supporting of significant changes in the gaap. accordingly, the conceptual framework project has been and is controversial (graham and carmichael, 2012). regarding the accounting standards, the main element in establishing the suggested rule will be induction. there can be no action which is totally abstract. although, when it is established, such a broad philosophy can be helpful in developing a relevant set of standards. however, this is not an inductive process and its product, the prescriptive standards of accounting, are not theoretical institutions at all. they are guidelines for action which have been proposed by a body established to serve this goal. if the aim of accounting standards is to form an integrated set of optimum accounting practices, these standards need to be deducted from a theoretical institutions with an upper hand, which is in fact the conceptual framework. in this situation, it is the real standards that form the theory in question. regarding the inductive theories, those practices that gain pervasive applications, constitute the positive accounting theory. however, regarding the deductive theory, standards that deduced from meta-theory play this role (roslender, 1992). dennis (2014) investigated the type of reasoning used in standard setting decisions. he proposed that when such decisions are accompanied by a consideration of the intended goals, the type of reasoning should not be taken as deductive but as a form of practical reasoning. decision making in standard setting is an argument for the demand of developing standards. in the rule-based approach of standard setting, the standard setter wants all of the rules that are related to the intended goal. it is easy to set standards in this approach since all the standard setter needs to do is identify the rule suitable for a certain goal and conclude that he asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 34 wants to publish it. in this situation, no decision or option is involved. this type of argument is deductive and the conclusions necessarily follow the premises. in this approach, the rule is something that needs to be followed under all circumstances. regarding accounting standards, this means that there is no probability of disagreement on what has been meant by a particular rule, since in deduction, if the premises are accepted, the conclusion will necessarily follow (dennis, 2014). if the argument is not deductive, then such an argument involves option or decision and there is a need for judgment in conclusion. the concluded result is not necessary, therefore an element of option or decision will be involved (salmon, 1992). when a principle-based approach is used for extracting specific standards, judgment is needed. this means, standard setters that use principle-based approach for extracting specific standards should use judgment in their argument. in this approach, the argument applied is a deductive one. in the subject of auditing, standards may require the auditor to search for pieces of evidence for confirming a claim in financial statements. here, searching for evidence, they have used inductive instead of deductive argument, and judgment should be applied (dennis, 2014). 7. summary and conclusion in this paper, while explaining deductive and inductive reasoning, we elaborated on their role in accounting theory, developing standards, and accounting research. accounting theory has been developed by the process of accounting research and has been modified gradually. accounting theory, along with political factors and economic circumstances, is one of the main factors influencing the development of accounting standards. the standards and other announcements of policy making organizations have been interpreted and executed. in the process of developing an accounting theory, the reasoning method is highly significant. developing the theory in the first place has a deductive process in social sciences. the researcher via observing phenomenon or studying the literature, presents a theory over why a phenomenon has happened. as it was mentioned, in the early years of developing accounting theory, inductive approach was used more and the goal was for practical applications to be the subject of later theories. then, a general shift in approach towards research based on deductive reasoning happened. however, after a few years, the focus of research and accounting theory was again shifted towards the inductive approach. therefore, as it was mentioned, accounting theories have been formed through combining deductive and inductive arguments. accounting theorists generally begin with inductive reasoning and change their course towards a deductive approach in order to improve the theory through development of understanding and explanation power. in accounting research, inductive reasoning is used more in qualitative research. while inductive reasoning is more applicable for quantitative research. however, inductive and deductive research methods are not mutually exclusive, and they are usually used to supplement each other. since, the researchers use their knowledge about the practical procedures of accounting. as riahi-belkaoui (1981) points it out: the general pronouncements are formed via an inductive process, but the principles and methods are obtained through deductive approach. he also believes that when littleton, an inductive asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 35 theorist, cooperates with paton, a deductive theorist, it shows a compromise between the two approaches. as an example, inductive approach may be used for evaluating the suitability of a set of premises which had been selected based on deductive system. the researchers usually begin with the results of other research and present new hypothesis, and then test the hypothesis. inductive research in accounting can shed light on present events and relations in the business context. this kind of research, can in turn be effective in the process of standard setting. a process based on which deductive reasoning will help to determine the rules that need prescription. in setting accounting standards, if the standard setting approach is rule-based, then the reasoning method is deductive. nevertheless, if the standard setting approach is principle-based, then inductive reasoning is more applicable. nowadays, according to the policy of moving towards principle-based approach in setting accounting standards, it can be concluded that the deductive approach is gradually replaced by the inductive approach in setting accounting standards. in inductive approach, the truth or falsity of the premise is not dependent on other premises, instead it needs to be confirmed empirically. in this approach, the truth of premises depends on the observation of sufficient cases of repeated relationships. accounting premises that have been obtained via inductive argument, show the specific accounting procedures only with a high probability. on the other hand, accounting premises that have been obtained via deductive argument, lead to specific accounting procedures along with certainty. the lack of philosophical issues and subjects in accounting discussions is quite tangible. this paper was 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(2006). making up users. accounting, organizations and society, 31(6). http://dx.doi.org/10.1016/j.aos.2005.12.005 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 8136-29379-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 35 closer view at the stock market liquidity: a literature review gaurav kumar1 phd research scholar, finance and accounting indian institute of technology (iit), kharagpur, india e-mail: gauravkumar@iitkgp.ac.in arun kumar misra associate professor, finance and accounting indian institute of technology (iit), kharagpur, india e-mail: arunmisra@vgsom.iitkgp.ernet.in received: august 8, 2015 accepted: sep. 1, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8136 url: http://dx.doi.org/10.5296/ajfa.v7i2.8136 abstract liquidity is said to be the lifeblood of stock markets. it has prominent implications for traders, regulators, stock exchanges and the listed firms. in recent years a huge amount of literature has emerged that deals with liquidity. this article classifies and organises the literature and provides a critical review of the frameworks currently available for modelling liquidity and its macroeconomic and firm specific drivers. commonality and intraday behaviour of liquidity in various markets is discussed under the umbrella of market microstructures. subsequently, liquidity risk as a factor in asset pricing is analysed taking various models in to consideration. finally, the study reviewed the impact of liquidity on corporate finance decisions viz. dividends, firm valuation, stock split, capital structure etc. key words: liquidity, determinants, commonality, asset pricing, corporate finance 1corresponding author asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 36 1. introduction the ability to trade large volume of stocks with least price impact, cost and postponement is termed as liquidity. as per o’hara (2004), “liquidity is hard to define, but easy to feel it”. liquidity has multi-dimensional characteristicsviz. tightness, immediacy, depth, breadth, and resiliency. all of these characteristics cannot be captured in a single measure. thus, a globally acceptable measure of liquidity which represents most of these characteristics continues to be an area of research. higher level of illiquidity poses the risk of higher losses for the investors along with higher gains in comparison to the liquid markets because of the price volatility. in illiquid markets, an investor is uncertain about executing a large transaction as it may cause significant price change resulting higher losses. therefore, the stock market development is impeded as higher illiquidity lower down the capital inflows. also, the firms can reduce cost of capital by increasing the liquidity of their respective stocks. fund managers can design improve trading strategies if they a better understanding of the liquidity dynamics. common determinants or the concept of commonality is a phenomenon in which individual stock liquidity is at least partly determined by marketwide factors (chordia et al., 2003). high degree of commonality indicates high degree of systematic risk resulting in to higher liquidity premium for holding such assets (fujimoto, 2003). designing of diversified portfolios becomes difficult because of presence of commonality in liquidity (domowitz and wang, 2002). regulators can improve market liquidity by changing the market designs. this can be achieved by empirically understanding common liquidity movements (coughenour and saad, 2004). with the above brief introduction about liquidity importance in field of financial economics, the study has initiated extensive review of literature with primary focus on the concept liquidity measurement, intraday behaviour, determinants, commonality and its implications on asset pricing and corporate finance. 2. liquidity proxies and characteristics as per keynes (1930), an asset is more liquid if it is immediately realized without loss. an investor may either insist on immediate execution at the current bid or ask price or wait to transact at a favorable price. the quoted ask (offer) price includes a premium for immediate buying, and the bid price similarly reflects a concession required for immediate sale. thus, the spread between the bid and ask prices is a measure of illiquidity, which is the sum of the buying premium and the selling concession. baker (1996) concluded that there is no single unambiguous, theoretically correct or universally accepted definition of liquidity. sarr and lybek (2002) opine that there is no universally accepted measure to determine a market’s degree of liquidity because of market specific factors and peculiarities. a liquid market has depth, tightness, and resilience dimensions (kyle, 1985). black (1971), harris (1990) and o’hara (1995) identified several other dimensions of liquidity viz. bid-ask spread also called width, number of tradable shares at bid and offer prices; and immediacy. as liquidity has multidimensional features, it is difficult to capture in single measure. so, there are various measures of liquidity. the results from different measures of liquidity can asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 37 point to different conclusions (benic and franic, 2008). liquidity measures are captured at different frequency viz. high frequency (captured in minutes or seconds) and low frequency (captured daily). study of market microstructure requires liquidity to be computed at a high frequency in order to capture sufficient variations within a day. bernstein (1987) examined different measures of stock liquidity and concluded that liquidity and efficiency are not compatible to each other. a liquid market, on arrival of new information, keeps the noise and sudden price changes minimal. on other hand, in efficient markets prices moves fast as the new information arrives. so, more liquidity leads to less efficient market. amihud and mendelson (1986) lay emphasis on the direct relationship between liquidity and cost of capital. high liquid markets are attractive to investors because of the easy exit from firm’s ownership. this in turn reduces the opportunity cost of capital significantly. hui and heubel (1984) hypothesizes that part of unsystematic risk represents liquidity of stock. they measure liquidity as the sensitivity of unsystematic risk to the changes in volume traded. saar and lybek (2002) classified liquidity measures into four categories based on their ability to capture a particular characteristic. the measures are transaction cost measures, volume-based (breadth and depth), equilibrium price based measures (resiliency) and market-impact measures (resiliency and speed of price discovery). hui-heubel liquidity ratio (1984) attempts to capture market breadth, which is related price impact of volume of trades. market efficiency coefficient (mec) is used as a price based measure which states that the price movements are more continuous in liquid markets, even if equilibrium prices are impacted by new information. among price impact proxies, amihud (2002) captures the lack of liquidity by dividing daily return by daily dollar volume. this measure is called as illiquidity (illiq), shows the price shock triggered by a unit of dollar volume. trizinkaet al. (2009) conclude the amihud measure does a better job than most other measures at capturing liquidity, and is robust to regime changes such as the change in minimum tick size to decimals. illiquidity (illiq) is estimated for every share using daily data and the impact of each share is weighted by its free float rate and market capitalisation. the “amivest measure”, introduced by cooper et al. (1985), compares daily returns with daily volume measured in number of shares. the two measuresviz. amihud and amivest, even if constructed in a similar way, differ in several aspects. for example, one uses dollar volume while the other uses share volume. amihud measure represents illiquidity, while amivest measure indicates liquidity. the limitation with amihud measure is it does not incorporate days without trading, which in and of itself contains important information for illiquidity. even if the amivest measure does not suffer from this limitation, it does not include information from days with a zero return. ps measure of liquidity, developed by pastor and stambaugh (2003), is obtained by regressing daily returns in excess of daily market index returns on signed daily dollar volume. high frequency benchmarks are categorized as (1) spread benchmarks and (2) price impact benchmarks. the difference between the ask quote and the bid quote at time “t” divided by the average of the two quotes is termed as quoted spread at that particular time. the quoted spread measures pre-trade transaction costs. even if the quoted spread provides important information about transaction costs, it is not necessarily translated to actual transaction costs. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 38 actual transaction costs borne by investors are better measured by the effective spread. the effective spread is defined as the absolute value of the difference between the transaction price and the midpoint of the quotes prevailing at the time of the transaction, divided by the transaction price. the realized spread matches the price of a trade with its post-trade true value. hasbrouck (2009) estimates the slope of the price function as price impact measure. five minute price impact introduced by goyenkoet al.(2009), captures the permanent price change over a 5-minute window subsequent to a trade. it measures the change in quote midpoints from the time of the trade to 5 minutes after the trade. huang and stoll (1996) calculate adverse selection costs by subtracting the realized spread from the effective spread. trzcinkaet al. (2011) compares percent-cost and cost-per-volume liquidity proxies computed from daily stock data to liquidity benchmarks computed from intraday data. trzcinkaet al. (2011)find that a new measure called fht by simplifying the lot model. this proxy has a high correlation with spread related measures viz. percent price impact, percent effective spread, percent quoted spread, and percent realized spread. also, this proxy captures the level of effective spread and quoted spread. however, it fails to capture the level of realized spread or price impact. mianbi and langnan (2007) made a empirical comparison of the high frequency measures of liquidity and low frequency measures of liquidity using pearson, partial pearson and spearman correlations on component stocks of sh180. hui-heubel liquidity ratio performs as the best measure. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 39 table 1.summary of empirical studies on liquidity proxies author/’s (year) frequency dimension remarks cooper et al. (1985) low (d) price impact amivest measure of liquidity chordia et al. (2000) high (min) transaction cost difference between bid and ask price datar (2000) low (d or m) price impact coefficient of elasticity of trading amihud (2002) low (d) price impact measures illiquidity, no zero trading days, sensitivity associated with the trade of one rupee of trading volume pastor and stambaugh (2003) low (d) price impact extent to which the volume of stocks traded impactsstock prices uddin (2009) low (m) relative measure stock cannot be illiquid if average market liquidity is low, factors systematic liquidity risk trzcinka et al. (2009) low (d), high (min) comparative analysis identify high quality proxies, amihud (2002)well measures price impact source: compiled by authors from cited research articles. d stands for daily measurement, m stands for monthly measurement, min stands for minute measurement of liquidity. appendix (i) at the end of the study summarises key low frequency liquidity proxies used by researchers. 3. determinants of liquidity in order to understand liquidity in financial markets it is important to understand its determinants. research in area of determinants is categorised in two types viz. firm specific factors and macroeconomic factors. jacoby and zheng (2010) studied the empirical relationship between ownership dispersion and market liquidity. the study found that higher ownership dispersion improves market liquidity. it is also found a positive relation between block holder ownership and quoted spread, effective spread, and the adverse selection component of effective spread. the relationship between ownership dispersion and market liquidity still exist even on small stocks listed on nyse/amex. baber et al. (2012) studied the relationship between institutional investors, liquidity, and liquidity risk. they find that institutional ownership generally predicts larger stock liquidity. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 40 stocks with concentrated institutional ownership and especially hedge fund ownership tend to have low returns with high market illiquidity, suggesting that crowded trading strategies have a detrimental impact on returns when markets are less liquid. yaghoobnezhadet al. (2011) studied of relationship between institutional ownership and stock liquidity on tehran stock exchange. the presence of the institutional investors can affect stock liquidity in two ways viz. informational benefits and increase of liquidity due to the increase of price discovery resulted from the competition between institutional investors (effectiveness of the information). næs (2004) takes account of the relationship between market liquidity and company ownership on norway stock exchange using a panel regression approach. the study reported owner concentration to be negatively related to spreads and information costs. no strong relationship can be documented between liquidity and institutional ownership. sharma (2005) studied ownership structure and stock liquidity on indian stock market and found that the promoters’ shareholding is not a statistically significant variable in explaining the determinants of liquidity in both nifty stocks and nifty junior stocks though it is contrary to the a priori relation proposed by the market microstructure literature. keim and blume (2012) provide evidence that institutional participation in the u.s. stock market explains the cross-sectional variation in stock market illiquidity. kim and verrecchia (1994) studied the relationship between earnings announcements, trading volume and liquidity and found that earnings announcements increase the information asymmetry, which in turn leads to reduced liquidity in an imperfect market. hendershott, jones and menkveld (2011) explained the empirical relationship between algorithmic trading (at) and liquidity. auto quoting on nyse is used as an instrumental variable for at. it reduces the trading costs, trading frictions, makes risk sharing more efficient, in-formativeness of the quotes increases and in turn it enhances liquidity. kumar et al. (2001) studied the impact of international listings like adr and gdr on liquidity of indian firm’s underlying domestic shares. gdr listings are associated with enhanced liquidity while adr listings (in most cases) are associated with reduced liquidity of the shares of domestic firm. chordiaet al. (2001) studied the relationship among liquidity, trading activity, market return and interest rate of nyse listed stocks. liquidity and trading activity is influenced by market returns, its volatility, short-term and long-term interest rates. macroeconomic news like gdp, unemployment rate also impact liquidity at the time of announcements. ding et al. (2013) empirically studied the relationship between foreign institutional investors and stock market liquidity on shanghai and shenzhen stock exchanges. the results indicated that with the increased participation of foreign institutions, stock market liquidity improves. chordia et al. (2005) reported modest predictive power of monetary policy for stock market liquidity. however, goyenko and ukhov (2009) gives strong evidence that monetary policy asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 41 predicts liquidity of the stocks listed on u.s. markets for the period 1962 to 2003. söderberg (2008) provides mixed evidence by studying the influence of 14 macroeconomic variables on the market liquidity of three scandinavian stock exchanges. table 2. summary of empirical studies on liquidity determinants author/’s (year) market area remarks naes (2004) norway stock exchange firm specific granger causality fails to explain relationship between market liquidity and company ownership soderberg (2008) scandinavian stock exchanges macroeconomic fourteen macroeconomic variables are taken as repressors against market liquidity agarwal (2009) usanyse, amex firm specific institutional ownership (granger) causes liquidity peter et al. (2011) euro zone stock exchanges macroeconomic stock market liquidityis increased by expansionary monetary policy ding et al. (2013) chinashe, sze firm specific relationship between foreign institutional investors and liquidity source: compiled by authors from cited research articles 4. market microstructures market microstructures in stock markets have attracted much research attention in recent years. this importance is due to the existence of intraday regularities in stock market that contests the efficient markets hypothesis. the researchers are now focusing on the causes generating this behaviour in order to analyze this anomaly. the variations in stock liquidity along with the costs involved in trading can be better understood by studying the behavior pattern of various liquidity proxies (amihud and mendelson, 1980; acharya and pedersen, 2005). this helps various agents in selecting stock exchanges in terms of liquidity. also, such studies also help the regulators particularly in emerging markets that believedto be less liquid in designing an efficient and transparent trading system. bekaert, campbell and lundblad (2007) argued that with the capital market liberalization in emerging economies, liquidity may have greater impacts. köksal (2012) studies intraday patterns of various liquidity proxies on istanbul stock exchange (ise) using limit order book. it is reported that the spreads follow an l-shaped pattern whereas returns, number of trades and volume follow a u-shaped pattern. in addition, wide spreads are accompanied by low depths and vice versa indicating that traders use spreads and depths simultaneously to carry out their strategies. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 42 tissaoui (2012) investigates the intraday pattern of trading activity, liquidity and return volatility of the stocks listed on tunisian stock exchange (tse). the majority of these studies showed that the trading volume, return volatility and liquidity profile follow the u-shaped patterns. krishnan and mishra (2013) investigates intraday liquidity patterns of twenty stocks listed on national stock exchange (nse). the study reported that many liquidity proxies have u-shaped pattern. this is in line with the studies done on other quote driven or hybrid markets. table 3.summary of empirical studies on liquidity patterns author/’s (year) market remarks guo and tian (2005) shanghai stock exchange (she) l-shaped pattern of bid ask spread köksal (2012) istanbul stock exchange (ise) l-shaped pattern of spreads,u-shaped pattern of returns, number of trades and volume tissaoui (2012) tunisian stock exchange (tse) existence of seasonality in trading activity, u-shaped pattern of trading volume and return volatility krishnan and mishra (2013) national stock exchange (nse) many liquidity proxies have u-shaped pattern. source: compiled by authors from cited research articles empirical market microstructure research has shifted its focus from studying individual stock liquidity to examining commonality. commonality is defined as the co-movement between variations in individual stock liquidity and variations in market and industry wide liquidity. chordia et al. (2000) empirically studied common underlying determinants of time series movements in liquidity, known as commonality. their study uncovers that the inter-temporal changes in liquidity is supported by the theory of inventory risks and theory of asymmetric information. trading volume causes variations in dealer inventory levels, which results in varying liquidity levels. inventory carrying costs depends on interest rates, hence it also co-moves. asymmetric information i.e. when few traders have more information than the rest also causes co variation in liquidity. the study attempts to find evidence that liquidity co-variation is much stronger for portfolios than individual stocks, a finding relevant for investment managers who turn over their holdings frequently. fabre and frino (2004) does not find support for commonality on asx and argued that commonality in liquidity might be attributed to market designs. narayan et al. (2011) made insightful analyses of the commonality on two stock exchanges of china comprising of 82 million transactions. they examined four hypothesis related to commonality. first, market-wide liquidity is variable influences liquidity of individual stocks. this is confirmed by positive and statistically significant beta. second, size of the firm is not asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 43 a determinant of commonality on chinese stock exchanges. this is different from the existing literature which says size effects in commonality. third, sector specific liquidity has a greater influence on liquidity of individual stocks in comparison to market-wide liquidity. commonality is found stronger during bear period then bull period as investors are more concerned of macroeconomic news in comparison to firm performance. the study finds evidencein support of commonality in liquidity and a greater influence of industry-wide liquidity in explaining liquidity of individual stocks. pukthuanthong-le and visaltanachoti (2009) studied commonality of stocks listed on stock exchange of thailand (set) using eight years tick data. the study reported empirical evidence in favour of market wide commonality across various liquidity proxies. also, it is found that industry wide commonality is stronger than market wide commonality. the implications of commonality in liquidity on investors are not fully understood. anderson et al. (2013) investigate whether investors are compensated for taking on commonality risk in equity portfolios. this study reports economical and statistical significance of return premium for commonality risk in nyse stocks. the commonality risk premium is robust to various measures of liquidity and estimating its systematic component. zheng and zhang (2006) examines to the degree at which liquidity is driven by common underlying factors in china that has adopted an order-driven trading system. the study found the influences of size, industry, and up and down markets effects in determining common trend in liquidity. tayahet al. (2015) argued that for most of the emerging economies intraday data is not available. so, they studied commonality on amman stock exchange employing daily liquidity measures. the study reported evidence of commonality across all size based portfolios for the proxies used except for price impact. also, the study reported weak evidence of industry-wide commonality which is in contrast with the previous studies. 5. liquidity risk and returns this section studies the linkage of stock liquidity, its variation and the associated returns. amihud and mendelson (1986) analyze the effect of bid ask spread or illiquidity on asset pricing. the focus of the study was to explore the area of market microstructure in order to determine asset returns. their model predicts that higher spread assets yield higher expected returns, net of trading costs. investors hold high spread assets for longer holding period because of the clientele effect. bali et al. (2013)revealed that stock market under-reacts to the stock level liquidity shocks on nyse, amex and nasdaq exchanges. investor inattention and illiquidity both drive this under reaction. this study finds evidence on the mechanism of processing information about stock level liquidity shocks. they opined that limited investor attention and illiquidity prevents public information being incorporated in security prices. bali et al. (2013) finds that immediate liquidity shocks have positive impact on contemporaneous stock returns. they examined double sorted portfolios using fama-macbeth regressions to confirm the significant relationship between future returns and liquidity shocks using large set of control asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 44 variables example level of illiquidity, systematic liquidity risk, size, book to market, price momentum etc. pastor and stambaugh (2001) find evidence that market-wide liquidity is a key state variable for asset pricing on nyse, amex and nasdaq. stock expected returns are cross-sectionally related to the sensitivities of the returns to fluctuations in aggregate liquidity. faff et al. (2010) analyzed the effect of liquidity on stock returns on tokyo stock exchange (tse). negative association is reported between expected stock returns and liquidity measures even after factoring risk adjustments in place of raw returns. this study found that liquidity is priced during expansionary phase of business cycle but not significantly priced during contraction phase. this is inconsistent with the notion that liquidity is more important in bad time which is a kind of liquidity puzzle. narayan and zheng (2011) investigated the impact of liquidity on returns on shanghai stock exchange (shse) and the shenzhen stock exchange (szse). liquidity has negative impact on returns more strongly on shse in comparison to szse. uddin (2009) examines the relationship between relative measure of liquidity and returns on nyse and amex using a relative measure of liquidity rml instead of absolute measure. rml links individual stock liquidity with market wide liquidity which more closely represents systematic liquidity risk. he argued that a stock cannot be illiquid just because it is not traded frequently if the average market liquidity as a whole is low. so, the study claims that rml is a better measure of liquidity. rubio et al. (2005) empirically studied the explanatory power of systematic liquidity on asset pricing on spanish stock market. based on 10 years dataset,the study cross sectionally regressed average returns regressed against betas computed relative to market wide liquidity risk factors. market wide liquidity is a plausible factor to be included in asset pricing models but as per this study none of the liquidity factors seems to be priced in spanish stock market. chordia et al. (2001) demonstrates the importance of trading activity related variables in the cross section of expected returns. strong negative relationship is reported between both the level of liquidity, its volatility and expected returns using monthly data from nyse and amex stock exchanges. petkovaet al. (2011) investigates relationship between volatility of liquidity and expected returns employing liquidity proxy as given by amihud (2002) on daily data derived from nyse and amex stock exchanges. positive and robust relationship is documented between volatility of liquidity and expected returns in regressions after controlling for various variables, systematic risk factors, and different sub periods. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 45 table 4. summaryof empirical studies on liquidity risk and returns author/’s (year) market remarks amihud (2002) usanyse, amex illiquidity measure, small firms effect, expected market illiquidity positively affects excess returns watanabe and watanabe (2008) usanyse, amex dynamics of liquidity betas faff et al. (2010) japantse negative relationship between liquidity proxies and returns, impact of business cycles narayan and zheng (2011) chinashse, shze liquidity have negative effect on returns, not robust across the three proxies petkovaet al. (2011) usanyse, amex idiosyncratic liquidity risk also positively priced in stock returns fu et al. (2012) usanyse, amex, nasdaq liquidity change predicts cross sectional stock returns source: compiled by authors from cited research articles 6. liquidity and assets pricing financial analysts consider liquidity as a driver in affecting price of the stocks while making investment portfolios (amihud and medelson, 1991). this section studies liquidity as a factor in asset pricing. acharya and pedersen (2005) propounded an asset pricing model incorporating economic significance of liquidity risk. the study finds that the liquidity-adjusted capm explains the data better than the standard capm. further, weak evidence is reported about the importance of liquidity risk over market risk and the level of liquidity. this model fails to explain the book-to-market effect but it is a good fit for portfolios sorted by liquidity, liquidity variation, and size. vu et. al (2014) examines the pricing of liquidity risk on australian market, using data from 1991-2010. they explored the impacts of various liquidity risk measures on stock returns using liquidity-adjusted capm model developed by acharya and pedersen (2005). the study find strong evidence of co-movements (i) between individual stock illiquidity and market illiquidity, (ii) between stock returns and market illiquidity and (iii) between stock illiquidity and market returns. overall, the net value of these liquidity co-movements is significantly priced in australia. hagstr mer et al.(2013) investigates the relation between illiquidity level, illiquidity risk, size, value and momentum anomalies for us stocks. in contrast to statistical factors both illiquidity level and illiquidity risk have a theoretical foundation in the liquidity adjusted capital asset pricing model (lcapm). lcapm outperforms the capm in terms of ability to explain risk premiums of size and value sorted test portfolios. the study finds a very strong asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 46 correlation between fama-french size betas and illiquidity level betas (about 0.96) and a fairly strong correlation between fama-french value betas and illiquidity risk betas (about 0.56) while carhart’s momentum beta has high negative correlation with betas both for illiquidity level and risk (-0.76 and -0.94 respectively). the premiums related to size can to large extent be explained as a compensation for illiquidity level. eleswarapu and reinganum (1993) empirically investigate the seasonal behavior of the liquidity premium in asset pricing. liquidity premium is reliably positive only during the month of january. however, for the non-january months, a positive liquidity premium is not detected. in contrast to amihud and mendelson (1986), the study shows evidence that the size effect is significant, even after controlling for spreads. hubers (2012) tested the relationship between asset prices and liquidity on london stock exchange (lse) taking three models viz. capm, capm with a liquidity factor and; capm with a liquidity factor along with the fama-french factors. the size and liquidity sorted portfolio returns are regressed against liquidity in each model. the study finds evidence regarding the relationship between liquidity and asset prices. table 5.summary of empirical studies on liquidity and asset pricing author/’s (year) market model tested remarks acharya and pederson (2005) usa nyse, amex lcapm liquidityadjustedcapm factors systematic liquidity risk (lcapm) piesse and hearn (2009) african markets augmentedfamacapm by sharpe (1964) size and liquidity are important valuation factors in large markets, premium associated with size is large lam and tam (2011) hong kong stock market fama and french (1993) three-factor model liquidity is important variablein pricing returns, momentum factor not priced faff et al. (2013) australia asx carhart four factor model new proxy of liquidity is added as factor vu et al. (2014) australia asx lcapm pricing of liquidity co-movements, asymmetric response of investors in up and down markets source: compiled by authors from cited research articles asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 47 7. liquidity and corporate finance one of the current issues in the market microstructure literature is whether liquidity affects firm value.hansen and sungsuk (2013) studied the relationship between stock liquidity and the firm value on indonesian stock market. the study employees panel data regressions to show that more liquid firms have higher operating profits as measured by tobin’s q, operating income-to-price ratio, leverage, operating income on assets etc. huang et al. (2013) reports the positive impact of stock liquidity corporate valuation on a broad sample of 53 countries. the findings are robust to various stock liquidity measures, host of firm-specific control variables, and different sub periods. stock liquidity promotes the informed trading, which in turn gives rise to an informative stock price. skjeltorp and ødegaard (2015) investigated the reason of incurring the cost of improving stock liquidity by the firms. the reasons reported being that the firm is going to raise capital in the near future or they are planning to repurchase their own shares. as per the study, the firms which hire a market maker resulted in to significant reduction in liquidity risk and hence cost of capital. huyghebaert and hulle (2004) investigated the role of institutional investors in corporate finance. they reported that institutional investors reduce information asymmetries between firms and (other) investors, which lead to enhanced liquidity of the firm’s share.guo and zhou (2006) reported that liquidity is enhanced after a stock split which is attributed to reduction in information asymmetries due to disclosure of private information to the public. weston et al. (2005) recommends that firms can reduce the cost of raising capital by improving the market liquidity of their stock. employing the large sample of firms, the study reports that the fees charged by the investment banking firms for fpo’s are lower for the firms having liquid stock.bundgaard and ahm (2012) reported that secondary market liquidity is a key factor in predicting combined cost of issuing securities under follow on public offers (fpo’s). firms with more liquid shares are able to issue fresh shares at reduced costs in comparison to the firms which have less liquid shares. the phenomenon closely falls in lines with the study of amihud and mendelson (1986) that illiquidity is priced in the market, making illiquid assets to trade at a discount. therefore, greater market liquidity of the stocks is in greater interests of the firms. spindtet al. (2007) reported empirical relationship between dividend policy and liquidity of firm’s share. investors demand for cash dividends is higher in illiquid markets. brockman et al. (2008) studied the impact of stock market liquidity on payout decisions of the firm of the stocks listed on nyse. they empirically confirmed that higher market liquidity encourages the use of repurchases over dividends. lipsona and mortal (2009) provide evidence that firms with more liquid shares have lower leverage and prefer equity financing when raising capital. enhanced liquidity reduced the required return on equity and cost of capital. therefore the firms make efforts in order to increase liquidity and hence equity in their capital structures. jayaraman and milbrourn (2011) asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 48 find evidence that firms with greater stock liquidity rely more on equity based compensation and less on cash-based compensation as part of annual contracts. the study further reports that the firms with greater stock liquidity have reliance on stock prices in designing executive compensation. hillert and obernberger (2015) studied the relationship between stock repurchases and liquidity on us markets. the study reports that smaller repurchases consume liquidity, whereas larger repurchases provide liquidity. repurchases tend to provide liquidity if they contain more information. the results of the study are interpreted context of recent research in market microstructure on limit order markets which says that, informed traders do make use of limit orders and provide liquidity to the market. 8. conclusion ‘stock liquidity’ as a concept research was first initiated by amihud in 1986. since then, research has been going on in area of defining liquidity, designing measures to quantify liquidity, identifying determinants of liquidity and implications of liquidity on asset pricing, dividend policy, returns and market efficiency. this study has analyzed various literature related to the ongoing research in area of liquidity in stock markets. the literature can be categorized into studying the factors that drives liquidity and how liquidity factors in determining the returns, asset pricing and corporate finance decisions. the factor that drives liquidity primarily focuses on macroeconomic, firm-specific determinants and commonality in liquidity. on other hand liquidity plays a key role in impacting daily as well as intraday returns, asset pricing and key corporate decisions viz. dividends, stock splits, executive compensation etc. so, far most of the studies are focused on quote driven markets e.g. usa. liquidity in stock markets as a research area have been bringing out quality research, however, the developing world lags behind the developed world which can have an impact on the policy by the security regulators. the extensive review of literature draws the future scope of study in this key area. to capture various characteristics and dimensions of liquidity multiplicities of proxies have been designed by many researchers. these proxies have been measuring liquidity in different degree in different markets. some liquidity proxies have been benchmarked using high frequency and order driven stock markets of developed countries. in emerging market economies low frequency proxies can be evaluated against bench marked proxies. macroeconomic and firm-specific factors as determinants of liquidity in a cross-section of firms have been significantly explored in developed economics. also, the well documented common determinants or commonality in liquidity may not be valid in emerging market economies. it is not fully understood why this phenomenon is observed. identification of causes driving common trends of liquidity can be an important scope for further research in market microstructure. in emerging markets the complex relationship among liquidity, stock return and liquidity risk premium has not been tested in a wider way. similarly, ownership structure and its impact on liquidity and implication of liquidity on cost of equity, dividend policy and market efficiency need to be explored in emerging market economies. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 49 acknowledgement: the authors would like to thank university grants commission (ugc), india. this research has been supported by ugc through junior research fellowship (jrf). references acharya, v.v. and pederson, l.h. 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(2006). commonality in liquidity in emerging markets: evidence from the chinese stock market. durham working paper in economics and finance, no. 06/04 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 56 appendix (i). summary of low frequency liquidity proxies reference proxy hui-heubel liquidity ratio (1984) l = ( − )⁄( ∗ )⁄ p is highest daily price over last 5 days, p is lowest daily price over last 5 days, v is the total dollar volume traded over last 5 days, s is the number of instruments outstanding and p is average closing price of the instrument over a 5 day period. datar (2000) cet = % change in trading volume% change in price cet is coefficient of elasticity of trading. hasbrouck and schwartz (1988) mec = long term price variabiltyshort term price variabilty measures used by saar and lybek (2002) s = (p − p ) s = (p − p )(p + p ) 2 where pa is the ask price and pb is the bid price measures used by saar and lybek (2002) v = p × q where v is the dollar volume traded, p and q are price and quantity of the ith trade during a specific period t = v(s × p) where s is the outstanding stock of the asset and p is the average price of ith trades. measures used by saar and lybek (2002) mec = var (r )t ∗ var (r ) var (r ) = variance of the logarithm of long period returns, var (r ) = variance of the logarithm of short period returns and t = number of short periods in each longer period roll (1984) roll = 2 −cov(∆p , ∆p ) if cov (∆p , ∆p ) < 00 if cov(∆p , ∆p ) ≥ 0 holden (2009) extended roll = 2 −cov(∆p∗, ∆p∗ )p if cov (∆p∗, ∆p∗ ) < 00 if cov (∆p∗, ∆p∗ ) > 0 , where the idiosyncratic adjusted price change ∆p∗ = z . p and z is the regression residual from the market model ar − r = α + β(r − r ) + z . goyenko, holden, and lot y − split = α − α where everything is the same as lot mixed, except that region 0 is r = 0, region 1 is r > 0, and region 2 is r < 0 and no asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 57 trzcinka (2009) upper bound cap is imposed. lesmond, ogden, and trzcinka (1999) zeros = ,where zrd is the number of zero return days, td is number of trading days and ntd is number of no trade days in a given stock month. goyenko, holden, and trzcinka (2009) zeros2 = # of positive volume days with zero returntd + ntd goyenko et al. (2009) 5 minute price impact = 2 × ln(m ) − ln(m ) if the t is a buy2 × ln(m ) − ln(m ) if the t is a sell in the above specification,m and m are the quote midpoints at t and five minutes after t, respectively. hasbrouck (2009) it is measured as the coefficient λ in the following regression model: r = λ sign(volume ) |volume | + u wherer is the return over the n five-minute interval, volume is the dollar volume of the t trade during the n interval, and sign(·) takes the value of +1 if the t transaction is a buy and -1 if it is a sell. u is the disturbance term trzcinka et al. (2011) fht ≡ s = 2σn 1 + z2 where s is the round-trip, percent transaction cost. amihud (2002) amihud = average | | , where r is the stock return on day t and volume is the currency value of volume on day t in units of local currency. goyenko, holden, and trzcinka (2009) extended amihud proxy = percent cost proxyaverage daily current volume pastor and stambaugh (2002) pastor and stambaugh = г , from the regression: r = θ + ∅r + гsign(r )(volume ) + ε , where r is the stock’s excess return above the crsp vwmr on day t, is the intercept, and regression coefficients, and ε is the error term. copper (1985) amivest = average volume|r | source: compiled by authors from cited research articles microsoft word 8165-29535-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 66 determinants of foreign portfolio inflows: analysis and implications for china fayyaz ahmad school of economics, lanzhou university lanzhou, gansu province, china dr. muhammad umar draz department of management and humanities universiti teknologi petronas 32610 seri iskandar, tronoh, perak darul ridzuan, malaysia tel: 60-5-368-7732 e-mail: umardraz2626@gmail.com su-chang yang school of economics, lanzhou university lanzhou, gansu province, china received: august 16, 2015 accepted: sep. 23, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8165 url: http://dx.doi.org/10.5296/ajfa.v7i2.8165 abstract in emerging markets, a number of factors like gdp growth, market efficiency and higher earnings expectations play a vital role in attracting stable and smooth foreign investment. this work is intended to explore the determinants of fpi in china and compare the results with determinants of fpi in india explored by garg and dua (2014). we have applied multiple-regression model for ten years’ data ranging from 2001 to 2010. the results indicate that external debts are the most significant determinant of fpi for china. we concur with garg and dua (2014) that gdp growth, fdi and exchange rate are among the significant determinants of fpi. our findings suggest that china needs to sustain its economic growth in order to attract more fpi. keywords: china, fpi, gdp, india asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 67 1. introduction growth of capital flows to emerging world since the end of the 20th century stimulated a hot debate among the scholars. generally, this shift is attributed to change in different economic, fundamental and country specific conditions round the globe. our interest here centers upon the study of different factors which are responsible in driving short term capital flows to china and india, focusing of fpi inflows of both countries. foreign capital flows play an important role in the economy. these flows bridge the investment gap and fulfill the capital needs of a country at the domestic and international level. in the present era of globalization and financial liberalization, foreign investors from various countries of the world are willing to invest in the rest of the world. recently, foreign portfolio investment (fpi) is becoming a common form of investment in many countries of the world. portfolio investors, as compared to fdi investors, invest for a short term period and their purpose is to speculate the market boom. investment in foreign countries is a source of earning as well as helpful to diversify the portfolio risk of the investors. since last decade, trend to invest in a foreign country is encouraging among foreign investors as mentioned by daly & xuan (2013) in their research that, still most of the investors like to invest in their domestic market. this phenomenon is known as investor home-bias. so, to attract a handsome amount of investment, the host country needs to provide an attractive package to the investors. fewer restrictions on capital flows, an attractive opportunity for investment and with the splendid growth rate of the economy, the emerging markets are the best place to invest from the last two decades. investors around the globe are interested to invest in financial markets of china and india because of their economic growth rates. foreign capital inflows started in india in 1991, while china received its first fpi in 1997. since the last decade, both countries experienced higher growth in fpi. china’s fpi growth is significantly higher than india on average, but both countries are growing with an increasing trend. global financial crises slowed down many economies of the world and fpi in china and india had a significant downfall in 2008. this work is intended to explore the determinants of fpi in china and compare the results with determinants of fpi in india explored by garg and dua (2014). after an introduction and background, the next section encompasses the review of available literature on determinants of fpi. section 3 provides the description of the variables employed while section 4 describes the data, methodology and empirical analysis. section 5, represents the results and discussions. finally, section 6 consists of concluding remarks and suggestions for policy makers. 2. literature review cross border equity flows are very imperative in current days and geographical components are very crucial in international capital flows. international capital markets are not frictionless and are segmented by information asymmetries. gross transaction flows depend on market size and the information cost, in source and as well as, in destination countries. imf survey dataset of cross border equity holdings established that market size, transaction cost and asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 68 information asymmetries are the major determinants of cross border portfolio selections. the importance of the drivers of portfolio capital flows fluctuates in countless time segments. key changes ensue in the importance of portfolio driving factors with the crucial market events or shocks. investors pay more attention to regional development of emerging markets when market tensions are elevated, but extreme tensions create panic and investors move their funds. at such times, market development plays only a marginal role (faruqee, li, & yan, 2004; portes & rey, 2005; duca, 2012) previous studies about determinants of international capital flows can be categorized into three concepts; home bias of investors, developed nations and emerging markets. each category has its specific elements which attract foreign capital to that region. one motivation behind foreign investment is, to diversify the investment risk of a portfolio investment. ancillary this, the source country investors with a higher level of home bias, prefers to invest towards those countries, which offer them better diversification opportunities. in different parts of the world, masses still prefer to invest in their own domestic markets and thus undervalue the diversification benefits. both developing and advanced nations have this trend; the australian investors invest a significant percentage of their portfolio in domestic market. trade, governance, market size, cross border capital controls and low transaction cost are ominously influential to lessen home bias of australian investors, and urge them to invest in international markets (coeurdacier & guibaud, 2011; daly & xuan, 2013). the strongest determinant of capital flows to the usa is the financial development of the country. the countries with less develop financial markets invest a large portion of their portfolio in us markets. the countries that trade more with us, and have fewer capital controls in their countries invest more in debt and equity market in the united states. internal countryspecific factors may influence foreign portfolio inflows. institutions and domestic risk of a country play an essential role to determine capital flows both in the shape of fdi and fpi. in south africa, secure property rights and low domestic risk affect positively to the absolute volume of short term and long term capital flows (egly, johnk, & liston, 2010; forbes, 2010; gwenhamo & fedderke, 2013). before the financial crisis of 2008, fpi shifted from advanced to developing nations. fpi flows have strong positive and a long term relationship with market capitalization and the degree of openness in nigeria. the neighboring countries also have a positive or negative impact on capital flows to a particular host country. the safety of funds is very important consideration among the investors. the level of the expected rate of return from any portfolio is associated with the level of political risk in that country. investors prefer to shift their funds from politically less stable to more stable countries. cultural characteristics of originating and destination countries are also important determinants of fpi flows (chukwuemeka, stella, oduh, & onyema, 2012; smimou, 2014). emerging markets like india received massive amounts of foreign investment during past two decades. the determinants of foreign institutional investment (fii) in india are exchange rate, domestic inflation, returns of domestic equity market and risk and return associated with us equity market. while, the foremost determinants of portfolio inflows are lower exchange rate asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 69 and greater diversification opportunities. higher equity returns of other emerging economies are depressing these flows. domestic stock market performance, exchange rate and domestic output growth are also important determinants of fpi in india. determinants of capital flows in the asian and latin american markets are gdp, interest rate, trade openness and financial interrelations. tax incentive and higher interest rates or dividend rates are an attractive tool to increase cross-border investment. low taxes on interest or dividend received by investors, associated with huge inflows of foreign capital to apec region, and thus, help to strengthen their competitive position among other countries (lee, huh, & kim, 2012; p. srinivasan & m. kalaivani 2013; (yang, xiong, & ze, 2013; garg & dua, 2014). equity market characteristics of host countries are pivotal in the decision making process of allocation of funds, in a country. whereas investing abroad, foreign portfolio equity investors keep in view numerous factors like, size, trading cost and market liquidity. foreign portfolio investors prefer to invest more in larger, more liquid and more efficient markets, with low trading cost. the population ageing, money, institution and deviation from uncovered interest parity (uip) are also the dominant factors in the development of capital flows. portfolio inflows are negatively correlated with low quality of institutions. cultural distance is also considerable; common language and religion among the countries, trading with each other, have a positive effect on the fpi holdings of both debt and equity. these effects are greater for the cross-border equity than debt. factors that influence the debt or equity flows at international level are important for researchers as well as policy makers; investor protection is one of these factors. investors tend to invest in those countries where better investors’ protection procedures are practiced. generally, countries which follow the common english law seem to attract the highest amount of foreign portfolio equity. especially in case of foreign investment, the investor protection regulations are important to attract fpi in the country. (de santis & lu¨hrmann, 2009; poshakwale & thapa, 2011; aggarwal, kearney, & lucey, 2012; thapa & poshakwale, 2012). after a large scale privatization in 1997 and 1998, all state owned enterprises, except a few monopolies, were liquidated and sold to private investors. in the late 90s, china became an open economy that led to a massive foreign capital inflows starting from 1997. during 2001-2004, the state owned enterprises reduced by 48%. meanwhile, chinese government reduced tariffs, trade barriers, modified the regulations and joined the world trade organization (wto) (shen, 2006). on the other hand, india adopted socialist policies after its independence in 1947. attempts to liberalize economic policies in different time spans went in vain. at first, the government attempted to open the economy in 1966 but it was reversed in the next year. prime minister rajiv gandhi made the second major contribution in 1985; although this process stopped in 1987 but was not reversed. later in 1991, the president and a technical team of intellectuals supported the finance minister manmohan singh for economic reforms. though political pressure was there, but the indian government was ready to take necessary steps for reforms (mukherji, 2009). as a result of the balance of payment crisis in 1991, india had to pledge 20 tons of gold to union bank of switzerland and 47 tons to bank of england to make a deal with the imf (weinraub, 1991). the imf imposed various conditions and demand for economic reforms asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 70 against the loan. in june 1991, following the general elections, the new government came to power inheriting one of the most complex trade regimes in indian history. the newly established government, as stated by krishna & mitra (1998), had to sort out the problem of severe restrictions on import export and extraordinary tariff on imports. later in july 1991, government announced liberal trade policy that resulted in removal of most of the licensing requirements, reductions in import tariff and other nontariff restrictions on trade. consequently, fpi investors started investing in the indian market for the first time in 1991. at present, india is the world’s second fastest growing economy just after china. as garg & dua (2014) mentioned that, the portfolio equity flows to developing countries are increased five times from fourteen billion dollars to sixty seven billion dollars during the period of five years. this amount reached to 128 billion dollars in 2010. among all developing countries, the prominent recipients are china, india, russia, brazil and south africa. china, india and brazil receive seventy percent of total portfolio investment invested in developing countries. china had made tremendous progress for the last thirty years. at present, it’s the second largest economy in the world after america. the chinese economic reforms called “socialism with chinese characteristics” started in 1978 under the chairmanship of premier deng xiaoping. the private sector of china grew remarkably, and the period of 19782005 accounted for as much as 70% of china’s gdp. at first, the reforms started with agriculture sector and then slowly for the whole economic system. in emerging markets, a number of factors like gdp growth, market efficiency and higher earnings expectations play a vital role in attracting stable and smooth foreign investment. in general, all these pull -factors on macro-economic level, with the help of fpi, prove to be crucial to finance the deficit of current account of host country. on the other hand, because of its volatile nature and reversal effect on economy, these flows are blamed for mexican and east asian crisis. as duca (2012) referred that, in normal circumstances fpi flows are beneficial, but at the same time cause economic instability in time of crisis. the literature on determinants of capital flows can be summarized into two main sets, internal or endogenous factors, and external or exogenous factors. advanced countries attract ample amount of capital because of their economic growth and stable financial system. while, interest rate, exchange rate, diversification opportunity, earning expectations, low taxes and changes in developed markets, are the factors mainly focused for developing countries. 2.1 research gap most of the literature addressed the topic by taking sample of countries including developing and developed nations. although, previous studies fairly contributed to enhance the understanding about the factors contributing towards growth of capital flows, but asian countries, especially china, demand special focus. so it will be valuable to conduct a focused study for china. 2.2 contribution of the paper this paper contributes to the current literature by studying the determinants of fpi in china and conducting a comparative study of china and india. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 71 3. methodology and results 3.1 data and variables data used in our analysis is taken from world bank site for last decade, for fdi, gdp, population growth and exd. data of fpi is taken from imf. fpi consists of total portfolio investment flows. the data of all variables is taken on annual bases and the currency unit is usd. also, some control variables are also discussed in earlier section to make this study comprehensive, which may influence fpi and considered in literature. the final sample for analysis consists of balanced panel of five variables, for the period from 2001 to 2010. our core variables used are largely adopted from literature to make comprehensive comparison of our findings with previous work. variables are abbreviated as follows: fpi = foreign portfolio investment {dependent variable} fdi = foreign direct investment {independent variable} gdp = gross domestic product {independent variable} exr = exchange rate {independent variable} exd = external debts {independent variable} p = population growth {independent variable} the following hypotheses are developed in light of theoretical discussion in the previous section, and will be used to certify the role of above mentioned variables and fpi: h0 = fdi / gdp / exr / p / exd is not significant in determining the fpi inflows in china h1 = fdi / gdp / exr / p / exd is significant in determining the fpi inflows in china 3.2 statistical analyses the analyses of our study are different from the existing literature. this paper is the only work that focuses on the determinants of fpi in china and finding out the most significant determinant. fpi of china has been taken as dependent variable, while fdi, gdp, exr, exd and population growth are used as independent variables. since fpi is function of all these variables, we can easily develop this into mathematical form. 1( , , , , )fdi gdp exr exd p t t t t t tfpi f u u u u u= (1) 2 ( , , , , , , )fdi gdp exd exr itr p ifn t t t t t t t tfpi f u u u u u u u= (2) equation (1) indicates variable of interest which includes; foreign direct investment, fdi tu , gross domestic product, gdp tu , population growth, p tu , exchange rate, exr tu ,and external debts, exd tu . frequently used variables in the existing literature include inflation and interest rate asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 72 (garg & dua, 2014; yang, xiong, & ze, 2013; thapa & poshakwale, 2012). equation (2) explains that fpi is a function of main and control variables, which include interest rate itr tu , and inflation ifn tu regression model will be used to determine the relationship among above mentioned variables. regression model has two types: the first is simple regression and the second one is multiple regression. the difference between two types is the number of independent variables, the former has only one independent variable and the latter has more than one while, the dependent variable in both cases is only one. in our model, we are dealing with more than one independent variable, hence linear regression or correlation analysis cannot provide satisfactory results because of their limitations. multiple regressions is the statistical tool, which is generally employed to examine the relationship between dependent and multiple independent variables. 1 1 2 2............... n ny a b x b x b x= + + + (3) equation (3) indicates that, to predict variable y we can use multiple independent variables; let’s say from 1x to nx . after adjusting our variables into above equation, mathematical representation of our final model is presented in equation (4). 1 1 2 2 3 3 4 4 5 5y a b fdi b gdp b exd b p b exr= + + + + + (4) 4. findings and discussion this section represents the empirical analyses and discusses implication of findings. table 1 represents the statistics summery of dependent and explanatory variables for sample period. in most cases, skewness >0 which indicates distribution is right skewed. table 1. summary statistics exr exd gdp fpi fdi p mean 7.74 3.18 10.49 2.20 1.25 0.57 median 8.08 3.03 10.05 1.91 1.22 0.57 std. dev. 0.65 1.22 1.77 1.87 7.57 0.07 skewness -0.62 0.61 0.91 0.30 0.55 0.56 kurtosis 1.60 2.42 2.89 1.47 2.35 2.27 jarque-bera 1.44 0.76 1.40 1.12 0.68 0.75 probability 0.48 0.68 0.49 0.56 0.70 0.68 source: authors’ analyses in eviews asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 73 kurtosis<3 shows that, distribution is flatter than normal with wider peak, which termed as platykurtic distribution. while, values of jarque-bera test are also not very high; particularly for fdi, p, and exd. the concept of stationary and non-stationary is important. a stationary series has a constant mean, variance and auto-covariance for each given lag. the results of a stationary series are reliable than non-stationary. augmented dickey-fuller (adf) using schwaz criterion and phillips perron (pp) test is used for evaluation of a series as unit root test and results are presented in table 2. table 2. unit root test augmented dickey-fuller (adf) phillips-perron (pp) variables adf test statistic critical value pp test statistic critical value exr -2.21 -1.98 -2.79 -2.00 fdi -3.06 -2.00 -2.76 -2.00 exd -2.39 -1.99 -4.53 -2.56 gdp -2.67 -1.99 -4.66 -3.40 fpi -3.73 -3.32 -6.61 -3.32 p -3.67 -3.25 -7.86 -3.25 source: authors’ analyses in eviews the computed adf and pp test statistics values are smaller than critical values for all variables, at 5% level of significance. the results support that all variables are stationary and reliable for regression results. prior to estimating the regression model, variables are also tested for multicollinearity. the results are presented in table 3, which indicates that most of cross correlation terms are fairly small for independent variables. so, there is no cause of concern about multicollinearity problem among variables. table 3. correlation matrix exd exr fdi gdp p exd 1 exr -0.59 1 fdi 0.69 -0.83 1 gdp 0.37 0.002 0.48 1 p -0.39 0.79 -0.83 0.0099 1 source: authors’ analyses in eviews regression results are presented in table 4, probability values for all variables are significant at the level of 5%, which indicates the strong relationship among fpi and independent variables. significant relationship exists between gdp and fpi which indicates that gdp is the strong determinant of fpi. substantial relation with strong probability of fdi, p, exr and exd elaborate that all these variables strongly influence fpi level in china. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 74 table 4. ordinary least square regression results variables coefficients t-statistics probabilities c 5.53 2.80 0.048 exd 2.06 9.53 0.0007 exr -2.74 -9.86 0.0006 fdi -2.50 -7.46 0.0017 gdp 6.90 13.37 0.0002 p 1.24 6.60 0.0027 2r 0.99 se 1.36 db 2.55 source: authors’ analyses in eviews while, r-squared value is higher than 0.9 and durbin watson 2.55 with f-statistics of 340, which demonstrates that variables applied in analysis are fairly uncorrelated. table 5. complementary test tests f-statistics probabilities** lm 0.56 (0.63)*** wh* 1.75 (0.25) arch 5.56 (0.99) reset 0.52 (0.49) source: authors’ analyses in eviews *wh is white heteroscedasticity test **level of significance is 5 per cent ***values in parenthesis are p-values furthermore, a series of specification tests is performed as cross check of results. the test battery includes test for serial correlation, lm test, white heteroscedasticity test, reset and arch test to check arch effect. results are presented in table 5, which indicates that in all cases corresponding values rejected the presence of autocorrelation in models. in addition, cusum test results presented in figure 1; do not indicate any instability in model. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 75 figure 1. cusum test for stability analysis, level of significance is 5%. the aforementioned empirical results show that, independent variables taken in our analysis are highly influential on fpi of china. relationship between exd and fpi is the most significant, which indicates that productive use of foreign loans is helpful to bring fpi flow in country. progressive loans give hand to improve social and economic infrastructure, which automatically results in better performance of various sectors of economy. relationship between gdp and fpi is obvious. since last decade, growth rates of china are approximately in double figures, which give an indication of smooth working of economy. comparatively few downfalls in economy and impressive growth rates attract foreign investors. exchange rate reflects a significant relationship with fpi. exchange rate appreciation indicates speculative opportunities for investors and with more investor’s rights and high earning expectations, international community fell safe and confident to invest. which leads to efficiency, transparency better infrastructure and improved investor’s rights of stock exchange in country, hence enhance economic growth. higher gdp growth and stable economic and political conditions urge foreign invests to invest long term funds in country, which specifies that chances of collapse are comparatively less. this situation increases investor’s confidence about safety of funds, and they diversify their portfolio in form of fpi, to earn more and minimize risk associated with investment. 5. conclusion we concur with the existing literature that determinants vary from country to country and generally include economic growth, interest rate differential, currency exchange rate, country’s political stability and capital control policy. in this paper, we investigated different factors which influence the fpi in china. based on regression model for previous decade, we found that gdp, exchange rate, population growth, foreign direct investment and external asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 76 debts significant determinants of fpi in china. these findings are similar to what garg & dua (2014) found in case of india. we further confirm that external debts are the most significant determinant of fpi in china. our findings suggest that china should pay attention to sustain its economic growth because its economic growth rate is already in double digits and comparatively higher than the indian economy. furthermore, reviewing its financial policies, especially the investors’ rights and financial openness, is highly crucial for china to attract more foreign capital from the international community. improved investors’ rights will provide support during economic turmoil to resist against these disasters. acknowledgement the authors are thankful to professor dr. jason zezhong xiao (cardiff university, uk) and assistant professor dr. ananda jeeva (ucsi university, malaysia) for their valuable suggestions and comments. references aggarwal, r., kearney, c., & 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(2013). a comparative study of determinants of international capital flows to asian and latin american emerging countries. procedia computer science, 1258 – 1265. http://dx.doi.org/ 10.1016/j.procs.2013.05.160 microsoft word 4133-15394-1-rv-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 268 ownership structure and non-performing loans: evidence from pakistan fawad ahmad fast school of management national university of computer and emerging sciences (fast-nuces) peshawar campus, pakistan e-mail: fawad.ahmad@nu.edu.pk received: august 16, 2013 accepted: november 28, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4133 url: http://dx.doi.org/10.5296/ajfa.v5i2.4133 abstract the main aim of this paper is to investigate the impact of ownership structure on the bank riskiness as measured by npls, by using traditional view that that concentrated ownership results in enhanced banking performance by reducing the bank riskiness, whereas dispersed ownership results in the reduced banking performance and increased bank riskiness against the opposite view that ownership concentration does not have impact on the bank riskiness. by using the data from pakistani banking sector results suggested the validity of traditional view that publically owned banks (dispersed ownership) reduces the banks performance and enhance the banks riskiness (npls), whereas rejected the view that concentrated ownership (privately owned banks and foreign banks) enhances bank performance and erodes the bank riskiness. keywords: npls, ownership structure, bank riskiness, efficiency, performance, concentrated and dispersed ownership asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 269 1. introduction the asian financial crisis of 1997 raised various questions relating the unstable nature and risk taking tendency of asian banks. in order to reform banking sector, asian banks regulators proposed and implemented reform measures to ensure the stability of the banking sector. first, asian governments discouraged the shutting down of banks by encouraging and in many cases forcing the distressed banks to merge with the safe banks (hawkins and turner, 1999; and gelos and roldos, 2004), at that time it was not confirmed that the mergers will result in the strong or weak intermediary, but it helped in improving the financial viability of the distressed banks (hawkins and turner, 1999). second, few asian governments announced bailout packages for distressed banks. these packages also enforced the banks to change their ownership structures (hawkins and turner, 1999). however, the government interventions to encourage mergers are much more cost-effective than bailout packages. third, asian governments allowed the foreign investors to own the banks in the countries in order to import best foreign banking practices, corporate governance and latest technology in the country (choi and dovutivate, 2004). fourth, many asian governments implemented the restructuring measures such as changes in corporate structure, polices, bank mangers or management. all these measures are closely related to the changing ownership structure and risk bearing tendency of banks, thus question arises here “ownership structure has effect on bank riskiness or not?” the banking reforms program begins immediately after 1997 and lasted till 2000. these reforms were aimed to change the ownership structure and governance of banks. the aim of this study is to check whether ownership concentration improves or do not affect the banks riskiness by using npls loans as measures of riskiness. how does bank riskiness is affected by ownership structure? in corporate finance literature, no concise result is given for this question. some studies have suggested that ownership structure increases firm riskiness while other suggests that ownership has no role in reducing firm riskiness. for instance, berle and means (1933) concluded that dispersed ownership reduces the decision influencing power of shareholders and control over firm management. thus risk in the firm increases because shareholders have no power to influence the firms decision making, thus management will make only those decisions which are in their own benefits, whereas concentrated ownership results in more corporate control because of increase in firm monitoring. this paper aims at investigating the berle and means (1933) traditional view that concentrated ownership results in enhanced banking performance by reducing the bank riskiness against the opposite view that ownership concentration does not have impact on the bank riskiness. in this paper bank riskiness is measured by the npls. this paper used three measures of ownership structure i.e. publicly, privately and foreign owned banks. 2. literature review banks that are publicly owned have different agency problems and challenges than those of the privately owned because of the wide separation of control and ownership. in publicly owned banks ownership is widely dispersed because of which the control of owners on the mangers is relatively weak resulting in the asymmetric of information and divergence of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 270 incentives between managers and owners (jensen and meckling, 1976). on the other hand private banks are mainly characterized with centralized ownership because ownership is less dispersed and owners are having larger shares and interest in the performance of banks. furthermore in centralized ownership owners can control the working of the mangers because of the access to the internal information and influence on the decision making. the difference between the publicly owned and privately owned banks are not only limited to the control and management but they also differs in terms of capital market access and market discipline. in case of publically owned banks risk taking ability is affected by the market discipline because it controls the risk taking behavior of banks thus when considering risk taking incentives of banks market discipline should also be considered (flannery, 2001; and bliss and flannery, 2002). market discipline is one of the main pillars of basel ii capital accord. the main idea behind market discipline is to enhance the bank supervision in order to reduce the risk taking incentives of publicly owned banks and privately owned banks that mainly dependent on the debts as the primary source of funding. public equity can be raised quickly and at lower costs as compared to the private equity. when publicly owned banks enter the market with high risk strategies, they have greater chance of raising funds as compared to their counterparts with same strategies. according to shleifer and vishny (1986) the extent to which ownership is concentrated, improves the corporate control by enhancing the control and monitoring of management. in dispersed ownership no individual investor has greater stake involve in firm therefore they are not much concerned with the control and monitoring the performance of firm, whereas in concentrated firms stake of individuals or closely related group of investors are involved, the loss in value of firm will have bad effect on these investors therefore they are more concerned with the control and performance of firms. burket, gromb, and panunzi (1997) challenged the view that reduction in managerial discretion by dispersed outside ownership is always beneficial. burket et al., (1997) suggested that the reduction in managerial discretion by dispersed outside ownership is not always beneficial, it comes with costs such as expropriation threat. they also argued that even in case of tight or concentrated outside ownership, it constitutes threat of expropriation that results in the reduction of the managerial incentives. with the reduction of managerial incentives the non-contractible investments (off-balance sheet) that mangers do for the benefits of shareholders also reduces, thus the threat of expropriation results in the reduction of firm value. large shareholders with concentrated majority groups are mostly the main drivers of the firms, and have different interest from minority shareholders. gomes and novaes (1999, 2005) concluded that conflicting groups of majority shareholders protects the interest of minority shareholders and also prevent the firms from taking efficient decisions. regulation of governments regarding the specific industry or sector also play important role in the working of mangers, which was studied by demsetz and lehan (1985), they argued that the strong regulation regarding specific industries such as financial sector, play important role in regulating the discipline and decisions of mangers, resulting in the reduced benefits of asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 271 ownership structure. elyasiani and jia (2008) supported the findings of demsetz and lehan (1985) and further concluded that institutional supervision can replace the owners monitoring of firms. the existing literature has also focused the risk taking ability of the publicly and privately owned banks. for instance, nichols, wahlen, and wieland (2009) suggested that publicly owned banks generally has more loan losses and loan losses provisions than privately owned banks. the existing literature has suggested that the risk taking ability and agency problems varies in firms with the nature of ownership. among agency problems first issue was identified by jensen and meckling (1976) known as conflict of interest, which suggests the diversified shareholders are willing to take higher risks to increase their earnings whereas mangers tries to reduce risk exposures and losses, in order to save their positions and to serve their personal benefits (jensen and meckling, 1976; and esty, 1998). one of the early empirical studies relating impact of ownership structure on bank risk taking incentives was conducted by saunders, strock, and travlos (1990). they hypothesized that stock holder controlled banks have greater incentives to take risks as compared to the privately owned banks, there results supported the hypothesis and suggested positive relation between stockholder control and risk taking incentives. they also concluded that risk taking incentives and managerial control are negatively associated with each other. like saunders et al., (1990) other studies also found significant association between ownership and risk taking incentives but without any consistent agreement on the sign of relationship. some studies found positive relationship, some suggested negative and few proved u-shaped or inverse u-shaped relationship. for instance, sullivan and spong (2007) concluded that the banks having mangers as their shareholders, the stock ownership of such banks are positively associated with the bank risk, which shows that under certain situations banks manger operates the banks for the benefits of their owners. furthermore, westman (2011) found that in non-traditional banks management ownership is positively associated with the profitability, whereas in traditional banks board ownership is positively associated with the profitability. existing literature has analyzed the association between ownership structure and banks performance with no concise empirical evidences on relation, furthermore theoretical explanation of the relation is also not clear. for instance aghion and tirole (1997) concluded that firm performance can be improved through concentrated ownership because of the increase in supervision and prevention of managerial takeovers, whereas, shleifer and vishny (1997) in there theoretical study argued that large shareholders can use their power to influence strategies in favor of their own benefits and can exploit the minority share holders. boubakri and ghouma (2010) found that expropriation by the ultimate owners affects the performance of firms bonds and ratings. laeven and levine (2009) found that the risk taking ability of the banks increases with powerful owners. later on haw, ho, hu, and wu (2010) confirmed the findings of laeven and levine (2009) by suggesting that the concentrated ownership exhibits higher insolvency risk, poor performance and greater earnings volatility. whereas shehzad et al., (2010) found that when the ownership concentration is 50 percent or more than npls decreases, they also suggested that weak shareholder protection rights are beneficial for the ownership concentration for banks. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 272 the existing literature has provided evidence relating the performance comparison between publicly and privately owned banks. agency costs in the government owned firms can results in the weak managerial rewards, under-utilization and misallocation of resources. agency cost view illustrates that private firm’s mangers do not work at their full potential as compared to private firm’s counterpart and usually use most of the resources for their personal benefits. from political corruption aspects state owned banks works to serve the supporters of government, political influence in banks decreases efficiency and loan quality by allocating the funds on political basis (khwaja and mian, 2005). the existing studies have proved that poorer loan quality and high npls are mainly associated with government owned banks (berger, clarke, cill, klapper, and udell, 2005; and iannota, giacomo, and sironi, 2007). iannota et al., (2007) also concluded that privately owned banks are more profitable than government owned and mutual banks. they also found that among mutual, private and public banks, publicly owned banks has the highest npls and bad loan quality whereas mutual banks has lowest npls and high quality loans. furthermore, micco, ugo, and monica (2007) have found that privately owned banks has the better performance than all other banks in developing countries. they also find that the state owned banks have higher costs and lower profitability as compared to the private banks, whereas opposite is the case for foreign owned banks. two important things must be considered while testing berle and means (1933) theory in the context of banking sector, first the minority shareholders protection, and second deposit holders protection. the existing studies showed that minority shareholder have no control over the firm management unless they are provided with proper legal protection (shleifer and vishny, 1997). similarly la porta, lópez, shleifer, and vishny (1998) found that ownership concentration is negatively associated with shareholder protection. their findings are consistent with the hypothesis that small dispersed shareholders are not important in those countries where their rights are not protected. because of these two reasons protection of minority share holders is considered in empirical model of this study. pathan (2008) investigated the importance of board structure of banks on their risk taking ability and used the data of usa banks and found that strong boards represented by most of share holders increases the risk appetite of banks. whereas, ceo powered banks have little or no risk appetite. supervisory authorities implement depositor protection rights, act in favor of depositors and protect their interests, whereas deposit insurance safeguards the wealth of the depositors. as a result depositors demand for lower interest rates, resulting in lower risk taking opportunity for banks (demirgϋç-kunt and huizinga, 2004). here the differences between the banking firm and non-financial institution must be considered. the main difference is that banks have both account holders and share holders, whereas non-financial institutions only have shareholders. banks have to look for the benefits of both the depositors and shareholders. but in order to increase the profits shareholders together with banks mangers enter into illegal acts against the depositors by increasing the lending to the risky borrowers at higher rates. this may results in growth of npls and capital inadequacy (boyd, chang, and smith, 1998). further it increases moral hazards problems because neither bank nor shareholders takes the responsibility of their illegal acts. to secure asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 273 the interest of banks supervisory authorities keep close look on the policies of banks. park and peristiani (2007) used the banking data to examine the moral hazard problem and investigated that bank shareholders can pursue risky strategies by using the insured deposits or not. their results showed that strong protection rules and supervision can reduce the moral hazard problem. therefore, role of supervisory institutions and deposits insurance are incorporated in the empirical model. four existing studies are closely related to the relationship between ownership structure and npls. caprio et al., (2007) investigated the impact of both share holder protection laws and ownership structure on the bank valuation. they used the data of 244 banks of 44 countries. they find that in few countries where protection laws are strong banks have dispersed ownership, whereas in countries where protection laws are weak banks are family or government owned. their results showed that ownership structure play vital role in governing of banks. furthermore they find that owner value is boosted by controlling large cash flows of banks, share holder value increases because of the strong protection laws and right on the cash flow decreases the adverse affect of minority shareholders. this study distinguishes from caprio et al., (2007) by using npls in place of the bank value. laeven and levine (2009) conducted the first empirical study on theories relating the banks risk appetite, national bank regulations and ownership structures. their study was based on investigating the impact of conflict between owners and managers over bank risk appetite. they find that comparative power of shareholders has positive impact on the risk taking ability of banks. they further proved that capital regulation, bank risk, restriction on bank activities and deposit insurance policies depends on the banks ownership structure. there are few differences between laeven and levine (2009) and current study. first, they used the ownership structure of 10% to 20% whereas this study uses dummy variable of publicly, privately and foreign owned banks as measures of ownership structure. second, they used z-score as a proxy for risk whereas this study uses npls as proxy of bank riskiness. third, they used data of 44 countries, but this study uses only the commercial banks data of pakistan. this study is similar to the study of shehzad et al., (2010), who investigated the impact of ownership on bank riskiness (measured by npls and capital adequacy). they used 500 banks data from 50 countries over the period of 2005-2007. they find that concentration of ownership has negative impact on the npls and helps in reducing npls, whereas concentration of ownership has positive impact on the capital adequacy ratio. they further argued that at low level of supervisory control and protection rights, ownership structure has negative impact of riskiness. the current study differs from shehzad et al., (2010) in three aspects, first, they have used the banks data from 50 countries but this study uses the data of pakistani banks. second, they have used npls and capital adequacy as measures of riskiness whereas this study uses only npls as riskiness measure. third, their study used three measures of ownership concentration i.e. 10% or more, 25% or more and 50% or more, whereas this study uses dummy variables of publicly, privately and foreign owned banks as the measure of ownership concentration. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 274 barry et al., (2011) used detailed european commercial banks ownership data to analyze the relationship between different ownership structures of privately and publicly owned banks and level of risk and profitability. they divided the ownership structure into five categories. they proved that ownership structure significantly explains the risk differences in different categories especially in private banks. they find that as the equity stake of individual or banking institution increases the assets riskiness and decreases default risk. when non-financial institutions or institutional investors are holding the highest shares then they go for the riskiest strategies. the results showed that change in ownership for the private banks have no affect on bank risk appetite. they also find that the regulation of banking supervision authorities increases the efficiency, lowers the npls and improves the quality of publicly held banks. the current study relates to barry et al., (2011) in two aspects, first, barry et al., (2011) have used five categories of ownership structure whereas this study uses three categories (public, private and foreign owned banks) because data is only available relating three categories. second, like barry et al., (2011) the current study also investigated the association between risk and ownership structure. based on existing literature current study formulated eight hypotheses relating association between npls and ownership structure and other related variables. the hypotheses are given below h1: public ownership results in the declined banking performance and increased npls. h2: private ownership results in the enhanced banking performance and decreased npls. h3: foreign ownership results in the enhanced banking performance and decreased npls. h4: high investor protection (deposit holder protection) results in the decline in npls. h5: high supervisory control results in the decline in npls. h6: high restrictions on activities results in the decline in npls. h7: high bank concentration results in the growth of npls. h8: listed or not listed bank may have positive or negative impact on the npls. the research frame work of ownership structure and other literature supported variables is given below asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 275 figure 1. ownership structure and other related variables research framework 3. explanatory variables this study investigates the berle and means (1933) traditional view that concentrated ownership results in enhanced banking performance by reducing the bank riskiness against the opposite view that ownership concentration does not have impact on the bank riskiness. this study used three measures of ownership structure i.e. publicly, privately and foreign owned banks. djankov, la porta, lopez-de-silanes and shleifer (2008) used investor protection index (ipi) to account for the shareholder protection rights in their model. following djankov et al., (2008) here ipi is used as a measure of shareholder protection rights. the ipi is based on legal protection to the minority shareholder. the ipi consist of the three main dimensions: ability of shareholder to sue directors and offices, transparency maintained by the firms in transactions and self-dealing liability. the value of ipi ranges from 0 to 10, representing low protection and high protection respectively. the data relating the supervisory control is available on the imf database which uses barth et al., (2001) methodology to measure supervisory control. the barth et al., (2001) methodology consists on a set of questions and total affirmative answers to these questions are averaged to obtain supervisory control. detailed information relating methodology of supervisory control is available in imf database and in barth et al., (2001). npls privetly owned banks publically owned banks listed banks bank concentrat ion activities restrictions supervisor y control investor protection rights foregin owned banks asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 276 for activities restriction, barth, caprio and levine (2001) measure of activities restriction is used. this measure consists of a set of questions developed by barth et al., (2001). the data relating this measure is available on the world bank database. it considers the restriction under which banks are engage in insurance, real estate and securities activities. its value is in range of 0 (low restriction) to 4 (high restriction). this study uses beck, demirgüç-kunt and levine (2000) measure of bank concentration, its data in available on the world bank database. bank concentration is measure of the three largest bank assets as a percentage of all banks assets in a country. this measure is also available on sbp website. the ownership concentration and other literature supported variables, there literature supported relation with npls and references are given in table 1. table 1. explanatory variables, literature supported relations, data source and references variables relation with npls data source references ownership concentration +/sbp caprio et al., 2007; and barry et al., 2011 investor protection index www.doingbusiness.org caprio et al., 2007; and shehzad et al., 2010 supervisory control imf barth et al., 2001; laeven and levine 2009; and shehzad et al., 2010 activities restrictions + world bank barth et al., 2001; laeven and levine 2009; and shehzad et al., 2010 bank concentration + sbp beck et al., 2000; laeven and levine, 2009); and shehzad et al., 2010 listed banks +/karachi stock exchange shehzad et al., (2010) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 277 4. data and procedures this section used panel data of commercial banks currently operating in pakistan. for each bank 5 years data is collected. currently there are 34 commercial banks operating in pakistan which can be divided into three broad categories i.e., public sector, private sector and foreign banks. out of 34 banks 30 banks fulfilled the data requirement. the data relating the bank concentration and dependent variable was collected from the sbp publication “financial statement analysis of the financial sector 2006-2009” and annual reports of commercial banks for the year 2010 given on sbp website. the variables such as ownership concentration data is collected from publication “financial statement analysis of the financial sector 2006-2009”, there the names of publicly, privately and foreign owned commercial banks are given. the data on ipi is collected form “www.doingbusiness.org”, data on activities restriction is collected form world bank data base and supervisory control data is collected form imf data base. at first random effect model is applied, after that hausman random effect test is run to check the validity of random effect model, in results chi-square statistics and its corresponding p-value is used to predict whether random effect model is valid or not. after getting the results of random or fixed effect, model is checked for its prediction ability by using certain features and characteristics. first model r-squared value with number of significant relation and f-statistics value is checked; commonly high r-squared value with maximum number of significant relations and f-statistics value with p-value less than 5% are considered best. second, residual correlation is checked by using durbin-watson statistics, commonly when its value is 2 or around 2 then there is no correlation. the model of the ownership structure and other related variables is given as follows = + + + + + + + (1) where is the dependent variable, banks riskiness (impaired loans to gross loans ratio) in time period “t” for cross-recessional unit “i” is the ownership concentration (publically, privately and foreign owned banks) in time period “t” for cross-recessional unit “i” is the investor protection index for cross-recessional unit “i” is the supervisory control for cross-recessional unit “i” is activities restriction for cross-recessional unit “i” is the bank concentration for cross-recessional unit “i” indicates whether bank is listed or not is the intercept mean value with individual intercept deviations from mean value asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 278 , , , , and are the respective co-effcient terms “ ” is the composite error term including is individual unit error component and is combined time and units error component. “i” is the cross section units (30 banks) “t” is the time period (2006 to 2010) 5. results and analysis the analysis of ownership structure and other related variables starts with the selection of ownership structure and other related variables. eight hypotheses are formulated for ownership structure and other related variables. the random effect model is applied by using eight explanatory variables; the results of random effect model are given in table 15. the fitness of the model is predicted with the help of r-squared, f-statistics and number of significant relationship between npls and explanatory variables. the r-squared value for the model is 0.608551, suggesting that almost 60% variance in npls are explained by eight ownership structure and other related variables. the f-statistics of the model has a p-value of 0.08542, suggesting that eight variables can not influence the npls jointly. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 279 table 2. random effect model results of ownership structure and other related variables variable coefficient standard error t-statistic probability publically owned banks 0.0328941 0.0355429 0.9255 0.35633 privately owned banks 0.0078972 0.0320113 0.2467 0.80551 foreign owned banks -0.03762 0.026471 -1.421191 0.1788 investor protection rights -0.0535625 0.0409358 -1.3085 0.19290 supervisory control 0.00962676 0.0111343 0.8646 0.38876 activities restrictions -0.65926 1.27521 -0.5170 0.60600 bank concentration 0.71676 0.645235 0.867675 0.0186 listed banks 0.0169231 0.0267529 0.6326 0.52806 c 0.548537 0.46921 1.1691 0.24439 r-squared 0.608551 adjusted r-squared 0.391080 f-statistic 2.79830 p-value 0.08542 after applying random effect model, hausman random effect test is run to check the validity of random effect model, in results chi-square statistics and its corresponding p-value is used to predict whether random effect model is valid or not. when p-value of chi-square statistics is less than 1 then it shows that random effect model is not appropriate and fixed effect model is preferred. if the p-value is less than 1 then fixed effect model will be used. the results of the hausman random effect test are given in table 3. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 280 table 3. hausman random effect test test summary chi-square statistic probability cross-section random 3.30351 0.769901 the results suggest that the p-value for the chi-square statistics is 0.769901, which is less than 1. this shows that random effect model is not valid and does not provide the preferred specification of the variables used in the analysis; therefore variables are regressed again by using fixed effect model. the result of fixed effect model is given in table 4. the fixed effect model is applied by using eight explanatory variables; the results of random effect model are given in table 4. the fitness of the model is predicted with the help of r-squared, f-statistics and number of significant relationship between npls and explanatory variables. the r-squared value for the model is 0.568181, suggesting that almost 57% variance in npls are explained by eight ownership structure and other related variables. the f-statistics of the model has a p-value of 0.363237, suggesting that eight variables can not influence the npls jointly. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 281 table 4. fixed effect model results of ownership structure and other related variables variable coefficient standard error t-statistic probability publically owned banks 0.05124 0.024705 2.074100 0.06791 privately owned banks 0.0230583 0.0379835 0.6071 0.56297 foreign owned banks -0.03362 0.025475 -1.191191 0.2388 investor protection rights 0.0164891 0.0481341 0.3426 0.74198 supervisory control 0.00962676 0.0111343 0.8646 0.38876 activities restrictions 0.60026 1.27821 0.4670 0.50600 bank concentration -3.1848 1.46809 -2.1693 0.06668 listed banks 0.011575 0.0465201 0.2488 0.81064 c 1.02908 0.64114 1.6051 0.15251 r-squared 0.568181 f-statistic 1.315786 adjusted r-squared 0.136362 p-value 0.363237 durbin-watson statistics 2.224787 the results provide only two significant relations whereas remaining six variables have insignificant association with npls. the results suggest significant positive association between the npls and public (dispersed) ownership. the existing studies have also found the positive association between npls and publically owned or dispersed ownership (shleifer and vishny, 1986; berger et al., 2005; iannota et al., 2007; and nichols et al., 2009). the results of current study confirms the validity of traditional view of berle and means (1933) that dispersed ownership has negative impact on the efficiency and performance of the banks and with dispersed ownership control and supervision on the firm declines results in the growth of firm riskiness. the positive relation confirms that in publicly owned banks (dispersed ownership) the control of the owners on the mangers is weak, resulting in the asymmetry of information and conflict asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 282 of interest between owners and managers (jensen and meckling, 1976), leading to the decisions that are in benefit to managers. due to less supervision and control, mangers increase the riskiness of the loan portfolio in order to improve the short term cost efficiency. they lend money to the low quality borrowers, resulting in the growth of future npls. in publically owned banks level of supervision and monitoring is very weak (shleifer and vishny, 1986), because stake of large number of dispersed investor is involved. as the stake of individual investor is small therefore they pay less attention on the working and risk exposure of the banks. corruption also play important role in the growth of npls in the publically owned banks. in country like pakistan regulatory and supervisory authorities are very weak in regulating and implementing laws, due to which lenders take advantage and do not repay loans because they know that no strong legal action will be taken against them because of this the rate of npls in public banks are on the higher side. the other reason for the increase in npls is the corruption in the political system of the country. most of the time political owned firms lend funds from the banks and by using the political power and corrupt practices do not repay loan (khwaja and mian, 2005). furthermore the management of the banks also by using corrupt practices lends money to low quality borrowers (barth, lin, lin and song, 2009), which results in the increase in npls. the other main reason for the positive relation between npls and publically owned banks is the lenient credit policies and inefficiency of the credit evolution departments of the banks; because public banks lend money to those who are ready to pay more than others and do not take collaterals rather lend funds on the warranties and political status. due to all these reason publically owned banks has high rate of npls than other banks (micco et al., 2007).the positive relation also confirms the findings of saunders et al., (1990) that in publically owned banks managers can take higher risks due to the weak supervision and monitoring. this results in the increase in loan portfolio riskiness and thus results in the growth of future npls. the results of current study reject the traditional view of berle and means (1933) that concentrated ownership (private ownership) has positive impact on the efficiency and performance of the banks and with concentrated ownership control and supervision on the firm increases, resulting in the achievement of owner’s goal. the justification for the positive relation can be that in private owned banks control of the owners on the management is strong, thus owners can influence the risk taking decision of the management and can force the management to increase the riskiness of the loan portfolio by lending funds to the low quality borrowers (saunders et al., 1990; laeven and levine, 2009), resulting in the future growth of npls. the results of current study confirm the traditional view of berle and means (1933) in case of foreign ownership that concentrated ownership has positive impact on the efficiency and performance of the banks. they further suggested that with concentrated ownership control and supervision on the firm increases resulting in the decline of firm riskiness (shleifer and vishny, 1986). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 283 the current study suggests that with the increase in protection to the investors the npls increases. this result is opposite to the findings of existing study that with the increases in investor protection rights bad loans declines. the justification of the negative relation is the weak and corrupt legal institution of pakistan that fails to implement the laws and regulations, because of which low quality borrowers defaults the loans with out any fear legal actions. the current study provides the expected sign between the npls and supervisory control. the association between npls and supervisory control as given by table 4 is insignificant, suggesting that supervisory control does not have significant influence in decreasing the level of npls. the result suggests that as the supervisory control over the banks in the from of supervision by the regulatory authorities increases then banks follow the standard procedures for the allocations of loan and thus the possibility of lending to the low quality borrowers decreases, resulting in the decline of npls. the results in table 4 provide insignificant positive association between npls and activities restrictions. the results reject the h6 of the current study that activities restriction results in the decline of npls. the justification for the positive sign is that the laws and rules are improving every day in pakistan, but the main problem is the implementation of the rules and laws. countries like pakistan has several laws for each and every department of the banks, but regulatory and supervisory authorities are very weak because of which they do not implement the laws and regulation in there complete form. they failed to implement all the rules and laws because of the corruption, both at the macro level and inside banks and supervisory authorizes. this is the reason because of which with the increase in the strength of legal rights npls also increases. the results reject the h7 by providing significant negative association between npls and bank concentration. this suggests that with the increase in the bank concentration results in the decline of npls. the bank concentration increases when the assets of 3 largest banks of the country increase. with the increase in assets the operations of 3 banks are diversified to different other sectors, this results in the reduction of bank risk and lending to the quality borrowers of other sectors. the risk of the banks reduces because the bad performance in one sector can be compensated by good performance of other sectors, resulting in the decline of the npls through diversification. the results in table 4 suggest positive association between listed or not listed banks. the association between both is insignificant therefore the bank is listed or not has no significant impact on the npls. this result suggests that listed banks management in order to show short term cost efficiency, invest less on the allocation, supervision and monitoring activities of loans which results in the allocation of loans to the low quality borrowers, which results in the growth of npls. the correlation of the residual of the model is checked by using durbin-watson statistics. the general rule for the durbin-watson statistics is that if its value is 2 or around 2 than the residual is not serially correlated whereas if its statistics is less than 2 than the residual is positively correlated and less than 4 represents the negative correlation. the durbin-watson asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 284 statistics for the model is given in table 4; the statistics is 2.224787 suggesting that residual is not serially correlated because statistics is around the 2. 6. conclusions, policy related implications and future research the analysis of ownership structure and other related variables starts with the selection of ownership structure and other related variables. eight hypotheses was formulated for ownership structure and other related variables. the current study used eight variables relating ownership structure and related variables and applied fixed effect model. the results provided only two significant associations of publically owned banks and bank concentration with npls, whereas remaining six variables were insignificantly associated with npls. the current study investigated the berle and means (1933) traditional view that concentrated ownership results in enhanced banking performance by reducing the bank riskiness against the opposite view that ownership concentration does not have impact on the bank riskiness. the results provided the validity of berle and means (1933) traditional view in terms of publically owned banks (dispersed ownership), that it reduces the bank performance and enhance the bank riskiness (npls). whereas in case of privately owned banks and foreign banks rejects the berle and means (1933) view that concentrated ownership enhances bank performance and erodes the bank riskiness. the positive association between npls and publically owned banks suggests that in publically owned banks supervision and monitoring of the owners over the management is very low, furthermore management show short term cost efficiency by sacrificing cost incurred on loan allocation process and corrupt practices of the management, lenient credit process and political pressures leads to the declined efficiency and performance of banks, which results in the growth of npls. the current study provides statistically significant positive relationship between bank concentration and npls. this result suggests that with the increase in bank concentration the operation of large banks are diversified; this leads to the distribution of funds among different sectors. in this way risk of the banks associated with one specific sector declines and loss of any sector is compensated by the good performance of other sector. the finding of the ownership structure and other related variables models also have implications of the policy makers. first, sbp should consider that their supervision policies have different impact on the banks according to their nature of ownership, for instance publically owned banks are less in control of their owners as compared to the private owned banks, and therefore sbp can develop supervision policies according to ownership structure. second, the current study provide the validity of berle and means (1933) in terms of dispersed ownership thus public banks performance can be improved by the constant supervision of the owners and sbp. third, sbp should take measure to strictly supervise the credit allocation process and make sure its proper implementation in the public owned banks. the ownership structure and other related model used only one measure of bank riskiness i.e. npls, shehzad et al., 2010 used two variables as measure of bank riskiness (i.e. npls and asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 285 capital adequacy). the future study in pakistan and other developing countries can be conducted by using two or more measures of bank riskiness. shehzad et al., 2010 in their study has used the percentage of ownership as measure for ownership structure i.e. 10% or more, 25% or more and 50% or more, whereas current study 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(2007). managerial wealth, ownership structure, and risk in commercial banks. journal of financial intermediation, 16, 229–248. http://dx.doi.org/10.1016/j.jfi.2006.12.001 microsoft word 8530-30977-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 215 the relationship between audit committee characteristics, audit firm quality and companies’ profitability laith a. aryan dept. of accounting, ajloun national university p.o.box 43, ajloun 26810, jordan tel: 962-2-646-6616 e-mail: laith.aryan@anu.edu.jo received: august, 5, 2015 accepted: nov. 9, 2015 published: december 9, 2015 doi:10.5296/ajfa.v7i2.8530 url: http://dx.doi.org/10.5296/ajfa.v7i2.8530 abstract jordan displayed keen interest in corporate governance in terms of enhancing the quality of financial statements and to restore the investors’ confidence. this study aimed to highlight the role of audit committee and external audit in enhancing companies’ profitability. since there are contradictions in previous studies results, there is a need to test these relationships in jordanian context to provide empirical evidence on this issue, especially after the corporate governance application became mandatory since 2009. this study has used industrial sector, which include 91 companies, only 69 companies were included in this study, the other 22 companies were excluded either newly listed or delisted during the study period (2009-2014). multiple regression were used to analyze the data, the result showed positive relationships between audit committee meeting, audit committee size and companies profitability, while no significant relationship between audit committee composition, audit committee members literacy, audit quality and companies profitability. such results would be beneficial to companies’ corporate governance committees to play their supervisory role. keywords: audit committee, audit quality, profitability, jordan asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 216 1. introduction the world has witnessed a big financial turmoil during the last few years, which led many big firms to go bankrupt. therewith, the investors became distrustful in the reliability of the global financial markets and the companies' financial information as well. as a result, interest in corporate governance has increased in both developed and developing countries in an attempt to regain the lost confidence. jordan also displayed keen interest in corporate governance in terms of enhancing the quality of financial statements. in doing so, the legislators have enacted laws to ensure public companies to apply corporate governance roles. in september 2009 jsc issued the corporate governance code for shareholding companies listed on the amman stock exchange which defines the responsibilities and formation of the committees. corporate governance code describes the committees formed by the board of directors such as audit committee. jsc (2009) stipulates that the members of audit committee must have knowledge in finance or accounting, and at least one of them must have worked previously in accounting or finance fields; and that person must have an academic or professional certificate in accounting, finance or related fields. also, this code ensures audit committee periodically meet and at least one meeting with external auditor must be held. the duties of audit committee are determined as follows: (1) discussing matters related to the nomination and working of the external auditor and reviewing the company's correspondence with the external auditor; (2) monitoring the company's compliance with laws and regulations in force and the requirements of regulatory institutions; (3) monitoring any change in the company's accounting policies, and any change in the company's accounts as a result of the auditing processes; (4) evaluating the internal control and auditing procedures and the auditor evaluation for internal control; and (5) ensuring that no conflict of interest may arise from the company's transactions, contracts or projects with related parties. the code also points out the power of audit committee, which are: (1) requesting the presence of the external auditor if the committee sees a need to meet him regarding his work; (2) nominating the external auditor to the board of directors for election by the general assembly; and (3) nominating a candidate to be appointed as the company's internal auditor (jsc, 2009) oecd (2005) defines corporate governance as "procedures and processes according to which an organization is directed and controlled. the corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organization such as the board, managers, shareholders and other stakeholders and lays down the rules and procedures for decision-making". audit committee and external audit play an important role in enhancing the quality of financial statements and the firm financial performance by mitigating financial distress, such results is supported by many researchers. for example, salloum, azzi, gebrayel (2014)found that the financial distress of banks has a significant negative relation with the meeting frequency of the audit committee. geiger and rama (2006) asserted that the big audit firms provide a high quality report in terms of producing lower errors compared with the non-big audit firms. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 217 in light of previous studies’ results, this study came to highlight the role that the audit committee characteristics and external audit can play to control the management actions and controlling the agency problems. the need for such study is to bridge the gap in literature since these relationships has not been researched extensivelyin jordan. moreover jordan has witnessed many financial scandals that led many companies to go bankrupt such as global business, and alshamyleh gate. thus jordan has issued the code of conduct in 2009 which require listed companies to form the committees as explained earlier. 2. literature review many researchers have examined the relationship between audit committee, audit quality and companies’ profitability, for example, merawati (2015) conducted his study on 11 insurance and reinsurance companies listed in the indonesian stock exchange in 2012, the results showed that the audit committee, the internal audit, the external audit and the corporate financial soundness, have influences on the company’s profitability. vuko, maretić, and čular (2015) analyzed the role and effectiveness of internal mechanism (audit committee) of corporate governance on credit institutions performance in croatia. sample consisted of 78 credit institutions listed in zagreb stock exchange, from 2007 to 2012 has been collected and efficiency index of audit committee (eiac) has been created. they found that audit committees of credit institutions have medium efficiency, and there is a significant difference in audit committee effectiveness in observed period, moreover there is a significant difference between level of audit committee effectiveness and audit firm type. while there is no positive relationship between audit committee effectiveness and credit institution performance. narwal and jindal (2015) examined the impact of corporate governance on the profitability of indian textile sectors. they collected data from annual reports of textiles companies for the period of five year ranging of 2009to 2014. the profitability has been taken as dependent variable and board size, audit committee members, board meetings, non-executive directors, directors remunerations as independent variables. for analyzing the data they used correlation and ols regression model in this study. finally, they found a strong positive association is observed between director’s remuneration and profitability. the audit committee members is observed negative associated with the profitability. the study concluded that board size, board meeting and non-executive directors do not significant association with the profitability on contrary, ojulari (2014) explores the relationships that exist between corporate governance and the performance of quoted companies in nigeria. he selected twenty five companies listed in the nigerian stock exchange. the results show that the two variables (i.e. corporate governance and financial performance) are more positively related on an individual proxy basis than on an overall proxy basis. the overall impact of corporate governance on the performance is also negative so also are the result of the regression models. this result shows that although there is a relationship between the two variables, the predictive power of corporate governance on companies’ performance is too low to be meaningful. salloum, et al(2014) aimed to highlight the impact of audit committee characteristics on lebanese financially distressed and non-distressed banks. they examined four characteristics of the asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 218 audit committee (i.e. size, composition, frequency of meeting and financial expertise. they found that the distressed banks have a significant negative relation with the meeting frequency of the audit committee. they added that meeting frequency plays an important role to ensure audit committee effectiveness and the audit committee with frequent meetings is able to help audit committee members to ensure the integrity of financial reporting, to provide better monitoring and to review effectively the operations. fulop (2013) analyzed the correlations between the audit committee and profitability. he used 25 companies listed on berlin stock exchange to test these relationships he found that the role of the audit committee is crucial. similarly zare et al (2013) examined the relationship between audit firm size and profitability. they used 97 companies’ annual reports to test the study hypotheses; they found a negative and significant relation between audit firm size institution and companies profitability. moreover, arshad et al (2011) found a there is positive effect of an audit committee on firm’s profitability ratio and on firm’s performance. zahirul-islam (2010) argues that an audit committee is one way to reduce the management incentive problem such as manipulating financial statements to get higher bonuses. this is because effective audit committees enhance the quality and credibility of annual audited financial statements. goodwin and seow (2002) found that the presence of a strong audit committee decreases errors in financial statements and increases the possibility of management fraud detection. song and windram (2004) found weak evidence on the relationship between the member financial literacy, meeting frequency, and outside directorships, and the effectiveness of audit committee. al-shareif (2008) found a positive relationship between independent audit committee and earnings quality in jordan. ismail et al. (2008) revealed that only audit committee with multiple directorship members is related positively to the quality of reporting. meca and ballesta (2009) found that independent audit committee is an effective mechanism in mitigating earnings management. wan-hussin and haji-abdullah (2009) examined the relationship between audit committee and the quality of financial statements in malaysia. they found that the presence of a big audit committee is related positively with quality of financial reporting. similarly, rainsbury et al. (2009) studied the relationship between the quality of audit committee and the financial reporting quality. they found no significant relationship between the quality of an audit committee and the quality of financial reporting. they remarked that this surprising result suggests that the benefits of high quality audit committee may be less expected by regulators and decision makers. al-khabash and al-thuneibat (2008) demonstrated that poor corporate governance such as the absence of an audit committee correlates positively and significantly with illegitimate earnings management. also, ismail et al. (2009) found that the size of the audit committee is positively correlated with earnings quality. lin and hwang (2010) found that earnings management has a negative relationship with independence, expertise, and number of meetings of audit committee. contrarily, wenyao and qin (2008) concluded that presence of audit committee did not reduce income-increasing earnings management. in jordan, al-khabash and al-thuneibat (2008) found that the absence of audit committee correlated positively with earning management, which confirms agency theory's assertion that is the presence of an audit committee enhances the quality of financial statements. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 219 watts and zimmerman (1990) state that an auditor plays a significant role in monitoring managements' behavior, which reduces the agency costs, similarly, xiao et al. (2004) note that agency theory postulates that audit mitigates the interest conflict between contracted parties. they add that big audit firms are more likely to be hired by managements with greater potential gains from external monitoring. salehi and mansoury (2009) assert that because large audit firms have their own resources such as superior technology and talented employees, these enable them to issue reports of higher quality than small audit firms do. agency theory proposes that because a big audit firm has a reputation that needs to be maintained they will perform better in their job(naser, 1998).dietrich, harries and muller (2001) indicated that the reliability of fair value estimations is higher when the firm is monitored by external auditors especially the big audit firms. bauwhede, willekens, and gaeremynck (2003) found that hiring one of the big auditors decreases the earnings management. geiger and rama (2006) found that the big audit firms provide a high quality report in terms of producing lower errors compared with the non-big audit firms. hayyani (2008) argue that big audit firms are better in predicting failure in companies in jordan. teitel and machuga (2010) provided evidence on the relationship between the audit quality and earnings quality. they found companies that hire a high quality auditor show a high earnings quality. similarly, bauwhede and willekens (2003) found a negative relationship between audit firm size and earnings management. in the contrary,moroney and dowling (2005) found no relationship between audit firm size and the auditor performance level. shanikat and abbadi (2011) indicated that the audit profession in jordan is dominated by big audit firms and a few smaller national audit firms. hence, they concluded that, in general, audit firms in jordan are of low quality. in malaysia, ismail, et al (2008) investigated the relationship between audit committee and external audit with quality of financial reporting for 45 companies listed on the bursa malaysia. they found that only the audit committee with multiple directorship members is positively related to the quality of reporting. they also found no relationship between the audit quality and quality of corporate reporting. shanikat and abbadi (2011) argued that the audit profession in jordan is dominated by big audit firms and a few smaller national audit firms. they also noted that most audit firms in jordan are of low quality. al-shareif (2008) examined the relationship between corporate governance and earnings quality in jordan. he revealed that the independent audit committee correlates positively with earnings quality, while there is no relationship between board size and board independence with earnings quality. correspondingly, al-khabash and althuneibat (2008) explored earnings management practices in jordan from the perspective of external and internal auditors. they found that the external and internal auditors believe that the management involves significantly in legitimate earnings management by decreasing or increasing the income, but the internal auditors believe that the management increases the income only. they also found no significant differences between small and big firms concerning earnings management practices. they demonstrated that poor corporate governance such absence of an audit committee, combination of the ceo and founder roles, and board of directors dominated by insiders correlate positively and significantly with illegitimate earnings asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 220 management. segovia (2003) tested the role of auditors in approving earnings management. he stated the current standards facilitate earnings management in companies. he added that interpretation of gaap confuse the auditors' decision making. 3. methodology this study extracted data from industrial companies’ annual reports for six years (2009-2014) to test the relationship between audit committee characteristics (i.e. audit committee size, audit committee composition, meeting frequency, and financial literacy), audit quality and companies’ profitability. hair et al (2007) assert that some of the advantages of using secondary data are that it saves time and cost of acquiring the information generated. it is helpful to acquire the actual state of phenomenon under study. data were collected from the industrial sector only because this sector makes up 48% of amman stock exchange (ase), the financial sector was excluded because it has different regulations and corporate governance code. to choose the companies relevant to the study, they had to meet two conditions: 1. the company has financial statements data for the study period. companies that are newly listed or delisted during the study period were excluded. 2. the companies traded regularly in the ase during the study period. 3.1 measurement this study has used many proxies to measure the dependent and independent variables. the audit committee characteristics as mentioned in jordanian code of conduct are audit committee size, audit committee composition, meeting frequency, and financial literacy. this study used the audit firm size as a proxy to measure audit quality. these measurements are explained below: measurement audit committee size the number of audit committee members audit committee composition the ratio of non-executives members meeting frequency the number of meeting held per year financial literacy the number of members who have a financial knowledge audit quality 1 = big 4 audit firm 0 = non big 4 audit firm profitability gross profit margin: the gross profit margin is calculated as follows: (sales – cost of goods sold) / sales 3.2 population and sample selection sekaranand bougie(2013) refer to population as the entire group, events, or things of interest that the researcher wishes to investigate, and the sample is a subset of the population. in this study, the population is industrial sector which consisted from 91 companies. out of 91 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 221 companies, 22 companies were excluded because they did not meet the abovementioned conditions. 4. hypotheses of the study based on the aforementioned argument and previous studies results, and following agency theory assumptions, the hypotheses of this study are formulated as following: h1: there is a significant relationship between audit committee size and company’s profitability. h2 there is a significant relationship between the composition of non-executive directors in audit committee and company’s profitability. h3: there is a significant relationship between the frequency of audit committee’s meeting and company’s profitability. h4: there is a significant relationship between the financial literacy of audit committee’s members and company’s profitability. h5: there is a significant relationship between audit quality and company’s profitability the model used to test the above hypotheses is as follows: profit = α + β1 acsize + β2 accomp + β3 acmeet + β4aclitr + β5aufsize + ε where: profit profitability accomp size of audit committee acmeet the frequency of audit committee meeting aclitr financial literacy of audit committee members aufsize audit firm size α = ε = constant; and disturbance term. 5. hypotheses testing before testing the hypotheses testing, this study has checked linearity, normality, and homoscedasticity. the need for normally distributed data is because the correlation represents a linear association between the variables while the nonlinear association is not represented. so the scatter plots should express the normal line for the independent and dependent variables. according to hair et al. (2010), testing the normality of the data can be done by exploring skewness and kurtosis ratio. normality is assumed when the skewness and the kurtosis are between ± 1.96 at alpha value .05 and ±2.58 at alpha .01, respectively. the values of skewness and kurtosis indicate that the data were normally distributed. the results of multiple regression showed that r2 is 0.319 that means the independent variables explain 31.9% of dependent variable as shown in table 1 below. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 222 table 1. model summary model r r square adjusted r square std. error of the estimate 1 .345a .319 .299 .038 the results of hypotheses testing shows there is a positive relationship between audit committee size, audit committee meetings and profitability. while there is no relationship between audit committee composition, audit committee members literacy, audit quality and company’s profitability. table 2 summarizes these results. table 2. coefficients model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) .320 .024 1.350 .018 acsize .384 .080 .359 2.007 .049 accomp .162 .134 .344 2.710 .102 acmeet .198 .158 .181 1.782 .038 aclitr .004 .023 .026 .183 .289 aufsize .033 .124 .034 .262 .194 dependent variable: profitability where: acsize audit committee size accomp audit committee composition acmeet audit committee meetings aclitr audit committee members literacy aufsize audit firm size 6. conclusions this study aimed to test the relationship between audit committee’s characteristics, external audit quality and profitability empirically. in doing so, i extracted data from companies’ annual reports to measure the study variables. the results of the study supported some previous studies (i.e. merawati (2015) vuko, maretić, and čular (2015) narwal and jindal (2015)) partially, for instance, merawati (2015) concluded that the audit committee, the external audit and the corporate financial soundness, have influences on the company’s profitability. salloum, et al (2014) found that the distressed banks have a significant negative relation with the meeting frequency of the audit committee. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 223 regarding to the relationship between audit quality, zare et al (2013) found a negative and significant relation between audit firm size and companies profitability. while this study found no relationship, this may refer to the low quality of audit firms as shanikat and abbadi (2011) claimed that the audit profession in jordan is dominated by big audit firms and a few smaller national audit firms. hence, they concluded that, in general, audit firms in jordan are of low quality. due to the contradicting pervious studies’ results on this issue, this study came to expand the literature on the relationship between audit committee characteristics, external audit and profitability and to provide empirical evidence on these relationships in jordanian context. such empirical study will be helpful in shedding light on the supervisory role of audit committee and external audit companies’ financial performance. such results highlighted the role of audit committee in enhancing companies’ profitability, by exercising its supervisory role. thus companies have to concentrate on audit committee size and increase the number of meetings as they have positive relationships to profitability. references al-khabash, a., & al-thuneibat, a. 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(2004). benchmarking audit committee effectiveness in financial reporting. international journal of auditing, 8(3), 195-205. teitel, k., & machuga, s. (2010). the interaction of audit firm quality and the mexican code of best corporate practices on earnings quality. review of business research, 10(1), 1-22. http://dx.doi.org/10.1111/j.1099-1123.2004.00090.x wan-hussin, w. n., & haji-abdullah, n. m. (2009).audit committee attributes, financial distress and the quality of financial reporting in malaysia, 1-40. retrieved from http://ssrn.com/abstract=1500134 watts, l., & zimmerman l. (1990). positive accounting theory: a ten year perspective. the accounting review, 65(1) 131-156. wenyao, l., & qin, l. (october, 2008). board composition and earnings management. paper presented at the 4th international conference on wireless communications, networking and mobile computing, dalian, china. vuko, t., maretić, m., &čular, m. (2015). the role and effectiveness of audit committee incorporate of credit institutions. international journal of social, behavioral, educational, economic, business and industrial engineering 9(4). governance xiao, j. z., yang, h., & chow, c. w. (2004). the determinants and characteristics of voluntary internet-based disclosures by listed chinese companies. journal of accounting and public policy 23(3), 191-225. http://dx.doi.org/10.1016/j.jaccpubpol.2004.04.002 zahirul-islam, m. (2010). agency problem and the role of audit committee: implications for corporate sector in bangladesh. international journal of economics and finance, 2(3), 177-188. http://dx.doi.org/10.5539/ijef.v2n3p177 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 ajfa.macrothink.org 226 zare, r., khedri, s., & farzanfar, f. (2013). examining the effect of auditing institution, internal auditing department and companies’ profitability on voluntary information disclosure in tehran stock exchange. international journal of economy, management and social sciences, 2(9). microsoft word m-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 159 macroeconomic variables, firm characteristics and stock returns during good and bad times: evidence from sea nafis alam1 assistant professor, nottingham university business school, the university of nottingham malaysia campus e-mail: nafis.alam@nottingham.edu.my received: august 23, 2013 accepted: october 27, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4025 url: http://dx.doi.org/10.5296/ajfa.v5i2.4025 abstract this paper investigates the role of macroeconomic factors and firm characteristics in explaining stock return in big four south east asian (sea) countries, namely, malaysia, indonesia, singapore and thailand. the factors model is employed for two time intervals, namely, sub-period a (from july 2003 to june 2007) and sub-period b (from july 2007 to june 2011) to examine the change in relationship between macroeconomic variables and stock returns during pre and post global financial crisis of 2007. our empirical findings reveal that the significance relationship between macroeconomic variables and portfolio stock returns were not consistent for both sub-periods. the result is highly dependent on portfolio, country and sub-period. keywords: stock returns; firm characteristics, macroeconomic variables; financial crisis jel classification codes: g11, g12, g14 1 nottingham university business school, university of nottingham, malaysia campus, jalan broga, 43500. semenyih, selangor, malaysia. tel: +60(3) 8924 8279. fax: +60(3) 8924 8019. email: nafis.alam@nottingham.edu.my asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 160 1. introduction over the years, researchers, economists and financial analysts have tried to use different types of information to explain stock market return, for example, the change in economic and financial factors have been commonly used to explain the behaviour of different stock markets around the world. as suggested by economic theory, the stock price should reflect the expectation of corporate performance, while corporate profit should reflect the level of economic activities. if the theory that the stock price reflects all the fundamental economic factors (macroeconomic and financial) is true, then the stock market should be able to be utilized as a leading indicator for current as well as future economic activities. in addition, the stock market has been seen as the major driver for economic growth and plays a significant role in allocation of economic resources into the productive activities of the economy in both emerging and developed countries (sudhahar & raja, 2010). so, the role of the stock market has made a significant area of research on the relationship between macroeconomic factor, financial factors and the stock return. moreover, it is envisaged that this study could be a good reference for policy makers wishing to develop and make decisions regarding their nation’s macroeconomics policy without fear of influencing capital formation and the stock trading process. with regard to the theoretical model for the relationship between macroeconomic factors and stock market return, capital asset pricing model (capm) has been commonly used to describe the link between factors and stock market return. this model emphasizes the positive linear relationship between expected security returns and risk (market betas), which builds on the work of markowitz (1952) on the mean value mode. this concept was further developed by sharpe (1964), lintner (1965) and mossin (1966). the suitability of the capm has been supported by a number of empirical studies such as those by black, jensen and scholes (1972) and fama and macbeth (1973). however, its shortcomings have been the subject of intense debate, for example, in relation to the use of the mean-variance model’s beta to determine the stock return and the poor market proxy by using the mean-variance efficient concept. the researcher has used firm-specific factors to explain the stock return for instance, the small firm effect (keim, 1983), leverage effect (bhandari, 1988), book-to-market effect (stattman, 1980; rosenberg et al., 1985) and the pe effect (ball, 1978; basu,1983) and the results show that these methods for the estimates are less noisy in comparison with capm beta. as a result of a number of shortcomings in the capm, the arbitrage pricing theory (apt) was developed by ross (1976a) and this development has been treated as the natural successor to the capm. unlike the capm, the apt allows for multiple risk factors to be taken into account in the process for generating calculations of asset return. generally, the factor selection can be streamlined into three main approaches. the first approach for factor selection estimates sample covariance matrices by using statistical techniques such as factor analysis proposed in the studies of roll and ross(1980), chen(1983) and lehman and modest(1988) and principal component analysis (pca) recommended by chamberlain and rothschild(1983) and connor and korajaczyk (1985, 1986). the second approach suggests the use of macroeconomic variables as factors. for instance, chen, roll and ross (1986) use asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 161 macroeconomic variables to explain the cross-sectional variations in estimated expected returns. macroeconomic factors include term structure, inflation rate, money supply, exchange rate, while additional factors have continued to be added by researchers (maysami, 2004; humpe & macmillan, 2007) as risk factors for stock market. the third approach is used the firm characteristics as the portfolio return and this are used to assess firm sensitivity and systematic risk in the economy. fama and french (1992) sorted firm characteristics such as size, leverage and book-to-market equity into different portfolio structures and determined the interaction between different portfolio structure returns and different betas estimation. other similar findings exist for this approach, such as those of rosenberg, reid and lanstein (1985), chan, hamao and lakonishok (1991), fama and french (1993), charitou and constantinidis (2004) and simlai (2009), which observe the interaction between stock return and ratio of book-to-market equity. on the other hand, the study of ball (1978), basu (1983), shen (2000) and truong (2009) observe the relationship between stock return and ratio of price-to-earning. many studies have documented the relationship between macroeconomic variables and stock returns. some of these studies have examined this relationship for developed markets such as usa, japan and europe (chen, roll and ross (1986), chen (1991), clare and thomas (1994), mukherjee and naka (1995), gjerde and saettem (1999), flannery and protopapadakis (2002)). on the other hand, some other studies investigated the situation for developing markets, particularly in the east asia (bailey and chung (1996), mookerjee and yu (1997), kwon and shin (1999), ibrahim and aziz (2003)). there are also studies that compare the phenomenon for group of countries (cheung and ng (1998), bilson, brailsford and hooper (2001), wongbangpo and sharma (2002)). these studies have provided different results. the results have changed according to the macroeconomic factors used, the research methodology employed and the countries examined. however, the studies were mainly focussed on one time series. there is not too much work done on testing the relationship during pre and post financial crisis period. in this study, the south east asia (sea) countries of malaysia, indonesia, singapore and thailand (mist) have been selected for empirical study. the selection of sea as the test target is based on two main reasons. first, sea has been recognized as having impressive economic growth and a thriving export sector. since 2000, mist countries market capitalization has grown from usd324, 311 billion to usd1, 694 trillion, which is around 431 percent growth in market capitalization in comparison with 392% for the asia region’s growth in market capitalization (wfe, 2011). second, the high growth in market capitalization shows that investors express interest in this region and the great potential of the firms in sea is the main attraction for investors that encourages them to invest in this region. this paper investigates the role of macroeconomics and firm specific factors in explaining the stock return for mist countries in two periods. the first period is before the 2007 global economic crisis (from july 2003 to june 2007) and the second period is during and after the global economic crisis (from july 2007 to june 2011). ordinary least square (ols) multi-regression models are deployed, following the previous studies by barrow and naka (1994), chen, kim and kim (2005), chiang and kee (2009). the present study employs asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 162 growth rate of industrial production, change in consumer price index, growth rate of the money supply, change in the exchange rate, change in term structure and growth rate of international crude oil price as the macroeconomic factors for the time period july 2003 to june 2011. most of the previous studies investigate the macroeconomic factor and stock return based on the main index. however, our analysis is based on stock portfolio returns rather than the stock indices return. in portfolio construction, three firm characteristics are identified to be the portfolio criteria, namely, price-to-earnings ratio, market equity and book-to-market ratio. furthermore, the different portfolios enable us to present a cross-sectional view of the overall stock market in mist. sea consists of countries with different market structures, for example, emerging countries (malaysia, thailand and indonesia) and a developed country (singapore). in addition, the emerging countries comprise countries with different demographics and economic structures which will provide the study with data to analyse the comparative effect of the factors in different countries and their effect in different periods of time. evidence showed that during the crisis and post crisis period (sub-period b), the stock markets of all four countries are more reactive to the change in oil price. on the other hand, the result of thailand shows the positive correlation between change in inflation and stock return during crisis and post crisis(sub-period b) while the result of malaysia and indonesia show inflation is negatively correlated to stock return before the crisis period(sub-period a). the rest of the paper is organized as follows. section 2 reviews the related literature. section 3 explains the data and the methodology while section 4 provides the empirical results and finally conclusion is presented in section 5. 2. literature review due to criticism capm in late 1970s and subsequent drawbacks of apt in 1980s led to development of macroeconomic factor model to test the stock market performance. in the macroeconomic factor model, the factors are defined based on economic intuition and external sources information such as macroeconomic variables are used as the factors. the estimated factor loadings are verified by using time series regression whether macroeconomic variables describe the cross-sectional variations in estimated expected return. the apt macroeconomic factors model can be written as follows: equation 1 where = expected return of the asset = constant = loading on the macroeconomic variables to kth number of factors = risk premium for the macroeconomic variables asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 163 = idiosyncratic error term based on this perspective, chan, chen and hsieh (1985) analysed the macroeconomic variables together with the size effect while chen, roll and ross (1986) attempted to identify the significant macroeconomic variables which influence asset return. their tests were conducted by using the two-step procedure of fama and macbeth (1973), where the factor betas are estimated via time-series regression of asset return relative to the time series factor return. the macroeconomic factor models in both studies utilize number of factors such as industrial production, inflation, real interest rate, term structure, oil price and risk premium. from their studies, industrial production, risk premium and term structure were found to be significant factors influencing stock return, while the inflation effect is rather weak. following these initial studies, other researchers proposed various macroeconomic variables for different countries: japan –hamao (1988), uk – priestley (1996), singapore –maysami et al. (2004), malaysia –ibrahim and abdul rahman (2003), thailand – tangjitprom (2011), philippines– bailey and chung (1996), and the literature in this area continues to grow. several macroeconomic variables were used in past studies and found to have significant impact on stock returns. for instance, studies by mukherjee and naka (1995) for japan, maysami, howe and hamzah (2004) for singapore, ratanapakorn and sharma (2007) for the us s&p500 and humpe and macmillan (2007) for us and japan indicate that industrial production is a significant factor and is positively correlated with stock return. for exchange rate impact, results were mixed. mukherjee and naka (1995) and ratanapakorn and sharma (2007) show that exchange rate is statistically significant and positively correlated with stock return in both japan and the us. however, there was evidence of negative correlation for stock price and exchange rate in the case of indonesia (rahajeng & akhsyim, 2010), malaysia (ibrahim & yosoff, 2001), taiwan (singh, mehta and varsha, 2010) and turkey (buyuksalvarci, 2010). in case of money supply, most of the studies show that there is a positive correlation between money supply and stock return (maysami, howe and hamzah, 2004; ratanapakorn and sharma, 2007; mukherjee and naka, 1995). theory always states that inflation negatively related with stock price and most of the studies support the theoretical findings, for instance in the case of japan (mukherjee & naka, 1995; humpe & macmillan, 2007), taiwan (singh, mehta & varsha, 2010), and the us (humpe & macmillan, 2007). however, the study by maysami, howe and hamzah (2004) shows a positive relationship in the case of singapore and the study by chen, roll and ross (1986) found that inflation is weakly significant in their study on the nyse from 1958 to 1984. term structure, which is derived from difference between long-term and short-term interest rate tend to be negatively correlated with stock return. the study of stock and watson (1989), davis and henry (1994) and plosser and rowenhorst (1994) indicates that term structure is more superior in predicting the future real economic activity than short-term interest rate in the us and european countries. the study of chen, roll and ross (1986) indicates that term structure is negatively correlated with stock return in us stock exchange. hamao (1988) indicates that the same correlation in japan stock market. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 164 there is no direct theory to describe the effect of oil price on stock price. however, based on the hypothesis, the oil price is a principal factor which could impact the profitability and revenue of a company and subsequently stock returns. the study by chen, roll and ross (1986) found no significant oil price effect on stock return. moreover, al-fayoumi’s (2009) study on the oil-importing countries found no significant relationship between oil price and stock return. however, the study by narayan and sharma (2011) shows that there are certain effects of the oil price on firm return and the stronger evidence can be found based on different firm size. on the other hand, the study by le and chang (2011) shows that for the period from 1986 to 2011 the stock market responds positively in japan and negatively in malaysia and an inefficient stock market responds slower to the shock of oil price. in another extension of factor model, fama and french (1992, 1993, 1996) designed a two-stage method to estimate the characteristic-based factor model. in the first stage, the returns of assets are sorted according to the portfolio based on the firm characteristic, such as book-to-market and market capitalization. in the second stage, the factor betas of the portfolio are estimated by time series regression of the asset return. the fama and french three-factor model has gained support from a number of empirical studies. for instance, maroney and protopapadakis (2002), faff (2001), drew and veeraraghavan (2002, 2003a, 2003b) and gaunt (2004) show the strong relationship between stock return and book-to-market equity and size in countries with different market structures such as australia, canada, germany, france, japan, the uk, the us, malaysia, china, hong kong and the philippines. the objective of sorting the portfolio return based on firm characteristics such as price-to-earning (pe) ratio, book-to-market (bm) ratio and market equity (me) is to further evaluate the impact of firm-specific factors on stock return as well as the interaction between different firm-specific factors and macroeconomic factors. as shown in table 1, there are evidence of relationship between the firm-specific factor and stock return. in general, the small size portfolio (low me) outperform large size portfolio (high me) in term of stock return; high bm portfolio outperform low bm portfolio in term of stock return; low pe portfolio outperform high pe portfolio in term of stock return. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 165 table 1. previous findings of the relationship between firm-specific factor and stock return firm specific factor previous literature observation price-to-earning(pe) ratio basu (1977) low pe portfolio outperform high pe portfolio ball (1978) low pe portfolio is associated to higher risks and expected return. basu (1983) low pe portfolio has higher risk adjusted return even. truong (2009) low pe portfolio outperform high pe portfolio in new zealand book-to-market(bm) ratio stattman (1980) high bm portfolios ratio outperform low bm portfolio in us stock market chan, hamao and lakonishok (1991) high bm portfolios ratio outperform low bm portfolio in japan stock market chui and wei(1998) high bm portfolios ratio outperform low bm portfolio in hong kong, korea and malaysia. daniel, titman and wei (2001) high bm portfolios ratio outperform low bm portfolio in japan stock market market equity(size effect) banz (1981) small size firms(low me) have higher average stock return than large size firms(high me) small size effect reinganum (1981) small size firms(low me) have higher average stock return than large size firms(high me) – small size effect reinganum (1992) the size effect is not stable over time 3. data & methodology in this paper, the analysis is conducted based on monthly time series data from july 2003 to june 2011. the data is divided into two categories. the first data set consists of macroeconomic variables while the second data set consists of stock market data. in the first data set, seven macroeconomic variables namely growth rate of industrial production, changes in money supply (m1 and m2), change in consumer price index as the proxy of inflation, change in exchange rate, change in term structure, and growth rate of crude oil price were obtained on monthly basis from the international financial statistics (ifs) in international monetary fund (imf) website. the monthly oil price data is obtained from the organization of petroleum exporting countries (opec). the short-term and long-term interest rates for indonesia are not available in ifs. accordingly, the 30-day bank indonesia certificate (sbi) is used in place of the short-term interest rate, while the 90-day asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 166 sbi is used as the proxy for the long-term interest rate; both of these sbis are obtained from the ceic database. in the second dataset, book-to-market equity and market capitalization are used to establish the portfolio for the stock return by grouping them into low, medium and high equity firm-specific factors. to match the variables of firms’ characteristics with stock returns, we match the accounting data for fiscal year end t-1 with the stock return of july of year t to june of year t+1. the objective in choosing a six months’ gap between fiscal year-end is to provide a conservative time for firm to release their accounting information to the public after fiscal year end t-1. the sorted stock returns are grouped into a stock portfolio based on firm characteristics. to avoid missing observations and any biases in the data sets which could potentially affect the study results, we established three criteria for stock selection. (i) the stock should not have negative book equity at fiscal year-end t-1 (fama & french, 1995), (ii) any stock without a trading record for more than one month will be excluded from the study and (iii) to keep the portfolio consistent, the portfolio only includes stock which was consistently traded during the eight-year period under study. for all firms by country in the sampling period, three equal groups of portfolio are formed according the firm characteristics of price-earnings (pe) ratio, book-to-market (bm) ratio and market equity (me). the portfolios are grouped into high, medium and low based on the rank in each firm characteristic. eventually, nine portfolios (3 portfolios x 3 firm-specific criteria) are established for each country for the time interval july 2003 to june 2011. the data definition, symbol, source of the basic series and derived series of data and portfolio construction are illustrated in table 2. table 2. glossary and definition of macroeconomic variables and portfolio construction symbol variable definition basic series ip industrial production monthly industrial production index inf inflation monthly consumer price er exchange rate monthly national currency per sdr rate stir short term interest rate monthly treasury bill interest rate ltir* long term interest rate monthly long term government bond rate ms money supply monthly money supply m1 and m2 op oil price monthly oil price – opec derived time series economic data ∆ip(t) monthly growth rate of industrial production ∆inf(t) monthly change in consumer price index asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 167 ∆er(t) monthly change in exchange rate ts(t) term structure ∆ts(t) monthly change in term structure ∆ms(t) monthly growth rate of money supply ∆op(t) monthly growth rate of oil price portfolio construction peh price-earnings ratio(high) market equity divided by annual net income of firm at the end of december in year t-1 the highest 33.33% of stock sort by price-earnings ratio pem price-earnings ratio(medium) the medium range 33.33% to 66.66% of stock sort by price-earnings ratio pel price-earnings ratio(low) the lowest 33.33% of stock sort by price-earnings ratio meh market equity (high) price times number of shares outstanding at the end of fiscal year t-1. the highest 33.33% of stock sort by market equity mem market equity (medium) the medium range 33.33% to 66.66% of stock sort by market equity-bloomberg mel market equity (low) the lowest 33.33% of stock sort by market equity bloomberg bml book-to-market (low) the lowest 33% of stock sort by book-to-market ratio– bloomberg bmm book-to-market (medium) the medium range 33.33% to 66.66% of stock sort by book-to-market ratio –bloomberg bmh book-to-market (high) book equity at the end of fiscal year t-1 divided by market equity at the end of fiscal year t-1. the highest 66% to 100% of stock sort by book-to-market ratio-bloomberg source: ifs imf international financial statistic, ceic & opec organisation of the petroleum exporting countries, bloomberg. all variables are converted into logarithm and ∆ denotes the first difference for the variables. *long-term and short-term interest rate for indonesia is obtained from ceic the numbers of stocks for each country that meet the criteria for stock selection, and which are distributed into high, medium and low portfolios, are shown in the following table 3. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 168 table 3. number of eligible firms for each country over the sample period country number of firms distribution number of firms into high, medium and low portfolio malaysia 222 high – 74, medium – 74, low – 74 indonesia 57 high – 19, medium – 19, low – 19 singapore 111 high – 37, medium – 37, low – 37 thailand 123 high – 41, medium – 41, low – 41 the economic variables are transformed into natural logarithms and their first differences to achieve stationary in data to prevent spurious regression (mukherjee & naka, 1995; maysami & koh, 2004). moreover, a natural logarithm helps in reducing the heteroscedasticity in the model. using the state variable as derived above, the stock portfolio return model can be formed as follows: equation 2 where the betas ( are the loading coefficient for the state variables, e represents the stock portfolio return, represents the constant term and e represents the error term. in order to estimate the regression models stated above, stationarity of the series should be examined. in this study, augmented dickey-fuller (adf) (dickey and fuller, 1979) test is used for testing the presence of unit roots. two assumptions should be checked when estimating a regression model. these assumptions are independency and homoscedasticity of residual errors. existence of serial correlation is checked by breusch-godfrey langrange multiplier test (breusch, 1978; godfrey, 1978). presence of heteroscedasticity is tested by white general heteroscedasticity test (white, 1980). the regressions are performed by ordinary least squares (ols) method. 4. empirical results first we examined the descriptive statistics for each variable and portfolio in all given countries. each country summary statistics are divided into two sub-periods, pre-crisis period (from july 2003 to june 2007) as sub-period a and during and after the crisis period (from july 2007 to june 2011) as sub-period b. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 169 table 4. descriptive statistics for malaysia, indonesia, singapore & thailand malaysia indonesia sub-period a july 2003 to june 2007) sub-period b july 2007 to june 2011) sub-period a july 2003 to june 2007) sub-period b july 2007 to june 2011) n mean std. deviation n mean std. deviation n mean std. deviation n mean std. deviation ∆inf 48 0.0020 0.0030 ∆inf 48 0.0023 0.0065 ∆inf 48 0.0072 0.0121 ∆inf 48 0.0051 0.0054 ∆ipi 48 0.0055 0.0505 ∆ipi 48 0.0005 0.0492 ∆ipi 48 0.0015 0.0680 ∆ipi 48 0.0026 0.0273 ∆ts 48 -0.0090 0.3237 ∆ts 48 0.0144 0.2315 ∆ts 48 -0.0275 0.4414 ∆ts 48 0.0161 0.1947 ∆ms 48 0.0126 0.0130 ∆ms 48 0.0088 0.0110 ∆ms 48 0.0108 0.0145 ∆ms 48 0.0114 0.0236 ∆er 48 -0.0003 0.0137 ∆er 48 -0.0017 0.0152 ∆er 48 0.0035 0.0243 ∆er 48 0.0001 0.0323 ∆op 48 0.0216 0.0775 ∆op 48 0.0087 0.1262 ∆op 48 0.0216 0.0775 ∆op 48 0.0087 0.1262 peh 48 0.624% 2.610% peh 48 0.503% 3.450% peh 48 1.813% 5.172% peh 48 1.199% 8.872% pem 48 1.437% 3.472% pem 48 0.604% 4.310% pem 48 2.837% 6.265% pem 48 2.230% 8.970% pel 48 1.288% 3.687% pel 48 0.879% 5.048% pel 48 4.691% 5.822% pel 48 3.590% 10.783% bmh 48 1.479% 4.630% bmh 48 0.885% 4.667% bmh 48 4.074% 7.606% bmh 48 4.188% 10.449% bmm 48 1.133% 3.511% bmm 48 0.540% 4.727% bmm 48 3.494% 5.730% bmm 48 2.146% 8.681% bml 48 0.886% 2.568% bml 48 0.600% 3.521% bml 48 2.448% 5.599% bml 48 1.833% 9.243% meh 48 1.143% 2.679% meh 48 0.686% 3.594% meh 48 2.578% 5.383% meh 48 2.092% 9.192% mem 48 0.881% 3.472% mem 48 0.359% 4.884% mem 48 3.935% 6.431% mem 48 2.339% 9.140% mel 48 0.851% 4.629% mel 48 0.765% 4.360% mel 48 3.224% 6.771% mel 48 2.466% 9.733% singapore thailand ∆inf 48 0.0009 0.0049 ∆inf 48 0.0032 0.0065 ∆inf 48 0.0030 0.0045 ∆inf 48 0.0024 0.0081 ∆ipi 48 0.0078 0.1171 ∆ipi 48 0.0065 0.1239 ∆ipi 48 0.0067 0.0707 ∆ipi 48 0.0038 0.0735 ∆ts 48 -0.0233 0.2623 ∆ts 48 0.0281 0.2999 ∆ts 48 0.0059 0.3385 ∆ts 48 -0.0104 0.3316 ∆ms 48 0.0097 0.0101 ∆ms 48 0.0091 0.0086 ∆ms 48 0.0057 0.0082 ∆ms 48 0.0074 0.0227 ∆er 48 -0.0012 0.0091 ∆er 48 -0.0035 0.0109 ∆er 48 -0.0024 0.0131 ∆er 48 -0.0013 0.0166 ∆op 48 0.0216 0.0775 ∆op 48 0.0087 0.1262 ∆op 48 0.0216 0.0775 ∆op 48 0.0087 0.1262 peh 48 2.334% 2.850% peh 48 0.047% 7.337% peh 48 0.945% 3.496% peh 48 0.464% 5.004% pem 48 2.298% 3.218% pem 48 -0.39% 7.618% pem 48 1.585% 3.928% pem 48 1.171% 5.800% pel 48 1.809% 3.975% pel 48 1.170% 7.840% pel 48 0.941% 4.272% pel 48 1.268% 6.021% bmh 48 2.498% 4.053% bmh 48 0.882% 7.138% bmh 48 0.775% 2.753% bmh 48 1.578% 5.708% bmm 48 2.162% 3.292% bmm 48 -0.09% 8.249% bmm 48 1.075% 4.313% bmm 48 0.872% 4.214% bml 48 2.083% 2.698% bml 48 0.046% 7.358% bml 48 1.265% 4.182% bml 48 0.742% 6.132% meh 48 2.091% 2.657% meh 48 0.287% 7.100% meh 48 1.306% 4.268% meh 48 0.842% 7.152% mem 48 2.455% 4.198% mem 48 -0.04% 8.476% mem 48 1.094% 3.812% mem 48 0.769% 3.793% mel 48 2.688% 5.422% mel 48 -0.18% 7.760% mel 48 0.722% 3.600% mel 48 1.425% 3.973% table 4 provides the summary statistics for the state variables and stock returns of each portfolio in all four countries. for malaysia, the results for the mean and standard deviation show that the change in the macroeconomic variables between the two different sub-periods asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 170 is consistent, except for ∆ts and ∆op. ∆ts shows a higher standard deviation in sub-period a (0.3237) than in sub-period b (0.23147). the standard deviation for ∆op is found to be higher in sub-period b (0.126). the overall summary of portfolio returns shows that the average monthly stock return for all portfolios in the sub-period a (ranging from 0.85% to 1.48%) is higher than sub-period b (ranging from 0.36% to 0.88%). the high bm portfolio outperforms the low and medium bm portfolios in both sub-periods. as for market equity, the high me portfolio outperforms the low and medium market equity portfolios in sub-period a, but the low me portfolio shows a better average return in sub-period b. in case of indonesia, the result for the mean and standard deviation shows that the changes in the macroeconomics variables are consistent, except for ∆ts, in both sub-periods. the overall portfolio return shows that the mean monthly stock return for all portfolios in sub-period a (ranging from 1.81% to 4.69%) is comparable with that of sub-period b (ranging from 1.20% to 4.19%). the high bm portfolio outperforms the low and medium bm portfolios in both sub-periods. for singapore, the mean and standard deviation for ∆ts show significant changes from -0.02333 to 0.02813 and from 0.2623 to 0.2999 for sub-period a and sub-period b, respectively. the overall portfolio return shows that the mean monthly stock return for all portfolios in sub-period a (ranging from 1.81% to 2.69%) is higher than in sub-period b (ranging from -0.4% to 1.17%). the high bm portfolio outperforms the low and medium bm portfolios in both sub-periods. the result for thailand shows that changes in macroeconomics variables are consistent in both sub-periods despite there being a change in ∆ts from 0.00592 to -1.043. the overall portfolio return shows that the mean monthly stock return for all portfolios in sub-period a (ranging from 0.72% to 1.31%) is comparable with that in sub-period b (ranging from 0.46% to 1.58%). our findings consistently show that, on average, stock returns with high bm outperform those with low and medium bm in both sub-periods in all countries in the analysis. this result is consistent with the findings in the literature, for instance fama and french (1992) and barber and lyon (1997), provided evidence that a high bm portfolio outperforms in term of the average stock return relative to the low bm portfolio in the us stock market, while cotter and donnellt (2006) show the same correlation in the uk stock market. likewise, in the asia region, chui and wei’s (1998) study indicates the same correlation for hong kong, south korea and malaysia, and chan, hamao and lakonishok (1991) obtain the same findings in their study on japan. the pe portfolio provides mixed findings on average stock return during our study period. the low pe portfolio shows higher average return in indonesia for both sub-periods and during sub-periods b in malaysia, singapore and thailand. this result is similar to that of basu (1977) and ball (1978). truong (2009) suggested that part of this phenomenon can be explained by investors’ erroneous extrapolation of their past performance and that the market corrects itself with new information that sheds light on incorrect expectations. moreover, truong (2009) suggests that low pe stock is low risk and low beta, but this stock more attractive than bonds. this could explain why low pe stocks become more attractive during asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 171 crisis periods because other than bonds, the low pe portfolio is characterized as a “safe haven” during crisis periods. in contrast, medium and high pe portfolios shows higher average return than low pe portfolios for malaysia, singapore and thailand during sub-period a, which is in line with the findings of lakonishok et al. (1994), who suggest that the high pe portfolios outperform in the past and are expected to continue to perform well and, vice versa, for low pe portfolios. this phenomenon occurred in malaysia, singapore and thailand during the economic boom period before the economic crisis of 2007. size effect (me) plays an important role in the value of stock return. based on the findings of banz (1981) and reinganum (1981), low me portfolio should outperform the high me portfolio. our study shows mixed findings in the two different sub-periods as well as in different countries. our findings shows that high and medium me portfolios are more lucrative than low portfolios in emerging countries (indonesia, malaysia and thailand) in sub-period a, but that the low me portfolio outperforms the medium and high me portfolios during sub-period b. in singapore, a developed economy, the low me portfolio outperforms the high and medium portfolios during sub-period a, but the high me portfolio has higher average return than the medium and low me portfolios during sub-period b. the study of brown, kleidon and marsh (1983) acknowledges that size effect is not stable over time periods. this phenomenon can be found in our study in the cases of indonesia, malaysia, singapore and thailand, where the me portfolio reacts differently in both sub-periods. as explained by reilly and brown (2006), size effect is an important factor in the capital market which cannot be explained by established theory so far. adf test concluded that all of the series are stationary; the effect of macroeconomic variables on the portfolio returns is then examined by ols estimation. ols estimation results are reported in table 5-8. table 5 summarizes the relationship between different pe, mb and me and the hypothesized macroeconomic variables for malaysia in both sub-periods. in sub-period a, the result of our analysis show that the change in consumer price index, shows a significance effect in regard to the stock return in portfolios peh, pem, bml and meh, with a negative relationship. the result is consistent with the studies of naka, mukherjee and tufte (1998), maghayereh (2002), nishat and shaheen (2004) and al-sharkas (2004) in the emerging countries. the negative correlation between stock returns and implies that the stock portfolios with peh, pem, bml and meh are not a good hedge against inflation. if we now look at the results for sub-period b, a meh portfolio has significance and positive effect to change in oil price, . the positive correlation might be due to the fact that malaysia is an oil exporting country and this result is in line with that of the study of park and ratti (2008), which investigated another oil exporting country, norway, and found positive oil price shock with stock return. moreover, the same effect was found by abdelaziz, chortareas and cipollini (2008) for the middle east oil exporting countries. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 172 table 5. relationship between stock portfolio and macroeconomic variables for malaysia sub-period a july 2003 to june 2008 adj r2 sub-period bjuly 2007 to june 2011 adj r2 ∆inf ∆ipi ∆ts ∆ms ∆er ∆op ∆inf ∆ipi ∆ts ∆ms ∆er ∆op peh -0.27* 0.05 0.00 0.07 -0.04 0.12 3.3% -0.13 0.06 -0.04 0.13 -0.12 0.25 3.7% pem -0.32** -0.01 0.13 0.14 -0.06 0.05 2.3% -0.11 0.10 0.03 0.08 -0.15 0.17 1.1% pel -0.09 -0.02 0.13 0.06 -0.04 0.15 7.9% -0.07 0.17 -0.06 0.02 -0.16 0.17 1.0% bmh -0.16 -0.03 0.07 0.02 -0.08 0.08 9.2% -0.10 0.16 0.01 0.06 -0.19 0.06 2.6% bmm -0.18 -0.06 0.10 0.10 -0.02 0.17 4.1% -0.09 0.08 0.01 0.10 -0.17 0.19 1.1% bml -0.31** 0.06 0.07 0.12 -0.04 0.09 0.3% -0.14 0.11 -0.05 0.09 -0.12 0.26 4.6% meh -0.27* 0.02 0.05 0.12 -0.09 0.09 2.9% -0.13 0.10 -0.06 0.09 -0.12 0.27* 5.1% mem -0.23 0.00 0.13 0.06 -0.01 0.13 3.1% -0.08 0.09 0.04 0.09 -0.20 0.14 1.6% mel -0.17 -0.05 0.07 0.01 0.04 0.13 7.0% -0.14 0.19 -0.01 0.04 -0.11 0.03 4.5% notes: ** and * denote significance at the 5% and 10%, level respectively. table 6 highlights the relationship between different pe, mb and me and the hypothesized macroeconomic variables for indonesia in both sub-periods. based on the results for sub-period a, change in cpi ( ) is negatively correlated with pem, pel, bmm, meh and mem portfolios. change in oil price ( ) is significant and positively correlated with peh, bmm, meh and mem portfolios. change in exchange rate ( ) is significant and negatively correlated with bmh, bml and mem portfolios. change in term structure is only significantly correlated with the mem portfolio. this shows that all portfolios, except the mel portfolio, are strongly affected by the macroeconomic variables , and . table 6. relationship between stock portfolio and macroeconomic variables for indonesia adj r2 sub-period bjuly 2007 to june 2011 adj r2 ∆inf ∆ipi ∆ts ∆ms ∆er ∆op ∆inf ∆ipi ∆ts ∆ms ∆er ∆op peh -0.11 0.05 0.09 -0.2 -0.282 0.27* 0.11% -0.1 0 -0.04 0.02 -0.45** 0.32** 0.24% pem -0.43** -0.2 0.29 -0.1 -0.241 0.2304 0.13% 0 0 -0.07 0.01 -0.46** 0.1592 0.12% pel -0.32** -0.1 0.12 -0.2 -0.213 0.1956 0.07% -0.1 0 -0.30** 0.08 -0.56** 0.33** 0.35% bmh -0.31 -0.2 0.12 -0.1 -0.29* 0.1929 0.08% -0.1 0.09 -0.24 0.03 -0.45** 0.1567 0.16% bmm -0.45** 0 0.26 -0.2 -0.19 0.31** 0.19% -0.1 -0.1 -0.04 0.14 -0.53** 0.0871 0.22% bml -0.28 -0.1 0.17 -0.1 -0.29* 0.2288 0.08% -0.1 0 -0.09 0.01 -0.46** 0.30** 0.21% meh -0.31* 0 0.18 -0.1 -0.262 0.26* 0.10% -0.1 -0.1 -0.11 0.02 -0.50** 0.28** 0.25% mem -0.48** -0.2 0.35** 0 -0.38** 0.25* 0.26% 0 0.12 -0.07 0.13 -0.52** 0.24** 0.23% mel -0.2 0 0 -0.2 -0.251 0.1287 0.03% 0.05 0.13 0.017 0.03 -0.39** -0.013 0.05% sub-period a july 2003 to june 2007 notes: ** and * denote significance at the 5% and 10%, level respectively. in sub-period a, the positive significant relationship between stock return and in indonesia is in line with a number of previous empirical studies (nandha and hammoudeh, 2006; ghorbel and younes, 2011). indonesia is a net exporter of oil, but the country has been pulling out from opec and became self-sufficient during 2008. in sub-period b, is asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 173 negatively correlated with all portfolios in indonesia. this further emphasizes the crucial role of the exchange rate with respect to stock return during the crisis and post-crisis period. while for , the result shows that is positively correlated with peh, pel, bml, meh and mem. shows a negative correlation, which is different to the result for sub-period a. the negative correlation of is in line with the chen, roll and ross (1986) and with our present findings for thailand for sub-period b. table 7 results shows that for singapore in sub-period a, change in exchange rate, has a significant effect on a number of portfolios in our analysis. from our regression results, it can be seen that shows significant negative correlation for the pem, pel, bmm and meh portfolios. the negative correlation indicates that the appreciation in the singapore dollar leads to a positive effect on stock return. this result is in line with the findings of maysami and koh (2000) and maysami, howe and hamzah (2004). they explain that singapore is a high import and export country and appreciation in the currency enables the country to access lower-priced imported raw material, which allows domestic producers to be more competitive in the international arena in turn attract more investor and thus increase in stock price. sub-period a further highlight that mel portfolio is positively correlated to term structure, . this positive correlation finding is different from chen, roll and ross (1986). however, canova and denicolo (2000) explain that term structure is related to the future development of the economy and a steeper term structure curve is associated with higher growth of the industrial sector and lower inflation. high growth of the industrial sector and low inflation are perceived as favourable news in the stock market and thus generate a positive shock to the stock market return. table 7. relationship between stock portfolio and macroeconomic variables for singapore sub-period a july 2003 to june 2008 adj r2 sub-period bjuly 2007 to june 2011 adj r2 ∆inf ∆ipi ∆ts ∆ms ∆er ∆op ∆inf ∆ipi ∆ts ∆ms ∆er ∆op peh 0.12 0.04 0.18 0.15 -0.17 -0.08 3.2% -0.17 0.10 0.01 -0.17 -0.17 0.30* 5.6% pem 0.01 0.10 0.16 0.13 -0.31** 0.19 4.5% -0.19 0.11 -0.05 -0.11 -0.13 0.28* 1.3% pel 0.01 -0.03 0.21 0.09 -0.30* 0.06 1.1% -0.12 0.06 0.09 -0.08 -0.14 0.285 1.0% bmh -0.04 0.03 0.16 0.20 -0.129 0.06 4.4% -0.20 0.10 0.08 -0.04 -0.18 0.27** 3.5% bmm 0.09 0.09 0.22 0.12 -0.36** -0.01 7.2% -0.13 0.09 0.00 -0.11 -0.11 0.267 1.9% bml 0.09 0.05 0.18 0.15 -0.24 0.12 0.1% -0.18 0.09 -0.01 -0.20 -0.17 0.32* 6.9% meh 0.10 0.09 0.18 0.16 -0.32** 0.05 3.9% -0.16 0.08 0.03 -0.12 -0.17 0.283 2.0% mem -0.01 -0.10 0.24 0.11 -0.164 0.00 3.1% -0.17 0.11 -0.02 -0.22 -0.16 0.33* 8.2% notes: ** and * denote significance at the 5% and 10%, level respectively. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 174 in the case of sub-period b, change in oil price, has significant effect on most of the portfolios in singapore. portfolios peh, pem, bmh, bml, mem and mel are positively correlated with which further substantiate that the overall singapore market is more responsive to the effect of than malaysia. singapore is not an oil-exporting country so the reasons for our findings cannot be explained in the same way as for malaysia. from the analysis, it is observed that became significant during the crisis and post-crisis period. le and chang (2011) explain that the rising crude oil price is reflected in the stronger business performance which results in increasing oil demand, and that this normally happens when the economy is recovering from recession – when there is high demand for oil for economic expansion. in their study of the situation in japan, based on monthly data from 1986 to 2011, they found that the japanese stock market responds positively in these circumstances. furthermore, mohan and harminder (2011) show the same correlation for china which they state is due to the aggregate demand side for oil, which increased the oil price, during economic expansion. the aggregate demand for oil could be due to a combination of economic stimulus events in most countries, as well as in singapore, during and post crisis. a stimulus event is denoted as favourable news because it is perceived as being a positive move to encourage real economic activities. hence, there is a consequent increase in stock return. assuming that past trend continues, the positive correlation between oil price and stock return may provide an effective hedge during oil price hikes. table 8 summarizes the relationship between different pe, mb and me and the hypothesized macroeconomic variables for thailand in both sub-periods. in sub-period a, change in exchange rate, and change in term structure, have significant effects on the portfolios in thailand. in this analysis, has a negative correlation with peh, bmh, mem and mel portfolios. the currency is stronger compared to other currencies when the required face value to exchange for other currencies is lower or vice versa. in this case, the negative relationship suggests that depreciation of currency may depress the stock market. this phenomenon is in line with a number of previous empirical studies. for instance, dimitrova (2005) finds that depreciation of currency can depress the stock market or vice versa. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 175 table 8. relationship between stock portfolio and macroeconomic variables for thailand sub-period a july 2003 to june 2008 adj r2 sub-period bjuly 2007 to june 2011 adj r2 ∆inf ∆ipi ∆ts ∆ms ∆er ∆op adj r2 ∆inf ∆ipi ∆ts ∆ms ∆er ∆op adj r2 peh -0.01 -0.04 0.19 0.21 -0.35* 0.10 1.2% 0.36** 0.14 -0.29* 0.31* 0.07 0.51** 14.6% pem -0.15 0.09 0.25 0.11 -0.16 -0.01 0.6% 0.36** 0.22 -0.26 0.41* 0.02 0.42** 11.3% pel -0.09 0.08 0.34* 0.11 -0.23 0.16 9.3% 0.37 0.15 -0.19 0.4 0.06 0.34 6.0% bmh -0.05 0.18 0.14 0.10 -0.38* 0.12 7.3% 0.11 0.13 -0.08 0.25 -0.03 0.23 5.3% bmm -0.18 0.07 0.32* 0.16 -0.23 0.07 10.7% 0.33* 0.27** -0.30* 0.38** -0.07 0.53** 21.8% bml -0.05 -0.03 0.24 0.16 -0.21 0.08 2.1% 0.40** 0.15 -0.30* 0.38** 0.1 0.46** 14.1% meh -0.10 0.00 0.27** 0.16 -0.20 0.02 3.0% 0.38** 0.14 -0.29* 0.38** 0.07 0.49** 14.1% mem 0.05 0.05 0.33* 0.10 -0.25** 0.22 10.5% 0.19 0.13 -0.17 0.19 0.04 0.25 6.5% notes: ** and * denote significance at the 5% and 10%, level respectively. for term structure, shows a positive correlation with pel, bmm, meh and mem portfolios. however, the analysis shows has a bigger spread over the portfolios than in the case of singapore during sub-period a. this positive correlation finding is different from chen, roll and ross (1986). this shows that the overall thailand stock market is more responsive to the effect of with the positive correlation whereby the narrower or negative magnitude in the term structure is related to the gloomy economic future outlook thus depressing the stock market. in contrast, a wider term structure is associated with a booming economic future outlook and thus increases the stock price. in sub-period b, all macroeconomic variables except for in our analysis shows significance effect on number of portfolios, namely, peh, pem, pel, bmm, bml, meh and mel. from table 8, , , and show a significant positive correlation with stock return, while shows a significant negative correlation with stock return. in this case, the thailand stimulus package seems to have made a strong contribution to the correlation of macroeconomic variables such as , , and with stock return during sub-period b. the study of chirathivat and malikamas (2010) explains that thailand instituted a few economic stimulus plans to stimulate the gloomy economy during the crisis and post-crisis period. an increase in money supply was required during this stimulus period and in the meantime real economic activities were expanding through this economic stimulus event. the oil price seems to have followed the aggregate demand side during the economic expansion period after the crisis when most countries were instituting economic stimulus events to boost the economic outlook. an economic stimulus event seems to be favourable event for the stock market during the crisis and post-crisis period. in addition, the escalation of the oil price could lead to higher inflation (wurzel et al., 2009). this is asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 176 because oil is major commodity in the economy and acts as an input or cost of production in most industries. 5. conclusion a large number of previous studies show that there is a relationship between macroeconomic variables and stock return. these studies have provided different findings due to the different periods covered, time spans, macroeconomic factors, methodologies and countries examined. this paper extends the literature by considering the effect of firm characteristics to examine a cross-sectional view of the stock markets in malaysia, indonesia, singapore and thailand. moreover, two sub-periods were analysed to examine the relationship between macroeconomic variables and different portfolios in different sub-periods. as mentioned in the study of erdogan and ozlale (2005), the relationship between macroeconomic variables and stock return has not been consistent over time due to structural change. our empirical findings showed that the significance relationship between macroeconomic variables and portfolio stock returns were not consistent for both sub-periods. results are highly dependent on portfolio, country and sub-period in our analysis. during pre-crisis period (sub-period a), portfolios in malaysia showed a significant relationship with ; portfolios in singapore showed a significant relationship with and ; portfolios in thailand showed a significant relationship with and ; and portfolios in indonesia showed a significant relationship with , and . on the other hand, during crisis and post crisis period (sub-period b), portfolios in malaysia showed a significant relationship with ; portfolios in singapore showed a significant relationship with ; portfolios in thailand showed a significant relationship with , , , and ; and portfolios in indonesia showed a significant relationship with , and . in conclusion, the results indicate macroeconomic factors have significance effect in malaysia, indonesia, singapore and thailand stock market. however, each factor may react differently based on different portfolios, different sub-periods and different countries in our analysis. for instance, the result shows that appreciate in currency in indonesia and singapore provides better stock return in return; during the crisis and post crisis period(sub-period b), the stock markets of mist are more reactive to the change in oil price; on the other hand, the result of thailand shows the positive correlation between change in inflation and stock return during crisis and post crisis(sub-period b) while the result of malaysia and indonesia show inflation is negatively correlated to stock return before the crisis period(sub-period a). all these findings can be served as good reference for the researchers in their future development in the asset valuation area. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 177 based on the findings presented here, there are a number of future research directions that could be taken. for instance, further studies could consider other macroeconomic variables such as balance of trade account and government budget (budget surplus or deficit) as well as 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(1938). the theory of investment value. north holland publishing, amsterdam, reprinted 1997 – fraser publishing, burlington, vt. microsoft word 6297-22604-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 278 project financial management and modern financial slavery: the case of a ksa metro project start-up dr paul james graduate school, bangkok university rama 4 road, klong-toey, bangkok, thailand tel: 662-350 3500 e-mail: paul.j@bu.ac.th received: sep. 11, 2014 accepted: oct. 14, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6297 url: http://dx.doi.org/10.5296/ajfa.v6i2.6297 abstract this paper explores the personal financial viewpoints on the project management of a metro in ksa and more particularly focuses on the financial issues raised by a group of design engineering staff. the paper examines the scope, reflections, attitudes to the project management in their management and unpredictable way of the development and application of the company’s financial policy to personnel. the paper examines the personal financial factors, which contribute to the establishment and strengthening of work interactions between a single group of engineering personnel of twelve (12) small, client interacting working design facility for a metro development in ksa. the paper develops a model that attempts to conceptualise the findings from a diverse range of qualitative personnel opinion into an engaged framework. outcomes from this inquiry suggests that the project managers show clear failings in attitude to its staff and that individual opinion regarding personal finances may be a logical factor in the development of very real negative corporate judgments in this group and explores the derived themes of namely eight (8) main themes, namely payment issue; trust issues; work issues; job related; managerial related; socially related; cost issues; and job issues. the outcomes shows clearly that the project management are not effectively managing the project as raised issues of staff financial slavery, project complexity problems, unviable cost overruns, delays to the project schedule through poor coordination, ineffective programme management of the projects activities, improper project preparation and managerial execution affect how the client trustworthiness may be stretched. the paper further suggests how these identified issues may be mitigated through the appropriate application of project management theory. keywords: project, management, financial, personnel, metro asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 279 1. introduction project management of a metro is a discipline that is seen by most people as complex, vast, uncompromising and difficult for all involved. as such, the project management literature is more focused on time, cost and quality considerations (babu, & suresh, 1996) on such a crucial role in construction (edum-fotwe & mccaffer, 2000). project managers plan, execute, and monitor (jabara, ismail, aziz, & janipha, 2013) functional project events to accomplish the contractual client requirements. however, since the focus of project managers are more towards functional project concerns and issues to reduce project problems (love, edwards & wood, 2011), internal financial issues are often imposed on staff increasing project exploitation (serpella, ferrada, howard & rubio, 2014), but lack managerial accountability and effectiveness (avots, 1969). little has been reported in the literature surrounding project management of financial issues affecting engineers working on construction projects. consequently, this paper explores the financial influences on the project management of a metro in ksa and more particularly focuses on the financial issues raised by a group of design engineering staff whom are “encouraged” to follow business policies and procedures that impose concerns on their personal finances. the influence of constructors business arrangements resulting in engineers being associated with difficulties concerning their personal finances has an immediate effect given the economic situation prevailing and its influences on human capital movement, especially in the middle east. 2. literature review 2.1 case project management at site in order to assess the ability of project management to manage design-engineering staff effectively on large construction projects, it would seem pertinent to establish some of the possible raised issues. mezher and tawil (1998) suggest teambuilding initiatives should be utilised to ensure that conflicts can be resolved easily. further, jamshidi, zeinahvazi, adel and ghasemi poor sabet (2012) suggests comprehensively that little attention is given to managing personnel aspects in construction projects. neither of these are considered capable of helping the present project situation. another way was to assess the client’s preparation using flyvberg, holm and buhl (2003) by planning, authorising and conducting post-sequence and event evaluation. on applying this assessment, it would appear that the client may not be aware of the issues raised by design engineering staff and thus have no knowledge of the implications such as turnover of 22%, schedule slippage of 54%, cost additive of 150% above estimate for the first 6 months, other legal and contractual implications such as an additional us$4mn in payments for missing critical design deadlines. it would appear that failing management (hughes, 1986) through weakening project management capacity (ika, 2012), inadequate project planning (james, 2005) and deficient project systems implementation (chung, skibniewski, lucas & kwak, 2008) has already cost the project an enormous amount of money with little to show for the efforts of the individuals attempting to maneuvre through this colossal problem underpinning the project. unfortunately, the reasons for such failure are many, such as no discernable staffing plan asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 280 (schwalbe, 2010) capturing details of the project's resource requirements (pinto, 2013) whilst establishing competency gaps in mission-critical positions as essential for good project management practices (liua, borman & gao, 2014). further, providing adequate administrative support was not available at site (eichinger & ulrich, 1995) and neither was allowing the questioning of project management ethical business judgments (small, 2006) leading to questionable financial management behaviour (farrell, 2003). 2.2 case project financial management consistently matching initial project cost-estimates (morris, 2008) can help raise client stakeholder confidence in the management of a construction project. however, actual cost overruns and schedule slips in the very short-term create tensions in the management of the project and leads to suggestions of inadequate management control and capability (okpala & aniekwu, 1988) due primarily to human resource issues (jackson, 2002). further, in the construction industry in ksa it would appear that cost overruns in the longer term maybe prevalent (assaf, al-khalil & al-hazml, 1995) but in many short-term exercises, management have clearly failed to examine their operational systems and hr needs when developing appropriate cost-estimates (baloi & price, 2003). additionally, cost overruns are seen as being initiated and built right from the start (kholi & chitkara, 2007) in poorly managed construction projects. reasons for cost overruns include poorly developed specifications which has also led to resource constriction and mismanagement (chester & hendrickson, 2005); inadequate and complex interfaces (locatelli, littau, brookes, & mancini, 2014); lack of experience of project management (kog & loh, 2012); unusual (zou, zhang & wang, 2007) or unrecognised methods of risk management (fisk, 2000); design variations (kog & loh, 2012); and not being able to manage human resources effectively (jackson, 2002). given the economic issues prevalent in western countries – europe, new zealand and australia (where most of the design engineering staff were from) – this supports the notion that the design engineers were subject to difficult economic working conditions. however, given that the project worth is in the tens of billions of dollars, it is perhaps a little difficult to accept that money is an issue at this early stage – 6 months into a 6-year project. however, from a professional standpoint being subject to such hr managerial behaviour affects not only the individuals involved, but also their families, who succumb to bad labour conditions by reactions to poverty constriction (bales, 1999; bales, 2002) as the effective management of relationships is considered essential to good project management (volckmann, 1997). these concerns can be resolutely circumscribed as underpinning exploitative practices and termed as modern slavery and are now further discussed. 2.3 case project modern slavery issues it is an anachronism, that in today’s construction economy in the middle east, that financial slavery practices still exist (van den anker, 2004). given the economic circumstances surrounding construction patterns of work in europe, it is perhaps understandable to see individual engineers seeking work elsewhere (shaw, 1999). in order to understand financial asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 281 slavery more effectively, the oxford dictionary defines slavery as “a person who works very hard without proper remuneration or appreciation” (oxford dictionary, 2014); and debt is often used to control another person or have an inordinate influence on them (global research, 2014). slavery of any kind today cannot be condoned, but unfortunately the “slavery of economics is very much of the present” (telegraph, 2014). to do it openly and in a way that puts severe pressures on people’s livelihoods is perhaps a little unacceptable and dehumanising. making staff pay for things that should be paid for by the employer is not a good way of doing business. nor is it a means to develop a caring culture for people whose work requires that they abandon their home and live in another country. economic dependence through participating in construction programmes in the middle east, leaves individuals open to such abuse. consequently, driving the financial mobilisation of engineers has always been globalization (doomernik, penninx & van amersfoort, 1997). this has created the economic ability for companies to behave in a way that offsets their risks – “let them pay if they want to work for us” gambit – representing disposable human capital (bales, 2012). further, making staff pay directly for things first, means that construction companies are circumventing the corruption issue by making lower staff responsible if corruption occurs rather than project managers. however, this has just recently changed in the uk through the publication of the anti-bribery act 2010, by making an organisation culpable if it fails to have “adequate procedures” in place to stop bribery and corruption from taking place – wherever it takes place in the world. consequently, this gives some protection to staff, but does little to stop the support and implementation of defined policies creating financial slavery activities. since the case reflects an american construction company, discussion of slavery aspects that affect their operations may be of use here. a definition of slavery in article 1 of the 1926 slavery convention (updated and adopted by the un in 1955) indicates that, ‘slavery is the status or condition of a person over whom any or all of the powers attaching to the right of ownership are exercised’ – taking possession of a passport to prevent movement and having great influence on a person’s ability to leave a foreign country, are examples of this. however, the american project manager company has to be managed in ways that ensure compliance with anti-slavery law in the us – wherever it is operating in the world. for example, the 2010 california transparency in supply chains act: the first law of its kind. since the company also operates in california, usa, it is globally required to adhere to this law california’s sb657 – and will require that all such companies disclose what they are doing to prevent labour abuse in their supply chains. 2.4 the american company’s culture this discussion would not be complete if the company’s managerial culture that is responsible for developing the metro wasn’t analysed briefly. it is an american company operating in the uk, across europe and the middle east. consequently, an assessment of why it operates the way it does, may give some indication of why project management behave the way they do. however, the company would not operate this way in the uk, so why is this a financial “modus operandi” in ksa? asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 282 in essence, the company should be considered to have a knowledge-creating and sharing culture (skyrme & amidon, 1997); utilising technology to support the application of km processes (alavi & leider, 2001); linking km to support the developing business strategy (maier & remus, 2002); and tending to exploit good business practices through the appropriate application of km (goh, 2004). unfortunately, the company in ksa behaves very differently. the company appears to be in the overall strategic sense a knowledge-intensive firm but not conforming to lowendahl’s (2000) typology as a strict technical service company, as the scope of it’s work arrangements mirrors an adhocracy (mintzberg, 1979) or at best a soft-bureaucracy (robertson & swan, 2004) depending on a person’s location in the project. in essence, the project is managed in a bureaucratic way, with design-engineering staff positioned as knowledge workers but without the apparent requirement of organisational or personal consideration. thus, project management was focused on organizational performance (seng, 1990) without knowing how to engage the substantive engineering workforce. the project is managed through the contextual and collective experiences, knowledge and capabilities that were seen as vital (lawson & lorenz, 1999) to the overall management of the project as their collective tacit knowledge provided mechanisms for developing and applying an appropriate business/project strategy. unfortunately, mismanagement at this level has had serious repercussions further downstream that affected the design output, technical uncertainty (morris & hough, 1987) and negatively impacted on many individual’s attitude to performing project work. this brings up three distinct research questions: 1: in what ways do financial management affect the design-engineering staff attitude to project management at site? 2: what factors affect design-engineering staff desire to continue to spend money on behalf of the company? 3: what issues affect design-engineering staff interests in staying at site? 3. methodology in order to develop a much broader approach surrounding the financial issues created within the engineering design facilities context, this empirical groundwork used an interpretative approach (walsh, white & young, 2008). this was an attempt to understand the perceptions of engineering staff regarding their opinions about the company’s financial practices. design engineering staff were considered specialist knowledge agents and actors (benn, buckingham, domingue, & mancini, 2008) as their opinions and experiences influenced the effectiveness of the design outcomes as essential project participants (chua, kog & loh, 1999). the research used a semi-structured interview process, which provided an appropriate element of context and flexibility (cassell & symon, 2004). given the lack of appropriately focused research in this area using this type of methodology, this is seen as suitable for creating contextual data for the purpose of forming richer theory development (cayla & eckhardt, 2007). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 283 the population for this study was made up from a total of twelve (12) design engineering personnel from differing engineering specialisms located at a single facility in a metro design/construction development – chosen through applying the approach of a targeted population of interest (carman, 1990) and this also reflected the criteria of theoretical purpose, relevance and appropriateness (glaser & strauss, 1967). further, using glaser’s (2004) sampling processes, a total of 8 engineers were thus determined as the resultant sample frame. each interview was audio recorded for future analysis. interviews were conducted in english and took approximately one hour. all interviews were recorded digitally after gaining explicit permission, and were later transcribed verbatim using nvivo 11 software. the conduct of the interviews follows a similar process used by gray and wilcox (1995). each interview was initially manually interrogated and coded initially using the acrobat software according to sub-themes that 'surfaced' from the interview dialogue – using a form of open-coding derived from glaser (1992a); and straus and corbin (1990). each interview was treated and coded independently. various themes were sensed from the use of the software packages, as well as from the initial manual-coding attempts. this dual form of interrogation was an attempt to increase the validity of the choice of both key themes and sub-themes through a triangulation process (thurmond, 2004) and led to a more effective convergent validity (huberman & miles, 2002). in this way, it was possible to capture each respondent's comments across transcripts (riessman, 1993) on each supported sub-theme and place them together for further consideration and analysis. 3.1 the research framework the outline of the research outcomes for this study is shown in figure 1 below. the framework also illustrated below in table 1, consists of five (8) main themes, namely payment issue; trust issues; work issues; job related; managerial related; socially related; cost issues; and job issues. table 1 further shows the nineteen (19) sub-themes and subsequent issues raised from the literature forming the basis for this framework. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 284 project financial m anagem ent paym ent issues fund location trust issues w ork issues job issues lack of leadership lack of trust w ork issues w ork interaction resentm ent trust issues personal respect m anagem ent trust job related issues h ierarchy c ost of leaving n ext job m anagerial related m anagerial c om petence professional n etw ork c om m unication socially related job a fter w ork c ost issues g oing h om e fam ily d ebt increase question 1 question 3question 2 figure 1. project financial management main themes asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 285 table 1. research questions, major themes, sub-themes research question main themes sub-themes no. refs q1 in what ways do financial management affect the design-engineering staff attitude to project management at site? payment issue trust issues work issues fund location funds available personal respect management trust work interaction resentment 11 12 9 11 7 9 q2 what factors affect design-engineering staff desire to continue to spend money on behalf of the company? job related managerial related socially related hierarchy cost of leaving next job managerial competence professional network communication job after work 6 11 9 11 8 9 8 10 q3 what issues affect design-engineering staff interests in staying at site? cost issues job issues going home family debt increase lack of leadership lack of trust 12 12 10 9 the outcomes are stated below where the discussion focuses on the sub-theme elements within each key theme. further, table 2, below, shows the connection between the research question, major themes and number of respondents. the discussion format used in this paper reflects the respondent’s voice through a streamlined and articulated approach for reporting. consequently, the style adopted for reporting and illustrating the data is greatly influenced by gonzalez (2008) and daniels et al. (2007), focusing on the raised research questions and the resultant main themes. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 286 table 2. major themes and respondent numbers research question major themes no. respondent 1 payment issues 1, 2, 3, 4, 5, 6, 7, 8, 9, 11, 12 trust issues 2, 3, 4, 6, 8, 9, 10,11, 12 work issues 3, 5, 6, 7, 9, 10, 11 2 job related 1, 2, 4, 5, 6, 8, 9, 12 managerial related 2, 3, 4, 5, 6, 7, 8, 10 socially related 1, 2, 5, 6, 7, 8, 11, 12 3 cost issues 1, 3, 4, 7, 8, 10, 12 job issues 3, 4, 5, 8, 9, 11, 12 4. results the results are presented below using the research questions as pointers and supportive empirical evidence through indicated extractions. consequently, considering the first research question in what ways do financial management affect the design-engineering staff attitude to project management at site? main theme – payment issues in terms of the sub-theme fund location, all interviewed design engineering staff used their own credit cards to fund their stay at site. as one respondent (r9) stated clearly, …a group of us met with the project director and informed him that our financial situation is not for use by [company]. it’s our money, not theirs. he told us that it is [company] policy to operate this way and it can’t be changed. another respondent (r1) indicated that, …i have to pay using my british bank account for a job in saudi… this doesn’t make sense. in terms of the sub-theme funds available, one respondent (r4) stated, …forcing me to use my own credit card – that not right. further, another respondent (r7) affirmed, …i just can’t afford to do this. as a contentious issue, this is further illustrated by another respondent (r11) who described, …i never thought i’d be caught like this. i’m a professional… …this shouldn’t be happening to me. another respondent (r2) indicated that …i can’t afford to be here. i certainly can’t afford to have a credit-card, but it doesn’t have enough in it. as a last point on this subject, one respondent (r8) indicated that …i have already had to raise my credit limit twice and it’s still not enough. main theme – trust issues in terms of the sub-theme personal respect, one respondent (r3) indicated that, …they [management] don’t respect anyone. they just make you pay for things and the system may pay it. there’s not much respect here. another respondent (r6) suggested that, …you’re just a number with a bank account for them. when the system doesn’t pay, they are not interested in solving the problem, i have to speak to someone in the states. further, another respondent (r10) stated that, …management are not here most of the time. they just don’t care. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 287 in terms of the sub-theme management trust, one respondent (12) indicated that, …no i don’t trust them at all. they won’t fight for us. another respondent (2) stated, …it’s easy for them, they don’t have to spend their own money. they even quibble when i ask them to sign my expense sheet. main theme – work issues in terms of the sub-theme work interaction, one respondent (r3) indicated that, …it is difficult to interact with management. they don’t seem to want to discuss this thing. they seem only focused on project financials. another respondent (r7) suggested that, …we’re working on the same project, but they seem miles away, as if they aren’t interested. in terms of the sub-theme resentment, one respondent (r11) suggested that, …i resent not being able to discuss everything in this project with management. they just do not want to be involved in what is a major financial issue. further, another respondent (r5) indicated that, …what is it with this management? are they trying to get rid of all of us? one respondent (r6) typified the interview outcome as, …i feel like i am paying to be here, not the other way round… it’s not what i expected from this company. considering the second research question what factors affect design-engineering staff desire to continue to spend money on behalf of the company? main theme – job related in terms of the sub-theme hierarchy, one respondent (r6) indicated that, …i think they are really putting on us. it’s as if they have no money. another respondent (r2) stated that, …it is as if they are arrogant of getting people to work for them. i think they are power mad. further, another respondent (r9) suggested that, …the system does not support us. they have built an empire of paper. in terms of cost of leaving, one respondent (r8) indicated that, …i cannot afford not to have a job. now i’m here, i can’t afford to leave. another respondent (r4) suggested that, …they owe me money. i cannot leave this place right now without causing myself and my family some hardship. in terms of the sub-theme next job, one respondent (r12) indicated that, …i wish i could move to another company – but they won’t let me go – i’ve asked, and now they make it more difficult for me financially by not paying my expenses on time. another respondent (r5) suggested that, …i have spoken with other engineers who are employed elsewhere – they have a much better job than me, but i cannot move now. further, another respondent (r1) stated that, …i need to move, but they won’t let me. it is sad that they keep me here like a prisoner financially or otherwise. main theme – managerial related in terms of the sub-theme managerial competence, one respondent (r3) indicated that, …i do not know where they managed before, but one is very aggressive, and the other manager isn’t one. he just isn’t. another respondent (r10) suggested that, …i think they must be asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 288 living in cuckoo-land. they just don’t seem to get it. some of us just won’t take this xxxx and leave. further, another respondent (r2) determined that, …they are really out of it. they are kind of running around from one meeting to another, not really knowing what to do. in terms of the sub-theme professional network, one respondent (r6) stated that, …i am lucky i belong to a network. i can talk with other people who have worked in similar situations and help make it easier to accept. further, another respondent (r5) stated that, …we talk amongst ourselves and my network helps. but it is difficult. the most difficult project i’ve been on. in terms of the sub-theme communication, one respondent (r7) indicated that, …management desperately need to go on a communication course. they are horrid communicators and worse managers. another respondent (r4) stated that, …no they [management] don’t communicate. they just take over a meeting and try to belittle everyone into submission. main theme – socially related in terms of the sub-theme job, one respondent (r2) states, ……the job is great, but i need to move, if i can it’s just the management here. another respondent (r8) signaled that, …the other people here are wonderful, it’s a pity about the management. we don’t get much social interaction with the management, but that’s good though. in terms of the sub-theme after work, one respondent (r12) suggested that, …we get together sometimes, even in the gym. but management don’t care. they [management] haven’t even invited us to dinner as a group. there are no social graces with these guys. further, another respondent (r11) indicated that, …there is no after work for management. sometimes, there is no management either since they are in dubai. so, nothing after work. nothing. considering the third research question what issues affect design-engineering staff interests in staying at site? main theme – cost issues in terms of the sub-theme going home, one respondent (r7) indicated that, …i have now been waiting 2 months for payments to be made. i am still paying my way and i am in gross debt to the tune of £10000. i can’t afford to move back home as i had friends here who resigned and who have received no expenses from [company] once they have returned to the uk. another respondent (r3) suggested that, ……i am expected to bear the financial cost first. then [company] can think about reimbursement… and they don’t always pay it, as i’ve been waiting for months… further another respondent (r10) stated, …i wish i hadn’t come here. i am made to think about the finances, rather than enjoying the job. it stinks. i prefer to go home, but can’t afford it now. in terms of the sub-theme family debt increase, one respondent (r1) stated, …i have paid my own flight because [company] couldn’t make up their mind… i still haven’t been paid for this. another respondent (r8) suggested that, …my bank manager does not like this asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 289 situation at all. it is demeaning to have to get extra loans to pay for things that [company] should pay for on international assignment. further, another respondent (r12) stated, …the further i am involved here the more debt i create. it’s a disaster! another respondent (r7) stated that, …i can’t get out of this because i am now too much indebted by the company. …i am trapped. main theme – job issues in terms of the sub-theme lack of leadership, one respondent (r8) suggested that, …they [management] are selfish. leadership is something they have missing. i don’t know what they’ve done before, but it sure wasn’t leading. another respondent (r11) indicated, …from an engineering perspective they are obsolete. they shouldn’t be here. further, one other respondent (r9) suggested, …it’s a mess. we look to them for guidance and leadership. but they only deliver threats. in terms of the sub-theme lack of trust, one respondent (r4) stated, …it is difficult to leave this place as they take your passport without my permission. this is not right at all. another respondent (r1) indicated that, …i am convinced that management don’t care about building trust. they are here for themselves. hopefully they will move on. further, another respondent (r12) outlined that, …we do not seem to be important to them. i don’t trust them at all. sad really. in order to triangulate some other data, an assessment was made of the work contract and how management treated staff. the result suggests that most engineers have a contract that with minimum salary conditions – same as in home country contract, but still with tax being extracted and kept by the company. it was also reported that the majority of engineers had their passport taken from them to be returned at the discretion of the company. further, documentation indicated that staff had no right to give up their job to join another company; nor the right to personal movement within the country; nor the right to just get on plane out of the country. as one respondent suggested, (r5) …it is unacceptable. it’s like being treated like animals. even in all this, one respondent (r9) indicated that, …my family expects me to earn a living. i can’t move from here now that i am owed so much, so i have to continue in the same way… trapped! 5. discussion in order to take this inquiry forward, the discussion focuses on the raised questions to help address some of the outcomes. consequently, the main focus for this discussion are the characteristics that include, personal financial management; financial controls; cost overruns; project schedule delays; enhancing the quality of interaction; team management; ineffective design management and inaccurate evaluation of the project. 1: in what ways do financial management affect the design-engineering staff attitude to project management at site? as a result of this inquiry, of continuing concern is the managerial response to issues of financial slavery. this is perhaps the most difficult from a personal perspective to manage asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 290 and serves to illustrate the negative effect of the company culture (hofstede & hofstede, 2005); management payment intent (doloi, 2013); and the quality of interaction (sacks, koskela & dave, 2010) between project management and other engineers, and needs to be addressed using more integrated processes (eastman, teicholz, sacks & liston, 2008) such as teambuilding (james, 2005); top management training in project strategy development (arttoa, kujalab, dietrichb & martinsuo, 2008); meeting the needs of project staff (roberts, 2005) rather than treating the project as an off-shoot of the parent company (milosevic & srivannaboon, 2006); utilising appropriate program management techniques in order to reduce project confusion and enhance financial and process efficiency (martinsuo & lehtonen, 2007a); reducing the impact of an established hierarchal approach (kerzner, 2003); and directing the project through program initiation (pellegrinelli, 1997). project complexity (kaming, olomolaiye, holt, & harris, 1997) appeared to show incongruent and divisible responses from the project management, which may underpin the cost overruns (gkritza & labi, 2008), and the consequent delays to the project schedule through poor coordination (ogc, 2010), leading to ineffective programme management of the projects activities (owen et al., 2010), and improper project preparation (gray & hughes, 2012). managerial execution (wainaina, 2008) of the project is considered a sum of the factors associated with leadership and good project administrative practices – neither of which are considered optimum by the staff. although there appears to be greater pressure on the project managers to deliver the project on time (patrick, guomin & jiayuan, 2007) due to increasing design complexity and scope (enshassi, mohamed, & abushaban, 2009), the business behaviour of management does not fit well with its functional, legal or ethical financial management requirements in line with the contract and the approval of ksa financial regulators. further, the perception of design-engineers suggest that project managers do not show that they accept that they need to engage in different practices to deal with the dynamic nature of the working environment of the project (turner, huemann & keegan, 2008) leading to better financial management and controls. it may also be useful to consider that the combination of ineffective scheduling and financial project controls (project overrun and project expenses) and the ineffective personnel financial management of the projects leaves the project critically mired in confusion and mistrust (zaghloul & hartman, 2003). the ineffective management of the design-engineers finances may also be considered a result of inadequate understanding of different social-cultural backgrounds (gilbert & devilbiss, 2010) that impose on their ability to manage the project (kwak, 2002). however, given that the majority of engineers are also from the same background context then this argument can be negated. the result of exposing engineering staff to such implausible financial mismanagement events is thus motivating engineers to want to leave (oyedele, 2013). 2: what factors affect design-engineering staff desire to continue to spend money on behalf of the company? asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 291 in this project the hierarchy in operations suggests a negative use of power (larson and gobeli, 1989) that denigrates good management practices. it also appears to have a negative effect on staff moral, notions of leaving and how the money spent on behalf of the company can be reimbursed. since the project team commitment is seen as an important success factor (chan, ho & tam, 2001) this element is considered a requisite in its application to this project. unfortunately, the project management appears to fail to provide an atmosphere of team commitment to individual engineers (peters, 2011) and thus may not be able to articulate how important this is when managing a project with so many design engineers. further, team commitment may also offset the issues of leaving through greater social integration (eskerod & blichfeldt, 2005). in terms of management, the level of competency (gapps standard) exhibited by project management especially in terms of context, criticality, collaboration, convergence and confluence (cpmcs, 2012) as perceived by engineering staff appears to be divisive, intransient and incapable of leading to an effective project outcome according to the schedule and the quality demanded. this further implies that the level of managerial competency of project management (martina, hana & jiří, 2012) does not appear to match international standards of application as the complex construction project requires additional competencies which the project management are not perceived to embrace or articulate; and present behaviour are not seen as proactive or relevant (pulakos, mueller-hanson, o’leary & meyrowitz, 2012) to project requirements. the notion of a professional network was raised which appeared to be used as moral support (neeraj & jha, 2011), developing employment relationships (amit & belcourt, 1999), and ongoing work-connections after the project concludes. however, in this instance, it could be assumed that the professional network provides reflective capability in order to support and underpin any exit decisions made during the project, as the project management did not appear to provide adequate standards of professional support and lack the application of business partnering (francis & keegan, 2006) where more effective financial decisions should be made. communication appears to be enhanced (earley & mosakowski, 2000) with team integration policies and initiatives (love, gunasekaran & lic, 1998) that are seen as ineffective in this project and could be enhanced through the application of partnering (bresnen & marshall, 2000) and teambuilding strategies. consequently, of immediate concern must be the ineffective design management and inaccurate evaluation of the project (olawale & sun, 2010), and the lack of suitable levels of ethical leadership (waddock, 2007). 3: what issues affect design-engineering staff interests in staying at site? when considering the project management who appeared not to care about whether engineers were getting into debt as a consequence of being on the project (hart & moore, 1994). this is part of a significant project management hr issue (huemann, keegan, & turner, 2007), as it asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 292 affects corporate governance of projects (sama, 2003) and influences project personal credibility (maloney, 2002) and strategic contribution (kerzner, 2013). the company’s project management appears to be making design-engineering staff experience a process whereby they pay-up first and then possibly get their money back. forcing an engineer to forgo salary or expenses given to other engineers is an unacceptable part of a company’s modern slavery strategy and the operating business model (shenhar, 2001) must be modified in line with good project management practices (koskela, huovila & leinonen, 2002). it further reflects the ineffectiveness of the country’s labour volatility and self-regulation of labour services (allain, crane, lebaron & behbahani, 2013). further, concern can be thrown at the effect of financial slavery on the individual who may react formally by withdrawing from the job, raising notions of inadequate project social justice (cannon, 2009). project leadership demands more than resource focus and attention to programme details (carter, 1988). it demands an engagement with staff emotions and communication (geaney, 1995). in terms of this project, there would appear to be a reluctance by project management to provide appropriate leadership (morris & pinto, 2004) and the application of proper project skills (engwall, 200) leading to staff perceptions of mistrust (adler, 2005). 6. conclusions managing cost performance as well as quality of design (james, 2005) when considered a success factor has been ignored by the project management in this project (chan, ho & tam, 2001). the project management in this study also appears to demonstrate a conclusive lack of duty of care to its staff. it is project management’s duty to prepare, design and bring to bear appropriate solutions (sambasivan & soon, 2007) to solve the issues at site. in so doing project management will provide a more enriched managerial environment (doloi, 2013) for engineers to trust and rely on, whilst undertaking fairly difficult and complex jobs in the design of a metro. the project management may need to point to contemporary developments in project management in order to understand how design-engineers need a unified performance-measurement system (nassar & abourizk, 2014) and plan and develop how to use human capital and other resources to equitably deliver a successful project outcome. 7. further work since this inquiry assessed the little known area of personal finances and how this has led to suggestions of financial slavery, the research orientation could be extended to project managers and clients as to their views of this. further implications could be drawn from such work and evaluations made as to how these could be mitigated in the present structuring and management of construction projects. references adler, t.r. 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(2007). understanding the key risks in construction projects in china. international journal of project management, 25(6), 601-614. http://dx.doi.org/10.1016/j.ijproman.2007.03.001. microsoft word 13599-49670-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 133 essential of central bank’s regulatory policy to strengthen green banking practice and reporting in a country sutap kumar ghosh assistant professor department of finance and banking, islamic university, bangladesh e-mail: ansutap@gmail.com protap kumar ghosh associate professor business administration discipline, khulna university, bangladesh e-mail: pkghosh1982@gmail.com sabrin chowdhury student at business administration discipline khulna university, bangladesh e-mail: sabrinchowdhury2011@gmail.com received: sep. 3, 2018 accepted: nov. 11, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13599 url: https://doi.org/10.5296/ajfa.v10i2.13599 abstract this paper has been designed to investigate the current scenarios of green banking practices in indian sub-continent and to disclose how central bank’s direct regulatory policy strengthens mandatory green banking practice and reporting in a country. this study is mainly a descriptive one based on review of different published literature. relevant information has been collected from different off-line and online sources. present scenario of green banking practices and central bank green banking policies in indian sub-continent (india, bangladesh and pakistan) are disclosed first and then how central bank regulatory asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 134 policies can create a competitive advantage to accelerate green banking practice in a country are disclosed. after critical evaluation of collected information, we find that if the central bank formulates green banking policies and enforces mandatory green banking practices and reporting for financial institutions rather than voluntary practices, a significant and distinguished progress in green banking practices and reporting may take place to ensure sustainable banking practice in a country. keywords: green banking, practice and reporting, central bank, regulatory policy, sustainability asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 135 1. introduction sustainability has become very critical issue nowadays. continuous global warming and climate change make it more complex nowadays. to ensure greater sustainability, the restless efforts are to be carried out for sustainable environment management across the world (cogan, 2008). the governmental authority as well as the direct emitters and other stakeholders especially financial institutions should also play an important role in this regard ( jha & bhoome, 2013 ). out of financial institutions, banking sector is the main economic negotiator that influence lending and financing different projects of different business houses in different industries. banking sector can promote sustainable operation in various business sectors for environmental sustainability (ravi, 2013). although banking in-house activities are not too much involved with the environment, the impacts of the activities of its clients are important. so, by adopting green banking policies into its operations, mostly in financing and investing, banks can influence its clients (nath et al., 2014). in twenty-first century, the most important issue in different operation is to safeguard sustainable ecological balance in every aspect. the term ‘green’ refers a broad range of social, ethical and environmental dimensions (ullah, 2013). indian banks association (iba, 2014) explained green banking is like a normal bank, which considers all the social and environmental/ecological factors with an aim to protect the environment and conserve natural resources. green banking is also known as ethical or sustainable banking that accelerate environment friendly practices in order to reducing the carbon emission from banking operations (bai,2011). the core objective of green banking is to protect ecological environment, and natural resources comprising biodiversity (lalon, 2015). green banking ensure effective and efficient usages of natural resources with greater responsibility to reduce wastage of natural resources to protect environment and biodiversity (habib et al., 2014). rajesh and dileep (2014) stated that green banking is a convention of transformation of banking objectives from “profit only” to “profit with responsibility”. according to bihari (2011), the motives for going green are many. the key factors are to reduce energy consumption, increase consumers’ awareness in environmentally-friendly goods and services social responsibilities etc. green banking promotes environment friendly technological advancement, operational efficiency and client habits in banking sector. it’s a smart and proactive way of thinking for future sustainability (nath et al., 2014). green banking is an eco-friendly approach that reduces environmental degradation to make this earth more livable (goyal & joshi, 2011). green banking is termed as sustainable banking or ethical banking that includes green mortgages, mobile banking, green credit cards and savings accounts, online banking, roof gardening, and green financing, green checking accounts etc. (azam, 2012). green banking involves two approaches. first one is to transform all internal banking operations to adopt suitable ways to utilize renewable energy, automation and other effective environment friendly procedures to lessen environmental degradation from banking operation. second one is that while financing to a firm, the entire bank should assess environmental riskiness of that financing to uphold environment friendly projects and business (afgan et al, 2014). green banking helps the bank to be sustainable in economic, environment, and social dimensions to reduce negative impact on environment (nath et al, 2014). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 136 a series of studies had been conducted to investigate the relationship between corporate environmental and financial performance. few studies found a positive relationship between financial performance and environment friendly activities of the company (russo & fouts, 1997). a study was conducted by hart & ahuja (1994, 1996) to check the relationship between green banking and financial performance of the banks and eventually concluded that green banking practice and financial performance of the bank was negatively related in the short-run but in the end it became positive. similarly, the positive relationship between green baking practice and financial performance of the bank was also found (printer et al., 2006; mathieson; 2008; galdeano-gomez, 2008; nanda & bihari, 2012). although few studies revealed positive relationship between green banking practice and profitability, an inverse relationship was also found in some studies as well (blum, 1995 & worrell et al., 1995). although the contradictory financial performance has been found in previous studies, the necessity of green banking to reduce environmental degradation cannot overlook. with a view to accelerating green banking practices, this study has been designed to detect how the central bank regulatory policies relating to green banking practices and reporting intensifies the green banking practices and reporting by other banks in a country. 2. methodology this study is mainly a descriptive one based on review of different published literature. indian subcontinent comprising bangladesh, pakistan and india has been selected to resolve our research question. the relevant published documents have been collected from various journals, online and offline sources. after critical review of these documents, the relevant information has been presented through diagram, tables and descriptive way. throughout the review process, we have tried to show the current scenarios of green banking practice and reporting in indian subcontinent and the degree of involvement of central bank in this regard. finally, we have tried to expose how the central bank direct involvement in green banking practice and reporting accelerates and establishes distinguished position in green banking practice and reporting in a country. 3. green banking practice in indian sub-continent 3.1 scenario of green banking practice in bangladesh bangladesh is a fast growing economy in south asia that suffers from global warming. because of negative impact of climate change on bangladesh economy, bangladesh bank (central bank of bangladesh) has been trying to contribute in enhancing green banking practice in bangladesh and eventually a circular was issued on green banking on february 27, 2011 (islam & das, 2013). bangladesh bank also ensures green banking practices in its head and branch offices. the whole activities of bb provide an effective message to all the financial organizations about the implementation green banking activities by other banks in bangladesh (islam & kamruzzaman, 2015). bb issued guidelines for the financial sector on “environment risk management (erm)”in 2011 to entertain the environmental and social issues by various financial institutions in bangladesh and these guidelines become mandatory for the financial institution to entertain environmental and social issues in every aspects of its lending, developing and investing activities. after that, bangladesh bank developed and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 137 released policy guidelines on “green banking” that proved an intensive policy and strategic framework for green banking practices by different financial institution especially banks (hasina & afgan s.m. 2014). green banking policy guideline was divided into three phasesphase-i, phase-ii and phase-iii. during phase-i ( until december 31, 2011),policy formulation & governance, incorporation of environmental risk in crm, initiating in-house environment management, introducing green finance, creation of climate risk fund, introducing green marketing, online banking, supporting employee training, consumer awareness & green event, reporting green banking practices etc. initiatives were taken. during phase-ii ( until december 31, 2012), bangladesh bank tried to achieve these targets i.e. sector-specific environmental policies, green strategic planning, setting up green branches, improved in-house environment management, formulation of bank specific environmental risk management plan & guidelines, disclosure & reporting of green banking activities etc. during phase-iii (until december 31, 2013), the objectives of bb were to designee, introduce innovative products, and report in standard format with external verification (bangladesh bank, 2011; ahmed, 2012). later on this policy guideline of bb enforced others banks to adopt and implement sustainable banking practices in formal and structured way in a three-phased approach with specific timelines for implementation of each phase ( out of which final phase was to be implemented by dec. 2013).bb rearranged this implementation deadline in 2013(bb annual report 2013). bangladesh bank (2012) described the objective of green banking in its annual report and focused on the usages of resources with responsibility and giving priority to environment and society as a part of corporate social responsibility (csr) activity to make this world livable without much damage environment. bangladesh bank divided its green banking activities into in-house and other than in-house activities. ‘in-house activity’ denotes those activities that are involved and performed in the office building conspiring daily green operation, networking, office automation,other initiatives that reduce paper works etc. (shakil et al., 2014). whereas, ‘other than in-house activities’ represents only refinance scheme and bb launched this refinance facility in 2011 and in 2012,it disbursed around bdt 2 billion in various financial institutions at only 5% rate of interest (bhal & sarta, 2012). shakil et al., (2014) stated that bangladesh bank authority considered green banking unit, green banking policy, green banking budget, online banking, mobile banking, green financing, environment risk rating activities as green banking practice. in bangladesh, 47 banks of56scheduledbanks as well as 11 financial institutions out of 32 institutions have direct and indirect exposure in green finance. although green banking practice is uprising, still now green finance by banks and financial institutions is focused on mostly indirect green finance (islam, 2015). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 138 figure 1. green banking initiatives by bangladesh bank source: annual report-2012, bangladesh bank 3.1.1 green banking practices by various banks bangladesh bank primarily selected ten commercial banks (bank asia ltd, dutch bangla bank ltd, eastern bank ltd, islami bank bangladesh ltd, mutual trust bank ltd, prime bank ltd, pubali bank ltd, standard chartered bank, shahjalal islami bank ltd and trust bank ltd) based on camel rating and risked based capital adequacy (rbca) measurement, which have been implementing sustainable green banking activities in bangladesh. bb also considers the environmental issues to give approval for new branches. nine banks have been established newly and out of which six banks have already formulated its green banking policy as well as 8 banks have established green banking unit (gbu). 29 financial institutes out of total 31 have constructed its green banking guidelines approved by respective board of directors and also opened green banking unit (gbu). 28 financial institutions have organized own green office guidelines for doing their in-house green activities (islam, 2015).name of various bank using green banking practices has been described in following table. green banking initiatives inhouse activities other than in-house activities asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 139 table 1. name of the banks doing green banking practices in bangladesh state owned commercial bank specialized banks private commercial banks foreign commercial banks 1. sonali 2. rupali 3. janata 4. agrani 5. bkb 6. rakub 7. bdbl 8. basic 9. the city 10. u.c.b.l 11. ab bank 12. ific 13. national 14. uttara 15. pubali u 16. eastern 17. nccbl 18. dhaka 19. southeast 20. prime 21. dbbl 22. mercantile 23. one 24. exim 25. premier 26. standard 27. fsibl 28. bcbl 29. mtbl 30. trust 31. bank asia 32. al-arafa 33. icb 34. islami 36. brac 37. jamuna 38. shahajalal 39. cb of ceylon 40. st. cert 41. sbl 42. habib 43. nbp 44. citi n.a 45. hsbc 46. woori 47. al-falah source: annual report-2015, bangladesh bank table 2. fund allocated and used in green banking activities annual allocated fund, 2015 (bdt in millions ) utilization of funds, 2015 (bdt in millions) type of bank/fi green finance climate risk fund marketing , training and capacity building total green finance climate risk fund marketing , training and capacity building total socbs 7,846.80 220.00 410.00 8,476.80 663.76 12.40 3.54 679.70 sdbs 210.00 0.20 0.10 210.30 5.10 0.00 0.00 5.10 pcbs 196,895.83 367.58 1,924.96 199,188.37 102,718.93 195.30 11.88 102,926.10 fcbs 57,718.61 1,178.00 40,465.40 99,362.01 20,620.27 27.48 0.00 20,647.75 new banks 1,862.52 0.00 0.00 1,862.52 638.41 2.39 0.00 640.80 total 264,533.76 1,765.78 42,800.46 309,100.00 124,646.47 237.57 15.42 124,899.45 fis 24,586.09 47.03 7.88 24,641.00 4,685.35 3.21 0.55 4,688.00 grand total 289,119.85 1,812.81 42,808.34 333,741.00 129,331.82 240.77 15.96 129,587.45 source: annual report-2015, bangladesh bank asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 140 table 3. major green banking activities in bangladesh in 2015 issue bank fi no. of banks/fis that have green banking unit 56 30 no. of banks/fis that have green banking policy 55 30 no. of banks/fis that have green office guides 54 30 no. of environmentally risky projects 13,704 796 financing no. of environmentally risky projects 11,587 574 total amount disbursed risk rated projects (in million bdt) 547,319.42 28,561.70 no. of solar power based branches 433 4 no. of solar power based atm/sme units 251 n/a % of online branches 75.07% n/a green financing (in million bdt) 124,646.47 4,685.35 % of green finance of loan disbursement 0.55% 2.12% bdt used from climate risk fund (in millions) 237.57 3.21 bdt used for green marketing, training and development (in millions ) 15.42 0.55 source: annual report-2015, bangladesh bank 3.1.2 green finance green finance contains both direct and indirect finances. the sources of direct green finance are bank’s own fund or funds from bangladesh bank for environment friendly renewable energy and other projects. projects having etp or alike system are included in the indirect finance (bhal, & sarta, 2012). moreover, 47 scheduled banks and 11 financial institutions have had exposure in green finance in direct and indirect form. although green finance practice is uprising, still now green finance by scheduled banks and financial institutions is focused on indirect green finance. direct green finance by banks and financial institutions is only 7.45% of total green finance and 0.63% of total loan disbursement in a quarter (bb annual report, 2015). table 4. green finance until december, 2015 (bdt in millions) types of banks/fis direct green finance indirect green finance total green finance socbs 540.89 122.87 663.76 sdbs 5.10 00.0 5.10 pcbs 6,834.88 95,884.05 102,718.93 fcbs 238.73 20,381.54 20,620.27 new banks 419.87 218.54 638.41 total 8,039.47 116,607.00 124,646.47 fis 1,596.82 3,088.53 4,685.35 grand total 9,636.29 119,695.53 129,331.82 source: annual report -2015, bangladesh bank asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 141 3.2 current scenario of green banking practice in india india is one of the fastest-developing nations in asia and also considered as major future economy in the world (etd 2015). the most important role in its economic growth story is played by the growing industrial sector. but, her industries face the challenges of controlling environmental impact of their business (sahoo & nayak, 2008; singh, 2016). india is the fourth biggest emitter in terms of per capita emission of greenhouse gases (mohan, 2015). according to central pollution control board (cpcb) of india, the major polluting industries are aluminum smelter, caustic soda, pesticides, pulp and paper, sugar, fertilizers, tanneries, textiles, chemicals/pharmaceuticals etc. (cpcb, 2016 ; sahoo & nayak, 2008). traditionally, india promotes sustainable development procedure for her business expansion and eventually has already started carbon tax system for business operation (sreesha, 2014). indian government has planned to sanction 10,192.83 corer rupees in the annual budget for the fiscal year 2016-17 to increase eco-friendly sustainable renewable energy resources for supplementing traditional energy requirements in the country (gandhi, 2016). moreover, reserve bank of india (rbi) has become conscious about the role of banks for sustainable development. rbi established institute of development and research in banking technology (idrbt) in march 1996 as an autonomous center for development and research in banking technology. among all the major initiatives started by idrbt, green banking best practices were published in august, 2013. the idrbt has suggested the standard rating for green efficient banks and banking practices in india and where both infrastructure development and daily operations of the banks are to be considered under this rating system. the green rating standard was termed as “green coin rating”. figure 2. dimention of green coin rating system by idrbt, india asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 142 in 2015, rbi targeted lending to social infrastructure and small renewable energy projects with a view to giving an auxiliary stimulus to green financing. the securities and exchange board of india (sebi) has designed required framework for the issuance and listing requirements of green bonds. india entered into the green bond market in 2015, with a total of us 1.1 billion dollar of green bonds (gandhi, 2016). rbi is continually urging the banks to act responsibly to facilitate sustainable development in india and highlighting the need to create institutional mechanisms to preserve sustainability (chowdhury, 2014). some banks india has already started biometric atm, solar-based atm, white-labeled atms, sms alerts, mobile banking, green loan, online banking services in banking operation (jha & bhome, 2013). dipika ( 2015) reported that in india different type of green banking servises like mobile banking, atm services, oneline banking etc are funtioning in different banks. she also reported that some oneline banking services like fund transfer to self-accounts, third party fund transfer, inter-bank payee fund transfer, ppf transfer, setting up standing instruction, e-tax payment, e-ticketing, bill payments, visa money transfer, online application for ipo etc. are given without manual intervention to reduce carbon foot prints in banking operation. innovative green banking financial products developed by indian banks are reducing carbon emission directly or sometimes indirectly. these banks can introduce green funds to provide green loan to the climate conscious customers to invest in the environmental friendly projects (bihari & pandey, 2015). green banking initiatives are taken by both public sector banks (holding more than 50% stock by the government) and private sector banks (holding more than 50% stock by the private shareholders). the public sector and private sector banks has initiated green initiatives in india are given below. table 5. green banking practice by various banks in india public sector banks private sector banks 1. state bank of india 2. punjab national bank 3. bank of baroda 4. canara bank 5. central bank 6. idbi bank 1. icici bank 2. hdfc bank 3. axis bank 4. yes bank 5. kotak mahindra bank 6. indusind bank source: money control (2015) 3.3 scenario of green banking practice in pakistan a resilient nation like pakistan has a serious need of practicing the concept of green economy into its policies (samad & manzoor, 2011). green growth for pakistan can signify effective and efficient use of natural resources and reduction of the climate change vulnerabilities (shaheen & khan, 2002). planning commission of pakistan (2012) asserted that the concept asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 143 of green economy is to be incorporated into policies and discourse. relationship of the green economy and growth needs to be examined in an innovative and focused manner regarding the economy along with productivity. green financing is a fairly new term in pakistan. some commercial banks in pakistan have started exploring its segment operating with energy efficient technologies. here, the part of microfinance banks in pakistan is worth mentioning since they literally opened up the scope of green financing for the large banks (farrukh, 2014).however, structuring green financing in this country can be a complex procedure because it is uncanny and still unconventional for the country as it necessitates more legal creativeness compared to the conventional financing. financing rules and requirements for alternate energy are not much developed yet. moreover, awareness among borrowers is still low. reacting to the problem, state bank of pakistan (sbp) has recently revised its prudential regulations of housing finance to let banks offer loans to individual customers providing affordable solar power solutions at their resident as part of home loans. these endeavors will create a platform for green finance to grow in pakistan (thombre, 2011). state bank of pakistan has taken different measures to expand activities of green banking among all banks and instructed them to follow (hasnain and afgan, 2014).''green banking unit'' (gbu) has been established in the state bank of pakistan (sbp) to coordinate and gear up the green banking initiatives. according to sbp annual performance review for the year 2014-15, this unit has a vision of sustainable and green banking orientation of banking practices by incorporating resource efficiency, renewable energy and environmental protection in banking operations and products/services. in this regard, sbp prepared a concept paper on "green banking" during the year providing several recommendations for future initiatives (bhatti, 2015). the gbu has enhanced co-ordination with multilateral agencies to work out proposals with joint initiatives. besides, sbp also joined sustainable banking network (sbn) of international finance corporation (ifc). so, the grass is certainly greener on the green financing side in pakistan. the financial institutions of pakistan should provide their best efforts towards green financing for making customer more aware about the significance of green financing and sustainable banking practices to enhance green banking activities (samad & manzoor, 2011). the names of banks involved in green banking practices in pakistan are given below. table 6. name of banks using green banking practices in pakistan name of banks 1. national bank of pakistan 2. bank alfalah limited 3. allied bank 4. mcb source: pakistan economic survey (2015) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 144 4. comparative picture of green banking among three countries to accelerate green banking practices in bangladesh, bangladesh bank (bb) formulated the green banking policy guideline and strategy framework in 2011 that requires other banks to implement a wide range of green banking activities in a three-phased approach (masukujjaman & akhtar, 2013). bb not only formulated the policy but also provided technical supports for green banking implementation (nath a., 2015). moreover, bb adopted green banking practices in its own in-house operations and also reports scenario of overall green banking practices by different scheduled banks and financial institutions. online banking and atm facilities are considered as the first step to implement green banking in bangladesh as it lessens lots of paper works and satisfies the principle of cleanliness at bank. 47 scheduled banks of bangladesh have its own green banking policy guidelines, green office guide as well as have green banking unit (gbu) for conducting in-house green activities (rahman m s. & barua s.,2016). reserve bank of india is much behind to be involved in green banking practices in its own operations and reporting overall green banking practices by other banks in india as compared bangladesh bank in bangladesh. mandatory regulatory policies have not been taken to implement green banking practices by others banks in india (chaurasia, 2014; trehan, 2015).but it cannot be claimed that reserve bank of india is much reluctant initiating green banking practices in india. public sector banks are emphasizing more on green initiatives as compared to the private sector banks but these private sector banks are generally inclined toward green initiatives for instance net banking, mobile banking etc.(sahoo & nayak, 2008; goyal & joshi, 2011). in december 2007, rbi issued a circular (rbi 2007-2008/216) emphasizing the importance of sustainable banking practice by designing institutional mechanism to act responsibly in order to contributing sustainable development in india (rahman et al., 2013). in 2015, india entered into the green bond market and also used green coin rating system where banks would be judged based on the rate of carbon emission out of their operations, the amount of reuse, refurbish (idrbt, 2013). to align financial systems with the sustainability domineering, india welcomes new green finance initiatives, issues green bond, ten solar based atm has been set up in coimbatore circle as per iad model and 2016 is set to be the year of green finance(gandhi, 2016). even after all these initiatives, it can be claimed that there is a lack of formal regulatory polices by reserve bank of india to accelerate mandatory green banking practices and reporting by other banks in india. consequently, very little number of banks as compared to total numbers is involved in green banking practices and reporting (nishi sharma, 2011; rajput, kaur et al., 2013; sudhalakshmi & chinnadorai 2014). in pakistan green banking is relatively a new approach. the banking sectors have started taking baby steps into this segment (ragupathi & sujatha, 2015). although structuring green banking is a complex procedure in pakistan because green banking is unconventional and still uncommon for the country (kandavel, 2013), a few number of commercial banks have taken steps to be involved in green banking (sreesha, 2014).the state bank of pakistan (sbp) has established a ''green banking unit'' (gbu) in its operations with a view to asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 145 coordinating and gearing up its initiatives on green banking and making their customer more aware about the importance of green financing and sustainable banking practices (iyer, 2015). but, still now sbp cannot introduce specific regulatory guidelines for mandatory green banking practices for banking sectors and much behind in implementing and reporting overall green banking practices by others banks in pakistan. table 7. comparative picture of country-wise green banking practice name of green banking initiatives bangladesh india pakistan e-statement rather than paper statement for customers √ √ online communications √ √ √ use daylight to reduce the usages electricity √ usages of energy efficient devise √ conversion of vehicles into cng √ both sides paper usages √ √ use eco-font for printing √ web based e-tendering system √ sending payment slips, reimbursement slips electronically √ mobile banking, tele banking, atm services √ √ √ issuance of green bond √ provides green services ( i.e. green deposit, green mortgages and loans, green credit cards, green checking accounts etc) √ √ green banking practices evaluation system √ √ solar powered operations √ √ n.b. this table is prepared based on availability of information 5. conclusion after an intensive investigation, we eventually declare that bangladesh bank, central bank of bangladesh, has directly included green banking practice in its operation and established specific policies and guidelines for other financial institutions to be involved in green banking practice as well. bb not only follows up the green banking practices by other financial institutions and but also discloses overall status green banking practices in bangladesh in its annual reports. in bangladesh, 47 scheduled banks out of 56 and29 out of 31 financial institutions have formulated their own green banking policy guidelines and have also formed green banking unit for pursuing green banking activities. whereas in india, the reserve bank of india is not too much involved with green banking policy making, monitoring and reporting overall green banking practices by different financial institutions. although a few numbers of public and private banks of india have already started green banking practices in its operations, the current status of overall green banking practices by various financial institutions is not at satisfactory level because of lack of central bank’s regulatory policies for mandatory green banking practices and reporting for other banks. in pakistan, green banking is totally a new concept in banking sector and remains at very early asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 146 stage although state bank of pakistan has already established ‘green banking unit’ to enhance green banking practices in pakistan. therefore, after critical review of existing literature, we can eventually conclude that central bank’s green banking policies can enhance significant and distinguishing green banking practices and reporting in a country. references ahmed, s. u. 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(2013). green banking in bangladesha comparative analysis. world review of business research, 3(4), 74-83. microsoft word 11077-40874-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 274 the foreign exchange exposures and enterprise risk management: evidence from hospitality industry in taiwan hsiao, chiu-ming department of finance, national chung cheng university, taiwan & national yunlin university of science and technology, taiwan no.168, sec. 1, university rd., min-hsiung township, chia-yi county 621, taiwan (r.o.c.) e-mail: shiaucm@yahoo.com.tw. received: april 2, 2017 accepted: may 17, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.11077 url: http://dx.doi.org/10.5296/ajfa.v9i1.11077 abstract this paper adopts arima model to explore the relationship between business performance and the fluctuation of exchange rate. the empirical results show that the impacts of the fluctuation of foreign exchange rate on the business performance of hotels are significant and different across currencies and the size of a hotel. furthermore, based on the framework of kim (2013), a modern portfolio theory proposed by markowitz (1952) gives an optimal allocation of foreign exchange for a hotel’s decision-makers, who would avoid exchange rate risk exposure and complete the construction of enterprise risk management system (erm) to reduce losses. keywords: foreign exchange exposures, modern portfolio theory, enterprise risk management, financial performances, arima asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 275 1. introduction tourism can be thought as an integral industry that combines public and private sectors. anderson and getz (2009) discussed that the public sectors should make the tourism policies to stimulate the development of tourism and promote some non-profit-festivals to attract tourists. likewise, the private sectors, such as in the field of transportation, communication, leisure, department, etc., should be integrated under the same goals to generate the profit from tourism-related businesses. the more the tourists and the longer they stay, the more revenue generates from the hospitality industry. in candela and figini (2011), they developed the tourism economics which is said to be a no-smokestack industry. from the economic point of view, tourism will create value from catering, hotels, aviation, transportation and many other related industries. in 2013, japanese prime minister shinzo abe implemented a policy combining fiscal expansion (i.e. quantitative easing) and structural reform in the hope of revitalizing japan’s domestic economy. indeed, this so-called “abenomics” has resulted in a significant growth in japan’s domestic economy. nieh and cho (2017) adopted the panel data analysis to investigate the relationship between foreign exchange rate and financial ratios of taiwanese automobile and integrated circuit industries. they found when the abenomics applied a policy of qe to instigate a sharp depreciation of the yen, the effects of the policies absolutely benefit to japanese export industries. accordingly, the impact of exchange rates on some industries becomes even more obvious and important, especially in the tourism industry while japanese yen is depreciated in order to stimulate the economy. a depreciation of the exchange rate against other currencies will increase a country’s international competitive advantage or exports. implementing quantitative easing policy that caused the depreciation of japanese yen increases japan’s foreign trade and also successfully leads the economy back to situation. surprisingly, the tourism industry has gained the most benefits of all. this paper, therefore, wants to study the case and examine if the situation could as well apply to the tourism industry in taiwan. oh (2005) addressed the causal relations between tourism growth and economic expansion for the korean economy. he employed the granger causality test and found that the korean tourism industry is economic-driven. kim, chen and jang (2006) examined the relationship between tourism expansion and economic development in taiwan. they found a bi-directional causality between them. in other words, in taiwan, tourism expansion and economic development reinforce each other. min (2013) used panel data approach to test the tourism-led economic growth hypothesis. he found that the tourism-led growth hypothesis is more strongly supported when the time-specific effects are eliminated, which will cause a biased estimate in the granger causality test. according to the data of the world tourism organization, the number of international tourist visited in taiwan in 2012 was estimated 9.91 million, ranked the world’s 31 and createdrevenues$14.7 billion. in 2014, taiwan inbound tourists grew 23.6%, ranked the 2nd place of the world’s top 50 tourist destinations, only less than of japan's growth rate 29.4%.tourism revenue has growth 18.9%, ranked the 4th place in the world’s top 50 tourism asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 276 revenue areas. gradually, taiwan’s tourism has been recognized considerable potential. po and huang (2008) used 88 cross-sectional countries’ data to investigate the nexus between tourism development and economic growth. they found a significantly positive relationship of them when the proportion of tourism receipts in gdp is either less than 4.05% or more than 4.73%, but not when it lies between these two ratios. moreover, chen and song zan (2009) showed that the tourism industry is greatly contributed to taiwan’s economy. in other words, taiwan is a tourism-led economy. taiwan authority has opened to chinese tourists since the summer of 2008. in order to increase the number of tourists, taiwanese government has undertaken a number of initiatives to promote the tourism industry, such as doubling tourist arrivals plan (dtap) introduced in 2002,challenge 2008, taiwan’s 2015-2018 tourism action plan, mid-term plan for construction of major scenic sites(2012-2015),project vanguard for excellence in tourism, and tour taiwan and experience the centennial. according to taiwan tourism bureau, these plans are proposed to deepen the “time for taiwan” core promotional programs, implement “quality, uniqueness, intelligence, and sustainability” as strategies toward the goals of “development of international tourism, enhancement of domestic travel quality, and increased foreign-exchange revenues” to bring taiwan’s new tourism allure to the attention of the world1. portnov and li (2013) suggested that in order to achieve a greater stability in the number of inbound tourist arrivals, taiwan should diversify sources of their inbound tourism, by giving priority to neighboring countries with relatively larger, more productive, and more steadily growing economies, such as china, malaysia, or the other emerging countries. according to taiwan tourism bureau, the inbound number of tourists was 2,624,037 in 2000, 9,910,204in 2014 and over 10 million in the end of 2015.this tendency shows the visibility and attractiveness of international tourists traveling to taiwan. moreover, taiwan’s foreign exchange earnings generated by tourism leaped from $3,738 million in 2000 to $14,615 million in 2014, which its share in total gdp reached 2.76% from 1.13%.it shows that taiwan tourism industry earns a large part of foreign exchange earnings. the fluctuation in exchange rates for taiwan’s tourism industry is an important factor for taiwan’s overall economic development. the recent ten-year annual revenues generated from tourism, foreign exchange and domestic tourism are shown in figure 1. the highest line is the tourism revenue (in red), which grows rapidly in 2009 due to the effect of opening of chinese tourists to visit taiwan. the lowest line is the domestic tourism revenue (in purple), which attains the maximum (331 billion of nt dollars) in 2011 and declines in the following years. the foreign exchange earnings (in green) smoothly increases in years. 1http://admin.taiwan.net.tw/public/public_en.aspx?no=6. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 277 figure 1. revenues generate from tourism and foreign exchange source: tourism bureau, m.o.t.c., republic of china (taiwan). taiwan’s tourism revenues have increased in recent years. the hotel industry plays an important role in the tourism industry, resulting in a huge source of foreign exchange earnings. among the tourists, the number of chinese tourists accounted for the largest part of all, followed by japanese, european and the united states. bilateral trade between taiwan and china, japan, europe and the united states, respectively, is not only very close, but also represents the effect of the changes in exchange rates. the number of tourists traveling to taiwan contributes the foreign exchange earnings. pritamani, shome and singal (2005) divided the u.s. companies into five categories and found that neither exporters nor multinational firms were the most affected by changes in exchange rates. the firms that suffered most from exchange rate fluctuations were wholly domestic u.s. companies facing foreign competition. taiwan’s hotel industry has the same situation. based on the above point of view, we mainly discuss taiwan’s hotel industry for exposure to foreign exchange fluctuations and corporate risk management. through our study, it suggests the hedging strategies to the decision-makers of firms and then to enhance taiwan’s hotel industry’s risk management. the structure of this study is as follows: section 2 is literature review and methodologies will be discussed in section 3; data collection and its statistical descriptions are in section 4. the empirical results and analysis are shown in section 5. the last section is the conclusion. 2. literature review from the 1980s, there are numerous studies to discuss the foreign exchange exposures. the landmark papers, dumas (1978), adler and dumas (1980) and then hodder (1982) implemented the change of foreign exchange rates into the regression models to study the u.s. multinational firm’s values. and jorion (1990, 1991) followed their studies and found that the stock returns of u.s. multinational firm are significantly positively correlated to the volatility of the u.s. dollar. moreover, bodnar and gentry (1993) studied the different effects of the fluctuations of foreign exchange rates on the different industries in u.s., canada and japan. schnabel (1989, 1994) extended the adler-dumas model to a multi-factor model by including several currencies exchange rate movement. 351.1 389.4 390.5 371.3 408.1 514.0 636.3 618.4 638.9 753.0 158.5 165.1 171.2 187.1 225.3 275.9 326.0 348.5 366.8 443.8193 224 219 184 183 238 313 270 272 309 0 500 1,000 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 toursim revenue (billions of nt$) foreign exchange earnings (billions of nt$) year asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 278 moreover, he and ng (1998) studied japan 171 multinational firms there are about 25% firm’s stock returns significantly positively correlated to the foreign exchange exposures, themselves. and the effects are increasing as firm’s size increases. morelli (2007) found the same effects of firm’s size on the uk listed firms’ stock returns. dominguez and tesar (2006) examined the relationship between exchange rate movement and firm value. no matter in the firmor industry-level, they found that the foreign exchange exposure do affect the value of firm. salifu, osei, and adjasi, (2007) examined the foreign exchange exposure of ghanaian listed companies. their results showed that about 55% companies are exposed to the fluctuation of us dollar and 35% companies are exposed to that of uk pound. moreover, chen and kuo (2016) found that the exchange rate variability was significantly related to foreign reserves foreign reserves growth rate and the stock index return. jahan (2016) studied the efficiency of using currency derivatives to reduce the effect of currency fluctuations on the performances of the advanced chemical industries in bangladesh. on the other hand, maloney (1990) and koo (1994) paid attention on the australian mining industry. they indicated that the fluctuations of the exchange rates between australia dollars against to the major currencies will affect the firm’s profit. so they suggested that firm should find some strategies to manage the positions of foreign currencies in order to avoid the losses caused by the fluctuations of exchange rates and then reduce the firm’s performance. aggarwal and harper, (2010) investigated the foreign exchange exposures that u.s. domestic companies faced to. their results showed that the domestic company suffers more foreign exchange exposures than mnes. they concluded that the mnes may use more currency derivatives and more trading skills to reduce the foreign exchange exposures than the pure domestic companies. in addae, nyark-baasi, and tetteh (2014), they found that the foreign exchange rate movement will affect the quality of assets of ghanaian banks. in fact, the foreign exchange market in taiwan is a small, regional market, so some foreign currencies transaction is not warm and the trading volume is small. the liquidities of the other currencies are lower than that of the international major currencies. as harris (2003) has said that liquidity is the ability to trade large size quickly, at low cost, when you want to trade. such that a lower liquidity will result to the company when buying foreign currency in order to circumvent the exposure of foreign exchange transactions, it cannot immediately trade at a predetermined price to the required foreign currency position. hence, the transaction costs and carrying costs of the currencies will increase the cost of risk reduction and then increase the liquidity risk of assets. here, according to campbell, medeiros, and viceira (2010), regression models can be adopt to help the company to find out the effect on its performance causing by the currency’s fluctuation. after finding the magnitudes of currency fluctuations which affect to the company’s performance, then the framework of the modern portfolio theory, proposed by bailey, ng, and stulz, (1992) and kim (2013), can be used to form their own foreign exchange risk management strategies and then to reduce the effect of foreign exchange exposures. this study applies the framework of kim (2013) to investigate the effects of foreign exchange exposures on the performance of taiwan hospitality industry and try to propose some hedging strategies and strengthen their corporate risk management. therefore, as the shown in jorion (1991), i will impose the changes of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 279 exchange rates of several currencies to study the effects of the fluctuations of exchange rates on the performance of taiwan hotel companies. 3. methodologies 3-1. modern portfolio theory, mpt modern portfolio theory is proposed by markowitz in 1952.in the paper, probability theory and linear algebra method are applied to investigate the correlation between the securities. it puts forward the possibility to diversify the main investment risks for this theory that regardless of the dispersion of individual investment targets the risks associated with some other securities can reduce the risk. in this way, individual company information becomes less important. the theory is mainly to solve an investor’s risk-reward problem and to form a rational combination of his/her own funds in order to maximize the proceeds. according to the markowitz’s framework, there is a certain special relationship between investment risk and return of a portfolio of financial assets. his assumptions are based on four conditions: 1. assume the market is efficient, investors can learn more of the benefits and risks of financial market changes and their causes. 2. suppose investors are risk averse and are willing to get a higher rate of return if they must bear a greater risk to get a higher expected return as compensation. risk is the variability of yields as measured by standard deviation. 3. investors’ choices are based on the expected returns and standard deviations of selected financial assets portfolio. they select portfolios with higher yields or lower risk. 4. the incomes between various financial assets are correlated with the correlation coefficient between each financial asset, it is possible to choose the lowest risk of the portfolio. an efficient portfolio should be subject to the following conditions: under certain risk (standard deviation).this combination of securities has the highest average reward; and in certain average reward, it has the lowest degree of risk (standard deviation).therefore, the portfolio should be on the curve of efficient frontier. according to huang and litzenberger (1988)and elton, gruber, brown, and goetzmann (2007), suppose an economy which there are n risky assets with its return and standard deviation ir and iσ , ni , , , 21= , respectively. moreover, the covariance between any two assets is ( )jiji rrcov , ≡,σ ， nji , , , 21=≠ . if we denote the portfolio weight on each assets in the portfolio to be iw , ni , , , 21= , then the expected return of the portfolio is rwp ⋅′≡μ , where ( )′≡ nrrrr , , , 21 and ( )′≡ nwwww , , , 21 。and the variance of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 280 the portfolio is wwp ⋅σ⋅′≡2σ , where ( ) ( ) nnjirvar × =≡σ , σ the variance-covariance matrix is. hence, in the framework of markowitz (1952) and kim (2013), we have to minimize the degree of risk of the portfolio under a pre-specified return, 0μ ,and budget constrain. namely, wwp wi ⋅σ⋅′= 2 1 2 2 min σ (1)       =≤≤ ==⋅′ ≥⋅′=  = niw wwj rw ts i n i in p , , , , 2110 1.. 1 0μμ (2) where, ( ) n nj ℜ∈′= 111 , , ,  . using the lagrange multipliers method, the above problem can be transformed as follows: ( ) ( )      ⋅′−⋅+⋅′−⋅+⋅σ⋅′= wjrwwww n wi 1 2 1 20121min 21 λμλλλ λλ , , , ,  . (3) hence, the f.o.c.is          =     ⋅′−= ∂ ∂ =     ⋅′−= ∂ ∂ =⋅−⋅−⋅σ= ∂ ∂ 01 0 0 2 0 1 21 pn p np wj rw jrw w λ μ λ λλ     np jrw ⋅σ⋅+⋅σ⋅= −− 1 2 1 1 * λλ . and then we have,     =⋅σ⋅′⋅+⋅σ⋅′⋅ =⋅σ⋅′⋅+⋅σ⋅′⋅ −− −− 11 2 1 1 0 1 2 1 1 nnn n jjrj rjrr λλ μλλ        ⋅−= − ⋅− = −⋅= − −⋅ = 02 0 2 02 0 1 μμλ μμλ d b d a bac ba d b d c bac bc , where, rra ⋅σ⋅′≡ −1 ， nn jrrjb ⋅σ⋅′=⋅σ⋅′≡ −− 11 , nn jjc ⋅σ⋅′≡ −1 , and 2bacd −≡ .such that, the optimal wealth allocation portfolio is np jrw ⋅σ⋅+⋅σ⋅= −− 1 2 1 1 * λλ nj d b d ar d b d c ⋅σ⋅      ⋅−+⋅σ⋅      −⋅= −− 1 0 1 0 μμ . (4) the properties of this portfolio are asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 281 1. rj d b d arr d b d crw npp ⋅σ⋅′⋅      ⋅−+⋅σ⋅′⋅      −⋅=⋅′= −− 1 0 1 0 * μμμ .000 2 00 μμμμμ ==⋅−=⋅      ⋅−+⋅      −⋅= d d d bacb d b d aa d b d c 2. **2 ppp ww ⋅σ⋅′=σ σ⋅ ′       σ⋅      −+σ⋅      −= −− nj d b d ar d b d c 1 0 1 0 μμ       σ⋅      −+σ⋅      −⋅ −− nj d b d ar d b d c 1 0 1 0 μμ nn jj d b d arr d b d c ⋅σ⋅′⋅      ⋅−+⋅σ⋅′⋅      −⋅= −− 1 2 0 1 2 0 μμ njr d b d a d b d c ⋅σ⋅′⋅      ⋅−⋅      −⋅+ −1 002 μμ 2 0 2 0       ⋅−⋅+      −⋅⋅= μμ d b d ac d b d ca       ⋅−⋅      −⋅⋅⋅+ 002 μμ d b d a d b d cb ( ) cc b d cabc d 121 2 00 2 0 +      −⋅=+⋅−⋅= μμμ (5) such that, cp 12 ≥σ , and the equality holds when c b=0μ . next, considering a riskless asset can be invested, and then the pre-described model will be rewritten as follows: wwp wi ⋅σ⋅′= 2 1 2 2 min σ (6) ( ) 01.. μμ ≥⋅′+⋅⋅′−= rwrjwts fnp , (7) where， fr is the return of the riskless asset. again, by using the lagrange multipliers method, we have to solve the following problem: ( ) ( )[ ]fn w rjwrwwww i ⋅⋅′−−⋅′−⋅+⋅σ⋅′= 1 2 1 021min μλλλ λ , , ,  . (8) thus, the f.o.c. is asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 282 ( ) ( )   =⋅⋅′−−⋅′−= =⋅−⋅−⋅σ= 01 0 0 fn fnw rjwrw rjrw μ λ λ   ( ) h r jrrw f nfp − ⋅⋅−⋅σ= − 01* μ , where, ( ) ( ) 21 2 ffnfnf rcrbajrrjrrh ⋅+⋅−=⋅−⋅σ⋅′⋅−≡ − . the properties of this portfolio are: 1. fnppp rjwrw ⋅     ⋅′−+⋅′= 1*μ ( ) fnp f nf rjwr h r jrr ⋅     ⋅′−+⋅ − σ⋅′⋅−= − 101 μ ( ) ( )nfnf f jrrjrr h r ⋅−⋅σ⋅′⋅−⋅ − = −10μ ( ) ( ) fnpnnf ff rjwjjrr h rr ⋅      ⋅ ′ −+⋅σ⋅′⋅−⋅ −⋅ + − *10 1 μ . 2. **2 ppp ww ⋅σ⋅′=σ ( ) ( )       − ⋅⋅−⋅σ⋅σ⋅      − σ⋅′⋅−= −− h r jrr h r jrr f nf f nf 0101 μμ ( ) ( )nfnf f jrrjrr h r ⋅−⋅σ⋅′⋅−⋅      − = −1 2 0μ     σ′⋅+σ′⋅−σ′⋅      − = −−− nnfnf f jjrjrrrr h r 121 2 0 2 μ ( ) h rf 2 0 − = μ . (9) hence, its standard deviation h rf p − = 0μ σ , that is, pf hr σμ ⋅±= 0 (10) 3.2 autoregression integrated moving average models, ( )qdparima ,, in witt and witt (1992，1995), they use many econometric models to investigate the topics of tourism industries. empirically, they suggested that the autoregression and moving average models can be implemented to forecast the performance of tourism industries. this study will focus on the effects of the fluctuations of foreign exchange on the performance of hotel industry. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 283 according to bodie, kane and marcus (2002) and muriithi, muturi, and waweru (2016), we can use the roa or roe, reported in the annual financial statements, to be the measures of the corporate’s performance. there are at least two reasons for applying roa/roe to proxy the firm’s performance. first, since roa is the return of corporate’s total assets, which is defined by the product of profit margin and total asset turnover, so it tells us how effectively a firm uses its assets to generate profits. therefore, a well-performed firm will have a higher roa. second, the definition of roe is the net profit over the average equity, so that by the dupont equation, we have ratio equity assetturnoverasset marginprofit net ××=roe . (11) as a result, it tells us how efficiently a company is operated. it also provides insights into the firm’s use of assets via turnover.that is, a well-performed firm also has a higher roe. as a result, in our study, we will apply these two measures to be the proxies of the firm’s performance and investigate the magnitude of the effects of foreign exchange rate’s fluctuations. hence, by the multi-factor model in jorion (1991) and bartram (2008), the autoregression moving average model is given as follows:  = −⋅+⋅+= p k ktikitmiiti eperformancrmrfeperformanc 1 , , , , φβα  = − = ⋅+⋅+δ⋅+ q s stistii n j tjji asizefx 01 , , , , θδγ , (12) ( ) ( ) itqpqpt , , , , , 2max1max ++= , ni , , , 21= . here, tieperformanc , represents the i-th firm’s performance in the t-th quarter, and ktieperformanc − , is its k-th lagged variable. in sharpe (1964), he defined that trmrf is the market portfolio’s excess return in the t-th quarter, i.e., ftt rrmrmrf −≡ ,and trm is the market portfolio’s return and fr is the rate of return of riskless asset. furthermore, as indicated in smithson andsimkins (2005), although themanagement of interest rate and foreign exchange rate risksdoes indeed add value, the effect is larger than would beexpected.and by the definition ofmuller and verschoor (2006),let tjfx , δ be the percentage change of exchange rate of the j-th currency in the t-th quarter, that is 100 1 1 × − ≡δ − − tj tjtj tj e ee fx , , , , , (13) where tje , is the closed price in the end of the quarter in terms of direct quotation. moreover, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 284 in fama and french (1993, 1995), they formed six portfolios of the stocks listed on nyse, amx, and nasdaq stock market by the firm’s size and found that firm’s size and be/me proxy for sensitivity to risk factors that capture strong common variation in stock returns and will help to explain the average returns and then firm’s profitability. such that, let tisize , denote the size of the i-th firm in the t-th quarter which is defined as ( )titi capsize , , ln≡ , and ticap , is the capitalization of the firm in the t-th quarter. tia , is the white noises. 4. data this paper selected twelve hotel companies listed on taiwan stock exchange (twse), and downloaded their quarterly roa, roe and capitalization from taiwan economic journal (tej). they are hotel holiday garden(2702), the ambassador hotel ltd.(2704), the leofoo development co., ltd.(2705), first hotel company ltd.(2706), formosa international hotels corporation(2707), farglory hotel co., ltd.(2712), pleasant hotels international inc.(2718), chateau international development co., ltd.(2722), fx hotels group inc.(2724-f), janfusun fancyworld corp.(5701), the landis taipei hotel co., ltd.(5703), and hotel royal chihpen(5704). period is from 2000q1 to 2015q3 and sum to 489 firm-quarters. table 1 shows the descriptive statistics of the firm’s roa and roe, respectively. table 1(a). descriptive statistics of roa. roa (%) obs. mean std. dev. max min median 2702hg 63 0.661 0.820 2.94 -1.43 0.740 2704ambh 63 0.641 0.565 1.47 -1.29 0.740 2705leofoo 32 -0.136 1.298 5.40 -5.03 -0.225 2706first hotel 32 1.398 1.105 7.28 0.54 1.160 2707gfrt 63 4.392 1.195 7.55 1.27 4.360 2712fgh 11 1.383 1.244 3.68 -0.12 0.870 2718ph 25 0.944 0.873 2.40 -1.20 0.840 2722chateau 21 2.732 2.632 8.38 -0.60 2.380 2724fx hotels 21 1.179 1.770 5.74 -2.45 1.550 5701jfs 32 -1.462 1.341 1.73 -5.76 -1.470 5703landis taipei 63 0.419 1.724 3.20 -8.97 0.740 5704chihpen royal 63 1.040 1.381 3.62 -3.49 1.210 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 285 table 1(b). descriptive statistics of roe roe (%) obs. mean std. dev. max min median 2702 hg 63 0.804 1.276 3.77 -2.97 0.940 2704ambh 63 0.704 0.956 2.18 -2.96 0.880 2705leofoo 32 -0.415 2.565 11.04 -9.90 -0.695 2706first hotel 32 1.668 1.339 8.71 0.67 1.390 2707gfrt 63 6.645 2.205 11.13 1.50 6.700 2712fgh 11 1.794 1.782 4.81 -0.44 1.100 2718ph 25 1.220 1.109 2.99 -1.62 1.160 2722chateau 21 3.313 3.335 11.24 -0.68 3.060 2724fx hotels 21 1.418 3.958 6.96 -8.83 2.210 5701jfs 32 -3.217 2.462 2.47 -11.24 -3.300 5703landis taipei 63 0.612 2.338 4.48 -11.76 1.040 5704chihpen royal 63 1.192 1.581 4.19 -3.83 1.300 source: taiwan economic journal (tej). in table 1, we may find that the formosa international hotels corporation(2707) has the highest roa and roe, however, janfusun fancyworld corp.(5701) has the lowest roa and roe. and except of janfusun fancyworld corp. and the leofoo development co., ltd. (2705), the others are well-performed since they all have a positive average roa or roe. moreover, the ambassador hotel ltd. (2704) has the lowest volatility of roa and roe. on the other hand, chateau international development co., ltd. (2722) and the fx hotels group inc. (2724-f)have the highest volatility of roa and roe, respectively. it may result from the shortest listing data of these two companies. next, the foreign exchange rates were collected from 2000 to 2015 through the website2 of the central bank of taiwan. the equation (13) calculates the quarterly and monthly percentage change of exchange rates for the currencies against to the nt dollars (ntd). table 2 shows the descriptive statistics of the monthly change of foreign exchange rates. 2http://www.cbc.gov.tw/content.asp?mp=1&cuitem=36599. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 286 table 2. descriptive statistics of the monthly change of exchange rates monthly change (%) mean std. dev. max min median cv usd 0.0280 1.1865 3.3313 -3.5798 0.0232 42.3750 jpy -0.0353 2.3233 8.8309 -6.0498 -0.2280 -65.8159 gbp 0.0135 1.9269 5.7608 -8.0517 0.0901 142.7333 cny 0.1664 1.1449 3.0715 -3.4686 0.1749 6.8804 eur 0.1016 2.2251 7.1016 -5.2660 0.2209 21.9006 hkd 0.0294 1.1841 3.3179 -3.5798 0.0205 40.2755 krw 0.0170 1.8737 6.7195 -12.3726 0.2496 110.2176 cad 0.0940 1.8282 5.0170 -8.6264 0.0351 19.4489 sgd 0.1155 0.9621 3.0253 -3.4506 0.1384 8.3299 aud 0.1074 2.6040 6.9746 -13.5568 0.2725 24.2458 idr -0.3005 3.1096 20.7023 -13.5534 -0.2083 -10.3481 thb 0.0602 1.2869 3.6022 -4.5300 0.0806 21.3771 myr -0.0366 1.2266 3.0689 -4.0603 -0.0825 -33.5137 php -0.0412 1.5530 4.3555 -4.5580 -0.1633 -37.6942 source: central bank of taiwan. in table 2, the lowest percentage change (0.96%) of the exchange rate is the singapore dollar against to nt dollar, and the highest percentage change (3.11%)of the exchange rate is the indonesian rupiah against to nt dollar. indonesian rupiah has a maximum appreciation (20.70%) and minimum depreciation (13.56%) against to nt dollar. moreover, the coefficient of variation is also reported in table 2.the standard deviation of data describes the dispersion of the data away from the mean. in contrast, the coefficient of variation is the multiple of the standard deviation to the mean, i.e. μ σ≡cv . for comparison between data sets with different units or widely different means, this paper uses the coefficient of variation instead of the standard deviation. scheel (1978) proposed that the coefficient of variation can also be a measure of relative risk in the elementary risk and insurance. an asset with lower value of coefficient of variation means either a lower-risk asset among that of the same return or a higher-return asset among that of same level of risk. as shown in table 2, china yuan (cny) and singapore dollar (sgd) have lower coefficient of variation, 6.8804and 8.3299, respectively, and great british pound and korean won have higher coefficient of variation. both great british pound and korean won are either high-risk or low-return. 5. empirical results and analysis first, we have to test whether the series of performance is stationary or not. that is, we should test the null hypothesis that it has a unit root. in tsay (2005), he indicated that the fundamental time series analysis is stationarity. a time series ty is said to be strictly asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 287 stationary if the joint distribution of ( )′ kttt yyy , , ,  21 is identical to that of ( )′+++ ststst k yyy , , ,  21 for all k, where s is an arbitrary positive integer. in other words, strict stationarity requires that the joint distribution of ( )′ kttt yyy , , ,  21 is invariant under time shift. and a time series ty is weakly stationary if both the mean of ty and ( )stt yycov −, are time-invariant, where sis an arbitrary integer. in the table 3, we show the augmented dicky-fuller test results. as shown in table 3, we can find that almost all the roa/roe series are non-stationary except the ambassador’s roa/roe. on the other hand, according to hurvich and tsai (1989), there will be biased estimates resulting from a non-stationary series. such that, applying wei (2006), we take the first-ordered difference on the series, i.e., 11 −−≡ ttt roaroaroad and 11 −−≡ ttt roeroeroed . (14) and then, we test the unit-root-test again to verify its stationarity. the augmented dicky-fuller test results are also shown in table 3. after differencing the series, all of them are stationary. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 288 table 3. the stationarity test results of company’s performances sec series obs. adf test statistic p-value stationarity 2702 roa 56 -1.539 0.5140 non-stationary △roa 61 -14.607 0.0000 stationary 2704 roa 56 -2.884 0.0472 stationary 2705 roa 56 -2.158 0.2217 non-stationary △roa 61 -12.592 0.0000 stationary 2706 roa 56 -2.312 0.1683 non-stationary △roa 61 -17.520 0.0000 stationary 2707 roa 56 -2.640 0.0849 non-stationary △roa 61 -12.541 0.0000 stationary 2712 roa 9 -3.466 0.0089 stationary 2718 roa 18 -1.651 0.4567 non-stationary △roa 23 -9.001 0.0000 stationary 2722 roa 14 -1.810 0.3755 non-stationary △roa 19 -5.904 0.0000 stationary 2724 roa 14 0.025 0.9606 non-stationary △roa 19 -5.816 0.0000 stationary 5701 roa 56 -1.476 0.5452 non-stationary △roa 61 -11.789 0.0000 stationary 5703 roa 56 -1.977 0.2967 non-stationary △roa 61 -10.758 0.0000 stationary 5704 roa 56 -1.421 0.5722 non-stationary △roa 61 -17.149 0.0000 stationary asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 289 table 3(b). the stationarity test results of company’s roe sec series obs. adf test statistic p-value stationarity 2702 roe 56 -1.604 0.4814 non-stationary △roe 61 -15.323 0.0000 stationary 2704 roe 56 -2.993 0.0356 stationary 2705 roe 25 -2.061 0.2604 non-stationary △roe 30 -8.296 0.0000 stationary 2706 roe 25 -2.441 0.1306 non-stationary △roe 30 -13.890 0.0000 stationary 2707 roe 56 -1.808 0.3764 non-stationary △roe 61 -11.738 0.0000 stationary 2712 roe 9 -3.501 0.0080 stationary 2718 roe 18 -1.689 0.4365 non-stationary △roe 23 -8.826 0.0000 stationary 2722 roe 14 -2.132 0.2320 non-stationary △roe 19 -6.034 0.0000 stationary 2724 roe 14 0.394 0.9813 non-stationary △roe 19 -7.304 0.0000 stationary 5701 roe 25 -2.505 0.1143 non-stationary △roe 30 -8.123 0.0000 stationary 5703 roe 56 -1.942 0.3124 non-stationary △roe 61 -10.652 0.0000 stationary 5704 roe 56 -1.332 0.6146 non-stationary △roe 61 -17.278 0.000 stationary next, patro, wald, and wu (2002) found the significant currency risk exposures in country equity index returns by using the garch model. and, polodoo, seetanah, and sannassee (2016) discussed the nexus between exchange rate volatility and manufacturing trade. they found that exchange rate volatility has an adverse effect on the real manufacturing trade of the africa countries. as shown in kelilume (2016), he applied the dynamic panel regression approach to investigate the effects of exchange rate volatility on firm performance by examining 20 companies listing in nigerian stock exchange. it revealed that exchange rate volatility has significant negative impacts on the roas, atrs. here, that the effects of the fluctuations of exchange rates on the firm’s performance is the main purpose of this study. therefore, like the work in kim (2012), the following autoregression moving average (arima) model:  = −⋅+⋅+= p k ktikitmiiti eperformancdrmrfeperformancd 1 11 , , , , φβα asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 290  = − = ⋅+⋅+δ⋅+ q s stistii n j tjji asizefx 01 , , , , θδγ ,(15) ( ) ( ) itqpqpt , , , , , 2max1max ++= , ni , , , 21= . where, tieperformancd , 1 represents the first-ordered difference of the i-th firm’s performance in the t-th quarter, and ktieperformancd − , 1 is its k-th lagged variable. use the stata13 to find the regression results and shown in the table 4. model i regresses road1 on all exchange fluctuations, lagged variables and the control variables. model ii regresses road1 on all variables but selected by eliminating higher p-value explanatory variables. table 4. regression on roa the regression model is given as follows: . , , , , , , , , titii n j tjji p k ktikitmiiti asizefxroadrmrfroad +⋅+δ⋅+⋅+⋅+=  == − δγφβα 11 11 model i regresses 1,,,1 −⋅⋅⋅ −≡ ttt roaroaroad on all exchange fluctuations, lagged variables and the control variables. model ii regresses road1 on all variables but selected by eliminating higher p-value explanatory variables. the values in the parentheses are standard error of the estimates. and *, ** and *** stand for 10%, 5% and 1% level of significance, respectively. company hotel holiday garden (2702) the leofoo development co., ltd. (2705) formosa international hotels corporation (2707) variables model i model ii model i model ii model i model ii const. 10.31 (7.59) 0.10 (0.09) 106.98 (81.09) 101.70** (47.14) 23.71 (16.21) -0.06 (0.14) rmrf 0.01 (0.01) -0.05 (0.07) -0.01 (0.02) usd 0.14 (0.14) 0.15 (0.33) 0.10 (0.20) jpy 0.03 (0.03) -0.01 (0.09) -0.05 (0.05) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 291 cny -0.09 (0.14) -0.38 (0.36) -0.21 (0.21) eur -0.05 (0.05) 0.09 (0.13) -0.00 (0.08) krw 0.02 (0.04) 0.28* (0.14) 0.20** (0.08) 0.04 (0.07) gbp 0.03 (0.05) -0.12 (0.17) -0.03 (0.08) sgd 0.05 (0.14) 0.51 (0.62) 0.41* (0.21) 0.06 (0.21) aud -0.04 (0.04) -0.04* (0.02) -0.21 (0.19) -0.20** (0.07) 0.06 (0.06) 0.09*** (0.03) idr 0.03 (0.03) 0.05** (0.02) 0.01 (0.13) -0.09* (0.05) -0.07** (0.03) thb 0.05 (0.06) 0.22 (0.20) -0.00 (010) myr -0.03 (0.07) -0.17 (0.21) -0.01 (0.11) php -0.04 (0.06) -0.07 (0.18) 0.09 (0.09) lag1 -0.83*** (0.18) 0.67*** (0.13) -0.91** (0.33) -0.76*** (0.18) -0.69*** (0.15) -0.57*** (0.12) lag2 -0.63*** (0.20) -0.49*** (0.14) -0.34 (0.34) -0.35** (0.17) -0.80*** (0.16) -0.67*** (0.12) lag 3 -0.45** (0.19) -0.45*** (0.11) 0.01 (0.33) -0.51*** (0.15) -0.35*** (0.11) lag4 0.01 (0.15) -0.04 (0.25) -0.13 (0.15) size -0.53 (0.36) -4.70 (3.57) -4.48** (2.08) -1.06 (0.73) adj. r2 0.46 0.51 0.03 0.32 0.38 0.44 obs. 59 58 32 32 58 58 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 292 table 4. regression on roa (continued) company first hotel company ltd. (2706) pleasant hotels international inc.(2718) chateau international development co., ltd. (2722) variables model i model ii model i model ii model i model ii const. -8.17 (15.86) -14.17* 37.34 (58.01) 0.71*** (0.12) -1957** (542.5) 0.29 (0.85) rmrf 0.01 (0.01) -0.12 (0.10) -0.06** (0.03) 3.33*** (0.79) usd 0.06 (0.05) 1.54 (1.07) 0.66*** (0.15) -13.15** (4.20) jpy 0.01 (0.01) -0.30 (0.12) 3.14*** (0.76) cny -0.05 (0.06) -1.36 (0.72) -0.78*** (0.14) 12.03** (3.78) eur 0.00 (0.02) -0.29 (0.20) -0.16*** (0.04) 7.60** (1.96) krw -0.00 (0.02) 0.23 (0.23) -5.31** (1.49) gbp -0.02 (0.03) -0.26 (0.38) -6.44*** (1.50) sgd -0.05 (0.07) -0.66 (0.43) -0.66** (0.11) 1.41 (0.74) 1.89** (0.85) aud -0.01 (0.02) 0.21 (0.13) 0.13** (0.05) -4.36*** (0.91) -0.58* (0.29) idr 0.03 (0.02) 0.20 (0.08) 0.22*** (0.03) 0.59* (0.24) thb 0.00 (0.04) 0.58 (0.32) 0.55*** (0.12) -13.42*** (3.22) myr -0.02 (0.03) -0.06 (0.16) 3.75** (0.96) php -0.04 (0.03) -0.04*** (0.01) -1.06 (0.43) 18.45** (4.82) lag1 -1.05*** (0.22) -1.21*** (0.14) -1.90 (0.46) -1.46*** (0.10) lag2 -0.28 (0.24) -1.46 (0.44) -1.13*** (0.12) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 293 lag 3 -0.47 (0.27) -0.98 (0.63) -0.44*** (0.10) lag4 0.34*** (0.10) -0.30*** (0.07) -0.22 (0.25) size 0.41 (0.72) 0.67* (0.34) -1.80 (2.85) 92.79** (25.69) adj. r2 0.81 0.82 0.84 0.93 0.78 0.16 obs. 32 32 20 20 20 20 table 4. regression on roa (continued) company janfusun fancyworld corp. (5701) the landis taipei hotel co., ltd. (5703) hotel royal chihpen(5704) variables model i model ii model i model ii model i model ii const. 29.91 (30.30) -0.12 (0.18) 55.80 (50.46) 0.13 (0.17) 32.16* (19.05) 0.00 (0.12) rmrf 0.04 (0.05) 0.06 (0.03) 0.07*** (0.02) 0.05** (0.02) 0.03** (0.01) usd -0.24 (0.31) 0.10 (0.24) 0.07 (0.17) jpy -0.01 (0.08) -0.11 (0.08) 0.07 (0.05) cny 0.38 (0.36) 0.10 (0.27) 0.22 (0.19) 0.22*** (0.07) eur 0.03 (0.12) -0.11 (0.10) -0.12* (0.07) 0.01 (0.07) krw 0.08 (0.12) 0.10* (0.05) 0.07 (0.09) 0.27*** (0.07) 0.17*** (0.04) gbp -0.24 (0.15) -0.16** (0.06) 0.00 (0.10) -0.09 (0.07) sgd 0.29 (0.37) -0.05 (0.24) -0.31* (0.18) -0.29*** (0.09) aud -0.10 (0.12) 0.22** (0.09) 0.20*** (0.06) 0.02 (0.06) idr 0.08 (0.11) -0.02 (0.06) -0.01 (0.04) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 294 thb -0.21 (0.18) -0.12 (0.12) -0.20** (0.08) 0.00 (0.09) myr 0.06 (0.17) -0.17 (0.13) 0.04 (0.10) php 0.06 (0.15) -0.02 (0.10) -0.10 (0.07) lag1 -0.65** (0.28) -0.64*** (0.16) -0.77*** (0.12) -0.77*** (0.09) -1.08*** (0.15) -0.99*** (0.09) lag2 -0.31 (0.36) -0.31* (0.16) -0.32** (0.14) -0.35*** (0.09) -0.83*** (0.18) -0.66*** (0.12) lag 3 0.09 (0.37) 0.01 (0.13) -0.71*** (0.19) -0.56*** (0.09) lag4 0.14 (0.26) -0.07 (0.11) -0.11 (0.16) size -1.35 (1.36) -2.68 (2.41) -1.58* (0.93) adj. r2 0.07 0.39 0.59 0.63 0.75 0.76 obs. 32 32 58 58 58 59 in table 4, almost all estimates of the lagged variables are significant and negative, such as, leofoo development co., ltd. (2705), formosa international hotels corporation (2707), janfusun fancyworld corp. (5701), the landis taipei hotel co., ltd. (5703), and hotel royal chihpen(5704).it implies that those road1 are mean-reverting. as the estimates of third-lagged variables are also significant, then we can conclude that there is a seasonal effect on the company’s roa. moreover, some estimates of size are significant in table 4. if it is positive, such as chateau international development co., ltd. (2722), then the company may increase its own assets to increase its road1 , so to its roa. hence, it can operate efficiently by its assets to generate profit and then to be a well-performed company. if the estimate of size is negative, such as those in leofoo development co., ltd. (2705) and fx hotels group inc. (2724-f), then the company may dispose some of its idle assets or non-performed assets to reduce the inefficient effect of these assets. as a result, the company’s roa will be improved. next, table 4 shows significant effects on the performances of taiwan hotel industry due to the fluctuations of foreign exchange rates. the changes of foreign exchange rates have significant impacts on the road1 s. some are positive and some are negative. the same currency has different impact on different companies. for example, singapore dollar has asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 295 positive effect on the road 1 of leofoo development co., ltd. (2705), chateau international development co., ltd. (2722), and on the roa of ambassador hotel ltd. (2704), but negative effect on that of pleasant hotels international inc.(2718) and hotel royal chihpen (5704). moreover, the australian dollar has positive effect on the road1 of formosa international hotels corporation (2707), pleasant hotels international inc. (2718), and landis taipei hotel co., ltd. (5703), and on the roa of ambassador hotel ltd. (2704), but negative effect on that of chateau international development co., ltd. (2722). and the korean won has a positive effect on the road1 of leofoo development co., ltd. (2705), janfusun fancyworld corp. (5701), hotel royal chihpen (5704), and then on those company’s roa. furthermore, the number of significant variables and the component of significant variables are different to each company. for example, the significant variables of the pleasant’s road1 are the change of usd, cny, eur, sgd, aud, idr, thb, however, that of the chateau’s road1 are only the changes of singapore dollar and australia dollar. as a result, the portfolio of currencies should be different for each company. table 5. regression on roe the regression model is given as follows: . , , , , , , , , titii n j tjji p k ktikitmiiti asizefxroedrmrfroed +⋅+δ⋅+⋅+⋅+=  == − δγφβα 11 11 model i regresses 1,,,1 −⋅⋅⋅ −≡ ttt roeroeroed on all exchange fluctuations, lagged variables and the control variables. model ii regresses roed 1 on all variables but selected by eliminating higher p-value explanatory variables. the values in the parentheses are standard error of the estimates. and *, ** and *** stand for 10%, 5% and 1% level of significance, respectively. company hotel holiday garden (2702) the leofoo development co., ltd. (2705) formosa international hotelscorporation (2707) variables model i model ii model i model ii model i model ii const. 8.39 (10.97) 0.14 (0.13) 550.62 (305.52) 232.88** (110.24) 28.18 (15.24) 0.10 (0.21) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 296 rmrf 0.01 (0.02) -0.07 (0.21) -0.03 (0.04) usd 0.24 (0.19) -1.77 (1.44) 0.05 (0.31) jpy 0.05 (0.05) 0.08** (0.03) -0.64* (0.33) -0.39** (0.14) -0.12 (0.08) -0.09* (0.05) cny -0.16 (0.20) 1.37 (1.40) -0.27 (0.33) -0.25** (0.11) eur -0.11 (0.08) -0.07* (0.04) -0.00 (0.34) -0.10 (0.13) krw 0.05 (0.06) 0.08* (0.04) 0.47 (0.46) 0.08 (0.11) gbp 0.00 (0.07) -0.19 (0.42) -0.04 (0.12) sgd 0.22 (0.20) 4.02** (1.70) 1.74** (0.62) 0.34 (0.34) 0.39** (0.19) aud -0.00 (0.20) -0.63 (0.50) 0.06 (0.10) idr 0.02 (0.05) 0.12 (0.28) -0.13* (0.07) -0.09* (0.05) thb 0.11 (0.09) 0.10* (0.06) -0.52 (0.77) 0.02 (0.16) myr -0.06 (0.11) -1.36** (0.56) -0.68** (0.29) -0.01 (0.18) php -0.11 (0.08) 0.92 (1.24) 0.05 (0.13) lag1 -0.90*** (0.15) -0.88*** (0.12) -1.27*** (0.37) -0.64*** (0.18) -0.61*** (0.15) -0.61*** (0.12) lag2 -0.67*** (0.19) -0.58** (0.15) -0.15 (0.43) -0.66*** (0.16) -0.63*** (0.12) lag 3 0.41** (0.19) -0.42*** (0.18) 0.20 (0.33) -0.49*** (0.16) -0.46*** (0.12) lag4 -0.04 (0.15) 0.33 (0.28) -0.01 (0.16) size -0.39 (0.57) -24.32 (13.46) -10.28** (4.86) -1.26 (1.13) adj. r2 0.51 0.54 0.16 0.32 0.30 0.39 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 297 obs. 58 58 27 27 58 58 table 5. regression on roe (continued) company first hotel company ltd. (2706) pleasant hotels international inc.(2718) chateau international development co., ltd. (2722) variables model i model ii model i model ii model i model ii const. -21.59 (37.72) 0.84** (0.38) 31.69 (89.17) 0.98*** (0.18) -2289** (737.7) -0.44 (1.05) rmrf 0.05* (0.02) 0.05*** (0.01) -0.15 (0.15) -0.08* (0.04) 3.87** (1.08) usd 0.39** (1.74) 0.12*** (0.04) 1.77 (1.66) 0.85*** (0.21) -15.42** (5.71) jpy 0.04 (0.03) -0.02 (0.18) 3.60** (1.03) cny -0.31* (0.16) -1.61 (1.12) -1.04*** (0.21) 14.08** (5.14) eur -0.05 (0.05) -0.37 (0.31) -0.24*** (0.06) 8.86** (2.67) krw -0.04 (0.05) 0.24 (0.35) -6.07** (2.03) gbp 0.01 (0.06) -0.35 (0.63) -7.56** (2.03) sgd 0.03 (0.14) -0.76 (0.72) -0.86*** (0.15) 1.93 (1.00) 2.46** (1.05) aud 0.03 (0.05) 0.25 (0.21) 0.16** (0.07) -5.22*** (1.24) -0.77** (0.36) idr -0.04 (0.05) 0.27 (0.13) 0.29*** (0.05) 0.77* (0.32) thb 0.05 (0.07) 0.77 (0.50) 0.74*** (0.17) -15.90** (4.38) myr -0.04 (0.06) -0.13 (0.25) 4.41** (1.30) php -0.08 (0.11) -1.32 (0.67) -0.93*** (0.23) 21.70** (6.56) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 298 lag1 -1.37*** (0.18) -2.88*** (0.37) -1.88 (0.55) -1.48*** (0.12) lag2 -0.31 (0.21) -0.82** (0.40) -1.50 (0.55) -1.15*** (0.13) lag 3 -0.19 (0.24) -0.99 (0.80) -0.44*** (0.11) lag4 0.50** (0.21) 1.86*** (0.36) -0.21 (0.29) size 1.06 (1.74) -1.51 (4.37) 108.51** (34.93) adj. r2 0.87 0.85 0.77 0.92 0.74 0.18 obs. 28 31 20 20 20 20 table 5. regression on roe (continued) company janfusun fancyworld corp. (5701) the landis taipei hotel co., ltd. (5703) hotel royal chihpen(5704) variables model i model ii model i model ii model i model ii const. 55.72 (141.90) 0.04 (0.42) 70.20 (69.75) -0.28 (0.23) 39.26* (21.32) 0.02 (0.14) rmrf 0.09 (0.33) 0.07 (0.04) 0.06** (0.02) 0.04** (0.02) usd 0.11 (1.45) 0.17 (0.33) 0.04 (0.19) jpy 0.12 (0.35) -0.15 (0.10) -0.15** (0.06) 0.08 (0.05) cny 0.01 (1.23) 0.11 (0.37) 0.28 (0.21) 0.25*** (0.08) eur 0.12 (0.45) -0.15 (0.14) -0.25*** (0.09) 0.02 (0.08) krw 0.37 (0.72) 0.08 (0.12) 0.30*** (0.07) 0.18*** (0.05) gbp -0.59 (0.43) -0.31** (0.14) -0.02 (0.14) -0.09 (0.08) sgd 0.16 (1.00) -0.09 (0.33) -0.36* (0.20) -0.32*** (0.10) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 299 aud -0.51 (0.37) -0.22* (0.11) 0.30** (0.12) 0.39*** (0.07) 0.01 (0.06) idr 0.23 (0.33) -0.03 (0.08) -0.01 (0.05) thb -0.42 (0.66) -0.11 (0.17) -0.00 (0.10) myr 0.51 (0.48) 0.36* (0.20) -0.23 (0.18) -0.24** (0.11) 0.05 (0.11) php 0.20 (1.13) -0.03 (0.14) -0.11 (0.08) lag1 -0.60* (0.31) -0.75*** (0.17) -0.76*** (0.13) -0.75*** (0.09) -1.09*** (0.14) -0.99*** (0.09) lag2 -0.29 (0.43) -0.52*** (0.17) -0.35** (0.15) -0.42*** (0.09) -0.83*** (0.19) -0.66*** (0.12) lag 3 0.30 (0.73) -0.01 (0.13) -0.73*** (0.19) -0.56*** (0.09) lag4 0.26 (0.48) -0.08 (0.11) -0.12 (0.16) size -2.50 (6.39) -3.37 (3.33) -1.93* (1.05) adj. r2 0.04 0.48 0.57 0.61 0.76 0.77 obs. 27 27 58 58 58 58 in table 5, model i regresses roed 1 on all exchange fluctuations, lagged variables and the control variables. model ii regresses roed 1 on all variables but selected by eliminating higher p-value explanatory variables. we may find that the results in table 5 are almost the same as in table 4. there is seasonal effect for taiwan hotel industry’s roe, too. and, roed1 of first hotel company ltd. (2706) and pleasant hotels international inc. (2718) are mean-reverting. moreover, the number of significant variables and the component of significant variables are different to each company. for example, the significant variables of the roe of landis taipei hotel co., ltd. (5703) are the changes of euro, japan yen, australia dollar and malaysian ringgit, but that of the chateau international development co., ltd. (2722) are the changes of euro, pound, chinese yuan, japan yen, korean won, singapore dollar, australia dollar, thailand baht, malaysian ringgit, and philippine peso. therefore, it supports the results in table 4, which the portfolio of currencies should be different for each company. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 300 table 6. regression on financial performances of the ambassador hotel the regression model is given as follows: . , , , , , , , , tti n j tjj p k ktktmt asizefxyrmrfy 27042704 1 2704 1 27042704270427042704 +⋅+δ⋅+⋅+⋅+=  == − δγφβα 2704y represents the performance of the ambassador hotel, that is, 2704roa or 2704roe . model i regresses 2704y on all exchange fluctuations, lagged variables and the control variables. model ii regresses 2704y on all variablesbut selected by eliminating higher p-value explanatory variables. the values in the parentheses are standard error of the estimates. and *, ** and *** stand for 10%, 5% and 1% level of significance, respectively. performance 2704roa 2704roe variables model i model ii model i model ii const. -25.80 (34.26) 0.28** (0.11) -34.80 (58.29) 0.25* (0.14) rmrf 0.02 (0.01) 0.15** (0.01) 0.03 (0.02) 0.03*** (0.01) usd -0.21** (0.09) -0.32** (0.15) jpy 0.01 (0.02) 0.02 (0.03) cny 0.22** (0.09) 0.34** (0.16) eur -0.05 (0.03) -0.05** (0.02) -0.08 (0.06) -0.08** (0.03) krw 0.01 (0.03) 0.03 (0.05) gbp 0.04 (0.03) 0.06 (0.06) sgd 0.10 (0.10) 0.14** (0.06) 0.17 (0.17) 0.26** (0.10) aud -0.02 (0.03) -0.05 (0.05) idr 0.01 (0.02) 0.02 (0.04) thb 0.02 (0.04) 0.04 (0.07) myr -0.11** (0.05) -0.10*** (0.04) -0.18** (0.08) -0.17*** (0.06) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 301 php 0.02 (0.04) 0.01 (0.07) lag1 0.20 (0.14) 0.26** (0.12) 0.30** (0.14) 0.32*** (0.11) lag2 -0.06 (0.16) -0.06 (0.15) lag 3 -0.12 (0.14) -0.10 (0.14) lag4 0.25* (0.14) 0.28** (0.11) 0.24* (0.14) 0.24** (0.11) size 1.13 (1.48) 1.52 (2.52) adj. r2 0.27 0.40 0.30 0.36 obs. 59 59 59 59 next, because taiwan’s foreign trade is mainly denominated in us dollars, taiwan foreign exchange market for a long time pegged to the dollar exchange rate. therefore, enterprises may have a greater proportion of dollar holdings. furthermore, due to the opening of chinese tourists to taiwan, it results in the hotel industry to increase its chinese yuan transaction needs, and thus roa/roe reflect the effect from the change of chinese yuan. in additional, taiwan is also the first choice for japanese and korean tourists traveling abroad, so accommodation of the korean won and the japanese yen in trading volume should not be underestimated. as shown in table 7, major hotels aggregated by taiwan’s tourism bureau in 2012 showed that the japanese and korean inbounds were over 1/5 of guests in the half of the hotels. for example, pleasant hotel located closed to the taoyuan international airport, and most chinese tourists stay at the hotel in order to conveniently entry and exit. both jang and chen (2008) and chen, jang and peng (2011) employed the modern portfolio theory to investigate the mixes of taiwan inbounds. they suggested that the government should take the high-reward/high-volatility option and shift more available resources to attract the japanese tourists. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 302 table 7. distribution of guests’ sources in 2012 hotel region royal hotel pleasant hotels (taoyuan) ambassa dor hotel landis taipei hotel formosa internatio nal hotels leofoo westin hotel holiday garden hotel farglory hotel domestic 55.2 18.0 34.0 24.2 21.3 9.7 61.2 94.9 oversea chinese 0.0 7.7 1.9 6.4 0.0 0.0 1.0 0.0 mainland 6.35 56.35 13.29 11.08 11.5 19.4 22.45 3.9 north american 4.7 0.3 6.9 10.3 8.4 20.8 0.8 0.2 japan 21.9 2.1 29.9 29.9 36.7 17.3 7.0 0.1 asian (exclusive japanese) 5.0 9.2 8.2 8.4 15.3 25.9 6.5 0.5 european 2.5 0.3 3.8 7.5 4.7 4.3 0.5 0.1 australia 0.3 0.0 0.4 1.8 0.9 1.4 0.5 0.0 others 4.1 6.1 1.6 0.4 1.2 1.2 0.0 0.3 total (%) 100 100 100 100 100 100 100 100 source: tourism bureau, m.o.t.c., republic of china (taiwan). kim (2013) discussed of foreign exchange position and make recommendations in table 8.in table 4,5, and 6, a portfolio of currencies that has significant impacts on the company’s roa/ roe can be formed. markowitz (1952) proposed the modern portfolio theory that based on the weighted each company the average cost of capital (wacc), and along with the calculation of matlab programs for foreign exchange positions, an optimum allocation of currencies can reach the lowest degree of risk under a pre-specified rate of return constraint. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 303 table 8. optimal portfolio of foreign currencies for each company. company 2702 2704 2705 2706 2707 2718 usd 0.00 6.35 gbp 62.18 eur 20.47 13.79 jpy 2.32 1.30 2.09 0.00 krw 3.84 1.56 30.56 cny 0.00 19.47 0.00 aud 52.35 83.81 74.37 sgd 84.35 3.84 0.00 idr 1.73 6.16 7.14 myr 1.85 9.94 5.17 5.53 thb 0.00 php 0.00 7.19 wacc (%) 10.00 12.00 13.50 12.80 9.50 12.60 portfolio risk (%) 0.431 1.850 0.513 2.501 0.356 0.458 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 304 table 8. optimal portfolio of foreign currencies for each company. (continued) currency 2722 2724 5701 5703 5704 full usd 3.27 2.26 0.00 gbp 2.24 34.33 0.29 eur 6.04 44.14 jpy 0.00 0.00 0.11 0.00 krw 6.07 0.31 0.76 14.90 0.07 cny 5.17 4.47 13.80 1.49 aud 73.79 82.84 85.53 79.93 9.41 sgd 0.00 0.00 0.00 0.00 idr 5.47 36.97 0.52 myr 4.66 11.47 13.03 0.64 thb 0.90 0.00 php 43.44 wacc (%) 10.60 9.80 13.20 11.50 9.80 12.20 portfolio risk (%) 0.515 0.481 0.520 0.476 2.062 0.055 the results in table 8 show the optimal allocation of currencies for each company. japanese yen, korean won, chinese yuan, australian dollar and malaysian ringgit configuration still play significant roles among those target companies, including leofoo development co., ltd. (2705), formosa international hotels corporation (2707),pleasant hotels international inc.(2718), chateau international development co., ltd. (2722), fx hotels group inc. (2724-f), janfusun fancyworld corp. (5701), the landis taipei hotel co., ltd. (5703).the configuration of the australian dollar reached 52.35%, 83.81%, 44.37%, 73.79%,85.48%, 82.84%, 85.53% and 79.93 %, respectively, more than 50% have switched. hotel holiday garden(2702), leofoo development co., ltd. (2705), first hotel company ltd. (2706), chateau international development co., ltd. (2722),fx hotels group inc. (2724-f), janfusun fancyworld corp. (5701), and landis taipei hotel co., ltd.(5703) for the korean asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 305 won configuration, respectively, 3.84%, 1.56%, 30.56%, 6.07%,0.31%, 0.76%, and 14.90. as to chinese yuan, formosa international hotels corporation (2707), chateau international development co., ltd. (2722), fx hotels group inc. (2724-f), and hotel royal chihpen(5704) should put the weight ranging from 4.47% to 19.47%. 6. conclusions in recent years, the changes in exchange rates significantly affect a company’s performances, such as, roe, roa, etc. faced with the dramatic changes in the international economic environment, many central banks continue to adopt a more aggressive monetary policy, such as, negative interest rates by bank of japan, the monetary easing by ecb, and monetary easing by people's bank of china. likewise, the gradual recovery of the economy of the united states have taken actions to raise interest rates. the auspices of monetary policy in these countries shows that the currencies flow across countries and international hot money have allowed changes in exchange rates. under these actions of monetary policies, enterprises in taiwan need to actively adopt configuration to reduce the negative impact. changes in the foreign exchange market in the past is not as dramatic as in today. in addition to monetary policies that attract more investors to the market, the investment of foreign exchange market as well significantly affect the change in exchange rates among countries. therefore, a positive formal foreign exchange risk management will better help for future operation, which can significantly reduce the risk of foreign exchange movements. this study found that hotels in taiwan, accounting for the largest part of the tourism industry, are subject to have the impacts on their performance and profitability due to the exchange rate fluctuations. enterprises may apply the results to manage their foreign exchange risk exposure, and then increase the overall capabilities and range of enterprise risk management (erm).by doing so, companies can increase their profits and reduce the negative impacts of exchange rate changes on corporate roe/roa through foreign exchange operations. more importantly, foreign exchange allocation can be a strategy to reduce the risk of foreign exchange exposure. references addae a. a., m. nyark-baasi, & m. tetteh. 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(1995). forecasting tourism demand: a review of empirical research. international journal of forecasting, 11(3), 447-475. https://doi.org/10.1016/0169-2070(95)00591-7. microsoft word 4527-16711-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 402 the reflection of applying new developed approaches in accounting information system on investment and credit decisions in commercial banks in aqaba special economic zone mousa mohammed abdullah saleh head of department of administrative and financial sciences al-balqa applied university, aqaba university college dr. ziad odeh ebniah al amaideh department of accounting, faculty of business administration mutah university dr. haitham mahmoud abudalla baniatta department of finance & administrative science, ajlun university college al-balqa applied university dr. ashraf mohammad salem alrjoub department of administrative and financial science, irbid university college al-balqa applied university received: nov. 8, 2013 accepted: january 25, 2014 published: june 1, 2014 doi:10.5296/ajfa.v6i1.4527 url: http://dx.doi.org/10.5296/ajfa.v6i1.4527 abstract this study aimed at investigating the applicability of applying commercial banks in aqaba to the modern methods of accounting information systems in its accounting and usefulness of such data when making decisions related to the interests of the banks and their customers credit and investment interests and achieve client satisfaction, and if there are differences between those banks in the application of those regulations and the degree of utilization. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 403 study sample consisted of (10) commercial banks in the aqaba special economic zone, which have been selected based on the level of cooperation we got from the 17 banks. the study found that the use of modern methods of accounting information systems in banks in the aqaba special economic zone have an impact on administrative decisions of the managers. the prepared budget based on modern accounting systems do not provide expected and accurate information to help the credit protection of the bank keywords: commercial banks, accounting information systems, reflection, investment, credit decisions, aqaba special economic zone asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 404 1. introduction banks have expanded in its work and functions to a new aspects due to the complexity of bank business in the world, and the change of the banks strategies in gaining customers and keeping them, it became important to it to have enough credit protection to keep the money of their clients and increase expected return from them to the customers, and to increase the proportion of revenues charged by banks. banks also play a vital role in the national economy through the dual role played by the compilation of national savings and accepting it in the form of deposits for generations on the one hand, and meanwhile employ the a large part of these deposits and savings in the form of credit facilities and loans to benefit all sectors of the national economy to fund its operations. add to that the many customers of those banks have resorted to it for advice and consulting on the assumption that these banks perform it work on a scientific basis, studies and deeper and wider experience than they have. and because those banks are designed to maintain and service their customers so they are required to provide all the data and information they require. there for taking any credit or investment decision are a picture of the administrative and accounting system of the bank strength and durability and the accuracy of their expectations and data and the sensitiveness of its forecasts. the accounting system applications have developed because of the of technology developed in the world, and jordan is the fastest in using it. the use of these banks for this new technology will help them in providing data and information that suits the speed of changes in the world economic and financial markets, and will save time and effort for financial analyst as the modern accounting software provide information and rates that may help him in these banks to keep up with events and changes and taking the appropriate decisions at the appropriate time. 2. the importance of the study the importance of the study came by linking modern methods in the modern accounting information systems with the environment of the commercial banks in aqaba region taking into account that banking sector is an active sectors in jordan's economy. as the infrastructure of the information technology is one of the most important components of accounting information systems, so knowing the impact of methods on technological considerations must get some sort of attention, especially with regard to the impact of those methods on accounting information systems and thus the commercial banks in aqaba city, having this in mind the study aims to: stating the most important methods used in the use of accounting information systems stating the most important international standards issued by the international accounting conferences with regard to accounting information systems asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 405 studying the reality of accounting information systems used in terms of the extent of the application of the methods to modernize and develop of such systems and the degree of their influence on the decision-making process in the commercial banks in the aqaba region show the impact of the methods used in the area of accounting information systems and its impact on credit and investment decision-making in business banks in the aqaba region. and with developments in accounting information systems in recent years, in the area of planning, control systems, management systems and quality properties of its output is expected to claim those methods to more efficiency and effectiveness in decision-making. the key role played by the output of accounting information systems in decision-making requires an in-depth study on the impact of methods and techniques used in the design and development of accounting information systems to increase its effectiveness and the efficiency of the decision-making process in investment banks in the city of aqaba but this impact goes over to pursue multiple aspects of work after decision-making, because the higher management can’t take its decisions and draw its policy properly without specification of the quality and quantity of information provided to management with a degree of detail and analysis with precision and objectivity when delivering it taking into account providing these accounting information in appropriate time. 3. the objective of the study the study aims to determine the extent of the application of commercial banks in aqaba to modern methods of accounting information systems in its accounting and usefulness of such data when making decisions related to the interests of the banks and their customers in their credit and investment and achieve client satisfaction, and if there are differences between those banks in the application of those regulations and the degree of utilization. the study also aims to measure the level of credit risk that the bank will face if it decided to approve granting a client a certain amount of credit facilities, through information supplied by the modern accounting systems, giving credit is always accompanied by risk, and this is due to the banking fact is that: "no credit without risks" so we use this study to see what benefit that modern accounting system provide to reduce these risks, and try to reach a situation where we can be most sure . and also aims to find the impact of application of modern accounting information systems and the evolution of its technologies, tools and it techniques and complexity and its impact on the efficiency and the performance of these systems which deal with banks on investment and credit transactions to improve and develop working procedures for the benefit of efficiency of these decisions. 4. problem of the study taking any decision is considered as preferring one alternative from a range of alternatives based on thorough and sufficient analysis for the event, the problem or the situation. financial resolution is one of the most important decisions taken by the banks for individuals, because its impact is reflected and quickly shown as either a profit or loss. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 406 banking institutions are based on full financial dealing therefore its strategies are based on protecting the deposited funds, increasing its revenues and maintaining the customers. financial decision making at the moment requires knowledge of the variables and the quickness of the procedure. and this can only be accessed through modern accounting systems that provide sufficient data and information, financial ratios and accurate financial analysis to help credit and investment decision taker to make that decision on the basis of being sure, accurate and in the required speed, to protect the bank and the customer at the same time. therefore, we believe that modern accounting information systems will help in taking sound, valid, conform to the reality financial decisions (investment and credit) and with acceptable effect to the bank and the customer. 4.1. the following questions can be formulated through the problem of study 1. do commercial banks operating in the aqaba region apply modern methods in accounting information systems? 2. do banks benefit from the modern methods in accounting information systems in credit and investment decision-making in the banks operating in the aqaba region? 3. do managers and staff in banks benefit from the modern methods of accounting information systems in aqaba in their decisions? 4. do the clients of commercial banks operating in aqaba benefit from information provided by modern accounting information systems in rationalizing their credit and investment decisions and in choosing their appropriate investment portfolio for them? 5. is there a strong correlation between the output of modern accounting information systems and credit and investment decisions in banks operating in the aqaba region? 5. methodology descriptive and analytic methodology (experimental) has been used in this study to describe, interpret and analyze everything related to computerized accounting information systems. 5.1. study community study community consists of all the (17) commercial banks in aqaba. 5.2. study sample study sample consisted of 10 banks which were chosen based on the level of cooperation that we have received from banks. 5.3. hypotheses of the study a. commercial banks operating in the aqaba region apply modern methods in accounting information systems asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 407 b. banks benefit from the modern methods in accounting information systems in credit and investment decision-making in the banks operating in the aqaba region c. managers and staff in banks benefit from the modern methods of accounting information systems in aqaba in their decisions d. the clients of commercial banks operating in aqaba benefit from information provided by modern accounting information systems in rationalizing their credit and investment decisions and in choosing their appropriate investment portfolio for them. e. there is a strong correlation between the output of modern accounting information systems and credit and investment decisions in banks operating in the aqaba region 5.4. study limitation a. place limitation: researcher meant by this the commercial banks operating in the aqaba special economic zone. b. time limitation: the researcher applied field procedures for study tools on commercial banks operating in aqaba during 2010/2011. 6. previous studies al mushrike study entitled” the role of information technology in analyzing problems and decision making in the industrial service organizations”. the study used the descriptive analytical approach that depends on the theoretical studies which have interest in studying the way that these industrial service organizations are managed by through using the appropriate technology for each one to reach the stage of making organizational decisions in them to reach higher or lower payments. the information systems based on the computer may support the organizational decision through facilitating the communication process between the participants in the decision making. the study recommended the amendment of the technology to suite the strategies of the service organizations, and the necessity to make harmony between the routine decision for the department and the non routine ones. the first type requires routine information (frequent and detailed) the second type requires information that is non-routine which means that the taken decision require skills and time), they are substantive decisions affect the whole organization 1. khaled (2004) study, entitled: “evaluate the performance of the accounting systems of computer-based appropriateness to meet management needs”. this study aimed to evaluate the performance of the computer-based accounting systems in the services and trade sector from various dimensions, (technical, behavioral and human) through the identification of the extent of efficiency and effectiveness as in the performance of its tasks, from human side to identify the satisfaction expressed by users of these systems and outputs. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 408 this study aimed to analyze some factors effecting the performance of these systems, the results of the study have shown that systems have a significant degree of effectiveness in achieving its objectives it showed that it is recognized with their ease of use and handle, speed and accuracy in it input and manipulating data with flexibility and integration with internal functions with other systems so you can enter adjustments to suit the environment and user needs. this makes it able to perform the required functions and to maintain a level of performance in different circumstances, and is recognized by a quality set of rules and control procedures that supports accuracy and increases the possibility of depending on it. the study recommends giving priority to environmental systems benefit from the modern technological methods such as networks and the internet, the user participation in systems development and design. it also recommends accounting students to develop their capacities and skills in the area of computer and learning how programming and design of such systems, the study also recommends assessing the performance of accounting systems based on computer in the service and commercial sectors. 2. sharif study (2006): "risk of electronic accounting information systems " this study aims to identify the risks of electronic accounting information systems in bank, identified the main causes that lead to such risks and actions to prevent those risks. the following conclusions have been reached: good management can reduce or limit the occurrence of risks facing the bank accounting information systems. application of information systems security procedures reduces the potential risk of accounting information systems. 3. almhasnh study (2005): "the impact of the efficiency of information systems in the effectiveness of the decision-making process". the study aims to identify the impact of the efficiency of information systems in the effectiveness of the process of making decisions, the study recognize the role of managers in the organizations in providing a basic rule of inclusiveness and specialized information systems to strengthen their role in sound decision-making. the most important results of the study indicate the impact of information systems to support physical, financial, technical, human and administrative in defining the problem and developing and comparing alternatives in control and follow-up. the study recommended that senior management should provide support to users through encouraging them to use the system, identify their needs, participate in the development of computerized information system, strengthening the relationship between users of information systems and the responsible people of this system then later set up training programs for users and increased attention to the human and material inputs and finance. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 409 4. seam (2004): "assessment of the effectiveness of computerized accounting information systems in jordanian commercial banks under technological development." this study aimed to evaluate the effectiveness of information systems and accounting systems in jordanian commercial banks under technological development through a set of agenda that reflects the effectiveness of the performance of such systems of quality and flexibility, simplicity and reliability. the study concentrates on the role of accounting information systems as a backbone between information systems in banks, by what these systems of accounting information summarizing the events and processes that have been used in the bank, and the resulting information necessary for effective decision-making. the results of the study showed that the computerized accounting information systems in commercial banks of jordan are characterized by the availability of four characteristics (quality, flexibility, simplicity, reliability). 5. abdel raziq (1993), entitled: "the use of computer information in administrative decisions relating to planning and control functions", applied study in jordanian general corporate companies ". this study was to determine the extent of the use of accounting information in administrative decisions relating to planning, controling functions and application to all (41) jordanian industrial corporations listed in amman financial market. one of the most important findings of the study that most jordanian industrial companies use accounting information, and convergent rates when making administrative decisions concerning the planning function or control or both of them. 6. kokhon (1988), the accounting control under electronic systems and their applications in the jordanian central bank. this study aimed to follow the procedures established in the department of computer control in the central bank of jordan, in its electronic accounting, compared to the control procedures that should be followed to enable checking control procedures and follow the latest scientific methods in the application of these procedures, the researcher used in her study the descriptive and analytical study of accounting control procedures in the electronic financial systems:. the study focused on the accounting control procedures, both the general control and the control on the application in computer service, and electronic accounting system, the study of electronic accounting system in the jordanian central bank and regulatory procedures followed in both phases of the system input stage or stage of data processing or output stage. 6.1. the most important characteristic of our previous studies the most important feature of our previous studies that it taken into account all affecting participant on accounting systems and its modern methods: bank managers/staff of the banks/investors/customers. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 410 the study results was also characterized by the ability to circulate its results to all banks (commercial and investment) because all the banks uses trade as a major activity of its dealings, given its high profitability. through the review of previous studies, it has been utilized in the theoretical side of the study as follows: 1. studying accounting information systems impact on the decision-making process of the bank. 2. factors affecting accounting information systems (environmental, organization ...). 3. the extent to which management depend on information systems in connection with decision making. 6.2. data analysis and hypothesis testing tool consistency: * the consistency of the tool has been tested by using cronbach's alpha, looking at table 1 we can notice the following: 1. alpha value for the application of modern methods in accounting information systems dimension was 0.84 2. alpha value for benefit from modern methods in decision-making dimension was 0.64 3. alpha value for the effect of using modern methods on administrative decisions dimension was 0.69 4. alpha value for customers benefit form information in rationalizing their decisions dimension was 0.85 5. alpha value for relationship between systems output with credit decisions and investment dimension was 0.6 6. alpha value to all paragraphs combined was 0.91 all these values are greater than 0.60 which means that the study tool is consistence. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 411 table 1. results of cronbach's alpha: dimension alpha value application of modern methods in accounting information systems 0.843 benefit from modern methods in decision-making 0.640 the effect of using modern methods on administrative decisions 0.697 customers benefit from information in rationalizing their decisions 0.065 relationship of output systems with investment and credit decisions 0.686 total 0.911 tool reliability: the reliability of the tool has been checked through: 1. displaying it to a number of arbitrators to make sure that all paragraphs reflect the areas to which they belong. in the light of the observations some paragraphs were amended to become clearer in terms of language and belonging to the dimension. 2. honesty of the tool has been confirmed also by using factor analysis tool to check how phrases are related to the dimension to which they belong to. description of demographics and profile of respondents: first: sex: table 7 shows that 63.5% of the sample was male and the rest are female. table 7. frequency and the percentage of gender variable gender frequency percentage% male 54 63.5 females 31 36.5 second: age table 8 shows that 42.4% of the sample were between 25-34 years, 30.6% of the respondents aged less than 25, 21.2% aged 35-44 years old, and 5.9% equal to or over the age of 45. table 8. frequency and the percentage of age variable age frequency percentage% less than 25 26 30.6 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 412 2534 36 42.4 35-44 18 21.2 = or greater than 45 5 5.9 third: qualification table (9) shows that 77.6% of the study sample are bs holders, 15.3% diploma, 4.7 master's degrees and 2.4% are secondary or less. table 9. frequency and the percentage of qualification variable qualification frequency percentage% secondary and below 2 2.4 average diploma 13 15.3 bs 66 77.6 master 4 4.7 md fourth: specialization table 10 shows that 40.0% of sample is accounting specialization, 18.8% of respondents are business management specialization, and 16.5 percent are financial sciences specialization, 7.1%, of them are economic and 17.6% from other disciplines. table 10. frequencies and the percentage of specialization variable specialization frequency percentage% accounting 34 40.0 business 16 18.8 economy 6 7.1 financial science 14 16.5 other 15 17.6 fifth: years of experience: table 11 shows that 43.5% of sample experiences is from one to 5 years and 24.7% of them their experience is over than or equal to 10 years. and 21.2% of them their experience is between 5-or less than 10 years. and 10.6% are less than one year of experience. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 413 table 11. frequencies and the percentage of experience variable experience frequency percentage% less than a year 9 10.6 1. less than 5 37 4305 5. less than 10 18 21.2 =, greater than 10 21 24.7 hypothesis testing and results of the analysis hypothesis 1: commercial banks operating in the aqaba special economic zone apply modern methods in accounting information systems. table 12 shows the following: with the exception of paragraphs 7, 8, all other paragraphs got arithmetical mean bigger than 3.00 and observation level less than 0.05, i.e. it is statistically significant, meaning that all these things are available. paragraph no. 4 which measures the extent of using modern methods of accounting information systems came in the first place with 4.31 arithmetical mean. paragraph no. 1 which measures the extent of using modern methods for accounting information systems planning in second place with 4.29 arithmetical mean. paragraph no. 9, which measure the effectiveness of electronic devices available in banks last place within statistically acceptable paragraphs with 4.01 arithmetical mean. paragraph no. 7 though arithmetical mean was greater than 3.00 but the observation level was greater than 0.05, i.e. it does not use modern methods to develop accounting information systems. paragraph no. 8 got 3.19 arithmetical mean which is greater than 3.00, the observation level was greater than 0.05 i.e. is not statistically significant, i.e. it does not use modern methods to develop the skills of interaction between users of accounting information systems and those systems. all paragraphs have got 3.96 arithmetical mean, the observation level is 0.00 which is less than 0.05. i.e. the first hypothesis is accepted, which means that any commercial banks operating in the aqaba special economic zone apply modern methods in accounting information systems. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 414 table 12. arithmetic mean, standard deviation and the value of t and observation level related to the application of modern methods in accounting information systems no. paragraph arithmetic mean standard deviation t value observation level 1. organization uses modern methods of accounting information systems planning 4.29 0.67 17.82 0.00 2. organization uses modern methods of accounting information systems security 4.28 0.76 16.00 0.00 3. organization employs modern methods of accounting information systems 4.22 0.76 14.81 0.00 4. organization uses modern methods of accounting information systems application 4.31 0.74 16.26 0.00 5. organization uses modern methods to support accounting information systems 4.13 0.80 13.04 0.00 6. organization employs modern methods to monitor the performance of accounting information systems 4.14 0.77 13.60 0.00 7. organization uses modern methods to develop accounting information systems applied in it 3.09 1.02 0.85 0.40 8. organization employs modern methods to develop the skills of interaction between users of accounting information systems and those systems 3.19 1.10 1.58 0.12 9. electronic devices available to the bank are of a high efficiency 4.01 1.01 9.27 0.00 total 3.96 0.47 18.88 0.00 hypothesis 2: banks benefits from modern accounting information systems in credit and investment decision-making in commercial banks operating in the aqaba special economic zone. table 13 shows the following: with the exception of paragraphs, 12 all other paragraphs got arithmetical mean bigger than 3.00 and observation level less than 0.05, i.e. it is statistically significant. paragraph no. 10 which measures the extent to which modern accounting systems help in determining the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 415 amount of the loan that may be granted for investment came in the first place with 4.27 arithmetical mean. paragraph no. 15 which measures the extent to which modern accounting systems help in determining the amount of time required to repay the loan in second place with 4.25 arithmetical mean. paragraph no. 13, which measure the impact of modern methods of accounting information systems to make a decision last place within statistically acceptable paragraphs with 4.14 arithmetical mean. paragraph no. 12 arithmetical mean was greater than 3.00 but the observation level was greater than 0.05, i.e. the banks don’t make any studies on investment stages to be distributed to shareholders. all paragraphs have got 4.05 arithmetical mean, the observation level is 0.00 which is less than 0.05. i.e. the second hypothesis is accepted, that banks benefit from modern accounting information systems in credit and investment decision-making in commercial banks operating in the aqaba special economic zone table 13. arithmetic mean, standard deviation, the value of t and the level of significance of taking advantage of modern method in decision-making no. paragraph arithmetic mean standard deviation t value observation level 10. modern accounting systems are used in determining the amount of the loan that could be granted for client investment. 4.27 0.73 16.05 0.00 11. application of modern methods in accounting information systems is important for bank action 4.22 0.90 12.47 0.00 12. bank conduct studies on investment stages and distributes it to shareholders. 3.05 0.83 0.52 0.60 13. modern methods of accounting affect information systems for decision-making. 4.14 0.73 14.49 0.00 14. accounting information system is features with the speed of the connection between itself and its users. 4.21 0.73 15.40 0.00 15. modern accounting systems help in determining the time required to repay the loan. 4.25 0.65 17.61 0.00 16. modern accounting systems help in accelerating the decision-making process in credit 4.21 0.76 14.75 0.00 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 416 and investment commercial banks. total 4.05 0.38 25.29 0.00 the third hypothesis: the use of modern methods of accounting information systems in banks in the aqaba special economic zone has an impact on administrative decisions made by managers. table 14 shows the following: with the exception of paragraphs 23 all other paragraphs got arithmetical mean bigger than 3.00 and observation level less than 0.05, i.e. it is statistically significant. paragraph no. 21 which measures the extracted estimated financial statements under modern methods to reduce credit risk, came in the first place with 4.26 arithmetical mean. paragraph no. 22 which measures the extent to which modern accounting information systems identifying the functions of staff to facilitate their work in second place with 4.21 arithmetical mean. paragraph no. 19, which measure the support of information of accounting information systems managers to better distribution of investment resources for the bank last place within statistically acceptable paragraphs with 4.00 arithmetical mean. paragraph no. 23 arithmetical mean was greater than 3.00 but the observation level was greater than 0.05, i.e. that there is difficulty in the use of accounting information systems or part of it. all paragraphs have got 4.00 arithmetical mean, the observation level is 0.00 which is less than 0.05. i.e. the second hypothesis is accepted, the use of modern methods of accounting information systems in banks in the aqaba special economic zone has an impact on administrative decisions made by managers. table 14. arithmetic mean, standard deviation and the value of t and observation level related to effect of suing modern method in making administrative decisions n o. paragraph arithmetic mean standard deviation t value observati on level 17 . accounting information systems provide mangers need to finish jobs and make their decisions in the expected way. 4.19 0.91 12.09 0.00 18 . modern accounting information systems benefits in helping the mangers to determine the available amount of money for investment. 4.05 0.71 13.68 0.00 19 . modern accounting information systems benefit managers in the best 4.00 0.80 11.50 0.00 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 417 distribution for the special investments in the bank 20 modern accounting information systems offer information on balance of loan at any time to help managers to take the appropriate decision. 4.19 0.68 16.08 0.00 21 estimated financial statements extracted under modern methods helps in reducing credit risk. 4.26 0.76 15.30 0.00 22 modern accounting information systems is working on identifying the functions of staff to facilitate their work. 4.21 0.80 13.91 0.00 23 there is no difficulty in using accounting information systems or part of it. 3.12 0.93 1.17 0.25 total 4.00 0.44 20.78 0.00 hypothesis 4: clients of commercial banks benefit from information provided by modern accounting information systems in credit and investment decisions on rationalization and choosing the appropriate investment portfolio. table 15 shows the following: all paragraphs got arithmetical mean bigger than 3.00 and observation level less than 0.05, i.e. it is statistically significant. paragraph no. 28 which measures the extent of usefulness of specific evaluated accounting systems in modern accounting systems in reducing the risks of credit offered to clients came in the first place with 4.19 arithmetical mean. paragraph no. 29 which measures the extent to which modern accounting information systems helps in providing the customer with a return on each investment tool available in the bank in second place with 4.12 arithmetical mean. paragraph no. 19, which measure the supporting of accounting information systems for customer diversification of investment instruments in their investment portfolio last place with 4.01 arithmetical mean. all paragraphs combined have got 4.08 arithmetical mean, the observation level is 0.00 which is less than 0.05. i.e. the fourth hypothesis is accepted, clients of commercial banks benefit from information provided by modern accounting information systems in credit and investment decisions on rationalization and choosing the appropriate investment portfolio. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 418 table 15. arithmetic mean, standard deviation and the value of t and observation level related to customers benefiting form information in rationalizing their decisions no. paragraph arithmetic mean standard deviation t value observation level 24 accounting information systems help clients for better to diversify their portfolios investment tools. 4.01 0.84 11.13 0.00 25 modern accounting information systems benefit in assisting the client to choose the appropriate investment portfolio for his orientation. 0.00 4.06 0.70 14.02 0.00 26 modern accounting systems helps to determine the appropriate time to make various credit services to customers. 4.08 0.85 11.77 0.00 27 accounting systems provide information on the bank's credit ceilings for each client. 4.00 0.67 13.71 0.00 28 estimated accounting systems specified according to the in modern accounting systems to reduce credit risks for customers. 4.19 0.68 16.08 0.00 29 modern accounting information systems provides the customer with a return on investment of each tool available in the bank 4.12 0.73 14.11 0.00 30 modern accounting information systems offers information on each customer balance quickly. 4.09 0.87 11.63 0.00 total 4.08 0.41 24.24 0.00 hypothesis 5: there is a strong relationship between output of modern accounting information systems and credit and investment decisions in the commercial banks in the aqaba special economic zone. table 16 shows: with the exception of paragraphs, 35 all other paragraphs got arithmetical mean bigger than 3.00 and observation level less than 0.05, i.e. it is statistically significant. paragraph no. 34 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 419 which measures the use of the published accounting reports in providing data about the client in terms of top roof for credit that can be granted to the customer, came in the first place with 4.14 arithmetical mean. paragraph no. 37, which measures the availability of modern accounting systems that accept the credit risk of the bank in second place with 4.07 arithmetical mean. paragraph no. 33, which measure the help provided to the client from the information of the modern information accounting systems in making his investment portfolio through its systems in the published financial statements last place within statistically acceptable paragraphs with 3.98 arithmetical mean. paragraph no. 35 arithmetical mean was greater than 3.00 but the observation level was greater than 0.05, i.e. the prepared budget on the basis of modern accounting systems do not provide accurate information to helps the bank in credit protection. paragraph 38 got arithmetical mean greater than 3.00, and the observation level greater than 0.05, so it's not statistically significant, meaning that modern accounting systems are not useful in identifying areas where the bank could invest in. all paragraphs have 3.83 arithmetical mean, the observation level is 0.00, which is less than 0.05. i.e. the fifth hypothesis is accepted, there is a strong relationship between output of modern accounting information systems and credit and investment decisions in the commercial banks in the aqaba special economic zone. table 16. arithmetic mean, standard deviation and the value of t and observation level related to the relation between the systems output and the investment and credit decision no. paragraph arithmetic mean standard deviation t value observation level 31 bank employees benefit from published financial statements in weighting investment decisions. 4.05 0.84 11.44 0.00 32 bank employees benefit from published financial statements in the weighting of credit decisions. 4.02 0.77 12.24 0.00 33. information of modern accounting information systems helps client in configuration of his portfolio through the what is provided in the system of the published financial statements 3.98 0.65 13.76 0.00 34 published accounting reports are used in providing data on the 4.14 0.62 16.97 0.00 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 420 client in terms of top roof for credit that can be granted to the client. 35 prepared budget on the basis of modern accounting systems provides unexpectedly accurate information that helps the bank to credit protection 3.14 1.14 1.15 0.26 36 modern accounting systems provide good credit protection for banks through the identification of appropriate ceiling for credit. 4.04 0.70 13.68 0.00 37 modern accounting systems provide the extent of credit risk that bank accepts 4.07 0.75 13.12 0.00 38 modern accounting systems helps in determining the areas in which the bank invest in 3.20 1.01 1.83 0.07 total 3.83 0.41 18.63 0.00 results the study found the following results: 1. commercial banks operating in the aqaba special economic zone apply modern methods in accounting information systems. 2. modern methods are not used to develop accounting information systems applied in them. 3. modern methods are not used to develop the skills of interaction between users of accounting information systems and those systems 4. banks benefit from modern accounting information systems in credit and investment decision-making in commercial banks operating in the aqaba special economic zone. 5. banks don't prepare studies on investment stages to be distributed to shareholders. 6. the use of modern methods of accounting information systems in banks in the aqaba special economic zone has an impact on administrative decisions for the managers. 7. there is a difficulty in the use of accounting information systems or part of it. 8. clients of commercial banks benefit from information provided by modern accounting information systems in rationalizing their credit and investment decisions and choosing the appropriate investment portfolio. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 1 www.macrothink.org/ajfa 421 9. there is a strong relationship between output of modern accounting information systems and credit and investment decisions in the commercial banks in the aqaba special economic zone. 10. finical budget prepared on the basis of modern accounting systems do not provide accurate and expected information to help the bank in credit protection 11. modern accounting systems are useful in identifying areas where the bank could invest in them. recommendations the study recommends the following: 1. banks in aqaba should use modern methods to develop accounting information systems applied to it. 2. the study recommends using modern methods to develop interaction skills between users of accounting information systems and those systems. 3. the need to prepare studies on investment stages to be distributed to shareholders. 4. trying to overcome the difficulty of using accounting information systems or any part of it. 5. working on the development of finical budget prepared on the basis of modern accounting systems that provide accurate and expected information to help the bank credit protection 6. activation of modern accounting systems to be able to identify areas where bank could invest in. 7. the study recommends the need for continuous improvement in accounting information systems for its positive role in credit and investment decision-making. 8. making further studies on the role of modern methods in accounting information systems in decision making other than credit and investment decisions. references abed al razak mohammed qasim. 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(2004). information systems analysis and design, first edition, publishing house of culture. microsoft word 11150-41119-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 261 determinants of banks’ capital structure: evidence from vietnamese commercial banks tong trung tin, mba dept. of business, chung yuan christian university no. 200, zhongbei road, zhongli district, taoyuan city, taiwan tel: 886-0938650687 e-mail: trungtintong@gmail.com john francis t. diaz, associate professor dept. of finance, chung yuan christian university no. 200, zhongbei road, zhongli district, taoyuan city, taiwan tel: 886-(03)265-5708 e-mail: johnfrancis_diaz@yahoo.com received: april 2, 2017 accepted: april 29, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.11150 url: http://dx.doi.org/10.5296/ajfa.v9i1.11150 abstract this paper investigates the important factors influencing capital structure decisions. the study focuses on the bank leverage of thirty-one vietnamese commercial banks from 2009 to 2014, because they play a key role as financial catalysts in the growing economy of vietnam. the analysis employs multiple linear panel regression models, namely, ordinary least squares (ols), fixed effects (fe), and random effects (re). this research examines five bank-specific factors (i.e., size, profitability, growth rate, taxation and business risk), and three financial market and economic variables (i.e., stock market condition, economy, and inflation) influencing capital structure with debt ratio as the dependent variable. both the ols and fe models agree that a vietnamese bank’s size positively affects leverage, which means that the larger the bank, the more debt is incurred. both models also determine that stock market and economic conditions have negative effects, which implies that in good market conditions, banks lessen their debt loads. in dividing vietnamese commercial banks into three groups of sizes (i.e., large, medium-sized and small banks) based on chartered capital, both the ols and re models agree that size is a positively contributing factor to leverage. however, unlike large vietnamese banks, medium-sized and small-sized banks tend to still carry a relatively high amount of debt because they are commonly ignored by the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 262 equity markets for reasons of illiquidity and instability, pushing them to rely on borrowing funds even to the point of having higher interest rates. another interesting finding of this paper is that, only small-sized vietnamese banks’ leverage is negatively affected by stock market and economic conditions. findings of this paper are robust in using two panel regression models, and can help vietnamese banks’ managers have a general perspective regarding capital structure determinants. this study also offers insights in creating appropriate strategies to controlling factors affecting banks’ leverage to achieve the target capital structure that minimizes the cost of capital and maximizes profitability. keywords: capital structure determinants, vietnamese commercial banks, ordinary least squares, fixed effect model, random effect model asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 263 1. introduction growing optimism has emerged both in the world economy, especially the banking industry as recovery continues to get stronger from the impact of the subprime mortgage crisis. the recent financial crisis, which started december 2007 to june 2009 is considered to be the worst crisis for banking industry all over the world, widely believed to be caused by banks’ excessive leverage. different from other industries, banks always have a very high leverage compared with other non-financial firms (osterberg & thompson, 1990) because most banks’ profits come from liabilities in the form of interest-bearing deposits that must be managed properly to maximize profits. banks have to ensure covering the risk of bankruptcy and hold more capital than required by regulations. factors affecting capital structure of financial institutions in the world have attracted numerous empirical studies highlighting the importance of properly managing a bank’s capital structure. in particular, juca et al. (2012) tested the influence of standard determinants of capital structure on the north american financial institutions under the effect of basel agreements. the study confirmed that the hypothesis holds, and among the significant determinants are asset risks, amount of deposits, profitability and growth opportunities. earlier studies conducted by octavia and brown (2010), and gropp and heider (2010) indicated that commercial banks with higher capital owned than the basel minimum requirement have lesser risk. the studies also found that company-specific factors like size, profitability, growth opportunity, bank guarantees1, dividend payment and assets risk, and as well as macroeconomic fundamental variables like gdp growth and market return all have positive significant effect on the capital structure. study on asia’s determinants of banking capital structure has also caught the attention of hoa and kayani (2013). the research found that economic growth stage of the countries under study determines the disparity in capital structure. moreover, findings showed that collateral is the only significant factor in asian developed countries, whereas profit is a significant factor in developing countries. vietnam is one of asia’s fastest growing economies has become a major player in global finance. although, vietnam’s organized banking industry has a short history of about three decades, it has reformed and accomplished remarkable changes in terms of structure, regulation, and operations of banks. these developments have moved the banking sector towards a fast-growing operation that closely resembles domestic banking sectors in other emerging markets and newly industrialized economies. vietnam’s economy is considered to be a market economy that uses ideologies of the capitalist system, but also maintains control of the government. most of vietnamese enterprises are smalland medium-scale enterprises, and most of them were owned and controlled by the government. however, since the economic reform was implemented in 1986, private partnerships reduced a large number of state-owned enterprises and encouraged the equalization of private firms, established joint-stock companies, as well as boosted the development of vietnamese stock market. although government plays less important role in 1 bank guarantee is defined as a promise from a bank that the liabilities of a debtor will be met in the event that a client fails to fulfill its contractual obligations. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 264 controlling enterprises, okuda and nhung (2012) still found a strong positive relationship between state-owned enterprises and company leverage. as a result, state-controlled companies tend to have higher debt ratio because they have more access to capital and can easily borrow money from state-controlled banks compared with non-state-owned companies. dung (2015) found that among industries in vietnam, construction, construction materials, real estate, and mining have the top highest leverage, followed by manufacturing, steel and plastics, and packaging. on the other hand, anh (2010) examined capital structure determinants of companies listed in the ho chi minh stock exchange. the study showed that the average debt ratio in the period of 2007-2009 is about 51.74%, however, there is a big disparity between industries, from 3.26% to 92.98%. for some vietnamese industry specific findings on capital structure, thu (2012) investigated capital structure determinants of listed real estate company. the findings showed that average leverage ratio of vietnam’s real estate industry is 54.93%; and the leverage which is contributed by short-term debt is 64.97%. this study also suggested four main explanatory determinants which are firm size, growth rate, profitability and cost of goods sold ratio. an earlier study of canh and cuong (2011) assessed the factors affecting the capital structure of vietnam’s seafood processing enterprises in comparison with enterprises of other processing industries. the results show that vietnam’s seafood industry has debt ratio of 60.3% and significant determinants include profitability, growth, agency cost and interest expense. this research is motivated by the lack of empirical literature in determining the factors that affect the capital structure of vietnam’s banking industry with particular focus on bank leverage. this paper plans to augment empirical findings on the banking industry of vietnam. this paper contributes to the literature by studying the determinants affecting the capital structure of vietnam’s banking industry using ordinary least squares (ols) model, fixed effect (fe) model, and random effect (re) model. the study will also try to improve contributions by attempting to divide the samples into three major categories based on chartered capital: a) large capitalization banks (8 banks with chartered capital greater than usd 468 million or vnd 10 trillion), b) medium capitalization banks (11 banks with chartered capital from usd 234 million to usd 468 million or vnd 5 trillion to vnd 10 trillion), and c) small capitalization banks (12 banks with chartered capital less than usd 234 million or vnd 5 trillion). the general objective of this research is to identify significant determinants of capital structure in vietnam’s banking industry; and the three specific objectives are: • to examine the degree of relationship (i.e., positive or negative relationship) between bank leverage and selected internal and external factors; • to identify which determinants from firm-specific to economic factors have stronger influence based on the coefficients’ outcome; and • to determine if there are differences on the significant factors determining the capital structure of large, medium and small capitalization banks. the study’s objectives are of significant interest, because identifying factors influencing asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 265 vietnamese banks’ capital structure can provide insights to bank decision-makers and corporate research divisions. given the paper’s future findings, responsible parties inside the bank are able to monitor and even control relevant firm-specific and macroeconomic factors to create timely and beneficial financial decisions. the paper is structured as follows: section 1 introduced the background of global banking capital structure and vietnam banking industry in general. section 2 defines the independent variables and their expected relationship to the capital structure. section 3 presents the data and explains the methodologies of the paper. section 4 discusses the empirical results in detail, and section 5 concludes and provides the limitations of the paper. 2. variables definition and hypotheses the relationships of independent variables to the degree of leverage, which corresponds to the percentage of total liabilities to the total assets of vietnamese commercial banks, as well as hypotheses are summarized in table 1. below are the definitions and hypotheses for dependent and independent variables: table 1. variables definition and measurement variables abbreviation relationship description formula financial leverage lev dependent variable correspond to the percentage of bank's liability total liabilities / total assets size size (+) correspond to the natural logarithm of the total assets ln (total assets) profitability prof (-) correspond to the bank's profitability percentage ebit / total assets growth opportunity grow (+) correspond to bank’s ebit ebit tax rates tax (+) correspond to the percentage of tax payment over ebit tax paid / ebit business risk risk (-) correspond to the probability of financial distress standard deviation of ebit stock market condition stk (-) correspond to the stock market index at respective time vietnam stock market index economic condition econ (-) correspond to the percentage of annual growth of gross domestic product (gdp) annual percentage change of vietnam’s gdp inflation inf (+) correspond to the percentage of annual growth of consumer price index (cpi) annual percentage change of vietnam’s cpi description: variable definitions and summary of related hypotheses source: organized by authors financial leverage is measured as the percentage of debt which firms utilize to acquire additional assets. according to the research of rajan and zingales (1995), they suggested asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 266 four alternative definitions for financial leverage, namely: ratio of total liabilities to total assets, ratio of debt to total assets, ratio of total debt to net assets, and ratio of ebit to interest expense. among these definitions, ratio of total liabilities to total assets is considered to be the broadest one, it can be viewed as a better proxy for what is left for shareholders in case of liquidation. also, this definition is supported by study of ali et al. (2011). for these reasons, this paper uses ratio of total liabilities to total assets as an indicator for financial leverage, and the primary dependent variable of the study. size is measured in terms of total assets. from this definition, we can conclude that the more assets a firm owns, the bigger its size is. according to the bankruptcy cost theory, firms with large size tend to borrow more debts than small ones, because of having easier access to capital markets (i.e., high credit rating and good reputation), as well as good relationship with creditors (vatavu, 2012). this claim was also supported by the study of strebulaev and kurshev (2006) and found that a firm with bigger size has positive relationship with leverage, and more often offered with low interest rate. hence, from these previous studies, this paper hypothesizes that size and leverage are positively related. profitability directly measures the performance of firms, and is defined as the money that company makes after accounting for all the expenses and taxes. thus, this paper considers the value of a bank’s net income to measure profitability. conclusions on the relationship of profitability and leverage are mixed. based on the agency cost theory, jensen (1986), and williamson (1988) stated that profitable firms usually have higher free cash flow which encourages managers to invest discretionally. to restrain this agency problem, debt is chosen as an effective tool for managers to be more disciplined in continuing profitability in order to service debt. thus, we can say that high profitable firms are absorbing more debt, making them positively related. on the contrary, aremu et al. (2013) used the pecking order theory to explain that profitable firms prefers internal financing. thus, profitable firms tend to retain more profit for expansion instead of servicing debts, which makes the relationship negatively related. for this paper, we will be taking the standpoint of the pecking order theory and will assume that profitability and debt have inverse relation. growth rates measures the potential of firms to expand their business in the future or the investment opportunities that a firm can foresee. in this paper, growth rate is measured using the market value of the firm over the book value of its total assets. based on the explanation of chen and zhao (2006) using the pecking order theory, they suggested that when firms see good opportunities in the future, they demand more capital for investment, and firms prefer debt over the issuance of stock; thus, making the relationship of growth and leverage positive. however, barclay et al. (2006), and pandey (2001) both explained through the agency cost theory that when firms have positive future prospects, they don’t want creditors to put pressure on corporate decisions as part of the conditions to the money being loaned, that’s why they lower the level of debt. another explanation was given earlier by myers (1977), assuming that growth opportunities may take risk, and managers don’t want to take more risky positions by incurring a higher level of debt. as the result, firms prefer internal capital sources instead of acquiring debt making the relationship negative. for the purposes of this paper, we will be taking again the position of the pecking order theory and will assume that asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 267 growth rate and leverage have positive relation. tax rates are compulsory contribution levied by the local government are applied to all of the firms and also play an important role in capital structure decision. firms with high degree of leverage can get much benefit from tax shield, because interest on debt is a tax-deductible expense. trade-off theory explains that in case of higher tax rate, firms will issue more debt to obtain a tax shield gain (modigliani & miller, 1963); and the study of mackinlay (2013) provided evidence that the marginal tax rate affect financing decision. however, study of vatavu (2012) showed evidences that tax rate is not a significant factor with leverage. for the purposes of this study, we hypothesize that tax rates are positively related with leverage, because of the influence of tax shields. business risk is the possibility of inadequate profits or even losses due to market uncertainties like changes in preferences of customers, employee strikes, increase competition, obsolescence and even changes in government policy, which immediately affects earnings before interest and taxes (ebit). the effect of risk on leverage is explained by the bankruptcy cost theory. an earlier study of titman and wessels (1988) explained that less stable earnings firms bear higher bankruptcy cost; thus, they refuse to add more debt. moreover, agency cost theory confirms that when facing bankruptcy risk, agency problems related to debt are worse (aremu et al., 2013). however, according to vatavu (2012), contrary with most of other studies, he said that firms continue to use debt even when they face high business risk, because of trying to maximize the benefits that come from leverage. for this paper, we will be taking the standpoint of the bankruptcy cost theory and will assume that business risk is negatively related with incurring more debt. stock market conditions refers to returns on the stock prices using a stock index, which affects the overall market valuation of firms. the relationship between stock market condition and leverage is explained by the market timing theory. frank and goyal (2009), and welch (2004) showed that firms issue equity (less of debt) when their market valuations are high, which negatively affects leverage. economic condition is general state of the economy, and will be measured by the annual percentage of vietnam’s gdp. in boom economy, most firms’ profit goes up and firms will prefer internal sources like retained earnings over debt during expansions according to the pecking order theory, and this was confirmed by the empirical studies of dincergok and yalciner (2011), stating the negative relationship between economic conditions and the level of debt. however, an earlier study of gertler and gilchrist (1993) showed that during good economic conditions, stock prices go up, bankruptcy cost declines, taxable income increases, and cash rises; and these factors encourage firms to borrow more making the relationship positive. for the purposes of this paper, we will be taking again the position of the pecking order theory and will assume that economic condition and leverage has negative relation. inflation directly affects the cost of debt based on market timing theory as explained in the study of frank and goyal (2009) suggesting that firms expecting increase in the inflation rate, they decide to employ more debt, because firms realize that the present cost of debt is cheaper. trade-off theory also views the same relationship, and adds that the real value of tax shield is asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 268 higher when inflation rises resulting to firms absorbing more debt to get more tax benefits (taggart jr, 1985). both theories agree that expected inflation has a positive impact on leverage. therefore, this paper assumes that expected inflation and financial leverage have direct relationship. 3. data and methodology this research paper focuses on the vietnamese banking industry, particularly, local commercial banks. currently, there are 38 local commercial banks operating in vietnam, however, due to some data limitations, this paper will only consider a panel yearly data consisting of 31 banks from 2009 to 2014. dependent and independent variables will be primarily based on the audited financial statements of banks collected from vietstock finance website (http://finance.vietstock.vn/), while macroeconomic data like gdp and inflation are collected from trading economics website (http://www.tradingeconomics.com/). the list of the proposed banks to be studied can be found in appendix 1. • h0: independent variables have no explanatory power on vietnamese banks’ leverage (βi = 0) • h1: independent variables have explanatory power on vietnamese banks’ leverage (βi ≠ 0) the hypotheses are tested by estimating the following regression equations: for the ols regression: levi,t = β0 + β1sizei,t + β2profi,t + β3growi,t + β4taxi,t + β5riski,t + β6stki,t + β7econi,t + β8infi,t + εi,t ; (1) and for both the fe and re regressions: levi,t = β1sizei,t + β2profi,t + β3growi,t + β4taxi,t + β5riski,t + β6stki,t + β7econi,t + β8infi,t + νi + εi,t (2) the relationship among bank-specific, and economic and financial market explanatory variables over vietnamese banks’ degree of leverage will be tested using a multivariable regression model to determine the significance, sign and magnitude of the effect of each variable on leverage ratio. the methodology will be carried out by initially checking multicollinearity problem to see if independent variables are highly correlated with each another. the objective is to detect near multicollinearity (i.e. correlation which is higher than 0.8) using the correlation matrix. detecting and solving multicollinearity is important, because: a) highly correlated variables make it difficult to observe individual positive or negative effect of variables to the general fit of the regression, which may result in having a high r2 making the regression equation look seemingly good, but with spurious results; b) the regression will be highly sensitive to every small changes in the regression asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 269 specification, making adding or removing regressors lead to larger change in coefficient values or the significance of other explanatory variables; and c) the problem of multicollinearity will lead to inappropriate conclusions for the regression equation that can reduce the accuracy of expected results. another test that the paper will perform is the white test to detect the presence of heteroscedasticity or the presence of inconstant variance. although, heteroscedasticity does not cause ols coefficients to be biased, it can cause ols estimates of the variance (i.e., standard errors) of the coefficients to be biased, which can be possibly above or below the true variance. biased standard errors lead to biased inference of the data, making the estimated results of hypothesis tests possibly inaccurate. once detected, the study will undertake the heteroscedasticity-corrected ols function to correct heteroscedasticity problem. the paper will then run two classes of estimator approaches to determine which model fits the panel data. first, the fe model assumes correlation between error term and variables. the model eliminates the specific effect of time-invariant features to determine the net effect of the explanatory variables and also to take into account the distinctiveness of these features by not correlating them with other individual characteristics. second, the re model on the other hand assumes that the variations across the entities are random and uncorrelated with the explanatory variables. this model also considers the inclusion of the time-invariant variables. this paper will perform the hausman test on the panel data set to examine the suitability of either the fe model or the re model. the paper examines factors that explain capital structure decision of banks with particular focus on the amount of debt they carry. there are 8 determinants to be tested, including 5 bank-specific factors: size (size), profits (prof), growth rate (grow), taxation (tax), and business risk (risk); and 3 economic and financial market variables: stock market condition (stk), economic condition (econ), and inflation (inf). these variables are tested against bank leverage (lev), and the general null and alternative hypotheses are: the hausman test compares the fixed and random effects estimates of coefficients, in two related hypotheses: • h0: the random effects are uncorrelated with the explanatory variables (i.e., re model is preferred) • h1: the random effects are correlated with the explanatory variables (i.e., fe model is preferred) after ensuring that the panel data is free from the above problems and has determined its characteristics, the study will then run and interpret the final results of the regression. findings will be analyzed based on their consistency with the above mentioned theories, and previous findings of our related literature. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 270 4. empirical results table 2 illustrates the summary statistics of vietnamese banks showing the average, median, standard deviation, and the minimum and maximum values for all data sets. for all the banks’ group, the average value for leverage is 89%, which means that 89% of vietnamese banks’ assets is debt, while the disparity within this data set is 8%. for the size, the average total asset is vnd123.50 trillion and the disparity within the banks is about vnd156.31 trillion. for the profitability factor, the industry’s average is around 2%, while the standard deviation is 1%. the average growth of the banking industry in terms of value are about vnd2.16 trillion, while the disparity among banks vnd3.25trillion. moreover, the average tax rate for all banks are about 17%, with a standard deviation of 1% within the industry. lastly, for the average risk of vietnamese banking industry is around vnd37.44 billion in possible losses with a standard deviation of vnd27.58 billion. table 2. summary statistics of vietnamese banks category lev size prof grow tax risk stk econ inf a ll ba nk s g ro up mean 0.89 123 503 0.02 2 158 0.17 37.44 465.83 0.11 0.09 median 0.91 64 172 0.02 755 0.17 27.48 489.72 0.10 0.08 standard deviation 0.08 156 308 0.01 3 251 0.07 27.58 64.52 0.04 0.05 min 0.39 2 524 0.00 35 0.01 5.99 351.55 0.07 0.04 max 0.97 729 564 0.06 15 070 0.39 122.76 545.63 0.17 0.19 la rg esiz ed b an ks gr ou p mean 0.92 313 058 0.02 6 059 0.16 72.18 465.83 0.11 0.09 median 0.92 243 004 0.02 5 155 0.15 71.80 489.72 0.10 0.08 standard deviation 0.03 197 723 0.01 4 307 0.08 29.46 65.02 0.04 0.05 min 0.80 54 492 0.00 428 0.01 20.70 351.55 0.07 0.04 max 0.96 729 564 0.03 15 070 0.39 122.76 545.63 0.17 0.19 m ed iu m -s iz ed b an ks gr ou p mean 0.91 91 015 0.01 1 277 0.16 33.22 465.83 0.11 0.09 median 0.92 79 889 0.01 991 0.17 31.48 489.72 0.10 0.08 standard deviation 0.03 55 144 0.01 1 017 0.07 13.27 64.84 0.04 0.05 min 0.78 10 729 0.00 105 0.01 10.23 351.55 0.07 0.04 max 0.96 281 019 0.03 4 563 0.30 67.55 545.63 0.17 0.19 sm al l-s iz ed b an ks gr ou p mean 0.84 26 919 0.02 365 0.18 18.15 465.83 0.11 0.09 median 0.86 22 505 0.02 317 0.19 17.81 489.72 0.10 0.08 standard deviation 0.10 16 267 0.01 225 0.06 6.02 64.79 0.04 0.05 min 0.39 2 524 0.00 35 0.01 5.99 351.55 0.07 0.04 max 0.97 69 263 0.06 970 0.38 31.15 545.63 0.17 0.19 source: collected by authors asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 271 this study initially tabulated the correlation matrix to check for correlation problems. if the correlation value is equal or larger than 0.8, the study decides to remove one of two variables based on the higher p-value using the ols model. white test is also employed to check for heteroscedasticity problems. all the findings presented in the study were heteroscedasticity-corrected models. the study also used the hausman test to check which model is preferable between fe and re models. overall, among the three models used, the highest log-likelihood value was utilized to decide which model is preferable. table 3 summarized the hypothesized and empirical relationships between leverage and its explanatory variables. table 3. summary of relationships between determinants and leverage variable hypothesized relationship empirical relationship all banks large-sized banks medium-sized banks small-sized banks size (+) (+) (+) (+) (+) prof (-) -(-) -- grow (+) ---(-) tax (+) ---- risk (-) ---- stk (-) (-) --(-) econ (-) (-) --(-) inf (+) ---- note: (+) means positive relationship; (-) means negative relationship; -means insignificant 4.1 check for correlation table 4 illustrates the correlation matrix. for all banks group, risk was removed from the model, because of its correlation with both size and grow variables. for large-sized banks group, we initially remove risk variable, because of its correlation with both grow and size factors. however, grow and size also have correlation with each other. the study decided to remove grow because of its higher p-value over size based on the ols model. for medium-sized banks group, the matrix shows that there is a correlation between risk and grow variables. the paper decided to omit risk because of its higher p-value over grow based on the ols model. lastly, for small-sized banks group, there also exists correlation between risk and grow, ols model result indicates that risk has higher p-value and should be removed. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 272 table 4. correlation matrix of variables category variables size prof grow tax risk stk econ inf a ll ba nk s size 1.0000 -0.1478 0.7728 -0.2796 0.8482 0.0118 0.0899 0.0972 prof 1.000 0.2376 0.1618 0.2819 -0.2320 0.1144 0.0215 grow 1.0000 -0.1493 0.9682 -0.0509 0.0926 0.0632 tax 1.0000 -0.1411 -0.1433 -0.1069 0.3063 risk 1.0000 -0.0654 0.1001 0.0618 stk 1.0000 -0.9121 0.4829 econ 1.0000 0.6823 inf 1.0000 la rg esiz ed ba nk s size 1.0000 0.1331 0.8851 -0.4579 0.8920 0.0312 0.1383 0.1852 prof 1.000 0.4486 0.2206 0.5257 -0.2774 0.2104 0.0560 grow 1.0000 -0.2815 0.9842 -0.0926 0.2084 0.1773 tax 1.0000 -0.2422 -0.0984 -0.1722 0.3001 risk 1.0000 -0.0923 0.1982 0.1705 stk 1.0000 -0.9121 0.4829 econ 1.0000 0.6823 inf 1.0000 m ed iu m -s iz ed ba nk s size 1.0000 -0.1806 0.6982 -0.2517 0.7345 -0.0075 0.2024 0.1877 prof 1.000 0.4422 0.2023 0.4780 -0.0673 -0.1287 0.2254 grow 1.0000 0.0551 0.9766 -0.0881 0.1108 0.0164 tax 1.0000 -0.0033 -0.2040 -0.0685 0.3314 risk 1.0000 -0.0598 0.0965 0.0074 stk 1.0000 -0.9121 0.4829 econ 1.0000 0.6823 inf 1.0000 sm al l-s iz ed ba nk s size 1.0000 -0.6010 0.2627 -0.3691 0.2192 0.0407 0.1247 0.1395 prof 1.000 0.5057 0.1252 0.5261 -0.3240 0.2106 0.0455 grow 1.000 -0.1653 0.9817 -0.3644 0.3644 0.1835 tax 1.000 -0.1054 -0.1236 -0.0948 0.2954 risk 1.000 -0.3573 0.3509 0.1648 stk 1.000 -0.9121 0.4829 econ 1.000 0.6823 inf 1.000 source: collected and organized by authors. 4.2 ols model results and interpretation 4.2.1 all banks group table 5 shows three regression results for all bank group using the ols, fe and re models. this study used the hausman test to decide between the fe and re models. for this table, p-value less than significance level of 1% made this study chose the fe model to represent asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 273 the relationship between bank’s leverage and its determinants. the ols model yielded five significant variables: banks size (size), profitability (prof), growth rate (grow), vietnamese stock market (stk), and the country’s economy (econ). on one hand, the fe model has three variables: banks size, stock market, and vietnam’s economy. table 5. summary of analysis results of ols, fe and re models for all banks group variables heteroscedasticity-corrected ols model fe model re model constant 0.454*** (0.000) 0.055 (0.719) 0.302** (0.030) size 0.039*** (0.000) 0.086*** (0.000) 0.062*** (0.000) prof -1.822*** (0.000) -0.626 (0.190) -1.021** (0.030) grow -0.000*** (0.002) -0.000 (0.730) -0.000* (0.058) tax 0.004 (0.925) -0.076 (0.101) -0.077 (0.106) stk -0.000*** (0.002) -0.001*** (0.000) -0.001*** (0.000) econ -1.568*** (0.008) -1.967*** (0.000) -1.346*** (0.000) inf -0.072 (0.245) 0.031 (0.684) -0.0432 (0.077) r2 0.618 0.889 white test p-value 134.172*** (0.000) log-likelihood -335.220 415.930 287.193 hausman p-value 24.842*** (0.001) note: *, ** and *** are significance at 10%, 5% and 1% levels, respectively; p-values are in parentheses source: collected and organized by authors. the banks’ size variable (size), which represents total assets of all vietnamese banks under study, has positive relationship with leverage based on both the ols and the fe models. this finding held up with our prediction, as well as the findings of vatavu (2012), and strebulaev and kurshev (2006). these studies discover that banks with huge asset base have easier access to capital markets because of their longstanding reputation. the paper suggests that banks capitalize on their reputation and a stronger marketing strategy to attract more individual depositors and easily get loans from interbank sources or from the government. banks’ profitability (prof), on the other hand is negatively associated with leverage. this result is consistent with the findings of aremu et al. (2013) and the pecking order theory, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 274 which explained that highly profitable banks prefer internal sources of financing as an alternative to borrowing from external sources. the more retained earnings are employed, the lesser is the debt ratio. this study observed that most vietnamese banks have low dividend payouts, about 10 13.5% (linh, 2015), because retained earnings are mostly used for capital expenditures and re-investment purposes. furthermore, internal sources have lower cost than external ones, that’s why banks rarely absorb debts when they have abundant internal funding sources. in this paper’s view, vietnamese banks should find the balance in using retained earnings and in acquiring a healthy amount of debt to maximize leveraging, and earn more after settling interest and principal payments. a well-balanced capital structure also helps banks in attracting and satisfying investors who prefer dividend from time to time. for growth rate variable (grow), the regression coefficient of this variable is negative under the ols model, which is actually in contrast with paper’s hypothesis that growth rate is positively related to financial leverage. however, this result supports the studies of barclay et al. (2006), and pandey (2001), which explained that when firms foresee the potential growth from their investments, companies prefer using their own capital over funds coming from creditors to avoid decisions being affected by creditors. this explanation is also related to the agency cost theory. thus, this paper suggests that banks should avoid borrowing too much money when experiencing a greater degree of profitability; because as mayers (1977) put it, sometimes higher profit leads to higher risk due to the greater uncertainty connected with expansion. for stock market condition variable (stk), both the ols and fe models result indicate a negative relationship between stock market conditions and debt ratio. this is consistent with the paper’s hypothesis and conforms with the previous studies of frank and goyal (2009), and welch (2004) which suggested that firms usually employ less debt when their market valuations are high in booming stock condition period. also, when large amounts of deposits from customer are transferred from banks to investing stock market, lower deposits decreases banks’ liability, which leads to increase in the stock markets because of more liquidity. it is recommended that vietnamese banks should join the stock market so that they can balance their leverage by also gaining equity on the capital structure, which helps banks’ leverage to be stable. currently, most vietnamese banks are not listed on stock exchanges, one of the reasons why stock market fluctuations do not affect much of their valuations. for the economic condition variable (econ), the regression shows a negative coefficient for both ols and fe models, which means that banks’ leverage is inversely affected by economic condition. this result supports the paper’s prediction, and follows the pecking order theory. this finding also confirms the study of dincergok and yalciner (2011) explaining that in a good economic condition, most firms get large profit and they prefer using internal source of financing instead of borrowing from external sources. furthermore, banks’ role of playing financial mediator pushes investment and borrowing from banks in a boom economy. this increases current assets, which reduces banks’ leverage. moreover, a booming economy encourages banks’ customers to transfer their capital from savings to investing in other higher profitable projects, which slightly reduces banks’ liability. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 275 in comparing the results of the ols and fe models, this research favors the results of the fe model as the better fitting model for all banks group, because of the higher log-likelihood value. 4.2.2 large-sized banks group table 6 again illustrates three regression results for large-sized vietnamese bank group using the ols, fe and re models. the hausman test prefers the re model over the fe model because of the insignificant p-value. both the ols and re models have similar two significant explanatory variables: banks size and profitability. consistent with earlier findings for all bank group, size variable is positively related with debt ratio for both the ols and fe models. this implies that bigger total assets of banks lead to higher debt ratio. this result is again consistent with the findings of vatavu (2012), and strebulaev and kurshev (2006) explaining the higher number of depositors, the easier access to loans. the study recommends that large banks capitalize on their market network to attract more depositors and easily get loans from interbank sources or from the government with lower interest. table 6. summary of analysis results of ols, fe and re models for large-sized banks group variables ols model fe model re model constant 0.643*** (0.000) 0.465* (0.060) 0.605*** (0.000) size 0.024*** (0.000) 0.036** (0.040) 0.025*** (0.000) prof -1.160** (0.021) -1.911*** (0.008) -1.395** (0.012) tax -0.021 (0.698) 0.026 (0.606) 0.000 (0.997) stk -0.000 (0.137) -0.000 (0.138) 0.000 (0.137) econ -0.325 (0.334) -0.461 (0.304) -0.292 (0.358) inf -0.0230 (0.818) -0.015 (0.867) -0.025 (0.786) r2 0.429 0.651 white test p-value 28.567 (0.195) log-likelihood 122.355 134.184 122.164 hausman p-value 9.413 (0.152) note: *, ** and *** are significance at 10%, 5% and 1% levels, respectively; p-values are in parentheses source: collected and organized by authors. profitability variable for large banks consistently has negative effects on leverage. this finding is again in-line with the initial result for all bank groups, consistent with the pecking asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 276 order theory, and related to the research of aremu et al. (2013) that profitable banks have less debt ratio. following this concept, it is suggested that large vietnamese banks with higher profit continue to use internal capital in the form of retained earnings and additional equity, to minimize borrowing from external sources. in comparing the results of the ols and re models, this study favors the findings of the ols model as the better fitting model for large vietnamese banks group, because of the higher log-likelihood value. 4.2.3 medium-sized banks group table 7 again illustrates three regression results for medium-sized vietnamese bank group using the ols, fe and re models. the hausman test prefers the re model over the fe model, because of the insignificant p-value. both the ols and re models again have similar two significant explanatory variables: banks size and profitability, which is similar with the results from the large bank group. the size factor is again positively related with the leverage table 7. summary of analysis results of ols, fe and re models for medium-sized banks group variables ols model fe model re model constant 0.235 (0.223) 0.494 (0.041) 0.2686 (0.168) size 0.046*** (0.000) 0.036** (0.020) 0.045*** (0.000) prof -1.181 (0.123) -2.608** (0.013) -1.3454* (0.086) grow -0.000 (0.374) 0.000 (0.457) -0.000 (0.497) tax 0.084 (0.119) 0.069 (0.299) 0.0801 (0.142) stk -0.000 (0.216) -0.000 (0.157) -0.000 (0.187) econ -0.340 (0.300) -0.591 (0.183) -0.369 (0.261) inf -0.121 (0.175) -0.083 (0.365) -0.118 (0.177) r2 0.663 0.743 white test p-value 39.070 (0151) log-likelihood 166.287 175.235 166.258 hausman p-value 8.029 (0.330) note: *, ** and *** are significance at 10%, 5% and 1% levels, respectively; p-values are in parentheses source: collected and organized by authors. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 277 ratio of medium-sized banks for both the ols and fe models consistent with the earlier findings for all bank and large-sized bank groups. this result is also related with the explanations of vatavu (2012), and strebulaev and kurshev (2006). the study suggests that medium-sized vietnamese banks should attract more depositors, and use lower interest loans whenever necessary for quicker expansions. this is because medium-sized banks sometimes are ignored by the equity markets for reasons of instability and unproven track records. the factor profitability based on the fe model is again negatively related with leverage, which is in-line with the initial results for all bank and large-sized bank groups. this also conforms to the pecking order theory, and consistent to the research of aremu et al. (2013) that profitable banks have less debt ratio. to balance the initial suggestion of encouraging medium-sized banks to borrow to become bigger, this paper additionally recommends that these banks should maintain a healthy amount of debt that will not sacrifice profitability by constantly monitoring their cash flows to cover interests and principal payments. once they maintained a consistent period of profitability, they should start using internal sources of funding to continue their profitable operations. in comparing the results of the ols and re models, this paper again favors the findings of the ols model as the better fitting model for medium vietnamese banks group, because of the re model has lower log-likelihood value. 4.2.4 small-sized banks group table 8 shows three regression results for small-sized bank group using the ols, fe and re models. the hausman test prefers the re model over the fe model because of insignificant p-value. the ols model yielded four significant variables: banks size, profitability, stock market conditions, and the country’s economy. on one hand, the re model also has four variables, but growth rate is significant instead of profitability. the size factor for small-sized vietnamese bank is again positively related with the leverage ratio based on both the ols and re models. this result is in accordance with the earlier findings for all bank, large-sized bank and medium-sized bank groups. this finding is again related with the initial explanations of vatavu (2012), and strebulaev and kurshev (2006). however, this paper posits that one of the reason why small-sized vietnamese banks also have a higher leverage because like their medium-sized counterparts, small banks are commonly ignored by investors in the equity markets for reasons of illiquidity and instability, pushing them to rely on attracting more depositors, and borrow funds even to the point of experiencing relatively higher interest rates. for small vietnamese banks, the factor profitability based on the ols model is again negatively related with their debt ratio, which is in-line with the initial results for all bank, large-sized bank and medium-sized bank groups. this also conforms to the research of aremu et al. (2013). as per the recommendations for medium-sized banks, small vietnamese banks should also borrow money to become bigger. however, small banks face bigger problems of illiquidity that may sometimes lead to counterproductive borrowings. this paper again recommends that small banks maintain a healthy amount of debt that will not sacrifice profitability by constantly monitoring their cash flows to cover interests and principal payments. once small vietnamese banks maintained a asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 278 consistent period of profitability, they should start using internal sources of funding to continue profitable operations. table 8. summary of analysis results of ols, fe and re models for small-sized banks group variables heteroscedasticity-corrected ols model fe model re model constant 0.062 (0.770) -0.676** (0.041) -0.642** (0.040) size 0.088*** (0.000) 0.164*** (0.000) 0.164*** (0.000) prof -1.842** (0.033) 1.3661 (0.1820) 1.1862 (0.227) grow 0.000 (0.869) -0.000* (0.094) -0.000* (0.086) tax 0.056 (0.355) -0.224 (0.108) -0.229 (0.102) stk -0.000*** (0.000) -0.002*** (0.000) -0.002 (0.000) econ -1.936*** (0.000) -3.629*** (0.000) -3.653*** (0.000) inf 0.018 (0.895) 0.145 (0.320) 0.143 (0.309) r2 0.761 0.920 white test p-value 65.554*** (0.000) log-likelihood -128.735 151.788 104.018 hausman p-value 1.753 (0.972) note: *, ** and *** are significance at 10%, 5% and 1% levels, respectively; p-values are in parentheses source: collected and organized by authors. the regression coefficient of the growth rate variable is negative under the re model, which is similar with the all bank group result, but do not conform to the paper’s hypothesis. however, this finding is again accordance with the agency cost theory and the studies of barclay et al. (2006), and pandey (2001) explaining that companies prefer using their own capital over funds coming from debtors. this is particularly true for small vietnamese banks, because it is riskier for them to borrow compared to the more stable large and medium-sized banks, because of lower total assets, and higher interest payments. small banks can also try tapping over-the-counter markets for equity issuance to fulfill their needs for external capital, pursue their investment choices, and diminish the risk of bankruptcy. both the ols and fe models finding indicate a negative relationship between stock market conditions and leverage of small vietnamese banks. this conforms to the paper’s hypothesis, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 279 and consistent with the previous findings of all bank group. this result is also in-line with the previous studies of frank and goyal (2009), and welch (2004), which explained that firms usually employ less debt when their market valuations are high in booming stock condition period. however, this does not entirely apply to most small banks in vietnam, because most of them are not listed on local stock bourses. small vietnamese banks often rely on debt to carry-out operations and maintain liquidity. the local equity market is normally not an option for small banks, because they are often ignored by investors due to unstable reputations. this is also one of the reasons why stock market fluctuations do not affect small vietnamese banks’ valuations. a negative coefficient for the economic condition variable in both ols and re models was also observed, which means that small vietnamese banks’ leverage is inversely affected by economic condition. this finding is in-line with the prediction of the paper, and also follows the pecking order theory. the result also is in accordance with the explanations of dincergok and yalciner (2011), frank and goyal (2009), and welch (2004), concluding that in a good economic condition, most firms, including small banks get higher than usual profits and they prefer using internal source of financing instead of borrowing from external sources, which is actually more costly for small vietnamese banks. this paper suggests that booming economic conditions should be exploited by small banks through aggressive marketing of products, and expanding operations to take advantage of general economic liquidity. and if they have a chance of borrowing lower than usual interests, small banks can also obtain a small and manageable amount of debt in economic booms. in comparing the results of the ols and re models, this paper again favors the findings of the re model as the better fitting model for small vietnamese banks group, because of the higher log-likelihood value. 5. conclusions and limitations this research examines whether the eight factors determined, namely: size, profitability, growth rate, risk, tax rate, stock market condition, economic condition, and inflation affect the capital structure of vietnamese banks. three types of models are employed to satisfy this main objective: ols model, fe model, and re model. aside from the regression models on all banks data, the study also divided the banks into three groups based on market capitalization (i.e., large-, medium-, and small-capitalization firms) to find out specific relationship and characteristics of each group with its bank’s leverage. generally, findings of this study are in-line with previous empirical evidences. there are some factors that do not have significant influence on leverage (i.e., risk, tax rate and inflation); but for the other determinants, bank size has been the most consistent variable affecting leverage in all bank groups. the findings lead to the belief that the bigger banks have higher leverage, and this can be attributed to the advantage of stable reputation and larger network, making them have easier access to external capital, including debt on selected occasions. on the other hand, mediumand small-capitalization banks’ leverage mostly comes from depositors instead of debtors because of their not consistent liquidity and instability. profitability has significant negative impact on large banks group’s leverage, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 280 suggesting that large vietnamese banks prefer using internal source of financing (i.e., retained earnings). growth rates shows its negative impact on small banks group, assuming that small vietnamese banks mostly use their profit for their investment rather than borrowing from external sources, which actually supports the pecking order theory. moreover, macroeconomic factors like stock market and economic conditions also have important influence on small-sized banks group. the study concludes that small banks tend to be more sensitive to every change of macroeconomic factors. in economic booms, small banks get more profit than usual, so they can utilize these profits for future investments, because this is the cheapest capital source. furthermore, with a chance of accessing low interest capital in good economic condition, small banks can seize this opportunity to absorb a controllable amount of debt to increase their profit. although, the study provides a considerable amount of contributions, there still exist some limitations and suggested future studies to be improved in next researches. first, the study did not cover all of the vietnamese banks, because some banks do not disclose their full financial statements. also, the vietnamese banking industry has just developed in recent years. these are the reasons why the study period is relatively short to fully cover the overall development of the vietnamese banking industry. future studies are suggested to increasing the data span and cover additional banks not included in the study. second, m&a activities have been an increasing trend in the vietnamese banking industry. it is recommended that future researches particularly focus on banks who underwent m&as. third, most of the vietnamese banks are still not publicly-listed. future studies can try investigating the factors affecting the leverage and possibly even the profitability of private banks and family-controlled banks. moreover, prospective research can also extend the number of significant determinants (i.e., ratios related to cash conversion cycles) to find out which factors is significantly important to determine vietnamese bank’s capital structure. regardless of these limitations, this paper can be considered as a pioneer in investigating the capital structure vietnamese banks, and provides a good perspective to the banking industry. the paper is also helpful for vietnamese academic researchers and banks’ managers who want to study factors affecting banks’ capital structure for their further researches and in making capital structure decisions, respectively. references ali, m. s., yadav, r., & jamal, a. 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(1988). corporate finance and corporate governance. journal of finance, 43(3), 567-591. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 283 appendix appendix 1. list of banks selected in the study in million usd (31/12/2014) no. english name abbreviation total assets total equity year of establishm ent 1 vietnam bank for agriculture and rural development agribank 34 112 2 295 1988 2 vietnam joint stock commercial bank for industry and trade vietinbank 30 912 2 583 1988 3 bank for investment and development of vietnam bidv 30 407 1 556 1957 4 joint stock commercial bank for foreign trade of vietnam vietcombank 26 978 2 027 1963 5 saigon joint stock commercial bank scb 11 325 616 1992 6 military commercial joint stock bank mbbank 9 374 774 1994 7 saigon thuong tin commercial joint stock bank sacombank 8 874 845 1991 8 asia commercial bank acb 8 398 580 1993 9 vietnam technological and commercial joint stock bank techcombank 8 225 701 1993 10 saigon-hanoi commercial joint stock bank shb 7 903 490 1993 11 vietnam prosperity commercial joint stock bank vpbank 7 633 420 1993 12 vietnam export import commercial joint stock bank eib 7 532 658 1989 13 maritime commercial joint stock bank msb 4 880 442 1991 14 lienviet post commercial joint stock bank lpb 4 713 346 2008 15 ho chi minh city housing development bank hdbank 4 653 415 1990 16 dong a commercial joint stock bank dongabank 4 073 264 1993 17 vietnam international commercial joint stock bank vib 3 771 397 1996 18 southeast asia commercial joint stock bank seabank 3 749 266 1994 19 ocean commercial joint stock ojb 3 216 205 1993 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 284 no. english name abbreviation total assets total equity year of establishm ent bank 20 an binh commercial joint stock bank abbank 3 154 267 1993 21 tien phong commercial joint stock bank tpbank 2 407 198 2008 22 housing bank of mekong delta mhd 2 111 165 1997 23 orient commercial joint stock bank ocb 1 828 188 1996 24 nam a commercial joint stock bank namabank 1 744 156 1992 25 national citizen commercial joint stock bank ncb 1 722 150 1995 26 viet a commercial joint stock bank vietabank 1 664 170 2003 27 viet capital commercial joint stock bank vietcapitalbank 1 205 155 1992 28 petrolimex group commercial joint stock bank pgbank 1 205 156 1993 29 kien long commercial joint stock bank kienlongbank 1 080 157 1995 30 saigon bank for industry & trade sgb 740 163 1987 31 mekong development joint stock commercial bank mdb 345 190 1992 source: collected by author from finance.vietstock.vn copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 9917-36372-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 135 the effect of problem-based learning on learning outcomes of accounting students chih-shun hsu department of accounting, tamkang university no.151, yingzhuan rd., tamsui dist., new taipei city 25137, taiwan (r.o.c.) e-mail: cshsu@mail.tku.edu.tw sin-hui yen department of accounting, tamkang university no.151, yingzhuan rd., tamsui dist., new taipei city 25137, taiwan (r.o.c.) e-mail: sinhui@mail.tku.edu.tw wei-hung lai (the corresponding author) graduate institute of management sciences in accounting section, tamkang university no.151, yingzhuan rd., tamsui dist., new taipei city 25137, taiwan (r.o.c.) e-mail: scatlai@kimo.com received: august 19, 2016 accepted: nov. 1, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.9917 url: http://dx.doi.org/10.5296/ajfa.v8i2.9917 abstract this study explores the influence of problem-based learning (pbl) on the learning outcomes of accounting students. the participants in this study were sophomore accounting students enrolled in an intermediate accounting course. we adopted a pre-test/post-test design in conjunction with a questionnaire survey. our results show that the learning outcomes of students in the pbl accounting course (experimental group) were superior to those in the control group. further analysis revealed that male students improved more than female students, and that the improvements of the male students who had passed the preliminary accounting exam were more pronounced than those who had not passed. in the after-class survey, students in the experimental group reported that pbl encouraged self-direct learning, and promoted their ability to think and learn independently. this study adds to the empirical asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 136 literature related to the application of pbl in accounting education and presents five suggestions to facilitate further research in such applications. keywords: problem-based learning, learning outcomes, experimental research, accounting course asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 137 1. introduction accounting educators and practitioners have been calling for reorientation in the content and delivery of accounting curriculum (aaa, 1986; aecc, 1990; aicpa, 1999; wells, 2011). their response has suggested that accounting students should be encouraged to be more active and independent and prepare themselves for lifelong learning. they also pointed out the need for a shift in the design of accounting curriculum from content-based to competency-based. one possible response to calls for reform would be the adoption of problem-based learning (pbl). milne and mcconnell (2001) and johnstone and biggs (1998) both advocated the incorporation of pbl into accounting education. unlike traditional teacher-led instruction, pbl places the primary emphasis on active learning. through teamwork, students collectively gather, interpret, and analyze data as they seek answers and construct their own meaningful knowledge systems. pbl moves beyond knowledge-oriented teaching by emphasizing competence-oriented teaching with the aim of enhancing independent-learning abilities, teamwork, and the integration of knowledge as well as problem-solving skills, critical thinking, and lifelong learning capacity. pbl emphasizes situational teaching (contextual learning) based on lesson plans designed to expose students to actual problematic situations. students can then learn how to integrate knowledge into their analysis and solving problems endeavors (yang, 2012). this study attempts to investigate the relationship between the pbl method and learning outcomes in an accounting course. our objective in this exploratory study was to compare traditional teaching methods with the pbl method using an experimental design. unlike previous studies (stanley and marsden 2012; giguere, 2006; milne and mcconnell, 2001), we adopted an experimental approach with pre-tests and post-tests in conjunction with an open-ended qualitative questionnaire to explore the effects of pbl on students’ learning outcomes. this approach using objective exam scores to gauge learning outcomes in conjunction with the subjective views of the students is rare in existing research. we therefore administered an after-class questionnaire survey to elucidate the subjective feelings of students and their degree of acceptance for this form of teaching. our results demonstrate that the learning outcomes of students in the pbl accounting course (experimental group) were superior to those in the control group. further analysis of student attributes revealed the improvements of male students were more pronounced than those of female students, and male students who had passed the elementary accounting review exam improved more than those who had not passed. in the after-class survey, students in the experimental group reported that pbl encouraged self-direct learning, and promoted their ability to think and learn independently. this work makes two major contributions: (1) we add to the empirical literature on the application of pbl to accounting education by providing an example using objective test scores in conjunction with subjective questionnaires for the assessment of learning outcomes; (2) based on student perceptions of pbl, we offer specific suggestions of importance to asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 138 future researchers. the remainder of this paper is organized as follows: section 2 provides a review of the literature related to learning outcomes, the application of pbl to accounting education, and the formulation of our hypotheses in this research. section 3 describes the research method, including the experiment design and survey on the perceptions of pbl students and the results are presented in section 4. section 5 summarized and concludes the study. 2. literature review 2.1 teaching models of pbl barrows (1985) described how the basic model of pbl involves a teacher giving students a series of problems based on a particular theme. the students then engage in self-study via situated learning before participating in group discussion, or engage in group discussion to achieve consensus prior to self-study. teacher-student discussion is used to deepen the understanding of at the individual level before sharing the results with other groups during class (barrows, 1985; barrows and tamblyn, 1980). researchers have proposed modifications to pbl model based on their personal opinions or individual circumstances; however, even these modifications tend to follow the underlying principles upon which the pbl model was devised. breton (1999) implemented a 10-step problem solving methodology while tan (2003) used a 7-step pbl process. although pbl follows many different processes in a course or curriculum (debessay, 2003), its implementation must take into consideration teaching skills, familiarity with the pbl model, conciseness and feasibility, as well as investment time and other factors. stanley and marsden (2012) developed fride (see table 1), a model that uses a five-step problem-solving process to make it easier for students through shared discussions, listening exercises, encouraging respect for the ideas of peers, and interaction with fellow team members. this approach is suitable for students new to pbl and helps them to improve their communication and problem-solving skills, as well as enhancing their learning outcomes (stanley and marsden, 2012). hong (2004) argued that the choice of teaching mode is contingent on student ability and the depth of the problem. pbl is effective because teachers are able to combine various teaching methods and strategies within the system. teachers should seek to tailor pbl teaching methods according to specific educational goals (barrows, 1985; 1986; 1996). using barrow’s pbl model as a framework, hong (2001; 2004) sought to achieve the advantages of traditional teaching by developing a hybrid pbl model. his model has operation processes such as student self-study; small panel discussions, discussions with teacher, small panel reconvene, and class discussions in groups. 2.2 pbl and learning outcomes a number of empirical studies have documented the outcomes of using pbl in the field of accounting to improve problem-solving abilities. strobel and van barneveld (2009) used the meta-analysis in a review of eight studies dealing with the outcomes of pbl versus asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 139 traditional teaching approaches. they established four categories based on the assessment of learning outcomes: (1) non-performance, non-skill-oriented and non-knowledge-based assessment (2) knowledge assessment (3) performance or skill-based assessment (4) mixed knowledge and skill-based assessment. table 1. firde pbl approacha step action facts define the problem, gather facts and ask relevant probing questions ideas generate ideas and consider alternatives research research each issue pertaining to the problem decide collaborate, share ideas and make a decision execute communicate the decision to the client and/or execute the chosen option note (a): stanley, t. and marsden, s. 2012. problem-based learning: does accounting education need it? journal of accounting education, 30, p. 273 strobel and van barneveld (2009) indicated that pbl is positively associated with learning outcomes in the first category of the assessment, including measures of student satisfaction. vernon and blake (1993) found that pbl is significantly superior to the traditional teaching method with regard to program evaluations. they found pbl students were less prone to depression, anxiety, hostility and somatic complaints than were their traditional counterparts. in the second category, the knowledge assessment includes short-term knowledge acquisition (i.e., true/false questions, multiple choice questions) as well as long-term knowledge retention (i.e., short answers, essay questions, and free recall). although the previous studies of knowledge assessment produced mixed results, gijbels et al. (2005) claimed that traditional teaching methods favor short-term knowledge, while the pbl appears to be more effective in the long-term retention of knowledge and know-how (strobel and van barneveld, 2009). the relationship between pbl and learning outcomes is significant and positive, particularly when using standardized rating scales for the evaluation of student performance (gijbels et al., 2005; strobel and van barneveld, 2009). this does not appear to vary whether the evaluations are made during or at the end of the term by the supervisor (performance or skill-based assessment), or if the students are assessed by the oral examinations or case-based examinations (mixed knowledge and skill-based assessment). breton (1999) divided 49studentsintoa control group and an experimental group and then used questionnaires to perform statistical analysis comparing traditional teaching methods and pbl. those results suggest pbl can lead to learning outcomes superior to those achieved using traditional teaching methods. pbl has also been shown to promote life-long learning. breton (1999) offered support for the hypothesis that in an accounting education context, pbl methods produce academic results superior to those achieved using traditional lectures. he also provided evidence suggesting that pbl students were cognizant of having acquired knowledge and abilities which they expect will eventually be even more useful over the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 140 long-term. in 2000, giguere (2006) implemented pbl in a cost accounting course, in which it was found that the learning outcomes of pbl students were significantly better than those of students using the conventional approach to cost accounting (as rated using semester grade point averages). milne and mcconnell (2001) adopted pbl in accounting education, using a case study approach as an incentive for students to acquire new knowledge in order to grant them the freedom to learn and develop on their own, and in so doing promote their independent learning ability. in a case discussion of foundation courses in accounting information systems, heagy and lehmann (2005) performed an investigation into the use of pbl using high school graduates as well as students still enrolled in school. no significant differences were observed between traditional or pbl teaching pedagogies with regard to learning results. it was also pointed out that pbl does not necessarily adversely affect access to basic knowledge and tends to promote the satisfaction of learners. stanley and marsden (2012) adopted a novel accountancy capstone unit. from the562students enrolled over seven semesters, 481 filled out questionnaires. the quantitative and qualitative data collected from these questionnaires revealed that these students generally found pbl to be effective, particularly in terms of developing skills in questioning, teamwork, and problem solving. despite these findings and the widespread use of pbl, it was found that experimental research on the application of pbl to accounting education is very limited, particularly with regard to outcomes. to the best of our knowledge, only two studies used experimental methodology in this area (heagy and lehmann, 2005; breton, 1999). through the implementation of pbl, collaborative learning can be used to guide students in the gathering of information pertain to the situational learning. this also helps to teach students the importance of listening and respecting the opinions of others while developing communication and problem solving skills. through guided participation, students learn to organize a variety of learning resources and acquire the ability to deal with complex issues similar to those they are expected to face in the future. as such, pbl can be considered a method that puts situational learning into practice. in this manner, students obtain professional knowledge in accordance with the conceptual framework of accounting and develop a deeper expertise in the basics of accounting. based on the above discussions, we propose the following hypothesis: h1: pbl can improve the learning outcomes of accounting students more than the traditional teaching method. 3. research method 3.1 participants this study investigated the impact of pbl on teaching outcomes for 133 sophomore accounting students divided into two groups as subjects in a teaching experiment. two second-year accounting classes were selected from a private university in northern taiwan. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 141 class a consisted of 55 students and functioned as a control group who received lessons based on traditional teaching methods. class b consisted of 60 students and functioned as the experimental group who received pbl-based instruction. the intermediate accounting (accounting ii) course in this study was extended from elementary accounting (accounting i). both of these are required courses for all accounting students. the period of the experiment spanned 18 weeks throughout the first semesters of 2011 and 2012. students in both groups spent four hours per week on the course. among the total of 115 individuals, 89 were female. a total of 59 students had passed the review exam in elementary accounting, while 56 students did not. only 25 students had work-study experience, and 47 students have experience with writing reports. 3.2 experiment design we adopted a pre-test/post-test design with a control group. for the first eight weeks of the experiment, the two groups of students took the same course on intermediate accounting using the same teaching method with the same schedule. students in both groups were given a midterm exam in the ninth week to evaluate the progress of students in the acquisition of accounting knowledge in the two groups. the midterm exam paper was collaboratively designed by the two participating teachers. these exam results were used to determine whether there was a significant difference between the groups with regard to an understanding of course content related to intermediate accounting. in the second half of the experiment, the two groups were taught the same content using different teaching methods. on the 18th week (the final week of the semester), both groups of students took the same final exam designed by an independent third party (an accounting teacher). this made it possible to observe differences in learning outcomes between the two groups. during the period of the experiment (from the 10th 17th weeks), the students in class b (pbl group) were divided into eight groups, each consisting of six to eight students. according to lohman and finkelstein (2000), this is considered the optimal size for learning groups of this type. according to duch (2001), the problems used for pbl are easily adapted from the cases in textbooks. thus, we did not completely design the experimental lessons based on situational problems. instead, we revised essay questions and cases from each unit in the existing textbooks on intermediate accounting. this led to three major themes, for which we designed four problems each. thus, our modified problems also conformed to the principles of pbl. this study sought to develop a problem-solving process that was easy to remember; particular considering that this was our students’ first exposure to pbl. thus, we adopted the mutatis mutandis procedures proposed by stanley and marsden (2012) firde as well as the first operational process of hong’s (2001; 2004) model. the pbl students attended two sessions of the course each week, with each lesson lasting 110 minutes, including a 10-minute break. for the sake of integration, we planned three major activities for problem-solving: lecturing, group discussion, and class discussion. details related to each step are compiled in table 2. details related to each step are compiled in table 2. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 142 3.3 variables dependent variables: learning outcomes were measured either by the change in the test scores achieved in the midterm and final examinations, or percentage difference between pre-test and post-test scores. independent variable: teaching method was represented using a dummy variable in which the experimental group was identified as 1 and the control group as 0. the effect of teaching method on learning outcomes was expected to be positive (i.e., a more pronounced improvement in the learning outcomes of the experimental group than the control group). control variable: (1) gender: several studies have identified differences between men and women regarding their willingness to seek feedback (fletcher, 1999; roberson et al., 2003; opdecam and everaert, 2012; zhang et. al, 2012). (2) elementary accounting review exam passed (earep): opdecam and everaert (2012) used the exam scores of the students prior to the experiment as a measure of their ability in accounting. accordingly, we used whether the student passed the elementary accounting review exam as an indication of the students’ knowledge related to elementary accounting. (3) average grade before midterm (avgbm): this variable was calculated by averaging students’ scores on the three tests prior to the midterms of accounting ii. we used this to indicate the average learning performance of the students prior to the experiment. (4) grade variation (grdvr): this variable was calculated using the variation coefficient of the scores on the elementary accounting review exam as well as the three tests prior to the midterms. we used this to measure the discrete learning ability of the students before the experiment as an indication of stability in their learning performance. (5) work study experience (wsexp) and writing report experience (wrexp): students with work study experience or experience with writing report tend to be more sophisticated and present a higher degree of socialization, which makes their opinions more diversified. during pbl, these individuals are more likely to express distinctive ideas, participate actively in discussions, and/or be more knowledgeable regarding where to the find information required to solve problems (zhang et al., 2012). all of the skills help to improve learning outcomes; therefore, we included them as the control variables in this study. 3.4 perceptions of pbl students to explore the lasting effects of pbl on accounting students, we administered a post-experiment survey of students in the experimental group six months after the experiment and obtained 52 valid responses. the survey consisted of two sections: declarative statements to evaluate student impressions related to the pbl course and open-ended questions to collect comments and suggestions regarding the implementation of pbl in the intermediate accounting course. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 143 table 2. the process of pbl applied to intermediate accounting stanley and marsden (2012) hong model 1 (2001, 2004) activities of this studya explanation facts lecture the teacher explains the key concepts in the theme with a focus on the definition of assets, conditions for asset recognition, and asset valuation in the ifrs framework. facts ideas research student self-study self-direct ed learning each student group should collect and read data related to the topic assigned by the teacher. the teacher will provide students channels to access and gather reference data, including books of intermediate accounting, ifrs international standards, monthly journals of accounting studies, and ifrs websites established by the big four. research small panel discussions first session of before-clas s discussion members in each group should meet once a week to discuss what they have collected and their preliminary answer to the discussion topic. research discussion with the teacher discussion with the teacher the teacher should discuss with the next reporting group one week in advance to help them identify and solve problems, and organize their answers into materials that conform to the learning objective and content. research student self-study small panel reconvene second session of before-clas s discussion members in each group should discuss again what they have learned from an earlier discussion with the teacher. the goal of this discussion session is to make sure that all members have sufficient understanding of the learning theme and prepare the materials to report in class. decide execute class discussions by group; class presentatio n each group has to present a report at the scheduled time and date. the group leader will serve as the moderator, and each member has to report their part on the stage. their report should cover the problem their group is responsible for, the concepts or knowledge they have previously learned, new concepts or knowledge they learn this time, solution to the problem, difficulties encountered, and findings. group inquiry during class report, non-reporting groups have to propose questions about the topic or the content of the report. the reporting group has to answer each question. the teacher will provide supplementary information if their answer is inadequate. note (a): mutatis mutandis steps of the three major activities: lecturing, group discussion, and class discussion. they are integrated by the authors. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 144 3.4.1 post-class impressions assessed using statements this consisted of 7 statements to be rated using a scale from 1 to 7 (1 for strongly disagree and 7 for strongly agree). these statements were meant to measure the post-class perceptions of participants learning outcomes. each respondent could assign a score ranging from a low of 7 to a high of 49. the expected score was 28. the cronbach’s alpha coefficients were 0.704 respectively. the value exceeded 0.70, which indicates a high degree of reliability. 3.4.2 open-ended questionnaire this section included three questions. content analysis was applied to the students’ responses in order to identify key phrases in their answers to each question. question 1: what is the main factor that makes pbl suitable for application in the intermediate accounting course? what is the main factor that makes it unsuitable? question 2: what are the main strengths and main weaknesses of the pbl course you took last semester? question 3: how could the pbl course be further improved? 4. results 4.1 descriptive statistics panel 1 in table 3 lists the descriptive statistics of the experimental and control groups with regard to the pre-test, post-test, score differences, percentage of score differences, average grade before midterm(avgbm), grade variation(grdvr), gender, including q1, q3, median, maximum, minimum, average, and standard deviation. the q1, q3, median, maximum, and minimum of the pre-test scores of the two groups shows that they do not differ significantly, and no skewness is apparent. the mean pre-test scores are as follows: pbl group (experimental) 56.36 (s.d. =10.75) and control group 56.55 (s.d. =12.46). following completion of the experimental instruction, the mean post-test scores are as follows: pbl group (experimental) 69.82 (s.d. =16.03) and control group 66.15 (s.d. =20.63). the mean avgbm scores are as follows: pbl group (experiment) 73.33 (s.d. =16.51) and control group 84.92 (s.d. =17.53). the mean grdvr scores are as follows: pbl group (experimental) 31.93 (s.d. =13.14) and control group 33.06 (s.d. =28.27). 4.2 pbl and learning outcomes 4.2.1 mann-whitney test panel 2 in table 3 presents mann-whitney test results in the form of pre-test scores1, score differences, and percentage of score differences between the two groups. as the score difference may not conform to the normal distribution assumption, the nonparametric mann-whitney test is more appropriate to adopt for the sound analysis. the results indicate 1we thank an anonymous referee for suggesting this as an analysis method. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 145 that the difference in pre-test scores is not significant. this suggests that no significant differences existed between the two groups with regard to accounting knowledge prior to the experiment. however, after the experiment, significance differences were observed with regard to the extent of improvement, which validates our hypothesis. the difference in scores shows only the absolute difference between the data obtained in the two periods, whereas the percentage of score difference standardizes the base period (midterm exam) using the same frame of reference, thereby eliminating the size-effect and thus enabling a comparison of the magnitude of difference based on this standard. meanwhile in the panel 1 of table 3, for the pbl and the control group, respectively, the mean of the score difference is 13.46 (s.d.=12.90) and 9.6 (s.d.=12.63), while mean of the percentage of score differences is 23.88% (s.d. =25.26) and 16.98% (s.d. =23.59). mann-whitney results show the significant difference between the pbl group and control group in term of the score difference and percentage of score difference. this implies that the adoption of pbl can have a significant influence on learning outcomes. 4.2 pbl and learning outcomes 4.2.1mann-whitney test panel 2 in table 3 presents mann-whitney test results in the form of pre-test scores, score differences, and percentage of score differences between the two groups. as the score difference may not conform to the normal distribution assumption, the nonparametric mann-whitney test is more appropriate to adopt for the sound analysis. the results indicate that the difference in pre-test scores is not significant. this suggests that no significant differences existed between the two groups with regard to accounting knowledge prior to the experiment. however, after the experiment, significance differences were observed with regard to the extent of improvement, which validates our hypothesis. the difference in scores shows only the absolute difference between the data obtained in the two periods, whereas the percentage of score difference standardizes the base period (midterm exam) using the same frame of reference, thereby eliminating the size-effect and thus enabling a comparison of the magnitude of difference based on this standard. meanwhile in the panel 1 of table 3, for the pbl and the control group, respectively, the mean of the score difference is 13.46 (s.d.=12.90) and 9.6 (s.d.=12.63), while mean of the percentage of score differences is 23.88% (s.d. =25.26) and 16.98% (s.d. =23.59). mann-whitney results show the significant difference between the pbl group and control group in term of the score difference and percentage of score difference. this implies that the adoption of pbl can have a significant influence on learning outcomes. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 146 table 3. descriptive statistics for univariate t-test panel 1：descriptive statistics min q1 median q3 max mean s. d. pre-test scores 18.00 49.00 58.00 64.00 84.00 56.46 11.62 pbl 26.00 51.00 59.00 63.00 76.50 56.36 10.75 control 18.00 48.25 58.00 65.75 84.00 56.55 12.46 post-test scores 15.00 56.00 68.00 83.00 100.00 67.90 18.58 pbl 25.00 59.00 69.00 83.00 97.00 69.82 16.03 control 15.00 53.50 67.00 83.50 100.00 66.15 20.63 score differencesa -18.00 1.00 12.00 21.50 35.00 11.44 12.85 pbl -15.00 3.00 16.50 22.50 35.00 13.46 12.90 control -18.00 0.00 9.75 20.00 34.00 9.60 12.63 percentage of score differencesb -41.86 2.33 19.15 38.46 78.38 20.24 24.79 pbl -41.86 6.02 26.83 42.55 78.38 23.88 25.26 control -38.46 0.00 14.71 33.67 64.00 16.98 23.59 avgbmc 0.00 68.33 83.67 94.00 100.00 79.38 17.95 pbl 41.17 59.83 77.83 84.83 98.00 73.33 16.51 control 0.00 79.58 89.34 97.17 100.00 84.92 17.53 grdvrd 7.72 22.11 27.84 37.82 223.61 32.52 22.26 pbl 12.07 22.11 32.52 39.71 68.38 31.93 13.14 control 7.72 21.52 27.11 36.93 223.61 33.06 28.27 gender 0.00 1.00 1.00 1.00 1.00 0.77 0.42 pbl 0.00 1.00 1.00 1.00 1.00 0.80 0.40 control 0.00 1.00 1.00 1.00 1.00 0.75 0.44 panel 2：mann-whitney u test mean median mann-whitney u zstatistice p-value pre-test pbl 57.16 59.00 3144.00 -.258 .797 control 58.77 58.00 score differencesa pbl 63.41 16.50 3182.50 -1,66* .096 control 53.04 9.75 percentage of score differencesb pbl 64.48 26.83 3123.50 -1.996** .046 control 52.06 14.71 note (a): it’s for the difference of two classes: difference between final and midterm grades (i.e., final minus midterm). (b): it’s for the difference of two classes: percentage difference between final and midterm grades (i.e., final minus midterm, divided by midterm grade). (c) avgbm: represents the average scores in the 3 tests before the mid-term exam of intermediate accounting. (d) grdvr: represents the variation coefficient of the scores on the elementary accounting review exam and the 3 tests before the mid-term exam of intermediate accounting. (e) it denotes * p < 10%, ** p < 5%, *** p < 1%. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 147 sample size is 55 for pbl group and 60 for control group. 4.2.2 regression analysis and learning outcomes panel 1 in table 4 presents our regression analysis of the learning outcomes. both by percentage of score difference and score differences as the dependent variable, our results indicated that pbl can have a significant and positive effect on learning outcomes. in other words, the adoption of pbl improved student performance in accounting ii, which our hypothesis that pbl-based lessons could improve the learning outcomes of accounting students. in addition, female students displayed learning achievements superior to those of their male counterparts. furthermore, students that had passed the elementary accounting review exam outperformed those who had not passed. in terms of the interaction effects between pbl and student attributes, our results revealed that gender moderates the relationship between pbl and learning outcomes (t=-2.006, p<0.05) under the learning outcome measured by the percentage of score differences. we then segmented the data according to gender and investigated the influence of pbl on the learning outcomes in the two groups (see panel 2 in table 4). our results indicate that the positive effects of pbl are more apparent in the learning outcomes of male students than that of female students (t=2.297; 2.120, p<0.05), regardless of whether we used percent difference or score difference. furthermore, the positive effects of pbl are more apparent among male students that had passed the elementary accounting review exam than those who had not (t=2.202; 3.072, p<0.05). 4.3 after-class perceptions based on student statements we distributed qualitative after-class surveys to students in the experimental group in order to capture their subjective impressions and their degree of acceptance toward pbl implementation. the survey consisted of two sections: declarative statements to evaluate student impressions related to the pbl course and open-ended questions to collect comments and suggestions regarding the implementation of pbl in the intermediate accounting course. three key elements were used for the categorization of responses to the questionnaire: 1) encouragement of self-directed learning, 2) promotion of independent thinking, and 3) gaining professional knowledge. table 5 presents the average scores indicating, except for gaining professional knowledge, encouragement of self-directed learning (t=7.80; 6.09, p<0.001) and promoting independent thinking (t=7.35; 3.54,3.54 p<0.00) are statistically significant, that is students believe that the pbl method helped them to develop a desire for self-directed learning and independent thinking. the responses to the open questions from pbl are extracted and summarized in the appendix 1. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 148 table 4. learning outcome differences panel 1：the overall sample percentage of score differences score differences variablea -value t-valuec vif -value t-valuec vif intercept -0.020 -0.236 -1.157 -.267 pbl 0.313 2.575** 7.755 13.161 2.109** 7.617 gender 0.131 1.711* 2.178 8.240 1.992** 2.390 earep 0.200 3.064** 2.253 10.750 3.211*** 2.194 avgbmb -0.016 -0.203 3.237 -.064 -.015 3.512 wsexp 0.029 0.358 2.431 .528 .124 2.465 wrexp -0.021 -0.293 2.512 -.269 -.072 2.621 pbl×gender -0.226 -2.006** 6.339 -4.968 -.998 3.890 pbl×earep -0.156 -1.612 3.969 -12.209 -2.064** 6.488 pbl×avgbm 0.038 0.364 3.895 3.208 .572 4.023 pbl×wsep 0.035 0.318 2.729 1.228 .216 2.764 pbl×wrexp -0.008 -0.084 3.856 -.220 -.043 3.936 fc 2.313** 2.631*** n 115 115 r2 0.198 0.224 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 149 panel 2：subsample by gender (with no interaction between pbl and control variables) percentage of score differences score differences female male female male variablesa -value t-valuec vif -value t-valuec vif -value t-valuec vif -value t-valuec vif intercept 0.093 1.478 0.089 1.015 5.172 1.494 2.475 0.593 pbl 0.041 0.724 1.379 0.235 2.297** 1.396 1.069 0.342 1.482 10.312 2.120** 1.396 earep 0.102 1.931* 1.175 0.226 2.202** 1.429 6.796 2.471** 1.145 14.986 3.072*** 1.429 avgbmb 0.043 0.733 1.284 -0.161 -1.596 1.355 3.577 1.134 1.330 -5.734 -1.196 1.355 wsexp 0.075 1.330 1.035 -0.349 -1.988* 1.202 2.256 0.762 1.045 -15.279 -1.826* 1.202 wrexp 0.001 0.013 1.249 -0.107 -1.128 1.162 1.036 0.349 1.282 -4.597 -1.020 1.162 fc 1.773 4.802*** 2.132* 5.727*** n 89 26 89 26 r2 0.097 0.546 0.118 0.589 note (a): variable definition: pbl (1 for experimental group, 0 for control group), gender (1 for female, 0 for male), earep (1 for passed, 0 for failed), avgbm (average scores in the 3 tests prior to mid-terms), wsexp: (1 for students with work-study experience, 0 for none), and wrexp (1 for students with written reports experience, 0 for none). (b) we attempt to use grade variation (grdvr) in place of average grade (avgbm) in the regression model. unfortunately, the result is not statistical significance and its vif value of the grdvr is 10.257, greater than 10. therefore, we exclude the grdvr variable from the regression model. (c) it denotes * p < 10%, ** p < 5%, *** p < 1%. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 150 table 5. pbl students’ perceptions about learning outcomes statements totala mean s.d. t-valueb panel 1: encouraging self-directed learning 1. pbl helps my development of lifelong and independent learning abilities. 257 4.94 0.85 7.80*** 2. pbl has increased the amount of time and effort i spend on reading financial accounting books. 267 5.13 1.34 6.09*** panel 2: promoting independent thinking 1. pbl allows me to have more critical thinking and judgment about ifrs issues. 261 5.02 1.00 7.35*** 2. through group discussion in pbl, i get to know people who share my interests. 235 4.52 1.06 3.54*** 3. pbl allows me to have the pleasure of learning something outside professional knowledge. 234 4.50 1.02 3.54*** panel 3: gaining more professional knowledge 1. pbl increases my interest in accounting studies. 216 4.15 0.83 1.34 2. pbl reduces my stress from learning accounting. 197 3.79 1.14 -1.34 note (a): using 7 points of the likert scale (7=strong agreement, 6=agreement, 5＝less agreement, 4 ＝inconclusive, 3＝less disagreement, 2＝disagreement, 1＝strong disagreement)，the total scores is the sum of the response score from the 52 students (b) it denotes *:p< 10%, **: p < 5%, ***: p < 1%. sample size is 52. 5. conclusion and suggestions this study addressed the reforms called for by accounting professionals and practitioners of accounting education to improve the quality of accounting education. we employed an experimental approach to the study of pbl within the context of a course on intermediate accounting at the university level. the pbl teaching mode used in this study was a combination of firde, proposed by stanley and marsden (2012), and hong’s (2001) pbl operation mode. our findings indicate that pbl can significantly improve learning outcomes. gender was shown to influence learning outcomes as was whether the student had passed the elementary accounting review exam. the improvements of male students were more pronounced that than those of female students. furthermore, male students that had passed the elementary accounting review exam performed better than those who had not. in a post-class survey applied to the experimental group, we examined the impressions of students with regard to pbl. our results demonstrate the ability of pbl to encourage self-directed learning, promote independent thinking, and facilitate the acquisition of professional knowledge. in fact, by picking up ifrs accounting issues, students benefited greatly from the cultivation of independent thinking and judgment as well as problem-solving asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 151 abilities. the profession of accounting requires of its employees the ability to identify problems, seek information, make decisions, and acquire documentation. pbl learning appears to be right on target in helping students develop the skills that will enhance their future competitiveness in the workplace. in the following, we provide concrete suggestions for accounting educators wishing to apply pbl to a curriculum in accounting, or for researchers interested in the implications of pbl for future study: (1) provide sufficient explanations about pbl prior to implementation. (2) use lecture-based and pbl approaches alternately and adjust the teaching approach according to the feedback from students. (3) use real-world problems moving from easier to harder. guide students in the identification of problems and seek to induce their interest in order to reduce their resistance to this new approach. (4) use one example topic to familiarize students with the steps of pbl. give students more time for preparation and discussion, and reduce the frequency of reporting to an appropriate level. build an online sharing platform that provides references for problem discussion. (5) use diverse evaluation methods, including teacher assessment, student self-evaluation, and peer evaluation. tests can be essay questions or exercises of practical problems. despite our careful research design and analysis methods, a number of inherent limitations may affect the generalizability of our findings. first, the experiment and control groups were taught by two different teachers, while the grading standards were the same. thus, interference effects may not have been completely eliminated. then, the content of the after-class pbl questionnaire was developed and modified based on multiple discussions and consultations with other experienced teachers of the intermediate accounting course with little or no guidance from the literature on pbl. finally, this study is a preliminary exploration into the application of pbl to intermediate accounting courses in taiwan. although the initial conclusion is that pbl enhances the learning outcomes of intermediate accounting courses, there may also be other factors that warrant further investigation. any interpretation of our study results should be done with caution due to the lack of generalizability to other courses or other education systems in other countries. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 152 references accounting education change commission, & american accounting association. 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(2012) the conceptof problem-based learning, inc. h. yang (eds), pbl teaching practice -in national yilan university experience and reflection, 2-12.yilan county: national yilan university. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 154 zhang, y., fang, y., wei, k. k., & wang, z. (2012) promoting the intention of students to continue their participation in e-learning systems: the role of the communication environment. information technology & people, 25(4), 356-375. http://dx.doi.org/10.1108/09593841211278776 appendix 1. pbl students’ responses to opened-questions regarding learning outcomes panel 1: encouraging self-directed learning 1. 1. pbl encourages us to be active learners. it enables us to acquire more accounting concepts than we could from books and it did not matter whether these concepts were highly important or not. 2. pbl enables us to use logic to think and learn, so we can gain a deeper impression of the learning material. 3. everyone is responsible for motivating themselves to preview themes, divide up the labor, and learn how to prepare reports. 4. this innovative method of learning increased learning pleasure. panel 2: promoting independent thinking 1. pbl is suitable for many ifrs issues. it facilitates independent thinking. 2. pbl allowed me to gain a deeper understanding of accounting procedures. i learned how to gather data to solve problems, rather than simply doing textbook exercises. 3. pbl gave me a clearer understanding of the definitions, and enabled me to escape the conventional way of learning through the repetition of exercises. panel 3: gaining more professional knowledge 1. using pbl, i gained a deeper understanding of intermediate accounting content, rather than just to prepare for exams. 2. it appears easier to learn from practical, real-world cases. 3. using pbl, i am motivated to look up international bulletins and related extracurricular books to obtain the data that i need. this makes the learning more in-depth and gives me a much better understanding of the blind spots i encounter. sample size is 52. microsoft word 8185-29584-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 93 foreign direct investments and economic growth: the primary drivers peter nderitu githaiga school of business and economics, department of accounting and finance moi university, eldoret, kenya tel: 254-722-350-383 e-mail: nderitugithaiga@mu.ac.ke josiah nyauncho school of business and economics, department of accounting and finance moi university, eldoret, kenya charles githinji kabiru finance department, moi university, eldoret, kenya received: august 21, 2015 accepted: sep. 23, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8185 url: http://dx.doi.org/10.5296/ajfa.v7i2.8185 abstract in order to achieve the global millennium development goals (mdgs) there is need for enhanced global partnerships in areas such as trade, health, security, environmental sustainability, food security and education. owing to these initiatives foreign direct investments (fdis), official foreign development assistance (odas) and other external capital flows are increasingly considered as drivers of economic growth for developing countries. by year 2000 fdis flow to developing countries accounted for 19% of the total global fdi flow compared to 52% in 2010. collectively fdi equates to 11% of global gdp and generates close to 80 million jobs globally. global fdi totaled to us$ 1.2 trillion in 2010, us$ 1.4 trillion in 2011 and us$ 1.8 trillion in 2012. similarly, the developing countries received half of the fdi and only invested a quarter of the fdi out flow. studies show that fdis contributes to economic growth by stimulating several macro-economic and demographic variables which are major agents of economic growth. this paper sought to explain the effect of fdi on the determinants of economic growth human capital asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 94 development, financial sector development and trade openness. a sample of 30 african countries was used for the study. the data used was retrieved from unctad and world bank online databases for the period between 1980 and 2012 and analyzed through a fixed effect regression model. the results of the study show that fdi had a positive impact on measures of financial sector development and trade openness. however the effect of fdi on human capital development was negative. the study recommends the need for favorable monetary policies that elicit more fdi for enhanced economic growth. the study also suggests increased global trade liberalization and integration to boost trade. finally the study recommends that additional fdi flows should be directed towards human capital development. keywords: fdi, economic growth, human capital development, financial sector development, trade openness jel classification: f23, f36, f43, o40 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 95 1. introduction the global urge to achieve the millennium development goals (mdgs) by 2015 has led to enhanced and integrated transnational partnerships in trade, health, education and security. these partnerships are demonstrated by the increased flow of fdis, official development assistance (odas) and other foreign capital flows to developing countries. this is true for africa which in the last five decades received a smaller portion of fdi inflows compared to developed countries (asiedu, 2003). today there is unprecedented increase in the volume of fdis flowing to africa. for instance in year 2000 fdis received by developing countries was estimated at 19% of total global fdis compared to 52% in 2010. fdis accounts for 11% of global gdp and creates close to 80 million jobs globally (unctad 2010). global fdi totaled to us$ 1.2 trillion in 2010, us$ 1.4 2011 and us$ 1.8 in 2012 notably the developing countries received half of the fdi and invested only a quarter of the fdi out flow (unctad 2012).it should also be noted that foreign direct investment have potentially desirable elements that affect the quality of growth which in the long run effect on poverty reduction, diffusion of technology, capital and managerial transfer and human capital accumulation. fdis also absorb adverse shocks emanating from inefficiencies in the financial systems that adversely affect the poor population. besides fdis support corporate governance through the creation of sound institutional frameworks. studies show that revenue generated from fdi support the development of safety nets for the underprivileged (klein, aaron and hadji michael, 2001). owing to the importance of fdi on economic growth, studies are focusing on the determinants of fdi in developing countries identify supportive infrastructures, technical and managerial skills, macroeconomic stability and sound institutions as the key pull factors of fdi. with globalization interconnectivity ict has been documented in empirical work (addison and heshmati, 2003). other determinants include lower borrowing costs, economic reforms, and commitments to macro-economic discipline dabla-norris et al (2010). fdi and other foreign capital flows such as remittances remain significant external sources of finance for developing countries are face serious credit constraints. another branch of studies concentrate on the impact of fdis on the recipient countries economic growth (alfaro and chanda 2006,) and technological advancement through a spillover effect associated with transnational interaction. important to note today is a growing relationship between china and african countries in areas such as trade and infrastructural development as noted by judith (2006). 2. theory and hypothesis development the impact of fdis and other foreign capital flows on human capital development, technology transfer and economic growth (through the spillover effect) is extensively debated in literature. theories in economics claim that an efficient financial sector, political stability and human capital development are the key drivers of a sound and sustainable economic growth. the effect of fdis on economic growth can be analyzed as either direct or indirect. the direct effect is exhibited by infrastructural development, new businesses, job creation and portfolio investments. indirectly, fdi leads to improved technical knowhow, transfer of managerial practices and concepts and technology spillovers. fdis also contributes to capital accumulation through initiating domestic demand and consumption of goods and services asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 96 (feenstra and markusen, 1994). studies by de mello (1997 and 1999) show that fdis contributes to new job opportunities, enhancement of technology transfer, and boosts overall economic growth in recipient countries. fdi are classified fdis as either horizontal or vertical beugelsdijk et al. (2008). the two types of fdis have different impacts and these differences arise from the type of fdi and the characteristics of the receiving countries. these country characteristics include economic, political institutions and other factors which determine a country’s affinity for fdis. for instance, developed countries enjoy solid institutional framework which make horizontal fdis have a higher impact on economic growth than vertical fdis. vertical fdis stimulate demand for labour. there is vast literature on the fdi – human capital – economic growth triangle. the impact of fdi solely depends on a country’s capacity to absorb the embodied technologies. this absorptive capacity depends on the level of human capital development. they estimate that 0.45 years of secondary school education is necessary to benefit from an infusion of foreign technology. the impact of fdis on human capital development is explained by lucas and romer endogenous growth model. endogenous growth model argue that endogenously accumulated human capital has a direct impact on productivity of labour since human capital development is specific to individuals thereby leaving innovation as a stock of knowledge as an exogenous factor. human capital development is vital for long term growth owing to its direct input into scientific knowledge (romer, 1990; aghion and howitt, 1992) or due to its positive externalities. lucas (1988) notes that growth differentials among countries originate from transnational variations in human capital development. the key constituents of human capital development are education and health care. foreign direct investment is classified based on the motive behind such foreign capital flows; natural resources fdis (access to natural resources), market seeking fdis (increase market share), efficiencies seeking fdis (reduction of production cost) and strategic asset seeking fdis (technological transfers) usaid (2005). notably fdis and other foreign capital flows remain important sources of capital for developing and emerging economies thereby prompting academicians, development agencies and governments’ agencies to carry out numerous studies focusing on the key drivers of fdis. most of these studies are aimed at policy issues that create an enabling economic climate for fdis to flourish and have a greater macro-economic impact. some studies argue that real gdp, inflation and political stability as the primary determinants of fdi. other determinants of fdi include; macro-economic conditions of the recipient country blonigen (2005); push factor in the source country and pull factor in the recipient country (fernandez–arias, eduordo, 1996); gdp and bi-directional causality, chowdhury and mavrotas( 2006) whose findings are premised on economic soundness as a precondition for external capital inflows and vice versa; trade protection, exchange rates, taxes and institutions (blonigen 2005); financial markets development (alfaro et al, 2003); skilled labour (waldkrich 2010); superior plant and management expertise (miyamoto 2003); financial sophistication (adeniyi et al 2012). several theories have attempted to explain the magnitude and direction of fdis and other foreign capital transfers. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 97 production cycle theory (vernon 1966) maintains that a production cycle has four stages: innovation, growth, maturity and decline. according to the theory, a product was created for developed and high income markets and as the market matures competition and imitation begins the product is standardized and this pushes the product to lower income markets in developing countries. subsequently, fdi will flow alongside the product life cycle. another theory is “the theory of exchange rates on imperfect capital markets” by itagaki (1981) and cushman (1985). this theory identifies exchange rate uncertainty as the determinant of fdi. cushman found that an appreciation in real exchange rate spurred fdi made by us$ while an appreciation in foreign currency reduced american fdi (denisia 2010). based on the theory of exchange rates speculative behaviour on exchange rates therefore determines the magnitude and the direction of fdis. the internalization theory by buckley and casson, (1976) modified by hennart (1982) later revised by casson, (1983) postulate that multinational corporations capitalize on their own internal capabilities accordingly will organize their internal processes in a manner that maximize specific foreign advantages in production and distribution. multinational corporation enjoys certain economies through direct foreign investment compared to other entry strategies to foreign markets. hyme (1976) found that fdi is a firm-level strategy decision rather than a capital-market financial decision. “the eclectic paradigm” theory by dunning (1988) merges both industrial economics and international trade to explain the existence, activities and strategies of mnes. the electric paradigm theory identifies three sources of competitive advantage which prompts the establishment of mncs; ownership advantage, geographical advantage and internalization advantage. lastly is the “transaction cost” theory developed by coase (1937) that suggest that cost discovering relevant to prices and cost of certainty, if high enough in market place, justifies firms’ decisions to coordinate economic activities locally and globally. since many studies have focused on the effect of fdi on economic growth; this study will shift its focus by looking at the effect of fdis on the key determinants of economic growth. the concept of economic growth is multifaceted and it’s the output of the interaction of a number of variables. some of the determinants of economic growth are; inflation, trade openness, and current account balance tolo (2011); demography, education, economic openness, institutions and trade policy bhalla (2012); rule of law and international, openness, human capital (barro 2003); human capital and foreign direct investment and stock market liquidity (salahuddin 2010); terms of trade, improvements on the quality of capital, and the presence of distortions; human and physical capital accumulation chumacero and fuentes (2003). the impact of fdi on economic growth is dependent on the casual relationship between remittances and the drivers of economic growth. this paper therefore sought to explain the effects of fdis on the primary drivers of economic growth namely; human capital development (hcd), trade openness (to), and financial sector development (fsd). these drivers are also considered as pull factors of fdis and other foreign capital flows. for example on human capital development, a report by unctad (1994:218) note mncs’ “demand for highly trained graduates manifests itself in the form of financial support, particularly to business schools and science facilities, the provision of assistance and advice through membership of advisory boards, curriculum review committees, councils and senates” asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 98 the study had three hypotheses as shown below: h01 foreign direct investment has a positive and statistically significant effect on financial sector development h02 foreign direct investment has a positive and statistically significant effect on human capital development h03 foreign direct investment has a positive and statistically significant effect on trade openness 2.2 conceptual framework the diagram below illustrates the conceptual framework of the research. in the diagram foreign direct investment is the independent variable while the three primary drivers of economic growth are considered as the dependent variables. independent variable dependent variable figure 1. conceptual framework 3. research methodology the study used a sample of 30 countries and their data for the period between 1980 and 2012(see the list of countries in table 7). the data used was collected and stored by world bank’s (world development indicator database) (2014) and unctad (2014). fdi was measured as a percentage of the recipient country gdp. this will help control for country size and population. economic and monetary policies were indexed by the rate of inflation and exchange rates. trade openness with be measured by the volume of exports as a percentage of gdp while the financial sector development was indexed by domestic credit to private sector as a percentage of gdp and bank deposit as a percentage of gdp. human capital development (hcd) is measured by health component indexed by infant mortality rate. the study controlled for monetary policies, gdp per capita income (initial state) and other foreign capital flows and local investment. a country’s monetary policy attracts or discourages local and foreign investor. the attractiveness of monetary policies is measured foreign direct investment (fdi) drivers of economic growth • human capital development (h1) • trade openness (h2) • financial sector development (h3) control variables • rate of inflation • exchange rate • gdp • remittances asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 99 by exchange rates (exch) and the level of inflation (inf). the determinants of economic growth were influenced by government and private citizens’ investments. gross capital formation (local investment denoted by li) controls for the aggregate improvement in a country’s capital stock. apart from fdi a country benefits from other external capital flows such as remittances and foreign aid which also have an impact on economic growth. the effect of these foreign capital inflows on the determinants of economic growth was controlled for by personal remittance received as a percentage of gdp (rem). the research model is shown below; degi = 0i+ 1fdii + 2mpi + 3 i + 4lii + 5remi + i . where; deg represents drivers of economic growth (financial sector development, trade openness and human capital development). fdi represent foreign direct investments (explanatory variable). mp represents monetary policy, gdp denote gross domestic product, rem represents other foreign capital flows and li local investment both (government and private investment). denotes an error term 4. empirical analysis 4.1 descriptive statistics table 1 shows the period averages and summary statistics for the research variables for the period 1980-2012. the mean fdi net inflows were estimated at 3.520% of the gdp of the receiving countries with a minimum value of -6.897 and maximum value of 35.24. table 1 confirms a significant increment in fdi in the last decade up from 1.4% in 1980 to 3.2% in 2012. the average domestic credit to private sector was estimated at 36.5% of gdp. credit to private sector double between 1980 and 2012 as shown by the average values of 2.6% in 1980 and 4.8% in 2012. the mean remittances received in the period were 5.38% of gdp. there was a slight improvement in these transfers of 0.6. what is worth noting is the fact that remittances are a larger component of the receiving countries gdp compared to gdp. the analysis further show that the combined effect of remittances and foreign direct investment is approximate 7.6% of gdp compared to an average local investment of 23.26% of gdp (approximately one-third of local investments)these figures suggest that foreign capital flows are important external sources of finance if well harnessed. the high exchange rate of 90.71% and inflation of 28.49% indicate ineffective monetary policies that discourage investment both local and foreign. the table further shows high infant mortality rate averaged at 45 deaths per 1000 of the population which is deterrence to human capital development. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 100 table 1. summary statistic of the research variable 4.2 correlation analysis the correlation matrix represented in table show that fdis are positively correlated with other foreign capital flows, gdp, trade openness (export), investments and domestic credit to private sector investment. the positive link between fdis and other foreign transfers could be due to similarities of push and pull factors. fdis and local investments have a dual causality. the existing state of infrastructure attract foreign investors or still foreign investors and donors would be willing to invest on infrastructural development where locals are not willing to invest due to the huge capital outlays, lack of expertise or risks involved. the relationship between fdis and bank credit is likely to be duo. availability of credit locally attracts foreign investors; likewise foreign investor interested in lending or interesting in securities can help alleviate credit constraints affecting households. the relationship between fdi and exchange rates, inflation and human capital development is negative. unfavorable monetary regime inhibits foreign investors. foreign capital flows are on the other hand associated with the dutch disease. table 2. pairwise correlation of the research variables rem 990 5.385063 11.88878 .0014116 106.4789 li 990 23.26887 7.992249 3.377636 74.82202 inf 990 28.4905 395.1565 -11.16159 12338.66 exch 990 90.71891 215.3887 .0000245 1401.437 gdp 990 5328.565 9819.106 168.7364 67435.95 export 990 31.02137 16.61088 3.279997 100.949 hcd 990 45.17061 30.49665 1.7 133.5 credit 990 36.57213 30.61217 1.542268 319.4609 deposit 990 27.18864 353.0369 -128.9158 11046.93 fdi 990 2.351571 3.520934 -6.897609 35.23495 variable obs mean std. dev. min max rem 0.2304 -0.0226 -0.1113 0.1599 0.0732 -0.1726 -0.1145 -0.0201 0.4520 1.0000 li 0.3083 -0.0153 0.2074 -0.1691 0.1661 0.0225 0.0291 -0.0248 1.0000 inf -0.0281 0.9972 -0.0313 0.0687 -0.0308 -0.0235 -0.0226 1.0000 exch -0.0862 -0.0159 0.1277 -0.1281 0.0382 0.0375 1.0000 gdp 0.1138 -0.0120 0.6043 -0.5503 -0.0676 1.0000 export 0.2837 -0.0245 0.2017 -0.3182 1.0000 hcd -0.1335 0.0553 -0.5388 1.0000 credit 0.2362 -0.0088 1.0000 deposit -0.0229 1.0000 fdi 1.0000 fdi deposit credit hcd export gdp exch inf li rem asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 101 4.2 results of panel regression the study predicts that 1% increase in fdi stimulates 1.4% growth in domestic credit to private sector and 0.4% expansion in bank deposits. however it’s only the link between fdi and domestic credit to private sector that was found as statistically significant as confirmed by t=8.39 and p=0.000 as shown in table 3. the regression results for fdi and bank deposits shown in table 5 with t=1.47 and p=0.141 illustrate that the effect of fdi on bank deposits is statistically insignificant. the study further established a significant and negative relationship between fdis and human capital development (infant mortality rate) as reported by t= 5.71 and p= 0.000 as shown in table 4. the beta coefficient suggests that 1% increase in fdi contributes to 0.87% deterioration in health care in the receiving country. the relationship between trade openness fdi was statistically significant and positive (t=3.8, p=0.000) illustrated in table 6.. one point improvement in fdi is accompanied by 0.35 point improvement in trade openness. it’s therefore logical to conclude that foreign capital flows be it official development assistance, portfolio investments or altruistic transfers such as personal remittances will open up a country’s economy. table 3. regression of fdi on domestic credit to private sector table 4. regression of fdi on human capital development _cons 13.50807 6.13415 2.20 0.036 .9623242 26.05382 rem .1376739 .1419627 0.97 0.340 -.1526723 .4280202 li .2572714 .1251571 2.06 0.049 .0012964 .5132464 inf -.0011974 .0003237 -3.70 0.001 -.0018594 -.0005355 exch .0191303 .0353532 0.54 0.593 -.0531751 .0914357 gdp .0021414 .0006562 3.26 0.003 .0007993 .0034835 fdi 1.37113 .7512414 1.83 0.078 -.1653311 2.907591 credit coef. std. err. t p>|t| [95% conf. interval] robust _cons 56.8733 6.44161 8.83 0.000 43.69873 70.04787 rem -.4430031 .2837535 -1.56 0.129 -1.023344 .137338 li -.1469277 .2457637 -0.60 0.555 -.6495709 .3557154 inf .0028719 .0003142 9.14 0.000 .0022292 .0035145 exch -.0289548 .0150678 -1.92 0.065 -.0597718 .0018622 gdp -.000244 .0001721 -1.42 0.167 -.000596 .0001079 fdi -.8730139 .3293321 -2.65 0.013 -1.546574 -.1994542 hcd coef. std. err. t p>|t| [95% conf. interval] robust asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 102 table 5. regression of fdi on bank deposits (claims to private sector% gdp) table 6: regression of fdi on trade openness 5. conclusion and recommendations the study concludes that fdis stimulates financial sector development. fdis enhance the availability of capital for investment purposes either through direct investments by the foreign investors or indirectly through investment vehicles such us investment banks, money markets or capital markets. the study also established that foreign direct investments boost trade openness. trade openness could be as a result of market drive fdis or spillover effect arising from cross border transactions. in the study fdi was found as having undesirable effect on health care replicating peter and nunnenkamp (2012) and wilkinson (2000) who maintain that fdis contributes to unequal societies that are described by relative deficiency and prolonged stress considered the main channels through which inequality ruins health. this observation is informed by the argument that fdis are market driven unlike official development assistance and remittances. many studies show that fdi have a positive effect on economic growth. this study sought to establish the direct impact of fdis on the primary drivers of economic growth. the study therefore recommends the need for favourable monetary regimes that attracts foreign investments. favorable monetary regime encompasses stable exchange rates, controlled inflation and interest rate regimes. favorable monetary policies attract more foreign direct investments for development purposes. the study further recommends preferential trade agreements and market liberation as a way of encouraging international trade. enhanced international trade facilitates the flow of factors of production including foreign capital. the study further recommends that foreign investors should consider investing directly into human capital development. _cons -13.01903 5.887971 -2.21 0.035 -25.06128 -.976776 rem .0055936 .0626753 0.09 0.929 -.1225917 .133779 li .6107197 .2393492 2.55 0.016 .1211955 1.100244 inf .8914029 .000979 910.52 0.000 .8894006 .8934052 exch .0084561 .0171578 0.49 0.626 -.0266355 .0435477 gdp -.0002186 .0002034 -1.07 0.292 -.0006346 .0001975 fdi .4115461 .3733992 1.10 0.279 -.3521409 1.175233 deposit coef. std. err. t p>|t| [95% conf. interval] robust _cons 28.99464 5.422434 5.35 0.000 17.90452 40.08476 rem -.1613849 .1707604 -0.95 0.352 -.510629 .1878593 li -.0291776 .2098073 -0.14 0.890 -.4582816 .3999264 inf -.0005887 .0001303 -4.52 0.000 -.0008552 -.0003223 exch .0240264 .0054303 4.42 0.000 .0129203 .0351325 gdp .0001116 .0000684 1.63 0.113 -.0000282 .0002514 fdi .3475294 .2111934 1.65 0.111 -.0844096 .7794684 export coef. std. err. t p>|t| [95% conf. interval] robust asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 103 references abdur chowdhury1, & george mavrotas. 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(2011) .the determinants of economic growth in the philippines: a new look. imf working paper asia and pacific department wp/11/288 table 7. list of countries whose data was used in the study (1980-2012) 1) algeria 2) botswana 3) cameroon 4) costa rica 5) dominican rep 6) egypt 7) guatemala 8) india 9) israel 10) jamaica 11) kenya 12) jordan 13) korea 14) lesotho 15) mexico 16) pakistan 17) senegal 18) sudan 19) swaziland 20) thailand 21) tunisia asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 106 22) turkey 23) usa 24) honduras 25) australia 26) bolivia 27) bangladesh 28) iceland 29) fiji 30) ghana microsoft word 9297-34054-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 195 japan’s corporate governance structures and credit rating ahmed zemzem (corresponding author) dept. of management, university of sousse rue khalifa el karoui sahloul bp n° 526 4002 sousse, tunisia e-mail: ahz963@yahoo.fr samir zouari dept. of economics, university of sousse rue khalifa el karoui sahloul bp n° 526 4002 sousse, tunisia e-mail: samir.zouari@yahoo.fr received: april 11, 2016 accepted: may 15, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.9297 url: http://dx.doi.org/10.5296/ajfa.v8i1.9297 abstract the aim of our research is to investigate whether good governance is associated with higher credit rating in japanese firms. mainly, this research seeks for the examination of the effect of governance attributes namely those related to the board and ownership structure also quality of information on credit ratings. empirical analyses are conducted from a sample of 75 japanese firms listed on topix 100, over the period 20062013 using ordered probit regression. the study shows that good governance is associated with higher credit rating and suggests that active monitoring by independent directors and better disclosure mitigate agency conflicts and protect the interests of debtholders. keywords: credit rating, board structure, ownership structure, transparency, debtholders asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 196 1. introduction first of all, we can say that there is a growing interest in corporate governance especially when many companies have experienced series of failures and frauds and suffered from losses. the resulting uncertainty has led to improved interest in corporate governance practices. one of the issues that have been raised is the presence of the agency problem which represents the existence of conflicts in the interests of managers and investors. the presence of the agency problem usually distorts corporate policy choices and weakens corporate performance besides, it generates agency costs to control agents. some ways to avoid these problems are to provide financial incentives as well as effective monitoring by independent directors also by improving transparency to create an appropriate environment. good governance is expected to reduce these problems, through its effective structures, to protect the interests of debtholders, to reduce the firm’s cost debt and to result in higher credit rating. in fact, a wide literature has already been built to focus on these issues such as aman and nguyen (2013) and ashbaugh-skaife et al. (2006) by using us firms. but we build up our study using a sample of japanese firms listed on topix 100 from 2006 to 2013. the results allow us to identify a significant relationship between credit rating and all governance attributes used in our study. indeed, credit rating has a significant and negative relationship with larger board therefore smaller boards are better effective monitoring, similarly credit rating has negative relationship with higher insider ownership. this may be due to the confluence of opposite factors and to the negative entrenchment effect, in contrast credit rating has a significant and positive effect on independent board and transparency. concerning control variables, the results show that credit rating is positively and significantly related to the firm size but negatively related to the leverage. so it’s better to have a higher size of the firm and less leverage to improve better ratings. the rest of the paper is structured as follows. section 2 presents an overview of the credit rating mechanism. section 3 presents literature review and hypotheses. section 4 describes the research design. findings will be discussed and summarized in section 5. finally, a conclusion and discussion are provided in section 6. 2. credit rating: an overview the emergence of a credit rating as a mechanism that helps to reduce market information asymmetry in the financial markets has come from the times of the u.s. rail road companies in the mid-19th century. the fact that corporate started mobilizing resources directly from savers instead of accessing it through banks caused a credit risk that is why the need for an independent rating agency capable of evaluating creditworthiness of borrowers has appeared. the study of the history of credit rating agencies may be divided into three distinct periods as mentioned by lawrence (2013). 2.1 the beginnings the present-day credit rating industry has a lengthy history, beginning in the 19th century asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 197 with financial publishing. the mercantile agency, one of the first credit reporting agencies, was established in 1841 by lewis tappan to ameliorate information asymmetries that probably lead to the financial crisis of 1837. then, in the 20th century, the emergence of credit rating agencies (cras), when john moody and henry poor started collecting financial and operating statistics on the railroad bond market and then selling this information to subscribers. credit ratings were first issued by moody’s analyses publishing company in 1909, moody’s entry into the public bond rating business was followed by others: the poor’s publishing company in 1916; the standard in 1922; and the fitch publishing company in 1924. 2.2 the 1930s until the 1970s in the early 1930s, regulators of commercial banks began introducing the use of ratings for the required accounting practices of their banks. however, in 1936 there was regulatory change that required to regulate banks to use an investment grade to make bonds just as loans and investments to be safe rather than speculative which lead to the expand of the market for those cras’s rating. during the following decades, the state regulators of insurance companies also started to incorporate the major cras’s ratings into their prudential regulation of their insurance companies. also in 1975, the securities and exchange commission (sec) began using cras’s ratings as the indicator of the riskiness of the bonds held by firms in their portfolios. as a consequence, the sec created a new category nationally recognized statistical rating organization (nrsro) and it certified moody’s, s&p, and fitch as nrsros which would be the appropriate ones for the security firms to use in the determination of their needed capital. in the late 1960s and early 1970s, the original business model adopted by john moody in 1909 was progressively changed to a business model whereby the bond issuers were charged with the ratings and distributed to the general public at no charge but this new model created potential conflicts of interest. 2.3 the 2000s until 2010s in november 2001, with the bankruptcy of the enron corporation, a considerable amount of media focused big attention on cras because enron’s bonds had been rated as “investment grade” by all three major cras until five days before the bankruptcy. this situation made cras in a difficult position, indeed congressional asked the cras why they were so slow to recognize enron’s weakened financial condition and the sec was asked about the nrsro system, how the sec managed it, and why there were only three certified nrsros? as a consequence, the sec tried to make some changes by certifying additional nrsros which got up to ten nrsro in 2013. even if rating agencies have experienced some difficulties during few years and have been harshly criticized, they remain a key mechanism in financial markets. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 198 3. literature review and hypotheses we start this section by explaining the effect of governance structures on corporate decisions and then we will examine the effect of governance structures on credit ratings through a series of hypotheses. 3.1 the effect of governance structures on corporate decisions the agency problem inherent in the separation of ownership and control of assets has occurred since the 18th century by adam smith in his wealth of nations, and in other studies such as those by berle and means (1934) and lorsch and maclver (1989). the agency literature underlines a number of conflicting preferences. indeed, when principal (shareholders) delegates some decision-making responsibility to agents (manager). the latter may make decisions that conflict with the best interests of the shareholders. the divergence of interests between principals and agents lead supporters of agency theory to specify some mechanisms for reducing agency losses (eisenhardt 1989). these mechanisms include incentive schemes for managers by obtaining shares perhaps at reduced price or receiving shares based on the company’s performance. another form of managerial compensation is the cash bonus and according to jensen and murhpy (1990) this cash bonus is a variable sum of money the ceo gets above his fixed salary, if he meets the targets of the shareholders. but money alone cannot often induce agents to act in the interests of the principal. there is intrinsic motivation that can be harnessed in solving agency problems by examining ways to improve non-pecuniary motivation. another solution to mitigate agency problems is monitored by the board of directors which is considered as key purpose to ensure the company’s continued growth and prosperity. the role of the board of directors is to act for the best interests of the company (shareholders and stakeholders). also we have shareholders monitoring which is considered as a mechanism that helps to reduce agency costs. demsetz (1983) and shleifer and vishny (1986) propose that the existence of large shareholders leads to better monitoring of managers. in fact, producing information and making it accessible to all stakeholders may reduce information asymmetries and mitigate the associated agency conflicts. this can help decrease incidents of skewed decision making, improving planning and formulation of strategy, and facilitating effective evaluation of past performance (yaron and manos 2010). good governance will try to mitigate these agency conflicts by previous solutions to guarantee the interest of investors and this brings us to study governance structures and their effect on credit ratings. 3.2 hypotheses development to begin with, we can say that prior studies on corporate governance have focused on one attribute “board independence”, but the results from these studies were limited (ashbaugh-skaife et al. 2004). since 2002, as research has been developed, they have become four attributes ownership structure and influence, financial stakeholder’s rights and relations, financial transparency and disclosure, and board structure and processes (standard asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 199 & poor’s 2002). based on these attributes good governance can reasonably be expected to mitigate agency problems, to reduce the risk to debtholders, to decrease the firm’s cost of debt and consequently higher credit ratings. 3.2.1 board structure board of directors has two essential functions which are advising and monitoring (raheja 2005; adams and ferriera 2007). the advisory function involves the provision of expert advice to the ceo and access to critical information and resources (fama and jensen 1983) performed by both insiders and outsiders. and the monitoring role involves monitoring company performance and reduce agency costs. many economic research has been interested in the board size, some of them have agreed that larger boards are more effective due to the fact that an increasing number of non-executive directors provides more information (lehn et al. 2004) and leads to higher performance (dalton and dalton 2005). also increasing board size may avoid the idea of choosing a risky project because it has to be accepted by all members. then the quality decision of a larger group is better (sah and stiglitz 1991). some other studies interested with the benefits of larger boards, in fact (upadhyay 2015) found that larger boards enjoy a better credit rating which indicates to lower default risk and hence greater bond valuation. despite the fact that larger board has positive effect on firm’s performance and thus on credit rating some other researchers found that smaller boards are more effective to mitigate agency problems due to the fact that when boards become larger the skills of directors are reduced and the agency costs will therefore increase, also coordination problems will appear because more board members will lead to more conflicts and disagreement in taking decision as explained by yarmack (1996) and eisenberg et al. (1998) as well as the occurrence of problems relating to processes of making decision will appear (conyon and peck 1998). with the balance of the arguments above, we suggest the following hypothesis: h1: firms with larger boards are associated with higher credit rating. an emerging strand of literature highlights on the effect of the composition of the board of directors and the importance of the percentage of independent outside directors on the performance of the firm and therefore their effect on credit ratings. boards dominated by outsiders are arguably in a better position to monitor and control managers (dunn 1987). outside directors are independent of the firm’s managers, and in addition bring a greater breadth of experience to the firm (firstenberg and malkiel 1980). also through their firm and industry specific experience, outside directors become valuable advisors in strategic decision making (kor and sundaramurthy 2009). bhojraj and sengupta (2003) found that firms with an independent board have a positive effect on credit ratings and contribute to decrease the cost of debt of us firms. traditionally, the boards of directors of most listed companies in japan have been composed solely of insiders, with the number of board members tending to be large by international asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 200 standards. even recently in 2010, less than half of japanese firms listed on the first section of the tokyo stock exchange had outside directors. however, the number of outside directors on japanese boards has increased dramatically since 2010 up to 62.2% in 2013 and the trend is expected to continue (jeff and hisateru 2014). based on the above arguments, our second hypothesis is: h2: firms with higher proportion of outside directors are associated with higher credit rating. 3.2.2 ownership structure the issue of insider ownership and agency problem has long been an interest in many researchers due to its impact on firms’ value and monitoring of management investment activities. on the one hand, higher insider ownership can help align the interests of management and shareholders and improves disclosure quality (han et al. 2013) and on the other hand, morck et al. (1988) argue that higher insider ownership would provide managers with deeper entrenchments and, therefore, greater scope for opportunistic behavior indeed, it increases the power of managers and allows them to thwart the monitoring of shareholders (demsetz 1983) which may be a concern for debtholders, also it may lead to the diversion of funds and then causes a lower efficiency (jensen and meckling 1976; morck et al. 1988). with the balance of the arguments above, we suggest the following hypothesis: h3: firms with higher insider ownership are associated with higher credit ratings. 3.2.3 financial transparency and disclosure many researchers have considered that information asymmetry as another reason for agency problems indeed, klein et al. (2002) observe that, “in corporate finance, asymmetric information refers to the notion that firm insiders, typically the managers, have better information than do market participants on the value of their firm’s assets and investment opportunities” and this results in an agency problem. shareholders, as principals, attempt to reduce agency problems and asymmetric information by changing the behavior of the manager through incentives such as bonuses and effective monitoring to improve long-term performance. lee et al. (2008) found that timely disclosure (quality disclosure) reduces information asymmetry and enhance the trust between managers and shareholders. consequently, shareholders will be more willing to invest in the company, thereby decreasing the cost of capital. also sengupta (1998) underlined that disclosure quality reduces the cost of debt because lenders considered high quality disclosure as having a lower likelihood of withholding unfavorable information. regarding the advantages and the benefits of greater transparency, we suggest the following hypothesis: h4: firms with greater transparency are associated with higher credit ratings. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 201 4. research methodology 4.1 sample selection and data sources we collect data relating to japanese firms listed on topix 100 which represents an important stock market index for the tokyo stock exchange (tse) in japan. since data are not available, the study will be based only on 75 companies during 2006–2013. long-term credit ratings were handed collected from reports published by rating and investments information (r&i)) and the leading credit rating agency in japan. firms are rated according to a well-determined scale (aaa, aa, a, bbb, bb, b) with aaa represents the highest grade and as follows to bhojraj and sengupta (2003) the letter is transformed into numerical values (from 1 to 6) and the safest firm obtains the highest value. to improve our results and to reduce the occurrences of insufficient observations, we group firms into rating categories without consideration of notches (or +). for example, our set of aa firms includes those with aa+, aa and aa− ratings. the explanatory variables and the control variables are collected from orbis database. 4.2 variables measurement governance variables are classified in three groups: the first one represents the firm’s board structure and it consists of board size which is measured by the number of directors and board independence calculated by the number of outside directors. in fact, many studies are based on these variables to determine the importance of the board of directors to improve performance and to ensure the company’s prosperity. the second group is an ownership structure and it consists of one variable. insider ownership measured by the proportion of shares owned by employees, directors …, this variable is equivalent to managerial ownership. ownership structures have also a significant importance in corporate governance because they affect their incentives of managers, and thereby the efficiency of firms. the third group represents the quality of information available to investors. it consists of one variable which is the timeliness of the firm’s disclosure and represents the number of days the firm takes to release its annual statements after the fiscal year-end. we define this variable as the same way calculated by aman and nguyen (2013) but we use the date of the end of the fiscal year instead of the date of the closure of the accounts: the maximum value (60 days) minus the number of days the firm is taking to release its annual statements after the fiscal year-end. since the governance variables are strongly correlated, they may create multicollinearity problems in the regressions. to mitigate this concern, we collapse the governance variables into a single factor using principal component analysis (pca). the untabulated results (available upon request) show that one of four components happen to exhibit eigenvalues higher than one (1.405106). then we look out to the variance. after that, we focus on the factor, called “governance score”, which accounts for 46.84% of the total variance. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 202 we also use some firm characteristics as control variables such as andrea et al. (2007) who argued that the most significant variables in explaining ratings were size, financial leverage, profitability and volatility; and supported the idea that the higher is financial leverage and the higher is the volatility the worst is the rating. firm size is proxied by the natural log of total assets and it is included as a control variable because larger firms face lower risk by having greater opportunities to diversify their risks across a wider range of products and markets, and thus are expected to have higher credit ratings ashbaugh-skaife et al. (2006). bhojraj and sengupta (2003) and bradley and chen (2011) indicate that firm size has a significantly positive influence on credit ratings and highly significant effect on the cost of debt. similarly, anderson et al. (2004) examine the relation between board size and the cost of debt financing and they find that firm with large size enjoy a lower cost of debt because lenders think that these companies are being monitored more effectively by a diversified portfolio of experts. moreover, as size increases, firms are allowed by financial intermediaries such as banks to invest more in a new project and thus will improve performance, and if large firms face financial problems, they can easily solve them by selling more assets. in addition, as follows to ashbaugh-skaife et al. (2006) and aman and nguyen (2013) financial leverage is measured by the ratio of debt to total capital. increasing a firm’s leverage affects the cost of debt financing and may imply a lower credit rating. bhojraj and sengupta (2003) confirm this prediction using the debt-to-equity ratio to measure leverage and to explore the effects of corporate governance in debt ratings and cost of debt financing. darren (2006) was interested in higher credit rating and the benefits that can provide to the firm and in this context he showed that firms depend on the level of leverage to upgrade their rating especially those with lower level and for those with upper range of ratings, they also depend on the leverage to avoid downgrades. ashbaugh-skaife et al. (2006) based on the leverage in their studies regarding the effects of corporate governance on firms ‘credit ratings as one of the firm-specific control variables considering the fact that it has significant effects on credit ratings. also, profitable firms attract more investors and enjoy a sustainable competitive advantage. profitability is proxied by the return on assets ratio (roa), and is calculated by the firm’s average operating profits over total assets over the last three years to smooth out annual fluctuations. bhojraj and sengupta (2003) showed that lower performing firms are associated with higher levels of default risk and profitability is associated with significantly higher ratings in the us. hung et al. (2013) showed in their study about what factors affect credit rating that as profitability increase probabilities of receiving higher ratings are expected to increase thus consistent with prior research credit ratings are positively related profitability. the final one is firm risk which has been proxied by the volatility of stock returns over the past 5 years. this volatility is measured by the standard deviation of monthly stock returns including dividends. one popular approach to assessing credit risk that involves merton’s (1974) model suggests that stock volatility increases the risk of default. bradley and chen (2011) showed that higher stock volatility is associated with lower credit ratings and higher asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 203 credit spreads. anderson et al. (2004) also found that stock volatility significantly increases yield spreads. 4.3 model research because of the discrete and ordering nature of the dependent variable in this study, ordinary least squares (ols) regression will be an inappropriate model (yang and raehsler 2005). therefore, we follow amato and furfine (2004) and aman and nhuyen (2013) by using the ordered probit model in our empirical analysis: cratingit = α0 + α1 bsizeit + α2 outdrit + α3 iownit + α4 timelinessit + α5 gscoreit + α6 fsizeit + α7 leverageit + α8 roait + α9 volatilityit + εit (1) where crating is the value corresponding to the long-term rating given by r&i, bsize is the number of directors on the board, outdr is the number of outside directors on the board, iown is the proportion of shares owned by employees, directors …, timeliness is the maximum value (60 days) minus the number of days the firm takes to release its annual statements after the fiscal year-end, gscore is the governance score as described above, fsize is the natural log of total assets, leverage is total debt over total assets, roa is operating income over total assets and volatility is the standard deviation of stock returns over the last 60 months. 5. empirical results 5.1 descriptive statistics table 1 reports descriptive statistics for our measures of credit rating, governance variables, and firm characteristics as control variables. the table shows that operating profitability (roa) is on average 3.5% with a narrow interquartile range of 1.65% and 5.22%. stock return is also distributed over a narrow range of 0.894% and 3.688%. among the governance variables, the average board size (bsize) consists of 12.7 directors. the average of outside directors (outdr) is 2.2% with a median of 2% and this proportion is a little low reflects the fact that japanese firms improve gradually their board by increasing the proportion of outside directors because japanese boards have been always controlled by insiders (aman and nguyen 2013). the average of insider ownership (iown) is 9.19% with a narrow range interquartile of 3.81% and 13.36%. the timeliness variable indicates that firms taken average 54.2 to release their annual statements (60 5.8 = 54.2). the average rating of 4.711 indicates that ratings are centered between “a” and “aaa”. this led us to conclude that japanese firms in our sample have improved their ratings over the period of 2006 -2013. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 204 table 1. sample descriptive statistics the table reports descriptive statistics of all variables used in the current study. mean s. d. q1 median q3 skewness kurtosis n rating variable: crating 4.711 0.564 4 5 5 -1.100 4.192 461 governance variables: bsize outdr iown timeliness gscore 12.703 2.213 9.194 5.814 0.070 7.547 1.890 6.969 17.334 1.180 9 0 3.81 0 -0.57 13 2 6.695 0 0.213 14 4 13.36 0 0.880 1.611 0.554 0.953 2.735 -0.357 8.891 2.796 2.977 8.609 2.658 529 529 186 538 126 firm characteristics: fsize leverage roa volatility 7.413 107.8 3.504 3.052 0.374 97.88 3.173 4.301 7.143 36.43 1.65 0.894 7.399 79.73 3.22 1.811 7.671 146.38 5.22 3.688 0.151 1.642 -0.220 5.752 2.653 6.115 7.472 53.006 531 530 531 530 notes: crating is the value corresponding to the long-term rating given by r&i, bsize is the number of directors in the board, outdr is the number of outside directors in the board, iown is the proportion of shares owned by employees, directors…, timeliness is the maximum value (60 days) minus the number of days the firm takes to release its annual statements after the fiscal year-end, gscore is the governance score as described above, fsize is the natural log of total assets, leverage is total debt over total assets, roa is operating income over total assets and volatility is the standard deviation of stock returns over the last 60 months. 5.2 correlation matrix to verify the absence of multicollinearity problems, we use the correlation matrix for the independent variables which can be found in table 2. the examination of the correlation coefficients allows us to study the null hypothesis of no correlation between explanatory variables. we consider 0.8 as the limit value of the correlation coefficient, which corresponds to the limit set by kennedy (1985), to confirm the null hypothesis. hence, if correlation between two variables exceeds 0.8, we have to reject the null hypothesis and we start having serious problems of multicollinearity. in our case, the correlation matrix shows that all coefficients are below 0.8. we can conclude, then, in the absence of multicollinearity between the explanatory variables. so, the problem of multicollinearity does not seem critical, and thereafter, all variables in our study can be accepted. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 205 table 2. correlation matrix the table presents the pairwise correlations between key regressor variables by using pearson’s correlation coefficients. 1. 2. 3. 4. 5. 6. 7. 8. 9. 1. bsize 1 2. outdr 0.155 1 3. iown 0.002 0.039 1 4. timeliness -0.173 0.046 0.009 1 5. gscore 0.757 0.791 0.374 0.000 1 6. fsize 0.079 0.162 -0.147 -0.065 0.046 1 7. leverage -0.168 -0.044 -0.191 -0.126 -0.131 0.511 1 8. roa 0.038 0.003 0.228 0.050 0.160 -0.334 -0.447 1 9. volatility 0.016 -0.011 0.073 -0.0495 -0.052 -0.070 0.021 0.187 1 notes: bsize is the number of directors in the board, outdr is the number of outside directors in the board, iown is the proportion of shares owned by employees, directors…, timeliness is the maximum value (60 days) minus the number of days the firm takes to release its annual statements after the fiscal year-end, gscore is the governance score as described above, fsize is the natural log of total assets, leverage is total debt over total assets, roa is operating income over total assets and volatility is the standard deviation of stock returns over the last 60 months. 5.3 regression analysis of credit rating on governance variables in order to investigate whether corporate governance has an effect on credit ratings we use a series of ordered probit models with panel data and in which the dependent variable is the firm’s credit rating and the explanatory variables are the firm’s governance attributes. also we utilize unbalanced panel because we have some missing dataset. this method was inspired by the study of aman and nguyen (2013). we use model 1 to identify whether larger boards are associated with higher credit rating. model 2 is associated with the ownership structure. model 3 is used to identify whether transparency and the information provided to investors are associated with higher credit rating. model 4 regroups all the individual governance variables that are included in the regression to evaluate their ability to provide explanatory power beyond what the other governance (and control) variables already explain, and model 5 is based on the aggregate score calculated by principal component analysis (pca). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 206 table 3. ordered probit regression of credit rating on governance variables the table reports the results from regressions in panel data. the use of a robust option for estimating the standard errors is based on a breusch-pagan test for heteroscedasticity; t-statistics are reported in parentheses. dependent variable: crating variables model 1 model 2 model 3 model 4 model 5 governance variables: bsize -0.0081944 (-0.68) -0.046278* ( -2.16) outdr 0.0743726* (2.21) 0.0915511 ( 1.49) iown 0.2273908 (-1.60) -0.03164** (-1.67) timeliness -0.464515* ( -2.82) 0.3676142 ( 1.40) gscore -0.0764576 ( -0.64) firm characteristics: fsize 1.125332* (4.67) 1.146093* (3.15) 1.279802* ( 5.93) 1.218704* ( 3.45) 1.248876* ( 2.68) leverage -0.006933* ( -6.83) -0.006338* (-3.85) -0.00809* ( -7.83) -0.008017* ( -4.26) -0.006236* ( -3.61) roa -0.0124177 (-0.42) -0.0120545 (-0.25) -0.059581* ( -2.20) -0.0079655 ( -0.16) 0.0030887 ( 0.06) volatility 0.0607296 (1.36) 0.2273908* (2.67) 0.098029* ( 2.75) 0.1182618 ( 1.46) 0.320123* ( 2.29) wald statistic 60.78* 24.52* 69.54* 54.51* 21.50* pseudo r2 0.0933 0.1140 0.1105 0.1406 0.1132 n 394 154 395 146 110 notes: crating is the value corresponding to the long-term rating given by r&i, bsize is the number of directors in the board, outdr is the number of outside directors in the board, iown is the proportion of shares owned by employees, directors…, timeliness is the maximum value (60 days) minus the number of days the firm takes to release its annual statements after the fiscal year-end, gscore is the governance score as described above, fsize is the natural log of total assets, leverage is total debt over total assets, roa is operating income over total assets and volatility is the standard deviation of stock returns over the last 60 months; *significance at the 5% level; **significance at the 10% level. these results indicate that the overall model is statistically significant (p-value <5%).to start with model 1, the coefficient of board size is negative and not significant. in contrast the coefficient of outside directors is positive and significant at the 5% and this result reveals that asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 207 outside directors have a positive effect on credit rating. therefore, independent boards are associated with higher credit rating and this finding is consistent with bhojraj and sengupta (2003), they found that firm with independent board has a positive effect on credit ratings and contributes to decrease the cost of debt of us firms. the regression in model 2 shows that the coefficient of insider ownership which refers to ownership structure is positive but not significant. it indicates that insider ownership has no effect on credit rating. this lack of effect may be due to the confluence of opposite factors because on the one hand, greater stock ownership may provide insider more incentives to make more effort and manager the firm more effectively. on the other hand, this increases their entrenchment effect which is detrimental to debtholders and this result is consistent with aman and nguyen (2013). we focus now on model 3, the coefficient representing the quality of information is negative and significant at the 5% level using p-value. this result may be due to the fact that these companies take more time to release its annual statements and this will lead to decrease the rating. as for model 4, the coefficient of board size becomes significant but negative which reveals that higher credit rating is associated with smaller boards. this result may due to the fact that smaller boards are more effective and have better monitoring which is consistent with eisenberg et al. (1998) who found that when boards become larger agency problems tend to arise. insider ownership becomes significant with negative coefficient. therefore, higher credit rating is associated with less insider ownership due to their entrenchment effect. in contrast outside directors and timeliness are positive but not significant. governance score in model 5 is not significant. this result is inconsistent with aman and nguyen (2013) due to the fact that we don’t use the same number of items given the lack of data. as for control variables, leverage have a negative and significant effect on credit rating in all models so increasing a firm’s leverage affect the cost of debt financing and may imply a lower credit rating which is consistent with bhojraj and sengupta (2003). firm size has a positive and significant effect on rating, therefore larger firms have greater opportunities to diversify their risks across a wider range of products and markets, and thus are expected to have higher credit ratings as mentioned by shbaugh-skaife et al. (2006). 6. conclusion the aim of our research is to investigate whether corporate governance has an effect on credit ratings through an empirical study of a sample of 75 japanese firms listed in topix 100 during the period 2006-2013 and using panel data analysis method and ordered probit model. our finding is consistent with some other researches. indeed, we find that firms with higher proportion of outside directors are associated with higher credit rating due to the importance of independent board to protect the interests of debtholders. and for size of the board we find asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 208 that higher credit rating is associated with smaller firms which are more effective due to the fact that these firms may mitigate agency problem by reducing their boards and this is consistent with eisenberg et al. (1998). higher insider ownership has a negative effect on credit rating because of the confluence of opposite factors especially their negative entrenchment effect. many researches have approved that timeliness has a positive effect on credit rating. indeed, timely disclosure (quality disclosure) reduces information asymmetry and therefore mitigate agency problems but in our sample we find that companies take more time to circulate their information so they have a problem of information asymmetry. this paper provides directions for future research by introducing more other explanatory variables to make it more significant. in addition, the study that we conduct should be considered as a preliminary to a more complete study on a larger sample. references adams, r.b., & ferreira, d. (2007). a theory of friendly boards. journal of finance, 26, 217-250. http://dx.doi.org/10.1111/j.1540-6261.2007.01206.x aman, h., & nguyen, p. 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(2010). information transparency and agency costs in the microfinance industry: the adequacy of the operational self-sufficiency index. review of market integration, 2, 87-99. http://dx.doi.org/10.1177/097492921000200106 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 440 real earnings management: a review of literature and future research belal ali (corresponding author) tunku puteri intan safinaz school of accountancy (tissa) college of business, universiti utara malaysia, malaysia e-mail: bel_ac2002@yahoo.com hasnah kamardin tunku puteri intan safinaz school of accountancy (tissa) college of business, universiti utara malaysia, malaysia e-mail: hasnahk@uum.edu.my received: april 7, 2018 accepted: may 17, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.13282 url: https://doi.org/10.5296/ajfa.v10i1.13282 abstract in recent years, increasing attention has been given to real earnings management (rem) as an alternative method to accrual-based earnings management. this paper reviews the recent studies on rem to provide updated and comprehensive information about this type of earnings management. specifically, the review focuses on rem definitions, motivations, techniques, consequences, and measurement. in addition, the paper provides a discussion of the theoretical frameworks used by researchers as underpinning theories of earnings management. the review of the literature showed that companies have shifted earnings management practising from accruals-based to real activities based. useful suggestions for rem research opportunities are also provided. keywords: real earnings management, agency theory, consequences. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 441 1. introduction earnings management is a widespread topic in the global business world. in the recent past, many high profile companies (e.g., enron, worldcom, etc.) have gone bankrupt after the announcement of accounting scandals and manipulated reported earnings has been the cornerstone of these scandals (note 1). these scandals have made earnings management an important issue for different users of accounting information such as scholars, investors and practitioners (callao, jarne, & wroblewski, 2014). its importance is driven by its significant effect on the financial reporting quality. earnings management is a complex issue that has been identified and interpreted in previous studies differently depending on the different perceptions of researchers on this issue (callao et al., 2014). some studies view earnings management as a problem that needs an urgent remedy, while others consider it as a purposeful intervention to gain some private benefits (callao et al., 2014; dechow & skinner, 2000; schipper, 1989). in this context, beneish (2001) distinguished between opportunistic earnings management (to mislead investors) and informative earnings management (to portray a good image to the stockholders about a company's performance). such differences may reflect that earnings management is not always a bad behaviour. for example, siregar and utama (2008) investigated whether companies in indonesia practised efficient contracting or opportunistic earnings management. the researchers found that the type of earnings management practised by indonesian listed companies was efficient contracting. evidence on earnings management practices has been empirically documented by numerous studies (cohen, dey, & lys, 2008; enomoto, kimura, & yamaguchi, 2015; ferentinou & anagnostopoulou, 2016; healy & wahlen, 1999; roychowdhury, 2006). overall, debates on the earnings management issue are still ongoing, which underlines the importance of earnings management in the accounting literature (callao et al., 2014). importantly, rem issue has grown in light of recent studies as an alternative for earnings management practices (chi, lisic, & pevzner, 2011; cohen & zarowin, 2010; cohen et al., 2008; ho, liao, & taylor, 2015; malik, 2015; roychowdhury, 2006; zang, 2012). cohen et al. (2008) stated that firms might shift manipulation practices from accrual earnings management (aem) to rem particularly after the passage of the sarbanes-oxley act 2002. in the same context, malik (2015) provided evidence that us companies manipulate earnings through real activities to avoid reporting losses or to meet the analysts’ predictions. this switch in earnings management practices has created a need to bring rem into public view. in this regard, talbi, omri, guesmi, and ftiti (2015) pointed out that previous studies have mostly focused on aem, whereas rem has remained largely unexplored area. to address this issue, this current paper reviews the recent literature of rem by specifically covering: 2) earnings management definitions and types; 3) the underpinning theories widely used in earnings management literature; 4) important studies on rem; 5) methodology of this paper; and 6) conclusion and suggestions for future research. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 442 2. earnings management definitions, types and frauds earnings management is considered to be a key indicator of financial reporting quality. from the literature review, a comprehensive definition of earnings management has been provided by (healy & wahlen, 1999). according to healy and wahlen, “earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (p. 368). similarly, leuz, nanda, and wysocki (2003) defined earnings management as insiders’ changes that affect economic performance recorded in financial reporting with the intention to influence contractual benefits or to mislead some stakeholders. callao et al.’s (2014) more recent definition combines many elements covered by previous researchers. this recent definition says that earnings management is “a purposeful intervention in financial reporting, designed to reach earnings targets by varying accounting practices. however, it can take place without necessarily violating accounting regulations by taking advantage of the possibilities of choice in accounting policy. the action may mislead stakeholders, causing them to make decisions on the basis of financial reports that they would not have made otherwise” (p. 137). importantly, earnings management has the same objectives of fraud in effecting the reported earnings and financial reporting quality of companies. yet, earnings management does not violate accounting principles, whereas fraud does violate accounting principles (dechow & skinner, 2000; ronen & yaari, 2008). nevertheless, howe (1999) stated that a possibility exists for companies to turn to fraud when they have already used all opportunities to manage earnings by the accruals-based method. perols and lougee (2011) documented that companies that have had major frauds are found to have practised more earnings management in prior years. however, it is not a precondition that a company must begin with earnings management before being involved in fraudulent practices. figure 1 summarises the effects of different activities on financial reporting quality reported in previous studies. from the above definitions, the conclusion can be made that there are several perceptions of earnings management. moreover, no consensus exists among researchers on a unified definition of earnings management. however, most studies share some aspects in common. these aspects include the intention of managers to obtain their own benefits as an initial incentive behind earnings management and the adoption of rem or aem. furthermore, previous researchers have paid much attention to earnings management through discretionary accruals (abdul rahman & ali, 2006; beneish, 2001; callao et al., 2014). this means that the earnings management literature has concentrated on aem, while rem remained the area requiring more investigations. in addition, more efforts need to be invested in establishing comprehensive definitions of earnings management considering all types of earnings manipulation. previous studies have classified earnings management practices into two broad categories, namely, aem and rem (e.g., ewert & wagenhofer, 2005; gunny, 2010). this classification is based on the earnings composition, including accruals and operations cash flow (xu, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 443 taylor, & dugan, 2007). managers may choose either one or both to reach their desired earnings targets. aem occurs when the manager of a given firm uses his/her judgment based on changing accruals with the intention to alter the reported earnings and mislead stockholders about firm’s performance (dechow & skinner, 2000; healy & wahlen, 1999; jones, 1991). on the other hand, rem refers to managing earnings through normal activities of manipulation to affect reporting earnings by using techniques such as sales, overproduction, discretionary expenditures and gains from fixed asset sales (brown, chen, & kim, 2015; graham, harvey, & rajgopal, 2005; roychowdhury, 2006; zang, 2012). previous research also distinguished aem from the rem based on the following points. first, aem deals with accounting principles and choices, and therefore, has no strong effect on cash flow operations, whereas rem has arguably more pronounced long-term cash flow implications (roychowdhury, 2006). second, aem has a high risk of the scrutiny of auditors as opposed to rem, which is less likely to be detected by auditors’ scrutiny (gunny, 2010). third, aem has a limitation of timing on practices and can be done quarterly or at the end of the year. thus, managers meet uncertainty in which adjustments will be accepted by the auditor (barton & simko, 2002). however, rem must be arranged during the year with operational activities or during the last quarter of the year (ising, 2013). fourth, real activities are under a manager’s control, whereas the activities of aem are subject to an auditor’s approval (gunny, 2010). figure 1. activities affecting financial reporting quality 3. theoretical framework theoretically, the literature on earnings management has shown that agency theory is an underpinning theory that can clearly explain the reasons behind earnings manipulation. an agency relationship arises when one or more than one person (being the owners or principals) delegates some duties to another person (s) (known as the agents/managers) to perform such no effect normal activities earnings management frauds rem aem financial reporting quality shareholders and other investors and financial reporting users effect effect asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 444 services on behalf of the principals under the contract conditions (fama, 1980; jensen & meckling, 1976). according to this theory, large corporations are characterised by the separation of ownership and management. therefore, owners (principals) appoint agents to manage the affairs of the companies on their behalf. such a separation creates an agency problem that arises as a result of the self-interests of agents. furthermore, the agency theory highlights that firms work under conditions of uncertainty, which may result in information asymmetries between managers and investors. jensen and meckling (1976) argued that there are good reasons why management will not always consider the interests of shareholders. additionally, the literature has highlighted another type of agency conflict that can exist, which is that between majority and minority shareholders (claessens & fan, 2002; fan & wong, 2002). company managers may make decisions to serve their interests instead of those of owners (arnold & de lange, 2004). for example, the enron financial scandal was a result of managers’ intentions to increase their benefits at the cost of other stakeholders (arnold & de lange, 2004). in fact, the flexibility of accounting standards and discretionary expenditures provides managers with the opportunity to manage earnings (dechow & skinner, 2000). as a result, managers tend to affect reported earnings that ultimately help them to direct financial reporting in such a way that they reflect their targets instead of shareholders’ targets. such opportunistic behaviour provides a basis for numerous studies to use agency theory as the underpinning concept in the investigation of earnings management (alexander, 2010). despite the general acceptability of the agency theory, this theory fails to explain its relationship with the accounting concepts. walker (2013) stated that the agency theory does not explain how accounting concept alternatives or shareholder funds can be useful for contracting purposes. 4. literature review of real earnings management 4.1 definitions of real earnings management several definitions of rem exist. schipper (1989) defined rem as an alternative type of earnings management that can be achieved by changing the timing of spending in investing or financing operations with the intention to manipulate the reported earnings. roychowdhury (2006) defined rem as “departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations. these departures do not necessarily contribute to firm value even though they enable managers to meet reporting goals” (p. 337). according to gunny (2010), rem refers to managing the normal operating activities of companies to adjust earnings according to managers’ targets. in contrast, aem is achieved by using different accounting standards and policies to represent operating activities. lastly, xu et al. (2007) provided a concise definition saying that rem was a deviation from normal operational activities to affect reported earnings. 4.2. real earnings management techniques and measurement prior studies have classified rem practices through three categories of activities: 1) operating activities decisions, 2) investment decisions, and 3) financing decisions asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 445 (roychowdhury, 2006; sellami, 2015; xu et al., 2007). the manipulation of operating activities refers to increasing sales, reducing discretionary expenses and increasing the production to avoid reporting losses or recording lower earnings (roychowdhury, 2006). manipulation through investment decisions refers to manipulating earnings through sales of long-term assets and myopic investments in research and development (r&d) (gunny, 2005; herrmann, inoue, & thomas, 2003). managing earnings through financing decisions refers to the process of affecting earnings per shares through stock repurchases and stock option (burnett, cripe, martin, & mcallister, 2012; hribar, jenkins, & johnson, 2006). the following is an explanation of each technique and its measurement as documented by previous researchers. 4.2.1. sales manipulation sale activities manipulation refers to the decisions of managers to temporarily boost sales by offering easier credit terms or higher discounts on sales prices (roychowdhury, 2006). manipulating earnings through this method will temporarily boost sale volumes, which leads to higher earnings and a lower current period cash flow due to surplus in sales (roychowdhury, 2006; sun, lan, & liu, 2014). roychowdhury (2006) developed the following model to measure abnormal cash flow from operations (a proxy for sales manipulation) for each year and industry that has been widely used in the literature: (1) where, is the cash flows from operations at the period t; is the total assets at the end of the period t-1; is the annual sale of the period t; is the change in the sales relative to the prior period. 4.2.2 discretionary expenditures the deviation of spending discretionary expenses from normal to abnormal activities to influence reported earnings is one technique used by managers in rem. graham et al. (2005) showed that managers could reduce discretionary expenses when they are likely to miss their earning targets. reducing such expenses will increase the reported earnings during the same period. empirical evidence by roychowdhury (2006) indicated that managers use r&d, selling, general, and administrative (sg&a), and advertising discretionary expenses in manipulating earnings to avoid recording losses. the researcher added that companies could reduce discretionary expenses to influence real earnings when these expenses do not have a direct effect on the immediate revenues. roychowdhury (2006) developed a model to measure abnormal discretionary expenses (disx) for each year and industry which is widely used in the literature and described as follow: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 446 (2) where, is the total discretionary expenditures during the period t (advertising, r&d, & sg&a). 4.2.3. overproduction overproduction refers to increasing production units to more than the expected market demand. prior studies have documented that managers of manufacturing companies use overproduction as a technique to manage earnings (graham et al., 2005; gunny, 2010; roychowdhury, 2006; tabassum, kaleem, & nazir, 2014). this technique allows managers to spread fixed production overhead costs on more units of production, which results in decreasing the cost of goods sold (roychowdhury, 2006). indeed, such reduced cost of goods sold leads to an increase in profit margins based on the assumption that other factors will remain fixed. according to manowan and lin (2013), the use of this technique by managers makes detection difficult for other users of accounting information. in addition, tabassum et al. (2014) reported that manufacturing companies in pakistan practised more rem through the overproduction technique. however, as a consequence of such practices, these companies face lower financial performance in subsequent years. roychowdhury (2006) identified production costs as the sum of the cost of goods sold and changes in inventory during the year. he developed the following model, which has been employed in previous studies to detect manipulation in production costs (a proxy for overproduction): where, is the sum of the cost of goods sold and changes in inventory during the year. 4.2.4. selling the fixed assets selling fixed assets is a flexible technique used by managers to enhance reported earnings when they realise that the targeted earnings may not materialise. the literature on earnings management has shown that managers might sell fixed assets and use the gains from such selling to avoid reporting losses or low earnings or to avoid debt covenant violations (bartov, 1993). in a study by herrmann et al. (2003), firms in japan were found to have managed earnings through selling marketable securities or fixed assets and using the gains (or losses) to adjust the actual operating income to meet forecasts. recently, gunny (2010) has developed a model for estimating the abnormal gain from assets sales (gain) based on (3) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 447 variables documented in the studies of (bartov, 1993; herrmann et al., 2003), which is illustrated as follows: (4) where is the gain from asset sales during the period t; is the natural logarithm of the market value; is tobin's q; is the internal funds; is the long-lived assets sales; is the long-lived investment sales. 4.2.5. stock repurchases stock repurchases are considered one of the rem techniques. previous studies have provided evidence that managers of companies may engage in the stock repurchases to increase earnings per share (bens, nagar, skinner, & wong, 2003; hribar et al., 2006). a study by burnett et al. (2012) provided evidence that companies under the pressure of high audit quality may shift earnings management practices from accrual to rem by stock repurchases. this evidence indicates that stock repurchases can be used as a tool for managing earnings per share. unlike the abovementioned techniques, this method of rem (stock repurchase) does not affect the reported earnings; rather, it is used to shore up the reported earnings per share. the first three measures developed by roychowdhury and largely employed in the rem literature (e.g., chi et al., 2011; cohen et al., 2008; ferentinou & anagnostopoulou, 2016) can be combined into one measurement. according to ferentinou and anagnostopoulou (2016), rem measurements can be calculated as one combined measure by multiplying abnormal cfo and disx values by -1 and adding the abnormal prod to one equation. this is because the lower values of the abnormal cfo and abnormal disx indicate higher rem, while higher values of abnormal prod indicate higher rem. hence, the following equation is the combined measurement of rem: rem = abcfo (-1) + abdisx (-1) + abprod (5) where abcfo is the abnormal cash flows from operations; abdisx is the abnormal discretionary expenses; abprod is the abnormal production costs. 4.3. important studies on the trade-off between rem and aem rem techniques are concerned with the manipulation of real activities. managers use these techniques to meet targeted earnings through the timing of spending on investments, expenditures and operational or financing activities. recently, researchers have turned their attention to rem as another method of earning management. in developed countries, studies have pointed to rem practices in companies (e.g., alhadab, clacher, & keasey, 2015; cohen asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 448 & zarowin, 2010; graham et al., 2005; roychowdhury, 2006; zang, 2012). for example, in a survey by graham et al. (2005) among 401 executives, the results showed that 80% of the participants preferred to take economic decisions such as cutting r&d expenses, maintenance, and advertising that may have negative long-term effects rather than using accruals-based methods to meet their targets on reporting earnings. gunny (2005) also reported the existence of rem by stating that managers have the intention to meet earnings targets by using techniques that negatively impact the future performance of companies. using the models of dechow, kothari, and watts (1998), roychowdhury (2006) developed new models to measure real activities manipulation. he found that, to avoid reporting losses, managers manipulate earnings by altering real activities such as increasing the sales volume through high discounts on prices or offering lax credit conditions, overproduction to report high earnings resulting from reducing the cost of goods sold and reducing discretionary expenses such as r&d, selling, advertising, administrative, and general expenditure (sg&a). eldenburg, gunny, hee, and soderstrom (2011) extended the literature on real operating decisions management in non-profit hospitals in california. they found that decreasing non-operating and non-revenue-generating activities expenditures reflects the existence of the practice of rem. during a seasoned equity offering (seo), companies look for new investors to raise their capital by offering shares. they may offer their shareholders the idea of buying extra shares with the preference of companies to sell shares at high prices. thus, it becomes possible for them to manage earnings to improve stock price (ronen & yaari, 2008). in the same context, cohen and zarowin (2010) examined both managing earnings techniques (real and accruals) by using a sample of seo companies. the researchers found that companies use rem techniques in managing earnings, which leads to declining performance of companies in subsequent years after the seo. the study also revealed that selecting one of the both techniques depends on the ability of the company to use accruals-based management and the cost of both methods. considerable studies have indicated that managers switch from aem to rem because of the ease of practising discretionary decisions on activities and being less likely to be detected by regulators and auditors. in other words, the pressure of auditor scrutiny and regulations have made managers shift to another type of earnings management. as reported by ewert and wagenhofer (2005), tighter accounting standards result in increasing rem and reducing aem at the same time. remarkable empirical evidence of this shift among managers was recorded by cohen et al. (2008), which illustrates the shift of earnings management practices from accruals to real activities under the pressure of the passage of sox. consistently, jungeun, jaimin, and jaehong (2012) reported that aem practices decrease, while rem practices increase after a financial crisis. they attributed this to the pressure of shifting from internal to external markets in financing sources, thus increasing the demand for more transparent financial information by capital market followers. other factors have been examined to identify the reasons behind the shift in earnings management practices from aem to rem. regarding this, studies have documented that asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 449 companies with high audit quality resort to rem when they have limitations in the use accrual techniques (burnett et al., 2012; chi et al., 2011). moreover, enomoto et al. (2015) examined the differences in aem and rem across countries from the perspective of investor protection. they used data from 38 countries for the period from 1991 to 2010. the results showed that rem is higher in countries with stronger investor protection. the result may reflect that managers of the companies may turn to rem instead of aem in countries with high levels of investor protection. baatour and othman (2016) studied the impact of the legal system and economic freedom on both types of earnings management in selected companies in the middle east and north african (mena). their results suggest that managers under the impact of the legal system tend to practice more rem, whereas no effect of the economic freedom is involved in rem practices. the adoption of the international financial reporting standards (ifrs) has been found to be a cause behind the movement to the rem alternative. for instance, ferentinou and anagnostopoulou (2016) conducted a study on the practices of both types of earnings management (aem & rem) during preand post-ifrs mandatory adoption in greek companies. their results indicate that companies shifted to rem after ifrs adoption. ho et al. (2015) carried out a similar study with the aim of investigating the existence of both aem and rem in preand post-ifrs adoption for chinese a-share firms. they reported that chinese firms turned to rem as an alternative method for upward earnings manipulations in the period after ifrs adoption. furthermore, ipino and parbonetti (2017) examined whether the use of rem was more than aem after the adoption of ifrs in companies distributed in 33 countries for the period from 2000 to 2010. their results showed that companies substituted rem for aem after ifrs adoption. however, sellami and fakhfakh (2013) documented a negative association between ifrs adoption and earnings management (both accrual and real). in fact, all the studies reviewed above-provided evidence on the movement in practice from aem to rem. however, such studies do not confirm the total switch from one to another. thus, rem can be used as a substitute or complementary with aem. in this context, zang (2012) questioned whether managers use both methods on earnings manipulation practices. based on a sample containing more than 6,500 firm-years over the period 1987–2008 to investigate the above question, the researcher found that managers used both techniques on earnings management as substitutes, and this depends on the cost of each one. furthermore, matsuura (2008) investigated the relationship between rem (measured by cash flow from operations activities) and aem to smooth earnings. the results demonstrated that the relationship between both rem and aem is sequential, and they are both used by managers complementarily. moreover, alhadab et al. (2015) provided evidence that companies during the ipo year used both earnings management techniques to upward earnings. figure (2) summarize reasons behind shifting in practice from aem to rem. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 450 figure 2. reasons behind the shifting of practices from aem to rem 4.3. consequences of real earnings management researchers have argued that earnings management victims are investors, regulators, customers, bankers, unions, suppliers, and competitors (e.g., lo, 2008). abad, cutillas-gomariz, sánchez-ballesta, and yague (2016) documented that rem is positively associated with the level of information asymmetry in spanish listed firms, which indicate that rem garbles the market. the literature suggests that rem activities affect companies in different aspects because they misrepresent the actual financial position and economic performance (sellami, 2015). rem is considered a signal of worse financial performance in the future (cohen & zarowin, 2010; gunny, 2005; tabassum, kaleem, & nazir, 2015). moreover, rem reflects weaknesses in the internal audit function (iaf). a study conducted by lenard, petruska, alam, and yu (2016) in the us market demonstrated that internal control weaknesses in companies is positively associated with rem, thus suggesting that companies which practice rem have lower performance in subsequent years. similarly, moradi, salehi, and zamanirad (2015) reported that rem is negatively associated with the future performance of companies. additionally, previous studies have reported that rem affects a company’s value. according to roychowdhury (2006), rem techniques such as price discounts and more lenient credit conditions increase earnings in the current period, but they may negatively affect cash flow in subsequent periods. researchers also postulate that rem is more costly than aem due to its negative consequences on cash flows and company value in the long run (chi et al., 2011; cohen & zarowin, 2010; cohen et al., 2008; ewert & wagenhofer, 2005; roychowdhury, 2006). kim and sohn (2013) investigated the influence of rem on the cost of equity in us companies and provided evidence on the positive relationship. such a result implies that increasing rem practices leads to increasing the costs of the equity market. furthermore, cupertino, martinez, and costa jr (2016) examined the impact of rem on the future return in brazilian capital market and found a negative impact of rem on return on assets. however, not all studies have documented a negative relationship between rem and the future performance of companies. for instance, taylor and xu (2010) found that companies that practice rem do not have a significant decline in operating performance in subsequent years. earnings management types aem rem ➢ tighter standards ➢ sox act passage. ➢ high audit quality ➢ forecast warnings ➢ ifrs adoption ➢ legal-system strength sh iftin g reasons asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 451 similarly, the evidence provided by pacheco paredes and wheatley (2017) indicates that rem is associated with improved future performance. 5. methodology this paper provided a review of previous studies on rem. the literature on rem has grown fast particularly in recent years, which makes it difficult to review all articles. in addition, this paper focused on the points that were initially specified. therefore, the current review only focused on the most important studies related to the aims of this paper, especially those investigating rem definitions, techniques, consequences, and measurement that are published in good journals. 6. conclusion and suggestions for future research the evidence on the movement of practice from accrual to real earnings management has created a need for reviewing and synthesising rem literature. therefore, this paper reviewed recent studies on rem. the findings of the review hopefully will benefit researchers and enhance the understanding of the financial reporting users about real activities manipulation. the review of the literature showed that there is a shift in earnings management practices from accruals-based practises to real activities management. the literature reported different reasons behind this shift such as tightening accounting standards, development of regulations like sox act, a shift in finance sources from internal to external market under the pressure of financial crisis, limitations in using aem under high audit quality scrutiny, and ifrs mandatory adoption. however, other studies have reported that the managers practise both techniques as a substitute or as complementary methods. therefore, a need exists for more investigation on such trade-offs to determine whether companies really shift earnings management practices from accruals to rem. future studies also can investigate why high audit quality and legal reforms have failed to prevent rem practices. furthermore, studies have provided mixed evidence on the effect of rem on the future performance of companies, and therefore, investigation is required in this area to determine whether rem is just business (good) or a manipulation (bad) to suggest remedies for such behaviour. references abad, d., cutillas-gomariz, m. f., sánchez-ballesta, j. p., & yague, j. 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(2012). evidence on the trade-off between real activities manipulation and accrual-based earnings management. the accounting review, 87(2), 675–703. https://doi.org/10.2308/accr-10196 notes note 1. for further information, you can refer the article titled as “the 10 worst corporate accounting scandals of all times” which is available at http://www.accounting-degree.org/scandals/ http://www.accounting-degree.org/scandals/ microsoft word 8898-32552-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 1 idiosyncratic volatility and cross-section of stock returns: evidences from india prashant sharma assistant professor and area chair (finance and accounts) jaipuria institute of management, jaipur, india e-mail: prashantsharma1989@gmail.com brajesh kumar assistant professor, department of economics national institute of financial management, faridabad, haryana, india e-mail: brajesh@nifm.ac.in received: jan. 19, 2016 accepted: feb. 22, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.8898 url: http://dx.doi.org/10.5296/ajfa.v8i1.8898 abstract the present study examines the cross-sectional pricing ability of idiosyncratic volatility (iv) in indian stock market and investigates the relationship amongst expected idiosyncratic volatility (ei), unexpected idiosyncratic volatility (ui), and cross-section of stocks returns. the study uses arima (2, 0, 1) model to iv into ei and ui. the stocks returns are regressed on iv, ei and ui using newey-west (1987) corrections, in order to investigate their empirical relationship. the study finds that iv is positively related with stock returns. further the iv significantly explains the cross-section of stock returns in indian context. after imposing control over ui, as it is highly correlated with unexpected returns, the inter-temporal relationship between ei and expected returns turns out to be positive. keywords: idiosyncratic risk, asset pricing, fama-french factor model, newey-west statistics, arima jel classification: c30, g11, g12 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 2 1. introduction asset pricing theories focus on the inter-temporal relationship between risk and return. the traditional theories focus majorly on the systematic risks but not on idiosyncratic risk, as it was assumed that perfect diversification in the portfolio can eliminate the idiosyncratic risk (markowitz, 1959; sharpe, 1964; treynor, 1961; and lintner, 1965). but, in real market scenario, it is very hard to diversify the portfolio perfectly. as mentioned by goyal and clara (2003), the reasons for not attaining fully diversified portfolios are transaction costs, taxes, concentration exposure that restrict the capacity of employees to sell their holdings received under employee compensation plans, private information about individual stocks, prone to invest in familiar stocks and irrationality of investors. to overcome such issue, in past two decades, the researchers have paid considerable attention to the role of iv in determining the excess returns. considering the importance of iv in asset pricing theory, merton (1987), in his theoretical model (assuming investor’s under-diversified portfolio) emphasized that it can have significant role in determining excess returns. following the theoretical model of merton (1987), numerous works had been conducted to see the inter-temporal relationship between iv and excess returns, which can be divided majorly into three categories; first category focusing on the time series trend ofiv in asset pricing process; second, emphasizing on the inter-temporal relationship between idiosyncratic volatility and future returns of stocks; and the third is on the time series association and predicting power of idiosyncratic volatility and cross-section of stock’s excess returns. the study conducted by campbell et. al., (2001) was in support of first branch of literature which focused to analyze the time series trends in idiosyncratic volatility. they divided total volatility into two i.e., firm volatility and the market volatility. employing data for period of 1962-1997, the results showed that the firm level volatility had increased over a period of time relative to market volatility and as result of that the explanatory power of market models had been declined. apart from this, the number of stocks needed for achieving a given level of diversification had increased. in line with second branch of literature, the predictability of stock returns with different risk measures was tested by goyal and clara (2003) for period of july 1962 to december 1999 and showed that there is significant positive relationship between average stock variance (largely idiosyncratic risk ) and market returns.these results were robust after controlling for various macroeconomic risk indicatorsi. these empirical evidences indicate the significant role of iv in asset pricing theory. the study conducted by anget. al., (2006), provides systematic investigation of pricing of iv in us context using the data from january 1986 to december 2000. this study examines the cross-sectional pricing ability of iv and provides a puzzle which is commonly known as idiosyncratic risk puzzle, and documented a negative relationship between iv and stock returns. these findings were robust after controlling for various firm characteristicsii. the focus of our study is on the second and third branch of literature; focusing on the inter-temporal relationship association between iv and stock’s excess returns; and the cross-sectional pricing ability of iv in indian stock market. the relationship between iv and cross-section of stock returns have shown mixed outcomes, some studies reported the significantly positive relationship while others have documented asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 3 that either there is no relationship or negative relationship. the studies conducted by goyal and clara (2003) and spiegal and wang (2005) presented significant positive relationship between iv and stock returns. the findings of goyal and clara (2003) were opposed by bali et. al., (2005), as they argued that the results were driven by small stocks traded on nasdaq, and was in part due to a liquidity premium. there were no evidences of relationship between value-weighted portfolio returns and the median value-weighted average stock volatility. the recent studies conducted by fu (2009), boehme et. al., (2009), chua et. al., (2010)and marcelo et. al., (2012) emphasized on the significant positive relationship between iv and cross-section of stocks returns while the studies of anget. al., (2006, 2009), guo and savickas (2010) and bley and saad (2012) documented the negative relationship. some other studies by bali et. al., (2005) and bali and cakici (2008) reported no significant relationship between iv and cross-section of stock returns. the relationship between cross-section of stock returns and iv are sensitive to model specification and the sample data used to measure the idiosyncratic risk and these mixed evidences are mainly due to lack of consistency choice of variable used to estimate idiosyncratic volatility. some of the existing studies have considered the total iv and while others have used the ei. fu (2009) addressed this issue and emphasized on the use of ei determined ex-ante, not the total idiosyncratic volatility, since the objective is to examine its relationship with expected returns. in addition, french, schwert and stambaugh (1987) indicated that the use of total volatility may present some obscure relationship between the market returns and market volatility, and suggested to decompose the total volatility to predictive and un-predictive components. following this decomposition approach, chua et. al., (2010) decomposed the iv into two, ei and ui and reported that ui controls for unexpected component of returns. the ei explains cross-section of stock returns significantly and have a positive relationship with returns. as discussed above, numerous evidences on relationship between idiosyncratic volatility and cross-section of stocks returns exist in global context, but there is dearth of literature in indian context. in this background, the present study has been designed to: examine the cross-sectional pricing ability of idiosyncratic risk in indian context; and investigates the empirical relationship amongst ei, ui, and stocks excess returns. the present study contributes in the existing body of literature by improving the international evidences with the exclusive in-depthanalysis of the indian market which is relatively less explored. the study follows the approach of chua et. al., (2010) for estimation of idiosyncratic volatility. similar to french, schwert and stambaugh (1987), the study employs arima (2, 0, 1) or arma (2, 1) model for decomposition of iv into ei and ui. the study employs monthly data from 2001 (fy) to 2012 (fy) of non banking and financial companies of bse 500 index. for estimation of iv, the monthly fama french (1993) factorsiiiare regressed on monthly returns of the individual sample firms. the square of the resulting regression residuals are treated as iv of the particular firm. additionally, for decomposition of iv, arma (2, 1) model is pressed into service for each company and the fitted values are termed as the ei and the residuals are termed as ui. in order examine the cross-section pricing ability of iv, ei and ui, the cross-sectional regression analysis are conducted with the estimation of newey-west (1987) t-statistics. the robustness of the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 4 relationship is tested after controlling for various firm characteristics such as market capitalization and book to market equity ratio. the study finds a significant positive relationship between ei and stocks expected returns, that is consistent with studies of merton (1987), fu (2009) and chua et. al., (2010) which reported the significant robust relationship between ei and expected returns. our results are different with the studies of anget. al., (2006, 2009) indicating negative relationship between the two, wherein bali and cakici (2008) found no significantly robust relationship between iv and expected returns. the study has been structured in following sections. section 2 presents the data and empirical methodology for estimation of iv and section 3 presents the empirical results and findings of the study and we conclude with section 4. 2. data and methodology for estimation of volatility the study employs monthly data on stocks returns, market returns, 91 dayst-bills rates, smb and hml of bse 500 companies (except banking and financial institutions) from 2001(fy) to 2012 (fy). the data are collected from cmie (center for monitoring indian economy) prowess 4.0 data base and the indiastatdsatabase. in order to maintain the consistency in the data, only those firms are considered which are having data for full sample period; this number turns out to be 273 firms. the data on variables; stock excess returns and market excess returns are derived by subtracting the 91 days t-bills rates from individual firmreturns and market returns series. the factors smb, hml are constructed using fama-french (1992) methodology. 2.1 construction of fama-french (1992) factors the factors smb and hml are constructed from a two-by-three sort on size and book-to-market value. at the end of march of each year from 2001 to 2011, all stocks are ranked on market capitalization (or size) and book to market value. the median value of the size is used as a size break point to split all stocks into two groups, small (s) and big (b). the stocks shorted on book to market value are divided into three book-to-market groups based on the break points for the bottom 30% (l), middle 40% (m), and top 30% (h). monthly equally-weighted returns on the six portfolios are calculated from april of year y to march of year y+1. smb is the difference, each month, between the simple average of the returns on the three small portfolios (s/l, s/m, and s/h) and the simple average of the returns on the three big stocks (b/l, b/m, and b/h). hml is the difference, each month, between the simple average of the returns on the two high book to market portfolios (s/h and b/h) and the simple average of the returns on the two low book to market portfolios (s/l and b/l). 2.2 idiosyncratic volatility: definition and estimation to estimate the idiosyncratic volatility, fama-french (1993) regression is conducted using the monthly returns of all stocks. tititititititititi hmlsmbrmr ,,3,,2,,,,, εβββα ++++= (1) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 5 where tir , represents the monthly excess returns on stock i on month t. similarly tirm , represents the monthly excess returns of bse 500 index, tismb , is the return difference on size factor and tihml , is the return difference on value factor. ti ,α is coefficient and ti ,β are parameters for each factors. following the anget. al., (2006) and chua et. al., (2010) methodology, the idiosyncratic volatility of stock i in month t is defined as; = titiiv ,, 2ε (2) where tiiv , is the idiosyncratic volatility measure for firm i in month t which is the square of the fama-french regression residuals ( ti ,2ε ). to decompose the idiosyncratic volatility into expected and unexpected components, arma (2, 1) model is used. for each stock, using monthly data, the following time series regression is performed; 112,21,10, −−− −++= ttititi iviviv ξφθθθ (3) here 1, −tiiv and 2, −tiiv are the lagged auto-regressive terms of order one and order two and 1−tξ is moving average terms of first order. following chua et. al., (2010), the fitted values of regression equation 3 are defined as ei and the residuals are termed as ui. 2.3 descriptive statistics table 1. descriptive statistics iv ei ui mean 0.035769 0.033425 0.002344 median 0.018008 0.01773 0.000004 std. dev. 0.119635 0.104803 0.029507 skewness 11.0647 12.29724 16.24822 kurtosis 129.1697 167.6131 266.9859 note: the sample is from june 2001 to march 2012. at every month, for each firm, the iv (idiosyncratic volatility) is calculated by following equation 2 and ei (expected idiosyncratic asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 6 volatility) and ui (unexpected idiosyncratic volatility) are estimated using equation 3. in order to provide point estimate, the cross-sectional averages of iv, ei and ui are reported. table 1 reports the summary statistics; mean, median, standard deviation, skewness and kurtosis of the cross-sectional series of iv, ei and ui. the cross-sectional mean of iv in indian stock market is 0.036 and the standard deviation is 0.12. the mean iv of indian market is higher than those reported for us context; while standard deviation is lower (see chua et. al., 2010, zang 2004); indicating that iv is less volatile in indian context. the mean of ei is 0.032 which is near to iv mean but ei is less volatile than iv since its standard deviation 0.1048. ui is having very low mean value of 0.0023 with standard deviation of 0.03, showing less volatile behavior. 3. results and discussions 3.1 cross-sectional regression of returns on iv following regression is performed to investigate the relationship between cross-section of stock returns and idiosyncratic volatility. tititi ivr ,,10, ησσ ++= (4) table 2. cross-sectional regression of returns on iv and control variables (size and value) variable model 1 model 2 parameter t-statistics parameter t-statistic c -0.04323 -3.0709 -0.10506 -0.49675 iv 0.48034* 3.4629 0.616778* 2.618798 lnbeme 0.007564 0.218268 lnmcap 0.026027** 0.807847 r-squared 0.153554 0.173427 note: the sample is from june 2001 to march 2012. at each month, the cross-section of returns is regressed on cross-section of iv of 273 sample firms of bse 500. the table reports the time-series average of parameters and the newey-west (1987) adjusted t-statistics. the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 7 adjusted r2 value is also reported. later on this regression were performed after controlling for lnmcap (size) and lnbeme (value) effect. * represent significant at 1% level of significance and ** for 5% level of significance. model 1 of table 2 reports the time series means of parameters and newey-west (1987) t-statistics for regression of returns on iv. the coefficient of iv is -0.04 which is very low and insignificant while the parameter of iv is 0.48 which is positive and significant at 1% level of significance. this indicates that in indian stock market, the iv is having significant explanatory power to predict the stock returns. the existing asset pricing literature had documented that the anomaly factors; market capitalization and book to market ratio (fama french, 1992) had significant explanatory power of explaining variation in the cross-section of stock returns. in order to test the robustness of the results reported in model 1 of table 2, cross-section of returns is regressed on iv after controlling for variables i.e., the logarithmic value of market capitalization and book to market ratio of individual firms. tititititi mcapbemeivr ,,3,2,10, lnln ησσσσ ++++= (5) the results are reported in the model 2 of table 2. the parameter of iv, after controlling for control variables, is 0.62 which is higher than those reported in model 1. it is significant at 1% level of significance, and the explanatory power (adjusted r2) of this model has improved after controlling for anomaly factors. this clearly indicates that iv is having significant explanatory power to explain cross-sectional variation in stock’s returns and the impact of iv is positive and significant. recent literature on the relationship between idiosyncratic volatility and stock returns advocates the decomposition of iv into ei and ui. fu (2009) addressed this issue and emphasized the use of ei determined ex-ante and not the total idiosyncratic volatility. 3.2 cross-sectional pricing ability of ei and ui to investigate the relationship of ei, ui and returns, the returns of companies are regressed on ei using following cross-sectional regression; tititi eir ,,10, ηϑϑ ++= (6) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 8 table 3. cross-sectional regression of stock returns on ei and both ei and ui model 3 model 4 variable parameter t-statistic parameter t-statistic c -0.0442 -1.3184 -0.0441 -1.482 ei 0.2596** 0.3026 0.24073** 0.4575 ui 0.525245* 2.0831 adjusted r2 0.1089 0.1610 note: the sample is from june 2001 to march 2012. at each month, the cross-section of returns is regressed on ei of 273 sample firms of bse 500. the table reports the time-series average of parameters and the newey-west (1987) adjusted t-statistics. the adjusted r2 value is also reported. later on this regression were performed after controlling for ui. * represent significant at 1% level of significance and ** for 5% level of significance. model 3 of table 3presents the mean of cross-sectional regression result of returns on ei. the parameter of ei is 0.26, which is statistically significant at 5% significance level. this indicates that ei is having significant explanatory power to explain cross-sectional variation in expected stock returns, but ei doesn’t outperform in comparison to iv. further the relationship of ei and returns is explored after controlling for ui and following cross-sectional regression equation is used; titititi uieir ,,2,10, ηϑϑϑ +++= (7) model 4 of table 3 represents the results of the cross-sectional regression of returns on ei and ui. the parameter of ui is 0.5252 which is significant at 1% level of significance, supports the findings of chua et. al., (2010), who reported that ui controls for unexpected variation in the future stock returns. the parameter of ei is 0.24 at 5% level of significance. this parameter value is marginally lower than the parameter of ei (when there was no control over ui). these results suggest that in indian context, ei’s explanatory power for explaining cross-section of expected returns, sustains after ui controlling for unexpected component of future stocks returns. the results also suggest that the impact of ei on returns is economically significant. a 1% increase in the ei will lead to 0.24% increase in the expected stock returns. the relationship of ei and returns is positive, which is in line with the existing literature. after controlling for unexpected returns, the ei’s explanatory power should increase but we don’t find any evidences in indian context. in order to re-examine and test the robustness of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 9 this relationship, the study uses the market capitalization and book to market ratio (fama french, 1992) as control variables. 3.3 control variable and relationship of ei, ui and returns to test the robustness of the relationship of ei and returns, these factors (market capitalization and book to market ratio) are introduced in following cross-sectional regression equation; titititititi bememcapuieir ,,4,3,2,10, lnln ηϑϑϑϑϑ +++++= (8) table 4. cross-sectional regression with control variables (size and value) variable parameter t-statistic c -0.1058 -0.4271 ei 0.55009** 0.55381 ui 0.66519* 1.95668 lnbeme 0.00701 0.16803 lnmcap 0.02441** 0.76829 adjusted r-squared 0.17999 note: the sample is from june 2001 to march 2012. at each month, the cross-section of returns is regressed on ei after controlling for ui, market capitalization and book to market ratio of 273 sample firms of bse 500. the table reports the time-series average of parameters and the newey-west (1987) adjusted t-statistics. the adjusted r2 value is also reported. * represent significant at 1% level of significance and ** for 5% level of significance. table 4 reports the mean of parameters and newey west (1987) t-statistics of the cross-sectional regression of returns on ei, after controlling for ui, market capitalization and book to market equity ratio. the parameter of ei is 0.55, which is significantly higher than the parameter (0.24) reported in model 4 of table 3, where no control were imposed on the relationship between returns and ei except ui. after controlling for ui along with market capitalization and book to market ratio, the explanatory power of ei has significantly improved. the parameter is statistically significant at 5% level of significance level; clearly asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 10 indicates that the ei explain the cross-section of stock returns significantly in indian market. these findings are consistent with fu (2009) and chua et. al., (2010). 4. conclusion the study aims to examine the relationship of iv and cross-section of stock returns in indian stock market. the existing literature suggests two approaches to investigate the relationship between idiosyncratic volatility and returns; first to regress stock returns on iv and second is to decompose the iv into expected and unexpected components and then find the resulting relationship. considering the second approach, the iv is decomposed into ei and ui, as fu (2009) emphasized the use of ei determined ex-ante and not the total iv to examine its impact on cross-section of stock returns. the findings of the study suggest that iv and ei explain the cross-section of stock returns significantly in indian context. the explanatory power of ei doesn’t improve after controlling for ui, but when we control for the fama french (1992) factors i.e., market capitalization and book to market equity, the explanatory power of ei improves significantly and then explains 55% of cross-sectional variation in expected stock returns. the relationship is positive, indicates that a 1% increase in ei will lead to 0.55% increase in expected stock returns. the results are consistent with the study of spiegel and wang (2005), fu (2009) and chua et. al., (2010), as they documented a significant positive relationship between expected returns, ei and ui. the findings don’t support anget. al., (2006, 2009) and bali and cakici (2008)because the former have documented negative relationship while later reported no significant relationship between iv and expected returns. the study concludes with a note that along with the systematic risk, the idiosyncratic risk should also be considered while determining the asset prices in indian stock market. references ang, a., hodrick, r., xing, & y., zhang, x. 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(1987). a simple, positive-definite, heteroskedasticity and autocorrelation consistent covariance matrix. econometrica, 55, 703-708. http://dx.doi.org/10.2307/1913610 sharpe, w. (1964). capital asset prices: a theory of market equilibrium. journal of finance, 19, 425–442. http://dx.doi.org/10.1111/j.1540-6261.1964.tb02865.x spiegel, m., & wang, x. (2006). cross-sectional variation in stock returns: liquidity and idiosyncratic risk. unpublished working paper, yale university. treynor, j. l. (1961). toward a theory of market value of risky assets. mimeo, subsequently published in korajczyk, robert a. 1999, asset pricing and portfolios performance: models, strategy and performance metrics london: risk books. i macroeconomic indicators used as control variable by goyal and clara (2003) were dividend price ratio, three-month treasury bill rate, term spread and default spread. ii firm characteristics i.e. size, value, volume, liquidity, momentum, analyst forecast dispersion and market conditions. iiithe factors (smb, hml and erm) were calculated using the fama french (1993) methodology which is described in section 2.1 of the study. microsoft word 8256-29890-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 152 wealth creators in the banking sector in uae during 2010-2015 period b rajesh kumar professor, finance area, institute of management technology dubai k s sujit associate professor, economics area, institute of management technology dubai received: sep. 5, 2015 accepted: oct. 19, 2015 published: december 1, 2015 doi:10.5296/ajfa.v7i2.8256 url: http://dx.doi.org/10.5296/ajfa.v7i2.8256 the returns of 20 actively traded banking stocks in uae were analysed during the five and half year period 2010 to mid-2015.the performance of the stocks of banking firms was analysed in terms of yearly average returns, cumulative total returns and holding period returns. the stock prices were obtained from abu dhabi stock exchange and dubai financial market websites. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 153 table 1. best banking stocks –total cumulative returns sl banks cumulative returns in percent 1 gulf finance house 184 2 abu dhabi commercial bank 183 3 emirates nbd 153 4 dubai islamic bank 134 5 ajman bank 127 6 commercial bank of dubai 107 7 union national bank 99 8 invest bank 81 9 abu dhabi islamic bank 80 10 rak bank 77 11 mashraq 65 12 commercial bank international 61 13 al salam bank 56 14 national bank of umm al qaiwaim 52 15 first gulf bank 35 16 finance house 27 17 national bank of abu dhabi 16 18 united arab bank 14 19 bank of sharjah 6 the total daily cumulative returns for each stock was calculated for the five and half year period ranging from jan 1 2010 to june 15 2015. the daily returns were cumulated to get the total cumulative returns for the above period.in terms of cumulative daily returns, gulf finance house was the greatest wealth creator among the banks. the stock price increased during the five and half year period 2010-mid 2015 to yield return of 184 per cent. during the same period, the second highest wealth creator abu dhabi commercial bank (adcb) generated return of 183 per cent. the other major wealth creators who generated returns of over 100 per cent are emirates nbd, dubai islamic bank, ajman bank and commercial bank of dubai. the analysis is based on the active strategy of buying and selling continuously for the period of five and half years. yearwise comparison the year 2014 and 2015 were the best performing years for the banking stocks in the uae. in the year 2013, all the 19 banking stocks had average positive yearly returns. in year 2014, 17 out of 19 stocks registered average positive yearly returns. only nine out of 20 banking stocks registered average positive yearly returns during the period jan-june 2015. in the year 2010 and 2011, 6 and 9 stocks documented average positive yearly returns. in 2012, 11 stocks out of 19 banking stocks had positive average yearly returns. the average yearly returns were positive for 16 out of 19 banking stocks during the period 2010-2014. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 154 table 2. bank stocks with highest average yearly returns 2010-2014 sl banks average yearly return in percent 1 national bank of umm al qaiwaim 144.62 2 commercial bank of dubai 60.25 3 gulf finance house 54.08 4 commercial international bank 52.27 5 abu dhabi commercial bank 50.40 6 ajman bank 43.34 7 emirates nbd 41.88 8 dubai islamic bank 38.55 9 rak bank 37.09 10 invest bank 35.63 11 abu dhabi islamic bank 26.28 12 union national bank 24.69 13 al salam bahrain 18.60 14 first gulf bank 13.52 15 national bank of abu dhabi 11.28 16 bank of sharjah 3.47 national bank of umm al qaiwaim had average yearly returns of approximately 145 per cent during the five year period 2010-2014. commercial bank of dubai and gulf finance house had an average yearly returns of approximately 60 per cent and 54 per cent during the five year period 2010-2014.abu dhabi commercial bank and ajman bank had an average yearly returns of 50 percent and 43 percent during the period 2010-2014.emirates nbd registered an yearly average return of approximately 42 per cent during the five year period 2010-2014.dubai islamic bank had registered an average return of 38.6 per cent during the five year period 2010-2014. table 3. best banking stocks in year 2010 sl banks average yearly returns in percent 1 finance house 136 2 rak bank 78 3 abu dhabi commercial bank 50 4 first gulf bank 21 5 abu dhabi islamic bank 9 6 union national bank 8 finance house, rak bank and abu dhabi commercial bank were the best performing stocks in terms of average yearly returns in year 2010. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 155 table 4. best banking stocks in year 2011 sl banks average yearly returns in percent 1 mashraq 1000 2 gulf finance house 419 3 abu dhabi commercial bank 46 4 al salam 31 5 bank of sharjah 21 6 emiratesnbd 20 7 abu dhabi islamic bank 13 8 rak bank 11 9 ajman bank 4 mashraq bank had registered the highest average stock returns of 1000% in the entire period of study of five and half years. in the year 2011, the next highest average stock returns were given by gulf finance house and abu dhabi commercial bank. table 5. wealth creators in the year 2012 sl banks average yearly returns in percent 1 commercial bank international 629 2 national bank of umm al qaiwaim 108 3 ajman bank 94 4 invest bank 53 5 al salam 27 6 commercial bank of dubai 26 7 abu dhabi commercial bank 19 8 union national bank 9 9 dubai islamic bank 7 10 abu dhabi islamic bank 3 11 national bank of abu dhabi 1 cbi, nbq and ajman bank were the biggest wealth creators in year 2012. cbi’s average yearly stock returns amounted to 629% during the year 2013. nbq registered average yearly returns of 108 per cent in year 2012. ajman bank had registered yearly average return of 94 per cent in year 2012. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 156 table 6. best banking stocks in year 2013 and 2014 2013 2014 sl banks average yearly returns in percent sl banks average yearly returns in percent 1 national bank of umm al qaiwaim 581 1 national bank of umm al qaiwaim 203 2 mashraq 446 2 mashraq 145 3 commercial bank international 369 3 commercial bank of dubai 129 4 united arab bank 329 4 emirates nbd 65 5 commercial bank of dubai 199 5 invest bank 55 6 finance house 191 6 united arab bank 53 7 dubai islamic bank 152 7 dubai islamic bank 52 8 invest bank 143 8 finance house 45 9 emirates nbd 128 9 ajman bank 42 10 abu dhabi commercial bank 125 10 rak bank 33 11 rak bank 113 11 al salaam 25 12 union national bank 105 12 bank of sharjah 23 13 abu dhabi islamic bank 95 13 national bank of abu dhabi 15 14 ajman bank 93 14 abu dhabi islamic bank 12 15 gulf finance house 84 15 abu dhabi commercial bank 12 16 first gulf bank 76 16 union national bank 8 17 bank of sharjah 73 17 commercial bank international 4 18 al salam 61 19 national bank of abu dhabi 50 national bank of umm al qaiwaim (nbq) and mashraq were the largest wealth creators in the year 2013 and 2014 respectively. nbq had average yearly returns of 581 percent and 203 percent in the year 2013 and 2014 respectively. mashraq bank had documented an average yearly returns of 446 per cent and 145 percent respectively during the period 2013 and 2014. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 157 table 7. half yearly average returns 2015 bank half yearly average returns in percent amlak finance 1694 gulf finance house 265 union national bank 25 commercial bank of dubai 24 abu dhabi commercial bank 23 emirates nbd 18 commercial bank international 12 finance house 12 invest bank 5 amlak finance was the highest wealth creator by the mid of year 2015 in terms of average yearly returns. the other two highest wealth creators by mid of the year 2015 was gulf finance house and union national bank. amlak finance documented half yearly average returns of 1694 per cent. gulf finance house and union national bank had documented half yearly average returns of approximately 265 per cent and 25 per cent respectively. table 8. volatility of stocks sl banks standard deviationof daily stock returns 1 unb 0.018 2 adib 0.018 3 dib 0.019 4 nbad 0.020 5 adcb 0.021 6 enbd 0.022 7 bos 0.023 8 fgb 0.023 9 rakbank 0.024 10 ajman 0.025 11 cbd 0.033 12 alsalam 0.041 13 investb 0.045 14 uab 0.051 15 mashraq 0.054 16 cbi 0.064 17 fh 0.065 18 nbq 0.068 19 gfh 0.097 asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 158 the volatility of stocks are measured in terms of standard deviation of the daily stock returns during the five and half year period jan 2010 –mid jan 2015. the stocks with most stable returns were the stocks of union national bank, abu dhabi islamic bank and dubai islamic bank. the most volatile stocks in terms of volatility of daily stock returns were finance house, nbq and gulf finance house stocks. holding period yield table 9. holding period yield sl year 3rd jan 2010 15thjun-2015 hpy in percent 1 adcb 1.61 7.5 366 2 enbd 2.95 9.63 226 3 dib 2.35 6.75 187 4 unb 3.090 6.65 115 5 ajman bank 0.93 1.99 114 6 cbd 3.6 6.51 81 7 adib 2.9 5.1 76 8 rak bank 4.5 7.55 68 9 invest bank 1.8 2.66 48 10 mashraq 83 118 42 11 cbi 1.4 1.65 18 in this section of analysis, it is assumed that a stock is bought on the first day of trading week in january 2010 and sold off on 15th june 2015. thus the stock is held for a period of five and half years and then the holding yield is calculated. for example, assume that an investor who brought a stock of adcb on 3rd jan 2010 sells it on june 15 2015. the holding period yield for this transaction resulted in a yield of 366 per cent during the five and half year period. table 10. holding period yield for the period jan 2015-june 2015 sl banks hpy in percent 1 gulf finance house 137 2 amlak finance 113 3 unb 15 4 emirates nbd 15 5 abu dhabi commercial bank 13 6 invest bank 4 the holding period yield is estimated under the assumption that a stock brought on the first day of trading in jan 2015 is held for investment till june 15 2015 and then sold off. gulf finance house and amlak finance had the highest holding yield for the six month period jan-june 2015. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 159 table 11. average holding period yield 2010-2014 sl year average holding period yield in percent 1 adcb 37 2 dib 33 3 enbd 30 4 ajman 30 5 mashraq .25 6 cbd 19 7 unb 18 8 adib 17 9 rak bank 16 10 uab 10 11 nbq 9 12 invest bank 9 13 cbi 6 14 fgb 3 15 nbad 3 16 bos 1 the average holding period yield for the period 2010 -2014 is estimated above. each stock’s holding period yield every year for the four year period is estimated and then the average yield is estimated. abu dhabi commercial bank and dubai islamic bank stock had given the highest average holding period yield during the period 2010-2014.out of the 19 banks studied, 16 banks had positive average holding period yield. in year 2010, abu dhabi commercial bank, rak bank and first gulf bank had the highest holding period yield with yield of 29%, 12% and 11% respectively. in 2011 mashraq bank, abu dhabi commercial bank, bank of sharjah and abudhabi islamic bank had the highest holding period yield with yield of 36%, 32%, 6 %, 6% respectively. in 2012 and 2013, the highest holding period yield was generated by ajman bank and dubai islamic bank. in 2014, commercial bank of dubai generated the highest holding period yield. the maximum holding period yield was generated in the year 2013 where four of the top high yielding banks generated yield of over 100 per cent. in the year 2013, dib and enbd generated holding period yield of 164 per cent and 124 per cent respectively. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 160 table 12. hpy in percent of five top banks in terms of yields. year 2010 year 2011 year 2012 year 2013 year 2014 1 adcb 29 1 mashraq 36 1 ajman 78 1 dib 164 1 cbd 48 2 rak bank 12 2 adcb 32 2 cbi 48 2 enbd 124 2 mashraq 40 3 fgb 11 3 bos 6 3 nbq 13 3 uab 115 3 enbd 34 4 fh 9 4 adib 6 4 adcb 12 4 adcb 110 4 dib 15 5 adib 3 5 enbd -1 5 unb 7 5 unb 92 5 nbq 14 microsoft word 13286-48591-1-sm-writer2-new2 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 1 does capital structure matter? the influence of capital structure on net interest margin: evidence from sri lanka lingesiya kengatharan department of financial management, university of jaffna, sri lanka logavathani sivalingam faculty of management studies & commerce, university of jaffna, sri lanka e-mail: lingesiya@univ.jfn.ac.lk received: may 14, 2018 accepted: june 30, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13286 url: https://doi.org/10.5296/ajfa.v10i2.13286 abstract objectives of this study were to examine the capital structure pattern of sri lankan commercial banks and to investigate the influence of capital structure on net interest margin of commercial banks in sri lanka. this study was conducted with 10 licensed commercial banks which are listed in colombo stock exchange (cse), sri lanka. panel data analysis was used to carry out the empirical study and data were extracted from the annual reports of selected companies for the ten years period from 2007 to 2016. capital structure patterns of licensed commercial banks were measured by total debt to total assets ratio, long term debt to total assets ratio, and short term debt to total assets ratio. net interest margin (nim) was measured by net interest income to average earnings assets ratio. nim specifies the cost and efficiency of financial intermediation by banks. size of the banks and growth in banks deposit were considered as control variables. descriptive statistics, correlation, pooled, fixed effect and random effect models were used for the data analysis. according to the descriptive statistics, present study found that commercial banks had lower leveraged capital structure pattern in sri lanka. f test was performed to diagnose the time fixed effect in the fixed effect model and outcome of the test revealed that p value was less than 0.05. therefore, null hypothesis was rejected and fixed effect model was most appropriate than pooled ols. further, lagrange multiplier test for random effect was performed. the result indicated that the p value was 0.000 and rejected the null hypothesis in favor of the alternative which implied that random effect model was more appropriate than pooled ols. therefore, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 2 hausman specification test was performed to find out whether fixed or random effect model is suitable to examine the relationship between capital structure and nim. fixed effect model was considered as the most suitable model to examine the influence of capital structure on nim in this study. as per the result of fixed effect model, total debt to total assets ratio and long term debt to total asset ratio were significantly negatively related to nim. short term debt to total assets ratio, and size were not significantly related nim. results of the study suggest that financial managers should try to finance from retained earnings rather than relying heavily on debt capital in their capital structure. outcome of the study may useful to the practitioners, investors and decision makers in order to maximize their return from their investments. keywords: total debt to total assets, long term debt to total assets, short term debt to total assets, growth in banks deposit, nim. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 3 1. introduction firm's capital structure can be defined as mix of debt and equity (pandey, 2005).the capital structure choice has long been an issue of great interest in the corporate finance literature. right form of the promotional stage up to end finances play an important role in firm’s life. capital structure theories deal with what is the optimum capital structure and guide to the maximum value of the firm. the overall cost of capital can be minimized by carefully mix up the debt and equity capital as well as maximize the shareholders wealth. the proportion of debt to equity is a most important strategic choice of corporate managers. the firm’s capital structure is considered optimum when the market value of shares is maximized. if debt capital does not exists in the capital structure, the shareholders’ return is equivalent to the firm’s return. the financial leverage can be understood that the change in the shareholders’ return caused by the change in the profits. commercial banks play an significant role in providing modern financial services in the country and they are being major financial intermediary in the fund transfer system. considerable and significant percentage of the total assets of financial system in sri lanka is accounted by commercial banks. as per the cse's annual report in 2015, commercial banks play a major role in the economic welfare of the cse. capital structure pattern of banks plays a fundamental role in their financial performance, solvency position and their overall public creditability. pahlavan, asgari and pahlavan, 2015 stated in their study that the ranking of companies regarding credibility is mostly dependent on their capital structure. 'managers in banks believed as agent of stockholders and people therefore, they should constantly attempt to regulate the bank's capital structure in order to minimize the cost of bank capital and maximize the profitability' (bose, 2002,p.9). literature reported that most of the bank investors trust that a constant interest guarantees higher profit payments in comparison to fluctuating interests (pahlavan et al., 2015). fluctuation on interest rates is regarded as most important risk measure for investors in banks. awadhi and hamdi (2012) stated that nim specifies the cost and efficiency of financial intermediation by banks. banking sector in sri lanka mainly focus on conventional business model. banks depend on owners’ capital as well developed equity market in sri lanka. further, it is the easy way to raise the funds to run the business compared to the debt financing in developing countries like sri lanka. due to the several reasons such as few corporate entities in the market, offering corporate bonds is expensive and less infrastructure facilities, debt market in sri lanka is still under the development stage. therefore, banks prefer to go for equity capital to finance their activities. there are several researches carried out at a worldwide to study the relationship between capital structure and performance of banks. for example, gebremichael (2016) conducted a study to examine the impact of capital structure on profitability of commercial banks of ethiopia. results of his study reported that there was a significant negative relationship between capital structure and nim. aymen (2013) investigated the impact of capital structure on financial performance of banks in tunisia and found that capital structure significantly positively influenced return on equity and nim. in addition, taani (2013) evaluated the capital structure effects on banking performance in jordan. the study of marandu and sibindi (2016) in south africa revealed that there was a relationship between return on assets and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 4 bank specific determinants of capital structure in terms of capital adequacy, size, credit risk and deposits. a study on the relationship between capital structure and bank performance in sub-sahara africa was conducted by anarfo in 2015. but results of this study indicated that capital structure does not determine bank performance. further, gohar and rehman (2016) studied the impact of capital structure on bank performance in pakistan. findings of this study reported that there was a significant negative relationship between capital structure and performance. similar studies were conducted by allahham (2015) in saudi arabia and by siddik, kabiraj and joghee (2017) in bangladesh. it was hard to see the study on the relationship between capital structure and bank performance in sri lanka. therefore, current study is to examine the capital structure pattern in sri lankan commercial banks and also to investigate the influence of capital structure patterns on nim of commercial banks in sri lanka. thus, current study is going to answer the following research question: • to what extent capital structure pattern influence on the net interest margin of licensed commercial banks in sri lanka? 2. empirical studies on the relationship between capital structure and financial performance a study on the effect of capital structure on the corporate profitability of the listed firms in ghana conducted by abor (2005). capital structure was measured by short-term debt ratio, long-term debt ratio, and total debt ratio. arbor (2005) reported significantly positive relationship between short term debt and profitability and negative association between long term debt and profitability. this implies that an increase in the long-term debt position is associated with a decrease in profitability. yegon, cheruiyot, sang and cheruiyot (2014) empirically investigated the relationship between capital structure and the firm’s profitability of banking industry in kenya, using panel data which were extracted from the financial statements of the companies listed on the nairobi stock exchange for the nine years period from 2004. findings were reported that short term debt had significant positive relationship with the profitability. fama and french (1998) argued that the use of excessive debt creates agency problems among shareholders and creditors, in turn, lead to negative relationship between leverage and profitability. majumdar and chhibber (1999), gleason, muthur and muthur (2000), and hammes (1998) found a negative effect of leverage on corporate profitability. jensen (1986) reported that profitable firms might signal quality by leveraging up, resulting in a positive relation between leverage and profitability. saeed, gull and rasheed (2013) assessed the impact of capital structure on the performance of banks in pakistan for the 5 years period from 2007. they have found that a positive relationship between determinants of capital structure and performance of banking industry. ronoh and ntoiti (2015) studied the effect of capital structure on financial performance of listed commercial banks in kenya and found that there was a negative effect of capital structure on financial performance of commercial banks. ramdan and ramdan (2015) examined the effect of capital structure and financial performance on jordanian companies and their findings suggested that negative effect of capital structure on return on assets were asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 5 observed in their study. the findings were contradicted with the findings of al-taani's study. taani (2013) conducted a study to investigate the relationship between capital structure and profitability. however, results illustrated that there was no relationship between debt ratio and return on assets. anyhow, this findings was consistent with the ebaid's (2009) study which was evaluated the relationship between capital structure and performance based on the 64 firms in egyptian companies during the period from 1997 2005. witowschi and luca (2016) studied about bank capital, risk and performance in european banking. they have evaluated that in which ways capital influences on profitability of banks for 7 european countries including austria, balgaria, greece, italy, romania, the netherlands and hungary. results of their study revealed that there was negative relationship between capital and risk, and also there was a significant positive relationship between capital and profitability. most recently, siddik, kabiraj and joghee (2017) conducted a study to examine the impact of capital structure and financial performance of banks in bangladesh. they have focused 22 banks for 10 years period from 2005. return on assets, return on equity and earnings per share were considered as the performance measures. capital structure was measures by short term debt to total assets ratio, long term debt to total assets ratio and total debt to total assets ratio. results of their study illustrated that capital structure inversely affects the banks performance. lingesiya and premkanth (2011) carried out a study on the impact of capital structure on financial performance of listed manufacturing companies in sri lanka. they have found that there was a significant negative relationship between capital structure and financial performance. niranjini and priya (2013) conducted a study to examine the impact of capital structure on financial performance of the listed manufacturing companies for the period from 2006 to 2010. findings of their study suggested that there was a positive significant relationship between capital structure and financial performance of listed trading companies in sri lanka. further, nadeesha and pieris (2014) conducted a study to investigate the impact of capital structure choice on firm performance in sri lanka with a 82 listed non financial firms during the period of 2011/2012. they have found that there was a positive relationship between debt to total assets and return on capital employed. recently, abewardhana and magoro (2017) completed a study on debt capital and financial performance which was a comparative analysis of south african and sri lankan listed companies. their findings of the study were, in case of sri lanka, debt financing in terms of short term debt had a negative impact on firm performance while long term debt had a positive impact. therefore, very few studies conducted to examine the impact of capital structure on nim in sri lanka. as a result, this study is expected to give the geographical contribution on the capital structure pattern in sri lanka and its influence on nim. 3. methodology 3.1 data collection according to the annual report of the central bank of sri lanka (2016), currently, twenty five (25) licensed commercial banks (lcb) and the seven (07) licensed specialized banks asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 6 (lsb) are in sri lanka. at the end of 2016, the licensed commercial banks dominated the financial system with a market share of 49 per cent of the entire financial system's assets and 84 per cent of the banking sector's assets. for this research, the data have been obtained from the annual reports and other financial statements of 10 randomly selected licensed commercial banks which includes two state banks and eight private banks from 2007 to 2016 based on the order in largest market capitalization. 3.2 conceptualization with the evidence of empirical review carried out in the current study, following conceptual model was formulated to answer the research question. figure 1. conceptual model based on the research problem and objectives, following hypotheses have been formulated to carry out the empirical study: 3.3 hypotheses h1: sri lankan commercial banks have lower leveraged capital structure h2: there is a significant relationship between total debt to total assets and net interest margin h3: there is a significant relationship between long term debt to total asset and net interest margin h4: there is a significant relationship between short term debt to total asset and net interest margin 3.4 models the current study is performed the balanced panel data analysis as all the selected banks have measurements on selected variables in all 10 years study period (2007-2016). therefore, panel data might have individual/ group effect, time effect or both, which can be analyzed by fixed effect or random effect model. therefore, the present study considered the fixed and random effect models in addition to the pooled model to carry out the analysis. capital structure td/ta std/ta ltd/ta control variables size growth net interest margin asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 7 i. pooled ols models use of pooled ols model is to analyze the impact of variable that are vary over time. nimit = α0 + α1sdtait +α2ldtait+ α3tdtait +α4sizeit + α5groit + (1) ii. fixed effect models use of fixed effect model is to analyze the impact of variable that are vary over time. nimit = α0 + α1sdtait +α2ldtait+ α3tdtait +α4sizeit + α5groit + (2) iii. random effect models in the random effect variations across entities is assumed to be random and uncorrelated with the predictor or independent variables included in the model. nimit = α0 + α1sdtait +α2ldtait+ α3tdtait +α4sizeit + α5groit + uit + εit (3) in the equation, sdtait is short term debt divided by total assets of bank i at time t. ldtait is long term debt divided by total assets of bank i at time t. tdtait is total debt divided by total assets of bank i at time t. sizeit is the log of total assets for firm i in time t; groit is changes in banks deposit εit: stochastic error term of firm i at time t uit: error term of firm i at time t 3.5 relationship between capital structure and nim using above models, relationship of short term debt, long term debt and total debt with the net interest margin were studied keeping size and growth controlling variables. 4. data analysis 4.1 descriptive analysis asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 8 table 4.1. descriptive statistics according to the table, mean value of nim was 4.62. value of nim ranged from 0.00 to 10.40. short term debt to total asset ratio ranged from 0.50 to 69.00 and mean value was 16.67 with the standard deviation of 16.69. long term debt to total asset ratio had the mean value of 3.49 with the minimum value was 0.20 and maximum value was 14.10. total debt to total assets ratio ranged from 3.10 to 72.50 and mean value was 20.16 with the standard deviation of 16.72. growth in banks deposit and size had the mean values 15.51and 5.18 respectively. furthermore, figure 2 describes the trend in the mean value of sdta, ldta and tdta for the time period from 2007-2016. a noteworthy portion of assets was financed with the short-term debt. this suggested that short-term debt tends to be easily available therefore banks used short term debt as their major source of financing other than deposit base. long term debt to total assets as compared to the short-term debt to assets was low i.e. 4%. overall 20% assets were financed with the debt that depicts banking sector was less leveraged industry. nim sdta ldta tdta size growth mean 4.62 16.67 3.49 20.16 5.18 15.51 median 4.50 11.30 3.05 15.65 5.30 10.50 maximum 10.40 69.00 14.10 72.50 6.20 87.30 minimum 0.00 0.50 0.20 3.10 4.00 1.50 std. dev. 1.90 16.69 2.53 16.72 0.54 15.53 skewness 0.25 1.71 1.41 1.67 -0.47 2.93 kurtosis 3.54 5.13 5.28 5.07 2.55 11.39 jarque-bera 6560.59 87.84 71.42 83.36 5.78 567.45 probability 0.000 0.00 0.00 0.00 0.06 0.00 sum 524.00 2166.72 453.50 2620.20 673.50 2015.70 sum sq. dev. 940.14 35933.21 824.47 36062.90 37.58 31097.63 observations 130 130 130 130 130 130 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 9 figure 2. mean value of sdta, ldta and tdta between 2007-2016 as per the result of the descriptive analysis, nearly 20% of the assets of the banks were financed through debt capital and they heavily depended on equity capital. further, debt market in sri lanka is still under the development stage. therefore, h1 has been supported with the results of the descriptive analysis that sri lankan commercial banks have lower leveraged capital structure. 4.2 correlation analysis table 4.2. correlation analysis sdta ldta tdta siz gro nim sdta 1.0000 ---- ldta -0.0638 1.0000 0.471 ---- tdta 0.9886 0.0875 1.0000 0.000 0.322 ---- siz -0.0733 -0.0910 -0.0870 1.0000 0.407 0.303 0.325 ---- gro 0.0197 0.0081 0.0209 -0.1156 1.0000 0.824 0.927 0.813 0.190 ---- nim 0.0736 -0.1875 -0.3778 0.0073 0.1251 1.0000 0.090 0.001 0.000 0.902 0.036 ---- as per the correlations results presented in table 4.2, there was a significant (at 10% level) positive association between short term debt to total asset and nim (r = 0.0736, p =0.090). however, long term debt to total asset ratio (r =-0.1875,p < 0.05), and total debt to total assets asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 10 ratio (r =-0.3778,p < 0.05) significantly negatively associated with nim. in terms of the control variables, there was no significant association between size and nim (r = 0.0073, p > 0.05 ) but, there was a significant positive association between growth and nim ( r = 0.1251, p = 0.036). if correlations among pairs of predictor variables are large, results of regression model may be bias. relationship between short term debt to total assets ratio and long term debt to total assets ratio seems to high. many regression analysts often rely on variance inflation factors to detect multicollinearity. therefore, current study performed the multicollinearity test using variable inflation factor and results are presented in table 4.3. 4.3 test on variable inflation factor (vif) a vif test is conducted to examine whether multicollinearity exists amongst independent variables. nachane (2006) suggested that vif < 10.0 is an acceptable. accordingly, to the table 4.3, the highest variance inflation factor (vif) is 3.32. the general rule of thumb is that vifs exceeding 4 warrant further investigation. therefore, vif does not seem to be an issue in this study. table 4.3. values of variance inflation factors variable vif 1/vif sdta 3.32 0.30120 ldta 2.10 0.47619 tdta 2.26 0.44248 siz 1.35 0.74074 gro 1.04 0.96153 mean vif 2.01 4.4. unit root test unit root test was conducted to check the variables have the unit root or not. in order to identify the stationary variables levin, lin and chu test was conducted (null: panel data has unit root) according to above model, null hypothesis could be rejected at 10% level of significance. therefore, ldta, sdta, tdta, nim, gro, siz were stationary series. results of the unit root test presented in table 4.4. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 11 table 4.4. unit root test (levin, lin and chu) variables t-statistic prob.* ldta -2.20525 0.0137 sdta -0.99336 0.0496 tdta -2.05462 0.0921 nim -1.00983 0.0000 gro -0.87610 0.0317 siz -0.56321 0.0090 4.5 relationship between capital structure and nim table 4.5. influence of capital structure on nim */**/*** indicate coefficient is statistically significant at the 10/5/1 percent level of significance respectively table 4.5, present the results of panel data multiple regression analysis to examine the relationship between capital structure and nim of banks in sri lanka. the f-statistics value for the pooled model was 6.58 (p<0.05), fixed effect model was 6.16(p<0.05) and random effect model was 10.32 (p<0.05) which illustrated that the independent variables were jointly significantly explain the variations in nim in the pooled, fixed and random models. the r-square statistics value of 0.2805, 0.5234 and 0.4988 showed that the independent variables jointly account for about 28.05%, 52.34%, and 49.88% variation in nim in the pooled, fixed variable pooled fixed effect random effect c 0.2654** 0.3956 0.4987 sdta -0.4876 -0.3126 -0.1467 ldta -0.7465 -0.5987* -0.2673* tdta --0.5432** -0.4098** -0.4356* siz 0.3421 -0.3245 0.3423 gro 0.1987 0.0976 0.0789 no. of obs 100 100 100 r-square 0.2805 0.5234 0.4988 f-statistic(p-value) 6.58(0.035) 6.16(0.029) 10.32(0.027) f value 7.5123 15.4562 prob > f 0.0000 0.0000 lagrange multiplier test (breush pegan,p value) 6.36 (0.000) hausman 0.69(0.0784) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 12 and random effects models respectively. f test was performed to diagnose the time fixed effect in the fixed effect model and outcome of the test revealed that p value was less than 0.05. therefore, null hypothesis (null: fixed effect does not exist, alternative = fixed effect exist) was rejected that there is time fixed effects in the model. further, lagrange multiplier test for random effect was performed. the result indicated that the p value was 0.000 and rejected the null hypothesis (null: random effect does not exist, alternative = random effect exist) in favor of the alternative which implied that random effect model was more appropriate than pooled ols. in order to decide which one of the alternative panel analysis model whether it is fixed effect model or random effect model, hausman specification test was performed. the hausman test is used to assess the uniqueness of the error term that whether they are correlated with the response variable or not. therefore, it can be formulated ho hypothesis claims that random effect exist and h1 hypothesis sates that random effect do not and result indicated that random effect exist. going by the hausman test statistics of (0.69, p <0.10) we rejected the null hypothesis at 10% level of significance that differences in coefficient of the fixed and random estimates are not systematic, thus we accept and interpret the fixed effect model. in this case, fixed effect model was the best model to explain the relationship between capital structure and nim. multicollinearity is not a problem in fixed effect model (park,2011). from the results of fixed effect model presented in the table 4.5, a significant negative relationship of long term debt to total asset ratio (α = -0.5987, p < 0.10) and total debt to total asset ratio (α = -0.4098, p < 0.05) with nim. however, short term debt to total assets ratio, growth and size were not significantly related with nim. therefore, as per the fixed effect model presented in the table 4.5, h2 is supported with the results of the study that there was a significant negative relationship between total debt to total assets ratio and nim. h3 was also supported with the results of the study that there was negative significant relationship between long term debt to total assets ratio and nim. further, h4 was not supported with the results of the study that there was no significant relationship between short term debt to total assets ratio and nim. when answering the research question, according to the result of fixed effect model presented in table 4.5, value of coefficient of determination of dimensions of nim in the study which is ;(r2) is 0.5234, whist this result implies that 52% of variance of nim is determined by capital structure of the bank. further, study concluded that total debt to total asset ratio and long term debt to total asset ratio had a significant negative impact on nim while short term debt to total asset ratio was not significantly influenced on the nim. conclusion and implication current study examined the influence of capital structure on nim of licensed commercial banks in sri lanka. empirical study was conducted with the panel data of randomly selected 10 licensed commercial banks in sri lanka for the period from 2007 to 2016. results of the study was reported that long term debt to total assets ratio and total debt to total assets ratio were significantly negatively influenced on nim. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 13 firstly, this study found out that nim reduced as financial leverage increased. this study suggests that financial managers should try to finance from retained earnings rather than relying heavily on debt capital from outside in their capital structure. however, they can employ debt capital as the last alternative source of finance. with a goal of maximizing the performance of banks, the managers should make an effort to attain an optimal level of capital structure and endeavor to uphold it as much as possible. references: abewardhana, d.k.y., & magoro, k.m.r. 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(2016). impact of capital structure on banking profitability. international journal of scientific & research publication, 6(3), 186-193. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 88 climate change disclosures in the annual reports: evidence from bangladesh pappu kumar dey assistant professor department of accounting & information systems jahangirnagar university, savar, dhaka-1342, bangladesh e-mail: pappudey@juniv.edu mohammad nakib postgraduate student department of accounting & information systems jahangirnagar university, savar, dhaka-1342, bangladesh probal dutta associate professor department of accounting & information systems jahangirnagar university, savar, dhaka-1342, bangladesh received: august 22, 2017 accepted: sep. 28, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11736 url: https://doi.org/10.5296/ajfa.v9i2.11736 abstract this study examines the nature and extent of climate change disclosures in the corporate annual reports of the listed companies in dhaka stock exchange, bangladesh. for this purpose, annual reports related to the year 2014 of the sample 88 listed companies have been scrutinized. in regard to this study, content analysis approach has been conducted considering thirteen different disclosure issues regarding climate change. our analysis provides the comprehension of below average climate change disclosure practices by the bangladeshi asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 89 companies, though 58 percent companies have reported at least one issue on climate change and global warming. „energy saving & efficiency‟ and „water management & pollution‟ are mostly reported issues that are industry specific requirements in some case. from the viewpoint of industry, banking industry and cement industry have started to report some issues related to the climate change, where 4 industries out of selected 17 industries have not provided any climate change disclosure. disseminating climate change disclosure within 10 sentences by most of the reported companies manifests the desideratum of in-depth disclosure practices. keywords: climate change, climate change disclosures, annual reports, content analysis, dhaka stock exchange, bangladesh asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 90 1. introduction climate change has been a burning issue as its drastic impacts are being apprehended and its dreadful effects are appearing and intensifying day by day. climate change is not just an environmental issue; it directly affects many social and economic phenomena such as poverty, health and economic development in a wider context (acca, 2009). according to global climate risk index 2016, bangladesh has been the sixth most affected countries with climate risk index (cri) score of 22.67 from 1995 to 2014. though developed countries in asia, europe and north america are held primarily responsible for this climate change, developing countries can no longer evade their responsibilities of working towards reducing the severe effects of climate change. having the recognition of lower-middle income country (world bank, 2015b), the business organizations of bangladesh are more being sought to work in reducing the impacts of climate change. business organizations are seen as one of the leading contributors to climate change and needed to perform works which are environmentally sustainable. while the world is facing the substantial threat of climate change, the business can act in response by ensuing more efficient product and production techniques, figuring a way out to attain the goals sustainably (cecp, 2010). abiding by the social contract, the business ensures that it enhances the welfare of the society as a whole. otherwise, it will have to undergo reproach of the society (donaldson, 1982). at present, changing social contract persuades business organizations to focus on their activities to reduce environmental hazards and make them more accountable towards their contribution to the climate change. over the last few decades, many companies across the world have voluntarily disclosed qualitative information on social & environmental related issues. legitimacy theory asserts that “organizations continually seek to ensure that they are perceived as operating within the bounds and norms of their respective societies-that is, they attempt to ensure that their activities are perceived by outside parties as being legitimate” (deegan, 2009). it depends on the notion of a social contract that is an implied contact between the firm and the society in which a firm operates. like an individual in the society, organizations have to comply with the rules, regulations, norms, values and ethics of the society. in addition, the activities of the businesses should not harm the society in any manner. therefore, to be „legitimate‟ in the society, business organizations should always go for some social activities to meet the expectations of society. in other word, corporate activities and performance disclosures are used to legitimize the ongoing operation of business. even when legitimacy is threatened, imparting disclosures are one strategy to restore legitimacy. corporate social activities and disclosures also help business manage impression. corporate environmental and climate change reporting can be considered as a strategic approach of managing impression and maintaining legitimacy to the society. the objective of this research is to conduct an analysis of the climate change disclosure practices in the corporate annual reports of the companies, listed in dhaka stock exchange (dse) of bangladesh. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 91 the paper proceeds as follows. the next section briefly discusses climate change and bangladesh. section three reviews the literature on climate change and its disclosures. section four explains the methodology of the study. findings and analysis are presented in section five. the final section provides conclusion. 2. climate change and bangladesh climate change refers to a long-term change in average weather conditions. climate change may be due to natural courses or external forces or persistent anthropogenic changes in the composition of the atmosphere or in land use. according to the united nations (1992), “climate change is a change of climate which is attributed directly or indirectly to human activity that alters the composition of the global atmosphere and which is in addition to natural climate variability observed over comparable time periods.” from the definition, united nations makes a clear distinction between „climate change‟ attributable to human activities and „climate variability (change)‟ attributable to natural causes. bangladesh is one of the most climate vulnerable countries in the world and will become more so as a result of climate change (moef, 2009). climate change is imposing a deal of great threats to the residents, ecological balances and living environments of bangladesh, a developing country which has just touched the recognition of lower-middle income (world bank, 2015b). millions of people are suffering because of climate change and each year handsome numbers of people are being added to the list. because of climate change and global warming, sea level rise in the coming decades will create over 25 million climate refugees (doe, 2007). this is twice the entire population of the netherlands (doe, 2007). according to ministry of planning (2016), about 13% of the households and 12.64% of the population live in the disaster prone area and are being affected by climate change. in 2015, bangladesh bureau of statistics reported that bangladesh suffered a financial loss of $2.33 billion because of natural calamities for which climate change is directly responsible (ministry of planning, 2016). during the last century, the temperature has experienced an increase of 2 to 4 degrees and this trend is intensifying gradually. climate change in bangladesh is demonstrating its devastative expressions by means of lower crop yields, higher sea levels, frequent floods, more intense cyclones and tornadoes, extreme rainfall, droughts, salinity, extreme fog and cold waves etc. (world bank, 2014). floods are frequently visiting in bangladesh. according to the report of international federation of red cross and red crescent societies (2014), by the flood of august of 2014, around 2.8 million people were affected. according to inter-governmental panel on climate change (ipcc) (2007), the sea level may rise by 31cm to 71cm by 2100. in case of bangladesh, the sea level may rise even by larger figure. ipcc forecasts that the sea level of bay of bengal can rise by 0.2m to 1m by 2100. in 2008, bangladesh water development board found that at hiron point of sundarban, the sea level rose by 5.6mm (the daily star, 2013). southeast coastal areas will be severely affected by increasing river salinity which will lead to shortages of drinking water, irrigation and impose a major threat to the aquatic systems. cropping yield in the coastal area is under great asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 92 intimidation for the soil salinity and it is anticipated that yield of rice will decline 15.6% by 2050 (world bank, 2015a). industries greatly rely on the burning fossil fuels for production. business sector is one of the main responsible parties for global warming and climate change. so since last decade, activities of the business are getting monitored by several stakeholders like the government, social parties, media and others. especially after the agreement naming the kyoto protocol in 1997 signed by almost 175 countries, business organizations are constantly facing pressure from the part of different stakeholders (ahmad & hossain, 2015). the bangladesh climate change strategy and action plan (moef, 2009) notes the involvement of the private and business sector in meeting the challenges of climate change. in this context, the extent and nature of actual responses in relation to climate changes of business firms can be examined. 3. literature review climate change is an issue that calls for a corporate response as climate change significantly impacts business operations. one of the main future risks to business and society is the consequences of climate change (acca, 2007). one possible response is to account for and report on these issues (hopwood, 2009). in the social and environmental accounting literature, corporate disclosures on social and environmental issue were studied over the last decade. of late, climate change and global warming issue has unlocked newer avenues for social and environmental accounting researchers (ahmad & hossain, 2015). given the emergent impact of climate change, more specific accounting and reporting standards have been developed e.g. climate disclosure standards board (cdsb)‟s climate change reporting framework (ccrf), greenhouse gas (ghg) protocol corporate accounting & reporting standard, ghg protocol corporate value chain accounting & reporting standard, ghg protocol product life cycle accounting & reporting standard. these standards mainly aim at eliciting information to stakeholders on how climate change affects the strategy, performance and prospect of organization through disclosure of ghg emissions, climate change mitigation, adaptation measures etc. climate change disclosure by the corporation is still an under-researched area (ahmad & hossain, 2015). ahmad & hossain (2015) have found four kinds of studies on climate change and environmental issues. they are (a) empirical studies on disclosure, (b) conceptual/ theoretical/ normative studies, (c) studies specially conducted for practitioners to provide with guidelines and (d) literature reviews. the empirical studies include mainly two types of research. firstly, the opinion surveys that generally include responses of the respondents. secondly, the content analysis that is found to be the most commonly used research techniques in the field of social and environmental accounting research (guthrie & abeysekera, 2006). most of the studies (e.g. freedman and jaggi, 2010; belal et al., 2010; rankin, windsor & wahyuni, 2011; pellegrino & lodhia, 2012; luo, tang & lan, 2013, ahmad & hossain, 2015) followed content analysis of annual reports and websites. hence in this research paper, content analysis research technique has also been used. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 93 nurunnabi (2015) found that the level of disclosure on climate change by the bangladeshi companies is very low i.e. only an average of 2.23%. the relationship between size of the company and the level of climate change disclosure is positively associated (nurunnabi, 2015; luo & tang, 2014; meng et al., 2014). large companies are disclosing more climate change related information in their annual reports in order to legitimize their position in the market (meng et al., 2014; patten, 2002). nurunnabi (2015) suggested that lack of regulation and a culture of low social accountability among the companies contribute to a low level of disclosure. belal et al. (2010) studied on developing country i.e. bangladesh. they found that the level of environmental and climate change disclosures in annual report and website is very low in bangladesh. only few companies made disclosures in the specific areas of climate change but interestingly they popularly disclose adaptation measures. the nature of disclosures is mostly positive and descriptive. luo, tang & lan (2013) studied on both developed and developing countries in order to make a comparison between their carbon disclosure patterns. most of the researchers on the climate change issues, especially on carbon accounting, are based on developed countries (stechemesser & guenther, 2012). developing or less developed countries, as well as the asian countries got less importance from the researchers (ahmad & hossain, 2015). therefore, ahmad & hossain (2015) studied on developing country, i.e. malaysia. they found that in spite of being voluntary of disclosing climate change and global warming issues in malaysia, some companies are disclosing some issues related to climate change and global warming and it is still at its introductory stage. the nature and extent of the language of disclosure were mostly ignored in the previous studies. notably, belal et al. (2010) selected top 100 companies listed in dse on the basis of their market capitalization. but in this research, 88 companies listed in dse of bangladesh were selected using systematic random sampling. this sample is more representable as companies from all industries have been selected in the sample. 4. methodology of the study this study is empirical in nature based on secondary data source. annual report is the most useful written form of communication for corporate reporting. hence, annual reports were chosen as the main source of secondary data. the study collected data on climate change disclosures from the annual reports of listed companies in bangladesh. all industrial sectors were considered to select sample companies. 88 companies listed in dhaka stock exchange (dse) of bangladesh have been selected using systematic random sampling. the data of this study covered the annual reports of 88 companies of the year 2014. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 94 table 1. sample description industry no of listed companies (n=248) no of sample companies (n=88) bank 30 10 cement 7 3 ceramics 5 2 engineering 26 9 financial institutions 23 8 food & allied 17 6 fuel & power 15 5 insurance 46 16 it 6 2 jute 3 1 paper & printing 1 1 pharmaceuticals & chemicals 24 8 services & real estate 4 2 tannery 5 2 telecommunication 2 1 textile 31 11 travel & leisure 3 1 total 248 88 the content analysis technique was conducted to analyze the annual reports. content analysis is found to be the most commonly used method of research in social and environmental accounting (guthrie & abeysekera, 2006). data were analyzed through using the content analysis outline of item (climate change disclosures index), nature and extent. a disclosure index is generally prepared to examine whether the sampled companies engage in disclosure practices of particular information in annual reports (marston & shrives, 1991). many researchers have developed different disclosure indices to measure the level of disclosure practices of selected companies (ahmad & hossain, 2015; belal et al., 2010). with the help of prior studies, the present study constructed a climate change disclosure index that comprises 13 issues/items on climate change. detailed descriptions of the particular items of the index are given in table 2 below: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 95 table 2. climate change disclosures index disclosure issue studies using the same items or new items added by the researchers energy saving & efficiency (ahmad & hossain, 2015) renewable energy & solar panel added by the researchers ghg (or carbon) emission (ahmad & hossain, 2015); (belal, et al., 2010) tree plantation (ahmad & hossain, 2015) air pollution (ahmad & hossain, 2015); (belal, et al., 2010) water management & pollution added by the researchers recycling & waste management added by the researchers preserving biodiversity (ahmad & hossain, 2015) adaption measures (belal et al., 2010) climate change policy statement (belal et al., 2010); (ahmad & hossain, 2015) product impacts on climate change (belal et al., 2010) reference to standard/protocol (belal et al., 2010); (ahmad & hossain, 2015) other climate change issues (belal et al., 2010) 5. findings and analysis this section deals with the analysis of nature and extent of the climate change disclosures by the sample bangladeshi companies and figures out the findings linked with current practices. the following table provides the enacting comprehension about the climate change disclosure practices by the bangladeshi companies. table 3. overall climate change disclosures by the bangladeshi companies description percentage (%) total percentage of companies with disclosures in at least one item or category 58 total percentage of companies with no disclosures 42 total 100 table 3 exhibits that 58% of the sample bangladeshi companies disclosed climate change disclosures in at least one item or category in their annual reports. 42% of the sample companies didn‟t disclose any issue on climate change. this table construes that the climate change disclosure practices by the bangladeshi companies is medium. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 96 table 4. main themes or issues of climate change disclosures by the bangladeshi companies issue/ theme no of companies disclosing the issue % of the total number of disclosing companies (51) % of the total sample (n=88) energy saving & efficiency 26 50.98 29.55 renewable energy & solar panel 8 15.69 9.09 ghg (or carbon) emission 14 27.45 15.91 tree plantation 14 27.45 15.91 air pollution 11 21.57 12.50 water management & pollution 30 58.82 34.09 recycling & waste management 9 17.65 10.23 preserving biodiversity 10 19.60 11.36 adaption measures 19 37.25 21.59 climate change policy statement 13 25.49 14.77 product impacts on climate change 13 25.49 14.77 reference to standard/protocol 15 29.41 17.05 other climate change issues 12 23.53 13.64 table 4 displays category or item-wise analysis of climate change disclosure practices. energy saving and efficiency is one of the most reported issues or themes by the sample companies. 26 sample companies (29.55%) reported energy saving and efficiency related disclosures. these companies are 50.98% of the total number of disclosing companies. batbc published in its annual reports, “we have installed energy efficient rated motors for compressors. we have installed an 11kw capacity solar panel to run office lights and ac’s. we have installed wind turbines and exhaust fan outlet to gain electricity. all these initiatives have contributed in reducing energy consumption and saving a lot of money.” (british american tobacco bangladesh company limited, 2015, p. 88). besides, renewable energy and solar panel have been observed to be reported in the annual reports. 8 companies out of our 88 sample companies, which are 15.69% of the disclosing companies and 9.09% of the sample companies, have reported renewable energy and solar panel in their annual reports. only 15.91% of the companies (14 sample companies) reported ghg or carbon emission related disclosures in their annual reports. an example of disclosing ghg or carbon emission disclosure is that brac bank ltd stated “bivl aims to provide services in climate change, agriculture, water, health, energy and financial sector by creating jobs, reducing ghg emission and utilizing suppliers living in the base of the financial pyramid.” (brac bank ltd, 2015, p. 127) tree plantation and air pollution got attention by 14 and 11 companies respectively. in case of water management and pollution, 34.09% of companies (30 sample companies) disclosed this issue. this is the most reported category or item disclosed by the sample companies in their annual reports, which are 58.82% of the total disclosing companies. most of the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 97 companies who reported water management and pollution related disclosures mentioned about the establishment of effluent treatment plant (etp) in order to reduce water pollution. the dacca dyeing and manufacturing co. ltd declared in its annual report, “the company has completed installation of a biological effluent treatment plant (etp) having 180cm capacity per hour with a cost of tk. 10 crore.” (dacca dyeing and manufacturing co. ltd, 2015, p. 16) recycling and waste management have been reported by 9 of the sample companies (10.23% of the sample companies) as they apprehended their responsibilities to reduce their individual contributions to the climate change. national polymer industries ltd. highlighted its initiative by mentioning in its annual report, “we recycle our waste materials and minimize waste of energy. we are very careful making our plant and its surroundings free from contamination”. (national polymer industries ltd., 2015, p.10) preserving biodiversity issue has been delineated in only 11.36% of the sample companies‟ annual reports which is the least reported issue regarding the climate change disclosures. only the companies from cement, food and allied and fuel and power industries tried to provide disclosures regarding preserving biodiversity to an average extent. regarding preservation of biodiversity summit power ltd alluded, “biodiversity entails protecting plant and animal species and ecosystems. this is an essential component of our health, safety and environmental commitments. we address biodiversity conservation during the planning and development of major projects by conducting environmental impact assessments, implementing mitigation and monitoring programs to reduce impacts.” (summit power ltd, 2015, p. 77) about 21.59% of the total sample companies or in another way 37.25% of the total disclosing companies disclosed adaptation measures. other than these, companies reported on climate change policy statements (14.77%), product impacts on climate change (14.77%) and reference to different standards, guidelines and protocol (17.09%). besides, 13.64% of the sample companies which are 23.53% of the disclosing companies disclosed other issues related to climate change. among such issues dust pollution, oil spillage, soil pollution etc. are noteworthy. premier cement ltd delineated, “we are cement manufacturer and dust is an integral part of our production process. suspended particle and dust can affect the environment and human health severely. without dust control equipment large dust emission with occur at several stages in the entire production process. as we never compromise on any issue related to environment, therefore our whole production units are equipped with adequate number of dust collectors to the amount of suspended particles in the air far below than the acceptable limit.” (premier cement ltd, 2015, p. 40) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 98 table 5. industry/sector-wise climate change disclosures index industry/sector no of sample companies (n=88) maximum probable score actual score % of disclosures bank 10 130 78 60.00 cement 3 39 18 46.15 ceramics 2 26 1 3.85 engineering 9 117 7 5.98 financial institutions 8 104 23 22.12 food & allied 6 78 16 20.51 fuel & power 5 65 18 27.69 insurance 16 208 14 6.73 it 2 26 0 nil jute 1 13 0 nil paper & printing 1 13 1 7.69 pharmaceuticals & chemicals 8 104 8 7.69 services & real estate 2 26 3 11.54 tannery 2 26 0 nil telecommunication 1 13 0 nil textile 11 143 6 4.20 travel & leisure 1 13 1 7.69 total 88 1144 194 16.96 table 5 shows, banking industry reports highest disclosures on climate change and global warming and the level of disclosures is 60%. this is due to mandatory green banking policy guidelines of bangladesh bank (2011). the guidelines cover the mandatory requirements of disclosure & reporting of green banking activities e.g. incorporation of environment and climate change risk in credit risk management (crm), in-house environment management, green finance, green marketing and creation of climate risk fund etc. in 2013, bangladesh bank issued similar mandatory policy guidelines for financial institutions (fis). so, fis have started to disclose the climate change and global warming issues in corporate annual reports. cement industry also pays attention on climate change through medium level of disclosures. all the companies of cement industry disclosed their concern about tree plantation to reduce the effect of climate change. premier cement ltd mentioned “to maintain ecological balance and to protect our environment our company continuously arranging numerous plantation drives and awareness programs to create environmental consciousness amongst the local inhabitants with the help of its stakeholders; intended to offset carbon emissions associated with the industry revolution in the country. during the period under review the company planted thousands of saplings in more than 16 different districts in the country asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 99 namely bogra, mongla, rangamati, bandarban and cox’s bazar etc.” (premier cement ltd, 2015, p. 40) industries namely financial institutions, food & allied and fuel & power reported few climate change related issues in their annual reports. their levels of disclosures are 22.12%, 20.51% and 27.69% respectively. some other industries reported only one or two issues in their annual reports. they may report those one or two issues to comply industry specific requirements which are mandatory. it is noted that it, jute, tannery and telecommunication sectors did not disclose any issue related to climate change and global warming in their annual reports. table 6. extent of climate change disclosures no. of sentences no. of companies disclosing percentage (%) equal or below 5 sentences 24 47.06 6 to 10 sentences 10 19.61 11 to 15 sentences 8 15.69 16 to 20 sentences 1 1.96 21 to 25 sentences 3 5.88 more than 25 sentences 5 9.80 total 51 100 table 6 indicates the volume of climate change disclosures by the number of sentences about the different issues of climate change disclosures noted down by the disclosing companies in their annual reports. almost half (47.06%) of the disclosing companies mentioned at best 5 sentences regarding different categories of climate change disclosures in their annual reports. 19.61% of the disclosing companies reported 6 to 10 sentences. climate change disclosure practices of 23.53% of the disclosing companies are considered mediocre because of reporting 11 to 25 sentences. finally, around 9.80% of the disclosing companies reported different issues of climate change rigorously as they reported more than 25 sentences. 6. conclusions despite less contribution to the global climate change, the companies of bangladesh are attempting to demonstrate their concerns for the legitimacy of their operations and their social contract with the society through climate change disclosure practices, even in the absence of any mandatory regulation. but the present climate change disclosure practices of the bangladeshi companies experience the deficiency of more detailed and in-depth practices. with the increasing awareness among the stakeholders regarding the adverse effects of the climate change, it is anticipated that there will be an increasing tendency to provide climate change disclosure practices. comparative studies will be needed in future to gauge any uprising trend in the climate change reporting practices by the bangladeshi companies. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 100 references acca. 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(2014). bangladesh: community-driven attempts to build climate change resiliency. [online] available at: http://www.worldbank.org/en/news /feature/2014/07/17 /bangladesh-community-driven-attempts-to-build-climate-change-resiliency [accessed 10 jun. 2016] world bank. (2015a). salinity intrusion in a changing climate scenario will hit coastal bangladesh hard. [online] available at: http://www.worldbank.org/en/news/feature/ 2015/02/17/salinity-intrusion-in-changing-climate-scenario-will-hit-coastal-bangladesh-hard [accessed 12 jun. 2016] world bank. (2015b). retrieved from world bank: http://www.worldbank.org/en/news/press release/2015/07/01/new-world-bank-update-shows-bangladesh-kenya-myanmar-and-tajikista n-as-middle-income-while-south-sudan-falls-back-to-low-income [accessed 12 jun. 2016] https://doi.org/10.1108/09513571111184751 https://doi.org/10.1016/j.jclepro.2012.02.021 microsoft word 4039-15083-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 84 exploring undergraduate students’ understanding of shari’ah based audit: implications for the future of shari’ah auditing labor market in brunei hisham yaacob (corresponding author) department of accounting & finance, faculty of business, economics & policy studies university of brunei darussalam, tungku link, gadong, brunei be1410 e-mail: hisham.yaacob@ubd.edu.bn fathima shafeek university of brunei darussalam, brunei hairul suhaimi nahar universiti putra malaysia, malaysia received: july 22, 2013 accepted: september 11, 2013 published: december 1, 2013 doi:10.5296/ajfa.v5i2.4039 url: http://dx.doi.org/10.5296/ajfa.v5i2.4039 abstract the worldwide islamic finance industry had grown remarkably in the past decades, primarily propelled by the strong demand for shari’ah (islamic law) compliant banking products by muslims and non-muslims alike. behind the façade of such outstanding industry’s development, there remain unresolved critical governance issues warranting for immediate attention by industry stakeholders. besides the presence of significant variations with regards to the scope and framework for shari’ah audit in the currently available shari’ah governance policy standards, another imperative issue surrounds the relatively small pool of knowledgeable and competent shari’ah auditors (vis-à-vis conventional auditors) to perform shari’ah auditing of islamic financial transactions and hence, the institutions. arguably, these pose a significant threat to the coordinated development of this religiously rooted industry. the study’s conjecture is that education holds the key to resolve the issue. accordingly, it asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 85 undertakes a preliminary survey on bruneian undergraduate students in the field of accounting, business and shari'ah related, majority of whom are expected to be part of brunei’s future shari’ah auditing labor market. the study finds that students’ understanding of shari’ah auditing is arguably "rudimentary" in nature. while the characteristics and knowledge expected of shari’ah auditor are well understood, the students are however unsure of the primary objective for shari’ah auditing. these highlight the practical imperative for the brunei government to consider a holistic revamp of its education strategies in meeting future market demands for qualified and well trained shari’ah auditors. keywords: islamic accounting, islamic finance, shari’ah audit, shari’ah auditor asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 86 1. introduction islamic finance has become a credible alternative to conventional, usury-based financing industry, registering a growth in excess of 20% in the past decades (global islamic finance, 2012). the religiously rooted industry has more than three hundred industry players called “islamic financial institutions (ifis)” operating in almost eighty countries globally with total assets stood at us$1.3 trillion in 2011 (grewal, 2012; pwc, 2011) and reached us$1.6 trillion in 2012 (global islamic finance, 2012). the islamic finance assets in the asian region alone constitute 22% of that amount (grewal, 2012). official statistics produced by kfh research, an independent professional research house indicate that islamic banking activities primarily drive the industry’s expansion globally with an estimated asset size of usd1.1 trillion as at 2011, which value attributed to almost 81% of the whole shari’ah based finance assets worldwide. this is followed by sukuk (islamic bond) with 14% islamic finance assets portion, equivalent to approximately usd178.2 billion outstanding sukuk value as at 2011. the global islamic finance assets are further expanded by the islamic fund management activities (4.5%) which assets under management closed to usd60 billion from 876 funds as at 2011. the remaining portion of the world islamic finance assets (0.5%) as at 2011 came from takaful (islamic insurance). amongst the growing islamic finance market in south east asia (sea) is a small islamic nation of brunei, a sovereign state located on the north coast of borneo island. the country’s population stood slightly above four hundred thousand as at july 2011 (us department of state, 2011). despite its small size geographically, brunei recorded the second highest human development index (hdi) among sea nations (singapore being the first) and this small nation is classified as a “developed country” (united nation, 2011). consistent with its “developed country” status, brunei is ranked fifth in the world by gross domestic product per capita at purchasing power parity of approximately us48,000 per capita (international monetary fund, 2011). this makes brunei the fifth richest nation out of 182 nations in the world, primarily due to its extensive petroleum and natural gas field exploration and discovery activities. the brunei islamic finance industry was practically introduced in 1991 following the establishment of the country’s trust fund named tabung amanah islam brunei darussalam, followed by the conversion of a conventional bank (island development bank) into a full-fledged islamic bank (islamic development bank of brunei (idbb)) in january 1993 and later merged with bank islam brunei darussalam (bibd). among the country’s notable islamic finance progress includes the introduction of equity-based islamic products of musharakah (partnership) to finance small and medium enterprises (smes) and a home-ownership financing based on musharakah mutanaqisaha instrument by bibd in 2010. sukuk (islamic bond) issuance remains a rare debt instrument in brunei with only two issuances to date. its first sukuk ijarah was only available in 2006, issued by the then idbb and subsequently a short-term money market sukuk ijarah program issued by the government. the government continuously supports the islamic finance development by providing the necessary infrastructure including the establishment of a regulatory authority called “autoriti asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 87 monetari brunei darussalam” in 2010. it takes up the role of a central bank for brunei, functions as a government institution that supervises and regulates the operations of the country’s islamic banks. further, the centre for islamic banking, finance and management (cibfm) was also established in 2012 by the ministry of finance, which aims at developing human talents required for the industry. among others, it provides professional learning courses in various academic disciplines including banking, finance, insurance, capital market as well as general management. at the global front, the immediate observable impacts arising from the emergence of islamic finance industry are diverse. among others it includes the surfacing of islamic accounting to cater for the accounting and reporting requirements of islamic financial transactions, shari’ah governance in the form of shari’ah audit or review, the consistent and increasing demand for knowledgeable and qualified individuals to serve as shari’ah advisors and shari’ah supervisory board members, and finally the official establishment of standard setters for ifis such as the accounting and auditing organization for islamic financial institution (aaoifi) and the international financial services board (ifsb). the former is an international non-profit organization established in 1991 which main objectives are to develop and disseminate islamic based accounting and auditing thought and standards for ifis. the latter on the other hand issues standards and guiding principles with the aim of promoting and enhancing prudential stability of the islamic financial services industry globally. behind the façade of such outstanding industry’s development however, there remain unresolved critical issues warranting for immediate attention by industry stakeholders. the notable major impediments to the coordinated growth of this sacred industry include weak islamic finance supporting infrastructure in markets in which islamic finance activities are currently operating (pwc, 2011). it covers that of legislative, regulatory, legal, accounting, tax, human capital and shari’ah governance and business framework. in the specific context of shari’ah governance, the shari’ah audit in effect pillars the shari’ah governance framework of ifis by providing independent assurance to ifi’s diverse stakeholders on matters related to ifi’s operations including products and services (mohamed-ibrahim, 2008). this effectively ensures that ifis are operating strictly within a shari’ah based operating environment. prior academic literature specific on shari’ah audit has indeed highlighted prevalent problems facing the islamic finance industry which include the small and limited pool of available skilled human capital (kasim, mohamed-ibrahim and sulaiman, 2009) in terms of knowledge and qualification (rammal and parker, 2010) and lack of proper shari’ah audit framework (shafii, salleh and shahwan, 2010). yaacob and donglah (2012) conduct a survey in brunei but they are using the postgraduate students as sample. they find that the postgraduate students’ lack of understanding of shari’ah auditing is mainly due to inadequate exposure by the institutions of higher learning and the industry. the study conclude that there is an impending need to promote shari’ah audit as a future potential career in order to address the shortages of talent (qualified and knowledgeable manpower) in the islamic finance industry. recent survey (in 2011) conducted by pricewaterhousecoopers (pwc), a global professional accounting firm in malaysia further reveals alarming shari’ah governance issues asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 88 including the urgency in expanding the talent pool of shari’ah auditors, enhancing the comprehensiveness of shari’ah audit scope and improving shari’ah audit methodologies (pwc, 2011). arguably, the above identified problems represent a significant threat to the coordinated development of this religiously rooted industry. the study’s conjecture is that education holds the key to address the above human capital issues. accordingly, it undertakes a preliminary survey on bruneian undergraduate students (currently enrolled in business and management related programs), whom are expected to be part of the country’s shari’ah auditing labor market in the future. the survey aims at gauging undergraduates’ knowledge on shari’ah auditing and their propensity of choosing shari’ah auditor as a prospect career. among others, the students were asked on their perceptions with regards to shari’ah auditor’s roles and responsibilities, characteristics needed for a shari’ah auditor and their current understanding with respect to the most suitable qualification(s) to become a shari’ah auditor. the study finds that the understanding of bruneian students towards shari’ah auditing is “rudimentary” on average. they understood well the characteristics and knowledge expected of shari’ah auditor but surprisingly however, they are unsure of the primary objective for shari’ah auditing activities. the results underscore the practical imperative for the brunei government to consider a holistic revamp of its education strategies in meeting future market demands for qualified and well trained shari’ah auditors. the study considers the awareness on islamic finance and its components among the undergraduate students as a crucial educational strategy as awareness forms part of the self-development processes. awareness is however expires only when individuals deemphasize the importance of acquiring and broadening their knowledge frontier. the paper is organized as follows: a discussion on auditing in general is presented next, followed by discussion on shari’ah audit. the roles, responsibilities and code of ethics of shari’ah auditor are also presented with the aim of putting the empirical survey into perspective. this is followed by sections explaining the empirical approach to the survey and its corresponding results. final section presents relevant discussions arising from the empirical results, conclusion and some recommendations and suggested future research. 2. auditing as a discipline and profession auditing is a specialized field which practically branches out from accounting. it involves individuals referred to as “auditors” to undertake the responsibilities of attesting that the “auditee(s)”–the one being audited have done their work according to prescribed pre-agreed rules, standards or regulations. audit comes in various forms including but not limited to financial, management and performance audit. in the specific context of financial audit, the american accounting association (aaa) defines auditing as: “a systematic assessments of evidences regarding economic events and to ascertain the correspondence of the two and communicate the results to interested users”. (www.aaahq.org/audit) asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 89 in a much broader context, the international federation of accountants (ifac), the global umbrella body for the accountancy profession defines auditing as: “an independent examination of financial statements or related financial information of an entity whether profit or not, irrespective of its size, or legal form, when such examination is conducted with a view to expressing an opinion thereon”. (www.ifac.org) audit process is usually performed at auditee’s premises during which an auditor will comprehensively assess auditee’s systems and records for among others, accuracy and validity. this involves audit activities of analyzing firm’s relevant risks as well as identifying system’s loopholes and subsequently recommending the necessary controls. these practically require auditors to understand client’s business processes and environment. in the specific context of financial audit, auditing activities and the corresponding independently expressed audit opinions conceptually adds credence to the financial statements produced by firm’s management. accordingly, this helps building confidence among financial statement users in relying on the audited financial statements to make appropriate and relevant decisions (karim, 1990). the auditing profession and hence its activities are primarily guided by professional standards called the international standards on auditing (isa) issued by ifac through the international auditing and assurance standards board (iaasb). mirroring the operations of international accounting standard board (iasb), the iaasb operates as an independent standard-setting body with the focus of serving the public interest by developing quality auditing and assurance standards as well as facilitating the convergence of international and local (national) auditing and assurance standards. similar to the expected end results of global convergence to international financial reporting standards (ifrs) developed by iasb, the iaasb also envisaged that the convergence efforts towards single assurance standards would improve the quality and consistency of global auditing practices, thereby strengthening public confidence in the auditing and assurance profession. 3. shari’ah audit extant literature on auditing claims that shari’ah based auditing is relatively new, the earliest being after the emergence of ifis during 1980s. the islamic history however explains the reverse whereby the institution of hisbah was noted to have already established during the time of prophet muhammad (peace be upon him). it aims at assisting human being in worshipping allah the almighty by ensuring allah’s rights and the rights of other human beings are being properly observed and fulfilled. even though it was institutionalized for the purpose of enjoining good and forbidding evil in general (as oppose to focusing specifically on economic and commercial activities), it forms an integral part of wider effort in establishing just economy in the society (kasim et al., 2009). the contemporary role of the shari’ah auditor resembles the role of muhtasib in the traditional hisbah institution in the early period of islam (yaacob, 2012). the muhtasib or al-khatib audits and checks on compliance and subsequently suggests recommendations on worldly matters from shari’ah perspective (kasim, 2010). arguably, while shari’ah audit may have some similarities with that of social asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 90 accountability audit (e.g. see courville, 2003) in the specific context of auditing techniques, it is however significantly different in their respective philosophy. the fact that auditing is not peculiar to the religion of islam is further substantiated by the availability of auditing essence in various verses in the main source of knowledge to the islamic religion called al-quran. the book is considered as the most sacred scriptures to muslims and it contains the words of allah which was sent down to his messenger, prophet muhammad (pbuh). the followings are several audit related verses found in the holy scriptures: “then as for he who is given his record in his right hand, he will be judged with an easy account, and return to his people in happiness” (quran, 84:7-9) “and indeed, [appointed] over you are keepers, noble and recording. they know whatever you do” (quran, 82:10-12) the above verses indicate that muslims (and non-muslims alike) will be audited by allah in the hereafter, during which human book of deeds will be presented and human will subsequently be rewarded or punished based on the “audit outcome”. comparably and in the specific context of islamic financial system, shari’ah audit presents a system of compliance checking on its operations with regards to shari’ah rulings. the reward and punishment system comes in the form of public perceptions (negative or positive) and confidence towards the shari’ah based products offered by the ifis. consistent with such indirect quranic explanation on auditing, shari’ah auditing has been comprehensively defined by mohamed-ibrahim (2008) as “a systematic process of objectively obtaining and evaluating evidence regarding assertions about socio-economic, religious and environmental actions and events in order to ascertain the degree of correspondence between those assertions and shari’ah, and communicating the results to users” (p.22). the aaoifi on the other hand provides a liberal view of audit from shari’ah perspective by merely referring it to the term “shari’ah review” without any further specifications. in aaoifi’s documents, the term “shari’ah audit” is used interchangeably to represent the checking of ifi’s financial statements. the objective of ifi’s auditing according to aaoifi is “to enable the auditor to express an opinion as to whether the financial statement are prepared, in all material respects, in accordance with shari’ah rules and principles, the accounting standards of aaoifi and relevant national accounting standards and practices in the country in which the financial institution operates” (aaoifi, 2010). shari’ah audit primarily aims at singularizing the religiously rooted financial system from its conventional counterpart, by undertaking the role of certifying the validity and enforceability of islamic financial contracts adopted. such role which is absent in the conventional financial system effectively addresses stakeholders’ perceptions and hence public confidence towards ifi’s operations. in a wider context, shari’ah audit forms an integral structure to the internal governance mechanisms of ifis by providing the necessary supervision and monitoring towards the whole spectrum of ifi’s operations (garas and pierce, 2010). asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 91 accumulating academic literature (empirical and theoretical) has highlighted critical problems associated with shari’ah auditing. khan (1985) for instance in discussing the role of shari’ah auditor, argues the unreasonable situation of having auditors ‘ingrained with secular capitalist philosophy’ to audit ifis on matters relating to shari’ah compliance. khan (1985) further suggests that auditing on ifis must ideally be done by auditors trained in accounting and audit, as well as having the necessary knowledge on shari’ah and fiqh. recent survey by grais and pellegrini (2006) reveals the fact that the existing compliance structure in ifis is alarmingly inadequate to address the issues of shari’ah compliance. they argued that the reliance on internal shari’ah review alone provides little assurance to ifi’s customers on the entity’s compliance level towards shari’ah rulings in their operations. perhaps the most observable problem in shari’ah auditing is the lack of expertise and human talent to perform shari’ah audit, a point highlighted by besar, abd-sukor, abdul-muthalib et al., (2009) in their recent survey in the malaysian context. 4. desirable ethical dimensions of shari’ah auditor the shari’ah highly emphasizes morality or ethics in human conduct, consistent with the sayings of prophet muhammad (pbuh) (the hadith): “i have been sent to complement the noblest morals”. accordingly, individuals undertaking shari’ah auditing activities are expected to have the following fundamental characteristics (not exhaustive) as promulgated by the islamic religion. the first is integrity, referring to individual’s consistency with his or her innate purpose (quran, 7:26). it reflects the extant of individual’s life being kept in alignment with their intrinsic function of worshipping allah (quran, 51:52). integrity effectively requires shari’ah auditor to be honest and truthful in all actions. as the end output of shari’ah auditing comes in the form of independent opinion with regards to shari’ah (non)compliance, observing integrity ensures accurate and impartial opinions by auditors. in this regards, accurate and impartial opinions further require auditors to be well-versed in their discipline and able to exercise authority with high competency. islam further emphasizes the characteristics of vicegerency (khalifah) and accountability (haniffa and hudaib, 2010; nahar and yaacob, 2011). human beings in islam are effectively temporary trustee to resources available on earth (haniffa and hudaib, 2010). being allah’s vicegerent, human undertook the responsibility (taklif) of being the khalifah in this world. allah says in the quran: truly, we did offer al-amanah (the trust or moral responsibility or honesty and all the duties which allah has ordained) to the heavens and the earth, and the mountains, but they declined to bear it and were afraid of it (i.e. afraid of allah’s torment). but man, bore it. verily, he was unjust (to himself) and ignorant (of the results)” (quran, 33:72). undertaking the responsibility necessitates human to take care and develop this world according to allah’s will. they will subsequently be made accountable for whatever (in)actions or decisions they made in this world (nahar and yaacob, 2011). shari’ah auditors are therefore expected to constantly observe strong ethical values as the auditing tasks are asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 92 principally an amanah (trust) to be questioned in the hereafter. the trust of expressing independent, correct and impartial opinions bears great repercussion not only to the auditors but also to other individuals relying on their opinions. 5. investigating undergraduate student’s understanding of shari’ah auditing: the method this empirical work aims at investigating bruneian undergraduates’ knowledge on shari’ah auditing and their propensity of choosing shari’ah auditor as a prospect career. specifically, the students were asked on their perceptions with regards to shari’ah auditor’s roles and responsibilities, shari’ah auditor’s characteristics and their current understanding with respect to the most suitable qualification(s) to become a shari’ah auditor. adopting a quantitative approach, this study used self-developed questionnaire survey to gather primary data from respondents. this is considered as the most appropriate method in collecting perspective information from respondents (ghauri and gronhaug, 2010). there are only three universities currently operating in brunei (university a, b and c), all of which are used as the research sample. university a is the oldest university in the country, established nearly three decades ago. university b is a full-fledged islamic university while university c is the youngest university, a former technical college recently upgraded to university status. all universities currently offer bachelors degree in business, economics, finance and accounting related programs. university a is the only university in the country which currently offers masters course in islamic finance by coursework and by research. target respondents are undergraduate students in the field of business, finance, accounting and shari’ah. these students are selected as they are expected to become part of shari’ah auditing labor market in the future. prior study by yavas & arsan (1996) found that students with accounting or auditing academic background are very likely to favor auditing as their career of choice. as shari’ah auditors are also expected to possess business and shari’ah knowledge, students enrolling in these two courses are also considered. first year students were also surveyed as they were found in previous studies to have made decisions with regards to their choice of profession during the first two years of their university studies (gul et al., 1989; mauldin et al., 2000; paolillo and estes, 1982). a total of 69 students agreed to participate in the survey, representing 27% from university a, 40% from university b and 33% from university c. the number is reasonable as students’ enrolment is on average, relatively small across the three universities given the small country’s population. further, a portion of the wealthiest elite societal group in the country sent their children overseas (mainly western nations) for quality education abroad, leaving a handful of youth to populate local universities. from the 69 copies of questionnaires distributed, 10 were unusable leaving only 59 copies available for analysis. 6. the understanding of undergraduate students towards shari’ah auditing: findings and discussions table 1 to 3 below explain respondents’ demographic information, with 29% of them are male and the remaining 71% are female. majority of respondents (95%) are in the age range asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 93 of twenty (20) to twenty four (24) years old and mostly in their second and third year of study (87%). only eight (8) respondents (13%) are in their final year of study. table 1. gender distribution (n = 59) gender frequency percentage male 17 29 female 42 71 total 59 100 table 2. age distribution (n=59) range frequency percentage 15 19 1 2 20 24 56 95 25 – 34 2 3 total 59 100 table 3. year of study distribution (n = 59) year of study no % 2nd 24 41 3rd 27 46 4th 8 13 total 59 100 asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 94 table 4 below shows the distributions of respondents according to their currently enrolled program. it indicates that almost all universities offer courses in finance with university c having the highest number of students enrolling for the course. university b being the sole full-fledged islamic university in the country is the only university providing respondents studying shari’ah. table 4. enrolled program distribution (n=59) enrolled program (%) enrolled program (%) u. a business administration 5 economics 2 accounting & finance 18 others 2 u. b islamic finance 18 business management 3 shari’ah 14 others 5 u. c accounting management finance& commerce 2 others finance 31 table 5. shari’ah auditor’s role (n=59) shari’ah auditors role (%) a) to express an opinion on the true and fair view of the financial statements 36% b) to check that ifis activities are shari’ah compliant 24% c) both 40% asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 95 table 5 above indicates that only 40% of the respondents expect shari’ah auditors to do both jobs of the normal financial auditors (i.e. expressing opinion as to whether the audited financial statements provide a true and fair view of ifi’s financial positions) and the true role of shari’ah auditors (i.e. checking ifi’s shari’ah compliance). this implies that majority of undergraduate students surveyed (60%) are not aware of what the precise role of shari’ah auditors. this is unsurprising as there are no specific academic courses or sections in any courses that touch on shari’ah auditing. the 40% view is however commendable as their understanding is apparently based on piecemeal knowledge of conventional auditing and shari’ah in isolation. table 6. characteristics of shari’ah auditors characteristics (%) honesty 92 accountability 81 highly ethical 78 confidentiality 68 competency 64 independence 41 respondent’s views on the characteristics of a shari’ah auditor (based on aaoifi) indicate high awareness among brunei undergraduate students towards the expected characteristics traits of shari’ah auditors. they ranked honesty as the first expected trait (92%), followed by accountability (81%), highly ethical (78%), confidentiality (68%), competency (64%) and the least is independence (41%). the low scoring on independence trait could potentially be attributed to their misconception with regards to the status of shari’ah auditor being part of the company, equivalent to the internal auditor or company’s shari’ah advisors. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 96 table 7. knowledge needed in a shari’ah audit profession discipline % islamic finance 93 shari’ah 92 auditing 81 accounting 78 conventional finance 53 students were also asked of their views with regards to the necessary knowledge background to become shari’ah auditor. they ranked islamic finance as the most important knowledge background (93%) followed by shari’ah (92%), auditing (81%), accounting (78%) and the least important is conventional finance (53%). this reflects student’s single-sided views whereby checking on shari’ah compliance to them requires little, if not none of conventional finance knowledge. this view effectively disregards the fact that islamic finance knowledge is primarily developed based on conventional finance techniques modified to suit shari’ah requirements. knowing both dimensions of finance essentially enables shari’ah auditors to analyze financial transactions and subsequently check on shari’ah compliance more effectively. the final part of the questionnaire deals with questions of whether the profession of shari’ah auditor should be further emphasized in the muslims dominated country and the student’s view of making shari’ah auditor as a career choice. an overwhelming response of 91% agrees that shari’ah auditing should be properly developed and the regulatory framework and structure must be strengthened. these necessitate for this religious based profession to provide more exposure to potential participants in its labor market. among common reason given by respondents in the questionnaire is the fact that brunei is a country established under the malay islamic monarchy system, with majority of the population are muslims. this reinforces the practical imperative of properly developing the islamic finance and putting it in the mainstream financing industry. therefore, having a sound shari’ah auditing framework in fortifying the industry’s integrity is not an option to brunei. unfortunately, nearly three quarter of the respondents (approximately 70%) confirms that they are not aware of shari’ah audit being another profession available in their career choice list. a heartening rate of 60% of the respondents however plans to consider shari’ah audit as their prospect career upon graduation. these results should send a clear alarming signal to the bruneian government as the development of this religiously based industry is known to be a function of human capital development. coordinated efforts are imperatively required to asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 97 expose shari’ah audit as another promising profession in light of the industry’s robust and exponential development. in this regard, the government in collaboration with industry players and academia should therefore work towards developing a strategic, short and long term blue print for human capital development in meeting the industry needs. for instance, comprehensive revamp of the current academic curriculum should be done to reflect the market demand for knowledgeable and competent shari’ah auditor. for instance, universities in brunei should consider incorporating shari’ah audit and islamic finance as core subjects in their degree programs, or at least part of the respective conventional courses, even though the degree programs may not be purely islamic. this should preferably be done at the earlier year of student’s study period as the first course taken by students at undergraduate level provides significant impact on students’ perceptions towards the prospective profession (jackling and calero, 2006). a more ambitious plan when the knowledge has been fully developed is to have stand-alone courses on shari’ah auditing and islamic accounting and finance. as for graduated individuals without shari’ah knowledge, educational and professional institutions may offer a focused certified shari’ah programs, providing them with the necessary shari’ah knowledge of becoming shari’ah auditor. on the other hand, shari’ah graduates without accounting and finance background could also be offered courses on accounting and finance certification, thereby offering them with equal opportunities of becoming shari’ah auditors. apart from that, industry-academic linkages must also be further strengthened, engaging in activities that disseminate relevant information on islamic finance including shari’ah audit to the public. ifis could consider organizing frequent visits to higher institutions and employment roadshow to public, informing the “positive sides” of the profession such as vast employment opportunities available in the industry and long term career prospect (dalci, arasli, tumer et al., 2013) particularly on shari’ah auditing. 7. conclusion despite the exponential growth of the islamic finance industry and the fact that it forms an integral part of the industry’s governance structure, shari’ah audit has perplexingly gained scarce attention (sultan, 2007). the focus of both academic research and industry’s attention mainly falls on the industry’s assets, products and services. de-emphasizing the check and balance (governance) perspective of the industry is unwarranted as it will adversely affect the industry’s sustainability in the long run. as the sacred industry develops, the increasing demand for competent shari’ah auditors is inevitable. the current shortages on qualified individuals in the labor market has effectively dampens the industry’s vision to serve the ummah and becoming a viable alternative to conventional, shari’ah non-complaint finance. this study finds that shari’ah audit has not been comprehensively introduced to the potential auditing labor market participants (i.e. the undergraduate students). this is despite the students are currently enrolled in islamic finance, accounting, business and shari’ah courses. the students are however found to have at least some basic ideas of what shari’ah audit is all asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 98 about, particularly on the roles and ethical characteristics of shari’ah auditor. concentrated and coordinated efforts between the government, industry and academia are further required to ensure the continuous supply of knowledgeable and qualified shari’ah auditor are not disrupted, potentially giving disastrous impact to this shari’ah based industry. references aaoifi (2010). accounting, auditing and governance standards for islamic financial institutions. manama, bahrain: accounting and auditing organization for islamic financial institutions. besar, m.h.a., abd-sukor, m.e., abdul-muthalib, n., & gunawa, a.y. (2009). the practice of shari’ah review as undertaken by islamic banking sector in malaysia. international review of business research papers, 5(1), 294-306. courville, s. (2003). social accountability audits: challenging or defending democratic governance?. law & policy, 25(3), 269–297. dalci, i., arasli, h., tumer, m., & baradarani, s. (2013). factors that influence iranian students’ decision to major in accounting. journal of accounting in emerging economies, 3(2), 145 163. garas, s.n., & pierce, c. (2010). shari’a supervision of islamic financial institutions. journal of financial regulation and compliance, 18(4), 386–407. ghauri, p., & gronhaug, k. (2010). research methods in business studies. 4th edition, pearson education limited, england. global islamic finance (2012). shari’ah compliant assets expected to reach $1.6trn. global islamic finance magazines, 1-3. grais, w., & pellegrini, m. (2006). corporate governance and shari’ah compliance in institutions offering islamic financial services. world bank policy research working paper no. 4054, the world bank, new york, usa. grewal, b.k. (2012). global islamic finance statistics. presentation at the global islamic finance forum 2012: bridging economies, introductory session & giff report, kfh research limited. gul, f. a., andrew, b.h., leong, s.c., &ismail, s. (1989). factors influencing choice of discipline of studyaccountancy, engineering, law and medicine. accounting and finance, 29(2), 93-100. haniffa, r., & hudaib, m. (2010). islamic finance: from sacred intentions to secular goals?. journal of islamic accounting and business research, 1(2), 85-91 international monetary fund. (2011). international financial statistics. http://www.imf.org/external/data.htm#data asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 99 jackling, b., & calero, c. (2006). influences on undergraduate students’ intentions to become qualified accountants: evidence from australia. accounting education: an international journal, 15(4), 419–438. karim, r.a.a. (1990). the independence of religious and external auditors: the case of islamic banks. accounting, auditing and accountability journal, 3(3), 34 – 44. kasim, n., mohamed-ibrahim, s.h., & sulaiman, m. (2009). shari’ah auditing in islamic financial institutions: exploring the gap between the ‘desired’ and the ‘actual’. global economy and finance journal, 2(2), 127-137. kasim, n. (2010). auditing from the islamic perspective. accountants today, malaysian institute of accountants, 28 – 31. khan, m.a. (1985). role of the auditor in an islamic economy. journal of research in islamic economics, 3(1), 31– 42. mauldin, s., crain, j.l., & mounce, p.h. 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(2010). audit and governance in islamic banks: selection and training of shari’ah advisors. 6th asia pacific interdisciplinary research in accounting (apira) conference sydney, australia. http://apira2010.econ.usyd.edu.au. shafii, z., salleh, s., & shahwan, s. (2010). management of shari’ah non-compliance audit risk in the islamic financial institutions via the development of shari’ah compliance audit framework and shari’ah audit programme. kyoto bulletin of islamic area studies, 3(2), 3–16. sultan, s.a.m. (2007). a mini guide to shari’ah audit for islamic financial institutions. cert publication, kuala lumpur. united nation. (2011). human development reports. http://hdr.undp.org/en/statistics/ us department of state. (2011). background note: brunei. available online at http://www.state.gov/r/pa/ei/bgn/2700.htm. asian journal of finance & accounting issn 1946-052x 2013, vol. 5, no. 2 www.macrothink.org/ajfa 100 yaacob, h. (2012). issues and challenges of shari’ah audit in islamic financial institutions: a contemporary view. in 3rd business and economic research international conference (icber) 2012 proceedings of the international conference in bandung, indonesia, 2012. yaacob, h., & donglah, n.k. (2012). shari’ah audit in islamic financial institutions: the postgraduates’ perspective. international journal of economics and finance, 4(12), 224 – 239. yavas, u., & arsan, n. (1996). image of auditing as a field of study and a career among college students. managerial auditing journal, 11(5), 41-44. microsoft word 13651-49837-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 16 factors influencing the dividend policy of vietnamese enterprises dang ngoc hung (corresponding author) faculty of accounting & auditing, hanoi university of industry, vietnam e-mail: toketoankinhte@gmail.com nguyen viet ha faculty of accounting & auditing, hanoi university of industry, vietnam dang thai binh vietnam institute for indian and southwest asian studies vietnam academy of social sciences (vass) received: august 27, 2018 accepted: oct. 5, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13651 url: https://doi.org/10.5296/ajfa.v10i2.13651 abstract the article explores the factors affecting company’s dividend policy such as profitability, firm size, financial leverage and growth rate. data is collected from enterprises listed on the vietnam securities market in the period of 2006 2017 with 2,150 observations. using the generalized least squares (gls), the authors have identified two factors that have a positive and significant effect: (i) return on total assets and (ii) firm size. at the same time, research results also show a negative impact of enterprise’s revenue growth rate on the dividend payment ratio. in addition, financial leverage has no impact on company’s dividend policy. keywords: dividend policy, gls model, dividend payout ratio; dividend per share ratio asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 17 1. introduction the aim of dividend policy is to allocate retained earnings for reinvestment and dividends for shareholders. retained earnings provide investors a source of potential future profit growth through reinvestment, while dividends provide them a current distribution. it determines how much the company's after-tax profit will be distributed, how much retained earnings for reinvestment will be, and how much dividends for shareholders will be. thus, dividend policy will affect the share of capital in the capital structure of the business and the cost of capital used by the business. the dividend policy plays an important role in business activities and will be affected by many factors such as profitability, growth rate, firm size, etc. this study focuses on the theories of factors influencing corporate dividend policy and determines how these factors influence the dividend payment decisions of joint stock companies that be listed on the stock market of vietnam. there have been many studies on the factors influencing the dividend policy in the world, such as rozeff (1982), fama & french (2001), liu & hu, (2005), deangelo, deangelo, & stulz (2006), nizar al-malkawi (2007), ahmed & javid (2008), gill, biger, & tibrewala (2010). these studies have some similar results but there are also inconsistent results that need to be studied. in vietnam, the research of vo (2013), t.m.h. nguyen, nguyen, & nguyen (2014), dinh & nguyen (2014), t.n.t. nguyen & bui (2018) use different model as well as the dependent variables so the results of the study are not consistent with each other. the purpose of this study is to clarify the theoretical basis, determine the factors influencing dividend policy (measured by dividend payout ratio, dividend per share ratio) based on empirical research of companies listed in the vietnam securities market for the period 2006-2017. 2. theoretical framework according to miller & modigliani (1961), dividend policy does not affect the value of a company. the value of a company depends on investment decisions. this conclusion of miller & modigliani (1961) is based on the assumptions of an efficient and perfect capital market. this research also relies on customer effect arguments to protect its conclusions. accordingly, company that change their dividend policy may lose some shareholders because they will move to another company that have an attractive dividend. thus, stock prices have fallen temporarily, but other investors who prefer the new dividend policy will think that the shares of the company are sold under the price and will buy more shares. gordon (1963) have a contrast argument with miller & modigliani (1961). he argued that if the assumptions in the m&m model do not exist, a company's dividend policy becomes more important because it can impact on company value. free cash flow theory assumes that company pay dividends to overcome the representative matter which stemming from the separation of ownership and control in a large and dispersed ownership company. in such company, most investors have no ability or incentive to monitor and control all activities of board management. in that case, managers are motivated to engage in activities that may not be in the best interests of the investor. m. c. jensen (1986) argues that asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 18 paying dividends is the way to achieve this goal. easterbrook (1984) also has the same argument. according to jensen (1986), managers have a motivation to expand the company exceeding the optimal scale because the increased size required to increase resources under their control. miller & rock (1985) suggested that a sudden change in income had a similar effect on corporate profits as a sudden change in dividends. they concluded that income, dividends and donations were closely related. in addition, the current dividend payment trend is the base for market to provide income in the future. dividend policy is the base for signaling expected income in the future. a lot of research has been done in this field, but there is not a complete answer. a huge researches have shown that tackling this problem is neither simple nor clear. dividends which are still one of the most critical issues in corporate finance need to be researched in many aspects 3. literature review 3.1. research in developed countries rozeff (1982) studied the dividend policy and the relationship of dividend policy and variables such as beta coefficient, growth rate, and ownership rate. in this research, the data was collected from 1000 companies in the united states. results showed that dividend payouts have the opposite effect with future revenue growth, beta coefficient, and ownership rate. in addition, the results of this study also show that dividend policy in a company is affected by investment policy. gr jensen, solberg, & zorn, et.al, (1992) studied the dividend policy in the us and they concluded that the debt ratio was negatively correlated with the rate of return. when company has higher debt ratio, which means that the greater the financial risk so that company usually pays lower dividends. fama & french (2001) used the logit model with the dependent variable take value 1 if companies pay dividends regularly for ordinary shares every years and value 0 if elsewhere. they point out that the dividends payout ability has positive correlation with firm size, profitability and has a negative relationship with growth opportunities. deangelo et al., (2006) extend the analysis of fama & french (2001). they include the life cycle measurement of a company and found out that the dividend payout ratio has a positive correlation with the rate of return on book value of common equity and they argue that the rate of return on book value of common equity is often the most important economic indicator influencing to the trend of dividends payout. gill et al., (2010) measured the effect of several factors on the dividend payout ratio of companies in the manufacturing and service sectors. in overall sample size, the dividend payout ratio depends on margin profit, revenue growth rate, debt to equity ratio and taxes. for service companies, margin profit, revenue growth rate, and debt to equity ratio are factors that influence the dividend rate of companies. for manufacturing companies, the dividend payout ratio depends on factors such as margins profit, tax and ratio of market value to book value. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 19 3.2. research in developing countries pandey (2001) studied the dividend payment behavior of companies in malaysia. the sample size was 248 companies from 1993 to 2000. the results show that there is a difference in dividends payout among sectors in malaysia. agricultural and manufacturing companies have a higher dividends payout ratio because they have limited opportunities to invest and increase working capital. this research also shows that profitability, company size and investment opportunities have an influence on dividend policy. a larger company with higher profitability usually pays higher dividends. liu & hu (2005) studied the dividend policy of companies in china. samples were randomly selected with 299 companies on the shanghai stock exchange. the results show that dividends payout ratio in chinese companies are directly related to the earning per share and total assets and have a negative relationship with the debt ratio. nizar al-malkawi (2007) used tobit model to determine the factors influencing dividend payout ratio of companies listed on the jordan stock exchange in the period of 1989-2000. research shows that the stock ownership ratio between people who work in that company and state ownership has a great influence on corporate dividend policy. in addition, firm size, the operating time and profit of the company are also factors that influence the dividends payout ratio. ahmed & javid (2008) identified the factors affecting the dividend payout ratio of 320 non-financial companies listed on the stock exchange market in pakistan for the period 2001-2006. using the lintner's model (1956), the authors point out that dividend payout ratio depends on the current eps and dividend payout ratio in the past. however, dividend payouts ratio of these companies are more sensitive to eps than dividend payouts ratio in the past. in addition, the results of this study also show that companies with high profit and stable eps have large free cash flow, so they often pay high dividends. dividend payout ratio is positively correlated with the concentration of ownership and liquidity of the market but it is negatively correlated with the investment opportunity, debt ratio and company size. thanatawee (2013) researched dividend policy of companies in thailand. the study used data from 287 firms listed on the thailand stock exchanges market for the period 2002-2008. the study found that in thailand, the dividend payout ratio depends on roe, firm size, and asset growth rate and financial leverage. he concluded that companies often use bank loans to pay dividends to shareholders. 3.3. research in vietnam vo (2013) conducted a study examining the factors influencing the cash dividend payout ratio with the data of enterprises on ho chi minh stock exchange from 2009 to 2012. research shows that factors such as debt ratio, firm size, tangible fixed assets, growth rate and business risk which have a statistically significant impact on cash dividend payout ratio of companies. in addition, the author indicates that profitability and liquidity do not affect the company's cash dividend payout ratio. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 20 t. m. h. nguyen et al., (2014) clarified the theories of factors influencing the dividend policy and determines the effect of these factors on the dividend payment decision. using the multivariate regression model with the data of 75 companies listed in vietnam stock market for the six years’ period from 2007 to 2012, this study shows that profitability, firm size has a significant impact on dividend payout ratio while the growth rate and financial leverage have a negligible impact. t.n.t. nguyen & bui (2018) examined the determinants of the dividend policy of non-financial companies listed on the vietnam stock market for the period 2008-2015 with the binary dependent variable. this research shows that profitability, the level of money holdings, the liquidity of stocks and the life cycle of companies play an important role in dividends policy. in addition, growth opportunities and financial leverage also have an effect on dividend payments decision. meanwhile, the other two factors namely the firm size and the risk does not affect the decision. with these contradictory research results, it is needed to have an explicitly research based on empirical results. in vietnam, although there have been a number of studies on dividend policy of listed companies in stock market, these research has only provided dividend policy analyzes and factors affecting dividend policy. this study, on the one hand, provides a more accurate assessment of the factors that influence the dividend policy of listed companies in stock market over a long period of time with the dependent variable measured (dividend payout ratio dividend per share ratio). finally, this study will be based on those assessments to suggest vietnamese companies to adopt appropriate dividend policy. 4. models and research methods studying dividend policy in developing and emerging markets shows that dividend policy in emerging market companies is similar to that of us companies. dividends are affected by profitability, debt ratio, market-to-book ratio (aivazian, booth, & cleary, 2003). examining the influencing factors including the effectiveness of business administration, firm size, total assets growth rate, profitability shows that the higher effectiveness of business administration a company have, the higher the dividend will be. in addition, the growth rate negative relationship with the dividend payout ratio. profitability: this factor directly affects the company's dividends payment ability (lintner, 1956). companies paying high dividend have high profit (baker & powell, 2000 and nizar al-malkawi, 2007). in vietnam, some studies show that return on total assets (roa) are positively affect to the company’s dividend policy (dinh & nguyen, 2014). earning per share (eps) is one of the factors that have a positive influence on the dividend decision (t.m.h. nguyen et al., 2014). research hypothesis is developed: h1: profitability is positively correlated with dividend policy. firm size: large companies have an easy access to capital market and a low cost capital mobilization because credit institutions believe their repayment capabilities, so it is not necessary to use internal funds. thus, firm size has an inversely relation with the level of internal fund dependence or large company can pay higher dividends (al-yahyaee, pham, & asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 21 walter, 2006; al-shubiri, 2011). meanwhile, the company size has a positive but unpredictable relationship (mitton, 2004). research hypothesis is developed: h2: the firm size has a positive relationship with dividend policy. financial leverage: financial leverage represents the level of corporate loan usage. loans will cause low dividends payment to maintain a certain amount of capital to meet their debt obligations and to pay for transaction costs (rozeff, 1982). the adverse effect of financial leverage on dividend has been demonstrated in studies such as mancinelli & ozkan, (2006), ahmed & javid (2008). g. r. jensen et al. (1992) studied the dividend policy of companies in the united states. they concluded that the debt ratio was negatively correlated with dividend payout ratio. research hypothesis was developed: h3: financial leverage has a negative relationship with dividend policy. growth rate: enterprises with higher growth rates, they will have more investment opportunities, and the managers tend to favor internal capital to conduct all projects with positive net present value, so their dividends are usually low. (gr jensen et al., 1992). this inverse relationship between growth rate and dividend was demonstrated in the study of ho (2003) and al-yahyaee et al., (2006). research hypothesis was developed: h4: the growth rate has a negative relationship with dividend policy. based on the previous study model, the author uses the following model: dpayout it = β0 + β1(roait) + β2(sizeit) + β3(dlfit)+ β4(growit)+ εit dpsr it = β0 + β1(roait) + β2(sizeit) + β3(dlfit)+ β4(growit)+ εit table 1. measurements and expected sign of variables no variables code calculation expected sign of variable 1 dividend payout ratio dpayout dividend per share /net income per share 2 dividend per share ratio dpsr dividend per share / par value shares 3 profitability roa net income/ average total assets (+) 4 firm size size ln (revenue) (+) 5 financial leverage dlf debt / total assets (-) 6 growth rate grow (turnover this period previously turnover) / (previous turnover) (-) source: author’s establishment asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 22 the data are collected from companies listed on ho chi minh city stock market for 12 years (2006-2017) with 2150 observations (unbalanced data) and the regression model is based on tabular data. regression methods include pool regression methods, fixed effect model (fem), and random effect model. after choosing the most appropriate method, the authors conducted a model selection test and a defect assessment test of the selected model. if the defect is violated, the author will use the generalized least squares (gls). 5. results and discussion in the period 2006-2017, the number of enterprises paying cash dividends ranged from 59.9% to 83%, with an average of 67.6%. thus, about two-thirds of enterprises pay cash dividends (table 2). table 2. number of enterprises paying cash dividends yearly year enterprise without cash dividends payment enterprise with cash dividends payment total quantity rate (%) quantity rate (%) 2006 22 31.4% 48 68.6% 70 2007 17 17.0% 83 83.0% 100 2008 25 20.7% 96 79.3% 121 2009 20 31.3% 44 68.8% 64 2010 18 20.9% 68 79.1% 86 2011 69 29.6% 164 70.4% 233 2012 85 35.7% 153 64.3% 238 2013 81 33.5% 161 66.5% 242 2014 89 35.9% 159 64.1% 248 2015 81 33.2% 163 66.8% 244 2016 83 33.2% 167 66.8% 250 2017 107 42.1% 147 57.9% 254 total 697 32.4% 1,453 67.6% 2,150 source: data extracted from financial statements and calculated from stata 13.0 by author table 3 shows that the average dividend payout ratio is 42.72%, which means that enterprises have used 42.72% of net profit to pay cash dividend. average dividend payout ratio was 18.72% compared to dividend per share ratio, the lowest was 0% and the highest was 660%. businesses usually pay cash dividends from 1-2 times a year, but in particular there are companies paying cash dividends 5 times a year. average return on assets (roa) is 6.80%. the logarithm of total revenue (size) is 13.53, average financial leverage (dlf) is 47.13% and average growth rate (grow) is 32.86%. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 23 table 3. descriptive statistic for variables variable obs mean std. dev. min max dpayout 2150 0.4272 0.4712 -0.5 6.04 dpsr 2150 0.1243 0.1968 0 6.6 roa 2150 0.0680 0.0931 -1.72 0.78 size 2150 13.5388 1.3897 8.63 18.32 dlf 2150 0.4713 0.2128 0 1.06 grow 2150 0.3286 1.3973 -0.99 18.2 source: data extracted from financial statements and calculated from stata 13.0 by author the correlation coefficients matrix among variables is used to analyze and examine the probability of multicollinearity occurrence. based on the data on table 4, the likelihood of multicollinearity in the regression model is small because most of the correlations among variables are relatively small. none of the cases have the absolute value exceeds 0.6 table 4. correlation coefficients matrix dpayout dpsr roa size dlf grow dpayout 1 dpsr 0.4279* 1 roa 0.1476* 0.4268* 1 size 0.0444* 0.1401* 0.1171* 1 dlf -0.0694* -0.1365* -0.3758* 0.3227* 1 grow -0.0302 -0.0042 0.0951* 0.0986* 0.0021 1 source: data extracted from financial statements and calculated from stata 13.0 by author based on the regression result (table 5, table 6) with the two dependent variables namely dividend payout and dividend per share ratio to consider and select the appropriate model among three regression methods, the author use f and hausman testing. using the f test, we see prob> f = 0.000 <α = 5%, thus with the significance level of 5 we reject h0. it means that with the data collected, fem model is appropriate, pool is inappropriate because of fixed effects existence in each enterprise over time. after selecting the fem model instead of the pool method, the authors in turn evaluated the existing tabular data based on fem and rem. from the fem and rem results, the hausman test will be use to compare fem and rem. hausman's test results are presented in table 5, table 6, which shows that prob> chi2 = 0.0000 <5%, thus h0 hypothesis will be rejected. that is the fixed-effects estimation (fem) is suitable than the random effects estimation (rem). however, before analyzing in detail the factors affecting the dividend policy, the author will use two tests (heteroscedasticity, autocorrelation) and make necessary corrections to overcome restrictions of the model. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 24 table 5. estimation results with dividend payout ratio vif pool rem fem gls roa 1.28 0.273** 0.273** -0.0806 0.681*** size 1.21 0.0190* 0.0190* 0.0211 0.0149* dlf 1.39 -0.0827 -0.0827 -0.0275 -0.0728 grow 1.02 -0.00954 -0.00954 -0.00516 -0.0159** _cons 0.19 0.19 0.162 0.219** n 2150 2150 2150 2150 r-sq 0.1097 0.1097 0.0017 lm test wald chi2(4) = 13.52 wald chi2(4) = 13.52 wald chi2(4) = 56.33 prob > chi2 = 0.0090 prob > chi2 = 0.0090 prob > chi2 = 0.0000 f test f(4,1890) = 0.58 prob > f = 0.6801 hausman test chi2(4) = 46.45 prob>chi2 = 0.0000 wooldridge test f( 1, 252) = 4.659 prob > f = 0.0318 modified wald test chi2 (256) = 4.6e+06 prob>chi2 = 0.0000 t statistics in brackets * p<0.1, ** p<0.05, *** p<0.01 source: data extracted from financial statements and calculated from stata 13.0 by author asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 25 table 6. estimation results with dividend per share ratio vif pool rem fem gls roa 1.48 0.746*** 0.746*** 0.428*** 0.878*** size 1.23 0.0147*** 0.0147*** 0.0168*** 0.0143*** dlf 1.38 0.00126 0.00126 0.129*** -0.0119 grow 1.02 -0.00674** -0.00674** -0.00513* -0.00755*** _cons -0.124*** -0.124*** -0.191** -0.121*** n 2150 2150 2150 2150 r-sq 0.6161 0.6161 lm test wald chi2(4) = 321.79 wald chi2(4) = 321.79 wald chi2(4) = 515.41 prob > chi2 = 0.0000 prob > chi2 = 0.0000 prob > chi2 = 0.0000 f test f(4,1890) = 21.09 prob > f = 0.0000 hausman test chi2(4) = 171.65 prob>chi2 = 0.0000 wooldridge test f( 1, 252) = 5.582 prob > f = 0.0189 modified wald test chi2 (256) = 5.5e+05 prob>chi2 = 0.0000 t statistics in brackets * p<0.1, ** p<0.05, *** p<0.01 source: data extracted from financial statements and calculated from stata 13.0 by author to test whether or not the model has heteroscedasticity, the authors used the breusch and pagan test. under the assumption h0: there is no heteroscedasticity, h1: there is heteroscedasticity. the p-value received is 0.0000 <α (5%), which implies that there is heteroscedasticity. the wooldridge test is used to test whether or not the model has autocorrelation. the value p-value = 0.0000 <α = 0.05, it means that h0 is rejected so the model has autocorrelation. to overcome these problems, gls method is used. the results presented in table 5, table 6 are the corrected results. based on table 8, the results of the study on the factors influencing the dividend policy. as a result of the gls model, the return on asset (roa) is positively correlated with the corporate dividend policy and is statistically significant at 1%. that is suitable with the expected results. this result is consistent with the results of baker & powell (2000), nizar al-malkawi (2007), nguyen et al. (2014) and t.m. nguyen et al., (2014). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 26 table 7. gls estimation results dividend payout dividend per share ratio roa 0.681*** 0.878*** size 0.0149* 0.0143*** dlf -0.0728 -0.0119 grow -0.0159** -0.00755*** _cons 0.219** -0.121*** n 2150 2150 r-sq 0.1097 0.6161 t statistics in brackets * p<0.1, ** p<0.05, *** p<0.01 source: data extracted from financial statements and calculated from stata 13.0 by author the results show that the firm size is positively correlated with the dividend per share ratio (statistically significant at 1%). this result is consistent with the study of al-yahyaee et al., (2006), al-shubiri (2011). when considered the dependent variable, dividend payout ratio is positively related to company size, but the statistically significant is 10%. the financial leverage is inversely related to dividend policy but is not statistically significant. this is not consistent with the original hypothesis. this finding is not consistent with previous research of rozeff (1982), mancinelli & ozkan (2006) and ahmed & javid (2008). as expected, regression results show a statistically significant negative relationship between growth rates and dividend policy. this points to the fact that the demand of capital to finance growth are increasingly and therefore dividends payment is low. in other words, growth companies have more investment opportunities, so businesses are more likely to pursue a lower dividend payout ratio as dividends and investments represent two competing object to use company’s cash. the results of this study are consistent with the results of ho (2003) and al-yahyaee et al., (2006). the results of the regression show that profitability, previous dividend payout ratio, financial leverage and growth rates have an impact to the dividend policy with statistical significance: (1) the profitability has a positive impact on the dividend policy of company listed on the securities market of vietnam. this may explain that company with good profitability will pay dividends to shareholders. at the same time, the previous dividend policy has a positive impact on the dividend policy of the next period, however, the company size does not affect the dividend policy. (2) financial leverage has a negative impact on dividend policy of enterprises listed on the securities market of vietnam. this can be explained that the higher the debt rate is higher the risk. when the cost of capital is high, the business must pay attention to the debt payment rather than dividends payment. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 27 6. conclusions and recommendations dividend policy is one of the three important decisions of financial management. based on the results of this study, the authors propose some recommendations: (i) investors need to study the financial status of the business as the profitability because it will affect to the dividends payment of the next period. high debt ratio will negatively affect dividend payment. (ii) the manager should have an analysis of the advantages and disadvantages of each type of dividend policy and consider which one will be suitable with the specific characteristics of company. most importantly, managers have a clear choice of dividends policy and pursue that choice. because, in order to maintain dividend payments, it is imperative for managers to have a long-term financial and investment strategy, a more responsible for raising capital efficiency, helping to increase the company value in the long run. 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(1982). growth, beta and agency costs as determinants of dividend payout ratios. journal of financial research, 5(3), 249-259. https://doi.org/10.1111/j.1475-6803.1982.tb00299.x thanatawee, y. (2013). ownership structure and dividend policy: evidence from thailand. international journal of economics and finance, 5(1), 121-132. võ, x. v. (2013). các yếu tố tác động đến chính sách cổ tức bằng tiền mặt. tạp chí kinh tế & phát triển, 210(1), 36-43. microsoft word 1_determinats-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 63 the determinants of capital structure decisions: evidence from chinese listed companies sunitha vijayakumaran(corresponding author) department of commerce faculty of management studies and commerce university of jaffna, sri lanka ratnam vijayakumaran department of financial management faculty of management studies and commerce university of jaffna, sri lanka received: april 27, 2018 accepted: nov. 13, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13065 url: https://doi.org/10.5296/ajfa.v10i2.13065 abstract in this paper, we examine the determinants of leverage in the context of china using a sample of 1844 chinese non-financial firms over the period 2003 to 2010. this study shows that the average leverage ratio of chinese listed firms is similar to those observed in other developing countries. the study also finds thatsize, tangibility, volatility and firm age are positively and significantly associated with leverage. firm’s profitability has statistically significant negative impact on leverage. furthermore, we find that firm size, profitability, tangibility, volatility and firm age are the robust determinants of leverage of chinese listed firms. keywords: capital structure, leverage, firm size, profitability, tangibility, growth opportunities, volatility, china. jel classification f30; g10; g32 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 64 1. introduction corporate capital structure decisions are not only important for firms to maximize their value but also for the growth and stability of firms and the corporate economy as a whole (jensen and meckling, 1976; benito, 2003). firm financing patterns have long been the object of study in the corporate finance literature (haris & raviv, 1991). the main issue of debate revolve primarily around the optimal capital structure that maximizes the value of the firm (e.g., modigliani and miller, 1958 and 1963; miller, 1977). capital structure means the mix of different sources of financing such as equity and debt (panday, 2006). capital structure choices of corporations have traditionally been analysed in the modigliani-miller (1958) framework, expanded to incorporate taxes, bankruptcy costs, agency cost, and asymmetric information issues (such as signalling, adverse selection). the trade-off theory, pecking order theory (myers and majluf, 1984; myers, 1984), and agency theory (jensen and meckling, 1976) are main theories that explain the use of leverage in firms’ capital structure. a large number of studies, for example titman and wessels (1988), wald (1999), have empirically examined determinants of capital structure in the context of developed economies. most early papers examine the case of us companies (see haris and raviv(1991) and graham, & leary, (2011) for reviews), whilst rajan and zingales (1995) test the theoretical and empirical lessons learnt from the us studies for the g7 countries. these authors find a similar behaviour of leverage across countries, thus refuting the idea that firms in bank-oriented countries are more leveraged than those in market-oriented countries. (note1) rajan and zingales (1995) also find that the determinants of capital structure that have been reported for the usa (size, growth opportunities, profitability, and tangible assets) are important in other countries as well. they show that a good understanding of the relevant institutional context (bankruptcy law, fiscal treatment, ownership concentration, and accounting standards) is required when identifying the fundamental determinants of capital structure (note that capital structure, leverage and debt capital or debt financing are used interchangeable throughout the paper). recently, there has been a growing body of literature on capital structure decisions from developing countries, for example wiwattanakantang (1999), booth et al. (2001), deesomsak et al. (2004), kim et al. (2006), and črnigoj and mramor (2009). in the context of china, a handful of empirical studies examine capital structure decisions (for example, chen, 2004; huang and song, 2006; zou and xiao, 2006; qian et al., 2009; moosa et al., 2011). a common feature of all these studies based on chinese listed companies is that they use data before 2005. therefore, these studies do not consider changes occurred after the major split-share reform initiated by chinese securities regulatory committee (csrc hereafter) and chinese government in 2005. the aim of the 2005 split-share structure reform is to convert non-tradable shares into tradable shares in order to facilitate the liquidity in the secondary market. before implementing the reform, the non-tradable shareholders of a firm have to negotiate with tradable shareholders to ensure that they get a suitable compensation package before trading occurs. (note 2) this study, therefore, provides first empirical evidence using a longer period of latest chinese listed company data on the effects of ownership reform on the corporate financing decisions. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 65 the reminder of the paper is organized as follows. section 2 reviews the theories and prior studies related to capital structure decisions and develops testable hypotheses. section 3 presents regression model and discusses our estimation methodologies. section 4 describes data and presents descriptive statistics. in section 5, we discuss our empirical results, before concluding in section 6. 2. review of the literature and hypothesis development this section presents the main capital structure theories: the static trade-off theory, the pecking order theory and the agency theory. the aim of reviewing the capital structure theories is to develop a theoretical framework for predicting the effects of the determinants of capital structure. in addition, we review prior evidence and develop hypotheses. 2.1 relevant capital structure theories for a long time, the issue of capital structure choices and the resulting effect on the value of the firm has been a controversial and much disputed area. the main issue of debate revolve primarily around the optimal capital structure that maximizes the value of the firm (modigliani and miller, 1958 and 1963; miller, 1977). capital structure means the mix of different sources of financing such as equity and debt (pandy, 2008). in fact, the debate on the modern theory of capital structure began with the seminal paper of modigliani and miller (1958) which shows that subject to some conditions, the impact of debt financing on the value of the firm is irrelevant. they contend in their first proposition that the market value of any firm is independent to its capital structure, and is given by capitalizing its expected return at the rate appropriate to the risk class (i.e. the levels of risk of the firm) (modigliani and miller 1958). this first proposition has been criticized and the main argument is that it is theoretically very sound but is based on the assumptions of perfect capital market, no taxes (personal or corporate), no distress costs and equal access to information which are not valid in reality. following the work of modigliani and miller (1958), the literature on capital structure has been expanded through many theoretical and empirical contributions. scholars have placed much emphasis on releasing the assumptions made by modigliani and miller (1958), in particular by taking into account corporate taxes (modigliani and miller, 1963), bankruptcy costs (stiglitz,1972; titman,1984), agency costs (jensen and meckling, 1976), information asymmetries (myers and majluf, 1984; myers, 1984), and imperfect capital markets (baker and jeffrey, 2002). the alternative theories that currently dominate the empirical studies include the trade-off theory, the pecking order theory and, the agency theory. the trade-off theory is a result of releasing assumptions of ‘no corporate taxes’ and ‘no financial distress costs’ (i.e. bankruptcy costs). for example, modigliani and miller (1963) relaxed their assumptions by incorporating the effect of taxes on the cost of capital. tax shields occur when firms use debt financing in their capital structure, as firms have to pay interest on debt which is generally tax deductible. thus, interest payments act as a tax shield and allow the firm to increase its value. however, when considering the financial distress costs that arise from maintaining high levels of debt (e.g., bankruptcy costs) (stiglitz, 1972), asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 66 the value of the firm is determined by its net benefits (i.e. tax shield benefits minus costs). therefore, the trade-off theory posits that firms maximise their value when the benefits that stem from debt (e.g. the tax shield and reduced costs of informational asymmetry attached to debt compared to outside equity) outweigh or equal the marginal cost of debt (e.g. bankruptcy costs, and agency costs) (modigliani and miller, 1963; stiglitz, 1972; jensen and meckling, 1976; myers, 1977; titman, 1984). the pecking order theory, which was developed by myers and majluf (1984) and myers (1984) is linked to information asymmetries existing between insiders of the firm and outsiders (i.e. the capital market). the theory suggests that managers adapt their financing policies to minimise the cost of information asymmetries. managers therefore prefer internal financing to external financing, and risky debt to equity since debt capital suffers less from information asymmetries than equity. that is debt is the first source of external finance on the pecking order and equity is issued only as a last resort, when the debt capacity is fully utilised. the above two theories (i.e. the static trade-off and pecking order theories) are based on the assumption that the interest of the managers of a corporation with dispersed ownership is always aligned with that of shareholders. in contrast, the agency theory assumes that self-interested managers always pursue their own objectives at the expenses of shareholders (jensen and meckling, 1976).jensen and meckling (1976) formally model the agency costs of equity and debt capital in a modern corporation. they identify two types of agency conflicts namely, conflicts between managers and shareholders, and conflicts between shareholders and bond holders, and the related agency costs in a firm. as argued in jensen and meckling (1976) and jensen (1986), debt capital not only brings in additional monitoring from outsiders (i.e. creditors) but also make managers commit to pay out cash, (i.e., it reduces the amount available to managers to overinvest). therefore, using debt capital in the capital structure helps to reduce agency costs arising from conflicts between managers and shareholders (see s.vijayakumaran (2016) and r. vijayakumaran (2017) for a discussion on the governance role of debt). the use of debt capital in the capital structure leads to conflicts between debt-holders and equity holders because debt contracts give equity holders an incentive to invest sub-optimally (jensen and meckling, 1976). that is, managers (who act on behalf of shareholders) have incentive to shift funds from low-risk investment projects to high-risk ones in order to earn higher profit in the short term period (also known as assets substitution effect). myers (1977) identifies another agency cost of debt. he argues that when firms are likely to go bankrupt in the near future, equity holders have no incentive to contribute new capital, even to invest in value-increasing projects because they bear the entire cost of the investment, while the returns may be captured mainly by debt-holders (i.e. the debt overhang problem). therefore, the firm may undesirably forego positive npv projects due to the conflicts of interest between equity holders and debt holders. this is well documented as “under invest problem” in the agency literature. considering the benefits and costs of debt financing from an agency perspective, the agency theory provides predictions for the potential effects of the firm characterises on the use of debt capital in the firm. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 67 2.2 the determinants of capital structure and hypotheses following rajan and zingales (1995), titman and wessels (1988), and frank and goyal (2009), the study uses seven important firm characteristics the expected relationship between the determinant variables and leverage are primarily guided by relevant theories as well as previous empirical studies. 2.2.1 firm size as discussed in rajan and zingales (1995), the theoretical prediction for the effect of size on leverage is ambiguous. it is argued that larger firms tend to be more diversified and have more tangible assets, stable cash flows and better reputations. the trade-off theory therefore postulates that compared to smaller ones, ceteris paribus, larger firms are expected to have a higher debt capacity due to a lower risk of bankruptcy (bankruptcy cost). in contrast, the pecking-order theory suggests that, bigger firms are more likely to use less debt due to lower asymmetric information problems between insiders and outside investors (i.e. larger firms provide more information to lenders than smaller firms, so the cost of issuing new equity is lower than the debt issuing cost). previous empirical studies from developed countries (titman and wessels, 1988; berger et al., 1997; brailsfore et al., 2002; florackis and ozken, 2009), from developing economics (wiwattanakantang, 1999; booth et al., 2001; pandey, 2001; deesomsak et al., 2004), as well as in the context of chinese firms (chen and strange, 2005; zou and xiao 2006; haung and song, 2006; qian et al., 2009) all uniformly find that leverage is positively related to firm size. we therefore expect a positive relationship between firm size and leverage. therefore, our hypothesis is that h1: there is a positive significant relationship between firm size and leverage. 2.2.2 profitability according to the static trade-off theory, the more profitable the firms, the greater the use of leverage, ceteris paribus, due to an increase in the tax shield benefits and, to a lower financial distress and agency costs of debt. thus, this theory predicts that profitability is positively related to leverage. in contrast, there is an opposite prediction based on the pecking-order theory that the most profitable firms tend to borrow less. in other, the pecking-order theory suggests that firms first finance their investment using internal resources (i.e. retained profit), and then move to debt and new equity financing as a last resort. previous empirical findings on financing behaviour of firms in developed economies (titman and wessels, 1988; chiarella et al., 1992; allem, 1993; wald, 1999; rajan and singales, 1995; berger et al., 1997; brailsfore et al., 2002; fama and french, 2002; frank and goyal, 2003; florackis and ozken, 2009), and in emerging economies (wiwattanakantang, 1999; booth et al., 2001; pandey, 2001; deesomsak et al., 2004) find a negative relationship between leverage ratios and profitability. in the context of chinese enterprises, several authors (chen, 2004; chen and strange, 2005; zou and xiao 2006; haung and song, 2006; qian et al., 2009) also report a similar relationship. in this study, the measure of earnings before interest and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 68 taxes scaled by total assets is employed to measure profitability (profit) of firms. we test the following hypothesis: h2: there is a negative significant relationship between profitability and leverage. 2.2.3 tangibility according to the pecking-order theory, firms with more fixed assets can easily access secured debt since tangible assets are used as collateral for debt. the static trade-off theory postulates that the larger the fixed assets of the firm (fixed assets are collateralised for debt and thus they reduce the risk of lenders), the lower the bankruptcy and financial distress costs. in line with the explanation of both theories, a positive relationship between tangibility and leverage is expected. the findings of prior empirical research on leverage based on developed countries (rajan and singales, 1995; berger et al., 1997; wald, 1999; brailsfore et al., 2002; florackis and ozken, 2009), and developing countries (wiwattanakantang, 1999; deesomsak et al., 2004) as well as china (chen, 2004; chen and strange, 2005; zou and xiao 2006; haung and song, 2006; qian et al., 2009), confirm this theoretical prediction. we thus expect a positive relationship between tangibility and leverage. in this study, tangibility (tang) is measured by net fixed assets normalized by total assets of the firm. we test the following hypothesis: h3: there is a positive significant relationship between tangibility and leverage. 2.2.4 growth opportunities according to the static trade-off theory, firms with high growth opportunities (which are a form of intangible assets) in the future are likely to be high risk, and this leads to a greater financial distress costs (frank and goyal, 2009). therefore, an inverse relationship between growth opportunities and leverage is postulated. the pecking-order theory, in contrast, predicts a positive relationship between these variables since high-growth opportunity firms are likely to face more information asymmetry problems between insiders and outsiders (i.e. company managers know more about their future investment opportunities than outside investors). so these firms use more debt than equity in the financing hierarchy, since debt capital suffers less from information asymmetries. most empirical work on capital structure decisions show an opposite relationship between growth opportunities and leverage. empirical studies from developed countries (titman and wessels, 1988; rajan and singales, 1995; fama and french, 2002; brailsfore et al., 2002; frank and goyal, 2009; florackis and ozken, 2009), from developing countries (wiwattanakantang, 1999; deesomsak et al., 2004), and from china (zou and xiao 2006; haung and song, 2006) obtain an inverse relationship between leverage and growth opportunities. therefore, we also expect to find a negative relationship between the two variables in chinese listed companies. following rajan and zingales (1995) and booth et al. (2001), we use the ratio of the sum of the market value of equity and the book value of debt to the book value of total assets to measure growth opportunities (growth) in our study. we test the following hypothesis: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 69 h4: there is a negative significant relationship between growth opportunities and leverage. 2.2.5 non-debt tax shields non-debt tax shields (nontaxshd) represent tax credits for investments and depreciation. non-debt tax shields reduce a firm’s tax payments and thus reduces the need for debt financing as a means to obtain tax advantages (dammon and senbet, 1988). that is, non-debt tax shields are substitutes for the tax benefits of debt financing. therefore, the trade-off theory predicts a negative relationship between non-debt tax shields and leverage. previous empirical studies from developed countries (wald, 1999; chaplinsky and niehaus, 1993), from developing countries (wiwattanakantang, 1999; deesomsak et al., 2004), as well as in the context of chinese firms (huang and song, 2006; qian et al., 2009), find an inverse relationship between non-debt tax shields and leverage. therefore, we expect a similar relationship between non-debt tax shields and leverage. in this study, we use non-debt tax shields (notaxshd) measured by depreciation scaled by the total assets as an inverse proxy for tax shield advantage. we test the following hypothesis: h5: there is a significant negative relationship between non-debt tax shields and leverage 2.2.6 volatility according to the trade-off theory, a firm with higher earnings volatility has a higher probability of financial distress, since the volatility of earnings is the chief factor in determining firms’ ability to meet debt obligations, such as interest charges. therefore, an inverse relationship between volatility and leverage is postulated. the findings of prior empirical studies on leverage based on developed countries (titman and wessels, 1988), and developing countries (booth et al., 2001) as well as chinese firms (huang and song, 2006) provide an inverse relationship between the volatility of earnings and leverage. we thus also expect to find a negative relationship between volatility and leverage. following johnson (2003), in this study, we define volatility (vol) as the standard deviation of the first differences of earnings before taxes and depreciation over the four years preceding the sample year, divided by average total assets for that period. we test the following hypothesis: h6: there is a negative significant relationship between volatility and leverage. 2.2.7 firm age both the static-trade off and pecking-order theories are silent as regards the relationship between the firm age and leverage. however, based on the agency framework, some authors (e.g. du et al., 2010) suggest that the older firms are less likely to face asymmetric information problems and should have much easier access debt financing compared to younger ones, ceteris paribus. also, older firms are less likely to invest in risky projects, since they are established over many years and well reputed in the market (diamond, 1991). moreover, tian and estrin (2007) also mention that firm with long history can easily establish their reputation in the debt market, resulting older firms are more likely to have a higher asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 70 leverage ratio than younger ones. previous empirical studies on chinese firms (for example, chen and strange, 2005) find that firm age is positively related to leverage. in line with the above explanation and previous findings, we expect a positive relationship between firm age and leverage. in this study, firm age (firmage) is measured by the natural logarithm of years since the establishment of the firm. we test the following hypothesis: h7: there is a positive significant relationship between fim age and leverage. 3. model specification and estimation methodology in this section, we first present our model specifications: static baseline model and dynamic model. following the model specification, the control variables that are used in the study are described lengthily with reference to relevant theories and prior empirical studies. finally, estimation methodologies are discussed. 3.1 model specification levit= β0 + β1sizeit + β2profitit + β3tangit + β4growthit + β5nontaxshdit +β6volit + β7firmageit + vi + vt + vj+ vk+ eit. (1) where i indexes firm, t years. the term vi, vt,, vj, and vk represent time-invariant firm specific fixed effects, time-specific effects, industry effects, and effects of regional differences, respectively; eit is a random/ idiosyncratic error term. 3.2 control variables in addition to the considered determinants of capital structure, we include year, industry and regional dummies as controls to control for year-specific, industry-specific and geographic effects. lemmon et al. (2008) provide strong evidence that firm-specific unobservable characteristics (vi) of the firm have a significant impact on firms’ capital structure decisions. they vary across firms but are assumed to remain constant for each firm through time. they include variables such as the quality of management, managers’ attitudes towards risk, and market reputation, etc. on the other hand, time-specific effects (vt), which we control for by including time dummies, vary through time but are the same for all the firms at a given point in time. vt captures macroeconomic factors such as interest rates, inflation and business cycle effects, which are outside the control of firms. finally, vj, effects of regional differences. on the left hand side of the equation (1), our dependent variable is the leverage ratio (the ratio of the book value of total debt to the book value of the firm’s total assets) of firm i in year t. on the right hand side a set of explanatory variables in addition to a set of control variables. the list of variables used in the paper, their definition and expected sign are summarized in table1 1. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 71 table 1. definition of variables variables name measures expected sign capital structure variable leverage lev : total debt / total assets determinants of leverage size size : natural logarithm of total real assets + profitability profit : roa =return on assets = earnings before interest, taxes and depreciation / total assets tangibility tang : net fixed assets/ total assets + growth opportunities growth : ratio of the sum of the market value of equity and the book value of debt to the book value of total assets. non-tradable share price is used to calculate as the market value of the tradable equity. non-debt tax shield notaxshd : depreciation / total assets volatility vol : standard deviation of the first differences of earnings before taxes and depreciation over the four years preceding the sample period, divided by average total assets for that period. firm age firmage : log of the number of years since the establishment of the firm + year dummies vt : year dummies for the years 2003 to 2010 industry dummies vj : csmar b classification: 5 industries : utilities, properties, conglomerates, industry, commerce (except financial industries) regional dummies vk : dummies indicating whether the firm is located in the coastal, western, or central region of china notes: ‘+’ means that leverage increases with the variables, ‘-’ means that leverage decreases with the variables. 3.3 estimation methodology in this study panel data estimation methodologies are used to examine the relationship between leverage and its determinants. panel data analysis presents several advantages: it increases the degree of freedom owing to large number observation, reduces the possibility of collinearity among the explanatory variables, and results in more efficient estimates. we first use a pooled ols (ordinary least square) model. however, a pooled ols does not take into account the potential unobserved firm heterogeneity, which may affect both the leverage and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 72 its determinants. therefore, we use fixed effects method which allows us to control for unobservable heterogeneity and, therefore, eliminates the risk of obtaining biased estimates for our variables. 4. data and descriptive statistics in this section, we describe the dataset and sample that is used in our study, and explain how the data is processed. this section also provides a discussion on summary statistics and correlation analysis of our variables. 4.1 data and sample selection our sample includes all the publicly held firms that have been listed on the shanghai and shenzhen stock exchanges over the period of 2003 to 2010. data are collected from the china stock market and accounting research (csmar) database and sino-fin. we first delete firms in the financial industry, since their capital structure is subject to many regulations. we then remove the potential outliers (i.e., extreme observations) by deleting observations below the 1st and above the 99th percentile of all our regression variables, expect dummy variables. our final sample has 1844 chinese firms and covers an unbalanced panel of 9624 firm-year observations. 4.2. summary statistics table 2 presents descriptive statistics for the dependent variables, explanatory used in our regression analysis. included are mean, median, standard deviations, minimum and maximum for the variables used in our study. table 2. summary statistics of leverage, corporate governance, and control variables of chinese listed firms over the period of 2003 to 2010 variables obs. mean median std. dev. min max dependent variable lev 9624 0.503 0.505 0.214 0.058 3.061 determinates of capital structure size (billion rmb) 9624 1.463 0.732 2.471 0.067 26.136 profit 9624 0.074 0.074 0.063 -0.254 0.268 tang 9624 0.460 0.457 0.165 0.061 0.845 growth 9624 2.082 1.659 1.237 0.807 8.504 notaxshd 9624 0.025 0.022 0.015 0.000 0.081 vol 9624 0.037 0.020 0.049 0.000 0.368 firmage 9624 10.543 10.000 4.132 1.000 26.000 note: definitions for all variables are provided in table.1. the minimum and maximum book values of leverage (lev) ratios for the sample firms range from 5.8 % to 306.1 % with an average of about 50% (median 50 %). this suggests that on average, half of total assets are financed by debt capital. furthermore, this figure implies that our sample firms in china have similar mean leverage compared with the findings of the previous studies in developed economies. for example, in their sample of firms from g-7 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 73 countries rajan and zingales (1995) report that mean leverage ratios (in book value) of 52 % and 54 %, respectively for the united states and the uk. moreover, the mean leverage ratio of chinese listed firms is also similar to the ratios observed in developing countries (which average 51 % according to booth et al., 2001). with regard to the determinants of leverage, the mean (median) of firm size (size) proxied by total assets of the firm is 1.463 billion rmb (732 billion rmb).(note 3) moreover, according to the sample, chinese firms have an average profitability (profit) of 7.4 %, an average tangibility (tang) of 46 %, and average growth opportunity (growth) of 20.82 %. average (median) nondebt tax shield (notaxshd) for the sample firms is 2.5% (2.2%) while average (median) volatility (vol) for the sample firms is 3.7 % (2%) . the average level of firm age (firmage) is 10.5 (10.00). using data 972 chinese plcs in 2003, chen and strange (2005) find a mean of 6.60 for firm age. the mean values of these variables are comparable to those reported in studies on capital structure decision in the context of china, such as huang and song (2006) among others. 5. empirical results 5.1 correlation analysis table 3 reports the pearson correlation coefficients between variables used in our regression analysis. firstly, firm size (size) shows a positive and statistically significant correlation with total leverage (lev). similarly, tangibility (tang) exhibits a positive association with total leverage. as expected, profitability (profit) and growth opportunities (growth)show a negative correlation with total leverage.the non-debt tax shield (nontaxshd) is positively and significantly related to leverage. finally, firm age (firmage) is positively and significantly related to leverage. furthermore, table 3 suggests that given that the observed correlation coefficients between independent variables are relatively low, multicollinearity should not be a serious problem in our study. table 3. pearson correlation matrices lev size profit tang growth nontaxshd vol firmage lev 1.00 size 0.20* 1.00 profit -0.33* 0.19* 1.00 tang 0.20* 0.16* 0.09* 1.00 growth -0.22* -0.30* 0.21* -0.21* 1.00 nontaxshd 0.29* -0.12* -0.21* -0.01 0.07* 1.00 vol -0.02 0.06* 0.23* 0.50* -0.08* 0.06* 1.00 firmage 0.25* 0.15* -0.10* 0.08* -0.03* 0.29* 0.02* 1.00 notes: * denotes significance at the 5% level. see table1 for definitions of all variables. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 74 5.2 multivariate analysis this section discusses the empirical results. we first report estimates from model obtained using the pooled ols and then firm fixed effects regressions which enable us to directly compare our results with previous studies based on developed countries as well as in the context of chinese firms. we can see that in column 1 of table4, firm size (size) attracts a positive and statistically significant coefficient. this is consistent with the previous empirical findings (e.g., berger et al., 1997; booth et al., 2001) and with the trade-off and agency theories, meaning that larger firms are more diversified compared to small ones and consequently, they are associated with a lower risk of bankruptcy cost and better borrowing capacity relative to smaller firms. in line with the pecking-order theory, the relationship between profitability (profit) and leverage is negative and precisely determined in all columns. this provides additional support to findings of previous empirical studies in the context of chinese listed companies. for example chen (2004) proposes ‘a new pecking-order’, whereby firms use first retained profits, then equity financing, and debt capital as a last resort since bond markets in china are not very much developed. he finds that firms with more profitable projects tend to use less external financing since these firms have better access to internal financing than firms with lower profits. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 75 table 4. the traditional determinants of capital structure variables predicted sign ols (1) fixed effects (2) size + 0.049*** 0.050*** (0.004) (0.008) profit -0.974*** -0.606*** (0.066) (0.044) tang + 0.270*** 0.175*** (0.026) (0.023) growth -0.012*** -0.002 (0.005) (0.003) nontaxshd -1.109*** -0.212 (0.300) (0.352) vol 1.042*** 0.566*** (0.140) (0.110) firmage + 0.053*** 0.072*** (0.009) (0.019) constant -0.744*** -0.815*** (0.097) (0.172) industry dummies yes yes regional dummies yes yes year dummies yes yes firm fixed effects yes observations 9624 9624 r2 0.298 0.192 adj. r2 0.296 0.191 f value 82.761 46.929 p values 0.000 0.000 notes: cluster robust standard errors are reported in columns 1 and 2 (clustered on firms). ***, **, and * denote significance levels of 1%, 5%and 10%, respectively. see table 1 for definitions of all variables. tangibility (tang) is positively related to leverage in columns 1 and 2, suggesting that the larger the proportion of fixed to total assets the firm has, the lower the bankruptcy costs. this finding is in line with the trade-off theory and the findings of previous empirical studies (e.g., rajan and zinghales, 1995; zou and xiao, 2006). furthermore, as can be seen in the ols regression in columns 1, growth opportunities (growth) exhibit a negative significant coefficient in line with the static trade-off theory. this can also be explained following myers (1977) who argues that high growth firms tend to use less leverage in order to reduce underinvestment problem. this result is also consistent with the findings of the previous studies in the context of china (zou and xiao 2006; haung and song, 2006; moosa et al., 2011), from developed countries (frank and goyal, 2003; florackis and ozken, 2009), and from developing countries (see e.g., wiwattanakantang, 1999; deesomsak et al., 2004). however, results from the fixed effects model in column 2 indicate that growth opportunities asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 76 have no significant impact on leverage ratios. column 1 of table 4 show that the non-debt tax shield (nontaxshd) is negatively and significantly related to leverage, confirming non-debt tax shields are substitutes for the tax benefits of debt financing (deangelo and masulis, 1980). this result is consistent with the findings of the previous empirical studies (deesomsak et al., 2004; wiwattanakantang, 1999; qian et al., 2009). however, as shown in column (2), the coefficient on non-debt tax shields is insignificant in fixed effects regressions. as can be seen in columns (1) and (2) of table 4, the estimated coefficient on volatility (vol) is significantly positive. these results are consistent with the findings of the previous studies for chinese listed firms (qian et al., 2009). finally, the results from both ols and fixed effects regressions in columns (1) and (2) indicate that firm age (firmage) is positively and significantly related to leverage, suggesting that older firms have much easier to access debt financing since they face less asymmetric information problems. this is consistent with the previous empirical finding in the context of chinese listed firms (chen and strang, 2005). so far, our analysis indicates that the average leverage ratio of chinese listed firms is similar to those observed in other developing countries and the level of leverage is well explained by the firm specific determinants such as firm size, profitability, tangibility, volatility and firm age. 6. conclusions capital structure theories have been subjected to extensive empirical testing in the context of developed economies, particularly the united states. in this paper, we study the determinants of leverage in the context of china. we use a sample of 1844 chinese non-financial firms over the period 2003 to 2010 for our empirical analysis. this empirical study uses data after the 2005 spilt -share reform. firstly, our study finds that that the average leverage ratio of chinese listed firms is similar to those observed in other developing countries. the study also finds that size, tangibility, volatility and firm age are positively and significantly associated with leverage. furthermore, firm’s profitability has statistically significant negative impact on leverage. furthermore, we find that we find that firm size, profitability, tangibility, volatility and firm age are the robust determinants of leverage of chinese listed firms. notes note1. market-oriented countries include the uk and the usa. bank-oriented countries include japan, france and germany. note 2. the compensation package/ plan should be approved by 2/3 of the total voting shareholders and the voting tradable shareholders. note 3. it should be noted that although firm size is measured as the logarithm of total real assets in the regression analysis, the figure reported in the descriptive statistics in table 3.1is not in logarithms as actual value is easier to interpret. 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(2006).the financing behaviour of listed chinese firms. the british accounting review, 38(3), 239-258. https://doi.org/10.1016/j.bar.2006.04.008 microsoft word 10605-39136-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 155 the behavior patterns of investors in thailand stock market quan n. tran school of business, national institute of development administration (nida) floor 8 boonchana autthakorn 118 moo3, sereethai road, klong-chan, bangkapi, bangkok 10240, thailand tel: 66-93-895-4658 e-mail: quantrannhu@gmail.com received: jan. 14, 2017 accepted: february 15, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10605 url: https://doi.org/10.5296/ajfa.v9i1.10605 abstract the purpose of this paper is to investigate behavioral patterns expressed by investors in the thailand stock market. the paper examines investment decision-making processes in the context of the current financial market in thailand to shed some light on behavioral-induced pattern behind such investments. data for this research was collated from 8 individual investors by semi-structured and in-depth interview. there are four behavioral factors of individual investors in thailand stock exchange: overconfidence, excessive optimism, psychology of risk, and herding behavior. securities companies may also use the findings of this research for better understanding on investors’ decision to give better recommendations to them. stock prices then reflect their true value and thailand stock market becomes the yardstick of the economy’s wealth and helps enterprises to raise capital for business activities. keywords: behavioral finance, individual investors, thailand set, stock market, qualitative inquiry asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 156 1. introduction one of the most common perceptions of being successful in stock markets is to have the right kind of knowledge about the market dynamics and knowing the right kind of firms to invest in. traditional finance theories have generally captured two vital assumptions to select different shares by investors, that is, investors are rational and unbiased. however, studies in behavioral finance has rapidly extended during the recent years and provided evidence that investors’ financial decisions depend deeply on internal and external behavioral factors (shefrin, 2000; shleifer, 2000). identification of the influencing factors on investors’ behavior can be effective for different policyholders, so that it would affect companies’ future policies and strategies from company’s perspective, in addition, it can affect the required legislations and the additional procedures needed in order to satisfy investors’ desires and also to give more supports to market efficiency from government perspective (wameryd, 2001). therefore, this research seeks the answer to the question: what is the behavior of individual investors in thailand stock market? 2. literature review in recent times, there has been a noteworthy progress in the field of behavioral finance. the literature on behavioral finance is voluminous, including survey and secondary data analysis. both approaches have significant contributions in this area. “behavior of investor is a part of behavior finance, which seeks to understand and predict systematic financial market implications of psychological decision processes. behavior finance closely combines individual behavior and market phenomena and uses knowledge taken from both the psychological field and financial theory.” (fromlet, 2001). 2.1 heuristics theory heuristics are defined as the rules of thumb, which makes decision making easier, especially in complex and uncertain environments (ritter, 2003) by reducing the complexity of assessing probabilities and predicting values to simpler judgments (kahneman & tversky, 1979). in general, these heuristics are quite useful, particularly when time is limited (waweru, munyoki, & uliana, 2008), but sometimes they lead to biases (ritter, 2003; tversky & kahneman, 1975). tversky and kahneman (1975) seem to be ones of the first writers studying the factors belonging to heuristics when introducing three factors namely representativeness, availability bias, and anchoring. waweru et al. (2008) also list two factors named gambler’s fallacy and overconfidence into heuristic theory. when people overestimate the reliability of their knowledge and skills, it is the manifestation of overconfidence (de bondt & thaler, 1995). many studies show that excessive trading is one effect of investors. there is evidence showing that financial analysts revise their assessment of a company slowly, even in case there is a strong indication proving that assessment is no longer correct. investors and analysts are often overconfident in areas that they have knowledge (evans, 2006). overconfidence is believed to improve persistence and determination, mental facility, and risk tolerance. in other words, overconfidence can help to promote professional performance. it is also noted that overconfidence can enhance other’s asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 157 perception of one’s abilities, which may help to achieve faster promotion and greater investment duration (oberlechner & osler, 2008). if an investor overestimates his ability to generate information or to identify the significance of existing data that others neglect, he will underestimate his forecast errors; he will tend to be overconfident about the information he has generated but not about public signals. thus, the person who overestimates the precision of his own information signal instead of received publicly information signals is defined as an overconfident investor. people tend to think that they are better than they really are. both the psychology and the recent finance literature characterize people with this type of behavior as being “overconfident.” studies in human behavior have shown that overconfidence is a major contributing factor to overtrading phenomenon of financial market participants. barber and odean (2001) attributed the high volume of trading to investors ‘overconfidence, in which makes investors believe their own judgment too definitely and not enough consider others’ assessment. the role of overconfidence in the trading tendency of stock has been studied by grinblatt and han (2002). they analyzed and found that overconfident investors tend to trade more frequently. 2.2 market factor de bondt and thaler (1995) state that financial markets can be affected by investors’ behaviors in the way of behavioral finance. if the perspectives of behavioral finance are correct, it is believed that the investors may have overor under-reaction to price changes or news; extrapolation of past trends into the future; a lack of attention to fundamentals underlying a stock; the focus on popular stocks and seasonal price cycles. these market factors, in turns, influence the decision making of investors in the stock market. waweru et al. (2008) identifies the factors of market that have impact on investors’ decision making: price changes, market information, past trends of stocks, customer preference, over-reaction to price changes, and fundamentals of underlying stocks. normally, changes in market information, fundamentals of the underlying stock and stock price can cause over/under-reaction to the price change. these changes are empirically proved to have the high influence on decision-making behavior of investors. researchers convince that over-reaction (de bondt & thaler, 1995) or under-reaction (lai, low, & lai, 2001) to news may result in different trading strategies by investors and hence influence their investment decisions. waweru et al. (2008) conclude that market information has very high impact on making decision of investors and this makes the investors, in some way, tend to focus on popular stocks and other attention-grabbing events that are relied on the stock market information. moreover, barber and odean (2001) emphasize that investors are impacted by events in the stock market which grab their attention, even when they do not know if these events can result good future investment performance. odean (1998) explores that many investors trade too much due to their overconfidence and excessive optimism. 2.3 prospect theory “prospect theory, which was developed by kahneman and tversky (1979), is one of the most often quoted and best-documented phenomena in economic psychology. the theory states that we have an irrational tendency to be less willing to gamble with profits than with losses.” asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 158 the prospect theory showed human behavior when they face with risk and uncertainly. in particular, people are prone to certainly, therefore people overweight on the outcomes that are perceived more certain than that are considered mere probable. this called certainly effect that human beings are not consistently risk-averse; rather they are risk-averse in gains but risk-takers in losses. in other words, traders are most inclined to take subsequent risks if they have already experienced losses. by contrast, trader who have experienced profit, usually their exposure to the next risk. therefore, people respond differently, depending on whether the choices are framed in terms of gains or in term of losses. the most famous example of framing effects was illustrated by tversky and kahneman (1975). psychology of risk refers to the difference level of mental penalty people have from a similar size loss or gain (barberis & huang, 2001). there is evidence showing that people are more distressed at the prospect of losses than they are pleased by equivalent gains (barberis & thaler, 2003). moreover, a loss coming after prior gain is proved less painful than usual while a loss arriving after a loss seems to be more painful than usual (barberis & huang, 2001). in addition, lehenkari and perttunen (2004) find that both positive and negative returns in the past can boost the negative relationship between the selling trend and capital losses of investors, suggesting that investors are loss averse. risk aversion can be understood as a common behavior of investor, nevertheless it may result in bad decision affecting investor’s wealth (odean, 1998). 2.4 herding behavior in stock market, herd behavior implies that investors tend to ignore the private information; and they incline to incompatible observed results with the fundamentals and the market’s foundation (bikhchandani & sharma, 2000). based on the observed actions of others, the individuals create the behavior; or in other words that are imitative actions of each others (hwang & salmon, 2004). according to banerjee (1992), herd behavior is defined that people act on what others are doing, even they should act differently based on their own information. if only a single investor has unreasonable behavior, this investor’s transactions have an insignificant impact on stock price in the market. even if a large investment organization takes actions separately, its influence is also limited. however, while the irrational behavior is systematic, meaning that a group of investors with the same unreasonable behavior, inappropriate pricing will appear and may be extended. barber, odean, and zhu (2009) explored that individual investors tend to contract the similar forms of deviant behavior at or around the same time. it is unnecessary for these investors to reject the each other’s actions, instead their actions have overall potentiality. in that case, individual investors can not be considered as noisy traders; and they all seem to be a giant organization having considerable impact on the market. this can lead the stock prices not to reflect their real and appropriate value. herd mentality is not only expressed in terms of the same action with the crowd, but also reflected in not acting against the crowd despite the information that they have. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 159 3. research methodology semi-structured and in-depth interviewing technique was employed to collect data from 8 individual investors in the thailand stock market. interviewees were investors with at least two-year experience in the market. these key informants were selected based on the following set of criteria: (1) maximizing over-18-aged diversification; (2) gender: there were both male and female informants in each group; (3) job: people work in stock, finance-banking, enterprises, governmental agencies, etc. relying on their sharing and knowledge in investment in stock market, better understanding of psychological factors influencing individuals’ investment behavior in the market has been revealed. the demography of the informants is summarized in table 1. table 1. informant demography no. gender age education experience value of portfolio (thb) a male 28 master 2 700,000 b male 29 master 2 250,000 c male 32 master over 5 years 400,000 d male 30 master 3 620,000 e female 28 bachelor 4 100,000 f male 28 master 3 300,000 g male over 35 master over 5 years over 800,000 h male over 35 master over 5 years 920,000 to gain a profound insight into individuals’ investment attitude and intention, the informants were asked to evaluate and make comments on the following main issues: 1. description of their stock investment process; 2. their foundation for selecting stock types to invest; 3. impact of the environment on their investment decision; 4. self-evaluation of their stock investment efficiency within the last 2 years and the ability to control individual investment; 5. their issues and interests in stock investment in the market; 6 their faith in the development of the thailand stock market. 4. results and discussions based on the interview results from 8 investors in thailand, there are 4 codes strongly supported by the data collected. individual investors in thailand express the overconfidence, excessive optimism, psychology of risk, and herding effect. 4.1 overconfidence overconfidence is manifested when investors overestimate their knowledge and skills without their consciousness. barberis and thaler (2003) lists many psychological studies in financial market and show that investors seem to be overconfident in areas that they have knowledge. overconfidence is believed to improve persistence and determination, mental facility, and risk tolerance. 6 out of 8 investors, comment a course of stock trading and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 160 portfolio management is not necessary in making any investment in the market. they believe that they are capable of self-learning about stock investment knowledge. three of the informants think that stock trading is all about understanding business specialization of the company. these investors have background in marketing, engineering and chemistry so they invest in the company that match their specialism. all investors are confident that they are of full control of their investment. taylor and brown (1988) mention a significant aspect of overconfidence in which investor rate themselves as the better-than-average compared to others or have unrealistic judgments about themselves. there are 5 investors affirm that their successful investment is the result of their own knowledge. specially all of the 8 informants believe that they are aware of thailand stock market. this implies the existence of overconfidence in the interviewed investors, which can be seen through their confidence in having full control of their investment in the market. this is also recognized by odean (1998) when he finds out that overconfident investors tend to believe that they are better than others at selecting best stocks as well as choosing right time to sign in or out of the market. individuals’ overconfidence is an important factor motivating them to take part in stock market. it helps them to gain more efficient transactions than in other financial markets. relevant comments made by informants are quoted as follows: “i can understand the value and the potential of stocks of company doing food chemistry when i invest in these companies. by finding out what they are doing, i can predict where they will be going”; “my experience in picking stocks come from the practice of trial and failure. no matter how you learn, you have to practice picking stocks and suffer from some pains to have gains”; “i understand the core value of the company business so i can estimate the real price of the stock.”; most investors also believe that the thailand stock market is not efficient. in the market of faith, that investors with good luck can easily gain successful investment. individuals’ investment list in thailand stock market is not diversified and does not correctly evaluate risks that investors might face with. they often make stock transactions at high frequency level to make use of information that they think they are the only one aware of. 4.2 excessive optimism investors pay close attention to the changes in market information, fundamentals of the underlying stock and stock price these changes cause over/under-reaction to the price change which in turn have the high influence on decision-making behavior of individual investors. 5 of 8 informants state that they would keep investing in the market even when it declines, which implies their faith in the high productivity of stock market. 6 individuals say that within the next one year they would increase investment capital for this market; 3 believe that within in the next one or two years, the thailand stock market would get back on track after the death of their beloved king. such findings imply excessive optimism which can also be seen in judgments made by individuals about the development potential for the thailand stock market as well as their expectation of profits gained in this market. gervais, heaton, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 161 and odean (2002) state that excessive optimism usually brings about positive impact as it encourages administrators to make investment. relevant comments made by informants are quoted as follows: “though the thailand stock market is now in its difficult phase, i believe that it will get back on track in the next 1 – 2 years. that is the reason why i am not much bothered by the current declining stock market”; “in my opinion, stock market is an attractive investment field compared with other markets in the country. therefore, i will keep investing in the stocks i trust despite the current fluctuating market”; “the market fluctuates a lot after the king passed away. my returns are not as what i expected. however, investing in stock market is a very good way to reserve my saving. i plan to increase my investment next year”. individual investor in thailand express a high degree of excessive optimism. they still have faith in the productivity of stock market even though they are facing with political crisis, taxes and fees. excessive optimism, at the same time, is the reason why individuals pay too much attention to companies they have invested in because they see other companies in market weaker than theirs in the race. in addition, excessive optimism can make individuals dignify reports on companies’ development potential made by analysts or the companies themselves. excessive optimism also makes individuals become less aware of negative information about their investment. 4.3 psychology of risk in the field of finance, loss aversion refers to the difference level of mental penalty people have from a similar size loss or gain while risk is an unexpected outcome and risk is linked to uncertainty. the study of tversky and kahneman (1975) suggested that people tend to be risk averse in the gain zone or when things go well and turn to be risk seeking when facing losses. in the interview, 2 out of 8 informants refer to the times of strong fluctuation in the stock as their chances to gain profits. it illustrates the attitude of finding profits in risk. when stock price on the declining trends, 6 informants state that they tend to hold the stocks longer till their price goes up or until they have information that stock price will stay low for a longer period. they also express the intention to buy more of the same stock while it prices decline. 4 informants invest in companies that they are familiar with or have much information about. this statement reveals their cautiousness and fear of risk or preference of familiarity. 4 individuals invest in companies paying steady dividend. their common choices are stocks of powerful companies in thailand such as cp all, ptt, true or ais (bluechip stocks). relevant comments made by informants are quoted as follows: “the current fluctuation in the stock market is the chance to make profit. i track my stock more frequently when the market declines. i estimate the time when my stock will bound back based on my knowledge and experiences. sometime i buy more declining stocks if i see the chance of profit”; asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 162 “i invest in companies with high prestige in the market such as the ones in natural resources exploitation, electricity or telecommunication since they very often have a stable business”; “even when stock price goes down, i do not hasten to sell my stock immediately as the price fluctuation is just temporary based on my experience”; “i do not want to sell my stock at loss but keep it for a while for better future chance”; “when joining the stock market, i am aware that it is a risky market but i still want to try because “high risk goes with big profit”; olsen (2007) states that risk is perceived from both emotion and cognition and the two main psychological moods which are risk aversion and risk seeking can exist in individuals under different conditions and contexts. therefore, comments made by the investors show that although they are risk-adverse but when the losses increase, they tend to assume more risks for making up the losses while they still perceive themselves as risk-averse investors. 4.4 herding behavior herding effect in financial market is identified as tendency of investors’ behaviors to follow the others’ actions. the investors’ reliance on crowding information rather than their own private information can result the price deviation of the securities from fundamental value and may trigger a chain of irrational buy-out or sell-off. herding impacts on stock price changes can influence the parameters of risk and return models in asset pricing implementation of institutional investors. bikhchandani and sharma (2000) give many examples and cases that investors usually imitate the others or the market movement in stead of following his/her source of information and strategy. investors do not always make lucid and reasonable decisions as expected. their behaviors, in stead, are also led by emotions as well as psychological mood of other investors. results from the interviews so that 6 out of 8 investors claim that they usually refer to others’ opinion before making any investment decisions. all the informants say that they would consider referring to movements on the digital stock board to make their own investment decision. this shows a tendency among individuals to observing others’ behavior when making investment decision. in other words, it is the act of mutual imitation among investors hwang and salmon (2004). in the study conducted in 1992, banerjee explained that herd behavior as acting following what other people are doing, even when their private source of information proves that they should act differently banerjee (1992). however, 5 out of 8 informants confirm that they will stay on their ground of decision when they are asked “what do you do if you see that market make opposite trading compare to yours, given all the private information you have at hand”. the other three informants state that they will carefully revise their decision. this result proves that investors do not entirely base on market movements to decide; in fact, it can be seen as an illustration of overconfidence when individuals consider their information of great value. on the other hand, 6 out of 8 also claim that they will decide to sell or buy certain stocks following the crowd if they do not have any information about such stocks. this is also the time when they often listen to market analysts and researchers. barber et al. (2009) argues that individual investors asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 163 tend to make similar deviation at or around a certain point of time. such investors do not necessarily reject each other’s actions; in fact, their actions share overall potential. comments revealing herd behavior made by the informants are quoted as below: “when i am unsure of which stock to invest, i asked for relevant information from friends and informal sources of information in stock market. such information has a rather high impact on my investment decision”; “it is the fact that information in the thailand stock market is still neither clear nor timely, hence i mainly rely on informal sources of information to make decision. i do not believe the market is efficient”; “there is a lack of formal information in the thailand stock market, which is actually a barrier to people’s investment decision. i myself often consult analysts, market researchers or foreign investors’ decision”; “the trading floor is really interesting with a lot of people and a lot of noises. those people may have inside information i do not have. collectively, they are the signal of the market. i cannot deny their influence on me”. herding behavior has a great impact on investment decision made by individuals in the thailand stock market especially when people have to make decision in an environment where information is inefficient, information accuracy is not reliable and information transparency is limited. when individual investors do not have faith in the quality and transparency of information in combination with limited information analysis ability, they tend to imitate others in the market (chiang & zheng, 2010). 5. conclusion this research determines four prominent behavioral biases of individual investors in the thailand stock market including overconfidence, excessive optimism, psychology of risk and herding behavior. it sends them a caution about influence of behavioral biases in decision-marking process. therefore, investors should have knowledge in behavioral finance, to realize behavioral biases which ones influence them. research result can be considered as basis for the next deep researches in behavioral finance in thailand. the psychological factors including overconfidence, excessive optimism, attitude towards risk and herd behavior are likely to exist naturally that people can not realize them. nevertheless, they have a profound impact on making investment decisions of investors. research result can also give some useful information to financial advisors. they can diagnose behavioral biases which ones can affect their clients in order that they can issue good advices the limitation of this research is that it is just an investigation into individual investors, not institutional investors. the research just chose sample randomly in thailand stock market. it is necessary to have further research studies to confirm the findings of this research with the larger sample size and the more diversity of respondents. further research studies are also suggested to apply behavioral finance to explore the behavioral factors of institutional investors at the thailand stock exchange. ethics should asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 164 also be included into behavioral factors of institutional investors, especially those in industries in which ethics of stakeholders play a crucial role such as healthcare services. the impact of corporate governance and corporate social responsibility on behavioral factors of institutional investors can attract researchers as well. the relationship between behavioral factors of institutional investors and marketing effectiveness and brand performance can be another interesting research avenue. behaviors of institutional investors as an important stakeholder group also can create sense of urgency for higher level of organizational changes and learning. references banerjee, a. v. 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(2010). an empirical analysis of herd behavior in global stock markets. journal of banking & finance, 34(8), 1911-1921. https://doi.org/10.1016/j.jbankfin.2009.12.014 de bondt, w. f., & thaler, r. h. (1995). financial decision-making in markets and firms: a behavioral perspective. handbooks in operations research and management science, 9, 385-410. https://doi.org/10.1016/s0927-0507(05)80057-x evans, d. a. (2006). subject perceptions of confidence and predictive validity in financial information cues. the journal of behavioral finance, 7(1), 12-28. https://doi.org/10.1207/s15427579jpfm0701_3 fromlet, h. (2001). behavioral finance-theory and practical application: systematic analysis of departures from the homo oeconomicus paradigm are essential for realistic financial research and analysis. business economics, 63-69. gervais, s., heaton, j., & odean, t. (2002). the positive role of overconfidence and optimism in investment policy. rodney l white center for financial research-working papers. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 165 grinblatt, m., & han, b. (2002). the disposition effect and momentum. retrieved from lai, m.-m., low, k., & lai, m.-l. (2001). are malaysian investors rational? the journal of psychology and financial markets, 2(4), 210-215. hwang, s., & salmon, m. (2004). market stress and herding. journal of empirical finance, 11(4), 585-616. https://doi.org/10.1016/j.jempfin.2004.04.003 kahneman, d., & tversky, a. (1979). prospect theory: an analysis of decision under risk. econometrica: journal of the econometric society, 263-291. https://doi.org/10.2307/1914185 lehenkari, m., & perttunen, j. (2004). holding on to the losers: finnish evidence. the journal of behavioral finance, 5(2), 116-126. https://doi.org/10.1207/s15427579jpfm0502_5 oberlechner, t., & osler, c. l. (2008). overconfidence in currency markets. available at ssrn 1108787. https://doi.org/10.2139/ssrn.1108787 odean, t. (1998). are investors reluctant to realize their losses? the journal of finance, 53(5), 1775-1798. https://doi.org/10.1111/0022-1082.00072 olsen, r. a. (2007). investors' predisposition for annuities: a psychological perspective. journal of financial service professionals, 61(5). ritter, j. r. (2003). behavioral finance. pacific-basin finance journal, 11(4), 429-437. https://doi.org/10.1016/s0927-538x(03)00048-9 shefrin, h. (2000). beyond greed and fear harvard business school press: boston. shleifer, a. (2000). inefficient markets: an introduction to behavioural finance: oup oxford. taylor, s., & brown, j. (1988). illusion and well-being: a social psychological perspective on mental health. psychological bulletin, 103(2), 193. https://doi.org/10.1037/0033-2909.103.2.193 tversky, a., & kahneman, d. (1975). judgment under uncertainty: heuristics and biases, utility, probability, and human decision making (pp. 141-162): springer. https://doi.org/10.1007/978-94-010-1834-0_8 wameryd, k.-e. (2001). stock-market psychology: how people value and trade stocks. northampton. usa: ma: edward elgar. waweru, n. m., munyoki, e., & uliana, e. (2008). the effects of behavioural factors in investment decision-making: a survey of institutional investors operating at the nairobi stock exchange. international journal of business and emerging markets, 1(1), 24-41. https://doi.org/10.1504/ijbem.2008.019243 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). search | asian journal of finance & accounting skip to main content skip to main navigation menu skip to site footer asian journal of finance & accounting current archives for authors submissions author guidelines pay article processing charge ethical guidelines for reviewers editorial team recruitment reviewers publication policies announcements about about the journal privacy statement contact search search register login home / search search search articles for advanced filters published after 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 january february march april may june july august september october november december 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 published before 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 january february march april may june july august september october november december 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 by author search no results make a submission issn: 1946-052x started: 2009 frequency: semiannual author guidelines publication policies pay article processing charge editorial team recruitment reviewers ethical guidelines the journal is included and abstracted in:  base (bielefeld academic search engine) crossref directory of research journals indexing dtu findit (dtu library) econbiz electronic journals library ezb (elektronische zeitschriftenbibliothek) google scholar hollis (harvard library) ici world of journals index copernicus pkp open archives harvester publons repec scilit sherpa/romeo the standard periodical directory information for readers for authors for librarians asian journal of finance & accounting issn 1946-052x email: ajfa@macrothink.org copyright © macrothink institute   to make sure that you can receive messages from us, please add the 'macrothink.org' domain to your e-mail 'safe list'. if you do not receive e-mail in your 'inbox', check your 'bulk mail' or 'junk mail' folders. microsoft word 8616-31272-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 60 macroeconomic approach of the determinants of stock price movements in jordan imad zeyad ramadan full prof., department of finance, applied science privet university, p.o. box 166, amman, jordan e-mail: i_ramadan@asu.edu.jo received: nov. 23, 2015 accepted: august 10, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.8616 url: http://dx.doi.org/10.5296/ajfa.v8i2.8616 abstract this study aimed to test the effect of macroeconomic factors on the movements of stock prices of jordanian industrial companies listed in amman stock exchange (ase) in order to provide empirical evidence about the determinants of the movements of stock prices. to achieve this objective, all the 77 jordanian industrial firms listed at ase for fifteen years from 2000 to 2014 have been selected, resulting in 1054 firm-year observations. the unbalanced pooled cross-sectional time series multiple least square regression method has been used to present data analysis. while the experiential results showed significant negative effect of two of the macroeconomic factors, namely, interest and inflation rates, on the movements of the jordanian industrial companies stock prices, results found that the effect of money supply and gdp on the movements of stock prices were significantly positive. these results are consistent with (mukherjee and naka, 1995, zhao, 1999 & udegbunam and eriki, 2001, al-qenae, li & wearing, 2002, dimitrios tsoukalas, 2003 , ibrahim 2003; chaudhuri and smiles, 2004) keywords: macroeconomic factors; stock price movements; jordan asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 61 1. introduction capital markets play a vital and important role in the economy by providing funding necessary for the growth of the economy all over the world. they are more than just a place for securities trading, where they are considered as a channel for fast and easy transition among savers who have a surplus of money and investors who have a need for money. a study carried out by (udegbunam and erkki, 2001) has concluded that the capital markets are necessary for economic growth because they ensure the transmission of resources to the most productive investment opportunities. ( guglielmo et al. (2004) have concluded that the basic feature of capital markets, which gives their significance, is that such markets set prices and increase the liquidity of financial instruments that are traded, as well as they distribute risks, which encourage the reduction of investment costs and thus contribute to economic growth on the long term. the movement of stock prices in the financial markets is one of the few financial phenomena that have received considerable attention from all subspecialties in the financial field, as it is apparent that there is a growing rejection of the efficient market theory in pilot research carried out by the researchers. the ideas related to market speculation are revived in order to explain the volatile nature of the capital market; and the future solely remains able to prove whether the current financial crisis will lead to an intellectual revolution that leads to the development of a coherent theory of the behavior of the capital market to be an alternative to market efficiency theory. under a free economy, the economists suggest that commodity prices are determined by the forces of demand and supply, without going into the details of the factors that influence these forces. in the stock market, pilot studies conducted on the market value of companies have concluded that the stock price is greatly affected by a number of factors that affect the value of the company such as the carrying value of the company, profit distribution policy, earnings per share, price earnings ratio and dividend cover ratio (gompers, ishii & metrick, 2003). therefore, it is normal to conclude that a large part of the movement in stock prices is caused by investors’ revision to their expectations of future cash flows. the factors that lead to movement of stock prices have become a major concern to academic researchers and investors alike. while a small number of researchers have studied the factors affecting the movement of stock prices at microeconomic level, also few researchers have studied these factors at macroeconomic level. few studies in jordan have tried to study the factors affecting the movements of stock prices for example (faris, 2010) which concluded that there was a statistically significant positive relationship between the market stock price, net asset value per share; market price of stock dividend percentage and gdp,and also there was a statistically significant inverse relationship with inflation and interest rate. it should be noted that the study of (faris ,2010) has been performed on the jordanian banking sector only, without addressing other sectors. at the state level, the studies that have examined the factors affecting the movement of stock prices have concluded discrepant results, although there is some consensus on some of these factors in all countries, and the reason for this is the different circumstances that surround asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 62 each state in terms of laws, specificities of the country, type of investors and other factors that characterize each country. thus, the main objective of this study is to provide quantitative evidence on the factors that determine the stock price movements in jordan. the importance of this study lies in that jordan has become increasingly investment destination for most arab financial investors as a result of the events witnessed by other arab countries and the reforms in the financial sector witnessed by jordan. 2. literature review all empirical evidences that linked the development of the financial markets and economic growth of the state have concluded the existence of a statistically significant positive impact for the development of financial markets on economy. a study carried out by levine and zervos (1998) has concluded that the various measurements of the activity of financial markets are linked by a statistically significant positive relationship with different real economic measures of growth in different countries, and that this relationship is strongest in developing countries. this study has also concluded that subsequent to controlling for initial conditions and financial and political variables, the different measures of the development of financial markets are strongly linked by a statistically significant relationship to current and future rates of economic growth and productivity. schwert (1989), kostoulas and kryzanowski (1996), and maysam and koh (2000) have concluded that the movements of stock prices can be understood through the study of macroeconomic variables. while the relationship between the stock market and economic activities is completely clear regardless of the direction of the relationship, but there is no agreement on a common set of macroeconomic variables that have an impact on the stock market activities whereas macroeconomic variables that were examined as determinants of the movements of stock prices showed different results through pilot studies. ibrahim and aziz (2003), booth and booth (1997), wongbangpo and sharma (2002), chen (2003), chen et al. (2005), maysami and koh (2000), and mukherjee and naka (1995) have concluded that rates of inflation, prevailing interest rates, rates of growth of money supply, size of reserves, local currency exchange rates and productivity of the sector are all considered as statistically significant determinants of stock prices movements. not macroeconomic variables alone that have an impact on the stock markets, as monetary policy also plays an important role in influencing the share prices in capital markets. for example, raising interest and discount rates reduces the current value of future cash flows, which would reduce the value of stock returns, and therefore the decline in stock prices. according to the substitution effect hypothesis, the increase in prevailing interest rates in the market increases the opportunity for cash alternative costs, and later to affect substitution between interest securities, as this hypothesis indicates the existence of an inverse relationship between interest rates and capital market returns. chen et al. (2005) concluded that the interest rates had no impact on the movements of stock prices. the reason for this was suggested by (mukherjee and naka 1995) that the change in asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 63 interest rates on short-term and long-term will affect –and in the same direction the discount rates. with regard to inflation, asprem (1989) concluded that inflation is linked by a positive relationship with stock returns, but pilot studies such as barrows and naka (1994), chen et al. (1986) and chen et al. (2005) have concluded that the negative inflation rates are associated by a statistically significant negative relationship with the capital market returns, so that, and within normal circumstances, the increase in inflation rates will lead to strict monetary policy, which would have a negative impact on stock prices. experimental studies on the effect of exchange rates on the movements of stock prices showed conflicting results. aggrawal (1981) concluded the existence of a statistically significant direct effect for exchange rates on stock prices. in contrast, ( soenen and hennigar,1988) have concluded that the relationship between exchange rates and stock prices is a statistically significant inverse relationship. but (ibrahim ,2000) concluded that in the long term there will not be a relationship between exchange rates and stock prices. a study carried out by (wohar & mark, 2006) has concluded that stock prices are very sensitive to expectations about future earnings and dividend distributions growth. cochrane (1992) and timmerman (1995) have concluded that fluctuation in stock prices can be attributed to change in dividend growth rates and earnings growth rates associated with stock. cochrane (1992) concluded that earnings distributions growth is more influential on the stock prices than its effect on company’s profits. corwin (2003) concluded that uncertainty and asymmetric information have a strong statistically significant impact on the movement of stock prices. in light of what has been previously mentioned, many microeconomic and macroeconomic factors have an impact on stock prices in the stock market, but the effect varies depending on the company, sector, economy and time, but it can be concluded that most factors have the same behavior regardless of time, sector or company. for example, increased inflation and interest rates, low profits, lower dividend rates and mismanagement have negative effects on stock prices and vice versa. 3. data and methodology the econometric methodology, mainly the multi-linear regression model has been utilized in this study following koutsoyianis (1977) who is stated that the advantage of this approach is its hypothetical believability, logical capacity, precision of parameter gauges. the necessary financial data for this study has been obtained from the amman stock exchange (ase) site and from the central bank of jordan (cbj). 3.1 dependent variable the dependent variable is the market value of the stocks prices (msp) of jordanian industrial companies listed on the amman stock exchange for the time period of 2000 to 2014.it should be noted that the last trading day of each year of the study has been used as proxy of the stock prices movements. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 64 3.2 independent variables four independent variables, most of the previous studies were unanimous that have an impact on the movements of stock prices, were selected to express macroeconomic variables as follows: • interest rate (int) • money supply (ms) • inflation rate (inf) , and • gross domestic product (gdp) of jordan. three more control variables were used in the econometric model for the study, related to the specific characteristics of the firm, to control the expected relationship between macroeconomic factors and the movements of stock prices in the jordanian market as follows: • net asset value per share (naps) • dividend payout ratio (dpr), and • earnings per share (eps). 3.3 the econometric model proceeding from the goal that the study seeks to achieve, the movements of the stock prices in the jordanian market in the econometric model of the study can be seen as follows: = ƒ( , , , ) (1) the econometric model in eq(1) can re-formulate mathematically as follows: = + + + + + ɛ (2) where; is the last trading day of each year of the study as proxy of the stock prices movements. are the cross-sectional company for the period, as i = 1,2,3,…,77, t = 1,2,3,…,15; α is a constant; β′s unknown parameters to be estimated; , , are the macroeconomic factors; ɛ is the random error. because the specific characteristics of the firm might affect the market value, as found in many of the empirical studies, three control variables i.e., net asset value per share (naps), dividend payout ratio (dpr), and earnings per share (eps) are added, and the econometric model is modified as follows: = + + + + + + ++ ɛ (3) where; are the cross-sectional company for the period, as i = 1,2,3,…,77, t = 1,2,3,…,15; β′s are unknown parameters to be estimated; , are the control variables. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 65 4. the results of regression analysis table 1 shows the results of the regression analysis based on two models: in model 1 the is regressed on , , in the absence of the control variables. table 1 also shows that is affected significantly negatively by one of the macroeconomic factors namely, the interest rate and is affected significantly positively by gross domestic product while the money supply and the inflation rate shows no significant effect on the stock price movement. also model 1 in table 1 shows that the adj. rsquare is 0.449 while the f-value is 215.277 indicating that the model can explain almost 45 percent of the stock price movements and the macroeconomic factors can play an important role in determining the share price movement in the jordanian financial market. in model 2, after adding the control variables, one can notice that the explanatory power of the model has improved almost 31 percent from 0.449 to 0.589 indicating that model 2 is the right model to explain the stock price movement in the jordanian stock market. model 2 in table 1has suggested that the jordanian stock prices msp are affected significantly by the macroeconomic factors utilized in the study, and while the interest rate and the inflation rate have a significant negative effect on the stock prices, and the money supply and gross domestic product positively affect the stock prices. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 66 table 1. regression analysis; dependent variable msp the result of the negative impact of inflation on the movements of stock prices is consistent with (zhao, 1999 & udegbunam and eriki, 2001) studies which concluded the existence of adverse impact of the inflation on stock prices. the negative effect of the interest rate on the stock prices is also consistent with (al-qenae, li & wearing ,2002, and mukherjee and naka, 1995) studies which have proved that there is a negative impact of interest rates on the movements of stock prices. also the positive impact of gdp and ms on the stock price movements in this study are consistent with (ibrahim 2003; mukherjee and naka 1995; chaudhuri and smiles, 2004) variable model 1 model 2 coefficient tvalue coefficient tvalue constant 12.254 0.094 int -0.025 8.610∗∗ -0.262 3.746∗∗ ms 0.021 1.287 0.108 2.519∗ inf -0.712 1.369 -0.552 2.738∗ gdp 0.752 3.229∗ 0.570 2.406∗ naps 0.848 3.312∗ dpr 0.672 2.382∗ eps 0.653 4.785∗∗ r-square 0.452 0.592 adjusted r-square 0.449 0.589 df regression 4 7 residual 1049 1046 total 1053 1053 f 215.277 216.61 sig. 0.000 0.000 *, ** significant at 0.05 and 0.01 respectively. int is the interest rate, ms is the money supply, inf is the inflation rate, gdp is the gross domestic product of jordan, naps is the net asset value per share, dpr is the dividend payout ratio and eps is the earnings per share. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 67 and (dimitrios tsoukalas, 2003, ibrahim, 2003 and maysami and koh, 2000) studies respectively. 5. conclusion the main objective of this study is to deliver empirical jordanian evidence regarding the impact of macroeconomic factors on the movements of the jordanian stock prices. the unbalanced pooled cross-sectional time series multiple least square regression method have been utilized to present data analysis, and the results of the study concluded that macroeconomic factors are significantly determinants of stock price movements in jordan. this paper makes an empirical contribution to the continuing discussion on the impact of macroeconomic factors on stock price movements in developing countries' economies, and a theoretical contribution to the present literature. at the level of decision-making, these results can provide solutions that contribute to the revitalization and stabilization of financial markets. acknowledgements the author is grateful to the applied science private university, amman, jordan, for the financial support granted to this research project (grant no. drgs–2014-2015-211). references aggarwal r (1981). exchange rates and stock prices: a study of the u.s. capital markets under floating exchange rates. akron bus. econ rev. 12, 7-12. al-qenae, rashid, li, carmen wearing, bob. 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(1999). stock prices, inflation and output: evidence from china. applied economics letters, 6. http://dx.doi.org/10.1080/135048599352835 microsoft word 12736-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 143 economic growth and financial development nexus in malaysia: dynamic simultaneous equations models mohamed ibrahim mugableh (corresponding author) head of financial &banking sciences department college of administrative &financial sciences irbid national university, p.o box: 2600−zip code: 21110, jordan tel: 96-27-9095-6497 e-mail: mugableh83@yahoo.com or mugableh83@gmail.com mohammad salem oudat applied science university, financial &banking sciences department, bahrain e-mail: mohammad.oudat@yahoo.com received: feb. 28, 2018 accepted: april 11, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12736 url: https://doi.org/10.5296/ajfa.v10i1.12736 abstract this paper estimates the equilibrium and causality relationships among gross domestic product, energy consumption, financial development, foreign direct investment inflows, and gross fixed capital formation. different econometrics tests like descriptive statistics, arch, kpss unit root, johansen and juselius’s co-integration, vecm granger causality, and ardl equilibrium relationships have been employed in malaysia over the (1971−2013) period. the correlation matrix results indicate a linear association among variables. the null hypotheses of heteroscedasticity and non-stationary have been rejected implying the appropriate use of vecm and ardl approach. the vecm granger causality findings show a long-run bidirectional among the variables. the ardl approach results demonstrate that energy consumption, financial development, foreign direct investment inflows, and gross fixed capital formation augment gross domestic product in long-run. however, the findings of this paper add essential implications to policy makers and scholars in fields of economic, energy, and finance. keywords: arch; ardl, economic growth, vecm; malaysia. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 144 1. introduction over the past era, several studies have been conducted to debate the relationships between gross domestic product (gdp) and its determinants. that is, numerous papers have debated the relationship between gdp and energy consumption (ec) (see alamet al.,2012; alamet al.,2011; altinay & karagol, 2004; apergis & payne, 2010; asafu-adjaye, 2000; belloumi, 2009; dagher & yacoubian, 2012; jobert & karanfil, 2007; lean & smith, 2010; menyah & wolde-rufael, 2010; ozturk & acaravci, 2010; wanget al.,2011; zhang &cheng, 2009). the relationship between gdp and financial development (fd) has been discussed by several studies (see abu-bader &abu-qarn, 2008; al-yousif, 2002; bojanic, 2012; calderon&liu, 2003; camposet al.,2012; chang, 2002; christopoulos & tsionas, 2003; deb & mukherjee, 2008; hassanet al.,2011; hondroyianniset al.,2005; hsuehet al.,2013; karet al.,2011; lee &chang, 2009; liang & teng, 2006; shan & jianhong, 2006; yang & yi, 2008; zhang et al.,2012). in addition, the relationship between gdp and foreign direct investment inflows (fdi) has been argued by studies of boutabba (2014) and hamdiet al.(2014). with regard to the research on the determinants of gdp in malaysia, a bulk of studies have been conducted in such area (e.g., ang, 2008a; ang, 2008b; ang & mckibbin, 2007; anwar &sun, 2011; azlina & mustapha, 2012; bekhet & othman, 2018; bekhet & yasmin, 2013; bekhet & othman, 2011; islamet al.,2013; shahbazet al.,2013). thus, the main purpose of the current article is to supplement the existing studies on the determinants of gdp by bringing a new evidence for the case of a developed country in south east asia (i.e., malaysia). unlike the previous studies for malaysia, this study employs the autoregressive conditional heteroscedasticity (arch) test proposed by engle (1982) to either accept or reject the null hypothesis of heteroscedasticity. if this hypothesis is rejected, then the error terms are homoscedastic and the vector error correction model (vecm) would be employed to examine the causality directions in long-run and short-run. in addition, it analyses the equilibrium relationships between gdp and its determinants by employing the econometrics approach (i.e., the autoregressive distributed lag (ardl) approach). 2. snapshot ofthe malaysian economy over the past two decades, the malaysian government has conducted the national vision policy and economic transformation policy. these policies have been concentrated on stimulating economic growth and achieving the 2020 vision. that is, the main objectives of these policies are to (1) focus on the high value added activities and total factor productivity in economic sectors (i.e., manufacturing, services, and agricultural). (2) emphasize on the collaboration between private and public sectors through establishing small and medium projects. (3) concentrate on the research activities, development activities, and human capital development. (4) improve the sustainability of energy supply and reduce the dependence on petroleum products through encouraging the use of biofuel, biodiesel, and solar energy (united nations development programme report, 2006). the objectives of these policies however, have improved the gdp, ec, fd, and fdi growth rates. fig. 1 shows that the gdp achieved an annual growth rate of 6% for the (1971−2013) period. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 145 figure 1. the growth rate of gross domestic product (2010 = 100) in malaysia for the (1971−2013) period figure 2. the growth rate of energy consumption in malaysia for the (1971−2013) period fig. 2 demonstrates that the ec registered an annual growth rate of 4% for the (1971−2013) period. fig. 3 shows that fd registers an annual growth rate of 3% for the (1971−2013) period. 0 200 400 600 800 1000 g d p (r m b ill io ns ) years gdp = 610e 0.06t r2 = 0.99 gdp 0 500 1000 1500 2000 2500 3000 ec (k g o f o il eq ui va le nt pe r c ap ita ) years ec = 534e 0.04t r2 = 0.97 ec asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 146 figure 3. the growth rate of financial development in malaysia for the (1971−2013) period fig. 4 also demonstrates that fdi inflows achieved an annual growth rate of 9% for the (1971−2013) period. figure 4. the growth rate of foreign direct investment flows into malaysia for the (1971−2013) period 3. review of literature the current paper has classified the review of literature into three groups. the first group deliberates the relationship between gdp and ec. the second group discusses the relationship between gdp and fd. the third group demonstrates the relationship between gdp and fdi. 3.1. gdp and ec the literature includes two perspectives for the relationships between gdp and ec. the first perspective is the neutrality hypothesis which states that a country might follow an energy 0 20 40 60 80 100 120 140 160 180 fd (d om es tic c re di t p ro vi de d by fi na nc ia l s ec to r, % o f g d p) years fd = 50.4e 0.03t r2 = 0.60 fd 0 2 4 6 8 10 12 14 fd i ( rm b ill io ns ) years fdi = 208e 0.09t r2 = 0.59 fdi asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 147 conservation policy that impedes gdp. for example, alamet al. (2011) found no causal relationship between ec and gdp for india. altinay and karagol (2004), jobert and karanfil (2007), and ozturk and acaravci (2010) found similar results for turkey, while zhang and cheng (2009) found them for china. the second perspective is the non-neutrality hypothesis which implies that a country’s gdp is highly dependent on ec, one of the main thrusts for achieving higher gdp. alamet al. (2012) found long-run bidirectional causality between electricity consumption (elc) and gdp for bangladesh. apergis and payne (2010) established bidirectional causality between ec and gdp in 20 oecd countries. asafu-adjaye (2000) showed bidirectional causality between ec and gdp for thailand and the philippines; similar results were found by belloumi (2009) for tunisia, dagher and yacoubian (2012) for lebanon and wang et al. (2011) for china. lean and smith (2010) pointed to unidirectional granger causality running from elc to gdp in the long-run for five asean countries. menyah and wolde-rufael (2010) established unidirectional causality running from ec to gdp for south korea. 3.2. gdp and fd recently, a pool of proof in the literature has argued that fd is an important driver of gdp. patrick (1966) argued that the relationship between fd and gdp is based in two hypotheses. the supply leading hypothesis in the case of fd causes gdp, while the demand following hypothesis if gdp causes fd. bojanic (2012) investigated the long-run relationship and the causality direction between fd and gdp for bolivia during the (1940−2010) period. the results indicated long-run relationship between fd and gdp. the findings also demonstrated the existence of supply-leading hypothesis (i.e., a unidirectional granger causality from fd to gdp). similar results were found by hsuehet al. (2013) in ten asian countries, lee and chang (2009) for a set of 37 countries, liu and hsu (2006) for three asian countries, namely, taiwan, korea, and japan, yang and yi (2008) for korea, and zhang et al. (2012) for 286 chinese cities over the (2001−2006) period. on the other hand, liang and teng (2006) examined the direction of causality between gdp and fd for the case of china over the (1952−2001) period. they employed the vector autoregressive (var) model and found a unidirectional causality running from gdp to fd. specifically, the results confirmed the existence of the demand following hypothesis. however, the bidirectional causality between fd and gdp was established by several studies (e.g., abu-bader & abu-qarn, 2008; al-yousif, 2002; calderon & liu, 2003; deb &mukherjee, 2008; hassan et al., 2011). the no clear consensus on the direction of causality between fd and gdp was found by chang (2002) in china, and karet al. (2011) in middle east and north africa countries for the (1980−2007) period. 3.3. gdp and fdi inflows the relationship between fdi inflows and gdp has been debated by diverse studies. ang (2008a) utilized the ardl approach to examine the relationship between fdi inflows and gdp for the case of malaysia. the results indicated that fdiinflows stimulated gdp via promoting foreign investments. ang and mckibbin (2007) investigated whether fdiinflows increased gdp using annual time-series data for the (1960−2001) period. they employed asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 148 co-integration and causality tests and found that fdi stimulated gdp in malaysia. anwar and sun (2011) examined the relationship between fdi inflows and gdp, based on annual time-series data for the (1970−2007) period. the findings revealed that the growth of fdi in malaysia enthused gdp. hamdiet al. (2014) analysed the determinants of gdp using quarterly time-series data for the (1980−2010) period. the results indicated bidirectional causality between fdi inflows and gdp in bahrain. 4. model construction and data the current paper analyses equilibrium and causality relationships among gdp, ec, fd, fdi inflows, and gross fixed capital formation (k, % of gdp) in malaysia over the (1971−2013) period. eq. (1) assumes that these variables determine the gdp. lngdpt = γ0 + γ1lnect + γ2lnfdt + γ3lnfdit + γ4lnkt + εt (1) where, γ0 denotes the intercept term; γis [i= 1…. 4] stand for the slope parameters; and εt denotes the error term. all the variables used in this paper were transformed into natural logarithmic forms (ln)s. the transformation into natural logarithmic form was used to stabilize the variance (σ2) of secondary time-series data. the secondary time-series variables have been collected from the world bank, development indicators databases, 2017, (http://data.worldbank.org/country/malaysia). 5. econometrics methodology methodologically speaking, the regression results are likely to be spurious if the variables are non-stationary. the solution to the spurious phenomenon is to differentiate variables and to use co-integration mechanism. nowadays, there are three models for implementing the co-integration mechanism: engle and granger’s (1987) two-step process, henceforth referred to as the var model; johansen and juselius’s (1990) trace and maximal eigenvalues statistics tests, hereafter referred to as the vecm; and pesaran, shin, and smith’s (2001) bounds f-statistics, henceforth referred to as the ardl approach. the var model in eq. (2) is conducted under the condition that variables are not co-integrated. zt = α + x1zt-1 + …. + xi zt-h + εt, xi (i= 1,…5) (2) where, zt is the 5 × 1 vector of selected variables (i.e., lngdpt, lnect, lnfdt, lnfdit, and lnkt)´. the series zt is stationary at level (i.e.,i(0)) and is said to be co-integrated if the series εt is stationary at i(0). α and εt are the 5 × 1 vector of intercepts and error terms, respectively. the xi is a 5 × 5 matrix of parameters at the lag length (h). the h is obtained by using the ackaike information criterion (aic). hamdiet al. (2014) argued that the aic is superior and improves performance over the schwartz information and hannan−quinn information criteria in a small sample size. the vecm is applied if the (εt)sin eq. (2) is homoscedastic using the arch test under the assumption that the series zt is stationary at the first differences (i.e., i(1)). thus, eq. (2) can be turned as in eq. (3). t t 1 t-1 2 t-2 i t -h tδz = πz + x δz + x δz + ....... + x δz + ε , xi (i= 1,…5) (3) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 149 where, ∆ denotes the first difference operator; ∏zt denotes the full rank that is used to test the null hypothesis (h0) of no co-integration among variables. t 1t 11s 13s 14s 15s12s t 2t 21s 23s 24s22sh t 3t 31s 33s 34s32s s=0 t 4t 41s 42s 43s 44s 52st 5t 51s 53s 54s δlngdp α β β β ββ δlnec α β β β ββ δlnfd = α + β β ...... ββ δlnfdi α β β β β βδlnk α β β β                                                          1t 1t 25s 2t 2t 35s 3t 3t 45s 4t 4t 55s 5t 5tt-s t-1 ζ εδlngdp eet ζ εδlnec eet β δlnfd + ζ eet + ε δlnfdi eetβ ζ ε δlnk eetβ ζ ε                                                                (4) where, eq. (4) represents the vecm; ∆ is the first difference operator; αit [i= 1,…. 5] represent the intercept terms; βij [i,j= 1,…., 5] denote the f-statistics coefficients to evaluate the causality directions in the short-run; ζit [i= 1,…. 5] signify the t-statistics coefficients of equilibrium error terms (eett-1)s that are used to evaluate the bidirectional causality in long-run; and εit [i= 1,…. 5] are the disturbance terms. the ardl approach has been employed in this paper to analyselong-run and short-run relationships among variables. bekhet and mugableh (2012), bekhet and mugableh (2013), bekhet and mugableh (2016), mugableh (2013, 2015a, 2015b, 2015c, 2017a, 2017b) and narayan (2005) argued that this approach has statistical and econometrics advantages. (1) the ardl approach can be utilized in a small sample size (i.e., less than 80 observations). (2) it can envelop the variables at i(0), i(1), and both. eq. (5) explains the coefficients of long-run and short-run relationships through the ardl approach. t 0 1t t-1 2t t-1 3t t-1 4t t-1 5t t-1δlngdp = α + α lngdp + α lnec + α lnfd + α lnfdi + α lnk h h h 6s t-s 7s t-s 8s t-s s=1 s=0 s=0 + α δlngdp + α δlnec + α δlnfd   h h 9s t-s 10s t-s t s=0 s=0 + α δlnfdi + α δlnk + ε  (5) here, ∆ represents the first difference operator; α0 denotes the intercept term; αit [i= 1, …. 5] represent the long-run coefficients that are used to test long-run relationships; αis [i= 6,…. 10] denote the short-run coefficients to estimate short-run relationships; h signifies the lag length that obtained by the aic; and εt is the error term. 6. results analyses and discussions 6.1. descriptive statistics test table 1 provides the findings of descriptive statistics tests. the correlation matrix results show that the variables are departed from dependence (i.e., linearly correlated). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 150 table 1. descriptive statistics test results. lngdpt lnect lnfdt lnfdit lnkt mean 3.0911 33084.9 104.93 3.8005 27.825 median 2.4811 27711.2 114.59 3.6253 25.318 maximum 7.5111 75907.3 163.35 8.7628 43.586 minimum 6.0411 6092.98 24.449 0.0567 20.570 stand. dev. 2.0911 23489.7 38.348 1.8407 6.8389 skewness 0.5726 0.52615 -0.569 0.5608 1.0085 kurtosis 2.0480 1.87294 2.1903 3.5022 2.7362 jarque−berra 3.8807 4.16080 3.4159 2.6426 5.2419 probability 0.1437 0.12488 0.1812 0.2668 0.1068 lngdpt 1.00 lnect 0.89 1.00 lnfdt 0.55 0.71 1.00 lnfdit 0.02 0.07 -0.01 1.00 lnkt -0.14 -0.05 0.17 0.67 1.00 r2 0.87 d−w 1.68 source: the output of e-views econometric software package (version 8.1). table 1 also shows that the h0 of non-normality has been rejected as the probability values of jarque−berra statistics test are greater than 10%. there is no evidence of spurious regression because the joint coefficient of determination (r2) equals 0.87 and less than 1.68 (i.e., the durbin−watson statistics (d−w) value).thus, these results lead us to further examining the equilibrium and causality relationships between gdp and its determinants. 6.2. arch test table 2 demonstrates that the h0 of heteroscedastic co-integrating relationship for the (εt)sin eq. (3) is rejected. the f-statistics probability value (i.e., 0.14) and the chi-square (χ2) probability value (i.e., 0.12) are greater than 10%. brooks (2008) argued that if f-statistics and the χ2 probabilities values are greater than 10%, the h0 of the heteroscedastic co-integrating relationship would be rejected. table 2. arch test results. computed value probability value f-statistics (q, 35) 1.96 0.14 t × r2 (χ2 (q)) 36.5 0.12 notes: (1) t is the number of observations. (2) q denotes the degree of freedom which equal the number of (h = 3) that obtained using aic. source: the output of e-views econometric software package (version 8.1). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 151 in other words, there is a homoscedastic co-integrating relationship and the vecm would be employed to examine the causality directions in long-run and short-run. before using vecm and ardl approach we have to confirm that the variables are stationary at i(1) using kwiatkowski, phillips, schmidt, and shin, kpss (1992) test 6.3. stationary test the third step in this paper is to determine the integration level of variables. the stationary testing is mandatory to detect the stability of time-series data. harris (1995) argued that the non-stationary variables are contained random and deterministic time trends. in other words, the appropriate procedure is to differentiate time-series variables in order to remove these trends. however, the kpss test has been employed to decide the integration levels of variables. the results in table 3 show that the variables are stationary at i(1). table 3. kpss test results variables kpss lm computed test statistics values decision lngdpt 0.35* stationary at i(1) lnect 0.36* stationary at i(1) lnfdt 0.23* stationary at i(1) lnfdit 0.13** stationary at i(1) lnkt 0.26* stationary at i(1) notes:(1)the kpss lm computed test statistics values are compared with the asymptotic critical values (i.e., 1% = 0.22, 5% = 0.15, and 10% = 0.12). (2) *, **represent the significance at 1% and 10% levels, respectively. (3) the analysis was conducted using intercept and time-trend. source: the output of e-views econometric software package (version 8.1). thus, the vecm is employed to evaluate the causality directions in long-run and short-run. also, the ardl approach is utilized to examine long-run and short-run relationships. 6.4. co-integration test the fourth step is principally important to either accept or reject the h0 of no co-integration. however, the results in last subsection confirm that the variables are stationary at i(1), then the full rank (i.e., ∏zt, eq. (3)) is employed to test co-integration among variables. in fact, the ∏ represents the number of eigenvalues in the trace statistics test (λ trace) and maximal statistics test (λ max). table 4 demonstrates the existence of two co-integrating vectors among variables. these results are in line with the results obtained for bahrain using bounds f-statistics test (hamdiet al., 2014). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 152 table 4. co-integration test results for the lngdpt function. no. of c.v λ trace 5% critical values λ max 5% critical values r = 1→ 96.5*→ 69.8 44.9*→ 33.9 r = 2→ 51.6*→ 47.9 29.8*→ 27.6 r = 3 21.8 29.8 16.8 21.1 r = 4 5.00 15.5 4.97 14.3 r = 5 0.03 3.84 0.03 3.84 notes: (1)r is the number of co-integrating vectors (c.v). (2) *represents the existence of co-integrating relationships at the 5% significance level. (3) the 5% critical values were obtained from mackinnon et al.(1999, p. 570). source: the output of e-views econometric software package (version 8.1). 6.5. vecm granger causality analyses the results of the arch test confirm the existence of a homoscedastic co-integration relationship among the variables. thus, the vecm in eq. (4) is employed to determine the causality directions in long-run and short-run. table 5 shows bidirectional granger causality between variables in long-run, as the coefficients of (eett-1)s are in negative signs and significant at the 1% and 5% levels. these results are in line with the findings obtained for india and bahrain (see boutabba, 2014 and hamdiet al., 2014, respectively). table 5. vecm granger causality analyses results. variables sources of causation short-run long-run ∆lngdpt ∆lnect ∆lnfdt ∆lnfdit ∆lnkt ∆lngdpt − 2.77(0.06)* 0.27(0.84) 0.46(0.71) 0.63(0.60) -0.2(0.03)** ∆lnect 1.25(0.31) − 2.29(0.10)* 1.16(0.34) 0.34(0.80) -0.6(0.00)*** ∆lnfdt 0.47(0.70) 0.23(0.88) − 2.11(0.11) 2.31(0.10)* -0.7(0.00)*** ∆lnfdit 1.09(0.37) 1.67(0.19) 0.78(0.52) − 1.66(0.20) -1.6(0.00)*** ∆lnkt 0.76(0.52) 1.79(0.17) 1.07(0.37) 1.08(0.37) − -2.7(0.01)*** note: ***, **, *denote the 1%, 5%, and 10% significance levels, respectively. source: the output of e-views econometric software package (version 8.1). the long-run bidirectional granger causality between ∆lnfdt and ∆lngdpt confirms the existence of supply and leading hypotheses in malaysia. table 5 also shows a unidirectional granger causality running from ∆lnect to ∆lngdpt; ∆lnfdt to ∆lnect; and ∆lnkt to ∆lnfdt. the unidirectional granger causality from ∆lnect to ∆lngdpt is similar to the finding obtained for south korea (menyah & wolde-rufael, 2010). therefore, the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 153 non-neutrality hypothesis is existed in malaysia because the gdp is highly dependent on the ec. 6.6. equilibrium relationships analyses the ardl approach has been implemented to estimate long-run and short-run relationships in eq. (5). table 6 demonstrates that lnect-1, lnfdt-1, lnfdit-1, and lnkt-1 are positively associated with the ∆lngdpt in the long-run.a 1% increases in energy consumption and gross fixed capital formation add in economic growth by 0.98 and 14.2, respectively.a 1% increases in financial development and foreign direct investment inflows improve economic growth by 0.27 and 0.25, respectively. these results are confirmed by the findings obtained for bahrain (hamdiet al., 2014). table 6. equilibrium relationships analyses results. dependent variable = lgdpt variable coefficient standard error probability value panel a: long-run analysis results constant 16.9*** 0.50 0.01 lnect-1 0.98* 0.05 0.10 lnfdt-1 0.27* 0.14 0.10 lnfdit-1 0.25* 0.16 0.10 lnkt-1 14.2*** 0.65 0.01 r2 0.88 adj-r2 0.85 panel b: short-run analysis results (the lag order = 0, 0, 0, 0, 1 based on the aic) ∆lnect 0.19*** 0.07 0.01 ∆lnfdt -0.05** 0.02 0.02 ∆lnfdit 0.01** 0.01 0.05 ∆lnkt 0.16** 0.04 0.02 ∆lnkt-1 -0.10** 0.04 0.03 r2 0.67 adj-r2 0.59 panel c: diagnostic tests: test f-statistics probability value χ2 serial 0.22 0.26 χ2 arch 0.31 0.42 χ2 white 0.66 0.88 χ2 ramsey 0.29 0.31 notes: (1) ***, **,*represent the significance at 1%, 5%, and 10% levels, respectively. (2) χ2 serial is for serial correlation, χ2 arch for autoregressive conditional heteroscedasticity, χ2 white for white heteroscedasticity, and χ2 ramsey for ramsey reset test. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 154 source: the output of micro-fit econometric software package (version 5.1). table 6 also shows that ∆lnect, ∆lnfdit, and ∆lnkt are positively linked with the ∆lngdpt in the short-run. in contrast, the ∆lnfdt and ∆lnkt-1 are negatively associated with the ∆lngdpt. the results of diagnostic tests are detailed in panel c of table 6. these results show that there is no evidence of serial autocorrelation and heteroscedasticity. 6.7. impulse response function test pesaran and shin (1998) argued that the impulse response function (irf) is a generalized forecast of error standard deviation to test the strength and credibility of causal relationship between variables. in fact, the vecm granger causality test has a limitation. this test cannot capture the strength and credibility of causal relation between the variables. to solve this issue, however, we employed the irf test. this test is based on the var model to display the reaction in one variable due to shocks stemming in other variables.fig. 5 indicates a positive response in the gdp due to standard shocks stemming in the ec over the next 10 periods. the contribution of the fd in the gdp is positive but becomes negative after the second year. both of the fdi and k contribute positively in the gdp but their contributions in the gdp become negatively after the next fifth year. response to cholesky one s.d. innovatios (+, -) 2 s.e. figure 5. impulse response function -100 -50 0 50 100 150 200 250 300 1 2 3 4 5 6 7 8 9 10 response of ec to gdp -20 -15 -10 -5 0 5 10 15 20 1 2 3 4 5 6 7 8 9 10 response of fd to gdp -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 1 2 3 4 5 6 7 8 9 10 response of fdi to gdp -4 -2 0 2 4 6 8 1 2 3 4 5 6 7 8 9 10 response of k to gdp asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 155 source: the output of e-views econometric software package (version 8.1). 7. conclusions this paper re-analyses equilibrium relationships and causality directions among economic growth, energy consumption, financial development, foreign direct investment inflows, and gross fixed capital formation in malaysia for the (1971−2013) period. the results of descriptive statistics tests show that variables have stable econometrics properties (i.e., (εt)s ~ n(0, σ2). the h0 of heteroscedasticity among variables has been rejected confirming the usage of vecm. the findings of kpss test demonstrate that variables are stationary at i(1). the trace and maximal eigenvalues statistics tests display the existence of two co-integrating vectors among variables. however, the vecm results show long-run bidirectional granger causality among variables as the coefficients of (eett-1)s are significant and in negative signs. furthermore, a short-run unidirectional granger causality has been detected from energy consumption to economic growth; financial development to energy consumption; gross fixed capital formation to financial development. the ardl findings show that energy consumption, financial development, foreign direct investment inflows, and gross fixed capital formation boost economic growth in long-run. 8. policy implications and further study the mutual long-run bidirectional granger causality among variables suggest the following notes: a) the bidirectional granger causality between economic growth and energy consumption suggest the existence of non-neutrality hypothesis. the malaysian economy is highly dependent on the consumption of energy to achieve the desired economic growth rate, 7%, by 2020 (economic transformation policy report, 2012). b) the bidirectional granger causality between economic growth and financial development implies the supply and leading hypotheses. the endogenous growth theory suggests that financial development is an important driver of economic growth through the allocation of resources, capital accumulation, and technological innovation (bencivenga & bruce, 1991; greenwood & jovanovic, 1990). c) the bidirectional granger causality between economic growth and foreign direct investment inflows indicates that foreign direct investment inflows would spur economic growth of the host country directly through the diffusion of technologies and accumulation of gross fixed capital formation. also, the foreign direct investment inflows would promote economic growth indirectly through labour training and skills acquisition. therefore, the malaysian government ought to continue implementing the national vision and economic transformation policies in order to spur economic growth. the emphasis on the total factor productivity strategy is necessary to boost high value activities in manufacturing, services, and agriculture sectors, which in turn improves the quality and quantity of output. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 156 the collaboration between private and public sectors is mandatory to establish more small and medium projects that ultimately attracts foreign investments and improves the output. the reduction of the dependence on the petroleum products through the usage of biofuel, biodiesel, and solar energy encourage the consumption of energy which is necessary to foster economic growth. however, a further research could be done to re-examine the determinants of economic growth by adding employment levels in economic sectors. references abu-bader, s., & abu-qarn, a.s. 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(2012). financial development and economic growth: recent evidence from china. journal of comparative economics, 40(3), 393-412. https://doi.org/10.1016/j.jce.2012.01.001 zhang, x.p., & cheng, x.m. (2009).energy consumption, carbon emissions, and economic growth in china. ecological economics, 68(10), 2706-2712. https://doi.org/10.1016/j.ecolecon.2009.05.011 microsoft word 10712-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 116 merchant banking operation: a case study of selected merchant banks in bangladesh farzana huda (corresponding author) senior lecturer, department of business administration east west university a/2 jahirul islam city, aftabnagar, dhaka 1212, bangladesh e-mail:farjana_huda@yahoo.com professor dr. tanbir ahmed chowdhury dean, faculty of business and economics east west university a/2 jahirul islam city, aftabnagar, dhaka 1212, bangladesh e-mail: tanbir@ewubd.edu received: april 22, 2016 accepted: february 22, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10712 url: https://doi.org/10.5296/ajfa.v9i1.10712 abstract in bangladesh the establishment of merchant bank added value to the stock market which plays a vital role in the progress of economic development. this study tried to analyze the performance of lanka bangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. seven trend equations have been tested for different activities of the selected merchant banks. it is observed that the selected merchant banks were able to achieve a stable growth of investment in securities, margin loan to clients, brokerage commission, capital gain/loss from securities, portfolio management services, issue management fees, corporate advisory fees and underwriting commission during the period of 2011-2015. among them the trend equation of investment in securities, margin loan to clients, and corporate advisory fees are positive incase of all the selected merchant banks. square of correlation coefficient (r2) has also been tested for all trend equations. the r2 of interest income from merchant bank, portfolio management asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 117 services, settlement and transaction fees and documentation fees, is more than 0.5. it indicates the prospect of merchant banks in bangladesh is bright. keywords: merchant bank, underwriter, brokerage commission asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 118 1. introduction the capital market is an intermediation through which the surplus money of the society can be mobilized and channeled into productive investments with the eventual aim of fostering development of the country's economy. merchant banks contributes greatly for the development of more authenticated and structured capital market and helps to form a more stable economy. it helps to serve the nation by generating production, employment and earning foreign currency as well as improving the foundation of capital market through equity investment participation. the core business of merchant banking comprises management services, portfolio management services and underwriting services. in bangladesh, new entrepreneurs are facing acute shortage of capital. there is not a single investment bank in the country which could provide direct equity funds to the entrepreneurs and in that situation merchant banks play the role of investment banks. merchant banks play major roles in listing securities with stock exchanges. it integrates fund for entrepreneurs in many ways like initial public offering (ipo), repeat public offering (rpo), rights share offer, and direct listing for selling of existing paid-up capital, issue of preference share, convertible or non-convertible in shares. investor confidence is a prerequisite for the growth and development of the securities market. through the regulations and guidelines of sec to merchant bank, issuer can raise their resources at low cost, effectively and easily, ensure a high degree of protection of the interests of the investors and provide a dynamic and competitive market with high standard of professional competence, honesty, integrity and solvency. the regulations promote a fair, efficient, and flexible capital market. 2. literature review animesh (2016) investigated that globalization of indian economy has made the whole economy open, which has move multinational player in era of the financial services. government has now open up the doors of investments especially in the area of banks and insurance which leads to competitive environment for the present players. the study also revealed that in india, at present, a substantial number of merchant bankers are operating under the direct supervision of securities and exchange board of india (sebi) and also evaluated the performance of selected merchant bank of india. nayak (2015) inspected that formal merchant banking activity in india was originated in 1969 with merchant banking division set up by the grindlays bank. he point out that the main service offered at that time to the corporate enterprises by the merchant banks included the management of public issues and some aspects of financial consultancy. the early and mid-seventies witnessed a boom in the growth of merchant banking organizations in the country with various commercial banks, financial institutions and broker’s firms entering in to the field of merchant banking. shreyas (2014) focused on the overall view of merchant banking in past as well as present with respect to india. the study revealed that merchant banking is one of the oldest and specialized financial intermediaries in the primary market and its activity has developed asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 119 rapidly in the indian capital market with more than 1450 merchant bankers and more than 930 has registered with sebi. merchant banking in india has a very bright future in the coming years and has all potential in competing with international countries. biswajit and pranab (2012) examined that merchant banking is a much desired innovative step undertaken by the commercial banks in india. the study focused that the need for merchant banking was strained by the banking commission (1972) and according to the commission, merchant banking institutions are to offer fund based on non-fund based services like syndication of financing, promotion of projects, investment, management and advisory services to medium and small savers and to provide funds and trusts to various types etc. their main function is to guide the preparation, planning, evaluation and execution of projects which are helpful to the growth of industries. anand (2009) explored privatization and globalization has become watch words today. the government of india has adopted the new liberalized economic policy from july 1991 and one of the main agendas of the new policy is banking reforms. in this process of reforms the importance of merchant banking should not be neglected. the whole banking system in india and abroad is bound to change in the second millennium. merchant banking cannot be an exception. sufian and majid (2007) examined the efficiency changes of malaysian non-bank financial institutions (nbfis), during the period of 2000-2004, by applying the non-parametric data envelopment analysis (dea) method which allows to distinguish between three different types of efficiencies such as technical, pure technical and scale efficiency. kohn (1999) examined that the evolution of merchant banks which specialized in remittance and credit and their sources of funds and the fund usage to which they put them in exchange trading, commercial credit, and sovereign lending. the study also discussed the methods the banks used to manage liquidity and risk and the crisis that resulted from sovereign defaults. erik (1999) analyzed the demise of merchant banking by considering the impact of globalization on the historical banking institutions; the pace of innovation and the necessity for securities; the transformation of domestic industry into financial supermarkets; and the reason that uk clearing banks failed in their attempts to become international players. michael (1995) studied that merchant banking within the sane country may cover a wide range of activities in process include a number of a different financial institutions. a merchant banker has been defined under the security and exchange board of india rules 1992 as any person who is engaged in the business of issue management either by making arrangement regarding buying, selling, or subscribing to securities as manger, consultant, advisor or rendering corporate advisory services in relation to such issue management. 3. objectives of the study • to present an overview of merchant bank of bangladesh. • to appraise the activities of merchant bank. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 120 • to appraise the performance of selected merchant banks of bangladesh. • to recommend remedial measures for the development of selected merchant banks of bangladesh. 4. scope and methodology of the study the study has been carried out mostly on the basis of secondary data to evaluate the performance of selected merchant banks of bangladesh. the selected merchant banks are lankabangla investment limited (lbil), prime finance capital management limited(pfcml), idlc investment limited(idlcil) and uttara finance and investment limited(ufil). others relevant data and information has been extracted from stock exchanges, annual reports of different merchant banks of bangladesh, bangladesh securities and exchange commission and web sites of relevant merchant banks of bangladesh etc. the study also incorporates existing literature and relevant articles on the performance of merchant bank. this article analyzed five years data i.e 2011-2015 of selected merchant banks of bangladesh. for evaluating the performance of selected merchant banks of bangladesh data has been analyzed through the various statistical measures like growth percentage, trend equation, square of correlation coefficient etc. 5. performance evaluation of selected merchant banks of bangladesh this section evaluates the activities, development and prospect of selected merchant banks from year 2011 to 2015. in esteem to this analysis various variables i.e. investment in securities, margin loan to clients, brokerage commission, capital gain/loss from securities, portfolio management services, issue management fees, corporate advisory fees and underwriting commission and their growth percentage has been considered to evaluate the performance of selected merchant banks in bangladesh. this study also measured the trend equations and r2 for the different mentioned variables. 5.1 investment in securities table: 1 showed growth pattern of investment in securities of selected merchant banks. it is observed from the table that investment in securities is highest in ufil that is tk. 823.84 million in 2014. the growth percentage of lbil is highest in 2014 is 552.55%. in 2015 growth percentage of lbil and ufil decreased to 36.49% and 17.17%. the lowest growth percentage of investment in securities is in lbil 2011. during 2011 to 2015 every year investment in securities of all selected merchant banks has increased but at a yearly decreasing rate. so it is reflected from the table that the investment in securities of all selected merchant banks has shown up and down trends during the period of 2011-2015. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 121 table 1. investment in securities bdt million company 2011 2012 2013 2014 2015 lbil 151.27 53.44 49.88 325.46 206.70 growth (%) - (64.68) (6.66) 552.55 (36.49) pfcml 292.94 374.34 245.56 273.45 375.13 growth (%) - 27.79 (34.40) 11.35 37.19 idlcil 152.48 36.62 218.95 410.08 437.31 growth (%) - (75.99) 497.97 87.30 6.64 ufil 2.10 0.96 207.57 823.84 682.40 growth (%) - (54.39) 21.55 296.90 (17.17) source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.2 margin loan to clients the growth patterns of margin loan to clients of selected merchant banks of bangladesh are revealed from table: 2. it is depicted from the table that every year margin loan to clients of selected merchant banks have increased from previous year. the growth of margin loan to clients is more than 6% in lbil, pfcml and ufil during 2012 to 2013. the lowest growth observed in pfcml. the growth percentage of margin loan to clients of idlcil in 2014 is very high. margin loan to clients of lbil and pfcml decreased from year 2014 to 2015. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 122 table 2. margin loan to clients bdt million company 2011 2012 2013 2014 2015 lbil 3911.64 4160.44 4646.26 4262.86 3559.65 growth (%) - 6.36 11.68 (8.25) (16.50) pfcml. 2926.98 3231.95 8195.72 7134.51 3616.25 growth (%) - 10.42 153.58 (12.95) (49.31) idlcil 327.307 0 91.145 29.622 33.74 growth (%) - 0 0 32 399.92 13.90 ufil 1333.73 1409.65 1586.81 1761.58 1994.85 growth (%) - 5.69 12.57 11.01 13.24 source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.3 brokerage commission table: 3 showed that during 2011 to 2015 brokerage commission of all selected merchant banks have up and down growth trend. brokerage commission of pfcml increased to tk.7,417,931 in year 2015 from year 2014. brokerage commission of ufil reached in highest peak in year 2014 i.e 18.62%. on the other hand brokerage commission of lbil and idlcil has positive growth rate in year 2014 i.e 41.64% and 24.94%. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 123 table 3. brokerage commission bdt million company 2011 2012 2013 2014 2015 lbil 758.51 475.12 477.10 675.78 560.59 growth (%) - (37.36) 0.42 41.64 17.04 pfcml 0.062 0.44 0.51 0.32 7.42 growth (%) - 602.24 16.23 (37.91) 2249.99 idlcil 206.986 163.53 149.46 186.73 216.03 growth (%) - (20.99) (8.61) 24.94 15.69 ufil 57.16 31.23 23.97 28.44 17.72 growth (%) - (45.37) (23.23) 18.62 (37.70) source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.4 capital gain/ (loss) from sale of securities it is observed from the table: 4 that during 2007 to 2011 capital gain/ (loss) from sale of securities of all selected merchant banks have increased from previous year. in most of the years capital gain/ (loss) from sale of securities have increased by more than 30%. the capital gain/ (loss) from sale of securities of lbil reached to tk. 406.18 million in year 2013. the capital gain/ (loss) from sale of securities of idlcil showed a decreasing trend in year 2012 and 2014. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 124 table 4. capital gain/ (loss) from sale of securities bdt million company name 2011 2012 2013 2014 2015 lbil 9.76 32.98 406.18 38.62 72.47 growth (%) -237.94 1131.72 (90.49) 87.66 pfcml 14.73 59.61 85.36 110.48 18.80 growth (%) -304.77 43.19 29.44 (82.99) idlcil (101.58) 4.74 29.30 (16.86) 0 growth (%) -(104.67) 517.62 (157.53) 0 ufil 61.39 0 10.93 83.26 86.87 growth (%) -0 0 661.96 4.33 source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.5 interest income from merchant bank activities table: 5 showed that during 2011 to 2015 interest income from merchant bank activities of all selected merchant banks have decreased from previous year. interest income from merchant bank activities of pfcml and ufil have increased by more than 20% during 2014 to 2015. interest income from merchant bank activities was peaked in 2011 of lbil. table 5. interest income from merchant bank activities bdt million company 2011 2012 2013 2014 2015 lbil 716.81 624.72 571.36 165.05 109.48 growth (%) - (12.85) (8.54) (71.11) (33.67) pfcml 473.51 328.40 163.29 234.12 286.27 growth (%) - (30.65) (50.28) 43.38 22.27 idlcil 67.64 86.18 103.89 82.03 74.30 growth (%) - 27.40 20.55 (21.04) (9.41) ufil 205.01 207.64 67.85 94.98 106.28 growth (%) - 1.28 (67.32) 39.98 11.89 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 125 source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.6 portfolio management services it is observed from table: 6 that portfolio management services of all selected merchant banks attained high in year 2011 but after that it is decreasing during 2012 to 2015. the highest growth rate observed in idlcil is 25.22% in 2014. the portfolio management services of lbil, pfcml and ufil were not stable during 2012 to 2015. in 2015 portfolio management services increased to 14.94% growth in pfcml from the previous year but portfolio management services has decreased during 2012 and 2014 of most of the companies. table 6. portfolio management services bdt million company 2011 2012 2013 2014 2015 lbil 129.43 68.61 41.75 34.02 2312 growth (%) - (6.99) (39.15) (18.52) (32.05) pfcml 146.69 99.63 84.94 60.68 69.74 growth (%) - (32.08) (14.74) (28.57) 14.94 idlcil 51.44 94.47 60.25 75.45 67.79 growth (%) - 83.64 (36.23) 25.22 (10.15) ufil 33.41 21.48 17.41 17.15 10.94 growth (%) - (35.70) (18.95) (1.50) (36.20) source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.7 settlement and transaction fees table: 7 showed growth pattern of settlement and transaction fees of selected merchant banks of bangladesh. the table reflected that the growth of settlement and transaction fees of all the selected merchant banks were very unstable every year. in lbil settlement and transaction fees growth rate was 37.87% and 10.38% in year 2012 and 2013 but suddenly decreased to 2.60% and 7.09% in year 2014 and 2015. the growth pattern of idlcil and ufil was quite unstable compared to lbil. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 126 table 7. settlement and transaction fees bdt million company name 2011 2012 2013 2014 2015 lbil 25.15 34.66 38.26 37.27 34.62 growth (%) -37.87 10.38 (2.60) (7.09) pfcml 0 0 0 0.003 0 growth (%) -0 0 0 0 idlcil 10.93 34.15 22.08 26.24 21.65 growth (%) -212.38 (35.34) 18.85 (17.49) ufil 23.27 0.12 0.42 0.35 0.24 growth (%) -(99.47) 237.81 (16.02) (29.24) source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.8 documentation fees the growth patterns of documentation fees of selected merchant banks of bangladesh are revealed from table: 8. it is depicted from the table that every year documentation fees of idlcil have increased from previous year and in year 2014 it reached in highest growth rate that is 94.34%. on the other hand documentation fees of lbil were high in 2014 that is tk.0.10 million. the growth pattern of documentation fees of pfcml has experienced a negative trend. the lowest growth observed in ufil in year 2012. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 127 table 8. documentation fees bdt million company 2011 2012 2013 2014 2015 lbil 0.05 0.01 0.006 0.10 0.026 growth (%) - (74.29) (55.56) (1591.67) (74.38) pfcml 0.04 0.04 0.014 0.012 0 growth (%) - (14.29) (61.11) (14.29) 0 idlcil 0.02 0.03 0.026 0.051 0.066 growth (%) - 11.11 6.00 94.34 28.16 ufil 3.04 0.16 0.82 0.10 0.13 growth (%) -(94.57) 398.76 (87.61) 33.29 source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.9 issue management fees table: 9 showed growth pattern of issue management fees of selected merchant banks. it is observed from the table that issue management fees were highest in lbil in year 2015 i.e tk. 23.43 million. the growth percentage of pfcml is highest in year 2014 is 104.01%%. in 2014 growth percentage of lbil, pfcml, and idlcil is 75.93%, 104.01% and 171.43% respectively. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 128 table 9. issue management fees bdt million company 2011 2012 2013 2014 2015 lbil 5.82 8.91 3.86 6.79 23.43 growth (%) - 53.10 (56.68) 75.93 245.02 pfcml 30.36 6.08 1.80 3.67 1.91 growth (%) - (79.95) (70.42) 104.01 (47.87) idlcil 2.00 0.30 3.50 9.50 4.61 growth (%) - (85.00) 1066.67 171.43 (51.47) ufil 0 1.01 0 0 0 growth (%) - 0 0 0 0 source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.10 corporate advisory fees it is observed from the table: 10 that corporate advisory fees of idlcil were high in year 2013 that is 48.56%. in most of the years corporate advisory fees decreased from previous year of all selected merchant banks. on the other hand idlcil experienced the highest corporate advisory fees in year 2015 that is tk.12.12 million. table 10. corporate advisory fees bdt million company name 2011 2012 2013 2014 2015 lbil 0.10 3.56 1.56 4.65 3.27 growth (%) -3460.00 (56.18) 198.08 (29.60) pfcml 0.10 0.52 1.50 1.39 1.25 growth (%) -415.00 191.26 (6.75) (10.63) idlcil 9.95 9.10 13.52 10.45 12.17 growth (%) -(8.53) 48.56 (22.71) 16.46 ufil n/a n/a n/a n/a n/a growth (%) -0 0 0 0 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 129 source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 note: n/a not available 5.11 underwriting commission table: 11 showed growth pattern of underwriting commission of selected merchant banks in bangladesh. the table reflected that growth of underwriting commission of idlcil showed upward sloping every year and it was highest in year 2014 that is tk.2.76 million. underwriting commission of lbil decreased from year 2011 to year 2013 but after that it increased tremendously in year 2014 and year 2015. table 11. underwriting commission bdt million company 2011 2012 2013 2014 2015 lbil 1.53 1.44 0.34 1.28 1.47 growth (%) - (5.62) (76.19) 274.45 14.38 pfcml 12.30 2.62 1.94 1.77 0.49 growth (%) - (78.68) (26.09) (8.49) (71.92) idlcil 0 0.75 0.92 2.76 1.28 growth (%) - 0 23.26 200.00 (53.62) ufil 0.04 0 0 0.30 0 growth (%) - 0 0 0 0 source: author’s calculation using the different issues of annual report of lankabangla investment ltd., prime finance capital management ltd., idlc investment ltd. and uttara finance and investment ltd. note: us $1 = bdt 78 5.12 trend equation of selected merchant banks table: 12 showed the summary of trend equation and r2 of investment in securities of selected merchant banks. it is reflected from the table that trend equation of all the selected merchant banks are positive and goodness of fit of all the equations are high i.e. more than 0.80 except lbil and pfcml. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 130 table 12. trend equation and r2 of investment in securities company yc= a+bx r2 lbil yc=157.35+38.29x 0.28 pfcml yc=312.29+6.35x 0.03 idlcil yc=251.09+94.31x 0.80 ufil yc=343.37+218.35x 0.80 table: 13 showed the summary of trend equation and r2 of margin loan to clients of selected merchant banks. it is imitated from the table that trend equations of all the selected merchant banks are positive except lbil. goodness of fit of idlcil and ufil is high i.e. more than 0.80. table 13. trend equation and r2 of margin loan to clients company yc= a+bx r2 lbil yc=410.82+(60.15)x 0.06 pfcml yc=5021.08+528.11x 0.12 idlcil yc=12.76+9.64x 0.80 ufil yc=1617.33+167.42x 0.97 table-14 shows the summary of trend equation and r2 of brokerage commission of selected merchant banks. it is replicated from the table that trend equations of all the selected merchant banks are positive except ufil. goodness of fit of pfcml and ufil is more than 0.50 except lbil and idlcil. table 14. trend equation and r2 of brokerage commission company yc= a+bx r2 lbil yc=589.42+-19.52x 0.06 pfcml yc=1.75+1.46x 0.53 idlcil yc=184.55+4.13x 0.05 ufil yc=31.70+(8.17)x 0.73 table: 15 shows the summary of trend equation and r2 of capital gain/loss from sale of securities of selected merchant banks it is simulated from the table that trend equations of all the selected banks are positive except idlcil. goodness of fit of all the selected banks is low. table 15. trend equation and r2 of capital gain/loss from sale of securities company yc= a+bx r2 lbil yc=112+13.12x 0.02 pfcml yc=57.80+5.90x 0.05 idlcil yc=(16.88)+18.16x 0.33 ufil yc=48.49+13.42x 0.27 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 131 table: 16 showed the summary of trend equation and r2 of interest income from merchant bank of selected merchant banks in bangladesh. it is reflected from the table that trend equation of all the selected merchant banks are positive and goodness of fit of all the equations are high i.e. more than 0.50 except pfcml and idlcil. table 16. trend equation and r2 of interest income from merchant bank company yc= a+bx r2 lbil yc=437.48+(167.43)x 0.90 pfcml yc=297.12+(46.88)x 0.41 idlcil yc=82.81+0.92x 0.01 ufil yc=136.35+(31.01)x 0.56 table: 17 showed the summary of trend equation and r2 of portfolio management services investment of fund of selected merchant bank. it is replicated from the table that trend equations of all the selected merchant banks are negative except idlcil. goodness of fit of all the selected merchant banks are high i.e. more than 0.80 except idlcil. table 17. trend equation and r2 of portfolio management services company yc= a+bx r2 lbil yc=59.39+(24.72)x 0.84 pfcml yc=92.34+(19.29)x 0.81 idlcil yc=69.88+1.37x 0.02 ufil yc=20.08+(4.93)x 0.87 table: 18 showed the summary of trend equation and r2 of settlement and transaction fees of selected merchant banks. it is observed from the table that except ufil, trend equation of the selected merchant banks is positive. table 18. trend equation and r2 of settlement and transaction fees company yc= a+bx r2 lbil yc=33.99+2.16x 0.43 pfcml yc=0.0006+0.0003x 0.13 idlcil yc=23.02+1,353,589x 0.06 ufil yc=4.88+(4.58)x 0.50 table-19 showed the summary of trend equation and r2 of documentation fees of selected merchant banks in bangladesh. it is revealed from the table that trend equation of lbil. idlcil are positive and goodness of fit of idlcil and pfcml is very high i.e. more than 0.90. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 132 table 19. trend equation and r2 of documentation fees company yc= a+bx r2 lbil yc=0.04+0.003x 0.02 pfcml yc=0.020+(0.010)x 0.94 idlcil yc=0.04+0.011x 0.91 ufil yc=0.85+(0.59)x 0.54 table: 20 showed the summary of trend equation and r2 of issue management fees of selected merchant banks. it is reflected from the table that trend equation of lbil and idlcil is positive and goodness of fit of all the equations are high except ufil. table 20. trend equation and r2 of issue management fees company yc= a+bx r2 lbil yc=9.76+3.31x 0.44 pfcml yc=8.77+(5.92)x 0.59 idlcil yc=3.98+1.44x 0.43 ufil yc=0.20+(0.10)x 0.13 table-21 showed the summary of trend equation and r2 of corporate advisory fees of selected merchant banks. it is exposed from the table that trend equation of all selected merchant banks are positive and goodness of fit of pfcml is high i.e. 0.67. table 21. trend equation and r2 of corporate advisory fees company yc= a+bx r2 lbil yc=2.63+0.07x 0.43 pfcml yc=0.94+0.32x 0.67 idlcil yc=11.04+0.58x 0.26 ufil n/a n/a table-22 showed the summary of trend equation and r2 of underwriting commission of selected merchant banks. it is exposed from the table that trend equations of idlcil and ufil are positive and goodness of fit of pfcml and idlcil is more than 0.50. table 22. trend equation and r2 of underwriting commission company yc= a+bx lbil yc=1.22+(0.03)x 0.01 pfcml yc=3.82+(2.44)x 0.65 idlcil yc=1.14+0.46x 0.50 ufil yc=0.07+0.02x 0.07 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 133 7. findings and conclusion the concept of merchant banking is not much familiar among mass people but in developed countries it becomes a prime mover of economic development. it contributes greatly for the development of more authenticated and structured capital market and helps to form a more stable economy. every year many potential companies are funded and discovered by merchant banks. their specialized investment techniques help many potential companies turn into business conglomerate within a decade from small sole proprietorships. in a more developed market, institutional investors such as merchant banks, commercial banks, insurance companies, are major traders of securities. merchant banks are considered as the original banking institutes which have been started during the middle ages. with the evolution of economic terms and practices, merchant banking services were differentiated from ordinary banks which provide services to common people as well as organizations, but merchant banking serves a number of needs and requirements of organizations and businesses. the fact that, merchant banks are the wholesale banks specifies the use of these banks for some important purposes. today, merchant banks are regarded as the banks of corporate house and organizations. the selected merchant banks create employment opportunities for the country. it has been observed that investment in securities, brokerage commission, underwriting commission, margin loan to clients, corporate advisory services, issue management fees, portfolio management fees, documentation fees, settlement and transaction fees of the selected merchant banks have increased from the previous year during 2011-2015. it is also reflected from the analysis that the margin loan to client, capital gain from securities of the selected merchant banks is relatively high during 2011-2015. it indicates the profitability of all the selected merchant banks is quite satisfactory. the study revealed that every year brokerage commission, settlement and transaction fees, issue management fees, corporate advisory services of the selected merchant banks increased at a decreasing trend which indicated the selected merchant banks should focus more and employ efficient manpower to this sector. seven trend equations have been tested for different activities of the merchant banks. among them the trend value of investment in securities and corporate advisory fees is positive of all selected merchant banks. square of correlation coefficient (r2) has also been tested for all trend equations. the r2 of documentation fees and portfolio management services is more than 0.5. it indicates the prospect of merchant banks in bangladesh is bright. the growth percentage of portfolio management services, settlement and transaction fees of all the selected merchant banks were very low and fluctuating. in order to increase activities and income these merchant banks need to increase their service income. from the series of our analysis it is reflected that every year corporate advisory services increases in a very unstable way and interest income merchant banks activities decrease in an alarming rate which should be highly focused and resolved by the sleeted merchant banks in bangladesh. it has been identified that although almost every year’s investment in securities of selected asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 134 merchant banks have increased from the previous year, but the growth rate of brokerage commission and underwriting commission is not satisfactory. so it should try to increase the growth rate. the authors are quite optimistic that if the given suggestions of this paper are implemented then the merchant banks sector will be able to overcome its present problems and may contribute in the rapid development of the economy of bangladesh. reference bauer, p.w., berger, a.n., ferrier, g.d., & humphrey, d.b. (1998). consistency conditions for regulatory analysis of financial institutions: a comparison of frontier efficiency methods. journal of economics and business 50(2), 85-114. https://doi.org/10.1016/s0148-6195(97)00072-6 berger, a.n., & d.b. humphrey. (1997). efficiency of financial institutions: international survey and directions for future research. european journal of operational research, 98(2). https://doi.org/10.1016/s0377-2217(96)00342-6 dyson, r.g., allen ,r., camanho, a.s., podinovski, v.v., sarrico, c.s., & shale, e.a. (2001). pitfalls and protocols in dea. european journal of operational research, 132, 245-259. https://doi.org/10.1016/s0377-2217(00)00149-1 idlc investment ltd. (2011-2015). annual report. keyurkumar, d., & m, nayak.(2015). does public sector merchant banks require pills to survive? indian journal of applied research, 5(1). lanka bangla investment ltd. (2011-2015). annual report. mcallister, p.h., & mcmanus, d.a. (1993). resolving the scale efficiencies puzzle in banking. journal of banking and finance, 17(2-3), 389-405. https://doi.org/10.1016/0378-4266(93)90039-g marshall, john f., & m. e. ellis. (1994). investment banking and brokerage. probus publishing. prime finance capital management ltd. (2011-2015). annual report. r., dutch., a. charnes, & w.w. cooper. (1984). some models for estimating technical and scale inefficiencies in data envelopment analysis. journal of management science, 30(9), 1078-1092. https://doi.org/10.1287/mnsc.30.9.1078 sealey, c., & j.t. lindley. (1977). inputs, outputs and a theory of production and cost at depository financial institutions. journal of finance, 32(4), 1251-1266. https://doi.org/10.1111/j.1540-6261.1977.tb03324.x shreyas b. s. (2014). merchant banking past and present: indian scenario. the international journal of business & management, 2(10). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 135 singh, a. (2009) merchant banking factors determining its shape in india. indian journal of finance, 3(5). sufian, f., zulkhibri, m., & majid, a. (2007). the efficiency of merchant banks and finance companies in an emerging market: determinants and policy issues. business, finance & economics in emerging economies, 2(1). uttara finance and investment ltd. (2011-2015). annual report. microsoft word 10343-new-final asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 105 a logical process about the chaos in forex financial market marco mele university of international studies, rome e-mail: marco.mele@unint.eu received: nov. 20, 2016 accepted: february 24, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10343 url: https://doi.org/10.5296/ajfa.v9i1.10343 abstract foreign exchange market has been subject of studies and discussions for many years. they were created modern theories and models to understand and predict the evolution of the price of money, and embarked on new discussions and new frontiers of study. in this paper we test the hypothesis of non-linearity and behavior chaotic the latest developments of the markets, to arrive at a solid and unambiguous conclusion on this type of dynamic systems analyzed. in particular, we introduce mathematical concepts and to study the properties of chaotic dynamics and non-linear in nature. it will delve into topics not therefore always present in economics courses in order to base the tests carried out on solid considerations from the point of view of formal mathematical. it will be followed, finally, a scientific rigor during the course of the analysis in order to give an interpretation of the results of logistic type can lead to scientific considerations different from econometric modeling. key words: financial markets, chaos, forex market, logic model, non-linearity asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 106 1. introduction and literature review since the end of the bretton woods exchange market has always been characterized by a high degree of volatility and uncertainty that makes this system different from that of fixed exchange rates. the unpredictability of future changes over the years has generated regular interventions by the authorities that have allowed the evolution of the economic literature. therefore, several models are created to understand and predict the evolution of the price of the currency. among these we can cite the literature on the model of target zones (krugman, 1991), those of rational expectations with stochastic rules of interventions by the monetary authorities (hsieh, 1989), as well as the many interpretations offered in the literature about the non-linearity of the exchange rates (diebol, 1988; chinn, 1989; meese e rose,1991; rogoff, 1999; mele, 2015). other studies, mainly concerned with the description of the dynamics of exchange rates and the forecast in the short term, they have developed in the univariate models. these works make use of the latest contributions of econometrics time series are non-linear and theoretical foundation in the principle of market efficiency. the basic idea is that if the exchange rate markets are characterized by a certain degree of efficiency, it is reasonable to assume that most of the information is contained in the most recent returns and is thus not necessary to include among the explanatory variables fundamentals cheap. among the most frequently used models (g) arch) and setar are those who have so far had the most successful in the description of the dynamics of many economic and financial variables, because they contain a clear economic interpretation (kräger-kugler, 1993; peel-speight, 1994; chappell et al., 1996). in the work of krager and kugler (1993) are estimated for descriptive purposes but also forecasting models auto-regressive threshold for changes in the exchange rate against the u.s. dollar, the french franc, the italian lira, japanese yen, german mark and franc. the authors identify three different regimes, both the first and the third regime have an estimated standard deviation higher than the intermediate regime, this would be due to the interventions of the central bank in response to strong appreciation or depreciation. the analysis of krager and kugler is, in fact, the theoretical foundation of rational expectations monetary model with stochastic rules of interventions by the central bank proposed by hsieh (1989); an autoregressive model with three regimes could approximate, therefore, represents the solution of this model. according to the authors, the model of hsieh provides a more adequate representation of the system of managed floating exchange rate than the model of target zones: the central bank intervention depends in the first model to be large variations in the exchange rate, while in the second by the approach the level of the exchange rate to certain thresholds that define the permitted fluctuation bands. in order to assess the relative importance of nonlinearity in the mean and variance of the one, for the same currencies are also proposed garch models; the conclusions at which they reach the authors indicate that neither the models nor the threshold autoregressive garch models are able to adequately describe the non-linearity present in the series of exchange rates. despite numerous attempts to model the exchange rates in the financial markets using econometric techniques and probabilistic mathematics evolved to take account of nonlinearity and asymmetry, are still relatively limited applications performance prediction beyond the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 107 usual direct comparisons with the simple random process walk, or in some studies with simulated data based on monte carlo experiments (clements e smith, 1997, 1999). in the literature, four basic reasons have been advanced concerning the non-linear models, and because not provide more accurate forecasts than simple linear models even when the assumption of linearity is significantly rejected for the estimation period (diebold e nason, 1990): (i) non-linearity affecting moments higher than the average and, therefore, does not prove useful to improve the point forecasts; (ii) non-linearity present during the estimation period are due to structural changes or outliers that cannot be exploited to improve the out-of-sample forecasts; (iii) non-linearities in average even though they are a feature of the data generating process are not relevant enough to offer most of the gains in terms of forecast accuracy; (iv) non-linearity present are described by the wrong type of non-linear model. the forecasting performance of non-linear models is, however, explained by clements and smith (1998) and dacco and satchell (1999) with emphasis on the inadequacy of the measurement approach; based on a monte carlo study, the first argue that the evaluation of the predictions of the density function allows us to understand better the gains that can be obtained from nonlinear models, gains that are systematically masked if the comparison with linear models is conducted only in terms of msfe. 2. financial markets and non-linearity starting in ‘90s numerous tests have been developed to verify the non-linearity is to detect the characteristics of the presence of an effect of non-linearity: the financial chaos in a series. in this context, the s & p500 has been recognized in multiple sources and by multiple authors as having non-linear characteristics and therefore chaotic. for example, according to peters the american market seems to be driven by a minimum of three variables, since the strange attractor of the system has size about 2.3, and has a positive lyapunov exponent: there exists therefore a chaotic dynamics. as the american market, even the british, japanese, and german have been studied and seem to have similar characteristics. this has given new insights for scholars to look for similar trends in related markets, but always on the basis of data in the very short term. in fact in the securities markets as in the foreign exchange markets is assumed a price based on fundamentals. these are not always the primary cause of changes in the price of the financial asset, and various models have been proposed to try to understand the dynamic processes hidden behind the price changes. the fact that these markets are non-linear shows that many of the movements of the indexes in question are endogenous. this does not mean that external changes have no influence on the data, but rather that these are not the only source of variability in the data. the theory of non-linearity could offer an interesting description of the financial market if it proves that it is realistic to assume non-linear responses of the operators to new information and new conditions of the market. the assumption underlying the traditional efficient market theory of fame rests on the assumption that investors rationally proceed to buy when the price is low and sell when it is high; the equilibrium price is therefore the best summary of expectations and lends itself to be a good indicator for the allocation of funds to the economy. everything is seemingly credible, but it is not consistent with the perception of the operators themselves. some recent results of "behavioral finance" that support the risk-averse behavior persists when the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 108 investor is earning, when it is in the area of loss is transformed into a subject frequently inclined to risk for anxiety to recover; it follows that the attitudes of investors, individual and professional, are different if you are in the area of profit or loss in the area and, therefore, the history of the investment even its graphical trend is an element that has its own importance. in particular, investments in the area of loss tend to not be mobilized into action because you want to keep the ability to remove them; so there is a psychological effect of blocking wallets in losing investments due to the reluctance to state-first of all to themselves-the error and savvy investors respond to this threat by defining from the outset with the rules of stop-loss. in addition also the investments in the area of profit are held for an excessive period; the hypothetical gains further, that would not be captured in the event of immediate sale, felt like losses and force the investor to recognize that they have not realized the gain set as a target. therefore, investors savvy respond to this threat immediately with the rules of take profit. in an ideal world, where players are rational in the strong form and the availability of information is ensured, most of the transactions in the markets is accounted for; in a situation of this kind, in fact, the exchanges would be originated by the progress of the life cycles of investors, from changes in preferences and allocations of funds (no trade problem). in fact, it is clear that the level of trade is much higher than we should believe on the basis of the above reasons. in fact, the level of the treated volume is therefore a good justification of the hypothesis of incomplete rationality of operators and of the phenomena of psychological dependence. the analysis of the problem under a profile empirical testing on historical data have ample space on a variety of magazines, mainly at international level. building a reality of the available results is not easy, since in many cases the results are conflicting and are based on methodologies do not fully “mature” and, for this reason did not adequately powerful. in any case, the attached table may suggest to the reader some interpretations of these tests, in order to develop a opinion about it. the modeling of the financial market can be done in different ways methodology: first, for it can be assumed that the relevant economic relations are linear and that to them is accompanied by a certain level of noise, ie stochastic elements; alternatively, one may think that the reports are non-linear in the absence of stochastic elements; alternatively you can use, too, but a non-linear modeling with significant stochastic elements. it 'clear that the winning line of interpretation may perhaps be the third, and probably not the second can be found in empirical data. 3. a computational model for chaos in traditional approach the complex systems are treated analytically, ie reducing the linear combination of simpler elements. in this situation a classic linear relationship is that of hook’s law: y = ax + b where (y) is the length, and (x) is the force applied that adjusts the spring force. when the elasticity disappears, stretching the very springy, the graph ceases to be linear. the system is no longer linear, and shows in certain circumstances a sharp change in comportment. in nature, many systems are linear or approximated to linearity, and thanks to the fourier transform for which every mathematical function can be periodic represented by a series of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 109 pure sine waves, it has come to the modeling of many natural phenomena. now, introducing the non-linearity, we can say that the linear functions are behave in such a way that: g(ax+by) = ag(x) + bg(y) in cases where this is not true equality, and here comes the non-linearity, everything becomes mathematically more difficult. for example, if g(x)=0 and g(y) = 0 and for every a and b is not worth g(ax + by)=0, therefore the solution must be sought methods special, like non-linear models. non-linear systems exhibit complex effects that are not deductible with linear methods, especially characteristic of dynamic systems. a system is said dynamic system when it expresses the variability of a state, ie a point in a vector space, in time: dx/dt = f(x,t) where f: w ∩ rn → rn is differentiable. in this case solution of the system will be the set of trajectories as a function of the initial conditions. a dynamic system is completely defined by a space phases or states, whose coordinates describe him at all times, and by a rule that specifies the future performance of all variables of state. dynamical systems are deterministic if there is only one result for each state, stochastic if it there are different with a certain probability distribution as the classic launch a coin. the phase space is the collection of all possible states of a system dynamic. it can be done, as in the case of the currency in which we have two states, either infinity if the variables are real numbers. for example, a swap may be a dynamic system with discrete time, discrete geometric space, and discrete state space s(i,;j), where i represents the spatial coordinates j the time, while the rule of fluctuation will be: s (i,j+1) = f(s). mathematically, we can say that a dynamical system is described by a value problem initial; the trajectory in the phase space traced by a solution of a initial value problem is the trajectory of the dynamical system. in this situation we can define trajectory constant a constant solution x (t) = x (0) of dx/dt = f(x,t), ie a vector x (0) for to which each component of the right part of dx/dt = f(x,t) is zero. a constant trajectory is said to be stable if the following conditions are met: there must be a positive number ԑ such that every trajectory that starts inside ԑ of x(0), must approach asymptotically to x (0); for every positive number ԑ, there must be a positive number ϭ(ԑ), this that, a trajectory is guaranteed to stay within ԑ of x (0) simply requiring that starts before ϭ(ԑ) of x (0); the set of all points that can be the initial states of trajectories that approach asymptotically to a stable trajectory is called the region of attraction of the stable trajectory. in summary, if some trajectories converge at some point, the set of states initials of these trajectories generated is said attraction region of the point. a region of attraction is ultimately a set of points in the state space of finite diameter such that each trajectory enters and does not go out. 4. logic of chaos for the forex’ analysis: empirical analysis data analysis about a time series on the forex market in a situation non-linearity needs to identify the chaotic characteristics, namely the presence of an underlying dynamic of chaotic origin. it is necessary, therefore, to analyze the behavior of deterministic and ergodicity. from the empirical point of view it is obviously difficult to verify whether the dynamics underlying the data is deterministic or not, except that you cannot use the equation that already plays them perfectly. the sensitivity to initial conditions can help once you have found the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 110 dynamics to verify the lyapunov exponents and among them observe whether the “major” is positive or not. ergodicity provides, however, a point of view entirely unique, objective and more conservative (ie, tending to accept the null hypothesis of the absence of chaos) to check whether the data have the characteristics necessary to continue the analysis of chaotic or less. in this situation, we will try to determine and estimate a chaotic situation in forex’ market through a new approach: the use of fuzzy logic. in a system of fuzzy logic applied to the paradox of the liar you can start from the premise that the same claim to always tell the fake is already a half-truth. we use the following statement: “this statement is false”. denote by now this statement with s, and s its truth value in two-valued logic of truth will be equal to s=1-s. this is because if s is true, then its negation, not-s is false, and its truth value is 0. then, we can say that 1-0=1 and 1-1=0. therefore, if the truth value of s is s, then the truth value of not-s is 1-s. hence the paradox: if s = 0, then s tells us that s = 1-0 = 1; and if s=1, then s tells us that s = 1-1 = 0. in both cases there is a contradiction. in fuzzy logic we can avoid the paradox by giving the value: s=0,5. the use of a dynamic logic obliges us to correct each time the estimate the truth value of the utterance in question. the value assigned before s = 0.5 is the only one that does not lead to an oscillation: if he had said, for example, that s is true at 30%, we would have found a continuous oscillation of s = 0.3, correct then s = 0.7, p = 0.3 with correct again, and so on with an infinite sequence of truth values ranging between 0.3 and 0.7. to see how fuzzy logic can be useful for us to observe and control chaotic systems through logic in the forex market take another example. consider the following statement: euro fluctuates more than the swiss franc. we denote this statement with k. we affirm that the truth value of k is k = 0.4. now consider this second statement g: k is 100% true. if g were 100% true, then k would also be 100% true, but we determined that k is not 100% true. the degree of truth of g, which relates k, depends actual truth value of g and the truth value assigned to k by g. the more our assessment will be inaccurate, false becomes more my statement. we know that k = 0.4, but according to the g value is 1. the difference in this case is equal to 0.6, then g is false to the extent of 60%, that is 40% true. if we said that k is true 50% difference would have been only 10%, then g would be true to 90%. logically, if we had said that k is true of 40%, we would have been right at 100%. in summary, if we assume that a sentence s with truth value s and a statement j that leads us to estimate the added value of truth of s, the value of truth of j is: j = 1 – (s – s') [1]. this mathematical representation will be our estimation formula. we can then formulate the statement of chaotic liar. this statement is as true as it is estimated false. if its truth value is ( c) then it tells us to estimate a truth value equal to 1-c. according to the formula [1] its truth value is: 1 – [c (1 c)] = 1 – [1 2c]. thus we find ourselves in front of a dynamic process: c = 1 – [1 2c]. now we choose two values starting at random, for example, c = 0.129741 and c = 0.13001. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 111 we will discover that successive values are chaotic. if we substitute the value of starting with: c = 1 – [0,999999 2c]. in this case we can observe the famous butterfly effect. of course we have to avoid that the calculation is stable with rounding to 0 or 1. finally, we start the idea of calculating the truth value of a set of sentences and selfleads to a dynamic process in which you can apply the techniques of chaos theory. 5. conclusion mechanisms that regulate the economy are complex and intricate. contractors, manufacturers, politicians and small investors are protagonists in good and bad markets. markets affected by macroeconomic events that no one is able to change , but you can learn to understand the economic logic that can help us to avoid making mistakes. there are several economic theories, in recent years the so-called econometric models are the most used. today, the economies of the countries are completely independent of each other to the point that the economic and political development of a country can influence, in a greater or lesser extent, the economy of another country or political-economic. this means that the economic economy is not longer able to control the effects of the choices made at the macro level from one country to another. the index shows that more than any other balance and economic imbalance between an economy and the other is the value of the currency of a country or economic area. theoretically there should be no special significance to the fact of knowing that the euro or other currency, we have a certain value, this happens until it expresses the value of a currency relating it to another as happens in forex. in the context of the foreign exchange market, which is named in finance forex, certainty about the knowledge of the exchange rate between two currencies is very low. this is because currencies are traded every second in the financial markets and all markets perfectly reflect the price of the effective exchange rate. in truth, the presence of non-regulatory markets, trading made by traders every second, the type of exchange rate (spot, forward, etc. ...) generates in trader uncertainty in the face of exchange rate volatility. and yet, in this situation of uncertainty, the system that drives these markets is still a dynamic and linear. in linear systems, a small change in the initial state of a physical system, chemical, biological, or economic causes a change correspondingly small in its final state, for example, hitting slightly stronger a billiard ball, it will go farther. in contrast, are non-linear situations of a system in which small differences in the initial conditions produce predictable differences in subsequent behavior. a system can also behave chaotically in some cases and not so chaotic in others. in this situation it is impossible to predict the behavior of a chaotic system will have after a fairly short period of time also. in fact, to calculate the future behavior of the system, even if described by a very simple equation, you must enter the values of the initial conditions. moreover, in the case of a complex system is not linear, given the large sensitivity of the system to agents who ask, a small error in the measurement of the initial conditions, or a change apparently irrelevant data entered, and of course also their subsequent rounding during the calculation, grows exponentially with time, producing a radical change of results. this means that the data relating to the initial conditions of the exchange rates in the forex market should be measured with an accuracy theoretically infinite, but this is virtually asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 112 impossible. therefore in this work we tried to propose a simplified model of reproduction of reality, ie an abstraction which considers only the main features of what is the real object of study by applying a logic process. however, such a model, although it may seem limited, as it does not fully reproduces the reality, let’s look at the most important aspects of a problem. at the end of the entire process of fuzzy logic can produce self-organization in a new situation, which in turn can play another chaotic moment and so on. this will remain unpredictable, though it is known that takes place in a strict and deterministic. at the end of the entire process of fuzzy logic can produce self-organization in a new situation, which in turn can play another chaotic moment and so on. this will remain unpredictable, though it is known that takes place in a strict and deterministic. it could be concluded that, at least, the use of a logic process avoids getting into chaos deterministic results only fruit of algorithms or methodologies econometric complex and away, in reality, from the original economic problem. references chappell, d., padmore, j., mistry, p., & ellis, c. (1996). a threshold model for the french franc/deutschemark exchange rate. journal of forecasting, 15, 155-64. https://doi.org/10.1002/(sici)1099-131x(199604)15:3<155::aid-for616>3.0.co;2-z chinn, m. (1989). can shifts in money demand explain the problems with exchange rate equations?. manuscript, university of california at berkeley. clements, m. p., & smith, j.p. (1997). the performance of alternative forecasting methods for setar model. international journal of forecasting, 13(4), 463-75. https://doi.org/10.1016/s0169-2070(97)00017-4 clements, m. p., & smith, j.p. (1999). a monte carlo study of the forecasting performance of empirical setar models, journal of applied econometrics, 14(2), 123-41. https://doi.org/10.1002/(sici)1099-1255(199903/04)14:2<123::aid-jae493>3.0.co;2-k dacco, r., & satchell, s. (1999). why do regime-switching models forecast so badly?. journal of forecasting, 18, 1-16. https://doi.org/10.1002/(sici)1099-131x(199901)18:1<1::aid-for685>3.0.co;2-b diebold, f.x., & nason, j.a. (1990). nonparametric exchange rate prediction?. journal of international economics, 28, 315-332. https://doi.org/10.1016/0022-1996(90)90006-8 hsieh, da. (1989). a nonlinear stochastic rational expectations model of exchange rates. unpublished manuscript, fuque school of business, duke university. kräger, h, & kugler, p. (1993). non-linearities in foreign exchange markets: a different perspective. journal of international money and finance, 12, 195-208. https://doi.org/10.1016/0261-5606(93)90024-6 krugman, p. (1991). target zones and exchange rate dynamics. the quarterly journal of economics, 106(39), 669-682. https://doi.org/10.2307/2937922 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 113 meese, r., & rose, a. (1991). an empirical assessment of nonlinearities in models of exchange rate determination. review of economic studies, 58, 603–619. https://doi.org/10.2307/2298014 mele, m. (2015). singapore’ exchange rate regime: a garch approach. journal of economic cooperation and development, 36, 25-42. peel, d.a., & spieght, a.e. (1994). testing for non-linear dependence in inter-war exchange rates. weltwirtschaftliches archiv, 130, 391-417. https://doi.org/10.1007/bf02707716 rogoff, k. (1999). monetary models of dollar/yen/euro nominal exchange rates: dead or undead?. the economic journal, 109, f655-f659. https://doi.org/10.1111/1468-0297.00477 microsoft word 12449-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 399 the impact of working capital management on firm value: evidence from a frontier market a.n. hingurala arachchi department of finance, faculty of management studies and commerce university of sri jayewardenepura wasantha perera department of finance, faculty of management studies and commerce university of sri jayewardenepura ratnam vijayakumaran (corresponding author) department of financial management, faculty of management studies and commerce university of jaffna received: oct. 7, 2017 accepted: nov. 24, 2017 published: december 24, 2017 doi:10.5296/ajfa.v9i2.12449 url: https://doi.org/10.5296/ajfa.v9i2.12449 abstract corporate finance literature and finance practitioners have the notion that the efficient working capital management (wcm) affects firm value. this study investigates the value effect of working capital management, using a sample of 44 listed companies on the colombo stock exchange (cse) over the period 2011-2015. the cse is currently recognized as a high growth frontier market (fm) in the world. the efficiency of wcm is measured using the cash conversion cycle (ccc) and its components while firm value is measured by the tobin q ratio. the firm size, leverage and sales growth are used as the control variables. using panel data regression methodology (the pooled ols and fixed effects regressions), the study finds that ccc is inversely related to tobin q, suggesting that managers can create value for their shareholders by efficiently managing investment in working capital of their firms. keywords: working capital management, firm value, tobin q, cash conversion cycle, panel data, sri lanka. jel classification: d22, g31, g32 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 400 1. introduction working capital management (wcm) has an important role in attaining firm’s ultimate goal of shareholder wealth maximization since it affects both profitability and liquidity of firms. unlike the relationship between long term financing and firm value, the relationship between wcm and firm value has not received much attention in the empirical research, though poor working capital management has been identified as the main reason for the failure of most firms (smith, 1978). this may occur due to the fact that working capital decisions are made frequently, and they are routine in nature and are reversible over time (pratap singh & kumar, 2014). most researchers failed to identify the significant contribution of wcm to attain the ultimate goal of shareholder value maximization (baker, kumar, colombage & singh, 2017). yet, it has gained much attention as a field of research after the recent global financial crisis which occurred in 2007-2009. working capital can be identified as the balance between current assets and current liabilities (pass & pike, 1984).wcm decisions involve choice of amount and composition of current asset as well as the financing of these assets. working capital allows firms to adapt to the dynamic business conditions; therefore, proper management of working capital becomes essential as it has direct impact on financial health and operational success of firm. the company’s liquidity position is especially important in today’s globalized and highly competitive business environment, as well as in times of economic and financial hardships such as recent financial crises characterized by decreasing cash inflows and deteriorating market conditions. maintaining high level of current assets may increase firm’s liquidity but at the expense of firm’s profitability. efficient working capital decisions must address this mismatch between asset and liability and utilize working capital in a way that it maximizes the shareholder wealth (padachi, 2006).shin and soenen (1998) suggest that the managers can create value for their shareholders by efficiently managing working capital of their firms. this implies that proper management of working capital would have an impact not only on accounting performance of firm but also on the market performance of firm. therefore, managers should consider a trade-off between efficiency and risk when making working capital decisions. although the notion that efficiency of wcm affects firm value seems to enjoy wide acceptance, the empirical evidence on the value effect of working capital investment is scarce (baños-caballero, garcía-teruel, &martínez-solano, 2014). therefore, this study focuses on the value effect of wcm from a frontier market perspective, namely sri lanka. to achieve this objective, the study consider tobin q ratio as a proxy for firm value and the cash conversion cycle (ccc), the most commonly used measure of working capital management efficiency. firms in emerging market are comparatively smaller in size. further, the sri lankan nascent capital market is characterized by high level of asymmetric information and agency problems like other asian capital markets compared with the markets of developed countries and thus the flow of additional capital is rather restricted for the firms in sri lanka (perera, & wickremasinghe, 2010; eswaran, 2015; vijayakumaran, 2015; dixon, guariglia, and vijayakumaran, 2015). therefore, it becomes vitally important for the firms in sri lanka to manage working capital efficiently and release the fund that may be unnecessarily tied up asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 401 in working capital to fund the long term projects and the expansion of their operations. using a panel of 44 companies listed in cse for the period of 2011-2015, the study finds that ccc is negatively associated with tobin q, suggesting that managers can increase their firm value by reducing the cash conversion cycle to a reasonable minimum. in other word, market provides higher valuation to the companies with the efficient working capital management. the rest of the paper is organised as follows. the next section reviews related literature and provides our testable hypothesis. the methodology used in this study is discussed in section 3. in section 4, we discuss the sample and data and describe descriptive statistics. section 5presents the empirical findings of the study and finally, section 5 provides the summary and conclusion. 2. prior literature and hypothesis development lewellen, mcconnel, and scott (1980) demonstrate that under perfect financial markets, trade credit decisions are independent of firm value. however, in reality capital markets are imperfect due to factors like asymmetric information and agency problems and, consequently, several papers show that trade credit and inventories influence firm value (see, for instance, bao & bao, 2004; emery, 1984). maness and zietlow (2004) develop two models of value creation that incorporate effective short-term financial management activities. similarly, schiff and lieber (1974), sartoris and hill (1983), and kim and chung (1990) model the effects of working capital management practices on firm value; yet, they do not provide empirical evidence on whether firms actually do maximize their value by their working capital management choices. although the notion that efficiency of wcm affects firm value seems to enjoy wide acceptance, the empirical evidence on the value effect of working capital investment is scarce (baños-caballeroet al., 2014). most of the previous empirical research has focused on the working capital determinants (e.g., garcia-teruel & solano, 2010;anagnostopoulou, 2012), policy practices (e.g., afza & nazir, 2007;pandey, gupta &perera, 1997; perera, & wickremasinghe, 2010; bei & wijewardena, 2012) and relationship between wcm and accounting performance of companies (e.g., deloof 2003;padachi 2006). majority of the empirical studies confirm a negative relationship between wcm measures and accounting profitability measures (e.g., deloof, 2003;lazaridis and tryfonidis,2006; garcia-teruel and martinez solano, 2007;jayarathne, 2014). there are considerable amount of research studies that investigate relationship between cash holdings and firm value. for instance, autukaite and molay (2011) find that shareholders of french companies undervalue cash holdings and net working capital since excess working capital means money tied up in current assets that does not generate a return; instead, an additional euro invested in net operating working capital than usual level decreases firm value. this can be considered as indirect conformation of the agency cost of free cash flow (jenson 1986). further, they find that shareholders of a highly levered firm tend to give less value to cash holdings and working capital since its returns are used to pay for debt holders. pinkowitzet al. (2006), lee and lee (2009) find negative association between cash holdings and firm value while bates et al.(2009), chen (2009) suggest that financial market value liquidity indicating a positive relationship between cash holding and firm value in their asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 402 studies. pinkowitz and williamson (2007) report that value of cash holdings differs on several factors and firms with high growth opportunities and operating risk tend to have high value to their cash holdings. the impact of efficiency of working capital management on market performance of the firms is overlooked. in fact, only a handful of studies investigate how the efficiency of wcm affects firm value. for example, studying a sample of 172 listed malaysia companies for the period of 20032007, mohamad and saad (2010) provide empirical evidence on the effect of efficiency of wcmon market value and profitability. their results show that there is a significant negative association between working capital management efficiency variables and firm’s market value and profitability. these results indicate the importance of efficient working capital management to increase firm’s market value and profitability and that this fact should be considered when formulating company’s strategic and operational planning in order to operate it effectively and efficiently. similarly, focusing on a sample of 75 manufacturing companies listed on istanbul stock exchange market for the period of 2002-2009, vural et al. (2012) examine the impact of wcm on both internal and external performance of the firm using tobin q as a proxy for market value and gross operating profit as a proxy for profitability. their results show that there is a significant relationship between ccc, accounts receivable period and profitability while tobin q shows insignificant relationship with working capital of the firms. mona al-mwalla (2012) focus on a sample of 57 listed companies on amman stock exchange for the period of 2001-2009 to examine the impact of working capital management policies on the firm’s profitability and value. they conclude that a conservative policy regarding wcm shows a positive effect on the firm’s profitability and value and vice versa. they also found that firm’s size, growth and gdp shows a positive effect on the profitability and value. abuzayed (2012) use a sample of 52 non-financial firms of amman stock market over the period 2000-2008 to examine the effect of wcm on firm performance. she uses two measures, namely accounting measure (profitability) and market based measure (tobin q)to measure firm performance and find that efficient wcm improves both firms’ market value and profitability. more recently, wasiuzzaman (2015) uses 192 malaysian listed companies over the period 1999-2008 to examine the relationship between working capital management efficiency and firm value and the influence of financing constraints on this relationship. her results show that improvements in working capital efficiency through reduction in working capital investments leads to higher firm value and this relationship is more pronounced in the financially constrained firms suggesting that firm value significantly increases by efficient management of working capital in financially constrained firms. although recent research has shown increasing interest on the relationship between wcm and firm value, only a study by bandara & weerakoon banda (2010) investigates the impact of working capital practices on firm value which is measured by market value added and economic value added in the context of sri lanka. focusing a sample of 72 companies listed on cse, they document that there is significant negative relationship between conservative wcm practices and market value added and moderate working capital practices yield higher market value added. furthermore, their results show that economic value added decreases asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 403 with aggressive working capital policy and firms following moderate working capital practices tend to improve both economic and market value added. in sum, existing literature regarding impact of working capital management on firm value is very limited and particularly, in the context of sri lanka, no one has focused on the relationship between the efficiency of wcm and tobin q which is a commonly used proxy for firm value. therefore, our study focuses on the linkage between the efficiency of wcm and firm value from a frontiers market, namely sri lanka. 2.2 hypothesis in this study, we use the cash conversion cycle as a comprehensive measure of working capital management efficiency. since the cash conversion cycle is an inverse proxy for the wcm efficiency, we would expect a negative relationship between ccc and firm value. h1: there is a negative relationship between the cash conversion cycle and firm value. 3. model specification and estimation methodology purpose of this study is to examine the relationship between wcm efficiency and firm value of listed companies in sri lankan context. this section describes our regression model, definition of variables, and estimation methodology. 3.1 model specification in order to estimate the impact of wcm efficiency on firm value, we estimate the following econometric model: tqit = β0+ β1cccit+ β2sizeit+β3levit+ β4sgrit+vt, +vj+ εit (1) where i indexes firms, t years. table 1 provides definitions for all variables used in this paper. the error term in equation (1) is made up of three components: vt, a time-specific effect, which we control for by including time dummies capturing business cycle effects;vj, an industry-specific effect, which we take into account by including industry dummies; and finally,εit is an idiosyncratic component. in addition, we estimate equation (1) by replacing ccc with components of ccc, namely number of days accounts receivable, number of days inventory and number of days accounts payable in isolation. in addition, we estimate following model with a firm specific fixed effects but it does not include industry effects. tqit = β0+ β1cccit+ β2sizeit+β3levit+ β4sgrit+vi + vt, + εit (2) the error term in equation (2) is made up of three components: vi is a firm-specific effect; vt, a time-specific effect and finally, εit is an idiosyncratic component. we also estimate equation (2) by replacing ccc with components of ccc, namely number of days accounts receivable, number of days inventory and number of days accounts payable in isolation. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 404 3.1.1 dependent variable in this study we use tobin’s q to measure firm value. tobin’s q is the ratio of the market value of a company’s assets (which is measured by the market value of its outstanding shares and book value of debt) divided by the book value of the company’s assets. 3.1.2 wcm efficiency variables the main independent variable is the cash conversion cycle (denoted by ccc) which is used as a comprehensive measure to capture the effect of firms’ working capital efficiency on corporate performance (deloof, 2003). the ccc links the time needed by firms to collect cash from customers with the time necessary in order to repay suppliers into one single measure (deloof, 2003). the cash conversion cycle is as the sum of number of days accounts receivable plus number of days inventory minus number of days accounts payable. the components of ccc are calculated as follows. number of day’s accounts receivable is calculated as a ratio of accounts receivable times 365 divided by sales. number of day’s inventories is calculated as a ratio of inventories times 365 divided by cost of sales. number of days accounts payable is accounts payable times 365 divided by cost of sales. we expect a negative relationship between number of day’s accounts receivable (a measure of accounts receivable policy) and number of day’s inventories and performance whereas a positive relationship between number of days accounts payable and performance. 3.1.3 control variables in line with previous studies, in addition our wcm variables, size (the natural logarithm of sales), sales growth ([this year’s sales previous year’s sales]/previous year’s sales), and the ratio of total debt to total assets (debt/total assets) are included as control variables in the regressions to control for a set of firm-specific observable characteristics that are likely to be correlated with firms’ performance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 405 table 1. definitions of variables variables acronyms measurement expected relationship with firm value dependent variables tobin’s q tq (market value of equity+book value of liabilities)/ book value of total assets wcm variables cash conversion cycle ccc aggregation of inventory, receivables and payables days accounts receivable days ard (accounts receivables/sales)*365 inventory days invd (inventories/ cost of sales)*365 accounts payables days apd (accounts payables/ cost of sales)*365 + control variables firm size size the natural logarithm of sales + leverage lev total non-current liabilities divided by total assets salesgrowth sgr difference between sales of end of year t and end of year t-1. + 3.3 estimation methodology in this study, pooled ordinary least square (ols) and fixed effects regression are used to test the hypotheses. a pooled ols (ordinary least square) does not take into account the unobserved firm heterogeneity. in random effect model it is presumed that regression model intercept varies across entities, and this variation is assumed to be random and uncorrelated with the independent variables included in the model while in the fixed effects model assumes that there is correlation between error term and predictor variable. therefore, fixed effect model removes the effect of time invariant characteristics from the model. we use the hausman specification test to decide whether fixed effect method (fem) or random effect method (rem) is econometrically a more appropriate approach to our data. highly significant hausman chi-square test statistics reveal systematic differences in coefficients between both models, which indicate highly significant firm-specific effects and thus showing that fem provides better specification of our model relative to rem. 4. sample and descriptive statistics this section discusses sample and descriptive statistics of the dependent and independent variables used in this study. 4.1 data set and sample the data used in this study was collected from annual reports of companies which are published in the cse website. initially 88 firms were included in the sample and only 46 companies were selected based on the data availability for all variables for the period of 2010-2015. to reduce the influence of potential outliers, we exclude observations in the one asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 406 percent tails of each of the regression variables. final sample consist of 44 listed firms in cse which is classified under manufacturing (20), health care (3), food and beverage (11), motors (5) and chemicals and pharmaceuticals (5). finally, after the screening process and computation of the variables, we end up with a panel of 194 firm-year observations for the period of 2011-2015 for our empirical analysis. 4.2 summary statistics table 2. summary statistics obs mean std. dev. median min max tobin’s q (tq) 194 1.92 1.84 1.40 0.24 13.62 cash conversion cycle (ccc) 194 65.77 53.72 44.67 2.31 222.17 accounts receivable days (apd) 194 52.00 34.19 34.02 6.39 160.53 inventory days (invd) 194 42.36 38.06 20.99 1.00 223.85 accounts payables days (ard) 194 28.58 28.11 50.61 1.15 242.55 firm size (size) (rs. billion) 194 4.39 5.57 2.61 0.061 32.902 leverage (lev) 194 0.45 0.156 0.40 0.080 0.820 sales growth (sgr) 194 0.125 0.248 0.10 -0.454 1.957 notes: see the table 1 for definitions of the variables. table 2 presents descriptive statistics for the variables used in the analysis for our pooled sample. the pooled mean (median) tobin’s q (tq) is 1.92(1.40). the average (median) cash conversion cycle is 65.77 days (44.67 days). firms receive payment from their credit sales after on average of 52 days with a median of 34.02 days. it takes on average 42.36 days (median is 33.8 days) to sell inventory. firms pay their suppliers after 28.58 days on average, (median is 50.61 days). turning to the control variables, average size of the sample firms measured by sales is about 4.39 billion rupees (2.61 billion rupees). the debt ratio has a mean and median value of 45% (40%), suggesting that about 45% of the sample firms’ assets are financed by debt capital. the average (median) sales growth, measured as changes in sales, is 12.5% (10%). the large disparity between mean and median values for the components of the ccc illustrates the dramatic variation in turnover ratios among the sample firms. 5. empirical results this section provides discussion of empirical results obtained from correlation and regression analysis. 5.1 correlation analysis table 3 provides the pearson correlation of coefficients for the pairs of variables of this study. it can be observed that ccc has a significant negative relationship with tobin q (tq)which is consistent with the literature that increase in time lag in cash conversion will negatively affect to the market performance of the firm. inefficient payment collection from debtors would decrease the market value of firm which is evident by significant negative correlation between accounts receivables and tq. as investors in financial markets are concerned about asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 407 credit sales and late collection of debt payments since this indicates the inefficient liquidity management of firms. similarly, as expected inventory days (invd) also exhibit a negative and significant relationship with tq. surprisingly, number of days accounts payable is not significantly associated with tq. looking at the control variables, leverage depicts a significant negative relationship with tq reflecting higher amount of debt would cause an adverse influence on market value of the firm since higher leverage increases the financial risk of the firm. furthermore, large firms have higher market value, exhibiting a positive significant correlation with tq. finally, table 3 suggests that given that the observed correlation coefficients are relatively low, multicollinearity should not be a serious problem in our study. table 3. pearson correlation matrix tq ccc ard invd apd size lev sgr tq 1.00 ccc -0.17** 1.00 ard -0.27*** 0.70*** 1.00 invd -0.02* 0.66*** 0.21*** 1.00 apd 0.03 -0.17** 0.17** 0.35*** 1.00 size 0.64*** -0.12* -0.21*** -0.03 -0.05 1.00 lev -0.12* -0.08 -0.17** 0.09 0.06 0.26*** 1.00 sgr 0.18 0.02 -0.05 0.13* 0.08 0.05 0.06 1.00 notes: asterisks denote statistical significance at the 1% (***), 5% (**), or 10% (*) level, respectively. see the table 1 for definitions of the variables. 5.2multivariate analysis 5.2.1 pooled ols regression results table 4 presents estimation results of pooled ols regressions [see eq. (1)]. column 1 reports results of our regression model (1) where the dependent variable namely, tobin’s q (tq) is regressed on ccc and a set of control variables including firm size, leverage, sales growth and a set of year dummies and industry dummies. in addition, columns 2-4 of table 4 report results of the effect of components of ccc, namely number of days accounts receivable, number of days inventory and number of days accounts payable on firm value, respectively. firstly, the coefficient of ccc is negative and statistically significant at the 5% level, supporting our hypothesis (h1). since the ccc is an inverse proxy for the efficiency of wcm, this result provides strong evidence to the predicted negative relationship between ccc and firm value (or equivalently, a positive relation between the efficiency of wcm and firm value). this implies that the shorter the time lag between the expenditure for the purchases of raw materials and the collection of sales of finished goods and the smaller the investment in working capital, the higher will be the firm value. this finding is consistent with the findings of mohamad and saad (2010), abuzayed (2012), wasiuzzaman (2015). as can be observed in columns 2-4 of the table 4, the coefficient associated with the accounts asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 408 receivable (a measure of accounts receivable policy) (ard) is negative and significant at the 1 % level. similarly, the coefficient on days inventories on hand ((invd) is negative and statistically significant at the 5 % level. the coefficient on the number of days accounts payable (apd) is positive and statistically significant at the 10 % level. table 4. pooled ols: the relationship between wcm and tobin q regression models 1 2 3 4 constant -7.198*** (-3.140) -6.317*** (-2.770) -7.622*** (-3.30) -7.636*** (-3.330) ccc -.0.038** (-2.250) apd -0.012*** (-0.280) inv -0.005** (-2.213) ard 0.002* (1.805) size 0.406*** (3.780) 0.386*** (0.3.640) 0.412*** (3.800) 0.414*** (3.830) lev -0.635** (-1.991) -0.443** (-2.151) -0.506** (-2.050) -0.524* (-0.1.89) sgr 0.086 (0.170) 0.166 (0.633) 0.220 (0.823) 0.097 (0.896) industry dummies yes yes yes yes year dummies yes yes yes yes adj r2 0.187 0.235 0.198 0.199 f-statistic 4.02 4.68 3.76 3.79 prob(f-statistic) 0.000 0.000 0.000 0.000 notes: asterisks denote statistical significance at the 1% (***), 5% (**), or 10% (*) level, respectively. t-statistics which are based on cluster robust slandered error (clustered at the firm level)are reported in the parentheses. see the table 1 for definitions of the variables. the results of regressions (1) to (4) suggest that managers can increase firm value by improving the efficiency of working capital management (i.e., by reducing the number of days accounts receivable and inventories and by delaying the payment to the creditors). turning to the control variables, we observe that the estimated coefficient on firm size (size) is positive and highly significant at the 1% level in all the models, suggesting that large firms enjoy economies of scale and are thus positively associated with firm value (tq). this finding is consistent with the finding of jahfer (2015). the coefficient associated with leverage is negative and statistically significant at the 5 % level, suggesting that the increase in financial risk associated with the leverage is not appealing to investors. finally, sales asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 409 growth (sgr) is not significantly associated with firm performance at conventional levels. this finding is consistent with the finding of jahfer (2015). 5.2.2 fixed effects regression results table 5 presents estimation results of fixed effects regressions [see eq. (2)]. column 1 reports results of our regression model (2) where the dependent variable namely, tobin’s q (tq) is regressed on ccc and a set of control variables including firm size, leverage, sales growth and a set of year dummies. in addition, columns 2-4 of the table 5 report results of the effect of components of ccc, namely number of days accounts receivable, number of days inventory and number of days accounts payable on firm value, respectively. table 5. fixed effects regression: the relationship between wcm and tobin q regression model 1 2 3 4 constant -4.635 (-0.990) -4.292* (-1.901) -4.159 (-1.210) -4.208** (-1.781) ccc -0.001** (-2.210) ard -0.004** (-1.992) inv -0.003* (-1.948) apd 0.001 (0.928) size 0.236*** (2.700) 0.396** (2.230) 0.237*** (2.670) 0.249*** (2.69) lev -0.410** (-1.980) -0.431** (-1.998) -0.462* (-1.894) -0.398** (-2.100) sgr 0.105 (0.853) 0.500 (1.090) 0.086 (0.971) 0.099 (0.851) firm fixed effects yes yes yes yes year dummies yes yes yes yes adj r2 0.153 0.149 0.1486 0.149 f-statistic 7.92 8.01 7.82 7.89 prob(f-statistic) 0.000 0.000 0.000 0.000 notes: asterisks denote statistical significance at the 1% (***), 5% (**), or 10% (*) level, respectively. t-statistics which are based on cluster robust slandered error (clustered at the firm level)are reported in the parentheses. see the table 1 for definitions of the variables. first, the coefficient of ccc is negative and statistically significant at the 5% level, supporting our hypothesis (h1). this result once again provides strong evidence to the predicted negative relationship between ccc and firm value. as can be observed in columns 2-4 of the table 5, the coefficient associated with the accounts receivable (ard) is negative and significant at the 5 % level. similarly, the coefficient on days inventories on hand ((invd) is negative and statistically significant at the 5 % level. the coefficient on the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 410 number of days accounts payable (apd) is positive but not statistically significant at the conventional levels. these results indicate that excess cash tiedupin inventories and accounts receivables is perceived as working capital management inefficiencies by the market causing a reduction in firm value. as for the control variables, they show qualitatively similar results to the ones observed in the table 4. overall, the results of regressions (1) to (4) suggest that managers can increase firm value by improving the efficiency of working capital management by reducing the number of days accounts receivable and inventories. the number of days accounts payable (apd) does not affect firm value. 6. conclusions investments in working capital involve a trade-off between profitability and liquidity and thus the efficient working capital management affects firm value. although a large number of previous empirical studies report that firm profitability is influenced by the efficient wcm, only a handful of studies examine the effect of wcm on firm value. therefore, this study focuses on the value effect of wcm efficiency. using a panel of 44 companies listed in cse for the period of 2011-2015, we find that the cash conversion cycle is negatively associated with tobin q, suggesting that efficient working capital management leads to an increase in the market value of the firms and thus helps to increase shareholder wealth. in other words, financial market will penalize the firms that fail to manage their working capital properly. our results also suggest that managers can increase the shareholder wealth by reducing the number of days in accounts receivable and inventories. references abuzayed, b. 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(2015). capital structure decisions agency conflict and corporate performance: evidence from sri lankan listed manufacturing companies, international journal of accounting and business finance, 1(1), 1-14. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 413 vural, g. (2012). affects of working capital management on firm’s performance : evidence from turkey, 2(4), 488-495. wasiuzzaman, s. (2015). working capital and firm value in an emerging market. international journal of managerial finance, 11(1), 60-79. https://doi.org/10.1108/ijmf-01-2013-0016 note: authors have equally contributed to this research paper and their names are in alphabetical order. microsoft word 9354-34280-1-sp-writer3-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 46 the dynamics application of accounting standards, and its importance in the measurement with fair value & disclosure dr. yaser s. al frijat accounting department / business faculty, tafila technical university p. o. box 179, tafila 66110, jordan e-mail: yaser_frejat@yahoo.com received: april 21, 2016 accepted: august 4, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.9354 url: http://dx.doi.org/10.5296/ajfa.v8i2.9354 abstract this study aimed to shed light on the dynamics application of accounting standards (ias/ifrs) in measurement with fair value and disclosure in companies listed on amman stock exchange (ase). the study of population consisted of financial managers amounting (220) manager. a questionnaire was designed and used as a major instrument to collect information. descriptive study showed number of findings including: the standards application contribute to creation of uniform accounting standards, creation active and semi-active markets, preparing financial statements with integrated quality characteristics, and it reduce financial crises occurrence and economic risks. in addition, it helps in attracting investments, and it enables local companies to invest in financial markets. in addition, it ensures sufficient disclosure to meet different needs of the beneficiary parties of information, and contributes to improving transparency level that reflects true economic value of organization. the study provided number of recommendations including, emphasizing the (ias/ifrs) application importance in companies listed on (ase). qualifying professional accounting staff, and governmental agencies that have to support through attracting foreign investment issue laws that encourage investment. joint coordination among arab countries at asia continent level to create an active market in which to fair value can be evaluated. keywords: international accounting standards (ias), international financial reporting standards (ifrs), fair value, amman stock exchange (ase). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 47 1. introduction the crisis and global economic problems that world countries suffered from, and the failure of many world's major companies was due to difficulty of accessing lot of information that confirms accuracy of measurement and disclosure processes and the comparison of many financial operations, obliged those countries to get rid of those financial harassment by adoption and implementation of (ias/ifrs) which support and provide the required financial information to solve these. moving to international standards is deemed as new revolution in financial information measurement, and their contribution in providing disclosure requirements, in order to provide trust to its users (abdul hamid, 2010). adopting these standards is a causal mechanism to improve information environment (horton et al, 2008), this was experience in recent years in terms a large-scale spread in use and adopting of (ias/ifrs) in developing countries in particular (zehri, & abdelbaki, 2013). according to procházka, (2011) it becomes the measurement by fair value, the most prevalent in the preparation of financial statements over the past years. shamkuts (2010) indicated that preparation of financial statements in accordance to fair value will achieve benefits for investors to estimate investments size.alhaj ahmad & aladwan, (2015) confirmed the importance of measurement and disclosure of fair value because they both are the related value that help different users in taking their decisions, by providing them with required accounting information. the importance of (ias/ifrs) application stems through the main role it will perform as an instrument of accounting tools regulation that contribute to providing accounting information that helps in taking many important decisions regarding organization work. abdullah, (1992) indicated that accounting standards (ias) are necessary for organization existing and continuity due to many reasons, including: comparison between available alternatives for the organization. hossain, et al., (2008) believe that adoption of (ifrs) will lead to increase in transparency, comparability, and quality of financial reports. the dynamic concept in applying the accounting standards(ias/ifrs)must take all fluctuations, events, changes, and globalization which global active markets faced, in order to put the accurate measurement for fair value, as the result for this the companies can prepare their financial statements clearly. the standards concept investigates uniformity subject in the systems, processors and accounting topics, through different dimensions that are prevailing between them, this means make it as one thing symmetrical, identical, regular and internationally compatible (talha, 2000). it also referred to as general decision rules derived from objectives and accounting concepts for the purposes of developing accounting methods (belkaoui, 1981). beke (2011) study showed that international accounting standards play an important role in enhancing managerial decisions within the organization, and increase liquidity level in the market, and reduce investment costs for investors. although improvements witnessed by financial reports environment in the last periods in light of (ias/ifrs)adoption, and its importance in fair value measurement, but developing asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 48 jordanian public companies environment is deemed narrow and limited faced by many challenges, represented by lack of active markets that have larger role in accurate measurement and disclosed of fair value, and the lack of qualified accounting personnel to deal with changes in fair value that should be given attention and follow up its use and implementation. alhaj ahmad &aladwan, (2015) indicated much criticism that were directed to fair value accounting application in developing countries due to non-availability of active markets for many assets and liabilities, which make companies financial departments use self-evaluation, which is less important for fair value, as well as costs and benefits upon production of information related to fair value measurement, for small businesses in particular. siam (2005) also indicated that there are barriers that limit adoption of international accounting standards and financial reporting commitment, where variation in laws, regulations and economic conditions are the most important. barth, m. e. (2006) criticized that many of unrealized revenue that arises as a result of fair value measurement, causing much volatility in stock prices, and market conditions that cannot be predicted. in addition to the above mentioned, and as a result of bankruptcy that happened to most major international companies, the (ias/ifrs) become important to investors through their claim for transparent financial reports that allow them to identify the most important risks and advantages within their investments (barlev b ., &haddoal j, r., 2003, in cited al azemi, 2012). this means that lack of standards and standardized accounting rules is an obstacle for capital globalization, so it limits the ability to make decisions based on knowledge of all alternatives that are available to the users (mosbah, 2012). measurement operations of financial assets and events are considered in accordance with concept of historical cost as one of the most common and widely used by majority of organizations upon preparing financial statements. since the characteristic of historical cost principal on the date of transaction that the reciprocity monetary value is the main source for measuring that value (gomaa, &khanfar, 2007). the process of measurement in accordance with the concept of historical cost has no doubt when occurred, since the accuracy in measurement varies and differs after original acquisition (al-najjar, 2013). this means that historical cost makes company’s financial position statements less realistic (paul, 2013). proceeding from the dynamic nature of economic conditions which constantly change currencies purchase power, several shortcoming of historical cost have been highlighted, so the use and application fair value concept was adopted (alqashi, 2008). dvořáková, (2011) considered fair value as most issued discussed in recent decades, which took part of wide interest especially in light of rapprochement process between (ifrs) andgenerallyaccepted accounting principles (gaap) in the united states related to international standard 13, because the goal is to unify the approach to determine the fair value. it is worth to note that by applying fair value accounting and disclosure contributes in achieving many objectives, including: the most realistic measurement of the profits under different economic fluctuations, and the most relevance for future cash flows, and contribution in improving companies operational performance (chenouf, &zaoui, 2009). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 49 elfaki, &elzain, (2015) confirmed that fair value has the ability to carry out fair comparison between organizations for several time periods, or with similar companies. alsolaux & leuz, (2009) and ryan (2008) confirmed that fair value accounting is not a cause of global financial crisis. with emphasizing that accounting disclosure concept has been associated with emergence of public shareholding companies, and its commitment to publish its financial statements on a regular basis in order to benefit relevant parties when making economic decisions (abdelmalek, 2015). wadi, (2006) defined disclosure that it is a tool that concerned with interpretation financial statements and reports, it is an ethical entrance to accounting and auditing professions. the most important reasons for major companies collapse such as (enron &worldcom) are due to disclosure level which was not duly perceptible, and that disclosure level has an impact on attracting capitals, that lead to benefit national economy (tawfeeq& abu nassar, 2014). aryan, (2016) indicated that jordanian auditor prefers fair value accounting for property, machines and equipment instead of historical cost in providing useful information. so the serious attention process by applying (ias/ifrs) contributes in creation of uniform accounting language that converges between accounting environment in jordan, and considers it as part of accounting and economic environment in the world, in order to provide ease of communication between them, and have efficiency in measuring with fair value and disclosure. ifrs 13"fair value measurement" was issued in 2011, and applies from beginning on january 1, 2013, "ifrs 13 is the result of a joint project conducted by the iasb together with fasb, which has led to the same definition of fair value as well as an alignment of measurement and disclosure requirements to fas 157", (palea,2014). ifrs 13 defines fair value "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date", and that the classification hierarchy of the inputs used in valuation techniques into three levels:(level 1)take a quoted prices for identical assets or liabilities in active markets, (level 2) take a quoted prices for identical assets or liabilities in inactive markets, (level 3)inputs are unavailable for the measurement of asset or liability. (http://www.iasplus.com/en/standards/ifrs/ifrs13). also the international accounting standards board (iasb) identified three stages to the fair value measurement: firstly, market approach "uses market prices relevant involving identical or comparable (similar) assets, liabilities", secondly, cost approach" reflects the amount that would be required currently to replace the service capacity of an asset". thirdly, income approach "converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts".(http://www.iasplus.com/en/standards/ifrs/ifrs13). & (rock & mihaela, 2009).benchmark showed that the application of the fair value of non-financial assets (non-financial assets) takes into account the potential for market participants of better asset utilization and economic benefit (abu-nassar & humidat, 2013). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 50 many standard’s discussed related to fair value accounting, "ias (16) property, plant and equipment, ias(26) accounting and reporting by retirement, ias(32) financial instruments, ias(36) impairment of assets, ias(38) intangible assets, ifrs(9) financial instruments, and ifrs(13) fair value measurement". research problem is due the obstacles that jordanian public companies listed on the amman stock exchange (ase) are facing in applying accounting standards and international financial reporting environment (ias/ifrs) for fair value measurement and disclosure, which have no serious attention, in addition to accompanied un realistic financial indicators that do not serve many parties to meet their needs within the world economic realty. based on these findings, the current study’s primary research problem is as follows: primary question for study, what is the importance of (ias/ifrs) dynamics application in the measurement with fair value and disclosure, in the companies listed on (ase)?. the study importance stems from the serious concern by applying (ias/ifrs), in companies listed on (ase), and its relation to fair value measurement and disclosure, in the light of increasing trend towards fair value usage as well as important developments which capital markets are witnessing in global investment and openness operations on the financial markets. and the goals of the study are as follows: firstly, identify the (ias/ifrs) and application importance in the companies listed on (ase). secondly, to identify the fair value measurement and disclosure, ifrs 13, and the hierarchy of the inputs used in valuation techniques for fair value. thirdly, identify on the relationship between the importance of (ias/ifrs) dynamics application, and the fair value accounting, in terms of measurement and disclosure. the paper is organized as follows: section 2 describes the literature review, whereas section 3methodology and study hypothses. section 4data analysis & discussion, and section 5conclousion. 2. literature review many studies discussed topics related to dynamics application of accounting standards and fair value accounting, as follows: joshi and ramadhan (2002) study aimed to verify the extent to which bahraini companies applied (ias/ifrs). the study found that the majority of surveyed companies are applying those standards, and are considered highly appropriate.galina & robert (2003) study investigated the role of (ias) in attracting foreign direct investment, and the study showed that lack of credibility in company’s financial statements has negative impact on attracting foreign capital due to non-application of (ias). siam, (2005) study aimed to investigate confirmation degree of accounting profession responsible commitment to adopt international accounting standards in jordan. the study concluded that there is considerable support those standards adoption commitment in jordan, and that there are barriers that reduce adopting commitment such as variation in laws, regulations and economic conditions. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 51 carmona, et al., (2008) study discussed the reason behind the wide acceptance of (ias/ifrs), and the study concluded that the reason was due to the role of standards in supporting accounting profession, and harmony process among all world countries.bkihl, (2008) study showed the importance of international accounting standards application in algeria under the partnership with european union. the study concluded that international accounting standards have a key role in the provision of european investments suitable investment environment in algeria, and enables companies algerian to enter european markets. alqashi and al abadi (2009) study aimed to find the effects that would result by application (ias/ifrs) in jordan to attract foreign investment. the study concluded that (ias/ifrs) application commitment by listed companies in the financial market contributes in attracting and increasing foreign financial investments. christensen & nikolaev, (2013) study aimed to identify the circumstances in which application of fair value accounting is used as an alternative to historical cost, and the study concluded that application of fair value accounting on non-current intangible assets such as equipment and buildings are with a lesser degree of efficiency for decision-makers if are not compared with historical cost.al-najjar, (2013) study discussed the effect of fair value accounting application on reliability and relevance. the study concluded that application of fair value increases reliability and relevance of information listed in the financial statements. fayaz, barzegari, & haneghah (2013) study showed the relationship between disclosure quality and organization value of a sample of iranian companies for the period 2002 to 2011,and the study concluded that disclosure quality level has an important effect on organization value .enahoro & jayeoba, (2013) study concluded that today's global economy requires increase in use of fair value measurement and disclosure (ifrs 13) more than the historical cost, because they offer the more relevance information, consistency, and comparable to users. zehri, & abdelbaki, (2013) study focused on the importance of adopting (ias/ifrs) in developing countries. the study concluded that the adoption of these standards has an impact on economic growth, and education level. kamel, & ani, (2014), study focused on the important role of adoption (ifrs) directed to fair value in the financial crisis, and the study concluded that fair value accounting provides new information that reflect future economic facts, and allow users of financial statements to make investment decisions related to their activities. ionaşcu, et al., (2014), confirmed in their study that international financial reporting standards adoption in developing countries contribute in increasing transparency level, and value of financial information importance. puspitasari, & yurisandi(2015), study discussed the importance of adopting international financial reporting standards on financial reporting quality. the study showed that adoption of international financial reporting standards has an increase and impact on qualitative characteristics of financial information, as a result of using fair value. abdelmalek (2015) study highlighted on element of financial statements measurement and disclosure in light of the financial accounting system, with emphasis on measurement and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 52 disclosure importance and their contribution to give a clear picture of organization performance which expresses the status and the reality of its activities. since it was found that there is no economic environment that applies disclosure requirements, which means the existence of shortcomings in financial information credibility. 3. methodology and study hypotheses the study population includes all jordanian public companies within (ase) no. (235)(http://www.ase.com.jo/ar/company_guide/information), except banks sector no.(15).sample will be chosen randomly, and its number (141), in accordance the following equation.(awad, 2000) n = n / (1 + ( n * 0.0025))n = 220 / (1 + (220 * 0.0025)) = 141 118 questionnaires were returned, which represent 84 % of the total sample. this study uses a descriptive analysis. in order to produce the study conclusion, the following approaches were used: firstly, secondary sources, the study referenced the most important modern studies, as well as previous arab and international studies and articles, and information published in books, periodicals, and conference proceedings of relevance to this study’s subject area, in addition to internet sources. secondly, primary source, the study questionnaire that was designed and distributed to sample. the study’s null primary and sub null research hypothesis are as follows: ho;"the dynamic application of accounting standards doesn't constitute a high importance in the fair value measurement and disclosure, in the companies within amman stock exchange". based on the null primary hypothesis above, it can be formulated sub-null hypothesis are as follows: ho1;"the dynamic application of accounting standards doesn't constitute high importance in the measurement with fair value in the companies within amman stock exchange". ho2;"the dynamic application of accounting standards doesn't constitute high importance in the disclosure of measurement with fair value, in the companies within amman stock exchange". 4. data analysis & discussion 4.1 demographic properties most of the respondents have experience in the financial management, which considered helpful to rely on them for access to accuracy in study result. with respect to academic qualifications the result shows respondents who had bachelor degree representing (64.4%) of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 53 total respondents, and the majority of the respondents belongs to the accounting specialization representing (75.4%) of total respondents. 4.2 reliability test this study used cronbach’s alpha coefficient to evaluate the internal consistency of the survey questions. table 1. cronbach's alpha coefficient for the questionnaire items reliability coefficient alpha cronbach's no. of items hypotheses .797 15 h1 .669 10 h2 .862 25 total as indicated in the above table, the questionnaire achieved a high reliability based on the questionnaire responses. so all values are accepted since they are over 60%. 4.3 descriptive statistics here are the results of descriptive statistics for sample’s responses of study as follows: table 2. descriptive statistics of hypothesis hypotheses mean std. deviation std. error mean h 3.8583 .57657 .05308 h1 3.8266 .59972 .05521 h2 3.9059 .61551 .05666 descriptive analysis of the results showed that in the above table, that the mean of questions collectively is ho (3.8583), ho1(3.8266) &ho2(3.9059), which is higher than average measurement tool, which (3).this shows a clear consistency and agreement between the answers of the study sample. 4.4 hypothses testing table 3 reports the one-sample t-testis used to test main (null) hypothesis: ho, the following table summarizes these results: table 3. one-sample ttest (h) t df sig. (2tailed) mean difference 95% confidence interval of the difference lower upper 16.171 117 .000 .85831 .7532 .9634 statistically significant at (α≤0.05) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 54 as indicated in the above table 3, one sample (t) test is used to test above hypothesis and it is found that t value calculated equal (16.171) is significant at (α ≤ 0.05) level, so that we reject ho, and accept the alternative hypothesis h1. this means;"the dynamic application of accounting standards constitutes high importance in the fair value measurement and disclosure in the companies within amman stock exchange". table 4 reports the one-sample t-testis used to test first sub null hypothesis ho1,the following table summarizes these results: table 4. one-sample t-test (h1) t df sig. (2-tailed) mean difference 95% confidence interval of the difference lower upper 14.971 117 .000 .82655 .7172 .9359 statistically significant at (α≤0.05) as indicated in the above table 4, one sample (t) test is used to test above hypothesis and it is found that t value calculated equal (14.971) is significant at (α ≤ 0.05) level, so that we reject ho1,and accept the alternative hypothesish11. this means;"the dynamic application of accounting standards constitutes high importance in the measurement with fair value in the companies within amman stock exchange". table 5 reports the one-sample t-testis used to test second sub null hypothesis ho2, the following table summarizes these results: table 5. one-sample t-test (h2) t df sig. (2-tailed) mean difference 95% confidence interval of the difference lower upper 15.988 117 .000 .90593 .7937 1.0181 statistically significant at (α≤0.05) as indicated in the above table 5,one sample (t) test is used to test above hypothesis and it is found that t value calculated equal (15.988) is significant at (α ≤ 0.05) level, so that we reject ho2, and accept the alternative hypothesis h12. this means;"the dynamic application of accounting standards constitutes high importance in the disclosure of measurement with fair value in the companies within amman stock exchange". 5. conclusion the study population includes all jordanian corporations within (ase) no. (235), except banks sector no.(15). it was found that application of (ias/ifrs) has high importance in fair value measurement and disclosure, due to multiple objectives it achieves. this was confirmed by most previous studies, such as joshi and ramadhan (2002), siam, (2005), kamel, & ani, (2014), abdelmalek, z., (2015), zehri, & abdelbaki, (2013), ionaşcu, m., ionaşcu, i., săcărin, m., and minu, m. (2014), such objectives are as follows: firstly, it contributes in asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 55 creatingthe uniform accounting standards, establishment of active and semi-active markets, and financial statements preparation with integrated quality characteristics. this is consistent with al-najjar, (2013), puspitasari, &yurisandi (2015), and kamel, & ani, (2014) studies. secondly, it develops accounting, cultural awareness and supports accounting profession, this is consistent with carmona, salvador & marco trombetta (2008), zehri, & abdelbaki, (2013) studies. thirdly, it contributes in attracting foreign investments to jordan, reduces difficulties faced by investors, providing them with appropriate investment opportunities, and it gives confidence to customers within the financial markets in light of the financial crisis in particular. this is consistent with alqashi and, al abadi (2008), and kamel, & ani, (2014) studies. fourthly, it contributes to providing sufficient evidences for assets that are received or obligations settled, provide information about interest rates and return on assets and liabilities listed in the market, and it contributes to information providing related to matched and similar assets. finally, it contribute in meeting disclosure requirements, improving transparency level, contributes to provide additional information regarding fluctuations in general prices level, and disclosure of measurement at fair value contributes in reducing financial crises and economic risks incidence. this is consistent with fayaz, barzegari, &haneghah(2013), abdelmalek, z., (2015), and ionaşcu, m., ionaşcu, i., săcărin, m., and minu, m. (2014) studies. the researcher had set some recommendations as follows: firstly, emphasizing on application importance (ias/ifrs), and exerting the necessary efforts to conclude real scale on which companies can depend on in application of fair value accounting measurement, such as the creation of active markets, and semi-active. secondly, governmental agencies have to support through attracting foreign investment by issuing laws that encourage investment, to create investment markets and jordanian market opening on global markets. thirdly, intensify holding meetings and training courses by professional and academic bodies to raise awareness regarding the importance of proper measurement and disclosure of fair value for beneficiaries. fourthly, to perform continuous contact with external experts and advisors from active global financial markets when using fair value measurement and disclosure. fifthly, in order to do joint coordination between arab countries in asia continent of to create an active market in which the fair value measurement is used. finally, to update systems and software applied in public shareholding companies so that they will comply with measurement and accounting disclosure requirements for fair value. references abdelmalek, z. 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(2015). financial reporting qualitybefore and after ifrs adoption using nice qualitative characteristics measurement, secondglobal conference on business and social science, gcbss-2015, 17-18. bahi, indonisia. available online at http://www.sciencedirect.com/science/article/pii/s1877042815054312 zehri, c., & abdelbaki, a. (2013). does adoption of international accounting standards promote economic growth in developing countries? international open journal of economics 1(1), 0113. available online at http://acascipub.com/journals.php. microsoft word 10878-40131-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 192 ownership patterns and control of top 100 turkish listed companies aree saeed mustafa (corresponding author) tunku puteri intan safinaz school of accountancy universiti utara malaysia, 06010 sintok, kedah, malaysia tel: 60-5-63-6344 e-mail: areealamedi@gmail.com ayoib che-ahmad tunku puteri intan safinaz school of accountancy universiti utara malaysia, 06010 sintok, kedah, malaysia tel: 60-4-928-4770 e-mail: ayoib@uum.edu.my sitraselvi a/p chandren tunku puteri intan safinaz school of accountancy universiti utara malaysia, 06010 sintok, kedah, malaysia tel: 60-4-928-7328 e-mail: sitraselvi@uum.edu.my received: feb.2, 2017 accepted: march 14, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10878 url: http://dx.doi.org/10.5296/ajfa.v9i1.10878 abstract this study aims to highlight the importance of protecting investors’ rights,and particularly those of minority shareholders. this study addresses the predominant control-ownership structure of the top 100 firms listed in bursa istanbul (bi) using the data for 2015. it shows the most common control-ownership structure within business groups, in which shareholders exercise control over a group of firms and maintain a small stake of firms’ equities. turkish firms are categorised with highly concentrated ownership and families’ being the dominant shareholders owning more than 80% of all publically listed firms in bi. the study results indicate that the divergence between cash rights and control rights (wedge)in the top 100 turkish firms is mainly achieved through pyramidal-ownership structure, dual class shares, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 193 and cross-ownership at about 41%, 40% and 11%, respectively, while approximately 8% of firms do not use wedge. hence, wedge exacerbates type ii agency problems. this paper calls for future research to study the environment of wedge for turkish firms listed in bi. keywords:pyramidal structure, dual class shares, cross-ownership, turkey. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 194 1. introduction the literature addresses firms’ ownership structure extensively. these studies compare ownership concentration with dispersed ownership, in which block ownership possesses a majority of the firms’ equities. in contrast, this paper investigates an ownership structure in which a founder exercises control and maintains a small portion of equity (cash-flow rights) in the affiliated firms. there are three principles ways to diversify between control rights and cash-flow rights: pyramids, dual class shares and cross-ownership. nevertheless,how this is exercised in this paper is referred to as wedge. this is because it allows shareholders to control affiliated firms with a small stake of investment (cash-flow rights). wedge is defined as a mechanism to separate control rights and cash-flow rights. wedge entrenches controllers from the market in terms of corporate control and it maintains firm control in the hands of the majority shareholders with a small fraction of cash-flow rights (claessens, djankov, & lang, 2000). this enriches the majority shareholders’ control rights. although this mitigates agency conflict between the agent and principal, the principal–principal agency conflicts still exist (demirag & serter, 2003). this facilitates expropriating minority shareholders’ rights in the interests of majority shareholders (ararat, aksu, & tansel cetin, 2015). this conflicts severely between controlling shareholders and minority shareholders, depending upon the relationship between the control rights and cash-flow rights (bebchuk, kraakman, & triantis, 2000;la porta, lopez-de-silanes, shleifer, & vishny, 2002). this paper defines control rights as a controller’s ability to change the direction of a firm’s operation (this is due to the controller’s ability to invest in unprofitable projects or vice-versa). whereas, cash-flow rights indicates a shareholder’s right toa firm’s profits and liquidity. wedge is common in markets controlled by a family-ownership structure. these kinds of ownership structures distort controllers’ incentives; hence, they put more concentration on the corporate governance mechanisms, extending from legal protection for minority shareholders to reputational limitations on controlling families. the same reason attracts political and market scrutiny in many countries to concentrate on problems inherent in exercising wedge. thus, this study is an analysis of the governance and incentive features of ownership structures. very few studies have examined the control-ownership structure in turkey (demirag & serter, 2003;yurtoglu, 2000). based on the available literature, this study provides a sectorial analysis on control-ownership structure practised by the firms listed in bi. the paper’s main objective is to determine the mechanisms of wedge exercised in bi, which will provide the bases for future research and to examine the type ii agency problem in the turkey business environment. in terms of theoretical contribution, this study extends the context of agency theory factors under investigation such as, ownership structure. a study by villalonga and amit (2006) reports that the most important factors that worsen agency problem is control-ownership structure. furthermore, in terms of practical contribution this study’s finding will provide a useful ground for capital market board of turkey (cmbt) and policy makers to provide a relevant policy to enhance corporate governance’s effectiveness to mitigate agency problems. 2.the characteristics of corporate governance in turkey the capital market of turkey (cmt) has a vital role to enhance the effectiveness of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 195 corporate governance regime (hacımahmutoğlu, 2007). the features of corporate governance system in turkey (cgt) are reflected clearly via the following characteristics of capital market of turkey: • a small portion of turkish firms are listed and traded in istanbul stock exchange (ise). • the number of firms publically listed and traded increases from 80 firms at the end of 1986 to 311 firms in 2001(wfe, 2009). • turkish economy faced several crises within the period of (1986-2001). these are due to international recessions, political reasons and macroeconomic instability. • accordingly, this assists greatly in decreasing the number of listed firms in ise to 288 firms in 2002. • the numbers of listed firms in ise were about 307, 316, 329 and 332 for the periods 2004, 2005, 2006 and 2007 respectively. • in the same vain, the number of corporations listed in ise has improved to 416 and 422 for the years 2014 and 2015 respectively, with more than tl554.9 billion and tl624.4 billion (us$189.8 billion and us$268.5 billion) respectively (cmb, 2015). the second feature of cgt is the lack of corporate control. this feature of cgt leads to an inactive capital market as a result of high concentrated ownership. therefore, it is not possible to acquire traded firms. any hostile takeover bid of whichever control, change in ownership should be approved by controlling shareholders. the third feature of cgt is the dominance of business groups (bgs). bgs in turkey are a coalition of financial and industrial firms recognised legally in the structure of holding firms. control of these bgs is in the hands of a single family or a collection of number of families. to sum it up, cg framework is characterised with few listed firms, a large number of substantial stakeholders and vast cross-ownership shareholding (ararat, black, & yurtoglu, 2014). 3. turkish institutional setting business group has shaped the characters of the large business corporations in turkey. turkish families are the founders and directors of majority of medium and large corporations in many industries particularly banking sector. families have significant role as a holder and by investing resources to the private sector. turkey’s largest corporations are associated with each other’s shaping large business groups. the investment of a single family or small collections of families formed these bgs. bgs work as a coherent bodies that assist to shift resources and personnel between them. commonly, turkish bgs firms control private banks or financial institution that serves as a main bank of these groups that are ultimately owned by single families. the important feature of turkey bgs despite the significant role they play in the banking sector is that it is not parallel to the german and japanese cases. leff (1978) argue that the most suitable clarification given to the bgs is that bgs are consider as useful substitutes for weak capital markets. on the other hand, there are some challenges facing bgs asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 196 firms such as managing business growth, resisting managerial ownership and sustaining families control business activities. affiliated firms link each other within holding firms through two techniques. the first technique might be defined as inter-corporate shareholding. meanwhile, the second technique is to exhibit pyramid ownership structure via distributing the voting rights of minority shareholders over a large number of affiliated firms and concentrate ultimate shareholders at the top of the pyramid structure. using the aforementioned techniques enhances the control of the legal entity (e.g. parent companies, individual or family) on a large number of firms. the divergence between controls rights (voting rights) and ownership rights (cash flow rights) relay on the length of the control-ownership chains of the pyramidal ownership structure. that consequently leads to exacerbate the agency problem (agency conflicts) between majority shareholders or controlling shareholders and minority shareholders. this kind of ownership structure assists the majority shareholders to keep control on many affiliated firms and provide a small stake of capital (ararat et al., 2015). therefore, the incentives of controlling shareholders are enhance to maximise their profit at the expense of minority shareholders. bgs in turkey are however, poorly structured mainly due to the typical features of bgs shares. families possess a significant control on holding firms which, in turns linked through shareholding in other firms inside the pyramidal structure. these type of cases exists in which a holding firm control many affiliated firms which are linked to each other by share ownership. 4. corporate ownership and control structure shareholders’ decision making power improves as a result of high concentration of voting rights of those shareholders. a prominent idea from the viewpoint of control over voting rights is that it enhances shareholders power to select the majority of board of directors (bod) members to work as a dominant party in shareholders meetings, and to hold a significant interests on the strategic decisions of the corporations (daniels & halpern, 1996). in turkey, 45 percentages of the 243 listed firms in bi are controlled by a single shareholder with more than 50 percentages of voting rights (aytac & sak, 2000). in most cases, the dominant shareholders are holding firms owned by families. a study by yurtoglu (2000), documented that “insider system” of corporate governance regime exists in turkey in the terminology of franks and mayer (2001). the study finding indicates that 99% of the 257 listed firms possess a single shareholder with an ownership portion of about 50% and 227 firms controlled by two shareholders or less than five shareholders with ownership portion of about 50%. the author documented that holding firms are the largest owners with 36% of ownership stakes in about 143 listed firms. the study also reported that large number of ultimate owners of turkish listed firms is single family members holding the control on cash flow rights using pyramidal and cross-ownership structures. families control about 198 firms out of 257 firms holding around 53% of the equity capital and this percentage is higher than direct shareholding of families which is about 27.1%. accordingly, the divergence between control rights and cash flow rights is 1.32 (53/27.1) which illustrates that ownership and cash asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 197 flow is not dramatically distributed. the ownership structures of firms listed in bi are relatively transparent. the cmb of turkey and bi requirements enforce the listed firms to notify them with any transactions (purchase or sale) in shares. this includes shareholders or acquirers who purchase about 1% of shares and are acting in the interest of those who own about 10% or more of the voting rights or shares. in addition, firms are mandatorily required to disclose the ownership structure details and major shareholders identities who own more than 10% of voting rights or shares. there is a debate that ownership structure influences on the quality of corporate governance and whether a specific ownership structure is more relevant than others. berle (1958) documents that some types of ownership structure such as ownership concentration are required to alleviate agency problems. in other words, concentrated ownership monitor management activities directly and possess incentives and abilities to oversight management and hold them for the accountability of actions not align with shareholders’ interests (davies, 2001;aguilera, 2005). in addition, concentrated ownership works extensively to enhance firms’ long-term value creation abilities. the same argument is provided by novaes (1999) who reportedly observed that the most appropriate corporate structure comprise of numerous of major shareholders and few of minority shareholders. on the other hand, dispersed ownership not only possesses weak incentives but also lack of abilities to monitor management activities. thereby, one of the challenges that dispersed ownership face is the difficulties to coordinate their monitoring efforts (desender, aguilera, crespi, & garcía‐cestona, 2013). consequently, dispersed ownership rely on the bod to conduct the monitoring function (bohinc & bainbridge, 2001). nevertheless, the aforementioned view point is questioned as a consequence of inconsistency of the results of previous studies conducted in the continental europe and the us. some contradicted results have been documented. for instance, fox and heller (2000) reported that corporate control employed by multiple large shareholders might enhance the performance of the corporations. carlsson (2001) examined a sample of scandinavian corporations, reports that “ownership matters and it all depends on the owner” highlighting shareholders responsibilities. a study by oman (2001) illustrated that issuing firms equity might not consider a source of funds in market dominants by high concentrated ownership. it indicates that the agency problems still exists and weak minority protection inherent the domination of concentrated ownership. the same view is provided by himmelberg, hubbard, and love (2004) who reported that agency conflicts enforce insiders to hold a large equity shares than they retain under a perfect risk diversification strategy. their studies examined 38 countries including turkey and the results indicate that there is negative relationship between minority protection and concentrated ownership. the author suggest that the higher the concentration of insider ownership, the weaker the protection of minority shareholders wealth and this argument is align with the argument of desender, aguilera, crespi-cladera, and garcia-cestona (2009). in addition, the study documented that high concentrated ownership increases the cost of capital and underinvestment of capital. the significance of the study is that capital flow is ineffective with the presence of weak minority protection in place even if the international barriers on capital are insufficient. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 198 previous studies examined corporates structure of turkish listed firms in bi. the study’s findings indicates that holding firms influence on firm’s economic performance in terms of investment decisions, profitability, return on assets and dividend payments. a study by yurtoglu (2000) reported that family ownership with high concentrated ownership and pyramidal structure influence negatively on inducing dividend payments, return on assets and market-to-book value. in addition, yurtoglu (2000) document that turkish affiliated firms structured within holding firms possess low rate of profit than firms work in more competitive market for long period of time and specially when the leverage rate of firms structure inside holding firms is at low level. 5. the legal framework and law enforcement studies have examined the relationship between countries’ legal system and market efficiency. countries that have adopted common law are more likely to provide protected environment for creditors than civil law countries. on the other hand, the interpretation of the correlation between law and culture has motivated licht, goldschmidt, and schwartz (2001) to propose that la porta, lopez-de-silanes, shleifer, and vishny (1997) legal methodology offers an incomplete description of the universal corporate governance system. the result of their study illustrates that cultural environment enhanced path dependency in corporate governance system. furthermore, the cultural values possess a vital role to determine the suitable legal system for each country to be accepted as legitimate. according to silanes, la porta, shleifer, and vishny (1998) civil law countries such as france are less likely to provide a safe environment to protect investors wealth particularly, minority shareholders. the same case exists in turkey, which adopts civil law from france. the commercial code of turkey (cct) has been derived directly from the french commercial code in 1850 and amended in 1926 and 1956 while; the provision was taken from italian, swiss and german. the last version of cct with its evidently electronic nature, provide the foundation for equity contracts and form the legal basis for incorporation, shareholders rights, general assemblies, definitions of equity shares and bonds and their issuance. the capital market law of turkey (cmlt) adopted the provisions directly from common law countries (anglo-saxon countries) but its roots still in civil law countries. it basically offers the legislative backing for security market actions and creates the capital market board of turkey (cmbt). the issue of legislation is correlated with the deficiency of decisiveness in law and contradictions between banking law, capital market law and commercial code in terms of disclosure requirements, accounting, taxation and shareholder rights (ararat & ugur, 2003). in turkey, the legal process and law enforcement suffer from several operational problems. turkey’s legal system is costly, slow and complex. therefore, cmbt is authorised to treat such impediments by restoring to managerial penalties such as de-listing and suspension. nevertheless, the aforementioned policies are as a result of the implementation of the incompetence of the legal process and lack of law enforcement. since 2000, the cmbt has notified the office of public prosecutors for about 100 violations against cmlt per year. in each year only a single case reach decree absolute, while other cases results in adjournments asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 199 and dismissal. on average 12 month is required between the cmbt appeal and the first verdict excluding time required to make decisions on dismissal and adjournments. for instance, in 2003 the public prosecutor addressed about 23 cases for 2001 and more than half of the cases for 2002. however, only 1% of the existed complains finalised with punishments. most of the violations for instance, 218 cases out of 272 are subject to article 27 of cmlt that offers the legal bases to overcome with market manipulations, distressing the fair trading environment and introduces penalties (cmb, 2012). a study by tannor (2002) provides obvious statement that explain the imbalanced between duties and authorities of the cmbt. the author indicates to the takeovers of under-capitalized banks as an illustration on how inequality between rule and its implementation surface clearly in practice. the cmlt identifies the private laws that are adopted in banks and makes references to them. nevertheless, listed banks in ise also implement cmlt as “issuers” in terms of disclosure provisions and audit. tannor (2002) argues that cmbt might utilise its authority as disclosure offences are of illegal nature. nonetheless, the cmbt desisted from doing such achievement and proved that it might avoid its accountability when difficult conclusions are arrived at. tannor (2002) pointed out the vital significance of regulatory authority to exercise its powers firmly and thoroughly in auditing and monitoring compliance. 6. mechanisms for separating cash flow and control in this part, the discussion concentrates on the turkish holding-ownership structure mechanisms used to maintain their control on affiliated firms through providing a small stake of equities, achieved via pyramidal-ownership structure, cross-ownership and dual class shares (ararat et al., 2015). this study symbolises the divergence between control rights and cash-flow rights by α, which reflects the stake of the majority shareholders’ equities(cash-flow rights). 6.1 dual class shares dual class shares represent the most straightforward mechanism for divergence between the control rights and cash-flow rights inside a single firm. in fact, this kind of ownership structure is the only one that can be exercised without creating multiple firms or a group of firms. the firms’ founders might sign all voting rights to a stake α of shares belonging to the controlling shareholders,withthe remaining shares distributed to the public with zero voting rights. the multiple class shares structure is especially dominant in sweden, south africa and turkey. in turkey, firms promulgate two or more classes of shares with disproportionate voting rights, which areknown as dual class shares (khalil, magnan,& cohen, 2008). this is because turkishcommerciallaw (tcl) does not embrace the principle of one-share one-vote. therefore, turkish firms issue more than one class of shares with different cash-flow rights and with dissimilar collateral rights in liquidation. according totcl article 401, firms can issue one class of shares with non-voting rights or with a high number of voting rights. in addition, according to tcl article 388,the decision about the scales of shares in terms of voting rights and cash-flow rights should be taken during the general assembly meeting. figure 1 shows an example of selçukgida a.ş.’s use of dual class shares to diverge between asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 200 control rights and cash-flow rights. this example explains the common dual class shares used by turkish firms listed in bi (yurtoglu, 2003). selçukgida a.ş. is a small firm operating in izmir city,located in the north east of turkey. this firm has two classes of shares: 280,000 classa and 4,520,000 classb shares. the class ashares and class bshares possess equal nominal value, creating 4,800,000 million shares as a complete stock capital. each classashare carries 50 voting rights,while eachclass bshare carries only one voting right. therefore, the ashares carry 78.18% of the voting rights, whereas the bshares carry 21.82% of the voting rights. selçukgida a.ş. has four controlling (largest) shareholders, namely mr ei alharal (general manager and board member), mr ev alharal (board member), mr v franco (board member), and mr t berkan. all ashares and some fraction of the bshares are owned by the largest shareholders, while the remaining bshares are owned by dispersed ownership. figure 1 displays the distribution of the a and b classof shares between the controlling shareholders and minority shareholders. mr ei alharalhas a portfolio of a and bclass shares which is 143,998 and 298,246, respectively. this indicates that mr ei alharal’s portion of cash-flow rights is about 9.2 ((143,998 + 298,246)/ 4,800,000). in contrast, the owner possesses control rights scaled with his ownership at about a 40.48 portion of total voting rights (a shares equal to 7,199,000 votes and b shares equal to 298,246 votes of a total of 18,520,000 votes). similar calculation indicates that the control rights of the other three controlling shareholders mr ev alharal, mr franco and mr berkan are about 13.36%, 13.34% and 10.97%, respectively. this shows that the alharal family possesses about 53.85% of the control rights on selҫukgida a.ş., whereas the alharal family possesses about 11.8% of the cash-flow rights, and so the wedge for this case is about 4.56 (= 53.85/11.8). in summary, the control-ownership structure reviewed above may reflect majority shareholders’ incentives to expropriate minority shareholders’ interests. this evidence proposes that majority shareholders use their control rights to jeopardise minority shareholders’ wealth. figure 1. an example of dual-class shares: selçukgida a.ş. (2001) source: (yurtoglu, 2003) selçuk gida a.ş. mr ei alharal 3%, a 6.2, b mr ev alharal 1%, a 1.6%, b mr v franco 1%, a 1.5%, b dispersed 84.2%, b mr t berkan 0.8%, a 0.7%, b asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 201 6.2 pyramids firms might exercise wedge using single class shares via a pyramidal-ownership structure. such a structure consists of two levels:the majority shareholders possess ultimate control in a holding firm that in turn possesses ultimate control in an operating firm. while in the three level pyramids, the main holding firm controls a second-level holding firm that in turn controls the operating firms. in order to explain the value of wedge for a sample case of pyramids comprising of two levels or n ≥ 2 firms,it is proposed thatthe majority shareholder possesses a portion s1 of the equity in firm 1, and firm1 possesses a portion s2 of the equity of firm 2, and so on.as long as si ≥ ½, i = 1… n, the controller possesses direct control of the assets. as to the cash-flow rights, the controller possesses a portion(bebchuk et al., 2000): 1 n i i sα =  =     ∏ for any portion α, however small, there is a pyramid that allows the majority shareholders to get full control ofthe firm’s assets without possessing more than α of the firm’s equity rights. in the barrier case in which the majority shareholder possesses 50 portions (the minimum requirement for control) of voting rights at each level of the pyramid, α = (0.5)n. for a clear example of how swiftly pyramiding splits equity from control, consider a three-level pyramid with si = 0.50 at each level. at this point, the minority shareholders control the firm with only 12.5 portions of its equity rights. the pyramid structure is the most dominant mechanism used to deviate between control rights and cash-flow rights (la porta, lopez-de-silanes, shleifer, & vishny, 1999). claessens et al. (2000) claim that the pyramidal-ownership structure is the most common ownership structure in asian countries,and particularly turkey (ararat et al., 2015),as well as in several european countries (holmén & högfeldt, 1999). çelikhalata.ş. represents an ideal example to illustrate the divergence between control rights and cash-flow rights using pyramidal structures in the context of turkey. figure 2 shows the pyramidal structure of çelikhalata.ş.this medium-size industrial firm has three direct ownerships: 48.44% for doğan holding, 10% for disbank and 4% of the equity for doğandişticaret. the remaining equity is dispersed equity which is about 37.56%. the second level as it appears in the pyramidal structure in figure 2 illustrates that 49% of doğan holding is owned by adilbey holding, with the remainder belonging to the doğan family and dispersed ownership at 16.70% and 34.24%, respectively. the sole owner of adilbey holding with 100% shareholding is the doğan family. therefore, it can be seen from figure 2 that the doğan family has the majority control at each level, which is about 62.44% (48.44% + 10% + 4%); whereas the cash-flow rights is about 39.82% as a result of calculations over relevant control chains. this is considered as a substantial gap between control rights and cash rights, known as wedge. this can be calculated through dividing the control rights (62.44%) by the cash-flow rights (39.82%), which is about 1.56, while the pyramidal structure is a 4 pyramidal layer (pyr). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 202 figure 2. example of a pyramidal-ownership structure of çelikhalata.ş. (2001) source: (yurtoglu, 2003) 6.3 cross-ownership in opposition to the pyramidal-ownership structure, the power of the controller reinforces and entrenches via horizontal cross-holdings of equities. cross-ownership structure exercise control through distributingthe voting rights of all the affiliated firms within the business group rather than concentratingthem in the hands of an individual firm or investor. the relationship between cross-holding and control can be explained via the following example. let us symbolise by sij the portion of n firm i equity which is possessed by firm j¸ and propose that the majority controller possesses directly a portion si of the equity of firm i. proposing that for each i, the majority shareholder preserves(bebchuk et al., 2000). 1 1 2 n j i i js s =    + >      the majority shareholder controls the assets of all n firms. hence, the majority shareholders may possess a small portion of equity (cash-flow rights) in these firms. the clear example of a similar case is that the majority shareholders possess direct portions of equities s in two firms with identical cross-ownership h in the other, such that s + h ≥ ½ (e.g. majority shareholders control both firms). for this case, bebchuk et al. (2000)report that the majority shareholder ratio of cash-flow rights is found out via its direct ownership s over the total dispersed 37.56% çelikhalat a.s dogan dis ticaret 4% disbank 10% dogan holding 48 44% dispersed 35% milpa a s 12% dogan holding 53% dogan holding 65% dispersed 35% dogan family 16.70 dispersed 34.24% adilbey holding 49% dogan family 100% adilbey holding 49% dogan family 16.70 disperse d 34.24% dispersed 34.24% dogan family 16 70 adilbey holding 49% dogan family 100% dogan family 100% asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 203 portion of equity that is not cross-held (1-h). 1 s h α  =  −  cross-holdings ownership is dominant in asian nations, for instance in turkey, where the most popular example is the largest pharmaceutical firm known as eczacibaşii̇laç(see figure3). this firm has three large shareholders with ownership portions ranging from 21.6 to 28.2%, whereas 22% of its capital is owned by dispersed ownership. all three large ownerships are under control of the eczacibaşi group. the eczacibaşi family is the founder and controller of this group, using two holding firms: eczacibaşiyatirim holding (traded) and eczacibaşi holding (non-traded). these two holding firms in turn are under the control of the same business group. eczacibaşii̇laç possesses 43.5% of the control rights (voting rights) in eczacibaşi holding. at the same time, the other two holding firms possess cross-ownerships between each other. figure 3. control-ownership of eczacibaşii̇laç (yurtoglu, 2000) 7. other mechanisms of control the previous part addresses the divergence between control rights and cash-flow rights using pyramidal, dual class shares and cross-ownership. in addition to these influential control-ownership mechanisms, turkish firms use some other mechanisms of control-enhancing corporate charter provisions. accordingly, controlling shareholders get eczacibaşiyatirim holding eczacibaşii̇laç 2% 21.2% 26.33% 22% 19.23% 37.39% eczacibaşiholdi ng eczacibaşifa mily dispersed eczacibaşiyatir im 46.23% 16.38% 24.32% 28.12 43.5% 23.03% asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 204 some preferential treatment in order to design the board of directors, and determinethe dividend policies and liquidation preferences between the different classes of shares.the controlling shareholders of the 38 firms included in this study’s sample have shares with privilege to select the absolute majority of the board of directors can solely be nominated by the controlling shareholders.for instance, odaşelektrikuretimsanayiticareta.ş. is listed firm in electricity gas and water/ electricity gas and steam sector. this firm issues more than one class of shares which are a and b. shareholders with a class of shares possess 15 voting rights for one share to select board of director members whereas class b shares have one voting right for each share. in addition, another case was found within the manufacturing industry/ chemicals, petroleum rubber and plastic products/ other chemical productssector, by the firmalkimalkali kimyaa.ş. this firm issues groups a,b,c and d with 100 votes per share while each shareholders within group e share have 1 vote per share. meanwhile, the case ofgsd holding a.ş that is listed infinancial institutions/ holdings and investment companies sectorissuesgroups a, b and d degree of shares with the privilege to choose board of directors and shareholders who hold a and b degree of shares have the privilege to choose external auditor. the controlling shareholders of the three firms of this study’s sample have shares with privilege that allows them to obtain dividend concessions. for instance, kartinsankartonsanayiveticaret a.ş. is manufacturing industry/ paper and paper products. according to firm’sarticles of association, a-class shares possess privileged regarding the dividend rights. furthermore, in the event of first dividend distribution, board of directors also have the right to receive the dividend. accordingly, the distributable profit is utilized to find out the initial amount of the first dividend, 10% of the paid-in capital is deducted, and 5% of the remainder is distributed to a-type shareholders, and a portion (to be decided by the general assembly) to the members of the board of directors as dividend. 8. research method and data collection the aim of this paper is to identify the extentto which the top 100 firms listed in bi for the year-end of 2015 use wedge. in order to hand-pick the wedge data, this study usesthe bi website, and particularly the public disclosure platform, as this platform provides firms’ data related to control rights, cash-flow rights, dual class shares and cross-ownership. this assists to identify the control-ownership structure of turkish firms and get a better grasp of turkish firms’ ownership structure and corporate governance system. the following analysis of the control-ownership structure is limited to the top 100 firms listed in bi at the end of 2015. financial institutionsuch as insurance firms, banks and other financial intermediaries that represents about 31 percentages of the top 100 firms listed in bi.manufacturing firms account for 37% of the top 100 listed firm in bi. wholesale and retail trade including hotels and restaurant account for 9% and transportation, telecommunication and storage/ transportation/ air transportare about 6% of the top 100 firms listed in bi. electricity gas and water/electricity gas is account for 5% while technology/ information technology is about 4%. the remaining (5%, 3%) comes from mining/ crude petroleum education, health, sport and other social services respectively. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 205 9. data analyses and results the descriptive statistics of control-ownership structure are disclosed in figure 4. firms using the pyramidal-ownership structure are about 41% of the top 100 firms listed in bi, while firms using cross-ownership structure are about 11% of the top 100 firms listed in bi and the rest have about 8% with no divergence between control rights and cash-flow rights. figure 4. control-ownership patterns in the top 100 listed firms in bi those firms using dual class shares in order to deviate between control rights and cash-flow rights are about 40%. firms using dual class shares are classified to two categories.the first category uses this ownership mechanism in order to control a large number of firms and maintain a small fraction of equity, and these firms represent about 5% of the top 100 firms listed in bi; for instance, alkimalkalikimya a.ş.. the second category consists of firms using dual class shares to obtain some privilege in a particular class of shares. this category comprises of three firms listed in bi using multiple classes of shares in order to get dividend concessions for example the case of kartonsankartonsanayiveticareta.ş., and 32% of the top 100 firms listed in bi use dual class shares to get privilege to nominate candidates to the board of directors and audit committee for instance the case of gsd holding a.ş. the bar graph in figure 5 shows information about the distribution of wedge exercised by the top 100 firms listed in bi in 2015 by sectors.figure 5 gives values for all the wedge mechanisms such as dual class shares, pyramidal, cross-ownership and firms with no wedge. according to the figure, the most dominant mechanism for separation between ownership and control is both the dual class shares and pyramidal structure, with 14% and 16% of firms working in the finance sector using dual class shares and pyramidal structure. while financial firms listed in the top 100 index are using cross ownership about 3 percentages and financial firms not involved in any mechanism of the separation between control rights and cash flow rights are about 4 percentages.firms using dual class shares are about 2% of firms listed in the manufacturing sector and the firms using pyramidal ownership structure are about 3% of firms listed within manufacturingsector (non-metallic mineral products/glass and glass products).whereas,about 1% of the manufacturing firms are using cross ownership and the rest of themanufacturing firms that are about (2%) are not using any kinds of wedge.on the 40% 11% 41% 8% dual class share cross-ownership pyramidal ownership no-wedge asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 206 other hand, about 1% of firms working in the construction exercise wedge using dual class shares and pyramidal structure. cross-ownership is exercised by 3% of firms listed in bi under each of the financial institution and wholesale and retail trade sectors. at the same time, of the firms listed in bi with no wedge about 4% work in the finance sector. figure 5. sectorial distribution of wedge 10. conclusion this paper analyses the control-ownership structure of the top 100 turkish firms publically listed in bi. the majority of these firms are controlled by families that control a group of affiliated firms through dual class shares, cross-ownership ties and pyramidal-ownership structure. therefore, the insider system is the most dominant in the turkish capital market, and this richest insider wealth is particularly the case for the family control structure. the ultimate controller uses the dual class shares mechanism to create divergence between control rights and cash-flow rights. this is in order to control a large number of firms, despite the decrease in their stake of equity in those firms. previous studies document that the previous control-ownership structure arrangement enhances majority shareholders’ incentive and ability to extract private benefits from the firms it controls, at the expense of the minority shareholders (ararat, süel, aytekin, & alkan, 2014;demirag & serter, 2003). this study recommendsto policy makers and regulators to provide relevant policies that will support investors position particularly minority shareholders, for instance, minority shareholders that possess a particular threshold of voting rights to hold a right to challenge management manipulation, andto call for an extraordinary general meeting or participate in firm’s decision such as select independent directors, or dividend policies. 0 2 4 6 8 10 12 14 16 18 dual class shares pyramidal cross ownership no wedge non-metalic mineral other manufacturing industry financial institutions electricity chemical products information technology asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 207 acknowledgements the author would like to thank professor ayoibche-ahmad and dr. sitraselvi a/p chandrenfor their guidelines and efforts. a special thanks also to the anonymous reviewers and the journal editor. references aguilera, r. v. 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(2003). corporate governance and implications for minority shareholders in turkey (rprt).corporate ownership and control, 1. discussion paper, turkish economic association. microsoft word 6287-22580-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 261 tendency to choose big audit firms: case of indonesia putu agus ardiana faculty of economics and business, udayana university, indonesia e-mail: ardiana.idea@gmail.com received: sep. 8, 2014 accepted: oct. 12, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6287 url: http://dx.doi.org/10.5296/ ajfa.v6i2.6287 abstract this paper investigates the tendency of companies to choose a big audit firm as their external auditor under the condition of their income smoothing tendency and risk tolerance to business and financial risks. using 2,240 company-year observations listed on the indonesian stock exchange, it generally reveals that companies with lower tendency to smooth earnings and companies with intolerable risk tend to choose big audit firms. these results are also consistent after controlling the asset size of companies (clients). in addition, companies would tend to show indifferent preference when the opportunistic and non-opportunistic income smoothing tendencies are in the same proportion. this paper also implies that audit firms tend to accept audit offers from clients with intolerable risk but with greater asset size to compensate higher risk. the situation where big audit firms accept clients with intolerable risk level indicates that non-big audit firms are not capable of doing so and audit firms in indonesia operate in weak litigation environment. keywords: income smoothing tendency, business and financial risk tolerance, client size, audit firm size asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 262 1. introduction the need of audit service from external auditors comes from a consequence of asymmetry information between stockholders or principal (external party) and management or agent (internal party). the asymmetry information leads to the need of independent party to provide assurance services that the financial statements prepared by the agent have been in accordance with accounting standards. in many cases, asymmetry information between principal and agent causes moral hazard in the sense that agent tend to act for their personal interest which is unlikely in the line with principal’s interest (jensen & meckling, 1976; watts & zimmerman, 1983). agency theory predicts that the awareness of principal and agent about the existence of moral hazard might be achieved by goal congruence or harmonization. the more complex the agency conflict, the greater the demand on external audit and the quality of audit (palmrose, 1984; francis & wilson, 1988; defond, 1992; and craswell et al., 1995). a number of research publications about audit quality and auditor reputation (proxied by audit firm size or auditor brand name) show that big audit firms or brand name auditors have greater monitoring strength which is capable of resulting greater information quality and credibility (deangelo, 1981; dopuch & simunic, 1982; titman & trueman, 1986; and beatty, 1986). more specifically, beatty (1986) shows that big audit firms or brand name auditors tend to provide audit services to clients with greater asset size but lower financial and litigation risks. an interesting empirical finding reveals that brand name audiors effectively reduce the tendency of companies to commit earnings management (dopuch & simunic, 1982). this is because the brand name auditors have greater resources with better quality to execute more complex audit procedures. becker et al. (1998) find that discretionary accruals are higher for companies audited by small audit firms or non-brand name auditors. the existence of higher discretionary accruals indicates greater tendency of earnings management. risk is basically the variation of an actual value from its expected value and each individual has different preference of risk level. even though companies do not have debt at all, those companies remain have risk associated with the business that the companies run (so called business risk). when companies start to have debt, those companies start to bear financial risk. there is a trade-off between business risk and financial risk. for example, mining companies have greater business risk than companies in consumer goods because mining companies are highly depended on climate, weather, temperature, and other extraordinary factors that are very difficult to control. if mining companies with greater business risk want to have debt, their financial risk tolerance is lower than those with lower business risk. beatty (1986) finds that brand name auditors prefer choosing clients with lower financial and litigation risks. previous research publications about the relationship between earnings management and audit quality (measured by audit firm size) result in endless debates regarding earnings management measurement and a critical question about whether or not brand name auditors really reflect better audit quality. most researchers measure earnings management indication by discretionary accruals. other researchers show that discretionary accruals fail to measure earnings management accurately (dechow et al., 1995; thomas & zhang, 2000; dechow et asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 263 al., 2003; stubben, 2008). consequently, researchers such as stubben (2008) and mcnichols & stubben (2008) propose an alternative technique which is arguably more accurate in measuring earnings management. they measure earnings management tendency by residuals resulted from single linear regression between annual change in accounts receivable and annual change in sales revenue. meanwhile, tucker & zarowin (2006) measure income smoothing tendency by determining the correlation between the change in discretionary accruals and the change in pre-managed earnings. they find that income smoothing tendency exists when the change in discretionary accruals and the change in pre-managed earnings have negative correlation. this research proposes an absolute value of earnings forecast errors as a measure of income smoothing tendency which revises the management forecast errors proposed by davidson & neu (1993). davidson & neu (1993) measure income smoothing tendency by the residuals resulted from the single linear regression between forecasted earnings and reported earnings. the forecasted earnings are likely very subjective from management or at least they are full of assumptions and judgements which reduce the accuracy of the measurement. this research uses absolute value of residuals from the regression between after-tax earnings and the reporting period (so called the absolute value of earnings forecast errors) and these absolute residuals are considered more objective because the ordinary least square will determine a linear line with the least sum of squared residuals objectively. if the absolute value of earnings forecast errors equals zero, it strongly indicates that management commits income smoothing. in other words, the lower the absolute value of earnings forecast errors or the more the absolute value of earnings forecast errors approaches zero, the greater the tendency of income smoothing while the greater the absolute value of earnings forecast errors, the less the tendency of income smoothing. previous studies about the relationship between company risks and audit quality often divide company risks as business and financial risks and measure audit quality by audit firm size. greater financial risk would not be a problem for companies with lower business risk but indeed would be a problem if the business risk is also high. this indicates that stakeholders have tolerance level for those two risks. this research uses risk tolerance instead of either business risk or financial risk as a proxy of company risk. business risk is measured by the standard deviation of profit before interests and taxes in four quarterly reporting periods of each company. the arithmetic mean of the business risk of each industry is determined as a measure of average business risk of each industry. a company’s business risk is classified as high (low) if the company’s business risk is higher than or equal to (lower than) the average business risk of the industry where the company runs it business. financial risk is measured by total debt to total equity ratio (der), a common used solvability ratio. a company’s financial risk is classified as high (low) if the company’s der is higher than or equal to (lower than) the average der of the industry where the company runs it business. tolerable risk refers to a condition in which a company has high business (financial) risk but low financial (business) risk, or it has both low business and financial risks. audit firm size in this research does not indicate audit quality but the decision of companies to choose one particular audit firm size (big or small audit firm). this research uses asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 264 companies’ asset size (natural logarithm of their asset size) as a control variable. this research is expected to contribute to earnings management techniques and company risk measures and their relationship with the decision to choose an audit firm in indonesia. 2. review of literatures and development of hypotheses the demand for audit services is surprisingly driven by the need of assurance services, not due to mandatory rules from an act. benston (1969) reports that 82 per cent of public companies listed on the new york stock exchange (nyse) were audited by audit firms before the securities act 1933 and 1934 were introduced. therefore, legal forces are not a trigger of the demand for audit services that are provided by independent auditors. meanwhile, the demand for audit quality is triggered by asymmetry information between stockholders and management. the agency conflict between those two parties were investigated by titman & trueman (1986), francis & wilson (1988), bachar (1989), datar et al. (1991), feltham et al. (1991), defond (1992), clarkson & simunic (1994). deangelo (1981) shows that each audit firm has certain specialization that creates certain level of audit quality. consequently, if a client wants to have a change in audit quality level, it should change the audit firms. in addition, deangelo (1981), dopuch & simunic (1982), titman & trueman (1986), and beatty (1989) find that brand name auditors (audit firms in indonesia which are affiliated with the big four audit firms) have greater monitoring strength leading to greater information quality and credibility. 2.1 earnings management and audit firms earnings management should not be considered taboo considering that there is a trade-off between relevance and reliability in accounting principles. financial statements prepared by management are expected to provide predictive value, feedback value, and timeliness in order to be relevant for decision making. for the reason of timeliness, management make estimations and judgments to several transactions, e.g. estimation and judgment for the recognition of bad debt expense and allowance for bad debts. these estimations and judgments are the main contributor in earnings management. as long as these estimations and judgments are in the corridor of accounting standard and not for the purpose of earning benefit at the expense of other parties, the earnings management should not be viewed as crime. investors generally focus their analyses on earnings informativeness and often ignore the process of how earnings are reported. this often becomes an opportunistic situation for management to commit earnings management. when the asymmetry information is too wide, the chance for earnings management is greater and investors are more negatively impacted. earnings management is basically a management activity in choosing an accounting policy from several alternatives allowed by accounting standards to meet stakeholders’ interest, especially stockholders as they are the principal. however, asymmetry information makes it possible for management to act for their personal interest through earnings management at the expense of stockholders and other stakeholders. this condition refers to opportunistic asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 265 earnings management (scott, 2000). in more negative connotation, this type of earnings management can be called earnings manipulation. meanwhile, earnings management should be viewed as a normal management activity if it is undertaken through managing accruals and cash-flow related transactions without any purpose of misleading the users of financial statements and remain in the line with accounting standards. r e p o r t e d e a r n i n g s 2007 2008 2009 2010 2011 2012 2013 year figure 1. illustration of earnings forecast errors by using scatter plot and ols mcnichols & stubben (2008) reveal that earnings management affects company’s investment decisions. during the period of earnings manipulation, companies found to be involved in accounting irregularities, improper accounting, and restatement of financial statement by securities and exchange commission (sec) undertook substantial over-investment but after the period of earnings manipulation, this decision dramatically declined. davidson & neu (1993) show that managers tend to reduce their activity of manipulating reported earnings to achieve targeted profit or forecasted earnings when companies where the managers work for are being audited by brand name auditors or big audit firms. according to davidson & neu (1993), it reveals that clients have little or even no chance at all to take benefits from accruals to minimize forecast errors (the difference between reported earnings and forecasted earnings). income smoothing is an earnings management technique that is widely used by managers. this type of earnings management comes from a logic reasoning that users of financial statements tend to prefer smooth trend of earnings to the fluctuated one. this research uses the absolute value of earnings forecast errors as the proxy of income smoothing tendency. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 266 earnings forecast errors are errors or residuals resulted from the ordinary least square (ols) between the reported after-tax profits and the period of reporting those profits, as illustrated by figure 1. the errors or residuals are the difference between the reported after-tax profits and the forecasted after-tax profits (dots lay on the ols line) in each year of reporting period. strong tendency of income smoothing is concluded if the difference of the reported after-tax profits and the forecasted after-tax profits is zero (in this case, the reported after-tax profits lay exactly on the ols line together with the forecasted after-tax profits). if the differences are positive or negative, these errors are then converted to their absolute values. the greater the distance between the reported and the forecasted after-tax profits, the greater the errors or residuals will be. this condition means that the lower the tendency of income smoothing. therefore, the hypothesis is: h1: the greater the absolute value of earnings forecast errors, the lower the tendency of income smoothing, thus the greater the probability of choosing big audit firms. 2.2 risk tolerance and audit firms risks faced by companies can be in the form of business and financial risk. business risk refers to the risk that is inherent to the company’s business. each company has different level of business risk, depending on its business characteristics and complexity. for example, companies in consumer goods industry has lower business risk than that of mining companies. meanwhile, financial risk refers to the risk faced by companies having debts. if the level of debts is too high and causes inability of the company to pay the debts, the company suffers from bankruptcy risk. it does not necessarily follow that all companies having debts tend to bankrupt. in a certain range (when marginal benefit of debt is greater than the marginal cost of debt), companies having debt may increase their value, but in other certain range (when marginal benefit of debt is less than the marginal cost of debt), the companies may suffer from a decline in their value or an increase of bankruptcy risk. reilly & brown (2009) reveal that high financial risk does not necessarily follow high bankruptcy risk. if companies operating business in certain industry have relatively low inherent business risk, higher financial risk perhaps does not necessarily mean greater probability of being bankrupt. however, if companies have inherently high business risk, the higher financial risk might increase the bankruptcy risk, or at least they are potentially having difficulty in paying their debts. table 1. matrix of tolerable business risk and financial risk business risk financial risk high low high intolerable tolerable low tolerable tolerable source: adapted from reilly & brown (2009) table 1 above shows that intolerable risk happens when companies have high business risk and financial risk while tolerable risk happens when (1) companies have high financial risk asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 267 but low business risk, or (2) companies have high business risk but low financial risk, or (3) companies have both low business and financial risks. datar, feltham, & hughes (1991) find that riskier companies require higher audit quality by getting assurance services from bigger audit firms. big audit firms (those which are affiliated with the big four) are considered to have greater monitoring strength leading to greater information quality and credibility in transmitting more positive signal to stakeholders. clarkson & simunic (1994) support the research finding of datar, feltham, & hughes (1991) that in less strong litigation environment, companies audited by big audit firms tend to have higher risk with low ownership retention. riskier companies require assurance services from big audit firm in order to increase their audit quality leading to an increase in the quality of their financial reporting. the companies expect more new investors are interested in purchasing their stocks. consequently, the proportion of stocks held by old stockholders tend to decline (lower ownership retention) because the they tend not to increase the stock ownership in companies that they realize having high risk and are pleased to welcome new stockholders to share the risk. therefore, the hypothesis is: h2: companies with intolerable risk tend to choose big audit firms. 3. research method this research uses 2,240 company-year observations which were consistently listed on the indonesian stock exchange from 2007 to 2013. table 2 shows that the number of company-year observations consistently listed were 2,240 observations, which are about 75,12 per cent of total company-year observations from 2007 to 2013. this research uses logit regression to investigate the probability of companies with certain degree of income smoothing tendency and risk tolerance to choose big audit firms. there are three variables operated in this research. the first two variables are independent variable, which are (1) the absolute value of earnings forecast errors (absefe) as a measure of income smoothing tendency, and (2) dummy variable of risk tolerance (dtol) as a measure of risk tolerance to business and financial risks. meanwhile, the last variable is dependent variable, which is dummy variable of audit firm size (dauditor) as a measure of audit firm size. in addition to independent and dependent variables, this research introduces one control variable, which is company’s or client’s size which is measured by the natural logarithm of total assets (size). table 2. number of samples 2007 2008 2009 2010 2011 2012 2013 total number of listed companies 383 396 398 420 440 462 483 2,982 number of companies with incomplete data 63 76 78 100 120 142 163 742 number of (sample) companies consistently listed from 2007 to 2013 320 320 320 320 320 320 320 2,240 the absolute value of earnings forecast errors (absefe) is the absolute value of the errors or asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 268 residuals (differences between the reported after-tax profits and the estimated after-tax profits from 2007 to 2013) resulted from ordinary least square regression of observed or reported after-tax profits and the period of reported profits from 2007 to 2013. the greater the distances (absolute value of the differences) between the reported after-tax profits and the estimated ones, the lower the income smoothing tendency. the strongest tendency of income smoothing is when the reported and the estimated after-tax profits are exactly the same amount. dummy variable of risk tolerance (dtol) is a measurement of a company’s risk tolerance to business and financial risks. dtol equals one if the company has intolerable risk and equals zero if it has tolerable risk. the risk is intolerable if only the business risk and financial risk are high. meanwhile, the risk is tolerable if the business risk is high but the financial risk is low or vice versa, or if both business risk and financial risk are low. business risk is measured by the standard deviation of profit before interests and taxes in four quarterly reporting periods of each company. the arithmetic mean of the business risk of each industry is determined as a measure of average business risk of each industry. a company’s business risk is classified as high (low) if the company’s business risk is higher than or equal to (lower than) the average business risk of the industry where the company runs it business. financial risk is measured by total debt to total equity ratio (der), a common used solvability ratio. a company’s financial risk is classified as high (low) if the company’s der is higher than or equal to (lower than) the average der of the industry where the company runs it business. table 3. the big four – affiliated audit firms in indonesia big four audit firms indonesian audit firms address pricewaterhousecoopers (pwc) kap tanudiredja, wibisana & rekan plaza 89 jl. h.r. rasuna said kav. x-7 no. 6 jakarta 12940 – indonesia p.o. box 2473 jkp 10001 phone: +62 21 5212901 fax: +62 21 52905555 / 52905050 deloitte kap osman bing satrio the plaza office tower 32nd floor jl. m.h. thamrin kav 28-30 jakarta indonesia. phone number: +62 21 2992 3100. ernst & young kap purwantono, suherman & surja indonesia stock exchange building tower 2, 7th floor jl. jend. sudirman kav. 52-53 jakarta 12190 indonesia phone: +62 21 5289 5000 klynveld, peat, marwick, goerdeler (kpmg) kap sidharta dan widjaja 33rd floor wisma gkbi 28, jl jend. sudirman jakarta 10210 indonesia tel: +62 21 574 2333 source: indonesian institute of certified public accountants (2013) dummy variable of audit firm size (dauditor) is a measurement of audit firm size. dauditor equals one if the company is audited by an audit firm which is affiliated with a big four audit firm and equals zero if the company is not audited by an audit firm which is affiliated with a big four audit firm. the list of indonesian audit firms which have affiliation with big four audit firms is presented on table 3. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 269 descriptive statistics in table 4 shows that the absolute value of earnings forecast errors (absefe) has an arithmetic mean of rp 9,762,564.69 thousand and standard deviation of rp 44,265,436.53 thousand. this relatively high average of absefe indicates that income smoothing tendency is relatively low on average. meanwhile, the relatively high standard deviation of absefe is confirmed by wide range between its maximum and minimum value. over 2,240 firm-year observations, 505 firm-year observations are intolerance to business and financial risks while 1,735 firm-year observations are tolerance to them. in addition, there are 1,356 out of 2,240 firm-year observations which choose big audit firms while 884 firm-year observations choose non-big audit firm. descriptive statistics of client’s size is not straight forwardly interpreted because it is measured by the natural logarithm of client’s total assets. size has an arithmetic mean of 12.14. this value is equivalent to total assets of rp 187,034 million. its standard deviation is considerably low with 0.93 or equivalent to about 2.5 million rupiahs. its low standard deviation implies that there is no wide range between the maximum and minimum value of client’s total assets. table 4. descriptive statistics statistics absefeb dtola sizec dauditora number of observations 2,240 2,240 2,240 2,240 number of observations d=1a 505 1,356 number of observations d=0a 1,735 884 arithmetic mean 9,762,564.69 0.23 12.14 0.61 standard deviation 44,265,436.53 0.42 0.93 0.49 median 1255885.5 0 11.92 1 maximum value 635618708 1 14.39 1 minimum value 901 0 10.40 0 source: output of descriptive statistics from eviews note: a) for dtol, d=1 refers to intolerable risk, while d=0 refers to tolerable risk. for dauditor, d=1 refers to big audit firm (affiliated with the big four) whereas d=0 refers to non-big audit firm (not affiliated with the big four) b) absefe is the absolute value of the difference between reported after-tax profit and predicted after-tax profit under ordinary least square. the numbers are presented in thousand rupiahs. c) size is the natural logarithm of client’s total assets, which is presented in million rupiahs according to table 5 below, all independent variables significantly affect the decision to choose audit firm size at 95 per cent of confidence level. these variables consistently show asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 270 significant effect on audit firm choice after controlling client’s size. more specifically, absefe has a positive coefficient sign, which implies that the greater the absolute value of the difference between reported after-tax profit and predicted after-tax profit, the lower the income smoothing tendency, and eventually the greater the probability of clients to choose big audit firms. dtol and size also have positive coefficient sign indicating that clients with intolerable risk and greater asset size has greater tendency to choose big audit firm. table 5. logit regression of all independent variables and dependent variable variables dependent variable: dauditor before control variable after control variable coef (s.e) z-stat sig odds ratio coef (s.e) z-stat sig odds ratio intercept -0.008452 (0.050083) -0.169 0.866 0.99 -1.744730 (0.60743) -2.872 0.004 0.17 absefe 9.93e-09 (1.79e-09) 5.544 0.000 1.00 1.01e-08 (1.79e-09) 5.614 0.000 1.00 dtol 2.111983 (0.152164) 13.88 0.000 8.26 2.121188 (0.15214) 13.94 0.000 8.34 size 0.142825 (0.04977) 2.870 0.041 1.15 pseudo r2 0.119910 0.122787 n 2,240 2,240 source: output of eviews note: the parentheses are the standard errors of corresponding variables. odds ratio is the exponential form of regression coefficient [exp( )] 4.1 income smoothing tendency and audit firm size table 6 shows that absefe, in partial logit regression, has consistent result to the overall test of variables as shown in previous table. absefe has a positive coefficient sign both before and after controlling client’s asset size, which implies that the greater the absolute value of the difference between reported after-tax profit and predicted after-tax profit (which also means the lower the income smoothing tendency), greater the probability of clients to choose big audit firms. consequently the first hypothesis is accepted. income smoothing might be opportunistic or non-opportunistic form. it is opportunistic income smoothing if company’s financial statement preparer takes benefit from either increasing or decreasing the reported profit at the expense of stakeholders while in non-opportunistic form of income smoothing, the financial preparer uses accounting accruals to best reflect the company’s current economic situation. there is a trade-off between opportunistic and non-opportunistic income smoothing that the greater the opportunistic income smoothing, the lower the non-opportunistic income smoothing. consequently, there asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 271 will be a point where opportunistic equal to non-opportunistic income smoothing. this is the point where the odds ratio (exponential form of absefe’s regression coefficient) equals 1.00 as explained below. table 6. partial logit regression of income smoothing tendency and audit firm size variables dependent variable: dauditor before control variable after control variable coef (s.e) z-stat sig odds ratio coef (s.e) z-stat sig odds ratio intercept 0.454 (0.045) 10.08 0.000 1.57 -0.96 (0.5779) -1.66 0.097 0.38 absefe 6.83e-09 (1.72e-09) 3.96 0.000 1.00 6.91e-09 (1.73e-09) 4.01 0.000 1.00 size 0.12 (0.048) 2.45 0.014 1.13 pseudo r2 0.007380 0.0075 n 2,240 2,240 source: output of eviews note: the parentheses are the standard errors of corresponding variables. odds ratio is the exponential form of regression coefficient [exp( )] 4.1.1 condition one: strong litigation environment in a country with strong litigation environment, audit firms will tend to have clients with lower risk. the cost of litigation is very high so that the audit firms are not interested in providing audit service to higher risk clients. in this case, opportunistic income smoothing is considered to have higher risk than the non-opportunistic income smoothing. figure 2 clearly shows that as (opportunistic) income smoothing tendency declines, the probability of companies to choose big audit firm increases. this is consistent with the positive regression coefficient sign of absefe that the greater the absolute value of earnings forecast errors, the lower the (opportunistic) income smoothing tendency, and ultimately the greater the probability of companies to choose big audit firm. figure 2 below comprises three important parts. the first part is when odds ratio is less than one, the second part is when odds ratio equals one, and the last part is when odds ratio is greater than one. the first part, with odds ratio is less than one (when the probability of companies choosing non-big audit firms is greater than the probability of companies choosing big audit firms), shows that opportunistic income smoothing is greater than non-opportunistic income smoothing. in this case, companies tend to choose non-big audit firms than the big audit firms. one possible reason is that non-big audit firms with weaker monitoring strength are less capable of detecting such practice of income smoothing. the other possible reason is asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 272 that big audit firms tend to reject audit offer from clients with greater risk (greater opportunistic income smoothing tendency). figure 2. illustration about the relationship between types of income smoothing and odds ratio in strong litigation environment the second part, with odds ratio equals one (when the probability of companies choosing non-big audit firms equals the probability of companies choosing big audit firms), shows that opportunistic income smoothing equals non-opportunistic income smoothing. in this case, companies have indifferent preference to audit firm size. the odds ratios of absefe of 1.00 both before and after controlling client’s asset size on table 5 and table 6 above indicate a situation that the portion of opportunistic and non-opportunistic income smoothing tendencies are the same. the last part, with odds ratio is greater than one (when the probability of companies choosing big audit firms is greater than the probability of companies choosing non-big audit firms), shows that non-opportunistic income smoothing is greater than opportunistic income smoothing. in this case, companies tend to choose big audit firms than non-big audit firms. one possible reason is that big audit firms tend to provide audit service to less risky clients (clients with greater non-opportunistic income smoothing tendency) in an environment with high litigation cost. 4.1.2 condition two: weak litigation environment in a country with weak litigation environment, audit firms may have clients with higher risk. the cost of litigation is relatively low so that the audit firms may diversify their client portfolio. in the case of having riskier clients, audit firms would charge higher audit fee to compensate higher risk (the higher the risk, the higher the expected return). once again, opportunistic income smoothing is considered to have higher risk than the non-opportunistic income smoothing. figure 3 shows that as (non-opportunistic) income smoothing tendency declines, the asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 273 probability of companies to choose big audit firm increases. this is consistent with the positive regression coefficient sign of absefe that the greater the absolute value of earnings forecast errors, the lower the (non-opportunistic) income smoothing tendency, and ultimately the greater the probability of companies to choose big audit firm. figure 3 also comprises three important parts. the first part is when odds ratio is less than one, the second part is when odds ratio equals one, and the last part is when odds ratio is greater than one figure 3. illustration about the relationship between types of income smoothing and odds ratio in weak litigation environment in the first part, in a situation where financial statements are prepared in accordance with accounting standards (non-opportunistic income smoothing tendency), the company might not need to obtain audit opinion from big audit firm in order to increase the reliability of its financial statements (holding other factors constant). this is why, according to the first part of the figure above, the probability of companies to choose non-big audit firms is greater than that of big audit firms when non-opportunistic income smoothing tendency is greater than the opportunistic income smoothing tendency. in the second part, when the proportion of non-opportunistic income smoothing equals the opportunistic income smoothing tendency, the odds ratio equals one. this odds ratio indicates that companies have indifferent preference to audit firm size. this condition applies both in strong and weak litigation environment. therefore, from the perspective of absefe’s odds ratio, it is unclear yet about the litigation environment in indonesia. lastly in the third part, in weak litigation environment, companies with lower non-opportunistic income smoothing tendency tend to choose big audit firms (alternatively speaking, big audit firms may accept audit offer from companies with greater opportunistic income smoothing tendency) with higher audit fee with a hope of having an increase in the reliability of its financial statements (holding other factors constant). in real-world practices, the same audit opinion from big audit firms is valued higher than that from non-big audit firms. from this reason, companies with greater risk (greater portion of opportunistic income asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 274 smoothing tendency) would tend to choose big audit firm with higher cost to avoid negative sentiment from stakeholders. in other words, brand-name auditor may become effective firm’s value control mechanism in weak litigation environment. if this is true, auditor independence is under a serious threat. 4.2 risk tolerance and audit firm size dummy variable of risk tolerance on table 5 and 7 consistently shows positive and significant effect on audit firm size. in addition to the positive coefficient sign and significant p-value, odds ratio of more than 11.00 on table 7 indicates that companies with intolerable risk have greater probability to choose big audit firm with the magnitude of about 11 times higher. table 7. logit regression of risk tolerance and audit firm size variables dependent variable: dauditor before control variable after control variable coef (s.e) z-stat sig odds ratio coef (s.e) z-stat sig odds ratio intercept 0.054 (0.048033) 1.128 0.259 1.055 -1.62096 (0.61016) -2.657 0.079 0.198 dtol 2.39897 (0.171632) 13.98 0.000 11.01 2.4150 (0.1719) 14.05 0.000 11.19 size 0.137812 (0.05) 2.753 0.006 1.15 pseudo r2 0.107001 0.109545 n 2,240 2,240 source: output of eviews note: the parentheses are the standard errors of corresponding variables. odds ratio is the exponential form of regression coefficient [exp( )] companies with intolerable risk (those with high business and financial risks) tend to choose big audit firms because they expect to have better image and more positive market response from the users of financial statements. to deal with this, they have to pay higher fees which indicate that companies with greater asset size tend to choose big audit firms. alternatively speaking, big audit firms accept audit offer from companies with high business and financial risk. from previous explanation, this confirms that litigation environment in indonesia is weak. in weak litigation environment, the cost of litigation is not high so that audit firms may diversify their portfolio of clients. having clients with higher risk should be followed by higher audit fee in order to compensate the risk exposure. another implication from this finding is that non-big audit firm in indonesia is less capable of accepting risky client due to weaker monitoring strength. meanwhile, the control variable of client’s asset size (size) consistently shows positive coefficient sign, significant p-value, and odds ratio of greater than asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 275 1.00 on table 5, table 6, and table 7. these statistical findings suggest that clients with greater asset size tend to choose big audit firm. 5. conclusion this research contributes to an alternative measurement of income smoothing tendency and company risk. income smoothing tendency is measured by the absolute value of differences between the reported after-tax profits and the estimated after-tax profits from 2007 to 2013 resulted from ordinary least square regression of observed or reported after-tax profits and the period of reported profits from 2007 to 2013. meanwhile, risk tolerance is measured by dummy variable of risk tolerance (1 if the company has intolerable risk, which is when the company has both high business and financial risks; and 0 if it has tolerable risk, which is when the company has both low business and financial risks, or when the company either has low business risk but high financial risk or high business risk but low financial risk), in which business risk and financial risk are classified high or low based on each company risk relative to its appropriate industry. business risk is measured by the standard deviation of profit before interests and taxes in four quarterly reporting periods of each company and classified as high (low) if the company’s business risk is higher than or equal to (lower than) the average business risk of the industry where the company runs it business. meanwhile, financial risk is measured by the ratio of total debt to total equity and classified as high (low) if the company’s financial risk is higher than or equal to (lower than) the average financial risk of the industry where the company runs it business. companies with greater absolute value of earnings forecast errors or lower tendency of income smoothing tend to choose big audit firms because big audit firms have greater monitoring strength which lower the probability of clients to commit opportunistic earnings management. meanwhile, companies with intolerable risk (those with high business and financial risks) tend to choose big audit firms because they expect to have better image and more positive market response from the users of financial statements. to deal with this, they have to pay higher fees which indicate that companies with greater asset size tend to choose big audit firms. this research partially supports beatty (1986), that big audit firms or brand name auditors tend to provide audit services to clients with greater asset size, but this research finds that clients with intolerable risk tend to choose big audit firms which opposes beatty’s finding (1986) that big audit firms prefer clients with lower financial and litigation risks. this research also implicitly finds that non-big audit firms are not capable of providing audit services to intolerable risk companies and litigation environment in indonesia is not strong, as suggested by datar, feltham, & hughes (1991), and clarkson & simunic (1994). they found that in less strong litigation environment, clients choosing big audit firms tend to have greater risk. acknowledgement this paper was initially entitled income smoothing tendency, risk tolerance, and audit firm size and presented in 1st international conference on business, economics, and social sciences at the grand inna kuta hotel, bali (25 – 26 june 2014). current version involves greater number of observations (2,240 company-year observations) whereas the previous asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 276 version was with 1,500 company-year observations. i am very 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(1983). agency problems, auditing, and the theory of the firm: some empirical evidence. the journal of law & economics, 10, 613-633. http://dx.doi.org/10.1086/467051 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 12229-44991-3-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 287 use of capital investment appraisal practices and effectiveness of investment decisions: a study on listed manufacturing companies in sri lanka kengatharan, l. (corresponding author) department of financial management, university of jaffna, sri lanka e-mail: lingesiya@yahoo.com c. prashanth diluxshan department of financial management, university of jaffna, sri lanka received: nov. 3, 2017 accepted: dec. 15, 2017 published: december 15, 2017 doi:10.5296/ajfa.v9i2.12229 url: https://doi.org/10.5296/ajfa.v9i2.12229 abstract primary objective of the present study was to examine the relationship between use of capital investment appraisal practices and effectiveness of investment decision of listed manufacturing companies in sri lanka. capital investment appraisal practices were measured by capital investment appraisal techniques and risk analysis techniques of investment projects. effectiveness of investment was measured by perceptions of cfos on the performance from investment. firm size was used as the control variable to examine the relationship between investment appraisal practices and effectiveness of investment decision. the study employed a field survey from january to march 2017 and primary data was collected through self-administered questionnaires from randomly selected 20 listed manufacturing companies. results of the study revealed that use of npv and irr have significantly positively related to effectiveness of investment decision while dpb has significantly negatively related to effectiveness of investment decision of listed manufacturing companies in sri lanka. risk analysis techniques were not significantly related to effectiveness of investment decision. findings of the study may useful to the investment decision makers in order to achieve the shareholders wealth. keywords: investment appraisal techniques, risk analysis techniques and effectiveness. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 288 1. background of the study primary objective of financial management is to maximize the shareholders’ wealth and principally concerns with three major decisions on investment (what to invest),financing (how to finance) and dividend decisions (how to reward shareholders) and interactions between them (freeman & hobbes, 1991). effective investment decision making is fundamental to corporate survival and long term success. in this scenario, investment appraisal practices are decisive to boost corporate performances as investment appraisal practices are process of evaluating and selecting long term investments consistent with the firm owners’ goal of wealth maximization (gitman, 1988). recently more attention has been given to some of the theoretical issues apparent in organizational theory since they are parallel issues in the development of financial management research. application of decision making of organizational theory to finance or investment decision predominantly important to improve the value of a company, support to organize organizational resource to achieve organizational goals and tells how to achieve expected results by the way of structuring activities and designing organizational processes (hatch & cunliffe,2006). managers and employees should focus to maximize both short term and long term investment yield. nonetheless it is critical and challenging task making investment decision. hatch and cunliffe (2006) connotes that few would disagree about that organization works in complex, uncertain and often contradictory situations. however, in reality, making investment decision is heavily complex in a cut-throat competitive world. decision making is not a simple task; its consequences are felt over many years in future (bhimani, horngren, datar, & rajan, 2012). that is, any decision over investments of money would have uncertain actual results that could have effects on the organization for many years (bhimani et al, 2012). thus, effectiveness of investment decision is paramount important for organizational survival. for example, poor investment decision can affect the organizational stability and often difficult to recover the invested money in bad investment (bhimani et al, 2012). this kind of the investment can have impact on firm’s strategy, brand and culture in which organization operates. thus the investment decision making may both directly and indirectly influence financial performance and economic viability. therefore research problem of this study is how far use of investment appraisal practices influencing effectiveness of investment decision. after the civil war the multinational companies were enter into the sri lankan market that means the most of sri lankan companies are involved with internationalization. because of internationalization some companies needed to make long term investment decision so that companies involved with investment appraisal practices. so that making a good investment decision is of important since available funds are scarce and interdependency of organizational long-term survival, success and growth; in turn it boosts the value of the organization (bennouna, meredith & marchant2010). thus, elumilade, asaolu and ologunde, (2006) explained that capital investment decision is one of the fundamental requirements; it should be properly applied to make trade-offs between expected return and riskiness that route to the effective firm performance which accelerate the economic development of a country. many asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 289 changes involve capital investment decisions, which can invariably involve large sums of money over the long period. 'capital investment decisions are critical in managing strategic change and sustaining long term corporate performance' (emmanuel et al., 2010, p. 47 ). instituting a systematic capital budgeting decision process proffers procedures to mitigate consequences of subjective capital expenditure decision making. the investment decision making is not a simple or straight forward approach, the risk is an important element in making investment decision. this study seeks to examine the relationship between investment appraisal techniques and effectiveness of investment decisions. 2. literature review 2.1 defining capital budgeting/ investment appraisal in the finance literature investment appraisal is known as capital budgeting. ekeha (2011) explained that capital budgeting is an integral part of the corporate plan of an organization. capital budgeting can be defined as ‘the process of evaluating and selecting long term investment consistent with the firm owners’ goal of wealth maximization’ (gitman, 1988). this is one of the important decision making process. it is a process of determining best investment projects which generate higher yielding in order to maximize shareholder value dayananda, irons, harrison, herbohn, and rowland (2002). more simply, quirin (1967) illustrated that capital budgeting is a stipulated avenue to invest present sum of funds more efficiently and effectively in the long run. however, current financial theory requires that firm should maximize its market value of shares. since capital investment decision deals with large sum of fund, it could cause drastic change in firms as well as in the whole economy. therefore, capital investment decision is one of the most critical and crucial decision that needs to be taken carefully to achieve organizational growth as well as economic development. 2.2 investment appraisal techniques seven investment appraisal techniques are more prevalent in today business world: net present value (mao,1970; elumilade et al. 2006; ryan & ryan,2002; pike,1988; grahm & harvey,2001; arnold & hatzopoulos,2000; brounen, de jong & koedijk,2004 ), profitability index (mao,1970; gitman & forrester,1977; elumilade et al.2006; ryan & ryan, 2002), internal rate of return (mao,1970; gitman & forrester,1977; elumilade et al.2006; ryan and ryan,2002: grahm & harvey,2001; arnold & hatzopoulos,2000; brounen, de jong & koedijk,2004), modified internal rate of return (ryan & ryan, 2002), payback (pike,1996; ryan & ryan,2002), discounted payback (ryan and ryan, 2002), and accounting rate of return (pike,1996; ryan & ryan,2002). net present value (npv) of an investment is the aggregation of the present values of all cash benefits throughout the investment deducing the present value of all cash (elumilade et al. 2006). profitability index (pi) is the ratio of the present value of future cash benefits at the required rate of return to the initial cash outlay, and thus referred to as “benefits-cost ratio” (elumilade et al. 2006). internal rate of return (irr) is the rate of interest at which the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 290 present value of expected capital investment outlays is exactly equivalent to the present value of expected cash earning on investment (elumilade et al. 2006). accounting rate of return (arr) is the annual accounting profits from an investment, divided by annual average capital investment outlay over a project’s life span (elumilade et al. 2006). payback period (pb) describes how many years will be taken for the future net cash flows on a capital investment to pay back initial cash outlay (elumilade et al. 2006). 2.3 discounted and non discounted cash flow methods investment appraisal can take either discounted cash flow (dcf) methods or non dcf methods. npv and irr are called dcf methods and pb and arr are considered to be non dfc methods .among these methods, from theoretical point of view, the npv is widely used technique to evaluate investment projects however non dfc methods could be less accurate but least sophisticated (brealey & myers, 2003). however, haka, gorden and pinches (1985) explained that the financial methods take two basic classes: sophisticated and naïve selection techniques. discounted cash flow methods known as sophisticated techniques consider the risk adjusted discounted net cash flows expected from a project. it thus considers risk, cash flows and the time value of money. npv, irr and pi are the mainly employed sophisticated selection techniques. non discounted cash flow methods known as naïve method does not use cash flow approach in contrast consider present value or incorporate risk in systematic way. arr and pb are the mainly used naive selection techniques. 2.4 risk analysis techniques in addition to the investment appraisal techniques, there are various supplementary capital budgeting tools available in making and supporting investment decision. ryan and ryan (2002) illustrated the followings are major tools of risk analysis and those were described by them in the following manner. sensitivity analysis allows to assess changes provided that one variable input change at a time for example to assess the change in npv if sales change. scenario analysis is similar to sensitivity analysis however, more than one variable changes at a time for scenario analysis. inflation adjusted cash flows adjusts expected future cash flows by an estimated inflation factor. economic value added describes managerial effectiveness in a given year, often calculated in terms of net profit after tax that support operations of a firm .internal irr is the difference in cash flows of two comparison projects, commonly used in replacement decisions. simulation is a method for calculating the probability distribution of the possible outcome. pert/cpm is the analysis and mapping most efficient duration based financial decision. decision tree is a decision making tool showing sequential outcomes, associated with their probabilities. complex mathematical model deals with various option pricing model techniques, complex, real option, and firm specific proprietary models and methods. linear programming is the mathematical solution that identifies a set of projects and works to maximize npv subject to constraints. option pricing model takes either binomial option pricing model or the black-scholes option pricing model. the black-scholes option pricing asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 291 model used by firms like merck with high research and development expenditures, although large positive npv investments (ryan & ryan, 2002). real options discuss the opportunity for expansion, contraction or abandonment of a capital project before the project life span (ryan & ryan, 2002) mostly, the long run success of a firm depends on excellent investment decisions than on any other factors (megginson, smart & lucey,2008). majority of firms’ investment decision involves acquisition of fixed assets, for example, purchase of land, plant, equipment, and building. effective investment decision is thus essential to help mould the firm’s future opportunities and to deserve competitive advantage. ‘capital investment decisions are critical in managing strategic change and sustaining long term corporate performance’emmanuel, harris & komakech, 2010, p. 47 ). instituting a systematic capital budgeting decision process proffers procedures to mitigate consequences of subjective capital expenditure decision making. the investment decision making is not a simple or straight forward approach, the risk is an important element in making investment decision. 2.5 empirical review several studies (klammer, 1973;kim, 1981; pike, 1984; farragher, kleiman & sahu, 2001) have noted that analyzing the relationship between capital budgeting sophistication and firm’s performance and the use of accounting information when constructing performance measures is widespread. munyao (2010) suggested that sophisticated capital budgeting procedures can under the assumption of economic rationality be regarded as a means a firm uses in order to fulfill its objective of shareholders wealth maximization. in jordan, ramadan (1991) found an increasing trend toward adopting more sophisticated capital budgeting techniques by jordanian industrial corporations when evaluating capital investment projects. ramadan neither found a relationship between the techniques used and the performance of the firms, nor between the firm size and the techniques used. the sample of ramadan’s study (1991) includes all listed jordanian industrial corporations; 46 corporations. a questionnaire was addressed to the persons in charge of the capital budgeting decision, 37 usable replies have been analyzed to reach at the results of the study.some corporations in ramadan’s study (1991) refused to fill the questionnaire because they either claimed privacy issues, not having time, or tired of filling frequently flowing questionnaires. the questionnaire that ramadan (1991) used, explored the techniques used by the respondents and some explanations for that use. npv and pi were the most popular 20 techniques followed by the pbp, 30% of the firms use more than one technique. the managers use the dcf techniques because of their beliefs about the superiority of these techniques knowing that most of the managers are well educated and experienced. moreover, firms are more adapting to the changes in the investment environment. the pbp is still used as a supplementary technique since it gives a good measure for the maturity of the project and because it is a good tool when the liquidity is the concern. when analyzing the relationship between the performance and the technique used, ramadan (1991) found that on the long run there was no relationship between these variables, and to make his result more reliable he asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 292 included the firms that use either the dcf techniques, or the non-dcf ones, but not both. ramadan (1991) used simple measures for the performance like return on investment. the analysis revealed that all variables included in the model except the degree of sophistication have their expected effects on the performance. the researchers expected that better performing companies use sophisticated capital budgeting practices, the results showed a negative relationship between performance and degree of capital budgeting sophistication. the results of farragher et al.’s study (2001) are consistent with the results of ramadan’s study (1991). farragher et al (2001) studied the relationship between the use of sophisticated capital budgeting practices and corporate performance. the researchers developed a multiple regression model that explains the performance through some variables including the degree of capital budgeting sophistication. the data measuring the company’s degree of sophistication was gathered through a mailed questionnaire addressed to cfos of 379 american industrial large companies, 34% returned questionnaire were usable replies. in the kingdom of saudi arabia, el-ebaishe, karbhari, and naser (2003) examined the use of selected management accounting techniques by medium and large sized saudi manufacturing firms. a questionnaire was developed in line with previous researches, the questionnaire included 15 different management accounting techniques; capital budgeting is one of them. before distributing the questionnaire, it was pretested through pilot interviews with 7 cfos of the manufacturing companies. these pilot interviews helped in minimizing the wording ambiguity of the questionnaire and improving the relevance of its questions. the pilot interviews made the researchers exclude the small firms from their study after being uncertain about their responses. the results showed that vast majority of the surveyed companies use management accounting techniques employed by the study. regarding capital budgeting, 60% of the sample use capital budgeting when making capital investment decisions. brounen, jong and koedijk (2004) studied corporate finance in europe. they examined the gap between theory and practice by measuring the extent to which theoretical concept are adopted by professionals. the researchers used a questionnaire developed by graham, & harvey (2002), which was awarded a jensen price in 2001. a sample of 313 european 21 cfos answered the questions and the results showed that pbp technique is still used remarkably in europe. the capital assets pricing model is the most used one to estimate the cost of equity. there is a positive relationship between the size of the firm on one hand and the use of dcf techniques and the capital assets pricing model on the other hand. small firms and firms that are less oriented toward maximizing the shareholders wealth are more likely to apply pbp. these firms use whatever their investors tell them to use as cost of capital when applying dcf techniques. the education background of the respondents was irrelevant to the trend of using specific capital assets pricing model. the gap between theory and practice appears to be consistent across borders. the results of brounen et al.’s study concerning capital budgeting was not significantly different from the results of the study conducted on the u.s firms by graham and harvey (2002). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 293 the relationship between the capital expenditures and the corporate earning was the title of a study conducted on tai corporations by jiang, chen & huang (2006). the study examined 357 manufacturing corporations listed on the taiwan stock exchange. a sample period of 11 years was divided into capital investment period and performance period. the sample firms are grouped into eight portfolios ranked by capital investment ratio which is estimated from the investment period. the researchers examined the earnings in the performance period for the eight portfolios to see if any positive relationship exists. the results of jiang et al.’s study (2006) showed a significant positive relationship between the performance of corporations in the sample and the capital expenditures. the study did not include the effect of the techniques used when making the capital expenditures, but it implicitly assumed the use of npv technique. graham and harvey (2002) reported that chief financial officers (cfo) said that they always or almost used a particular evaluation technique i.e., irr and npv. the survey was based on the responses of three hundred and ninety two cfos. another study conducted by ehrhardt and wachowicz (2006) found that according to their surveys, most companies use dcf methods to evaluate capital budgeting decisions. dcf methods typically assume that a project’s initial cash outlay (ico) is known with certainty. a proper capital budgeting analysis should incorporate the additional risk that due to uncertain ico. sensitivity analysis is an effective way to address ico risk, but the finance literature often overlooks the adjustments needed to satisfactory address ico risk within a sensitivity analysis (as cited in rishi & rao,2005) verbeteen (2006) classified the capital budgeting practices as simple or naive capital budgeting practices (such as the payback and accounting rate of return) generally do not use cash flows, do not consider the time value of money and do not incorporate risk in a systematic manner. advanced capital budgeting practices (such as the internal rate of return and the net present value) are those that consider cash flows, risk, and the time value of money. capital budgeting decision makers have used various techniques to evaluate the proposed capital investment projects, and to determine the ones that benefit the firm the most. the adoption of particular techniques rather than others is determined by individual a study conducted on jordanian corporations provided empirical evidence on capital budgeting practices in jordan, the study was conducted by khamees, al-fayoumi, and al-thuneibat. (2010). the researchers used a questionnaire and conducted interviews to collect the data of the study. most of the 28 questions in the questionnaire were closed type questions, while the interviews were conducted before the distribution of the questionnaire. the interviews were conducted to clarify any ambiguity related to the questions in the questionnaire, to assure confidentiality to the respondents, and to show respondents the importance of their responses. according to the previous studies, investment appraisal techniques and risk analysis techniques have been included under capital investment appraisal practices. based on literature review following hypotheses have been formulated to conduct the study. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 294 h1: there is significant relationship between use of investment appraisal techniques and effectiveness of investment decisions h2: there is significant relationship between use risk analysis techniques and effectiveness of investment decisions further, following conceptual framework was formulated to examine the relationship between capital investment appraisal practices and effectiveness of investment decisions with support of literature review and empirical review. figure 1. conceptual framework 3. methodology the study focused to examine the relationship between use of investment appraisal practices and effectiveness of investment decision making in listed manufacturing companies in sri lanka. deductive approach was chosen for this study because it best suited as it was exploratory and gave the researcher an opportunity collect the relevant data to meet the objectives of the study. there are 295 companies listed on colombo stock exchange representing 20 business sectors. from the 20 business sectors, the manufacturing sector was selected for this study as it gives the much contribution to the gpd than other sectors. population consisted of the 40 manufacturing companies listed on the colombo stock exchange. 20 manufacturing companies were randomly selected as a sample from the population of 40 listed manufacturing companies. the field survey was used to collect the data from january to march and questionnaire was used as a survey instrument. 3.1 data collection 20 listed manufacturing companies in sri lanka have been randomly selected and self-reported questionnaire has been administered to gather data. the questionnaire adopted has been originally used and developed in pervious seminal studies (verma et al., 2009; graham & harvey, 2001). there are some modifications have been done on questionnaire based on the sri lankan context. the structured questionnaire includes closed ended questions inquiring the investment appraisal practices investment appraisal techniques (dcf & ndcf) risk analysis effectiveness of investment decisions control variable firm size asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 295 size of capital budgeting, educational qualification and experience of the people who responded to the survey and investment appraisal techniques and risk analysis techniques were on the likert scale of 1 to 5. effectiveness of investment decision was measured by perceived performance of chief financial officers (cfos) on the investment decision. questions on effectiveness of investment decision were developed based on the previous studies of verbeeten (2006) and pike (1988) then questionnaire was modified based on the sri lankan context and used likert scale of 1 to 5. firm size was considered as control variable as suggested from previous studies that if the firm size is high, company can employ the staff to evaluate the investment projects and make effective investment decision (verbeeten,2006). total assets of the companies were considered as size of the firms and which were collected from annual reports of the respective companies. one of the researchers visited to 20 listed manufacturing companies by getting appointment and collected the data by issuing questionnaire to the cfos / finance managers/ management accountants/ budget controllers of the companies. a reliability analysis of the item-scales was performed using spss. cronbach’s alpha (α) values were assessed for each variable with item-scales. the reliability of the measures was well above the minimum threshold of 0.60 in every case (gliner and morgan, 2000). thus, it can be concluded that all of the measures were generally reliable. 4. data analysis 4.1 descriptive statistics on demographic characteristics table 1 shows the demographical characteristics of the respondents; it shows the age of the company, planning horizon of the capital budget, size of capital budgeting, educational qualification and the experience of the cfo who responded to the questions of the questionnaire. the table shows the frequency, the percentage and mean of each variable as follows. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 296 table 1. demographical characteristics panels frequency percent panel a age below 30 5 25.0 30-40 7 35.0 40-50 3 15.0 more than 50 5 25.0 total 20 100.0 panel b capital budgeting planning horizon 1 year ahead 9 45.0 2 years ahead 4 20.0 3 years ahead 2 10.0 4 years ahead 3 15.0 more than 4 years 2 10.0 total 20 100.0 panel c size of capital budget < 10 million 4 20.0 10-99 million 5 25.0 100-499 million 5 25.0 500-999 million 3 15.0 >1 billion 3 15.0 total 20 100.0 panel d respondents experience less than 5 years 9 45.0 5 to 10 years 5 25.0 more than 10 years 6 30.0 total 20 100.0 panel e education qualification of respondents bachelor degree 5 25.0 mba 6 30.0 professional 9 45.0 total 20 100.0 source: survey data panel a: age the sampled manufacturing companies have been classified in terms of number of years which are in business. number of years has been categorized into four groups which are presented in panel a. 35 percent of the sample companies have been in business between 30 and 40 years (n-7). five companies (25 percent) have less than 30 years in business. five companies (25 percent) have more than 50 years in business. remaining companies reported that they are operating business between 40 and 50 years. panel b: capital budgeting planning horizon the sampled manufacturing companies have been classified in terms of capital budgeting planning horizon. number of years has been categorized into five groups which are presented in panel b. 45 percent of the sample companies involved with the capital budgeting 1 year ahead (n-9). four companies (20 percent) involved with 2 years ahead. three companies (15 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 297 percent) involved with 4 years ahead. remaining companies reported that same percentage they involved capital budgeting planning horizon. panel c: size of capital budgeting size of the capital budget has been categorized into five groups which are presented in panel c. the size generally takes minimum of ten million and a maximum of more than one billion. 20 percent of companies’ size of the capital budget is less than ten million while only 15 percent represented for more than one billion; 25 percent of companies’ capital budget is between 10 and 99 million. five companies (25 percent) mentioned that their size of the capital budget is 100-499 million and rest of the companies (15 percent) falls between 500 and 999 million. panel d: respondents experience experience of respondents has been classified into three groups in terms of number of years they worked in a particular profession. 45 percent of respondents are having less than 5 years of experience. 30 percent of respondents reported that they have experience more than 10 years. remaining respondents’ experience observed between 5 to 10 years. results are depicted in table 1 panel d. panel e: education qualification of respondents classification of educational qualification of respondents is presented in table i panel e. 45 percent (n=9) of respondents had professional qualification, followed by mba and bachelor degree qualification with 30 percent (n=6) and 25 percent (n=5) respectively. 4.2 analysis on the use of capital investment appraisal practices asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 298 table 2. investment appraisal techniques for evaluating investment projects in sri lanka never (1) rarely (2) some times (3) often (4) always (5) total mean rank % % % % % % payback (pb) 25 (5) 10 (2) 10 (2) 10 (2) 45 (9) 100 (20) 3.4 4 discounted payback (dpb) 10 (2) 0 (0) 5 (1) 45 (9) 40 (8) 100 (20) 4.05 3 accounting rate of return (arr) 35 (7) 10 (2) 10 (2) 30 (6) 15 (3) 100 (20) 2.8 6 net present value(npv) 0 (0) 0 (0) 0 (0) 20 (4) 80 (16) 100 (20) 4.65 1 internal rate of return (irr) 0 (0) 0 (0) 25 (5) 15 (3) 60 (12) 100 (20) 4.35 2 modified internal rate of return (mirr) 45 (9) 20 (4) 10 (2) 10 (2) 15 (3) 100 (20) 2.30 7 adjusted present value (apv) 50 (10) 10 (2) 10 (2) 25 (5) 5 (1) 100 (20) 2.25 8 profitability index (pi) 30 (6) 15 (3) 10 (2) 15 (3) 30 (6) 100 (20) 2.9 5 real option theory 70 (14) 20 (4) 5 (1) 0 (0) 5 (1) 100 (20) 1.50 10 game theory 90 (18) 5 (1) 0 (0) 0 (0) 5 (1) 100 (20) 1.25 11 non-financial decision 55 (11) 10 (2) 15 (3) 5 (1) 15 (3) 100 (20) 2.15 9 source: survey data cfos further have been requested to report use of capital budgeting methods and how they frequently used these methods on a likert scale from always (5) to never (1). results of the prevalence usage of capital budgeting methods have been summarized in table 2. npv is the most preferred method of investment appraisal where 80 percent of cfos are “always” preferred it which yielding mean value of 4.65. this is followed by irr “always” by 60 percent (m=4.35). dpb is the next “always” preferred method by 45 percent (m=3.4). 45 percent cfos revealed that dpb is an “often” preferred method which is dominant among all methods followed by pb (10 percent), irr and npv (15 percent and 20 percent). this findings are consistent with the studies of babu and sharma (1995),cooper et al.(2002), verma et al.(2009),truong, partington, and peat(2008) and nurullah and kengatharan (2015). the rest of the methods like pi, arr, mirr, and apv, real option theory, game theory and non-financial decision are not well popular in its usage where mean values are less than 3.0. appraisal techniques have been considered which have asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 299 mean value more than three for the analysis on the relationship between investment appraisal techniques and effectiveness of investment decision, as they are mostly used by selected companies. table 3. risk analysis techniques used by sri lankan listed manufacturing companies never rarely sometimes often always total mean rank % % % % % % sensitivity analysis 10 (2) 0 (0) 20 (4) 40 (8) 30 (6) 100 (20) 3.80 4 scenario analysis 20 (4) 5 (1) 20 (4) 20 (4) 35 (7) 100 (20) 3.45 5 monte carlo simulation 60 (12) 15 (3) 25 (5) 0 (0) 0 (0) 100 (20) 1.65 13 decision tree 30 (6) 10 (2) 20 (4) 30 (6) 10 (2) 100 (20) 2.80 6 capm 45 (9) 25 (5) 20 (4) 10 (2) 0 (0) 100 (20) 1.95 11 high cutoff rate 70 (14) 10 (2) 10 (2) 10 (2) 0 (0) 100 (20) 1.60 14 uncertainty absorption 50 (10) 0 (0) 25 (5) 25 (5) 0 (0) 100 (20) 2.25 9 breakeven analysis 0 (0) 0 (0) 10 (2) 20 (4) 70 (14) 100 (20) 4.60 1 adjusting the required return 35 (7) 15 (3) 20 (4) 25 (5) 5 (1) 100 (20) 2.50 7 inflation adjusted cash flow 15 (3) 0 (0) 10 (2) 25 (5) 50 (10) 100 (20) 3.95 2 market value added 40 (8) 10 (2) 25 (5) 15 (3) 10 (2) 100 (20) 2.45 8 complex mathematical model 65 (13) 30 (6) 5 (1) 0 (0) 0 (0) 100 (20) 1.40 16 linear programming 60 (12) 35 (7) 5 (1) 0 (0) 0 (0) 100 (20) 1.45 15 short payback period 55 (11) 15 (3) 10 (2) 15 (3) 5 (1) 100 (20) 2.00 10 use of certainty equivalent 65 (13) 10 (2) 15 (3) 10 (2) 0 (0) 100 (20) 1.70 12 probability analysis 10 (2) 10 (2) 10 (2) 25 (5) 45 (9) 100 (20) 3.85 3 source: survey data risk is mostly intertwined with capital investment decision. table 3 summarizes the risk analysis techniques used for incorporating risk in the investment analysis. according to the table 3, majority of cfos revealed that they use breakeven analysis for incorporating risk in the evaluation of investment proposal (always 70 percent and often 20 percent) yielding mean value of 4.60. inflation adjusted cash flow is the second most preferred method for incorporating risk (always 50 percent and often 25 percent) yielding second highest mean value of 3.95, followed by probability analysis (always 45 percent and often 25 percent), sensitivity analysis (always 30 percent and often 40 percent) and scenario analysis (always 35 percent and often 20 percent) yielding next highest mean value of 3.85, 3.80 and 3.45, respectively. all other risk analysis tools are hardly used in sampled companies. the results are consistent with the studies of babu and sharma (1995) verma et al. (2009) and nurullah and kengatharan (2015). risk analysis techniques have been considered which have mean value more than three asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 300 for the analysis on the relationship between risk analysis techniques and effectiveness of investment decision, as they are mostly used by selected companies. 4.3 correlation analysis correlation analysis is the statistical tool that can be utilized to determine the level of association between two variables (levin and rubin, 1998). this analysis can be seen as the initial step in statistical modeling to determine the relationship between the investment appraisal practices and effectiveness of investment decision. result of correlations analysis presented in the table 4. table 4. correlations between investment appraisal techniques and effectiveness of investment decision correlations pb dpb npv irr effectiveness pb pearson correlation 1 sig. (2-tailed) dpb pearson correlation .552* 1 sig. (2-tailed) .012 npv pearson correlation .193 .022 1 sig. (2-tailed) .415 .928 irr pearson correlation -.132 -.068 .498* 1 sig. (2-tailed) .579 .775 .025 effectiveness pearson correlation -.389 -.556* .535* .607** 1 sig. (2-tailed) .090 .011 .015 .005 *. correlation is significant at the 0.05 level (2-tailed). **. correlation is significant at the 0.01 level (2-tailed). source: survey data as a result presented in table 4, dpb, npv and irr significantly associated with the effectiveness of investment decision. there was a positive relationship between npv and effectiveness of investment decision that shows r= 0.535 at the significant level of 0.05 (p= 0.015) and also there was a positive relationship between irr and effectiveness of investment decision that shows r=0.607 at the significant level of 0.01 (p= 0.005). here the researcher found a negative relationship between the discounted payback period and effectiveness of investment decision that shows r=-0.556 at the significant level of 0.05. any other 5% level of significant relationship among the variables was not found in this study. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 301 table 5. correlations between risk analysis techniques and effectiveness of investment decisions correlations sensitivity analysis scenario analysis breakeven analysis inflation adjusted cash flow probability analysis effectiveness sensitivity analysis pearson correlation 1 sig. (2-tailed) scenario analysis pearson correlation .566** 1 sig. (2-tailed) .009 breakeven analysis pearson correlation .026 -.272 1 sig. (2-tailed) .914 .247 inflation adjusted cash flow pearson correlation .670** .298 .356 1 sig. (2-tailed) .001 .203 .123 probability analysis pearson correlation -.273 -.065 .546* .102 1 sig. (2-tailed) .245 .784 .013 .669 effectiveness pearson correlation -.486* -.179 .138 -.226 .339 1 sig. (2-tailed) .030 .451 .563 .337 .144 **. correlation is significant at the 0.01 level (2-tailed). *. correlation is significant at the 0.05 level (2-tailed). source: survey data as a result of correlations analysis presented in table 5, there was a negative relationship between the sensitivity analysis and effectiveness of investment decision (r=-0.486, p <0.05). none of the other techniques were significantly associated with effectiveness of investment decision in this study. 4.4 regression analysis regression analysis was performed to evaluate the impact of capital investment appraisal techniques and effectiveness of investment decision. result of regression analysis presented in the table 6. as per the result, specification of five variables firm size, pb, npv, irr, dpb revealed the ability to predict the effectiveness of investment decision (adj.r2 =75.3%) in this asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 302 model. it denoted that 75.3% of the observed variability in effectiveness could be explained by the differences in independent variable such as pb, npv, irr, dpb and firm size. the remaining 24.7% of the variances was not explained in this model. from the table 6, for model 1f value is 8.554 (p = 0.001, < 0.01). it was noted that the corresponding f value was significant. thus the distribution of effectiveness explained a significant portion of the variation in investment appraisal techniques evidenced by the significant p-value. therefore model was significant. model 1: effectiveness = 1.385β00.046 pb0.150dpb+ 0.413npv + 0.184irr + 0.050fs (1) table 6. regression analysis model unstandardized coefficients t sig. b std. error 1 (constant) 1.385 1.020 1.357 .196 pb -.046 .042 -1.098 .291 dpb -.150 .059 -2.539 .024 npv .413 .168 2.454 .028 irr .184 .079 2.316 .036 firm size (fs) .050 .071 .706 .491 adj.r2 = 0.753 f =8.554 p= 0.001 a. dependent variable: effectiveness in terms of pb, the coefficient of pb (coef = -0.046, p= .291) was negative but not significant. therefore it was concluded that there was no significant relationship between pb and effectiveness of investment decision. in addition, the coefficient of dpb was negatively significantly influenced on effectiveness of investment decision (coef= -.150, p < 0.05). reason for the negative relationship between dpb and effectiveness of investment decision may be dpb is not considered the risk analysis in a systematic way and was not considered time value of money. npv (coef = .413, p< 0.05) and irr (coef = .184, p< 0.05) are significantly positively influenced on effectiveness of investment decision. therefore, hypothesis h1 is supported that there is significant relationship between investment appraisal techniques and effectiveness of investment decision in terms of npv, irr and dpb. npv and irr are treated as advanced investment appraisal techniques in the literature (verbeeten,2006). advanced investment appraisal techniques lead to higher level of performance (farragher, kleiman & sahu, 2001). therefore the findings of the study are consistent with the literature. model 2: effectiveness = 4.013β0 0.220 sen+ 0.052 sce + 0.070 be + 0.023 in + 0.035 pa 0.004f….. (2) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 303 table 7. regression analysis for risk analysis techniques coefficientsa model unstandardized coefficients t sig. b std. error 2 (constant) 4.013 1.633 2.458 .029 sensitivity analysis (sen) -.220 .152 -1.449 .171 scenario analysis (sce) .052 .092 .565 .582 breakeven analysis (be) .070 .219 .322 .752 inflation adjusted cash flow (in) .023 .107 .217 .832 probability analysis (pa) .035 .103 .340 .739 firm size (fs) -.004 .130 -.029 .977 a. dependent variable: effectiveness adj.r2 =0.303 f= 0.941 p=0.499 .source : survey data as per the results presented in the table 7, model was not significant in this study (f = 0.941, p> 0.05). it was not found any significant relationship between risk analysis techniques and effectiveness investment decision. therefore h2 was not supported that there is no significant relationship between use risk analysis techniques and effectiveness of investment decision. findings of the study is inconsistent with the literature (e.g: pike,1988) 5. conclusion primary objective of the present study was to examine the relationship between use of capital investment appraisal practices and effectiveness of investment decision of listed manufacturing companies in sri lanka. capital investment appraisal practices were measured by capital investment appraisal techniques and risk analysis techniques of the projects. effectiveness of investment was measured by perceptions of cfos on the performance on investment. firm size was used as the control variable to examine the relationship between investment appraisal practices and effectiveness of investment decision. the study employed a field survey from january to march 2017 and primary data was collected through self-administered questionnaires from randomly selected 20 listed manufacturing companies. the data was analyzed using the descriptive analysis and inferential statistical analysis by using statistical package for social sciences (spss) version 20. results of the study revealed that npv and irr significantly positively related to effectiveness of investment decision while dpb significantly negatively related to effectiveness of investment decision of listed manufacturing companies in sri lanka. risk analysis techniques were not significantly related to effectiveness of investment decision. findings of the study may useful to the investment decision makers in order to achieve the shareholders wealth. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 304 references arnold, g.c., & hatzopoulos, p.d. 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(2009). a survey of capital budgeting practices in corporate india, the journal of business perspective, 13(3), 1-17. https://doi.org/10.1177/097226290901300301. microsoft word 11129-41046-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 333 politically connected independent directors and effective tax rates in china hong fan (corresponding author) department of accounting, saint mary’s university 923 robie street, halifax, ns canada e-mail: hong.fan@smu.ca liqiang chen department of finance, information systems and management science saint mary’s university 923 robie street, halifax, ns canada e-mail: liqiang.chen@smu.ca received: march 2, 2017 accepted: may 27, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.11129 url: http://dx.doi.org/10.5296/ajfa.v9i1.11129 abstract this paper empirically investigates politically connected independent directors in chinese public firms using 200 state-owned enterprises (soes) and 200 non-soes from 2002–2014. we find that, in general, firms with politically connected independent directors have higher effective tax rates than firms without such directors. we argue this is because that politically connected independent directors work for the interests of the government and restrict firms’ tax planning activities. additionally, the effect of politically connected directors on tax rates is weaker in soes than in non-soes, possibly because of the redundancy of the political ties that both independent directors and ownership bring in soes. our study reveals the potential cost of political connections that prior studies have overlooked. keywords: tax planning, effective tax rates, chinese soe, independent directors, corporate governance asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 334 1. introduction studies have found political connections to be critical to a firm’s success in a transitioning or emerging economy such as china’s (conyon, he, & zhou, 2015; li & zhang, 2007; li, meng, & zhang, 2006). china’s economy has become the second largest in the world, and analysts expect it to grow to become the largest very soon. however, china’s economic system still needs many improvements such as enhancing investor protection, strengthening institutional support, increasing contract and property rights enforcement, and decreasing government interventions (li, meng, wang, & zhou, 2008). the literature documents that a firm’s political connections could work as a substitute for formal institutions to overcome the voids in china’s weak institutional environment and allow the firm to expand to more markets (luo, 2003), access capital more easily(wu, wu, & liu, 2008), enjoy a lower cost of capital(fan& hope, 2013), and enhance its monopoly status (naughton, 2008). while the extant literature focuses on the political connections that ceos (wu et al., 2008)or firm ownership (fan& hope, 2013)bring, scholars seldom study the political connections of the board – especially those of independent directors’ political connections(wang, 2015). this study fills the gap in the literature by investigating the association between politically connected independent directors and the extent of tax aggressiveness in chinese public firms. tax aggressiveness is the downward manipulation of tax burden (frank, lynch, & rego, 2009). by definition, independent directors have no relation with the controlling party of their companies, and they are responsible for protecting shareholders—more importantly, minority shareholders—from expropriation by the management (wang, 2015). however, in the chinese context, the state tends to appoint politically connected independent directors to state-owned enterprises (soes) to influence their operations (wang, 2015). additionally, many non-soes welcome independent directors who have political connections with the government(i.e., politically connected independent directors), probably because of the firms’ strong need for these connections. the strong need is induced by the benefits of political connections as discussed earlier. in 2013, 44.9% of independent directors in the firms listed on the shanghai and shenzhen stock exchanges had political backgrounds.1 on the one hand, shareholders may react positively to politically connected independent directors because their political connections could help their firms enjoy preferential treatment from the government, such as a lower borrowing rate from government controlled banks, which could improve firms’ performance and value. on the other hand, shareholders may be concerned about whether these independent directors will expropriate them on behalf of the government. one common way of expropriation is to require firms be less aggressive in tax saving or even pay more taxes to the government, because a politically connected independent director is closely aligned with the government and may influence a firm’s tax behaviors for the interest of the government. therefore, a politically connected independent director may expropriate the shareholders’ interests to some extent. prior studies show that the behaviors of soes and non-soes are different because of their 1 http://fanfu.people.com.cn/n/2013/0909/c64371-22852586.html (in chinese) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 335 ownership structures. for example, soes are generally less aggressive in earnings management than non-soes are (wang & yung, 2011). the majority shareholder of a soe is the state, which means that soes have inherent political connections, while non-soes strive to earn political connections via their top managers and/or board members. the state may appoint politically connected independent board members for soes, while non-soes may need to invite independent board members with political connections to join their boards. because of these differences, politically connected independent board members may be more powerful in non-soes than soes. furthermore, the government monitors the tax activities of soes by itself, so potential monitoring by independent directors might be redundant. however, in non-soes, politically connected board directors could be crucial to monitor tax activities for the government. in this paper, we also test whether the effect of politically connected independent directors on firms’ tax aggressiveness is different for the two firm types. by studying 400 public firms included in the chinese securities index state-owned enterprises 200 (csi soe 200) and the chinese securities index privately-owned enterprises 200 (csi poe 200) for the period 2002–2014, we find that cash effective tax rates (cash etrs) are positively associated with politically connected independent directors in chinese firms. further, the effect of politically connected independent directors is weaker for soes than for non-soes. together, our results show that politically connected independent directors serve the interests of the state and closely monitor the tax activities of firms. as a result, firms with politically connected board directors pay more taxes than counterparts without politically connected independent directors. however, this does not necessarily mean that politically connected independent directors hurt the interests of shareholders even though they cause their firms to pay more taxes. preventing firms from being tax aggressive could benefit shareholders in the long term. studies have shown the tax aggressiveness may have negative impact on firm value, and the stock market reacts negatively to tax aggressive firms(hanlon & slemrod, 2009). our study contributes both to the tax literature and the corporate governance literature. first, our study contributes to the understanding of the role of independent board directors in china, which is understudied in the literature (wang, 2015). we find that firms with politically connected independent board director have higher cash etrs than other firms, suggesting that politically connected board directors represent the government and make firms comply with tax laws more strictly or even pay more taxes. second, our finding contributes to the tax literature by identifying another way to prevent firms from being aggressive in tax planning. finally, prior studies predict the differences in the behaviors between soes and non-soes due to their different ownership structures and major goals(friedman, johnson, & mitton, 2003; johnson, la porta, lopez-de-silanes, & shleifer, 2000; liet al., 2008; riyanto & toolsema, 2008). our study supports this prediction by providing empirical evidence about the different impacts of politically connected board directors on firms’ tax activities in soes and non-soes. our study has important practical implications as well. although people commonly believe that obtaining a political connection is critical to a firm’s success in china, they overlook the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 336 costs of that connection. our study is one of the first to point out the potential cost of a political connection in china—more specifically, the additional taxes a firm with such a connection may pay to the government. china is opening to the world and has more investment opportunities for foreign investors; however, people’s understanding of the chinese business environment is still limited. our study could interest companies that want to operate in china or collaborate with chinese partners. our findings reveal the necessary trade-off associated with politically connected board directors. foreign firms in china should consider these costs and choose their optimal board structures. the next section of this paper introduces regulations on independent board directors and related tax policies in china, reviews the literature, and proposes two hypotheses. the third section introduces the data and research design, followed by the empirical test results. the last section further discusses the results and concludes the paper. 2. literature review and hypotheses development 2.1 independent board directors and political connections in china the shanghai and shenzhen stock exchanges were established in 1990 and 1991, respectively. the first milestone for regulating independent board directors was the guidance on the establishment of an independent director system in listed companies (guidance) that the china securities regulatory commission issued in 2001. the guidance required all public firms listed on the shanghai or shenzhen stock exchanges to include at least two independent directors on their boards of directors, and at least one of those independent board directors had to be in the accounting profession. additionally, the independent directors had to make up a minimum of one-third of the total board members. although china’s economy has developed significantly in the past 30 years, it is still less developed than those of western countries. the gaps in the chinese economic system include weak investor protection, weak institutional support, weak contract and property rights enforcement, and overreaching interventions by the government (li et al., 2008). studies prove that the political connections of firms effectively work as a substitute for formal institutions to overcome the gaps in china’s weak institutional environment. for example, the political connection of a firm can help it expand to more markets (luo, 2003), access capital more easily (wu et al., 2008), enjoy a lower capital cost(fan& hope, 2013), and enhance its monopoly status (naughton, 2008). chinese firms strive to acquire political connections because of the enormous benefits they provide. soes have inherent political connections because their controlling shareholder is the government. the government tends to appoint politically connected independent board directors to sit on boards to direct soes to operate in its best interests. non-soes could gain political connections via their ceo and/or managers’ political ties and invite politically connected independent board directors to sit on their boards. in 2013, 44.9% of the independent board directors in firms listed on the shanghai and shenzhen stock exchanges had political connections. the literature usually refers to two types of political connections: past working experience in asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 337 the government or military, and membership in two key institutions of the central government—the national people’s congress (npc) and the chinese people’s political consultative conference (cppcc) (conyon at al., 2015; li et al., 2008). both the npc and cppcc operate at central and local levels. the npc is a legislative authority in the government, and npc members have the right to vote on laws and official appointments, whereas the cppcc is a consultative organization that provides suggestions and comments to the government (guo, 2001). by 2013, independent board directors who were retired government officials were receiving considerable attention from the media because the public questioned their legitimacy.2investors were concerned that officials might bestow unearned benefits on firms before retiring from the government to secure positions as independent directors because the salary for an independent director is significant. the public was also concerned about whether retired officials might provide special treatment to these firms such as leaked confidential information. to regulate independent directors further, the organization department of the communist party of china (odcps) issued the opinions on further regulating the issue of part-time (post-service) work of party and government leading officers in enterprises in october 2013, which requires government officials to justify positions they served with enterprises within three years of retirement. after three years, firms that hire former government officials need to report their hiring to the relevant government entity. additionally, no former officials can work for any firm without government approval. after the odcps issued this regulation, most retired officials resigned from their positions as independent directors. in our study, we did not include the past working experience in the definition of political connection and focused on the other type of political connection: npc membership and/or cppcc membership. we define “politically connected independent directors” as ones who are or were npc or cppcc members. 2.2 chinese income tax policy china began transitioning from a planned economy to a market economy in the late 1970s. in 1994, it enforced the corporate income tax code to regulate tax policies. at the time, china had just opened its door the outside of the world, and it was striving to attract foreign investors to raise funds and learn about management practices, advanced technology, and so on. therefore, the chinese government offered different income tax rates to domestic and foreign firms. before 2008, domestic companies in china faced a tax rate of 33%, while foreign firms faced rates as low as 15%—not to mention additional preferential tax treatments they received. the different tax rates competitively disadvantaged domestic chinese firms. in 2008, the chinese government enacted the uniform version of the corporate income tax law to make the tax rates the same for both domestic and foreign firms.3 china classifies taxes as central and local which the central and local governments collect, 2 http://www.qikan.com/article/74a54c7a-3072-404d-a6f6-a6b95997c0f4 (in chinese) 3 http://finance.sina.com.cn/g/20070227/00493357397.shtml (in chinese) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 338 respectively(wu, wu, zhou, & wu, 2012). for example, duties are central taxes while personal income taxes are local taxes. the central government collects income taxes of soes it controls. the central and local governments share income taxes from non-soes and soes that the local government controls. income taxes from enterprises are an important source of revenue for the central government and are the main sources of revenue for the local government. therefore, the government enforce tax practices in several ways, including annual tax auditing by the national taxation bureau and provincial bureaus. 2.3 tax aggressiveness and politically connected board directors the literature commonly defines “tax aggressiveness” as the downward manipulation of tax burdens of firms (frank et al., 2009). many researchers have found that corporate government mechanisms are significantly associated with tax aggressiveness(desai & dharmapala, 2008; shleifer & vishny, 1997). good corporate governance such as the presence of independent directors is one mechanism that may mitigate tax aggressiveness. however, chinese independent directors with political connections may act differently than their counterparts without political connections. politically connected independent board directors who have relationships with the government may act in the best interests of the government instead of shareholders. independent directors may prioritize government interests because their political connections are their capital assets rather than firm assets. these capital assets move with directors. at the same time, if directors act against the interests of the government, they may lose their political connections. we argue that independent directors will not risk their political ties with the government. if there is any conflict of interest between shareholders and the government, they will choose to protect government interests rather than shareholder interests, unlike independent directors in western countries. as discussed above, income taxes from enterprises are important sources of funds for both central and local governments. the governments expect firms to be less aggressive in tax planning so they can collect more tax. therefore, we predict that politically connected independent board directors can restrict the tax planning activities of their firms, resulting in lower tax aggressiveness (i.e., higher effective tax rate). our first hypothesis is: hypothesis 1: a firm’s effective tax rate is positively associated with the presence of politically connected independent directors on its board. 2.4 soes vs. non-soes in 1978, china opened its market to the world and started transitioning from a planned economy to a market economy. to modernize soes and increase their profitability, the chinese government decided to separate the ownership of these organizations from their management. in fact, the term “state-owned enterprises” was first introduced during this period of transition(fan & hope, 2013). the state still owned and controlled most firms, but this separation gave soes more autonomy in running their businesses while also providing them with incentives to improve their performance. the government has controlled soes via the state-owned assets supervision and administration commission (sasac) since it created the sasac in 2003. on behalf of the central government, the national sasac asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 339 supervises the 112 central soes, but it is not involved in any of their daily operations.4subnational sasacs at the provincial, municipal, and county levels supervise the non-central soes, and the role of these subnational sasacs is similar to that of the national sasac. the sasac controls the performance of soes by appointing managers, evaluating enterprise performance, and so on. soes and non-soes behave differently; for example, soes are found to be less aggressive in boosting their income. li et al. (2008) speculate that the main goals of these two types firms are different. while non-soes aim to maximize their profit, soes need to fulfill their social and political responsibilities. this explains the findings in the literature regarding their different behaviors. wu et al. (2012) provide empirical evidence to support li et al.’s conjecture. they find that the effects of political connections on firms are different for soes and non-soes. private firms with politically connected ceos outperform their counterparts without politically connected ceos, whereas local soes with politically connected ceos underperform compared to their counterparts that lack politically connected ceos. local soes may prioritize their social and political needs (e.g., lower unemployment rates) and sacrifice some business profits. wang (2015) provides further evidence of li et al.’s speculation by finding that non-soes with politically connected board directors can access external debt more easily than their non-connected counterparts can, while politically connected board directors in soes do not have a significant impact on their firms. wang argues that this is because soes care less about profits than non-soes do, so they do not try as hard to access external debt as non-soes. thus, independent directors in soes do not use their political connections to help them access debt. an alternative explanation of the findings of wang (2015) might be that soes have political connections from their state ownership, so the political connections associated with ceos and/or independent directors are redundant. soes may have easier access to external debt due to the political connections brought by the government ownership, and the political connections associated with managers or board members do not have significant incremental impact on obtaining external debt. we predict that the effects of the political connections of board directorsare weaker in soes than in non-soes, in line with the prior literature. in non-soes, politically connected board directors would work in the interest of the government and closely monitor the firms’ tax activities as argued in hypothesis 1. however, in soes, the government influences soes’ tax activities via their controlling of the firm, its influence on the ceos, and policies, making the monitoring of the politically connected board directors redundant. we predict the tax monitoring effect of the politically connected board director is weaker in soes than in non-soes. our second hypothesis is: hypothesis 2: the association between effective tax rate and the presence of politically connected independent board directors is weaker in soes than in non-soes. 4 http://www.sasac.gov.cn/n1180/n1226/n2425/index.html asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 340 3. data and research design 3.1 data our sample consists of 400 firms included in both the csi soe 200and csi poe 200 for 13 years from 2002 to 2014 based on the index components of 2014. the 200 firms in csi soe (poe) 200 are the state-owned (privately-owned) firms with the largest market capitalization and liquidity of all the public a-share companies listed on the shanghai or shenzhen stock exchanges. our data collection began with gathering director names and types (independent or not) from audited annual financial statements. once we obtained the names of independent directors, we followed prior research (peng, sun, & markóczy, 2015) and collected independent directors’ background information and npc/cppcc membership from the profile of directors and senior managers sections in the annual reports. because disclosing npc/cppcc membership is voluntary, we retrieved the full list of members of the national npc and cppcc from their official websites and searched the names of each independent director in the last 20 years. if we found a relevant name on this list, we then further checked whether the member was the same individual as the director in our sample by searching for additional information about him or her such as news and pictures. we defined a politically connected independent director (pboard) as a dummy variable equal to 1 if at least one independent director on the board is or was a member of the npc or cppcc and equal to 0 otherwise. to control for ceos’ political connections, we performed the same procedure for independent directors’ political connections to collect information about ceo’s political connections. we defined politically connected ceos (pceo) as a dummy variable equal to 1 if the ceo is or was a member of the npc or cppcc and equal to 0 otherwise. we also obtained ceo tenure data from the profile of directors and senior managers sections of annual reports. we retrieved financialand market-related data from capital iq. table 1 describes our data selection procedure. of the 5,200 (400 firms x 13 years) firm–year observations, 594went public after the initial sample year of 2002, thus reducing our sample size. among the remaining observations, 872 were missing political connection information on ceos and/or board members from their annual reports. we then merged the data with financeand market-related data from capital iq. after we deleted cases with missing data, the final sample size had 3,147 firm–year observations. a preliminary analysis of the data indicated certain extreme values. to reduce the effect of these outliers on the results, we winsorized all the continuous variables by 1% at the top and 99% at the bottom, including cash effective tax rate (etr), firm size, tenure, return on assets (roa), market-to-book ratio, leverage, capital intensity, and inventory intensity. 3.2 research design there are many ways to measure the aggressiveness of tax planning such as generally accepted accounting principles effective tax rate (gaap etr), cash etr, book-tax asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 341 difference (btd), and discretionary book-tax difference (dbtd)(lennox, lisowsky, & pittman, 2013). we believe that cash etr should be the best measure for our study. we argue that politically connected board members might require their firms to be less aggressive in tax savings or even pay more taxes because they act in the best interests of the government. the government cares more about the amount of cash tax collected than it cares about other measures of tax aggressiveness, because it collects cash to run its daily operations. therefore, we used cash etr as our dependent variable. our sample consists of panel data. we first performed hausman tests to compare a fixed effect model with random effect model and ordinary least squares model. the fixed effect model was preferred over the other two models. to test hypothesis 1, we used cash etrs as our dependent variable and controlled for the basic determinants of cash etrs, including return on assets (roa), market-to-book ratio (mtb), leverage (lev), ceo tenure (tenure), capital intensity (fix), inventory intensity (inv), net loss carry forward (loss), and size (size)(rego& wilson, 2012; zeng, 2010). we also included the dummy variable of pceo to measure the political connection of ceo(wu et al., 2012). we used the industry fixed effect model to control for any other industry-level characteristics. next, we incorporated our test variable pboard in the model. our model is: cash etrit = β0 + β1pboardit + β2pceoit + β3sizeit +β4mtbit + β5levit + β6invit + β7fixit + β8tenureit + β9roait+ β10lossit + βyears +εit (1) where cash etrit = cash etr is income taxes paid divided by pre-tax income for year t; pboardit = the politically connected independent director is a dummy variable that equals 1 if at least one independent director on board is or was a member of npc or cppcc and equals 0 otherwise; pceoit = the politically connected ceo is a dummy variable that equals 1 if the ceo is or was a member of npc or cppcc and equals 0 otherwise; sizeit = size is the natural log of the market value; mtbit = market-to-book ratio is the market value of common equity divided by the book value of common equity at the end of the current year; levit = leverage is the long-term debt of the current year-end divided by the book value of equity at current year-end; invit = inventory intensity is the total inventory of current year-end divided by the total assets of the firm at current year-end; fixit= capital intensity is the total fixed assets for the current year-end divided by the total assets of the firm at current year-end; tenureit=tenure is the number of years the ceo serves in this position; asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 342 roait = roa is the net income for firm i in year t divided by total assets for firm i in year t-1; lossit= loss is a dummy variable that assumes the value of 1 if there is a net loss carry forward and 0 otherwise. the data would support hypothesis 1 if β1 is positive and significant, suggesting that firms with politically connected board directors pay higher taxes for each dollar income than firms without politically connected board directors do, probably because of the strong tax monitoring of these politically connected board directors on behalf of the government. to test hypothesis 2, we used a similar model as previously described, and we introduced the interaction of pboard and the dummy variable of soe to the model. if the interaction of pboard and soe was negative and significant, the data would support hypothesis 2, indicating that the tax monitoring effect of politically connected independent board directors is weaker in soes. the model is: cash etrit = β0 + β1pboardit + β2soei * pboardit+ β3soei + β4 pceoit + β5 sizeit+β6 mtbit+ β7 levit + β8 invit + β9 fixit + β10tenureit + β11roait+ β12lossit + βyears +εit (2) where soei = seo is a dummy variable that takes the value of 1 if the firm is included in the csi soe 200 index and takes the value of 0 if the firm is included in the csi poe 200 index. 4. empirical results 4.1 descriptive statistics table 2 reports the summary statistics for the variables. panel a reports the descriptive statistics for the dependent variable (cash etr), and panel b reports the descriptive statistics for the continuous variables (roa, mtb, lev, tenure, fix, inv, and size). panel c presents the descriptive statistics for the discrete variables (pboard, pceo, soe, and loss). panel a indicates that the mean level of cash etr is 43.3%, which is higher than other studies(e.g., wu et al., 2012). we speculated this is because we include only large size firms (i.e., largest 200 soes and largest 200 poes) in our study. larger firms are less aggressive in tax saving for several reasons, such as more analysts following larger firms, the higher reputation costs for larger firms. in addition, we cover more current sample years. we tested the tax behavior of chinese public firms with a sample extending to 2014, while other studies focused on the period prior to 2008(wu et al., 2012; zeng, 2010). panel c presents the descriptive statistics for pboard, pceo, soe, and loss. our data show that about 20% of firm-year observations have the independent board directors with political connections via npc or cppcc membership and that about 18% of the ceos were npc or cppcc members, consistent with prior studies (wu et al., 2012). the soes and non-soes were almost equally distributed in our sample. the other control variable statistics presented in panel b were generally consistent with zeng (2010). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 343 table 3 presents the pearson correlation matrix for independent variables. no correlations are higher than 50%, suggesting that multicollinearity is not a significant concern in this study. 4.2 regression results for hypotheses 1 and 2 (table 4) table 4 shows the results of hypotheses tests using multivariable regression. model 1 presents the regression results of equation 1 and tests hypothesis 1. model 2 presents the regression results of equations 1 and 2 and tests hypotheses 1 and 2 simultaneously. in model 1, pboard is positively and significantly associated with the dependent variable cash etr, thus supporting hypothesis 1. this result supports our argument that independent board directors work as brakes for firms’ tax aggressive behaviors and require their firms to pay relatively more taxes than other firms do. in model 2, the interaction of pboard and soe was negative and significant, supporting hypothesis 2 that the effect of politically connected independent board directors on tax is weaker in soes than in non-soes, probably because the government—as the majority shareholder—can monitor the behaviors of the soes by itself, rendering the monitoring function of politically connected board director redundant to some extent. further, the coefficient of pboard is positive and significant, while the sum of the coefficients of the pboard and the interaction of pboard and the soe is not significantly different from 0 (untabulated), suggesting that non-seos mainly drive the positive relationship between pboard and cash etr. this indicates that non-seos still support hypothesis 1 and further supports hypothesis 2. we also find that the average cash etr is higher for soes than it is for non-soes, consistent with prior studies. similar to zeng (2010), we find roa to be negatively associated with cash etr in our study. loss is also negatively associated with the cash etr. firms with loss carry forward pay less tax. both inv and fix proxy the opportunities for firms to manipulate their taxes, and we find these two variables are positive and significant in model 2. further, pceo is positively and significantly associated with cash etr, suggesting that ceos with political connections are willing to pay relatively more taxes than ceos without political connections are. like politically connected independent board directors, politically connected ceos are aligned with the government and may be more conservative in tax planning. additionally, political connections are the assets of ceos instead of firms. ceos may not want to risk their political assets to benefit shareholders’ interests, and they especially may not want to be aggressive in tax planning to please shareholders at the risk of upsetting the government. 4.3 robustness tests (tables 5) we conducted robustness tests to check whether our results were sensitive to the model we used and the measures of tax aggressiveness we adopted. we retested our two hypotheses by using tobit model. then we used gaap etr to retest the two hypotheses using both fixed and tobit models. first, we reexamined the two hypotheses by using the tobit model and reported on the results in the first column of table 5. we expected cash etr to be within the range of 0 to 1, and we asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 344 set the upper level to 1 and the lower level to 0 in the tobit analysis. we found that the coefficient of pboardwas positive and significant, and the coefficient of the interaction between pboard and soe was negative and significant, which is consistent with the findings in table 4. further, the data supports our two hypotheses. second, we changed the measure of tax aggressiveness and substituted gaap etr for cash etr. gaap etr is the income tax expense divided by the pretax income. gaap etr is an alternative way to measure tax aggressiveness and the literature widely uses it(lennox et al., 2013). we reported regression results based on the fixed effect model in the second column of table 5 and the results based on the tobit model in the third column. gaap etr was positively and significantly associated with pboard and was also negatively and significantly associated with the interaction of pboard and soe. the results suggest that firms with a politically connected independent board director have higher effective tax rates than firms without such directors do, but this effect is less strong in soes than in non-soes. taken together, the findings for the two hypotheses are robust to different models and to the different measures of tax effective rates. 5. discussion and conclusion our study investigates the association between cash etrs and politically connected board directors. we find that firms with at least one politically connected board director had higher cash etrs than firms without politically connected board directors did. additional analyses showed that this association was stronger in non-soes than in soes. this result is robust to different models and different measures of tax aggressiveness. our findings highlight the potential costs (i.e., higher taxes) of independent board directors’ political connections. however, a relatively higher cash etr is not necessarily bad for shareholders. the chance of a tax authority auditing a firm is significantly higher when its book-tax difference is larger (mills, 1998), and the book-tax difference is the gap between financial income and taxable income. when firms are more aggressive in tax savings, the book-tax difference becomes larger and may attract more attention from the tax authority. if the tax authority discovers firms’ tax aggressiveness, the stock market will react negatively to this news (hanlon & slemrod, 2009). in the long run, being too aggressive in tax saving might hurt the interests of shareholders. our findings provide the boards of firms in china with a new angle to evaluate politically connected board directors. we recommend including at least one politically connected board director in non-soe boards to gain political connections and act as a brake for tax aggressive activities. however, the value of such directors is not significant in soes. our paper studied chinese firms, so the results may not be generalizable to other countries due to its unique institutional context. we acknowledge this as a limitation of our paper. references conyon, m. j., he, l., & zhou, x. 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(2010). ownership concentration, state ownership, and effective tax rates: evidence from china’s listed firms. accounting perspectives, 9(4), 271-289. https://doi.org/10.1111/j.1911-3838.2010.00014.x table 1. sample selection initial sample (firm-year observations) 5,200 (a) deletions due to missing data for prior ipo -594 ceo’s political connection -811 board’s political connection -61 cash etr in capital iq -21 control variables -566 sample size 3,147 (a) csi soe 200 firms and csi poe 200 firms 13 years (2002-2014) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 347 table 2. summary statistics for dependent and independent variables panel a: dependent variables variables mean std dev 25th 50th 75th cash etr 0.433 0.836 0.208 0.433 0.797 panel b: continuous variables variable mean std dev 25th 50th 75th tenure 4.4903 3.3514 2 3 6 roa 5.0155 5.0921 1.780 3.880 7.150 lev 0.2221 0.1652 0.078 0.212 0.337 mtb 3.6569 2.8570 1.756 2.745 4.603 fix 0.2712 0.1983 0.115 0.237 0.394 inv 0.1670 0.1582 0.056 0.130 0.218 size 9.1942 1.8707 7.923 8.914 10.169 panel c: discrete variables variable value percent value percent pboard 1 19.67% 0 80.33% pceo 1 17.57% 0 82.43% soe 1 52.59% 0 47.41% loss 1 3.84% 0 96.16% variable definitions dependent variable: cash etrit = cash etr calculated as income taxes paid divided by the pre-tax income in year t; independent variables: tenure = number of years the ceo serves in this position; roait = roa calculated as the net income for firm i in year t divided by total assets for firm i in year t-1; mtbit = market-to-book ratio calculated as the market value of common equity divided by book value of common equity at end of current year; levit= leverage calculated as long-term debt at current year-end divided by book value of equity at current year-end; fixit = capital intensity calculated as total fixed assets at current year-end divided by total assets of the firm at current year-end; invit = inventory intensity calculated as total inventory at current year-end divided by total assets of the firm at current year-end; sizeit = natural log of market value; discrete variables: pboardit = the politically connected independent director is a dummy variable that equals to 1 if at least one independent director on board is or was a member of npc or cppcc, and equals to 0 otherwise; pceoit = the politically connected ceo is a dummy variable that equals to 1 if the ceo is or was a member of npc or cppcc, and equals to 0 otherwise; soei = seo is a dummy variable that takes the value of 1 if the firm is included in the csi soe 200 index, and take the value of 0 if the firm is included in the csi poe 200 index; lossit = loss is a dummy variable that takes value of 1 if there is a net loss carry forward and 0 otherwise. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 348 table 3. correlations cash etr pboar d soe pce o size mtb lev inv fix tenur e roa pboar d 0.010 1.000 soe 0.091 0.199 1.000 pceo 0.065 0.064 -0.02 5 1.000 size 0.070 0.320 0.469 0.153 1.000 mtb -0.093 -0.127 -0.16 4 -0.08 8 -0.34 6 1.000 lev 0.070 -0.017 -0.05 8 0.013 0.046 -0.16 7 1.000 inv 0.097 -0.097 -0.09 0 0.039 -0.05 4 -0.00 2 0.188 1.000 fix 0.089 -0.020 0.124 -0.00 5 -0.08 2 -0.10 7 0.313 -0.33 8 1.000 tenure 0.043 0.019 -0.07 6 0.198 0.162 -0.02 8 -0.04 4 0.054 -0.08 4 1.000 roa -0.139 -0.103 -0.06 3 -0.05 1 -0.21 5 0.337 -0.27 5 -0.02 6 0.019 0.025 1.000 loss -0.025 -0.032 -0.02 5 -0.04 5 -0.10 0 0.075 0.166 -0.03 5 0.098 -0.081 -0.14 2 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 349 table 4. hypotheses tests model 1 model 2 pboard (h1) 0.093 0.123 (1.99)** (1.94)** pboard *soe (h2) -0.141 (1.84)* pceo -0.006 0.064 (0.13) (1.72)* size -0.009 0.018 (0.31) (1.16) mtb -0.006 0.001 (0.85) (0.21) lev 0.027 -0.161 (0.19) (1.54) inv 0.234 0.457 (1.39) (3.53)*** fix -0.049 0.331 (0.31) (3.12)*** tenure -0.005 0.002 (0.83) (0.41) roa -0.045 -0.040 (11.70)*** (12.63)*** loss -0.144 -0.103 (2.14)** (1.43) soe 0.118 (3.10)*** intercept 0.975 0.527 (4.02)*** (3.80)*** years included included industries included included r2 0.14 0.13 n 3,147 3,147 *p<0.10; ** p<0.05; *** p<0.01 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 350 table 5. robustness tests dependent variable: cash etr dependent variable: gaap etr tobit model fixed effects tobit model pboard (h1) 0.112 0.025 0.025 (3.49)*** (2.46)** (2.58)*** pboard *soe (h2) -0.158 -0.035 -0.034 (4.10)*** (2.78)*** (2.85)*** pceo 0.047 -0.012 -0.013 (2.51)** (1.96)* (2.24)** size 0.016 0.002 0.002 (2.10)** (0.85) (0.85) mtb -0.002 -0.003 -0.003 (0.66) (2.57)** (2.64)*** lev -0.085 0.055 0.054 (1.62) (3.21)*** (3.34)*** inv 0.391 0.083 0.086 (5.99)*** (3.95)*** (4.29)*** fix 0.076 0.002 -0.000 (1.42) (0.14) (0.00) tenure 0.000 0.000 0.000 (0.12) (0.17) (0.21) roa -0.012 0.002 0.002 (7.66)*** (4.47)*** (3.68)*** loss -0.097 0.000 0.001 (2.57) ** (0.02) (0.06) soe 0.078 0.001 0.002 (4.10)*** (0.20) (0.40) intercept 0.354 0.150 0.113 (62.97)*** (6.62)*** (76.66)*** years included included included industries included included included r2 0.31 0.03 0.01 n 3,147 3,147 3,147 *p<0.10; ** p<0.05; *** p<0.01 microsoft word 9339-34224-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 182 does the type of material information matter to ceo turnover? ya-fang wang department of accounting, providence university 200, sec. 7, taiwan boulevard, shalu dist., taichung city 43301 taiwan (r.o.c.) tel: 886-4-2632-8001 ext.13216 e-mail: yfwang2@pu.edu.tw received: feb. 20, 2016 accepted: may 6, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.9339 url: http://dx.doi.org/10.5296/ajfa.v8i1.9339 abstract using hand-collected data to obtain the nature of material information, i examine whether and how the likelihood of ceo turnover is associated with material information disclosures. i find the likelihood of ceo turnover increases following different types of material information announcements. further, i partitioned the sample into the various stages of company life cycle in order to determine whether life cycle stage affects the relationship between the disclosure of material information and ceo turnover. the results show that the disclosure of material information by companies only in maturity and decline is associated with high ceo turnover. keywords: material information, ceo turnover asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 183 1. introduction issuing material information is a people-oriented corporate culture in which product safety and consumer rights are paramount. hence, encouraging companies to issues material information is particularly important, because such companies of issuing material information are more likely to reject illegal act when they face the beneficial temptation. one key to sustainable operations is to bear in mind material information in the full weight of any corporate decision. companies are more likely to disclose material information when they think such information is important to corporate decisions and are therefore more likely to win trust and respect from customers and stockholders. in this study, i focus on whether material information disclosures are associated with following economic consequences, because i argue that the nature of material information disclosures is of particular importance and may cause various influences on companies and market participants (foster and viswanathan 1993; kim and verrecchia 1991; holthausen and verrecchia 1988). material information disclosures belong to voluntary disclosures in taiwan, and taiwan has specific sections designated to encourage companies to disclose material information in a timely and accurate manner. material information is defined as (1) financial or nonfinancial information having a material impact on a public company’s financial and business performance, or (2) financial or nonfinancial information having a material impact on the price of the securities or investment decision of market participants. according to the laws stated in the taiwan stock exchange corporation procedures, material information can be classified into six categories to capture the nature of material information from different perspectives. according to the taiwan stock exchange corporation procedures for verification and disclosure of material information of companies with listed securities, i divided the disclosure of material information into six classifications: (1) material change in shareholder equity, (2) material change in business policy, (3) material disasters resulting in serious reduction or complete cessation of production, (4) material effects on shareholder equity or company operations resulting from a change in laws, regulations, or rules of the home country, (5) mass media reportage about the parent company sufficient to affect securities prices of a listed subsidiary in the roc, and (6) occurrence of any other material event that shall be immediately reported pursuant to law or regulation of a foreign company’s home country. although prior studies show that voluntary disclosures provided have the potential to reveal incremental information (bushee and goodman 2007; al-tuwaijri et al. 2004; orlitzky et al. 2003; margolis and walsh 2001) and these disclosures can affect firms’ performance (dhaliwal et al. 2011; cohen et al. 2011; cruise 2011; lev et al. 2010; cica survey 2010; rodríguez et al. 2006; gelb and strawser 2001), there is yet systematic evidence on the association between material information disclosures and following economic consequences. particularly a series of food safety scandals (e.g., chang chi foodstuff factory co., flavor full food inc. and ting hsin international group) led many to pay attention to the competence of companies and the importance of material information disclosures. additionally, iatridis and alexakis (2012) further find that corporate disclosures are a more reliable reflection of a firm’s financial health. hence, material information disclosures can asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 184 interpret as signals of firms’ financial health. this raises the question of whether companies are likely to terminate their ceos when they think the ceo shall be responsible for material information disclosures. the remainder of this study is organized as follows: section 2 presents a literature review. section 3 describes the sample selection process and research design. section 4 reports the empirical results. conclusions are discussed in section 5. 2. literature review according to furtado and karen (1990), the research on executive turnover comprises three broad categories: (1) factors contributing to turnover, (2) immediate market reactions to executive turnover events, and (3) subsequent performance post management turnover. many studies on executive turnover change the focus from poor performance to financial reporting quality. and, these empirical studies have proved the existence of the relationship between poor performance and the likelihood of managerial turnover (coughlan and schmidt 1985; warner et al. 1988; weisbach 1988; denis et al. 1997; engel et al. 2003; bonnier and bruner 1989; furtado and rozeff 1987; kaplan and minton 2006; kim 2008; karpoff et al. 2008). in this study, i focus on whether material information disclosures are associated with following executive turnover, because i argue that the nature of material information disclosures is of particular importance and may cause various influences on companies and market participants (foster and viswanathan 1993; kim and verrecchia 1991; holthausen and verrecchia 1988). thus, my study represents initial attempt to reveal the intricacy between executive turnover and material information. corporate disclosures can reduce inefficiency in the market and identified the factors underlying the motives of mangers in the voluntarily disclosure of information (lambert et al. 2007; core 2001; healy and palepu 2001; diamond and verrecchia 1991), and these disclosures are associated with management incentives (merkley 2014; kravet and muslu 2013; davis et al. 2012; price et al. 2012; loughran and mcdonald 2011; henry 2008; li 2006). some studies (desai et al. 2006; arthuad-day et al. 2006; burks 2010; collins et al. 2009) further reported that companies of issuing material information generally experience a series of turmoil, including negative publicity, difficulty in accessing capital markets, decrease in stock price, lawsuits, and potential enforcement by the securities and exchange commission. despite the growing importance of information regarding firms’ voluntarily disclosures to executive turnover, evidence on its role in responsible behavior of information disclosures is scant. in particular, there is little evidence on whether information about executive turnover conveyed through material information provides incremental information to investors by reducing uncertainty. therefore, i examine whether companies are more likely to terminate their ceos following material information announcements, because material information matters to the market, and assessments of disclosing behavior can potentially provide useful and timely information to investors. when a company issues its relevance information through the disclosure of material information, market participants may interpret executive turnover following disclosing decisions as responsible behavior. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 185 3. research design 3.1. data sources to test research questions, i collected publicly listed companies in taiwan over the period from 2007 to 2012. my sample comprised 7,777 firm-year observations and this sample was identified through two sources. i began by hand collecting data related to types of mi disclosures from the market observation post system. i then accessed company-level data related to ceo turnover and accounting from the taiwan economic journal (tej) database. table 1 provides the distribution of research samples across industries and years and shows that electronics industry has the highest percentages in research samples (61.87%), while cement industry has the lowest percentages in research samples (0.46%). table 1. sample distribution year industry 2007 2008 2009 2010 2011 2012 total chemicals 76 78 80 81 86 88 489 cement 6 6 6 6 6 6 36 glass & ceramics 12 12 12 12 12 12 72 constructions 70 69 69 70 69 70 417 food 24 24 24 24 25 25 146 textile 54 54 54 54 53 54 323 transportations 24 23 23 23 24 24 141 trading 22 22 22 22 22 22 132 plastic 25 25 25 26 26 26 153 electronics 780 789 798 805 818 822 4,812 appliance & cable 15 16 17 18 18 18 102 electric & machinery 67 68 68 71 75 75 424 tourism 19 20 20 20 19 19 117 others 65 65 65 69 74 75 413 total 1,259 1,271 1,283 1,301 1,327 1,336 7,777 3.2 model specification－material information vs. ceo turnover i constructed a research model to explore whether material information is associated with ceo turnover, and test which types of material information can better describe companies’ reactions to releases of material information. the research model (1) is as follows: )1(,65432610 tiyeargcosizelevlossroamiceo εϕααααααα ++++++++= − where ceo equals 1 if the ceo leaves the company following the material information, else 0; mi-1 equals 1 if the company disclosed material change in shareholder equity, else 0; mi-2 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 186 equals 1 if the company disclosed material change in business policy, else 0; mi-3 equals 1 if the company disclosed material disaster resulting in serious reduction or complete cessation of production, else 0; mi-4 equals 1 if the company disclosed material effect on shareholders' equity or company operations resulting from a change in laws, regulations, or rules of the home country, else 0; mi-5 equals 1 if the company disclosed mass media reportage about the parent company sufficient to affect securities prices of a listed subsidiary in the roc, else 0; mi-6 equals 1 if the company disclosed occurrence of any other material event that shall be immediately reported pursuant to law or regulation of the foreign company's home country, else 0; roa equals net income divided by total assets; loss equals 1 if operating income is less than zero, else 0; lev equals long-term debt divided by total assets; size equals the natural log of total assets; gco equals 1 if the company receives a going concern opinion, else 0; and year equals dummy variables controlling for years. 4. results and analysis table 2 presents the descriptive statistics for all variables used in our research models, partitioned by two subsamples: cases of companies with ceo turnover (n = 1,089), and cases without ceo turnover (n = 6,688). as such, comparing two subsamples provides evidence as to whether or not ceo turnover is more likely to be associated with types of material information. the means (medians) of mi-1, mi-2 and mi-4 reported in the subsample with ceo turnover are at the 0.01 level for both tests, which is significantly larger than those reported in the subsample with no ceo turnover. in addition, the means (medians) of loss and gco reported in the ceo turnover subsample are at the 0.01 level for both tests, which is significantly larger than those reported in the subsample without ceo turnover. the means (medians) of roa and size reported in the ceo turnover subsample are at the 0.01 level for both tests, which is significantly smaller than those reported in the subsample without ceo turnover. univariate comparisons indicate that companies of ceo turnover have high more material information (mi-1, mi-2, mi-4), perform bad (roa) and suffer more losses (loss), receive more going-concern opinions (gco), and are smaller in size (size) than companies without ceo turnover. overall, my findings suggest that material information is likely to be associated with ceo turnover. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 187 table 2. descriptive statistics ceo turnover (n=1,089) no ceo turnover (n=6,688) t-test1 wilcoxon variables mean median mean median mi-1 0.672 1.000 0.608 1.000 4.028*** 4.024*** mi-2 0.914 1.000 0.859 1.000 4.895*** 4.888*** mi-3 0.031 0.000 0.029 0.000 0.374 0.374 mi-4 0.803 1.000 0.768 1.000 2.577*** 2.576*** mi-5 0.490 0.000 0.481 0.000 0.591 0.591 mi-6 0.021 0.000 0.020 0.000 0.269 0.269 roa 0.004 0.025 0.042 0.045 -10.520*** -9.769*** loss 0.347 0.000 0.208 0.000 10.236*** 10.169*** lev 0.076 0.027 0.069 0.026 2.067** 1.067 size 15.027 14.814 15.212 15.027 -3.866*** -4.465*** gco 0.035 0.000 0.011 0.000 6.268*** 6.253*** 1 asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels. table 3 represents the pearson correlation for all variables used in the research models. results show that ceo is positively correlated with mi-1 (0.046), mi-2 (0.055), and mi-4 (0.029), implying that companies with material information releases are more likely to terminate their ceo. ceo was also shown to be correlated with roa (-0.019), loss (0.115), lev (0.023), size (-0.044), and gco (0.071), suggesting that smaller companies, bad performance, unfavorable audit opinion, and those with more pronounced losses and higher leverage, were more strongly associated with ceo turnover. as depicted in this table, most explanatory variables are not significantly correlated to each other. i also estimate variance inflation factors (vifs) to test for possible multicollinearity while considering all independent and control variables. none of the vifs is greater than 1.7, indicating no presence of multicollinearity in my study. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 188 table 3. correlation matrix variables 1 mi1 mi2 mi3 mi-4 mi-5 mi-6 roa loss lev size gco ceo 0.046 * 0.055 * 0.004 0.029* 0.007 0.003 -0.119* 0.115* 0.023* -0.044* 0.071* mi-1 0.147 * 0.007 0.098* 0.160 * 0.022 -0.018 0.016 0.073* 0.142* 0.045* mi-2 0.012 0.006 0.111 * 0.016 -0.019 -0.006 0.078* 0.152* -0.020 mi-3 -0.022 0.036 * 0.013 0.004 -0.004 0.037* 0.048* -0.002 mi-4 0.099 * 0.021 0.030* -0.040* 0.038* 0.094* -0.013 mi-5 0.044 * 0.142* -0.129* 0.100* 0.394* -0.046* mi-6 -0.041* 0.001 0.004 0.066* -0.009 roa -0.600* -0.103* 0.176* -0.228* loss 0.115* -0.181* 0.179* lev 0.294* 0.048* size -0.131* 1 * indicates significance at the 5 percent level. table 4 shows empirical evidence for companies of issuing material information are associated with higher rates of ceo termination. as predicted, the coefficient on mi-1, mi-2, mi-4, and mi-5 are significantly positive at least at the 0.05 significance level, suggesting material information involving (1) material change in shareholder equity, (2) material change in business policy, (3) material effect on shareholders' equity or company operations resulting from a change in laws, regulations, or rules of the home country, and (4) mass media reportage about the parent company sufficient to affect securities prices of a listed subsidiary in the roc are more likely to terminate their ceos following material information announcements. the coefficients on control variables (roa, loss, size, gco) indicate that companies with better performance (roa), fewer losses (loss), larger size (size) and fewer unfavorable opinions (gco) are associated with lower ceo turnover rates. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 189 table 4. material information and ceo turnover variables pred. sign coef. z-value1 constant -1.005 -4.65*** mi-1 ＋/－ 0.089 2.30** mi-2 ＋/－ 0.282 4.72*** mi-3 ＋/－ 0.050 0.48 mi-4 ＋/－ 0.128 2.87*** mi-5 ＋/－ 0.082 2.09** mi-6 ＋/－ -0.010 -0.08 roa － -0.672 -3.98*** loss ＋ 0.254 5.12*** lev ＋ 0.190 1.00 size ＋/－ -0.043 -3.02*** gco ＋ 0.327 2.46*** year included pseudo r2 3.05% nobs. 7,777 1 asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively. one-tailed for directional expectations, two-tailed for others. prior studies suggest that considering different stages of firm life cycle in marking decisions can improve the ability of managers to implement appropriate strategies, and to benchmark their performance (hanks et al. 1993; galbraith 1982). thus, i partitioned the sample into the various stages of company life cycle in order to determine whether life cycle stage affects the relationship between the disclosure of material information and ceo turnover. following prior studies (black 1998; anthony and ramesh 1992), i first construct life cycle model that incorporates a firm’s five-year history of four classification variables: age, sales growth, dividend yield, and capital expenditures. second, i assign each firm-year scores based on their relative ranking of these four classification variables. third, the scores for each of the four classification variables combine into a composite score categorizing each firm-year observation into one of the following three life cycle stages: (1) growth, (2) maturity, and (3) decline. table 5 presents the results related to the association between material information and ceo turnover in different stages of a company’s life cycle. surprisingly, coefficients of material information were significant (at least at the 5% significance level) only in companies in maturity and decline, which implies that the disclosure of material information by companies in maturity and decline is associated with high ceo turnover. on the contrary, none of coefficient of material information in growth subsample is significant. a possible reason underlying this finding is that growth companies may less likely to issue material information. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 190 table 5. material information and ceo turnover: consider life cycle (1) (2) (3) growth maturity decline variables pred. sign coef. z-value1 coef. z-value coef. z-value constant -1.572 -3.48*** -0.621 -2.15** -1.546 -3.04*** mi-1 ＋/－ -0.011 -0.12 0.120 2.31** 0.097 1.17 mi-2 ＋/－ 0.163 1.29 0.264 3.23*** 0.468 3.68*** mi-3 ＋/－ 0.163 0.83 0.043 0.31 -0.062 -0.21 mi-4 ＋/－ 0.133 1.47 0.070 1.18 0.328 3.00*** mi-5 ＋/－ 0.083 1.00 0.055 1.03 0.169 1.91* mi-6 ＋/－ 0.241 0.96 -0.225 -1.24 0.346 1.20 roa － -0.732 -1.52 -0.598 -3.12*** -1.251 -1.80* loss ＋ 0.283 2.40** 0.280 4.39*** 0.068 0.52 lev ＋ -0.284 -0.76 0.379 1.49 0.405 0.80 size ＋/－ 0.005 0.16 -0.067 -3.47*** -0.027 -0.81 gco ＋ 0.500 1.40* 0.211 1.32 0.541 1.50 year included included included pseudo r2 2.8% 3.56% 4.36% nobs. 1,765 4,400 1,612 1 asterisks *, **, *** indicate significance at the 0.10, 0.05, and 0.01 levels, respectively. one-tailed for directional expectations, two-tailed for others. 5. conclusions this study provides empirical evidence to explore whether material information is associated with ceo turnover based on a sample of 7,777 observations from 2007 to 2012. overall, evidence shows that companies are more likely to terminate their ceos following material information announcements. i further consider the various stages of company life cycle in order to determine whether life cycle stage affects the relationship between the disclosure of material information and ceo turnover. notably, i find that the disclosure of material information by companies only in maturity and decline is associated with high ceo turnover. one major limitation of this study is that approximately 99% of companies in taiwan discloses material information, indicating that material information disclosures are a very common phenomenon in taiwan. a possible reason underlying this finding is that material information disclosures in taiwan are voluntary disclosures and taiwan’s government encourages companies to disclose material information with respect to the public interest. thus, the skewness of material information disclosures may cause misspecification when this skewness in the dependent variable of eq. (1). future research can explore whether and how material information announcements can improve information transparency. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 191 references al-tuwaijri, s. a., t. e. christensen, & k. e. hughes ii. (2004). the relations among environmental disclosure, environmental performance, and economic performance: a simultaneous equations approach. accounting, organizations and society, 29(5-6), 447-471. http://dx.doi.org/10.1016/s0361-3682(03)00032-1 anthony, j., & k. ramesh. (1992). association between accounting performance measures and stock prices: a test of the life cycle hypothesis. journal of accounting and economics, 15(2-3), 203-227. http://dx.doi.org/10.1016/0165-4101(92)90018-w arthaud-day, m.l., certo, s.t., dalton, c.m., & dalton, d.r. 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(1988). outside directors and ceo turnover. journal of financial economics, 20, 431-460. http://dx.doi.org/10.1016/0304-405x(88)90053-0 microsoft word 13142-48000-1-sm-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 336 the impact of human capital development cost on the net income and dividend: an applied study over jordanian islamic banks dr. atef aqeel al-bawab irbid national university, jordan tel: 96-277-732-6901 e-mail: atefbawab@yahoo.com dr. hani ali aref al-rawashdeh irbid national university, irbid, jordan received: may 7, 2018 accepted: june 4, 2018 published: june 4, 2018 doi:10.5296/ajfa.v10i1.13142 url: https://doi.org/10.5296/ajfa.v10i1.13142 abstract the study aimed at identifying the effect of the cost of human capital development through training employees on the net income and dividend at jordanian islamic banks; three banks. the study followed the descriptive analytical approach. the financial data of published financial statements of the study population over the period (2012-2015) were brought and analyzed by mathematical modules to test the study hypotheses. the study concluded several results, the most important are: there is an effect for the cost of training employees over the pre-tax annual profit development at jordanian islamic banks with variant proportions. there is also an effect with variant proportions for the cost of training employees over dividend. the study recommended several recommendations; the most important was the need of jordanian islamic banks to disclose in their financial statements in details the cost of their human capital development. keywords: cost, human capital, net income, market share value, jordanian islamic banks. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 337 introduction human capital is considered one of the modern administrative and accounting topics whose literature has been presented in terms of measurements and the way it is shown in the financial statements. management started being aware that competitiveness, increasing profits and sustainability in the market cannot be achieved depending on investing in tangible assets only, whereas the company’s advantage lies in its employees’ minds; these human minds are the real investment of companies. out of this, companies including banks started working on developing their human capital to achieve revenues higher than those of companies that depend solely on investing in tangible assets. one of the most important items that appear in the published financial statements indicating the development of human capital is the continuous training, preparation and qualification of employees at all levels. hence, the researchers will rely on the annual cost of continuous training at jordanian islamic banks as a measure of human capital development at these banks. since islamic banks enjoy acceptance within the jordanian community, as they consider the legitimate rules in all their transactions, they should work on developing and training their human capital (employees at all levels) to be able to perfectly present services and achieve a competitive advantage for these banks which will positively be reflected on the annual net income at the end of a financial period. the study came to investigate the effect of the cost of human capital development on the pre-tax net income and the dividend at jordanian islamic banks, and to measure this effect in case it was found. the problem of the study there is no doubt that remarkable human resources are a key element within companies to enhance their operational performance, even within countries, due to their importance in achieving the competitive advantage among companies, therefore; companies should develop and qualify them continuously to gain experiences. the process of developing and qualifying them needs financial costs and companies usually spend for the purpose of gaining revenues. out of this, the problem of the study emerged; that is to identify the effect of the cost of human capital development through training employees at jordanian islamic banks over the pre-tax net income and dividend. the study questions can be formed as follows: q1: is there an effect for the cost of human capital development through training employees over the pre-tax net income at jordanian islamic companies? q2: q1: is there an effect for the cost of human capital development through training employees over dividend at jordanian islamic companies? the objectives of the study the study aims at the following: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 338 1. identify the concept of cost. 2. identify the ways applied at banks in order to develop the human capital. 3. clarify the concept of human capital. 4. measure the effect of the cost of human capital development over the net income and dividend at jordanian islamic bank. literature review 1. the study of mehsen (2017) entitled: “the effect of intellectual capital disclosure on the financial performance at the jordanian commercial banks”. this study aimed at identifying the effect of the disclosure of intellectual capital components (the human capital, the structural capital, and the relational capital) on the financial performance at the commercial banks listed in amman stock exchange. this study was applied over all banks listed in amman stock exchange; that is (13) jordanian commercial banks for the period (2009 – 2015). to achieve the study’s objectives, the analytical descriptive approach was applied, which includes the variables that refer to the intellectual capital. the results showed that there is a statistically significant correlation of the disclosure of human capital on the financial performance, also there is a statistically significant correlation for the disclosure of structural capital on the financial performance, as well as; there is a statistically significant correlation for the disclosure of relational capital on the financial performance. the study recommended that the optional disclosure items should include qualitative and quantitative information about the bank which benefits all parties that have common interests and objectives connected with the bank to help them make the investment decisions and increase the attention toward the disclosure of intellectual capital components (human capital, structural capital and relational capital). 2. the study of abd al-muniem (2016) entitled: “the intellectual capital and its effect on the industrial establishments’ business, a study case for the jordanian ready-made garments company”. the study aimed at identifying the effect of intellectual capital on the financial performance of industrial companies. the study sample was made of the ready-made garments company’s employees. the analytical approach was applied through analyzing the theories and studies related to the intellectual capital. the results showed that the concept of intellectual capital is a revolving diversified concept due to the quick changeability of the surrounding environment at all the company’s divisions. they also show that the intellectual capital is achieved by the management taking over the knowledge kept in its employees’ minds and make them transfer this knowledge to the new employees. there is a weak tendency of the company’s management to activate the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 339 intellectual capital in terms of encouraging the workers industrialists to follow the method of brainstorming to raise the creative abilities, which the management of the company pays all its efforts to maintain intellectual capital. the study recommended the necessity to understand and realize the importance of the intellectual capital by the industrial companies’ managements due its value in increasing the companies’ efficiency locally and globally. 3. the study of luiza (2016) entitled: “the role of intellectual capital in achieving the competitive advantage of economic institutions within the economy of knowledge: a case study of the cement company ain al-touta-batna”. this study aimed at identifying the effect of intellectual capital and its role in achieving the competitive advantage within the economy of knowledge and determining the role of intellectual capital in all its dimensions (the human capital, the customer-relations capital and the structural capital). a questionnaire has been prepared and the study’s sample was made of (78) employees who work in the cement company ain al-touta. several approaches have been applies such as the descriptive statistics and the single sample testing. the results showed that there is a statistically strong correlation between the human capital and achieving the competitive advantage. there is also a statistically strong correlation between the customer-relation capital and achieving the competitive advantage within the cement company ain al-touta. the study recommended the necessity to focus on the importance of measurement and accounting disclosure of the intellectual capital in achieving the competitive advantage. 4. the study of al-shikirji & mahmoud, (2010) entitled: “measuring the intellectual capital and its effect on the profitibility of banks”. intellectual capital is considered one of the administrative topics that were mentioned in modern literature. researches started paying attention to it in the early nineties of this century. literature presented several topics that changed the traditional view of the concepts of capital and profitability; as individuals became the real capital of business units; revenues are no longer those gained by business units through investing in fixed and current assets only, but rather the intellectual revenues became more important. business units realized that resources alone are no longer enough to fulfill their activities without investing them in the best possible way. this research represents an analytical study of the intellectual capital and its components, the ways of measuring it within financial statement and the difficulties of its measurement. this study was concerned in measuring the intellectual capital and its effect on banks profitability. the research was applied over a sample made of fifteen banks of nine countries in order to test the research’s hypotheses. statistical approaches have been used to test these hypotheses. in the light of the obtained results the researcher reached a number of conclusions, the most important was that despite the multiple indicators (financial and non-financial) in measuring the intellectual capital, the usage of these indicators is limited with what is presented by the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 340 financial statements of the study sample. they showed that there is a significant correlation between the intellectual capital and profitability of banks. the research recommended a number of recommendations, the most important was the necessity of paying attention to the (intellectual capital) within banks under the condition of presenting it in the their financial statements and presenting its corresponding intellectual assets as well, so the bank’s budget starts with them. 5. the study of al-bishtawi & bani taha, (2014) entitled: “the effect of intellectual capital in enhancing the profitability of jordanian pharmaceutical companies”. abstract this study aimed at identifying the effect of intellectual capital on enhancing the profitability of jordanian pharmaceutical companies. the study tried to answer the following main question: what is the effect of intellectual capital and its components (the human, structural and customer-relation capitals) on enhancing the establishment’s profitability? the study population included the pharmaceutical companies in jordan. the researchers chose a sample made of eleven pharmaceutical companies in jordan. the sample’s members were chosen depending on the model of stratified sampleto achieve the study’s objectives, the researchers prepared a questionnaire of (38) items. the number of valid questionnaires was (80) out of (88) distributed questionnaires with a percentage of (9.90%). data was analyzed using spss and the hypotheses were tested using (test-t) and cronbach alpha to verify the reliability and validity of the study tool. the study reached a number of conclusions the most important was that the intellectual capital and its three main components (the human, structural and customer-relation capitals) have a great role in enhancing the profitability of jordanian pharmaceutical companies. the recommendations were about the importance of investing funds in the intellectual capital in order to gain intellectual resources and to put a plan to maintain the intellectual capital through the programs of physical and moral motivation as well as providing the appropriate atmosphere to attract expertise, skills and competencies. key word: intellectual capital, profitability enhancement, companies’ profitability, pharmaceutical industries. 6. the study of al-a’raj, (2016) entitled: “the usage of a model to measure the human capital and its contribution in the net income”. abstract this study aimed at identifying the methods of measuring human resources (human capital), as well as measuring the human capital of blom bank in jordan for the financial periods of 20011-2014 using the model of schwartz & lev based on the most recommended model by the researcher which is the model of cost. the study measured the human resources using the approach of value by deriving a mathematical equation that measures the value of net income resulting from operating human resources ( ) = ∗ 2 3 ∗ √( ) 2 1.5 the study used the descriptive analytical approach. the research tackled an applied case over asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 341 blom bank in jordan. the data was collected though a questionnaire about human recourses to get the data needed for completing the objective of this study. the study concluded that the results of operating human resources of expenditure and revenue can be determined with an acceptable level of fairness, accuracy and objectivity. it also concluded that the results of blom bank's investment in its human resources regarding profit or loss were determined with acceptable quantities. the results showed a decrease in returns on the investment of blom bank in its human resources. the study recommended that the derived model should be disseminated and applied more widely. it also recommended for researchers to link human resources performance to the financial performance of companies in general and to study the nature of the relationship between the two. moreover, it recommended to blom bank to increase the productivity of its employees. the hypotheses of the study based on the study problem and its questions the following hypotheses were founded: h01: there is no statistically significant effect at α ≤ 0.05 for the cost of human capital development through training employees over the pre-tax net income at jordanian islamic banks. h02: there is no statistically significant effect at α ≤ 0.05 for the cost of human capital development through training employees over dividend at jordanian islamic banks. what distinguishes this study from previous studies previous studies focused on the effect of intellectual capital on achieving the competitive advantage in different sectors and on the profitability and its improvement, as well as the usage of models to measure the human capital and its participation in the net income, whereas the current study focused on the effect of the cost used in the human capital development over the net income and dividend at jordanian islamic banks. the theoretical framework (the human capital (human resource): is the combination of knowledge, abilities, skills, and experiences of the establishment’s members of employees and managers) (al-a’raj, mu’az, 2016). it is also identified as the efforts that affect the future of real income through mobilizing the resources in individuals. human capital is accumulated in a human being through career training, schooling, research and other ways of acquiring knowledge (g.s.becker, 2012). (xera, 2001) sees that the human capital frame includes: (knowledge – education – qualifications – employees’ participation in social committees – career development – initiative, creativity and the ability to face changes – training programs – equity in customs, experience and religion – issues related to property and allowance – cultural activity – the activity of unity – the number of employees – offers for employees – a guidance plan for employees – employees’ dues – employees’ benefit – employees’ share – employees’ share in options and plans – the employees average of experience – the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 342 educational level – the added value from each element – the added value for each employee). (bernadette, 1999) sees that the human capital is always expressed through the skills and knowledge acquired by the company’s workers and employees. both researchers believe that human capital is the distinguished experienced minds that have the capability to innovate and solve problems. it is the company’s real capital that achieves the management’s success which in turns is positively reflected on the company’s revenues. this is realized by the continuous training and development of human resources. the concept of costs there is almost a consensus on the definition of costs as they are the sacrifices or the amounts incurred by the establishment for the sake of obtaining a commodity, a service, utility or realizing a specific goal. in order to have a meaning for the definition of costs, they should be linked to what is known as the subject of cost, in other words the subject that we want to find its cost, be is the production of a commodity, offering a service, one of the establishment divisions or a particular production phase (abu nassar, 2016, p.14). (matz, 1980) defined cost as the sacrifice of a specific resources in order to gain an expected utility (a commodity or a service) to achieve a particular goal (al-rabi’i & al-saqi, 2008, p.15). the researchers identified cost as the sacrifice or the amounts incurred by the establishment in order to obtain revenues or a future utility that lasts for several financial periods. despite the high cost of human capital, it would achieve the competitive advantage and sustainability in the market if it was met with high revenues. islamic bank (al-najjar, 1982) identified it as a financial and banking institution that collects money and uses it to build an islamic integrated society, achieve distribution justice and to put the money within an islamic course. (arshid, 2001) identified the islamic bank as a financial and banking institution that complies with the islamic legislation in all its transactions, investments and administrative activities, as well as with the islamic community internally and externally. (fatahi, 2009) identified it as a financial institution that collects, invests and develops money for the benefit of the participants according to the islamic legislation. (al-wadi & samhan, 2012) identified it as a financial banking institution that collects money and uses it according to the islamic legislation to serve building an integrated society, achieve distribution justice and to put the money within an islamic course. or it is an islamic organization that works in the field of business for the objective of building the muslim individual and the muslim community; giving it the needed opportunities to rise on islamic basis adhering to the rule of halal (allowed) and haram (forbidden). the researchers believe that islamic banks are financial institutions that collect assets and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 343 reinvest it in all fields according to the islamic legislation to achieve a real economic development in order to reach an integrated islamic economy. the islamic banks characteristics: there are several essential characteristics that distinguishes the islamic bank from others: (al-rawashdeh and al-bawab, 2017) 1. the complete commitment to the islamic legislation in all its transactions. 2. not dealing with riba (interest) whether it is given or taken nor even in concealed ways as for it is haram (forbidden). 3. establish the principle of participation in profit and loss through intermediating the bank between the owners of funds and the applicants for funding without terminating the risk and thronging it on the shoulders of one party without the other. 4. create real economic and social development in the society. 5. establish the principle of social solidarity, not only by collecting and disbursing zakat in its legislative courses, but also by seeking justice in distributing the returns of invested funds and maximizing the social return of investment. the concept of dividend dividend is one of the commonly used criteria for analyzing the profitability of a company. the dividend of the company is either compared with previous years for the same company or with other companies in the same sector. dividend plays a key role in determining the share market price due to its effect on the decisions of investors. the international accounting standard no. 33 obliged shareholding companies that offer their shares for subscription and trading in the financial market to calculate the dividend and to present it in the financial statements, particularly in the statement of income ias (33). the types of dividend: there are two types of dividend; the first is the basic earnings per share and the second is the diluted earnings per share (abu nassar, 2016). earnings per share are calculated through the following formula: after-tax net income – the distribution of preferred shares the weighted average number of shares during the year this ratio also shows the profit achieved for each ordinary share during the financial period. it is also known as the ratio of the ordinary share of profits. this ratio is considered as the most important ratio in the market and is used by current and potential investors. the measurement of the ordinary share yield depends on the financing structure of establishments which is of two types: a simple financing structure or a complex financing structure. the simple structure consists of ordinary shares and does not include any other sources of financing that are convertible into ordinary shares such as preferred shares and deeds that converting them has a financial effect on reducing the ordinary share of profits (khanfar & asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 344 al-matarneh, 2006, p.146). the methodology and procedures: here we will present the methodology on which the research was based to carry on this study as well as the study’s population, sample, tool, applied procedures and the used statistical approaches. 1. the methodology of the study: the researchers followed the descriptive analytical approach by obtaining the study’s theoretical and scientific data from the published annual reports of jordanian islamic banks. 2. the population and sample of the study: the study’s population and sample were made of all jordanian islamic banks’ employees who received training courses on the expenses of the banks under study from (2012) to (2016). the following table shows the distribution of the study’s sample regarding the participants and the number of the courses they received within the period of the study. table 1. the distribution of the study’s sample regarding the participants and the number of courses for the years (2012-2016) bank’s name year 2012 2013 2014 2015 2016 courses participants courses participants courses participants courses participants courses participants safwa bank 137 1321 152 2334 41 994 56 1482 297 3500 islamic arab bank 198 2539 207 1669 209 1773 193 1107 234 1661 jordan islamic bank 391 3062 460 3934 500 3577 590 3607 628 4199 total 726 6922 819 7937 750 6344 839 6196 1159 9360 the previous table shows that there is a remarkable variation in the number of courses that each bank offers to his employees during the years (2012-2016). there is also a variation in the number of courses from one year to another and in the number of participating employees in each bank. 3. the tool of the study: the researchers depended on the annual financial reports of the banks under study, issued during the years (2012-2016). these reports formed the basic source of data which will be used to answer the study’s questions. the following table shows this. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 345 4. the sources of the collected information: primary sources: the researchers depended on the annual financial reports of the jordanian islamic banks from 2012 to 2016. secondary sources: the researchers depended on books, scientific references, and theses for the theoretical framework. table 2. the cost of employees’ training, the pre-tax annual profit, and dividend / dinar at jordanian islamic banks for the years (2012-2016) bank’s name safwa bank islamic arab bank jordan islamic bank training cost pre-tax annual profit after-tax dividend / dinar training cost pre-tax annual profit after-tax dividend / dinar training cost pre-tax annual profit after-tax dividend / dinar 2012 141673.00 761906 0.0230 154115.00 16495001 0.1155 137147.00 51198005 0.2920 2013 79279.00 2170312 0.0150 131780.00 22511480 0.1575 147943.00 64680715 0.3610 2014 67146.00 2700831 0.0190 123827.00 19092135 0.1337 159589.00 63971706 0.3010 2015 73446.00 4781999 0.0330 98706.00 25009759 0.1664 189097.00 74685076 0.3250 2016 132188.00 8836214 0.0570 99321.00 34642860 0.2301 200574.00 83747933 0.3600 4. the used statistical approaches to analyze the study’s data and answer its questions the researchers applied the simple linear regression analysis. 5. results and discussion after applying the simple linear regression over the study’s data and carrying out the descriptive statistical analyses, the following results were reached: 1. regarding the first question: is there an effect for the cost of training employees over the annual profit development at jordanian islamic banks? the effect of the cost of training employees over the pre-tax annual profit development will be measured. the tax was excluded because it is a sovereign decision and does not reflect the effect of human capital on profit. table 3. the simple linear regression analysis for the effect of the cost of training employees over the pre-tax annual profit development at the jordanian islamic banks the cost of training employees t value sig. f value df sig. r2 3.813 0.002 14.539 1 13 14 0.002 0.727 from the previous table we see that the cost of training employees contributes with a percentage of (72.7%) in the annual profit development of jordanian islamic banks for the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 346 years (2012-2016). it also shows that there is a significant explanatory force at (α=0.05), where the calculated value of f was (14.539) with a significance of (0.002). the table as well shows that the cost of training employees has a statistically significant effect on the annual profit development at the jordanian islamic banks where the calculated t value was (3.813) with a significance of (0.002), this indicates that the cost of training employees by the islamic banks has a positive effect over the annual profit development. the researchers calculated the percentages of effect for each bank separately in order to be able to compare among the three banks and determine which bank has the highest effect of training employees over the annual profit development. the following table shows the above mentioned: table 4. the simple linear regression analysis of the cost of training employees over the pre-tax annual profit development at jordanian islamic banks separately the cost of training employees t value sig. f value df sig. coefficient of selection safwa bank 0.321 0.769 0.103 1 3 4 0.769 0.182 jordan islamic bank 5.793 0.010 33.554 1 3 4 0.010 0.958 islamic arab bank 2.397 0.096 5.745 1 3 4 0.096 0.811 from the previous table we see that the values of the coefficient of selection for the three banks varied between (0.182 – 0.958). the explanatory force was not of significance for each of safwa bank and the islamic arab bank, as the calculated f value was (0.103, 5.745) respectively with a significance of (0.769, 0.096) respectively as well. the table also shows that the cost of training employees has a statistically significant effect on the annual profit development at the jordan islamic bank where the f value was (33.554) with a significance of (0.010). the cost of training employees was not statistically significant for each of safwa bank and the islamic arab bank. from this, we can say that the annual profit development of islamic banks does not only depend on the cost of training employees at the jordanian islamic banks; this indicates that there are other factors that have a high effect over the profitability of islamic banks such as the factors of supply and demand for investment or financing opportunities offered by jordanian islamic banks, which are affected by the size of the savings of individuals and the regional surrounding conditions as well as the commitment to the islamic legislation by those who deal with the islamic banks. we find that a large proportion is cautious and carful in terms of dealing with riba and thus they refuge to islamic banks whether to borrow or save money. we can also say that jordan islamic bank gives a great deal of attention toward training asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 347 employees due to the utility reflected on the annual profit development, as the number and cost of courses offered by this bank was remarkably more than those offered by safwa and islamic arab banks. 2. regarding the second question: is there an effect for training employees over the annual basic and diluted earnings per share at the jordanian islamic banks? table 5. the simple linear regression analysis for the effect of the cost of training employees over the annual basic and diluted earnings per share development / dinar at the jordanian islamic banks the cost of training employees t value sig. f value df sig. prediction coefficient 3.595 0.003 12.927 1 13 14 0.003 0.706 from the previous table we found that the cost of training employees participates with a percentage of (70.6%) in the annual basic and diluted earnings per share at the jordanian islamic banks for the years (2012 – 2016). the table also shows that there is a significant explanatory force at (α=0.05), where the calculated f value was (12.927) with a significance of (0.003). moreover, the table shows that the cost of training employees has a statistically significant effect over the annual basic and diluted earnings per share development at the jordanian islamic banks, where the calculated t value was (3.595) with a significance of (0.003). this shows that the cost of training employees by the islamic banks has a statistically significant effect over the annual basic and diluted earnings per share development at the jordanian islamic banks. researchers calculated the percentages of effect for each bank separately in order to be able to compare among the three banks and determine which bank has the highest effect of training employees over the annual basic and diluted earnings per share development / dinar. the following table shows the above mentioned: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 348 table 6. the simple linear regression analysis for the effect of the cost of training employees over the annual basic and diluted earnings per share development / dinar at the jordanian islamic banks the cost of training employees t value sig. f value df sig. coefficient of selection safwa bank 0.977 0.401 0.955 1 3 4 0.401 0.491 jordan islamic bank 6.288 0.023 11.874 1 3 4 0.023 0.775 islamic arab bank 2.255 0.109 0.988 1 3 4 0.109 0.493 from the previous table we see that the values of the coefficient of selection for the three banks varied between (0.491 – 0.775). the explanatory force was not of significance for each of safwa bank and the islamic arab bank, as the calculated f value was (0.955, 0.988) respectively with a significance of (0.401, 0.109) respectively as well. the table also shows that the cost of training employees has a statistically significant effect on the annual basic and diluted earnings per share development / dinar at the jordan islamic bank where the calculated t value was (6.288) with a significance of (0.023). the cost of training employees didn’t have a statistically significant effect on the annual basic and diluted earnings per share development / dinar for each of safwa bank and the islamic arab bank. from this, we can say that the annual basic and diluted earnings per share development of islamic banks does not only depend on the cost of training employees at the jordanian islamic banks; this indicates that there are other factors that have a high effect over the annual basic and diluted earnings per share development/ dinar of islamic banks such as: 1. the cost of training employees. 2. the weighted average number of shares per year. 3. tax rate. 4. the distribution of preferred shares, if any. as the earnings per share are calculated by subtracting preferred dividends (if any) from after-tax net income, divided by the weighted average number of shares per year; going back to the weighted average number of shares shown in the financial reports of the islamic banks stated in this study we see that the weighted average number of shares was not fixed sometimes. results: 1. there is an effect for the cost of training employees over the pre-tax annual profit asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 349 development at the jordanian islamic banks with variant proportions. this result agrees with the result of the study of (al-bashtawi & bani taha, 2014) which was applied over a different sector; the pharmaceutical sectors. 2. there is an effect with variant proportions for the cost of training employees over dividend at the jordanian islamic banks. 3. the cost of human capital development at jordanian islamic banks’ financial statements was not disclosed except for the cost of training employees. 4. the jordanian islamic banks did not disclose the scholarships granted for their employees for the purpose of human capital development. 5. the cost of the employees’ rewards and incentives within jordanian islamic banks has not been separated from their salaries, as for salaries are an entitlement whereas incentives and rewards are an encouragement for the employees to enhance their performance and they are only for those who are distinguished in their performance. recommendations 1. the importance of the disclosure of jordanian islamic banks of the human capital development cost in details within their financial statements. 2. the jordanian islamic banks should care about granting scholarships to their employees to finish their studies due the effect reflected on enhancing their work performance. 3. the importance of separating the item of rewards and incentives from the employees’ salaries at the jordanian islamic banks to help researchers in measuring the effect of the human capital development cost. 4. focusing on the continuous training for employees within the jordanian islamic banks due to the effect of this training on the company’s profit development and dividend. 5. the necessity of carrying out more researches and studies about this important subject. references abd almuneim, usama. 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(2008). industrial accounting costs – a scientific and practical curriculum, al-isra university, the library of the university, ithra’ for publishing, amman-jordan. al-rawashdeh, al-bawab, hani, & atef aqeel. (2017). the extent of the obligation for the islamic banks working in jordan’ in the disclosure of the social responsibility accounting in their financial statements. international journal of economics and finance (ijef), canadian center of science and education, 9(1). al-shikraji, bashar, & mahmoud. (2010). measuring the intellectual capital and its effect on the benefit of banks, tikrit university – faculty of administration and economics, tikrit journal for administrative & economics sciences/ volume 6/ issue 20/ 2010. al-wadi, & samhan. (2012). islamic banks, 4th edition, al-masirah for publishing, amman, jordan, p.42. arshid, mahmoud abd al-kareem. (2001). the comprehensibility in islamic banks’ transactions and operations, 1st edition, al-nafais for publishing, aman – jordan. bernadette, l. (1999). intellectual capital key to value added, success in the next millennium, financial & management accounting committee. international federation of accountants, p13. bin ramadan, iman. (2016). the investment in the human capital and its role in the economic development, an econometric field study, abou bakr belkaid university, a master thesis. g. s.becker. (1962). investment in human capital: a theoretical analysis. journal of political economy, 1962,p49, http://ses.ens-lyon.fr/a-les-fondements-de-la-theorie-du-capital-humain-68304.kjsp,05/11/20 12. international accounting standards, ais. (33) khanfar & al-matarneh. (2006). financial statements’ analysis, a theoretical and applied framework, al-masirah for publishing, 1st edition, p.146. luiza, farhati. (2016). the role of intellectual capital in achieving the competitive advantage of economic institutions within the economy of knowledge, a case study of the cement company ain al-touta-batna, phd thesis, university of mohamed khader, biskra, algeria. matz,usry. (1980). cost accounting-planning and control, 7th.ed.south-western publishing co, us.1980.p39. muhsen,abd allatif,ahmad. (2017). the effect of intellectual capital disclosure on the financial performance at jordanian commercial banks. master thesis in accounting, irbid national university. xera, i, a. (2001). a framework to audit intellectual capital. journal of knowledge management practice, august, pp1-8. microsoft word 10913-40306-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 224 generalised lambda distributions by method of moments and maximum likelihood using the jse-asi returns peterson owusu junior (corresponding author) institute of distance learning (idl) kwame nkrumah university of science & technology (knust) pmb kumasi, ghana tel: 233-260-006-397 e-mail:bethpeniel@gmail.com carl h. korkpoe department of computer science, school of physical sciences university of cape coast, pmb cape coast, ghana tel: 233-543-179-583 e-mail: ckorkpoe@ucc.edu.gh received: feb. 10, 2017 accepted: april 5, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10913 url: http://dx.doi.org/10.5296/ajfa.v9i1.10913 abstract the four-parameter generalised lambda distribution provides the flexibility required to describe the key moments of any distribution as compared with the normal distribution which characterises the distribution with only two moments. as markets have increasingly become nervous, the inadequacies of the normal distribution in capturing correctly the tail events and describing fully the entire distribution of market returns have been laid bare. the focus of this paper is to compare the generalised method of moments (gmm) and maximum likelihood essential estimates (mle) methods as subsets of the gld for a better fit of jse all share index returns data. we have demonstrated that the appropriate method of the gld to completely describe the measures of central tendency and dispersion by additionally capturing the risk dimensions of skewness and kurtosis of the return distribution is the generalised method of moments (gmm) with the kolmogorov-smirnoff distance good-of-fit statistics and the quantile-quantile graph. these measures are very important to any investor in the equity markets. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 225 keywords: generalised hyperbolic distribution (ghd), generalised lambda distribution (gld), modified bessel function, mle, gmm asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 226 1. introduction risk is important to investors for any level of market return. in frontier markets with short histories, long historical data may be lacking for modeling purposes. market analysts are also absent in most cases to follow usually thinly traded equities to serve the investor community. this makes it extra challenging for investors to assess the risk-return characteristics of their portfolios in such markets. we seek to ameliorate this challenge by providing a flexible four-parameter distribution model; the generalised lambda distribution (gld) to model the characteristics of market returns and the tails risk essential to guide market participants in forming efficient portfolios. in the process of comparing the better fit between the gmm and mle under gld we show the performance of our models by comparing them to the two-parameter normal distribution; a popular but rather discredited model in risk modeling of equity returns (see fama & macbeth, 1973; giot & laurent, 2004; hull & white, 1998). modeling market returns by using the normal distribution does not provide the flexibility needed as compared to, for instance, the four-parameter generalised lambda distribution. to capture the stylised facts of a security or a return series there arises the need to model the returns in their entirety. value-at-risk (var) vis-a-vis expected shortfall (es), as good examples, requires us to capture the risk properties of a return using only the quantile values in the left tail of the distribution. the need to model just the tail behaviour of the losses in assets returns is a matter of empirical concern. but is it well known that the normal distribution is a poor model for stock returns (eberlein & keller, 1995). the classes of generalised hyperbolic distribution (ghd) have the capabilities of mirroring both tail behaviour and asymmetries of returns which is a desired property of distributions in finance. besides the normal distribution many models have been investigated (see eberlein & keller, 1995) but it was the class of hyperbolic distributions which turned out to be an excellent candidate to provide a more realistic model. in this paper we model the johannesburg stock exchange all share index (jse asi) with the generalised lambda distribution (gld) using the generalised method of moments (gmm) and the maximum likelihood estimation (mle) approaches to establish the better fit for the data. except for corrado (2001), tarsitano (2004), chalabi, scott, & wuertz (2012), and pfaff, (2013) there has been little application of ghd; especially of the generalised lambda distribution (gld) to data. pfaff (2013) for instance, applies the ghd and its special cases, namely; hyperbolic distribution (hyp), normal inverse gaussian distribution (nig), and generalised lambda distribution (gld) to financial market data; the hewlett-packard (hwp), to draw useful insights. the shape range of the gld family, for instance, is so large that it can accommodate almost any financial time series especially useful in the estimation of risk measures where the choice of distribution is crucial for accuracy (chalabi et al., 2012). his work also showed that these multi-parameter distributions provide a good description of the distribution of equity returns asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 227 for the dow. we have, however, not seen these distributions in empirical work in emerging and frontier markets. given investors perception that these two markets are risky (see claessens, dasgupta, & glen, 1995; errunza & padmanabhan, 1988; hassan, maroney, el-sady, & telfah, 2003; hearn, piesse, & strange, 2010); the need arises to establish risk-return characteristics in equity and indeed related securities in these markets on a sound theoretical footing. in this paper, therefore, we find the better fit for log returns of the johannesburg stock exchange all share index (jse-asi) between the gmm and mle methods. 2. theoretical framework 2.1 generalised hyperbolic distributions (ghd) hyperbolic distributions are characterised by their log-density being a hyperbola unlike normal distributions whose log-density is a parabola. one can then expect to obtain a reasonable alternative for heavy tail distribution (eberlein & keller, 1995). the parameterised hyperbolic density function can be given as ℎ ( ) = −2 κ − exp − + ( − ) + ( − ) (2.1) where κ is the modified bessel function of the third kind with index ι. and with > 0 and 0 ≤ | | < determine the shape of the distribution, while and are scale and location parameters respectively. koudou & ley (2014) assert that in 1977 barndorff-nielsen and halgreen showed that the generalised inverse gaussian distribution (gigd), sometimes called halphen type a distribution, with the following probability density function ( ; , , ) = ( / ) /2κ exp − 12 ( + ) , ( > 0) (2.2) has the property of infinite divisibility which is used in the representation of hyperbolic distributions as a mixture of normals. any mixture of the r-dimensional normal distributions ( , σ) determined by setting = + δ and σ = δ. this class of mixtures includes the r-dimensional hyperbolic distribution ( , , , δ) − + ( − )δ ( − ) + (( − )) (2.3) where δ is a positive definite × matrix with determinant |δ| = 1 and setting κ =− δ , the norming constant is given by ( , , , δ) = 1(2 )( )/ . κ( )/2 ( )/ κ( )/ ( ) (2.4) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 228 was introduced by the same authors a year earlier (barndorff-nielsen, blaesild, & halgreen, 1978; o. barndorff-nielsen & halgreen, 1977). based on the daily prices of the 30 dax shares over a three-year period eberlein & keller (1995) investigated the distributional form of compound returns after performing a number of statistical tests to the logical conclusion that some standard assumptions could not be justified. hence, they introduced the class of hyperbolic distributions which can be fitted to empirical returns with high accuracy. this was the application of ghd to the increments of financial market price processes probably first proposed by eberlein and keller in 1995 (i.e. the returns resulting from geometric brownian motion are increments of a brownian motion process, thus are independent and normally distributed). again tests applied to real data in this way demonstrate failure of the normality assumption. the popularity of the class of ghds in finance was pioneered in seminal papers in the late 1990s (see (barndorff-nielsen & shephard, 1998; barndorff-nielsen & halgreen, 1977; eberlein, keller, & prause, 1998; prause, 1997, 1999). however the application of hyperbolic distributions in fields other than finance is not limited. the motivation for barndorff-nielsen & halgreen (1977) to introduce the hyperbolic distributions was the observation by bagnold (1941) that the logarithm of the density function of distribution of the logarithm of the grain size in natural sand deposits looks more like a hyperbola than a parabola (sørensen, 2006). 2.2 generalised lambda distribution (gld) the four-parameter (quantile) gld family is known for its high flexibility, producing distributions with a range of different shapes. to start with (ramberg & schmeister, 1974) show six regions in which the shape parameters can lie for which the shapes of the gld are similar, as shown in figure 1; the figure is as given in king & macgillivray (1999) with notation introduced by ramberg, dudewicz, tadikamalla, & mykytka (1979), chalabi et al. (2012), and chalabi, scott, & würtz (2010). the modern freimer, kollia, mudholkar, & lin (1988) fmkl gld (2.6) places the only restriction of > 0. the fundamental motivation for the development of fmkl gld is that the distribution is defined over all and (su, 2007b). the quantile probability density function of the gld (henceforth referred to as rs gld) is given as the inverse distribution function of tukey’s lambda distribution (tld) ( | ) = ( | , , , ) = + − (1 − ) (2.5) where are the probabilities, ∈ [0,1], , are the location and scale parameters, and , are the shape parameters jointly related to the strengths of the lower and upper tails, respectively. the original one-parameter tld results in the limiting case = 0 and = = = (chalabi et al., 2010). the fmkl gld can be written as asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 229 ( | ) = ( | , , , ) = + − ( ) (2.6) figure 1. graph of the parameters regions of the gld in the vs. space that produce proper statistical distributions. source: (chalabi et al., 2010) the parameter constellations that fall in the third quadrant imply skewed and heavy-tailed distributions; that is a nice characteristic of stylised facts about financial return series giving more credence to the use of non-normal distributions, in this case gld to capture this behaviour (pfaff, 2013). the various methods for estimation of the optimal values for the parameter vector in the literature include, among others (1) moment-matching approach by ramberg & schmeister (1974) and ramberg et al. (1979), (2) percentile-based approach by karian & dudewicz (1999), (3) histogram-based approach by su (2005), (4) goodness-of-fit approach by owen (1988), (5) maximum likelihood (ml) and maximum spacing approaches by cheng & amin (1983) and ranneby (1984) and (6) least squares (ls)-approach (see karvanen & nuutinen, 2008; öztürk & dale, 1982, 1985). su (2007a) discussed two general approaches to fitting generalised lambda distributions to data; using the discretised method and maximum likelihood estimation (or an approach that aims to provide a definite fit to the data set such as maximising the goodness of fit) with his own authored gldex package in r (r core team, 2016). however, the maximum likelihood estimation is preferred to the former not just for its efficiency but also likely to produce gld with closer first four moments to the data set (see su, 2005, 2007a). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 230 stemming from an extensive investigation by karian & dudewicz (2000), king & macgillivray (1999), ramberg & schmeister (1974), ramberg et al. (1979), etc. on the symmetry distribution version of the gld given for = , not all parameter combinations yield valid density functions (pfaff, 2013). the probability density function of the gld at = ( | ) is given by ( ) = ( ( | )) = − (1 − ) (2.7) valid parameter combinations of must yield (2.8) and (2.9): ( ) ≥ 0 (2.8) ( ) = 1 (2.9) for ( ) in (2.7) to qualify as density function (pfaff, 2013). this is going to be the only mention of symmetry in this paper since the focus is fitting the gld to financial return series. the limitation pointed out here does not affect the superiority of the gld over normal distribution, at least, in fitting the jse-asi. one advantage of the gld is that the computation of var and es can easily be achieved after a return series has been fitted herewith; expressed as positive numbers of returns and not for losses (pfaff, 2013). hyperbolic distributions are characterised by their log-density being a hyperbola unlike normal distributions whose log-density is a parabola. one can then expect to obtain a reasonable alternative for heavy tail distribution (eberlein & keller, 1995). the parameterised hyperbolic density function can be given as ℎ ( ) = −2 κ − exp − + ( − ) + ( − ) (2.2) where κ is the modified bessel function of the third kind with index ι. and with > 0 and 0 ≤ | | < determine the shape of the distribution, while and are scale and location parameters respectively. koudou & ley (2014) assert that in 1977 barndorff-nielsen and halgreen showed that the generalised inverse gaussian distribution (gigd), sometimes called halphen type a distribution, with the following probability density function ( ; , , ) = ( / ) /2κ exp − 12 ( + ) , ( > 0) (2.2) has the property of infinite divisibility which is used in the representation of hyperbolic distributions as a mixture of normals. any mixture of the r-dimensional normal distributions ( , σ) determined by setting = + δ and σ = δ. this class of mixtures includes the r-dimensional hyperbolic distribution asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 231 ( , , , δ) − + ( − )δ ( − ) + (( − )) (2.3) where δ is a positive definite × matrix with determinant |δ| = 1 and setting κ =− δ , the norming constant is given by ( , , , δ) = 1(2 )( )/ . κ( )/2 ( )/ κ( )/ ( ) (2.4) was introduced by the same authors a year earlier (barndorff-nielsen, blaesild, & halgreen, 1978; o. barndorff-nielsen & halgreen, 1977). 3. methodology in comparing mle and gmm we are embarking on a journey of goodness of fit. thus going through parameter estimation procedure to find the values of gmm and mle that best fit the jse-asi data. the gmm and mle have come head-to-head as alternatives to statistical estimation since over two decades after the former was introduced in 1894 by karl pearson. in recent years, however, financial econometricians have found working under assumed likelihood functions restrictive, and have suggested using a generalised version of pearson’s mm approach, commonly known as gmm estimation procedure as advocated by bera & bilias (2002) and hansen (1982). fisher (1922) asserts that the parameters of the mm are those of an infinite population of the specified type having the same moments as those calculated from the sample, its application has not been shown except in the case of the normal curve. to discover whether this approximation is good or bad he proposes an improvement, if possible, by requiring a more adequate criterion. by assessing the suggestions from fisher (1922), pearson (1936) found that the additional computing work after the determination by moments is “as long as, i think longer than, the first fitting by moments”. the blunders in both mm and mle are explored in the same paper thereof. notwithstanding, gmm is seen, largely, as an applicable parameter estimation strategy which shells the classic method of moments, linear regression, and maximum likelihood (chaussé, 2010, 2012). 3.1 generalised method of moments (gmm) pearson (1894) introduced a formal approach to statistical estimation through his method of moments (mm) where estimators or parameters are derived from moment conditions estimating parameters of distributions using moment equations. as hinted by pearson (1936) gmm estimation is often possible where a likelihood analysis is extremely difficult and wooldridge (2001); that the mm applies in more complicated situations. the theory of gmm, restricted to large-sample comparisons helps with the use of two unbiased consistent method of moments estimators in a manner that minimises the asymptotic variance among method of moment’s estimators (wooldridge, 2001). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 232 the gmm is relatively advantageous for time series data. this comes as no surprise for the reason that hansen (1982) introduced the gmm primarily with time series applications in mind, and it can be used to obtain parameter estimators that are consistent under weak distributional assumptions (wooldridge, 2001). the method of moments consists of equating empirical moments with theoretical moments focardi & fabozzi (2004) in order to get estimators of the parameters (iacus, 2011). chaussé (2010) and chaussé (2012) thus conclude; because gmm depends only on moment conditions, it is a reliable estimation procedure for many models in economics and finance. with the right moment conditions the gmm is more appropriate than maximum likelihood. in this paper we see how that plays out for our set of data; a corroboration. further, in finance, there is no satisfying parametric distribution which reproduces the properties of stock returns except that the family of stable distributions is a good candidate. in this regard only the densities of the normal, cauchy, and levy distributions have a closed form expression (chaussé, 2010). the mathematical narrative that follows is based on chaussé (2010). we would want a vector of parameters ∈ ℝ based on × 1 vector of unconditional moments below: [ ( , )] = 0 (3.0) where is vector of cross-sectional data, time series, or both. has to be the unique solution to (3.0) and be an element of a compact space for gmm to produce consistent estimates. higher boundary conditions of ( , ) are also needed. given the linear model (3.1) in ( × 1) and ( × 1) matrices: = + (3.1) the most common method of estimating the parameter is least squares (ls) approach by solving || || hence the solution to the first order condition: 1 ⊺ ( ) = 0 (3.2) equation (3.1) is the estimate of the moment condition of: , ( ) = 0 (3.3) the same model can be estimated by ml in which case the moment condition becomes (3.4) below similar to (3.8): asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 233 ( ) = 0 (3.4) given that ( ) is the density of (baum, schaffer, & stillman, 2003; baum et al., 2003; baum, schaffer, stillman, & others, 2007; hansen, 1982; hansen, heaton, & yaron, 1996; stock, wright, & yogo, 2002). a lot of estimation methods including ls, ml, or instrumental variables (iv) can also be seen as being based on such moment conditions as in (3.2), therefore, they are special cases of gmm (chaussé, 2010, 2012). the moment condition is obtained by equating the derivatives of a log-likelihood to zero that mle can be given an mm interpretation as well; (see chaussé, 2010, 2012) for the relationships between gmm and iv, generalised ls, and ml, and pseudo-ml. generally, the moment conditions [ ( , )] = 0 (3.0) is a vector of non-linear functions of the parameter with the number of unlimited by the same parameter (chaussé, 2010, 2012). it is, therefore, a step in the right direction to estimate the parameters on gld by gmm as well as mle in this paper. in order to reduce the possibility of inefficiency there is the need to increase the number of instruments which is often greater than rendering (3.5) with no solution. ̅( ) = 1 ( , ) = 0 (3.5) remedial methods for this situation are offered by hansen (1982), with so-called two-stage gmm (2sgmm) in the original version of gmm, also andrews (1991) and newey & west (1987) with a heteroscedasticity and autocorrelation consistent (hac)-like matrix. further improvement to the properties of 2sgmm by hansen et al. (1996) are the iterative 2sgmm (it2sgmm) and the continuous updated estimator. like the mle, gmm estimators are easily consistent, however, efficiency bias depend on the choice of moment conditions (chaussé, 2010). though the distribution-free feature of gmm gives a very good appeal, it is as good as its moment conditions. 3.2 maximum likelihood estimation (mle) originally developed by r.a. fisher in the 1920s, the principle of the mle states that the desired probability distribution is the one that makes the observed data ‘most likely’, which means that one seeks the value of the parameter vector that maximises the likelihood function (3.1) where = ( , … , ) is parameter vector defined on a multi-dimensional parameter space and = ( , … , ) is a random sample data vector (myung, 2003). it is a principle of statistical estimation which, given a parametric model such as the gld, prescribes choosing those parameters that maximises the likelihood of the sample under the model; focardi & fabozzi (2004) find this idea highly intuitive. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 234 unlike least-squares estimation which is primarily a descriptive tool, mle is a preferred method of parameter estimation in statistics and it’s an indispensable tool for many statistical modelling techniques, in particular non-linear modeling with non-normal data (myung, 2003). out of two possible general approaches to fitting gld to data, according to su (2007a); using the discretised method and a definite fit to the data set such as maximising the goodness of fit, the mle is usually the preferred method (see king & macgillivray, 1999). let ( | ) denote the probability density function (pdf) that specifies the probability of observing vector given the parameter . the likelihood function can be given as: ( | ) = ( | ) (3.6) for computational convenience the mle estimate is obtained by maximising the log-likelihood function myung (2003) so that the product (3.2) is transformed into a sum. since the logarithm is an increasing function, maximising the likelihood or the log-likelihood gives the same results (focardi & fabozzi, 2004). if the sample is iid then the likelihood is the product of individual likelihoods: ( | ) = ( | ) (3.7) assuming the log-likelihood function ( | ), is differentiable, if (mle estimate) exists, it must satisfy the following partial differential equation called the likelihood equation: ( | ) = 0 (3.8)* equation (3.3) is only a necessary condition for the existence of mle estimates. a sufficient condition requires that ( | ) is a maximum and not minimum. hence the shape of the function be convex. again from calculus (3.4) below must be true for = 1,2, … , . ( | ) < 0 (3.8) for further reading see (myung 2003; iacus 2011). in estimating the parameters of gld the gld and gldex packages in r were employed. it is necessary to obtain quantiles, under the rs or fmkl for every observation , for = 1,2,3, … , under a set of initial values by solving (2.5) via newton-raphson method or numerically (su, 2007b). by substituting ’s obtained into the appropriate numerical log asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 235 likelihood equations (3.9) and (3.10) below: = + (1 − ) (3.9) = + (1 − ) (3.10) the key is to maximise the likelihood in (3.5) and (3.6); this can be done through the nelder-simplex algorithm (su, 2007b). the mle estimates can be heavily biased but asymptotically consistent, efficient, and unbiased for adequately large sample size (iacus, 2011). 4. data and terminology the price series of the jse-asi is collected daily from january 02, 2003 to december 31, 2015 giving a total of three thousand two hundred and fifty-two data points. the log return series of the jse asi was calculated as: = ln(1 + ) = ln ( ) − ln ( ) (3.11) where is the continuously compounded return (natural logarithm of the simple gross return of an asset). according to tsay (2010), statistical properties of log returns are more tractable. for average investors, returns is a complete scale-free summary of investment prospect. campbell et al. (1998) also showed that returns have more attractive statistical properties such as stationarity and ergodicity. a time series plot of the returns is show in figure 2. figure 2. a time series plot of the jse asi returns from january 2003 to january 2015 jan 03 2003 jul 01 2004 jan 03 2006 jul 02 2007 jan 02 2009 jul 01 2010 jan 03 2012 jul 01 2013 jan 02 2015 -0 .0 6 -0 .0 2 0. 00 0. 02 0. 04 0. 06 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 236 the time series plot exhibits two regimes 2003 to 2009 and 2010 to 2015. in the first period the markets returns appeared more volatile particularly towards the end of the period in 2009. this is contrast to the period 2010 to 2015 when the market showed moderate volatility. such behaviour in financial assets in the markets has been observed by previous researchers (assoe, 1998; chkili & nguyen, 2014; hamilton, 1989; m. r., 2001; van norden & schaller, 1993). thus the statistical properties of the returns series will differ according to period. we therefore analysed the return series of the latter period of 2010 to 2015. campbell, lo, mackinlay, & whitelaw (1998) discuss at length the problem associated with using long-term horizon data series. among others they posit the breakdown of the asymptotic inferences from such data. most likely that may be due to what hamilton (1989) identified as regime switching in the literature. we believe our data window more reflects the recent developments in the underlying economy which are transmitted to the market. 4.1 testing for classical normality assumptions a test of the classical assumptions of normality looks at the first four moments of the distribution. the skewness and kurtosis show slight deviations from normality. the curve of the distribution is skewed to the left with fat-tails as the results show in the table 1. table 1. moments of the jse asi returns from january, 2003 to january 2015 mean variance skewness kurtosis 0.0005 0.00009 -0.1701 1.4194 a qualitative method for testing goodness of fit is quantile-quantile (qq) plots juxtaposed with empirical densities (eberlein & keller, 1995). the q-q plots alongside the histogram with the normal distribution curve of the log returns of the jse-asi provide an explicit empirical deviation from normality as shown in figure 3. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 237 figure 3. q-q plot and normal distribution curve of the jse asi returns from january, 2003 to january 2015 finally in the jarque-bera and cramer-von mises normality tests; p-values respectively are nearly zero thus rejecting the null hypothesis of normality (cromwell, labys, & terraza, 1994; d’agostino, 1986). we were, therefore, able to reach the conclusion that the returns series of the jse returns were not normally distributed. 4.2 empirical results from methodology from the above series of tests it is obvious the return series of the jse all share index distribution shows marked departures from normality. we thus use the generalized lambda distribution (gld) to fit the entire distribution the gld not only models the tail behaviour but also the entirety of the return distribution (pfaff, 2013). we used our selected method of moments and maximum likelihood estimation respectively. 4.3 method of moments the estimated parameters of the generalized lambda distribution using the method of moments are shown in table 2. table 2: the four parameters gld obtained from the jse asi returns from january, 2003 to january 2015 λ1 λ2 λ3 λ4 0.072966 1.899254 -0.0288 0.00986 the parameters are the used to estimate the moments of the markets returns in table 3. -3 -2 -1 0 1 2 3 -0 .0 4 -0 .0 2 0. 00 0. 02 0. 04 normal q-q plot theoretical quantiles s am pl e q ua nt ile s jse returns jse d en si ty -0.04 -0.02 0.00 0.02 0.04 0 10 20 30 40 50 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 238 table 3. the four moments of gmm obtained from the jse asi returns from january, 2003 to january 2015 mean variance skewness kurtosis 0.0522 0.9453 -0.1701 1.4193 these values compared to the moments from the normal distribution are almost the same. however a test of kolmogorov-smirnoff distance (d) recommended by su (2007b), gave the distance d = 0.97411 with a p-value of 0.1. this test has the null hypothesis that the sample data is drawn from the same distribution as the fitted distribution. with a p-value of 0.1, we fail reject the null hypothesis and conclude that the returns data came from the gld using the method of moments. 4.4 maximum likelihood method parametrising the gld using the maximum likelihood method we get the values as shown in the table 4. table 4. the four parameters of the parameterised gld obtained from the jse asi returns from january, 2003 to january 2015 λ1 λ2 λ3 λ4 0.092051 2.037581 -0.0832 -0.01676 using these parameters to compute the moments of the distribution we get table 5. table 5. the four moments of the parameterised gld obtained from the jse asi returns from january, 2003 to january 2015 mean variance skewness kurtosis 0.055878 0.957247 -0.36028 2.520229 a test of goodness-of-fit using the kolmogorov-smirnoff distance test gives d = 0.97185 with a p-value of almost zero which is far the 5% level of significance. therefore, we reject the null hypothesis that the sample is drawn from the gld using the maximum likelihood method. a graphical plot of the histograms for either method of estimation is shown in figure 4 and figure 5. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 239 figure 4. a histogram of the jse asi returns from january, 2003 to january 2015 obtained by mm figure 5. a histogram of the jse asi returns from january, 2003 to january 2015 obtained by mle from figure 4 and figure 5 it is clear that using the gld with the method of moments gave a histogram that closely described the entire distribution. though the maximum likelihood method fairly described the data, it comes at a further computational effort making the method of moments more suitable for the estimation period. 5. conclusions measuring volatility accurately has become the preoccupation of financial institutions as it determines their survival in increasingly turbulent markets. for tail risk measures like value-at-risk (var) and expected tail loss (etl), the correct distribution of the data is a first method of moments fit returns d en si ty -4 -2 0 2 4 0. 0 0. 1 0. 2 0. 3 0. 4 0. 5 method of maximum likelihood jse returns d en si ty -4 -2 0 2 4 0. 0 0. 1 0. 2 0. 3 0. 4 0. 5 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 240 step. markets have swung from end to end on the volatility spectrum so violently that the normal distribution no longer accurately describes the entire distribution nor gives the correct quantiles in the tails for risk 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(2001). applications of generalized method of moments estimation. the journal of economic perspectives, 15(4), 87-100. microsoft word 13183-48210-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 129 corporate restructuring and investment dr. alhassan ndekugri allen university, 1530 harden street, columbia, sc, 29204 e-mail: andekugri@allenuniversity.edu received: may22, 2018 accepted: june 17, 2018 published: june 17, 2018 doi:10.5296/ajfa.v10i1.13183 url: https://doi.org/10.5296/ajfa.v10i1.13183 abstract corporate restructuring looked at the strategies employed by managers and leaders of a corporation in times of performance decline to put the corporation back to its normalcy. it is of no doubt that a good performing corporation motivate people to invest. this research was conducted to investigate how the participants as investors and potential investors want from their corporate managers and leaders in terms of putting the corporation in good shape. this research used a survey technique and data was analyzed using spss and excel software. the results showed that there was a relationship between corporate previous performance and investment decision, at a p-values of 0.779 and 1.000 respectively, which was greater than the significance level of 0.05 we failed to reject the null hypothesis and concluded both corporate previous performance and corporate location may have an influence on investors decision making. keywords: corporate restructuring, decision making, investment asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 130 introduction corporate restructuring plays a very important role in the success of a company in times of performance decline. according to allen and bonaccorsi di patti, ashta and tolle (2004), gilson (2001), lai and suddarsanam (2001), weston et al. (2004), restructuring has three main groups: the first is business restructuring (hillier et al. 2005; lang et al.,1995; lasfer et al.,1996; kang and shivdasani,1997; muherin and boone; shleifer and vihny,1992; weston et al. ,2004). cost rationalization and finding new market. financial restructuring (finnerty,1985 powell & yawson,2008). the third refers to management restructuring (datta & iskandar-datta,1995; furtado & vijay,1990). tricker (2012) said that corporate governance concerns the way power is exercised over corporate entities, including but not limited to board activities and its relationship with shareholders or members, those in charge of managing the enterprise and other stakeholders whose input are necessary to help sustain the company’s survival. brown and gioai (2002) examine organizational identity challenges in the context of a new division within an organization. likewise, corley and gioai (2004) examine ambiguity in the context of corporate spinoffs and said that corporate brand name changes may help to restore successful operations of the company. motivation by this research this research was conducted as a result of the many problems engulfing companies of late, for instance, there was no doubt that several well-known companies such as sears, kmart, wall-mart, toys r us, best buy, macy’s, jcpenney, target, sam’s club, and many more other companies not listed here were among the companies that have closed some of their stores because of non-performance. restructuring if taken would to identify areas of concern to address them instead of permanent closure thereby having an effect on investors and potential investors and employees purpose of the research the purpose of this research was to investigate how individual’s thoughts about corporate restructuring may have an effect on their future investment decisions hypothesis statement null hypothesis: 1. a corporate previous performance would have an influence on future investment decision 2. corporate location would affect investors decisions to invest research question 1. is there any relationship between corporate previous performance and investment decision by investors? asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 131 significance of the study it was the firm believe that this research would contribute significantly in the field of academia especially in the area of finance to help discover problems that faced companies such as performance decline due to poor products, leadership crises, employee non-involvement and failure of brand name. several companies had closed stores because of lack of restructuring techniques and being reactive to problems instead of being proactive. as a result of these many problems that existed in companies, investors and potential investors are reluctant in making a decision to invest for fear of not making profit. for future leaders of a company, this research will help to understand the need of customers, investors and potential investors by being proactive instead of reactive in solving problems relating to their companies. literature review aggarwal and dahiya (2006) had lookedabout 20 listed stock exchanges by analyzing their performance and conclude that making change helps to improve performance after listing analogy was also supported by otchere and abou-zied (2008) who also investigated the demutualization process of the australian stock exchange and concluded that the conversion from mutual to publicly traded exchange was helpful in the stock market liquidity. these results were also confirmed by azzam (2010) and oldford and otchere (2011). according to brown (2011:164), it very imperative for organization to respond to challenges in the internal and external environment by introducing some changes that may help to bring about improvement. by undertaking a diagnosis process, organizations are able to identify the problem areas and apply structural, behavioral or technical programs to help put back the company on its feet, (brown, 2011:136). for this change of programs to work successfully, armenika and harris (2009:130) pointed out that the company should involve the employees who are the backbone of the company who must have confidence in the diagnosis of the problems to help in the implementation process. why the need to restructure corporate restructuring is initiated with a purpose and requires leadership commitment whereby leaders deals with issues proactively and not reactively, over the years, corporation have continuously been changing to meet the needs of the consumer only when there was a problem that was brought to the attention of management. to avoid reactive ways of problem solving, ac brown (2011) said that, random or haphazard are the two types of changes that occur in organization that should take place holistically. a change can bring about some positive or negative results depending on how it is carried out; any change that brings a positive result on the organization will help to meet the objective of that organization, on the other hand, any change that produces a negative result is only sinking the company further. it is no doubt that, corporate america have been in constant search of ways to improve, as a result, management skills and efficiency of employees were most considered besides improving the products for consumers. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 132 restructuring to produce quality quality drives business in any organization, when the consumer is satisfied with the product they bought, then they can be sure of coming back next time, as a result, restructuring of organizations will have to take into consideration quality management to gain the trust of customers, for this reason, for an organization to be successful in the restructuring process, every member of the organization should have a clear picture of the measurement of quality (nica, monole, and potcovaru,2016). developing their position, the work they performed(morselli,2015). in other parts of the world for instance, in europe, there had been an established european foundation for quality management which approaches quality based on a widely-recognized model called efqm excellence model. this model was implemented in more than 30,000 organizations in europe and had yielded a positive result. the efqm model explains how quality can significantly contribute to development of an organization and business excellence. apart from europe, quality restructuring also occurred in romania where specialist had provided a relevant picture on how the total quality excellence model is implemented in companies in romania (olaru et al.2010), the emphasis was that total quality management was made up of several integration of all functions and processes taking place in an organization in order to meet the need of the customer. customer satisfaction in the restructuring process staya (2003) believes that having good customer satisfaction is important in maintaining customer loyalty. heskett etal (1997) also believe that having customer loyalty is important it has a direct link with the continued survival and strengthening future growth. as a result, for a company to maintain stable profit, there must be a corresponding evaluation of the company from time to time to ensure that issues that hinder company performance are addressed. in other parts of the world such as the case of germany, thyssenkrupp had announced its upcoming portfolio transformation to drastically reduce its dependency on steel production to become a modern technology conglomerate, focusing on business activities such as elevators, refineries, ships, machinery and parts for the automotive industry [3]. research in the field of business portfolio restructuring has emerged from more general research on corporate restructuring to ensure success over the years and have been considered a response factor in most corporation poor performance (jonson,1996; brauer,2006). methodology this research used a survey technique, a sample size of 100 was administered to students and staff workers in allen university using a random sampling of the participants. each participant had the chance of answering the questions to the best of their knowledge, whiles it was required that participants completed the questionnaire within two weeks, some of the participant were not able to do so and other also answered the questions half way. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 133 research design, data analysis and interpretation polit and hungler (1995:155) described research design as a blue print or outline for conducting the study in such a way that will have maximum control and would exercise over factors that could interfere with the validity of the research results. the research design is the researchers’ overall plan for obtaining answers to the research questions guiding the study. burns and gove (2001:223) state that designing a study helps researchers to plan and implement the study in a way that will help obtain the intended results. in this research,the questionnaires were designed to follow the survey technique, subjective in nature and allowed participants enough room to express themselves besides just answering the questions data analysis play an important role in research so as to convert information gathered during the research into a meaningful and understandable information. this data was analyzed using excel software with color coding technique and spss interpretation of results null hypothesis one 1. a corporate previous performance would have an influence on future investment decision. according to the results analyzed using non-parametric, one sample test, the outcome showed a value of 0.779 which was more than the significant level of 0.05, as a result we failed to reject the null hypothesis and concluded that a company previous performance may have an effect on investors decision to invest in a company. null hypothesis two 2. corporate location would affect investors decisions to invest the results of the non-parametric one sample test showed a result of 1.000 which was also more than the significant value of 0.05, as a result we also retained the null hypothesis and concluded that company location whether local or abroad may have an effect on the investors decision to invest. table 1. mean comparison of securities z-score values bonds 1 -0.65760 stocks 2 -0.49320 diversify 3 1.15079 as indicated on the table above, a descriptive statistic was also used to compare means of the three securities: bonds, stocks and diversify from the formula z=(x-µ)/σ. the absolute value of the z-score tells the number of standard deviations the security is way from the mean. in this scenario, it means that diversification is about 1.151 standard deviation away from the mean and bonds and stocks are -0.658 and -0.493 below the mean respectively. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 134 table 2. descriptive statistics of securities descriptive statistics n minimum maximum mean std. deviation skewness kurtosis statistic statistic statistic statistic statistic statistic std. error statistic std. error v4 0 v2 0 v3 0 v5 0 v6 0 v7 0 v8 3 1 23 9.00 12.166 1.680 1.225 . . valid n (listwise) 0 table 3. statistic values of the securities statistics v8 n valid 3 missing 0 mean 9.00 std. error of mean 7.024 median 3.00 mode 1a std. deviation 12.166 variance 148.000 skewness 1.680 std. error of skewness 1.225 range 22 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 135 figure 1. response on investment from the figure above, out of the 41 questionnaires that were returned, 24 of the respondents said that they have invested and 12 said they have not invested before, 5 respondents gave no response figure 2. type of security invested from the figure, of those who said they invested before, 1 person invested in bonds, that is investment in debt securities, giving the investor a fixed income payment over a given period of time. the bond investor can either invest in government or corporate, thereby lending money to these entities in return for interest. at maturity, the principal investment is return to the investor. in the bond investment, the face or par value is specified e.g. $1000 and the coupon rate is also specified that is used to determine the coupon amount. 3 respondents said they invested in stocks. the stock investor buys shares of a corporation and become a part owner, this gives the investor an opportunity to take part in decision making such as voting in the case of a common stock investment, however, the preferred stock investor has no voting right but has preference in terms of dividend payment other the common stock holder. while the bond has a maturity date, the stock has no maturity date. 23 respondents said they 12 24 5 0 5 10 15 20 25 30 yes no no response have you ever invested in a company? bonds stocks 2 or more 1 3 23 1 3 23 0 5 10 15 20 25 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 136 invested in more than one security such as stocks, bonds, commercial paper, exchange traded fund… figure 3. potential investors figure 4. source of information for investment as far as information is concern for investors, 12 respondents said they got their information for investment on fortune 500 list, 2 respondents said they previously know the company before the investment, 6 respondents said they their information from newspapers, 1 respondent said the information was from government source and 26 respondents said they got their information from other sources such as family and friends, online search engines, radio… 37 8 0 5 10 15 20 25 30 35 40 yes no if you have not invested would you to do so in future? 12 2 6 26 1 0 5 10 15 20 25 30 fortune 500 list previously known the company news paper other government forums how did you get this information about this investment opportunity? asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 137 figure 5. potential problems faced by investors as far as investment and problem is concern, 10 respondents said that they have not experienced any problem during their period of investment, 6 respondents said that since their investment, there was no communication about the performance of the portfolio and that those companies’ communication system was not the best. 2 respondents said their companies folded after their investment and 7 said they experienced other problems such as roi, and management styles of the company they invested. figure 6. reason for investment making a decision to invest instead of saving has some repercussions, as a result, 37 respondents said they had taken the risk to invest instead of savings and 7 respondents said they don’t trust banks. 7 2 6 10 0 2 4 6 8 10 12 other company folded no communication no problem did you face any problem in the process of your investment? 37 4 -20 -10 0 10 20 30 40 50 60 taking a risk don't trust banks do you have any reason for investing instead saving in a bank? asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 138 figure 7. information for investment in making a decision to invest, some investors need some amount of information to help them, 20 respondents in this survey said that they need the current financial statement to help them understand the company performance before going ahead to invest, 7 of the respondents said they need the previous financial statement and 8 respondents said they need a detailed information to them make an investment decision and 7 respondents said they only need the company’s business plan so that they can understand both the short and long run objective of the company they putting their resources in. figure 8. making decision based on size of company most investors have preference on the size of the company they want to invest, in this survey, 28 respondents in this survey said they prefer to invest in a company with 500 employees or less and 14 respondents said they prefer to invest in a company of 500 employees or more 20 7 8 7 0 5 10 15 20 25 current financial statement previous financial statement detailed company description company business plan what information do you want to be provided in order an invest decision? 28 14 0 5 10 15 20 25 30 company with less than 500 employees company with more than 500 employees does a company size matters in your investment decision? asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 139 figure 9. information on investment performance when people invest they may want to know a certain information regarding their investment, in this survey, 14 respondents said they want to know about the risk involved and how that will affect their money, 4 respondents said they only want know the return on investment, and 19 of the respondents said they need to know other information such as time value of money of their investment, how their wealth will be maximized, and how their investment performs from time to time figure 10. location of company and investment most people may have some concerns about locational investment and its prospects, in this survey, 11 respondents said they prefer their investment to be put into companies based in their local country, 7 respondents said they want to invest in companies abroad and 23 respondents said they want to invest in both local and companies abroad 14 4 19 0 2 4 6 8 10 12 14 16 18 20 risk involved roi other what information would you like to know about your investment? 11 7 23 0 5 10 15 20 25 local company abroad both would you prefer to invest in a local company or company abroad? asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 140 figure 11. type of industry and investment most investors have preference on the type of industry to invest, in this survey,6 respondents said they want to invest in the sports industry, 3 respondents prefer to invest in the health sector, 1 respondent wants to invest in the tourism sector, 4 respondents want to invest in the automobile industry, and 15 respondents wants to invest in other sectors such as restaurants, technology, education, real estates of those who responded that they did not invest, they propped further on their future investment decision and most of them said they will invest in the future with a few maintaining that they will not invest at all. implication of the study this research would serve as a document for corporation who are in trouble in terms of performance decline and needs restructuring. for the success of any corporation, the communication aspect was very important by making sure that investors get up to date information regarding the company performance to help investors make an informed decision. giving a true information of company would be the best way forward instead of false information that does not stand the test of time. conclusion in all views expressed and data analyzed, most of the participants wanted frequent communications about their investment performance, for instance the risk related to their investment, company financial statement will help to make an informed decision. most of the participants also wanted to know about the size of the company to understand whether the company is growing and how that would play a role in their investment decision. others also said that they would invest in a company irrespective of location, whiles some also said that location would influence their decision to invest. 6 3 1 4 15 0 2 4 6 8 10 12 14 16 sports health tourism automobiles other which of these 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(2017). corporate restructuring. microsoft word 9759-35829-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 1 share repurchases: a literature review mr. sarthak kumar jena (corresponding author) vinod gupta school of management, indian institute of technology kharagpur-721302, india e-mail: srkjena@gmail.com dr. chandra sekhar mishra associate professor in accounting and finance vinod gupta school of management, indian institute of technology kharagpur-721302, india tel: (office): +91-3222-282318 e-mail: csmishra@vgsom.iitkgp.ernet.in dr. prabina rajib professor in accounting and finance vinod gupta school of management, indian institute of technology kharagpur-721302, india tel: (office): +91-3222-283886 e-mail: prabina@vgsom.iitkgp.ernet.in received: june 20, 2016 accepted: august 10, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.9759 url: http://dx.doi.org/10.5296/ajfa.v8i2.9759 abstract share repurchases evolved as an alternative method of payout and a corporate finance tool in 1950 in the usa. from 1980 to 2000 it has achieved a significant growth as compared to dividend payment by companies. then, share repurchase is gradually spread to other countries like uk, canada, etc. pertinent to its growing importance, over the years an enormous literature has emerged that deals with many facets of share repurchase. this article classifies and organizes literature in relations to the established hypotheses, determinants affecting share repurchase decisions, the effect of share repurchase on liquidity and earning management around share repurchase. in additions to the above, this article also analyses the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 2 regulatory framework of indian buyback starting from 1998. it gives a brief view of sections of old companies act (1956) and new companies act (2013) dealing with buyback. this article also provides a snapshot of sebi buyback regulations, 1998 and also accommodates all the amendments. keywords: share buyback, determinants, liquidity, earnings management, sebi buyback regulations (1998), companies act 2013. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 3 1. introduction share repurchase or buyback of shares means companies purchase their shares from the shareholders. it is an investment technique used by the companies to invest in their shares. repurchased shares may be either cancelled or kept in treasury for further issue depending on the country’s rules and regulation. firms have to extinguish the repurchased shares in countries like india, australia, sweden, france, canada and uk. in countries like the us and spain, the companies keep the repurchased shares in treasury for reissue. in italy, companies can either extinguish the shares or held as treasury stock for reselling. share repurchases1 are similar to a dividend on the distribution of cash to the shareholders. however, the dividend is pervasive in the sense; companies have been paying regular cash dividend since the inception of joint stock companies around three hundredyears ago. initially, it is the only method of payment of surplus to the stakeholders. miller and modigliani, (1961) first-time proposes that the value of companies remains same before and after dividend payment. so dividend payment is considered as a puzzle in corporate finance. before 1980, companies preferred dividend as a favorite method of payout despite the relative tax advantage of repurchase (barclay and smith, 1988). but after 1980 the growth of repurchase has been tremendous in the us. repurchase as expenditure increased from 4.8% in 1980 to 41.8% in 2000.the average growth of repurchase is almost four times than the average growth in dividends. share repurchase as a percentage of total dividend increased from 13.1% in 1980 to 113.1% in 2000. in 1999-2000 for the first time in us history companies spent more on repurchase than dividends (grullion and michaely, 2000). after this growth, many countries adopted share repurchase as an alternative method of payout. after the us, uk is the second most developed country where repurchase has gained popularity and then spread to countries like canada, australia, japan, france, etc. the rest of the paper is organized as follows. section 2 provides a brief view of the rules and regulation relating to buyback in india. section 3 discusses the hypotheses responsible for share buyback decisions. section 4 discusses the indian buyback scenario. section 5 discusses the determinants of share repurchase. section 6 discusses the impact of share repurchase on post-buyback market liquidity of the firm. section 7 discusses the earnings management around share repurchase and section 8 concludes the paper. 2. law regulating share buyback in india the principal act responsible for share buyback in india is companies act 1956.in 1999 an amendment to the companies act allowed indian companies to repurchase their shares with retrospective effect from october 1998.this enactment introduced three sections(77a,77aa & 77b) to the existing companies act to allow repurchase of shares. before this amendment, the company is restricted to repurchase their shares under section 77 of companies act 1956.companies are only allowed to repurchase their shares under section 100 and 402 of companies act 1956.section 100 deals with capital reduction with due approval from a court not lower than high court. section 402 allows companies to repurchase shares with the 1 share repurchase and share buyback are used interchangeably throughout the paper. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 4 permission from company law board (clb) in a case of mismanagement or oppression. the new sections overrule the previous section such as sections like 100,402 and 77. section 77a deals with rules and regulations relating to share buyback. section 77aa deals in the transfer of certain sum to the capital redemption reserve account. when companies repurchase shares out of their free reserve, then a sum equal to the nominal value of shares is transferred to the capital redemption reserve account. section 77b prohibits companies to buy their shares in certain circumstances. the details of section 77a 77b are discussed below. 2.1 section 77a a company cannot repurchase its own shares unless it is authorized by the articles of association. companies have to pass only a board resolution if the share buyback is less than 10% of the paid up capital and free reserves but if it exceeds 10% then a special resolution in the general body meeting has to be passed by the shareholders. the maximum ceiling of buyback of shares is 25% of the paid up capital and free reserves. a company is not allowed to offer share buyback within a period of 365 days of the preceding offer. a company may purchase their shares out of the free reserve, securities premium, and proceeds of any shares and specified securities. no shares will be bought back from the proceeds of an earlier issue of the same kind of securities. every share buyback shall be completed within 12 months from the passing of the special resolution. the company has to file a solvency report along with the resolution to the registrar of companies and securities board of india (sebi).the report is an assurance from the board of directors that it enquired about the financial condition of the company and found that the company is capable of meeting all its obligation and will not be insolvent within one year of the share repurchases. the report should be signed by at least two directors including managing director. once the company repurchases its shares, then it cannot issue the same kind of shares within six months. post-buyback, the debt of the company should not be more than twice of the capital and free reserves. companies can buy back shares from the existing security-holders on a proportionate basis or from the open market operation or from odd lots or from the employees to whom shares are issued under the stock option plan. a company has to extinguish the securities physically within seven days after the completion of the share buyback. a post buyback report has to be submitted to the registrar of companies and sebi within 30 days of the completion of the offer. if any company fails to comply with the rule and regulations of this section, then the officer-in-charge who is in default shall be punishable with imprisonment for maximum up to 2 years or a fine of 50000 or both. 2.2 section 77b a company is prohibited from repurchasing shares directly or indirectly through a subsidiary or an investment company. a company cannot repurchase shares if it is in default of payment of interest or dividend to debentures and preference share holder respectively. if a company is in default of interest payment to financial institutions then also it is debarred from buying its shares. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 5 2.3 companies act 2013 a new companies act came into existence in 2013 by scraping old companies act 1956.the rules and regulation relating share buyback are almost same in the new act except some minor changes. the new act contains share buyback provisions under sections 68, 69 and 70.the changes are as follows (i) the restriction period for share buyback is changed from 365 days to one year from the date of closure of the previous offer (ii) the period of share buyback is altered from 12 months to one year from the date of passing of the special resolution (iii) the fine amount for contravention of rules and regulations under companies act is increased from fifty thousand to maximum 3lakh rupees and a minimum of 1lakh rupees. the imprisonment period is increased from maximum 2 years to 3 years. 2.4 sebi rules regarding share buyback company’s (amendment) act, 1999 contains a clause that all companies whose shares are listed on any recognized stock exchange have to repurchase shares in accordance with the regulations made by security exchange board of india (sebi).companies whose shares are listed on any stock exchange have to comply with both companies act and sebi regulations. the first objective of sebi since its inception in the year 1992, is to regulate the capital market and to make it more investor friendly. another important objective of sebi is to make the capital market more transparent and to match with international standard. so to fulfill the twin objectives of market development and investor protection it formulates various rules in all the concerned areas. sebi for the first time prescribed rules regarding share buyback in the year 1998. it has been subsequently amended in the years 1999, 2001, 2004, 2006, 2007, 2008, 2012, and 2013. 2.5 securities and exchange board of india (buy back of securities), regulations, 1998 sebi for the first time introduced a comprehensive set of rules and regulations regarding share buyback in 1998 after companies act 1956 amended its provision related to repurchasing of shares by companies. the rules and regulations under this act are applicable to only those companies whose shares are listed on any stock exchange in india. a company cannot repurchase its shares for the purpose of delisting from the stock exchange. share repurchases through tender offer, open market operation and from odd-lot holders are the three methods of share buyback in india. companies are restricted to repurchase their shares through negotiated deals either on or off the stock exchange or through private arrangement. a special resolution passed in general body meeting and the resolution passed by the board of directors authorizing buyback should be filed with the sebi and stock exchanges where the shares are listed within seven and two days of the passing of the resolution respectively. 2.6 securities and exchange board of india (buy back of securities), regulations, 1998 the sebi regulations 1998 prescribes the following rules to be followed for share buyback through tender offer. in share buyback through a tender offer, repurchase is made from the existing shareholders on a proportionate basis. this method reserves 15% of targeted shares (the number of shares likely to be bought back), or a number of securities entitled to small shareholders should be kept for them. the offer document should disclose the maximum asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 6 price at which the shares will be repurchased. it should publish the information regarding the quantum of shares tendered by the promoters and detail of their transactions of last six months before passing the resolution, such as a number of shares acquired, price, and date of acquisition. the company has to make an announcement in public within two working days of passing of the resolution in at least one national english newspaper, one hindi newspaper and a regional language newspaper widely circulated in the area where the registered office of the company is located. a company has to submit a draft offer letter to the sebi within five working days of the public announcement, and the board has to give its comment on the draft offer within seven working days of receiving the draft letter. before the opening of buyback offer, every company shall announce a record date for identifying the legal shareholders who are entitled to participate in the offer. the letter of offer and a tender form shall be sent to the eligible shareholders within five working days of approval from sebi. the date of opening of the offer is within five working days from the dispatch of the offer letter to the shareholders. the duration of the tender offer was initially not less than fifteen days and maximum thirty days, after the 2012 amendment it is reduced to ten working days. every company going for share buyback has to open an escrow account and deposit 25% of the amount if the total consideration payable is not exceeding 100 cores. if the total consideration exceeds 100 cores, then 25% of up to 100 cores and 10% of the rest amount will be deposited. the escrow account consists of cash deposited in a scheduled commercial bank or bank guarantee in favor of merchant banker or a combination of both. on fulfillment of the entire obligation relating to share buyback offer the amount or guarantee kept in the escrow account will be released to the company. on non-compliance, sebi forfeits the account fully or partly and distribute the amount to the tendering shareholders within seven working days of closure of the offer. all securities bought back in the offer shall be extinguished and physically destroyed in the presence of merchant banker, registrar to the issue and statutory auditor within seven days of completion of the share buyback. the company shall submit a certificate of compliance to the sebi duly certified and authorized by the registrar, two directors of the company including managing director and statutory auditor within seven days of extinguishment of shares. a company also furnishes a report containing the particulars of the shares destroyed to the respective stock exchange where the shares were listed earlier. 2.7 share buyback from the open market companies can repurchase from the open market via two methods such as through stock exchange or book-building process. for any method under open market method, a company has to pass a special resolution in the general body meeting or board meeting of the directors. the maximum price per share is fixed in the special resolution but the price at which shares are bought depends on the market forces. unlike tender offer, promoters and persons in control of the company are restricted to offer their share for sale in the process of open market share repurchase. companies have to announce the repurchase at least seven days before the opening of the offer to the public. such announcement has to be filed with sebi within two days of the announcement. share buyback under this method is only done through a stock exchange having a nation wide trading terminal. the company and the merchant asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 7 banker shall furnish a daily report to the stock exchange on the shares bought back and published this information in a national newspaper on a fortnightly basis. every time the company purchases additional five percent shares from the market, it has to be published in a national newspaper. the rule regarding cancellation or extinguishment of shares bought back is similar to tender offer. the rules and regulations under share buyback through book-building are quite similar to share buyback through the stock exchange. the book-building process will be made through an electronically linked transparent facility. the number of bidding center should be not less than thirty including at least one electronically linked computer terminal at all the bidding center. the offer will remain open for not less than 15 days and not exceed 30 days. the highest price accepted for share buyback will be paid to all the holders whose shares are accepted. the public announcement must contain true, factual, and material information rather than misleading information. directors must take the responsibility of the information published in the announcement. the consideration for share buyback must be paid in cash. the company cannot withdraw the offer after the draft letter of offer is filed with the sebi or public announcement. the company will publish a report on share buyback such as a number of shares bought, the price at which shares are bought, the total amount invested and changes in the capital structure and shareholding pattern within two days of the completion of the offer in a national daily newspaper. all the subsequent amendments in the year 1999, 2001, 2004,2006,2007,2008, and 2012 are already inserted in the 1998 sebi regulations act except 2013 amendment. 2.8 share buyback of securities (amendment) regulations, 2013 to make share buyback environment more transparent sebi made certain changes in the rules of open market method of share buyback in the year 2013. these changes came into force on 8th august 2013. companies can share buyback maximum up to 15% of the capital and free reserves through the open market. if the companies want to exceed the limit specified in the amendment then, it should adopt tender offer route. no offer of share buyback shall be made within a year of completion of the previous share buyback. initially, companies only make the public announcement for share repurchase without any intention of actually repurchasing shares. so in order to prevent such unethical practice, sebi for the first time mandates at least 50% of the amount allotted towards share buyback in the special resolution must be utilized for buying back the shares. the public announcement shall be made within 7 working days after passing the resolution. the company has to file a copy of announcement to the sebi simultaneously with the issue of the announcement by the company. earlier the time limit for filing the copy with sebi is within two days of such announcement. the company will furnish the daily data of share repurchase to the exchange in a format prescribed by it, and the stock exchange will upload the information to its official website immediately on a daily basis. now the open market share buybacks commence not later than seven days after the public announcement and shall close within six months from the opening of the offer. through this amendment, a new provision of the separate window is created by the stock exchange for buying of the securities in physical form. this window will remain open for all the share buyback period. before the opening of the offer, the company asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 8 will deposit 25% of the amount that likely to be invested in the share buyback (decided at the time of passing the resolution) in an escrow account. the minimum balance of the escrow account will be 2.5% of the amount kept for share buyback in the resolution. if sebi found any irregularities in the process of the share buyback, then it forfeit the amount and then amount will be deposited in the investor protection and education fund of sebi. the company cannot raise further capital for a period of one year from the closure of share buyback to expect in the discharge of its subsisting obligations. 3. indian share buyback environment as share buyback activity started lately in india, the only handful of research studies was carried on since the introduction of the share buyback. the previous research in india identifies many incentives for share repurchase such as: signalling hypothesis (reddy et al.,2013; rajagopalan and shankar, 2012), substitutes hypothesis (hyderabad,2013),free cash flow hypothesis (hyderabad, 2013), liquidity hypothesis (arora,2012), share price performance (chavali and shemeem, 2011; dua et al., 2010; rajagopalan and shankar, 2013) and on motivations of share buyback (arora and pasricha, 2012. table 1.year wise number of share repurchases and values from 1998-2015 year no of share repurchases amount of share repurchase (rs in millions) mean (%) share repurchases 1998-99 1 13.73 5.60 1999-00 12 249.80 19.29 2000-01 14 926.26 16.70 2001-02 27 797.82 13.01 2002-03 31 326.04 14.24 2003-04 8 64.66 17.52 2004-05 11 3272.52 29.71 2005-06 10 362.60 4.48 2006-07 7 421.78 4.77 2007-08 10 2004.44 5.19 2008-09 37 916.94 5.64 2009-10 20 411.99 8.80 2010-11 20 2147.51 8.99 2011-12 35 4440.46 7.16 2012-13 21 806.71 8.45 2013-14 32 3557.22 7.56 2014-15 9 605.21 14.05 total 305 21325.70 source: authors own compilation. in india, the option of share repurchase started on october 31, 1998, by amendment of companies act 1956 and introduction of securities and exchange board of india (share asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 9 buyback of securities) regulations 1998. since 1998 till 2014, 219 companies have undertaken 305 share buybacks. india ranked fifteenth in the most active nation in share repurchase globally (reddy et al., 2013). according to the economic times (2008), reliance energy’s us$ 885.9 million share buyback offer was the biggest corporate event in asia during 2008-09.the year wise distribution of companies and the value of their repurchase are given in table 1. table 1 also shows the mean percentage of share buyback calculated as the number of shares offered for the share buyback to the number of outstanding shares in the previous year. it is quite evident from table 1 that number of the share buyback is maximum (37) in the year 2008-09 and minimum (1) in the year 1998-99, the year when share buyback started in india. the value of share repurchase is maximum in the year 2011-12 (4440.46 million) and the value of share repurchase is lowest in the year 1998-99 (13.73 million).the mean percent of the share buyback is lowest in the year 2005-06 and highest in the year 2004-05. table 2 shows the frequency of repurchase by indian companies during the year from 1998-99 to 2014-15. only 162 companies repurchased once, 39 companies purchased twice, 12 firms purchased thrice;two companies purchased fourth times ;three companies boughtfifth times and selan exploration topped the list by doing share buyback six times during this period. table 2. frequency of share repurchases from 1998-2015 frequency of share repurchases no of companies no of share repurchases once 162 162 twice 39 78 thrice 12 36 fourth 2 8 fifth 3 15 sixth 1 6 total 219 305 source: authors own compilation. table 3 shows the industry wise classification of total number share buybacks during the study period. the information technology industry topped the list by the maximum number of share buybacks (29) followed by pharmaceuticals industry (24). pie chart 1 divides the total number of share buyback into three categories i.e. open market repurchase, tender offer, and book building. there is only two book building method of share repurchase till date from the starting of the share buyback. mainly the indian share buybacks are categorized as under two method i.e. stock exchange (220) and tender offer (83). in india companies going for share buyback are supposed to state one reason for the share buyback in the offer document. pie chart 2 shows three different reasons i.e., returning of available cash, provide liquidity and exit option, stated by the indian companies in the offer document. the dominant reason for share buyback in india is to return the available cash with the company to reduce the agency cost. the second important reason for the share buyback is to provide liquidity, as repurchase increases the trading of the shares during the offer period. the least stated reason for the share buyback is to give an opportunity to the investors to exit from the company. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 10 4. indian share buyback environment share repurchase as a payout method exists in the us since 1950. but share repurchase as a tool of corporate finance gradually spread to the uk in 1980 and accepted worldwide during the 1990s. in this period, share repurchase started in france and germany (1998), japan (1995), malaysia (1997), singapore and hong kong (1998) and taiwan (2000). but the significant surge in the repurchase activity started from 1980 to 2000. during these two decades, companies in the us spent more on repurchase than the dividend. this extraordinary growth of repurchase as a payout method has caught the attention of many researchers towards the cause and factors that motivate companies for repurchases. the extensive literature on share repurchase proposed many hypotheses, those drives companies for undertaking share buyback. the subsequent section discusess the hypotheses. 4.1 signaling hypothesis as the company’s management and ownership are in different hand, information possessed by the insider is higher than outsiders. so to maintain information symmetry or pass private information to outsiders many corporate decisions are taken such as dividend payment and share repurchase signaling power of the dividend decisions is first pronounced by ross (1977) and bhattacharya (1979) by adopting spence (1973) signaling model. repurchase gives two types of signals such as undervaluation of shares of the company or about the future growth prospects of the company or both. when a company is announcing to buy-back shares at a huge premium, it gives a signal of undervaluation. varmaelen (1981) found that signalling is the most prominent and plausible explanation for abnormal return after repurchase announcement. so it shows that repurchase conveys private information to the investors. the abnormal return after the tender offer is more than open market repurchase because tender offer provides more credible signal than open market share repurchase. in the case of a tender offer, the firm is more committed to doing share repurchase than open market share repurchase. small firms announcing share repurchase through a tender offer, is consistent with the signalling hypothesis. bartov (1991) found that open market repurchase conveys information about both earnings and risk changes. so these firms enjoy unexpected annual earnings in the year of repurchase announcement. the repurchase announcement return is positively relatedtoearning and negatively relatedto systematic risk. according to stephens and weisbach (1998), there is a negative relationship between share repurchase and prior price performance of the stock. he found that firms increase their repurchase depending on the perceived undervaluation of their stock. comment & jarrell (1991) examined three types of repurchases of shares such as dutch auction self-tender offer, fixed price self-tender, and open market repurchase in the us to study the signalling effect of these methods and found that fixed price selftender method conveys astrong signal of undervaluation than others.the study reported by louis and white (2007) is consistent with comment & jarrell (1991). haw et al. (2013) examined the signalling effect of real repurchase and mimicking repurchase. the study found that long-term operating and market performance followed by the announcement of repurchase improves less for mimicking firms. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 11 4.2 excess capital or cash flow hypothesis firms are having the excess capital or cash flow than the profitable investment opportunities likely to distribute the surplus cash to the shareholders to reduce the agency cost jensen (1986).if firms are over flooded with cash or capital, there is a probability that firms may undertake negative net value projects. so higher payout reduces the free cash available at the discretion of the managers and also restricts the empire building desire of the managers. vafeas and joy (1995) reported empirical evidence supporting jensen (1986).the study found that the announcement return arising around theannouncement of open market repurchases is the result of the reduction of agency cost. boudry (2013) reported a positive relationship between the availability of cash and repurchase keeping invest opportunities constant. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 12 table 3. industry wise classification of share repurchases from 1998-2015 industry category no. of companies percentage (%) agro chemical 2 0.64 automobile 13 4.18 cables 3 0.96 carbone black 3 0.96 cement & construction materials 12 3.86 chemicals 12 3.86 diamond cutting & jewellery 4 1.29 diversified 13 4.18 electric lamps & accessories 21 6.75 engineering 5 1.61 financial services 20 6.43 food & food processing 7 2.25 hotels & resorts 3 0.96 housing/ civil construction/ real estate 5 1.61 information technology 29 9.32 machine tools 3 0.96 oil exploration/drilling/refining 8 2.57 packaging &plastic 3 0.96 paints/varnishes 5 1.61 personal care 10 3.22 petrochemicals 2 0.64 pharmaceuticals & drugs 24 7.72 plastics 8 2.57 power generation & supply 6 1.93 project contracting/ machinery manufacture 7 2.25 publishing 6 1.93 shipping (repairing/ breaking) 3 0.96 steel tubes/pipes/wires 12 3.86 sugar breweries & distilleries 3 0.96 tea/ coffee 4 1.29 telecommunications 16 5.14 textiles 15 4.82 trading(exports) 6 1.93 others 12 5.79 total 305 100 source: authors own compilation. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 13 4.3 optimum leverage hypothesis leverage hypothesis posits that companies are more likely to do repurchase if their actual debt equity ratio is less than the target ratio (bagwell and shoven, 1988; dittmar, 2000; and mitchell and dharmawan, 2007). titman et al. (2001) reported that the difference between the actual and target leverage ratio plays an important role in repurchase decision. the higher the difference between actual and optimal leverage ratio, the probability of repurchase is also more. so by undertaking share repurchase firms increase the proportion of leverage in the capital structure of the firm, as a result the overall cost of capital is reduced.share repurchases make the underlevered firm get more tax shield and increase the value of the firm. source: authors own compilation figure 1. methods of share repurchase figure 2. reason of share repurchases 4.4 stock option hypothesis around 1950s, companies in usa started giving stock options to their senior executive as a part of compensation but later on, started giving these to all employees. when stock options are exercised by employees, outstanding shares of the companies increases resulting in eps dilution. so to neutralise the effect of stock options on eps, companies repurchase shares. kahle (2002) reported that firms announce repurchase when executives have large stock options outstanding because dividend declaration will decrease the value of stock option. but the actual share repurchase depends on the total options exercisable by all the employee. skinner et al. (2003) reported that companies increase repurchase to offset the dilutive effect of stock option. 4.5 takeover deterrence hypothesis takeover hypothesis posit that companies use share repurchase as a defensive strategy to prevent hostile takeover. when there is a threat from the competitor, firms immediately increase their stake to prevent hostile takeover. bagwell (1990) documented that company’s face upward sloping supply curve at the time of repurchase in a dutch auction tender offer. it means the shareholders who believe that the values of their shares are more than the repurchased price, don’t tender their shares for sale. so the cost of non-selling shares will be more than the repurchased shares. bagwell (1991) reported that under the condition of upward sloping supply curve, the takeover cost to the acquirer will be more if the target firm distribute asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 14 cash through repurchase than dividend. sinha (1991) documented that a debt-financed repurchase is a defence mechanism available with the target firm from being sold out to the acquirer. this transaction increases the value of the firm and makes it less attractive target. debt-financed repurchase is a trade-off between the lower probability of takeover and financial distress cost. 4.5 substitution hypothesis substitution hypothesis means the preference for share buyback of shares as a payout method to shareholders over the dividend. in this case, companies finance their share buyback with the funds that can be otherwise used to increase the dividend. the main cause for substitution hypothesis is the taxable nature of income from dividend paid and share buyback in the hands of shareholders. the gain from share repurchase is taxed under either short term or long term capital gain at the hands of shareholder and dividend paid by the company is taxed as a regular income in the hands of shareholders. as capital gain tax is much lower than the dividend, share repurchase is more tax efficient and valuable to shareholders (grullon and michaely, 2000).the second important aspect of substitution is the timing and flexibility associated with share buyback. unlike dividends, share repurchase does not promise cash flow in a regular interval (dittmar, 2000). stephens et al. (2000) documented that firms having more volatile cash flow are likely to repurchase shares rather than increasing dividend. firms with operating (permanent) cash flow are more likely to increase dividend and firm with non-operating (temporary) cash flow are more likely to repurchase shares. this study concludes that repurchase have not completely replaced dividend, but it is growing fast as an important form of payout method. 4.6 liquidity hypothesis the relation of liquidity with repurchase is first propounded by barclay and smith (1988).they reported that repurchasereduces liquidity in the market. brockman et al. (2008) reported for the first time the effect of liquidity on the repurchase. before this, many studies examined the effect of repurchase on post-buyback liquidity of the stocks. this paper posited that liquidity has a direct impact on the repurchase of the firm and a residual effect on the dividend decisions of the firm. repurchase initiating firms are more liquid than dividend initiating firms and the size of repurchase increases with liquidity. so liquidity may be a motivation for the firm to do repurchase. 4.7 corporate governance hypothesis lee et al. (2007) documented that managers pose timing ability in the context of repurchase announcement. managers have more information about the internal affair of the company than outsiders, so they can time the repurchase to get the advantage of undervaluation of shares. by the timing of repurchase, thefirm can repurchase their shares at a very less price. if the ownership of the firmis concentrated among insiders, then there is a probability of windfall gain of the insiders by timing the repurchase. so there should be a check on the repurchase decision of the firms. rules regarding repurchase are different in the various countries. in india, if the firm wants to repurchase less than 10% of paid-up capital and free reserve then only asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 15 board approval is necessary and above 10% it requires shareholders’ approval. so the directors should be fair and justified enough at the time of approval of share repurchase. yarram (2014) examined the relationship between the corporate governance variables and found a positive relationship between board independence and share repurchase decisions. corporate governance parameters of a company may influence the share repurchase decision. table 4. relationship of hypotheses with share buyback decision hypothesis sign signaling + excess capital + leverage + stock option + takeover deterrence + substitution liquidity + corporate governance + 5. determinants of share buyback vafeas (1997) found that both agency cost and signaling play an important role inchoosing tender method over open market repurchase. an overinvestment firm backed by excess cash flow is more likely to choose tender offer than open market repurchase. firm’s choice in between tender offer and open market repurchase depends on short term or long term undervaluation of shares. dittmar (2000) examined the motivations behind share repurchase in the us by taking all the hypotheses simultaneously together viz. excess capital, undervaluation, optimal leverage, management incentive and takeover deterrence. the objective of the study is to find out the effect of all the hypotheses together without ignoring the effect of any single hypothesis. the study found that out of the above hypotheses undervaluation is the prime determinants for repurchase followed by excess capital hypothesis. jagannathan and stephens (2003) examined motives of firms, behind infrequent, occasional and frequent repurchases. frequentrepurchasers are large, less variation in operating income, more institutional ownership, and higher dividend pay-out ratio than infrequent repurchasers. in case of infrequent repurchasers, undervaluation is a primary motive for share buybacks, unlike frequent repuchasers. the marketfavors all repurchases, but market reaction to infrequent repurchase is stronger than other repurchases. backer et al. (2003) used survey method to examine the reasons of recent share buyback among us corporations. they tested five hypotheses i.e. signaling, agency cost of free cash flow, capital market allocations, tax-motivated substitutions for dividend and capital structure adjustments, and found that undervaluation is the most important motive behind repurchase followed by lack of investment opportunities. grullon and michaely (2004) explored the economic motivations behind open market asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 16 repurchase in the us. the findings of this study show that repurchasing firms reduce the current level of investment in capital expenditure and r&d to finance the repurchase program. this study found that that systematic risk and cost of capital of repurchasing firm declines after the announcement. the positive market reaction to the announcement is due to decrease in the free cash flow at management’s disposal and systematic risk of the firm. mitchell and dharmawan (2007) examined the substitution, undervaluation signaling, excess debt capacity and free cash flow hypotheses of repurchase in a standardized and transparent market, unlike the us. the study found that signaling of undervaluation and reduction of agency cost is the primary determinant of share buyback of share followed by excess debt capacity in the australian market. li and mcnally (2007) examined signalling, agency, undervaluation, optimal capital structure and dividend substitution hypotheses to identify the determinants of share repurchase decisions in canada. the study found that firms with greater free cash flow, lower market to book ratio, negative return prior announcement and more insider holdings are more likely to repurchase. in canada, firms are motivated to repurchase mainly by the agency hypothesis followed by undervaluation hypothesis. benhamouda and watson (2010) examined the determinants influencing open market repurchase decisions in the uk. the study found that excess capital and substitution hypotheses are the motivating factors for share repurchase. this study doesn't support stock option hypothesis. farrugia et al. (2011) examined the relationship between the economic states and repurchase of shares by taking australian data. this study shows that share repurchase programs are positive and statistically significant in high economic states compared to other states. they also reported that firms going for frequent repurchase enjoyed a stronger return all across the business cycle compared to the firms going for infrequent or occasional repurchase. lee and suh (2011) examined the relationship between excess cash holding and the intention to repurchase shares by taking seven countries such as australia, germany, japan, france, canada, uk and the us. they established a positive relationship between large cash holdings and repurchase of shares and also found that excess cash arises out of reduction in capital expenditure. the findings of the paper support two hypotheses such as excess capital hypothesis and temporary cash flow hypothesis. andriosopoulos and hoque (2013) reported that firm size, cash dividend, and ownership concentration have a significant impact on the repurchase decision of the firms in all these countries (uk, germany and france). the results show that large and widely held firms are more likely to make share buyback announcement and also found a complementary relationship between dividend payment and share repurchase in uk and germany. chung et al. (2013) explored signalling, free cash flow, management incentives, leverage, substitution and moral hazard hypotheses for determining factors influencing repurchase decision in taiwan. the study found that out of the above hypotheses only signalling and free cash flow hypotheses play a significant role in influencing repurchase decisions. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 17 bonaime et al. (2014) examined the determinants of share buyback of shares under the condition of target capital structure and equity that is mispriced. the study found that out of the four combinations of target capital structure and mispricing (under levered/undervalued, under levered/overvalued, over-levered/undervalued, over-levered/overvalued) the firms add more value when it is under levered and undervalued both. so this paper concluded that under levered and undervalued firms are more likely to announce repurchase than other firms. yarram (2014) examined various factors influencing open market repurchases in australia. the study supports the agency, signaling, and leverage hypotheses and doesn’t support excess cash flow and substitution hypotheses. the unique contribution of this study is, it blends corporate governance variables with other firm-specific parameters to examine the impact of corporate governance on repurchase decisions in australia. the results show that board independence has a positive influence on repurchase decisions. table 5. summary of empirical studies on determinants of share repurchase author(s) & year country & period of study method findings dittmar(2000) usa (1977-1996) tobit model undervaluation is the prime motive for share repurchase followed by excess capital. jagannathan and stephens (2003) usa (1986-1996) logit model frequent repurchasersare characterized by larger firm size, less variation in operating income than infrequent repurchasers. li & mcnally (2007) canada (1987-2000) conditional even study the repurchaseis motivated by agency cost followed by undervaluation hypothesis. mitchell and dharmawan (2007) australia (1996-2001) logit model the repurchaseis motivated by signaling of undervaluation followed by leverage hypothesis. andriosopoulos and hoque (2013) uk, germany, and france (1997-2006) logit model excess cash flow hypothesis is the prime motive for share repurchase in all the three countries yarram (2014) australia (2004-2010) probit model the repurchaseis motivated by signaling, leverage and agency cost hypothesis. source: compiled by authors from cited research articles. 6. share repurchases and liquidity barclay and smith (1988) reported for the first time that liquidity plays asignificant role in choosing between cash dividend and open market repurchase as a payout method to shareholders in the us. this study coined two new terms in the field of liquidity viz. competing market maker hypothesis and information asymmetry hypothesis. competing market maker hypothesis states that repurchase enhances liquidity by creating a lower bound asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 18 in the buyer side and narrowing bid-ask spread when the market is efficient. information asymmetry hypothesis states that repurchasedecreases liquidity by increasing bid-ask spread if managers pose more inside information than outsiders. this study supported the information asymmetry hypothesis and rejected the other hypothesis. repurchase widens the bid-ask spread, resulting a decrease in stock liquidity and increase the cost of capital to the firm and a reduction in total value of the firm. but there is no liquidity issue associated with the dividend, so companies prefer dividend over repurchase despite tax benefit attached to repurchase. singh k. et al. (1994) examined the proposition that bid-ask spread widens at the time of repurchase given by barclay and smith. this study has taken volume, relative volume, spread and percentage of spread to measure liquidity. this paper compared the above parameter between pre-announcement period and post-announcement period. the result of this study is not consistent with the proposition that liquidity decreases during repurchase activity. the finding of this paper is that the percentage increase in the spread occurred in the period preceding to the announcement and remains stable during repurchase period. wiggins b. (1994) extended the study of barclay and smith (1988) by taking 195 announcementsin the us. in this study spread and depth have been taken as proxies to measure liquidity. this study has taken a control group for comparison of spread and depth with the sample. this paper finds no evidence to support the information asymmetry hypothesis given by barclay and smith (1988). miller and mcconnell (1995) reviewed the proposition provided by barclay and smith (1988) by taking 248(158 new repurchases and 90 ongoing repurchases) announcements in nyse. this study found no evidence to support the information asymmetry hypothesis proposed by the earlier research. so it concludes that firms should not deter themselves from buying back shares in the fear that it widens the bid-ask spread and reduces liquidity in the market. franz et al. (1995) examined changes in spread around repurchase to know the liquidity of the stocks. the result shows that both spread and percentage of spread narrow but only change in the spread is significant. the change of spread is caused by a reduction in information asymmetry cost after the announcement. brockman & chung (2001) examined the relationship between repurchase and liquidity by taking absolute spread, relative spread, and total depth, bid depth and ask depth as proxy measures in hong kong. this study found that when managers enter the market as informed trader, then the bid-ask spread widens and depth falls significantly. but when managers disclose their activity on the following day of repurchase then the spread and depth come back to the pre-repurchase level. this study documented that out of the three components of bid-ask spread (order processing cost, inventory cost, and adverse selection cost), adverse selection cost increases due to the presence of informed traders in the market. so it leads to widening the bid-ask spread and reduction in the depth of the market. ahn et al. (2001) examined the market maker hypothesis in the context of tender offers by taking 65 fixed tender offers listed on the nyse or american stockexchange (amex). this asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 19 study has taken quoted spread; percentage quoted spread, effective spread, effectivepercentage spread, trading volume, and depth to measure liquidity. the results of this study show that liquidity increases during the offer period and again reverse back to the pre-announcement period after expiration of the offer. so the increase in liquidity in the market is temporary in nature. cook et al. (2004) explored the relationship between repurchase and liquidity by taking 64 us listed firms those additionally disclose the repurchase data. this study found that repurchase contributes to market liquidity by narrowing the bid-ask spread. the bid-ask spread is comparedwith three benchmarks such as the period before the announcement, then the non-share repurchase day before the repurchase day (lag day) and the non-repurchase day after the repurchase transaction (lead day). ginglinger and hamon (2007) examined the relationship between actual repurchase and their impact on liquidity in france by taking bid-ask spread as a proxy for liquidity. the study found that the spread on repurchase days are significantly more than the non-repurchase day. so the study lends its support to information asymmetry hypothesis. nayar et al. (2008) examined the effect of dutch auction (da), and fixed price tender offer (fpto) repurchase on liquidity in the us by taking spread and depth as a proxy for liquidity. the study reported that liquidity increases during the offer period and bounce back to the original pre-announcement period after expiration of the offer. the change in the liquidity is transitory in nature. ridder and råsbrant (2009) examined the effect of repurchase on liquidity in sweden. this study has taken absolute & relative spread, total depth, bid depth and ask depth to measure liquidity. the study found that repurchases narrow down the bid-ask spread resulting increase in liquidity and also increase the depth of the market. this study finds a significant decrease in the bid-ask spread (3%) from non-repurchase days to repurchase day. mcnally and smith (2011) examined both price support and information asymmetry hypotheses to determine the impact of repurchase on liquidity in canada. the results show that the spreads narrows and depth increase on repurchase days than non-repurchase days. the study also segregated the components of spreads and compared these cost (adverse selection and inventory cost) to the non-repurchase days. this study finds no evidence that adverse selection cost increases due to repurchase, so it rejects the information asymmetry hypothesis. cesaride et al. (2011) examined two competing hypotheses,i.e., information asymmetry andcompeting market maker in italy. the study found evidence to support the competing market maker hypothesis. it means repurchases enhance liquidity by a reducing in bid-ask spread. 7. share repurchases and earnings management bartov et al. (2002) reported that after controlling the overall earnings performance of the quarter, firms those can match the analysts’ expectations earn 3% more than their peer who asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 20 failed to do so. to save the firms from great economic loss, managers always try to achieve the earnings expected by analyst. but when the actual earning is not enough to meet or beat analyst forecast, then manager take help of earnings management to achieve the target. earning management is an accounting strategy used by the management to achieve the twin objectives of the firm’s (income smoothing and meeting or beating analysts).managers can manipulate the reported financial statement because of certain assumptions followed in accounting practices. due to these assumptions, managers get a scope for using their discretion or judgment while reporting accounting figures to external stakeholders. more specifically, this type of earnings management is an activity where managers use their discretion to mislead stakeholders about the economic performance of the company to influence contractual outcomes (healy and walhen, 1999). there are two types of earnings management viz. accrual-based earnings management (am) and real earnings management (rm).changing methods of depreciation of fixed assets and changing the provisions of doubtful debts are two examples of am. in contrast, rm is accomplished by changing the firm’s underlying operations (roychowdhury, 2006). examples of rm include cutting prices towards the end of the year for increasing sales, delaying desirable investment, and selling fixed assets to affect gain and loss so as to influence current period earnings. table 6. summary of empirical studies on liquidity after share repurchase author(s) & year country & period of study proxies findings barclay and smith(1988) usa (1970-78) bid-ask spread support information asymmetry hypothesis, liquidity decreases after share buybacks wiggins b (1994) usa (1988-90) bid-ask spread bid –ask spread decreases and no significant change in depth during repurchase. depth cook et al. (2004) usa (1993-94) spread liquidity increases due to share repurchase. price impact ginglinger and hamon (2007) france (2000-02) bid-ask spread liquidity decreases due to share repurchase. ridder and råsbrant (2009) sweden (2002-05) absolute spread liquidity increases due to share repurchase. relative spread total depth bid depth ask depth cesaride et al.(2012) usa (2004-06) amihud illiquidity ratio firms are likely to purchase when liquidity is high. source: compiled by authors from cited research articles. managers do earning management for three broad reasons: (1) when executive compensation is associated with the earnings. (2) public traded companies are under constant pressure to meet or beat the analysts earning forecast. (3) before any corporate activities such as initial public offering (ipo), seasoned equity offering (seo), merger and repurchase. prior research on earnings management has found evidence of earning manipulation around different corporate activities. perry and williams (1994) reported earning management before asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 21 management buyouts and teoh, welch, and wong (1998a) reported that managers inflate earning before ipo to sell their shares at a higher price. shivkumar (2000), teoh, welch, and wong (1998b) reported that managers inflate earning before seo to sell their shares at a higher price, and erickson and wang (1999) reported that acquiring firms overstate earnings before stock for stock merger. above studies examine two hypotheses around corporate events such as managerial opportunism and market response. managerial opportunism states that managers have incentives to deflate (inflate) their earnings before the corporate event. market response hypothesis states that managers do earnings management because the market expects them to do so. though there are a large number of studies on earnings management around different corporate activity, thereare very few studies on earnings management around repurchase. vafeaset al. (2003) examined the relationship between earnings management and tender offer of repurchase by considering discretionary accrual as a proxy. this study tested the managerial opportunism hypothesis around repurchase. according to this hypothesis, companies deflate their earnings before repurchase to attract shareholders to sell their shares at a low price. in this case, non-tendering shareholders gain at the cost of tendering shareholders. but the study found a weak evidence of earnings management before tender repurchase in the us. rodriguez and yue (2005) examined earnings management around open market share repurchases. this study tested two hypotheses relating to earnings management viz. managerial opportunism and market response. managerial opportunism hypothesis states that managers are motivated to deflate their earning before repurchase to buy the shares at a low price. market response hypothesis assumes that market is efficient, and investors get to know about the earnings management by the firm after the announcement. the study found that discretionary accruals are significantly negative in the year before repurchase, which is consistent with both the hypotheses. the results of the studyshow that firms those aggressively deflate their earnings earn 28% more return than control firms. the study also examined the relationship between manager’s ownership and reporting behavior of firms and found that more the stake of manager in the firm the higher degree of negative earnings management. louis and white (2007) examined the relationship between pre-repurchase reporting behavior (fixed tender offer and dutch auction fixed tender offer) and the motive behind repurchase. it posits that firms undertaking share buyback for signaling are not likely to deflate their earnings before repurchase. this study finds significant negative discretionary accruals before dutch auction tender offer than the fixed tender offer. it concludes that fixed price tender offer gives a strong signal of undervaluation than dutch auction fixed tender offer. gong et al. (2008) examined the relationship among post-repurchase operating performance, abnormal stock return and earnings management before repurchase announcement. this study has taken abnormal accruals as a proxy for earnings management. the study found that firms deflate their earning if repurchase announcement is followed by actual repurchase in the announcement quarter or the next quarter. the study finds no evidence of negative abnormal asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 22 accruals for firms, only announcing repurchase without any intention of actual repurchase. the finding of the study shows a negative relationship between abnormal accruals and improvement in post operating performance and abnormal stock return. the study also reported that if the earnings management effects are wiped out, then there is no significant increase in post operating performance and abnormal stock return. so it proves that increase in operating performance and abnormal stock return after repurchase is partly explained by earnings management. ikenberry et al. (2010) examined managerial intention behind repurchase announcement by taking discretionary accruals as a proxy because of the failure of traditional proxies (program size and post completion rate) to explain the motives behind repurchase. the study found that the managers of firms with poor earning quality reported high positive discretionary accrual before repurchase announcement to boost the stock price due to either their incentives are linked to the value of the firms or stock options held by the executives. but in the long run,high discretionary accrual firms underperform other non-high accrual firms. huang and chen (2013) examined the effect of sarbanes-oxley act (sox) on earnings management by the firms before the announcement of open market repurchases. this piece of legislation was passed in 2002 to improve the quality of the reported financial information after multiple scams in the us to keep the investor’s confidence intact. the act increased the role of independent director in the board and required that all members of an audit committee should be independent directors in a public company. this study found that managers of open market repurchases are less likely to deflate their earnings before repurchasing after the passage of sox due to the stringent regulations. di and marciukaityte (2015) examined the cause behind earning management around share repurchases in the form of two hypotheses viz. managerial opportunism and income smoothing. the objective of managerial opportunism hypothesis is to mislead the investors by deflating income before repurchase. the purpose of income smoothing hypothesis is to reduce volatility in the reported income due to a sudden increase or decrease in revenue. it also reduces information asymmetry and improves informativeness of earnings. the study found a negative relationship between discretionary current accruals and contemporaneous cash flow and give its support for income smoothing. this study provides an alternative explanation behind negative pre-repurchase discretionary accruals. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 23 table 7. summary of empirical studies on earnings management around share repurchase author(s) & year country & period of study proxies findings vafeas et al. (2003) usa (1984-89) discretionary accruals managers deflate earnings before repurchase. rodriguez and yue (2005) usa (1980-98) discretionary accruals discretionary accruals are significantly negative before repurchase. louis and white (2007) usa (1981-01) discretionary accruals firms never deflate their earnings if they want to give signals gong et al.(2008) usa (1984-02) abnormal accruals significant negative abnormal accruals around share repurchase. ikenberry et al. (2010) usa (1980-00) discretionary abnormal accruals managers reported high positive discretionary accrual to boost the stock price to mislead the investors. source: compiled by authors from cited research articles. 8. conclusion share repurchase as a pay-out method first started in the usa during 1950.since then, research has been going on this area in determining the various reason for share repurchase, the value of firms after share repurchase, the timing of repurchase and the impact on stock price and return after the announcement of repurchase. this study only analysed the literature relating to factors influencing share repurchase, the impact of repurchase on the liquidity of the stock and earnings management around share repurchase. the factors those drive repurchase decisions may differ from country to country depending on the institutional framework of share buyback in the particular country. for this reason, in a differentcountry, different hypothesis are influencing share buyback decisions. the impact of share repurchase on liquidity is also distinctin the various countries. in some country, liquidity increases after repurchase and vice-versa in other countries. managers deflate earnings in the previous year of repurchase to entice shareholder to sell their shares. in this process, non-selling shareholders or long-term shareholders gain at the cost of short-term shareholders. the level of earnings management depends on upon the country’s audit quality and corporate governance. the study also gives a close and brief view of the indian rules and regulations those monitor share buybacks by indian companies. all the amendments in the sebi regulations and the changes in new companies act 2013 from the old companies act 1956, is also illustrated in the paper. the extensive review of literature opens the future scope of study in this area. to find out the motivation or determinant of share repurchase, different firm-specific parameters have been taken by various researchers. in developing countries or emerging economy where share repurchase started in the last decade of 20th century, the only handful of research has been carried out in this area. due to the market transparency and difference in the regulatory framework, the well documented common determinants for share buyback may not be valid asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 24 in emerging market economies. so it is examined on country wise, and the findings are different than developed countries. in emerging markets, the complex relationship among share buyback announcement, stock return, and the premium paid on share buyback and value of the firm has not been tested in a wider way. similarly, ownership structure and its impact on repurchase decision and implication of liquidity on share repurchase or impact of repurchase on stock market liquidity and the relationship between dividend payment and share buybacks need to be explored in emerging market economies. acknowledgement the research is financed by university grant commission, government of india. references ahn, h. j., cao, c., & choe, h. 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(2013). an empirical study on influential determinants for enterprise capital reduction: evidence from cash reduction and stock repurchase. the international journal of organizational innovation, 100-114. microsoft word 10056-36955-1-sm _1_-writer2-new2 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 113 the impact of the financial sector on asset pricing tests: evidence from the colombo stock exchange amal peter abeysekera department of finance, university of sri jayewardenepura, sri lanka po box 10250, nugegoda, sri lanka e-mail: amalabey@sjp.ac.lk p. d. nimal (corresponding author) department of finance, university of sri jayewardenepura, sri lanka po box 10250, nugegoda, sri lanka tel: 94-71-70-06713 e-mail: pdnimal@sjp.ac.lk received: sep. 20, 2016 accepted: oct. 12, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.10056 url: http://dx.doi.org/10.5296/ajfa.v8i2.10056 abstract this paper aims to identify how the inclusion of financial sector affects the ability of asset pricing models to explain the average stock returns in the cse. most of the asset pricing researches, the firms in the financial sector are excluded on the basis that their characteristics and the leverage are notably different than firms in other industries. therefore the objective of this study is to identify the impact of the inclusion of financial sector on the ability of the carhart four-factor model to explain the average stock returns in the cse and to compare its performance with the capital asset pricing model (capm) and the fama and french three-factor model. the study finds that the four-factor model; incorporating the market premium, size premium, value premium and momentum premium provides a satisfactory explanation of the variation in the cross-section of average stock returns in the cse, even when the financial sector is included. it is found that the carhart four-factor model performs better than the capm in all scenarios; and that it performs notably better than the fama and french three-factor model.however, there is no notable difference in the findings either the financial sector is included or not. keywords: capm, carhart four-factor model, fama and french three-factor model, financial sector, stock returns jel: g12, g13 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 114 1. introduction empirical asset pricing models attempt to explain the variation in the cross section of average returns via the identification of systematic risk factors. fama and french (1992) study the impact of several factors, including leverage on security returns of non-financial firms and conclude that size and book-to-market (b/m) ratios are the strongest factors. fama and french (1993) propose a three-factor model, which posits that the cross-section of average returns can be explained by the excess market return ( − ), a size factor )and a book-to-market (b/m) factor ). carhart (1997) proposes the addition of a fourth factor termed the momentum factor ) to the fama and french (1993) three-factor model. in these empirically motivated studies it has become a standard practice to exclude financial firms from the sample. the rationale for such exclusion is that financial firms have high leverage, and high leverage may not have the same meaning as it does for non-financial firms; i.e. high leverage for non-financial firms generally translates as “distress”. however, there are some studies that have analyzed the relationship between factors and security returns of financial firms (barber and lyon (1997)), cooper, jackson and patterson (2003), foerster and sapp (2005) and have produced mix results. as far as sri lankan market is concern almost all studies on this theme have been conducted only for non-financial firms though the size of the financial sector is quite large. therefore the focus of this paper is not to identify factors that could contribute to the explanation of the variation in the cross-section of average returns but rather to identify the impact of the inclusion of financial sector on the relationship between security returns andrisk factors. specifically, this study tests the ability of the carhart (1997) four-factor model to explain the variation in the cross-section of average returns in the cse with and without the financial sector. furthermore the performance of the four-factor model is evaluated against the capm and the fama and french (1993) three-factor model, and it is examined whether the inclusion of the financial sector alters the conclusions arrived at when the financial sector was excluded. the rest of the paper is organized as follows; section 2 provides a brief review of the literature, section 3 describes the sample and data and section 4 deals with the methodology used in the study. section 5 presents the summary statistics and section 6 turns to the tests of asset pricing models. section 7 concludes the paper. 2. literature review barber and lyon (1997) analyze the relationship between size, b/m and security returns for financial firms. while they agree that high leverage of financial firms may not have the same meaning as for non-financial firms, they argue that there is no reason to expect that size and b/m ratios should have different meanings for financial and non-financial firms. the focus of their paper is on comparing the summary characteristics of the returns of both financial and non-financial firms. they use the same approach used by fama and french (1992) and form portfolios based on size deciles and b/m deciles. they document that financial and non-financial firms have very similar return patterns and that both types of firms exhibit a asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 115 significant size and b/m premium. further they report that neither the size premium nor the b/m premium statistically differs across financial and non-financial firms. cooper, jackson and patterson (2003) examine the predictability of the cross-section of stock returns of financial firms by using information contained in fundamental variables of financial firms such as income from derivative usage, loan-loss reserves, earnings and leverage. they conclude that neither size nor b/m is important in their sample. foerster and sapp (2005) analyze the impact of excluding financial firms from asset pricing tests in countries with large financial sectors, by comparing results when financial firms are included and excluded. they find that including financial firms in empirical asset pricing tests can impact the corresponding inferences. in their study the inclusion of the financial sector affects the significance of the factors and their corresponding betas, and some models are accepted when financial firms are included but are rejected when they are excluded. in the sri lankan context the research done in the area of empirical asset pricing tests exclude the financial sector (samarakoon, 1997; nimal, 1997;nanayakkara, 2008).moreover, abeysekera and nimal (2016) find that the four-factor model performs better than the capm and the three-factor model for non-financial firms listed in the cse.therefore it is important to identify the impact the financial sector has in empirical asset pricing tests done with regard to the cse. 3. sample and data the sample period of this study extends from october 1997 to september 2012. all tests are done for the entire population of firms listed in the cse (including financial firms) and are compared with the results of abeysekara and nimal (2016) where the financial firms are excluded. the total number of companies listed in the cse range from 127 (26 finance) companies in 1998 to 217 (60 finance) companies in 2012 and the number of companies selected each year for the study range from 80 (21 finance)companies to 160 (31 finance) companies that satisfy the selection criteria.monthly stock returns are calculated under a reinvestment assumption and they include all forms of benefits given to shareholders that are measurable in monetary terms. following nimal (2006), monthly stock returns are calculated as percentagereturns incorporating the net effect of capital gains/losses, dividends, stock splits, bonus issues and right issues. information required in calculating the monthly stock returns are obtained from the cse. similar to pathirawasam and weerakoon (2008); anuradha and nimal (2013) monthly stock returns greater than + 50% or less than -50%, are considered as outliers and are removed from the sample. monthly excess returns are calculated as the returns in excess of the risk-free rate. the percentage change in the total return index (tri) is used as a surrogate for the market return. the tri reflects returns due to both price changes and dividends; it is calculated under the assumption that dividends earned are reinvested in the market. since the tri was introduced only in january 2004; the tri values till october 1997 are obtained by extrapolating the tri backwards.the monthly risk-free ratesare derived from the 91-days treasury bill ratesobtained from the central bank of sri lanka. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 116 4. methodology empirical asset pricing tests require specifying the risk factors (explanatory variables) and the test assets (dependent variables) which are to be used in the regressions. in doing so portfolios are formed to generate the explanatory and dependent variables. the portfolios forming the explanatory variables are referred to as the right-hand side (rhs) portfolios and the portfolios generating the dependent variables are referred to as the left-hand side (lhs) portfolios. 4.1 portfolio formation following the factor mimicking portfolio approach of fama and french (1996, 2012) portfolios are formed based on size and b/m ratio; and on size and momentum in order to obtain explanatory returns for the regressions. all portfolios’ returns are calculated using excess stock returns. company size is measured in terms of market capitalization. book equity is calculated as the difference between total assets and total liabilities. the b/m ratio is calculated at the end of the fiscal year of each company; i.e. the book equity of a company at the end of its fiscal year is divided by its market capitalization on that day. as the financial years of companies listed in the cse end either in december or march, this generates a series of b/m ratios on the 31st of december for december-end companies and another series of b/m ratios on the 31st of march for march-end companies. following the fama and french (1996, 2012) methodology stocks with negative b/m ratios are not considered. in the present study similar to fama and french (2012), momentum is represented by the lagged return. lagged momentum return of a stock is its cumulative excessreturn from t-11 to t-1. skipping the sort month in this manner is a standard practice in momentum tests, due to jegadeesh’s (1990) evidence of negative correlation (i.e. reversal rather than continuation) of month-to-month returns. it is to be noted that the first momentum calculation absorbs a year of data; therefore the sample period for the regression is actually 14 years, although data of 15 years are used for the calculations. the explanatory returns are calculated by forming rhs portfolios from 2×3 sorts on size and b/m. portfolios are formed at the end of september of year t and the monthly equal-weighted stock returns for each portfolio is calculated from october of year t to september of year t+1; after which portfolios are reformed in september of year t+1. the cse requires each company to publish their audited accounts by june for december-end companies and by september for march-end companies. therefore following samarakoon (1997) september 31st is chosen as the portfolio formation date in order to provide a gap between the financial year-end and return calculation period. this is done in order to avoid the ‘look-ahead’ bias as emphasized by banz and breen (1986). further to be included in a size-b/m portfolio a stock is required to have a return for each of the twelve months following the portfolio formation. in the 2×3 sorts on size and b/m; stocks are grouped into two portfolios based on the median market capitalization. further the same stocks are grouped in to three portfolios based on b/m ratio, where the breakpoints are taken as the 30th and 70th percentiles of the b/m ratio. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 117 the intersection of the independent 2×3 sorts on size and b/m produces six portfolios: sg,sn,sv,bg,bn and bv, where s and b indicate small and big and g, n and v indicate growth, neutral and value respectively. growth firms have a lower b/m (below the 30th percentile) and value firms have a higher b/m (above the 70th percentile). the monthly size factor (smb) is calculated as the difference between the average return on the three small-cap stock portfolios and the three big-cap stock portfolios. the monthly value factor (hml) is calculated as the difference between the average return of the two high b/m portfolios (value portfolios) and the average return of the two low b/m portfolios (growth portfolios). in order to generate returns to be used for the regression as dependent variables, lhs portfolios are created using 3×3 sorts on size and b/m, resulting in 9 portfolios. given the minute size of the cse, tertiles are used as the breakpoints; using quartiles or quintiles result in some portfolios having zero stocks. in order to calculate the momentum factor (wml) another 2×3 sorts is used where b/m is replaced by the lagged return. since momentum returns are short term (jegadeesh and titman, 1993) size-momentum portfolios are formed monthly and the return of the portfolios are calculated for the succeeding month (fama and french, 2008 and 2012). therefore to be included in a size-momentum portfolio, a stock is required to have a return for the month following the portfolio formation. all other mechanics of portfolio formation remains the same; thus generating another set of six portfolios: sl,sn,sw,bl,bn and bw, where s and b indicate small and big, and l, n and w indicate losers, neutral and winners respectively. losers are firms with a lagged return below the 30th percentile and winners are firms with a lagged return higher than the 70th percentile. the monthly momentum factor (wml) is calculated as the difference between the average return of the two winners’ portfolios and the average return of the two losers’ portfolios. a group of lhs portfolios are formed withtertiles as the breakpoints by using 3×3 sorts on size and momentum. this is done so that another set of regressions could be run using these nine portfolio returns as the dependent variables. 4.2 statistical methods in order to evaluate the overall validity of the four-factor model, in its ability to explain the differences of the cross sectional average excess returns of the cse and to compare its performance relative to the capm and the three-factor model; the grs f-statistic along with its p-value, the average absolute intercept (denoted by |a|), the average adjusted r2, the average standard error of the intercepts [s(a)] and the sharpe ratio for the intercepts [denoted by sr(a)] are reported and analyzed. the grs f-statistic is used to test the hypothesis that the regression intercepts for a set of 9 portfolios are statistically indistinguishable from zero (gibbons, ross and shanken, 1989). the sr(a) is the maximum sharpe ratio for excess returns on the portfolios of the lhs assets contracted to have zero slopes on the rhs returns. in other words it can be termed as the sharpe ratio for the intercepts (i.e. unexplained average returns) of a model (fama and french, 2012). given the above definition for the sr(a) it follows that lower the sharpe ratio for the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 118 intercepts better the model is. as the sr(a) combines information about both the magnitude and the precision of the intercepts into one summary statistic, the average absolute intercept (as a measure of the relative magnitude) and the average r2 and the average standard error of the intercepts (as measures of precision) are also reported separately so that information on the magnitude and the precision of intercepts are not lost. 5. summary statistics these summary statistics are intended to provide a preliminary insight in to the nature of the data that has been considered in this study. 5.1 explanatory returns (factors)/rhs portfolio returns given in table 1 are the average premiums and their standard deviations for the period under consideration. t-mean is the ratio of the mean to its standard error. the average market premium (i.e. the average difference between the monthly market return and risk-free rate) is 1.17% (t = 2.00). however the market premium is highly volatile compared to the other factors with a standard deviation of 7.58%. the average size premium is positive when financial firms are excluded but is found to be negative when all companies are considered. it is to be noted that in both cases the size premium is minute and insignificant compared to the equity or value premium.in both scenarios the value premium is positive and fairly large. however there hardly appears to be a momentum premium present, with the average wml factor being less than 0.00 (t = -0.01) when the financial firms are excluded and 0.02 (t = 0.08) when all companies are considered. following fama and french (2012), table 1 also presents the average hml and wml factors and the standard deviation for both small-cap and big-cap stocks. when the financial sector is excluded the big-cap stocks have a larger value premium compared to small-cap stocks albeit not very much different from the small-cap stocks. the momentum premium is seen only with big-cap stocks and it is negative for small-cap stocks. when all the sectors of the cse are considered still the value premiums are larger for big-cap stocks. again the momentum premium is seen only in the big-cap stocks and is negative for the small-cap stocks. table 1. summary statistics for explanatory variables rm-rf smb hml hmls hmlb hmls-b wml wmls wmlb wmls-b excludingfinance mean 1.17 0.09 0.54 0.52 0.57 -0.06 0.00 -0.22 0.21 -0.43 standar 7.58 2.93 3.55 4.79 4.67 6.25 4.17 5.28 4.89 5.84 t-mean 2.00 0.42 1.99 1.40 1.59 -0.12 -0.01 -0.54 0.57 -0.96 all companies mean 1.17 -0.12 0.70 0.67 0.74 -0.07 0.02 -0.14 0.19 -0.34 standar 7.58 2.90 3.42 4.92 4.37 6.32 3.90 4.90 4.52 5.29 t-mean 2.00 -0.53 2.67 1.75 2.20 -0.15 0.08 -0.38 0.55 -0.82 the section on excluding finance is extracted from abeysekera and nimal (2016) for comparison asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 119 purpose.portfolios are formed at the end of september each year t by sorting stocks into two market-cap and three b/m groups. big-cap stocks are those stocks above the median market-cap and small-cap stocks are those below the median market cap. the b/m breakpoints are the 30th and 70th percentiles of b/m. the independent 2×3 sorts on size and b/m produce six portfolios, sg, sn, sv, bg, bn, and bv, where s and b indicate small and big and g, n, and v indicate growth, neutral, and value (bottom 30%, middle 40%, and top 30% of b/m) respectively. monthly returns on the portfolios are calculated from october to the following september.smb is the equal-weight average of the returns on the three small-cap stock portfolios minus the average of the returns on the three big-cap stock portfolios. the 2×3 sorts on size and lagged momentum are similar, but the size-momentum portfolios are formed monthly. for portfolios formed at the end of month t, the lagged momentum return is a stock’s cumulative return for t-11 to t-1. the independent 2×3 sorts on size and momentum produce six portfolios, sl, sn, sw, bl, bn, and bw, where s and b indicate small and big and l, n, and w indicate losers, neutral, and winners (bottom 30%, middle 40%, and top 30% of lagged momentum) respectively. all returns are in lkr. rm-rf is the return calculated from the total return index (tri) minus the one-month t-bill rate (derived from the 91-day treasury bill rate). size is the market capitalization at the end of september of each year t. the book equity is calculated as the difference between total assets and total liabilities. negative book equity firms are excluded. the b/m ratio used to form portfolios in september of year t is the book common equity for the fiscal year ending in march (december) of year t (t-1) divided by the market equity on the same day. the t-mean is the ratio of the mean to its standard error. value-growth returns for small-cap and big-cap stocks as well as winner-loser returns for small-cap and big-cap stocks are presented. hmls = sv-sg and hmlb = bv-bg, and hml is the equal-weight average of hmls and hmlb. wmls = sw-sl and wmlb = bw-bl, and wml is the equal-weight average of wmls and wmlb. hmls-b (wmls-b)is the difference between hmls and hmlb (wmls and wmlb). these results are markedly different with the findings of fama and french (2012) with regard to developed markets, where the small-cap stocks were found to drive both the value and momentum premiums. 5.2 dependent variables/lhs excess portfolio returns when portfolios are formed on size and b/m ratios, the standard size effect (i.e. smaller firms having a larger average return) is not to be seen (table 2), and there appears to be no persistent pattern in the size effect. although traces of a reverse size effect can be seen, it is indisputably seen only in the neutral stocks when the financial sector is excluded (0.85, 0.89, and 0.91). there is a value pattern in all size groups as the theory predicts (fama and french, 1992, 1996, 2012); that is the average excess returns increase as you move from left to right in the size-b/m matrices. further the spread in value versus growth average returns is highest for the big-cap stocks; i.e. 0.99% (= 1.61% 0.62%) when financial firms are excluded and 0.95 % (=1.67% 0.72%) when all companies are considered. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 120 table 2. summary statistics for the 9 size-b/m portfolios’ average excess returns the section on excluding finance is extracted from abeysekera and nimal (2016) for comparison purpose. at the end of september of each year, size-b/m portfolios are constructed using tertiles as the breakpoints. the intersections of the 3×3 independent size and b/m sorts produce 9 size-b/m portfolios. table 3. summary statistics for the 9 size-momentum portfolios’ average excess returns lagged return (tertiles) size 1 2 3 1 2 3 mean excess returns standard deviation excluding finance 1 1.06 1.03 0.39 1 8.73 8.10 7.98 2 0.52 0.96 0.76 2 8.86 8.10 8.20 3 0.61 0.78 1.03 3 8.12 7.12 7.23 all companies 1 0.93 0.91 0.53 1 8.90 8.18 8.04 2 0.57 1.02 0.60 2 8.78 8.01 7.82 3 0.63 0.94 1.08 3 8.11 7.29 7.28 the section on excluding finance is extracted from abeysekera and nimal (2016) for comparison purpose. the 3×3 sorts on size and momentum use the same breakpoint conventions as the size-b/m sorts, except that the size-momentum portfolios are formed monthly. the intersections of the independent 3×3 size and momentum sorts produce 9 size-momentum portfolios. for both scenarios shown in table 3, where portfolios are formed on size and momentum, the momentum pattern prevails in big-cap companies; i.e. when you move from left (last year’s losers) to right (last year’s winners) the average return increases. however there is a reversal of the momentum pattern for small-cap companies, suggesting a ‘contrarian’ pattern with the average return decreasing when moving from left to right. in both scenarios the medium-cap firms show a momentum pattern and a reversal when moving from left to right. the spread in momentum average returns is highest for the small-cap stocks when financial firms are excluded and it is highest for the big-cap stocks when all companies are considered. 6. asset pricing tests book-to-market equity (tertiles) size 1 2 3 1 2 3 mean excess returns standard deviation excluding finance 1 0.81 0.85 1.18 1 9.06 7.54 7.66 2 0.11 0.89 0.98 2 8.96 7.74 8.36 3 0.62 0.91 1.61 3 6.48 7.59 9.25 all companies 1 0.43 0.90 1.11 1 8.99 7.75 7.81 2 0.11 0.98 0.98 2 8.34 7.72 8.18 3 0.72 0.87 1.67 3 6.53 7.53 9.02 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 121 the regressions run for the four-factor model (not reported) all show a clear size, value and momentum pattern on the coefficients when the financial sector is both excluded and included. further in both scenarios most of the intercepts were statistically insignificant while most coefficients were statistically significant. table 4. summary statistics for regressions to explain excess returns on the 9 size-b/m portfolios the section on excluding finance is extracted from abeysekera and nimal (2016) for comparison purpose. the regressions use the capm, three-factor and four-factor models to explain the returns on portfolios formed on size and b/m. the grs f-statistic tests whether all intercepts in a set of 9 (3×3) regressions are zero; |a| is the average absolute intercept for a set of regressions; s(a) is the average standard error of the intercepts; r2 is the average adjusted r2 and sr(a) is the sharpe ratio for the intercepts. given in table 4 are the summary statistics for the regressions of the 9 size-b/m portfolios. as the grs f-statistics for the capm regressions are 6.64 and 7.54 when financial firms are excluded and included respectively, and as they are far into the right tail of the relevant f-distribution, the capm is rejected. however when shifting from capm to the three-factor model or the four-factor model there is a large drop in the grs f-statistic and the p-value increases. therefore the null hypothesis stating that all regression intercepts are statistically equal to zero is not rejected, i.e. the three-factor model and four-factor model are accepted under both scenarios. further when moving from capm to the three-factor and four-factor model, all other summary statistics mark a clear improvement implying that the three-factor and four-factor model capture the cross section of average returns notably better than the capm. however, the four-factor model does not perform extraordinarily better than the three-factor model. when portfolios are formed on size and momentum (table 5), the results are different from the size-b/m portfolios in two aspects. firstly, all three models are to be accepted based on the grs f-test, as the p-values of the respective f-statistics are higher than 0.05. secondly, the four-factor model turns out to be indisputably the superior model compared to both the capm and the three-factor model, as the grs f-statistic is clearly lower for the four-factor model and its p-value is higher than the other two models. further the adjusted r2 and sr(a) grs test |a| r2 s(a) sr(a f-stat p excluding finance capm 6.64* 0.00 0.29 0.67 0.11 0.62 three-factor 1.04 0.41 0.30 0.75 0.08 0.25 four-factor 0.81 0.61 0.30 0.74 0.09 0.22 all companies capm 7.54* 0.00 0.31 0.71 0.14 0.66 three-factor 0.77 0.64 0.24 0.80 0.08 0.21 four-factor 0.76 0.66 0.23 0.81 0.08 0.21 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 122 improve in favor of the four-factor model when moving from capm and the three-factor model to the four-factor model. table 5. summary statistics for regressions to explain excess returns on the 9 size-momentum portfolios the section on excluding finance is extracted from abeysekera and nimal (2016) for comparison purpose. the regressions use the capm, three-factor and four-factor models to explain the returns on portfolios formed on size and momentum. the grs f-statistic tests whether all intercepts in a set of 9 (3×3) regressions are zero; |a| is the average absolute intercept for a set of regressions; s(a) is the average standard error of the intercepts; r2 is the average adjusted r2 and sr(a) is the sharpe ratio for the intercepts. 7. summary and conclusions this study investigates whether the inclusion of the financial sector would have any bearing on the inferences drawn from asset pricing tests done with regard to the cse. it uses monthly stock return data from october 1997 to september 2012, and all tests are done for a sample excluding the financial sector as well as for the entire population of firms listed in the cse (including the financial sector). the factor mimicking portfolio approach of fama and french (1996, 2012) is applied in this study; portfolios are formed based on size and b/m, as well as on size and momentum. the study focuses largely on the carhart (1997) four-factor model. in order to test the ability of the four-factor model in explaining the average stock returns and to evaluate its performance in comparison with the capm and the three-factor model; the adjusted r2, grs f-test and the sharpe ratio for the intercepts are used. the study finds that the inclusion of the financial sector does not alter the conclusions arrived at when the financial sector was excluded. clear size, value and momentum patterns were seen when observing the loadings or coefficients generated via the regressions excluding and including the financial sector. further most of the coefficients were statistically significant and most of the intercepts were statistically insignificant. these results strengthen barber and lyon’s (1997) findings where they conclude that size and b/m ratios have similar meanings for both financial and non-financial firms. the four-factor model is not rejected in either scenario but is found to perform notably better than the capm and three-factor model in the size-momentum portfolios. however, the results of the current study contrast with foerster grs test |a| r2 s(a) sr(a) f-stat p excluding finance capm 1.36 0.21 0.24 0.66 0.09 0.28 three-factor 1.18 0.31 0.38 0.72 0.08 0.27 four-factor 0.83 0.59 0.37 0.76 0.09 0.22 all companies capm 1.25 0.27 0.25 0.70 0.07 0.27 three-factor 0.86 0.56 0.30 0.78 0.08 0.23 four-factor 0.77 0.64 0.29 0.81 0.07 0.21 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 123 and sapp (2005), who conclude that the inclusion of financial firms affect the inferences drawn from asset pricing tests. in conclusion with regard to the cse, it can be said that including the financial sector does not alter the findings of empirical asset pricing tests done by excluding them. references abeysekera, a. p.,&nimal, p. d. 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(1992). the cross-section of expected stock returns. journal of finance,47(2), 427-65.http://dx.doi.org/10.1111/j.1540-6261.1992.tb04398.x fama, e. f.,& french, k. r. (1993). common risk factors in the returns on stocks and bonds. journal of financialeconomics,33(1), 2-56.http://dx.doi.org/10.1016/0304-405x(93)90023-5 fama, e. f.,& french, k. r. (1996). multifactor explanations of asset pricing anomalies. journal of finance,51(1), 55-84.http://dx.doi.org/10.1111/j.1540-6261.1996.tb05202.x fama, e. f.,& french, k. r.(2012). size, value and momentum in international stock returns. journal of financial economics,105(3), 457-72.http://dx.doi.org/10.1016/j.jfineco.2012.05.011 foerster, s.r.,&sapp, s. g. (2005). valuation of financial versus non-financial firms:a global perspective. journal of international financial markets, institutions and money,15, 1-20.http://dx.doi.org/10.1016/j.intfin.2004.01.003 gibbons, m. r., ross, s. a.,& shanken, j. 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(2006). empirical analysis of the capital asset pricing model, university of shiga, japan: ph.d thesis. pathirawasam, c.,& weerakoon banda, y.k.(2008). profitability of momentum and contrarian strategies in the colombo stock exchange. in: proceedings of fifth international conference of business management. sri lanka,university of sri jayewardenepura. 27-31. samarakoon, l. p. (1997). the cross-section of expected stock returns in sri lanka. sri lankan journal of management, 2(3), 234-50. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 407 the effects of board compositions and audit committee characteristics on information disclosure practices: a case of singapore nunthapin chantachaimongkol (corresponding author) department of management and economics, dalian university of technology, dalian, china shuwen chen department of management and economics, dalian university of technology, dalian, china received: april 7, 2018 accepted: june 27, 2018 published: june 27, 2018 doi:10.5296/ajfa.v10i1.13261 url: https://doi.org/10.5296/ajfa.v10i1.13261 abstract this paper aims to investigate the effects of board compositions and audit committee characteristics on disclosure practices in singapore. the asean disclosure index, covering 212 items in 3 domains: financial information, non-financial information, and strategic management information, was constructed to capture disclosed information of 22 listed companies from 2011-2015, made out of 110 observations. in the analytical procedure, multiple regression models were tested through eviews 10 with an ordinary least squares (ols) method to estimate the connection between the predictors and the dependent variable. an empirical result reports that board size, audit committee independence, a number of audit committee meetings and a number of audit committee participation rates have a positive relationship with the level of corporate disclosure while ceo duality has a negative association with information disclosure practices. for other variables covering board independence, a number of board meetings, a number of director participation rates and gender diversity, no significant relationship was found. the findings might help regulators in enhancing the level of corporate disclosure in singapore as well as neighboring countries in southeast asia region. furthermore, this study also contributes to the literature by offering a new instrument for assessing the extent of corporate disclosure in southeast asia region and also providing some insight into the relationship between corporate governance mechanisms on information disclosure practices based on the asia’s developed country perspective. keywords: corporate governance, board of directors, audit committee, information disclosure, singapore asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 408 1. introduction over the last few decades, the research frontier in corporate disclosure has been enlarged in both scope and quality. several types of research have been conducted a research to investigate the determinants of corporate disclosure in various aspects around the world. this includes an observation of the relationship between corporate governance mechanisms and information disclosure practices in the association of southeast asian nations (asean). for instance, a study of zainon et al. (2014) and apadore and zainol (2014) reveal that the extent of corporate disclosure in malaysia is dominated by ownership concentration, audit quality, board independence, ceo duality, board size and the presence of external auditors. alternatively, based on a study by haniffa and cooke (2002), the results show that only two corporate governance characteristics, which are a family member on the board and chairperson are a non-executive director, are negatively correlated with the voluntary disclosure practices of both financial and non-financial information in the annual reports of malaysian listed corporations. regarding the previous finding, it has been confirmed by a study by akhtaruddin et al. (2009) which remarks that family control has a negative effect on the extent of voluntary disclosure in malaysia. furthermore, the result also highlights that there is a significant positive correlation between voluntary disclosure and board size, the proportion of independent non-executive directors on the board and amount of outside ownership. similarly, utama (2012) also found that companies with medium block-holder ownership (between 20.1%-50%) are likely to disclose less information than companies with low block-holder ownership (less than or equal 20%) while companies with high block-holder ownership (greater than 50%) generally provides a high level of information disclosure. based on the evidence, it has been confirmed that block-holder ownership is significantly impacted on disclosure level of a company in indonesia. together with a study of luo et al. (2006), the finding is still consistent with the previous results by indicating that the level of voluntary disclosure in singapore is significantly and positively related to high management ownership and outside block-holder ownership. again, ghazalia and weetman (2006) also conclude that director ownership has a vital role in transforming the extent of voluntary disclosure, but government ownership is insignificant with corporate disclosure practices in malaysia. however, the result appears to contradict another empirical study conducted in malaysia. htay et al. (2011) reveal that the relationship between director ownership and the extent of risk management information disclosure is highly statistically significant, with the negative sign while the proportion of independent non-executive directors is found to have a positive significant impact. supported by the practices of a firm in singapore, eng, and mak (2003) claim that an increasing number of outside directors and managerial ownership are negatively associated with voluntary disclosure while the role of government ownership is positively influenced on disclosure practices. based on a study by vu (2012), the result still strongly points out that the association between voluntary disclosure practices and the proportion of independent directors on the board is significant and positive in vietnam. however, the extent of voluntary disclosure is negative significant with a higher proportion of state ownership and managerial ownership. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 409 similarly, cheng and courtenay (2006) who examine the influence of board composition on voluntary disclosure in singapore also assert that the proportion of independent directors is significantly connected to the level of voluntary disclosure. in other words, hieu and lan (2015) point out that in vietnam, there is a positive relationship between foreign ownership and the level of voluntary disclosure, indicating that companies with high foreign ownership will disclose more corporate information compared with companies with low foreign ownership. this finding is concurrent with a study of craig and diga (1998) which investigates corporate accounting disclosure in five countries in asean: indonesia, malaysia, philippines, singapore, and thailand. the result finds that foreign ownership has a positive significant correlation with financial information disclosure at a significant level of 0.05. as briefly reviewed, it is obvious that the existing solid evidence acknowledging the success (or failure) of the significant improvements in promoting good corporate cultures in asean is still limited while existing literature has been focused on the factors related to ownership structure and often ignored other governance variables. consequently, this study aims to investigate current situation of corporate disclosure in singapore and identify the factors contributing to the practices, with a particular focus on board compositions and audit committee characteristics. 2. theoretical framework traditionally, a variety of theories have been employed to design an appropriate framework for allocating variables attributing to corporate disclosure practices. however, since this paper typically focuses on the attributes of corporate governance, only agency theory is applied as a benchmark to verify factors contributing to corporate disclosure practices. agency theory principally, businesses in a modern society have been forced to separate the role of the business owner out of management functions with a belief that this business structure might be more effective for reducing an inequality in access to organizational power and promoting sustainable development. that means shareholders (the principal), whether majority or minority, are unable to get involved directly with operational procedures, but they have to take an action through the agents or called as managers (fauziah and alhaji, 2012; sharma, 2013). nevertheless, in practice, such a model has rarely matched the expectation since a variety of problems might fruitfully occur in a workplace when the two parties have different opinions or conflicts of interest. along with this matter, jensen and meckling (1976) proposed the “agency theory” to visible the interaction among stakeholders and managerial capitals. they suggest that a kinship among business actors (e.g. owners, managers, and investors) is strongly associated with corporate behaviors, resulting in business growth and increased profitability. in other words, it can be said that since self-interests of managers may potentially affect their decision-making quality, one of the most powerful applications that companies could apply to balance their passion with business goals is offering them a good compensation package. to do so, management will operate the business enthusiastically and make a good decision to increase market capitalization and maximize profit for investors, in return. regarding this action, it is apparent that governance structures could enhance the relationship between shareholders and managers, resulting in fewer agency conflicts. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 410 hence, healthy companies are more likely to create a flavor platform which helps them to engage with outside financing and more competitive in the market (watts and zimmerman, 1990; an et al., 2011; randoy and nielsen, 2002). as noted, it is clear that agency theory is an important framework for linking internal control systems with business activities. hence, its notion would be adapted to enlarge an understanding on the linkage between corporate governance and disclosure practices in singapore. 3. literature review 3.1. corporate disclosure in general, the term “corporate disclosure” is regularly used to refer to a communication activity that managers utilize to connect with stakeholders. it can be broadly sub-divided into two dimensions: mandatory and voluntary. in terms of mandatory disclosure, it is regularly related to national rules and regulations which are set to determine minimum practices that every company must comply with, otherwise be immediately penalized by a regulatory authority. on the other hand, voluntary disclosure normally implies that supplementary actions (above the mandatory requirements that a company can choose to apply or not apply based on its current situation and future challenge) (eng and mak, 2003; akhtaruddin, 2005; barako et al., 2006; hassan et al. 2009; trang and phuong, 2015). 3.2. the frameworks of corporate disclosure in singapore singapore has been widely recognized as the most effective country in asia in promoting good governance. however, the regulations of disclosure standards still reflect a diversity of legal heritages as exhibited in the below table: table 1. laws and regulations related to corporate disclosure in singapore laws and regulations the year of announcement type of enforcement regulatory authorities sgx’s corporate disclosure policy 2002 mandatory requirement singapore stock exchange companies (accounting standards) regulations 2004 (revised edition) mandatory requirement accounting standards council singapore the company act (chapter 50) 2006 (revised edition) mandatory requirement singapore government the securities and futures act (chapter 289) 2006 (revised edition) mandatory requirement singapore government the singapore exchange listing rules (chapter 12) 2011, as amended in 2017 mandatory requirement singapore government singapore code of corporate governance 2012 mandatory requirement monetary authority of singapore (mas) and singapore stock exchange source: collected by the author asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 411 according to the table 1, it is also conspicuous the regulatory framework of corporate disclosure in singapore has been shaped based on four legal sources: the company laws, the accounting standards, the securities regulations, and the corporate governance codes. additionally, it is found that since the first enactment, the disclosure regulatory frameworks of singapore have been constantly improved in both scope and intensity, to increase the efficiency of enforcement and response with the changes of global business environment. 3.3. corporate governance theoretically, the term “corporate governance” is intricate to describe in details because it is a broad concept that encompasses multifaceted disciplines of social sciences together. it includes the notions of business administration, financial and accounting, law, psychology, and many of the others (claessens and yurtoglu, 2013). regarding the pervasive arrangements, its definition is abundantly designed in the governance literature. for example, according to the oecd principles (1999), it recommends that corporate governance is procedures and processes according to which an organization is managed and structured. supported by the study of blair (1995), the evidence suggests that the external mechanisms including legal system, cultural framework, and institutional principle can be related to the internal applications such as the extent of corporate authorities, the persons who are in charge of the company, the governance structure, and the allocations between risks and return portfolios from the corporate activities. together with the study conducted by jensen and meckling (1976) as well as shleifer and vishny (2007), the evidence also offer that corporate governance is an effective way to cope with the agency cost that arising from the conflicts among objectives of owner-shareholders and managers and establish institutions, policies, and procedures assure that the investors will get the benefits from their investment in return. as cited above, it can be concluded the that corporate governance is the strategies or techniques that an organization uses for organizing the management structures, defining the rights and responsibilities of the executives, controlling the procedures for making a decision; sharpening the fairness, accountability, responsibility, and transparency of a company; and attracting the long-term investment from the foreign investors. yet, besides a variety of the meanings in an empirical research study, the concept of corporate governance can be specifically explained into two main streams: the anglo-american model and the central european model. generally, the anglo-american model is widely applied in the uk, the us, australia, canada, new zealand and several other countries. its principles are relevant to an open system that is implicitly based on a wider diffusion of ownership, a well-developed of shareholder rights and responsibilities, a short-term equity financing, and an easy procedure for shareholders to interact with the key players, known as management and directors. on the other hands, the central european model is notably introduced in germany, austria, netherland, scandinavia, france, belgium, and among others. it is a closed system that is governed based on a highly concentrated ownership environment, a banking system that defines both the scope of participation and a movement of a corporation and a cross-holding of debt and equity. (three models of corporate governance from developed capital markets, 2011; naciri, 2008) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 412 to acquaint with the above statements, it can be interpreted that in businesses, several issues associated with asymmetric information might emerge from key players including business owners, the board of directors, and executive managers. with respect to this matter, the notion of corporate governance is generally implemented to rearrange the organizational structure, the authorized hierarchy, and the relationship with the stakeholders; in order to solve such a challenge and achieve sustainable development. 3.4. the relationship between corporate governance and information disclosure since the principle of information disclosure typically plays an important role in protecting investors’ right and wealth, it has often been linked with the concept of corporate governance. with regard to this network, several studies have been conducted to identify interactions between these two concepts. the results of which reported that corporate disclosure can affect the quality of corporate governance as a mechanism to sharpen business lucidity and accountability. that is because it is beneficial to promote better governance and raise operational efficiencies. subsequently, the firms with the high degree of disclosure quality always perform good practices in term of corporate governance. however, based on the other side of the connection, many pieces of evidence strongly pointed out that corporate governance quality also has an effect on the flow of information. as a result, firms with good health conditions trend to disclose more information than the ones with poor governance practices. yet, the results also mentioned that because the outcomes of the differentiation of corporate governance characteristics can be implicitly transferred to a firm, a company’s disclosure practices are, therefore, flexible in each area and the level of corporate disclosure practices in each firm are unparalleled as well (craig and diga, 1998; alberti-alhtaybat et al, 2012; abdullah and minhat, 2013; eng and mak, 2003). regarding the variations in the degree of corporate disclosure practices among companies; many questions are asked to find out the facts that why not all companies comply fully with the disclosure requirements or why some of them are willing to reveal more corporate information than the others. under such puzzles, a lot of studies found that there are multiple governance factors involved in the decision to divulge or conceal corporate information, specifically if it is highly sensitive and confidential for internal users (owusu-ansah, 1998; archambault & archambault, 2003; barako, hancock, & izan, 2006; qu & leung, 2006; galani, alexandridis, & stavropoulos, 2011). more to the point, a study of mandzila and zéghal (2016) posits that the extent of corporate disclosure is driven by a firm’s corporate governance attributes including board size, board independence, ceo duality and ownership structure. this evidence can be supported by a study of fiori et al., (2016) which explores the effects of corporate governance on voluntary disclosure in the eu, debates that size of the board is positively correlated with the adoption of the integrated report, leading to greater disclosure practices. similarly, a study of al-janadi, et al. (2013) also argues that the level of corporate disclosure will increase with a large number of non-executive directors and a high proportion of board size, implying that the role of independent directors could help to protect the shareholders’ interests. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 413 supported by hashima et al., (2015), they summarize that board size and director independence are positively related to sustainability disclosure practices of islamic financial institutions (ifis) in gulf council cooperation (gcc). together with a study conducted by yang et al. which analyzes the relationship between corporate governance and voluntary financial disclosure on social media in the uk, the result still confirms that earning disclosure had a significant and positive connection with larger board size, greater gender diversity, and higher board effectiveness. then, the finding of lim et al., (2007) also exhibits that the extent of voluntary information disclosure in australia has a positively significant relationship with board composition. additionally, the independence of the board members has been found to be significant with an increase in forward-looking information and strategic information. alternatively, garcía-meca and sánchez-ballesta (2010) also emphasize that in the countries where to provide a high standard of investor protection rights are appointed to the positive relationship between board independence and voluntary disclosure. later, the result of agyei-mensah (2016) recommends that board independence has a significant effect on internal control information disclosure of listed companies in ghana. according to ho and wong (2001), they record that the extent of voluntary disclosure in hong kong is positively related to an audit committee, but negatively correlated with the number of a family member on the board at a significant level of 0.05. this result is consistent with the finding of al-shammari and al-sultan (2010) which proposes that there is a significantly and positively relationship between a voluntary of an audit committee and the extent of voluntary disclosure in kuwait. again, aboagye-otchere and kwakye (2012) interpret that the existence of audit committee with a financial expert(s) is a significant positive correlation with the level of corporate disclosure. 4. hypothesis development as observed, it is apparent that a large number of governance structures are strongly connected to corporate disclosure practices. but, most prior studies have been focused on the relationship between ownership structure and corporate disclosure. hence, this paper would simply observe the factors related to the board of directors and auditors, to provide a new insight to the theory. however, due to research limitation, only attractive variables that are sensitive with the time have been further considered based on the theoretical foundations and disclosure literature, in order to formulate relevant hypotheses. 4.1. board size regarding agency theory, it is believed that an individual person often lacks knowledge to operate the business smoothly. as a result of this, a great team with diverse backgrounds is required to bring on adequate expertise, resulting in more accurate decision-making. supporting this view, it is assumed that the large size of the board is one of the significant determinants to decide the effectiveness of operational processes including the information disclosure behavior of a firm. in conformity with this opinion, several studies have documented that board size significantly influences on the degree of corporate disclosure (zainon et al., 2014; al-janadi et al., 2016; mandzila and zéghal, 2016). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 414 most of them (e.g. cheung et al., 2007; akhtaruddin et al., 2009; al-janadi et al., 2013; hashima et al., 2015; fiori et al., 2016; yang et al.) suggest that size of a board has a positive correlation with a decision of management to disclose or not disclose information, indicating that firms with a large board size are generally more willing to disclose corporate information to the stakeholders than the others. as supported by both theoretical insights and the harmonious signal from several empirical studies, it might be postulated that there could be a positive relationship between board size and disclosure practices in the singapore context. as a result of this, the following hypothesis is proposed: h1: board size is positively related to the extent of corporate disclosure in singapore 4.2. board independence indeed, members of a board are roughly classified into two categories. first is an executive director who is a full-time employee of a company and generally responsible for daily operations and overall performance including key achievements, long-term investment, and stakeholder engagements. second is an independent non-executive director who is not under the control of the employer and not is a part of management team. hence, the person who is appointed to this position can remain independence and probably provide some good advice from the outsider perspective to reduce the risks of getting in wrong directions of the management’s decision. with the different types of directors, agency theory suggests that a board with a high number of independent directors would be more effective in making a decision. hence, non-executive directors are needed on the boards to monitor and control the actions of executive directors. through this insight, it could be supported by multiple studies which argue that there is a significant connection between the proportion of non-executive directors and information disclosure practices (apadore and zainol, 2014; agyei-mensah, 2016; al-janadi et al., 2016; mandzila and zéghal, 2016; ben-amar and zeghal). furthermore, cheung et al. (2007); huafang and jianguo (2007); lim et al. (2007); akhtaruddin et al. (2009); yuen et al. (2009); chau and gray (2010); garcía-meca and sánchez-ballesta (2010); htay et al. (2011); vu (2012); barros et al. (2013); uyar et al. (2013); hashima et al. (2015); and scholtz and smit (2015) have provided more concrete evidences to enlarge an understanding on the topic. they confirm that the responsibility of non-executive directors is positively associated to the level of corporate disclosure, indicating that an independent board has an ability to influence managers to voluntarily deliver some necessary information excess from the requirements. to be specific, cheng and courtenay (2006) declare that under a disclosure-based regulatory regime; firms with a high number of independent directors have a significantly higher level of voluntary disclosure. together with al-janadi et al. (2013) who reveals that when directors are more dependent on making decisions and monitoring management, they are willing to the public the quality reports with accurate information. as aforementioned, it can be assumed that board independence is positively related to corporate disclosure practices in singapore. consequently, the following hypothesis is proposed: h2: the proportion of independent non-executive directors on board has a positive association with the extent of corporate disclosure in singapore asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 415 4.3. board effectiveness in practice, board effectiveness depends on two main elements: an active board and a dedication of directors to operational activities. an active board often refers to the frequency of board meeting which is a necessary platform to carry out management functions. these include reviewing the completed tasks and updating a progress of the project, discussing critical issues and brainstorming to find the proper solution, determining a strategic plan and future direction of the company, informing the members about the changes in an organization, maintaining the connectivity between the leaders and so on. on the other hands, a dedication of directors to operational activities is ordinarily described by the number of directors’ attendance at the board meetings. from these particular parameters, agency theory convinces that management ability is strongly related to board effectiveness. this means firms with more frequency board meeting usually have stronger internal control systems for safeguarding the interests of shareholders. so, the decisions made are more in line with the desired directions and opportunity for future growth. similarly, firms that authorized persons regularly participate in the meetings typically have more opportunities to achieve business goals and receive additional benefits. that is because the main tasks of each director will be continuously followed up and rigorously assessed to minimize unpredicted risks and maintain the quality of expected results. furthermore, by working together as a supportive team, the members of the board can share their expertise and obtain professional coaching to handle a challenging situation, contributing to the successful outcomes. to interpret such correlations, barros et al. (2013), who conducted a research in france during the period 2006-2009, found that the level of voluntary disclosure of non-financial listed companies has been increased due to board meeting frequency. together with a study of yang et al. which reveals that board performance is positively significant with the extent of information dissemination, proposing that firms with a high frequency of board meetings tend to disclose more information related to financial status and earnings management. as remarked, it is assumed that the extent of corporate disclosure in singapore will be increased when a number of board meetings held in the year and a number of director participation rate is high. along with this assumption, the two hypotheses are generated as follow: h3a: the number of board meetings held during the year is positively correlated with the extent of corporate disclosure in singapore h3b: there is a positive association between director participation rate and the extent of corporate disclosure in singapore 4.4. gender diversity based on a concept of agency theory, it is asserted that a more diverse board can lead to better decision making, contributing to higher earnings. however, since personalities including traits between men and women are typically distinct from each other, some of which could reflect in management behaviors such as leadership styles, decision-making processes, techniques to communicate with co-workers, working relationships with employees and so on. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 416 in this sense, it potentially highlights the fact that quality of the board has been shaped by the variety of characteristics. as observed by yang et al., they insist that the extent of earning disclosure of public listed companies in the united kingdom (uk) is positively significantly associated with gender diversity on the board of directors, indicating that female representation can potentially enhance the quality of corporate disclosure. according to the aforementioned, both theoretical background and disclosure literature support the fact that a number of women directors on the board is one of the key factors to induce the level of corporate disclosure. for this reason, the hypothesis is derived as follow: h4: the proportion of women directors on the board has a positive related with the extent of corporate disclosure in singapore 4.5. ceo duality regarding a study of yuen et al. (2009); apadore and zainol (2014) and mandzila and zéghal (2016), empirical evidence promptly indicate that there is a relationship between ceo duality and disclosure practices. furthermore, haniffa and cooke (2002); eng and mak (2003); huafang and jianguo (2007); chau and gray (2010); al-janadi et al. (2013) point out that ceo duality has a negative effect with the extent of corporate disclosure. it is obvious that these evidence are similar to the notion of agency theory which believes that firms with ceo duality would often create conflicts of interest in the workplace. with regard to this matter, it can be assumed that role of chairman and ceo could be one of the significant factors in determining the level of corporate disclosure. hence, the following hypothesis is hypothesized as follow: h5: ceo duality is negatively linked to the extent of corporate disclosure singapore 4.6. audit committee independence in the literature, audit committee independence is normally considered as the number of independent non-executive directors on the audit committee. agency theory suggests that outside directors could play an important role in monitoring transparency and accountability of a firm. as a result of this matter, it is expected that companies with more independence of audit committee members would more likely to engage in information disclosure. to support this argument, ho and wong (2001); barako et al. (2006); yuen et al. (2009); al-shammari and al-sultan (2010) and barros et al. (2013) reveal that the level of corporate disclosure is positively related to the proportion of independent directors on the board. therefore, the hypothesis is stated as follow: h6: the proportion of independent non-executive directors on the audit committee has a positive connection with the extent of corporate disclosure in singapore 4.7. audit committee effectiveness agency theory believes that an active audit committee is more effective in monitoring management behaviors. consequently, firms with a high number of audit committee meeting and audit committee participation rate are significantly connected to the higher level of corporate disclosure. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 417 this understanding is in agreement with a study of aboagye-otchere et al. (2012) and apadore and zainol (2014) which deploys that there is a relationship between the extent of disclosure practices and audit competency. as a result, it can be assumed that an effectiveness of audit committee is positively associated with corporate disclosure practices of corporations in singapore. regarding this expectation, the two hypotheses are formulated as follow: h7a: the number of audit committee meeting held during the year is positively associated with the extent of corporate disclosure in singapore h7b: there is a positive association between audit committee participation rate and the extent of corporate disclosure in singapore 5. research methodology 5.1. sample and data this study aims to conduct a longitudinal analysis between the years 2011 and 2015. as a result of this, only a small number of samples are taken. all of them are drawn from the top 50 of singapore’s companies in 2014 in regard to the belief that their corporate disclosure practices should be held to a higher standard compared with other listed companies and could be the stereotypes for other firms, whether in the local regime or at the regional level. nonetheless, because the activities including disclosure rules of the bank and insurance industry are not quite comparable with the others, they were automatically excluded from the list. then, the remainder samplings were selected based on the following criteria: (i) annual reports from the year 2011 to 2015 must be publicly available online (ii) firms must have been listed on the stock exchange of singapore during 2011 2015 the final sample covers 22 listed companies over five year period (from 2011 to 2015), generating 110 observations for this study. 5.2. asean disclosure index this study used a self-constructed research instrument, namely the asean disclosure index, to assess the extent of corporate disclosure in the asean through the annual reports and other company filings such as financial reports, corporate governance reports, and corporate social responsibility reports. it is developed based on the requirements of the renewal asean disclosure standards, consisting of 212 information items, with three attributes: financial information (76 items), non-financial information (68 items) and strategic information (68 items). to evaluate the level of disclosure practices in the asean, 1 code is assigned to every information item that was expressed on the company’s documents and 0 if otherwise. then, the total disclosure score is calculated by summing the value of each information category and converted to the ratio of the actual scores that were awarded to a company when requested information was disclosed to the total scores that are expected to earn. the formula of the aforementioned index is given as follows: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 418 asean disclosure index (adi) = ∑ 𝒅𝒊𝒏 𝒊=𝟏 𝒏 where:  asean disclosure index (adi) = the ratio of the actual scores that were awarded to a company when requested information was disclosed to the total scores that are expected to earn. it is ranged from 0 to 1, meaning that if a firm disclosed all 212 items of information, it would receive a score of 1, accounting for 100%.  n = the total number of items that could be disclosed, where n ≤ 212  di = the actual value that was awarded to a company when the requested information is disclosed (assigned as 1 if the item di is disclosed, and 0 otherwise) 5.3. statistical tool and measurement of variables regarding the purpose, a multiple regression model with pooled ordinary least square (ols) method was applied to analyze the panel data by neglecting the differences between cross-sectional and time-series effects. to estimate transfer functions with the dependent variable (as represented by the extent of corporate disclosure in singapore), the predictors or better known as the independent variables were tested through eviews 10. the analytical equations in the pooled form are as follow: adiit = 𝛽0 + 𝛽1 𝐵𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽2 𝐵𝐼𝑁𝐷𝑖𝑡 + 𝛽3 𝐵𝑀𝐸𝐸𝑇𝑖𝑡 +𝛽4 𝐷𝑃𝑅𝑖𝑡 + 𝛽5 𝐺𝐸𝑁𝑖𝑡 + 𝛽6 𝐷𝑈𝐴𝐿𝑖𝑡 +𝜀𝑖𝑡 (1) adiit = 𝛽0 + 𝛽1 𝐴𝐶𝐼𝑖𝑡 +𝛽2 𝐴𝐶𝑀𝐸𝐸𝑇𝑖𝑡 + 𝛽3𝐴𝐶𝑃𝑅𝑖𝑡 +𝜀𝑖𝑡 (2) adiit= 𝛽0 + 𝛽1 𝐵𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽2 𝐵𝐼𝑁𝐷𝑖𝑡 + 𝛽3 𝐵𝑀𝐸𝐸𝑇𝑖𝑡 + 𝛽4 𝐷𝑃𝑅𝑖𝑡 + 𝛽5 𝐺𝐸𝑁𝑖𝑡 +𝛽6 𝐷𝑈𝐴𝐿𝑖𝑡 + 𝛽7 𝐴𝐶𝐼𝑖𝑡 +𝛽8 𝐴𝐶𝑀𝐸𝐸𝑇𝑖𝑡 +𝛽9𝐴𝐶𝑃𝑅𝑖𝑡 +𝜀𝑖𝑡 (3) where 𝐴𝐷𝐼𝑖𝑡 is the extent of corporate disclosure practices of a firm i in time t; 𝛽0 is the constant term; 𝛽𝑖 is the parameter of the correlation; 𝐵𝑆𝐼𝑍𝐸𝑖𝑡 is the total size of the board; 𝐵𝐼𝑁𝐷𝑖𝑡 is the proportion of independent non-executive directors on board; 𝐵𝑀𝐸𝐸𝑇𝑖𝑡 is the number of board meeting held during the year; 𝐷𝑃𝑅𝑖𝑡 is tthe he average director participation rate; 𝐺𝐸𝑁𝑖𝑗𝑡 is the proportion of women on the board; 𝐷𝑈𝐴𝐿𝑖𝑡 is the dummy of duality of roles between the chairman and ceo of a firm; 𝐴𝐶𝐼𝑖𝑡 is the proportion the of independent directors on the audit committee; 𝐴𝐶𝑀𝐸𝐸𝑇𝑖𝑡 is the number of audit committee meeting held during the year; 𝐴𝐶𝑃𝑅𝑖𝑡 is the average audit committee participation rate; 𝜀𝑖𝑡 is the error term; i is the ith observation firm and t is the year of observation. 6. results 6.1. descriptive analysis of independent variables table 2 provides an overview of descriptive statistics for the selected variables in the multiple regression models. the results cover the pooled data from 22 listed companies in singapore over the years 2011-2015 as present in the below table: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 419 table 2. the summary result of descriptive analysis mean median maximum minimum std. dev. skewness kurtosis jarque-bera dscore 0.606 0.599 0.741 0.509 0.053 0.401 2.518 4.015 f_dscore 0.613 0.618 0.737 0.474 0.060 -0.104 2.581 1.001 nf_dscore 0.612 0.610 0.765 0.485 0.059 0.248 3.000 1.131 s_dscore 0.593 0.588 0.735 0.471 0.061 0.195 2.317 2.835 bsize 9.809 10.000 15.000 5.000 1.956 -0.174 3.496 1.682 bind 0.625 0.631 0.917 0.333 0.165 -0.199 2.131 4.185 bmeet 6.236 5.500 18.000 4.000 2.726 2.284 9.495 288.989 dpr 8.875 9.000 13.000 0.097 1.945 -0.889 6.061 57.429 gen 0.077 0.083 0.364 0.000 0.082 0.827 3.319 12.998 dual 0.136 0.000 1.000 0.000 0.345 2.119 5.491 110.784 aci 0.890 1.000 1.250 0.250 0.159 -0.918 4.312 23.342 acmeet 4.527 4.000 9.000 2.000 1.029 2.210 9.363 275.110 acpr 3.708 3.800 5.000 2.250 0.621 -0.267 2.623 1.955 6.2. correlation analysis the correlation analysis always plays a significant role in the regression model because this can be the indicators to measure how independent variables impact dependent variable. as a result of this, it is used to analyze the relationship between each explanatory variables and dependent variable to explain the determinants of disclosure score as presented in table3: table 3. the summary result of correlation analysis dscore bsize bind bmeet dpr gen dual aci acmeet acpr dscore 1.000 bsize 0.102 1.000 bind -0.379 -0.148 1.000 bmeet -0.101 0.194 0.276 1.000 dpr 0.120 0.778 -0.168 0.124 1.000 gen -0.232 0.025 0.419 0.183 0.074 1.000 dual 0.397 -0.288 -0.304 -0.035 -0.173 -0.111 1.000 aci -0.419 0.085 0.441 0.127 -0.012 0.103 -0.510 1.000 acmeet -0.051 0.269 0.052 0.318 0.207 -0.038 0.002 -0.121 1.000 acpr 0.036 0.110 0.069 0.034 0.216 0.010 -0.246 0.074 0.204 1.000 the result found that there is a correlation coefficient between board size and director participation rate is higher than 0.7. hence, it can be implied that there is a multicollinearity problem between these variables. however, since they have a low correlation with the disclosure scores and they are expected to have an effect with information disclosure practices, both of them have still been included in the analytical model. besides this pair, other relationships are in between low and moderate level, ranging from 0.002 to 0.510 in both negative and positive direction, indicating that independent variables do not suffer from the problem of multicollinearity. so, none of them have been removed from the list. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 420 6.3. panel regression analysis to eliminate the heteroskedasticity and multicollinearity problems, the regression result is estimated based on the robust standard errors of white as present in the below table: table 4. the summary result of panel regression analysis *significant at 99% level, **significant at 95% level regarding the panel regression analysis, the result of the model 1, which is formulated to test the effect of the board of directors on information disclosure practices, shows that ceo duality is significant at 99% confidence level. the r-squared of this model is quite high, accounted for 0.272. this means the entire set of variables can explain the variation in corporate disclosure practices around 27.20% for model 2, variables related to auditors covering audit committee independence (aci), number of audit committee meetings held in the year (acmeet), audit committee participation rate (acpr) and quality of external auditors (big4) are tested. the finding from the regression estimation addresses that only variable aci is statically significant at 99% level, with a positive direction. the r-squared of this model equals 0.195, meaning that a set of auditors’ variables can explain corporate disclosure practices only 19.50%. model 3 includes all variables of the board of directors and auditors for testing the combined effect of corporate governance mechanisms on information disclosure practices. the result reveals that board size, audit committee independence, a number of audit committee meetings held in the year and a number of audit committee participation rates have a positive relationship with corporate disclosure practice at 95% level while ceo duality has a negative association. the r-squared of this equation equals to 0.343, indicating that a whole set of independent variables can explain the variation in corporate disclosure practices around 34.30%. variable h model1 model2 model3 result coef. prob coef. prob coef. prob c 0.588 0.000 0.736 0.000 0.624 0.000 bsize h1 -0.005 0.136 -0.007 0.018** accepted bind h2a -0.052 0.109 -0.020 0.566 rejected bmeet h2b -0.001 0.561 0.000 0.932 rejected dpr h3 0.001 0.663 -0.001 0.752 rejected gen h4 -0.076 0.176 -0.099 0.065 rejected dual h5 -0.060 0.000* -0.053 0.014** accepted aci h6 0.147 0.000* 0.086 0.025** accepted acmeet h7a 0.006 0.087 0.009 0.022** accepted acpr h7b 0.008 0.242 0.014 0.028** accepted r-squared 0.272 0.195 0.343 adjusted r-squared 0.230 0.172 0.284 f-statistic 6.414 8.546 5.807 prob(f-statistic) 0.000 0.000 0.000 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 421 as described above, it is obvious that model 3 obtains the highest r-squared value. this means a full model is most suitable for explaining corporate disclosure practices in singapore’s context. hence, the only result obtained from this model is considered for analysis and conclusion. 7. analysis and discussion for the hypothesis 1, the variable bsize is statistically significant at the level of 0.05 (p-value = 0.018) with a negative coefficient of 0.007. unexpectedly, the finding contradicts from previous studies, which generally support agency theory by demonstrating a positive relationship between board size and disclosure practices. however, it is in accordance with the stewardship theory which suggests that oversized board of directors provides a vested interest in the success of the business, leading to poor quality of management and decreased firm performance. hence, it can be argued that a small board size is more effective in enhancing the quality of decision-making processes and reducing free-rider problems. with this insight, it is not surprising that the extent of corporate disclosure in singapore has a negative relationship with board size. in other words, it can be said that the corporations in the singapore countries tend to more disclose information when board size is small. as a result of this, hypothesis 1 is accepted, with a negative direction. hypothesis 2 is proposed to test the relationship between board independence and disclosure practices of the firms. the result suggests that there is no significant relationship between variable bind and the level of corporate disclosure at 95% level (p-value = 0.566). this finding is against the traditional belief of agency theory which emphasizes a positive relationship between the two variables. also, it is contrary to many prior studies which likely mention that firms with a high number of independent directors on the board often disclose more corporate information to the public (e.g. cheung et al, 2007; huafang and jianguo, 2007; lim et al., 2007; akhtaruddinet al., 2009; htay et al., 2011; vu, 2012; barros et al., 2013; uyar et al., 2013). however, the result could be debated by a concept of stewardship theory which suggests that behavioral patterns of the management are subjected to the person desires. as a result of this, neither dependent nor independent directors might have a less impact on operational practices. this has been confirmed by a study by aboagye-otchere et al. (2012) which also conducted a research in developing countries, namely ghana. the result of this study reveals that corporate board composition is not a supportive factor for enhancing the extent of corporate disclosure. with this evidence, it could be implied that board independence has no relationship with the level of corporate disclosure in singapore as well. as a result of this, hypothesis 2 is rejected. in terms of board effectiveness, the results show that the level of corporate disclosure in singapore has no connection with a number of the board meetings held in the year (p-value = 0.932) and director participation rate (p-value = 0.752) at a significant level of 0.05. with these findings, it has implications for stewardship theory which asserts that directors attempt to work in response to self-motivation and shareholders’ requirements. so, a number of the board meetings held in the year and number of directors participated in the meeting are not an important factor for determining the operational procedures and performance of the board. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 422 under this circumstance, it is reasonable to claim that there is no relationship between director participation rate and the level of corporate disclosure in singapore. consequently, hypothesis h3a and h3b are rejected. hypothesis 4 is carried out to estimate the effect of gender diversity on corporate disclosure practices. the result demonstrates that a different gender of board members has no significant relationship with the extent of corporate disclosure in singapore (p-value = 0.065). regarding this finding, it can be supported by the stewardship theory which states that a variety of members on the board might not impact the board actions. as a result of this, it can be concluded that whether male or female directors would not influence on disclosure practices of a firm in singapore. therefore, hypothesis 4 is rejected. according to the hypothesis 5, the result reports that variable dual is statistically significant at the significant level of 0.01 (p-value =0.014) with a negative correlation coefficient of 0.053, indicating that the separation of position between chairman and ceo could impact on corporate disclosure of the firms in singapore. this is consistent with agency theory which remarks that a separate leadership structure has the ability to contribute quality of the reports. under this scheme, it can be asserted by chau and gray (2010); apadore and zainol (2014); and mandzila and zéghal (2016) who found an association between ceo duality and disclosure practices. later, many researchers (e.g. haniffa and cooke (2002); eng and mak (2003); huafang and jianguo (2007); and al-janadi et al. (2013)) have found that firms, where chairman and ceo are the same person, tend to have a lower level of corporate disclosure. as a result of this, it is reasonable to believe that there is a negative relationship between ceo duality and disclosure practices. in contrast, it can be said that ceo-chairman separation could infer in a better quality of reporting. hence, hypothesis 5 is accepted, with a negative direction. with regard to audit committee independence, the results show that there is a positively significant relationship between the variable aci and the extent of corporate disclosure at 95% level (p-value = 0.025 with a positive correlation coefficient of 0.086 ). this is in the line with a study by aboagye-otchere et al. (2012) which addresses that corporations in ghana tend to disclose more corporate information when audit committee is independent. as a result of this, it can be said that a number of independent directors on the audit committee could dominate the level of corporate disclosure. according to this insight, it is can be referred that there is a positive relationship between audit commit independence and the level of corporate disclosure in singapore. for this reason, hypothesis 6 is accepted. accoring to audit committee effectiveness, the results show that the variable acmeet and acpr is positively related to the extent of corporate disclosure at 95% level (p-value = 0.022 with a correlation coefficient of 0.009 for the variable acmeet and p-value = 0.028 with a correlation coefficient of 0.014 for the variable acpr). with this finding, it can be interpreted that firms in singapore tend to more disclosure corporate information when the quality of audit committee is high. to support this matter, apadore and zainol (2014) reveal that there is a relationship between quality of audit committee and corporate disclosure practices in singapore. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 423 together, aboagye-otchere et al. (2012) emphasize that frequency of audit committee meetings is associated with increased level of corporate disclosure. as discussed, it can be accepted that corporate disclosure of firms in singapore could be dominated by a number of audit committee meeting. hence, hypothesis 7a and 7b are accepted. as debated above, it is clear that all variables related to audit committee characteristics, covering three variables: audit committee independence, a number of audit committee held in the year and a number of audit committee participation rate, are positively and statistically significant at 95% level. as a result of this, it can be concluded that audit committee is an important factor for enhancing the level of corporate disclosure in singapore. furthermore, the finding still points out that board size has a positive relationship with information disclosure practices at 95% level while ceo duality has a negative association with the extent of corporate disclosure at 95% level. according to the finding, indicating that board size and ceo duality could influence on the extent of corporate disclosure in singapore as well, but with a different direction. 8. conclusion this paper aims to investigate the effects of corporate governance mechanisms on information disclosure practices in singapore, with a particular focus on board composition and audit committee characteristics. in the analytical procedure, a multiple regression model was tested through eviews 10 with an ordinary least squares (ols) method in order to estimate the connection between the predictors and the dependent variable. an empirical result reports that all variables related to audit committee characteristics, covering three variables: audit committee independence, a number of audit committee held in the year and a number of audit committee participation rate, are positively and statistically significant at 95% level. as a result of this, it can be concluded that audit committee is an important factor for enhancing the level of corporate disclosure in singapore. furthermore, the finding still points out that board size has a positive relationship with information disclosure practices while ceo duality has a negative association with the extent of corporate disclosure, indicating that board size and ceo duality could influence on the extent of corporate disclosure in singapore as well, but with a different direction. for other variables covering board independence, a number of board meetings, a number of director participation rates and gender diversity, no significant relationship was found. as remarked, it is apparent that the results provide empirical evidence for the regulators who would like to enhance a flavor business environment in singapore and this might be used as a reference for other developing countries within the same region. the paper also contributes to the literature on disclosure by offering some insight into the relationship between corporate governance mechanisms on information disclosure practices based on the asia’s developed country perspective. furthermore, it is obvious that stewardship theory seems to be more powerful for explaining the phenomenon of corporate disclosure in southeast asia region. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 424 9. limitations there are two main limitations inherent in this study. first has criticized the lack of diversity of expected factors. as identified from the literature survey, numerous variables have been found to formalize the disclosure practices of a company. however, this paper focuses only on two determinants of corporate governance: board of directors and auditors. hence, it is necessary to enlarge an understanding by testing with other corporate governance attributes such as ownership structure. alternatively, a further research might include other groups of variables such as national characteristics, firm characteristics and so on in the next investigation. second has been discussed about the bias of population. because the representative sample was extracted from top 50 listed companies in 2014 of singapore, both scope and size are restricted. therefore, a future research should be conducted with randomly selected population, covering whether public or private, big or small, and profit or non-profit organizations. references abdullah, m., & minhat, m. 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(2014). an empirical study on the determinants of information disclosure of malaysian non-profit organizations. asian review of accounting, 35-55. https://doi.org/10.1108/ara-04-2013-0026 https://doi.org/10.1108/02686900610652991 https://doi.org/10.1080/10291954.2015.999471 https://doi.org/10.5296/ajfa.v5i1.3210 https://doi.org/10.1111/j.1540-6261.1997.tb04820.x https://doi.org/10.1108/ara-04-2013-0026 abstract microsoft word 12804-46788-3-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 178 risk reporting of the banking sector of bangladesh: a time horizon analysis niluthpaul sarker (corresponding author) school of management, huazhong university of science and technology 1037 luoyu road, hongshan district, wuhan 430074, p.r.china tel: 86-13-12-518-4590 e-mail: niluthpaul@yahoo.com dr. shamsun nahar department of accounting & information systems, jagannath university 9-10, chittaranjan avenue, dhaka 1100, dhaka, bangladesh tel: 88-019-1104-7956 e-mail: snahar8079@yahoo.com received: feb. 12, 2018 accepted: april 26, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12804 url: https://doi.org/10.5296/ajfa.v10i1.12804 abstract the study focused on the practical scenarios of bank risk disclosures where it is assumed that adequate risk disclosures expand the path of transparency in the marketplace. the reason is that the financial disclosures, including risk items, represent their image of the current and potential investors, and can impact their mentality about investment. the research analyzed the credit risk, market risk and operational risk reporting intensities in their reports. it is noted that the maximum risk weighted assets (rwa) are held for credit risk of the banking system whereas the remaining part of the system utilized by the market risk and operational risk. it is found that the risk for the top five (5) or the top ten (10) banks is extremely high. the concentration symptom of risk is not good as the fewer borrowers occupied the most of the credit. keywords: bank risk, disclosures, bangladesh jel classifications: g21; g32. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 179 1. introduction risk disclosure is the most contemporary issue debated in the developed and developing economy. in corporate financial reporting, risk disclosure is widening the path of transparency in the marketplace. the reason is that financial disclosures along with risk items represents the image of the banks to their current and prospective investors and can affect their mindset. in every step of operation, it should be remembered that transparency acted as the key point of accounting and investment practice (abraham and cox, 2007). in fact, information is disclosed in the annual reports due to minimizing the gaps of asymmetric information. the benefits of disclosing the risk related information are not only for shareholders, analysts, investors, but also extended to other stakeholders (lajili and zeghal, 2005). linsley and shrives (2005b) notified that the distorted facts or unimportant information in the disclosure may not ensure transparency. the quality of voluntary disclosure of primary sources of corporate communication in the annual report is at the heart of modern financial reporting. the confidence of a lack of investors lags behind the failure of companies in the main global companies. the credibility crisis, coupled with the threat of terrorist attacks on businesses and the global financial crisis, has led to calls for better disclosure of information, making sensible investment decisions. as a result, the annual enterprise report is no longer focused on account-quantitative information, but on the qualitative information of volunteers on a variety of topics, such as corporate risk. voluntary risk disclosure can be defined as an amateur confession by the enterprises on corporate strategy, firm characteristics, business operations, and other external factors that may affect expected outcomes of the company. 2. classification of bank risk the risk may be defined as the product of uncertainties associated with the imperfection of human knowledge and incapability of human reasoning (habibullah and ghosh, 1986) (note 1). one can narrow down the boundaries of uncertainties and define the future through better information and better comprehension. apparently, the risk is the uncertainty that exists about the occurrence of some events. in the banking sector, the mandatory unit held for the risk management as risk management unit (rmu). the risk generated in the banking entity is not obviously by the internal factors but also extended to the external forces. sometimes the risk management process is called the four (4) step process, and it differs by service rendered. however the risk can be broken down into six (6) generic types (namely): systematic or market risk, credit risk, counterparty risk, liquidity risk, operational risk, and legal risks. the table below presents the clarification of each type of risk: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 180 table 1. ramifications of bank risk sn risk definition 1. market risk the risk arising from the movement of prices and have an adverse effect on bank performance. 2. credit risk the risk adversely affects the bank asset because of selecting the lower quality of borrowers or counterparties.  the loss initiated from the decreased value of credit quality where the default is the extreme situation.  sometimes, bank use credit risk as an issue when they deferred the payment obligation 3. liquidity risk the loss arises due to the increase of operating cycle or interruption in cash conversion cycle. 4. operational risk the most significant cause of lost generation from the weak internal control system and governance system.  intentional misstatement  model risk (using the wrong pricing model, for instance)  human factor 5. legal and regulatory risk the abolishment of enacted rules or any prohibitedactivities that are not valid in the eye of law.  transactions that are voided due to lack of appropriate licenses.  changes in tax laws in general, the risk classification depends on the context or scenarios may differ and very tough to express quantitatively. therefore, bank risks based on types that are disclosed and quantifiable are primarily focused on four distinct types of risk (hitchins et al., 2001). these are presented below: figure 1. the principal components of bank risk asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 181 however, in the case of this study, risk classification is most appropriately adapted for the banking sector is the guidance of ifrs 7. by ifrs 7, the risk of the financial institutions is comprisedof credit risk, market risk, and liquidity risk. 2.1 credit risk credit risk is very important and significant ramification of bank risk (lin, 2009; bonfim 2009, angelini et al., 2008; richared, 2008; al-tamimi and al-mazrooei, 2007). it creates in a position where the borrower is unable to pay the installment as well as interest. here the most important discussion is the selection of quality borrower. it is true that banks are the intermediaries where they take a deposit from the people in a small pool but invest in a large volume, the net interest is their main source of income. so the parties, like depositors and borrowers should keep in the same line and give more effort in collecting loans. it is found that more than 50% or risk arising from credit risk. over the years, most of the banks in the country's public and private sector have aggressive banking. in the last six months, private banks have disbursed loans at the double the rate of deposit growth. this has created a crisis of liquidity or cash in most of the private banks of the country. in this situation, the decision to reduce the debt-deposit ratio or the capital adequacy ratio has been decided. the main function of the bank is to distribute loans to customers from deposits. in this case, if the general public of the country can collect bdt 100 then the maximum loan of bdt 85 can be given. however, islamic banks can lend money up to bdt 90. but most of the private banks have recently passed 90 percent of ad ratio. as a result, most of the private banks have created liquidity or cash crisis. in this situation, the bankers strictly ordered the commercial banks to refrain from aggressive investments in the bankers meeting. after the circular issue from the bangladesh bank, the new rate of ed ratio will be determined. this rate may be more than 80 percent for the general banks and 85 percent for the islamic banks. the rates will be determined by excluding cash deposits (crrs) and statutory deposits (slrs) in the central bank. banks have been asked to prepare the matter from now on. it is found that huge amount of credit has been distributed among the banks recently. it has been discussed whether the delivery of the loan has gone in the appropriate sector. deposit rates have not been deposited at the rate of interest. as a result, the ad ratio of the banks increased. bangladesh bank said 85 percent of the ad would not be able to live in any bank. for the country's existing gdp growth, 15-16 percent of the loan growth in the private sector is sufficient. but in recent times the private sector credit growth grew from 19 to 20 percent. bangladesh bank does not think it is in line with the situation. country's import expenditure has increased over the past year in comparison, export earnings and remittance did not increase. as a result, there is a shortage of current fund. there is a discussion about how the deficit can be overcome. increasing the quality of the loan and raising the loan for the import of quality products, instead of increasing the distribution of luxury goods, should be followed. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 182 2.2 market risk market risk is “the risk related to the uncertainty of a financial institution’s earnings on its trading portfolio caused by changes in market conditions such as the price of an asset, interest rates, market volatility, and market liquidity” (saunders, chapter 10). bank exposed the market risk in different ways. generally, it categories into two heads based on the situations, where the volatility of similar assets are affected by systematic risk in the financial markets; alternatively the individual asset is affected by specific risk ( apostolik et al. 2009). in the banking industry, four (4) common types of market risk are found which are: interest rate risk (irr), foreign exchange rate risk (eer), equity price risk (epr) and lastly commodities risk (apostolik et al., 2009; jorion, 2003; and greuning and bratanovic, 2003). the market risk measurement is very important, because: a) management decision: the strategic level employee wants market risk related information for better and decision making. b) limit setup: market risk information helps in target setting or position limits. c) utilization of resources: market risk profile compares and contrast the risk and return tradeoff in each asset class and help to keep sufficient capital for the risky assets. d) performance judgment: the risk-return composition easily identified the less risky projects and can set the real benefit scheme. e) the effectiveness of regulation: the internal rating based techniques can ensure superior capital allotment. 2.3 liquidity risk liquidity risk concept is inherently involved with the financial risk in the contemporary banking system. in fact, the shortage of liquid assets makes the banks more vulnerable as banks involved with loan grants and further investments which cannot be extended due to fund crisis. though, different research outcomes based on different categories of bank risk but all of them are interlinked with one another. the logic behind this inefficient credit approval or unworthy investment initiated the future liquidity crisis that leads to the higher market risk due to lower performance and higher volatility of return. after the global financial crisis, the practitioner, regulators and market participants are more concern about the liquidity crisis and tried to update the existing standards with incorporating preventive measures for bank liquidity crunch. 2.3.1 liquidity risk component: banks liquidity thresholds categorize the core components of liquidity risk based on meeting the liquidity using assets conversion or funds creation. the types of liquidity risk are exposed with the purpose of the banks. these are: i) firstly, banks are leveling the liquidity risk by liquidity risk management practice within the banks and termed it as an idiosyncratic risk. it is found that good corporate culture is incorporating strong liquidity risk management and exposed to lower idiosyncratic risk. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 183 ii) secondly, the liquidity risk involved with the maturity of assets that influence the market. in fact, the mismatch in market liquidity grounds the higher propensity to fund crisis in the bank. however, the liquidity disruption affects the market negatively due to inconsistent waves of cash-flows. 2.3.2 liquidity risk under basel iii according to basel iii (section 8.1.3.4), liquidity risk can be defined by maturity or cash conversion cycle. when given security or asset is failed to trade quickly in the market to avoid probable losses or unable to acquire obligatory profit or the bank is fall in a position where they could not fulfill the commitments in time or the payment to creditors become due, then it is called liquidity risk. liquidity risk is categorized into two types: i. funding liquidity risk (flr) ii. market liquidity risk (mlr) table 2. compare and contrast of liquidity risk s.n. subject flr mlr 1. definition funding liquidity risk (flr) is the risk where a bank is failed to meet its current obligation or loss future cash flows. market liquidity risk (mlr) is the risk where a bank falls in a position where they cannot easily offset or sell position without incurring a loss. 2. subject matter liquidity illiquidity 3. indicator current ratio; quick ratio bid-ask-spread (width); position size; resiliency 4. dimension the ability of a financial entity to raise cash by borrowing on either an unsecured or a secured basis. market liquidity as the cost—both in expense and time—of buying or selling an asset for cash. 5. declining effect if funding liquidity declines because of market stress, for example, this may cause intermediaries to become less willing to provide market liquidity. declines in market liquidity, in turn, may further impair funding liquidity, creating negative feedback dynamic. 6. relationship when market liquidity is drying up (i.e., is low), funding liquidity risk is high high funding liquidity risk is associated with high market liquidity risk 3. empirical studies in the asian region, corporate disclosure requirements and transparency took keen attention of the regulators after the financial crisis in 1997. the crisis bears negative effects on the investors’ choice resulting international investors were reluctant to their lending decisions in favor of developing countries. at that time, imf took a proactive role to recover the economic meltdown of the affected countries and also forced to enact transparency in financial reporting system (fung, 2014). researchers are not only emphasized on disclosure asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 184 transparency but also encouraged to develop a culture of transparency in the organization (bennis and o’ toole, 2009). baumann and nier (2004) found that banks with more disclosures have lower stock volatility compared to the banks those disclose less information. these findings also confirm the “stakeholder theory” which states the greater amount of disclosure affirms rational choice of users and inversely affect the bank risk. risk disclosure reduced information asymmetry and noticed both the informed and uninformed investors (poskitt, 2005). however, linsley and shives (2005) concluded that disclosures itself never be transparent when there is a lack of useful information. the prudent users take effective decisions based on market signals about the bank’s financial position and performance. the high quality of disclosure can make it possible only by fair presentation of the statements. critically examining the market signal in due time, banks took corrective measures to reduce risk exposure (oliveira et al., 2011). healy, p.m. and palepu, k.g. (2001) explained the role of disclosures in the modern capital market. they found that corporate disclosure is a function of the efficient capital market. they showed that asymmetric information creates noise in the investment decision and increase the cost of capital. the reason is that investors claim a high rate of premium for their investment in an unknown scenario. the following figure 2shows the financial and information flows in the economy: source: healy, p.m. and palepu, k.g. (2001) figure 2. financial and information flows in a capital market economy the above scenario depicts that financial intermediaries are directly connected with all sectors. it is also vital in the ordinary course of sense that economy is controlled by its interactive response. the efficient market hypothesis states that all the available information is reflected in the current market price. that is why; information is a more powerful tool in the economy. now a day, private information is traded for the sake of replicating fact and safeguarding predicted decisions. due to the regulatory pressure, publicly listed companies mandatorily produce different reports as the requirement and compliance. the financial institutions like banks are in the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 185 position of intermediary that deals with the small depositor and large lender, so the demand for disclosures is higher to settle their position stable. by the pillar 3 of basel norm, the banking sector should disclose risk-related information as a compliance basis and will be monitored by the owner and regulators so that the conflicts between the management and shareholders can be minimized. most of the evidencesupport in favor of the adequate disclosure practice of banks as it positively affects the stability of banks, though some of the authors have doubt. jensen and meckling (1976) initially addressed the need for disclosure in the moral hazard problem on the grounds of ownership and control. the reason is that the outside shareholders have the right to know all the relevant information happened within the business organization and based on this information they are evaluating the performance and take their decision whether they hold the share or release it. in fact, the adequate level of disclosures removes the conflict and confusion from the mind of the shareholder and mitigate agency problem. in the case of the banking sector, a significant part of their liabilities isshort-term obligations. so the release of appropriate information can strictly monitor the risk-taking behavior of banks which led to the depositors in their deposit decision whether they keep it or withdraw the money that may face higher cost of funding (cordella and yeyati, 1998, botosan & plumlee, 2002; bertay, demicgüç-kunt & huizinga, 2013). disclosure is not only reduced the risk-taking incentives but also control the probability of bank failure. several studies (fischer, 1999; nier, 2005; tadesse, 2006) showed the evidence that banking crisis initiated not only by the risk absorption but also the lack of bank transparency and both are caused due to information asymmetry. it is also found that banks that are disclosed more information to the public regarding their risk is in a better position (baumann and nier, 2004). on the other hand, nier (2005) revealed that bank’s transparent disclosures eliminate financial problems and reduce risk experience that reflects the image in the stock market and controls the volatility of share price. the study provided a composite set of disclosure indices which contain seventeen items under four broad heads, e.g. (i) assets (ii) liabilities (iii) memo lines and (iv) income statement and considered those indices as a measure of transparency. however, nier and baumann (2006) found that the banks that provide more disclosure to the public are more transparent that is the indication of strong market discipline and are encouraged to avoid risk. it also found that the disclosures effect became obsolete or in diminishing trends when the bank failure supported by the government. sometimes, government prioritizes the political agendas rather than the economic consequences and make bound to the government-owned banks to release or grant loans to some unproductive sectors. though, a higher level of disclosures may be found unproductive for transparency when the cost related to information production and dissemination is more than the benefit achieved from this information. the key problem identified of corporate disclosure is the weakening in a strategic fight with the competitor as the competitor get all the information and can set appropriate strategy for his business or exploit can affect the competitors (hyytinen and takalo, 2003). it is also argued that bank stability is greatly influenced by the transparency of banks (tadesse, 2006). according to “disclosure-fragility’ view, it is assumed that negligible amount of distorted facts may misguide the depositors or lose public confidence. this view asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 186 ignores the fact that banking business is reliant on public trust. prior studies conducted by gilbert and vaugan (1998), kaufman and scott (2003), gorton & huang (2006) revealed that more disclosures could act negatively in bank stability where any specific problem identified and generalized for the baking sector as a whole that will create panic. furthermore, disclosure sometimes distorted the investor's mind and fall their confidence level that led to bank failure rather than used as a monitoring tool (tadesse, 2006). in fact, the psychology of the investor differs concerning the positive and negatives news of the business. another finding extracted from bushee and noe (2000) that firms with a large volume of institutional investors required more disclosure to reduce the monitoring cost. the reason behind this, higher disclosure has negative effect on stock price volatility as it decreases information asymmetry. the findings also revealed that lower variance of share price could draw the attention of the investor as well as external sources that result in thelower cost of capital. some of the studies (healy and palepu, 2001; hassan & marston, 2010) found that investors those do not have direct access to the privately generated information are mostly depend on public information. therefore, assuming other things remaining constant, investors select banks that have a higher level of disclosure. in the above discussion, it is found that the effects of disclosure on bank risk are debatable and to some extent conflicting. however, agency theory advocates in favor of higher disclosure as it mitigates the conflict of interest and controls the risk-takingbehavior of banks. banks should have stringent disclosure requirement as its nature is more opaque than other industries. the disclosure stability theory depicts that higher disclosure and transparency allow the investors to stay longer period in the structure of strong market discipline. it could happen by proper allocation of assets and elimination of asymmetric information in the marketplace among the participants. in fact, investors can evaluate the performance of banks accurately in the presence of adequate disclosures. it is true that the funding cost of the risky banks is more than the less risky banks as the association with the probability of default is more. therefore, the banks those provide higher disclosures are more transparent pursue lower risk strategies. on the contrary, banks with higher level of disclosures may create a noise where important information may be covered by unimportantinformation. to conclude, it is found that the effect of disclosures on bank risk (overall risk, credit risk, market risk, and liquidity risk) may be either positive or negative. it is also argued that disclosures and corporate governance havestrong positive relation, so banks governance system also responsible for the riskiness of banks. 4. risk reporting of the banking sector of bangladesh: a time horizon analysis the introduction to risk and objectives of risk management are describedby the guidelines issued by bangladesh bank (note 2) under section forty-five (section 45) of “bank companies act, 1991”. it provides a systematic way of identifying and measuring potential risk for the sake of diversifying and preventing their impact on bank performance. from february 2012, bangladesh bank implemented the guidelines mandatorily for all the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 187 scheduled banks operated in bangladesh. the “risk management guidelines for banks” are structured by following aspects: figure 3. aspects of risk management guidelines for banks source: risk management guidelines for banks (2012), department of off-site supervision, bangladesh bank the guidelines of the above-stated structure are setby the prescribed framework issued by basel committee on banking supervision (bcbs) in october 2006. the requirements of the core principles (cp) in “risk management processes” is the identifying, evaluating, monitoring and controlling or mitigating risk and also estimate the capital adequacy requirements to cover up the probable risk profile. the processes start with the size and riskiness of banks in the premises of credit risk, market risk, liquidity risk, operational risk, and interest rate risk. in the table 3 below categorized the banks in five (5) groups based on the ranges and performances of banks with their experiences, like, group 1 ( private commercial banks), group 2 (state-owned and private commercial banks under special attention), group 3 (full-fledged islamic private commercial banks), group 4 (foreign commercial banks), and group 5 (fourth generation private commercial banks). the new forms of bank categories are used in bank risk analysis that is significantly apart from traditional form. the prospect of new look appears considering financial health and orientation: table 3. group of banks bank group description of the group group 1 private commercial banks group 2 state-owned and private commercial banks under special attention (note 3) group 3 full-fledged islamic private commercial banks group 4 foreign commercial banks group 5 fourth generation (note 4) private commercial banks the table 4 below presents the share in total banking assets (%) concerningnumber of banks in each bank group. the time series data contains the year of 2014, 2015 and 2016 with five (5) groups of banks. in the case of number of banks, it is found that group 1 includes twenty-two (22) private commercial banks; group 2 includes ten (10) state-owned and private commercial banks under special attention; group 3 includes seven (7)full-fledged asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 188 islamic private commercial banks; group 4 includes nine (9) foreign commercial banks, and group 5 includes nine (9) fourth generation private commercial banks in the year 2016. the deviation found only in the case of fourth generation private commercial banks where the number of banks is eight (8) in the year of 2014 and 2015.again, in the case of share in total banking sector assets, it is found that group 1(private commercial banks) possesses 44% in the year 2014 and 2015, and 43.4%, in the year 2016; group 2 (state-owned and private commercial banks under special attention) possesses 32%, 31%, and 30.6% subsequent to the year 2014, 2015 and 2016; group 3 (full-fledge islamic private commercial banks) kept its share 18% in both of the years 2014 and 2015 but slightly increase in 2015 which is 18.4%; group 4 (foreign commercial banks) hold their share in total banking sector assets in a decreasing trends which are 6% in the year 2014, 5% in the year 2015 and 4.8% in the year 2016; and lastly group 5 hold their portion at 2% in the year 2014 and 2015 but 2.9% in the year 2016 which showed slightly increasing trend compared with previous years. table 4. grouping of banks for risk analysis year bank group description of the group no. of banks share in total banking sector assets (%) 2016 group 1 private commercial banks 22 43.4 group 2 state-owned and private commercial banks under special attention 10 30.6 group 3 full-fledged islamic private commercial banks 7 18.4 group 4 foreign commercial banks 9 4.8 group 5 fourth generation private commercial banks 9 2.9 2015 group 1 private commercial banks 22 44 group 2 state-owned and private commercial banks under special attention 10 31 group 3 full-fledged islamic private commercial banks 7 18 group 4 foreign commercial banks 9 5 group 5 fourth generation private commercial banks 8 2 2014 group 1 private commercial banks 22 44 group 2 state-owned and private commercial banks under special attention 10 32 group 3 full-fledged islamic private commercial banks 7 18 group 4 foreign commercial banks 9 6 group 5 fourth generation private commercial banks 8 2 4.1 the overall risk profile of the banking sector the chart below showed the trends of risk-weighted asset density ratio over the period of 2013 to 2016 with group comparison. the risk weighted asset density ratio is defined by the quick and simple clarification or measures of bank’s on-balance sheet and off-balance sheet exposure in the market. although there is a stiff criticism of rwa density ratio due to its substantial divergence across banksand inconsistent application in risk management process through jurisdictions. however, omitting the individual effect, the study considers the banking industry as a whole under uniform authorities that may give more accurate results. in the year 2013, it is found that group 4 (foreign commercial banks) has the highest asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 189 risk-weighted asset density ratio which is 85.40% whereas the lowest position attained by group 5 (fourth generation private commercial banks). the second position took by group 1 (private commercial banks) with 82.95% of rwa density ratio, but group 2 (state-owned and private commercial banks under special attention) and group 3 (full-fledged islamic private commercial banks) lies on average point with 54.10% and 66.73%. in the year 2014, the phenomenon is same for all groups except group 5 those have higher rwadr (risk weighted asset density ratio) in comparison with previous year. however, in the year 2015, group 1 stood highest position with 80.08% of rwadr and group 4 and group 5 jointly possessed the second position with 78%. the position of group 2 is worse within the groups which are 49.30% and have gradual decreasing trends. finally, in the year 2016, the major finding is the decreasing trends of group 2 (state-owned and private commercial banks under special attention) which has 77.1%. in the case of the industry average, it is revealed that the trend is the downward slope and most importantly group 2 and group 3 in all cases lie below the average line. so, there is a need for taking care of the two groups otherwise the average industry risk will increase. chart 1. risk weighted asset density ratio 4.2 banking sector risk structure under basel iii the regulatory authority, bangladesh bank, the central bank of bangladesh, provides specific guidelines for risk reporting standards under basel iii accord. it is found that all of the banks report their credit risk, market risk as well as operational risk in their annual report. the trend of the risk structure is shown in the following chart. the findings are very interesting and valuable for the relevant users. the reason is that the concern parties can take their decisions giving priorities on the risk exposure. it is notable that among the three risk categories the major portion occupied by the credit risk exposure of banks. in 2016, it is revealed that the weighted risk asset (rwa) was mostly attributed to credit risk which was 87.20% of a total risk-weighted asset of the baking system whereas the remaining portion consumed by market risk and operational risk at 3.80% and 9.0% as well. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 190 chart 2. banking sector risk structure in bangladesh 4.3 credit risk disclosures under basel iii the credit risk is defined by the probability of loss or non-recovery of loans generating from loans grants causes by the counterparties for their unwillingness or inabilities that results in the breach of contract. the chart below showed the structure of credit risk which is segregated as balance sheet risk and off-balance sheet risk. the study found that the balance sheet risk is significantly higher than the off-balance sheet risk. the trends of the balance sheet risk showed the upward slope from 2010 to 2016 which were ranges from 85.4% to 87.60%. however, the blessing thing is the decreasing trend of off-balance sheet risk during the period of 2010 to 2016 with 14.60% to 12.40%. the enforcement of basel norms is restraining the banks from off-balance sheet activities. regarding the regulatory capital, banking sector remains in the same position in compare with the previous year. although the capital to risk-weighted ratio was 10.80% at the end of 2016, it was lower by four (4) basis points contrast with the most recent year. the deterioration is not for the fall of credit quality but for the shift of regulatory framework which shifts from basel ii to basel iii accord. there was an improvement in non-performing loan rate in comparison with the previous year and also decreasing the required provisions on loan defaults. in basel iii, the calculation of regulatory capital is stringier. under the new framework, the eligible capital determination process is slightly changed where deferred tax assets and revaluation reserve (20% per year) are excluded, and only a specific percentage of the general provision was allowed to include. the sought of deductions reduce the eligible capital in compared with weighted risk assets. the study concludes that the increasing trend of credit risk overlooks the capital regulation due to weak governance system. in the case of a non-performing loan, the trend is very disappointed which showed a growing trend from the year 2015 to 2016 at the rate of 8.80% to 9.20%. it is also found that the weighted risk asset (rwa) amount allocated for credit risk was bdt 7754.4 billion for both balance sheet and off-balance sheet exposure whereas bdt 299.7 billion kept for operational risk and bdt 696.4 billion were kept for market risk. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 191 chart 3. banking sector credit risk structure under basel iii 4.3.1 the share of credit risk the chart 6.4 below showed the share in industry credit risk of top 5 and 10 banks. in fact, it covers the area of risk concentration which is the most significant area in financial management. in evaluating top 5 banks from the year 2010 to 2016, it was found that the credit risk concentration was very high which were 28.00% in 2010; 26.90% in 2011; 27.50% in 2012; 25.5% in 2013; 25.5% in 2014; 24.4% in 2015; and 23.6% in 2016, although the trend was decreasing. it indicates that approximately 26% of credit risk holds by the top 5 banks. however, in the case of top 10 banks, the result was very disappointing. it is notable that the credit risk share increased in the year 2011 from 2010 by 5% and the average trend of risk occupied by top 10 banks was 45%. it revealed that the remaining forty-seven (47) banks only hold 55% credit risk in the industry. this is the red signal for the industry that the risk concentration is very high and can affect negatively in the economy. chart 4. share in industry credit risk (%) 4.3.1.1 share in industry overall risk according to the framework, the overall risk comprises into credit risk, market risk, and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 192 operational risk. the study found that among all the categories, credit risk occupied the major or significant portion of the overall risk. in the case of top 5 banks, it is found that in 2013 the overall risk share slightly increased which was 24.6%. the average trend was approximately 23%. again, in the case of top 10 banks, the share in overall risk has a decreasing trend after the year of 2013. from the year 2010 to 2016, the highest position was in 2013 which showed 41.4%. the average trend was 38% which indicates that top 10 banks captured the major portion of risk as the remaining 47 banks hold only 52% of risk. the risk concentration was very high both in the case of credit risk and overall risk. the regulatory authority should take preventive measures to disseminate the big chunk of risk over the banks. risk dissemination and risk reduction are the only solutions to handle the market without intervention. the open market theory may be distorted by the intervention of the regulators, but there is no way to tackle the situation. chart 5. share in overall industry risk (%) 4.3.1.2 group allotment of share in credit risk the group-wise distribution of credit risk is presented in the chart below. it is found that group 1 (consists of twenty-two (22) private commercial banks) kept the maximum portion of credit risk which is more than 50%. however, the lower percentage of credit risk occupied by group 4 (foreign commercial banks) and group 5 (fourth generation private commercial banks) which is approximately 8%, the accumulation of both groups. but group 2 and group 3 together consumed on an average 42% of the risk. the result is that 22 banks consume on an average 50% of risk where 42% of risk consumed by 17 banks and the remaining 8 % risk for 18 banks. the most vulnerable position is for the group 2 (state-owned and private commercial banks under special attention) and group 3 (full-fledged islamic banks). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 193 chart 6. share in industry credit risk (%) 4.3.1.3 group allotment of share in the overall risk the group-wise allocation of shares in overall risk is depictedin the chart below. it is found that twenty-two (22) private commercial banks which are leveled by group 1 hold the maximum portion of risk which is 45% on an average. the lowest portionholds by foreign commercial banks (group 4) and fourth generation private commercial banks (group 5), all together have a mean value of 7%. therefore, the remaining 48% of average risk is consumed by 17 banks that are the accumulation of group 2 and group 3 banks. from the above discussion, the study identified that the state-owned banks, as well as full-fledged islamic banks, are responsible in taking the extravagantrisk since they have the market share of 30.60% in the industry level. the study conducted by sarker and nahar (2017) identified that state-owned banks are mostly working as an agent of the government and busy with the implementation of political agendas as the governance system are not strong enough that can follow the contractionary policy. on the other hand, the islamic banks are operated with religious belief but not efficient in all respect. the rules and regulation should be changed and make uniform standards for all types of banks otherwise the controlling power of the regulator will be fall under pressure. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 194 chart 7. share in overall industry risk (%) 4.3.2market risk disclosures under basel iii norms the nature of market risk is characterized by the loss of onand off-balance sheet position due to the shift in market price. the adverse shift in market price depends on the interest rate (note 5), foreign exchange rate (note 6), equity price(note 7), credit spreads (note 8) and commodity prices (note 9). the sources of market risk are explained in basel iii where the main attribution concerned with interest rate related instruments and equities and also with currency fluctuation in the global economy. the chart below shows the trend of market risk under basel iii from the year 2010 to 2016. the study found that market risk has downward trend from the year 2010 to 2012 which were 7.0% in 2010, 6.2% in 2011 and 5.2% in 2012 but in 2013 it had an upward trend which was 6%. later on, from the year 2013 to 2016, there was a decreasing trend which was 5.3% in 2014, 4.5% in 2015 and 3.8% in 2016. the turbulence in the security market during the year 2011, the reaction negatively affects the market sentiment which did not work enough to in recovery and volatility in turnover in the year 2013. it is also found that the moderate level of volatility in the turnover attributed to the market risk for banks in the year 2013. the market risk is usually quantified grounded on the volatility of bank earnings and the economic value of its capital. except in the year 2013, the overall trend of market risk showed a very strategic decline through the portion of the risk is small regarding overall risk. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 195 chart 8. market risk under basel iii reported from the year 2010 to 2016 4.3.2.1 the trend of market risk in comparison with other risk in comparisonto market risk with another risk, the study found that the portion of the market risk is the insignificant portion of the total risk. in fact, the highest portion occupied by the credit risk and led by the non-performing loans. however, the market risk exposures are structured and have lower involvement of internal factors that are generated in the marketplace. the study found that the market risk has downward trends whereas the other risk has an upward trend from the year 2010 to 2016. the value of other risk as a percentage of total risk was 93.0% in 2010; 93.8% in 2011; 94.8% in 2012; 94.0% in 2013; 94.7% in 2014; 95.5% in 2015; and 96.2% in 2016. therefore the remaining portion held for market risk is insignificant in consideration of total risk exposure. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 196 chart 9. market risk in comparison with other risk from the year 2010 to 2016 4.3.2.2 the component of market risk and its trend the market risk is largely affected by its broad-headed components which are equity risk, interest rate risk and foreign exchange position risk. among these aspects, equity risk occupied the maximum portion whereas the interest rate risk and foreign exchange position risk jointly take the position below equity risk. the trend curve showed that equity risk gradually decreased from the year 2010 of 62.7% to 2011 of 52.1% whereas interest rate risk also has a downward trend which was 27.8% in 2010 and 21.1% in 2011 but the foreign exchange position risk sharply increased in 2011 which was 6.7% more than the previous year. in the year 2011 to 2012, the case was reversed for equity risk and foreign exchange position risk but similar to the case of interest rate risk. from the year 2012, it is found that the equity price risk are gradually decreased with 63.4% in 2012; 56.6% in 2013; 49.5% in 2014; 48.7% in 2015; and 48.7% in 2016 whereas interest rate risk has a growing trends with 20.2% in 2012; 26.1% in 2013; 32.2% in 2014; 32.7% in 2015 and 32.7% in 2016. in the case of foreign exchange position risk, it is found that there was a slightly increasing trend from the year 2012 to 2016 with value 16.4% to 18.5%. to sum up, it is revealed that equity price risk constituted the highest position of market risk in the stated time horizon and interest rate risk also have the same tendency but flowed below the equity price risk. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 197 chart 10. market risk components from the year 2010 to 2016 4.3.2.3: group wise share of market risk the table below showed the group-wiseshare of market risk focusing on interest rate risk, equity price risk, and exchange rate risk. it is found that group 1 ( 22 private commercial banks) and group 2 ( 10 state-owned and private commercial banks under special attention) are aggregately occupied 90.2% of interest rate risk in the segment of market risk in 2016 whereas both of the groups exposed 86.6% of equity price risk. these statistics found that local banks both state-owned and private commercial are engaged with interest rate related instruments and responsible for the stock market investment in the baking system. moreover, these groups are possessed combined 62.3% of exchange rate risk in 2016 but in the case of group 3 (7 full-fledged islamic banks) is unexpectedly higher consumer of exchange rate risk which is 27%. it is noticeable that, group 4 (9 foreign commercial banks) and group 5 (9 fourth generation private commercial banks) are less exposed to market risk in the banking industry. in the year 2015, it is found that group 1 and group 2 were combinedly occupied by 88.1% of interest rate risk and 88.9% of equity price risk. group 2 alone exposed more share in exchange rate risk which was 37.5% in the year of 2015. in all cases, group 4 and group 5 are less exposed to market risk in both of the year 2015 and 2016 as well. the question may be raised that why group 3 banks have zero (0) share of interest rate risk in both of the years. the answer comes from the basic principle of group 3 (full-fledged islamic banks) banks that they are initiatedby religious belief where interest is totally prohibited and banned in ideological thoughts. they are dealing with money and distribute profits but ignore the interest. so, their reporting system omits the interest related items from the statements. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 198 table 5. group wise dissection of market risk in the banking system year bank group share in industry interest rate risk share in industry equity price risk share in industry exchange rate risk group 1 32.8 53.1 36.6 group 2 57.4 33.3 25.7 2016 group 3 0.0 12.2 27.0 group 4 2.4 0.0 9.0 group 5 7.4 1.4 1.7 total 100 100 100 group 1 47.7 53.5 34.1 group 2 40.4 35.4 37.5 2015 group 3 0.0 9.7 22.8 group 4 5.8 0.0 2.8 group 5 6.1 1.4 2.8 total 100 100 100 4.3.2.4. market risk concentration the market risk concentration is explained by the top 5, and top 10 banks risk exposure in the banking industry. it is very important for the economy that how many are the player or big giants who arrange the market and keep the control. if the lower position of banks exposed higher risk, then it will be a threat to the industry.the best thing is the allocation of risk over the participants in a rational way. in the case of interest rate risk (irr), it is found that top 5 banks were captured 46% in 2010; 43.4% in 2011; 45.6% in 2012; 67.7% in 2013; 46.7% in 2014; 53.2% in 2015; and 67% in 2016. it indicates that top 5 banks expose approximately 53% of the interest rate risk. only 47% irr is consumed by remaining 52 banks in the baking industry of bangladesh. the case is severe for those five (5) banks that experienced higher market risk over the period. the top 5 banks in this regard are three (3) state-owned commercial banks and two (2) private commercial banks. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 199 chart 11. interest rate risk exposed by top 5 banks in the case of to 10 banks, it is found that, the irr has increasing trend that was in 2010; 67.6% in 2011; 72% in 2012; 94.9% in 2013; 68.8% in 2014; 72.1% in 2015; and 83.7 % in 2016. the average value is 75.44% indicates that only ten (10) banks consume amaximum portion of interest rate risk (irr) remaining 24.56% held for forty-seven (47) banks. therefore the regulators should evaluate the consequences and take immediate action for the disposal of extravagant risk. chart 12. interest rate risk exposed by top 10 banks in the case of exchange rate risk (err), top 5 banks holdon an average 52.9% risk and remaining 47.1% held for 52 banks. the risk concentration for the top 5 banks is very high. among the years, the highest risk was exposed in 2011 which was 71.1%. it also indicates that the top 10 banks hold major portion of interest rate risk (irr) which is detrimental to the economic stabilization. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 200 chart 13. exchange rate risk exposed by top 5 banks the chart below showed the exchange rate risk exposure of top10 banks in the banking sector of bangladesh. it was found that the trends of err was 62.0% in 2010; 81.8% in 2011; 67.8% in 2012; 72.1% in 2013; 69.4% in 2014; 67.5% in 2015; and 64.6% in 2016 with average value of 69.31%. the study revealed that remaining 30.69% of exchange rate risk (err) held for 47 banks. the risk concentration is very high for both top 5 and top 10 banks. chart 14. exchange rate risk exposed by top 10 banks in the case of equity price risk (epr), top 5 banks showed that they exposed thehighest risk in 2010 which was 47% but later on from the year 2011 to 2013, there was a gradual increase of epr with the value of 37.8%, 45.3%, and 48.6% successively. after the year of 2013, the trend of err slightly decreased. in the year of 2016, the err stood 38.1% which was the lowest among the selected periods. it also revealed that 43.29% of average risk was consumed by the top 5 banks from the year 2010 to 2016. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 201 chart 15. equity price risk exposed by top 5 banks however, the concentration of top 10 banks showed that equity price risk (epr) was 72% in 2010; 50.9% in 2011; 69.6% in 2012; 71.0% in 2013; 68.6% in 2014; 67.3% in 2015; and 59.5% in 2016. the average value was 65.56% which indicates that the major portion of epr exposed by to 10 banks. chart 16. equity price risk exposed by top 10 banks 4.3.3 operational risk disclosures the operational risk arises from the financial losses and causes by the disruption of the internal control system and corporate governance. the causes may be initiated using human error, inadequate internal control system, interrupted technical system, intentional misstatement or any sought of adverse situations. in the context of present-day banking and financial sector irregularities, balance development and high growth are not possible. that is why radical reform in this sector is the time demand. while there are many questions about the list of top 100 loan defaulters, this type of listing asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 202 can encourage banks to get default loans and encourage borrowers not to be defaulted. most of the top 100 loan defaulters have been published by the public bank's customers. due to irregularities and corruption of the years to years, lack of good governance, the central bank's control has become less and more difficult for these banks. there are some institutions in debt defaulters who have defaulters in more than one government bank. some companies, government banks, as well as private banks, have defaulters. but many other institutions are out of the list of debt restructures and reconstructions and the court writings. also, banks have excluded many institutions and excluded the accounts from the accounts. if these are considered then the picture of the defaulted loan will be even worse. in operational risk, the entity is fall in the crisis due to their loose governance policy, improper monitoring system and weak internal control policy. 4.3.3.1. operational risk concentration the chart below showed that to 5 banks is exposed less than 30 % of risk from the year 2010 to 2016. it is noticeable that the highest operational risk was in the year of 2011 and lowest stood in 2013. however, the share of operational risk in overall industry risk was negligible from 2010 to 2016 at the value of 2.3%, 2.6%, 2.4%, 2.2%, 2.5%, 2.6%, and 2.5% consecutive from the beginning. chart 17. operational risk exposed by top 5 banks in the case of top 10 banks, the study found that operational risk exposed 46.0% in 2010; 48.2% in 2011; 47.7% in 2012; 35.1% in 2013; 45.9% in 2014; 45.4% in 2015; and finally 44.4% in 2016. that indicates that top 10 banks occupied more than 40% of operational risk whereas 60% held for 47 banks. therefore, in all respects, risk concentration for top 5 or top 10 banks was higher in position. the risk concentration symptom is not good for the developing country like bangladesh. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 203 chart 18. operational risk exposed by top 10 banks 4.3.3.2 group-wise dissection of operational risk the table below found that group 1 and group 2 banks aggregately exposed 73.1% share of industry operational risk in 2016 and also in the same trend in the prior periods. the lowest risk exposed by the group 5 banks where they have 1.0% in 2014, 1.5% in 2015, and 2.3% in 2016 as a share of operational risk. again, in the case of overall risk, it is found that group 1 banks have more risk in comparison with other groups. the lowest risk held for group 4 in the year of 2014, 2015, and 2016 as well. table 6. group-wise dissection of operational risk in the banking system percentage (%) share in operational industry risk share in industry overall risk year 2014 year2015 year 2016 year2014 year2015 year2016 group 1 50.7 50.3 50.9 4.6 4.5 4.6 group 2 22.9 22.7 22.2 2.1 2.1 2 group 3 14.8 14.8 14.9 1.3 1.3 1.3 group 4 10.6 10.7 9.7 0.9 1.0 0.9 group 5 1.0 1.5 2.3 0.1 0.1 0.2 5. conclusions the finance ministry, bangladesh bank, parliamentary committees have provided guidelines to prevent the defaulting loan. the governing board of the state-owned commercial banks, the management authority and the finance ministry and the instructions of the bangladesh bank, according to the advice; are taking steps to upgrade the defaulting loan of their banks. organizing regular meetings, monitoring the results of the workflow is taken at the field level. the branches have jumped with the supremacy of defaulting money. the absence of defaulting loan is a good sign of the banking sector. such images are shown due to credit without scrutiny. in this way, the discipline of the bank will be broken. moreover, there will be a negative impact on interest rates as well as on investments. political influences for asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 204 granting credit by the chairman, director and managing directors (mds) of the bank is the main reason behind the inadequacies of the credit. this is the high time to buildup an awareness program to stop the loan path without checking. otherwise, the amount of bad credit can be increased. bangladesh securities and exchange commission (bsec) has given permission the following eight (8) credit rating agencies along with moody’s investors service, standard & poor’s rating service, and fitch ratings so that the real scenario of the baking position can be imaginable. table 7. commencement of credit rating agencies in bangladesh sl. no. rating agency year of inception subsidiary/technical partner of 1 credit rating information and services ltd. 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(2003). analyzing and managing banking risk: a framework for assessing corporate governance and financial risk management, second edition. washington, dc: world bank. © world bank. https://doi.org/10.1596/0-8213-5418-3 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 207 notes note 1. mohammad habibullah and santi narayan ghosh in their books “risk management” define the risk along with classifications. the book published in 1986 under bureau of business research, dhaka university press. note 2. bangladesh bank, the central bank and apex regulatory body for the country's monetary and financial system, was established in dhaka as a body corporate vide the bangladesh bank order, 1972 (p.o. no. 127 of 1972) with effect from 16 december 1971. note 3. the legislative framework applied in the form of memorandum of understanding (mou) with the directives of bangladesh bank (dobb) that are considered as the low performer banks in terms of asset quality, capital adequacy and weak governance systems. these banks are required special attention and supervision by the regulatory bodies in upgrading their performance. note 4. the newly established banks that got license in 2013 and operated in bangladesh as schedule banks except one islamic bank that are included in group 3. note 5. the risk arises from the change of the value of cash flows with regard to change of the real interest rate. in fact, it indicates the mismatch of cash flows maturities by the ends of decreasing financial earnings. note 6. the current and forthcoming effect on banks’ earnings that is deliberately initiated by the unpredicted movements of currency exchange rates. note 7. the probable losses are arising from the change in equity price. note 8. credit spread is measured by the variance of treasury bond yield and debt security yield with uniform maturity periods but have lesser quality. note 9. the uncertainty arising from the price movement that is negatively affected the financial results of those who are the producer and consumer at the same time. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 208 appendix a-1: group-wise dissection of credit risk in the banking system year bank group description of the group share in industry credit risk (%) share in industry overall risk (%) 2016 group 1 private commercial banks 52.4 45.7 group 2 state-owned and private commercial banks under special attention 20.6 17.9 group 3 full-fledge islamic private commercial banks 18.2 15.9 group 4 foreign commercial banks 5.3 4.7 group 5 fourth generation private commercial banks 3.5 3 2015 group 1 private commercial banks 52.1 45 group 2 state-owned and private commercial banks under special attention 21.7 18.8 group 3 full-fledge islamic private commercial banks 17.7 15.4 group 4 foreign commercial banks 5.7 4.9 group 5 fourth generation private commercial banks 2.8 2.4 2014 group 1 private commercial banks 51.6 44.2 group 2 state-owned and private commercial banks under special attention 22.9 19.6 group 3 full-fledge islamic private commercial banks 17.4 14.9 group 4 foreign commercial banks 6.5 5.6 group 5 fourth generation private commercial banks 1.6 1.4 source: financial stability report (2014-2016), bangladesh bank a-2: market risk under basel iii: from the year 2010-2016 year market risk other risk total 2010 7 93 100 2011 6.2 93.8 100 2012 5.2 94.8 100 2013 6 94 100 2014 5.3 94.7 100 2015 4.5 95.5 100 2016 3.8 96.2 100 a-3: market risk components under basel iii: from the year 2010-2016 year equity risk interest rate risk fx position risk total 2010 62.7 27.8 9.5 100 2011 52.1 21.1 26.8 100 2012 63.4 20.2 16.4 100 2013 56.6 26.1 17.3 100 2014 49.5 32.2 18.3 100 2015 48.7 32.7 18.6 100 2016 48.8 32.7 18.5 100 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 209 a-4: market risk components: top 5 banks irr in the banking system err in the banking system epr in the banking system year interest rate risk (irr) share in market risk share in overall risk exchange rate risk share in market risk share in overall risk equity price risk share in market risk share in overall risk 2010 46 36 13 45 4 0.3 47 30 2.2 2011 43.4 9.1 0.6 71.1 19 1.2 37.8 19.7 1.2 2012 45.6 9.2 0.5 46.2 7.6 0.4 45.3 28.7 1.5 2013 67.6 16.4 1 56.8 10.5 0.6 48.6 30.2 1.8 2014 46.7 15 0.8 50.9 9.3 0.5 44.5 22 1.2 2015 53.2 17.4 0.8 51.9 9.6 0.4 41.7 20.3 0.9 2016 67 21.9 0.9 48.4 9 0.4 38.1 18.6 0.7 a-5: market risk components: top 10 banks: irr in the banking system err in the banking system epr in the banking system year interest rate risk share in market risk share in overall risk exchange rate risk share in market risk share in overall risk equity price risk share in market risk share in overall risk 2010 69 38 19 62 6 0.4 72 45 3.3 2011 67.6 14.3 0.9 81.8 21.9 1.4 50.9 26.5 1.6 2012 72 14.5 0.7 67.8 11.1 0.6 69.6 44.2 2.3 2013 94.9 23 1.4 72.1 13.3 0.8 71 44.2 2.6 2014 68.8 22.1 1.1 69.4 12.7 0.7 68.6 33.9 1.8 2015 72.1 23.6 1.1 67.5 12.5 0.6 67.3 32.8 1.5 2016 83.7 27.4 1.1 64.6 11.9 0.5 59.5 29 1.1 a-6: operational risk under basel iii: from the year 2010-2016 top 5 banks top 10 banks year share in industry operational risk share in industry overall risk share in industry operational risk share in industry overall risk 2010 29 2.3 46 3.8 2011 30.6 2.6 48.2 4.2 2012 30.6 2.4 47.7 4.4 2013 24.5 2.2 35.1 3.1 2014 28.2 2.5 45.9 4.1 2015 28.5 2.6 45.4 4.1 2016 27.5 2.5 44.4 4 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 11832-43450-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 206 macroeconomic variables and stock market returns in sri lanka saseela balagobei senior lecturer, department of financial management faculty of management studies and commerce university of jaffna received: sep. 11, 2017 accepted: nov. 20, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11832 url: https://doi.org/10.5296/ajfa.v9i2.11832 abstract the stock market is one of the most energetic sectors that play an important role in contributing to the wealth of the economy. it plays a crucial role in the economic growth and development of an economy which would benefit industries, trade and commerce as a whole. the aim of this study is to investigate the impact of macroeconomic variables on stock market returns in sri lanka. dependent variable of this study is stock market return measured by all share price index (aspi) and all share total return index (astri) and independent variables are macroeconomic variables, such as interest rate (ir), inflation rate (inf), exchange rate (er), factory industry production index (fipi) and money supply (ms). the study targets all the companies listed and active in colombo stock exchange (cse) from 2006 to 2015. for analysis, secondary data was collected from annual reports of central bank of sri lanka, colombo stock exchange, securities and exchange commission and department of census and statistics. the results of the study reveal that the stock market returns is influenced by macroeconomic variables except money supply in sri lanka. interest rate and factory industry production have negative influence on stock market return in colombo stock exchange while inflation rate and exchange rate have positive influence on stock market return. the findings of the study may be useful to public and economy especially stock market investors to focus the macroeconomic variables for making their effective decisions in order to enhance their stock market returns. keywords: macroeconomic variables, stock market return, all share price index and all share total return index. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 207 introduction stock market has a paramount importance in an economy. although most of the growing economies are endowed with growing stock markets, due to prevailed unfavorable economic and political condition in sri lanka, colombo stock exchange (cse) remained underdeveloped during the pre-war period. however, due to considerable economic growth and peaceful political environment, cse reported a robust growth in the post-war period. nevertheless, despite the impressive economic environment emerged, the stock market growth was not sustained after 2012. therefore, the constraints for stock market development remain unclear (kulathunga, 2015). the colombo stock exchange (cse) operates as the only share market in the economy and is responsible for providing a transparent and regulated environment where both institutional and individual investors can operate in the capital market. the study intends to investigate the impact of macroeconomic variables on stock market returns in colombo stock exchange, sri lanka. stock market is somehow abstract for the mechanism that enables the trading of company stock. it is also used to describe the totality of all stocks, especially within a country. the stock market is the market where common stock representing ownership in a company, are traded (mishkin and eakins, 2011). it plays an important role in national economies, as they are considered to be very helpful in channeling and diversifying the domestic savings and foreign capital into productive investment, fostering capital formation and sustaining economic growth and development (lakshmi and tuwajri, 2014). the association between macroeconomic variables and stock market returns has been extensively studied and documented in developed capital markets such as usa, japan, australia, canada and european countries. notable among them is one by chen, richard roll and ross (1986) on the us stock market, which set the tone for a series of recent studies within the arbitrage pricing theory (apt) framework. according to fama (1981), macroeconomic variable such as industrial production index is positively related with stock market performance. when industrial production index increases, the stock returns also increase. the industrial production and interest rate in germany have a positive relationship with other european stock market returns as well such as united kingdom, france and italy (cheung & ng 1998, nasseh & strauss 2000, mukherjee & naka 1995, mcmillan 2001 and chaudhuri & smiles 2004). stock market returns are the returns that the investors generate out of the stock market. these returns can be in the form of profit through trading or in the form of dividends given by the company to its shareholders from time-to-time. macroeconomic variables show the overall strength or weakness of the economy. the most important macroeconomic variables are gross domestic product (gdp), inflation, money supply, interest rate, exchange rate, unemployment rate, foreign direct investment and index of industrial production (alam & rashid, 2014). it is a matter of great interest for academician, researchers, investors, regulators and government bodies to identify impact of macroeconomic variables on the stock market. stock asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 208 markets being a leading indicator of an economy reflect the level of economic activities in the country (menike, 2006). in related to the literature there were many studies have been investigated the relationship between macroeconomic variables and stock market returns in developed countries, for instance, chen et al., (1986) who examined us stock market and it is obvious that there is a shortage of literature concerning on emerging stock markets, but it is particularly lacking in regards to the sri lankan market. however, there is only a little number of studies in emerging sri lankan stock market such as of samarakoon, (1996, 1998), nimal, (1997), premawardhana (1997), samarakoon et al. (2000). for example, samarakoon (1996) reported a positive relationship between stock market returns and inflation. based on the best of researcher’s knowledge still on sri lankan markets, of the reviewed literature, no specific one has attempted to examine the impact of macroeconomic variables such as interest rate, inflation rate, exchange rate, factory industry production index and money supply on stock market returns. knowing how the stock market returns affect as a response to macroeconomic changes is essential for those who are looking for returns on their investments and policy makers. frequently, research in this area has found statistical proof to support the theory that macroeconomic variables impact the stock market returns, however there are also studies that found no causal relationship between some of the variables such as factory industry production index, business surveys of manufacturing orders, short and long term interest rates as well as foreign stock prices, short-term interest rates and production (nasseh and strauss, 2000; tangjitprom, 2012). a common feature of these studies is that they focus on the whole market and examine the aggregate market of countries (rapach, wohar and rangvid, 2005; pierdzioch, döpke and hartmann, 2008). they assume that the firms are homogenous. to address this issue this study was undertaken to explore the answer to the following research question: to what extent macroeconomic variables impact on stock market returns? the objective of this study is to investigate the impact of macroeconomic variables on stock market returns in sri lanka during the period of 2006 to 2015. literature review this section reviews literature on the concepts relevant to the study. the effect of macroeconomic variables on stock market return has been documented in developing countries as well as developed countries. using data from 1976 to 1993 on 41 countries including both developed and developing, levine and zervos (1996) examined the relationship between economic growth and stock market development. they found a strong positive association between the stock market development and long-run economic growth after controlling for the initial level of per capita gdp, initial level of investment in human capital, political instability and measures of fiscal and monetary policies as well as exchange rate policy. atje and jovanovic (1993) found strong evidence to support the view that stock market development leads to economic growth. johansen and juselus (1999) investigated the long run relationship between the jordanian stock prices and selected macroeconomic variables by using cointegration analysis and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 209 monthly time series data for the period of january 1987 to december 2000.the study reveals that macroeconomic variables were reflected in stock prices in the jordanian capital market. gunasekarage, pisedtasalasai and power (2004) examined the influence of macroeconomic variables on stock market equity values in sri lanka, using the colombo all share price index to represent the stock market and (1) the money supply, (2) the treasury bill rate (as a measure of interest rates), (3) the consumer price index (as a measure of inflation), and (4) the exchange rate as macroeconomic variables. with monthly data for the 17-year period from january 1985 to december 2001 and using unit root tests, cointegration, and vecm, they examined both long-run and short-run relationships between the stock market index and the economic variables. the vecm analysis provides support for the argument that the lagged values of macroeconomic variables such as the consumer price index, the money supply and the treasury bill rate have a significant influence on the stock market. patra and poshakwale (2006) examined the short-run dynamic adjustments and the long-run equilibrium relationships between selected macroeconomic variables, trading volume and stock returns in the greek stock market during the period of 1990 to 1999. they reach results showing that short run and long run equilibrium relationship exists between inflation, money supply and trading volume and the stock prices in the athens stock exchange. no short run or long run equilibrium relationship is found between the exchange rates and stock prices. abugri (2006) performed a study to determine whether selected macroeconomic indicators like exchange rates, interest rates, industrial production and money supply in four latin american countries significantly explain market returns. his research results indicated that the global factors are consistently significant in explaining returns in all the markets. the country macroeconomic variables are found to impact the markets at varying significance and magnitudes. according to chen et al. (1986) economic variables have a systematic consequence on stock market returns because economic forces affect the discount rates, the ability of firms to generate cash flows and future dividend payments. it is through this mechanism that macroeconomic variables become part of risk factors in equity markets. they (1986) analyzed the macroeconomic variables and stock returns and found a strong relationship between stock returns and macroeconomic variables of short term and long term interest rates, expected and unexpected inflation rate and industrial production growth. menike (2006) studied impact of macroeconomic variables on stock price in emerging sri lankan stock market using monthly data for the period from september 1991 to december 2002. the study held that inflation rate, treasury bill rate and exchange rate react mainly negatively to stock prices. however, lagged money supply variables were held not to have a strong prediction of the movements of stock prices. samarakoon (1998) investigated the relationship between stock returns and inflation in sri lanka with a view to providing empirical evidence on the generalized fisher hypothesis which states that nominal stock returns are positively related to expected inflation in a one-to-one correspondence. the results indicate that both lagged inflation and expected asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 210 inflation are significantly positively related to stock returns in a manner predicted by the fisher hypothesis suggesting that stocks in sri lanka. rahman (2009) believes that in long term, foreign exchange reserve and industrial production positively affect on stock market, while interest rate and exchange rate have the reverse influence on malaysian stock market. maysami (2004) using the same analysis found that singapore stock market has a cointergrating relationship with changes in the short and long-term interest rates, industrial production, price levels, exchange rate and money supply. imbrahim and yusoff (2001) stated that malaysian stock market is strongly affected by domestic macroeconomic factors, in which money supply is one of the strongest influences. money supply has short-term positive effect on this stock market but negatively effect in long term, while industrial production and inflation rate have positively effect on the market. for the case of malaysia, ibrahim and yusoff (2001) find a negative relationship between stock prices and money supply in the long-run but the analysis actually between the stock prices (klci) and macroeconomic variables which are real output as a measure of industrial production (ip), money supply (m2), price level as a measure of consumer price index (cpi) and exchange rate. klci is positively related to cpi and negatively related to m2. the positive association between klci and cpi seems to support the view that the stock prices are a good hedge against inflation. mukherjee and naka (1995) applied johansen’s vecm method and found a cointergrating relationship between japan stock market and inflation, exchange rate, money supply, real economic activity, long-term government bond rate, and call money rate. azman-saini, habibullah, law and dayang-afizzah (2006) in their study by using granger non-causality found that malaysian stock prices are led by the exchange rate during the crisis period. during the crisis period, the malaysian ringgit depreciated against us dollar and it significantly influences the malaysian stock prices. this study considers a longer time span (2006-2015) and more observations and also considers the impact of macroeconomic variables (interest rate, inflation, exchange rate, factory industry production index and money supply) on the changes in the stock market return of colombo stock exchange based on the above literature review, the following testable hypotheses are developed: h1: interest rate significantly influences on stock market returns. h2: inflation rate significantly influences on stock market returns. h3: exchange rate significantly influences on stock market returns. h4: factory industry production index significantly influences on stock market returns. h5: money supply significantly influences on stock market returns. methodology this section focuses on the research process, kind of tools and procedures to be used. this study tends to investigate the impact of macroeconomic variables on stock market return in asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 211 sri lanka. the colombo stock exchange (cse) is the only one share market in sri lanka and this study focuses on the stock market as wholly. the researcher mainly focuses on secondary data which is collected from annual reports of central bank of sri lanka, cse and department of census and statistics, and academic journals for the period of 2006-2015. further all share price index (aspi) and all share total return index (astri) represent the total 295 listed companies’ performance in sri lanka. five variables have been considered as macro economic variables: interest rate (364 days treasury bill weighted annual average yield rate); inflation rate (changes in colombo consumers’ price index); exchange rate (sri lankan rupee to the us dollar has been used); factory industry production (index of factory industry production); and money supply (broad money supply (m2b)) whereas all share price index (the base year is 1985, and the base value of the index is 100) and all share total return index (the aspi computed on total returns is known as astri) are used as the proxies for stock market return. a multiple linear regression model attempts to investigate the influence of selected macro economic variables on stock market return. aspi = β0 +β1ir+β2inf+ β3er+β4fipi+ β5ms + ε (1) astri = β0 +β1ir+β2inf+ β3er+β4fipi+ β5ms + ε (2) where: β1, β2 β3, β4, β5 –regression coefficient ir – interest rate inf – inflation er – exchange rate fipi – factory industry production index ms –money supply ε – error term data analysis descriptive analysis table 1 represents the descriptive statistics of macroeconomic variables and stock market return measured by aspi and astri in sri lanka from 2006 to 2015. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 212 table 1. descriptive statistics the table 01 summarizes the descriptive statistics for the variables employed in the study. this shows that the average interest rate of 11.07 % with a standard deviation of 4.09 and has a wide range from 6.60 to 18.89. this table also shows that the average inflation rate is 8.35% with a standard deviation of 6.46 and has a range from 0.90 to 22.60. money supply has the average of rs.2530.95 billion while minimum value of rs.1204.60 billion and maximum of rs.4565.90 billion. the average annual aspi and astri are 4861.15 and 6015.34 respectively. there is a highest standard deviation of stock market returns and lower standard deviation of interest rate. 8.2 correlation analysis this study employs a correlation analysis to discover the association and direction of the variables, mainly macroeconomic variables and stock market return. minimum maximum mean std. deviation interest rate 6.60 18.89 11.07 4.09 inflation rate 0.90 22.60 8.35 6.46 exchange rate 103.96 135.94 118.52 11.25 factory industry production index 86.60 124.60 104.76 13.00 money supply 1204.60 4565.90 2530.95 1138.26 aspi 1503.00 7298.95 4861.15 2103.65 astri 1783.60 9579.20 6015.34 2829.73 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 213 table 2. correlation matrix ir inf er fipi ms aspi astri ir pearson correlation 1 . sig. (2-tailed) inf pearson correlation .873** 1 sig. (2-tailed) .001 er pearson correlation -.497 -.612 1 sig. (2-tailed) .144 .060 fipi pearson correlation -.745* -.559 .534 1 sig. (2-tailed) .013 .093 .112 ms pearson correlation -.658* -.649* .950** .662* 1 sig. (2-tailed) .039 .042 .000 .037 aspi pearson correlation -.886** -.792** .720* .617 .817** 1 sig. (2-tailed) .001 .006 .019 .057 .004 astri pearson correlation -.870** -.782** .773** .639* .866** .995** 1 sig. (2-tailed) .001 .008 .009 .047 .001 .000 **correlation is significant at the 0.01 level (2tailed). * correlation is significant at the 0.05 level (2-tailed). according to the table 02 the value of correlation between interest rate and aspi is -0.886** which is significant at 0.01 levels; indicates that there is strong negative association between ir and aspi, also strong negative relationship exists between interest rate and astri at the 0.01 significant levels since the value of correlation between interest rate and astri is -0.87**. as can be seen in table 02, the value of correlation between inflation and aspi is -0.792** which is significant negative relationship between inflation and aspi at 0.01 levels. the value of correlation between inflation and astri is -0.782** indicates that there is significant negative relationship between inflation and astri at 0.01 levels. the correlation between exchange rate and aspi is 0.720** which represents a positive significant relationship between er and aspi at 0.05 significant levels. the value of correlation between exchange rate and astri is 0.773** which is significant at 0.01 levels represents the positive relationship between er and astri. further there is insignificant relationship between factory industry production index and aspi at 0.05 significant levels. but there is significant positive relationship between fipi and astri at 0.05 significant levels. further the correlation between money supply and aspi is 0.817** which indicates a strong positive relationship between money supply and aspi at the 0.01 significant level and also there is strong positive relationship between money supply and astri at 0.01 significant level. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 214 regression analysis in order to examine the impact of macroeconomic variables on stock market return, multiple regression analysis is performed in this study. results of the multiple regression analysis are presented in the table 03 and table 04. table 3. multiple regression analysis for aspi dependent variable: aspi according to the table 03, coefficient of determination for macroeconomic variables (r2) is 0.977 which denotes that 97.7% of the observed variability in aspi can be explained by the differences in the variables such as ir, inf, er, fipi and ms the remaining 2.3% of the variances is related to the other variables which are not depicted in this model. an analysis of variance (anova) indicated that f=33.937, p < 0.05, that the model is significant. it means that the regression results are acceptable for this analysis. among the all five macroeconomic variables considered in the analysis, only four macroeconomic variables have a significant impact on aspi which are interest rate, inflation rate, exchange rate and factory industry production index. interest rate significantly negatively influences on aspi (b= -963.513, p<0.05), similar pattern is observed in factory industry production index that has significant negative impact on aspi (b= -74.230, p<0.05). further inflation rate significantly positively influences on aspi (b= 287.214, p<0.05), and exchange rate has a significant positive impact on aspi (b= 264.991, p<0.05). the coefficient of money supply shows that money supply has no significant impact on aspi. variables beta std. error t value sig. (constant) -6345.741 7114.305 -.892 .423 ir -963.513 183.785 -5.243 .006 inf 287.214 90.032 3.190 .033 er 264.991 88.600 2.991 .040 fipi -74.230 21.887 -3.391 .027 ms -1.759 .984 -1.788 .148 r2 = .977 adj. r2 = .948 f=33.937 p(f statistic)= 0.002 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 215 table 4. regression analysis for all share price index variables beta std. error t value sig. (constant) -8647.289 7361.440 -1.175 .305 ir -1159.700 190.169 -6.098 .004 inf 356.587 93.159 3.828 .019 er 320.023 91.678 3.491 .025 fipi -89.050 22.648 -3.932 .017 ms -1.725 1.018 -1.694 .166 r2 = 0.986 adj. r2 = .969 f=57.904 p(f statistic)= 0.001 dependent variable: astri according to the table 04, coefficient of determination for macroeconomic variables (r2) is 0.986 which denotes that 98.6 % of the observed variability in astri can be explained by the differences in the variables such as ir, inf, er, fipi and ms the remaining 1.4% of the variances is related to the other variables which are not depicted in this model. an analysis of variance (anova) indicated that f=57.904, p < 0.05, that the model is significant. it means that the regression results are acceptable for this analysis. only four macroeconomic variables have a significant impact on astri which are interest rate, inflation rate, exchange rate and factory industry production index. interest rate significantly negatively influences on astri (b= -1159.700, p<0.05), similar pattern is observed in factory industry production index that has significant negative impact on astri (b= -89.050, p<0.05). further inflation rate significantly positively influences on astri (b= 356.587, p<0.05), and exchange rate has a significant positive impact on astri (b= 320.023, p<0.05). the coefficient of money supply shows that money supply has no significant impact on astri. by using the multiple regression analysis the hypotheses are examined in this study. hypothesis (h1) stated that interest rate significantly influences on stock market returns. according to the table 03 and table 04, there is a significant negative impact of interest rate on stock market return measured by aspi and astri (p=0.006 < 0.05, p=0.004 respectively), as a result h1 is supported. the result is consistence with the findings of previous researches such as johansen and juselus (1999); abugri (2006); chen et al. (1986) and menike (2006). hypothesis (h2) stated that inflation rate significantly influences on stock market returns measured by aspi and astri. since the p-values of t test for inflation rate are 0.033 <0.05 and 0.019 <0.05, which illustrated that there is a significant positive impact of inflation rate on stock market returns, as a result h2 is supported. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 216 hypothesis (h3) stated that exchange rate significantly influences on stock market returns. since the p-values of t test for exchange rate are 0.04 <0.05 and 0.025 <0.05, which illustrated that there is a significant positive impact of exchange rate on stock market returns, as a result h3 is supported. hypothesis (h4) stated that factory industry production index significantly influences on stock market returns. since the p-values of t test for factory industry production index are 0.027 <0.05 and 0.017 <0.05, which illustrated that there is a significant negative impact of factory industry production index on stock market returns, as a result h4 is supported. hypothesis (h5) stated that money supply significantly influences on stock market returns. since the p-values of t test for money supply are 0.148 > 0.05 and 0.166 >0.05, which illustrated that there is no significant impact of money supply on stock market returns, as a result h5 is not supported. conclusion having understood the importance of macroeconomic variables and stock market return to the country, the present study has been carried out to assess the impact of macroeconomic variables on stock market return in sri lanka. there is a whole listed companies considered in this study. results of the study reveal that among the five macroeconomic variables, only interest rate and factory industry production have a significant negative influence on stock market return in colombo stock exchange. further inflation rate and exchange rate have a significant positive influence on stock market return while there is no significant impact of money supply on stock market return in colombo stock exchange. therefore the stock market returns is influenced by macroeconomic variables except money supply in sri lanka. so considering the macroeconomic variables, every investor should make good decisions regarding their investment and every firm should contribute to the overall stock market return in order to carry out their business successfully and to maintain the good investor relationship. interest rate is a crucial variable of stock market return in sri lanka. in this study, interest rate is found to have negative significant impact on stock market return. according to the findings, the stock returns react negatively to rising interest rates. therefore, high interest rates influence the stock market returns and subsequently causing stock prices to fall. whenever returns on government assets increase, investors are likely to change out of stocks and causing a decrease in stock prices. this can be explained through the behavior of the weighted average yield rates of 364 days treasury bill. inflation rate is one of the pivotal variables of stock market returns which have positive significant impact on stock market return. investors should put more caution about inflation in the market. the central bank of sri lanka being the monetary authority in sri lanka need to constantly be reviewing the interest rate trends, inflation rates as well as the exchange rate by comparing them with the developed economies. the finding of the study may be useful to public and economy especially stock market investors to focus the macroeconomic variables for making their effective decisions in order asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 217 to enhance their stock market return. other stakeholders such as policy maker, central bank of sri lanka, economist, and stock market participants should be more awareness in the situation of sri lankan stock market trend and the significant impact of interest rate, inflation rate, exchange rate, fipi and money supply on stock market return. references abugri b.a. 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(1996b). stock market returns and inflation: sri lankan evidence. sri lankan journal of management, 1, 293 311. microsoft word 11212-41364-3-sm _1_-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 375 the possibility of the jordanian industrial corporations to apply the ifrs no. 15 hasan mahmoud al-shatnawi department of accounting, irbid national university, jordan e-mail: hsnshatnawi@gmail.com received: may 13, 2017 accepted: june 11, 2017 published: june 11, 2017 doi:10.5296/ajfa.v9i1.11212 url: http://dx.doi.org/10.5296/ajfa.v9i1.11212 abstract the goal of this study is to explore the possibility for the jordanian industrial corporations to apply the international financial reporting standers (ifrs) no. 15 from the point of view of the financial reporting preparers. to achieve the objectives of the study, a questionnaire was designed and distributed to a sample consisting of 84 individuals. descriptive statistics were used to describe the study sample such as the frequencies, arithmetic mean, and standard deviation. in addition, the one-sample t-test was employed to test the study hypotheses at the 0.05 level of significance. this study showed that it is possible for the jordanian industrial corporations to commit to the requirements for revenue recognition and the accounting measurement. as well as it is not possible commit to the requirements for the accounting disclosure of the revenues according to the ifrs 15. furthermore, this study recommended to encouraging the corporations to commit to the requirements for revenue disclosure according to the ifrs 15 in such a way as to reinforce/foster trust of the users of the accounting information in the financial reports. keywords: ifrs 15, revenue recognition, revenue measurement, revenue disclosure, jordanian industrial asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 376 1. introduction accounting plays an essential and important role in efficiency of the capital markets and in influencing the investment decisions through the financial reports which the companies prepare. these reports must provide the correct and adequate information for the investors in the right time for taking their investment decisions. usually, the accountants face the potential risks of bias and misinterpretation when preparing the financial reports. based on this, use of the international financial reporting standards (ifrss) when preparing and processing the financial reports became a basic requirement for the different parties to reinforce transparency and lend them credibility (aburman and abdel latif, 2014). because of emergence of various fraud processes in recording the revenues at the time of disclosure, the present standards became relatively weak and inadequate to perform their desired purpose as the methods multiplied and the selling ways varied and no important changes in the accounting evidence emerged. this shortcoming in the accounting standards led the companies to manipulating their fixed revenues and inveigling the investor, viewer, and reviewer of the status of the company in ways that are consistent with old standards that do not satisfy the new developments in the working methods. therefore, many court cases are raised against companies, especially the publicly-listed ones, and against the legal audit offices. most of these cases concern the process of proving and recognition of the revenues. hence, the international organizations specific to issuance of the accounting standards wakened and issued a new standard that organizes the revenue recording process and the time of recognition of them, which is the international financial reporting standard no. 15 (ifrs 15): revenue from contracts with the customers (lim et al., 2015). the ifrs 15 is considered as one of the modern and important standards that address the requirements for recognition, measurement, and disclosure related to the revenues from the contracts with the customers. this standard sets the principles of reporting the information useful for the users of the accounting information about the nature, amounts, timing, and uncertainty cases pertaining to the revenue and the flows emanating from the contracts with the customers. this standard came as an alternative to the international accounting standards no. 18 (revenue) and no. 11 (construction contracts) because of the difficulty of applying these standards on the overlapping and complex cases for revenue recognition. significance of this study stems from its main subject, represented by the ifrs 15: revenues from contracts with customers; its fundamentals, principles, and practical application. the study significance revolves around that this standard was issued under the umbrella of the efforts of convergence between the bodies specialized in setting the american accounting standards and those specialized in setting the international accounting standards, which leads to harmonization of methods and ways of the international accounting standards as this standard seeks to remove the cases of inconsistency and to present robust frame for dealing with those cases and improve the comparability and the disclosure requirements, and reduce the requirements for recognition of the revenue in preparation of the financial reports. as well, this study has academic significance represented in scarcity of the studies which addressed the ifrs 15 for preparation of the financial statements in view of modernity of the subject. it asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 377 is hoped that the current study contributes to enrichment of the scientific library in the accounting area with theoretical substance at a high level of importance and modernity. the ifrs 15 was issued in may 2014 to be put into practice in the first annual financial reports prepared on, or after, 1 january 2018. this standard came as a joint project between the international accounting standards board (iasb) and the american financial accounting standards board (fasb) to develop common requirements for revenues. consequently, this study came to determine the possibility for the jordanian industrial corporations to apply ifrs 15, which is related to the revenues of the contracts with the customers. the problem of the present study is investigating the commitment of the jordanian industrial corporations to the requirements for revenue recognition, for the accounting measurement of revenues and for the accounting disclosure of revenues according to ifrs 15. as well as the commitment of the jordanian industrial corporations to obstacles that prevent application of the ifrs 15. the main goal of this study is to determining the potential for the jordanian industrial corporations to apply ifrs 15. by studying its potential to commit to the requirements for revenue recognition and the accounting measurement of the revenues as well as the accounting disclosure of the revenues according to ifrs 15. as well as the basics, practical and principles of the ifrs 15 and the obstacles that prevent the jordanian industrial corporations from applying the ifrs 15 will be studied. the remaining parts of this paper are organized as follows: section 2 and 3 presents a review of the recent, related literature and the research theoretical framework. section 4 highlights the research design and the hypothesis building while section 5 describes the research methodology. then, the last section lists the major findings of this study and discusses them and underlines the main conclusions of the present study and gives few recommendations. 2. literature review khamis (2016) "perception of preparers and auditors of revenue from contract with customer (ifrs 15): evidence from egypt", the main aim of this study was to check the differences between preparers and auditors in their observations of level of standard clarity, familiarity, and ease of application of ifrs 15 in various business segments in egypt. this case study was depending on (i) individual interviews with the contributors who were requested to apply ifrs 15 and (ii) a questionnaire for them to record their levels of understanding with the standard. the final sample of this study contained of 34 preparers and 31 auditors across various business segments and sectors in egypt. the study concluded that in common the egyptian auditors and accountants surveyed were not yet set to adopt ifrs 15 and that they did not have adequate knowledge about ifrs 15. the researcher highlighted a need to improve skills and knowledge of the employees and a need for continuing training and education to improve the knowledge of the employees of the new international financial reporting standards. benavides (2015) "flattening the revenue recognition standard" this study examined both the future and the current standards of the u.s generally-accepted accounting principles (gaaps) and discussed major areas of the new standard that will theatrically affect the financial reporting and processes sectors and segments of organizations. the researcher asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 378 supports that the push back of the actual date is a sigh of comfort for all organizations to be affected by the new standards. the researcher underlined that neither the boards nor those organizations to be affected by the new revenue recognition standard were actually ready to adopt it on its initial efficient date. there is additional interpretation needed from the boards regarding to complex areas of the standard, and the organizations requisite to manipulate their infrastructure in order to successfully implement that standard. kasztelnik (2015) “the value relevance of revenue recognition under international financial reporting standards” this research examined if there a main alteration in the value relevance of revenue recognition contents has occurred since adoption of the ifrs 15 in the united states. the study problem was the lack of recognizing of the value relation of revenue recognition under the ifrs and its application to influence the telecommunication industry. the results presented that revenue recognition in the public firms is value relation under the gaap and that it remains so after adoption of the ifrs and that this leads to an increase in the value relation in the future. lim et al. (2015) "perception of auditors and preparers of ifrs 15: evidence from malaysia" the main aim of the research was to check the differences between preparers and auditors in their levels of understanding, standard clarity, and ease of application across variance business segments and sectors in malaysia. the five-step revenue recognition model has moved from the concept of ‘risks and rewards’ presently in practice to the concept of ‘control’. this is predicted to have influence on industries, especially those including long-term contracts with customers, since the style and timing of revenue recognition may be influenced. this study provided an overview of the perceptions of malaysian auditors and preparers of the ifrs 15. results of the study showed that the malaysian accountants surveyed were not yet prepared to adopt the ifrs 15 and that they recognized that the standard is not easy to be implemented in various business sectors and segments. ismail (2014) “the regulation of financial reporting: ic 15 and revenue recognition for malaysian property developers” this research discussed the suggested ifric 15 in the context of malaysia’s financial reporting convergence trip for companies in the property improvement sector and segment. the sample consisted of 15 preparers and 15 auditors of financial reports of property makers. the study explored the change brought about when ic15 is adopted. the revenue recognition policy discovers in the annual reports of 113 property establishments presented that only 2 out of 133 establishments have adopted the suggested method in ifric15. this study contributed to the current discussion on convergence to ifrs and estimation of the benefits of convergence. dalkiliç (2014): “the real step in convergence project: a paradigm shift from revenue recognition to revenue from contracts with customers” the objective of this research was two-fold, the first is to highlight the background and the history of the new standard; and, the second is to produce some policy recommendations for establishments on making ready for new standard. results presented that industry-specific directing is missing. thus, the new approach is heavily depending on professional judgment and contract terms and conditions. in addition, the new procedures will implement to all things that record into contracts with asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 379 customers. that coming up with a mutual standard about revenue recognition is a main accomplishment for the standard producers, but for the company world the real work is fast oncoming. the first paragraph of the ifrs 15 establishes rules for reporting suitable information to users of financial statements about the amount, nature, uncertainty and timing of the revenue and cash flows growing from contracts of an entity with customers. mccarthy & mccarthy (2014): "financial statement preparers’ revenue decisions: accuracy in applying rules-based standards and the iasb-fasb revenue recognition model" the objective of this study was to check financial managers’ revenue decisions under a principles-based accounting standard in comparison to a rules-based accounting standard. this study experiment involved 127 experienced financial leaders with an average of 20 years of knowledge and experience. eighty-two percent of those financial managers were at the level of manager or above. the results indicated that implementing rules-based standards affords less precise revenue decisions than implementing principles-based accounting standard. furthermore, there was no statistically-significant variance in the amount of judgment requested between the subjects implementing rules-based standards and those implementing principles-based standards. hasanen et al. (2014): “a proposed model to address convergence determinants, ifrs and fasb: measurement and disclosure of revenue recognition: "the case of egypt" this study focused mainly on the convergence of revenue recognition from contracts with customers, which was started in june 2010 and has since then been improved using wide-ranging due process rules into a nearly-finished product. thus, this study demonstrated the effects of these convergence steps on the egyptian accounting determinants and practice. 3. theoretical framework this study framework is presented in the following sections: 3.1 the international financial reporting standards (ifrss) the standards are defined as general obligatory models that lead to direction and rationalization of the practical application in accounting, auditing, or review of the accounts. therefore, the standards differ from the procedures since the standards have the general obligation character while the procedures deal with the executive approach of these standards applied on certain empirical cases (al-gadi and hamdan, 2008). importance of the ifrss points in what follows (nawaal, 2011): 1) the ifrss contribute to the process of control and organization of the accounting practice. 2) presence of a subjective frame of the ifrss governs that the measurement and communication guarantees achieving the balance between the different interests of the users of the financial reports. 3) reliance on the ifrss has a gig and necessary importance in the shade of failure of the accounting theories about treatment that prepares the accounting alternatives at the level of the economic establishment. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 380 4) presence of the ifrss helps the professionals and these standards specify their reactions under certain conditions. in addition, these standards are counted as a defense upon presence of interferences from, or supervision by, external parties. one of the most significant factors that led to imparting importance and credibility to the ifrss is the recognizing memorandum which was signed by the iasb and the american fasb for combined cooperation to remove the disagreement and discrepancy between the iasb and the fasb, and from which numerous ifrss emanated. of these is the ifrs 15 (revenue from contracts with customers), which came as an alternative to the two international accounting standards ias 18 (revenue) and ias 11 (construction contracts) because of the difficulty of implementing them to recognition of revenue for the sophisticated and overlapping cases. this standard emerged as a combined project between the iasb and the american fasb to improve common requirements for the revenue topic that work on accomplishing the following objectives (ciesielski and weirich, 2011; holzmann and munter, 2014; khamis, 2016): 1. remove the several weaknesses and inconsistencies in current revenue requirements. 2. provide a stronger framework of supervision that will be useful in manipulating revenue recognition problems and issues. 3. enhance comparability of revenue practices among jurisdictions, entities, capital markets and industries. 4. presents more suitable information to users of financial statements through enhanced disclosure requirements. 5. simplify the preparation of the financial statements by decreasing the number of requests to that an entity necessity refers. 6. joining international and u.s standards on revenue recognition. the aim of ifrs 15 is to found the principles that an entity shall implement to report suitable information to users of the financial statements about the uncertainty, nature, amount of revenue and cash flows arising from a contract with a customer (ias plus). 3.2 the concept of revenue according to ifrs 15 accounting is connected with projects that are continuous in operation and production, and not with one economic activity, and it divides the activity of the project into time periods and in the meantime attempts to devote to each accounting period its revenues and expenses. the revenues are represented in cash inflows or in growth of the assets of the accounting unit or its fulfillment of its obligations through production and delivery of the commodities during a certain period since accounting recognizes the revenue of the financial period in an independent manner, then the expenses in this period are measured for the purpose of determining the amount of income during the accounting period (al-qashi and al-aqla, 2015). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 381 revenue is defined as the cash flows in flowing into the unit or any increase in its assets or settlement (reimbursement) of its discounts, or both, that result from production and sale of the goods and implementation of services for others or any other activities, which constitute the regular basic and continuous actions (al-shirazi, 1990). the revenue is recognized in full at the point of completing the selling and delivery, i.e., upon incidence of actual exchange between the accounting unit and the others. at that point in time, the important event has taken place in the revenue acquisition cycle for the majority of the accounting units. in the meantime, the selling and delivery process provides objective indicator for measuring the revenue for the majority of the units, and it is possible to determine the degree of certainty or uncertainty through the possibility of procurement (al-naqib, 2004). revenue is measured on the basis of the fair value of the return which is received or is receivable. the value of the revenue resulting from any operation is determined by agreement between the establishment and the buyer or the user of the asset, and it is measured by the fair value of the received or receivable return, taking into consideration any commercial discount or quantity discount which the establishment bestows (aburman, 2014). 3.3 the accounting requirements for revenue recognition and measurement according to the ifrs 15 the fundamental principle of the ifrs 15 stands on that the establishment recognizes the revenue of the contracts that include diversion of the goods for an amount that represents the return which the establishment is expected to get inn return of that good which is diverted to the customer. according to this standard, the basic principle for revenue recognition takes place through application of the steps of the five-step model framework. these five steps are the following (abu nassar and hamidat, 2016; robert, 2015; steele. 2012): step 1: identify the contract(s) with a customer this stage is considered as one of the accounting recognition stages as the contracts with the customers are considered as falling within the domain of this standard when they achieve all the following characteristics: consent of the contract parties on the terms of the contract, in writing or orally or according to the generally-accepted practices within the business sector. the potentials for determining the rights of the contract parties as regards the goods transferred from one party to another in the contract. it is possible to determine the settlement provisions that are relating to the good provided by the establishment to the customer. the contract has commercial substance. it is possible that the establishment procures the return as a result of the contract of selling the good, taking into consideration the ability and desire of the customer to pay back. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 382 step 2: identify the performance obligations in the contract this stage too is considered as one of the stages of accounting recognition. the establishment has at the beginning of the contract to evaluate the goods due to be presented to the customer according to the contract and determine them, considering them obligations that must be performed for the customer. the commodity is considered as distinguishable if the following two conditions are true: it is possible for the customer to benefit from the goods. commitment of the establishment to deliver a commodity that is identifiable to the customer independently of any other obligations or promises in the contract. step 3: determine the transaction price this stage is considered as one of the stages of accounting recognition where the transaction price, which is the return which the establishment is expected to get in return of the process of selling the commodity, represents the obligations of the establishment appearing in the contract. it is also taken into consideration the practices prevalent in the industry when determining the price of the contract. the return which the establishment is expected to get from the contract is influenced by several factors, including the changing return; presence of any funding element as a result of early settlement or a settlement paid in advance; presence of the non-cash return; and any return deserved by the customer. as when the contract includes receipt of a changing return the establishment assesses the return expected to be received within the terms of the contract which results from several factors, including presence of discounts or allowances for the customer; presence of incentives in the contract, or presence of fines on the establishment in the contract. the changing return which expected to be received is listed in the price of the transaction only to the extent when listing it in the price of the transaction is highly likely not to lead to substantial reduction in the revenue in the future periods upon demise of the cases of uncertainty. step 4: allocating the transaction price to performance obligations if the contract contained several items of revenue, then the establishment has to distribute the overall price of the transaction over those constituents proportionally on the basis of the separate selling prices for each item in the contract. if those prices were unknown and clearly specified, then the establishment has to evaluate them. when the return in paid in advance or lately, then the establishment has to determine if the contract does, or does not, contain funding arrangements. then, it is taken into consideration the time value of the period between the good and settlement of the recompense, and, consequently, considering any increase in the price of the operation over the cash selling price an interest revenue and any expenditure reduction as an interest. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 383 step 5-recognize revenue when the entity satisfies a performance obligation. revenue recognition takes place when the establishment performs the obligations and duties required from it through transferring the good to the customer. the transfer process occurs upon control of the customer over the asset and control over the revenue occurs either by passage of time (temporal basis), e.g., the rental income, or at a specified time point like selling of the ready commodity. 3.4 the accounting requirements for revenue disclosure according to ifrs 15 the goal of these disclosures is presenting information sufficient to enable the users of the accounting information to understand the nature and timing, amounts, and cases of uncertainty specific to revenue and the cash flows from the contracts with the customers. the ifrs 15 includes several disclosures that include (tysiac, 2014; tong, 2015; abu nassar and hamidat, 2016): 1) disclosing quantitative and descriptive information about the contracts with the customers, such as the amount of revenue recognized. the impairment losses acknowledged any contract assets. 2) the important provisions and the estimates on them when applying the instructions of this standard on the contracts with the customers. in consequence, the establishment has to disclose: timing of performance obligations and transaction price and amounts assigned to performance obligations. 3) any recognized assets resulting from the costs of gaining the contracts with the customers and accomplishment of those contracts. these include specification of: the amount of the costs incurred to get a contract with a customer. the method utilized for amortization. the closing stabilities of the contract assets. 4. research design and hypothesis building as was noticed in the literature review and the theoretical framework, many studies presented the ifrs no. 15 and the possibility of applying it in the different organizations. the study of lim et al. (2015) aimed to check the differences between preparers and auditors in their levels of understanding, standard clarity, and ease of application across variance business segments and sectors in malaysia. this is predicted to have influence on industries, especially those including long-term contracts with customers, since the style and timing of revenue recognition may be influenced. the same methodologies are used by khamis (2016) by checking the differences between preparers and auditors in their observations of level of standard clarity, familiarity, and ease of application of ifrs 15 in various business segments in egypt. ismail (2014) discussed the suggested ifric 15 in the context of malaysia’s financial reporting convergence trip for companies in the property improvement sector and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 384 segment. therefore, based on foregoing arguments and the literature reviewed in this work, the present study aims to explore the possibility for the jordanian industrial corporations to apply the ifrs no. 15 from the point of view of the financial reporting preparers. therefore, the researcher poses the following hypotheses: the first hypothesis (h1): it is not possible for the jordanian industrial corporations to commit to the requirements for revenue recognition according to the ifrs 15. the second hypothesis (h2): it is not possible for the jordanian industrial corporations to commit to the requirements for the accounting measurement of the revenues according to the ifrs 15. the third hypothesis (h3): it is not possible for the jordanian industrial corporations to commit to the requirements for the accounting disclosure of the revenues according to the ifrs 15. the fourth hypothesis (h4): there are no obstacles that prevent the jordanian industrial corporations from applying the ifrs 15. 5. research methodology this study employed a quantitative research methodology. it aims to explore the possibility for the jordanian industrial corporations to apply the ifrs no. 15 from the point of view of the financial reporting preparers 5.1 participants and sampling in this study, the researchers employed non-probability techniques to collect the study sample because according to this method the researchers could distribute questionnaire forms to financial reporting preparers in the jordanian industrial corporations. thus, by using this technique the researchers could select the sample in the most convenient way. the study population includes the industrial companies listed on the stock exchange market in the hashemite kingdom of jordan, which amounted to 64 companies during the period of the field study according to amman stock exchange market (asem). a random sample was taken, consisting of 100 individuals of the preparers of the financial reports for these companies. the questionnaire was distributed to those individuals. eighty-four questionnaire forms were responded to and retrieved. all of them were valid for performing the study on them. 5.2 procedures and data collection this study relied on the analytical descriptive approach and depended on two sources for data collection, which are primary and secondary data. saunders et al, (2007) defined the primary data as that data specifically collected for the research project being implemented. thereupon, researchers use distinct methods to collect data that can help them reach to relevant findings and conclusions. then, after the primary data have been collected they will be analyzed and distilled to make them useful such that the researchers can depend on their results to give appropriate, meaningful recommendations. for obtaining the primary data necessary for asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 385 testing the hypotheses, a questionnaire was developed and arbitrated. it was embodied with a set of questions related to the study questions. the questionnaire was distributed to the members of the study sample. descriptive statistics were employed to describe the study sample and the study hypotheses were tested using the one-sample t-test. in this study, both primary (self-completion questionnaire) and secondary data were employed. nonetheless, the researchers used qualitative and quantitative data. after the research data had been managed, they were analyzed using the statistical package for social sciences (spss) software. 5.3 measurement the questionnaire was designed such that it will provide information about the possibility for the jordanian industrial corporations to apply the international financial reporting standers (ifrs) no. 15 from the point of view of the financial reporting preparers. hence, feedback on the questionnaire is due to reflect the opinions of financial reporting preparers of the companies. the questionnaire used in the current study consisted of two parts: 1) demographic part, which sought information about respondent's academics qualification, scientific specialization, experience and follow up of ifrs no.15. 2) research part, which sought information about the possibility to apply the international financial reporting standers (ifrs) no. 15 for the jordanian industrial corporations. 6. data analysis and results this section presents results of analysis of the data collected using the questionnaire, which was addressed to financial reporting preparers in the jordanian industrial corporations. the aim of the questionnaire was to explore the possibility to apply the international financial reporting standers (ifrs) no. 15 for the jordanian industrial corporations. a sample of 100 individuals of the preparers of the financial reports were distributed. eighty-four questionnaire forms were responded to and retrieved. all of them were valid for performing the study. 6.1 normality test the researcher tested for normality of distribution of this research variables using the kolmogorov-smirnov test. the test outcomes (table 1) reveal that the study variables are normally distributed (kolmogorov-smirnov z = 1.084, p = .190). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 386 table 1. normality test. (one-sample kolmogorov-smirnov test) total n 84 normal parametersa,b mean 3.7143 std. deviation .54078 most extreme differences absolute .118 positive .118 negative -.071 kolmogorov-smirnov z 1.084 asymp. sig. (2-tailed) .190 a. test distribution is normal. b. calculated from data. 6.2 reliability test the internal consistency reliability was assessed using cronbach’s alfa coefficient as an indicator of the reliability of the questionnaire items in terms of that they measure the aspects they were designed to measure in the answers of the members of the study sample as well as the instrument as a whole. the results of this test are summarized by table 2. it is seen in table 2 that the values of cronbach’s alpha coefficient for the study domains and for the instrument as a whole are higher than 0.70. this indicates a high level of reliability of the research instrument, which means the possibility of depending on the questionnaire results and reassurance to its credibility in achieving the study goals. table 2. results of reliability analysis of the research instrument domain reliability coefficient requirements for recognition of revenue 0.81 requirements for the accounting measurement of the revenue 0.88 requirements for the accounting disclosure of the revenue 0.75 obstacles to application of the ifrs 15 0.84 the instrument as a whole 0.89 6.3 analysis of the characteristics of the study sample the sample study consisted of 84 employees of jordanian industrial corporations who were randomly selected from the study population. table 3 summarizes distribution of the sample members depending on their personal characteristics. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 387 table 3. distribution of the sample members based on their personal characteristics variable categories frequency percent academic qualification diploma-college 8 9.5% b.a 61 72.6 % m.a 11 13.1% ph.d 4 4.8% total 84 100% scientific specialization accounting 65 77.4% banking and financial sciences 9 10.7% business administration 8 9.5% other 2 2.4% total 84 100% experience in the field of work 5 years or less 20 23.8% 6 -10 years 43 51.2% 11 – 15 years 11 13.1% 16 years or more 10 11.9% total 84 100% follow-up of the ifrss issued by the iasb ongoing 40 47.6% medium 23 27.4% few 14 16.7% none 7 8.3% total 84 100% table 3 shows that: in terms of academic qualification, the highest number of respondents (72.6%) was people with b.a qualification while people with phd qualification were the lowest in number (4.8%). with respect to scientific specialization, the majority of the respondents (77.4%) were specialized in accounting whereas the lowest percentage was that of individuals specialized in business administration. as regards experience in the field of work, about half of the sample members (51.2%) had 6-10 years of working experience. meantime, the subject with having 16 years or more of working experience were the lowest in percentage (11.9%). regarding frequency of following up the ifrs, the relatively highest percentage of the respondents (47.6%) was for the individuals with ongoing follow up of these standards. individuals not following up these standards were the lowest in number (8.3%). 6.4 descriptive analysis tables 4-7 provide a description of each of the study questions, showing the mean, standard deviation, and rank of each individual question. the results listed in these tables are discussed asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 388 next. the respondents’ mean total score of agreement on compliance of the jordanian industrial corporations with the revenue recognition requirements of the ifrs 15 is high; 3.89. table 4 shows that the highest mean score was 4.35 for item 6, which states that revenue is recognized when there is a high degree of certainty that the economic benefits associated with the contract will flow to the company. meanwhile, the lowest mean agreement score (3.68), which is nonetheless high, was for item 3, which states that the company specifies the terms of payment for the goods and services transferred from the establishment to the customer. table 4. descriptive statistics for the questionnaire items related to compliance of the jordanian industrial corporations with the revenue recognition requirements of the ifrs 15. no items mean standard. deviation rank agreeme nt degree 1 the contract parties commit to implementing the terms of the contract, whether they are written or oral. 4.02 1.03 2 high 2 the company can determine the rights of each party regarding the goods and services transferred. 3.83 1.07 4 high 3 the company specifies the terms of payment for the goods and services transferred from the establishment to the customer. 3.68 1.09 7 high 4 the contract is classified in its essence as a commercial contract, which affects the timing and amounts of the cash flows for the contract. 3.69 1.17 6 high 5 the company procures the material return of the contract as a result of the sale of the goods taking into consideration the desire and ability of the customer to pay back. 3.90 1.06 3 high 6 revenue is recognized when there is a high degree of certainty that the economic benefits associated with the contract will flow to the company. 4.35 0.75 1 high 7 at the beginning of the contract, the company evaluates the goods it wishes to provide to the customer according to the contract, and which are considered as part of the fulfillment of the requirements of the contract. 3.73 1.15 5 high total means 3.89 0.49 high as table 5 demonstrates, the respondents’ mean total score of agreement on compliance of the jordanian industrial corporations with the accounting revenue measurement requirements of the ifrs 15 is high; 3.96. table 5 also shows that the respondents’ highest mean agreement score (4.42) was for item 4, which states that the establishment recognizes the revenue from the sale of goods upon transfer of control over the goods from the establishment to the customer. alternatively, the lowest agreement score (3.60) was reported for the fifth item, which states that when there is a total discount, it is distributed over the items of the contract on the basis of the selling price and in a proportional way. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 389 table 5. descriptive statistics for the questionnaire items related to compliance of the jordanian industrial corporations with the accounting revenue measurement requirements of the ifrs 15. no items mean standard. deviation rank agreement degree 1 the practices prevailing in the industry are taken into consideration when determining the price of the contract 3.99 1.00 3 high 2 when the payment is deferred, the revenues from sale of the goods are recognized on the cash sale price and the increase is treated as interest revenue. 3.90 1.07 4 high 3 when the contract includes receipt of a changing return, the company estimates the return and lists it within the transaction price to some extent. 3.67 1.08 5 high 4 the establishment recognizes the revenue from the sale of goods upon transfer of control over the goods from the establishment to the customer. 4.42 0.73 1 high 5 when there is a total discount, it is distributed over the items of the contract on the basis of the selling price and in a proportional way. 3.60 1.13 6 medium 6 the establishment distributes the total transaction price if the contract includes a total of revenue on the basis of separate selling prices for each revenue item. 4.19 0.83 2 high total means 3.96 0.78 high the statistical analysis results given in table 6 bring to light that the sample members’ overall total score of agreement on compliance of the jordanian industrial corporations with the accounting disclosure requirements of the ifrs 15 is medium (2.94). additionally, this table points out that the respondents’ highest mean agreement score was medium (3.02) and related to the fifth item, which states that the establishment provides quantitative and descriptive information on any recognized assets resulting from the costs of obtaining and accomplishing contracts with customers. on the other hand, the lowest mean agreement score (2.56) was medium and associated with item 7 (the entity shows information about the performance obligations arising from contracts with customers). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 390 table 6. descriptive statistics for the questionnaire items related to compliance of the jordanian industrial corporations with the accounting disclosure requirements of the ifrs 15. no items mean standard. deviation rank agreement degree 1 the establishment shows the revenues from contracts with customers separately from the other sources of revenues for the establishment. 3.63 1.22 1 medium 2 the establishment discloses the nature, timing, amounts, and cases of uncertainties of related to revenue and the cash flows from the contracts with customers. 2.80 1.14 5 medium 3 the establishment provides quantitative and descriptive information about its contracts with the customers and the methods used to recognize the revenue. 3.01 1.08 3 medium 4 the establishment provides quantitative and descriptive information about the important rules and evaluations which affect determination of the timing and amounts of revenues from contracts with the customers. 2.88 1.17 4 medium 5 the establishment provides quantitative and descriptive information on any recognized assets resulting from the costs of obtaining and accomplishing contracts with customers. 3.02 1.24 2 medium 6 the establishment presents the opening and closing balances of the accounts receivable, assets, and liabilities arising from contracts with customers. 2.69 1.21 6 medium 7 the entity shows information about the performance obligations arising from contracts with customers. 2.56 1.17 7 medium total means 2.94 0.75 medium the outcomes of statistical analysis displayed in table 7 disclose that the respondents’ overall total score of agreement on the items pertaining to obstacles to application of the ifrs 15 by the jordanian industrial corporations is high (4.17). moreover, table 7 points out that the sample members expressed the highest level of agreement (4.4) with the fourth listed obstacle, that is, management's lack of awareness of the importance of the ifrss and the improvements on them. meanwhile, the lowest mean level of agreement, which too was nonetheless high (3.96), was associated with the fifth listed obstacle, namely, inadequacy of the training programs held in the domain of the ifrss and the most important amendments to them. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 391 table 7. descriptive statistics for the questionnaire items related to the obstacles to application of the ifrs 15 by the jordanian industrial corporations no items mean standard. deviation rank agreement degree 1 unavailability of the scientific and practical qualifications sufficient for the employees of the financial department in the industrial companies. 4.10 0.96 4 high 2 difficulty in understanding and interpreting the requirements of ifrs 15. 4.12 0.97 3 high 3 there are no sufficient accounting systems to facilitate the application of the accounting treatments specific to revenue from contracts with customers. 4.38 0.88 2 high 4 management's lack of awareness of the importance of the ifrss and the improvements on them. 4.40 0.79 1 high 5 inadequacy of the training programs held in the domain of the ifrss and the most important amendments to them. 3.96 1.11 6 high 6 lack of adequate penalties by the financial market regulators in the case of non-commitment to application of the ifrss. 4.05 1.09 5 high total means 4.17 0.72 high 6.5 hypothesis testing the first hypothesis (h1): it is not possible for the jordanian industrial public corporations to commit to the requirements for revenue recognition according to the ifrs 15. this hypothesis was tested using the one sample t-test. the testing results (table 8) uncover that the calculated t value is 16.414 and that it is statistically significant (p = 0.000). hence, the null hypothesis is rejected whereas the alternative hypothesis is accepted. this finding leads the researcher to the conclusion that it is possible for the jordanian industrial corporations to commit to the requirements for revenue recognition according to the ifrs 15. table 8. results of the one-sample t-test of the first hypothesis mean std. deviation fd t. value sig result of the null hypothesis h1 3.89 0.49 83 16.414 0.000 rejected the second hypothesis (h2): it is not possible for the jordanian industrial corporations to commit to the requirements for the accounting measurement of the revenues according to the ifrs 15. much like in the case of the first hypothesis, the researcher tested soundness of the second hypothesis by using the one sample t-test. the outputs of this test (table 9) reveal that the calculated t value is 11.342 and that it is significant statistically (p = 0.000). accordingly, the null hypothesis is rejected in favor of the corresponding alternative hypothesis, which is asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 392 accepted. on account of this, the researcher conclude that is possible for the jordanian industrial corporations to commit to the requirements for the accounting measurement of the revenues according to the ifrs 15. table 9. results of the one-sample t-test of the second hypothesis mean std. deviation fd t. value sig result of the null hypothesis h2 3.96 0.78 83 11.342 0.000 rejected the third hypothesis (h3): it is not possible for the jordanian industrial corporations to commit to the requirements for the accounting disclosure of the revenues according to the ifrs 15. table 10 presents the results of the one-sample t-test of the third hypothesis. it was found that the calculated t value is – 0.709 and that it is statistically non-significant (p = .480). based on this, the null hypothesis is accepted while the associated alternative hypothesis is rejected. consequently, the researcher conclude that it is not possible for the jordanian industrial corporations to commit to the requirements for the accounting disclosure of the revenues according to the ifrs 15. table 10. results of the one-sample t-test of the third hypothesis mean std. deviation fd t. value sig. result of the null hypothesis h3 2.94 0.75 83 -0.709 0.480 accepted the fourth hypothesis (h4): there are no obstacles that prevent the jordanian industrial corporations from applying the ifrs 15. outcomes of the one-sample t-test of the fourth hypothesis are provided by table 11. the researcher find that the calculated t value is 14.857 and that it is statistically significant (p = .000). the null hypothesis is therefore rejected and the concomitant alternative hypothesis is accepted. in consequence, the researcher reach to the conclusion that it is are obstacles that prevent the jordanian industrial corporations from applying the ifrs 15. table 11. results of the one-sample t-test of the fourth hypothesis mean std. deviation fd t. value sig. result of the null hypothesis h4 4.17 0.72 83 14.857 0.000 rejected 7. conclusions and recommendations in view of the study findings, the researcher concludes the following: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 393 it is possible for the jordanian industrial corporations to commit to the requirements for revenue recognition according to the ifrs 15. based on that, the contract parties will abide by specification and execution of the contract provisions, whether they were written or oral, and specification the obligations due to be implemented according to the contract. it is possible for the jordanian industrial corporations to commit to the requirements of the accounting measurement of the revenues according to ifrs 15, and, in consequence, determine the price of the transaction through the return which they will get and distribute the transaction price over the components of the contract. it is not possible for the jordanian industrial corporations to commit to the requirements for the accounting disclosure of the revenues according to the ifrs 15, since they do not adequately disclose the quantitative and descriptive information on the contracts with the customers as well as the important provisions and appraisals of them when applying the instructions of this standard. there are obstacles that prevent the jordanian industrial corporations from applying the ifrs 15. of these obstacles are (i) the difficulty in understanding and explaining the requirements of this standard; and (i) the lack of adequate accounting systems that facilitate application of the accounting treatments specific to the revenues according to this standard. in view of the study recommendations, the researcher recomended the following: encouraging the corporations to commit to the requirements for revenue disclosure according to the ifrs 15 in such a way as to foster trust of the users of the accounting information in the financial reports. encouraging the corporations to provide sufficient accounting systems that facilitate application of the accounting treatments specific the ifrs 15. the financial market regulators are due to encourage the corporations to commit to application of the standards of the international financial reporting standards and to impose sufficient penalties in the case of non-compliance. encouraging the corporations to provide accounting and financial cadre that is competent, qualified, capable, and with good knowledge of the measurement and recognition of the revenue generated from the income in the companies. organizing training programs for the employees of the financial administrations in the jordanian corporations on application of the international financial reporting standards and the accounting measurement methods, especially as regards the ifrs 15. references abu nassar, mohammed, & hamidat juma. (2016). international accounting and financial reporting standards, dar wael, third edition, amman-jordan. aburman, shadi, & abdel latif. (2014). impact of revenue recognition standard on the accounting problems in the jordanian construction companies. unpublished master’s thesis, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 394 amman arab university, jordan. al naqib, kamal, & abdul aziz. (2004). introduction to accounting theory. amman: dar wael publishing alqadi, hussein, & hamdan, mamoun. (2008). international accounting and standards, amman-jordan, dar al-thaqafa for publishing and distribution, first edition. al-qashi, thaher shaher, & al-aqla, mohammed mansour. (2015). the impact of compliance of revenue recognition principle on the problems of measuring income resources in arab satellite channels. algerian journal of accounting and finance, 1. al-shirazi, abbas. mahdi. (1990). introduction to accounting theory. kuwait: al-sallas for printing and publishing. amman stock exchange. (2017). http://www.ase.com.jo/ar/equities, 15/2. benavides, luis. (2015). flattening the revenue recognition standard. ssrn 2597787. 28 apr. https://doi.org/10.2139/ssrn.2597787 ciesielski, jack. t., & weirich., thomas. r. (2011). convergence collaboration: revising revenue recognition. management accounting quarterly, 12(3). dalkiliç, ali fatih. (2014). the real step in convergence project: a paradigm shift from revenue recognition to revenue from contracts with customers. international journal of contemporary economics and administrative sciences, 4(3-4), 67-84. hasanen, mostafa, hamed, sadek, & abo talib, mohamed. 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(2016). perception of preparers and auditors on revenue from contract with customer (ifrs 15): evidence from egypt. 35th international business research conference 30 31 may 2016, american university in the emirates, dubai, uae. saunders, m., lewis, p., & thornhill. (2007). a. research methods for business students, fourth edition. essex, england: person education limited. lim, y., devi, s. s., & mahzan, n. (2015). perception of auditors and preparers on ifrs 15: evidence from malaysia. advanced science letters, 21(6), 1781-1785. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 395 https://doi.org/10.1166/asl.2015.6212 mccarthy, m., & mccarthy, r. (2014). financial statement preparers’ revenue decisions: accuracy in applying rules-based standards and the iasb-fasb revenue recognition model. journal of accounting and finance, 14(6), 21. robert a. (2015). case studies in the new revenue recognition guidance. the cpa journal, 85(3). sabayhi, nawal. (2011). the effect of accounting disclosure under international accounting standards (ias) and its impact on information quality", unpublished master’s thesis, university of algiers, algeria. steele, c. a. (2012). the convergence of us gaap and ifrs: revenue recognition. honors theses, paper 87. tong, tan liong. (2015). a review of ifrs 15 revenue from contracts with customers. see more at: http://www.masb.org.my/pdf.php?pdf=2014-095%20review%20of%20ifrs%2015%20(tl t).pdf&file_path=pdf tysiac, ken. (2014). substantial new disclosures required by revenue standard. microsoft word 13039-47629-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 257 factors affecting learning performance of accounting information system yung-yu lai department of business administration, overseas chinese university no.100, chiao kwang rd., taichung, taiwan r.o.c. tel: 886-92-819-5897 e-mail: caesar@ocu.edu.tw an-an chiu(corresponding author) department of international business, feng chia university no. 100, wenhwa rd., taichung, taiwan r.o.c. tel: 886-910045312 e-mail: ananchiu2009@gmail.com received: april 7, 2018 accepted: may 17, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.13039 url: https://doi.org/10.5296/ajfa.v10i1.13039 abstract due to the advancement of computer and information technology (it), integrating the information and computing technology into the accounting curriculum is one of the critical issues. this paper discusses whether the learning attitude towards information technology and the major in which these students enrolled will affect their respective learning performance based on testing results obtained from the questionnaire of the accounting information system contest. important findings include the following items: 1) different learning attitude may affect the learning performance; 2) there is a significant difference in terms of the subjects of academic content and associated skills in the contest for the participated candidates enrolled in different majors. from the results, it is notable that academic institutions should train instructors to help students develop better critical and creative skills required for pursuing their future profession and redesign the curriculum to integrate more relevant, practical skills in the emerging technology and accounting knowledge areas. in addition, businesses should provide distinctive job training for employees from/with different education backgrounds to help them become more quickly adapted to the job. keywords: accounting information system, information technology (it), learning attitude, learning performance asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 258 1. introduction nowadays, information technology (it) tops the agenda of almost every college and university due to the predictions of and irresistible changes in a technologically advancing society (milligan, 2010).moreover, aggressive it utilization is viewed as a vital sign of a progressive institution. these rapid it advances have affected to all aspects of the business disciplines including the accounting profession. in specific, the influences of the nature of it on accounting practices may push the entire accounting education profession to reform its system to be in concert with the dynamic, computing changes. moreover, it is noted that computer skills have become the required skill for the practicing accountants (bouchard, 2005; kepczyk, 2005). to this end, the issue of integrating computer skills in accounting education has certainly been a continuing challenge and issue to discuss with professionals and educators (jones and abraham, 2007). although the application of information technology in assisting the learning outcome has proved to enhance the critical and creative thinking skill and develop a more global perspective (speaker, 2004), many students in accounting failed to learn to apply the needed computer skills as fast as students in other disciplines. this is simply because the attitude that these students may have while using information technology is a vital aspect of their use of technology (huffman et al., 2013).from the above discussion, the purpose of this paper is to investigate whether the learning attitude and the major in which these students enrolled will affect their learning performance of accounting information systems. most of the studies simply discussing the factors of influencing computer learning attitudes focused mainly on the subjects’ background variables or the relationships of students’ computer learning attitudes and their learning effectiveness. in specific, the subjects’ background variables may include gender, department majors, availability of computer facilities, and computer experiences. however, there were few studies emphasized on the relationships of learners’ learning attitudes and their learning motivation. accounting information is crucial for handling such tasks as decision making, record keeping, and discovery and prevention of theft. business school students need to receive the adequate accounting training at schools such as financial reports analysis and this mainly because the financial report is vital to all businesses in every industry. because of the development of information system technologies, the accounting information systems (ais)become indispensable in the business sectors. accounting information system not only provides added value to improve the product quality and reduce the cost but also offer in-time and relevant information. one important aspect of today’s workplace is that teams consist of a mosaic of interdisciplinary members with diverse functional areas as their primary responsibility. such teams are now at the core of handling such task as how work is accomplished in today’s corporations. thus, students should learn how to function effectively as members of interdisciplinary teams. as technology continues to subvert various business models, the application of it in all areas is no doubt the needed concept of/for cross-domain integration. this paper analyzes the results by collecting questionnaires from the candidates participating in the accounting information system contest to understand the key factors affecting asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 259 learning performance in the areas of the information system. in total, 88 candidates participated in the information skill contest in year 2010. among them, 36 had an information technology education background and it only accounts for around 40.91%. surprisingly, this number stimulates the authors’ curiosity whether the educational backgrounds of the participants (e.g., credits of accounting-related courses taken) make their learning performance different. further, this paper is interested in investigating which type of students will perform better in ais learning (e.g., those with an information technology background vs. those with an accounting background).further, it is interesting to uncover which stage does the difference mainly result from if the students’ performance does vary with various educational backgrounds? in other words, the authors want to locate these key factors in students’ learning so as to enhance the learning performance for the area of accounting information systems in the future. it is the authors’ attempt to uncover the complementary knowledge/skills needed to help these students with a prior information technology background and hence, assist them to actively learn the integrated ais subject knowledge and hence achieve the best educational outcomes. the result of this study could be useful and feasible for instructors in improving the learning quality of information systems courses, developing the corresponding curriculum,and understanding the key factors in improving the learning about the information system and related technologies. targeting business-related departments including accounting, business management, international trade, and data processing provide a clearer understanding of the students’ overall recognition and also provides a valuable opportunity to infer the insights for all students in a reasonable manner. it is expected that this study will provide information system learners without the sufficient relevant backgrounds with the key factors to be employed to overcome the educational difficulties and hence, improve their skills in adopting/utilizing the related systems. this study could also be used as an important guideline to enhance the learning effectiveness for students enrolled in accounting and/or information technology departments. 2. literature review 2.1 accounting information technology learning in the past few years, information technology has created a significant impact on business organizations. knowledgeable and skilled users are critical to the successful implementation and for maximizing the benefits to utilize information technology. consequently, universities and corporate training programs have incorporated learning information technology knowledge into the accounting curriculum and conducted the required training. it has been suggested that digital tools, combined with appropriate pedagogy, may have been the potential to address some of the issues commonly associated with education (ter vrugte et al., 2015). however, many authors propose that although the use of technology in classroom is increasing, the outcomes of its utilization do not live up to their perceived potential to enhance the learning experience research reveals that attitudes may form the foundations of one’s beliefs which influence one’s behaviors (ajzen & fishbein, 2000). it further proves that there are significant asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 260 relationships between attitudes and beliefs and between attitudes and behaviors. the positive attitude may create aninfluence on learning performance and learning motivation which are important for enhancing the learning outcome.if the students develop a positive attitude towards the use of computers in learning,they may try to make use of this technology often in learning and by doing so, it will make the learning process simpler and more effective. in the modern era, computer assists students to use/enhance their capability to assimilate, evaluate, and apply the available information. workman (2005) suggests that users with a favorable attitude towards a specific technology are more likely to use that technology. students’ learning attitude affects the learning performance (credé & kuncel, 2008).learning attitude is one of the import factors affecting learning performance (castillo-merino, & serradell-lópez, 2014). students’ academic achievement varies between public and private universities in taiwan (chen et al., 2010). for example, students enrolled in the public university are more active learners, such as asking teachers questions and discussing academic issues with peers, which contributes to a healthy learning culture and should therefore may create more impact on student academic achievement. in taiwan, public universities differ from private universities in terms of faculty quality, student quality and resource acquisition. not only do public universities have a higher percentage of faculty receiving a doctoral degree and a higher admission score requirement for incoming students, but they also have a better learning environment with more resources such as research facilities and computing support. in taiwan, public universities enjoy a more prestigious status than their private counterparts. students who studied in the public universities tended to use computers to fulfill more forms of various needs in their daily lives than their private university counterparts. further, the students in public universities may perform better in the computing knowledge test than the students in private universities. outstanding students with a good learning attitude prefer to choose the public university over the private university as their first choice in the admission or entrance exam. taking the difference in students’ quality into consideration, it is expected that there may exist a significant difference in their learning performance between the public and private university students in accounting majors. as a result, this paper suggests that the learning performance of students in accounting information system with different learning attitudes may be different. hypothesis 1: there is a significant difference between the learning attitude and learning performance of the accounting information system. prior researches (he & freeman, 2010; caputo, 2010) indicate that users’ backgrounds such as major subject area may affect their learning attitude towards information technology. students who major in science and technology area may possess a better information and computing literacy. in addition, respondents who have learned computing and information technology apparently have a lower anxiety than those who have no learning experience. the participants are mainly from the following four business-related majors including accounting, business management, international trade, and data processing. all curriculums of four aforementioned majors teach the related information system courses. further, it is asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 261 noted that the contents of the courses offered by accounting department are more professional and specialized by its nature. on the other hand, the department of data processing may focus more on gaining a deeper insight and having more sophisticated manipulation of information technologies. from above discussion, this research assumes that students from different majors may perform differently in their learning performance. hypothesis 2: there is a significant relation between the major and learning performance of the accounting information system. 3. research methodology 3.1 research data candidates may come from public and private vocational schools across the country. according to the statistics gathered by the ministry of education, 95 vocational schools had a business-related department in 2010. of those 95 schools, 88 signed up for the skill contest, which accounted for 92.63%. our questionnaires covered almost all the vocational school students across the country. further, the questionnaires were distributed to the candidates and their advisers at the point where the candidates completed their contest and in specific, they were actually collected right after the competition. in total, 38 questionnaires were received from 88 students, while 30 questionnaires were received from the advisors/instructors group who leads the same 88 students. the total of response questionnaires gathered was 68, with a response rate of 38.6%. a summary of the aforementioned statistics is shown in table 1. table 1. summary of questionnaires collection in the contest, there are 40 multiple choice questions with 2.5 points each; additional penalty marks are not taken off for the wrong answers. the total points are 100, which accounts for 50% of the total results of the entire competition. the contest is conducted in the second day and it is mainly the computer-based test focusing on the skill subjects, which accounts for the remaining 50% of the total results. candidates are asked to answer questions using the provided accounting information system example in the following order: (1) printing out the balance sheet before the company goes to a full computerization; (2) inputting entries and then printing out journals; (3) posting accounts and then printing out the general/subsidiary ledgers; and (4) printing out p&l and balance sheet accordingly. the result of the skill subject is calculated by points, which are converted into a hundred-mark system. the accounting information systems example used in the competition contest is a stand-alone version and has the general ledger accounts and purchase/sales/inventory modules. most students used “beyond” software (82), others used “es-ais” software (4) and “e-go” category number sent number of responses response rate students 88 38 43.2% instructors 88 30 34.1% total 176 68 38.6% asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 262 software (2) (note 1), and all of these aforementioned software are not erp systems. 3.2 .content of questionnaire there are three accounting and information technology questions and namely, they include the following items: 1. do you have a better understanding of practical accounting procedures after participating in this competition? 2. can this competition contest enhance your knowledge and skills to apply the information technologies? 3. do you understand better that the employed accounting information system example is implemented using a database system or software? the answers provided in the questionnaire are measured on a five-point scale. namely, 5 represents “strongly agree,” 4 indicates “agree,” 3 refers a “neutral,” 2 means “disagree,” and finally 1 stands for a “strongly disagree.”in order to get the necessary information for a further analysis, the respondents were asked to provide the following demographic information such as school, gender, department, and status as a student or an adviser. 3. data analysis methods the purpose of accounting education is mainly to teach students the basic knowledge and professional techniques about accounting matters and thus provide the adequate training on related accounting skills to pursue the future career in this subject field. accounting information system contest was first organized at taiwan in 1954. this contest highlights the value to improve the vocational learning performance among different schools. through a competition and observation of each other's performance, the contest, in fact, motivates the participating schools to strengthen the value of vocational education and thus, improve their students' learning in terms of specialized skills such as accounting. accounting information system contest is a competition associated with the integration of accounting and information technology knowledge and skills/capabilities. as noted earlier, students with a different learning background may have their own learning process about accounting and information technology knowledge. for example, students studying in the department of accounting may have a better understanding toward the accounting-related knowledge and skills while those studying in the department of data processing or information technology may have a good knowledge in terms of the information and computing technologies. consequently, there maybe some variation occurred from the different study areas, courses, and curriculum which may affect students’ corresponding learning processes, and thus their learning outcomes. to discover the critical differences among the students from different departments and/or programs will certainly enhance the learning performance in this subject area. moreover, by studying, understanding and then improving these potential problems identified, students from the department of data processing or information technology can thus, maintain a balance and healthy integration of accounting and information technology knowledge and hence avoid the over-reliance on their asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 263 operational skill of information technology to acquire, manipulate, and sometimes misuse the professional knowledge they need in the future career related to accounting information systems during their learning period. on the other hand, the students from the accounting department may also be able to learn more information system and technology knowledge even if they lack sufficient information system and technology background, prerequisite, and/or adequate capability which will affect the resulting learning performance in the area of ais. respondents are categorized by either public school or private school groups to conduct the analysis. in addition, respondents are divided into four categories based on their majors including business management, international trade, accounting, and data processing. this research employs a one-way analysis of variance to analyze whether there is any difference among the aforementioned groups in terms of the academic performance. this study will next analyze each result in terms of the following items in terms of the skill subjects: “opening balance sheet,”“journals,”“general (subsidiary) ledger,”“profit and loss,” and “closing balance sheet.” lastly, this study analyzes and discussed if there exists any difference in the total result. with regard to information technology knowledge cognition, this research also divides the students into three groups according to the top, middle, and low achievement performance in terms of the academic background and skill subjects and then analyzes by using one-way anova. students and instructors/advisors are analyzed to understand if they have a similar recognition in terms of the information technology knowledge. f-test is employed to identify whether different results will lead to differences in recognition of skill contest and information technology knowledge. 4. empirical analysis results and discussion the number of candidates participating in the skill contest in 2010 was 88. the descriptive statistics results are presented in table 2.the mean for these academic subjects is 45.085 and is transformed to 50.852after converting it into using a hundred-mark system. in addition, the lowest total score is 11, while the highest one is 85, and consequently, the average is 50.852. further, 45 of the research subjects came from public schools, which accounts for 51.1% of the total participants. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 264 table 2. descriptive statistics of participants’ results n minimum maximum mean standard deviation subject result 88 10 73 45.085 13.199 opening balance sheet 88 0 23 20.932 5.177 journals 88 0 69 34.602 18.069 general (subsidiary) ledger 88 0 61 31.932 22.105 profit and loss 88 0 15 5.330 3.865 closing balance sheet 88 0 21 10.250 5.102 total scores for skill subjects 88 0 182 103.045 45.535 converted scores 88 0 100 56.618 25.019 total scores 88 11 85 50.852 17.287 public 1/private 0 88 0 1 0.511 0.503 this research adopts cronbach’s α coefficient approach to verify reliability and measure the internal consistency. in general, if the coefficient α is greater, the reliability is higher. further, α value which is greater than 0.7 means a very high reliability; a value between 0.5 and 0.7 is considered to be acceptable; and a value which is lower than 0.35 should be rejected. a structural reliability analysis is conducted on each factor, and cronbach’s α obtained is 0.836. it is also noted that α coefficient of each factor is greater than 0.7 and thus it shows the good reliability. the validity of this study is measured by using pearson and spearman coefficients as shown in table 3. the following proposed questions are positively correlated and reach the significance level at 1%. namely, these questions include “you have a deeper understanding of the practical accounting procedures after participating in this competition;” “this competition can enhance the knowledge in the area of information technology;”“this competition can enhance the knowledge in understanding more information technology;” and “i understand accounting information system in this test is operated by a database system/software.” as for the skill contest results, variables of each contest subjects are positively correlated and reach a significance level of 1%. namely, these variables are selected from the academic content such as opening balance sheet, journals, general (subsidiary) ledge, profit and loss, closing balance sheet and also included the following two items total scores for skill subjects and total scores. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 265 table 3. pearson and spearman correlation coefficient matrix q1 q2 q3 subject results opening balance sheet journal s general (subsidiar y) ledge profit and loss closing balance sheet total scores for skill subjects total scores q1 1 0.357** 0.071 -0.112 -0.130 -0.199 -0.084 0.093 0.078 -0.102 -0.092 q2 0.390** 1 0.403** -0.195 -0.073 -0.133 -0.312** -0.016 0.022 -0.227 -0.211 q3 -0.035 0.312** 1 0.052 0.035 0.149 -0.135 0.106 0.125 0.021 0.026 subject results -0.108 -0.203 0.077 1 0.425** 0.782** 0.665** 0.606** 0.690** 0.807** 0.916** opening balance sheet -0.113 -0.045 -0.012 0.354** 1 0.514** 0.343** 0.506** 0.497** 0.502** 0.510** journals -0.197 -0.187 0.136 0.757** 0.435** 1 0.712** 0.635** 0.763** 0.891** 0.898** general (subsidiary) ledge -0.048 -0.334** -0.083 0.646** 0.366** 0.667** 1 0.529** 0.605** 0.914** 0.849** profit and loss 0.061 -0.064 0.145 0.625** 0.419** 0.584** 0.554** 1 0.808** 0.743** 0.739** closing balance sheet 0.089 -0.073 0.054 0.708** 0.468** 0.689** 0.620** 0.770** 1 0.814** 0.824** total scores for skill subjects -0.098 -0.256* 0.033 0.785** 0.526** 0.895** 0.906** 0.716** 0.798** 1 0.967** total scores -0.107 -0.250* 0.052 0.911** 0.488** 0.890** 0.854** 0.719** 0.807** 0.971** 1 remarks:1. q1:you have a deeper understanding in practical accounting procedures after participating in this competition. 2. q2:this competition can enhance the knowledge in understanding information technology. 3. q3:i understand accounting information system provide in this test is operated by a database system or software. 4. top right corner of the diagonal shows spearman rank correlation coefficient and bottom left one shows pearson product-moment correlation coefficient. 5. figure in brackets represents the probability value (p-value) of two-tailed. ** means a significance level at 1%. * means a significance level at 5%. table 4presented below shows the results of academic knowledge and related it skill contest for both public and private schools. in specific, 45 students are from public schools, while the other 43 students are from private schools. in terms of the academic knowledge results, the f-value obtained from one-way anova is 2.325 and the p-value is 0.131. these results indicate that no difference exists between the public and private schools. further, this finding tends to justify the fact that students’ educational backgrounds do not affect their performance in terms of academic subjects. this research further analyzes the skill subject scores for each accounting subject matter. no difference is found in “opening balance sheet” scores between public and private schools. however, the mean score of “starting from completing transaction entries and printing out journals” for the public-school students is 38.600.consequently, this performance from the public schools is better than the results obtained from their counterparts (mean 30.419, p value 0.033). this difference between these aforementioned two groups (public vs. private schools) reaches a significant level. the mean score of “general (subsidiary) ledger” for public school students is 36.244, which is also better than the mean of private school students (mean27.419, p-value0.061). the difference between these two aforementioned groups also reaches a significant level. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 266 moreover, the mean score of “profit and loss” for public school students is 6.111, which surpasses the mean scores of private school students (mean4.512, p-value 0.052) and this difference also reaches a significant level. the mean of “total points for skill subject” from public school students is 113.133, which also surpasses the mean scores from private school students (mean92.488, p-value 0.033). this difference existed between two groups reaches also a significance level. finally, combining the results of both academic and skill subjects, the total mean score (with a 50% each for both academic subjects and skill subjects after converting them with a hundred-mark scale) for public school students is 54.664,which far exceeds the mean(46.862)of the private school students. moreover, f-value from anova is 4.667 and p-value is 0.034; and this means that the result difference between the public and private schools is significant. the results of skill subjects are affected by the difference between students in public and private schools and this difference mainly comes from the capability of preparing journal entries. table 4. analysis of difference between public and private schools’ results in the accounting information system contest detail group number mean f-test significance subject results private 43 42.907 2.325 0.131 public 45 47.167 opening balance sheet private 43 20.535 0.491 0.485 public 45 21.311 journals private 43 30.419 4.700 0.033 public 45 38.600 general (subsidiary) ledge private 43 27.419 3.611 0.061 public 45 36.244 profit and loss private 43 4.512 3.892 0.052 public 45 6.111 closing balance sheet private 43 9.605 1.351 0.248 public 45 10.867 total scores for skill subjects private 43 92.488 4.713 0.033 public 45 113.133 total scores (skill subjects 50%、 academic subject50%) private 43 46.862 4.667 0.034 public 45 54.664 the skill contest part only involves some basic daily/routine operations of the ais, such as opening accounts, daily transactions, and printing statements. as noted, completing accounting entries requires a higher specialized knowledge in accounting. this study finds out that the difference existed between the groups of public and private schools is in the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 267 category of “journals.”the possible reason may be the different type of schools and the students’ personality. the difference of students’ academic achievement between public and private universities in taiwan is huge. students enrolled in the public university are usually more active learners than those in private university in many ways. for example, actively asking teachers questions and discussing academic issues with peers which make up for learning attitude, contribute to a healthy learning culture, and therefore may create more impact on the student academic achievement. because of the huge difference in learning attitude, it is expected that there may exist a significant difference in their learning performance between the public and private university students. as a result, this paper suggests that the learning performance of students with different learning attitudes may be different. as previously reported, there are in total 88 students participating in the accounting information system contest. two are excluded due to the insufficient and incomplete data. as a result, a total of 86 students is analyzed in this paper. table 5 analyzes the performance of students with different major participated in the skill contest. in specific, 27 students major in business management, 13 students are from international trade, 10 students with a major in accounting, and finally, 36 students are in data processing area. candidates from the department of data processing have the highest ratio, which accounts for41% of the total participants. in terms of academic performance, the department of accounting obtained the highest scores (mean53.750), followed by the department of international trade (mean51.154) and the department of business management(mean45.556), while the lowest one is the department of data processing (mean 40.139). the f-value from one-way anova is 3.368, while the p-value is 0.013.these results indicate that the difference existed among various majors may reach a significant level. in other words, it implies that students from different departments may have distinct differences in terms of their performance in the accounting information system contest. in fact, students from the department of accounting excel in the academic subject. the major justification for this aforementioned fact could be their better understanding of accounting knowledge and also because of the fact that more accounting-related courses offered in their department. in terms of skills results, there is no dramatic difference exists among different departments. the mean of “journal” item is 48.000 in department of accounting, 43.154 in department of international trade,35.889 in department of business management, and finally 26.667indepartment of data processing. the f-value from one-way anova is 4.513 and the p-value is 0.002. thus, the difference in journals task reaches a significant level. the possible reason may be that accounting activities are composed of a series of processes and the different practices/protocols may also exist in handling the following tasks such as subsidiary ledger, profit, and loss, closing balance sheet; and consequently, the total scores of skill subject may vary. the f-value obtained from one-way anova is 5.031 and the p-value is 0.001, which justify that there is a difference. it is obvious that students from department of accounting may perform better than those from department of data processing. it in asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 268 education may encompass the complex processes to be engaged in by both individuals and organizations. learning information technology is one of the ways to cultivate logical thinking and problem-solving ability. but there is a need for mastering interdisciplinary subject areas such as accounting and information technology to reinforce the employment of it students. school can push students to build their own interdisciplinary pathway by choosing courses which make sense to them. as a result, having a double major or adding the additional minor in accounting since the goal of these it-related departments is quite different in preparing the students' future career. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 269 table 5. analysis of differences among department’s result in the accounting information system contest major number mean f-test significance subject results business management 27 45.556 3.368 0.013 international trade 13 51.154 accounting 10 53.750 data processing 36 40.139 opening balance sheet business management 27 21.444 0.569 0.686 international trade 13 20.692 accounting 10 22.600 data processing 36 20.111 journals business management 27 35.889 4.513 0.002 international trade 13 43.154 accounting 10 48.000 data processing 36 26.667 general (subsidiary) ledge business management 27 33.815 2.857 0.029 international trade 13 36.000 accounting 10 47.500 data processing 36 24.139 profit and loss business management 27 5.259 3.154 0.018 international trade 13 6.769 accounting 10 8.000 data processing 36 4.000 closing balance sheet business management 27 10.630 2.724 0.035 international trade 13 11.231 accounting 10 13.800 data processing 36 8.500 total scores for skill subjects business management 27 107.037 4.382 0.003 international trade 13 117.846 accounting 10 139.900 data processing 36 83.417 total scores business management 27 52.184 5.031 0.001 international trade 13 57.952 accounting 10 65.309 data processing 36 42.986 table 6 below can be used to provide some additional details. in terms of the question“can this competition enhance the information technology knowledge?” the anova results for students in the “low,”“middle,” and “high” categories do not reach the significant level. as for the advisors/instructors, the f-value is 6.021 and the p-value is 0.007 and these facts asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 270 indicate that the significant level is reached. this finding implies that different groups will affect the recognition of enhancing the information technology knowledge. the mean score of the questionnaires answered by the low achievement students is 4.100 while the means of questionnaires answered by the middle and high achievement students are 3.800 and 3.000, respectively. instructors/advisors under the low achievement student category tend to agree with their group of students. however, it is interesting to note that the instructors of the high achievement students tend to be neutral. furthermore, instructors with better performance results can deliver the adequate information technology knowledge to their students. instructors assisting the accounting information system contest will have a true understanding of the extent and subject content of information technology knowledge associated with the competition contest. comparing with students, instructors may view this contest as a more useful tool to know students’ ability to design the suitable course. for this reason, they can deliver and teach the relevant information to the candidates in a timely manner to avoid any misunderstandings in learning and also apply the needed information technology knowledge. table 6. analysis of the students and instructors’ recognition of information technology knowledge in the accounting information system contest identity score numbe r mean f-test significance 1. you have the deeper understanding of practical accounting procedures after participating in this competition student low 13 3.769 0.974 0.388 middle 12 3.250 high 13 3.615 instructor low 10 3.600 1.136 0.336 middle 10 3.900 high 10 3.300 2. this competition can enhance the knowledge in information technology student low 13 3.769 0.107 0.899 middle 12 3.667 high 13 3.615 instructor low 10 4.100 6.021 0.007 middle 10 3.800 high 10 3.000 3. i understand accounting information system is operated by the database system student low 13 3.615 0.664 0.521 middle 12 3.917 high 13 3.923 instructor low 10 3.900 0.664 0.523 middle 10 3.900 high 10 3.600 5. conclusions and future implications prior researches (huang et al., 2014) about learning performance of information systems mainly focus on systems and/or applications such as e-mail, internet, and word processing or asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 271 the learning attitude mainly towards erp adoption and/or implementation. in addition, most research (zhang et al., 2013; he & yen, 2014)samples are rather limited to specific groups. there has been relatively little research and/or studies emphasizing the factors affecting learning performance of young students studying the subject of accounting information systems in the elementary level of the professional/vocational schools. these students, with the capability of handling accounting information systems related tasks, are the major resources as a professional accounting staff to enterprises in the future. by understanding the factors of learning performance for vocational school students, this paper expects to be served as a critical reference for educational institutions in the area of information system and accounting fields. secondly, the findings of this paper can be utilized to improve some research gaps that exist in current teaching methods and pedagogies in it area. there are certain differences that may exist during some phases of the learning process of the information system education for students with various backgrounds. instructors also have different recognition in terms of information technology, which will/may affect the learning results of their students. after an analysis, this study uncovers that the learning performance of students in private school is insufficient, because of their learning attitude. as a result, this finding indicates that students may have a poor performance from private schools than that of the students from public schools. private school students shall strengthen their capability in the area of basic accounting in the future, which will further benefit their learning performance in the area of the information system by understanding the underlying accounting concepts. as for the learning backgrounds of candidates, there is a significant difference among the associated departments in the school. empirical results also show that different departments have a dramatic difference in terms of the coverage of the relevant academic and skill subjects. students who performed the best are mainly from the department of accounting, department of international trade, department of business management, and department of data processing. since the mean is lower than that of the average, coming from different departments may have a significant influence on the results. students from departments that are outside of accounting should considerably strengthen the coverage in the relevant courses to improve their basic accounting knowledge. it is highly suggested that people who intend to work in an accounting information field start their learning from the basic accounting concepts instead of the skills of information technology in order to enhance their resulting learning performance and improve the competitiveness. after a further analysis, it is notable that the major reason for the difference is mainly their professionalism in accounting knowledge, not from the lack of skill in information technology. furthermore, the results obtained in the skill contest do significantly affect the cognition of information technology. this paper evaluates a student’s learning performance using the fair and objective scores obtained in the skill contest organized by the government to analyze the possible obstacles to affect the learning in the accounting area. accounting information system contest conducted every year is an important activity for continuously improving the relevant accounting curriculum of the vocational education in taiwan. the organizing agents should review the exam questions strictly to guarantee the fairness of the contest, which is a critical component asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 272 to encourage the students’ participation, competition, and make future skills’ improvements. in addition, how to integrate the it knowledge and/or skills embedded in the accounting area and examine the content of the accounting courses offered by the vocational schools in different programs/departments and enhance the practices to improve the capabilities required in job market would be an important issue that deserves to be taken into account seriously by the educators in accounting and other related fields. from the results, academic institutions should train instructors to help students develop critical thinking skills affecting the skill test results and most importantly required for their future profession and furthermore, to redesign the curriculum integrating more related practical/technological skill. moreover, non-accounting major students should enrich their accounting profession and supplement accounting information system knowledge to achieve the best effect on learning. businesses can also provide different on-job training for employees from different education backgrounds (e.g., those with an information technology background or those with an accounting background) to help their employees become more quickly adapted to the job. references ajzen, i., & fishbein, m. 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(2013). teaching introductory programming to is students: the impact of teaching approaches on learning performance. journal of information systems education, 24(2), 147. notes note 1. the authors do not conduct variance analysis against software because most students used “beyond” and there are too little samples in the other two. microsoft word 11930-43894-1-sm-writer3-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 295 towards enhanced tax compliance in kenya san lio chandaria school of business, united states international university-africa john mirichii chandaria school of business, united states international university-africa received: sep. 29, 2017 accepted: may 30, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.11930 url: https://doi.org/10.5296/ajfa.v10i1.11930 abstract tax is the bottom line source of revenue for the world’s governments. taxation is the only known realistic means of collecting resources to finance public expenditure. this study aims at unraveling efficient mechanisms to be employed in kenya to enhance income tax compliance to boost tax revenue for the current and future governments. with the new governance structure of forty seven county governments in place following the promulgation of the new constitution 2010, this exercise is timely. this was a descriptive survey study and used both secondary and primary sources of data in eliciting the required information necessary for the research findings. the sample size was made up of two hundred thirty seven companies drawn from the kenyan manufacturing sector firms operating within the nairobi county. the statistical package for the social sciences (spss) version 20was used in the data analysis and presentation of findings. the overall finding was that a tax system should be simple, withstraightforward rules for lay citizens to understand and at the same time guarantee that the cost of tax collection and administration is not higher than the actual tax revenue raised. the research findings lead to a conclusion that multiple rates of income tax, varied dates of making tax returns and a bulky legal tax framework make income tax compliance unforeseeable in kenya. keywords: kenya revenue authority, taxable income, tax rates, tax regimes, legal tax framework asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 296 1. introduction the purpose of taxation in kenya is to finance government planned activities. article 209 of the constitution of kenya 2010 grants powers to impose taxes as a revenue source by both the national and the county governments. tax may be defined as a levy charged by governments either on individuals’ or corporate entities’ incomes and/or on the price of a good or service. the former is known as direct tax and the latter indirect tax. the focus of the study is income tax, in the category of the direct tax, which accounts for approximately forty percent (40%) of the total tax revenue in kenya. the g20 summit in moscow held in september 2013 had observations on tax evasion in africa worth noting. available data indicate that the amounts of tax revenue lost by the african nations between 1970 and 2010 amounted to eight hundred fourteen billion usa dollars. this amount is twice, the level of development aid given to the continent the same period. the loss is today estimated at thirty eight billion usa dollars a year, according to experts (business daily, 2013). the loss is mainly corporation tax, and is not only attributable to individuals and small and medium enterprises (smes), but also renowned multinational corporations. since factually every coin earned in kenya is subject to income tax, and with the tax rate averaging approximately thirty percent, the loss in income tax revenue in kenya could be estimated at kenya shillings seven hundred billion a year. this raises important questions on tax evasion, avoidance and planning, as well as compliance in kenya and africa. kenya’s gdp for the year 2013 was estimated at $40.7 billion, with economic growth of 4.6% in the year 2012 compared to 4.4% in the year 2011. this growth was envisaged to be 5.7% in 2013 and 6.0% in 2014 (world bank, 2013), with income tax revenue averaging 10% of gdp. the country however has the potential to achieve a double digit gdp growth rate as the economic performance over the past decade has lagged behind the average for sub-saharan africa. accordingly, the country’s income tax potential is untapped. income tax is a direct tax charged on incomes of individuals and corporate entities, from employment, self-employment, profits on trading activities, rent, dividends, interests, pensions, royalties, professional fees, and other incomes. these sources of income on individuals may not all be accounted for via the paye system, with different rates applied, making the process of accountability and compliance difficult. kenyan resident and non-resident corporate entities are charged different tax rates. the tax is also dependent on whether the company is listed in the nairobi stock exchange (nse), percentage of issued share capital, number of years as a listed company, gross income, and whether the company is in the export processing zone (epz). tax is also charged on the income earned by persons resident in kenya. a resident is defined for tax purposes as an individual who has permanent residence in kenya, and has spent any part of the working year(s) in the country; or, one without permanent residence in kenya but has spent one hundred eighty three days or more, working in the country during the period of asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 297 assessment. a foreign employee in a non-kenyan firm who is resident in kenya is subject to income tax on all emoluments. to avoid double taxation on resident individuals and corporate entities earning income by contacting business in other countries, kenya has signed double taxation treaties with most nations. income tax is governed under the income tax act cap 470, of the laws of kenya. the principle law, the income tax act has 14 parts, 133 sections and 13 schedules, all directing its implementation. besides these, are the finance bills and acts issued regularly to amend the main act. this brings to fore, a glaring complexity on the ordinary citizen and professionals alike. 2. indirect taxes indirect taxes may be categorised as including the vat, excise duty, import duty and stamp duty & other taxes. vat is levied on the consumption of goods and services, and charged at each stage of production and distribution chain to the retail stage. the tax is charged on the value added on the good or service. it is also levied on imported taxable goods and services. traders are allowed to offset input vat against output vat in the final accounting, usually done on or before the twentieth day following the trading month. the rates (pwc, 2014) vary, ranging from zero, for the items that are zero rated and twelve percent on petroleum products. the standard rate in kenya is sixteen percent. vat is governed under the vat act cap 476, of the laws of kenya, which has fifty nine sections, nine schedules and nine subsidiaries. excise duty is a tax charged on traders, but passed on to the consumers in form of increased prices. the rates vary accordingly: ordinary beer is charged at kenya shillings seventy a litre or fifty percent of ex factory selling pricing; other alcoholic beverages between kenya shillings seventy, eighty or one hundred twenty a litre or thirty five percent of the value (whichever is higher) or fifty percent ex factory selling pricing; tobacco at kenya shillings one thousand two hundred per mile or thirty five percent of recommended selling price (rsp), excisable services are charged between seven and fifty percent depending on the service and various other rates for other excisable products. there is no specific chapter of law dealing with this particular tax. import duty is charged on imported goods and services, and paid before the items are allowed passage into the country from the ports. the rates are: rice 35%, wheat grain 10%, maize grain 50%, of the selling prices among other rates charged on various imported items. other than the east african community customs union (eaccu) established in the year 2005 to harmonize importation of goods and services into the partner states, and which provides the rates to be applied accordingly, there is no chapter of the kenyan laws dealing with this particular tax. there is currently no export duty/tax charged in kenya. in fact the government of kenya through the tax remission for exports office encourages local manufacturers to export their products. this is achieved by remitting duty and vat on raw materials used in the manufacture of goods for export. stamp duty tax is charged as follows: transfer of immovable property within a county, 4%; asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 298 outside a county, 2%; issue of debentures or mortgage, 0.1%; transfer of unquoted and quoted stock of marketable securities, 1% and 0% percent respectively; creation and/or increase of share capital, 1%; lease of a period of zero to three years and more, 1% and 2% respectively, among others. in the case of excise, import and stamp duty taxes, there are in consistencies in as far as the legal frameworks are concerned. 3. motivation of the study tax compliance in kenya has been at its lows since independence, as witnessed by the low tax revenues. in the financial year 2000/01 for example, revenue collected from taxes amounted to kenya shillings 200 billion, rising to only kenya shilling 800 billion in the financial year 2011/2013, a period of over ten years. kenya’s gdp has been growing steadily at almost the same rate, rising from sixteen billion usa dollars in the financial year 2003/4 to thirty seven billion dollars in the financial year 2012/13. the tax revenue base should have been expected to grow at a much higher rate than what has been witnessed, to sufficiently fund government planned development projects, with deficits experienced to date; as can be seen in the table 1. table 1. vote year 2009/10 ksh billion 2010/11 ksh billion 2011/12 ksh billion 2012/13 ksh billion revenue 574.10 673.27 781.63 971.33 expenditure 574.30 733.35 833.02 1,123.42 deficit 0.20 60.08 51.39 152.09 source: kenya bureau of statistics, facts & figures 2013 & office of the controller of budget 2014(figures in brackets are actual) for example, budgetary planned activities for the financial year 2013/14, whose theme was transformation and shared prosperity amounted to kenya shillings 1.6trillion. kra planned to collect the amount of kenya shillings 974billion, hence an anticipated deficit of kenya shillings 626 billion (kenya national bureau of statistics, 2013). these accumulated deficits have continued to raise the debt burden on the kenyan people, estimated at kenya shillings two point one trillion (ksh 2.11 trillion), which is 58% of the country’s gdp. the types of tax revenue streams in kenya, from which the above mentioned revenue is derived, include income tax, vat, excise duty, import duty, stamp duty and others; accounting for 40%, 28%, 15%, 8% and 9%respectively.accordingly, income tax accounts asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 299 for the lion’s share of the kenya’s tax revenue at forty percent hence the focus of this research work. the amounts collected in recent years relative to gdp are summarized in table 2. table 2. income tax revenue collection item year 2009/10 ksh billion 2010/11 ksh billion 2011/12 ksh billion 2012/13 ksh billion income tax revenue 219 272 329 403 government expenditure 574 733 833 1,123 %contribution expenditure 38% 37% 39% 36% gdp 2367 2554 3049 3440 %contribution gdp 9% 11% 11% 12% source: kenya bureau of statistics, facts & figures 2013 these figures translate to an average of 37% contribution on government planned expenditure, and 11% of gdp for the financial periods. this in a nutshell, is dismal. the question the researchers seek to answer is why this poor performance? the study hypotheses h1 multiple tax rates charged on individuals and corporate entities on various incomes have a significant relationship with income tax revenue poor performance in kenya h2disparate dates set by kra for filling and accounting for income tax returns have a significant relationship with income tax revenue poor performance in kenya h3 bulky legislation and unfriendly legal jargon in the kenya’s income tax act has a significant relationship with income tax revenue poor performance in kenya. 4. theoretical review kenya’s economy is operating below its potential (world bank, 2013) hence unable to achieve its tax revenue objectives. however, the triumphant elections held in march 2013 and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 300 the peaceful handover of power in the following month of april ushered in a new era of political leadership in kenya, which would guide the implementation of kenya’s ambitious program of devolution. if these developments reflected the maturing of kenya’s political system, there was equal optimism that kenya had put behind the troubling economic periods that had regularly followed its previous election cycles. kenya could do much better, and there was no doubt that the new government wanted to unleash the potential of the kenyan economy. this would see poverty levels reduce from the estimated forty two percent and bring in more individuals into the income tax bracket. however to enhance income tax collections, a simple tax system is envisaged. many authors have taken interest in the administration of income tax in its current bureaucratic form, and largely ignored the more fundamental issues of simplicity and transparency, expected to enhance revenue. a simple tax system is one that ordinary tax payers are able to understand (holtzman, 2007). the imf (2001) contends that simplicity of a tax system is paramount. the tax justice network for africa (tjn-a) (2014), notes that the tax system in kenya is derived from the colonial laws which are heavily complicated. according to the institute of economic affairs kenya (iea-k) (2006) kenya introduced a tax modernisation programme in 1986 with the hope that this would, among other things, improve tax administration and reduce compliance and collection costs without success. iea-k (2012) has promoted the breakdown of kenya’s complex tax system into a user friendly scheme. cheeseman and robert(2004) found that governance issues have been largely to blame for ill tax revenue performance in most sub-sahara african nations. they add that kra’s focus should have been working on mechanisms to simplify particularly the income tax system since this tax accounts for the biggest percentage of government revenue. 5. methodology the population of the study consisted of 582 companies drawn from kenya association of manufactures (kam) in the nairobi county.nairobi county was selected because of its size in economic performance, with the second largest county, kakamega, having a budget half that of nairobi, and smallest nearly sixteen times less.table3 shows the largest four, and smallest counties in kenya budget wise, and revenue sources. a sample of 237 financial managers was selected using the yamane formula. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 301 table 3. county budget ksh billion revenue source national government ksh billion local sources ksh billion % of total budget nairobi 25.3 9.4 15.9 63% kakamega 13.2 9.7 3.5 27% mombasa 11.7 6.6 5.1 44% nakuru 10.0 6.9 3.1 31% lamu 1.6 1.514 0.086 5% source: controller of budget, county reports 2013-2014 a total 237 questionnaires were administered to the respondents and 30 returned for analysis. all the 30 returned questionnaires were complete and met the study requirements. this represented a 13% response rate. the data was analysed using descriptive statistics specifically frequencies and charts; using the statistical package for the social sciences (spss) version 20. 6. results and findings the results and study findings on the various variables are summarized in the table 4 and figure 1 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 302 table 4. results and findings variable understood not understood income tax flat rates paye 88% 12% corporation 76% 24% tax incentives tax holidays 0% 100% capital allowances 47% 53% reliefs pensions 14% 86% insurance 17% 86% mortgage 17% 86% legal framework filing returns paye 100% 0% corporation 94% 6% tax act and bills 0% 100% penalties 29% 71% tax refunds 6% 94% financial records 18% 82% modernization ict 83% 17% reforms 59% 41% properly used not properly used accountability of income tax revenue 47% 53% formal informal the structure of economy 2% 98 % asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 303 figure 1. results and findings the average of 82% of the respondents understood and applied income tax flat rates, and 18% did not. the average of a mere 19% of the respondents knew about the tax incentives offered tax payers by kra meant to motivate them to comply with income tax payment, and 81% did not know. a hundred percent of the respondents filed paye returns and 94% filed corporation tax returns. eighty two percent of the respondents read the income tax act but said they did not understand it as it was lengthy and complex. twenty nine percent of the respondents understood the income tax penalties. a mere 6% of the respondents knew and applied for tax refunds; and only 18% knew how long financial records should be preserved for income tax purposes. on average, 71% of the respondents were aware of efforts being made by kra to improve the compliance on income tax; 83% used kra ict platform to make income tax transactions. forty seven percent of the respondents were satisfied with the utilization of income tax revenues by the government. 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 pa ye co rp or at io n ta x h ol id ay s ca pi ta l a llo w an ce s re lie fs fi lin g re tu rn s ta x a ct a nd b ill s pe na lti es ta x r ef un ds fi na nc ia l r ec or ds ic t re fo rm s income tax flat rates tax incentives legal framework modernization understood not understood asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 304 7. discussion the purpose of the study was to establish the factors which determine income tax compliance in kenya. the primary data was collected from 237 companies operating within the nairobi county using simple random sampling technique. nairobi was selected for the sampling since it largest county in kenya in economic performance. all the selected companies are from the manufacturing sector of the kenya’s economy. the analysis of the data and presentation of findings was made using the spss version 20. income tax is a direct tax charged on incomes of individuals and corporate entities. individual income tax rates are based on employment income and benefits, self-employment, profits on trading activities, rent, dividends, interests, pensions, royalties, professional fees, and other incomes. employment benefits include housing, car, per diem, commissions, international passage, medical cover, insurance premiums, loans, utilities, school fees for children, meals, pensions & gratuities and benefits in kind. some of these sources of income on individuals may not be accounted for via the paye system, with different rates applied on each. in addition, there are different income tax rates for residents and non-residents as well as directors. only 15% of the respondents were willing to disclose other benefits paid to employees other than salaries and wages, for tax purposes. therefore we could not establish how various benefits including insurance premiums, mortgage payments, car benefits, per diems, housing allowances, and utilities were treated for income tax purposes. it is important to note that these benefits are taxed at different rates on a graduated scale. eighteen percent of the respondents did not include salaries and wages in the paye payroll system, meaning that their employees were not taxed. thirty percent of the respondents did not endeavor to find whether employees in their payrolls were working for other entities and/or earning taxable income from other sources, implying that it is difficult to bring all employee earnings in the tax bracket. however, most taxpayers appreciated that most benefits were taxable. thirty five percent of the respondents did not know their business’s initial capital outlay, making it difficult to claim capital allowances. twelve percent of the respondents had initial capital outlay ranging from ksh 5 to 10 million, but only 47%of these claimed capital allowances. a hundred percent of those with turnover of less than ksh 5 million, and are supposed to apply three percent tax rate, actually applied thirty percent, translating to a huge tax expense. a hundred percent of the respondents from the listed companies did not indicate the percentage of listed shares, and neither did they indicate the number of years they have been listed, and yet tax rates are a function of both. the taxation authorities provide tax incentives aimed at improving on income tax compliance. these are tax holidays, capital allowances and reliefs. a tax holiday is a temporary period, during which time the government removes certain taxes on certain items, in order to encourage the consumption or purchase of these items. capital allowance is a reduction in the amount of corporation tax payable, offered as an incentive for investment in large-scale projects. a certain percentage of the capital asset's cost is allowed as capital allowance during the accounting period in which it was purchased. this amount is greater than the depreciation asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 305 charge on the asset during that period. a tax relief is any program or incentive that reduces the amount of tax owed by an individual or business entity. a hundred percent of the respondents did not apply for tax holidays, indicating that they were unaware about it. forty seven percent of the respondents were unaware of the existence of the capital allowances. fourteen percent, seventeen percent and seventeen percent of respondents did not apply pensions, insurance and mortgage reliefs for income tax purposes respectively. eighty eight percent of the respondents engaged consultants and other professionals; eighty percent of these withheld tax on the payments. eighty five percent applied national social security fund (nssf) and national hospital insurance fund (nhif) tax reliefs correctly. income tax is governed under the income tax act cap 470, of the laws of kenya. the principle law of the income tax act has 14 parts, 133 sections and 13 schedules, all directing its implementation. the act is bulky, with heavy legal jargon undertones. subsequent finance bills and acts are issued on a continuous basis, with the aim of making amendments on the tax laws appearing in the income tax act. the finance acts and bills are written on a ‘delete –insert’ basis, further complicating the system, and making it more unfriendly. this brings to fore, a glaring complexity on the ordinary citizen and professionals alike. the results of our survey indicate that none of respondents understood the acts and bills. a mere twenty nine percent, six percent, and eighteen percent of the respondents understood the income taxation penalties, refunds and preservation of financial records respectively. seventy one percent of those aware of the applicable penalties described them as unfair. penalties are charged by the tax authorities as deterrent to non-income tax compliance. penalties are applied on instalment, final, withholding, paye, and the filing of self-assessment tax returns. penalty rates range from five to twenty five percent on the unpaid amount, and a monthly compound interest charge of two percent. tax refunds are payments made by kra to the tax payer on account of overpayments of income tax. kra has been weak in making the follow-ups on this important area to the tax payer. individuals and corporate entities are required under the act to preserve their financial records for a minimum period of seven years. a hundred and ninety four percent of the respondents filed their paye and corporation tax returns correctly, respectively; but none of them knew the date of filing the corporation tax returns, against 77% who knew the date of filing the paye returns. five percent claimed that their corporation returns are filed by their external auditors. seventy one percent did not know the amendments introduced in the new finance bill requiring that individual employees file their own personal income tax returns. modernization of the income tax system involves the transformation of the structural tax agency and the inculcation of ict and is crucial for improved income tax compliance. eighty three percent of the respondents were using the kra ict platforms, but indicated that the system is inaccessible most of the times. this explains why there are always long queues at the kra offices. furthermore, respondents complained that penalties are applied even when the system was to blame for their delays in making returns and payments. fifty nine percent of the respondents were aware of efforts being made by the tax agency to improve on income tax compliance; however sixty three percent of them said they needed continuous tax education, with some twenty percent suggesting the restructuring of the agency. visits by asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 306 kra staff are important in the modernization efforts. eighty two percent of respondents said they were never visited by kra staff, and those visited suggested that the cycle should be reduced from the current five year one. all of those visited indicated that the kra staffs are competent. furthermore, 53% of the respondents indicated that the income tax revenues were not properly utilised and accounted for. this no doubt, discourages the income tax compliance. accordingly, all the hypotheses is supported. 8. recommendations based on the research findings, there is the need to simplify the income tax systems to improve income tax compliance by: 1) rewriting the income tax laws in a friendly business language to make them understandable and clear to the common tax payer, as opposed to the current legal jargon, 2) minimizing the number of applicable tax brackets and rates in similar tax categories in an effort to reduce the income tax schedules so as to simplify them, 3) companies to employ professional tax officers. to achieve this goal, it is recommended that kenya accountants & secretaries national examinations board (kasneb) should design a program to train specialized tax officers, 4) kra to employ tax educators and supervisors to improve that ratio of officers to tax payers, 5) improvement on the accountability of tax revenues by the taxation authorities, 6) rolling modernization programs at the county level, and 7) kra publicizing tax laws publications. 9. conclusion the researchers conclude that there is the need to carry out more elaborate research in the area in kenya and other african nations. references business daily newspaper. (2013). africa loses billions in tax evasion. business daily, 9th september, nairobi, kenya. cheeseman, n. & robert, g. (2004). increasing tax revenue in sub-saharan africa, the case of kenya. the oxford council on good governance. http://www.ocgg.org/fileadmin/publications/ey006.pdf, accessed on 15, april 2014. holtzman, y. (2007). challenges in achieving transparency, simplicity and administering of the usa tax code. journal of management development, 26(5), 418-427. https://doi.org/10.1108/02621710710748257 institute of economic affairs-kenya (iea-k). (2006). taxation and tax modernization in kenya: a diagnosis of performance and options for further reform. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 307 (http://www.ieakenya.or.ke/publications/cat_view/1-publications/4-research-papers?start=20), ‘citizen handbook on taxation, 2012’ (http://www.ieakenya.or.ke/publications/cat_view/1-publications/5-books), accessed on 14, april 2014. international monetary fund (imf). (2001). tax policy for developing countries. economic issue no. 27. (http://www.imf.org/external/pubs/ft/issues/issues27/#1), accessed on 14 april 2014. kenya national bureau of statistics (knbs). (2013). fact and figures.http://www.knbs.or.ke/index.php?option=com_phocadownload&view=category&id= 20:kenya-facts-figures&itemid=595, accessed on 14 april 2014. national treasury. (2013). kenya monthly debt bulletin.http://www.treasury.go.ke/index.php/resource-center/cat_view/124-debt-reports/108monthly-debt-bulletin, accessed on 15, april 2014. office of the controller of budget. (2014). budget implementation review. file:///c:/users/user/downloads/budget%20implementation%20review%20fourth%20quat er.pdf, accessed on 23, may 2014. price waterhouse coopers (pwc). (2014). doing business: know your taxes, east africa tax guide 2013/2014. http://www.pwc.com/ke/en/publications/east-africa-tax-guide-2013-2014.jhtml, accessed on 13, april 2014. tax justice network for africa. (2014). taxation and state building in kenya: enhancing revenue capacity to advance human welfare, kenya report.http://www.taxjusticeafrica.net/category/country-tax-reports, accessed on 13, april 2014. world bank. (2013). kenya economy update, edition no.8:produced by poverty reduction and economic management unit africa region,www.worldbank.org/kenya/keu, accessed on 13. april 2014. http://www.tradingeconomics.com/uganda/tax-revenue-percent-of-gdp-wb-data.html, accessed on june 29, 2014. microsoft word 10372-38326-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 35 contingency factors, risk management, and performance of indonesian banks saiful dept. of accounting, bengkulu university po box 38371a, bengkulu, indonesia tel: 62-736-21170 e-mail: saifulak@yahoo.com received: nov. 28, 2016 accepted: february 1, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10372 url: http://dx.doi.org/10.5296/ajfa.v9i1.10372 abstract the purpose of this study is to examine the effect of enterprise risk management (erm) and credit risk management (cmr) on indonesian bank performance. this study also investigates the moderating role of bank contingency factors on those impacts. by exploring purposive sampling method, 24 indonesian public listed banks were selected as the sample of this study for four years observations. this study found erm and crm positively influence on indonesian bank performance. this study also reported that the influencing of erm on bank performance will be stronger for large bank and the bank which operate in higher environmental uncertainty, higher complexity, and lower independent board monitoring. in contrast this study provide an empirical evidence on strangtern crm-bank performance relationship will be exist for small bank and the bank which operate in lower environmental uncertainty, lower complexity, and higher independent board monitoring. keywords: risk management, firm performance, environmental uncertainty, business complexity, and independent board asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 36 1. introduction banks play a very important role in creating economic growth in both developed and developing countries. in order to achieve those objectives. banks must continuously be able to maintain the stability of their financial performance. however, it is not easy for banks to continuously report their superior performance in along time because of highly competitive business environment. the bank currently facing various risks that may affect the achievement of the bank's performance. for example, some of indonesia top ten banks highlighted decline net profit in 2015 including the bank negara indonesia (bni), panin bank, and bank danamon. its indicates there is not easy for indonesian banks to maintain sustanability of their higher performance because of various risks. fraser and kolari (2001) concluded that banking industries deal with credit, country, market, interest rate, liquidity, operational, legal and reputation risk. in addition basel committee on banking supervision (2000) define credit risk as the potential failing of banks borrower orcounter party to meet its obligations. moreover, the committe highlighted that banks face credit risk sourced from loan and other various financial instruments, including acceptances, interbank transactions, trade financing foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transaction. thoses risks would have a negative impact on the bank's performance. since the bank facing a variety of potential risks throughout the bank's operations, management must be able to implement an effective risk management to control and manage risk. banks’ managers should consider the best way to reduce risks. gordon et al.(2009) describe management in any industries including banking must view and manage risk as firm fundamental concern based on a holistic perspective known as enterprise risk management (erm) in addition pagach and warr (2011) state that erm is a strategy that holistically evaluate and manage the risks. however, for banking industries credit risk should be given greater attention in risk management compared to other risks. therefore, banks’ managers should implement a holistic risk management (erm) as well as specific credit risk management (crm) principles some previous studies highlighted that the implementation of erm provide the postive impact to firm performance (e.g. barton et al., 2002 & liebenberg & hoyt, 2003). furthermore, beasley et al. (2005) found that erm promote the better operational performance. in addition, miccolis and shah (2000), lam (2001), meulbroek (2002) indicate that erm can reduce the volatility of stock prices, reduced capital costs, increase efficiency, and create synergies. however, rafika (2012) and fitrianti (2013) found that erm positively impact on firm value, and gordon, et.al (2009) found the strengtern influencing of enterprise risk management on firm performance companies defend on the companies and environmental conditions. in another persepective, banks should also focus on mitigating credit risk as inherent risk in their business activities through implementation crm. bank for international settlements (basel committee on banking supervision, 2000) describes the credit risk as a potential lending or counter party will fail in repayment obligations. credit risk is the greatest risk asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 37 faced by commercial banks and a major cause of failure (fraser & kolari. 2001; angerer 2004). the effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success banks. al shatti (2015) found that crm which proxied by non performing loan ratio (npl) positively effect on the performance of the jordan commercial.banks in contrast, poudel (2012 reported the negative relationship between crm and financial performance of nepal commercial banks. ruth (2013) found the negatively relationship between crm and firm performance, and independent board moderate that relationship. abiola (2014) found a positive (unusual) relationship between non–performing loans (npl) and bank’s profitability. its means the better credit risk management will be followed by lower bank performance. adeusi, akeke, adebisi and oladunjoye (2013) concluded that npl is not effected on banks performance. fan and yijun (2014) found that there is a negative relationship between npl and roe and between npl and roa. however, the findings on year by year analysis demonstrate a fluctuating relationship between those variables dependent on the contigency factors such economic crisis.kurawa and garba (2014) provide additional evidence on a positive relationship between npl and roa poudel (2012) found credit risk management indicators including npl negatively affected banks’ financial performance. ogboi and unuafe (2013) found sound credit risk management that measured by npl is not affected on bank’s financial performance. however, according to the contingency theory, the organization's performance is a consequence of external factors such as environmental, organizational structure, corporate culture, and technological factors. moreover, contingency theory states that organization must adapt a variety of contingent factors, such as organizational structure, environment, organizational size, and business strategy in achieving higher performance (lawrence & lorsch, 1967). meanwhile, otley (1980) conclude that the stronger relationship between erm and firm performance dependent on firm contextual factors. therefore, contingency theory plays a very important role in explaining what factors are contributing to firm performance. in context of risk management-firm performance relationship, contingency factors need to be taken into account are: (1) the environment uncertainty (tjahjadi, 2011), (2) complexity (husaini, et. al. 2013), (3) firm size (husaini et al. 2013), and independent board monitoring (beasley, et.al, 2005). so the purpose of this study is to investigate the moderating role of contengency (firm specific) factors on the influence of erm and crm on indonesian bank/s performance. 2. literature review and hypothesis development 2.1 erm and bank performance coso (2004) defines erm as “a process, affected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 38 objectives.” while, the casuality actuarial society (cas) defines erm process of assessing, controlling, financial exploitation, and monitoring risks from various sources which aims to increase the short term and long termfirm value for all stakeholders. erm encompasses aligning risk appetite and strategy, enhancing risk response decisions, reducing operational surprises and losses, identifying and managing multiple and cross-enterprise risks, seizing opportunities, and improving deployment of capital (beasley, et al., 2005). coso (2004), explains that the effectiveness of an organization's erm should be determined based on the achievement of four objectives erm ie strategy, operations, compliance, and reporting. some studies using those objective as conprehensive proxies for measuring implementation of erm (for example see gordon et al, 2009) barton et al (2002), lam (2002, liebenberg, (2003) proved that erm implementation can improve the performance of the company. miccolis and shah (2000), lam (2001), and meulbroek (2002) highlighted that erm can reduce the volatility of stock prices, reduced capital costs, increase efficiency, in context of indonesia rafika (2012) and fitrianti (2013), found that the positively relationship between erm and firm value. so we come up with hypothesis: h1: erm positively effect on bank performance 2.2 crm and bank performance according to indonesian central bank regulation number: 11/25 / pbi / 2009, the credit risk is the risk of the failure of the debtor and / or other parties to meet obligations to the bank. meanwhile, investopedia defines credit risk as a potential lost of loan principal and interest for the borrower's failure to fulfill obligations in accordance with the loan contract. most previous studies on credit risk measured those potential lost through non performing loan proxy (see ratih, 2013; al shatti,2015) . the effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation. credit risk can arise from the various bank businesses. ratih (2013) use of non-performing loans as a proxy for measuring credit risk management efectiveness therefore credit risk management will positively affect the profitability of the banking (li and zou in alshatti, 2015). furtheremore, al shatti, (2015) measure credit risk management using some indicators, namely the capital adequency ratio, the ratio of credit facilities, net facilities ratio, leverage ratio and non-performing loans. credit risk management is commonly proxied by the non-performing loans (npl), because it shows the bank's ability to manage their loans. the high npl will lead to a decrease in profit (almilia and herdiningtyas, 2005). the lower the npl ratio, the lower the credit risk, and the higher of credir risk management successfully. low credit risk will affect the the higher bank's financial performance and market. this is because the lower credit risk will give confidence to the owners and other stakeholders on the success of the bank implement credit risk management well. poudel (2012) states that credit risk management is proxied by npl negatively affect the financial performance of banks in nepal. so we come up with asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 39 hypothesis: h2: credit risk management positive effect on bank performance 2.3 risk management, environment uncertainty, and bank performance gerloff et al. (1991) states that the environment uncertainty consist of contingencies and perceptual aspects. aspects of contingencies related to the understanding of the environment and organizational adjustment to the reality of the environment. while the perceptual aspect relates to a process orientation, comprehension, interpretation, and scanning of the environment. gong et al. (2009) measures the uncertainty of the environment by using cash flow volatility. gordon et. al. (2009) measures the uncertainty of the environment with a combination of: (1) market (coefficient of variation of sales), (2) technology (coefficient of variation of r & d costs and capital expenditures divided by total assets), (3) income (coefficient of variation of income before taxes). risks to be borne by the company will vary depending on environmental uncertainty to be faced. the higher the environmental uncertainty facing companies will affect the relationship between the risk management systems with the performance of this. gordon, et.al. (2009) find environmental uncertainties affect the relationship between the implementation of erm and firm performance. so we come up with hypothesis h3: environmental uncertainty moderates erm-bank performance relationship. many economic theories state that the credit cycle and failures are still common with empirical conditions of uncertainty in the cycle. lesmana (2006) suggested that the need for a credit risk management model specific to anticipate the credit risk of failure of the borrower to repay the loan principal and interest. the credit risk management model should be appropriate to the conditions of environmental uncertainty. when banks operating at a high environmental uncertainty impacting on the increased likelihood of a borrower experiencing financial difficulty and fail to repay the loan, bank managers must implement a good credit risk management. in that condition, the effect of credit risk management on firm performance will be stronger. so we come up with hypothesis h4: environmental uncertainty moderates crm-bank performance relationship. 2.4. risk management, complexity, and bank performance the complexity of the company can be proxied by the number of business segments owned by a company (doyle et.al. 2007). meanwhile, merchant (1981) concludes that highly diversified companies will require intensively internal control than the less diversified and decentralized companies. this is due to the complexity of such operations which pose more risks to be faced by the companies. doyle et al. (2007) highlighted that the material weaknesses internal control occurs in companies with more complex operations. hoyt et al. (2006) found that the high complexity companies need to implement better erm, in order to improve their financial performance. we therefore conclude that the company with a high level of complexity will strengthen affect erm implementation on firm performance. so we come up with hypothesis asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 40 h5: bank complexity moderates erm-bank performance relationship. credit risk is the assessment of the quality of the bank's operational risk management. credit risk of them comes from bad loans, if large amounts will affect every corner of the bank's operations. bad credit will hamper banking operations because bank profits obtained from the difference between deposits and lending interest (elizabeth, 2009). credit risk will increase when the bank has a high complex or relatively broad diversification. in this condition should menerapan bank with good credit risk management in order to achieve optimum performance. so we come up with hypothesis h6: bank complexity moderates crm-bank performance relationship. 2.5. risk management, size, and bank performance the relationship between firm size and organizational structure has been a major consideration in the organization theory literature (lawrence dan lorsch, 1967). in addition, the accounting scholars also conclude that firm size is an important factor when considering the design and use of management control systems. hoyt et al. (2006) found firm size is positively related to the the level risk management implementation. beasley et al. (2005) showed that organization size positively related to the risk management implementation phase. merchant (1981) argues that the growth of the organization raises communication and control escalation. so organization size will affect risk management firm performance relationship. so we come up with hypothesis: h7: bank size moderates erm-bank performance relationship. rachdi, et. al. (2003) found that small size banks assume lower credit risk, so there is no incentive to implemented intensive credit risk management. moreover, ranjan and dahl (2003) states that the bigger the bank, the smaller the rate of non-performing loans. so management needs to implement an effective credit risk management to reduce the risk of the loans in order to improve bank performance. so we come up with hypothesis h8: bank size moderates crm-bank performance relationship 2.6. risk management, independent board, and bank performance enterprise risk management as a strategy to manage the risks that can reach all parts of the company, not in spite of the existence of an independent commissioner who oversees the effort to control the risks that have been applied. kleffner et al. (2003) suggests that the main factor underlying the adoption of erm strategy firms in canada was a drive of the board of directors. coso (2004) also argues that the board of directors plays an important role in erm implementation strategy. beasley et al. (2005) suggested that independent directors on the board is positively related to the stage of implementation of erm. in addition, gordon et al. (2009), concluded the relationship between erm and the performance of the company depends on the monitoring of the board of directors. so we come up with hypothesis: h9: independent board moderates erm-bank performance relationship. dannon (2009) states that the internal governance mechanism including independent board asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 41 role more effective in explaining bank risk. moreover, pathan (2009) found that independent board monitoring could contribution to reduction of various banking risks. since credit risk can be metigated by independent board monitoring, credit management will not be strong contribution to increase bank performance. so we come up with hypothesis: h10: independent board moderates crm-bank performance relationship. 3. research method and model 3.1. population and sample the populations in this study are all banking companies listed in indonesia stock exchange (idx) from 2010 until 2013. the samples in this study were selected by using purposive sampling method where the selection of samples taken in accordance with the criteria of the samples described in chapter previous. from several samples into the population there are some companies that are not used as samples because they do not meet the criteria. 24 of 31 banking companies have met the sample’s criteria of this study or 96 observations in four (4) years. 3.2. definition and measurement of variables 3.2.1. bank performance (bp) there are two approaches that commonly employed in measuring firm performance i.e. financial accounting based measures (fab) such as return on asset (roa), return on equity (roe), and return on sales (ros), financial market based measures (fmb) such as stock return, market to book ratio, and tobin-q. this study measures the bank performance using ratio of return on assets (roa) to adjust the indonesian central bank regulation on guidelines for calculation of financial ratios: bp = x100 % (1) 3.2.2. enterprise risk management enterprise risk management (erm) is calculated using erm index (ermi) that developed by gordon, et al. (2009) based on coso erm objectives, namely strategy, operations, reporting, and compliance. ermi = σ strategy + σ operation + σ reporting + σ compliance (2) strategy refers to the way the company positions itself against the competition in the market. its means that the greater the income received by a company relative to the average industry income, the better strategy of that company or the higher erm implementation, so. strategy1 1= .(3) note revenue revenue i µ revenue asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 42 revenuei : revenue bank i in year t µ revenue : evarege revenue all banks in year t revenue : standard deviation revenue all banks in year t another approach to measure a success strategic is based on competitive advantage of a bank in reducing systemic risk through diversification strategy compared to other banks (thompson, 1984). strategy 2= . (4) note : ∆βi : -( βi year t βi year t-1) βi : beta bank i µ∆β : average all bank ∆β in year t ∆β : standard deviation ∆β all bank operating efficiency can be measured as an input-output relationship in the process of operating bank (banker et al. 1989). the greater the output at a certain level of input or lack of inputs for a given level of output indicates better operating efficiency. so turnover of assets defined as income on total assets is one measure of the efficiency of operation (kiymaz, 2006), operation1= (5) the second measurement for the operating ratio is determined by the income on the number of employees of the bank. opertioni2 = (6) reporting refers reliability reporting: illegal earnings management, financial restatements, and financial fraud are the obstacle in the achievement of reliable financial statements (cohen et al. 2004). reliability of reporting is proxied by the three dimensions are easily observed: namely: material weaknesses, the auditor's opinion, and restatements. reporting1 = (material weakness) + (auditor opinion) + (restatement) (7) reporting1 obtains a value -1 for each component reliability include (1) the disclosure of material weaknesses in the annual report, (2) the audit report with an unqualified opinion, and (3) announced the restatement in year t, and the value 0 if otherwise, the second measure of the reliability of bank reporting is using the relative proportion of ∆β revenue total asset ∆βi -µ ∆β asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 43 absolute normal accruals divided by the sum of the absolute accrual normal and abnormal accruals. abnormal accruals are measured using cross-sectional jones (1991) model of accrual measurement, as described in defond and subramanyam (1998) and herawaty (2008). calculation of total accruals are measured as the difference between profit and operating cash flows using the formula: ta = net income – net operating cash flows (8) to compose a total accrual becomes abnormal and normal accrual then calculated with the following steps. = + + ∆ ∆ + + (9) = + ∆ ∆ + (10) = + ∆ ∆ + or = (11) note: : constant : regression coefficient : total acrual bank i in year t : discresionary accrual bank i in year t : nondiscresionary accrual bank i in year t : total asset change bank i in year t ∆ : operating revenue change bank i in year t ∆ : receivable (loan) change bank i in year t : fixed asset plus accumulated depreziation bank i in year t : error bank i in year t ols (ordinary least squares) was used to obtain the coefficients of each variable above. the value of the coefficient α of equation (9) is put back into the equation (10) to get the value of normal accruals (nda). furthermore, abnormal accruals (da) is computed by inputting the coefficient α of equation (10) into the equation (11). if the actual value of the normal and abnormal accruals has been obtained, the next step is to calculate the value of the reliability of reporting. reliability of reporting is measured by using the following formula: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 44 = | || | | | (12) compliance: o'keefe, et. al. (1994) found evidence that firm compliance can be increased with an increase in audit fees. thus, compliance in this study measured by the auditor fee for financial statement audit, certification, check the individual accounts and consolidated, review due-diligence, agreed procedures (for example, confirmation of compliance with specific contractual agreements), as well as compliance and consulting tax, using the following equation: compliance1= (13) 3.2.3. credit risk management management of credit risk in this study is proxied by the reversal of the non-performing loan ratio. this is because the higher non-performing loan (npl) indicates the worse the credit risk management, so that this study did reversal npl value by multiplying by negative1. the formula used to calculate credit risk management are as follows: = x 100% x (-1) (14) 3.2.4. environmental uncertainty this research uses gong et al. (2009) approach in measuring environmental uncertainty by using cash flow volatility, which is formulated as follows: euc = (operating cash flows + δ operating cash flows)/total asset) (15) 3.2.5. bank complexity bank complexity is the number of business segments owned by a bank (doyle &mcvay 2007): bc = σ business segments (16) 3.2.6. bank size bank size can be measured by total assets (sudjoko and soebiantoro, 2007). the greater bank total assets, the greater the bank size. so: bs = (ln) total asset (17) 3.2.7. independent board fama and jensen (1983) stated that non-executive director (independent directors) can act as a mediator in disputes between managers and oversee internal management policy and provide advice to management. the number of independent directors should be able to ensure that the monitoring mechanism run in accordance with applicable regulations. the formula in calculating the independent directors, namely: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 45 = ∑ ∑ (18) 3.3. data analysis techniques in order to test the hypotheses of this study, five regression models has been developed as follows: bpit = +ß1ermit+ß2crmit+eit (19) bpit = +ß1ermit+ß2crmit+ß3eucit+ß4erm x eucit+ß5crmitx eucit+eit (20) bpit = +ß1ermit+ß2crmit+ß3fcit+ß4erm x fcit+ß5crmit x fcit+ eit (21) bpit = +ß1ermit+ß2crmit+ß3sizeit+ß4erm x sizeit+ß5crmit x sizeit+eit (22) bpit = +ß1ermit+ß2crmit+ß3ibit+ß4erm x ib it+ß5crmit x ib it+eit (23) note : bpit : bank i performance in year t, as measured by roa : constant ß1-ß5 : regressions coeffisient ermit : enterprise risk management index crmit : credit risk management measured by non performing loan bank i in year t eucit : bank i cash flow volatility in year t bcit : bank i complexity in year t sizeit : bank i size in year t kiit : bank i independent board in year t 4. the findings 4.1. statistic descriptive a statistic description of variables that included in this study is presented in table 1. table 1 shows that on average erm index score is -0.33 with maximum score is 3.31 and the minimum score is -5,31. it indicates that some indonesian listed banks have been effectively implemented erm system. in term of crm, on overal indonesian listed bank have no effectively adopted better credit risk management. table 1 also shows that indonesian listed bank operate in not so complexity, well business environment, and better independent board asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 46 monitoring. on average indonesian listed bank highlighted lower net profit aruond 2.16% of total assets, even some bank reported loss. table 1. statistic descriptive variables min max mean std. dev bp -7,58 5,15 2,16 1,68 erm -5,31 3,31 -0,33 1,53 crm -0,02 -6,25 -1,59 1,35 euc -0,34 0,45 0,01 0,15 fc 2,00 8,00 3,97 1,28 size 28,08 34,23 31.11 1,75 ib 0,25 1,00 0,57 0,12 4.2. correlation analysis firstly, this study analyzed the correlation among independent and moderating variables in order to detect multicolinearity problem. hair, black, babin, anderson, and tatham (2006) stated that multicolinearity problem occurs since the correlation among independent and moderating variables is 0.90 and higher. table 2 presents the correlation matrix among independent variables and between independent and dependent variables. erm is positively significant correlated to crm (r = 0.259, p-value < 0.05), bc ( r = 0.479, p value<0.01), bs ( r = 0.372, p value<0.01) and ib ( r = 0.479, p value˃0.05) but erm negatively not significant related to euc (r = -0.020, p value ˃ 0.05). this result indicated that there is no multicolinearity problem occurred in this study. secondly, this study analyzed the correlation between independent and dependent variables in order to determine the relationship between independent and dependent variables induvidually. this found that bp is positively significant associated with erm (r = 0.345, p value < 0.01) and crm (r = 0.353, p value < 0.01). bp is also postively significant correlated two moderating variables i.e. bc (r = 0.347, p value < 0.01) and bs (r = 0.489, p value < 0.01). this findings indicate that an individual erm and crm positively influence indonesian listed bank performance. table 2. pearson correlation bp erm euc bc bs ib crm bp 1 erm 0.345*** 1 euc -0.088 -0.020 1 bc 0.347*** 0.479*** -0.005 1 bs 0.489*** 0.372*** 0.027 0.441*** 1 ib -0.113 0.116 -0.091 -0.016 -0.166 1 crm 0.353*** 0.259** -0.119 0.188 0.195 -0.185 1 ***represents statistical significance at the 1% level (two-tailed test) **represents statistical significance at the 5% level (two-tailed test) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 47 4.3. hypothesis testing table 3 consists of the five regression models results: the first model using to test hypotheses 1 and 2 (direct influencing of erm and crm to bp). the second model using to test hypotheses 3 and 4 (moderating role of euc on influencing of erm and crm to bp). the third model using to test hypotheses 5 and 6 (moderating role of bc on influencing of erm and crm to bp). the second model using to test hypotheses 3 and 4 (moderating role of euc influencing of erm and crm to bp). the forth model using to test hypotheses 7 and 8 (moderating role of bs on influencing of erm and crm to bp). the fifth model using to test hypotheses 9 and 10 (moderating role of ib on influencing of erm and crm to bp). based on the regression results in table 3 model 1, the r square 0.194 and significance p-value of f <0.01 indicate the model is fit and 19.4% variation of bp could be explained by erm and crm, this finds that by putting moderating variables in the model (euc in model 2; bc in model 3; bs in model 4; and ib in model 5) the model still fitt and the explanation power increase, it indicate that moderating variable play an important role in explaining variation of indonesian listed bank performance. 4.3.1. risk management and bank performance the regression results in table 3 model 1 showed that erm (β=0.238 and p-value < 0,01)and crm (β=0.281and p-value < 0,01) are positively significant influence bp. this result suggested that h1 and h2 were supported. the results of this study are consistent with barton et al., (2002). lam (2002),and liebenberg (2003) who found that the erm implementation can improve firm performance. this finding also indicates that bank with higher erm practices followed by superior performance. this result is also align with gustina (2015), ruth (2013), almilia and herdiningtyas, (2005), and poudel (2012) which states that credit risk management positively affects on firm performance. 4.3.2. risk management, environment uncertainty, and bank performance the regression results in table 3 model 2 showed that interaction erm and euc (β=1.633 and p-value < 0,01) is positively significant influence bp. however, interaction crm and euc (β=-1.383 and p-value < 0,01) is negatively significant influence bp this result suggested that h3 and h4 were supported. the results indicate that euc strengtern the influencing of erm and crm on bp. the strengtern relationship between erm and bp will be exist when euc is high. meanwhile strengtern relationship between crm and bp will be exist when euc is low the results of this study are consistent with research tseng et al. (2009), who obtained the result that the relationship between erm and firm performance is highly dependent on environmental uncertainty factors. this argument is in line with the view that concluded that the environment is an important contextual factors that have very strong impact on the direction and strategy of the company (hamel and prahalad, 1994). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 48 the uncertainty of the environment is based on the basis of contingency theory which states that the relationship between two or more factors are very dependent on other factors (contingent) that can not be controlled by an organization (otley, 1980). uncertainty environment is always changing, causing the company to be able to adjust the implementation of erm in accordance with the conditions of their environment. so the application of enterprise risk management to improve corporate performance more effective when high environmental uncertainty table 3. summary results of erm, crm, bank specific factors, and bank performance variables model 1 2 3 4 5 constant 2.781 (14.369)*** 2.750 (15.023)*** 2.282 (3.343)*** -1.344 (-0.427) 1.064 (1.107) erm 0.238 (2.801)*** 0.224 (2.766)*** -0.365 (-1.317) -3.662 (-2.537)** 0.945 (2.211)** crm 0.281 (2.921)*** 0.279 (3.030)*** 0.281 (1.998)** 4.429 (2.447)** -1.177 (-2.876)*** envuc -1.884 (-1.505) fc 0.641 (0.490) size 0.123 (1.217) ib 2.706 (1.669)* erm x envuc 1.633 (3.055)*** crm x envuc -1.383 (-2.688)*** erm x bc 0.115 (1.992)** crm x bc -0.099 (-1.137) erm x size 0.120 (2.626)*** crm x size -0.137 (-2.304)** erm x ib -1.245 (-1.644)*** crm x ib 2.266 (3.628)*** f-stat 11.046*** 7.962*** 6.525*** 11.772*** 8.014*** r2 0.194 0.309 0.268 0.398 0.310 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 49 ***represents statistical significance at the 1% level (two-tailed test) **represents statistical significance at the 5% level (two-tailed test) *represents statistical significance at the 10% level (two-tailed test) 4.4.3. risk management, complexity, and bank performance the regression results in table 3 model 3 showed that interaction erm and bc (β=0.115 and p-value < 0,05) is positively significant influence bp. however, interaction crm and bc (β=-0.099 and p-value ˃ 0,05) is negatively not significant influence bp this result suggested that h5 was supported and h6 was not supported. the results indicate that bc strengtern the influencing of erm on bp. the strengtern relationship between erm and bp will be exist when bc is high. 4.3.4. risk management, size, and bank performance the regression results in table 3 model 4 showed that interaction erm and bs (β=0.120 and p-value < 0,01) is positively significant influence bp. however, interaction crm and euc (β=-0.137and p-value < 0,05) is negatively significant influence bp this result suggested that h7 and h8 were supported. the results indicate that bs strengtern the influencing of erm and crm on bp. the strengtern relationship between erm and bp will be exist in larger bank. meanwhile strengtern relationship between crm and bp will be exist in smaller bank. 4.3.5. risk management, independent board, and bank performance the regression results in table 3 model 4 showed that interaction erm and ib (β=-1.245 and p-value < 0,01) is negatively significant influence bp. however, interaction crm and ib (β=2.266 and p-value < 0,01) is positively significant influence bp this result suggested that h7 and h8 were supported. the results indicate that ib strengtern the influencing of erm and crm on bp. the strengtern relationship between erm and bp will be exist in lower independent board monitoring bank. meanwhile strengtern relationship between crm and bp will be exist in hgher independent board monitoring bank. 5. conclusions the objectives of this study are to examine the influence enterprise (erm) and credit (crm) risk management on bank performance as well the moderating role of bank specific factor including bank environment uncertainty, conplexity, size, and independent board monitoring. this study found enterprise and credit risk management positively influence on indonesian listed bank performance. this study also reported that the influencing of erm on bank performance will be stronger since indonesian listed bank clasified as large bank and the bank operate in higher environmental uncertainty, higher complexity, and lower independent board monitoring. in contrast this study provide an empirical evidence on strangtern crm-bank performance relationship will be occur when indonesian listed bank clasified as small bank and the bank operate in lower environmental uncertainty, lower complexity, and higher independent board monitoring. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 50 this results imply that erm and crm are complementer risk management components that 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(2007). pengaruh struktur kepemilikan saham, leverage, faktor intern dan faktor ekstern terhadap nilai perusahaan. jurnal manajemen dan kewirausahaan, 9, 47-67. tjahjadi, b. (2011). hubungan sistem manajemen risiko dengan ketidakpastian lingkungan dan strategi serta dampaknya terhadap kinerja organisasi. majalah ekonomi, xxi, 22-40. microsoft word 10322-38088-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 68 does board supervisory quality enhance corporate social performance?-evidence from taiwanese listed firms yaying mary chou yeh (corresponding author) associate professor department of accounting, national dong hwa university no. 1, sec. 2, da hsueh rd., shoufeng, hualien 97401, taiwan, r.o.c. tel: 886-3-8633075 e-mail: marychou@mail.ndhu.edu.tw wen-chi hsieh auditor, audit department, deloitte & touche in taiwan first fl., no. 65, minzu 5th st., xizhi dist., new taipei city 221, taiwan, roc authors’ short bio: yaying mary chou yeh, dba, cpa, is the dean and an associated professor of department of accounting, national dong hwa university and teaches financial accounting, advanced auditing, accounting information system and financial reporting and analysis. she received her doctoral degree from nova southeastern university, usa. her research areas include financial accounting, corporate governance and financial reporting. her research papers have been published at journal of business research, total quality management & business excellence, asia pacific journal of accounting and economics and other peer-reviewed journals. received: nov. 18, 2016 accepted: feb. 17, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10322 url: http://dx.doi.org/10.5296/ajfa.v9i1.10322 abstract this study uses taiwanese public firms as a sample to examine if board supervisory quality enhances csp. the present study uses four proxies for supervisory quality of board at group level: board meeting attendance rate, number of board meetings, social capital of the board and average training hours of directors. we obtain 348 csr data from an international csr rating agent and match them with double size non-csr firms. we find that csr firms exhibit asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 69 significantly higher board attendance rate, board meeting frequency and board social capital than non-csr firms. for csr firms, board attendance rate and board meeting frequency positively impact csr ratings, implying that board diligence is essential to monitoring management to achieve higher social objectives. however, board social capital and training significantly but negatively impact csp, implying busy board and inexperienced board detriments csp. board success in csr means directors must be passionate about the issues on csr. additionally, firms that are behind social agenda need to recruit resourceful directors to diversify information base for advises about stakeholder issues and trends. firms that have taken steps in csr activities should not recruit overly busy directors or inexperienced directors. our paper provides both theoretical and practical implications. keywords: supervisory quality of board, corporate social responsibility, corporate social performance asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 70 introduction the concept of corporate social responsibility (csr) is widely accepted in advanced economies. enlightened firms with their own ethical traditions, along with the promotion by government legislation and regulatory institution, have laid down good foundations and development in csr guidelines and practices. the abstract concept of csr has been transformed into a long list of corporate practices in developed countries, such as environmental management systems, eco-friendly and safe products, labor protection and welfare plans, corporate philanthropy and community development projects, and corporate social and environmental performance disclosure. firms from asian countries, however, have low csr awareness both on the corporate and state level (clsa, 2014).there are limited csr practices except for minority firms with global operations (ip, 2008).recent cases of corporate failures highlight the need for firms involving social responsible activities to gain the legitimacy to operate (mallin & michelon, 2011). internal and external pressure forces businesses to fulfill social goals (davies, 2003). this raises a serious question on how to form ethic leadership to promote corporate social performance (csp) in asian emerging markets. the question is important considering the limited csr awareness and practices in this region (clsa, 2014; ip, 2008). board responsibilities are to approve management decisions and provide strategic directions for corporate executives, and to ensure accountability to all stakeholders (oece, 2004). the role of board has become more complex due to legislative mandates on the board’s composition, function and authority (andrés, azofra& lópez, 2005). additionally, increased attention to nonfinancial risk and opportunity has caused boards to consider issues related to social and environment. a good corporate governance system can prevent managers from making poor social decisions (xu et al., 2014) and board efficacy is the key to ensure responsible corporate governance and firm performance (lin et al., 2014).numerous studies demonstrate that board composition and director background contribute to corporate social performance (e.g. bear, noushi & post, 2010; beltratti, m 2005; boulouta, 2013; fernandez-feijoo, romero& ruiz2012; mallen&michelon, 2011). this paper is an attempt to identify what constitutes a good board of directors in terms of board effectiveness to enhance csp. the investigation is important because active board engagement ensures ethical leadership on company strategy toward long-term value creation. this study uses taiwanese public firms as a sample over the period of 2010-2012 to examine their relationships. we propose four proxies to measure supervisory quality of a board at group level: directors’ attendance rate, board meeting frequency, board social capital and board training. each represents directors’ devotion to the board responsibilities. empirical results indicate that csr firms exhibit significantly higher attendance rate, board meeting frequency and board social capital than non-csr firms, implying that board efficacy is critical in promoting corporate social awareness and initives. for csr firms, board attendance rate and board meeting frequency positively impact csr ratings. however, we find board social capital and board training negatively affect csr ratings, implying that busy and inexperienced board detriment a firm’s social performance. the results are robust after a battery of tests. overall, the combined results support our expectations that board supervisory asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 71 quality is important governance related contextual factor influencing corporate social performance. our study makes several contributions to the literature and practice. first, the economic consequences of csp have been studied extensively. there is little evidence on drivers of csp (moser & martin, 2012). we add to the literature by studying the effects of board supervisions on csp. second, tradition academic research focuses on a limited number of quantifiable board characteristics and their impact on csp. we argue that the soft elements of the board are of equal importance. mallen and michelon (2011) document board reputation is an attribute to csp. we extend this line of research by showing board efficacyare important to achieve csp, a topic never explored in the literature. lastly, csr is gaining importance in asia, and this trend is expected to continue in the future. as governments in asian countries have promulgated csr guidelines and practices on listed firms, our results add an important missing picture to the existing literature: effective board monitoring as a way to ensure ethic leadership. corporate social initiatives in taiwan in the past 20 years, taiwan has built strong economies as it produced companies with global brands in high-tech consumer goods and others. despite its standing in the global economy, corporate governance in taiwan has some way to go to match global standards (clsa, 2014).regulators in taiwan, therefore, are dutifully trying to compel modern governance practices on companies to catch up the trend in global corporate governance best practices. for example, board of directors constitutes the most important instrument in taiwanese corporate governance (ip 2008). the performance of a board depends on how all members commit them to their supervisory responsibilities. thus, the securities and exchange act of taiwan requires a firm to undertake self-evaluation of board and director performance on an annual basis, and organize training programmers for directors and disclose this information in annual reports, along with the board attendance records of directors. in 2011, all listed firms are required to establish compensation committee for setting executive remuneration policy. in terms of corporate reporting for listed companies, the taiwanese government has brought its accounting and financial reporting standards closer in line with international financial reporting standards in 2013, and improved non-financial reporting standards. however, very few companies establish audit committee. as far as csr is concerned, there are limited practices of corporate social responsibility in the public and private sectors. government agencies, namely the department of investment services, industrial development bureau of ministry of economic affairs, financial supervisory commission, and executive yuan, are said to spare limited effort to encourage enterprises to boost csr. as for listed firms, taiwan stock exchange and over the counter gretai securities market jointly enacted corporate social responsibility best practice principles for twse/gtsm-listed companiesin august of 2011 which advises listed firms to promulgate their own corporate social responsibility principles in accordance with the oecd principles to manage their environmental and social risks and impact. firms are responsible to establish their policies, systems or relevant management protocols for asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 72 corporate social responsibility programs, which shall be approved by the board of directors. by 2014, more and more enterprises have issued csr reports according to gri standards with few accredited by a third party, i.e., bsi of the united kingdom, sgs of taiwan and dnv of norway. however, recent high-profile cases of corporate misconduct in taiwan have resulted in large investor losses and public distrust. in 2011, soft drink makers had used industrial plasticiser as a clouding agent to save cost. in 2013, famous oil companies mixed olive oil with the cheaper cottonseed variety purified with a controlled colouring agent, copper chlorophyllin. the cooking oil scandal is ongoing in 2014 involving a food conglomerate ting hsin international group who are accused of using lard meant for animal feed in their cooking oil products. these incidents have sparked widespread outrage among consumers in taiwan, leading to a campaign to boycott the group’s products and brands. the wave of scandals involved listed firms and raised serious questions on corporate ethos and what can the board do to improve corporate responsibilities. the taiwanese government responded to these instances seriously. in 2014, the taiwan stock exchange corporation (tsec) and gretai securities market (gtsm) require listed companies with capital more than nt$10 billion, or firms in the food finance chemical industries are required to file cpa certified csr report in gri format. in total, 233 firms are required to file csr report beginning in 2014 although 77 of them have voluntarily done so beforehand. however, the establishment of board committee responsible for social and environmental issues is still not mandated. in the practical realm, there is no agency formally rate corporate social related performance except for two magazines awarding 30-50 best corporate citizens in taiwan. overall, corporate social responsibility is still on the budding phase. taiwan is not yet quite mature in csr accreditation system and leaves plenty of rooms for future development ahead. literature review and hypothesis development board supervisory quality the role of the board of directors has received a great deal of attention lately for being the apex of the decision-making process (kassinis and vafeas, 2006). the role of the board is to ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders(oecd, 2004).hence, a responsible board should apply high ethical standards taking into account of the interests of all stakeholders. the fiduciary duty of a board is to serve as effective stewards of their companies’ success. the performance of a board relies on how well each member commits herself to the supervisory responsibility. directors are expected to be actively involved in assessing and shaping company policies and practices, particularly on issues related to social and environment. however, most directors are busy with competing demands from various tasks. time constraints prevent them from devoting themselves unselfishly to various board issues. thus, board efficacy is important to ensure responsible corporate governance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 73 traditional academic research focuses mostly on the economic consequences of board-level characteristics, such as board structure and background. for instance, fama and jensen (1983) document that outside directors is less likely to engage in value-reducing behaviors. bear et al. (2010) finds that firms with woman directors achieve higher csp. van den berghe and levrau (2004) contend that practitioners attach greater importance to soft elements of the board which is rare in the literature. a stream of research has emerged since to study how board conducts affect corporate performance. ferris et al., (2003) finds that busy directors fail to fulfill board responsibilities. firms with diligent directors perform better (lin et al., 2014). mallin and michelon (2011) propose that board reputation attributes are important determinants of corporate social performance. it is important to extend this line of research to comprehend the economic consequences of board conduct. supervisory quality of board is hard to measure. the literature uses various proxies to appraise. jirapornet al., 2009 and lin et al. (2013) propose board attendance rate as an indication of board efficacy which provoke future performances. vafeas (1999) argue that board meeting frequency increases when a firm’s performance is deteriorating, meaning board meeting frequency could serve as an index of board efforts. yermack (1996) proposes board size as a measure as he finds the monitoring capacity of larger boards may be outweighed by increased problems of communication and group decision-making, leading to lower firm value. mallin and michelon (2011) propose that board composition, competence, diversity, leadership, structure and links to external environment could serve as board reputation attributes. board supervisory quality and corporate social performance csr has become a prominent issue for all companies worldwide. csr is about achieving commercial success in ways that honor ethical values and respect people, communities and environment. csp represents outcomes of a firm’s csr related operations. the rationale of csr is justified either by enabling managers to protect firms from external threats or to benefit from external opportunities, which in turn contribute toward firm profitability. the literature provides evidences on future benefits of csp, including sales (lev et al., 2010), financing (dhaliwal et al., 2011) and access to valuable resources (waddock& graves, 1997). the theory provides two perspectives: agency theory and stakeholder theory, for the link between board supervisory quality and csp. agency theory (jensen & meckling, 1976; fama & jensen, 1983) argues that the separation of ownership and control offers the threats of managerial interests overwhelming shareholders’ interests. in neoclassical economics’ view, csr initiatives are essentially an added cost to a firm (dhaliwal et al., 2011).opportunistic managers may direct a firm’s resources towards unprofitable csr activities (brammer & millington, 2008). agency costs arise when individual managers have preferences for societal benefit but at the expenses of owners (moser & martin, 2012). board monitoring represents a disciplining force within firms. as such, actions can be taken at the board level to balance the degree of managers’ discretion to engage in csr activities at the optimal level. using 100 best corporate citizens in the u. s., mallin and michelon (2011) propose that board reputation attributes are important determinants of corporate social performance. specifically, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 74 they find that bringing in more independent directors, community influential members, and female directors can effectively enhance corporate social performance. bear et al. (2010) finds that the number of women on the board hasa positive relationship with csp because of their sensitivity to csr(williams, 2003) and participative decision-making styles (konrad et al., 2008), and these benefits may contribute to enhanced corporate responsibility strength ratings. additionally, fernandez-feijoo et al. (2012) argue that boards with three or more women are more forthcoming in csr disclosure. the above literature investigates mainly on board composition but ignoring influences from board efficacy. stakeholder theory, on the other hand, argues that managers must satisfy a variety of constituents to achieve firm outcomes (dhaliwal et al., 2011; friedman, 1970). thus, organization legitimacy theory supports the view that businesses are bound by the social contract in which the firms agree to perform various socially desired actions appropriate to social norms, values and beliefs, in return for approval of its objectives and continued existence (suchman, 1995). by doing so, legitimacy helps firms to survive and grow (dobrev & gotsopoulos 2010; ruef & scott 1998), be more predictable (bansal &clelland 2004), and profitable (dacin et al 2007). managers will engage in csr activities that benefit society even when doing so decreases shareholder value (dhaliwal et al., 2011). thus, csp affects the reputation of a firm, which in turn enables a firm to gain social legitimacy. we argue that board efforts are important in lending support to the corporation in understanding and responding to its environmental and social issue. a well-designed corporate system should align managers to engage in csr activities to improve firm reputation. hence, corporate board of directors is expected to be actively involved in assessing and shaping company policies and practices on important social and environmental issues. the board is required to exercise due diligence to evaluate management and assess business strategies to ensure firms to expand the set of value-creating exchanges with customers, suppliers, communities and employees to yield returns in the long run. in sum, both agency and stakeholder theories support our predictions that board supervision is necessary to ensure firms are ethical toward environment and social responsibilities. the relationship between board composition and csp has been explored extensively. whether or not board supervisory quality affects a firm’s social performance is a empirical question never been explored in the literature. the efficacy of board is hard to measure. by consulting previous literature (e.g. jirapornet al., 2009; lin et al., 2013;mallin&michelon, 2011; vafeas,1999;yermack,1996), this study proposes four proxies to measure board supervisory quality at group level: attendance, meeting frequency, social capital and training, each representing a board’s devotion to a firm. board attendance directors exercise their oversight responsibilities mainly in board meetings. directors who actively involve themselves in board meetings are less likely to have attendance problem (adams & ferreira, 2012). absent in board meetings could be a sign of reduced monitoring quality. the financial supervisory commission, the top regulative body of listed firms in taiwan, requires firms undertaking self-evaluation of board and director performance on an asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 75 annual basis, and disclosing board attendance records of each individual director in company annual report. therefore, board attendance rate is a good indication of board diligence (adams & ferreira, 2012). lin et al. (2014) examine the relationships between board attendance and firm value and find that higher board attendance enhances higher firm accounting performance. this verifies that firms could view board attendance rate as an indication of board supervisory quality. this study proposes that the higher board attendance rate, the more likely they are fulfilling monitoring responsibilities in csr activities. board meeting frequency board meetings are critical to a firm’s performance (vafeas, 1999). when a board intends to closely monitor corporate managers, the intensity of board meeting increases (adams & ferreira, 2012).vafeas (1999) finds that the number of board meeting increases following poor performance, and poorly performing firms with higher meeting frequency in subsequent years improve their performance. this study proposes that the higher frequency of board meeting, the higher possibility of board exercises monitory functions in corporate social behaviors. board social capital directors usually hold top executive jobs and other directorships. multiple tasks enable directors build networks and obtain prudent information. fich and shivdasani (2006) argue that the number of directorships is closely linked to directors’ social capital. when directors hold multiple directorships, they accumulate bridging ability between firms and outside constituents (fich & shivdasani, 2006).director’s social capital offers entities links to external environment through which a firm can gain information, resources and legitimacy (kim & cannella, 2008) and these valuable experiences have positive impacts on how directors perform in a board (loderer & peyer, 2002; perry& peyer, 2005). kim and cannella (2008) contend that the aggregate social capital of the board is firm-specific intangible assets, which is critical to a firm’s sustainable competitive advantage. it should be noted that multiple directorships may cause directors to become overcommitted on other tasks(fich & shivdasani, 2006). regardless the business effects, this study argues that board-level social capital is positively associated with board effectiveness (mallin and michelon, 2011). board training a board should recruit individual directors with competencies and skills. after on board, individual directors should be regularly assessed and that these assessments should consider the applicable position description(s), as well as the competencies and technical ability each individual director is expected to bring to the board. thus, on-job training is important for directors continuously acquire knowledge and skill necessary to perform. in taiwan, listed firms are required to undertake self-evaluation of board and director performance on an annual basis, and organize training programmers for all directors. directors must obtain at least three hours of training and newly appointed directors should attend training program for at least 12 hours per year to gain experiences on company affairs. article 40 of the corporate asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 76 social responsibility best practice principles for twse/gtsm listed companies advises members of the board of directors to participate in training courses on finance, risk management, business, commerce, accounting, law or corporate social responsibility. these training are to ensure directors acquire technical ability for ethic leadership. overall, the present study predicts that the quality of board supervision is critical to a firm’s social awareness in initializing csr activities. as such, we propose h1to test their impact. h1a: board attendance rate positively impacts a firm’s csr initiatives. h1b: board meeting frequency positively impacts a firm’s csr initiatives. h1c: board social capital positively impacts a firm’s csr initiatives. h1d: board training positively impacts a firm’s a firm’s csr initiatives. using business ethics 100 best u. s. corporate citizens as samples, mallin and michelon (2011) claim that board reputation in terms of board composition, competence, diversity, leadership, structure and links with the external environment are associated with csp. for csr firms, this study proposes that the supervisory quality of board should have positive impact on a firm’s social performance. h2 states: h2a: board attendance rate positively affects a firm’s social rating. h2b: board meeting frequency positively affects a firm’s social rating. h2c: board social capital positively affects a firm’s social rating. h2d: board training positively affects a firm’s social rating. research design sampling procedure the examined data includes listed firms in taiwan covering 2010-2012. we begin with a search in csrhub database, a global internet csr rating company, for firms disclosing corporate social information in taiwan. there are 83 firms in 2010, 129 firms in 2011 and 136 firms in 2012, resulting363 firm-year samples. we then delete firms lacing board and financial information, leaving 348 firm years. we group these samples as csr firms and match them with double size non-csr firms, resulting in 1005 sample firms to test hypotheses h1a-h1d. non-csr firms are chosen from the same industry and in the sample year as the csr firms, limiting to size not more(less) than 40% of the size of these csr firms. as to hypothesis h2a-h2d, we use csr firms to test the relations between board supervisory quality and csp. table 1 presents our sample selection results and table 2 describe sample distribution. financial data is from taiwan economic journal (tej). the securities and exchange act of taiwan require listed firms to disclose corporate governance information in their annual reports, including board meetings and attendance rate. for each director under study, we hand asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 77 collect their trainings hours and directorship from company annual report. we begin with the names of each director and then match this data with names of other listed firms to calculate multiple directorships. table 1. sample selection firms evaluated in csrhub database 363 firms missing board or financial information -15 csr firms (h2a-h2d) 348 double size matching firms (noncsr firms) 657 total sample(h1a-h1d) 1005 models and variables this paper uses multiple regressions to analyze the impacts of board supervisory quality on csp. two models are in place. model 1 tests the relationships between various board efficacy measures and corporate social performance. model 2 adds additional corporate governance variables to control for their potential effects. cspi,t=α0+α1attendi,t-1 +α2meetingsi,t-1+α3sci,t-1+α4trainingi,t-1+α5levi,t-1 +α6roeit-1+α7sizei,t-1+α8year+α9industry+ εi (1) cspi,t=α0+α1attendi,t-1 +α2meetingsi,t-1+α3sci,t-1+α4trainingi,t-1 +α5ownshipi,t-1+α6indbdsi,t-1+α7internali,t-1+α8dualityi,t-1 +α9bsizei,t-1+α10levi,t-1+α11roei,t-1+α12sizei,t-1+α13year +α14industry+ εi (2) where εi is an error term csp∈csr_dum, csr_socre asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 78 table 2. sample distribution csr firms non-csr firms all observations industry code industries no. of observations % industry code industries no. of observations % industry code industries no. of observations % 11 cement 6 1.72 11 cement 12 1.83 11 cement 18 1.79 12 food 4 1.15 12 food industry 8 1.29 12 food 12 1.19 13 plastic 11 3.16 13 plastic 22 3.35 13 plastic 33 3.28 14 textile 7 2.01 14 textile 14 2.13 14 textile 21 2.09 15 elec machinery 10 2.87 15 elec machinery 20 3.04 15 elec machinery 30 2.99 17 bio&medical 9 2.59 17 bio &medical 18 2.74 17 bio &medical 27 2.69 18 glass &ceramic 3 0.86 18 glass &ceramic 6 0.91 18 glass &ceramic 9 0.90 19 paper and pulp 1 0.29 19 paper and pulp 2 0.30 19 paper and pulp 3 0.30 20 iron and steel 8 2.30 20 iron and steel 16 2.44 20 iron and steel 24 2.39 21 rubber 6 1.72 21 rubber 12 1.83 21 rubber 18 1.79 22 automobile 8 2.30 22 automobile 6 0.91 22 automobile 14 1.39 23 electronics 182 52.30 23 electronics 364 55.40 23 electronics 546 54.33 25 building material and construction 4 1.15 25 building material and construction 8 1.22 25 building material and construction 12 1.19 26 shipping &trans 16 4.60 26 shipping & trans 32 4.87 26 shipping & trans 48 4.78 27 tourism 2 0.59 27 tourism 4 0.619 27 tourism 6 0.60 28 fin and ins 43 12.36 28 fin and ins 57 8.68 28 fin and ins 100 9.95 29 trading 9 2.59 29 trading 18 2.74 29 trading 27 2.69 60 securities 5 1.44 60 securities 10 1.52 60 securities 15 1.49 97 oil and gas 3 0.86 97 oil and gas 6 0.91 97 oil and gas 9 0.90 99 other 11 3.16 99 other 22 3.35 99 other 33 3.28 total 348 100 total 657 100 total 1005 100 dependent variables corporate social performance: including csr_dum and csr_score. corporate social performance dummy (csr_dum): dummy variable equals to 1 for csr asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 79 firms, and 0 for non-csr firms. corporate social performance score (csr_socre): log of measures of csp. prior studies mostly use measures of csr ratings from kld’s socrates data base (e.g. bear et al., 2010, boulouta, 2013, mallin and michelon, 2011, turban and greening, 1996). however, very few listed firms in taiwan are indexed in kld. this study uses csrhub database, a global internet csr rating company, for suitable measures of corporate social ratings. firms are rated in four categories: community, employee relations, environment and corporate governance adhering to the global reporting initiative (gri) g3.1 guidelines. we measure a firm’s rating based on the average score obtained in each of the four areas (mallin & michelon, 2011). independent variables board meeting attendance (attend): the average attendance rate for all directors. board meeting frequency(meetings): the number of board meeting in a year. board social capital (sc): social capital of the board by setting 1 if more than 50% of directors holding multiple directorships of three or more (excluding own firm), and 0 otherwise. directors’ training hours (training): the average training hours for each director by taking total training hours of the board divided by the number of directors control variables this study controls the firm characteristic variables to avoid possible interference with the test results. leverage (lev) is the ratio of total debt to total asset. roe (roe) is return on equity. size (size) is the total sales in logarithm form to deflate scale differences. additionally, we control for year control(year): this study uses year as dummy variables to control for year effects (year) and industry effects (industry). for model 2, we add in board characteristics to control for their effects on csp. directors’ ownership (ownship) is the directors’ shareholding at end of the year. proportion of independent directors (indbds) is the percentage of independent directors on the board. internal directors (internal) is the percentage of management holding director seat. duality is a dummy variable equals to 1 if ceo is also chairman of the board, 0 otherwise. size of board (bsize) is the board size. table 2 summarizes all variable definitions. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 80 table 3. variable definitions dependentv. definitions csr_dum csr_socre dummy variable equals to 1 for csr firms, and 0 otherwise.. corporate social performance score (csr_socre):log of measures of csp. independent v. attend board meeting attendance; the average attendance rate for all directors. meetings board meeting frequency; the number meetings in a year. sc social capital; social capital of the board by setting 1 if more than 50% of directors holding multiple directorships of three or more (excluding own firm), and 0 otherwise. training the average training hours for each director by taking total training hours of the board divided by the number of directors corporate governance control ownship directors’ ownership; the directors’ shareholding at end of the year. indbds the percentage of independent directors on the board. internal the percentage of management holding director seat. duality dummy variable equals to 1 if ceo is also chairman of the board, 0 otherwise. bsize board size. firm control lev the ratio of total debt to total asset roe return on equity size total sales in logarithm form to deflate scale differences. year dummy variables to control for year effects. industry dummy variables to control for industry effects. empirical results descriptive statistics table 4 presents the descriptive statistics for the full sample (n=1005) and differential analysis for the csr (n=348) and non-csr (n=657) subsamples. for the full sample, the average for attend is 91.5% with sd of 0.117. the average for meeting is 8.251 with a sd of 3.648. the average for sc is 0.57 with a sd for 0.495, meaning about 57% of firms having half of directors holding multiple director seats. the average training hours for directors is about 4.193 hours. in terms of firm characteristics, the average debt ratio is about 51.5% and roe is 0.114. the average for size is 23.799. as to corporate governance controls, the average ownership by directors is about 19.8%. the average percentage of independent directors is about 15.4%. about 20% of firms who’s ceos also act as the chairman of the board. as to the size of the board, the average size is about 7.95 members. differential analysis in table 4 reveals that csr firms have significantly higher meeting, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 81 sc and train than non-csr firms. as to board characteristics, csr firms hire significant less internal directors and less ceo duality. csr firms are significantly larger in size and acquire more debt than non-csr firms. table 4. descriptive statistics and differential analysis n =1005 mean sd test of differences csr firms mean(sd) non-csr firms mean (sd) t value csr_dum 0.350 0.476 n/a n/a n/a attend 0.815 0.117 0.825(0.109) 0.809(0.120) 0.201 meetings 8.251 3.649 8.651(3.976) 8.042(3.448) 0.016** sc 0.570 0.495 0.640(0.481) 0.540(0.499) 0.000*** training 4.193 6.107 4.772(7.600) 3.887(5.125) 0.028** ownship 0.198 0.150 0.196(0.144) 0.199(0.154) 0.210 indbds 0.154 0.159 0.164(0.167) 0.148(0.155) 0.212 internal 0.253 0.175 0.255(0.200) 0.253(0.161) 0.000*** duality 0.200 0.396 0.150(0.360) 0.220(0.413) 0.000*** bsize 7.950 2.575 8.300(2.408) 7.770(2.643) 0.568 lev 0.515 0.203 0.515(0.218) 0.516(0.195) 0.004*** roe 0.114 0.194 0.136(0.187) 0.102(0.196) 0.435 size 23.799 1.350 24.882(1.338) 23.226(0.943) 0.000*** correlation analysis for h1, correlation analysis (table omitted) indicates that all of our board supervisory quality proxies: attend, meeting, sc and training are significantly related to csr_dum, supporting h1. as to control variables， ownship, internal and duality are significantly but negatively related to csr_dum while roe and size are positively related to csr_dum. however, for h2 we find only meeting is significantly related to scr_score (table omitted) . more tests are warranted to consider confounding effects from other factors. regression results for h1 we apply logistic regression to analyze the relationship between our supervisory quality proxies and csr_dum. regression results in table 5 indicate that attend (2.451, p=0.007), meeting (0.059, p=0.035) and sc (0.610, p=0.003) significantly affect csr_dum, supporting h1a, h1b and h1c respectively. this implies that diligent boards and boards with affluent social capital have higher social awareness. however, we fail to find any significant relationships between training and csr_dum (-0.008, p=0.733)，h1dis not asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 82 supported. as to firm control，highly leveraged and larger size firms have higher social awareness. model(2)adds corporate governance related variables. the results are similar that three of our supervisory quality proxies (attend, meeting and sc significantly impact scr_dum (2.273, p=0.015; 0.051, p=0.071; 0.586, p=0.005). again, there is no material association between training and our csr_dum (-0.013, p=0.578). as to corporate governance related variables, ownship (-1.454, p=0.031) and internal (-1.045, p=0.090) significantly but negatively related to csr_dum, implying that firms with high director ownership or manager directors have lower social awareness. as to firm control, the results are similar to the main tests. table 5. regression results for h1(y=csr_dum) model (1) model (2) intercept -50.830 *** 0.000 -51.089 *** 0.000 attend 2.451 *** 0.007 2.273 ** 0.015 meetings 0.059 ** 0.035 0.051 * 0.071 sc 0.610 *** 0.003 0.586 *** 0.005 training -0.008 0.733 -0.013 0.578 ownship -1.454 ** 0.031 indbds 1.066 0.158 internal -1.045 * 0.090 duality -0.139 0.606 bsize -0.052 0.234 lev -7.331 *** 0.000 -7.775 *** 0.000 roe -0.501 0.390 -0.570 0.358 size 2.150 *** 0.000 2.225 *** 0.000 year included included industry included included n 1005 1005 walds tests 91.872 91.872 significance 0.000 *** 0.000 *** nagelkerker 0.604 0.613 ***, **, and * represent significance at 1, 5, and 10%levels. definitions of variables appear in table 3. for h2 h2 test the relationships between board supervisory quality and corporate social ratings for csr firms. table 6 present regression results. we find that attend (0.107, p=0.037) and meeting(0.004, p=0.007) significantly impact csr_score, implying board diligence in holding and attending meetings can push up corporate social performance. however, the results indicate that sc (-0.022, p=0.042) significantly but negatively impact csp. when a asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 83 board is too busy with multiple directorships, they are less likely to monitor corporate social activities of a firm, h2c is not supported. surprisingly, training (-0.002, p=0.015) is also a factor negatively impact csp. one possible explanation is that regulations in taiwan require newly appointed directors to obtain much more training hours. the results imply that boards with inexperienced directors are less effective in monitoring corporate social activities. as to firm control variables, larger and profitable firms have higher social performance model (2) adds in corporate governance related variables. the results are similar that attend (0.098, p=0.054)and meeting (0.004, p=0.006)significantly impact scr_score. again, we find significant but negative association between sc and csr_score (-0.022, p=0.043), h2c is not supported. training also negatively impact csr_score (-0.002, p=0.013), h2d is not supported. as to corporate governance related variables, internal (-0.111, p=0.090) and duality (-0.026, p=0.090) significantly but negatively related to csr_score, meaning that firms with more manager directors or ceo also acting as board chair have lower social performance. as to firm control, the results are similar to the main tests. table 6. regression results for h2(y=csr_score) model (1) model (2) intercept 1.279 *** 0.000 1.324 *** 0.000 attend 0.107 ** 0.037 0.098 * 0.054 meetings 0.004 *** 0.007 0.004 *** 0.006 sc -0.022 ** 0.042 -0.022 ** 0.043 training -0.002 ** 0.015 -0.002 ** 0.013 ownship -0.062 0.161 indbds -0.013 0.713 internal -0.111 *** 0.000 duality -0.026 * 0.090 bsize -0.003 0.227 lev -0.001 0.984 -0.010 0.791 roe 0.082 *** 0.004 0.077 *** 0.008 size 0.012 ** 0.019 0.014 *** 0.006 year included included industry included included n 348 348 adj.r 0.268 0.303 ***, **, and * represent significance at 1, 5, and 10%levels. definitions of variables appear in table 3. robustness tests this study performs additional tests for robustness. kim et al. (2014) argue that corporate social performance ratings includes corporate governance dimension. this study eliminates this dimension from our scp score and rerun the regression models and table 7 presents our asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 84 results. similar to our main tests, attend and meeting are still significantly related to csr_score (0.113, p=0.042; 0.004, p=0.009) while sc and training are negatively impact csr_score (-0.031, p=0.010; -0.002, p=0.010). table 7. regression results for h2-eliminating cg factor from csr-score measure model(1) model(2) intercept 1.247 *** 0.000 1.290 *** 0.000 attend 0.113 ** 0.042 0.104 ** 0.060 meetings 0.004 *** 0.009 0.005 *** 0.008 sc -0.031 *** 0.010 -0.031 *** 0.010 training -0.002 ** 0.011 -0.002 *** 0.010 ownship -0.060 0.212 indbds 0.017 0.661 internal -0.116 *** 0.000 duality -0.004 0.169 bsize -0.030 * 0.067 lev 0.004 0.924 -0.006 0.887 roe -0.037 *** 0.010 0.088 *** 0.005 size 0.072 *** 0.000 0.015 *** 0.008 year included included industry included included n 348 348 adj. 0.273 0.307 ***, **, and * represent significance at 1, 5, and 10%levels. definitions of variables appear in table 3. kim et al. (2012) also indicate that certain industries are more inclined to disclose csr related information and the inclusion of these industries may alter our results. we thus eliminate firms from chemical, biochemical and automobile industries (dhaliwal et al., 2012; kotchen and moon, 2011), leaving 331 sample firms. the results are similar (table 8). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 85 table 8. regression results for h2-eliminating environmental sensitive firms model(1) model(2) intercept 1.241 *** 0.000 1.293 *** 0.000 attend 0.111 ** 0.033 0.105 ** 0.042 meetings 0.006 *** 0.001 0.006 *** 0.002 sc -0.023 ** 0.039 -0.024 ** 0.035 training -0.002 ** 0.014 -0.002 *** 0.011 ownship -0.078 ** 0.089 indbds -0.029 0.445 internal -0.116 *** 0.000 duality -0.028 * 0.078 bsize -0.003 0.329 lev 0.004 0.930 -0.006 0.879 roe 0.090 *** 0.002 0.087 *** 0.003 size 0.012 ** 0.018 0.015 *** 0.006 year included included industry included included n 331 331 adj. 0.278 0.315 ***, **, and * represent significance at 1, 5, and 10%levels. definitions of variables appear in table 3. discussion and conclusion the concept of a board’s fiduciary duty has been expanding to include a number of social environmental and human rights issues that may have a material impact on company performance. this study proposes board efficacy as a driving force to promote corporate social performance. the investigation is important considering the relatively low csr awareness in asian firms and the increasing social and legislative demands board monitoring on corporate social operations. using a sample of taiwanese listed firms, empirical results confirm our expectations. below summarizes our findings. 1. board supervision quality is critical in promoting corporate social awareness. h1 tests if board supervision quality is significantly higher for csr firms comparing to firms not yet taking csr seriously. we find board attendance rate, meeting frequency and social capital significantly influencing a firm’s csr awareness and initiatives. the results imply that a board should hire directors with social capital and encourage directors dutifully engage in board affairs to promote corporate social awareness. 2. board supervision quality can improve corporate social ratings h2 tests if improving board supervision quality can indeed enhance corporate social ratings. among csr firms, empirical results indicate that attendance rate and meeting frequency positively affects a firm’s csp, implying that board diligence is essential to monitoring management to achieve higher social objectives. however, board social capital and training asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 86 significantly but negatively impact csp, implying busy board and inexperienced board detriments csp. csr has attracted worldwide attention nowadays as it requires firms to conduct business beyond compliance with the law and beyond share holder wealth maximization. firms nowadays provide not only the quantity of goods, services, and employment but also the quality of life for those whose interests are affected by corporate activities. together the evidences suggest that board success in csr means directors must sincerely want to engage and individual directors must be passionate about the issues and champion the board’s effort. additionally, firms that are behind social agenda need to recruit resourceful directors to diversify information base for advises about stakeholder issues and trends. firms that have taken steps in csr activities, on the other hand, should not recruit overly busy directors or inexperienced directors. this will ensure total directors’ total devotion to company goals and strategies addressing social and environment issues. managerial and practical implications our paper provides both theoretical and practical implications. theoretically, our findings highlight the need for a better understanding of the soft elements that determines board effectiveness for csp. social and environmental considerations are no longer seen as soft areas in conducing businesses. rather, boards are instrumental in shaping and overseeing such strategies. the findings of this study have practical implications for boards and investors. first, the role of board is evolving and an effective board ought to position herself in a strong leadership role as to csr practices and oversight. second, investors make investment decisions not only based on financial data but also on nonfinancial performance. csr is one of the critical areas for careful scrutiny. this research provides investors an additional channel when assessing potential investment. references adams, r. b., & ferreira, d. 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(1996). higher market valuation of companies with a small board of dirctors. journal of financial economics, 40(2), 185-211. https://doi.org/10.1016/0304-405x(95)00844-5 microsoft word 13674-49903-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 30 models for prediction of industrial insolvency of manufacturing companies in india nisarg a joshi (corresponding author) economics & finance area institute of management, nirma university, ahmedabad, india e-mail: nisarg@nirmauni.ac.in jay m desai b. k. school of business management gujarat university, ahmedabad, india e-mail: jay@jaydesai.net received: sep. 19, 2018 accepted: oct. 15, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13674 url: https://doi.org/10.5296/ajfa.v10i2.13674 abstract investors, activists and corporations across the world are emphasizing on prediction of insolvency well in advance so that corrective actions can be taken and erosion of funds can be prevented. for this purpose, this study attempts to construct models for forecasting industrial sickness and to validate the performance of these models. this paper proposes new models for prediction of industrial sickness or leading bankruptcy using three different techniques i.e. a model using multi discriminant analysis (mda), a model using mda + pca (principle component analysis), and a model using ann (artificial neural network).this paper focuses to propose prediction models for bankruptcy which contribute more to this impact in emerging economies like india. the results show that the forecasting ability of the models is higher than the empirical models already available such altman’s z score model, ohlson’s model and model developed by odom and sharda to name a few. the prediction accuracy of mda model is highest among proposed models for prediction of industrial sickness. these results are recommended to financial institutions, banks and executives. this study may also be used for evaluating the repayment behavior of a borrower. these models may be used by the potential investors for screening out undesirable investments. since the models are of predictive nature, the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 31 investors may use it for portfolio selection. keywords: bankruptcy prediction, insolvency, accounting ratios, neural network, multi-discriminant, pca. jel classification: g33, c02, c38, c45, c52, c53 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 32 1. introduction the achievement of success had been the enunciation in management research for last few decades. the companies had been judged on the basis of how rapidly they had grown and how fast they increased their market share. the bankruptcy or insolvency of a company has been a very important part of a manager’s job as the accomplishment of its success. this role is becoming more significant and crucial as the penalties of failure are becoming more modest. a number of activities are performed in the business by each company. but the outcomes of certain activities are uncertain and risky. this involves risk for every business. “among the different risks that an organization is faced with, default risk is possibly one of the ancient financial risks, though there have not been many instruments to manage and hedge this type of risk till recently” (gupta, 2014). the majority business transactions are of financial nature (yadav, 1986) which leads to default risk and finally results into non-repayment of debt. default risk has gained utter importance because of innovative financial instruments, different tools of risk management and change in economic conditions. the risk of default is at the center of credit risk: credit rating agencies (cras) are the most important supply for measuring the credit superiority of businesses/borrowers in developing economies like asian countries. since improvement and deterioration of ratings will influence the worth of equity and debt that is being listed within the market, participants of area unit are fascinated in developing sensible models for prediction. the failure of a firm brings stress to entrepreneurs, managers and the society at large. the unemployment goes up, availability of goods and services goes down, the cost goes up and a large sum of funds is blocked up. the shareholders lose their investments, creditors lose their funds the customer is deprived of the product. therefore, a model is required which predicts the insolvency at the earliest and would serve to minimize such losses by providing alarm and a warning in advance to all the concerned parties. this requirement has been the primary motivation for us to investigate the prediction of industrial insolvency as an interesting area. with a small improvement in assessing the credit risk, reduction in a considerable amount of savings for an economy can be achieved. (lee and choi, 2013). an improvement in the accuracy of even a fraction of percent in scoring of models, to estimate the probability of default leads to enormous future savings for the credit industry. (west, dellana and qian, 2005). though a wide number of analytical/mathematical/statistical models are present, there was a great emphasis to be given to an emerging economy like india to develop bankruptcy forecasting model. there are numerous models developed over the years due to growing data availability and development of econometrical techniques during the decades of 80s and 90s. there are two groups in which methods of bankruptcy prediction can be categorized: statistical models and intelligent models. the statistical models include the formalization of relationships between variables in the form of mathematical equations whereas intelligent asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 33 models include machine learning which includes an algorithm that can learn from data without rules-based programming. the statistical models include mda, logit regression etc. the first techniques applied to insolvency forecasting was the univariate data analysis (beaver, 1966) followed by the multi discriminant analysis (altman, 1968) and logit regression (ohlson, 1980). the second group consists of principal component analysis (pca), artificial neural networks (chauhan, ravi & chandra, 2009; cho, kim & bae, 2009; pendharkar, 2005; ravishankar & ravi; 2010; kim & kang, 2010; tseng & hu, 2010; lee & choi, 2013), genetic algorithms ( lensberg, eilifsen & mckee, 2006; etemadi, rostamy & dehkordi, 2009; ahn & kim, 2009), support vector machines (svm) ( min & lee, 2005; hardle, lee, schafer, & yeh, 2009; yang, you & guoli ji, 2011) and case based reasoning (ahn & kim, 2009; cho hong & ha, 2010; li & sun, 2010, 2011; li, adeli, sun, & han, 2011) this paper exhibits the detailed analysis of the construction and validation of the models for prediction of industrial sickness. the analysis is organized into five sections. the first section shows the detailed description of the financial ratios for non-sick and sick companies. the second section deals with various statistical tests which show the financial ratios as discriminators. the third section involves the analysis of the predictor ratios. the fourth section presents a comprehensive discussion of the model construction for prediction of industrial sickness using different methodologies. finally, the last section shows the validation of the models and their accuracy results. the purpose of the study is to assess the projecting capability of four insolvency forecasting models for manufacturing firms which are listed on stock exchanges: a discriminant analysis using j-score, a proposed model using mda+pca and a proposed model using artificial intelligence. 2. literature review previous research studies have used several financial ratios to different sample sets in various countries to study prediction of corporate sickness. beaver (1966) found out that cash flow to total debt ratio exhibited statistically significant warnings prior to business failure and concluded that the firms with lower liquid assets were more prone to bankruptcy and vice versa. the study also suggested the possibility of using multiple ratios simultaneously in order to have the higher predictive ability. altman (1968) proved that a prediction model based on multiple discriminant analysis had been extremely accurate in predicting bankruptcy. the majority of the studies found that debt and profitability related ratios significantly determine the corporate failure. gupta (1983) concluded that net worth to short and long term debt and outside liabilities to tangible assets ratios were useful in predicting corporate failure. kumar and kumar (2012) found that ohlson’s o-score model using binary logistic regression technique performed better than altman’s model and suggested the possibility of using domestic data through new models based on different combinations of financial ratios. many researchers have employed multiple discriminant analysis (gupta, 1983; lincoln, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 34 1984; izan, 1984) and logit analysis (mohamed, li, and sanda, 2001; abdullah, hallim, ahmad and rus, 2008) in determining the predictors of corporate failure. some of these studies have compared the results of multiple discriminant analysis and logit analysis. early warning models for predicting corporate bankruptcy have been developed by some of these researchers. in the past, several studies indicated various financial ratios as predictors of corporate sickness. patrick (1932) showed that the net worth to debt and net profits to net worth were the best indicators of failure among the ratios used. the financial ratios commonly used by researchers were net income to total assets (beaver, 1966; deakin, 1976; libby, 1975; ohlson, 1980; lennox, 1999), total liabilities to total assets (beaver, 1966; deakin, 1976; ohlson, 1980; zmijewski, 1984). net income ratio was used to represent growth. in uk context, lennox (1999) used cash to current liabilities, debtor turnover ratio and gross cash flow ratio as the predictors. the bankruptcy in korea studied by nam and jinn (2000) revealed that it was due to financial expenses to sales, debt coverage and receivables turnover ratio. we have reviewed different research studies which were relevant to the current work under wide areas. beaver (1966, 1968) and altman (1968) had developed the first set of accounting models to measure the bankruptcy threat for a firm. beaver (1966) had developed a univariate model for forecasting indebtedness of a firm. altman (1968) had developed a model by adopting discriminant analysis with the use of financial ratios for discretion between insolvent and solvent firms. later altman et al. (1977) developed z-score models called zeta and another model was developed by altman et al. (1995) for the companies/firms in emerging markets. a study was conducted in 22 countries by altman and narayanan (1997) where they concluded that the default risk can be predicted effectively with the ratios based models. recently, gupta (2014) had developed an accounting based prediction model using discriminant analysis and logit regression and compared the predictive ability of these models. “for logistic regressions, an attempt was made to combine macro variables and dummy industry variables along with accounting ratios. the paper had analyzed that the predictive ability of the proposed z-score model was higher when compared to both the altman original z-score model and the altman model for emerging markets. the research findings establish the superiority of logit model over discriminant analysis and demonstrate the significance of accounting ratios in predicting default.” (gupta, 2014) the first attempt to use anns to predict bankruptcy was made by odom and sharda (1990). in their study, three-layer feed forward networks were used and the results were compared to those of multivariate discriminant analysis. using different ratios of bankrupt firms to non-bankrupt firms in training samples, they test the effects of different mixture level on the predictive capability of neural networks and discriminant analysis. neural networks are found to be more accurate and robust in both training and test results. a number of network training parameters are varied to identify the most efficient training paradigm. the focus of this study is mainly on the improvement in efficiency of the back propagation algorithm. coleman et al. also report improved accuracy over that of odom and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 35 sharda (1990) by using their neural ware adss system. boritz et al. (1995) use the algorithms of back propagation and optimal estimation theory in training neural networks. the benchmark models by altman (1968) and ohlson (1980) are employed. results show that the performance of different classifiers depends on the proportions of bankrupt firms in the training and testing data sets, the variables used in the models, and the relative cost of type i and type ii errors. boritz and kennedy (1995) also investigate the effectiveness of several types of neural networks for bankruptcy prediction problems. cheng, chen, and fu (2006) predicted corporate bankruptcy by combining logit model with neural network, which avoids drawbacks of both methods and incorporate advantages of both methods. hua, wang, xu, zhang, and liang (2007) adopted logistic regression to minimize the risk of support vector machine in prediction of business failure. sun and li (2008b) constructed multi-classifiers system for bankruptcy prediction using mda and logit as components. lee and choi (2013) used back-propagation neural network (bnn) for investigating multi-industry bankruptcy of korean companies. the study intended on suggesting the industry specific model to predict bankruptcy by selecting appropriate independent variables. they compared the prediction accuracy of bnn to multivariate discriminant analysis. according to their study, the industry sample has better performance of prediction than the non-classified sample by the variation of 6 12%. the prediction accuracy of bankruptcy using bnn was found better than that of mda. principal component analysis (pca) is an expedient statistical technique for feature extraction. pca can help a classifier produce more accurate predictive performance (avci & turkoglu, 2009). it is assuming that most of information about classification is contained in the directions along which the feature values are the largest (polat & günes, 2008). the component scores and loadings can be used to interpret the results of a pca (shaw, 2003). li and sun (2011) constructed a new hybrid model for bankruptcy prediction by integrating principal component analysis (pca) with mda and logit to have better predictive performance. this study has followed data mining approach, case based reasoning, neural network, support vector machine technique and discriminant analysis based on previous studies (for example, jo, han, & lee, 1997; li, sun, & sun, 2009; lin & mcclean, 2001; min & lee, 2005; min, lee, & han, 2006; sun & li, 2008a) without differentiating type i and type ii errors. they have done a pilot study which demonstrated the use of pca with mda and logit in bankruptcy prediction. the model was developed by using stepwise method of mda, stepwise method of logit, and independent sample t test as the preprocessing procedure, on the basis of which pca is further used to extract features for mda and logit. they have obtained the optimal preprocessing procedure by splitting the available data for 30 times for pca. this model was used to investigate the bankruptcy prediction of listed companies of china. the results show that the hybrid model of pca with mda and logit has better prediction power and it has outperformed all other models. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 36 after a comprehensive literature review on bankruptcy prediction, it was found that a plenty of work had been done in this area but we can see a gap in development of prediction models for manufacturing sector in emerging economies like india. though there are models available in the indian context, but these models are quite old and are constructed adopting the financial ratios which had been used in the previous studies decades back. as the businesses have changed, there has been a change in the financial ratios affecting the solvency of the companies. the research gap for this study is to identify the financial ratios which are discriminating between sick and non-sick companies and use those financial ratios as predictive variables of industrial sickness. it had been found from the literature that the discriminating financial ratios between sick and non-sick companies have changed over the year in different studies. we are focusing on constructing and validating the prediction models using such discriminating variables. given the research gap, this study emphasizes to construct and validate bankruptcy prediction models using different financial ratios with a high predictive power and generalized applicability. for this purpose, we have formulated following hypotheses: hypothesis 1: there is no significant difference between mean values of financial ratios of non-sick and sick companies. (for determination of discriminators) hypothesis 2: the financial ratios do not predict industrial sickness. the predictors have no significant effect on either of the outcomes, namely sick and non-sick. (for determination of predictors) hypothesis 3: the prediction models are not capable of making correct predictions of industrial sickness. 3. methodology this study emphasizes on development of a forecasting model using various techniques. for this purpose, secondary data was collected from the financial statements of the companies from ace equity database. a sample was obtained on the basis of the credit ratings given by the credit rating agencies. a sample of 80 companies was obtained in which the companies were stratified as far different industries pertaining to manufacturing sector. entire sample was divided on the basis of their credit ratings of the financial year ending on march 31, 2014, signifying their solvency position. out of the entire sample, there were 40 companies which were given lowest ratings (credit rating: d) by the agencies (failed/defaulted companies) and other 40 companies which belonged to the same industries and of same size and were given highest ratings by the agencies (credit rating: aaa) (non-failed/solvent companies). out of the total sample size, we have used a sample of 50 firms (25 firms of each category of solvent and insolvent companies) as the training sample. whereas the remaining 30 companies were used as the holdout or validation sample. following table 1 provides the number of companies selected as a sample from different industries for the purpose of this study. this study covers manufacturing companies of india which are listed on stock exchanges. service sector companies have been excluded from the sample. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 37 table 1. list of companies in dataset/sample industry no. of companies electricals 4 chemicals 6 pharmaceuticals 20 textile 18 machinery 12 consumer food & sugar 12 cement & metals 6 others 2 total 80 3.1 methodology for selection of variables a set of 56 ratios were taken on the basis of previous literature such as (altman, 1968; ohlson, 1980; gupta, 1983) for the years 2009 2013 from financial statements of the companies for identifying the ratios which discriminate between sick and non-sick companies. these ratios involve various categories such as liquidity ratios, solvency ratios, and profitability ratios, productivity ratios, operating efficiency ratios, leverage ratios, growth ratios, and net worth ratios, turnover ratios and cash flows ratios. 3.2 determination of discriminators for industrial sickness to construct a model for prediction of industrial sickness, the initial step is to identify and determine the financial ratios which discriminate significantly between non-sick and sick companies. the financial ratios should fulfill following conditions for determination of discriminators. 1. the sample must be normally distributed 2. the samples must have equal variances 3. the observations of samples should be independent of each other, within the groups and between the groups. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 38 test of normality has been used to find out if financial ratios of both sick and non-sick companies were normally distributed. spearman’s correlation coefficient was used to find out if the ratios were independent ones. test of equality of variance was carried out to observe if financial ratios have equal variances between sick and non-sick companies. the parametric tests which we apply in this study examine the difference between the two group means and conclude whether there exists a significant difference between the two distributions. as seen in the previous studies (e.g. gnanadesikan and kettenring 1972, belsley et al. 1980, laitinen, 1991), the requirement of normality has been frequently violated in the case of distributions of financial ratios in several previous studies and even transformation of the data to approximate normality did not improve normality in all cases. if the above mentioned conditions are not met and when majority of the ratios are found to be of non-normal distribution, non-parametric tests can be applied. the distribution of the non-parametric test statistics may give a more reliable result (laitinen e., 1991). non-parametric tests use ranks of the variables to compare medians rather than means. this consideration facilitated the use of parametric statistical tests in the present study. for selection of variables, first, the normality of data was checked using anderson-darling normality test. the results showed that majority of the ratios were normally distributed. for the purpose of analyzing the equality of variances between two samples of sick and non-sick companies, levene’s test of equality of variance was performed. the correlation coefficient was calculated between two samples to avoid multi-collinearity and it was found that most of the variables have low correlations with each other. using the results of the of independent two sample t test and manova, emerging discriminators were identified. it is including the financial ratios which were discriminators between non-sick and sick companies in the years i.e. 2009 2013 prior to the year 2014 in which their credit rating was showing them industrially sick. financial ratios were identified as discriminators on the basis of the analysis of independent two sample test and the results of manova. out of the analysis, there are total 32 ratios who have come out as emerging discriminators from the results of independent two sample t test. we have also taken 9 other financial ratios which were not emerging as discriminators as a result of independent t test but found to be significant according to manova analysis whose p value is less than 0.05. there are total 41 financial ratios who have been identified as discriminators shown in the table below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 39 table 2. summary of financial ratios identified as discriminators variable description of ratios variable description of ratios r1 retained earnings/total assets (re/ta) r21 total tangible assets/total debt (tta/td) r2 interest coverage ratio (icr based on earnings before interest, taxes, depreciation and amortization) r22 total tangible assets/long-term debt (tta/ltd) r3 debt equity ratio (d/e) r23 net worth/total debt (nw/td) r4 net sales/total assets (ns/ta) r24 cash/total tangible assets (cash/tta) r5 earnings before interest and taxes/total assets (ebit/ta) r25 quick assets/total tangible assets (qa/tta) r6 profit after taxes/total assets (pat/ta) r26 current assets/total tangible assets (ca/tta) r7 profit after taxes/net sales (pat/ns) r27 cash/current liabilities (cash/cl) r8 profit before depreciation and interest after taxes/net sales (pbdita/ns) r28 net sales/debtors (ns/debtors) r9 market value of equity/book value of liabilities (mve/bvl) r29 net sales/inventories (ns/inv.) r10 book value of equity/book value of liabilities (bve/bvl) r30 net sales/fixed assets (ns/fa) r11 total debt/total assets (td/ta) r31 cash/total operating expenditure (cash/toe) r12 fixed cost/total assets r32 earnings before interest depreciation and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 40 (fc/ta) taxes/(total assets + depreciation) [ebidt/(ta+dep)] r13 earnings before interest and taxes/total tangible assets (ebit/tta) r33 operating cash flow/(total assets + depreciation) [ocf/(ta+dep)] r14 net sales/total tangible assets (ns/tta) r34 net worth/total tangible assets (nw/tta) r15 operating cash flow/total tangible assets (ocf/tta) r35 current ratio (cr) r16 operating cash flow/total debt (ocf/td) r36 quick ratio (qr) r17 profit after taxes/total tangible assets (pat/tta) r37 profit after taxes/capital employed (pat/ce) r18 profit after taxes/total debt (pat/td) r38 current liabilities/total assets (cl/ta) r19 earnings before interest and taxes/interest (ebit/int.) r39 profit after taxes/net worth (pat/nw) r20 total tangible assets/current debt (tta/cd) r40 net assets/quick assets (na/qa) r41 operating cash flows/net sales (ocf/ns) the discriminators identified in the present study align with the findings of beaver (1966) that non-parametric analysis resulted in five ratios namely cash flow to total debt, net income to total assets ratio along with two other ratios discriminating between non-sick and sick companies; gupta (1983) on the basis of a simple non-parametric test found that operating cash flow to (total assets + depreciation), net worth to total tangible assets and ebdit to (total assets + depreciation) as few of the seven ratios having differentiating power. the results of the discriminators of the present study support the findings of altman (1968) where four out of five ratios of altman’s z score model are found to be discriminating between non-sick and sick companies. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 41 3.3 determination of predictors for industrial sickness after identifying the discriminating financial ratios, the procedure was conducted to identify the financial ratios that are significant in the prediction of industrial sickness. this section is emphasizing on the other objective of determination of financial ratios that are important in prediction of bankruptcy. we have used canonical correlation analysis, wilk’s lambda and mean difference of 41 financial ratios to identify significant predictors. from this analysis, we found two sets of ratios which have emerged as the predictors. out of these two sets, one set is having 16 ratios and another set is having 22 ratios. following discussion focuses on identification of the financial ratios which are significant predictors of industrial sickness. 3.3.1 canonical correlation is used for ratio selection in present study the canonical correlation for each ratio of solvent and insolvent company is calculated. initially, we found 22 linear combinations (22 ratios for solvent and insolvent companies) out of 41 ratios that maximize the correlations between the members of each canonical variate pair. then we adopted a method of substituting or removing a ratio out of these 22 pairs to find out how the canonical correlation changes. after substituting the pairs of ratios, we found that there are other 16 linear combinations for which the correlation is very high. if the ratios were reduced more than 16, the correlation was affected. therefore, we identified the values of two sets of linear combinations where canonical correlation for 16 and 22 ratios clearly show that they are highly correlated. these two groups of ratios which were identified as predictors contain partly the same variables. there are 16 financial ratios which are same in both the groups and 6 other ratios were identified on the basis of significant canonical correlation and added in the group of 16 ratios to make 22 ratios. furthermore, these 16 ratios and 22 ratios of the firms were used as predictors to develop different models i.e. a model using 16 ratios and a model using 22 ratios to check which model has a better predictive ability. 3.3.2 wilk’s lambda is used in the study wilk’s lambda was calculated for 16 and 22 ratios both. the value for 16 ratio is 0.47593 and 22 ratio is 0.38993. the inputs are the 16 dimensional or 22 dimensional vectors of average data of solvent and insolvent companies for last 5 years. 3.3.3 mean difference is used in the study average of each ratio is taken for last five years for solvent and insolvent companies. the ratios which showed the highest difference between two classes were selected as predictors. out of the 41 ratios which were identified as discriminators, there are 22 ratios which have emerged as significant predictors based on canonical correlation, wilk’s lambda and mean difference. the findings of the study are supporting the results of datta (2013) who had used canonical correlation to identify the financial ratios which are emerging as discriminators and predictors. in the same study, wilk’s lambda was used to determine predictors. the findings asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 42 of the study are also in line with the findings of the study done by mahalkshmi a. (2013) who had used wilk’s lambda, pillai’s trace and manova for identifying predictors. the 22 ratios which have emerged as predictor ratios are shown in the table below. table 3: summary of financial ratios identified as predictors variable description of ratios variable description of ratios r1 cr r12 ns/debtors r2 qr r13 ns/inv. r3 fc/ta r14 na/qa r4 cl/ta r15 ns/fa r5 pat/ce r16 cash/toe r6 pat/nw r17 pbdit/ns r7 tta/cd r18 ocf/ns r8 tta/ltd r19 nw/td r9 cash/tta r20 ebidt/(ta+dep) r10 qa/tta r21 ocf/(ta+dep) r11 ca/tta r22 nw/tta these 22 ratios are used to construct models using mda technique where one model was created using the first 16 ratios in the above list and another model was constructed using all 22 ratios by including the remaining 6 ratios. for models using mda + pca and neural networks, we have used 22 ratios. 4. development of models 4.1 multi discriminant analysis mda based model was first propounded by altman (1968) as multivariate model on the basis of 5 financial ratios which had become a widely accepted tool for prediction of industrial sickness. the model construction on the basis of mda is based on the empirical studies done by altman (1968), srivastava and yadav (1986), altman (1977) etc. mda is used when dependent variable is categorical and independent variables are metric. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 43 in our case, dependent variable is the solvency of a company which is categorical and independent variables are company’s different financial ratios. mda drives variate that best distinguishes between priori groups. mda sets variate’s weights to maximise between group variance rather than within group variance. thus it creates the large distance between the groups. in mda, with the help of derived coefficients of each of the independent variables, a j score is calculated. average j score of a group gives the centroid. thus the classification j score is determined by cutting scores which are derived from group centroids. mda is a technique for measuring the probability of insolvency. this method assigns independent observations to groups defined by a qualitative feature as sick or non-sick. for this purpose, mda develops a linear combination of inputs which can be called discriminating variables between the groups. mda works as a classification technique with a capacity to analyse the descriptive importance of financial ratios. the percentage of firms which are correctly classified on the basis of such discriminant function shows the explanatory power of the model which is equivalent to r2 in the regression equation. in the mda based model, multivariate gaussian distribution is used to generate data using each class. the data (x) is assumed to have a normal distribution. in case of a linear mda, each class will have equal covariance matrix in the model but the mean values will differ. whereas in case of quadratic mda, each class will have different covariance and mean values. 4.1.1 model preparation in the mda based model, multivariate gaussian distribution is used to generate data using each class. the data (x) is assumed to have a normal distribution. in case of a linear mda, each class will have equal covariance matrix in the model but the mean values will differ. whereas in case of quadratic mda, each class will have different covariance and mean values. in the first step, sample mean will be calculated for each class for linear mda. after that, sample covariance will be calculated by subtracting the mean of each class from the observations of that class and considering the experimental covariance matrix. it does not use prior probabilities or costs for fitting. the weighted classifiers will be constructed in the model by adopting the following procedure. suppose m is an n-by-k class membership matrix: mnk = 1 if observation n is from class k mnk = 0 otherwise. the estimated mean value of the class for un-weighted data asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 44 ^ 1 1 n nk n n k n nk n m x m μ = = =   (1) calculation of natural generalization for weighted data having positive weights wn ^ 1 1 n nk n n n k n nk n n m w x m w μ = = =   (2) the unbiased estimate of the pooled-in covariance matrix for un-weighted data is 1 1 ^ ^ ^ ( )( ) n n t k kn k n n n n m x x n k μ μ = = − − = −    (3) for quadratic discriminant analysis, model uses k = 1. for weighted data, assuming the weights sum to 1, the unbiased estimate of the pooled-in covariance matrix is ^ 1 1 2 ^ ^ 1 ( )( ) 1 n n t k knk n n n n n k k k k m w x x w w μ μ = = = − − = −    (4) predictor uses three quantities to classify observations: posterior probability, prior probability, and cost. predict classifies so as to minimize the expected classification cost: ^ ^ 1 arg min ( ) ( ) k k y p k x c y k = =  (5) where • ^ y is the predicted classification. • k is the number of classes. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 45 • p (k/x) is the posterior probability of class k for observation x and • c (y/k) is the cost of classifying an observation as y when its true class is k. the space of x values divides into regions where a classification y is a particular value. the regions are separated by straight lines for linear discriminant analysis. posterior probability the posterior probability that a point x belongs to class k is the product of the prior probability and the multivariate normal density. the density function of the multivariate normal with mean μk and covariance σk at a point x is 1 1/2 1 1( ) exp( ( ) ( )) 2(2 ) t k kk k p x k x xμ μ π −= − − − (6) let p (k) represent the prior probability of class k. then the posterior probability that an observation x is of class k is ^ ( ) ( )( ) ( ) p x k p kp k x p x = (7) where p(x) is a normalization constant, namely, the sum over k of p(x|k) p(k). with da grouping and classification, two costs are associated, i.e. the true misclassification cost per class and the anticipated misclassification cost per observation. the cost of classifying an observation into class is b if its true class is a where it is cost (a, b). in other words, the cost is 0 for correct classification, and 1 for incorrect classification. after you create a classifier objective you can set a custom cost using dot notation: objective cost = l; l is a square matrix of size k-by-k when there are k classes. you do not need to retrain the classifier when you set a new cost. anticipated misclassification cost per observation. each row of the cost matrix contains the expected (average) cost of classifying the observation into each of the k classes. cost (n,k) is ^ 1 ( ( )) ( / ) k i p i xnew n c k i =  (8) where • k is the number of classes. • is the posterior probability of class i for observation xnew(n). • is the cost of classifying an observation as k when its true class is i. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 46 back et al. (1996) stated that mda focuses to construct a linear combination of predictors which are able to discriminate between groups of sick and non-sick companies. it may be achieved through maximization of between the group variance as compared to within the group variance. this association can be explained by the fisher’s discriminant function in the following form: ( ( ) ( )) ( ) ( ( ) ( )) t t i ii t t i c i cc i c w x x w j w w x x w ε μ μ μ μ − − = − −    (9) in the process, sample mean will be calculated for each class for linear mda. after that, sample covariance will be calculated by subtracting the mean of each class from the observations of that class and considering the experimental covariance matrix. it does not use prior probabilities or costs for fitting. three mda functions are constructed using the methodology described above. these models are constructed using a set of 16 ratios, a set of 22 ratios and a set of 22 ratios along with pca. these models are named as j score models and the threshold limits/cut-off points for all the models are identified which results in minimum number of misclassifications. the discriminant function used in this study indicating the linear combination of independent variables as follows: 0 1 1 2 2 ...... n nj a a x a x a x= + + + + (10) hair et al. (2006) defined the threshold limits as the dividing point which will be used to categorize observations into groups based on the function scores. the threshold point between two groups is calculated on the basis of the group centroids and size of the groups. the optimum threshold limit assuming equal size of two groups with prior probabilities of 0.5 can be calculated as follows: a b b a a b n z n zcut off n n +− = + (11) the above formula shows the optimal cut off score between groups a and b, where na, nb are sizes of group a and b, za, zb are centroids for both groups a and b, respectively. the j score thresholds/cut-off points for three models are given below.  16 ratio model using mda: threshold=0  22 ratio model using mda: threshold=0.33  mda+pca model using 22 ratios: threshold=0.3 the major disadvantages of mda over other methods include statistical or methodological issues which hinders the practical applicability of the models. such issues include (i) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 47 dispersions of the group, (ii) the classification error estimations, (iii) the costs of misclassifications and appropriate a priori probabilities, (iv) dimension reduction, (v) the distribution of variables, (vi) the groups’ definitions, and (vii) the inference of variable’s significance. 4.2 principal component analysis (pca) principal component analysis is a technique used to express a relationship in the data when there are many variables and a significant relationship can be developed. pca as a technique helps us to reduce the large number of variables with much lesser number of variables that represents the same data more effectively. in this study, we have used pca as a dimension reduction technique. such lesser number of simulated/synthetic variables are called principal components. pca is a way of identifying patterns in data, and expressing the data in such a way as to highlight their similarities and differences. since patterns in data can be hard to find in data of high dimension, where the luxury of graphical representation is not available, pca is a powerful tool for analysing data. the other main advantage of pca is that once you have found these patterns in the data, and you compress the data, i.e. by reducing the number of dimensions, without much loss of information. the previous studies by alici (1996) and rekha pai, vijayalakshmi pai and annapoorani (2006) on the application of principal component analysis (pca) for the prediction of industrial bankruptcy has shown potential of pca in prediction of industrial sickness. as per their study, pca not only works as a method for dimension reduction but also shows better predictive ability. in the present study, pca had been adopted for the pattern recognition, dimension reduction and prediction of industrial sickness. pca is a useful statistical technique for pattern recognition and data compression. pca makes use of multiple statistical concepts like a. standard deviation b. variance and covariance c. eigen vectors and eigen values pca is a way of identifying patterns in data, and expressing the data in such a way as to highlight their similarities and differences. since patterns in data can be hard to find in data of high dimension, where the luxury of graphical representation is not available, pca is a powerful tool for analysing data. the other main advantage of pca is that once you have found these patterns in the data, and you compress the data, i.e. by reducing the number of dimensions, without much loss of information. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 48 4.2.1 pca procedure a. we have collected the data of the sample and stored it in a matrix form. for the purpose of pca, mean was subtracted from the data. mean values for each dimension were calculated and subtracted from corresponding dimension. this way a data set of zero mean value is created. then we created covariance matrix of the prepared data set was calculated. thus if data set has n direction then covariance matrix will be a square matrix of size n. b. as covariance matrix is a square matrix, its eigen vector and eigen value can be calculated. eigen vector is a square matrix of size n. eigen values is a vertical vector of size 1xn. c. every eigenvector would be a column vector with as many elements as the number of variables in the original dataset. thus if we had an initial dataset of the size t x n (recall: rows are the observations, columns represent variables, and therefore we have t observations of n variables), the covariance matrix would be of the size n x n, and each of the eigenvectors will be n x 1. eigen value clearly indicates that not all of the eigen vectors were contributing significantly. d. the eigenvalues for each of the eigenvectors represent the amount of variance that the given eigenvector accounts for. we arrange the eigenvectors in decreasing order of the eigenvalues, and pick the top 2, 3 or as many eigenvalues that we are interested in depending upon how much variance we want to capture in our model. if we include all the eigenvectors, then we would have captured all the variance but this would not give us any advantage over our initial data. e. thus eigen vectors having higher eigen values were selected as feature vector. now as few eigen vectors were selected, the data can be transformed to lower dimensional data. below is the formula to calculate final data. final data = transpose of feature vector matrix * transpose of mean adjusted data 4.2.2 how pca is useful for ratio selection: eigen values shows the contribution of each eigen vector in the data set. as we have seen that with the help of eigen values, we can determine most contributing eigen vectors i.e. feature vector. the dimension of vector can vary from 1 to n (dimension of original data set). thus when data set is multiplied with feature vector then the resulting matrix is of same dimension as feature vector. the original data of n dimension is now transformed over a new m (n>m) dimension space. this is how pca is useful for ratio reduction. we have used pca in combination with mda with 22 ratios. pca matrix for all the companies for the selected 22 ratios is calculated with the help of methodology discussed. 4.3 artificial neural network (ann) artificial neural networks are non-parametric and flexible tools for estimation and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 49 classification. anns are capable of performing complex function mapping with desired accuracy. neural networks (anns) are composed of layers of several computing elements called nodes or neurons. every node receives a signal called inputs from other nodes and after processing inputs through a transfer function, a transformed signal is sent to other nodes for final result. anns are different by network architecture. there is input layer, hidden layers and output layer in a neural net. every layer can have different number of neurons/nodes. the nodes and layers are built in a feed forward method. a multi-layer feed forward network with an input layer, one hidden layer and output node is shown in the figure below. the three layer feed-forward neural network is commonly used for bankruptcy prediction in previous studies such as wilson and sharda (1994), tam and kiang (1992), and wilson and sharda (1994). in a statistical model, parameters or weights of an ann is required to be estimated. the process of discovering these weights is referred as training. the training of neural network is critical for estimation problem. in the training of neural networks, patterns and examples are introduced to the first or input layer of ann. the activated values of the input layer nodes are weighted and subsequently accumulated in the hidden layer node. the weighted sum is then transferred by a suitable transfer function in the nodes activation value. subsequently, it is then treated as an input into the nodes in the final or output layer. afterwards, an output value gets achieved to match the value desired. the training process of an ann minimizes the deviation between the neural net output and known targets. 4.3.1 application of neural networks for bankruptcy prediction neural networks have been a tool of interest for many business applications including insolvency forecasting/industrial sickness in few decades. ann models have already been used successfully for many financial problems including bankruptcy prediction trippi (1993), zahedi (1996). many researchers in bankruptcy forecasting including lacher et al. (1995), wilson and sharda (1994), tam and kiang (1992), and wilson and sharda (1994) report that neural networks produce significantly better prediction accuracy than classical statistical techniques. the model based on ann constructed for prediction of industrial sickness in this study is feed-forward multi layered back propagation neural network. for construction of ann, the data is randomly divided into a training set and a test set which is generally known as in-sample and out-of-sample set. the training set is generally used for training of the neural network whereas the test set is used to evaluate the predictive capability of the model. neural networks contend with the genetic structures in a streamlined way (bischof et al., 1992). in reality, the ann are internally multivariate mathematical models that use iterative procedures processes to minimize error functions. artificial neurons, as well as biological ones, are defined to be in state of activation at all times, which can be expressed by a numeric value corresponding to the formula: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 50 1 n i i i a w x = = (12) being xi the value of from each previous neuron activation layer, and wi the weight assigned to that value. a transfer or output function transforms this value into an output signal that travels through the connections to other neurons of the subsequent levels, eliminating the linearity of the network and limiting values within a certain range. in this study, a three-layer feed-forward back propagation neural network was used. the structure of the ann was including 3 layer i.e. input layer, hidden layer and output layer. in this study, based upon the selection of inputs, 22 ratios were selected as input variables. the neural net had one hidden layer with 22 nodes and output node. there was one output node which will be indicating the j score. the network was run for 10,000 iterations for making predictions. desai and joshi (2015). there are no rules to follow as far as the architecture of the neural net is concerned. the architecture of the neural net would depend upon the forecasting objective. in a neural network, if too complex architecture is used, then the problem of over fitting would harm the forecasting ability. too simple a network would result in loose estimation and thus would deteriorate the predicting capabilities. the architecture of the neural network for effective forecasting is a process of trial and error. based upon the complexities of data, the neural network used in the study has three layers as mentioned above. if the results of the training on out of sample data is not effective, there would be a need to increase or decrease the complexity of the neural net but the basics of the feed-forward network with back propagation algorithm would remain the same. in this study, the functional form is generated by using a multi-layered feed forward artificial neural network. artificial neural networks (anns) are simplified models of the interconnections between cells of the brain. in fact they are defined by wasserman and schwartz (1988) as "highly simplified models of the human nervous system, exhibiting abilities such as learning, generalization and abstraction.” hawley, johnson and raina (1990) studied that “such models were developed in an attempt to examine the manner in which information is processed by the brain. these models have, in concept, been in existence for many years but the computer hardware requirements of even the most rudimentary systems exceeded existing technology.” the quality of the data has a high impact on the performance and the reliability of the ann. the neural networks recognize the patterns of the data to a great extent which influence the accurateness of the outcome. the pre-processing of the input variable of the nn enables de-trending of the figures and explain the important relationship to provide appropriate process of learning. during the learning process, the ann identifies weights for the input variables. a non-linear scaling method is adopted for the improvement of the network’s performance. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 51 figure 1. neural network architecture the figure 1 above represents a feed forward artificial neural network with five input nodes in the input layer, five nodes in the hidden layer and one node in the output layer. there are no rules available on the architecture of an ann for forecasting of insolvency. the structure of an ann is developed based on experimentation. high complexity in the architecture can result in over fitting and low complexity can result in loss of learning. for this study a similar three layer ann with one input layer, one hidden layer and one output layer has been used. the input layer has 22 nodes, hidden layer has 22 nodes and output layer has one output node. this three layer feed forward is commonly used ann for insolvency prediction and estimation. during the study the neural network was tested with 0, 5, 10, 15 and 22 nodes in the hidden layer, the ann with 22 nodes in the hidden layer was found to be more suitable in the study. 5. analysis and validation of models the models are developed on 80 firms split into two categories (solvent/insolvent) of 40 each. out of the total sample size, we have used a sample of 50 firms (25 firms of each category) as the training sample. whereas the remaining 30 companies were used as the holdout or validation sample. the firms selected for the training set were based on the weightage of a particular industry in the entire sample. the predictive ability of the models was found to be very high on the validation sample. the following table shows the predictive ability of the models on the entire sample including the training sample as well as validation sample. the models show that there are 22 financial ratios which have emerged as predictors of industrial sickness out of which two models were developed using mda i.e. model using 16 ratios and model using 22 ratios. then using these 22 ratios models were developed using mda + pca and ann. all the models used the training and out-of-sample test for validating the model results. input layer hidden layer output layer asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 52 table 4. models for prediction of industrial sickness models correct classificati ons solvent firms correct classific ations insolven t firms overall correct classification mda based model using 16 ratios j = 2.6068 3.9099 r1 + 4.5035 r2 + 0.1997 r3 12.9819 r4 + 0.0289 r5 + 0.1985 r6 + 0.0033 r7 0.0018 r8 + 20.6122 r9 3.8964 r10 + 7.9591 r11 + 0.0305 r13 + 0.1488 r12 + 0.494 r14 + 0.0795 r15 12.6974 r16 95% 80% 87.5% mda based model using 22 ratios j = -0.6039 5.4072 r1 + 5.1417 r2 2.692 r3 12.6854 r4 + 0.4379 r5 + 0.2299 r6 + 0.1946 r7 0.0024 r8 + 19.8018 r9 12.2403 r10 + 11.4643 r11 + 0.0038 r12 0.1788 r13 + 0.5525 r14 + 0.5273 r15 10.1682 r16 + 1.7545 r17 + 1.5981 r18 0.0039 r19 + 12.3612 r20 + 5.8985 r21+ 8.2321 r22 87.5% 95% 91.25% mda+ pca based model using 22 ratios 22x22 matrix 85% 95% 90% ann based model using 22 ratios artificial neural network model ann algorithm: back propagation structure: 3 layers (input, hidden, output) 84% 96% 86% asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 53 22 neurons in input layer 22 neurons in hidden layer 1 neuron in output layer (j score) the network was run for 10,000 iterations for making predictions. observations used for training: 302 out of sample prediction was tasted on: 100 observations the present study shows that different models developed using different methodologies deliver different prediction accuracy results and misclassification errors respectively. the previous research works also exhibited different results of prediction accuracy and misclassification errors when different sets of financial ratios were employed. this study concludes that out of the four proposed models, predictive ability of mda based model using 22 ratios is found to be highest. mda based model using 22 ratios shown the predictive accuracy of 91.25% followed by the pca+mda model with an accuracy of 90%. the ann based model is able to predict the industrial sickness in two years advance with the predictive accuracy of 86%. these models constructed and validated are preferred over the existing empirical models like altman (1968) and ohlson (1980). altman’s z score model and the logit model of ohlson were estimated on the same sample used in the study and they gave the predictive accuracy of 78% and 81% respectively. therefore, the comparison of empirical analyses is done on the basis of rejection rates of the same sample and not on the basis of the rejection rates from the literature on different samples. the results of these models are in line with the previous studies though other studies have considered different sets of financial ratios; mohamed, li and sanda (2001) found leverage ratio and efficiency ratio (total asset turnover) to be significant in explaining bankruptcy during the period 1987 to 1997 (abdullah, halim, ahmad and rus., 2008) mine and hakan (2006) identified ebitda/total assets as the most important predictor of financial distress in both mda and logit models; sharma and rao (1976) arrived at a discriminant function using mda, that comprised of five financial ratios namely, net worth to total assets, debtors turnover, working capital to total assets, retained earnings to total assets and ebit to total assets. gupta (1983) by employing discriminant analysis, found that net worth to short and long term debt and all outside liabilities to tangible assets were useful. patrick (1932) reported that two significant ratios were net worth to debt and net profits to net worth. the present study shows that different models developed using different methodologies deliver different prediction accuracy results and misclassification errors respectively. the previous research works also exhibited different results of prediction accuracy and misclassification errors when different sets of financial ratios were employed; deakin (1976) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 54 employed mda with 14 factors and found that the failed firms had 77%, 96%, 94%, 91% and 87% prediction accuracy in the years before failure and non-failed firms showing 82%, 92%, 82%, 67% and 78% in respective years. ohlson (1980) logit model was employed with 9 factors, 96% accuracy in both found that when was observed. aziz, emanuel and lawson (1988) found bankrupt firms showing prediction accuracy of 85.7% in 1 79.6% in 3rd year, 81.3% in 4th and 84.8% in 5th used logit analysis and ear, year prior to sickness whereas non-bankrupt firms showing 98.0%, 83.7%, 77.6%, 79.2% and 76.7% in respective years. dimitras, slowinksi, susmaga and zopounidis (1999) mda resulting in bankrupt firms with accuracy at 63.2%, 42.1% and 36.8% in the 1st, 2nd and 3rd years prior to sickness and non-bankrupt firms at 68.4%, 63.7% and 73.7% in respective years and logit model resulting in bankrupt firms with prediction accuracy of 63.2%, 31.6% and 36.8% and non-bankrupt firms at 57.9%, 84.2% and 84.2% in respective years. 6. implications bankruptcy prediction is an interesting and important problem. a better understanding of the causes and prediction accuracy will have tremendous financial and managerial consequences. this study provide bankruptcy prediction models for multiple industries. this study focuses on independent variables which can be used to predict bankruptcy for firms in various industries such as textile, cement, electricals, pharmaceuticals, consumer food etc. the use of these models for bankruptcy prediction had shown several advantages and bankers, credit managers, executives, and investors. industrial sickness has become a severe problem requiring a comprehensive redressal rather than inventing quick fixes to revive sick/insolvent firms. the progressive increase in industrial sickness has been causing considerable concern to the government, financial institutions and banks. this study has a huge commercial impact as these models can be used by the financial institutions and banks in their credit appraisal procedure. the banks and financial institutions can improve the quality of their lending which can help them reduce their non-performing assets. these models will assist the lenders to classify the borrowing units into a potentially solvent or insolvent category. however, it should not be the only means of credit evaluation. other important non-accounting variables such as the purpose of the loan, maturity of the loan, security involved and deposit status of the applicant should also be considered along with the model score. this study may also be used for evaluating the repayment behavior of a borrower. this will assist the lenders and enable them to tighten their grip of inspections to force the units to improve their performance. these models will be able to reduce the locking up of financial resources, wastage of capital assets, loss of production and decrease in employment. this study tries to bridge the gap between theory and practice. these models can be used to check the firm’s future health and survival. this study shows a coherent framework consisting of the dynamics of sickness and a forewarning system which can identify the incidence of sickness in different industries so that timely action can be taken. it can also be used for the purpose of teaching various parameters which can lead to industrial sickness or corporate insolvency, how the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 55 intervention can be made which may involve change in management of the firms or funding by other organisations to prevent further sickness. these models can be used to stem further growth of industrial sickness in the country which may influence the quality of life. the models may be used by the potential investors for screening out undesirable investments. since the models are of predictive nature, the investors may use it for portfolio selection. 7. limitations of the study a number of limitations of the study and needs for the future research must be noted. the results of the models should be read with caution as only financial ratios were used as quantitative variables. there may be other qualitative and quantitative variables which can be included. another limitation of this study is that there are four different models using different techniques which have their advantages and disadvantages. a major limitation of this study is that the prediction models constructed include the use of 22 ratios. models with such huge number of ratios as inputs make them more complicated. this study includes the sample of listed manufacturing companies in india and the service sector companies, small and medium enterprises are out of the scope of the study which can be considered as the limitation of the study. another limitation of this study is the possibility of the model to be extended for general application. we are of the opinion that these models can be generalized to other industries in india but these models may not be generalized for other time periods or other countries. this is a major limitation of this study as we have used a relatively smaller sample and a particular year of defaults. 8. conclusion the models which are constructed and validated in the study show that there are 22 financial ratios which have emerged as predictors of industrial sickness out of which two models were developed using mda i.e. model using 16 ratios and model using 22 ratios. then using these 22 ratios models were developed using mda + pca and ann. beyond all this, ann based model has shown better results than other models in another sense. where mda based models give the score of the year on the basis of which prediction regarding industrial sickness can be made for the next year. whereas ann based model gives you the predicted results (score) of the next year on the basis of which the industrial sickness can be predicted for the next 2 years. for example, mda based model in the present study gives the j score of the year 2014 on the basis of which the sickness can be predicted for the year 2015. on the other side, ann based model gives you the results/score of the year 2015 on the basis of which the sickness can be predicted for the year 2016. in other words, ann based model was able to predict the sickness two years in advance as compared to other models which were predicting sickness in one year advance. thus, ann model is having more accuracy than other models. out of the four proposed models, predictive ability of mda based model using 22 ratios is found to be highest. the research findings establish the superiority of artificial intelligence asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 56 model over discriminant analysis if certain functions and weights are changed and demonstrate the significance of accounting ratios in predicting default. 9. scope for further research the most imperative area for further research is to extend these models to service sector firms. an attempt can be made to extend the analysis to private limited companies and unincorporated entities where the incidence of failure is more than big corporations. another valuable development can be made by including non-financial measures such as operational and technical parameters which may improve the results. a combination of these parameters can be used for early detection of sickness. statistical methods have been applied to many areas, 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(1996) a meta-analysis of financial application of neural networks. international journal of computational intelligence and organizations, 1(3), 164-178. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 63 zmijewski, m. e. (1984). methodological issues related to estimation of financial distress prediction models. journal of accounting research, 22, 59-82. https://doi.org/10.2307/2490859 microsoft word 15481-55654-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 1 the impact of saving and financial development on economic growth in turkey dr. hatem hatef abdulkadhim altaee head of accounting department cihan university, sulaimani camp sulaimaniyah–kurdistan region, iraq tel: 964-771-423-1853 e-mail: hatm.hatf@sulicihan.edu.krd dr. mohamed khaled al-jafari (corresponding author) head of the accounting and finance department prince mohammad bin fahd university al khobar, kingdom of saudi arabia tel: 966-530052740 e-mail: aljafarimohamedkhaled@yahoo.com received: august 5, 2019 accepted: oct. 21, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15481 url: https://doi.org/10.5296/ajfa.v11i2.15481 abstract since saving and financial development are vital to economic growth, this research empirically investigates the impact of saving and financial development on economic growth in turkey. therefore, a time series data from 1968 until 2017 were tested utilizing both the error correction model (ecm) and the autoregressive distributed lag approach (ardl). the findings reveal an existence of a short-run and a long-run positive and significant effect of savings and financial development on economic growth. conventional inputs such as capital and labor proved to be the most important factors in achieving economic growth in turkey. the study concludes that an appropriate policy mix will enhance domestic saving in the country. keywords: saving, financial development, economic growth, ardl, turkey jel classification: c22, c32, o11, o16, o40 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 2 1. introduction a growing body of theoretical and empirical work would push even skeptics toward the belief that saving and financial development are crucial to economic growth. however and despite the large number of scientific research on economic growth and the financial development of the turkish economy, there is still a need to examine empirically the relationship between saving and the development of the financial sector on the one hand and economic growth on the other hand, for a longer period of time. saving from the point of view of economic intellectuals is an important requirement for economic growth (lewis, 1955; solow, 1956; romer, 1986; lucas, 1988). at the same time, many quantitative studies have concluded that gross domestic saving rate boosts investment rate and this higher investment rate in turn influences economic growth. as mentioned earlier, there is no shortages in literature (demirhan, 2016; yildiz and atasaygin, 2015; zeran and akbas, 2013; şamiloğlu and savaş, 2010) that studied the influences of different economic variables on economic growth in turkey. however, results were always mixed and ambiguous, and this may be due in part to the sample size or to the period that previous studies covered. to avoid such an issue, this study used a larger sample size that covers the period for the past fifty years to investigate the effect of savings and financial developments on growth in the republic of turkey. another important incentive to undertake this study, we strongly believe that low domestic saving rate in turkey might be a constraint placed on its ability to achieve a rapid economic growth and worthwhile to investigate. this paper is organized into the following sections: section 2 sheds some lights on major macroeconomic facts that are related to the turkish economy for the past fifty years. on the other hand, section 3 displays pertinent previous literatures. section 4 introduces the data and illustrates the empirical methods that were used, while section 5 discusses thoroughly the empirical findings. the concluding remarks and recommendations are presented in section 6. 2. an overview of major macroeconomic indicators in turkey turkey is one of the mint countries (mexico, indonesia, nigeria and turkey) that were listed to be the world’s next big emerging economies after the brics (brazil, russia, india, china, and south africa). it is one of the world’s top 20 economies. in fact, it ranks 18 among the 20 most developed countries according to world bank classification (world development indicators, 2018). accordingly, selected macroeconomic data on turkey’s economy in an indexed form with base year 1968 are depicted in figure 1. the graph shows that the general trend in all of the variables have been upwards since 2001, with variations varying in intensity from one variable to another. turkey’s real gdp grew at an average annual rate of 4.2% over the entire period. this was higher than the global growth average of the last 3 years and nearly 3 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 3 percentage points more than the average growth accomplished by emerging markets and developing economies. however, the rate of growth varied from time to time. in fact, from the year 2000 to 2017 turkey’s gdp growth rate averaged 4.2 percent but this figure climbed to 5.63 percent during the period ranging from 2010 to 2017. similarly, the intensity of the variation of the rest of the variables varied as well. for instance, there is a high variation in saving, capital and financial development. however, gdp and labor variables showed almost a stable trend with low variation. 70 80 90 100 110 120 130 140 150 5 10 15 20 25 30 35 40 45 50 fd index gdp index k index l index s index figure 1. trends of index of real gdp, capital (k), labor (l), financial development (fd), and saving (s), (1968=100) in addition, figure 1 shows that gross domestic saving as a percentage of gdp has declined from an average of 38 percent in 1968 to an average of slightly less than 17% in the year of 1991. indeed, this rate has been declining by around -0.09 percent throughout the entire period. however, since 2004, it started picking up and was reported at 26.4 % in 2017. on the other hand, growth of financial development was very considerable, especially in the years that followed the year 2002. labor input growth trend has been consistent with the gdp movement. for the purpose of comparing the turkish economy with those of mint countries, the gross domestic savings as a percentage of gdp, and the economic growth rates in those countries are presented in table1. from the figures in table 1, it is clear that the turkish gross domestic saving during the period 1981 to 2017 was almost the lowest in comparison with the rest of the countries in the bloc, and currently is considered low in international comparison. nigeria, for example, enjoyed an aggregate savings rate averaged to 43.3 %. this ratio associated with a growth rate of gdp equals to 4.4 percent (world development indicators, 2018). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 4 table 1. gdp growth and average of gross domestic saving (% of gdp) in mint countries (1981-2017) rati o/ rate tur ke y mexico ind onesia nigeri a growth rate of gdp 4.33 2.41 4.64 4.39 average ratio of gds (% of gdp) 24.04 23.7 29.1 43.3 source: world development indicators (wdi), 2018. the world bank group similarly, indonesia has achieved a growth rate of 4.64 % in its gross domestic product with a ratio of domestic saving to gdp around 29.1%. on the other hand, mexico, had the lowest percentage of gross domestic saving and average growth rate of gdp among the mint countries. they amounted to 23.7% and 2.41% respectively. the previous comparisons have led us to think that there is a relationship between saving and growth. the lower the saving rate in the economy, the lower the growth rate will be and this was applicable to turkey as well. therefore, we found this relationship to be intriguing enough to warrant further investigation. 3. literature review this section presents previous literatures that studied the influences of different economic variables on economic growth in turkey, and displayed in a descending chronological order. starting with the most recent study by demirhan (2016) who tested the relationship between financial development and investment amount in turkey. the author utilized the todayamamoto method on a sample that covers the first quarter of 1990 until the second quarter of 2015. the results revealed a uni-directional causality from stock market development to investment amount, and a uni-directional causality from investment amount to banking sector development. in addition, the findings revealed a bi-directional causality between banking sector development and stock market development, concluding that there is indirectly causality from banking sector development to investment amount, which will lead ultimately to a higher economic growth rate. on the other hand, yildiz and atasaygin (2015) examined the relationship between financial deepening and economic growth in turkey. the results of the ecm approach to cointegration revealed a long-run relationship between financial development and economic growth and that the demand-pulling hypothesis is valid for the turkish economy. similarly, güngör, çiftçioğlu, and balcılar (2014) investigated the causality between financial development and private savings using the bounds tests. the results show that private savings had a positive and significant impact on financial development. in addition, inflation rate found to have a negative but insignificant effect on savings. on the other hand, the variable of per capita disposable income found to have a positive and significant impact on private savings. in addition, zeran and akbas (2013) empirically tested the savings-growth nexus in turkey utilizing several econometric techniques to include bootstrap, process-based, toda-yamamoto, and linear granger causality test. the results showed a bi-directional causality between saving and economic growth providing evidence supporting the feedback hypothesis. the study concluded that domestic saving increases investment and eventually has a positive effect on asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 5 economic growth. moreover, economic and political stability is a must requirement to create a suitable environment for investment. further, şamiloğlu and savaş (2010) investigated the effect of financial development on economic growth in turkey utilizing the ardl bounds testing approach. the study concluded that financial development is a long-run process stimulated by economic prosperity. on the other hand, domestic credit provided by the banking sector influenced economic growth in turkey. the results of the granger causality tests provided evidence supporting the supplyleading hypothesis in the long-run, and both the supply-leading and the demand-following hypotheses in the short-run. correspondingly, yucel (2009) studied the relationship between financial development, trade openness and economic growth in turkey. the author utilized several econometric methods to test the data to include: the augmented dickey-fuller (adf) unit root test, johansen and juselius (jj) for cointegration test and granger causality test. the results showed a positive and statistically significant effect between trade openness and economic growth and a significant negative impact between financial development and economic growth. the findings revealed also a bi-causal relationship between trade openness, financial development and economic growth. finally, ardic and damar (2006) examined the effects of financial sector deepening on economic growth in turkey between 1996 and 2001. contrary to the results of previous researches, the study found a strong negative relationship between financial deepening and economic growth. the authors concluded that financial development does not always contribute to economic growth. 4. data and econometric methods the savings-growth nexus is a topical issue in current growth literature. levine (1991) explains what the financial system does and how it affects, and is affected by economic growth. therefore, this study aims to examine the relationship between gross domestic savings, financial development and economic growth in turkey for a period spanning from 1968 to 2017. the ardl model or bounds testing approach as in pesaran and shin (1998), is employed to examine empirically the existence of short-and long-run relationship. this approach is preferred to other approaches for several reasons. first, it can capture both long-run and short-run effect of saving and financial development on economic growth with other control variables. second, this approach allows the variables of the model to possess a mixed order of integration, but none of them are i(2). third, the ardl method is more appropriate for a small size sample, and finally, this technique can eradicate the endogeneity problems existing in the model (pesaran et al. 2001; narayan, 2005). 4.1 data selection and variables an annual data from 1968 to 2017 were collected from two main sources: world bank and penn world tables. data related to variables of economic growth, capital, saving and financial developments were obtained from world bank, world development indicators asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 6 (http://microdata.worldbank.org/index.php/home). data for labor variable obtained for the year 1968 to 1990 from penn world tables (http://www.ggdc.net/pwt.); and from the year 1991 to 2017 from world bank (http://microdata.worldbank.org/index.php/home). natural logarithmic transformation was applied to the variables in order to have a more stable data variance. table 2 below presents the variables under investigation, their definitions, and descriptive statistics. table 2. definition of variables and summary statistics variables definition mean sd max min econgr the log of real gdp (2010 =100) in $us 26.691 27.818 25.643 0.6169 labor total labor force 16.633 17.258 16.233 0.2518 capital gross fixed capital formation (% of gdp) 3.0245 3.3948 2.4743 0.2757 saving gross domestic savings (% of gdp) 3.2448 3.6632 2.8320 0.2152 financialde domestic credit to private sector (% of gdp) 3.1148 4.2464 2.6092 0.4675 4.2 the econometric model and methodology the long-run elasticities estimate between the regressors and growth in turkey can be represented in a linear function expressed as: ln 𝐸𝑐𝑜𝑛𝐺𝑅 = 𝑓(ln𝐿𝑎𝑏𝑜𝑟 , ln𝐶𝑎𝑝𝑖𝑡𝑎𝑙 , ln𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐷𝐸 , ln𝑆𝑎𝑣𝑖𝑛𝑔 ) (1) where ln econgr represents the natural logarithm of gross domestic product. on the other hand, ln𝑆𝑎𝑣𝑖𝑛𝑔 is the natural logarithm of gross domestic saving as a percentage of gdp, and ln𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐷𝐸 is the natural logarithm of financial development. ln𝐿𝑎𝑏𝑜𝑟 is the natural logarithm of the labor force, and ln𝐶𝑎𝑝𝑖𝑡𝑎𝑙 is the natural logarithm of gross fixed capital formation as a ratio of the gdp. the ardl bounds testing procedure consists of multiple stages: in the first stage, testing the presence of a long-run relationship between the dependent variable and its driving variables as stated by economic theory. in the second stage, the ardl model is constructed based on the results of stage one. in the third stage, the short-run dynamic is estimated. in view of the benefits of the ardl approach to cointegration, and our sample size, we specify the following model: 𝛥(ln𝐸𝑐𝑜𝑛𝐺𝑅) = 𝛽 + ∑ 𝛽 𝛥(ln𝐸𝑐𝑜𝑛𝐺𝑅) + ∑ 𝛽 𝛥(ln𝑆𝑎𝑣𝑖𝑛𝑔) + ∑ 𝛽 𝛥(ln𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐷𝐸) + ∑ 𝛽 𝛥(ln𝐿𝑎𝑏𝑜𝑟) + ∑ 𝛽 𝛥(ln𝐶𝑎𝑝𝑖𝑡𝑎𝑙) + 𝛽 (ln𝑆𝑎𝑣𝑖𝑛𝑔) + 𝛽 (ln𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐷𝐸) +𝛽 (ln𝐿𝑎𝑏𝑜𝑟) + 𝛽 (ln𝐶𝑎𝑝𝑖𝑡𝑎𝑙) + 𝛽 (ln𝐸𝑐𝑜𝑛𝐺𝑅) + 𝑒 (2) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 7 where, 𝛥 is the first difference operator, q and p are the optimal lag length. 𝛽 , 𝛽 , 𝛽 𝛽 , and 𝛽 represent shortrun dynamic coefficients and 𝛽 , 𝛽 , 𝛽 , 𝛽 , and 𝛽 represent the long-run multipliers of the underlying ardl model. 𝛽 is the intercept, and 𝑒 represents the white noise error term. ln is the log of the variables ln econgr, lnlabor, lncapital, lnsaving, and lnfinancialde. for the long-run results to be trustworthy, the variables have to be cointegrated. the cointegrating relationship among the variables is tested through the joint significance of the coefficients. the null hypothesis of long-run cointegration (𝐻 = 𝛽 = 𝛽 = 𝛽 = 𝛽 = 𝛽 = 0), and the alternative hypothesis implying no cointegration among the variables (𝐻 ≠ 𝛽 ≠ 𝛽 ≠ 𝛽 ≠ 𝛽 ≠ 𝛽 ≠ 0) is tested. the computed f-statistic from equation (2) will be compared with the critical tabulated value (narayan, 2005). before estimating the long-run specification, it is important to determine the lag order through var. once we ascertain the long-run relationship among the variables, we proceed to estimate the short-run dynamic parameter by estimating the error correction model. the error correction model (ecm) is specified as follows: 𝛥(ln𝐸𝑐𝑜𝑛𝐺𝑅) = 𝛽 + 𝛽 𝛥(ln𝐸𝑐𝑜𝑛𝐺𝑅) + 𝛽 𝛥(ln𝑆𝑎𝑣𝑖𝑛𝑔) + 𝛽 𝛥(ln𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝐸) + 𝛽 𝛥(ln𝐿𝑎𝑏𝑜𝑟) + 𝛽 𝛥(ln𝐶𝑎𝑝𝑖𝑡𝑎𝑙) + ψ𝐸𝐶𝑇 + 𝑒 (3) the 𝐸𝐶𝑇 denotes the error correction term or speed of adjustment of convergence towards equilibrium. the sign must be negative and significant to ensure convergence of the dynamics to the long-run equilibrium. in order to confirm the goodness of fit of the model, numbers of diagnostic tests were conducted. these tests examine the normality, serial correlation, and heteroscedasticity. as recommended by pesaran et al. (2001), the cumulative sum of the recursive residuals (cusum) and the cumulative sum of squared recursive residuals (cusumsq) tests, suggested by brown et al. (1975) are also used to test a null hypothesis of parameter constancy over the sample period. 5. the empirical results and discussion 5.1 stationary test the first requirement for employing the ardl approach is affirming that none of the variables is i(2) to avoid ardl model crash in the presence of integrated stochastic trend of i(2). thus, to confirm that none of the series is i(2), the augmented dickey-fuller (adf) and the phillipsperron unit root tests are used and the results are reported in table 3. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 8 table 3. the results of unit root tests notes: ***, ** and * denote that the nonstationary hypothesis is rejected at the 1%, 5% and 10% level respectively. the inference derived from the unit root tests indicates that all variables are stationary at first difference and are non-stationary at level. before estimating the ardl bound test, we need to select the lag length for the equations (2) and (3). it should be noted that there is a divergence of opinion on the most reliable criterion. although akaike’s information criterion (aic) and final prediction error (fpe) are superior to other criteria in the case of a smaller sample size (sample size 60 and below). when the sample size is 60 and below and not monthly series, fpe is preferred (liew, 2004; ivanov and kilian, 2005). fortunately, in our case, there is an agreement among the criteria. these results are not reported here owing to space constraints. in fact, 5 of which agreed on a lag length of 1. after having the optimal lag length, we further perform the ardl bound test to examine the long-run relationship between economic growth and its drivers. it should be noted that the preferred ardl bounds testing approach to cointegration specification chosen is that with intercept and trend. 5.2 the results of long-run relationship the outcomes of the estimate of long-term relationship among the variables are reported in table 4. since the f-statistic exceeds the upper bound values, the null hypothesis of the absence of no level relationship among the variables is rejected at the 1 percent significant level. this indicates that there is a long-run causal relationship among the variables. variables level first difference adf pp adf pp without time trend ln econgr 0.163111 0.178036 -6.851000*** -6.846762*** ln labor 0.055248 0.178329 -7.502353*** -7.526356*** ln capital -1.780574 -1.770142 -6.598181*** -6.639286*** ln saving -2.365818 -2.238817 -9.301975*** -9.353133*** ln financialde 0.452644 0.241465 -5.378890*** -5.321863*** with time trend ln ecoongr -2.517542 -2.669179 -6.789659*** -6.795540*** ln labor -2.325493 -2.399109 -7.457608*** -7.485984*** ln capital -2.881461 -3.004923 -6.557889*** -6.595940*** ln saving -2.303729 -2.141537 -9.415142*** -9.665056*** ln financialde -0.863561 -0.959400 -5.573310*** -5.392730*** asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 9 table 4. bounds f-test for cointegration test statistic value sig. level i(0) i(1) f-statistic 5.973*** 10% 3.03 4.06 5% 3.47 4. 57 1% 4.40 5.72 notes: (1) null hypothesis: no levels relationship, (2) *** significant at 1% having established the existence of cointegration, we progress by estimating the long-run and the short-run ardl growth model for the study based on schwartz bayesian criteria (sbc). the estimated long-run coefficients of our ardl model are presented in table 5. results reveal a statistically significant relationship between saving and economic growth. the coefficient value pointed that an increase of 1 percent in saving as a percentage of gdp would lead to an increase of 15 percent in economic growth. this result is in line with the findings of altuğ, et al. (2008); karamelikli and bayar (2015); zeren and yusuf (2013); er et al. (2014). further, the result in general is consistent with solow (1956) growth model. table 5. the long-run coefficients variables coefficient std. error t-statistic prob. ln saving 0.1488*** 0.0547 2.7194 0.0095 ln financialde 0.0635*** 0.0217 2.9261 0.0056 ln capital 0.2908*** 0.0480 6.0559 0.0000 ln labor 0.3164** 0.1365 2.3175 0.0255 note: ***, **, * indicate significance at 1%, 5%, and 10%. on the other hand, at a 1% level of significance, figures in table 6 show that the coefficient of financial development is statistically significant. this implies that financial development had contributed to economic growth. this result contradicts the findings of demetriades and hussein (1996); ozturk (2008); and kenza and eddine (2016). they documented that there is no significant relationship exist between financial development as a percentage of gdp and economic growth. however, the findings are in line with the results of kar et al. (2011) and dilek et al. (2016), where they noted that a significant relationship is existed between financial development and economic growth for turkey. similarly, the empirical results show that the coefficient of labor is positive and significant at the 5 percent level. therefore, an increase in the labor force by 1 percent would increase economic growth by 32%. this indicates that labor input does have a substantial and statistically significant effect on the gdp growth performance. in addition, the results show that capital comes second in influencing turkish economic growth. specifically, a 1% increase in gross fixed capital formation as a percentage of the gdp, would cause the level of economic growth to increase by over 0.29%. moreover, the coefficient of lncapital turned to be significant at the 1 percent significant level. this result is in line with the findings of lains (2003) and altuğ et al. (2008) which indicate that many developing countries, including some asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 10 high-performers such as the east asian or south european countries, that capital input is vital to economic growth in turkey. 5.3 the results of short-run relationship turning to the economic growth response of deviations from long-run equilibrium, the shortrun coefficients associated with the long-run were estimated and the results are shown in table 6. the coefficient of the ectt-1 is negative and statistically significant at the 1 percent level, providing additional evidence to the cointegrating relationships among the model variables. in fact, the ecm indicated that about 64 percent of the deviations from an equilibrium path arising from the model are restored within a period of one year. table 6. the short-run error correction estimates ardl (1, 1, 1, 0, 0,0) based on akaike information criteria variables coefficient std. error tstatistic prob. d ln saving 0.094913** 0.039446 2.406141 0.0207 d ln financialde 0.040476*** 0.013958 2.899869 0.0060 d ln labor 0.201813** 0.091957 2.194655 0.0339 d ln capital 0.268974*** 0.030746 8.748191 0.0000 trend 12.02399*** 2.095177 5.738889 0.0000 intercept 0.019793*** 0.003408 5.808549 0.0000 ect(-1) -0.637751*** 0.111392 -5.725281 0.0000 note: the asterisk denotes rejection ***p ‹ 0.01, ** p ‹ 0.05 *, p ‹ 0.1 the results of the above table also show that in the short-run, gross domestic saving have a very significant effect on growth of gdp and a 1% increase in saving calculated as a percentage to gdp leads to a 9.5% increase in gdp. furthermore, the impact of saving to gdp in the short-run is much lower than its effect in long-run. on the other hand, financial development is positively related to economic growth and this relationship is statistically significant at the 1 percent level. other things remain the same, a 1% increase in financial development increases economic growth by 4.0 percent. the results also show that gross fixed capital formation contributes positively and significantly to economic growth. keeping all else the same, a 1% increase in this variable leads to about 27 percent increase in the real gdp. similarly, a 1% increase in labor leads to a 20.2% increase in gdp. this indicates that labor input is the second important contributor to growth of gdp. in order to check the robustness and the validity of the estimated model, an essential post estimation diagnostic tests were performed. the results of these tests are presented in table 7. the empirical finding shows normality of the error term. thus, the null hypothesis of no serial correlation is not rejected. the arch test also confirms that the residuals are homoscedastic, suggesting no autoregressive conditional homoscedasticity. the empirical evidence from jarque-bera test statistic confirmed the normality behavior of the estimated residual series of the model. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 11 table 7. the results of the diagnostic tests normality jarque-bera 2.08367 (0.7583) serial correlation breusch-godfrey serial correlation lm test 0.04030 (0.8419) heteroscedasticity arch test for heteroscedasticity 0.74862 (0.6327) furthermore, to examine the structural stability of the model, we conduct the cusum and the cusumsq tests as suggested in brown et al. (1975) to test for parameter stability throughout the sample. figure 2 and 3 present the plot of the two tests. the results show that both the cusum and cusumsq plots lie within the 5% critical bound; hence, they infer that the parameters of the model do not suffer from any structural instability during the period under review. thus, the null hypothesis that all coefficients are stable cannot be rejected. -20 -15 -10 -5 0 5 10 15 20 1980 1985 1990 1995 2000 2005 2010 2015 cusum 5% significance figure 2. plot of cusum -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1980 1985 1990 1995 2000 2005 2010 2015 cusum of squares 5% significance figure 3. plot of cusumsq 6. conclusion and policy implications this paper examines the impact of gross domestic saving and financial development on economic growth in turkey during the period 1968 to 2017. the long-run relationships between economic growth and saving as well as financial development are intriguing and are of acute interest to policy makers. the long-run coefficients of the natural logarithm of gross domestic saving and financial development are both positive and statistically significant at 1% percent level implying that these two variables have a significant and positive impact on growth in the long-run. specifically, a 1% increment in saving leads to 14.9% rise in economic growth in the long-run, on average, keeping other things constant. similarly, a 1% change in financial development results in 6.35% change in economic growth in the long-run, on average, ceteris paribus. these results came up with the same conclusion as in şamiloğlu and savaş (2010), zeran and akbas asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 12 (2013), and yildiz and atasaygin (2015) where financial development found to have a positive and significant effect on economic growth in turkey. contrary to the findings of ardic and damar (2006), and yucel (2009) where financial development found to have a negative and significant influences on economic growth. furthermore, long-run coefficients of capital and labor are both statistically significant. the results suggest, on the long-run, labor input plays the most important role in economic growth process of turkey. this result is similar to that of harvie and pahlavani (2006) in relation to korea; akhtar (2006) in relation to indonesia; gupta et al. (2017) in relation to india. the second important driver to the growth of the turkish economy is capital followed by saving and finally financial development. similarly, the coefficients of saving and financial development found to have a significant and positive impact on economic growth in turkey in the short-run. it was also found that the speed of adjustment in the estimated model is high with 64 percent of disequilibrium eliminated within one year. it is important to state that given this scenario, policy makers should pay keen attention on implementing policies that result in increasing the share of gross domestic saving in gdp. similarly, fostering the development of a country’s financial sector will provide the necessary funds to the productive sector of the economy, which in turn enhances the country's economic growth. in addition, the results elucidated that higher capital formation as well as higher employment were essential for the turkish economy to achieve a sustained increase in its growth rate. references akhtar h. 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(1998). an autoregressive distributed-lag modelling approach to cointegration analysis. econometric society monographs, 31, 371–413. https://doi.org/10.1017/ccol0521633230.011 pesaran, m. h., shin, y., and smith, r. j. (2001). bounds testing approaches to the analysis of level relationship. journal of applied econometrics, 16(3), 289–326. https://doi.org/10.1002/jae.616 romer, p. m. (1986). increasing returns and long-run growth. the journal of political economy, 94(5), 1002-1037. https://doi.org/10.1086/261420 şamiloğlu, f., and savaş, b. (2010). financial development and economic growth in turkey: an ardl bounds testing approach. çankırı karatekin üniversitesi sosyal bilimler enstitüsü dergisi, 1, 25‐34. solow, r. m. 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(2013). empirical analysis of the savings-growth nexus in turkey. journal of business, economics and finance, 2(3), 67-74. microsoft word 12237-45025-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 307 sme growth: the role of government grant andrea quintiliani assistant professor department of law and economic sciences, pegaso telematic university, naples, italy e-mail: andrea.quintiliani@unipegaso.it received: oct. 7, 2017 accepted: nov. 24, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.12237 url: https://doi.org/10.5296/ajfa.v9i2.12237 abstract the objectives of this research are two: to understand, if government grants create favorable conditions for enterprises which mean to promote diversification process by increasing range of company products; and to understand if diversification strategy, stimulated by public grants, can lead to a growth of company value. this research is carried out through the balance sheets of the data-base aida and analysis of questionnaires submitted to a sample of 100 small and medium-sized enterprises located in molise region (italy), operating in the agro-alimentary sector, and which benefited from public grants during the period 2007-2008. the analysis covering the period 2003-2014. the empirical evidence from january 2003 to december 2014 indicates a strong relationship between government grant, strategy diversification and growth of enterprise value. it should be emphasized that present work limits its field of investigation to a few variables without fully addressing other elements of uncertainty that may adversely affect on sme’s eva. this work will be useful to stimulate debate on policies to support smes. the originality of this study is the correlation between public grants, corporate strategies and added economic value. keywords: diversification strategy, financial performance, government grant, eva, enterprise value jel classification: g32, g38, l25 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 308 1. introduction in business literature there is a significant presence of studies regarding product differentiation and optimizing resources to attain it, as diversification is too expensive to carry out and often requires vast resources (internal and external). however, the analyses which investigate the role of financing of these diversification strategies, has been less explored. as a result, it seemed interesting to examine the links between the politics of diversification and the characteristics of the financial resources, which they sustained with a particular regard to government grant. most famous studies have demonstrated that financing decisions could be “irrelevant” in the process of company strategies (modigliani and miller, 1958), but a change in the company working conditions has shown that these decisions can affect the value of the company, because of market imperfections, highlighting the role of finance in the implementation of business strategies (myers and majluf, 1984). a large number of studies have supported a link between decisions and financing sources in the formulation of a business strategy (barton and gordon, 1988; bromiley, 1990; chatterjee, 1990; chatterjee and wernerfelt, 1991; kochhar, 1996) enhancing the importance of funding in firms development strategies (jensen, 1986). on the other hand, a series of studies postulated that diversification is not associated to the type of funding (ramanujam and varadarajan, 1989; chatterjee and singh, 1995) or that the nature of diversification depends, in part, on the financing sources available to the firm (chatterjee and wernerfelt, 1991). given the necessity and the substantial endowment of financing sources required by a strategic process of product differentiation, many companies must turn to external financing. finally, from a methodological point of view, the importance of studies analyzing the company value generated by diversification (guatri, 1991; ezzamel, 1996; donna, 1999; bennet stewart, 2000; copeland et al., 2002; di lazzaro, 2003; lothian, 2005) appears relevant because the instruments for measuring strategic performances induced by government grant, object of the study, can be placed in this work. in this work we use economic value added (eva) as indicator of performance to evaluate the value generated by corporate strategies. economic value added is an important indicator to measure the creation of current and potential value, therefore, to give concrete implementation to the business strategies that have the founding objective in the creation of value. as evidenced by study of unnisa and janakiramudu (2014): «economic value added (eva) is the best available measure for evaluating shareholders value. it is a measure of economic profit and not accounting profit. eva calculation shows the difference between the cost of capital and the return on that capital. the shareholders of the company invest with the aim of getting return and increase in the value». for further information on economic value added concept, following studies are suggested: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 309 bennet stewart, 1991; brealey and myers, 1991; stern et al., 2001; grant, 2003; ray, 2012; shil, 2009). based on aforementioned scenario this study focusing on the analysis of relationships between diversification strategies, government grant and company value. in particular, the following research questions are formulated as below: 1) is there a direct relationship between government grant given to the firm and the diversification strategy adopted? 2) is it possible to measure quantitatively the benefits that diversification strategy can bring to the growth of company value? 2. method this project, initiated in 2015, analysed a sample of enterprises of the molise region, operating in the agro-alimentary industry, to collect qualitative data such as: the institutional and organisational set-up, the competitive level in the markets, development strategies and the modalities to access government grants. qualitative data have been collected through questionnaires. the enterprises, which participated in this project, belong to a sample of 180 companies selected according to the following research criteria: a) the enterprises were working in the agro-alimentary industry; b) they were operating between 2003 and 2014; c) they were not dependent by parent companies. this further research key has allowed the balance sheet analyst to get around problems related to intra-group transactions; d) they were small and medium-sized. all of the interviewed enterprises respect quantitative parameters imposed by the european union for the classification of small and medium-sized enterprises (number of employees under 250 and turnover less than 40 million euro); e) they have benefitted from government grants in the period 2007-2008 (interest subsidies, operating expenses subsidies, capital subsidies and investment subsidies). the interest subsidy is a benefit, generally middle or long term, conceded against a financing granted by authorized subjects working in the banking system. it can be issued in two ways. in the first case, it acts upon the financial contract initially stipulated according to market conditions, cutting down interest rates. in the second case, the financing provides a soft tax from the beginning. subsidies for operating costs have the function to cut down on operating costs, capital subsidies aim to enlarge the enterprise wealth but do not oblige a specific investment while investment subsidies are granted specifically in relation to the acquisition of depreciable assets. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 310 presently, the research has overall updated the database of 100 enterprises from the molise region while for the remaining 80 enterprises the interview phase has yet to be completed. research data were collected using questionnaires and balance sheets. the questions on the questionnaire with fixed answers were directed to investigate: − competitive characteristics; − organizational structure; − adopted development strategies; − qualitative and quantitative variables concerning government grants. 3. results the quantitative analysis of the enterprise balance sheet. in order to develop the quantitative analyses of the study, a known method of calculating company value eva economic value added –has been used (bennet stewart, 2000). the fundamental concept, on which modern financial theory is based, is that an enterprise is economically profitable if it produces a superior return to the financial funds it uses. even if this statement seems obvious, even more often the success of an enterprise is measured with regards to profitable gains, return on equity (roe), rate of growth, cash-flow, gross operative margin, market share and in the case of listed enterprises the relationship between price and earnings (p/e), and earnings per share (eps). even if all of these elements are relevant to the performance evaluation, none of them refers directly to the concept here expressed and it is highly possible that enterprises with a high growth level of roe, p/e, etc. do not have a high economic return rate. on the contrary, eva measures economic return directly, eva = k×(r-c) (1) where “k” stands for the invested capital (financial resources used in the enterprise), “r” is the rate of return on invested capital and “c” (or wacc) is the cost of the capital. the capital invested is the sum of the economic value of money invested in various forms in the enterprise while the rate of return on invested capital is calculated by dividing the net operating profit after taxes (nopat) for the invested capital. nopat in return can be seen as the difference between net operating profits (inclusive of amortization) and “cash operating taxes”.even nopat is subject to a multiplicity of adjustments, which vary according to the method of accounting used for the stock, to the presence in the balance of amortization for the start-up of acquired societies, the capitalization of research costs. this is naturally only an indication: the true objective is to single out the relationship between enterprise debt and capital in an average period. nopat is therefore a measure of the earning performance of an enterprise, which contrary to roe, it is independent from financial structure. it can be easily shown that with equal operating results, an indebted enterprise asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 311 tends to show a higher roe and vice versa. nopat in this case would remain unvaried. the rate of capital return (r) can therefore be calculated as: r = nopat÷k. the cost of capital represents conceptually the minimum return requested by shareholders and creditors to compensate the risk they run and can be calculated in various ways. this study used a method commonly used by external financial analysists called capm (capital asset pricing model) in circulation for more than a quarter of a century, but still used. the relationship between enterprise debt and capital is calculated on a time of 2 years (about this aspect, it is only an indication; the true aim is the individuation of ratio debt-capital of enterprise of middle period) and then the remuneration requested by the enterprise shareholders is calculated in the following way: y = rf+β×(rm-rf) (2) where “rf” represents the return on long-term government securities, “rm” represents the rate of return on the stock market and “β” represents the riskiness of the enterprise with regard to the stock market. the return on long-term government securities affects the average interest rate of ten-year treasury bonds. the source of data is the state treasury’s official internet site. the rate of return on the stock market is calculated as average of roe on the balance data and afferent to italian agro-alimentary industry. most of the data used in the work are taken from databases aida by bureau van dijk. for this study beta is calculated with the aid of aswath damodaran database (food processing sector).if β>1 the enterprise is riskier than the market and viceversa if β<1. even if this formula regards the stock market, it can also be used to calculate enterprise value of unlisted companies by making some adjustments. for both the “rf” and the “rm”, it is appropriate to calculate an average of a time horizon of at least three years. at this point, the average cost of capital after taxes is calculated in the following way: c = [(k-d) × y + d × b × (1-t)] ÷ k (3) where “d” represents the average of total enterprise debt in two years and “t” is the rate fiscal taxation. emerging data from the sample. the following charts show the calculation of all the dimensions presented up to now and afferent to the aggregate enterprise sample. it is presumed that the data has been “adjusted” according to the preceding description. according to the calculations, the aggregate in question realized the following: − in the period 2003-2004 a negative eva equal to -2.242.499 with a capital return inferior to 1.37% with respect to its cost (-1.37 = 2.84-4.21); asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 312 − in the period 2005-2006 a negative eva equal to -6.236.067 with a capital return inferior to 3.63% with respect to its cost (-3.63 = -0.33-3.30); − in the period 2007-2008 a negative eva equal to -2.866.099 with a capital return inferior to 2.37% with respect to its cost (-2.37 = 1.75-4.12); − in the period 2009-2010 a positive eva equal to 683.038 with a capital return superior to 0.82% with respect to its cost (0.82 = 6.54-5.72); − in the period 2011-2012 a positive eva equal to 5.300.169 with a capital return superior to 2.24% with respect to its cost (2.24 = 5.02-2.78); − in the period 2013-2014a negative eva equal to -4.693.099 with a capital return inferior to 1.14% with respect to its cost (-1.14 = 2.32-3.46). the application of the formula of value creation allows the assessment of which enterprises create value and which destroy it (tab. 1; tab.2). table 1. estimation results of eva period k r c nopat eva 2003-2004 1.636.860,58 2,84 4,21 4.648.684,06 -2.242.499,00 2005-2006 2.099.685,86 0,33 3,3 692.896,33 -6.236.067,00 2007-2008 1.209.324,47 1,75 4,12 2.116.317,83 -2.866.099,00 2009-2010 832.973,17 6,54 5,72 5.447.644,54 683.038,00 2011-2012 2.366.146,88 5,02 2,78 11.878.057,31 5.300.169,00 2013-2014 4.116.753,51 2,32 3,46 9.550.868,14 -4.693.099,00 source: our elaboration on “aida” data table 2. financial statements data period net income net cash flow equity capital total assets roe roa 2003-2004 18.260,00 1.022.710,49 1.489.543,13 2.127.918,76 1,23% 0,86% 2005-2006 15.210,00 152.437,19 1.910.714,13 2.729.591,62 0,80% 0,56% 2007-2008 22.000,00 465.589,92 1.100.485,27 1.572.121,81 2,00% 1,40% 2009-2010 72.589,00 1.198.481,80 758.005,59 1.082.865,12 9,58% 6,70% 2011-2012 225.879,00 2.613.172,61 2.153.193,66 3.075.990,94 10,49% 7,34% 2013-2014 61.458,00 764.069,45 3.746.245,69 5.351.779,56 1,64% 1,15% source: our elaboration on “aida” data the next step in the investigative methodology is to single out how enterprise profits, directly responsible for the measure of enterprise value, are referable to phenomena linked to the generating processes of diversification. for this purpose, figure 1 singles out the variables, which influence enterprise value and our suggested model for the investigation. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 313 figure 1. generators of enterprise value in the construction of a theoretical model, the value is the result of a series of phenomena expressed qualitatively and quantitatively by enterprise management and absolutely interdependent. the presumption of the analysis is that functional managing facts which generate diversification and measurable with the aid of micro-drivers (having no financial value) influence the macro-drivers (having economical-financial value) as they are destroyers and/or generators of value. in the sphere of diversification measurement, the value micro-drivers are indicators of performance with regards to output parameters and analyzed at the end of the assessment of the level of efficiency of an enterprise system expressed as level of growth of enterprise value. the following step in defining the investigation is to establish a relationship between macro-drivers and series value micro-drivers. our research, with regards to a theoretical model projected and used to demonstrate the relational logic of cause and effect, where financial incentives activators of diversification strategies (and demonstrable with the questionnaires), produce effects on the enterprise value creation, focuses the investigation on the demonstration of the relations relating solely to rate of growth of the turnover linked to the magnitude of the range of company products. survey questionnaires highlighted, in synthesis, how government grants have a significant impact on extent product range. the results are given table 3. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 314 table 3. correlation between “government grant” and “extent product range” variable regression coefficients (t-statistics in parentheses) statistical relationship between government grant andextent product range 12.5 (16.8) adjusted-r2 0.3810 source: our elaboration on survey questionnaires to understand how the value driver (turnover) relates to diversification (magnitude of product range), the investigation uses an econometric model which allows to evaluate the effect of value creation following a change in the parameter measuring diversification in the sample enterprises. for this purpose, statistical instruments directed to investigate the sensitivity (ß) of the independent variable (micro-driver) compared to the dependent variable (macro-driver) is used and it is represented in the equation of straight-line regression: y = a – βx (4) the sensitivity, about the demonstration, is calculated with the following formula: β = ( / , ) ( / ) (5) the equation of straight line regression, represents the linear function which describes in the best of ways turnover growth (the dependent variable “y” in the equation in question) in function of the level of magnitude of the range of enterprise products (the independent variable “x” on the right-hand side of the equation) and the curve (ß) expresses its sensitivity. analyzing and interpreting a temporal series (from 2003 to 2014), with annual data of company turnover and magnitude of product range with relative increase or decrease percentage rates, we proceed as follows: − yi = growth rates of annual turnover (with i = 1 to n=789); − xi = growth rate of the range/product (with i = 1 to n=789). the arithmetic average of x and y is calculated as: = ∑ = 0.0175 (6) = ∑ = 0.0098 (7) from this, the covariance is equal to: , = ∑ ( − ) − = 0.0017 (8) given that the variable x presents n modalities x1,x2,x3, n having an average μx the quantity asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 315 takes on the name of the variance defined in this manner: ∑ ( ) = 0,0047 (9) beta is therefore: β = ( / , ) ( / ) = .. = 0.3667 (10) the equation of straight-line regression: y = 0.3667x + 0.0034 indicates that an increase or decrease of 1% in the range of enterprise products and that an indicator of the level of enterprise diversification brings on an increase or a decrease of 0.3667% of turnover. the coefficient r2 = 0.2286 indicates, instead, that about 23% of turnover variation is “explained” by the variation in product range. to conclude the analysis, the coefficient r2 becomes a parameter to weigh the value system of the economic-financial matrix and measured by eva. from this, the expression of the contribution level of “diversification”, on company value generated or destroyed. at this point of the analysis, eva and the other parameters are re-elaborated with the aid of appropriate weighting (r2) and therefore: nopatp = (nop× r2) – cot (11) eva = k × (rp – c) (12) nopatp = weighted net operating profit after tax; nop = net operating profit; r2 = square error; cot = cash operating taxes; k = capital employed; rp = return rate of capital employed; evap = weighted economic value added. in our analysis, weighted eva singles out the value generated by the enterprise sample and attributed to diversification; the latter measured in economical-financial terms by the importance it assumes in the construction of return rate (r), from this weighted (rp). the value of weighted eva is reported as follows (tab. 4): − in the period 2003-2004 a negative evap equal to -740.024; − in the period 2005-2006 a negative evap equal to -2.507.903; − in the period 2007-2008 a negative evap equal to -945.813; − in the period 2009-2010 a positive evap equal to 225.402; − in the period 2011-2012 a positive evap equal to 1.749.055; − in the period 2013-2014 a negative evap equal to -15.488.146. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 316 table 4. the value of weighted eva period k rp c r2 nopatp nop cot evap 2003-2004 207.826,61 0,649224 4,21 0,2286 134.926,02 87.701,91 -114.877,36 -740.024,00 2005-2006 777.749,97 0,075438 3,3 0,2286 58.671,90 38.136,74 -49.953,84 -2.507.903,00 2007-2008 254.254,22 0,40005 4,12 0,2286 101.714,40 66.114,36 -86.600,66 -945.813,00 2009-2010 -53.350,14 1,495044 5,72 0,2286 -79.760,81 -51.844,53 67.909,15 225.402,00 2011-2012 -1.071.443,89 1,147572 2,78 0,2286 -1.229.559,00 -799.213,35 1.046.858,83 1.749.055,00 2013-2014 5.286.691,78 0,530352 3,46 0,2286 2.803.807,56 1.822.474,91 -2.387.189,79 -15.488.146,00 source: our elaboration on “aida” data the results indicate the positive impact of diversification on evap starting from the period in which government grant are concentrated (2007-2008). the last period analyzed (2013-2014) shows an inversion; this inversion is to be considered attributable to outdoor environmental factors that have not been taken into account in this study. 4. discussion this research has explored the links between strategic and financial management. specifically, the theory that links company diversification strategies to capital structure was questioned and experimented. acting as a link between strategic research and corporate finance studies, this study examined how strategic decisions linked to the product can be influenced by financial structure and specifically, how government grant intervenes to strategic decision process. results emerging from questionnaires indicate the considerable weight that public financial grant have in conditioning product policy (adjusted r-squared equal to 38%). to understand how diversification stimulated by government grant, have influenced the enterprise value, our research suggests a useful method to evaluate cause-effect relationships and a model in the research of created or destroyed economic value. from the elaboration carried out with eva, appropriately parameterized, emerges the weight of diversification strategy in the growth or destruction of company value; this weight is estimated equal to 23%. the analysis shows favorable trend of evap starting from the period in which government grants are provide. therefore, this study suggests the considerable weight that product strategy has in modifying business economic-financial profiles. nevertheless, some empirical studies not sustain this hypothesis (chatterjee, 1990; yip, 1982). this result is in accordance with chatterjee and singh (1995) which highlighted the importance of diversification in the growth of company value and the strong link between sources of financing and adopted strategy. according to the studies conducted previously (balakrishnan and fox, 1993; barton and gordon, 1988; bromiley, 1990; jensen, 1986), this work has shown that financial strategy is asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 317 influenced by diversification strategy and that capital structure influences simultaneously the relative diversification strategy. moreover, this study highlights the importance of diversification on firm value creation. references balakrishnan, s., & fox, i. 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(1982). diversification entry: internal development versus acquisition. strategic management journal, 3(4), 331-345. https://doi.org/10.1002/smj.4250030405. microsoft word 11193-41277-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 396 factors affecting the profitability of indonesian real estate publicly-listed companies dr. john francis t. diaz, associate professor dept. of finance, chung yuan christian university no. 200, zhongbei road, zhongli district, taoyuan city, taiwan tel: 1-416-777-7777 e-mail: johnfrancis_diaz@yahoo.com martha christianie tjokro hindro dept. of business, chung yuan christian university no. 200, zhongbei road, zhongli district, taoyuan city, taiwan tel: 886-0975349102 e-mail: martha.christianie@yahoo.com received: may 8, 2017 accepted: june 12, 2017 published: june 12, 2017 doi:10.5296/ajfa.v9i1.11193 url: http://dx.doi.org/10.5296/ajfa.v9i1.11193 abstract the research studies the relationship between eight firm-specific factors on the profitability of large-, medium-, and small-scale real estate indonesian companies. the data uses forty-seven real estate companies listed in the indonesian stock exchange from 2010 to 2014. the study utilized multiple linear panel regression models, namely, ordinary least squares (ols), fixed effects (fe) and random effects (re) in examining the effect on the return on asset of firm-specific factors, which include: number of days account receivables, number of days inventory, number of days of account payable, size of the company, current ratio, debt ratio, sales growth, and tangibility. empirical findings show that the number of days account receivable has negative relationship with profitability, but it has no effect on medium-size indonesian real estate companies. the factor number of days inventories has negative relationship in small-size companies, but the inverse is true for large companies, because large real estate firms have more liquid assets that covers maintenance costs related to real estate inventories. size and sales growth have positive relationship on profitability for both large and small indonesian real estate firms. on one hand, current ratio has positive relationship in large companies, while a negative relationship was found in small companies, because of the lower current asset base usually being experienced by smaller real estate firms. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 397 lastly, tangibility has negative relationship with profitability for large companies, while the opposite is true for medium-sized real estate firms. findings of this research are strong in using two panel regression models, and can help real estate managers have a general perspective regarding determinants of profitability in the expanding indonesian market. this study also provides fresh perspectives in creating suitable strategies to controlling factors that maximizes profitability. keywords: profitability, real estate indonesia, return on asset asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 398 1. introduction the recovering global economy, particularly of the us has been setting an uptrend for the real estate industry where prices are seen to be reaching equilibrium levels. indeed, the subprime mortgage crisis of 2008 became the biggest blow to the seem-to-be-invincible real estate industry in recent years. however, investors, traders, speculators and even scholars are keeping an eye on the industry’s current profitability because of the returning prospect that real estate industry still has a greater and more solid value compared to other investments in the long-term. the industry is experiencing renewed liquidity, because of the growing optimism in the future prospects of the industry. according to an online survey of 4,555 real estate executives conducted by the national association of realtors profile of real estate firms of 2015, 69% of residential real estate firms are very positive of the industry, and are expecting an increase in their net income next year. however, 46% still cited that keeping liquidity and profitability may still be the big challenges in the next two years, because of the shock caused by the recent crisis. the subprime meltdown made industry players very cautious in maintaining sufficient inventories, and in monitoring local and regional economic conditions. liquidity and profitability as the major concerns nowadays have been studied by gitman (1974), and introduced the model to measure liquidity with its study of the cash conversion cycle (ccc), which offers a potential gauge for businesses with longer cycles. ccc measures the number of days accounts receivable, the number of days inventories, and the number of days accounts payable, and the study of deloof (2003) has proven that ccc influences the profitability of a company. in terms of real estate and construction industries, mehta (2014) examined publicly-listed companies in the abu dhabi stock exchange and showed that with longer ccc, the lesser the profitability of the companies. moreover, hammes and chen (2005) earlier noticed that the determinants of firm’s profitability in one country compare to the others could be the same, but the result in the different aspects like liquidity and leverage depend on the general economic conditions of a country. this was supported by their study regarding private property companies in 13 european countries. companies with businesses related to the real estate and property sectors in indonesia are still expected to be promising and profitable for two main reasons: a) property prices in indonesia are still among the cheapest in the southeast asian region; and b) a high demand for property is still present due to the large and young indonesian population. these mean that properties are still affordable, and many more first house buyers are yet to be expected. in the beginning of 2012 and the first half of 2013, indonesian property developers experienced a rapid growth. twenty-six out of the forty-five real estate companies experienced more than 50% growth on profit. accordingly, property prices rose nearly 30% per year between 2011 and 2013. this property boom was attributed with the strong demand, and increased demographic income. middle class consumers are the biggest drivers in the residential segment, and became the largest contributor to indonesia’s property growth; about 60% of the total property sector. the expansion of population complementing with increasing urbanization create more asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 399 demands in the future, especially that 50% of indonesia’s population is below the age of 30, which is the future consumers of real estate. the united nations (un) predicted that by 2050, two-thirds of indonesia’s population is expected to live in urban areas (schaar, 2015). this trend, coupled with limited land in urban areas will tend to make prices to increase rapidly making developers to focus on vertical residential development, such as apartments and condominiums. the other factor causing the property boom was the bank indonesia (bi), the country’s central bank’s easy credit policy. from february 2012 until the middle of 2013, the central bank’s rate was 5.75%, which is considered a low-policy rate for the country as the southeast asia’s largest economy. this condition also pushed commercial banks rose their mortgage loans. according to schaar (2015), about 46% of banks’ total credit was allocated to consumers’ mortgage loans since may of 2013. however, bi became more cautious about the rapid increase in mortgage loans, because the general economy experiences a slow growth in the second half of 2013. bi decided to be stricter with their low-rate policy, and implemented the following measures: a) raised the minimum down payment requirement for property purchases, b) restricted mortgages for second home ownership to prevent excessive increase of housing debt, and c) banks were prohibited to provide loans for purchasing property that was still under construction. moreover, bi raised its rate between june 2013 and november 2013 to 7.50%, in order to resist the high inflation, to lessen the country’s wide current account deficit, and to manage the uncertain international climate. furthermore, bi’s survey showed a sharp drop in residential property sales, from 40.1% in the fourth quarter of 2014 to 26.6% in the first quarter of 2015. given all these trends in the indonesian real estate and property sectors, companies control their leverage due to the high interest rate to avoid negatively affecting firm performance. according to mayasari (2012), leverage has adverse effects on the firm’s profitability, because it may control a firm’s liquidity due to interest and principal obligations. the study also found that liquidity has positive relationship with the profitability, which means that the more cash or cash-related assets the company own, the higher the profit they could generate. the study is motivated by the projected boom of the indonesian real estate industry in the future. indonesia’s high demographic growth, increasing income levels, and relatively cheaper real estate properties provide great opportunities for real estate companies to gain higher liquidity and profitability in the future. the lack of empirical literature in determining the factors that affecting profitability of indonesia’s real estate is also one of the main motivations of the study, thus, this paper contributes to the literature by identifying these factors using ordinary least squares (ols) model. the broader objective of this research is to identify significant factors affecting profitability of indonesia’s real estate industry; and the three specific objectives are: • to identify significant positive and negative relationships between real estate company’s profitability and related factors; • to determine which firm-specific factors have stronger influence on profitability based asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 400 on the coefficients’ outcome; and • to examine if there are differences on the significant factors determining the profitability of large-, medium-, and smallcompanies based on market capitalization. this study’s objectives will provide more empirical evidence in determining financial factors that management can utilize to better understand changes in company profitability. also, the more recent data range, extended variables considered (i.e., three components of ccc, current ratio, and tangibility), and dividing real estate firms into three major categories make-up the distinction of this paper from the previous studies of azlina (2009), apriliyani (2011), and karina and khafid (2015), in indonesia. findings can also benefit managers of real estate companies in controlling certain financial variables that will help corporate strategies in order to minimize losses and maximize gains. the paper is organized as follows. this section discussed the background of the study; section 2 reviews the related literature; section 3 defines the variables and related hypotheses; section 4 presents the data and explains the methodologies of the research; section 5 explains the empirical result; and section 6 provides the conclusions, and limitations of this study. 2. literature review previous studies provide empirical evidences revealing the relationship between profitability and its different factors in several types of industries including the real estate industry. these researches will be discussed in the following sections: first, reviews literature that discusses factors affecting profitability; second, covers studies on factors affecting profitability of real estate firms in other countries; and lastly, features profitability of various industries in indonesia. 2.1 proxy variables affecting profitability a set of literature has examined the effect of ccc as a proxy for firm profitability. shin and soenen (1998) examined the relationship of net trade cycle (ntc) with profitability, and showed strong negative relation between the length of ntc and profitability. same results were shown in deloof (2003), and lazaridis and tryfonidis (2006), wherein they used ccc and its components to be tested toward gross operating income (goi) as a proxy for profitability. on one hand, garcia-teruel and martinez-solano (2007) investigated return on asset (roa) to stand for profitability, and revealed the same results, negative relationship between the number of days accounts receivable and inventories. in addition, enqvist et al. (2014) investigated the role of business cycles on the working capital–profitability relationship, and showed that the negative impact of business cycle is more obvious in economic downturns relative to economic booms. the significance of efficient inventory management and accounts receivables conversion periods is negatively related to corporate profitability, and also is also magnified during periods of economic downturns. obert and olawale (2010) investigated the impact of the use of debt on the profitability of small manufacturing firms, and found that there was a negative relationship between debt usage and the value of the firm. similar research about the impact of debt level on asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 401 profitability in three classes (i.e., small, medium and large capitalization) of company size, conducted by kebewar (2013), found that the debt negatively affects profitability. this finding corresponds to shin and soenen (1998), deloof (2003), lazaridis and tryfonidis (2006), garcia-teruel and martinez-solano (2007), and pervan and višić (2012). however, burja (2011) found the opposite, wherein debt ratio is positively related to profitability because of properly managing the advantage of leverage. pervan and višić (2012) on the other hand, focused on firm size, and found that size has a significant positive influence on firm’s profitability. in addition, asset turnover has positive significant influence and debt ratio has negative significant influence on firms’ performance while current ratio doesn’t prove to be an important explanatory variable of firms’ profitability. burja (2011) also analyzed profitability, and found negative relationship between the variable and fixed asset and expense ratios. however, the efficiency of managing inventories, debt levels, and efficiency of managing capital have positive effect on profitability. in an earlier study, zubairi (2010) research results showed a positive relationship between profitability and average share price, liquidity, growth of revenue, and economic factor, gdp growth. but the relationship between profitability and financial leverage is negative. 2.2 factors affecting profitability of real estate firms globally hammes and chen (2005) conducted research to discover factors that influence profitability of real estate firms in european countries. generally, the study found that borrowing has a negative effect, while firm size firm has a weak positive effect on performance except for austria, which has a negative effect. also, in most european countries tangibility factor was positively related to borrowing, but not to profitability. in an earlier study of the same authors, hammes and chen (2004) analyzed the performance of the swedish real estate industry, and showed that firm performance could be explained by capital structure, size, age, tangibility and debt ratio. in addition, tangible assets (i.e., plant and equipment) contribute to the profitability of a firm serving as collateral for bank loans. however, excessive tangible assets were negatively related to profitability in the short-term, because of the expensive maintenance inherent with these assets. studies in the middle east and africa were also present. for example, mehta (2014) investigated the relationship of working capital management and the profitability in the real estate and construction sectors of the united arab emirates (uae). the results showed a significant negative relationship between profitability and the length of the firm’s cash conversion cycle. this means that the longer the cash conversion cycle, the lesser will be the profitability. in jordan, dahmash (2014) studied about the effect of size on the profitability of listed companies in the amman stock exchange. the results indicated that total assets has an insignificant coefficient values in relation to company size for real estate companies. in africa, the study of emoh and uzuanje (2015) research about the influence of increasing cost of capital on the profitability of real estate developments in a particular locale in nigeria, benin city. the study showed that cost of capital negatively affects rate of returns, which implied that increasing cost of capital reduced profit levels of real estate developers. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 402 in asia, malaysia’s real estate industry has been highlighted in two studies. a unique relationship was established by jarad and sulaiman (2011) who investigated the connection between design as strategy of real estate firms and its relation to their profitability. the results showed that design innovativeness was positively correlated with profitability. on one hand, mahmood and zakaria (2007) also studied malaysian property developers and constructors with regards to profitability and capital structure. the findings indicated that financial leverage was negatively related with net profit margins and price earning ratio for both property and construction sectors. the greater china region also had its shares of studies about factors affecting the profitability of real estate firms. feng and guo (2015) analyzed the relationship between capital structure and financial performance of real estate listed companies in shanghai, and showed that the high debt ratio is negatively related to its financial performance. wu and hsieh (2006) analyzed the correlation between debt ratios and corporate performance of taiwanese property development firms during economic contractions. the study found that industry profits decline during periods of contraction. moreover, industry characteristics and short-term debt ratio has positive correlation, however a negative correlation exists between stock dividend policy and operating risk in terms of total debt and short-term debt ratios. in addition, lee (2009) investigated the factors that influence the profitability of construction companies in hong kong. the results indicated negative relationship between the company size and profit margin. also, the degree of sub-contracting and the level of material content have significant negative impact on profitability. 2.3 determinants of profitability in various indonesian industries empirical studies that examined firms of various industries in indonesia showed various results about factors that influence firm’s profitability. in the financial industry, martani and munaiseche (2010) examined the determinants of profitability of indonesian financial companies, which considered both internal and external factors. the study showed that operation expense, company size and inflation have negative effects on profitability, while credit risk has positive effect. another study of maberya and suaryana (2009) investigated publicly-listed banks about the effects of company size, and debt to equity ratio on profitability, and included the moderating variable, earnings growth. results showed that with the moderating variable, company size did not influence the profitability, while debt to equity ratio negatively affected profitability. however, kusumajaya (2011) examined manufacturing companies, and showed that capital structure, which was represented by debt equity ratio, positively affected profitability and corporate value. the other empirical study on the manufacturing industry was provided by ismiati et al. (2013), which showed a negative relationship between working capital turnover and profitability of indonesian manufacturing companies. in other types of businesses, margaretha and supartika (2015) conducted research on the profitability of small to medium enterprises (smes) and found that firm size, growth opportunities, and lagged profitability have negative effects on profitability, while firm productivity and industry affiliations have positive impacts on profitability. studies on property and real estate industry in indonesia are also present. for example, azlina asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 403 (2009) revealed that working capital turnover and debt to equity ratio positively influenced the profitability of real estate companies. also, apriliyani (2011) showed a decreased condition for profitability in relation to asset structure, and the size of the company in 2004 and 2008 because of the financial crisis. moreover, profitability, asset structure, and company size positive significantly influence the capital structure. limbago and juniarti (2014) showed that size, sales growth and proxy variable for family control have positive significant effects on profitability, but not on the firm’s value of family-controlled companies. on the other hand, leverage had no effect on profitability, but had significant positive effect on the firm’s value. karina and khafid (2015) showed that the size of real estate companies and receivable turnover ratio has positive relationship. another study of mayasari (2012) found that has negative significant relationship with profitability. however, leverage and liquidity have positive significant effects. 3. variable description and hypotheses from the various empirical studies investigating factors influencing profitability of several industries, this research considers eight factors that may influence profitability of indonesian real estate companies. the definitions and hypotheses of each variable are discussed below, while formulas, and expected relationship are summarized in table 1. a) return on asset (roa) roa is a measure of profitability per unit of assets (net income / total assets). it reflects financial performance of a firm by measuring how efficiently a firm creates profits using its assets during a year. it shows the ability of the firm's management to produce profit from the company's assets (aissa and goaied, 2016). in the previous studies, garcia-teruel and martinez-solano (2007), zubairi (2010), and enqvist et al. (2014) used roa as a proxy for company profitability. since roa gauge in total assets, which includes the operating assets, it can be used to measure the overall profitability of a company. for the purposes of this research, roa will be designated as the dependent variable, and will have the following as the eight independent variables: b) cash conversion cycle (ccc) ccc is a measure of ongoing liquidity, as introduced by gitman (1974). it quantifies the days between the expenditure of raw material procurement and the collection of finished goods’ sales. enqvist et al. (2014) explained that the shorter time of ccc, the higher the profitability, since short ccc indicates quick collection of receivables and delays in payments to suppliers, thus, increases efficiency of working capital management. the ccc aims to shorten the a) number of days account receivable, the b) number of days inventory; and the c) number of days account payable. deloof (2003), lazaridis and tryfonidis (2006), and enqvist et al. (2014) all claim a negative relationship between the length of ccc, and corporate profitability. thus, this study formulates the following hypotheses: h01: ccc components (number of days accounts receivable, number of days in inventory, and number of days accounts payable) have no effect on profitability. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 404 h1: ccc components (number of days accounts receivable, number of days in inventory, and number of days accounts payable) have negative relationship with the profitability. c) size size will be measured by the company’s total asset. it is assumed that huge companies with bigger assets optimize operations to create more profit. according to the studies of deloof (2003), lazaridis and tryfonidis (2006), and garcia-teruel and martinez-solano (2007), the relationship between company size and profitability is positive, which means that the bigger the company, the higher profitability the company has than smaller firms. however, enqvist et al. (2014) showed a result of negative relationship between the size and profitability. for the purposes of this study, we’ll be going with the following hypotheses: h02 : size of the company has no effect on profitability. h2 : size of the company has positive relationship with profitability. d) current ratio current ratio is an indicator of a company’s short-term liquidity, and is measured by: current asset / current liabilities. the higher the ratio, the more capable the company is to pay back its current liabilities and continue its daily operations. previous studies, such as zubairi (2010) and enqvist et al. (2014) proposed positive relationship between current ratio and profitability, because of maintained liquidity in the short-run. thus, this paper suggests the following hypotheses: h03 : current ratio has no effect on profitability. h3 : current ratio has positive relationship with profitability. e) debt ratio debt ratio indicates the percentage of company’s assets that are supported by external financing (shortand long-term debt). the higher the ratio, the greater the amount of debt used to operate and generate profits. a firm needs to maintain a manageable optimal debt ratio to reduce the cost of capital, which also means maximizing firm’s profitability (modigliani and miller, 1963). several previous studies like deloof (2003), kebewar (2013), and enqvist et al. (2014) showed a negative relationship between higher debt ratio and profitability. therefore, this study creates the following hypotheses: h04: debt ratio has no effect on the profitability. h4: debt ratio has negative relationship with the profitability. f) sales growth sales growth is the primary factor that improves profitability. firms with high sales growth opportunities are expected to have a high performance ratio, as growth firms are able to generate profit from investment. previous studies, such as shin and soenen (1998), garcia-teruel and martinez-solano (2007), and zubairi (2010), showed a positive asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 405 relationship between sales growth and profitability. thus, this paper suggests the following hypotheses: h05 : sales growth has no effect on profitability. h5 : sales growth has positive relationship with profitability. g) tangibility tangibility of real estate firms refers to the tangible assets or the fixed and current assets that they have in a particular accounting year. fixed assets include property, plant and equipment, while current assets include real estate assets as inventory. firms with high levels of tangible assets tend to be less profitable, because according to kebewar (2013), these firms have less sales innovation, low research and development, and lower investment opportunities in the long term. the papers of hammes and chen (2004) and kebewar (2013) proposed that there is negative relationship between tangibility and profitability. therefore, this study suggests the following hypotheses: h06: tangibility has no effect on profitability. h6: tangibility has negative relationship with profitability. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 406 table 1. summary of variables description independent variables abbreviation description formula expected relationship with return on asset roa proxy for profitability net income / total assets dependent variable no. of days account receivable ar amount of days to collect payments (account receivable / sales) x 365 negative (-) no. of days inventory in amount of days to hold the inventory (inventory / cost of good sold) x 365 negative (-) no. of days account payable ap amount of days to pay the supplier (account payables / cost of good sold) x 365 negative (-) size size natural logarithm of sales ln (sales) positive (+) current ratio cr indicator of a company’s liquidity current asset / current liabilities positive (+) debt ratio dr percentage of external financing total debt / total asset negative (-) sales growth sg company’s growth opportunities (sales1 – sales0)/ sales0 positive (+) tangibility tang fixed and current tangible assets net tangible asset/ total asset negative (-) 4. data and methodology 4.1 data and sample selection this study collects yearly financial statement, includes balance sheet, income statement, and cash flow of listed property and real estate companies in indonesia stock exchange (idx) from 2010 to 2014. the financial report was obtained from the website of idx (http://www.idx.co.id). there are 60 listed companies, but the companies with unavailable data of the year financial report are excluded. this study examined 47 real estate companies with 5-year dataset of financial statements and was categorized into large, medium, and small groups of companies. the size is classified by the companies’ total market capitalization as of december 2014. this paper follows the classification set by ardiyan (2011) of indonesian firms. large-scale companies have more than idr 5 trillion (about usd 0.4 billion) of market capitalization; medium companies have idr 1-5 trillion (about usd 0.08 0.4 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 407 billion), and small companies have less than idr 1 trillion (about usd 0.08 billion). the complete list of companies under study can be found on appendix tables a to c. table 2 presents the descriptive statistics for the variables used in this study. in general, the average roa of indonesian real estate companies is 6% with data variations of 5%. the average accounts receivables, inventory, and account payables conversion periods are 80.36 days, 777.54 days, and 73.71 days, respectively. for company sizes, the average of the total asset is idr 5.23 trillion (usd 396.89 million) with dispersion of around idr 6.12 trillion (usd 464.26 million). on average, current ratio of all companies is 2.61 with data variations of 4.65, and 42% of the company’s assets are financed with debt with a disparity of around 19%. for sales growth and tangibility, the average values are 38% and 31%, respectively. 4.2 methodology this study examines 8 firm-specific factors that determine the profitability of real estate companies. those factors are: number of days account receivable (ar), number of days inventories (in), number of days account payable (ap) or collectively known as the ccc; size (size), current ratio (cr), debt ratio (dr), sales growth (sg), and tangibility (tang). these variables are tested against return on asset (roa) as a proxy for profitability, and the general null and alternative hypotheses are: • h0: independent variables have no explanatory power on profitability of indonesian real estate companies (βi = 0) • h1: independent variables have explanatory power on profitability of indonesian real estate companies (βi ≠ 0) the hypotheses testing use multiple regression, and the estimation of regression model is as follows: roai,t = β0 + β1ari,t + β2ini,t + β3api,t + β4sizei,t + β5cri,t + β6dri,t + β7sgi,t + β8tangi,t + εi,t the results on the coefficients from the regression are expected to show whether a positive or negative relationship exist between the independent and dependent variables. furthermore, the significance of the coefficients will be analyzed by comparing the p values with α = 10%, 5%, and 1% levels of significance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 408 table 2. summary statistics *size is in billion of rupiah variables used will be initially checked using the multicollinearity test to check whether two or more explanatory variables are highly linearly related. multicollinearity problem exist if the coefficient from the pearson correlation matrix is higher than 0.8. in addition, heteroscedasticity test is important to check possible disturbance in the variance. to detect heteroscedasticity, white’s general test will be applied. if the p value of the computed chi-square value is low, it means that there is heteroscedasticity. on the other hand, if the p value is large (i.e., above 10%), it means that heteroscedasticity does not exist. this research will then run two classes of estimator approaches to determine which model fits the panel data. first, the correlation between error term and variables is assumed with the fixed effects model and then terminates the specific effect of time-invariant features. it aims to assign the net effect of the explanatory variables, and also to discover the uniqueness of these features without correlating them with other individual characteristics. the equation for the fixed effect model is: yit = αi + β1ari,t + β2ini,t + β3api,t + β4sizei,t + β5cri,t + β6dri,t + β7sgi,t + β8tangi,t + uit category roa ar in ap size* cr dr sg tang a llsiz e mean 0.06 80.36 777.54 73.71 5,230.96 2.61 0.42 0.38 0.31 median 0.05 38.60 498.89 43.35 3,250.72 1.56 0.43 0.21 0.26 std. dev. 0.05 175.17 1,052.49 96.05 6,118.93 4.65 0.19 1.06 0.19 min -0.10 0.00 0.00 0.00 2.23 0.19 0.02 -1.00 0.03 max 0.32 1,544.44 6,799.66 816.78 37,761.22 59.71 0.85 11.97 0.85 la rg esiz e mean 0.07 42.83 596.38 69.24 8,339.83 1.92 0.48 0.37 0.29 median 0.06 31.36 406.12 41.27 6,102.35 1.40 0.50 0.26 0.24 std. dev. 0.05 49.35 789.50 79.65 6,546.34 1.43 0.19 0.55 0.16 min 0.00 2.11 0.00 0.00 1,187.41 0.39 0.07 -0.65 0.04 max 0.32 420.31 6,499.60 524.59 37,761.22 9.14 0.85 4.05 0.72 m ed iu m -s iz e mean 0.05 82.18 1,072.48 76.64 3,263.30 3.99 0.36 0.45 0.35 median 0.04 53.38 499.84 54.56 1,589.35 1.58 0.37 0.14 0.26 std. dev. 0.05 76.20 1,473.08 71.00 4,481.64 8.71 0.17 1.65 0.23 min -0.08 0.00 0.00 8.25 2.23 0.24 0.02 -1.00 0.03 max 0.20 311.85 6,799.66 294.56 17,707.95 59.71 0.71 11.97 0.85 sm al l-s iz e mean 0.03 153.75 869.50 79.95 816.91 2.72 0.36 0.31 0.32 median 0.03 38.68 657.88 37.11 612.94 1.76 0.33 0.05 0.28 std. dev. 0.06 321.13 996.82 138.15 772.43 3.07 0.16 1.15 0.19 min -0.10 0.00 0.00 0.00 92.33 0.19 0.07 -0.60 0.03 max 0.19 1,544.44 4,695.53 816.78 3,156.29 18.99 0.74 8.43 0.76 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 409 as αi is the unknown intercept for each entity and uit is the error term. second, the random effects model assumes that the variations across the entities are random and uncorrelated with the explanatory variables. this model also considers the inclusion of the time-invariant variables. the equation for the random effect model is: yi,t = αi + β1ari,t + β2ini,t + β3api,t + β4sizei,t + β5cri,t + β6dri,t + β7sgi,t + β8tangi,t + ui,t + εi,t as αi is the unknown intercept for each entity, uit is the error term between entity, and εi,t is the error term within entity. this research continued to the hausman test to investigate whether fixed effect model or the random effects model is suitable. the proposed hypotheses from hausman test are: • h0: the random effects are uncorrelated with the explanatory variables (i.e., random effects model is preferred) • h1: the random effects are correlated with the explanatory variables (i.e., fixed effects model is preferred). following the test above, this study will analyze the final results of the regression based on the consistency of the panel data with the previous findings of the related literature. 5. empirical result 5.1 initial screenings and findings summary multicollinearity test was used to examine whether two or more explanatory variables are hlinearly related by observing the pearson correlation coefficient matrix. multicollinearity exists if the coefficient exceeds 0.8. table 3 shows the correlation matrix between variables in the four groups of data analyses. the study found that there is no relationship coefficient exceeding 0.8, which means that multicollinearity problem does not exist and all variables are reliable as explanatory factors of profitability. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 410 table 3. correlation matrix of the eight firm-specific independent variables heteroskedasticity was conducted to check the disturbance in variance. if the p-value of computed chi-square value is low (less than 10%), it means that heteroskedasticity exists. table 4 shows the p-values of computed chi-square value obtained from white’s general test. in all size and large companies group, heteroskedasticity exist because the p-value is very low, but in medium and small companies groups, heteroskedasticity does not exist because the p-value exceeds 10%. for all size and large companies groups, heteroskedasticity corrected model was applied. category variables ar in ap size cr dr sg tang a llsiz e ar 1.000 0.344 0.641 -0.291 0.025 -0.106 -0.083 0.204 in 1.000 0.513 -0.284 0.321 -0.190 -0.070 0.410 ap 1.000 -0.066 0.137 0.072 -0.048 0.120 size 1.000 -0.271 0.514 0.009 -0.156 cr 1.000 -0.312 0.085 -0.037 dr 1.000 -0.141 -0.140 sg 1.000 -0.126 tang 1.000 la rg esiz e ar 1.000 0.063 0.511 -0.121 -0.006 0.037 -0.018 -0.194 in 1.000 0.301 -0.136 0.047 -0.128 -0.089 0.292 ap 1.000 0.221 -0.134 0.388 -0.101 -0.214 size 1.000 -0.134 0.680 -0.106 -0.217 cr 1.000 -0.412 0.034 0.173 dr 1.000 -0.119 -0.175 sg 1.000 -0.076 tang 1.000 m ed iu m -s iz e ar 1.000 0.492 0.640 0.229 -0.031 -0.131 -0.131 0.319 in 1.000 0.804 -0.263 0.458 -0.411 -0.072 0.266 ap 1.000 -0.051 0.411 -0.278 -0.125 0.226 size 1.000 -0.287 0.241 0.023 0.120 cr 1.000 -0.296 0.123 -0.148 dr 1.000 -0.258 -0.316 sg 1.000 -0.163 tang 1.000 sm al l-s iz e ar 1.000 0.545 0.782 -0.400 0.039 -0.080 -0.111 0.361 in 1.000 0.635 -0.367 0.031 0.175 -0.075 0.759 ap 1.000 -0.290 0.069 -0.109 0.019 0.390 size 1.000 -0.410 0.366 0.062 -0.383 cr 1.000 -0.555 -0.031 -0.017 dr 1.000 -0.096 0.237 sg 1.000 -0.141 tang 1.000 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 411 table 4. white’s general test result category p-value null hypothesis (no heteroskedasticity) all-size p(chi-square(44) > 104.373828) = 0.000001 reject large-size p(chi-square(44) > 92.304009) = 0.000028 reject medium-size p(chi-square(44) > 43.635248) = 0.487156 accept small-size p(chi-square(44) > 49.728857) = 0.255769 accept the study used three multiple linear panel regression models, namely, ols, fe and re models, and the hausman test was utilized to examine whether the fe model or the re model is suitable. the null hypothesis (random effects model is preferred) is rejected when the p-value is greater than 10%. the log-likelihood value will be also utilized to determine the best fitting models based on the applications of chen and diaz (2014). table 5 provides the summary of the main findings of the relationship (i.e., positive and negative) found in this study. 5.2 result of all-size market capitalization companies table 6 presents comparison results of the ols, fe, and re models in determining the significant factors that affect the roa of indonesian real estate companies. based on hausman test, the p-value is smaller than 5%, which indicates that the null hypothesis is rejected, and the fe model is preferred. the significant result from ols model indicates negative relationship between the number of days account receivable and profitability of indonesian real estate companies. this is in-line with the alternative hypothesis, and the previous studies of shin and soenen (1998), deloof (2003) and enqvist et al. (2014) stating that a long account receivable negatively affects liquidity because of the firm’s slow collection. hence, this study suggests that indonesian real estate companies shorten their number of days account receivable by offering early payment discounts to customers to streamline the ccc and create more liquidity. the variable number of days inventories has positive significant relationship with profitability based on the ols model, which means that higher inventories help companies generate better profit. this finding is not consistent with the previous studies of shin and soenen (1998) and enqvist et al. (2014), and also contradicts with the alternative hypothesis. however, deloof (2003) argued that larger inventories can prevent stock-outs that results to additional sales. hence, this study argues that indonesian real estate companies in general can still maintain a healthy higher level of inventories to serve higher unexpected demand, but this should be compensated by higher liquid assets like cash or near cash securities to support the maintenance of real estate properties. size has significant positive relationship with profitability as per the results of both the ols and the fe models, and is consistent with the alternative hypothesis of the study and supports the previous findings of deloof (2003), garcia-teruel and martinez-solano (2007), and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 412 pervan and višić (2012). these papers claimed that large companies can benefit from its size because of bigger asset base that transforms to more productivity. they also have larger network that reaches more clients, and higher market power that allows them to charge premium prices, thus higher profits. table 5. summary of the relationship between the dependent and independent variables note: * means significant results current ratio has a negative significant relationship based on the ols model alone. this is beyond the expectations of the study and inconsistent with the alternative hypotheses. however, this result finds support from the previous studies of vieira (2010), who argued that high current ratio is undesirable due to the additional cost of maintaining what’s being generated by the current asset, which lead to decreased profitability. a later study of pervan and višić (2012) supported this claim, who explained that liquidity and profitability compliment each other up to a certain level, then profitability will remain constant even when liquidity improves and exceeds a certain level. these explanations are all related with piling inventories, which is a huge part of real estate companies’ current assets, and the culprit in increasing maintenance costs. thus, this paper suggests to pull down the cost of inventories for all indonesian real estate firms by making routine demand forecast to reduce overstocks of real estate properties, but should still maintain a reasonable amount of cash to support a smooth-running of day-to-day operations. ar in ap size cr dr sg tang expectation + + + a llsiz e ols -* +* +* -* + +* fixed + +* +* -* +* -* random -* + + +* -* + + la rg esiz e ols -* +* -* +* +* -* fixed + +* +* +* +* -* +* -* random -* +* + +* + -* +* -* m ed iu m -s iz e ols + + +* fixed +* + + random + + +* sm al l-s iz e ols -* + +* -* + + fixed + -* +* + -* -* +* + random + + +* -* -* + + asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 413 table 6. multiple regression results for all indonesian real estate companies group (all sizes) ols (heteroskedasticity corrected) fe re ar −0.000 *** (0.000) −0.000 (0.449) −0.000*** (0.001) in 0.000 * (0.050) 0.000 (0.147) 0.000 (0.401) ap −0.000 (0.817) 0.000 *** (0.008) 0.000 (0.346) size 0.004 ** (0.033) 0.012 *** (0.004) 0.011 *** (0.000) cr −0.002 *** (0.000) −0.000 (0.590) −0.001 (0.173) dr −0.014 (0.396) −0.140 *** (0.000) −0.077 *** (0.0024) sg 0.004 (0.249) 0.009 ** (0.013) 0.003 (0.377) tang 0.0221136 * (0.0857) −0.062 ** (0.044) 0.004 (0.873) constant −0.056 (0.276) −0.206 * (0.066) −0.201 *** (0.005) r-squared 0.441 0.233 log-likelihood −483.817 462.284 375.919 hausman test (p-value) 44.713*** (0.000) note: *, ** and *** are significance at the 10, 5 and 1% levels, respectively; p-values are in parentheses based on the ols model, tangibility positively affects profitability for all indonesian real estate companies. tangibility has positive significant relationship with roa, which is the proxy for profitability. this means that higher tangible assets can result in higher profitability, which is not actually consistent with the initial findings of kebewar (2013), and also not in-line with the alternative hypothesis of the study. a plausible reason is that tangible asset benefits the company as collateral of bank loan which can help the company borrow funds to expand and create more profits based on hammes and chen (2004). on one hand, tangibility based on the fe model shows a negatively relationship with profitability, which means that high tangible assets lead to declining profitability. this result conforms to the alternative hypothesis of the study, and the previous paper of hammes and chen (2004). the study explained that profitability decreases when a company puts too much investment in fixed asset, because of the higher maintenance cost that reduces profitability. therefore, this study suggests that indonesian real estate companies should minimize the acquisition unproductive property, plant and equipment, because these lead to more costs instead of revenues in the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 414 future. based on the fe model, days account payable has positive significant relationship with profitability. this result does not correspond to the alternative hypothesis of the study, but is consistent with previous findings of deloof (2003). having longer periods to pay suppliers can make indonesian real estate companies more liquid, and may increase profitability. in-line with this result, the paper suggests that companies should better build good business relationships with suppliers to bargain for longer payment terms, because constantly extending days account payable may lead to bad relationships with suppliers that may negatively affect firms in the long-run. debt ratio on the other hand has significant negative relationship with profitability based on both the fe model. this again corresponds to the alternative hypothesis and previous researches of deloof (2003), kebewar (2013), and enqvist et al (2014). modigliani and miller (1963) earlier explained that the optimal debt ratio should reduce the total cost of capital to the point of maximizing profitability. this paper suggests that indonesian real estate companies should reduce the amount of debt, because of the debilitating consequence of paying interest and principal when the firm is not doing well. loans also carry conditions that limit the flexibility of real estate companies in running the firm. sales growth of all indonesian real estate companies has positive significant relationship with profitability based on the fe model. this again corresponds to the alternative hypothesis and supports the findings of garcia-teruel and martinez-solano (2007), and limbago and juniarti (2014). this paper suggests that real estate companies, can better boost sales by offering discounts and more flexible payment terms to attract more customers. in comparing the results of the ols and fe models, this research favors the results of the fe model as the better fitting model for all indonesian real estate companies group, because of the higher log-likelihood value. 5.3 result of large-size market capitalization companies table 7 illustrates the comparison of findings for the ols, fe, and re models in determining the significant variables factors that affect the profitability of large indonesian real estate companies. based on hausman test, the p-value is again smaller than 5%, which indicates that the null hypothesis is rejected, and the fe model is preferred. the significant result from ols model indicates negative relationship between number of days ar and profitability of large indonesian real estate companies. this is similar with the results with the studies of shin and soenen (1998), deloof (2003) and enqvist et al. (2014), and the findings for all indonesian real estate companies. the paper believes that flexible payments terms and discounts to customer as earlier suggested are better handled by larger firms because of larger current asset base like cash and near-cash assets like short-term marketable securities. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 415 table 7. multiple regression result for large indonesian real estate companies firm-specific variables ols (heteroskedasticity corrected) fe re ar −0.000 *** (0.002) 0.000 (0.990) −0.000 * (0.091) in 0.000 * (0.079) 0.000 ** (0.0157) 0.000 ** (0.012) ap −0.000 ** (0.013) 0.000 ** (0.027) 0.000 (0.164) size 0.006 * (0.094) 0.039 *** (0.000) 0.023 *** (0.0003) cr −0.001 (0.687) 0.012 *** (0.001) 0.003 (0.288) dr −0.030 (0.252) −0.123 *** (0.004) −0.136 *** (0.001) sg 0.015 ** (0.022) 0.033 *** (0.000) 0.029 *** (0.000) tang −0.065 ** (0.017) −0.074 ** (0.044) −0.058 * (0.081) constant −0.058 (0.516) −1.01446 *** (0.000) −0.520 *** (0.003) r-squared 0.348 0.618 log-likelihood −228.964 273.640 194.490 hausman test (p-value) 62.016*** (0.000) note: *, ** and *** are significance at the 10, 5 and 1% levels, respectively; p-values are in parentheses the number of days inventories also has positive significant relationship with profitability in both the ols and the fe models and also conforms with the previous studies of shin and soenen (1998) and enqvist et al. (2014), and the results for all real estate companies. the initial suggestion of this paper again favors large companies, because of their ability to maintain higher liquid assets that supports maintenance costs related to real estate inventories. the number of days account payable has negative relationship with roa based on the ols model, which means that the longer days of account payable, the lesser company produces profits. this corresponds to the alternative hypotheses, and also confirms the study of enqvist et al. (2014), which explained that huge cash discounts being availed by large real estate companies on the early settlement of payables can be source of financing that increases cash holdings. accordingly, this study suggests that large indonesian companies to avail of cash discount deals from suppliers, and maintain closer business relationship that may increase asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 416 positive goodwill in the future. on the other hand, based on the fe model, days account payable has positive significant relationship with profitability, which is also consistent with previous findings of deloof (2003), and similar with the findings for all real estate companies. this paper believes that large companies have better bargaining power over with suppliers over other companies because of their larger network and better reputation in the industry. size has significant positive relationship with profitability as per the results of both the ols and the fe models, supports the previous findings of deloof (2003), garcia-teruel and martinez-solano (2007), and pervan and višić (2012); and is consistent with the findings for all indonesian real estate firms. this paper favors larger firms because of their bigger business network, and higher market power that allows them to be more flexible in operating their business over its smaller competitors. sales growth for large indonesian real estate companies also has positive significant relationship with profitability for both the ols and the fe models, which is consistent to the fe model findings for all real estate company group. this again corresponds to the alternative hypothesis and supports the findings of garcia-teruel and martinez-solano (2007), and limbago and juniarti (2014). this study suggests that large companies, given their more liquid and established situation, can better boost sales by offering discounts and more flexible payment terms to attract more customers. tangibility findings of both the ols and the fe models show that the variable is negatively related to the profitability of large indonesian real estate companies, which means that high tangible assets lead to declining profitability. this conforms to the alternative hypothesis of the study, and the previous paper of hammes and chen (2004). the study explained that profitability decreases when a company puts too much investment in fixed asset, because of the higher maintenance cost that reduces profitability. therefore, this study suggests that large indonesian real estate companies should minimize the acquisition unproductive property, plant and equipment, because these lead to more costs instead of revenues in the future. the fe model alone finds current ratio to be positively related with the roa, which means that the more liquid the company is, the higher profit the company can create. this is not consistent with the ols model findings for all real estate group, but corresponds to the alternative hypothesis of the study and to the paper of enqvist et al. (2014). the research explained that the larger the ratio means the more capable the company is liquid and can cover current liabilities, which is necessary for the smoother running of daily operations without pressure from lenders. higher current assets will benefit the company in being more flexible and in getting more investments in the future, which increases the profitability. it is suggested that large indonesian real estate companies maintain a higher ratio by keeping current assets revolving, particularly account receivables and inventories and paying off liabilities, especially those with higher interest rates whenever necessary. debt ratio has a negative significant relationship with profitability based on the results of the fe model. this finding supports the alternative hypothesis and the conclusions of deloof asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 417 (2003), kebewar (2013), and enqvist et al. (2014). it is explained that high debt ratio decreases profitability, because of the high cost of capital and the restrictions being set by lending institutions with regards to the use of money. the study advises that large real estate companies can restructure their debts by replacing existing loans with lower interest rate borrowings, or find an investor and finance operations by using equity. in comparing the findings of the ols and fe models, this study prefers the results of the fe model as the better fitting model for large indonesian real estate companies group, because of the higher log-likelihood value. 5.4 result of medium-size market capitalization companies table 8 illustrates the comparison of findings for the ols, fe, and re models in determining the significant variables factors that affect the roa medium-size indonesian real estate companies. based on hausman test, the p-value is again smaller than 5%, which indicates that the null hypothesis is rejected, and the fe model is preferred. table 8. multiple regression result for medium indonesian real estate companies firm-specific variables ols fe re ar −0.000 (0.286) −0.000 (0.756) −0.000 (0.270) in −0.000 (0.219) −0.000 (0.334) −0.000 (0.1321) ap −0.000 (0.632) 0.000 * (0.059) −0.000 (0.979) size 0.000 (0.883) −0.000 (0.929) 0.000 (0.938) cr 0.000 (0.810) −0.000 (0.527) 0.000 (0.885) dr −0.000 (0.993) −0.022 (0.688) −0.001 (0.979) sg −0.003 (0.411) 0.002 (0.620) −0.003 (0.466) tang 0.097 *** (0.002) 0.019 (0.738) 0.094 *** (0.004) constant 0.024 (0.800) 0.050 (0.638) 0.030 (0.755) r-squared 0.342 0.112 log-likelihood 101.609 127.324 101.439 hausman test (p-value) 63.303*** (0.000) note: *, ** and *** are significance at the 10, 5 and 1% levels, respectively; p-values are in parentheses asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 418 based on the ols model, tangibility is the only significant variable that affects profitability for medium-scale indonesian real estate companies. tangibility has positive significant relationship with roa, which is not consistent with the findings for large indonesian real estate companies. this means that higher tangible assets can result in higher profitability, which is not actually consistent with the initial findings of kebewar (2013), and with the alternative hypothesis of this study. a plausible reason is that tangible asset benefits the company as collateral of bank loan which can help the company borrow funds to expand and create more profits based on hammes and chen (2004). thus, this study encourages medium-size companies to raise their fixed asset, such as purchasing more equipment or building for office, as a support for getting more cash in the form of bank loans. on the other hand, based on the fe model, the number of days account payable is also the only significant variable that positively affects profitability for medium-scale indonesian real estate companies. this finding is similar to the result of the fe model in the large companies group; and is consistent with the previous study of lazaridis and tryfonidis (2006), however goes against the alternative hypotheses of decreasing days in account payable. the paper similarly suggests that medium-scale indonesian real estate companies should have better business relationships with the supplier for better negotiations in having longer payment terms. in comparing the results of the ols and fe models, this paper favors the findings of the fe model as the better fitting model for medium-size indonesian real estate companies group, because of the higher log-likelihood value. 5.5 result of small-size market capitalization companies table 9 shows the comparison of findings for the ols, fe, and re models in determining the significant variables factors that affect the profitability of small indonesian real estate companies. based on hausman test, the p-value is again smaller than 5%, which indicates that the null hypothesis is rejected, and the fe model is again preferred. in ols model, the number of days account receivable variable has negative significant relationship with the profitability of small indonesian real estate companies, and this is similar with the findings for large real estate firms. this result is consistent with the alternative hypotheses, and previous studies of shin and soenen (1998), deloof (2003) and enqvist et al. (2014). these previous literature stated that long account receivable cycles, increase the ccc, which leads to decreased efficiency and profitability. hence, this study suggests that small indonesian real estate companies reduce the number of days account receivable to a reasonable minimum that won’t sacrifice customer relations. these companies should encourage customers to pay early by offering payment discounts. sending notices and invoices immediately upon the completion of construction projects also is a prerogative, because customers pay bills sooner after they have received invoices closer to the performance of services rendered. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 419 table 9. multiple regression results for small indonesian real estate companies firm-specific variables ols fe re ar -0.000 * (0.056) 0.000 (0.113) 0.000 (0.224) in 0.000 (0.717) −0.000 ** (0.029) −0.000 (0.591) ap −0.000 (0.666) 0.000** (0.017) 0.000 (0.843) size 0.012 * (0.084) 0.028 (0.170) 0.018 * (0.083) cr −0.004 (0.157) −0.005 * (0.078) −0.005 * (0.077) dr −0.102 * (0.080) −0.318 *** (0.0003) −0.197 *** (0.006) sg 0.002 (0.771) 0.023 * (0.052) 0.002 (0.744) tang 0.088 (0.123) 0.073 (0.270) 0.094 (0.122) constant −0.254 (0.170) −0.597 (0.253) −0.356 (0.177) r-squared 0.302 0.476 log-likelihood 98.664 119.843 93.830 hausman test (p-value) 26.026*** (0.001) note: *, ** and *** are significance at the 10, 5 and 1% levels, respectively; p-values are in parentheses the size variable has significant positive relationship, and is also consistent with the alternative hypotheses, with all of the previous results for large and all real estate groups, and the findings of lazaridis and tryfonidis (2006), and pervan and višić (2012). these studies stated that growing asset base of small indonesian real estate companies, will lead to higher profitability because the total asset owned can optimize operations, which increases the bottom line. the paper urges small real estate companies to purchase more equipment to accelerate company operations, or sell equipment that are no longer productive in order to save and gain more cash. debt ratio on the other hand has significant negative relationship with profitability based on both the ols and fe models, and similar with the results for large real estate companies. this again corresponds to the alternative hypotheses and previous researches of deloof (2003), kebewar (2013), and enqvist et al (2014). modigliani and miller (1963) earlier explained that the optimal debt ratio should reduce the total cost of capital to the point of maximizing profitability. this paper suggests that small real estate companies should reduce asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 420 the amount of debt. small companies planning to expand their asset base can reduce the cost of capital by raising funds through increasing sales, and efficiently use retained earning; selling stocks, or setting up investment funds to avoid acquiring more debt. this paper additionally suggests that small real estate companies should restructure their trade credits and loans, by bargaining for longer payment terms with suppliers, and replace existing loans with the loans that has lower interest rate, respectively. the number of days inventories has negative significant relationship with profitability based on the fe model alone. the finding is consistent with the alternative hypothesis and previous studies of shin and soenen (1998), deloof (2003), and enqvist et al. (2014). these studies stated that excess inventories indicate decrease profitability, and a sign of efficiency. this paper suggests that small indonesian real estate companies to shorten the period of keeping inventories. these companies should study the average inventory conversion period to predict better time in selling up inventories with respect to seasonal demands, or to improve commission rates and benefits for their real estate brokers. moreover, the number of days accounts payable has a positive significant relationship with profitability, and similar with the results for all and large real estate companies groups. this is also consistent with the previous study of lazaridis and tryfonidis (2006), however goes against the alternative hypotheses of decreasing days in account payable. this finding agrees with the explanation of enqvist et al. (2014) that by extending period of time in settling payables to suppliers, the company can increase its liquidity that may be channeled to more profitable ventures. the paper suggests that small indonesian real estate companies should have better understanding of the supplier’s business to enable bargaining for longer payment terms without hurting the relationship and transactions. the fe model shows that current ratio has a negative relationship with profitability, which is similar with the ols findings for the all companies group. this is again beyond the expectations of the study and inconsistent with the alternative hypothesis. however, this result finds support from the previous studies of vieira (2010), and pervan and višić (2012) explaining that this can be related with piling inventories, and the reason for increasing maintenance costs especially for small scale realtors. hence, this paper suggests that small indonesian real estate companies make better and more efficient demand forecast to reduce overstocks of real estate inventories. sales growth has positive significant relationship with profitability based on the fe model, and similar with the results for large real estate group. this finding also corresponds to the alternative hypothesis and supports the findings of garcia-teruel and martinez-solano (2007), and limbago and juniarti (2014). the literature explains that higher sales are expected to generate higher profit. the study suggests that small real estate companies should be more aggressive in tapping new markets and in increasing the sales through innovative marketing strategy, such as special offers and discounts. in comparing the findings of the ols and fe models, this study prefers the results of the fe model as the better fitting model for small indonesian real estate companies group, because of the higher log-likelihood value. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 421 6. conclusions and limitations the paper determines the effects of eight firm-specific factors on the profitability of large-, medium-, and small-scale real estate indonesian companies. the study used forty-seven real estate companies listed in the indonesian stock exchange, using three multiple linear panel regression models (i.e, ols, fe and re models) in examining the effect on the roa. this study found that the number of days account receivable has negative relationship to profitability; and it is advised that real estate companies shorten their number of days account receivable by encouraging customers to pay early through payment discounts. the number of days inventories has positive relationship, and it is suggested that real estate companies can have a healthier level of inventories to prevent stock-out, especially for large companies that are more capable of covering maintenance costs. on the contrary, small indonesian real estate companies are suggested to shorten the period of keeping inventories by calculating the average inventory conversion period to forecast the most suitable time in selling up inventories with respect to seasonal demands. indonesian real estate companies are recommended to have a better understanding of the supplier’s business cycle to have better negotiations for longer payment terms, because the number of days account payable has positive relationship to profitability. size and sales growth have consistent positive relationship to profitability, which means that larger asset base is beneficial because it can optimize operations, and benefits from having larger network and higher market power. in line with this, this paper earlier suggested that indonesian real estate companies should efficiently acquire for more productive equipment or sell equipment that is no longer productive. this is consistent to the tangibility factor having a negative relationship to profitability. minimizing the procurement of unproductive property, plant and equipment leads to lower costs and savings in the future. however, for medium-size indonesian real estate companies, it suggested to raise their fixed assets that are valuable as loan collateral, because the results show tangibility having a positive relationship with profitability. current ratio having a negative relationship with profitability for all and small real estate companies groups is beyond the expectations of this research. however, this study posits that this relationship is inventory-based, and it is advised that indonesian real estate companies should to pull down the cost of inventories by making routine demand forecasting to reduce overstock or backorders, but should still maintain a reasonable amount of cash to support a smooth-running of day-to-day operations. however, a positive relationship prevailed for large companies, and the paper suggested to maintain a higher ratio by keeping current assets revolving, particularly ars and inventories and paying off liabilities, especially those with higher interest rates whenever necessary. in line with this, the paper also recommended that indonesian real estate companies maintain lower amount of debt, because debt ratio has negative relationship to profitability. this suggestion also increases the flexibility of real estate companies in running the firm. the above findings provide a considerable perspective in examining internal factors that affect profitability of indonesian real estate companies, even though some results are quite asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 422 limiting like having only two variables significant for the medium-size real estate firms. further studies are suggested to examine similar variables using other quantitative methods (e.g., grey relational analysis) to determine factors based on company size. qualitative type of research can also be considered for future studies to personally better know how managers observe and control particular variables (e.g., number of days account payable and tangibility) in increasing profit and adding value of the firm. another limitation of this study is that it did not consider external or macroeconomic factors (i.e., economic status, interest rates, government regulations and stock market conditions) that are also important in determining profitability of companies. future studies can further consider these factors, and can also extend the data to cover private companies, because the study is only limited to publicly-listed companies. future research can also extend the data to cover other publicly-listed companies (e.g., banking, mining and transportation companies), and even compare these data with other developing countries’ findings. references aissa, s. b., & goaied, m. 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(2010). an investigation of the influence of key financial and economic indicators on profitability of cement sector companies in pakistan. in finance and corporate governance conference. https://doi.org/10.2139/ssrn.1534186 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 426 appendix a. list of large real estate companies selected in million usd (2014/31/12) no company name code total asset market cap listed date 1 surya semesta internusa ssia 479.37 402.70 1997 mar 27 2 ciputra property ctrp 708.79 415.67 2007 nov 07 3 ciputra surya ctrs 489.62 468.52 1999 jan 15 4 kawasan industri jababeka kija 680.31 477.48 1995 jan 10 5 adhi karya adhi 836.58 501.41 2004 mar 18 6 modernland realty mdln 835.62 521.29 1993 jan 18 7 danayasa arthatama scbd 0.45 531.45 2002 apr 19 8 intiland development dild 720.28 538.94 1991 sep 04 9 agung podomoro land apln 1.89 549.34 2010 nov 11 10 bekasi fajar industrial estate best 292.19 563.20 2012 apr 10 11 lippo cikarang lpck 344.73 578.98 1997 jul 24 12 mnc land kpig 797.04 667.71 2000 mar 30 13 duta pertiwi duti 641.84 722.12 1994 nov 02 14 alam sutera realty asri 1.35 880.15 2007 dec 18 15 plaza indonesia realty plin 0.36 1064.83 1992 jun 15 16 jaya real property jrpt 0.53 1143.82 1994 jun 29 17 metropolitan kentjana mkpi 345.24 1160.40 2009 jul 10 18 pembangunan perumahan ptpp 1,168.76 1384.72 2010 feb 09 19 ciputra development ctra 1,862.38 1516.34 2994 mar 28 20 summarecon agung smra 1.23 1754.02 1990 may 07 21 wijaya karya wika 1.27 1810.04 2007 oct 29 22 lippo karawaci lpkr 3,020.41 1882.84 1996 jun 28 23 pakuwon jati pwon 1.34 1983.86 1989 oct 19 24 bumi serpong damai bsde 2,250.42 2652.47 2008 jun 06 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 427 appendix table b. list of medium real estate companies selected in million usd (2014/31/12) no company name code total asset market cap listed date 1. bumi citra permai bcip 47.22 88.07 2009 dec 11 2. fortune mate indonesia fmii 36.75 97.72 2000 jun 30 3. perdana gapuraprima gpra 121.39 102.28 2007 oct 10 4. roda vivatex rdtx 131.45 112.88 1990 may 14 5. duta anggada realty dart 0.41 170.86 1990 may 08 6. bakrieland development elty 1,160.30 174.06 1995 oct 30 7. cowell development cowl 294.54 243.52 2007 dec 19 8. sentul city bksl 783.56 261.18 1997 jul 28 9. metropolitan land mtla 0.26 269.78 2011 jun 20 10 eureka prima jakarta lcgp 138.85 270.20 2007 jul 13 11 total bangun persada totl 0.20 305.49 2006 jul 15 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 428 appendix table c. list of small real estate companies selected in million usd (2014/31/12) no company name code total asset market cap listed date 1. ristia bintang mahkotasejati rbms 0.01 2.30 1997 dec 19 2. bekasi asri pemula bapa 14.09 2.65 2008 jan 14 3. pudjiadi prestige pudp 32.14 11.63 1994 nov 18 4. metro realty mtsm 7.38 12.85 1992 jan 08 5. bhuwanatala indah permai bipp 49.10 23.04 1995 oct 23 6. lamicitra nusantara lami 0.05 25.54 2001 jul 18 7. megapolitan developments emde 94.31 36.71 2011 jan 12 8. suryamas dutamakmur smdm 0.25 47.33 1995 oct 12 9. indonesia prima property omre 65.22 47.46 1994 aug 22 10 gowa makassar tourism development gmtd 121.93 49.54 2000 dec 11 11 bukit darmo property bkdp 66.32 57.34 2007 jun 15 12 nusa konstruksi enjiniring dgik 163.60 79.34 2007 dec 19 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 12768-46665-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 131 earnings smoothing as information signaling or garbling: a review of literature nor afifah shabani (corresponding author) department of accounting and finance, faculty of management universiti teknologi malaysia, 81110 johor, malaysia e-mail: norafifah85@gmail.com saudah sofian department of accounting and finance, faculty of management universiti teknologi malaysia, 81110 johor, malaysia e-mail: saudah@utm.my received: march 6, 2018 accepted: march 27, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12768 url: https://doi.org/10.5296/ajfa.v10i1.12768 abstract earnings smoothing, which refers to the action of managers managing earnings to reduce fluctuations of reported earnings, is a special type of earnings management because while earnings smoothing may be used to distort shareholders and creditors’ view of corporate actual performance, it may also serve as a tool to communicate corporate private information of future earnings to the aforementioned stakeholders. hence, it comes to no surprise when prior literatures reveal that the studies on the role of earnings smoothing are divided into two streams: as information signaling and information garbling. this paper aims to review prior literatures, specifically on the role of earnings smoothing either as information signaling or garbling based on four themes: firm value, financing need, compensation contract and outsiders’ intervention. this paper reviews journal articles gathered from web of science database. based on the shortcomings of prior literatures, this paper highlights avenue for future research. keywords: earnings smoothing, information garbling, information signaling, firm value, financing need, compensation contract, outsiders’ intervention asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 132 1. introduction earnings smoothing, which refers to the action of managers managing earnings to reduce fluctuations of reported earnings, is a special type of earnings management because while earnings smoothing may be used to distort shareholders and creditors’ view of corporate actual performance, it may also serve as a tool to communicate corporate private information of future earnings to the aforementioned stakeholders (dechow et al., 2010; goel & thakor, 2003). although most studies generally use earnings smoothing as a proxy for earnings management (bhattacharya et al., 2003; burgstahler et al., 2006; leuz et al., 2003), some studies find that earnings smoothing in fact is associated with improved earnings quality (ewert & wagenhofer, 2015; shubita, 2015; subramanyam, 1996; tucker & zarowin, 2006). hence, it comes to no surprise when prior literatures reveal that the studies on the role of earnings smoothing are divided into two streams: as information signaling and information garbling. the role of earnings smoothing as information signaling is usually associated with managers’ motivation to improve firm value (di & marciukaityte, 2015; graham et al., 2005; shuto & iwasaki, 2014), and to achieve lower cost of debt from creditors (dou et al., 2013; gassen & fülbier, 2015; li & richie, 2016). based on the view of earnings smoothing as information signaling, managers who have private information about firm’s future earnings and yet are not allowed to directly disclose the information to outsiders (shareholders, creditors and other stakeholders), may convey the private information through bias reported earnings, to maximize firm’s value (sankar & subramanyam, 2001). in addition, using managers’ discretion, as allowed by the generally accepted accounting principle (gaap), managers would choose to present a smoother earnings stream to signal the stability of the firm’s underlying earnings process. in turn, the firm’s cost of borrowing is reduced as creditors lower their assessment of the probability of firm’s bankruptcy, and hence increases firm’s value (trueman & titman, 1988). on the other hand, earnings smoothing is viewed as information garbling when earnings smoothing distorts information and consequently leads to higher information opacity. bhattacharya et al. (2003) argue that earnings smoothing resulted in reported earnings not depicting the true underlying economic performance of the firm, and hence reducing the informativeness of reported earnings and increasing information opacity. earnings smoothing as information garbling is usually associated with managers’ concerned on compensation contract (das et al., 2013; defond & park, 1997; grant et al., 2009) as well as to avoid outsiders’ intervention in management (acharya & lambrecht, 2015; khurana et al., 2017). managers boost earnings during bad times, to lengthen their job tenure, or to reduce earnings during good times, to save for future bad times (fudenberg & tirole, 1995; lambert, 1984). further, asymmetric information theory argues that investor’s estimate is unbiased and ‘best’ based on the information they have. therefore, it is considered rational for shareholders to require earnings outcome that is consistent with their expectation (acharya & lambrecht, 2015; kirschenheiter & melumad, 2002). accordingly, managers have to report an earnings figure that corresponds to outside shareholders’ expectation rather than true income, to avoid asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 133 outsiders’ intervention. specifically, during bad times, managers use smoothing to conceal unfavourable earnings realizations and create reserves for future periods by understating earnings during good times (acharya & lambrecht, 2015; khurana et al., 2017). generally, investors give managers the benefit of the doubt and perceive low risk when earnings are relatively smooth. however, when additional information suggests that managers have incentives to garble information, they no longer give managers the benefit of the doubt (erickson et al., 2017). studies related to earnings smoothing have been around for more than six decades. however, the recent decades show the most development with more than 80 percent of studies in this field was published after year 2000. following hepworth's (1953) note that firms with smooth earnings signal stable corporate management to the shareholders and creditors, the study on corporate earnings smoothing has evolved ever since. until recently, scholars have been trying to prove the existence of earnings smoothing activities (beidleman, 1973; boterenbrood, 2014; khalil & simon, 2014), figuring how (atik, 2009; francis et al., 2016) and when (gassen et al., 2006; gill de albornoz & alcarria, 2003) managers smooth earnings, characterizing earnings smoothing firms (bigus et al., 2016; bouwman, 2014; z. huang & xue, 2016; safdar & yan, 2016; silhan, 2014), and most importantly understanding the motivation (goel & thakor, 2003; lambert, 1984; trueman & titman, 1988) and consequences (houcine, 2017; shubita, 2015; tucker & zarowin, 2006) of such behavior. this paper aims to review prior literatures, specifically on the role of earnings smoothing. based on the discussion of the past literature, this paper also makes some suggestions for future research. to achieve these objectives, this paper reviews journal articles published in web of science database. a broad search was initiated based on the keywords used for the title. the literature of earnings smoothing is divided into 2 categories: (1) banks and (2) other business sectors. since the regulations between banks and other sectors are governed by different policies (banks are governed by bafia act while other firms are governed by companies act), the financial reporting practices between these firms are significantly different. hence, this paper chooses to focus only on smoothing behavior in the latter category. in addition, the paper also does not review papers on dividend smoothing. 2. accruals and real smoothing smoothing can occur through accounting accrual (also known as artificial) and real smoothing activities. accrual smoothing, which refers to the accounting choices that usually occur at the end of the fiscal year, change reported earnings without changing the underlying cash flows. examples of accrual smoothing include adjusting reserves for losses, delaying or forwarding the recognition of revenue and expenses, and reclassifying the expense items into capital accounts. meanwhile, real smoothing activities usually occur throughout the fiscal year, by which managers change its operation. examples of real smoothing activities include altering shipment schedule, offering end-of-period sales, and speeding up or deferring maintenance (fudenberg & tirole, 1995; lambert, 1984). generally, managers utilize income-increasing smoothing to boost revenue when expected earnings fall short the desired threshold, and income-decreasing smoothing when expected earnings is greater than the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 134 desired threshold (sankar & subramanyam, 2001). overall, most studies which examine earnings smoothing as information signaling or garbling, measure earnings smoothing using accrual smoothing instead of real smoothing. only very few studies measure earnings smoothing using real smoothing, such as dhole et al. (2016), francis et al. (2016), huang et al. (2009) and khurana et al. (2017). therefore, this section is contributed to the studies that examine real smoothing activities while the rest of the paper i.e. from section 2.1 until 2.4 discuss the roles of both real and accrual smoothing activities. except for studies mentioned in this section, all studies mentioned from section 2.1 until 2.4 use accruals as their earnings smoothing measurement. based on the view that earnings smoothing is used to garble information by managers, khurana et al. (2017) find positive association between real earnings smoothing and firm-specific stock price crash risk. real earnings smoothing allows managers to conceal firm’s actual performance. therefore, when the accumulated bad news bubble burst, stock price crash as a result of investors’ negative reaction. francis et al. (2016) also find that firms engage in downward real earnings management to garble information. managers manage earnings downward immediately before share repurchases, management buyouts and ceo option awards to lower the stock prices, for their private benefits. in similar vein, dhole et al. (2016) find that ceo incentives to smooth earnings (due to garbling role) through both artifical and real earnings management is mitigated via ceo inside debt (debt-like component of executive compensation such as deferred compensation and pensions). however, using derivatives as the measure of real earnings smoothing, huang et al. (2009) find that real earnings smoothing is less pronounced in firms with weak governance, showing that real earnings smoothing does not serve as information garbling. instead, they find evidence that derivaties (real earnings smoothing proxy), serves as information signaling and add greater value to firms with weak investor protection. they argue that derivatives have been used to eliminate extraneous shocks and hence improve the informativeness of management ability and project quality. based on the discussion above, prior studies provide evidences on the existence of real earnings smoothing activities. the lack of empirical evidence on the role of real earnings smoothing, either as information signaling or garbling, summons for more research in this area. the role of accrual earnings smoothing is discussed in the following sections, as categorised into four factors: firm value, financing need, compensation contract and outsiders’ intervention. 2.1 earnings smoothing and firm value earnings smoothing is related to the increased in firm value via meeting earnings prediction (goel & thakor, 2003; graham et al., 2005; kirschenheiter & melumad, 2002), and reducing investors and creditors’ perception of firm’s bankruptcy probability (trueman & titman, 1988). under information signaling view, managers are expected to smooth earnings and report earnings that are close to investors’ expectation or target. smaller earnings surprise signals asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 135 higher earnings quality of previously reported earnings (dejong et al., 2014; kirschenheiter & melumad, 2002), while managers inability to meet investors’ expectation is perceived as a signal of hidden problems at the firm, for which the firm would be severely punished (graham et al., 2005). accordingly, graham et al. (2005) find that managers are willing to sacrifice long-term value to meet earnings expectations. in addition, investors abhor earnings volatility and pay less for firms with higher earnings volatility because it is associated with greater expected losses (goel & thakor, 2003). hence, they contend that investors want managers to smooth earnings as much as possible, so that future earnings are more predictible. consistent with this argument, di and marciukaityte (2015) find that repurchasing firms use earnings smoothing to increase the predictability of reported earnings. further, trueman and titman (1988) argue that earnings smoothing may be able to reduce investors and creditors’ expectation of firm’s bankruptcy probability; hence they are willing to do transaction at lower costs. this would result in the increase of firm’s value. in relation to this argument, empirical researches provide mix evidences where lev and kunitzky (1974) find evidence of earnings smoothing reducing firm’s common stock risk while mcinnis (2010) find no evidence on the relation between earnings smoothness and average stock returns – shareholders of firms with volatile earnings are not compensated with higher returns. based on the literature discussed above, abundant theoretical and empirical researches have been trying to explain the role of earnings smoothing as information signaling, based on managers’ incentives to maximize firm value. future research may want to look into the effect of earnings smoothing on firm value in the long-term basis. 2.2 earnings smoothing and financing need the roles of financial reporting in debt contracting arise from two situations: (1) during the credit-granting decision stage and (2) during subsequent ongoing monitoring by creditors. during the credit-granting decision stage, lenders demand high quality financial reporting from firms to reduce their information risk in forecasting future cash flows. in addition, creditors also demand high-quality financing reporting to increase debt-contracting efficiency during subsequent ongoing monitoring. based on these two situations, the role of earnings smoothing as information signaling is stronger during credit-granting stage because firms need to signal credible financial information to lower their cost of debt. consistent with this argument, amiram and owens (2017), gassen and fülbier (2015), and li and richie (2016) find that earnings smoothing is associated with lower cost of debt; creditors perceive smooth earnings as a signal of business stability and lower loan default risk. in addition, jung et al. (2013) find that credit rating agencies also perceive earnings smoothing as a signal of business stability; managers reduce earnings volatility in order to improve or maintain credit ratings. on the other hand, during ongoing monitoring of covenant compliance by creditors, the role of earnings smoothing as information garbling is stronger because firms may engage in earnings management to avoid breaching debt covenants. in support to this argument, gassen asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 136 and fülbier (2015) find that firms with more credit report smoother earnings stream, to avoid debt-renegotiation and bankruptcy costs. nonetheless, the need to use earnings smoothing as information signaling is the strongest in the situation where information asymmetry between firm and creditors are very high, for example, in the countries with weak creditors’ protection or specific industries where high information asymmetry exist. in these situations, earnings smoothing serves as information signaling, to mitigate agency problem of debt (bigus & häfele, 2016; dou et al., 2013). garcía-teruel et al. (2014) find that smes (smes are characterized with high information asymmetry) with smoother earnings have more access to trade credit from suppliers. while the researches on the role of earnings smoothing as information signaling, during credit-granting decision stage, are plenty, researches on its role as information garbling, during subsequent ongoing monitoring, is still lacking. therefore, more researches in this area are warranted. in addition, future researches may be directed towards understanding the role of earnings smoothing in the situation where firms are in great need of finance, for example financially distressed firms. 2.3 earnings smoothing and compensation contract in line with information garbling theory, studies in executive compensation generally view earnings smoothing as an outcome of managers’ opportunistic behavior; to maximize their current and future compensation, as well as to secure their job contracts (fudenberg & tirole, 1995). managers underreport earnings when realized earnings are sufficiently high, or when their bonus reaches the bonus cap, and the over-report earnings when realized earnings fall between a lower and upper bound of bonus (defond & park, 1997; grant et al., 2009; healy, 1985; spagnolo, 2005). however, when the realized earnings is really bad, they would engage in ‘big bath’ – managers underreport earnings by the maximum amount possible, in order to report higher and smoother earnings in the future (kirschenheiter & melumad, 2002). hence, to mitigate managers incentives of using earnings smoothing as information garbling, manager inside debt may be used as a new compensation strategy (dhole et al., 2016). inside debt refers to use of debt as a portion of managers compensation, using defined benefit pensions and other deferred compensation, with the premise that managers’ compensation is paid at or after retirement, as long as the firm in solvent. in the case of firm insolvency, managers would lose all these benefits. apart from managerial opportunism behavior, das et al. (2013) find that earnings smoothing is partly induced by compensation contracts that reward managers for smoother earnings. they find that smooth earnings are used as a performance metric for manager compensation. this relatively new findings summons for more researches to disentangle the role of earnings smoothing in compensation contract, whether they solely serve as information garbling for private benefits of managers, or they are actually part of managers duty, in which shareholders want managers to smooth earnings and that managers are being compensated for doing so. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 137 2.4 earnings smoothing and outsiders’ intervention the theory of earnings smoothing as information garbling to avoid outsiders’ intervention is a newly emerged theory, proposed by acharya & lambrecht (2015). based on asymmetric information theory, investor’s estimate is unbiased and ‘best’ based on the information they have. therefore, it is considered rational for shareholders to require earnings outcome that is consistent with their expectation. outsiders may take collective action against insiders if they do not receive a fair payout that meets their expectations. hence, managers need to report earnings that are close to shareholders’ expectation, to keep them at bay. in addition, since earnings smoothing held investors from intervening with management, managers are able to keep unprofitable projects, continue with ineffective risk management practice and withhold bad news. in line with this argument, chen et al. (2017), khurana et al. (2017) and yu et al. (2017) find that managers use earnings smoothing as a mean to hide or withhold bad news from shareholders. as a consequence, firms are exposed to a greater stock price crash risk, especially when the accumulated bad news burst. these contemporary findings open up more opportunities for future research, for example, using other measures of firms’ risk to examine the effect of earnings smoothing or, examining the effect of earnings smoothing in relation to industry-specific risks. 3. conclusion this paper reviews the literature on the role of earnings smoothing, either as information garbling or information signaling. based on the literature discussed above, the role of earnings smoothing depends on how managers intend to use it, either to maximize firm value, avoiding outsiders’ intervention, for personal gain or to get better debt covenant terms from creditors. while there are relatively plenty of researches have been examining the role of earnings smoothing, more researches are needed as highlighted below: • while the role of earnings smoothing either as information signaling or garbling can generally be attributed into four factors (signaling: firm value and financing need; garbling: compensation contract and avoiding outsiders’ intervention), the mixed evidences as found in the literature shows that more research is needed to better understand the role of earnings smoothing for each factor • the role of earnings smoothing may not be attributed by a single factor. rather, managers’ decision to signal or garble information via earnings smoothing may be dependent on various factors at a time. hence, future research may want to look at which factor dominates when multiple factors arise • prior researches rely solely on archival data in arriving at their findings. future research should integrate analysis from both secondary and primary data source to get a more comprehensive picture of the role of earnings smoothing • majority of research on earnings smoothing are conducted in the us and european countries. due to the different economic conditions, listing requirements, and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 138 government policies, more research should be conducted in countries with emerging economies references acharya, v., & lambrecht, b. m. 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(2017). income smoothing may result in increased perceived riskiness: evidence from bid-ask spreads around loss announcements. journal of corporate finance. https://doi.org/10.1016/j.jcorpfin.2017.11.007 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 8537-31000-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 281 does ownership structure affect jordanian companies’ tendency to practice earnings management? imad zeyad ramadan (corresponding author) full prof., department of finance, applied science university p.o. box 166, amman, jordan e-mail: i_ramadan@asu.edu.jo received: august 8, 2015 accepted: dec. 7, 2015 published: december 7, 2015 doi:10.5296/ajfa.v7i2.8537 url: http://dx.doi.org/10.5296/ajfa.v7i2.8537 abstract the aim of this paper is to examine the effect of ownership structure on a firm’s ability to practice earnings management. to achieve this goal all 77th jordanian industrial companies listed at amman stock exchange (ase) for the period 2000-2014 were selected resulting in 1089 firm-year observations. the empirical results suggest that the earnings management practices of jordanian industrial companies listed at ase are influenced by the ownership structure. precisely, the result shows that equity concentration, management ownership and institutional investor equity are associated inversely with the practices of earnings management. our results are consistent with the alignment of interest hypothesis and the efficient monitoring hypothesis which suggest that large shareholders have less motivation to manipulate earnings, and can reduce the scope of managerial opportunism. keywords: ownership structure; earnings management; jordan asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 282 1. introduction most of the firm managers seek their own benefits on the expense of the shareholders. this is known as the agency problem. in the agency problem the managers interfere and manipulate the financial statements to appear them in a way that serve their own benefits even though these statements do not coincide with the real situation. the management interference in financial disclosure process may affect the figures in the financial statements. this matter may affect the quality of the content for these statements which may negatively affect the financial decisions taken by the users of these financial statements. according to black et al. (2000), in many situations, the overdoing and misusing of the earnings management led to the collapse of many companies as a result of the low quality of the accounting information contained in the disclosed financial statements which decreased the investor’s trust in data. this decrease in the trust had negative reflections on the capital markets around the globe as well as in the arab world. many studies like lev (1988)and shiller and pound (1989) show that the practice of earnings management will be much harder when there is equity concentration and high percentage of institutional investor’s equity because the institutional investors have larger amount of information than the individual investors and also they have more financial capabilities and motivations to control the management. greavs and waddock (1990), jacobs (1991), and potter (1992) concluded that the institutional investors practice pressure on the managers to focus on short term profits on the expense of long term profits when the evaluation of their companies depends on short term performance of their portfolios. lang and mc-nichols (1998) concluded that the trading volume from the institutional investors depends on short term profit which motivates the managers to practice earnings management in order to achieve short term profits as a result of the institutional investors' pressure. the institutional investors play a major role in the capital markets due to their financial capabilities, investments experience, and their management skills compared to the individual investors. according to that, the essence of the problem statement of this study lies in the lack of evidence about the impact of the ownership structure on the ability of the companies to practice earnings management. thus, this study seeks to answer the following question: is there any significant effect of the ownership structure, expressed as the percentage of institutional investor’s equity, on the capability of the jordanian industrial companies to exercise earnings management? this study aims to investigate the effect of ownership structure on the ability of the managers to practice earnings management in the jordanian industrial companies. thus, this study seeks to test the hypothesis that the ability of the jordanian industrial companies to practice earnings management is affected significantly by the ownership structure. 2. literature review the number of studies that handled the effect of corporate governance on the earnings management (em) is relatively small in literature. beeker et al. (1998), francis et al. (1999), and chung et. al. (2002) are considered among the few researchers that have asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 283 conducted pieces of research in this area. those researchers studied the relation between the quality of auditing and accruals management and they concluded that the auditing by the six big auditors reduces the level by which the managers practice earnings management through manipulating discretionary accruals. in addition, the study of francis et al. (1999) concluded that the auditing of the six big auditors reduces the ability of the managers to manipulate the accounting accruals. moreover, chung et al. (2002) concluded that the increase in the percentage of the institutional investor’s equity reduces the ability of the management to practice earnings management to smooth the income in order to reach the target profit. klein (2002) suggested that the change in the independent status of the auditing committee coincides with the change in the ability of the managers to practice the earnings management. furthermore, he concluded that an independent auditing committee is more efficient in controlling the disclosure of the financial data because the companies with high number of independent auditors have lower volume of extra ordinary accruals. sanjar s. et al. (2012), investigated the effect of ownership structure on earnings management for tehran stock exchange. the researchers divided the firms into two groups according to the type of investors; group 1 included the institutional investors whereas group 2 involved the individual investors. the results show that the firms which have low profits before accruals practice earnings management are more than those firms with high profits before accruals. also the study suggested that firms with high percentage of institutional investors are involved heavily in practicing earnings management. frooq o. and el jai h., (2012) studied the effect of ownership structure on earnings management in morocco. the results have showed that the institutional investors play a major role in reducing the earnings management practices because those investors have greater resources to monitor managers within the firms than individual investors. also their study suggested that the ownership concentration has no significant effect on earnings management. this result seems to contradict with other studies. rajgopal, s., (1999) investigated the difference between two contradicting views about institutional owners. on one hand, the institutional owners can be fooled by earnings management practiced by the managers in generating short term profits to satisfy institutional owner’s interest. on the other hand, institutional owners are sophisticated investors so they cannot be fooled by earnings management practices. the results supported the view that the institutional owners are sophisticated investors and thus suggested an inverse relation between the institutional owners and earnings management practices. 3. methodology 3.1 data this study used econometric analysis utilizing unbalanced panel data regression of all 77th jordanian industrial companies listed at amman stock exchange for the period 2000-2014 resulting in 1089 firm-year observations. the needed data were derived from the ase. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 284 3.2 study variables 3.2.1 dependent variable: earnings management the dependent variable in the study is the earnings management expressed as the discretionary accruals. the discretionary accruals can be calculated as the difference between the total accruals and the non-discretionary accruals. jones (1991) calculated the total accruals as the difference between the annual sales change and the change in the accounts receivables to which the gross property is added based on equation (1): = α + β (∆s − ∆ar ) + β ppe + ε (1) where is total accruals for company i within the period t, is the linear regression line constant, are the coefficients of the linear regression line, is the annual change, s is the annual sales, ar is the accounts receivable, ppe is the gross property that includes property, plants, and equipment's, and is the random error. to reduce the effect of the potential heteroscedasticity problem the equation was divide by the previous year total assets of the company. therefore equation (1) can be rewritten as: where is the total asset for company i at time t-1. to calculate the discretionary accruals equation (2) will be applied for each company of the study sample independently, and then the coefficient of the linear regression estimated by equation (2) is used to estimate the non-discretionary accruals independently for each company. the discretionary accruals will be calculated by subtracting the estimated non-discretionary accruals from the total accruals. this value can be seen as the residuals of equation (2) and thus can be mathematically calculated by equation (3) as follows: where; the discretionary accruals, proxy of the earnings management, for company i at time t, are the estimations for the linear regression model. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 285 3.2.2 explanatory variables (ownership structure) • equity concentration (ec): is defined as the concentration of the company’s shares and will be expressed as the percentage of the major investors of the company (those who own more than 5% of the company’s shares). zeskhauser and pound (1990) investigated the impact of the major investors on the financing decision of the company. they have concluded that there is no significant effect of the major investors on the capital structure of the company and that there is a significant role for the major investors in the monitoring the management for the benefit of the other investors which can reduce the ability of the management to practice earnings management. large shareholders have more prominent motivators to monitor management, on the grounds that the expenses connected with monitor management are less than the expected benefits due to their great equity assets in the firm. ramsey and blair (1993) propose that increased equity concentration delivers large shareholders with necessary incentives to screen managers. • management ownership (mo): can be defined as the percentage of shares owned by the management. previous studies have shown a significant relation between the management ownership and earnings management. warfield et al. (1995) have concluded that there is an inverse relation between the management ownership and earnings management because as the management ownership percentage increases the management interest and the individual investors' interest become more and more coincide. this will lead the management to depend more on long term investments and to thus reduce the need for earnings management practices. • institutional investor equity (iie): institutional investors play a significant role in reducing the agency cost as they monitor the performance of the management to make sure that their interests are maintained when the decisions are taken. various studies (jensen (1986), shleifer and vishny (1997), and pound (1988)) concluded that the institutional investors played a major role in monitoring the performance of the managers. shome and singh (1995) have concluded that the institutional investors are forced to play a major role in monitoring the performance of the managers due to the responsibility that the institutional investors feel toward the individual investors and also to protect their own investments. 3.2.3 control variables depending on previous studies three control variables that have impact on the ability of practicing earning management will be used in this study. those variables are: 1. firm’s size (siz): the firm’s size will be defined as the logarithm for the total assets. kim et al., (2003) have concluded that firm’s size effect on practicing earnings management differs among the companies. while the small firms are more attracted to practice earnings management to avoid losses disclosure, the large companies are more aggressive in practicing earnings management to maintain constant level of profit or to avoid losses disclosure. 2. the financial leverage (lev): the financial leverage will be expressed as the debt ratio that can be calculated as the ratio of the total liabilities to the total assets. the debt ratio measures the ability of the firm to fulfill its financial obligations toward others. as the debt asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 286 percentage increases the ability of the firm to fulfill its financial obligations decreases. defond and jiambalvo (1994) have concluded that as the firm reaches the situation where it cannot fulfill its financial obligations, the earnings management practices increase to enhance the image of the company. duke and hunt (1990) have concluded that there is a direct and significant relation between the debt ratio and earnings management practicing. 3. profitability: it can be expressed as the returns on assets (roa), which can be calculated as the ratio of the net profit before interest, tax, and extra ordinaries to the total assets. mcnichols (2000) concluded that including profitability variable in the multi regression models that determine the determinants of the earnings management will enhance the explanation power of the model. 3.3 the model based on the foregoing, the ability of the company to practice earnings management can be seen as a function in its equity concentration, management ownership's percentage, firm’s size, profitability, and institutional investor equity as follows: where the discretionary accruals, proxy of the earnings management, for cross-sectional firm on the time period, with i = 1,2,3,…,77, t = 1,2,3,…,15, α is constant, are unknown parameters to be estimated, is the equity concentration, is the institutional investors; is the managerial ownership; is the firm’s sizes; is the leverage ratio, is the profitability measure, and ε is the error. 4. results table 1 shows the results of the unbalanced panel data regression analysis models we used to achieve our objective. as expected, the results appear in table 1 that equity concentration (ec) does have an inverse statistically significant impact on the earnings management at a statistically significant level less than 0.1 (coeff.= -0.093, p-value = 0.098). asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 287 table 1. results of the unbalanced panel data regression analysis variables coeff. t-value sig constant 1.274 1.045 0.336 ec -0.093 -1.957* 0.098 mo -0.117 -2.043* 0.087 iie -0.193 -4.014*** 0.007 siz -0.082 -2.508** 0.046 lev -0.201 1.907 0.105 roa 0.231 -3.796*** 0.009 df regression 6 residual 1083 total 1088 r-square 31.032 adjusted r2 30.64 f-value 81.140 p-value 0.000 n. 1089 where; ***,** and* indicate significant at 1%, 5% and 10% respectively; ec is the equity concentration; iie is the institutional investor equity; mo is the management ownership; siz is the firm’s size; lev is the firm's financial leverage; roa is the firm's profitability; t test critical value for 1%, 5%, and 10% are 3.7074, 2.4469, and 1.943 respectively. this result is consistent with the view that the large shareholders have the ability and the desire to monitor managers to protect their investments, managers at publicly traded firms lose their control to large shareholders and equity concentration should cut management’s ability to modify accounting earnings and rise the reliability earnings. the result of this study supports the results of (klein 2002; kao and chen 2004; davidson et al. 2005 and jaggi et al. 2007). the results also show that there is an adversely impact at a statistical significance level less than 0.1 for the management ownership (mo) on the earnings management practices (coeff.= -0.117, p-value = 0.087). this result is consistent with the view that lower managerial ownership has bigger motivations to practice earnings management in order to achieve their personal interests, or to mitigate the behavioral restrictions imposed in accounting-based contracts. this result is inconsistent with the entrenchment hypothesis, which states that management ownership, instead of tumbling managerial motivation problems, may imbed the incumbent management team, leading to increasing managerial opportunism, as the entrenchment hypothesis suggests a positive association between management ownership and earnings management practices. asian journal of finance & accounting issn 1946-052x 2015, vol. 7, no. 2 288 as for the institutional investor equity (iie) results came by expectation, an adversely statistically significant association between iie and earnings management at significant level less than 0.01(coeff.= -0.193, p-value = 0.007). this result is consistent with the efficient monitoring hypothesis which suggests that institutional investors are associated with a better monitoring of management activities, dropping the ability of managers to manage earnings. this result supports the results of (chung et al. 2002; ebrahim 2007 and cornett et al. 2008). furthermore, the results in table 1 show that the greater the size of the company, the less the managers are motivated to practice earnings management, this result can be explained by understanding that the large-size companies are usually have more profitability, and this result confirms the inverse relationship between profitability and earnings management shown in table 1. 5. conclusion the aim of this paper is to examine the effect of ownership structure on a firm’s ability to practice earnings management. to achieve this goal all 77th jordanian industrial companies listed at amman stock exchange (ase) for the period 2000-2014 were selected resulting in 1089 firm-year observations. the empirical results suggest that the earnings management practices of jordanian industrial companies listed at ase are influenced by their ownership structure. precisely, the result shows that equity concentration, management ownership and institutional investor equity associated inversely with the practices of earnings management. our results are consistent with the alignment of interest hypothesis and the efficient monitoring hypothesis which suggests that large shareholders have less motivation to manipulate earnings, and can reduce the scope of managerial opportunism. acknowledgements the author is grateful to the applied science private university, amman, jordan, for the financial support granted to this research project (grant no. drgs–2014-2015-210). references becker, c.l., m.l. defond, j. jiambalvo, & k.r. subramanium. 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(ed), asymmetric information, corporate finance and investment, university of chicago press. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 464 international financial reporting standard (ifrs) adoption and its impact on financial reporting: evidence from listed nigeria oil and gas companies murtala zakari post graduate school of accounting and finance leeds beckett university, leeds, uk e-mail: murhafs2010@gmail.com received: april 2, 2017 accepted: may 17, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.11407 url: https://doi.org/10.5296/ajfa.v9i1.11407 abstract this study seeks to investigate the impact of ifrs adoption on financial reporting in nigeria oil and gas sector; whether it leads to significant financial reporting improvement in terms of value addition and quality; whether it reduces information asymmetry and increases investors’ confidence and understanding of the financial reports. to achieve this, data were collected from financial statements prepared using ifrs for the periods 2012-2016, and financial statements prepared using nigeria gaap for the periods 2007-2011, i.e. pre and post ifrs adoption in nigeria for a period of 5years each. analysis was conducted to test for the significance level of roe, pat/sales, ca/cl, and debt-to-equity using mean, standard deviation of ratios, and t-test (paired) for both periods. the researcher found that nigerian gaap is more attractive and promising to shareholders than ifrs. in the same vein, ifrs is more attractive and promising to long term lenders than nigerian gaap. the study concludes that there is no significant financial reporting difference and quality in adopting ifrs compare to the nigeria gaap by the listed oil and gas companies of nigeria. keywords: ifrs, nigeria, oil and gas, financial reporting, financial statement asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 465 1. introduction 1.1general background ifrs is an international financial reporting standard issued by the international accounting standards board (iasb), an independent organization registered in the united states of america (usa) but based in london, united kingdom. they pronounce financial reporting standards that ideally would apply equally to financial reporting by public interest entities worldwide. between 1973 and 2000, international standards were issued by the iasb's predecessor organization, the international accounting standards committee (iasc), a body established in 1973 by the professional accountancy bodies in australia, canada, france, germany, japan, mexico, netherlands, united kingdom and ireland, and the u.s. during that period, the iasc's pronouncements were described as international accounting standards (ias). since april 2001, this rulemaking function has been taken over by a newly constituted iasb. the iasb describes its pronouncements under the label "international financial reporting standards", though it continues to recognize the ias issued by the defunct iasc (deloitte, 2012).the adoption of ifrs in over 120 countries is an issue of global relevance among various countries of the world due to quest for uniformity, reliability and comparability of financial statements of companies. the benefit of adopting a standardized set of financials is to benchmark company performance against their peers, to allow global investors to compare firms globally (iasb, 2015). nigeria has joined the league of nations reporting ifrs. with the adoption of ifrs in nigeria, a lot stands to be gained from the seemingly distressed global economy. with successful implementation of ifrs, nigeria will benefit economically by receiving a boost on foreign direct investments (fdis) and increasing investors’ confidence when investors are uncertain about the information available to them. by providing reliable and internationally comparable financial information, ifrss are a very important fundamental of global market economy. the federal government of nigeria formally announced its adoption and launched the roadmap for its implementation on 2nd september 2010. the approval was seen as a milestone for nigeria as it becomes a member state among those countries that have adopted ifrs. the roadmap for implementation mandates listed and significant public interest entities to prepare their financial statements using applicable ifrss by december 31, 2012. at a seminar organized by financial reporting council (frc) formerly known as the ‘nigerian accounting standards board’, the former minister of trade and commerce martins-kuye noted that the decision by government to adopt the global standards was due to its immense benefits, adding that apart from assurance of useful and meaningful decision on investment portfolio in the country, there would also be attraction of foreign investments. he noted that convergence would also create easier access to external capital; reduction in the cost of doing business across borders by eliminating the need for supplementary information from nigerian companies; easier regulation of financial information in the country, and also enhance knowledge of global financial reporting standards by tertiary institutions, amongst others (financial reporting council, 2012). the proponents of ifrs are of the view that its benefits exceed the cost of compliance and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 466 that international accounting standards are superior to domestic standards (ashbaugh and pincus, 2001). this entails that with better accounting standards and greater transparency, investors would be more confident of the financial information available (daske, 2006) and would have greater confidence in investing in equity markets. higher quality of financial reporting will lead more investors and thus reduce the firm’s cost of capital (leuz, 2003; and lambert et al., 2007). there are significant differences between the nigeria gaap and ifrs, this involves a huge cost of transition and will change many accounting practices in the areas of revenue recognition, inventory valuations, current and non-current classification of assets, fixed assets accounting, business combination, etc. with the adoption and implementation of ifrs in nigeria, the following principles will have to be followed; recognize and derecognize all assets and liabilities as required by ifrs; classify all assets and liabilities in accordance with ifrs; and measure all assets and liabilities in accordance with ifrs (iasb, 2015). all these requirements would involve a huge cost, and unless the benefits exceed the cost, ifrs adoption will not be meaningful. this study aims to examine the benefits of adopting ifrs.the study seeks to investigate the impact of ifrs adoption on financial reporting in nigeria oil and gas sector; whether it leads to significant financial reporting improvement in terms of value addition and quality; whether it reduces information asymmetry and increases investors’ confidence and understanding of the financial reports. oil and gas sector is chosen because it is the largest on the african continent, the sector is very important, as government revenues and foreign exchange heavily rely on this sector, it is the main stay of nigeria economy and contributes up to 70% of gdp and has been the focal point of attraction to both local and foreign investors, and to the researcher best knowledge, this has not been analyzed before. the major contribution of this study is demonstrating the benefits of ifrs adoption using key financial ratios for the accounts prepared with nigeria gaap and ifrs, what would be interesting is the variability in the ratios. the study will enlighten readers and users of financial statements with new insights on ifrs adoption. it will also provide useful guidelines for effective measurement of the impact of ifrs adoption to researchers, preparers of financial statements, regulators, investors, and other stakeholders. 1.2 research questions 1. does adopting ifrs lead to a significant difference in financial reporting quality? 2. does adopting ifrs reduces information asymmetry and attract more investors? 1.3 research objectives 1. to assess if ifrs adoption in nigeria leads to significant financial reporting difference in terms of improved earnings quality of investors. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 467 2. to determine if ifrs adoption in nigeria reduces information asymmetry and increases investors’ confidence and understanding of the financial reports in terms of comparability and investors’ earning forecast. 2. literature review in view of the seemingly inexorable rise of ifrs as the global accounting benchmark (chua and taylor, 2008) and critics’ concerns over its uniform applicability and relevance to different institutional, political, and economic contexts (cahan, liu, and sun, 2008), it is increasingly important to empirically examine the impact of ifrs adoption on accounting quality in countries of different contexts (liu, et al. 2011). global adoption of international accounting standards has been increasingly debated. supporters of international financial reporting standards (ifrs) argue that the use of ifrs increases the quality of financial reporting and benefits investors (daske et al., 2008). opponents argue that a single set of standards may not be suitable for all settings and thus may not uniformly improve value relevance and reliability due to differences among countries (soderstrom and sun, 2007). empirical studies have mixed results on quality change after the adoption of ifrs in different countries. one of the inter-nationality dimensions is that the standard is not closely aligned with the economic or political institutions of any particular nation (chua and taylor, 2008), so there are arguments for assessment of ifrs practice on a country-by-country basis (nobes, 2006). the international accounting standards committee (iasc) foundation has documented the ‘‘need to have an understanding of the impact of ifrs as they are adopted in particular regions’’ (iasb, 2004, para. 93).there are advantages for developing countries to converge with ifrs which include rapid improvement in the perceived quality and status of financial reports (tyrrall et al., 2007). tendeloo and vanstraelen (2005) argue that ifrs which are considered as high quality standards can be a condition for a high quality financial statement. the findings of the study do not fully support that companies adopting ifrs clearly show higher accounting quality after the compliance. after the adoption of the international accounting standards, several studies were carried out to assess the impact of such adoption on the capital market aiming to check whether the ifrs adoption had changed the accounting information. barth et al. (2008) studied the information disclosed by companies in different countries before and after the convergence to the international accounting standards. the authors found evidences of improvement in the informational content after the ifrs adoption. emenyonu and gray (1996), dumontier and raffournier (1998), el-gazzar et al. (1999), and murphy (1999) examine to what extent accounting disclosures and measures of companies applying ifrs have become harmonized and what motivates these companies to report using ifrs. they found that the decision to apply ifrs is driven by their financing policy and performance, multiple listing in various stock exchanges in different countries, and their foreign operations. ashbaugh and pincus (2001) conclude that financial reports using ifrs are better suited for forecasting and convergence in accounting policies by using ifrs improves the analyst’s forecast of earnings and the quality of earnings. street and bryant asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 468 (2000) and ashbaugh and pincus (2001) support these findings by identifying the differences between non-us companies reporting using ifrs or us gaap. they conclude that companies use ifrs to provide more standardized information than financial reports prepared using national gaap. the findings of brochet et al. (2013) are consistent with earlier findings that ifrs adoption leads to capital market benefits of lesser return to insider as the financial results are more comparable, allowing all users to make a better comparison. the findings of armstrong et al. (2010) support that ifrs adoption leads to positive reaction from investors for firms with high quality information. a greater positive impact on quality is documented for banking stocks. the overall findings support increase in information quality, decrease in asymmetry of information, more rigorous enforcement and convergence. according to lee et al. (2010), the adoption of the international accounting standards increases the quality of information disclosed, thus reducing the information asymmetry and, consequently, the costs for analysis and decision-making by investors, reflecting directly in the reduction of capital cost of companies. glaum et al. (2013) assesses the impact of the ifrs adoption in germany on the accuracy of analysts’ forecasts from 1997 to 2005. the results indicated a significant increase in analysts’ accuracy after the international accounting adoption, suggesting that greater information disclosure affects the quality of forecast performed. international accounting standard setters and accounting regulators who plan to converge with ifrs should assess the relevance of ifrs to their national needs. nobes (1998 cited in gray et al.,2001)makes a distinction between the needs of microeconomic and the needs of macroeconomic systems. research has uncovered the major factors influencing the national need for accounting information. such factors include strength of equity markets such as the relative size of the public and private sectors and the state of capital market development, the degree of similarity in economic and social environment to the original economy where an accounting system is developed, and the accounting needs and regulation of a nation (chamisa, 2000; nobesand parker, 2006; radebaugh et al., 2006; tyrrall et al., 2007). researchers including cairns (1990) argue that ifrs are relevant to developing countries. major disadvantages for developing countries to converge with ifrs such as ‘‘information overloads’’ (choi and mueller, 1984) and the additional cost of unnecessary complexity (belkaoui, 2004) occur when ifrs are unsuited or irrelevant to national needs. many researchers doubt the relevance of ifrs to developing countries. xiang (1998) raises concerns over the relevance of ifrs to china. if ifrs are irrelevant, advantages such as improved accounting quality may not result from ifrs adoption or convergence. this study extends prior research on ifrs adoption and adds to the literature by examining the relevance and impact of ifrs on financial reporting under rapid change in a major developing country like nigeria. 3. research methodology 3.1 research approach this research is guided by an overarching research philosophy of positivism. it is based on observable and measurable variables to search for patterns and causal relationships. the study asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 469 uses a deductive approach because it is testing and expanding upon existing theoretical and empirical research. the advantage of using a deductive approach over an inductive approach is that it takes on a clearer structure and the methodology is easier to replicate which is important to achieve reliability (saunders and lewis, 2012).this descriptive study is based on quantitative analysis in order to achieve the desired research objectives. quantitative research focuses on measurable, quantifiable data which is more generalizable than qualitative methods (bell and bryman, 2003). the researcher utilizes longitudinal study using secondary data from the published annual reports and accounts of nigeria oil and gas listed companies. this method is consistent with other research in the literature (liu et al., 2011; bodhanwala and shernaz, 2016).the use of secondary data is justified by the fact that written or printed document are more accurate and reliable in ascertaining compliance to principles in research work than primary data gathered through personal interview or questionnaire administration (dandago and muktar, 2003 cited in zakari, 2006) 3.2 research design and data collection 3.2.1 timeframe two periodspre and post ifrs adoption were studied. ifrs in nigeria was adopted in 2012 financial year by the listed companies in preparing their accounts. however, before the adoption, nigeria gaap (sas) was in used. this study covers 5years financial statements using nigeria gaap from 2007 – 2011, and 5years financial statements using ifrs from 2012 – 2016. the five years each represents a sufficient time period to factor in seasonality and full reporting cycles. (ekatah et al., 2011, bodhanwala and shernaz, 2016) 3.2.2 population of the study the population of this study comprises of allthe ten (10) listed companies in the oil and gas sector of nigeria. 3.2.3 sample of the study a reasonable size of the population in nigeria oil and gas space wererandomly selected for the study. this includes; total nigeria plc, oando plc, forte oil plc, and con oil plc. to achieve this, the names of the listed companies were written on pieces of papers and mixed up, each paper was picked without a replacement and each time a paper was picked, the remaining pieces of papers were reshuffled and mixed up again before picking the second one, this process continued until the required number of sample was made. this method is unbiased and gives every member of the population an equal chance of being selected and similar method was adopted by zakari (2006) in arriving at his sample size. 3.2.4 data the companies covered in this study have financial statements using ifrs for the periods between 2012 and 2016. however, for comparisons, the periods between 2007 and 2011 in which the companies’ annual reports were prepared using nigeria gaapwould be usedto test asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 470 for the significance level of roe, pat/sales, current asset/current liability, debt-to-equity using financial statement prepared with nigeria gaap and ifrs. 3.2.5 variables in this study, statistical test of comparing ratios related to shareholder (i.e., return on equity and profitability) and creditors (shortand long-term liquidity) is used to provide evidence if ifrs reporting leads to more meaningful ratios with less variability. the following ratios will be used as proxies for this study: roe for shareholder, profitability for sales, current ratio for short-term liquidity, and debt-equity ratio for long-term liquidity. financial statements prepared using nigeria gaap and ifrs would lead to different ratios; what would be interesting to study is the variability in ratios. in the literature, bodhanwala and shernaz (2016) adopted similar variables. 4. analysis and discussion this section present statistical test of comparing ratios related to shareholder (i.e., return on equity and profitability) and creditors (shortand long-term liquidity) to provide evidence if ifrs reporting leads to more meaningful ratios with less variability. table 1. mean value of ratios with nigerian gaap and ifrs variables n mean nig. gaap mean ifrs t-test p-value roe 4 0.11 0.00 0.45 0.67 pat/sales 4 0.04 -0.91 1.02 0.35 ca/cl 4 1.14 1.01 1.17 0.29 debt/equity 4 0.24 0.31 -0.37 0.73 source: spss output analyzed from financial reports of selected oil & gas companies the above table 1 result depicts that there is no significant variability in the average ratios of roe, pat/sales, ca/cl and debt/equity between nigerian gaap and ifrs of listed oil and gas companies of nigeria because the p-values from the table are all greater than 0.05 level of significance, at 95% confidence level. however, the mean values of roe, pat/sales, ca/cl, debt/equity ratios for all the companies following nigerian gaap and ifrs are not significantly different. the p-values exceed the critical values for all the four variables. the proportion of companies that report higher roe as per nigerian gaap than ifrs is around 67%. this shows that nigerian gaap is more attractive and promising to shareholders than ifrs when it comes to calculation of roe. in the same vein, ratio concerning long term lenders of funds (debt/equity), the proportion of companies that report higher debt/equity as per ifrs than nigerian gaap is 73%.this shows that ifrs is more attractive and promising to long term lenders than nigerian gaap when it comes to calculation of debt/equity. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 471 table 2. standard deviation of ratios under nigerian gaap and ifrs standard deviation standard error variables n nig. gaap ifrs nig. gaap ifrs roe 4 0.26 0.38 0.13 0.19 pat/sales 4 0.07 1.85 0.04 0.93 ca/cl 4 0.19 0.13 0.10 0.07 debt/equity 4 0.26 0.22 0.13 0.11 source: spss output analyzed from financial reports of selected oil & gas companies the above table 2 result depicts that mean values of standard deviation of the ratios are also not significantly different. looking at the second ratio concerning shareholders (i.e pat/sales), the proportion of cases where standard deviation is higher as per ifrs is around 93%. this shows that ifrs is more attractive and promising to shareholders than nigerian gaap when it comes to calculation of pat/sales. 5. conclusion this research finds that there is no significant variability in the average ratios of roe, pat/sales, ca/cl and debt/equity between nigerian gaap and ifrs of listed oil and gas companies in nigeria. this research finding means that ifrs reporting does not have higher accounting quality and reporting impact for shareholders, short and long term lenders of fund. the finding is consistent with that of (bodhanwala and shernaz, 2016; 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(2006). “an assessment of depreciation practice in nigeria commercial banks”. unpublished project, for a partial fulfillment for the award of bachelor degree, bayero university kano, nigeria https://doi.org/10.1016/s0020-7063(99)80006-5 https://doi.org/10.1111/1467-6281.00028 https://doi.org/10.1080/00014788.2006.9730023 https://doi.org/10.1080/09638180701706732 https://doi.org/10.1016/j.intacc.2006.12.004 microsoft word 12290-45179-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 387 audit committee and value relevance of accounting information of listed hotels and travels in sri lanka saseela balagobei senior lecturer, department of financial management, university of jaffna, sri lanka e-mail: saseelas@yahoo.com received: july 3, 2017 accepted: august 2, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.12290 url: https://doi.org/10.5296/ajfa.v9i2.12290 abstract the audit committee (ac) is the potential mechanism that reduces the agency problems in organizations and investigating this mechanism separate from alternate corporate governance mechanisms may have led to different results in the literature. the aim of this study is to examine the impact of audit committee on value relevance of accounting information of listed hotels and travels in sri lanka. value relevance of accounting information is measured by earning per share (eps) and book value per share (bvps) while audit committee consists of ac size, ac independence, ac experts and ac meetings. the sample consists of 15 hotels and travels listed in colombo stock exchange. in this study, data was collected from secondary sources and hypotheses are examined by using pearson’s correlation and regression analysis. the results reveal that audit committee attributes such as ac size, ac experts and ac meetings have a significant impact on book value per share of listed hotels and travels in sri lanka. further only ac experts influence earnings per share. ac independence is not found to have a significant impact on the value relevance of accounting information. the findings could be useful to regulators in other jurisdiction who are looking at ways to enhance the effectiveness of audit committee, overall firm governance. keywords: audit committee, value relevance of accounting information, audit committee size, audit committee experts, audit committee meetings jel: g3 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 388 1. introduction increasing the investment in capital market leads to improve strength of the capital market and development of economy. investors rely on accounting information in their pricing of shares and firms which provide good quality information have thus an advantage in a lower cost of capital. investors in developed counties are keen on the accounting information of the intended investing companies. so that, investigation of the audit committee with value relevance of accounting information is an important matter for the developing countries, like sri lanka. the audit committee is one of the key elements in the corporate governance structure that helps control and monitor management (ruzaidah and takiah, 2004). the committee plays a vital role in monitoring the organization’s operation and internal control system with the purpose of protecting the interest of the shareholders. the audit committee (ac) contributes to the development of the strategic plan of the company and is expected to provide input and recommendations to the board with regard to any financial or operational matters. hence, it is recognized that an effective audit committee would focus on improving the company performance and competitiveness, particularly in a changing business environment which is beyond the control of the company (charan, 1998; craven and wallace, 2001). an effective audit committee is expected to focus on the optimization of shareholders’ wealth and prevent the maximization of personal interests by the top management (wathne and heide, 2000). the primary role of the audit committee is to oversee the firm’s financial reporting process, the review of financial reports, internal accounting controls, the audit process and, more recently, its risk management practices (klein, 2002). the main focus of audit committees is to strengthen transparency, promote effective enforcement, and identify needs for training and education for directors and key players of an organization. in march 2013, the securities and exchange commission of sri lanka and the institute of chartered accountants of sri lanka developed the code of the best practices of corporate governance, which provides guidelines on the formation of the audit committee, particularly with respect to size, independence, duties and responsibilities of members to ensure good practices of corporate governance. detailed guidance on the scope and functions of the audit committee can be found in the code of best practice on audit committees issued by the institute of chartered accountants of sri lanka in 2002. porter and gendall (1993) discussed audit committee development in canada, the united states, the united kingdom, australia and new zealand, identifying unexpected corporate failure and corporate malpractice as the primary stimuli to their development. teoh and lim (1996) also explained the establishment of audit committees in malaysia as a response to corporate scandals. value relevance is the ability of accounting numbers to explain market price per share. beisland (2009) describes value relevance as the capability of financial statement information to tap and summarize firm value. kalbers and fogarty (1993) suggested that audit committee members with expertsise in accounting and finance, enhances the effectiveness of the audit committee. furthermore, it is also established that audit committee expertsise enhances the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 389 quality of financial reporting. the hotel and travels industry is a decisive player in promoting tourism industry in sri lanka. incubating market centrism has received particular attention in the modern business world as a mode of reaping higher business performances. according to the central bank of sri lanka (2014), the contribution of hotels and restaurants to the country's gross domestic product is increased by 11.5%. the accommodation facilities prevailing in the hotel industry in sri lanka are dominated by tourist hotels. according to sri lanka’s tourism authority, the country has a target of 2.2 million visitors for 2016, which would be a 26% growth compared with 2015. the tourism authority’s statistics show that sri lanka has welcomed 1.7 million visitors as of october, a 14.6% increase compared with the same time period last year. through the efforts to help sri lanka’s tourism industry grow, the country’s hotel demand has increased 3.5% based on october 2016 year-to-date data. supply, however, has also increased (+4.2%), with around 900 new rooms added to the market in the first ten months of the year. therefore the objective of this study is to investigate the impact of audit committee on value relevance of accounting information of listed hotels and travels in sri lanka during the period of 2012 to 2016. 2. problem of the statement although many sri lanka listed companies had appointed an audit committee as in many other asian countries (oecd white paper 2003), a transparent procedure was absent in the determination of directors’ remuneration in them (senaratne and gunaratne, 2007). the prominence of audit committees in sri lankan companies may have been associated with the dominance of accounting professionals in the boards of these companies and the developed accounting profession in sri lanka (senaratne, 2007). however, the appointment of a nomination committee to oversee board appointments including succession planning and performance evaluation of directors is not yet mandatory for listed companies except for licensed commercial banks for which it is mandatory under the central bank direction. it is questionable why the listing rules have not made the establishment of a nomination committee mandatory. a proper and transparent procedure on board appointments is a key to have an effective board as the roles and responsibilities of directors underpin the task of corporate governance. the lack of transparency in the board appointments has also been found as a negative corporate governance feature in many sri lankan listed companies (senaratne and gunaratne, 2007). hence, this area needs special attention. to address this issue the study was undertaken to explore the answer to the following research question: to what extent audit committee impacts on value relevance of accounting information? 3. literature review and hypotheses development according to the code of best practice on corporate governance (2013) issued jointly by the securities and exchange commission of sri lanka and the institute of chartered accountants of sri lanka, the audit committee should be comprised of a minimum of two independent asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 390 non-executive directors or exclusively by non-executive directors, a majority of whom should be independent, whichever is higher. the guideline further requires that the chairman of the committee should be a nonexecutive director, appointed by the board. an extensive body of market-based accounting research (mbar) tests for relevance of accounting information by investigating the association of such information with equity prices (ball and brown, 1968). mbar research relied on earnings, or a component of earnings, as explanatory variables for security returns. this is logical, because the valuation theory has long posited a relationship between earnings and the value of common stock (miller and modigliani, 1961; graham et al.,1962). subsequent analytical work by ohlson (1995) includes another valuation construct, book value of equity, along with earnings in tests of market pricing of accounting information. an effective corporate governance system ensures the provision of credible accounting information to financial statement user groups by constraining opportunistic earnings management by managers. corporate governance also helps investors by aligning the interest of managers with the interests of shareholders and enhancing the reliability of financial information and the integrity of the financial reporting process (watts and zimmerman, 1986). klein (2002) investigates the relationship between board independence, board size and audit quality and shows that audit quality is negatively related with board book value per share and abnormal accruals. davison al (2005) investigates the relationship between audit comity, non-executive director on the board and earning management in australia and shows that audit comity and non executive director has negative relationship with earning management. outside director were financial experts who efficiently monitor the activity of audit committee of the firm. as financial expert, director was able to monitor and detect any kind of manipulation in financial reports (abbott et al., 2002). dezoorts and salterio (2001) and carcello and neal (2003) found that there was negative association between financial expertise and auditor dismissal in cases of disputes between auditor and management. similarly, abbott, park, and parker (2000) suggested that there was negative relationship between financial expertise and financial fraud. further, according to felo, krishnamurthy, and soloeri (2003), there is positive association between financial expertise and financial reporting quality. based on the above discussion, the following hypotheses are developed: h1 : audit committee size significantly influences value relevance of accounting information. h2 : audit committee independence significantly influences value relevance of accounting information. h3 : audit committee experts significantly influences value relevance of accounting information. h4: audit committee meetings significantly influence value relevance of accounting information. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 391 4. research methodology the research methodology focuses on the research process, kind of tools and procedures to be used. this study tends to analyze the impact of audit committee on value relevance of accounting information. 4.1 sample and data the population of the study comprises firms listed under hotel and travels sector in colombo stock exchange (cse). cse is the only one share market in sri lanka and has 295 companies representing 20 business sectors as at 30th september 2017, with a market capitalization of rs. 2,919.7 bn. since the number of hotels and travels companies listed on the main market was only 38, only 15companies were selected as sample of this study based on market capitalization. the study used secondary data that was collected from the published financial statements of the companies available from the web site of colombo stock exchange during the period of 2012 – 2016. the two most important and fundamental characteristics of any measurement procedure are reliability and validity. in this study secondary data was extracted from audited annual report of the listed companies as fairly accurate and reliable. therefore, these data may be considered as reliable for the study. necessary checking and cross checking were one while scrutinizing information and data from the secondary sources. therefore the researcher satisfied with the content and construct validity, then it was decided to continue the analysis. 4.2 model specification a multiple linear regression model attempts to investigate the influence of audit committee on value relevance of accounting information. the regression was performed by using statistical program eviews 9. specifically, the study was operated based on the following research models, model i: eps = β0 + β1 acs +β2 aci + β3acfe + β4 acm+ β5 fs + ε model ii: bvps = β0 + β1 acs +β2 aci + β3acfe + β4 acm+ β5 fs + ε where: β0, β1, β2 β3, β4, β5 –regression coefficient acs – audit committee size aci – audit committee independence acfe – audit committee financial expertise acm – audit committee meetings fs – firm size asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 392 ε – error term 4.3 operationalisation table 1. operationalisation of variables concept variables measurement audit committee audit committee size number of audit committee members audit committee independence proportion of independent directors to audit committee size audit committee financial expertise proportion of audit committee members with financial expertise to the total number of audit committee members audit committee meetings number of meetings held in financial year value relevance of accounting information earnings per share net profit after tax divided by number of outstanding shares book value per share total stockholder’s equity divided by number of outstanding shares control variable firm size the natural logarithm of total assets 5. empirical results 5.1 descriptive analysis table 02 represents the descriptive statistics of audit committee variables and value relevance of accounting information measured by eps and bvps in sri lanka during the period of 2012 to 2016. table 2. descriptive statistics ac_size ac_ independence ac_ experts ac_ meetings firm_ size eps bvps mean 3.000 0.777 0.916 4.183 9.246 2.632 39.597 median 3.000 0.750 1.000 4.000 9.264 1.587 26.983 maximum 4.000 1.000 1.000 6.000 9.874 11.587 155.137 minimum 2.000 0.500 0.000 3.000 8.484 -2.549 4.594 std. dev. 0.576 0.177 0.278 0.469 0.386 3.093 36.968 skewness -0.021 0.153 -3.015 1.571 -0.494 1.341 1.512 kurtosis 2.716 1.675 10.090 6.177 2.462 4.706 4.897 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 393 table 02 presents the descriptive statistics of all variables employed in this study. on average companies have the audit committee size of 3. the maximum available audit members on the board in the sample are 4. the standard deviation is only 0.576 (aprox.) audit members. profile analysis shows that companies have the audit independence of 77% (aprox) on average. this table also shows that the average audit committee experts of 91.66 % with a standard deviation of 0.278 and has a wide range from 1 to 0. audit meeting has the average of 4.183 held per year with the standard deviation of 0.469. average firm size is 9.246 with standard deviation of 0.386. average of eps and bvps are 2.632 and 39.597 respectively. there is a highest standard deviation of bvps and lower audit committee independence. 5.2 correlation analysis this study employs a correlation analysis to discover the association and direction of the variables, mainly audit committee and value relevance of accounting information. table 3. correlation matrix correlation probability ac_size ac_ independ ac_experts ac_meeting firm_size eps bvps ac_size 1.000000 ---- ac_independence -0.5525 1.000000 0.0000 ---- ac_experts -0.476477 -3.58e-17 1.000000 0.0001 1.0000 ---- ac_meetings -0.200599 0.209344 0.161265 1.000000 0.1243 0.1084 0.2183 ---- firm_size 0.298223 0.033949 -0.394334 0.201592 1.000000 0.0206 0.7968 0.0018 0.1224 ---- eps -0.055053 -0.047853 -0.219888 0.045461 -0.243781 1.000000 0.6761 0.7165 0.0914 0.7302 0.0605 ---- bvps -0.055116 0.283523 -0.689587 0.052628 0.019916 0.545113 1.000000 0.6758 0.0281 0.0000 0.6896 0.8799 0.0000 ---- according to the table 03 the value of correlation between audit committee independence and bvps is 0.283523 which is significant at 0.05 levels; indicates that there is a weak positive association between audit committee independence and bvps while the value of correlation asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 394 between audit committee experts and bvps is -0.689587 which is significant at 0.01 levels, represents negative moderate association between audit committee experts and bvps. other audit committees variables such as audit committee size, audit committee meeting and control variable of firm size have an insignificant association with bvps. audit committee variables don’t have any association with eps (p>0.05). 5.3 regression analysis in order to examine the impact of audit committee on value relevance of accounting information measured by eps and bvps, least squares method by using e-views is performed in this study. results of the analysis are presented in the table 04 and 05. table 4. multiple regression analysis for eps according to the table 04, coefficient of determination for audit committee variables (r2) is 0.228922 which denotes that 22.89% of the observed variability in eps can be explained by the differences in the variables such as audit committee size, audit committee independence, audit committee experts, audit committee meetings and firm size. the remaining 77.11% of the variances is related to the other variables which are not depicted in this model. in this analysis, f statistic is 3.206364, p < 0.05, indicated that the model is significant. it means that the regression results are acceptable for this analysis and all variables (audit committee size, audit committee independence, audit committee experts, audit committee meeting and firm size) jointly in the model significantly affect the eps at 5% significant levels. among the all four audit committee variables considered in the analysis, only one audit committee variable has a significant impact on eps. audit committee experts has a significant negative influences on eps (b= -14.59498, p<0.05), similar pattern is observed in firm size that has a significant negative impact on value relevance of accounting information variable coefficient std. error t-statistic prob. c 39.96258 10.61069 3.766255 0.0004 ac_size -1.570735 0.961126 -1.634265 0.1080 ac_independence -3.803871 2.732074 -1.392302 0.1695 ac_experts -14.59498 4.258034 -3.427634 0.0012 ac_meetings 0.671838 0.856580 0.784326 0.4363 firm_size -3.010572 1.115149 -2.699704 0.0092 r-squared 0.228922 mean dependent var 2.632527 adjusted r-squared 0.157526 s.d. dependent var 3.093165 s.e. of regression 2.839105 akaike info criterion 5.019494 sum squared resid 435.2678 schwarz criterion 5.228928 log likelihood -144.5848 hannan-quinn criter. 5.101415 f-statistic 3.206364 durbin-watson stat 0.884716 prob(f-statistic) 0.013174 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 395 (b= -3.010572, p<0.05). further audit committee variables such as ac size, ac independence and ac meetings have no significant impact on eps. table 5. multiple regression analysis for bvps variable coefficient std. error t-statistic prob. c 426.1849 72.61375 5.869204 0.0000 ac_size -25.45047 6.577417 -3.869371 0.0003 ac_independence 7.086670 18.69681 0.379031 0.7062 ac_experts -343.3952 29.13964 -11.78447 0.0000 ac_meetings 15.33787 5.861959 2.616510 0.0115 firm_size -29.54916 7.631465 -3.872016 0.0003 r-squared 0.747190 mean dependent var 39.59759 adjusted r-squared 0.723781 s.d. dependent var 36.96833 s.e. of regression 19.42927 akaike info criterion 8.866078 sum squared resid 20384.81 schwarz criterion 9.075512 log likelihood -259.9823 hannan-quinn criter. 8.947999 f-statistic 31.91975 durbin-watson stat 0.308415 prob(f-statistic) 0.000000 according to the table 05, coefficient of determination for audit committee variables (r2) is 0.747190 which denotes that 74.71 % of the observed variability in bvps can be explained by the differences in the variables such as audit committee size, audit committee independence, audit committee experts, audit committee meeting and firm size. the remaining 25.29% of the variances is related to the other variables which are not depicted in this model. in this analysis, f statistic is 31.91975, p < 0.05, indicated that the model is significant. it means that the regression results are acceptable for this analysis and all variables (audit committee size, audit committee independence, audit committee experts, audit committee meetings and firm size) jointly in the model significantly affect the bvps at 5% significant levels. among the all four audit committee variables considered in the analysis, only three audit committee variables have a significant impact on bvps which are audit committee size, audit committee experts and audit committee meeting. audit committee size has a significant negative influences on bvps (b= -25.45047, p<0.05), similar pattern is observed in audit committee experts that has a significant negative impact on bvps (b= -343.3952, p<0.05). further audit committee meetings has a significant positive influences on bvps (b= 15.33787, p<0.05). firm size has a significant negative influences on bvps (b= -29.54916, p<0.05). the coefficient of audit committee independence shows that audit committee asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 396 independence has no significant impact on bvps. by using the multiple regression analysis the hypotheses are examined in this study. hypothesis (h1) stated that audit committee size significantly influences value relevance of accounting information measured by eps and bvps. according to the table 04 and table 05, there isn’t a significantly impact of ac size on eps (p=0.1080 >0.05) and ac size has a significant influence on bvps (p=0.0003 < 0.05) as a result h1 is supported in terms of bvps. hypothesis (h2) stated that audit committee independence significantly influences value relevance of accounting information. according to the table 04 and table 05, there isn’t a significantly impact of ac independence on value relevance of accounting information measured by eps (p=0.1695>0.05) and bvps (p=0.7062 >0.05), as a result h2 is not supported. hypothesis (h3) states that audit committee experts significantly influences value relevance of accounting information. according to the table 04 and table 05 there is a significant negative impact of audit committee experts on value relevance of accounting information measured by eps (p=0.0012<0.05) and bvps (p=0.00 < 0.05, as a result h3 is supported. hypothesis (h4) stated that audit committee meetings significantly influence value relevance of accounting information measured by eps and bvps. according to the table 04 and table 05, there isn’t a significantly impact of ac meetings on eps (p=0.4363>0.05) and ac meetings has a significant influence on bvps (p=0.0115 < 0.05) as a result h4 is supported in terms of bvps. 6. conclusion the overall goal of this study is to investigate the impact of various ac attributes, such as the ac size, ac independence, ac expertise and ac meetings on the value relevance of accounting information measured by eps and bvps for the listed hotels and travels. audit committee attributes such as ac size, ac experts and ac meetings have a significant impact on bvps of listed hotels and travels in sri lanka. further, ac experts significantly influence the eps. the results of the study suggest that the features of audit committees in sri lanka are relevant with value relevance of accounting information in terms of bvps. the findings could be useful to regulators in other jurisdiction who are looking at ways to enhance the effectiveness of ac, overall firm governance and enhance investors’ confidence in the firms. future studies could examine other committee attributes such as size, individual characteristics of the directors on the committee and the internal processes of the committee. 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(1986), positive accounting theory, prentice-hall, englewoodcliffs, nj. microsoft word 9610-35285-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 230 the relationship between financing policy, earnings management and governance practices yi-mien lin department of accounting, national chung hsing university, taiwan hsiu-fang chien (corresponding author) department of finance, st. john’s university, taiwan 2f, no. 136 ming ang east road, xinzhuang district, 24247 new taipei city, taiwan. tel: 88-69-3305-1417 e-mail: queenie@mail.sju.edu.tw received: june 1, 2016 accepted: june 30, 2016 published: june 30, 2016 doi:10.5296/ajfa.v8i1.9610 url: http://dx.doi.org/10.5296/ajfa.v8i1.9610 abstract this paper examines the effect of managers manipulated earnings management methods on the firm’s financing policies and investigates the relationship between internal control, audit quality, and earnings management. we adopt the two-stage model to control self-selection of earnings management and the principal component analysis to extract the first principal component as the corporate governance. the findings show that firms choose the earning management tools in advance in year -1. corporate governance can restrain real earnings management, but the effect decline when firms engaged in financing activities. only the larger shareholdings of institutional investors and firms audited by industry specialist can restrain real earnings management when firms undertake financing policies. the firms of issuing bonds choose real earnings management to avoid frequent outsider monitoring. and then, it causes operating performance to decline continuously two years after bond financing. moreover, investors don’t correct the price impact of earlier earnings overstates for seos and bonds sample. keywords: accrual-based earnings management, real activities, seasoned equity offering, corporate bond, corporate governance jel codes: g32, m20, m42, m48 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 231 1. introduction trade liberalization and investment have developed rapidly, and the need for capital has grown. in addition, the recent trend towards lower profits has made managers take financing decisions very seriously. there are three sources of corporate financing, internal funds, debt and new equity issues. myers and majluf (1984) propose the pecking order theory in the context of information asymmetry; financing new projects has an effect on a firm’s capital structures. internal financing is the most-preferred source, of course, followed by low-risk debt, and equity issuance is the least-preferred source. the trade-off theory of capital structure posits that a company balances costs and benefits to choose how much debt and equity to use in its financing. once a firm has financed projects, managers might manipulate earnings1 to achieve their desired objectives or to satisfy the projections made by financial analysts. the aim of earnings management is to influence share prices so that new shares are issued at higher prices, to issue debt financing at lower costs or to avoid violating debt covenants. the prior literature suggests that ipos (ducharme, malatesta, and sefcik, 2001; cotten, 2008), seasoned equity offerings (thereafter seos) (teoh, welch, and wong, 1998; zhou and elder, 2004; kim and park, 2005; cohen and zarowin, 2010), convertible bonds issuance (chou et al., 2009), debt financing (jelinek, 2007; liu, ning, and davidson, 2010), and financial crises (jaggi and lee, 2002) offer incentives for earnings management. healy and wahlen (1999) and kim and park (2005) show that managers manipulate earnings to acquire more capital by means of a higher issuing price in an ipo. jelinek (2007) notes that firms with debt contracts may have incentives to manage earnings to avoid debt covenant violations. liu, ning, and davidson (2010) find significant income-increasing earnings management prior to bond offerings. they also find that firms that managed earnings upward issue debt at lower costs after controlling for various bond issuer and bond issue characteristics. most papers measure earnings management with discretionary or abnormal accruals and few discuss real earnings management. dechow, kothari, watts (1998) are the first to have established an empirical model for real earnings management. roychowdhury (2006) finds that managers manipulate business activities to avoid reporting losses, such as price discounts to temporarily increase sales, overproducing to report lower costs of goods sold, and reducing discretionary expenditures to improve reported margins. in practice, different earnings management devices have different costs and benefits, and managers may consider their characteristics in choosing the appropriate devices to engage in earnings management; moreover, certain devices may be applied concurrently. in response to the sarbanes-oxley act in the united states that aimed at improving corporate governance, certain companies switched from accrual-based earnings management to real earnings management,2 which is difficult to monitor. therefore, this paper explores whether management chooses different earnings management methods with different financing types, whether by issuing bonds or 1 healy and wahlen (1999) define earnings management as managers using their influence in reporting and in structuring transactions to alter financial reports to either mislead certain stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers. 2 most prior studies on earnings management use accruals as a proxy. in fact, management may simultaneously adopt accrual-based and real earnings management to achieve earnings targets. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 232 seos. additionally, the government try to improve investment environment to attract foreign investment in taiwan, corporate governance become an important critical factor. the business economic scales are small in taiwan. most of taiwanese businesses are family owned companies. they may use cross-shareholding of affiliated companies or pyramidal ownership structures to ensure a disproportionately high level (almost 50%) of controlling rights to strengthen their control of listed companies. moreover, the management and monitor in family owned firms are under the table because board of directors and supervisors are linear, collateral relatives or relatives by marriage and hence the information is asymmetric. high percentage of individual investor and “head account” 3 culture make controlling shareholders in high position management. the controlling shareholders ignore minority shareholders and business risk. hence minority shareholders become disadvantaged, and the board of directors that control companies become advantaged (wei, lee, and deng, 2007). recently, the capital market of taiwan faces competition from hong kong, china, and singapore. taiwan faces serious crisis to be on the edge of the global capital market. on the other hand, foreign institutional investors are more likely to request high quality corporate governance. if the whole performance of the taiwan corporate governance doesn’t make progress, we might be caught up by the other asian country. hence, we try to find out effective taiwan’s corporate governance variables as a reference for taiwan government. since the united states congress passed the sarbanes-oxley act in july 2002, substantial research has focused on the effects of corporate governance. xie, davidson, and dadalt (2003) suggest that earnings management is less likely when there are outside directors on the board and when those directors have backgrounds in corporate governance or finance. krishnan (2003) indicates that the absolute discretionary accruals of companies audited by non-specialist auditors report 1.2 percent of total assets, which is higher than companies audited by specialist auditors. balsam, krishnan, and yang (2003) also note that firms audited by industry specialists exhibit higher earnings quality than firms audited by non-specialists. myers, myers, and omer (2003) and ghosh and moon (2005) suggest that audit quality is higher when auditor tenure is longer; thus, earnings quality improves with auditors who have longer tenure. zhou and elder (2004) indicate that companies audited by big 5 report lower levels of earnings management than the previous year, during the year of the audit, and in the years following seos. davidson, goodwin-stewart, and kent (2005) find a majority of non-executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management. basiruddin (2011) suggests that higher quality auditors (who either charge higher audit fees or are industry specialist auditors) are likely to reduce earnings manipulation. robust corporate governance (cg) can suppress earnings management. brown, beekes and verhoeven (2011) stress the importance of how cg is measured and in particular, the construction of cg indices, which should be sensitive to local institutional arrangements, and the need to capture both internal and external aspects of governance. therefore, we choose several special corporate governance variables in taiwan to explore whether these variables can restrain taiwanese company from 3 “head account” means people open dummy or fraud bank accounts, but they doesn’t have the ownership of accounts. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 233 manipulating real earnings management or not. because real earnings management can harm enterprise value, this paper finally examines whether the operational performances of firms engaging in real earnings management that issue bonds or seos deteriorate after financing compared to firms financing through bond issuance or seos who have adopted accrual based earnings management. this paper extends past studies by considering real earnings management to explore whether stronger corporate governance can restrain real earnings management. two related studies by liu, ning, and davidson (2010) and cohen and zarowin (2010) examine earnings management for firms issuing bonds and offering seos, respectively. liu et al. (2010) find significant income-increasing earnings management prior to bond offerings by using accrual-based accounting as a proxy variable of earnings management. cohen and zarowin (2010) examine both accrual-based and real earnings management from seos and find that real activities-based earnings management at the time of the seo is strongly associated with the deterioration of the post-seo operating performance. according to the pecking order theory, internal financing is the most preferred, followed by low-risk debt, and equity is the least preferred. this paper is the first to examine two methods of earnings management from two types of firm financing, i.e., bond issuances and seos. the contribution of the paper is that the paper expands the two previously mentioned studies by exploring the correlation between financing vehicles (debt or equity) and earnings management methods. moreover, we also use the principal components analysis to extract the first principal component as the corporate governance index. we also choose several special corporate governance variables in taiwan to explore whether these variables can restrain taiwanese company from manipulating real earnings management or not. in addition, we consider market reaction to examine whether the rational expectations models differs with respect to equity compared with debt rising. the remainder of this paper is organized as follows. section 2 presents a review of the literature and develops the hypotheses. section 3 explains the research design, research periods, sampling criteria, and variable definitions; it also proposes the empirical model. section 4 summarizes the empirical findings and analyses. section 5 offers conclusions and suggestions. 2. literature review and hypotheses development myers and majluf (1984) suggest the pecking order theory based on the concept of information asymmetry.4 dye (1988) and trueman and titman (1988) posit that information asymmetry between managers and shareholders results in earnings management because it is difficult for shareholders to monitor corporate performance and prospects, and managers can use accounting flexibility to manage earnings.5 healy and wahlen (1999) indicate that the 4 pecking order theory explains that firms with high profitability have fewer debts because they are able to apply internal funds and do not depend on external financing. thus, the debt ratio is lower; firms with lower profitability do not have sufficient internal funds and must depend on external financing. based on pecking order theory, external financing by debt is preferred over equity financing. 5 schipper (1989) focuses on the following three issues: defining the object of earnings management, exploring conditions that give rise to earnings management, and designing empirical tests of earnings management. under an informational perspective, earnings are one of the signals that may be used to make certain decisions and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 234 motivation of managing earnings is to affect the stock price for specific purposes, particularly for initial public offerings and seasoned equity offerings. richardson (2000) finds that information asymmetry (measured by bid-ask spreads and analyst forecast dispersion) is positively related to earnings management. the methods of earnings management are typically either actual earnings management (real) or artificial earnings management (accrual-based).6 real earnings management is typically defined as management actions that deviate from actual operating activities with the purpose of meeting earnings thresholds. compared to accrual-based earnings management, real earnings management does affect cash flow. roychowdhury (2006) suggests that real earnings management impairs corporate value. the activity in the current period may increase current earnings but will reduce cash flow in the future period. for example, increasing a price discount can increase sales volume to meet short-term earnings targets; however, customers may anticipate the same discount in the future and the future gross profit of the company will most likely decrease. therefore, real earnings management affects earnings through real economic action, the timing of expenditures that are subject to managerial discretion, and the use of working capital management to affect earnings. this method will affect real performance and will have economic consequences.7 accrual-based earnings management refers to earnings that are manipulated through accounting flexibility during the financial reporting process, such as accounting estimates or the choice of accounting methods. this method will affect accounting earnings but will not affect economic consequences. graham, harvey, and rajgopal (2005) suggest that real and accrual-based earnings management are different because real earnings management directly affects cash flow and is not easily detected by auditors and regulators. managers can achieve earnings target through different earnings management methods. do different earnings management methods act as substitutes or complements? zang (2012) conducts a cost analysis to test the trade-off between accrual-based and real earnings management and finds that real earnings management is positively correlated with the cost of accrual-based earnings management – managers treat the two as substitutes. myers and majluf (1984) propose the pecking order theory, which creates a preference ranking over financing sources, beginning with internal funds, followed by debt, and then equity. myers (1984) argues that a firm follows the trade-off theory to set a target debt-to-value ratio and then gradually moves towards the target. the target is determined by balancing debt tax shields against the costs of bankruptcy. market timing also influences the financing policy. managers attempt to sell highly priced shares when stock market conditions are favorable. different incentives and characteristics cause various financing decisions. judgments, such as valuing securities. the informational perspective on earnings management assumes that managers have private information that they can use in making decisions. 6 mcvay (2006) suggests another method of earnings management in which current-period operating expenses in the income statement are misclassified as special items. the findings show that this method will not affect net income; thus, it is not detected by auditors or regulatory agencies. barua, lin, and sbaraglia (2010) study whether management uses classification shifting to manipulating earnings when reporting discontinued operations and find that companies will shift operating expenses to discontinued departments to reduce the net income of discontinued departments and to increase the core earnings of operating departments. above earnings management methods are not discussed in this paper. 7 previous studies indicate most real earnings management through real activities occurs in investment, such as reduction of research and development cost. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 235 frank and goyal (2008) find that private firms appear to favor retained earnings and bank debt, small public firms make active use of equity financing, and large public firms primarily use retained earnings and corporate bonds. teoh et al. (1998) find that earnings growth in the year of issuance of seos is higher than matched non-issuance industry peers and underperform those matches after the issuance of the seos.8 decomposing net income into cash flow from operations and accruals, the key factor in the performance difference for the year of the seos and post-seos is accruals. similarly, barton (2001) indicates that companies may use derivatives and accruals to reduce earnings volatility. zhou and elder (2004) indicate that companies issuing a seo are motivated to conduct earnings management to increase reported net income and ensure the success of the seo. kim and park (2006) find that the discount of the seo’s offer price is negatively correlated to discretionary accruals. thus, seo companies may conduct aggressive earnings management to increase the offering price and obtain more capital. cohen and zarowin (2010) consider two types of measurement methods for earnings management, indicating that downward performance of post-seo is greater than accrual-based earnings management when companies conduct real earnings management activities during the seos. after seos, performance declines are attributed to the reversal of accruals and to the decision to engage in real earnings management. because differential characteristics and incentives lead managers to finance differently and to utilize different earnings management tools, this study focuses on companies conducting financing and to discuss whether they show differences in earnings management methods when companies engage in equity financing and debt financing, which leads to the following hypothesis: h1: companies engage in equity and debt financing policies which lead the differences in the use of earnings management methods. there have been many studies on the effects of corporate governance on earnings management. dechow et al. (1998) find that the problem of earnings management is more serious in companies whose ceo is also the chairman of its board, and the company has large number of inside directors and a higher percentage of outstanding shares owned by inside directors, and when the audit committee is not established. xie et al. (2003) indicate that the possibility of earnings management is small when the board of directors has more outside independent directors with richer corporate and financial experience. rajgopal and venkatachalam (1997) indicate the absolute value of earnings management and positive earnings management will be reduced with an increase in the percentage of shares owned by institutional investors, i.e., a high proportion of institutional shareholders can restrain earnings management. zhou and elder (2004) indicate that companies with financial statements audited by the big five auditing firms have lower earnings management before, during and after seos; 8 teoh et al. (1998) decompose accruals into long-term discretionary accruals, short-term discretionary accruals, long-term nondiscretionary accruals, and short-term nondiscretionary accruals, according to time period and manager control. the empirical results indicate short-term discretionary accruals have better predictability for underperformance after seos. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 236 therefore, they suggest that larger audit firms can restrain earnings management. johnson, khurana, and reynolds (2002) suggest that the financial report quality from a new auditor is lower, and the audit quality is better if the tenures of auditors exceed four years. myers et al. (2003) and ghosh and moon (2005) indicate that the longer the tenure of the cpa, the better the quality of corporate earnings. krishnan (2003) indicates that the absolute values of discretionary accruals for companies audited by non-specialist auditors are higher than that of companies audited by industry experts. balsam et al. (2003) also indicate that the quality of audits by industry specialist auditors is better. based on the above literature, earnings management conducted by management may be constrained when corporate governance is stronger, which leads to the following hypothesis: h2: companies with stronger internal control and audit quality may conduct less real earnings management. accruals often may be reversed. for example, an allowance for doubtful accounts, which can be manipulated by companies, makes future earnings look better at the expense of current earnings. a higher recognition for bad debts expense in the current period but it will be decreased recognized in the next period. similarly, underestimates of bad debt losses in the last period should be corrected by increased provisions for bad debts in the current period. thus, to the extent that companies conduct accrual-based earnings management, the earnings management will be reversed in the following period. ducharme et al. (2001) show that the abnormal accruals of companies prior to initial public offerings are positively correlated to the value of the companies engaging in the ipo. this indicates that, prior to the ipo, companies can manipulate earnings through accruals to increase the offering price. the abnormal accruals during the offer year are negatively correlated to the performance of the companies, which indicates that companies conduct income-increasing earnings management to raise more capital during the ipo. after the ipo, the performance and stock returns of companies decrease because of the reversal of the pre-ipo accrual-based earnings management. ducharme, malatesta, and sefcik (2004) find that the abnormal accruals of companies around stock offers are higher on average than those without stock offers. after the stock offers, the accruals are negative because of the reversal of the positive abnormal accruals around stock offers.9 gunny (2005) indicates that firms that engage in real earnings management from real activities increase income by reducing research and development expenses, cut prices to boost sales in current period, overproduce to deduct cogs expenses, and time income recognition by selling long-term assets. the findings indicate real earnings management is significantly and negatively correlated with subsequent earnings and operating cash flow. cotten (2008) indicates that firm issuing only primary shares will manipulate earnings management upward in the ipo; firms issuing both primary shares and secondary shares10 will not manipulate earnings management upward or downward. however, firms issuing only secondary shares will manipulate earnings management downward during the ipo. in 9 lewis, rogalski, and seward (2001) indicate that operating performance and stock price are reduced by 4%-8% up to five years following the issue date compared to corporations that have no issuance of convertible debts. 10 the author defined primary shares as the shares issued by a company, and secondary shares as those sold by insiders. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 237 addition, earnings management is the reason for corporate underperformance in the five years following the ipo. chou et al. (2009) indicate that companies will have inferior operation performance and stock returns over the five-year period after the issuance of convertible bonds because these companies may increase their reported earnings through discretionary accruals prior to the issuance of convertible corporate bonds. after the passage of the sarbanes-oxley act (sox) in the united states, taiwan also reviewed and standardized its corporate governance system. this study expects that the effect of accrual-based earnings management has limitations. if financing companies must manage higher earnings, they will tend to conduct real earnings management, which affects economic essence. after financing, the operating performance of the companies will be worse than those conducting accrual-based earnings management, which leads to the following hypothesis: h3: after financing, companies have different financial performances under conducting real activities and accrual-based earnings management. 3. data and method 3.1 sample selection this study retrieves data for taiwan stock exchange (tse) or over-the-counter securities exchange (otc) stocks from the database of economic journal database (tej) for the period of 2004-2009. to be included in the sample, this study requires that a stock be continually listed on the tse and otc throughout the research period and have all the data required for estimating the variables involved. this paper excludes firms in financial distress and newly listed firms during the research period. we also exclude financial and insurance firms due to their characteristics of operations and financial structures, which are different from firms in other industries. observations with missing information are also excluded. moreover, audit fees and non-audit fees are disclosed by the companies only when certain requirements are met in taiwan. thus, we delete observations which missing these two variables once we discuss audit fees and non-audit fees. because the number of our samples is not many, we analyze our data by winsorized method11 to avoid biased estimators because of the deleted observations. our data are based on the taiwan economic journal database (tej). table 1 summarized the sample selection process. it presents a final sample contains 5,916 observations from 2004 to 2009, after deleting the sample that had missing variables. table 2 reports the industries distribution of the test sample. the 3,512 observations are concentrated in the electronics industry, 59.36% of the sample, comprised the highest percentage. 11 to reduce the effect of outliers, variables have been winsorized at the 1% and the 99% of their empirical distribution. moreover, our samples are not many, for example, the financing subsample or companies disclosure auditing fees. we also analyze our data by winsorized method to avoid biased estimators because of the deleted observations. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 238 table 1. sample analysis initial number of samples obtained from taiwan 7,013 (1) exclude missing value of calculating earnings management variable 888 (2) exclude missing value of beta variable 209 available samples (firm year) (2004~2009) 5,916 table 2. industry distribution of sample tej industry number of observations(2004~2009) % of obs. cement (11) 41 0.69 food products (12) 114 1.93 petroleum refining(13) 157 2.65 textile(14) 267 4.51 electric machinery(15) 205 3.47 electrical equipment & cable(16) 65 1.10 chemical & medical products(17) 207 3.50 glass &ceramics(18) 37 0.63 paper and paper products (19) 41 0.69 iron &steel(20) 153 2.59 rubber(21) 51 0.86 automobile(22) 27 0.46 electronics(23) 3,512 59.36 construction(25) 370 6.25 air transportation(26) 124 2.10 entertainment(27) 61 1.03 misc. retail(29) 94 1.59 other(97、99) 390 6.59 total 5,916 100 3.2 empirical models in order to test hypothesis 1, the financing companies may have differences in the use of earnings management methods due to different financing policies, this study conducts mean difference analysis on the earnings management of corporations in the four years prior to and in the three years after the announcement date of issuing corporate bonds and seos, to examine whether the companies with different financing policies have differences in using earnings management methods. on the other hand, we expect that companies with stronger corporate governance may conduct less real earnings management. in order to test hypothesis 2, this study uses the two-stage model followed by heckman (1979) to control the self-section of earnings management. the first stage explains whether financing firms will adopt earnings management, including accrual-based and real activities two tools. we use tem_tit to judge whether the financing firm engage in earnings management based on asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 239 discretionary accruals of ball and shivakumar (2006, 2008) or on real activities earnings management. the second stage examines the effects of internal control and audit quality on real earnings management. following lin and hsu (2011), we adopt the following two-stage models. ititititititit eindusmbasizearoaabetaafinanaattem +++++++= 543210 3_ (1a) itititit itititititit einvsmillbspeaudbcpachgb bigbinstbmshahdbindedrbbrdsizebbrem ++++ +++++= 876 543210 4 (1b) where tem_t= a dummy variable and takes the value of 1 if the company performs accruals or real earnings management, and 0 otherwise; finan3= a dummy variable and sets to 1 if the company issues bonds or seasoned equity offerings and 0 otherwise; beta= systematic risk; roa= return on assets; size= company size; mb= market-to-book ratio; indus=industry type; rem= real earnings management; brdsize= board size; indedr = ratio of independent directors; mshahd= shareholdings of directors supervisors and managers; inst= shareholdings of institutional investors; big4= big 4/non-big 4 indicator variable; cpachg= auditor change indicator variable in current or previous period; speaud= industry specialist/non-specialist indicator variable; invsmill= the inverse mills’ ratio that is generated from the first stage regression based on heckman’s two-step estimation procedure (heckman, 1979). moreover, in order to drive a comprehensive measure for corporate governance, we use the principal components analysis (pca) to extract the first principal component as the corporate governance. the empirical model is as follows: ititit invsmillgirem εβββ +++= 210 (1c) where gi= corporate governance composite index and the definitions of other variables are the same as the above model. to test hypothesis 3, this study examines whether the post-financing operating performance of the financing companies which engage in real earnings management is worse than accruals-based earnings management. referring to lin and hsu (2011), this paper builds the following model. itkitkit kitkitkitkitk(itkit stanretdretund mbd sizedbetadrtemddtemddroa ε+++ +++++= −+−+ −+−+−+−+−++ )1(7)1(6 )1(5)1(4)1(3)1(2)110 __ (2) where roait+k is return of assets, k denotes the period and k=1,2,3. return is stock returns, stanret is volatility of stock returns, and the definitions of other variables are the same as those in the above model. 3.3 measurement of variables real earnings management (rem): given sales levels, companies that manage earnings upwards are likely to have one or all of these properties: abnormal low cash flow from asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 240 operations, and/or abnormal low discretionary expenses, and/or abnormal high production costs, we follow the measure of cohen and zarowin (2010).12 rem is an aggregate measure of real earning management activities and is calculated as the sum of abnormal cash flows multiplied by -1, abnormal discretionary expenses multiplied by -1 and abnormal production costs. three estimates are as follows: (1)acfoit: abnormal operating cash flows, which are estimated as the deviations from the predicted values from the following industry-year regression (residualε). it ti it ti it titi it assets salesh assets salesh assets h assets cfo ε+δ++= −−−− 1, 3 1, 2 1, 1 1, 1 (3a) where cfo=operating cash flows, assets=total assets, sales=annual net sales, δsales = change in net sales. (2)aprodit: abnormal production costs, which are estimated as the deviations from the predicted values from the following industry-year regressions (the sum of residuals in (3b) and (3c)). it ti it titi it asset salesh assets h assets cogs ε++= −−− 1, 2 1, 1 1, 1 (3b) it ti ti ti it titi it assets sales h assets salesh assets h assets inv ε+ δ +δ+=δ − − −−− 1, 1, 3 1, 2 1, 1 1, 1 (3c) where cogs= costs of goods sold, δinv= the change in inventories during the year. (3)adisxit: abnormal discretionary expenses (residualε). we first model discretionary expenses as a function of lagged sales and estimate the following model to derive normal levels of discretionary expenses, and then obtain residuals in the following industry-year regression. it ti ti titi it assets sales h assets h assets disx ε++= − − −− 1, 1, 2 1, 1 1, 1 (3d) where disxit= discretionary expenses during the year, and are defined as the sum of advertising expenses, r&d expenses and sg&a expense. discretionary accruals (pdem)：pdem is accrual-based earnings management. hribar and 12 roychowdhury (2006) and cohen and zarowin (2010) use the real earnings management model followed by dechow et al. (1998). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 241 collins (2002) find that studies using a balance sheet approach to test for earnings management are potentially contaminated by measurement error in accruals estimates. therefore, they measure accruals directly from cash flows statement. we calculate the accrual-based earnings management (pdem) based on the model adapted from ball and shivakumar (2006, 2008). the measures are as follows:13 (4a) jtjtjtjtjtjtjt cfodcfogdcfogcfogfassetgsalesggndac ∗++++δ+= 543210  (4b) jtjtjt ndactacdac −= (4c) where tacit is total accruals (actual accruals) for firm i in year t, cfoit is operating cash flow, △salesit is the change in sales, and fassetit is book value of fixed assets (all above variables are scaled by beginning total assets). dcfoit takes the value 1 if cfoit <0 and 0 otherwise. ndacjt is nondiscretionary accruals (normal accruals). dacjt is discretionary accruals (abnormal accruals) for firm j in year t, which is computed as the difference between the actual accruals and estimated normal accruals. pdem is the absolute value of dacit. financing type (finanj, j =1, 2, 3): j=1 represents a dummy variable and takes the value of 1 if the firm issues bonds and 0 otherwise; j=2 is a dummy variable and sets 1 if the firm issues seos and 0 otherwise; j=3 is a dummy variable and sets 1 if the firm issues bonds or seos and 0 otherwise. dummy variable of earnings management (temj, j =d, r, t): tem_d= 1 if the firm’s accrual-based earnings management is higher than the industry-year median and 0 otherwise. tem_r= 1 if the firm’s real earnings management is higher than the industry-year median and 0 otherwise. tem_t= 1 if the firm performs accruals or real earnings management and 0 otherwise. corporate governance variables board size (brdsiz): there are more independent directors with business knowledge or financial experience when the board size is larger, thus they can restrain earnings management behavior (xie et al. 2003). brdsiz is measured by the natural logarithm of the number of directors on the board. ratio of independent directors (indedr)14: independent directors can facilitate to effectively restrain earnings management (xie et al. 2003). indedr is measured by the percentage of independent directors to the total number of directors. shareholdings of managers (mshahd): managers have the incentives to engage in earnings management because their wealth is closely linked to the firm’s stock price (bartov and mohanram, 2004; ronen, tzur, and yaari, 2006). mshahd is measured by the shareholdings of directors, supervisors and managers divided by total shareholding at 13 this paper firsts estimate the parameters 1g , 2g , 3g , 4g and 5g in equation (4a) using the industry-specific regression. in robustness check, section 4.5.3, the model parameters 1g , 2g , 3g , 4g and 5g are estimated using contemporaneous data of non-offering firms in the same industry. 14 we measure the indedr variable by calculating the number of independent directors on market observation post system (m.o.p.s) which was set up by the taiwan stock exchange inc. & gre tai securities market, 2002. independent directors in taiwan require fitting independent director criteria to follow company law and securities law. itititititititit cfodcfogdcfogcfogfassetgsalesggtac ε+∗++++δ+= 543210 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 242 year-ending. shareholdings of institutional investors (inst): there are increased incentives to conduct earnings management when the shareholding of institutional investors is increasing (rajgopal and venkatachalam, 1997). big 4/non-big 4 indicator variable (big4): francis, maydew, and sparks (1999) find that large audit firms are more independent than small audit firms, and they can restrain the manipulation of discretionary accruals. big4 is a dummy variable and sets to 1 if financial statements of company are audited by big4 firms and 0 otherwise. auditor change indicator variable (cpachg): johnson et al. (2002) indicate that the audit quality is low as the company changes auditor. cpachg is a dummy variable and sets to 1 if the company has changed independent auditor in current or prior period and 0 otherwise. industry specialist/non-specialist indicator variable (speaud): the industry market shares are used to classify auditors as industry specialists/non-specialists. chen, moroney and houghton (2005) find a higher proportion of non-executive directors on an audit committee have a positive association with the quality of the audit firm used. audit quality is proxied by industry specialization. a market share based measure of auditor industry specialization is from hogan and jeter (1999) and based on total assets for audited company. the market share (ms) of industry i which is audited by auditor k can be calculated as follows:   = = == i ik ijk ik ijk ki k i j j j j a a ms 1 1 1 (5) where msik = market share of audit firm k in industry i; i = 1, 2,…,i, industry code of listed company (client); j=1,2,…,j, code of listed company(client); k=1,2,…,k, code of accounting (audit) firm; ki = number of accounting firms in industry i; aijk = total assets for client j of audit firm k in industry i. how to decide the auditor is classified as an industry specialist, many researchers have examined the issue of auditor specialization or concentration in a variety of contexts. craswell, francis, and taylor (1995) and ferguson and stokes (2002) define an industry specialist as the market share of audit firms is at least 10% (or 20%), and there is more than 30 firms in this industry. but casterella et al. (2004) adopt 20% cutoff. another threshold of measuring an industry specialist is to use the industry ranking. palmrose (1986), and ferguson and stokes (2002) suggest the auditor has the largest market share is an industry specialist, and ferguson, francis and stokes (2003) suggest the largest and the second largest market share are the industry specialists. hogan and jeter (1999), and defond, francis, and wong (2000) suggest the top three firms in the market share ranking list are the industry specialists. this study employs the two thresholds for measuring whether an audit firm is an industry specialist. one threshold is the market share of the audit firm is more than 20% and more than 30 firms in an industry. if less than 30 firms in an industry, then we choose the auditor who has largest and the second largest market share to be industry specialists, total market asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 243 share is over 20%. the specialist auditor (speaud) is a dummy variable, and takes the value of 1 if financial statements of company are audited by industry specialist auditor and 0 otherwise. corporate governance composite index (gi): gi that comes from principal component analysis.15 in order to drive a comprehensive measure for corporate governance, we use the principal components analysis (pca) to extract the first principal component as the corporate governance index. we construct a comprehensive corporate governance metric gi that first incorporates ceo duality, shareholdings of directors and supervisors, shareholdings of blockholders, shareholdings of managers, shareholdings of outside investors (=shareholdings of individual investor + shareholdings of unlisted firm + shareholdings of foundation + shareholdings of listed firm), shareholdings of ultimate controller, shareholdings of natural persons, shareholdings of institutional investors, equity pledge ratio of directors and supervisors, the seats of directors and supervisor, the ratio of the seats of managers to the seats of directors and supervisors, the ratio of the seats of outsiders to the seats of directors and supervisors, the seats of independent directors, the change times of cpa during three years, big 4 auditor, and industry expert. next, we use the pca to extract the first principal component as a comprehensive corporate governance variable. the extraction of the common component using pca and construction of the index is a parsimonious way to capture corporate governance, and it reduces the measurement error associated with using the individual measure. control variable in general, the higher the profitability of a corporation is or the better the operating performance is, the higher the return on assets will be. thus, managers will not conduct upward earnings management. bowen, ducharme, and shores (1995) found that managers will not conduct upward earning management when the return on assets is higher. the larger the corporate size is, the higher the possibility of accounting manipulation will be (jeong and rho, 2004). the market-to-book ratio can show corporate growth. the company with higher growth opportunities has more discretionary accruals than do corporations with fewer growth opportunities. in addition, fields, lys, and vincent (2001) and cohen and zarowin (2010) use return on assets (roa), company size (size) and market-to-book ratio (mb) as control variables to control profitability, scale, and growth because these factors affect earnings management. hence, our control variables include systematic risk, company size, market-to-book ratio, 15 the estimation of pca coefficients and the computation of a composite corporate governance index are conducted as follows: gi= ceo duality×0.058 + shareholdings of directors and supervisors×(-0.119) + shareholdings of blockholders×0.474 + shareholdings of manager×0.055 + shareholding of outside investors (=shareholdings of individual + shareholdings of unlisted firm + shareholdings of foundation + shareholding of listed firm)×0.372 + shareholdings of ultimate controller×(-0.179) + shareholding of natural persons×(-0.270) + shareholding of institutional investors×0.270 + equity pledge ratio of directors and supervisors×(-0.032) + seats of directors and supervisors×(-0.126) + ratio of the seats of managers to the seats of directors and supervisors ×0.039 + ratio of the seats of outsiders to the seats of directors and supervisors×0.018 + seats of independent directors×0.028 + change times of cpa during three years×0.060 + big 4 auditor×0.016 + industry expert×(-0.024). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 244 stock returns, and volatility of stock returns. the measurements are as follows. market systematic risk (beta) is measured by capm model. return on assets (roa) is earnings before interest but after taxes divided by average assets. company size (size) is the natural log of year-end total assets. (mb) is measured by market value of net assets divided by book value of equity. stock return (return) is return on current annul stock price. volatility or stock returns (stanret) is standard deviation of current, lagged 1 and lagged 2 stock returns. 4. empirical results 4.1 descriptive statistics table 3 summarizes the descriptive statistics of all variables. in panel a, the number of samples is 5,916 for h1 and h2. the means of accrual-based earnings management (pdem) and real earnings management (rem) are both positive during the current and previous periods. on average, sample companies manage earnings upward. tem_r and tem_d represent the dummy variables of real and accrual-based earnings managements, respectively. the value is 1 when each type’s earnings management value of the sample companies is greater than the median value in the industry; otherwise, the value is 0. this paper chooses to use medians instead of means, to avoid the influence of extreme values. according to the means in table 3, 81.35% of the sample company-years are engaged in earnings management, 50.08% of the samples are engaged in real earnings management, 49.13% are engaged in accrual-based earnings management. this means some sample companies are engaged in both real and accrual-based earnings managements. meanwhile, variables big4, cpachg, and speaud denote whether auditors are big 4, whether auditors have been changed, and whether auditors are industry specialist. the table shows that 81.48% of the sample companies are audited by big 4, and 28.28% has ever changed the auditors, which sample size is small that there may be bias in measurements. about 36.66% of the samples are audited by industry specialist auditors. panel b shows the samples for h3, and focuses on only financing firms. there are 521 and 222 sample company-years from the issue of bonds and seos, respectively. there are 56 samples issuing bonds and seos during the same year. the study does not eliminate these samples, as the purpose is to explore the relationship between financing companies and real earnings management.16 the means of variables tem_d (accrual-based) and tem_r (real activities) are 0.5514 and 0.5014, indicating 55.14% and 50.14% of the financing companies are engaged in accrual-based and real earnings managements, respectively. these figures are higher than the means of tem_d and tem_r (50.08% and 49.13%) in panel a, and suggest that the sample companies are motivated for earnings management as performing financing. 16 however, if the purpose is to examine the relationship between financing policies and real earnings management, these samples should be eliminated. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 245 table 3. descriptive statistics variable mean median minimum maximum sta. dev. panel a: h1 and h2 (n=5,916) finan3 0.1250 0.0000 0.0000 1.0000 0.3308 pdem 0.0574 0.0425 0.0000 0.2204 0.0512 rem 0.0017 0.0152 -3.0414 1.5327 0.2050 tem_t 0.8135 1.0000 0.0000 1.0000 0.3896 tem_r 0.5008 1.0000 0.0000 1.0000 0.5000 tem_d 0.4913 0.0000 0.0000 1.0000 0.5000 beta 0.8335 0.8531 -2.7545 3.2931 0.3613 roa 0.0468 0.0514 -1.0577 0.5310 0.1124 size 15.1191 14.9476 11.5533 20.5411 1.3269 mb 0.6259 0.6319 -0.1696 0.9873 0.1697 brdsize 9.4567 9.0000 1.0000 26.0000 2.3430 indedr 0.1466 0.1000 0.0000 0.7500 0.1592 mshahd 0.2212 0.0285 0.0123 1.0000 0.1394 inst 0.3459 0.3067 0.0001 1.0000 0.2192 big4 0.8148 1.0000 0.0000 1.0000 0.3885 cpachg 0.2828 0.0000 0.0000 1.0000 0.4504 speaud 0.3666 1.0000 0.0000 1.0000 0.4819 invsmill 0.0097 0.3190 -1.8658 0.6243 0.6816 gi -0.6000 -2.6017 -42.0724 61.9745 15.8036 panel b: h3 (n=687) roat+1 0.0468 0.0531 -0.7741 0.5310 0.1072 tem_d 0.5514 1.0000 0.0000 1.0000 0.4977 tem_r 0.5014 1.0000 0.0000 1.0000 0.5003 beta 0.9206 0.9467 -1.1083 1.8471 0.3471 size 15.5484 15.2064 12.5916 20.5411 1.5488 mb 0.5673 0.5713 0.1237 0.9804 0.1374 return 0.2752 0.0039 -0.8524 10.2532 1.0595 stanret 0.5192 0.4049 0.0028 3.4323 0.4732 note: the definitions of variables are: finan3= a dummy variable and takes the value of 1 if the company issues bonds or seasoned equity offerings, and 0 otherwise; pdem=accruals-based earnings management; rem=real earnings management; tem_t= a dummy variable and takes the value of 1 if the company performs accruals or real earnings management, and 0 otherwise; tem_r= a dummy variable and takes the value of 1 if the company’s real earnings management is higher than median of its industry, and 0 otherwise; tem_d= a dummy variable and takes the value of 1 if the company’s accruals-based earnings management is higher than median of its industry, and 0 otherwise; beta=market systematic risk; roa=return on assets; size=company size; mb=market-to-book ratio; brdsize=board size measured by the natural logarithm of the number of directors on the board; inderdr =ratio of independent directors; mshahd=percentage of shareholdings of managers; inst=percentage of shareholdings of institutional investors; big4＝a dummy variable and takes the value of 1 if financial statements of company are audited by big 4 accounting firms, and 0 otherwise; cpachg= a dummy variable and takes the value of 1 if the company has changed its independent auditor, and 0 otherwise; speaud= a dummy variable and takes the value of 1 if financial statements of company are audited by industry specialist auditor, and 0 otherwise; invsmill=the inverse mills’ ratio that is generated from the first stage based on heckman’s two-step estimation procedure (heckman,1978); return=return on current stock price; stanret=standard deviation of current, lagged 1 and lagged 2 stock returns. 4.2 financing policy and earnings management tools table 4 shows the results of a mean difference test of earnings management tools used for the issuance of corporate bonds and seos. this paper divides real earnings management tools asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 246 into abnormal cash flows (acfo), abnormal production costs (aprod), and abnormal discretionary expenses (adisx). according to table 4, acfo values are all negative; when a company intends to use real earnings management, firms may relax credit terms for customers or provide discounts to boost revenues; this explains why abnormal cash flows will be lower. abnormal production costs result from a change in inventory and cost of goods sold. most of aprod values are positive because manufacturers can lower the allocated fixed costs per unit and therefore the cost of goods sold by overproducing. according to gaap, if the production quantities are larger than the quantities sold, the net profit will be higher under absorption costing. real earnings management in the form of production cost manipulation leads to abnormally high production costs. finally, all adisx values are negative because companies can increase recognized earnings by lowering discretionary expenses. because abnormal cash flows, abnormal production costs, and abnormal discretionary expenses have different signs, this paper first multiplies both acfo and adisx by minus 1, and then sums acfo, adisx and aprod to measure real earnings management (rem). the higher the rem values, the higher the degree of involvement in real earnings management. the results show that once the financing firms adopt accrual-based earnings management (pdem), the means of discretionary accruals between bonds issues and seos are significantly different during the pre-financing years (year -1, -2, -3, and -4) and post-financing years (year +1 and +2). there is no significant difference in the issuing year of the financing and year +3. it reveals that firms’ choose accrual earnings management based on different financing policy except the financing year and year +3. on the other hand, once the financing firms adopt real earnings management (rem), the means of real earnings management between bonds issues and seos are significantly different in the financing year, year -1 and -3. it reveals that firms will choose real earnings management depending on different financing policy during the financing year, year -1 and year -3. overall, firms choose different earnings management tools depending on whether they issue corporate bonds or seos on the first year before financing. that is, firms choose the earning management tools in advance in year -1. the magnitudes of accrual-based earnings management (bonds issues is 0.0664 and seos is 0.0730) in the issuing year for financing firms are higher than the magnitudes in the pre-financing periods, indicating that upward earnings management might be one of the motives for firms to finance successfully. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 247 table 4. mean difference test for earnings management of bonds and seos variable year mean of bonds issues means of seos difference of earnings management tools mean t test p value pdem -4 0.0593 0.0715 -2.3174 0.0211 ** -3 0.0618 0.0727 -2.0763 0.0387 ** -2 0.0634 0.0762 -2.4852 0.0134 ** -1 0.0657 0.0717 -1.8942 0.0585 * 0 0.0664 0.0730 -1.2636 0.2067 1 0.0666 0.0758 -1.7885 0.0742 * 2 0.0644 0.0744 -2.0817 0.0378 ** 3 0.0629 0.0687 -1.1963 0.2319 rem -4 0.0239 0.0536 0.9300 0.3554 -3 0.0194 -0.0147 -2.1623 0.0312 ** -2 -0.1120 -01020 0.5568 0.5779 -1 -0.0002 -0.0261 -1.8969 0.0584 * 0 -0.0043 -0.0389 -2.2612 0.0240 ** 1 0.0387 0.0339 -0.3215 0.7479 2 0.0333 0.0250 -0.7362 0.4620 3 0.0273 0.0111 -1.5752 0.1160 acfo -4 -0.0125 0.0124 1.3214 0.1874 -3 -0.0054 -0.0240 -1.7328 0.0854 * -2 -0.0772 -0.0635 1.1251 0.2611 -1 -0.0178 -0.0204 -0.2267 0.8208 0 -0.0205 -0.0285 -0.7819 0.4345 1 -0.0175 -0.0253 -0.0078 0.5046 2 -0.0082 -0.0006 1.0347 0.3014 3 -0.0069 -0.0061 0.1161 0.9076 aprod -4 0.0274 0.0353 0.4315 0.6664 -3 0.0168 0.0025 -1.2166 0.2245 -2 -0.0468 -0.0458 0.0862 0.9314 -1 0.0090 -0.0059 -1.4365 0.1522 *** 0 0.0112 -0.0036 -1.2764 0.2025 1 0.0360 0.0242 -1.1266 0.2603 2 0.0290 0.0224 -0.6906 0.4902 3 0.0254 0.0115 -1.6347 0.1029 adisx -4 -0.0097 -0.0111 -0.3626 0.7171 -3 -0.0078 -0.0056 0.5869 0.5576 -2 -0.0101 -0.0073 0.9233 0.3563 -1 -0.0077 -0.0050 0.9535 0.3407 0 -0.0066 0.0023 3.3363 0.0009 *** 1 -0.0108 -0.0053 2.1155 0.0347 ** 2 -0.0119 -0.0047 2.9055 0.0038 *** 3 -0.0083 -0.0066 0.6973 0.4858 note: 1. total sample of issuing corporate bonds is 562 and total sample of issuing seasoned equity offerings is 238. 2. pdem=accruals-based earnings management, rem=real earnings management; acfo=abnormal cash flows, aprod=abnormal production costs, adisx=abnormal discretionary expenses. 3. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 248 4.3 internal control, audit quality and real earnings management this paper runs the two-stage model to control for the self-selection of earnings management. the first stage explains whether financing firms will adopt earnings management, whereas the second stage examines the correlation between corporate governance and real earnings management. according to the empirical results shown in table 5, the coefficient of invsmill is significantly positive, which indicates that financing firms are engaged in earnings management. h2 examines the effects of corporate governance and external monitoring on real earnings management. corporate governance is measured with proxy variables, such as board sizes (brdsiz), percentage of independent directors (indedr), shareholdings of managers (mshahd), and shareholdings of institutional investors (inst). external monitoring (that is, audit quality) is measured with proxy variables, such as big 4 accounting firms (big4), changes of auditors (cpachg), and auditing by industry experts (speaud). in addition, we use the principal components analysis (pca) to extract the first principal component as the corporate governance proxy variable. this paper explores the effects of corporate governance and external monitoring on real earnings management of firms conducting financing activities. all the samples total 5,916 firm-years, but the number of the samples for financing firms is only 739. panel a of table 5 shows that effective corporate governance (as presented by “indedr” and “inst”) can effectively control the engagement in real earnings management. all the variables concerning external monitoring show a negative relationship when financial statements are audited by big 4 (big4) and when the companies are audited by industry experts (speaud). this suggests that auditing by the big 4 and industry experts may control engagement in real earnings management. conversely, the results of whether accountants have been changed (cpachg) is not statistically significant. if we compare full sample to subsample with financing, we find the effect that corporate governance restrain real earnings management declines only when firms’ share hold by institutional investors (inst) and when the companies are audited by industry experts (speaud) with both seos and bond issuing firms taken into consideration. these findings reveal that when managers suffer capital needs, they are more likely to manipulate real earnings management, although it might cause severe economic consequences in later periods. also, they are less likely to restrain real earnings management from corporate governance at the same time. however, regardless of full sample or financing subsample, the composite corporate governance index gi is negatively related to rem, implying that firms with poor corporate governance are more likely engaged in real earnings management. this paper further reclassifies real earnings management into three components, namely, abnormal operating cash flows (acfo), abnormal production costs (aprod), and abnormal discretionary expenses (adisx) (the sign direction of acfo and adisx are different from aprod), to investigate the relationships among these components and corporate governance factors. the findings show that ratio of independent directors (indedr), shareholdings of institutional investors (inst), and big4 can restrain three components of real earnings asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 249 management in the full sample. we also find that the variables of suppressing real earnings management decline in financing sample. results on panel b in the subsample of financing, board size (brdsiz), shareholdings of institutional investors (inst), and big4 can suppress abnormal operating cash flows (acfo), but the ratio of independent directors (indedr) can’t, compared to full sample. results on panel c, shareholdings of institutional investors (inst) and audit by industry specialist (speaud) can suppress abnormal production costs (aprod) in the financing sample, but the ratio of independent directors (indedr) can’t, compared to full sample. results on panel d in the subsample of financing, all variables of corporate governance factor and audit quality are unrelated to abnormal discretionary expenses (adisx). on the other hand, the composite corporate governance index gi is significantly negatively related to aprod, but is unrelated to acfo and adisx in financing subsample. however, gi is significantly related to all three components of real earnings management in full sample. it reveals that corporate governance of firms can restrain real earnings management, but the effect decline when firms engaged in financing activities. meanwhile, corporate governance cannot effectively control financing firms to manipulate real earnings through abnormal discretionary expenses. table 5. internal control, audit quality and real earnings management ititititititit indusmbsizeroabetafinanttem εαααααα +++++++= 543210 3_ itititit itititititit invsmillspeaudcpachg biginstmshahdindedrbrdsizerem εβββ ββββββ ++++ ++++= + 876 543210 4 ititit invsmillgirem εβββ +++= 210 panel a dependent variable=rem variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0019 0.6856 0.1115*** 8.2300 0.0342*** 3.9601 0.1241*** 2.8067 gi -0.0014*** -7.9351 -0.0016*** -2.7222 brdsize -0.0006 -0.4991 -0.0040 0.9927 indedr -0.1623*** -9.1953 0.0381 0.6984 mshahd 0.0009 0.0438 0.0261 0.3415 inst -0.1197 *** -8.5842 -0.1279*** -2.8845 big4 -0.0396*** -5.1028 0.0007 0.0286 cpachg + 0.0050 0.8002 -0.0023 -0.1180 speaud -0.0195*** -3.1785 -0.0437** -2.3389 invsmill ? 0.0178*** 4.2987 0.0202 *** 4.9452 0.0034 -0.2537 -0.0036 -0.2718 samples 5,916 5,916 739 739 adjusted r2 0.013 0.03945 0.008 0.017 f value (p value) 38.949 (<.0001) 35.814 (<.0001) 3.805 (<.05) 2.630 (<.01) panel b dependent variable=acfo variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0005 -0.3288 -0.0533*** -6.9000 -0.0249*** -4.5614 -0.0884*** -3.1729 gi + 0.0006*** 6.0298 0.0005 1.3726 brdsize + 0.0014** 2.0260 0.0016* 0.6301 indedr + 0.0372*** 3.7041 0.0604 -1.7586 mshahd + 0.0033 0.2683 0.0373 0.7742 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 250 inst + 0.0479*** 6.0568 0.0522* 1.8682 big4 + 0.0186*** 4.2214 0.0286* 1.7537 cpachg 0.0015 -0.4292 0.0051 0.4114 speaud + 0.0043 1.2182 0.0135 1.1458 invsmill ? 0.0261*** 11.1945 0.0254*** 10.9766 0.0372*** 4.4171 0.0373*** 4.4324 samples 5,916 5,916 739 739 adjusted r2 0.028 0.039 0.027 0.042 f value (p value) 84.845 (<.0001) 31.271 (<.0001) 11.183 (<.0001) 5.024 (<.0001) panel c dependent variable=aprod variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0011 0.5835 0.0507*** 5.3815 0.0061 1.0009 0.0371 1.1769 gi -0.0007*** -5.9788 -0.0010** -2.4273 brdsize 0.0007 0.8462 -0.0027 -0.9527 indedr -0.1005*** -8.2041 -0.0168 -0.4324 mshahd -0.0115 -0.7629 0.0498 0.9153 inst -0.0645*** -6.6708 -0.0707** -2.2374 big4 -0.0136** -2.5293 0.0275 1.4920 cpachg + 0.0030 0.6908 0.0013 0.0931 speaud -0.0157*** -3.6777 -0.0277** -2.0801 invsmill ? 0.0267*** 9.3397 0.0282*** 9.9585 0.0183* 1.9395 0.0181* 1.8990 samples 5,916 5,916 739 739 adjusted r2 0.019 0.041 0.009 0.010 f value (p value) 58.570 (<.0001) 32.365 (<.0001) 4.516 (<.0001) 1.896 (<.1) panel d dependent variable=adisx variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0005 -1.0883 -0.0074*** 2.9979 0.0032** -2.5362 0.0015 0.2289 gi + 0.0001** 2.5431 0.0001 -0.9599 brdsize + 0.0001 0.5727 0.0003 0.5823 indedr + 0.0233*** 7.3031 0.0050 0.6147 mshahd + -0.0106*** 2.7037 0.0132 -1.1603 inst + 0.0066*** 2.6041 0.0050 0.7631 big4 + 0.0064*** 4.5341 0.0018 0.4600 cpachg 0.0004 0.3819 0.0017 0.5730 speaud + 0.0003 0.2766 0.0025 0.8806 invsmill ? -0.0167*** -22.5423 -0.0169*** -22.9783 -0.0153*** -7.7726 -0.0154*** -7.7420 samples 5,916 5,916 739 739 adjusted r2 0.079 0.092 0.074 0.069 f value (p value) 254.914 (<.0001) 76.053 (<.0001) 30.291 (<.0001) 7.814 (<.0001) note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. to compare the effects of corporate governance on the two different earnings management methods, this paper adopts discretionary accruals (pdem) as the dependent variable to examine the relationship between accrual-based earnings management and corporate governance factors. table 6 shows that percentage of independent directors (indedr), shareholdings of institutional investors (inst), changes of auditors (cpachg), and auditing by industry experts (speaud) can restrain managers from manipulating accrual-based earnings asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 251 management for the full sample. in the financing subsample, both percentage of independent directors (indedr) and shareholdings of institutional investors (inst) are negatively related to pdem, implying that financing firms with higher percentage of independent directors and higher shareholdings of institutional investors are less likely to engage in accrual-based earnings management. moreover, regardless of full sample or financing subsample, the composite corporate governance index gi is negatively related to pdem, indicating that firms with poor corporate governance are more likely to engage in accrual-based earnings management. table 6. internal control, audit quality and accruals itititit itititititit invsmillspeaudcpachg biginstmshahdindedrbrdsizepdem εβββ ββββββ ++++ ++++= + 876 543210 4 itititit invsmillgipdem εβββ +++= 210 variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept 0.0023** 2.3656 0.0251*** 5.4523 -0.0096*** -3.2204 0.0175 1.1533 gi -0.0004*** -7.3271 -0.0006*** -3.0400 brdsize 0.0000 0.0752 -0.0003 0.1978 indedr -0.0456*** -7.6166 -0.0515*** 2.7547 mshahd 0.0118 1.6027 0.0385 1.4681 inst -0.0463*** -9.8045 -0.0557*** 3.6640 big4 0.0031 -1.1806 0.0009 0.1066 cpachg + 0.0063*** 3.0082 0.0025 -0.3756 speaud -0.0067*** -3.1912 0.0104 -1.6174 invsmill ? -0.0324*** -23.1468 -0.0317*** -22.8938 -0.0420*** -9.1921 -0.0405*** -8.8393 samples 5,916 5,916 739 739 adjusted r2 0.093 0.115 0.115 0.127 f value (p value) 305.082 (<.0001) 97.133 (<.0001) 49.095 (<.0001) 14.369 (<.0001) note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. we order the empirical result in tables 5 and 6 to table 7, and it reveals brdsize and mshahd cannot restrain earning management in taiwan because of many family owned firms. the right to operate and own a business is not separate. company executive officers are a part of the family or the insider. in 2002, the listing rules of taiwan stock exchange (tse) and taiwan’s computerized over-the-counter market (gtsm) have made amendment so that every public company applying for listing should have at least two independent directors and one independent supervisor. the january 2006 amendment of securities & exchange act provides an alternative system that replaces supervisors with audit committee system. the effects seem to work out. our empirical result reveals that indedr and inst can control accrual and real earning management effectively in all sample. both of them can control accrual earnings management in financing subsample. however, they cannot control real earnings management effectively. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 252 table 7. corporate governance variables and manipulating earnings management pdem rem all sample financing sample all sample financing sample variable pdem pdem acfo aprod adisx acfo aprod adisx brdsize x x x x x x x x indedr v v v v v x x v mshahd x x x x v x x x inst v v v v v v v x note: 1. the definitions of all variables are the same as those in table 3. 2. “v” means the variable can restrain accrual or real earnings management. 3. “x” means the variable cannot restrain accrual or real earnings management. 4.4 earnings management tool and future performance h3 examines whether the adoption of different earnings management tools by financing firms affects their post-financing operating performances. the number of financing firms is 687 and includes 521 samples from the issuance of corporate bonds and 222 samples from the issuance of seasoned equity offerings; thus, the sample number of corporate bond and seasoned equity offering issues concurrent in the same year during the research period is 56. we do not delete the samples that issue both corporate bonds and seasoned equity offerings concurrently in the same year because we want to investigate the relationship between the firms with financing and real earnings management. if the purpose were to investigate the relationship between different financing policies and real earnings management, then we would delete 56 observations to avoid noise. this paper also examines the effect of adopting earnings management tools on the post-financing operating performances (roa), which include 5,614 total samples. according to all the samples in table 8, there is a negative relationship between both real earnings management (tem_r) and accrual-based earnings management (tem_d) and operating performance (roa) in financing year +1 and +2. it constantly affects two years. moreover, it reports significant negative relationship of tem_r in year +3. even if firms have no financing activities, the engagement of real earnings management is detrimental to firm value. therefore, h3 is supported, which is consistent with graham et al. (2005) and roychowdhury (2006), by the fact that real earnings management affects cash flows and causes severe economic consequences. in addition, the results on financing subsamples in panel a of table 8 show that operating performance (roa) are negatively related to real earnings management (tem_r) in financing year +1 and +2, but are unrelated to accrual-based earnings management (tem_d). this implies that managers may increase income by reducing research, development expenses, cut prices to boost sales, and overproduce to deduct cogs expenses during the financing year. after that, the operating performance of the company will decrease for the following two years. as shown on panel b, we also distinguish between bond issuers and seo firms in the multivariate test. it reveals that operating performance (roa) will decrease in the bonds financing year +1 to +2, when firms conduct real earnings management in bonds issuing year. however, there is no significant relationship between accrual-based earnings management asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 253 (tem_d) and operating performance after bonds or seo financings. firms issue bonds and engage in the real earnings management to avoid frequent outside monitoring by investors, cpa or government in bond issuing year. and then, it also causes operating performance to decline continuously two years after bond financing. table 8. earnings management and future performance ititititititititit returnmbsizebetartemdtemroa εββββββββ ++++++++=+ stanret __ 765432101 panel a variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.2658 *** -14.2409 -0.1944 *** -4.2792 tem_d -0.0057 ** -2.0370 -0.0042 -0.5228 tem_r -0.0184 *** -6.5220 -0.0250 *** -3.1108 beta -0.0218 *** -4.6877 -0.0101 -0.7807 size + 0.0163 *** 13.6933 0.0100 *** 3.6607 mb + 0.1340 *** 15.8748 0.1831 *** 6.2378 return + 0.0038 *** 2.7669 -0.0041 -0.9462 stanret 0.0130 *** 3.9257 0.0102 1.1303 samples 5,614 687 adjusted r2 0.072 0.068 f value (p value) 63.005 (<.0001 ) 8.180 (<.0001) panel b variable expected sign seos sample bond sample coefficient t value coefficient t value intercept -0.3538 ** -2.5864 -0.1936 *** -4.0913 tem_d -0.0117 -0.7334 -0.0024 -0.2657 tem_r -0.0183 -1.1465 -0.0317 *** -3.5192 beta -0.0051 -0.2003 -0.0166 -1.1193 size + 0.0193 ** 2.3059 0.0099 *** 3.4701 mb + 0.2036 *** 3.8801 0.2015 *** 5.4103 return + -0.0114 -1.3048 -0.0009 -0.1859 stanret 0.0138 0.8054 0.0082 0.8066 samples 222 521 adjusted r2 0.051 0.076 f value (p value) 2.690 (<.05 ) 7.117 (<.0001 ) ititititititititit returnmbsizebetartemdtemroa εββββββββ ++++++++=+ stanret __ 765432102 panel a variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.1885 *** -10.1789 -0.0841 * -1.8415 tem_d -0.0060 ** -2.1297 0.0006 0.0713 tem_r -0.0134 *** -4.7835 -0.0157 * -1.9416 beta -0.0235 *** --5.1029 -0.0097 -0.7464 size + 0.0129 *** 10.8889 0.0049 * 1.7958 mb + 0.0987 *** 11.7894 0.1165 *** 3.9474 return + -0.0058 *** -4.2385 -0.0129 *** -2.9801 stanret 0.0058 * 1.7712 -0.0011 -0.1226 samples 5,607 689 adjusted r2 0.043 0.031 f value (p value) 36.616 (<.0001 ) 4.110 (<.0001 ) panel b asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 254 variable expected sign seos sample bond sample coefficient t value coefficient t value intercept -0.1850 -1.3989 -0.0854 * -1.8579 tem_d -0.0141 -0.9147 0.0060 0.6848 tem_r -0.0183 -1.1868 -0.0162 * -1.8483 beta -0.0030 -0.1216 -0.0168 -1.1626 size + 0.0111 1.3671 0.0046 * 1.6572 mb + 0.1202 ** 2.3691 0.1409 *** 3.8936 return + -0.0223 *** -2.6501 -0.0094 ** -2.0505 stanret 0.0106 0.6402 -0.0018 -0.1829 samples 222 521 adjusted r2 0.026 0.033 f value (p value) 1.857 (<.1 ) 3.550 (<.001 ) titititititititit returnmbsizebetartemdtemroa εββββββββ ++++++++=+ stanret __ 765432103 panel a variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.1655 *** -8.8126 0.0101 0.2135 tem_d -0.0041 -1.4388 -0.0035 -0.4172 tem_r -0.0140 *** -4.9245 -0.0136 -1.6361 beta -0.0327 *** -7.0004 -0.0267 ** -1.9879 size + 0.0119 *** 9.9487 0.0006 0.2105 mb + 0.0913 *** 10.7527 0.1011 *** 3.3207 return + -0.0068 *** -4.8277 -0.0214 *** -4.8010 stanret 0.0012 0.3621 -0.0010 -0.1082 samples 5,599 687 adjusted r2 0.041 0.057 f value (p value) 33.783(<.0001 ) 9.016 (<.0001 ) panel b variable expected sign seos sample bond sample coefficient t value coefficient t value intercept 0.0116 0.0938 0.0119 0.2463 tem_d -0.0080 -0.5529 -0.0007 -0.0788 tem_r -0.0198 -1.3704 -0.0146 -1.5841 beta 0.0227 0.9923 -0.0448 *** -2.9531 size + -0.0018 -0.2375 0.0011 0.3695 mb + 0.0944 ** 1.9903 0.1179 *** 3.0968 return + -0.0364 *** -4.6234 -0.0158 *** -3.2776 stanret -0.0100 -0.6487 0.0011 0.1038 samples 222 521 adjusted r2 0.098 0.042 f value (p value) 4.433 (<.0001 ) 4.278 (<.0001 ) note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. 4.5 robustness check 4.5.1 audit fee, non-audit fee and real earnings management according to our empirical finding from h2, among external monitoring variable, only firms audited by big 4 can restrain real earnings management by using acfo, aprod and adisx in full sample. therefore, we try to find out another external monitoring variable to constrain earnings manipulation. the audit fee is generally used as a proxy of audit quality. the u.s. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 255 securities and exchange commission believes that non-audit fees compromise the independence of auditors and the reliability of financial reports. also, non-audit fees increase capital costs of companies. larker and richardson (2004) find that the ratio of non-audit fees to total fees has a positive relation with the absolute value of accruals similar to frankel, johnson, and nelson (2002). frankel et al. (2002) find that non-audit fees are positively correlated to earnings management, and that audit fees are negatively correlated to earnings management. ferguson, seow, and young (2004) indicate that earnings management is positively associated with non-audit services purchase. after considering the endogenity, antle et al. (2006) find that there exist an endogenous relationship among abnormal accruals, audit and non-audit fees. srinidhi and gul (2007) find that accruals are negatively correlated to non-audit fees but are positively correlated audit fees. cahan et al. (2008) find that the growth of non-audit fees or the length of non-audit service period is unrelated to discretionary accruals. in other words, auditors and clients will have economic relations due to non-audit fees, and auditor independence will be impaired when the clients are important to the audit firms. due to the inconsistent results of prior studies, we use audit fee and non-audit fee to measure external monitoring and to further re-check the correlation among audit, non-audit fees and real earnings management before the announcement of financing for financing firms. according to article 10-4, criteria governing information to be published in annual reports of public companies, as released by the financial supervisory commission in taiwan, if the non-audit fees amount to more than 25% of audit fees payable to accounting firms, listed companies should disclose the amounts of audit fees and non-audit fees, as well as the details of audit services and non-audit services. not all the listed companies disclose audit fees and non-audit fees in taiwan, the number of financing samples is down to 185 for the validation. it includes 126 samples for the issuance of corporate bonds and 59 samples for the issuance of seasoned equity offerings. from all sample in table 9, there is a negative correlation between audit fees (audfee) and real earnings management (rem). this shows the higher the audit fees are, the less likely real earnings management is to be adopted, a result consistent with expectations, and therefore h2 is supported. the result is consistent with frankel et al. (2002), but inconsistent with srinidhi and gul (2007). there is a positive but insignificant correlation between non-audit fees (naudfee) and real earnings management. on the other hand, for financing subsample, there is also a negative correlation between audit fees (audfee) and rem, but not significant. the possible explanation for the result is that the number of samples for the validation is a few. besides, regardless of full sample or financing subsample, gi and inst are significantly and negatively related to rem, implying that the composite corporate governance index gi and shareholdings of institutional investors (inst) can control real earnings management effectively. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 256 table 9. audit fee, non-audit fee and real earnings management itititititititit itititititititit speaudcpachgbiginstmshahdindedrbrdsiz mbsizeroabetapdemnaudfeeaudfeerem εβββββββ ββββββββ ++++++++ +++++++= −− 141312111098 7654312110 4 ititit ititititititit mbsize roabetapdemnaudfeeaudfeegirem εββ βββββββ +++ ++++++= −− 87 654131210 variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept 0.0140 0.1819 -0.0355 -0.4033 0.1450 0.7200 0.0564 -0.2408 gi 0.0007** -2.2686 -0.0030** -3.0208 audfeet-1 0.0227 * -1.8868 -0.0237** -1.8972 -0.0260 -0.8196 0.0124 -0.3722 naudfeet-1 + 0.0038 1.0017 0.0033 0.8303 0.0110 0.9091 0.0150 1.1480 pdem 0.0915 1.0275 0.0790 0.8825 0.1181 0.5141 0.0878 0.3668 beta 0.0194 -1.1965 -0.0211 -1.2725 0.0543 1.2741 0.0749 1.5693 roa -1.1150 *** -19.6568 -1.1313*** -18.9540 -0.8020*** -5.0561 0.8075*** -4.9391 size + 0.0185*** 3.5222 0.0247*** 4.1143 0.0093 0.7042 0.0179 1.0678 mb ? -0.1094*** 3.3820 -0.1011*** -3.0923 -0.1819* -1.7571 -0.1403 -1.2720 brdsize -0.0024 -0.9799 -0.0051 -0.6576 indedr 0.0492 1.4616 0.0751 0.8108 mshahd 0.0312 0.7819 0.1650 1.3673 inst -0.0672** -2.4546 -0.2085*** -2.6100 big4 -0.0030 -0.1885 -0.0453 -0.9546 cpachg -0.0080 -0.6932 0.0382 1.1063 speaud -0.0020 -0.1886 -0.0003 -0.0093 samples 1,286 1,286 185 185 adjusted r2 0.295 0.295 0.213 0.195 f value (p value) 68.33 (<.0001) 39.337 (<.0001) 7.216 (<.0001) 4.177 (<.0001) note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. 4.5.2 degree of accruals and real earnings management h3 is to examine the post-financing operating performances after conducting different earnings management mechanism, in which earnings management mechanism is a dummy variable (tem_d, tem_r). this section uses pdem and rem instead of dummy variables (tem_d, tem_r). table 10 finds a significant negative relationship between real earnings management (rem) and operating performance in financing year +1 to +3, meaning that the firm performance will worse after financing. however, there is no significant relation between accrual-based earnings management (pdem) and post-financing operating performances. these results are the same in both full sample and financing subsample. we conclude that the erosion of post operating performance by manipulating real earnings management is more serious than manipulating accrual-based earnings management. these results are consistent with h3. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 257 table 10. degree of earnings management and future performance ititititititititit returnmbsizebetarempdemroa εββββββββ ++++++++=+ stanret 765432101 panel a variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.2724 *** -14.4413 0.0007 0.0143 pdem -0.0192 -0.6791 0.0153 0.2023 rem -0.0515 *** -7.3899 -0.0377 ** -2.0606 beta -0.0215 *** -4.6186 -0.0285 ** -2.1191 size + 0.0159 *** 13.3531 0.0006 ** 0.2261 mb + .0.1355 *** 16.0520 0.1019 *** 3.3487 return + 0.0038 *** 2.7789 -0.0213 *** -4.7879 stanret 0.0126 *** 3.8039 -0.0016 -0.1664 samples 5,614 687 adjusted r2 0.073 0.05 f value (p value) 64.309 (<.0001) 6.109 (<.0001) ittiititititititit returnmbsizebetarempdemroa εββββββββ ++++++++=+ stanret 765432102 panel b variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.1916 *** -10.2239 -0.0912 ** -1.9769 pdem -0.0338 -1.2046 0.0201 0.2733 rem -0.0283 *** -4.0850 -0.0301 * -1.6969 beta -0.0229 *** -4.9590 -0.0119 -0.9102 size + 0.0125 *** 10.5367 0.0049 * 1.7756 mb + 0.0993 *** 11.8357 0.1173 *** 3.9688 return + -0.0058 *** -4.2309 -0.0128 *** -2.9643 stanret 0.0057 * 1.7299 -0.0011 -0.1213 samples 5,607 687 adjusted r2 0.041 0.03 f value (p value) 35.254 (<.0001) 3.996 (<.0001) ititititititititit returnmbsizebetarempdemroa εββββββββ ++++++++=+ stanret 765432103 panel c variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.1680 *** -8.8441 0.0007 0.0143 pdem -0.0287 -1.0081 0.0153 0.2023 rem -0.0298 *** -4.2454 -0.0377 ** -2.0606 beta -0.0322 *** -6.8779 -0.0285 ** -2.1191 size + 0.0115 *** 9.6016 0.0006 0.2261 mb + 0.0919 *** 10.8029 0.1019 *** 3.3487 return + -0.0068 *** -4.8298 -0.0213 *** -4.7879 stanret 0.0011 0.3328 -0.0016 -0.1664 samples 5,599 687 adjusted r2 0.038 0.050 f value (p value) 32.723 (<.0001) 6.109 (<.0001) note: 1. pdem and rem substitute for tem_d and tem_r, respectively. 2. the definitions of all variables are the same as those in table 3. 3. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 258 4.5.3 matching method we follow the matching method of shivakumar (2000) and ball and shivakumar (2006, 2008) to use non-offering firms to measure accrual-based earnings management in equation (4a). the model parameters 1g , 2g , 3g , 4g and 5g are estimated from non-offering firms. we insert the model’s parameters of equation (4a) into (4b) to obtain expected accrual-based earnings management for offering firms. next, abnormal accruals for offering firm are computed as the difference between the actual accruals and expected accrual-based earnings management. therefore, this paper re-checks our hypothesis by using matching method. the untabulated result shows that once the financing firms adopt accrual-based earnings management which calculates by using matching method, the means of discretionary accruals between bonds issues and seos are significantly different during the financing year, pre-financing year (event year -1 to -4) and post-financing period (event year +1 to +3). it implies that firms choose accrual-based earnings management depending on different financing policy in the financing period from year -4 to +3. according to the empirical results shown in table 11, in full sample, ratio of independent directors (indedr), shareholdings of institutional investors (inst) and composite corporate governance variable (gi) are significantly related to three components (acfo, aprod and adisx) of rem, implying those can control real earnings management effectively. hence, h2 is supported in full sample. in financing subsample, although only board size (brdsiz) among corporate governance variables can restrain real earnings management, but gi is significantly negative to rem, implying that h2 is also supported in financing subsample. table 11. internal control, audit quality and real earnings management ititititititit indusmbsizeroabetafinanttem εαααααα +++++++= 543210 3_ itititit itititititit invsmillspeaudcpachg biginstmshahdindedrbrdsizerem εβββ ββββββ ++++ ++++= + 876 543210 4 ititit invsmillgirem εβββ +++= 210 panel a dependent variable=rem variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0020 0.7538 0.1108*** 8.7445 0.0273*** 3.5539 -0.0138 -0.4167 gi -0.0014*** -8.4501 -0.0017*** -3.1910 brdsize -0.0005 -0.4438 -0.0002** -0.0588 indedr -0.1619*** -9.8292 -0.0846 -2.0799 mshahd -0.0103 -0.5084 0.0757 1.3271 inst -0.1165*** -8.9755 -0.0122 -0.3680 big4 -0.0380*** -5.2560 0.0248 1.2773 cpachg + 0.0037 0.6460 0.0095 -0.6385 speaud -0.0164*** -2.8610 0.0207 -1.4863 invsmill ? 0.0366*** 10.1144 0.0235*** 6.1395 0.0232* 1.9411 0.0761*** 7.6136 samples 5,916 5,916 739 739 adjusted r2 0.027 0.050 0.014 0.073 f value (p value) 84.089 (<.0001) 40.291 (<.0001) 6.369 (<.0001) 8.281 (<.0001) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 259 panel b dependent variable=acfo variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.001 0.391 -0.0504*** -7.6015 -0.0178*** 4.2015 -0.0675*** -3.1157 gi + 0.001*** 8.044 0.0006** 2.1630 brdsize + 0.0011* 1.8334 0.0010 0.5193 indedr + 0.0367*** 4.2658 -0.0488* -1.8309 mshahd + 0.0013 0.1187 0.0410 1.0979 inst + 0.0553*** 8.1525 0.0537** 2.4735 big4 + 0.0173 4.5617 0.0200 1.5706 cpachg 0.0004 0.1477 -0.0040 0.4095 speaud + 0.0032 1.0668 0.0083 0.9037 invsmill ? 0.024*** 11.790 -0.0231*** 11.5329 0.0313*** 4.7976 0.0313*** 4.7841 samples 5,916 5,916 739 739 adjusted r2 0.035 0.049 0.036 0.053 f value (p value) 107.091 (<.0001) 39.32 (<.0001) 14.972 (<.0001) 6.196 (<.0001) panel c dependent variable=aprod variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0010 0.5085 0.0508*** 5.3929 0.0060 0.9857 0.0400 1.2769 gi -0.0007*** -6.0082 -0.0011*** 2.6195 brdsize 0.0007 0.8765 0.0024 0.8423 indedr -0.1023*** 8.3647 0.0204 0.5283 mshahd 0.0132 0.8766 0.0485 0.8969 inst -0.0647*** 6.7115 -0.0748** 2.3769 big4 0.0132 2.4487 0.0238 1.2941 cpachg + 0.0030 0.6986 0.0015 0.1034 speaud -0.0157*** -3.6816 0.0277** 2.0872 invsmill ? 0.0297*** 10.3231 0.0314*** 11.0276 0.0317*** 3.3865 0.0310*** 3.2668 samples 5,916 5,916 739 739 adjusted r2 0.022 0.044 0.02 0.019 f value (p value) 68.286 (<.0001) 35.244 (<.0001) 8.397 (<.0001) 2.793 (<.005) panel d dependent variable=adisx variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0005 0.9411 -0.0074*** 3.0038 -0.0034*** 2.6448 0.0000 0.0041 gi + 0.0001** 2.5193 0.0001 1.1701 brdsize + 0.0001 0.5991 -0.0004 0.6776 indedr + 0.0242*** 7.6083 0.0046 0.5699 mshahd + 0.0097** 2.4671 0.0114 -1.0089 inst + 0.0065*** 2.5973 0.0057 0.8615 big4 + 0.0061*** 4.3555 -0.0003 -0.0871 cpachg 0.0005 0.4056 0.0008 -0.2846 speaud + 0.0003 0.3137 0.0021 0.7727 invsmill ? 0.0175*** 23.4632 0.0177*** 23.9309 0.0157*** 7.9933 0.0157*** 7.8976 samples 5,916 5,916 739 739 adjusted r2 0.085 0.098 0.078 0.072 f value (p value) 276.105 (<.0001) 81.709 (<.0001) 32.031 (<.0001) 8.119 (<.0001) note: 1. the definitions of all variables are the same as those in table 3. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 260 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. from the empirical results shown in table 12, the results between matching and non-matching methods are almost consistent. compared with table 6, there are more variables which can restrain accrual-based earnings management in both samples. in the all sample, pdem is negatively related to indedr, inst, speaud, and gi, but positively related to cpachg. as for financing subsample, indedr and inst can restrain accrual-based earnings, but external monitoring variable cannot. moreover, from table 13, the operating performance will significantly decline in financing year +1, when firms conduct real earnings management in both all sample and financing subsample. the decline is more significant on bond issuers, continuing for two years when bond issuing firms conduct real earnings management. table 12. internal control, audit quality and accruals itititititititititit invsmillspeaudcpachgbiginstmshahdindedrbrdsizepdem εβββββββββ ++++++++= + 876543210 4 itititit invsmillgipdem εβββ +++= 210 variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept ? 0.0024** 2.4643 0.0183*** 3.9650 -0.0179*** -5.4924 0.0033 0.1990 gi -0.0004*** 6.5550 -0.0006*** -2.5909 brdsize 0.0000 0.0627 0.0006 0.3801 indedr -0.0499*** 8.2991 -0.0584*** 2.8463 mshahd 0.0183** 2.4720 0.0747*** 2.5966 inst -0.0437*** 9.2171 -0.0603*** 3.6073 big4 -0.0023 0.8842 0.0037 0.3751 cpachg + 0.0066*** 3.1059 0.0005 0.0670 speaud -0.0064*** 3.0694 0.0096 1.3639 invsmill ? 0.0335*** 23.6952 -0.0327*** -23.3947 -0.0542*** -10.7940 0.0529*** 10.4898 samples 5,916 5,916 739 739 adjusted r2 0.095 0.117 0.148 0.161 model f value 311.153 98.823 65.862 18.748 p value <.0001 <.0001 <.0001 <.0001 note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. table 13. earnings management and future performance panel a: roat+1 variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.2479 *** -14.9417 -0.1639 *** -3.9876 tem_d -0.0014 -0.5537 -0.0032 -0.4442 tem_r -0.0179 *** -7.1192 -0.0228 *** -3.1683 beta -0.0219 *** -5.1684 -0.0071 -0.6034 size + 0.0152 *** 14.3440 0.0085 *** 3.4582 mb + 0.1286 *** 17.1180 0.1669 *** 6.3263 return + 0.0045 *** 3.1755 -0.0031 -0.7100 stanret 0.0144 *** 4.3642 0.0070 0.7866 samples 5,615 687 adjusted r2 0.081 0.069 f value (p value) 71.618 (<.0001) 8.223 (<.0001) panel b: roat+1 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 261 variable expected sign seos sample bond sample coefficient t value coefficient t value intercept -0.2139 * -1.9028 -0.1613 *** -3.7165 tem_d 0.0141 1.0883 -0.0099 -1.2145 tem_r -0.0188 -1.4440 -0.0269 *** -3.2806 beta 0.0093 0.4432 -0.0131 -0.9585 size + 0.0108 1.5745 0.0087 *** 3.3336 mb + 0.1583 *** 3.6816 0.1777 *** 5.2496 return + -0.0102 -1.1743 0.0001 0.0121 stanret 0.0066 0.4332 0.0049 0.4765 samples 222 521 adjusted r2 0.047 0.073 f value (p value) 2.573 (<.05) 6.883 (<.0001) panel a: roat+2 variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.1955 *** -10.5803 -0.0863 * -1.8746 tem_d -0.0033 -1.1653 -0.0026 -0.3207 tem_r -0.0134 -4.7887 -0.0158 * -1.9530 beta -0.0268 *** -5.6655 -0.0111 -0.8396 size + 0.0132 *** 11.2240 0.0051 * 1.8526 mb + 0.1000 *** 11.9405 0.1187 *** 4.0165 return + -0.0074 *** -4.6157 -0.0143 *** -2.8821 stanret 0.0101 *** 2.7657 0.0014 0.1351 samples 5,607 687 adjusted r2 0.043 0.03 f value (p value) 37.375 (<.0001) 3.997 (<.0001) panel b: roat+2 variable expected sign seos sample bond sample coefficient t value coefficient t value intercept -0.1701 -1.3087 -0.0805 * -1.7392 tem_d 0.0502 *** 3.1580 -0.0107 -1.2273 tem_r -0.0064 -0.4104 -0.0158 * -1.8058 beta -0.0145 -0.5934 -0.0180 *** -1.2345 size + 0.0084 1.0602 0.0047 * 1.7012 mb + 0.0994 * 1.9663 0.1435 *** 3.9764 return + -0.0198 * -1.9384 -0.0109 ** -2.0767 stanret 0.0199 1.1280 0.0003 0.0297 samples 222 521 adjusted r2 0.062 0.035 f value (p value) 3.069 (<.01) 3.725 (<.001) panel a : roat+3 variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.1652 *** -8.8189 0.0130 0.2748 tem_d -0.0084 *** -2.9561 -0.0142 * -1.7175 tem_r -0.0138 *** -4.8692 -0.0130 -1.5585 beta -0.0335 *** -7.0022 -0.0278 ** -2.0359 size + 0.0120 *** 10.0193 0.0006 0.2212 mb + 0.0916 *** 10.8005 0.1041 *** 3.4200 return + -0.0082 *** -5.0763 -0.0238 *** -4.6601 stanret 0.0041 1.0968 -0.0214 -0.0214 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 262 samples 5,599 687 adjusted r2 0.040 0.049 f value (p value) 37.746 (<.0001) 6.048 (<.0001) panel b: roat+3 variable expected sign seos sample bond sample coefficient t value coefficient t value intercept 0.0135 0.1076 0.0196 0.4032 tem_d 0.0001 0.0042 -0.0187 ** -2.0544 tem_r -0.0208 -1.4330 -0.0137 -1.4835 beta 0.0208 0.8923 -0.0455 *** -2.9686 size + -0.0023 -0.3064 0.0011 0.3821 mb + 0.0996 ** 2.0813 0.1186 *** 3.1279 return + -0.0441 *** -4.5770 -0.0172 *** 3.1032 stanret -0.0066 -0.3874 0.0011 0.0969 samples 222 521 adjusted r2 0.092 0.048 f value (p value) 4.215 (<.0001) 4.747 (<.0001) note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. from the result of all samples in table 14, there is a significant negative correlation between audit fees (audfee) and real earnings management (rem), but the correlation is insignificant in financing subsample. the result is consistent with non-matching method. moreover, there is a positive correlation between rem and accrual-based earnings management (pdem) in both all sample and financing subsample, indicating that these two tools are complementary to each other. it reveals that firms might conduct both real and accrual-based earnings management at the same time. furthermore, gi is negatively related to rem either in the all sample or in the financing subsample. it implies that corporate governance can control real earning management effectively whether the firm finance or not. on the other hand, for both all sample and financing subsample, table 15 finds the significant negatively relationship between real earnings management (rem) and operating performance from financing year +1 to +3. the same result occurs as firms conduct accrual-based earnings management (pdem). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 263 table 14. audit fee, non-audit fee and real earnings management variable expected sign all sample financing sample coef. t value coef. t value coef. t value coef. t value intercept 0.0352 0.4639 0.0316 0.3835 0.2235 1.1292 0.0543 0.2370 gi -0.0007** -2.3026 -0.0032** -3.2183 audfeet-1 -0.0222* -1.8579 -0.0239* -1.9505 -0.0334 -1.0686 -0.0252 -0.7602 naudfeet-1 + 0.0037 0.9830 0.0035 0.8720 0.0095 0.8181 0.0137 1.0843 pdem 0.3629*** 4.9500 0.3610*** 4.9146 0.4523** 2.5460 0.4128** 2.2767 beta -0.0187 -1.1704 -0.0220 -1.3542 0.0466 1.1259 0.0521 1.1632 roa -1.2893*** -19.3230 -1.2876*** -18.4150 -1.1349*** -5.5892 -1.1555*** -5.3894 size + 0.0178*** 3.4382 0.0212*** 3.6250 0.0108 0.8354 0.0209 1.2404 mb ? -0.1133*** -3.5350 -0.1103*** -3.4032 -0.1948* -1.9339 -0.1519 -1.4059 brdsize -0.0011 -0.4806 -0.0042 -0.5498 indedr 0.0682** 2.0595 0.0948 1.0729 mshahd -0.4232** -2.1195 0.4610 0.8320 inst -0.0668*** -2.6453 -0.1663** -2.1581 big4 0.0039 0.2471 -0.0458 -0.9772 cpachg -0.0079 -0.6884 0.0313 0.9171 speaud -0.0054 -0.5150 0.0034 0.1146 samples 1,286 1,286 185 185 adjusted r2 0.308 0.309 0.240 0.214 f value (p value) 72.512 (<.0001) 42.135 (<.0001) 8.246 (<.0001) 4.579 (<.0001) note: 1. dependent variable is rem. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 264 table 15. degree of earnings management and future performance panel a: roat+1 variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.1219 *** -8.3741 -0.0857 ** -2.3028 pdem -0.4392 *** -29.5834 -0.3204 *** -9.0679 rem -0.1516 *** -26.2368 -0.1245 *** -7.3831 beta -0.0163 *** -4.4529 -0.0055 -0.5172 size + 0.0096 *** 10.4712 0.0060 *** 2.7139 mb + 0.0466 *** 6.8916 0.0712 *** 2.8781 return + 0.0065 *** 5.2368 0.0024 0.6094 stanret 0.0046 1.6048 0.0028 0.3497 samples 5,615 687 adjusted r2 0.316 0.249 f value (p value) 371.150 (<.0001) 33.547 (<.0001) panel b: roat+2 variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.0756 *** -5.0127 -0.0106 -0.2695 pdem -0.3496 *** -22.6857 -0.2815 *** -7.5229 rem -0.1323 *** -22.0807 -0.1079 *** -6.0432 beta -0.0200 *** -5.2666 -0.0068 -0.6039 size + 0.0077 *** 8.1000 0.0025 1.0671 mb + 0.0294 *** 4.1991 0.0352 1.3454 return + -0.0054 *** -4.2383 -0.0095 ** -2.2411 stanret -0.0003 -0.1086 -0.0033 -0.3908 samples 5,607 687 adjusted r2 0.223 0.175 f value (p value) 230.614 (<.0001) 21.833 (<.0001) panel c: roat+3 variable expected sign all sample financing sample coefficient t value coefficient t value intercept -0.0739 *** -4.1284 0.0661 1.4455 pdem -0.3253 *** -17.7715 -0.2918 *** -6.7281 rem -0.1202 *** -16.8790 -0.0693 *** -3.3510 beta -0.0296 *** -6.5753 -0.0266 ** -2.0381 size + 0.0079 *** 6.9559 -0.0012 -0.4379 mb + 0.0283 *** 3.4021 0.0329 *** 1.0821 return + -0.0068 *** -4.4305 -0.0197 *** -4.0034 stanret -0.0034 -0.9632 -0.0051 -0.5204 samples 5,599 687 adjusted r2 0.151 0.131 f value (p value) 143.335 (<.0001) 15.777 (<.0001) note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. 4.5.4 shivakumar (2000) rational expectations models we extend shivakumar (2000) to consider whether the rational expectations models differs with respect to equity compared with debt raising. to examine the relation between pre-announcement abnormal accruals and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 265 post-announcement changes in net income. if financing firms use abnormal accruals to borrow income from the future, then a negative relation is expected between abnormal accruals around the issuing and subsequent earnings changes. table 16 presents the regression results. the abnormal accruals in year -1 are positive and statistically significant to the change in net income in year 0, no matter all financing sample, seos sample or bonds sample. it reveals financing firms prefer to manipulate upward earning. when the change in net income in year +1 is the dependent variable, the abnormal accruals in year-1 are negative and statistically significant to the change in net income in year +1 in bond sample. it implies issuing bonds firms borrow income from the future, and reversals occurring in year +1 to cause income decreasing. the abnormal accruals in year-1 are negative but not statistically significant to the change in net income in year +1 in seos sample. moreover, the evidence of reversals occurring only in year +1 and not in year 0. table 16. regression of change in net income on prior abnormal accruals panel a: all financing sample variable expected sign △net income (year 0) △net income (year +1) coefficient t value coefficient t value intercept 0.0208 *** 4.4501 0.0052 1.0920 pdem (year -1) +/0.1820 *** 3.3065 -0.2323 *** -3.5607 pdem (year 0) + 0.4116 *** 6.2413 samples 664 656 adjusted r2 0.015 0.054 f value (p value) 10.933 (<.001) 19.609 (<.0001) panel b: seos sample variable expected sign △net income (year 0) △net income (year +1) coefficient t value coefficient t value intercept 0.0228 *** 3.0993 0.0180 ** 2.1397 pdem (year -1) +/0.4587 *** 5.4947 -0.0425 -0.3710 pdem (year 0) + 0.3432 *** 3.0367 samples 213 211 adjusted r2 0.121 0.045 f value (p value) 30.192(<.0001) 5.941 (<.005) panel c: bond sample variable expected sign △net income (year 0) △net income (year +1) coefficient t value coefficient t value intercept 0.0078 0.9881 0.0000 0.0019 pdem (year -1) +/0.2195 ** 2.2996 -0.2768 *** 5.6798 pdem (year 0) + 0.4264 *** -3.7445 samples 504 497 adjusted r2 0.008 0.06 f value (p value) 5.288 (<.05) 16.960 (<.0001) note: 1. the definitions of all variables are the same as those in table 3. for year 0 and +1, δnet income is computed by subtracting the net income in year -2 from that year’s net income. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 266 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. to examine market reaction to earnings announcements around financing announcement. we also analyse investors’ price response to earnings released around offering announcements (in event quarters -8 through +7). an issuing announcement can signal that the increased incentives for managers to overstate earnings. it will lead to positive earnings and positive market reaction at earnings before issuing announcement. the price reaction to earnings releases will be lower in the post-announcement quarters. the result presented in table 17 in seos sample shows that earnings announcement returns are positive before issuing announcement except in quarter -1 and -6 and it is significant in quarter -2. there are insignificantly negative earnings announcement returns in quarter 0 and +2. most of the earnings announcement returns are insignificantly negative before and after issuing announcement in bonds sample. the reason of insignificant result might issuing information is not conveyed to investors. table 17. market reaction to earnings announcements around financing offering announcement event quarter seos sample bond sample mean (percent) t-statistic mean (percent) t-statistic -8 0.1913 0.4260 -0.6117 -0.2260 -7 0.2021 -0.4013 -0.7804 -0.9203 -6 -0.0141 0.8726 -0.5743 0.7530 -5 0.5308 0.4694 -0.7853 1.2636 -4 0.9118 0.7115 -0.2775 0.1777 -3 0.6495 -0.5822 0.7650 1.0617 -2 0.2822* -1.7228* -0.1024 1.6007 -1 -0.7227 -0.8544 -0.4123 0.5145 0 -0.3411 -0.1849 -0.1050 0.6806 1 0.4101 -0.8145 -0.0705 -1.5124 2 -0.8339 -0.6446 -0.3143 -0.9299 3 0.0964 -0.4451 -0.0475 -0.2678 4 1.0616 -0.4892 0.3934 -0.7276 5 0.5686 -0.0035 1.0924 1.0371 6 0.7218 0.9411 1.2558 1.0994 7 0.0334 0.0681 0.2001 0.4888 samples 235 469 note: earnings announcement period consists of day-1 to +4 around the earnings announcement date (day 0).the earnings announcement returns are computed by subtracting from the returns of a matched non-issuing firm that has the closest sales growth in prior two years to the sample firm. earnings management and the market reaction to issuing announcements. it examines whether the issuing announcements cause investors to correct misevaluations which caused by earlier earnings management. there is a negative relation between the market’s price reaction to issuing announcements and pre-announcement earnings management. table 18 presents the regression results. regression i and ii in seos sample, it asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 267 reveals that sdret(yr-1) is negatively related to the price reaction to seos issuing announcement (ebret), but it is not significant. seos investors may correct the price impact of earlier earnings overstates; it weakly consists with rational expectations model. in contrast, bond’s earnings announcement return sdret(yr-1) is insignificantly positively related to the price reaction to bond issuing announcement (ebret) and therefore, investors may not correct stock price to response to earnings overestimation around bond issuing announcement. regression iii and iv in seos sample and bond sample, pdem(yr-1) is significantly positive to the market price reaction to seos or bond issuing announcement (ebret). it reveals that investors doesn’t correct the price impact of earlier earnings overstates in both seos and bonds sample. these finding supports managerial opportunism which is consistent with the arguments of teoh et al.(1998) and rangan(1998). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 268 table 18. market reaction to financing announcements on prior earnings announcement returns and on lagged abnormal accruals i ii iii iv panel a: all financing sample intercept 0.0022 (1.2593) -0.0020 (-0.2635) 0.001 (0.614) -0.0024 (-0.2969) sdret(yr-1) -0.0092 (-0.7978) -0.0101 (-0.8707) pdem(yr-1) 0.033** (2.260) 0.0315** (2.1105) leve 0.0007 (0.0494) 0.0048 (0.3386) mb -0.0021 (-1.5179) -0.0007 (-0.4513) samples 702 699 620 618 panel b: seos sample intercept 0.0103*** (3.1891) -0.0209 (-1.4961) 0.0093*** (2.6345) -0.0178 (-1.2162) sdret(yr-1) -0.0254 (-1.3508) -0.0206 (-1.0951) pdem(yr-1) 0.0261 (1.3568) 0.0337* (1.6801) leve 0.0216 (1.0224) 0.0173 (0.7604) mb -0.0046* (-1.6680) -0.0024 (-0.7769) offsize 0.0007** (2.2614) 0.0008** (2.4788) samples 238 234 211 209 panel c: bond sample intercept -0.0022 (-1.0869) 0.0010 (0.0971) -0.0035* (-1.6538) -0.0030 (-0.2877) sdret(yr-1) 0.0027 (0.1847) 0.0002 (0.0153) pdem(yr-1) 0.0446* (1.7652) 0.0464* (1.7934) leve -0.0113 (-0.6264) -0.0026 (-0.1412) mb -0.0015 (-0.9298) -0.0005 (-0.2959) samples 469 468 414 413 note: 1. the definitions of all variables are the same as those in table 3. the price reaction to equity or bond of issuing announcement (ebret) is measured as the cumulative returns in the day of the and the day preceding the first public announcement of the issuing. the earnings announcement return sdret(yr-1) are computed by summing the corresponding quarterly variables in quarters -4 through -1. the quarterly earnings announcement returns are the six-day cumulative returns in days -1 through +4 around the earnings announcement dates. offsize is the ratio of shares offered to shares outstanding before the issuing seos. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. 4.5.5 three cutoffs to classify earnings management we further do robustness checks by using three cutoffs (top 5%, 10% or 25% by industry) to classify earnings management for both accruals and real earnings management. in tables 19 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 269 and 20, tem_t=1 if the firm performs accruals or real earnings management and 0 otherwise. tem_d=1 if the firm’s accrual-based earnings management is higher than the sample median, top 5%, 10%, and 15% and 0 otherwise; tem_r=1 if the firm’s real earnings management is higher than the sample median, top 5%, 10%, and 15% and 0 otherwise. panel a in table 19 reports there is a significant negative relationship between rem and indedr, inst, big4, speaud in full sample, and there is also a significant negative relationship between rem and inst, spedaud in financing subsample, whether the cutoff is median, 5%, 10% or 25%. if we compare the three cutoffs with the median, panel b, c and d report almost equally significant variables. on the other hand, table 20 reveals indedr, inst, cpachg and spedaud are significant to pdem in full sample among different cutoffs, and indedr and inst are significant to pdem in financing subsample among different cutoffs. the evidences show that the significant variables are almost same as our decision to classify firms above the median as earnings managers. table 19. internal control, audit quality and real earnings management ititititititititit indusmblevesizeroabetafinanttem εαααααααα ++++++++= 76543210 3_ itititititititititit invsmillspeaudcpachgbiginstmshahdindedrbrdsizerem εβββββββββ ++++++++= + 876543210 4 panel a dependent variable = rem all sample financing sample coef. variable cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% intercept 0.1115*** 0.1101*** 0.1101*** 0.1102*** 0.1241*** 0.1164*** 0.1195*** 0.1227*** brdsize 0.0006 -0.0007 -0.0007 -0.0007 -0.0040 -0.0030 -0.0034 -0.0032 indedr -0.1623*** -0.1572*** -0.1574*** -0.1577*** 0.0381 0.0032 0.0025 0.0018 mshahd 0.0009 -0.0104 -0.0097 -0.0092 0.0261 0.0035 0.0035 -0.0060 inst -0.1197 *** -0.1106*** -0.1113*** -0.1120*** -0.1279*** -0.1234*** -0.1234*** -0.1285 *** big4 -0.0396 *** -0.0386*** -0.0383*** -0.0381*** 0.0007 0.0004 0.0007 0.0010 cpachg 0.0050 0.0036 0.0040 0.0039 0.0023 -0.0022 -0.0022 0.0031 speaud -0.019*** -0.0156*** -0.0159*** -0.0158*** 0.0437** -0.0374** -0.0372** -0.0370** invsmill 0.0202 *** -0.0122*** -0.0066** -0.0028 0.0036 0.0152 0.0160 0.0213** samples 5,916 5,916 5,916 5,916 739 739 739 739 adj r2 0.03945 0.046 0.045 0.045 0.017 0.020 0.021 0.023 f value 35.814 36.742 35.861 35.436 2.630 2.874 2.966 3.163 p value <.0001 <.0001 <.0001 <.0001 <.05 <.05 <.001 <.001 panel b dependent variable=acfo all sample financing sample coef. variable cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% intercept 0.0533*** -0.0536 *** -0.0536*** -0.0537*** -0.0884*** -0.0882*** -0.0895** * -0.0926*** brdsize 0.0014** 0.0012* 0.0012* 0.0012* 0.0016* 0.0009 0.0011 0.0012 indedr 0.0372** * 0.0400*** 0.0401 0.0402*** -0.0604 -0.0467 -0.0474** -0.0472 mshahd 0.0033 0.0035 0.0032 0.0031 0.0373 0.0298 0.0312 0.0369 inst 0.0479** * 0.0520*** 0.0523*** 0.0525*** 0.0522* 0.0601** 0.0612 0.0645** big4 0.0186** * 0.0191*** 0.0190*** 0.0189*** 0.0286* 0.0318* 0.0308* 0.0300* cpachg -0.0015 -0.0012 -0.0013 -0.0013 0.0051 0.0086 0.0083 0.0086 speaud 0.0043 0.0050 0.0051 0.0051 0.0135 0.0151 0.0152 0.0151 invsmill 0.0254** * 0.0041 0.0017 0.0003 0.0373*** 0.0051 -0.0032 -0.0110 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 270 samples 5,916 5,916 5,916 5,916 739 739 739 739 adj r2 0.039 0.021 0.020 0.020 0.042 0.017 0.016 0.019 f value 31.271 16.291 15.978 15.888 5.024 3.039 2.528 2.780 p value <.0001 <.0001 <.0001 <.0001 <.0001 <.001 <0.05 <0.05 panel c dependent variable=aprod all sample financing sample coef. variable cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% intercept 0.0507*** 0.0501*** 0.0501*** 0.0502*** 0.0371 0.0383 0.0406 0.0422 brdsize 0.0007 0.0005 0.0005 0.0005 0.0027 -0.0033 -0.0035 -0.0033 indedr -0.1005*** -0.0966*** -0.0968 -0.0970*** -0.0168 -0.0089 -0.0098 -0.0104 mshahd -0.0115 -0.0124 -0.0120 -0.0118 0.0498 0.0439 0.0445 0.0383 inst -0.0645*** -0.0582*** -0.0587*** -0.0591*** -0.0707** -0.0687** -0.0682** -0.0714** big4 -0.0136** -0.0135** -0.0134 ** -0.0133** 0.0275 0.0306* 0.0305* 0.0304* cpachg 0.0030 0.0030 0.0033 0.0032 0.0013 0.0036 0.0034 0.0027 speaud -0.0157*** -0.0147*** -0.0149*** -0.0148*** -0.0277** -0.0272** -0.0270** -0.0268** invsmill 0.0282*** -0.0071** -0.0035 -0.0011 0.0181* 0.0160* 0.0130** 0.0147* samples 5,916 5,916 5,916 5,916 739 739 739 739 adj r2 0.041 0.026 0.025 0.025 0.010 0.009 0.008 0.009 f value 32.365 24.475 29.894 19.663 1.896 1.866 1.785 1.829 p value <.0001 <.0001 <.0001 <.0001 <.1 <.1 <.1 <.1 panel d dependent variable=adisx all sample financing sample coef. variable cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% intercept -0.0074*** -0.0079*** -0.0078*** 0.0078*** 0.0015 0.0017 -0.0010 0.0001 brdsize -0.0001 0.0000 0.0000 0.0000 0.0003 -0.0004 0.0000 -0.0001 indedr 0.0233*** 0.0219*** 0.0220*** 0.0220*** 0.0050 0.0045 -0.0009 -0.0008 mshahd -0.0106*** -0.0103** -0.0105** 0.0106** -0.0132 -0.0132 -0.0124 -0.0124 inst 0.0066*** 0.0026 0.0027*** 0.0028 0.0050 0.0049 0.0044 0.0037 big4 0.0064*** 0.0074*** 0.0073*** 0.0072*** -0.0018 -0.0016 -0.0017 -0.0019 cpachg -0.0004 -0.0005 -0.0006 0.0006 -0.0017 -0.0017 -0.0013 0.0017 speaud -0.0003 -0.0010 -0.0009 0.0009 0.0025 0.0023 0.0020 0.0019 invsmill -0.0169*** 0.0034*** 0.0023*** 0.0016** -0.0154*** -0.0152*** -0.016*** -0.0103 *** samples 5,916 5,916 5,916 5,916 739 739 739 739 adj r2 0.092 0.014 0.013 0.012 0.069 0.070 0.028 0.019 f value 76.053 11.622 10.673 9.938 7.814 7.919 3.688 2.749 p value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.05 note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 271 table 20. internal control, audit quality and accruals itititititititit indusmbsizeroabetafinanttem εααααααα +++++++= 6543210 3_ itititititititititit invsmillspeaudcpachgbiginstmshahdindedrbrdsizepdem εβββββββββ ++++++++= + 876543210 4 all sample financing sample coef. variable cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% cutoff = median cutoff = 5% cutoff = 10% cutoff = 25% intercept 0.038*** 0.0256*** 0.0255*** 0.0257*** 0.0175 0.0178 0.0186 0.0213 brdsize 0.0000 0.0003 0.0003 0.0003 0.0003 0.0004 0.0003 0.0002 indedr -0.0456*** -0.0492*** -0.0492*** -0.0494*** 0.0515*** -0.0656*** -0.0656*** -0.0658*** mshahd 0.0118 0.0118 0.0119 0.0121 0.0385 0.0453 0.0451 0.0400 inst -0.0463*** -0.0516 *** -0.0516*** -0.0521*** 0.0557*** -0.0653*** -0.0655*** -0.0684*** big4 0.0031 -0.0036 -0.0036 -0.0035 0.0009 -0.0017 -0.0015 -0.0008 cpachg 0.0063*** 0.0060*** 0.0061*** 0.0061*** 0.0025 -0.0061 -0.0060 -0.0063 speaud -0.0067*** -0.0076*** -0.0077*** -0.0076*** 0.0104 -0.0122* -0.0122* -0.0121* invsmill -0.0317*** -0.0032** -0.0030** 0.0001 -0.0405*** 0.0020 0.0034 0.0100** samples 5,916 5,916 5,916 5,916 739 739 739 739 adj. r2 0.115 0.037 0.039 0.037 0.127 0.033 0.034 0.041 f value 97.133 29.688 29.775 29.042 14.369 4.185 4.251 4.895 p value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 note: 1. the definitions of all variables are the same as those in table 3. 2. *, **, *** are significant at the 10, 5, and 1 percent levels, respectively. 5. conclusions when companies require external funding, they provide financial statements to represent their operating status as a reference for investors. to ensure access to or to lower the cost of capital, managers may be motivated to manipulate earnings. studies show that better corporate governance for a company can restrain earnings management. most studies use accrual-based earnings management as a proxy variable, and there are few discussions about real earnings management. in fact, managers may use accrual-based and real earnings management concurrently. this paper examines whether the adoption of different earnings management tools by companies undertaking financing activities and the degree of earnings management vary according to different financing choices. additionally, the paper considers taiwan’s invest environment to investigate whether stronger corporate governance can restrain real earnings management and examines whether different earnings management tools have different effects on post-financing operating performances. finally, we consider market reaction to examine whether the rational expectations models differs with respect to equity compared with debt raising. overall, firms choose different earnings management tools depending on whether they issue corporate bonds or seos on the first year before financing. that is, firms choose the earning management tools in advance in year -1. this paper adopts the two-stage model to control self-selection of earnings management. and the empirical results suggest that firms with greater percentages of independent directors, larger shareholdings of institutional investors and auditing by big 4 firms all indicate lower levels of engagement in real earnings management in the all sample. this paper further reclassifies real earnings management into asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 272 three components, abnormal operating cash flows, abnormal production cost and abnormal discretionary expenses. therefore, when the samples are reduced to firms undertaking financing, showing that only the larger shareholdings of institutional investors can restrain two components of real earnings management (abnormal operating cash flows and abnormal production cost). firms audited by industry specialist can restrain real earnings management by abnormal production cost. corporate government cannot restrain real earnings management by abnormal discretionary expenses. we also use the principal components analysis to extract the first principal component as the corporate governance. it reveals that corporate governance can restrain real earnings management, but the effect decline when firms engaged in financing activities. compare accrual earnings management to real earnings management, there are more variables can restrain accrual earnings management in both all and financing subsamples. percentages of independent directors and shareholdings of institutional investors can control accrual earnings management when firms undertaking financing. this paper infers that real earnings management is more likely to occur in the event of a capital shortage and the requirement of external funds, regardless of the severe economic consequences. since issuing seo or bond announcement can signal that the increased incentives for managers to overstate earnings. this paper considers shivakumar (2000) rational expectations model that examine whether the issuing announcements cause investors to correct misevaluations which caused by earlier earnings management. we find that investors don't correct the price impact of earlier earnings overstates in both seos and bonds sample. it supports managerial opportunism which is consistent with the arguments of teoh et al. (1998) and rangan (1998). this paper also distinguishes between bond issuers and seo firms in the multivariate test to examine the effect of adopting earnings management tools on the post-financing operating performances. for companies issuing bonds, there is a negative relationship between real earnings management and post-financing performances, but no association between accrual-based earnings management and operating performances. this paper argues that real earnings management is a set of subjective decisions over the timing of expenses and utilization of working capital, utilizing actual transactions; these decisions affect real performance or economic substance. firms choose the real earnings management to avoid frequent outside monitoring by investors, cpa or government when firms issued bonds. and then, it also causes operating performance to decline continuously two years after bond financing. the audit fee is generally used as a proxy of audit quality. and the results of past studies on the relationship between audit and non-audit fees and earnings quality are inconsistent. this paper further explores the effects of audit and non-audit fees on real earnings management. the results show that the higher the audit fees, the less involvement in real earnings management and the better the earnings quality for full sample, but not for financing firms. however, there is a positive association between non-audit fees and real earnings management in the full and financing subsample. the higher the non-audit fees, the more involvement in real earnings management and the lower the earnings quality. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 273 there are some research restrictions in this paper. first, only the issue of corporate bonds and seos are included in the samples of financing firms; long-term loans are not included. second, this paper performs variance analyses to determine whether there are differences in the relationships between financing choices and earnings management tools. future studies should design empirical models to examine whether different financing choices have different influences on earnings management tools. moreover, future research should explore the effects of other earnings management tools on ex-post performances to determine which tools are the most detrimental to company performance. references antle, r., gordon, e., narayanamoorthy, g., & zhou, l. 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(2004). audit quality and earnings management by seasoned equity offering firms. asia-pacific journal of accounting and economics, 11(2), 95-120. http://dx.doi.org/10.1080/16081625.2004.10510638 microsoft word 12234-45013-2-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 319 spinoffs and firm policy seoungpil ahn sogang business school sogang university pa706, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: spahn@sogang.ac.kr received: nov. 5, 2017 accepted: dec. 22, 2017 published: december 24, 2017 doi:10.5296/ajfa.v9i2.12234 url: https://doi.org/10.5296/ajfa.v9i2.12234 abstract i investigate the nature of reconstructing by examining the changes in firm policies around spinoff. because the pre-spinoff contract structure is more suitable for larger divisions of firms, separated units experience relatively large changes in contracts following spinoffs. compared to the post-spinoff parent firms, separated units have lower tendency to pay dividends, lower ownership by ceos, higher fraction of outside directors, smaller board, younger board members, higher block ownerships, and higher incentive payment. there are significant changes in the firm policies in both high q and low q units, however the market response is more positive for units with higher growth opportunities. keywords: ipo, valuation, holding company, ownership structure, governance structure jel classification: g30; g32; g34 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 320 1. introduction previous studies provide limited evidence on the causal relation between board structure and its determinants. hermalin and weisbach (2003) argue that board structure and variables that are associated with board structure are jointly determined by past performance. as long as the explanatory variables such as firm size and growth opportunities are reasonably stable over time, board structure remains stable and exhibits path dependence on its past structure. in the case, the change in board structure is more likely affected by economic shocks rather than change in firm specific characteristics. denis and sarin (1999) shows that large change in board structure is typically preceded by fundamental changes in the business conditions, but it is only weakly related to the changes in firm-specific determinants of board structure. wintoki, linck, and netter (2012) argue that board size and composition are affected by past firm performance. lehn, patro, and zhao (2004) provide direct evidence of path dependence showing that lagged board structure is positively correlated with current board structure. therefore, explicit modeling of the endogeniety is necessary in cross-sectional analysis of the determinants of board structure. alternative approach is to examine unique samples relatively free from the endogeniety issue. boone, field, karpoff, and raheja (2007) address the concern by examining board structure of ipo firms. ipo firms experience significant changes in governance structure to meet the requirement as public firms. nonetheless, it is unclear whether the board structure at the time of ipo is truly independent from past performance. because past board structure as private companies is unknown, it is impossible to check path-independence of their sample. the approach to examine newly emerged companies from spinoffs is similar to boone, field, karpoff, and raheja (2007) in an effort to find unique sample that are less subject to the endogeniety problem. there are benefits of examining board structure of spunoff units. firstly, as long as optimal board structure of units is different from that of parent, a spinoff creates an opportunity for newly established spun off units to set up their own board structure which is suitable for units. second, spunoff units experience significant change in their asset structure over the short period. therefore, the influence of the changes in firm characteristics on board structure can be easily detected. third, with pre-spinoff board data, i can examine path dependence of post-spinoff units. thereby, i can verify assumption on the endogeniety in the sample. for spinoffs completed during the period of 1993 to 2010, i investigate the nature of reconstructing following spinoffs. specifically, i examine changes in debt policy, dividend policy, changes in ownership structure and board structure, and compensation policy. spinoff units represent about 20% of assets in the combined firms. since pre-spinoff contract structure is more suitable for larger remaining parents, units experience relatively large changes in contracts following spinoffs. compared to post-spinoff parents, separated units have lower tendency to pay dividends, lower ownership by ceos, higher fraction of outside directors, smaller board, younger board members, higher block ownerships, and higher incentive payment. although i have observed significant changes in contract structure in both high q and low q units, the market response is more positive when spin off units have higher asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 321 growth opportunities. therefore, the reconstructing benefit of spin-offs exists only when high q units are separated. 2. data description spinoff sample is collected with the following procedure. initial data of spinoffs is collected from sdc m&a database. for spinoffs announced and completed during the period of 1993 to 2010, i use factiva (formerly, dow jones newswire) to verify the spinoff event and identify spinoff announcement date and ex-dividend date. spinoffs of which related news on spinoff transaction are unavailable from factiva are discarded. pre-spinoff firms shall distribute more than 80% of spinoff units’ ownership to be included in the sample and any partial spinoffs or equity carve-outs are excluded. both spinoffs by single segment firms and multiple-segment firms are included. following previous studies, spinoffs conducted by financial companies, firms in regulated industries, and foreign companies are excluded. in addition, spinoff firms shall have financial data for both parent and spinoff units on compustat for at least two years around the spinoff and stock return data on crsp around the spinoff announcement date. finally, i require that both parent and spinoff units have proxy statements filed in lexis-lexus for two years around the spinoff. the final sample consists of 211 spin-offs table 1 reports time profile of spinoffs and data description. panel a reports the number of completed spinoffs in each year during the period of 1993 to 2010. panel b is financial characteristics of pre-spinoff firms (pb), post-spinoff parents (pa) and post-spinoff units (ua). last three columns reports the absolute differences of the financial characteristics among these three groups. all variables are winsorized at 5% and 95%. in tables, *, **, and *** indicate statistical significance at 10%, 5%, and 1%, respectively. table 1. descriptive statistics panel a. time profile year number of spinoffs year number of spinoffs 1993 4 2002 7 1994 11 2003 4 1995 10 2004 8 1996 20 2005 10 1997 12 2006 12 1998 14 2007 15 1999 16 2008 13 2000 21 2009 10 2001 13 2010 11 n 211 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 322 panel b. descriptive statistics pb pa ua difference (pa pb) difference (ua -pb) difference (ua -pa) assets 5,980.57 [2,089.51] 5208.45 [2086.00] 1517.25 [508.86] -423.19** [-64.69]*** -4535.7*** [-1579.3]*** -3928.3*** [-1316.9]*** sales 5621.47 [2,574.49] 4345.83 [1920.36] 1300.69 [571.73] -747.27*** [-210.81]*** -4133.1*** [-2063.5]*** -3129.5*** [-1152.4]*** mtob 1.92 [1.69] 1.90 [1.57] 2.03 [1.66] -0.0023 [-0.0167] 0.1599 [0.0254] 0.1519 [-0.0651] roa 0.1525 [0.1543] 0.1340 [0.1314] 0.0838 [0.1310] -0.0205*** [-0.0148]*** -0.0614*** [-0.0225]*** -0.0471*** [-0.0064] om 0.1603 [0.1552] 0.1483 [0.1522] -0.0278 [0.1128] -0.0088 [0.0000] -0.1903*** [-0.0364]*** -0.1721*** [-0.0346]*** from panel b of table 1, spinoff units are relatively weak segments: smaller in size and lower operating performance. growth opportunities measured by market-to-book (mtob) is insignificantly different between parents and aunts, but absolute difference is quite large, 1.18 in the mean. this suggests that high variation in the form of spinoffs where some units have higher q than parents and other units have lower q than parents. parents after spinoffs also show higher roa and operating margin (om) than those of units. 3. empirical results and discussion next, i compare announcement period abnormal returns for firms completed spinoffs between 1993 and 2010. market-adjusted returns (mars) using crsp value weighted returns are measured in the (-1, +1) days window surrounding the spinoff announcement date. all variables are winsorized at 5% and 95%. mean and median differences are tested with t-test and wilcoxson signed rank test. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 323 table 2. announcment abnormal return n mean mars median mars full sample 211 3.54%*** 3.36%*** cross-industry spinoffs at 2-digit sic 139 3.60%*** 3.45%*** same-industry spinoffs at 2-digit sic 72 3.42%*** 3.21%*** p-value (difference) 0.89 0.87 cross-industry spinoffs at 3-digit sic 166 3.75%*** 3.51%*** same-industry spinoffs at 3-digit sic 45 2.73%* 3.19%** p-value (difference) 0.50 0.59 difference in mtob > top 1/3 70 3.88%*** 5.15%*** difference in mtob in the middle 71 3.43%*** 3.01%*** difference in mtob < bottom 1/3 70 3.30%*** 3.19%*** p-value (difference) 0.92 0.89 units’ mtob > top 1/3 70 5.20%*** 5.85%*** units’ mtob in the middle 71 3.87%*** 3.76%*** units’ mtob < bottom 1/3 71 1.54% 1.81% p-value (difference) 0.05** 0.03** table 2 reports announcement abnormal return with market adjusted returns (mars). on average, two-day announcement mars is 3.54% which is consistent with the finding in previous literature (see for example, hite and owers, 1983; cusatis, miles and woolridge, 1993; allen, lummer, mcconnell and reed, 1995). mars in the cross-industry spinoffs is higher than mars in the same-industry spinoffs. however, the differences in mean and median mars are insignificant. under the hypothesis that larger difference in growth opportunities between parents and units leads to higher benefits from recontracting, sample firms are divided into three sub-groups based on the absolute difference in market-to-book ratios between parents and units. mars among three-groups are insignificantly different. since pre-spinoff contract structure is more suitable for larger remaining parents, units experience relatively large changes in contracts following spinoffs. therefore, it is possible that the benefit of recontracting is concentrated in spinoff units and those with higher growth opportunities. thus, i further divide sample firms into three groups based on units’ market-to-book ratio, which is a measure of growth opportunity. the result shows that announcement returns are higher for spinoffs separating higher q units. next we investigate whether this larger announcement return reflects recontracting benefits by examining changes in contracts in spunoff units. in table 3, i compare contract structure in pre-spinoff firms (pb), post-spinoff parents (pa) and post-spinoff units (ua). units are experiencing more changes in contracts than parents. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 324 specifically, separated units have relatively lower tendency to pay dividends, lower ownership by ceos, higher fraction of outside directors, smaller board, younger board members, higher block ownerships, and higher incentive payment. the result confirms that pre-spinoff contract structure is designed to be more suitable for larger remaining parents. table 3. recontracting of parents and units pb pa ua difference (ua-pa) debt policy leverage 0.2449 [0.2598] 0.2623 [0.2566] 0.2313 [0.1889] -0.0155 [-0.0111] total liability/total assets 0.5930 [0.6002] 0.6207 [0.6142] 0.5408 [0.5617] -0.0351 [-0.0340]** dividend policy dividends/net income 0.2637 [0.2122] 0.2225 [0.0431] 0.0565 [0.0000] -0.1973*** [-0.1000]*** dividend/price 0.0139 [0.0110] 0.0131 [0.0050] 0.0036 [0.0000] -0.0095*** [-0.0036]*** ownership structure % ownership by officers and directors 0.1164 [0.0466] 0.1120 [0.0515] 0.0830 [0.0371] -0.0276*** [-0.0068]*** % ownership by ceo 0.0354 [0.0080] 0.0326 [0.0080] 0.0151 [0.0073] -0.0177*** [-0.0010]** % blockownership 0.1209 [0.1060] 0.1416 [0.0996] 0.1833 [0.1697] 0.0653*** [0.0564]*** board composition board size 10.19 [10.00] 9.37 [9.00] 7.34 [7.00] -2.81*** [-3.00]*** fraction of independent directors 0.7378 [0.7778] 0.7477 [0.7778] 0.7718 [0.8000] 0.0371*** [0.0223]*** fraction of insiders 0.2179 [0.1818] 0.1899 [0.1667] 0.2147 [0.1818] 0.0004 [0.0048] age of board members 57.85 [58.93] 58.06 [58.80] 56.56 [56.85] -1.61*** [-0.77]*** compensation policy proportion of equity based incentives 0.3402 [0.2888] 0.3431 [0.3189] 0.5308 [0.5451] 0.1932*** [0.2067]*** total compensation (including stock options) 4488.46 [3039.32] 5617.00 [2993.56] 4833.17 [3118.43] 79.6 [27.8] total compensation (excluding stock options) 2294.95 [1576.54] 2586.57 [1630.35] 1503.09 [894.07] -798.04*** [-458.64]*** asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 325 since renegotiation/set-up by units could be costly, the benefits of separation shall exceed the related costs. in entrepreneurship-type spinoffs where spinoffs are initiated to pursue high growth opportunities available in units, it could be worthwhile to pursue the growth opportunities by setting-up their own contracts. to the contrary, in efficiency-type spinoffs where the spinoff is conducted to eliminate non-promising units, renegotiation is costly in separated units. in this second type of spinoff, there is not much room for recontracting gains for parents since the pre-spinoff contracts are already fitted contracts for the remaining parents. table 4 shows the directions of the recontracting depending on the magnitude of growth opportunities of units. high q units are defiend as spunoff units whose mtob is higheste one third of sample firms. low q unit are those having lowest one third of mtob. table 4. growth opportunities of units and announcement returns units’ mtob < bottom 1/3 units’ mtob > top 1/3 p-value for difference mtob of units 1.00 [1.02] 3.97 [3.03] <0.0001 [<0.0001] mtob of parents 1.70 [1.26] 2.05 [1.76] 0.1598 [0.0020] difference (ua – pa) -0.68*** [-0.26]*** 1.94*** [1.33]*** <0.0001 [<0.0001] absolute difference 0.82 [0.32] 2.27 [1.42] 0.0014 [<0.0001] mars (-1, +1) 1.54% [1.81%] 5.20%*** [5.85%]*** 0.0221 [0.0180] difference (ua – pa) debt policy leverage -0.0607* [-0.0476]* -0.0418 [-0.0655] 0.7001 [0.8595] total liability/total assets -0.1102*** [-0.1038]*** -0.0665 [-0.0905]* 0.5130 [0.8392] dividend policy dividends/net income -0.1762 [0.0000]** 0.0170 [0.0000] 0.3297 [0.5884] dividend/price -0.0097*** [0.0000]*** -0.0095*** [-0.0008]*** 0.9423 [0.8326] ownership structure % ownership by officers and directors -0.0214* [-0.0176]** -0.0281*** [-0.0057]*** 0.6250 [0.9202] % ownership by ceo -0.0167* [0.0004] -0.0265** [-0.0007] 0.5745 [0.3289] % blockownership 0.0451* [0.0489]* -0.0358 [-0.0025] 0.0173 [0.0255] asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 326 board composition board size -2.3182*** [-2.0000]*** -1.8409*** [-1.0000]*** 0.3965 [0.4260] fraction of independt directors 0.0624*** [0.0452]*** -0.0048 [-0.0056] 0.0096 [0.0388] fraction of insiders -0.0077 [0.0087] 0.0444a [0.0250]a 0.0446 [0.0316] age of board members -1.0939 [-0.2000] -1.7426a [-0.6528]a 0.4648 [0.4863] compensation policy proportion of equity based incentives 0.1770*** [0.1804]*** 0.2295*** [0.2202]*** 0.5374 [0.4859] total compensation (including stock options) 483.87 [-316.60] 105.67 [73.18] 0.8798 [0.6674] total compensation (excluding stock options) 87.50 [-426.78]*** -1222.53 [-387.51]*** 0.5245 [0.8839] from table 4, units’ growth opportunities are significantly related to announcement mars. the results show that units having low growth opportunities have restructured to have higher block ownership and higher independent outside directors, while units having high growth opportunities have larger insiders in the board. in both sub-samples, units commonly have lower dividend payment, lower ownerships, smaller board, younger board members, and higher proportion of stock option payment. the recontracting seems related to more positive market response only in spinoffs where units have highest growth opportunities. 4. determinant of board structure i also examine the determinants of board size and composition after spinoffs. although thre are some significant results, more tests are needed to find causal relationships. using firm characteristics known to be related with board size, i examine cross-sectional determinants of board size in the pre-spinoff parents(pb). here, i only summarize the result and prvide detailed tests on the changes in board composition in table 5. in untabulated result, the number of segment and firm size are positively related with board size. the post-spinoff parents(pa) show significant path dependence on the past board size. however, the board size of units(ua) is independent from the past board size. in all regressions, firm size is only variable that are consistently associated with board size. interestingly, market-to-book ratio used as proxy for firm performance and/or growth opportunities is insignificant in all regressions. also, the previously documented negative relation between board size and the proportion of insiders are not present in our data. similar test is conducted on board composition. in untabulated result, units’ board composition is appeared to get less influence of past board, but it is still significantly path dependent. also, market-to-book is insignificant in all regressions and the previously documented negative relation between board size and the proportion of insiders are not present. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 327 lastly, i examine the change in units’ board size and composition relative to post-spinoff parents(pa). all explanatory variables are computed to percentage changes. in this way, i can exclude endogeneous fixed factors of past history that might affect both remaining parents and separated units. this provides stronger test than simple change analysis of the same firm over two periods because the base number of the begining year is controlled. from table 5, dependent variables are the change in board size and the change in percentage of inside directors. change is measured as difference between the value of spunoff units and the value of parents in the post-spinoff periods. p-values are reported in parenthesis. standard errors are estimated using huber/white robust method. all regressions include year dummy variables. all final variables are winsorized at 5% and 95% percentiles. in model (1) of table 5, firm size is consistently associated with board size. surprisingly, relative market-to-book ratio is positively related with board size. board size is negatively related with the proportion of inside directors. similar results are found with the inclusion of additional control variables in model (2) and in probit model of model (3). units having relatively higher free cash flow (proxy for agency problem) are organized with smaller board. regarding board composition in model (1) to (3) of table 5 , the only variable consistently significant is the change in board size. coefficients on market-to-book are weakly positive in model (4) and (5). there is some evidence that ownership structure is affecting board composition. higher ceo ownership and higher outside directors’ ownership, both indicating higher incentives to behave on behalf of shareholders’ interests, are associate with fewer insiders or more outsiders at the board. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 328 table 5. determinants of board size and composition change in board size (ua-pa)/pa change in % of insiders (ua-pa)/pa (1) (2) (3) (4) (5) (6) ols ols probit ols ols probit relative diversity 0.0265 (0.386) 0.0337 (0.254) 0.0044 (0.982) -0.1262 (0.141) -0.1099 (0.220) -0.1405 (0.532) relative size 0.0448 (0.007) 0.0409 (0.018) 0.5344 (0.000) 0.1816 (0.152) 0.1910 (0.152) -0.0068 (0.933) relative leverage 0.0011 (0.636) 0.0019 (0.447) -0.0004 (0.983) -0.0150 (0.073) -0.0132 (0.141) -0.0112 (0.635) relative tangible assets -0.0187 (0.187) -0.0165 (0.312) -0.0115 (0.923) -0.0081 (0.914) -0.0066 (0.931) -0.0418 (0.646) relative mtob 0.0755 (0.001) 0.0813 (0.001) 0.5246 (0.000) 0.1644 (0.054) 0.1687 (0.064) 0.0054 (0.970) relative freecash/assets -0.0060 (0.013) -0.0504 (0.027) -0.1929 (0.238) -0.0257 (0.247) relative industry herfindahl index 0.0165 (0.392) 0.2465 (0.079) -0.0020 (0.978) 0.0740 (0.497) relative ceo ownership 0.0005 (0.622) 0.0027 (0.476) -0.0044 (0.030) -0.0048 (0.205) relative outside director ownership 0.0003 (0.375) 0.0020 (0.569) -0.0016 (0.105) -0.0076 (0.046) change in % of insiders -0.0972 (0.001) -0.0906 (0.002) -0.9147 (0.002) change in board size -1.3757 (0.001) -1.3733 (0.001) -2.1901 (0.000) intercept -0.1873 (0.051) -0.2130 (0.040) -0.6004 (0.003) 0.0787 (0.781) 0.0829 (0.752) 0.0330 (0.873) f-stat 3.69*** 4.17*** 2.40*** 3.38*** adj. r2 0.212 0.219 0.196 0.193 chi2 32.11*** 28.28*** pseudo r2 0.295 0.168 n 208 205 205 205 208 207 5. conclusion a firm is a nexus of contracts. these contracts represent the optimal decisions of the firm to reflect the characteristics of the firm’s assets and the growth opportunities. for the firms with multiple divisions, the contracting becomes more complicated if each division is composed of assets have various growth opportunities. examing reconstructing following spinoffs provide an unique experiment to examine a firm’s policies as compared to those existed in the pre-spinoff period. i find that units adjust firm policies after they are separated from parent asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 329 firms. i also find some evidence that the reconstructing benefit of spin-offs is concentrated in high q units being separated. further analysis shows that ownership structure affects board composition. higher incentives to ceo are associate with fewer insiders and more outsiders in the board. references allen, j., s. lummer, j. mcconnell, & d. reed (1995). can takeover losses explain spin-off gains? journal of financial and quantitative analysis, 30, 465-485. https://doi.org/10.2307/2331273 boone, a., l. field, j. karpoff, & c. raheja, (2007). the determinants of corporate board size and composition: an empirical analysis, journal of financial economics, 85, 66-101. https://doi.org/10.1016/j.jfineco.2006.05.004 cusatis, p., j. miles, & j. woolridge (1993). restructuring through spinoffs: the stock market evidence, journal of finanical economics, 33, 293-312. https://doi.org/10.1016/0304-405x(93)90009-z denis, d., & a. sarin (1999). ownership and board structures in publicly traded corporations, journal of financial economics, 52, 187-223. https://doi.org/10.1016/s0304-405x(99)00008-2 hermalin, b., & m. weisbach (2003). boards of directors as an endogenously determined institution: a survey of the economic literature, economic policy review, 7-26. https://dx.doi.org/10.2139/ssrn.233111 hite, g., & j. owers (1983). security price reactions around corporate spin-off announcements, journal of financial economics, 12, 409-436. https://doi.org/10.1016/0304-405x(83)90042-9 lehn, k., s. patro, & m. zhao (2007). governance indexes and valuation: which causes which? journal of corporate finance, 13, 907-928. https://doi.org/10.1016/j.jcorpfin.2007.07.002 wintoki, m., j. linck, & j. netter (2012). endogeneity and the dynamics of internal corporate governance, journal of financial economics, 105, 581-606. https://doi.org/10.1016/j.jfineco.2012.03.005 microsoft word 12606-46168-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 390 extent of implementing target costing and value engineering approach to reducing costs: a survey in jordanian shareholding companies for food industries prof suleiman mustafa eldalahmeh faculty of economic and administrative science accounting department –jerash university e-mail: dr.el-dalahmeh97@live.com received: jan. 3, 2018 accepted: feb. 22, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12606 url: https://doi.org/10.5296/ajfa.v10i1.12606 abstract this study aims at identifying the extent of implementing target costing and value engineering approach to reducing costs of jordanian public shareholding companies for food industries. to achieve the study objectives, the researcher distributed personally a questionnaire to a random sample of (145) accountants in the hashemite kingdom of jordan. (100) questionnaires were returned. the response rate was 69%. in addition, the survey sought to verify the five basic hypothesis of the study. in order to analysis the data, the researcher used means, standard deviations and t-test. the results of the survey revealed that availability of the components of application of target cost, as well as companies have awareness, concepts, principles and the importance of applying target costs to managing costs so as to improve profitability, and the companies are using value engineering to achieve a cost to reach the target costs. the results also showed that there were some difficulties to hinder the application of target costs and value engineering in jordanian shareholding companies for food industries. the most important difficulties were: the lack of sufficient knowledge to manage the company on how to implement the target cost and value engineering. the lack of research and publication related to the benefits target cost and value engineering. application costs greater than the expected benefits. keywords: target costs, value engineering, management accounting, the jordanian shareholding companies for food industries. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 391 1. introduction the world is witnessing huge technological developments in the production on and management systems from japanese companies and most of the major industrial companies in most of the developed countries, also, these have achieved remarkable successes for japanese companies, making them the world’s leading companies interims of cost control and high level of quality. there is no doubt that theses development in administrative thought and production technology have been accounting thought, especially in the field of managerial accounting and information systems supporting administrative decisions. the introduction of target costing and value engineering has emerged as one of the important approaches in marrying costs through reducing them, while maintaining quality. due to the important of target costs and value engineering in reducing costs, whether the shareholding companies for food industries in jordan have begun to manage their costs through their use of the target cost approach and value engineering as an entrance to reducing costs. 2. the problem of study the problem of study is to identify the extent of the implementation of the target costs of the jordanian as entrance to reducing costs of the jordanian shareholding industrial companies. 3. the importance of the study the importance of this study comes from the importance of implementing the target costs and value engineering as entrance to reducing costs of the shareholding companies for food industries in jordan. 4. purposes of the study this study seeks to achieve the following objective: 1identify the availability of the components of implementing target costing entrance in shareholding companies for food industries in jordan. 2identify the extent to which jordanian shareholding companies for food industries are aware of concepts, principles and importance of using the target cost approach. 3the extent to which jordanian shareholding for food industries companies use the cost target to manage their costs to improve profitability. 4the extent to which jordanian shareholding companies for food industries use the value engineering to reduce the cost of its products to reach the target cost. 5to identify the difficulties that hinder the adoption of the target costing and value engineering in jordanian shareholding companies for food industries in jordan. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 392 5. terminology of study target costs: one of methods of management accounting for cost management, which aims to reduce the cost of product during the stages of planning design and product development with high quality to satisfy the desires and needs of customers and reach a predefined value of cost under the market prices of the product produced. (horngran. etal,2011,p218). value engineering is searches to potential areas of cost reduction during the product planning design of the product, while maintaining the functional status and quality of product (hilton, 2005, p233). 6. literature review in the accounting literature much has been written about the implementing target costing and value engineering entrance to reducing cost, the concept of target cost was introduced in 1973 in japan. the association of japanese accountants has been defined target cost as a profit management process by determining the product quality, price, distribution and other product –related objective that enable the company to achieve its profit strategy, this is achieved during the planning design and developing the product to the level that meets the needs of customers (http://www.jps-dir.com /forum /uploads/13379/what target cost. pdf).since 1995, there has been increased interest in studying the implementing of the target cost after the application showed positive results in japan. researcher’s opinions in the target cost field are divided into two groups: first groups see the target cost as a cost –cutting tool without being exposed to its impact in profitability planning (monden & hamad,1991,p16) defined target cost as a system that helps reduce costs in the design of the new product or when the design model of the current product is completely changed or the model is partially modified. (lgangne & discenza, 1993, p34) explained the concept of target cost as a method of accounting management aimed at cost management during the stage of planning and design of product in order to save the ongoing costs using various optimization tools such as value engineering. (kaplan, 1998, p61) believes that the target cost is the most effective way to support competitive advantages in order to reduce cost and achieve customer satisfaction. (cooper & salgmulder, 2003, p60) said that the target cost is the most effective way to maintain low-cost as well as the manufacturing phase of the product life cycle. in the same vine, kazizen sees it is a cost – planning and design to reduce cost in the manufacturing phase to the required levels (davies & boczko, 2005, p437). moreover, (kee.r & matherly 2006, p268) introduced a definition of target cost as a cost control tool to help control the costs that occur during the product life cycle from the design stage. furthermore, (garrison, etal 2011, p723) pointed out that the target cost process of determining the maximum permitted costs for a new product and through the development of an initial model can provide the maximum target cost. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 393 from the point of view of the second group, the target cost approach is a method aimed at improving the profitability of the enterprise and reducing costs. in other words, the target cost is a process aimed at reaching the desired financial results of the product at a given time by reducing the cost and improving profitability (the difference between the expected selling price and profit ability planned establishment). (castellano & young,2003,p144) explained the target cost as a profit planning and cost management system based on sales price, costumer focus, product design and an integrated team that is committed to implementing the system. in this regards, (hematfaret al, 2011, p3) concluded that target cost is a process to determine the target cost of new products before they are produced by providing the cost information intended for design engineers to achieve the application of new cost management in order to ensure the profitability of the new product when it is put on the market. 6.1 advantages of target cost nowadays, companies face severs pressures from different stakeholders to keep prices low and to increase their profit at the same time. thus, they use different strategies to increase profits without affecting price. one of these strategies is target costing. (hilton, 2005, p650) (ellarm, 2001, p11)(garrison & etal, 2001, p720) (okana & suzk, 2007, p176) (collier & knight, 2008,p p 7-8) (bahar, m.2012,p p 21-33) pointed out many advantages to the target cost, include; contributes to the strategic management of future profit; it is a tool for managing cost and profitability simultaneously; reduce costs from product planning and design to after sales; important tool to control the promotion of management awareness of costs; cost control by comparing actual costs with target costs; target costs approach works; target cost encourages team work; achieves continuous cost reduction for its reliance on continuous improvement as a value engineering entry; and achieves positive interaction between the internal environment of establishment and the extranet environment (customers and suppliers). 6.2 components application of target cost approach (hilton, 2005, p649) (yazdifar & askarony 2011, p p2-6) (evera, et al. 2006) (cima, 2005, p4) noted that the implementation of target cost approach is based on the following basic components: 1price –led costing: target cost = target profit – target price. 2focus on the costumer: management needs to know consumers preferences about the product and the price that suits them. 3focus on product design: this means designing the product in a way that can be produced without exceeding the target cost. 4focus on process design: this requires examining the aspects of the production process to ensure that the product is manufactured at the highest possible cost. 5cross – functional teams: this requires the cooperation of all the different task forces in the establishment. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 394 6life cycle costs: taking all costs related to the life cycle of the product in to account. 7value chain orientation: cancel all costs that don’t add value in order to reduce the planned cost. the researcher believes that the goal of the target cost is to reduce costs without prejudice to specifications of the product and maintain the level of feasibility required by the client. the cost of the product is reduced and reached to the target cost through the following stages: (hematfar, et al. p p3-7) (ansari, 1997 p10) (williams& et al, 2005, p811) (hilton 2005 p 651) (ibuski & kaminski, 2007, p459) 1planning and product design. 2cost analysis phase. 3value engineering phase (value analysis). 4production phase (final decision). 6.3 use the value engineering in achieving the target cost: the entrance of value engineering is one of the main tools that production designers use to achieve their target cost. the value engineering seeks to find potential areas for cost reduction during the product design and planning phase as an integral to the target cost approach. the important aspect of value engineering is to achieve a certain level of cost reduction. in other words, value engineering aims at reducing the gap between the estimated cost of the product and the allowable cost (blocher. et al, 2008, p p362-365). 6.4 the difficulties that facing the adoption of the target cost approach the difficulties that facing the adoption of the target cost approach:(yoshikawa etal, 1993 pp.211-214) pointed out that there are a number of difficulties that impede the adoption of the target cost approach. 1the concept of the target costing and value engineering is not clear in practice in many economic units. 2rapid technological development. 3the difficulty of predicting in new competitors. 4the difficulty of managing the target cost to achieve the target cost. 5the continuous rise in prices of raw materials. 6great pressure on employees to reach the target cost within a specified time frame. 7lack of full product cost information. 8the unpredictability of future customer desires. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 395 6.5 previous studies a number of studies have been undertaken about the topic of the study; particularly the application of the target cost entrance to reducing costs of production. (ratlray, et al (2007)) examined the extent of implementing target costing in new zealand manufacturing firms. the study was conducted on (80) industrial companies in new zealand. the study revealed that the production department contributes effectively to achieving the target cost through the addition of improvements to the product design and modifications to the manufacturing methods, which led to the reduction of costs to be equal to the target cost. (kocsoy,et al, (2008)) the study aimed to how the turkish industrial projects benefit from modern techniques in administrative accounting and the most important of these methods is the target cost the study showed that companies must follow a parallel competitive strategy especially that majority of companies operate under competitive market conditions and in order for companies to achieve the expected benefits of the target costs, they must pay great attention to customer expectation before designing the product. (filomena & et. al (2009)).this study was conducted in brazil and aimed to activate the target cost through product development as a model for implementing by recognizing the experience of the cost of product development at any stage in medium sized brazilian enterprises by applying the cost target model. the study concluded that the participants in the procurement of special engineers and designers are more the precisely controlling the cost, as the study showed that there were limitations in the lack of discussion of the specific cost estimate and cost reduction techniques. (yazdifor & ashkarany (2011)) the study aimed at comparing the adoption and application of the target cost in the united kingdom, australia and new zealand by applying them to qualified administrative accountants with a legal administrative accounting certificate who work in the (2041) industrial and service companies. the researchers used the survey method in their study the distribution of (584) questionnaires. the results of the study showed that the prevalence of the use of the target cost approach between the industrial and service companies in the countries in which the study was conducted and there is an increasing interest of companies in testing all the cost reduction strategies at the stage of plan and adopt value engineering to integrate customer requirements rather than to adopt a cost cutting strategy. (alkababji (2014)) this study was conducted in palestine and aimed at the availability of components of the application of the target cost entrance in the industrial companies of the palestinian. (11) companies have represented the study sample, (9) industrial public shareholding companies responded to the researcher. the study revealed that ingredients of implementing target costing entrance in industrial companies, which means that the palestinian industrial companies have appropriate environment for using the target costing, also the results showed that were some difficulties which could hinder the application. (norhafiza bashrudin & ruzitajuson, 2015) this study was conducted in malaysia. the purpose of the study is to explore how the target cost method is being practiced and what the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 396 major factors are that influence target cost method in non-japanese environment.according to the researchers the results of the study showed that the fundamental concept of target cost practices at the case company was similar to the japanese companies practices in spite of the were some difference in details. the differences were due to the case company coordinated and reconfigured its resources to adopt with the contextual constraints as highlighted in four propositions developed this study focused on a single case study in a single industry. (talebnia, g. et al, 2017) studied the linkages between target costing and value engineering and expected profit and kaizen. the results of study showed that there is a relation between customer orientations, the product has a direct effect on target costing and product lifecycle costs are directly related to the objectives. (bock, s & pütz, m, 2017) proposed new quality-oriented control approach for value engineering based on a discrete quality measure that allows for the mapping of multidimensional dependencies. they found that understanding the decision-making process in sales and production departments, and their frequent application provides systematic access to controlled operations and, in doing so, supports management-oriented decision-making. 7. hypotheses of the study h01: the jordanian shareholding companies for food industries don’t have the ingredients to implement the target cost approach. h02: the jordanian shareholding companies for food industries do not awareness the concept, principles and importance of applying the target cost approach. h03: the jordanian shareholding companies for food industries do not use the target cost management to improve their profitability. h04: the use of value engineering does not reduce costs to reach the target cost in the jordanian shareholding companies for food industries. h05: there are no difficulties in adopting the cost target and value engineering in jordanian shareholding companies for food industries. 8. methodology and discussion of results 8.1 methodology the study reveals the results of a survey of accountants in shareholding companies for food industries in jordan regarding the extent of implementing target costing and value engineering entrance to reducing costs in jordanian shareholding companies for food industries. the questionnaire was distributes personally to a random sample of 145 accountants. (100) questionnaires were returned, and the response rate of which was 69%. it is to be noted that a majority of the respondent, have a bachelor’s degree in accounting, as well as professional qualification such as cpa, jcpa. average experiences of respondent were about (10) years with a maximum more than (15) years and a minimum of (5) years at asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 397 the time of conducted this survey. the purpose of the above analysis was to ensure that accounting professional who have experience who completed the survey. 8.2 study tools after reviewing the literature of accounting and previous studies that relating to target costing and value engineering entrance to reducing costs. the researcher developed a questionnaire which consisted of (34) items regarding the adoption and implementation of target costing and value engineering entrance to reducing costs in the jordanian shareholding companies for food industries. 8.3 statistical tests statistical methods applied to analyze data are means, standard deviations and percentages and ttest. scale likert scale was adopted, which consists of five degrees to determine how much the responders agree or disagree with each item in the questionnaire as how in table (1). table 1. likert scale scale strongly disagree disagree neutral agree strongly agree degree 1 2 3 4 5 relative weight 20% 40% 60% 80% 100% 8.4 results analysis and discussion asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 398 table 2. trends of the sample of the study on the availability of components of the application of the target cost in jordanian share holding companies for food industries. no items mean standard deviation percentage 1 the company uses a cost accounting system that is commensurate with its activity 4.84 0.51 96.80% 2 the management of the company is interested in managing its costs 4.76 0.47 95.20% 3 the company determines the price at which the product can be sold by subtracting the price from the target cost 4.50 0.58 90% 4 the company determines the cost of its product as following (expected selling price – profit required =target cost) 4.42 0.56 88.40% 5 the company is interested in the customers desires related to the product and price 4.31 0.78 86.20% 6 the company designs it’s product according to planned allowable and eliminate costs that do not add value 4.21 0.81 84.20% 7 the company manufactures its products efficiently without exceeding the permitted cots 4.11 0.70 82.20% 8 the company is composed of teams from various departments to achieve the planned cost 4.04 0.63 81.10% general average 4.405 0.61 88.10% table 2 shows that the trends of the sample of the study are positive in all items about the availability of the ingredients of the implementation of the target cost in the jordanian shareholding companies for food industries, where the general average (4.405) is greater than the mean of the study tool (3),the standard deviation (0.61) and the percentage (88.10%),also, the standard deviation (0.61) indicates to the agreement of the sample of the study on the availability of the target cost in jordanian shareholding companies for food industries and the percentage (88.10%) reinforce this. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 399 in order to test the hypotheses of the study the t-test was performed at a level of (0.05) according to the rule of decision: the null hypothesis accepted if the calculated (t) is less than (t) value and sig value is greater than (0.05).the null hypothesis is rejected if the calculated (t) value is greater than the (t) value and the significant value equal or less than (0.05). ho1: the jordanian shareholding companies for food industries do not have the ingredients to implementing the target cost approach. table 3. results of t. test (first hypothesis) sig calculated(t) value tabulated (t)value mean standard deviation results 0.00 14.680 1.9842 4.405 0.61 reject asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 400 table 4. trends of the sample study on the awareness of jordanian shareholding for food industries for the el concepts a principles and importance of applying the target cost approach in managing their costs n o items mean standard deviation percent age 1 the management of the company is concerned with adopting the target cost approach to reduce their cost with preservatives required quality 4.34 0.934 86.80% 2 management company strives to know the competitive price of the product for its impact in calculating the maximum allowable cost 4.31 0.775 86.20% 3 the management of the company recognizes the importance of desires needs of consumers and their tastes in terms of price and quality when reducing the costs to reach the target cost according to adopting the cost target approach 4.30 0.69 86% 4 the company urges all department towards reducing costs to reach the target cost which does not affect the quality of product 4.10 0.70 82% 5 the company is aware that the cost reducing of the product is during the planning and design stages 4.24 0.71 84.80% general average 4.26 0.439 85.20% table 4 shows the results of the analysis show that jordanian shareholding companies for food industries realize the concepts, principles, and importance of applying the target cost to manage their costs. this is evidenced by the general average of (4.26) as it is larger than the mean of the study tool (3) as the standard deviation of (0.439) indicates the absence of a large dispersion between the study sample opinions and enhances the approved level is (85.20%). ho2: the jordanian shareholding companies for food industries do not awareness the concepts, principles and importance of using the target cost approach. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 401 table 5. results of t test (second hypothesis) sig calculated (t)value tabulated(t) value standard deviation mean results 0.000 12.170 1.9842 0.439 4.26 rejects table 5 showed that the mean of the jordanian shareholding companies for food industries awareness of the target cost in managing their costs is greater than the mean of the study tool (3) and the difference of (0.26) is considered significant based on the value of sig =6.000 which is less than 0.05. there for the researcher rejects the null hypothesis and accepts the alternative hypothesis which stipulates that jordanian shareholding companies for principles and importance of using the target cost in managing their cost. table 6. trends of the sample study on the use of the target cost in management of their cost to improve profitability. no items mean standard deviation percent age 1 the target cost approach contributes in the strategic management to the future profits of the company 4.32 0.69 86.40% 2 the target cost approach contributes to giving incentives to the employees which leads to increased productivity and thus improved the level of profits 4.24 0.75 84.80% 3 using the target cost approach helps in minimize waste in cost elements to the maximum extent possible 4.21 0.64 84% 4 the company is concerned with the results of analyzing the desires and needs of the target consumers when planning and designing the product that achieves the target cost and profit target 4.20 0.65 82.40% 5 the company studies the market to identify new competitive products and competitors 4.12 0.74 79.88% 6 the company determines the competitive price of the product through the study of competitive prices in the market 3.99 0.97 79.80% 7 the company is interested in applying total quality management on productivity stages with the aim of improving profitability 3.95 0.99 79% general average 4.147 0.644 82.9% asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 402 table 6shows that the trends of the study sample on all the items were positive and ranged between (4.32-3.95) the general average (4.147) is greater than the mean of study tool (3) in addition to the standard deviation which indicates the absence of a large dispersion between the sample study. this result confirms that the jordanian shareholding companies for food industries are using the cost target in managing their costs to improve profitability with a degree of approved 82.90%. h03: the jordanian shareholding companies for food industries do not use the target cost management to improve their profitability. table 7. results of t. test (third hypothesis) sig calculated (t) value tabulated (t) value standard deviation mean results 0.00 14.321 1.9842 0.644 4.147 reject table 8. trends of the sample of the study on the use of the jordanian shareholding companies for food industries the value engineering to reach the target cost no items mean standard deviation percentage 1 the company determines the cost of its products during the planning and design stages 4.40 0.501 88.00% 2 the company has a design team of different departments to provide the best product design and achieve the target cost 4.31 0.50 86.20% 3 the company cancels activities that do not add value to the product and incorporate similar activities 4.22 0.70 84.40% 4 the company uses cost tables that include cost drives to help select materials the are involved in product manufacturing within the target cost level 4.01 0.35 80.20% 5 the company encourages teamwork to reduce waste 3.90 0.77 78.00% 6 the company is interested in the quality of similar parts used in two or more manufactures to reduce costs 3.84 0.67 76.80% general average 4.10 0.388 82.00% table 8 shows that the overall mean level of all the paragraphs was (4.10) with the standard deviation of (0.388) the mean for all the items ranged between (4.40-3.84). the relative importance of all items was 82%. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 403 h04: the use of value engineering does not reduce costs to reach the target cost in the jordanian share holding companies for food industries. table 9. results of t test (forth hypothesis) sig calculated (t) value tabulated (t) value standard deviation mean result 0.00 17.051 1.9842 3.88 4.10 reject table 10. trends of the study sample on the difficulties that facing the adoption of target costing and value engineering in jordanian shareholding companies for food industries. no items mean standard deviation percentage 1 lack of sufficient knowledge to manage the company on how to implement the target costing and value engineering approach. 3.07 0.76 81.40% 2 lack of research and publications related to the introduction of the target cost and value engineering. 3.97 1.10 79.40% 3 application costs increased the expected benefit 3.85 0.96 77.80% 4 lack of clear and detailed information on product cost 3.41 0.87 68.20% 5 lack of training for the employees on the implementation of the target cost and value engineering 3.75 0.48 75.00% 6 the difficulty of predicting new competitors 3.34 0.88 66.80% general average 3.75 0.319 75% table 10 indicates that the general average (3.75) the standard deviation (0.931) and the degree of approval (75%) this means that the average degree of difficulties hindering the adoption of the target cost and the value engineering in the shareholding companies for food industries is higher than the mean of the study tool (3) also the standard deviation of (0.391) indicates a sample study agreement that there are difficulties impeding the adoption of target asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 404 costing and value engineering approach in jordanian shareholding companies for food industries. h05: there are no difficulties in adopting the cost target and value engineering in jordanian shareholding companies for food industries. table 11. results of t. test (fifth hypothesis) sig calculated (t) value tabulated (t) value standard deviation mean results 0.000 13.380` 1.9842 0.931 3.75 reject 9. conclusion the results of survey revealed that there is agreement in the opinion of the study sample on the availability of the components of the application of the target costs approach, as well as on the awareness of the jordanian shareholding companies for food industries regarding their costs to improve profitability. in addition, the jordanian shareholding companies for food industries are using the value engineering approach to achieve a cost reduction to reach the target cost. the results also indicated that there were some difficulties which hider the application of target costing and value engineering in the jordanian shareholding companies for food industries. the most important difficulties were: 1the lack of sufficient knowledge to manage the company on how to implement the target cost and value engineering. 2the lack of research and publication related to the benefits target cost and value engineering. 3application costs greater than the expected benefits. the results of the survey confirm the results of previous studies such as that conducted by alkababji (2014).the researcher believes that jordanian shareholding industrial companies which do not apply target costing and value engineering will not be able to fulfill the desires and expectations that are placed upon them by customers references ansari, s. l., & bell., j. (1997). target costing: the next frontier in strategic cost management. new york: megraw-hill. bahar, m. (2012). conceptual framework for launching and implementing target costing in automotive industry. international journal of research in it & management, 2(6), 21-33. bhimani, a., horngren, c. t., sundem, g. l., stratton, w. o., schatzberg, j., & burgstahler, d. (2012). introduction to management accounting. pearson asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 405 blocher, e., stout, d., juras, p., & cokins, g. (2016). cost management-a strategic emphasis, megraw-hill irwin bock, s. & pütz, m. (2017). implementing value engineering based on a multidimensional quality-oriented control calculus within a target costing and target pricing approach. international journal of production economics, 183, 146-158. https://doi.org/10.1016/j.ijpe.2016.09.007 castellano, f., & young, s. (2003). speed splashier: an interactive, team-based target costing exercise. journal of accounting education, 84(2), 293-305. cooper, r. & slagmulder, r. (1999). develop profitable new products with target costing. mit sloan management review. davies, t., & boczko, t. (2005). business accounting and finance, mcgraw hill higher education. ellram, l. m. (2001). the role of supply management in target costing. arizona state university, arizona. evereat.p, loosveld.s,.t, a., schollier.m, & sarens.g. (2006). characteristics of target costing: theoretical and field study perspective. qualitative research in accounting and management, 3(3), 236-263. https://doi.org/10.1108/11766090610705425 garrison, r., noreen, e., & brewer, p. (2011). managerial accounting, megraw-hill irwin. hematfar, m., sanati-arasteh, a., & nooryan, s. (2009). the steps of implementing target costing, ssrn. available: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1455184 hilton, r. w. (2005). managerial accounting: creating value in a dynamic business environment. new york: megraw hill. ibusuki, u., & kaminski, p. c. (2007). product development process with focus on value engineering and target-costing: a case study in an automotive company. international journal of production economics, 105(2), 459-474. https://doi.org/10.1016/j.ijpe.2005.08.009 knight, k., & collier, p. m. (2009). target costing in the automotive industry: a case study of dynamic capabilities, ssrn. lgagne, m., & discenza, r. (1993). new product costing, japanese style. the cpa journal online: pp. 68-71. majdi, a. (2014). the extent of implementing target costing and value engineering entrance to reducing costs of palestinian shareholding industrial companies. dirasat: administrative sciences, 41(2), 170-190. mansour, m. what target cost is? available: http://www.jps-dir.com/forum/uploads/13379/what_target_cost.pdf asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 406 pascoal, t., filomena, netob, f. j. k., & duffey, m. r. (2009). target costing operationalization during product development: model and application. international journal of production economics, 118(2), 398-409. https://doi.org/10.1016/j.ijpe.2008.12.007 talebnia, g., baghiyan, f., baghiyan, z., moussavi, f., & abadi, n. (2017). target costing, the linkages between target costing and value engineering and expected profit and kaizen. international journal of engineering management, 1(1), 11-15. microsoft word 10198-37541-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 171 capital structure effect on the practices of earnings management phenomenon? the evidence of listed firms in abu dhabi securities exchange dr. mohammed ibrahim sultan obeidat business administration department, al ain campus al khawarizmi international college al ain-united aram emirates, p.o. box: 68297 e-mail: misobeidat_2015@yahoo.com / m.obeidat@khawarizmi.com received: oct. 23, 2016 accepted: nov. 17, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.10198 url: http://dx.doi.org/10.5296/ajfa.v8i2.10198 abstract the study objects for determining whether the listed firms in abu dhabi securities exchange exercise the phenomenon of earnings management in its financial reporting, and whether these practices are affected or driven by the capital structure of firms. to achieve the objectives of the study, a sample consisting of 29 listed firms at abu dhabi securities exchange (adx) out of total 83 listed firms, had been selected using the simple random sampling method. data covering 4-years was collected from the included firms in the sample, starting from 2012 till the end of 2015. the binomial distribution test is used to determine whether listed firms at adx exercise the phenomenon of earnings management using the modified jones 1995 model, whereas, the simple linear regression method is used to test whether the proportion of financial leverage in the capital structure of firms drives the practices of earnings management. the study shows that the firms exercise the phenomenon of earnings management, and the regression outputs show a significant positive effect of financial leverage on the practices of earnings management phenomenon. keywords: earnings management phenomenon, financial leverage, discretional accruals, debt ratio, and capital structure asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 172 1. introduction earnings or what is called “net income”, and “bottom line”, is the most important item in the financial statements as a whole. managers of business organizations may attempt to manage this item, mainly to affect the theoretical value of firms’ stock, since the theoretical value of a firm’s stock is actually the present value of its expected future cash flows (lev, 1989). other motives, in addition to firm value, may be available for managements to manage earnings. some people misunderstand the term of earnings management when they believe that the practices of this phenomenon can’t be considered ethical, and believe that it is normal ethical practice. in opposite to unethical accounting manipulation, earnings management is considered ethical, since it is a type of exploiting the flexibility level of accounting standards, where firms can select among alternative methods of measurement and recognition of revenues and expenses. therefore, earnings management is seen by some interested people as a reasonable and an ethical management of decision making in intent to achieve a type of stable profits (gaa, 2007). despite the viewpoint that exercising earnings management is legal, financial information should be relevant and reliable to enable investors, creditors, and other users of to make good and beneficial decisions. managements have some incentives to exercise the phenomenon of earnings management, where this reduces the reliability of the reported earnings, so decisions taken by investors, creditors, and other users, may not be enough good. the phenomenon of earnings management, when exercised by managements leads to deceiving earnings to stockholders, investors, creditors, and other users, when they depend on this deceiving information. management exploits the high level of flexibility that available in the accounting standards, where this flexibility enables management to use judgment in applying the revenue recognition principle. therefore, more techniques and methods should be developed to detect the phenomenon of earnings management when it is exercised to influence the amount of the reported profits. next to several financial crises occurred during the last years of the last century and the first decade of the current century, the phenomenon of earnings management became under the focus of academics, authors, practitioners, and other interested people. earnings management means revealing above or below the actual earnings through choosing the accounting methods that may lead to the desired result (roychowdhury, 2006). some financial indicators can be used to detect this phenomenon through using several available approaches and models, where some of these models are used to separate the nondiscretionary accruals from the total accruals. non-discretional accruals do not involve earnings management practice, whereas discretionary accruals are rich field for practicing the phenomenon of earnings management. the capital structure of business organizations consists of two sources, equity and debt. using debt in the capital structure of firms differs from one country to another, from an industry to other, and also from firm to firm in the same industry and same country, depending on the needs of funding, and whether current stockholders have the desire and ability to provide the firm with its funding needs. the relationship between capital structure asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 173 of firms and the practices of earnings management is still questionable, and no conclusive answer that debt affects or does not affect the practices of earnings management. moreover, the consequences of earnings management may have strong negative effect on debt providers, in case the firm fails, and the fair value of its assets is less than the its total financial obligations. the problem of the study may seem clear. next to financial crises and firm’s scandals during the last few years of the twentieth century, and the starting years of the current century, finding solutions to the phenomenon of earnings management and other manipulation practices became an urgent issue to protect investors, creditors, shareholders, and other groups of users from losses. several procedures are taken to reduce the practices of earnings management such as the issuance of sarbanes-oxley act, and corporate governance to reduce earnings management practices. moreover, because the impact of financial leverage in terms of its proportion in this structure, is still questionable, the effect of financial leverage needs more and more investigations, since some studies found a positive effect of leverage on earnings management, others found no effect, whereas some found no relation. the problem of the study can be summarized in determining whether listed organization in abu dhabi securities exchange (adx) exercise the phenomenon of earnings management, and to detect whether the financial leverage of these firms has an effect on these practices. the following two questions can better express the problem of the study. the first is; do listed firms at adx exercise the phenomenon of earnings management? whereas, the second is; do the financial leverage of listed firms in adx affects the practices of earnings management by these firms? the study attempts to find clear cut answers for these two questions using the reported information by firms. the study is important especially these days, where most firms attempt to reveal more profits than the actual. managements have strong incentives to manage earnings, but the most important incentive is financial rewards, where more financial rewards will be received by managers when the reported profit is high, and in opposite, less or no financial rewards may be received by managers when less profit is reported. the importance of the study increases because no clear and conclusive answer to the effect of financial leverage on the practices of earnings management is available. the study also educates users and decision makers with the phenomenon of earnings management and offers methods or ways for its detection. in the united arab emirates (uae), stock exchanges and the environment of earnings management had not been enough investigated, so this study is important to all developing stock exchanges and stockholders in developing countries, because it helps finding more protection to small investors and creditors against the harmful effects of earnings management phenomenon. the study is important also because it highlights the incentives for managers to manage earnings, so stronger and more incentives mean more probability to practice earnings management, and therefore these practices can be detected and users can be protected. more practices of earnings management lead to more fails among business organizations, and reducing the phenomenon practices means more investment growth in businesses and less fails. the study objects for: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 174 1. add more literature to the phenomenon of earnings management, including incentives, results, and the models that can be used to detect the practices of this phenomenon. 2. measuring the practices of earnings management phenomenon by the listed firms at adx, especially where this phenomenon is rarely studied in oil-based countries, where oil extraction forms a large proportion of its local production and income. 3. determine whether the capital structure of listed firms in adx affects the practices of earnings management phenomenon. the remainder of the study proceeds as follows. section 2 is dedicated for the literature and prior related researches. the hypotheses of the study are shown in section 3, whereas section 4 presents the methodology used to accomplish the study. results and analysis are shown in section 5, whereas section 6 shows the conclusions and findings of the study. 2. literature review and prior researches despite that the issue of earnings management is one among the hot topics since the collapse and corporate scandals in the last few years of the twentieth century, the term may still ambiguous for several groups of people. earnings management is defined by schipper (1998), as “a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain”. the term of earnings management is also defined by levitt (1998) as “a gray area where the accounting is being perverted, where managers are cutting corners and where earnings reports reflect the desire of management rather than the underlying financial performance of the company”. other authors define earnings management as “a reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results” “rahman, moniruzzaman, and sharif, (2012).healy and wahlen (1998), provide a complete and clear definition of the term earnings management when they define it as “earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers”. the discussion of the term of earnings management should include seven overlapping elements including, crime, suspects, weapons used, victims, motives, opportunity to carry out, and alternative explanations (lo, 2007). actually, when some one or more is exercising the phenomenon of earnings management, this means that a crime is committed. when there is a crime, there should be a perpetrator or more that made that crime. the murder, or the individual or group that are more common to carry out the crime of earnings management are normally the management or the managers because they have the motives to do that, whereas users of financial statements such as investors, creditors, and shareholders, are in most cases the victims. people normally do not commit without a motive or a reason. these reasons are called incentives which encourage people to commit a crime. sometimes, earnings management phenomenon is exercised by managers just to satisfy the prior expectations of earnings. in other situations, the management may manage earnings to receive high financial rewards because the amount of these rewards depends on the amount of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 175 reported earnings. managers may manage earnings also to reduce the amount of income tax payables, or to influence the firm’s share market price. additional motives are available for managers to exercise the phenomenon of earnings management, but these are the most common incentives. the opportunity to manage earnings can be interpreted through the relationship between earnings management and earnings quality. a link or a relationship between earnings management and earnings quality exists. ball and shivakumar (2007), stated that a negative relationship exists between earnings management and earnings quality, where quality of earnings quality declines as the level of earning management practices increases. several methods and techniques can be used to manage earnings. one common method is what is called acquisition accounting. under the idea of acquisition accounting, gaap had been amended in 2001, where the pooling of interests method became not allowed to be followed, and business firms should follow the purchase method as a unique method based on these amendments (abu ajeelah and hamdan, (2009).the misuse of materiality is also another method that can be followed in exercising the phenomenon of earnings management. materiality means the level of omission, misstatement, fraud, or change which may lead a decision maker to change his judgment may change and therefore the decision may change. the applications of revenue recognition principle are also an important instrument for managing earnings. revenue is recognized when earned, realized, or realizable. the general rule is that revenue is recognized at point of sale for sales of tangible products, and when the service is rendered in full in case of services, because a probability appears that resource will inflow to the firm with amount can be measured reliably. in practice, firms may recognize revenue despite no enough ability exists that the resources will inflow to the fir, or may recognize revenue early or delaying this recognition intentionally to achieve an attractive purpose for the management. cooking the books is also a known method in the practices of earnings management such as trade loading and channel staffing. more methods of managing earnings are available such as capitalizing expenses despite that it should be expensed within the current period. nonrecurring expenses, pension plans, off balance sheet items, artificial rents, and cookie jar reserves, are all among the methods available to practice earnings management. the decision of capital structure formation is one among the most important decisions in business organizations that taken by the firm’s management or its board regarding the capital structure. the term capital structure refers to the proportion of each of equity and debt in funding the assets of the firm, so debt means the part that borrowed from creditors, whether it is cash as loans or purchasing and receiving services on credit. the term financial leverage refers to the amount of debt used in the capital structure of firms. more borrowing leads to more risks, but borrowing is preferable when the cost of borrowed funds is less than the rate that may be achieved when these borrowed funds are invested somewhere. it is already known that more borrowing increases risk, but also borrowing may increase the profitability of the borrower when rate of interests on borrowing funds is sharply lower than the rate on these funds when used in investment. actually this is called trade in equity, asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 176 because this difference at end is due to shareholders, so rarely a firm borrows with a rate of interests exceeds the expected rate of return on investment. the weight of debt in the capital structure can be measured using different measures such as debt ratio and debt to equity ratio, but in this study the debt to equity ratio is used because it finds debt in proportional relation to total assets. the issue of earnings management had been given enough interests and its importance is perceived carefully in the developed and western countries, but in the developing countries, including the arab and other middle east countries, the problem had not been given the deserved importance, especially that arab gulf countries do not impose income tax, so its economic system can be considered as different and unique system, where governmental revenues are not based on taxes. actually, and based on the survey made to the literature of earnings management, no prior researches that investigating the issue of earnings management had been found, not only in uae, but also in other arab gulf countries. the most important and recent important study is that what carried out by al momani (2016), where the author investigated whether the traditional and modern performance indicators can explain the practices of earnings management phenomenon of the listed manufacturing firms at amman stock exchange. the author used the modified (1995) jones model in measuring the practices of earnings management for a data of a sample consisting of 29 firms covering the period 2006-2013. in details, three traditional indicators had been taken with consideration by the author including return on assets, return on sales, and cash flows from operations. modern indicators tat the study takes into consideration are tobin’s-q and the economic value added. the study shows that the manufacturing listed firms at amman stock exchange are still exercising the phenomenon of earnings management, and a significant relationship exists between both of the traditional and modern indicators in one hand, and the practices of earnings management. the final conclusion of the study is that both of traditional and modern indicators have the ability to interpret the practices of earnings management. some of the prior researches that investigated the impact of financial leverage on the practices of earnings management phenomenon found that leverages increases earnings management practices, such as kontorizos (2008), and beatty and weber (2003). in opposite, other prior researches found a negative impact of financial leverage on the phenomenon of earnings management and added that financial leverage restricts the management desire to manage earnings (jelinek, 2007), (wasimullah and others, 2010) . the characteristics of firms and their effect on earnings management were among the interests of uwuigbe, ranti, and bernard, (2015). their study is based on a sample consisting of 20 listed firms at the nigerian stock exchange using the judgmental sampling method, and data covering the years 2006-2010 of these firms had collected and analyzed. in addition to the descriptive statistics and econometric analysis, the least square regression method had been used in data analysis and hypotheses testing. the study revealed an impact of each of firm size and corporate strategy on earnings management, but it did not find a significant effect of financial leverage on earnings management. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 177 mozarpour and norouzi (2015), investigated the effect of both capital structure and growth opportunities on earnings management using a sample of listed firms in tehran stock exchange. the pooled data method had been used in data analysis and hypotheses testing. results showed that there is a significant relationship between financial leverage and earnings management practices, whereas regarding the growth opportunities, the study revealed that there is a nonlinear and significant relationship between this variable and earnings management, and growth opportunities have a significant influence on this relationship. the impact of corporate governance on earning management practices was among the interests of patrick, paulinus, and nympha, (2015). the authors actually investigated this relationship using a sample of nigerian firms, where this sample had been selected using the purposive sampling technique between a period of 2011-2014. simple linear regression had been used in data analysis and hypotheses testing. the study finds that the practices of corporate governance such as board size, board independency, firm size and the strength of audit committees, have a significant effect on earnings management practices. miloud (2014), studied the existence of earnings management in initial public offerings of french firms. the author states that it is difficult to detect earnings management practices when the purpose of these practices is to increase the attractiveness of the offered stock. in case of exercising earnings management to make shares more attractive, these practices are done before the initial public offerings are made. in this study, the author examined earnings management through observing a time-series, where a sample consisting of french firms that went public between 1995 and 1998 on the euronext paris exchange. the most important finding is that initial public offering firms with the highest discretionary current accruals are underperformed, compared with the equivalent firms in the third year following the initial public offering. uwuigbe, peter, and oyeniyi (2014) also investigated the effect of corporate governance mechanisms on earnings management in nigeria. a sample of 40 listed firms in the nigerian stock exchange had been used as a source of the primary required data using the judgmental sampling method. regression analysis had been used in data analysis and in hypotheses testing. the findings of the study revealed that the board size and board independency had a negative significant influence on earnings management practices, whereas ceo duality had a positive significant impact. the study concludes that firms with larger boards and diverse knowledge have more ability to restrict the practices of earnings management, than smaller boards. kighir, omar, and mohamed (2014) made a revision to the different types of models used in detecting the practices of earnings management. the review found that robust models have been discovered in detecting earnings management, but these models are only available on the shelves of authors without utilization by industries. the authors recommended designing software of auditing or fraud detection from these models, especially discretionary accruals models, to be used by professionals and shareholders. the relationship between board committees and earnings management was under the attention of liu, harris, and omar (2013). the study investigates this relationship next to the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 178 international methods that made to strengthen corporate governance. a sample of 138 listed firms in australian stock exchange had been selected to examine whether this relation exists. the main finding of the study is that the independency and activities of the board and sub-committees have a significant negative relationship with earnings management represented by the discretionary accruals. several researchers investigated the effect of firms’ size on earnings management, among them is cabej (2013), who studied this effect by using a sample of listed firms in albania. log of total assets is used to measure firms’ size, while discretionary accruals used to measure the practices of earnings management using jones model. results showed that albanian listed firms are engaged in earnings management initiatives but there are no significant differences among firms of different sized in their effect on the practices of earnings management phenomenon. an, li, and yu, (2013, investigated the effect of earnings management practices on financial leverage, and the way this relationship is affected by institutional environments. the study employed using the data of 25,798 firms across 37 countries along the years 1889-2009. the study found that firms with high earnings management practices tend to have high corporate leverage, and this positive relationship is attenuated by strong institutional environments. moreover, the results of the study lend strong support to the agency theory of free cash flows. zamri, abdul rahman, and isa (2013), investigated the impact of financial leverage on real earnings management. the primary purpose of this study was to determine whether the financial leverage has an impact on the real earnings management. the abnormal cash flows from operations, the abnormal production costs, and the abnormal discretionary model by roychowdhury, 2006, is used in this study as a proxy for real earnings management. the study is based on 3,745 firm-year observations along the period 2006-2011, listed in bursa, malaysia. the main finding of the study is that a significant negative correlation between financial leverage and the practices of earnings management and leveraged firms have lower level of earnings management. rani, hussain, and chand (2013), investigated the incentives standing behind managements’ practices of earnings management. the authors developed a questionnaire directed toward a group of firms’ key managers and members of board of directors of fiji. the study demonstrated that the common incentives of earnings management of fiji firms include management compensation, borrowing cost, meat/beat targets and expectations, and increase or decrease regulatory benefits or costs. gerakos (2012), stated that the current techniques used in identifying earnings management are sorely lacking, and they based on an assumption that accruals unexplained by discretionary accruals represent either earnings management practices or weak earnings quality, where these techniques suffer from measurement error and correlated omitted variables which lead to type i error and type ii error. in addition, these techniques are estimated in the cross section where they do not take into consideration that earnings are better described by dynamic processes. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 179 a study that carried out by rahman, moniruzzaman, and sharif (2012), investigated the techniques, motives, and controls of earnings management. in details, this study investigated some techniques that are used in managing earnings like cookie jar reserve, big bath, and big bet. moreover, the study investigates some incentives for the practices of earnings management such as, market incentives, personal incentives, and political and regulatory motives. the study found that rigorous accounting standards, corporate governance and consciousness, awareness of the audit committee, and the morality of stakeholders, each of which plays a vital role in restricting the practices of earnings management and can control these practices (lo, 2007). following the recent financial scandals and therefore the recent changes in the french institutional context, benkraiem, (2012) investigated the role of corporate governance mechanisms in guaranteeing reliable and more accurate financial information that french firms issue. empirical findings of the study showed that the present of independent directors can moderate the discretionary accruals management. the study adds that discretionary accruals management can also be restricted through the big 4 audit firms. moreover, the study demonstrates that there is no significant relationship between ownership structure and the management of these accruals. the impact of corporate governance on earnings management practices was the focus of roodpohti and chashmi (2011). the authors of the study hypothesized that corporate governance plays a role in reducing the harmful effects of earnings management practiced on shareholders and other users of financial information. the key objective of the study was to investigate the relationship between corporate governance internal and external mechanisms, and earnings management, where internal mechanisms of corporate governance includes ownership concentration, board independency, and ceo dominance, while external mechanisms include institutional shareholders according to the authors classification of corporate governance mechanisms. required information was gathered based on a sample consisting of 196 firms of tehran stock exchange between 2004 and 2008. panel data method was used in the study to estimate its models. findings of the study includes that firms with higher ownership concentration and board independence tend to manage earnings less than firms with higher institutional holdings. one additional finding of the study is that a positive relationship exists between ceo-chairman duality and earnings management. moreover, the study showed that firm size and leverage had been found that they have a positive relationship with earnings management phenomenon. tahir (2011), was among interested people with earnings management and its relation with the capital structure. the objective of the study was to identify the relating factors to earnings management and factors that having impact on capital structure. it is based on the published balance sheet by state bank of pakistan on non-financial listed firms at the karachi stock exchange along 2001-2005. the study shows a negative coefficient, where the gearing ratio is negatively affected by return on assets. this negative relationship is justified that earnings management may have some effects on the capital structure of listed firms at karachi stock exchange. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 180 chen, cheng, and wang (2011), investigated whether increasing board independence leads to a reduction in earnings management practices. the study finds that non-compliance firms (firms that did not have a majority of independent directors prior to reforms), do not experience a significant reduction in earnings management practices from prior to afterwards of the reform. the study also shows that non-compliance firms that have low information acquisition cost experience a significant reduction in earnings management, when compared with other firms. the authors concluded that independent directors’ control is more effective in environments of rich information. dechow, hutton, and kim (2011), provided a new approach for testing the accrual-based testing models of earnings management. in this new approach, the authors assumed that any accrual-based earnings management in one accounting period should be reversed in another accounting period, and incorporating the priors concerning the time of reversal will improve the power and specification of tests used to detect earnings management. the authors of the study found that incorporating the reversal increases the test power by more than 40%, and provides a robust solution for reducing the model misspecification resulting from the correlated neglected variables. an applied comparison is made between the modified jones model (1995), and the korean model to determine which is the most effective one in detecting the practices of earnings management (islam, ali, and ahmed, 2010). the authors mentioned that the modified jones model is effective in detecting earnings management in the developed countries, but a model applied on the korean stock exchange found more effective. therefore, the authors of the study applied both of the modified jones model and the korean model on bangladesh capital market, and found that the korean model is more powerful than the modified jones model in detecting the practices of earnings management. zhang and liu (2009) carried out a study to investigate the impact of capital structure on earnings management and applied their study on chinese listed firms from 2003 to 2007. the study demonstrates that the equity proportion of controlling shareholders has a u-shape relationship with earnings management practices, while a strong positive relationship of debt ratio on earnings management. in addition, the study shows that the equity proportion of executives and external majority shareholders’ share impact on earnings management is weak. earnings management through real activities manipulation had been investigated carefully by roychowdhury (2006). the author took into consideration the relationship between some factors and earnings management. the study found evidence that managers manipulate real activities of firms to avoid losses reporting. in more details, the study showed evidence for making price discounts to increase sales, overproduction to reduce cost of goods sold, and reduction of discretionary expenditures to increase reported margins. moreover, the study reveals that industry membership, the stock of inventories and receivables, and incentives to meet zero profits, are all affect the manipulation of real activities. kim and liu (2003), also carried out a study to investigate the effect of firms’ size on earning management. the authors of the study classified firms into small, medium, and large sized asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 181 firms. the study finds that both large and small sized-firms manage earnings to avoid the announcement of small negative earnings or small reduction in earnings. the study concludes that small firms exercise more earnings management than large and medium sized-firms to avoid the reporting of small losses, whereas medium and large-sized firms manage earnings to avoid reporting earnings decreases than small-sized firms. one study by peasnell, pope, and young (1999) used a developed model called margin model, in addition to (jones 1991) and (dechow 1995) models. the study found that each of the above three mentioned models is well specified when applied to a random sample of firm-years, but the margin model generates relatively better specified estimates of abnormal accruals when cash flow is extreme. the analysis of the above three mentioned models, revealed that the ability to detect earnings management are capable to generate powerful tests for economically plausible levels of accruals management. the study demonstrated that the standard-jones and modified-jones are more powerful for revenue and bad-debt manipulation, but the margin model is more powerful in detecting non-bad debt expense manipulation. therefore, the study concludes that different models are required in different circumstances. dechow, sloan, and sweeney (1995), investigated the alternative accrual-based models for detecting the practices of earnings management. they used several measures of discretionary accrual models. the authors applied all available models to a random sample of us firms. their study highlighted the importance of controlling financial performance in investigating whether earnings management phenomenon is used. among the available models, the study found that the modified jones model has the strongest power in investigating earnings management phenomenon. based on the review made to the related literature of earnings management phenomenon, and the prior related researches, it is apparent, that some prior researches found no relationship between the capital structure and the phenomenon of earnings management (mozarpour and norouzi, 2015) (an, li, and yu, 2013) (zamri, abdul rahman, and isa, 2013) (roodpohti and chashmi, 2011), whereas other showed that this relation exists (uwuigbe, ranti, and bernard, 2015) (benkraiem, 2012) (tahir, 2011) (zhang and liu, 2009), despite that among which, some declared that this relation is positive, while others declared that it is negative. these different findings must be considered incentives for authors and academics for more investigations of the phenomenon of earnings management in different countries, especially the developing countries. table (1) summarizes the findings of some related prior researches regarding the relationship between the capital structure and the phenomenon of earnings management. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 182 table 1. summary of prior researches conclusions author year significant relationship no significant relationship uwuigbe, ranti, and bernard 2015  mozarpour and norouzi 2015  an, li, and yu 2013  zamri, abdul rahman, and isa 2013  benkraiem, (2012) 2012  tahir 2011  roodpohti and chashmi 2011  zhang and liu 2009  the table summarizes the conclusions of the most related prior researches, where it includes only the findings of those prior researches that investigated the relationship between debt and earnings management phenomenon 3. research hypotheses based on the revision that made to the literature of earnings management, and the consideration of prior related researches, five hypotheses were developed to achieve the objectives of the study. all hypotheses had been stated in their null form. these hypotheses are as follows: ho1: listed firms in abu dhabi securities exchange do not exercise the phenomenon of earnings management. ho2: capital structure of listed construction equipment firms in abu securities exchange does not affect the practices of earnings management in these firms. 4. research methodology the structure of the study consists of one dependent variable and one independent variable. the dependent variable is earnings management, while the capital structure is the independent variable. a sample consisting of 29 firms had been selected from the total 82 listed firms in adx, using simple random sampling method. : based on the concept of earnings management, which occurs when managers use their judgment in financial reporting and in structuring transactions to alter the financial reports to mislead stakeholders regarding the economic performance of a firm or to affect the contractual outcomes that normally depend on the amounts of reported items in the financial statements (healy and whalen, 1998),the modified jones model is used for separating discretionary accruals from total accruals, and discretionary accruals is used as a measure for the practices of earnings management phenomenon. different authors found that the modified jones (1995) model that adjusted by dechow, sloan, and sweeney, (1995), is the most asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 183 powerful among the available models to detect earnings management, (dechow, sloan, and sweeney, 1995)(islam, ali, and ahmed, 2010), (peasnell, pope, and young, 1999), (momani, 2016).the modified (1995) jones model uses the discretionary accruals as an indicator of earnings management practice, where a higher absolute value of discretionary accruals means less earning quality. two approaches are available to determine total accruals, the income statement approach, and the balance sheet approach. for the purposes of the current study, the income statement approach is used, where based on this approach total accruals are computed by subtracting the net cash flows from operating activities from the operating income in the income statement. thefollowing equation is used to determine the amount of net income from the financial statement. tat = oit – cffoat (1) where: tat: total accruals in period t oit: income of year t cffoat: cash flows from operating activities in year t. to compute the nondiscretional accruals for firm j in year t, the parameters of the cross-sectional modified jones (1991) model are estimated using the following equation. taj,t/aj,t-1 = α + 1(1/a,jt-1) + 2 (∆ , − ∆ , )/ , + 3(ppej,t/aj,t-1) + ej,t. (2) where: taj,t = total accruals of firm j for year t. δrevj,t = change in revenue of firm j between year t and year t-1. δrecej,t: change in receivables of firm j between year t and year t-1. ppej,t: gross property, plant, and equipment of firm j industry j for year t. aj,t-1:total assets of firm j by the end of year t-1. ɛt: residuals, where it represents that part of total accruals that cannot be interpreted by the variables of regression, and used as a proxy representing discretionary accruals. applying the above regression equation, 29 equations became available for each year of 2012, 2013, 2014, and 2015. using the parameters ( 1, 2, 3) the nondiscretional accruals had been estimated using the following equation: taj,t/aj,t-1 = â + 1(1/a,jt-1) + 2 (∆ , − ∆ , )/ , + 3(ppej,t/aj,t-1) + ej,t (3) then the discretional accruals had been computed using the following relation: |dacі,t/ aі,t-1| = |tacі,t/aіt-1 – ndacі,t /aі,t-1 | (4) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 184 where dacj,t/ai,t-1 refers to discretional accruals to prior assets of firm j in year t. next to the computations of discretionary accruals of each firm for 4 years, the absolute value of discretional accruals and the average of this value were computed for each firm along the period of the study. to determine whether each included firm in the sample exercised earnings management, the absolute value of accruals is compared with average of these accruals, so when the absolute value of the firm’s accruals is above the average, this means that the firm exercised the phenomenon of earnings management, and given number 1 as a factious, while it is given 0, when the absolute value of accruals is less than the average of its discretional accruals. the single independent variable of the study is capital structure. debt ratio is used to measure the capital structure of firms, where debt ratio is the relation of total debts to total assets. therefore, the following regression method is used as the model of the study. em = a + bdt + e (5) em: refers to the phenomenon of earnings management dt: refers to debt ratio a: constant represent the value of earnings management when debt ratio equals zero. b. represents the slope of debt ratio on discretionary accruals or the phenomenon of earnings management. e: the standard error of the model. the binomial distribution method is used to analyze the first hypotheses which hypothesized that the listed firms in adx exercise the phenomenon of earnings management, whereas the simple linear regression method is used to test the second hypothesis regarding whether the capital structure of listed firms in adx affects the practice of earnings management phenomenon. a 95 percent level of confidence (sig = 0.05) is used for the decision rule of accepting or rejecting the null hypotheses. 5. results and analysis 5.1 the first hypothesis applying the steps of finding the discretional accruals, table (2) shows the average as a good central tendency measure, the standard deviation as a good measure of variation, the minimum value, and the maximum value of the proportional discretionary accruals to total assets of prior year. based on information appearing in table (2), the highest mean of the discretionary accruals to total prior assets is due to year 2013, whereas the lowest one is attributed to year 2015. the standard deviation for the year of the highest mean is 0.05734, whereas its value for the year of the lowest mean is 0.033. mean of the total period of the study is -0.0288 at a standard deviation of 0.0228. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 185 table 2. discretionary accruals to total prior assets discretionary accruals to total prior assets year mean standard deviation maximum minimum 2012 -.01999 0.01922 0.01869 -0.01922 2013 -0.05827 0.05734 0.03454 -0.28340 2014 -0.02222 0.017522 -0.00010 -0.06141 2015 -0.01553 0.03309 0.05023 -0.10245 along the period of the study -0.02880 0.02280 0.01186 -0.11976 the table shows the descriptive statistics for the discretionary accruals in proportion to total prior assets the average for each firm had been computed, and when the firm has accruals in one year above the average it is classified as a practitioner to the phenomenon of earnings management in that year and therefore given the number one, whereas if it’s accruals below the mean, it is considered not practitioner to the phenomenon, and therefore given the number zero for the purpose of using the binomial distribution test. the results of this process are shown in table (3). based on information appears in table (3), the least number of firms that practiced earnings management was on 2012, where only 5 firms, or 17 percent of the total firms included in the sample exercised the phenomenon. in opposite the highest number of firms that exercised the phenomenon is recorded on year 2014, where 19 firms, or 66 percent of the firms included in the sample exercised earnings management. in total, 47 observations of practicing earnings management, while 69 negative observation of non-practicing earnings management. table 3. practicing firms of earnings management phenomenon year exercising firms non-exercising firms total proportion total frequencyfrequency proportion frequency proportion 2012 5 0.17 24 0,83 100% 29 2013 9 0.31 20 0.69 100% 29 2014 19 0.66 10 0.34 100% 29 2015 14 0.48 15 0.52 100% 29 total 47 41% 69 59% 100% 116 the table shows both of frequency and proportion of practicing and non-practicing firms to the phenomenon of earnings management 5.1.1 testing the first hypothesis the first hypothesis of the study assumes that the listed firms in adx do not practice the phenomenon of earnings management. the hypothesis is represented again as follows: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 186 ho1: listed firms in abu dhabi securities exchange do not exercise the phenomenon of earnings management. the binomial distribution test had been used to test the first hypothesis, since a firm practices or does not practice the phenomenon and no third possible option is available. the hypothesis is tested at 95 percent level of confidence. the analysis shows that 47 out of 116 observations were positive or exercising, which represents 41 percent out of 116 total observations, whereas 69 observations are negative observations or not exercising, or 59 percent of the total number of observations. the p-value (exact-sig) is exactly 0.05. because the computed p-value exceeds the tabulated one, the null hypotheses is rejected, while instead the alternative one is accepted, which states that listed firms in adx practice the phenomenon of earnings management. in other words, the test of the hypothesis approves the practice of earnings management phenomenon by some listed firms in adx. table (4) shows the binomial distribution results of analysis. table 4. binomial statistics hypothesis no. of firms exercising ear. management proportion no. of firms not exercising ear. management proportion p-value (sig) ho1 47 41% 69 59% 0.05 the table shows the related statistics to hypothesis (1),using binomial distribution 5.2the second hypothesis the second hypothesis is developed to examine whether the capital structure of firms affect the practices of earnings management phenomenon. as mentioned above, the debt ratio is used as indicator for the capital structure. debt ratio is computed by dividing total liabilities by total assets. table (5) shows the mean, standard deviation, minimum debt ratio, and the maximum one for each year and in total for all years together. based on the table, the mean of debt ratio of all years is between o.4 and 0.5, which is considered normal, despite that some high and low debt ratios for some firms in few years. the highest mean of debt ratio is recorded on year 2013, where it is 0.47775, whereas the lowest is 0.41576, and attributed to year 2012. the standard deviation for the year of the highest mean is 0.276, whereas the one for the year of the lowest mean is 0.306. table 5. debt ratio statistics year mean minimum maximum standard deviation 2012 0.41576 0.001 0.896 0.306 2013 0.47775 0.056 0.899 0.276 2014 0.47587 0.047 0.924 0.283 2015 0.46520 0.064 0.933 0.286 total 0.45864 0.001 0.933 0.285 the table presents the descriptive statistics of debt ratio asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 187 5.2.1 testing the second hypothesis the second hypothesis is developed to represent the assumed effect of capital structure of firms on the practices of earnings management phenomenon. the second hypothesis is presented again as follows: ho2: capital structure of listed construction equipment firms in abu securities exchange does not affect the practices of earnings management in these firms. table (6) shows total assets, total liabilities, and the debt ratio for each firm within the sample in each year along the period of the study. the table shows that the debt ratio sharply differs from one firm to another and slightly from year to year for the same firm. the large differences are attributed to the difference in industry each firm in the sample belongs for. some firms belong to building equipment, others for commercial banking industry, and others for food or and services. the highest debt ratio is 93.3 percent, and recorded in year 2015, whereas the least on is 0.001, and recorded on 2002. table 6. debt ratio ser. no year liabilities total assets debt ratio firm 1 2012 408,246 3,585,558 .0.114 2013 338,139 3,309,349 0.102 2014 1,892,244 4,304,946 0.440 2015 2,055,211 4,670,458 0.440 firm 2 2012 1,812,111 301,000 0.001 2013 1,401,907 1,847,401 0.759 2014 1,356,480 1,738,787 0.780 2015 987,538 1,365,781 0.723 firm 3 2012 754,787 1,128,931 0.669 2013 713,786 1,249,832 0.571 2014 829,570 1,379,713 0.601 2015 830,633 1,544,411 0.538 firm 4 2012 1,584,301 3,240,494 0.489 2013 1,802,194 3,505,489 0.514 2014 1,907,507 3,697,540 0.516 2015 1,846,258 3,693,626 0.500 firm 5 2012 612,552 1,454,565 0.421 2013 627,538 1,236,810 0.507 2014 107,283 559,194 0.192 2015 99,028 605,995 0.163 firm 6 2012 473,576,6 792,563.421 0.006 2013 452,066.8 884,329.690 0.511 2014 439,815.4 842,417.115 0.522 2015 340,870.3 585,947.931 0.582 firm 7 2012 10,734,886 12,739,343 0.843 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 188 2013 12,624,387 14,814,659 0.852 2014 17,383,368 19,683,444 0.883 2015 14,211,801 16,477,070 0.863 firm 8 2012 18,650,639 22,832,688 0.817 2013 20,619,887 24,972,508 0.826 2014 20,641,724 25,054,383 0.824 2015 22,964,474 27,586,918 0.832 firm 9 2012 3,896,000 12,903,000 0.302 2013 3,568,000 12,907,000 0.276 2014 3,305,000 13,237,000 0.250 2015 3,816,000 14,338,000 0.266 firm 10 2012 58,689.7 405,344.979 0.145 2013 59,678 431,290.385 0.138 2014 78,996.1 498,317.687 0.159 2015 86,087.1 572,973.668 0.150 firm 11 2012 278,088,350 1,596,188.732 0.174 2013 363,112,716 2,228,625.041 0.163 2014 272,198,268 2,254,633.702 0.121 2015 284,763,347 2,265,319.728 0.126 firm 12 2012 34,693,574 80,146,363 0.433 2013 36٫122,838 85,715,534 0.421 2014 67,894,945 129,584,558 0.424 2015 68,889,448 128,264,557 0.537 firm 13 2012 242,383,793 445,547.814 0.544 2013 214,151,943 424,997.848 0.504 2014 193,096,843 409,791.652 0.471 2015 186,075,241 409,980.020 0.454 firm 14 2012 840,209,290 1,778,007.732 0.473 2013 795,396,822 1,721,005.239 0.462 2014 781,577,270 1,732,959.507 0.451 2015 732,719,184 1,734,750.246 0.422 firm 15 2012 145,185,324 1,371,921.552 0.106 2013 279,224,667 1,512,540.189 0.185 2014 298,578,273 1,518,920.334 0.197 2015 229,227,534 1,445,091.816 0.159 firm 16 2012 821,136,141 1,698,802.719 0.483 2013 814,860,666 1,885,918.000 0.432 2014 661,631,000 1,826,273.000 0.362 2015 651,085,000 1,878,168.000 0.347 firm 17 2012 835,644 2,544,433 0.328 2013 1,164,640 3,051,302 0.382 2014 1,041,316 3,248,529 0.321 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 189 2015 1,163,045 3,455,834 0.337 firm 18 2012 52,385,535 283,826,793 0.185 2013 50,345,046 333,701,647 0.151 2014 55,754,252 365,920,988 0.152 2015 65,052,839 378,367,249 0.172 firm 19 2012 269,466,078 300,599,169 0.896. 2013 290,383,115 325,061,656 0.893 2014 338,135,330 376,098,712 0.899 2015 363,345,154 406,563,807 0.894 firm 20 2012 1,801,558 3,486,496 0.517 2013 1,758,945 3,340,409 0.527 2014 1,617,237 3,354,870 0.482 2015 1,188,446 4,615,329 0.257 firm 21 2012 49,693,834 723,040.547 0.069 2013 41,346,210 736,586.793 0.056 2014 33,439,336 710,784.059 0.047 2015 43,150,443 674,858.591 0.064 firm 22 2012 30,054,032 5,311,992 0.006 2013 3,039,861 5,679,296 0.535 2014 2,965,062 5,999,875 0.494 2015 3,044,323 5,981,775 0.509 firm 23 2012 73,431,869 85,664,555 0.857 2013 90,086,594 103,160,486 0.873 2014 98,217,136 111,903,803 0.878 2015 103,302,431 118,377,662 0.873 firm 24 2012 243,920,739 977,439.645 0.250 2013 359,933,672 1,244,536.911 0.289 2014 362,343,555 1,256,066.884 0.288 2015 294,017,652 1,141,042.624 0.258 firm 25 2012 442,695 1,755,287 0,522 2013 454,874 1,883,814 0.241 2014 449,023 1,889,157 0.238 2015 458,952 1,851,124 0.248 firm 26 2012 13,872,331 17,733,142 0.782 2013 17,195,994 21,731,901 0.791 2014 21,424,496 26,012,888 0.824 2015 25,178,292 28,882,693 0.872 firm 27 2012 109,277 122,590,000 0.891 2013 109611 121,925,000 0.899 2014 106,254 115,038,000 0.924 2015 101,436 108,767,000 0.933 firm 28 2012 13,367,992 15,012,589 0.890 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 190 the table provides the liabilities, total assets, debt ratio and amount of discretionary accruals for each firm in the sample in each year. the simple linear regression method had been used in testing the second hypothesis since it is appropriate to examine whether a single independent variable affects another dependent variable. the dependent variable in this study is the practices of earnings management phenomenon, whereas the independent one is the capital structure of firms. while the practices of earnings management phenomenon are measured through the discretional accruals of firms along the period of the study, the capital structure is measured through the debt ration of each firm in each year along the period of the study. table (7) shows the results of simple linear regression using the spss. based on information appearing in table (7), the computed t-value is 2.997 and the coefficient of significance is 0.003. because the computed t-value is higher than the tabulated one that equals 1..96, and because the coefficient of significance is less the predetermined one, which equals 0.05, the null hypotheses which states that the capital structure of listed firms at adx doesn’t affect the practices of earnings management phenomenon, is rejected. in opposite, the alternative hypothesis which states that capital structure affects earnings management practices is accepted. in other words, the test of the hypotheses finds that the capital structure of listed firms in adx affects the practices of earnings management phenomenon of these firms. table 7. statistics of the effect of debt ratio on discretionary accruals hypothesis adjusted r2 t-value significance coefficient standard error ho2 0.065 2.997 0.003 0.022 the table shows the regression statistics of the effect of debt ratio on discretionary accruals based on the results of regression analysis, the model of the study takes the following form em = -0.39 + 0.022dt+ 0.022 (6) 6. findings and conclusions the primary two objectives of the study is to identify whether listed firms in adx practice the phenomenon of earnings management, and to examine whether the capital structure of these firms affects the practices of earnings management. data of a sample consisting of 29 listed firms had been collected covering the period2012-2015, and analyzed. both of the two 2013 19,068,225 21,549,756 0.885 2014 22,797,624 25,709,285 0.887 2015 21,093,668 23,681,623 0.891 firm 29 2012 162,271 1,418,071 0.114 2013 150,887 1,407,870 0.107 2014 104,892 1,391,264 0.075 2015 114,138 1,368,832 0.083 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 191 hypotheses that constructing the study had been tested using the binomial distribution test for practices of earnings management, and the simple linear regression method for the impact of capital structure. the analysis of discretionary accruals revealed that listed firms at adx have practices of earnings management. data covering the period 2012-2015 regarding debt ratio for the firms included in the sample had been analyzed with discretionary accruals of the same period, and the finding shows no significant effect of capital structure on earnings 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(2013). the impact of leverage on earnings management. procedia economics and finance, 7, 86-95. https://doi.org/10.1016/s2212-5671(13)00222-0 microsoft word 8614-31269-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 13 eva and the impact of the macroeconomic variables: evidence from the jordanian manufacturing companies imad zeyad ramadan full prof., department of finance, applied science privet university, p.o. box 166, amman, jordan e-mail: e-mail: i_ramadan@asu.edu.jo received: nov. 5, 2015 accepted: dec. 9, 2015 published: june 1, 2016 doi:10.5296/ajfa.v8i1.8614 url: http://dx.doi.org/10.5296/ajfa.v8i1.8614 abstract this study aimed at examining the effect of macroeconomic variables on the performance of jordanian manufacturing companies listed in amman stock exchange expressed by eva using unbalanced panel data pooled ordinary least square (ols) regression model of all 77th jordanian manufacturing companies listed at ase for the period 2000-2014 resulting in 1085 firm-year observations connecting firm level and time series data set. this study has revealed that interest rate has statistically significant inverse effect on the performance of the jordanian manufacturing companies (β=-0.064, p-value <0.01).the results of this study have also revealed that inflation (β=0.0945, p-value <0.05) and government expenditure ratio(β=0.0734, p-value <0.05) have a statistically significant positive effect on the performance of the jordanian manufacturing companies at the significance level <0.05.also, gross domestic product(β=0.00395, p-value <0.10) affects the performance of the jordanian manufacturing companies at the significance level< 0.10, and finally, the study has revealed that money supply and the labor force indicator have no statistically significant effect on the performance of the jordanian manufacturing companies. basically, and depending on the results of this study, we can conclude that economic value add (eva) of the jordanian manufacturing companies, as a proxy of the performance, is a function of inflation, interest rate, government expenditure ratio and gross domestic product. keywords: eva; macroeconomic variables; jordan asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 14 1. introduction in light of the significant changes and developments in recent economic aspects witnessed on the global level, financial accounting performance measurement systems –which basically depend on profitability become incapable to perform proper performance measurement of the facility. this incapability encouraged the emergence of modern standards to measure the financial performance of the companies, which depend essentially on the creation of firm’s value but not on accounting profit which has recently faced many criticisms and a lot of controversy. it is known that the interests of investors are not affected by the profitability of the company only, but are also affected by the changes associated with the market value of the company, what in turns formed a pressure that prompted companies to adopt appropriate measures that enable them to measure and determine the actual realizable value; of which, the most important and most famous was economic value added (eva). economic value added eva can be defined as the difference between the value of company’s inputs and outputs (booth, 1998) during the company’s activity, so whenever the value of the company's revenue is greater than the cost of purchasing inputs of company's activities, the company is working to create value. according to (lieberman and balasubramania, 2007) eva concept differs from one person to another depending on the nature of such person, for example, for the consumer eva is the production of goods or the provision of services continuously, but for the staff eva means a great deal of respect in dealing, participation in decision-making, continuous training and lucrative rewards, while for the investors eva means continuous high returns on capital which should include a high revenue growth and large profit margins and this can be achieved only if the company achieves a value continuously. these various value-added concepts impose the measurement of achieving the goals of the company through value-added instead of the traditional view of short-term profits. the traditional notion of the function of managers lies in their continuous quest to achieve growth in the wealth of the owners of the company and growth in return on assets, but modern managers have become aware that the new target for the company must be creating value to stakeholders regardless whether stakeholders have financial claims against the company or not, and thus, managers discovered that traditional measures of corporate performance should not be the main objective to be achieved, because these traditional measures are essentially considered as indicators to achieve the main goal of adding as much as possible economic value for the company. the traditional accounting methods used in assessing the financial situation of the company, which rely on accounting profits (return on assets (roa), return on equity (roe), earnings per share (eps), cash flow from operations (cfo) have faced several criticisms because they depend on estimation, as they are also affected by the used accounting methods, where the rate of accounting return has always been criticized for its inability to measure the economic profit (fisher & mcgowan, 1983). financial accounting reports have also faced several criticisms because of their low quality and lack of coherence and consistency in information-rich environment, so there has almost become a general consensus that asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 15 traditional methods must be reviewed to overcome their shortcomings (mashayekhi and bahavarnia, 2007) there became an urgent need to provide more accurate tools by relying on various standard methods such as: value based management (vbm)) which provides awareness of a high degree of value of shares; also cash value added (cva) and (economic value added (eva) which have been developed by stern stewart & co. in 1989. these methods are all working to provide more accurate standardized methods as compared to inaccurate traditional ways of accounting. relying on accounting thought that considers profit as the sole criterion upon which performance measurement and evaluation depend on, and restricting financial reports to meet the needs of investors, have led to focus the company's efforts towards maximizing the profitability in the short term, as the generally accepted performance measures have become ineffective because they focus on results without addressing their causes; as such measures are almost away from value achieving activities. the importance of this study stems from identifying the concept of economic value added (eva) as a new measure for corporate performance. the study problem stems from the unclarity of the extent to which economic value added (eva) of jordanian manufacturing companies listed in amman stock exchange is affected by macroeconomic variables whereas studies that addressed economic value added (eva) have focused on the internal factors of the company and the extent to which economic value added (eva) is affected by such factors without addressing macroeconomic variables. 2. literature review previous studies have included a lot of discussion and controversy over the definition of the concept of value, the concept of created value or value-added, and the reason is that many researchers have explicitly declared that value added equals ordinary shareholders returns, which necessarily means that value created by a company belongs only to ordinary shareholders, and this idea stems mainly from the idea that the increase in the firm’s value is achieved through maximizing short-term profits of shareholders. it is no secret that the firm’s value is affected by several factors such as the financial risk of the company (bartram, 2000) the resources available to the company (moran and ghoshal, 1997) organizational capacity of the company (ghashal, hahn and moran, 1997) intangible assets (bounfour, 2000) as well as the classical accounting variables, which include roe, structure of assets, the structure of capital, debt ratio, growth opportunities (pariente, 2000) as well as acquisitions and capital allocation improvement. many studies (fama and french, (2007); martin, (2007); glushkov, (2007)) have stated that there was a statistically significant relationship between the economic added value of the company and each of sales growth, assets growth and in retained earnings growth. but the base of created value lies in keeping the profitability higher than the cost of equity. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 16 pilot studies that examined the strength of the relationship between market value or market return and eva comparing between market return and traditional measures of income such as o'byrne, (1996) have concluded that eva, and unlike traditional measures of income or profits, are systematically linked with market value of the company. therefore, eva has a greater ability to predict the market value more than other measures. uyemura, kantor and pettit, (1996) study has confirmed this result, however, biddle, bowen and wallace, (1997) failed to reach evidence that strongly link eva with earnings and firm’s value as it is the case in stern stewart, (2000). chen and dodd, (1997) have concluded that eva offers information more than traditional measures about stock return association, but eva should be resolved once and for all rather than traditional measures, since these traditional measures such as roa, e / p have incremental value in monitoring the firm's performance, as they have also concluded that there were no statistically significant differences between eva and ri scale with stock return. imoughela (2014) has carried out a study aiming at examining the effect of monetary policies on the performance of the nigerian manufacturing companies during the period 1986-2012. the study concluded that there were a positive statistically significant relationship between the exchange rate, foreign exchange reserves and interest rates on the growth of industrial sector. also, the study has concluded the presence of a statistically significant effect of monetary policies on the performance of the industrial sector. dior (2013) has examined the effect of macroeconomic variables on the productivity of the industrial sector in niger during the period 1975-2011. the study concluded that there was a statistically significant effect for credit of the manufacturing sector and foreign direct investment on the productivity of the industrial sector, while money supply did not have a significant impact on the productivity of the industrial sector. eze, onyekachi and okiji (2013) aimed at identifying the effect of fiscal policy on the performance of the industrial sector. the study concluded that there was statistically significant negative effect for government tax on industrial companies, while the government expenditure had had a positive impact on the industrial sector, also the results have confirmed the effect of the fiscal policy on the industrial sector. charles (2012) has examined the effect of monetary policy on the industrial sector in nigeria and the study concluded that there were a statistically significant positive impact for money supply on the performance of the industrial sector, while there was a statistically significant negative impact for each of (inflation, tax and exchange rate) on the performance of industrial companies. tkalec and vizek (2009) aimed to study the effect of macroeconomic variables on the productivity of industrial companies in croatia. the study concluded that high-tech industries were elastic for change in investment, foreign demand and fiscal policy and the impact of the fiscal policy was significant on the performance of industrial companies in croatia. the study also found that the performance of low-tech industrial companies asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 17 increases with the decline of exchange rate, while the performance of industrial companies classified as medium and high technological companies declines depending on the decline in exchange rate. tahma siew, (1997) concluded that while the productivity of industrial companies in malaysia is positively affected by direct investment, the productivity of the industrial sector is adversely affected by capital intensity. ray (1997) found a statistically significant positive impact for each of urbaization and higher capital-labour ratio on the productivity of indian companies. 3. methodology 3.1. data the study utilized econometric analysis using unbalanced panel data pooled ordinary least square (ols) regression model of all 77th jordanian manufacturing companies listed at ase for the period 2000-2014 resulting in 1085 firm-year observations connecting firm level and time series data set. the needed financial and economic data to test the impact of the macroeconomic variables on the jordanian manufacturing economics value added were derived from the ase website, jordanian department of statistics website and the central bank of jordan website. following odior (2013) and omojimite (2012), macroeconomic variables were expressed as: interest rates (in_r), inflation (inf), gross domestic product (gdp), labor force (la_f), government expenditure ratio (g_ex) and money supply (mo_s). 3.2. the model base on the above, eva in this study, can be seen as a function of the macroeconomic variable as follows: = ƒ ( ) (1) where, is the economic value added for the company during the period. is the macroeconomic variables supposed to affect the company in the period. the mathematical model for this study, based on equation (1) can be formatted as: = + _ + + + _ + _ + _ + ɛ (2) where is the economic value added for the cross-sectional company for the period, as i = 1,2,3,…,77, t = 1,2,3,…,15; α is the constant of the regression model; ′ unknown parameters in the regression model to be estimated; in_r is the interest rate, inf is the inflation rate, gdp is the gross domestic product, la_f is the labor force indicator, g_ex is the government expenditure ratio and mo_s is the money supply. thus, the macroeconomic factors; and ɛ is the random error. two variables that the previous studies have found to be significantly affecting the economic value added have been added as control variables to remove their effects from the equation. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 18 firms size (siz) is expressed as the natural logarithm of the total assets and firms' profitability (roa) is expressed as the return on the assets. thus mathematical model in equation 2 can be reformed to include the two control variables as follow: = + _ + + + _ + _ + _ ++ + ɛ (3) eva value will be calculated for each of the companies within the sample through the following equation: = + = × = − (4) 4. results and discussions 4.1. correlation analysis data in table 1 shows the results of correlation analysis between macroeconomic variables. the results indicate in the table that the correlation coefficients between macroeconomic variables, the independent variables in the study sample, were generally low, where the results have showed no strong correlation between the independent variables transforms that have been used as independent variables in the study sample. table 1. correlation analysis between the variables of interest in_r inf gdp la_f g_ex mo_s in_r 1 inf 0.3339 1 gdp 0.5310 0.1860 1 la_f -0.0912 -0.3880 0.2037 1 g_ex -0.0224 0.1258 -0.4995 -0.1485 1 mo_s -0.5502 -0.3454 -0.1667 -0.0849 0.3262 1 in_r is the interest rate,inf is the inflation rate, gdp is the gross domestic product, la_f is the labor force indicator, g_ex is the government expenditure ratio and mo_s is the money supply source: calculations from spss by the author, 2015. the results appear in table 1 that there is a negative correlation between interest rate (in_r) and la_f, g_ex and mo_s, and an inverse correlation between inflation (inf) and la_f asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 19 and mo_s. also the results show negative correlation between gross domestic product (gdp) and g_ex and mo_s, and an inverse correlation between labor force indicator (la_f) and mo_s, while the other interactions were positively correlated. 4.2 regression analysis table (2) shows the results that have been obtained by applying the mathematical model for the study using unbalanced panel data pooled ordinary least square (ols) regression model. table 2. regression analysis results variables β t-value inf 0.0945 ** 1.970 in_r -0.0640* -2.616 gdp 0.00395*** 1.696 la_f 0.0279 1.440 g_ex 0.0734** 2.115 mo_s 1.874 1.305 siz 0.021** 2.186 roa 1.912 n. 1085 adj. r-square 0.233 f-statistics 0.00 durbin-watson 2.013 *, ** and *** indicate level of significance at 1%, 5% and 10%, respectively; in_r is the interest rates,inf is the inflation rate, gdp is the gross domestic product, la_f is the labor force indicator, g_ex is the government expenditure ratio and mo_s is the money supply. source: calculations from spss by the author, 2015. the table shows that the results of the regression coefficients of the explanatory variables were of statistical significance in most of them, the results showed that the inf positively significantly affected the performance of the jordanian manufacturing companies (β= 0.0945, p<0.05). this is consistent with what was expected that the impact of inflation on companies' performance measured by eva is significantly positive. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 20 the impact of in_r is significantly negative on the jordanian manufacturing companies (β= 0.0641, p<0.01). this result is consistent with what is expected, where that with the increase in funding costs the total cost of factors of production increases, which negatively affects the performance of the company. also, the table shows that the impact of gdp on eva is positive and statistically significant (β= 0.00395, p<0.10), the table also shows that g_ex appeared to have a positive significant impact on the jordanian manufacturing companies (β=0.0734, p<0.05). the results also show a positive insignificant effect of la_f and mo_s on eva (β=0.0279, p>0.10) and (β=1.874, p>0.10) respectively. 5. summary and conclusion basically, depending on the results of this study, we can conclude: firstly, the economic value add (eva) of the jordanian manufacturing companies, as a proxy of the performance, is a function of inflation, interest rate, government expenditure ratio and gross domestic product. secondly, jordanian manufacturing companies have to develop their policies that aim to exploitation and utilization of variables that positively affect the eva. finally, government should design regulatory policies to enhance its efficiency in reducing inflation rates to ease the negative effects of inflation on the potential eva of the companies. acknowledgements the author is grateful to the applied science private university, amman, jordan, for the financial support granted to this research project (grant no. drgs–2014-2015-209). references biddle, g. c., bowen, r. m., & wallace, j. s. (1997). does eva beat earnings? evidence on associations with stock returns and firm values. journal of accounting and economics, 24(3), 301-336. http://dx.doi.org/10.1016/s0165-4101(98)00010-x bounfour, a. (2000). le valeurdynamique du capital immateriel (the dynamic nature of intangible capital), revue francaise de gestion; 0 (130), september – october. bowman, c., & ambrosini, v. (2000). value creation versus value capture: towards a coherent definition of value in strategy. british journal of management, 11(l), 1-15. http://dx.doi.org/10.1111/1467-8551.00147 charles, a. n. b. (2012). investigating the performance of monetary policy on manufacturing sector in nigeria. arabian journal of business and management review, 2(1), 12 – 25. chen, s., & dodd, j. l. 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(2007). eva versus earnings: evidence from iran. international journal of accounting and information management, 18, (1). moran, p., & ghoshal, s. (1997). value creation by firms; insead working papers: 97/19/sm, february. o'byrne, s. f. (1996). eva and market value. journal of applied corporate finance, 9(1), 116 125. http://dx.doi.org/10.1111/j.1745-6622.1996.tb00109.x odior, e.s. (2013). macroeconomic variables and the productivity of the manufacturing sector in nigeria: a static analysis approach. journal of emerging issues in economics, finance and banking (jeiefb), 5, 362-380. omojimite, b. (2012). institutions, macroeconomic policy and the growth of the agricultural sector in nigeria. global journal of human social science, 12(1), 1-9. pariente, s. (2000). rendementboursier, creation de valeuretdonneescomptables: une etude sur le marchefranchais (with english summary). revue finance controlestrategie, 3(3), september. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 22 ray, s. c. (1997). regional variation in productivity growth in indian manufacturing: a nonparametric analysis. journal of quantitative economics, 13(1), 73-94. stern stewart, & co. (2000). www home page. [online] available: http://www.sternstewart.com/index2.shtml. taham, siew yean. (1997). determinants of productivity growth in the malaysian manufacturing sector. asean economic bulletin, 13(3), 333-343. http://dx.doi.org/10.1355/ae13-3d tkalec, m., & vizek, m. (2009). the impact of macroeconomic policies on manufacturing production in croatia. privredna kretanja i ekonomska politika 121/2009. uyemura, d. g., kantor, c. c., & pettit, j. m. (1996). eva® for banks: value creation, risk management, and profitability measurement. journal of applied corporate finance, 9(2), 94-113. http://dx.doi.org/10.1111/j.1745-6622.1996.tb00118.x microsoft word takhtaei & karimi-writer2 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 90 the effect of firm size on predictability future cash flows using earnings and operating cash flows nasrollahtakhtaei (corresponding author) assistant professor, accounting department dezful branch, islamic azad university, dezful, iran e-mail: nasrollah_takhtaei@yahoo.com hassan karimi accounting department, dezful branch islamic azad university, dezful, iran e-mail: hasankarimi73@yahoo.com received: nov. 2, 2016 accepted: dec. 1, 2016 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10795 url: https://doi.org/10.5296/ajfa.v9i1.10795 abstract the aim of this research is to investigate earnings relative ability, operating cash flow, and two traditional criteria of cash flow, that is, net earnings plus depreciation and operating working capital in predicting operating future cash flows. further, the effect of firm size on the ability to predict these criteria is investigated in this research. the sample firms contain listed companies in tehran stock exchange (tse) over the period 2005-2009. the results show that net earnings relative to operating cash flows and its traditional criteria have greater ability to predict future cash flows in small firms whereas operating cash flows compared with other criteria are better predictors in big firms. results indicate that the predictability of all models increases considerably when firm size increases. keywords: cash flow from operations, net earnings, small firms, large firms asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 91 1. introduction during period between 1930 and 1960, many cases of corporation's merger and acquisition were occurred and a new form of financial transaction was generated. these issues caused new problems in the area of financial reporting which standard setters accomplished required actions to meet those concerns as soon as possible. this leads to a situation where managers could select accounting choices and procedures to mitigate for example earnings per share (eps). the occurrence of numerous cases of managers' fraud was indicating managers' potential ability to misstate financial reporting due to different interpretations of generally accepted accounting principles (gaap).therefore, the ability of accrual-based financial reporting system as a main means of providing relevant and useful information for users was criticized (birkett and walker, 1971; hendriksen, 1977). in order to satisfy limitations and inherent problems relating to accrual-based accounting, cash flow statement was extensively widespread as well as income statement and balance sheet. in the early 1970s, using voluntary reporting of funds statement by companies led accounting standard setters to require companies to prepare and publish funds statement by means of available accounting information within the income statement and balance sheet in a way that reflects financial resources flow. however, after 1970 and following a number of bankruptcies in some of the famous companies, usefulness of available information in cash flow statement for economic making-decision was strongly questioned. they argue that information of cash flows is better proxy for evaluating firms' financial flexibility. lastly, a formal statement was issued by standard setters on which cash flow statement should be used instead of fund statement due to the strong support of cash flow statement by academician, financial managers, and organizations(lee, 1971; donleavy, 1994; mulford and comiskey, 2005). 1.1 usefulness of accruals accounting data regarding earnings as one of the key proxies of evaluating operations efficiency,calabrese and rafferty (2003) discuss that one of the advantages of using earnings is that operations evaluation process is not misstated by means of uncertain and changing cash flows. this is why financial transactions are recorded based on historical cost. furthermore, using allocation, amortization, depreciation, and other existing processes in accruals basis allows companies to allocate assets cost during their useful life or during time in which interest result from those assets are acquired. otherwise, if assets cost is regarded as expense in acquisition year, income statement report very small earnings or even result in loss for that given year and for the rest of the life years of those assets are not recognized any expenses in spite of the fact that those assets are being used to gain earnings which this does not seem rational and logical. obviously, there are some arguments regarding data quality which is based on accruals accounting and specifically earnings as a measure of firm performance. this information provides situations involving manipulations using different accounting choices and mental factor and various estimates. therefore, accounting information from accruals basis may be misstatement and calculated earnings also are changed to an unreliable proxy of firm performance(bernard and stober, 1989; dechow, 1994). accordingly, based-accruals earnings may not be useful significantly in predicting future cash flows notwithstanding these issues and problems and thus accounting information users apply cash flows rather than earnings in order to forecast asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 92 future cash flows(bierman, 1988; sharma, 2001). after 1980, u.s. and uk researchers and academician support the cash accounting concepts in order to change and adjust financial reporting systems. cash accounting can avoid existing uncertain and unclear classifications and provide financial reports users with the more objective financial information and fundamental and key data as well(lee, 1993). this is due to the fact that cash accounting does not contain concepts such as allocation and matching. in cash basis, transactions are recorded when either is paid or received cash related to. it is expected to be less manipulated cash basis relative to accruals basis(ali, 1994; sharma, 2001).despite of the advantages of cash basis which supporters have put forward in the defense of this method, it has been criticized. egginton (1984)and rutherford (1982)assert that cash basis is not well protected from manipulation and discretionary classifications. lee (1993)agrees with this problem and states that cash reporting system similar to other reporting systems has problems and states that individual judgments play an important role in reporting cash events. for instance, an individual judgment is necessitated when segments reporting are prepared. classification of some of the cases such as operational cash flows or other cases related to cash also requires individual judgments. the succeeding problem is related to the disclosure of cash flows. in other words, cash flow statement is consisted of expressionssuch as cash flow from operations, expenditure, and cash equivalents which may not be easily understood by users. 2. background literature and hypotheses development aghaei and shakeri (2010) examine the ability of cash flow and accruals components of earnings in predicting firm's cash flow over the period 1382-1386. based on their subject conceptual, they developed three regression models including; 1) earnings, 2) cash flow, and 3) cash flow and accruals components. they indicate that earnings, cash flow, and cash flow and accruals components have ability to predict future cash flow. further, they also demonstrate that cash flow model and the model of cash flow and accruals components have better ability to predict relative to earnings model. in another study carried out by arab mazar yazdi and safar zadeh (2007), the earnings components in predicting future operational cash flows is investigated using a sample of 44 companies listed on tehran stock exchange (tse) over the period 1360-1384. they separate earnings into cash component and accruals component and they provide evidence indicating earnings components reflects different information concerning future cash flow. in addition, they separate accrual components into five components and they find that model explanatory power is improved by separating accrual components into more components. using a sample of 55 listed firms in tehran stock exchange (tse) during period 1374-1381, gholam ali pour (2004) examines the ability of non-discretionary accruals in predicting earnings and future cash flows. they find that discretionary accruals have the ability of predicting future earnings but related r-squares is low whereas non-discretionary accruals do not have the ability of forecasting future cash flow. furthermore, they indicate that the combination of non-discretionary accruals and cash flows in all years investigated have explanatory power but r-squares are relatively small. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 93 to predict cash flows, modares and diyanato deilami (2003)considering four models with independent variables; 1) historical operating cash flows, 2) historical accounting earnings, 3) both historical operating cash flows and historical accounting earnings, and 4) operating cash flows, accounting earnings and items related to historical current assets and liabilities, investigate the ability of each models and accuracy of each model relative to other models. their results show that predicting operating cash flows using historical operating cash flows is not possible whereas predicting operating cash flows using historical accounting earnings is significantly possible and hence superiority earnings relative to cash flows is confirmed in operating cash flows. they also indicate that both model of historical operating cash flows and historical accounting earnings, and model of operating cash flows, accounting earnings and items related to historical current assets and liabilities improve models considerably. raeiyat kashani (1993) investigates the association between 1) accruals-based accounting earnings and different types of cash flows and 2) working capital from operation and operating cash flows during the period 1361-1368. the results indicate that earnings cannot show presents a clear interpretation as regard to cash flows and its related information. in australian context, farshadfar, ng, and brimble (2008)explore the relative ability of earnings and cash flow and two traditional measures of cash flow (earnings plus depreciation plus amortization and operational working capital) in predicting future cash flow. they provide evidence that operating cash flow in comparison with earnings and calculated cash using traditional method has more power in forecasting future cash flow. moreover, the ability of earnings and operating cash flow increase when firm size increases and superiority of operating cash flow over earnings is intensify as firm size increases in predicting operating cash flow. using a time series regression, kim and kross (2005)investigate the ability of current earnings in predicting succeeding operating cash flows during the period 1973-2000. they provide evidence that relation between earnings and succeeding operating cash flow is increased along with passing the time (with the exception of the some of the period, earnings in comparison to operating cash flow has more increased information contents). cheng and hollie (2008)investigate the role of core and non-core cash flows in predicting future cash flows using barth, cram, and nelson (2001)model. they demonstrate that core components relative to non-core components reflect different information as regard to future cash flows and separation cash components relative to barth, cram, and nelson (2001) model improves predicting cash flow noticeably. in another study conducted by al-attar and hussain (2004)using barth, cram, and nelson (2001)model, the accounting data ability including earnings, cash flows, and cash flows and accruals in predicting future cash flows for a sample of uk companies over period 1990-2000 is examined. using panel data as well as ordinary least squares (ols) regression; they provide evidence that separating earnings into cash and accruals improves predicting cash flows. additionally, they indicate that historical cash flows in comparison with historical earnings have more ability to forecast cash flows and historical cash flows in comparison to using cash flows and earnings accruals components contemporaneously are less powerful in predicting future cash flows. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 94 using quarterly data for 30 companies over a period of 10 years, jordan and waldron (2001)investigate the ability of accrual-based accounting measures and cash-based accounting measures in order to predict future cash flows. the results indicate that all models have important predictability in predicting cash flows. additionally, both r-squares and forecast errors percent show that predictability of nidpr (net income before extraordinary items plus depreciation and amortization) model is more than other models. krishnan and largay iii (2000) compare the direct and indirect methods of preparing cash flow statement in order to predict future cash flows during the period 1993-1998. their sample includes all firms whose cash flow statement is prepared and reported in direct method. they compare two predictability models. the first one uses direct method cash flow information and the second one uses indirect method cash flow information in order to predict. they indicate that direct method cash flows prepare more accurate prediction than that of indirect method cash flows. furthermore, they show that past cash flows of direct method are better predictors for future cash flows compared with accruals data and merely income. dechow, kothari, and l. watts (1998)develop a model of earnings, cash flows and accruals. they assume that sales create accounting cycle as to accounts receivable, accounts payable, and inventory. the model explains why current earnings compared with current operating cash flows are better predictors for future cash flows. they apply annual data for a sample of 667 firms over the period from 1963 to 1992. in their analysis, they define earnings as the earnings before extraordinary items and discontinued operations; cash flows from operations as the as operating income before depreciation minus interest minus taxes minus changes in noncash working capital; and also operating accruals as the earnings before extraordinary items and discontinued operations minus cash flow from operations. using simple and multiple regressions, they demonstrate that current earnings are better predictors than that of current cash flows for future cash flows and difference in ability of earnings and historical cash flows for predicting future cash flows is subject to expected operating cash cycle of firms. to provide an optimal model for predicting future cash flow, lorek and willinger (1996) use seasonal data rather than annual data. they developed a multivariate time series model using operating income, operating cash flows, and current assets and liabilities. their results indicate that multivariate time series model predict operating cash flows in a better way. according to findings, the use of accruals has better ability for predicting cash flows than cash flows which is consistent with the claim of financial accounting standards board (fasb). mcbeth (1993) examines the ability of cash flows and earnings in order to predict the future cash flows. he directly obtains cash flow from operations from statement of cash flows and earnings from income statement of the companies. he finds that neither past earnings nor cash flows from operations could be suitable predictor for future cash flows. percy and stokes (1992) replicate the analysis conducted by bowen, burgstahler, and daley (1986). they employ two measures of cash flows. the first measure which is traditional is composed of net income plus depreciation and amortization plus working capital from operations and the second measure is comprised of working capital from operations plus extra adjustments from changes in current non-cash and current liabilities which was more modified. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 95 in order to investigate the relationship between cash flows and earnings, they apply data from a sample of 99 australian firms in23 industry groups over the period from 1974 to 1985. their findings were in line with the findings of the bowen, burgstahler, and daley (1986). this means that traditional measure of cash flows (first measure) provide more accurate prediction for predicting cash flows for one or two future years compared with the measure of modified cash flows (second measure). bowen, burgstahler, and daley (1986) investigate the association between earnings and different measures of cash flows. additionally, they compare the predictability of earnings versus cash flows in order to predict future cash flows. using financial statements data of a sample of 324 firms during period from 1971 to 1981, they demonstrate that accruals-based earnings are highly related to traditional measures of cash flows (working capital from operations and earnings before extraordinary items and discontinued operations plus depreciation). however, they report a low association between other measures such as cash flow from operations, cash flow after investing activities and before financing activities, finally changes in cash during the financial period. according to the literature, this study developed four hypotheses as follows: h1: operational cash flows have ability to predict future cash flows. h2: current earnings have ability to predict future cash flows. h3: current earnings plus depreciation have ability to predict future cash flows. h4: operational working capital has ability to predict future cash flows. 3. research design the main purpose of this study is to provide evidence with respect to relative usefulness of accruals-based earnings cash flow from operations (reported in cash flow statement) in predicting future cash flow. therefore, to investigate the predictive ability of measures of earnings and cash flow in predicting future cash flows, this study estimates the following model explaining cash flow from operations in year t (cfoi,t), incorporating the four primary variables of net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1), net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1), working capital from operations in year t – 1 (wcfoi,t-1), cash flow from operations in year t – 1 (cfoi,t-1), initially using ols regression analysis. this study investigates to what extent the association of earnings and cash flow from operations with future cash flow from operations is influenced by firm size. 3.1. sample selection process the sampleconsists of 94 iranian companies, representing almost all non-financial firms listed on the tehran stock exchange (tse) for the period 2005-2009. however, the sample selection process is based on the following criteria: (i) the companies should be listed on tehran stock exchange during the period from 2005 to 2009,(ii) in order to compare data, the end of financial year (20th march) of the selected companies should be the same and the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 96 companies should not change their financial year during the covered period, and (iii) financial companies such as banks, investment companies are excluded because their balance sheet data are not comparable with those of nonfinancial firms. additionally, in order to test the research hypotheses in two groups of companies, this study decomposes the full sample into large and small companies based on firms' shares market value. the decomposition has also been done based on median of firms' shares market value where companies with shares market value equal or larger than median are regarded as large companies and small companies otherwise. finally, the result of the decomposition indicates 45 large and 49 small companies. 3.2. variables definition 3.2.1 cash flow from operations (cfo): operating activities is composed of main activities of business entity's revenue productive. these operations require production and sell goods and render service and expenses, revenues relating to those are considered in determination of operational income or loss in income statement. cash flows from operational activities are basically consisting cash inflows and outflows with regard to mentioned operations that it is the latest figure reported in the section of cash flows from operating activities in cash flow statement. 3.2.2 earnings (earns): net earnings after tax but before extraordinary items (reported in income statement) 3.2.3 net earnings before extraordinary items plus depreciation and amortization expense (nebepda): one of the traditional measures is cash flow that is calculated with adding period depreciation expense (tangible and intangible assets) to net earnings before extraordinary items. 3.2.4 working capital from operations (wcfo): working capital from operations is the second traditional measure of cash flow that is calculated as following: operational cash flows = change in current assets with the exception of cash change in current liabilities 3.3. 2eemodel specifications to test the hypotheses with respect to impact of net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1), net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1), working capital from operations in year t – 1 (wcfoi,t-1), cash flow from operations in year t – 1 (cfoi,t-1) on cash flow from operations in year t (cfoi,t), the following multivariate ols regression model is established: , = + , + , + , + , + , where; asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 97 cfoi,t = cash flow from operations in year t; earnsi,t-1 = net earnings before tax and after extraordinary items in year t–1; nebepda i,t-1 = net earnings before extraordinary items plus depreciation and amortization expense in year t– 1;nebepda wcfo i,t-1 = working capital from operations in year t– 1; cfo i,t-1 = cash flow from operations in year t– 1; εi,t= residuals; 4. empirical results and analysis table 4.1 indicates ols regression of cash flow from operations in year t (cfoi,t) onnet earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1), net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1), working capital from operations in year t – 1 (wcfoi,t-1), cash flow from operations in year t – 1 (cfoi,t-1) in large companies. table 4.1 shows that in model1, cash flow from operations in year t – 1 (cfoi,t-1) (β=0.8483, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and r2 is 33.80%. durbin-watson test is 1.98, indicating no autocorrelation in residuals. therefore, the results support the first hypothesis for large companies. in model2, net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1) (β=0.5494, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and r2 is 31.58%. durbin-watson test is 2.09, indicating no autocorrelation in residuals. therefore, the results support the second hypothesis for large companies. in model3, net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1) (β=0.5674, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and r2 is 32.11%. durbin-watson test is 2.08, indicating no autocorrelation in residuals. therefore, the results support the third hypothesis for large companies. in model4, working capital from operations in year t – 1 (wcfoi,t-1) (β=0.2515, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and r2 is 25.38%. durbin-watson test is 2.11, indicating no autocorrelation in residuals. therefore, the results support the fourth hypothesis for large companies. in order to use multiple regressions in addition to simple regression, we have to check the potential multicollinearity problem for independent variables using variance inflation factor (vif) test. in terms of vif test, the results indicate that variance inflation factor (vif) for variables such as cfoi,t-1, earnsi,t-1, nebepdai,t-1, wcfoi,t-1, is 2.482, 27.138, 27.636, and 2.512 respectively. the multicollinearity is likely to be a substantive issue in this study, since the vif for variables such as net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1), net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1) is larger than 10. therefore, in addition to the simple regression for each hypothesis and to remove the molticollinearity, we run two multiple asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 98 regression, one (model5) with variables such as cfoi,t-1, nebepdai,t-1, and wcfoi,t-1, the other (model6) with cfoi,t-1, earnsi,t-1, and wcfoi,t-1. in model5, cash flow from operations in year t – 1 (cfoi,t-1) (β=0.4970, p<0.01) and net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1)(β=0.4153, p<0.01) are positively and significantly associated with cash flow from operations in year t (cfoi,t). however, working capital from operations in year t – 1 (wcfoi,t-1) (β=-0.0201, p>0.05) is not significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and adjusted r2 is 38.49%. durbin-watson test is 2.17, indicating no autocorrelation in residuals. in model6, cash flow from operations in year t – 1 (cfoi,t-1) (β=0.5054, p<0.01) and net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1) (β=0.5494, p<0.01) are positively and significantly associated with cash flow from operations in year t (cfoi,t). however, working capital from operations in year t – 1 (wcfoi,t-1) (β=-0.0122, p>0.05) is not significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and adjusted r2 is 38.05%. durbin-watson test is 2.16, indicating no autocorrelation in residuals. table 4.1. multiple regression results for large companies variables model1 model2 model3 model4 model5 model6 cfoi,t-1 0.8483*** 0.4970*** 0.5054*** (0.0000) (0.0002) (0.0001) earnsi,t-1 0.5494*** 0.3994*** (0.0000) (0.0050) nebepdai,t-1 0.5674*** 0.4153*** (0.0000) (0.0041) wcfoi,t-1 0.2515*** -0.0201 -0.0122 (0.0000) (0.8276) (0.8944) constant 0.0844*** 0.1175*** 0.1024*** 0.2007*** 0.0469** 0.0558** (0.0000) (0.0003) (0.0029) (0.0000) (0.0467) (0.0119) observations 225 225 225 225 225 225 d-w statistics 1.98 2.09 2.08 2.11 2.17 2.16 r2 33.80% 31.58% 32.11% 25.38% 39.32% 38.88% adj. r2 33.21% 30.96% 31.49% 24.71% 38.49% 38.05% f-statistics 56.4354*** 51.0077*** 52.2531*** 37.5918*** 47.7290*** 46.8607*** note: p-values in parentheses, *, **, *** denote two-tailed significance at the 10%, 5%, 1% level, respectively. variables definition: cfoi,t-1 = cash flow from operations in year t – 1; earnsi,t-1 = net earnings before tax and after extraordinary items in year t – 1; nebepdai,t-1 = net earnings before extraordinary items plus depreciation and amortization expense in year t – 1; wcfoi,t-1 = working capital from operations in year t – 1 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 99 table 4.2 indicates ols regression of cash flow from operations in year t (cfoi,t) oncash flow from operations in year t – 1 (cfoi,t-1), net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1), net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1), working capital from operations in year t – 1 (wcfoi,t-1)in small companies. table 4.2 shows that in model1, cash flow from operations in year t – 1 (cfoi,t-1) (β=0.3617, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) andr2 is 11.08%. durbin-watson test is 2.10, indicating no autocorrelation in residuals. therefore, the results support the first hypothesis for small companies. in model2, net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1) (β=0.5548, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and r2 is 17.09%. durbin-watson test is 1.82, indicating no autocorrelation in residuals. therefore, the results support the second hypothesis for small companies. in model3, net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1) (β=0.5478, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and r2 is 17.14%. durbin-watson test is 1.83, indicating no autocorrelation in residuals. therefore, the results support the third hypothesis for small companies. in model4, working capital from operations in year t – 1 (wcfoi,t-1) (β=0.2865, p<0.01) is positively and significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and r2 is 12.97%. durbin-watson test is 2.00, indicating no autocorrelation in residuals. therefore, the results support the fourth hypothesis for large companies. in model5, net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1)(β=0.4092, p<0.01) are positively and significantly associated with cash flow from operations in year t (cfoi,t). however, cash flow from operations in year t – 1 (cfoi,t-1)(β=0.1079, p>0.05) and working capital from operations in year t – 1 (wcfoi,t-1) (β=0.1070, p>0.05) is not significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and adjusted r2 is 20.22%. durbin-watson test is 2.06, indicating no autocorrelation in residuals. in model6, net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1) (β=0.4131, p<0.01) are positively and significantly associated with cash flow from operations in year t (cfoi,t). however, cash flow from operations in year t – 1 (cfoi,t-1) (β=0.1150, p>0.05) and working capital from operations in year t – 1 (wcfoi,t-1) (β=0.1074, p>0.05) is not significantly associated with cash flow from operations in year t (cfoi,t). f-statistics is significant (p<0.01) and adjusted r2 is 20.13%. durbin-watson test is 2.07, indicating no autocorrelation in residuals. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 100 table 4.2. multiple regression results for small companies variables model1 model2 model3 model4 model5 model6 cfoi,t-1 0.3617*** 0.1079 0.1150 (0.0009) (0.4179) (0.3810) earnsi,t-1 0.5548*** 0.4131*** (0.0000) (0.0012) nebepdai,t-1 0.5478*** 0.4092*** (0.0000) (0.0010) wcfoi,t-1 0.2865*** 0.1070 0.1074 (0.0000) (0.1517) (0.1474) constant 0.0804*** 0.0559*** 0.0424*** 0.0104*** 0.0382*** 0.0477** (0.0000) (0.0000) (0.0017) (0.0000) (0.0041) (0.0003) observations 245 245 245 245 245 245 d-w statistics 2.10 1.82 1.83 2.00 2.06 2.07 r2 11.08% 17.09% 17.14% 12.97% 21.20% 21.11% adj. r2 10.72% 16.75% 13.47% 12.61% 20.22% 20.13% f-statistics 30.2884*** 50.0797*** 51.4755*** 36.2212*** 21.6187*** 21.4990*** note: p-values in parentheses, *, **, *** denote two-tailed significance at the 10%, 5%, 1% level, respectively. variables definition: cfoi,t-1 = cash flow from operations in year t – 1; earnsi,t-1 = net earnings before tax and after extraordinary items in year t – 1; nebepdai,t-1 = net earnings before extraordinary items plus depreciation and amortization expense in year t – 1; wcfoi,t-1 = working capital from operations in year t – 1 5. conclusion and discussion according to findings, the results of hypotheses test at the level of large companies are relatively different from that of small companies. as it is shown in table 2.5, net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1)rather than net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1)is the best predictor with a little different. net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1), working capital from operations in year t – 1 (wcfoi,t-1) and cash flow from operations in year t – 1 (cfoi,t-1)are other best predictors respectively after net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1). with regard to the multiple regression models(models 5 and 6) in small companies, although the coefficients of variables in multiple regression models5 and 6 are significant and coefficients of variables such as cash flow from operations in year t – 1 (cfoi,t-1) and working capital from operations in year t – 1 (wcfoi,t-1) are not significant in both model 5 and model 6, the multiple regression models may not be used to predict future cash flows. in large companies, cash flow from operations in year t – 1 (cfoi,t-1) in relation to net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1) is better predictor for predicting future cash flow from operations, whereas in small companies asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 101 net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1) is better predictor than cash flow from operations in year t – 1 (cfoi,t-1). these results are consistent with the findings of farshadfar, ng, and brimble (2008), al-attar and hussain (2004), and quirin et al. (1999).the reason of this finding may be explained by political costs hypothesis. the political costs hypothesis has been raised in positive accounting theories by politician and regulators due to the use of earnings numbers. the report of lower earnings would probably leads to reduction of any actions against these companies and would increase the probability of governmental subsidies receiving, while increases and high positive percentages would attract the attention of national media and authorities as the proxy for crisis and monopoly(khosh tinat and nowrouzbeigi, 2008). therefore, it can be said that due to the manipulating earnings numbers in large companies, reliability of cash flow from operations in year t – 1 (cfoi,t-1) is higher which can be used as a better measure for predicting future cash flows. this is a significant difference that it can be seen between the results of large and small companies.moreover, it can be stated that in large companies unlike small companies, using cash flow from operations in year t – 1 (cfoi,t-1), net earnings before extraordinary items plus depreciation and amortization expense in year t – 1 (nebepdai,t-1), and working capital from operations in year t – 1 (wcfoi,t-1) (model5) simultaneously, and also the use of cash flow from operations in year t – 1 (cfoi,t-1), net earnings before tax and after extraordinary items in year t – 1 (earnsi,t-1), and working capital from operations in year t – 1 (wcfoi,t-1) simultaneously (model6), in relation to use of only each variable improve the prediction model to a great extent. additionally, as the results indicate, the predictive ability of all models for large companies is larger than that of all models for small companies. in other words, as the firm size increases, the predictive ability increases for all models. therefore, it can be said that firm size plays an important role in predictability future cash flows using aforementioned models. references aghaei, m., & shakeri, a. . 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(1993). evidence on the association between accounting earnings measureing by cash flow. (m.a .dissertation), university of tarbiyat modares, tehran. rutherford, b. a. (1982). the interpretation of cash flow reports and the other allocation problem. abacus, 18(1), 40-49. https://doi.org/10.1111/j.1467-6281.1982.tb00019.x asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 104 sharma, divesh s. (2001). the role of cash flow information in predictingcorporate failure: the state of the literature. managerial finance, 27(4), 3-28. https://doi.org/10.1108/03074350110767114 microsoft word 9455-34614-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 212 association between degree of leverages and firm value pradeep kumar gupta (corresponding author) l m thapar school of management thapar university derabassi campus e-mails: pradeep.gupta@thapar.edu; gupta.pk1977@gmail.com shailendra kumar indian institute of information technology allahabad (u.p.), india e-mails: shailendrak@iiita.ac.in; blyshailendra@gmail.com piyushverma l m thapar school of management thapar university derabassi campus derabassi, sas nagar (punjab), india e-mails: pverma@thapar.edu; piyushverma77@gmail.com received: april 5, 2016 accepted: may 22, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.9455 url: http://dx.doi.org/10.5296/ajfa.v8i1.9455 abstract this study aims to empirically investigate the association between degree of leverages, operating and financial, and firm value in the context of india, one of big ten emerging markets (garten, 1997). this study examines this association for 231 manufacturing firms listed in national stock exchange (nse) in india over a period from 2001-2002 to 2010-2011. the independent variables, degrees of operating and financial leverage, and a market price-based dependent variable, called price-earnings ratio as a proxy of firm value, are taken to examine this relationship by using standard ordinary least square regression asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 213 models at the levels of individual firm and portfolio of firms. the findings of this study show a statistically significant negative relationship between firm value and degree of operating leverage and a statistically insignificant relationship between firm value and degree of financial leverage both at the levels of individual firm and portfolio of firms. using the data from a country like india, one of fastest growing emerging markets in the world, this study provides an important insight on the effect of leverages on the firm value, the association between independent accounting variables and stock price-based dependent variable, to the practitioners, the scholars and the finance managers. keywords: portfolio; operating leverage, financial leverage, price-earnings, firm value jel classification: g11; g30; g32 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 214 1. introduction the appropriate and reliable accounting information in the financial statements are required by the active investors to analyze the economic performance and value of a firm. the usefulness of financial information to investors was assessed by the extensive studies on the value relevance of accounting data (papadaki & siougle, 2007). various empirical examinations and theoretical models have investigated the real determinants of stock price. ball and brown (1968) investigated the relationship between a stock price-based dependent variable and a set of accounting variables often viewed as capital market-based accounting research (cmbar). habib (2004) investigates the quality of accounting information with respect to stock price. the financial reports are unable to fulfill one of their primary objectives if no association between accounting information and the market value of the company is found (beisland, 2009). therefore, there is always of great interest for the scholars and the practitioners to enquire about the impact of accounting numbers on the stock price and this relationship is extensively explored in the literature of value relevance research. an accounting number can be considered to be value relevant if it is helpful in explaining value or returns over long windows (holthausen & watts, 2001). an accounting amount will be value relevant only if the amount reflects relevant and reliable information to investors in valuing the firms (barth et al., 2001). francis and schipper (1999) reported that a statistical relationship between financial information and stock prices or returns is to be established for measuring the value relevance. there is a positive relationship between stock returns and debt to equity ratio of the firms (bhandari, 1988). thus, debt to equity ratio is considered to be value relevant. dimitrov and jain (2008) find that annual stock returns are significantly associated with contemporaneous changes in financial leverage and, hence, changes in financial leverage are value relevant. habib and azim (2008) find that firm-specific economic variables are important determinants of the value-relevance of accounting information. thus, this study is an attempt to explore whether the market values the accounting numbers of the firms. this study takes two accounting variables, degrees of operating and financial leverage, to investigate their impact on value of the firm represented by one of the market-based performance indicators, called price-earnings (hereafter, pe) ratio. moreover, the leverage becomes an important factor to design the structures of cost and capital to entail reducing the overall cost of operations including financing costs to attaining overall competitiveness by the firms operating in the manufacturing sector of india (sharma, 2006) and it is also considered a leading factor to determine the firms' risk premium (zimmer, 1990). a significant relationship between any fundamental variable and stock prices indicates that this fundamental variable is a value-relevant (trabelsi, 2013) as its use may lead the value of firm close to its market value (dumontier & raffournier, 2002). the main objective of this study is to empirically investigate the combined effect of degrees of operating and financial leverage (hereafter, dol and dfl) on the pe ratio, proxy for firm value, for 231 national stock exchange (nse) listed manufacturing firms in india. since much research studies in this topic have not been explored in the context of india, one of big 10 emerging markets (garten, 1997) and listed as an emerging market by dow jones (2010), economist (2009), ftse (2010), msci (2010) and hoskisson, et al. (2000) in the study of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 215 merchant and allen-ford (2012, pp.369). therefore, our study claims to questioning this relationship in the context of india. two control variables, return on assets (flatt & kowalczyk, 2008; lee & swenson, 2012) and firm size measured as sales (shehata, 1991) of the firms, that could affect firm value are also included in this study to determine the extent of their impact in explaining the firm value. the standard ordinary least square regression models at the levels of individual firm and portfolio of firms are performed to find the empirical results. the rest of the paper is organized as follows. the next section is described related literature and hypotheses development. section iii explains the empirical test and design used in the paper. the results and analysis are taken in section iv, and finally, section v concludes. 2. literature review and hypothesis development over a period of five decades, empirical investigation of the relationship between leverage and firm value has always been of great interest for the scholars and practitioners around the world. in 1958 modigliani and miller found that the value of any firm does not depend on its capital structure in a perfect capital markets. in other words, the firm value is independent of its leverage. sarma and rao (1969) employed merton h. miller and franco modigliani’s model to a non-regulated industry and tested the mm hypothesis on the influence of debt on the value of a firm and found the results in support of their hypothesis that “after allowing for the tax advantage from the interest paid on debt, the value of a firm is independent of its capital structure”. however, we take both the leverages (operating and financial) to test our proposed hypotheses as only few studies have taken operating leverage as a determinant of firm value. azmat (2014) investigate the relationship between firm value and cash holdings and find a concave relationship between firm value and cash holdings. the firms’ value and financial leverage are significantly and directly associated (sharma, 2006). garcia and jorgensen (2010) reported that a trade-off (dotan & ravid, 1985; trezevant, 1992) or a u-shaped relation (huffman, 1983; prezas, 1987; kale, noe, & ramirez, 1991) between operating and financial leverage exists due to the interactions between investment and financing decisions. the leverage causes a change in the volatility of stock returns (christie, 1982; french, schwert & stambaugh, 1987; schwert, 1989; cheung & ng, 1992 and nishat, 2000). many empirical studies (gahlon & gentry, 1982; mandelker & rhee, 1984; huffman, 1989; carlson et al. 2004; zhang, 2005; cooper, 2006; garcia & jorgensen, 2010) use dol and dfl to test their respective hypotheses in the context of developed markets. we take dol and dfl to empirically examine their impact on firm value in the context of india since the structures of business organizations in the emerging or developing markets are different from those in developed markets (sarkar et al. 2008). liquidity, taxation, stock market benchmarks, and different transactions and accounting methods are some of the parameters where international stock markets differ (capital markets in 2025, www.pwc.de). the process of integration of emerging markets into world markets is incomplete though correlations between developed and emerging markets have increased (bekaert & harvey, 2013). moreover, the replication of the depth of institutional liquidity, the kind of infrastructure and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 216 pools of human capital built by the developed markets organically is very difficult for emerging markets (international equity markets, www.bauer.uh.edu). furthermore, emerging markets are heterogeneous in their level of development and environmental surroundings (bianchi, 2014). thus, 'developed' and 'emerging' markets are realistically different in many aspects including the structures of business organizations. an enormous scale of scholarly interest in emerging market phenomenon in management discipline is found in a casual review of academic literature on emerging markets (merchant and allen-ford, 2012). mandelker and rhee (1984) and ang and peterson (1984) were the pioneers to use the time-series regression method for estimating dol and dfl. several studies (e.g. huffman, 1989; deyoung & roland, 2001; griffin & dugan, 2003; ho, xu, & yap, 2004; garcia & jorgensen, 2010) used this method of estimation of dol and dfl. however, a point-to-point method has also been used extensively in the literature for estimating dol and dfl (garcia & jorgensen, 2010). the point-to-point approach estimates dol and dfl as net fixed assets to total assets ratio (ferri & jones, 1979; mandelker & rhee, 1984; garcia & jorgensen, 2010) and total debt to total assets ratio (mandelker & rhee, 1984; garcia & jorgensen, 2010), respectively. our study takes the point-to-point approach to measure dol and dfl. moreover, the study of garcia and jorgensen (2010) find similar results from both the approaches. when making equity valuation decisions investors consider firms' fundamentals as reflected in financial statements. however, which line item is more important for equity valuation is an important consideration (habib, 2010). cheng and tzeng (2011) explored the impact of leverage on firm value and how does the firm financial quality influence this impact of leverage on firm value? they find the positive relationship between leverage and firm value when the firm financial quality is better. kumar and warne (2009) find two most significant parametric determinants, variability in market price and corporate size, of pe ratio in the context of indian capital market. anderson and brooks (2006) find that the size of the firm, the year in which pe ratio is measured and the industry effect are the most influencing factors of firms' pe ratios. sharma (2006) finds a significant correlation between firms' value and financial leverage. a significant portion of the variations in pe ratios is explained by the selection of firms based upon industry (alford, 1992). pe ratio, first introduced in literature by graham and dodd (1934) as a benchmark for equity valuation, has the application based on the idea that earnings are related to value (stefanis, 2005). there were of considerable interests to be known about the behaviour of pe ratio overtime and the relative importance of the factors influencing its behaviour (beaver & morse, 1978). our study takes book values of degrees of operating and financial leverage to investigate their influence over pe ratio to value the firms as there is a maintained popularity of using pe approach to security/equity valuation among practitioners and academics due to its simplicity (pari, carvell & sullivan, 1989; lie & lie, 2002). an accurate measure of equity valuation is the pe ratio found in the study of alford (1992). with these arguments, an alternative hypothesis of this study is proposed at firm level. hypothesis: at firm level, degrees of operating and financial leverage are associated with firm value (pe ratio). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 217 other than the main interest variables (dol and dfl), there are some other firm-level factors which could influence the firm value and these firm-level factors are to be controlled to improve the explanatory power of interest variables. an essential aspect of a research into a business activity must include the firm size (zadeh & eskandari, 2012). al-khazali and zoubi (2005) reported that accounting studies used size of the firms to explain differences across firms in their methods of accounting and decisions related to corporate disclosures (jensen & meckling, 1978; deakin, 1979, collins, rozeff & dhaliwal, 1981; zmijewski & hagerman, 1981; zimmerman, 1983; hughes & ricks, 1984; and shehata, 1991). for example, shehata (1991) has used the total sales as firm size. thus, it is important to include firm size as a control variable in the study. the firm size is measured as logarithm [1] of sales. moreover, this study also includes return on assets (roa, hereafter) as a control variable (lee and swenson, 2012) which could impact the firm value. roa is measured as net operating profit after tax divided by total assets. the study of beaver et al. (1970) reports a widely thought evident fact that large firms have low variability of risk and asset returns than smaller firms in the literature. this means firm size and roa should be included in the study for improving the explanatory power of dol and dfl. thus, the hypothesis proposed above is also examined the impact of dol and dfl after controlling for firm size and roa. mandelkar and rhee (1984) found measurement errors of variables at the level of individual firm. therefore, the portfolio-grouping procedures (beaver et al. 1970; black et al. 1972; fama & macbeth, 1973) employed by mandelkar and rhee (1984) are used to reduce these measurement errors of variables. under this approach, the average values of interest variables (pe, dol and dfl) of total 231 sample firms are ranked in ascending order on the basis of beta values [2] of each firm's common stock and every three firms from above rank order are grouped together to form a portfolio. since the same study period is used to perform the grouping and cross-sectional regressions, there is a possibility of potential selection bias (mandelkar and rhee, 1984). to correct potential selection bias, the beta values which are significantly correlated (see table 2) with the two independent variables (dol and dfl) are used as the basis of ranking to form portfolios. in the study of mandelkar and rhee (1984) the explanatory power (r2) of the regression model increases at the portfolio level of the firms. therefore, the stated hypothesis is to be investigated further at the portfolio level of the firms in anticipation of increased explanatory power (r2) of the regression model. the next section will describe about the collection of data and estimation of dependent and independent variables and the regression models to find empirical results of this study. 3. empirical test design the prowess database created by the center for monitoring indian economy (cmie) is used to collect the data of required variables of the 10 financial years from 2002-2011 of 231 nse listed manufacturing firms. the study of sarkar, sarkar and sen, (2008) reports that cmie prowess database has become the basis of several published empirical studies on the indian corporate sector (e.g., khanna & palepu, 1999; sarkar & sarkar, 2000; bertrand, mehta & mullainathan, 2002). the financial year from april 1 to march 31 of the following asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 218 year is considered in india (sarkar, sarkar & sen, 2008). total sample of 231 firms for this study is distributed across nine industries (chemical, diversified, machinery, food & beverage, textiles, transport equipments, non-metallic mineral products, metal & metal products and miscellaneous) by the cmie prowess database. the nse listed manufacturing firms with the values of required accounting variables (annual sales, net operating profit after tax, pe ratio, fixed assets, total debt, total assets, stock prices and earnings per share) as on march 31 every year from 2002 to 2011 have been extracted from cmie prowess database for estimating the dependent variable (pe ratio), the independent variables (dol and dfl) and the control variables (roa and firm size). finally, the complete set of data of 231 manufacturing firms distributed over nine industries has been taken to find the results. to test the proposed hypothesis, a model 1 is formulated to empirically examine the joint impact of dol and dfl on the pe ratio for the sample of 231 listed manufacturing firms. the control variables, return on assets (roa) and firm size, are also taken to form model 2 for examining the association of control variables with firm value. we choose the point-to-point approach (ferri & jones, 1979; mandelker & rhee, 1984; garcia & jorgensen, 2010) to measure book dol and book dfl. therefore, the ten year average ratio of fixed assets to total assets is used to estimate the book dol, and the book dfl is the ten year average ratio of total debt to total assets [3]. similarly, the ten year average of annual sales and the ten year average ratio of net operating profit after tax (nopat) to total assets (ta) are used to measure firm size (logarithm of average sales) and roa of each firm, respectively. additionally, the 10-year average ratio of price-earnings (pe) of each firm is included in the study to run these cross-sectional regression models. model 1: ln(pe)i = ω 0 + ω 1 (dol)i + ω 2 (dfl)i + €i (i=1-231) where, pe, dol and dfl are price-earnings ratio, degree of operating leverage and degree of financial leverage, respectively. model 2: ln(pe)i = λ0 + λ 1 (dol)i + λ 2 (dfl)i + λ 3 ln(sales)i + λ 4 (roa)i + ɇi (i=1-231) where, pe, dol, dfl are price-earnings ratio, degree of operating leverage, degree of financial leverage, respectively. roa (return on assets) = nopat / ta. firm size = ln(sales). to further examining the model 1 we also use a portfolio-grouping procedures (beaver et al. 1970; black et al. 1972; fama & macbeth, 1973) employed by mandelkar and rhee (1984) to reduce the errors-in-variables bias. under this approach, the average values of pe, dol and dfl of total 231 sample firms are ranked in ascending order on the basis of ten year average value of beta of each firm and every three firms [4] from above rank order are grouped together to form a portfolio. this means the first three firms form portfolio 1, the next three firms form portfolio 2 and so on. thus, a total of 77 portfolios are formed for 231 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 219 firms and the regression model 3 is to be performed for finding the empirical results. to have the optimum number of portfolios in the regression model 3, three firms in each portfolio have been considered. the portfolio of four firms (huffman, 1989) and five firms (mandelkar and rhee, 1984) could also be considered. model 3: ln(pe)p = μ0 + μ1 dolp + μ2 dflp + ∂p , (p=1-77) where, pe p, dolp and dflp are the portfolio (p) means of eachportfolio respectively. ∂p is the error term. 4. results and analysis under this section, we present results and discuss the findings by tabulating table 1, table 2 and table 3. table 1 presents comparison of means of pe ratio, dol, dfl, roa, sales and beta for 231 sample firms distributed over nine industries. table 2 depicts the correlations among the variables under study. finally, table 3 presents the results of the proposed hypotheses formulated in regression models (model 1, 2 & 3). we assign the codes from one to nine to the total sample of 231 firms distributed over nine industries. table 1 presents comparison of means of pe ratio, dol, dfl, roa, sales and beta across nine industries. the findings from the results of table 1 indicate that there are significant differences among group means of dol, dfl, roa, sales and beta across industries. this means there is a significant variation in the values of accounting variables across industries. however, an insignificant difference among group means of pe ratio across industries is found. this suggests that industry-wise pe ratio does not vary with the variation in any of accounting variables under study. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 220 table 1. comparison of means across nine industries sum of squares degree of freedom (df) mean square f-statistic sig. pe ratio between groups within groups total 3.854 109.932 113.786 8 222 230 .482 .495 0.973 .458 dol between groups within groups total 0.584 4.645 5.229 8 222 230 .073 .021 3.486 .001* dfl between groups within groups total 0.534 6.603 7.137 8 222 230 .067 .030 2.243 .025** sales between groups within groups total 28.246 435.692 463.939 8 222 230 3.531 1.963 1.799 .078*** roa between groups within groups total 0.477 1.253 1.730 8 222 230 .060 .006 10.566 .000* beta between groups within groups total 1.160 11.501 12.661 8 222 230 .145 .052 2.798 .006* * significance levels at the 01 per cent; ** significance levels at the 05 per cent, *** significance levels at the 10 per cent. the correlation matrix is presented in table 2 for the variables under study. in table 2, there is significant negative correlation between log of pe and dol and log of pe and dfl. this means degrees of operating and financial leverage adversely affect the pe ratio. no significant correlation is found between log of pe and roa. however, there is a significant positive correlation between log of pe and firm size (log of sales). therefore, it is expected that size of the firm could impact the price-earnings ratio but it may not be affected by roa. this indicates the price-earnings ratio of firms operating in manufacturing sector in india could significantly be captured by dol, dfl and firm size. moreover, a significant positive correlation is found between dol and dfl, the independent variables. thus, any increased (decreased) investments in fixed assets can also increase (decrease) the total debt of the firms since we measure dol (the ten year average ratio of net fixed assets to total assets) and dfl (the ten year average ratio of total debt to total assets). however, the problem of multicollinearity [5] does not seem to exist even though independent variables (dol and dfl) are highly correlated. the beta values of the firms are also significantly correlated with dol and dfl. thus, the portfolio regression model 3, formed on the basis of beta values, is expected to improve its explanatory power as compared to regression model 1 and model 2. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 221 table 2. correlation (pearson) matrix ln(pe) dol dfl ln(sales) roa beta ln(pe) 1.000 -0.213* -0.188* 0.117** -0.007 -0.078 dol 1.000 0.488* 0.024 0.088 0.155* dfl 1.000 -0.071 -0.084 0.282* ln(sales) 1.000 0.033 0.219* roa 1.000 -0.153* beta 1.000 * significance levels at the 01 per cent; ** significance levels at the 05 per cent, *** significance levels at the 10 per cent. in table 3, the cross-section regression models run for 231 firms estimate the regression coefficients (t-statistic) for the predicted variable (pe ratio). the regression coefficient (positive or negative) signs are predicted for the relationship between a predicted variable (pe ratio) and each explanatory variable (dol, dfl, roa and firm size) based upon the correlations among variables under study as presented in table 2. all models are found statistically fit on the basis of the values of f-statistic and prob(f-statistic) presented in table 3 (model 1: 6.582, p<1%; model 2: 3.973, p<1%; model 3: 2.773, p<10%). the model 1 indicates that dol has a statistically significant (p<.05, -0.739) negative association with pe ratio. however, insignificant (p>.10, -0.444) negative association is found between dfl and pe ratio. thus, dol has a significant impact on the firm value but dfl does not impact the firm value. further, the results of model 2 shows that the control variables, roa and firm size, have a statistically insignificant association with the pe ratio. this means that dfl, roa and firm size have no impact on the firm value. however, a statistically significant negative (p<.05, -.741) impact of dol on the firm value in model 2 support the results of model 1. in order to further check the robustness of model 1 and model 2, a portfolio-grouping approach is adopted and 77 portfolios (three firms in a portfolio for 231 firms) are formed in ascending order based upon the beta values of 231 sample firms in model 3. the results of model 3 indicates the consistency in the results, significant association between dol and firm value and insignificant association between dfl and firm value, found in model 1 and model 2. besides, as expected the explanatory power of model 3 (r2=7%) is slightly higher than the model 1 and model 2. however, the expected results are not found if portfolios are formed on the basis of four firms and five firms for 232 firms (58 portfolios of four firms each) and 230 firms (46 portfolios of five firms each), respectively. it happens due to less number of portfolios in regression model 3. thus, the findings partially support our empirical investigation that dol impacts firm value; thereby dol is valued by asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 222 the investors at the levels of individual firm and portfolio of firms. since dfl has no impact on firm value, therefore this shows that firm value is independent of the capital structure (portion of total debt in total assets) of the firms which is consistent with the mm hypothesis that "the market value of any firm is independent of its capital structure" (modigliani and miller, 1958). table 3. results from regression models model 1 : ln(pe)i = ω 0 + ω 1 (dol)i + ω 2 (dfl)i + €i , (i=1-231) model 2 : ln(pe)i = λ0 + λ 1 (dol)i + λ 2 (dfl)i + λ 3 ln(sales)i + λ 4 (roa)i + ɇi (i=1-231) model 3 : ln(pe)p = μ0 + μ1 dolp + μ2 dflp + ∂p , (p=1-77) dependent variable: pe ratio coefficient estimate (t-statistic) variable predicted sign model 1 model 2 model 3 intercept 2.845* (24.557) 2.365* (7.397) 3.144* (13.416) dol - 0.739** (-2.146) 0.741** (-2.133) 1.524** (-2.084) dfl -0.444 (-1.506) 0.414 (-1.391) 0.010 (0.017) ln(sales) + 0.052 (1.639) roa - 0.043 (-0.081) r2 0.055 0.066 0.070 f-statistic 6.582 3.973 2.773 prob(f-statistic) 0.002 0.004 0.069 sample firms 231 231 231 * significance levels at the 01 percent; ** significance levels at the 05 per cent, *** significance levels at the 10 per cent. figures in parentheses are t-values. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 223 5. conclusion the empirical results and discussion of this study partially support the hypothesis that dol and dfl do impact the firm value. dol does significantly adversely affects the firm value over long windows; however dfl and firm value are not associated. interestingly, both dol and dfl are significantly negatively correlated with the firm value (see table 2). moreover, controlling for firm size and roa does not affect the results of the study and both control variables do not explain the firm value. our findings remain intact even after a well established portfolio-grouping approach is used to find the empirical results of the study. thus, investors consider dol an important accounting number in valuing the firms at marketplace. our empirical results also indicate that firm value is independent of its capital structure (portion of total debt in total assets) as dfl does not impact firm value. no significant difference in pe ratio, proxy of firm value, of 231 sample firms distributed over nine industries is found though they are significantly different in terms of size (annual sales), profitability (roa) and degree of leverages (see table 1). this study is an addition to the literature of capital market-based accounting research (cmbar) which studies the association between stock price-based dependent variable and accounting variables in indian context. the association between degree of leverages and stock risk and returns could be explored in the context of emerging or developing markets. besides, the same study could be revisited in the context of under-developed markets to reexamine the reliability in the findings of this study. end notes [1] logarithm transformation for symmetrical and normal distribution of data. [2] the market model approach (mandelkar and rhee, 1984) is used to estimate the beta values of each firm's common stock with 10 years of monthly data. rit = αi + βi rmt + uit i = 1-231, t=1-120 where, ri and rm = the monthly rates of return in month t on a common stock and an market index (nse nifty 50); αi , βi = the intercept and slope coefficient representing the beta values, respectively. [3] note that garcia and jorgensen (2010) use the five-year average ratio of fixed assets to total assets is used to estimate the book dol, and the book dfl is the five-year average ratio of total debt divided by total assets. mandelker and rhee (1984) use these two ratios, ratio of fixed assets to total assets and ratio of total debt to total assets, as the instrumental variables for dol and dfl, respectively. [4] note that huffman (1989) and mandelkar and rhee (1984) were used portfolio of four stocks and five stocks, respectively. 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(1981). an income strategy to the positive theory of accounting standard setting choice. journal of accounting and economics, 3(1), 129-149. http://dx.doi.org/10.1016/0165-4101(81)90010-0 microsoft word 10197-37539-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 155 effect of human capital expenditure on the profitability of quoted manufacturing companies in nigeria olowolaju, philip segun department of accounting, federal university of technology, akure, nigeria p. o. box 297, akure, nigeria. tel: 234-803-352-4368 e-mail: olowosegun2014@gmail.com oluwasesin, olayemi deborah centre for continuing education federal university of technology, akure, nigeria tel: 234-803-439-2248 email: yemifiaji@yahoo.com received: june 19, 2016 accepted: july 22, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.10197 url: http://dx.doi.org/10.5296/ajfa.v8i2.10197 abstract the study examined the effect of human capital on the profitability of quoted manufacturing companies in nigeria. the study aimed at determining if expenditure on human has influence on the profitability of listed manufacturing companies on the nigeria stock exchange. a sample of 10 listed manufacturing companies on the nigeria stock exchange was used for the study. this study used data mainly from secondary sources and the analysis of data collected was done using descriptive and inferential statistics. the descriptive statistics include mean, standard deviation, kurtosis, skewness while inferential statistics that was used in testing the hypotheses include panel regression and correlation. the study revealed that all the explanatory variables have positive relationship with profitability, however, expenditure on health contributed more to the profitability of the firms with a beta value of 27.8609 than expenditures on salaries and wages, training and contributory pension with beta values of 0.3107, 2.6752 and 3.4519 respectively. the study also found that that only expenditure on health can significantly predict net profit at 5% level of significance. the study concluded that human capital expenditure significantly influenced profitability of manufacturing asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 156 companies quoted on the nigerian stock exchange and companies that place more emphasis on human capital, maintaining it and treating it as a pure asset will have motivated work force. keywords: human capital, expenditure, profitability, manufacturing, companies asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 157 1. introduction despite the advent of information technology which has made the whole world to become a global village, human intellect is still the brain behind its success. there is no technological or service base evolution however sound it may be, that has not and will not be driven by human intellect which is the ability, knowledge and skill of such an individual. for companies to seek new ways of developing and maintaining competitive advantage in the present dynamic environment, it is important that firms truly leverage on their workforce as a competitive weapon. to leverage on the workforce means an improvement largely on the procurement of the right people with high level of intellectual competence, hence the need for expenditure on human capital. basically, the concept of human capital expenditure arose from the transformation of individual competence into highly productive human capital with the effective input of education, health and moral value. human capital is the mixture of human and capital. in the economic perspective, the capital refers to factors of production used to create goods and services that are not themselves significantly consumed in the production process. along with the meaning of capital in the economic perspective, boldizzoni (2008) stressed that the human is the subject to take charge of all economic activities such as production and consumption. therefore, it can be deduced that human capital means one of the production elements that can generate added value through inputting it. on the other hand, expenditure is the sacrifice incurred for the procurement of some anticipated benefits. however, for the purpose of this study, such expenditure is incurred by the organizations selected for the study on the procurement of human capital, which can be revenue or capital in nature. organizations’ survival, growth and profitability are dependent more on intellectual assets than physical assets. today, human capital is perceived to be a resource that requires strategic attention. therefore, clear estimation of expenditure on it has gained significant importance (ifrueze, 2014), this present century is knowledge driven, it is therefore necessary for organizations to utilize its human capital in such a way that will not make its success to be at stake. this can be achieved by ensuring that the human capital that will drive the economy be recognized as a valuable part of the total value of an organization in order to assess the effect it has on the corporate profitability. the recent challenge of globalization in the nigeria economy is gradually shifting most of the quoted manufacturing companies to customer oriented organizations where knowledge, skill and attitude count. this has given rise to importance in the way organizations invest on the human capital which runs them, largely because many organizations’ expenditure on human capital has risen faster than those of non-human capital (world economic forum 2015). an upward shift in the organization’s expenditure on human capital, has led to an increased demand for its inclusion in the financial report to measure it effect on the overall profitability of quoted companies. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 158 besides, most organisations increase the staff salaries and wages in order to motivate them and to ensure they put in their best for the achievement of the organizational goals. these efforts are expected to affect their profitability if the cost incurred will not be a waste the rate of increase in human capital expenditure to train and retrain quality staff in many of these quoted companies appears not to be commensurate with the rate of growth in their profitability. thus, the objective of this study is to assess the effect of human capital expenditure on the profitability of selected quoted manufacturing companies in nigeria, 2.1 conceptual framework the concept of human capital was first developed by sir williams pretty in the year 1691 but the research into human capital began in 1960 by rensis likert. with the emergence of classical economics, a scientific theory on human capital was later developed (fitzsimons, 1999). after the manifestation of that concept as a theory, human capital began to develop as an academic field which prompted some researchers to expansively clarify how the expenditure on such human capital could affect profitability. ismaila (2013) recognised human capital as a significant factor for the sustainability of companies in the emerging knowledge based economy. the concept of human capital has been variously categorized from different perspectives in the academic fields. the first aspect is from the individual point of view. schultz (1961) recognized the human capital as ‘something akin to property’ against the concept of labour force in the classical perspective. it can be deduced from his view that human capital is knowledge, skill, attitude and ability acquired through training and embedded in an individual. baker (2012) conceptualized human capital as the loop that linked together the knowledge, abilities, skills, experiences and creation owned by the members of the organization. the second view point is on the accumulation process of human capital itself. the stock of human capital is accumulated through the process of education and training. the educational process ranges from compulsory education, vocational education and tertiary education. the training aspect can be acquired through employer-sponsored training, self-sponsored training or training acquired through individual experience (alan, 2008). the third view on human capital is closely linked to the production-oriented aspect of human capital. rosen (1999) states the human capital as ‘an investment that people make in themselves to increase their productivity’. more recently, frank and bemanke (2007) defined human capital to be ‘an amalgam of factors such as education, experience, training, intelligence, energy, work habits, trustworthiness, and initiative that affect the value of a worker’s marginal product’. from these perspectives, one can conclude that economic benefit can be generated through making use of the stock of skills, knowledge and abilities embedded in an individual to perform. also, rodriguez and loomis (2007) define human capital as ‘the knowledge, skills, competences and attributes in individuals that facilitates the creation of personal, social and economic well being. in defining the concept of human capital, greater importance has to be given to education and training. this is because education and training are instrumental to the outcome of human asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 159 capital which is uniqueness and value. therefore, in order to dependently or independently generate the uniqueness and values embedded in human capital, learning through education and training must be given higher preference. kwon (2010) characterized human capital as; expandable, self-generating, transportable and shareable. the expandable and self-generating characteristics of human capital can be said to mean the possibility that the stock of knowledge increases individual human capital. while the transportable and shareable characteristics can be likened to the ability of an individual to be able to impact the knowledge acquired into others in form of training. 2.2 theoretical framework human capital as the knowledge based economy has its roots from the field of macroeconomic theory. becker (1976) developed the theory by identifying employees in the organization as human capital which allows them to be highly valued. he thereby divided human capital into general human capital and firm specific human capital which for the first time provided a comparative insight into the incentives for the accumulation of capabilities. davenport (1999) supported becker’s theory in that it permits the model where employees are ‘investors in a business, paying in human capital and expecting a return on their investment’. they also relate the rate of return on human capital to investment in education and training which is also a key factor that influences the competitiveness of firms. schmidt (2004) defined human capital as a form intangible asset that creates future economic value which includes the competencies of frontline employees and organizational capabilities. human capital theory encompasses many components but essentially describing the quality of the labour force. schultz (1961) in his own notion of human capital theory, conceives that human capital is the result of investment, and so it value is the expenditure that is invested to enhance ability. furthermore, tseng and goowang (2005) viewed human capital to be a holistic output, which is the total value of personal physical strength, intelligence, knowledge and skills for utilization. the total output is the sum of labour abilities of a particular population. therefore, going by the above views on the theory of human capital, it can be deduced that human capital is the labour ability (skill, strength, knowledge, and expertise) of any person in terms of output which is as a result of investment and the worth of such an individual. from the perspective of classical economic theory, human capital is considered as labour and as a commodity that can be traded in terms of purchase and sale. traditionally, human capital is associated with labour. unlike the traditionally meaning, human capital refers to the ability, expertise, knowledge and skills possessed by an individual, especially those acquired through education, training and development that enhance the potential economic value of such an individual. human capital as separated by becker (1976) has two major divisions; the firm-specific human capital and the general purpose human capital. according to oecd world forum (2009), the firm-specific human capital is accumulated through education and training tailored towards a particular task which will probably give the firm outstanding performance and in turn bring about competitive advantage over others. while the general purpose human capital on the other hand is the basic knowledge and skill that is useful to a asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 160 variety of firms, not specific to a task or company and can be accumulated through education or working experience. emphasizing the social and economic importance of human capital theory, kwon (2010) noted that the most valuable of all capital is that of investing in human being through education, training, health and development. the theory of human capital brings about expenditure on human capital. expenditures on human capital such as; education, training and development are not just ordinary cost in the course of running an organisation, but an investment from which valuable returns that can be calculated are expected. it is an important agent for boosting organizations profitability. this study capitalized on this theory by emphasizing that expenditure on human capital becomes an integral (that is, essential) part of the profitability of quoted manufacturing companies. 2.3 empirical framework realizing the importance of human capital as a valuable resource for innovation, enhancement and maintenance of organizational competitive advantage and at the same time improving its corporate image in the global market, many researchers in nigeria, united states, europe, united kingdom, australian, china, denmark, india, finland, kujansiva and some other countries all over the world have conducted intensive research on various aspects of human capital expenditure. one of the best examples is that of the denmark government (danish memo 2004). the danish ministry of business and industry issued a directive that with effect from the trading year 2005, all companies registered in denmark would be required to include in their annual reports information on human capital expenditure. a minimum of five measures for each was required and comparison with the previous two years must be shown. figure for investment in human asset must be shown and compared with the previous two years. a narrative should accompany each set of figures. information for investors about human capital both current and future should occupy at least one third of their report. demos and leadbeater (2009) reported that few companies in europe have measured and reported on their human capital cost. also, their study conducted on companies in the united kingdom, revealed that methods used to measure expenditure on human capital depend on which user group the result was meant for. roslender and fincham ( 2011) affirms that few companies like bhel, inlosys and reliance industries in india have implemented accounting for human capital expenditure and some are working on it. 2.3.1 relationship between human capital expenditure and corporate profitability the relationship between human capital expenditure and corporate profitability can be assessed by classifying the two variables into dependent and independent variables. the human capital expenditure is the independent variable while profitability is the dependent variable. the profitability of a quoted company is a function of its human capital and the quality of the human capital is also a function of training and development (t&d) which is a cost to the organization. some recent researchers have argued whether the human capital cost and profitability of quoted companies are of positive or negative relationship. maimuna (2009) analysed the positive relationship between human capital expenditure and profitability in that expenditure on education, training and development increased productivity over twice the size of the wage increase of the trainee. this is because not all productivity gain brought asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 161 about by training is compensated by increase in individual remuneration thereby making such investment remains profitable for organizations. gene (2008), a chief executive officer of capital analytics consulting firm based in north carolina, united state of america (usa) gave analyses of conagra foods inc. based in the united states of america. he emphasized the positive impact of a new leadership initiative by studying the overall twelve months turnover of supervisors that underwent training which translated to a saving of $2.3 million in the first year of new leadership initiative. he further explained how training also increased audit scores at the company’s smaller plant to 8.9 up from 7.3 on a scale of 10. some recent researchers, salman and tayib (2013) examined the interaction between expenditure on human capital and financial performance of 50 public listed companies in nigeria and provide evidence of interaction between the two variables which further revealed that expenditure on human capital influence performance of the sampled companies positively. ahangar (2011) and okwy and christopher (2010) found human capital to be relevant in both companies financial performance and future benefits using cost models and economic approaches. however, shrader and siegal (2007) remarked that human capital concept are like other assets since they are acquired to generate future profits, hence they should be treated as other assets and be considered when valuing a company by capitalizing them instead of expensing them in the current period. they maintained that there is the need for companies to disaggregate human capital cost as revenue and capital cost and report it with other assets despite the difficulty in quantifying the value, expertise knowledge, skills and competences of human capital. the constraint of separating the cost relating to human capital into its revenue and capital expenditure element was also noted. this is because it will in not measure increase profitability, net worth and market value. chang and hseih (2011) using the value added intellectual co-efficient model(vaicm) found expenditure on human capital to have strong correlation in both company performance and market capitalisation of the companies selected for the study in china. temitope and abdulbakar (2014) in their studies provided empirical evidence of significant relationship between the human capital and profitability of some of the sampled nigerian companies on which the studies were conducted. on the other hand, they found some nigerian sampled companies having no or weak correlation between the two variables. 2.3.2 classification of human capital expenditure and its effect on profitability of quoted manufacturing companies in nigeria classifying human capital expenditure in quoted manufacturing companies seems to have significant effect on their profitability. these can be analysed from the short run effect and the long run effect. onafaluyo, eke and akinlabi (2011) cited in anuonye (2015) restate the short run and long run effect of classifying human capital expenditure. looking at the short run effect, if an organization is starting operation newly, the cost incurred to procure staff, train them and pay their salaries may not initially translate to profit. in fact, it may end up with the organization incurring losses all because there is tendency of using up more cash than they earn. but the long run effect on the other hand, start showing as the organisation is growing and having competitive advantage over others which can be through cost leadership or differentiation. cost leadership is when organization reduces its cost to ensure that it asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 162 becomes the lowest-cost producer. differentiation means when a company uses some strategies to make its producst or services to be considered by customers as different from those of its competitors. also, the profit will increase tremendously when the manufacturing company becomes a star in the market. to be a star in the market means to have a high relative market share and a high growth market. all these long run achievements do not just come, but as a result of that which the organization has invested in the human capital that runs the organization. to make clear the inclusion of expenditure on human capital in the financial statement and to ensure accounting for it, ifurueze (2013) opined that from the international financial reporting standard (ifrs), human capital expenditure should be classified into either capital expenditure or revenue expenditure. the classification adopted by an organization will determine its effect on the profitability of such organization. some organization capitalizes the substantial part of their training expenditure because they believe that the benefit of the training will accrue for some years. when this classification is adopted it will increase the profitability as the training cost will be spread over a number of years for which the training benefit is to accrue on human capital and must be treated differently. capital expenditure should be capitalized and recorded in the statement of financial position as intangible assets and amortised over the useful life of the human asset. the amortised value should be recorded as expenses in the statement of comprehensive income. however, revenue expenditure is charged to expenses in the statement of profit or loss. the capital expenditure will be treated as investment in human capital asset under intangible asset according to international accounting standards (ias38) and are expected to be recognized in the financial statement. mirvis and macy (1976) cited in ifrueze (2013) analysed the logic behind this treatment to be the development cost which provides benefits beyond the current accounting period. odesa (2014), also acknowledged the effect of classification on profitability to some users of the financial statement who need information about the human capital asset of the organisation such as; investors and managers. investors are the existing and potential shareholders of a company who need the information about the value of human resource assets of the organization to assist them in making decision to acquire, retain or disposed off stock of the organization because human asset is the lifeline of the future of an organization. while managers are those that ensure smooth running of the organization and ensure that human capital are efficiently invested to enhance future earning power of the organization. charging this investment to the statement of comprehensive income as expense will produce relatively lower net profit in the current year. 3. research method the study was analytical in nature and panel regression was employed to look at the relationship of human capital expenditure on the profitability of quoted companies in the manufacturing sector .the total manufacturing companies listed on the nigeria stock exchange as at 31st dec 2014, were forty-five (45) in number which covers manufacturing activities in eight (8) sectors of the economy. a sample of ten (10) companies was purposively selected for the study and the study covered a period of (ten) 10 years from 2005 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 163 to 2014. data was collected from the published financial statements of the companies selected for the study. 3.1 model specification and measurement of variables being a study on manufacturing companies, cost model was adopted which was premised on the assessment of human capital expenditure on profitability of quoted companies. this study established empirical evidence that expenditure on human capital can have effect on the profitability of the firms. therefore, the functions below represent the relationship. pbt = f (thce) (1) where: pbt = profit before tax thce = total human capital expenditure the function above can be written as a model thus: pbt = βo + β1sw + β2tr + β3cp + β4h + µ (basic model) (2) pbt = profit before tax sw = salaries and wages tr = training cp = contributory pension ht = health µ = error term 4. results and discussion the study sought to determine the relationship between human capital expenditure and profitability of the selected quoted manufacturing companies in nigeria. to make clear the result of this study, the variables used in determining the effect of human capital expenditure on the profitability of the selected firms were stated below. np = net profit sw = salaries and wages tr = training cp = contributory pension ht = health 4.2 the relationship between human capital expenditure and profitability of selected quoted manufacturing companies. the variables used in the study to identify the relationship between expenditure on human capital and the profitability of selected quoted manufacturing companies are dependent and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 164 independent variables which formed the model designed for the study and it consist of five variables. the summary of the descriptive statistics relating to these variables are presented in table 1 below.it reveals that net profit (np) shows the highest variability from the mean of 5,549,634 with a standard deviation of 8,529,301, this can be explained from the fact that net profit (np) increase as a result of expensing on human capital by the organizations involved in the study. the variables have standard deviations higher than the mean which indicates the spread of the variables. also, from table 2, the normality test was used in testing the skewness and kurtosis of the identified determinants of profitability. it shows that all the variables were normally skewed and are significant at 1% level. table 3 shows the shapiro wilk test for the normality of variables used in determining the profitability of the selected firms. from the table, it shows that all the variables has mild w values which are close to one and are all significant at 1% level. thus indicating how normally distributed the variables are,. shapiro wilk is regarded as the best estimator of the variance to the usual corrected sum of squares estimator of variance (park 2008). the test is used when the sample size is between 7 and 2000 which satisfies the sample size of this study. the distribution indicates normality when the test is positive and less than or equal to one. a significant p value of the w ratio indicates the probability that the normality is true. therefore, if the p value is not significant, it means that the distribution is statistically not normally distributed. table 1. descriptive statistics of human capital efficiency variables mean maximum minimum observations np 5549634. 64261549 759.3650 98 cp 253396.7 1757497. 680.3560 98 tr 229381.8 1581086. 0.000000 98 sw 2446310. 13956840 346.6160 98 ht 72622.58 555398.0 335.0000 98 source: author’s field report 2016 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 165 table 2. skewness/kurtosis test of human capital expenditure and profitability relationship variables std. dev. skewness kurtosis probability np 8529301. 3.915178 24.73814 0.00000 cp 345449.4 2.084749 7.661108 0.00000 tr 374028.8 1.785743 5.261246 0.00000 sw 2681400. 1.858753 6.963889 0.00000 ht 110247.7 2.134762 7.427070 0.00000 source: author’s field report 2016 table 3. shapiro-wilk w test for normal data variable obs w v z prob>z np 100 0.61588 31.714 7.668 0.00000 sw 100 0.79503 16.923 6.275 0.00000 tr 100 0.66160 27.940 7.387 0.00000 cp 100 0.74469 21.079 6.762 0.00000 ht 99 0.69300 25.135 7.149 0.00000 source: author’s field report 2016 table 4 explains the correlation matrices between the dependent and the independent variables. the correlation matrix helps to ascertain the extent of relationship existing amongst the dependent and independent variables on one hand as well as relationship existing amongst the independent variables on the other hand. the relationship between the dependent and independent variables is a predetermination of how the regression result would look like. from the table, the result of the correlation shows that sw, tr, cp and ht have significant positive correlation with np indicating that np is influenced by sw, tr, cp and ht to the tune of 39%, 24%, 40% and 52% respectively. the correlation between sw, tr, cp and ht with np indicates that expensing on human capital enhance the performance of companies in terms of profitability. though, all the relationship is positive but most of them are weak with the exception of health having a strong relationship. this finding corroborates salman and tayib (2013) who examined interaction between expenditure on human capital and financial performance of 50 public listed companies in nigeria and provided evidence of positive interaction between the two variables. also, it corroborates the studies of temitope and abdulbakar (2014) who found some of the sampled nigeria companies having strong asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 166 correlation and some having weak correlation. amongst the independent variables, a significant positive correlation exists between sw, tr, cp and ht. table 4. correlation matrix for np, sw, tr, cp and ht pearson correlation np sw tr cp ht np 1.0000 sw 0.389** 1.0000 (0.0000) tr 0.243* 0.278** 1.0000 (0.015) (0.005) cp 0.399** 0.444** 0.340** 1,0000 (0.000) (0.000) (0.001) ht 0.526** 0.693** 0.245* 0.566** 1.0000 (0.000) (0.000) (0.014) (0.000) ** correlation is significant at 0.01 level (2-tailed). * correlation is significant at 0.05 level (2-tailed). source: authors field report 2016 table 5 shows the result of the regression model used in relating the joint power of sw, tr, cp and ht to np. this indicates that the joint power of sw, tr, cp and ht can significantly predict np as shown by the model p value of 0.0000. this means that the model is fitted at 1%. also the joint power of sw, tr, cp and ht contributed about 33% to the total variation of np. ht contributed more to the model with a wide variation than cp, tr and sw as indicated by the coefficients. individually, sw showed the weakest influence on pbt. the result also indicates that only ht can significantly predict np at 5% level of significance. the model can be re written thus; pbt = βo + β1 sw + β2tr + β3 cp + β4 ht + µ. (3) pbt = 1277892. +0.310699sw + 2.675213tr + 3.451895cp + 27.86091ht (4) the equation indicates that all the explanatory variables have positive relationship with profitability. from the result, the beta value of ht (27.86091) contributed more to the profitability of the firms than the beta values of cp, tr and sw expenditures. the result of the regression is the same with the correlation result which also has ht as having the strongest relationship with profitability. the r2 is also a little above the result of firer and williams (2003) who found r2 to be 30% in identifying the relationship between human capital expenditure and profitability. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 167 table 5. regression result for the model variable co efficient p value sw 0.3106 0.4195 tr 2.6752 0.2042 cp 3.4519 0.1941 ht 27.8609 0.0066 constant 1277892. 0.2209 r – squared 0.33021 adjusted r – squared 0.301402 model p value 0.00000 f statistic 11.46239 source: author’s field report 2016 4.3 summary of findings the findings from the studies as presented above confirm results from previous similar studies as well as also contradict some, the study found that there is positive relationship between expenditure on human capital in general and the profitability of the selected firms. this indicates that expensing on human capital has positive influence on firms’ performance in terms of profitability, but despite the positive relationship very few of the companies are having their p value not significant. this finding is in line with the study conducted by salim and tayib (2013) but contradict the works of kujansiva and lonnquist (2007) who reported that there was no clear evidence of relationship between the two. also, the result of the correlation shows that all the variables are having significant positive correlation with np. though very few of them are weak but on the whole correlation exist among the variables. this indicates that expensing on human capital enhances the performance of the selected firms in terms of profitability. this findings is consistent with ahangar (2011) and okwy and christopher (2010). the result also found r2 in general to be 33%. this is different from the r2 of individual organisation’s classification of human capital expenditure in relation to profitability which ranges between 20% and 95%. 5.1 conclusions the findings from the study revealed that human capital expenditure significantly influenced profitability of manufacturing companies quoted on the nigeria stock exchange. from these findings, the study therefore conclude that companies that place more emphasis on human capital, maintaining it and treating it as a pure asset will stand apart. expert says, “the work force is the primary way to drive revenue”. also, companies that do a proper job of making sure they have the right people at the right time at the price are going to be in the position to asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 168 have a sustainable competitive advantage. in today’s global business environment and a changing world, success is driven by talent, vision and leadership capability of employee. companies should therefore ensure that they secure the best leadership teams for the ongoing success of the business. 5.2 recommendations human capital expenditure is being incurred by various organizations to ensure that their profitability is enhanced for the sustainability and overall performance of their business. from the findings of the study, we recommend the followings; 2. companies should imbibe the culture of capitalizing and reporting investment on human resources that can improve the quality and productivity. this will impact positively and significantly on their profitability and consequently on their share price value. h4. it is important for management of quoted manufacturing companies should invest judiciously in their knowledge assets so as to attain desired profitability. this will avail organizations to attain greater success and remain competitive to achieve their long term value creation and survival goals. 6. manufacturing companies should provide an enabling organization structure for qualified, experienced and skilled human resources to fully utilize their potentials and thus increase human capital efficiency. this will enable the organizations to achieve higher profitability, because the higher the human capital efficiency, the greater the profitability. references ahangan r.g. 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(2015). https//www.weforum.org. retrieved 20/08201 microsoft word 6062-21822-1-sm-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 87 is stock price synchronicity a measure of noise or stock price informativeness: evidence from audit pricing model jim wang (corresponding author) school of business, tung wah college mongkok, kowloon, hong kong tel: (852) 34686871 e-mail: jimwang@twc.edu.hk received: august 3, 2014 accepted: august 23, 2014 published: december 1, 2014 doi:10.5296/ajfa.v6i2.6062 url: http://dx.doi.org/10.5296/ajfa.v6i2.6062 abstract it is an unsettled issue of whether stock price synchronicity (hereafter syn) measures market-wide noise or market-wide informativeness. the sarbanes-oxley act (hereafter sox) provides an experimental setting to re-examine the issue of syn. as internal control reports and assessments required by sox are available to the stock market in annual reports, this market-wide financial statement-related information will affect auditors’ risk assessment and therefore audit work and consequently audit fees as well. using this experimental setting, this study uses an audit pricing model to examine the relation between audit fees and syn. using a sample consisting of u.s. firms from 2004 to 2006, the study documents a significantly positive relation between audit fees and syn only in year 2004, but insignificant relations in years 2005 and 2006. the results are consistent with syn representing market-wide financial statement-related information in 2004 when a regulatory change in financial statements due to sox; while syn representing market-wide noise (i.e. non-financial statement-related information) in 2005 and 2006. keywords: audit fee, stock price synchronicity, audit pricing model, r2, stock price informativeness jel classification: m42, g34 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 88 1. introduction financial analysts and government regulatory agencies attach great importance to stock markets, which function as a resource-allocation mechanism by incorporating market-wide, industrial-wide and firm-level information into stock prices. the recent melt-down of global financial markets shows that stock markets are highly susceptible to market-wide news. stock prices go up (down) when good (bad) news hits the market. as a consequence, individual stocks move synchronously or un-synchronously with the stock market as a whole. stock price synchronicity (syn) has been a very important topic for a number of prior studies (e.g. roll, 1988; morck et al., 2000). syn is measured by the r2 of the “market model” 1 or log-transformed r2, (i.e. log(r2/(1-r2)). roll (1988) calculated the r2 (i.e. the coefficient of determinants) of the “market model” and found that the r2 is around 0.35 for monthly data and 0.20 for daily data using the crsp u.s. data from 1982 to 1987. the r2 should be close to 1.0” (roll, 1988; p542), which contradicts the belief that authenticated information, with hindsight, could explain most asset price movements. roll (1988) argued that r2 “seems to imply the existence of either private information or occasional frenzy unrelated to concrete information”. it is unclear whether syn is caused by the noise of stock prices due to market sentiments or more market-wide information incorporated into stock prices. prior studies show mixed results. for example, jin and myers (2006), piotroski and roulstone (2004) and chan and hameed (2006) support that syn measures informativeness. on the contrary, yang and zhang (2006), skaife et al. (2006) and li et al. (2014) suggest that syn measures noise. it thus remains an unsettled issue whether syn measures noise or informativeness. this study re-examine the syn issue. it differs from prior research on two grounds. first, this research uses an audit pricing model. auditors are required to respond to information affecting material misstatements of financial statements by revising risk assessment and audit procedures. thus, the audit pricing model can be used to test whether syn measures financial statement-related information or noise (i.e. non-financial statement-related). second, this research uses a post-sox sample. sox provides an experimental setting of regulatory changes regarding disclosure of internal control reports and assessment in annual reports. as internal control information is available for the first time in the post-sox period, syn is more likely to capture market-wide information. this sample helps to find the significant relation between audit fees and syn. the next section reviews the literature and describes the background of sox. section three develops testable hypotheses. section four presents methodology used in empirical tests. section five describes the sample and provides empirical results. the final section concludes. 2. literature review and sarbanesoxley act background 2.1 literature review prior studies show mixed results on whether syn measures informativeness or noise. 1 roll (1988) uses two versions of market model. one is the single factor model based on capm. the other is the multiple factors model based on apt. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 89 morck et al. (2000) argued that syn measures returns reflecting more market-wide information. moreover, jin and myers (2006), piotroski and roulstone (2004) and chan and hameed (2006) argued that syn measures informativeness. jin and myers (2006) documented a positive association between syn and opaqueness, which is in line with the theory that opaqueness increases the ratio of market to total risk for investors and results in a high level of syn. piotroski and roulstone (2004) found a positive association between syn and analyst forecast revisions. similarly, chan and hameed (2006) reported a positive association between syn and analyst following, which is consistent with the theory that analyst following incorporates market-wide/industry-wide information into stock prices. in addition, xing and anderson (2011) argued that syn represents public information by documenting an inversely u-shaped relation between syn and proxies of firm-specific public information. in contrast, yang and zhang (2006), skaife et al. (2006) and li et al. (2014) argued that syn measures noise. yang and zhang (2006) tested the relation between syn and post-earnings-announcement drift, v/p anomalies and earnings response coefficient, and their results support the noise interpretation of syn. skaife et al. (2006) examined the association between syn and informativeness proxies from the following four aspects: 1) stock pricing of future earnings information, 2) analyst forecast errors, 3) cross-listing in the u.s. and 4) firm fundamentals. however, they found little evidence of syn measuring informativeness. li et al. (2014) found that syn resembles noise. with all the conflicting findings mentioned above, whether syn measures informativeness or noise thus remains an unsettled issue. to add new insights on the issue, this study draws on audit pricing literature, which use audit pricing model as a research method to investigate various issues (e.g. frankel et al. 2002; asbaugh et al. 2003; francis et al. 2005; wang and yang 2011). based on this line of literature, if syn measures market-wide informativeness (i.e. market-wide financial statement-related information), this will affect an auditor’s assessment of risk of misstatement and consequently auditors will exercise more audit effort and thus charge high level of audit fees; if syn measures market-wide noise or sentiment, this will not affect an auditor’s assessment of risk of misstatement and consequently auditors will not exercise more audit effort and hence charge higher audit fees. 2. 2 sarbanes-oxley act background the sarbanes-oxley act provides an experimental setting in this study. this study takes advantage of the sox experimental setting by using a post-sox sample of u.s. firms from 2004 to 2009. the sarbanes-oxley act was approved by the congress on july 25, 2002. sec voted to adopt management’s report on internal control (sox section 404) on may 27, 2003. accordingly, accelerated filers have been expected to comply for fiscal years since june 15, 2004. section 404 of sox requires each annual report to contain an internal control report. this internal control report should state the responsibility of management for establishing and maintaining adequate internal control procedures for financial reporting. the report should also contain an assessment of the effectiveness of the internal control. in addition, section 404 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 90 specifically requires that the attestation on internal control shall not be the subject of a separate engagement. thus, a public accounting firm which issues audit reports shall attest to internal control assessment made by the management. the attestation shall be made in accordance with standards for attestation engagements issued or adopted by the pcaob (the public company accounting oversight board). based on sec release no. 33-8183, fees for attestation services on internal control assessment belong to the audit fees category. overall, these regulatory rules significantly change the structure of audit fees between pre-sox and post-sox periods. 3. hypothesis development 3.1 link between audit fees and syn auditors are hired as an external monitoring mechanism to mitigate agency problems according to the agency theory (watts & zimmerman, 1980). based on gaas (generally accepted auditing standards), audit procedures ensure that auditors understand their clients in terms of client business environment and governance, and identify areas venerable to misstatements and errors or frauds and consequently auditors’ tests can be adequate and effective. for example, the first standard of field work requires auditors to “adequately plan the work” (auditing standards sas no. 105, amendment to statement on auditing standards no.95); the second standard of field work requires auditors to “obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement whether due to error or fraud, and to design the nature, timing and extent of further audit procedures” (auditing standards sas no. 105, amendment to statement on auditing standards no.95). moreover, auditors need to assess audit risk, which is “the likelihood of material errors in the client’s financial statements” (gul & tsui, 1998, p221; accounting standards board, statement on auditing standards, no. 47). overall, auditors face three kinds of audit risk: 1) “inherent risk”, which is the likelihood of environmental factors producing a material error without taking account of internal control quality; 2) “control risk”, which is the likelihood that the internal control system fails in preventing or detecting of a material error; and 3) “detection risk”, which is the likelihood of failures of audit procedures in detecting a material error unfound by the internal control system. with respect to clients of greater inherent risk/control risk, auditors will use more resources to obtain “sufficient appropriate audit evidence” to lower “detection risk”. auditors’ assessment of clients’ risk of misstatement can be used to test the two competing syn arguments: 1) syn informativeness argument and 2) syn noise argument. morck et al. (2000), jin and myers (2006), piotroski and roulstone (2004) and chan and hameed (2006) support the syn informativeness argument. they argued that syn measures returns reflecting more market-wide information. on the contrary, yang and zhang (2006), skaife et al. (2006) and li et al. (2014) support the syn noise argument because of insignificant associations between syn and informativeness measures. one the one hand, if syn measures market-wide informativeness (i.e. market-wide financial statement-related information such as sox internal control requirements), this will affect an asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 91 auditor’s assessment of risk of misstatement and consequently will affect audit procedures, audit effort and audit fees, thus predicting a significantly positive relation between audit fees and syn. on the other hand, if syn measures market-wide noise or sentiment, this will not affect an auditor’s assessment of risk of misstatement and consequently will not affect audit effort or audit fees, thus predicting no significant association between audit fees and syn. 3.2 hypothesis development 2004 was the first fiscal year when internal control information was required by sox section 404 available to the market, thus resulting in market-wide financial statement-related information. in 2004, syn measured market-wide financial statement-related information. auditors had to respond to syn caused by first-time internal control information available to the market and assess the effect on the risk of material misstatement of financial statements. consequently, auditors spent more resources and thus charged higher audit fees. according to a.r.c. morgan (2005), the estimated initial section 404 compliance was estimated at $1 million per $1 billion in revenue. the disclosed average cost of external resources for section 404 compliance ranged from $1.56 million for firms with annual sales less than $250 million to $10 million for firms with annual sales between $7 billion and $10 billion (a.r.c. morgan, 2005). this leads to the first hypothesis. hypothesis 1: there was a significantly positive relation between audit fees and syn in 2004. in comparison to 2004, this internal control information is no longer new to auditors in 2005 and 2006. in 2005 and 2006, syn was more likely to measure noise or sentiment because the market had incorporated internal control information in 2004 and internal control information is no longer new to the market. therefore, auditors are less likely to respond to internal control information as they did for the first time in 2004 unless there are significant changes in the internal control of their clients. it is assumed that there were no significant changes in the internal control in 2005 and 2006 compared with 2004, and thus there were no changes in auditors’ responses to risk assessment, audit effort and, as a result, audit fees, which leads to the second hypothesis. hypothesis 2: there was no significant relation between audit fees and syn in 2005 and 2006. 4. methodology 4.1 stock price synchronicity syn measures how firms’ stock returns are closely tied to market and industry returns. following prior research works (e.g. morck et al., 2000; durnev et al., 2003; durnev et al., 2004), the syn measure is derived from the r2 of the following regression: ret = a + b1marett + b3indrett + ε (1) the weekly return (ret) of each firm is defined as the compounded return over five consecutive trading days within each week. each firm’s weekly industry return (indret) is asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 92 calculated as the value-weighted average of firms’ weekly returns, using all firms within the same two-digit sic code excluding the firm in question. for each firm year’s observations, weekly returns are regressed on the value-weighted market returns and value-weighted two-digit sic industry returns. according to piotroski and roulstone (2004), a minimum of 45 weekly observations is required for each firm year to retain sufficient observations for regression by each firm year. stock price synchronicity (syn) is defined as follows: syn= log(r2/(1-r2)) where r2 is the coefficient of determination from the estimation of the above equation (1). 4.2 auditing pricing model simunic (1980) regarded audit service as economic goods to the auditee (i.e. the client) and built a positive analytical model in which an auditor, as a supplier of a service, performs the work under the demands of a customer. for the customer (i.e. auditee), the consumption of auditing and the consumption of internal accounting control system are mutual substitutes and complements. moreover, the demand for auditing or internal accounting control systems is affected by the potential legal liability of auditees and auditors to third-party users of financial statements (i.e. litigation risk). regarding auditors and auditees, simunic (1980) assumed that 1) both auditors and auditees are risk-neutral and maximize their expected profits; and 2) auditors and auditees jointly share their proportion of users’ financial losses caused by omissions or misrepresentations in audited financial statements2. under these assumptions, the marginal benefit (or loss avoidance) of an internal accounting system (auditing) is decreasing at an increasing rate with more input of auditing (internal accounting control). thus, the equilibrium demand for auditing service is determined by the marginal benefit and the cost of the auditing/internal accounting control system. the equilibrium demand for auditing shows that audit pricing is determined by the loss exposure of the auditee, the loss-sharing ratio between auditors and auditees, and auditors’ production functions (simunic, 1980). regarding the loss exposure of the auditee, it increases litigation risk (i.e. the possibility of undetected omissions or material misstatements in financial statements discovered after auditors issued their opinion reports). talking to professionals from both audit firms and insurance organizations providing liability coverage for auditors, simunic (1980) indentified and measured five determinant factors in loss exposure. the first factor is the client (or auditee) size in terms of total assets rather then revenues. because auditing processes are based on sampling, increases in total assets together with individual components of total assets can increase the sample size required to achieve a given confidence level. the second factor is the client’s business operation complexity and diversification, with complexity measured by the number of subsidiaries and diversification 2 section 11(f) of the securities act 1933 and section 18 (b) of the securities exchange act of 1934 provide for joint and several liability on the part of auditees and auditors. under these provisions, the entire amount of damages suffered by a third party can be controlled from any one of the liable persons, with that person generally retaining rights to collect from all other persons who are also liable. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 93 measured by the number of business segments (i.e. two-digit sic industries of the client’s operation) and the percentage of foreign assets to total assets. more complex and diversified business operation increases the number of business decision centers and therefore the loss exposure. the third factor is certain high-risk line items of financial statements (e.g. inventory and accounts receivables) measured by the ratio of receivables to total assets or the ratio of inventory to total assets3. both receivables and inventory are “risky” items on balance sheets because these items need specific confirmation and observation auditing procedures and the valuation of these items is based on assumptions of forecasts on future events. the fourth factor is the industry of the client’s operation because loss exposure is likely to vary from industry to industry. the fifth factor is the client status as a publicly listed or privately held company4. the loss-sharing ratio is determined by the financial insolvency (financial distress) of both the auditor and the auditee. however, there is almost no data available to assess the financial difficulty of auditors, and thus the focus is on the following measures of the client’s insolvency: 1) the client’s profitability, measured by the ratio of net income to total assets (i.e. the accounting rate of return); 2) a loss indicator on whether the client endures loss over the period of the current year or two previous years; and 3) an indicator of a qualified audit opinion5 (including going-concern opinion) in the current year. auditors’ production functions (i.e. the scale of economies) are not directly observable. however, differentiated audits are manifested through price differences associated with product characteristics (e.g. the brand-name of auditors). big auditors provide a higher level of assurance than non-big auditors (palmrose, 1988). 4.3 empirical model based on the research works by simunic (1980), palmrose (1986), frankel et al. (2002), asbaugh et al. (2003) and francis et al. (2005), the following audit pricing model is used to test the audit pricing of syn: laf = b0 + b1lta + b2 lseg + b3 cata + b4quick + b5de + b6roa + b7foreign + b8opinion + b9ye + b10loss + b11big + b12syn + industry effect where: laf = natural log of audit fees in dollars lta = natural log of total assets in millions of dollars lseg = natural log of number of unique business segments cata = ratio of current assets to total assets quick = ratio of current assets (less inventory) to current liabilities de = ratio of long-term debt to total assets roa = ratio of earnings before extraordinary items to total assets 3 total assets in the denominator is used to control cross-sectional variation in firm size. 4 most previous studies and this research use the sample of publicly listed companies and thus there is no variation in the client status. 5 qualified audit opinions indicate either a significant deviation from the gaap (generally accepted accounting principle) or a scope of limitation on certain areas of financial statements, which show significant uncertainties of clients. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 94 foreign = proportion of total sales from foreign operations opinion = indicator variable, 1=qualified audit report ye = indicator variable, 1= non-dec 31 year end loss = indicator variable, 1= loss in current fiscal year big = big auditors syn = stock price synchronicity industry effects = industry dummy variables for two-digit sic industry audit fees are the dependent variable. the independent variables client size lta (measured by total assets), the client’s business operation complexity lseg (measured by the number of business segments), the client’s operation diversity foreign (measured by the proportion of total sales from foreign operations) and industry effects are measures of the loss exposure of the auditee. return on assets roa, a loss dummy loss and an indicator of a qualified audit opinion opinion are measures of the client’s insolvency. a big auditor dummy big measures the premium of auditors’ brand-name (i.e. auditors’ production functions). in addition, a dummy of a non-calendar year end ye is included to control the non-busy season in auditing; the current ratio cata (measured by the ratio of current assets to current liabilities), the quick ratio quick (measured by the ratio of current assets excluding inventory to current liabilities) and the financial leverage de (measured by the long-term debt to total assets) are also included to control the client’s risk. the variable of interest is syn. based on hypothesis 1, b12 is expected to be significantly positive in 2004. based on hypothesis 2, b12 is expected to be insignificant in 2005 and 2006. 5. sample and results 5.1 sample this study uses the post-sox (sarbanes-oxley act) sample period from 2004 to 2006 for two reasons. first, most previous studies were conducted with the pre-sox sample. there is a scarcity of research using the post-sox sample. second, the structures of audit fees are significantly different between pre-sox and post-sox. thus, the post-sox sample is homogenous in terms of the structures of audit fees. the audit fee data are from audit analytics. the financial variable data are from compustat. the data of stock market returns used to calculate stock price synchronicity are from crsp. the daily return and market return data are from crsp and the data of weekly return are calculated by using the daily return data. all databases used in this study are from wharton research data service. by following piotroski and roulstone (2004), a minimum of 45 weekly observations is required to calculate syn for each firm-year. regarding the unavailable data on analyst forecast revisions, changes in institutional ownership and insider trading are assumed to be “zero”.6 after excluding observations with missing values, the 6 the reported results of this study use the sample with these “zero” observations. however, this study also conducts tests without these “zero” observations. the unreported results show that the pooled regression results remain unchanged without these “zero” observations, while the results of annual regressions show insignificant coefficients on both abnormal audit/non-audit fees. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 95 sample size is 9,056 firm-year observations over the period of 2004 to 2006. the final sample size is 7,884 firm-year observations after excluding top and bottom 1% outliers7, with 2,903, 2,732, 2,249 firm-year observations for 2004, 2005 and 2006 respectively. 5.2 results table 1. descriptive statistics (n=7,884) variable minimum q1 mean median q3 maximum audit_fees 0 119000 1391425 445000 1257000 90200000 non_audit_fees 0 11428 419153.3 68190 282000 55100000 laf 0 11.687 12.815 13.006 14.044 18.318 lnonf 0 9.344 9.869 11.130 12.550 17.825 lta 0.001 3.302 5.123 5.146 6.901 12.509 lseg 0.693 0.693 1.047 0.693 1.386 3.219 cata 0 0.300 0.521 0.520 0.744 1 quick 0 0.822 3.658 1.395 2.705 2348 de 0 0 0.246 0.078 0.265 219 roa -2038 -0.140 -1.777 0.022 0.071 40.96 foreign -0.4 0 0.186 0 0.320 2.117 opinion 0 0 0.432 0 1 1 ye 0 0 0.300 0 1 1 loss 0 0 0.410 0 1 1 big 0 0 0.681 1 1 1 syn -10.635 -2.628 -1.805 -1.593 -0.755 1.804 the variables are defined as follows: audit_fees = audit fees in dollars non_audit_fees = non-audit fees in dollars laf(lnonf) = natural log of audit (non-audit) fees in dollars lta = natural log of total assets in millions of dollars lseg = natural log of number of unique business segments cata = ratio of current assets to total assets quick = ratio of current assets (less inventories) to current liabilities de = ratio of long-term debt to total assets roa = ratio of earnings before extraordinary items to total assets foreign = proportion of total sales from foreign operations opinion = indicator variable, 1=qualified audit report ye = indicator variable, 1= non-dec 31 year end loss = indicator variable, 1= loss in current fiscal year big = big auditors syn = stock price synchronicity 7 the final sample excludes observations of top and bottom 1% in audit fees (laf), total assets (lta), current ratios (cata), quick ratios (quick), leverage (de), return on assets (roa), proportion of foreign operation (foreign) and stock price synchronicity (syn). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 96 table 1 shows the descriptive statistics of the audit pricing model. there are 7,884 firm-year observations with 2,903, 2,732, 2,249 firm-year observations for 2004, 2005 and 2006 respectively. table 1 also shows that non-audit fees are much lower than audit fees in the post-sox period, which is caused by the restrictions of sox (sarbanes-oxley act) on non-audit services. table 2. regression results of audit pricing model the regression results of the following audit/non-audit fee model: laf = b0 + b1lta + b2 lseg + b3 cata + b4quick + b5de + b6roa + b7foreign + b8opinion + b9ye + b10loss + b11big + industry effect+ year effect audit fee model variable estimate p value intercept 9.011 <.0001 lta 0.594 <.0001 lseg 0.223 <.0001 cata 0.478 <.0001 quick -0.001 0.004 de 0.004 0.294 roa 0.000 0.952 foreign 0.282 <.0001 opinion 0.218 <.0001 ye -0.138 <.0001 loss 0.180 <.0001 big 0.135 <.0001 ind1 0.355 <.0001 ind2 0.216 <.0001 ind3 0.171 <.0001 ind4 0.332 <.0001 ind5 0.265 <.0001 ind6 -0.440 <.0001 ind7 -0.088 0.089 ind8 -0.233 <.0001 ind9 -0.033 0.643 ind10 0.378 <.0001 ind11 0.179 0.013 y2004 -0.213 <.0001 y2005 -0.039 0.155 n 7884 r2 0.591 asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 97 the variables are defined as follows: laf(lnonf) = natural log of audit (non-audit) fees in dollars lta = natural log of total assets in millions of dollars lseg = natural log of number of unique business segments cata = ratio of current assets to total assets quick = ratio of current assets (less inventories) to current liabilities de = ratio of long-term debt to total assets roa = ratio of earnings before extraordinary items to total assets foreign = proportion of total sales from foreign operations opinion = indicator variable, 1=qualified audit report ye = indicator variable, 1= non-dec 31 year end loss = indicator variable, 1= loss in current fiscal year big = big auditors the 11 industry dummies (ind1-ind11) are the two-digit sic industries of 37, 87, 50, 13, 48, 49, 35, 38, 36, 28 and 73 respectively. for brevity of reporting8, table 2 presents the results of the pooled regression of the audit pricing model without syn. however, audit fee regressions are run each year by industry with a requirement of at least 10 observations for each industry in each year. table 2 shows that the r2 of the audit fee model is 0.59, which is comparable to the r2 of 0.66 of defond et al. (2002, table 4) and 0.66 of ashbaugh et al. (2003, table 2). table 3. regression results of audit pricing of syn the results of the pooled regression on the audit pricing of stock prince synchronicity: laf = b0 + b1lta + b2lseg + b3cata + b4quick + b5de + b6roa + b7foreign + b8opinion + b9ye + b10loss + b11big + b12syn + industry effect variable estimate t value p value intercept 9.579 162.44 <.0001 lta 0.542 80.82 <.0001 lseg 0.218 13.29 <.0001 cata 0.494 11.07 <.0001 quick -0.043 -9.75 <.0001 de 0.031 0.59 0.557 roa -0.47 -8.43 <.0001 foreign 0.345 10.99 <.0001 opinion 0.155 8.64 <.0001 ye -0.222 -13.49 <.0001 loss 0.093 4.06 <.0001 8 the unreported results show that most mean coefficients of regressions by each industry and year are insignificant compared the reported pooled regression results. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 98 big 0.266 11.86 <.0001 syn 0.018 2.42 0.015 ind1 -0.273 -5.64 <.0001 ind2 0.006 0.13 0.896 ind3 -0.337 -7.98 <.0001 ind4 0.176 5.39 <.0001 ind5 0.287 9.32 <.0001 ind6 0.117 4.1 <.0001 ind7 0.058 1.98 0.048 ind8 0.362 14.46 <.0001 y2004 -0.239 -11.64 <.0001 y2005 -0.005 -0.22 0.829 n 7884 r2 0.727 the above sample excludes the top and bottom 1 percentiles of laf, lta, cata, quick, de, roa, foreign and syn. the variables are defined as follows: laf = natural log of audit fees in dollars lta = natural log of total assets in millions of dollars lseg = natural log of number of unique business segments cata = ratio of current assets to total assets quick = ratio of current assets (less inventories) to current liabilities de = ratio of long-term debt to total assets roa = ratio of earnings before extraordinary items to total assets foreign = proportion of total sales from foreign operations opinion = indicator variable, 1=qualified audit report ye = indicator variable, 1= non-dec 31 year end loss = indicator variable, 1= loss in current fiscal year big = big auditors syn = stock price synchronicity industry effects = industry dummy variables for two-digit sic industry the eight industry groups are two-digit sic code of 13, 48, 49, 35, 38, 36, 28, 73 with more than 500 observations for each industry. table 3 presents the results for the pooled regression. note that the r2 of the pooled regression is 0.727, which is comparable to the r2 of 0.66 of defond et al. (2002, table 4) and 0.66 of ashbaugh et al. (2003, table2). the coefficient on syn is 0.018 and significant (p value of 0.015), which seems to support hypothesis 1 not only in 2004 but also 2005 to 2006. however, the annual results of table 4 support hypothesis 1 in 2004 only. asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 99 table 4. annual regression results of audit pricing of syn the results of the annual regressions on the audit pricing of stock prince synchronicity: laf = b0 + b1lta + b2lseg + b3cata + b4quick + b5de + b6roa + b7foreign + b8opinion + b9ye + b10loss + b11big + b12syn + industry effect year 2004 year 2005 year 2006 variable estimate p value estimate p value estimate p value intercept 9.512 <.0001 9.383 <.0001 9.579 <.0001 lta 0.533 <.0001 0.557 <.0001 0.526 <.0001 lseg 0.208 <.0001 0.21 <.0001 0.245 <.0001 cata 0.514 <.0001 0.536 <.0001 0.436 <.0001 quick -0.055 <.0001 -0.034 <.0001 -0.042 <.0001 de 0.109 0.213 0.002 0.985 0.011 0.899 roa -0.491 <.0001 -0.623 <.0001 -0.28 0.002 foreign 0.267 <.0001 0.381 <.0001 0.397 <.0001 opinion 0.154 <.0001 0.133 0.000 0.241 <.0001 ye -0.532 <.0001 -0.028 0.326 -0.031 0.273 loss 0.083 0.029 0.091 0.024 0.099 0.012 big 0.285 <.0001 0.276 <.0001 0.231 <.0001 syn 0.028 0.02 0.012 0.374 0.012 0.301 ind1 -0.301 0.000 -0.216 0.015 -0.285 0.000 ind2 0.004 0.962 0.029 0.722 -0.017 0.83 ind3 -0.341 <.0001 -0.353 <.0001 -0.297 <.0001 ind4 0.262 <.0001 0.15 0.01 0.087 0.118 ind5 0.338 <.0001 0.237 <.0001 0.284 <.0001 ind6 0.162 0.001 0.068 0.173 0.11 0.022 ind7 0.153 0.002 -0.004 0.943 0.033 0.486 ind8 0.402 <.0001 0.359 <.0001 0.299 <.0001 n 2903 2732 2249 r2 0.737 0.708 0.756 the above sample excludes the top and bottom 1 percentiles of laf, lta, cata, quick, de, roa, foreign and syn. the variables are defined as follows: laf = natural log of audit fees in dollars lta = natural log of total assets in millions of dollars lseg = natural log of number of unique business segments cata = ratio of current assets to total assets quick = ratio of current assets (less inventories) to current liabilities de = ratio of long-term debt to total assets roa = ratio of earnings before extraordinary items to total assets foreign = proportion of total sales from foreign operations opinion = indicator variable, 1=qualified audit report asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 100 ye = indicator variable, 1= non-dec 31 year end loss = indicator variable, 1= loss in current fiscal year big = big auditors syn = stock price synchronicity industry effects = industry dummy variables for two-digit sic industry the eight industry groups are two-digit sic code of 13, 48, 49, 35, 38, 36, 28, 73 with more than 500 observations for each industry. the annual regression results in table 4 indicate that the coefficient on syn is positive and significant in 2004, but the coefficients on syn are insignificant in 2005 and 2006, supporting both hypotheses 1 and 2. 5.3 additional tests this research conducts additional tests on reverse causality. the results remain unchanged after using simultaneous equations which takes into account that firms may incorporate firm-specific audit fees or abnormal audit fees into stock prices. 6. conclusion the results of this study support that syn measures both informativeness and noise in different situations. this provides new insights to reconcile the mixed findings of the syn literature regarding whether syn measures informativeness or noise. this study suggests that syn measured market-wide financial statement-related informativeness in times of regulatory changes in 2004 and syn measured noise in other times such as in 2005 and 2006. moreover, the results may suggest that the benefit of sox internal control requirements on overall market-wide informativeness is temporary (only in one year 2004); the cost of the high level of audit fees from 2004 afterward due to sox may not justify the temporary benefit. in summary, this research contributes to both syn literature and audit pricing literature. first, this research provides empirical evidence that syn measured market-wide financial statement-related information in times of regulatory changes affecting financial statements (e.g. sox section 404) in 2004, and that syn measured market-wide noise or sentiment in 2005 and 2006, which was usually non-financial statement related. this provides new insights to reconcile of mixed results of prior syn literature. second, this research contributes to audit pricing literature by documenting empirical evidence that market-wide financial statement-related information, such as internal control disclosure requirements, affects the auditor’s risk assessment and, as a result, incurs higher audit fees. acknowledgement this study is based on a part of my phd thesis conducted at the school of accounting and finance of the hong kong polytechnic university. i also gratefully appreciate the research grant provided by the national natural science foundation of china (approval numbers: 71202090). asian journal of finance & accounting issn 1946-052x 2014, vol. 6, no. 2 www.macrothink.org/ajfa 101 references a.r.c. morgan. 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(2011). stock price synchronicity and public firm-specific information. journal of financial markets, 14(2), 259-276. http://dx.doi.org/10.1016/j.finmar.2010.10.001 copyright disclaimer copyright reserved by the author. this article is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 9359-new-final asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 1 the determinants of capital structure: empirical analysis of oil and gas firms during 2000-2015 aws yousef shambor university of hull, uk e-mail: shambouraws@gmail.com received: april 22, 2016 accepted: january 18, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.9359 url: http://dx.doi.org/10.5296/ajfa.v9i1.9359 abstract this study investigates the capital structure determinants of 346 oil and gas firms that are the constituents of the global oil and gas index (oilgswd) over the period of 2000 – 2015, taking into account the effect of the global financial crisis of2007-2009 on the determinants of the capital structure. thus, six firm level explanatory variables (namely: liquidity, profitability, growth, non-debt tax shield, tangibility and size) are selected and regressed against the appropriate capital structure measure, leverage, the ratio of total debt to book value of total assets. the data is collected from secondary sources depending on the data from the datastream database. the major findings of the study indicate that tangibility, profitability, size, liquidity and non-debt tax shield are the significant determinants of capital structure of oil and gas firms, while growth is considered insignificant. the capital structure is analyzed in terms of the three main theories of capital structure: trade-off theory, pecking order theory, and agency cost theory. finally, the global financial crisis has to some extent a significant impact on the capital structure determinants of oil and gas firms and has no significant impact on liquidity, as indicated by the ols regression analysis results. keywords: capital structure, global oil and gas index, leverage, tangibility, liquidity, size, profitability, growth, and the global financial crisis. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 2 1. introduction 1.1 background of the study capital structure is a very important topic in corporate finance field since it has a very significant effect on the firm financial performance and efficiency. pandey (2005) defines capital structure as a decision made by firms regarding suitable financing sources i.e. whether they should use external or internal resource of financing or both. according to brealey and myers (1991), the financing sources of any firm are equity, debt, or hybrid securities that the firm issues. however, leverage is known as the amount of debt used by a firm to finance its assets is termed leverage; firms that have a lot of debt in their capital structure are called highly levered firms, while firms that have no debt are called unlevered firms. overall, the capital structure decision focuses on both the impact of leverage and the impact of the different outcomes on the firm’s value as well as the capital cost. it is one of the most significant decisions made by financial managers of any company. maximizing the company shareholders’ wealth with low cost of capital is considered the main objective of corporate financial managers. thus, capital structure is considered an efficient management tool for managing the capital cost. once the cost of capital is minimal, the optimal capital structure is achieved. therefore, investigating the determinants of capital structure is very important for reaching the optimal capital structure for any company. for this reason, the literature contains numerous studies conducted to examine the capital structure determinants in many countries and to find the similarities as well as the differences in capital structure choices among different countries and among different industries even in the same country. example includes bradley et al study in(1984), rajan and zingalesstudy in (1995), ojah and gwatidzo’s study in (2009), and muzir’s study in (2011). according to bradley et al. (1984), there is a correlation between the industry nature that the firm operates in and the capital structure choice. harris and raviv (1991) state that the ratios of leverage seem to be nearly the same for firms that are in the same industry and dissimilar between different industries; talberg et al. (2008) indicate that industry specific characteristics significantly affect the capital structure decision of a firm. according to baker and martin (2011), the effects of industry nature on capital structure decisions are very significant, either because firm financial managers utilize industry median leverage as a point of reference for the leverage of their own firms or because the effects of industry nature are a sign of a set of interrelated factors. in view of this significance, this study examines the determinants of capital structure of oil and gas companies listed on the global index over the period of 2000 – 2015, in order to describe the process of decision making on the capital structure for this industry, thus contributing to the existing literature of empirical research in the field of corporate finance. additionally, in view of the fact that this study is about the determinants of capital structure choice over the period of 20002015, the question arises “is there any effect of the global asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 3 financial crisis of 2007-2009on the financing decision?” to the best of the knowledge of the researcher, is no previous research has been conducted on investigating the impact of the global financial crisis of 2007-2009 on the capital structure choice in companies of the oil and gas industry. particularly, this study examines the determinants of capital structure (leverage) by using the ols regression model on the available data for three periods: the pre-crisis period of 2000-2006, during the crisis in 2007-2009 and, the post crisis period of 2010-2015as well as during the total period as a whole 2000-2015, in order to determine whether the 2007-2009 global financial crisis has any influence on the capital structure determinants of the oil and gas companies. 1.2 importance of the study capital structure is one of the most debated topics in the field of corporate finance, and attracts many researchers to investigate it. some researchers examine the capital structure choice of companies from different industries such as jensen & langemeier (1966)’s study for agricultural companies, long & malitz (1985)’s study and titman &wessels (1988)’s study for manufacturing firms, and wedig et al (1988)’s study about non-profit making hospitals; such studies give evidence that the industry nature has a significant impact on the capital structure choice as, indicated by joseph ooi (1999). nevertheless, the capital structure of oil and gas firms is still a relatively under-investigation part in the literature of capital structure. actually, none till now has examined the determinants of capital structure choice of oil and gas firms over the period 2000-2015, taking into account the impact of the global financial crisis in the period 2007-2009 on the capital structure decision of the firms. as a result, this study tries to fill the gap in the literature by making a contribution to the growing body of investigational corporate financial research in the oil and gas industry. a base thereby set for further research and improvements into the capital structure decisions of the oil and gas industry. 1.3 research objectives the main goal of this study is to investigate the capital structure determinants of a panel of 436oil and gas firms listed on the global index during the period 2000 – 2015, taking into account the impact, if any, of the global financial crisis of 2007-2009 on the capital structure choice of the firms studied. particularly, this study is intended to:  identify the capital structure determinants of oil and gas firms.  show how profitability, growth, size, non-debt tax shield, liquidity and tangibility affect the capital structure decisions of oil and gas firms.  find out the capital structure theory that can best describe the capital structure decisions of oil and gas firms.  investigate the influence of the global financial crisis of 2007-2009 on capital structureof oil and gas firms. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 4 1.4 research questions this study is conducted to answer the following two questions: 1to what extent and do firm specific factors, namely, liquidity, non-debt tax shield, profitability, tangibility, size and growth determine the capital structure decisions of oil and gas firms? 2which theories of capital structure can best describe the capital structure choice of oil and gas firms? 3is there any impact of the global financial crisis of 2007-2009 on the determinant of the capital structure of oil and gas firms? 2.1 literature review a huge volume of research has been conducted on investigating the capital structure decision. modigliani and miller’s theory (1958) is considered the revolutionary theory in the capital structure studies. since the appearance of this theory in 1958, several theories and studies have emerged that are in a partial agreement with the propositions of modigliani and miller’s theory which concludes that financial policy is not significant, not useful and not related. till now, no theory on debt and equity has been completely acknowledged as the best theory to describe the financing decisions of all companies, because of the unique characteristics of each company that make it difficult to establish one capital structure for all, according to schwartz (1959). as a result, some studies are conducted on critically explaining capital structure theories, such as afrasiabishaniet al. (2012); some criticize the weaknesses of the theories, such as the studies conducted by chirinkoandsingha (2000) and zhaoet al. (2004), and other studies are conducted to test the capital structure theories experimentally like the one that is conducted by shyam-sunder and myers (1999).in this study, five significant theories in capital structure are described below: modigliani and miller, trade-off theory, pecking order theory, agency cost theory, and market timing theory. 2.1.1 the theory of modigliani and miller the central postulation of the theory of modigliani& miller (1958) is known as “the irrelevance theorem” which suggests that profitability is what determines the company’s value, not its capital structure; modigliani & miller(1958) suggest that the company’s value is free of capital structure and that a levered company’s value is equal to that of an unlevered one. the second proposition of modigliani & miller is that the expected rate of return on equity increases proportionately with the gearing ratio. the equity cost is equivalent to the capital cost of an unlevered company in addition to the difference between the capital cost of an unlevered company and the debt cost, weighted by the ratio of debt-equity. the third preposition is that new projects should be evaluated by weighted average cost of capital (wacc) which is constant regardless of gearing. in fact, their theory is considered as the essential groundwork of the capital structure theories, even though it faces a great deal of criticism. one of the criticisms is that this theory is not appropriate for the current environment because it assumes that there is an ideal capital asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 5 market that has no bankruptcy cost, no equity risk, no debt risk, no business cost, and no taxes. certainly, there is no such an environment in reality (handoo and sharma, 2014). however, in a later study, modigliani and miller (1963) take into account tax to modify their first published theory and conclude that a levered company’s value is more than that is of an unlevered one and this value and the value of the tax shield are equal because of taking the factor of tax shield on debt into consideration. as mentioned in handoo and sharma (2014), a further modification (modigliani and miller, 1966) includes the impact of personal taxes which are categorized into tax on income from debt securities and tax on income from holdings shares. to summaries, modigliani and miller’s theory is still the basic theory of capital structure, which opens extensive discussion in the capital structure topic. 2.1.2 the trade-off theory the trade-off theory supposes that a company makes debt the major source of its financing in its capital structure. using more debt is beneficial for a firm because the marginal value of tax on more debt compensates the financial cost of the extra debt; this is known as the tax shield or the deductible tax as indicated by myers (1984, 2001). according to myers (1984), this theory refers to the trade-off of the benefits of tax and the costs of financial distresses. companies with high debt may be more exposed to bankruptcy or financial troubles if they are not able to acquire enough cash by their operational or financial activities to be able to cover their borrowings. in addition, a firm with heavy debt is exposed to pay interest payment, while a firm without debt would invest all its profit again, according to modigliani and miller (1958).one of the most significant disadvantages of making debt the main source of firm finance is that the possibility of financial distress rises. in addition, brealey, myers and allen (2006) state that if the firm raises debt and it is reluctant benefit from tax shield, the firm can have bankruptcy and financial distresses without benefiting from raising debt. according to myers (1984), firms that are financially risky are supposed to borrow less. therefore, companies are supposed to assess the advantages as well as the costs resulting from financing by debt for maximizing their value. 2.1.3 pecking order theory this theory was presented by myers & majluf (1984). pecking order theory is one of the most significant theories explaining the capital structure choice. it supposes that a company likes to use its internal financing resources first, and then it uses the external sources of finance including debt and equity as the final resort for funding because equity is more costly compared to and the internal sources of finance, which are considered the cheapest. if the firm needs external financing sources, it prefers to issue stocks, which are considered costless and safer compared other external financing sources that are used as the last resort, according to myers & majluf (1984). thus, the cost of each source of finance, which is related to information asymmetryand the fact that using internal finance sources is easier and more available than external ones play important roles in making firms prefer internal finance sources over external ones. thus, the financing hierarchy suggested by pecking order theory means that the external and internal sources of firm finance are not ideal alternatives.pecking order theory explains firms’ financing decisions by considering the essential information asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 6 asymmetry existing between the various parties of a firm such as managers, creditors, and external investors. 2.2 determinants of capital structure the literature has a plethora of research and studies conducted to investigate the determinants of capital structure in many countries, since the decision of a firm capital structure is one of the main and most significant decisions the managers make. myers (1977)states that companies with a high amount of debt are expected to miss out on beneficial investment opportunities; thus, companies that look forward to better future growth will be encouraged to issue equity in order to fund their projects. deangelo and masulis (1980) argue that companies with high non-debt tax shields will be less motivated to benefit from the debt’s tax advantage, so they will take on less leverage. furthermore, myers and majluf (1984) state that there is a positive relationship between leverage and the assets’ collateral value; for reducing information asymmetries, companies should preferably sell secured debt. according to titman (1988), specialized industry companies should have higher leverage compared to manufacturing companies. similarly, large companies may take on higher leverage in order to be more diversified and thus, have lower bankruptcy risks, according to anget al (1982).in fact, many studies are conducted to investigate the factors that play a role in shaping companies’ debt policy; for example, bancel and mittoo (2011) indicate that level of interest rates, credit ratings, share price, flexibility, and tax advantage of debt all affect the financing decisions of companies in europe. however, the determinants of capital structure vary from one industry to another and from one country to another, as the literature indicates. 2.3 empirical studies the value of empirical studies that testthe capital structure theories is enormous. for example, shyam-sunder & myers (1999) investigate one hundred and fifty seven us firms over the period 1971-1989 to find out whether trade off theory or pecking order theory best explains the financing practices of the firms selected. in a similar study, fama& french (2002) investigate three thousand us firms over the period of 1965 -1999 in order to test the applicability of pecking order and trade off theory by the selected firms. both shyam-sunder & myers (1999) and fama & french (2002) find that their results support the pecking order theory’s assumption that firms that have high profit have a tendency to have less leverage. however, the findings of a study conducted by frank and goyal (2003) are contrary to the pecking order theory’s prophecies depending on their investigation of us public trade firms over the period 1971-1998. according to them, deficit financing is less strongly followed by net debt issues than the net equity issues; they notice that pecking order theory’s relevance declines over time for all firms, regardless of size. for that reason, frank & goyal (2009) conduct another study to investigate many crucial factors in giving explanation of the capital structure choice of an enormous number of us public trade firms. they find that most selected firms apply the trade-off theory in their capital structure and they find that there are some factors that positively influence leverage, such as size, collateral, median industry factors, top corporate income tax rate, change in total firm assets, asset tangibility, and treasury bill rate. conversely, it is found that there are some factors that negatively influence asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 7 leverage, such as profitability, market to book ratio, financial constraints, dividend-paying, net operating loss, and bankruptcy risk. bevan and danbolt(2004) conduct a study to investigate the determinants of the capital structure of 1054 firms in the united kingdom over the period of 1991-1997, taking into consideration the impact on these determinants of time-invariant firm-specific heterogeneity. it is found that smaller firms have less short-term and long-term debt, compared to larger firms; profitability is negatively related to gearing, even thoughless profitable firms have less short-term bank borrowing than profitable firms, and tangibility is positively related to short-term bank borrowing, as well as all long-term debt elements. on the other hand, they find that growth has little influence on gearing.additionally, rajan & zingales (1995) conduct a study in order to examine the capital structure choice made bynon-financial firms in seven countries, namely, canada, the usa, japan, the uk, france, germany, and italy. they find that uk and germany firms are less levered than firms in other countries. also, they find that specific factors such as profitability, size, and asset tangibility significantly influence leverage; in particular, profitability is negatively correlated to leverage, while size and asset tangibility are positively correlated to leverage according to their investigated sample. in addition, ozkan (2001) examines the capital structure determinants of 390 non-financial companies over the period of 1984-1996; it is found that liquidity, growth and profitability influence negatively on leverage. in addition, khrawish and khraiwesh (2010) conduct a study to investigate the determinants of the capital structure of 30 industrial companies in jordan over the period of 2001-2005; it is found that size and tangibility are positively related to leverage whereas profitability is negatively related to leverage. finally, table 2.1 in the appendix gives a summary of past empirical studies conducted on the determinants of capital structure. 3. data and methodology 3.1 data sources and collection this study investigates the capital structure determinants of the oil and gas sector firms over the period 2000 2015.mostprevious empirical studies examining significant relationships between leverage and determinants are based on generally quantitative data from financial materials. similarly, this study investigates the data that is collected from secondary sources; in particular, it depends on the data from datastream database. the sample of this study is a panel of357 non-financial firms categorized as oil & gas companies. however, companies that have any missing observations for any variable in the model during the period of the study are excluded; in fact, there are eleven companies with incomplete information. thus, the final sample of this study includes only 346 firms and 4,181 observations in the regression analysis. to eliminate the effect of outliers, all variables are winsorized at the top and lowest 1% levels. the 346 companies are categorized as follows : 57 in oceania , 74 in europe , 12 in russia, 81 in asia, 12 in south america, 9 in africa, 83 in the united state , and 18 in the united kingdom, as shown in table 3.1 in the appendix. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 8 3.2 data analysis procedures this study presents quantitative analysis as well as theoretical data analysis. to analyze the data, both descriptive time series statistics and correlations are used to examine the relationship between the considered variables. furthermore, this study employs multivariate ordinary least square (ols) regression in order to determine if there is a correlation between leverage, the dependent variable, and the multiple independent variables (tangibility, size, profitability, non-debt tax shield, growth and liquidity). this study uses one regression equation to test the hypotheses created in relation to leverage and the firm-specific determinants. moreover, excel 2013is used to compute and feed suitable data into the stata software, to assess the trustworthiness of the data, to test validity of the specified model and to analyze it. 3.3 model specification this study investigates the determinants of capital structure of the companies listed on the global oil and gas index. to achieve this aim, a quantitative rather than qualitative method is used. most of the existing empirical studies on capital structure use linear regression techniques with proxies for the determinant factors used to explain the variation in leverage ratios across firms. thus, this study uses one multivariate ordinary least square (ols) regression model to run the analysis of the data collected in order to test and analyze the relationship between the financial leverage and its determinant factors, since it is known that regression analysis is able to examine the associative correlation between the dependent variable and one or more independent variables. it identifies the relative significance of independent variables, calculates the values of the dependent variable and determines the form or structure of the relationship. in order to apply regression analysis, it is assumed that there are linear relationships between leverage and the seven firm-specific internal factors, the error term is independent, constant and under a normal distribution. the multivariate ordinary least square (ols) regression model used in this study is defined as follows: the model equation is: leverage (firmit) = β0 + β1(tangit)+ β2(profit)+ β3(growit)+ β4(sizeit)+ β5(liqit)+ β6(ndtsit)+ εit where: standard coefficients and error term i = represent the individual companies t =represent the year β0 = coefficient of intercept (constant) β4 = coefficient of size β1 = coefficient oftangibility β5= coefficient of liquidity β2 = coefficient of profitability β6 = coefficient of tax-shield β3 = coefficient of firm growth ε= the error term asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 9 dependent variable  tda represents leverage, which is measured by the ratio of total debt to book value of total assets. independent variables  tang represents tangibility of assets, measured by the ratio of fixed assets to total assets.  prof represents profitability, measured by using the ratio of ebit over total assets.  grow represents growth, measured by the percentage change of total assets.  size represents size, measured by the natural logarithm of total assets.  liq represents liquidity, measured by the total current assets over total current liability.  ndts represents non-debt tax shield, measured by the ratio of annual depreciation expense to total assets. 3.4 definition and measurement of variables explanatory variables based on the previous studies, the researcher limits himself to the study of seven firm-specific factors, namely, tangibility (tang), size (size), profitability (prof), liquidity (liq), growth (grow), and non-debt tax shield (ndts). according to hsiao (1985), applying panel data gives more efficient coefficients and facilitates reduction of collinearity among explanatory variables. therefore, the effects of explanatory variables on leverage (dependent variable) are estimated by using panel data or timeseries cross-sectional data. in addition, there is one dummy variable which refers to the effect of financial crisis of 2007-2009 on leverage. dependent variable (leverage) according to deesomsak et al. (2004), the literature has many alternative definitions of leverage depending on whether market values or book measures are used and depending also on whether only long-term debt or total debt is taken into account. thus, there are the following definitions of leverage: the ratio of total debt to book value of assets (tda), the ratio of total debt to market value of assets (tdm), the ratio of long term debt to market value of assets (ldm), and the ratio of long-term debt to book value of assets (lda).this study uses the capital structure (leverage) as the dependent variable and it is defined as the ratio of total debt to book value of total assets (tda), the same model used by rajan and zingales (1995) and ozkan (2001). independent variables the estimated variables used in this study as the independent variables to clarify variations in leverage are tangibility, profitability, growth, size, liquidity and non-debt tax shield. in appendix, table 3.2 shows the proxies used to measure the variables selected by the study according to literature. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 10 3.5 research hypotheses the study hypotheses are: h 1: there is a positive impact of tangibility of oil and gas firms on leverage. h 2: there is a negative impact of profitability of oil and gas firms on leverage. h 3: there is a negative impact of growth of oil and gas firms on leverage. h 4: there is a positive impact of size of oil and gas firms on leverage. h 5: there is a negative impact of liquidity of oil and gas firms on leverage. h 6: there is a negative impact of ndts of oil and gas firms on leverage. h7: there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, assets tangibility. h8: there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, profitability. h9: there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, growth. h10: there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, size. h11: there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, liquidity. h12: there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, non-debt tax shield. h13: there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, age. 4. results and discussion 4.1 data testing in order to ensure that the available data of the study present reliable results and the model used fits the data, three tests are applied, which are normality, multicollinearity and heteroscedasticity tests. the three tests are related to the conventional linear regression model used for the selected data. testing the data by these tests is required since multivariate ordinary least squares (ols) is a technique for estimation that has many desirable properties; data testing verifies that the testing of hypotheses for the coefficient estimations is validly conducted. 4.2 descriptive statistics table 4.4, in the appendix, shows descriptive statistics for the values of the variables used after removal of extreme observations in the data selected. the data is now seen as disturbed, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 11 since removal of some estimations leads to an irregular distribution. in table 4.4, contains the following information: the number of observations, number of firms, mean, median, standard deviation, minimum and maximum of one dependent variable (tda) and seven explanatory variables which are : tangibility, profitability, growth, size, liquidity and ndts. the data consists of a panel of 346 firms. o the total debt ratio (tda), which is “the average ratio of total debt to book value of total assets” of oil and gas firms is found to be 0.2457, which means that only 24.6 % of the firms’ funds is provided by borrowing and the other 75.4 % is provided by other financing sources. it can be said that the capital structure of the selected firms is not heavily dependent on debt.according to frank and goyal (2009), getting an average leverage at book value of 0.29 % means that the firms investigated are fairly low leveraged. o the asset tangibility mean is found to be 52.3 %, which indicates that the oil and gas fixed assets represent 52.3 % of the total assets, since the business nature of oil and gas business is distinguished by having high fixed assets. tangibility of the oil and gas firms is measured by the ratio of fixed assets to total assets. o the annual average of profitability of the oil and gas firms investigated is found to be 9.2%. because the ratio of earnings before interest, tax and depreciation (ebitd)to total assets is used as a proxy to measure profitability, the maximum average profitability rate is 4% while the lowest recorded average profitability rate is -2.2 %, which indicates that the firms have a constant profitability rate every year. o the size proxy used in this study is the assets logarithm. consequently, the mean, maximum and minimum statistics make slight economic sense. nevertheless, a bench mark variation of 2.687 reveals great dissimilarities in size between the investigated firms. o liquidity, which is defined as the ratio of current assets over current liabilities, is more than 1.5, indicating that the firms have some strength in facing financial distress because of this amount of liquidity and that they have the ability to meet this obligation. since the selected firms are from the oil and gas industry, it is expected that they have relatively high fixed assets. therefore, for every one unit of current liabilities, firms are found to have 1.78 unit of current assets in order to cover their short-term liabilities. in ozkan’s (2001) study, the achieved liquidity ratio of it’s the sample is found to be 1.64 of current assets, which suggests that, by comparison, oil and gas firms are to some extent better at meeting their short-term obligations. o the mean of non-debt tax shield is found to be 0.047. this finding is somewhat higher than the mean of 0.036 found by ozkan (2001) although this study applies the same standard deviation used by ozkan (2001), who reports a non-debt tax shield isof0.020, which is lower than what is found in this study. 4.3 correlation analysis regression and correlation analyses are considered to be related to each other because they are both concerned with relationships among variables. the correlation coefficient stands for asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 12 a measure of linear relationship between two variables. correlation coefficient values range between -1 and +1. a correlation coefficient of +1 shows that two variables are entirely related positively in a linear sense; whereas a correlation coefficient of -1shows that two variables are entirely related negatively in a linear sense. in contrast, a correlation coefficient of zero indicates that there is no linear relationship between the two variables at all. for simple linear regression, the coefficient of sample correlation is measured by the square root of the determination coefficient. the correlation coefficient is concerned only with measuring the level of linear relationship between two variables. table 4.5, in the appendix, shows that the ratio of total debt to book value of total assets is correlated at 0.249 with tangibility, at the 1 % significance level, at -0.238 with profitability at the 1 % significance level, at 0.030 with growth, at the 5 % significance level, at 0.072 with firm size, at the 1 % significance level, at -0.317 with liquidity at the 1 % significance level, at -0.081 with non-debt tax shield at the 1% significance level. in addition, table 4.5 indicates that tangibility, size, and growth positively influence leverage whereas profitability, liquidity and non-debt tax shield negatively influence leverage. also, it is found that size, ndts and growth are positively correlated to profitability while tangibility and liquidity are negatively correlated to profitability. this means that larger oil and gas firms are disposed to have higher profitability. to conclude, the explanatory variables chosen are found to have a significant and strong association with the dependent variable, tda. for that reason, the independent variables chosen can explain the dependent variable to a significant degree. 4.4 multivariate regression analysis this section aims at analyzing the regression model results. multiple regression analysis on the cross sectional data is carried out in order to investigate the instantaneous impact of all the independent variables on the dependent variable. the multivariate linear regression model before estimation is: leverage (firmit) = β0 + β1(tangit)+ β2(profit)+ β3(growit)+β4(sizeit)+ β5(liqit)+ β6(ndtsit) + ε table 4.6 , in the appendix, represents the outcomes of the regression analysis in for each of the independent variables. as shown in table 4.6, r-squared is 0.2309, which shows that about 23.09 % of the variability of debt to equity ratio is explained by the chosen firm-specific factors. in other words, about 23.09 % of the change in the dependent variable is explained by the independent variables that are included in the model. the estimated regression equation: leverage = 0.239 + 0.1639 tan 0.419 pro + 0.017 grow + 0.004 size – 0.025 liq – 1.053 ndts + ε asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 13 4.5 the relationship between capital structure determinants and leverage over the whole sample period, 2000-2015. 4.5.1 leverage with assets tangibility the ratio of fixed asset to total assets is taken as a proxy for tangibility. the results of the regression model indicate that the correlation between leverage and asset structure is statistically significant at the level 1 %. the sign of the coefficient is positive; thus, when there is an increase in tangibility by 1 %, debt will increase by 0.16. this result is supports the first hypothesis (h1), namely, “there is a positive impact of tangibility of oil and gas firms on leverage”. in addition, this findings is in line with the finding of many previous studies such as jensen and meckling (1976), harris and raviv (1991), bennett and donnelly (1993), rajan and zingales (1995), gaud et al. (2003), and frank and goyal (2009). rajan and zingales (1995) state that firms with higher collateral assets are more likely to get a high level of debt in view of the fact that tangible assets are easy to collateralize and thus they reduce the agency cost of debt. moreover, this finding is in line with the agency cost theory as debt providers demand securities as collateral to put them in more secure position. according to the pecking order theory, the information asymmetry is supposed to be lower for firms that have more tangible assets, which results in more debt. conversely, harris and raviv(1991) state that tangibility negatively influences leverage as suggested by the pecking order theory; they suggest also firms that have few tangible assets are assumed to have more asymmetry troubles, and thus, the coefficient is not expected to be significant. however, the trade-off theory suggests that tangibility is positively correlated to leverage in view of the fact that a higher degree of asset tangibility leads to lower bankruptcy costs. 4.5.2 leverage with profitability the ratio of ebitd to total assetsis taken as the proxy of profitability. profitability is statistically significant at the 1 % level. the sign of the coefficient is negative, which means that an increase in profitability by 1 %,will be associated with a decline in debt by 0.42%. thus, this result is in line with the second hypothesis (h2), namely, “there is a negative impact of profitable of oil and gas firms on leverage”. this means that the firms that are more profitable are the ones that have lower leverage. in other words, firms that have higher levels of profitability are likely to use less leverage in their capital structure. this behavior means that trade-off theory fails to explain the relationship between leverage and profitability. trade-off theory argues that firms with high profit are likely to have higher leverage and more taxable income to shield, as stated by barclay and smith (2005). our result gives more support to pecking order theory that implies that firms prefer to finance projects with internal funding. this finding is in line with many previous studies such as rajan and zingales (1995), ozkan (2001), and gaud et al. (2005) who state that profitability is negatively related to debt (leverage). 4.5.3 leverage with growth opportunity the ratio of percentage increase in total assets is taken as the proxy for growth opportunity. growth opportunity is positively related to leverage. this positive coefficient means that a asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 14 1 % change in growth rate measured by the percentage change in total assets leads to a 0.028 change in leverage ratio , and thus the variable is not significant. consequently, the third hypothesis (h3), namely, “there is a negative impact of growth of oil and gas firms on leverage” is rejected. in addition, this finding is not in line with either trade-off theory or agency cost theory, while it supports pecking order theory, which suggests that if firms have to depend on external financing sources, they would prefer to use debt over equity. this finding means that firms of oil and gas industry that have higher growth rate maintain higher leverage ratios. thus, growth is considered a significant factor that plays a key role in making the capital structure decisions in oil and gas sector; firms that have lower growth rates borrow less than firms that have high growth rates. furthermore, this finding is in agreement with the findings of beck and demirguc-kunt (2006) who find that small firms have greater growth restrictions and are less likely to use external financing sources, and with the finding of michaelas et al. (1999) who state that small firms that are rapidly growing are likely to have insufficient earnings for financing all of their growth internally. this positive sign indicates that growing oil and gas firms are expected of to rely more on external borrowing, in order to grasp market opportunities. therefore, there is a positive relationship between growth and leverage. 4.5.4 leverage with size the natural logarithm of assets is taken as the proxy for size. according to the finding of this study, the result of beta coefficient that is related to size, the fourth hypothesis (h4), namely, “there is a positive impact of size of oil and gas firms on leverage” is accepted. this relation between size and leverage is in line with the trade-off theory. large firms are highly leveraged for the reason that they have no fear of bankruptcy. debt providers are also more willing to lend to larger firms because the instability of earnings in these firms is not very high and firms have the ability to pay back their debts. however, in case the firms do not have the ability to repay their debt, they have a high level of assets that can be used as collateral. moreover, this finding is in agreement with many studies, for instance, o zkan (2001), bevan and danbolt (2004), and frank and goyal (2009),who all find that size is positively related to leverage; they all suggest that small firms should not depend on long term debts and instead, they should borrow short term, in case they are sure enough of being able to repay their debts. because this study has chosen 346 firms in the oil and gas industry, and most of these firms are active all over the world with gigantic market capitalization, debt is positively correlated to size. 4.5.5 leverage with liquidity the ratio of current assets to current liabilities is taken as a proxy of liquidity. liquidity is statistically significant at the 1% level. the sign of its coefficient is negative, which means that liquidity negatively influences leverage. thus, the fifth hypothesis (h5), namely, “there is a negative impact of liquidity of oil and gas firms on leverage” is accepted. this can be interpreted by the fact that when there is an increase in liquidity by 1%, debt will decrease by 0.02%.thus, it can be concluded that borrowing in the selected oil and gas firms could be expensive and oil and gas firms prefer to finance their needed fund through their liquid assets. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 15 in the other words, firms that have higher liquidity prefer to use internal assets as a finance source; this is in agreement with pecking order theory assumptions. in addition, it is found that in case of not having enough internal financing, oil and gas firms tend to choose equity financing as an alternative financing source. thus, this finding is in line with ozkan (2001), who states that liquidity is negatively related to debt. according to ozkan (2001), this kind of relationship may arise from conflicts among shareholders. this could be interpreted by the fact that if firm shareholders attempt to change the price of firm assets for their personal benefits and impose the expenses on bond and stock holders, there will be a conflict. however, if firms have a consistent reserve of cash, there is no need to increase the debt. money or cash is constantly taken into account as the best indicator of liquidity. therefore, it is assumed that large firms have more cash. in some critical situations like a recession, debt is considered a threat, to liquid assets. as a result, it is better for firms to have no borrowing. 4.5.6 leverage with non-debt tax shield the ratio of annual depreciation expense to total assets is taken as a proxy for non-debt tax shield. this study finds that non-debt tax shield is negatively related to leverage; the relationship is significant at the 1% level. thus, the sixth hypothesis (h6), namely, “there is a negative impact of ndts of oil and gas firms on leverage” is accepted. according to the finding that an increase in non-debt tax shields negatively affects leverage, non-debt tax shields are considered as an alternative for the tax benefits of leverage financing to depreciation, as suggested by wald (1999).oil and gas companies that are with higher non-debt tax shields are assumed to have less long-term debt in relative to other firms of other industries. according to ozkan (2001), a non-debt tax shield is significant and inversely related to leverage. he suggests that firms that have a high level of non-debt tax shields that can be deducted from taxable income are supposed to have less debt compared to other firms, ceteris paribus. in a study conducted by deangelo and masulis (1980), it is found that firms that have greater non-debt tax deductions use less debt compared to equity. therefore, this finding is in line with many previous studies such as wald (1999), wanzenried (2002), and gaud et al. (2003).also, it is consistent with trade-off theory, which suggests that when there is an increase in the amount of non-debt tax shield in a firm, debt would be not needed. 4.6 the effect of the global financial crisis on the capital structure determinants in order to investigate the impact of the global financial crisis on the determinants of capital structure of oil and gas firms, the study examines the potential effects of the crisis through dividing the study period into three different periods: namely, 2000-2006 as the pre-crisis period, 2007-2009 as the crisis period, and 2010 2015 as the post-crisis period. then, this study implements the both the descriptive statistics analysis and the ols regression analysis of the three different periods separately, as shown in table 4.7 and table 4.8 in the appendix. 4.6.1 descriptive statistics in order to investigates if there is any impact of the financial crisis of 2007-2009 on the capital structure determinants of oil and gas firms in terms of the descriptive statistics, mean, which is defined as the total of the observations divided by the total number of observations asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 16 is examined during the three different periods: pre-crisis period, the crisis period, and the post crisis period. as shown in table 4.7 in the appendix, mean of each variable is affected by the financial crisis. the difference of mean value of each variable becomes less or more during the crisis. particularly, the mean of the total debt ratio decreases slightly, from approximately 0.24 to 0.23 during the crisis and then it goes back to raise to become about 0.25. the mean value of profitability, size and liquidity go up during the crisis. the mean of both profitability and liquidity go down again after the crisis while size continue to go up after the crisis. on the other hand, the mean value of tangibility, growth, and non-debt tax shields decrease slightly during the crisis. after the crisis, the mean of tangibility returns again approximately the same in the pre-crisis period. however, the mean of growth goes down strongly to be 0.12 while it is 0.19, 0.18 in pre-crisis period and during the crisis period, respectively. to sum up, it is clear that the global financial crisis affect the mean value of the capital structure determinants of oil and gas firm. 4.6.2 regression statistics the ols regression analysis results illustrate whether the capital structure determinants of oil and gas firms become more or less significant when they are related to leverage during the crisis.the impact of the global financial crisis on the explanatory variables is illustrated in table 4.8 in the appendix . assets tangibility the results reveal that there is a positive relationship between tangibility and leverage, which is significant at the 1% level for all three periods. it is found that the coefficient of tangible assets in the crisis period is almost 22%, which is higher than in the pre-crisis period. this increase means that tangible assets had a greater impact on leverage during the financial crisis period, compared to its impact during the preceding period of economic expansion. in other words it is more important in the crisis period. according to jimenez and saurina (2004), mitigating the difficult selection problem that lenders face is considered the most important function of tangible assets. this problem was more difficult during the 2008 financial crisis; therefore, it seems reasonable that during the financial crisis, debt providers look for better quantity and quality of tangible assets to compensate as stated by barrell and davis (2008).for this reason, the need for security would make this variable have greater impact on firm leverage. thus, it can be said that h8, namely, “there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, assets tangibility” is accepted. profitability the results indicate that there is a negative relationship between profitability and leverage, which is significant at the 1% level for all three periods. in addition, it is found that profitability has a relative decrease in relation to leverage, which suggests that it is less related to leverage in the crisis period, the coefficient of profitability during the crisis period is almost 35% which is lower than the one in the pre-crisis period, when it is almost 54%.thus, profitability is less importance in relation to leverage during the crisis period. this asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 17 implies that during the crisis period oil and gas firms with higher profitability were using less debt for financing, comparing with the pre-crisis period. therefore, it can be said that h9, namely, “there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, profitability” is accepted. growth the results indicate that there is a positive relationship between growth and leverage and growth is statistically insignificant in the whole period of the study, 2000-2015. however, it is found that the relationship is insignificant in both the crisis period and post-crisis period, whereas it is statistically significant at the 10 % level in the pre-crisis period. the positive relationship is in agreement with pecking-order theory, which suggests that companies that have high growth level will issue debt to mitigate the trouble of asymmetric information. however, growth in the pre-crisis period is different from that in the other periods, in that it is statistically significant at the 10% level. the coefficient of growth in the pre-crisis period is almost 3%, which is higher than in the crisis and post crisis periods, when it is 1% and almost 2%, respectively, which they are statistically insignificant. according to baily and elliott (2009), during difficult times where there is a decline in the economy, such as in case of a financial crisis, there would be less or no growth at all for some quarters. for that reason, growth is negatively related to leverage and has less importance in times of crisis. thus, it can be said that h10, namely, “there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, growth” is accepted. size the results indicate that there is a positive relationship between size and leverage over the period of 2000-2015. size is statistically significant at the 1% level for the whole period of the study. there is a slight difference in the level of size significance among the three different periods; size is significant at 1% for the pre-crisis and crisis periods while it is significant at the 5% level for the post crisis. however, the coefficient of size has a relative decrease in relation to leverage during the crisis period, compared to during the pre-crisis period; the coefficient of size in the pre-crisis period is almost 0.6% which is higher than in the crisis where the coefficient is almost 0.2%.this implies that firm size is less related to leverage in the crisis period; thus it is less significant in relation to leverage during the crisis period. therefore, it can be said that h11, namely, “there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, size” is accepted. liquidity the financial crisis starting in 2007 in the market of sub-prime credit caused a liquidity crisis in the short-term debt markets. in this difficult situation, firms tended to use this credit line mainly in order to deal with the unexpected liquidity shocks. in fact, several firms were straggly influenced by the decreasing demand for their products during the crisis period; however, they had no liquidity problems because they had large cash holdings, in the case of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 18 bp and baker hughes oil and gas firms, whose liquidity was not affected by the financial crisis. in this study, the relationship between liquidity and leverage is negative for all three periods and significant at 1%.the coefficient of liquidity during the period of post crisis period is almost 4%, which is higher than those in the pre-crisis and crisis periods, when in each period were almost 1%. thus, there is no impact of the global financial crisis on the coefficient of liquidity. therefore, it can be said that h12, namely, “there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, liquidity” is rejected. non-debt tax shield in the pre-crisis period, many firms prefer debt financing because interest payments can be subtracted from corporate tax liability, which is known as a ‘tax shield’ whereby interest is deducted from firm profits before tax as stated by miller and modigliani (1958). if the firm is in profit, then this decreases the borrowing cost. thus, the coefficient of ndts is significantat the 1% levelfor all periods in this study and it is negatively related to leverage. it is found that the global financial crisis in the period of 2007-2009influences ndtsofoil and gas firms. the coefficient of ndts increases strongly in the crisis and post crisis periods; it is -0.53 in the pre-crisis period while it is -1.27 and -1.35 in the crisis period and post crisis period, respectively. this implies that firm ndts is more related to leverage during the post crisis period. therefore, it can be said that h13, namely, “there is a strong impact of the global financial crisis in the period of 2007-2009 on the capital structure determinant of oil and gas firms, non-debt tax shield” is accepted. 4.7 test of the consistency with capital structure theories one of the aims of this study is to find out which of the capital structure theories best explains the financing decisions of oil and gas firms investigated over the period of 2000-2015.as mentioned before, this study is concerned with three capital structure theories, namely, trade-off theory, pecking order theory and agency cost theory. the theories are different in terms of their traits in explaining the corporate capital structure. the trade-off theory assumes that the optimal capital structure is a trade-off between bankruptcy costs and the net tax benefit of using debt as a main finance source. firms that have high tangible assets are able to provide collateral for debts, so these firms can use more debt. also, firms that are larger in size and have high profitability have high debt ratio and firms that have high growth opportunities rate use less debt. on the other hand, pecking order theory suggests that a firm prefers internal financing sources to external financing ones and dangerous debt to equity because of the information asymmetries between shareholders and outsider investors. in addition, the third theory, agency cost theory, gives an explanation of firms’ financial behaviour in the context of agent and manager relationship. table 4.9, in the appendix, summarizes the hypothesized, expected and observed theoretical signs of the explanatory variables. therefore, a test of the consistency with theory of the capital structure in the oil and gas firms is made relying on the expected and observed signs of the coefficients of the explanatory variables. hence, this study concludes the following: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 19 table 4.9 shows that all determinants of the capital structure choice of oil and gas firms except size and ndts are in agreement with the pecking order theory. thus, it can now be announced that the pecking order theory best explains the capital structure theory of oil and gas firms listed on the global oil and gas index over the period of 2000-2015. 5. conclusion capital structure is still considered an important topic that attracts corporate managers and academics. this study explored the determinants of capital structure of 346 firms listed on the global oil and gas index over the period of 2000-2015. pooled ordinary least squares (ols) regression techniques were been used on panel data as well as using the statistical computer package of stata. for this study, the total debt ratio is taken as a measure of leverage, the dependent variable. also, liquidity, profitability, size, growth, non-debt shield, and tangibility are all selected to be independent variables. additionally, this study examines the impact of the global financial crisis on the firm-specific determinants of capital structure of oil and gas firms. even since miller and modigliani’s (1958) claim that capital structure is irrelevant to firm value, some theories that suggest the opposite have been developed. in this study, the main three capital structure theories, namely, trade-off theory, pecking order theory and agency cost theory are investigated to find out which one best explains the financial behavior of the selected firms since they give different explanations of the capital structure decision. furthermore, literature has a lot of research and study about this topic conducted on many different countries as well as on many different determinants of the capital structure decision. consequently, the primary objective of the study is to fill up the gap in the current literature by optimistically providing some helpful information and useful finding about the capital structure determinants of oil and gas firms. according to the descriptive statistic, shown in table 4.4, leverage, defined as the average ratio of total debt to book value of total assets (tda), is found to be 0.246, indicating that only 24.6 % of the firms’ funds is provided by borrowing and the other 75.4 % is provided by other financing sources. also, the results of the correlation matrix that are illustrated in table 4.5 show the linear correlations between the chosen explanatory variables and leverage are significant. furthermore, the regression results shown in table 4.6 for the leverage determinants show that the r squared is 0.231, which implies that 23.1% of the leverage variability firms is explained by the selected firm-specific factors. moreover, all the selected explanatory variables, are found to be the significant determinants of the capital structure of oil and gas firms. conversely, it is found that profitability, liquidity, and non-debt tax shield are negatively related to leverage while tangibility, growth and size are positively related to leverage. as a result, by testing the hypotheses, it can be said that the regression results of the coefficients of capital structure determinants support hypotheses 1, 2, 4, 5, and 6, whereas hypotheses 3 and 7 are rejected. additionally, this study covers the impact of the global financial crisis in the period of 2007-2009 on the capital structure determinants of oil and gas firms. in particular, this study asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 20 investigates how much the capital structure is sensitive to its determinants, how it is changed, and what other ratios could have effects on the capital structure during the crisis period. the sample period is divided into three periods of interest: one is from 2000 to 2006, identified as the pre-crisis period, one from 2007 to 2009,identified as the crisis period, and one from 2010-2015,identified as the post-crisis period.it is found that there is a strong impact of the global financial crisis in the period of 2007-2009 on all capital structure determinants of oil and gas firms except liquidity, where it is found that there is no significant impact at all. however, the other capital structure determinants become more or less significant when they are related to leverage during the crisis. in addition, this study examines the capital structure of oil and gas firms in terms of the three main theories of capital structure, namely, trade-off theory, pecking order theory, and agency cost theory. it is found that all the chosen determinant factors, except size and ndts, of capital structure decisions made by the oil and gas firms are in line with the pecking order theory. on the other hand, the positive effect of size on capital structure decision is found to be in accordance with both the trade-off theory and agency cost theory, and the sign of ndts is found to be consistent with trade-off theory predictions. references abdwahab s., & ramli n. 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(2004). testing the picking order theory and the signalling theory for farm businesses. paper presented at the american agricultural economics association annual meeting, denver, colorado, july 1-4 (2004). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 25 appendix table 2.1. summary of past empirical studies. (arranged alphabetically) author data period focus journal sample dependent variables 1 sign of determinants of capital structure tang prof grow size liq ndts 2abd wahaab and ramli (2014) 1997-2009 the determinants of capital structure international journal of economics and financial issues 13 malaysian listed government linked companies leverage + *** * *** *** 2bevan and danbolt (2002) 1991 re-examines the relationship of (rajan&zingales 1995) to variations in gearing measure by examining more debt measure. applied finance economics 822 uk companies debt + ** *** + *** deloof and verschueren 1998 1992-1994 are leases and debt substitutes? journal of economics and management 1,066 non-financial belgian firms leases + without std with std * + *** frank and goyal (2009) 1950-2003 examines the factors affecting publicly traded american firms financial management leverage + *** *** + *** gaud et al. (2003) 1991-2000 the determinants of the capital structure european financial management 106 listed swiss companies leverage + *** + *** huang & song (2006) 1994-2003 the determinants of capital structure china economic review 1200 chinese listed companies leverage + *** *** + *** -*** 2joseph ooi, (1999). 1989-1996 the determinants of capital structure journal of property investment & finance 83 property companies quoted in the uk leverage + * author data period focus journal sample dependent variables 1 sign of determinants of capital structure tang prof grow size liq ndts khrawish and khrawish 2001-2005 investigate what are the economics and 150 companies on leverage + + asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 26 determinants of capital structure administration amman stock exchange 2michaelas et al. (1999) 1986-1995 financial policy and capital structure choice small business economics 3500 choice in u.k. smes leverage + + + + * najjar&petrov (2011) 2005-2009 capital structure of insurance companies in bahrain international journal of business and management 25 insurance companies in bahrain leverage + * + + *** -* ojah& manrique (2005) 1998-1999 determinants of corporate debt structure in a privately dominated debt market applied financial economics spanish capital market leverage + ** oke m. and obalade a.(2015) 2005-2012 testing the validity of optimal capital structure theory international journal of economics 6 nigerian oil industry leverage + *** ** ozkan (2001) 1984-1996 determines target capital structure journal of business finance and accounting 390 non-financial uk companies total debt *** * + *** *** psillaki and daskalakis (2008) 1998-2002 are the determinants of capital structure country or firm specific? small business economics, springer 3630 smes from greece, france, italy and portugal leverage *** except in portugal (+) *** greece, france, italy portugal greece, france, italy and portugal + *** greece + ** portugal + * france + italy ragan and zingales (1995) 1987-1991 tests wither capital structure of the g7 (uk, us, japan, france, canada, germany, italy) is affected by the same factors as us firms journal of finance g-7 countries (uk, us, japan, germany, france, italy and canada) leverage + *** uk, us, japan, france, canada + ** germany *** us, japan ** canada *** uk, us, france, canada ** france + except in germany (-) + *** us, japan, germany, uk, canada author data focus journal sample dependent 1 sign of determinants of capital structure asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 27 period variables tang prof grow size liq ndts 2song (2005) 1992-2000 this study investigates capital structure determinants the royal institute of technology centre 6000 swedish companies leverage + *** *** *** + *** ** sritharan, v (2014). 2008-2012 investigate what are the determinants of capital structure international journal of economics 28 colombo stock exchange in srilanka leverage + + 2titman and wessels (1988) 1974-1982 investigate what are the determinants of capital structure journal of finance 469 us firms long term debt, short-term debt and convertible debt + 2upneja a. and dalbor m.c. (2001). 1991-1998 an examination of capital structure in the restaurant industry international journal of contemporary hospitality management 393 restaurant firms listed on the stock exchange classification code of 5812 leverage wald (1999) 1991-1992 investigates the factors affecting the capital structure journal of finance research 4404 french, german, uk and japanese companies leverage uk, us, japan, france germany uk, us, japan, france + germany + uk, us, japan germany, france uk, us, japan, france germany note: ***, **, and * mean statistically different from zero at the 1%, 5% and 10% level, respectively 1even there are many variables have been investigated in the literature, this study selects only seven variables which are tangibility (tang), profitability (prof), growth (grow), size (size), liquidity (liq) and non debt tax shield (ndts). 2these studies use more than one model to measure leverage. however, their result that are mentioned in this table are suitable to this study since they are resulted from applying the same model that this study applies to measure leverage which is the one that defined as the ratio of total debt to book value of total assets asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 28 table 3.1. the distribution of oil and gas firms according to region category number of companies oceania 57 europe 74 russia 12 asia 81 south america 12 africa 9 the united state 83 the united kingdom 18 total 346 table 3.2. summary of variables, proxy and references variables proxy references dependent variable leverage ratio of total debt to book value of total assets ozkan (2001) ; rajan and zingales (1995) independent variables tangibility tangible fixed assets / total assets rajan and zingales, (1995); ozkan (2001) profitability earnings before interest and tax / total assets rajan and zingales, (1995); ozkan, (2001) size logarithm of total assets padron et al (2005) and frank & goyal (2009) growth percentage increase in total assets titman &wessele(1988) liquidity current assets/ current liabilities deesomsak et al (2004) ; ozkan (2001) non-debt tax shield depreciation / total assets titman and wessels (1988) ; ozkan (2001) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 29 table 3.4. summarizes the hypothesized, expected theoretical signs of the independent variables depending on the theoretical and empirical literature explanatory variable hypothesis signs mostly reported in the empirical literature pecking order theory trade-off theory agency cost theory expected sign tangibility + + + + + + profitability + ? growth + + size + + + + + liquidity ? non-debt tax shield + ? ?  the theoretical signs of explanatory variables are presented in summary based on the previous capital structure theories and were used by different researchers such as titman and wessels (1988), haris and ravive (1991), gaud et al (2005),  “+” represents that the specified theory suggests a positive relationship between the explanatory variable and leverage.  “-” represents that the specified theory proposes a negative relationship between the explanatory variable and leverage.  “ ? ” represents that there is no clear prediction. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 30 table 4.4. summary of descriptive statistic after removal of outliers. variable obs. no. of fs mean median std. dev. min max tda 4181 346 0.2457 0.2290 0.1717 0.0000 0.7136 tangibility 4181 346 0.5233 0.5401 0.2589 0.0422 0.9537 profitability 4181 346 0.0920 0.0832 0.0942 -0.2216 0.3967 growth 4181 346 0.1622 0.1132 0.2530 -0.4858 1.0000 size 4181 346 15.9889 15.6293 2.6866 9.9686 23.2964 liquidity 4181 346 1.7761 1.2366 2.0473 0.2246 15.6961 ndts 4181 346 0.0473 0.0412 0.0317 0.0000 0.1638 notes: the dependent variable tda is defined as the ratio of total debt to book value of total assets. “tangibility” is the ratio of fixed assets to total assets. “profitability”' is the ratio of ebitd to total assets. “growth” is the ratio of percentage increase (change) in total assets (total assets current year minus total assets previous year to total assets current year “size” is the natural logarithm of assets. “liquidity” is the ratio of current assets to current liabilities. “ndts” is the ratio of annual depreciation expense to total assets. table 4.5. correlation analysis variable tda tang prof grow size liq ndts tda 1 tangibility 0.249*** 1 profitabilit y -0.238*** -0.006 1 growth 0.030** 0.002 0.076*** 1 size 0.072*** 0.005 0.159*** -0.127*** 1 liquidity -0.317*** -0.285*** -0.033 0.047*** -0.136*** 1 ndts -0.081*** 0.422*** 0.142*** -0.15*** -0.095*** -0.219*** 1 notes: the dependent variable tda is defined as the ratio of total debt to book value of total assets. “tangibility” is the ratio of fixed assets to total assets. “profitability”' is the ratio of ebitd to total assets. “growth” is the ratio of percentage increase (change) in total assets (total assets current year minus total assets previous year to total assets current year “size” is the natural logarithm of assets. “liquidity” is the ratio of current assets to current liabilities. “ndts” is the ratio of annual depreciation expense to total assets. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 31 table 4.6. regression result of tda and the independents variables variables all periods (2000-2014) pre-crisis period (2000-2006) crisis period (2007-2009) post-crisis period (2010-2014) tangibility 0.1639*** 0.1678*** 0.2147*** 0.1583*** (0.0115) (0.0180) (0.0308) (0.0175) profitability -0.4189*** -0.5389*** -0.3453*** -0.3601*** (0.0279) (0.0438) (0.0760) (0.0434) growth 0.0173 0.0257* -0.0105 0.0162 (0.0122) (0.0165) (0.0335) (0.0221) size 0.0038*** 0.0057*** 0.0018*** 0.0039** (0.0009) (0.0016) (0.0025) (0.0013) liquidity -0.0245*** -0.0128*** -0.0081*** -0.0348*** (0.0012) (0.0010) (0.0011) (0.0025) ndts -1.0531*** -0.5289*** -1.2707*** -1.3561*** (0.0942) (0.1520) (0.2490) (0.1341) pre-crisis dummy2001 0.0108 0.00863 (0.0154) (0.0153) pre-crisis dummy2002 0.00551 0.000416 (0.0154) (0.0154) pre-crisis dummy2003 -0.00629 -0.00824 (0.0146) (0.0146) e-crisis dummy2004 -0.00751 -0.00873 (0.0145) (0.0144) pre-crisis dummy2005 -0.0238* -0.0222 (0.0145) (0.0143) pre-crisis dummy2006 -0.0144 -0.0118 (0.0145) (0.0145) crisis dummy 2007 -0.0267* asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 32 (0.0140) crisis dummy 2008 -0.0152 0.0108 (0.0141) (0.0124) crisis dummy 2009 -0.0246* 0.00199 (0.0141) (0.0127) post-crisis dummy2010 -0.0309** (0.0138) post-crisis dummy2011 -0.0215 0.00916 (0.0137) (0.0114) post-crisis dummy2012 -0.0156 0.0161 (0.0139) (0.0116) post-crisis dummy2013 -0.00782 0.0243** (0.0142) (0.0120) post-crisis dummy2014 0.00240 0.0357*** (0.0140) (0.0117) post-crisis dummy2015 0.00225 0.0267*** (0.0142) (0.0119) constant 0.2387*** 0.1782*** 0.2121*** 0.2625*** (0.0179) (0.0284) (0.0462) (0.0267) r2 0.2309 0.2232 0.2180 0.2373 notes: the dependent variable tda is defined as the ratio of total debt to total assets. “tangibility” is the ratio of fixed assets to total assets. “profitability”' is the ratio of ebitd to total assets. “growth” is the ratio of percentage increase (change) in total assets (total assets current year minus total assets previous year to total assets current year “size” is the natural logarithm of assets. “liquidity” is the ratio of current assets to current liabilities. “ndts” is the ratio of annual depreciation expense to total assets. “age “of the firm in years at the time of the survey. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 33 (***) significant at the 1% level; (**) significant at the 5% level; (*) significant at the 10% level table 4.7. the impact of the global financial crisis on the descriptive statistics, (mean) pre-crisis period (2000-2006) crisis period (2007-2009) post-crisis period (2010-2014) explanatory variable 0.2534 0.2298 0.2422 tda 0.523 0.5076 0.5296 tangibility 0.0724 0.1117 0.1088 profitability 0.1238 0.1896 0.1975 growth 16.4411 16.0171 15.4347 size 1.6871 2.2527 1.9493 liquidity 0.0457 0.0443 0.0504 ndts notes: the dependent variable tda is defined as the ratio of total debt to total assets. “tangibility” is the ratio of fixed assets to total assets. “profitability”' is the ratio of ebitd to total assets. “growth” is the ratio of percentage increase (change) in total assets (total assets current year minus total assets previous year to total assets current year “size” is the natural logarithm of assets. “liquidity” is the ratio of current assets to current liabilities. “ndts” is the ratio of annual depreciation expense to total assets. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 34 table 4.8. comparison of the determinants during the three different periods table 4.9. summary of results supporting capital structure theories variable effect theory tangibility + pecking order theory, trade-off theory, agency cost theory profitability pecking order theory growth + pecking order theory size + trade-off theory, agency cost theory liquidity pecking order theory, agency cost theory ndts trade-off theory explanatory variable all period (2000-2014) pre-crisis period (2000-2006) crisis period (2007-2009) post-crisis period (2010-2014) tangibility 0.1639*** 0.1678*** 0.2147*** 0.1583*** profitability 0.4189*** 0.5389*** 0.3453*** 0.3601*** growth 0.0173 0.0257* 0.0105 0.0162 size 0.0038*** 0.0057*** 0.0018*** 0.0039** liquidity 0.0245*** 0.0128*** 0.0081*** 0.0348*** non-debt tax shield 1.0531*** 0.5289*** 1.2707*** 1.3561*** constant 0.2387*** 0.1933* 0.1933** 0.2551*** r-squared 0.2309 0.2232 0.2180 0.2373 notes: “tangibility” is the ratio of fixed assets to total assets. “profitability”' is the ratio of ebitd to total assets. “growth” is the ratio of percentage increase (change) in total assets (total assets current year minus total assets previous year to total assets current year “size” is the natural logarithm of assets. “liquidity” is the ratio of current assets to current liabilities. “ndts” is the ratio of annual depreciation expense to total assets. (***) significant at the 1% level; (**) significant at the 5% level; (*) significant at the 10% level microsoft word 10074-37042-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 429 audit firm size, audit fee, audit reputation and audit quality: the case of listed companies in vietnam ngoc kim pham, hung nguyen duong, & tin pham quang university of economics, danang university nga ho thi thuy hue university college of economics, vietnam received: sep. 26, 2016 accepted: june 29, 2017 published: june 29, 2017 doi:10.5296/ajfa.v9i1.10074 url: http://dx.doi.org/10.5296/ajfa.v9i1.10074 abstract audit quality is considered as an essential factor affecting the reliability of financial information. the aim of this study is to assess the effects of audit firm characteristics, including audit reputation, audit fees and audit firm size, on audit quality. a sample of 192 companies listed on hanoi and ho chi minh stock exchange for the period of 2006-2014 was selected. multiple regression was used to analyze the data. the findings show that big 4 auditors in vietnam provide high audit quality than non-big 4 auditors. interestingly, in vietnam context, except for the audit firms in the big 4 group, the findings suggest that smaller audit firms provide better audit quality. additionally, the results reveal that the more audit fees the auditors receive, the lower audit quality they provide. the critical role of audit quality has attracted significantly scholarly attention, however, prior studies have mainly focused on firms in developed countries. little is known about audit quality in an emerging economy context such as vietnam. this study adds to the limited number of studies on audit quality of listed companies in emerging economies. keywords: audit quality, audit reputation, audit firm size, audit fees, proxies of audit quality. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 430 1. introduction the agency conflicts between managers and principals (e.g. shareholders and creditors) may affect the quality of reported information. managers may provide financial information dishonestly to protect their own interests while the principals cannot directly observe managers’ behavior (ramadan, 2015; williams, 1988). external audits help to reduce information asymmetries between managers and principals by lending credibility to financial statements (almomani, 2015; carey, 2008). thus, audit quality needs to be high to ensure their client firms to disclose better quality of information in a timelier manner to protect principals. the critical role of audit quality has attracted significantly scholarly attention. however, prior studies have mainly focused on firms in developed countries (beisland et al., 2015). this is the first study to examine the relationship between audit firm characteristics and audit quality from firms operating in a an emerging economy – vietnam. emerging economies, especially vietnam, still exists a big gap between entities and their providers of capital because their corporate-governance mechanisms are still evolving (mamun and badir, 2014). it is also because the legal systems in emerging economies are not sufficient enough to protect investors’ rights as such in developed countries (pham and hoang, 2015). recent studies (ha, 2014; pham and hoang, 2015) indicated that the findings of the audit quality in the developed economies may not necessary apply in emerging economies. audit quality is a major concern for young independent audit sector in vietnam. independent audit industry in vietnam was formed in 1991 with only two audit firms. this number increased to 134 firms with the average number of employees being 78 people in 2014 (bùi văn mai, 2014). although the number of independent audit firms in vietnam grew rapidly, they still do not meet the demand of external audit services of firms operating in vietnam (vu, 2010). further, the collapse of a number of public companies in vietnam, such as bach tuyet corporation and far east pharmaceutical jsc raises series of problems posed for the fraudulent financial information of these public companies and the audit quality of audit firms in vietnam (oxford analytica, 2008). although audit quality is very important for vietnam, research on this issue is still limited. only a few studies (e.g. pham et al., 2014) have investigated the audit quality of listed companies in vietnam. pham et al. (2014) examined the relationships between audit engagement, non-audit services, auditor’s expertises and audit quality. this study did not investigate the associations between audit firms characteristics and audit quality. therefore, understanding the associations between audit firm characteristics and audit quality in vietnam is still a significant gap in the literature. this study addressed this gap by examining the relationship between audit firm size, audit reputation and audit fees, and audit quality. this paper is structured as follows. the paper begins with a literature review on audit quality. this is followed by hypotheses development. research methods and the results of this study are also presented. the paper concludes with discussion of the results, limitations and suggestions for future research. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 431 2. literature review 2.1 audit quality several studies provided definitions of audit quality with diverse ideas. these definitions can be classified into two approaches, namely: 1) the probability that auditors detect and report misstatements, and 2) the level compliance with auditing standards (defond and zhang, 2014; tritscher, 2013), which will be discussed next. following the first approach, researcher defines audit quality based on the quality of financial statements (tritscher, 2013). deangelo (1981) defined audit quality as ’the market-assessed joint probability that given an auditor will both discover a breach in the client’s accounting system, and report the breach’ (p.186). audit quality depends on both the probability that auditors detect misstatements and on whether auditors report such misstatements (deangelo, 1981; palmrose, 1988). low audit quality occurs when audited financial reports contain misstatements that are not detected and reported by the auditor. thus, audit quality is associated with the quality of audited financial reports as higher audit quality provides greater assurance of high financial reporting quality (defond and zhang, 2014). with regard to the second approach, defond and zhang (2014) suggested that auditors have responsibilities to comply with generally accepted auditing standards to ensure high audit quality. carcello (2002) also argued that audit quality is associated with the level of compliance with auditing standards. thus, audit quality is measured by the differences between the required level of assurance and the actual level of assurance achieved by audit procedure (carcello et al., 2002). due to the lack of the method to directly assess audit quality, researchers (e.g. grenier et al., 2007) focused on defining “poor audit quality” by identifying adverse outcomes from an audit, such as audit failures. it is easy to operationalize the definition of audit quality in terms of audit failures as the failures can be observable (augustine et al., 2014). for example, poor audit quality can be measured when a litigation claim against the audit firm (casterella et al., 2009). however, it is difficult to measure audit quality since relatively few cases of audit failures have been detected (francis, 2011). in vietnam, in particular, audit quality has not been specifically and clearly defined in any existing studies. directly measuring and assessing audit quality, hence, are complicated since audit quality cannot be observed explicitly. moreover, the factors contributing to audit procedure in order to create the final result of the audit report, are not published by audit firms. lacking such information makes it difficult for users to assess audit quality directly. this consequently triggers the critical need of vietnamese audit firms as well as the authority to create a framework for assessing and managing audit operation appropriately. 2.2 proxy to measure audit quality due to different views on defining audit quality, the measurements of audit quality have yet not been reached a general acceptance. however, proxies to measure audit quality can be classified into three categories: 1) going-concern opinions, 2) material misstatements and 3) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 432 earnings management, which will be discussed in the following sections. 2.2.1 going-concern opinions. as for going-concern opinions approach, researchers (francis, 2011; lennox, 1999) measure audit quality by relying on the relationship between going-concern audit reports and client business failures. incorrect going-concern opinions are appropriate indicators for low audit quality (francis, 2011; lennox, 1999). low audit quality happens when a going-concern opinion is not issued before client failures (francis, 2011). following this approach, audit firms have high audit quality when a going-concern opinion is an appropriate indicator of client’ failures (francis, 2011). however, using going-concern opinions as a proxy to measure audit quality is challenging, because the business failures of clients can be consequences of unforeseen business situations in the future (tritscher, 2013). it may be related to business forecasting rather than analyzing facts obtained from historical financial reporting (tritscher, 2013). further, going-concern opinions can contribute to a client’ business failures when banks and suppliers refuse credits to this client (tritscher, 2013). in addition, inappropriate going-concern opinions only contribute a small portion of low audit quality as many types of material misstatements are not related to a going-concern opinion (tritscher, 2013). therefore, whether going-concern opinions is an appropriate measure of audit quality depends on each cases (tritscher, 2013). 2.2.2 material misstatements. the two most commonly used misstatement measures in prior studies includes restatements and accounting and auditing enforcement releases (aaers) (defond and zhang, 2014). accounting restatements refer to the corrections of material misstatements in the client’s previously issued financial statements (alyousef and almutairi, 2010). restatements and aaers are actually direct measures of audit quality because they indicate that the auditor issued an unqualified opinion on materially misstated financial statements, and the audit opinion is the auditor’s full responsibility and directly under his or her control (defond and zhang, 2014). empirical studies (e.g. raghunandan et al., 2003) show that there is an implicit relationship between financial statement restatements and low audit quality. for instance, raghunandan, read, and whisenant (2003) asserted that their examination of the relationship between non-audit fees and subsequent restatements indicates a direct relationship between non-audit fees and audit quality. palmrose and scholz (2000) studied auditor litigation resulting from restatements which are at the intersection of financial reporting quality and audit quality. further, misstatements arise from not adequately identifying of high-risk accounts and transactions by the auditors (palmrose and scholz, 2000). restatements in their sample identified accounting issues such as revenue recognition could have been identified by the auditors as high risk in their audit planning and performance. however, financial restatements and aaers are not always good indicators of poor audit quality (defond, 2010; tritscher, 2013). firms normally merit their financial statements when poor earning quality is detected and judged by the firms (defond, 2010). thus, financial restatements and aaers may not capture unintentional or undetected errors (defond, 2010). further, financial restatements may be due to changes in accounting policies, therefore, they are not results of audit failures (tritscher, 2013). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 433 2.2.3 earnings management. there are different definitions of earnings management in the literature (ronen and yaari, 2008). according to ronen and yaari (2008), prior studies follow at least two approaches to define earnings management, namely: (1) earnings management is choosing accounting treatment to enhance the transparency of reports or (2) to maximize the utility of management. given these different approaches, healy and wahlen’s (1999) definition is the best description of earnings management in the literature (ronen and yaari, 2008). healy and wahlen (1999) stated that "earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers" (p. 368). however, it is difficult to observe earnings management directly, thus, most prior studies use discretionary or abnormal accruals as proxies for earnings management (tritscher, 2013). the discretionary accruals measurement of jones (1991) is the most influential model which is represented in equation (1) and (2). the equation (1) is used to measure discretionary accruals which are equal total accruals minus non-discretionary accruals. total accruals are calculated from net profit minus net cash flow. dat = tat ndat = (npt ncft) – (β1(1/at-1 )+ β2(revt / at-1 )+ β3(ppet/at-1 )) (1) where dat discretionary accruals in year t tat total accruals in year t ndat non-discretionary accruals in year t npt net profit in year t ncft net cash flow in year t revt revenues in year t less revenues in year t-1 ppe t gross property plant and equipment at the end of year t at_1 total assets at the end of year t-1 β1, β2, β estimated firm-specific parameters by using the model in equation (3) tat/at-1=α1(1/at-1 )+ α2((revt /at-1 )+ α3(ppe/at-1 ) + εt (3) where α1, α2, α3 denote the ols estimatesof β1, β2, β3 εt residual (the firm-specific discretionary portion of total accruals) earnings management (discretionary/abnormal accruals) is an appropriate measure to asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 434 evaluate audit quality as audited financial statements are working outcomes of both managers and auditors (defond and zhang, 2014; sundgren and svanström, 2013). indeed, abnormal portion of accruals is initiated by managers in order to control earnings that benefit for themselves rather than other financial users (tritscher, 2013). managers tends to choose accounting treatment for managing earnings in order to get higher bonus from their firms’ earnings (becker et al., 1998; schipper, 1989), to satisfy the debt covenants (becker et al., 1998) or to reduce political costs (jones, 1991). auditors may not detect earnings management due to their limited resources or may not report earnings management since audit comfort is highest when the audit risk is lowest (tritscher, 2013). in another word, earnings management is eliminated by high audit quality, thus, it is an appropriate proxy of audit quality (defond and zhang, 2014). table i summarizes strengths and weaknesses of the proxies for audit quality. table i. audit quality proxy measurement comparative proxy category strengths weaknesses material misstatements  strong evidence of poor audit quality  does not capture subtle quality variation  cannot infer high quality from lack of misstatements going concern opinions  strong evidence of poor audit quality  uniquely captures auditor independence  does not capture subtle quality variation  only applies to distressed firms, limits generalizability earning quality (eq)  tightly linked to concept of audit quality  evidence of within generally accepted accounting principles manipulation  may signal more egregious undetected misstatements  captures quality variation for a large number of firms  results of the measurement depend on previous data  some case, materiality of classification and disclosure on the financial statement not include on the earning quality. there for no exactly when using the eq is proxy for audit quality  limited consensus on measurement  potentially large measurement errors source: defond & zhang (2014) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 435 in vietnam, data about errors and weaknesses of audit firms in the investigation of appropriate authorities is not available (bùi văn mai, 2014). the quantity of audit firms that are under suspicion about their audit service quality does not represent all audit firms in vietnam. further, the portion of going-concern opinions of auditors is extremely low; hence, this cannot be used to reflect audit quality. correspondingly, this study uses earnings management measurement (discretionary accruals) as a proxy for the quality of auditing vietnamese listed companies’ financial statements. 2.3. studies of audit quality in emerging economies there are few research on audit quality in the emerging economies context, which showed indicated that the findings of the audit quality in the developed economies may not necessary apply in emerging economies (beisland et al., 2015; ha, 2014; pham and hoang, 2015). because firms operated in emerging economies have different legal systems and corporate governances from that of firms located in developed one. the following paragraphs will critically synthesis previous studies on audit quality in emerging economies to highlight the above differences and the need for additional research on audit quality in an emerging economy, such as vietnam. beisland et al. (2015) examined the relationships between audit quality (measured by big 4 auditors) and corporate governances of microfinance institutions from 73 emerging or developing economies. the results of the study showed that there are no or weak correlations between audit quality and corporate-governance factors. the findings of the study provide evidences that microfinance institions in emerging/developing economies are different from those in developed economies in terms of auditor choice when they appoint auditors with fundamental economic forces rather than devoting much attention to corporate governance. competition 2.4. vietnam context this research was conducted in an emerging economy context, vietnam, for three main reasons. first, vietnam had young stock exchanges which are associated with many issues related to the transparency of both financial and non-financial information (quang, 2013). information disclosures of listed companies in vietnam are more perfunctory in nature and are not detailed (international finance corporation, 2011). most vietnam listed companies do not report regularly or in details the management information so that it is hard to analyze and evaluate the actual business activities of these companies in a timely manner (do and ngo, 2015). second, most of vietnam listed companies have poor corporate governance (international finance corporation, 2012; quang, 2013). board of directors is decentralized with great power (do and ngo, 2015), whereas shareholders and audit committees do not undertake their full rights (vietnam investment review, 2015). the weakness area of corporate governance of vietnam listed companies is the effectiveness of the shareholders’ rights when these companies less adhere shareholders’ rights (international finance corporation, 2012). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 436 the decentralization of power to executive board lead to financial frauds that help protect the interest of executive board while detriment that of shareholders (do and ngo, 2015). third, auditor independence is an another issue. according to the law of vietnam (vietnamese government office, 2002), audit committees have to oversight the activities of external auditors. in fact, external auditors normally work with the board of directors. further, shareholders normally empower their rights to appoint external auditors and negotiate with auditors to the board of directors. meanwhile, the disclosure of auditor independence and audit activities are rare in either annual general meeting or other company documents (international finance corporation, 2012). thus, the close relationship between auditors and board of directors, and the dislosure in vietnam listed companies may impair auditor independence (international finance corporation, 2012). although there are few of studies on audit quality have conducted in other emerging economies, the results were still mixed. with the three key institutional factors of vietnam, the finding of the studies in other emerging economies may not apply for the vietnam context. therefore, there is still a significant gap in the literature to understand the audit quality in vietnam listed companies. 3. hypotheses development 3.1 audit firm reputation and audit quality audit firm reputation relates to the corporate image which comes over time (aronmwan et al., 2013). it may be a consequence of the array of auditors, the firm possesses, the brand name, the perceived audit quality and the fees charged (aronmwan et al., 2013). reputation is also a result of audit firms’ technical and functional quality (sucher et al., 1999). audit firms can be broadly classified into two groups: big 4 auditors as a reputable group and non-big 4 auditors as a non-reputable group (boulila taktak and mbarki, 2014; deangelo, 1981). big 4 auditors are argued to provide better quality audits than non-big 4 auditors (boulila taktak and mbarki, 2014; klein and leffler, 1981). this is because reputable firms (e.g. big 4 auditors) want to sustain their reputation and fear losing what they have built if they provide low quality services (bigus, 2015; klein and leffler, 1981). extreme audit failures can damage audit firms’ reputation and these firms may lose all of their customers (defond and zhang, 2014). reputable audit firms also have high quality auditing because they normally have higher income from their assurance services and have higher power to maintain their recognized qualifications (aronmwan et al., 2013). with a higher financial resource, reputable audit firms also have higher motivation to spend on training and hiring competent auditors to protect their reputation (rezaei and shabani, 2014). reputable audit firms have motivations to provide better assurance services to maintain their reputation, which, in turn, lead to higher price premium that these firms can receive from their clients (choi et al., 2010; desai et al., 2016). further, reputable audit firms normally have higher motivation to reduce errors and mistakes than non-reputable partners (beatty, 1989; bigus, 2015). thus, reputable audit firms have high audit quality as they can ensure their clients disclose better quality of information asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 437 (aronmwan et al., 2013). thus, higher earnings response coefficient was also found in clients audited by big 4 firms compared to those audited by non-big 4 firms (teoh and wong, 1993). big 4 auditors are better at constraining client earnings management than non-big 4 auditors, with evidence showing that clients of non-big 4 auditors have higher levels of discretionary accruals or lower audit quality (becker et al., 1998; francis and wang, 2008; krishnan, 2003). thus, the following hypothesis is proposed: h1. audit firm reputation is positively related to audit quality. 3.2 audit firm size and audit quality several studies (e.g. deangelo, 1981; lawrence et al., 2011; rezaei and shabani, 2014) have supported that larger audit firms provide higher quality-audit services than smaller ones. this is because larger auditors are less likely to depend on their particular clients’ economic (rezaei and shabani, 2014). thus, they are less likely to agree with their client pressure for reporting misstatements than small audit firms (choi et al., 2010). further, they have higher motivation to deliver high-quality services in order to protect their brand name reputation (rezaei and shabani, 2014) as larger audit firms may have greater reputation losses in case of audit failures than small firms (deangelo, 1981). further, big audit firms have higher technical competence and greater resources (lawrence et al., 2010). they also have more experienced and competent auditors and greater expertise than small audit firms (francis and yu, 2009). francis, maydew and sparks (1999), however, argued that high audit quality in larger audit firms may be not because of their excellent auditor's performance but mainly because of the large client effect (francis et al., 1999). given different perspectives on explaining the effect of the audit firm size on audit quality, several empirical studies have provided evidences supporting that the bigger audit firm size is positively associated with higher audit quality. hence, the study proposes the next hypothesis as follows: h2. audit firm size is positively related to audit quality. 3.3 audit fees and audit quality the fees paid to auditors may influence audit quality (simunic, 1980). the positive association between audit fees and proxies for audit quality has been supported in prior studies (e.g. ettredge et al., 2014; hoitash et al., 2007; simunic, 1980). for example, hoitash et al. (2007) found that the total audit and non-audit fees are negatively related to both proxies to measure audit quality (the standard deviation of residuals from regressions relating current accruals to cash flows and the absolute value of performance-adjusted discretionary accruals). ettredge et al. (2014) supported that audit fee pressure during the economic downturn is positively related to accounting misstatements. there are some explanations for the positive relationships between audit fees and audit quality. choi et al. (2010) indicated that audit firms that provide high-quality audit services charge higher audit fees than those offer low-quality services as costs to deliver high audit quality are higher than that of low-quality auditing. high fees may encourage auditors to increase their efforts, which in turn, positively affects audit quality (hoitash et al., 2007; wooten, 2003). hence, the following hypothesis is proposed: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 438 h3. audit fees are positively related to audit quality. figure i shows the conceptual model of factors related to audit firm characteristics affecting audit quality. figure 1. hypothesized model of factors effecting audit quality 4. research method 4.1 sample selection we selected all publicly-listed companies in hanoi, ho chi minh stock exchange over the entire duration of the estimated time period (2006–2014) as initial samples. a company included in the sample needs to be satisfied the following four conditions: (1) the company remains listed during the period 2006 to 2014; (2) audit firms of the company are relatively stable over time; (3) a company that has either missing financial variables or insufficient data is eliminated; and (4) the company does not belong to financial institutions, banking, finance and investment firms, since their accounting and reporting environments differ from those in other industries. these conditions give a final sample of 192 firms. 4.2 regression model and measurement of variables the equation (3) is used to test hypotheses developed for this study. aq = β0+ β1adfrep + β2adfsize + β3adfee + β4cfo + β5lev + β6 roa+ε (3) in equation (3), dependent variable is audit quality (aqit) which is measured by discretionary accruals in equation (1). independent variables included audit firm reputation (adfrep), audit firm size (adfsize) and audit fees (adfee). the following is the measurements of these independent variables. adfrep 1 if the firm is audited by a big 4 auditor, 0 otherwise. adfsize natural log of audit firm’s total assets. adfee natural log of total audit fees of the firm we used cash flow from operations (cfo) as a control variable because cfo influences corporate management actions in managing earnings which are proxy of audit quality (becker h3 (+) h2 (+) audit firm reputation audit firm size audit fees audit quality h1 (+) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 439 et al., 1998). leverage (lev) is included as firms with a higher likelihood of violating debt agreements are more likely to have an incentive to engage in earnings management so as to reduce audit quality (ramadan, 2015; sweeney, 1994). we also controlled for return on assets (roa) as performance of the firm may affect the application of accruals to manage earnings (kothari et al., 2005) which indicate low audit quality. the following is the measurements of these control variables. cfo operating cash flow divided by total assets at fiscal year end lev ration of total debt to total assets roa total income before extraordinary items divided by average total assets 5. results table ii presents a summary of descriptive statistics of the dependent and independent variables used in the study. the mean value for audit quality (aq) is 0.06 with 27 percent of the sample are audited by vietnamese big 4 auditors. the positive values of the mean and median of audit quality (aq) suggest that most of the companies manipulate earnings upward. the mean value for adfee is 18.046, which is equivalent to 2,918 usd. the mean value of lev is 1.26 which suggests that vietnamese listed companies operate with high level of financial leverage. table ii. descriptive statistics aq adfsize adf reputation adfee cfo lev roa n 192 192 192 192 192 192 192 valid missing 0 0 0 0 0 0 0 mean 0.060 26.677 0.27 18.046 0.05 1.26 0.049 median 0.063 27 0 18 0.04 0 0.039 std. deviation 0.228 1.562 0.446 0.704 0.132 5.384 0.084 minimum -0.705 23 0 17 -0.542 0 -0.657 maximum 0.909 30 1 19 0.755 70 0.293 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 440 table iii. model summary model r r square adjusted r square std. error of the estimate 1 ,294a ,087 ,057 3,1210061063 predictors: (constant), lev, adfee, cfo, adfsize, adfrep table iii shows that the r2 of 8.7 percent of the variation of audit quality which is explained by the effects of the three firm characteristics. to investigate the existence of multicollinearity, the variance inflation factors (vif) for each of the independent variables are calculated. as reported in column 8 of table iv, vifs for the explanatory variables are all below 5, suggesting that multicollinearity is not likely to be an influential factor driving the results. table iv. multiple regression results coefficientsa model unstandardized coefficients standardized coefficients t sig. collinearity statistics b std. error beta tolerance vif (constant) -41.227 11.56 -3.565 .000 adfee 1.629 .577 .356 2.823 .005 .309 3.233 adfrep -2.913 1.003 -.403 -2.90 .004 .256 3.912 adfsize .533 .179 .259 2.968 .003 .649 1.541 cfo -.072 .056 -.090 -1.281 .202 .992 1.008 lev -.016 .043 -.027 -.380 .705 .973 1.028 a. dependent variable: da proxy for aq (audit quality) table iv shows that the standardized coefficient of audrep in the model is 0.403 and is significant at the 0.05 level. this result indicates a significant positive relationship between audit reputation and audit quality. thus, the result supports h1. the standardized coefficients for adfsize and audfee in the model are negative 0.259 and 0.356, respectively. they are all significant at the 0.05 level. the results suggest a significantly negative relationship between audit firm size and audit quality, and between audit fees and audit quality. the analysis, thus, does not support the hypothesis h2 and h3. table v shows the results of hypotheses testing. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 441 table 5. results of hypotheses testing no. hypothesis result of the test hypothesis relation h1 audit quality has a positive association with audit firm reputation support positive h2 audit quality has a positive association with audit firm size not support negative h3 audit quality has a positive association with audit fees not support negative 6. discussion and conclusion 6.1. discussion prior studies on audit quality have focused on firms from developed countries (beisland et al., 2015). little is known about audit quality in emerging economies, such as vietnam. this study is the first to investigate the impacts of audit firms’ characteristics on audit quality of listed firms in vietnam, using earnings management measurement as a proxy for audit quality. based on a sample of 192 firms from hanoi and ho chi minh stock exchange for fiscal years 2005 to 2014, the study finds that only audit firm reputation is positively associated with audit quality. the results of this study are broadly in line with prior studies (e.g. becker et al., 1998; francis and wang, 2008; krishnan, 2003). this study measured the audit firm reputation by big 4 auditors versus non-big 4 auditors. the results of this study indicate that companies which are audited by big 4 auditors generally engage in less earnings management than firms audited by non-big 4. it means that big 4 auditors in vietnam provide high audit quality than non-big 4 auditors. the higher audit quality of the big 4 auditors in vietnam may also be explained by the institutional context of vietnam where there is a big gap in the quality-control systems that ensure the high quality of assurance services between the big four in vietnam and vietnam audit firms (do, 2013). the big four in vietnam normally adapts the quality control system, such as audit guidelines, working papers and other technical resources, from their mother companies (do, 2013). meanwhile, most of vietnam audit companies have a lack of financial resource to spend on training or hiring reputation auditors and do not have high technical competence compared to that of the big four. all of these factors are big barriers for vietnam audit firms in improving their assurance services. the results indicate that audit firm size is significantly negatively related to audit quality. the results of this study are not consistent with prior studies (e.g. rezaei and shabani, 2014; sundgren and svanström, 2013) who argue that bigger audit firms often provide better assurance services. except for the audit firms in the big 4 group, the findings suggest that smaller audit firms provide better audit quality while bigger audit firms does not necessary asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 442 result in better audit quality. in vietnam context, although larger audit firms have a better internal control system, however, larger audit firms in vietnam normally have larger clients and gain more benefit to indulging clients more than smaller audit firms, which lead to the dependence of auditors on their clients. the appointment of audit firms of most listed companies in vietnam heavily emphasis on the brand name, the prestige and the capacity to deliver an audit on time and less rely on the independence of auditors (international finance corporation, 2011). especially, the shareholders’ role and interfacing with the auditor is poor in vietnam (international finance corporation, 2011, 2012). the board of directors normally appoint of the external auditor (international finance corporation, 2012), thus they may select large audit firms to send a signal of high audit quality to shareholders, on another hand, they may enter into collusion with these audit firms to protect their own interests. the findings of this study also reveal that audit fees significantly negatively affect audit quality. the result of this study is not consistent with prior studies (e.g. hoitash et al., 2007; simunic, 1980; sundgren and svanström, 2013), who argued that low audit fees lead to the decreasing number of auditors and shorter time of auditing which results in lower audit quality. in contrast, the result of this study suggests that high audit fees can lead to an independence issue for auditors. when the auditor receives high audit fees from their clients, the auditors may allow the client to engage in opportunistic earnings management. thus, the results of this study support kinney and libby (2002) who stated that ''unexpected non-audit and audit fees may more accurately be likened to attempted bribes and will reduce the quality of reported earnings through the auditor's reduced willingness to resist client biases to manage earnings” (p.109). the results also suggest that high audit fees make them more economically dependent on their clients which can lead to the independent issues of auditors (wooten, 2003). 6.2. implications this study has implications with respect to selecting audit firms in vietnam. first, the finding highlights that, excepting for big 4 audit firms, the audit quality of vietnamese audit firms is still a big issue – larger audit firms tend to ignore more of their clients’ manipulations of earnings and higher fees may reflect the collusion between audit firms and their clients. thus, the decision of choosing big audit firms or whose having higher audit fees with the expectation of them providing good service of audit quality has to be considered carefully and base on many different assessments. second, the finding also indicates that the big 4 auditors have higher audit quality than the non-big 4, thus the non-big 4 in vietnam should invest more resources in training or hiring competent auditors and upgrade their technical competence. vietnam association of certified public accounting should play more significant role in oversight the audit activities of both vietnam audit firms and other foreign non-big 4 firms in vietnam. thus, these firms can improve their competencies to compete with the big 4 auditors. third, shareholders of listed companies in vietnam should understand and fully conduct their asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 443 rights, such as appoint external auditors and oversight the independence of auditors to ensure the audit quality of external auditors. the conducting of shareholders right also prevent the board of directors from choosing larger audit firms, paying higher audit fees and also impairing auditor independence. 6.3. limitations and future research in vietnam, data availability is limited, therefore, this research examined only the three factors, including: (1) audit firm size, (2) audit firm reputation, and (3) audit fees. future research needs to include other factors of audit firms, such as auditor’s competence, audit effort, audit methodology and audit support system which may also affect audit quality. in addition, this study is based on data from a short period of 8 years to estimate discretionary accruals which is the proxy for audit quality in 2014. however, financial reporting quality may also depend on other factors than solely accruals. for instance, shifts within the income statement between operating profit and non-operating profit, presentation and classification of assets and liabilities, accounting of business combinations, and certain notes are also important proxies to measure audit quality. that is the limitation of discretionary accruals for being used to measure audit quality in this study. future research can use other input-base factors to measure the audit quality and determine their effects on audit quality. references almomani, m. a. 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(2003). research about audit quality. the cpa journal, 73(1), 48-51. microsoft word 11249-41806-2-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 448 the determinants of foreign exchange exposure of egx30 companies "an empirical study" m.s.nada professor in accounting, faculty of commerce, ain shams university e-mail: sabrynada@hotmail.com r. e. ibrahim assistant lecturer in accounting, faculty of commerce, new cairo academy e-mail: rehabemadeldeen@gmail.com received: may13, 2017accepted: june28, 2017 published: june 28, 2017 doi:10.5296/ajfa.v9i1.11249 url: https://doi.org/10.5296/ajfa.v9i1.11249 abstract this study aims to examine the evidence for measuring the significance of foreign exchange exposure (fxe) for egx30 companies during the period from 2000-2016. the problem of the study is concerned with the fluctuations of the foreign exchange (fx) rate in egypt, which have a great effect on the financial performance of egx30 companies. following prior studies (e.g. aggarwal r., 2010; lee, 2011 and sam agyei-ampomah k. m., 2012), this study uses fama-french (ff) model to measure the fxe.the resultof the study shows that 70% of egx30 companies were significant to the foreign exchange exposure; the results are robust to the choice of model design. keywords: foreign exchange exposure, egx30 companies, fama-french model, financial performance, foreign exchange rate. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 449 1. introduction foreign exchange exposure (fxe) has been widely discussed recently due to the high fluctuations in the fx rate. the most dangerous effect of the fxe is that it makes the company more exposed to bankruptcy during the fluctuation of the fx rate. therefore, in order to grow and compete in the market, companies need to improve their protection against the fluctuation in the fx rate. fxe has been studied by several authors. these authors arrived at different conclusions using different approaches. as (mwangi j. w., 2015)measured the fxe through measuring the types of the fxe (transactiontranslation and economic exposure) applying it on the oil marketing companies and (peter blum, 2001) applying it on the reinsurance companies. moreover, some studies measured the fxe using the foreign sales and liability model dependent and cross-sectional model such as (ngarifrancis gachua, 2011) and (lee, 2011)applying it on the listed companies and u.s multinational companies respectively. however, (raj aggarwal j. t., 2010, pp. 1619-1636) approved that the domestic companies face a fxe not less than the multinational companies, and he measured the indirect fxe of the u.s domestic companies using ff model. other studies such as (sam agyei-ampomah k. m., 2012, pp. 251–260) and (d'almeida, dec. 2016) used jorianand ff model to measure the effect of the fxe on the financial performance of the u.k non-financial companies. the study will cover some of the most important cases,asit focuses on the stock market because of the high uncertainty of their prices and their high effect on the economic growth through different channels.our study will also focus on the indirect effect of the fxe on egx30 companies for two reasons; first, egx30 companies did not disclose the foreign currency operations in their financial statement, second, high globalization of financial and product markets will increase the competition with the foreign and international companies. the reminder of the paper is structured as follows: section 2 is the problem identification. section 3 is the objective of the study. section 4 is the literature review. section 5 is the data and methodology. section 6 is the empirical result. the paper ends with section 7 where we present the summary and conclusion. 2.problem identification the problem of the study is that the fluctuations of the fx rate (jump from l.e 3.55/$ in 2000 to l.e 17.929/$ in 2016) may harm the financial performance of egx30 companies. moreover, egx30 companies did not have a basis to measure the determinants of the fxe in order to mitigate its risk. 3. objective of the study the most important aim is to examine the significance of the fxe in the egx30 companies. moreover, the specific objectives of the study are as follows: • measure the fxe to mitigate the risk of losses generated from the fx rate fluctuation. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 450 • identify the most important variables that determine the fxe. • investigate the effect of the fxe on the financial performance of egx30 companies. 4. literature review measuring the fxecan be made using (adler, 1984, pp. 41-50) model, who states a procedure for assessing the fxe using a single factor to estimate the changeability of the company’s equity returns to exchange rates. r , = α + γ xr , + ε where , is the return on company i, over the period t. , is the change in exchange rate. the coefficient measures the company’s total exposure to fx rate. after that, (jorion, 1991, pp. 363–376)measured the exposure using two-factor model, which became the standard for controlling the exchange rate risk. r , = α + β r , + γ xr , + ε where , is the return on the marketindex.the rest of the variables are defined as above.finally, (bill b. francis i. h., 2008, pp. 169-196.)measured the exposure using three-factor model, also known as ff model;which studied the fx risk premia or risk premium (the difference between the expected return on a portfolio and the riskless exchange rate). r , = α + β mrp + β smb + β hml + γ xr , + ε where mrp is the market risk premium, smb is the return of the small minuslarge stocks. hml is the return for the value relative to growth stocks.(stephen p.huffman, 2010, pp. 1-12) found more fxe coefficients that are significant using ff three-factor model compared to the traditional market model. therefore, the study will use ff model to measure the fxeofegx30companies. various studies found the determinants of the fxe such as (ines chaieb, 2013, pp. 781808) revealed that the level of exposure in the u.s company over the period 1973–2005 was negatively related to growth opportunities and size. however, it was positively related to the degree of leverage and international involvement. (bergbrant, 2014, pp. 885-916) found that exposure rises with the strength of competition. (raj aggarwal j. t., 2010, pp. 1619-1636) showed that the domestic companies face significant fxe, and the level of domestic company exposure was inversely related to size. however, it was positively related to the level of research & development expenses and to a smaller extent, positively related to financial leverage (debt ratio) and growth opportunities (mtbv). finally, it was negatively related to asset turnover, asset tangibility and industry concentration. in other words, small domestic companies that have a great mtbv, debt ratio and little asset turnover located in extremely competitive industries are likely to face the highest exposure to fxrisk. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 451 (starks, 2013, pp. 709 735) showed that the level of fxe elasticity representative for the probability of financial distress, growth opportunities and product uniqueness. furthermore, companies with a greater probability and higher costs of financial distress exhibit superior returns in response to large exchange rate shocks. in addition,(donghui li, 2009, pp. 306-320) found that the significant operational and size effects were documented and that the frequency of fxe increases with the time horizon in the u.s industries. however, various studies disagree with those previous studies such as (sam agyei-ampomah k. m., 2012, pp. 251–260)pointed out that the determinants of fxe were model-dependent. nevertheless, the cross-sectional analysis proposes specific-company factors (size, growth opportunities, leverage and liquidity of the non-financial company) have very little or no impact on a company's exposure to fx risk, combining the data across companies and time rises the explanatory power of some of these factors. additionally, (kamar, 2015) found that the size, liquidity, debt, asset turnover, profit margin, currency diversification and foreign subsidiary diversification were not significant in determining the fxe. according to the previous studies, the study will use the following model to identify the most important and significant variables causing this exposure. =α+β1reinr+β2current+β3mtbv+β4debt+β5assetturn+β6assettang+β7size+β8hhi+β 9roa+ β10gpm+∈ where reinr is the reinvestment ratio, current is the current ratio, mtbv is the market to book value ratio, debt is the debt ratio, assetturn is the asset turnover, assettang is the asset tangibility, size, hhi is the average industry herfindahl index, roa is the return on asset, gpm is the gross profit margin ratio. 5. data and methodology 5.1 data to conduct this study, secondary data is used. the study is conducted on the egx30 companies. all the data is collectedovera period of 16 years from 2000 to 2016 for 30 companies. 5.2 hypotheses h1 : there is a negative relationship between the firm’s stock return and fx rate. h2 : there is a positive relationship between the firm’s reinvestment ratio and fxe. h3 : there is a negative relationship between the firm’s liquidity ratio and fxe. h4 : there is a negative relationship between the firm’s growth opportunities and fxe. h5 : there is a positive relationship between the firm’s financial leverage and fxe. h6 : there is a positive relationship between the firm’s asset turnover and fxe. h7 : there is a positive relationship between the firm’s asset tangibility and fxe. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 452 h8 : there is a positive relationship between the firm’s size and fxe. h9 : there is a positiverelationship between the firm’s competitiveness ratio and fxe. h10 : there is a negative relationship between the firm’s profitability ratio and fxe. 5.3 identification of the variables the study uses two model, 5.3.1. thefirst model 5.3.1.1 the dependent variable: firm’s stock return. • the study uses the firm’s stock return as a proxyfor the stock return (financial performance) of the egx30 companies, , =(close price − open price) open price 5.3.1.2 the independent variables: • mrp (market risk premium) =market return – risk-free rate. where market return = (p − p ) p • smb (small minusbig stocks) =return of small stocks – return of large stocks. using market capitalization to identify the small and big stocks. • hml (high minus low) = return of high stocks – return of low stocks using mtbv to identify the high and low stocks. • xr (exchange rate) = (fx − fx ) fx 5.3.2. the second model 5.3.2.1the dependent variable the regression coefficient of the change in the fx rate on the stock return of the egx 30 companies (fxe). 5.3.2.2 the independent variables: the study conductsnine variables as follows: • reinvestment ratio: it refers to the amount of cash flow that the firm reinvests it. • liquidity ratio: it shows the ability of the current assets to cover the current liabilities. as high current ratio indicates that,the firm will be able to pay its obligation and vise verse. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 453 current ratio = current asset current liability • growth opportunity: the study uses mtbv as a proxy for the firm’s growth opportunity. if market value is greater than book value, the ratio will be greater than one. on the other hand, if the ratio is lower than one, it indicates that the company reputation and shareholder expectations in the market are not favorable. mtbv ratio = m. v of capital b. v of capital • financial leverage: it indicates theproportion of debt usedby the company to finance its assets. a high debt/asset ratio generally means that a company has been aggressive in financing its growth with debt. (raj aggarwal j. t., 2010, pp. 1619-1636) debt ratio =total debt total asset • asset turnover: it is a financial ratio thatshows the degree ofthe firm’s efficiency use of its asset in generating sales. a firm with low-profit margin will be likely to have high asset turnover and vise verse. asset turnover = sales total asset • asset tangibility: it is the company’s fixed asset compared to its total assets. asset tangibility = fixed asset total asset • firm’s size: the study uses the logarithm market value of the firm’s capital. size = log (m.v of capital) • firm’s competitiveness: it refers to the rate of the firm’s competitiveness between the egx30 companies. hhi= firm sales market sales • profitability: it refers to how profitable a company is relative to its total assets. a high roa indicates that management is effectively utilizing the company’s assets to generate profit. roa and gpm are the best representativesof the profitability ratio of the firm. roa = net income total asset gpm =net income revenue asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 454 6. empirical result 6.1descriptive statistics the study uses ff model to measure the fxe. the study finds that the fxe may be positive for some companies and negative for others. therefore, the study divides the companies into two categories with respect to their exposure to fx risk; positive exposure companies and negative exposure companies. as the positive exposure companies are positively affected by the fx rate, they have enough foreign cash flow to mitigate the risk arises from the fxfluctuation for availing investment opportunities. on the contrary, negative exposure companiesare negatively affected by the fx rate; they have major difficulties, losses and bankruptcy during the fluctuation of the fx rate. therefore, the empirical result for the positive exposure companies may differ from the negative exposure companies. the fxe will be estimated using ffmodel for each company from 2000 to 2016 for quarterly time horizon. table (i), in the appendix, panel apresents the mean and standard deviation of the fxe for egx30companies, panel bis for positive exposure companies and panel cis fornegative exposure companies. last three columns report the companies that have a significant exposure at 10% significance.the table reveals that 70% of egx30companies are significant to fxe(44.5% positive exposure companies, 55.5% negative exposure companies). according to that, the study will reject h1. the empirical result will exclude the 30% of egx30companiesthat not significant to fxe. table (ii), in the appendix, shows the descriptive statistics of the variables used on model ii. it shows that the reinvestment ratio and gpm have the highest variation from the mean and high divergence in their value. 96% of the variation in the reinvestment ratio is generated from the positive exposure sample and the remaining percentage is generated from the negative exposure sample. the dispersion in the gpm ratio is generated from the negative exposure sample as the positive exposure sample has a good homogeneity in the data of the gpm. it also shows that there are dispersions in current ratio, mtbv, asset turnover, hhi and roa, as the minimum and maximum for each variable have a great divergence in their value. the dispersions in the data of roa and current ratio are generated from the positive exposure sample more than the negative exposure sample. however, the dispersions in the data of mtbv, asset turnover and hhiare generatedfrom negative exposure sample more than the positive exposure sample. moreover, there is a good homogeneity in the debt ratio, asset tangibility and size, as the minimum and maximum for each variable have a good homogeneity in their value. therefore, it makes the model more appropriate. figure (i) and figure(ii), in the appendix, will prove the normality of the model.figure (i) shows that all the points are too close to the line. in addition, figure (ii) clarifies the normality of the fxe along the companies, as it shows that the data’s behavior is normal, so asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 455 the regression modelcan be used. 6.2regression analysis the coefficient of determinationr2 indicates the proportion of variations in the dependent variable because of the effect of the independent variables. model i used to estimate the fxe ( )as discussed before, using ff model. r , = α + β mrp + β smb + β hml + γ xr , + ε model i by using the quarterly data of fxe ( ) as a dependent variable in model ii, the regression coefficient of the model (clarified in table (iii)), in the appendix,can be estimated. =α+β1reinr+β2current+β3mtbv+β4debt+β5assetturn+β6assettang+β7size+β8hhi+β 9roa +β10gpm +∈model ii the result in panel b shows that the reinvestment ratio has a positive effect on the fxe by 0.038. therefore, when the reinvestment ratio increases by one point, the fxe will increase by 0.038. as a result, companieswith high reinvestment will exhibit more risk due to the high fluctuation in prices. therefore, they will exhibit high fxe. according to that, the study will accept h2. •the result shows that the current ratio isnotsignificant to the fxe. according to that, the study will reject h3. •the resultsin panel a&b point out that the mtbv has a negative effect on the fxe by 0.014. therefore, when the mtbv increases by one point, the fxe will decrease by 0.014. consequently, when the company has high growth opportunities, it will have more diversifications either through product or through client. therefore, it will exhibit low fxe. according to that, the study will accept h4. •the results in panel a&b reveal that the debt ratio has a positive effect on the fxe by 0.227. therefore, when the debt ratio increases by one point, the fxe will increase by 0.227. the high debt ratio indicates that the firm has poor financial leverage and expected to be more subject to additional risks. according to that, the study will accept h5. •the results in panel a&b also show that the asset turnover has a positive effect on the fxe by 0.842. therefore, when the asset turnover increases by one point, the fxe will increase by 0.842. thus, when the company has a large amount of sales, it will exhibit high fxe due to the high change in prices and competitive environment. according to that, the study will accepth6. •the results in panel a&b also show that the asset tangibility has a positive effect on the fxe by 0.161. therefore, when the asset tangibility increases by one point, the fxe will increase by 0.161. as a result, when the company has high fixed asset compared to total asset, it will exhibit high fxe. the reason behind that is that the fixed asset in the positive exposure asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 456 companies may be more sensitive to the fx rate, which leads to high risk associated with this fixed asset. according to that, the study will accept h7 in panel a&b. however,the result in panel c is not compatible with this result.they can use the fixed asset toprotect themselves from the high fxe, as the lower current assets insulate them from changing input cost,which was replaced by fixed asset. therefore, the fxe will have minimal impact on the balance sheet. therefore, when the fx rate has a negative effect on the firm’s stock return, the asset tangibility will have a negativeeffect on the fxe. according to that, the study will reject h7 in panel c. •the results in panel a & cpoint out that the size of the company has a positive effect on the fxe by 0.151. therefore, when the size increases by one point, the fxe will increase by 0.151.consequently, large companies will exhibit more fxe than small companies because of their high ability to compete. according to that, the study will accept h8. •the results in panel a & creveal that the hhi has a positive effect on the fxe by 0.829. therefore, when the hhi increases by one point, the fxe will increase by 0.829. so,fxe is greater when companies face price competition in domestic markets and when the competitors compete using an unfair financial benefit. according to that, the study will accept h9. •the result in panel b reveals that the gpmratio has a negative effect on the fxe by 0.143. therefore, when the profit increases by one point, the fxe will decrease by 0.143. as a result,companies with high profitmargin will have more flexibility in pricing goods and services and can absorb any shocks more easily than companies with low profitmargin. therefore, they will exhibit low fxe. •the result in panel b shows that the roa ratio has a negative effect on the fxe by 3.451. therefore, when the roa increases by one point, the fxe will decrease by 3.451. thus, the companies with high profit will have a natural protection against any risk so they will exhibit low fxe. according to that, the study will accept h10. however, this result is not compatible with panel cas their high profit leads to high fxe. the reason behind that is that their profit may be generated from high-risk operations. therefore, when the fx rate has a negativeeffect on the firm’s stock return, the roa will have a positive effect on the fxe. according to that, the study will reject h10 in panel c •the table concludes that the variables in;  panel (a) can interpret 20.6% from the change in the fxe. moreover, the hhiand asset turnover have the most affection on the fxe.  panel (b) can interpret 40% from the change in the fxe. in addition, the asset tangibility, asset turnover and roa have the most affection on the fxe.  panel (c) can interpret 15.7% from the change in the fxe. in addition, thehhi androa have the most affection on the fxe. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 457 7. summary &conclusion the study estimated the model of fxe and its cross-sectional variation in the egx30 companies’data for the period from 2000 to 2016. the results show that 70% of egx30 companies were significant to fxe. moreover, the fxe is positively related to competitiveness ratio, financial leverage, asset turnover, size, reinvestment ratio, but it is negatively related to growth opportunitiesand gpm; however, the liquidity ratio is not significant to the fxe. positive exposure companiescharacterized by achieving profit during inflation period while negative exposure companies characterized by achieving losses during the inflation period. therefore, the positive exposure companies with high growth opportunities, profitability and low debt ratio will have low fxe. however, the negative exposure companies with high size, profitability and competitiveness will have high fxe. therefore, the resultsof the positive exposure companiesdiffer from the results of the negative exposure companies. figure (iii), in the appendix, shows the effect of the fxe on the financial performance of the egx30 companies. itcan be concluded that egx30companies were affected positively from the floating of the egyptian pound. as the stock return (financial performance) was low before 2002. however, after the floating of the egyptian pound at 2002-2003, the stock return increased to a high point. then, in 2007, there was a decrease in the main index of the stock exchange market by 56.4%, which led to decrease the stock prices by more than 50% at the global financial crises. therefore, the financial performance of egx30companies decreased in this period by high amount. after that, itincreaseduntil 2008 and then decreaseduntil 2011 to be negative because of the egyptian revolution 2011. the financial performance fluctuated after that but not by the same way as before. however, after the floating of the egyptian pound at the end of 2015, the financial performance began to increase. therefore, the study can conclude that the floating of the egyptian pound leads to high performance in the stock market, as the investors expect more profit on their investment. the result disagrees with (javed bin kamal, 2016, pp. 175-195)that point out that the instability dies immediately after a crisis; meanwhile, positive news generates more instability than negatives. therefore, the financial performance of egx30companies has a great connection with the fx rate, especially at the floating period. according to the result, the study recommendsthe positive exposure companies to depend on the profit to mitigate the fxe, as it has a good homogeneity in its data and the empirical result shows its negative relation with the fxe. however, the negative exposure companies should hold more fixed asset compared to the total asset to mitigate the fxe, as it has a good homogeneity in its data and the empirical result shows its negative relation with the fxe. the studyalso recommends the egx30 companies to improve the disclosure of the foreign operation and clarifying the foreign currency for each operation in order to measure the direct asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 458 effect of the fx rate on the financial performance of the egx30 companies. the study limited to the indirect effect of the egx30 companies. it also did not use the transaction, translation and economic exposure measures to measure the fxe. further studies can measure the direct fxe and its effect on the companies’ financial statement. appendix: table (i). descriptive statistics of foreign exchange exposure source: output of spss notes: averaged estimates of foreign exchange exposure for egx 30 used in the sample from 2000 until 2016. full sample (panel a) positive exposure (panel b) negative exposure (panel c) significant at 0.1 level n mean standard deviation n mean standard deviation n mean standard deviation tot al +/% 3 month 1260 -.20145317 .780599332 525 .28835810 .297082123 735 -.55131837 .829449862 878 391/ 487 70% asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 459 table (ii). descriptive statistics for the variablesusing quarterly data panel a mean std. deviation coefficient of variation minimum maximum reinvestment ratio -.0153652 .83747795 -54.5047 -26.86900 .75800 current ratio 1.454087 1.6347978 1.124278 .0000 38.0300 mtbv 2.315508 4.7803949 2.064512 -71.3778 32.1200 debt ratio .639788 .2565643 0.401014 .0373 2.0425 asset turnover .115791 .1212990 1.047567 -.0531 1.1536 asset tangibility .437312 .2316803 0.529782 .0073 1.2994 size 3.694940 .5608549 0.15179 1.7880 5.8885 hhi .0577970 .11754244 2.033712 -.12490 .99940 roa .011470 .0441006 3.844981 -.9210 .2858 gpm .732407 9.7864579 13.36205 -8.0000 319.5000 panel b mean std. deviation coefficient of variation minimum maximum reinvestment ratio -.0470190 1.40303847 -29.83981943 -26.86900 .63600 current ratio 1.275652 2.0903574 1.638658035 .0000 38.0300 mtbv 2.033663 2.0076264 0.98719719 -3.1300 14.5000 debt ratio .665330 .2207549 0.331797604 .0863 2.0425 asset turnover .152065 .1009714 0.664001578 -.0531 .4783 asset tangibility .487540 .1908851 0.391527054 .0376 1.2994 size 3.811222 .4724413 0.123960583 2.1048 4.9996 hhi .1006526 .12676381 1.259419131 -.12490 .79367 roa .017427 .0357539 2.051638262 -.3618 .2115 gpm .342631 .2580007 0.752998707 -.5131 2.3532 panel c mean std. deviation coefficient of variation minimum maximum reinvestment ratio .0346710 .08094544 2.334672781 -.31600 .75400 current ratio 1.566888 1.4393577 0.918609179 .0000 8.5000 mtbv 3.506688 4.0387975 1.15174133 .0000 27.2900 debt ratio .653100 .2049482 0.313808299 .0972 1.4986 asset turnover .093004 .1149759 1.236246828 -.0067 .6245 asset tangibility .341376 .2490487 0.72954367 .0073 .9569 size 3.571371 .4883675 0.136745104 1.7880 4.9488 hhi .0465667 .13783767 2.960005111 -.00211 .99940 roa .016303 .0237937 1.459467583 -.0695 .2209 gpm 1.367501 15.6464519 11.44163836 -8.0000 319.5000 source: output of spss notes: the sample is the period 2000 until december 2016 (64 quarterly) for egx30 companies. panel a is the full sample, panel b is the positive exposure sample and panel c is the negative exposure sample. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 460 table (iii). regression analysis using quarterly data dependent variable independent variables β t f r collinearity statistics value sig. value sig. tolera nce vif panel a foreign exchange exposure mtbv -.014 -3.244 .001 34.181 0.000 .206 .461 .955 1.047 debt ratio .227 -3.140 .002 .852 1.174 asset turnover .842 6.288 .000 .901 1.110 asset tangibility .161 2.448 .015 .807 1.239 size .151 4.380 .000 .894 1.118 hhi .829 5.435 .000 .726 1.376 panel b foreign exchange exposure reinvestment ratio .038 3.393 .001 33.669 0.000 0.4 .642 .560 1.787 mtbv -.015 -2.141 .033 .725 1.380 debt ratio .212 -2.748 .006 .495 2.022 asset turnover .983 6.846 .000 .697 1.435 asset tangibility .744 10.107 .000 .741 1.350 roa -3.451 -6.073 .000 .341 2.931 gpm -.143 -2.442 .015 .611 1.638 panel c foreign exchange exposure asset tangibility -.373 -7.645 .000 20.780 0.000 .157 .406 .977 1.024 size .061 2.213 .027 .984 1.017 hhi .583 4.549 .000 .971 1.030 roa 1.514 2.626 .009 .985 1.015 source: output of spss notes: the sample is the period 2000 until december 2016 (64 quarterly) for egx30 companies. panel a is the full sample, panel b is the positive exposure sample and panel c is the negative exposure sample. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 461 source: output of spss figure (i). normal q-q plot of the foreign exchange exposure using quarterly data source: output of spss figure (ii). horizontal for linear distribution using quarterly data source: output of spss figure (iii). the financial performance of egx 30 companies -20.00000 -10.00000 0.00000 10.00000 20.00000 30.00000 40.00000 50.00000 60.00000 70.00000 80.00000 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 fi na nc ia l p er fo rm an ce years asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 462 references adler, m. &. 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(2013). foreign exchange elasticity and financial distress. financial managementjournal,709-735. https://doi.org/10.1111/fima.12016 abbreviations 1gpm: gross profit margin 2ff: fama-french 3hhi: average industry herfindahl index 4fxe: foreign exchange exposure 5fx: foreign exchange 6mtbk: market to book value 7roa: return on asset microsoft word 8943-32704-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 77 the ability of traditional and modern performance indicators in interpreting the phenomenon of earnings management: evidence manufacturing firms in amman stock exchange dr mohammad abdallah almomani accounting department, jadara university e-mail: momani@jadara.edu.jo received: jan. 26, 2016 accepted: march 17, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.8943 url: http://dx.doi.org/10.5296/ajfa.v8i1.8943 abstract the study objects for investigating the ability of traditional and modern performance indicators in interpreting earnings management phenomena of listed manufacturing firms in the amman stock exchange (ase), using adjusted jones method for measuring earnings management. the study takes into considerations three traditional indicators, including; return on assets (roa), return on sales (ros), and operating cash flow, while the market value added (mva), tobin's-q, and economic value added (eva) are used as modern indicators for financial performance. a sample consisted of 29 firms had been selected, and data covering the period 2006-2013 had been collected from these firms, where 232 observations were used in the analysis. the study found that the earnings management of listed manufacturing firms at (ase) still practice the phenomenon of earnings management, at low level based on the measures followed by the study, and that there is a significant linear relationship between performance indicators (traditional and modern) and earnings management. the results indicate that there is a significant as well inverse relationship between (roa) and earnings management. also, the study found that modern performance indicators are able to interpret earnings management, where the results indicate that there is a significant as well as inverse relationship between (eva), and (tobin's-q) and earnings management. one important finding showed that (eve) is effective and followed by (tobin's-q) indicator in interpreting the earnings management phenomena. however, the study did not show a significant relationship between cfo, lev ratio, ros, and mva with earnings management. based on these results, the study made many recommendations to the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 78 interested parties and the most important one is that companies must disclose the economic value added in the financial statements to enable investors and related parties to be aware of the amount of value-added that lead to increase the wealth of shareholders, and to help managers to consider all costs of capital. in addition, these indicators can be used with other indicators such as (roa, roe) to evaluate firm’s performance. keywords: earnings management, modern performance indicators, traditional performance indicators, industrial companies, amman stock exchange (ase) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 79 1. introduction financial reports are the main source of financial performance that investors, creditors, and other parties depend on to receive necessary information for decision making. to be beneficial, this information should be reliable and relevant. literature accounting has taken care of the issue of intentional interventions by managements in the content of the announced accounting information. this intervention focuses on the measurement and disclosure of accounting operations for profit and result in either inflating the profits or reduce or the stability of the levels to serve their interests, so associated with the benefit that you get by management through the practice of earnings management. often managements intervene in the earnings reporting process in order to influence the reported income figures for their own benefits, in this case, managers have engaged in earnings management. earnings management involves the alteration of financial reports to mislead stakeholders about firms underlying performance. generally accepted accounting principles (gaap) offer some flexibility in preparing the financial statements and give the management some freedom to select among accounting policies and alternatives approaches of measurement. earning management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports (healy and whalen, 1999). earnings management has a negative effect on earnings quality, and may weaken the credibility of financial reporting process. lo(2008), shows highly managed earnings can yield low quality earning. earnings management is one among the important issues nowadays in the minds of investors and accounting standard setters, especially next to financial scandals and crises, occurred by the starting of the current century, where users' trust in financial reports declined, if not missed. the identifying signals of earning quality would be useful to investors and others. accounting, market, and economic performance indicators are important in the measurement of firm’s performance, which is used to make necessary comparisons and analyses. there are some studies where it used accounting performance indicators such as return on assets (roa), return on equity (roe), and return on sales (ros). boardman and vining, (1989), showed that the accounting performance indicators, still have a wide spread use as a measure of performance, whereas haddad and haddad, (2003) showed that investors are focusing on reported accounting profits in the financial statements of firms when making their decision investment and when building their expectations and evaluate their investments, as they have a significant impact on the reversing information on future profits and therefore the impact on the price of market share of the company. the traditional accounting indicators are used to assess the status of the company including, roa, roe, eps, and operating cash flows (ocf), have faced several criticisms of their reliance on estimate. these indicators are also influenced by the followed accounting method, since the rate of returns on accounting yield has always been criticized for its inability to measure the economic profit (fisher and mcgowan, 1983),. in addition, the financial reports has been criticized because of low quality and the lack of correlation where the environment is rich with information, (mashayekhi and bahavarnia, 2007), and there was almost a general consensus that traditional methods must be reviewed to overcome the defects. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 80 in the early eighties, stern stewart has announced a new measure of performance called the term economic value added (eva). the entrance of economic value added as a tool to measure the internal and external performance of the company takes into consideration the cost of capital (o'byrne, 1996). it was found that the economic value-added measure is one of the best performance metrics that have emerged in recent times. grant, (1996) asserted that the economic value-added measure is a proper way to measure profitability. stern and stewart (1995), defined economic value added as "the difference between the net operating profit after tax and average cost of owned capital. when the eva > 0, it can be considered as good indicator for firms success, because there is an increase in the wealth of owners, whereas when the eva= 0, there is a probability that the firm produces as much as the funds invested, but when if eva< 1, the means that there is a decrease in the wealth of owners. currently, increased attention around the world has risen to create economic value. the driving force behind this attention is the increase in the intensity of competition and the interest of investors out more effectively. so there is a need to provide more accurate tools instead of depending various standard methods such as value based management (vbm), which provides awareness of a high degree of value of shares and economic value added (eva), which was developed by the american company entitled stern stewart in 1989, all of these methods work to provide more accurate standardized methods compared with the traditional methods of accounting, especially where accounting rate of return is criticized of its inability to measure the economic profit (fisher and mcgowan, 1983). traditional performance measurement systems were designed to measure performance and accountability to confirm that people meet their budget and followed orders. this encourages managements to practice earnings management by using many alternative methods of accounting measurement. these practices found that all of roa, roe, eps, and revenue growth can be adjusted by altering accounting methods or capital structure. o`byrne (1996), found that returns only explain 24% of the change in the market value of a firm. however, relying on the amount of net profit only, without taking into account the factors that lead to reduction in the level of quality, such as the practice of earnings management, and the high proportion of accruals, affects the safety of the decisions taken by stakeholders, so the focus is on the profit level while the quality of the profit is neglected. (chan et al, 2006, pp, 1041-1082).no common agreement yet is available for the definition of the term earnings quality. sloan (1996), indicates that the quality of earnings sustainability of cash flows means more continuity receivables, while schipper and vincent, (2003) showed that earnings quality is the reduction in the differences between the accounting reported income and economic income. ghosh and moom (2010), demonstrated that earnings quality is the ability of earnings to predict future cash flows. moreover, bellovaryet al, (2005), stated that earnings quality is achieved when the reported earnings reflect the actual performance, and can be used in predicting future earnings, so earnings quality is represented by the continuity of earnings. while teets (2002), found that some people look to the quality of earnings during the term reflected in the economic performance of companies, and others see the quality of profits by the extent to which they contain information from accounting profits reflecting the economic performance of companies. fariha and moreira (2007), have defined the quality of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 81 earnings as profits devoid of the use of certain accounting options to get to figure profit target, especially accounting options that lead to report earnings for future periods in the current period, or vice versa. in addition, bagaeva (2010), defined the quality of earnings on the basis of the timing of recognition of economic losses in the income statement. based on the above mentioned definitions and descriptions for the term of earnings quality, it is apparent that earnings quality stems its importance from the accounting income, which can be considered the most important resource of accounting information for investors, creditors, and other users of accounting information through the different accounting reports. earnings quality is important for users of accounting reports, since it enables them to take good decisions, evaluate manager's performance, evaluate the financial position of the firm, and estimate the future expected earnings. prior researches mentioned different measures for the determination of earnings quality level. several recommendations for the interpretations of earnings quality are available; among these is the use of earnings continuity as indicator for quality. sloan (1996), showed that earnings quality means cash flows continuity at a higher rate of accruals continuity. richardson, et al, (2005), developed a model for the measurement of future profits continuity. other prior researches used accruals method for measuring earnings quality using the absolute value of discretionary accruals. to compute discretionary accruals jones method (1991), which adjusted by dechow et, al, (1995) can be used. this method is the most common used method for earnings management measurement, and can also be used for measuring earnings quality. that is a higher absolute value of discretionary accruals suggests lower earning quality. the market performance indicators that measure the investment attractiveness of firm’s shares to the dealers in the financial market, and measure the extent of the company's management's ability to maximize the wealth of owners, panahaian and hosseini (2013), found a lack in the statistically of the significant relationship between market performance of proportion (tobin's-q) and the equality of reporting, and there is a significant and positive relationship between the market added value and quality of the financial reports, as measured by the quality of financial reporting standards quality profits. panigrahi, et al. (2014), showed that earning per share as a traditional measure still enables the measurement of shareholders’ creation. in addition, the study shows that eva was not used by investors for their investment decisions. nakhaei and hamid (2013), indicated that there are more association between accounting variables and share market value, than economic value added, and the significant relationship between eva and market value. peixoto (2002), shows that economic value added does not have more information content than traditional performance measures in explaining equity market value. under the changing economic developments, the financial performance of firm and its measures became one among today’s hot issues. where traditional accounting measures became less useful, new modern measures appeared. modern economic measures are more useful than traditional measures, especially where these measures can identify the quality of earnings. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 82 therefore, the study investigates the ability of traditional and modern performance indicators to interpret the phenomenon of earnings management. based on this discussion, the problem of the study can be well presented through the following questions: 1-are the traditional accounting performance indicators of roa, roe, cfo able to interpret the phenomenon of earnings management of the listed manufacturing firms in the amman stock exchange (ase)? 2are the modern performance indicators (market and economic) able to interpret the phenomenon of earnings management of the listed manufacturing firms of ase? two branch questions are stemmed from this question, as follows: aare the market performance indicators consisting of mva, and tobin's-q, able to interpret the phenomenon of earnings management of ase? bis eva as an economic performance indicator able to interpret the phenomenon of earnings management of listed manufacturing firms in ase? the study objects for investigating whether the traditional and modern performance indicators are able to interpret the phenomenon of earnings management. this objective can be better expressed through the following sub-objectives: 1to determine the ability of accounting performance indicators (roa, roe, and cfo) in interpreting the phenomenon of earnings management that the listed manufacturing firms in ase may exercise. 2to determine the ability of market performance indicators (mva, and tobin's-q) in interpreting the practice of earnings management phenomenon by the listed manufacturing firms in ase. 3to determine the ability of economic performance indicators (eva) in interpreting the phenomenon of earnings management that may be exercised by the listed manufacturing firms in ase. this study is important because it investigates a topic that recently became on focus of accounting literature, next to firm's scandals and firm's collapses. experts and professional people interpreted the firm collapses by the manipulation practices in those firms there managements. the managements of those firms exploited the level of flexibility that available in accounting methods, where more than one accounting method can be used to account for each item of the financial statements. as a result, the announced information of collapsing firms did not reflect the actual economic events occurred during accounting periods, so the financial positions and results of operations of those firms were overstated. the importance of the study also increases because it is considered an attempt to interpret the phenomenon of earnings management by using modern metrics of performance indicators of the economic and market. the findings of the study will be beneficial and important for different parties including, shareholders, managements, creditors, and other interested users, because the quality of the reported represents an important aspect in the assessment of asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 83 financial position, and in estimating future earnings, in addition to its importance in the decision making process that users are required to take. this research is organized as follows: section 2, covers the related prior researches, while the related literature is provided in section 3. section 4 presents the hypotheses of the study whereas section 5 shows the methodology used in the study. section 6 shows the analysis of the data and hypotheses testing, and section 7 explores the findings and the conclusions. 2. prior researches several prior researches investigated some aspects of the earnings management phenomenon. some of these researches were based on a questionnaire, while others are based on secondary available data. despite that, some aspects had not been given the deserved importance by researchers, and still they need more and more investigations. panigrahi, et, al.2014), compared between the traditional and economic performance measures for creating shareholders value. the study had been based on a sample consisted of (28) construction public listed firms in main board of bursa malaysia over the period 2003-2012.the study revealed the existence of a positive and significant relationship between economic value added (eva) and shareholder’s wealth maximization. the study also shows that earnings per share as a traditional measure still enables the measurement of value creation for shareholders. in addition, the study shows that the eva was not used by investors for their investment decisions. ongeri (2014) carried out an empirical to investigate the relationship between economic value and accounting value among commercial banks in kenya as a basis of company value. this study is based on a survey that encompasses a target population consisting of 43 commercial banks in kenya, where a sample consisting of 30 commercial banks had been used among that population. secondary data of published financial reports was used to achieve the objectives of the study over the period 2008–2012, encompassing 150 observations. the econometric results reveal that both roi and earnings per share (eps), have a significant positive relationship with economic value. on the other hand, the findings show an inverse relationship between roe and economic value panahaianand hosseini (2013), investigated the effects of performance criteria including accounting, market, and economy, on the quality of financial reporting. the statistical population research consisted of the companies listed on tehran stock exchange over the period 2006-2011. the results of the tests that conducted on 99 firms indicate that there is a significant positive relation between roe, and eps from one hand, and the quality of financial reporting on the other hand. in addition, the study shows no relationship between tobin's-q and the quality of financial reporting. finally, the results indicate the existence of a significant positive relation between market-value added and the quality of financial reporting. nakhaei and hamid (2013), examined the relative explanatory power of the economic value added (eva) model with respect to share market value (mv) compared to recognized accounting variables (net profit and operational profit)in tehran stock exchange. the study asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 84 was based on a sample consisting of 87 non-financial firms over the period 2004-2008. the results indicated there the availability of more association between accounting variables and share market value than economic value added. moreover, the study found a significant relationship between eva and market value. hamdan (2012), examined the factors affecting the level of earnings quality in different types of firms. accounting conservatism, company size, debt contracts, return on investment, corporate governance, auditing quality and audit committees, all of these factors had been investigated in their effect on earnings quality. the study sample consisted of 50 listed in ase, over the period 2009-2004. the study shows the existence of a high level of earnings quality in jordanian industrial corporations. it also found evidence that company size, debt contracts and auditing quality have effect on earnings quality. naimi(2012), investigated the relationship between the equation (tobin's-q) each of stock price, market value to book value per share (mv/bv) and price per share, based on a sample of 10 listed firms in the iraq stock exchange. the study found that the modern performance measure (tobin's-q) expresses the real situation of firms more than traditional scale (mv / bv), and the reliance on a scale (tobin's-q) provides an appropriate opportunity for investors to predict future performance and profitability. nassirzadeh.et, al. (2012), examined the factors affecting earnings management of listed companies in tehran stock exchange. so, the effects of the debt-equity ratio, firm size, managers' bonus and effective tax rate on earnings management are examined. the sample of the study consisted of 114 listed firms in tehran stock exchange over the period 2006-2010. the results indicate that there is a significant as well inverse relationship between debt to equality ratio and earnings management. moreover, it shows a significant positive relationship between firm size and earnings management. however, the study did not find a significant relationship between changes in managers' bonuses and the effective tax rate with earnings management. radwan (2011), investigated the nature of the relationship between economic indicators (eva and mva), and indicators of traditional accounting performance (return on investment and roe) in one hand, and stock returns in the other hand.the study was conducted based on a sample of 34 registered firms in the saudi stock market over the period 2009-2005.the study showed that traditional accounting performance indicators were more capable of economic performance indicators in the interpretation of changes to stock returns. the study also revealed that the accounting and economic performance indicators together were able to interpret 26% of the changes in stock returns, which highlights the importance of measurement and disclosure of economic performance indicators, as well as the accounting of performance indicators, in order to assist management in maximizing the wealth of owners through making investment decisions that achieve returns to investors. aldabbas (2007), carried out a study to investigate the relationship between economic evaluation metrics (eva, the value of the modified economic value added, mva, and residual income) and accounting evaluation metrics (roa, roe, net profit, and operating cash flows) in one hand, and performance of firms, in the other hand. the study found that asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 85 the economic assessment indicators have a significant effect on firm’s performance, and there are differences between the economic performance indicators and accounting performance indicators in assessing the performance of firms. irala (2005), concluded that eva is considered a better measure of performance than the traditional measures such as roe, eps, roi, and the profit measures. eva used as a performance measure stimulates managers to employ a firm’s assets more productively and it assists in reducing differences in the interests of the managers and shareholders. peixoto (2002), investigated the relationship between operating profit, net profit, and eva with firm’s market value. the study had been prepared based on a sample consisting of 39 listed firms in lisbon securities stock exchange of portugal, along the period 1995-1998. the main conclusion of the study is that a correlation exists among eva, operating profit, and net profit, with market value. the study also shows that eva does not have more information content than traditional performance measures in explaining equity market value. dechowand dichev (2002), suggested a new measure of one aspect of the quality of working capital, accruals, and earnings. one role of accruals is to shift or adjust the recognition of cash flows over time, so that the adjusted amount of earnings measures in a better form the financial performance of firms. the sample of the study consisted 1,725 firms, had been obtained from the compust at annual industrial and research files, along the period 1987-1999. the study derives an empirical measure of accrual quality as the residuals from firm‐specific regressions of changes in working capital on past, present, and future operating cash flows. the study finds that the measure of accrual quality is positively related to earnings persistence, and the most important conclusion is that everything equal large accruals signify low quality of earnings, and less persistent earning. alkhalayleh (2001), investigated the relationship between the accounting performance indicators of market performance, and market indicators such as eps in the long-range. the study was conducted based on a sample consisting 40 manufacturing listed firms in ase 0ver the period 1996-1984. the results showed the existence of a statistically significant positive relationship between the return on the stock market and all of roa, roe, and that the relationship between eps and accounting performance indicators (roe, roa) be strong whenever it increased probationary period sloan (1996) identifies the source of information in accruals about earnings quality. the results show that information in accruals about earnings quality originates from both growth in the scale of operations and deterioration in the efficiency of asset usage. the main conclusion of the study is that a total accruals, defined as the difference between earnings and free cash flows, provide an intuitive, robust and parsimonious measure of earnings quality. also results indicate that the information in accruals about earnings quality is not attributable to a single factor, such as 'discretionary' accruals or firm growth. based on the above related research, it is noted that most of prior researches had addressed a relationship between eva, market value per share, and their ability to explain the change in the market value of the shares. some prior researches focused on the comparison between the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 86 nature of the relationship between traditional measurement methods and their ability such as: roa, roe and cfo, where all the studies focused on the effect of the eva on the market value of shares, or studied the relationship between them. this study is different where it investigating the extent of performance indicators of economic, market, and accounting in interpreting the phenomenon of earnings management to show the benefits of these indicators for users of financial statements to enable them to take good decisions. 3. study hypotheses based on the survey made of the related literature and prior researches of traditional,modern performance indicators and earnings quality, two key hypotheses had been developed in there null form. these two hypotheses are as follows. ho1: traditional performance indicators including return on assets, return on sales, and cash flows from operations, are unable to interpret the phenomenon of earnings management that the manufacturing listed firms in amman stock exchange may exercise ho2: modern performance indicators including market and economic indicators are unable to interpret the phenomenon of earnings management that the manufacturing listed firms in amman stock exchange may exercise. to simplify the test of the second hypothesis, two sub-hypotheses had been derived as listed below, in their null form. ho21: indicators of market performance included the added market value and the firm’s opportunity of growth (tobin’s-q), are unable to interpret the phenomenon of earnings management that may be exercised by the listed manufacturing firms in amman stock exchange. ho22: economic performance indicators represented by the economic value added is unable to interpret the phenomenon of earnings management that may be exercised by the listed manufacturing firms in amman stock exchange. 4. methodology the population of the study includes all manufacturing listed firms in ase. the number of listed manufacturing firms in ase is 68 firms, by the end of 2013. a portion of needed data for the measurement of the study variables requires the availability of data one year before the period of the study, which is extended over the period 2006-2013. number of observations that were subject to analysis is (232), attributed to 29 listed manufacturing firms in ase for 8 year period, so this composes (42.6) percent from the total population of the study. actually, two terms should be available in a firm in order to be included in the sample. first, all needed data regarding the firm should be available; whereas the second is that the firm was not stopped or merged with other entity during the period of the study. based on the literature, the earnings quality is one of the most important factors of assessing and determining the value of an organization. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 87 the study adopted the jones method (1991), which adjusted by dechow and et.al, (1995) for measuring earnings management, which is considered as the most famous model to detect earning management nowadays. the model is based on using the discretionary accruals as an indictor of earnings management. that is a higher absolute value of discretionary accruals suggests lower earning quality. the absolute value of discretionary accruals is viewed as an inverse measure of earnings quality. to compute the absolute value of discretionary accruals, the following equation can be used. total accruals (ta) are measured as follows: , = , + , (1) where: ni i,t: net income of firm j for year t. cffo i,t: cash flows from operations of firm j for year t. in order to estimate discretionary accruals for firm i in year t, we first estimate parameters of the cross-sectional modified jones (1991) model using all other firms in the same industry (same first two-digit sic as firm i). the model is as follows: ,, = , , + 1 , (∆ , − ∆ , )/ , + 2 , ,, + , (2) where : ta j,t = total accruals of industry j for year t. δrev j,t = change in revenue of industry j between year t and year t-1. δrece j,t: change in receivables of industry j between year t and year t-1. ppe j,t: gross property, plant, and equipment of industry j industry j for year t. a j,t-1:total assets of industry j by the end of year t-1. the industry-specific estimates of parameters from equation (2) imply an expected association between non-discretionary accruals and accounting variables for firms in industry j. thus, the non-discretionary accruals for firm i in year t can be computed as follows: nda , = , , + 1 , (∆ , − ∆ , )/ , + 2 , ,, + , (3) the absolute value of discretionary accruals for firm i in year t is computed as follows: | da , | = | ta , – , | (4) where: da , : discretionary accruals in year t, that used to measure earnings management. and it can be placed (the main form), as mathematical as follows: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 88 em i,t = β0 +β1 roa i,t +β2 ros i,t +β3 cfo i,t +β4mva i,t + β5 tobin's-q i,t + β6 eva i,t +β7 firm's size i,t + β8 leverage i,t + εi,t table 1. methods and symbols used in variables measurement no. criterion type of variable variables & symbol method of calculation 1 accounting independent return on assets (roa) roa = 2 accounting independent return on sales(ros) ros = 3 accounting independent cash flow operations(cfo) cfois divided by total assets for conversion purposes 4 market independent market value added(mva) mva = 5 market independent tobin's-q tobin's-q = 6 economic independent economic value added (eva) ∗ = nopat – (wacc ×ic) where: nopat is operation profit after tax, wacc is weighted average cost of capital, and ic is invested capital. 7 accounting control firm size(fs) log.of total asset 8 accounting control leverage(lev.) lev = 9 accounting dependent earnings management(em) using modified jones model proposed bydechowetal.,(1995). 5. results and analysis to examine whether the data is appropriate for analysis and measurement, and whether it achieves the objectives of the study, several tests had been made such as, normal distribution test, multicollinearity test, and correlation. table (2) shows these tests. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 89 table 2. test of data validity and study model variables multicollinearity autocorrelation tolerance vif durbin watson roa .594 1.684 1.589 ros .701 1.427 cfo .882 1.134 mva .559 1.789 tobin's-q .456 2.194 eva .645 1.551 log fs .495 2.020 lev. .842 1.188 em .594 1.684 with regard to normal distribution, the study was conducted to include all available data to each firm included in the study sample. in addition, since the sample size composes about 43 percent from the total population of the study, then the model can be considered useful and valid. tolerance coefficient is computed for each variable, to test the overlapping among variables. thereafter, the variance inflation factor (vif) had been used. since vif coefficient for each variable is not more than 5, it is concluded that no overlapping is available among variables, so this means that the model is highly appropriate for interpreting the effect of independent variables on the dependent one. regarding autocorrelation, durbin watson test (d-w) had been used, and its value is 1.65, so this is a good indicator that autocorrelation problem is not existed among variables. in occasion, the optimal value of (d-w) test is between 1.5 and 2.5(gujarati, 2003, p, 496). 5.1 descriptive statistics table (3) shows the descriptive statistics for all variables. based on information appears in the table, it is notable that the mean of the traditional indicators of financial performance (roa, ros, cfo) are low, which means that the financial performance was low. when the financial performance is low, this creates an incentive for firms to practice the phenomenon of earnings management, so managements have alternative methods to manipulate these indicators. regarding the modern indicators of financial performance, they can't be subject to earnings management methods or manipulation. regarding the mean of mva and tobin's-q, it seems acceptable, and not low, because it is greater than the bv. considering em, the means are, in general, minus, which means that firms have good earnings quality. as a result, the management's intervention in earnings measurement is somewhat limited. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 90 table 3. descriptive statistics of variables for all companies: 2006-2013 variable minimum maximum mean median. standard deviation roa -96.49 43.94 3.2296 3.93 12.04779 ros -358.80 160.12 -1.6547 3.77 46.55993 cfo -7.38 8.49 2.7308 5.91 5.56495 mva -8.34 9.46 .5924 5.17 6.79991 tobin's-q .01 5.10 .7472 .59 .70584 eva -4799059 79813337 2094829 57670 8542695 fs 2347989 1223269000 86110776 18814117 208897583 lev. 1.48 79.07 32.1721 30.02 17.01 em -110629346 87305017 -1561707 -169899 16074902 5.2 hypotheses testing the hypotheses of the study object for examining the ability of traditional and modern performance indicators to interpret earnings management phenomenaof the listed manufacturing firms in ase along the period 2006-2013. at the beginning, i examined the study sample whether the firms of the sample exercise the phenomena of earnings management. therefore, the mean of the absolute value of the discretionary accruals had been computed, where the rule states that when the value of the discretionary accruals is in excess of the mean, there is a probability that the firm practices the phenomenon of earnings management. in opposite, when that value is less than the mean, there is no probability that the firm does not exercise what is called earnings management. (al-sartawi, et,. al, 2013). when this rule is applied on the sample of the study, i find that the percentage of companies that do not practice earnings management is 66.2%. testing the first hypothesis the first hypothesis had been developed to test whether the traditional performance indicators (roa, roe, and cfo) are able to interpret whether the phenomenon of earnings management is exercised by the listed manufacturing firms in ase. the hypothesis is presented again as follows. ho1: traditional performance indicators including return on assets, return on sales, and cash flows from operations, are unable to interpret the phenomenon of earnings management that the manufacturing listed firms in amman stock exchange may exercise. the multiple linear regression method had been used in testing the hypothesis. table (4) shows the results of the study model asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 91 table 4. statistical results of the traditional indicators em i,t = β0 +β1 roa i,t +β2 ros i,t +β3 cfo i,t + β7 firm's size i,t + β8 lev i,t + i,t . variable unstandardized coefficient ( ) standardized coefficient (beta) (t) sig. constant 38743329 roa i,t -219666 -.165 -2.061 *.040 ros i,t 24803 .072 .953 .341 cfo i,t 13381 .005 .069 .945 firm's size i,t -5697402 -.195 -2.644 *.009 lev. i,t 84475.678 .089 1.334 .184 r2 .089 adj. r .069 f 4.442 sig. .001 a. predictors:(constant)roa i,t, roe i,t, cfo i,t, firm's size i,t, lev. i, b. dependent variable: em c. * significant at the level ≤ 5%. information appears in table (4) demonstrates that a linear relationship between the traditional performance indicators and the phenomenon of earnings management, is existed. the computed f-value equals 4.442, with a computed coefficient of significance of zero. when the coefficient of significance is compared with the predetermined corresponding one, which equals 0.05, it is apparent that computed one is lower than the predetermined. therefore, and based on this result, the null hypothesis is rejected; while it's alternative one, is accepted. this result means that traditional performance indicators have an effect on the phenomenon of earnings management, and plays a role in interpreting the quality of these earnings. therefore, the result indicates that there is an effect of at least one indicator of these indicators, and it contributes in interpreting the variance of the dependent variable. results reveal that the coefficient of determination (r2) equals 8.9 percent, where this refers that traditional performance indicators interpret 8.9 percent in the total variance in the phenomenon of earnings management. this is also considered as an indicator for the existence of a linear relationship between the traditional performance indicators and earnings management phenomenon. in addition, this means that other factors, the study did not take into consideration, are affecting the phenomenon of earnings management. to determine which indicator has the most significant effect in interpreting the earnings management phenomenon, beta coefficient had been used. table (4) shows that the indicator which has the most significant effect on earnings management is firm's size (fs), where beta coefficient equals -.195. actually, firm’s size is followed by roa, where its beta coefficient asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 92 equals -.165. in addition, results indicate that the coefficient of significance for these indicators is less than 0.05, which means that each of these indicators has a significant effect on interpreting earnings management phenomenon. it can be concluded that the variables of firms’ sizes and roa, are able to interpret the phenomenon of earnings management, and it is through the effect of these indicators on limiting the practices of earnings management, there is a probability that the managements of those firms exercise the phenomenon. therefore, through the restriction of managements’ interventions in measurement, the disclosed financial information reflects, in a better form, the events that occurred during the accounting period. based on these findings, it is believed that the inverse relationship between each of roa, and the firms’ size with the practice of earnings management, which was expected to be positive. attributed to the interested bodies by reliable and relevant accounting information, measurement, disclosure, and earnings management practices, a regular supervision on this phenomenon is recommended. in addition to the role of auditors are required to take several actions to reduce the practices of earnings management, whenever indicators for such practices appear. in addition, the rules of corporate governance can restrict the practices of earnings management phenomenon, when applied. no prior researches reached to this conclusion. testing the second hypothesis the second hypothesis had developed to test the ability of modern performance indicators (market and economic) to interpret the phenomenon of earnings management that the listed manufacturing firms in ase may exercise. ho2: modern performance indicators including market and economic indicators are unable to interpret the phenomenon of earnings management that the manufacturing listed firms in amman stock exchange may exercise. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 93 table 5. the model and statistics of modern performance indicators . variable unstandardized coefficient ( ) standardized coefficient (beta) (t) sig. constant -3588860.726 mva i,t -4188.810 -.002 -.023 .982 tobin's-q i,t -3435945.841 -.151 -1.687 **.093 eva i,t -.606 -.322 -4.286 *.000 firm's size i,t 566413.400 .019 .236 .814 lev. i,t 51624.912 .055 .879 .380 r2 .168 adj. r .150 f 9.123 sig. .000 a. predictors:(constant)roa i,t, roe i,t, cfo i,t, firm's size i,t, lev. i, b.dependent variable: me c. * significant at the level ≤ 5%. d. ** significant at the level ≤ 10%. information appears in table (5) demonstrate the existence of a significant linear relationship between the modern performance indicators (market and economic) and earnings management phenomena. the computed f-value equals 9.123, with a computed coefficient of significance of zero. when the coefficient of significance is compared with the predetermined corresponding one, which equals 0.05, it is apparent that computed one is lower than the predetermined one. therefore, and based on this result, the null hypothesis is rejected while, it's alternative one is accepted. this result means that modern performance indicators (market and economic) have an effect on the phenomenon of earnings management, and that these factors play a role in interpreting the phenomenon of earnings management. this means that there is an effect of at least one indicator among the modern performance indicators, and that contributes in interpreting the variance of the dependent variable. results revealed that the coefficient of determination (r2) equals 16.8 percent, where this refers that modern performance indicators interpret 16.8 percent in the variance of earnings management phenomenon. this is considered as indicator for the existence of linear relationship between the modern performance indicators and earnings management phenomenon. to determine which modern performance indicator has the most significant effect on interpreting the phenomenon of earnings management, beta coefficient had been used. table (5) shows that the indicator which has the most significant effect on earnings management where beta coefficient for this indicator equals -.322. tobin’s q comes next to eva at beta asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 94 coefficient of -0.151. in addition, results indicate that the coefficient of significance for these indicators is less than 0.05, which approves the significant effect of these indicators in interpreting the phenomenon of earnings management. it can be concluded that eva and tobin's-q have ability to interpret phenomenon of earnings management, through restricting the practices of earnings management that firms’ managements may exercise, and through the restricting these managements interventions in measurement, disclosure, and recognition of items appearing in the financial statements. testing branch hypotheses table (6) shows the results of testing the ability of each modern performance indicators in interpreting earnings management phenomena of the listed manufacturing firms in ase. table 6. results of branch hypotheses testing ability of marketing performance indicators to interpreting earnings management phenomena model(1) emi,t = β0 + β1mva i,t+β2 tobin's-q i,t +β3 firm's sizei,t +β4leverage i,t + i,t coefficien t 0 1 β2 3 β4 r2 adj. r f-statis tic sig. coefficien t value -.005 -.202 -.131 .093 .100 .084 6.328 .000 t-test -.063 -2.193 -1.699 1.455 sig. .950 .029* .091** .147 ability of economic performance indicators to interpreting earnings management phenomena model(2) emi,t = β0 + β1 eva i,t +β2 firm's sizei,t +β3leverage i,t + i,t . coefficien t 0 1 β2 3 r2 adj. r f-statistic sig. coefficien t value -.347 -.054 .058 .153 .142 13.723 .000 t-test -4.659 -.732 .947 sig. 0.000* .465 .345 a. predictors:(constant)roa i,t, roe i,t, cfo i,t, firm's size i,t, lev. i, b.dependent variable: em c. * significant at the level ≤ 5%. e. ** significant at the level ≤ 10%. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 95 the first branching hypothesis text is again presented, in its null form, as follows: ho21: indicators of market performance included the added market value and the firm’s opportunity of growth (tobin’s-q, are unable to interpret the phenomenon of earnings management that may be exercised by the listed manufacturing firms in amman stock exchange. the results of multiple linear regression method for model (1) are shown in table (6). based on information appears in the table, a linear relationship exists between the indicators of the market performance and the phenomenon of earnings management, since f value equals 6.328, with zero coefficient of significance. because the computed coefficient of significance is less than the predetermined one, which equals 0.05, the null hypothesis is rejected, whereas the alternative one, which refers to the existence of an effect of audit office size on the quality of reported earnings, is accepted. the results also indicate that the value of the related coefficient of determination (adjusted r2) equals 10 percent, which means that 10 percent of the change in the earnings management can be attributed to the indicators of market performance. this is also can be considered as a good indicator for the existence of a linear relationship between market performance indicators and earnings management phenomenon. in addition, results demonstrate that the coefficient of the tobin's-q is significant and negative and equals -0.202. moreover, the table shows that the computed t-value equals -2.193, with a computed coefficient of significance of less than 0.05. the second branching hypothesis had developed to measure the ability economic performance indicators in interpreting earnings management phenomena that may be exercised by the listed manufacturing firms in ase. the test of the second branching hypothesis is again presented, in its null form, as follows. ho22: economic performance indicators represented by the economic value added is unable to interpret the phenomenon of earnings management that may be exercised by the listed manufacturing firms in amman stock exchange. information appears in table (6) shows the results of multiple linear regressions for model number (2), which shows the effect of economic performance indicators on interpreting the earnings management phenomena that the listed manufacturing firms in ase may exercise. results reveal the existence of a significant linear relationship between economic performance indicators and earnings management phenomenon, where f-value equals 13.723, with zero coefficient of significance. it is notable that the computed coefficient of significance, which equals zero, is less than the predetermined one, which equals 0.05. the value of the computed coefficient of significance is of statistical significance. because the computed level of significance is less than the corresponding predetermined one, the null hypothesis is rejected, while the alternative on is accepted. this means that the economic performance indicators contribute in interpreting the earnings management phenomena. the coefficient of determination (adjusted r2) equals 14.2 percent, which means that the economic performance indicators can interpret 14.2 percent of the change taking place in the phenomenon of earnings management. this is a good indicator for the existence of a linear relationship between economic performance indicators and the phenomenon of earnings asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 96 management. in addition, results demonstrate that the coefficient of the eva is significant and negative and equals -0.347. moreover, the table shows that the computed t-value equals -4.659, with a computed coefficient of significance of less than 0.05. 7. conclusions and findings the main objective of the study is to investigate the ability of traditional and modern performance indicators in interpreting the phenomenon of earnings management that the listed manufacturing firms in ase may exercise. based on the data analysis and hypotheses testing, the study finds that the listed manufacturing firms in ase are still exercising the phenomenon of earnings management, but at a lower level based on the analysis of data. in other word, firm have enough or acceptable of earnings quality. in addition, the study shows that a linear regression relationship exists between the traditional and modern performance indicators to interpret earnings management phenomena. the results indicate that there is a significant as well inverse relationship between (fs), (roa) in one hand and earnings management phenomenon on the other hand, which approves that traditional performance indicators has a significant effect in interpreting earnings management phenomenon. the study also finds that modern performance indicators have an ability to interpret earnings management phenomenon, where the results indicate that there is a significant, as well inverse relationship between (eva), (tobin's-q) and earnings management. the study concludes that (eve) is an effective indicator in interpreting the earnings management phenomena that the listed manufacturing firms in ase may exercise. however, the study does not demonstrate a significant relationship between cfo, lev. ratio, 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(2002). quality of earnings: an introduction to the issues in accounting education special issues. issues in accounting education, 17(4), 355-360. http://dx.doi.org/10.2308/iace.2002.17.4.335 microsoft word 11456-42177-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 1 profitability of style based investment strategies: evidence from india srividya subramaniam assistant professor, department of economics sgtb khalsa college, university of delhi delhi-110007 e-mail: srividyadse@gmail.com gagan sharma research fellow, department of financial studies university of delhi, south campus, new delhi-110021 e-mail: gagan585@gmail.com srishti sehgal, senior executive-capital markets jll, india e-mail: srishtisehgal95@gmail.com received: june 2, 2017 accepted: july 15, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11456 url: https://doi.org/10.5296/ajfa.v9i2.11456 abstract in this paper, we aim to identify profitable investment styles on the indian stock market by using various combinations of important stock pricing anomalies consisting of. size, value, volume, profitability, earnings surprises, short term and long term prior returns. using nse200 stocks, three different investment styles viz. univariate, independent bivariate and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 2 conditional bivariate are constructed for the period july 2005-june 2016.results show that on an absolute return basis, bivariate strategies do not seem to outperform univariate strategies. the unifactor capm is able to absorb 42% of the returns owing to the explanatory power of beta. after adjusting for risk using the three factor fama and french (1993) model, 42% of the alphas are explained. however, additional risk factors from the carhart (1997) model and fama and french (2015) model do not provide any incremental explanatory power over the three factor model, recommending the use of the latter as a baseline to evaluate investment strategies in india. the highest supernormal returns of 1.1% per month are obtained from combining attributes and employing the conditional bivariate investment strategy viz.e2l1 (earnings momentum-liquidity), m2s1 (price momentum-size), e2m3 (earnings momentum-price momentum). the findings are pertinent to portfolio managers, financial regulators and other stakeholders. keywords: capm, fama french model, stock pricing anomalies, investment strategies, nse200 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 3 1. introduction the relationship between risk and return of a security which was first quantified by the single factor capm of sharpe (1964) and lintner (1965) proposes that the risk, return relation is linear, only a fraction of total risk is systematic and measured by beta. however, the inadequacy of beta in explaining stock returns paved the way for the development of multifactor asset pricing models most popular of which are fama and french (1993), carhart (1997), fama and french (2015). empirical results which are not consistent with asset pricing models are called anomalies and they indicate that the market is inefficient (schwert, 2003). hence portfolio managersand market analysts are always hunting for such anomalies which can be used to design investment strategies to earn consistent and superior risk adjusted returns. prior empirical research shows that stock return anomalies exist on the following dimensions/firm characteristics, i.e.size (banz, 1981), value (book to market-stattman, 1980), volume/liquidity(amihud & mendelson, 1986), profitability (haugen & baker, 1996); fama & french, 2008), earnings surprises(ball & brown, 1968), net stock issues(fama & french, 2008) and prior returns-momentum (jegadeesh & titman, 1993), reversal (de bondt &thaler, 1985, 1987) the broad categories like size, value, etc. into which investors group assets in the process of portfolio allocation decision are called styles and the process of investing between styles is called style investing (see barberis & shleifer, 2003). abundant literature confirms that stock return anomalies exist and thus it is feasible to exploit them to construct profitable trading strategies/styles. however, the ability of the above company characteristics in providing anomalous returns should be verified both independently and in combinations. several refinements to a single style can earn higher returns than that obtained from the univariate style itself. chen, chen, hsin and lee (2010) in their study of price, revenue and earnings momentum strategies point out that strategies based on multiple styles will give higher profits than from a single style provided each style has additional information content different from information content provided by other styles and that stock prices have not included this information i.e each measure provides anomalous returns. taylor (2011) points out the possibility of enhancing the returns and reducing the risks from holding an underdiversified portfolio by combining the information on a single style with additional public information (attributes) associated with it in the context of size and earnings momentum. it is also likely that investors react differently to joint information on various company attributes. hence, combining information on two/more different attributes to construct an investment style, could possibly generate higher risk adjusted returns. existing research shows that bivariate/trivariate investment styles using some of the above-mentioned attributes generate superior returns than univariate investment stylefor some markets (chen, chen, hsin& lee,2010;lee& swaminathan, 2000, asness, moskowitz &pederson, 2013; sagi & seasholes, 2007; teixeira, 2011). analogous research of the indian stock market is thin, since it has focused for the most part asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 4 on prior return patterns, i.e. momentum and contrarian (sehgal & balakrishnan, 2008; sehgal & jain 2011; polak &ejaz, 2012; rastogi, chaturvedula & bang,2009 and on earnings momentum, revenue momentum, volume momentum (sehgal & jain,2015: sehgal &vasishth,2015). literature on the trading strategies constructed from combinations of company attributes/styles like size, value, liquidity, profitability, earnings surprises and prior returns for india is limited. the present research adds to the existing literature on investment strategies in the indian context in the following ways. firstly, the most recent sample period from july 2005-june 2016 is studied. the sample period was chosen to avoid thinness of data. since this period encompasses the global financial crisis of 2008-2009, it was decided to take few data points prior to the crisis to cover market upturns and downturns. secondly, the data set comprises of nse200 stocks, a narrow basket (note 1) which is chosen to remove problems arising out of illiquidity whereas existing papers have always studied a larger basket of 500 stocks. thus, by including the size, value and volume parameter we are in effect studying relative size, relative value and the relative liquidity (small among large, low pb among high pb, low volume among high volume). next profitability from constructing investment styles by using univariate and two types of bivariate combinations on all prominent stock return anomalies viz. size, value, liquidity, profitability, earnings surprises and prior returns (note 2) is investigated in this paper which till now had been unexplored. this is done by first building a univariate investment style, followed by bivariate independent and bivariate conditional investment styles to explore the joint information content of attributes. since data set consists of 200 stocks, constructing trivariate strategy would reduce the number of stocks in each portfolio drastically. as a diversified portfolio, should contain between 8-10 stocks (see evans &archer,1968), a trivariate strategy was not constructed. lastly, we verify if standard risk models can explain the abnormal returns generated by these investment strategies. this paper attempts to answer the following closely related questions: 1. is it possible to construct profitable investment strategies/styles based on the following company characteristics/investment styles viz. size, value, volume, prior returns patterns, earnings surprises and profitability on a univariate basis (single sorted)? do some of these anomalies which have been earlier documented persist or have they disappeared? 2. do bivariate investment strategies outperform univariate investment style (single sorted)? does constructing a conditional bivariate investment strategy give higher returns than that obtained from independent bivariate strategy? 3. can the returns on the sample strategies so designed be absorbed by risk models vizuni-factor capm or multifactor models like fama and french (1993), carhart (1997), fama and french (2015)? this paper is structured as follows. the following section discusses the rationale for using various anomalies to construct investment styles. section 3 gives details on the data and methodology is explained in the fourth section. the empirical results are discussed in section asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 5 5. the final section contains conclusions and policy implications. 2. the rationale of various investment styles if return on a security cannot be explained by the amount of risk as defined by the selected asset pricing model, then the stock market is said to be informationally inefficient and investment strategies can be constructed to consistently outperform the market. literature on both mature and emerging markets, including india shows that profitable investment styles can be formed if the market is inefficient with respect to the following attributes size, value, liquidity, profitability, earnings surprises and prior returns which are discussed below. 2.1. size banz (1981) documented that firms which are small in size provide superior risk adjusted returns as compared to their larger counterparts. several causes of this size anomaly identified in the literature are infrequent trading (roll, 1981)), transaction costs (stoll &whaley, 1983), january effect (keim, 1983), different risk and return characteristics (chan &chen, 1991), illiquidity (amihud & mendelson, 1986), business cycles (chan. chen & hseih, 1985)), perez-quiros & timmermann, 2000)), presence of micro stocks (fama & french, 2008). over the past few years size anomaly seems to have weakened for a few markets or become insignificant (schwert (2003); gaunt (2004); nartea, ward & djajadikerta, 2009; horowitz, loughran & savin, 2000; crain, 2011; michou et al, 2010).nevertheless, in the indian stock market a significant size premium has been obtained consistently over varying time periods. (mohanty, 2002;kumar & sehgal,2004; behl, 2006;sehgal & tripathi, 2007; sehgal & balakrishnan, 2013; sehgal et al, 2012; pandey &sehgal, 2016). this makes it imperative to explore if information contained in size to could be used to develop investment strategies which promise abnormal profits. 2.2 value-value stocks are stocks which have low prices compared to fundamentals and perform better than growth stocks i.e. stocks which have high prices compared to fundamentals, also called value anomaly. tests of the value anomaly using book to market measure was performed by stattman (1980).reasons for the value anomaly consist of risk (fama & french, 1992, 1996), overreaction hypothesis (debondt &thaler, 1987;lakonishok, shleifer and vishny, 1994), stock characteristics (daniel &titman, 2006). research on value anomaly for other stock markets include chan and chen (1991), gaunt (2004), nartea, ward and djajadikerta (2009), chen and fang (2009), bundoo (2008), groot and verschoor(2002). evidence of a significant value premium in the indian market is found in kumar and sehgal (2004), behl (2006), sehgal and tripathi (2006), nair et al, 2009), gupta and kumar (2009),) and sehgal et al, 2012). 2.3prior return patterns (momentum/contrarian) prior return patterns are of two types: momentum and contrarian. momentum trading strategies mean that winners over the past 3-12 months continue to be winners and losers over the same period remain losers (jegadeesh & titman, 1993). contrarian trading strategies imply that past losers become future winners and vice versa (de bondt & thaler, 1985, 1987). risk based explanations for momentum include past trading volume (lee and swaminathan (2000)), sectoral returns (moskowitz and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 6 grinblatt, 1999; liu &zhang, 2008)), macro economic factors (chordia & shivkumar, 2002), investor bias in processing information could also lead to momentum profits (barberis, shleifer & vishny, 1998; daniel, hirshleifer & subrahmanyam, 1998;hong& stein, 1999).nevertheless, momentum remains a puzzle generating high risk adjusted returns and hence capturing the attention of investment managers. risk based explanation for contrarian is that stocks that had low past returns (losers) tended to be smaller and relatively more distressed while those that had high past returns (winners) were bigger and relatively less distressed (fama &french, 1995). momentum and contrarian strategies have been tested for several mature and emerging markets (rouwenhorst, 1998; griffin, ji &martin, 2003; chui, titman & wei, 2010, mcinish, ding, pyun & wongchoti, 2008; hameed & kusnadi, 2002; antoniou, lam & paudyal, 2007; swanson& lin, 2005, schiereck, debondt &weber, 1999; vu, 2012). momentum has consistently emerged as a profitable investment strategy in the indian market over various time periods. (sehgal and jain, 2011;sehgal &jain,2015;polak &eiaz,2012; sehgal &balakrishnan ,2004, 2008). contrarian investment strategy was found to generate high returns (rastogi, chaturvedula &bang 2009; sehgal & balakrishnan,2002; tripathi & gupta, 2009; dhankar & maheswari, 2014). 2.4. liquidity/volume returns are negatively related to liquidity since investors need to be compensated for holding illiquid stocks. amihud and mendelson (1986) documented role of liquidity in asset pricing models and were followed by brennan and subrahmanyam (1996), datar, naik and radcliffe (1998), lee and swaminathan (2000), liu (2004). the negative relationship between liquidity and returns has been established in the literature for various mature and emerging markets (gharghori, lee &veeraraghavan, 2009; hwang &lu, 2007; drew, mardsen &veeraraghavan, 2006; unlu, 2013; machado & mediros, 2012; rahim &mohd. nor, 2006). sehgal, subramaniam and morandiere(2012) and sehgal and vasishth (2015) confirm the presence of liquidity anomaly for the indian stock market. 2.5. profitability research on mature markets documents a positive relationship between profitability and stock returns (haugen & baker, 1996; cohen, gompers & vuolteenaho, 2002; fama& french, 2008;artmann, fintner & kempf, 2011; fitzpatrick & ogden, 2009; novy marx, 2013).however, it is found that more profitable firms have lower returns for the indian market (sehgal &subramaniam, 2012; singh & yadav, 2015). it is plausible the investors find a profitable firm to be less risky and hence are satisfied with low returns. 2.6. earnings momentum ball and brown (1968) recognized that stock prices move in the direction of earnings surprises. chan, jegadeesh & lakonishok (1996) termed the strategy based on earnings surprises as earnings momentum. persistent profits from earnings momentum strategy is obtained by hong, lee and swaminathan (2003), leippold and lohre (2009),chan, chen, hsin and lee (2010). literature attributes the existence of this anomaly to macroeconomic asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 7 factors (chordia & shivkumar, 2005, 2006),liquidity (sadka, 2006), limited investor attention (hirschleifer et al 2009) and role of information (vega, 2006)). nevertheless, earnings momentum strategy has been in conflict with market efficiency for around four decades. significant profits have been found from employing the earnings momentum strategy in indian markets (sehgal& jain, 2015). 3. data and their sources the paper uses data for 200 companies which comprise nse200 equity index. the time period considered is from july 2005 to june 2016. month-end closing share prices after adjusting for capitalization changes such as bonus shares, rights issues, stock splits, etc. stock prices are transformed into percentage return series for further evaluation. the national stock exchange’s nse200 index is used as a proxy for the market factor. we measure company size by using the log of market capitalization i.e. the natural log of price multiplied by shares outstanding. price to book value is used as a surrogate for value. average daily trading volume is used as a substitute for liquidity. profitability is measured by return on total assets. investments is calculated as the change in total assets over the previous year. quarterly earnings (i.e., earnings per share, excluding extraordinary items) have been used to calculate standardized unexpected earnings (sue). sue is estimated as earnings of the current quarter (eiq) minus average earnings of previous eight quarters(e iq-8),divided by the standard deviation of the earnings changes in previous eight quarters (sdiq) sue = (eiq-e iq-8)/sdiq (1) implicit yields on 91-day treasury bills are used a proxy for risk free rate. the source of data for share prices, company attributes and market index is cmie prowess. 91-day t-bill rates have been sourced from the reserve bank of india website. 4. methodology in this section, we discuss the methodology followed firstly in constructing various investment styles-based portfolios that may be univariate (based on one style), independent bivariate (based on two styles) and conditional bivariate. then we discuss the estimation of risk adjusted returns by employing standard risk models such as capm and select multifactor models. to construct the univariate investment style /single sorted strategy, single ranking style is adopted for portfolio formation. the portfolios are constructed on (i months/j months) strategy where i and j are periods of portfolio formation and portfolio holding respectively. we estimate 6-6 investment style based on all company characteristics and momentum (m) and 48-12-6(note 3) strategy for contrarian(c). the 6 months/6 months investment strategies are constructed on the following attributes viz. size(s), value (v), volume (l), profitability (p), earnings surprises (e) as follows. starting in july of the year t, we rank the securities based on the value of the chosen attribute. july is the starting date for portfolio formation by sorting on the end-of-june values on the attributes identified by us. june-end quarter is chosen to smoothen the impact of the large changes that might occur in the share prices of the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 8 firms after the declarations and disclosures at the end of the financial year (for india) on 31st march. attributes are then sorted into quintiles-named p1 to p5.next equally-weighted monthly excess returns are calculated for the next 6 months (year t). 20% of companies with lowest attribute would fall in p1 while p5 consists of top 20% companies with highest chosen attribute. the portfolios are re-balanced in january based on values for six months up to december of the year t, wherein all securities are again ranked into quintiles on the basis of the characteristic and equally weighted monthly excess returns are estimated for the next six months from jan to june (year t+1). we repeat the process till june 2016.in case of momentum past six months average returns are used as the sorting criterion. next, two types of bivariate styles are constructed viz. independent bivariate and conditional bivariate. under both categories, 2*3 and 3*2 sorting is adopted. in independent bivariate sorted strategy, securities are ranked separately based on any 2 characteristics and the intersection of the two independently formed groups is used to form portfolios. for instance, to form a 3*2 bivariate strategy comprising of size and value we proceed as follows. stocks are sorted independently on market cap at the end of june of year t and divided into terciles s1 to s3, s1 being the smallest size tercile and s3 being the largest size tercile. a similar exercise is to create portfolio v1 and v2 based on value. then from the intersection of these two characteristics we form 6 bivariate independent sorted portfolios. s1v3 consists of a combination of stocks which are in bottom 33 1/3 % in terms of size and top 50% in terms of value. in contrast s3v2 consists of stocks with high 33 1/3% in terms of size and bottom 50% in terms of value. monthly excess returns are then calculated for these six equally weighted portfolios for the next six months and the process is repeated half yearly till june 2016.distribution of nse 200 shares is limited to terciles to prevent loss of informational content, especially in the initial years of portfolio formation when we have about 30% less stocks for portfolio formation on the chosen attributes. too many smaller combinations of portfolios will be less diversified and may also have non-systematic risk. for the same reason3*3 formations in bivariate strategies are avoided so as have a sizeable portfolio in the initial years of this study. to construct a bivariate conditionally sorted strategy, the securities are ranked on the chosen attribute and then subgroups are formed within each group based on another attribute. this is done on both 3*2 and 2*3 formations as described earlier. for instance, to form a bivariate strategy of size conditional on value on 3*2 basis, we proceed as follows. stocks are ranked on the basis of market cap at the end of june of year t and divided into terciles s1 to s3. within each tercile stocks are again ranked on the basis of previous six months of value characteristic and two groups v1 and v2 are formed. so, in 3*2 conditional bivariate s1v2 implies lowest 33.3% companies in terms of size and within these companies the top 50% the of stocks having the highest value. then the equal weighted returns for these 6 portfolios are observed for the subsequent six months, i.e. till dec of year t. this process is repeated for the entire sample period. portfolios using other characteristics are formed using the same procedure. the same procedure is followed to obtain 2*3 formations as well. results on returns are reported only for the corner portfolios, which are the winners and losers in each case. since there are restrictions on short-selling in the indian market, we focus asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 9 our study on only long strategies. results for intermediate portfolios not reported due to space constraints can be obtained from the authors. thus, a total of two hundred and sixty-six investment stylized portfolios are considered comprising of fourteen univariate investment styles, sixty bivariate unconditional investment styles and one hundred ninety-two bivariate conditional investment styles. we next estimate the returns on the above portfolios. first, the unadjusted mean excess returns are calculated for all the portfolios and their statistical significance is tested. next to see if risk factors can be identified to explain these abnormal returns, we use asset pricing models viz. capm, fama and french (1993), carhart (1997), fama and french (2015). the “excess return” form of the market model is used for estimating capm regression rpt – rft = a + b(rmt – rft) + et (2) where rpt – rft denotes the portfolio monthly excess return rmt – rft is the market excess return, etis the error term and b shows sensitivity of market factor. if the intercept (a) is positive (negative) significant, it implies that the strategy constructed generates extra-normal profits (losses).this is an indicator that the capm has failed to explain the returns of the portfolios. next it is evaluated if these excess returns can be absorbed by the fama and french (1993) (ff 1993) model which uses size and value as additional variables to explain returns as follows, rpt – rft= a + b (rmt rft) + s (smbt ) + h (lmht )+ et (3) where smbt is the difference in returns on small and big stocks and lmht is the difference in returns on the low price to book and high price to book portfolio. since price to book is used as the value proxy, lmh is used in the ff model instead of hml and the intersection of two independent size sorted portfolios and three independent value sorted portfolios gives the smb and lmh.s and h denote the sensitivity coefficients of smbt and lmht the other two terms are same as defined in equation (2). insignificant intercepts from the ff (1993) model regressions means that the three factor ff model is good in explanation of returns. presence of statistically significant intercepts leads us to employ the carhart(1997) four factor model. carhart (1997) four-factor model adds one-year return momentum to the fama french factors, to capture patterns in returns as follows: rpt – rft = a + b (rmt rft )+ s (smbt )+ h (lmht )+ w (wmlt )+ et (4) where wml is the difference between the returns of the winner and loser portfolios.the other terms are same as in equation (3). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 10 if the carhart model fails to explain the abnormal returns, then we use the fama and french (2015) (ff 2015)five factor model. this model augments the three factor model with profitability and investment as additional explanatory variables. rpt – rft = a + b (rmt rft )+ s (smbt )+ h (lmht )+ r (rmwt )+ c (cma)t+et (5) rmw is the difference in returns on portfolios with high and low profitability. cma is the difference in returns on stocks with low and high investment. the other terms are same as in the previous equation. 5. empirical results table 1, panel a, presents the empirical results of the univariate strategies. results of bivariate independent and bivariate conditional strategies are reported in panels b and c in table 1 respectively. results on univariate strategies in panel a, show that unadjusted returns vary inversely with firm size, price to book value, volume and directly with short term prior returns and earnings surprises which is in line with prior research for the indian market. more profitable firms generate higher returns vis a vis less profitable ones which is consistent with international findings (note 4). long term momentum patterns are weaker and dominated by short term momentum so we abandon long term prior returns for further construction of the investment strategies (note 5). thus, after abandoning contrarian strategies the total estimated strategies are reduced by two to264. on an unadjusted basis, significant returns are obtained on winner portfolios of all univariate investment styles among which size sorted portfolios provided the highest monthly returns (2.7%)followed by volume (2.2%) and momentum (1.86%). based on unadjusted returns from univariate analysis, winners are identified in each style group. this combination of winners used to construct bivariate strategies is found to give highest returns among that group and are designated as winners. for instance, in the univariate analysis smallest size, s1, and highest prior returns m5 are winner portfolios. so, the combination of smallest size and highest momentum in bivariate strategies i.e. s1m2/s1m3 strategy has been classified as a ‘winner’ strategy. highest monthly returns in the bivariate independent investment styles are provided by s1e2(2.63%), s1m2 (2.60%) and s1l1 (2. 5%).m2s1 (2.7%), l1s1 (2.7%) and s1l1 (2.6%)are the investment styles in the conditional bivariate category providing highest monthly risk unadjusted returns. the above empirical results indicate that on an absolute return basis bivariate strategies do not outperform univariate strategies. the highest unadjusted returns of 2.7% per month is obtained from employing s1 (small size sorted strategy) on a standalone basis as well as bivariate m2s1 (momentum-size) and l1s1(liquidity-size). next, we assess if returns can be explained by standard risk models. employing risk models, we find that capm market factor is able to explain 42% (110/264) of the returns, proving that beta stand alone has an explanatory power. however, market beta is unable to account for remaining 154 strategies of which 114 are winners and 40 are losers. since, the average alpha asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 11 for capm loser strategies is 0.34% per month (4.08% p.a.), a long-short strategy seems feasible. the size and value factors of the ff (1993) model explain 65/154 (42%) strategies, thus it can be inferred that the ff three factor model is a better description of a cross section of average stock returns in line with existing research for indian stock market(sehgal et al 2012; sehgal & balakrishnan, 2013). nevertheless, the ff (1993) model is unable to explain returns on 89/154portfolios, which comprises of 79 winner portfolios and 10 loser portfolios. thus, there are substantial winners at the three factor model level. out of this the carhart model augmented with a momentum factor is able to explain alphas in only 7cases, whereas the five-factor model with profitability and investment as additional factors explain only three strategies completely. thus, there are still 79 strategies which defy the risk argument, consisting of 70 winners and 9 losers. this shows that the four factor carhart model and five factor ff model are redundant in providing a risk based explanation and the ff three factor model should be considered as the benchmark for portfolio evaluation in the indian context for nse200 universe. the failure of the risk models in completely explaining extra normal returns in about 31%(82/264) of the cases suggests missing risk factors or search for a behavioral reason. yet these unexplained alphas of the strategies show the potential for superior returns in the indian stock market. the highest risk adjusted returns among all strategies considered are obtained from constructing the conditional bivariate investment strategy viz. e2l1 (earnings momentum-liquidity), m2s1 (price momentum-size), e2m3 (earnings momentumprice momentum) (1.1% per month). this shows that conditional bivariate investment strategies provide higher risk adjusted returns than independent bivariate and univariate strategies. table 1. unadjusted and risk adjusted returns on univariate, independent bivariate and conditional bivariate strategies. panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 w s1 0.027 3.437 0.020 5.634 0.801 0.007 3.574 0.951 0.007 3.628 0.951 0.007 3.530 0.951 s5 0.005 0.800 -0.001 -1.424 0.978 w v1 0.015 1.584 0.006 1.548 0.821 v5 0.013 2.326 0.007 3.744 0.866 0.004 2.483 0.940 0.004 2.356 0.940 0.004 2.421 0.940 m1 0.014 1.710 0.007 1.756 0.795 w m5 0.019 2.698 0.012 4.291 0.832 0.006 2.336 0.872 0.003 1.914 0.956 w l1 0.022 3.719 0.017 6.073 0.787 0.008 3.829 0.899 0.008 3.964 0.899 0.008 3.714 0.899 l5 0.006 0.729 -0.002 -0.773 0.902 e1 0.013 1.660 0.005 1.882 0.857 w e5 0.018 2.558 0.011 5.770 0.926 0.007 3.823 0.942 0.007 3.623 0.942 0.007 3.752 0.946 p1 0.013 1.666 0.006 2.219 0.902 -0.001 -0.449 0.951 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 12 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 w p5 0.017 2.545 0.010 4.693 0.887 0.005 2.655 0.914 0.005 2.634 0.913 0.004 3.024 0.958 panel b—independent bivariate, 2x3 unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 s2v3 0.010 1.664 0.004 2.311 0.912 0.003 2.113 0.946 0.003 2.220 0.946 0.003 2.043 0.946 w s1v1 0.018 2.057 0.010 2.597 0.810 -0.001 -0.798 0.978 w s1m3 0.022 3.046 0.012 3.354 0.799 0.005 2.062 0.908 0.003 1.486 0.934 s2m1 0.008 1.000 0.001 0.166 0.829 w s1l1 0.022 3.324 0.016 5.446 0.806 0.005 2.823 0.934 0.006 3.080 0.935 0.005 2.703 0.934 s2l3 0.005 0.648 -0.002 -1.290 0.935 w s1e3 0.022 3.087 0.015 5.123 0.824 0.006 2.480 0.915 0.006 2.550 0.915 0.005 2.339 0.920 s2e1 0.005 0.717 -0.002 -0.972 0.925 w s1p3 0.020 2.965 0.014 4.541 0.798 0.004 1.804 0.905 s2p1 0.006 0.752 -0.002 -0.783 0.917 w v1m3 0.017 2.014 0.009 2.722 0.845 0.002 0.773 0.891 v2m1 0.009 1.288 0.003 0.819 0.782 w v1l1 0.022 2.868 0.015 4.450 0.809 0.005 1.990 0.908 0.006 2.278 0.911 0.005 1.890 0.908 v2l3 0.008 1.279 0.002 1.046 0.919 w v1e3 0.018 2.175 0.010 3.290 0.862 0.005 2.239 0.928 0.005 2.325 0.927 0.005 2.103 0.928 v2e1 0.013 1.969 0.006 3.093 0.896 0.001 0.733 0.926 m1p1 0.013 1.543 0.005 1.598 0.863 w m2p3 0.015 2.517 0.010 4.330 0.871 0.005 2.552 0.893 0.003 2.064 0.937 0.005 2.434 0.916 m1e1 0.011 1.434 0.004 1.224 0.834 w m2e3 0.018 2.715 0.011 5.095 0.882 0.007 3.307 0.909 0.005 2.969 0.940 0.006 3.173 0.916 p1e1 0.012 1.529 0.004 1.624 0.876 w p2e3 0.018 2.851 0.012 5.720 0.892 0.007 3.771 0.917 0.007 3.607 0.917 0.007 3.804 0.930 w l1p3 0.019 3.121 0.013 5.334 0.832 0.006 2.990 0.909 0.006 3.137 0.902 0.005 3.029 0.926 l2p1 0.011 1.260 0.003 0.875 0.883 w l1m3 0.021 3.220 0.015 5.264 0.811 0.008 3.132 0.882 0.006 2.730 0.913 0.007 3.035 0.888 l2m1 0.010 1.244 0.003 0.750 0.824 w v1p3 0.016 1.865 0.008 2.096 0.795 0.002 0.794 0.904 v2p1 0.011 1.587 0.005 1.739 0.868 w l1e3 0.022 3.393 0.016 6.311 0.850 0.010 4.477 0.904 0.010 4.439 0.903 0.009 4.394 0.909 l2e1 0.009 1.166 0.002 0.586 0.869 independent bivariate, 3x2 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 13 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 s3v2 0.007 1.215 0.001 0.923 0.942 w s1v1 0.023 2.711 0.015 4.066 0.807 0.003 1.764 0.966 w s1m2 0.026 3.621 0.020 6.025 0.799 0.009 3.683 0.913 0.007 3.343 0.932 0.008 3.645 0.918 s3m1 0.006 0.866 -0.001 -0.359 0.909 w s1l1 0.025 3.568 0.018 6.422 0.833 0.007 4.687 0.958 0.007 4.813 0.958 0.007 4.599 0.960 s3l2 0.006 0.818 -0.022 -1.196 0.975 w s1e2 0.026 3.667 0.020 6.386 0.817 0.009 4.263 0.925 0.009 4.269 0.925 0.009 4.151 0.930 s3e1 0.004 0.586 -0.003 -1.948 0.955 w s1p2 0.025 3.505 0.019 5.754 0.799 0.007 3.407 0.923 0.008 3.569 0.924 0.007 3.375 0.934 s3p1 0.005 0.737 -0.002 -1.083 0.944 w v1p2 0.013 1.403 0.005 1.069 0.786 v3p1 0.013 1.847 0.006 2.376 0.857 0.001 0.288 0.906 m1p1 0.014 1.735 0.007 1.932 0.828 w m3p2 0.017 2.650 0.011 4.529 0.860 0.007 2.880 0.884 0.005 2.563 0.941 0.006 2.745 0.896 w l1m2 0.019 3.160 0.014 4.773 0.778 0.006 2.586 0.873 0.005 2.165 0.889 0.006 2.472 0.877 l3m1 0.007 0.779 -0.001 -0.432 0.854 w v1m2 0.016 0.178 0.007 2.131 0.847 0.002 0.691 0.909 v3m1 0.011 1.588 0.005 1.504 0.802 w v1l1 0.021 2.538 0.013 4.025 0.844 0.004 1.776 0.929 v3l2 0.008 1.388 0.003 1.298 0.895 w v1e2 0.017 1.942 0.008 2.603 0.854 0.004 1.721 0.942 v3e1 0.010 1.655 0.004 2.110 0.895 0.000 -0.104 0.927 w l1e2 0.022 3.629 0.017 6.230 0.813 0.009 4.316 0.894 0.010 4.376 0.894 0.009 4.205 0.898 l3e1 0.006 0.745 -0.002 -0.604 0.877 p1e1 0.012 1.513 0.004 1.662 0.892 w p3e2 0.017 2.734 0.011 4.984 0.873 0.006 3.028 0.899 0.006 2.885 0.899 0.005 3.050 0.924 m1e1 0.013 1.540 0.005 1.401 0.803 w m3e2 0.018 2.724 0.012 4.723 0.868 0.006 2.866 0.898 0.004 2.436 0.932 0.006 2.730 0.904 w l1p2 0.022 3.567 0.016 6.076 0.812 0.009 4.179 0.900 0.009 4.379 0.901 0.008 4.253 0.916 l3p1 0.007 0.811 -0.001 -0.488 0.897 panel c-conditional bivariate, 2x3 unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 14 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 w e1s1 0.021 2.645 0.014 3.678 0.777 0.002 0.845 0.908 e1s3 0.004 0.609 -0.003 -1.258 0.915 w e2s1 0.025 3.605 0.019 5.800 0.785 0.009 3.481 0.875 0.009 3.441 0.874 0.009 3.353 0.880 e2s3 0.007 1.150 0.001 0.591 0.918 w m1s1 0.019 2.392 0.012 3.082 0.766 0.001 0.228 0.896 m1s3 0.005 0.721 -0.002 -0.626 0.866 w m2s1 0.027 3.890 0.021 5.981 0.750 0.011 3.753 0.842 0.010 3.407 0.866 0.011 3.658 0.846 m2s3 0.008 1.193 0.001 0.675 0.882 s1m1 0.020 2.421 0.012 3.304 0.792 0.001 0.485 0.928 w s1m3 0.023 3.185 0.016 5.176 0.810 0.006 2.562 0.910 0.004 2.068 0.935 0.006 2.455 0.912 s2m1 0.007 0.976 0.000 0.101 0.835 w s2m3 0.009 1.398 0.003 1.296 0.890 e1m1 0.010 1.210 0.003 0.643 0.753 w e2m3 0.021 3.196 0.015 4.988 0.791 0.011 3.722 0.820 0.009 3.397 0.862 0.011 3.590 0.825 w l1s1 0.027 3.640 0.020 6.058 0.799 0.007 3.869 0.940 0.008 3.938 0.939 0.008 3.809 0.939 l2s3 0.005 0.836 -0.001 -1.062 0.973 w s1l1 0.023 3.701 0.017 5.736 0.762 0.007 3.323 0.911 0.007 3.397 0.911 0.006 3.192 0.913 s2l3 0.005 0.618 -0.003 -1.252 0.918 m1e1 0.009 1.093 0.001 0.395 0.811 w m2e3 0.020 2.920 0.013 4.977 0.843 0.010 3.571 0.861 0.008 3.213 0.880 0.009 3.450 0.863 s1e1 0.019 2.475 0.012 2.342 0.780 0.002 0.837 0.897 w s1e3 0.023 3.230 0.017 5.472 0.825 0.008 3.125 0.893 0.008 3.112 0.892 0.008 3.023 0.896 s2e1 0.005 0.668 -0.002 -0.921 0.895 w s2e3 0.001 1.667 0.005 2.321 0.912 0.005 2.573 0.912 0.005 2.546 0.911 0.005 2.500 0.911 w e1l1 0.016 2.414 0.010 3.231 0.784 0.002 0.710 0.854 e1l3 0.004 0.573 -0.003 -0.971 0.854 w e2l1 0.023 3.873 0.018 6.125 0.765 0.011 4.338 0.851 0.011 4.330 0.850 0.010 4.231 0.855 e2l3 0.010 1.372 0.003 1.217 0.887 w m1l1 0.017 2.338 0.011 3.145 0.780 0.003 0.822 0.840 m1l3 0.004 0.508 -0.003 -1.050 0.837 w m2l1 0.020 3.463 0.015 4.984 0.732 0.008 3.110 0.810 0.007 2.732 0.836 0.008 3.004 0.814 m2l3 0.012 1.552 0.004 1.564 0.849 l1m1 0.017 2.215 0.010 3.097 0.830 0.002 0.662 0.887 w l1m3 0.022 3.430 0.016 5.827 0.815 0.009 3.773 0.879 0.007 3.474 0.912 0.009 3.698 0.887 l2m1 0.009 1.105 0.002 0.420 0.819 w l2m3 0.010 1.359 0.003 1.164 0.884 l1e1 0.015 2.202 0.009 3.235 0.849 0.001 0.416 0.917 w l1e3 0.022 3.346 0.016 6.409 0.861 0.009 4.553 0.912 0.009 4.475 0.911 0.009 4.458 0.916 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 15 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 l2e1 0.009 1.203 0.002 0.686 0.865 w l2e3 0.012 1.625 0.005 2.237 0.917 0.002 1.028 0.934 w e1v1 0.011 1.242 0.003 0.719 0.779 e1v3 0.011 1.792 0.005 2.327 0.872 0.001 0.637 0.898 w e2v1 0.018 2.125 0.009 3.020 0.848 0.005 1.990 0.922 0.005 1.975 0.922 0.005 1.880 0.922 e2v3 0.017 3.025 0.012 4.365 0.763 0.008 3.572 0.857 0.008 3.379 0.858 0.008 3.460 0.860 w m1v1 0.011 1.250 0.003 0.726 0.759 m1v3 0.010 1.512 0.004 1.324 0.796 w m2v1 0.017 2.060 0.009 2.804 0.841 0.005 1.535 0.806 m2v3 0.016 2.742 0.011 3.838 0.771 0.007 2.950 0.853 0.005 2.525 0.896 0.007 2.874 0.854 w s1v1 0.018 2.052 0.010 2.530 0.799 0.000 0.044 0.937 s2v3 0.009 1.552 0.003 1.625 0.834 w l1v1 0.022 2.736 0.014 4.699 0.856 0.005 2.510 0.936 0.006 2.658 0.936 0.005 2.391 0.937 l2v3 0.008 1.374 0.002 1.410 0.922 v1e1 0.010 1.312 0.003 0.889 0.804 w v1e3 0.017 2.131 0.010 3.112 0.856 0.006 2.238 0.913 0.006 2.167 0.913 0.005 2.121 0.913 v2e1 0.012 2.003 0.006 2.980 0.878 0.003 1.380 0.894 w v2e3 0.016 2.595 0.010 3.932 0.821 0.006 2.797 0.887 0.006 2.772 0.886 0.006 2.732 0.892 v1m1 0.013 1.550 0.005 1.376 0.781 w v1m3 0.018 2.235 0.011 3.263 0.843 0.006 2.016 0.877 0.004 1.475 0.904 v2m1 0.019 1.469 0.004 1.275 0.820 w v2m3 0.019 3.057 0.013 4.253 0.740 0.009 3.178 0.808 0.007 2.796 0.865 0.009 3.116 0.811 w v1s1 0.023 2.737 0.015 3.767 0.762 0.003 1.270 0.903 v2s3 0.006 1.012 0.000 0.132 0.903 w v1l1 0.020 2.734 0.013 4.160 0.811 0.005 1.825 0.884 v2l3 0.009 1.415 0.003 1.344 0.880 p1e1 0.012 1.539 0.005 1.548 0.853 w p2e3 0.018 0.740 0.012 4.675 0.854 0.008 2.979 0.875 0.007 2.830 0.875 0.007 2.980 0.888 p1m1 0.012 1.441 0.004 1.208 0.820 w p2m3 0.019 2.898 0.013 4.322 0.789 0.010 3.188 0.805 0.007 2.848 0.876 0.009 3.055 0.817 w p1l1 0.015 2.231 0.009 2.779 0.772 0.001 0.323 0.838 p1l3 0.006 0.705 0.000 0.000 0.888 w p2l1 0.022 3.720 0.016 5.870 0.771 0.010 4.001 0.849 0.010 4.040 0.849 0.010 4.025 0.868 p2l3 0.008 1.173 0.002 0.585 0.834 w p1s1 0.023 2.874 0.016 4.225 0.784 0.005 1.687 0.898 p2s3 0.007 1.146 0.001 0.572 0.912 p1s3 0.005 0.677 0.000 -1.037 0.917 w p2s1 0.024 3.475 0.018 5.363 0.770 0.008 2.968 0.870 0.008 3.037 0.870 0.007 2.947 0.886 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 16 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 l1p1 0.017 2.294 0.010 3.606 0.862 0.002 0.968 0.914 w l1p3 0.020 3.327 0.015 5.944 0.840 0.008 3.749 0.907 0.008 3.945 0.908 0.007 3.805 0.925 l2p1 0.011 1.231 0.002 0.787 0.882 w l2p3 0.011 1.565 0.004 1.949 0.909 s1p1 0.020 2.473 0.012 3.723 0.830 0.003 1.200 0.905 w s1p3 0.021 3.167 0.015 4.739 0.772 0.006 2.353 0.856 0.006 2.300 0.855 0.006 2.270 0.880 s2p1 0.006 0.763 0.000 -0.646 0.899 w s2p3 0.010 1.647 0.004 2.068 0.892 0.005 2.084 0.891 0.004 1.945 0.890 e1p1 0.011 1.420 0.004 1.268 0.863 w e2p3 0.017 2.846 0.012 4.352 0.805 0.008 2.855 0.832 0.007 2.860 0.833 0.007 2.854 0.871 m1p1 0.012 1.398 0.004 1.135 0.835 w m2p3 0.018 2.911 0.012 4.619 0.816 0.009 3.378 0.832 0.007 3.008 0.873 0.008 3.305 0.854 w p1v1 0.015 1.662 0.006 1.768 0.831 p1v3 0.011 1.696 0.005 1.905 0.843 w p2v1 0.013 1.534 0.005 1.339 0.780 p2v3 0.015 2.781 0.010 4.303 0.815 0.007 3.599 0.892 -0.318 -8.204 0.891 v1p1 0.015 1.756 0.007 2.198 0.867 0.001 0.327 0.949 w v1p3 0.015 1.775 0.007 2.002 0.822 0.001 0.395 0.925 v2p1 0.010 1.458 0.002 1.415 0.875 w v2p3 0.016 2.861 0.011 4.979 0.853 0.007 3.735 0.915 0.007 3.661 0.914 0.006 3.991 0.942 conditional bivariate, 3x2 unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 s1e1 0.021 2.597 0.014 3.725 0.951 0.001 0.524 0.951 w s1e2 0.026 3.579 0.019 6.318 0.825 0.008 4.180 0.935 0.008 4.183 0.935 -0.014 -0.402 0.935 s3e1 0.004 0.607 0.000 -1.770 0.952 w s3e2 0.021 2.597 0.013 3.725 0.797 0.001 0.524 0.951 w e1s1 0.019 2.370 0.012 3.272 0.804 0.000 0.290 0.943 e1s2 0.005 0.720 0.000 -0.949 0.924 w e3s1 0.022 3.120 0.016 5.440 0.840 0.007 2.949 0.918 0.006 2.940 0.927 0.006 2.820 0.925 e3s2 0.011 1.769 0.005 3.286 0.945 0.005 3.135 0.944 0.005 3.123 0.943 0.005 3.048 0.944 w s1l1 0.026 3.752 0.020 5.845 0.763 0.007 3.450 0.917 0.008 3.622 0.918 0.007 3.328 0.918 s3l2 0.004 0.539 -0.003 -0.915 0.944 l1e1 0.017 2.535 0.011 3.669 0.807 0.002 0.759 0.896 w l1e2 0.022 3.470 0.016 5.860 0.812 0.008 3.872 0.898 0.008 3.963 0.898 0.008 3.761 0.903 l3e1 0.006 0.760 -0.001 -0.536 0.870 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 17 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 w l3e2 0.009 1.139 0.001 0.540 0.907 w e1l1 0.015 2.199 0.009 3.245 0.852 0.000 0.387 0.924 e1l2 0.008 1.089 0.000 0.375 0.866 w e3l1 0.022 3.450 0.016 6.324 0.843 0.010 4.455 0.899 0.010 4.492 0.899 0.010 4.379 0.903 e3l2 0.012 1.642 0.005 2.351 0.915 0.002 0.979 0.934 w l1s1 0.024 3.382 0.018 5.276 0.781 0.006 2.560 0.922 0.006 2.901 0.926 0.005 2.480 0.922 l3s2 0.002 0.345 -0.004 -2.852 0.949 e1m1 0.012 1.442 0.004 1.213 0.822 w e3m2 0.018 2.699 0.012 4.939 0.876 0.007 3.240 0.907 0.005 2.890 0.938 0.007 3.103 0.913 s1m1 0.021 2.569 0.014 3.669 0.798 0.001 0.670 0.946 w s1m2 0.026 3.590 0.020 6.015 0.803 0.008 3.683 0.923 0.007 3.331 0.936 0.008 3.603 0.926 s3m1 0.006 0.820 0.000 0.000 0.913 w s3m2 0.006 0.932 -0.003 -0.156 0.916 l1m1 0.019 2.653 0.012 3.875 0.800 0.004 1.351 0.872 w l1m2 0.020 3.288 0.004 1.351 0.872 l3m1 0.006 0.661 -0.002 -0.680 0.839 w l3m2 0.009 1.244 0.002 0.828 0.885 m1e1 0.013 1.604 0.006 1.535 0.799 w m3e2 0.018 2.700 0.012 4.718 0.863 0.007 3.001 0.895 0.005 2.595 0.929 0.007 2.870 0.900 w m1l1 0.018 2.331 0.011 3.358 0.827 0.003 1.102 0.890 m1l2 0.010 1.212 0.002 0.664 0.804 w m3l1 0.021 3.242 0.015 5.348 0.813 0.008 3.257 0.881 0.006 2.870 0.913 0.007 3.170 0.889 m3l2 0.011 1.462 0.004 1.404 0.870 w m1s1 0.020 2.411 0.012 3.770 0.806 0.001 0.631 0.930 m1s2 0.008 1.020 0.000 0.212 0.833 w m3s1 0.023 3.210 0.016 5.110 0.799 0.006 2.520 0.899 0.004 2.023 0.927 0.006 2.422 0.903 m3s2 0.009 1.320 0.002 1.040 0.881 w l1v1 0.021 2.890 0.014 4.715 0.828 0.005 2.085 0.914 0.005 2.346 0.916 0.005 2.032 0.915 l3v2 0.008 1.121 0.000 0.503 0.926 v1e1 0.011 1.200 0.003 0.639 0.810 w v1e2 0.016 1.957 0.008 2.704 0.862 0.004 1.991 0.952 0.004 1.957 0.952 v3e1 0.001 1.648 0.004 2.116 0.897 -0.001 -0.311 0.940 w v3e2 0.017 2.867 0.011 4.562 0.820 0.007 3.678 0.910 0.007 3.560 0.910 0.007 3.558 0.912 w e1v1 0.011 1.240 0.003 0.728 0.803 e1v2 0.013 1.983 0.007 3.196 0.900 0.002 1.118 0.921 w e3v1 0.017 2.212 0.010 3.620 0.881 0.005 2.326 0.930 0.006 2.471 0.931 0.005 2.208 0.932 e3v2 0.017 2.790 0.011 4.440 0.826 0.006 3.516 0.913 0.006 3.342 0.913 0.006 3.413 0.920 m1v2 0.011 1.515 0.004 1.393 0.814 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 18 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 w m1v1 0.016 1.850 0.008 2.035 0.787 0.001 0.365 0.931 w m3v1 0.018 2.195 0.010 3.255 0.853 0.004 1.275 0.898 m3v2 0.014 2.432 0.009 3.231 0.777 0.004 1.798 0.864 w s1v1 0.024 2.870 0.016 4.292 0.793 0.003 1.739 0.957 s3v2 0.005 0.676 -0.002 -1.503 0.954 m1p1 0.013 1.603 0.006 1.161 0.827 w m3p2 0.017 2.624 0.011 4.420 0.857 0.007 2.940 0.878 0.005 2.640 0.939 0.007 2.798 0.890 s1p1 0.023 2.784 0.015 4.440 0.827 0.003 1.594 0.951 w s1p2 0.025 3.408 0.018 5.593 0.803 0.006 3.233 0.936 0.007 3.472 0.937 0.006 3.204 0.943 s3p1 0.004 0.552 -0.003 -1.830 0.943 w s3p2 0.008 1.309 0.002 1.492 0.957 l1p1 0.016 2.367 0.010 3.263 0.804 0.005 0.211 0.895 w l1p2 0.022 3.707 0.010 4.500 0.890 0.010 4.689 0.891 0.009 4.605 0.907 0.009 4.606 0.908 l3p1 0.006 0.717 -0.002 -0.706 0.893 w l3p2 0.009 1.246 0.002 0.805 0.868 p1e1 0.014 1.670 0.006 2.205 0.878 0.000 -0.225 0.934 w p3e2 0.018 2.817 0.012 5.570 0.890 0.008 3.725 0.912 0.007 3.560 0.912 0.007 3.770 0.927 v1m1 0.014 1.570 0.006 1.481 0.808 w v1m2 0.014 1.558 0.005 1.620 0.858 v3m1 0.012 1.932 0.006 2.512 0.845 0.002 0.825 0.880 w v3m2 0.015 2.487 0.009 3.423 0.789 0.005 2.098 0.880 0.003 1.493 0.923 w v1s1 0.020 2.132 0.011 2.751 0.807 0.000 -0.565 0.972 v3s2 0.009 1.462 0.003 1.591 0.906 w v1l1 0.019 2.248 0.011 3.260 0.840 0.002 0.987 0.956 v3l2 0.009 1.572 0.004 1.962 0.908 0.001 0.719 0.947 e1p1 0.011 1.421 0.004 1.339 0.947 w e3p2 0.018 2.876 0.012 5.306 0.870 0.007 3.409 0.895 0.007 3.219 0.895 0.007 3.431 0.914 p1m1 0.015 1.720 0.007 2.049 0.859 0.001 0.452 0.926 w p3m2 0.016 2.538 0.010 4.295 0.864 0.006 2.681 0.890 0.004 2.239 0.935 0.005 2.547 0.904 w p1s1 0.021 2.561 0.014 4.090 0.844 0.003 1.365 0.938 p1s2 0.080 1.061 0.005 3.323 0.942 0.004 2.807 0.942 0.004 2.795 0.942 0.004 2.780 0.957 w p3s1 0.020 3.005 0.014 4.090 0.844 0.003 1.365 0.938 p3s2 0.011 1.795 0.005 3.323 0.942 0.004 2.807 0.942 0.004 2.795 0.942 0.004 2.780 0.957 w p1l1 0.019 2.520 0.012 4.035 0.848 0.004 1.673 0.895 p3l2 0.011 1.549 0.004 1.925 0.912 p1l2 0.011 1.253 0.003 0.831 0.873 w p3l1 0.021 3.414 0.015 6.051 0.902 0.008 3.927 0.902 0.008 4.048 0.902 0.007 4.003 0.920 w p1v1 0.017 1.880 0.008 2.423 0.851 0.002 1.005 0.950 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 19 panel a--univariate unadjusted capm fama french-3 factor carhart fama french-5 factor p # i.s.* mean return t-stat α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 α t-stat adj-r2 p1v2 0.013 1.726 0.006 2.088 0.863 0.005 0.196 0.886 w p3v1 0.016 2.074 0.009 2.963 0.856 0.003 0.120 0.920 p3v2 0.015 2.874 0.010 4.984 0.815 0.007 4.158 0.914 0.007 4.117 0.913 0.006 4.296 0.935 v1p1 0.015 1.729 0.007 2.089 0.862 0.001 0.379 0.961 w v1p2 0.012 1.393 0.004 1.054 0.791 v3p1 0.013 1.924 0.006 2.645 0.866 0.001 0.383 0.924 w v3p2 0.014 2.709 0.009 4.589 0.853 0.006 3.797 0.924 0.006 3.706 0.924 0.005 3.910 0.943 #column 1 named ‘p’ shows the portfolios where ‘w’ represents the ‘winner’ portfolios as per the trends identified by the authors from studying the univariate attributes. *column 2 named ‘i.s.’ indicates the investment strategies 6. conclusions in this paper, we try to identify profitable investment styles on the indian stock market by using various combinations of important asset pricing anomalies. using nse 200 stocks, three different investment styles, i.e.univariate, independent bivariate and conditional bivariate are created with the following attributes-size, value, volume, profitability, earnings surprises and prior returns. we start with the best performing univariate investment style and then augment it with attributes to explore the possibility of an improvement in returns. the results indicate that on an absolute return basis bivariate strategies do not outperform univariate strategies. the highest unadjusted returns of 2.7% per month is obtained from employing s1 (small size sorted strategy) on a standalone basis as well as bivariate m2s1(price momentum-size) and l1s1(liquidity-size). employing risk models, we find that the unifactor capm can explain returns only in 42% of the investment strategies. the size and value factors of the fama &french(1993) model perform better as they explain 42% of the alphas. however, additional momentum factor (carhart, 1997) and profitability, investment factors (fama &french, 2015) do not have any incremental power in explaining the alphas. hence, we suggest the three factor ff model as the benchmark for evaluating investment strategies in the indian context. in sum, the highest risk adjusted returns are obtained from constructing the conditional bivariate investment strategies viz. e2l1 (earnings momentum-liquidity), m2s1 (price momentum-size), e2m3 (earnings momentum-price momentum). (1.1% per month). this means that these unexplained strategies hold a potential for supernormal returns. results obtained in this paper have significant policy implications and are of immense value to portfolio managers, market regulator and other stakeholders. portfolio managers and asset management companies who are in pursuit of earning supernormal returns, could use this information on designing portfolios from top 200 stocks by combining company attributes. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 20 short selling restrictions exist in the indian stock market. however, in view of the low returns on the short side portfolio (losers), such restrictions should be relaxed to facilitate execution of long-short strategy given their low implicit financing cost. thus, a policy recommendation to the market regulator is to withdraw short selling restrictions. on the other hand, presence of significantly positive alphas even at the multifactor risk models stage implies violations of the efficient market hypothesis. thus, strengthening corporate governance standards, better corporate disclosures and investor education would help in making markets informationally efficient. in addition, from a research perspective the unexplained alphas prompt a search for new risk factors or a behavioral justification. the paper contributes to the literature on market efficiency and style based trading strategies for the indian stock market. notes 1. nse200 market cap as percentage of total market cap=82% as of june, 2016 2. net stock issues have not provided anomalous returns in the indian stock market (sehgal et al, 2012). 3. in the contrarian strategy, returns from previous 48 months have been used for formation of portfolios, 6 months is the holding period. in case of contrarian portfolios, the middle number of 12 months implies the period which is skipped between portfolio holding and portfolio formation periods, in order to control for short term momentum patterns in stock returns (see fama and french, 1996). 4. an inverse relationship between returns and investment was obtained. 5. monthly average unadjusted returns on contrarian strategy, p1 = 0.013(t-stat=1.76), p5 = 0.018(t-stat=2.36). references amihud, y., & mendelson, h. 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(2012). do momentum strategy generate profits in emerging stock markets?. problems and perspectives in management, 10(3), 9-22. microsoft word 11937-43911-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 161 resourcing the internal audit function: how effective is the audit committee? ng shir li (corresponding author) lecturer, department of accounting, sunway university business school 47500 subang jaya, selangor, malaysia e-mail: shirlin@sunway.edu.my dennis w taylor professor, school of accounting, rmit university 3000 melbourne, victoria, australia e-mail: dennis.taylor@rmit.edu.au received: july 3, 2017 accepted: oct. 30, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11937 url: https://doi.org/10.5296/ajfa.v9i2.11937 abstract the aim of this study is to investigate the extent to which an audit committee (ac)’s own governance characteristics impact on its role effectiveness in achieving enhanced resourcing and by extension, improved the scope and quality of the internal audit function (iaf). sample is drawn from top 300 companies listed on the australian stock exchange (asx). this study combines data from a questionnaire administered to the internal audit executive (iae) with information from annual reports and financial databases. hypotheses are developed and tested using multiple regression analysis. this analysis is supplemented by insights from a comparative case study for two companies in the sample. results reveal that ac size is significantly positively related to the financial resources (budget) allocated to iaf, while both ac financial expertise and ac size are significantly positively related to iaf labour hours. results also confirm that iaf’s with higher resourcing are able to concentrate those resources on areas expected of a high quality iaf. further, comparative case study analysis gives insights to the superior ways a larger size ac can be effective in fulfilling its oversight role, building its working relationships and obtaining resources for the iaf. study asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 162 contributes to current auditing-related governance literature by introducing a comprehensive empirical model of ac effectiveness in facilitating the scope and quality of the iaf’s work. also, the findings have implications for regulators and the institute of internal auditors (iia) in terms of the composition and functioning of acs. keywords: audit committee, internal audit function, corporate governance, audit committee effectiveness, audit committee characteristics asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 163 1. introduction the role of audit committees (acs) has broadened since the corporate governance reforms of the mid-2000s and the subsequent risk excesses exposed by the global financial crisis. prior to the mid-2000s, the focus of acs was predominantly on vetting the company’s financial reporting compliance and overseeing the external auditors. since then, the role of acs has extended into a more comprehensive oversight of internal control and risk management systems. an ac is now expected to play a key role in assisting the board to fulfil its corporate governance and oversight responsibilities in relation to risk management, control, and governance processes (aldamen et al, 2012). this direction of role expansion of acs brings their work more fully into the field of the internal audit function (iaf). the iaf is clearly central to the ac’s expanded role because, according to institute of internal auditors (2004), the responsibility of internal auditing is to evaluate and provide reasonable assurance such that risk management, controls, and governance systems are functioning as intended. while existing corporate governance regulations do not address the interaction between the ac and the iaf, the tradition in most companies has been that the internal audit executive (iae) reports to either the chief financial officer (cfo) or the chief risk officer (cro) (deloitte, 2013). however, today the iae usually reports directly to the ac, or the ac will have a role in hiring, firing, evaluating and compensating the iae (deloitte, 2015). the ac’s increasing role with regard to internal auditing is being undertaken to help ensure the iae’s independence and adequate resourcing of the iaf (iia research foundation, 2003). previous studies in australia on relationships between the ac and the iaf (cooper, 1993; goodwin, 2003; goodwin & kent, 2006; singh & newby, 2010) have been conducted on data from the years before the refinement of corporate governance guidelines, especially before the implementation of the australian stock exchange corporate governance council (asx cgc) revised 2007 edition. thus, this study seeks to update the evidence in the research literature on the effectiveness of acs in fulfilling their expanded role in the area of the iaf. moreover, previous studies on the interface between the ac and the iaf have mainly been from the perspective of the iaf. for example, gwilliam and kilcommins (1998) investigate how the independence of the iaf is enhanced by support from the ac, scarbrough et al (1998) address the issue of iae having good communications with the ac, and goodwin (2003) investigates how the iaf facilitates the responsibilities of the ac. therefore, there is a dearth of research that has examined the relationship between the iaf and the ac from the viewpoint of the ac. complexity in the relationship between the ac and the iaf stems from the multiple demands on their roles. both the ac and the iaf are expected to perform a monitoring role and also an advisory role. the ac monitors the iaf (and other functions) and advises the board, whereas the iaf monitors the company’s systems and processes and advises management and the ac. overlaying these roles in the corporate governance fabric are the key issue of independence. in corporate governance, independence is important in three fundamental contexts. these are that external auditors are independent of their clients; that internal auditors are independent of the colleagues they are auditing; and that non-executive directors have a degree of independence from their executive colleagues on a board. the independence of the ac and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 164 the iaf respectively can be conflicted by their need to simultaneously play a monitoring and advisory role. strong resourcing of the iaf, both in the iaf’s budget allocation and labour hours would be a prerequisite for enhancing the scope and quality of the iaf’s monitoring and advisory activities. the extent of influence of the ac over management in the resourcing of the iaf would also be a factor in maintenance the iaf’s independence from management. this ac role of overseeing the resourcing of the iaf could be carried out through the ac exercising either greater advocacy or greater authority in obtaining improved company budget allocation for the iaf and higher labour hours devoted to the iaf. in this study, the focus is on the ac’s effectiveness in fulfilling its critical modern-day role of overseeing and supporting the resourcing of the iaf. the concept of ac effectiveness has been benchmarked in prior corporate governance studies against the ac’s own structure and members’ governance characteristics. these good governance characteristics of the ac and its members include independence, financial and industry expertise, frequency of meetings, size of the committee, and the existence of an ac charter (kalbers & fogarty, 1993; goodwin & yeo, 2001; dezoort et al, 2002; carcello et al, 2002; abbott et al, 2003; carcello et al, 2005; lary & taylor, 2012). the inference is that the effectiveness of an ac in fulfilling its combined monitoring, advisory and independence roles will be reflected in the strength of its own good governance characteristics. as argued by dezoort and salterio (2001), the effectiveness of an ac is likely to be embodied in its members’ collective characteristics of being competent, inquisitive and decisive. thus, this leads to the primary objective of this study: to investigate the extent to which an ac’s own governance characteristics impact on its role effectiveness in achieving enhanced resourcing for the iaf. the reminder of this paper is structured as follows. section 2 provides a discussion on the literature review. this is followed by formulation of hypothesis of this study. section 4 describes the research method used, with section 5 providing data analysis and discussion. further, section 6 provides a comparative case study analysis for two companies in the sample. section 7 concludes by summarizing the findings and discussing the implications of the results and future opportunities for this study. 2. literature review 2.1 audit committee and internal audit function previous studies have concluded that an effective ac can heighten the status of the iaf and at the same time, the iaf can help the ac in its oversight role (cooper, 1993; scarbrough et al, 1998; raghunandan et al, 1998; raghunandan et al, 2001; goodwin, 2003; abbott et al, 2003; carcello et al, 2005; abbott et al, 2010). in addressing the relationship between the ac and the iaf, studies such as scarbrough et al (1998) and raghunandan et al (2001) examine the association between ac composition and the committee’s interaction with internal auditing. both studies use the same method by surveying a sample of iaes in publicly held manufacturing companies. scarbrough et al (1998)’s study is performed in canada using a larger sample size while raghunandan et al (2001)’s united states study uses a smaller asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 165 sample. both consistently find that acs consisting of solely non-employee directors are more likely to have frequent meetings with the iae and review the internal auditing program. goodwin (2003) performs a similar study in australia and new zealand in which the separate influences of independence and financial expertise on ac relations with the iaf are investigated. goodwin (2003) finds independence and accounting experience have a complementary impact on ac relations with internal auditing. in a similar vein, raghunandan et al. (1998) analyses the perceived level of knowledge of acs. they find that acs granted private access to the iaes and reviewed both the plans and results of internal auditing are more likely to be perceived as knowledgeable. it is likely that acs having closer communication with the iaf and have better knowledge of the iaf activities will be more willing/able to achieve stronger resourcing for the iaf in the expectation of attaining high quality for the iaf. another perspective on the effect of the ac on resourcing of the iaf is given by abbott et al (2010). based on a survey of 134 iaes from fortune 1000 companies, they find that acs with greater iaf oversight are associated with a larger percentage of iaf hours being worked. their result infers that acs demanding strong internal controls, risk management and good governance compliance will tend to cause higher iaf effort (reflected in hours) on these areas of responsibility. 2.2 audit committee effectiveness the subjectivity of the notion of ac effectiveness and its multi-facetted nature means that a more indirect measure of ac effectiveness based on objective and publicly available data have been taken. previous literature has adopted different proxies to determine the effectiveness of acs in their monitoring roles. dezoort et al (2002) characterize the effectiveness of ac as having qualified members with the authority and resources to protect stakeholders’ interests by ensuring reliable financial reporting, internal controls, and risk management through its diligent oversight efforts. similarly, kalbers and fogarty (1993) define ac effectiveness as the competency of ac to undertake specified oversight responsibilities in the company. specific focus has also been given to ac effectiveness in overseeing and supporting the iaf. carcello et al (2005) conceive ac effectiveness as an ability to oversee the iaf’s activities which are measured by total internal audit budget. alternatively, goodwin and yeo (2001) assess the effectiveness of ac as an ability to maintain iaf independence whether in appearance or fact. as suggested by lary and taylor (2012), the effectiveness of australian acs can be benchmarked against their many roles and responsibilities. thus, drawing upon the recommendations in the australian asx corporate governance council (2007), it can be argued that for an ac to be effective, it must exhibit at least five characteristics. these five characteristics which are explained in turn below, can act as a suitable construct in testing the effect of ac effectiveness on the resourcing of the iaf in this study. 2.2.1 audit committee independence the independence of ac chair and members is deemed to be an important characteristic asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 166 enabling ac effectiveness. fama and jensen (1983) argue that independent ac members as outside directors may view the directorate as a means of enhancing their reputations as experts in monitoring and achieving quality from agents they monitor. according to asx corporate governance council (2007) recommendation 4.2, the ac should be structured so that it comprises only of non-executive directors, consists of a majority of independent directors and is chaired by an independent chair who is not the chair of the board. this recommendation is justified by the findings of previous studies which establish that ac independence is associated with the committee’s performance of its roles (abbott et al, 2000; beasley et al, 2000; carcello & neal, 2000; goodwin & yeo, 2001; klein, 2002; abbott et al, 2004). 2.2.2 audit committee expertise ac expertise is considered another key characteristic for the ac to effectively fulfil its roles. asx corporate governance council (2007) recommendation 4.3 states that an ac should include members who are all financially competent, at least one member should have relevant accounting or financial qualifications and also some members should have an understanding of the industry in which the entity operates. this would not only enable the ac to vet the financial statements, but also to understand and evaluate the financial resources needs of the iaf for achieving its scope and quality of work (munro & buckby, 2008). findings from earlier studies have shown that financial expertise is essential for ac members to perform their role well (raghunandan et al, 2001; dezoort & salterio, 2001; abbott et al, 2003; goodwin, 2003; xie et al, 2003; abbott et al, 2004; davidson et al, 2004). 2.2.3 audit committee frequency of meetings asx corporate governance council does not provide recommendations on the number of meetings that an ac should have each year. the number of ac meetings held each year may differ and should depend on the size and the risk of the business. evidence supports the significance of ac frequency of meetings (beasley et al, 2000; xie et al, 2003; abbott et al, 2004). beasley et al (2000) find that more frequent ac meetings is associated with less fraud. this and other results infer that acs that meet more frequently are more likely to be up to date about, and attentive to the company’s current auditing issues and auditing resourcing needs. 2.2.4 audit committee size ac size of membership is also important to the overall strength of the ac. felo et al (2003) posit that a larger ac increases financial reporting quality because it is more likely to discover and solve potential risks in the financial reporting process. furthermore, lin et al (2006) find that companies with acs comprising of at least four members are less likely to experience earnings restatements. dalton et al (1998) also find a positive association between ac size and the monitoring function of the board. based on these results, a larger ac is necessary for effective monitoring of the iaf and its resourcing needs. although asx corporate governance council (2007) recommendation 4.2 states that an ac should have at least three members, companies may choose to have more than three members. this study asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 167 uses the same argument that a larger size ac would have more diverse skills and knowledge to enhance its monitoring and advisory roles and potentially, its advocacy role in respect of the iaf’s resourcing determination. 2.2.5 audit committee charter an ac charter can provide effectiveness to the ac because it gives formality, and hence authority to the scope of the ac’s roles, responsibilities, powers and rights. according to asx corporate governance council (2007) recommendation 4.3, an ac should have a formal charter. kalbers and fogarty (1993) argue that the existence of a clear ac charter provides power for authoritative decision-making and enables the ac to achieve its oversight role more effectively. 3. hypothesis formulation as discussed, the responsibilities of the iaf have broadened and the oversight role of acs has expanded more fully into the field of the iaf in recent years. this field of the iaf covers responsibilities for evaluating and providing reasonable assurance so that risk management, internal control, and governance systems are functioning as intended. hence, an effective ac with a strong working relationship with the iaf can be helpful to the iaf in performing its responsibilities (scarbrough et al, 1998; institute of internal auditors, 2002a; institute of internal auditors, 2002b; institute of internal auditors, 2003b). this study’s primary aim is to investigate whether the effectiveness of an ac, benchmarked on its own governance characteristics is associated with the resourcing level of the iaf, both in funding and labour hours devoted to the iaf. it is argued that a more independent, diligent, expert and powerful ac will be more effective in communicating with and understanding the scope and quality of the iaf’s work and its resourcing needs. hence, an ac with an independent chair, more frequent meetings, a higher proportion of financially qualified and industry experienced members, a larger size of membership and a strong charter, will be more cognizant of and capable of advocating for the resourcing needs required by the iaf to fulfil its complex scope of responsibilities at a high level of quality. the following hypothesis is formulated: the ac’s mechanisms for role effectiveness based on its governance characteristics are positively related to (a) financial resources (budget) and (b) labour resources (hours) devoted to the iaf. 4. research methods 4.1 sample the sampling frame for this study is top 300 companies listed on the asx for the financial year ending in 30 june 2010. a total of 255 companies are drawn from the sampling frame on an elimination basis. company data for the financial year ending in 30 june 2010 is selected because the asx listing rules require top 300 listed companies to have an audit committee and comply with the recommendations of the asx corporate governance council’s asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 168 principles and recommendations on the composition, operation and responsibility of an ac (auditing & assurance standards board, australian institute of company directors, & institute of internal auditors australia, 2008). 4.2 questionnaire a questionnaire is developed and administered to iaes of the sampled companies. this method is considered appropriate because iae is likely to be knowledgeable about the company’s iaf and the operations of the ac (goodwin & yeo, 2001). the information sought from iae in the questionnaire is divided into four sections. section one relates to background of both the iae and the company. section two asks respondents about the iaf activities while section three seeks data on the relationship between the ac and the iaf. the fourth section asks respondents about the independence of the iaf. the questionnaire is pre-tested on four academics with familiarity in auditing and corporate governance research experience. it is also presented to the manager of research and publishing at the institute of internal auditors (iia) australia for review and approval before its distribution to iia members for pilot testing. 4.3 data collection there are two stages of data collection employed in this study. in the first stage, primary data is collected by mailing a questionnaire to iaes of sampled companies. the pilot test of the questionnaire is electronically sent by iia australia to a limited number of their members who are iaes in the top 300 asx listed companies. a total of 9 usable responses are received, yielding a response rate of only 15%. due to poor response rate, the questionnaire is administered directly to the iaes of top 300 asx listed companies. a total of 36 respondents are received, representing a response rate of 14%. compared to other studies’ response rates (carcello et al, 2005 (25%); christopher et al, 2009 (17%); abbott et al, 2010 (13%)), the response rate for this study is deemed fairly reasonable and may present a fair reflection of the view of the iaes. in the second stage of data collection, secondary data (i.e., financial, market data and text in the annual reports) is obtained from online databases. 4.4 variables and measurements the independent variables for this study are proxy measures of ac governance characteristics. first, ac chair independence (acchairind) is measured as a scale where scores are assigned to ac chair, chief executive officer (ceo) and chief financial officer (cfo) based on respective qualification and industry experience categories as shown in table 1. the numbers assigned to categories in table 1 are for purposes of determining the extent of matching/non-matching of the background of ac chair with the backgrounds of the ceo and the cfo. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 169 table 1. qualification, industry and category qualification category accounting and finance 1 engineering 2 law and arts 3 health and science 4 management and marketing 5 industry category mining and energy 1 banking, insurance, finance and law 2 service and retail 3 manufacturing 4 health 5 because there can be multiple qualifications and industry experiences in the background of any individual, the numbering scheme needs to ensure uniqueness of multiple backgrounds. this is achieved by adding a 0 to the category number if a single background category applies to an individual, and combining the digits if a multiple background applies. for example, if an ac chair has an accounting qualification, a score of 10 would be given as 1 for accounting and finance qualification category and 0 for no second qualification. scores for ac chair qualification, ac chair industry experience, ceo qualification, ceo industry experience, cfo qualification and cfo industry experience are each collected. subsequently, a new single numbered score is assigned if chair of ac matches or does not match one or more of the requirements: same qualifications to ceo and cfo and same industry experience to ceo and cfo. in the end, the scores will be totaled up. thus, the scale can range from 0 (i.e., chair of ac is very independent) to 4 (i.e., chair of ac is not independent) as shown in table 2. it can be argued that with different qualifications and industry experience between the chair of the ac, ceo and cfo, the chair of the ac can be viewed as independent from the management because he/she would have a different mindset and arguments relating to particular financial reporting and internal auditing issues in the company and it is not dominated by one individual. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 170 table 2. overview or total scores ac chair independence qualification industry experience chief executive officer (ceo) 1/0 1/0 chief financial officer (cfo) 1/0 1/0 total 4/0 is the maximum/minimum score for ac chair independence from both the ceo and cfo second, ac expertise is measured by two independent variables: accounting/financial expertise (acexp) and industry expertise (acindus). acexp is a ratio of number of ac members with accounting or financial qualification to total number of ac members while acindus is a ratio of number of ac members who has worked in the same industry as the company for a substantial number of years (at least 10 years) to total number of ac members. third, ac frequency of meetings (acmeet) is measured as the number of ac meetings held during the financial year. fourth, ac size (acsize) is measured as the number of members serving on the ac during the financial year (goodwin & kent, 2006; yatim et al, 2006; hoitash & hoitash, 2008; singh & newby, 2010). lastly, ac charter (acchar) is measured as a categorical variable, equal to the value of “1” if the ac has a charter and “0” otherwise. there are two dependent variables employed in this study. first, the iaf’s budget (iafbud) is measured as total annual iaf budget multiplied by full-time equivalent staff. total iaf budget is presented in categories and self-selected by the respondent in the questionnaire. second, the iaf labour hours (iahour) is measured as full-time equivalent staff working in the iaf. full-time equivalent staff is a unit that indicates the workload of a full-time employee employed in the iaf in a way that makes workload comparable across the companies collected in the sample of this study. to obtain a measure of full-time equivalent staff, the numerator of the formula is a multiplication of two products: maximum weekly working hours multiply by working weeks per year. the standard maximum weekly working hours in australia is 38 weeks and the average working weeks per year is 52 weeks. the denominator of the formula is total hours per employee that are devoted to internal audit services which are obtained from the questionnaire. then, the whole fraction is multiply by the number of internal audit staff employed in the company which is also obtained from the questionnaire. a mathematical representation of full-time equivalent staff is shown in table 3. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 171 table 3. mathematical representation of full-time equivalent staff maximum weekly working hours × working weeks per year × total hours per employee that are devoted to internal audit services control variables that may affect the hypothesized relationship in this study are considered. this study controls for firm size: natural log of total assets (lnta). it also includes the ratio of total long-term debt to total assets (leverage). positive associations between these control variables and iaf resources (dependent variables) would be expected. since firm complexity has the potential to increase the need for assurance of internal controls and risk management, this study expects the control variables such as ratio of inventory to total assets (invenratio), ratio of receivables to total assets (recratio), ratio of number of foreign subsidiaries to total number of subsidiaries (forsub) and square root of total number of subsidiaries (sub) to be positively related to the dependent variables. this study also controls for firm growth (carcello et al, 2005; abbott et al, 2010) where there will be a positive relationship between the three-year rate of sales growth (growth) and the dependent variables. furthermore, similar to carcello et al (2005), this study also expects a positive sign for operating cash flow (opcash) and ratio of current assets to current liabilities (curatio). 4.5 research design the two regression models used to test the two part of the hypothesis are: model 1 iafbud = b0 + b1acchairind + b2acexp + b3acindus + b4acmeet + b5acsize + b6acchar + b7big4 + b8lnta + b9leverage + b10recratio + b11invenratio + b12curatio + b13opcash + b14forsub + b15sub + b16lnaudfees + b17growth + ε model 2 iahour = b0 + b1acchairind + b2acexp + b3acindus + b4acmeet + b5acsize + b6acchar + b7big4 + b8lnta + b9leverage + b10recratio + b11invenratio + b12curatio + b13opcash + b14forsub + b15sub + b16lnaudfees + b17growth + ε where: iafbud is the total annual internal audit budget measure x fulltime equivalent staff. iahour is the fulltime equivalent staff working in the iaf. acchairind is the ratio of total scores assigned to ac chair independence. acexp is the ratio of number of ac members with accounting or financial qualifications to total ac members. number of internal audit staff employed in the company asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 172 acindus is the ratio of number of ac members worked in the same industry for a substantial number of years (at least 10 years) to total ac members. acmeet is the number of ac meetings held during the financial year. acsize is the number of members serving on the ac during the financial year. acchar is equal to the value of “1” if ac has a charter and “0” otherwise. big4 is equal to the value of “1” if a big 4 auditor is used and “0” when a smaller audit firm is used. lnta is the natural log of total assets. leverage is the ratio of total long-term debt to total assets. recratio is the ratio of receivables to total assets. invenratio is the ratio of inventory to total assets. curatio is the ratio of current assets to current liabilities. opcash is the ratio of operating cash flow to total assets. forsub is the ratio of number of foreign subsidiaries to total number of subsidiaries. sub is the square root of total number of subsidiaries. lnaudfees is the natural log of total audit fees paid to external auditor. growth is the three-year rate of sales growth. ε is the error term of the ordinary least squares regression. 5. results and discussion 5.1 descriptive statistics the descriptive statistics for variables in the regression models are presented in tables 4 and 5. table 4 gives results relating to the iaf’s resources. in panel a, it shows 58% of the respondents’ iaf have less than 5 professional internal audit staff employed and only 8% have more than 20 professional internal audit staff employed. panel a further shows the extent of money resources in the form of the total annual iaf budget. more than half, 54% of the respondents’ iaf has a total annual budget ranging from $201 000 to $1 000 000, with a further 31% reporting a total annual budget, above $1 000 000. turning to the work activity level of the iaf, panel b in table 4 indicates the total hours devoted to internal audit services. on average, 1489 hours per annum (or 29 hours per week) per person are devoted to internal audit services by professional staff during the 2010 financial year. this suggests not all professional staff is employed in the iaf on a full-time basis. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 173 table 4. internal audit function activities panel a no. questionnaire items frequency no % 8. how many professional internal audit staff is employed in your company? less than 5 21 58 between 5-10 9 25 between 11-15 2 6 between 16-20 1 3 more than 20 3 8 9. what is the total annual internal audit budget? $20 000 and below 1 3 $21 000 to $50 000 1 3 $51 000 to $100 000 1 3 $101 000 to $200 000 2 6 $201 000 to $500 000 10 27 $501 000 to $1 000 000 $1 001 000 and above 10 11 27 31 panel b no. questionnaire items mean median 25th % 75th % std. dev. 10. how many total hours are devoted to internal audit services by professional staff (per person) during your company’s most recent financial year? 1 488.89 1 550.00 1 060.00 1 975.00 661.13 descriptive statistics for the variables in table 5 are drawn from published data of the 36 respondents’ companies. panel a of table 5 shows that size of acs (acsize) ranges from 2 to 9 members, with a mean of 3.53 members. on average, 4.47 ac frequency of meetings (acmeet) are held during the 2010 financial year with a minimum of 0 meeting and a maximum of 9 meetings. the mean percentage of ac members with accounting or financial qualifications to total members (acexp) is 69%, ranging from 25% to 100%. furthermore, the mean percentage of total ac members that have worked in the same industry for at least 10 years (acindus) is about 50%. further, the mean ac chair independence (acchairind) is 65% of cases. the inference from these results is that ac characteristics of size and frequency of meetings, expertise and independence are quite variable across the 36 companies. the total audit fees paid to the external auditors (audfees) range from a minimum of $0.13 million to a maximum of $16.38 million, with a mean of $2.74 million. in regression models 1 and 2, the dependent variables are measures of the iaf’s relative extent of monetary resourcing (iafbud) and human resourcing (iafhour). they reflect asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 174 the importance accorded to the iaf, which should largely be championed by the ac as the company’s oversight body for the iaf. table 5, panel a, shows that the average total annual internal audit budget per full-time equivalent internal audit staff member (iafbud) is $45.56, ranging from a minimum of $0 to a maximum of $532. the number of full-time equivalent staff working in the iaf (iahour) is between 0 and 76 with an average staff size of 6.83. additional corporate governance characteristics are shown in panel b of table 5. results indicate that almost all companies in the sample have a formal charter for their ac. also almost all companies engage a big 4 auditor firm as their external auditors. table 5. descriptive statistics for model 1 and model 2 panel a: continuous variables variable name mean median minimum maximum standard deviation acchairind 0.65 0.75 0.25 1.00 0.24 acexp 0.69 0.67 0.25 1.00 0.21 acindus 0.50 0.33 0.00 1.00 0.28 acmeet 4.47 4.00 0.00 9.00 1.86 acsize 3.53 3.00 2.00 9.00 1.16 iafbud 45.56 13.00 0.00 532.00 96.20 iahour 6.83 2.00 0.00 76.00 13.67 audfees ($) 2.74m 1.14m 0.13m 16.38m 4.11m panel b: dichotomous variables variable name mean median number of firms coded “0” number of firms coded “1” acchar 0.94 1.00 2 34 big4 0.97 1.00 1 35 5.2 hypothesis testing 5.2.1 normality of the variables initial descriptive statistics for the variables to be modeled in this study suggest that all the independent variables have non-normality in their data distributions. non-normality is detected for these variables due to significance values for both kolmogorov-smirnov test and shapiro-walk test (p < 0.05). also, skewness and kurtosis levels are found to be outside normal tolerance limits. for all the independent variables in both the models employed to test the hypothesis of the study, blom normal score transformation is applied because neither logarithmic nor square root transformation is able to yield a normal distribution of these measures (kanel et al, 2008). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 175 5.2.2 test for small sample size to gauge whether the sample size in this study has a direct and sizable impact on statistical power, hair et al (1995)’s criterion is used. this criterion compares the significance level (α) and the number of independent variables in detecting a significant r2. the values provided are the minimum r2 that the given sample size will detect as statistically significant at significance level (α) of 0.05. this study employs 6 independent variables and 11 control variables. with sample size of 36 (> 20), these results satisfy the sample size statistical power test as regression models have r2 more than 70%. according to hair et al (1995) the minimum r2 that a specified sample size will detect as statistically significant at the 0.05 significance level is 42%. 5.2.3 choice of stepwise regression in stepwise multiple regression, the independent variables are entered according to their statistical contribution in explaining the variance in the dependent variable. stepwise regression is used in this study because it reduces the number of independent variables in the model by excluding non-significant variables. this study has 6 independent variables and 11 control variables. therefore, stepwise regression is considered the suitable choice of analysis by finding the set of predictors that are most effective in predicting the dependent variable. 5.2.4 regression analysis panel a of table 6 shows the stepwise regression model summary. the model is low in autocorrelation (durbin-watson = 2.43) which is significant at p < 0.05. panel b of table 6 presents the regression coefficients. only acsize (number of members serving on the ac) and sub (square root of number of subsidiaries) are left in the model after stepwise regression excludes all non-significant independent variables. the coefficient for acsize is positive and significant (t = 2.73, p < 0.05), indicating that the iaf budget is higher in companies where the ac has more members. moreover, the coefficient for sub (control variable) has a positive and significant (t = 4.11, p < 0.05) relationship with the iaf budget. interestingly, the extent of the iaf budget which would reflect on its work effectiveness is only impacted by the size of ac. hence, part (a) of the hypothesis is only minimally supported. this result suggests that a larger sized ac is likely to have more influence over the board of directors in advocating an adequate budget for the iaf. a larger ac may also have more time to work with the iae and cfo in preparing a stronger case for the iaf budget to be presented to the board. moreover, a larger ac can give greater attention to monitoring the iaf’s funding needs and budget constraints. such a commitment to reviewing the internal audit’s on-going budgetary needs is likely to improve the resources allocated to the iaf. carcello et al (2005) find that the internal audit budget is higher when an ac reviews the internal audit budget. raghunandan et al (2001) also find that acs that review the internal audit budget are associated with a larger budget for internal audit monitoring. both studies have similar findings to this study. a further possibility is that the iae can use the ac as a lever if ac is larger and more powerful within the company when negotiating for extra asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 176 funding within management, particularly during meetings with the management (abbott et al, 2010). table 6. stepwise regression results for model 1 panel a: model summary r r square adjusted r square std. error of the estimate durbinwatson f-ratio sig. 0.688 0.473 0.441 0.709 2.434 7.434 0.000 panel b: regression coefficients dependent variable iafbud unstandardized coefficients standardized coefficients collinearity statistics b std. error beta t-value sig. toler ance vif intercept 0.002 0.118 0.018 0.986 independent variables acsize 0.411 0.151 0.351 2.726 0.010 0.964 1.037 sub 0.514 0.125 0.529 4.110 0.000 0.964 1.037 note: acchairind, acexp, acindus, acmeet, acchar, big4, lnta, leverage, recratio, invenratio, curatio, opcash, forsub, lnaudfees and growth are not a significant predictor in this model. turning to the test of part (b) of the hypothesis, regression results are shown in table 7. the model is also low in autocorrelation (durbin-watson = 2.45, p < 0.05). the results in panel b of table 7 shows that acexp (number of ac members with accounting/financial qualifications to total ac members), acsize (number of members serving on the ac) and sub (square root of number of subsidiaries) are left in the model after stepwise regression excludes all non-significant variables. the coefficients for acexp and acsize are positive and significant (t = 2.10 and 2.46 respectively, p < 0.05), indicating that labour hours undertaken by the iaf are higher in companies where the ac has more accounting/financial experts and a larger number of members. in addition, the coefficient for sub (control variable in the model) is positively and significantly (t = 4.47, p < 0.05) related to the iaf labour hours. number of subsidiaries could be a proxy for the complexity of the iaf’s tasks. hence, part (b) of the hypothesis is also partially supported. the inference from this result is that an ac with larger size and comprising of more members with accounting or financial qualifications will be able to bring more pressure on ensuring that labour hours allocated to the iaf are not compromised. in addition, ac members equipped with financial expertise are more likely to have a better understanding of the technicalities and complexities of internal audit tasks related to the company in a particular industry. results of this study are supported by goodwin (2003)’s study that find ac members with accounting expertise are more involved in reviewing the work of the iaf and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 177 ensuring that resources are allocated to the iaf. moreover, during the review of the iaf budget and plan, larger size and financial experts’ ac members have the power to influence the board and management over, not only the amount of labour hours to be allocated to the internal control activities, but also the nature and scope of internal audit programs (abbott et al, 2010). furthermore, an ac with financial expertise is more likely to demand the iaf to act and to improve the existing internal control system or increase the amount of work to be done in higher risk areas (carcello et al, 2005). table 7. stepwise regression results for model 2 panel a: model summary r r square adjusted r square std. error of the estimate durbinwatson f-ratio sig. 0.728 0.531 0.487 0.675 2.447 4.415 0.044 panel b: regression coefficients dependent variable iahour unstandardized coefficients standardized coefficients collinearity statistics b std. error beta t-value sig. toler ance vif intercept 0.001 0.113 0.013 0.990 independent variables acexp 0.271 0.129 0.257 2.101 0.044 0.979 1.021 acsize 0.355 0.145 0.306 2.456 0.020 0.948 1.055 sub 0.535 0.210 0.554 4.473 0.000 0.957 1.045 note: acchairind, acindus, acmeet, acchar, big4, lnta, leverage, recratio, invenratio, curatio, opcash, forsub, lnaudfees and growth are not a significant predictor in this model. based on the findings above, it can be posited that ac size and ac expertise have an important impact on the effectiveness of an ac’s role in supporting the resourcing of the iaf. the evidence indicates that ac size is more associated with the internal audit budget while both ac expertise and size are associated with the internal audit labour hours. 5.3 internal audit function resourcing and its scope of activities while some aspects of ac effectiveness as reflected in its governance characteristics have been found to affect the level of budget and hours devoted to the iaf, it can only be assumed that this higher resourcing brings about higher quality of iaf activities. one indicator of iaf quality is the scope of responsibilities it is actively pursuing through its range of activities. thus, an iaf that devotes its resources to a more complete range of responsibilities as listed by iia would be providing a more comprehensive range of internal assurance services to the company. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 178 table 8 gives cross-tabulation results for higher versus lower iaf budget and hours, respectively. it reveals in panel a that those companies with higher iaf budget and hours devote a greater proportion of their iaf resources to the activities of control systems, financial statement auditing and risk management. these are all the mainstream assurance functions that would maintain high quality processes and systems needed for internal control, financial reporting and risk management. in contrast, panel a shows companies with lower iaf budget and hours allocate a greater proportion of these resources to fraud and corporate governance issues. these activities tend to reflect the iaf dealing mainly with crisis situations resulting from inadequate control systems and structures. moreover, table 8, panel b, shows that firms with higher iaf budget and hours undertake a greater diversity of activities. in contrast, firms with lower iaf resourcing have failed to engage in any activity (responsibility) in respect of two or more key categories of responsibility put forward by the iia. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 179 table 8. comparison of internal audit function resources groupings and internal audit function activities panel a proportion of hours allocated to types of activities mean % of total hours mean size of internal audit function budget total hours devoted to internal audit function high low high low fraud 9 above mean 7 33% 8 53% 7 37% 8 47% below mean 14 67% 7 47% 12 63% 9 53% control systems 45 above mean 15 71% 4 27% 11 58% 8 47% below mean 6 29% 11 73% 8 42% 9 53% financial statement auditing 6 above mean 13 62% 4 27% 12 63% 5 29% below mean 8 38% 11 73% 7 37% 12 71% risk management 25 above mean 17 81% 9 60% 14 74% 8 47% below mean 4 19% 6 40% 5 26% 9 53% corporate governance 10 above mean 1 5% 7 47% 4 21% 4 24% below mean 20 95% 8 53% 15 79% 13 76% others 5 above mean 11 52% 2 13% 8 42% 5 29% below mean 10 48% 13 87% 11 58% 12 71% total 100% panel b diversity of activities undertaken high low high low diversity devote hours to 5 or more iaf activities 16 76% 8 53% 12 63% 11 65% devote hours to 4 or less iaf activities 5 24 7 47% 7 37% 6 35% 6. comparative case study findings in tables 6 and table 7 concerning both the regression models show that ac size plays a significant role in relation to the effectiveness of ac in resourcing the iaf. a larger ac size in a company brings about a higher budget and hours for the iaf and as suggested in table 8, this translates into higher quality of iaf services to the company. using additional information collected from the questionnaire, this section presents a comparative case study analysis between two companies from the financials industry (i.e., banking, finance and insurance) drawn from the sample size of 36 respondents. the companies will be called company a and company b hereinafter. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 180 company a is a bank and is listed on the asx top 20 while company b is an insurance company and is listed on the asx top 21-100. company a and company b are chosen because company a has the largest ac size with a total of nine members while company b has the smallest ac size with a total of three members in the sample. both companies have the same level of ac expertise but a different ac frequency of meetings per year. from the comparison of questionnaire data provided by the iae of company a and company b, it can be seen that there are several distinguish differences between these two companies. firstly, substantial differences are found in the distribution of total labour hours allocated to different iaf activities. company a devotes a consideration portion of internal audit hours to more internal control activities compared to company b. it can be argued that company a, having a larger ac size, has a more diverse set of skills and knowledge to oversee and support the iaf’s development and execution of its internal control systems. a larger ac will put a stronger emphasis on preventing material control weaknesses and reacting proactively to increase internal controls. the second main difference is company a’s ac has more authority than the ceo and cfo in internal audit budget setting, compared to company b where the ac has no authority to override the ceo and cfo. it is likely that company a’s larger ac size gives it more authority and voice in internal audit budget setting than company b’s smaller ac size. larger acs should command relatively more iaf oversight and be able to demand relatively greater resources and internal audit focus allocated to internal controls. carcello et al (2005) find a positive association between acs that reviewed the internal audit’s budget and the size of the budget. to ensure an effective internal control system is implemented within an organization, the ac is responsible to review the internal audit proposals related to plans, programs and coordination with external auditors (raghunandan et al, 2001). from the comparison between these two companies, it can be seen that company a’s ac often reviews or assesses the plans of the iaf in terms of scheduling of work projects and coordinating with the external auditors, but company b’s ac never does so. this implies that company a’s larger ac has more members with technical expertise collectively have a better understanding of the iaf’s work and have the ability to review all the work and plans done by the iaf. also, company a’s ac receives more reports from its iaf regarding routine internal audit activities and special investigations compared to company b’s ac. it can be argued that more members in the ac will ensure better quality of the iaf by demanding that internal auditors to provide more reports related to internal audit activities. felo et al (2003) argue that a larger ac increases financial reporting quality as it is more likely to discover and solve potential risks in the financial reporting process. this may be possible if the resources available to the ac are increased to improve the oversight of financial reporting. the next main difference reported is that company a’s internal audit employees have a longer length of meetings with their ac (on average 150 minutes per meetings longer) compared to company b. to improve the effectiveness of the iaf, conducting regular meetings between the ac and the iaf is vital (scarbrough et al, 1998). hence, this shows that company a’s larger ac is more efficient in organizing meetings with its internal audit employees and ensures that longer meetings are conducted. more hours spent on conducting a asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 181 meeting will better enable the needs of the organization to be met by ensuring the planned scope of internal auditing issues are discussed and reviewed during the meeting. for iaf independence, it is found that company a’s iaf has a better existing relationship with its ac. also company a’s internal auditors provide a strong backing for the maintenance of their iaf’s independence in contrast to company b. it is likely that the strong iaf of company a (i.e., the internal auditors provide a strong backing for the maintenance of their iaf’s independence) can enhance the effectiveness of the ac; an effective ac (i.e., larger size) in turn can strengthen the position of the iaf. based on the assessment above of the main differences found in the comparative case study analysis between company a (largest ac size) and company b (smallest ac size), the findings are compatible with the results from the hypothesis testing. 7. conclusions the roles of the ac and the iaf have been expanding in the same direction over the past decade. the ac is increasingly expected to play a key role in assisting the board to fulfil its oversight responsibilities in relation to risk management, control, and governance processes, while the iaf’s responsibilities now should embrace the evaluation and provision of assurance to management and the ac on the functioning of these same areas. strong resourcing of iaf, both in its budget allocation and labour hours, would be a prerequisite for enhancing the scope and quality of its work. the ac’s oversight role would clearly be tied to the maintenance or improvement of the scope and quality of the iaf’s work which in turn depends on the iaf achieving adequate resourcing. this study uses the ac’s governance characteristics to benchmark its effectiveness in relation to the resourcing of the iaf and by extension, the scope and quality of the iaf’s activities. based on the questionnaire sent to iaes of top 300 listed companies, the results of this study reveal that ac size is significantly positively related to the financial resources (budget) allocated to the iaf, while both ac financial expertise and ac size are significantly positively related to iaf labour hours. these results infer that a larger size of ac membership, ac would wield more influence over the executive management of the company (and possibly the board) in advocating or gaining authority for a strong budget allocation to the iaf. moreover, the results show that an ac with larger size and comprising of more members with accounting or financial qualification will bring more pressure on the company’s executive management and board to obtain greater labour hours allocated for the iaf. results also confirm that iaf’s with higher resourcing are able to concentrate those resources in mainstream areas of control systems, risk management and financial statement integrity while also covering the full diversity of activities expected of a high quality iaf. further, to provide a more in-depth understanding of the ac governance characteristics that are significant in the regression analysis, a comparative case study between two companies is undertaken. the practices identified in this case study give insights to the superior ways a larger size ac can be effective in fulfilling its oversight role, building its working relationships and obtaining resources for the iaf. this study has several limitations. first, the data are collected from the use of a questionnaire asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 182 instrument and from hand-extracted secondary data in the annual reports. this data could be subjected to error and bias. in terms of the primary data obtained using the questionnaire, limitations are embodied in the design and administration of any field surveys. second, the model specification uses variables that do not directly measure the concept of ‘role effectiveness’ of acs. instead various governance characteristics of the ac are measured. the six ac governance characteristics used to measure ac effectiveness (chair independence, financial and industry expertise, size, frequency of meetings and charter) are likely to be built from behavioral and organizational aspects that are not reflected in the proxy measures. third, the scope of generalization for the results of this study is limited as the sample is confined to the top 300 asx listed companies and to the 20092010 financial year. also, the low response rate to the questionnaire means that sample used in this study may not be representative of the population of iaes. nevertheless, the findings of the study have important implications for regulators of corporate governance practices in terms of the composition and functioning of acs in australia. more generally, the results of this study should provide iia australia or accounting professional bodies with better understanding regarding the effective practice of acs in overseeing the resourcing needs of the iaf. furthermore, the results have implications to the users of the annual reports especially the shareholders. lastly, the findings of this study can help the board of directors to choose ideal ac members to ensure that ac is at its best in performing its roles as a key corporate governance mechanism in the company. this study leaves open a number of opportunities for future research. first, future quantitative studies may consider using a more refined measure of independence, expertise, diligence and authority of acs. moreover, this study could extend its database to include an investigation of smaller companies listed on the asx or for privately owned companies, or companies operating in countries with differing regulatory requirements. second, this study uses quantitative data that serves to highlight statistical average relationships between formally measured variables. a complementary research approach would be to undertake interpretative qualitative methods, particularly case-based interviews and observations that could give deeper understanding of behaviors amongst key organizational players. future research could consider whether the impacts of behavioral relationships between the ac and the board, and between the ac and management, are linked to the notion of the ac’s effectiveness in fulfilling its roles. acknowledgement the authors are extremely 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(2003). earnings management and corporate governance: the role of the board and the audit committee. journal of corporate finance, 9, 295-316. https://doi.org/10.1016/s0929-1199(02)00006-8 yatim, p., kent, p., & clarkson, p. (2006). governance structures, ethnicity, and audit fees of malaysian listed firms. managerial auditing journal, 21(7), 757-782. https://doi.org/10.1108/02686900610680530 glossary ac: audit committee. asx: australian stock exchange asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 187 ceo: chief executive officer. cfo: chief financial officer. cro: chief risk officer. iae: internal audit executive. iaf: internal audit function. iia: internal auditors australia. appendix 1: part of extracts from survey questions question 6: size of your company based on market capitalization: asx top 20 asx 21-100 asx 101-300 asx 301-500 asx below 500 question 7: industry of your company: consumer discretionary consumer staples energy financials health care industrials information technology materials telecommunication services utilities others question 8: how many professional internal audit staff is employed in your company? ___________________________________________________________________________ question 9: what is the total annual internal audit budget? (approximately dollar) $20 000 and below $21 000 to $50 000 $51 000 to $100 000 $101 000 to $200 000 $201 000 to $500 000 $501 000 to $1 000 000 $1 001 000 and above question 10: how many total hours per employee (approximately) were devoted to internal asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 188 audit services during your company’s most recent financial year? ___________________________________________________________________________ question 11: for the total hours indicated in question 10, what proportion was allocated to each of the following activities? (please note that the percentage of hours should add up to 100%): activity description % of hours deterring and investigating fraud maintaining the efficacy of management control systems financial statement auditing in collaboration with the external auditors evaluating the effectiveness of risk management, including safe guarding assets engaging in board and other corporate governance support work other activities (please specify: ) question 13: please indicate your level of agreement with the following statements: (please tick and answer in all three columns) statement audit committee chief executive officer chief financial officer your internal audit function regularly reports to: strongly disagree disagree neutral agree strongly agree strongly disagree disagree neutral agree strongly agree strongly disagree disagree neutral agree strongly agree in setting the internal audit’s annual budget, there is substantial involvement by: strongly disagree disagree neutral agree strongly agree strongly disagree disagree neutral agree strongly agree strongly disagree disagree neutral agree strongly agree question 16: how many times a year does you/ your internal audit function meet with the audit committee and how long is the length of the meeting? number of meetings a year : _______________________________________ asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 189 length of the meetings (on average, minutes) : _______________________________________ question 19: how often does the audit committee review or assess the plans of the internal audit function in terms of its: never seldom sometimes often almost always scheduling of work projects co-ordinating with the external auditor question 20: how often per year does the audit committee receive reports from your internal audit function related to: none per year 12 per year 35 per year 6 or more per year routine internal audit activities special investigations question 21: please indicate your level of agreement with the following statements: statement strongly disagree disagree neutral agree strongly agree the existing relationship between the audit committee (or its chair) and the internal auditor provides a strong backing for the maintenance of your internal audit function’s independence copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 12904-47161-3-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 162 earnings smoothing and bankruptcy risk in liquidating private firms nor afifah shabani (corresponding author) department of accounting and finance faculty of management, universiti teknologi malaysia, 81110 johor, malaysia e-mail: norafifah85@gmail.com saudah sofian department of accounting and finance faculty of management, universiti teknologi malaysia, 81110 johor, malaysia e-mail: saudah@utm.my received: march 18, 2018 accepted: april 10, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12904 url: https://doi.org/10.5296/ajfa.v10i1.12904 abstract keywords: earnings smooth earnings are preferred by managers and creditors because they represent a stable business operations as well as low loan default risks and thus creditors reward firms which have smooth earnings with better loan covenant terms and lower interest rates. nonetheless, recent literature shows that earnings smoothing in public firms is associated with stock price crash risk. using altman z” score to measure firm’s specific bankruptcy risk, this study examines the association between accrual earnings smoothing and bankruptcy risk in liquidating private firms in uk and finds that earnings smoothing significantly negatively affects those firms' bankruptcy risk. the finding implies that financially distressed firms engage with less earnings smoothing, possibly because they do not have the opportunity to engage in accrual earnings smoothing anymore. nonetheless, further examination shows that these firms engage less with earnings smoothing because they are being monitored by external creditors, indicated by significantly high leverage during the last period before they are being liquidated. keywords: smoothing, private firms, bankruptcy risk, liquidation, distressed firms, creditors asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 163 1. introduction earnings smoothing is the result of management’s attempts to make earnings look less variable over time (goel & thakor, 2003). while managers in public firms may engage in earnings smoothing activities for various reasons such as to gain higher compensation contract in the future, to secure bonus which are tied to current performance, or to manage firm’s credit ratings (goel & thakor, 2003; jung, soderstrom, & yang, 2013; moses, 1987), managers in private firms smooth earnings mainly to meet creditors’ demand (bigus & häfele, 2016; gassen & fülbier, 2015). due to the nature of private firms, they do not have access to public debt. as a consequence, private firm’s source of financing is limited to creditors such as banks and trade creditors. hence, external creditors have direct and indirect influence on private firm’s financial reporting (hope & vyas, 2017). for instance, creditors view smooth earnings as the signal of a stable and viable business operation. they classify firms with smooth earnings as low loan default risk (demerjian, donovan, & lewis-western, 2017) and reward this type of firm with lower interest rate (amiram & owens, 2018; gassen & fülbier, 2015). therefore, managers of private firms are inherently obliged to report smooth earnings to enjoy a better loan covenant and lower interest rate from creditors. in contrast with the view of creditors that smooth earnings signals business’ viability (e.g. tucker & zarowin 2006; amiram & owens 2017; dou et al. 2013), recent literature finds that earnings smoothing is associated with stock price crash risk. studies by chen et al. (2017) and khurana et al. (2017) find that both artificial and real earnings smoothing are positively associated with stock price crash risk. these findings are consistent with the view that earnings smoothing encourages manager’s opportunistic behavior and helps obfuscates the true underlying performance of a firm. consequently, the findings of chen et al. (2017) and khurana et al. (2017) raise the following question: does earnings smoothing has the same impact on private firms destroying firm’s value and putting firm at risk? unfortunately, the same inference cannot be made about private firms since private firms do not have stock price crash risk. this study, therefore, intends to fill the gap by examining the effect of earnings smoothing behavior on private firm’s bankruptcy risk. firms that are in liquidation process are chosen as the sample group because these firms are facing bankruptcy. therefore, if earnings smoothing are indeed related to bankruptcy risk in private firms, the relation will be highlighted in the examination. using firm-specific bankruptcy risk, as measured by altman (1983) z” score, this study finds that among the financially distressed firms, firms with smoother earnings is found to be significantly negatively associated with bankruptcy risk. the finding implies that financially distressed firms engage with less accrual earnings smoothing because they have run out of opportunities to manipulate earnings via accrual earnings smoothing. nonetheless, further examination shows that these firms engage less with earnings smoothing because they are being monitored by external creditors, indicated by significantly high leverage during the last year before they are being liquidated as compared to two or three years prior to the liquidation event. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 164 this study makes three important contributions to the body of knowledge regarding earnings smoothing and private firms. firstly, this study contributes to the literature that investigates the attributes of earnings smoothing. previous research on earnings smoothing have been focusing on public firms (shabani & sofian, 2018). only few research examine the attributes of earnings smoothing in private firms such as bigus and häfele (2016) and gassen and fulbier (2015). to our knowledge, this is the first paper that examines earnings smoothing behavior in financially distressed private firms. the findings highlight that, contrary to the findings in public firms, earnings smoothing does not contribute to private firm’s value being destroyed. secondly, this study provides additional evidence on the attributes of financial reporting for private firms. this study finds that private firms’ behavior in reporting their earnings is highly influenced by their creditors financially distressed firms with higher leverage engage with lesser earnings smoothing, similar to the findings by gassen and fülbier (2015). finally, this study contributes to the debate of earnings smoothing as information signaling versus information garbling. this study finds evidence that financially distressed firms do not use earnings smoothing to garble information because they cannot use accruals to smooth earnings anymore. 2. literature review earnings smoothing is part of earnings management, where managers report manipulated earnings which does not accurately represent economic earnings for the reporting period. earnings smoothing involves intertemporal smoothing of reported earnings related to economic earnings, to make earnings look less variable over time. the literature shows that managers smooth earnings for either one of two main reasons: as information signaling or information garbling. earnings smoothing is regarded as information signaling when managers use earnings smoothing as a vehicle to communicate private information about firm’s future earnings to outside stakeholders (arya, glover, & sunder, 2003; kirschenheiter & melumad, 2002; sankar & subramanyam, 2001). under this view, earnings smoothing plays an important role in bridging the information opacity between management and other stakeholders (goel & thakor, 2003) and therefore earnings smoothing is considered very useful to the stakeholders like participants in public market, creditors and credit rating agencies. public market participants reward firms which report smooth earnings with lower cost of equity (francis, lafond, olsson, & schipper, 2005) and lower cost of debt (bond) (li & richie, 2016). similarly, creditors and credit rating agencies also reward firms which have smoother income with lower cost of debt and better credit rating; they believe that smooth earnings signals reduced the probability of default risks (amiram & owens, 2018; jung et al., 2013; trueman & titman, 1988). given these findings, it comes to no surprise when graham et al. (2005) find that vast majority of top management prefer smooth earnings path. on the other hand, earnings smoothing is considered as information garbling when earnings smoothing distorts information and consequently leads to higher information opacity. bhattacharya et al. (2003) argue that earnings smoothing resulted in reported earnings not depicting the true underlying economic performance of the firm, and hence reducing the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 165 informativeness of reported earnings and increasing information opacity. in line with this view, jayaraman (2008) documents that earnings smoothing is associated with higher bid-ask spreads and the probability of informed trading while cahan et al. (2008) and maffet (2012) find that firms in countries with weak investor protection use earnings smoothing for opportunistic reasons. based on the extant literature, earnings smoothing as information garbling is associated with manager’s opportunistic behaviour managers smooth earnings for personal gain such as to meet bonus target (das, hong, & kim, 2013; gaver, gaver, & austin, 1995; healy, 1985; moses, 1987) or for job security (grant, markarian, & parbonetti, 2009; ronen & sadan, 1981). according to ronen and sadan (1981), manager’s compensation and tenure is associated with business risk. therefore, to secure their job tenure and compensation, managers smooth earnings to manage shareholders’ perception on firm’s risk, since shareholders perceive lower earnings volatility as lower business risk. 2.1 earnings smoothing and bankruptcy risk besides personal reasons, managers may also smooth earnings for professional reason to maximize firm’s value. firm’s value is dependent on shareholders’ perception; asymmetric information theory argues that investor’s estimate is unbiased and ‘best’ based on the information they have. therefore, it is considered rational for shareholders to require earnings outcome that is consistent with their expectation (acharya & lambrecht, 2015). in addition, shareholders infer reported earnings to be of high quality, and value firm higher, if earnings surprise is smaller (i.e. reported earnings is closer to expected earnings) (kirschenheiter & melumad, 2002). accordingly, managers have to report an earnings figure that corresponds to outside shareholders’ expectation rather than true income. in line with the view that managers smooth earnings to maximize firm’s value, earnings smoothing also provides managers with the opportunity to withhold bad news. during good times, managers manage earnings downward, giving them opportunity to conceal bad news in the future. graham et al. (2005) report that managers withhold bad news; in case things might turn around in the future, they may be able to bury the bad news. similarly, kothari et al. (2009) find that managers withhold bad news to a certain threshold, but disclosed good news as soon as possible. while their intention may be good (i.e. to increase firm’s value), earnings smoothing may lead to firm’s value being destroyed and putting firm at the risk of bankruptcy, especially when the news is particularly bad and managers cannot hoard the news any longer. using firm-specific stock price crash, chen et al. (2017) discover that earnings smoothing can lead to abrupt decline in stock price, due to managers dumping all bad news at once. likewise, khurana et al. (2017) find that real earnings smoothing influences stock price crash risk since real earnings smoothing facilitates bad news hoarding, allows poor-performing projects to continue, conceal resource diversion, and enables ineffective risk management for extended periods. based on the discussion above, it is clear that earnings smoothing, either artificial or real, is related to the firm’s value being destroyed. while the evidence on the association between earnings smoothing and destroyed firm’s value for public firms may be examined through asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 166 stock price crash risk, it is impossible to do the same with private firms since private firms do not have stock price information. alternatively, the effect of earnings smoothing on private firms may be examined using firm-specific bankruptcy risk. 2.2 earnings smoothing behaviour in private firms research on earnings management behaviour in private firms finds that private firms report lower earnings quality as well as higher earnings management, as compared to their public firms’ counterpart, (e.g. ball & shivakumar 2005; burgstahler et al. 2006; coppens & peek 2005) due to the absence of capital market pressure. ball and shivakumar (2005) find that private firms in the uk report less timely earnings and they suggest this finding indicates that creditors of private firms might be using alternative source of information, instead of earnings information, to assess the private firms’ business stability and ability to repay loan. nonetheless, hope et al. (2011) find that private firms with audited financial statement experience significantly lower financial constraint in accessing credit. this finding implies that creditors of private firms use financial reports in their loan decision process. in addition, gassen and fulbier (2015) find that creditors of private firms demand smooth earnings and that firms with smoother earnings receive lower interest rate for their loan. while earnings smoothing is beneficial to private firms (i.e. they receive lower interest rate), it is argued that earnings smoothing poses a higher threat to private firm’s sustainability, especially when firms can no longer hoard bad news. when bad news ruptured, private firms are exposed to the risk of breaching debt covenants, which could lead to increased bankruptcy risk. violation of debt covenants resulted in control rights of management reverting to creditors, providing creditors the opportunity to take action (e.g. renegotiation, winding up petition) to protect the value of their claim (aghion & bolton, 1992). hence, prior research find that firms that are in distressed, or closer to the violation of debt covenants have more incentives to manage their earnings (franz, hassabelnaby, & lobo, 2014; saleh & ahmed, 2005; sweeney, 1994). based on the discussion above, it is hypothesized that: h1: earnings smoothing is associated with bankruptcy risk in private firms, ceteris paribus. h2: private firms engage more earnings smoothing as they are getting more distressed, ceteris paribus. 3. data and research design the data for this study is collected from financial analysis made easy (fame) database. the initial data selection process acquires financial data from 3,962 private firms in uk which were in liquidation process during 2012-2017. among these firms, 802 firms have to be removed because they their last account data were prior to 2012. year 2012 has been chosen as the cut-off date because the main variable, smooth , requires at least three years financial data prior to the announcement date, and to make sure that the financial crisis in 2008 does not affect the result of this study. after eliminating firms with missing data, the final sample is left with 372 firms. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 167 3.1 research design following chen et al. (2017) and khurana et al. (2017), the model used to test h1 is as follows: − , = + , + ∑ ∗ , + − + , (1) the dependent variable, firm-specific bankruptcy risk, is calculated using altman (1983) z” score model and the term is multiplied by minus one so that larger values imply higher bankruptcy risk. z” score = 6.56*x1 + 3.26*x2 + 6.72* x3 + 1.05* x4 (2) where: x1 is working capital scaled by total assets x2 is retained profit scaled by total assets x3 is ebit scaled by total assets x4 is shareholders’ equity scaled by total assets the main variable of interest, smooth, is measured using a model established by gassen and fulbier (2015) as follows: = _ _ / _ _ (3) where: std_net_income is standard deviation of net income, scaled by lagged total assets std_cash_flow is standard deviation of cash flow from operation, scaled by lagged total assets the measure of earnings smoothing is calculated based on firm-specific time-series of data, requiring at least three annual observations for each firm, before the announcement date. as a result, there is only one smooth observation per firm in the sample. the term is multiplied by minus one so that larger values imply higher earnings smoothing. prior studies (e.g. altman 1983; altman & sabato 2007; bellovary et al. 2007) find that a firm’s bankruptcy risk is associated with high leverage, low profitability, low liquidity and high insolvency. therefore, leverage, profitability, liquidity, and solvency are used as controlling variables. firm’s leverage is calculated using current liabilities, divided with shareholder’s equity; profitability is calculated using ebitda, divided with total assets; liquidity is measured by dividing cash with total assets; and solvency is measured by dividing current liabilities with inventory. industry fixed-effect is represented by two digit sic code. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 168 4. findings 4.1 descriptive analysis table 1 presents the structure of this cross-sectional sample. the sample largely consists of firms in construction and wholesale (39.8 percent), public and administration (12.6 percent) and manufacturing of refined goods (10.5 percent) industries. about one-third of the firms in the sample (36 percent) received the notice for liquidation in 2017. number of firms that received the notice for liquidation reduced from year to year. for example, the number of firms in 2017 is 134, but the number of firms in 2016 is 107. the main reason for this trend is due to the technical limitation. while the firms might receive the notice for liquidation in 2015, for example, their last account date is not necessarily in 2014 or 2015. rather, they might have last account date of two or more years prior to the notice for liquidation. as the model requires financial data of at least three years consecutively, and the exclusion of year 2008 due to financial crisis, many firms have to be dropped from the sample list, especially those firms which receive notice for liquidation in earlier periods. table 2 exhibits distributional properties and correlations between the dependent and independent variables in the sample. the size of average sample firms, as measured by total assets, is around £6.6 million (median), which is similar to previous studies focusing on private firms in uk (e.g. ball & shivakumar 2005). smooth variable indicates that majority of the sample firms (69.9 percent) has earnings that are less volatile than cash flows (i.e. smooth > -1). z” score indicates that majority of the sample firms (76.01 percent) have high risk for bankruptcy (i.e. z” score>-2.9). this is as expected because the sample firms consists of firms that are in the process of liquidation; either voluntary by members or creditors, or by court orders. consistent with this notion, many of the sample firms have negative net income (49.7 percent), negative ebit (48.1 percent) and negative cfo (30.6 percent). on average, the sample firms are highly leveraged (current liabilities to equity of 112.9 percent) and highly insolvent (current liabilities to inventory of 483.7 percent), indicating that these firms are highly dependent on external debt to finance their operation and that they are having difficulties to repay their debts. they also have low profitability (roa of 4.2 percent) and low liquidity (cash to total liabilities of 4.9 percent). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 169 table 1. tabulation of sample based on industry and liquidation status year industry liquidation status year 1xxxx manuf. (basic goods). 2xxxx manuf. (refined goods) 3xxxx utilities 4xxxx const., wholesale 5xxxx transp., accomm. 6xxxx comm. 7xxxx admin., & support service 8xxxx public admin. 9xxxx entertain., & other service total percent (%) 2013 0 1 1 5 1 1 0 1 0 10 2.7 2014 3 1 6 24 3 2 1 3 1 44 11.8 2015 5 8 5 28 7 7 3 9 5 77 20.7 2016 7 15 7 42 4 10 8 12 2 107 28.8 2017 6 14 7 49 4 14 15 22 3 134 36.0 total 21 39 26 148 19 34 27 47 11 372 100 percent 5.6 10.5 7.0 39.8 5.1 9.1 7.3 12.6 3.0 100 table 2. descriptive statistics panel a: distributional properties (n=372) variable mean standard deviation 1st quartile 2nd quartile 3rd quartile z” score -2.352 74.093 -2.833 -0.692 1.145 smooth -1.378 2.962 -1.227 -0.569 -0.272 total assets (£ ‘000) 44,091.740 210,316.000 3,776.612 6,599.725 15,373.500 ppe (£ ‘000) 11,847.000 69,460.940 351.380 1,158.000 3,602.000 inventory (£ ‘000) 3,238.282 9,787.318 143.000 735.624 2,218.000 debtors (£ ‘000) 4,424.354 12,651.540 449.000 1,430.500 3,151.000 ebit (£ ‘000) 1,144.658 96,424.360 -544.944 13.448 441.611 net income (£ ‘000) 1,310.894 95,637.920 -533.352 15.221 375.708 cfo (£ ‘000) 3,249.167 24,247.550 -156.921 329.500 1,544.000 neg income (%) 0.497 0.501 0.000 0.000 1.000 leverage 727.760 14,007.480 0.135 1.129 3.436 profitability -0.150 2.450 -0.011 0.042 0.109 liquidity 1.159 11.763 0.008 0.049 0.218 solvency 155.642 1,238.959 1.913 4.837 23.62 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 170 continued panel b: correlations variable a b c d e f g h i j k l m n a: z” score -0.023 0.015 0.007 -0.008 -0.007 -0.017 -0.017 0.000 -0.004 0.004 0.580 -0.006 0.012 b: smooth -0.243 -0.243 -0.168 -0.034 -0.217 0.109 0.108 -0.202 -0.178 -0.173 -0.015 0.032 -0.064 c: total assets 0.012 -0.083 0.410 0.181 0.720 0.602 0.603 0.615 0.016 0.271 0.019 -0.012 0.261 d: ppe 0.236 -0.135 0.556 0.237 0.241 -0.002 -0.004 0.144 0.100 0.630 0.009 0.003 0.031 e: inventory -0.105 -0.032 0.372 0.129 0.292 -0.100 -0.104 -0.013 0.083 0.023 -0.010 -0.019 -0.039 f: debtors -0.087 0.081 0.424 0.169 0.323 0.438 0.445 0.428 0.012 0.051 0.015 -0.018 0.019 g: ebit -0.645 0.206 0.027 -0.116 0.060 0.115 0.998 0.531 -0.095 -0.053 -0.010 0.000 -0.005 h: net income -0.296 0.190 0.386 0.214 0.049 0.257 0.622 0.487 -0.098 -0.026 0.038 -0.007 0.058 i: cfo -0.026 -0.010 0.316 0.213 0.164 0.241 0.189 0.203 -0.092 0.144 0.018 -0.015 0.131 j: neg income 0.318 -0.275 -0.159 -0.091 0.052 -0.119 -0.538 -0.806 -0.267 0.082 -0.174 0.093 -0.019 k: leverage 0.051 0.155 -0.011 -0.034 0.120 0.271 0.132 0.144 0.022 -0.180 0.003 -0.005 -0.004 l:profitability -0.371 0.140 0.125 0.098 -0.029 0.160 0.657 0.639 0.350 -0.674 0.167 0.004 0.006 m: liquidity -0.487 0.058 0.004 -0.177 0.001 -0.036 0.236 0.230 0.027 -0.170 -0.277 0.148 -0.011 n:solvency 0.320 -0.035 0.102 0.194 -0.722 0.093 -0.093 -0.084 0.045 0.067 0.008 0.076 -0.146 table 2 presents descriptive statistics for the sample firms. in panel b, pearson correlations are shown above and spearman correlations are shown below the diagonal. variables are as defined in appendix a. panel b of table 2 reports the correlation of the variables. pearson correlations are presented above and spearman correlations are presented below the diagonal. the correlations between dependent and independent variables are generally low to moderate. although there are a few independent variables (such as net income and ebit) that show high correlations due to mechanic reasons, further examination reveals that these relations do not result in multicollinearity issue (i.e. variance inflation factor or vif<4). 4.2 regression analysis table 3 presents the regression results for h1 the association between earnings smoothing and bankruptcy risk. the main independent variable, smooth, is measured using model 3. the regression results show that earnings smoothing is negatively and significantly affecting bankruptcy risk, rejecting null hypothesis for h1. the results suggest that firms with higher bankruptcy risk smooth less. the result is similar with previous research which find firms with higher earnings smoothing has lower likelihood of spurious technical default (demerjian et al., 2017). this finding implies that financially distressed firms have run out of chances to garble information via accrual earnings smoothing. additional regression analyses; smooth being measured with four and five years’ data (using unbalanced panel), find similar results to the result of smooth using three years data. however, the value of the coefficient and t for smooth using and five years data are higher than three years data. the value of r-squared is slightly higher using four years data (98.5 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 171 percent) as compared to three years data (95.5 percent), but reduces significantly for smooth using five years data (57.8 percent). based on the regression results, smooth variable using three years data is the best to explain the relation between earnings smoothing and bankruptcy risk as compared to using four and five years data because more samples are included in the analysis, and therefore the result is more generalizable. the regression results in table 3 also show that firms with lower profitability and lower liquidity are associated with higher bankruptcy risk, and the relations are statistically significant. the results also show that firms with higher leverage, and higher insolvency are associated with higher bankruptcy risk; however the relations are not statistically significant. to test h2 to examine whether private firms engage in more earnings smoothing as they are getting more distressed, paired t-test of a balanced panel of 173 samples, is used. table 4 presents the results between earnings smoothing and bankruptcy risk-related variables, using data of one, two and three years prior to liquidation. the paired t-test finds weak evidence that firms engage with less earnings smoothing as they are getting more distressed. therefore null hypothesis for h2 private firms do not engage in more earnings smoothing as they are getting more distressed, is not rejected. further examination (table 5) shows that this relation is due to the monitoring effect from creditors. regression analysis shows that private firms with more leverage have lower earnings smoothing. table 3. earnings smoothing behavior and bankruptcy risk 3 years smoothing 4 years smoothing 5 years smoothing variable expected sign coef. t coef. t coef. t smooth ? -0.5245*** -4.36 -1.2761*** -9.89 -1.5001*** -12.21 leverage positive 0.0000*** -0.85 0.0000*** -1.1 0.0000*** 0.24 profitability negative -18.4715*** -76.45 -18.5176*** -117.03 -10.0158*** -8.49 liquidity negative -1.7461*** -3.02 -1.6534*** -4.35 -1.9335*** -3.23 solvency positive 0.0001*** 0.30 0.0001*** 0.66 -0.0010*** -0.86 industry fixed effect 0.0671*** 3.66 0.0422*** 3.03 0.0274*** 2.11 constant -2.4659*** -2.48 -2.1596*** -2.95 -1.4471*** -2.27 r-squared 0.9552*** 0.9849*** 0.5775*** adjusted r-squared 0.9540*** 0.9844*** 0.5564*** n 283*** 219*** 148*** ***, **, * indicate two-sided significance at 1, 5 and 10 percent levels, respectively. table 3 presents the results of income smoothing behaviour and bankruptcy risk based on model 1, with z” score of more than -2.90. the main variable, smooth , is measured according to model 3 using 3, 4 and 5 years of data. the definition for all variables can be found in appendix a. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 172 table 4. earnings smoothing behaviour prior to liquidation 1 year prior (a) 2 years prior (b) 3 years prior (c) variable mean mean mean diff (a-b) diff (a-c) diff (b-c) smooth -1.4487 -1.2600 -1.1621 -0.1887** -0.2866** -0.0978** leverage 1562.9870 1283.0640 534.4561 279.9239** 1028.5310** 748.6074** profitability 0.0210 0.0435 0.0552 -0.0225** -0.0342** -0.0117** liquidity 0.5987 0.3561 0.3404 0.2426** 0.2583** 0.0157** solvency 51.3924 61.2809 63.9856 -9.8885** -12.5932 -2.7047** ***, **, * indicate two-sided significance at 1, 5 and 10 percent levels, respectively. n=173 table 4 presents the results of paired t-test of a balanced panel between 1 year, 2 years and 3 years prior to liquidation of earnings smoothing and bankruptcy risk-related variables. the definition for all variables can be found in appendix a. meanwhile, firms’ profitability and solvency are the highest in 3 years prior to the liquidation as compared to one and two years prior to liquidation while firms’ leverage and liquidity are the highest in the one year prior to liquidation as compared to two and three years prior to liquidation, as expected. however, only profitability and liquidity show statistically significant differences. this finding is similar to akbar et al. (2013) who find that private firms hold more cash when they are in distressed to hedge against the effect of bankruptcy risk. 5. conclusion this study examines how earnings smoothing affects the likelihood of bankruptcy risk in liquidating private firms in uk. firms which are in liquidation from 2012 to 2017 are used as the sample. it is found that earnings smoothing is negatively associated with bankruptcy risk which indicates that private firms engage less with earnings smoothing as they are getting more distressed. further examination reveals that this relationship is influenced by creditors monitoring activities, since firms were getting more credit when they are in distressed. firms were getting more credit because they want to hold more cash (liquidity), as their strategy to hedge against distressed times. the results emphasize how little we know about earnings management practices, specifically earnings smoothing, in private firms. therefore, more researches are needed to enlighten our understanding on this matter. future researches might want to consider the role of real earnings smoothing in private firms since this earnings behaviour is more prevalent in the real accounting practice. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 173 table 5. earnings smoothing prior liquidation 1 year prior 2 year prior 3 year prior variable expected sign coef. t coef. t coef. t leverage negative -0.0000*** -5.45 -0.0000*** -5.35 -0.0001*** -5.02 profitability positive -0.0088*** -0.21 0.1874 ** 0.39 1.2337*** 1.97 liquidity positive 0.0066*** 0.75 0.0816*** 0.97 0.1216*** 0.89 solvency positive -0.0001*** -1.25 0.0000*** 0.52 0.0005*** 1.19 industry fixed effect -0.0061*** -1.20 -0.0086*** -1.54 -0.0107*** -1.58 constant -0.8296*** -3.02 -0.7725*** -2.54 -0.7049*** -1.95 r-squared 0.0872*** 0.1039*** 0.1334*** adjusted r-squared 0.0747*** 0.0887*** 0.1147*** n 372*** 300*** 237*** ***, **, * indicate two-sided significance at 1, 5 and 10 percent levels, respectively. table 5 presents the results of income smoothing behavior 1, 2 and 3 years prior to liquidation. the definition for all variables can be found in appendix a. references acharya, v., & lambrecht, b. m. 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(2006). does income smoothing improve earnings informativeness? the accounting review, 81(1), 251-270. retrieved from https://doi.org/10.2308/accr.2006.81.1.251 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 177 appendix a definition of variables variable definition z” score z” score = 6.56*x1 + 3.26*x2 + 6.72* x3 + 1.05* x4 where: x1 is working capital scaled by total assets x2 is retained profit scaled by total assets x3 is ebit scaled by total assets x4 is shareholders’ equity scaled by total assets smooth smooth = std_net_income/ std_cash_flow where: std_net_income is standard deviation of net income, scaled by lagged total assets std_cash_flow is standard deviation of cash flow from operation, scaled by lagged total assets standard deviation of net income and cash flow from operation is measured using 3,4 and 5 years data leverage current liabilities divided with shareholder’s equity profitability ebitda divided with total assets liquidity cash divided with total assets solvency current liabilities divided with inventory industry fixed-effect two digit sic code copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 13749-50179-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 81 religiosity and corporate risk-taking calvin w. h cheong faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malaysia tel: 60-82-260-996 email: ccheong@swinburne.edu.my received: august 27, 2018 accepted: oct. 23, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13749 url: https://doi.org/10.5296/ajfa.v10i2.13749 abstract this paper studies the influence of religiosity on corporate risk-taking. the study uses unique micro-level data on religious devotion and distinguishes between manager religiosity, firm intrinsic religiosity, firm extrinsic religiosity, and social capital. analysis shows that manager religiosity is associated with lower risk-taking. firm intrinsic religiosity however, moderates this association. further analysis shows that managers of islamic firms are more likely to make risky decisions as compared to managers of other firms due to socio-religious pressure. manager religiosity is also associated with lower firm equity risk. the results also suggest that strong external monitoring weakens the negative relationship between religiosity and risk-taking. this study shows how religious managers may be a double-edged sword. religious managers are not risk-takers but are susceptible to social pressure. they are however, also more well-adjusted to a changing environment which inspires confidence in the markets. keywords: religiosity, religion, risk-taking, firm risk, market confidence, institutional ownership asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 82 1. introduction corporations face increasing pressure to be more culturally inclusive by increasing gender, racial, and/or religious diversity of its employees. although well-intentioned, little is known on the effects of such policies. investigation into the effects of diversity (e.g. gender and race) on business and economic behavior have been made but stern (2000), schultz et al. (2000), hilary and hui (2009), gul and ng (2016), and jiang et al. (2015) notwithstanding, not much has been said about religion. as one’s religious beliefs explains one’s economic attitudes, behaviors, and decisions (iannacone, 1998), the religious beliefs of managers too have an impact on their decisions at work. a missing element from these studies however, is one’s devotion to religion. distinction should be made between those who are genuine followers of the faith, those who are pressured to, or because the law requires it (note 1) (granger et al., 2014). additionally, as social norm theory suggests (cialdini and goldstein 2004) the effects of firm intrinsic and firm extrinsic religiosity need to be considered as well. both forms of firm religiosity are primarily related to the environment that nourishes religious activities and devotion and has been found to play a major role in influencing and guiding attitudes and behaviors (kohlberg 1984; sunstein,1996). furthermore, most if not all prior studies have exclusively focused on the abrahamic religions. religious philosophy and its practice is however, multi-faceted. the abrahamic religions typically preach the existence of one supreme being whom their followers worship and communicate with in hopes of achieving salvation or eternal life. the polytheistic religions (e.g. hinduism, buddhism, and taoism) in contrast focus on ‘a philosophy of life’; preaching the virtues of detachment, compassion, and karma to achieve enlightenment. to further our understanding of religious influence on corporate behavior, an examination of each religion and its effects on manager risk-taking behavior and firm risk is required. this paper is an improvement over prior studies as i first examine manager religiosity i.e. the manager’s devotion to religion, and its association with risk-taking. i then examine whether a firm’s intrinsic religiosity has a moderating effect on manager religiosity and risk-taking, and is associated with lower firm risk, after controlling for its extrinsic religiosity, and social capital. i include firm religiosity in studying risk-taking since it directly affects firm behavior and the market is likely to take these into account when assessing the firm’s strategic choices. this study also explores the effects of institutional ownership on the relationship between firm intrinsic religiosity and firm risk. this study examines these issues in malaysia where multiculturalism (note 2) is lived on a national scale. management teams have representation from different ethnic and/or religious groups thereby avoiding the pitfalls of using a u.s.-centric and/or predominantly christian sample besides allowing for investigation into how cultural entanglement, contamination and, pluralism can influence the dynamics of cultural influence and behavior (cruz et al., 2017). furthermore, using a malaysian sample allows for investigating the effects each religion has on corporate risk-taking due to their much larger representation, as compared to other countries. using a dynamic panel system gmm, the results show that firms with high manager religiosity have lower levels of leverage, investment in fixed assets, and r&d and advertising expenditure. this relationship is stronger for firms with high intrinsic religiosity, after asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 83 controlling for other determinants of risk-taking behavior including extrinsic religiosity, social capital, and other firm-specific attributes. i also hypothesized and show that the effect of manager and firm intrinsic religiosity on risk-taking is secondary to external institutional monitoring mechanism i.e. institutional ownership. i also examined the effects of firm religion on risk-taking behavior. though muslim managers are the most religious, islamic firms are most likely to engage in risky behavior. interestingly, the relationship between manager religiosity and advertising expenditure was significantly positive, with firm intrinsic religiosity having a strong moderating effect on this relationship. substituting the measures of risk-taking with firm equity risk shows that high firm intrinsic religiosity lowered total and systematic risk while high manager religiosity lowered systematic and idiosyncratic risk. strong presence of an external monitor also negates the effects of religion on firm equity risk. additionally, islamic firms with high manager religiosity experience greater idiosyncratic risk but face lower total and systematic risk. firms of other religions with high manager religiosity meanwhile experience lower idiosyncratic risk. this paper extends the literature on the role of religion within markets in a few ways. first, this study makes use of unique micro-level data to take into account each manager’s religious devotion and investigates how their devotion affects risk-taking behavior. additionally, this study accounts for the firm’s socio-religious environment and how it influences the risk-taking behavior of either the manager, the firm, or both. second, using a pluralistic market sample furthers our understanding of the risk-religion relationship in a cross-cultural context, allowing examination of the influence of different religions on risk-taking separately. i argue that we can no longer make sweeping statements regarding religious influence on corporate behavior, particularly in an emerging market. third, this study explores the influence of religion on the financial market as well, which has not been considered in prior studies. finally, this paper contributes to the external monitoring literature by providing evidence that a strong presence of institutional investors can negate the influence of religion on within-firm and market decisions. the rest of this paper is as follows. section 2 provides a review of related studies and hypotheses development. section 3 describes the data and methodology. results are in section 4. section 5 discusses the findings on the relationship between religiosity and risk-taking behavior. section 6 concludes. 2. literature review 2.1 religiosity and behavior religiosity is defined as a belief in god followed by a commitment to follow principles believed to be set by god (mcdaniel and burnett, 1990). it is widely understood that religion is strongly tied to morality, in that religion prescribes morality (geyer and baumeister, 2005) and drives behavior. the impact of religious norms, virtues, and ethics on human behavior has been widely acknowledged in the social sciences. in exploring the relationship between religiosity and economic outcomes (shariff and norenzayan, 2007; norenzayan and shariff, 2008) and business behavior (stern, 2000; schultz et al., 2000) the literature asociates stronger religiosity with greater risk-aversion. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 84 distinction is also made between intrinsic and extrinsic orientations of religiosity. in a business context, intrinsic religiosity drives managerial behavior while extrinsic religiosity provides the environmental or contextual setting for managers to behave (benabou and tirole, 2003). intrinsic religious practices and values have important consequences for economic development. as social norms, values, and even behavior can be transmitted through interactions within organized religious groups (brammer et al., 2007), repeated interaction by attending social and religious ceremonies further strengthens their religiosity, social beliefs and values (parboteetah et al., 2008). hilary and hui (2009) extend the religiosity literature by investigating its effects on managerial decisions, concluding that companies located in u.s. counties that have higher intrinsic religiosity are more risk-averse. minton et al. (2015) similarly found that religious individuals are more likely to display sustainable behaviors (e.g. recycling, purchasing ‘green’ supplies). extrinsic religiosity is the environment that feeds religious activity. studies on extrinsic religiosity find that both culture and socially endorsed norms influence and guide attitudes and behaviors (barro and mccleary 2003; festre 2010). social attitudes displaying (dis)approval and specifying what ought (not) to be done are important determinants of human behavior (stavrova and siegers, 2014). la porta et al. (1997) and guiso et al. (2006) similarly argue that religious persons are more likely to comply with the understandings and expectations of the socio-religious norms of their environment to avoid punishment, stigmatization, and even isolation (sunstein, 1996; horne, 2009; festre, 2010). meanwhile, those that adhere and comply are rewarded with approval, support from the community, and respect (stavrova and siegers, 2014). various studies have also suggested that business and social environment affect corporate decisions (bedard and johnstone 2004; leventis et al. 2015). 2.2 religion and risk-taking the role of religion in the markets and the social sciences have been studied over the years. strong convictions of faith and religion are also associated with virtuous economic attitudes such as trust in others, trust in the government and legal system, and the belief that market outcomes are fair (guiso et al., 2003). by extension, stulz and williamson (2003) found countries that are predominantly catholic to display lower levels of creditor protection rights, partly due to the anti-usury culture prevalent in catholic teachings. generally, religious people are risk-averse. iannacone (1998) for example, found religion to have a strong impact on one’s inclination to commit crimes, consume drugs and alcohol, and engage in premarital sex. miller and hoffman (1995) found a negative correlation between religiosity and self-reported attitudes towards risk and danger. religious individuals are also less inclined to gamble (diaz, 2000). why are religious people risk-averse? the literature seems to suggest that it may be anxiety and the fear of uncertainty that makes them drawn to religion (miller and hoffmann, 1995), using religion as a spiritual anchor to ease their fears. followers of polytheistic religions also appear to be less risk-averse as compared to followers of abrahamic religions owing to its philosophy of acceptance of uncertainty (miller, 2000). in studying the risk-taking behavior of family firms, jiang et al. (2015) similarly found firms with founders who professed an abrahamic faith to be more risk-averse, while firms with asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 85 founders who followed an eastern religion did not appear to have a specific preference for risk however, recent studies (sedikides and gebauer, 2010; gebauer et al., 2012) show that religious people are more confident, more psychologically adjusted, and highly valued in society exuding calm and inspiring confidence in others. 2.3 research gap the contribution of jiang et al. (2015) on the influence of religion on corporate decision-making is significant but there are still some matters that need to be addressed. first, they did not take into consideration the effects of extrinsic religiosity. social norm theory posits that managers are affected by (religious) norms in their local geographic area. since extrinsic religiosity has a significant role in developing individual attitudes and behaviors, and eventually, corporate behavior as well, a firm’s risk-taking behaviour may either be extrinsically or intrinsically driven (cheong et al., 2017) or both. second, they contend that it is difficult to determine how religious a firm’s decision makers are, especially in public-listed firms. as a result, the amount of authority a manager has over policy is difficult to determine. the present study addresses this issue by examining the religiosity of all levels of management. third, although they made effort in identifying the religious adherence of the firm’s founder, categorizing them simply as western or eastern does account for the subtle nuances between religions. fourth, this study not only examines the religiosity of its top management team, but that of middle and lower managers as well, controlling for extrinsic religiosity and social capital. finally, this study also examines the influence of different religions on firm risk-taking behavior. 2.4 hypotheses development the literature argues that there should be a negative relationship between religiosity and risky behavior. generally, it is hypothesized that firms with religious managers will exhibit lower levels of risk-taking than firms manned by non-religious managers. specifically, this study observes a number of risk-taking measures to test this general hypothesis more specifically. first, religious managers choose to hold low levels of debt in order to maintain low risk of default (anderson and reeb, 2003), hypothesis 1a is stated as: h1a: firms with religious managers (i.e. high manager religiosity) have lower levels of leverage than firms with nonreligious managers (i.e. low manager religiosity). second, as risk-averse managers are likely to only invest in projects that are safest and provides the highest value to the firm, a conservative level of investment in fixed assets can also be an indicator of risk-aversion (hilary and hui, 2009). therefore, hypothesis 1b is stated as: h1b: firms with religious managers have lower levels of fixed asset investment than firms with nonreligious managers. finally, risk-averse managers are also less likely to invest in intangible assets as they have uncertain payoffs with salvage values that are almost always zero (jiang et al., 2015). morck et al. (1988) contend that r&d and advertising expenditures are key intangibles for a firm. therefore, hypothesis 1c is stated as: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 86 h1c: firms with religious managers have lower levels of intangible assets i.e. r&d and advertising expenditures, than firms with nonreligious managers. manager religiosity however, does not necessarily stem from within themselves but also the religiosity of their immediate social circle and of the external environment (i.e. firm intrinsic religiosity). this has been shown to have an impact on managers’ risk attitudes (jaggi and xin, 2014; jha and chen, 2015). therefore, hypothesis 2 is stated as: h2: the negative relationship between manager religiosity and risk-taking is stronger for firms with high intrinsic religiosity, after controlling for firm extrinsic religiosity and social capital a study on the firm’s external environment on risk-taking is incomplete without considering external monitoring mechanisms. an important external monitor considered here is the role of institutional ownership. institutional ownership lowers agency costs (bushee and noe, 2000) as they are more knowledgeable and actively participate in strategic decision-making (graves and waddock, 1990). as a result, firms with higher levels of institutional ownership engage in less risky behavior and experience lower risk (jafarinejad et al., 2015; barinov, 2017). hypothesis 3 can thus be stated as: h3: the negative relationship between manager religiosity and risk taking is weaker for firms with higher levels of institutional ownership, after controlling for firm intrinsic religiosity, firm extrinsic religiosity, and social capital. the final hypothesis is motivated by the findings of cheong and sinnakkannu (2014) and jiang et al. (2015). the former found significant differences in the performance of firms with boards that consisted of only one ethnicity. jiang et al. (2015) similarly found differences in the risk-aversion between firms with founders that professed a western and eastern faith. since no prior study has studied the influence of different religions (i.e. islam, christianity, buddhism, hinduism) in this context separately, hypothesis 4 is stated in the null as follows: h4: there is no difference in the risk-taking behavior of firms of different religions, after controlling for manager religiosity, firm intrinsic religiosity, firm extrinsic religiosity, and social capital. 3. data & methodology 3.1 manager religiosity data for all religion-based variables were obtained from a survey conducted by a private research and consulting institute. the survey is part of a broader ongoing survey that seeks to provide a clearer understanding of corporate issues prevalent in a pluralistic (note 3) market to make policy recommendations to the government on the promotion and guidance towards development of enterprises. the survey was conducted every year for 4 years from 2013 to 2016 (note 4). the respondents were managers from all three levels of management in malaysian public firms. the response rate to the survey was 89.5%. the section on religion in the survey comprised of self-reported questions on personal practice, attendance at religious institutions, participation of events and ceremonies, understanding of the faith, and devotion and propagating the faith. each category was scored out of 20 with a combined total of 100. the higher the score, the more religious the manager. a manager religiosity index was asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 87 then constructed from the scores of each manager. the index is a weighted index. the weights are assigned depending on the level of influence each category of management (top, middle, low) has on business processes. as the sample firms are public firms, the level of authority top management (i.e. the board of directors) have on executing firm policies are hard to ascertain (bertrand and schoar, 2003). rather, studies suggest that it is the middle managers that have a greater influence on effective execution of policy (moss, 1982; mollick, 2012). middle managers are thus assigned a weight of 3, top managers 2, and low-level managers 1. since subordinate attitudes can shape or even restrain a manager’s influence (grant et al., 2011) the religion scores of each management level is scaled by the number of subordinates. 3.2 firm religiosity and attributes the dataset also contains information on religious adherence and social activities among the general populace. this allows for the consideration of firm intrinsic religiosity, defined as the percentage of religious adherents in the population of the district where the sample firm is headquartered (hilary and hui, 2009). firm extrinsic religiosity is defined as the number of religious institutions in the district where the sample firm is headquartered (gul and ng, 2016). social capital is in the form of a social capital index. the index is constructed following the method employed by rupasingha and goetz (2008) and jha and chen (2015). the survey also provided data for the dependent variables in this study i.e. leverage, fixed assets, r&d and advertising expenditure. the survey also contained information on each firm’s return on equity, size, manager age, education and experience. since the board of directors were also respondents in the survey, board-specific attributes that have an impact on firm risk must also be controlled for. these are board size (sah and stiglitz, 1986; 1991), board independence (fama and jensen, 1983) and director connectedness (fich and shivdasani, 2007; masulis and mobbs, 2014). variable definitions are in table a1 of appendix a. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 88 3.3 a simple visualization of religiosity and risk-taking figure 1. geographic variation of manager religiosity across peninsular malaysia, by district for the year 2016 (source: author’s own) figure 1 shows manager religiosity scores in peninsular malaysia(note 5) at the district level for the year 2016. the figures for 2013, 2014, and 2015 are qualitatively similar and thus not shown. correlation between these 3 years and 2016’s scores are 0.91, 0.93, and 0.92 respectively. variation in manager religiosity is apparent. districts in the north and along the east coast score the highest. those along the west coast, particularly in the capital city of kuala lumpur scored the lowest. the district at centre has no religiosity score as no firms were headquartered there. generally, figure 1 shows the significance of religion in the country. apart from the metropolis, manager religiosity is relatively high across all districts. 3.4 endogeneity in the risk-religion relationship establishing a causal relationship between religiosity and risk-taking is challenging as two sources of endogeneity are likely to bias the estimates. first, omitted unobservable fixed and time-varying firm characteristics may affect the manager appointment process and firm risk-taking. risk-averse firms may choose to employ managers with diverse religious backgrounds but it could also be that such firms attract managers from diverse religious backgrounds. omitted unobservable variables in this instance may result in a spurious interpretation of religion and risk-taking. second, the direction of causality between asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 89 risk-taking and manager religiosity is not clear ex-ante. wintoki et al. (2012) and cicero et al. (2013) show that reverse causality issues surrounding board characteristics are dynamic i.e. instead of manager religiosity affecting firm risk-aversion, it is risk-aversion that affects manager religiosity. farrell and hersch (2005) provides an example of how female directors may choose to serve in lower risk firms as a result of their higher level of risk aversion. in this study, there is therefore a chance that current manager religiosity is influenced by past realizations of firm risk. endogeneity issues are typically resolved through identification of instrumental variables that explain manager religiosity but is also exogenous to risk-taking. however, identifying a truly exogenous variable is near impossible. due to the dynamic nature of the endogeneity issues and the difficulty in identifying truly exogenous suitable instruments, this study uses a dynamic panel system gmm (dps-gmm) estimator (arellano and bover, 1995; blundell and bond, 1998) to account for the influence of unobserved heterogeneity and past realizations of risk-taking on manager religiosity and current risk-taking. firm risk is highly correlated across time (sila et al., 2016). as such, the estimator is only consistent when the relationship between past and present risk weakens over time over a long sample period. owing to the short sample period and the dynamism of the relationship studied here, the dps-gmm is more appropriate. 4. results 4.1 summary statistics table 1 provides the summary statistics of the variables used in this study. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 90 table 1. summary statistics full sample manager religiosity mean s.d. p25 p50 p75 0 20 21 40 41 60 61 80 81 100 religiosity measures manager religiosity 71.381 4.111 18.753 65.223 84.372 firm intrinsic religiosity 0.493 0.138 0.227 0.525 0.927 0.155 0.278 0.555 0.763 0.849 firm extrinsic religiosity 15.844 3.334 7.848 16.331 24.512 6.381 12.464 16.155 19.758 23.816 social capital -3.859 5.233 -4.532 -3.660 4.338 -2.582 -1.993 1.589 2.773 3.885 risk measures leverage 0.151 0.092 0.018 0.152 0.281 0.284 0.217 0.178 0.125 0.103 fixed assets 0.045 0.108 0.051 0.065 0.123 0.138 0.113 0.074 0.055 0.039 r&d expenditure 0.012 0.033 0.009 0.025 0.089 0.101 0.077 0.041 0.019 0.009 advertising expenditure 0.019 0.027 0.010 0.021 0.055 0.110 0.089 0.052 0.031 0.008 board characteristics board size 8.601 2.032 3.541 7.964 10.110 6.332 7.013 7.248 8.131 8.222 board independence 4.023 0.955 2.519 3.884 4.588 2.321 2.899 3.555 4.031 4.311 director connectedness 2.001 0.811 1.257 1.858 2.537 2.348 2.111 1.768 1.552 1.325 firm characteristics return on equity 0.015 0.431 -0.333 0.024 0.398 -0.219 0.083 0.154 0.218 0.259 ln(1 + sales growth) 0.085 0.211 0.001 0.067 0.188 0.137 0.115 0.098 0.072 0.056 surplus cash 0.072 0.077 0.034 0.076 0.148 0.038 0.055 0.068 0.089 0.112 dividends 0.587 0.499 0.000 1.000 1.000 0.238 0.337 0.458 0.656 0.753 manager age 44.532 6.549 36.653 48.412 65.615 35.341 39.912 45.486 53.874 59.701 manager experience 8.99 5.25 4.04 11.45 15.61 3.56 5.13 6.08 7.88 10.16 this table reports summary statistics for the full sample and subsamples by the manager religiosity score. the sample comprises 3,280 firm-year observations from 820 firms for the 4-year sample period, 2013 2016. data for all variables are obtained from the survey. risk measures, board, and firm characteristics are then cross-checked with the bloomberg database and the filed annual reports to ensure accuracy. risk measures, roe, fsize, cash, and div are winsorized at the 1st and 99th percentiles. variables are defined in table a1. generally, managers in malaysia are fairly religious with an average religiosity score of 71.381. firm intrinsic and extrinsic religiosity is also relatively high with an average of approximately 50 percent of the district population adhering to a religion and 16 religious institutions in the district. social capital across districts on average scored much lower. table 1 shows relatively low mean values for the risk measures, suggesting a lower propensity for malaysian firms to take risks. table 1 also provides the mean values of all variables by manager religiosity. positive monotonic relations between manager religiosity and firm intrinsic and extrinsic religiosity as well as social capital can be observed, suggesting that manager religiosity also stems from their external environment. boards that are larger also tend to be more religious. similarly, firms with more religious managers have boards with a asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 91 greater number of independent directors and hold less external board seats. firms with more religious managers seem to perform better in terms of roe but are more conservative in terms of sales and surplus cash holdings. they are also more likely to declare dividends. managers who are older and are more experienced also tend to be more religious. there is also a negative monotonic relationship between manager religiosity and all four risk measures. a two-sample t-test (with unequal variances) was conducted to ascertain whether there exists a statistically significant difference in the level of risk-taking between firms with different manager religiosity scores. the test shows that an increase in manager religiosity tends to result in lower risk-taking (note 6). 4.2 dynamic panel gmm estimation table 2 provides the coefficient estimates of the dps-gmm. in this estimation, two lags of each risk-taking measure is included in the model. the results provide evidence to suggest that manager religiosity reduces risk-taking behavior. all coefficients on manager religiosity are statistically significant and negative. the magnitude of effect manager religiosity has on each risk-taking measure is also considerable. for example, a 1-point increase in manager religiosity reduces leverage by 0.074 units. in comparison, the average leverage in the sample is 0.151. results of the hansen test of overidentifying restrictions suggest that past values of the variables in the model are exogenous. autocorrelation tests also show that there is no evidence of second-order autocorrelation in the residuals. the specification tests thus reveal that the instruments used in estimating the relationship between manager religiosity and risk-taking behavior are not endogenous. the estimates in table 2 thus provides evidence to support h1a, h1b, and h1c. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 92 table 2. manager religiosity on risk-taking (dps-gmm) risk measure = leverage fixed assets r&d advertising manager religiosity -0.074*** (0.155) -0.165** (0.445) -0.003** (0.343) -0.005** (0.224) board size 0.091* (0.015) 0.131** (0.122) 0.012* (0.252) 0.016* (0.154) board independence -0.177** (0.189) -0.212** (0.213) 0.019 (0.311) 0.021 (0.222) director connectedness 0.018 (0.345) -0.318 (0.247) 0.011 (0.251) 0.008 (0.365) return on equity 0.227* (0.451) 0.333** (0.276) 0.015* (0.318) 0.013* (0.422) ln(1 + sales growth) 0.141* (0.133) 0.458* (0.387) 0.017* (0.219) 0.015* (0.331) surplus cash -0.318* (0.222) -0.517** (0.338) -0.026** (0.652) -0.024** (0.443) dividends -0.011 (0.234) -0.138 (0.159) -0.001 (0.245) -0.003 (0.318) manager age -0.115* (0.177) 0.144* (0.213) -0.051* (0.563) -0.029* (0.481) manager experience 0.187* (0.259) 0.383* (0.215) 0.008* (0.404) 0.003* (0.391) risk measure (lag 1) 0.444*** (0.314) 0.513 (0.332) 0.411*** (0.456) 0.392** (0.568) risk measure (lag 2) 0.134* (0.438) 0.211 (0.313) 0.186* (0.287) 0.190* (0.333) observations 3,280 3,280 3,280 3,280 hansen (df = 35) 25.861 23.849 29.664 31.214 ar(1) 1.589* 1.791* 2.335*** 2.458*** ar(2) 0.101 0.359 0.241 0.185 this table reports two-step dynamic panel system gmm estimations of risk measures on manager religiosity and other control variables. all models include year and industry dummies. the null hypothesis for the hansen test of overidentification is that all instruments are exogenous. ar(1) and ar(2) are test statistics for the null hypothesis that there is no serial correlation of orders 1 and 2 in the first-difference residuals. finite-sample robust standard errors (windmeijer, 2005) are in parentheses. ***, **, and * denotes statistical significance at 1%, 5% and 10% respectively. to examine the effects of firm intrinsic religiosity on manager religiosity and risk taking, the sample is split by level of firm intrinsic religiosity into three terciles. the dps-gmm is then applied to the top and bottom terciles separately, controlling for firm extrinsic religiosity and social capital. the estimates are in table 3. coefficients for manager religiosity are insignificant when estimating for firms with low intrinsic religiosity (bottom panel). results asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 93 for the high firm intrinsic religiosity are significantly negative for all risk measures. coefficients for firm extrinsic religiosity are significantly negative in the top panel while only marginally so in the bottom panel. social capital meanwhile had no impact on risk-taking. one notable observation is the coefficient estimates on advertising expenditure are positive, contrary to expectations. i explore this in section 4.6. generally, the results show that the negative effect of manager religiosity on risk-taking is stronger for firms with high intrinsic religiosity, providing evidence to support h2. table 3. manager religiosity on risk-taking, with high (low) firm intrinsic religiosity, controlling for firm extrinsic religiosity, and social capital (dps-gmm) risk measure leverage fixed assets r&d advertising high firm intrinsic religiosity (n = 1,105) manager religiosity -0.078*** (0.257) -2.666** (0.338) -0.025** (0.413) 0.018*** (0.429) firm extrinsic religiosity -0.041** (0.443) -0.551** (0.249) -0.023* (0.291) 0.010** (0.315) social capital 0.518 (0.258) 1.245 (0.678) 0.005 (0.559) 0.007 (0.341) control variables yes yes yes yes industry dummy yes yes yes yes year dummy yes yes yes yes hansen (df = 37) 22.331 25.854 26.567 23.873 low firm intrinsic religiosity (n = 1,180) manager religiosity -0.021 (0.348) -1.247 (0.289) -0.015 (0.315) 0.009 (0.287) firm extrinsic religiosity -0.011* (0.443) -0.238** (0.331) -0.012* (0.458) 0.005* (0.388) social capital 0.388 (0.413) 1.005 (0.328) 0.008 (0.468) 0.009 (0.681) control variables yes yes yes yes industry dummy yes yes yes yes year dummy yes yes yes yes hansen (df = 37) 22.857 24.329 23.335 28.511 this table reports two-step dynamic panel system gmm estimations of manage religiosity on risk-taking, controlling for institutional ownership. high (low) firm intrinsic religiosity is defined as the top (bottom) tercile of the sample ranked based on the percentage of religious adherents in the population of the district where the sample firm is headquartered. finite-sample robust standard errors (windmeijer, 2005) are in parentheses. ***, **, and * denotes statistical significance at 1%, 5% and 10% respectively. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 94 4.3 institutional ownership to examine the effects of prior year institutional ownership on manager religiosity and risk-taking, the sample is split by level of institutional ownership into three terciles. the dps-gmm is then applied to the top and bottom terciles separately, controlling for firm intrinsic and extrinsic religiosity, and social capital. results are in table 4. the top (bottom) panel provides the dps-gmm estimates for firms with high (low) prior year institutional ownership. none of the coefficients are statistically significant for the high institutional ownership sample save firm extrinsic religiosity. in the lower institutional ownership sample, all three religiosity coefficients are significantly negative across all risk-taking measures, except for advertising expenditure where it was significantly positive. social capital remained statistically insignificant. the results in table 4 suggests that external monitoring mechanisms have a direct impact on manager behavior but no obvious impact on social capital and extrinsic religiosity since they can only influence manager behavior but cannot control how the environment affects manager behavior (gul and ng, 2016). the results in table 4 shows that when external monitoring is weak, manager religiosity is a key determinant of risk-taking, and that external monitoring and manager religiosity are substitutes to moderating risk-taking, providing evidence to support h3. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 95 table 4. effects of manager religiosity on risk-taking, controlling for institutional ownership (dps-gmm) risk measure leverage fixed assets r&d advertising high institutional ownership (n = 1,151) manager religiosity -0.018 (0.313) -1.055 (0.349) -0.001 (0.458) 0.003 (0.329) firm intrinsic religiosity -0.015 (0.661) -0.165 (0.399) -0.001 (0.314) 0.002 (0.406) firm extrinsic religiosity -0.022** (0.533) -0.213*** (0.283) -0.006* (0.298) 0.005* (0.355) social capital 0.278 (0.277) 1.115 (0.681) 0.003 (0.553) 0.005 (0.308) control variables yes yes yes yes industry dummy yes yes yes yes year dummy yes yes yes yes low institutional ownership (n = 1,280) manager religiosity -0.051** (0.308) -1.516** (0.338) -0.007** (0.413) 0.008** (0.429) firm intrinsic religiosity -0.048** (0.613) -0.186** (0.308) -0.002* (0.277) 0.005*** (0.371) firm extrinsic religiosity -0.018* (0.419) -0.144* (0.668) -0.003* (0.391) 0.002* (0.328) social capital 0.332 (0.270) 1.439 (0.628) 0.003 (0.438) 0.005 (0.325) control variables yes yes yes yes industry dummy yes yes yes yes year dummy yes yes yes yes this table reports two-step dynamic panel system gmm estimations of manager religiosity on risk-taking, controlling for institutional ownership. high (low) institutional ownership is defined as the top (bottom) tercile of the sample ranked based on percentage of institutional ownership in the prior fiscal year. endogenous variables are instrumented by two of their past values. finite-sample robust standard errors (windmeijer, 2005) are in parentheses. ***, **, and * denotes statistical significance at 1%, 5% and 10% respectively. 4.4 firm religion to investigate the influence each religion has on risk-taking, the sample firms are first sorted according to firm religion. firm religion is defined as the professed religion of at least 60% of the surveyed managers. for example, if at least 60 percent of the managers are muslims, the firm’s religion is therefore islam. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 96 table 5. mean values by firm religion firm religion islam christianity buddhism hinduism religiosity measures manager religiosity 81.235 72.311 69.458 73.643 firm intrinsic religiosity 0.853 0.612 0.578 0.663 firm extrinsic religiosity 18.221 12.464 10.203 9.584 social capital 3.555 2.784 2.557 2.893 risk measures leverage 0.495 0.158 0.205 0.223 fixed assets 0.581 0.231 0.253 0.224 r&d expenditure 0.011 0.122 0.108 0.095 advertising expenditure 0.256 0.213 0.208 0.201 board characteristics board size 9.015 7.123 7.556 7.312 board independence 2.111 3.587 4.005 3.223 director connectedness 3.018 2.015 2.187 2.039 firm characteristics return on equity -0.157 0.065 0.050 0.010 ln(1 + sales growth) 0.085 0.109 0.099 0.101 surplus cash 0.005 0.055 0.067 0.034 dividends 0.157 0.264 0.174 0.351 manager age 45.889 41.123 46.481 42.331 manager experience 2.51 3.85 5.12 3.53 this table reports the mean values for the full sample sorted by firm religion. the sample comprises 3,280 firm-year observations from 820 firms for the 4-year sample period, 2013 2016. data for all variables are obtained from the survey. risk measures, board, and firm characteristics are then cross-checked with the bloomberg database and the filed annual reports to ensure accuracy. risk measures, roe, fsize, cash, and div are winsorized at the 1st and 99th percentile values. full summary statistics are in table 1. all variables are defined in table a1. the mean values in table 5 suggest significant differences in risk-taking and firm characteristics across the four main religions. religiosity scores of islamic firms are the highest. however, the amount of leverage, fixed assets, and advertising expenditure of islamic firms are also disproportionately larger than other firms, although they also record the lowest r&d expenditure. their boards are the largest but also the least independent while their directors have the greatest connectedness. as for firms of other religions, slight differences can be observed across all variables, especially those on religiosity and risk-taking but not to the extent of that seen for islamic firms. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 97 table 6. effects of firm religion on risk-taking (dps-gmm) risk measure leverage fixed assets r&d advertising islam (n = 940) manager religiosity 0.015*** (0.358) 0.853** (0.443) 0.000* (0.648) 0.008** (0.712) firm intrinsic religiosity 0.018* (0.216) 0.523** (0.322) -0.001 (0.583) 0.018*** (0.332) firm extrinsic religiosity -0.005* (0.325) -0.335** (0.286) -0.002* (0.189) 0.008*** (0.439) social capital 0.321 (0.585) 0.224 (0.335) 0.018 (0.456) 0.003 (0.333) christianity (n = 858) manager religiosity -0.038*** (0.451) -1.115** (0.503) -0.008** (0.383) 0.001* (0.267) firm intrinsic religiosity -0.028** (0.334) -1.088*** (0.228) -0.007* (0.386) 0.002* (0.239) firm extrinsic religiosity -0.031* (0.411) -1.003*** (0.287) -0.008** (0.339) 0.004* (0.384) social capital 0.248 (0.573) 0.333 (0.600) 0.014 (0.617) 0.004 (0.487) buddhism (n = 832) manager religiosity -0.054** (0.341) -1.347** (0.511) -0.010* (0.287) 0.003** (0.448) firm intrinsic religiosity -0.027** (0.277) -1.212*** (0.379) -0.006* (0.454) 0.002 (0.348) firm extrinsic religiosity -0.033*** (0.453) -1.017* (0.384) -0.005** (0.462) 0.005 (0.333) social capital 0.298 (0.499) 0.387 (0.513) 0.004 (0.385) 0.002 (0.457) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 98 table 6 continued hinduism (n = 650) manager religiosity -0.043** (0.383) -1.221* (0.298) -0.011* (0.314) 0.004* (0.223) firm intrinsic religiosity -0.031** (0.441) -1.314*** (0.378) -0.008 (0.417) 0.006*** (0.222) firm extrinsic religiosity -0.011* (0.392) -1.285*** (0.333) -0.002* (0.228) 0.003*** (0.414) social capital 0.319 (0.378) 0.425 (0.493) 0.001 (0.242) 0.008 (0.359) control variables yes yes yes yes industry dummy yes yes yes yes year dummy yes yes yes yes this table reports two-step dynamic panel system gmm estimations of firm religion (islam, christianity, buddhism, and hinduism) on risk-taking measures. all models include year and industry dummiesfinite-sample robust standard errors (windmeijer, 2005) are in parentheses. ***, **, and * denotes statistical significance at the 1%, 5% and 10% respectively. the results in table 6 show the influence of firm religion on the relationship between religiosity and risk-taking. we see a significant positive relationship between manager religiosity and risk-taking for islamic firms, contrary to the hypothesis. the coefficient estimates for firms of other religions meanwhile are qualitatively similar to those presented earlier and support the hypothesis that greater manager religiosity reduces risk-taking. there are however, obvious differences in the magnitude of effect. buddhist firms are the least likely to take on risks as followed by hindu and christian firms. we can also see that the positive relationship between religiosity and advertising expenditure persists across all firm religions. 4.5 religion and equity risk although religiosity may reduce managers’ risky behavior but their lower-risk policies may not necessarily translate into less volatile stock prices. stock price volatility is also driven by investor sentiments. firms that behave in a manner that conforms to social expectations experience lower stock price volatility (cheong et al., 2017). as religious managers are highly valued and inspire confidence (gebauer et al., 2012) firms with religious managers should experience lower equity risk. to test this proposition, i observe three measures of equity risk: total risk, systematic risk, and idiosyncratic risk. total risk is the standard deviation of daily stock returns over the preceding year. systematic risk is the coefficient on the market portfolio from a market-model regression using the kuala lumpur stock exchange equally-weighted index. idiosyncratic risk is the standard deviation of the residuals from the fama-french three-factor model (fama and french, 1993). all returns are exclusive of dividends. returns data was sourced from bloomberg. annualizing total and idiosyncratic standard deviations was simply by multiplying them by the square root of 250. table 7 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 99 provides the results of the dps-gmm. table 7. manager religiosity on firm equity risk (dps-gmm) risk measure total risk systematic risk idiosyncratic risk manager religiosity -0.075 (0.165) -0.328*** (0.519) -0.111*** (0.381) firm intrinsic religiosity -0.115*** (0.328) -0.522** (0.653) -0.089 (0.266) firm extrinsic religiosity -0.134 (0.551) -0.428 (0.444) -0.140 (0.315) social capital 0.218 (0.517) 0.387* (0.610) 0.112 (0.266) board size 0.108 (0.333) 0.184** (0.348) 0.203* (0.411) board independence -0.238** (0.430) -0.400** (0.222) -0.021*** (0.163) director connectedness 0.305 (0.115) -0.284* (0.155) 0.123 (0.339) return on equity -0.215** (0.383) -0.308** (0.556) -0.110*** (0.314) ln(1 + sales growth) 0.122 (0.099) 0.138 (0.186) 0.089 (0.098) surplus cash 0.266 (0.199) 0.377 (0.496) 0.163** (0.832) dividends -0.202 (0.311) -0.148 (0.249) -0.128 (0.143) manager age -0.314 (0.182) -0.166 (0.304) -0.085 (0.439) manager experience 0.286 (0.145) 0.148 (0.191) 0.235*** (0.245) risk measure (lag 1) 0.244*** (0.121) 0.396** (0.150) 0.256*** (0.189) risk measure (lag 2) 0.131 (0.226) 0.159 (0.189) 0.148 (0.169) observations 3,280 3,280 3,280 hansen (df = 35) 25.687 22.659 25.415 ar(1) 2.132** 1.228 3.554*** ar(2) 1.028 1.335 1.546 all specifications are as table 2 above. ***, **, and * denotes statistical significance at 1%, 5% and 10% respectively. the first column of table 7 shows no statistically significant relationship between manager religiosity and total risk while firm intrinsic religiosity lowers total risk. in the second column, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 100 both manager and firm intrinsic religiosity lowers systematic risk while manager religiosity has a significant negative relationship with idiosyncratic risk. i repeat the dps-gmm estimations by controlling for institutional ownership, and then investigating the impact of firm religion. the results are in table 8 and 9. table 8. effects of manager religiosity on firm equity risk, controlling for institutional ownership (dps-gmm) risk measure total risk systematic risk idiosyncratic risk high institutional ownership (n = 1,151) manager religiosity -0.115 (0.228) -0.634 (0.189) -0.120 (0.307) firm intrinsic religiosity -0.128 (0.585) -0.565* (0.440) -0.135 (0.299) firm extrinsic religiosity -0.149 (0.444) -0.408 (0.319) -0.356 (0.367) social capital 0.245 (0.190) 0.486 (0.556) 0.253 (0.322) control variables yes yes yes industry dummy yes yes yes year dummy yes yes yes low institutional ownership (n = 1,280) manager religiosity -0.218 (0.188) -0.788** (0.415) -0.233** (0.300) firm intrinsic religiosity -0.342** (0.550) -0.663** (0.275) -0.269 (0.344) firm extrinsic religiosity -0.250* (0.323) -0.518* (0.399) -0.411 (0.376) social capital 0.482 (0.285) 0.557 (0.313) 0.333 (0.195) control variables yes yes yes industry dummy yes yes yes year dummy yes yes yes this table reports two-step dynamic panel system gmm estimations of manager religiosity on firm equity risk, controlling for institutional ownership. all specifications are as above. ***, **, and * denotes statistical significance at 1%, 5% and 10% respectively. the estimates in table 8 are qualitatively similar to those in table 4 and 7, even after controlling for institutional ownership. in the top panel, we see that manager religiosity as well as other religious factors have no statistically significant impact on firm risk. in the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 101 bottom panel, low institutional ownership firms only exhibited a significant negative relationship between firm intrinsic religiosity and total and systematic risk. manager religiosity only has a significant negative relationship with idiosyncratic risk. table 9. effects of firm religion on firm equity risk risk measure total risk systematic risk idiosyncratic risk islam (n = 940) manager religiosity 0.011 (0.367) -0.866*** (0.412) 0.011** (0.555) firm intrinsic religiosity -0.015*** (0.222) -0.611*** (0.286) -0.009 (0.486) firm extrinsic religiosity -0.003 (0.345) -0.344 (0.261) -0.003 (0.201) social capital 0.214 (0.475) 0.310 (0.341) 0.022 (0.316) christianity (n = 858) manager religiosity -0.041 (0.413) -1.223** (0.511) -0.016** (0.209) firm intrinsic religiosity -0.031 (0.355) -1.009 (0.331) -0.011 (0.448) firm extrinsic religiosity -0.028 (0.422) -1.011 (0.384) -0.020 (0.257) social capital 0.235 (0.559) 0.311 (0.676) 0.018 (0.558) buddhism (n = 832) manager religiosity -0.035* (0.311) -1.441* (0.385) -0.025** (0.196) firm intrinsic religiosity -0.029 (0.288) -1.243 (0.388) -0.016 (0.334) firm extrinsic religiosity -0.038 (0.449) -1.009 (0.277) -0.011 (0.237) social capital 0.288 (0.319) 0.400 (0.409) 0.009 (0.225) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 102 table 9 continued hinduism (n = 650) manager religiosity -0.051 (0.399) -1.099* (0.301) -0.016*** (0.300) firm intrinsic religiosity -0.027 (0.271) -1.044 (0.318) -0.010 (0.481) firm extrinsic religiosity -0.021 (0.411) -1.113 (0.322) -0.008 (0.273) social capital 0.306 (0.344) 0.400 (0.413) 0.005 (0.213) control variables yes yes yes industry dummy yes yes yes year dummy yes yes yes this table reports two-step dynamic panel system gmm estimations of firm religion (islam, christianity, buddhism, and hinduism) on firm equity risk. all specifications are as above. ***, **, and * denotes statistical significance at 1%, 5% and 10% respectively. 4.6 the case of advertising summary statistics and table 1 show a negative relationship but estimates in tables 3 to 6 show a positive relationship between manager religiosity and advertising expenditure. this could be the result of: (1) reverse causality i.e. advertising expenditure influences manager religiosity; (2) the contrary relationship is driven by other observable factors such as firm and board characteristics; and (3) the relationship is driven by other unobservable factors such as leadership styles and corporate culture. i investigate this by estimating a static model between manager religiosity and advertising expenditure using ols and a fixed effects estimator. if the positive relationship was caused by observable factors, ols estimates of manager religiosity on advertising expenditure would be insignificant once these factors were included. if it was caused by unobservable factors, this should be captured by the fixed effects. ols and fixed effects estimations are presented in table 10. ols and fixed effects show significant negative relationships between manager religiosity and advertising expenditure. only by including firm intrinsic religiosity, firm extrinsic religiosity, and social capital into the estimation does the positive relationship become evident (model 2, table 10). the firm religiosity variables likewise, are positively related to advertising expenditure. to determine which firm religiosity variable has the strongest influence on the relationship, i include interaction terms of the three firm religiosity variables with manager religiosity and regress these on advertising expenditure. we can see that the only statistically significant interaction term is between manager religiosity and firm intrinsic religiosity (model 3, table 10). the results in table 10 suggests that religious managers typically incur lower advertising expenditures. however, social influence, particularly those arising from the firm’s as well as the manager’s socio-religious circle is strong enough to reverse their risk-aversion. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 103 table 10. advertising expenditure on manager religiosity (ols, firm-level fixed effects, and dps-gmm) risk measure = advertising ols fixed effects dps-gmm (1) (2) (3) (1) (2) (3) (1) (2) (3) manager religiosity -0.033*** (0.179) 0.038*** (0.213) 0.025*** (0.158) -0.025*** (0.087) 0.029*** (0.098) 0.022*** (0.101) -0.005** (0.224) 0.017*** (0.115) 0.014*** (0.204) firm intrinsic religiosity 0.027*** (0.315) 0.034*** (0.149) 0.021*** (0.105) 0.028*** (0.228) 0.024*** (0.093) 0.026*** (0.101) firm extrinsic religiosity 0.051** (0.261) 0.043** (0.237) 0.044** (0.215) 0.037** (0.374) 0.018*** (0.065) 0.015** (0.109) social capital 0.019** (0.306) 0.014* (0.244) 0.013* (0.153) 0.011 (0.251) 0.009* (0.126) 0.005 (0.249) manager religiosity × firm intrinsic religiosity 0.058*** (0.338) 0.045*** (0.193) 0.033*** (0.097) manager religiosity × firm extrinsic religiosity 0.034 (0.168) 0.025 (0.133) 0.011 (0.088) manager religiosity × social capital 0.007 (0.334) 0.008 (0.287) 0.004 (0.413) board size 0.025** (0.384) 0.021** (0.277) 0.013* (0.386) 0.022*** (0.176) 0.019** (0.259) 0.009 (0.181) 0.016* (0.154) 0.012* (0.105) 0.009 (0.134) board independence 0.033* (0.411) 0.028* (0.388) 0.020 (0.277) 0.028** (0.233) 0.023* (0.368) 0.016* (0.334) 0.021 (0.222) 0.017 (0.163) 0.011 (0.233) director connectedness 0.019** (0.241) 0.016* (0.415) 0.011 (0.458) 0.015 (0.091) 0.011 (0.086) 0.008 (0.141) 0.008 (0.365) 0.005 (0.152) 0.003 (0.211) return on equity 0.035** (0.288) 0.027* (0.195) 0.014* (0.228) 0.029** (0.178) 0.018** (0.204) 0.014** (0.355) 0.013* (0.422) 0.011* (0.222) 0.006 (0.148) ln(1 + sales growth) 0.055*** (0.333) 0.041** (0.280) 0.022* (0.165) 0.043*** (0.247) 0.032** (0.166) 0.017** (0.200) 0.015* (0.331) 0.009 (0.271) 0.004 (0.181) surplus cash -0.046*** (0.318) -0.036* (0.248) -0.021* (0.273) -0.033** (0.143) -0.026** (0.235) -0.015* (0.118) -0.024** (0.443) -0.012 (0.338) -0.007 (0.264) dividends -0.015* (0.277) -0.011* (0.179) -0.008 (0.333) -0.010* (0.192) -0.008 (0.217) -0.005 (0.373) -0.003 (0.318) -0.002 (0.415) -0.001 (0.189) manager age -0.051** (0.268) -0.043** (0.367) -0.029* (0.232) -0.046** (0.110) -0.033 (0.241) -0.014 (0.123) -0.029* (0.481) -0.015 (0.503) -0.011 (0.221) manager experience 0.017*** (0.192) 0.012* (0.215) 0.008* (0.179) 0.014** (0.238) 0.011* (0.378) 0.005 (0.244) 0.003* (0.391) 0.002* (0.402) 0.001* (0.333) risk measure (lag 1) 0.392** (0.568) 0.277** (0.443) 0.181* (0.200) risk measure (lag 2) 0.190* (0.333) 0.176* (0.288) 0.123 (0.138) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 104 table 10 continued observations 3,280 3,280 3,280 3,280 3,280 3,280 3,280 3,280 3,280 r2 0.526 0.553 0.589 0.477 0.554 0.612 this table reports ordinary least squares (ols), firm-level fixed effects, and dynamic panel system gmm (dps-gmm) estimations of advertising expenditure on manager religiosity and control variables. all models include year and industry dummy variables. intercepts were included but not reported here. cluster-robust standard errors (for ols), within-cluster heteroscedasticity and serial correlation (for fixed effects) and finite-sample (for dps-gmm) robust standard errors are reported in parentheses. ***, **, and * denotes statistical significance at the 1%, 5% and 10% respectively. 5. discussion the results show that manager religiosity affects firm risk-taking, after controlling for other determinants of risk-taking behavior including firm intrinsic and extrinsic religiosity, social capital of the district where the firm is headquartered, and institutional ownership. however, the results suggest a fair amount of social pressure on religious managers. for example, although religious managers are risk-averse, the effects are more pronounced for firms with high intrinsic religiosity. the literature suggests that followers of the abrahamic faiths are generally more risk-averse. this is not the case in malaysia. while managers of christian firms show an aversion towards risk, managers of islamic firms seem to be risk-takers, especially in terms of leverage and investment in fixed assets. islam, from the writings contained within the quran, strongly advocates entrepreneurship and acknowledges risk-taking as an essential element of business, which may explain this observation. the effects may be amplified by government policies that provide loose lines of credit for malays or bumiputeras (many of whom are muslims), on top of other policies and initiatives that seek to provide them with additional economic support such as discounts on real-estate investment (cheong and sinnakkannu, 2014). religious managers also spent less on advertising but then spend more once firm intrinsic religiosity was included in the model. in accordance with social norm theory, it may imply that pressure from the manager’s socio-religious circle influenced them to behave in contrary ways. the effects of religiosity on risk-taking is not limited to managers alone. substituting the risk-taking measures with equity risk revealed that religiosity also has an impact on market decisions. specifically, firm intrinsic religiosity reduces total risk and systematic risk but not idiosyncratic risk while manager religiosity reduced systematic and idiosyncratic risk, suggesting a greater level of cultural entanglement and religious influence on financial decision-making than previously thought. religious managers are more confident and better able to adjust to their environment (gebauer et al., 2012) and so will be better equipped to handle the demands placed on them, inspiring greater confidence from within the firm and the financial markets. religiosity-driven behavior is nevertheless, secondary in the face of strong external monitoring mechanisms. firms and managers are still subject to the oversight and controls imposed by a strong presence of institutional owners. only in the absence of oversight by institutional owners do we see religiosity influencing risk-taking. the same can also be said of the market’s response (i.e. total and systematic risk) towards religiosity. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 105 5.1 theoretical and practical implications first, studying the effects of religiosity on risk-taking at the micro-level allowed us to establish a direct link between an individual’s religious devotion and his/her propensity to take risks, in the context of managerial decisions. furthermore, by examining the religiosity of all layers of management, we are able to capture the influence of religiosity on different levels of authority in the decision-making process in a public firm. allowing managers to self-report their religious devotion, also accounts for any socio-religious environment effects on the manager’s behavior. second, social pressure causes religious managers to behave in peculiar ways. in a pluralistic market, religious managers may choose to increase advertising expenditure to appeal to the imaginations of the locals (abela, 2014) in efforts to make themselves and/or the firm appear more devout, conform to social expectations and win over social favour and goodwill (hopkins et al., 2014). as regional effects in terms of culture and behaviour have been found to affect firm performance (burrus et al., 2018), firms headquartered in religious districts are also likely to be less risky due to the influence of religious local residents (brammer et al., 2007). managers in these districts likewise are thus more likely to be more religious and display greater risk-aversion. third, many studies in the finance literature have tended to categorize religion in a binary fashion (i.e. east and west). religion however, transcends geographical borders. the differences between religions in terms of philosophy and practice especially regarding their impact on firms cannot be stressed enough. the findings in this study is testament to this fact. finally, in 2018, firms are increasingly pressured to have more inclusive and diverse workforces but remain hesitant owing to a lack of evidence on its benefits. findings from this research are particularly beneficial to firms looking to implement or improve their cultural inclusiveness as it provides evidence that, religious managers are more calm, stable, and resilient (gebauer et al., 2012) and are thus less likely to make hasty, risky decisions than non-religious managers, inspiring greater confidence from financial markets. firms that have yet to take religious diversity into consideration when hiring new managers may finally be motivated to do so from the findings of this study. additionally, we cannot downplay the significance of socio-religious pressure on firm risk especially in a pluralistic market. firms whose employees that are predominantly of a particular religion may choose to establish operations in ceteris paribus, highly religious districts so as to build goodwill and trust, taking advantage of the local market’s greater sense of confidence in the firm. 6. conclusion in their haste to become more culturally inclusive, firms fail to form a deeper understanding of race, religion and/or culture and how these affect the decision-making process. in this study i used micro-level data on the religiosity of managers in malaysian public firms to examine how religion influences risk-taking. in so doing, i avoid the pitfalls of prior studies that tended to ignore the subtle nuances of religious philosophy. from this study, it is clear that regardless of religion, religious managers are generally more risk-averse. however, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 106 managers in malaysia muslim, in particular are susceptible to social pressures. the evidence also suggests that it is not only the managers that are susceptible to social pressure. firm equity risk is also sensitive towards the religiosity of the district where the firm is based, suggesting that religious pressure has further-reaching effects on a firm than mere managerial behavior. this study is not without its limitations. first, firm religion was defined as the majority religion of the firm. there is some degree of generalization in this definition which dampens socio-religious dynamics, hence further research should study each religious manager separately to find out how their religion influences their decision-making process at every step. second, i only studied the four main religions of the world. further research should ideally explore the influence of other religions (e.g. judaism, sikhism, aboriginal beliefs) to construct a more holistic understanding of how religion shapes a firm. future research may also want to explore how the belief in the non-existence of god(s) (i.e. atheism) or the contemporary understanding of spiritualism i.e. the well-being of the ‘mind-body-spirit’ (heelas, 2009) influences this process. finally, are there other demographic (e.g. ethnicity, gender, socio-economic status) or psychographic (e.g. values, interests, opinions) factors that might moderate the influence of religion? with a rich variety of questions arising from this study, the time is right to start humanizing finance literature. notes note 1. in malaysia, every citizen is by law, required to have a religion. while religious conversion is permitted, there have been many instances where muslims were denied a change of religion by the national registration department, even though they no longer practice it (samuri and quraishi, 2014). note 2. malaysia is often characterized culturally, economically, and politically by its pluralism. the 2010 national census showed that of its 28.7 million population, 67% were malays or bumiputeras, 25% were chinese, 7% were indians while the remaining 1% consisted of various smaller ethnic groups. note 3. many social and legal issues in malaysia are religiously-driven. this was again brought to attention after a recent ruling by the country’s apex court on the religious conversion of minors split public opinion into two camps (teoh and rodzi, 2018; nokman, 2018). note 4. as the survey was conducted annually, changes to the composition of managers will be reflected in the religiosity scores for the corresponding year. i thank the anonymous reviewer for making this clarification. note 5. i excluded the east malaysian states of sabah, sarawak, and labuan due to the unavailability of data. note 6. for brevity, these results are not shown here. i am happy to provide them on request. references abela, a. v. 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(2012). endogeneity and the dynamics of internal corporate governance. journal of financial economics, 105, 581-606. https://doi.org/10.1016/j.jfineco.2012.03.005 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 112 appendix table a1. definition of variables variable definition risk measures leverage total debt to total assets fixed assets capital expenditure to total assets r&d research and development expenditure to total assets advertising advertising expenditure to total assets religiosity measures manager religiosity combined sum of religion scores from each level of management multiplied by their assigned weights divided by the number of employees in the firm firm intrinsic religiosity the percentage of religious adherents in the population of the district where the sample firm is headquartered firm extrinsic religiosity the number of religious institutions in the district where the sample firm is headquartered social capital an index constructed following rupasingha and goetz (2008) and jha and chen (2015) board characteristics board size number of directors on the board board independence number of independent directors divided by number of directors director connectedness total number of external board seats held by all directors firm characteristics return on equity net income to total equity ln(1 + sales growth) natural logarithm of 1 + sales growth; a proxy for firm size surplus cash net cash flow from operating activities less depreciation and amortization plus research and development expenditure divided by book value of total assets dividends dichotomous variable that is ‘1’ if the firm pays dividends manager age average age of managers in the firm manager experience average number of years managers has been employed in the firm in a managerial position asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 113 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 12933-47260-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 210 corporate governance and firm performance: the role of the board and audit committee netai kumar saha (corresponding author) senior lecturer, dept. of business administration east west university, dhaka-1212, bangladesh e-mail: netaish006@gmail.com rehnuma hoque moutushi lecturer, dept. of business administration east west university, dhaka-1212, bangladesh mohammad salauddin graduate student, dept. of business administration east west university, dhaka-1212, bangladesh received: april 1, 2018 accepted: may 3, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12933 url: https://doi.org/10.5296/ajfa.v10i1.12933 abstract corporate governance (cg) has become a paramount issue due to its greater significance of practicing accuracy, maintaining accountability, establishing effective internal control and regulating organizations for achieving organizational goals. the study is conducted to explore the relationship between corporate governance and firm performance with considering the role of board and audit committee. the multiple liner regression analysis is used as the underlying statistical test on the dependent variables, roa, roe and tq to test the association between the independent variables (board size, board independence, size of audit committee and audit committee composition) with firm performance. homogeneous purposive sampling has been used. the sample size of the study is 81 listed companies in dse. the results of the study signify that board independence ratio and audit committee is statistically significant and has positive impact on roa and tq. but it is not statistically significant in the case of firm performance indicator roe in this study. in addition to, board size is not statistically significant and has negative correlation with firm performance due to group dynamics, communication gaps and indecisiveness of larger groups. keywords: corporate governance, firm performance, board size, board independence and audit composition asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 211 1. introduction at present, corporate governance (cg) has become a topical issue of global concern because of its significant contribution to the economic growth of a nation. sound corporate governance gives assurance to the investor of providing transparent disclosure and relevant information that are investor-friendly (okiro, aduda and omoro, 2015). good corporate governance minimizes the risk of bankruptcy (shleifer and vishny, 1997). in absence of good cg, many well-performing companies have faced a tremendous downfall across the world. existing literature suggests that good corporate governance has a significant positive influence on organizational performance (oecd, 2009; moxey and berendt, 2008; gompers et al., 2003; claessens et al., 2002). corporate governance has been defined by scholars from several points of view. according to metrick and ishii (2002), corporate governance refers to the commitment to the actual return of the invested capital and it also describes the process of operating an organization. similarly, magdi and nadereh (2002) stated that good cg ensures that an organization is running well and making fair rate of return for investors. cg gives a vivid description of the systems and structure in order to observe managers of higher positions so that they can efficiently manage the organizations. the topic of corporate governance had come under the spotlight in the mid-1990s. according to cadbury committee (1992), corporate governance is the process by which organizations can be directed and appropriately controlled. corporate governance is defined as the framework for monitoring, regulating and controlling of organizations which permit to exercise the mechanisms of internal and external alternative for achieving the organizational goals. the internal mechanism consists of managerial ownership, board composition and individual and institutional shareholders. on the contrary, the market for corporate control, the statutory audit and the evaluation of stock market are included in the external mechanism (keasey and wright, 1993). in other sense, corporate governance refers to the relationship among the directors, corporate managers and shareholders. it also concerned about the relationship of the organization to the stakeholders and the society. corporate governance more widely describes the combination of laws, listing rules, regulations and practices of private sectors that make the organization capable of attracting capital, give an efficient performance, generate revenue and meet societal expectation legal obligation (yasser, 2011). the performance of an organization and its financial decisions are severely affected by the agency conflict between a company's management and the company's stockholders. to solve this issue, the role of corporate governance is very much noteworthy. corporate governance increases the effectiveness of companies with the association of enough control and supervision. it also has importance in managing the interest of stakeholders and managers to minimize the agency conflicts (shleifer and vishny, 1997). maintaining good corporate governance leads an organization towards achieving its ultimate goals and this is the actual reason for which corporate governance is attaining significant attention now (shil et al., 2017). previous empirical studies (drobetz et al., 2003; byrd and hickman, 1992; brickley et al., asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 212 1994; williams, 2000; rajan and zingale, 1998; hossain et al., 2000; rosenstein and wyatt, 1990; hermalin, 1988; gemmill and thomas, 2004) have mentioned positive correlation between corporate governance and better firm performance. on the contrary, very few studies (hutchinson, 2002; bathala and rao, 1995) found no association between corporate governance and better firm performance. in spite of these contradictory results, the researchers argue that there is no doubt that maintaining good corporate governance increases the firm’s performance. some major characteristics of the corporate governance are board size, board composition, board independence, audit committee and whether the position of board chairman is given to the ceo role (kyereboah and biekpe, 2008). the issue of corporate governance has become essential in the present situation because of increasing fraudulent activities, agency conflicts and insider trading which weaken the corporate performance (enobakhare, 2010). in recent time, the downfall of enron in 2001, the bank of credit and commerce international (bcci), world.com in 2002 (okiro, aduda and omoro, 2015) and hallmark and basic bank scandals in banking sector of bangladesh (shil et al., 2017)) are the noteworthy example of corporate failure because of less efficiency of corporate governance. there are some other problems such as inconsistent accounting standards, weak regulatory systems and weak accounting practices. again inefficiency in boards of directors, poor management of capital markets and little concentration on the minority stockholders interest have a negative influence on corporate governance (world bank, 2000). most of the researches have been conducted in the developed countries but the application of the results and finding may not be applicable for the developing countries like bangladesh loctating in south east asia. very few researches have conducted to find the nexus between corporate governance and firms performances. some existing studies used a small set of samples, whereas a large set of samples are used in this study which includes 81 listed financial organizations at the dhaka stock exchanges. therefore this study is intended to answer two research questions; what is the role of board size and the board independence to enhance the firm’s financial performance? and how do the audit committee and its composition contribute to enhance better corporate performance? 2. literature review 2.1 corporate governance and firm performance there are many accepted definition of corporate governance; on the basis of a framework and cultural condition of a country the definition of cg varies (armstrong and sweeney, 2002). in the 1980s the term “corporate governance” came under focus to vividly describe the principles of directing and controlling of business and management of an organization (bozec 2005). o. donovan (2003) defines corporate governance as a system of covering the policies and process which manages the shareholders and other stakeholders needs by their management activities with well performing of business, integrity and objective. in other sense, it can be defined as the legal, moral and ethical values of an organization in order to protect the interest of shareholders. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 213 the purpose of corporate governance is to manage the interest of the shareholders and other stakeholders of an organization. the concept of corporate governance can be applied especially to the listed companies where the significant portion of the shareholders cannot participate in management functions. although this concept can also be applied to other types of organizations like firms with very few owners, partner-owned firms and also privately owned organizations where ownership are transferred through inheritance generation after generation(ahmed, alam, jafar & zaman 2008). the research is mainly conducted on the theory of agency conflicts which is evaluated to describe the nexus between the principals and the agents. the board members are elected to manage the company by the shareholders at acm who are also the owners as well. himmelberg et al. (2002) stated that corporate governance and performance of an organization is driven by some common characteristics which are not exactly measurable and observable. managers are intended to retain a significant portion of ownership of the high growth firms to give importance to their commitment and utilization of remuneration based on equity; based on stable performance insider ownership gradually increases. cremers and nair (2005) found that internal corporate governance and external corporate governance have a positive relationship with organizational performance. 2.2 board size and firm performance board size is the most discussed attribute of cg in the literature. enobakhare (2010) defined board size as the total number of board members that a company has in its board structure. the functions and performance of a board are influenced by the number as well as the quality of the directors in any organization. previous studies showed both positive and negative association between board size and firm’s performance. most of the studies indicated that a large board size affects organizational performance when it is not conclusive. because the probability of large board size has the opportunity of having better skills and knowledge at their settlement that will increase performance (williams, 2002). on the contrary, it was argued that when boards become large, they gradually lose their efficiency ramano et al. (2012). according to jensen (1993), massive board size has the possibility to create a reduced sense of the responsibility of an individual. it also might be more attached to the problems of bureaucracy. another prominent scholar kajola (2002) has the belief that small board size can improve the performance of an organization to a particular level and it is because the improvement done by larger boards of enhanced controlling becomes less effective because of weaker communication and indecisiveness of larger groups. some research put emphasis on the relationship between board size and organizational performance. it was found that small board size is more suitable for better firm performance and small board size is positively correlated with it (sanda et al., 2003). similarly, (lipton and lorsch, 1992, coles et al., 2007 and pathan et al., 2007) concluded smaller board size is more effective than large board size. another major issue which is found in research that larger board size causes some problems such as group dynamics, gaps in communication, the rise of coordination cost, poor firm performance etc. (dey and chauhan 2009). there are also counter-arguments. it was revealed asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 214 that in case of proper monitoring and advising functions larger boards have more efficiency than small board size. more value is created for an organization if board size is larger (andres and vallelado 2008; chen et al., 2006). according to the report of spencer stuart board index (2008), it was shown that a continued trend was going towards smaller boards. again that report also indicated that board size has also been shrinking over the years. on the contrary, it was also proved that a genuine relationship exists between the performance of firms and size of the board. this relationship is made on the basis of the utilization of tobin’s q as a performance indicator for bhc (bank holding companies) (belkhir 2004; adams and mehran 2005). a large number of studies put a focus on the fact that there is no significant correlation between board size and firm performance (busta, 2007; zulkafli & samad 2007; shelash al-hawary; 2011; staikouras et al., 2007 and trabelsi, 2010) oppose to the previous argument and they indicated that larger board size does not have any positive influence on firm’s performance. cornett et al., (2009) puts another counter-argument that indeed if the size of the boards is large those are positively associated with corporate performance. it was concluded that a larger board is more desirable and demanding for bank holdings structures and activities. ramano et al; (2012) stated if the board size can be increased with additional directors having supplementary directorships that will be helpful to add value. h1: the board size has positive relation on firm performance. 2.3 board independence and firm performance the necessity of independent board directors in composition of a board is very much significant for several reasons. firstly, they are considered as real monitors. secondly, they have strong capability of management and maintaining discipline. thirdly, they can play very much effective role to increase organizational performance (duchin et al., 2010). again rhodes et al., (2000) sated that independent directors have financial freedom and hardly have to face the possible conflicting conditions. they are also able to reduce agency problems and the obstacles in managerial self-interest. additionally they have the capability to give protection to the interest of shareholders. they have efficiency in performing monitoring and control function in an excellent way in order to align organizational resources for better performance (kumar and singh, 2012). board composition refers to the total number of directors brought from outside the organization in order to sit on the board (enobakhare 2010). it was found in some research that board composition has a relationship with good governance. in order to ensure organizational growth and corporate accountability non executive and independent or outside board directors are considered as one of the most important elements (ramano et al, 2012). on the contrary it was also indicated that superfluous proportion of non executive board directors could hamper or damage the instructor role of boards as executive directors naturalize the transfer of information between directors and management and provide information as well as knowledge which independent directors would find difficult to gather (de andres and vallelado,2008). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 215 there is a counter-argument which includes evidence that organizations committing financial reporting false are more likely to have a weaker board of directors who are dominated by the insiders (farber, 2005 and ramano et al., 2012). some empirical studies on the board composition of directors found some positive effects on the organizational performance as a result of having uncommitted directors on the board of the organizations (xie et al.,2003, choi et al, 2007, abor and adjasi, 2007, awan, 2012, and kumar and singh, 2012). xiao-lan and zong-jim (2006), adams and ferreira (2009), and kajola (2002) on the other found that composition of boards with representation of outside uncommitted directors and organizational performance there can hardly be any relationship. this particular consequence was attributed to the lack of selection of the uncommitted directors on their sagacity and experience. it was also added that lack of wisdom, sagacity and proper knowledge, lack of proper skills of organizational affairs such directors would not have the capability to perform their roles in an effective manner (rahman, mohamed and ali, 2006). according to kaplan (1995), poor corporate performance is very closely associated with the appointment of an outside, independent and uncommitted board director. finally, it can be concluded that a mixed result is found about the relationship between organizational performance and the freedom of board from the different perspective. this result was found from most of the empirical studies. there is a very strong recommendation by different countries on the composition of a board and independence in the organizations (gabrielsson and huse, 2005). necessarily those boards which have a lot of uncommitted directors show a kind of elevated efficiency and they function to enhance the organizational performance (daily & dalton, 1993). h2: board independence has positive association with firm performance. 2.4 audit committee and firm performance audit committees are most predominant governance mechanism aimed at safeguarding the rights of investors by reducing information asymmetry and providing trustworthy information about the company (abdul rahman and ali, 2006; dezoort et al., 2002). the audit committee can play a vital role in reducing information asymmetry between corporate managers and providers of finance as financial reporting is the most important mode of communicating the financial performance of a company to stakeholders (dhaliwal et al., 2006; krishnan, 2009). meanwhile, the characteristics of audit committees emerge as salient factor to be considered in contemporary corporate governance research and practice. these characteristics are associated with effective task execution. in one study, yige et al. (2012) showed the relation of audit committee meeting and board of director’s independence. audit committee meetings and board of director independence are complementary in corporate governance. moreover, they find that as audit committees meet more frequently the board independence increases more. research findings of xie et al. (2003) indicate that frequent meetings of the audit committee show greater diligence. research evidence of raghunandan and rama (2007) and sharma et al. (2009) shows that profitability and growth are related in a positive way to audit committee meeting frequency. moreover, more frequent audit committee meetings are associated with better quality asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 216 financial statements (abbott et al., 2000; and beasley et al., 2000). in another study, a pessimistic relation between audit committee independence and earnings management is observed by klein (1998), and this finding of the study is similar with the idea that a paucity of independence impairs the ability of boards and audit committees to superintend management. in another study, dezoort et al. (2002) drew a framework universal four-dimensional (composition, resources, authority and diligence) with respect to benefits and effectiveness of audit committees. according to the study, while the composition reflects independence, the other three relate to the inputs to the corporate governance processes adopted by the firms. from the above, it can be determined that the key purpose of the board’s audit committee is to inspect the financial reporting process of a firm. there is a remarkable literature that links independence, size and other characteristics of the board of directors and audit committees in order to improved firm performance and value (klein, 1998). increased level of independence and expertise on board and audit committees increase firm value (chan and li, 2008). the common wisdom is that the level of independence of audit committee members is closely related with improved monitoring of the financial reporting process (bronson et al., 2009). independence is often heralded as the single most important board and audit committee characteristic; however, the evidence is somewhat mixed. bhagat and black (2001) find no relationship in their study between the ratio of outsider versus insider board members and firm performance. kirkpatrick (2009) finds that independent members on the audit committees contribute to a higher market value. beasley (1996) finds that presence of an audit committee does not affect the likelihood of fraud, but more independent members on the board of directors should decrease the possibility of fraud. how-ever, abbott et al. (2004) ensured that an audit committee consisting of independent members and who meet minimum twice a year decreases the probability that the firm will be associated with misleading reporting. h3: the audit committee size has positive relation on firm performance. h4: the presence of independent directors on audit committee has positive relation on firm performance. 3. methodology of the study the study is mainly conducted by deriving data from the secondary sources by using sample size of 81 listed companies in dse. data has been collected from published annual reports, company websites and sever other sources. 5 years data ranging from the period of 2013 to 2017 has been considered to conduct the study. homogeneous purposive sampling has been used for the selection of sample size. the sample includes all the listed companies from banking industry (30), financial institutions (23), fuel and power industry (18), it sector (8) and telecommunication (2). 3.1 model specification for the purpose of empirical analysis, the multiple liner regression analysis is used as the underlying statistical test on the dependent variables, roa, roe and tq to test the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 217 association between the independent variables (board size, board independence, size of audit committee and audit committee composition) with firm performance. the conceptual model of the study is presented below: source: conceptual framework of the anglo american model the following regression models are developed to test the relationship between corporate governance variables and firm performance. fp_ roe = + bsize+ β2 bind+β3 acsize +β4accom+ ε fp_ roa = + bsize+ β2 bind +β3 acsize +β7accom+ ε tq = + bsize+ β2 bind +β3 acsize +β7accom+ ε the following table shows the corporate governance variables and their description in this study. bsize bind acsize accom corporate governance characteristics firm performance roa roe tq asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 218 table 1. variables, definition and measurement variables description measurement performance measures roa return on asset net profit after tax and provision divided by the total asset at the end of each year roe return on equity net profit after tax and provision divided by the total equity as at the end of each year tq tobin’s q firm market to book value measured by the book value of total assets minus the book value of common equity plus the market value of common equity divided by the book value of total assets. governance characteristics bsize board size total number of directors on the board as at the end of each year bind board independence number of independent directors / total number of directors acsize audit committee size numbers of members in audit committee. accom audit committee composition total number of directors in audit committee / number of independent directors in audit committee 4. results and discussion 4.1 impact of cg variables on roa asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 219 anovab model sum of squares df mean square f sig. 1 regression .114 4 .029 7.339 .000a residual 1.520 391 .004 total 1.634 395 a. predictors: (constant), audit composition, board independence ratio, board size, audit committee b. dependent variable: roa the anova table is showing the association between the corporate governance variable identified in this study and the dependent variable roa. as the p value is 0.000 which is less than .05; thus, the result supports the hypothesis1 that the corporate governance variables have positive impact on response variable roa. coefficientsa model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) .100 .018 5.673 .000 board size -.003 .001 -.109 -1.885 .060 board independence ratio .061 .028 .110 2.182 .030 audit committee .011 .004 164 2.776 .006 audit composition .014 .020 037 .703 .483 a. dependent variable: roa the above table is showing the four explanatory variables, whether they are statistically significant and their impact on roa. board independence ratio and audit committee is statistically significant at 5% level of significance since the p values is less than 0.05 and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 220 have positive impact on roa as reflected by positive coefficients (b). in addition to, p value of board size and audit composition is not statistically significant since its p value is greater than 0.05. the negative coefficients of board size indicates that the larger the size of board, the lesser the firm performance. because, organizations having larger boards may face less effective control mechanisms due to weaker communication and indecisiveness of larger groups. 4.2 impact of cg variables on roe anovab model sum of squares df mean square f sig. 2 regression .151 4 .038 .933 .444a residual 15.844 391 .041 total 15.995 395 a. predictors: (constant), audit composition, board independence ratio, board size, audit committee b. dependent variable: roe from the anova table, the calculated p value is 0.15 which is greater than 0.05; thus the outcome does not support the hypothesis2. hence, the result of the test signifies no association between the dependent variable roe and the independent corporate governance variable. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 221 coefficientsa model unstandardized coefficients standardized coefficients t sig. b std. error beta 2 (constant) .186 .057 3.269 .001 board size .001 .004 .014 .241 .810 board independence ratio .086 .090 .049 .950 .343 audit committee .016 .013 .078 1.271 .204 audit composition .076 .063 .066 1.197 .232 a. dependent variable: roe from the above table, it is found none of the above explanatory variable is statistically significant since p value is greater than 0.05 at 5% level of significance. but the positive coefficients reflect the positive direction of the above variables on firm performance as measured by roe in this study. 4.3 impact of cg variables on tq anovab model sum of squares df mean square f sig. 3 regression 4422.353 4 1105.588 7.184 .000a residual 60177.471 391 153.907 total 64599.824 395 a. predictors: (constant), audit composition, board independence ratio, board size, audit committee b. dependent variable: tobin-q asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 222 the anova test result on depended variable (tobin-q) and independent variable (board size, board independence, size of audit committee and audit committee composition) is indicating that there is a significant relationship between tobin-q and corporate governance variables. as the p value is 0.000 which is less than .05, thus, the test support the hypothesis and reveal that the corporate governance variables have positive impact on overvaluation of firm value in the security market. coefficientsa model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 20.662 3.498 5.908 .000 board size -.606 .274 -.128 -2.214 .027 board independence ratio 14.461 5.545 .131 -2.608 .009 audit committee 1.792 .780 .136 -2.298 .022 audit composition 11.901 3.898 .162 -3.053 .002 a. dependent variable: tobin-q since the p values of all predictors are less than general acceptable limit 0.05 at 5% level of significance, all the explanatory variables are statistically significant and have impact on measurement of firm value in the securities market as measured by tobin-q in this study. 5. conclusion the issue of corporate governance has become essential in the present situation because of increasing fraudulent activities, agency conflicts and insider trading which weaken the corporate performance. sound corporate governance gives assurance to the investor of providing transparent disclosure and relevant information that are investor-friendly. the study is mainly conducted to investigate the relationship between corporate governance and firm performance with taking into account of the role of board and audit committee. the sample size of the study is 81 listed companies containing from banking industry (30), financial institutions (23), fuel and power industry (18), it sector (8) and telecommunication (2). homogeneous purposive sampling has been used for the selection of sample size. secondary data for the period of 5 years ranging from 2013 to 2017 has been taken into consideration for conducting the study. conceptual framework of the anglo american model is used in this asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 223 research study. the multiple liner regression analysis is done as the underlying statistical test on the response variables, roa, roe and tq to test the association between the explanatory variables (board size, board independence, size of audit committee and audit committee composition) with firm performance. the empirical findings of the study state that board independence ratio and audit committee is statistically significant and has positive impact on roa and tq. in the case of firm performance measure roe, none of the explanatory variables considered in this research is statistically significant but has positive direction individually on roe. noticeably, board size is statistically insignificant and has negative correlation with roa and tq and small margin of positive correlation with roe. it suggests that larger the board size, lesser the firm performance. because, organizations having larger boards may face less effective control mechanisms due to weaker communication and indecisiveness of larger groups. the study is not beyond limitations. the study is conducted using a only four corporate governance variables and 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(2007). corporate governance and performance of banking firms: evidence from asian emerging markets. advances in financial economics 12, 49-74. https://doi.org/10.1016/s1569-3732(07)12003-x microsoft word 11942-43921-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 128 does ownership structure matter for bank performance in the mena region? an empirical evidence sara fathi (corresponding author) assistant lecturer of finance, department of accounting and finance german university in cairo, egypt po box 11835, new cairo, egypt tel: 20-27-589-990 e-mail: sara.fathi@guc.edu.eg mona a. el bannan assistant professor of finance, department of accounting and finance german university in cairo, egypt po box 11835, new cairo, egypt tel: 20-27-589-990 e-mail: mona.elbannan@guc.edu.eg received: sep. 21, 2017 accepted: oct. 29, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11942 url: https://doi.org/10.5296/ajfa.v9i2.11942 abstract the aim of this study is to examine the effect of bank ownership structure on bank performance in middle east and north africa (mena) region using the balanced scorecard (bsc) method. usinga panel data of 137 commercial banks during the period from 2010 to 2014 across twelve countries in the mena region, the study highlights the effect of ownership type and concentration on bank performance using the balanced scorecard as a performance measurement technique. the results show that government ownership and foreign ownership have statistically significant positive effect on bank performance measured by bsc index. on the contrary, domestic private ownership and ownership concentration have statistically significant negative effect on bank’s bsc index. additional analysis on each asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 129 of the bsc perspective separately reveals that ownership concentration is negatively correlated with the customer and learning and growth factors, while positively correlated with the internal process factor. government ownership shows statistically significant negative effect on the financial factor and the internal process factor while associated with statistically significant positive effect on the customer factor. foreign ownership has statistically significant positive effect on the financial and the internal process factor but does not have statistically significant effect on the other two perspectives. finally, domestic private ownership reveals a statistically significant negative effect on the learning and growth factor. keywords: ownership concentration, government ownership, foreign ownership, domestic private ownership, balanced scorecard, bank performance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 130 1. introduction bank ownership structure has become an important topic for many researchers and economists. while some researchers support the existence of foreign ownership in the banking sectors, others are concerned with the new challenges escalated by foreign banks entry. foreign banks help host countries to engage in the international business cycle which stimulate the economy and lower the amplification effect of domestic shocks (goldberg 2007; clarke et al., 2003). foreign banks entry is claimed to increases the efficiency of the local banking system by introducing better regulations and modern techniques of management and operations (boussaada and karmani, 2015; peek and rosengren, 2000). nonetheless, economists debate that the entrance of these banks represents a threat for the host economy. foreign ownership in the banking sector gives the chance to the developed countries to interfere in the host country economy and bank’s regulations. consequently, host countries lose the control over foreign banks' operations (levine, 1996; dermine, 2002; barth et al., 2004; cetorelli and goldberg, 2009; clarke et al., 2003). this study is motivated by the recent restructuring process that takes place in the mena region. banks merger and acquisition, privatization and foreign banks entry have directed the economists and policy makers’ attention to the effect of the ownership structure change on bank performance. accordingly, the study aims to empirically investigate the effect of ownership type and concentration on bank performance using the balanced scorecard method. after the success of the balanced scorecard application on a corporate level, practitioners start to apply the balanced scorecard technique in banks and financial institutions to spot the light on the non-financial perspectives as well. further, additional regression analysis is conducted to ensure the validity of the results and serve as a robustness check by reexamining the impact of the ownership structure on each of the four perspectives of the bsc separately. this study contributes to the debate on the relation between ownership structure and bank performance in several important ways. it provides empirical evidence from a cross-country, emerging markets perspective, in which restructuring events affect the national economy significantly. examining this relationship in mena region is of much interest, as the banking industries in mena countries have experienced many restructuring activities over the past decade. furthermore, while most of the literature on the relationship between ownership structure and the financial performance of banks uses financial measures, only scant studies have paid little attention to the non-financial performance. to the best of my knowledge, the few studies and researches that focus on the balanced scorecard in the banking sector represent case studies considering only one or small sample of banks. accordingly, this is the first study to employ the balanced scorecard (bsc) approach in examining the relationship between the ownership structure and bank performance using panel data of commercial banks in the mena region. 2. literature review and hypothesis development 2.1 balanced scorecard definition and its implementation in the banking sector the concept of "balanced scorecard” was first introduced by robert kaplan and david asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 131 norton in 1992. the balanced scorecard can be defined as performance measurement method that incorporates the traditional financial measures with operational measures on customer satisfaction, internal business process and organization’s innovation and growth (kaplan and norton, 1992). despite the fact that some versions incorporate more stakeholders and perspectives such as the environmental perspective, the basic frame of the balanced scorecard consists of four perspectives; customer perspective, internal process perspective, learning and growth perspective and the financial perspective (kaplan and norton, 1997). the learning and growth perspective focuses on the organizations ability to innovate, improve, grow and learn in order to accomplish their strategic objectives (atkinson, 2006; kaplan and norton, 1992).the internal process perspective helps determining the crucial business processes, competencies and technologies that the organization should excel at in order to achieve the organizational objectives and meet customers’ expectations. accordingly, the internal business supports the customer perspective and the financial perspective .the customer perspective looks at the organization’s ability to deliver high quality of goods and services to customers in order to maintain their satisfaction and retention.the financial perspective highlights the shareholders’ interests and satisfaction through focusing on the financial success of the organization. financial measures reveal the effect of other three perspectives of the balanced scorecard due to the causal relationship between the four perspectives (atkinson, 2006; kaplan and norton, 1992; vagizova and klass, 2014; isoraite, 2007). after the success achieved through balanced scorecard implementation in corporate level, scholars and practitioners start to focus on the balanced scorecard application in the banking sector. al-mawali, zainuddin and ali (2010) study the effect of balanced scorecard on bank performance in the jordanian banking sector. using a sample of 120 branches, the results reveal that there is statistically significant positive relationship between bsc application and the financial performance of the branch. ombuna et al., (2012) examine the impact of the bsc application on commercial banks performance in kenya. through conducting surveys on 72 department managers from 18 commercial banks, the results show that around 51.8% of the respondents strongly agree that bsc is a strategic management system and 57.1% strongly agree that bsc translates the organization’s mission to actionable goals. ibrahim and murtala (2015)conduct surveys on bank executives using a sample of 11 banks in nigeria. the study concludes that banks’ executives recognize the usefulness and importance of the bsc in improving the bank performance. 2.2 the relationship between ownership concentration and bank performance many theories examine the effect of ownership concentration on bank performance. recent researches and literature spot the light on the monitoring hypothesis, the expropriation hypothesis and neutrality hypothesis which are three contradictory hypotheses explaining the relationship between ownership concentration and bank performance. the monitoring hypothesis supports the positive relationship between ownership concentration and corporate performance. it states that concentrated ownership helps resolving the free riding problem raised by ownership dispersion as large shareholders are highly motivated to collect asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 132 information, monitor bank's operating strategies, lending behavior and risk management which results in better governance structure (jensen and meckling, 1976; shleifer and vishny, 1986). in contrary with the monitoring hypothesis, the expropriation hypothesis indicates that there is a negative association between the concentration of ownership and bank performance. the inverse relation rises when large shareholders collude with managers to expropriate minority shareholders and depositors. the expropriation hypothesis claims that ownership concentration increases the agency costs and causes tunneling problem (gutiérrez &tribo, 2004; boyd et al., 1998). the third hypothesis is the neutrality hypothesis which is first introduced by demsetz (1983). it indicates that there is no relationship between concentrated ownership and corporate performance claiming that the ownership structure is an endogenous variable that depends on the owners’ professional knowledge, the operations scale and the technology required for business. accordingly, there is no uniform structure of ownership is optimal for all conditions. zouari and taktak (2014) support the neutrality hypothesis and show that there is no relation between ownership concentration and the financial performance of islamic banks measured by roa and roe. on the corporate level, using a sample of firms listed on the shanghai and shenzhen stock markets over the period 1997–1999, hovey, li and naughton (2003) conclude that ownership concentration is irrelevant to firm performance measured by tobin’s q. referring to the studies conducted in the mena region, aymen (2014)confirms the expropriation hypothesis using a sample of 19 banks over the period from 2000-2010 in tunisia. the study shows that there is a negative relationship between ownership concentration and bank performance measured by roa. the same negative association between concentrated ownership and bank performance is reported by arouri, hossain and muttakin (2011) using the data of 27 banks from all the gcc countries except kuwait for the year 2008. on the contrary, al-amarneh (2014) supports the monitoring hypothesis. using a panel data for thirteen listed banks in jordan during the period from 2000 to 2012, the results show that ownership concentration is statistically positively correlated with the roa ratio. the same positive association is supported by boussaada and karmani (2015) who investigate the effect of ownership concentration on banks performance in the mena region using a sample covering 38 commercial banks during the period from 2004 to 2011. since the effect of ownership concentration is still debatable and unclear, following the stream of the researches and studies stating a positive correlation between bank performance and ownership concentration, the first hypothesis to be tested in this study is: h1: there is a significant positive relationship between ownership concentration and bank performance asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 133 2.3 the relationship between ownership type and bank performance 2.3.1 government ownership the social welfare theory and the political theory are two of the important theories explaining the behavior of state owned organizations. the social welfare theory indicates that state owned banks are social welfaremaximizing organizations that focus on economic and social growth. pursing economic development might force public banks to engage in less profitable and riskier activities in order to motivate the business cycle and resolve financial market failures (sapienza, 2002; boussaada and karmani, 2015). on the other side, the political theory claims that governmental institutions are created to serve political goals. according to this view, state owned banks serve the personal interests of politicians and act as capital suppliers for the favored political parties (shleifer and vishny, 1994; shleifer, 1998). the poor performance of state owned banks is heavily supported by many studies and articles. kobeissi and sun (2010) examine the effect of bank ownership structure on bank performance using panel data of 221 banks from 17 countries for the period 2000-2007. they find that government ownership has a significant negative effect on bank performance measured by roa, roe and profit x-efficiency. the same results are reported by boussaada and karmani (2015) using a sample of 38 commercial banks from the mena region during the period from 2004-2011 and farazi, feyen and rocha (2011) using a sample of 106 banks in nine non-gcc mena countries for the period 2001-2008.the researchers refer the negative association between government ownership and bank performance to the reason that governmental banks finance public and political enterprises which raise the nonperforming loan ratios, deteriorate the loans portfolio and induce the performance measures of these banks. in conflict with the social welfare and the political theory, loukil and chaabane (2005) report a positive relationship between government ownership and bank performance in tunisia. they refer the good performance of public banks to the social benefits they receive in comparison with their private counterparts. sathye (2003) study the effect of ownership structure on bank productive efficiency in india during the period from 1997 to 1998. using data envelopment analysis (dea), the results indicate that state owned banks outperform privately owned banks particularly during the expansionary phase when the fixed costs of privately owned banks are high. as the previous researches report conflicted results with respect to the effect of government ownership on bank performance and based on the majority of the studies and researches covering this relationship, the second hypothesis to be examined in this study is: h2: there is a significant negative relationship between government ownership and bank performance. 2.3.2 foreign versus domestic ownership the effect of foreign ownership on bank performance is still an area of argument between researchers and practitioners. in this respect, berger et al., (2000) compare between the performance of foreign banks and the domestic ones. he argues that two core contradictory asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 134 hypotheses reveal the relationship between foreign ownership and bank performance: home field advantage hypothesis versus global advantage hypothesis. home field advantage may partially appear because of the organizational diseconomies and the high operations and monitoring costs of working abroad. foreign institutions may lack local information about the new market which escalates difficulties in maintaining deposit relationships with domestic clients or lending relationships with small and mid-size enterprises. consequently, domestic banks have privileges over foreign ones making the latter less efficient and profitable (berger et al., 2000). on the other side, global advantage hypothesis indicates that efficiently managed foreign institutions can resolve the problems of operating in a distant market. foreign institutions may have better operating strategies, more advanced techniques and superior diversification and risk management skills. accordingly, foreign institutions can offer better financial access for households and improve the quality of the service offered to customers (berger et al., 2000; akhtar, 2010). using a sample of commercial banks in pakistan for the period from 2001 to 2006,akhtar (2010) examines the effect of the ownership structure on bank efficiency applying data envelopment analysis (dea). the results supports the global advantage theory that foreign banks are able to overcome the challenges of operating in new market through their superior management techniques, well diversified investment portfolio and better services. the positive relationship between foreign ownership and bank performance is confirmed by many studies and researches that focus on the mena region (al-amarneh, 2014; boussaada and karmani, 2015; arouri, hossain and muttakin, 2011). on the contrary,lensink and i. naaborg (2007) support the home field advantage. employing the system generalized methods of moments (gmm) technique on a panel data of banks worldwide, they report negative relationship between foreign ownership and banks’ interest revenues and profitability. the researchers refer to the home field advantage as a main reason justifying the findings. based on the above mentioned arguments, the following hypotheses are developed; h3: there is a significant positive relationship between foreign ownership and bank performance. h4: there is a significant positive relationship between domestic private ownership and bank performance. 3. research methodology 3.1 sample and data the sample of this study includes 137 commercial banks during the period from 2010 to 2014 across twelve countries in the mena region: egypt, algeria, bahrain, jordan, kuwait, morocco, oman, qatar, saudi arabia tunisia, united arab emirates and yemen. other countries like iraq, syria, libya, lebanon, palestinian territory and israel are excluded due to the wars and political instability. from other side, iran is excluded from the sample as it asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 135 follows islamic economy and it has only 1 commercial bank started to operate in 2012. this study excludes islamic banks as they have different objectives and strategies. accordingly, the balanced scorecard for islamic banks should include different measures to convey their missions and goals. the 137 banks considered in this study for 5 years from the year 2010 till 2014 resulted in 685 bank-year observations. table (1) shows the final sample after dropping the missing data since some banks start to operate after the year 2010 and other banks are merged or acquired by other banks during the sample period, it ends up with 637 bank–year observations. table 1. sample by country country target population sample size percentage egypt 23 23 17% yemen 5 4 3% oman 6 6 4% kuwait 6 5 4% uae 20 18 13% bahrain 12 10 7% qatar 7 7 5% tunisia 17 16 12% jordan 10 10 7% morocco 14 13 9% algeria 17 17 12% saudi arabia 8 8 6% total 145 137 100% notes: distribution of the sample by country with respect to the data collection, all the bank-level accounting information and financial ratios are mainly obtained from the bank scope database and in case of a missing data and sometimes for the reason of double check, the balance sheet and income statements are retrieved from the bank website. other data like the number of employees, number of branches and the ownership data are obtained from the banks’ annual reports and websites. the inflation rate and gdp growth rate obtained from the world bank database and the annual reports of the central bank in each country. 3.2 econometric models in order to test the study hypotheses, four pooled ols regression models are constructed to estimate the relationships of the study and test each hypothesis. each regression model is used to test all four hypotheses, while relying on two alternative measures for ownership concentration and liquidity to ensure robustness of results. in other words, the main asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 136 relationships are re-estimated using different measures to assure that results obtained are not violated. model 1 bsc index = α + β1 for % +β2 gov % + β3 d_prv % + β4 con1 + β5 size + β6 liq1+ β7 capadq+ β8 gdp+ β9 inf + β10 year+ ε (1) model 2 bsc index = α + β1 for % +β2 gov % + β3 d_prv % + β4 majsh + β5 size + β6 liq1+ β7 capadq+ β8 gdp+ β9 inf + β10 year+ ε (2) model 3 bsc index = α + β1 for % +β2 gov % + β3 d_prv %+ β4 con1 + β5 size + β6 liq2+ β7 capadq+ β8 gdp+ β9 inf + β10 year+ ε (3) model 4 bsc index = α + β1 for % +β2 gov % + β3 d_prv + β4 majsh + β5 size + β6 liq2 + β7 capadq+ β8 gdp+ β9 inf + β10 year+ ε (4) 3.3 variables definition to measure the bank performance as a dependent variable using balance scorecard composite index, different variables are used to represent each of the four perspectives of the balanced scorecard. consistent with the previous studies (al-najjar and kalaf, 2012; elbannan and elbannan, 2014; tominac, 2014), return on equity (roe), return on assets (roa) and net interest margin (nim) are used as indicators for the financial performance of the bank. following the study conducted by laeven and levine (2009). the customer perspective is measured using bank’s deposit market share (dmktsh,).the dmktsh is used as a proxy for the customer retention and satisfaction. for the internal business perspective, credit growth and deposits growth (current, saving, and term) are used as an indicator of the growth of the banking services. the cost to income ratio (cti) is used as efficiency indicator. it reflects the management ability to control its costs and raise high income relative to the total costs (rose and hudgins, 2008). to reflect the asset quality, the nonperforming loan ratio (npl) is employed. many scholars argue that asset quality measured by the ratio of nonperforming loans to total loans have significant negative impact on bank efficiency. high npl ratio reveals inadequate credit policy and poor evaluation and monitoring process (karim et al., 2010; hughes and mester, 1993; altunbas et al., 2000; girardone et al., 2004). the fourth and final perspective in the bsc is the leaning and growth. following wang (2005), employee productivity (e. prod) and branch productivity (b. prod) are used as proxies for bank learning and growth. regarding the explanatory variables, the ownership type is classified into 3 types: foreign ownership, government ownership and domestic private ownership. each one of them is measured as a percentage. ownership concentration is measured by two mutually used asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 137 variables: con1 is the percentage of equity held by the largest shareholder and majsh is the percentage of equity held by major shareholders who owe 5% or more. other factors that may affect bank performance are taken into consideration as control variables like capital adequacy, liquidity, bank size, gdp growth and inflation rate. capital adequacy is expected to have positive effect on bank performance as banks with good capital adequacy ratio are less exposed to bankruptcy problems which decreases the fund raising costs and results in better bank performance (berger et al., 1995; goddard et al., 2004). bank size is expected to have positive effect on bank performance assuming increasing return to scale. bank size in terms of total assets is found to have a direct effect on bank profitability especially on the return on assets ratio (roa) (panayiotis et al., 2005; sudin, 1996; valentina et al., 2009; arif et al., 2013). from other side, liquidity is expected to have a negative effect on bank performance. assuming competitive deposits market, high liquidity ratios result in low net interest margin which inversely affects the bank performance. two liquidity indicators are used in this study, the ratio of liquid assets to total deposits and short term funding shows what percentage of a bank's deposits and short term finding is held in liquid form. the second indicator for the bank liquidity is liquid asset to total deposit and borrowing which relates liquid assets to the deposits and borrowing levels (naceur and kandil, 2009). macroeconomic factors like the real gpd growth and the inflation rate (inf) are taken into consideration. during the period of economic boom and high real gdp, banks are expected to report high performance measures and vice versa during economic recession. from other side, prior studies do not report a clear relationship between the bank performance and the inflation rate. based on the economic conditions in the mena region, inflation is expected to have a negative effect on banks' performance as inflation decreases the real income for households which lead to a fall in the total demand on goods and services. consequently, organizations reduce their production and cut their investments and borrowing plans especially for variable-rate loans (athanasoglou et al., 2008; perry, 1992; boyd et al., 2001; umer et al., 2014). table 2. variables definition dependent variables variable measurement source return on average assets roaa net income/ average total assets,% bankscope/financial statements return on average equity roae net income/ average total equity,% bankscope/financial statements return on average equity roae net income/ average total equity,% bankscope/financial statements net interest margin nim net interest revenue/ total earning assets bankscope/financial statements credit growth cr. percentage change in total loans bankscope/financial asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 138 growth statements deposit market share dmsh bank deposits divided by total deposits of all banks bankscope/financial statements current deposits growth cdg percentage change in current accounts bankscope/financial statements saving deposits growth sdg percentage change in saving accounts bankscope/financial statements term deposit growth tdg percentage change in term accounts bankscope/financial statements non-performing loan rate npl impaired loans/ gross loans bankscope/financial statements cost to income ratio cir overhead costs/ (other operating income+net interest rvenue) bankscope/financial statements employees productivity e.prod log of ( operating income/ no. of employees) bankscope/financial statements branch productivity b.prod log of ( operating income/ no. of branches) bankscope/financial statements learning composite index learn f. leanin score generated by factor analysis of bank i's in year t. factor analysis author constructed financial composite index fin. f financial score generated by factor analysis of bank i's in year t factor analysis author constructed internal business composite index inpro.f internal business score generated by factor analysis of bank i's in year t factor analysis authorconstructed customer composite index cust.f customer score generated by factor analysis of bank i's in year t factor analysis authorconstructed bsc composite index. bsc index bank performance score measured as a multidimensional composite index generated by factor analysis of banks i's score in year t on each of the following indicators: factor 1 leaning, factor 2 financial, factor 3 internal business and factor 4 customer. factor analysis author constructed explanatory variables foreign ownership percentage for % percentage of shares held by the foreign investors annual reports/ bank website governmental ownership percentage gov% percentage of shares held by the government annual reports/ bank website asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 139 domestic private ownership percentage d_prv % percentage of shares held by domestic private institutions or individuals annual reports/ bank website major shareholders majsh adding up all shareholding owning 5% or more annual reports/ bank website largest shareholder con1 the shareholder owning the highest percentage of shares annual reports/ bank website control variables liquid assets to total deposits and short term funding liq 1 liquid assets divided by total deposits and short term funding bankscope /financial statements liquid assets to total deposits and borrowing liq 2 liquid assets divided by total deposits and borrowing bankscope/financial statements equity to total assets capadq book value of equity to total assets bankscope/financial statements bank size size natural logarithm of total assets bankscope/financial statements real gdp growth gdp official annual gdp growth figures world development indicators of the world bank/ central banks reports inflation rate inf official annual inflation rate world development indicators of the world bank/ central banks reports time effect yearcode categorical variable representing code of year t author-constructed notes: variables definition and data source 4. empirical results 4.1 descriptive analysis the descriptive statistics for the entire set of included variables are reported in table 3. the table presents the descriptive statistics for the various bank characteristics variables, in addition to those for the macroeconomic variables. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 140 table 3. descriptive statistics variables mean median std. dev skewness kurtosis min. max. roaa 1.333 1.558 3.420 -12.172 184.828 -55.487 7.393 roae 10.867 12.024 20.793 -7.897 173.478 -357.108 218.009 nim 3.650 3.282 1.903 1.368 4.376 -3.445 12.204 dmsh 0.096 0.053 0.120 2.327 6.527 0.000 0.782 cdg 0.260 0.130 0.840 8.009 81.785 -1.000 11.000 sdg 0.170 0.100 0.588 7.883 86.495 -1.000 8.000 tdg 0.240 0.040 2.480 18.147 363.059 -1.000 51.000 cr.growth 15.964 8.930 55.766 10.992 140.570 -99.740 789.270 npl 8.124 5.004 9.382 3.146 12.548 0.053 65.936 cir 45.430 42.050 23.534 5.086 47.315 9.000 333.000 e. prod. 2.256 2.234 0.387 0.702 1.788 1.227 3.921 b. prod. 3.652 3.595 0.546 -2.013 13.713 -0.609 4.632 capadq 14.175 12.341 10.229 -0.794 26.979 -95.936 66.830 size 6.664 6.629 0.670 -0.133 -0.369 4.504 8.126 liq 1 35.756 25.628 28.156 1.719 3.373 2.011 186.522 liq2 30.695 23.302 23.502 1.732 3.293 1.375 147.864 gov % 0.789 0.793 0.209 -0.157 -1.738 0.492 1.000 for % 0.819 0.880 0.178 -0.410 -1.406 0.500 1.000 d_prv% 0.744 0.750 0.178 0.011 -1.437 0.503 1.000 con 1 0.567 0.500 0.309 0.170 -1.350 0.050 1.000 majsh. 0.776 0.845 0.231 -0.957 0.327 0.010 1.000 inf. 4.950 4.200 3.489 0.652 0.085 -2.400 19.500 gdp 3.459 3.000 2.877 0.767 15.502 -15.100 19.600 notes: the table presents the distribution of variables by showing mean, median, standard deviation, skewness, kurtosis, minimum and maximum. see table 2 for variable definitions. table (3) shows that the average roa for the banks included in the sample is low 1.33% while the average value of roe is a bit higher 10.87% as a result of financial leverage. the average nim is 3.65%. the average cost to income ratio is 45.43% indicating low operating efficiency due to high operating expenses. the average ownership concentration is high for the two measures. the average shares hold by the major shareholder owning higher than 5 % is 56.7% while the average shares hold by the largest 5 shareholders is 77.6%. there is a high trend of foreign ownership in the banking sector in the mena region. foreign ownership represents on average 81.9%. the average government ownership is 78.9% while the domestic private ownership is 74.4% asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 141 figure 1. distribution of the sample figure 1 shows that egypt and the united arab emirates represent the highest percentage of banks included in the sample 17% and 13% respectively while yemen represents the lowest percentage; only 3% of total banks in the sample. 4.2 pearson correlation matrix table 4 represents the pearson correlation results between variables. the results reveal that foreign ownership is positively correlated with financial performance variables; roaa, roae and nim. the positive correlation between foreign ownership and roa is significant at 10% while the positive correlation between foreign ownership and the roe is significant at 1%. government ownership is negatively correlated with the roa and positively correlated with the roe and nim however the results are not statistically significant. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 142 table 4. correlation matrix roa roe nim dmsh cdg sdg tdg cr.grow npl cir e.prod b.prod capadq size gov % for% d_prv % con 1 majsh inf gdp roa 1 roe .165*** 1 nim .395*** .146*** 1 dmsh -.009 .054** -.111*** 1 cdg -.018 -.003 -.045 -.057* 1 sdg .047 .022 -.009 .014 -.045 1 tdg .001 .029 -.056 -.038 -.09** -.026 1 cr.grow .034 -.029 -.026 -.07** .126*** .128*** .157*** 1 npl -.292*** -.182*** .141*** .091** -.057 -.076* -.008 -.082** 1 cir -.626*** -.297*** -.285*** -.173*** .044 .031 .057* .098*** .232*** 1 e. prod. .374*** .227*** -.187*** .173*** .014 .117** -.104* -.176*** -.266*** -.624*** 1 b. prod. .274*** .183*** -.147** .06 .076 -.045 -.026 -.268*** -.33*** -.616*** .884*** 1 capadq .314*** -.121*** .343*** -.203*** .018 .049 .036 .124*** -.162*** -.132*** .174*** .228*** 1 size .144*** .099*** -.173*** .585*** -.024 .05 -.038 -.141*** -.357*** -.329*** .469*** .429*** -.302*** 1 liq 1 .041 -.038 .102*** -.123*** .067* .011 .019 .17*** .118*** .076** -.214*** -.308*** .315*** -.35*** gov % -.069 .015 .067 -.023 .07 -.36*** .129 .203** .493*** .333*** -.628*** -.63*** -.167** -.146* 1 for % .089* .004 .182*** -.154*** .032 .006 -.089 .125** -.095 -.054 .018 -.272*** .101* -.154*** 1 d_prv % -.131** -.003 .007 .023 .03 .026 -.086 -.107* .061 .087 -.258** -.317*** -.12* .01 1 con 1 -.06* -.016 .048 -.109*** .014 -.064* -.007 .037 .176*** .176*** -.348*** -.527*** -.139*** -.227*** .949*** .666*** .084 1 majsh. -.026 .021 .121*** -.229*** .062* -.038 .035 .06* .231*** .167*** -.33*** -.402*** .02 -.279*** .898*** .617*** -.188** .721*** 1 inf. .005 -.002 .148*** -.045 .01 -.106** .017 -.048 .41*** .105*** -.462*** -.325*** -.105*** -.222*** .618*** .157*** .126* .394*** .355*** 1 gdp .051* .041 -.086** .005 .02 .087** -.018 -.013 -.25*** -.086** .317*** .313*** .102*** .209*** -.306*** .071 -.031 -.187*** -.195*** -.403*** 1 notes: the table shows pearson pairs-wise correlation matrix. *,**,***significant at 1, 5 and 10 percent levels, respectively. variables definition is presented in table 2 4.3 principal component analysis in order to construct the four components representing the four perspectives of the balanced scorecard, principal component analysis is used as a data reduction technique for the twelve dependent variables used as indicators for the different perspectives. afterward, the balanced scorecard index is obtained by multiplying each individual score with their respective factor loading scores and then added up all products together to get a weighted average score. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 143 table 5. rotated component matrixa component 1 2 3 4 roaa .251 .887 -.033 -.038 roae .095 .866 .016 .013 nim -.668 .576 -.029 -.118 dmktsh .200 -.138 -.127 .659 cdg .000 .106 .788 .275 sdg .007 -.105 .820 -.040 tdg .165 -.247 -.234 -.710 cr. growth .107 -.086 .856 -.151 e.prod .886 .296 .058 .160 b.prod .885 .205 -.026 -.010 cir -.445 -.671 .175 -.204 npl -.513 -.264 -.225 .282 the rotated component matrix shows the factor loadings for each variable. factor 1 is highly correlated with employee productivity and branch productivity and accordingly it represents the learning and growth perspective. factor 2 is most highly correlated with roaa, roae and nim which represent the financial perspective. current deposits growth, saving deposits growth and credit growth loaded strongly on factor 3 which represents the internal process perspective. deposit market share strongly loaded on factor 4 which represent the customer perspective. table 6. kmo and bartlett's test kaiser-meyer-olkin measure of sampling adequacy. .642 bartlett's test of sphericity approx. chi-square 816.926 df 66 sig. .000 kmo test is a measure of sampling adequacy for factor analysis. in this study, the kmo measure is 0.642 indicating that the sampling adequacy is mediocre. accordingly, the factors extracted will account for fair amount of variance but not a substantial amount. the conducted factor analysis is statistically significant at 1%. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 144 table 7. total variance explained initial eigenvalues rotation sums of squared loadings total % of variance cumulative % total % of variance cumulative % 1 3.368 28.063 28.063 2.628 21.897 21.897 2 2.241 18.671 46.734 2.626 21.886 43.783 3 1.853 15.441 62.175 2.184 18.204 61.987 4 1.178 9.817 71.991 1.201 10.005 71.991 5 .953 7.946 79.937 6 .735 6.129 86.066 7 .468 3.896 89.962 8 .400 3.337 93.299 9 .321 2.678 95.977 10 .241 2.006 97.983 11 .162 1.352 99.334 12 .080 .666 100.000 notes: extraction method: principal component analysis. in table 7, the total column in the initial eigenvalues shows the amount of variance in the original variables accounted for by each component. considering the components with eigenvalues higher than one, the first four components are chosen. factor 1 learning and growth has an eigenvalue = 3.368 which means that this factor explains more variance than a single variable. factor 2 financial has an eigenvalue = 2.241 which means that total variance explained by this factor is 18.671%. factor 3 internal process has an eigenvalue = 1.853 and explains 15.441% of the total variance. factor 4 customer has an eigenvalue = 1.178 and the total variance explained by this factor is 9.817%. these four components account for 71.991% of the variability on the dependent variable which is the bank performance measured by the bsc index. 4.4 regression analysis asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 145 table 7. bsc models bsc index model 1 model 2 model 3 model 4 coef. t-statistics coef. t-statistics coef. t-statistics coef. t-statistics (constant) -.174 -1.094 -.100 -.630 -.184 -1.153 -.111 -.696 gov% -.011 -.107 .038 .357 .019 .174 .061 .566** for % .130 1.670** .135 1.817** .141 1.821* .145 1.950*** d_prv% -.372 -3.994*** -.420 -4.465*** -.361 -3.878*** -.405 -4.311*** con1 -.064 -1.883** -.061 -1.802* majsh -.146 -3.178*** -.134 -2.939 capadq .000 .433 .001 .609 .001 .793 .001 .973 size .058 3.994*** .056 3.891*** .056 3.874*** .053 3.750*** liq1 6.85e-5 .195 .000 .590 liq2 -.001 -1.215 .000 -.800 inf -.004 -1.412* -.003 -1.257 -.004 -1.462* -.004 -1.358* gdp .003 .841 .002 .773 .002 .782 .002 .711 f-statistics 5.226 5.777 5.348 5.802 p-value for ftest .000 .000 .000 .000 r-squared .090 0.098 .092 .099 adjusted r2 .073 .081 .075 .082 mean vif 1.3 1.28 1.78 1.26 notes: *** statistically significant at 1%, ** statistically significant at 5%, *statistically significant at 10%. in table 8, the four bsc models are highly significant with p-value=0.000. the average variance inflation factor (vif) of the model variables are below 10 indicating that there is no multicollinearity problem exists. the findings of the four models reveal that foreign ownership has a significant positive effect on overall bank performance measured by bsc index. the result is statistically significant at 5% in model 1 and 2, significant at 10% in model 3 and significant at 1% in model 4. this result supports the global advantage hypothesis that an increase in foreign ownership leads to higher bank performance, better operating strategies, more advanced techniques and superior diversification and risk management skills. the result is consistent with the results of the previous studies (al-amarneh, 2014; akhtar, 2010; boussaada and karmani, 2015; arouri, hossain and muttakin, 2011). on the other side, domestic private ownership shows a negative impact on bank performance that is statistically significant at 1% in the four models. this negative relationship between asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 146 domestic private ownership and bank performance might be due to the high fixed costs they bear during the expansionary phase or the ineffective strategy to attract more customer deposits at low cost. the result is consistent with the result found by (chaabane and loukil, 2005; sathye, 2003; wanniarachchige, 2011). government ownership has no statistically significant effect in model 1, 2 and 3 while it shows positive significant effect on bank performance in model 4. the result is statistically significant at 5%. the positive effect of government ownership on bank performance is consistent with the previous results by loukil and chaabane, 2005; sathye, 2003 and wanniarachchige, 2011 who refer the positive relation between state ownership and bank performance to the strong support of the government and long experience in the sector. governmental banks may enjoy superior advantage in attracting customer deposits at lower costs compared to foreign and domestic private counterparts. another reason for the positive association between government ownership and bank performance is that governmental banks may have more credits transactions, investments and projects in different and district regions in that are not targeted by foreign and domestic private banks which help raise governmental banks performance. on the other hand, this positive relationship contradicts the social welfare theory and the political theory (sapienza, 2002; boussaada and karmani, 2015; shleifer and vishny, 1994; shleifer, 1998). the regression results reveal that the two measures used for ownership concentration are associated with negative bank performance measured by bsc index. in model 1 and 3, ownership concentration measure con1 has statistically significant negative effect on bank performance. the result is statistically significant at 5% in model 1 and significant at 10% in model 3. in model 2, ownership concentration measure majsh has significant negative effect on overall bank performance. the result is statistically significant at 1%. this confirm the expropriation hypothesis which states that ownership concentration has an adverse effect on bank performance as it may increase the agency costs and cause tunneling problem. the results is consistent with (gutiérrez &tribo, 2004; boyd et al., 1998; filatotchev et al.,2001; alimehmeti and paletta, 2012; pinto and augusto,2014; lee, 2008; su and he,2012) and contradicts with (jensen and meckling, 1976; shleifer and vishny, 1986; affes and hakim, 2013; heugens et al., 2009; son et al.,2015) who support the positive association between ownership concentration and bank performance according to the monitoring hypothesis. bank size has a significant positive effect on overall bank performance measured by bsc. the result is statistically significant at 1% in the four models which is consistent with sudin (1996) and valentina et al., (2009) due to increasing return to scale. inflation has a negative effect on bank performance that is statistically significant at 10% in model 1, 3 and 4. the result is consistent with boyd et al. (2001) and umer et al., (2014). 4.5 additional analysis additional regression analyses are made to test the effect of ownership structure on each perspective of the balanced scorecard separately (the financial perspective, customer, internal process and learning and growth perspective). the main relationship of the study will be reexamined by using each perspective of the balanced scorecard as a dependent variable and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 147 re-estimate the regression models. these additional robustness checks are performed to check the robustness of the study results. table 9. learning and growth factor models learning & growth model 1 model 2 model 3 model 4 coef. t-statistics coef. t-statistics coef. t-statistics coef. t-statistics (constant) .107 .361 .248 .834 .080 .272 .220 .736 gov% .113 .572 .059 .292 .160 .805 .090 .449 for % .008 .054 -.099 -.714 .025 .173 -.089 -.642 d_prv% -1.444 -8.347*** -1.499 -8.498*** -1.429 -8.270*** -1.482 -8.417*** con1 -.217 -3.436*** -.215 -3.439*** majsh -.182 -2.120** -1.996 -1.996** capadq .004 2.008** .005 2.617*** .004 2.274** 2.844 2.844*** size .150 5.533*** .157 5.762*** .148 5.557*** 5.831 5.831*** liq1 .000 -.523 .000 -.521 liq2 -.001 -1.587* -1.409 -1.409* inf -.011 -2.095** -.013 -2.488*** -.011 -2.084** -2.497 -2.497*** gdp .011 1.809** .010 1.751** .011 1.785** 1.736 1.736** f-statistics 14.524 13.820 14.744 13.986 p-value for ftest .000 .000 .000 0.000 r-squared .215 .207 .218 .209 adjusted r2 .200 .192 .203 .194 mean vif 1.3 1.28 1.28 1.26 notes: *** statistically significant at 1%, ** statistically significant at 5%, *statistically significant at 10% in table 9, the four models are highly significant with p-value= .000. the average inflation vif of the models is lower than 10 indicating no multicollinearity problem exists. the regression results show that domestic private ownership has negative effect on the learning and growth factor. the result is statistically significant at 1% in the four models. accordingly, domestic private banks should use modern technologies and new advanced techniques to enhance the workplace. also, it is important to invest more in their stuff through offering training courses and workshops in order to improve their knowledge, skills and productivity. ownership concentration also shows negative relationship with the learning and growth perspective. in model 1 and 3, ownership concentration measure con1 has statistically significant negative effect learning and growth perspective. the result is statistically significant at 1%. in model 2 and 4, ownership concentration measure majsh has significant negative effect on the learning and growth perspective. the result is statistically significant at 5%. this negative effect can be justified by the expropriation hypothesis which comes at the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 148 cost of improving the workplace and investing in their stuff. the results is consistent with (gutiérrez & tribo,2004; boyd et al., 1998; filatotchev et al.,2001;alimehmeti and paletta, 2012; pinto and augusto, 2014; lee, 2008; su and he, 2012) and contradicts with (jensen and meckling,1976; shleifer and vishny,1986; affes and hakim,2013; heugenset al., 2009, son et al., 2015). with respect to the control variables, the results reveal that there is a negative association between inflation rate and the learning and growth perspective. the result is statistically significant at 1% in model 2 and 4 while it is significant at 5% in model 1 and 3. when inflation increases, organizations find it costly to replace the old it systems or to acquire new technologies. moreover, offering new training courses or workshops for the employees will be at high cost. gdp growth shows positive effect on the leaning and growth perspective. the result is statistically significant at 5% in the four models. during the period of high gdp growth, organizations recognizes the importance of enhancing their workplace, adapting new technologies and improving their staff skills in order to cope with the increased activity levels and to exploit the upward economic potentials. liquidity is negatively correlated with the learning and growth factor. the result is statistically significant at 10% in model 3 and 4. high liquidity ratios affect the bank ability to invest in their staff, offer workshops and training programs, update their it systems and adopt new techniques. the negative association between bank liquidity and performance is consistent with the result reported (molyneux and thornton, 1992; bordeleau and graham, 2010; holmström and tirole, 1998). capital adequacy is positively associated with the learning and growth factor. the result is statistically significant at 1% in model 2 and 4 and highly significant at 1% in model 1 and 3. capital adequacy is a crucial determinant of bank safety and soundness. therefore, maintaining adequate capital ratio positively affects the bank long term financial position which consequently affects its future potential growth (uremadu, 2000; and furlong &keeley, 1989). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 149 table 10. internal process factor models internal process model 1 model 2 model 3 model 4 coef. t-statistics coef. t-statistics coef. t-statistics coef. t-statistics gov% -.199 -7.872*** -.174 -6.705*** -.187 -7.381*** -.163 -6.282*** for % -.006 -.240 .032 1.284* .000 .006 .038 1.538* d_prv% .002 .085 .004 .177 .007 .286 .011 .478 con1 .135 4.705*** .140 4.943*** majsh .026 .919 .040 1.419* capadq .144 5.474*** .119 4.565*** .160 6.149*** .137 5.287 size .829 31.306*** .813 30.334*** .819 31.476*** .802 30.429 liq1 .025 .949 .036 1.323* liq2 -.036 -1.403* -.035 -1.328* inf .002 .079 .027 .980 -.001 -.041 .021 .792 gdp -.016 -.613 -.015 -.581 -.019 -.731 -.019 -.706 f-statistics 93.469 89.083 93.696 89.086 p-value for ftest .000 .000 .000 0.001 r-squared .638 .627 .639 .627 adjusted r2 .631 .620 .632 .620 mean vif 1.3 1.28 1.27 1.25 notes: *** statistically significant at 1%, ** statistically significant at 5%, *statistically significant at 10%. table (10) shows that the models are highly significant with p-value=0.000. the average vif of the model variables does not indicate multicollinearity problem. government ownership has a negative effect on the internal process factor that is statistically significant at 1% in the four models. referring to the social welfare theory and the political theory, government owned banks suffer from high nonperforming loan ratios, poor loan portfolio and high non interest expenditures which inversely affect the efficiency of their internal process. this is consistent with the findings of (farazi et al., 2011; boussaada and karmani. 2015; kobeissi and sun, 2010; bonin, hasan and wachtel, 2004). on the contrary, foreign ownership shows positive effect on the internal process factor. the result is statistically significant at 10% in model 2 and 4 which supports the global advantage hypothesis thatforeign banks have new advanced portfolio, risk management and strategic techniques which increase their internal process efficiency (akhtar, 2010; and berger et al., 2000). ownership concentration measure con1 is positively related to the internal process factor in model 1 and 3 and the relation is statistically significant at 1%. likewise, ownership concentration measure majsh has positive correlation with the internal factor in model 4 and the result is statistically significant at 10%. the results support the monitoring hypothesis asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 150 that ownership concentration leads to more efficient internal process and governance structure. this result is consistent with the results reported by (jensen and meckling, 1976; shleifer and vishny, 1986; affes and hakim, 2013; son et al., 2015; heugens et al., 2009). regarding the control variables, capital adequacy hasstatistically significant positive effect at 1% on the internal process factor in models 1, 2 and 3. well–capitalized banks has less bankruptcy risk and are more efficient in raising fund at lower cost which positively affects the internal process mechanisms (berger et al,1995; demirgüç-kunt and huizinga,2000). bank size also shows positive association with bank internal process factor in model 1,2 and 3.the result is statistically significant at 1%. due to increasing economies of scale, banks with large size have the necessary resources to adequately monitor the internal operations and the work processes. the result confirms the findings of kwan (2003) and boussaada and karmani, (2015). liquidity shows contradictory results with respect to the internal process factor. in model 2, the liquidity measure liq 1 is positively correlated with the internal process factor. the result is statistically significant at 10%. consistent with the results reported by (bourke, 1989; almazari, 2014; anyanwu, 1993; nwankwo, 1991), maintaining adequate liquidity level smoothes the bank operations during the period of financial distress and helps compensating the net cash outflow. on the other side, the liquidity measure liq2 has a negative correlation with the internal process factor in model 3 and 4. the result is statistically significant at 10% in model 3 and 4. high liquidity ratio comes at the cost of using this fund in improving the business techniques and operations. the result is consistent with the findings reported by (molyneux and thornton, 1992; bordeleau and graham, 2010; holmström and tirole, 1998). capital adequacy shows significant positive effect on the internal process factor. the result is statistically significant at 1% in model 1, 2 and 3. consistent with the results reported (molyneux and thorton, 1992; berger et al., 1995), capital adequacy enables banks to absorb the financial shocks which ensures the soundness of the banking system and improves the internal operations of the banks. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 151 table 11. customer factor models customer model 1 model 2 model 3 model 4 coef. t-statistics coef. t-statistics coef. t-statistics coef. t-statistics (constant) -1.169 -3.580*** -1.025 -3.147*** -1.173 -3.583*** -1.039 -3.175*** gov% .510 2.332*** .626 2.851*** .590 2.677*** .690 3.120*** for % .312 1.960** .338 2.221** .345 2.163** .369 2.421*** d_prv% -.144 -.755 -.242 -1.257 -.111 -.581 -.197 -1.020 con1 -.112 -1.609* -.097 -1.402* majsh -.297 -3.160*** -.259 -2.766*** capadq -.001 -.747 -.001 -.659 .000 -.201 .000 -.109 size .103 3.426*** .098 3.281*** .091 3.093*** .086 2.921*** liq1 .001 1.401* .001 1.819** liq2 -.001 -.628 .000 -.226 inf -.005 -.822 -.003 -.599 -.006 -.977 -.004 -.809 gdp -.010 -1.539* -.011 -1.618* -.011 -1.654** -.011 -1.731** f-statistics 2.345 2.937 2.219 2.674 p-value for ftest .005 .000 .008 0.001 r-squared .042 .053 .040 .048 adjusted r2 .024 .035 .022 .030 mean vif 1.3 1.28 1.27 1.25 notes: *** statistically significant at 1%, ** statistically significant at 5%, *statistically significant at 10% regarding the customer perspective, table (11) shows that the regression models are highly significant with p-value=0.000 and no multicollinearity problem exists as the averagevif of the model variables are below 10. the findings reveal astatistically significant positive association between governmental ownership and the customer at 1% in the four models.this result is consistent with (loukil and chaabane, 2005; sathye, 2003; wanniarachchige, 2011).governmental banks have superior advantage in attracting customer deposits at lower costs compared to the private counterparts, accordingly they have more credits transactions, investments and projects in different regions that are not reachable by their counterparts. similarly, foreign ownership has positive effect on the customer factor. the result is statistically significant at 1% in model 4 and significant at 5 % in model 1, 2 and 3. the result confirms the global advantage hypothesis and consistent with (al-amarneh, 2014; boussaada and karmani, 2015; arouri, hossain and muttakin, 2011; akhtar, 2010). foreign banks have innovative deposit insurance and financial services which positively affect their relationship with the clients. moreover, customers perceive foreign banks as safe haven during domestic asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 152 financial crisis (peek and rosengren, 2000; hull 2002). ownership concentration is negatively related to the customer factor in the four models. the concentration measure con1 has statistically significant negative relationship to the customer factor in model 1 and 3 at 10% and the concentration measure majsh has a statistically significant negative relationship with the customer factor at 1% in model 2 and 4. referring to the expropriation effect, highly concentrated ownership negatively affects the customers' perception of the bank, the investment opportunities and the customer service offered by the bank (johnson et al., 2000; gutiérrez and tribo, 2004; boyd et al., 1998; filatotchev et al., 2001). bank size is positively correlated to the customer factor in the four models. the result is statistically significant at 1%. assuming increasing return to scale, bank size is associated with higher bank profitability which positively affects the bank reputation, rank and the customer perception of the bank (sudin: 1996, valentina et al., 2009). liquidity has positive effect on the customer factor. the result is statistically significant at 10% in model 1 and significant at 5% in model 2. liquidity is crucial determinant of bank performance specifically the customer factor. the positive effect of liquidity on the customer factor is consistent with the previous results of (anyanwu, 1993; spindt, 1980) who report that bank liquidity is critical to maintain the customers' confidence. the gdp growth shows statistically significant negative effect on the customer factor in the four models. high gdp growth increases the customer marginal propensity to consume which negatively influences the customer factor measured by the deposit market share (blanchard et al., 2013; krugman and wells, 2013; parkin, 2014). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 153 table 12. financial factor models financial model 1 model 2 model 3 model 4 coef. t-statistics coef. t-statistics coef t-statistics coef t-statistics (constant) -.237 -.724 -.219 -.667 -.240 -.730 -.227 -.688 gov% -.563 -2.566*** -.512 -2.313** -.531 -2.406*** -.486 -2.185** for % .428 2.682*** .459 2.994*** .441 2.760*** .472 3.078*** d_prv% .104 .544 .083 .429 .117 .611 .102 .523 con1 .008 .121 .014 .203 majsh -.060 -.634 -.045 -.477 capadq .001 .548 .001 .484 .001 .766 .001 .707 size .030 .991 .027 .891 .026 .862 .022 .752 liq1 .000 .502 .000 .638 liq2 .000 -.284 .000 -.186 inf .005 .816 .005 .974 .004 .764 .005 .902 gdp -.003 -.399 -.003 -.414 -.003 -.443 -.003 -.458 f-statistics 1.962 1.993 1.949 1.963 p-value for ftest .021 .019 .023 .021 r-squared .036 .036 .035 .036 adjusted r2 .018 .018 .017 .018 mean vif 1.3 1.28 1.275 1.258 notes: *** statistically significant at 1%, ** statistically significant at 5%, *statistically significant at 10% with respect to the financial perspective, the regression results show that there is a negative relationship between governmental ownership and the financial performance of the bank and the result is statistically significant at 1% in model 1 and 3 and statistically significant at 5% in model 2 and 4. the poor financial performance of the governmental banks is supported by the social welfare theory and the political theory. (bonin, hasan and wachtel, 2004; micco, panizzaand yañez, 2004; fungacova et al., 2013; bertay et al., 2015; shleifer and vishny 1994; shleifer, 1998; sapienza, 2004; micco and panniza, 2006; dinç, 2005). foreign ownership has a statistically significant positive effect on the financial performance at 1% in the four models. this result supports the global advantage hypothesis and is consistent with the previous studies by (al-amarneh, 2014; boussaada and karmani, 2015; arouri, hossain and muttakin, 2011; akhtar, 2010). on the other side, domestic private ownership and ownership concentration do not show statistically significant effect on the financial factor in the four models. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 154 5. conclusion this study investigates the effect of ownership structure on bank performance in the mena region by applying the balanced scorecard method using a panel of 137 commercial banks during the period from 2010 to 2014 across twelve countries in the mena region. the regression results reveal a statistically significant positive association between foreign ownership and bsc index while domestic private ownership shows a statistically significant negative effect on the bsc index. in contrary with the social welfare theory and the political theory, government ownership has a statistically significant positive effect on the bsc index (loukil and chaabane, 2005; sathye, 2003; wanniarachchige, 2011). consistent with the expropriation hypothesis, ownership concentration has a statistically significant negative effect on the bsc index. with respect to the control variables, the regression results convey that there is statistically significant positive correlation between bank size and bsc index due to increasing return to scale whereas inflation has a negative effect on the bsc index that is statistically significant at 10%. analyzing the impact of the ownership structure on each of the four perspective of the balanced scorecard, additional regression analyses are run. government ownership has statistically negative impact on the banks’ financial performance. this result is consistent with the social welfare theory and the political theory. on the contrary, ownership concentration and domestic private ownership does not show statistically significant effect on bank’s financial performance. regarding the learning and growth factor, the results convey that domestic private ownership has a statistically significant negative impact on the learning and growth factor. similarly, ownership concentration, inflation and liquidity are negatively correlated with the learning and growth factor. on the hand, bank size, capital adequacy and the gdp growth show a statistically significant positive impact on this factor. concerning the customer perspective, the findings reveal that there is a positive association between government ownership and the customer factor as customer perceive state owned banks as safe banks. consistent with global advantage hypothesis, foreign ownership also shows statistically significant positive effect on the customer. ownership concentration and gdp growth have a statistically significant negative effect on the customer factor while bank size and liquidity are positively correlated with the customer factor. with respect to the internal process perspective, government ownership has a negative effect on the internal process factor in confirmatory with the social welfare theory and the political theory while foreign ownership is positively correlated with the internal process factor which is consistent with the global advantage hypothesis.. similarly, ownership concentration shows statistically significant positive effect on the internal process factor due to the monitoring effect. bank size and capital adequacy show statistically significant effect on the internal process factor while liquidity shows contradictory results with respect to the internal process factor. references affes,h., & hakim, n. h. 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(2011). how does ownership affect bank performance. the case of indian commercial banks. the international business and economics research journal, 10(3), 71-81. https://doi.org/10.19030/iber.v10i3.4103 zouari,s. b., taktak, n.b. (2014). ownership structure and financial performance in islamic banks: does bank ownership matter?. international journal of islamic and middle eastern finance and management, 7(2), 146-160. https://doi.org/10.1108/imefm-01-2013-0002 microsoft word women in board-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 48 women in board of directors and real earnings management: accretive share buyback in malaysia abdulsalam saad alquhaif a phd candidate, college of business tunku puteri intan safinaz school of accountancy (tissa) universiti utara malaysia, 06010 sintok, kedah, malaysia b faculty of business and accounting, ibb university tel: 60-19-245-5907 e-mail: alquhif20@gmail.com rohaida abdul latif associated professor, college of business, tunku puteri intan safinaz school of accountancy (tissa) universiti utara malaysia, 06010 sintok, kedah, malaysia tel: 60-4-928-7310 e-mail: roaida@uum.edu.my sitraselvi chandren senior lecturer, college of business, tunku puteri intan safinaz school of accountancy (tissa) universiti utara malaysia, 06010 sintok, kedah, malaysia tel: 60-4-928-7328 e-mail: sitraselvi@uum.edu.my received: july 3, 2017 accepted: august 2, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11752 url: https://doi.org/10.5296/ajfa.v9i2.11752 abstract gender diversity of boards and reporting of earnings are two most debated issues in the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 49 corporate world. in this context, the paper explores how the presence of women directors on the corporate board influence real earnings management through accretive buyback programs. using a sample of 601 firms’ observations that engage in accretive share buyback from 2010-2015, the findings reveal that existence of women directors on the board is associated with less engagement in accretive share buyback activities. we further find that firms with a higher number of independent directors are less likely to practice real earnings management through accretive buyback programs. our paper contributes to the debate on gender diversity on boards and its influence on the utilisation of accretive buyback programs as a tool to real earnings management. keywords: women directors, board of directors, real earnings management, accretive share buyback, malaysia asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 50 1. introduction in the recent decades, gender diversity on top corporate positions has attracted rising attention subsequently to financial scandals and legislative reforms. since researchers have focused on the pattern of appointing women as directors on the board or as executives, researchers find women’s participations on top management level varies across countries. existing literature reveals that women on boardrooms are under-represented despite their high participation in the workforce (amran et al., 2014). malaysian authorities in 2004 have required the public-sector agencies to increase the representation of women on decision-making level to reach 30 percent. subsequently, the governance in 2011 protracted the policy and involve the private sector in the strategy of represented-women to increase the existing of women on the top management and identify the year 2016 as the date to match the target 30 percent (the star, june 27, 2011). deloitte (2015) has provided a professional report for gender diversity on board of directors worldwide. norway and france have the highest women representative on the board which accounted about 36.7 and 29.9 percent respectively. japan has the lowest percentage of women held seats on board which was about 2.4 percent. regarding malaysia, deloitte's report (2015) reveals that women represented about 10.4 percent of board seats, which is slightly less than the average of world rate, which is 12 percent. recently, in april 2016 fmt state report on women participation on the boardrooms, which reveals that the presence of women in top management increase from 8.3 percent to 12.5 percent during 2014. the report also shows that malaysia is the second country after australia 21.9 percent in women nominated on board of directors (fmt, april 20, 2016). the literature on boards’ gender diversity commonly supports the argument that representation of women on the board enhances firm's financial performance (s. m. adams, gupta, & leeth, 2009; campbell & mínguez-vera, 2008; lam, mcguinness, & paulo, 2013). regarding board of directors’ effectiveness, prior studies indicate an effective role for gender diversity in enhancing monitoring tasks and improving decisions quality (r. b. adams & ferreira, 2009; nielsen & huse, 2010; valenti, 2008). regarding earnings management, previous studies of gavious, segev and yosef (2012), peni and vähämaa (2010) and krishnan and parsons (2008), provide evidence that firms with a higher number of women on the board are less likely to manipulate earnings. recently, arun, almahrog and ali aribi (2015) find that firms with a higher number of women and independent women directors are adopting restrained earnings management practices. according to prior studies, managers have several incentives to manage earnings; to maximise stock price prior to security issuance (graham, harvey, & rajgopal, 2005; s. h. teoh, welch, & wong, 1998; s. teoh, welch, & wong, 1998) to meet analyst forecasts (sitrasellvi chandren, 2016; gunny, 2010; skinner & sloan, 2002), and to increase managerial compensation (cheng & warfield, 2005; healy, 1985). recent literature reveals that managers using firms’ real activities to manipulate earnings, which directly affect cash flows (cohen, dey, & lys, 2008; roychowdhury, 2006; sun, lan, & liu, 2014). managers also employ share buyback activities as a tool for managing reported eps through adjusted asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 51 outstanding shares that represent denominators of eps equation (burnett, cripe, martin, & mcallister, 2012; hribar, jenkins, & johnson, 2006). based on these different views, this paper examines the association between women directors and real earnings management through accretive share buyback in malaysia. our paper contributes to the existing literature by focusing on the women serving on the board of directors as a determinant of accretive buyback activities during the scope of malaysian code of corporate governance (mccg 2012). previous studies focus on influence of some firms’ financial characteristics (farrell, unlu, & yu, 2014) and some governance features such as board of directors, audit quality and managerial ownership (s chandren, ahmad, & ali, 2015; farrell, yu, & zhang, 2013; farrell et al., 2014). the findings of this paper may help policy makers and regulators to draw policy implications on the importance of existing women on the top management, where the results reveal the efficacy of women on boardrooms especially in emerging market. it also supports the orientation of policy makers to increase gender diversity on the top level of decision making. the paper is organised as follows. the development hypothesis of women directors and earnings management are set out in section 2. section 3 discusses the empirical research methods used. section 4 shows the findings and discussions and section 5 displays the conclusion. 2 hypotheses development previous studies report that women are more ethical in the workplace and less likely to engage in unethical behaviour to gain financial rewards (betz & skepard, 1989; khazanchi, 1995). they argue that the existence of female directors on top management level reduce information asymmetry between women directors and managers through obtaining voluntary information as well as better to demonstrate greater ethical behaviour and risk aversion (francis, hasan, park, & wu, 2009; gul, yu, fung, & jaggi, 2009). byrnes, miller, and schafer (1999) provide evidence that women are less likely to take risks, particularly in the financial decision environment. further, arun et al. (2015) and powell and ansic (1997) indicate that women on top management are more cautious and less aggressive than men in a variety of decision-making contexts. regarding earnings management, prior studies reveal that the quality of earnings is higher for firms with more women directors (krishnan & parsons, 2008; peni & vähämaa, 2010; thiruvadi & hua-wei huang, 2011). further, gavious et al. (2012) and barua, davidson, rama, and thiruvadi (2010) reveal that firms with women ceos have fewer earnings management than those with males, and document a negative relationship between women executives and earnings management. liu, wei, & xie (2016) provide evidence that that man cfos to save their job they aggressively engage in earnings management more than women cfos, suggesting that women cfos are more conservative in financial reporting than their counterparts from men as well as less involved in earnings management. based on this view, we hypothesise that: firms with women directors on the board are less likely to engage in real earnings management through an accretive share buyback. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 52 3 methodology 3.1 sample following hribar et al. (2006), we measure the accretive share buyback as a real earnings management model. he establishes two steps to distinguish between accretive and non-accretive buyback activities; firstly, we begin to remove the impact of buyback activities from eps by computing eps without shares buyback which is called asif eps. the paper calculates asif_eps by estimating the denominator and numerator effects of accretive shares buyback on eps as follows: asif_eps = ni it / (shares outstanding it +0.5 x shares issued it) (1) where asif_eps represents the estimated eps in the absence of accretive share buybacks, ni it is reported earnings before comprehensive income available to ordinary shareholders for fiscal year, shares outstanding it is the reported number of ordinary shares outstanding, at the beginning of the firm year, shares issued it is the actual or estimated number of ordinary shares issued during a year. the second step is to compute the difference between reported eps as presented in financial statement and eps without shares buyback impact (asif eps). if the difference between them is a positive value, it is an accretive shares buyback. based on prior studies such burnett et al. (2012), farrell et al. (2014) and hribar et al. (2006), shares buyback is accretive shares buyback when it leads to change in eps by one cent. the total number of malaysian listed firms that engaged in accretive share buyback from 2010 to 2015 is 106 firms based on the hribar’ model. as displayed in table 1, we excluded financial listed firms because they apply different regulatory requirements. further, we excluded firms with incomplete data or missing annual report from the sample selected. these processes yield an ultimate sample consisting of 601 firm year observations with 225 observations of accretive share buybacks (39.1% of the sample) and 374 none-accretive share buybacks (60.9% of the sample). the information on accretive share buyback, women directors, independence and size of the board, and big 4 audit firms are obtained from the annual reports available on the bursa malaysia website. whereas the other control variables, roe, fsize, lev and fcf showed in the model below are collected from thomson datastream. the actual annual eps data for a year from 2010 – 2015 were obtained from the annual reports on bursa malaysia websites. table 1. sample selection process during the sample period calculation of 601 observations: firms year observations. accretive buyback firms 2010-2015 106 less: financial accretive buyback 5 non-financial accretive buyback firms 101 accretive buyback firm’s observations (101 firms *6 years) 606 less: firms’ observations without prior years’ data 2 less: unlisted firms’ observations in 2015 3 total observations for accretive buybacks firms 601 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 53 3.2 empirical models this paper utilised logistic regression since the dependent variable (abbd) is a dichotomous variable. based on previous studies, this paper uses the following model to examine the proposed hypothesis. abbd = β0+ β1 gender + β2bind + β3 bsize + β4 big4 + β5 roe + β6 fsize+ β7 lev t-1 + β8 fcf t-1 + e (2) where abbd a dichotomous variable equal 1 for accretive share buyback; 0 otherwise. gender a dichotomous variable equal to one if board of directors contain at least one women, and zero otherwise; bind percentage of independent directors serving on board of directors scaled by the board size; bsize the number of directors serving on board of directors; big4 a dichotomous variable equal to one if the firms audited by one of big4 audit firms, and zero otherwise; roe the net income scaled by shareholders’ equity fsize t-1 natural log of total assets at the beginning of the year. lev t-1 the ratio of current plus long-term debt to total assets at the beginning of the year. fcf t-1 the ratio of firm’s beginning of the year cash and cash equivalents scaled by total assets. 4. findings and discussions 4.1. descriptive statistics and univariate tests the descriptive statistics for the women serving on the board variable as well as for the other control variables are presented in table ii. the table shows the statistics for the entire sample of 601 observations. the statistics demonstrate that nearly 48 percent of the sample firms contain women serving on their boardroom during the sample period 2010-2015. accordingly, independent directors represent 45 percent of board size which is consistent with the recommendation of mccg 2012. the table also reveals that big 4 audit firms audit about 50 percent of the sample firms. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 54 table 2. descriptive statistics of independent variables. variables mean median std. dev. min max number obs. = 601 abbd 0.3910 0 0.4883 0 1 gender 0.4792 0 0.4999 0 1 bind 0.4544 0.4285 0.1202 0.1667 1 bsize 7.4309 7 1.9754 4 14 big4 0.5024 1 0.5004 0 1 roe 0.0999 0.0842 0.3342 -1.1469 7.4308 fsize(log) 19.993 19.763 1.6103 16.7523 24.834 lev 0.1813 0.1649 0.1446 0 0.7601 fcf 0.1622 0.1201 0.1408 -0.0378 0.8801 the following table 3 shows the pearson correlation results of independent and control variables. results in table 3 show low coefficient correlations which indicate that less serious multicollinearity problems between independent variables, where the highest correlation is 54 percent which is between fsize and lev. table 3. correlation matrix of variables variables abbd gender bind bsize big4 roe fsize lev fcf abbd 1 gender -0.038 1 bind -0.090* -0.26*** 1 bsize 0.065 0.28*** -0.36*** 1 big4 -0.021 0.009 -0.15** 0.09* 1 roe -0.003 -0.07 -0.058 0.019 0.072 1 fsize 0.047 0.13** -0.056 0.45*** 0.35*** 0.092 1 lev -0.028 0.22*** -0.19*** 0.33*** 0.14** -0.027 0.55*** 1 fcf 0.034 -0.09* 0.028 -0.08 -0.060 0.098 -0.18*** -0.3*** 1 notes: *, **, *** significant at 10%, 5%, and 1% levels, respectively. 4.2 multivariate analysis the results of panel logistic regression are presented in table 4, which provide considerable evidence regarding the tested hypothesis of our paper. as shown in in the table, the coefficient on the percentage of women serving on the board of directors (gender) is -0.3007 which is significantly negative accretive share buyback (z=-1.65, p < 0.10). the findings are somewhat consistent with our prediction that the presence of women directors on firms’ board of directors is less likely to utilise accretive share buyback to manage eps. the result is also slightly consistent with the argument that women are more conservative and less risk tolerance than a man in making decisions related to managing earnings (ittonen & peni, 2012; krishnan & parsons, 2008; peni & vähämaa, 2010). practically, the results of this asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 55 paper support the policy of the malaysian government to increase the presence of women in decision-making positions to become 30 percent in both public and private sectors. the findings reveal the association between women on the board of directors and accretive buyback is significant only at 0.10, which support the outcomes of the reports that reveal the presence of women in the top management in malaysia is still under normal level (delliotte, 2015; fmt, 2016). regarding control variables, the result also reported a negatively significant association between accretive share buyback (earnings management proxy) and board of directors independent (bind) with t = -2.65 and coefficient at -2.1467, which is consistent with siagian and tresnaningsih (2011) and xie et al. (2003) who found effective role of the board independence in constraining earnings management. this empirical evidence hence supports the role of independent directors as an effective mechanism in monitoring managers’ behaviours. however, bsize and big4 variables have no significant association with accretive share buyback actions. consistent with abdul latif and taufil-mohd (2013), free cash flow (fcf) has an insignificant relationship which means accretive share buyback activities do not influence by excess cash flow. whereas, firm size (z= 2.1, p = 0.036) is significantly positive, indicating that large firms are more likely to manage earnings through an accretive share buyback. finally, the table shows a significantly negative linkage among firms’ leverage and accretive buyback, suggesting high leverage firms are less likely to increase eps by share buyback activities, or firms may use share buyback programs to reach the optimal capital structure (dittmar, 2000). table 4. result of multivariate logistic regression independent variables coefficient std. err. z p.value constant -2.3002 1.2869 -1.99 0.047** gender -0.3007 0.1825 -1.65 0.099* bind -2.1467 0.8098 -2.65 0.008*** bsize 0.02866 0.0526 0.54 0.586 big4 -0.2751 0.1857 -1.48 0.139 roe -0.18595 0.3043 -0.57 0.568 fsize 0.15530 0.0741 2.1 0.036** lev -1.40112 0.7659 -1.83 0.067* fcf 0.35498 0.6402 0.55 0.579 log likelihood -394.229 lr chi2(8) 15.92 no obs. 601 notes: *, **, *** significant at 10%, 5%, and 1% levels, respectively. abbd is a dichotomous variable equal 1 for accretive share buyback; 0 otherwise.; gender is a dichotomous variable equal to one if board of directors contain at least one women, and zero otherwise; bind is a percentage of independent directors serving on the board of directors; bsize is the number of directors serving on the board; big4 is a dichotomous variable equal to one if firm is audited by big4 auditors, and zero asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 56 otherwise; roe t-1 is return on equity at the beginning of the year ;fsize t-1 is the logarithm of the firm’s total assets at the beginning of the year; lev t-1 is total debt at the beginning of the year, deflated by total assets; fcf t-1 is cash and cash equivalent at the beginning of the year, deflated by total assets. 5. conclusions the purpose of our paper is to examine the nature of shares buyback activities between malaysian listed firms for the years 2010-2015 and to examine whether the existence of women directors on the board is associated with activities of earnings management through an accretive share buyback. using a sample of 601 firms’ observations that engage in accretive share buyback from 2010-2015, the findings reveal that existing of women directors serving on the board are associated with less likelihood of accretive share buyback activities. the outcome shows that women directors are effective in monitoring managers’ actions, especially regarding earnings management practices. our results thus are consistent with previous studies proving the effective monitoring by women directors (krishnan & parsons, 2008; peni & vähämaa, 2010). further, the results of our paper are consistent with a malaysian government orientation to increase the representation of women on boards of directors to 30 percent. the findings of our paper may provide input for the policy makers and the regulatory bodies in malaysia to pay more attentions for shares buyback programs. in addition to being a tool for financial policy, managers may use share buyback to manage earnings and shares price. our findings also provide implications that support the policy of regulatory bodies to increase the representation of women on the firms’ boardroom. it further supports mccg 2012 regarding reinforcing the independence of the board of directors through evidencing effective role for independent directors in eliminating earnings managements by using accretive share buyback activities. for future research, academicians could demonstrate deeper on nature of women involvements on top management such as independent, executives, chairman and family member. future studies could also consider the qualities of women representations on decision making through follow qualitative instruments. references abdul latif, r., & taufil-mohd, k. n. 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(2003). earnings management and corporate governance: the role of the board and the audit committee. journal of corporate finance, 9(3), 295–316. https://doi.org/10.1016/s0929-1199(02)00006-8 microsoft word 10186-37493-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 125 protection of investors’ rights and the long-run performance of rule 144a private equity offerings seoungpil ahn (corresponding author) sogang business school, sogang university pa706, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: spahn@sogang.ac.kr gwangheon hong sogang business school, sogang university pa711, 35 baekbeom-ro, mapo-gu, seoul 121-742, korea e-mail: ghong@sogang.ac.kr received: sep. 21, 2016 accepted: oct. 31, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.10186 url: http://dx.doi.org/10.5296/ajfa.v8i2.10186 abstract equity private placement is the newest method of corporate financing strategy. the private equity financing under sec rule 144a is exploding and yet not much is known about the motivation behind private equity placement by public firms. considering that privately placed firms have no bonding benefit, private equity investors would discount their capital by the amount of expected consumption of private benefits. therefore, the issuers are unable to lower the cost of capital nor increase managerial perquisites. one possible motivation for private placement then is that firms offering the private dr increase their private benefits with the capital raised subsequently. our approach is new to literature by incorporating both benefit (conceal private information) and cost (informational monopoly) associated with private equity financing. keywords: private equity offering, rule 144a, cross listing, firm performance, investor rights, bonding, monitoring jel: g15, g24, g34 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 126 1. introduction new capital raising is one of reason why non-us firms listed in the us exchange. non-us firms can raise equity capital in the us either through public offerings (levl iii adrs) or through private offerings (rule 144a). level iii adrs requires full registration and disclosure of financial statements to sec and compliance with us gaap. rule 144a offerings, however, are exempt from sec registration and compliance with us gaap. accordingly, rule 144a securities are available only to qualified institutional buyers (qibs) and can be traded in the portal (private offerings, resale and trading through automated linkages) system. since 1990, increasing numbers of foreign companies are raising equity capital in the u.s capital market through rule 144a private equity placement in the us. between 1993 and 2002, $117.1 billion was raised in 557 new public depositary receipt (dr) offerings and $41 billion was raised in 486 new private depositary receipt (dr) offerings.i the majority of non-us firms in rule 144a private equity market is from developing countries. in 2002, companies from taiwan, mexico, russia, india, and korea represent more than 90% of new private dr program in terms of capital raised and the number of issuance. benefits associated with cross-listing, in general, include the reduction of cost of capital and the increase of liquidity in the home market through an enlarged investor base (foerster and karolyi, 2000) and reduced information asymmetry with higher disclosure requirement (hertzel and smith, 1993). more recently, reese and weisbach (2002), and doidge, karolyi, and stultz (2004) argue that a us listing provides bonding and monitoring benefit to cross-listed firms. they argue that the disclosure and accounting compliance requirements for a us exchange listing enhance the protection of the minority shareholders and reduce the agency costs of controlling shareholders. the bonding and monitoring benefit can be applicable to public exchange listings which require registration and compliance with the us gaap. however, with its exemption from registration, non-us firms in rule 144a private market are unlikely to benefit from monitoring from higher investor protection. because the resales of the securities are restricted to qibs and privately placed equity is trading at substantial discount, other commonly argued cross-listing benefits such as liquidity effects and the reduction of cost of capital are unlikely to be applicable to rule 144a private offerings. we explore the motive for non-us firms to raise equity capital in the us privately. reese and weisbach (2002) find that firms from weak investor protection are less likely to cross-list in the public us exchange in afraid of the potential loss of private benefits of control. the private dr program, however, is dominated by firms from countries with weak investor protection. considering that these firms will not have bonding benefit, private equity investors would discount their capital by the amount of expected consumption of private benefits and the issuers will not lower their cost of capital or increase perquisites. however, it is possible that firms offering the private dr increase their private benefits with the capital raised subsequently. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 127 reese and weisbach (2002) also document the increase in equity issues following cross-listing, specially from issuers from countries with weak investor protection. they conclude that a bonding mechanism provided with the us listing allows firms to raise more capital subsequently. again, rule 144a private placement does not require such compliance with sec regulations and, consequently, non-us firms in rule 144a will not benefit from bonding and monitoring under the us regulation. it is questionable how non-us firms listed in portal can also raise more capital subsequently. in emerging markets, the government, oftentimes, guarantee that a firm will not let bankrupt in order to persuade foreign investors to participate in the capital raising. private dr issuers also might delude home country investors as if their firms receive the same scrutiny as firms listed in the public us exchange such as nyse and nasdaq. a listing in formal us exchange can provide prestige and reputation for the non-us firms specially for firms from countries with weak investor protection. if the home country investors are naive, the private equity placement under rule 144a could give false signal as if the firms achieved the prestige provided by the us public exchange. once the non-us firms get the “fake” prestige, they can raise capital at lower cost from home capital market and increase private benefits of managers. some anecdotal evidence illustrates this point: lg telecom, a south korea based telecommunication company, issued equity in rule 144a market in january 2001. local market newspaper evaluated the issuance as a success as it indicates foreign investors value the future growth opportunities of the company. though there is a criticism arguing that lg telecom issued the equity at too low price, lg telecom could raise more capital from domestic banks and overseas subsequently. foster and karolyi (2000) find that the long-run stock market performance is lowest for the private dr issuers from lower home market accounting standards, while it is highest for the public dr issuers from lower home market accounting standards. if rule 144a equity issuance gives domestic investors a false signal about bonding, we expect that more frequent and larger magnitude of capital raising activities after the private dr offering, specially for firms from countries with poor investor protection or undeveloped capital market. we expect that post capital raising activities will be positively related to the discount and negatively related to the amount of capital raised in the private dr issuance. we also expect that the subsequent capital raising activities will be associated with the observed long-term underperformance. one might argue that private dr offering would be preferred by small, young companies who can not meet the listing requirements of public us exchanges and still want to raise capital in the us quickly and at lower costs. however, considering the deep discount and illiquidity in the private equity market, it is questionable whether the firms can raise capital at lower cost in private dr market than in home capital market.ii the empirical evidence on private dr issuance also suggests that the potential benefits of private dr offerings do not outweigh its costs. miller (1999) finds negative (but insignificant) short-term abnormal return for private dr offerings. foster and karolyi (2000) find that private dr issuers significantly underperform market up to three years after the issuances. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 128 2. previous literature recent empirical work documents that in countries where legal protections for minority shareholders are weak, it is considerably more difficult for a firm to raise external capital than for a firm in a country that protects minority interest will (la porta, lopez, shleifer, and vishny 1998, 1999). reese and weisbach (2002) and doidge, karolyi, and stultz (2004) argue that the managers under poor investor protection would either expropriate firm’s resource at the cost of minority shareholders or pursue growth opportunities by raising capital. outside investors will not commit their capital unless there is a bonding and monitoring to prevent managers pursuing private benefits. cross-listing to the us exchange provides such bonding mechanism through higher regulation standards. reese and weisbach (2002), and doidge, karolyi, and stultz (2004) argue that the disclosure and accounting compliance requirements for a us listing enhance the protection of the minority shareholders and reduce the agency costs of controlling shareholders. they argue that the benefits of bonding and monitoring through us listing will be higher for firms from poor investor protection. doidge, karolyi, and stultz (2004) argue that the benefits of bonding and monitoring through us listing will be higher for exchange offerings firms than rule 144a offerings which provides a safe harbor exemption from sec registration requirement. consistently with the argument, reese and weisbach (2002) document the increase in equity issues following cross-listing, specially from issuers from countries with weak investor protection. doidge, karolyi, and stultz (2004) find that foreign firms cross-listed in the us are valued higher than the local firms not cross-listed. rule 144a issuers are also valued more than other local firms, but the listing premium is smaller than exchange (public) issuers. lins, strickland, and zenner (2005) ague that a us listing in the public exchange improves access to capital, specially for firms from emerging market. with higher disclosure and accounting compliance requirement and higher protection on minority shareholders’ rights, us exchange listing potentially enhance the protection of the minority shareholders and reduce the agency costs of controlling shareholders. however, rule 144a private placement does not require such compliance with sec regulations. consequently, non-us firms in rule 144a will not benefit from bonding and monitoring under the us regulation. 3. data description initial sample of rule 144a offerings is obtained from adr database in the bank of new york adr division. between 1991 and 2002, 362 non-us firms raise capital in the us through rule 144a private equity offerings. we collected stock price data from datastream. after excluding firms with no data in datastream, we have 220 non-us firms. from table1, companies from india are the most frequent issuers in rule 144a equity market followed by taiwan, korea, russia, mexico, and turkey. among the largest issuing countries, datastream does not cover russia and mexico. we collect country level variables regarding shareholders’ legal protection from la porta, lopez, shleifer, and vishny (llsv, 1998). llsv(1998) provides legal origin of the country, index of anti-director rights, and judicial efficiency. english common law countries are viewed, in general, as providing higher investor protection than french civil law and german asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 129 countries. scandinavian civil law countries are in between. higher index number in anti-director rights and judicial efficiency indicates higher investor protector. table 1. rule 144a issuance by countries country initial data ds data legal origin anti-direct or rights judicial efficiency accounting standards india 53 39 english 5 8.00 57 taiwan 41 38 german 3 6.75 65 korea 22 20 german 2 6.00 62 russia 18 0 na na na na mexico 17 0 french 1 6.00 60 turkey 15 12 french 2 4.00 51 poland 13 6 na na na na egypt 9 5 na na na na italy 9 7 french 1 6.75 62 south africa 9 9 english 5 6.00 70 greece 8 6 french 2 7.00 55 hungary 8 5 na na na na argentina 7 5 french 4 6.00 45 china 7 2 na na na na australia 6 6 english 4 10.00 75 france 6 4 french 3 8.00 69 philippines 6 6 french 3 4.75 65 switzerland 6 5 german 2 10.00 68 uk 6 3 english 5 10.00 78 columbia 5 1 french 3 7.25 50 japan 5 1 german 4 10.00 65 germany 4 4 german 1 9.00 62 peru 4 3 french 3 6.75 38 portugal 4 3 french 3 5.50 36 spain 4 1 french 4 6.25 64 austria 3 3 german 2 9.50 54 brazil 3 1 french 3 5.75 54 chile 3 1 french 5 7.25 52 croatia 3 1 na na na na finland 3 2 scandinavian 3 10.00 77 ireland 3 1 english 4 8.75 74 israel 3 0 english 3 10.00 64 lebanon 3 1 na na na na netherlands 3 1 french 2 10.00 64 norway 3 2 scandinavian 4 10.00 74 pakistan 3 1 english 5 5.00 61 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 130 singapore 3 3 english 4 10.00 78 venezuela 3 3 french 1 6.50 40 czech republic 2 2 na na na na estonia 2 0 na na na na indonesia 2 0 french 2 3.98 65 kazakhstan 2 0 na na na na lithuania 2 0 na na na na luxembourg 2 0 na na na na thailand 2 1 english 2 3.25 64 denmark 1 0 scandinavian 2 10.00 62 ecuador 1 1 na na na na ghana 1 1 na na na na hong kong 1 1 english 5 10.00 69 jordan 1 0 na na na na latvia 1 0 na na na na malta 1 0 na na na na morocco 1 1 na na na na nigeria 1 0 na na na na qatar 1 0 na na na na romania 1 0 na na na na slovakia 1 0 na na na na slovenia 1 0 na na na na sri lanka 1 1 na na na na sweden 1 1 scandinavian 3 10.00 83 tunisia 1 0 na na na na virgin islands 1 0 na na na na total 362 220 we added index of accounting standards produced by the center for international financial analysis and research.iii from table 2, the private dr issuers are dominated by companies from countries with poorer investor protection. there are 89 companies from english common law origin versus, 180 companies from french or german civil law origin. anti-director rights, judicial efficiency and accounting standards of french and german civil law countries are poor compared with english common law countries. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 131 table 2. legal origins and investor protection initial data ds data anti-director rights judicial efficiency accounting standards english common law 89 64 4.2 [4.5] 8.1 [9.4] 69.0 [69.5] french civil law 99 54 2.6 [3.0] 6.4 [6.4] 54.4 [54.5] german civil law 81 71 2.3 [2.0] 8.5 [9.3] 62.7 [63.5] scandinavian civil law 8 5 3.0 [3.0] 10.0 [10.0] 74.0 [75.5] f [χ2] 5.58a [11.63]a 5.67a [12.02]a 8.59a [14.41]a a: significant at 1% significance level 4. model the rational expectation model and signaling can be used in solving this problem. the objective function of firm value maximizing manager includes proprietary costs (c), financing costs (f), monitoring benefits of private financing (m) and the valuation loss from rent seeking activities (r). )),((:financingequitypublic ))(|),((:financingequityprivate cgcfveev gmigrfveev hpu lpr −−= −−= evpr and evpu represent expected value of project from private equity financing and public equity financing, respectively. v is the revenue from the project. v is distributed normally with mean μ and variance 2σ . fl and fh are financing costs of private and public equity offering, where fl < fh. the financing costs include discounts due to informational asymmetry and floatation costs (see besley and kohers, 2007). c(g,c) is proprietary costs associated with public equity financing (see dye, 1985, 1998), which is increasing function of the project quality, g, and industry competition, c. intuition is that, the higher the project quality, the more to lose if the firm’s private information is disclosed to its competitors. m(g) is monitoring benefits from private equity financing, which is decreasing function of g. r(g) is the rents demanded by inside financiers. the information monopoly of inside financiers gives them the proprietary rights to extract rents. r(g) is increasing function of the project profitability and decreasing function of the information advantage over outsider investors, i. the main result we want to prove is as followings. for a given level of c and i, there will be unique level of project quality, g*, above which private equity financing is strictly preferred, and below which public equity financing is strictly dominant. as the project quality (g) increases, the sum of the benefits from concealing private information and monitoring increases faster than the cost of rent by inside financiers. the cost of rent by inside financiers is asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 132 bounded not only by i, but also by the sum of the benefits from concealing private information and monitoring. industry competition has an important role in determining inter-industry patterns of private versus public equity financing. 5. proposal for empirical tests for further analysis, we can test the price run-up before the private dr issuance, announcement return, and long-term performance in the post-issue period. additional tests include the post-listing capital raising activities and the change in investment rate around listing. if the us capital raising relaxes financial constraints, we expect that the private dr issuers raise more capital subsequently and invest more. if the raised capital flows into positive npv projects and do not increase private benefits, we expect the increase in investment will be positively related with long-term abnormal return. however, if the private dr issuance increases managers’ private benefits, we can expect negative relationship between post-issuance capital raising activities or capital expenditure and long-term performance. we can also directly measure the change in private benefits as in benos and weisbach (2004). private equity financing is preferred over public equity offering in the following reasons. first, the flotation costs are much lower in the private equity offering than in public equity offering. second, if the information asymmetry between manager and private equity buyers is less than that between manager and other outside investors, private equity is less discounted. third, the private equity financiers exert monitoring on the operational and organizational decisions and thus increases the monitoring efficiency. fourth, as verrecchia (1990) argues, when a manager has discretion in disclosing information or withholding information in the presence of traders who have rational expectations about his motivation, the threshold level of disclosure is determined by exogenous proprietary costs. for a firm operating in highly competitive industry and having high growth opportunities may prefer private equity financing to conceal its private information (darrough, 1993). however, the private equity financing is not always preferred because of the hold-up problem of private equity financing. because information asymmetry is much higher for the outside investors, the hold-up problem gives the inside financiers bargaining power over the firm’s profits. this valuation loss associated with hold-up problem represents sever discounts in the private equity financing. in conclusion, the private versus public equity offering decision would be determined by the trades off between benefits and costs associated with private equity offering. 6. conclusion and implication the results are crucially dependent on the form of each cost/benefit functions because we assume that proprietary costs (c), monitoring benefits of private financing (m) and the valuation loss from rent seeking activities (r) are all functions of the project quality, g. we assume that the revenue from the project (v) is normally distributed, but it will be much easier when discrete distribution is assumed. although we can solve the problem by assuming the first differentiation of c(g) and f(g) is c’(g) > r’(g), still it may be hard to define each function asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 133 with proper rationale. in addition, we need to specify the distribution of information advantage which determines the upper-bound of rents. the informational advantage of the inside financiers occurred because they receive less noisy signal about the project value than outside investors do. this paper is meaningful and interesting in that (1) recently, the private equity financing under sec rule 144a is exploding and not much is known about the motivation for private equity financing by a publicly traded firm; (2) our approach is new to literature by incorporating both benefit (conceal private information) and cost (informational monopoly) associated with private equity financing. references besley, s., & n. kohers (2007). reactions of issuers and rivals to private placements of common equity. applied financial economics, 17, 559-568. http://dx.doi.org/10.1080/09603100600706741. benos, e., & m. weisbach (2004). private benefits and cross-listings in the united states. emerging market review, 5, 217-240. http://dx.doi.org/10.1016/j.ememar.2004.01.002. doidge, c., a. karolyi, & r. stulz (2004). why are foreign firms listed in the u.s. worth more?. journal of financial economics, 70, 205-238. http://dx.doi.org/10.1016/s0304-405x(03)00183-1. dye, r. (1985). disclosure of nonproprietary information. journal of accounting research, 23, 123-145. http://dx.doi.org/ 10.2307/2490910. dye, r., (1998). discussion of on the frequency, quality and informational role of mandatory financial reports. journal of accounting research, 36, 149-160. http://dx.doi.org/ 10.2307/2491311. foerster, s., & a. karolyi (2000). the long-run performance of global equity offerings. journal of financial and quantitative analysis, 35, 499-528. http://dx.doi.org/ 10.2307/2676253. hertzel, m., & r. smith (1993). market discounts and shareholder gains for placing equity privately. journal of finance, 58, 459-485. http://dx.doi.org/ 10.2307/2328908. kaplan, s., & p. strömberg (2002). financial contracting theory meets the real world: an empirical analysis of venture capital contracts. review of economic studies, 70, 281-315. http://dx.doi.org/10.1111/1467-937x.00245. la porta, r., f. lopez-de-silanes, a. shleifer, & r. vishny (1998). law and finance, journal of political economy, 106, 1113-1155. http://dx.doi.org/10.1257/jel.47.4.1076. lins, k., d. strickland, & m. zenner (2005). do non-u.s. firms issue equity on u.s. stock exchanges to relax financial constraints?. journal of financial and quantitative analysis, 40, 109-133. http://dx.doi.org/10.1017/s0022109000001769. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 134 miller, d. (1999). the market reaction to international cross-listings: evidence from depository receipts, journal of financial economics, 51, 103-123. http://dx.doi.org/10.1016/s0304-405x(98)00045-2. reese, w., & m. weisbach (2002). protection of minority shareholder interests, cross-listings in the united states, and subsequent equity offerings. journal of financial economics, 66, 65-104. http://dx.doi.org/ 10.1016/s0304-405x(02)00151-4 verrechia, r. (1990). information quality and discretionary disclosure. journal of accounting and economic, 12, 365-380. http://dx.doi.org/10.1016/0165-4101(90)90021-u i bank of new york’s “depositary receipts: 2002 year-end market review” ii securities in us private equity market (excluding rule 144a private equity market) are usually traded in deep discount of about 40% in the us. however, the announcement reaction is on average positive in the stock market. the deep discount associated with the positive announcement return is views as the private issuance has good investment opportunities to overcome the effect of discount. iii chapter 1, volume 1 of international accounting and auditing trends (2nd edition 1991), center for international financial analysis and research, princeton, new jersey. microsoft word 13900-50701-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 167 on malaysian house price growth: the effects of market sentiments calvin w. h. cheong (corresponding author) faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malaysia tel: 60-82-260-996 e-mail: ccheong@swinburne.edu.my lisa l. h. ngui faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malaysia tel: 60-82-260-706 e-mail: lngui@swinburne.edu.my shella georgina beatrice faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malaysia tel: 60-82-260-940 e-mail: sbeatrice@swinburne.edu.my received: nov. 13, 2018 accepted: dec. 18, 2018 published: december18, 2018 doi:10.5296/ajfa.v10i2.13900 url: https://doi.org/10.5296/ajfa.v10i2.13900 abstract this paper examines the factors that drive the recent exponential growth in malaysian house prices. we first construct a sentiment index for the housing market in malaysia guided by the methods employed by baker and wurgler (2006). preliminary analyses of our bias-free sentiment index indicate a strong correlation with overall market confidence which attests to the reliability of our index. the results also show contemporaneous sentiment to strongly influence future housing market returns especially in the short-term. contrary to the literature, our results suggest that it is property developer behaviour that drive sentiments and property prices. the study contributes to the literature by providing an easily generalizable method of constructing a housing market sentiment index in other countries that holistically accounts for asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 168 essential housing market elements that are otherwise ignored in confidence indices. this study also contributes to practice as it provides evidence to policy-makers who wish to cool property markets may want to design interventions that are targeted at property developers instead of home-buyers or speculators. keywords: house prices, market sentiments, property market, property returns asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 169 1. introduction classical economic and finance theory rely on the assumption of rational investors to work. on this assumption, all assets are priced without influence from the sentiments of the interested parties. even if pricing errors exist, they will have no long-term impact on prices, as they will quickly be arbitraged away. however, literature over the past decade has shown that we can no longer rely on this assumption. commonly defined as the propensity of investors to behave in a manner that is not justified by the exogenous information at hand, investor sentiments have been shown to have significant influence over asset prices (baker & wurgler, 2006; 2007). the effects are no different in the housing market (clayton, ling, and naranjo, 2009; hui, zheng, and wang, 2013). in fact, clayton, mackinnon, and peng (2008) contend that effects of investor sentiments in the housing market are stronger due to the market’s illiquid nature and a lack of short-selling mechanisms. an absence of short-selling mechanisms restricts the market’s ability to correct mispricings (clayton et al., 2008). as a result, investors in the private housing market become more susceptible to sentiments especially since they comprise individuals and households that have less ability and access to complete information. years of persistent house price growth in malaysia over the past decade has reignited fears of another asian financial crisis that sends prices tumbling after the bubble bursts. to allay these fears, the malaysian government, and the central bank, bank negara malaysia (bnm), introduced various monetary, fiscal, and legislative measures in hopes of slowing the growth in house prices. market participants however, opine that these measures have only succeeded in reducing the number of transactions taking place, and not the price of the house itself (yeong, 2014). matters are exacerbated when parties with surplus financial resources artificially inflate resale prices after securing substantial discounts from developers. bnm itself has indicated that the growth in house prices are not in line with long-term averages as well as economic fundamentals, attributing the growth to market sentiment and speculation (hisyam, 2013). this raises questions on the drivers of house price growth in malaysia. does market optimism drive house prices in malaysia? can a reliable and holistic measure of property market sentiments be built for malaysia? this paper seeks to answer these questions. the primary region of focus in our study is the west coast of peninsular malaysia. the reasons behind this focus are manifold. first, many economic policies have been focused on this part of the country leading to a disparity in development, pricing, and inflation between states. to put things into perspective, an apartment unit in the state of selangor measuring 1,000 square feet will cost anywhere between myr350,000 to myr1 million. a similarly sized unit in say, kuantan, a city on the east coast of peninsular malaysia will cost only half that. various commentators have cited speculation and sentiment as the reason behind this difference providing us with an ideal setting to test for market sentiments. second, developer activity has been heavily concentrated in this region of malaysia. demand for housing continue to rise as economic opportunities continue to attract emigrants from other states of malaysia. this again, provides a suitable backdrop to evaluate factors affecting house prices and market sentiments. third, detailed records of transactions maintained by the national property information centre (napic) provides us with valuable data to observe and analyse asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 170 micro-level trends within the malaysian housing market. we begin our study with a construction of a sentiment index following baker and wurgler (2006). this first required proxies that reflected sentiments in the malaysian housing market, selected intuitively with reference to prior literature. we then perform a principal component analysis on the sentiment proxies to determine which among them had the strongest impact on sentiments before regressing each of the proxies against economic fundamentals variables to negate the effects of business and economic cycle variations. we then use a partial least squares (pls) regression to derive a housing market sentiment index. we find our sentiment index to be strongly correlated with malaysia’s consumer and business confidence index. to be precise, we find the correlation between our sentiment index and business confidence to be greater than its correlation with consumer confidence. since the literature suggests that sentiments drive asset prices and returns, we assess our sentiment index’s reliability in predicting housing market returns. we find a positive relationship between housing market sentiments and current returns as well as future returns. however, contrary to the literature (e.g. stambaugh, yu & yuan, 2012; berger & turtle, 2015; zhou, 2017), we find periods of high sentiment to be followed by higher returns. several contributions arise from this study. first, our approach in measuring housing market sentiments by way of proxies complements that of soo (2013) who used a textual analysis approach and hui and wang (2014). our approach also complements zhou (2017) in that we show how the proxy selection process can be adapted in ways that best reflect local market conditions and data availability. this not only improves the relevancy of the index but also its comprehensiveness and reliability. the ease of its construction also provides a simple guide for the government and other parties interested in monitoring housing market conditions to replicate. second, our results empirically confirm the opinions of various market commentators on the role of property developers in drumming up sentiments and subsequently, house prices. specifically, our results provide evidence to show that the interventions currently in place are incorrectly targeted at house-buyers. to be effective, policies that attempt to cool the property market should be targeted at property developers. the rest of this paper is as follows. section 2 provides a brief history on the malaysian housing market and a review of literature on sentiments in the housing market. in section 3 we detail the process of constructing the sentiment index. in section 4 we show the results to our tests. section 5 provides a discussion of results and implications before concluding. 2. literature review 2.1 a recent history of the malaysian housing market for over a decade prior to 2010, national house prices (as measured by the house price index, hpi) were on an upward trend that was in line with the long-term average annual growth of house prices of 3.2 percent, as well as national income levels and economic development (bnm, 2010). however, from q1 2010 to q3 2014, national house prices exceeded the average annual growth with a year-on-year increase of 9.41 percent. a large part of this sudden growth was the result of sharp rises in the three largest urban centres of malaysia, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 171 namely the greater klang valley, penang, and johor. house prices in these regions grew at a rate of 11.38, 10.60, and 10.36 percent respectively, outstripping the already high national average. figure 1. growth in the malaysian house price index, q1 2000 – q3 2014, by state. source: ceic as we can see from figure 1, on average, the hpi for the whole country rose by about 80 points between q1 2010 to q3 2014. in that same period, the hpi for the greater klang valley (i.e. kuala lumpur and selangor) collectively rose by 180 points while the hpi for penang and johor rose by 90 and 60 points respectively. findings from a survey conducted by the international monetary fund (2015) (see figure 2) found further evidence that showed how house prices had exceeded national income and rent. figure 2. house prices to rent and income. source: imf (2015) 70 90 110 130 150 170 190 210 230 250 q 1 20 00 q 3 20 00 q 1 20 01 q 3 20 01 q 1 20 02 q 3 20 02 q 1 20 03 q 3 20 03 q 1 20 04 q 3 20 04 q 1 20 05 q 3 20 05 q 1 20 06 q 3 20 06 q 1 20 07 q 3 20 07 q 1 20 08 q 3 20 08 q 1 20 09 q 3 20 09 q 1 20 10 q 3 20 10 q 1 20 11 q 3 20 11 q 1 20 12 q 3 20 12 q 1 20 13 q 3 20 13 q 1 20 14 q 3 20 14 house price index: west coast peninsular malaysia (2000 = 100 base value) malaysia kuala lumpur selangor johor pulau pinang negeri sembilan perak asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 172 bnm acknowledges the misalignment of prices in these regions against the national average, suggesting that such growth rates were strong signals of speculative investment activity. bnm also recognised the danger of the rising house prices that were not in line with income and population growth figures, giving rise to what commentators fear would be an over-optimistic, overheated property market, and eventually housing bubble (daily express, 2015; hisyam, 2013). house price trends in recent years brings to mind the asian financial crisis of the late 90s. the crisis, particularly in thailand, hong kong, singapore, and malaysia had illustrated the effects of excessive exposure to the housing market. prior to the crisis, houses were used as a form of tradeable asset for capital gains instead of fulfilling residential needs. as house prices began to reach unsustainable highs, speculators lost confidence and began selling off their property holdings from their portfolios. plunging house prices soon led to costly financial market crashes and economic recession in many asian countries that were highly dependent on houses as collateral (herrera & perry, 2003; pomerleano, 2003). there is a genuine concern that the housing market will crash in 2018 after it was revealed that the number of unsold residential units rose by 40 percent (kaur, 2017). representatives of developer associations however, rubbished claims that there will be a crash in the coming months, arguing that market optimism and housing demand will persist (augustin, 2017) as buyers will find different means of supporting their purchases, or adjust their expectations. the accuracy of these claims notwithstanding, they are highly indicative of the influence sentiments have in the housing market; and warrants further study. recognizing the dangers of an overheated housing market, the malaysian government and bnm introduced various fiscal and monetary measures in an attempt to curb speculative activity, and improve housing affordability. first, bnm imposed a limit to the loan-to-value (ltv) on personal third and subsequent mortgages at 70 percent (bnm, 2013; kamalavacini, 2014). the ltv for first and second mortgages were not affected, and are still dependent on each bank’s internal credit policies but bnm raised the capital risk-weights to 100 percent for personal mortgages with ltvs exceeding 90 percent. the malaysian government on the other hand, re-introduced the real property gains tax (rpgt) in 2010 after a 3-year suspension before gradually raising the rates over the years. when this study was undertaken, the rpgt rates stood at 30% for houses sold within the first three years; 20% for houses sold in the fourth year; and 15% for houses sold in the fifth year. the rpgt aimed to discourage speculators from entering the housing market for capital gains from ‘flipping’, as more tax is to be paid for a shorter ‘flipping’ duration. the government also established perbadanan pr1ma malaysia under the pr1ma act 2012; a government-owned developer tasked to construct housing projects that are affordable to the middle-income group. these housing projects are located in key urban centres around the country, and are built to compete with the design and build quality of private developers in the country. open to only malaysian citizens, the pr1ma projects are meant to curb speculative activity in the housing market by firstly cutting out the middlemen, and secondly, imposing various restrictions on eligibility of applicants. finally, the government in october 2013 abolished the developer interest bearing scheme (dibs). dibs allowed developers to bear the interest cost for buyers until the projects were completed, in hopes of lowering the barriers to ownership especially for first-time house-buyers. despite these measures, house prices continued to rise rapidly asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 173 (yeong, 2014) which raises the question of what drives house prices in malaysia. 2.2 sentiments in the housing market for many years, the decision-making behind property purchases was assumed to be a rational process, utilizing factual data, leading to optimal decisions. in instances where there are data deficiencies, buyers turn to market sentiments to augment their decisions and pricing (gallimore and gray, 2002). this however is problematic as the housing market has a number of discerning features that makes pricing difficult. first is the high percentage of individual traders, all of whom have very individualised criteria in asset selection and pricing. second, the housing market is a market for lemons. unlike the stock market where information asymmetry is reduced through various disclosure mechanisms, developers, sellers or real estate agents have an incentive to withhold information if they feel that it will help them get the best price. the lack of a centralised market makes pricing opaque and difficult to compare across asset types and locations. also, without a short-sale mechanism, overvalued assets will remain overvalued until such a time when the market decides otherwise. it is for these reasons that the housing market is highly vulnerable to sentiment-induced mispricing (clayton et al., 2009; hui & wang, 2014). moreover, it only takes optimism from a small number of investors to have a huge effect on house prices (piazessi and schneider, 2009). various studies support the notion that house prices are driven by irrational expectations, even under perfect market conditions (clayton, 1997; clayton et al., 2009). jin, soydemir, and tidwell (2014) similarly, found irrational consumer sentiment to be a significant exogenous variable in the pricing of u.s. residential real estate. in fact, the susceptibility of the housing market to sentiments – positive in particular – is so strong that so long as there is uncertainty over the economic outlook of the country, and optimistic agents continue to hold firmer views than others do, the housing boom will continue (burnside, eichenbaum, & rebelo, 2015). the persistent rise in house prices in malaysia in spite of the measures introduced by the government and central bank provides an ideal setting for us to conduct this study. due to inherent structural and policy differences between the housing markets of malaysia and those seen in prior studies, further investigation into the interactions between various housing market factors, government policy, and sentiment is warranted. 3. methodology 3.1 data our data is from the secondary housing market on the west coast of peninsular malaysia, widely acknowledged to be the most developed region in the country. collectively, the west coast contributes to approximately 70 percent of the national gdp. the data provided by the national property information centre (napic) included the details of 208,627 secondary housing market transactions along the west coast, over a 7-year sample period from january 2010 to december 2016. we however, chose to focus on four key states namely kuala lumpur, selangor, johor, and penang. these four states alone contribute approximately 50 percent to the national gdp and has been a hotbed of real estate transactions throughout the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 174 sample period. the secondary market transactions in these four states alone account for approximately 70 percent of the total transactions that occurred on the west coast. the variables in our data include the district, house address, type, number of floors, lot size, valuation date, transacted price, and the identities of the buyer(s) and seller(s). 3.2 housing market sentiment index proxies sentiment indices were made popular by baker and wurgler (2006). while seemingly complex, the construction of a sentiment index is an intuitive process. instead of using a single indicator (e.g. momentum, turnover) as a measure of sentiment, we introduce sentiment proxies that are directly relevant to the housing market in malaysia by adopting the process of generating proxies provided by baker and wurgler (2006). so far, we identified only three other studies that adopted this approach (see hui & wang, 2014; ling, naranjo, & scheick, 2014; and zhou, 2017). we discuss the intuition behind each of our sentiment proxies below. malaysia adopts a sale-before-construction system. the system provides a substantial investment incentive to property developers to demand and purchase more land-space as they are able to lock in the profits of the project even before commencement. as demand for land-space and buy-side investment incentives are major determinants of new housing projects (tse, ho, & ganesan, 1999), it is reasonable to assume that developers are driving and simultaneously sensitive to market sentiments. in baker and wurgler (2006), the number of ipos was a sentiment proxy for the stock market. the greater the number of ipos, the more optimistic the sentiment. similarly, we argue that the incoming and completed supply of residential units scaled by the existing stock of residential units in the past quarter reflects sentiments in the housing market. we call this proxy newstock and expect it to be positively correlated with housing market sentiments. while news outlets may have reported instances where individuals were able to save up and purchase a home in cash, house prices in malaysia are well beyond what a significant percentage of the population can afford (lee, sinnakkannu, & ramasamy, 2015). furthermore, due to legal and financial restrictions, even if they can afford to pay for it in cash, house buyers in malaysia must finance the purchase with a mortgage. some may argue that the distinction between investors and house-consumers (genesove & mayer, 2001) may influence the terms and conditions of the mortgage. however, as mentioned above, the house-buying process in malaysia is the same for everyone regardless of intention. as the newstock proxy represents the position of developers, we contend that total residential mortgage divided by total loans in the country represents the position of buyers. we call this proxy resmort and expect it to be positively correlated with housing market sentiments. having accounted for the supply and demand drivers in the housing market, we now consider the matter of liquidity. liquidity has often been regarded as an indicator of sentiment (baker and stein, 2004; clayton et al., 2008). rising liquidity in the housing market is a channel through which a pricing-sentiment spiral in the housing market is amplified (ling, ooi, & le, 2011). typically, liquidity is measured through turnover. in the housing market, this may be reflected in the length of time the buyer owns the property. however, malaysia imposes a 30 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 175 percent real property gains tax for holding periods of up to 3 years. this may affect the suitability of the holding period as a proxy for housing market sentiments. nevertheless, in keeping with the literature, we include the natural log of the median holding period of sellers (in months) as a proxy for turnover. we also propose an alternative. since we are able to identify the buyer(s) and seller(s) for each transaction, we instead use the number of sub-sales (note 1) in a month as a proxy for turnover. while it can be argued that sub-sales are also affected by the real property gains tax, they also account for instances where the housing project took longer than 4 years to complete (note 2). we call these proxies holdper and subsale respectively. we expect holdper to be negatively correlated while expecting subsale to be positively correlated with housing market sentiments. the final aspect of sentiment we consider here is buyer confidence. the corporate finance literature suggests that overconfident managers are more likely to overinvest or pay a premium on acquisitions when there are surplus funds available (malmeinder & tate, 2005; 2008). similarly, a buyer’s confidence in the housing market and future property values will have a strong part to play in the price paid for the house. the greater their confidence in future house prices, the more they will be willing to pay for the house now. we feel that simply taking the size of the house (in square meters) transacted would not accurately reflect buyer’s confidence in malaysia as there are many large houses that are cheap and vice versa. instead, we use the transacted price per square meter (in ringgit) as a measure of buyer confidence. it is also not uncommon for sellers to factor various elements (e.g. location, fixtures and fittings, accessibility, security) into their asking prices. the value attached to many of these elements however, are subject to buyer preferences and cannot be captured by the price per square meter measure. as an alternative, we also use the number of transactions that are rm1 million (note 3) and above in a month as a proxy for buyer confidence. we call these proxies psqm and p1m respectively. we expect both proxies to be positively correlated with housing market sentiments. table 1. annual averages of the sentiment proxies, 2010 – 2016. year newstock resmort holdper subsale psqm p1m 2010 2.541 0.456 6.853 10.578 158.54 5.231 2011 3.289 0.679 6.024 13.911 179.61 5.385 2012 2.132 0.568 6.172 12.118 205.32 6.123 2013 2.291 0.632 6.125 12.654 245.25 6.549 2014 2.875 0.659 7.056 13.271 305.33 7.167 2015 2.116 0.559 7.011 12.513 363.87 7.385 2016 2.758 0.551 6.954 12.245 401.51 8.134 table 1 provides the annual averages of the six proposed proxies of housing market sentiments from 2010 to 2016. the proxies reached peaked averages in 2011 except for psqm and p1m. the numbers fell in 2012 after the pr1ma project was launched at the end of 2011, after which they rose until 2014, the same year the dibs was abolished, which slowed down the figures in 2015 before climbing again in 2016. while newstock, resmort, holdper, and subsale may be correlated with economic fundamentals, and affected by asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 176 cooling measures, both psqm and p1m continued to rise regardless, suggesting a high level of confidence in house prices. the pertinent question here is what is driving these prices. 3.3 constructing the sentiment index we begin by negating the effects of business cycle variations and macro factors from the proxies through an orthogonalization process by regressing each of the standardised sentiment proxies on eight economic fundamental variables (ling, et al., 2014). the eight variables are the purchasing manager’s index (pmi), the industrial production index (ipi), the profit margin of the real estate industry in the last calendar year (rep), the growth of the consumer price index (cpi), and the growth of m2 (m2). we include total loans to the property sector divided by the total loans in the country (tlp) as a reflection of the developers’ access to credit. we also include npl, which is the total non-performing loans to the real estate market divided by the total loans in the country to account for the risks of loan defaults. finally, we also include blr+ which is the average premium (discount) charged by banks in the country above (below) the base lending rate determined by the central bank to negate the interest rate incentive effect. the residuals from these regressions should thus contain a measure of housing market sentiment that is orthogonal to business cycle and macro factors. we then perform a three-month smoothing of the residuals (huang, jiang, tu, and zhou, 2014). this is followed by a principal component analysis for all sentiment proxies and their one-month lagged values. this is to account for the possibility that one proxy may have an impact on another in the future (baker & wurgler, 2006). we then compute the correlation between the first principal component (p1) and each of the current and lagged proxies. whichever proxy has the highest statistically significant correlation magnitude is chosen as a proxy for our housing market sentiment. table 2. current and lagged sentiment proxy correlation with the first principal component, p1 current correlation with p1 obs. 1-month lag correlation with p1 obs. newstock 0.815*** 83 newstock 0.754** 83 resmort 0.787*** 83 resmort 0.511*** 83 holdper -0.523*** 83 holdper -0.428** 83 subsale 0.519*** 83 subsale 0.476*** 83 psqm 0.654*** 83 psqm 0.793*** 83 p1m 0.058 83 p1m 0.132 83 the principal component analysis suggests the selection of the current value of newstock, resmort, holdper, subsale, and the lagged value of psqm as our housing market sentiment proxies. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 177 pxi,t – 1 = βi,0,t + βi,1,t rt + βi,2,t rt – 1 + ei, t – 1 (1) pxi,t = αt + st + vi,t (2) finally, we estimate a partial least squares regression (1) to construct a look-ahead-bias-free sentiment index (huang et al., 2014). we estimate equation 1 for each of our chosen proxies, pxi, where rt is the housing market return at time t. the series βi,1,t captures the time-varying sensitivity of pxi to the market sentiment instrumented by future housing market returns (note 4). including rt – 1 on the right side of equation 1 is intuitive in the malaysian market since transacted prices are also driven by previous transacted prices in the same locale. it also controls for short-term reversals (zhou, 2017). after estimating equation 1, we then perform a cross-sectional regression (equation 2), where the independent variable is the loadings estimated from equation 1. the time series of the slope s represents our sentiment index. 4. results & discussion 4.1 a simple illustration our sentiment index from january 2010 to december 2016 has a mean of 0.521 and a median of 0.548. the index had a maximum value of 0.991, a minimum value of 0.028, and a standard deviation of 0.299. in figure 3 below, we plot our sentiment index against malaysia’s house price index. house prices in malaysia has been on the rise since 2010 and has yet to show any signs of slowing down, despite the steps taken by the government to curb speculation and to cool overheating prices. in the same period, housing market sentiments have fluctuated, peaking towards the end of 2011. a cursory glance at figure 3 suggests that the policies implemented by the government has done little to curb housing market sentiments and rising house prices. for example, when the government launched the pr1ma project in q4 2011, sentiments fell before climbing up again within a few months. similarly, when the government announced the abolishment of the dibs in q4 2013, sentiments fell before climbing up again in the next quarter. it would seem that malaysian housing market sentiments are driven by other factors and are not affected by government policy. figure 3. house price index and the sentiment index, january 2010 – december 2016 0 0.2 0.4 0.6 0.8 1 1.2 0 50 100 150 200 250 300 20 10 q 1 20 10 q 3 20 11 q 1 20 11 q 3 20 12 q 1 20 12 q 3 20 13 q 1 20 13 q 3 20 14 q 1 20 14 q 3 20 15 q 1 20 15 q 3 20 16 q 1 20 16 q 3 se nt im en t i nd ex h ou se p ric e in de x hpi sentiment asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 178 to establish the reliability of our sentiment index, we first plot our sentiment index against a couple of confidence indices for the country. as of writing, the only available confidence indices for malaysia was the consumer confidence and business confidence index. we reason that these indices suffice for malaysia since the housing market not only attracts consumers and investors (han, 2013; miller & pandher, 2008) but businesses (i.e. property developers) as well. the consumer confidence index would thus represent consumer and investor outlook while the business confidence index represents developer outlook. in figure 4 below, we can see that our sentiment index seems to move in the same direction as the consumer and business confidence index. the correlation between our sentiment index and the consumer confidence index is 0.41 while correlation between our sentiment index and the business confidence is 0.56 (note 5). what this seems to suggest is housing market sentiments in malaysia are more strongly driven by developers instead of consumers and investors. figure 4. consumer and business confidence index and the sentiment index, january 2010 – december 2016 4.2 the impact of sentiments on housing market returns we first establish our housing market sentiment index’s ability to predict future housing market returns. to do so, we estimate the following regression: r[t + 1, t + b] = α + β1st + β2festivalt + β3holidayt + β4rt + β5m2t + β6blrt + εt (3); where r[t + 1, t + b] is the cumulative housing market return from month t + 1 to month t + b where b = 1, 3, 6, 9, and 12; and s is the value of our sentiment index at month t. we account for seasonal effects (kaplanski & levy, 2012) in malaysia’s housing market by including the variables festivalt which is a binary variable that is ‘1’ if month t or its immediate preceding month has a major festival (note 6); and holidayt which is a binary variable that is ‘1’ if month t coincides with the school holidays (note 7). the festival and holiday season in malaysia typically witnesses a growth in home-related transactions including but not limited 0 0.2 0.4 0.6 0.8 1 1.2 0 20 40 60 80 100 120 140 20 10 q 1 20 10 q 2 20 10 q 3 20 10 q 4 20 11 q 1 20 11 q 2 20 11 q 3 20 11 q 4 20 12 q 1 20 12 q 2 20 12 q 3 20 12 q 4 20 13 q 1 20 13 q 2 20 13 q 3 20 13 q 4 20 14 q 1 20 14 q 2 20 14 q 3 20 14 q 4 20 15 q 1 20 15 q 2 20 15 q 3 20 15 q 4 20 16 q 1 20 16 q 2 20 16 q 3 20 16 q 4 se nt im en t i nd ex c on fid en ce i nd ex consumer business sentiment asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 179 to house purchase, moving homes, renovations and modifications to the home. it is also during these periods where developers typically offer various promotions and discounts on their housing projects. we control for current month returns (rt) to account for current transacted price trends and short-term reversals. we include the growth of m2 (m2t) to control for effects arising from changing monetary policies over time. we also control for the influence the base lending rate (blrt) has on consumer and investor propensity to take up a mortgage. regression (3) estimates are in table 3 below. table 3. predicting future housing market returns with current housing market sentiments model (1) (2) (3) (4) (5) (6) (7) intercept 0.548*** (0.08) 0.421** (0.11) 0.345*** (0.13) 0.217** (0.14) 0.639*** (0.33) 0.254*** (0.21) 0.358** (0.33) s 0.235*** (0.05) 0.331*** (0.06) 0.414*** (0.11) 0.364*** (0.22) 0.570* (0.20) 0.481* (0.19) 0.366* (0.23) festival 0.114 (0.15) 0.210 (0.16) 0.254 (0.18) 0.244 (0.20) 0.211 (0.15) holiday 0.187 (0.12) 0.231 (0.13) 0.279 (0.18) 0.144 (0.11) 0.116 (0.07) r 0.212*** (0.03) 0.164*** (0.18) 0.101*** (0.10) 0.148** (0.25) 0.128* (0.33) 0.173* (0.31) 0.159* (0.44) m2 0.111 (0.14) 0.154 (0.21) 0.164 (0.26) 0.191 (0.25) 0.187 (0.22) 0.223 (0.31) blr -0.221** (0.12) -0.219* (0.17) -0.197** (0.15) -0.183*** (0.13) -0.178** (0.18) -0.187* (0.20) r2 0.2113 0.2203 0.2298 0.2315 0.2154 0.2332 0.2287 note: model (1) is the basic model; model (2) includes the control variables m2 and blr; model (3) includes all variables and controls for seasonal effects. the dependent variable for models (1) – (3) is rt+1. the dependent variable for models (4) – (7) is rt+1,t+3 ; rt+1,t+6 ; rt+1,t+9 ; and rt+1,t+12 respectively. ***, **, and * denotes statistical significance at the 1%, 5%, and 10% level respectively. standard errors are in parentheses. from table 3 we can see that s has a positive coefficient across all models. however, the statistical significance of the relationship weakens when we attempt to predict returns farther into the future (i.e. models (5) – (7)). we can also see that the seasonal effects have no impact on housing market returns in malaysia. changes to monetary policy likewise, has no statistically significant effect on housing market returns. the base lending rate in contrast reduces housing market returns; an effect that is well within expectations since the interest expense on mortgage repayments lowers the returns sellers earn. in keeping with the literature on market sentiments, we re-estimate models (3) – (7) in table 3 but this time, instead of using a single measure of sentiment (st), we consider the impact of optimistic and pessimistic sentiments on housing market returns. here we dissect our sentiment index into two: s+ and s-. s+ equals s when s has a positive value while sequals s when s is negative. we denote both s+ and sas zero otherwise. the regression estimates are in table 4 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 180 table 4. the impact of optimistic and pessimistic sentiments on housing market returns model (1) (2) (3) (4) (5) intercept 0.145*** (0.23) 0.327** (0.25) 0.396*** (0.31) 0.413*** (0.22) 0.368** (0.31) s+ 0.342*** (0.12) 0.358** (0.24) 0.367* (0.29) 0.339* (0.21) 0.351* (0.20) s-0.073 (0.41) -0.104 (0.34) -0.089 (0.37) -0.078 (0.31) -0.101 (0.42) festival 0.214 (0.25) 0.178 (0.21) 0.191 (0.16) 0.188 (0.28) 0.231 (0.31) holiday 0.237 (0.16) 0.222 (0.18) 0.238 (0.11) 0.256 (0.15) 0.161 (0.19) r 0.155*** (0.13) 0.160** (0.19) 0.165* (0.17) 0.141* (0.12) 0.167* (0.19) m2 0.161 (0.24) 0.148 (0.21) 0.153 (0.19) 0.172 (0.14) 0.134 (0.24) blr -0.221* (0.18) -0.217** (0.14) -0.210*** (0.19) -0.198** (0.23) -0.207* (0.28) r2 0.2318 0.2327 0.2296 0.2112 0.2378 the dependent variable for models (1) – (5) is rt+1,t+3 ; rt+1,t+6 ; rt+1,t+9 ; and rt+1,t+12 respectively. ***, **, and * denotes statistical significance at the 1%, 5%, and 10% level respectively. standard errors are in parentheses. the results in table 4 are consistent with those in table 3; that positive sentiments drive housing market returns. although not statistically significant, we can also see that negative sentiments drive housing market returns down. the coefficient signs and statistical significance of all other variables are the same as those in table 3. however, we note that r has the same coefficient sign as s (table 3) and s+ (table 4). the statistical significance of s / s+ may be spurious if there is a positive correlation between r and s / s+. to address this possibility, we re-estimate equation 3 without s before regressing the residuals on s, s+ and s-. the statistically significant positive relationship between s and s+ on housing market returns persist as what we saw in table 3 and 4. thus, it is safe to assume that the predictive power of s / s+ was not the result of its correlation with r. 4.3 individual component effects indices offer a convenient manner of measuring and presenting data that can otherwise be difficult to visualize. however, aggregated data can sometimes lead to misleading interpretations and the development of ineffective policies. to ensure the validity of our interpretation, we disaggregate our sentiment index into its individual components i.e. the current values of newstock, resmort, holdper, subsale, and the one-period lagged value of psqm and regress these against r[t + 1, t + b] as follows: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 181 r[t + 1, t + b] = α + β1newstockt + β2resmortt + β3holdpert + β4subsalet + β5psqmt 1 + β6festivalt + β7holidayt + β8rt + β9m2t + β10blrt + εt (4). all variable definitions are as above. equation 4 estimates are presented in table 5. table 5. sentiment component effects on housing market returns model (1) (2) (3) (4) (5) intercept 0.145*** (0.23) 0.327** (0.25) 0.396*** (0.31) 0.413*** (0.22) 0.368** (0.31) newstock 0.554*** (0.14) 0.513*** (0.22) 0.498** (0.34) 0.412** (0.37) 0.387** (0.41) resmort 0.331** (0.23) 0.304** (0.27) 0.277* (0.35) 0.253* (0.32) 0.224* (0.44) holdper -0.224* (0.36) -0.244* (0.22) -0.204 (0.31) -0.218 (0.35) -0.224 (0.44) subsale 0.301** (0.28) 0.299* (0.31) 0.242 (0.44) 0.223 (0.35) 0.219 (0.33) psqmt – 1 0.386*** (0.24) 0.334*** (0.36) 0.317** (0.22) 0.300** (0.26) 0.285* (0.33) festival 0.214 (0.25) 0.178 (0.21) 0.191 (0.16) 0.188 (0.28) 0.231 (0.31) holiday 0.237 (0.16) 0.222 (0.18) 0.238 (0.11) 0.256 (0.15) 0.161 (0.19) r 0.155*** (0.13) 0.160** (0.19) 0.165* (0.17) 0.141* (0.12) 0.167* (0.19) m2 0.161 (0.24) 0.148 (0.21) 0.153 (0.19) 0.172 (0.14) 0.134 (0.24) blr -0.221* (0.18) -0.217** (0.14) -0.210*** (0.19) -0.198** (0.23) -0.207* (0.28) r2 0.2318 0.2327 0.2296 0.2112 0.2378 the dependent variable for models (1) – (5) is rt+1 ; rt+1,t+3 ; rt+1,t+6 ; rt+1,t+9 ; and rt+1,t+12 respectively. ***, **, and * denotes statistical significance at the 1%, 5%, and 10% level respectively. standard errors are in parentheses. as we can see from table 5, each of the five components of our housing market sentiment index display their predicted signs. the coefficient estimates are also consistent with those seen earlier in that the magnitude of effect remain relatively persistent and statistically significant for periods of up to 12 months except for holdper and subsale. most notably is that newstock displays the greatest magnitude in absolute terms. given that newstock is a supply-side factor, its strong positive impact on house prices relative to other factors is rather surprising. this would seem to suggest that house prices in malaysia are driven by property developer behaviour as opposed to house buyer or speculator behaviour. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 182 4.4 robustness tests to ensure that our constructed sentiment index accurately reflects sentiments in the housing market of other states, we perform an out-of-sample test using data from the states not included in the earlier estimations (note 8). we first calculate the monthly sentiment index for the out-of-sample states before estimating equation 4 using data from the remaining states. as the earlier results show that the strongest statistical significance was at b = 1, we only perform estimates using this parameter. table 6 provides the regression estimates for every state in our dataset. table 6. impact of sentiments (a) and sentiment components (b) on housing market returns, by state. kuala lumpur selangor johor penang kedah perak negeri sembilan malacca panel a intercept 0.541*** (0.28) 0.551** (0.21) 0.415*** (0.23) 0.627** (0.44) 0.239*** (0.38) 0.254*** (0.41) 0.333*** (0.22) 0.311*** (0.21) s 0.622*** (0.24) 0.628*** (0.31) 0.437*** (0.27) 0.741*** (0.38) 0.247*** (0.33) 0.258*** (0.25) 0.329*** (0.28) 0.278*** (0.31) festival 0.181 (0.31) 0.158 (0.41) 0.121 (0.18) 0.182 (0.17) 0.115 (0.39) 0.102 (0.13) 0.103 (0.22) 0.094 (0.18) holiday 0.148 (0.27) 0.133 (0.12) 0.156 (0.27) 0.111 (0.29) 0.189 (0.28) 0.141 (0.21) 0.113 (0.33) 0.121 (0.41) r 0.217*** (0.81) 0.269*** (0.69) 0.189*** (0.58) 0.273*** (0.74) 0.141** (0.38) 0.118** (0.29) 0.120*** (0.33) 0.143** (0.45) m2 0.111 (0.55) 0.141 (0.41) 0.150 (0.39) 0.132 (0.46) 0.114 (0.31) 0.139 (0.29) 0.118 (0.11) 0.108 (0.14) blr -0.211** (0.29) -0.237** (0.24) -0.251** (0.21) -0.231** (0.28) -0.139** (0.22) -0.175** (0.25) -0.151** (0.37) -0.138** (0.41) r2 0.2415 0.2387 0.2341 0.2401 0.2043 0.2115 0.2124 0.2201 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 183 table 6 continued panel b intercept 0.811*** (0.41) 0.745*** (0.38) 0.523*** (0.43) 0.779** (0.34) 0.245** (0.39) 0.251*** (0.17) 0.314** (0.16) 0.229** (0.17) newstock 0.419*** (0.22) 0.522*** (0.42) 0.387*** (0.39) 0.448*** (0.29) 0.372*** (0.21) 0.323*** (0.25) 0.401*** (0.18) 0.433*** (0.21) resmort 0.461*** (0.33) 0.489*** (0.38) 0.444** (0.23) 0.473*** (0.43) 0.212** (0.24) 0.263** (0.33) 0.233** (0.33) 0.212* (0.29) holdper -0.261*** (0.31) -0.244*** (0.41) -0.216*** (0.48) -0.212*** (0.26) -0.141** (0.33) -0.132** (0.55) -0.211** (0.40) -0.177* (0.28) subsale 0.215*** (0.38) 0.374*** (0.44) 0.187** (0.36) 0.183** (0.49) 0.138* (0.38) 0.164* (0.24) 0.191** (0.37) 0.144** (0.41) psqmt – 1 0.347*** (0.89) 0.499*** (0.98) 0.265** (0.45) 0.357*** (0.30) 0.184* (0.18) 0.186** (0.13) 0.191*** (0.68) 0.148* (0.38) festival 0.431 (0.31) 0.338 (0.14) 0.139 (0.14) 0.318 (0.43) 0.055 (0.34) 0.032 (0.27) 0.101 (0.21) 0.084 (0.18) holiday 0.267 (0.68) 0.246 (0.79) 0.148 (0.73) 0.243 (0.83) 0.051 (0.39) 0.036 (0.21) 0.114 (0.48) 0.087 (0.33) r 0.113*** (0.37) 0.121*** (0.45) 0.135*** (0.35) 0.116*** (0.40) 0.122* (0.23) 0.181** (0.17) 0.110** (0.23) 0.107** (0.28) m2 0.186 (0.41) 0.156 (0.28) 0.111 (0.34) 0.168 (0.24) 0.110 (0.43) 0.067 (0.42) 0.103 (0.33) 0.098 (0.41) blr -0.225*** (0.38) -0.284** (0.44) -0.237*** (0.36) -0.313*** (0.39) -0.178** (0.23) -0.165** (0.23) -0.195** (0.34) -0.164* (0.31) r2 0.2227 0.2444 0.2879 0.2564 0.2794 0.2556 0.2348 0.2401 ***, **, and * denotes statistical significance at the 1%, 5%, and 10% level respectively. standard errors are in parentheses. the results of our out-of-sample test in panel a and b of table 6 affirms the earlier findings that housing market sentiments drive malaysian house prices. there also seems to be a clear difference in the magnitude of the relationship between the former (i.e. kuala lumpur, selangor, johor, and penang) and latter (i.e. kedah, perak, negeri sembilan, and malacca) states. finally, we address a possible concern of insufficient degrees of freedom arising from using monthly observations over a 7-year sample period. to do so, we re-estimate equation 3 using daily observations. after excluding weekends, we have 1,827 observations, which should address this concern. the results are in table 7 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 184 table 7. impact of sentiments (a) and sentiment components (b) on housing market returns, by state, daily frequency kuala lumpur selangor johor penang kedah perak negeri sembilan malacca panel a intercept 0.443*** (0.24) 0.441** (0.23) 0.325*** (0.21) 0.522** (0.41) 0.222*** (0.37) 0.231*** (0.33) 0.311*** (0.19) 0.292*** (0.25) s 0.521*** (0.24) 0.618*** (0.31) 0.417*** (0.27) 0.540*** (0.38) 0.235*** (0.33) 0.228*** (0.25) 0.333*** (0.28) 0.258*** (0.31) festival 0.146 (0.22) 0.148 (0.43) 0.131 (0.14) 0.172 (0.14) 0.125 (0.19) 0.120 (0.13) 0.122 (0.18) 0.104 (0.29) holiday 0.144 (0.27) 0.131 (0.12) 0.116 (0.17) 0.131 (0.39) 0.184 (0.21) 0.111 (0.27) 0.115 (0.30) 0.125 (0.42) r 0.221*** (0.56) 0.231*** (0.41) 0.178*** (0.51) 0.213*** (0.44) 0.131** (0.28) 0.108** (0.29) 0.125*** (0.31) 0.151** (0.46) m2 0.100 (0.51) 0.118 (0.37) 0.149 (0.32) 0.123 (0.44) 0.141 (0.25) 0.137 (0.22) 0.121 (0.16) 0.118 (0.24) blr -0.231** (0.25) -0.234** (0.22) -0.211** (0.27) -0.244** (0.29) -0.153** (0.24) -0.178** (0.29) -0.156** (0.38) -0.139** (0.23) r2 0.2325 0.2277 0.2222 0.2341 0.2133 0.2329 0.2301 0.2331 panel b intercept 0.633*** (0.43) 0.645** (0.34) 0.532*** (0.41) 0.649** (0.39) 0.215*** (0.35) 0.253** (0.13) 0.324*** (0.18) 0.224** (0.17) newstock 0.551*** (0.21) 0.512** (0.41) 0.477*** (0.35) 0.438** (0.27) 0.182** (0.21) 0.133*** (0.24) 0.211** (0.19) 0.222** (0.23) resmort 0.341** (0.31) 0.323*** (0.34) 0.298*** (0.22) 0.289** (0.40) 0.145*** (0.23) 0.153** (0.23) 0.222*** (0.35) 0.142* (0.27) holdper -0.259*** (0.32) -0.234*** (0.45) -0.266*** (0.38) -0.242** (0.20) -0.131** (0.32) -0.133** (0.51) -0.184** (0.45) 0.158** (0.28) subsale 0.312** (0.38) 0.432** (0.44) 0.389* (0.36) 0.411*** (0.39) 0.178** (0.23) 0.135** (0.23) 0.190*** (0.34) 0.164* (0.31) psqmt – 1 0.507*** (0.66) 0.489*** (0.67) 0.345*** (0.35) 0.398** (0.28) 0.167** (0.18) 0.155* (0.13) 0.179** (0.55) 0.138*** (0.34) festival 0.231 (0.31) 0.248 (0.17) 0.149 (0.15) 0.338 (0.42) 0.075 (0.31) 0.042 (0.21) 0.111 (0.25) 0.044 (0.19) holiday 0.166 (0.64) 0.156 (0.49) 0.137 (0.53) 0.213 (0.43) 0.081 (0.49) 0.076 (0.31) 0.104 (0.38) 0.077 (0.34) r 0.103** (0.31) 0.111*** (0.42) 0.145** (0.39) 0.126** (0.44) 0.123* (0.21) 0.155** (0.11) 0.116** (0.21) 0.117** (0.27) m2 0.156 (0.33) 0.126 (0.27) 0.104 (0.22) 0.158 (0.29) 0.114 (0.42) 0.077 (0.32) 0.113 (0.23) 0.058 (0.31) blr -0.256* (0.28) -0.267* (0.23) -0.271* (0.29) -0.263** (0.24) -0.212* (0.33) -0.269** (0.21) -0.275** (0.23) -0.228** (0.30) r2 0.2631 0.2224 0.2824 0.2813 0.2034 0.2124 0.2318 0.2415 the dependent variable is r[t + 1, t + b] , where b = 30. ***, **, and * denotes statistical significance at the 1%, 5%, and 10% level respectively. standard errors are in parentheses. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 185 on the whole, the results in table 7 are qualitatively similar with the earlier findings that housing market sentiment is a strong driver of housing market returns, and that the cooling measures introduced by the government and central bank have so far been ineffective in dampening sentiment. 5. discussion & conclusion the results above lead us to a few key observations. first, housing market optimism drives house prices in malaysia. pessimism meanwhile does not bring prices down. however, as opposed to the literature (zhou, 2017; berger & turtle, 2015; stambaugh et al., 2012), periods of market optimism are followed by higher rather than lower housing market returns. we believe that this could be the result of substantial growth in a recent trend to hit the malaysian housing market – rental returns. a casual observation of the classifieds shows that instead of earning returns through capital gains, the housing market is flooded with listings citing substantial rental opportunities, largely driven by the advent of crowd-sourced accommodation platforms such as airbnb. our personal correspondence with ten real estate negotiators (all of whom wished to remain anonymous) indicate that a substantial number of deals closed were the result of optimism in the potential rental returns, rather than capital gains. the greater the potential rental return, the higher the price buyers were willing to pay for the house. second, disaggregating our housing market sentiment measure into its individual components, we find property developer behaviour to have the greatest influence on housing market returns as compared to other factors such as mortgage terms and previously transacted prices. this observation is rather interesting especially since our proxy for developer behaviour is a supply-side variable that is normally negatively related to prices. what we can infer is instead of lowering prices, increments in the supply of new residential units by developers is a signal of further optimism in the market. because pricing mechanisms in property markets are often opaque, developers are deemed to be more informed of future prospects in the market as compared to house buyers. as a result, new project launches send strong signals to other players that the market remains robust, hence the continued growth in prices. our results also show a disparity in the effects of market optimism in different states. the effects of optimism are much stronger in the states of kuala lumpur, selangor, johor, and penang, as compared to kedah, perak, negeri sembilan, and malacca. understandably, house prices in the former four states are more strongly driven by housing market sentiments as compared to the latter four owing to the substantial amounts of development taking place in the former. the latter in contrast, are geographically larger with a much wider dispersion of population and development. second, throughout history agriculture has been the main economic activity in the latter states. infrastructural development progressed at a much slower pace. it is only in recent years that buyers consider seremban, the capital of negeri sembilan, a satellite city to kuala lumpur, hence the stronger impact of sentiments in the state. the findings of this study have a number of policy implications. first, we provide evidence that out of all the proxies, newstock had the strongest influence on housing market asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 186 sentiments and returns. this suggests that contrary to popular opinion, developers instead of individual sellers drive housing market sentiments in malaysia. in fact, homeowners looking to sell have an incentive to set asking prices that match the prices of new developments in the area. when new projects are sold at high prices, there is an incentive for real estate negotiators to keep the seller’s asking price high. driven by the optimism in the initial few transactions, more sellers will follow suit driving sentiments and subsequently prices higher. second, the populace of an emerging market like malaysia remains unsophisticated in their investment choices. many investors still prefer real estate as the ‘safer’ choice compared to financial securities. a lack of attractive investment alternatives in the financial markets also contribute to the demand for real estate investment. to address the first issue, local governments can begin by reducing the number of new projects approved. as of q3 2017, there is approximately 5.4 million residential units in stock with a further 480,000 units of incoming supply, and another 427,692 units planned across the country. with an estimated population of 32 million (as of 2017), the number of persons per residential unit will be about 5 when all current projects are completed. in comparison, the average household size in malaysia is 4.31 persons. these simple calculations suggest that the current stock of residential units are sufficient to house the country’s population. measures should be taken to ensure that the growth of new housing projects approved should be in tandem with population requirements. addressing the second issue is a matter of financial education, provision of investment incentives such as tax exemptions, and a reduction in the barriers to entry for new investors. while prudence is always advised, liberalization of the financial markets to allow a wider range of investment alternatives is also required. we conclude by providing a few suggestions for future research. first, we recommend further investigation of housing market sentiments with respect to rental returns. the costs and restrictions in property transactions can be substantial. as a result, many young adults are looking to renting as opposed to owning as a means to independent living. how then does the prospect of future rental receipts factor into housing market sentiments, especially since there is no guarantee of occupancy given the growing supply of residential units? second, although bank negara’s lending policies are considered one of the most prudent, it does not stop the non-performance of housing loans. to develop more holistic measures in addressing housing market sentiments, one can study the bank-specific factors that dampen or drive sentiments. finally, one may also choose to study the influence of micro-factors (e.g. house characteristics, address, neighbourhood demographics) on housing market sentiments to assist in the development of policies that are more targeted. notes note 1. in malaysia, a sub-sale is when a buyer buys a house from the developer (under a new project) only to sell it off in the secondary market. note 2. housing developers in malaysia are legally allowed to extend the completion date of a housing project up to 48 months. the real property gains tax rate after the 48th month of ownership is 15%. this provides a significant incentive for sellers to hold-off a sub-sale until after that period. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 187 note 3. a transacted price of rm1 million in our dataset lies in the 90th percentile. in comparison, the average transacted price across all four states is approximately rm600,000. a premium of rm400,000 above the average price would suggest some degree of confidence in the housing market. note 4. we assume that the sentiment proxies are related to the expected housing market returns and uncorrelated with unpredictable return shocks. note 5. both correlation coefficients are statistically significant at the 1% level. the major festivals in malaysia are chinese new year (january – february); eid al-fitr; diwali (typically october – november); and christmas. note 6. school holidays in malaysia are typically in the months 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(2017). housing market sentiment and intervention effectiveness: evidence from china, emerging market review, (in press). copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 10871-40081-1-sm-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 166 stock market investors’ guide to corporate dividend policy: evidence from pharmaceuticals and chemicals industries in bangladesh tanbir ahmed chowdhury dept. of business administration, east west university a/2, jahurul islam city gate, aftab nagar main rd, dhaka-1212, bangladesh tel: 88-017-4842-7741 e-mail: tanbir@ewubd.edu jannatunnesa (corresponding author) dept. of business administration, east west university a/2, jahurul islam city gate, aftab nagar main rd, dhaka-1212, bangladesh tel: 88-017-1110-7944 e-mail: moniducbl68@yahoo.com received: march 2, 2017 accepted: march 25, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10871 url: https://doi.org/10.5296/ajfa.v9i1.10871 abstract dividend policy has been an important component in the arena of financial literature and providing evidence that dividend payout decisions are affected by various factors. numerous studies have been conducted so far on corporate dividend policy in bangladesh. the pharmaceuticals and chemicals industries of bangladesh offer a lot of investment panorama for the retail investors. this research has been an endeavor to determine the factors affecting the dividend policy of these promising industries, and guide the investment decisions of the equity investors. in this attempt, this study is also a unique one to incorporate the chemicals industry along with the pharmaceuticals industry as both the industries constitute the 'pharmaceuticals and chemicals sector' listed in the stock market of bangladesh. the study is a quantitative one based on secondary data. it comprises of different statistical analyses such as descriptive statistics, correlation matrix and multiple linear regression analysis, etc. firm size, growth, liquidity, profitability, last year's dividend and p/e ratio are used as dependent variables. besides, ownership structure, firm age, market share, and risk are used as control variables. the study explores that firm size has significant negative and last year’s dividend asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 167 has significant positive relationship with dividend payout. however, dividend payout does not depend on firm growth, liquidity, profitability and p/e ratio of a firm. the research outcome may have important implications for the improvement of investors' perceptions, which may assist them in their investment decisions in the researched industries. certainly more work lies ahead to add to explanations for why some of the factors affect the dividend policy of the industries, while others have no significant impact thereon. keywords: dividend policy, multiple regression analysis, pharmaceuticals and chemicals industries, investors asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 168 1. introduction dividend policy has been an important component in the arena of financial literature and providing evidence that dividend payout decisions are affected by various factors. the pharmaceuticals and chemicals industries of bangladesh offer a lot of investment panorama in the stock market, especially for the retail investors. this research has been an endeavor to determine the factors affecting the dividend policy of these promising industries of the country. the relevance and irrelevance of dividend policy have been analyzed by finance scholars based on a number of dividend policy theories (miller and modigliani, 1961; gordon, 1956; linter, 1959). however, studies revealed that investors expect firms to be fairly valued irrespective of the dividend policies followed by the firms. current dividend decreases the shareholders' uncertainty, which contributes to the company’s higher stock value and in turn higher value of the firm (gitman, 2009). therefore, research concentrated on studies relating to dividend policy and the value of the firm as well as the wealth of shareholders (baker and powell, 1999; omran & pointon, 2004). numerous studies examined the individual factors affecting dividend policy with detailed analyses and interpretations, especially in the developed globe. nevertheless, hardly any research attempts have been taken so far in this context in bangladesh, particularly for the stock market investors. the study intends to depict the determinants of corporate dividend policy, especially as a basic guideline for the actual and potential investors in the stock market. in this regard, this study proceeds to examine the relationship of dividend payout with a number of firm-specific factors, with explicit focus on both the pharmaceuticals and chemicals industries of bangladesh. the study is a quantitative one comprising of different statistical analyses. in order to construct the theoretical framework, relevant secondary data have been used from different sources such as journal articles, websites, books, etc. besides, the dataset for the statistical analysis consists of mainly secondary data collected from the websites of dse and annual reports of sample companies. a total of 15 companies are selected from both the pharmaceuticals and chemicals companies listed under the sector titled 'pharmaceuticals and chemicals' in dhaka stock exchange (dse), the main stock exchange of bangladesh. a number of variables have been scrutinized based on empirical studies, and have been analyzed using basic descriptive statistics. in order to examine the relative influence of each of the factors on a firm's dividend payout, several hypotheses have been formulated and tested using correlation matrix and multiple regression analysis. the study outcomes may offer important guidelines to the actual and prospective stock market investors, especially those interested in the pharmaceuticals and chemicals sectors of dse. among the other stakeholders, regulators in the capital market, corporations' management, stock dealers and brokers, etc. can also be informed of the results of the investigation and concentrate on necessary policy implications accordingly. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 169 the rest of the document is organized as follows. section 2 consists of the objective of the study and research questions. section 3 discusses the rationale for the study. section 4 constructs the literature review. section 5 reports the empirical methodology including sample and data collection, and statistical analyses. section 6 illustrates the approaches to investigate a number of variables in terms of their influence on corporate dividend policy of the pharmaceuticals and chemicals industries of bangladesh. section 7 consists of empirical analysis comprising of a number of statistical analyses. section 8 presents possible contributions and implications of the research outcome. section 9 concludes. section 10 outlines some limitations of the study as well as probable approaches to future research. 2. objective of the study it is important to ascertain the factors that influence corporation's dividend policy, which in turn may control the equity investment decisions of individual investors. an understanding of these factors can dig up investors’ notion to such an extent that brings stability in their investment. thus, the study intended to analyze the potential determinants of dividend policy in the pharmaceuticals and chemicals industries of bangladesh. therefore, the research questions are: 1. what are the factors (variables) that specifically affect the dividend policy of these industries? 2. what is the relative importance of every individual determinant on the dividend payout simultaneously? 3. rationale for the study most of the studies conducted so far focused only on the pharmaceuticals industry, and mainly on perspectives such as performance analysis, problems and prospects of the sector, the impact of trips agreement, etc. dividend policy of an industry, however, concentrates on the determination of level of dividends for its shareholders. thus, an understanding of the dividend policy of a particular industry bears significance for the stock market investors. nevertheless, very few studies have been conducted on the dividend policy of corporations of bangladesh, especially for capital market investors. this study concentrated utterly on the pharmaceuticals and chemicals industries of bangladesh in order to identify the relative significance of some recognized factors that affect dividend policy. this research will instill value to the existing financial literature in bangladesh, especially in the context of corporate dividend policy. from this research, stock market investors can enlighten themselves with the understanding of the factors that should methodically influence a firm's dividend policy in the pharmaceuticals and chemicals industries in bangladesh. thus, the study has important implications for the improvement of investors' perceptions, which may assist them in their capital market investment decisions. the study is also expected to offer an opportunity to the respective company' management, capital market regulators, stock brokers and dealers, researches, etc. to apply the knowledge of the research findings in their respective work arena. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 170 4. literature review dividend policy decision is one of the most controversial concerns in modern corporate finance. as stated by black (1976), "the harder we look at dividend, the more it seems like a puzzle with pieces that just don’t fit together." according to saravanakumar (2011), dividend declaration is a critical decision, and dividends play a vital role in influencing the growth of the company through retained earnings and market value of the equity shares. a number of studies have been carried out on dividend policy so far in different countries of the world (agyei and marfo-yiadom, 2011; ahmed and javid, 2008; al‐deehani, 2003; al-malkawi, rafferty, and pillai, 2010; almazan, et al., 2010; amidu and abor, 2006; anand, 2004; anil and kapoor, 2008; arnott & asness 2003; baker, farrelly and edelman, 1985; baker and powell, 2000; chen and dhiensiri, 2009; farsio, geary, and moser, 2004; gillet, lapointe, and raimbourg, 2008; pandey, 2003). alli, khan and ramirez (1993) supported the residual theory of dividends, pecking order argument, tax clientele argument, and the function of dividends in reducing the agency cost. however, the study of denis and osobov (2008) highlighted the agency cost-based lifecycle theories but kept reservation on signaling, clientele, and catering explanations for dividends. according to the demonstration of hardin and hill (2008), higher dividend payment can contribute towards reducing agency costs, reinforcing operating performance, executing a stock repurchase plan and assisting the access to short-term bank debt. researches intended to identify the expected influence of variables on the dividend policy of firms listed in different stock exchanges (al-twairjy, 2007; baker, rafique, 2012; kim and wonsiksul, 2010; veit and powell, 2001). the research of moradi, salehi & honarmand (2010) on all listed companies in the tehran stock exchange revealed a positive relationship of dividend with profitability; and a negative relationship of dividend with p/e, beta rate and debt ratio. in another study, kumar and jha (2012) worked on the indian information technology sector listed at bombay stock exchange (bse) and found that net profit after tax, cash flow and amount of depreciation charged have significant impact on the equity dividend. besides, zameer, et al (2013) studied a sample of 27 foreign and domestic banks operating in pakistan listed at different stock exchanges. the results of the research demonstrated that profitability, last year dividend and ownership structure have significant positive impact and liquidity has significant negative impact on the dividend payout of the banking industry. researchers intended to identify the influence of numerous variables on the dividend payout of corporations. rozeff (1982) found an inverse relationship of dividend payment with a corporations' future growth in sales, beta rate, and management ownership ratio, and a positive relationship with the number of shareholders. the study also confirmed that a corporation's investment policies also affect its dividend policy. dhanani (2005) identified that dividend policy of a company may vary significantly depending on firm size, industry sector, growth prospects, ownership structure, and information indiscretion. according to banerjee, gatchev and spindr (2007), more liquid common stock holders are less likely to receive cash dividend and vice versa; and historical liquidity has a noteworthy part in the initiation and exclusion of dividend. besides, papadopoulos and charalambidis (2007) found asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 171 cash flow of the firm as the key determinant of dividend policy. as stated by gupta and banga (2010), a corporation's dividend payment decisions are influence by its leverage, liquidity, profitability, growth and ownership structure. saravanakumar (2011) intended to determine the relationship of corporate dividend decisions with factors such as net profits, liquidity and reserve position, share prices, investors' expectations, volume of sales, windfall gains, etc. poshakwale, patra and ow-yong (2012) found positive relationship of size, profitability and liquidity with dividend payment, but negative relationship of investment opportunities, financial leverage and business risk. badu (2013) found from his study that the major determinants of dividend policy of financial institutions in ghana are age of the firm, collateral and liquidity. table 1 reviews several factors related to corporate dividend policy and summarizes existing empirical evidence from the financial literatures. previous studies revealed that dividend policy may have impact on shareholders wealth or firm value (adesola & okwong, 2009; afza and mirza, 2010; aharony, and swary, 1980; amidu, 2007; black and scholes, 1974; brennan and thakor, 1990; gordon, 1959; malcolm and wurgler, 2004 [a], [b]; travlos, trigeorgis and vafeas, 2001). such influence of dividend policy may be evident with respect to the firm's capital structure or investment decisions (aivazian, booth and clearly, 2003; baker, veit and powell, 2001; faulkender, milbourn, and thakor, 2006); reduced agency problems (bartram et al., 2009; deangelo, deangelo and stulz, 2006); tax treatment (alli, khan and ramirez, 1993; howatt, et al., 2009; singhania, 2006), etc. akhigbe and madura (1996) found positive drive of dividend instigations as well as negative impact of dividend omissions on share price in the long run. according to ramachandran and packkirisamy (2010), considering retained earnings as the lowest cost source of capital, managers may prefer lower dividend payout ratio in situations of higher capital requirements. however, they must also recognize investors' expectations about dividend yield, and thus, declare at least reasonable rate of dividend. empirical studies used different mathematical and statistical tools to examine dividend determinants. kumar and jha (2012) used regression models, lintner’s model (1956), darling’s model (1957), brittain’s cash flow model (1966) and brittain’s explicit depreciation model (1966). other studies observed dividend determinants using panel regression (amidu, 2007); categorical and regression analysis (nissim & ziv, 2001), generalized method of moments (poshakwale, patra and ow-yong, 2012), etc. numerous researches have spotted light on the dividend policy of pharmaceuticals industry. khan (2012) has presented that dividend irrelevance theory is not pertinent to the chemical and pharmaceutical sector of pakistan. alam and hossain (2012) made a comparative study on the dividend policy of pharmaceutical industry of uk and bangladesh, and revealed that for the uk based companies, dividend rate is a positive function of leverage, profitability and market capitalization; whereas dividend rate is a reverse function of liquidity and growth. on the other hand, liquidity, leverage, profitability and market capitalization have negative influence on the dividend rate, while growth has positive influence in case of a bangladeshi companies. however, in bangladesh very few researches focused on the application of dividend policy theories on companies of a particular industry listed in a stock exchange. moreover, in case of pharmaceutical industry of bangladesh, a number of research efforts asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 172 table 1. summary of empirical evidence on factors affecting corporate dividend policy literature variable significant positive significant negative insignificant adedeji, 1998 investment negative financial leverage positive agyei and marfo-yiadom, 2011 firm performance significant positive growth positive profitability positive ahmed and javid, 2008 free cash flows positive ownership concentration positive market liquidity positive leverage negative market capitalization negative size of the firms negative al-twairjy, 2007 leverage significant negative cash per share significant positive share book value significant positive al-najjar and hussainey, 2009 number of outside directors on the board of directors negative amidu and abor, 2006 profitability significant positive cash flow significant positive tax positive risk negative asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 173 table 1. summary of empirical evidence on factors affecting corporate dividend policy literature variable significant positive significant negative insignificant institutional holding negative growth significant negative market‐to‐book value. significant negative amidu, 2007 return on assets negative leverage negative chen and dhiensiri, 2009 growth negative diamond, 1989 age negative d’souza, 1999 market risk significant negative institutional ownership of a firm’s shares significant negative howatt et al., 2009 changes in earnings per share positive jensen,solberg,& zorn, 1992 high insider ownership firms negative la porta et al., 2000 growth negative liquidity/ cash flow positive nnadi & akpomi, 2005 tax significant positive naceur,goaied & belanes, 2006 profitability positive free cash flows positive growth positive asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 174 table 1. summary of empirical evidence on factors affecting corporate dividend policy literature variable significant positive significant negative insignificant ownership concentration no impact financial leverage no impact liquidity of stock market negative size negative naceur et al., 2006 liquidity/ cash flow positive nissim & ziv, 2001 earnings changes positive pandey, 2003 earnings positive patra, poshakwale & ow-yong, 2012 size positive profitability positive liquidity positive investment opportunities negative financial leverage negative business risk negative rozeff, 1982 agency costs negative transactions cost of external financing positive zameer, et al, 2013 profitability significant positive last year dividend significant positive ownership structure significant positive asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 175 table 1. summary of empirical evidence on factors affecting corporate dividend policy literature variable significant positive significant negative insignificant zameer, et al, 2013 liquidity significant negative size no impact leverage no impact agency cost no impact growth no impact risk no impact have been employed so far, especially focusing on the performance, problems and prospects, dividend determinants, etc. (alam and hossain, 2012; azam, and richardson, 2010; dcci, 2008; habib, and alam, 2011; islam and mili, 2012; majumder and rahman, 2011; saad, 2012; vanduzer, 2003; world bank, 2008). however, studies hardly worked on the pharmaceuticals dividend policy determinants, particularly focusing on the interest of the stock market investors. unlike earlier studies, this study attempted to examine the dividend policy determinants of the pharmaceuticals and chemicals industries, and guide the equity market investors in making their investment decisions. in this attempt, this study is also a unique one to incorporate the chemicals industry along with the pharmaceuticals industry as both the industries constitute the pharmaceuticals and chemicals sector listed in the stock market of bangladesh. 5. methodology this study is an investigative one and it deliberated largely on the analysis of dividend policy and its determinants in the context of the pharmaceuticals and chemicals industries in bangladesh. at present 28 companies are listed under the pharmaceuticals and chemicals sector in dse. the data set consists of a sample of 15 companies among these listed companies. table 2 presents a list of the sample companies as well as their short names used in the data set. the research covered a time period of fourteen years from 2001 to 2014. the study used mostly secondary data and the database has been developed based on the secondary data collected from the annual reports of concerned companies, monthly publications of dse, websites of dse and relevant pharmaceuticals and chemicals companies, etc. various books, journals and online publications are consulted in developing the variables and attributes. pertinent information from such sources also supported the construction of the theoretical framework related to the dividend policy of the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 176 pharmaceuticals and chemicals industries, and the determinants thereof. table 2. sample pharmaceuticals and chemicals companies and short names used sl. no. company name short name sl. no. company name short name 1 aci limited aci 9 renata limited renata 2 ambee pharmaceuticals ltd. ambph 10 square pharmaceuticals limited sqrph 3 beximco pharmaceuticals ltd (bpl) bexph 11 reckitt benckiser reckben 4 glaxo smithkline glaxo 12 kohinnor chemicals kochem 5 the ibn-sina pharmaceutical industry ltd. ibnsina 13 keya cosmetics keyacos 6 libra infusion ltd. libra 14 beximco synthetics bsynth 7 orion infusion ltd. orion 15 imam button ibutton 8 pharma aids phaid the study indented to recognize and evaluate the relative explanatory power of firm characteristics on dividend policy. particularly this research explored the influence of firm-specific factors (size, growth, liquidity, profitability, last year's dividend, p/e ratio) on dividend payout. the study involved the tabulation, analysis and interpretation of collected data; and the data analysis process consists of descriptive statistics, correlation matrix and multiple linear regression analysis. in order to find out the key factors that affect the dividend policy of the firms, the research took a number of hypotheses and used multiple regression analysis to test those hypotheses statistically. 6. determinants of dividend policy of pharmaceuticals and chemicals industries in bangladesh 6.1 hypothesis development the key intent of this study is to recognize the determinants of dividend policy of the pharmaceuticals and chemicals companies in bangladesh. variables and their proxies are selected on the basis of empirical researches carried out worldwide to show the relationship between dividend policy and its determining factors. the variables focused in this study include: firm size, firm growth, liquidity, profitability, last year's dividend, p/e ratio, ownership structure, firm age, market share, and risk. 6.1.1 dividend payout only final cash dividends paid by the companies have been considered here, and stock dividend and stock repurchases by the companies have been ignored. previous studies mostly used dividend payout ratio as a determinant of dividend (chen, jian and xu, 2009; holder et al., 1998; jensen, solberg and zorn, 1992; lloyd, jahera and page, 1985). this study also used dividend payout ratio as the dependent variable because the dividend payout ratio considers both dividend payout and dividend retention. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 177 6.1.2 firm size firm size is one of the most acknowledged determinants of a firm's dividend policy. "the idea that firm size and dividend payout are positively correlated is generally accepted by many financial economists" (redding, 1997). the result of this study shows that large companies are indeed more likely to pay dividends than small companies. larger firms have better access to capital market which allows them to be less dependent on retained earnings for internal financing and thus, pay more dividends. the positive relationship between firm size and dividend payout is also supported by a growing number of studies (adedeji, 1998; al-kuwari, 2007; al-shubiri, 2011; al-twaijry, 2007; anupam, 2012; gaver and gaver, 1993; mahira, 2012; vogt, 1994). other studies related dividend and firm size to transaction cost (alli, khan and ramirez, 1993). large firms can raise financing by paying lower transaction costs than smaller firms, and can pay more dividends. on the basis of the theoretical outline and the literature review, the first hypothesis is developed as: hypothesis 1: there is a significant association between firm size and dividend payout. 6.1.3 firm growth firm growth enlightens historical achievement of a firm as well as predicts what is expected to materialize in future. different stages of development and growth of the firm influence dividend payout. a number of studies revealed inverse relationship between dividend payment and growth opportunities (gaver, and gaver, 1993; higgins, 1981). firms having higher growth opportunities use internally generated funds to finance their investment projects and hence, cut or reduce dividend payments. on the other hand, firms having low growth opportunities and fewer investment projects are exposed to low incentive to retain more. such firms remove resources by paying more dividends and reduce the agency costs of free cash flows (al-malkawi, 2007; d’souza, 1999). kania (2005) found positive correlation between growth and level of dividend payment. following empirical research, sales/revenues is used as a proxy variable for growth opportunities in this study. since previous studies portray both negative and positive relationship between the dividend and sales growth, the second hypothesis is: hypothesis 2: there is a significant relationship between firm growth and dividend payout. 6.1.4 liquidity liquidity position of a company for dividend payment is another vital determinant of dividend policy. a number of studies found positive relationship between liquidity and payout ratio (ahmed and javed, 2008; ahmed and carlos, 2008; amidu and abor, 2006; anil and kapoor, 2008; benito and young, 2001; gunasekarage and power, 2006). this positive relationship explains that firms with high liquidity are in position to pay higher dividends, while firms with poor liquidity are forced to reduce or cut dividends. some other studies found reverse relationship between liquidity and dividend payout ratios (barclay et al. 1995; marfo-yiadom and agyei, 2011). the negative relationship explains that increasing dividend payout ratios reduce the liquidity; because higher return on equity stimulates the firm to retain more for reinvestment purpose and thus, lower the dividend. the third hypothesis of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 178 this study is: hypothesis 3: liquidity has a significant relationship with dividend payout. 6.1.5 profitability profitability can be termed as the capacity of a firm to generate profit. profitability is exposed to be one of the most critical determinants of the dividend policy of firms (al-najjar and hussainey, 2009). highly profitable firms can pay more dividends, while less profitable firms find it difficult to pay dividends. the studies of linter, 1956; baker et al. 1985; matthias, nnadi and meg, 2008 depicted that dividend payment pattern of firms are influenced by current earnings and the previous year dividends. however, pruitt and gitman, 1991 argued that both current and past year profits determine dividend payments. a considerable number of other studies also found positive relationship between dividend payout and profitability of firms (amidu and abor, 2006; baker and powell, 2000; fama and french, 2001; han, lee and suck, 1999; jensen, solberg and zorn, 1992; kohli, sharma and sood, 2011). based on the theory and past research findings, the fourth hypothesis is: hypothesis 4: there is a significant relationship between profitability and dividend payout. 6.1.6 last year dividend rehman (2012) found that last year dividend has significant impact on the dividend payout of current period, and firms strive to increase the payout ratio for the subsequent years rather than reducing it. according to zameer et al., 2013 and lintner, 1965, firms try to maintain previous pay out pattern to ensure a stable dividend payout and to progressively increase the dividend payout ratio. these findings point out that previous year dividends positively affect current year dividends and therefore, the fifth hypothesis becomes: hypothesis 5: last year dividend has a significant relationship with dividend payout. 6.1.7 price to earnings (p/e) ratio scholarly research considered dividend payout of a company to have substantial impact on the price of its shares in the equity market (banz, 1981; howatt et al., 2009; miller and modigliani, 1961; ohlson and juettner-nauroth, 2005). studies also focused on the relationship between earnings of a corporation and its dividend policy (pandey, 2003; nissim & ziv, 2001). based on the empirical literature, the sixth hypothesis becomes: hypothesis 6: there is significant relationship between p/e ratio and dividend payout. besides the variables scrutinized as determinants of dividend payout, some other variables such as ownership structure, firm age, market share and risk have been used in the study as control variables. 6.2 model specification linear multiple regression model has been used for testing the hypotheses presented here. the dependent variable of the model is dividend payout ratio (div) and the independent variables are firm size (size), firm growth (grth), liquidity (liq), profitability (prof), last asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 179 year dividend (divt-1) and price to earnings ratio (p/e ratio). the control variables used here are ownership structure (own), firm age (age), market share (mktshr) and risk (risk). therefore, the regression equation is as follows: div = β0 + β1 (size) + β2 (grth) + β3 (liq) + β4 (prof) + β5 (divt-1) + β6 (p/e ratio) + β7 (own) + β8 (age) + β9 (mktshr) + β10 (risk) + e0 6.3 variable definition 1. firm size (size) is an algebraic expression of the natural logarithm of firms’ total asset. 2. growth rate (grow) is measured as the growth rate of sales 3. liquidity (liq) is measured as a natural logarithm of a firm’s cash flow from operations. 4. return on equity (roe) has been used as a proxy for profitability (prof). roe is calculated as: return on equity = net income/shareholder's equity. 5. last year's dividend is used as a proxy for last year dividend (divt-1) 6. price to earnings ratio (p/e ratio) is calculated as: p/e ratio = price per share/earnings per share (eps) 7. natural logarithm of no. of shareholders is used as a proxy for ownership structure (own) 8. age of each of the sample firms (age) is considered from the year of its listing in the dse till 2014. firm age is measured as a natural logarithm of a firm's listing age in dse. 9. market share (mktshr) is calculated as sales revenue of individual firms for a given year divided by the total sales revenue of all the firms included in the data set for the same year. 10. variability in profitability is measured by the standard deviation of roe, which is used as proxy for risk (risk) 11. dividend is expressed as dividend payout ratio which is calculated as dividend divided by net income of the firm. 7. empirical analysis the empirical research griped an examination of determinants of dividend policy of the pharmaceuticals and chemicals industries of bangladesh. the result of the study is illustrated through the relationship of a number of scrutinized variables to dividend payout, an indicator of dividend policy. 7.1 descriptive statistics table 3 depicts the descriptive statistics of data after normalization of firm size, liquidity, last year's dividend, number of shareholders and firm listing age. the table lists the mean, median, standard deviation (sd), sample variance (variance), minimum (min) and maximum (max) values of each of the variables. the mean of the dividend payout ratio of the sample firms signifies that on an average 49% asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 180 table 3. descriptive statistics div size (n. log) grth liq (n. log) prof (roe) divt-1 (n. log) p/e ratio own (n. log) age (n. log) mktshr risk mean 0.49 9.03 0.15 7.07 0.16 6.84 46.3 3.6 1.23 0.07 0.25 median 0.43 9.01 0.13 7.81 0.14 7.3 16.56 3.62 1.26 0.04 0.06 sd 0.49 0.68 0.23 2.73 0.48 2.09 108.7 0.71 0.25 0.08 0.39 sample variance 0.24 0.46 0.05 7.43 0.23 4.36 11818 0.51 0.06 0.01 0.16 minimum -1.23 7.76 -0.36 0 -1.87 0 -95.4 0 0 0 0.01 maximum 4.66 10.46 1.4 9.75 5.44 8.97 723.5 4.97 1.58 0.29 1.47 count 210 210 210 210 210 210 210 210 210 210 210 confidence level (95%) 0.07 0.09 0.03 0.37 0.07 0.28 14.79 0.1 0.03 0.01 0.05 of the net profits are distributed by the firms as dividend. the standard deviation of dividend payout ratio is 49%, which indicates a high dispersion of the dividend payout ratio among the firms in the industry. average p/e ratio of the industry is 46.30 with a significantly high standard deviation of 108.71. industry average profitability, as measured by roe is 0.1644793; while, company roe is maximum 5.44 and minimum -1.87. maximum market share held by a particular company is 29.12%. on the other hand, the minimum market share constitutes 0.054%. industry average growth rate is 14.55%, whereas, average risk is about 25%. 7.2 correlation matrix before the multiple regression is run, the existence of multicollinearity among all employed table 4. correlation matrix div size (n. log) grt h liq (n. log) prof (roe) divt-1 (n. log) p/e ratio ow n (n. log) age (n. log) mkt shr risk div 1 size (n. log) -0.21 1 grth -0.02 0.07 1 liq (n. log) 0.02 0.4 0.19 1 prof (roe) -0.07 0.04 0.1 0.14 1 divt-1 (n. log) 0.12 0.42 0.24 0.34 0.19 1 p/e ratio 0.18 -0.02 0 0.1 0.05 0.1 1 own (n. log) -0.06 0.54 0.1 0.26 0.01 0.25 0.08 1 age (n. log) -0.05 0.26 -0.08 0.27 0.09 0.24 0.05 0.05 1 mktshr -0.18 0.78 0.09 0.38 0.04 0.44 -0.12 0.49 0.17 1 risk 0 -0.29 0.04 -0.04 0.14 -0.09 0.13 0.01 0.05 -0.26 1 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 181 independent variables and the dependent variable has been tasted using correlation matrix. the correlation matrix, comprised of the normalized value of the variables, has been presented in table 4. the matrix illustrates low correlation among the scrutinized variables (less than 0.8) which symbolizes no multicollinearity problem. 7.3 multiple regression analysis the study investigates the factors affecting the dividend policy of pharmaceuticals and chemicals industries by testing a number of hypotheses using multiple regression analysis. summary statistics of the regression analysis is illustrated in table 5. the coefficient of determination (r2) is 0.158394789 which indicates that about 15.83% of the changes in the dependent variable, that is dividend payout, are explained by the changes in the independent and control variables of the model. among the dependent variables, firm size (size) has low p-value (<0.05) which indicates the acceptance of the first hypothesis. therefore, dividend payout of bangladesh pharmaceuticals and chemicals industries depends significantly on the size of a firm. the coefficient of firm size is -0.23177 which indicates that if firm size increase by 1 unit, dividend payout decreases by 0.23 units. therefore, dividend payout of bangladesh pharmaceuticals and chemicals industries has significant negative relationship with size of firm. the result supports the findings of ahmed and javid, (2008). hence, as firms become larger, investors should expect a lower divided and vice versa. last year’s dividend (divt-1) is another variable having a low p-value which indicates that the fifth hypothesis has been accepted. the positive coefficient of the variable (0.0679) indicates a positive relationship between dividend payout and divt-1. thus, dividend payout has significant positive relationship with last year’s dividend payment by the firms. this outcome is consistent with naceu, goaied and belanes’s (2006), who analyzed tunisian firms and found that the level of dividend payment depends on both the current earnings as well as historical dividends. thus, more stable earnings and rapid growth of profitable companies contribute to larger free cash flows and assist in paying higher dividend. conversely, firm growth, liquidity, profitability and p/e ratio have larger p-values (≥ 0.05) which leads to the rejection of the second, third, fourth and sixth hypotheses. thus, firm growth, liquidity, profitability and p/e ratio have been found to have no significant relationship with dividend payout of the pharmaceuticals and chemicals industries. empirically researchers explored liquidity to have no significant impact on dividend policy (adedeji, 1998; anupam, 2012). besides, zameer, et al (2013) explored firm growth to have no impact on dividend payout. in addition, all the control variables in the study have higher p values which represent that dividend policy of a firm does not depend directly on the factors like no. of shareholders, firm age, market share and risk. therefore, changes in these variables do not impact the dividend payout of the industry. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 182 table 5. multiple regression analysis summary output regression statistics multiple r 0.4 r square 0.16 adjusted r square 0.12 standard error 0.46 observations 210 anova df ss ms f significance f regression 10 7.98 0.8 3.75 0.00 residual 199 42.39 0.21 total 209 50.37 coefficients standard error t stat p-value lowe r 95% upper 95% lower 95.0% upper 95.0% intercept 1.99 0.67 2.96 0 0.67 3.31 0.67 3.31 firm size (natural log) -0.23 0.08 -2.73 0.01 -0.4 -0.06 -0.4 -0.06 firm growth -0.14 0.15 -0.95 0.34 -0.43 0.15 -0.43 0.15 liquidity (natural log) 0.02 0.01 1.35 0.18 -0.01 0.05 -0.01 0.05 return on equity -0.11 0.07 -1.6 0.11 -0.25 0.03 -0.25 0.03 last year's dividend (natural log) 0.07 0.02 3.67 0 0.03 0.1 0.03 0.1 p/e ratio 0 0 1.94 0.05 0 0 0 0 no. of shareholders (natural log) 0.05 0.06 0.96 0.34 -0.06 0.16 -0.06 0.16 firm listing age (natural log) -0.08 0.14 -0.57 0.57 -0.36 0.2 -0.36 0.2 market share -0.85 0.73 -1.17 0.24 -2.28 0.58 -2.28 0.58 risk -0.11 0.09 -1.26 0.21 -0.29 0.06 -0.29 0.06 8. contribution and practical implications numerous research works have been carried out in this field, especially covering the developed world. such studies have noteworthy contribution to the financial literature of developing countries like bangladesh. however, their outcomes may not have direct implications in bangladesh context due to dissimilarity of cultural, political, and economic asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 183 arrangements. the upshot of the research is expected to offer unique hub to investors, especially in their security selection process. moreover, policy makers and management authority of bangladeshi pharmaceuticals and chemicals companies may want to re-sketch their dividend policies based on the outcomes of the study in order to draw the attention of equity investors towards their companies. investment consultants can edify themselves based on the outcomes of the study and guide their clients accordingly. regulators in the stock market can also be aware of the impact of the examined factors on the dividend payout of such a promising sector listed in bangladesh stock market; which may help them in updating their regulations with respect to dividend issues, and thus, maintaining stability in the stock market. 9. conclusion dividend policy can be marked as a vital research arena in corporate finance. this research is an endeavor to determine the factors that affect the dividend policy of the firms in the pharmaceuticals and chemicals industries. the study explores that firm size has a significant and negative effect on the dividend policy of the pharmaceuticals and chemicals industries. in addition, last year's divided is confirmed to have a significant positive impact on the dividend payout of the firms. however, the study found no significant relationship of dividend payment with firm growth, liquidity, profitability and p/e ratio. based on the findings of the research, investors can be suggested to focus exclusively on the size of the corporations and their previous dividend payment trend while investing in the shares of the companies in these industries. 10. limitations of the study and scope for further research the research is based on pharmaceuticals and chemicals companies listed in dse. compared to the stock markets of developed countries around the world, dse is at its emerging stage. the securities and exchange commission (sec) also needs to be more structured and regulated. corporate governance is yet to be properly implemented here. different manipulation, inconsistency, misspecification and misrepresentation in data may create misleading information for investors, analysts, professionals and researchers. for this study, most of the data were collected from the financial statements of the sample companies, where data manipulation is a common phenomenon. due to the absence of strong corporate governance, regulatory bindings and accountability to dse and sec, some companies get the opportunity to manipulate data, which is not the concern of this study. moreover, although there has been an ample amount of research regarding industry dividend policy, limited substantial work has been done thus far in bangladesh on the dividend policy determinants of pharmaceuticals companies. therefore, an insufficiency of empirical literature exists in this arena. the study attempted to paint the set of factors with a deliberately large brush, given its objective is to explore the dividend determinants of the pharmaceuticals and chemicals industries, especially to guide the stock market investors. certainly more work lies ahead to add to explanations for why some of the factors affect the dividend policy of the industries, while others have no significant impact thereon. further research can also be done in order to asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 184 identify the stock market investors' view on dividend policy. in this regard, portfolios of various investors can be investigated and analyzed in terms of their demographic and other behavioral features. in addition, research efforts can also be employed including more variables for meticulous understanding of the determinants of dividend policy in the industry. references: adedeji, a. 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(2008). public and private sector approaches to improving pharmaceutical quality in bangladesh. dhaka: world bank. retrieved 25 february 2013 from http://siteresources.worldbank.org/intbangladesh/resources/pharmaceutical.pdf zameer, h., rasool, s., iqbal, s., & arshad, u. (2013). determinants of dividend policy: a case of banking sector in pakistan. middle-east journal of scientific research, 18(3), 410-424. microsoft word 11761-43225-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 103 debt capital and financial performance: a comparative analysis of south african and sri lankan listed companies d.k.y. abeywardhana department of accountancy, university of kelaniya, sri lanka e-mail: dilyapa@kln.ac.lk k.m.r.magoro e-mail: kmr2175@gmail.com received: july3, 2017 accepted: october 4, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11761 url: https://doi.org/10.5296/ajfa.v9i2.11761 abstract this study compares how the debt capital of the listed companies operating in the wholesale and retail sectors of south africa and sri lanka affect their financial performance. objective of this study is to examine whether debt capital affects the financial performance of the wholesale and retail sector companies in south africa and sri lanka. to examine the impact of debt financing on financial performance of companies over the 2011-2015 period. fixed-effects (within) regression model was used. the findings the study confirms that debt financing, in terms of short-term debt and long-term debt, has a negative impact on the financial performance of wholesale and retail sector companies in the context of south africa. in sri lanka, debt financing, in terms of short-term debt has a negative impact on firm performance, while long-term debt has a positive impact. this study gives special focus to identify in which industries do different components of the capital structure have significant impact or weak-to-no impact on firm performances. this suggests for the south african wholesale and retail sector can use equity capital and retained earnings efficiently, thereby minimizing conflicts of agency or agency costs and remaining independent of external financiers. in the case of sri lanka, the owners and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 104 managers of the retail companies should consider reducing the use of short-term debt and increase long-term debt capital as long-term debt seems to influence their financial performances positively. keywords: debt capital, financial performance, south africa, sri lanka; capital structure asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 105 1. introduction firms of different sizes often have a common problem, which is, deciding on whether to use debt or equity or both to finance their operations. the decision is of extreme importance given the impact it has on firm value and performance. the capital structure of a firm is a specific mix of debt and equity the firm uses to finance its operations (abor, 2005). there are many alternative capital structures from which the firm can choose. it has the option, if it can, to issue a large amount of debt or very little debt. it can also finance its business operations by means of leasing, issue convertible bonds, use warrants, trade bond swaps or sign forward contracts. the firm can issue a lot of various securities in countless combinations. it is important for the firm however, to find the particular combination of debt and equity that maximizes its overall market value (abor, 2007). sharp and practical business managers who are able to identify and bring the appropriate mix of debt and equity into effective action are fully rewarded in the marketplace because this optimum composition of debt and equity minimizes the cost of financing of the firm, all things being equal. given revenue and pre-financing profit streams that are generated through non-financial factors, minimizing cost of financing maximizes net returns for the firm, thereby improving its competitive advantage in the marketplace (gleason, mathur and mathur, 2000). gleason et al. (2000) suggested that utilization of different levels of debt and equity in the firm’s capital structure is one such firm-specific strategy used by managers in search for improved performance. the interplay between capital structure and firm performance is a crucial and frequently discussed issue, and has been the subject of many studies. modigliani and miller (1958) were the pioneers of this study area, and since then there have been a wide range of contributors that have stretched this supposed solution further. the choice of capital structure (the composition of debt and equity) is greatly linked with firm performance as capital structure is said to play a determinant role in firm profitability. modigliani and miller (1958) developed a proposition highlighting the irrelevance of capital structure, thereby hypothesized that in perfect markets, it matters not what capital structure a company uses to finance its operations as a firm’s financing choice does not affect its capital cost, value or real operations, including performance. the scholars theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends. for this view to hold, modigliani and miller (1958) based their proposition on a number of assumptions; for example, that no taxes or transaction costs exist, that both companies and investors have equivalence in borrowing and lending money, that companies and investors have the same market information (symmetry) and that agency costs exist. ‘although modigliani and miller (1963) suggested that firms can gain the benefits of tax-deductible interest payments by increasing the amount of debt in their capital structure, this view has been questioned due to its assumption of market perfection and its limited applicability to small firms. different researchers followed with theories that contributed to the literature. now there are well-known capital structure theories, which include pecking order theory, trade-off, agency costs, corporate taxes, financial distress, and signalling. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 106 the capital structure literature is varied with mixed results in different times and locations. however, the few studies (gleason et al., 2000; yazdanfar and öhman, 2015) which have investigated multiple sectors; including wholesale and retail, have found common results. the researchers found that, although the results of the impact of capital structure on firm performance could be mixed in other sectors, the relationship is however negative in the wholesale and retail sector. different measures have been used in different researches, which led to dissimilar findings. while on the other hand, some researchers from different countries (ghana abor (2005); sri lanka – nirajini and priya (2013); malaysia – san and heng (2011) &salim and yadav (2012); usa – roden and lewellen (1995); china huang (2006); india – kakani et al. (2001); etc.), have used similar measures and still found contradicting results, which shows that location of trade for firms could bring about different results from those already found in other studies. it is from these reasons that the motivation of this research is derived. however, it should be noted that although a large body of supporting empirical evidence is available for most of the developed countries very little research has been conducted in developing countries like south africa and sri lanka, particularly in the currently researched wholesale and retail sector. most of the previous researches conducted under the capital structure study area (goddard et al., 2005; abor, 2005;nimalathasan and brabete, 2010; salim and yadav, 2012), specifically those that examined the impact of debt and equity mix on firm performance did not incorporate the wholesale and retail sector, with the exception of gleason et al. (2000) and yazdanfar and öhman (2015), who, to the knowledge of the researcher, are the only scholars that studied and examined this impact in the wholesale and retail sector among other sectors. this study seeks to study comparatively the impact of debt capital on the financial performance of companies operating in the wholesale and retail sectors of south africa and sri lanka. that is done using the fixed-effects (within) regression model on the accounting measures of profitability and financial performance. this research is interested to see whether the same negative relationship as found by gleason et al. (2000) and yazdanfar and öhman (2015) exists in the johannesburg stock exchange (jse) and colombo stock exchange (cse) listed companies and to find out the reasons for this negative relationship, particularly because these previous findings were found in researches that included all non-financial institutions industries as opposed to the special focus given to only the wholesale and retail industry in this research. objective of this study is to examine whether debt capital affects the financial performance of the wholesale and retail sector companies in south africa and sri lanka. the findings of this research will help south african wholesalers and retailers as well as sri lankan retail companies to understand the impact of debt capital on company performances. this study will help them make decisions that will ensure profit maximization and reduction of costs associated with debt. previous researchers have focused on the impact of the entire capital structure (both debt and equity components) of the firms on their performances. the originality of this research is that it seeks to test the impact that the debt component of the capital structure (debt capital) has on the company’s financial performance, if there’s any asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 107 impact at all. the debt capital will be measured as the ratio of short-term debt and long-term debt. the impact of these debt ratios on the financial performance ratios is what this study seeks to examine. this research was inspired by contradicting findings from different researchers in different industries. it is also in response to dawar (2014) which suggested that future researchers should incorporate sectoral analysis so as to explore whether relationship is any different given the specific attributes particular to an industry. gleason et al. (2000) also stated that ‘selecting all firms from one industry ameliorates problems associated with analysis of firms from different industries.’ the rest of the paper is organized as follows. section 2 discusses the theoretical literature review of capital structure and financial performance. section 3 presents the research design, hypotheses and methodology employed to address the research questions of the study. it also explains data collection and sampling, as well as the measurement of research variables. section 4 presents the results of the research, data analysis and the discussion and section 5 presents the conclusions, recommendations and limitations of the study. most of the previous researchers have focused on the impact of the entire capital structure (both debt and equity components) of the firms on their performances. the originality of this research is that it seeks to test the impact that the debt component of the capital structure (debt capital) has on the company’s financial performance, if there’s any impact at all. this supports and extends the work of other researchers (campello, 2006; abor, 2007; eldomiaty and mohamed, 2008; sadeghian et al., 2012; yazdanfar and öhman, 2015; moon et al, 2015; davydov, 2015) that have studied the impact of debt financing on firm performance. as pointed out by eldomiaty and mohamed (2008), ‘the literature on determinants of capital structure lends itself to firms’ debt structure. the literature is rich in research papers that discuss the determinants of capital structure, mostly focusing on using the debt ratio as a proxy for capital structure.’ the other unique factor is that most previous researchers (e.g., goddard et al., 2005; campello, 2006; david &olorunfemi, 2010; salim and yadav, 2012; sadeghian et al., 2012; dawar, 2014; abeywardhana, 2015; yazdanfar and öhman, 2015, etc.) have conducted their researches on all non-financial institutions industries (listed or non-listed) together in one study, while this study seeks to research only about the wholesale and retail sector (industry) due to the little amount of research conducted, as well as the negative relationships found by the few researchers on the impact of capital structure on firm performances in this particular industry (gleason et al., 2000; yazdanfar and öhman, 2015). this study proposes ratios and financial links that have not been used by previous researchers in one study. the study proposes the following ratios to show a direct link between the company’s debts (with yearly movements/changes) and its performance in terms of sales and profitability as additional tools to measure the impact of the firm’s debt capital on the company’s performance, size kept constant: debt growth rate vs. sales growth rate debt growth rate vs. profit growth rate asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 108 this study seeks to pioneer the addressing of the root causes and reasons of research contradictions in this study area by breaking down the broader areas (i.e. capital structure) into small components that make up the whole study area, and to identify in which industries do different components of the capital structure have significant impact or weak-to-no impact on firm performances. 2. literature review the impact of debt financing and financial performance has been the subject of many studies. while most of these studies ignore wholesale and retail sector in favour of manufacturing and other sectors (goddard et al., 2005; abor, 2005; abu-tapanjeh, 2006; nimalathasan and brabete, 2010; sheikh and wang, 2011; salim and yadav, 2012), the current study highlights the significance of the less researched sector and the importance of location of trade for the companies being researched. in south africa, according to south africa’s key sectors contribution to gross domestic product (gdp) growth in 2013, wholesale and retail trade contributed 12.5% to the gdp. that is the fourth largest contributing factor in the country. abor (2005) adapted regression analysis to test the relationship between capital structure and performance in terms of profitability among 22 listed firms in ghana over the 1998-2002 period. the study of abor (2005) revealed a significantly positive relation between the ratio of short-term debt to total assets and return on equity (roe). on the other hand, abor (2005) indicated that there was a negative relationship between the ratio of long-term debt to total assets and roe. going further, abor (2007) used a generalized least squares regression to study a sample of 160 ghanaian and 200 south african small and medium sized enterprises (smes) over the 1998-2003 period. the results of abor (2007) indicate that capital structure influences financial performance of ghanaian and south african firms, although not exclusively. on the other hand, abor (2007) found that by and large, the results indicate that capital structure, especially long-term and total debt ratios, negatively affect performance of smes. the two studies show that there was a definite negative relationship between long-term debt ratios and the financial performance of the firm; while the short-term debt ratios impact the firm performance positively.ebaid (2009) used multiple regression analysis and revealed that capital structure choice decision, in general terms, has a weak-to-no impact on firm’s performance. booth et al. (2001) found that debt ratios and profitability are negatively correlated for a set of ten developing countries including brazil, mexico, south korea, zimbabwe and malaysia among others. american researchers in general have found mixed results in their studies of the impact of debt financing on firm performance. many show that the use of debt at different levels (high debt financing or low debt financing) would yield different results as far as the debt impact or influence on firm performance is concerned. according to hadlock and james (2002) american corporations with high level of profitability use high level of debts, citing a positive relationship between debt and profitability only when the level of debt is higher or the other way round. mesquita and lara (2003) study 70 brazilian industrial and service companies over the 1995-2001 period, employing the ordinary least squares (ols) method indicated that the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 109 return rates present a positive correlation with short-term debt and equity, and an inverse correlation with long-term debt. in contrast, byoun and xu (2013) reported that large debt-free firms are more profitable than levered firms of similar size. this was backed by moon et al. (2015) when it was found that zero-debt firms generate positive abnormal returns in the long. this notion takes the contradictions further by indicating that large firms with no debt at all are performing better than their debt-loaded counterparts. this shows that according to these researchers, debt has no impact on profitability or financial performance of the firm when the firm is large. moon et al. (2015) used fama and french’s (1993) three-factor and carhart’s (1997) four-factor models to examine the subsequent 1, 2, 3, 4 and 5-year stock returns of firms that stayed debt free for 3and 5-year periods. kakani et al. (2001) studied 566 large indian firms for eight years and divided into two sub-periods (viz., 1992-96, and 1996-2000) to examine the financial performance of indian firms across various dimensions. the study found that leverage ‘again’ came out as having a significant negative effect on accounting profitability measures. leverage ratio proved to have a significant negative effect on shareholder value in both the sub-periods. in support of kakani et al.’s (2001) exploratory study, dawar (2014) used the fixed effect panel regression model to find the relationship between leverage and firm performance after controlling for factors such as size, age, tangibility, growth, liquidity and advertising. the results suggested that leverage has a negative influence on financial performance of indian firms, which is in contrast with the assumptions of agency theory. dawar, (2014) incorporated sectoral analysis to explore whether relationship is any different given the specific attributes particular to an industry. this support of what the previous authors, (williams and goodman, 1971; gupta and huefner, 1972; bowen et al, 1982; mensah, 1984), said when it was suggested that applying the same variables across different sector produces overly general models that overlook the specific attributes of the sectors. sheikh and wang (2011) used several methods, including ols, fixed effects and random effects, to study the influence of capital structure on the performance and concluded that long-term and short-term debt ratios are negatively related to roa. sri lankan researchers have mixed results in terms of the impact of capital structure on profitability with majority finding a positive relationship. nimalathasan and brabete (2010) found that capital structure has a great impact onprofitability performing multiple regression analysis. nirajini and priya (2013) adapted a regression model to analyse the extent to which capital structure impacts financial performance of listed companies in sri lanka. the empirical research found that firm capital structure has a significant impact on financial performance. in the case of jordan, abu-tapanjeh (2006) found that a weak relationship existed between some of the independent variable and profitability, except for debt ratio. the author states that ‘as far as debt ratio’s relation with profitability of the selected jordanian industrial companies is concerned, there was a significant positive relation during the years 1999-2003 as well as for the pooled sample. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 110 sadeghian et al. (2012), study the probable relationship between the performance indicators and debt ratios of tehran stock exchange companies, using regression model and found that an increase in current debts, non-current debts, and total debts has a negative influence on the corporate performance. zeitun and saleh (2015) used a panel data to examine the effect of financial leverage on firm’s performance using the dynamic generalised method of moments (gmm) estimator to investigate the effects of financial leverage on firm’s performance in gulf cooperation council (gcc) countries. firms leverage affects their performance significantly and negatively, showing that higher financial leverage in gcc companies’ capital structure decreased their performance. this is consistent with twairesh, (2014),chinaemerem and anthony (2012), gleason et al., (2000)majumdar and chhibber (1999). european studies (gleason et al., 2000; goddard et al., 2005; yazdanfar and öhman, 2015) have found the relationship between capital structure and company performances to be negative in various sectors. gleason et al. (2000) and yazdanfar and öhman (2015) have studied the ‘wholesale and retail’ sector. goddard et al. (2005) estimated a profitability model using a two-step gmm estimator, applicable to data sets with a large cross-sectional and a small time-series dimension. the findings show that profitability was inversely related to the firm’s gearing ratio with regards to the european manufacturing and services sectors, but also noted that firms with higher liquidity tend to be more profitable. yazdanfar and öhman (2015) used three-stage least squares (3sls) and fixed-effects models to analyse a comprehensive, cross-sectoral sample swedish smes operating in five industry sectors during the 2009-2012 period. the study confirmed that debt ratios, in terms of trade credit, short-term debt and long-term debt, negatively affect firm performance in terms of profitability. as a high debt ratio seems to increase the agency costs and the risk of losing control of the firm, sme owners and managers tend to finance their businesses with equity capital to a fairly high degree. in confirmation of the study of yazdanfar and öhman (2015), abeywardhana (2015) found that long-term debt to total assets ratio is negatively related with the profitability of nonfinancial smes in the uk. the researcher used the two stage least squares (2sls) model to examine the relationship between capital structure and the profitability of nonfinancial smes in the uk for the period of 1998-2008. weill (2008) found mixed results that financial leverage, is related to firm performance positively and significantly in spain and italy, but negatively and significantly in germany, france, belgium and norway, and negatively and insignificantly in portugal. kebewar (2012) underlined that evidence from french service sector shows that debt has no influence on profitability either in a linear way, or in a non-linear way. this study found that even when the analysis is presented using different size classes there is no impact regardless of the size of the enterprise. using gmm kebewar (2012) shows that debt ratio has no effect on corporate profitability, regardless of the size of company. as abor (2005) concluded, ‘there is no universal theory of the debt-equity choice.’ this is supported by the above review of the literature which shows contradictions in the findings of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 111 the many studies conducted in an attempt to find the optimal capital structure which should ensure an increase or improvement in the firm’s performance and value. the studies had varying structures, used different measures of firm performance and reported mixed results. the fact that the results were obtained from studies conducted in varying socio-economic contexts, can to some extent explain the contradictions of the results, as the underlying structure, form or nature of the researched institutions may play a role in the relationship between the firm’s financial leverage and its financial performance. this is therefore a rational motive (reason) why it is relevant to study this relationship and the impact between these variables (debt financing and firm performance) in both the south african and sri lankan contexts. to the best knowledge of the researcher, the wholesale and retail sectors of the two countries have not been studied under the capital structure study area, which is another reason why it is befitting to explore the impact of debt capital on the financial performance of companies in a comparative study between the two countries. 3. methodology in terms of the research methodology employed, the research applied longitudinal (panel data) research techniques to analyse data across the sampled publicly listed companies for the five year period from 2011 to 2015. data collection was undertaken using a secondary data method that depended mainly on firms’ annual reports. the variables were developed in a manner that gave consistency to prior studies and underlying theories. the variables as well as the hypotheses were measured according to accounting and financial guidelines in order to answer the research questions. entire dataset is 205 observations (125 from south africa and 80 from sri lanka) which will be analysed separately for a comparative study. panel data regression models have been employed for the purpose of this study for which hausman test was conducted and showed support for fixed-effects (within) regression model. 3.1 hypothesis development agency cost theory affirmed the assertion made by the pecking order theory as it suggests that , conflicts of interest between owners and creditors should likely lead to a negative relationship between financial leverage and profitability. the agency cost theory adds that profitable firms would tend to decrease their agency costs of debt by using retained earnings and thereby reducing their debt ratios. based on the agency cost view, the effects of accounts payable, short-term debts and long-term debts on performance in terms of profitability are all likely to be negative (yazdanfar and öhman, 2015). there have been quite a good number of researchers that have conducted their studies based on the above theories, but to date, there’s still no determined conclusive relationship between capital structure and financial performance of firms. campello (2006) found that debt financing may either boost or hinder firm competitive performance as the study conducted suggests that moderate debt taking by a firm may, on the margin, yield market share gains. after some point though, additional indebtedness leads to significant sales underperformance. gleason et al. (2000) as well as yazdanfar and öhman (2015) found that agency conflicts asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 112 may be primarily responsible for overleveraging of retailers, resulting in a negative relationship between capital structure and performance. on that basis, the following hypothesis is developed: h1: debt capital has a negative impact on the financial performance of the wholesale and retail sector companies in south africa and sri lanka. h1.1: short-term debt has a negative impact on the financial performance of the firm. h1.2: long-term debt has a negative impact on the financial performance of the firm. there are other variables which are going to be controlled in this study, that have been proven to have an impact on the profitability or financial performance of the firm, such as size and age. based on that, the second and third hypotheses are developed as follows: h2: firm size has a positive impact on the financial performance of the wholesale and retail sector companies in south africa and sri lanka. h3: firm age has a positive impact on the financial performance of the wholesale and retail sector companies in south africa and sri lanka. source: developed by author from selective review of literature debt ratios, in terms of short-term debt and long-term debt are expected to influence performance of the firm in terms of profitability. the literature provides empirical evidence that the outcome of the impact of debt financing, as measured by the debt ratios, on firm performance, depends entirely on the industry in which the researched firms operate as well as the region (location) in which they are based. the previous studies show mixed results with some (mesquita and lara, 2003; abor, 2005; david &olorunfemi, 2010; nimalathasan and brabete, 2010; salim and yadav, 2012; etc.) finding positive relationships (impacts) short-term debt long-term debt firm performance size age asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 113 while others (gleason et al., 2000; goddard et al., 2005; sadeghian et al., 2012; yazdanfar and öhman, 2015; etc.) are showing negative results, and a few (abu-tapanjeh, 2006 and ebaid, 2009) finding a weak-to no-impact relationship. abor (2007) found that short-term debt has a positive influence on firm performance in terms of roa, while long-term debt has a negative influence. based on the studies of gleason et al. (2000) and yazdanfar and öhman (2015), which have analysed the wholesale and retail sector among others, debt ratios are expected to have a negative impact on the financial performance of the firm. theory has shown that size has a positive impact on the financial performance of the firm as the larger firms achieve and make good use of the economies of scale and that their greatness allows them to have better abilities to use technology in order to achieve larger market shares and better diversification of products, and thus profitability (majumdar and chhibber, 1999; frank and goyal, 2003;). on that note, size of the firm is expected to have a positive impact on the financial performance of the firm. age of the firm is another factor that has been suggested as a positive influencer of firm performance, particularly because older firms have and back themselves with the vast business experience that they have accumulated over the years. older firms can easily avoid that type of liability due to their experience and familiarity in the market. hence it is said that they (older firms) achieve experience-based economies as a result of their experience which has proven to be an added advantage for them. majumdar and chhibber (1999) built on (supported) that notion and added that the learning and business experience of older firms will enable them to gain economic advantage, and to have access to more resources and reputation effects. this generates opportunities for better performance, and this assertion was backed by cabral and mata (2003). on that note, firm age is also expected to have a positive impact on the financial performance of the firm. the population of this study is defined in terms of the number of the publicly listed companies in the wholesale and retail sector as stipulated by the johannesburg stock exchange (jse) as well as colombo stock exchange (cse). according to jse data, there are 47 publicly listed companies operating in the wholesale and retail sector. cse has just recently adopted the global industry classification standard (gics) which was developed by morgan stanley capital international (msci). according to the gics sector classification at cse, there are 12 companies in the consumer discretionary sector which are classified under the retailing industry group. there are 4 more companies classified to be operating in the food & staples retailing industry group, which fall under the consumer staples sector. the total population of data collected from cse was 16 companies, and they were all considered for this research as they met the criteria for selection in this study. data were collected from the listed companies on the jse as well as cse for 2011-2015 periods. the analysis is based on 25 publicly listed firms in the wholesale and retail sector from south africa and 16 from sri lanka. using data from 2011 to 2015 period is considered reasonable as it is recent and shows relevance to this study, and most importantly to the firms operating in the researched sector. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 114 another reason is that this was a period during which the companies had just come out of the recovery phase following the global recession in 2008-09; and in the case of sri lanka, this period followed the recovery phase that took place after the end of the civil war in 2009. the relationship between debt capital and firm performance as well as the impact thereof was tested by the following regression models: , = + , + , + , + , + , , = + , + , + , + , + , where: , = short term debt to total assets for firm i in year t; , = long term debt to total assets for firm i in year t; , = logarithm of sales for firm i in year t; , = age of firm i at time t, measured as the natural logarithm of thenumber of years since firm inception, as of the year of data collection; and , = error term. 4.data analysis and discussion 4.1 analysis of south africa’s dataset this section starts by presenting the results of the descriptive statistics in 4.2.1, 4.2.2 presents the correlation analysis. 4.2.3 presents and discusses results of the fixed-effects (within) regression model. table 4.1 below shows the summary of the descriptive statistics. the most important measure that shows the balance point and is the exertion center of distribution is arithmetic mean (sadeghian et al., 2012). the sampled companies are characterized by an average age of just above 63 years. the mean age show that these companies have been in business for long and are generally well established. the mean value for company size is 9.8. the mean values of both company size and age indicate that the sampled companies are fairly large and have reached a significant scale of operations. the roa and ros reveal that companies operating in this sector achieve modest profitability, with mean profitability of 8.85% and 5.52% for roa and ros respectively. the descriptive statistics indicate that profitability of the sampled firms (as measured by roa and ros) as well as long-term debt are highly volatile, as the standard deviations of these variables are greater than their mean values. however, levels of short-term debt, size and age indicate that they are less volatile, and thereby showing the quality of being similar or comparable in nature (homogeneousness) of the sampled companies. as shown in the descriptive statistics table below, 37% of total assets of the sampled companies were on average financed using short-term debt, while long-term debt was used as a means of financing for approximately 15% of the total assets. this means that just about asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 115 52% of the total assets in the sampled companies are financed by debt, and thereby revealing that companies in this sector generally use internal financial sources (i.e. equity capital and retained earnings) to finance around 48% of the total assets. the proportion between debt use and equity use is not much (approximately 4%), and that indicates the balance of financing options maintained when using these two components of the capital structure by companies in the wholesale and retail sector, with slight preference to debt over equity. companies in this sector seem to prefer short-term debt as their external source of financing. they use long-term debt less often or minimally. the reason for this was better explained by yazdanfar and öhman (2015) when the researchers indicated that ‘financial institutions such as banks usually agree to issue short-term debt, because it can be cancelled on short notice. therefore, firms can use short-term debt as an additional funding source to increase internal sources of capital.’ the mean values of all the variables are significant at 5 percent level. table 4.1. descriptive statistics for the dependent and independent variables variable mean std. dev. min max observatio roa overall 0.0885 0.1056 -0.2799 0.3312 n= 125 between 0.0986 -0.1644 0.3063 n= 25 within 0.0416 -0.0270 0.2823 t= 5 ros overall 0.0552 0.0758 -0.1834 0.2278 n= 125 between 0.0728 -0.0994 0.2152 n= 25 within 0.0246 -0.0334 0.1770 t= 5 std overall 0.3721 0.9143 0.0985 0.8699 n= 125 between 0.1841 0.1281 0.7163 n= 25 within 0.0704 0.1676 0.6336 t= 5 ltd overall 0.1478 0.1631 0.0109 0.9469 n= 125 between 0.1591 0.0145 0.8329 n= 25 within 0.0459 0.0064 0.3927 t= 5 size overall 9.8033 0.8625 7.7526 11.0557 n= 125 between 0.8741 7.8606 10.9615 n= 25 within 0.0668 9.6393 10.0099 t= 5 age overall 63.16 35.6808 8.00 130.00 n= 125 between 36.2418 10.00 128.00 n= 25 within 1.4199 61.16 65.16 t= 5 roa = return on assets; ros = return on sales; std = short-term debt; ltd = long-term debt; size = natural logarithm of total sales; age = number of years since establishment. the results of correlation analysis between the dependent variables, which are represented in terms of roa and ros, as well as each independent and control variable are reported in table 4.2 below. the results also confirm that all the coefficients between variables are fairly low, so there is no indication of multicollinearity among the variables included in the model. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 116 table 4.2. correlation of analyses of the variables included in the study roa ros std ltd size age roa 1 0.862** -0.238* -0.496** 0.271** 0.113** ros 0.862* 1 -0.452* -0.428** 0.135** 0.155** std -0.238** -0.452** 1 -0.162* 0.282** -0.396** ltd -0.496** -0.428** -0.162* 1 0.143** 0.237** size 0.271** 0.135** 0.282* 0.143** 1 0.200** age 0.113** 0.154** 0.3955 0.237** 0.200** 1 notes: ** correlation is significant at 5 percent level. roa = return on assets; ros = return on sales; std = short-term debt; ltd = long-term debt; size = natural logarithm of total sales; age = number of years since establishment. table 4.3 and 4.4 below present the regression results using the fixed-effects (within) regression model to test the impact of debt capital on the financial performance of companies measured by roa and ros. as indicated by the results of the complete model and consistent with h1, debt capital i.e. short-term debt and long-term debt – has a negative impact on firm performance in the case of both roa and ros. in terms of roa, the slope coefficients of long-term debt and short-term debt are both negative and statistically significant at 5 per cent level. the slope coefficient of the long-term debt ratio variable (β = -0.3663613; p>|t| = 0.000) represents the highest debt ratio, while the slope coefficient of the short-term debt ratio variable (β = -0.2283428; p>|t| = 0.000) represent the lowest. in terms of ros, the results are somewhat similar with the slope coefficients of both long-term debt and short-term debt being negative and statistically significant at 5 per cent level. however, the slope coefficients of both debt ratio variables are comparatively lower than in roa. in the case of ros, the slope coefficient of the long-term debt ratio variable (β = -0.1719025; p>|t| = 0.002) still represents the highest debt ratio, while the slope coefficient of the short-term debt ratio variable (β = -0.1188747; p>|t| = 0.001) represent the lowest. these results suggest that an increase in the amount of both or either short-term debt and long-term debt is associated with a decrease in the financial performance of the firm. size of the firm is proved to have a significant positive impact on firm performance as measured by both roa and ros. this is consistent with h2, indicating that larger companies in the wholesale and retail sector operating in the south african market are, on average, more likely to be profitable or perform well financially. this could also mean that larger companies in south africa are able to achieve the economies of scale and are also able to exercise considerable influence in product and factor markets. contrary to h3 put forward, the firm’s age was found to have significantly negative associations with both roa and ros, and thus implying that younger firms tend to perform well financially than their older counterparts, as they may be flexible in adjusting or adapting to rapid changes that have been one of characteristics of this particular industry in recent years. overall, the empirical results in table 4.3 and 4.4 below indicate that after controlling for factors such as firm size and firm age, debt capital (debt ratios) has a negative impact on the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 117 financial performance of the firms operating in the south african wholesale and retail sector in terms of profitability (roa and ros). companies which have lower debt ratios appear to be performing well and are able to achieve higher profits. the evidence provided by the current study is in accordance with the pecking order theory. the empirical findings of the current study support those of previous studies from other countries and different sectors, e.g. majumdar and chhibber (1999), gleason et al. (2000); goddard et al. (2005), abor (2007), sheikh and wang (2011); salim and yadav (2012); dawar (2014); and yazdanfar and öhman (2015). table 4.3. regression results of debt capital and firm performance measured by roa roa coefficient std. err. t-statistics significanc short term debt -0.2283 0.0516 -4.42** 0.000 long term debt -0.3664 0.0821 -4.46** 0.000 size 0.227 0.0843 2.69** 0.008 age -0.0158 0.0039 -4.03** 0.000 constant -1.0009 0.6552 -1.53** 0.130 r2 within 0.4028 r2 within 0.0021 r2 overall 0.0029 sigma u 0.5641 sigma e 0.0365 rho 0.9958 prob >f 0 notes: ** significant at 5 percent level. roa = return on assets; size = natural logarithm of total sales; age = number of years since establishment table 4.4. regression results of debt capital and firm performance measured by ros ros coefficient std. err. t-statistics significanc short term debt -0.1189 0.0331 -3.59** 0.001 long term debt -0.1719 0.0526 -3.27** 0.002 size 0.1565 0.054 2.90** 0.005 age -0.0089 0.0025 -3.55** 0.001 constant -0.8461 0.4199 -2.01** 0.047 r2 within 0.3007 r2 within 0.0013 r2 overall 0.0007 sigma u 0.3305 sigma e 0.0234 rho 0.9950 prob >f 0.0000 notes: ** significant at 5 percent level. roa = return on assets; size = natural logarithm of total sales; age = number of years since establishment. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 118 4.2 analysis of sri lanka’s dataset table 4.5 below presents the summary of the descriptive statistics of both the dependent and independent variables.the sri lankan companies are characterized by an average age of approximately 59 years. this shows that the companies operating in the retail industry of sri lanka are generally old and well established in the market. the mean size is around 9.5, and thus indicating that the sampled companies are fairly and generally large. the average size and age of the sampled companies indicate that they have reached a significant scale of operations. the profits achieved by companies in this sector are not high, as shown by mean values of roa and ros. roa show that companies make returns of approximately 6.7% from their investments in assets, while ros show that they gain almost 13% from their total sales. the statistics below reveal that the sampled companies prefer to finance their assets using more short-term debt over long-term debt. approximately 37% of total assets of the sampled companies were on average financed using short-term debt, while long-term debt was only used to finance approximately 7% of the total assets. the total debt financing of the sri lankan companies in this sector adds up to more or less than 44%, which means debt as a means of financing is least preferred by sri lankan firms as they only use it to finance less than half of their total assets. this also indicates slight preference by the sampled companies to use internal financial sources (i.e. equity capital and retained earnings) as opposed to external funding. funding other than external financing is used to finance approximately 56% of the total assets. although the difference in percentages between debt use and equity use is not too high (approximately 12%), it is clear from the descriptive statistics that sri lanka retail companies prefer to use internal funds more than external ones (i.e., debt financing). just as is the case in south african companies, sri lankan firms prefer to use short-term debt over long-term debt, and this could be due to the ease of access of short-term debt as opposed to long-term debt which usually has unattractive terms and conditions for businesses. the use of short-term debt is to be expected, as working capital loans are better secured and less risky than fixed investment loans (yazdanfar and öhman; 2015). the descriptive statistics below indicate that profitability of the sampled companies (as measured by roa and ros) as well as long-term debt are highly volatile, as the standard deviations of these variables are greater than their mean values. however, levels of short-term debt, size and age indicate that they are less volatile, and thereby showing the quality of being similar or comparable in nature (homogeneousness) of the sampled companies. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 119 table 4.5. descriptive statistics for the dependent and independent variables roa = return on assets; ros = return on sales; std = short-term debt; ltd = long-term debt; size = natural logarithm of total sales; age = number of years since establishment. table 4.6 below presents the results of the correlation analysis of the variables using sri lanka’s dataset. table 4.6. correlation of analyses of the variables included in the study roa ros std ltd size age roa 1 0.575** -0.041** -0.162** 0.052** 0.073** ros 0.575** 1 -0.1444** 0.162** -0.347** -0.021** std -0.041** -0.1444** 1 0.046** 0.294** -0.415** ltd -0.162** -0.162** 0.046** 1 0.141** -0.195** size 0.052** -0.347** 0.294** 0.141** 1 0.140** age 0.073** -0.021** -0.415** -0.195** 0.140** 1 notes: ** correlation is significant at 5 percent level. roa = return on assets; ros = return on sales; std = short-term debt; ltd = long-term debt; size = natural logarithm of total sales; age = number of years since establishment. table 4.7 and 4.8 below present the regression results using the fixed-effects (within) regression model., and this is consistent with h1.1. in terms of roa, the slope coefficient of short-term debt is negative and statistically significant at 5 per cent level. the slope coefficient of the short-term debt ratio variable is β = -0.325733; p>|t| = 0.004. however, the results show that long-term debt has no statistically significant relationship and influence on roa. the significance level of long-term debt is at 13.5% and falls outside the acceptable significance level of 5%. in terms of ros, the slope coefficient of short-term debt is negative and statistically significant at 5 per cent level. the slope coefficient of the short-term debt ratio variable is β = variable mean std. dev. min max observatio roa overall 0.0676 0.0764 -0.0754 0.3605 n= 80 between 0.0510 -0.0094 0.1673 n= 16 within 0.0580 0.0523 0.3013 t= 5 ros overall 0.1288 0.2630 -0.1115 1.7566 n= 80 between 0.1815 0.0281 0.6353 n= 16 within 0.1947 0.3280 1.4363 t= 5 std overall 0.3666 0.1997 0.0231 0.8575 n= 80 between 0.1927 0.1383 0.7813 n= 16 within 0.0679 0.1475 0.5299 t= 5 ltd overall 0.0679 0.6820 0.0037 0.3659 n= 80 between 0.0528 0.0158 0.2133 n= 16 within 0.0448 -0.0274 0.3096 t= 5 size overall 9.5663 0.7612 8.1963 10.7898 n= 80 between 0.7681 8.3267 10.7105 n= 16 within 0.1391 9.0667 10.0462 t= 5 age overall 58.625 30.0861 12 106 n= 80 between 30.8434 14 104 n= 16 within 1.4231 56.625 60.625 t= 5 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 120 -0. 8790638; p>|t| = 0.016. it is noticeable that the slope coefficient of the short-term debt in the model developed for ros is quite high as compared to the slope coefficient of short-term debt in the roa model. however, long-term debt, in contrast with h1.2, appears to have a positive impact on firm performance as measured by ros. the slope coefficient of long-term debt is negative and statistically significant at 5 per cent level. the slope coefficient of long-term debt ratio variable is β = 2.352159; p>|t| = 0.000, and it’s clear that it’s very high. this shows that an increase in the amount of long-term debt will result in an increase in the profitability of the sri lankan firms operating in the retail sector, while an increase in the amount of short-term debt will lead to a decline in the firms’ profitability. in confirmation of h2, size of the firm is proved to have a significant positive impact on firm performance as measured by roa, and thereby indicating that larger companies in the sri lankan retail sector are, on average, more likely to be profitable or perform well financially. this could also mean that larger companies in sri lanka are able to achieve the economies of scale and are also able to exercise considerable influence in product and factor markets. the results of the ros model indicate that size has no statistically significant relationship and influence of the financial performance of the firm. the significance level of firm size in the ros model is at 34.7%. contrary to h3 put forward, and similar to south africa’s regression results, the firm’s age was found to have significantly negative associations with both roa and ros, and thus implying that younger firms tend to perform well financially than their older counterparts, as they may be flexible in adjusting or adapting to rapid changes that have been one of characteristics of this particular industry in recent years. the relationship between all the variables and the influence of explanatory variables on dependent variables are confirmed by the ‘t-values’ which tested the hypotheses, and the results show that short-term debt (independent variable) and the age of the firm (control variable) affect both roa and ros negatively. long-term debt (independent variable) affects ros positively, while the size of the firm affects roa positively. the fixed-effects (within) regression model indicate that independent variables explain approximately 34.42 percent of the change in roa, and 37.05 percent of the change in ros, as shown by ‘r-squared’ in their respective regression results. this suggests that other firm-level, industry and/or macroeconomic variables obviously affect the financial performance of the firm. approximately 99% of the variance in the roa regression results is due to differences across the panels, while for ros the variance is approximately 97%. this is depicted by ‘rho’ which is known as the intraclass correlation or the percentage of the variation that’s explained by individual specific effects. the high percentage of ‘rho’ in the two regression results (in terms of roa and ros) is good as it means that it’s not just idiosyncratic. overall, the empirical results in table 4.7 and 4.9 below indicate that after controlling for factors such as firm size and firm age, short-term debt has a negative impact on the financial performance of the firm, while long-term impacts firm performance positively. firm performance was measured in terms of profitability ratios (roa and ros), and this results are for all the sri lankan companies operating in the retail sector as per the gcis classification. the results show that companies that finance their businesses using long-term asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 121 debt appear to be performing well as opposed to the ones that use more of short-term debt capital. therefore, lower levels of short-term debt and higher levels of long-term debt can ensure better financial performance for the sri lankan firms operating in the retail sector. the results of the current study, using sri lanka’s dataset, are in contrast with the findings of gleason et al. (2000) which studied the relationship between capital structure and performance of the retailers in 14 european countries and found that agency issues may lead to use of higher than appropriate levels of debt in the capital structure, thereby producing lower performance. other studies that found the same results as gleason et al. (2000) are abor (2007); dawar (2014); yazdanfar and öhman (2015), amongst others. table 1. regression results of debt capital and firm performance measured by roa coefficient std. err. t-statistics significanc short term debt -0.3257 0.1084 -3.01** 0.004 long term debt 0.2174 0.1435 1.52** 0.135 size 0.1815 0.0472 3.85** 0.000 age -0.022 0.005 -4.43** 0.000 constant -0.2756 0.4968 -0.55** 0.581 r2 within 0.3442 r2 within 0.0096 r2 overall 0.0077 sigma u 0.6439 sigma e 0.0539 rho 0.993 prob >f 0 notes: ** significant at 5 percent level. roa = return on assets; size = natural logarithm of total sales; age = number of years since establishment. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 122 table 4.8. regression results of debt capital and firm performance measured by ros ros coefficient std. err. t-statistics significanc short term debt -0.8791 0.3563 -2.47** 0.016 long term debt 2.3522 0.4718 4.99** 0.000 size 0.147 0.155 0.95** 0.347 age -0.0335 0.0163 -2.05** 0.045 constant 0.847 1.6332 0.52** 0.606 r2 within 0.3705 r2 within 0.0009 r2 overall 0.0012 sigma u 1.0194 sigma e 0.1773 rho 0.9706 prob >f 0.0000 notes: ** significant at 5 percent level. roa = return on assets; size = natural logarithm of total sales; age = number of years since establishment. 5. conclusion and recommendations firms of different sizes often have one common problem, which is, deciding on whether to use debt and/or equity to finance their operations. the decision is of extreme importance given the impact it has on firm value and performance. from a managerial and owner’s perspective, this financial decision requires thorough examination before it can be made. this study provides empirical evidence on that issue. the purpose of the study is to examine the impact of debt capital on the financial performance of companies operating in the wholesale and retail sectors of south africa and sri lanka during a five year period, 2011-2015. the study attempted to explore the gaps in the study of capital structure in order to provide empirical evidence that could be the basis for further research and improved understanding in this field. the study also attempted to determine the extent of use of debt capital between companies in south africa and how they compare with their sri lankan counterparts. contrary to the agency-cost theory which suggests that high leverage levels can help firms increase market value and performance, the overall results of this study indicate that debt capital, in the form of both long-term debt and short-term debt affects the financial performance of the south african firms operating in the wholesale and retail sector significantly and negatively. these results are consistent with the pecking order theory and confirm the findings of gleason et al. (2000) and yazdanfar and öhman (2015) which indicated that debt financing affects the financial performance of wholesalers and retailers negatively. the results also support the most influential evidence provided by myers (1984) against the static tradeoff theory. the study by myers (1984) founda strong inverse correlation between profitability and financial leverage. other researchers that have found similar results are, amongst others, booth et al. (2001); fama and french (2002); goddard et al. (2005); dawar(2014), etc. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 123 the results from the south african firms confirm dawar (2014)’s suggestions that the assumptions of the agency cost theory may be commonly received and accepted in developed and other emerging markets, but this is not the case in many developing and/or underdeveloped markets. although both short-term debt capital and long-term debt capital affect firm performance negatively in south african firms, only short-term debt capital affect the performance of the sri lankan retail companies significantly and negatively. long-term debt capital of the sri lankan retail companies has a significant positive impact on the financial their performance. the companies from both countries seem to prioritize the use of short-term debt before long-term debt, and this could be due to the ease of access of short-term debt as opposed to long-term debt which usually has unattractive terms and conditions for businesses. as pointed out by yazdanfar and öhman (2015), ‘such a strategy can reduce the costs related to information asymmetry and agency conflicts. the lower the leverage level, the lower the agency costs of external debt and the higher the firm profitability.’ sri lankan retailers seem to slightly prefer the use of internal financial sources (i.e. equity capital and retained earnings) as opposed to external funding as they use debt capitalto finance less than half of their total assets. the size of the firm, in the case of both south africa and sri lanka, has a significant and positive impact on company performances, which is a contradiction to the findings of yazdanfar and öhman (2015)’s study which indicated that size had a significantly negative relationship with profitability in the retail trade and wholesale sectors. however, the size-performance relationship supports the findings of gleason et al. (2000)’s study which indicated that firm size also influences performance, with larger retailers earning higher return on assets compared to smaller retailers. this indicates that larger companies in the wholesale and retail sector are, on average, more likely to be profitable or perform well financially than their small counterparts. younger firms from both countries seem to be performing well financially than their older counterparts, as they may be flexible in adjusting or adapting to rapid changes that have been one of the characteristics of this particular industry in recent years. this is shown by the significant negative relationship between age of the south african firms and the financial performance of the firm. the same age-performance association is found in sri lankan retailers as well. this confirms the results of warusawitharana (2014), dawar (2014) and yazdanfar and öhman (2015).the researcher stated that as firms age, they tend to be more likely to transition towards being less-profitable firms. although the south african firms seem to be trying to balance the use of debt and equity in terms of percentage (debt use = 52%; equity use = 48%), the empirical evidence provided by the current study shows that the negative impact of debt capital on firm performance suggest that debt levels in these firms need to be cut down to ensure improved performances. this suggests that managers of profitable companies operating in the south african wholesale and retail sector can use equity capital and retained earnings efficiently, thereby minimizing conflicts of agency or agency costs and remaining independent of external financiers. in the case of sri lanka, the owners and managers of the retail companies should consider reducing the use of short-term debt and increase long-term debt capital as long-term debt seems to asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 124 influence their financial performances positively. they can use more long-term debt capital to a point where profits are maximized and it’s no longer sensible for them to issue more long-term debt. future research can explore and study the impact of debt capital on the financial performance of companies in other sectors individually for in-depth understanding of this impact in specific sectors. it is suggested to contribute to the literature by studying the wholesale and retail sector individually in other regions (countries) as location has proved to be a significant factor when it comes to the choice of capital structure and its impact on the financial performance of the companies. references abeywardhana, d. k. y. 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(2015). dynamic performance, financial leverage and financial crisis: evidence from gcc countries. euro med journal of business, 10(2), 147-162. https://doi.org/10.1108/emjb-08-2014-0022 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 100 can the audit committee provide better oversight of listed companies? –an efficiency of cash holdings perspective cheng-li huang department of accounting, tamkang university no.151, yingzhuan rd., tamsui dist., new taipei city 25137, taiwan (r.o.c.) tel: 886-2-2621-5656 ext.3368e-mail: chengli@mail.tku.edu.tw wei-ju chen department of accounting, tamkang university no.151, yingzhuan rd., tamsui dist., new taipei city 25137, taiwan (r.o.c.) tel: 886-2-2621-5656 ext.3365e-mail:weiju@mail.tku.edu.tw kuo-chen lu (corresponding author) graduate institute of management sciences, tamkang university no.151, yingzhuan rd., tamsui dist.,new taipei city 25137, taiwan (r.o.c.) tel: 886-2-2658-5801 ext.2712e-mail: david.lu @takming.edu.tw received: feb. 20, 2016 accepted: march22, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.9064 url: http://dx.doi.org/10.5296/ajfa.v8i1.9064 abstract this study attempts to inspection the efficient of using cash holdings whether is improved after setting up audit committee sound corporate governance from the perspective of reducing agency costs. we use the difference in difference method to investigate the effect of oversight of audit committee from 2007 to 2010 the company with audit committee for sample. the empirical results show that the using efficiency of cash holdings isn’t promoted after setting up audit committee with all listed companies sample. we further divided the sample into the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 101 over-the-counter (otc) market and the taiwan stock exchange (tse) market according to the stock market feather. the empirical indicated that the taiwan stock exchange (tse) market listed sample exhibited the effect of oversight of audit committee; however, the over-the-counter (otc) market listed is not. it indicated that the different market structure did affect the effect of oversight of audit committee. keywords: cash holdings, corporate governance, audit committee, agency costs, difference in difference method asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 102 1. introduction the sarbanes-oxley act of 2002 is a law legislated to strengthen the internal control of publicly listed firms and to specify the roles and responsibilities of audit committees in publicly listed firms. in taiwan, all new listed firms have been required to adopt the independent director system since feb, 2002. in an attempt to improve corporate governance, the legislature in taiwan passed a major amendment to securities and exchange act on dec 20, 2005. this amendment introduces the audit committee system to reinforce financial supervision. as to the independent director system, the authority has adopted a once-for-all policy, which requires all publicly listed firms to appoint independent directors before the end of 2017. to ensure the independence of their audit committee, the audit committee must be composed of only independent directors. this requirement is intended to prepare for full implementation of mandatory establishment of an audit committee. it is believed that after full implementation of this system, corporate governance in taiwan will be completely different and more effective. according to financial supervisory commission, the authority of publicly listed firms in taiwan, the goal of this reform is to improve corporate governance, reduce occurrence of abnormal or illegal events in publicly listed firms, and progressively boost firm performance and investor confidence. the audit committee system was first developed in the us to play an important role in corporate governance. in 1972, the securities and exchange commission of the us issued accounting standard release no. 123, titled ‘standing audit committees composed of outside directors’. in 1977, the new york stock exchange (nyse) adopted a requirement for all listed firms to establish an audit committee composed of independent directors before jun 30, 1978. meanwhile, american stock exchange (amex) also made the same suggestion to all listed firms. in 1987, national association of securities dealers automated quotations (nasdaq) passed a rule that requires all listed firms to set up an audit committee composed mainly of independent directors. later, the audit committee system began increasingly prevalent across the capital markets in the us. the corporate governance environment in the us has evolved to a very mature level. effective corporate governance is contributive to higher firm performance, lower managerial risk, and better firmtransparency1. it is prescribed in the 2006 amendment to taiwan’s securities and exchange act that all listed firms are required to adopt either the existing dual-track oversight system where both directors and supervisors are needed or the single-track oversight system where an audit committee is established. firms which adopt the latter system are not required to appoint supervisors according to the company act (article 14-4 of the securities and exchange act). however, whether this system suits the financial environment and development of corporate governance in taiwan and how implementation of this system will affect corporate governance of local firms is an issue worthy of long-term observation and research. previous research of the impact of audit committees focuses mainly on improvement in various dimensions from the perspective of earnings management, financial restatements, firm operation, and information transparency. abbott and parker (2000) find that the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 103 independence of audit committees and the frequency of meeting of committee members are negatively related to restatement of financial statements. felo et al. (2003) show that having more experts with an accounting or financial background in the audit committee may be beneficial to the quality of financial reporting. the evidence in hsu (2014) suggests that the presence of an audit committee can lead to a significant improvement in earnings quality. the quality of working capital management is critical to a firm’s performance. cash is a type of asset that is easiest to acquire and control for firm managers. in this paper, we attempt to explore how the audit committee is related to the value of cash holdings and further examine if the audit committee can exert its oversight functions to reduce agency cost incurred by self-serving behavior of managers. drawing upon a sample of firms which had established an audit committee during 2007-2010 and the value of cash holdings model developed by faulkender and wang (2006), we will perform a difference-in-differences analysis to investigate whether establishment of an audit committee can result in higher marginal value of cash holdings. in this analysis, differences between firms with and without an audit committee as well as differences before and after establishment of an audit committee will be examined. in contrast to previous research that focuses primarily on the accounting and financial aspects, we will discuss whether establishment of an audit committee can reduce agency cost and explore the effects in broader aspects from the corporate governance perspective. our empirical evidence suggests that overall, publicly listed firms do not have a significant improvement in use efficiency of cash holdings after setting up an audit committee. in taiwan, firms apply to go public in either the taiwan stock exchange (tse) or the over-the-counter (otc) market. the amount of capital is the main differentiator between tse-listed firms and otc-listed firms. however, in addition to the amount of capital, tse-listed firms and otc-listed firms also differ greatly in firm size, ratio of institutional investors, and stock liquidity. therefore, we further divide the sample by market into the tse-listed group and the otc-listed group for further analysis. our finding from tse-listed firms shows that the value of cash holdings increases after establishment of an audit committee. this finding suggests that the audit committee can effectively exert its oversight functions in tse-listed firms. our finding from otc-listed firms shows that the value of cash holdings declines after establishment of an audit committee. this finding implies that firms with lower stock liquidity attract relatively less attention from investors, and their managers are therefore less motivated to fairly report the firm’s financial information to facilitate oversight by shareholders. in addition, these firms are smaller in size, so the cost of complying with the audit committee system is higher for them. as a result, for otc-listed firms, the adverse effects of setting up an audit committee often come before the benefits of doing it. the remainder of this paper is as follows: section 2 reviews related literature and presents hypotheses. section 3 explains the methodology, including the empirical model, variable measurement, and sampling method. section 4 presents the analysis results, and section 5 concludes findings of this paper. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 104 2. literature review and hypotheses development 2.1 the benefits of setting up an audit committee basically, the primary purpose of an audit committee is to provide oversight of the financial reporting process, the self-discipline, and the effectiveness of internal controls of the firm. an audit committee is mainly composed of independent directors. independence is vital to its functions in the firm. bedard et al. (2004) use the ratio of independent directors in the audit committee as a measure of independence of the committee and find a negative relation between the ratio and occurrence of restatement of financial statements. abbott et al. (2003) show that the independence and frequency of meeting of the audit committee are negatively related to restatement of financial statements to the level of significance. the presence of an audit committee can increase oversight of financial statements, leading to higher accrual quality and less earnings management. hsu (2014) explores the improvement in earnings quality among firms that have switched from the supervisor system to the audit committee system. it is empirically found that firms tend to have improved earnings quality and pay more attention to shareholder equity after adopting the audit committee system. wild (1996) points out that investors have greater trust in a firm’s financial statements if the firm has set up an audit committee. this suggests that an audit committee can improve a firm’s financial reporting quality. according to the signaling theory (grossman, 1981; milgrom, 1981; verrecchia, 1983), managers disclose favorable information concerning their firm performance when they learn that their firm value exceeds market expectation. this positive signal can usually cause a rise of the firm’s stock price. therefore, it can be inferred that when a firm discloses information regarding its establishment of an audit committee, investors will also show higher trust in the firm’s financial reporting processes, and their increased trust will be reflected upon the firm’s stock price. as to the expertise of audit committee members, cohen et al. (2014) point out that audit committee members who are both accounting and industry experts perform better than those with only accounting expertise. besides, they find that audit committee members often increase audit fees to provide more assurance on the quality of the financial reports. 2.2 theories and literature on cash holdings the concept of cash holding was first mentioned in keynes’ (1936) liquidity preference theory, which identifies three motives behind the desire to hold cash: (1) transaction motive, precautionary motive, and speculative motive. under these motives, how much cash is held and how the cash is used are important financial decisions for firms in management and value creation. however, due to the high liquidity nature, cash is often used by managers as a means of manipulation or as a means to fulfill personal interests. jensen and meckling (1976) identify the agency problem caused by free cash flow. they suggest that self-serving managers may waste firm resources on personal interests or enjoyment or invest cash holdings in negative net present value projects, and either of which behaviors will do harm to shareholder interest. according to myers and rajan (1998), it is easier for managers to turn liquid assets into private benefits at a lower cost compared to fixed assets. the greater the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 105 amount of liquid assets is available, the more likely that a serious agency problem will occur. hence, the value of cash held by a firm can be used to explain whether the firm’s resources have been inefficiently used by its managers for personal interests. pinkowitz et al. (2006) point out that due to the agency cost, the marginal value of a dollar is lower than a dollar, and the short part is expropriated for personal interests. they also find that the marginal value of a dollar cash is lower in countries with poor corporate governance than in countries with good corporate governance. dittmar and mahrt-smith (2007) investigate how corporate governance affects firm value through cash holdings among firms with good governance and firms without. they find that poorly governed firms dissipate excess cash quickly and therefore suffer lower performance. they suggest that cash is easy to manage, less monitored, and flexible for use. hence, managers tend to waste firm resources on the pursuit of personal interests. their empirical finding indicates that the value of a dollar cash ranges between 0.42~0.88 in poorly governed firms, and the value of a dollar cash is approximately two times this value in firms with good governance. 2.3 hypotheses previous research suggests that the presence of an audit committee can improve earnings quality and reduce earnings management. because the audit committee provides oversight of financial reporting processes, investors show greater trust in the reliability of financial reports prepared by firms with an audit committee, and their trust will be reflected on the firm’s stock price. previous research of cash holdings suggests that firm managers may take advantage of the high liquidity of cash to fulfill personal interests at the expense of shareholder interest, and the efficiency of cash holdings is often higher in well governed firms than in poorly governed firms. the audit committee plays an important role in corporate governance. if the committee effectively exerts its functions, it can help a firm improve its overall performance and governance, reduce its agency cost, and increase the value of its cash holdings. therefore, we propose the following hypothesis: h1: the presence of an audit committee can improve the marginal value of cash holdings. in taiwan, firms stocks can be traded in the exchange market or the over-the-counter market. firms whose stocks are traded in the exchange market are called tse-listed firms, and firms whose stocks are traded in the over-the-counter market are called otc-listed firms. in this study, we attempt to explore the effect of the audit committee on the value of cash holdings. as the two markets are structurally different, we will further divide the sample into the tse-listed group and the otc-listed group to examine if the above-mentioned effect differs between the two markets. we will consider three major structural differences between the two markets, including investor structure, market liquidity, and firm size. for firms planning to go public, the requirements for the tse market are higher. to be eligible for being listed in the tse market, firms need to meet a higher capital and a higher profitability requirements. the otc market is intended to facilitate development of small and medium-sized enterprises and thus has lower requirements for applicants. firms with an actual paid-in capital exceeding nt$50 million and having innovation or development asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 106 potentials are eligible to become an otc-listed firm. hence, small capital stock is a major characteristic of otc-listed firms. the otc market was created in 1994. after a series of reforms of the trading system, there has been a significant growth in the number of otc-listed firms, accounts, and trading volume. despite the dominance of individual investors in this market, the number of institutional investors is increasing year by year. chui and wei (1998) compare the stock markets in hong kong, south korea, malaysia, thailand, and taiwan and find that individual investors favor small-cap stocks while institutional investors tend to invest in large-cap stocks. the efficient monitoring hypothesis posited by pound (1988) suggests that institutional investors have more specialized human resources and are therefore more able to efficiently monitor the firms they invest in. huang et al. (2014) contend that external supervision is mainly performed by institutional investors, so the effect of information disclosure on corporate governance is stronger in markets dominated by institutional investors. according to taiwan stock exchange (tse) and gretai securities market (gtsm), the ratios of individual investors in the tse market and the otc market as of 2010 are 58.54% and 67.68% respectively2 . the otc market has an approximately 10% higher ratio. individual investors have a limited ability and time to collect and analyze data, so the effect of the audit committee on the value of cash holdings may be smaller in the otc market. thus, we infer that the relation between the presence of audit committee and the value of cash holdings is weaker in the otc market that is dominated by individual investors. in addition to investor structure, the two markets also differ greatly in liquidity. according to tse and gtsm, the turnover rates in the two markets as of 2010 are 1.44 and 1.31 respectively3 . by comparison, the otc market has a lower liquidity. in a study of liquidity of the stock markets in taiwan, huang (2013) finds that the tse market has a significantly higher liquidity than the otc market. according to bernstein (1987) and hasbrouck and schwartz (1988), liquidity is a measure of how promptly that securities can be traded in a market or how minimal the market prices will be affected by the trading. it has been empirically confirmed in many studies that market size is positively related to liquidity (fraser and groth, 1985; cooper et al., 1985; marsh and rock, 1986; hasbrouck and schwartz, 1988). naidu and rozeff (1994) argue that stock prices are more volatile in a market with lower liquidity. in this kind of market, the trading cost for investors is higher, and there is a weaker incentive for firms to provide financial information. as a result, investors will demand higher returns to compensate for these unfavorable conditions, and the capital cost for firms in this market will be higher. in other words, the capital cost is lower in market with higher liquidity. fang et al. (2009) show a positive relation between stock liquidity and firm value. from firms’ point of view, higher stock liquidity means lower rate of return expected by investors. increasing stock liquidity is therefore a way for them to reduce capital cost and increase firm value. besides, maug (1998) investigates the relationship between stock liquidity and firm governance using a self-developed model and finds that liquidity provides an incentive for large shareholders to monitor public corporations and their increased oversight will lead to better governance of the corporations. ball et al. (2000) state that the effectiveness of corporate governance mechanisms depends on whether financial asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 107 information is reported in a fair way that allows shareholders to exert their oversight and secure their interest. markets with lower liquidity or a lower ratio of institutional investors receive less attention from investors, so information asymmetry is usually higher in this kind of markets. high information asymmetry will weaken external oversight and the positive effect of corporate governance on the use efficiency of cash holdings. last but not least, firm size is also a key difference between the tse market and the otc market. the tse market requires firms to have an actual paid-in capital exceeding nt$600 million, while the otc market requires only a minimum of nt$50 million. studies have shown that some of the authority’s control mechanisms have different effects on firms of different sizes. since the end of 2001, many financial scandals in the us have been reported. in order to recover investors’ confidence in public corporations, the us congress passed sox in 2002 in a relatively prompt manner. sox prescribes that all public corporations shall set up an audit committee. after this law went into effect, all firms whose stocks are traded in any capital market (including the otc market) must comply with this new requirement. it should be noted that sox does not have different regulations for firms of different sizes. as a result, since implementation, this law has incurred a huge compliance cost4 to a portion of small companies. the compliance cost includes the cost of additional human resources, the cost of consulting, the cost of information technology, and additional audit fees. holmstrom and kaplan (2003) mention that this compliance cost is a heavy burden for small firms. in order to avoid the complicated procedures and the high cost of complying with sox requirements, small firms in the us are inclined to reduce the amount of its outstanding shares or directly apply for withdrawal from the market (akhigbe and martin, 2006; block, 2004; koehn and del vecehio, 2004; mount, 2005). according to blundell and robinson (2000), the total compliance cost of federal regulations for public firms in the us is around us$700 billion, about 30 times the cost of all the administrative agencies in the us. spence (2001) points out that small and medium-sized firms suffer a greater deficiency of resources for coping with this cost compared to large ones. chittenden et al. (2002; 2003) survey the compliance cost for firms in the us, uk, australia, and new zealand. their finding confirms that the compliance cost is higher for small firms than for large ones. michaelis et al. (2001) show that small and medium-sized companies need to spend 30% more time on administrative tasks and a 20% more labor cost to meet the requirements of related regulations compared to large firms. bull and sharp (1989) mention that firms must bear a certain cost to have independent directors or set up an audit committee. from the economic efficiency perspective, the cost can bring more benefits to larger firms. digabriele (2008) finds that since implementation of sox, nonpublic firms have suffered a significant increase in loss of firm value. menon and williams (1994) show that firms with a larger board can benefit more from setting up an audit committee. besides, larger firms are harder to monitor, so the presence of an audit committee is more essential for larger firms. abbott et al. (2003) argue that although the audit committee can help increase the reliability of financial statements, the higher audit assurance it demands will increase the audit fees. in taiwan, tse-listed firms are significantly larger than otc-listed firms. larger firms are more capable to afford all the asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 108 costs of an audit committee. therefore, the benefits of setting up an audit committee are certainly more pronounced in larger firms. otc-listed firms are smaller in nature. in addition to the necessity, they need to consider the costs and benefits of an audit committee. if the costs exceed the benefits, setting up an audit committee may contrarily reduce their overall performance. in summary, the tse market has a higher ratio of institutional investors than the otc market. the effect of setting up an audit committee on the value of cash holdings may be weaker in the otc market that is dominated by individual investors. in terms of stock liquidity, the liquidity is higher in the tse market than in the otc market. in a less liquid market, investors pay less attention to financial information disclosed by firms. since external oversight is weak, the presence of an audit committee alone cannot help reflect the effect of higher efficiency of cash holdings on stork returns. besides, compared to tse-listed firms, otc-listed firms are smaller in size. as mentioned above, the compliance cost will be higher for otc-listed firms. we argue that the high compliance cost will mitigate the increase in the value of cash holdings resulting from setting up an audit committee. based on the above discussion, we propose the following hypothesis: h2: the presence of an audit committee can generate a higher increase in the marginal value of cash holdings for tse-listed firms than for otc-listed ones. 3. method 3.1 sample composition the sample consists of tse-listed firms and otc-listed firms. article 14-4 of the securities and exchange act prescribes that all public firms shall establish either an audit committee or a supervisor starting in jan 1, 2007. our sample period is between 2007 and 2010. excluding foreign firms that went public in taiwan, a total of 31 firms do not have data before establishment of an audit committee for comparison. the final sample consists of 28 firms. of these firms, 16 are tse-listed and 12 are otc-listed. in terms of distribution of industries, most firms are from the electronics industry (86%). in terms of intention to establish an audit committee, approximately 86% of the firms set up an audit committee voluntarily. the purpose of this study is to investigate whether the improvement in firm value contributed by one unit of cash holdings after setting up an audit committee is greater than the improvement before setting up an audit committee. we define the period from the year when an audit committee is established to the end of the next year as the post-establishment period, and the two-year period prior to establishment of the committee as the pre-establishment period. for instance, if a firm establishes an audit committee in 2007, its post-establishment period is between 2007 and 2008, and its pre-establishment period is between 2005 and 2006. hence, our observations span from 2005 to 2011. each sample firm has data across four years. from 28 sample firms, we collect a total of 112 observations. in addition to differences between the pre-establishment period and the post-establishment period, we also analyze differences between firms with an audit committee and firms without. thus, we adopt the difference-in-differences method. in this method, we classify firms with asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 109 an audit committee into the treatment group and firms without into the control group. to avoid the effect of a large size difference between the two groups, we adopt a pairing approach which involves choosing one firm for each firm in the treatment group. to build the paired sample, we have to select firms which have not set up an audit committee during 2007~2010. market, industry, and firm size are all considered in the selection process, and firm size is measured by the market value of equity. each sample firm has a different paired firm in each year. for the 28 sample firms over the four-year period from 2007 to 2010, we select a total of 112 paired firms without an audit committee. the data of firms with an audit committee are extracted from ‘the summary of firms that have established an audit committee according to article 14-4 of the securities and exchange act’ published in the corporate governance section of market observation post system set up by tse. the financial data of these firms are obtained from taiwan economic journal (tej). the sample selection process, market distribution and industry distribution of the sample firms, and their intention to set up an audit committee are detailed in table 1. table 1.sample composition panel a: sample selection 2007 2008 2009 2010 total having an audit committee 11 17 12 27 67 financial and insurance industry -2 -4 -2 0 -8 missing data of market value or returns -2 -2 -5 -22 -31 total 7 11 5 5 28 panel b: market type tse 6 5 2 3 16 otc 1 6 3 2 12 total 7 11 5 5 28 panel c: industry chemical and bioengineering 0 0 0 1 1 steel 0 1 0 0 1 electronics 6 10 4 4 24 construction 0 0 1 0 1 others 1 0 0 0 1 total 7 11 5 5 28 panel d: implementation type mandatory 2 1 1 0 4 non-mandatory 5 10 4 5 24 total 7 11 5 5 28 3.2definition of variables 3.2.1 explained variable in our empirical model, the explained variable is abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ). it is defined as the difference between the actual return of a stock and the benchmark return. the benchmark asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 110 return is the return of a portfolio of stocks with similar size and book-to-market characteristics (fama and french 1993). fama and french (1993) argue that a model consisting of a market factor, a risk factor related to size, and a risk factor related to book-to-market can better explain market returns. moreover, this kind of model can explain risk factors that βin capm cannot capture. in this paper, we adopt fama and french’s (1993) three-factor model to estimate abnormal return. in this model, 𝑟𝑖,𝑡is the actual return of firm i over year t, and 𝑅𝑖,𝑡 𝐵 is the benchmark return for firm i over year t. we sort all the firms by market value and book-to-market ratio (be/me) in ascending order and divide them into five groups by each index. by doing so, we can obtain a total of 25 combinations of size and book-to-market ratio. 𝑅𝑖,𝑡 𝐵 is the return of a portfolio of stocks to which firm i belongs over year t. finally, we compute the difference between the actual return and the benchmark return to obtain the abnormal return of each firm. 3.2.2 explanatory variables ∆𝐶𝑖,𝑡is the change in cash and cash equivalent over year t, and 𝑀𝑖,𝑡−1is the market value of equity at the end of year t-1. the focus of our analysis is to find the effect of change in each unit of cash on equity value. the variations of stock returns are mainly between 𝑀𝑖,𝑡and 𝑀𝑖,𝑡−1, so we use 𝑀𝑖,𝑡−1as the basis for shifting.this allows us to eliminate size differences and use the marginal value to estimate the coefficients. 3.2.3 moderator variables post-establishment of an audit committee (𝑃𝑂𝑆𝑇𝑖,𝑡): this is a dummy variable. 1 denotes the year when an audit committee is established and the following year; 0 denotes the two-year periodprior to establishment of an audit committee. this variable is used to observe if there is a significant difference in efficiency of cash holdings before and after an audit committee is established. presence of an audit committee (𝐴𝐶𝑖,𝑡):this variable is also a dummy variable. if an audit committee has been established, this variable is 1; if otherwise, this variable is 0. this variable is a differentiator between paired firms (control group) and sample firms (treatment group). 3.2.4control variables the control variables are mainly variables related to firm characteristics. in the financial dimension, the variables include change in interest expense (∆𝐼𝑖,𝑡), change in dividends on common shares (∆𝐷𝑖,𝑡), and change in net financing (𝑁𝑖,𝑡), which is the total equity issuance minus repurchases plus debt issuance minus redemption. in the earnings dimension, the variables include earnings before extraordinary items and interest (∆𝐸𝑖,𝑡), change in total assets minus cash and cash equivalents (∆𝑁𝐴𝑖,𝑡), and change in research and development expense (∆𝑅𝐷𝑖,𝑡). other control variables include cash and cash equivalent in the previous year (𝐶𝑖,𝑡−1) and leverage (𝐿𝑖,𝑡). as our observations span six years from 2005 to 2011, we use six dummy variables of year to control the effect of year. besides, the industry of each asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 111 sample is determined according to tej’s classification. as shown in table 5, we classify the sample firms into five major industries. hence, we use four dummy variables of industry. the operational definition of each variable is provided in table 2. table 2. definition of variables variable operational definition rt − rt b it is defined as the difference between the actual return of a stock and the benchmark return. rtis the actual return of stock of firm i over year t. the benchmark return is the return of a portfolio of stocks with similar size and book-to-market characteristics (fama and french, 1993).we sort all the listed firms by market value and book-to-market ratio (be/me) in ascending order and divide them into five groups by each index. by doing so, we can obtain a total of 25 combinations of size and book-to-market ratio. 𝑅𝑖,𝑡 𝐵 is the return of a portfolio of stocks to which firm i belongs over year t. ∆𝐶𝑡 change in cash and cash equivalent from t-1 to tdivided by the lagged market value of equity 𝐴𝐶𝑡 if the firm has an audit committee,this variable is 1; if otherwise, this variable is 0. 𝑃𝑂𝑆𝑇𝑡 1 denotes the year when an audit committee is established and the following year, and 0 denotes other periods of time. ∆𝐸𝑡 change in earnings before extraordinary items and interest divided by the lagged market value of equity ∆𝑁𝐴𝑡 change in total assets minus cash and cash equivalents divided by the lagged market value of equity ∆𝑅𝐷𝑡 change in research and development expense divided by the lagged market value of equity ∆𝐼𝑡 change in interest expense divided by the lagged market value of equity ∆𝐷𝑡 change in dividends on common shares divided by the lagged market value of equity 𝐶𝑡−1 cash and cash equivalents at t-1 divided by the lagged market value of equity 𝐿𝑡 the ratio of total debts to the sum of market value of equities and total debts 𝑁𝐹𝑡 the total equity issuance minus repurchases plus debt issuance minus debt redemption divided by the lagged market value of equity 𝑀𝑡−1 market value of the firm over year t-1 3.3 empirical model we extend the value model of cash holdings developed by faulkender and wang (2006) as shown in equation (1) to investigate whether the relation between abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ) and change in cash (∆𝐶𝑖,𝑡) varies significantly after establishment of an audit committee. if the effect of agency cost is controlled for, each additional dollar held can bring a proportional amount of price return to the firm. we extend faulkender and wang’s (2006) model by asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 112 including a few extra variables. one of them is a product term of post-establishment of an audit committee (𝑃𝑂𝑆𝑇𝑖,𝑡) and change in cash. this variable is used to examine whether the marginal value of each dollar rises after establishment of an audit committee, that is, whether setting up an audit committee can lead to a reduction of agency cost. to control the effect of industry on stock returns, we also include the fixed effects of industry. 𝛿13is a focus variable in this empirical model. a significantly positive value of this coefficient suggests a rise in the value of cash holdings after establishment of an audit committee. it can offer preliminary evidence that setting up an audit committee contributes to reduction of agency costs. 𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 = 𝛿0 + 𝛿1∆𝐶𝑖,𝑡 + 𝛿2𝑃𝑂𝑆𝑇𝑖,𝑡 + 𝛿3∆𝐸𝑖,𝑡 + 𝛿4∆𝑁𝐴𝑖,𝑡 + 𝛿5∆𝑅𝐷𝑖,𝑡 + 𝛿6∆𝐼𝑖,𝑡 + 𝛿7∆𝐷𝑖,𝑡 + 𝛿8𝐶𝑖,𝑡−1 + 𝛿9𝐿𝑖,𝑡 + 𝛿10𝑁𝐹𝑖,𝑡 + 𝛿11𝐶𝑖,𝑡−1 ∗ ∆𝐶𝑖,𝑡 + 𝛿12𝐿𝑖,𝑡 ∗ ∆𝐶𝑖,𝑡 + 𝛿13𝑃𝑂𝑆𝑇𝑖,𝑡 ∗ ∆𝐶𝑖,𝑡 +𝜑𝑦𝑒𝑎𝑟𝑓𝑖𝑥𝑒𝑑𝑒𝑓𝑓𝑒𝑐𝑡𝑠 + 𝜑1𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦𝑓𝑖𝑥𝑒𝑑𝑒𝑓𝑓𝑒𝑐𝑡𝑠 + 𝜇𝑖,𝑡(1) we attempt to capture differences in the value of cash holdings before and after establishment of an audit committee. however, the differences may be a common tendency among all the firms over time and not contributed by the audit committee. to control the effect of temporal trends, we use the did method, which is extensively used in various areas of research to observe the effect of an event or policy. to use this method, we divide the sample into the treatment group and the control group and classify firm data by the time of establishment of an audit committee into pre-establishment and post-establishment. hence, the cross-sectional differences between the two groups and differences between pre-establishment and post-establishment can be compared. as the effects of permanent, unobservable differences and temporal trends can be simultaneously controlled for, the effect of a particular event can be captured. in this study, firms with an audit committee are classified into the treatment group, and firms without are classified into the control group. we apply the did method to test if the marginal value of cash holdings significantly improves due to establishment of an audit committee. in the test, 𝐴𝐶𝑖,𝑡is used to differentiate the treatment group and the control group. using equation (1) as a basic model, we further consider ac, the product term of ac and change in cash, the product term of ac and post, and the product term of ac, post, and change in cash to create equation (2) where 𝛿14is the difference in the value of cash holdings in firms without an audit committee before and after their paired firms set up an audit committee; 𝛿16is the difference in value of cash holdings in firms with an audit committee compared to firms without an audit committee during the pre-establishment period; 𝛿17is the difference in value of cash holdings after establishment of an audit committee among firms with an audit committee minus the difference in the value of cash holdings after establishment of an audit committee among firms without an audit committee. 𝛿17is a variable of our primary interest. if it is significantly positive, we can infer that setting up an audit committee can lead to a higher value of cash holdings after the effects of permanent, unobservable differences and common temporal trends are controlled for. 𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 = 𝛿0 + 𝛿1∆𝐶𝑖,𝑡 + 𝛿2𝐴𝐶𝑖,𝑡 + 𝛿3𝑃𝑂𝑆𝑇𝑖,𝑡 + 𝛿4∆𝐸𝑖,𝑡 + 𝛿5∆𝑁𝐴𝑖,𝑡 + 𝛿6∆𝑅𝐷𝑖,𝑡 + 𝛿7∆𝐼𝑖,𝑡 + 𝛿8∆𝐷𝑖,𝑡 + 𝛿9𝐶𝑖,𝑡−1 + 𝛿10𝐿𝑖,𝑡 + 𝛿11𝑁𝐹𝑖,𝑡 + 𝛿12𝐶𝑖,𝑡−1 ∗ ∆𝐶𝑖,𝑡 + 𝛿13𝐿𝑖,𝑡 ∗ ∆𝐶𝑖,𝑡 + 𝛿14𝑃𝑂𝑆𝑇𝑖,𝑡 ∗ ∆𝐶𝑖,𝑡 + 𝛿15𝑃𝑂𝑆𝑇𝑖,𝑡 ∗ 𝐴𝐶𝑖,𝑡 + 𝛿16∆𝐶𝑖,𝑡 ∗ 𝐴𝐶𝑖,𝑡 + 𝛿17𝑃𝑂𝑆𝑇𝑖,𝑡 ∗ ∆𝐶𝑖,𝑡 ∗ 𝐴𝐶𝑖,𝑡 + 𝜑𝑦𝑒𝑎𝑟𝑓𝑖𝑥𝑒𝑑𝑒𝑓𝑓𝑒𝑐𝑡𝑠 + 𝜑1𝑦𝑒𝑎𝑟𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦𝑒𝑓𝑓𝑒𝑐𝑡𝑠 + 𝜇𝑖,𝑡(2) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 113 4. empirical results 4.1 descriptive statistics the descriptive statistics of the sample are provided in table 3. the sample firms over 2007~2010 are divided into firms with an audit committee (panel a) and firms without (panel b). in each panel, we further analyze the statistics for data before and after establishment of an audit committee. the mean, standard deviation, max, and min statistics in table 3 provide a general description of the sample. the panel a of table 3 shows the descriptive data of firms with an audit committee. after establishment of the audit committee, the standard deviation of abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ) declines from 0.89 to 0.79, suggesting a decrease in variations. panel b shows the descriptive data of paired firms (without an audit committee). their data are divided by the treatment group’s (i.e. firms with an audit committee) time of establishing an audit committee into two periods for comparison. the comparison of means shows that before establishment of an audit committee, except for the change in research and development expense (∆rdt)which reaches 0.17, the mean differences before and after establishment of an audit committee are smaller than 0.1 across all the variables. besides, after establishment of an audit committee, the mean differences between the treatment group and the control group are smaller than 0.07 across all the variables, suggesting high similarities between firms with an audit committee and the paired firms. in panel c and panel d, we compare differences between tse-listed firms and otc-listed firms. among firms with an audit committee, tse-listed firms have a mean market value (mt) of $155.73 million, while otc-listed firms have a mean market value of $5.72 million. this findingconfirms that tse-listed firms are much larger in size than otc-listed firms. 4.2 correlation analysis to test the correlations between variables, we perform pearson’s correlation analysis. the correlation coefficient matrix is shown in table 4. as shown in this table, all the coefficients are smaller than 0.5, indicating absence of a serious collinearity. it should be noted that although (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ) and 𝐴𝐶𝑡 are positively related, the relation is not significant. in other words, the presence of an audit committee is not positively related to abnormal return to the level of significance. 4.3 regression analysis our extended model is aimed at testing the effect of setting up an audit committee on the value of cash holdings, that is, testing whether the use efficiency of cash holdings improves significantly after establishment of an audit committee. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 114 table 3. descriptive statistics variable mean sd min max mean sd min max 0.06 0.89 -1.53 4.70 -0.12 0.79 -1.40 3.99 0.03 0.09 -0.13 0.40 0.00 0.10 -0.29 0.20 0.02 0.16 -0.21 0.75 0.01 0.23 -0.64 1.20 0.12 0.39 -0.49 1.66 0.10 0.57 -0.55 3.97 0.01 0.17 -0.49 1.03 0.08 0.85 -1.83 5.95 0.00 0.00 -0.03 0.01 0.00 0.00 -0.02 0.02 0.01 0.05 -0.06 0.23 0.00 0.03 -0.06 0.10 0.12 0.12 0.00 0.48 0.17 0.23 0.00 1.19 0.22 0.17 0.01 0.65 0.24 0.20 0.00 0.79 0.06 0.19 -0.14 1.26 0.05 0.22 -0.13 1.51 (million) 95.15 310.87 0.12 1743.50 87.72 271.46 0.43 1638.48 variable mean sd min max mean sd min max -0.04 0.56 -1.08 1.92 -0.10 0.56 -2.15 2.12 0.02 0.08 -0.32 0.33 0.00 0.25 -1.72 0.27 0.02 0.10 -0.18 0.37 0.01 0.14 -0.48 0.76 0.09 0.23 -0.48 0.78 0.09 0.28 -0.54 1.54 0.18 0.83 -0.05 5.73 0.01 0.24 -0.88 1.48 0.00 0.00 -0.02 0.01 0.00 0.00 -0.01 0.00 0.00 0.04 -0.08 0.16 0.01 0.04 -0.06 0.20 0.11 0.11 0.00 0.55 0.17 0.30 0.00 2.26 0.26 0.18 0.01 0.73 0.25 0.17 0.03 0.77 0.05 0.10 -0.15 0.43 0.04 0.11 -0.03 0.56 (million) 42.30 95.19 0.12 585.87 55.60 180.37 0.43 1270.74 pre-establishment(n=56) post-establishment(n=56) panel a:firms with an audit committee panel a:firms without an audit committee pre-establishment(n=56) post-establishment(n=56) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 115 table 3. descriptive statistics (continued) variable mean sd min max mean sd min max 0.04 0.82 -1.53 4.70 -0.12 0.86 -1.40 3.99 0.01 0.08 -0.29 0.25 0.02 0.12 -0.24 0.40 0.05 0.23 -0.36 1.20 -0.03 0.13 -0.64 0.30 0.16 0.59 -0.49 3.97 0.05 0.29 -0.55 1.31 0.08 0.81 -1.83 5.95 0.00 0.03 -0.12 0.04 0.00 0.00 -0.03 0.01 0.00 0.00 -0.02 0.02 0.01 0.05 -0.04 0.23 0.00 0.03 -0.06 0.09 0.11 0.12 0.00 0.48 0.19 0.24 0.00 1.19 0.23 0.19 0.01 0.79 0.23 0.18 0.00 0.76 0.02 0.09 -0.14 0.57 0.11 0.28 0.00 1.51 (million) 155.73 372.65 1.14 1743.50 5.72 8.88 0.12 40.89 variable mean sd min max mean sd min max 0.00 0.50 -1.08 1.92 -0.16 0.63 -2.15 2.12 0.03 0.07 -0.11 0.33 -0.01 0.27 -1.72 0.27 0.01 0.08 -0.18 0.32 0.03 0.17 -0.48 0.76 0.09 0.21 -0.54 0.78 0.09 0.31 -0.48 1.54 0.15 0.78 -0.27 5.73 0.02 0.26 -0.88 1.48 0.00 0.00 -0.01 0.01 0.00 0.00 -0.02 0.01 0.00 0.03 -0.08 0.14 0.01 0.05 -0.06 0.20 0.11 0.10 0.00 0.50 0.18 0.33 0.01 2.26 0.25 0.18 0.01 0.77 0.26 0.17 0.03 0.73 0.03 0.09 -0.15 0.43 0.06 0.12 -0.03 0.56 (million) 82.15 183.35 1.14 1270.73 4.67 7.37 0.12 35.38 panel c:firms with an audit committee (divided by market) tse-listed(n=64) otc-listed(n=48) panel d:firms without an audit committee (divided by market) tse-listed(n=64) otc-listed(n=48) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 116 table 4. correlation coefficient matrix notes: 1.*** p<0.01, ** p<0.05, * p<0.1 2. variable definition: 𝑟𝑡 − 𝑅𝑡 𝐵denotes abnormal returns; ∆𝐶𝑡 denotes change in cash and cash equivalents divided by market value of the previous period; 𝑃𝑂𝑆𝑇𝑡 is a dummy variable where 1 indicates the year when an audit committee is established or the next year, and 0 indicates other periods of time; 𝐴𝐶𝑡 is a dummy variable where 1 indicates presence of an audit committee and 0 indicates absence of an audit committee; ∆𝐸𝑡 denotes earnings from extraordinary items and interest divided by market value of the previous period; ∆𝑁𝐴𝑡 denotes change in assets minus cash divided by market value of the previous period; ∆𝑅𝐷𝑡 denotes change in research and development expense divided by market value of the previous period; ∆𝐼𝑡denotes change in interest expense divided by market value of the previous period; ∆𝐷𝑡 denotes change in dividends on common shares divided by market value of the previous period; 𝐶𝑡−1 denotes the sum of cash and cash equivalent over yeart-1; 𝐿𝑡 denotes total debt divided by the sum of market value of equity and total debt; 𝑁𝐹𝑡 denotes the total equity issuance minus repurchases plus debt issuance minus debt redemption. in table 5, regression equation (1) first tests the effect of setting up an audit committee among all the 112 firms with an audit committee during 2007~2010. this test is intended to find if an additional dollar held can create a value higher than a dollar in the presence of an audit committee. in other words, it is to test the use efficiency of cash holdings. it should be noted in table 5 that among all the sample firms, the product term of change in cash and post-establishment (∆ct*𝑃𝑂𝑆𝑇t) is positively related to abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ). the coefficient is 2.034 and p-value=0.182. the coefficient is not significant. this explains that among firms with an audit committee, there has not been a significant increase in the marginal value of one dollar cash since an audit committee was established. to control the effect of common temporal trends on the value of cash holdings, we build a sample of firms without an audit committee to pair with firms with an audit committee (treatment group). the firms in this paired sample are selected by industry, market, year, and market value. this paired sample is then used as the control group. each group consists of 112 firms. using did method, we evaluate the effect of the policy of audit committee establishment on the value of cash holdings. the result of regression equation (2) shows that the product term of change in cash, presence of an audit committee, and post-establishment of variable 1 0.217*** 1 -0.088 -0.108 1 0.029 0.013 0 1 0.293*** -0.188** -0.024 -0.001 1 0.253*** -0.167* -0.015 0.032 0.407*** 1 0.119 0.178** -0.042 -0.042 0.030 0.461*** 1 -0.142* 0.071 -0.011 0.044 -0.255*** -0.026 -0.061 1 0.426*** 0.112 -0.013 0.019 0.480*** 0.325*** -0.140* -0.149* 1 -0.121 -0.597*** 0.141* 0.012 0.268*** 0.175** -0.096 -0.181** 0.074 1 -0.181** 0.061 0.017 -0.062 -0.190** -0.090 -0.041 0.045 -0.212** -0.049 1 0.06 0.140* -0.01 0.039 0.036 0.266*** -0.079 0.015 0.187** -0.028 -0.014 1 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 117 an audit committee (∆𝐶𝑡*𝐴𝐶𝑡*𝑃𝑂𝑆𝑇𝑡) is positively related to abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ). the coefficient is 0.264, and p-value is 0.891. the coefficient is not significant. findings from regression equations (1) which tests the effect of an audit committee on the value of cash holdings for firms without an audit committee and regression equation (2) where the effect of temporal trends is controlled all suggest that setting up an audit committee cannot lead to a significant increase in the value of cash holdings and a reduction of agency costs. hence, h1 is not supported. in further observation of the relations between other control variables and abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ) in equation (1) and equation (2),we find that the coefficients on ∆𝑁𝐴𝑡are 0.757 with p-value=0.005 and 0.355 with p-value=0.033 respectively; the coefficients on ∆𝐷𝑡are 8.135 with p-value<0.000 and 6.334 with p-value<0.000. in other words, both change in assets minus cash and cash equivalents and change in dividends on common shares are positively related to abnormal return to the level of significance. consistent results are obtained from equation (1) and equation (2). the coefficients on ∆𝐼𝑡are -56.540 with p-value=0.001 and -22.930 with p-value=0.032; the coefficients on 𝐿𝑡 are -0.713 with p-value=0.075 and -0.732 with p-value=0.004, suggesting that change in interest expense and leverage are negatively related to abnormal return to the level of significance. consistent findings are obtained from equation (1) and equation (2). to further examine if the effect of an audit committee on the value of cash holdings varies by market, we divide the sample by market into tse-listed firms and otc-listed firms. using did method, we evaluate the association between an audit committee and the value of cash holdings in the two markets. as shown in table 6, the product term of change in cash, post-establishment of an audit committee, and presence of an audit committee (∆𝐶𝑡*𝑃𝑂𝑆𝑇𝑡*𝐴c𝑡) is positively related to abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ) among tse-listed firms, and the relation is significant (coefficient=6.657, p-value=0.060). this finding indicates that after the effect of temporal trends is controlled for, setting up an audit committee can lead to a significant rise of the value of cash holdings in tse-listed firms, allowing the firms to reduce their agency costs. among otc-listed firms, the product term of change in cash, post-establishment of an audit committee and presence of an audit committee (∆𝐶𝑡*𝑃𝑂𝑆𝑇𝑡*𝐴𝐶𝑡) is negatively related to abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ) , and the relation is significant (coefficient=-6.105, p-value=0.046). this finding suggests that after the effect of temporal trends is controlled for, the value of cash holdings in otc-listed firms declines significantly, and the expected reduction of agency costs cannot be achieved. this finding supports our second hypothesis which proposes that the presence of an audit committee can generate a higher increase in the marginal value of cash holdings for tse-listed firms than for otc-listed ones. in the otc market, individual investors account for a higher proportion compared to institutional investors. in addition, stock liquidity is lower, and the compliance cost for firms is higher. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 118 these are the reasons why setting up an audit committee contrarily leads to a decline in the value of cash holdings. as to the relations between control variables and abnormal return, the relation between the change in dividends on common shares and abnormal return (𝑟𝑖,𝑡 − 𝑅𝑖,𝑡 𝐵 ) is consistent across tse-listed and otc-listed firms. the coefficients on ∆𝐷𝑡 among tse-listed firms and otc-listed firms are 4.103 with p-value<0.052 and 7.019 with p-value<0.001, suggesting that change in dividends on common shares is significantly and positively related to abnormal return. table 5. the effect of setting up an audit committee on the values of cash holdings notes: 1. *** p<0.01, ** p<0.05, * p<0.1 2. variable definition: 𝑟𝑡 − 𝑅𝑡 𝐵 denotes abnormal returns; ∆𝐶𝑡 denotes change in cash and cash equivalents divided by market value of the previous period;𝑃𝑂𝑆𝑇𝑡 is a dummy variable where 1 indicates the year when an audit committee is established or the next year, and 0 indicates other periods of time; 𝐴𝐶𝑡 is a dummy variable where 1 indicates presence of an audit committee and 0 indicates absence of an audit committee; ∆𝐸𝑡denotes independent variable coefficient p-values coefficient p-values intercept 0.580 0.286 0.057 0.816 -2.323 0.237 0.902 0.457 -0.043 0.821 -0.173 0.221 0.012 0.921 0.263 0.542 0.329 0.310 0.757*** 0.005 0.355** 0.033 -0.532*** 0.006 -0.049 0.628 -56.540*** 0.001 -22.93** 0.032 8.135*** 0.000 6.334*** 0.000 -0.473 0.281 -0.358 0.252 -0.713* 0.075 -0.732*** 0.004 -0.409 0.325 -0.312 0.306 * -1.973 0.570 -0.430 0.470 * 11.040*** 0.005 2.657 0.320 * 2.034 0.182 0.309 0.826 * 0.0475 0.777 * -1.064 0.455 * * 0.264 0.891 adjusted 0.443 0.310 n 112 224 (1)before pairing (2)after pairing dependent variable= asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 119 earnings from extraordinary items and interest divided by market value of the previous period; ∆𝑁𝐴𝑡 denotes change in assets minus cash divided by market value of the previous period; ∆𝑅𝐷𝑡 denotes change in research and development expense divided by market value of the previous period; ∆𝐼𝑡 denotes change in interest expense divided by market value of the previous period; ∆𝐷𝑡denotes change in dividends on common shares divided by market value of the previous period; 𝐶𝑡−1 denotes the sum of cash and cash equivalent over year t-1; 𝐿𝑡 denotes total debt divided by the sum of market value of equity and total debt; 𝑁𝐹𝑡 denotes the total equity issuance minus repurchases plus debt issuance minus debt redemption. 3. n denotes the number of observations. table 6. the effect of setting up an audit committee after pairing (by market) notes: 1. *** p<0.01, ** p<0.05, * p<0.1 2. variable definition: 𝑟𝑡 − 𝑅𝑡 𝐵 denotes abnormal returns; ∆𝐶𝑡 denotes change in cash and cash equivalents divided by market value of the previous period;𝑃𝑂𝑆𝑇𝑡 is a dummy variable where 1 indicates the year when an audit committee is established or the next year, and 0 indicates other periods of time; 𝐴𝐶𝑡 is a dummy variable where 1 indicates presence of an audit committee and 0 indicates absence of an audit committee; ∆𝐸𝑡denotes earnings from extraordinary items and interest divided by market value of the previous period; ∆𝑁𝐴𝑡 denotes change in assets minus cash divided by market value of the previous period; ∆𝑅𝐷𝑡 denotes change in research and development expense divided by market value of the previous period; ∆𝐼𝑡 denotes change in interest independent variable coefficient p-values coefficient p-values intercept 0.082 0.817 1.603*** 0.001 2.508 0.249 -0.479 0.796 0.026 0.894 -0.264 0.294 0.100 0.543 -0.181 0.396 0.395 0.290 -0.515 0.525 0.449** 0.029 0.649 0.115 -0.216** 0.089 -0.393 0.408 -58.170*** 0.000 -0.103 0.996 4.103** 0.052 7.09*** 0.001 -0.150 0.819 -0.492 0.259 -0.549 0.140 -0.887* 0.078 -0.176 0.827 -0.626 0.137 * 5.776 0.333 -0.873 0.332 * 0.923 0.840 -4.876 0.289 * -2.082 0.396 3.375 0.134 * -0.110 0.627 0.3170 0.271 * -5.498** 0.025 4.587* 0.059 * * 6.657* 0.060 -6.105** 0.046 adjusted 0.443 0.347 n 128 96 dependent variable= tse-listed firms otc-listed firms asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 120 expense divided by market value of the previous period; ∆𝐷𝑡denotes change in dividends on common shares divided by market value of the previous period; 𝐶𝑡−1 denotes the sum of cash and cash equivalent over year t-1; 𝐿𝑡 denotes total debt divided by the sum of market value of equity and total debt; 𝑁𝐹𝑡 denotes the total equity issuance minus repurchases plus debt issuance minus debt redemption. 3. n denotes the number of observations. 4. tse-listed firms: firms are required to have an actual paid-in capital exceeding nt$600 million; otc-listed firms: firms are required to have an actual paid-in capital exceeding nt$50 million. 5. conclusions and suggestions the existing corporate governance systems can be classified into the single-track anglo-saxon system based on the independent board system with an audit committee and the two-tiered continental system based on the supervisor system. despite mixed conclusions about the monitoring effectiveness of the two major systems, there is a trend toward establishment of an audit committee in nations using a dual-track system. the requirement of setting up an audit committee is mainly intended to reinforce corporate governance and increase the quality and reliability of financial reporting. previous research has focused primarily on the effect of setting up an audit committee on the quality of financial statements and seldom examined from a broader perspective if the presence of an audit committee can lead to a higher firm performance due to improvement of the corporate governance environment, in this study, we focus on the improvement of the agency problem through establishment of an audit committee. we examine if setting up an audit committee can lead to a rise of the value of cash holdings. we draw upon a sample of publicly listed firms with an audit committee in taiwan during 2007~2010 to examine if the use efficiency of cash holdings significantly improves after establishment of an audit committee, without discounting the marginal value of cash holdings. empirical findings from the test with only firms with an audit committee and the test with two groups of firms based on a did approach all indicate that the use efficiency of cash holdings does not improve significantly after an audit committee is established. we further divide the sample by market into tse-listed firms and otc-listed firms for regression analysis. we obtain completely different findings from the two markets. from tse-listed firms, we find that the presence of an audit committee can contribute to a higher marginal value of cash holdings and mitigate the effect of agency costs on firm efficiency. from otc-listed firms, we find that the presence of an audit committee will contrarily reduce the marginal value of cash holdings. this finding suggests that if a market has a lower liquidity and a lower ratio of institutional investors, the market will receive less attention from investors and thus have a higher degree of information asymmetry. with the weakening of external oversight, the benefits of setting up an audit committee cannot be reflected upon the efficiency of cash holdings. besides, otc-listed firms are smaller, so the cost of complying with regulations regarding establishment of an audit committee will be higher for them. as a result, these firms may suffer adverse effects before they can reap the benefits of adopting the audit committee system. regarding to the burden caused by sox requirements on small firms, most of scholars have made several suggestions, including alleviation of the burden and relaxation of format and asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 121 content requirements for financial reports. rose suggests that it is faster to alleviate the burden on small firms than to increase the benefits of going public for them. in recent years, the legislature and authorities in taiwan have made several amendments to the company act and the securities and exchange act to promote corporate governance, increase the reliability of financial reports, and facilitate smooth operations of capital markets. however, costs and benefits should be simultaneously considered while making a decision over establishment of a new system. if the compliance cost exceeds the benefits, the authority concerned is advised to adjust their policy based on empirical evidence. for smaller firms and markets with lower liquidity, direct introduction of foreign governance systems is not advisable. instead, the authority concerned should tailor-make a governance system that can effectively exert its oversight functions in small firms while ensuring that the monitoring effects are greater than the costs of compliance. this system better conforms to the conditions and development of corporate governance in our nation. our empirical evidence shows that the authority concerned in taiwan has taken into account the effect of firm size when introducing the new system. in the beginning, the law prescribes that starting 2006, all publicly listed firms shall establish an audit committee or a supervisor. later, it is regulated that starting in 2013, it is mandatory for all financial institutions and publicly listed firms in non-financial sectors with an actual paid-in capital exceeding nt$50 billion to establish an audit committee. at the end of 2013, the authority concerned resolved to implement the audit committee system in stages, requiring all publicly listed firms with a capital exceeding nt$10 billion shall establish an audit committee immediately, and those with a capital exceeding nt$2 billion shall comply with the requirement by 20175. the development of these requirements manifests that the audit committee system has been progressively implemented in taiwan with consideration of firm size. in our study, we find that most firms with an audit committee have implemented the system voluntarily (about 90%). hence, we suggest firms planning to set up an audit committee not under a mandatory compliance requirement should also evaluate the compatibility of their internal and external environments, so as to avoid being negatively impacted by adoption of the system before it pays off. note 1. the importance of corporate governance can be extended to other governance areas, including quality of earnings 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(1989). boards of directors and corporate financial performance: a review and integrated model. journal of management, 15(2), 291-334.http://dx.doi.org/10.1177/014920638901500208 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). http://doi.org/10.1086/467039 http://doi.org/10.1177/014920638901500208 microsoft word 12655-46322-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 115 insight into the links among external business environments, corporate governance and organisational performance quang linh huynh (corresponding author) school of economics & law, tra vinh university, tra vinh, vietnam e-mail: huynhquanglinh@tvu.edu.vn received: feb. 12, 2018 accepted: march 19, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12655 url: https://doi.org/10.5296/ajfa.v10i1.12655 abstract the existing literature has acknowledged the complicated links among external business environments, corporate governance and organisational performance. however, a large void exists in the extant research models of corporate governance, because none have discussed and empirically examined the intervenient effect of the corporate governance mechanism on the external business environments and organisational performance. a thorough review of the literature on corporate governance, external business environments and organisational performance comes to the proposed hypotheses. the indirect effect of external business environments on organisational performance via corporate governance is statistically tested. the research provides empirical evidence that organisational performance is the consequence of both corporate governance and external business environments that is, in turn, the causality of corporate governance. more importantly, it offers insight into the mediating effect of corporate governance in transforming the uncertainty of external business environments into organisational performance. the findings suggest that firms facing uncertainty in external business environments should adopt suitable corporate governance to achieve the best organisational performance. keywords: corporate governance, organisational performance, external business environments, quantitative method, mediation effect jel code: c51, g34, l25 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 116 1. introduction the fall of worldcom (in 2002) and enron (in 2001) in the united states has drawn scholarly attention to corporate governance research (altunoglu 2012). these scandals have also triggered the adoption of good corporate governance within firms, especially those that are publicly listed (james and joseph 2015). research on corporate governance has been traditionally grounded in agency theory, which explicates the interplays of principals (owners) with agents (managers) and agent-principal problems resulting from conflicts between the owners and managers in term of interests (eisenhardt 1989). the agency theory emphasises the role of corporate governance as an instrument to lessen agency conflicts between the shareholders and the executives running their firms. hence, it can enhance organisational competitive advantages and gain sustainable improved performance (fooladi and chaleshtori 2011). several corporate governance academics have revealed that agency theory has become governing in the code of corporate governance practices due to its contribution to management knowledge and practice and policy implementation (lan and heracleous 2010; shleifer and vishny 1997). following lan and heracleous (2010), almost all experiential research has attempted to comprehend the mechanism of corporate governance by employing the agency theory to examine relationships between the mechanism of corporate governance and organisational effectiveness. nevertheless, aguilera et al. (2008) argues that agency theory has been censured for its viewpoint of the closed system of organisation, establishing a general set of links between corporate governance mechanisms and organisational performance, without paying much attention to the organisation’s contextual conditions. this will affect the agency theory’s ability to correctly explain suitable corporate governance mechanisms across different external business environments (aguilera et al. 2008; aguilera and jackson 2003). conversely, the contingency theory supports the approach of an open organisation and declines the perspective of the general best mechanisms advocated by the agency theory (donaldson 2001). the core of the contingency theory advocates that different corporate governance practices can be more or less efficient in diverse business environments (aguilera et al. 2008; scott 2003), conditional upon numerous contextual factors (e.g., external business environments (otley 1980)). scholars have drawn on the agency theory to emphasise the importance of a sound corporate governance mechanism in enhancing organisational performance (aguilera et al. 2008; aguilera and jackson 2003). other academics have relied on the contingency theory to recommend that organisational effectiveness stems from the matching between organisational characteristics (e.g. corporate governance practices) and contextual contingencies (e.g. external business environments) facing the organisation (donaldson 2001; ezzamel and hart 1987). implied from the contingency theory, the mechanism of corporate governance plays a role as a mediator in transmitting the effect of external business environments into organisational performance (donaldson 2001; aguilera et al. 2008; scott 2003; ezzamel and hart 1987). furthermore, for margolis and walsh (2003), it is necessary to develop research models asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 117 which integrate contextual conditions and organisational variables, and test mediating mechanisms often ignored, as well as set up the causal relationships among the environmental contexts, organisational variables and organisational performance. therefore, this research takes into account the potential for a mediating influence to more broadly explore the contribution of corporate governance and external business environments to organisational effectiveness. for this objective, this article makes an imperative contribution to the hypothetical advancement of the external business environments corporate governance firm performance linkage suggested by elghrabawy (2012). this study joins agency problems with contingencies and an institutional perspective to conjecture a hypothetical model of the dynamics of corporate governance and organisational performance (figure 1) and investigate the extent to which the influence of external business environments on organisational performance is mediated by corporate governance mechanisms. figure 1. the link among corporate governance, external business environments and organisational performance. to the best of the researcher’s knowledge, this paper is the first to study the mediation of the corporate governance mechanism on the impact of external business environments on organisational performance. the findings are expected to provide researchers and executives with new insight into the complex research model of corporate governance. the findings are expected to be helpful to business directors of firms in making better decisions on the application of suitable corporate governance for their external business environments, so as to best improve organisational effectiveness. 2. conceptual developments and hypotheses all business organisations, which are open systems connected to their external business environments, aim to achieve their best organisational performance by wisely using resources to obtain profits (scott 2001). organisational performance is the actual outcome of a firm that is evaluated in terms of non-financial and financial indicators (hudson et al. 2001; droge et al. 2003). anchored in agency theory, this article establishes the role of the corporate governance mechanism in boosting firm performance, based on aguilera et al. (2008) and aguilera and jackson (2003). it is based on the contingency theory to recommend that the best organisational performance originates from the fitting between the corporate governance mechanism and its external business environments (donaldson 2001). the contingency theory mentions firm performance, when discussing the effects of externally environmental variables on organisational variables. however, this theory cannot clearly explain the interdependence between external business environments and organisational performance (volberda et al. 2012). on the contrary, institutional theory focusing on a firm’s relationship with its external business environments asserts that the organisational effectiveness, in part, depends on the external business environments (scott 2001; zucker 1987). external business environments corporate governance organisational performance asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 118 grounded in agency theory, bhagat and bolton (2008) discover a positive correlation between corporate governance and organisational performance. research on the role of managerial boards highlights that an individual taking charge of the chief executive officer, together with the chairman, often pursues their own benefit at the expense of other stakeholders. however, if the chief executive officers hold a large number of their firm’s stocks, then their benefits are in agreement with other shareholders (white and ingrassia 1992). therefore, they would act in n ways that benefit the firm. furthermore, organisations with managerial boards composed of independent directors in a majority will counteract agency problems, because these managerial boards could oversee the self-interested actions taken by executives, which alleviates the agency problems, and leads to a more enhanced organisational performance (kaymak and bektas 2008; nicholson and kiel 2007). independent executives are generally recruited for their excellent qualifications, knowledge and experience. in this way, they may make more efficient business decisions. at the same standpoint, bebenroth and donghao (2007) underline the important supervisory role of the independent executives, which is to reduce the agency costs enhancing the organisational performance. this means that a firm can undergo poorer performance, if its managerial boards cannot supervise the underperforming directors. in addition, several previous studies suggest that a good mechanism of corporate governance will promote the creation of good organisational performance (ljubojevic et al. 2013; zabri et al. 2016; bualla et al. 2017). drawing on the contingency theory, soltani (2005) examines the factors affecting corporate governance and identifies a positive relationship between a firm’s existing corporate governance and its external business environments. duncan (1972) relates external business environments to suppliers, customers or clients, competitors, technologies and social-political issues. heinrich et al. (2007) proposes four elements of external business environments: 1. contingent factors related to being under pressure from outside minority shareholders, 2. pressure from majority shareholders, 3. pressure from state legal regulations, and 4. pressure from globalization. heinrich et al. (2007) then emphasise that these elements likely drive corporate governance. the importance of external business environments in structuring corporate governance is confirmed in altunoglu (2012), where the uncertainty of external business environments will force executives to build appropriate corporate governance mechanisms to deal with the changing situation for survival. for aguilera et al. (2008) and afolabi (2015), external business environments are imperative to a firm’s corporate governance mechanism in which high environmental uncertainty requires managers to build a sound corporate governance mechanism. volberda et al. (2012) adhere to the institutional perspective to explore the dependence of organisational behaviour on organisational context. these academics highlight that numerous facets of firms are driven by the desire to attain the fit with their external business environments. institutional fit improves organisational performance through diverse managerial mechanisms (e.g., corporate governance (levitt and march 1988)). other research has discussed and examined the effect of external business environments on organisational asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 119 performance. choe (2003) suggests external business environments as a causation of organisational performance. additionally, adeoye and elegunde (2012) explore the causal links between external business environments and organisational performance, verifying that external business environments impose a significant effect on organisational performance. given the interaction between organisations and their external business environments, the business organisations try to understand, react and impact external business environment changes to obtain the best possible organisational performance (adeoye and elegunde 2012). similarly, drawing on mia and clarke (1999), organisational performance is expected to be improved in a highly competitive business environment. furthermore, when external business environments are progressively uncertain, executives often pay more attention to their business activities, which would result in improved organisational performance (ajibolade et al. 2010). moreover, the specific external business environments facing an organisation could make an essential contribution to the organisational competitive capability and organisational performance (vo 2015; ibrahim and primiana 2015; pratistha 2016; kuznetsova et al. 2017). the interdependence between external business environments and organisational performance is also examined by abdallah and persson (2014), who argue that an organisation facing high environmental uncertainty needs to fit itself to the environmental change to improve its organisational performance. for the role of corporate governance, volberda et al. (2012) incorporate institutional and contingency perspectives to propose that an organisation needs to match its corporate governance with external business environments to achieve superior performance. this means that an appropriate mechanism of corporate governance depends on external business environments to attempt to obtain greater organisational performance. the previously discussed reasoning leads to a mediating mechanism in which external business environments will increase their organisational performance through a good mechanism of corporate governance. consequently, four hypotheses can be developed: (1) hypothesis 1: higher uncertainty of external business environments can lead to better organisational performance; (2) hypothesis 2: good corporate governance can bring about superior organisational performance; (3) hypothesis 3: higher uncertainty of external business environments is positively related to better corporate governance; and (4) hypothesis 4: corporate governance can mediate the causal link from external business environments to organisational performance 3. research methodology data was collected from executives involved in corporate governance (one executive for each selected firm). each executive was asked to fill out a survey. the research population was composed of all 1142 public firms listed on the vietnamese stock exchanges in the first asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 120 quarter of 2017. vietnam was selected, because it is the most rapidly growing and emerging market in asia and little attention to vietnamese corporate governance has been paid (ahmad et al. 2003; vo 2015). a simple random sampling was employed to gather the data. the 400 executives of the randomly selected firms were interviewed in person with the questionnaires based on the following constructs (hair et al. 2009). surveys without essential adequate information were deleted from the database. overall, there were 349 usable responses. external business environments (ebe) were judged on five elements: 1) governmental policies-ebe1, 2) economy-ebe2, 3) resources and services used by the firm-ebe3, 4) product market and demand-ebe4, and 5) competition-ebe5 (miller 1993; brouthers et al. 2002). these elements were measured on a five level scale: always forecasted, easily forecasted, a little hard to be forecasted, quite hard to be forecasted and very hard to be forecasted (chenhall and morris 1986). organisational performance (ope) is assessed on five items: 1) innovativeness-ope1, 2) quality in products or services-ope2, 3) customer satisfaction-ope3 (nonfinancial), 4) return on assets-ope4, and 5) return on equity-ope5 (financial) (hudson et al. 2001; droge et al. 2003). a comparison of the industry-average for the items with a five-point scale from no growth, a little growth, average growth, fast growth and very fast growth, during the last three years, was made. corporate governance (cgo) refers to the proportion of independent directors-cgo1, the proportion of independent supervisors-cgo2 and the proportion of the firm's stock owned by the chief executive officer-cgo3 (bhagat and bolton 2008). this research uses path analyses to explore the causal relationships among external business environments, corporate governance and organisational performance. path analysis is an expansion of multiple regressions applied to simultaneously examine a set of causal relationships. it is also employed to inspect the mediation of one variable on the causal links among the other variables (hair et al. 2009). this research applies path analyses, because the method of maximum likelihood used in the path analyses takes into consideration the potential correlations amongst disturbances, which is robust to abnormality and misspecification (olsson et al. 2000). it then employs the mediating analytic technique to test the statistical significance for the intermediary effect of corporate governance by using the methods advocated by baron and kenny (1986) and spencer (2011). the indirect influence by mediation is tested with a t-test, in which the t-statistic is calculated as a ratio of the indirect estimate to its standard error. 4. empirical findings after the data was collected and cleaned, a confirmatory factor analysis was conducted to test the factor structure of the set of measured variables. this analysis tests how well the observed variables represent their underlying latent factors or how well the data fits the theorised measurement model. the statistical indices used to assess the goodness of fit of the theorised measurement model are presented in table 1. the figures in table 1 convey the information on the goodness of fit for the theoretical measurement model. the χ2/df value of 1.964 is smaller than 2, indicating an acceptable fit asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 121 of the theoretical model with the analysed data (byrne 1991). rmsea is the index of the root mean square error of approximation, obtaining the value of 0.053, which is lower than the recommended threshold of 0.06 (hu and bentler 1999). the ifi (incremental fit index) was 0.966, the tli (tucker-lewis coefficient) was 0.956, the cfi (comparative fit index) was 0.965 and the gfi (goodness of fit index) was 0.949. all of these values were larger than 0.9, the smallest cutoff value suggested by hair et al. (2009). on the whole, these indicators demonstrate a good fit of the theoretical model to the sample data. table 1. goodness of fit indices fit index χ2/df rmsea ifi tli cfi gfi value 1.964 0.053 0.966 0.956 0.965 0.949 results good good good good good good the statistics for the construct validity and reliability of the theoretical model are illustrated in tables 2 and 3, stipulated by hair et al. (2009). the factor loading is simply the correlation between each measured variable and its latent construct. hence, it represents the relationship of the latent construct with each measured variable. the average variance extracted (ave) is a summary measure of convergence among a set of measured variables representing a latent construct and computed on the average percent of variance in the latent construct explained among the measured variables. the construct reliability (cr) is a measure of the overall reliability of a set of heterogeneous, but similar, measured variables. the cr for each factor could be achieved by the sum of the squared standardised factor loadings divided by the total of that sum and the sum of the error variances for the measured variables of the factor. table 2. measurement model results observed variables constructs factor loading ebe1 external business environment (ebe) 0.762*** ebe2 0.715*** ebe3 0.685*** ebe4 0.684*** ebe5 0.708*** cgo1 corporate governance (cgo) 0.702*** cgo2 0.679*** cgo3 0.772*** ope1 organizational performance (ope) 0.765*** ope2 0.645*** ope3 0.753*** ope4 0.704*** ope5 0.688*** ***significance at the 1% level the factor loadings of the three main constructs in table 2, ranging from 0.645 to 0.772, are over 0.5, the acceptable cutoff value proposed by hair et al. (2009). the relationship from the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 122 latent construct “ope” to item “ope2” is the lowest, at 0.645. the correlation between the latent factor “cgo” and indicator “cgo3” was 0.772, the highest value. all factor loadings achieve statistical significance at the 1% level. the findings are acceptable, because the high correlations between the latent factor and its indicators demonstrate high reliability. table 3 illustrates the aves, varying from 0.506 to 0.517, where numbers greater than 0.5 are acceptable. in addition, all three crs obtain values greater than the acceptable threshold of 0.7 (ranging from 0.762 to 0.838) (see table 3). as such, the high estimates illustrate the high reliability of the constructs. consequently, it can be concluded that a set of measured variables reflect their theorised latent construct. the theoretical measurement model achieves adequate convergent validity. table 3 also offers support for discriminant validity. that is, all the aves are bigger than their corresponding sics. this result indicates that the observed items have more in common with their factors than they do with the other factors. to test whether the problem of multicollinearity occurs within the sample data, kennedy (1992) suggests that an acceptable level of inter-construct correlation (ic) should not be larger than the 0.8 cutoff. the ics in table 3 range from 0.407 to 0.707. hence, multicollinearity does not exist for the dataset. in addition, the bootstrapping technique, a non-parametric method relying on random sampling with replacement for 1,000 times, is used to assess the accuracy of the measurement model (efron 1988). this research estimates all loadings and related bootstrapping t-critical ratios through 1000 bootstrapping runs. all the indices in the measurement model obtain the values of the bootstrapping t-critical as above 1.96 (un-tabulated), the lowest value suggested by hulland (1999). this demonstrates a highly adequate reliability of the statistical estimates in the measurement model. these results collectively offer adequate validity of the measurement model with the analysed data. table 3. matrix of ic, ave, cr and sic ebe cgo ope ebe 0.174 0.166 cgo 0.417 0.499 ope 0.407 0.707 ave 0.506 0.517 0.510 cr 0.836 0.762 0.838 values below the diagonal are crs, aves and ics (inter-construct correlations) values above the diagonal are sics (squared inter-construct correlations) in regard to the causal links in the research model, the results are outlined in figures 1 and 2. the findings of the path analyses offer statistically empirical support for hypotheses 1 through 3. both figures 1 and 2 indicate that the uncertainty of the external business environments positively influences the organisational performance, with β=0.33 (figure 2) and β=0.15 (figure 3), at a significance level of 1%. furthermore, figure 3 demonstrates that the uncertainty of the external business environments and corporate governance are both positively related to the organisational performance, in that corporate governance (β=0.54) is stronger than the uncertainty of external business environments (β=0.15) in improving the organisational performance. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 123 figure 2. path diagram denoting the causal relationship (***significance at the 1% level) the models achieve an adequate goodness of fit at a significance level of 1%. the uncertainty of the external business environments alone statistically explains 12% of the variation in the organisational performance at a statistical significance level of 1% (figure 2). the uncertainty of the external business environments and the corporate governance explain 38% of the variation in the organisational performance (figure 3). these findings empirically support hypotheses 1 and 2. in addition, the statistics in figure 3 empirically support the causal link from the uncertainty of external business environments to corporate governance with an affecting coefficient of 0.33 at a statistical significance level of 1%. the uncertainty of external business environments alone accounts for 11% of the variance in corporate governance, supporting hypothesis 1. figure 3. path diagram denoting the theorized causal models (***significance at the 1% level) overall, the path diagram in figure 2 shows that the uncertainty of the external business environments alone affects organisational performance at a statistical significance of 1%. the addition of corporate governance into the research model results in a decrease in the affecting magnitude of external business environments uncertainty on organisational performance from 0.33 (in figure 2) to 0.15 (in figure 3). the positive relationships of corporate governance with external business environments, as well as organisational performance, are statistically significant at 1%. in addition, the total effect of the external business environments on organisational performance is 0.33, while the direct effect is 0.15 and the indirect effect through corporate governance is 0.18 (=0.33*0.54). these findings suggest the mediating role of corporate governance in the research model. the ebe ope (r2 = 0.12***) 0.33*** ebe cgo ope 0.54*** (r2 = 0.11***) (r2 = 0.38***) 0.33*** 0.15*** asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 124 results of the mediation test presented in table 4 offers empirical evidence of the indirect effect of external business environments to organisational performance through corporate governance. the causal link from external business environments to organisational performance is statistically mediated by corporate governance at the significance level of 1%, with t-statistics (indirect) of 5.755, in support of hypothesis 4. it can be therefore concluded that when corporate governance is included in the research model, the influence of external business environments uncertainty on organisational performance is partially transmitted through it. as a consequence, the influence will decrease. table 4. results for testing the mediating effect mediator causal effect tindirect pvalue cgo ebe on ope 5.755 0.000 5. discussion and conclusions the research findings shed insight on the complicated relationships among external business environments, corporate governance and organisational performance. this study provides statistical support for the argument that the uncertainty of external business environments has a significant influence on organisational performance, revealing that executives facing a high level of uncertainty in their external business environments become more concerned about organisational performance. this is consistent with the findings of pelham (1999), nicolaescu (2012) and ajayi (2016), which state that higher environmental uncertainty makes firms use their limited resources more effectively and efficiently. this may help them gain a competitive advantage over their business rivals. this study also emphasises the relationships of corporate governance with organisational performance and external business environments. in the context of corporate governance, previous research (choe 2003; soltani 2005; heinrich et al. 2007; nicholson and kiel 2007; bhagat and bolton 2008; altunoglu 2012) argues that the uncertainty of external business environments pushes firms to develop better corporate governance, which results in a better system of management and better organisational performance is achieved. in this way, the firms survive and develop in an increasingly competitive external business environment. this research takes this theoretical contention and offers empirical verification that corporate governance is statistically supported as a consequence of external business environments, but as a causal factor of organisational performance. this is consistent with most of the previous findings (e.g., choe 2003; bhagat and bolton 2008; aguilera et al. 2008; volberda et al. 2012; adeoye and elegunde 2012; abdallah and persson 2014; afolabi 2015; vo 2015). however, these results contradict the findings of weir and laing (2001), that report an unclear connection between corporate governance and organisational performance. this inconsistency could be related to the difference in the empirical context in that one study was performed in the uk, a developed country, and the other in vietnam, a developing country. finally, the current research highlights and focuses on the important role of corporate governance in the research model. the findings offer significant support for the indirect effect of external business environments on organisational performance. this is mediated through corporate governance, which is an important extension of the extant management literature of asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 125 the simply causal relationships among external business environments, corporate governance and organisational performance. this hypothesises a theoretical contention, rather than a direct effect. external business environments indirectly contribute to organisational performance via corporate governance by the mediating mechanism. this insight reflects the essential role of corporate governance in business activities in which corporate governance should appropriately respond to the uncertainty of external business environments to achieve competitive advantages and gain the best possible organisational performance. more significantly, the corporate governance model in this study has been statistically explored in the context of an emerging economy in asia (including vietnam), which has received little attention in terms of corporate governance (ahmad et al. 2003). therefore, this finding can be an extension of the existing literature on corporate governance theory to developing asian countries. furthermore, this research provides some implications for business managers and practitioners, shedding light on the important role of corporate governance in improving organisational performance. with that new knowledge, executive officers could decide to fit corporate governance with the uncertainty of the external business environments facing the firms. this would boost sustainable business development and transmit the uncertainty of external business environments into better organisational performance. 6. limitations and future directions the author acknowledges some limitations of this investigation. first, the data used in the research is based on survey responses offered by a single respondent in each firm. hence, a bias problem can exist, because different respondents across firms are pooled into a single dataset (bou-llusar 2016). future research should employ multiple-informant research designs to eradicate the potential bias problem. second, this study was performed in vietnam, as an emerging business environment in asia. however, the findings are expected to be applied to other emerging business environments. business conditions among emerging business environments may be dissimilar (tu 2012). therefore, care must be taken in generalizing these results. furthermore, there is an inconsistency in the link between corporate governance and organisational performance. future research should compare the relationship between developed and developing business environments. 7. acknowledgements the author is deeply thankful to the informants in the selected firms for providing necessary information for this project. the author himself makes all the contributions to the conception and design as well as the acquisition, analysis and interpretation of the data. there is no conflict of interest for this work. references adeoye a.o., & elegunde a.f. 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(1987). institutional theories of organisation. annual review of sociology, 13(1), 443-464. https://doi.org/10.1146/annurev.so.13.080187.002303 microsoft word 12076-44378-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 369 the impact of capital structure on the financial performance of the jordanian industrial companies listed on the amman stock exchange for the period 2012-2015 shireen mahmoud alali head of finance and banking department ajloun national university, jordan received: july 3, 2017 accepted: august 2, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.12076 url: https://doi.org/10.5296/ajfa.v9i2.12076 abstract the purpose of this study was to identify the effect of the capital structure as a percentage of total liabilities to total assets on the financial performance of the jordanian industrial companies listed on the amman stock exchange for the period 2012-2015. the study population included all the jordanian general industrial companies listed on the amman stock exchange. the sample of the study included 10 industrial companies listed on the amman stock exchange. the linear regression analysis was used to test the relationship between variables using the ordinary least squares method (ols). the results showed that there is a positive significant impact on the capital structure of the industrial shareholding companies listed in the amman stock exchange as measured by the ratio of equity to total assets, return on equity and return on assets and net earnings per share as an indicator of financial performance. the results also showed a negative significant impact on the capital structure of industrial shareholding companies listed on the amman stock exchange as measured by total liabilities to total assets, return on equity and return on assets as an indicator of financial performance, and net earnings per share as an indicator of the financial performance indicators. keywords: capital structure, financial performance, equity, assets, earning per share (eps) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 370 1. introduction financing and investment are two major decision areas in a firm. in the financing decision the manager is concerned with determining the best financing mix or capital structure for his firm. capital structure decision is the mix of debt and equity that a company uses to finance its business (damodaran, 2001). the relationship between capital structure decisions and firm value has been extensively investigated in the past few decades. capital structure could have two effects; according to desai (2007) firms of the same risk class could possibly have higher cost of capital with higher leverage. second, capital structure may affect the valuation of the firm, with more leveraged firms, being riskier and consequently valued lower than the less leveraged firms. if the manager of a firm has the shareholders' wealth maximization as his objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximizes the market price per share of the firm. industrial and commercial activities need to be financed, as these activities will not continue unless they have the appropriate funding to enhance the fixed assets and capital requirements of these companies. capital means the company's total investments in fixed and current assets. working capital is the total investment of the company in current assets that is converted into cash through the company's normal operations over a period of one year or the operational cycle whichever is longer (sobh, 2002). companies differ in the choice of capital structure due to variety of their use of the available sources of finance as this affects their financial decisions and thus affects their investment decisions. as a result, companies find out the available sources of financing and the characteristics of each one so that they can choose between them to achieve a capital structure that achieves the company's goal, which is to maximize the profitability of the company. the financing decision is made to determine the appropriate financing structure for the company's investments, meaning that it is related to the way of financing the total assets of the company (ie, the left side of the balance sheet, which is the side of liabilities and shareholders' equity, which shows all sources of funding used by the company) (almaydani 2004). after determining the funding elements available to the company, the company sets its specific policy regarding the mix of capital structure and the ratio of each component. the cost of each component varies by the degree of risk to which the return of that component is incurred. therefore, the cost of capital is expected to vary, according to the company's decision to identify the constituent elements of the capital structure (alhindi, 1999). as for the investment decision, it goes to profitable capital investment projects and then determines the appropriate size of the capital budget (almaydani, 2004). the performance of the institutions is measured by the ability of the institution to maximize the profit to shareholders and owners, through appropriate financial decisions. these decisions are divided into investment decisions, which consist of investment in fixed and current income generating assets, as well as finance decisions, which are to differentiate asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 371 between sources of internal financing (equity) and short and long-term sources of external financing (loans)(brindusa, 2012) 1.2 factors influencing the capital structure there are many factors influencing the capital structure the most important that affect the capital structure of the company are the following: a) profitability: the expected rate of return of any investment project must be greater than the required rate of return in the capital market so that the economic project can be considered profitable, as the profitability of the company depends on the level of sales and the returns of its investment projects, and this is important in determining the company's borrowing ratio. as the profitability of the company increases, its reliance on borrowing decreases and thus plays a major role in the decision to choose the appropriate capital structure (hanafi, 2004). b) repayment capacity: in the sense that the company is able to pay the loan amount and interest at the maturity date of the loan, by comparing the expected cash flow of the project for the coming years with the loan charge, as the company's ability to pay its financial liabilities affects its good performance and low risk of bankruptcy. (pouraghajan & malekian, 2012 ). c) flexibility: flexibility is defined as the ability of a company's capital structure to cope with changing circumstances, that is, the company is able to transfer from a source of financing to another source with high flexibility without affecting the company's objective and performance. (1995, pandy). d) control: the ability of the company to impose greater control over elements of the capital structure through its administrative control resulting from the preference of long-term financing owners to borrow instead of issuing new shares so as not to lose part of their control of the company to new shareholders(siddik, et al., 2016). not to mention, the requirements of the capital structure differ from one company to another according to its policy of adapting to these requirements as it sees fit for its objectives and interests (pandy, 1995). one of the most important functions of the financial manager is to plan the structure of the company's capital. accordingly, the finance manager determines the sources of finance for the capital structure in terms of internal finances and external financing and then select the appropriate sources of financing to achieve the objectives of the company. thus, determining share of funds to be financed by borrowing or ownership, and this can be done through the use of certain methods to determine the appropriate capital structure of the company. the most important of these methods are: a) financial and operational leverage method the financial and operational leverage is defined by using fixed costs in the company to maximize profits. the upper part of the income statement (i / s) is the business activity of the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 372 company. the leverage of this part is called the operational leverage, while the lower part of the (i / s) reflects the financial activity of the company and therefore the lever for this part is called financial leverage and reflects the value of debt financed to the capital structure (gibson, 2007). the impact of the operational leverage is as follows: any relative change in sales will result in a greater relative change in operating profit (ebit: earning before interest and tax).operating leverage is greater in companies where fixed financial costs are high and this leads to increased profits. the financial leverage effect is as follows: (any relative change in operating profit will reflect a larger increase in eps). the effect of the increase in borrowing ratio on the capital structure can be measured by degree of financial leverage, which is defined as the change in the ratio of earnings per share to the percentage of change in operating profit. (gibson, 2007). 1.3 degree of financial leverage (dfl = ebit / ebt) this means that if the eps ratio changes more than the change in the ratio of operating profit, the leverage degree is greater than the correct one >1. this indicates the higher financial risk resulting from the larger use of borrowing funds. otherwise, if the earnings per share changes less than the change in operating profit then the dfl is less than the correct one<1. this means that the financial risk is reduced because the company tends to use the financing of the property more than the financing by borrowing. if the capital structure does not include loans or there are no fixed financial obligations on the company, the dfl is equal to the right one =1, which means that there is no financial risk for the company and it is because of using property financing only (goyal, 2013). b) debt ratio analysis using debt ratio, the capital structure can be determined by long-term financing sources, because this type of ratio gives an accurate indication of the financial position of the enterprise in the long term. this ratio shows the extent to which the company is able to meet the fixed obligations and also shows the amount of the debt contribution to capital (khan and ghraibeh, 1995). one of the advantages of using debt in financing the company is to increase the company's profits by reducing the value of the company's income tax (tax shield). a disadvantage of using debt is that it represents the cost of the loan represented by the financial obligations and the service of those obligations of interest. 2. problem statement the choice between finance based on short and long-term bank and commercial debt and bonds, or reliance on equity represented by ordinary shares, compulsory and voluntary reserves and undistributed profits, is one of the important financial decisions facing the financial management of industrial joint stock companies (ogebe, et al. 2013). the relationship between the capital structure and the value of the enterprise has attracted the attention of researchers, academics and the management of facilities and employees. the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 373 study examined the relationship between the capital structure as measured by the ratio of liabilities to assets and equity to the assets of jordanian industrial companies listed on the amman stock exchange on the performance of these companies measured by return on assets, return on equity and share of net profits in order to reach to the results and recommendations that will enhance the performance of jordanian industrial joint stock companies. the problem of the study is to answer the following main question: does the capital structure affect the financial performance of jordanian industrial joint-stock companies? 3. literature review several studies have been conducted to examine the impact of capital structure on performance. using panel data of 22 banks for the period of2005-2014 (siddik, et al., 2016) explain that capital structure decision plays an imperative role in firm’s performance. recognizing the importance, there has been many studies inspected the rapport of capital structure with performance of firms and findings of those studies are inconclusive. in addition, there is relative deficiency of empirical studies examining the link of capital structure with performance of banks in bangladesh. results from pooled ordinary least square analysis show that there are inverse impacts of capital structure on bank’s performance. to investigate empirically the impact of capital structure on firm performance, (abeywardhana, 2015) conduct a study examined the impact of capital structure on firm performance of manufacturing sector smes in uk for the period of 1998-2008. results of this study reveals that there is a significant negative relationship between leverage and firm performance (roa, roce), strong negative relationship between liquidity and firm performance and highly significant positive relationship between size and the firm performance. this study concluded that firms which perform well do not rely on debt capital and they finance their operations from retained earnings and specially smes have less access to external finance and face difficulties in borrowing funds. the study of (mwangi, et al., 2014) investigated the relationship between capital structure on the performance of non-financial companies listed in the nairobi securities exchange, kenya. the study employed an explanatory nonexperimental research design. a census of 42 non-financial companies listed in the nairobi securities exchange, kenya was taken. the study used secondary panel data contained in the annual reports and financial statements of listed non-financial companies. the results revealed that financial leverage had a statistically significant negative association with performance as measured by return on assets (roa) and return on equity (roe). the research conduct by (akeem, et al., 2014) examines the effect of capital structure on firm’s performance with a case study of manufacturing companies in nigeria from 2003 to 2012 with the purpose of providing a critical appraisal of the need and importance of capital structure. this research observes that capital structure measures (total debt and debt to equity ratio) are negatively related to firm performance. it is hereby recommended that firms should asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 374 use more of equity than debt in financing their business activities, in as much as the value of a business can be enhanced using debt capital. hence firms should establish the point at which the weighted average cost of capital is minimal and maintain that gearing ratio so that the company’s value will not be eroded, as the firm’s capital structure is optimal at this point ceteris paribus. the paper of (goyal, 2013) seeks to study the impact of capital structure on profitability of public sector banks in india listed on national stock exchange during 2008 to 2012 methodology-regression analysis has been used for establishing relationship between return on equity, return on assets & eps with capital structure results. the findings reveal positive relationship of short term debt with profitability as measured by roe, roa & eps. the (alhamdan & alqudah 2013) study aims to test the effect of the capital structure on the performance of the jordanian banks listed on the amman stock exchange (13 banks) for the period 1991-2010. the study used the analysis of table data (panel data) using the fixed and random effects models and the general lower squares method (gls) to test the hypotheses of the study. the results of the study showed that the capital structure measured by the ratio of liabilities to assets has a positive and statistically significant effect on the performance of jordanian banks measured by return on assets, return on equity, and share of net profits. as for the ratio of equity to assets, the results showed a positive and statistically significant impact on the return on assets and a negative and statistically significant impact on share per net profits and return on equity, while the size of the bank had a positive and statistically significant impact on performance of jordanian banks. ebrati et al. (2013) try to examined the impact of the capital structure measured by (liabilities to assets and liabilities to equity) on the financial performance of (85) companies listed on the tehran market using the multiple regression in the period 2006-2011. the study found that the capital structure has a positive and statistically significant effect on the financial performance measured by the return on equity, while it has a negative and statistically significant impact on the return on assets and the share of net profits. (saeed, et al., 2013)the study examined the impact of the capital structure on the performance of pakistani banks for the period 2007-2011 using the data of the banks listed on the karachi stock exchange, and models of multiple regression were applied to estimate the relationship between capital structure and banking performance. performance was measured by return on assets, return on equity and return on earnings per share. capital structure determinants include long-term debt to capital, short-term debt to capital and ratio of total debt to capital. the study found a positive relationship between the determinants of the capital structure and the performance of the banking industry. 4. methodology the study population includes all the jordanian general industrial shareholding companies listed on the amman stock exchange. the sample of the study includes (10) industrial asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 375 companies listed on the amman financial market, which meet the following conditions to ensure measurement of the study variables: 1) the capital of the company exceeds (15) million jd. 2) to be listed in the market for more than (15) years ago. 3) they have not been incorporated during the study period. 4) not to be suspended from trading. 5) the necessary financial data on the companies during the study period to measure the variables of the study. the following table shows, sample study companies: table 1. sample study companies no company name authorized capital (million jd ) 2012 2013 2014 2015 1 the jordanian pharmaceutical manufacturing 20 20 20 20 2 jordan poultry processing & marketing 15 17 23 23 3 ready mix concrete and construction supplies 25 25 25 25 4 middle east specialized cables company 39 39 39 39 5 arab electrical industries 16 16 16 16 6 national poultry 30 30 30 30 7 dar al dawa development & investment 23 25 25 25 8 the jordan cement factories 60.5 60.5 60.5 60.5 9 united cable industries 40 40 40 40 10 jordan phosphate mines 75 75 75 75 4.1 data collection sources the study data were collected from the following sources: 1) directory of public shareholding companies for the years that cover the study period. 2) published annual financial reports for public shareholding companies in the jordanian industry, which constitute the study sample for the period 2012-2015. 4.2 study model to achieve the study objective, the following model has been used: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 376 (study model) the impact of the capital structure on the financial performance of companies was measured using the linear regression model, which is the following equation: y = α + βx where (x) is the independent variables which is the capital structure and (y) is the dependent variable, which is the company's financial performance (profitability ratios). independent variables the independent variables are the capital structure ratios. these ratios are used as a tool to assess the ability of companies to meet their long-term liabilities. the following metrics for capital structure ratios will be used in this study: 1total liability to total assets ratio (lar). 2equity to total assets ratio (ear) the dependent variable the dependent variable is the company's financial performance (profitability ratios). these percentages are as follows: 1 return on equity (roe). 2return on assets (roa) independent variable dependent variable capital structure financial performance total liabilities to total assets. equity to total assets. return on equity (roe) return on assets (roa) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 377 3earnings per share (eps) 5. hypotheses of the study to achieve the objectives of the study and to reach results that can be utilized, the following hypotheses are designed the main hypothesis: (there is a statistically significant impact at the level (α ≤ 0.05) of the capital structure on financial performance of jordanian industrial companies listed on the amman stock exchange. the following sub-assumptions are derived from this hypothesis: there is a statistically significant impact at the level (α ≤ 0.05) of the capital structure as measured by (total liabilities to total assets and equity ratio) and the financial performance of jordanian industrial companies listed on the amman stock exchange as measured by return onequity (roe). there is a statistically impact at the level (α ≤ 0.05) of the capital structure as measured by (total liabilities to total assets and equity ratio) and the financial performance of jordanian industrial companies listed on the amman stock exchange as measured by return on assets (roa). there is a statistically impact at the level (α ≤ 0.05) of the capital structure as measured by (total liabilities to total assets and equity ratio) and the financial performance of jordanian industrial companies listed on the amman stock exchange as measured by earning per share (eps). the linear regression equation thus becomes as follows: roe = α + β1 (lar) + β2 (ear) (1) roa = α + (lar) + β2 (ear) (2) ep = α + (lar) + β2 (ear) (3) 6. methods of data analysis the linear regression analysis was used to test the relationship between independent and dependent variables. the regression equation described in the study model was estimated using the ols method, which results in a regression line where the sum of the square deviations from the line of points observed, is minimal. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 378 7. analysis of results and hypothesis testing 7.1 descriptive analysis of study data based on aggregated data of ten jordanian shareholding companies listed on the amman stock exchange for the period (2012-2015), the following table shows the data of these companies, which will be used in the model and test hypotheses. table 2. cumulative financial dataof industrial companies sample of study (n = 10) 2012 2013 2014 2015 data of independent variables total assets (ta) 1,867,200,595 1,781,414,637 1,660,045,853 1,614,928,066 total liabilities(tl) 754,770,686 688,201,257 528,689,125 549,719,345 equity(e) 1,090,452,546 1,071,991,993 1,110,246,651 1,046,854,876 total liabilities to total assets (lar). 0.40 0.39 0.32 0.34 equity to total assets(ear) 0.69 0.64 0.48 0.53 data of independent variables return on equity (roe)% 62 76 811 (207) return on assets (roa)% 17 9 6 2 earnings per share (eps)% 0.43 -0.12 1.16 2.45 7.2 the suitability of the regression model test to determine the suitability of the regression model in the analysis of the study data and to reach real results, the following tests were carried out: 7.2.1the unit root test for time series stability this test aims to examine the dormancy of time series, in order to avoid the problem of false regression resulting from the non-dormancy of the time series, and the most important tests of the root of the unit, the first step in the analysis of the data of the study is to test the dormancy of these time series through the unit root test. the most important test used to test unit root: (augmented dickey-fuller test, phillips peron test). a. augmented dickey fuller, 1981: the dickey-fuller test is one of the most popular tests in practical application. this test is used to verify the dormancy of the time series. the adf test is based on the nihilistic hypothesis, which states that the presence of the root of the unit leads to the non-dormancy of the time series (bhunia and das, 2012). table (2) shows the results of the augmented/dicky fuller test for the study data. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 379 table 3. augmented dickey – fuller test variable (t) value (t) tabled value sig total liabilities to total assets (lar). -1.694 -2.945 0.427 equity to total assets (ear) -1.676 -2.945 0.433 return on equity (roe)% 1.141 -2.945 0.997 return on assets (roa)% -0.942 -2.945 0.761 earnings per share (eps)% -0.651 -2.945 0.845 at first difference total liabilities to total assets (lar). -5.970 -2.957 0.000 equity to total assets (ear) -4.646 -2.957 0.000 return on equity (roe)% -4.549 -2.957 0.001 return on assets (roa)% -5.149 -2.957 0.000 earnings per share (eps)% -4.574 -2.957 0.000 the data of the previous table indicate that all the variables of the study are not dormant at the time of the augmented dicky-fuller test application, since the absolute values of the calculated (t) are lower than the absolute values of the tabular (critical) (t) of all variables. this indicates -according to this testthat there is unit root. after consideration of the first difference, all variables seemed dormant at a significant level (0.05). the absolute values of calculated (t) are greater than the absolute values of tabular (critical) (t) for all variables. b. phillips-perron, 1988: the phillips-byron test aims to verify the dormancy of the time series by testing the hypothesis of the root of the unit in the time series. what distinguishes the phillips and byron test is that it does not solve the problem of serial correlation of errors in the same way as the augmented dicky-fuller test (fahami et al., 2014). the null hypothesis is usually rejected for the existence of the unit root, i.e., the non-dormancy of the series if the calculated absolute values of the test are greater than the critical absolute values. table (4-3) shows the results of the phillips and perron test for the study data. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 380 table 4. phillips-perron test variable (t) value (t) tabled value sig )lar( -1.71 -2.954 0.412 )ear( -1.67 -2.954 0.433 )roe%( 1.912 -2.954 0.999 )roa%( -1.169 -2.954 0.675 )er%( -0.736 -2.954 0.823 at first difference )lar( -5.970 -2.957 0.000 )ear( -7.175 -2.957 0.000 )roe%( -4.549 -2.957 0.001 )roa%( -5.149 -2.957 0.000 )er%( -4.484 -2.957 0.001 the results of the phillips-perron test (pp) indicate that all the study variables are non-dormant at the time of this test; the absolute values of calculated (t) are lower than the absolute values of tabular (critical) (t) for all variables. that indicates the existence of the root of the unit according to this test. after taking the first difference, all the variables were marked dormant at a significant level (0.05), where the absolute values of calculated (t) are greater than the absolute values of tabular (critical) (t) for all variables. the results shown in tables 2 and 3 clearly indicate the stability and dormancy of the time series of the study data. this means that the results obtained from the linear and multigraph regression test will be real and will not be false. 7.2.2 the unit root test table (4) shows the results of the unit root test between independent study variables. table 5. unit root test lags q – stat prob )lar( 0.711 0.422 )ear( 1.047 0.354 )roe%( 1.462 0.723 )roa%( 1.465 0.922 )er%( 1.465 0.687 the above table shows that the probability value of all study variables was greater than (0.05). this indicates that there is no problem of self-correlation among study variables. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 381 7.3 testing hypotheses after confirming the dormancy and stability of the time series of the study data, and the absence of the problem of self-correlation between the variables of the study, the hypotheses of the study will be tested based on the multiple regression model, as follows: 7.3.1 first: testing the first sub-hypothesis this hypothesis states that (there is a statistically significant impact at the level (α ≤ 0.05) of the capital structure as measured by (total liabilities to total assets and equity ratio) and the financial performance of jordanian industrial companies listed on the amman stock exchange as measured by return on equity (roe). table 6. regression test (the impact of capital structure on return on equity) dependent variable constant )α( r2 (f) value sig. level independent variable )β( (t) value (t) sig return on equity (roe) 0.32 0.965 204.37 0.000 total liabilities to total assets 0.0877 -0.074 0.941 equity ratio 0.7370 6.511 0.000 * the effect is statistically significant at (α ≤ 0.05) from the previous table, the regression equation for the effect of (gross liabilities to total assets, equity ratio) on roe can be calculated as follows: y=α+β1x1+ β2x2 whereas: y = return on equity. α = equation constant (y value when total liabilities to total assets, equity ratio is constant). β1 = coefficient, the amount of change in the return on equity if the total liability to the total assets changes in a single unit. β2 = coefficient, the amount of change in the return on equity if the equity ratio changes in one unit. x1 = total liabilities to total assets. x2 = equity ratio. thus, the equation is as follows:7 return on equity = 0.32 0.0877 (total liabilities to total assets) + 0.737 (equity ratio) thus, the effect of total liabilities to total assets on return on equity is negative, and the equity ratio on return on equity is positive. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 382 the results of table (6) indicate that the value of (r2)=( 0.965). this means that the variance in (total liabilities to total assets, equity ratio) has explained (96.5%) of variance in return on equity, and (3.5%) due to other factors not covered in the study. the value of (f) was (204.37) at a significant level (0.000), which confirms the significance of the regression model at a significant level (α≤0.05). 7.3.2 second: testing the second sub-hypothesis the hypothesis assumes that (there is a statistically impact at the level (α ≤ 0.05) of the capital structure as measured by (total liabilities to total assets and equity ratio) and the financial performance of jordanian industrial companies listed on the amman stock exchange as measured by return on assets (roa). table 7. regression test (the impact of capital structure on return on assets) dependent variable constant )α( r2 (f) value sig. level independent variable )β( (t) value (t) sig return on assets (roa) 0.86 0.842 122.6 0.000 total liabilities to total assets 0.024 42.55 0.000 equity ratio 0.66 6.511 0.000 * the effect is statistically significant at (α≤0.05) from the previous table, the regression equation for the effect of (gross liabilities to total assets, equity ratio) on return on assets can be calculated as follows: y = α + β1x1 + β2x2 whereas: y = return on assets. α = equation constant (y value when total liabilities to total assets, equity ratio is constant). β1 = coefficient, the amount of change in the return on assets if total liabilities to total assetschange in one unit. β2= coefficient, the amount of change in the return on assets if the equity ratio changes by one unit. x1 = total liabilities to total assets. x2 = equity ratio. thus, the equation is as follows: return on assets = 0.86 0.024 (total liabilities to total assets) + 0.66 (equity ratio) thus, the effect of total liabilities to total assets on return on assets has had a negative impact, and the equity ratio on return on assets has had a positive effect. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 383 the results of table (7) indicate that the value of the coefficient of determination reached (r2 = 0.842). this means that the difference in (total liabilities to total assets, equity ratio) has been explained by 84.2% of the variance in return on assets and 15.8% due to other factors not covered by the study. the value of (f) was (122.6) at a significant level (0.000), which confirms the significance of the regression model at a significant level (α≤0.05). 7.3.3third: testing the third hypothesis the hypothesis states that (there is a statistically impact at the level (α ≤ 0.05) of the capital structure as measured by (total liabilities to total assets and equity ratio) and the financial performance of jordanian industrial companies listed on the amman stock exchange as measured by earning per share (eps). table 8. regression test (the impact of capital structure on earning per share) dependent variable constant )α( r2 (f) value sig. level independent variable )β( (t) value (t) sig earnings per share (eps) 0.58 0.893 205.05 0.000 total liabilities to total assets 0.102 38.55 0.000 equity ratio 0.74 12.221 0.000 * the effect is statistically significant at (p≤0.05) from the previous table, the regression equation for the effect of (total liabilities to total assets, equity ratio) on net profit per share can be calculated as follows: y=α+β1x1+ β2x2 whereas: y = net profit per share. α = equation constant (y value when total liabilities to total assets, equity ratio is constant). β1 = conjugate, the amount of change per share of net profit if total liabilities to total assets change in one unit. β2 = conjugate, which is the amount of change per share of net profit if the equity ratio changes in one unit. x1= total liabilities to total assets. x2 = equity ratio. thus, the equation is as follows: net profit per share = 0.58 0.102 (total liabilities to total assets) + 0.74 (equity ratio) thus, the effect of total liabilities to total assets on net profit per share is negative, and the effect of equity ratio on net profit per share has had a positive effect. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 384 the results of table (4-7) indicate that the value of (r2) = (0.893). this means that the difference in (total liabilities to total assets, equity ratio) has explained (89.3% of variance in net profits per share, and 10.7% of the net profit due to other factors not covered in the study. the value of (f) was (205.05) at a significant level (prob = 0.000), which confirms the significance of the regression model at the level of significance (α≤0.05). the results obtained in tables (4-5), (4-6) and (4-7) show that there is a statistically significant effect on the capital structure (as measured by total liabilities to total assets, equity ratio) on each one of the following: return on equity (roe), return on assets (roa) and earnings per share (eps). 8. conclusions the study concluded that there is a statistically significant positive effect of capital structure in the industrial shareholding companies listed in the amman stock exchange as measured by the ratio of equity to total assets, on return on equity (roe), return on assets (roa), and earning per share(eps) as an indicator of financial performance. the study also concluded that there is a statistically significant positive effect of capital structure in the industrial shareholding companies listed in the amman stock exchange as measured by the ratio of equity to total assets, on return on equity (roe), return on assets(roa) and earning per share (epr), as an indicator of financial performance. 9. recommendations after discussing the results of the statistical analysis of this study on the impact of the capital structure on the financial performance of jordanian industrial joint stock companies, the researcher recommends the following: 1disclose more and more accurately about the financial and accounting information of jordanian industrial joint stock companies listed on the amman stock exchange. 2lenders can use the results of this study as factors in estimating the expected volume of demand on their money. lenders can predict the financial performance of a company by estimating its need for funds to fund its various activities. 3jordanian industrial joint stock companies should take into consideration when deciding to increase their debt or reduce it and its effect on the financial performance of the company. 4the jordanian industrial joint stock companies should develop new strategies to increase the efficiency of the financial performance of the company, such as the use of efficient management. 5jordanian industrial joint stock companies should use modern technological tools and means, thus reducing the value of costs and thus increasing the value of profits as an indicator of the efficiency of financial performance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 385 references abeywardhana, k. 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(2013). the impact of capital structure on firms' performance in nigeria. augustine college of education, nigeria. pandy, im. (1995). financial management. 7thedition.vikas publishing house. new dellhi. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 386 pouraghajan, a., & malekian, e. (2012). the relationship between capital structure and firm performance evaluation measures: evidence from the tehran stock exchange. international journal of business and commerce, 1(9), 166-181. saeed, m, m., gull, a, a., & rasheed, m, y. (2013). impact of capital structure on banking performance (a case study of pakistan). interdisciplinary journal of contemporary research in business copyright. institute of interdisciplinary business research, 4(10), 220-240. siddik, n., kabiraj, s., & joghee, s. (2016). impacts of capital structure on performance of banks in a developing economy: evidence from bangladesh. journal of financial studies, 5(13), 1-13. https://doi.org/10.20944/preprints201611.0110.v1 sobh, m. (2002). working capital and project finance. al-bayan for printing and publishing, second edition. microsoft word 11578-42657-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 60 accounting reforms and foreign portfolio investment in china: an empirical investigation muhammad umar draz (corresponding author) department of management and humanities universiti teknologi petronas 32610 bandar seri iskandar, perak darul ridzuan, malaysia tel: 60-5-368-7732 e-mail: umardraz2626@gmail.com fayyaz ahmad school of economics, lanzhou university lanzhou, gansu, china received: july 21, 2017 accepted: sep. 14, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11578 url: https://doi.org/10.5296/ajfa.v9i2.11578 abstract the relationship between foreign portfolio investment (fpi) and various macroeconomic variables of china has been discussed in the existing literature. however, the link between china’s accounting reforms and fpi is yet to be explored. this study intends to discover the impact of changes in china’s accounting system and convergence of its domestic accounting standards (henceforth referred to as accounting reforms) on fpi. we have used binary choice model in eviews for two decades’ data. in our analyses, fpi has been taken as dependent variable, whereas accounting reforms, annual increase in listed companies, gdp growth of china and financial crises are taken as explanatory variables. the results of our model reveal a significant relationship between accounting reforms and fpi; moreover, granger causality test shows a significant causal relationship between yearly increase in listed companies and fpi. our findings are theoretically rational and can be useful for both investors and the policymakers. keywords: accounting reforms, accounting standards, china, financial crises, fpi, gdp asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 61 1. introduction foreign investment is normally a foreign direct investment (fdi) or a foreign portfolio investment (fpi); the former is made for long term purpose e.g. joint ventures and sharing the technology, etc. while the latter is a short term investment. overseas investments are highly linked with the rising level of globalization; by using the wide range of updated information and efficient means of communication, the investors can easily figure out when and where to invest their funds worldwide. for making investment decisions, financial disclosures of the relevant entity are one of the vital categories of information. without having sufficient know-how of the operating results, cash flows and financial position of an organization, investing funds can lead towards negative returns; and when that organization to be invested in is a foreign company, even more refined details are required for making an investment decision. china is one of the countries having its own accounting standards and it has an extensive and distinguished vestige of accounting as well. aiken & lu (1998) described that …“the first complete single entry bookkeeping system was almost certainly invented during the west zhou dynasty (1100-771 b.c.)”… archaeological facts prove that people of ancient asia used to carve their financial details on the stones more than one thousand years ago (kumarasinghe, 2011); it shows that accounting was probably being used in other parts of asia as well during that time. the accounting archives of salt-mining companies in zigong city, sichuan province show that chinese companies were using double-entry bookkeeping during the early twentieth (20th) century (auyeung et al., 2005) (note 1). china introduced major economic reforms in 1978 by opening its economy to the rest of the world. the first delegation of international accounting standards committee came to china in 1992; china became its member in 1997 (cairns, 1998). another important event in china’s recent accounting history took place during 1992 when first b-share company, shanghai vacuum electron devices, was listed at shanghai stock exchange (sse) (note 2). furthermore, in order to harmonize the domestic accounting standards with the international accounting standards (ias), the chinese government issue a regulation in 1998 (chen et al., 2002). the main assumption behind studying the relationship of accounting reforms and fpi is that uniformity of financial statements enhances the confidence of foreign investors, and consequently increases the level of fpi. if every country uses its own accounting standards, format and native language for preparing the financial statements, the accounting disclosures will be difficult to understand. complexities in financial reporting will discourage the foreign investors to invest in other countries, because they will be unable to understand those financial disclosures. another premise of studying the relationship of accounting reforms and fpi, as mentioned by chen et al. (2011), is the reduction in ‘information processing cost for foreign investors’. it is logical to assume that accounting reforms in terms of convergence of chinese gaap with ias will facilitate the foreign investors; they can easily understand the financial asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 62 reporting for different categories of shares issued by the chinese companies, their operating results, financial condition and investing activities of the desired firms. consequently, the better understanding of financial statements and financial system can attract investors. but fpi depends on many other variables as well, e.g. level of economic growth in the country to be invested in, returns and other strengths of the companies, better law and order situation and less systematic and regulatory complications for foreign investors etc. despite all of these variables and their importance, accounting reforms for improving the understandability of financial records has its prime and unique worth. our study is aimed to find out the linkage between accounting reforms and fpi in china. while finding the interrelation of accounting reforms and fpi, we intend to observe whether accounting reforms brought about a change in the level of fpi or there is no significant relationship between these variables. 2. literature review to study the relationship of accounting standards’ convergence and fdi, the work of akisik (2008) deals with the association of accounting standards, corportate governance and fdi; the results of this study, which analyzed the data of twenty seven emerging nations, indicated a significant relationship between increase in the quality of accounting standards and increase in fdi. chen et al. (2011) used the sample of thirty member countries of organization for economic co-operation and development (oecd) and found that such convergence is positively linked with the level of fdi. on the other hand, wang (2004) (note 3) asserted that local as well as foreign investors were less attracted to invest in china due to its state-owned enterprises (soes). during 1990s, the soes of china started to go public through stock exchange listings. once a company goes public, obviously it has to publish the books of accounts as well; hence, accounting reforms were required to provide the appropriate guidelines to these newly listed soes. on the other hand, such accounting reforms are also linked with the level of fpi. the publically available financial statements of soes enabled the local and foreign investors to analyze the data of these companies and to draw their investment decisions thereof. if these enterprises were not listed and remained entirely state owned, foreign as well as local investment in their shares was not possible. it is an evident fact that facilitates for overseas investors result into more investment by them. since uniform financial statements make it easy and cost effective for the foreign investors to access the required information, they can make their investment decisions more effectively and efficiently; as a result, the level of fdi and fpi increase. the former chairman of the iasb, sir david tweedie, has also stated this linkage (note 4) (deloitte, 2006). on the other hand, peng and bewley (2010) have noted the decreases in cost of capital for the ifrs adopting nations. moreover, before the introduction of the chinese accounting standards of 2006, the experts of earnst & young suggested the european investors to observe due diligence before investing for the mergers and acquisitions in china (haagmans and partridge, 2005). it shows that foreign investors were in a state of distrust about the chinese accounting asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 63 disclosures before the convergence of 2006; it also serves as a basis for studying the linkage between foreign investment and the accounting reforms of a country. china’s financial links with the world in 1978, and the incorporation of its first b-share company (note 5) in 1992 are another reason of studying the link of china’s accounting reforms with fpi for the post-1992 period. saudagaran (2001) noted that, along with other determinants, the level of fdi in a country has robust relationship with the standardization and convergence of accounting standards. gao & handley-schachler (2003) have asserted that the main aim of abandonment of the increase-decrease system of accounting in china and adopting the debit-credit system of accounting was to attract more foreign capital. the amount of fdi in china reached usd 1.63 trillion by the end of september 2011 (china daily, 2012); on the other hand, the level of fpi was recorded at usd 231.8 billion during the same month of 2011. obviously, in case of continuing the local system of accounting, overseas investors would not have become aware of the chinese financial disclosures in depth, which might have resulted into low levels of fdi and fpi; hence, accounting reforms played an important role in accumulating such a huge level of fdi. though some of the foreign investors in the chinese listed companies sold their stocks (the economist, 2010), still there was no decrease in the level of fpi in china during 2010. in a study on accounting change and its connection with the equity incentive and performance of the chinese listed companies, zhang et al. (2009) used factor analysis to the changes in the chinese accounting standard number 11, i.e. share-based payment, and its impact on the equity incentive and performance of listed companies. however, this study only consists of one accounting standard and its impact. among the recent studies, ahmad et al. (2015) found external debts to be the most important determinant of fpi in china; the authors also agreed with garg & dua (2014) on the other significant factors affecting the level of fpi in china. in another study concerning fpi and economic growth of asean5 nations, ahmad et al. (2016) confirmed a significant relationship betweeen economic growth and fpi for indonesia, malaysia, the philippines and thailand. the number of listed companies, especially those who are authorized to issue b-shares, can cause variations in the fpi level. when the number of listed companies increases, the chances of fpi will also increase. as mentioned earlier, the first chinese company with b-shares was listed at sse in 1992, whereas number of listed companies at sse has increased every year since its inception in 1990 till 2008 (note 6) on the other hand, the number of listed companies at shenzhen stock exchange (szse), from its establishment in 1990 till 2010, decreased during 2001 and 2003 (note 7). the details of china’s accounting reforms and its possbile linkage with the level of fpi reveals that accounting reforms is not the only variable affecting fpi in china; financial crises, economic growth and number of listed companies are also very vital in this regard. therefore, we will include these variables in our statistical analysis. 2.1 research gap asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 64 the available literature mostly deals with the impact of accounting reforms on the level of fdi in china. to the best of our knowledge, the impact of china’s accounting reforms on its fpi is yet to be studied. our study is aimed to fill this research gap by evaluating the relationship of china’s accounting reforms and fpi. 2.2 contribution of the paper this paper contributes to the current literature by evaluating the relationship of china’s accounting reforms and fpi. 3. methodology and results 3.1 data and variables in the statistical analysis, five variables are used to study the relationship of fpi and china’s accounting reforms. fpi is used as dependent variable; while chinese accounting reforms, annual increase in listed companies of china, china’s gdp growth and financial crises are used as explanatory variables. the explanation of including those variables is as follows: when listed companies increase in a country, there is possibility of increase in fpi as well; foreign investors might be attracted by the economic growth of their investment destination, so they will pay attention to the gdp growth; the financial crises can decrease the level of fpi due to the impact of crisis on country’s economy and companies, etc. the data of accounting reforms introduced by the international accounting bodies has been obtained from the official website of iasb; while the data of chinese accounting reforms has been taken from literature on chinese accounting history and the accounting standards issued and revised by the ministry of finance, china. the gdp growth figures have been taken from the national bureau of statistics, china. we have collected the data of fpi from the world bank website and the state administration of foreign exchange, china; the data about listed companies of china is obtained from the fact books of sse and szse. our statistical analysis consists of data from 1992 to 2011. since first b-share company of china was listed on sse in 1992 and there was no possibility of fpi in china before this year; therefore, we have selected this year as our starting point for the analysis. following are the details of variables, their abbreviation during statistical analysis and the hypothesis to be tested by using the binary choice model and other statistical analysis: fpi = foreign portfolio investment (dependent variable) ch_acrf = china’s accounting reforms (explanatory variable # 1) list_co = annual increase in listed companies (explanatory variable # 2) gdp_gr = gdp growth of china (explanatory variable # 3) fin_cr = financial crises (explanatory variable # 4) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 65 moreover: 1, increase in fpi 1, accounting reforms in china fpi = ch_acrf = 0, otherwise 0, otherwise 1, crisis fin_cr = 0, otherwise the fpi, ch_acrf and fin_cr are dummy variables that represent the presence or absence of foreign portfolio investment, china’s accounting reforms and financial crises respectively; whereas gdp growth is used with the real figures because its data is available in yearly form. following hypothesis has been tested at 10% level of significance (i.e. α = 0.10): h0: there is no significant relationship between fpi in china and the chinese accounting reforms h1: there is significant relationship between fpi in china and the chinese accounting reforms 3.2 statistical analysis in our statistical analysis, we have used binary choice model and granger causality test. the reason of selecting binary choice model is the nature of our data and variables; accounting reforms and financial crises, which are to be used during the statistical analysis, are not time series variables and their data entirely depends on the occurrence or non-occurrence. for instance, financial crises do not occur every year and same is the case with accounting reforms. the use of binary choice model will enable us to record the presence of absence of these variables in certain years and we can make our required analysis. on the other hand, the use of granger causality test in our statistical analysis is due to its primary logic i.e. “future cannot cause the past” (granger, 1969); so we can know the causal impact of one or more variables towards another variable. since we want to know the causal relationship between our variables i.e. accounting reforms and fpi, that’s why granger causality test best fits our needs. 4. findings and discussion the outcome of binary choice model, given in table 1, shows that the probability of z-statistic for the first explanatory variable (i.e. ch_acrf) is 0.0685, 0.0817 and 0.0971 by using probit, logit and extreme value methods respectively. in all of these cases, the probability of z-statistic is less than the level of significance; therefore, we reject the null hypothesis (h0), which states that the fpi and the chinese accounting reforms have no significant relationship. we accept the alternative hypothesis (h1) i.e. there is significant relationship between fpi and the chinese accounting reforms. it must be noted that we have asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 66 used 10% level of significance for the ease of observing the relationship between variables; even if we use the 5% level of significance, the relationship of fpi and the chinese accounting reforms is not totally insignificant, rather it will be considered as less significant. table 1: output of binary choice model method variables coefficient standard error z-statistic probability binary (probit) ch_acrf -1.459662 0.801189 -1.821870 0.0685 list_co 0.001311 0.004479 0.292588 0.7698 gdp_gr -0.249985 0.250618 -0.997474 0.3185 fin_cr 0.255622 0.409523 0.624195 0.5325 binary (logit) ch_acrf -2.427205 1.394144 -1.741000 0.0817 list_co 0.002707 0.007783 0.347801 0.7280 gdp_gr -0.372090 0.418680 -0.888723 0.3742 fin_cr 0.490469 0.745909 0.657545 0.5108 binary (extreme value) ch_acrf -1.812787 1.092602 -1.659147 0.0971 list_co 0.002961 0.006048 0.489655 0.6244 gdp_gr -0.267601 0.309839 -0.863676 0.3878 fin_cr 0.459960 0.534803 0.860055 0.3898 source: authors’ analysis by using eviews for all other explanatory variables, the probability of z-statistic is more than the 10% level of significance by using the probit, logit and extreme value methods of binary choice model; hence these results suggest that the annual number of listed companies in china, gdp growth of china and financial crises have statistically insignificant relationship with fpi. it is worth mentioning that the relationship of gdp_gr with fpi is not insignificant like other explanatory variables; the probability of z-statistic for gdp_gr is 0.3185, 0.3742 and 0.3878 by using the binary probit, logit and extreme value methods respectively; while other explanatory variables are far beyond as compared to gdp_gr. though these values can’t be considered as having statistically significant relationship with fpi, but it obviously shows that gdp_gr has less insignificant relationship than rest of the insignificant explanatory variables. we have used four explanatory variables for the statistical analysis of our research question; however in granger causality test, only one of those variables, i.e. list_co (annual increase in the listed companies), has shown its significant relationship with the level of fpi. following are its details: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 67 table 2. granger causality test for china pairs for causality test f-statistic probability causal relationship list_co → fpi fpi → list_co 2.7814 0.2083 (0.0987) (0.8146) yes no source: authors’ analyses in eviews this extract from the granger causality test shows that the probability of f-statistic is 0.0987 while studying the causal relationship of list_co towards fpi. since this probability is less than the level of significance, that’s why it suggests that the yearly increase in listed companies have significant causal relationship with the level of foreign investment in the listed companies of china. this result is theoretically understandable because the foreign investors will get more opportunities to invest their funds if the number of listed companies is increasing; in case of no or few listed companies, even if willing to invest, investors can make investment in another country. 5. conclusion the aim of this study was to observe the impact of china’s accounting reforms on fpi. the results of binary choice model illustrate that the chinese accounting reforms have statistically significant relationship with the level of fpi; moreover, the gdp growth of china is also linked with the foreign investment somehow but its relationship is statistically insignificant. on the other hand, the granger causality test showed the significant causal relationship of number of listed companies with the level of foreign investment in the chinese listed companies. these results of binary choice model and granger causality test are theoretically acceptable, because gdp growth shows the strength of economy and it can attract the overseas investors to bring their funds into a country; moreover, the number of listed companies can also enhance the level of foreign investment by providing a chance of investment to the prospective overseas investors. financial crises did not show any significant relationship with fpi in our statistical analysis. our findings suggest that china’s accounting reforms and increase in the listed companies have statistically significant impact on the level of fpi. an important implication of our study is that china should further develop its corporate sector and introduce accounting reforms, because both of the variables are significantly related to the level of fpi. the results of our study should not be generalized for other countries because the statistical analysis are purely based on china’s data; hence, conclusions drawn thereof are also meant for china. to obtain more refined and wide-ranging results, the data set must be expanded to regional or continental level. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 68 references ahmad, f., draz, m. u., & yang, s. c. 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(2010). adaptability to fair value accounting in an emerging economy: a case study of china’s ifrs convergence. accounting, auditing & accountability journal, 982-1011. https://doi.org/10.1108/09513571011092529 people's-daily, o. e. (2006, june 8). china eases restriction on foreign investment of listed companies. retrieved from people's daily website: http://english.peopledaily.com.cn/200606/08/eng20060608_271967.html saudagaran, s. m. (2001). international accounting: a user perspective. cincinnati, ohio: south-western college publishing / thomson learning. the economist, o. e. (2010, september 16). foreign investment in china: even harder than it looks. retrieved from the economist website: http://www.economist.com/node/17046627 wang, j. (2004). dancing with wolves: regulation and deregulation of foreign investment in china’s stock market. asian-pacific law and policy journal, 1-61. world bank, t. (2012). portfolio equity, net inflows (bop, current us$). retrieved from the world bank website: http://data.worldbank.org/indicator/bx.pef.totl.cd.wd/countries?page=2 zhang, d., chu, y., & liu, n. (2009). accounting change, equity incentive and performance of listed companies (in chinese). accountant (会计师), 5-8. endnotes note 1. according to auyeung et al. (2005) …‘chinese accounting scholars adopted fundamental equations that required an equality of variables in an exchange transaction, which is the basis of littleton's concept of duality. the chinese system allowed gains or losses from ventured capital to be more easily calculated, thus enabling businesses to determine their income-earning power. furthermore, before these archival records were made available, most historians believed that certain features of nineteenth-century western accounting, such as depreciation and the treatment of unexpired costs, were not being used in late qing china.’ … note 2. the details are available in the shanghai stock exchange fact book 2009. note 3. the author stated that …‘due to the absence of liberal ownership ideology and effective institutional operation, china’s stock market is suffering from over-reaching asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 70 regulations, under-enforcement of laws, a swaying regulatory culture, massive market manipulation and insider trading, as well as poor corporate governance and little minority investor protection – with the root of all these problems being the soes (i.e. state-owned enterprises). the predominance of state shareholders in listed companies, coupled with an undefined role of the state as shareholder and regulatory, provide the source for flaws in the market – and with these flaws, china faces difficulty in attracting international and even domestic investors.’… note 4. sir david tweedie stated that …“the new chinese standards that incorporate accounting principles familiar to investors worldwide will encourage investor confidence in china’s capital markets and financial reporting and will be an additional spur for investment from both domestic and foreign sources of capital.” note 5. since a-share companies were allowed to issue shares to the local investors only, fpi started in china after the incorporation of b-share companies. note 6. the details are available in the shanghai stock exchange fact book 2009. note 7. the details are available in the shenzhen stock exchange fact book 2005. microsoft word 10383-38383-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 205 the impact of second generation national health insurance on stock pricesbased upon supplementary premium charges on dividend income ku-jun lin department of accounting, tamkang university tel: 886-93-378-3713 e-mail: vaughn@mail.tku.edu.tw hai-ming chen department of management sciences, tamkang university tel: 886-95-543-7199 e-mail: haiming@mail.tku.edu.tw hsiu-mei chen(corresponding author) department of management sciences, tamkang university tel: 886-92-016-8775 e-mail: smchen@motcmpb.gov.tw wen-chen lo department of business administration, st. john's university tel: 886-93-378-3190 e-mail: wenchen@mail.sju.edu.tw received: nov. 7, 2016 accepted: dec. 20, 2016 published: december 20, 2016 doi:10.5296/ajfa.v8i2.10383 url: http://dx.doi.org/10.5296/ajfa.v8i2.10383 abstract the purpose of this study is to explore the influences of second generation national health insurance (nhi) on the stock prices of listed companies in taiwan. we employed the event study methodology to analyze the impact on listed companies’ stock prices during the period asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 206 of nhi act amendment. moreover, with a seemingly unrelated regression model, we discovered whether or not the new national health insurance system exerts different influences on different industries. the main results are as follows. first, the second generation nhi affects the stock prices of listed companies during the nhi act revision period. secondly, the second generation nhi has different influences on industries. one possible reason is that the second generation nhi’s charges of supplementary premium on dividend income makes investors feel pessimistic about this new insurance policy. this issue alters investment decisions and has a negative influence on building material and construction industry. keywords: national health insurance, second generation national health insurance, event study, seemingly unrelated regression. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 207 1. introduction taiwan began the implementation of national health insurance (nhi) on march 1, 1995. for the past decade, nhi safeguards all residents’ health care rights, becoming one of the influential welfare policies in taiwan. nhi provides reliable public medical service with reasonable expenses for r.o.c. citizens. taiwan’s nhi system is known all over the world as a successful welfare system. the misfortune of poverty and sickness often go hand in hand. since nhi began in taiwan, family poverty rate decreased from 21.90% to 20.30%. in addition, the average life expectancy has increased to 80 years of age, according to data from theunited daily news(chiang, 2014). the nhi is a compulsory social insurance program run by the government. through nhi, citizens enjoy complete medical care, including clinic visits, hospitalization, home nursing care, and rehabilitation services. one important advantage in implementing nhi is that through risk-sharing, the average citizen significantly reduces his or her financial burden due to medical needs. hence, surveys show that citizens in taiwan are highly satisfied with nhi. however, nhi is a non-profit social insurance system, so financial support for the continuance of nhi has become a main issue. the fact that nhi is inexpensive and convenient has, unfortunately, led to wasteful use of medical resources. the lowering of itemized payments to hospitals also drove many medical practitioners to prefer cosmetic medical service over traditional medicine, with the number of plastic surgeons increasing by 190% (peng, 2014). nhi supplementary premium charges based on income from part-time jobs, business income, dividend income, interest income and rental income have sprouted many fee-avoidance measures. such measures include false reporting of salary levels from high to low, changing to short-term investments for returns below the threshold where additional premium would kick in, fund splitting for savings accounts, and transfer of additional premium charges to employees. past nhi studies tend to explore the regulations and the issue of fairness. after implementation, social policies or systems usually become political issues (skocpol and amenta, 1986). therefore the amendment of nhi inevitability leads to different reactions from the stakeholders. the premium income is paid by the insured, group insurance applicants, and the government. however, like other developed countries such as france or germany with nhi systems, in recent years health care costs have risen significantly due to increasing elderly population, home nursing care, rehabilitation and new expensive medical technologies. if premium income is not adjusted high enough, it is not able to cover medical expenses fully. according to the ministry of health and welfare’s december 20, 2012 statistics, the 2011 insurance income (includes premium income and other income) totaling nt$4,968 million, however, over the past 10 years, the ratio of premium income to insurance income has decreased 5.3% from 99.8% to 94.5%, shown as figure 1. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 208 fig. 1. financial income and cost of nhi from 2001 to 2011 on october 30 of 2012, the ministry of health and welfare finalized regulation for supplementary premium, which includes charges based on bonuses, income from salaries and wages, income from professional practice, dividend income, income from interest and income from lease. the nhi revision, effective starting on january 1, 2013, is known as the second generation nhi. the purpose of the revision is to support the continuance of the nhi social welfare system for the benefit of all residents. however, the second generation nhi’s new premium contribution requirements have had some negative impact. for example, investment institutions consider supplementary premium charges on dividend income as a negative factor for the stock market. new policies decrease stockholders’ real dividend income after deduction of necessary supplementary premium. hence, the investors are reluctant to participate in dividend distribution, which leads to declining stock prices. many researches already demonstrate how government policies affect the stock prices. for example, the operation of the stock market is dependent not only on market mechanism but also on governmental policies (ju, 2007).there are crucial relationships between the stock market and governmental policies (kaustia and torstila, 2011). the formation of a healthcare system involves a wide range of issues such as fairness and justice. given that the stock market is the nation’s economic showcase, the current lack of research on the effects of nhi on the stock market has prompted this study, which investigates the nhi’s policy of premium charges based on dividend income and its effects on the stock market. through the results of this study, hopefully the public will view nhi from a positive perspective. this study can also serve as reference for future development of governmental policies. the remainder of the study is organized as follows. section 2 introduces nhi and related literature. section 3 presents the research methodology, while section 4 lists and interprets this study’s empirical results. finally, section 5 summarizes conclusions and provides a discussion of the implications. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 209 2. related literature this study discusses the influence of the second generation nhi on the stock market. the differences between the nhi and the second generation nhi, and the core value of the second generation nhi are described below. 2.1 major changes in the second generation nhi the original nhi program satisfied the needs of most people, but suffered from financial problems. therefore, the second generation nhi proposal considered national, social, political and economic factors. major changes in the second generation nhi are as followings. 2.1.1 single supervisory committee for the sustainability of the second generation nhi, two organizations, the nhi supervisory committee and the nhi medical expenditure negotiation committee were merged into a single supervisory committee to strengthen the financial mechanism. the supervisory committee is responsible for the financial balance sheet of the second generation nhi. 2.1.2 extended premium base to extend the premium calculation base, the premium of the second generation nhi includes “general premium” and “supplemental premium”. based upon the principles of fairness, supplemental premium regulation levies charges on other relevant income sources. 2.1.3. more information exposure of healthcare quality improving healthcare quality is one of the most important missions of the second generation nhi. therefore, large medical care institutions are required to provide nhi-related financial reports, to disclose information on healthcare quality. 2.1.4. other to prevent overseas citizens from using medical resources without adequate contribution, they would need to wait four months before entering the nhi program again if they failed to pay premiums for a long time. however, if overseas citizens have insurance records within the last two years, they are still under the protection of the second generation nhi. there are three core perspectives for the second generation nhi. they are “constructing an nhi organizational system that is accountable,” “expanding diversified social participation,” “balancing finances and increasing service-purchasing efficiency,” and “strengthening the provision of information to enhance medical care quality.” besides, the core value of the second generation nhi are “quality,” “fairness,” and “efficiency,” shown in figure 2. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 210 fig. 2. core value of the second generation nhi 2.2 the influence of the second generation nhi on the stock market this study intends to discuss the impact of the second generation nhi on the stock market. 2.2.1 impact on businesses the second generation nhi supplementary premium, paid by employers, should be based on the difference between the total monthly salary payment and the total premium ratable wage basis. most importantly, there is no upper limit for supplementary premium. therefore, companies with high bonuses pay much more supplementary premiums than those with low bonuses. the illustration is shown as table 1. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 211 table 1. illustration of premium differences between nhi and the second generation (nt dollars) premium of nhi (premium rate = 5.17%) (1) premium of the second generation nhi differences (5)=(4)-(1) general (premium rate = 4.91%) (2) supplemental (premium rate = 2%) (3) total (4)=(2)+(3) company without bonus: company a ● with 500 employees the monthly average premium ratable wage base is nt $ 30,300 for one employee ●without any additional bonuses nt $30,300 × 5.17% × 0.6 × 1.7 × 500 = nt $799,000 nt $30,3 00× 4.91% × 0.6 × 1.7 × 500 =nt $758,500 (nt $30,300 × 500 nt $30,3 00× 500) ×2% =nt$0 nt $758,500 nt $40,500 high bonus company: company b ● with 200 employees the monthly average premium ratable wage base is nt $ 18,300 for one employee ●the total employees’ monthly salary is nt $ 5,000,000 nt $18,300 × 5.17% × 0.6×1.7×200 = nt $193,000 nt $18,300 × 4.91% × 0.6×1.7×200 =nt $183,400 (nt $5,000,000 nt $ 18,300× 200) × 2% = nt $26,800 nt $210,800 nt $17,200 table 1 shows how premiums are calculated and supplementary premium differences based on different salary structures. under the second generation nhi, total premiums paid by asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 212 companies without bonuses are less than before, while premiums paid by companies with high bonus expenditures are higher than before. 2.2.2 impact on investors the impact on ordinary investors is much greater than the impact on major shareholders. based upon the premium calculation principles of the second generation nhi, when the dividend income is less than nt$5,000, there is no supplementary premium. when the dividend income is more than nt$5,000 but less than nt$10 million, the supplementary premium rate is 2%. when the dividend income is more than nt$10 million, the supplementary premium is the same amount as a nt$10 million income that is, nt$200,000 is the upper limit for supplementary premium. more favorably, institutional investors do not have to pay any supplementary premium. therefore, the impact of the second generation nhi on major shareholders is smaller than ordinary investors. the research manager of capital securities corp (csc) stated that investors are less willing to participate in earnings distribution after the implementation of the second generation nhi(zeng, 2011).the closer to the implementation date, the stronger negative attitudes showed. moreover, the implementation of the second generation nhi encourages short-term investment behavior, which leads to greater fluctuation of the stock market. in summary, the nhi is not only a social insurance, it also serves as protection of citizens’ rights for medical care. for fairness sake, it is necessary to extend the premium calculation base. however, such new policy disturbs investment behavior and decreases participation in the stock market. 2.2.3 event study an event study explores whether or not a particular event would cause the fluctuation of stock prices and result in abnormal returns (shen and lee, 2000).this methodology is very good at measuring the effects of a new event on stock prices. it can also be used to estimate whether abnormal returns happen before or after an event. an abnormal return is the difference between the realized return and the expected return(brown and warner, 1980).there are four steps to applying the event study: first, determine the date of the event; second, estimate the abnormal return; third, examine the abnormal return; and finally, analyze the results (shen and lee, 2000). event study is one of the most widely used research methods in business studies (chan, martin and kensinger, 1990; doukas and switzer, 1992; kelm, narayanan and pinches, 1995).event study investigates the influence on stock prices after an announcement of accounting earnings(ball and brown, 1968). event study is also employed on some public policies, such as formulation and changes of securities and exchange act, and anti-trust and tax laws. for example, from 1907 to 1920, the united states began to control electricity price in 32 states. scholars used the event study method to discuss how the policies influenced power companies (stigler and friedland, 1962).another research analyzed 205 cases of antitrust litigation charged by the u.s. asset asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 213 forfeiture program or the federal trade commission from 1950 to 1971. there was no significant effect on the companies’ stock prices before and after the litigations (ellert, 1976). the prosecuted companies that violated the securities exchange act enacted in 1934 were charged because they released false financial statements, which led to investors’ losses. furthermore, researchers found that when the company’s accounting deficiencies was discovered and publicized, the market value decreased by one billion u.s. dollars)(kellogg, 1984). researcher also studied 50 companies affected by the sugar tariff reform in 1912. the biggest effect of the reform was the date when the news was released by the senate and the president, and not when the reform was being discussed earlier(ellison and mullin, 1995).in addition, investigators studied the impact of land appreciation tax (lat) deduction on companies. they found that the policy stimulated the real estate market and had significant influences on the stock prices (wang, chen and lin, 2005).all the above studies explored whether policies affected companies by using the event study methodology. as shown in the above literature, the event study can be also help to investigate a particular event occurrence, whether the rmb exchange rate was affected(liu and pauwels, 2012);whether the eu sovereign bond yields were affected(afonso, furceri and gomes, 2012);and whether the asset prices were affected(vithessonthi and tongurai, 2012).moreover, some investigators also studied how investors’ sentiments affect the stock prices on the date of compulsory acquisition(okoń,2012; schijven and hitt, 2012).there are many such studies discussing the influence of public policies on stock prices. using the event study method, this study will explore stock price fluctuations due to related governmental policies. 2.2.4 seemingly unrelated model the seemingly unrelated regression (sur) is the system of equations which can deal with both cross-sectional and time series data (zellner, 1962).when employing the event study, we consider the data as cross-sectional independent, except in the case of event clustering. there are three types of event clustering. event calendar clustering means several event dates are the same calendar date or very closely together. industry clustering is that sampling firms are almost in the same industry, while risk clustering is that such events have influences on companies with similar risk levels (shen and lee, 2000). researchers found that event clustering would increase the variances of abnormal returns, thus affecting the accuracy of results(brown and warner, 1985).non-synchronous trading, event calendar clustering or industry clustering, whichever happens, the results of event study would be not persuadable(henderson, 1990).the scholars also found that stock returns of companies in the same industry were related during the same time period (schwert, 1981).besides, one academic researcher employed both event study and sur to discover the impact of policy reforms on stock returns(binder, 1985). this study analyzes the impact of the amendment and implementation of the second generation nhi on stock returns. since some event dates are close to others, to avoid cross-sectional dependency resulting from event clustering, we employ two methodologies, namely event asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 214 study method and sur, to discuss the issue. 2.2.5 hypothesis the second generation nhi is the social welfare system which may benefit the people in taiwan. the second generation nhi reform would have great impact on people and firms. furthermore, the second generation nhi charges supplementary premium based on dividend income – it is estimated that about 1 million investors were affected when the policy took effect. for roughly one ninth of the investors, the realized dividend income would decrease by 2% because of supplementary premiums. the investors are then less likely to actively participate in the firms’ dividend distribution, thereby influencing stock prices. scholars found that the investors’ participation of the stock market was closely related to the policy reforms (kaustia and torstila, 2011).academics also discovered that there is a strong relationship between the political event and the stock returns(kim, pantzalis and chul park, 2012).thus, we propose hypothesis1 as follows: hypothesis h1: the second generation nhi influences the stock prices. next, this study focuses on the issue of supplementary premium charges from dividend income. also, people with different salary structures are affected by the second generation nhi in different ways. some companies pay higher fixed salaries with lower amount of bonuses, while others pay lower fixed salaries with higher bonuses. the impact of supplementary premiums on companies and people would be different. thus hypothesis 2 is: hypothesish2: the second generation nhi amendment has different impact on different industries. 3. methods using the event study method(duchin and sosyura, 2012)and the sur(zellner,1962)during the period of amendment and implementation of the second generation nhi act, this research explores the impact of the second generation nhi act on the stock prices of taiwan’s listed companies. the data and methodologies are as follows. 3.1 data and sample this study seeks to discover the impact of the second generation nhi act on stock returns. all stock returns are listed in daily frequency, with data from the taiwan economic journal (tej). there are sample companies in total and they are from the taiex (taiwan stock exchange). all listed companies are included, except full-cash delivery and missing-data stocks. 3.2 the event study 3.2.1 event day event day refers to the date when the market received relevant information about the event. in the united states scholars choose event day when the information is delivered to the market by wall street journal. however, there is no benchmark media in taiwan like the wall asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 215 street journal, so most studies choose the information announcement date as event day. this research followed the studies(liao, 2009; zang, 2011)and chose event day as the announcement dates when the first, second and the third readings of the second generation nhi act passed. events 1, 2, and 3 are the passing dates of the first, second and the third readings of the second generation nhi act, respectively. event 4 is the day when the government announced the draft of supplementary premiums act. finally, event 5 is the day of decree for the supplementary premiums act. 3.2.2 event period for daily frequency data, event period could be 2 to 21 days (shen and lee, 2000).scholars explored the impact of political pressure on the changes of the rmb exchange rate. they selected seven days as event period, mainly due to the risk of overlapping events. the shorter the period, the lower the risk of overlapping (liu and pauwels, 2012).therefore, this study also selected seven days as the event study period. event period starts from three-days-before event day up to three-days-after event day. 3.2.3 estimation period the estimation period is a period which can establish the expected model for the estimation of the expected stock returns (shen and lee, 2000).scholars suggested that the estimation period should be set before event period(peterson, 1989).the length of the estimation period could depend on the objective of the studies. however, if the estimation period is too short, the efficiency of the model may be undermined; if it is too long, the instability of the model may occur due to structural changes within the period. academics have suggested that the estimation period should be anywhere from 100 to 300 days for daily data (shen and lee, 2000).for this study, the estimation period is set as 200 trading days before event day. since event 2 and 3 are close to each other, to avoid the overlapping of estimation period 2 and estimation period 3, we set the estimation period of event 2 and 3 in the same period by following the scholars’ studies (liao, 2009; zang, 2011).in this study, we also take the market model to estimate the abnormal returns of event period. table 2 is the summary of event day, event period, and estimation period. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 216 table 2. summary of event day, event period, and estimation period eve nt event day the relevant events of the amendment and announcement of the second generation nhi event period estimated period 1 2010.4.16 (fri) the first reading of the second generation nhi act was accomplished and sent to the social welfare and environmental hygiene committee of the legislative yuan to review. 2010.4.13(tue) ～ 2010.4.21(wed) 2009.6.26(fri) ～ 2010.4.12(mon) 2 2010.12.7 (tue) the second generation nhi act entered the second reading nhi act. 2010.12.1(wed) ～ 2010.12.10(fri) 2010.2.11(thu) ～ 2010.11.30(tue) 3 2011.1.4 (tue) the second generation nhi act entered the third reading nhi act. 2010.12.30(thu) ～2011.1.7(fri) 2010.2.11(thu) ～ 2010.11.30(tue) 4 2012.5.7 (mon) the department of health published the draft of “regulations governing the deduction and payment of the supplementary insurance premium of the national health insurance” and is going to implement on january 1, 2013. 2012.5.2(wed) ～ 2012.5.10(thu) 2011.7.14(thu) ～ 2012.4.30(mon) 5 2012.10.3 0 (tue) no. 1012600179 decree of the department of health announced “regulations governing the deduction and payment of the supplementary insurance premium of the national health insurance” and is going to implement on january 1, 2013. 2012.10.25(thu) ～ 2012.11.5(mon) 2012.1.6(fri) ～ 2012.10.24(wed) 3.3 seemingly unrelated model researchers employed the sur model to discuss the effect of the decree reform on the stock market (binder, 1985).the sur model can avoid cross-sectional dependence resulting from event clustering and can also analyze the effect of a particular event on different industries. however, while there are more than 15 sur model equations, higher statistical errors could result (schwert, 1981).hence this study chooses six industries from taiex, to analyze whether or not different industries are impacted differently by the second generation nhi supplementary premium charges based on dividend income. the industries chosen include asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 217 plastic, building material and construction, finance and insurance, chemical and biotechnology, electronics, and others. these are the top six industries with higher proportion of turnover in taiex. the model specification is as follows: 4 3 t r b r dpt p p mt pt pt t α γ εττ = + + + = the stock returns for p industry at period t，p=1,….6, t=-203,……,+3, the market returns at period t, intercept and regression coefficient of p industry, dummyvariable, when event period occurs, dτ=1; otherwise, dτ=0, the regression coefficient of event period occur for p industry p at period t, the residual 4. results this section reveals the empirical results of this study. the first is the impact of the second generation nhi act on the stock returns. the second is whether the second generation nhi act exerts different influences on different industries. 3.4 impact of the second generation nhi act on the stock returns table 3 shows the impact of the second generation nhi act on the stock returns according to the event study. there are a total of 741 sample companies. event days are the dates when the first, second and the third readings of the second generation nhi act passed, the announcement date of the supplementary premiums draft, and the date of decree for the supplementary premiums act. for event period 1, it is possible to find stock market’s response after the legislature passed the first reading of the second generation nhi act. from table 3, on the three-days-before event day, the average abnormal return and the cumulative average abnormal return are not significant for both the cross-sectional statistics and the standardized cross-sectional statistics. on the two-days-before event day, both the average abnormal return and the cumulative average abnormal return show positive results at 1% significance level. on the one-day-before event day, only the cumulative average abnormal return shows significant positive results, while the average abnormal return does not. in sum, before the first reading of the second generation nhi act passage date, most investors were not familiar with the second generation nhi. since investors did not have enough information about the second generation nhi proposal, they did not really understand how the new regulation would affect them and the stock market. hence, the results would not asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 218 be consistent. on event day 1, the average abnormal return and the cumulative average abnormal return are all positive at 1% significance level. investors were optimistic about the second generation nhi, since the nhi reform would benefit more people in the society. on the one-day-after event day, the average abnormal return and the cumulative average abnormal return also show significant results but now on the negative side. on the two-days-after event day, the average abnormal return shows significant negative results. however, the negative average abnormal return becomes smaller, so the negative cumulative average abnormal return becomes smaller and does not show statistical significance. on the three-days-after event day, only the average abnormal return shows significant results but it turns into apositive number. to sum up, all the results of event 1 imply that investors did not get information about the second generation nhi when the first reading passed. hence, for event period 1, the results do not show consistent responses. for event period 2, the effects on the stock market when the legislative yuan passed the second reading of the second generation nhi act may be found. in table 3,the average abnormal return and the cumulative average abnormal return on the three-days-before, two-days-before as well as one-day-before event dayarealmost all significant with both the cross-sectional statistics and the standardized cross-sectional statistics. besides, all significant results are negative and nearly at 1% significance level. in summary, before the second reading of the second generation nhi act passage date, most investors were getting familiar with the second generation nhi and the results reveal that the new regulation had negative impact on the stock market. however, on event day 2, one-day-after, two-days-after as well as three-days-after event day, the average abnormal returns become positive and significant. thus, the cumulative average abnormal returns become larger, going from negative to positive numbers. in the short run, all investors and firms would pay more premiums, therefore their real income would decline. but the new premium system would support the second generation nhi program and benefit everyone in the society in the long run. these negative to positive results imply that people gained a better understanding of the advantages of the second generation nhi. event day 3 is the day when the third reading of the second generation nhi act passed. table 3 shows the average abnormal return is significantly negative only on the three-days-before event day. the average abnormal returns show positive and significant results on other days, including one-day-before, one-day-after as well as two-days-after event day. since the average abnormal returns are from negative to positive at the significance level, the cumulative average abnormal returns also become positive after event day. the results of event period 3 are consistent with the arguments of event period 2. even though people felt losses in the beginning because the second generation nhi asks for more premium, they come to realize that medical cost will decrease, and in the end most people would benefit. for event period 4, the stock market responses about the draft of the supplementary asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 219 premiums act may be found. in table 3, on the three-days-before event day, the average abnormal return and the cumulative average abnormal return are significant for both cross-sectional statistics and the standardized cross-sectional statistics. on the two-days-before event day, only the cumulative average abnormal return shows a positive number at 1% significance level. on the one-day-before event day, the average abnormal return and the cumulative average abnormal return show significantly positive results. on event day and one-day-after event day, the average abnormal return and the cumulative average abnormal return also show significant positive results. on the two-days-after event day, the cumulative average abnormal return shows significant positive results, but the average abnormal return does not. however, on the three-days-after event day, the average abnormal return and the cumulative average abnormal return show significant results, with the average abnormal return turning into a negative number. the stock market response on the announcement of the supplementary premiums draft regulation goes from positive to negative. one possible reason is that people learned of the benefits of the second generation nhi, so the results show consistently positive numbers before event day 4. however, after the detail of the supplementary premiums act was announced, investors began to understand that the main source of supplementary premium would come from charges based on dividends. each dividend income above nt$5,000 should be charged a 2% supplementary premium contribution. millions of investors would be affected by the supplementary premiums act, when their realized dividend income would decrease by 2%. thus, when investors became fully aware of the detail of the proposed regulation, they exhibited a pessimistic attitude toward the supplementary premiums act. the result of event period 4, therefore, goes from positive to negative. event day 5 is the decreed date of the supplementary premiums act. in table 3, one can find the average abnormal returns and the cumulative average abnormal returns before event day 5, which all show significantly negative results at 1% significance level. these negative results are consistent with the arguments above. people showed pessimistic attitude toward the supplementary premiums charges based on dividend income. however, on event day 5 and two-days-after event day, the average abnormal returns are both positive at 1% significance level. the average abnormal return of three-days-after event day turns to be significantly negative. plus,the cumulative average abnormal returns are all significantly negative. at first people responded negatively to supplementary premium charges on dividend income because the new regulation decreases investors’ gains. furthermore, after the supplementary premiums act is decreed, people understood that the new regulation could no longer be postponed or changed. therefore, investors adjusted their thinking to try and be more rational. after all, the supplementary premiums act supports the financial framework of the second generation nhi and increases social benefits. that is the reason why on the decree date and afterwards, the average abnormal returns became positive again. in addition, on three-days-after event day, the average abnormal return becomes negative. it is consistent with the argument that people try to agree with supplementary premiums act from the viewpoint of social welfare. in fact, investors suffer losses due to the supplementary premium asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 220 charges, and they do not change attitudes totally in a short period. hence, the average abnormal return of three-days-after event day is significantly negative. the fact that the cumulative average abnormal returns of event period 5 are all significantly negative is another fact supporting our argument. in summary, from table 3, there is significant evidence that the second generation nhi act has impact on the stock market. thus hypothesis one is valid. table 3. test results of taiwan listed companies’ abnormal returns on event day event period ar t(ar) z(ar) car t(car) z(car) 1 -3 0.0158 0.2132 0.7290 0.0158 0.2132 0.7290 -2 0.3089*** 4.3067*** 4.2071*** 0.3247*** 3.3140**** 3.6119*** -1 -0.0780 -0.9837 0.1214 0.2467* 1.9305* 2.7397*** 0 0.5722 7.5881*** 7.8646*** 0.8189*** 5.3465*** 6.0253*** 1 -1.2839*** -13.646*** -12.8698*** -0.4650** -2.5469** -1.4106 2 0.2230*** 2.9371*** 2.8683*** -0.2419 -1.2228 -0.2559 3 0.3556*** 5.228*** 4.8118*** 0.1137 0.5524 1.2765 2 -3 -0.3587*** -5.7549*** -5.3839*** -0.3587*** -5.7549*** -5.3839*** -2 -0.1799** -2.8500*** -4.2419*** -0.5386*** -6.0129*** -6.6641*** -1 -0.2116*** -3.1661*** -1.8603* -0.7502*** -6.9773*** -6.7550*** 0 0.3912*** 6.4194*** 7.2905*** -0.3590** -2.8800*** -2.3828** 1 0.2709*** 3.9111*** 3.7565*** -0.0881 -0.6086 -0.2858 2 0.1689** 2.2740** 2.4547** 0.0808 0.4604 0.8328 3 0.1503** 2.0098** 1.4766 0.2311 1.1253 1.2717 3 -3 -0.1695** -3.0403*** -4.5477*** -0.1695** -3.0403*** -4.5477*** -2 -0.1031 -1.5861 -1.3121 -0.2725*** -3.2594*** -4.0312*** -1 0.1493** 1.6748* 3.1028*** -0.1232 -1.0181 -0.6321 0 0.7256*** 9.0706*** 8.3120*** 0.6024*** 4.4815*** 4.7196*** 1 0.5286*** 7.3157*** 6.5947*** 1.1310*** 7.5992*** 7.5577*** 2 0.1984*** 3.1316*** 3.9041*** 1.3293*** 8.0293*** 8.3430*** 3 -0.0543 -0.7536 -2.0699** 1.2750*** 7.6118*** 7.4667*** 4 -3 0.7835*** 11.1619*** 10.1589*** 0.7835*** 11.1619*** 10.1589*** -2 0.0175 0.2816 -0.0612 0.8010*** 7.8243*** 7.2006*** -1 0.3629*** 6.1137*** 5.8174*** 1.1639*** 9.6489*** 9.1242*** 0 0.6962*** 12.3855*** 13.5810*** 1.8601*** 13.6633*** 14.0374*** 1 0.2095*** 3.7758*** 4.0024*** 2.0696*** 14.2223*** 14.6908*** 2 0.0801 1.0292 1.3691 2.1497*** 12.7333*** 14.0445*** 3 -0.4452*** -7.8254*** -8.1613*** 1.7045*** 10.3705*** 11.3825*** 5 -3 -0.5102*** -8.1571*** -7.8103*** -0.5102*** -8.1571*** -7.8103*** -2 -1.8566*** -23.5726*** -23.893*** -2.3668 -20.5622*** -21.8632*** -1 -1.6983*** -17.5306*** -17.2923*** -4.0651*** -23.6279*** -25.4038*** 0 0.3426*** 4.7537*** 6.5522*** -3.7225*** -21.2370*** -22.2270*** 1 0.0160 0.2467 0.2955 -3.7065*** -20.4417*** -20.8989*** 2 0.4374*** 6.0364*** 5.5353*** -3.2691*** -18.0429*** -17.7482*** 3 -0.1874*** -2.6656*** -1.4510 -3.4565*** -18.0526*** -17.4180*** note: a.ar is the average abnormal return, t (ar) is the cross-sectional statistics of ar, z(ar) is the standardized cross-sectional statistics of ar, car is the cumulative average asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 221 abnormal return, t(car) is the cross-sectional statistics of car, and z(car) for the standardized cross-sectional statistics of car. b. *, **, and *** denote coefficient estimates significance at 10%, 5%, and 1% level, respectively. 3.5 the second generation nhi act exerts different impact on different industries hypothesis 2 explores whether the second generation nhi has different impact on different industries. in the traditional event study method, the cross-sectional return of each company is assumed to be independent. the sur model can deal with cross-sectional dependency resulting from event clustering, and analyze the effect of a particular event on different industries. next, this study further employs the sur to investigate whether different industries have different reactions to the second generation nhi act. six industries are considered for hypothesis 2, including plastics, building material and construction, finance and insurance, chemical and biotechnology, electronics and other industry. the empirical results are shown in table 4. first, event date 1 is the passage date of the first reading of the second generation nhi act. the empirical result of table 4 shows that there is no significant evidence to support that six industries have different impacts for event period 1. secondly, event period 2 is the passage date of the second reading of the second generation nhi act. since the building material and construction industry show significantly negative results, passing the second reading of the second generation nhi act has different effects on different industries. thirdly, event period 3 is the passage date of the third reading of the second generation nhi act, and there is no significant evidence here. next, event period 4 is the announcement date of the supplementary premiums draft. in table 4, the results are not significant at all. finally, event period 5 is the decree date of the supplementary premiums act; here, none of the results are significant. this section investigates whether or not the five events of the second generation nhi act have different impacts on different industries. there is one event showing significant evidence: the second reading of the second generation nhi act. event 1, 2, and 3 are the passage dates of the first, second and third readings of the second generation nhi act, respectively. the evidences show that when the second reading of the amendment passed, building material and construction industry show significant negative results. the results reveal that this one industry felt strongly negative attitude toward the second generation nhi act. the reason is perhaps because more professionals invest inthe building material and construction industry. as professional investors gathered more information about the second generation nhi act, after decree they found that they must pay more premiums after the regulation became effective. hence, significant results appear during event period 2 and not event period 1. for event period 3, there is no significant evidence. one possible reason is that most investors understood by now the detail of the second generation nhi act. therefore, there would be no significant different impact on different industries. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 222 moreover, event period 4 and 5 are the announcement date and decree date of the draft of supplementary premiums. event period 4 and 5 show no evidence of any significant different influence on different industries. in conclusion, the results support hypothesis 2: the second generation nhi exerts different impact on different industries. table 4. test results of different companies’ abnormal returns  = +++= 4 3 t t ptptmtpppt drr τ τ εγβα event period industry plastic building material and construction finance and insurance chemical and biotechnology electronics other 1 -0.193 -0.651 1.072 -0.725 -1.285 0.332 (0.847) (0.515) (0.284) (0.468) (0.199) (0.740) 2 -0.321 -2.127 0.598 -1.835 0.860 -1.168 (0.748) (0.03)** (0.550) (0.07)* (0.390) (0.243) 3 -0.936 0.635 0.809 1.068 -0.061 -0.339 (0.349) (0.545) (0.419) (0.286) (0.951) (0.735) 4 -1.303 0.506 0.341 0.512 -0.305 0.663 (0.193) (0.613) (0.733) (0.608) (0.761) (0.507) 5 -0.931 -1.946 0.816 -0.066 0.018 -1.857 (0.352) (0.052)* (0.414) (0.947) (0.986) (0.063) * note: a. the estimates and p-value (shown in the parenthesis) are showing above. the p = 1, 2, 3, 4, 5, and 6 represent the plastic industry, building material and construction industry, finance and insurance industry, chemical and biotechnology industry, electronics industry, and other industry, respectively. b. *, **, and *** denote coefficient estimates significant at 10%, 5%, and 1% level, respectively. 5. discussion the purpose of this study is to explore the impact of the second generation nhi on the stock prices of listed companies in taiwan. the event study methodology and seemingly unrelated regression model were employed to analyze the impact on companies’ stock prices during the period of nhi revision, and to discover whether or not the new national health insurance system exerts different influences on different industries. the main results are as follows. first of all, the second generation nhi does affect companies’ stock prices during the period of nhi regulation revision. investigation of five events related to the second generation nhi act found that all events indeed affect the stock market. people respond negatively to the second generation nhi act in the beginning, due to additional premium charges. afterwards, asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 223 people’s attitudes became positive because they realized that the new premium system would benefit all citizens in the long run. however, for event period 5 which is the supplementary premiums act decree date, significantly negative response was observed again. investors realized that supplementary premiums charges levied on dividends would decrease their income. the results show evidence of significant negativity. however, rational thinking draws people to consider the benefit of the new social welfare system. thus after the supplementary premiums act is decreed, people understand that the regulation cannot be postponed or changed. after all, everyone benefits from the second generation nhi. finally, people adjust their attitudes rationally and become positive about the nhi revision. secondly, the second generation nhi exerts different influences on different industries. one possible reason is that the second generation nhi charges supplementary premium on dividend income, which makes investors feel pessimistic about the revised insurance policy. as a result, investors altered their investment decisions, with a negative impact on the building material and construction industry. during the second generation nhi deliberation phase, it was still possible that the government may give up on the idea due to public opposition, or that the implementation date could be postponed. thus investors of the six selected industries had reasons to believe that the information was not all negative for the prices of their stocks. however, after the announcement of the second reading of the second generation nhi act and the announcement of the supplementary premiums final draft proposal, building material and construction industry showed significant negative effect. for the event periods analyzed by this research, according to the “taiwan capitalization weighted stock index” (taiex) released by the taiwan stock exchange corp. (see table 5), the stock market fluctuated up and down during the period starting from the first reading passage of the second generation nhi, until the ministry of the health and welfare’s national health insurance administration announced the finalized “regulations governing the deduction and payment of the supplementary insurance premium of the national health insurance”. overall, the circulation taiex declined by 96.47 points from 10404.75 to 10308.28 points. for six industries with high transaction volume, including plastics, building material and construction, finance and insurance, chemical and biotechnology, electronics and other industry, the stock market index went down for all but two industries, namely plastics and other industry. the stock market index decline is an indication that people were concerned about additional premium charges after the second generation nhi took effect – this is the same as the empirical results of this study. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 224 table 5. the “taiwan capitalization weighted stock index” (taiex) for each event period event period closing index up (down) up (down) % circulation taiex plastics building material and construction finance and insurance bio technology electronics other 1 10404.75 224.26 314.97 944.56 118.92 383.25 159.26 (77.44) (0.74) 2 11572.12 281.72 382.45 1074.25 140.12 405.24 176.58 3.03 0.03 3 11961.39 290.75 399.73 1178.66 140.69 410.89 178.93 (37.37) (0.31) 4 10429.23 258.90 305.86 908.27 119.67 359.87 192.76 (224.74) (2.22) 5 10308.28 242.11 310.32 911.14 114.88 352.43 212.39 130.56 1.28 source: taiwan stock exchange corp. furthermore, there are some managerial implications from the results of this study. the calculation of the nhi premiums was based on regular salary income. regulation states that the amount of insurance coverage shall not be less than their labor premium and monthly labor pension. however, some of people who are insured have only income that is not regular salary income. thus the second generation nhi includes supplementary premium that is based on dividends, interest, and rental income, etc. as result, people without regular salary income, but have high income from interest, dividends, and rental revenue, will need to pay supplementary premiums under the new regulation. this new insurance system, charging nhi premiums according to the insureds’ real financial condition, is much more equitable. since governmental policies have the power to affect the lives of ordinary citizens, the government must actively communicate with the public before actual implementation, fully explaining the pros and cons of new policies while paying attention to the public’s response. such communication would help to avoid the situation where not all investors receive adequate information, and react pessimistically due to policy misunderstandings. in summary, regardless of whether people are rich or poor, when they get sick, the nhi system provides appropriate medical care for all. according to the estimates from the department of health, only 17% of the public are required to pay supplementary premiums after the implementation of the second generation nhi. hence, the impact is rather limited, and investors do not have to be too pessimistic. people should think rationally about the benefits and advantages provided by the second generation nhi, and let the stock market function accordingly. the second generation nhi has been in effect for nearly two years. according to a survey released on august, 2014 by the ministry of health and welfare's national health insurance administration, the overall satisfaction level of the second generation nhi is 79.80%. the main reasons the satisfaction level was lower than before were that many people still did not fully understand the regulation, people worrying about being overcharged for premiums, and possible waste of medical resources. however, the spirit of the national health insurance is emphasis on social responsibilities, relying on collective community power to distribute risks shouldered by each individual. the system is designed with a mechanism to allow those with more economic resources to pay higher premiums, and those without to pay less, to achieve asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 225 one type of income redistribution effect. taiwan is currently facing a multitude of healthcare problems, including an aging population, continuous advancement of the latest medical technology, and non-stop economic crises. when the available budget is always less than necessary, the national healthcare insurance’s greatest challenge in the future, is proper management of the insurance practice towards the pursuit of an ideal welfare system for all. references afonso, a., furceri, d., & gomes, p. 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(2011). nhi impact of the stock market 4 phenomena, smart zhi fu monthly section, 151. http://dx.doi.org/10.2139/ssrn.1970869 microsoft word 14469-52423-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 76 perception of government accountants on current public sector accounting practices and implementation of public sector accounting standards in the sri lanka vickneswaran anojan lecturer (probationary), department of accounting, faculty of management studies & commerce, university of jaffna, sri lanka. e-mail: v.anoabt@gmail.com received: nov. 29, 2018 accepted: march 24, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14469 url: https://doi.org/10.5296/ajfa.v11i1.14469 abstract the main aim of the study is to find out the perception of government accountants on current public sector accounting practices and implementation of public sector accounting standards in the sri lanka. public sector accounting practices involve with public expenditure, budget preparation, maintain proper accounting records, assets management, public financial management and provide reports on the public expenditure and revenue. most of the public sector organizations do not prepare final accounts on accrual basis in the sri lanka. primary data used in this study which data collected from government accountants in sri lanka. mean analysis confirmed that there is moderate level of public sector accounting practices and implementation of public sector accounting standards in the sri lanka. correlation analysis confirmed that there is significant relationship between public sector accounting practices and implementation of public sector accounting standards. implementation of public sector accounting standards are positively impact on the public sector’s financial reporting practices and assets management practices in the sri lanka. also below 23 percentage of public sector organizations are preparing final accounts on accrual basis. more than 97 percentage government accountants have ability to prepare annual accounts on accrual basis. government administrators, policy makers and professional institutions should motivate effective and efficient implementation of the public sector accounting standards which will lead to a healthy public sector accounting practices in sri lanka. keywords: perception, government accountant, public sector accounting, practices, sri lanka. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 77 introduction public financial management is an important part of every country. it involves with the national development of the country. financial statement provides financial information to the economic decision makers. today economic decision makers are expecting financial and relevant non-financial information for their effective decision making. public sector organization is one of the high level expenditure organizations in sri lanka. mostly public sector organizations involve with public expenditure here income generation of public sector organization is very low level. a huge amount of money spends for the total recurrent expenditure and total public investment of the country. according to annual report (2017) of sri lanka, it can be seen that total recurrent expenditure was rs. 1,945,575,039,924 and total public investment was rs. 657,530,018,379 in sri lanka. administrative structure of sri lanka has three major structures such as central government, provincial government and local government. here public sector accounting practices are different in above three structures of the administration. most of the public sector organizations are preparing their accounts based on cash basis. payables and receivables do not reflect in the final accounts of the public sector organization. further it can be seen that most of the public sector organizations do not prepare statement of financial position. due to that such public sector organization does not know about their total assets and liabilities. government accountant has a major role in the public sector accounting practices of sri lanka. most of the public sector organization has government accountant even though there is no government accountant in the pradeshiya sabha. there are a number of publications such as public procurement manual, guidelines, financial regulations, administration regulations and circulars which are providing guidance for the public sector accounting practices in the sri lanka. there is software for the accounts preparation of public sector organization and software for the salary preparation in the sri lanka. there is no a specific software for the assets management of the government organizations in sri lanka. most of the country is trying to adopt accrual basis accounting practices in the public sector. sri lanka is trying to adopt accrual basis accounting practices in the public sector. here provincial council and local authorities start to prepare the accounts on accrual basis. also government owned public enterprises and companies prepare the financial statements based on accrual basis. chartered accountant of sri lanka has best annual report and accounts awards competition for the public sector. the main aim of the initiation is to improve the quality of the annual report of the public sector and promote accrual basis accounting practices in the public sector. the government of sri lanka spends a huge amount of money to give training for the public officers on the public sector accounting practices and accrual basis accounting practices in the public sector. however public sector firms are unable to adopt the accrual basis accounting practices in sri lanka. literature review a) theoretical review public financial reporting practices in sri lanka generally government departments are preparing its budget then allocation is allocated asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 78 according to the budget of the particular government department in sri lanka. then fund is released for the central, provincial and local government of the sri lanka by the general treasury. provincial treasury has responsibility to release fund for the provincial and local government of sri lanka. then particular government department has the responsibility to report on its income and expenditure for that particular financial year. financial year starts on 1st january and end on 31st december of the same year. department of state account has the responsibility to prepare accounts and publish government final accounts. for example divisional secretariat accounts are prepared by accountant of that particular divisional secretariat office then divisional secretariat accounts send to the chief accountant of district secretariat. chief accountant has responsibility to accumulate all the divisional secretariat accounts of the district with district secretariat accounts. then final accounts of the district send to the department of state accounts, general treasury of sri lanka. all other government organizations are practicing like above example in sri lanka. most of the government organization is practicing software for their financial reporting which is computerized integrated government accounting system (cigas). according to the financial regulations and treasury circulars most of the government organization has to prepare the appropriation accounts and should be submitted to department of state accounts, auditor general department and chief internal auditor. according to the financial regulation and treasury circulars the following accounts should be prepared by the government organizations such as,  annual appropriation accounts,  advance account,  imprest account,  deposit accounts etc. most of the government organization does not prepare income statement, statement of financial position and cash flow statement in sri lanka. public assets management practices in sri lanka a huge amount of money spends on assets purchase for government organization. there are a lot of non-current assets procurement for the government organization. due to that assets management play a vital role in the government organization of the sri lanka. according to the financial regulation every government organization has to do annual board of survey on its assets like stock counting and physical verification in the private sector. board of survey is carried out by board of survey committee. board of survey committee is appointed on before 15th december of every year. the board composes with minimum two responsible officers. board of survey committee has responsibility to verify stores and report on unserviceable stores of the government organization. there is two forms in board of survey such as form t & a.66 for the verification of stores and form general 47 for reporting on unserviceable stores. store officer and store keeper should be appointed for every government organization here generally store officer should be staff grade officer. store keeper has responsibility to maintain the store of the government organization and store officer has responsibility to supervise store keeper and store of the government organizations of the sri lanka. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 79 public financial management practices in sri lanka the financial regulations of the government of sri lanka is a subject that has been assigned to the minister of finance by the president exercising the powers vested in him under article 44(1) a of the constitution of the democratic socialist republic of sri lanka. minister of finance has delegated his/ her powers to the secretary of the ministry of finance. he or she is the secretary to the treasury. further deputy secretary of the treasury is the head of the treasury. treasury has a major role in the public financial management. according to ministry of finance there are the following key departments each department under a director general.  department of national budget  department of fiscal policy  department of public finance  department of public enterprises  department of state accounts  department of external resources  department of development finance  department of information technology management  department of legal affairs  department of management service  department of management audit  department of trade and investment policy  department of treasury operations public financial management of the country should be based on the financial regulations 1992, government gazette notifications, government circulars and administration regulations of the sri lanka. these financial regulations are binding on all government departments, statutory boards and similar institutions. all government officers are hereby required to acquaint themselves with the provisions of these regulations. chapter three of the financial regulations clearly describes about financial management and accountability of the sri lanka. there are three key officers such as chief accounting officers, accounting officers and revenue accounting officers in the public financial management of the sri lanka. minister of finance has the duty to account to parliament on all receipts and payments of the country. therefore minister of finance appoints a secretary to each ministry as chief accounting officer. in addition to secretaries to ministries, the officers in charge of the departments specified in article 52 (7) of the constitution and other departments not supervised by secretaries to ministries will be chief accounting officers. chief accounting officer has the responsibility for supervising departmental financial transactions according to the directions of the treasury. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 80 head of each department will be the accounting officer in respect of all the financial transactions of his department. as such, he is immediately responsible to, his chief accounting officer in the manner laid down in the financial regulations. the treasury will indicate from time to time the officers who will be responsible for the preparation of the estimates of revenue under the different heads, sub-heads, items and sub-items, and who will ultimately be accountable for variations between the estimates and actual collections. such officers shall, for the purpose of these regulations, be referred to as revenue accounting officers. there are a several public officers involve in the public financial management. especially head of the departments and government accountants play a major role of the public financial management in the sri lanka. public budget preparation and implementation in sri lanka budget preparation is the key function of every country. country’s budget preparation is a big process. there is a separate department for the budget preparation for the sri lanka. it is department of national budget which operates under the treasury of sri lanka. generally national budget is prepared for a year which is from 1st january to 31st december. according to department of national budget circular no. 2/2017 provides guidelines, and calls for budgets for the fiscal year 2018 to be formulated based on the performance-based budgeting approach. department of national budget has the responsibility to give proper guidelines to all the public sector’s budget preparation and collect budgets from all the public sector organizations through the proper channel then department of national budget will accumulate received budget. national budget department will finalize the national budget as draft budget estimate. according to the constitution of the country, minister of finance has the responsibility to submit the draft budget estimates for the approval of cabinets then draft budget estimates will be submitted for the corrections, changes and approval in the parliament. generally government accounts prepare the budget of their organization according to the available data and discussion with the head of the department. according to the financial management systems – sri lanka (2018), annual national budget calendar of the sri lanka can be seen as follow.  department of national budget issues budget call or budget letter to secretaries of line ministries, chief secretaries of provincial councils, and heads of departments setting guidelines and directions for annual budget preparation in july.  cabinet approves initial cabinet memorandum on the budget, indicating the government’s overall revenue and expenditure position in august.  budget discussions are held with spending agencies, revenue departments, and other stakeholders in relation to allocations to sectors, ministries, other institutions, programs, and projects, based on priorities within the government’s overall development framework and the firmed-up budget theme during august to september.  second cabinet memorandum is presented to the cabinet of ministers and appropriation bill is published in the gazette in october. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 81  at least 7 days after the publication of the appropriation bill: bill is presented to parliament (first budget reading).  budget details are presented to parliament and minister of finance and planning delivers budget speech (second reading of budget) in november.  second-reading debate is held and appropriation bill is put to a vote maximum of 7 days after budget speech (last week of november).  draft estimates for each line ministry are discussed separately with secretaries of relevant ministries (committee-stage debates) and approved maximum of 22 days from the end of the second reading debate (last week of november to third week of december).  appropriation act is endorsed by speaker (budget is passed in parliament) in third week of december.  before the end of december, minister of finance and planning issues warrant(s) authorizing expenditure.  department of national budget issues expenditure authorization circular to spending agencies in last week of the december. public sector accounting standards in sri lanka according to sri lanka public sector accounting standards (2009), the sri lanka public sector accounting standards issued in 2009 by the institute of chartered accountants of sri lanka are, with the permission of the international federation of accountants (ifac), largely, based on the international public sector accounting standards published by ifac. ca introduced four standards for the public sector in 2009 such as,  slpsas 1 presentation of financial statements  slpsas 2 cash flow statements  slpsas 3 accounting policies, changes in accounting estimates and errors  slpsas 4 borrowing cost sri lanka public sector accounting standards volume ii published by ca, sri lanka in 2012. it covers further six standards such as,  slpsas 5 the effects of changes in foreign exchange rates  slpsas 6 events after the reporting date  slpsas 7 property, plant & equipment  slpsas 8 provisions, contingent liabilities and contingent assets  slpsas 9 inventories  slpsas 10 revenue from exchange transactions asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 82 ca, sri lanka is motivating accrual basis accounting and public sector accounting standards implementation in the sri lanka. ca, sri lanka provides award on best annual report and accounts awards for the public sector. according to sunday observer news dated on 4th november 2018, second best annual report and accounts award was organised by the association of public accountants of sri lanka, the public sector wing of ca sri lanka in 2018. twenty-six public institutions were honoured at the awards ceremony with nine public sector organisations winning the main awards which was categorised into nine sectors covering universities, research institutions, statutory boards, ministries, departments, provincial councils, urban councils, municipal councils and pradeshiya sabhas. b) empirical review davor and gorana (2010) tested the appropriateness of existing modified accrual accounting and financial reporting system in croatian public healthcare sector. this study reveals that accounting information system contains discrepancies and constraints in assuring true and fair view of organization’s financial position and performance. analysis of the study confirmed low level of cost and managerial accounting methods development, and external and internal financial reporting convergence. researcher argued that croatian public healthcare sector represents a segmental accounting subsystem within the integral public sector accounting framework, where accruals implementation might prove justifiable. rozaidy, siti, rasid and raman (2017) analysed the possible contextual and application gaps derived from the utilisation of van helden and northcott’s (2010) method of study for classifying themes in published public sector’s accrual accounting papers according to their research objectives. objectives of the study were proposing new financial/management accounting techniques/approaches for public sector accrual accounting systems, examining the effectiveness of accrual accounting techniques/approaches, identifying the conditions for the successful/failure of the implementation of accrual accounting techniques/approaches and knowledge-building in understanding, explaining and critiquing the adoption and use of accrual accounting techniques/approaches, both theoretically and practically. researchers were able to find which areas of study have received less attention and which areas have room for further exploration. the findings show that research objective explaining and critiquing the adoption and use of accrual accounting techniques/approaches was the most popular subject among the researchers, followed by research objective examining the effectiveness of accrual accounting techniques/approaches. research objective identifying the conditions for the successful/failure of the implementation of accrual accounting techniques/approaches and knowledge-building in understanding is usually chosen as a complimentary focus, along with the two previous research objectives being mentioned earlier. most of the papers are less directed towards research objective proposing new financial/management accounting techniques/approaches for public sector accrual accounting systems. tatjana (…..) stated the public sector accounting as the ex post recording and reporting of financial operations of government represents the fundamental management process in public sector entities. researcher pointed that countries are facing a challenge to improve the information served by public accounting for the state budgeting purpose, most often by asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 83 reforming accounting principle from cash flow into accrual in time of financial and economic crisis. researcher recommended that accrual principle obtains more transparent and complete review of the business activities and property of the users of public funds then cash principle does. this study analysed the three accounting models and principles of state budgeting in order to assess the connection between stages of accrual principle implementation and budgeting. analysis of the study confirmed that regardless of the stage of accruals implementation in the national accounting legislation, the planning and execution of the state budgets is still on the cash principle. andrew (2010) reveals that a broad review of the public sector accounting research in recent years, including that undertaken in the united states. an analysis of this research found a methodological distinction between research undertaken in the us and that undertaken in the rest of the world. this study concluded that with an exhortation for psar researchers to explore multi paradigmatic methodologies in future research. rossana, adriana, roberta and jorge (2013) this study evaluated the perceptions of internal and external users and preparers of accounting information in the brazilian public sector regarding a change to an accrual based accounting system and the potential for such a system to provide informational benefits to decision-makers and managers of public entities. the results of the study confirmed that the survey respondents perceived accrual basis accounting as having the potential to provide informational benefits for decision-making within governmental agencies. researchers suggested that the adoption of this new accounting system is not entirely driven by a mandatory requirement or pressure from international institutions. differences in levels of perceived usefulness among different respondent groups recommended that actions taken by the managers of the brazilian accounting standards applied to the public sector to improve dissemination of information and implement training programs may be paying off because internal and external users were more likely than other respondents to perceive accrual basis accounting as having high potential for generating information for decision-making. further this study noted that the need for public sector managers to focus the implementation process on the activities of other stakeholders to generate an environment that is receptive to this new paradigm. jane and james (2008) purpose of the study was to review and critique the field of public sector accounting research. many nation states deliver essential public services. in recent times, many of these nations have been involved in programmes of “modernisation”, which, in part, means that these public services now are significantly managed, delivered and governed by private and third sector organisations. this study employed a literature-based analysis and critique of public sector accounting articles published in the selected journals from 1992 to 2006. from this, a descriptive meta-analysis of the characteristics of the research discussed. the descriptive analysis highlighted that among the research papers reviewed several interesting patterns emerged concerning public service research. also, the dominance of australasia and uk research was noted. the extent of research in different levels of government/jurisdiction indicated that the majority of research was organisationally based. various functional types of accounting are considered, management asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 84 accounting remained the most researched area of interest. tatjana (2015) the constant challenge countries face to improve the information served by public accounting due to the recent financial and economic crisis. the crisis has shown that accounting based on the accrual principle provides a more transparent and complete overview of business activities and assets than accounting based on the cash principle. the paper analysed and compared the accounting systems in slovenia and croatia in order to assess the conditions for transparent and management-oriented financial information, and the progress of the implementation of the accrual principle in budgeting. findings of the study revealed that regardless of the stage of accrual implementation in national accounting legislation, the planning and execution of state budgets is still based on the cash principle. salah and mahfuzul (2016) this study focused to review the public sector accounting research (psar). through the review of the papers published from 1992 to 2015, the nature, trends and character of psar have been tried to identify. this review covered three justified aspects of psa research have been used – theory initiation of reforming the psa, practice of reforming the psa and standards development for reforming the psa. the review found that over the time, the trends of psar have been changed and have been enriched from different areas. researchers found that while some researchers used to concentrate more on the adoption of developed standards, a number of contemporary researches concentrate on comparative adoption, innovation in practice and probable integration with the new areas. statement of the problem according to the literature review and working experience as government accountant, most of the government organization did not prepare the final accounts on accrual basis in the sri lanka. public sector organizations are unable to calculate its total assets, liabilities, payables and receivables as organization wise. further there is no proper software and record system for the assets management of public sector in sri lanka. there is a huge amount of money spend for the assets purchase in the public sector even though there is no proper method on assets management. according to the annual report (2017) ministry of finance, sri lanka, it can be seen that budget estimate of total revenue was rs. 1,913,650,000,000 and actual total revenue was rs. 1,845,017,336,787 further budget estimate of total expenditure was rs. 2,962,212,371,000 and actual total revenue was rs. 2,603,105,058,303. according to the above figures it can be seen that there is problem in the public financial management, budget preparation and implementation in sri lanka. finally problem statement of the study can be stated there is problem in the current public sector accounting practices and implementation of public sector accounting standards in sri lanka. research objectives main objective of the study is to identify the perception of government accountant on current public sector accounting practices and implementation of public sector accounting standards in the sri lanka. the followings are the sub objectives of this study; asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 85  to find out the relationship between perception of government accountant on current public sector accounting practices and implementation of public sector accounting standards in the sri lanka.  to find out the impact of perception of government accountant on current public sector accounting practices and implementation of public sector accounting standards in the sri lanka.  to identify mean differences between perception of government accountant on current public sector accounting practices and implementation of public sector accounting standards in central government and provincial government of the sri lanka. methodology a) sample this study is based on perception of government accountants in sri lanka. researcher considered government accountants who are working in the central, provincial and local government in the sri lanka. researcher selected 60 government accountants from central government, 30 government accountants from provincial government and 10 government accountants from local government through convenience sampling. this study covers totally 100 government accountants in the sri lanka. response rate of this study is disclosed in table 1. table 1. sample size and response rate government accountants sent returned response rate central government 60 24 40% provincial government 30 10 33.33% local government 10 01 10% total 100 35 35% b) data source this study is mainly based on primary data from government accountants in the sri lanka. researcher developed 1-5 point likert scale questionnaire. questionnaire covered statements for four major contents under the current public sector accounting practices such as financial reporting, public financial management, assets management and budget preparation and implementation. developed questionnaire used to collect date from respondents of the study through google form. google survey form is one of the user friendly, very cost effective and green environment primary data collection techniques. c) hypotheses this study considers the following hypotheses based on perception of government accountants asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 86 in sri lanka. h1: there is a significant relationship between perceptions of government accountants on current public sector accounting practices and the implementation of public sector accounting standards in the sri lanka. h2: there is a significant impact of implementation of public sector accounting standards on public sector financial reporting practices in the sri lanka. h3: there is a significant impact of implementation of public sector accounting standards on public sector assets management practices in the sri lanka. h4: there is significant mean difference between perceptions of government accountants on current public sector accounting practices and implementation of public sector accounting standards in central government and provincial government of the sri lanka. d) data analysis strategies researcher did descriptive analysis and inferential analysis in this study. mainly descriptive analysis used to reveal the mean value of perception of government accountants on current public sector accounting practices and implementation of public sector accounting standards in the sri lanka. correlation, regression and independent-samples t test performed to test the hypotheses of the study. researcher used spss latest version for the data analysis of the study. descriptive analysis and interpretation a) demographic profiles of the respondents demographic profiles of the respondents are shown in the table 2, 3 and 4. demographic profiles cover age, gender and working experience of the respondents of the study. table 2. age of the respondents age number of respondents response rate below 30 years 02 06 30-40 years 24 68 40-50 years 08 23 50-60 years 01 03 total 35 100% according to above table it can be seen that nearly 70 percentage respondents are 30 40 years old in this study. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 87 table 3. gender of the respondents gender number of respondents response rate male 20 57% female 15 43% total 35 100% table 3 shows that most of the respondents of the study are male. table 4. working experience of the respondents years number of respondents response rate 1-10 years 24 69% 10-20 years 11 31% total 35 100% most of the respondents working experience is one to ten years in this study. b) reliability analysis table 5. reliability statistics (cronbach’s alpha test) questions title number of questions cronbach’s alpha financial reporting 27 0.825 assets management 06 0.846 public financial management 14 0.827 budget preparation and implementation 07 0.680 the implementation of public sector accounting standards 18 0.868 total 72 0.928 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 88 according to table 5 it can be seen that the score of cronbach’s alpha range is 0.680 to 0.868 further cronbach’s alpha for the total is 0.928. it reflects that validity of the data which is high level in this study. c) descriptive analysis table 6. descriptive analysis minimum maximum mean std. deviation variance financial reporting practices 2.26 3.81 3.127 0.41402 0.171 assets management practices 1 4.5 2.719 0.7251 0.526 financial management practices 2 4.36 3.3959 0.49619 0.246 budget preparation and implementation 2 4.57 3.3061 0.54799 0.3 public sector accounting standards implementation 2 4.67 3.3444 0.49833 0.248 according to the above table it can be stated that assets management practices are in very low level in the public sector. financial management practices are high level in the public sector even though it can be seen that there is no any accounting practices and public sector implementation more than mean value 3.50. perception of the accountant regarding current public sector accounting practices and implementation of the public sector accounting standards are in moderately agree level. table 7. are you aware on the financial report preparation on accrual basis frequency percent valid percent cumulative percent valid no 1 2.9 2.9 2.9 yes 34 97.1 97.1 100.0 total 35 100.0 100.0 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 89 according to the table 7, it can be seen that more than 97 percentage of government accountants are aware on the accrual basis financial report preparation. it gives green signal that government accountants can prepare and understand accrual basis financial report. table 8. did you prepare annual accounts on accrual basis in sri lankan public sector more than 77 percentage accountants did not prepare annual accounts on accrual basis in sri lankan public sector according to the above table 8. according to the above table 9, more than 50 percentage government accountants prepared annual accounts on accrual basis in provincial government public sector on the other hand only below than 9 percentage government accountants prepared annual accounts based on accrual basis in central government public sector of sri lanka. inferential analysis and interpretation a) correlation analysis frequency percent valid percent cumulative percent valid no 27 77.1 77.1 77.1 yes 8 22.9 22.9 100.0 total 35 100.0 100.0 table 9. did you prepare annual accounts on accrual basis in sri lankan public sector * working station cross tabulation working station total central government provincial government local government did you prepare annual accounts on accrual basis in sri lankan public sector no 22 4 1 27 yes 2 6 0 8 total 24 10 1 35 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 90 table 10. correlations frp amp pfmp bp ipsas frp pearson correlation 1 .481** .716** .249 .367* sig. (2-tailed) .003 .000 .149 .030 n 35 35 35 35 35 amp pearson correlation .481** 1 .795** .618** .344* sig. (2-tailed) .003 .000 .000 .043 n 35 35 35 35 35 pfmp pearson correlation .716** .795** 1 .525** .450** sig. (2-tailed) .000 .000 .001 .007 n 35 35 35 35 35 bp pearson correlation .249 .618** .525** 1 .361* sig. (2-tailed) .149 .000 .001 .033 n 35 35 35 35 35 ipsas pearson correlation .367* .344* .450** .361* 1 sig. (2-tailed) .030 .043 .007 .033 n 35 35 35 35 35 **. correlation is significant at the 0.01 level (2-tailed). *. correlation is significant at the 0.05 level (2-tailed). according to the correlation analysis of the study it can be seen that there is a significant relationship between perceptions of government accountants on current public sector accounting practices and the implementation of public sector accounting standards in sri lanka. therefore h1 is accepted in this study. further it can be stated that through the proper and healthy implementation of public sector accounting standards, public sector accounting practices can be improved in the sri lanka. b) regression analysis asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 91 table 11. coefficientsa model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 2.108 .455 4.635 .000 ipsas .305 .135 .367 2.264 .030 a. dependent variable: frp table 11 reveals that implementation of public sector accounting standard is significantly impact on financial reporting practices of public sector in the sri lanka. that means, effective and efficient implementation of public sector accounting standard will lead for the significant positive impact on the financial reporting practices of public sector in the sri lanka. therefore h2 is accepted in this study. table 12. coefficientsa c) independent-samples t test model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 1.044 .804 1.298 .203 ipsas .501 .238 .344 2.107 .043 a. dependent variable: amp according to the above table 12, it can be seen that there is a significant impact of implementation of public sector accounting standards on public sector assets management practices in sri lanka. therefore h3 is accepted in this study. further public sector assets management can be improved through the effective and efficient implementation of the public sector accounting standards in sri lanka. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 92 table 13. group statistics working station n mean std. deviation std. error mean frp central government 24 3.1127 .43364 .08852 provincial government 10 3.2185 .34764 .10993 amp central government 24 2.6389 .78122 .15947 provincial government 10 3.0167 .43355 .13710 pfmp central government 24 3.3482 .53714 .10964 provincial government 10 3.5786 .31307 .09900 bpi central government 24 3.2202 .53780 .10978 provincial government 10 3.5571 .53218 .16829 ipsas central government 24 3.2176 .44351 .09053 provincial government 10 3.6167 .54650 .17282 current public sector accounting practices are high level in provincial government rather than central government. as well implementation of public sector accounting standard is high level in provincial government than central government of the sri lanka. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 93 table 14. independent samples test levene's test for equality of variances t-test for equality of means f sig. t df sig. (2tailed) frp equal variances assumed .853 .363 -.684 32 .499 equal variances not assumed -.750 20.999 .462 amp equal variances assumed 2.767 .106 -1.432 32 .162 equal variances not assumed -1.796 29.032 .083 pfmp equal variances assumed 2.971 .094 -1.263 32 .216 equal variances not assumed -1.559 28.084 .130 bpi equal variances assumed .029 .867 -1.669 32 .105 equal variances not assumed -1.677 17.079 .112 ipsas equal variances assumed .201 .657 -2.233 32 .033 equal variances not assumed -2.046 14.199 .060 according to the above table there is mean difference between perception of government accountant in provincial government and central government of the sri lanka. however there is no significant mean difference. therefore h4 is rejected in this study. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 94 conclusion today every country tries to adopt accrual basis accounting practices in public sector. there is a number of public sector accounting standards in the sri lanka. general treasury has a vital responsibility on public sector accounting practices and the implementation of public sector accounting standards in the sri lanka. according to the analysis of the study it can be seen that overall current public sector accounting practices and the implementation of public sector accounting standards are not in effective and efficient position based on the perception of government accountants. however current public sector accounting practices and the implementation of the public sector accounting standards are high level in provincial government rather than central government of the sri lanka. government accountants suggested that proper awareness and training on public sector accounting standard implementation will lead to effective and efficient usage of the standards and accrual basis adoption in the public sector. finally it can be concluded that current public sector accounting practices can be improved through the proper implementation of public sector accounting standards in the sri lanka. references andrew, g. (2010). contemporary public sector accounting research – an international comparison of journal papers. the british accounting review, 42, 75-87. https://doi.org/10.1016/j.bar.2010.02.006 annual report. (2017). ministry of finance sri lanka. retrieved from: http://www.treasury.gov.lk/web/guest/publications/annual-report. davor, v., & gorana, r. (2010). accounting system in croatian public healthcare organizations: an empirical analysis. theoretical and applied economics, 17, 37-58. retrieved from: https://www.researchgate.net/publication/46567511. financial regulations of the government of the democratic socialist republic of sri lanka. (1992). ministry of finance sri lanka. retrieved from: file:///e:/2019%20research/research%20on%20public%20sector/ps/lr/financialregulation-english.pdf. jane, b., & james, g. (2008). public sector to public services: 20 years of “contextual” accounting research. accounting, auditing & accountability journal, 21, 129-169. https://doi.org/10.1108/09513570810854383 jovanovič, t. (2015). public sector accounting in slovenia and croatia. hkju-ccpa, 15, 791814. retrieved from: file:///c:/users/pc/appdata/local/temp/jovanovic.pdf. rossana, g., adriana, f., roberta, l., & jorge, k. (2013). accrual basis accounting in the brazilian public sector: empirical research on the usefulness of accounting information. paper presented at the 12th usp congress of controllership and accounting. retrieved from: file:///c:/users/pc/appdata/local/temp/en_05.pdf. rozaidy, m., siti, n., rasid, m., & raman, n. (2017). accrual accounting in public sectors: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 95 possible contextual and application gaps for future research agenda. asian journal of finance & accounting, 9, 245-260. https://doi.org/10.5296/ajfa.v9i1.10968 salah, u., & mahfuzul, h. (2016). a literature review on public sector accounting research. the jahangirnagar journal of business studies, 5, 35-52. sri lanka public sector accounting standards. (2009). institute of chartered accountants sri lanka. retrieved from: file:///e:/2019%20research/research%20on%20public%20sector/ps/lr/publicsectoraccost d2009.pdf. sri lanka public sector accounting standards volume ii. (2012). institute of chartered accountants sri lanka. retrieved from: file:///e:/2019%20research/research%20on%20public%20sector/ps/lr/slpsasvolii.pdf microsoft word 11810-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 81 motivating capital investment by using the audit process to increase financial transparency j. reid cummings, d.b.a. (corresponding author) university of south alabama 5811 usa south drive, mcob 126, mobile, alabama 36688 e-mail: cummings@southalabama.edu gabriel g. ramirez, ph.d. kennesaw state university divesh s. sharma, ph.d. kennesaw state university kyre d. lahtinen, ph.d. university of south alabama received: sep. 5, 2017 accepted: march 10, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.11810 url: https://doi.org/10.5296/ajfa.v10i1.11810 abstract this study examines the relationship between reits’ uses of the audit process to increase financial transparency, and their ability to attract and/or maintain reasonable access to capital investment. we find that capital investment is positively and significantly associated with auditor quality, specialization, and reputation. after controlling for the effects of the 2007-2008 financial crisis, we find that when reits seek to attract new capital investment, using the audit process to increase financial transparency is just as important before the crisis as after it. these findings suggest that regardless of the economic conditions, auditor quality, specialization, and reputation add value. keywords: real estate investment trusts, financial transparency, auditor quality, auditor specialization, auditor reputation, capital investment asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 82 1. introduction united states federal law requires real estate investment trusts (reits) to distribute at least 90% of their net income to shareholders as dividends (scherrer, 2004). the resulting reduced cash flow constraint propels reits to access capital markets frequently. historically, reits’ have successfully done so, possibly due to investors’ views that reits present a safe way to invest in real estate (goebel & kim, 1989; goodman, 2000, 2003).(note 1) as lingering economic uncertainties hampered financial markets after the 2007-2008 financial crisis, raising new capital proved challenging for many firms. even though during the post-crisis period reits continued to offer attractive investment opportunities,(note 2) because many post-crisis real estate markets were in decline, attracting investors was challenging (basse, friedrich, & bea, 2009). therefore, because of the need for new capital, it was important that reits pursue strategies that worked to increase financial transparency so they could motivate new capital investment. the complexity of a firm’s capital structure decisions often increases because of information asymmetries between firm managers and potential investors (myers, 1984; titman & wessels, 1988). by decreasing information asymmetries, firms can increase their financial transparency; when they do so successfully, they are more likely to motivate new capital investment (beatty, 1989; carter & manaster, 1990). in the course of seeking new capital, the offering prospectus is a tool firms use to send signals of increased financial transparency to potential investors and lenders. by including information beyond that which is required by regulators, firms can reveal additional information about their intrinsic value, investment grade, and future prospects (deeds, decarolis, and coombs, 1997). by revealing extensive, detailed information about their auditor, and audit process, firms can effectively decrease information asymmetries and send signals about their increased financial transparency (danielsen, van ness, & warr, 2007; danielsen, harrison, van ness, & warr, 2009, 2014; datar, feltham, & hughes, 1991; feltham, hughes, & simunic, 1991; titman & trueman, 1986). for example, research shows that firms hire higher quality auditors, and often pay much higher audit fees to signal investors that their financial information is highly credible (datar, feltham, & hughes, 1991; titman & trueman, 1986). because investors interpret the signal to mean the auditor will be less likely to yield to management pressures to withhold or obfuscate negative information, they often view the firm as being more financially transparent. thus, in a sense, the firm is relying on the reputational capital of the higher quality, more expensive auditor to signal investors that they are more financially transparent (feltham, hughes, & simunic, 1991). if firms can successfully use the audit process to convey increased financial transparency, in doing so, logic dictates expectations of heightened access to capital investment. thus far, however, there has been no examination of whether increased transparency via the auditing process leads to better access to capital markets, or more importantly, whether it does so during periods of high capital market illiquidity caused by major financial system shocks. in this study, we examine the connection between reits’ uses of the audit-related attributes of auditor quality, auditor specialization, and auditor reputation to signal increased financial asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 83 transparency, and reits’ access to capital investment. this is an important issue because as reits must frequently access capital markets, they need strategies that enhance their efforts to motivate investment. moreover, for reits, this issue takes on added significance when volatile financial market conditions make accessing capital difficult. overall, we find that capital investment is positively and significantly associated with three commonly used audit-related attributes: auditor quality (captured by higher audit fees), auditor specialization (captured by industry-audit specialization), and auditor reputation (captured by the audit firm being a big 4 auditor). after controlling for the effects of the financial crisis, we find that when reits seek to attract new capital investment, using the audit process to increase financial transparency is just as important before the crisis as after it. the remainder of this paper proceeds as follows. the next section discusses existing research supporting using the audit process to convey increased financial transparency to investors. the third section presents hypotheses development. the fourth section describes dataset construction. the fifth section outlines the study’s research design and methodology. the sixth section presents results and analysis discussion. the last section offers concluding remarks. 2. literature review we base our examination on a wide-ranging, well-developed body of academic literature. drawing on economics, signaling theory provides the foundation for our study. guided by the finance literature, we include often-used measures to capture financial transparency, and information asymmetry and opacity. following the auditing and accounting literature, we use three audit-related attributes to proxy for reits’ efforts to increase transparency. finally, we take into account multiple reit-related regulatory, structural, investment, and operational characteristics rooted in the real estate literature. 2.1 information asymmetry, financial transparency signaling, liquidity, and the audit process although providing financial information can reduce information asymmetries between firms and prospective investors and lenders, to be effective, it must also be transparent (bushman & smith, 2001, 2003; diamond & verrecchia, 1991; fama & jensen, 1983). to view financial information as transparent, the receiver must believe that both the information itself and its sender are credible (spence, 1973). financial transparency is important to investors, and researchers show that firms successfully increase their liquidity by becoming more financially transparent when seeking new capital investment (cohen, krishnamoorthy, & wright, 2002; danielsen et al., 2014; karamanou & vafeas, 2005). francis, lys, and vincent (2004) find that reits typically experience more favorable investor reaction than other types of firms when issuing securities, and that signaling plays a significant role in the way investors react to such offerings. hence, signaling is important to firms seeking to reduce information asymmetries and increase financial transparency because doing so enhances their abilities to attract investment. for firms such as reits that must access capital often to maintain their liquidity, successfully signaling financial transparency can often prove to be critical. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 84 when raising capital, firms can use the audit process to signal investors about their reduced information asymmetry and increased financial transparency (healy & palepu, 2001). firms can signal their financial transparency, and by extension, their credibility, by providing highly accurate and reliable audited financial statements (hope, thomas, & vyas, 2009). to be credible, signals must be costly and difficult to replicate (spence, 1973). three audit process attributes investors use to evaluate a firm’s financial transparency are hiring high quality auditors (costs associated with higher audit fees), audit industry specialists (costs associated with industry audit specialization), and audit firms with superior reputations (costs associated with big 4 audit firm status) (datar et al., 1991; titman & trueman, 1986). 2.2financial transparency and auditor quality numerous studies use audit fees to signal financial transparency. danielsen et al. (2009) examine which firms are most likely to benefit from a higher priced audit. they find that firms that signal greater financial transparency through heavier investment in audit services reduce their capital costs when offering seasoned equity issues. beatty (1989) finds that firms who pay a premium for audit services have lower initial returns after going public, which suggests that firms willing to pay more for audit services do so to send investors signals of increased financial transparency. higgs and skantz (2006) conclude that investors interpret high audit fees as signals of a firm’s commitment to high earnings quality. hay and davis (2002) find that firms seeking higher quality audits do so for signaling reasons. peel and roberts (2003) find that small firms willingly hire higher priced audit firms to send signals of operations and earnings quality to investors. danielson et al., (2009), suggest that because reits can derive benefits from hiring high quality auditors, doing so to convey financial transparency can be an important aspect of reits’ capital structure mechanisms. it seems logical, therefore, that if using vigorous audit services “can improve liquidity for any firm, it seems especially likely to do so for reits” (danielsen et al., 2009, p. 517). 2.3financial transparency and auditor specialization reit audits are complex, partly because they operate in a highly regulated environment, and partly because the majority of their assets are valuation driven. equity reits hold independent, self-contained property investments, each with their own sources and uses of funds, and each with their own varying degrees of risk. these may be difficult for the auditor to understand or value (danielsen et al., 2009; friday & sirmans, 1998). because mortgage reits hold myriad commercial mortgage-backed securities, real estate mortgage notes, and other types of real estate credit facilities, without a thorough understanding of the specific risks associated with each instrument within the portfolio, auditing a mortgage reit might prove difficult. reits can signal investors about their efforts to increase financial transparency by hiring reit industry-audit specialists. hiring an auditor with industry specialization is likely to play an important role in conveying financial transparency to the markets, especially when the auditee presents a complex audit (abdolmohammadi, searfoss, & shanteau, 2004). choosing to specialize in a particular industry is not a decision that audit firms take lightly, as doing so requires committing substantial amounts of time and money to train audit personnel on the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 85 workings of a particular industry (lim & tan, 2010). because of the auditor’s advanced knowledge about the specific nature of an auditee’s industry, it is less likely its managers will deceive or mislead the auditor (solomon, shields, & whittington, 1999). equally important is that precisely because of the audit firm’s industry specialization, safeguarding its reputational capital is also an important incentive for the auditor to perform quality audits (watts & zimmerman, 1983). investors understand industry-audit specialists have more to lose. because they value the significance of an audit firm’s commitment to becoming an industry specialist, they also realize that firms often hire industry-audit specialists to improve their disclosures (dunn & mayhew, 2004), thereby enhancing their transparency. 2.4financial transparency and auditor reputation auditor reputation is often associated with auditor size, because larger audit firms have more resources and can provide higher quality audits than smaller audit firms can (deangelo, 1981). simunic and stein (1987), beatty (1989), and chan, ezzamel, and gwilliam (1993) show that large audit firms charge higher audit fees than their smaller competitors because of the demand for their higher quality services, generally driven by their higher audit quality reputation. audit firm size and reputation are also likely to convey information about the financial transparency of the auditee. because hiring auditors with higher quality reputations is costly, firms often do so as a way of signaling increased financial transparency to investors (titman and trueman, 1986; feltham et al., 1991). when firms hire auditors with higher quality reputations (such as big 4 firms), they also benefit from the reputational quality of the audit firm (danielson et al., 2007). when information asymmetry is high, such as when a firm is preparing to issue equity for the first time, firms are more likely to engage a larger audit firm (e.g. big 4 auditor) to signal financial transparency. balvers et al. (1988) and firth and smith (1992) find that firms experience less initial public offering underpricing when they hire larger audit firms. as investors’ perceptions of higher quality auditor reputation add credibility to the audit process and enhance financial transparency, it is more likely that investors will view firms that hire auditors with higher quality reputations more favorably than those that do not. 2.5 reits’ capital access and the financial crisis reits operate in a highly regulated environment. even the simplest of reits are complex in structure, owning and operating their assets through a vast network of subsidiaries, partnerships, and joint venture arrangements. because of their multifaceted nature, reits routinely face persistent and difficult challenges of minimizing information asymmetries between themselves and investors. financial market volatility after the crisis exacerbated these difficulties (hardin & wu, 2010). because of their frequent need for capital investment, after the crisis it was especially critical for reits to find ways to meet and overcome these challenges. by hiring higher quality auditors, industry-audit specialists, and/or auditors with superior reputations, reits could take steps designed to reduce information asymmetries, and, more importantly, send clear financial transparency signals to investors in order to motivate new capital investment. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 86 3. methodology exogenous events such as the financial crisis can shock and disrupt capital markets. as many investors respond to such shocks by moving money from equities and corporate debt into safer investments such as government debt and cash, often the result is substantially increased capital market illiquidity. the severity of the financial crisis’ shock to the financial system, and the ensuing post-crisis market conditions caused major problems for many firms needing to raise new capital. after the crisis, values in many real estate market values were declining and investors were generally shying away from real estate investments (delisle, 2007, 2008). thus, for reits, attracting new capital in such an environment was likely quite difficult. 3.1 hypothesis development earlier, we highlight several studies that examine the different ways firms signal financial transparency to investors to attract new capital investment. in this study, we use a two-part approach to examine the relationship between reits’ use of the audit process to signal increased financial transparency and their access to new capital. in the first part of the analysis, we examine the relationship between reits’ use of the audit process and their access to new capital, posited by the following hypothesis: hypothesis 1:there is a positive association between the audit process and (a) equity investment in reits, (b) debt investment in reits; and (c) combined equity and debt investment in reits. in the second part of the analysis, we examine the relationship between reits’ use of the audit process and their access to new capital, accounting for possible mediating effects of the financial crisis, posited by the following hypothesis: hypothesis 2: the financial crisis of 2007-2008 positively influenced the relationship between the audit process and (a) equity investment in reits, (b) debt investment in reits, and (c) combined equity and debt investment in reits. 3.2 data selection and sample construction after compiling a list of publicly traded reits that operated at some point during the period 2002-2011, we reduce the sample to include only those reits that operated in and elected reit status for each year during the study period. (note 3) we then review each reit’s annual report to determine the total number of subsidiaries owned or operated, and properties owned or controlled, respectively.(note 4) we collect financialand audit-related information from the center for research and security prices (crsp), compustat, and audit analytics databases. (note 5) because crsp, compustat, and audit analytics databases do not have a common identifier, we hand match all necessary reits’ financial, accounting, audit, and other firm-specific data to construct the final data sample comprised of 98 publicly traded reits. because 27 of the 980 firm year observations had missing items, the final dataset includes 953 firm year observations. table 1 below lists and describes the variables used in the analysis. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 87 table 1. description of variables variable variable description log(equity investment) natural log of (proceeds from common and preferred stock issuance + 1)1 log(debt investment) natural log of (proceeds from debt issuance + 1)1 log(equity & debt investment) total value of log(equity investment) and log(debt investment) as defined above log(audit fees) natural log of (total audit fees + 1)2 specialist a dummy variable taking the value of 1 if the auditor employed by an individual reit performs more than 30% of all reit audits in the sample, and 0 otherwise3 big 4 auditor a dummy variable taking the value of 1 if the auditor ranks as a big 4 audit firm, and 0 otherwise4 bid-ask spread the standard deviation of the mean annual bid-ask spread log(intan. assets) natural log of (intangible assets + 1) book-to-market computed as book value divided by market value return on assets net annual income1 divided by total assets leverage total assets divided by total liabilities initial a dummy variable taking the value of 1 if an individual reit's audit firm is in either the first or second year of engagement, and 0 otherwise3 log(other fees) natural log of (all non-audit fees = income tax preparation services + information systems consulting + benefits administration + other non-audit fees + 1)2 log(properties) the natural log of (total number of properties owned or controlled by the individual reits or their respective subsidiaries as reported in their annual 10-k report + 1)5 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 88 log(subsidiaries) the natural log of (total number of subsidiaries owned or controlled by the individual reits or their respective subsidiaries as reported in their annual 10-k report + 1)5 foreign a dummy variable taking the value of 1 if an individual reit has operations outside of the united states as reported in crsp/compustat database, and 0 otherwise extra/disc items a dummy variable taking the value of 1 if an individual reit has extraordinary items and/or discontinued operations as reported in the crsp/compustat database, and 0 otherwise reit type a dummy variable taking the value of 1 if an individual reit is y-type, and 0 otherwise6 notes:1log values computed on values reported in the compustat database. 2log values computed on values reported in the audit analytics database. 3specific reit audit and auditor information reported in the audit analytics database. 4the group of audit firms currently known as the “big 4” includes pricewaterhousecoopers, deloitte & touche, ernst & young, and kpmg, ranked "1" through "4" based on annual revenues, respectively, as reported at http://www.big4.com. 5specific, individual reit 10-k annual reports accessed at http://www.sec.gov.6reit type indicates type of reit industry classification including multifamily, manufacturing, healthcare, shopping center, freestanding, regional mall, lodging/resort, diversified, office, industrial, office/industrial mixed, self-storage, commercial mortgage, and residential mortgage. as shown in table 2 below, 17.35% of the reits in the sample hold a diversified portfolio of properties. there are 11 multifamily and 11 residential reits, accounting for 22.44% of the sample. office, healthcare, and lodging and resort reits comprise 27.6% of the sample with nine properties each. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 89 table 2. reit-type distributions reit specialization reit type # of reits in sample % of reits in sample diversified portfolio of properties equity 17 17.35% multifamily residential properties equity 11 11.22% retail shopping center properties equity 11 11.22% office properties equity 9 9.18% healthcare properties equity 9 9.18% lodging & resort properties equity 9 9.18% retail regional mall properties equity 6 6.12% residential mortgage investments mortgage 6 6.12% office & industrial properties equity 5 5.10% freestanding single-tenant properties equity 4 4.08% industrial properties equity 4 4.08% residential manufactured home properties equity 3 3.06% commercial mortgage investments mortgage 3 3.06% self-storage & mini-warehouse properties equity 1 1.02% totals 98 100.00% notes:98 reits maintained reit status during the entire sample period of 2002-2011 as confirmed in specific, individual reit 10-k annual reports. table 3 below presents selected financial data for the reits in the sample. total assets and liabilities average $4.19 and $2.83 billion, respectively, while average stockholder equity and long-term debt are $1.25 and $1.85 billion, respectively. on average, reits have net income of $89.73 million, on annual revenues of $581.79 million. mean equity investment in reits is $133.28 million, while debt investment averages $2.47 billion. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 90 table 3. selected reit summary statistics variable n mean std. dev. 25th median 75th total assets 953 4191.31 6981.59 999.01 2252.66 4749.60 intangible assets 953 51.73 245.25 0.00 0.00 11.90 total liabilities 953 2829.91 5725.35 521.51 1408.01 2993.72 long term debt 953 1854.77 2572.82 327.08 1047.55 2206.24 annual revenues 953 581.79 888.24 137.81 298.01 642.39 earnings before interest & taxes 953 190.09 315.80 45.44 103.90 226.28 net income 953 89.73 219.60 12.09 45.56 128.61 stockholder equity 953 1253.45 1615.30 302.20 774.85 1538.09 equity investment1 953 133.28 314.73 1.16 32.63 158.19 debt investment1 953 2465.17 4998.52 453.69 1248.33 2557.69 equity & debt investment1 953 2598.26 5196.16 487.60 1354.85 2719.49 audit fees2 953 895.94 976.44 341.35 666.85 1060.50 other fees2 953 420.02 885.92 47.00 159.55 378.76 properties3 953 245.79 369.18 32.00 111.00 273.00 subsidiaries3 953 137.12 284.99 14.00 45.00 147.00 notes: all information is for the entire sample period of 2002-2011. audit fees and other fees expressed in $0,000’s; all other financial data presented in $0,000,000’s. 1financial data are as reported in the crsp/compustat databases. 2audit and other fees are as reported in the audit analytics database. 3properties and subsidiaries information are as reported in each of the reits' annual reports available at http://www.sec.gov. 3.3 research design and methodology in our examination of the relationship between reits’ use of the audit process to signal asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 91 financial transparency and their access to capital investment, the outcome of interest is capital investment, for which we proxy by using three investment measures: equity, debt, and combined equity and debt investment. we incorporate the audit-related attributes of auditor quality and auditor reputation (following danielson et al., 2009), with auditor specialization to capture audit process transparency. in the first part of the analysis, the study period is much broader, covering the years of 2002-2011. in the second part of the analysis, we gauge the impact of the financial crisis. 3.3.1 empirical model – part 1 in addition to the variables we use to capture the transparency dimension as detailed below, we include three additional vectors of variables to capture the dimensions of firm characteristics, auditor relationship, and reit complexity. we also use a number of dummy variables to control for effects related to specific reit-types and/or changes across time. the empirical model for the first part of the analysis takes the following form: capital investment = ᶂ {transparency, firm characteristics, auditor relationship, reit complexity}. (1) 3.3.2 transparency vector earlier, we mention research findings that firms often pay higher audit fees to hire higher quality auditors to signal investors that their financial information is highly credible (datar, feltham, & hughes, 1991; titman & trueman, 1986). therefore, the central piece of the investigation centers on transparency. to proxy for auditor quality, we use the variable log(audit fees),(note 6) which is the natural log of the sum of one and audit fees.(note 7) to capture auditor specialization, we use the variable specialist,(note 8) a dummy variable that takes the value of one if the auditing firm has performed audits on more than 30% of the audits in the entire sample in each year, and zero otherwise. finally, to proxy for auditor reputation, we use the variable big 4 auditor, (note 9) a dummy variable that takes the value of one if the auditor ranks as one of the big 4 audit firms, and zero otherwise. table 4 below presents the reit auditors contained in the sample, as well as number of audits performed, percentage of reit audits performed, and fees paid to the auditors. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 92 table 4. reit auditors. reit auditor name reit auditor rank # reit audits % of reit audits total reit audit fees ($,000s) average per-audit fees ($,000s) ernst & young 1 317 33.37% 361,702 1,141 kpmg 2 168 17.86% 133,336 794 pricewaterhousecoopers 3 163 17.04% 139,498 856 deloitte & touche 4 118 12.04% 128,541 1,089 bdo usa 5 69 7.04% 42,508 616 grant thornton 6 43 5.00% 29,249 680 pkf o’connor davies 7 14 1.43% 3,077 220 reznick group 8 14 1.43% 1,736 124 berenfeld spritzer shechter & sheer 9 8 0.82% 667 83 swalm & associates 10 8 0.82% 451 56 mcgladrey & pullen 11 7 0.71% 1,662 237 burr pilger mayer 12 6 0.61% 1,690 282 calvetti ferguson & wagner 13 5 0.51% 7,286 1,457 moss adams 14 5 0.51% 653 131 donaldson holman & west 15 2 0.20% 1,402 701 epstein weber & conover 16 2 0.20% 154 77 moore stephens 17 1 0.10% 79 79 cherry bekaert & holland 18 1 0.10% 77 77 brady martz & associates 19 1 0.10% 51 51 farmer fuqua & huff 20 1 0.10% 10 10 totals 953 100.00% 853,829 896 notes:reit auditor rank ranked first by the number of reit audits performed and then by the total audit fees for reit auditsas reported in audit analytics database. previously, we discuss the association between information asymmetry, financial transparency, and the bid-ask spread. researchers frequently use bid-ask spread as an indicator of transparency (bagehot, 1971; demsetz, 1968). intangible assets are difficult to asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 93 define or value, aggravated by the fact that firms often choose not to reveal certain information that they view as proprietary. researchers commonly use intangible assets to proxy for information asymmetry or opacity. therefore, we include two additional variables within the transparency vector: bid-ask spread, which we construct using the standard deviation of the mean annual bid-ask spread of each reit’s stock price; and log(intang assets), which is the natural log of the sum of one and the total value of each reit’s intangible assets.(note 10) 3.3.3 firm characteristics vector within the sample, reits vary by type, size, and industry focus. to capture and control for the differences between them, we use variables within the firm characteristics vector. first in the group is book-to-market, which we calculate by dividing book value (total assets minus total liabilities and total intangible assets) by market value (common shares outstanding at year’s end multiplied by share price at year’s end). the second variable is return-on-assets, the result of dividing net income by total assets. rounding out the firm characteristics vector is leverage, which we compute by dividing total liabilities by total assets. 3.3.4 auditor relationship vector in addition to the three audit-related attributes of auditor quality, specialization, and reputation, we also use a vector of two additional observable variables to control for other aspects of the relationship between the audit firm and its client. investors understand that over time auditors gain significant understanding about the nature of their clients’ business operations (aicpa, 1978; bells, marrs, solomon, & thomas, 1997), and numerous researchers find a positive association between auditor tenure and audit quality (geiger & raghunanandan, 2002; johnson, khurana & reynolds, 2002; myers, myers, & omer, 2003; mansi, maxwell, & miller, 2004). to control for the possible learning curve facing a new auditor, in the auditor relationship vector we include initial, a dummy variable taking the value of one if the current auditor is in either the first or second year of engagement, and zero otherwise. audit firms commonly provide clients with non-audit services such as tax preparation, risk management, and pension plan administration consulting services. fees for these types of services can often exceed those paid for audits. some researchers theorize that audit firms price audit services somewhat as a ‘loss-leader’ in order to gain a foothold in to a firm, thus paving the way for the provision of more profitable ‘non-audit’ services (antle, gordon, narayanamoorthy, & zhou, 2006; knechel & sharma 2012). even so, regulators have long had concerns about the relationship between an auditor and its client, and the relationship’s impact on firm transparency. in 2001, the u.s. securities and exchange commission began requiring full disclosure of audit and non-audit fees amidst concerns over firm transparency, audit and non-audit fees, and auditor independence (danielson et al., 2009). less than two years later, the u.s. congress went even further when they passed the sarbanes-oxley act of 2002, which established stringent new standards designed to enhance auditor independence and limit conflicts of interest (naiker, sharma, & sharma, 2013). because the rationale is that high non-audit fees weaken auditor independence, and hence, by asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 94 extension, reduce audit quality, non-audit fees can influence investors’ perceptions of firm transparency. although the research in this paper does not specifically explore the impact of non-audit fees, we include the variable log(other fees), the natural log of the sum of non-audit fees and one, (note 11) to control for the impact of non-audit fees. 3.3.5 reit complexity vector as we discuss earlier, auditing reits is often a complex process, partly because reits operate in a highly regulated environment, and partly because of the means used to value investments within their portfolios. we include a number of observable variables within the reit complexity vector to capture the complex asset types and/or corporate structures associated with the reits within the sample. the variables we use include log(subsidiaries), the natural log of the sum of one and the total number of subsidiaries owned or controlled by the reit; (note 12) log(properties), the natural log of the sum of one and the total number of properties owned or controlled by the reit or one of its subsidiaries;(note 13) foreign, a dummy variable taking the value of one if the reit conducts business outside of the united states, and zero otherwise; and extra/disc items, a dummy variable taking the value of one if the reit has extraordinary items or discontinued operations, and zero otherwise.within the sample, there are 12 different equity reits and 2 different mortgage reits, so for robustness, we also use dummy variables to control for each of the different reit-types. 3.3.6 testable equation for hypotheses 1-3 to test each of hypotheses 1-3, we conduct four separate estimations. in the first three estimations, we individually test each of the audit-related attributes. in the fourth estimation, we combine all attributes together. we do this to account for any potential collinearity problems that may occur from grouping all variables within the same model. again, using data from all reits during the entire sample period, the outcome of interest is capital investment, which we capture using equity, debt, and combined equity and debt investment, using the testable form of equation (1) as follows: capital investment =β0+β1∙log(audit fees)+β2∙specialist + β3∙big 4 auditor +β4∙bid-ask spread + β5∙log(intan assets) + β6∙book-to-market + β7∙return-on-assets + β8∙leverage+β9∙initial+β10∙log(otherfees)+β11∙log(properties) + β12∙log(subsidiaries) + β13∙foreign + β14∙extra/disc items + β15-26∙reit type + ε. (2) 3.3.7empirical model – part 2 thus far, the research question examines the relationship between reits’ use of the audit process as a means to convey increased financial transparency and access to capital investment. in the second part of the analysis, we consider the impact of the financial crisis. after adding a fifth vector, financial crisis, the extended empirical model takes the following form: capital investment = ᶂ {transparency, firm characteristics, auditor relationship, reit complexity, financial crisis}. (3) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 95 3.3.8 financial crisis vector using the model shown in the form of equation (2), we add additional variables within the financial crisis vector to investigate the interactive effects between the crisis and each of the audit-related attributes. the first variable added is crisis, a dummy variable that takes the value of one for the period 2008-2011, and zero for the period 2002-2007. we also add three interaction terms. first, we use crisis*log(audit fees), which captures the interaction between crisis and log(audit fees), to measure whether or not the relationship between audit fees and capital investment is affected by the financial crisis. second, we use crisis*specialist, which captures the interaction between crisis and specialist, to measure whether or not the relationship between industry-audit specialist and capital investment is affected by the financial crisis. third, we use crisis*big 4 auditor, which captures the interaction between crisis and big 4 auditor, to measure whether or not the relationship between big 4 auditor and capital investment is affected by the financial crisis. the testable form of equation (3) is as follows: capital investment = β0 + β1∙crisis + β2∙log(audit fees) + β3∙crisis*log(audit fees) + β4∙specialist + β5∙crisis*specialist + β6∙big 4 auditor + β7∙crisis*big 4 auditor + β8∙bid-ask spread + β9∙log(intan assets) + β10∙book-to-market + β11∙return-on-assets + β12∙leverage + β13∙initial + β14∙log(other fees) + β15∙log(properties) + β16∙log(subsidiaries) + β17∙foreign+ β18∙extra/disc items + β19-30∙reit type + ε. (4) we test each hypothesis using robust regression estimations. we also account for the possibility of any firmor time-related invariant characteristics affecting the reits within the sample. for example, a diversified reit that invests in different types of properties, such as regional shopping malls, office properties, or timberland, may have entirely different factors affecting their abilities to raise capital, than for example, a reit that only invests in one type of property. likewise, as business cycles change over time, it is possible that a reit that invests strictly in one property type, for example retail properties, may experience different investor responses when seeking equity as opposed to another type of reit. this may be due to one particular property sector falling out of favor as an investment, or having trouble at one point in time versus other types of reits in the same period. therefore, in addition to using dummy variables for each firm year to account for changes over time, we also use dummies to control for the different types of reits within the sample. 4. results and discussion 4.1 descriptive statistics table 3 referenced above shows that on average, reits issue $133 million in equity and $2,465 million in debt annually, for a combined annual total of $2,598 million. audit fees and non-audit fees average $895,938 thousand and $420,018 thousand, respectively. reits in the sample own an average of 246 properties, and have 137 subsidiaries. table 5 below presents descriptive statistics for all variables that we use in the regression analyses. more than a third of the firms in the sample use a reit industry-audit specialist, nearly all use a big 4 auditor, and close to 20% of auditors are in their first or second year of engagement. only a fraction asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 96 of reits conducts foreign operations. slightly more than half of the audits report either an extraordinary item (a net income adjustment made due to an unusual or infrequent occurrence, such as a loss due to a hurricane), or a discontinued operation (a net income adjustment made because a portion of a company’s operation is discontinued, such as due to the sale of an asset). table 5. descriptive statistics: dependent & independent variables variable n mean std. dev. 25th median 75th log(equity investment) 953 3.132471 2.217645 0.77 3.52 5.07 log(debt investment) 953 6.792827 1.707107 6.12 7.13 7.85 log(equity & debt investment) 953 6.880828 1.680798 6.19 7.21 7.91 log(audit fees) 953 13.28539 0.9523914 12.74 13.41 13.87 specialist 953 0.3326338 0.471404 0.00 0.00 1.00 big 4 auditor 953 0.9223505 0.2677598 1.00 1.00 1.00 bid-ask spread 953 0.0043952 0.00625 0.00 0.00 0.00 log(intangible assets) 953 1.351846 1.936908 0.00 0.00 2.56 book-to-market ratio 953 0.5723122 2.181254 0.35 0.52 0.72 return on assets 953 0.0263103 0.0562677 0.01 0.03 0.05 leverage 953 0.6018785 0.1928988 0.50 0.59 0.70 initial 953 0.1867786 0.3899383 0.00 0.00 0.00 log(other fees) 953 11.27902 3.13359 10.76 11.98 12.84 log(properties) 953 4.258593 2.04574 3.50 4.72 5.61 log(subsidiaries) 953 3.805615 1.611061 2.71 3.83 5.00 foreign 953 0.0209864 0.1434138 0.00 0.00 0.00 extra.& disc. items 953 0.5299056 0.4993669 0.00 1.00 1.00 notes: the table above presents descriptive statistics for the variables used in the regressions (except for reit-type and year dummies). 4.2 results of hypothesis testing in the initial empirical analysis, we test hypotheses 1. we expect to find a positive relationship between the audit process and equity, debt, and combined equity and debt capital investment in reits, respectively. positive and significant coefficients for individual audit-related attributes would indicate support for the hypotheses with respect to each attribute. in the extended empirical analysis, we test hypotheses 2. we expect to find that capital investment is lower for all reits after the financial crisis because of the significant asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 97 drop in financial markets activity after the crisis. negative and significant coefficients for the financial crisis dummy would confirm this expectation. we also expect to find that after the crisis, reits that utilize the audit process to increase financial transparency would experience greater equity, debt, and combined equity and debt capital investment than reits that did not do so. positive and significant coefficients for the interaction terms will confirm these expectations, and allow interpretation of the main effects of the individual audit-related attributes. 4.2.1 hypothesis 1 results table 6 below shows the results for testing hypothesis 1(a) that there is a positive association between the audit process and equity investment in reits. in models 1a and 1b, the coefficients for log(audit fees) and specialist are positive and significant (log(audit fees), β = 0.421 and specialist, β = 0.358, respectively). model 1d yields similar results (log(audit fees), β = 0.409 and specialist, β = 0.278, respectively). these results provide partial support for the hypothesis, suggesting that investors view reits that either pay higher audit fees or engage industry-audit specialists as more transparent, and are willing to provide equity investment. table 6. results of ols regression testing the expectation of a positive association between audit-related attributes and equity investment in reits variable model 1a model 1b model 1c model 1d coefficient coefficient coefficient coefficient [t-statistic] [t-statistic] [t-statistic] [t-statistic] log(audit fees) 0.421*** 0.409*** [3.701] [3.341] specialist 0.358** 0.278* [2.383] [1.841] big 4 auditor 0.155 -0.218 [0.620] [-0.794] bid-ask spread -71.044*** -84.971*** -83.848*** -74.153*** [-6.059] [-7.530] [-6.619] [-5.950] log(intan. assets) 0.082* 0.111** 0.110** 0.084* [1.896] [2.526] [2.515] [1.916] book-to-market 0.064*** 0.062*** 0.058*** 0.067*** [3.353] [3.301] [3.185] [3.434] return on assets -0.496 -0.762 -0.696 -0.576 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 98 [-0.472] [-0.716] [-0.668] [-0.535] leverage -0.331 -0.096 -0.084 -0.313 [-0.753] [-0.222] [-0.191] [-0.713] initial auditor year 0.058 0.036 0.038 0.044 [0.331] [0.206] [0.215] [0.247] log(other fees) 0.050** 0.066*** 0.071*** 0.048* [2.002] [2.789] [2.938] [1.920] log(properties) 0.208*** 0.208*** 0.233*** 0.191*** [4.029] [3.901] [4.419] [3.651] log(subsidiaries) 0.106* 0.192*** 0.171*** 0.126** [1.774] [3.444] [3.027] [2.114] foreign operations -0.704 -0.436 -0.355 -0.759 [-1.321] [-0.797] [-0.667] [-1.391] extra/disc items -0.011 0.064 0.043 0.010 [-0.082] [0.456] [0.301] [0.071] constant -2.029 2.474*** 2.484*** -1.811 [-1.517] [4.789] [4.441] [-1.331] # observations 953 953 953 953 f 17.759 16.396 16.651 17.103 adjusted r2 0.261 0.255 0.250 0.263 notes: in all models, the dependent variable is log(equity investment), with the model variation being the respective inclusion or exclusion of log(audit fees), specialist, and big 4 auditor. bid-ask spread is an often-used measure to capture transparency. log(intan. assets) captures firm's level of information asymmetry or opacity.book-to-market, return on assets, and leverage capture individual reit firm characteristics. initial and log(other fees) capture individual reit-auditor relationships. log(properties), log(subsidiaries), foreign, and extra/disc items capture firm complexity. reit type and year dummies not reported. regression estimations are robust and statistical significance shown as: * p < 0.05, ** p < 0.01, *** p < 0.001, respectively. table 7 below shows the results for testing hypothesis 1(b) that there is a positive association between the audit process and debt investment in reits. results show stronger, albeit still partial support for the hypothesis. in models 2a, 2b, and 2c, the coefficients for each of the audit-related attributes are positive and significant (log(audit fees), β = 0.697; specialist, β = 0.368; and, big 4 auditor, β = 0.454, respectively), while in model 2d, only the coefficients asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 99 for log(audit fees) and specialist are positive and significant (β = 0.679 and β = 0.218, respectively). when viewed independently of each other, these results suggest that investors are willing to invest in reit debt when reits increase their financial transparency (as captured by higher audit fees or hiring industry-audit specialists or hiring auditors with higher reputations). table 7. results of ols regression testing the expectation of a positive association between audit-related attributes and debt investment in reits variable model 2a model 2b model 2c model 2d coefficient coefficient coefficient coefficient [t-statistic] [t-statistic] [t-statistic] [t-statistic] log(audit fees) 0.697*** 0.679*** [10.701] [9.740] specialist 0.368*** 0.218*** [5.412] [3.344] big 4 auditor 0.454*** -0.104 [3.860] [-0.929] bid-ask spread -45.816*** -69.949*** -63.406*** -47.313*** [-6.644] [-9.230] [-8.171] [-6.795] log(intan. assets) 0.028 0.074*** 0.072*** 0.029 [1.263] [3.253] [3.186] [1.327] book-to-market 0.071*** 0.064*** 0.061*** 0.073*** [4.487] [4.513] [4.294] [4.550] return on assets 0.741 0.321 0.454 0.690 [1.529] [0.629] [0.900] [1.405] leverage 3.946*** 4.362*** 4.317*** 3.952*** [13.367] [13.911] [13.628] [13.382] initial auditor year 0.080 0.035 0.070 0.076 [1.077] [0.433] [0.845] [1.000] log(other fees) 0.002 0.032*** 0.035*** 0.000 [0.246] [3.547] [3.765] [0.037] log(properties) 0.251*** 0.267*** 0.290*** 0.237*** [5.611] [5.677] [6.193] [5.278] asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 100 log(subsidiaries) 0.064** 0.195*** 0.168*** 0.080** [2.011] [5.677] [4.866] [2.464] foreign operations -0.310 0.183 0.271 -0.345 [-1.219] [0.608] [1.018] [-1.263] extra/disc items 0.178** 0.293*** 0.261*** 0.194*** [2.457] [3.835] [3.370] [2.692] constant -4.079*** 3.477*** 3.209*** -3.884*** [-4.728] [9.261] [8.132] [-4.427] # observations 953 953 953 953 f 79.981 60.441 61.604 79.313 adjusted r2 0.713 0.670 0.665 0.715 notes: in all models, the dependent variable is log(debt investment), with the model variation being the respective inclusion or exclusion of log(audit fees), specialist, and big 4 auditor. bid-ask spread is an often-used measure to capture transparency. log(intan. assets) captures firm's level of information asymmetry or opacity.book-to-market, return on assets, and leverage capture individual reit firm characteristics. initial and log(other fees) capture individual reit-auditor relationships. log(properties), log(subsidiaries), foreign, and extra/disc items capture firm complexity. reit type and year dummies not reported. regression estimations are robust and statistical significance shown as: * p < 0.05, ** p < 0.01, *** p < 0.001, respectively. table 8 below shows the results of testing hypothesis 1(c) that there is a positive association between the audit process and combined equity and debt investment in reits. in models 3a, 3b, and 3c, the coefficients for log(audit fees), specialist, and big 4 auditor are all positive and significant (β = 0.693, β = 0.384, and β = 0.497, respectively). however, in model 3d, only the coefficients for log(audit fees) and specialist are positive and significant (β = 0.668 and β = 0.234, respectively). these results suggest that investors are willing to invest in reit equity and debt when reits increase their financial transparency (either as captured by higher audit fees, hiring industry-audit specialists, or hiring auditors with higher reputations). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 101 table 8. results of ols regression testing the expectation of a positive association between audit-related attributes and combined equity and debt investment in reits variable model 3a model 3b model 3c model 3d coefficient coefficient coefficient coefficient [t-statistic] [t-statistic] [t-statistic] [t-statistic] log(audit fees) 0.693*** 0.668*** [10.499] [9.447] specialist 0.384*** 0.234*** [5.613] [3.541] big 4 auditor 0.497*** -0.057 [4.228] [-0.501] bid-ask spread -48.196*** -72.102*** -64.863*** -49.043*** [-6.971] [-9.466] [-8.317] [-7.003] log(intan. assets) 0.032 0.078*** 0.076*** 0.034 [1.457] [3.430] [3.361] [1.540] book-to-market 0.062*** 0.056*** 0.053*** 0.064*** [4.249] [4.175] [3.935] [4.322] return on assets 0.484 0.065 0.209 0.438 [0.959] [0.121] [0.404] [0.846] leverage 3.468*** 3.879*** 3.828*** 3.468*** [11.731] [12.393] [12.124] [11.722] initial auditor year 0.079 0.035 0.075 0.081 [1.057] [0.436] [0.893] [1.051] log(other fees) 0.008 0.038*** 0.041*** 0.006 [0.883] [4.091] [4.268] [0.699] log(properties) 0.244*** 0.258*** 0.282*** 0.228*** [5.404] [5.449] [5.986] [5.0370] log(subsidiaries) 0.074** 0.205*** 0.177*** 0.091*** [2.305] [5.954] [5.099] [2.781] foreign operations -0.388 0.098 0.191 -0.420 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 102 [-1.561] [0.331] [0.734] [-1.565] extra/disc items 0.138* 0.253*** 0.218*** 0.154** [1.885] [3.291] [2.812] [2.117] constant -3.670*** 3.834*** 3.533*** -3.443*** [-4.203] [10.082] [8.875] [-3.876] # observations 953 953 953 953 f 75.038 57.086 58.786 74.847 adjusted r2 0.700 0.657 0.652 0.702 notes: in all models, the dependent variable is log(equity & debt investment), with the model variation being the respective inclusion or exclusion of log(audit fees), specialist, and big 4 auditor. bid-ask spread is an often-used measure to capture transparency. log(intan.assets) captures firm's level of information asymmetry or opacity.book-to-market, return on assets, and leverage capture individual reit firm characteristics. initial and log(other fees) capture individual reit-auditor relationships. log(properties), log(subsidiaries), foreign, and extra/disc items capture firm complexity. reit type and year dummies not reported. regression estimations are robust and statistical significance shown as: * p < 0.05, ** p < 0.01, *** p < 0.001, respectively. 4.2.2 hypothesis 2 results table 9 below shows the results for testing hypothesis 2(a) that the financial crisis positively influenced the relationship between the audit process and equity investment in reits. as stated earlier, the financial crisis caused major disruptions in the capital markets, resulting in capital flight, and conditions of severe illiquidity. therefore, we expect to find that there was less equity investment for all reits post crisis. thus, an important question is how reits differentiate themselves from others seeking capital under such restricted market conditions. across all models, there is no statistical significance for crisis. this result provides no support for our expectation that equity capital investment is lower for all reits after the financial crisis due to financial market decline. additionally, there is no statistical significance for the interaction terms crisis*audit fees, crisis*specialist, and crisis*big 4 auditor. accordingly, we are unable to interpret the main effects of the individual audit-related attributes. a reasonable inference from these results is that when seeking equity investment, using the audit process as a means of increasing financial transparency is important irrespective of the state of the economy. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 103 table 9. results of ols regression testing the expectation that the financial crisis of 2007-2008 positively influenced the relationship between audit-related attributes and equity investment in reits variable model 4a model 4b model 4c model 4d coefficient coefficient coefficient coefficient [t-statistic] [t-statistic] [t-statistic] [t-statistic] crisis -1.045 0.172 0.198 -1.153 [-0.502] [0.559] [0.451] [-0.471] crisis*log(audit fees) 0.067 0.069 [0.424] [0.331] log(audit fees) 0.403*** 0.394*** [3.432] [3.062] crisis*specialist -0.025 -0.015 [-0.086] [-0.050] specialist 0.368** 0.282 [2.0136] [1.525] crisis*big 4 auditor 0.001 0.049 [0.003] [0.095] big 4 auditor 0.154 -0.264 [0.519] [-0.795] bid-ask spread -70.079*** -85.004*** -83.845*** -73.322*** [-5.760] [-7.523] [-6.582] [-5.750] log(intan. assets) 0.082* 0.111** 0.110** 0.083* [1.868] [2.521] [2.512] [1.876] book-to-market 0.066*** 0.061*** 0.058*** 0.068*** [3.334] [3.265] [3.177] [3.395] return on assets -0.533 -0.757 -0.697 -0.613 [-0.507] [-0.710] [-0.668] [-0.569] leverage -0.341 -0.098 -0.084 -0.325 [-0.776] [-0.225] [-0.190] [-0.734] initial auditor year 0.054 0.036 0.038 0.036 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 104 [0.307] [0.205] [0.214] [0.204] log(other fees) 0.050** 0.066*** 0.071*** 0.047* [1.993] [2.783] [2.935] [1.904] log(properties) 0.208*** 0.207*** 0.233*** 0.190*** [4.014] [3.885] [4.417] [3.625] log(subsidiaries) 0.105* 0.192*** 0.171*** 0.124** [1.753] [3.441] [3.024] [2.080] foreign operations -0.708 -0.437 -0.355 -0.764 [-1.333] [-0.798] [-0.666] [-1.398] extra/disc items -0.011 0.064 0.043 0.011 [-0.076] [0.456] [0.301] [0.081] constant -1.803 2.472*** 2.485*** -1.574 [-1.300] [4.784] [4.261] [-1.113] # observations 953 953 953 953 f 17.221 15.887 16.217 15.737 adjusted r2 0.261 0.254 0.250 0.261 notes: in all models, the dependent variable is log(equity investment). in model 4a, crisis and crisis*log(audit fees) are added to examine the impact of audit fees on post-crisis equity investment. in model 4b, crisis and crisis*specialist are added to examine the impact of auditor specialization on post-crisis equity investment. in model 4c, crisis and crisis*big 4 auditor are added to examine the impact of auditor reputation on post-crisis equity investment. in model 4d, crisis and all three interaction terms are included to examine the impact of the audit-related attributes of auditor quality, specialization, and reputation on post-crisis equity investment. bid-ask spread is an often-used measure to capture transparency. log(intan. assets) captures firm's level of information asymmetry or opacity.book-to-market, return on assets, and leverage capture individual reit firm characteristics.initial and log(other fees) are used to capture individual reit-auditor relationships. log(properties), log(subsidiaries), foreign, and extra/disc items capture firm complexity. reit type and year dummies not reported. regression estimations are robust and statistical significance shown as: * p < 0.05, ** p < 0.01, *** p < 0.001, respectively. table 10 below shows the results for testing hypothesis 2(b) that the financial crisis positively influenced the relationship between the audit process and debt investment in reits. only in model 5c is the crisis dummy coefficient is positive and significant (β = 0.552). this suggests that reits relied more heavily on debt capital after the crisis than before it. additionally, the coefficient for the interaction term crisis*big 4 auditor is negative and significant (β = -0.544). this suggests that even though reits relied more heavily on debt asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 105 capital after the crisis than before it, auditor reputation was of less importance. there is no statistical significance for the interactive terms for crisis*specialist and crisis*big4 auditor. table 10. results of ols regression testing the expectation that the financial crisis of 2007-2008 positively influenced the relationship between audit-related attributes and debt investment in reits variable model 5a model 5b model 5c model 5d coefficient coefficient coefficient coefficient [t-statistic] [t-statistic] [t-statistic] [t-statistic] crisis 0.084 -0.086 0.552** -0.109 [0.070] [-0.489] [2.200] [-0.079] crisis*audit fees -0.052 -0.018 [-0.581] [-0.162] log(audit fees) 0.711*** 0.679*** [10.767] [9.302] crisis*specialist 0.099 0.197 [0.712] [1.469] specialist 0.327*** 0.140* [3.851] [1.748] crisis*big 4 auditor -0.544*** -0.341 [-2.880] [-1.480] big 4 auditor 0.745*** 0.077 [4.945] [0.496] bid-ask spread -46.561*** -69.823*** -64.600*** -48.270*** [-6.944] [-9.182] [-8.667] [-7.190] log(intan. assets) 0.028 0.072*** 0.074*** 0.028 [1.280] [3.214] [3.227] [1.266] book-to-market 0.070*** 0.065*** 0.059*** 0.074*** [4.353] [4.613] [4.335] [4.585] return on assets 0.769 0.304 0.461 0.666 [1.584] [0.597] [0.914] [1.358] leverage 3.954*** 4.368*** 4.333*** 3.980*** asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 106 [13.562] [14.014] [13.672] [13.693] initial auditor year 0.083 0.036 0.086 0.088 [1.121] [0.444] [1.031] [1.158] log(other fees) 0.002 0.032*** 0.035*** 0.001 [0.263] [3.562] [3.731] [0.0570] log(properties) 0.252*** 0.267*** 0.289*** 0.238*** [5.600] [5.669] [6.214] [5.273] log(subsidiaries) 0.065** 0.194*** 0.169*** 0.081** [2.067] [5.660] [4.894] [2.537] foreign operations -0.307 0.184 0.244 -0.354 [-1.204] [0.612] [0.908] [-1.290] extra/disc items 0.177** 0.292*** 0.257*** 0.191*** [2.450] [3.828] [3.333] [2.667] constant -4.253*** 3.484*** 2.922*** -4.056*** [-5.014] [9.249] [7.077] [-4.773] # observations 953 953 953 953 f 78.253 58.569 65.637 78.513 adjusted r2 0.713 0.670 0.666 0.716 notes: in all models, the dependent variable is log(debt investment). in model 5a, crisis and crisis*log(audit fees) are added to examine the impact of audit fees on post-crisis equity investment. in model 5b, crisis and crisis*specialist are added to examine the impact of auditor specialization on post-crisis equity investment. in model 5c, crisis and crisis*big 4 auditor are added to examine the impact of auditor reputation on post-crisis equity investment. in model 5d, crisis and all three interaction terms are included to examine the impact of the audit-related attributes of auditor quality, specialization, and reputation on post-crisis equity investment. bid-ask spread is an often-used measure to capture transparency. log(intan. assets) captures firm's level of information asymmetry or opacity.book-to-market, return on assets, and leverage capture individual reit firm characteristics.initial and log(other fees) are used to capture individual reit-auditor relationships. log(properties), log(subsidiaries), foreign, and extra/disc items capture firm complexity. reit type and year dummies not reported. regression estimations are robust and statistical significance shown as: * p < 0.05, ** p < 0.01, *** p < 0.001, respectively. table 11 below shows the results for testing hypothesis 2(c) that the financial crisis positively influenced the relationship between the audit process and combined equity and debt investment in reits. the results are similar to those found in model 5, with a positive, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 107 significant coefficient for crisis (β = 0.552) in model 6c, suggesting that reits relied more heavily on combined equity and debt capital after the crisis than before it. again, similar to model 5, the crisis*big 4 auditor interaction term coefficient is negative and significant in model 6c (β = -0.528). these findings point to a heavier reliance upon combined equity and debt capital after the crisis than before it, yet at the same time, auditor reputation was of less importance. neither of the interactive terms crisis*specialist and crisis*big4 auditor produced significant results. table 11. results of ols regression testing the expectation that the financial crisis of 2007-2008 positively influenced the relationship between audit-related attributes and combined equity and debt investment in reits variable model 6a model 6b model 6c model 6d coefficient coefficient coefficient coefficient [t-statistic] [t-statistic] [t-statistic] [t-statistic] crisis -0.129 -0.074 0.552** -0.287 [-0.107] [-0.420] [2.216] [-0.207] crisis*log(audit fees) -0.035 -0.002 [-0.392] [-0.018] log(audit fees) 0.702*** 0.663*** [10.460] [8.940] crisis*specialist 0.077 0.168 [0.557] [1.248] specialist 0.353*** 0.167** [4.109] [2.059] crisis*big 4 auditor -0.528*** -0.343 [-2.822] [-1.477] big 4 auditor 0.778*** 0.122 [5.125] [0.762] bid-ask spread -48.698*** -72.003*** -66.020*** -49.864*** [-7.210] [-9.422] [-8.781] [-7.356] log(intan. assets) 0.032 0.077*** 0.077*** 0.033 [1.465] [3.401] [3.402] [1.489] book-to-market 0.062*** 0.057*** 0.051*** 0.065*** asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 108 [4.1009] [4.297] [3.925] [4.369] return on assets 0.503 0.051 0.216 0.410 [0.996] [0.096] [0.417] [0.793] leverage 3.474*** 3.884*** 3.843*** 3.492*** [11.886] [12.472] [12.171] [11.974] initial auditor year 0.081 0.036 0.090 0.091 [1.087] [0.444] [1.072] [1.186] log(other fees) 0.009 0.038*** 0.041*** 0.007 [0.892] [4.103] [4.235] [0.713] log(properties) 0.244*** 0.258*** 0.281*** 0.230*** [5.387] [5.437] [6.005] [5.022] log(subsidiaries) 0.075** 0.205*** 0.178*** 0.092*** [2.355] [5.937] [5.125] [2.851] foreign operations -0.386 0.099 0.165 -0.430 [-1.551] [0.335] [0.627] [-1.598] extra/disc items 0.137* 0.252*** 0.215*** 0.152** [1.880] [3.285] [2.774] [2.095] constant -3.788*** 3.839*** 3.255*** -3.559*** [-4.391] [10.061] [7.829] [-4.116] # observations 953 953 953 953 f 73.080 55.324 62.526 73.510 adjusted r2 0.699 0.656 0.653 0.702 notes: in all models, the dependent variable is log(equity & debt investment). in model 6a, crisis and crisis*log(audit fees) are added to examine the impact of audit fees on post-crisis equity investment. in model 6b, crisis and crisis*specialist are added to examine the impact of auditor specialization on post-crisis equity investment. in model 6c, crisis and crisis*big 4 auditor are added to examine the impact of auditor reputation on post-crisis equity investment. in model 6d, crisis and all three interaction terms are included to examine the impact of the audit-related attributes of auditor quality, specialization, and reputation on post-crisis equity investment. bid-ask spread is an often-used measure to capture transparency. log(intan. assets) captures firm's level of information asymmetry or opacity.book-to-market, return on assets, and leverage capture individual reit firm characteristics.initial and log(other fees) are used to capture individual reit-auditor relationships. log(properties), log(subsidiaries), foreign, and extra/disc items capture firm asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 109 complexity. reit type and year dummies not reported. regression estimations are robust and statistical significance shown as: * p < 0.05, ** p < 0.01, *** p < 0.001, respectively. many of the control variables provide interesting results. for example, bid-ask spread, one of the variables used to capture financial transparency, is also negative and significant in all models. log(intan assets), our proxy for information asymmetry/opacity, is largely positive and significant, which suggests that when reit investors view reits as more transparent (lower bid-ask spreads), or when they perceive lower levels of information asymmetry (lower levels of intangible assets), they are more inclined to invest in reits. the number of properties owned by reits and/or their subsidiaries contributes to their demand for capital investment. to control for this, we use the variable log(properties). in all models, the coefficients for log(properties) are positive and significant, revealing a positive relationship between the number of properties owned and reit capital investment. this finding is not altogether surprising. because reits have to distribute the bulk of their available cash as dividends, to acquire additional properties, they need new capital. as reits acquire more properties, and increase needs for additional capital, implementing strategies to lower information asymmetries and increase financial transparency takes on added importance. in a similar fashion, all models show positive and significant coefficients for log(subsidiaries), another reit complexity indicator. logically, increased subsidiary investment and operation requires increased capital investment. 5. conclusion existing research indicates that firms use the audit process as a means of conveying information to investors, often in attempts to signal their increased financial transparency. in this paper, we examine how reits use the audit-related attributes of auditor quality, specialization, and reputation to signal or convey financial transparency to potential investors in order to motivate capital investment. we first analyze the relationship between these three audit-related attributes and reit equity, debt, and combined equity and debt capital investment. we then analyze this relationship by considering the financial crisis to investigate whether the use of these audit-related attributes has a stronger impact on capital issuance after the crisis. studies confirm that when firms signal their increased financial transparency to investors, they improve their abilities to motivate capital investment. empirical analysis results show a positive association between the audit process and increased capital investment before the crisis. moreover, notwithstanding declined use of equity and debt by all reits after the crisis, the results indicate the existence of a positive association between the audit process and increased capital investment after the crisis. this means that regardless of whether the economy is growing or contracting, using the 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(1983). agency problems, auditing, and the theory of the firm: some evidence. journal of law and economics, 26(3), 613-633. notes note 1. from 1976-2011, the average annual return of the ftse-nareit all-reit index was 12.98%. over the same period, the average annual returns of the s&p 500 index, the dow jones industrial average, and the nasdaq composite index were 10.57%, 7.40%, and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 114 9.83%, respectively. data obtained from nareit, available at www.reit.com. note 2. the average annual returns of the ftse-nareit all-reit index in the years 2009, 2010, and 2011, were 27.45%, 27.58%, and 7.28%, respectively. the average annual returns of the s&p 500 index in the years 2009, 2010, and 2011, were 23.45%, 12.78%, and 0.01%, respectively. the average annual returns of the dow jones industrial average in the years 2009, 2010, and 2011, were 18.82%, 11.02%, and 5.53%, respectively. the average annual historical returns of the nasdaq composite index in the years 2009, 2010, and 2011, were 43.89%, 16.91%, and -1.80%, respectively. data obtained from nareit, available at www.reit.com. note 3. reits must annually elect reit status, and disclose their election in their annual proxy statement. data available at http://www.sec.gov. note 4. data available at http://www.sec.gov. note 5. data obtained by licensed access to the university of pennsylvania’s wharton research data services, available at http://wrds-web.wharton.upenn.edu/wrds/index.cfm. note 6. audit fee information comes from the audit analytics database. note 7. so as not to lose zero value observations when log transforming variables, researchers commonly compute the natural log of the sum of the variable and one (for examples, see campbell & shiller, 1988; chen & steiner, 1999; cornett, marcus, & tehranian, 2008; ritter, 1984). throughout this paper, we follow this approach when log transforming variables. note 8. for the purposes of this research, auditor specialization includes auditors that performed 30% or more of all reit audits in the sample. table 4 groups all reit audits by audit firm, total audit fees, and average audit fees. of the 980 total reit audits performed in the sample, ernst & young, llp performed 327, or 33.37%. all other auditors each performed less than 18% of the total number of reit audits in the sample. auditor rank order is by percentage of reit audits performed. note 9. the group of audit firms currently known as the “big 4” includes price waterhouse coopers, llp, deloitte & touche, llp, ernst & young, llp and kpmg, llp ranked 1 through 4 based on annual revenues, respectively (www.big4.com, 2012). note 10. ibid, footnote 7. note 11. ibid, footnote 7. note 12. ibid, footnote 7. note 13. ibid, footnote 7. copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 12592-46134-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 40 effect of corporate social responsibility disclosure on financial performance hang thi thuy ta university of labor and social affairs, vietnam ngoc thi bui (corresponding author) university of labor and social affairs, vietnam room no. 44, a8, 120 hoang quoc viet street, cau giay district, hanoi, vietnam e-mail: buithingoc.ldxh@gmail.com received: jan. 3, 2018 accepted: feb. 22, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12592 url: https://doi.org/10.5296/ajfa.v10i1.12592 abstract corporate social responsibility is the commitment by business to contribute to sustainable development through the balance of three factors which are economic, social and environmental factor. enterprises carry out corporate social responsibility through specific activities such as controlling environmental pollution, natural resource conservation, energy conservation, employment safety, especially supporting and developing community. corporate social responsibility disclosure plays an important role in implementation of corporate social responsibility, promotion of business’s image and creation of good impression to stakeholders. this study was conducted using a two-step generalized method of moment (gmm) technique with instrumental variables for balanced panel data through the annual reports and sustainable development reports of 43 enterprises listed on the vietnam stock market from 2006 to 2016 (473 observations). the results showed that the level of corporate social responsibility disclosure has a positive effect on return on assets. this study has important implications for enterprises in terms of investing activities and corporate social responsibility disclosure. keywords: corporate social responsibility disclosure, financial effectiveness, return on assets (roa) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 41 1. introduction sustainable development is the trend of the times and businesses cannot afford to ignore this trend. the practice and disclosure of corporate social responsibility information is considered a tool for businesses to communicate the activities of sustainable development of society. gray et al. (1995) provided that corporate social responsibility disclosure is the process of providing information about corporate activities affecting environment and society. enterprises are accountable for such information to related parties, apart from financial information publicized to shareholders. non-governmental organizations and nations have introduced standards and regulations to guide firms to establish and display corporate social responsibility information, including the united nations global compact (ungc), international finance corporation (ifc), global reporting initiative (gri), international integrated reporting council (iirc), the sustainability accounting standards board (sasb). depending on conditions, legal regulations and needs, enterprises can disclose corporate social responsibility information in accordance with standard or legal requirements. according to the above standards, corporate social responsibility may include following key information: environment: environmental policies or environmental concerns of enterprises, environmental pollution control in business operations, conservation of natural resources, prevention and remedies for environmental consequences of the manufacturing process or natural resources, information about emissions, discharge of waste water, waste treatment. energy: information about a company's energy policies, energy conservation in the course of business operations, utilization of waste materials for energy production, research towards energy savings by reprocessing products. employment: information regarding regulations and standards on labor safety, working conditions, health care for workers, training, financial support for housing, information about the daily allowance for employees, maternity leaves, holidays, information regarding policies for seasonal/ contractual employees or plan of hiring seasonal/ contractual employees, provision of information regarding recruitment/ jobs for women or ethnic minorities or special interest groups. supporting and developing community: information about donations with money, artifacts or services of enterprises to support community activities, events, arts, sports, funding for health projects and providing information related to public health. products: researching and developing products to improve product quality and to meet safety standards. with increasing community interest in corporate social responsibility, many studies in the world have been conducted to verify the impact of corporate social responsibility disclosure to business efficiency such as mahoney & roberts (2007), makni et al. (2009), saleh et al. (2011), tjia & setiawati (2012), vurro & perrini (2011), lu et al. (2015), strouhal et al. (2015), jitaree (2015). impacts are expressed in a variety of indicators, such as the impact on a firm's share price, return on assets (roa), return on equity (roe), market value compared to book value tobin'q, revenues of enterprises. although these studies had different results, the majority asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 42 concluded that corporate social responsibility disclosure has a positive impact on business efficiency. several studies had reported negative results makni et al (2009) and in some cases there were not statistically significant strouhal et al. (2015), khlif et al. (2015), tjia& setiawati (2012). in vietnam, some studies have investigated the current state and benefits of corporate social responsibility disclosure. the results showed that corporate social responsibility disclosure increases the value of enterprises tobin'q nguyen et al. (2015), nguyen & trinh (2016), increases the return on assets ho & ho (2017). however, research time was short and these studies used panel data with the fixed effects model (fem) and the random effects model (rem) for the survey. using these estimation methods will not be reliable if endogenous phenomena exists in the model. to overcome this situation, it is necessary to use other estimation methods and extend research time. it is critical to ensure reliability of the study on the effect of corporate social responsibility disclosure on corporate financial performance. for this purpose, in this study the authors used a two-step generalized method of moment (gmm) for balanced panel data with 473 observations of 43 firms over a period of 11 years from 2006 to 2016. 2. theoretical foundations and hypothesis from an academic point of view, many researchers have investigated the theoretical basis to explain the relationship between practice and disclosure of corporate social responsibility and financial performance of firms in different contexts. in this study, the authors used two theories to explain the relationship between corporate social responsibility disclosure and corporate financial performance. stakeholder theory edward (1984) was the first to propose the stakeholder theory. he supposed that the goal of a business is to meet the needs of stakeholders who may influence or be influenced by the attainment of their goals. if this is done a firm’s profits will be generated. based on the stakeholder theory in strategic management, ullmann (1985) presented 8 scenarios to explain the differences in the results of the relationship between corporate social responsibility disclosure and corporate financial performance. according to him, the relationship between corporate social responsibility disclosure and corporate financial performance depends on other factors such as the power of stakeholders and management strategies. he provided that corporate financial performance has a positive impact on social efficiency and corporate social responsibility disclosure. legitimacy theory legitimacy theory is derived from the concept of organizational legitimacy, dowling & pfeffer (1975) defined: “an entity can exist when its value system is congruent with the value system of the larger social system. when there is a real or potential disparity between two value systems, the legitimacy of that entity is threatened”. developing legitimacy theory, deegan (2002) supposed that enterprises and society have a continuous and interconnected relationship. for example, companies buy human resources, raw materials from society, conversely, companies provide products and services for society, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 43 discharge waste from the production process of enterprises to environment and society has to pay for the consequences. enterprises try to control their legitimate existence to ensure capital flow, labor and customers, while avoiding the management activities of the government harming the business and boycotting products or other disruptive actions of competitors. stakeholder theory and legitimacy theory indicate that practice and disclosure of corporate social responsibility will lead to better financial performance. conversely, in the case of good corporate financial performance, corporate social responsibility disclosure is also greater. based on these theoretical foundations, the author constructed the following hypothesis: h1: there is a positive relationship between social responsibility disclosure and financial performance. 3. methodology 3.1. data collection samples selected by the authors were non-financial companies listed on the stock market from 2006 to 2016. the reason why the author chose this period is because 2006 vietnamese stock market boom with the appearance of the hanoi securities trading center in march 2005. the number of listed companies increased sharply. as of 31 december 2006, there were 193 companies listed on both exchanges (106 companies listed on hochiminh stock exchange and 87 companies listed on hanoi stock exchange).financial and banking organizations were not chosen because information provided by these companies is significantly different from other types of enterprises. the last sample was 43 listed companies on the vietnam stock market randomly selected by the elimination of financial firms, creditors, and those were not listed companies during the research period as well as companies which the authors could not collect annual reports or sustainable development reports. thus, 43 enterprises were surveyed for 11 years with the balanced panel data with a total observations of43 x 11 = 473.shown in table1. table 1. list of companies surveyed code company's name 1 agf an giang fisheries 2 bhs bien hoa sugar 3 bmc binh dinh minerals 4 bmp binh minh plastics 5 can halong canfoco 6 cii ho chi minh infrastructure 7 clc cat loi tobacco 8 cyc chang yih ceramic 9 dha hoa an stones and materials 10 dhg hau giang pharmaceutical 11 dmc domesco medical 12 dtt do thanh technology corp. 13 fpt fpt group asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 44 14 gil binh thanh im-export 15 gmd gemadept 16 htv ha tien transport 17 imp imexpharm pharmaceutical 18 ita tan tao industrial park 19 kdc kinh do corporation 20 kha khanh hoi investment and services 21 khp khanh hoa power 22 mcp my chau printing and packaging 23 pgc petrolimex gas 24 pjt petrolimex tanker 25 pnc phuong nam cultural 26 ppc pha lai thermal power 27 ree refrigeration electrical engineering 28 sfc saigon fuel co. 29 sfi sea and air freight international 30 sgh saigon hotel corp. 31 sjd can don hydro power 32 smc smc trading and invm't 33 ssc southern seed jsc 34 tac tuong an vegetable oil 35 tdh thu duc house 36 tna thien nam trading and exim 37 ts4 seafood no 4 38 tya taya (vietnam) electric wire & cable 39 vgp vegetexco port 40 vip viet nam petroleum transport 41 vis vietnam italy steel 42 vnm vinamilk 43 vtc vtc telecom 3.2. determining and measuring variables 3.2.1. corporate social responsibility disclosure variable in this study, the author measured corporate social responsibility disclosure according to content analysis method based on annual reports and sustainable development reports of companies. the analyzing process was based on the list of indicators categorized in 4 groups shown in table2: information about environment (10 indicators), information about employment (12 indicators), information about supporting and developing community (8 indicators) and information about the products (5 indicators). the indicators of information were inherited from studies of gunsanan et al. (2009), jitaree (2015), nguyen (2016) and according to circular 155/2015issued on 06/10/2015 by vietnamese ministry of finance on asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 45 guidelines on information disclosure on the stock market. table 2. list of indicators of information about corporate social responsibility symbol indicators (observed variables) env i. information about environment responsibility env 1 the enterprise complies with the law and regulations on prevention of environmental pollution (including number of times and amount of fine for violation of laws and regulations on environment) env 2 information about pollution control activities in the course of business / the report indicates that the polluting activities of enterprise has been and will be reduced. env 3 information about conservation of natural resources such as the use of recycled materials, recycled glass, metal, oil, water, recycled paper env 4 information about preventing and dealing with environmental consequences due to production process or exploitation of natural resources, such as soil improvement or reforestation. env 5 information about strategies and supporting activities of enterprises towards environmental protection / improving environment env 6 information about environmentally friendly design of infrastructure env 7 report information on emissions env 8 report information on discharging waste water env 9 report information on solid waste disposal env 10 report on information on environmental protection awards emp ii. information on responsibilities to employees emp 1 information about enterprises complying with safety standards and working conditions for employees emp 2 information about health care for employees emp 3 information about training, financial support of training courses for employees emp 4 information about recreational activities for employees emp 5 information about homestay accommodation or plan of homeownership, food and other benefits for employees emp 6 information on compensation for employees, maternity leave, holidays emp 7 information about salaries, bonuses and other benefits for employees asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 46 emp 8 information about employee stock purchase plan emp 9 information about qualifications and experiences of employees emp 10 information on job stability of current and future employees emp 11 information about the relationship of enterprise with the union or workers through the movement of culture, sports, emulation of production emp 12 information about discrimination at workplace and jobs com iii. information about responsibilities with community com 1 information about charitable activities with money, products / services or corporate employees participating in these activities, community events such as sports, culture and arts. com 2 information about employment opportunities for students, special people such as ethnic minorities, children of war invalids, disabled people, victims of agent orange and those in difficult circumstances. com 3 information about sponsoring projects of community health and providing health information to the community / supporting medical research com 4 information about establishing education funds or scholarships or educational conferences com 5 information about supporting victims of natural disasters, family under preferential treatment policy, victims of agent orange, contributions to charity, sponsoring disabled children and orphan com 6 information about supporting the development of industries, economic projects bringing benefits to the local com 7 creating jobs and developing skills for local people com 8 contribution to building electricity infrastructure, roads, schools and stations for localities cus iv. information about responsibilities to customers cus 1 information about product safety of enterprise cus 2 information about product quality cus 3 information about production and product development cus 4 commitment to quality, product safety and supporting when having trouble using the products cus 5 building customer relationships, collecting contributions and resolving customer complaints asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 47 steps of the process: corporate social responsibility is a complex field and there are many guiding standards, selecting ofstandards depends on economic conditions, laws and environment of each country. therefore, in order to ensure the objectivity of the standard selection process, data collection and survey were conducted by two steps. step 1 was conducting a survey of the 57 largest listed companies on the vietnamese stock market, the survey year in2015. the purpose of this step was to adjust and select the appropriate indicators with conditions and characteristics of vietnam. step 2 was based on the indicators of information selected and corrected through step 1, the authors conducted the survey on 43 listed companies with 473 observations. this approach has been carried out by several authors, such as branco & rodrigues (2006), gunawan et al (2009), saleh et al. (2011), tjia & setiawati (2012), bayoud et al (2012), jitaree ). technical process: first the authors read reports and find information related to the indicators in the evaluation list. if an enterprise did not disclose the ith indicator, the label is “0”, if the indicator was disclosed with general presentation or only with quantitative presentation without specific explanation, the label is “1”,if the indicator was disclosed with specific information about activities k, the label is “2”. after determining the score for each indicator for each enterprise in each year, the level of corporate social responsibility disclosure (csrd) under the average number specified is determined as follows: csrdj = ∑ ij 35 in which: csrdj: indicator of information disclosure of jth enterprise xij = 0 ifith indicator of information is not disclosed in enterprise j xij = 1 ifith indicator of information disclosed in enterprise j is general information or quantitative information without specific explanation xij = 2 ifithindicator of information disclosed in enterprise j is detailed information about specific activities 3.2.2. financial performance variable studies of authors such as mahoney & roberts (2007), makni et al. (2009), platonova et al. (2016), cheung & mak (2010), jitaree (2015), mohammed et al. (2016) used roa as a measure of financial performance and verify the relationship between corporate social responsibility disclosure and corporate financial performance. inheriting this research model, the author selected roa as a measure of financial performance. roa is determined by the following formula: the reason why profit before taxes was used is because the corporate income tax rate in roa = profit before tax average total assets asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 48 vietnam during the period 2006 2016 varied from 28%, 25%, 22% and 20%. thus, to eliminate the effect of the corporate income tax rate on roa, the author used profit before tax for analysis. 3.2.3. controlling variables following variables are controlling variables of the model: corporate size, leverage (debts/equity), foreign ownership, government ownership, revenue growth. those are variables used by many authors when analyzing corporate profits. they are important factors influencing the estimation of variables affecting corporate financial performance. corporate size (size). bayoud et al. (2012) argue that large-scale enterprises are likely to generate more profits than smaller ones. therefore, the size of enterprises is considered as an important factor affecting the relationship between corporate social responsibility disclosure and corporate financial performance. leverage (debts/equity) (lev). financial leverage is used by research as a factor affecting corporate financial performance. nguyen & dang (2017) argued that when a company is dominated by creditors, its financial performance may be affected. therefore, financial leverage is necessary in the model to test the correlation between corporate social responsibility disclosure and corporate financial performance. foreign ownership (fro). foreign ownership is an important variable affecting corporate fianncial performance (zeitun, 2014). zeitun assumed that foreign shareholders coming from developed countries with higher profit orientation, they have expertises, experiences and management skills which help boostingcorporate performance. similarly, a study of nguyen & dang (2017) also concludeda positive relationship between foreign ownership and corporate fiancial performance government ownership (gro). according to doan & nguyen (2017) state-owned enterprises tend to have less incentive to maximize profits because their profitability and investment are guaranteed by the government. therefore, gro variable is necessary to consider the relationship between corporate social responsibility disclosure and corporate financial performance. revenue growth (grw). in a study of zeitun's (2014) on capital structure and corporate performance of jordanian countries demonstrated that revenue growth has a positive effect on corporate performance. the author explained that corporates with high growth rate will have better results because they can have more investment opportunities and more profits. 3.3. data analysis to examine whether next year's financial performance has a positive relationship with corporate social responsibility disclosure of previous year, the author used the regression equation of dependent variable which is roa and independent variable which is the level of csrd and controlling variables as follows: roai,t= βo + β1csrdi,t+ β2sizei,t + β3levi,t+ β4froi,t + β5groi,t + β6grwi,t+ ui,t method of data analysis used in this study is gmm. the reason why the author chose gmm asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 49 is that according to stakeholder theory and legitimacy theory, there is a two-way relationship between social responsibility disclosure and corporate financial performance. this statement was also demonstrated in the study of ullmann (1985), jitaree (2015). this results in an endogenous relationship between csrdand roa. endogenous phenomena makesestimation unstable. to overcome this phenomenon, the author usedgmm developed by arellano & bover (1995) and blundell & bond (1998). 4. results 4.1. descriptive statistics according to survey on the level of corporate social responsibility disclosure of 43 listed companies during the period from 2006 to 2016, the average level of corporate social responsibility disclosure has increased steadily from 2006 to 2016. this indicates that more corporate concern about corporate social responsibility disclosure as well as focus on long-term development goals and bring benefits to the community. source: created by authors figure 1. average level of csrd of enterprises during the period from 2006 -2016 detailed information on average level of corporate social responsibility disclosure on environmental responsibility (env), employment responsibility (emp), community responsibility (com), responsibilities to customers (cus) showed that the level of environmental information disclosure is the lowest. this means that vietnamese enterprises do not pay much attention to environmental responsibility. the activities of waste discharge, pollution control in business process, strategies to support environmental protection activities have not received enough care from enterprises. this is the difference between vietnam and developed countries in europe, where enterprises focus on information disclosure on environment, energy, recycling, pollution due to pressure from customers and investors on the environmental protection actions of enterprises. information about responsibilities to customers announced by most enterprises includes information on product quality, product safety, production process, product commitment. enterprises want to use this information to 0.000 0.100 0.200 0.300 0.400 0.500 0.600 0.700 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 csrd csrd asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 50 promote their products to customers and also to show corporate responsibility towards products they provide. source: created by authors figure 2. level of information disclosure according to indicators of enterprises during the period from 2006 -2016 4.2. correlation analysis table 3. correlation coefficient among variables in the model variables roa csrd fro gro size lev gwr roa 1 csrd 0.4385 1 fro 0.3525 0.488 1 gro 0.1005 -0.0941 -0.1842 1 size 0.0202 0.46 0.3797 -0.1636 1 lev -0.4182 -0.2684 -0.2768 -0.1024 0.18 1 gwr 0.1569 0.0148 0.0716 -0.0352 0.0344 -0.0414 1 source: calculation of authors based on stata 12 table 3 shows that corporate social responsibility disclosure in previous year has a relatively high correlation with roa. this indicates that corporates with more information disclosure 0.000 0.100 0.200 0.300 0.400 0.500 0.600 0.700 0.800 0.900 1.000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 env emp com cus asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 51 have better asset usage efficiency. in addition, table 2 also shows that return on assets is positively correlated with firm size, the rate of government ownership, the rate of foreign ownership and growth rate but it is negatively correlated with the ratio of debt on equity. this proves that high margin firms are large-scale enterprises with a high proportion of government ownership, high proportion of foreign ownership, high revenue growth rates and low debt-to-equity ratio. 4.3. regression analysis detecting multi-collinearity authors used command if with model ols and command vif, uncentered with model rem and fem. tables 4showed that in the model rem and fem variables size have coefficient vif> 10, with presence of multi-collinearity. size variable will be discarded from the model. table 4. detecting multi-collinearity of variables in the model variables model ols model rem model fem vif 1/vif vif 1/vif vif 1/vif size 1.58 0.611736 10.77 0.092864 10.77 0.092864 csrd 1.63 0.631599 3.8 0.263049 3.8 0.263049 fro 1.52 0.658508 3.5 0.285404 3.5 0.285404 lev 1.35 0.738728 3.11 0.322046 3.11 0.322046 gro 1.07 0.937104 2.59 0.386327 2.59 0.386327 gwr 1.01 0.992073 1.16 0.86241 1.16 0.86241 mean vif 1.36 4.15 4.15 source: calculation of authors based on stata 12 auto-correlation test command xt serial was used to implement wooldridge test with hypothesis ho: there is no auto-correlation. the result showed prob > f = 0.5122, there is no evidence to reject ho. there is no auto-correlation in the model. heteroskedasticity test tác giả dùng kiểm định breusch-pagan test was used with hypothesis ho: there is no heteroskedasticity in the model ols. breusch and pagan lagrangian test with hypothesis ho: there is c in the model rem. modified wald test with hypothesis ho: there is no heteroskedasticity in the model fem. the results in table5showed that heteroskedasticity exists in all models. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 52 table 5. summary of heteroskedasticity tests model test chi-squar e statistic pro>chisquare test result ols breusch-pagan 83.40 0.0000 there is heteroskedasticity rem breusch and pagan lagrangian 140.87 0.0000 there is eteroskedasticity fem modified wald 11435.69 0.0000 there is eteroskedasticity source: calculation of authors based on stata 12 generalized method of moment(gmm) as discussed above, there exists an endogenous relationship between csrd and roa. endogenous phenomena makes estimation unstable. to overcome this phenomenon, regression method gmm was used which was developed by arellano & bover (1995) and blundell & bond (1998) to solve this problem. in addition, gmm can solve problems of heteroskedasticity and auto-correlation. in gmm, it is necessary to distinguish between instrumented variable and instrument variable. if the variables are predicted to be endogenous, then they are classified as instrumented variables according to gmm and then only the last values of these variables are appropriate tools. if the explanatory variables are defined as exogenous extrinsic variables, they are grouped into the instrument variable group (iv_instrument variable). the rationale for the gmm test is shown in the hansen test results to determine whether the equation has used enough variables to measure the difference. the hypothesis in hansen's test is as follows: ho is an exogenous variable, meaning that it is not correlated with the error of the model. the p value of hansen statistic> 0.05 is not sufficient basis to reject ho means that the tool is exogenous. then the model with instrument variables are appropriate. in addition, if hansen test is strong, the number of instruments must be less than or equal to number of groups. arellano bond test about the auto-correlation with hypothesis ho: there is no auto-correlation. in arellano-bond test ar (2) if pr>0.05, we can include that there is no auto-correlation. in order to implement gmm, authors used command: xtabond2 with endogenous variable csrd and selecting two step to make two-step estimation. the results are shown in the table 6as follows: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 53 table 6. regression result of gmm variables coefficient β p-value roa (-1) 0.618209 0 csrd 0.033219 0 fro -0.00273 0.583 gro 0.026129 0 lev -0.0134 0 gwr 0.050793 0 _cons 0.02455 0 number of obs= 430 number of groups =43 number of instruments = 31 sargan test of overid. restrictions: chi2(34)=49.82prob > chi2 =0.039 hansen test of overid. restrictions: chi2(34)=38.44prob > chi2 =0.275 arellano-bond test for ar(2) in first differences: z =-0.18pr > z =0.859 source: calculation of authors based on stata 12 the results of gmm in table 6are appropriate. table 6 shows that there is no auto-correlation as arellano-bond test ar (2) pr > z which is greater than α (5%). furthermore, hansen test shows that there is no endogenous phenomenon in the model as prob > chi 2 of hansen test which is greater than α (5%). besides, the number of instrument variables = 41 <the number of groups of variables = 43 which ensures that hansen test is strong. regression results in table6shows that the level of influence of csrd on roa was 0.033% with a significance of 1%.this result was also found in study of jitaree (2015) and ho & yekini (2014). the results of this study also showed that the debt-to-equity ratio negatively affects roa with 0.013% with significance of 1% significance. it can be seen that in vietnam, firms with high debt-to-equity ratios are often low-performing firms, therefore, when firms borrowing with high interests, their financial performance will be reduced. the results also showed that the proportion of government ownership has a positive influence on the efficiency of asset utilization with the coefficient β = 0.026 at 1% significance. this shows that enterprises with government ownership in vietnam have made great efforts in production process and had good results. government investment in corporates has contributed corporate financial performance. in addition, regression result in table 6 also shows that corporate performance depends on revenue growth. if the growth rate of enterprise revenue increased by 1%, the asset usage efficiency used by enterprises increased by 0.05% with a significance of 1%. 5. conclusion the regression results shows that coefficient β = 0.032 and sig = 0.000 in table 6indicating that impact of csrd of the previous year on roa was positive and if the average score of csrd increases by 1 point, roa would increase by 0.032%. although the level of influence is weak, this shows a positive sign of practicing and disclosing of corporate social responsibility in terms of environmental responsibility, concern for workers’ lives, investment in training and development of community, and specially, information on product quality has contributed to improving corporate performance. many companies are afraid of costs and resources they must asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 54 pay to implement and report corporate social responsibility, but the results of this research showed that the resources of enterprises will be offset because it brings benefits to enterprises such as improving the capacity of employees, attracting good workers, creating business opportunities for enterprises in new markets, creating prestigious image to the community, improving revenue, increasing brand value. as a result, corporate financial performance depends on corporate social responsibility disclosure. although the level of influence is weak, it also shows that if an enterprise has an investment strategy for implementing and disclosing corporate social responsibility, it can contribute a small part to the development of enterprises, especially in the new era of investment in sustainable development. however, the survey results also show that the level of corporate social responsibility disclosure of vietnamese enterprises is low. for that reason, increasing of practicing and disclosing corporate and public disclosure of corporate social responsibility is imperative. here are some solutions: for the vietnamese government, it is necessary to develop a legal framework for the practice and disclosure of corporate social responsibility in vietnamese legal system, and consider corporate social responsibility as mandatory in order to raise corporates’ awareness for the sake of sustainable development. to achieve this, the government should soon issue standards and codes of conduct for sectoral and national level on corporate social responsibility which depends heavily on the will and the interests of enterprises. today, corporate social responsibility has become more common, more practical, and more encouraging for enterprises to implement with common standards and criteria. vietnam has not yet developed a code of conduct for corporate social responsibility. a small number of enterprises, if they want to implement corporate social responsibility, find it very difficult to implement in a systematic way. it is, therefore, important to develop a set of corporate social responsibility standards based on international experiences while taking into account local conditions. along with that is the independent, responsible corporate social responsibility rating system. step-by-step applying policy of corporate social responsibility disclosure: annual or periodic reports on corporate social responsibility are not only a means of promotion, verifying quality but also an informational tool for owners, government, community and other stakeholders to consider and communicate information with enterprises. the application of corporate social responsibility reporting in vietnam is a gradual process of institutionalization, both from the government and from enterprises and other organizations, and there may not sufficient conditions for most vietnamese enterprises to apply in the short term. first of all, this reporting regime should be applied by large-scale enterprises and enterprises which have great impacts on society and environment, such as corporations and specially important corporations and listed companies. raising awareness of enterprises on corporate social responsibility has not yet been adequately concerned in vietnam, in terms of perspective, content and implementation. most enterprises do not have sufficient awareness of corporate social responsibility as well as its role in enhancing the capacity competition and sustainable development of their business, specially some consider corporate social responsibility as a burden of costs. in particular, people, communities, workers and consumers are more difficult to approach in this problem, while asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 55 these are related parties who can promote corporate social responsibility. therefore, the first thing to do is to continue to propagate and raise awareness of corporate social responsibility more strongly and in a broader scope and subjects, not just limit in the business community, enterprises but move to communities and localities, including general education programs. enterprises and stakeholders need to be more aware of corporate social responsibility, especially in the context of ever-widening and deeper integration. 6. limitations and recommendations for future research firstly, the research applied a content analysis method to measure the level of corporate social responsibility disclosure. since corporate social responsibility is a broad category with many guiding standards, in the process of analyzing the authors did not rely on any standard but selectively chose regulations of vietnam from previous studies to develop a new scale of social responsibility content of vietnamese enterprises. therefore, errors and subjectivity of authors are inevitable. the authors wish to be able to measure corporate social responsibility disclosure based on reports of corporate social responsibility of vietnamese enterprises when regulations on this topic are standardized. secondly, gmm is appropriate with short data table with a short period of time but with a large number of firms. however, in this study the number of enterprises classified by sectors was too small, so the examination of the relationship between corporate social responsibility disclosure and financial performance of each sector could not be conducted. the authors wish to have further studies which can add different categories of sectors. thirdly, in this study, the authors only used the return on assets roa as measure of financial performance. future studies may use a variety of financial performance measures to supplement research results such as return on equity roe, market value compared to book value tobin'q. references aras, g., aybars, a., & kutlu, o. 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(2014). corporate governance, capital structure and corporate performance: evidence from gcc countries. review of middle east economics and finance, 75-96. https://doi.org/10.1515/rmeef-2012-0028 microsoft word 10600-39116-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 54 the relationship between liquidity and firms’ profitability: a case study of karachi stock exchange nazish bibi management sciences comsats institute of information and technology abbottabad, pakistan shehla amjad management sciences comsats institute of information and technology abbottabad, pakistan received: jan. 13, 2017 accepted: feb. 8, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10600 url: http://dx.doi.org/10.5296/ajfa.v9i1.10600 abstract the purpose of this paper is to investigate the relationship between firm’s liquidity and profitability; and to find out the effects of different components of liquidity on firms’ profitability.the relationship between liquidity and firms’ profitability is empirically examined by collecting the data of 50 listed firms of karachi stock exchange, pakistan. panel data has been collected from secondary sources for the year 2007 to 2011 .net operating income and return on assets are used measure of firm’s profitability. liquidity of the firm is measured by using cash gap in days and current ratio. firm size measured by net sales, total assets and market capitalization .the study applies regression analysis to determine factors affecting profitability. incremental tests are carried out to see the importance of individual variables in the model.the results of correlation and regression analysis showed that there is a significant negative relationship between cash gap and return on assets while current ratio has significant positive relationship with profitability. results further indicate that log of sales and log of total assets has positive significant relationship with profitability. the findings of this study are based on firms listed on the karachi stock exchange (kse). hence, the results cannot be generalizable to those firms which are not listed on karachi stock exchange. the sample of the study comprises only the merchandising and manufacturing firms. banks are excluded due to their nature of work. keywords: liquidity management; profitability; current ratio; cash gap; return on assets; total assets. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 55 1. introduction liquidity management is important for every firm as it virtually affects its overall liquidity and profitability (appuhami, 2008). firms involved in the processing of goods (manufacturing companies), usually keep working capital in the form of the cash, marketable securities, cash equivalents and the inventories. the working capital comprises almost half of the sum of the asset side of the balance sheet, whereas this proportion may be higher in the case of firms involved in the business of trading these products (merchandising companies). the excessive amount of investment in these assets may result in the barrier of the company’s precious cash resources and eventually profit of firms may decline. there is always tradeoff between liquidity and profitability (eljelly, 2004). liquidity and profitability are important goals for any firm and to sacrifice one goal at the cost of other can create severe problems for the firm (kargar and bluementhal, 1994).profitability is important for long term survival of firms which helps to maximize the wealth of shareholders. on the other hand liquidity is important to cover its short term obligations like payment to supplier and to protect itself from bankruptcy (howorth and westhead, 2003, deloof, 2003, afza and nazir, 2007,afza and nazir, 2008)liquidity management requires a careful attention since it plays a major role in firms effectiveness, value and risk (smith, 1980). large inventory and a substantial trade credit policy may lead to high sales. firms kept larger inventory to reduce the risk of a stock out. trade credit may arouse sales because it allows customers to assess product quality before paying (long, maltiz & ravid 1993). liquidity is concerned with making sure that firms have exactly the right amount of money and lines of credit available to the business at all times. a popular measure of liquidity is cash gap or cash conversion cycle, the time lag between the expenditure for the purchases of raw materials and the collection of sales of finished goods (deloof, 2003). the longer this time lag, the larger the investment in working capital. a longer cash gap might increase profitability because it leads to increase in sales of companies. however, corporate profitability might also decrease with the cash gap. a firm is required to maintain a balance between liquidity and profitability for the sake of its short term obligations. liquidity is a prerequisite to ensure that firms are able to pay its short term debt and its continued flow can be guaranteed from a profitable business enterprise. liquidity for the ongoing firm is not dependent on the liquidation value of its assets, but also depends on the operating cash flows generated by those assets of firms (soenen, 1993). brigham and ehrhardt (2005: 745 ) define cash gap as “nets out the three periods just defined and which therefore equals the length of time between the firm’s actual cash gap expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables).” working capital management basically cover the planning and controlling activities of the firms regarding their current assets and current liabilities in a manner that guarantees their ability to meet their current obligations satisfactorily as well as a maximum return on their precious investment in these revolving assets (eljelly, 2004). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 56 efficient management of liquidity is a fundamental part of the overall corporate strategy to maximize the wealth of shareholders. firms try to keep an optimal level of liquidity that maximizes their value (howorth and westhead, 2003; deloof, 2003; afza and nazir, 2007). according to chief financial officer (cfo), liquidity management a simple and straightforward concept of ensuring the ability of the organization to fund the difference between the current assets and current liabilities (harris, 2005). however, a “total approach should be followed which cover all the company’s activities relating to customer, supplier and product” (hall, 2002). the overall objective of this study is to investigate the relationship between liquidity and profitability of firms in pakistan and to find out the effects of different components of liquidity on profitability of firms. 2. literature review liquidity is an important issue in financial decision making. it includes investment in asset that requires appropriate financing investment. however, liquidity issues are usually neglected by the firms in financial decision making as it involves investment and financing in the short term period. if firms have good relationships with their trade creditors, they might be able to solicit their help in providing short term working capital. samiloglu and demirgunes (2008) defined that liquidity management in literature is simple and a straightforward concept that ensures the ability of the organization to fund the difference between the current assets and current liabilities. muhammad etal., (2015) analyzed the impact of working capital management on the profitability of seven firms listed on the nigerian stock exchange over the periods of 2008 to 2012. they found that current ratio (cr),the size of the firm (logsize) and average collection period (acp)is positively influenced with profitability, while inventory turnover period (itp), average payment period (app) has shown negative relationship. the paper therefore endorses that idle funds or excessive liquidity lead to less profitability. it has been suggested that in order to raise profit cash collected should be re-invested into short-term investment. delavaretal.,(2015)empirically investigated the relationship between company performance and working capital management of 71companies listed at tehran stock exchange. data has been collected from annual reports of firms for the period 2004 to 2012. tobin's q-ratio has been used to measure firm performance. the results indicate that there is no significant relationship between working capital management and firm performance. the result further implies that the relationship between working capital management and financial performance of companies has not been influenced by financial constraints. eljelly (2004) explicated that efficient liquidity management comprises planning and controlling of current assets and current liabilities in such a manner which helps organizations to meet its current obligations as well as avoid excessive investment in these assets .the relation between profitability and liquidity was examined on a sample of 29 joint stock companies in saudi arabia as measured by current ratio and cash gap (cash conversion cycle) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 57 by using correlation and regression analysis. the study found that dynamic approach (cash gap) of liquidity was of more important as compare to static approach (current ratio) that affects profitability. the size variables (total assets & sales growth) were found to have significant effect on profitability at the industry level. deloof (2003) examined the relationship between working capital management and firm profitability by using ccc as a measure of working capital management on a sample of 1009 large belgian non-financial firms for the years 1992-1996. a statistically significant negative relationship has been found between the number of days accounts receivable, inventories and accounts payable and gross operating income .the findings suggests that by reducing the number of day’s accounts receivable and inventories to a reasonable minimum, the managers can maximize the shareholder’s wealth. lazaridis and tryfonidis (2006) analysed 131 companies listed at athens stock exchange for the period 2001 -2004. they found a negative relationship between ccc and profitability. the garcia-teruel and martinez-solano (2007) studied the relationship between profitability and ccc for small and medium sized firms from spain and zariyawati et al. (2009) investigated malaysian firms for the period 1996-2006. the results of both studies found consistent with the aforementioned studies. padachi (2006) examined the impact of trends in liquidity management on firm performance for the sample of 58 mauritian small manufacturing firms, his findings exposed that firm is required to retain stability between liquidity and profitability while conducting its day to day operations. the study also asserts that liquidity ensure firms ability to meet its short-term obligations. the results also declare that nonstop flow of liquidity can be guaranteed from the profitable ventures of a firm. alipour (2011) examined the sample of 1063 firms listed at tehran stock exchange. his studies revealed a negative association between profitability and inventory turnover, cash conversion cycle, number of day’s accounts receivable whereas a positive significant relationship with noofdays accounts payables. he argued the profitability of the firms has been significantly influenced by working capital management. raheman and nasr (2007) studied the effect of components of working capital management on liquidity and profitability in pakistan. they conducted their study on 94 firms listed on karachi stock exchange for the period of 1999-2004. their findings showed a significant negative correlation between working capital management components and profitability. furthermore, they also reported the same relationship between liquidity and profitability. anser and malik (2013) analyzed the effect of cash conversion cycle on profitability of firms in the manufacturing sector of pakistan for the year 2007 to 2011. the dependent variables of the study were return on assets and return on equity and cash conversion cycle was used as an independent variable in the study. the findings of the study show that there exists an inverse relationship between cash conversion cycle and measures of firm profitability. the authors suggest that lesser cash conversion cycles are favorable for manufacturing sector in pakistan. in another study, majeedetal., (2013) also finds a negative relationship between cash conversion cycle and measures of firm performance which includes return on assets, return on equity and ebit in pakistan. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 58 afza and nazir (2009) also studied the association between working capital management practices and a firm’s profitability. a sample selected by them was 204 non-financial firms listed on kse for years 1998-2005. they found a strong positive association of low profitability and aggressive working capital management. their study recommends a conservative approach towards working capital management in pakistan. zuberi (2010) took a sample of pakistan’s automobile sector and find that the growth and current ratio of the firms in automobile sector have direct relation with the profitability of the firms. in pakistan there have been few researches on working capital management. sana and shah (2006) worked on oil and gas sector. they took a very small sample of consisting only seven firms and they concluded that profitability and value of shareholders can be increased by managing the working capital efficiently. usama (2012) also investigated the impact of liquidity and profitability on firms in the food sector of pakistan for the time period of 2006 to 2010. the findings of his study reveal that the management of working capital has a significant positive influence on profitability as well as liquidity of firms. the study conducted by malik and bukhari (2014) on pakistani firms also shows significant positive association between cash conversion cycle and return on equity. 3. data and methodology the sample in this study includes 50 listed firms of karachi stock exchange. the sample comprises merchandising and manufacturing firms from twelve sectors (i.e. food, cement, automobile, engineering chemicals, textile, electricity, fixed line telecommunication health, travel and oil and gas). data collected from secondary sources. the analysis is based on information from annual reports over the five year from 2007 to 2011.the effect of liquidity on profitability is tested using the panel data methodology. based on the literature, conceptual framework has been designed to study the relationship between liquidity and profitability of different firms of kse. there are seven variables, with two profitability measures (net operating income and return on assets) and five independent variables (cash gap in days, current ratio, net sales, total assets and market capitalization). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 59 source: based oneljelly (2004) figure 1. conceptual framework static view uses the traditional ratios calculated from balance sheet such as current and quick ratios for analyzing the liquidity management and financial policies. while a dynamic measure of liquidity cash conversion cycle is used that measure cash outflow and cash inflow in days for a given period of time. market capitalization, net sales and total assets are moderating variables in a model which influence the impact of liquidity on profitability. two dependent variables used as proxy variables of profitability i.e.net operating income and return on assets. study assumes that there may be a relationship between profitability of the company and its liquidity, as a result of savings or external financing costs. due to presence of these elements of costs and cost savings, this relationship between profitability and liquidity is most likely be negative. consequently, first hypotheses of this study can be stated as follows: there is a negative relationship between liquidity of a firms and its profitability. profitability may be a function of the size of firms which are measured in terms of total assets and sales. the company size may affect liquidity, cash gaps and profitability in different ways. large firms purchase inventory in large quantities in order to get quantity discounts. further, large firms may qualify for quantity discounts from suppliers due to their size. on the other hand, large firms also able to get favorable credit terms from their suppliers in terms of longer credit periods. moreover, large firms may have more success in their receivables collection efforts relative to small companies. all these factors may push liquidity levels and cash gaps of large firms to levels lower than that of small companies. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 60 there is a positive relationship between the firm’s size and its profitability 4. empirical modeling the basic regression equation of study is as follows: noi= b0+b1cr+b2cgs+b3logs+e (1) (eljelly, 2004) where noi is net operating income, cr is current ratio, cgs is cash gap in days and logs is log of net sales. more specifically equations estimated are: noi =β0+ β1 (cr) + β2 (cgs) + β3 (mc) +β4 (logs) +β5 (logta) + ε (2) roa= β0+ β1 (cr) + β2 (cgs) + β3 (mc) +β4 (logs) +β5 (logta) + ε (3) 5. result and analysis 5.1. descriptive analysis descriptive analysis helps to describe relevant aspects and provide information about each relevant variable. these results are summarized in the following table 2. table 2. descriptive statistics noi roa roe cg cr mc sales ta mean 0.008 6.64 24.20 13.248 1.44 2.10 0.063 0.11 median .0001 4.74 16.34 4.424 1.08 0.766 0.003 0.002 maximum 1.11 51.57 2788.20 270.5 6.87 24.7 15.2 3.92 minimum -.154 -36.49 -1290.33 0.00 0.10 0.004 .0001 .000 std. dev. 0.074 11.46 207.36 30.42 1.06 3.66 0.201 0.498 table 2 shows the result of descriptive statistics for 50 non-financial firms for a period of five years from 2007 to 2011. net operating income, return on assets and return on equity used as proxy variable for measuring firm’s profitability. mean value of noi is rs.0.008 billion which shows the firms average profit after taxation. average value roa is 6.64 with standard deviation 11.46.the mean for dependent variable roe is 24.20, the standard deviation is 207 which is higher as compare to roa; it shows values are not close to mean due to different pattern of investment and capital structure of different firms. mean value of cash gap in days is 13.24 days and its standard deviation is 30.24 days, it means firms average length of time between actual cash expenditures on productive resources and actual cash receipts from the sale of products or services is 13 days. current ratio is a traditional tool use for measuring the liquidity. the average value of cr is 1.44 and standard deviation is 1.06.the highest value of current ratio for a company in a particular year is 6.87 and the minimum value for a year is 0.10. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 61 market capitalization is moderating variable which is used for measuring the size of firms. average value of mean is rs. 2.10 billion and its deviation from its mean is 3.66. sales and total asset are also used as moderating variables in the study. sales and total assets are used as proxy variables for measuring the size of firms. mean value of sales is rs.0.063 billion and standard deviation is 0.201. while mean of total assets is rs.0.11 billion and standard deviation is 0.498. 5.2. correlation results table 3. correlation cr sales cgs mc ta noi roa cr 1 -.014 (.825) -.083 (.192) -.039 (.537) -.061 (.333) .100 (.116) .090 (.155) sales 1 -.116 (.067) .114 (.072) .911** (.000) .231** (.000) .143* (.024) cgs 1 -.345** ( .000) -.145* (.022) .005 (.938) -.047 (.459) mc 1 .117 (.064) .003 ( .961) .125* (.048) ta 1 .305** (.000) -.011 .(868) noi 1 .119 (.061) roa 1 ** correlation is significant at the .0 l level (2-tailed) * correlation is significant at the .05 level (2-tailed) table 3 shows correlation analysis for return on assets and net operating income. return on assets has weak positive relationship with current ratio. the log of sales has a positive relation with the profitability of the firm. it implies that the size is associated with increase in the performance of firm. in the same way sales growth is also associated with increase in the profitability of the firm because increase in sales is associated with increase in profits. the results indicated that there is insignificant negative correlation between the cash gap and return on assets. the firms with shorter cash gap are more likely to be more profitable than the firms with longer cash gap. a probable explanation to this finding is that when the cash gap is relatively shorter, the firm does not need external financing, which results in incurring less borrowing cost. hence, profitability increases. return on assets has positive significant relationship with market capitalization which shows that volume of shares are increase the income of shareholder which leads increase in return on assets while negative relationship found with total assets. net operating income is positively correlated with current ratio .log of sales and log of total assets have positive significant relationship with net operating income which indicates that as asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 62 the size of firms increases in term of sales and assets net operating income also increases in same direction and vice versa. cash gap in days and market capitalization has weak positive association with net operating income. log of sales and log of total assets have strong positive significant relationship which illustrate that these two variables are substitute measures of size. cash gap has negative significant relationship with market capitalization and total assets which demonstrate that as length between actual cash expenditures and cash receipts decreases firms’ performance will increase. 5.3. regressions analysis table 4. multiple regression analysis for net operating income coefficient std. error t-statistic prob. c -1.79e+09 3.78e+08 -4.726277 0.0000 cgs 45927095 44410686 1.034145 0.3021 cr 96619490 42501271 2.273332 0.0239 mc -8.74e-05 0.001304 -0.067030 0.9466 sales -1.07e+08 49779412 -2.144693 0.0330 ta 2.06e+08 49624137 4.147002 0.0000 r-squared 0.127317 adjusted r2 0.109434 durbin-watson 1.784227 f-statistic 7.119484 prob(f-statistic) 0.000003 table 4 shows multiple regression analysis of independent variables and control variables on dependent variable i.e., net operating income used as proxy of profitability. the coefficient of the current ratio variable is positive and significant, implies that an increase in the current ratio by 1 unit is associated with an increase in net operating income 96619490 unit. significant positive coefficient of current ratio shows that as firms improve in managing their short term obligations it has positive impact on the firm’s profitability. the results are contradicted with (rehaman and nasar, 2007) who found negative significant relationship between current ratio and profitability. this finding rejects the hypothesis (h1) that there is negative relationship between current liquidity and profitability. the natural logarithm of sales is used for size in the regression model as this log transformation reduces the hetroskedasticity and influences of outliers in the regression model. coefficient of cr is positive while coefficient of cash gap is a negative, but are insignificant and so is logs. this indicates that when liquidity levels are low, denoted by insignificant cash gap, the effect on profitability is not significant. this effect is multiplied when the company size is large, evidenced by the significant negative coefficients of logs. results are consistent with eljelly (2004). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 63 total assets has positive coefficient and highly significant which shows that total assets has great significance in firm’s profitability. size is positively related to profitability and is significant which suggests that larger size seems to favor the generation of profitability therefore larger firms are more profitable. results indicate that 1% change in total assets leads to 2.6% unit change in profitability of firms. this finding support (h2) that there exists a positive relation between the company size and its profitability. the value of f statistics is 7.11 which are significant endorsing the validity and stability of the model relevant for the study. the value of durbin-watson is near about 2 which show that there is not a problem of autocorrelation exits among independent variables. table 5 shows multiple regression analysis with dependent variable return on assets. the results shows that r square of model is .15 for return on asset which endorse that only 15% variation are explained by the explanatory variables of models the value of f statistics is 7.43 being significant. the value of durbin-watson is 1.77 which shows that autocorrelation problem does not exist among independent variables. table 5. multiple regression analysis for return on assets results indicate that current ratio and cash gap has insignificant coefficients. log of sales and log total assets are highly significant with return on assets. it endorse that with increase in size of firms has positive impact on firm’s ability to utilize its assets to create profits by comparing profits with the assets that generate the profits. table 6 shows the results of variance inflation factor and tolerance factor .vif ranges 1.029 to 6.029 which shows no sign of multicollenarity in the model .similarly the results of tolerance factor vary from .166 to.972 which confirm the absence of multicollenarity the lowest value of tf is .166 for log of total assets while current ratio has highest value .972. coefficient std. error t-statistic prob. c -6.951407 11.25026 -0.617889 0.5372 cgs 1.160137 1.260112 0.920662 0.3581 cr -0.393233 1.315690 -0.298880 0.7653 mc 7.18e-11 3.86e-11 1.856479 0.0646 sales 8.993556 1.477349 6.087629 0.0000 ta -8.345104 1.470989 -5.673124 0.0000 ar 0.002500 0.064460 0.038784 0.9691 rsquare 0.155678 adjusted r2 0.134744 durbin-watson 1.770572 f-statistic 7.436738 prob(f-statistic) 0.000000 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 64 table 6. values of variance inflation factor and tolerance factor variables vif tf cr 1.029 .972 sales 5.962 .168 cgs 1.168 .856 mc 1.148 .871 total assets 6.029 .166 6. conclusion this study empirically examines the association between profitability and liquidity for a sample of 50 companies of different sectors of karachi stock exchange. the study found that current ratio is important variable as compared to cash gap having a significant relationship with net operating income and with return on assets which implies that firms properly manage their short term obligations which have positive consequences on firm’s profitability. negative correlation has been found between cash gap and firm’s profitability. superficially it would seem that a relatively short cash cycle would be a sign of good management. a firm is quick to collect cash from sales once it pays for purchases. however in case of pakistan negative cash gap is due to pending payments of bills resulting in payment cycle longer than operating cycle. this measure reflects both operating and financing decisions of the firm. current ratio and total assets show a positive and significant relationship with net operating income while cash gap in days depicts a negative relationship. the value of f statistics significantly endorsing the validity and stability of the model .the value of durbin-watson shows that there is not a problem of autocorrelation. references afza, t., & nazir, m. s. 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(2010). impact of working capital management and capital structure on profitability: the case of kse quoted automobile firms. pakistan business review, 444. microsoft word 12199-44905-1-sm-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 59 cost efficiency of indian life insurance service providers using data envelopment analysis mihir dash school of business, alliance university india arpana muthyala school of business, alliance university received: nov. 27, 2017 accepted: march 8, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12199 url: https://doi.org/10.5296/ajfa.v10i1.12199 abstract this study examines the cost efficiency of indian life insurance service providers using data envelopment analysis. the study was performed for a sample of fifteen of the major life insurance companies in india, accounting for 94.77% of the total market for life insurance in india, over the period of 2010-17. the study extends the scope of cost efficiency by disaggregating the premium collection into components. also, to provide more detailed insights, the efficiency of the life insurance companies is also analysed with respect to each input and output individually. the results of the study show that the most efficient indian life insurance companies are life insurance corporation, which has been consistently 100% efficient throughout the research period, followed by sbi life and icici prudential life, which have also shown consistently high efficiency over the research period. on the other hand, the least efficient life insurance companies are max new york life, followed by pnb met life, reliance life, and bharati axa life. the results of the study also indicate the strengths and weaknesses of the indian life insurance providers. keywords: cost efficiency, life insurance service providers, data envelopment analysis. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 60 introduction traditionally, india is a country of savers, with household savings either lying idle or invested in non-productive physical assets such as real estate and gold. this is a worrying trend as the savings are getting trapped into non-productive physical assets. in developed countries, insurance is mandatory by law. in developing countries like india, the need for financial security is much greater, as the poor and the middle class constitute a large segment of more than one billion population. the vulnerability to risk of this segment is much greater than the opportunities available to them to recover from a large loss. life insurance provides financial security against unforeseen circumstances such as death of earning family members. the indian insurance industry has been witnessing a period of tremendous growth with the advent of liberalisation, privatization, and globalization policies in the early 1990s. following the separation of non-life and life businesses of the insurance market, the number of players has increased drastically. with the increase in the number of players, the growing awareness among the middle-class population, convenience in investing, and the tax benefits, the trend is slowly bending towards insurance and in particular, life insurance. there are now twenty-four companies operating in india’s life insurance market, of which the life insurance corporation (lic) is the lone public sector company and the other twenty-three companies belong to private sector. in the last few years, the private players have made steady progress in terms of business growth. the prime business operational goal of these players is performance, efficiency, and effectiveness. efficiency is one of the major concerns for further development of the insurance industry and increased profitability. the list of all registered life insurance companies in india is presented in table 1 below. table 1. registered life insurance companies in india 1 bajaj allianz life 13 sahara life 2 exide life 14 shriram life 3 reliance life 15 bharti axa life 4 sbi life 16 future generali life 5 tata aia life 17 idbi federal life 6 hdfc standard life 18 canara hsbc obc life 7 icici prudential life 19 aegon life 8 birla sun life 20 dhfl pramerica life 9 aviva life 21 star union dai-ichi life 10 kotak mahindra old mutual life 22 indiafirst life 11 max life 23 edelweiss tokio life 12 pnb met life 24 life insurance corporation over the next ten years, the life insurance market in india is slated to cross us$ 160 billion making it a huge business opportunity. india currently accounts for only 2% of the world’s life insurance premiums though it is the second most populous nation. it is the fifteenth largest insurance market in the world in terms of premium volume, and has the potential to grow exponentially in the coming years. life insurance is emerging as one of the big saving asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 61 instruments and the future looks promising for the industry. india’s insurable population is expected to touch 750 million in 2020, and life insurance is expected to comprise 35% of total savings by the end of this decade, as against 26% in 2009-10. the indian life insurance industry grew at 22.55% new business premium in 2015-16, due to the high growth in the group single premium policy, with private insurers growing at 17.63% and life insurance corporation of india registering a higher growth at 24.74%.the industry is expected to grow at15% for the next five years. literature review there have been several studies examining the efficiency of life insurance companies. much of the literature on insurance efficiency is for developed countries, particularly for the us insurance industry (gardner and grace, 1993; yuengert, 1993; cummins et al, 1999; greene and segal, 2004). the following is a review of some of the pertinent efficiency studies in the indian life insurance context. the two most common approaches used for efficiency measurement are data envelopment analysis (dea) and the stochastic frontier approach (sfa). dea is a nonparametric method that is useful particularly for efficiency measurement for companies in service industries, as it does not require explicit functional form of the production function nor assumptions on the distribution of the inefficiency or random error terms which are required in sfa (sinha and chatterjee, 2009). jarraya and bouri (2012) provides an extensive survey of different efficiency concepts and measurement methods in the insurance industry. wise (2017) provides an even more elaborate discussion on the same. sinha and chatterjee (2009) estimated cost efficiency of the life insurance companies operating in india for the period 2002-07 using a modified dea model approach. they found a trend increase in cost efficiency in 2002-05, which reversed in 2005-07. shinde (2012) and noronh and shinde (2012) evaluated the cost efficiency of life insurance companies operating in india in the period 2000-10 using dea. the inputs considered were operational expenditure and commissions paid, while the outputs were benefits paid and net premium. they found life insurance corporation of india to consistently secure a cost efficiency score of 100%, while the cost efficiency score in the case of the private life insurance companies was not very consistent. sinha (2015) used a dynamic slacks-based dea model for measuring the efficiency of life insurance companies in india in the period 2005-12. his results indicated that there was a decline in mean technical efficiency scores for2011-12 as compared to 2008-09, due to the slowdown in the life insurance industry. he also found that the mean technical efficiency of the life insurance companies fluctuated significantly during the research period. nandi (2014) examined the efficiency of the top thirteen life insurance companies of india in the period 2002-12 using dea. the study utilized two inputs, viz. commission paid and operating expenses, and two outputs, viz. premium and net benefit. he estimated the average technical efficiency of the life insurance companies to be 82.6%, pure technical efficiency 87.5% asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 62 and scale efficiency 94.7%. he also found that life insurance corporation of india was far more efficient than the other life insurance companies. bawa and bhagat (2015) examined the efficiency of life insurance companies registered in punjab in the period 2006-13 using dea. they used the number of agents and the number of offices as inputs and net premium and the number of policies as outputs. they found that lic was 100% efficient in all the years, and that aviva life and sbi life were 100% efficient in the first four years of the study period. they estimated the average technical efficiency of life insurance companies in punjab to be 55.0%, pure technical efficiency 67.9%, and scale efficiency 80.5%. the review of literature indicates that dea is the most appropriate technique for efficiency measurement in the life insurance industry. the cost efficiency concept, using commission paid and operating expenses as inputs and net premium and benefits as outputs, is used by most of the studies in the context of the indian life insurance industry. methodology the objective of the study is to examine the cost efficiency of life insurance providers in india. to this end, the study uses data envelopment analysis to measure cost efficiency of indian life insurance service providers. also, it explores the relationship between efficiency and market power in the indian life insurance industry. the analysis was performed for fifteen of the twenty-four registered life insurance service providers, accounting for 94.77% of the total market for life insurance in india. the list of sample companies is presented in the table 2 below. table 2. bajaj allianz life max new york life reliance life pnb met life sbi life bharti axa life hdfc standard life future generali life icici prudential life idbi federal life birla sun life aegon life aviva life edelweiss tokio life life insurance corporation the data for the service providers was obtained from the irda (note 1), life insurance council of india (lici)(note 2) and the public disclosures from the insurers’ websites (note 3). the data for the study was taken on a quarterly basis for the period 2010-17. the efficiency of the life insurance service providers was measured using data envelopment analysis (farrell, 1957; charnes et al, 1978; banker et al, 1984). data envelopment analysis is a non-parametric technique that identifies the proportion of a dmu’s inputs that are effectively required to produce its given levels of outputs, as compared to other dmus. mathematically, it is formulated as a linear programming problem follows: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 63 !* *. 1..min iijj iijj j oow ieiw wtse ≥ ≤ =    in the above formulation, the weights wj are associated with the jth dmu; iij represents the quantity of the ith input used by the jth dmu; and oij represents the quantity of the ith output produced by the jth dmu. the target dmu’s inputs and outputs are represented by ii* and oi*, respectively, and the efficiency score of the target dmu is represented as e. if the target dmu is not efficient, the formulation above describes a composite of the remaining dmus that produces at least as much of all the target dmu’s outputs using a fraction of its inputs. the efficiency score in this case is the least such fraction. on the other hand, if the target dmu is efficient, in the sense that it is not possible to produce at least as much of all outputs using a fraction of the inputs, its efficiency score is 100%. in the context of financial service firms, there are three major approaches to measure outputs: the asset or intermediation approach, the user-cost approach, and the value-added approach (berger and humphrey, 1992).the asset/intermediation approach views financial service firms purely as financial intermediaries, borrowing funds from customers and transforming the into assets by investing them, and compensating the time value of the funds used through interest payments. however, this approach only considers the intermediation services provided by life insurance firms, ignoring their risk-pooling and risk-bearing functions. the user-cost approach (hancock, 1985) classifies financial instruments as an inputs or outputs by analysing if their net contribution to the revenues of the firm is positive or negative. if the returns of an asset exceed the opportunity costs of funds or if the costs of a liability are lower than the opportunity costs, the product is considered as an output; otherwise it is categorised as an input. however, this approach requires detailed information on product revenues and opportunity costs which are difficult to obtain for indian life insurance firms. the value-added approach considers all assets and liabilities with substantial value added as the major outputs, and the remaining assets and liabilities are treated either as unimportant outputs, intermediate products, or inputs. this approach is considered most appropriate for measuring output of financial firms and is widely used in insurance studies (sinha, 2015). for the present study, the inputs considered include the commissions expenses, operating expenses, and net benefits paid, while the outputs considered include the individual single premium, individual non-single premium, group single premium, and group non-single premium. this is similar to the approach of shinde (2012), noronh and shinde (2012), and nandi (2014), who used a similar concept of cost efficiency in the context of life insurance firms. by disaggregating premium collections, the efficiency estimates would be expected to be more sensitive. in the research period, individual single premium accounted for 17.26% of the total premium collection, individual non-single premium accounted for 36.02%, group single premium 37.80%, and group non-single 8.93%. in the last two/three years, years, however, there has been a shift towards group single premium, with about 15% of total premium collection from individual single premium, about 30%-33% from individual asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 64 non-single premium, 46%-50% from group single premium, and 5%-7% from group non-single premium. to provide more detailed insights, the efficiency of the sample life insurance companies was also analysed with respect to each input and output individually. further, to examine the relationship of efficiency with market power (chuang and tang, 2015), the resultant efficiency scores were plotted against market shares. findings the descriptive statistics of the overall efficiency scores for the sample life insurance companies are presented in table 3 below. table 3. descriptive statistics of overall efficiency scores for the sample life insurance companies average std dev coeff var aegon life 86.71% 24.91% 28.73% aviva life 93.92% 12.99% 13.83% bajaj allianz life 93.29% 18.33% 19.65% bharati axa life 79.79% 29.78% 37.32% birla sunlife 82.04% 25.46% 31.03% edelweiss tokio life 94.74% 22.94% 24.22% future generali life 83.42% 27.36% 32.80% hdfc life 88.46% 19.17% 21.67% icici prudential life 96.22% 19.23% 19.99% idbi federal life 92.95% 24.81% 26.70% life insurance corporation 100.00% 0.00% 0.00% max new york life 52.22% 31.94% 61.16% pnb met life 69.60% 28.69% 41.21% reliance life 74.89% 23.28% 31.09% sbi life 96.65% 8.16% 8.44% the efficiency scores indicate that life insurance corporation has been consistently 100% efficient throughout the research period. sbi life and icici prudential life have also shown consistently high efficiency over the research period. the least efficient of the sample life insurance companies was max new york life, followed by pnb met life and reliance life. bharati axa life was also relatively less efficient, and showed high variability in efficiency over the research period. the descriptive statistics of the efficiency scores with respect to commissions paid (against all of the outputs) for the sample life insurance companies are presented in table 4 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 65 table 4. descriptive statistics of efficiency scores w.r.t. commissions paid for the sample life insurance companies average std dev coeff var aegon life 76.77% 41.85% 54.51% aviva life 82.64% 29.47% 35.66% bajaj allianz life 93.05% 21.59% 23.20% bharati axa life 64.48% 40.22% 62.37% birla sun life 91.37% 21.92% 23.99% edelweiss tokio life 77.67% 39.29% 50.58% future generali life 81.54% 31.66% 38.83% hdfc life 92.45% 26.66% 28.83% icici prudential life 95.13% 19.96% 20.98% idbi federal life 79.42% 36.15% 45.52% life insurance corporation 100.00% 0.00% 0.00% max new york life 44.39% 31.62% 71.24% pnb met life 74.00% 26.91% 36.37% reliance life 75.64% 24.95% 32.98% sbi life 90.07% 28.05% 31.14% life insurance corporation was found to be consistently 100% efficient throughout the research period with respect to commissions paid. icici prudential life and bajaj allianz life were also found to be consistently highly efficient over the research period. the least efficient of the sample life insurance companies was max new york life, followed by bharati axa life, pnb met life, and reliance life. aegon life and edelweiss tokio life were also relatively less efficient, and showed high variability over the research period. the descriptive statistics of the efficiency scores with respect to operational expenses (against all of the outputs) for the sample life insurance companies are presented in table 5 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 66 table 5. descriptive statistics of efficiency scores w.r.t. operational expenses for the sample life insurance companies average std dev coeff var aegon life 78.14% 23.58% 30.18% aviva life 87.12% 18.65% 21.41% bajaj allianz life 91.53% 17.41% 19.02% bharati axa life 53.44% 27.59% 51.63% birla sun life 95.86% 16.36% 17.06% edelweiss tokio life 100.00% 0.00% 0.00% future generali life 72.02% 30.58% 42.46% hdfc life 97.30% 29.32% 30.13% icici prudential life 89.79% 16.06% 17.89% idbi federal life 93.32% 20.82% 22.31% life insurance corporation 100.00% 0.00% 0.00% max new york life 55.17% 31.56% 57.21% pnb met life 73.62% 25.03% 34.00% reliance life 80.19% 21.20% 26.43% sbi life 99.30% 3.66% 3.69% life insurance corporation and edelweiss tokio life were found to be consistently 100% efficient throughout the research period with respect to operational expenses. sbi life was also found to be consistently highly efficient over the research period. hdfc life was also relatively highly efficient, but with higher variability. the least efficient of the sample life insurance companies was bharati axa life, followed by max new york life, future generali life, pnb met life, and aegon life. bharati axa life and max new york life also had high variability in efficiency over the research period. the descriptive statistics of the efficiency scores with respect to individual single premium (against all of the inputs) for the sample life insurance companies are presented in table 6 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 67 table 6. descriptive statistics of efficiency scores w.r.t. individual single premium for the sample life insurance companies average std dev coeff var aegon life 72.27% 33.86% 46.85% aviva life 42.69% 23.68% 55.47% bajaj allianz life 74.71% 28.58% 38.25% bharati axa life 41.78% 25.48% 60.98% birla sun life 16.70% 7.21% 43.20% edelweiss tokio life 93.98% 14.61% 15.54% future generali life 60.71% 31.37% 51.66% hdfc life 33.87% 23.58% 69.62% icici prudential life 24.69% 27.44% 111.13% idbi federal life 90.86% 23.32% 25.67% life insurance corporation 100.00% 0.00% 0.00% max new york life 24.98% 21.36% 85.51% pnb met life 47.93% 32.39% 67.57% reliance life 22.30% 12.90% 57.86% sbi life 79.79% 25.57% 32.05% life insurance corporation was found to be consistently 100% efficient throughout the research period with respect to individual single premium. edelweiss tokio life and idbi federal life were also found to be consistently highly efficient over the research period. the least efficient of the sample life insurance companies was birla sun life, followed by reliance life, icici prudential life, and max new york life, all of which had relatively high variability in efficiency over the research period. the descriptive statistics of the efficiency scores with respect to individual non-single premium (against all of the inputs) for the sample life insurance companies are presented in table7 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 68 table 7. descriptive statistics of efficiency scores w.r.t. individual non-single premium for the sample life insurance companies average std dev coeff var aegon life 58.58% 43.10% 73.58% aviva life 52.09% 35.97% 69.05% bajaj allianz life 58.42% 33.25% 56.91% bharati axa life 48.32% 38.32% 79.31% birla sun life 51.47% 25.60% 49.75% edelweiss tokio life 57.87% 46.18% 79.79% future generali life 50.61% 34.11% 67.40% hdfc life 86.76% 18.84% 21.71% icici prudential life 81.89% 25.77% 31.47% idbi federal life 65.35% 43.05% 65.88% life insurance corporation 100.00% 0.00% 0.00% max new york life 29.27% 21.74% 74.25% pnb met life 57.93% 30.93% 53.40% reliance life 49.91% 26.88% 53.86% sbi life 93.45% 12.09% 12.93% life insurance corporation was found to be consistently 100% efficient throughout the research period with respect to individual single premium. sbi life was also found to be consistently highly efficient over the research period, followed by hdfc life and icici prudential life. the least efficient of the sample life insurance companies was max new york life, followed by bharati axa life and reliance life. in fact, most of the sample life insurance companies had relatively low efficiency and relatively high variability in efficiency over the research period. the descriptive statistics of the efficiency scores with respect to group single premium (against all of the inputs) for the sample life insurance companies are presented in table 8 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 69 table 8. descriptive statistics of efficiency scores w.r.t. group single premium for the sample life insurance companies average std dev coeff var aegon life 83.59% 25.54% 30.55% aviva life 49.95% 23.61% 47.28% bajaj allianz life 68.99% 39.46% 57.20% bharati axa life 59.29% 26.73% 45.08% birla sun life 15.59% 7.67% 49.21% edelweiss tokio life 91.30% 23.39% 25.62% future generali life 62.32% 18.11% 29.07% hdfc life 58.34% 34.16% 58.55% icici prudential life 13.64% 15.83% 116.08% idbi federal life 87.60% 22.61% 25.82% life insurance corporation 100.00% 0.00% 0.00% max new york life 7.32% 5.14% 70.24% pnb met life 27.27% 12.80% 46.95% reliance life 12.91% 7.63% 59.05% sbi life 78.63% 30.85% 39.24% life insurance corporation was found to be consistently 100% efficient throughout the research period with respect to group single premium. edelweiss tokio life and idbi federal life were also found to be relatively highly efficient over the research period. the least efficient of the sample life insurance companies was max new york life, followed by reliance life, icici prudential life, and birla sun life. the descriptive statistics of the efficiency scores with respect to group non-single premium (against all of the inputs) for the sample life insurance companies are presented in table 9 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 70 table 9. descriptive statistics of efficiency scores w.r.t. group non-single premium for the sample life insurance companies average std dev coeff var aegon life 75.66% 37.32% 49.33% aviva life 56.37% 36.50% 64.74% bajaj allianz life 66.32% 34.84% 52.53% bharati axa life 42.71% 27.85% 65.20% birla sun life 82.94% 29.44% 35.50% edelweiss tokio life 63.79% 45.51% 71.35% future generali life 44.16% 37.92% 85.88% hdfc life 23.83% 26.67% 111.88% icici prudential life 29.46% 39.27% 133.30% idbi federal life 75.47% 34.78% 46.08% life insurance corporation 91.11% 26.00% 28.53% max new york life 6.12% 7.87% 128.72% pnb met life 30.41% 23.57% 77.53% reliance life 43.25% 35.59% 82.27% sbi life 30.55% 29.30% 95.91% the efficiency scores with respect to group non-single premium showed relatively high variability for all of the sample insurance companies. life insurance corporation and birla sun life were found to be consistently highly efficient throughout the research period with respect to group non-single premium. the least efficient of the sample life insurance companies was max new york life, followed by hdfc life and icici prudential life. the relationship between overall efficiency and market share for the sample private life insurance companies are presented in table 10 and figure 1 below. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 71 table 10. overall efficiency vs. market share average efficiency market share aegon life 86.71% 0.14% aviva life 93.92% 0.48% bajaj allianz life 93.29% 2.31% bharati axa life 79.79% 0.32% birla sun life 82.04% 1.62% edelweiss tokio life 94.74% 0.08% future generali life 83.42% 0.24% hdfc life 88.46% 3.76% icici prudential life 96.22% 4.58% idbi federal life 92.95% 0.52% max new york life 52.22% 1.91% pnb met life 69.60% 0.71% reliance life 74.89% 1.57% sbi life 96.65% 5.13% figure 1. overall efficiency vs. market share there was generally a positive relationship between overall efficiency and market share, with some exceptions. however, for each individual insurance company, the relationship between overall efficiency and market share was not statistically significant. the relationship between efficiency with respect to commissions paid and market share for the sample private life insurance companies are presented in table 11 and figure 2 below. 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% m ar ke t s ha re efficiency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 72 table 11. efficiency w.r.t. commissions paid vs. market share average efficiency market share aegon life 76.77% 0.14% aviva life 82.64% 0.48% bajaj allianz life 93.05% 2.31% bharati axa life 64.48% 0.32% birla sun life 91.37% 1.62% edelweiss tokio life 77.67% 0.08% future generali life 81.54% 0.24% hdfc life 92.45% 3.76% icici prudential life 95.13% 4.58% idbi federal life 79.42% 0.52% max new york life 44.39% 1.91% pnb met life 74.00% 0.71% reliance life 75.64% 1.57% sbi life 90.07% 5.13% figure 2. efficiency w.r.t. commissions paid vs. market share there was generally a positive relationship between efficiency with respect to commissions paid and market share, with some exceptions. the relationship between efficiency with respect to operational expenses and market share for the sample private life insurance companies are presented in table 12 and figure 3 below. 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% m ar ke t s ha re efficiency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 73 table 12. efficiency w.r.t. operational expenses vs. market share average efficiency market share aegon life 78.14% 0.14% aviva life 87.12% 0.48% bajaj allianz life 91.53% 2.31% bharati axa life 53.44% 0.32% birla sun life 95.86% 1.62% edelweiss tokio life 100.00% 0.08% future generali life 72.02% 0.24% hdfc life 97.30% 3.76% icici prudential life 89.79% 4.58% idbi federal life 93.32% 0.52% max new york life 55.17% 1.91% pnb met life 73.62% 0.71% reliance life 80.19% 1.57% sbi life 99.30% 5.13% figure 3. efficiency w.r.t. operational expenses vs. market share there was generally a positive relationship between efficiency with respect operational expenses and market share, with some exceptions. the relationship between efficiency with respect to individual single premium and market share for the sample private life insurance companies are presented in table 13 and figure 4 below. 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% m ar ke t s ha re efficiency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 74 table 13. efficiency w.r.t. individual single premium vs. market share average efficiency market share aegon life 72.27% 0.14% aviva life 42.69% 0.48% bajaj allianz life 74.71% 2.31% bharati axa life 41.78% 0.32% birla sun life 16.70% 1.62% edelweiss tokio life 93.98% 0.08% future generali life 60.71% 0.24% hdfc life 33.87% 3.76% icici prudential life 24.69% 4.58% idbi federal life 90.86% 0.52% max new york life 24.98% 1.91% pnb met life 47.93% 0.71% reliance life 22.30% 1.57% sbi life 79.79% 5.13% figure 4. efficiency w.r.t. individual single premium vs. market share the relationship between efficiency with respect to individual non-single premium and market share for the sample private life insurance companies are presented in table 14 and figure 5 below. 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% m ar ke t s ha re efficiency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 75 table 14. efficiency w.r.t. individual non-single premium vs. market share average efficiency market share aegon life 58.58% 0.14% aviva life 52.09% 0.48% bajaj allianz life 58.42% 2.31% bharati axa life 48.32% 0.32% birla sun life 51.47% 1.62% edelweiss tokio life 57.87% 0.08% future generali life 50.61% 0.24% hdfc life 86.76% 3.76% icici prudential life 81.89% 4.58% idbi federal life 65.35% 0.52% max new york life 29.27% 1.91% pnb met life 57.93% 0.71% reliance life 49.91% 1.57% sbi life 93.45% 5.13% figure 5. efficiency w.r.t. individual non-single premium vs. market share the relationship between efficiency with respect to group single premium and market share for the sample private life insurance companies are presented in table 15 and figure 6 below. 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% m ar ke t s ha re efficiency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 76 table 15. efficiency w.r.t. group single premium vs. market share average efficiency market share aegon life 83.59% 0.14% aviva life 49.95% 0.48% bajaj allianz life 68.99% 2.31% bharati axa life 59.29% 0.32% birla sun life 15.59% 1.62% edelweiss tokio life 91.30% 0.08% future generali life 62.32% 0.24% hdfc life 58.34% 3.76% icici prudential life 13.64% 4.58% idbi federal life 87.60% 0.52% max new york life 7.32% 1.91% pnb met life 27.27% 0.71% reliance life 12.91% 1.57% sbi life 78.63% 5.13% figure 6. efficiency w.r.t. group single premium vs. market share the relationship between efficiency with respect to group non-single premium and market share for the sample private life insurance companies are presented in table 16 and figure 7 below. 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% m ar ke t s ha re efficiency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 77 table 16. efficiency w.r.t. group non-single premium vs. market share average efficiency market share aegon life 75.66% 0.14% aviva life 56.37% 0.48% bajaj allianz life 66.32% 2.31% bharati axa life 42.71% 0.32% birla sun life 82.94% 1.62% edelweiss tokio life 63.79% 0.08% future generali life 44.16% 0.24% hdfc life 23.83% 3.76% icici prudential life 29.46% 4.58% idbi federal life 75.47% 0.52% max new york life 6.12% 1.91% pnb met life 30.41% 0.71% reliance life 43.25% 1.57% sbi life 30.55% 5.13% figure 7. efficiency w.r.t. group non-single premium vs. market share there was generally a positive relationship between efficiency with respect individual non-single premium and market share, but the relationship between efficiency with respect to other outputs and market share was mixed. discussion the results of the study show that the most efficient indian life insurance companies are life insurance corporation, which has been consistently 100% efficient throughout the research period, followed by sbi life and icici prudential life, which have also shown consistently 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% m ar ke t s ha re efficiency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 78 high efficiency over the research period. on the other hand, the least efficient life insurance companies are max new york life, followed by pnb met life, and reliance life. bharati axa life is also relatively less efficient, with high variability in efficiency over the research period. the results of the analysis of efficiency with respect to individual inputs and outputs were similar, with life insurance corporation almost always 100% efficient throughout the research period, along with sbi life and icici prudential life at the higher end, and max new york life, pnb met life, reliance life, and bharati axa life at the lower end. the results of the study emphasise that life insurance corporation is the dominant player in the indian life insurance industry. this conforms with the results of most previous studies (shinde, 2012, noronh and shinde, 2012; nandi, 2014; bawa and bhagat, 2015). life insurance corporation was found to be 100% efficient in all the analyses except for efficiency with respect to group non-single premium. this could be an effect of the decline in this sub-segment of the life insurance industry in recent years. the results suggest very high variability in efficiency of most of the sample life insurance companies. this conforms with the results of sinha and chatterjee (2009) and sinha (2015). it is a possibility that life insurance business is affected by seasonality. the two expected peak seasons are q2 and q4. the former, q2, is expected to be a peak as it is the festival season in india, and almost all sectors have a spurt in sales in this quarter. the latter, q4, is the close of the financial year, and many individuals and firms tend to buy insurance in this quarter, for example, to manage their investments and tax deductions. the data for the current study was taken for this reason. unfortunately, apart from some evidence in seasonality in the market share of life insurance corporation in the early part of the research period (with a low in q3), no seasonality in the efficiency scores was identifiable. there are some limitations inherent in the study. the data for the study was censored to some extent; in some years, some data was unavailable. for example, cost data for future generali life was not available for the year 2015-16 and q3 of 2016-17. also, edelweiss tokio life entered the industry in 2011-12, and its cost data was available only from q1 of 2012-13. the efficiency scores may thus be somewhat biased. a limitation of dea is that the results are generally sensitive to the choice of inputs and outputs (gutierrez-nieto et al., 2007). although the study has extended the concept of cost efficiency by disaggregating the outputs, the results are not really very different from those of earlier studies. some in efficiencies that have been identified need to be analysed further, particularly for the weak players, viz. max new york life, pnb met life, reliance life, and bharati axa life, in order to understand how they can improve their efficiency. there is a scope to include more variables in the analysis to refine the efficiency score. also, the study may be extended by analysing the critical factors predicting inefficiency. this would be of interest to regulators to help identify inefficient players. another limitation of dea is that it may overestimate the efficiency of the smallest and largest dmus. this could have distorted the efficiency estimates for the smaller players, for example, for edelweiss tokio life, even if the outputs are negligible. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 79 references bawa, s.k., & bhagat, n. 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(2017). a survey of life insurance efficiency papers: methods, pros and cons, trends. accounting, 3, 137-170. https://doi.org/10.5267/j.ac.2016.12.001 yuengert, m.a. (1993). the measurement of efficiency in life insurance: estimates of mixed normal-gamma error model. journal of banking and finance, 17, 483-496. https://doi.org/10.1016/0378-4266(93)90047-h notes note 1. https://www.irdai.gov.in/ note 2. http://www.lifeinscouncil.org/ note 3. https://www.lifeinscouncil.org/industry%20information/public_disclosures.aspx microsoft word 14920-54664-1-ed-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 236 financial mismatch, assets specificity and capital structure yanwu li (corresponding author) shu-uts silc business school, shanghai university 20 chengzhong road, jiading district, shanghai 201899, china e-mail, 617445625@qq.com received, august 5, 2019 accepted, sep 21, 2019 published, december 1, 2019 doi,10.5296/ajfa.v11i2.14920 url, https,//doi.org/10.5296/ajfa.v11i2.14920 abstract at present, the problem of financial mismatch poses great challenge to china’s financial market. financial mismatch blurs the market governance structure of debt financing, thus distorting the relationship between asset specificity and capital structure. this paper investigates companies listed on the a-share of shanghai and shenzhen stock exchange from 2012 to 2017. it tests the existence of financial mismatch and the impact of financial mismatch on asset specificity and capital structure. empirical results show that the impact of financial mismatch on the relationship between asset specificity and capital structure of sample companies exhibits no differences in ownership. both state-owned listed companies and private companies face the same degree of financial mismatch issues, which leads to changes in the property-specific governance structure of assets, and asset specificity is positively related to capital structure. keywords: financial mismatch, asset specificity, governance structure, capital structure asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 237 introduction since the appearance of the modigliani–miller theorem, a great deal of literature pertains on the factors affecting capital structure. the characteristics of companies, institutional factors, macroeconomic factors etc. have all been found to have an impact on the capital structure of companies (xiao, 2003; li, 2007). according to transaction cost economics, the key factor in determining the capital structure of a company is the asset specificity of the company. asset specificity refers to the impairment of the value of an asset caused by changes in the entity of users or its application without sacrificing its production value. on the one hand, the higher the level of corporate asset specificity is, the higher the risk of losing the realized value of the asset will be. the risk cannot be fully paid back so that creditors will trigger a reverse adjustment in debt financing. on the other hand, according to the governance structure selection theory of transaction cost economics, equity and liabilities are assigned to the hierarchy and market governance structure attributes, respectively. with the increase of asset specificity level, the application of equity financing can save financing transaction costs and results in a greater efficiency of financing transactions (willison, 1979). previous research has tested the correlation between asset specificity and capital structure through empirical methods. however, research that investigates listed companies in china often neglects the impact of financial mismatch (dai and zhang, 2003). financial mismatch refers to the mismatch between the allocation structure and the efficiency of financial resources. as a scarce resource, financial resources should flow to high-efficiency departments and companies to ensure the efficiency of financial resource allocation. however, the allocation of financial resources in china exhibits a problem of inefficient and unbalanced mismatch. first, the capital structure of a company is directly affected by the allocation structure of financial resources. secondly, the transaction cost economics is based on the historical market experience, while the financial mismatch as a non-marketization behavior eases the assumptions of transaction cost economics, restricting and distorting the governance ability of debt financing in financing contracts. hence, it breaks the bond between asset specificity and capital structure, and causes an impact on the relationship between the two. this paper focuses on the impact of finance mismatch on the asset specificity and capital structure. and test if the phenomenon of finance mismatch widely exists in listed companies of china and if this existence and its impacts differentiate because of the ownership of companies. moreover, this paper proposes regressions to determine if the effect of asset specificity on the capital structure works under the situation that finance mismatch issue exists. contributing to relevant theories of transaction cost economics, this paper attempts to investigate the correlation between asset specificity and capital structure under the existing financial mismatch issue in china. first, this paper constructs a theoretical framework and reexamines the relationship between asset specificity and capital structure from the impact of financial mismatch on debt financing governance structure. it takes into account of the economic reality and institutional background of china and fills in the void of existing research in this area. secondly, by evaluating the economic consequences of financial mismatch and its impact on the relationship between asset specificity and capital structure, this paper provides asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 238 empirical evidence on how to ease financial mismatch, how to improve the efficiency of financial resource allocation, and how to improve the financial market of china. the remaining part of this paper is organized as follows. section 2 reviews related literature. section 3 is devoted to theoretical analysis, hypothesis development and introduces the data. section 4 presents the empirical analysis. section 5 concludes and proposes policy implications. related literature 2.1 financial mismatch the concept of financial mismatch arises from the theory of resource allocation efficiency. samuelson (2005) pointed out that the scarcity of resources is what economics is for. the scarcity of resources and the infinite demand of people create resource allocation problems. resource allocation efficiency reflects the benefits of the allocation of scarce resources among different production entities, i.e., the efficiency of resource allocation to the most efficient departments and compaies (cai, 2006). the allocation of financial resources plays a leading role in resource allocation, as the flow of financial resources drives the flow of other economic resources. as coase (1965) pointed out, whether a company’s demand for financial resources can be met determines its economic development. according to the resource allocation efficiency theory, financial resources should flow to the departments and companies with the highest operating efficiency. the efficiency and financial resource allocation should be consistent to achieve the pareto optimality of financial resource allocation (wang, 1999; he et al., 2004). financial mismatch is an inefficient state of financial resource allocation, i.e., departments and companies that occupy financial resources cannot work in high efficiency. financial mismatch wildly exist in china’s financial system. the asymmetric financing ability of state-owned enterprises and private enterprises are the main reflection of financial mismatch (lu, 2008). although the asymmetric financing ability of state-owned enterprises and private enterprises stems from weaknesses of private enterprises, such as poor anti-risk ability and insufficient collateral, the main effect from institutional problems cannot be neglected (li et al., 2011). private enterprises are more efficient than state-owned enterprises, but more difficult to obtain financial resources (liu, 2000; ayyagarietal, 2008). private enterprises need to pay a higher price for obtaining financial resources than state-owned enterprises (as shown in table 1). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 239 table 1. average interest rate of the above-scale* state-owned enterprises and private enterprises *before 2011, the above-scale enterprise refers to the annual operating income of enterprises above 5 million yuan. this standard was improved to 20 million in 2011. there are two concepts that need to be discerned, financial mismatch and credit discrimination. credit discrimination emphasizes the flow of financial resources to state-owned enterprises, while financial mismatch emphasizes the flow of financial resources to inefficient enterprises. at the present stage, the low efficiency of state-owned enterprises in china leads to the overlap of credit discrimination and financial mismatch, but there are essential differences between the two concepts. first of all, the starting point of the two is different. the starting point of credit discrimination is the nature of property rights of enterprises, and the starting point of financial mismatch is enterprise efficiency. secondly, credit discrimination is one of the manifestations of financial mismatch, but it cannot cover all financial mismatch. lastly, credit discrimination is a narrow concept, while financial mismatch is a broad concept — a financial mismatch can also exist in firms of the same property right. for example, local governments do not hesitate to obtain loans for inefficient state-owned enterprises through administrative interventions. other high-efficiency state-owned enterprises cannot obtain such strong government support, which reflects the problem of financial mismatch within state-owned enterprises. wang (2000) mainly focused on the allocation of financial resources. by analyzing the distribution of financial resources in china, wang(2000) pointed out that the current allocation efficiency is low. mainly occurred in, (1) financial institutions do not have flexible operating methods as well as lack of high-level management, and are unable to provide high-quality financial services. hence it leads to lower financial market efficiency. (2) although stateowned enterprises are state-backed, their operating management concepts lag behind, management level is low, and the operating mechanism is not flexible. although financial institutions such as banks will make large amounts of loans in terms of access to funds, poor business management leads to fail to create value, which makes it impossible for banks to effectively withdrawal of funds and increases financial risks. in addition, the reason for the low financial efficiency is information asymmetry and unreasonable resource allocation. deng (2003) analyzes financial efficiency by constructing a model of economic efficiency and then using this as a tool to analyze financial efficiency. the result is that china’s current financial efficiency is low. shen (2006) pointed out that chinese financial efficiency is still at a low level at the macro level, and the main reason for the low efficiency is the lack of highlevel financial resources. the most urgent task is to insist on efficiency priority in principle. as zhang and ma (2012) pointed out that the macroeconomic indicators cannot fully reflect the status quo of financial mismatch in china, yu (2003) pointed out that the debt management in the capital structure of listed companies in china exhibits ineffectiveness, leading to the firm 2004 2005 2006 2007 2008 2009 2010 2011 average interest rate state-owned 1.77% 1.82% 2.25% 2.05% 1.88% 1.84% 1.90% 1.93% private 2.40% 2.33% 2.61% 2.40% 2.17% 2.17% 2.07% 2.08% asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 240 inefficiency of financial resource allocation, and the company’s debt level is significantly negatively correlated with corporate performance. zhang (2004) pointed out that in an incomplete information dynamic game theory, the debt ratio can convey the profit distribution information to investors. the better the performance, the higher the debt ratio should be. however, the financial resource allocation structure of some listed companies in china is contrary to the operational efficiency. wen (2014) pointed out that for chinese enterprises, the financial mismatch will greatly affect the performance of enterprises, and this negative effect will not only be reflected in the current period, but also in the later developing period. for the intensity of the research and development, a large amount of resources invested will affect the performance improvement, and the results will be difficult to work at the present stage. however, for the later stage, the longer research time extend, the greater increase of performance come from research result will be present. zhou (2016) conducted a comparative analysis of private and state-owned enterprises. the result showed that for private enterprises, there is a positive relationship between the degree of mismatch and the rate of return on capital. for state-owned enterprises, the relationship between the two shows a negative correlation. after analyzing the comparison of the degree of mismatch in the past years, it argued that the degree of mismatch of state-owned enterprises is higher. lu (2008) used the ratio of the total credit of the big four state-owned banks to the total credit of the bank and the deposit-loan ratio of the state-owned commercial banks as indicators to measure the financial mismatch in the financial system. lu (2008) concluded that the chinese government control finance strictly and financial mismatch is concentrated in the problem of the asymmetry of productivity and financing capacity of state-owned enterprises and private enterprises, thus restraining economic growth. shao (2009) studies the mismatch of financial resources among enterprises from the perspective of financial structure. it also found that banks allocate loans to state-owned enterprises at a lower cost and charge higher credit costs to non-state-owned enterprises. the return on capital for stated-owned is much lower than that of non-state-owned enterprises. if we can reduce the mismatch of financial resources among enterprises, it will increase gdp growth by 2%-8%. qi (2015) based on the micro-data of china’s manufacturing industrial enterprises to measure the mismatch of financial resources, taking the hsieh & klenow (2009) as reference which proposed interindustry capital mismatch measurement method for heterogeneous enterprise under monopolistic competition. by measuring the actual productivity and effective productivity of the two departments of the state-owned sector and the non-state sector, the model compares the loss of social total factor productivity caused by the mismatch of financial resources. in summary, previous research on the relationship between asset specificity and capital structure of listed companies in china does not lead to a more consistent conclusion. as a manifestation of the non-marketization of financial resources allocation in china, financial mismatch widely exists. financial mismatch not only reduces the efficiency of financial resource allocation, but also causes the lack of governance in the debt financing market. therefore, research on the relationship between asset specificity and capital structure for listed firms in china must consider the impact of financial mismatch. based on the above research, this paper proposes hypothesis 1, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 241 hypothesis 1, there is a financial mismatch in listed companies in china, and the financial mismatch phenomenon of state-owned listed companies is more significant than that of private listed companies. 2.2 asset specificity and capital structure previous research on the relationship between asset specificity and capital structure is basically carried out within the framework of transaction cost economics, relatively consistent conclusions have been reached. balakrishnan and fox (1993) measured asset specificity by the ratio of the sum of advertising costs and research and development expenses to revenue. the study found that there is a significant negative correlation between the two. different previous research measures asset specificity in different ways, including asset specificity index, ratio of government sales revenue to total revenue, or ratio of advertising expenditure to total revenue. previous research has generally obtained consistent conclusion that asset specificity is inversely related to debt financing (cushing and mccart, 1996; mocnik, 2001; miknler and vilasusoh, 2001). however, empirical findings on the relationship between asset specificity and capital structure in china are inconsistent. qian et al. (2002) use questionnaire survey of selected companies as the research method and mainly focus on shanghai manufacturing industry, when they are studying the specificity of assets and the internal capital structure of enterprises. they investigated the financial data of these enterprises from 1992 to 1999. the survey results showed that the company’s debt ratio will fluctuate with the change of asset specificity, and the two are positively correlated. this is contrary to the research conclusions of scholars outside china. liu et al(2003) discuss the ratio of asset specificity to internal capital formation. they combine existing related academic achievements and relevant field expertise to explore whether the company’s internal capital formation ratio will be affected by the proportion of specific assets. the final research results show that the proportion of internal capital formation is significantly affected by the proportion of specific assets, and is numerically positively correlated. wang and fan (2004) used a combination of theoretical analysis and empirical analysis when studying the proportion of internal capital formation in enterprises, which is influenced by the proportion of specific assets. their theoretical basis is based on jon vilasusoh and alanson minkler (2001) theoretical research. then, based on this empirical research, it chose two indicators to replace the proportion of the specific assets in the enterprise assets. the two variables are the ratio of the income generated by the main business of the enterprise to the income generated by all businesses and the ratio of the expenses incurred by the enterprise for advertising consumption to the income generated by the normal business of the company, when face the question about how to measure the proportion of the specific assets of corporate assets. the empirical results of their research are that the greater the proportion of specific assets in corporate assets, the higher the debt ratio formed by external borrowing, and the two are positively correlated. cheng (2004) used implicit contract theory to study asset specificity and capital structure. he chose 193 listed companies in 2001 as the research object, and divided the listed companies into two categories, namely food items and home appliances. for the measurement of asset asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 242 specificity, he selected the fixed assets/total assets, intangible assets/total assets as two indicators. he chose five variables as the control variables for empirical analysis considering that the capital structure has many factors. the empirical results showed that different industries have different effects on asset specificity. the effect of the food industry group is not very obvious, while the effect of the home appliance group is obvious, and the two have a negative correlation. yuan and zhao (2006) first use theoretical analysis to illustrate, making use of transaction cost theory, and then based on theory to conduct an empirical analysis. the empirical model mainly draws on vilasusoh and minkler (2001) model. the model takes china’s a-share listed companies as academic research objects. the empirical data proves that asset specificity and capital structure will affect each other, and there is a numerically proportional relationship between the asset specificity and capital structure. li et al. (2007) analyzed the relationship between capital structure and asset specificity in corporate assets, adding the analysis of market competition factors. first, the relationship among capital structure, asset specificity in corporate assets and market competition factors under the perspective of transaction costs. then based on theoretical analysis, it established an empirical analysis model. the empirical results show that when the product competition of the enterprise increases, the financial leverage will increase at the beginning, but as the competition continues to increase, the internal financial leverage ratio will decrease after the proportion of the asset specificity in the enterprise assets reaching a certain value. huang (2008) analyzed the relationship between asset specificity and capital structure, taking into account the difficulty of the measurement of assets specific indicators and the certainty of the selection of capital structure indicators. he chose the two indexes of the enterprise to measure the degree of asset specificity. one is the income generated by the main business accounting for the proportion of the total income of all the business. the other is the proportion of the intangible assets of all the assets of the enterprise. the measurement of the capital structure index is long-term liabilities/total assets, total liabilities/total assets, and finally the conclusions reached by the study are consistent with williamson, that is, the relationship between the two is negatively correlated. liu and sun (2010) also supported this conclusion. lei (2010) studied listed companies in the manufacturing industry in 2005-2006, and found that asset specificity of listed companies in china does not affect their capital structure. it can be seen that there are significant differences in the conclusions between literature on the relationship of asset specificity and capital structure. empirical evidence found in western countries cannot be directly applied to china. for listed companies in china, research on the correlation between asset specificity and capital structure must take into account of special factors of china’s economic operation and institutional background. based on the above research, this paper proposes the following hypothesis, hypothesis 2a, asset specificity is negatively related to a company’s capital structure. in state-owned listed companies, the market governance structure of debt financing will be denied, if financial mismatch does exist. besides, financial institutions represented by stateowned banks are the main source of corporate debt financing in china. therefore, in the debt financing contract of state-owned enterprises, due to the high consistency of the nature of asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 243 ownership for both sides, debt financing has evolved into an internal contract with a lower cost than the equity financing contract, and becomes a bureaucratic governance structure. to save transaction costs, state-owned listed companies with high asset specificity will choose debt financing. while the situation of private listed companies is different from that of state-owned listed companies, on the one hand, the high asset specificity level will increase the risk of huge potential loss of realized value, which makes it difficult to obtain credit capital. on the other hand, because debt financing may still have market governance function, the reverse adjustment of debt financing can save more transaction costs if the company has a higher asset specificity level. therefore, the following hypothesis is made, hypothesis 2b, among state-owned listed companies, asset specificity is positively related to the company’s capital structure. hypothesis 2c, in private listed companies, asset specificity is negatively related to the company’s capital structure. 2.3 factors affecting corporate performance shen (2010) conducted an analysis of the factors affecting corporate performance, from the perspective of corporate financing structure, and concluded that the existence of long-term debt will affect enterprise performance. the long-term debt and the enterprise performance are negatively correlated. the relationship between the bank loans and the performance of enterprises is also negative. at the same time, the greater the size of bond financing, the more obvious the improvement of corporate performance. ren (2011) chose to conduct analysis from various aspects simultaneously, when analyzing the factors affecting enterprise performance. the result is that the factors inhibit the performance of the company include the intensity of board meetings and state-owned holdings. the managerial equity incentive is a factor which can promote the performance of enterprises. however, the institutional investors and independent directors are factors which not have an influence on business performance. zhou (2013) pointed out that the external governance environment is an important factor affecting the performance of enterprises. with the improvement of the external governance environment, the improvement of enterprise performance is more obvious, and if the government has excessive government involvement , it will have a serious impact on business performance. mao and yang (2014) selected a-share listed companies during the research. the results show that as the concentration of the company’s equity increases, the relationship between the actual controller’s interests and the company’s interests will be stronger. the actual controller makes efforts to better manage the business. therefore, equity concentration will positively affect the company’s performance. wei (2014) analyzed the relationship between financing scale and performance from the perspective of various financing methods. the results showed that different financing methods asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 244 have various impact. but this cannot obtain the good or bad result of contrast. thus, how to choose the financing method should also be based on the actual situation of the enterprise. cheng et al. (2015) pointed out that if a company has a high degree of financial resource mismatch, it will not be able to invest more resources in research and development, so it will lead to a continuous decline in corporate performance. methodology and empirical research design 3.1 data source and sample selection the data are gathered from wind database. data of state-owned listed companies and private listed companies on a-share of shanghai and shenzhen stock exchange are selected. this paper excludes (1) listed companies in the financial industry. (2) listed companies with missing or imputed data. (3) st listed companies and pt listed companies, if a listed company makes loss for two consecutive years, or makes loss for one year, and the net assets fall below the face value, or one of the major illegal acts occurs during the company’s operation, the stock exchange will deal with the company’s stock in a special way, that is, the st system. for st companies, if there are any further problems, such as continuing to lose money in the next year and meet the three-year loss limit in the company law, then pt processing will be carried out. after the screening described above, there are 550 listed companies with 3,300 observations. among them, there are 229 state-owned listed companies with 1,374 firm-year observations, and 321 private listed companies with 1,926 annual observations. 3.2 variable selection in selecting variables, this paper draws on previous researches and foucus on the purpose of this paper. the variables are represented respectively as table 3, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 245 table 3. introduction of variables variable definition long-term debt ratio (lon) the ratio of non-current liabilities to total assets return on assets (roa) the ratio of net profit to average assets asset specificity (asi) the ratio of the sum of net fixed assets, construction in progress, intangible assets and long-term deferred expenses to the total assets of the enterprise financial mismatch burden level (fm) the ratio of interest expenses divided by liabilities removed accounts payable company size (size) the natural logarithm of total assets growth (growth) operating income growth rate equity structure (ncsp) the total share ratio of the top ten shareholders dividend payout ratio (sto) the ratio of cash dividend to earnings per share non-debt tax shield (tax) the ratio of accumulated depreciation to total asset industry (ind) industry dummy variables year (year) annual dummy variables 3.3 model to test hypothesis 1, we build a model (1) as follows, 𝑅𝑂𝐴 = 𝛼 + 𝛼 𝐿𝑂𝑁 + 𝛼 𝐹𝑀 + 𝛼 𝐹𝑀 × 𝐿𝑂𝑁 + 𝛼 𝑆𝐼𝑍𝐸 + 𝛼 𝐺𝑅𝑂𝑊𝑇𝐻 + 𝛼 𝑁𝐶𝑆𝑃 + 𝛼 𝑅𝐸𝑆 + 𝛼 𝐼𝑁𝐷 + 𝛼 𝑌𝐸𝐴𝑅 + 𝜇 (1) where α is the intercept term, α（i=1,2,3,4,5,6,7,8,9）is the regression coefficient of the model(1),μ is the random error term. to test the hypothesis 2, we build the model (2) as follows, 𝐿𝑂𝑁 = 𝛽 + 𝛽 𝐴𝑆𝐼 + 𝛽 𝑅𝑂𝐴 + 𝛽 𝑆𝐼𝑍𝐸 + 𝛽 𝐺𝑅𝑂𝑊𝑇𝐻 + 𝛽 𝑁𝐶𝑆𝑃 + 𝛽 𝑅𝐸𝑆 + 𝛽 𝑇𝐴𝑋 + 𝛽 𝐼𝑁𝐷 + 𝛽 𝑌𝐸𝐴𝑅 + 𝛿 (2) where 𝛽 is the intercept term, 𝛽（i=1,2,3,4,5,6,7,8,9）is the regression coefficient of the model(2),𝛿 is the random error term. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 246 empirical analysis 4.1 descriptive statistics in this paper, descriptive statistics are performed on the full sample and the subsample (as shown in table 4). the results of descriptive statistics show that the long-term debt ratio of state-owned listed companies (lon mean = 22.12%) is significantly higher than that of private listed companies (lon mean = 12.05%). in a sharp contrast, the rate of return on total assets of state-controlled listed companies (roa = 7.23%) is significantly lower than that of private listed companies (roa mean = 8.37%). for asset specificity level, state-controlled listed companies (asi mean = 36.01%) is significantly higher than private listed companies (asi mean = 30.90%). as shown in the descriptive statistics results, the level of financial mismatch burden of private listed companies (fm mean = 1. 2035) is significantly higher than that of state-owned listed companies (fm mean = 0.7148). in addition, there are also significant differences in firm size, growth and equity concentration, state-owned listed companies have larger average company size and higher equity concentration than private listed companies, while private listed companies have significantly higher average growth rate (growth=19.00%) than stateowned listed companies (growth=10.97%). therefore, the financial resource in listed companies of china shows a mismatched feature based on the ownership of them. state-controlled listed companies with poor average performance and high average asset specificity can obtain more long-term loans at a lower cost, while private companies with better performance needs to pay more to obtain long-term loans. to a certain extent, this reflects the phenomenon of financial mismatch. this inequality between state-owned enterprises and private enterprises violates the principle of effective allocation of resources and the theoretical analysis of transaction cost economics. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 247 table 4. results of descriptive statistics variables total state-owned private t test (n=3300) (n=1374) (n=1926) mean std.. min max mean std.. min max mean std.. min max t-value roa 0.0790 0.0491 -0.1252 0.4276 0.0723 0.0414 -0.1252 0.3805 0.0837 0.0534 -0.0802 0.4276 5.833*** lon 0.1624 0.1696 0.0000 0.7533 0.2212 0.1900 0.0002 0.7475 0.1205 0.1390 0.0000 0.7533 -16.750*** growth 0.1565 0.2665 -0.5436 4.4291 0.1097 0.2276 -0.5418 3.8940 0.1900 0.2865 -0.5436 4.4291 9.525*** ncsp 0.5971 0.1523 0.1272 1.0116 0.6170 0.1535 0.1745 1.0116 0.5829 0.1499 0.1272 0.9559 -5.134*** asi 0.3303 0.1904 0.0080 0.9265 0.3601 0.2215 0.0095 0.9265 0.3090 0.1615 0.0080 0.8570 -4.850*** fm 1.0000 2.1194 -0.9595 60.8417 0.7148 0.5945 0.0001 6.7000 1.2035 2.7104 -0.9595 60.8417 5.729*** sto 0.3651 0.4383 -0.5714 10.2041 0.3665 0.5432 -0.5000 10.2041 0.3640 0.3447 -0.5714 5.0000 0.226 size 22.7019 1.3533 19.8104 28.5087 23.3615 1.4151 20.6897 28.5087 22.2314 1.0855 19.8104 26.6525 -23.620*** tax 0.1197 0.1041 0.0017 0.6939 0.1407 0.1185 0.0037 0.6939 0.1048 0.0895 0.0017 0.6722 -9.017*** 4.2 empirical analysis of hypothesizes, based on panel data the data used in this paper are short panel data. the unit root test results show that all variables appear to have no unit roots. therefore, this paper does not need to do cointegration test for non-stationary economic variables. for the selection of models, the fixed effect model is selected for regression analysis. for crosssectional correlation testing, the test result shows that there is no cross-sectional dependency in the panel data. for heteroskedasticity testing, the final result shows that the heteroskedasticity of the panel data collected in this paper is very significant. therefore, this paper finally chooses the fixed effect model that controls heteroskedasticity. all the samples are winsorized. 4.2.1 financial mismatch the model(1) regression results are shown in the table 5, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 248 table 5. financial mismatch variables fixed-effect whole samples sub-samples state-owned private lon -0.0701*** -0.0724*** -0.0714*** (-6.97) (-5.43) (-4.57) fm -0.00193** -0.00233 -0.00157 (-2.07) (-0.76) (-1.55) fmlon 0.0269*** 0.0330** 0.0280** (2.97) (2.34) (2.06) size 0.00412 0.00306 0.000771 (0.98) (0.60) (0.13) growth 0.0278*** 0.0200*** 0.0318*** (8.14) (5.39) (6.56) ncsp 0.0238* 0.0371* 0.0257 (1.82) (1.89) (1.50) sto -0.0336*** -0.0251*** -0.0367*** (-9.39) (-6.08) (-7.71) tax -0.00278 0.00894 -0.0405 (-0.08) (0.18) (-0.83) _cons -0.00388 0.00623 0.0735 (-0.04) (0.05) (0.55) industry yes yes yes year yes yes yes n 3300 1374 1926 r² 0.153 0.209 0.145 t statistics in parentheses * p < .1, ** p < .05, *** p < .01 in fixed-effect model, the whole sample presents significant economic issues of financial mismatch, and the long-term debt ratio is significantly negatively correlated with the return on total assets at 5% significance level. this can be understood as the fact that among the listed companies in china, enterprises with more debt capital have not achieved higher efficiency, resulting in inefficient allocation of financial resources, which also confirms the research asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 249 findings of yu (2003) and xiao (2005). in the sample of state-controlled listed companies, the long-term debt ratio and the return on total assets were significantly negatively correlated at the 1% significance level, indicating that there are also financial mismatches issues in statecontrolled listed companies. the increase in liabilities significantly reduces the performance of the company. the increased claims of creditors encroach the surplus of the enterprise, and the allocation of debt capital pulls down the operating efficiency. in the sample of private listed companies, the long-term debt ratio and the return on total assets are also significantly negatively correlated at the level of 1%. the correlation coefficient is almost the same as that of state-owned listed companies, which reflects the level of financial mismatch of private listed companies is similar with state-owned companies. listed companies with more debt capital even company with lower performance. the phenomenon of financial mismatch seriously affects the efficiency of financial resources. the regression results partially support the hypothesis 1 of this paper, that is, the financial mismatch issue significantly exists in listed companies in china, but the level of financial mismatch of state-owned enterprises is not significantly higher than that of private enterprises. meanwhile, the financial mismatch burden level (fm) of enterprises has a significant negative correlation with the return on total assets in the total sample, which is contrary to the research of restuccia and rogerson (2007) and shao (2010). on the assumption of a fixed alternative elastic production function and the cobb-douglas production function, they point out that firm performance is positively related to the financial mismatch burden level that the company bears, because only high corporate performance can compensate for the premium in capital use costs. however, the regression results show that, on the contrary, the cost of capital use can negatively affect the performance of the company. to reflect the financial mismatch issue and its economic consequences in listed companies further, this paper introduces the cross term (fm×lon) of long-term debt ratio and financial mismatch burden level. the regression results show that the cross term is significantly related to the return on total assets, that is, the impact of long-term debt ratio on total return on assets is constrained by the level of financial mismatch burden. in both the total sample and the subsample, the cross term has a significant positive correlation with the return on total assets. this reveals that in china’s listed companies, the higher the level of financial mismatch burden faced by enterprises, the more the increase in debt level can encourage listed companies to improve their financial performance to make up for the increase in the cost of use of funds, and to avoid default on debt contracts. there is a positive correlation between company size variables and total return on assets, but not significant, which means that the scale expansion of listed companies is not all efficient, and there is no significant correlation between company size and financial performance. there is a significant positive correlation between the growth rate of operating income and the rate of return on total assets, and the coefficient of private enterprises is higher than that of stateowned enterprises, indicating that the impact of operating income growth on the performance of private enterprises is significantly higher than that of state-owned enterprises. the shareholding structure in the state-owned sample has a significant positive correlation with the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 250 return on total assets of the enterprise, which is consistent with the research of xu et al. (2006). the dividend payout ratio is significantly negatively correlated with the return on total assets. an excessive dividend payout rate will affect the performance of listed companies. the company should retain more profit for company development. 4.2.2 asset specificity and capital structure then, we do the same preliminary tests on model (2) as model (1). the result is same as model (1). the model(2) regression results are shown as follows, table 6. asset specificity and capital structure variables fixed-effect whole samples sub-samples state-owned private asi 0.191*** 0.207** 0.177*** (3.69) (2.10) (3.81) roa -0.338*** -0.632*** -0.235*** (-4.86) (-4.08) (-3.21) size 0.111*** 0.107*** 0.116*** (8.58) (3.36) (8.87) growth 0.0179* 0.0173 0.0171 (1.88) (0.90) (1.61) ncsp -0.0692 -0.0347 -0.0841 (-1.56) (-0.44) (-1.57) sto -0.0140 -0.00397 -0.0185* (-1.53) (-0.21) (-1.82) tax -0.303*** -0.490*** -0.147 (-3.18) (-2.72) (-1.39) _cons -2.274*** -2.179*** -2.403*** (-7.67) (-2.96) (-8.07) industry yes yes yes year yes yes yes n 3300 1374 1926 r² 0.198 0.179 0.228 t statistics in parentheses * p < .1, ** p < .05, *** p < .01 in fixed-effect model, asset specificity and long-term debt ratio were significantly positively correlated at the significance level of 1% in the full sample, which rejects the hypothesis 2a of this paper. this is clearly deviated from the theoretical analysis of transaction cost economics, and the result is consistent with the findings of lei (2010), which is, the economic consequences of asset specificity must be considered in consideration of special institutional background of china. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 251 asset specificity is also significantly positively correlated with long-term debt ratio at the 5% confidence level in the sample of state-controlled listed companies, which validates the hypothesis 2b. this can be explained as, on the one hand, when a creditor makes a credit decision on a state-controlled listed company, for the guarantee value of the asset, only the material properties will be taken into consideration, and its specificity will be ignored. this situation is also mentioned in the policy burden and budget soft constraint of china’s commercial banks proposed by lin and li (2004), which is, the non-marketization behavior of financial resources allocation. on the other hand, the financial mismatch that deviates from the market has changed the governance structure of debt financing. a high asset specificity can reduce transaction costs by adopting high debt financing instead. in the sample of private listed companies, asset specificity and corporate long-term debt ratio still shows a significant positive correlation, which rejects e hypothesis 2c of this paper. in decision of making credit loan to private listed companies, creditors are considered to be more cautious about the company’s asset specificity in order to reduce risks. therefore, debt financing will effectively maintain and play its role in market governance. this is in line with the basic logic of transaction cost economics, asset specificity acts on the capital structure through the governance structure attributes of different financing methods. however, the result of the regression is in opposite and reveals that increasing the asset specificity will not decrease the financial mismatch level of an enterprise. in the full sample and the subsample, the relationship between the return on total assets and the long-term debt ratio is consistent with the regression results of the model (1). listed companies with more debt capital company with lower performance instead. the phenomenon of financial mismatch seriously affects the efficiency of financial resources. the size of the firm is positively correlated with the long-term debt ratio, indicating that companies with more assets and larger scales are more likely to obtain long-term borrowing. growth is positively correlated with long-term debt ratios in both full and subsamples, but the correlation is not significant. the shareholding structure was negatively correlated with the long-term debt ratio in the full sample and the sub-sample, but the correlation is also not significant. the dividend payout ratio is significantly positively correlated with the long-term debt ratio in the sample of private enterprises, indicating that the more cash dividends allocated by private enterprises, the more surplus they may retain, and the lower the demand for financing long-term debt. the non-debt tax shield is significantly negatively correlated with the longterm debt ratio in the sample of the total sample and the state-controlled listed company. companies with large non-debt tax shields use less debt than companies without non-debt tax shields, and non-debt tax shields can be used as a substitute for debt to reduce corporate tax burdens. in robustness check, this paper used pcse, system gmm, seemingly unrelated regression and three-stage model on the sample with a phase lag. the regression results are shown as follows, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 252 table 7. robustness check and further discussion variables pcse system gmm seemingly unrelated regression three-stage roa lon roa lon roa lon roa lon l.lon -0.115*** 0.0212* 0.793*** -0.152*** -0.147*** (-6.07) (1.66) (17.58) (-16.70) (-15.66) l.fm -0.00128*** -0.000847 -0.00127 -0.00211*** (-2.92) (-0.78) (-1.60) (-2.81) l.fmlon 0.0373*** 0.00950 0.0407*** 0.0454*** (3.44) (0.78) (4.55) (5.01) l.size 0.00265 0.0715*** -0.0103*** -0.0301*** 0.00546*** 0.0702*** 0.00666*** 0.0648*** (1.63) (55.69) (-4.58) (-4.74) (6.61) (37.94) (7.93) (32.86) l.growth 0.0403*** 0.0667*** -0.00532 -0.0144 0.0418*** 0.0769*** 0.0391*** 0.0703*** (4.60) (3.86) (-1.38) (-1.41) (10.76) (6.84) (10.63) (6.58) l.ncsp 0.0284*** -0.0584*** -0.0184 0.112*** 0.0253*** -0.0454*** 0.0188*** -0.0504*** (8.48) (-5.01) (-1.37) (2.80) (4.47) (-2.82) (3.47) (-3.27) l.sto 0.00278 -0.0602*** 0.0325*** -0.0130 0.00136 -0.0642*** -0.00109 -0.0542*** (0.66) (-6.45) (8.32) (-1.17) (0.39) (-6.45) (-0.33) (-5.74) l.tax 0.0475*** -0.249*** 0.133*** 0.355*** 0.0492*** -0.226*** 0.0411*** -0.131*** (4.63) (-10.39) (4.47) (3.45) (5.61) (-7.19) (4.41) (-4.17) l.asi 0.253*** -0.202*** 0.243*** 0.236*** (26.85) (-4.71) (15.27) (13.62) l.roa -0.853*** 0.796*** -0.0207 -1.159*** -1.024*** (-10.24) (17.62) (-0.24) (-22.28) (-19.29) _cons 0.00391 -1.393*** 0.229*** 0.685*** -0.0522*** -1.347*** -0.0854*** -1.270*** (0.12) (-60.34) (4.18) (4.59) (-2.93) (-32.23) (-4.23) (-25.21) industry yes yes yes yes yes yes year yes yes yes yes yes yes sargon test yes yes n 2750 2750 2750 2750 2750 2750 2750 2750 r2 0.127 0.459 0.117 0.117 0.254 0.254 t statistics in parentheses * p < .1, ** p < .05, *** p < .01 in three-stage model, the long-term debt ratio is significantly negatively correlated with the return on total assets at 1% significance level. the financial mismatch burden level (fm) of enterprises is significantly negatively correlated at the significance level of 1% in the full sample and the cross term (fm×lon) is significantly positively related to the return on total assets. asset specificity and long-term debt ratio were significantly positively correlated at the significance level of 1% in the full sample. the return on total assets and the long-term debt ratio were significantly negatively correlated at the significance level of 1%. the above regression results further prove several hypotheses of this paper. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 253 conclusion and policy implications according to the theoretical analysis of transaction cost economics, the capital structure works as a governance structure to save transaction costs, which can be affected by the asset specificity, the higher the asset specificity level of the enterprise, the lower the debt level should be. however, the financial mismatch issue will distort the governance structure nature of debt financing and thus affect the applicability of this conclusion of transaction cost economics in china. based on the empirical data of a-share listed companies of china from 2012 to 2017, this paper finds that the phenomenon of financial mismatch is widespread in chinese listed companies and is not related to the ownership of companies. the degree of financial mismatches of listed companies in china is based on the soft budget constraints and the degree of marketization. the corporate performance is significantly negatively correlated with the level of financial mismatch, which indicates financial mismatches severely restrict the efficiency of listed companies in china. the asset specificity of the listed company is positively correlated with the capital structure, and the higher the asset specificity level of the enterprise, the higher its debt level will be. based on the results of research in this paper, we find that there is a premise of asset specificity affecting the capital structure, which is, the financial resource allocation market is effective. this paper argues that financial mismatches, as the characteristics in the economic transition period, inhibit the effect of asset specificity, void the market governance structure of debt financing, and reduce the efficiency of the financial system. based on this, there are four relevant policy recommendations can be proposed, first, enhance the support of credit policies and promote the rational allocation of financial resources, based on state macro-control and industrial development policies, the utilization rate of idle money and new money will be improved. based on the actual situation of regional economic development, we should adopt reasonable and scientific financial measures to promote the optimization of the economic structure, and improve credit according to the principle of rational distribution; effective measures can be taken to promote the full implementation of the credit policy. we can evaluate the effectiveness of the special credit policy to motivate the financial sector to support the company. we can try to use the relationship between government, banks and enterprises to drive the policy mechanism. in addition, financial institutions are encouraged to actively infiltrate emerging industries and provide adequate financial support for their further development. we will improve the construction of credit information platform, provide comprehensive credit services for enterprises, and facilitate investment and financing of enterprises. at the same time, we can try to open an intangible asset mortgage channel for enterprises such as intellectual property mortgages and guarantee company guarantees. second, actively promote the liberalization of interest rates, comprehensively promote the improvement of capital utilization rate. the capital price is expressed through interest rates, and the liberalization of interest rates can promote the optimal distribution of financial resources. in addition, we can further improve the functional setup of financial institutions, provide channels for private capital entry, increase the amount of funds for small and mediumsized financial institutions, and provide financial support for their scale development. we can also establish and improve the credit rating system for non-state-owned enterprises, simplify asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 254 the loan process, improve the mortgage and secured loan business, provide “one-stop” service for mortgages and secured loans that meet the conditions, and appropriately reduce costs to ensure loan efficiency. at the same time, we are committed to improving the application of financial resources, accelerating financial product innovation, and enriching the types of banking services to meet the various needs of customers. third, accelerate the development of various financing channels and gradually improve the financial structure of indirect financing, the government should provide support in the process of listing enterprises; supporting the development of small and medium-sized financial institutions. we should also encourage private capital to set up various forms of financial institutions such as microcredit, rural banks, etc; we should innovate in the form of bond issuance, commit to develop and build local bond markets, and guide and encourage powerful enterprises to issue bonds independently. financial institutions should use reasonable channels and models to guide the integration of private stock currency funds into the bond issuance business and improve the utilization rate of private funds. fourth, improve the understanding of asset specificity. listed companies should be encouraged to disclose asset-specific information to the market, especially those companies that rely heavily on asset specificity. companies will raise loan easier if they provide more relevant information for stakeholders to understand the company’s capital structure. for internal, a company should pay attention to acquisitions and increase the level of its asset specificity. and give full play to the role of asset specificity in financing decisions. through the analysis of the existing research results, we found that the current research on financial resource mismatch still has the following problems, 1. domestic research is mostly concentrated between state-owned enterprises and private enterprises, and less research on other aspects. there are many forms of misallocation channels for financial resources. financial resources are likely to be allocated to inefficient state-owned enterprises rather than highly efficient stateowned enterprises. for different regions, the mismatching of financial resources of state-owned enterprises and non-state-owned enterprises are not same; different industries will present different mismatches. it is also necessary to pay attention to the fact that the mismatch of financial resources has been initiated since the beginning of the process. finance is the core sector of china’s national economy. understanding the current state of financial development, making up for the shortcomings of financial development, and deepening financial development are crucial to china’s economic growth. 2. the mechanism of interaction between financial resource mismatch and economic growth still needs to be carefully scrutinized. at present, the impact of financial development on economic growth has obtained relatively consistent empirical results both at home and abroad, and it is believed that financial development has obvious economic growth. however, the research on the mismatch between financial resources and financial development or the mechanism of impact on economic growth is still unclear. because different mismatch metrics and different economic growth metrics asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 255 often produce different results, the current theory of financial resource mismatch does not achieve a more unified measurement. these issues require further research. besides, the research on the economic consequences of asset specificity in china is not fully carried out. within the framework of new institutional economics, the theoretical analysis of the impact of asset specificity on capital structure in china’s special institutional context still needs to be deepened. in empirical research, it is still necessary to explore a more reasonable, effective and accurate method to measure asset specificity. therefore, the research on the relationship between asset specificity and capital structure still needs to be further improved. references acemoglu d, aghion p, & zilibotti f. 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(2007). capital structure and corporate performance, empirical evidence from chinese state-controlled listed companies and private listed companies. china soft science, 12,92-107 (chinese) microsoft word revised & final versionnaser yousef alzoubi_1_ asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 367 the extent use of contemporary management accounting practices and its effect on operational performance of industrial corporations in jordan naser yousef alzoubi accounting department, irbid national university, po box 2600, irbid 21110, jordan e-mail: naseryz@yahoo.com received: dec. 18, 2017 accepted: feb. 21, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12270 url: https://doi.org/10.5296/ajfa.v10i1.12270 abstract the purpose and aims of this study is to illustrate the extent use of contemporary management accounting practices maps in the jordanian industrial corporations listed on amman stock exchange ase, and an attempt to find out the most common practice used. a field study conducted by using a questionnaire distributed to accountants working in 25 different industrial corporations, a total of 75 questionnaires distributed, 52 were valid for analysis purposes. the financial data related to the operational performance were collected for the periods 2013-2016. the study used arithmetic mean and standard deviation to describe the study sample and determine degree of implementation of contemporary maps.multiple regression analysis used to detect the effect of maps on each indicator of operational performance. results of the study showed a moderate use of contemporary maps, such as target costing, kaizen costing and just-in-time manufacturing, moreover a least used practices were activity base costing and balance scorecard, and analysis revealed a different effect of applied contemporary maps on operational performance indicators, an effects on inventory turnover rate is observed, and no statistically effect on operational ratio, receivables turnover and total assets turnover. worthwhile, the researcher proposed a number of proposals and recommendations, emphasis in reconsideration of application mechanism of contemporary maps applied in the corporations, and activate the role of various contemporary maps used as an information system, which could assess the corporate managers and decision-makers serving the management's objectives in the industrial corporations. keywords: management accounting practices, operational performance, industrial corporations asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 368 1. introduction since the middle of the last century, there has been increasing interest in studying the effect of industrial applications resulted from technological and economic developments in manufacturing environment, leading to an increased competition among industrial companies in all fields, and resulting a rapid changes in design and developing the concept of accounting information system in general, and information systems of managerial accounting and cost accounting in particular, thus, companies can maintain their competitive position and market share, therefore the use of new and improved of contemporary maps plays an important role in creating competitive advantages for industrial companies within the market in which they operate. maps provide decision makers with means to maintain competitive advantage (waldron,2007). furthermore, companies seek to provide the best and most accurate, most appropriate and flexible information in order to provide suitable and valuable information needed for the management of industrial companies to address the problems related to manufacturing and production. however, significant changes in the business environment and emergence of modern manufacturing environment have reflected the effectiveness of modern accounting information systems and the effectiveness of managerial accounting information systems and cost accounting. maps provide information to managers and help them to find solution of problems and assess performance.( heitger et al., 2008) the development in industrial sector has been accompanied by the emergence of modern philosophies and concepts of manufacturing methods and the orientation of many industries to improve and develop their business programs. the emphasis was emerged toward the need to develop maps, techniques and methods in accordance with these changes in order to achieve the company's economic objectives in general and its financial objectives in particular. moreover, generating of profit ensures growth and continuity of companies which are subject to the efficiency and effectiveness of their operational performance. 2. problem statement the concepts and methods of management accounting have evolved through the development of its tools to assist corporate management and decision makers to perform their tasks of planning, monitoring and evaluating performance, as well as helps management to balance between cost reduction and product quality, which will result an increase in company's sales and reduce costs at the same time. this justifies the belief that it will raise the capacity of the operational performance of those corporations which are applying different maps. the study problem can be summarized as follows: 2.1 to what extent the application of contemporary maps in jordanian industrial corporations are utilized? the practices are presented as independent variables: activity based costing (abc), balance scorecard (bsc), just-in-time manufacturing (jit) target costing (tc),kaizen costing (kc). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 369 2.2 what is the effect of using different contemporary maps on operational performance of jordanian industrial corporations? the operational indicators presented as dependent variables are: total assets,turnover, receivables turnover, inventory turnover and operating ratio. 3. objectives of the study this study attempt to investigate the relationship between two important variables, the contemporary maps applied and the operational performance of the corporation, which carry important indicators for management, investors and owners. the objective of this study is to measure the extent use of contemporary maps and its effect on operational performance of jordanian industrial corporations through the following steps: 3.1 measuring the degree of application contemporary maps in jordanian industrial corporations listed on amman stock exchange. 3.2 use appropriate indicators to measure operational performance of corporations represented in the study sample. 3.3 determine to what extent the utilization of different contemporary maps effects the operational performance of the jordanian industrial corporations. 4. background and previous studies 4.1 management accounting practices maps the application of maps and tools aims to provide the necessary data and information for management to carry out planning, control, performance evaluation and management decisions, leading to the optimal utilization of available economic resources through the application of various maps. management accounting information service several major roles in organization, it enhances decision making, guides strategy development and evaluate existing strategies (kaplan & atkinson,1998).management accounting is a process of measuring, analyzing, preparation and interpretation of financial information used by management for planning, evaluation and oversight within the organization to ensure the appropriate use and accountability of its resources(moscove&wright,1990; bhattacharyya & dearder,1996). managerial accounting is concerned with providing information to managers and users within the organization directly and it provides the organization with the necessary basic information through the preparation of various types of reports, some of them related to performance and comparison with what is planned, and the other frequently and periodically, analytical reports to investigate specific problems facing the organization (garrison, et al., 2012). managerial accounting is the process of identifying, measuring, analyzing, interpreting and communicating information in pursuit of an organization’s goals, it’s an integrated part of the management process, and are important strategic partner in an organization’s management team (hilton, 2002). the scientific and industrial progress has led to fundamental and continuous changes in the performance of business, as well as the intensification of competition between industrial and economic establishments. it requires the economic establishments to apply modern concepts and maps to meet the new challenges and competition imposed in markets, this requires management to intensify its work to achieve better productivity and achieve the best possible asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 370 performance and work to increase profits and improve the level of services and products manufacturing. the researcher believes that maps are applied in the jordanian industrial corporations either fully or partially, therefore the study will focus on the following contemporary maps: activity based costing (abc) -target costing (tc) kaizen costing (kc) balance scorecard (bsc) just-in-time manufacturing (jit) i. activity based costing (abc) the abc concept is an integrated and comprehensive framework that tries to identify activities that consume resources and then trace the source of the costs associated with those activities resources, whereas the total cost of these activities is obtained. the next stage is to allocate the (activity costs) to the products by specifying the cost driver for each activity by calculating the average cost of that (cost drive) and using it as a basis on how much of a particular activity is needed to produce a product. (abc) as a strategic tool for the company to obtain more accurate cost and information operations, products, services and customers, whereas contributes making many important decisions, including pricing decisions, marketing and design of the product or service, and resource utilization decisions ( cooper & kaplan, 1988 )( argyris & kaplan,1994). it’s a cost calculation method designed to provide managers with the cost information needed to make strategic decisions and other decisions that are likely to affect the company's production capacity as well as fixed costs as well as variable costs, which is used as a support tool to the company's cost system rather than as a substitute (garrison, et al., 2012). ii. target costing (tc) most target costing definitions are related to what happens in competitive markets where cost reduction is a requirement and a necessary element to achieve profitability. cost reduction is necessary in all phases of product design and development which will be reflected in cost reduction for the entire product lifecycle. target costing is a cost management tool that planners use during product and process design to drive improvement efforts aimed at reducing the product’s future manufacturing costs, it’s a tool that promote an facilitate communication among the members of the cross-functional team that is responsible for product design, it begins with price,quality and punctuality requirements defined by customers (kaplan & atkinson,1998). target costing involves seven key principles: priceled costing, that is subtracting the target profit margin from this target price yields the target cost. focus on the customer, management must listen to the company’s customers. focus on product design, engineers must design a product from the ground up so that it can be produced at its target cost. focus in process design, every aspect of the production process must be examined to make sure that the product is produced as efficiently as possible. cross-functional team, manufacturing a product at or below its target cost requires the involvement of people from many different functions in an organization. life –cycle cost, in specifying a product’s target cost, analyzing must be careful to incorporate all of product’s life-cycle costs. value-chain orientation, efforts are made to eliminate non-value added costs to bring the projected cost down (ansari & bell asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 371 2010). target costing is an important tool to enhance management's awareness of costs and therefore focus on profit margin, which strengthens the competitive position of the company (bahar, 2012).target cost management provides analytical methods and tools to develop new products and supporting strategic objectives such as market share and profit of the company, target costing can be a critical tool for management as it seeks to strategic ally manage the company’s cost and profit,by ensuring that product are designed so that they can be produced at a low enough cost to be priced competitively (hilton, 2002). iii. kaizen costing (kc) kaizen costing is a continuous development system, which is consistent with the target cost system in terms of the objectives of reducing costs and product development. it achieves this through continuous control of the production process at all stages of manufacturing to ensure that they are in the correct manner. the concept of continuous improvement is a performance objective that seeks to maximize the benefit of the consumer by reducing costs. therefore, it relates mainly to the operational aspects of the company under the concept of continuous improvement. it aims to eliminate all causes of waste, reduce waste of production or administrative activities, and thus obtain sophisticated and low-cost products ( howell, 1994).kaizen costing focuses the organization’s attention on things that managers or operators of an existing system can do to reduce costs, and the cost reduction efforts driven by kaizen costing is incremental improvement to the current production process or product design,these improvements take the form of developing improved process, improving machine performance to reduce waste, and increasing employee training and motivation to encourage employees to identify and implement the incremental daily changes that can improve cost and quality performance. organization attack continuous improvement in different ways and the kaizen costing system will reflect the cost reduction strategy (hilton, 2002).continuous improvement is a process of gradual change that focuses on performing existing tasks in a more effective way, and constantly working to make some improvements, even if they are simple. continuous improvement continuous journey, aiming to identify road signs, set goals, solve problems, develop skills and training to reach the best results(dodds,1992). iv. balanced scorecard (bsc) the bsc technique was developed by kaplan and norton (1992, 1996) in order to combine financial control measures with non-financial control measures. the bsc was developed to communicate the multiple, linked objectives that companies must archive to compete on the basis of capabilities and innovation, not just tangible physical assets, organized in four perspectives: financial, customer, internal business process, and learning and growth (kaplan & atkinson,1998). it is a strategic tool that relies on four perspectives to assess the organization's performance rather than focusing solely on the financial perspective, moreover creating an overview of the organization, furthermore the traditional measures that focus on the financial perspective are not sufficient for the contemporary business environment and attention to a broader set of standards that relate to quality, market share, customer satisfaction and employees can lead to greater insight of the organization’s position. bsc is a model that presents a variety of ways to manage the organization to earn satisfactory returns through strategic decision making and taking into consideration the effects reflected on financial measurement, customers, internal business process, and learning. it’s a performance analysis asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 372 and measurement based on the analysis of financial and non-financial performance measures. this card is an evaluation tool for a short and long term performance. the bsc contributes to providing a clear vision of the organization about its current status and future, it is an approach based on the premise that measurement is a precondition for strategic management (horngren, et al., 2009). it’s a tool consisting of a set of performance metrics derived from the organization's strategy that enables the organization to translate its strategy through four sets of performance measures labor, internal processes, growth and development, and financial measures, (garrison, et al., 2012). v. just-in-time manufacturing (jit) the aim of jit manufacturing is based on the idea of not purchasing or producing a particular item as long as it does not the company receives a request from the customers, meaning that the purchase or production of a particular item is made immediately after the company receives an order from its customers. the philosophy of this system is based on that the revenue of the company is not the production or purchase or accumulation of goods in warehouses, but revenue occurs when conduct the sales process. it is natural that producers have to predict the future demand for their products in order to facilitate the production process to meet this demand on the one hand, and to employ the highly skilled workers on the other, in order to reduce production costs for maximum profits (garrison, et al., 2012).toyota was the first to adopt jit manufacturing in the fifties of the last century, it has achieved the a remarkable results in increasing production capacity by reducing waste (kaneko & nojiri, 2008). jit is a philosophy that eliminates waste in all activities and processes involved in a particular production process within the company, leading to development and reduction of costs (cobb, 1992). jit is a system that works to reduce the levels of inventory of raw materials, units under production and inventory of producing units, thus improving the efficiency and quality of production and improving profitability.jit manufacturing rely on a limited number of suppliers ready to supply small quantities in several batches per day required by the company on time without delay (garrison, et al., 2012). jit inventory and production management system, all inventories are kept very low, since finished goods inventories are minimal. in jit production process, setups would be quicker and more frequent and production runs would be smaller and fewer inspection would be required due to total quality control philosophy that often accompanies jit (hilton(2002). 4.2 the concept of performance the concept of performance evaluation is a comprehensive objective specifying the strategies, policies and procedures to examine the results of the activities and effectiveness and compare plans and specific rules in order to detect positive and negative deviations, and to ensure the efficient management of economic resources. performance is known as a reflection of the organization ability to achieve its goals (eccles, 1991), which is also a reflection of how to use the organization's financial, human resources and exploitation of resources to enable the managements to achieve objectives (miller & bromiley, 1990). (robins & wiersema, 1995) defined it as the organization's ability to achieve its long-term goals. 4.3 previous studies many studies and researches conducted about maps in order to investigate the applying of asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 373 deferent management accounting approaches or the contemporary management accounting philosophies. waldron (2007) he made a comparative analysis of maps used by new zealand companies, and mainly focused on showing the levels of application of maps in many countries in order to propose international standards for comparison purposes. the study concluded that the traditional management accounting tools are still widely used in most companies, and the modern methods of management accounting are less used. the study showed the difference of applying of maps by new zealand companies mainly depend to the size of each company. simon, et al (2005) the study sought to measure and evaluate the different maps in slovenian companies and compare the application of different maps as well as in different industrial sectors. the study concluded that the most common method of managerial accounting used by slovenian companies is the capital budgets, followed by evaluation of competitors' performance, the method of assessing customers as assets, the client's profitability and cost of product life cycle, there is a difference in application of maps in different sectors, capital budgets, competitors' performance assessment, competitor status control, pricing strategy and customer profitability analysis. the most widely used sector of maps where industrial sector, transportation and logistics, and the less utilization of maps are the construction general services companies. topor, et al (2011) the study explained and clarified the role of maps in providing the necessary information to managers within institutions to provide more ability and make better decisions by studying the case of the romanian manufacturing industries. the study relied on the descriptive approach. the most important results were that the management accounting information is very important within the entities and emphasis that managers of these companies need the management accounting information in time for decision making. the study recommended that there is a need to improve utilization of maps, and emphasized the need to increase implementation of maps in romanian manufacturing industries. al-khalil (2012) the research aimed to demonstrate the application of modern maps in the jordanian industrial companies and to identify the difficulties encountered in use of these methods. results showed that the jordanian industrial companies apply modern managerial accounting techniques, and indicate that industrial companies are implementing to a high degree the activity based costing. conclusions emphasized the necessity of continue applying and enhancing utilization of these techniques and managers should select the appropriate technique to utilize the best of it. the study out lined the importance of conducting a feasibility study for each new method to be applied and a comparison between costs incurred by this application and benefits the company could gain of it. also, researcher believes that there is a need to ensure the existence of an active administration structure which is the main and most important reason for the success of applying the modern maps, moreover, the necessity to train employees before the adoption of maps in order to benefit from these techniques ideally. ashfaq, et al (2014) the study examined the level of using maps in service sector in pakistan represented by insurance, banking, telecommunication and computer service companies. investigation made to assess the use of maps in companies which are moving from growth to maturity stage. the study concluded that traditional maps are still used more than advanced methods. conclusion reveals that both traditional and advanced maps are important for asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 374 service sector and companies can get more benefits. andrei (2017) believes that an implementing of management accounting systems should take into account the mentality and culture that people involved in practicing the maps. he also pointed out that management behavior can affect the practices of managerial accounting, and applying of management accounting systems suffering due to the lack of professionals in the field and inadequate managerial vision at national level in romania. he concluded that organizations need more stimulation to adopt management accounting systems and call the professional and academic accountants to be more active in identifying and assessing the new management accounting systems, as well as more empirical studies and field research are necessary to assess the aspects related to the implications of human nature in implementation processes shouldn’t be ignored. cuzdriorean (2017) the objective of the study was to examines the maps adopted by the romanian small and medium size enterprises. the researcher investigated thirty seven enterprises to determine which tools are being used by romanian small and medium size enterprises, moreover to identify reasons why some specific maps are not being used. the study pointed out that a large number of enterprises use a few number of maps such as budgeting systems for controlling costs and planning cash flows, and a very little use of modern maps such as benchmarking and performance reporting based on financial and non-financial indicators. the researcher attributed the finding to the fact that the main reasons for not adopting certain traditional and modern maps were the lack of management commitment or high costs of implementation and that have led to a conclusion that romanian small and medium size enterprises heavily rely on traditional maps rather than modern maps. ahmad (2017) the study aimed to explore the extent use and implementation of maps among malaysian small and medium size enterprises in manufacturing sector and focused in finding a relationship between maps and performance. the study sought to measure the level of applying maps and found a difference between traditional and sophisticated approach. furthermore, sophisticated maps are frequently utilized by larger enterprises and effect of size is an important factor leads to adoption of maps. the study indicated that a certain maps are found to have significant relationships with performance and findings have emphasized the importance and need of maps in malaysian organizations. the most utilized practices were, costing system and performance measurement system, budgeting system, decision support system and strategic management accounting, but the study revealed that an employment of new management accounting skills, such as activity based costing and strategic management accounting and other modern techniques, are less utilized than basic techniques, and the traditional maps are still dominant. finding were concluded that using of maps have significant roles for increasing the level of efficiency and performance of small and medium size enterprises, and suggests to improve awareness and understanding the effect and the relationship between maps and performance. 5. study hypotheses based on the above presentation, and in order to answer the main question of the study "what is the effect of using different contemporary maps on operational performance of jordanian industrial corporations" the null hypothesis summarized as follows: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 375 h01: there is no statistically significant effect of applied contemporary maps on the rate of total assets turnover in the jordanian industrial corporations. h02: there is no statistically significant effect of applied contemporary maps on the rate of receivables turnover in the jordanian industrial corporations. h03: there is no statistically significant effect of applied contemporary maps on the rate of inventory turnover in the jordanian industrial corporations. h04: there is no statistically significant effect of applied contemporary maps on operating ratio in the jordanian industrial corporations. 6. methodology 6.1 research instrument to achieve the study objectives and testing hypotheses, an analytical descriptive approach used, and relies on reviewing previous related studies to the topic addressed in the current study. the researcher also used a field study approach, which is based on collecting field data using a questionnaire distributed to a group of accountants working in different jordanian industrial corporations, moreover, the data regarding dependent variables, which is total assets turnover, receivable turnover, inventory turnover and operating ratio are collected from official published financial reports. 6.2 the study population and sample the study population consists of all listed industrial corporations in amman stock exchange (ase). the questionnaires were distributed to a group of accountants working in deferent jordanian industrial corporations, a sample of the study was selected using random sampling procedures, 75 questionnaires were distributed, 52 questionnaires received representing a response rate of (80%), which are valid for analysis of the total questionnaires distributed and suitable for the process of statistical analysis. cronbach alpha was used to measure the reliability of study tool and the internal consistency of all questionnaire paragraphs, the cronbach alpha was (88.3%), which is sufficient, high and acceptable for the purposes of testing the reliability of study tool. the study sample includes the jordanian industrial corporations listed in (ase).published financial reports during the period of the study were 68 corporations according to (ase) for the periods 2013-2016.data collected as shown in (table 1) below a random sample of 25 corporations, which represent (36%) of total number of industrial corporations listed in (ase). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 376 table 1. the study sample of industrial corporations category frequency percent chemical industries 3 12.00 electrical industries 2 8.00 engineering and construction 3 12.00 food and beverages 5 20.00 mining and extraction industries 5 20.00 pharmaceutical and medical industries 4 16.00 textiles, leathers and clothing 2 8.00 tobacco and cigarettes 1 4.00 total 25 100.00 6.3 statistical analysis and hypothesis testing the statistical package for social sciences program has been used (statistical package for social sciences (spss) to analysis the data collected. descriptive statistics methods used in order to make a comparison among the responses of the study sample, the means value used to measure the central tendency and standard deviation to measure the dispersion of the answers around the averages for the various statements questionnaire. 6.4 description of the study sample responses tables (2, 3, 4, 5 and 6) illustrate a description of the study sample answers using the mean and standard deviation for each answer of statements in the questionnaire, as well as the order of each statement according to the arithmetic mean. moreover, the following tables show the perceptions of respondents concerning the utilization of contemporary maps. to what extent the application of contemporary maps in jordanian industrial corporations are utilized. these practices are (abc),(tc),(kc),(bsc) and. (jit). table 2. means and standard deviation of activity based costing (abc) domain, total means (n= 52) no domain mean standard. deviation rank agreement degree asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 377 1 the cost for each activity is determined 1.86 0.78 8 low 2 administration has the ability to separate direct and indirect costs. 1.74 0.78 9 low 3 multiple upload rates are used for activity costs taking account causal relationship between costs and the activities that cause the cost. 2.00 0.79 7 low 4 ability to identify activities that each product consumes. 2.38 0.83 3 medium 5 activities are divided into activities which add value to the product and activities that do not add . 2.16 0.81 6 low 6 administration has the ability to determine the exact number of activities that cause the cost of each activity. 3.69 1.14 1 high 7 indirect costs are allocated to activities. 2.24 0.86 4 low 8 production divided into sub-activities to facilitate the determinant costs of each product. 2.17 0.86 5 low 9 reduction of activities that do not add value to the product such as (storage and handling costs). 2.67 1.03 2 medium total means 2.32 0.34 low table (2) shows that the highest means reached (3.69) out of (5) for item (6) "administration has the ability to determine the exact number of activities that cause the cost of each activity" by high agreement degree, then for item (9) "reduction of activities that do not add value to the product such as to the product such as (storage and handling costs)." (means 2.67) by medium agreement degree, then for item (4) "ability to identify activities that each product consumes" (means 2.38) by medium agreement degree, and the lowest means was (1.74) for item (2) "administration has the ability to separate direct and indirect costs" by low agreement degree. the total means for "activity based costing" reached (2.32) by low agreement degree. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 378 table 3. means and standard deviation for target costing (tc) domain, total means (n= 52) no domain mean standard. deviation rank agreement degree 1 competitive products are studied, analyzed and compared with the company's products. 3.21 0.89 6 medium 2 the total cost of the product is determined before starting the production process. 3.76 1.00 1 high 3 the profit margin of the product is determined prior production. 3.40 0.86 3 medium 4 the selling price of the product is determined based on market studies before starting the production process. 3.00 0.75 8 medium 5 the profit margin of the product is determined based on the product's status among its competitors. 3.31 0.78 4 medium 6 administration seeks to reduce product costs at an early stage of production. 3.21 0.83 6 medium 7 the cost of the product is taken into account during the design and planning phase. 3.64 0.85 2 medium 8 administration is working on reducing cost through measures leading to cost reduction during production. 3.22 0.56 5 medium 9 the profit margin of the product is determined based on the expected sales volume of the production. 2.28 0.74 9 low total means 3.22 0.40 medium table (3) shows that the highest means reached (3.76) out of (5) for item (2) "the total cost of the product is determined before starting the production process" by high agreement degree, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 379 then for item (7) "the cost of the product is taken into account during the design and planning phase." (means 3.64) by high agreement degree, then for item (3) "the profit margin of the product is determined prior production" (means 3.40) by medium agreement degree, and the lowest means was (2.28) for item (9) "the profit margin of the product is determined based on the expected sales volume of the product" by low agreement degree. the total means for "target costing" reached (3.22) by medium agreement degree. table 4. means and standard deviation for kaizen costing (kc) domain, total means (n= 52) no domain mean standard. deviation rank agreement degree 1 administration analyzes the competing products and compares them with company’s products. 2.28 1.02 10 low 2 administration works and study all possible ways of reducing the cost of manufacturing during every stage. 3.66 0.98 8 medium 3 administration is concerned with product features and specifications. 3.84 1.04 5 high 4 administration seeks to eliminate waste of resources. 3.95 0.78 3 high 5 inspections and control of products are carried out continuously to ensure quality. 3.78 0.80 6 high 6 administration adopts continuous improvement system at every stage of product life cycle. 4.14 0.83 2 high 7 administration works to increase the efficiency of the employees to increase their productivity. 3.38 1.15 9 medium 8 administration adopts continuous improvement system at every stage since product design until the sales stage of it. 4.17 0.86 1 high 9 reducing costs is done by reducing the 3.76 0.82 7 high asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 380 number of defective and damaged units. 10 administration adopts a continuous improvement approach. 3.86 0.89 4 high total means 3.68 0.34 high table (4) shows that the highest means reached (4.17) out of (5) for item (8) "administration adopts continuous improvement system at every stage since product design until the sales stage of it" by high agreement degree, then for item (6) "administration adopts continuous improvement system at every stage of product life cycle" (means 4.14) by high agreement degree, then for item (4) "administration seeks to eliminate waste of resources" (means 3.95) by high agreement degree, and the lowest means was (2.28) for item (1) "administration analyzes the competing products and compares them with company’s products" by low agreement degree. the total means for "kaizen costing" reached (3.68) by high agreement degree. table 5. means and standard deviation for balanced scorecard (bsc) domain, total means (n= 52) no domain mean standard. deviation rank agreement degree 1 application of the balanced scorecard system helps in evaluating the performance of the company contributes to the development of strategic plans. 3.69 0.94 1 high 2 application of a balanced scorecard system helps in evaluating the performance of the company and strengthening the control system. 2.43 0.84 2 medium 3 application of a balanced scorecard system helps in evaluating the performance of the company and development of tactical plans. 1.84 0.83 9 low 4 administration monitors the performance and to what extent objectives are achieved. 2.33 0.85 4 low 5 administration sets standards for 1.95 0.83 8 low asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 381 financial performance and profitability. 6 administration sets standards to measure the customer’s satisfaction regarding the company's products. 1.98 0.81 6 low 7 the company's performance evaluation system includes different financial measures. 2.40 0.70 3 medium 8 application of a balanced scorecard helps in evaluating the performance of the company and helps in measuring the performance of non-financial aspects. 2.12 0.96 5 low 9 the expected results of implementation exceed the cost of implementing the balanced scorecard system. 1.97 0.79 7 low total means 2.30 0.34 low table (5) shows that the highest means reached (3.69) out of (5) for item (1) "application of the balanced scorecard system helps in evaluating the performance of the company contributes to the development of strategic plans" by high agreement degree, then for item (2) "application of a balanced scorecard system helps in evaluating the performance of the company and strengthening the control system" (means 2.43) by medium agreement degree, then for item (7) "the company's performance evaluation system includes different financial measures" (means 2.40) by medium agreement degree, and the lowest means was (1.84) for item (3) "application of a balanced scorecard system helps in evaluating the performance of the company and development of tactical plans" by low agreement degree. the total means for "balanced scorecard" reached (2.30) by low agreement degree. table 6. means and standard deviation for just-in-time manufacturing (jit) domain, total means (n= 52) no domain mean standard. deviation rank agreement degree 1 production is scheduled at predetermined timing. 2.78 0.94 8 medium 2 the company has a collaborative team responsible for carrying out tasks and coordinating their activities to maintain 2.93 0.95 5 medium asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 382 a smooth flow of operations. 3 reductions of stock quantities of raw materials are taking into consideration. 3.00 0.92 3 medium 4 machines are classified as manufacturing cells based on production processes. 3.88 1.08 2 high 5 work is done to shorten and minimize activities that do not add value to the product such as (storage and handling costs). 2.98 0.93 4 medium 6 the time utilization in production process is optimized to minimize waste in time. 3.98 1.12 1 high 7 the machines or service offices are arranged in such a way to optimize the utilization of workspace. 2.83 0.98 7 medium 8 machines or services work are arranged in a manner that does not permit the existence of unfinished production or unfinished services in production process. 2.91 0.94 6 medium 9 the company relies on a certain number of reliable suppliers, whom committed to deliver raw materials and production requirements on time. 2.16 1.15 9 low total means 3.05 0.42 medium table (6) shows that the highest means reached (3.98) out of (5) for item (6) "the time utilization in production is optimized to minimize waste in time." by high agreement degree, then for item (4) "machines are classified as manufacturing cells based on production processes" (means 3.88) by high agreement degree, then for item (3) "reduction of stock quantities of raw materials are taking into consideration." (means 3.00) by medium agreement degree, and the lowest means was (2.16) for item (9) company relies on a certain number of reliable suppliers, whom committed to deliver raw materials and production requirements on time" by low agreement degree. the total means for "just-in-time manufacturing" reached asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 383 (3.05) by medium agreement degree. table (7) shows the aggregate level of application of each maps used in the jordanian industrial corporations. table 7. means and standard deviation for each domain and total means (n= 52) no domain mean standard. deviation rank agreement degree 1 target costing 3.22 0.40 2 medium 2 just-in-time manufacturing 3.05 0.42 3 medium 3 activity based costing 2.32 0.34 4 low 4 balanced scorecard 2.30 0.34 5 low 5 kaizen costing 3.68 0.34 1 high total means 2.93 0.16 medium table (7) shows that the highest means reached (3.68) for the domain (5) "kaizen costing" by high agreement degree, then for domain (1) "target costing" (means 3.22) by medium agreement degree, then for domain (2) "just in time manufacturing" (means 3.05) by medium agreement degree, and the lowest means were for domain (3) "activity based costing" (means 2.32) and (2.30) for domain (4) "balanced scorecard" by low agreement degree. the total means of "study tool" reached (2.93) by medium agreement degree. according to the results shown in the previous table, the aggregate level of application of maps in the industrial corporations is medium. 6.5 hypothesis testing for testing hypotheses. multiple regressions analysis was used to measure the effect of contemporary maps on operational performance (total assets turnover, receivable turnover, inventory turnover and operating ratio) extracted from the financial reports of the study sample consisting of 25 jordanian industrial corporations.table (8) shows the aggregate calculation for the dependent variables (operational performance). table 8. means and standard deviation of operational performance in the jordanian industrial corporations. (n= 25) no variable minimum value maximum value mean standard deviation asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 384 1 total assets turnover 0.04 1.61 0.69 0.34 2 receivables turnover 0.34 16.82 5.32 4.12 3 inventory turnover 0.39 12.14 3.01 2.32 4 operating ratio 67.62 1106.02 136.33 176.31 h01: there is no statistically significant effect of applied contemporary maps on the rate of total assets turnover in the jordanian industrial corporations. table 9 : effect of maps on total assets turnover (n = 52) independent variable t value t sig beta r r2 f value f sig target costing 0.137 0.892 0.018 0.389 0.151 1.852 0.119 just-in-time manufacturing 0.258 0.797 0.037 activity based costing 0.180 0.858 0.024 balanced scorecard 2.085 0.042 0.296 kaizen costing 2.493 0.016 0.379 * dependent variable: total assets turnover results of testing h01 table (9) shows that: there are no statistically significant effect at significant level (α≤0.05) of modern administrative accounting methods on total assets turnover in jordanian industrial corporations, where f value reached (1.852) by statistically significant (0.119), (r) value reached (0.389) and (r2) value reached (0.151). h02: there is no statistically significant effect of applied contemporary maps on the rate of receivables turnover in the jordanian industrial corporations. table 10. effect of maps on receivables turnover (n = 52) independent variable t value t sig beta r r2 f value f sig asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 385 target costing 0.190 0.850 0.026 0.324 0.105 1.216 0.315 just in time manufacturing 0.128 0.899 0.019 activity based costing 1.062 0.293 0.148 balanced scorecard 0.137 0.892 0.020 kizen costing 1.822 0.072 0.284 * dependent variable: receivables turnover results of testing h02 table (10) shows that: there are no statistically significant effect at significant level (α≤0.05) of maps on receivables turnover in jordanian industrial corporations, where f value reached (1.216) by statistically significant (0.315), (r) value reached (0.324) and (r2) value reached (0.105). h03: there is no statistically significant effect of applied contemporary maps on the rate of inventory turnover in the jordanian industrial corporations. table 11. effect of maps on inventory turnover (n = 52) independent variable t value t sig beta r r2 f value f sig target costing 0.019 0.985 0.002 0.466 0.218 2.892 0.022 just in time manufacturing 0.331 0.742 0.046 activity based costing 0.835 0.407 0.109 balanced scorecard 2.546 0.014 0.347 kizen costing 2.553 0.014 0.372 * dependent variable: inventory turnover results of testing h03 table (11) shows that: there are a statistically significant effect at significant level (α≤0.05) of maps on inventory turnover in jordanian industrial corporations, where f value reached (2.892) by statistically significant (0.022), (r) value reached (0.466) and (r2) value reached asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 386 (0.218). h04: there is no statistically significant effect of applied contemporary maps on operating ratio in the jordanian industrial corporations. table 12. effect of maps on operating ratio (n = 52) independent variable t value t sig beta r r2 f value f sig target costing 0.114 0.910 0.016 0.322 0.104 1.207 0.319 just in time manufacturing 0.744 0.460 0.110 activity based costing 0.229 0.820 0.032 balanced scorecard 2.356 0.022 0.343 kizen costing 1.476 0.146 0.230 * dependent variable: operating ratio results of testing h04 table (12) shows that: there are no statistically significant effect at significant level (α≤0.05) of maps on operating ratio in jordanian industrial corporations, where f value reached (1.207) by statistically significant (0.319), (r) value reached (0.322) and (r2) value reached (0.104). 5. results and recommendations 5.1 results this study designed to examine the extent use and utilization of contemporary maps in jordanian industrial corporations, and to reveal if there are any significant effects of maps on operational performance. based on the results of statistical analysis and hypothesis testing, results can be summarized as follows: difference were remarkable in utilization of contemporary maps. according to the opinions of accountants responding to the questionnaire, most of jordanian industrial corporations engaged in utilizing contemporary maps at different levels, with an overall medium mean value (2.93). the findings produce some original results on the use of contemporary maps by the jordanian industrial corporations; in general, industrial corporations have wide adoption of maps, such as kaizen costing, just-in-time manufacturing and target costing. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 387 maps have rather a limited extent use or inadequate implementation. furthermore, results show that the implementation rate of abc and bsc was the lowest among all five areas of contemporary maps examined results of descriptive analysis of the study sample responses shows that kaizen costing domain was the highest domain utilized with a mean value (3.68), and the least domain used is bsc with mean value of (2.30). there are no statically effects of contemporary maps on operational performance, with f value of (1.852) with statistically significant (0.119) for the domain total assets turnover and f value of (0.315) with statistically significant (0.324) for the domain receivables turnover and f value of (1.207) with statistically significant (0.319) for the domain operating ratio. there is a statistically significant effect of maps on operational performance, with f value of (2.892) with statistically significant (0.022) for the domain inventory turnover. results reveal some supports for the hypothesized proposition that there is significance effect of applied maps on operational performance. none the less, study results of data analyzed showed that there are no effects observed of applied contemporary maps on operational performance of industrial corporations except of inventory turnover indicator. 5.2 recommendations based on the aforementioned results and in order to provide references in light of previous findings, the study recommends the following: corporate managers and decision-makers should reconsider the mechanism of contemporary maps applied in the industrial corporations. reaffirmation to the industrial corporation’s administration to apply and utilize the various contemporary maps to achieve the advantages and benefits of using these practices. increase the awareness of administrations in industrial corporations to the importance of applying the various contemporary maps and its roles in improving operational performance and increasing profitability. activate the role of various contemporary maps used as an information system contribution in serving the management's objectives. develop the accounting and administrative systems in industrial corporations to be more compatible and suitable with the development of modern manufacturing systems. the benefits of each practice used should be examined and cost benefit analysis should be made for each practice applied and realize the benefits obtained. need to ensure that there is an appropriate administrative structure and qualified staff before applying any of contemporary maps, furthermore the administrative structure is the most important factor to realize success in application of these practices. necessity of continuing and enhancing the adoption of maps in jordanian industrial asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 388 corporations, and keeping abreast of the latest developments in this field and select what is appropriate for the company. overall, the researcher emphasis the necessity to improve the awareness of applying various maps and its effect on operational performance in jordanian industrial corporations, moreover, further researches could consider additional practices and operational variables that may reveal the important roles and relationship between maps and operational performance. conducting further similar studies in future involving other sectors such as service and commercial sectors. references ahmad, k. 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(2007). today's management accounting techniques in nz businesses, chartered accountants journal, feb, 32-34. microsoft word 13690-49965-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 63 financial engineering and its role in the growth and development of islamic banking in palestine dr. amer s. jaber phd islamic finance tel: 97-059-937-4274 e-mail: amer.jaber2010@hotmail.com received: august 27, 2018 accepted: oct. 21, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13690 url: https://doi.org/10.5296/ajfa.v10i2.13690 abstract the study aimed to identify the role of financial engineering in the growth and development of islamic banking in palestine; this is through the acknowledgment of the role of the sharia supervisory board represented by the jurisprudential opinions on new islamic products and tools. moreover, the role of the regulations and instructions issued by the palestine monetary authority (pma) concerning islamic banks. in addition to the impact of experience and employees’ training, as well as the impact of modern technology on the growth and development of islamic banking in palestine. the researcher used the analytical descriptive approach to reach conclusions and recommendations that can be generalized. the study population was employees working at islamic banks in palestine, who are (1049) employees. the sample for the study targeted 315 employees, which consists 30% of the total population. the tool used for the study was questionnaires distributed on the sample to collect preliminary data. the number of respondents was (258) employees which composes 81% of the sample. the study has reached many conclusions, and the following are the most important ones: the views of the sharia supervisory board in the banks operating in palestine play a major role in the growth and development of islamic banking, while the other areas play a moderate role in the growth and development of islamic banking in palestine. the study recommended the need to spread the culture of electronic islamic banking, and the need to update the regulations and instructions governing islamic banking. in addition to the need for cooperation and coordination between the sharia supervisory boards of the banks and the unified authority that is affiliated with the pma. keywords: islamic banks, financial engineering, palestine. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 64 1. introduction islamic banks in palestine seek to provide a range of financial services to their clients, through islamic financial instruments, either modern or original. this is in order to differentiate themselves from the traditional banking sector and attract more customers, which is beneficial to the islamic banks in palestine, by managing its liquidity in a profitable and glorious way, which is known as financial engineering. the international financial engineers association (ife) has defined the concept of financial engineering as “the process by which the financial instruments used by the financial institution are developed, as well as the application of the financial theory in an innovative manner and finding solutions to the financial problems that the institution suffers through finding financial instruments that benefit the institution finance”. (kunduz, 2007, p. 10) islamic banking in palestine is considered a banking system that adheres to the provisions of the islamic sharia. unlike other existing banking systems, it considers the introduction of banking services as the embodiment of islamic principles to reach a functional and economic society within the limits of islamic law. a banking institution committed in all transactions and investment activities and management of all its work islamic law and purposes as well as the objectives of the islamic community internally and externally. (rifai, 2004, p. 20) 2. methodology the study was based on the descriptive analytical approach. the secondary data were obtained from relevant books and financial reports. while the primary data were collected, through using a questionnaire, from the study population and were analyzed statistically to obtain the results of the study. the questionnaire was a primary data collection tool that aimed to identifying the role played by financial engineering in the growth and development of islamic banking. islamic banks in palestine should re-formulate their tools and products, or create new ones in a creative way, in line with the global developments in the field of islamic banking. this can be achieved through using the financial engineering tools and products, and the result is exploitation of the opportunities inherent, especially in light of the rapid development and renewal in the sector. islamic banks, hence the problem of the study, which is the question of the following questioning: what is the role of financial engineering in the growth and development of islamic banking in palestine? there are several sub-questions that the study seeks to answer: 1. what is the role of the sharia supervisory board represented by the jurisprudential opinions on the new islamic products in the growth and development of islamic banking in palestine? 2. what is the role of the regulations and instructions issued by the palestinian monetary authority concerning islamic banks in the growth and development of islamic banking? asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 65 3. what is the impact of experience and staff training on the growth and development of islamic banking in palestine? 4. what is the impact of modern technology on the growth and development of islamic banking in palestine? this study aims to identify the role of the sharia supervisory board to devise creative solutions to the problems of financing granted by the palestinian islamic banks. as well as to recognize the role of the regulations and instructions issued by the pma concerning islamic banks in the growth and development of islamic banking. also recognizing the impact of experience and employees’ training on the growth and development of islamic banking in palestine. in addition to learning about the impact of modern technology on the growth and development of islamic banking in palestine. the importance of the study is in its contribution to highlighting the importance of financial engineering in the development of islamic banking in palestine and its attempt to uncover modern methods for the development and growth of islamic banking in palestine. the study aims to enhance the studies and researches for those interested in the development of islamic banking in palestine. the results of the study are expected to reach an important source for the islamic banks in palestine to rely on them to develop their tools and products to serve the palestinian society. 3. hypotheses of the study the following hypotheses were formulated in an attempt to answer the questions posed by the study: 3.1 there is a statistically significant relationship between the clarity of the opinion of the shari'ah supervisory board of the palestinian islamic banks and the growth and development of islamic banking in palestine. 3.2 there is a statistically significant relationship between the restrictions on regulations and instructions issued by the palestinian monetary authority concerning islamic banks and the growth and development of islamic banking. 3.3 there is a statistically significant relationship between experience and employees' training and the growth and development of islamic banking in palestine. 3.4 there is a statistically significant relationship between the use of modern technology and the growth and development of islamic banking in palestine. 4. society and study sample the society of the study is composed of employees of the three islamic banks operating in palestine. the number of employees was (1049) employees until the end of 2017 according to the annual report 2017 issued by each bank. a stratified sample targeted 30% of the society, the sample size was (315) employees. the following table shows the society and the sample of the study in numbers: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 66 table 1. distribution of the society and sample of the study name of islamic bank study society / number of employees sample study 30% palestine islamic bank 568 170 arab islamic bank 411 123 safa bank 70 21 total 1049 315 5. statistical treatments after the data was collected and processed statistically using the statistical program (spss) using the following statistical treatments: 5.1 calculations, percentages, and repetitions to calculate the relative weight of the subjects and areas of the study instrument 5.2 examining the stability of the questionnaire using the formula alpha kronbach. 6. literature review 6.1 previous studies 6.1.1 sabreena rashad, 2017, "islamic financial engineering as a mechanism to provide islamic banking financing" this study aimed to understand the role of islamic financial engineering in providing islamic banking financing in order to meet the diverse financial needs of various concerned parties, as well as clarifying the concept of islamic financial engineering and its scientific and practical importance in the growth and development of islamic finance. the researcher used the analytical descriptive approach to collect data on financial engineering and islamic banking financing. the researcher adopted the consolidated financial reports issued by the international islamic financial market to access the preliminary data for analysis and access to the results, the most important of which is that islamic engineering supports islamic banking by providing products and tools, and that these products are generated by innovation by simulation and not by real innovation. the study recommended the need to move away from imitating the products of conventional banks to create new products, and the need to develop and control the methods of islamic finance depending on the specialists in the subject of financial engineering, in addition to the need to establish units for research and development in financial institutions. 6.1.2 bonkab, 2016, "the role of islamic financial engineering in risk management of islamic financing formulations a case study of al baraka bank of algeria" this study aimed to identify the role of islamic financial engineering in managing the risks of the financing formulas of al baraka algeria bank. the researcher used the analytical descriptive approach for studying the concepts of risk management and financial engineering. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 67 the researcher also used the case study to clarify the mechanism of risk management at al baraka bank of algeria. the study concluded that islamic financial engineering contributes to the risk management of al baraka bank of algeria, but this contribution is limited to the sales formulas related to murabaha and leasing, and the regulations and instructions issued by the regulatory authorities in algeria regarding the islamic banking business applied by al baraka bank are effective and serve islamic finance. moreover, the opinion of the sharia supervisory board has a significant impact on the growth and development of the services of the bank. the study recommended the need for al baraka bank to adjust some of its procedures in risk management, as well as the need to follow up the funds granted to customers on an ongoing basis. 6.1.3. moenis, 2016 "the rules of engineering islamic financial products analytical study" this study aimed to prove the role of financial engineering in finding new financing products that meet the needs of the customers. the study has addressed the concept of islamic financial products engineering and the need for them. it concluded that the engineering of islamic finance products was based on several rules that gain advantages and specificities from conventional financing. the rules of product engineering are the engineering of finance products to achieve the goal of islamic finance and the legitimacy of the contractual system. the production is the basis for the benefit contributed by the financing product. the efficiency criterion in islamic financial products is to reduce costs to achieve economic efficiency and credibility of legitimacy. the study recommended the need to allocate specialized studies to each of the rules of financial engineering, which provides a clearer vision of islamic finance in the context of its ability to meet the wishes and needs of customers. 6.1.4. omrana & aboulaich (2016) "islamic financial engineering al arboun sale" the aim of this study is to clarify the possible alternatives to the sale of mortgages under financial engineering, as well as to identify the role of financial engineering in the creation of islamic financial services. the study concluded that the sale of mortgages can be an islamic alternative in the case of traditional buying under sound management of potential risks. the study recommended that the islamic finance operations should be performed separately and continuously to ensure the development and innovation, to keep abreast of the technological progress in islamic banking. 6.1.5. kok (2014), "derivative products and innovation in islamic finance" this study aimed to highlight the possibility of organizing an islamic option that includes an element of risk participation rather than risk transfer through what is known as innovation and financial engineering. the researcher used the analytical descriptive method to examine the possibility of forming an islamic option to share the risks between the promise and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 68 murabaha. the study relied on bi-period results. the study concluded that the results obtained are based on the final trend of the market. the study presented arguments for the adoption of risk sharing, compared to the risk transfer methodology, when it comes to structuring management tools. the study recommended the use of islamic financial architecture as a modern method of organizing risk management in islamic finance, as well as keeping abreast of the technological developments of the markets and financial transactions, as they are important in reducing the risk ratio of institutions. 6.1.6. ginanjar, 2013, "islamic financial engineering: comparative study agreements in islamic capital market in malaysia and indonesia" this study aimed to provide a discussion of islamic financial engineering in terms of its practice in the indonesian capital market and the malaysian capital market and compare them; in order to verify whether the regulator can play an effective role in achieving islamic demands. the researcher used the analytical descriptive method to study the market response. during the analysis of the regulation of the islamic capital market in the middle east countries. the study concluded that the growth in the islamic capital market in the malaysian capital market is higher than that of the indonesian capital market due to the use of islamic financial engineering for modern technology and the expertise of its managers and the resulting regulation of islamic capital. islamic capital market in indonesia to compete with regional markets. 6.2. the situation of this study from previous ones it is clear from the analysis of previous studies that they addressed mainly the concept of innovation and islamic financial engineering and its reflection on islamic banks, including the application of financial engineering as a tool to reduce risk in some financing tools. the majority of the researchers in the previous studies used the descriptive method to analyze financial data of some banks, content analysis. as for the current study, it is distinguished from the scientific point of view, that it is one of the few studies that discussed the subject of financial engineering and its role in the development of islamic banking in palestine. the study also selects a study society that touches upon the practical reality of islamic banking in palestine. 7. the tool study the researcher used the questionnaire as a tool for gathering information and reaching the objectives of the study. a number of previous studies and tools were used. a special questionnaire was developed to measure the role of financial engineering in the development and growth of islamic banking in palestine. the second section included paragraphs that measure the role of each field in the development and growth of islamic banking in palestine, the number of these paragraphs was (28) were addressed to employees in islamic banks in asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 69 palestine. the questionnaire was distributed from electronically on the study sample, and the total number of respondents was (258), which composes 81% of the selected sample. 8. description of personal respondents table (2) shows a description of the personal factors of the sample of the study: it is clear from table (2) that the majority of the study sample was for the age group from 25 years to 45 years. which indicates the high percentage of young people working in palestinian islamic banks, and 97% have majors in finance, banking and accounting only 7% of the sample had scientific qualifications related to islamic banks and finance, this indicates that the palestinian universities lack islamic financial specialization. the functional characteristics of the study sample were the largest proportion of the head of department and director of department and other names without that. which indicates that the members of the sample of the study have the ability to answer the questionnaire professionally and objectively. and the number of years of experience of the study sample we find that the majority of those who have years of experience from 5 to 15 years. indicating that they have sufficient knowledge in the subject of the study. table 2. frequencies and percentages for the personal variables of respondents variable classification frequency % age under 25 years 31 12 from 25 years to less than 35 years 127 49 from 35 to 45 years old 89 34 45 and above 11 4 qualification diploma or less 8 3 bachelor 179 69 master and above 71 28 specialization accounting 65 25 banking and financial sciences 71 28 islamic banks 18 7 economy 41 16 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 70 business administration 48 19 other 15 6 job title general manger 1 0 deputy general manager 1 0 assistant of a general manager 2 1 director 43 17 head of the department 59 23 other 152 59 years' experience 5 years and less 127 49 from 5 to less than 10 years 81 31 from 10 to less than 15 years 27 10 from 15 to less than 20 years 13 5 from 20 to 25 years 7 3 25 years and over 3 1 the sum of each variable 258 100% 8. stability of the tool stability of the tool was tested by cronbach alpha coefficient test; table (3) shows the following: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 71 table 3. internal stability coefficients in the alpha cronbach on the different fields of resolution and on the total score variable number of paragraphs cronbach alfa the clarity of the opinion of the sharia supervisory board on the palestinian islamic banks 8 0.75 restrictions on regulations and instructions issued by the palestinian monetary authority 7 0.89 experience with the employees of islamic banks in palestine and their training 6 0.77 use of modern technology 7 0.79 all variable 28 0.78 it is clear from table(3) that the stability coefficients of the different areas of the α-cronbach resolution on the axes range from 0.75 to 0.89, thus reflecting the consistency of the resolution paragraphs, which enables them to measure and examine the questions that the study went to. all values in table 3 were > 0.60 that means a stability of the tools (scatter 19), it thus reflects the stability of the questionnaire paragraphs, enabling them to measure and examine the questions that the study has gone through. the scale was designed based on a five-dimensional likert scale. the paragraphs were built in a positive direction and weights were given to the paragraphs as follows: strongly agree: five degrees, agree: four degrees, neutral: three degrees, disagree: two degrees, strongly disagree: one degree. the default is medium (3) which can be found by calculating the average of the previous options (5 + 4 + 3 + 2 + 1) ÷ 5. table 4. estimating the level of role of financial engineering in the development and growth of islamic banking in palestine range % estimate the level of the role less than 3.44 68.8 % less than very low 3.443.82 %68.8 -76.4 % low 3.83-4.21 76.5-84.2 % moderate 4.22-4.60 84.3-92.0 % high 4.61 and above more than 92% very high 9. hypotheses 9.1 test of first hypothesis there is a statistically significant relationship between the role of the sharia supervisory board represented by the jurisprudential opinions about new islamic products and products and the growth and development of islamic banking in palestine. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 72 table (5) shows that all grouped items have a mean of 4.37, is the larger of about 1.37 average defaults (3). this means that this hypothesis is accepted. and there is a statistical relationship between the clarity of the opinion of the sharia supervisory board of the palestinian islamic banks and the growth and development of islamic banking in palestine. it is clear from the data of table (5) that paragraph (8) was ranked first in terms of ranking, with an average of 4.76 and a (%95.4) of islamic bank in palestine with regard to traditional and islamic financing instruments. the researcher connects this result with the requirements of the palestinian monetary authority, the need to provide sufficient expertise in the sharia supervisory board of the islamic bank. the monetary authority shall study the scientific qualifications of the members and the expertise available to them before approving the members of the authority. right to infringe the sharia supervisory board. the table also indicates that paragraph (4) was ranked last in terms of ranking, with an average of (3.53) and a (%69.3) in low order. the researcher believes that this result is consistent with the actual reality of the role of the sharia supervisory board. the legitimacy of tools and banking services and their approval of islamic law. and the control of implementation is the functions of the auditor or the legitimate observer. which is the link between the sharia supervisory board and the employees of the bank. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 73 table 5. arithmetical averages, standard deviations and percentages of the clarity of the opinion of the shari'ah supervisory board of the palestinian islamic banks. no paragraph arithmeti c means standard deviations % relative importanc e 8 members of the sharia supervisory board at the bank have sufficient expertise on traditional and islamic financing instruments. 4.76 0.44 95.4 very high 3 the opinions of the sharia supervisory board for your bank are clear and understandable to all employees of the bank. 4.72 0.46 94.4 very high 6 members of the sharia supervisory board are constantly updated. 4.68 0.69 93.6 very high 7 the number of members of the sharia supervisory board at the bank is appropriate for the size of the instruments used. 4.68 0.69 93.6 very high 5 the bank shall ensure the independence of the sharia supervisory board from the executive management, and shall be subordinate to the board of directors. 4.64 0.49 92.8 very high 2 the opinions of the sharia supervisory board for your bank are in line with the standards issued by the accounting and auditing organization for islamic financial institutions. 4.08 1.19 81.6 moderate 1 the sharia supervisory board of your bank issues clear and binding mechanisms to implement various islamic financing formulas. 3.56 1.16 71.2 low 4 the sharia supervisory board shall ensure the implementation of the islamic financing formulas in accordance with its prior opinion. 3.53 1.2 69.3 low all grouped items 4.37 0.45 86.4 high in analyzing the above data, it is clear to us that this is in line with the study of (boonakab, 2016) in which sharia supervisory board opinion has a significant impact on the growth and development of the bank's services, and also agrees with the study of (al suwailem , 2007) in its recommendations to select the sharia supervisory board very carefully because of this asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 74 importance in the development of banks islamic. 13.2 second hypothesis there is a statistically significant relationship between the regulations and the instructions issued by the palestinian monetary authority concerning islamic banks and the growth and development of islamic banking. table(6) shows that all grouped items have a mean of 4.01,is the larger of about 1.01 average default (3), which means that this hypothesis is accepted, and there is a statistical relationship between the regulations and the instructions issued by the palestinian monetary authority concerning islamic banks and the growth and development of islamic banking. table (6) shows that paragraph (5) ranked first in terms of ranking, with an average of 4.68 and a (%93.6) is in a very high order. this indicates that the difference between the legitimate opinions of the banks. the most important impediments to the development and growth of islamic banks, and what the palestinian monetary authority has set up to form a unified sharia supervisory board is one of the fundamentals of the growth and development of islamic banking in palestine. this generates an atmosphere of competition under an agreed jurisprudential opinion to apply islamic tools or banking services. . the table also shows that paragraph (1) was ranked last in terms of ranking, with an average of 3.36 and (%67.2). this is a true result. the work of the islamic banks in palestine is organized according to the fourth chapter of the banking act 2010.table 5. arithmetical averages, standard deviations and percentages of the promotional campaigns offered by islamic banks in palestine. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 75 table 6. arithmetical averages, standard deviations and percentages of the regulations and the instructions issued by the palestinian monetary authority concerning islamic banks. no paragraph arithmetic means standard deviations % relative importance 5 the formation of the unified sharia supervisory board by the monetary authority is one of the most important solutions related to the problem of divergent jurisprudential views in transactions. 4.68 0.56 93.6 very high 3 the monetary authority helps islamic banks in palestine to find innovative solutions to the problems they face. 4.52 0.59 90.4 high 7 the monetary authority shall provide laws and regulations regulating the work of islamic banks and shall comply with the provisions of islamic sharia. 4.48 82 89.6 high 6 the monetary authority charges fines for any illegal violations of the work of the islamic finance institutions in palestine. 4.16 0.94 83.2 moderate 4 the monetary authority shall monitor and monitors the activities of the islamic banks in palestine and the extent to which they apply the provisions of the islamic shari'a on an ongoing basis. 4.12 0.97 82.4 moderate 2 the monetary authority holds educational workshops on islamic banking and its modern financing tools. 3.72 1.06 74.4 low 1 the pma continuously updates regulations and instructions in line with modern islamic banking standards. 3.36 1.15 67.2 very low all grouped items 4.01 0.51 82.9 moderate in analyzing the above data, we show that the result contradicts with the (bonkab, 2016) study that the regulations and instructions issued by the regulatory authorities in algeria regarding islamic banking, which is implemented by al baraka bank is effective and serves islamic finance, but it agrees with the recommendations of the study (ali and naajah, 2013) the need to develop regulations and instructions governing work islamic banking in line with progress in all fields. 13.3 third hypothesis there is a statistically significant relationship between experience and employees' training and the growth and development of islamic banking in palestine. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 76 table (7) shows that all grouped items have a mean of 4.12, is the larger of about 1.12 average defaults (3), which means that this hypothesis is accepted, and there is a statistical relationship between experience and employees training and the growth and development of islamic banking in palestine. table (7) shows paragraph (5) ranked first in terms of ranking, with an average of 4.72 and 95.1% in a very high order. this shows that the executive management of islamic banks in palestine. the table also indicates that paragraph (4) was ranked last in terms of ranking, with an average of 3.28 and 65.6% in a low order. table 7. arithmetical averages, standard deviations and percentages of the diversifying and developing the services of palestinian islamic banks no paragraph arithmetic means standard deviations % relative importance 5 the executive directorate issues an indicative guide to the application of new funding modalities. 4.72 0.48 95.1 very high 2 the management is keen to train all employees of the bank on the development and innovation in the field of islamic banking. 4.32 0.69 86.4 high 1 the bank has a department specializing in developing financial instruments and innovating islamic products. 4.12 0.88 82.4 moderate 6 training workshops are held for all employees of the bank to publish the findings of other countries in the field of islamic banking. 4.08 0.91 81.6 moderate 3 participate in international conferences and training courses on developing islamic tools and products. 3.76 1.2 75.2 low 4 creative and innovative employees are motivated by a financial reward or a moral assessment 3.28 1.17 65.6 very low all grouped items 3.72 0.48 81 moderate in view of the table's data, we note that the result is in line with the study of othman (2008), which concluded that islamic banks in order to continue to innovate and develop their tools must seek to create the appropriate environment for financial institutions for development and innovation, such as motivating employees to innovate and develop and preserve the moral rights of the owner of the idea or innovation. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 77 13.4 fourth hypothesis there is a statistically significant relationship between the use of modern technology and the growth and development of islamic banking in palestine. table (8) shows that all grouped items have a mean of 3.72, is the larger of about 0.72 of average defaults (3), which means that this hypothesis is accepted, and there is a statistical relationship between the use of modern technology and the growth and development of islamic banking in palestine. it is clear from the data of table (8) that paragraph (5) ranked first in terms of ranking, with an average of (4.56) and a percentage (92.8) is in a very high order. dealing with atms, which reduces the effort and cost incurred by the bank because of regular banking operations through branch employees. the table also indicates that paragraph (7) ranked last in terms of order, with an average of 2.6 and 52% is by a very low order. these shows not motivate customers to deal with atms by imposing additional commissions. table 8. arithmetical averages, standard deviations and percentages of use of modern technology. no paragraph arithmetic means standard deviations % relative importance 5 your bank adopts the spread through atms that offer check and deposit services. 4.56 0.48 92.8 very high 3 the bank offers sharia-compliant credit cards 4.32 0.69 86.4 high 1 the bank offers its customers internet banking services for electronic payments 4.12 0.88 82.4 moderate 2 the bank provides smart phone applications for financial transactions 4.08 0.91 81.6 moderate 4 the bank relies on sms to deploy its new services 3.96 0.79 79.2 moderate 6 the customer requests electronic services by attending the bank. 3.72 0.98 74.4 low 7 your bank charges additional fees for withdrawals and deposits made within branches and through bank employees. 2.6 0.87 52 very low all grouped items 3.72 0.48 78.4 moderate this is in line with the study of omrana & aboulaich (2016), which recommended that the islamic finance operations should be carried out separately and continuously to ensure the development, innovation and pace of technological progress in islamic banking. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 78 results 1. the overall degree of the role of financial engineering in the growth and development of islamic banking in palestine was medium, with the total percentage of respondents' answers to all paragraphs in all fields (82.1). 2. the results of the factors analysis showed that the most important factors to growth and development of islamic banking in palestine are ranked as important: first: the clarity of the opinion of the sharia supervisory board of islamic banks in palestine. the role of this field was high (86.4). second: the restrictions and regulations issued by the palestinian monetary authority (pma). the role of this area was averaged (82.9). third: the experience of the employees at islamic banks in palestine and their training. the role of this field was also average with an average of (81) fourth: the application of modern technology in the islamic banks in palestine and the role of average and average arithmetic (78.4). 3. the percentage of young people working in islamic banks in palestine, where the majority of the study sample was for the age group from 25 years to 45 years. 4. the interest of islamic banks to employ their scientific competencies, since 97% of the sample have academic qualifications bachelor or above. recomendations 1. to spread the culture of islamic banking through the imposition of additional fees on withdrawals and deposits made within the branches and through the employees of the bank. 2. the need for all employees at the bank to be informed about the global developments in the field of islamic banking through their participation in international conferences and training courses on the development of islamic products. 3. the need for the palestinian monetary authority to adopt the role of guide for the islamic banking in palestine by holding educational workshops on islamic banking and its modern financing tools. 4. the need to update the regulations and instructions governing the islamic banking continuously in line with the modern standards of islamic banking. 5. establishing clear mechanisms for the implementation of islamic financing formulas, in coordination between the sharia supervisory board and the executive management of banks. 6. enhancing the role of the sharia supervisory board in ensuring the implementation of the islamic financing formulas in accordance with its pre-vision on islamic tools and services. 7. the need for cooperation and coordination between the sharia supervisory boards of the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 79 banks on the one hand and the unified body that is affiliated with the palestinian monetary authority , in order to consolidate the legal opinions on the islamic financial instruments and services. 8. the need to establish special sections dealing with financial engineering in islamic banks operating in palestine. references bonakab, mokhtar. (2017). the role of islamic financial engineering in risk management of islamic financing formulations a case study of al baraka aljazairy bank. algerian journal of economic development, university of qasidi marbah, algeria, issue 5. suwailam, sami. (2004). the financial engineering industry looks at the islamic approach. research center, al rajhi banking investment company, 165. sabrina, buteba, rashad, mardasi,(2017). islamic financial engineering as a mechanism for the provision of islamic banking financing. journal of economics of business and finance, institute of economic and commercial sciences, university center abdelhafeez boulosouf, mila, algeria, no. 2. othman, abdelkawi mohamed. (2008). the use of financial engineering in islamic banks (modern financial instruments). 3rd conference of islamic banks and financial institutions, damascus. ali, hamza and abdul rahman. (2013). the shari'a controls for the use of financial engineering as an approach to the development of islamic financial products. 2nd international islamic financial industry forum. kunduz, abdul karim. (2007). islamic financial engineering. journal of islamic economics, 20(2), 10. king abdul aziz university. moanis, raed nasri. (2016). rules of engineering of islamic financial products analytical study. journal of sharia and law studies, 43(1). faculty of sharia, university of jordan, jordan. omrana, siham, & aboulaich, rajae. (2016). islamic financial engineering al arboun sale. international journal of applied engineering research, 11(8), 5584-5590. issn 0973-4562. seng kiong kok, gianluigi giorgioni, & jason laws. (2014). derivative products and innovation in islamic finance: a hybrid tool for risk-sharing options. international journal of islamic and middle eastern finance and management, 7(3), 242-257. https://doi.org/10.1108/imefm-07-2013-0084 ginanjar, adhitya. islamic financial engineering: comparative study agreements in islamic capital market in malaysia and indonesia. tazkia islamic finance and business review journal, 8(1). al suwailem, sami. (2007). financial engineering: an islamic perspective. ka jian bisnis dan manajemen, 9(1), 87-102. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 80 iqbal, zamir. (1999). financial engineering in islamic finance. second harvard university forum on islamic finance: islamic finance into the 21st century cambridge, massachusetts. center for middle eastern studies, harvard university. pp.229-238. https://doi.org/10.1002/tie.4270410414 microsoft word 11020-40653-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 261 the factors that affect to attract deposits in palestinian islamic banks amer saadi jaber islamic finance jinan university lebanon tel: 97-059-937-4274 e-mail: amer.jaber2010@hotmail.com mohammed shuaib manasrah islamic finance jinan university lebanon tel: 97-059-911-2555 e-mail: manasrah503@gmail.com received: feb.2, 2017 accepted: april 27, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.11020 url: http://dx.doi.org/10.5296/ajfa.v9i1.11020 abstract this study aims to identify the factors that affect to attract deposits in palestinian islamic banks. the researcher used the descriptive approach to reach the results and recommendations of the study. the study society is a branches manager of islamic banks operating in palestine. the sample was the sam of study society; because the small size of study society. it found that there is a relation between the geographical location of the branches of islamic banks, advertising campaigns and promotion, diversification, development of services, experience of bank staff, and attracting deposits in islamic banks in palestine. the study recommended that the islamic banks in palestine continuously provide savings campaigns to increase deposits, and must choose locations based on the recommendations of branch managers and the involvement of marketing departments. in addition, they should increase investment in human resources in terms of training, qualification. and work to provide them with the necessary skills to attract customers. keywords: islamic banks, attracting deposits, palestine, palestinian monetary authority, branch managers. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 262 1. introduction bank deposits are one of the most important elements on which banks are based in general, whether islamic or commercial. it is a service to the client on the one hand, is the preservation or investment, and the supplier of the bank is an obligation on the other hand is the ability to grant facilities to other customers. the deposit is an agreement between the client and the bank under which the customer to deposit a sum of money with the bank for the purpose of conservation or investment and the bank undertakes to refund the money to the client at a certain date upon request, according to terms agreed upon in advance. islamic banks are competing to increase their deposits due to the basic rule of the islamic banks based on participation in profit or loss. islamic banks rely on speculation in the implementation of financial transactions related to deposits. it should be noted that the laws and instructions issued by the central bank in the country has a significant impact on the size of deposits with any bank, where the proportion of deposits to facilities by the central bank and be obliged to grant funds or attract deposits. the emergence of the islamic banks in palestine began after the arrival of the palestinian authority in 1996 and the signing of the paris economic agreement in 1994. article 4 of the paris economic protocol concluded between the palestinians and the israeli side establishes a monetary authority that supervises and inspection the work of the banking sector, as it will become the financial agent of the palestinian authority in the control of financial policy, and works in palestine until the end of 2016 three islamic banks are the arab islamic bank and the palestinian islamic bank and safa bank. 2. methodology the study was based on the descriptive analytical approach. the secondary data were obtained from relevant books and financial reports. in addition, the primary data were collected from the study population and were analyzed statistically to obtain the results of the study. the questionnaire was a primary data collection tool that is aimed to identifying the most important factors for attracting deposits in palestinian islamic banks. deposits play an important role in the banking process. as they are considered the most important pillars of banking activity, and as the demand of customers have become increasing on islamic banking, this study will try to answer the main study question, which is the problem of study: what are the factors that affect the attraction of deposits in palestinian islamic banks? there are a several sub-questions that the study will try to answer: what is the impact of the geographic location of branches of banks in attracting deposits in palestinian islamic banks? what is the impact of advertising and promotional campaigns in attracting deposits in palestinian islamic banks? asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 263 what is the impact of diversification and development of services provided in attracting deposits in palestinian islamic banks? what is the impact of the experience of the customer service staff in attracting deposits in the palestinian islamic banks? this study aims to identify the geographical location of bank branches, advertising and promotional campaigns, diversify and develop the services provided and the experience of the customer service staff in attracting deposits in the palestinian islamic banks. the importance of this study stems from the role played by islamic banks as an alternative to commercial or conventional banks. the banking sector in general is considered one of the most important economic poles of the country. this study acquires scientific importance as a recent study within the limits of the researcher's knowledge. the islamic bank has to make and provide them in order to attract and increase deposits. its practical importance is due to the study's findings to the decision-makers of islamic banks in palestine to find new ways to attract deposits and increase savings. 3. hypotheses of the study the following hypotheses were formulated in an attempt to answer the questions posed by the study: there is a statistical relationship between attracting deposits and the geographical location of branches of palestinian islamic banks. there is a statistical relationship between attracting deposits and advertising and campaigns promoted by islamic banks. there is a statistical relationship between attracting deposits and diversifying and developing the services of palestinian islamic banks. there is a statistical relationship between attracting deposits and the experience of customer service staff in palestinian islamic banks. 4. society and study sample the study society consist the branch managers of the islamic banks operating in palestine. and the number of branches of the islamic banks (45) distributed throughout palestine. the survey population will be completely surveyed so that the sample is the same as the study population due to the small size of the study society. 5. statistical treatments after the data was collected and processed statistically using the statistical program (spss) using the following statistical treatments: 5.1 calculations, percentages, and repetitions to calculate the relative weight of the subjects and areas of the study instrument 5.2 examining the stability of the questionnaire using the formula alpha kronbach. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 264 6. literature review 6.1 previous studies 6.1.1 almejyesh & rajha, (2014), a study entitled “behavioral determinants and their impact on customer savings deposits in islamic banks in saudi arabia”. this study aimed to test the behavioral determinants that affect customers, savings deposits in islamic banks in saudi arabia of a sample of three islamic banks are: alrajhi bank, bank al-bilad, and al-inma bank. the researchers used the descriptive approach to reach the results of the study. the study reached several results. the most important of which is geographical spread, distribution of profits and religious beliefs are the most factors that attract customers to choose the islamic bank. the study recommended the need to increase the awareness of customers in islamic banking, which will lead to maximizing deposits with islamic banks. 6.1.2 cevik and charap, (2011), a study entitled "the behavior of return on deposits of islamic banks and conventional banks in malaysia and turkey" this study aimed to test the behavior of interest rates on bank deposits at conventional banks and the rate of return on investment accounts involved in the profit and loss among islamic banks. the analysis of the financial ratios was used to reach results that could be published and disseminated. the sample included traditional and islamic banks in turkey and malaysia during the period 1997-2010. the study focused on explaining the factors influencing deposits in both types of banks. the study concluded that interest rates in conventional banks integrated with investment accounts in islamic banks in the long term. 6.1.3. mohammed,(2010), a study entitled “the strategy of attracting and maintaining deposits in the banking sector, applying to the tadamon islamic bank in sudan”. the study aimed to finding out the practical way to develop an appropriate strategy for attracting deposits, and to know the impact of applying the strategy of attracting deposits and preventing their leakage in the tadamon islamic bank. the most important results of the study are the existence of the marketing strategy in the bank leading to attract new customers and thus increase bank deposits. the study recommended that we need to seek to attract funds outside the banking system and its necessary to increase the training and rehabilitation of employees in islamic banks. 6.1.4. abu samra, (2007), a study entitled "developing the policy of bank deposits under the liability management theory" an empirical study on commercial banks operating in palestine. the study aimed to identify the factors leading to the decrease in deposits in commercial banks in palestine. the researcher used the analytical descriptive method. the study society is the managers of commercial bank branches in palestine. the study concluded that there is a relationship between the size of deposits and the level of economic activity. the study recommended that we need to develop policy of branch managers to attract deposits. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 265 6.2. the situation of this study from previous ones this study differs from other studies in the following points: 6.2.1 the study examines the factors that affect to attract deposits in palestinian islamic banks from four dimensions: the geographic location, the advertising and promotional campaigns, the diversification and development of services, and the experience of the customer service staff. 6.2.2 previous studies have focused on the factors influencing customer attraction from the point of view of customers, but this study is a modern and unique according to the researcher knowledge, and it focused on the factors affecting the attractiveness of clients from the point of view of branch managers. 7. the characteristics of the study sample the number of forms that have been distributed 45 forms, while returned 40 forms; this makes a response to high and forms up to 88% of the number of forms distributed. and all the forms are valid for analysis. 8. description of personal respondents table (1) shows a description of the personal factors of the sample of branch managers of islamic banks in palestine as follows: 1. age: 50 % of the sample more than 40 years, 37.5 % between 30-40 years, 12.5 % less than 30 years. this means that the age group above 40 years is the majority in the study sample. this is proportional to the practical experience. the more practical experience, the more able to manage the banking operations. it should be noted that the instructions of the palestinian monetary authority in the appointment of branch managers require that the candidate for the branch management have at least 8 years of practical experience. 2. qualifications: the study showed that 82.5% of the study sample held bachelor degrees, 12.5% 7.41 % of the sample held masters, 5% of the sample are diploma holders, 0% of the sample held p.h.d degree. this means that the bachelor degree is the majority of the sample of the study, and this is consistent with the requirements of the palestinian monetary authority to appoint branch managers. 3. years of experience: the study showed that 62% of the samples have experience between 10 15 years, 27.5 % have experience more than 15 years, and 10% of the samples have experience less than 10 years. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 266 4. specialization: 42.5 % of the sample specialized in business administration, 25 % specialized in finance, 25 % specialized in accounting, and 7.5 % specialized in islamic finance. an analysis of the specialization variable shows that there is rarity in islamic finance specialization, or that islamic banks do not assign islamic finance disciplines to supervisory positions. table 1. frequencies and percentages for the personal variables of respondents factor freq % age less than 30 years 5 12.5 from 30-40 years 15 37.5 more than 40 years 20 50 total 40 100 qualifications diploma 2 5 bachelor 33 82.5 master 5 12.5 phd 0 0 total 40 100 years of experience less than 10 years 4 10 from 10-15 years 25 62.5 more than 15 years 11 27.5 total 40 100 specialization accounting 10 25 finance 10 25 business administration 17 42.5 islamic finance 3 7.5 total 40 100 8. stability of the tool stability of the tool was tested by cronbach alpha coefficient test; table (2) shows the following: 8.1 the alpha value for the items of the geographic location to attracting deposits was 0.72. 8.2 the alpha value for the items of the advertising and campaignsto attracting deposits was 0.76. 8.3 the alpha value for the items of the diversifying and developing to attracting deposits was .85. 8.4 the alpha value for the items of the experience of customer service staff to attracting deposits was 0.82. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 267 table 2. alpha cronbach values variable paragraph number of paragraphs number of answers cronbach alfa geographical location 1-7 7 40 0.72 advertising and campaigns 8 13 6 40 0.76 diversifying and developing 14 19 6 40 0.85 experience of customer service staff 20 24 5 40 0.82 all variable 1 24 24 40 0.83 all values in table 2 were > 0.60 that means a stability of the tools (scatter 19), it thus reflects the stability of the questionnaire paragraphs, enabling them to measure and examine the questions that the study has gone through. the scale was designed based on a five-dimensional likert scale. the paragraphs were built in a positive direction and weights were given to the paragraphs as follows: strongly agree: five degrees, agree: four degrees, neutral: three degrees, disagree: two degrees, strongly disagree: one degree. the default is medium (3) which can be found by calculating the average of the previous options (5 + 4 + 3 + 2 + 1) ÷ 5. so if the average variable (3) or above that means that the study sample tend to accept the presence of variable importance in attracting deposit, the higher of average increased the degree of acceptance by the respondents. if the average lower than average variable default (3) it means that the study sample tend not to accept the presence of the impact of variable selection, the lower the average figure (3) more no acceptance by members of the study sample. table3. estimating the level of factors affecting attracting deposits in islamic banks in palestine range % estimate the level of the role less than 3.44 68.8 % less than very low 3.443.82 %68.8 -76.4 % low 3.83-4.21 76.5-84.2 % moderate 4.22-4.60 84.3-92.0 % high 9. hypotheses 9.1 test of first hypothesis there is a statistical relationship between attracting deposits and the geographical location of branches of palestinian islamic banks. the table (4) shows that all grouped items have a mean of 4.37, is the larger of about 1.37 average defaults (3). this means that this hypothesis is accepted. and there is a statistical asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 268 relationship between attracting deposits and the geographical location of branches of palestinian islamic banks. table (4) shows that the geographic location of branches of islamic banks in palestine plays a high role in attracting deposits. paragraphs (1, 2, and 3) have a very high effect. the percentage of respondents' (93.6, 92.8, 93.1) respectively, while in paragraphs (4, 5) have a high effect, the percentages of responses (90.4 and 89.6) respectively were moderate in paragraph (6) per cent (81.6), and was low in paragraph (7) where the percentage of percentage of respondents' (71.2). the overall degree of geographical location was high, with the overall percentage of responses in this area (89.2). table 4. arithmetical averages, standard deviations and percentages of the geographical location of branches of islamic banks no paragraph arithmeti c means standard deviations % relative importanc e 1 your bank has obvious plan for selecting branches based on estimates of deposit concentration. 4.68 0.69 93.6 very high 2 branches are selected sites based on the size of business activity in the surrounding area. 4.64 0.49 92.8 very high 3 your bank takes population density when choosing branch locations. 4.63 0.63 93.1 very high 4 your bank branches more in the city than in the countryside. 4.52 0.77 90.4 high 5 branches are selected sites based on the reports of deposits in atms near the target area for the opening of branches. 4.48 0.87 89.6 high 6 when selecting branch locations, your bank will consider the absence of branches of competing islamic banks. 4.08 1.19 81.6 moderate 7 your bank is based on a feasibility study when selecting branch locations. 3.56 1.16 71.2 low all grouped items 4.37 0.45 87 high in analyzing the above data, it is clear to us that the location of the branch has high impact on attracting deposits. this is because the islamic banks in palestine tend to choose their branch locations based on the concentration of deposits, selected sites based on the size of business activity in the surrounding area, and this is consistent with the study of almejyesh & rajha (2014), which concluded that geographical spread plays an important role in attracting deposits. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 269 13.2 second hypothesis there is a statistical relationship between attracting deposits and advertising and campaigns promoted by islamic banks. the table (5) shows that all grouped items have a mean of 4.4,is the larger of about 1.40 average default (3), which means that this hypothesis is accepted, and there is a statistical relationship between attracting deposits and the promotional campaigns offered by islamic banks in palestine. table (5) shows that the promotional campaigns offered by islamic banks in palestine plays a high role in attracting deposits. paragraphs (1, 2, 3, and 4) have a high effect. the percentage of respondents' (91.2, 91.2, 89.6, and 89.6) respectively, while in paragraphs (5, 6) have a moderate effect, the percentages of responses (84and 83.2) respectively. the overall degree of geographical location was high, with the overall percentage of responses in this area (88.1). table 5. arithmetical averages, standard deviations and percentages of the promotional campaigns offered by islamic banks in palestine no paragraph arithmetic means standard deviations % relative importance 1 your bank has a specialized department in promotional and promotional campaigns. 4.56 0.51 91.2 high 2 the branch manager has the authority to offer gifts to customers without reference to the general administration. 4.56 0.71 91.2 high 3 existing and potential customers are notified of campaigns by all methods of communication. 4.48 0.51 89.6 high 4 your bank updates and renews promotional and campaigns that result in an increase in deposits. 4.48 0.51 89.6 high 5 your bank is allocated savings campaigns for specific segments of the community. 4.2 0.82 84 moderate 6 your bank is promoting the culture of savings through advertising and promotional campaigns. 4.16 0.75 83.2 moderate all grouped items 4.4 0.27 88.1 high in analyzing the above data, we show that the promotional campaigns offered by islamic banks in palestine have high impact in attracting deposits. this is because the islamic banks asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 270 in palestine specialized department in promotional and promotional campaigns and the branch manager has authority to offer gifts to customers without reference to the general administration, and the bank updates, renews promotional, and campaigns that result in an increase in deposits. 13.3 third hypothesis there is a statistical relationship between attracting deposits and diversifying and developing the services of palestinian islamic banks. the table (6) shows that all grouped items have a mean of 4.1, is the larger of about 1.10 average defaults (3), which means that this hypothesis is accepted, and there is a statistical relationship between attracting deposits and the diversifying and developing the services of palestinian islamic banks. table (6) shows that the diversifying and developing the services of palestinian islamic bank splay a moderate role in attracting deposits. paragraphs (1 and2) have a high effect. the percentage of respondents' (88.8 and 85.6) respectively, while in paragraphs (3, 4, and 5) have a moderate effect, the percentages of responses (83.2, 83.2and 82.4) respectively. the overall degree of diversifying and developing the services was moderate, with the overall percentage of responses in this area (83). table 6. arithmetical averages, standard deviations and percentages of the diversifying and developing the services of palestinian islamic banks no paragraph arithmetic means standard deviations % relative importance 1 your bank will develop and diversify services that will attract deposits. 4.44 0.87 88.8 high 2 your bank develops e-services to attract customers. 4.28 0.74 85.6 high 3 your bank offers completely banking services. 4.16 0.94 83.2 moderate 4 your bank continuously reviews the services provided by international islamic banks. 4.16 0.94 83.2 moderate 5 your bank focuses on providing banking services with the utmost accuracy and speed. 4.12 0.97 82.4 moderate 6 your bank focuses on providing banking services at the lowest cost to customers. 3.72 1.06 74.4 low all grouped items 4.1 0.51 83 moderate in view of the table data, we note that the diversifying and developing services of palestinian asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 271 islamic banks has a moderate impact on attracting deposits. this is because the islamic banks in palestine are not focused on providing banking services with the utmost accuracy and speed, and are not focused on providing banking services at the lowest cost to customers, because that the semi-fixed cost in the all of banks operating in palestine. 13.4 fourth hypothesis there is a statistical relationship between attracting deposits and the experience of customer service staff in palestinian islamic banks. the table (7) shows that all grouped items have a mean of 4.2, is the larger of about 1.2 average defaults (3), which means that this hypothesis is accepted, and there is a statistical relationship between attracting deposits and the diversifying and developing the services of palestinian islamic banks. table (7) shows that the experience of customer service staff in palestinian islamic banks play a high role in attracting deposits. paragraph (1) has a very high effect. the percentage of respondents' (93.6), while in paragraph (2) has a high effect. the percentages of responses (86.4), and the paragraphs (3, 4, and 5) have a moderate effect and percentages of responses (82.4, 81.6, and 79.2) respectively. the overall degree of experience of customer service staff was a high. with the overall percentage of responses in this area (84.6). table 7. arithmetical averages, standard deviations and percentages of the experience of customer service staff in palestinian islamic banks. no paragraph arithmetic means standard deviations % relative importance 1 your bank is keen to training customer service staff to attract deposits. 4.68 0.48 93.6 very high 2 lack of knowledge of foreign-language to customer service staff hinders the process of attracting deposits. 4.32 0.69 86.4 high 3 there is obvious plan to training customer service staff to attract deposits. 4.12 0.88 82.4 moderate 4 the results of the training assessment are used to improve staff performance to attract deposits. 4.08 0.91 81.6 moderate 5 training workshops held for customer a service staff who is interested in spreading islamic banks in other countries in the field of attracting deposits. 3.96 0.79 79.2 moderate all grouped items 4.2 0.48 84.6 high asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 272 the table's data reflect that islamic banks compete by taking care of customers through the experience of the employees and training them to attract customers, and that the other languages are important to attract deposits. this is consistent with mohammed, (2010) study which recommended that the banks need to seek to attract funds outside the banking system, and it’s necessary to increase the training and rehabilitation of employees in islamic banks. results there is a statistically significant relationship between the study variables (geographic location, advertising campaigns promotions, diversification and development of services, employee experience) and attracting deposits in islamic banks in palestine. 1. the results of the factors analysis showed that the most important factors to attract deposits in the palestinian islamic banks are ranked as important: first: the advertising campaigns promotions offered by the palestinian islamic banks. second: the geographical location of branches of the islamic bank. third: the experience of customer service staff in palestinian islamic banks. forth: the diversity and the development of services offered by islamic banks in palestine. 2. the results also showed a shortage of islamic finance specialty, which could increase the volume of deposits in islamic banks for religious beliefs. 3. the results also revealed that there are restrictions by the supervisors of islamic banks regarding the appointment of branch managers, namely the specialization, the number of years of experience, and some training courses. recomendations 1. the study recommends that the islamic banks in palestine continuously provide savings campaigns to increase deposits. 2. the study recommends that the islamic banks must choose locations based on the recommendations of branch managers. and the involvement of marketing departments. 3. the management of islamic banks in palestine should direct their appointments to the managers and staff of customer service for islamic finance specialty. 4. the islamic banks in palestine should increase investment in human resources in terms of training, qualification and work to provide them with the necessary skills to attract customers. references almejyesh,s., & rajha, k. (2014). behavioral determinants and their impact on customer savings deposits in islamic banks in saudi arabia. journal of islamic banking and finance, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 273 2(1). garit, essam. (2010). the impact of central bank control in deposits and credit in islamic banks applied in syria international islamic bank. damascus university journal of economics and legal, 27(3). kasri, r., & kassim, s. (2009). empirical determinants of saving in the islamic banks: evidence from indonesia. jkau: islamic econ., 22(2). matloob, mustafa nateq saleh. (2012). obstacles to the work of islamic banks and access to treatment for their development. journal of islamic research and studies, 29, 20712847: issn pages, 287-333. rosly, s., & zaini, m. (2008). risk-return analysis of islamic banks’ investment deposits and shareholders’ fund. emerald group publishing limited. managerial finance, 34(10), 695-707. https://doi.org/10.1108/03074350810891010 alwadi, hussein, & samhan, hussein. (2009). islamic banks the theoretical foundations and practical applications. first edition, dar al-massira for publishing and distribution, amman. jordan al-zubaidi, mahmoud. (2011). department of banking deposit mobilization strategy and the extension of credit. alwarraq foundation for publishing and distribution, amman. othman, ahmed. (2010). statistical analysis of the role of commercial banks in mobilization of domestic savings to finance development in syria. faculty of economics. tishreen university. samhan, hussein. (2013). foundations of islamic banking operations. first edition. dar al-massira for publishing. distribution and printing. amman. jordan. sheikh, othman, & fahad, omar. (2009).management of assets to liabilities of traditional banks and islamic banks. arabic academy for banking and financial sciences. damascus. syrian arabic republic. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 26 the effect of intangible assets on financial performance, financial policies, and market value of technology firms: a global comparative analysis muhammad junaid qureshi (corresponding author) research scholar karachi university business school, university of karachi, pakistan e-mail: junaidqureshi94@gmail.com dr. danish ahmed siddiqui associate professor karachi university business school, university of karachi, pakistan e-mail: daanish79@hotmail.com received: march 1, 2020 accepted: april 15, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.16655 url: https://doi.org/10.5296/ajfa.v12i1.16655 abstract purpose: the purpose of this study is to examine the degree to which intangible assets effect financial performance, financial policies and market value of the technology firm. design/methodology/approachstructural equation modeling analysis was used to ascertain the relationship among intangible assets, firm performance, firm policies, and market value in the year 2015 to 2018 of 80 companies according to the market capitalization of their respective countries in the technology sector globally. the measures used in this study profitability efficiency, capital structure, dividend policy and market value that is calculated through the proxies roa, roe, roic, ato, net profit margin, debt to equity ratio, dividend payout ratio, price-earnings ratio, price to sales and price to book value. findingthe results from multi group analysis (mga) revealed that there are differences (p < .05) in the significance of the impact of assets on the criterion variable between a few countries for instance asset’s impact on roic is significantly different between russia & china and usa. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 27 practical implicationsowners and managers of technological sector global companies must recognize the importance of both the physical capital and the intangible resources to the best interest of the companies originality/value– this is the first paper to examine the impact of intangible assets on firm performance, policies and value through cross country analysis in the technological sector. keywords: firm performance, firm policies, firm value, intangible assets, sem analysis, technological industry asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 28 1. introduction 1.1 background of the study researchers and practitioners have reached a consensus that intangible assets play a vital role in the success and survival of firms in today’s economy satt, harit & youssef, chetioui. (2017). in recent decades, the focus has shifted from the traditional financial statements that focus on tangible assets into intangible assets like innovation, knowledge, intellectual property, and goodwill. rapidly changing dynamics of globalization and increasing market competition, companies all around the world confronting several new challenges and opportunities (bchini, 2015). to be competitive and successful apart from the relative importance of physical sources, companies have to adopt modern strategies and policies regarding market flexibility and development (hejazi, ghanbari, & alipour, 2016). moreover, the evolution of the knowledge economy from the industrial economy also puts greater pressure on companies to use soft resources efficiently as human capital and knowledge, which have become major factors of economic growth. in past, companies’ success, profitability and value mainly depend on tangible assets like land, infrastructure, and equipment (nuryaman, 2015) but in current global economy intangible assets contributing approximately 80% in companies’ value through human capital development and knowledge management (vodák, 2011). amortization of ‘goodwill’ has serious shortcomings, hence, the emergence of ifrs 3, sfas 141r and sfas 142. that is, goodwill and other intangibles are made up of unrelated components: the new goodwill comprising of reputation (iwu-egwuonwu, 2011), human capital and organizational capital, have indefinite life albeit highly volatile and perishable. conversely, there are definite lives for patents, copyrights, licenses, trademarks and royalties. to order to assess how intangibles increase the value and profitability of a business, these components should be evaluated separately and their effects recorded. (henning, lewis and shaw, 2000). regrettably, only those components which have definite valid lives can be calculated quantitatively. those components with infinite lives which have a major positive impact on firm value / growth are highly qualitative and are not easily quantitatively calculated. in the modern business era, intangible assets are vital strategic resources. they are extremely important in creating corporate value (gamayuni, 2015) and improving company performance. researches indicated that intangible assets abound throughout the business world, touching nearly all aspects of a company, from product development to human capital, and staff functions such as legal, accounting, finance, and line operations such as research and development, marketing, and general management. in a macro scenario, investments in intangible assets have grown rapidly among companies in the united states, japan, and europe. such growth has been amplified by intensified global competition, use of information and communication technologies, adoption of new business models, and prevalence of the services sector. the report of the organization for economic cooperation and development (oecd, 2011) cited that such investments have a significant asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 29 impact on productivity. it also indicated that in some cases the investments match or exceed those in the traditional capital such as machinery, equipment, and buildings. (lim macias et al 2018) found a strong relationship between identifiable intangible assets & financial leverage. overall identifiable intangible assets support debt financing in firm that lack abundant tangible assets. while the dataset provides the fair value estimates of intangible assets for only a small subset of firms. harrit satt et al (2017) studied the effect of goodwill on firm performance found that a high level of goodwill has a positive impact on firm’s performance, however, the research is conducted in the mena region. rufo mendoza (2017) studied the importance of intangible assets in improving financial performance, creating value & maintain competitiveness, it was conducted in the philippines stock exchange. the effect of intangible assets on financial policy, financial performance & firm value covered rarely in previous literature, only one paper available in gamayuni (2015) but that is also in the context of indonesia in the manufacturing industry. in short, studies undertaken are mostly limited to country or region-specific studies. in our opinion, intangible assets are not related to region but to sectors, different sectors have their own peculiar requirement. we for the first time covered the whole sector globally. we choose the technology sector, as it as a high degree of intangibles as compared to other, and have a more pronounced effect on performance. moreover, comparative analysis of factors affected by intangible assets could also highlight the countryspecific underlying trend in tech sector, and where it’s significant enough to overshadow industryspecific characteristics. researchers have long recognized that intangible assets can be critically important to firm value and affect firms’ financial policies. for example, the patents of apple and pfizer, the brands of coke and amazon, the unique supply chain of walmart, and the highly efficient business process of southwest airlines have bolstered the competitive advantages and corporate values of these firms in the knowledge economy (lev and gu 2016). however, it has been difficult to document intangibles’ effects on firms’ financial policies because the conservative accounting practice does not recognize the most internally-generated intangible assets on the balance sheet. for example, firm’s expense advertising as well as research and development (r&d) expenditures, except for certain software development costs. in contrast, accounting capitalizes externally acquired intangible assets. peters and taylor (2017) estimate that firms purchase only 19% of their intangible assets externally.1 the economist (2014) reports that “in 2005 procter & gamble, a consumer-goods company, paid $57 billion for the gillette razor company. the brand alone, p&g reckoned, was worth $24 billion.” for these intangible assets, researchers typically can observe neither book nor market or fair values. in this information era, intangible assets dominate the environment compared to during the industrial era that was dominated by tangible assets. zhang (2017) found that the inferred intangibles have predictive power for stock returns, which might be because of mean‐reverting misevaluation by the stock market; and the way the inferred intangibles predict stock returns is consistent with the three‐factor model of fama and french (1992). these changes have led the role of intangibles to increase to provide a more informative and reflective business performance intended for the investors in the decision-making process asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 30 which the traditional accounting standards cannot fulfill anymore (wilson, et.al. 2014; yu-chi and lin, 2018). 1.2 problem statement some types of intangible assets or intellectual property are not mentioned in any other financial statements, because monetary value is difficult to calculate or quantify. intellectual capital is the community of information assets assigned to an organization, which contributes most significantly to this organization's improved competitive position, identified by adding value to key stakeholders (marr and schiuma, 2001). according to sveiby (1998), the unseen intangible component of the balance sheet can be described as a family of three, individual competence, internal structure and external structure”. meanwhile, leif edvinsson, as quoted by equates intellectual capital as amount of human capital and structural capital (eg, relationships with consumers, network management and information technology). choong (2008) calculated excess roa intellectual capital as composed of intangible individual, company and institutional properties. intellectual capital can thus be characterized as the amount of what is generated by the organization's three main elements (human capital, structural capital, and customer capital) related to information and technology which can provide a competitive form of organization with more value for the client. roos et al. (1997) revealed that these companies 'market value is several times their net asset value which is the value of their tangible value. the difference between the two values is the "secret value" of the product, which can be expressed as a market value percentage. on the basis of these statements it can be inferred that intellectual capital is the key factors which can increase the market value and therefore the profitability of a business r&d investment occupies an significant role in terms of intangible asset efficiency, value, and risk. r&d investments also influence the market value of the company which is expressed in sales and return (sougiannis, 1994). under ias 38, spending on research and development may be counted as investment or assets. the option will have an effect on financial results. intangible assets have 5 unique characteristics according to holmstrom (1989): 1. long-run, 2. unable to predict the outcome, 3. strong bankruptcy risk, n. 4. intense labour, 5. local. such specific features impact financial policies within the company. investment in intangible assets influences the budget and dividend policy of the company's debt. theory of agencies (jensen and meckling, 1976) argues that company expenses are dictated by monetary policy. the expense of the business is projected to be higher in businesses with concentrated intangible assets, based on the particular characteristics of intangible assets. intangible assets will raise the cost of the agency to shareholders (due to more details and secret action), as well as the cost of the debtor agency (asset replacement and underinvestment problem). thus, investment in intangible assets will affect the company's financial policy. previous studies have been conducted to prove the influence of company’s financial performance to stock return. it has been shown that the ratios extracted from the financial statements have a strong relationship with the stock market metrics, which indicates that the financial statements are also useful to investors in decision making and may clarify the value asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 31 of the stock market. several other studies found that the structure of financial risks and smoothing earnings has worked at firm value. investment opportunity set and the leverage effect on firm value. these results are consistent with modigliani and miller's opinion that the enterprise value is determined by the earnings power of the company's assets. so roa is one of the factors that affect firm value. the same results on the research by carlson and bathala (1997). according to the wall street journal, the rate of intangible investment as a percentage of private-sector gross domestic product (gdp) overtook tangible investment in the mid-1990s. intangible assets in term of improvement firm performance, impact on firm value & policies covered rarely in previous literates, some paper cover some aspects of intangible assets (rindu rika gamayun, 2015); (vladimir dženopoljac stevo janoševic nick bontis 2016). but that is also in the context of certain countries not cross-sectional for the majority of countries. some other investigated in majority about intangible assets, as studied in different papers (melsa et al, 2015); (onipe a. yahya et al,2015); (lihard stevanus et al 2017); (rufo r mendoza 2017);(zeb, s. & rashid a 2016); (lim s.c macias et al 2018). previously studies were conducting examining intangible assets of a particular country or market in different sectors. 1.3 research objective we have studied sectorial analysis of the manufacturing & services sector globally among 14 countries in technological sectors from 2015 to 2018 because of the most recent data availability of company’s annual reports, where most companies spend a large amount of investment in intangible assets & also try to compare different groups with each other. this study is particularly important because intangible assets ratio in total assets has been significantly increased in many countries. we tend to find the impact of intangible assets on financial performance, firm policy & firm value in the global technology sector. the current paper covers how intangibles impact dependent variables & how these vary among countries. 1.4 outline of the study we review in all previous papers & find the gap that the intangible plays a very prominent role to drive the firm performance & impact on the firm value & policies. we design our methodology to test the validity of intangible assets globally by sectorial analysis of each country & its influence on the financial performance of companies. we collect data on financial indicators of 14 countries from financial statement of 80 companies in technological sector. we rely on the financial statement data source because of authenticity of data. we obtain data for 14 countries of roa, roe, roic, ato, operating profit, intangible assets, debt to equity, dividend payout ratio, price to earnings ratio, price to book value & price to sales ratio. we make intangible assets as independent variable & rest of all as dependent variables. we take four years from 2015 to 2018 and run different test to support our results. we run test on smart pls 3 and find correlation and regression analysis. based on test result we interpret and conclude our research. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 32 2. literature review haji and ghazali (2018) suggest the better investment in intangible resources to improve the financial performance of companies. investment in human capital and technology has the perspective to improve the profitability and the lack of investment can results in weaker firm performance. ozkan, cakan, and kayacan (2017) examine the association among investment in intangible assets and banking profitability in the short and long run by using panel data. their results indicate that the intangible assets improve the banking performance in the long run nijun zhang (2017) researched on the effect of intangible assets on firms’ economic performance in listed telecommunication firms in china. intangible assets ratio (intangible assets divided by total assets) is used as an independent variable whereas the return on assets (roa) as the dependent variable. assets are future economic benefits controlled by using the entity as an end result of past transactions or other previous events. intangible assets are the companies’ aggressive advantage and challenging to imitate. in the chinese accounting standards, intangible belongings include patents, copyright, franchise, and land-use right. there is an assumption that if in china, intangible belongings owned with the aid of businesses can promote corporation’s performance higher than tangible assets, the market structure is aggressive and mature. hence a positive and significant correlation was found between intangible assets and the firm’s profitability. vladimir dženopoljac, stevo janoševic & nick bontis degroote (2016) investigated the influence of intellectual capital (ic) on financial performance in information communication technology (ict) industry of serbia. financial performance is measured by the following ratios; return on equity, return on assets, return on invested capital, profitability, and asset turnover. knowledge administration and ic are regarded among the youngest administration disciplines to have received acceptance in the scientific community. the results of this study indicate that there are no significant differences found in economic performance among different ict subsectors. jasenka bubic & toni susak (2015) study the relationship between investment in intangible assets represented by intangible assets to total assets ratio and financial performance of companies represented by return on assets, return on equity, net profit margin, and gross profit margin. intangible assets are commercial enterprise sources of a company. gamayuni (2015) empirically tests the relationship between intangible assets, financial policies, and financial performance on firm value in indonesia's going-public business. process analysis was used in 2007-2009 to assess the relationship between intangible assets, financial policies, financial performance, and firm value in indonesia's going-public company. interestingly, intangible assets, financial policies, and financial performance have a significant impact on firm value. important assets have no significant influence on financial policies but have had a positive and significant impact on financial performance (roa) and firm value. debt policies and financial performance (roa) have had a strong and important impact on firm price. limitation of financial statements in measuring and disclosing asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 33 intangible assets is the cause of a significant difference between equity of book value and equity of market value. intangible assets are being transformed into an unrivaled resource for business wealth creation. while tangible assets such as structures, facilities and equipment continue to be the main elements in the production of goods and services, the relative importance has declined over time as the significance of intangible assets replaces tangible assets (martins & alves, 2010) 3. conceptual framework 3.1 dependent variables the dependent variable in this paper is profitability, efficiency, capital structure, dividend policy and market value which is measured through the proxies of roa, roe, roic, ato, net profit margin, debt to equity ratio, dividend payout ratio, price earnings ratio, price to sales ratio and price to book value. definitions of the variables mentioned in table 1: asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 34 table 1. definitions of variables variables definitions 1 return on assets (roa) return on assets (roa) is an indicator of how profitable a company is relative to its total assets. roa gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings 2 return on equity (roe) return on equity (roe) is a measure of financial performance calculated by dividing net income by shareholders' equity. because shareholders' equity is equal to a company's assets minus its debt, roe could be thought of as the return on net assets. 3 return on invested capital (roic) return on invested capital and is a profitability or performance ratio that aims to measure the percentage return that investors in a company are earning from their invested capital. it also represents the residual value of assets minus liabilities. 4 assets turnover (ato) asset turnover (ato) or asset turns is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company 5 profitability profitability ratios consist of a group of metrics that assess a company's ability to generate revenue relative to its revenue, operating costs, balance sheet assets, and shareholders' equity. 6 debt to equity ratio the debt-to-equity (d/e) ratio is calculated by dividing a company's total liabilities by its shareholder equity. these numbers are available on the balance sheet of a company's financial statements. the ratio is used to evaluate a company's financial leverage. 7 dividend payout ratio the dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company. it is the percentage of earnings paid to shareholders in dividends. 8 price earnings ratio the price to earnings ratio (pe ratio) is the measure of the share price relative to the annual net income earned by the firm per share. pe ratio shows current investor demand for a company share 9 price to sales ratio the price-to-sales ratio (price/sales or p/s) is calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price) and divide it by the company's total sales or revenue over the past 12 months. 10 price to book value the price-to-book, or p/b ratio, is calculated by dividing a company's stock price by its book value per share, which is defined as its total assets minus any liabilities asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 35 3.2 independent variable in this paper data collected for 4 years (2015-2018) from 80 companies selected for intangible assets. intangible assets are an important indicator and taken as an independent variable in this study. intangible assets are non-monetary assets besides physical traits that can be identified. they include of following categories of assets: research and development, patents, concession rights, trademarks, software, permissions for fishing, franchisees, and other rights, goodwill, boost repayments for the buy of intangible asset and different intangible assets. capitalized intangible fixed assets and expensed r&d expenses scaled by total assets represent our explanatory variables whereas market to book value ratio as the dependent variable. intangible belongings lack bodily substance and do not have a monetary embodiment. the valuation of this form of belongings is tough and uncertain. intangible property commonly relates to improvements implementation, technological know-how improvement or advertising and marketing activities. the increase in the quantity of company intangible belongings influences the firms’ behavior. one of the modern-day tendencies is that intangible belongings emerge as the foremost transferring channel of income shifting and switch pricing manipulation. the function of intangibility is related to a number of issues of valuation of internally generated intangible assets. those are divided into two groups: identifiable and unidentifiable intangible assets. the valuation of intangible belongings is particularly necessary for the pricing of mergers and acquisitions. results assert that there is a positive and significant relationship among dependent and independent variables. 3.3 development of research hypothesis according to ias 38, spending on r&d can be counted as investment or assets. this option will impact financial performance, but it is difficult to estimate the effect because it raises the information asymmetry between shareholders and managers. canibano, garcia-ayuso, and sanchez (2000) in lantz, et al. (2005) show the presence of improved returns due to increased spending on research and development, so hypothesis derived from this literature review. h1. intangible asset has a direct positive impact on financial performance of the technology firm h1a. intangible assets has significant effect on roe. h1b. intangible assets has significant effect on roa. h1c. intangible assets has significant effect on roic. h1d. intangible assets has significant effect on net profit margin. h1e. intangible assets has significant effect ato. the theory of the agency cost (jensen and meckling, 1976) suggests that the expense of the agency cost influences monetary policy. depending on the unique characteristics of asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 36 intangible assets, in organizations with concentrated intangible assets, the expense of the business is projected to be higher. intangible assets would increase the cost of the business to shareholders (due to more details and secret action), including the cost of the debtor agency (asset substitution and underinvestment problem) so the second testing hypothesis derived from this theory. h2. intangible asset has a direct positive impact on financial policy of technology firm h2a. intangible assets affect debt policy. h2b. intangible assets affect the dividend policy. agrawal and knoeber (1996) result in a positive and important connection of intangible investment to the market value of the company. and so, in her research, connolly and hirschey's (1984) show a positive correlation between intangible spending and firm interest. erawati and sudana (2005) suggested the idea that, together with the tangible assets, intangible assets are one category that: (1) assess the company's value and (2) influence the financial performance of the company. h3. intangible asset has a direct positive impact on market value of technology firm. h3a. intangible assets has significant effect on p/e. h3b. intangible assets has significant effect on p/book value. h3c. intangible assets has significant effect on p/sales. by testing the h4, we can determine that if there is significant differences occur in the sector of the technological firm or not that is (manufacturing & service) because in some papers such as miyagawa (2015) investigate and proposed that service sector rely more on intangible assets than manufacturing so we tested this among global technology firms h4. the contribution of intangible assets to a company’s financial performance, financial policies & market value will not be significantly different among the global technological subsector. hypothesis 5 is used to test that if result varies from country to country or not because in most countries this is not reported due to the lack of ability of the accounting standards issued to date. intangibles are among the fundamental determinant of the value of business enterprises. currently, most of the intangibles are only revealed indirectly by incremental economic performance (mortensen, eustace and lannoo, 1997). h5: the contribution of intangible assets to the company’s financial performance, financial policy, and market value will not be significantly different among different country’s groups. 3.4 model evaluation the model developed in this study examines the inter-relationship between intangible assets, financial performance (profitability, roa, ato, roe, roic), financial policy (debt policy and dividend policy), and firm value (p/e, p/book value, and p/sales). the pls model is asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 37 shown in figure 1. figure 1. model of the study 4. methodology 4.1 sample the sample of the study included globally technological sector companies of high market capitalization in their respective country. the sample was restricted only to companies that reported financial information about intangible assets in their balance sheet or annual reports for the years 2015-2018 due to availability these years’ data on the company’s websites. the number of companies included in the sample was 80 companies with respect to its market capitalization in their respective countries that heavily rely on intangible assets. in the technological sector; the total number of observations collected from years understudy was 320 observations. table 2. list of countries with companies name & sectors s # country companies name sector 1 brazil adobe inc. services broadcom inc. manufacturing asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 38 sinqia s.a services 2 china hangzou manufacturing midea group manufacturing haier smart home manufacturing tencent holding limited services zte corporation manufacturing 3 finland nokia corporation manufacturing telefonaktiebolaget lm ericsson services vaisala oyj (vaias.he) manufacturing 4 germany dell technologies manufacturing sap se services 5 india accelya services mastek services birlasoft services hcl technologies services himachal manufacturing infosys services l & t services mphasis services sonata software services sterlite manufacturing asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 39 tata consultancy services tech mahindra services wipro services zensar services heg manufacturing ifb manufacturing voltamp manufacturing 6 indonesia pt sarana menara manufacturing pt supreme cable manufacturing manufacturing 7 japan kanematsu services baycurrent services keyence corp manufacturing sato holding manufacturing sony corp manufacturing tokyo electron manufacturing omron corporation manufacturing otsuka corporation services ns solutions corporation services 8 netherland asm holding manufacturing 9 pakistan avanceaon manufacturing hum network services asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 40 netsol services ptc services system limited services trg manufacturing 10 russia yandex n.v services public joint stock company rbc services open joint stock company manufacturing levenhuk jsc (lvhk.me) manufacturing 11 south africa car track services mix telematics limited services data tec services nasper services 12 south korea asia pacific sataellite manufacturing cymechs manufacturing dongwon system manufacturing duksan neolux manufacturing eo technics manufacturing hankook services kl-net corp services mico limited manufacturing nexteye co manufacturing asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 41 samsung electronic manufacturing signetic corporation manufacturing 13 taiwan taiwan semiconductor manufacturing yageo corporation manufacturing 14 usa amadeus services accenture services cisco systems manufacturing cognizant services fujitsu services intel corporation manufacturing international business machine services microsoft corporation services nividia manufacturing oracle services texas instruments manufacturing 4.2 trend analysis 4.2.1 scatter plot analysis: asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 42 plot a (roa vs intangible/total assets in plot a, the data points line up very nicely! we can easily draw a horizontal line amongst these dots, and the line would be a good fit to the data. however, the fact that the line would be horizontal means that the input values (that is, intangibles/total assets) are irrelevant to the output values (that is, roa). so there is a definite trend to the data, and there is an excellent good-fit line for it, but that line only says that the input values are irrelevant. if the inputs are irrelevant, then there can't possibly be a correlation between inputs and outputs. plot b (debt to equity vs intangible/total assets in plot b shows a bunch of dots, we can draw a horizontal line amongst these dots, and the line would be a good fit for the data but at some extent increasing at the bottom. however, the fact that the line would be horizontal means that the input values (that is, intangibles/total assets) are irrelevant to the output values (that is, debt to equity ratio). if the inputs are irrelevant, then there can't possibly be a correlation between inputs and outputs. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 43 plot c (dividend payout ratio vs intangible/total assets plot c shows a bunch of dots, where low x-values that is (intangible assets/total assets) correspond to low y-values (dividend payout ratio), and high x-values correspond to high y-values. it's fairly obvious to me that we could draw a straight line, starting near the left-most dot and angling upwards as i move to the right, amongst the plotted data points, and the line would look like a good match to the points. such a line would have a positive slope, and the plotted data points would all lie on or very close to that drawn line. so there does appear to be a strong correlation here and, because the good-fit line drawn amongst these points would have a positive slope, that correlation is positive. plot d (price earning ratio vs intangible/total assets asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 44 plot d shows a bunch of dots, where low x-values (intangible assets/total assets) correspond to high y-values (p/e), and high x-values correspond to low y-values. it's fairly obvious to me that i could draw a straight line, starting from around the left-most dot and angling downwards as i move to the right, amongst the plotted data points, and the line would look like a good match to the points. such a line would have a negative slope, and the plotted data points would all lie on or very close to that drawn line. so there does appear to be a strong correlation here and, because a good-fit line drawn amongst these points would have a negative slope, that correlation is negative. country wise time series graph from 2015-2018 time series line chart indicates that trends in brazil, china, finland, pakistan, taiwan, and usa are increasing over a while from 2015 to 2018 and rest of the countries follow the trend of decreasing over a period of time. 4.3 research method the study used accounting-based data for intangible assets & financial indicators of the firm’s income statement & balance sheet or in disclosures of the annual report. to examine the effect of the firm’s intangible assets on the firm’s performance, firm policy & firm value we estimate sem equation model through smart pls 3. ia=α+β1roa+β2ato+β3roe+β4roic+β5profitability+β6der+β7dpr+β8pe +β9pbv+β10psr+e asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 45 table 3. model variables variable type description intangible assets independent variable posted in financial statement of companies return on assets dependent variable net income divided by total assets asset turnover ratio dependent variable sales divided by average total assets return on equity dependent variable net income divided by total equity return on invested capital dependent variable (net income dividend) / (debt + equity). profitability dependent variable net income divided by total profitability debt to equity ratio dependent variable total debt divided by total equity dividend payout ratio dependent variable dividend per share divided by the earnings per share price earnings ratio dependent variable dividing the market value price per share by the earnings per share price to book value dependent variable dividing the market value price per share by the book value per share price to sales ratio dependent variable dividing the market value price per share by the sales per share 5. results and data analysis 5.1 descriptive statistics (construct means and sd) this section presents the values for minimum, maximum, mean, and standard deviation for each of the used variables in the research (table 4) table 4. descriptive statistics (country groups) 5.2 inter-construct correlation the table 5 summarizes the inter-construct correlation between different constructs in the study. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 46 table 5. inter-construct correlation analysis 1 2 3 4 5 6 7 8 9 10 11 roa (1) 1 roe (2) 0.818 1 roic (3) 0.89 0.84 1 ato (4) 0.7 0.632 0.662 1 profitability (5) -0.054 -0.043 -0.052 -0.047 1 intangible assets (6) -0.057 -0.046 -0.054 -0.056 -0.013 1 debttoequityratio (7) -0.091 -0.071 -0.094 -0.077 0.007 -0.016 1 dividendpayoutratio (8) -0.014 0.014 -0.021 -0.067 0.063 0.085 -0.114 1 pe (9) -0.049 -0.042 -0.052 -0.058 -0.009 0.31 -0.022 0.067 1 pbookvalue (10) -0.062 -0.052 -0.063 -0.068 -0.011 -0.016 0.019 -0.052 -0.024 1 psales (11) 0.066 -0.073 -0.084 -0.089 -0.013 -0.026 -0.016 0.029 0.022 0.44 1 structural equation model this section ascertains the proposed relationships in the study. the structural model shows how well the theoretical model predicts the hypothesized paths. 5.3 hypotheses testing (overall data) h1. intangible asset has a direct positive impact on the financial performance of the technology firm h1a: intangible assets has significant effect on roe h1a evaluates the impact of intangible assets on roe. the hypotheses results show that assets have a significant negative impact on roe (β = -0.045, t = 2.619, p = 0.000). this shows that higher intangible assets would lead to lower roe. hence, the hypotheses h1a was not supported. h1b: intangible assets has significant effect on roa h1b evaluates the impact of intangible assets on roa. the hypotheses results show that assets have a significant negative impact on roa (β = -0.056, t = 2.570, p = 0.01). this shows that higher intangible assets would lead to lower roa. hence, the hypotheses h1b was not supported. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 47 figure 2. pls model h1c: intangible assets has significant effect on roic h1c evaluates the impact of intangible assets on roic. the hypotheses results show that assets have a significant negative impact on roic (β = -0.053, t = 2.990, p = 0.003). this shows that higher intangible assets would lead to lower roic. hence, the hypotheses h1c was not supported. h1d: intangible assets has significant effect on net profit margin h1d evaluates the impact of intangible assets on net profit margin. the hypotheses results show that assets have an insignificant impact on profitability (β = -0.013, t = 1.602, p = 0.11). hence, the hypotheses h1d was not supported. h1e: intangible assets has significant effect ato. ato h1e evaluates the impact of intangible assets on ato. the hypotheses results show that assets have a significant negative impact on ato (β = -0.055, t = 3.982, p < 0.001). this shows that higher intangible assets would lead to lower ato. hence, the hypotheses h1e was not supported. h2. intangible asset has a direct positive impact on the financial policies of technology asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 48 firm. h2a: intangible assets affect debt policy h2a evaluates the impact of intangible assets on debt to equity. the hypotheses results show that assets have an insignificant impact on debt to equity (β = -0.016, t = 0.582, p = 0.561). hence, the hypotheses h2a was not supported. h2b: intangible assets affect the dividend policy h2b evaluates the impact of intangible assets on dividend policy. the hypotheses results show that assets have a significant positive impact on dividend policy (β = 0.084, t = 2.516, p = 0.012). this shows that higher intangible assets would lead to higher dividend payout. hence, the hypotheses h2b was supported. h3. intangible asset has a direct positive impact on market value of technology firm h3a: intangible assets has significant effect on p/e h3a evaluates the impact of intangible assets on p/e. the hypotheses results show that assets have an insignificant effect on p/e (β = 0.304, t = 1.242, p = 0.215). hence, the hypotheses h3a was not supported. h3b: intangible assets has significant effect on p/book value h3b evaluates the effect of intangible assets on p/book value. the hypotheses results show that assets have a significant negative effect on p/book value (β = -0.016, t = 2.693, p = 0.007). this shows that higher intangible assets would lead to lower p/book value. hence, the hypotheses h3b was not supported. h3c: intangible assets has significant effect on p/sales. h3c evaluates the effect of intangible assets on p/book value. the hypotheses results show that assets have a significant negative effect on p/sale (β = -0.026, t = 2.850, p = 0.005). this shows that higher intangible assets would lead to lower p/sale. hence, the hypotheses h3c was not supported. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 49 table 6. overall sample results beta sd t statistics p values assets -> roe -0.045 0.017 2.619 0.009 assets -> roa -0.056 0.022 2.57 0.01 assets -> roic -0.053 0.018 2.99 0.003 assets -> profitability -0.013 0.008 1.602 0.11 assets -> ato -0.055 0.014 3.982 0.000 assets -> debttoequity -0.016 0.028 0.582 0.561 assets -> dividentpayout 0.084 0.033 2.516 0.012 assets -> pe 0.304 0.245 1.242 0.215 assets -> bookvalue -0.016 0.006 2.693 0.007 assets -> psale -0.026 0.009 2.85 0.005 5.4 country group wise results this section after ascertaining the hypothesized relationship in the overall data evaluates the relationships in each of the sample countries. the results are summarized in table 7. the hypothesis results of country group-wise results show that h1a was supported in finland group, h1b was also supported in finland group, h1c was not supported in any country, h1d was supported in russia and china group, h1e was not supported in any group, h2a was supported in pakistan and russia and china group, h2b supported in japan and usa group and h3a, h3b h3c was not supported in any country group. 5.5 in technology manufacturing sector this section after ascertaining the hypothesized relationship in the overall data evaluates the relationships in each of the sample sectors (manufacturing and services). the results are summarized in table 8. the hypotheses results of manufacturing sectors show that assets have a significant negative impact on roa, roic, ato, debt to equity, price to book value and price to sales, insignificant impact on roe, profitability, dividend policy. 5.6 in technology services sector the hypotheses results in table 8 of service sectors show that assets have a significant negative impact on roe, roa, roic and p/book value, insignificant impact on profitability, ato, dividend policy, p/e and p/sales, only debt to equity has a significant positive impact with intangible assets so h2a was supported in services sector. h4: the contribution of intangible assets to a company’s financial performance, financial policies & market value will not be significantly different among the global technological subsector. to assess whether there are significant differences in the company’s financial performance, financial policy, and firm value between the manufacturing and services sector, multi-group analysis (mga) was performed. the results from mga revealed that there are differences in asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 50 the significance of the impact of assets on roa, roe, and roic (p < .05), however all other differences in significance between the two groups are insignificant. the results are summarized in table 8. h5: the contribution of intangible assets to the company’s financial performance, financial policy, and market value will not be significantly different among different country’s groups. the study evaluated whether there are significant differences in the company’s financial performance, financial policy, and firm value across different countries (finland, japan, pakistan, russia & china, and the usa), multi-group analysis (mga) was performed. the results from mga revealed that there are differences (p < .05) in the significance of the impact of assets on the criterion variable between a few countries for instance asset’s impact on roic is significantly different between russia & china and usa. results are presented in table 9, a p-value less than .05 indicate a significant difference in the impact of assets on different outcomes variables between the countries. table 7. country group wise analysis finland japan pakistan russia and china usa beta sd t p beta sd t p beta sd t p beta sd t p beta sd t p assets -> roe 0.202 0.099 2.044 0.041 -0.073 0.023 3.151 0.002 -0.173 0.047 3.715 0.000 -0.133 0.081 1.645 0.101 -0.129 0.053 2.424 0.016 assets -> roa 0.218 0.116 1.878 0.061 -0.062 0.021 3.023 0.003 -0.246 0.031 8.046 0.000 0.094 0.103 0.914 0.361 -0.130 0.059 2.217 0.027 assets -> roic 0.065 0.146 0.448 0.654 -0.083 0.025 3.274 0.001 -0.197 0.035 5.588 0.000 0.115 0.095 1.201 0.230 -0.127 0.061 2.092 0.037 assets -> profitability -0.111 0.117 0.947 0.344 -0.075 0.021 3.533 0.000 -0.106 0.074 1.426 0.154 0.523 0.193 2.714 0.007 -0.099 0.039 2.542 0.011 assets -> ato 0.019 0.141 0.136 0.892 -0.069 0.031 2.202 0.028 -0.132 0.058 2.286 0.023 -0.242 0.160 1.515 0.130 0.027 0.083 0.318 0.750 assets -> debttoequity -0.136 0.097 1.397 0.163 -0.062 0.054 1.150 0.251 0.351 0.179 1.965 0.050 0.314 0.105 2.983 0.003 -0.105 0.104 1.007 0.314 assets -> dividentpayout 0.088 0.199 0.443 0.658 0.265 0.057 4.685 0.000 -0.055 0.089 0.615 0.539 0.127 0.146 0.867 0.386 0.188 0.060 3.115 0.002 assets -> pe -0.137 0.127 1.073 0.284 0.300 0.235 1.278 0.202 0.081 0.160 0.509 0.611 -0.210 0.092 2.280 0.023 -0.089 0.154 0.579 0.563 assets -> book value -0.211 0.138 1.528 0.127 -0.027 0.048 0.557 0.578 -0.054 0.014 3.990 0.000 -0.055 0.144 0.378 0.705 -0.442 0.083 5.315 0.000 assets -> psale -0.311 0.093 3.366 0.001 -0.056 0.056 0.993 0.321 -0.031 0.063 0.489 0.625 -0.214 0.093 2.306 0.022 -0.478 0.125 3.828 0.000 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 51 table 8. manufacturing and services sector analysis manufacturing services beta sd t statistics p values beta sd t statistics p values assets -> roe -0.019 0.017 1.155 0.249 -0.176 0.036 4.851 0.000 assets -> roa -0.049 0.014 3.400 0.001 -0.217 0.024 9.018 0.000 assets -> roic -0.055 0.016 3.382 0.001 -0.194 0.024 8.136 0.000 assets -> profitability -0.031 0.019 1.631 0.104 -0.039 0.021 1.880 0.061 assets -> ato -0.056 0.015 3.774 0.000 -0.085 0.058 1.465 0.144 assets -> debttoequity -0.038 0.014 2.698 0.007 0.324 0.137 2.366 0.018 assets -> dividentpayout 0.100 0.052 1.903 0.058 0.010 0.097 0.101 0.919 assets -> pe 0.301 0.238 1.265 0.206 0.039 0.091 0.432 0.666 assets -> bookvalue -0.090 0.020 4.427 0.000 -0.060 0.012 4.951 0.000 assets -> psale -0.105 0.029 3.578 0.000 -0.051 0.052 0.997 0.319 table 9. multi-group analysis – manufacturing and services sector manufacturing – services p-value(manufacturing vs services) assets -> roe 0.157 0.000 assets -> roa 0.169 0.000 assets -> roic 0.139 0.000 assets -> profitability 0.007 0.372 assets -> ato 0.029 0.308 assets -> debttoequity 0.361 0.995 assets -> dividentpayout 0.090 0.204 assets -> pe 0.262 0.118 assets -> bookvalue 0.030 0.890 assets -> psale 0.054 0.832 table 10. multi-group analysis-country groups 6. discussion these results support previous research of haji and ghazali (2018), nijun zhang (2017) vladimir dženopoljac, stevo janoševic & nick bontis degroote (2016) and gamayuni (2015) found that the higher the intangible assets, the higher the ability of companies to return earnings assets. the higher the intangible assets owned by the company, the higher asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 52 company's ability to generate profits, and investors will appreciate the company (seen from the large market capitalization of companies) that will increase the value of the company. model 1 of the study shows that intangible assets have a positive impact on the financial performance of the enterprise because out of five proxies, four have the significantly affected by intangibles. model 2 shows that sub hypothesis dividend policy affects from the intangibles that supported the model also. model 3 result shows that price/book value and price/sales negatively affected from the intangibles. model 4 used for sectorial analysis of the technological sector of 80 companies and multi group analysis revealed that there difference in the significance on profitability and efficiency, however, all other differences in significance between manufacturing and service are insignificant. the results of the model 5 revealed that there are significant differences in the company’s financial performance, financial policy, and firm value across different countries (finland, japan, pakistan, russia & china, and the usa), multi-group analysis (mga) was performed. this paper covers the gap by taking comparative analysis among 14 countries and find that results vary country to country and also varies among sectors. this study is will help in find out that the impact of intangibles in technology firm and identify country or sectors means (manufacturing or services) that capitalize intangibles more efficiently. intangibles assets are nowadays become the safest investment because it will make your firm stronger and more productive by increasing the market efficiency as well build on profitable channels by showing your goodwill in numbers at the financial position statement of business. by studying from different aspects it is concluded intangible assets is useful resource of the business, it should fairly recorded and disclosed in the balance sheet. 7. conclusion the current paper supports the impact of intangibles on profitability, efficiency, capital structure, and dividend policy, and market value of technology firms. this paper attempt to cover broader portrait drew from the impact of intangibles by introducing 14 countries financial indicators from 2015 to 2018. in previous studies, only one country and any specific market aspect covered not global comparative analysis conducted. the main purpose of this study is to find out whether intangibles impact financial indicators of the company or not. for this sem analysis was conducted that revealed several important points. firstly in overall data analysis, intangible assets have a significant negative effect on roe, roa, roic, ato, debt to equity ratio, p/book value, p/sales and insignificant positive impact on profitability, p/e and significant positive impact on dividend policy. secondly, country group-wise data revealed that in finland group intangible assets have significant impact on roa, roe and p/sales, in japan group intangible assets have significant impact on roa, roe, profitability, ato, dividend policy and p/book value, in pakistan group, significant impact on roe, roa, roic, ato, debt to equity ratio and p/book value, in russia group significant impact on profitability, debt to equity, p/e and p/sales ratio and in usa group have a significant impact on roe, roa, roic, profitability, debt to equity, dividend policy, p/book value, and p/sales ratio. third, to assess whether there are significant difference in company’s financial performance, financial policy, and firm value between manufacturing asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 53 and services sector, multi-group analysis (mga) was performed. the results from mga also revealed that there are difference in the significance of impact of assets on roa, roe, and roic (p < .05), however all other differences in significance between the two groups are insignificant. multi group analysis revealed that the significance of impact of assets on roa, roe, and roic (p < .05), however all other differences in significance between the two groups are insignificant. these results support previous research that found that the higher the intangible assets, the higher the ability of companies to return earnings assets. the higher the intangible assets owned by the company, the higher company's ability to generate profits, and investors will appreciate the company (seen from the large market capitalization in companies) that will increase the value of the company. 7.1 implication in the last few years, the critical importance of intangible assets for enterprises has intensified. as today’s corporate asset values shift radically from tangible assets (buildings, inventory, products) to intangible assets (ideas, patents, intellectual property or ip), smart companies are using their intangible assets to boost their stock price and create shareholder value (kahn, 2002). studies undertaken are mostly limited to a country or region-specific studies. in our opinion, intangible assets are not related to region but to sectors, different sectors have their own peculiar requirement. this research will determine if investment in intangibles is the way out towards improvement in profitability, efficiency, capital structure, and dividend policy, and market value of technology firms as compared to other variables. our research complements and extends other empirical work that uses financial markets to value it and other intangible assets. the results direct managers to understand and realize the importance of intangible assets and keenly invest in r&d, technology, software, advertising, crm and human resources to further augment their performance. 7.2 limitations the research shows some limitations which, nonetheless, did not affect the results of the study. one limitation is concerned with the lack of information about research and development in regular financial statements or in annual reports or disclosures; further lack was also in accounting information related to intangible assets. the second limitation was linked to the sample of the study; the number of observations was decreased because we excluded many companies that did not provide continuous information over the selected period of the study. 7.3 future research 1. the study uses the metric of market capitalization, which is the most suitable measure because under the analysis it can represent variable intangible assets as a hidden value as a goal. in future studies, other metrics of intangible assets may be used to compare the results. 2. we recommend that public companies use fair value approaches to evaluate the value of assets to improve the quality of earnings and the relevance of financial statements. 3. in the filing of financial statements, some forms of intellectual capital which cannot 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(2017). relationship between intangible assets and financial performance of listed telecommunication firms in china, base on empirical analysis. african journal of business management, 11(24), 751-757. copyright disclaimer copyright for this article is retained by the author(s), with first publication right granted to the journal. this is open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/license/by/4.0). https://doi.org/10.2308/jeta-10570 microsoft word 12252-45066-1-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 274 ajfa.macrothink.org effect of liberalization of amman stock market on the prices fluctuation for the period (1994-2015) ahmad abdallah alrafayia al-balqa applied university –shobak university collage department of basic and applied sciencesjordan e-mail: ahmadalrafayah@gmail.com received: dec. 7, 2017 accepted: march 10, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12252 url: https://doi.org/10.5296/ajfa.v10i1.12252 abstract this study aimed to identify the relationship between the information and fluctuations in stocks return following the liberalization process of financial market, and illustrate the effect of liberalization of amman stock exchange on price fluctuations, and the trend of this influence. to achieve this goal the researcher depended on the data of the daily stocks returns for amman stock market for the period (1994-2015). the study was based on the analytical descriptive method. the period from which the financial data were taken was divided into two periods: first, the pre-liberalization of the financial market (1994-2000), and the second period, the post-liberalization which extended from 2001 to 2015, the appropriate statistical analysis was conducted through (e-views) program, and using the (garch) model. the results showed that there is an effect of the stock market liberalization on the fluctuations pattern in the jordanian stock exchange, the speed and accuracy of information flow to the market has increased after stock market liberalization, it also appeared that there are some events and factors such as wars and catastrophes which lead to strong and illogical fluctuations in the stock market, and that the variation in price changes before the liberalization period was integrated variation which indicates that news have perpetual influences on price changes. keywords: liberalization, stock market, prices fluctuation asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 275 ajfa.macrothink.org introduction financial liberalization is considered a relatively new phenomenon which started in the 1960s in many developed countries, followed by the developing countries through reforms and economic transformation. this reform includes a set of procedures that work on developing the financial markets, applying an indirect monetary control system, establishing a strong supervisory system, privatization of public sectors’ banks, encouraging the private sector to establish banks, allowing the entry of foreign banks in the local banking market, free interest rate, liberalization of exchange prices, and free capitals inflow and outflow (hamanah and ben ma’zo, 2013). jordan, and based on the economic and financial structure reform program agreed upon with the world bank and the international monetary fund, adopted by the end of 1980s and the early 1990s from the 20th century the financial liberalization policy, which aims to move from the planned economy to the free economy (market economy), by liberalization of the financial sector from the constraints to raise the capacity and capability of its financial system by motivating saving and encouraging investment, aiming to acquire high and sustained rates of economic growth. following an extreme financial crisis that influenced all major financial indicators, the jordanian monetary and financial authorities applied interest rate liberalization programs, decreasing financial confinements and privatization of many financial institutions, and opening the financial sector to foreign investors in order to encourage economic growth. financial liberalization policy goes back to (shaw and mckinnon, 1973) when they introduced theoretical and analytical studies through which they severely criticized the process of applying the financial control by most of the developing countries, because it has left negative effects on both the financial and economic development of those countries. considering that abandonment of the policy of financial confinement and applying the financial liberalization policy in the developing countries is the optimal solution for these countries to improve their financial and monetary systems abilities to bring and mobilize financial resources sufficiently to allow achieving positive economic growth rates, and advanced levels of financial development. they have demonstrated from their studies that applying the financial liberalization policy can encourage the accumulation of savings and rising investment, this will lead to achieving high economic growth and advanced levels of financial development (ghassan and alhajhooj, 2012). problem and study questions financial market represents the field in which the wishes of economic units with financial surplus meet up with economic units with financial deficit through financial intermediaries. financial market performs many functions for the national economy most importantly, gathering, mobilizing, and channeling financial resources, contributing to specifying the economic resources effectively, facilitating trading, distribution and diversification of risks, and increasing investments. thus, the financial market works on achieving economic efficiency in resources utilization by transferring financial surpluses from accumulated savings to productive uses that widen the productive base and increase employment opportunities and the national income, leading to increase of economic welfare levels. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 276 ajfa.macrothink.org the important role the financial market plays, must be taken into consideration, and different policies that make it plays its role to the fullest, must be followed. jordan's adoption of the policy of financial liberalization will affect the financial sector and consequently the volatility of stock returns. it was therefore necessary to identify the direction and magnitude of this effect, and the extent of this effect positively. this study aims to answer the following questions: 1. does the financial market liberalization process affect the stocks returns fluctuations (market fluctuations)? 2. if there is an impact of market liberalization on stock fluctuations, how is the market affected? 3. what is the relationship between the information and fluctuations in stocks returns that follows the financial market liberalization process? study importance significance of the study comes from the financial development occurred in jordan, for example, accession to free trade organization, making agreements with both america and european union, which requires removing all the constraints of the capital. these developments affect all economic sectors, including the financial sector. study objectives: this study aims to: 1. searching the effect of market liberalization on stocks returns fluctuations in amman stock market depending on the daily stocks incomes statements. 2. to know the effect of financial market liberalization processes on the fluctuation of the stock returns by using (garch) model. 3. to know how amman stock market is affected by financial liberalization , and the relationship between information and fluctuations in the stocks returns following the financial market liberalization process. study hypotheses ho1: there is no effect with statistical significance at the level (α≤0.05) of the financial liberalization process on the stocks returns fluctuations in amman stock market. ho2: there is no statistical relationship at the level (α≤0.05) between the information and the fluctuations which follow the financial liberalization process on stocks returns in amman stock market. financial liberalization financial liberalization policy aspects have appeared in the beginning of 1970s, as an inevitable consequence after the failure of the financial restraint policy adopted by most of the developing countries, which resulted in constraining the interest rate, which negatively affected the economy of these countries. as a result, many countries followed the economic liberalization program, opened their markets and liberalized them from the constraints, and pursued attracting new financial instruments and institutions to increase their competitive capabilities in the financial services asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 277 ajfa.macrothink.org field, and to facilitate the flow of capitals (shakoori, 2010). also, the financial liberalization policies involve a set of procedures and methods that reduce financial sector constraints. thus, the financial liberalization includes liberalization of the banking and insurance sectors, liberalization of capital flows, liberalization of exchange markets, and liberalization of the capital market. the concept of financial liberalization financial liberalization based on eliminating the restrictions and obstacles that prevent the free activity of the financial sector at the local and international level. the financial liberalization process in the developed countries has started and has been complemented by the expansion of the financial sector activities and globalization. it has expanded to include many developing countries, especially those that are known as the transition or unstable economies from planned ones to market economy, known as policies of financial restraint, for economic liberalization can only be completed by paying attention to financial sector reform and liberalization, from all aspects of financial suppression to play its role in economic activity (shakoori, 2010). and so, financial liberalization can be defined as: "a set of procedures by countries to remove any conditions imposed on the financial sector by opening markets to foreign and external companies to invest in it." (orj, et al., 2015) financial suppression policies: shaw and mckinnon (1973) defined financial suppression as “the state’s intervention in the financial sector that is characterized by determining the interest rate limit below its balance level, and imposing building of big compulsory reserves, and directing the credit .so, financial suppression is a financial policy with group of imposed constraints from the countries which do not permit the mediation to employ its full capabilities available to it. however, this policy has caused harm to countries’ financial systems, with the following negative effects (hariri, 2014) : financial sector lack of diversity, as marked by the dominance of banking sector, and the decline in the relative importance of the financial securities markets. decrease in the nominal interest rates on deposits and loans, which reflected negatively on all returns of other financial assets and then on their prices. putting negative pressures on banks profitability and its capital base. this came up with a higher margin between interest rates on deposits and interest rates on loans, which led to shrinkage of the banking activity. local financial assets became less attractive than other alternatives of the foreign assets. this led to shrinkage of the official system measured by the ratio of domestic financial assets to gross domestic product. and thus, financial liberalization strategy and the financial reform took place which aim at mobilizing domestic savings and encouraging direct and indirect foreign investments in a way that guarantees efficiency, mobilization of resources and allocation to investments, with the need of foreign capital flow in the form of direct or indirect investments. financial liberalization includes liberalizing the following transactions (akpan, 2004): transactions related to investment in the financial market, such as the shares, bonds and the investment securities and derivatives. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 278 ajfa.macrothink.org transactions related to real-estate assets, transactions specific to buying or selling real-estate locally by the non-residents or buying the real estates in the outside by the residents. transactions specific to financial and commercial credit, guarantees, and financial facilities that include the inflows and outflows of capital. transactions related to the commercial banks, including the local deposits, banks credit from outside that represent the inflows, the loans and foreign deposits that represent outflows. transactions related to personal capitals movements, including transactions specific to deposits, loans, gifts, grants, heritage, or debts settlements. transactions related to direct foreign investment, including liberalization from the imposed constraints on the direct investment flowing inside or directed outside, or earnings clearance across borders. development of financial liberalization the financial and monetary markets have witnessed an expanding pattern towards the canceling or decreasing of restrictions, including legislation, regulations and confinements that limit its freedom and movement. after its failure and inefficiency in restricting capital and achieving monetary policy objectives, the process of restrictions removal has begun. this process aims to put an end to the direct governmental interference in monetary and banking systems, by which the period after the second world war was featured. this process, which took many forms, involving determining the maximum interest rates that can be paid on deposits, and those that are loaded on loans, determining legal reserve ratios and the minimum ratio of capital to assets, and specifying banks allocating and its specialty and the allowed services provided (ghassan and al-hajhooj, 2012). there was a difference between countries at the beginning of the implementation of the liberalization policy by restrictions removal. it took many forms, such as credit and debit rates restrictions removal, abolition of control of external financing processes, decreasing restrictions and procedures limiting the movement of capitals flow, removing commissioning restrictions, pricing of banking services, cancelling credit limits, and foreign exchange processes restrictions removal (ghassan and al-hajhooj, 2012). thus, the essentiality of financial market liberalization is to liberalize the capital account by restrictions and controls removal on capital movements of short periods across national borders, giving the market an absolute effectiveness in the processes of guaranteeing, distributing and allocating financial resources, determining the prices of financial processes depending on supply and demand, cancellation of governmental financial control and giving banks and financial institutions complete independence, and not to impose any restrictions on the free entry and exit of the financial services industry. (hamanah and ben ma’zo, 2013) and so, the process of financial liberalization is to give the financial market the freedom in financial resources distributing, redistributing, and allocating according to the law of supply and demand forces, in addition to local credit allocation restrictions abolition and interest rates liberalization, giving banks and financial institutions the freedom to manage their financial activities through canceling different restrictions and regulations on banking, stopping the government intervention in the financial sector, in addition to liberalization of transactions related to capital account and financial accounts of balance of payments (mnif, 2013) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 279 ajfa.macrothink.org financial liberalization involves two types: internal (domestic) financial liberalization and external financial liberalization. the first is the liberalization of interest rates, leaving policies of credit guidance and mandatory reserve, reliance of indirect tools of monetary policy, encouraging the competition among financial institutions, and opening the financial system to external competition. the second means liberalization of capital account transactions and the financial accounts of the balance of payments, including transactions related to different forms of capital, such as debt, equity, direct investment, real estate and personal wealth, and liberalization of the capital account means the abolition of restrictions on foreign financial transactions and other controls related to these transactions (adeusi, et al., 2012). there are many indicators of financial liberalization, according to the bekaert et al. (2006). these indicators are considered the newest of financial liberalization: 1 liberalizing interest rates: elimination of restrictions on the movements of interest rates so that the interest rate is determined depending on the equilibrium between the supply and demand of funds, that can be loaned according to the market mechanism, without interference of the central bank. 2. privatization: transferring of ownership of the public sector to ownership of the private sector, which means the transition from the totalitarian economy to market economy and financial liberalization. 3. improving laws related to capital adequacy issue: the increasing competition between large and small banks resulted in increased banking risks, and to increase the bank's capability of managing credit risk, laws of capital adequacy are getting improved, and so improvement of laws related to capital adequacy reflect the increase in financial liberalization. 4. reducing credit restrictions and the legal reserve: the central bank regulates and manages credit in economy through economic policy. the more the central bank tends to reduce credit restrictions and reduce the legal reserve, the more it indicates the direction of the economy towards liberalization of monetary policy, which proves the trend towards financial liberalization. 5. increasing foreign ownership in banks: by opening all sectors for foreign investments, restrictions abolition on foreign ownership, allowing the transfer of profits and capital abroad, and confinements removal on foreign ownership has made the ownership of economic sectors common between foreign and local investors, at rates to be determined based on an agreement of the parties. financial liberalization and the stock market: financial liberalization is considered an important option in the macro-economic policies, because the correlation between the movement of capital and its speed depends on communication among these markets. and the evolution and the development of the financial liberalization have been an important factor in accelerating that movement, and the growth of the current capitals size in the international financial markets which helped in the liberalization of the securities market (omet and maghyereh, 2003). thus, it is possible to define the stock markets liberalization as: “the deletion of all imposed restrictions and obstacles facing the foreign investor’s acquisition of stocks that listed on the stock exchange, and issued by local financial institutions (like shares and the financial derivatives), and limiting the forced localization of capital, premium profits, and interests, i.e., asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 280 ajfa.macrothink.org abolition of limitations at invested foreign funds and its profits inside to exit, this is by allowing the foreigners to buy shares in the local stocks market which is considered encouraging to increase the foreign capitals that enter in the companies’ equity (adamopoulos, 2010). many rising economies have opened stock markets to foreign investors, but in some countries and to a large extent, stock markets stayed closed to foreign participation. and may be the fear of financial and economic crises in these countries due to decrease of government oversight role and fear of foreign control, but the reality indicates that foreign participation in the stock market contributes to improve sharing of risk, and better distribution of these risks, and so, reducing the cost of the share. moreover, improvement in risk distribution between the investors and increasing liquidity in the stock market will reduce the risks, and at the end will lead to reducing of capital cost, and increasing of private investments which positively reflects on the economic growth. so, the improvement in risk distribution between the investors and increasing liquidity in the stock market leads to more efficient capital distribution, and this has a direct positive effect on productivity and growth (agu et al., 2014). liberalization of stock markets objectives: (al-asali2006) achieving more efficiency and greater efficacy for stock market work, in order to mobilize local and foreign savings and take advantage from them in financing the stock market economics, as well as increasing their investment rates, also rising the access of investors and local borrowers to the fields of investment and international financing sources. this will increase the involvement of investors, local borrowers, and local and foreign financial companies, thus, facilitating the entry of foreign companies and investors in the domestic financial markets. stock markets liberalization policies correspond with the strong trend towards liberalization of international trade and the globalization of financial transactions, as well as in commercial transactions, especially after introducing public services trading and the trade of financial and banking services in particular, within the commercial negotiations of several parties of the international trade organization omc and put it under its guardianship, through coming out with the general agreement on the liberalization of services trade (gats). increasing the competition among the financial markets across the world to get the largest possible amount of capitals internationally, so abundance of changes that spread through the capitalist economies, most importantly by changes in the exchange rates of international currencies especially the dollar and the euro in the last years of the twenty-first century, changes in international interest rates, which have changed the international monetary and financial system, for it pushed many of these economies to give greater freedom to external transferences with the liberalization of currency exchange. these changes have weakened the effectiveness of control of the country over capital movement. and so, the liberalization of stock markets aims to make these markets work more efficiently and more effectively, having the ability to compete with the rest of the international financial markets to give investment chances and loan resources. however, it is clear that these effects are greater in the first year of applying of liberalization and then decrease and vanish gradually over the following years. it is may be because of the expectations that arise by the participants in the market before and during the application of liberalization stage . effect of the financial liberalization on the stock prices fluctuation: stock prices fluctuation issue has gained a great interest in the financial literature. the studies asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 281 ajfa.macrothink.org that have predicted the fluctuation have included the prices and its explanation using different models. the first one who has analyzed the stock prices fluctuations so far was (schwert, 1989), and noticed the presence of great fluctuations in the stock prices in many economic variables, such as interest rate and inflation, but none of these economic variables only can explain the behavior of stock prices fluctuation through history (adamopoulos, 2010). it has been found that the economic recession is mostly preceded by regression in the stock market prices, this assures that the total economic variables and the recession’s periods, financial crises, and different banking crises are directly related to the stock prices fluctuation. high level fluctuation can leads to a negative future of stock prices, which can reduce the performance of the financial system as a whole. moreover, frequent fluctuations drive the investors and the depositors to resent from the financial market. also, stock prices fluctuations lead to increase in the capital cost for the companies, this will make waiting a more valuable option and so delaying the investments. fluctuations can work on reducing institutions work in the stock market, and attempt to collect the funds by other means, and thus, high level of market fluctuations can impair investments and slow down the total economic growth (mnif, 2013). stock prices fluctuation might negatively affect the consumer’s spending through wealth changes and consumer trust. in addition, great stock price fluctuations may cause a crisis in the financial system, and disruption in the financial mediatory, which cause monetary and credit problems in the economic system (mnif, 2013). from the latter, it is clear that there are many other factors affecting the fluctuation of the stock prices incomes. so, does liberalization and the trend towards a greater capital markets increase the fluctuation in the local stock prices incomes? it is believed that the foreign capitals flows are very sensitive in the economic expectations at the short-term in the emerging markets, which makes the flow of capitals very fluctuated, without restrictions. in addition to that, market liberalization means the exposure to the foreign influence, so if the foreign stocks prices are more fluctuating for any reason, the local prices also might become more fluctuating. hence, the presence of greater fluctuations in the stocks prices makes the investors resent to the stock contract, demanding a higher risk bearing premium, which indicates an increase in capital cost and a fewer investment (omet and maghyereh, 2003). amman stock market: stock markets play an important role in transforming financial resources from residual units to deficit units, they represent excellent investment opportunities and important factor in attracting foreign and local capitals. also the importance of investment in the stock markets appears in the risk of investment decision making, and forming the appropriate investment portfolio according to the investor’s desire of the investment. it is difficult for the investor to decide accurately the expected return rate on the investment. the expected return and the surrounding risks represent the two basic variables for the investment decision (al-omari, 2007). amman stock market is founded according to the temporary amman stock market law no. (31) year 1976, because of the increasing importance of the stock markets, and the necessary economic goals it achieves, such as the financial liquidity. there was a cooperation between asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 282 ajfa.macrothink.org jordan central bank and the world bank’s international finance corporation, however, business didn’t precede and wasn’t officially opened. it started its work officially in 1/1/1987, (saleh, 2009). the amman stock market managed to grow rapidly since the beginning of its work in 1978 in response to the increasing demand for stocks in jordan. amman stock market is facing qualitative changes in various fields of investment, regulatory, and technical fields, to cope with its special position among many emerging markets. the most important goals established by amman financial market for the stocks: (saleh, 2009) 1. developing saving through encouraging investment of stocks, and directing the savings for serving the national economy. 2. regulating and monitoring the stocks issuance and dealing with it in a way that guarantees its speed and simplicity, and to ensure the country’s financial interest and protection of small depositors. 3. collecting and disseminating information and statistics from the related companies to the market’s work, which allows investors to make decisions that serve the economic development. 4. working on investment advantages on the largest extent of shareholders by operating the capitals of the large productive units to improve living levels. 5. working on attracting capitals and operating it by its distribution to the more productive investment alternatives, to achieve capitals accumulation and strengthen the economy. development of financial liberalization in jordanian market in the framework of inducing foreign investment, the maximum foreign ownership of 50% has been canceled. so, investors other than jordanian ones are being treated the same, and they have the right to possess a part or all of any project or company except for some sectors which limit the maximum range for foreigners as 50%, which are three sectors; construction & contracting sector, general retail sales, and mining (amman stock market location). the ratio of the value of shares bought by foreign investors to trading value reached 1.6% in 1996, 28.3% in 1997, 44.1% in 1998, 24.1% in 1999, and 20.4% during the first half of the year. 2000 (khatib, 2008). in july 2001, 14.8 million jds was the value of purchased shares by investors who are not jordanian. 58.8% of it were purchased by non-arab investors. foreign investors sold, simultaneously, shares of 82 million jds, 95.7% of it were sold by arab investors. this means that there is a total declined of foreign investment reaching a negative value of 67.3 million jds, compared to a net inflow of 1.5 million jds at the same period last year. not to mention, net foreign investments have reached a positive value of jd 12.7 million in the first quarter of 1999 (khatib, 2008). on the other hand, during 1997, and for the first time, gdr's certificates of deposit were issued outside jordan for the arab potash company with a value of $ 32.5 million in the london market. and it was fully covered. the jordan phosphate mines company also issued bonds worth $ 141.2 million in european markets. these bonds were fully covered at competitive interest rates, reflecting the confidence of international investors in these exporting companies (khatib, 2008). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 283 ajfa.macrothink.org previous studies orj et al., 2015 entitled as financial liberalization and growth outcomes in nigeria. this study included the effect of financial liberalization on the gross domestic product growth in nigeria during the period 1986-2011. the researcher used the method of leastsquares in his analysis. the experimental results revealed that the financial liberalization policy is negatively correlated with the growth of the gross domestic product in nigeria during that period. also, the researcher indicated in this study that financial liberalization in nigeria has a role in encouraging the gross domestic product growth and shows that there is a need for banks and financial institutions to review methods of lending the private sector and giving loans available for those with profitable business plans and willing to invest in the local economy. farhani et al., 2015, entitled: the effect of financial liberalization on the probability of banking crises. the study inspected the relationship between financial liberalization and the possibility of banking crises due to institutional quality. the researcher utilized information from 50 countries from 1990 to 2014. the study concluded that there is a positive relationship between financial liberalization and banking crises, and the reinforcement of institutional quality overcomes the banking crises obstacle. agu et al., 2015, entitled financial liberalization, interest rate framework and savings mobilization. this study aimed to know the nature of the causal relationship between financial liberalization, real interest rate, mobilization of savings and how they interact with each other in nigeria. the researcher used the statistical model var (vectorial auto-regressive) to see how financial liberalization, real interest rate, and savings mobilization interact with each other. the results showed no causal relationship between financial liberalization, real interest rate and savings mobilization. a study of hamanah and ben ma’zo (2013), entitled: measuring the relationship between financial liberalization and economic growth in algeria. the purpose of this study is to know the relationship between financial liberalization and economic growth on an extreme and between trade openness on the other extreme on the long-term by depending on the kaopen index in the period 1970-2010. the study concluded that there is a long-term adverse relationship between financial liberalization and economic growth, and that there was a negative relationship between trade openness and financial liberalization. mnif, 2013, entitled: effects of financial liberalization on stock market courses. the study aimed to compare the market cycles behavior in the wake of financial liberalization in the short and long term in latin american countries (argentina, brazil and chile) and asian countries (philippines, korea, taiwan and thailand) during 1975-2005. it concluded that, liberalization makes stock market more fluctuating, yet, more stable over the longer term to create financial markets. stock market cycles in asian countries continue to be very high in the period after reparation; however, after financial liberalization, the latin american stock market leads to more stable cycles. the study of ghassan and al hajhooj (2012) entitled: the impact of liberalization of the capital market on instability in saudi stocks. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 284 ajfa.macrothink.org this study is meant to analyze the instability in the saudi stock market by testing the structural changes through the garch model, depending on a daily database for the period 2001-2010. the results of the return equation show a positive relationship between return and risk. this result indicates high risk, also it indicates a negative relationship between size and risk. moreover, results show that the opening up phase of domestic and foreign capital is more important for information inflow to the market in comparison with the period preceding 2005. additionally, equity prices influence the value of the ongoing index in the first phase of 2001-2005, while it weakens in the second phase 2005-2010, it has been confirmed that entry of foreign investors may reduce the instability of returns in the trading market, and that giving a chance for foreign investment has led to significant decrease in volatility in the short-term, while the existence of foreigners has not made it in decreasing long-term volatility, and the extent of the temporary effect is more sharp and relatively larger in comparison to the impact of the global financial crisis, especially during 2008. adeusi et al. (2012): the effect of financial liberalization on the official capital market. the study inspected the impact of financial liberalization on the performance of informal capital market institutions in nigeria. the researcher used the method of the leastsquares for regression analysis for ten years (2001-2010). the researcher came up with three models: the first model discussed the change in financial liberalization (savings rate) with the loans granted by the informal capital market in nigeria, and the second model inspected the change in financial liberalization (the lending rate) with the total deposits in the informal capital market in nigeria and the loans granted. the last model studied changes of financial liberalization (savings and lending rates) with total deposits and loans granted by the informal capital market in nigeria and the net surplus from the market. the researchers found that financial liberalization had a great effect on the total deposits and loans granted by the market but it did not have a significant impact on the net surplus, and therefore the researcher recommended that the market should be under the supervision of policies that would enhance the performance of the informal financial sector in nigeria in addition to reducing the gap between loans and saving rates in banks. -al-asali study (2006). “the effect of the financial liberalization on the returns and trading volume in the shares of the jordanian banking sector” this study aimed at measuring the effect of the financial liberalization’s indicators on the development of the trading volume and shares' return of the jordanian banking sector for the period (1980-2004). in addition to knowing the concepts of shares' returns, trading volume, it also contains how to measure them. study population consisted of a sample included nine banks excluding the banks that were initiated after 1980, based on the assumption that there is a relation with statistical significance between financial liberalization indicators and returns on shares of the jordanian banking sector. the study depended on four indexes of the financial liberalization, which are: liberalization of interest rates, improving the laws related to capital sufficiency, eliminating the constraints on the foreign property and on the credit. the researcher used measurement models based on (panel data), and to show the effect and the increase of the explanatory capability, control variables were added. the study concluded the absence of a relation between financial liberalization indexes and each of the trading volume and the shares' returns of the jordanian banking sector. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 285 ajfa.macrothink.org study methodology the study adopted a descriptive analytical approach , which included a survey of the library's resources by referring to the references and readymade resources to build the theoretical framework and previous studies, and then the use of the descriptive analytical method to estimate the standard model used , based on the previous studies, to analyze financial data statistically to test the validity of the study hypotheses, in order to achieve the objectives of the study, and the findings and recommendations.. data collection sources the study adopted a descriptive and analytical method to collect the data and information necessary for the completion of this study, based on: secondary sources: originally dependent on the library survey and the financial books and periodicals specialized in financial liberalization, and amman stock exchange as well as some arabic and foreign publications and studies and some financial reports published on the internet. primary sources: which are aggregate financial data for the purposes of the study, through periodic bulletins and the monthly bulletin of amman stock exchange as well as the annual reports published by the amman stock exchange, which are specific to the market indicators, return on shares, and closing prices for public shareholding companies listed on the amman financial market for the period (1994-2015)t. study model this study aimed to know the effect of the financial market liberalization on the fluctuations of the shares' returns. to achieve this goal, market price indexes were analyzed, and stock return reached during the closing prices of the companies listed in amman financial market for the period (1994-2015). (garch) model was used which indicates that the market’s fluctuations take the following equations (1a,1b): (1a) (1b) where is: 1a = conditional mean equation 1b = conditional mean equation ψt-1= information in the time period α and =equation’s constant β= independent variable’s coefficient (accompanying). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 286 ajfa.macrothink.org when conducting data analysis process to know the effect of financial market liberalization on the market’s fluctuations through stocks' return, there is a need for answering the following questions: 1. does the financial market liberalization process influence the stock return’s fluctuations (market fluctuations)? 2. in the case of the presence of effect for the market liberalization process on the stock' fluctuations, how the market is influenced by it? 3. what is the relationship between the information and the fluctuations in stock' returns that follows the financial market liberalization? to achieve that and to answer the first question, the conditional variation equation was used, and the dealing with the (dummy variable), which takes two values (0) for data before liberalization, and (1) for the data after liberalization, so the conditional variation equation (2) becomes as follows: (2) where (d) is the dummy variable, and if the dummy variable was statistically significant, this means that the financial market liberalization process effects the market fluctuations (stock' returns), and: α = equation’s constant β= independent variable’s coefficient (accompanying). to answer the second and third questions, the time period was divided for the stocks' returns in the financial market into two periods; before and after the market liberalization process, and predicting by using (garch) model in its two forms (la) and (lb) for the two periods (before and after the financial market liberalization process), which enables the comparison between the fluctuation nature before and after the financial liberalization. data analysis and hypotheses testing: financial data related to the closing prices are collected through amman financial market, then calculating the stocks' return using the difference between the logarithmic base (ln) of the closing prices for the period (1994-2015), and dividing the period from which the financial data was taken into two periods; the first period was before the financial market liberalization (1994-2000) and the second period was after the market liberalization, which extended from (2001-2015); following the cancellation of the days in which there was no trading including the days during which the market closed, official holidays, it was found that the daily timed series for each of the closing prices, market indicators and return on shares, was (5423) days, figure (1) explains the direction of the market price index before and after the liberalization, which were obtained from the publications and reports of the amman financial market, whereas figure (2) shows the direction of stock return, which were calculated by the researcher, according to the following equation(3) as follow: (3) where is: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 287 ajfa.macrothink.org rt = stock' returns. p = market price index. t, t-1 = today and the previous day figure 1. time chain of the market price index direction figure 2. time chain of the stock return direction table 1 below shows a summary of the main statistical characteristics for the stock' returns in amman stock market for the year (2000) as a year separating between the two time series, which explain the stock' daily returns before and after liberalization. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 288 ajfa.macrothink.org table 1. descriptive analysis of stock' return before and after liberalization. period no mean media n sd skw flatte n normalit y auto correlatio n (1994-2015) 542 3 0.0000822 0.0000 0.00720 2 -0.5909 14.56 30511.98 256.21* pre liberalizatio n 171 8 -0.0000017 0.0003 1 0.00685 -0.0730 18.69 17635.99 77.2* post liberalizatio n 370 5 0.000121 0.0001 8 0.00709 -0.8086 12.88 15488 24.3* variance test 0.549 2.598* 6.066* table 1 shows the presence of statistical significance of the natural distribution for the whole period, and the coefficient of skewness was (0.5909.). this indicates that, there is very nonidentical time series, the natural distribution inclines to the left. this deviation confirms the high statistical significance to the normal distribution test (jarque-bera). the high value of self-link test (q12), amounting (256.21) refers to the presence of statistically significant self-link for the whole time period, and this indicates the presence of fluctuations in the time series of the values of stock' returns during the period (1993-2014). the results shown previously in table (1) agree with (mnif, 2013) study whose results showed that liberalization makes the stock market more fluctuating. results in table 1 also showed that the stock' return mean before liberalization was negative (0.0000017), and this is might be due to the deceleration in value of this index and its value rose after liberalization to (.000121). that was because of the occurrence of high fluctuations in the stock' returns, in addition to the desire to buy them by the foreign investors which led to rise in the demand and price for the stock. table 1 also shows that the rising value of the coefficient of skewness for the stock' return (0.0730-) for the time period before liberalization in comparison with that after liberalization (-0.8086) indicates the presence of big changes in the stock' prices, and the change in the stock' prices increase before liberalization was greater than after liberalization. when using the standard deviation of the shares' returns for the non-conditional fluctuations, the table shows the presence of fluctuations in the market for the period that preceded the market liberalization process, this is inconsistent with the hypothesis put forward by the supporters of the liberalization of financial markets, which presupposes the alleviation of fluctuations in the financial markets as a result of liberating them. in addition, results in table (1) also show that the standard deviation of the changes in the stock' returns for the period after the liberalization was greater than the standard deviation of the changes in the stock' returns for the period before the liberalization. after explaining the statistical properties of the stock' returns of market during the period asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 289 ajfa.macrothink.org (1994-2015), considering that the year (2000) is the year of separation, in which liberalization occurred, garch model will be used to detect the impact of liberalization on the amman financial market fluctuations. to achieve that, garch model was used for all groups (p=1.2.3.4.5) and (q=1.2.3.4.5), by the equations(4a, 4b) as follow: where: rt= daily stock' returns d= dummy variable / (0) value for the period before liberalization and (1) value for the period after liberalization. 4a = conditional mean equation 4b = conditional variance equation ψt-1= information in the time period α and = equation’s constant β= independent variable’s coefficient (accompanying). table 2. complete sample results for the period (1994-2015) with the dummy variable (d) by using the previous two equations(4a, 4b): 1η 0α 1α 1β γ -0.498 4.562 0.99 0.3660 0.4322 0.499 (2.124-)* (2.667)** (8.922)* (10.285)* (12.321)* (4.873)* ** statistical significance at (0.01) * statistical significance at (0.05) rt= daily stock' returns d= dummy variable / (0) value for the period before liberalization and (1) value for the period after liberalization. 4a = conditional mean equation 4b = conditional variance equation ψt-1= information in the time period α and = equation’s constant asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 290 ajfa.macrothink.org β= independent variable’s coefficient (accompanying). results in the above table (2) show the variance in the market fluctuations during the period (1994-2015) depending on the dummy variable. with acknowledging that in order to better read figures, the coefficient of (η0) was multiplied by (103) and the coefficient of (α0) was multiplied by (105). the table (2) also shows that all coefficients are statistically significant at level (0.05) and level (0.01). the significance of the parameter (α1) in the model indicates the direction towards the sudden change in the stock' returns for the entire period, and the coefficients of the parameters of the continuous fluctuation (α1+β1), the value of each individually and combined was less than one unit, and this refers to the tendency or direction of market fluctuations to respond to sudden changes in the short term. data from table (2) also indicates that the positive value of the dummy value (γ) concludes that the increase in the stock' prices fluctuation in the financial market may be due to the fully open of the financial market completely to the foreign investment, or due to the process of financial market liberalization by itself. this means that this stage of the analysis neither affirmed nor confirmed the cause of this change, and in order to make sure of the results of the (garch) model to know the behavior of the parameters and the direction of impact, this model has been tested for two periods: the first, before liberalization and the second after the liberalization, as shown in table (3). table 3. full sample results for two periods: before liberalization (1994-2000) and after liberalization (2001-2015) by using equations(5a, 5b) as follow: (5a) (5b) 0η 1η 0α 1α 1β pre liberalizatio n n= 1718 -0.596 11.642 0.552 0.278 0.489 (2.091-)* (1.889)** (6.987)* (9.265)* (20.641)* post liberalizatio n n= 3705 -0.754 2.622 1.99 0.397 0.256 (1.856-)* (2.010)** (5.942)* (7.112)* (4.023)* ** statistically significant at (0.01) * statistically significant at (0.05) rt= daily stock' returns v= fluctuations' value = the estimated standard error α and = equation’s constant asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 291 ajfa.macrothink.org β= independent variable’s coefficient (accompanying). results in the above table (3) show the variance in the market fluctuations during two periods; the first is before the full liberalization of the market (1994-2000) and the second is after liberalization (2001-2015). with acknowledging that in order to better read figures, the coefficient of (η0) was multiplied by (103) and the coefficient of (α0) was multiplied by (105). through table (3), it is clear that all coefficients are statistically significant at level (0.05) and level (0.01). the first point that can be observed through the comparison between the preliberalization period and the period after the liberalization is that the nature of the fluctuations of the market did not change. the big rise of (α0) and change for each of the (α1 and β1) in the period after the liberalization refers to the rise in the provisional variance which was calculated by the equation (α0/1-α1-β1) which equals (2.369) for the period before liberalization, and (5.734) for the period after the liberalization, this gives more information as a result of the full liberalization of the financial market. the value of (α1) in the period after the liberalization rose, suggesting a higher market fluctuations for this period, since the (α1) is a parameter linked to the remoteness of the squares of coefficient standard error (squared error term), and in this analysis, the divergence of the standard error is due to price change in the previous day that is attributed to a particular factor or a specific component, and assuming that the market is highly efficient (an efficient market), this change in price is due to receiving of the information identifying the market prices. it can therefore be regarded that (α1) as the coefficient of news or information, on the basis that the information of the specific stock' prices had arrived or been clarified in the past. thus, the higher the value of the current information specifying current prices means more impact on price changes, therefore, the rise in the value of the (α1) in the period after the liberalization, refers to the impact of prices' information on the prices and configuration of the market. considering the coefficient of (α1) reflects the impact of the recent news about prices in the financial market, the coefficient of (β1) reflects the impact of old news; the coefficient of (β1) for the heterogeneous variation shows the impact of change in prices of the previous days; thus, any news that arrive the day before yesterday. the rise in the rate of information that follows the process of change is expected to reduce the issue of uncertainty on the previous news, which in turn will lead to a decrease in the continuity of information, thus, the old news and information will have decreased impact on the change in the price of the current days, and this is confirmed by the decline in value (β1) for the period after liberalization. this finding further supports the fact that the model before liberalization was a candidate for (i-garch) model, while the model after the liberalization is not fully clear. when comparing the total transactions of (α1) and (α1) before liberalization of (0.77) with the total of the same transactions after liberalization, amounting (0.65), we conclude that the opening of the stock' market increases the risk of changes with time and the continuation of the market fluctuations with the passage of time. all the results that were reached through the change in the parameters of (garch) model suggests or indicates that the market is exposed to further fluctuations in the post-liberalization, but this is as a result of the increase in the rate of flow of information to the market. this result agreed with the result of the study (hamanah, and ben ma’zo, 2013), which indicates that the liberalization of markets and their opening for the foreign investors freely increase the flow of information about prices and other prices-relevant information. it also agreed with the study (ghassan et al., 2012), the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 292 ajfa.macrothink.org results of which indicated that the stage of openness on domestic and foreign capitals are of even greater importance for the flow of information coming to the market compared to the pre-openness stage. anyhow, there are some events or general conditions, lead to fluctuations in the financial markets, such as the sadness in the death of a leader or an important beloved figure, and this is what happened on the death of the late king hussein bin talal in (1998) and its impact on amman financial market, in addition to some movements or other events, such as the holding of peace talks in the middle east, as well as the occurrence of wars and disasters, as happened in us-iraq war and the occupation of baghdad in (2003), and other incidents. to learn how the results of the model (garch) are affected in accordance with the abnormal and severe changes that happen for a sudden and unexpected reason as previously stated, the model will be re-assessed after deleting all views where the average return exceeds the standard deviation value more than once, as shown in table (4) below, the results of this table are close to the results of table (3), which was previously reported. table 4. full sample results for two periods: before liberalization (1994-2000) and after liberalization (2001-2015) after omitting the cases with severe deviation by using the previous equations (5a, 5b): 0η 1η 0α 1α 1β pre liberalizatio n n= 1718 -0.7223 10.132 0.754 0.272 0.488 (1.255-)* (2.425)* (3.882)* (6.871)* (15.574)* post liberalizatio n n= 3705 -0.332 2.263 3.442 0.387 0.322 (1.091-)* (2.899)** (4.651)* (5.092)* (3.895)* ** statistically significant at (0.01) * statistically significant at (0.05) rt= daily shares' returns v= fluctuations' value = the estimated standard error α and = equation’s constant β= independent variable’s coefficient (accompanying). the results of table (4) show the variation in market fluctuations during two periods, the first is before the full liberalization of the market (1994-2000) and the other after liberalization (2001-2015), with the deletion of some observations for years during which abnormal events have occurred, which led to severe and illogical fluctuations, with acknowledging that in order to better read figures, the coefficient of (η0) was multiplied by (103) and the coefficient of (α0) was multiplied by (105). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 293 ajfa.macrothink.org it is clear from the table that all coefficients are statistically significant at level (0.05) and level (0.01). results the results came as follow: 1. there is an effect of the financial market liberalization on the fluctuations mode in amman financial market (jordanian stock exchange). 2. after liberalization of the financial market, speed and accuracy of information flow to the market were increased. 3. there are some events and factors like wars and disasters that suddenly occur leading to severe and illogical fluctuations in the financial market, this has happened to amman financial market at the death of late king hussein ben talal, the event was repeated during the americaniraqi war and baghdad occupation in 2003. 4. variance in the prices changes before the liberalization period was integrated which means that the news has permanent influence on the prices changes. recommendations 1. the necessity for studying the market fluctuations mode before undertaking the liberalization process, and predicting what the market liberalization will cause on those fluctuations. 2. the necessity for taking into consideration some important factors and events which might occur on the financial markets environment and dealing with them with severe reservation. 3. the work to study the news and information in a scientific way and delivering it to the target investors, whether they were small or senior investors, and in a preservative way. 4. establishing a national center for information to work permanently on the delivery of news and information appropriately to the investors, and confounds the wrong news and rumors. references adamopoulos, a. (2010). financial development and economic growth an empirical analysis for ireland. international journal of economic sciences and applied research, 3(1), 75-88. adeusi, s. o. azeez, bolanle a., & olanrewaju, h. a. (2012). effect of financial liberalization on the performance of informal capital market. research journal of finance and accounting, 3(6), 63-77. agu, c.c., orji, a., & eigbiremolen. g. (2014). financial liberalization, interest rate structure and savings mobilization: the nigerian experience. international journal of current research, 6(2), 5101-5109. akpan, d.b. (2004). financial liberalization and endogenous growth: case of nigeria.african institute for economic development and planning, senegal, p.1-93. al-asali, h. 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(2003). financial liberalization and stock market efficiency: empirical evidence from an emerging. african finance journal, 4, 24-35. orj, a., jonathan e. ogbuabor, i., onyinye i., & anthony, o. (2015). financial liberalization and economic growth in nigeria: an empirical evidence. international journal of economics and financial issues,5(3), 270-283. saleh, m. (2009). effect of shares' returns on the market value in amman stock market for the period (1999-2007). dirasat journal, university of jordan, 2(12), 167-180. shakoori, m. (2010). financial liberalization and its effect on the economic growth: algeria case study, unpublished master thesis, monetarism, banks and finance major, faculty of economic sciences, abou bekr belkaid university tlemcen, algeria. shaw, e., & mckinnon, r. (1973). financial deepening in economic development, (new york: the brookings institution. schwert, w. (1989). why does stock market volatility change over time?, the journal of finance, 44(5), 15-53 . microsoft word 12032-44216-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 238 is eva an effective performance measure evidence from colombo stock exchange, sri lanka yathra mullage chithrasheeli gunaratne department of management sciences, faculty of management uvawellassa university of sri lanka, badulla, sri lanka tel: 94-718-285-587 e-mail: gunaratneymc@gmail.com received: oct. 23, 2017 accepted: dec. 1, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.12032 url: https://doi.org/10.5296/ajfa.v9i2.12032 abstract the aim of this study is to explore the relationship between economic value added (eva) and stock return in sri lanka. the study sample consists of 1695 firm year observations covering 113 public limited companies listed in colombo stock exchange (cse) for 15 years period from 1999 to 2013. this study was based on secondary data, collected from the cse data library and the published financial statements of companies considered in the sample. pearson correlation coefficient analysis and the fixed effect model of panel data regression analysis techniques were used as the statistical techniques to analyze data. the statistical analysis revealed that there is no significant positive relationship between eva and stock return in sri lanka. contrary to the arguments of eva proponents, the researcher suggests the market participants of colombo stock exchange to select other performance measures instead of eva to make rational economic decisions. keywords: eva, performance measure, panel data, stock return, cse asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 239 1. introduction performance measurement of corporations is an important and essential task for any business entity. the economic value added (eva) is one of the financial performance measurement technique used by corporations worldwide. it is a value based performance measure which goes beyond the rate of return and considers the cost of equity capital as well. it measures the earnings of a company after providing for the cost of equity capital. according to paliam (2006), the eva is an incarnation of the underlying residual income (ri) concept. pandey (2005) defined the eva as net earnings (pat) in excess of the charges (cost) for shareholders’ invested capital (equity). this technique was initially developed by stern stewart & company consultant group in 1980s (stern, 1985; stewart, 1991; stern, stewart and chew, 1995; ferguson, rentzler and yu, 2005; paliam, 2006; kumar and sharma, 2011). they introduced this concept to the business world and argued that this is the superior performance measurement technique compared to other performance measures available. later some other scholars and practitioners have empirically supported the argument of eva proponents and many corporations have adopted eva as a technique used in firm performance measurement and portfolio selections decisions (teitelbaum,1997) considering that the eva as one of the best techniques that measures the true economic profit of a firm (swaroop and chandra, 2009). the eva is the most researched value based performance measure in the academic literature. however, having identified that many scholars confirmed the findings of eva promoters (for example; o’byrne, 1996; uyemura, kantor and petit, 1996; milunovich and tsuei,1996; lehn and makhija,1997; herzberg,1998; and forker and powell, 2004;worthington and west , 2004; haddad, 2012) there are sufficient number of researchers (peterson and, peterson, 1996; appleby, 1997; turvey et al. ,2000; garvey and milbourn, 2000; keefand rush, 2003; sparling and turvay, 2003; paulo, 2003; threemanna and gunaratne, 2015)who have concluded in contrary to eva proponents argument on the value relevance of eva. according to peterson and peterson (1996), the eva type measures do not provide much more information while appleby (1997) have reported that the eva is a measure which only looks into a company’s historical performance where it provides no any indication of the future performance of the company. in contrary to the eva proponents’ argument, turveyet al. (2000) have reported that there is no any relationship between eva and stock return. similarly, keefand rush (2003) too reported that eva and stock return shows no any relationship. further keef and rush (2003) have mentioned that the concept of eva as an enigma. slightly different to peterson and peterson (1996); appleby (1997); and keef and rush (2003) findings on the relationship between eva and stock return, sparling and turvey (2003) have reported that there is a weak correlation between these two elements. though the reported results of the empirical studies which have been conducted worldwide show large discrepancies, this concept has not yet been studied adequately in sri lankan context. kosalathevi (2013) has studied the impact of eva on firm performance using data from selected private banks in sri lanka and found that there is a relationship between eva and firm financial performance. however her study did not focus on the explanatory power of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 240 eva on the stock returns. threemanna and gunaratne (2016) have studied the association of eva on stock return taking data only from the beverage, food and tobacco sector companies in cse. the reported results of threemanna and gunaratne (2016) indicated that the eva is not a statistically significant performance measure which could explain stock return in sri lanka. it was hard to find any other published work other than these two studies. the discrepancies in the reported results of the relationship between eva and stock returns in the international context for both developed and emerging markets and the inadequacy of the studies conducted in sri lankan context creates an obvious necessity to study this matter further in sri lankan context for colombo stock exchange. accordingly the present study was conducted to bridge the identified gap with the hypothesis that there is a strong positive relationship between eva and stock return in sri lanka. the remainder of this paper has been organized as follows. the section 2 describes the detailed analysis of literature and the section 3 explains the research methodology used in this study. the section 4 describes the results and discussion and finally the conclusion of the study is given in the fifth section. 2. literature review the economic value added is commercially developed in 1982 by the corporate advisory team of joel stern and stewart iii (grant, 2003) though the initial step of eva was taken by stewart in 1974. as the value has become primary concern of the investors, the proponents of eva claimed that the eva is a performance measures which tied directly to stock’s intrinsic value (stewart, 1991; grant, 1996, 2003). stewart (1991) has mentioned “forget about earnings, earnings per share, earnings growth, rate of return, dividends, and even cash flow. all of them are fundamentally flawed measures of performance and value. eva is all that really matters”. further stewart (1994) argued that “eva is almost 50% better than its closest accounting based competitor in explaining changes in shareholder wealth.” finegan (1991) extended the initial analysis of stewart (1991) by focusing the middle 450 companies in usa and have found that eva outperformed the other performance measurers. eva showed 61 percent explanatory ability compared to 47 percent explanatory ability of return on capital, the second best performance measure. grant (1996) too studied the association between eva and mva in us stocks and have reported that eva has proven to be a valuable analytical tool for corporate managers. eva has a significant impact on firm’s market value added (mva). further grant (1996) found that a fluctuation of eva has a direct impact on the intrinsic value of firm’s outstanding debt and equity securities. grant (2003) validate the relationship between eva and corporate valuation using a sample of 983 us companies. he argued that eva has a significant impact on the mva of a firm thereby supporting stern stewart hypothesis that eva is superior performance measure compared to traditional accounting based performance measures. lehn and makhija (1996) studied the relationship between the performance measures and stock returns using a sample of 241 us companies over the period from 1987 to 1993, and the reported results are consistent with the stewart (1991) claim on the superior explanatory asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 241 power of the eva on stock returns. o’byrne (1996) found that eva is systematically linked to the market value unlike nopat or other earnings measures and further he argued that the eva is a powerful tool for understanding the investor expectations that are built into a company’s current share price. uyemura, kantot and pettit (1996) studied this taking data from 100 largest us banks for ten year period from 1986 to 1995. the results depicted that eva is the performance measure that best correlated with the market value added. the findings of uyemura, kantot and pettit (1996) lend the support towards stewart (1991). milunovich and tseui (1996) have found that eva is more highly correlated with mva. bacidoreat. el (1997) too found that eva can be used in explaining stock returns. girotra and yadav (2001) empirically investigated the eva concept to find out its utility and limitations in value based management framework in indian context. in common with stewart (1991) they found that eva has information content. misra and kanwal (2007) too studied the value relevance of eva in indian context. results of their study revealed that eva is the most significant determinant of mva as it explains the variations in share value better than the other conventional accounting based performance measures. irala (2007) revisited whether economic value added has got a better predictive power relative to the traditional accounting measures taking data from 1000 companies across 6 years. the reported results very much support the claim that the eva is the better predictor of market value compared to other accounting measures. ismail (2008) revealed that eva is able to correlate with stock returns and is superior in explaining variations in the stock returns in malaysian context. popa, mihailescu and caragea (2009) investigated the romanian banking systems and have found that eva can be an important tool that bankers can use to measure and improve the financial performance of their bank. haddad (2012) examined this relationship in jordanian banking sector. the results showed a positive and significant relationship between eva and stock returns. these results are consistent with the empirical results provided on banking sector by girotra and yadav (2001), and popa, mihailescu and caragea (2009) for emerging markets. further the results of haddad (2012) are consistent with the argument of stewart (1991) on the superiority of eva over traditional accounting performance measures. in contrary to the empirical evidence provided by the above studies on the positive relationship between eva and stock return and the support lend to the argument brought to light by the proponents of eva on the superior value relevance of the concept of eva, many other scholars have come up with different findings. there are numerous studies that have argued that eva is not superior to other measures and even it is not a significant performance measure to be considered in decision making. chen and dodd (1997, 1998);biddle, bowen and wallace (1997);worthington and west (2001); kim (2006); ismail (2006) and maditinos, sevic and theriou (2009) have reported that though eva shows a relationship with return, the eva is not a superior performance measure as argued by stewart (1991) . some other researchers (peterson and peterson, (1996); turvey et. al (2000); keef and rush, (2003); sparling and turvey, (2003); palliam, (2006)) have concluded that the eva does not have any correlation with stock returns, and the use of such value based method is somewhat invalid and unreliable. kramer and pushner (1997) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 242 studied the effectiveness of the eva as a proxy for mva using the stern stewart 1000 companies for ten year period from 1982 to 1992 and have reported without lending any support to the eva proponents, that there is no any evidence to prove the superiority of eva over the traditional accounting performance measures. kramer and peter (2001) have undergone inter industrial analysis using data from the stern stewart 1000 database and by analyzing the data categorizing to 56 industries, they have not found any evidence to support the superiority of eva instead they have found that in most of the industries the marginal cost of using eva are not justified by any marginal benefits. clinton and chen (1998) analyzed the relationship of eva to stock price and stock returns selecting 325 companies from standard & poor’s 500 and the stern stewart 1996 performance 1,000 databases and have found that eva has no consistent significant association with either stock price or stock return. biddle, bowen and wallace (1997) too examined the us market to tests assertions that economic value added (eva) with stock returns and firm values. further their study extended to evaluates which components of eva, if any, contribute to these associations. their conclusion is that, although for some firms eva may be an effective tool for internal decision making, performance measurement and incentive compensation, it does not dominate earnings in its association with stock market returns for the sample firms and period studied. further biddle, bowen and wallace (1998) argued that their independent examination suggests that some of the claims over eva are over stated while evidence confirmed that managers respond to eva incentives, there is no evidence thus far to support claims that eva is more closely associated with equity returns or firm values than is net income. devilliers (1997), devillers and auret (1998) and dewet (2005) among other have provided contradicting conclusion on this regard in south african market. devilliers (1997) found that eva is not able to explain variation of stock return than accounting earnings. devilliers and auret (1998) found that eps had more explanatory power than eva in explaining stock prices in south africa. gunter, landrock and muche (2001) examined this relationship in german market and they too do not found any evidence to prove the superiority of eva in explaining stock returns in the context of germany stock market. worthington and west (2001) found the same for australian context and peixoto (2002) for portuguese public companies listed on the lisbon stock exchange. ismail (2006) conducted a study and have found that eva is not a superior performance measure in uk context. paulo (2010) too used uk data to investigate whether the eva is a superior financial performance metric as claimed by stern and stewart company and argued that there is no supportive evidence to validate the claims of eva. kyriazis and anastasis (2007) studied this for a sample of 121 non-financial publicly traded greek firms listed in the athens stock exchange and argued that eva does not appear to have a stronger correlation with firms' market value added than the other variables. the empirical results of kumar and sharma (2011a) too proposed that eva is not a superior performance measure in indian market. despite the broad and contradicting literature available on the field of eva stock returns in international stock exchanges, the available knowledge on this context in sri lanka is very asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 243 poor. it was hard to find published studies related to this matter other than kosalathevi (2013) and threemanna and gunaratne (2016). kosalathevi (2013) has studied the impact of eva on firm performance using data from selected private banks in sri lanka and found that there is a relationship between eva and firm financial performance. her study too did not focus on the explanatory power of eva on the stock returns. threemanna and gunaratne (2016) have reported that eva is not a significant performance measure in explaining stock returns of food beverage and tobacco sector companies in sri lanka. the above analysis of literature clearly shows that there is no conclusion on the relationship between eva and stock return either in the international context or in the local context. hence it is worth to study the association between eva and stock return in sri lankan context. 3. methodology 3.1 hypothesis h0: there is no significant positive relationship between eva and stock return in sri lanka h1: there is a significant positive relationship between eva and stock return in sri lanka 3.2 population and sample the population of the study is all the quoted public limited companies (plc) listed in the colombo stock exchange (cse) sri lanka. the cse has 295 companies representing 20 business sectors as at 31st august 2017, with a market capitalization of rs. 2,897.7 bn. the sample size of this study was 1695 firm year observations obtained from 113 public limited companies registered in cse and the sample period spans for 15 years from the year 1998/1999 to the year 2012/2013. this sample was selected using five criterions. the first criterion is how long the company is trading in the cse. as the sample period spans for 15 years from the year 1998/1999 to 2012/2013, any public limited company quoted on or before 1/4/1998 and operates continuously for 15 years period are qualified to consider in the sample of this study. but to calculate the variables under the study it is required to use the data of two prior years’ to the sample period. hence it was required to consider only the companies quoted on or before 1/4/1996 and operating 17 years continuously. the second and third criterion was to exclude the companies registered under the bank finance and insurance sector and diversified holdings sector from the sample. the bank finance and insurance sector companies were removed due to the inherent conditions of financial institutes compared to the companies in any other sectors in cse. this exclusion is empirically supported by the fogelberg and griffith (2000) and bandara and weerakoon (2011). the forth criterion is the balance sheet date (financial year end) of the companies. the researcher considered only the companies whose financial year ends as at 31st march each year. hence the researcher removed all the companies whose financial year ending any dates other than 31st march from the sample of this study. the fifth and last criterion is the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 244 availability of all the required data for entire 17 years period to have a strongly balanced panel data set. there were only 113 companies satisfied all five criterions. 3.3 data and data collection the entire study was based on secondary data. the required secondary data was collected from two main sources namely the data library of the cse and the published financial statements of the companies considered in the sample of the study. finally the relevant calculations were made by the researcher using excel worksheets to derive the variables used in this study. 3.4 variables definition and calculation the dependent variable of the study is annual stock returns of the companies listed in cse. the stock return calculation was based on the mostly applied reinvestment assumption. all the types of remittances such as dividend payment, bonus issues, stock splits and right issues were considered for the calculation of stock return. as per the ph.dthesis of nimal (2006) the following formula was used to calculate the monthly returns of each company. 1001 )( )1( 0 ×      −      + ++++ = rrc rrrrct it prpp dbsrppr where; rit : return of the stock i in the month t pt : price of the stock at the end of the month t pc : closing price of the stock on ex-right date/ the stock price immediately before the ex-right date rr : right ratio sr : split ratio dr: dividend ratio br: bonus ratio p0: price of the stock at the beginning of the month t pr: right issue price of a stock finally the annual returns were calculated as the aggregation of the monthly returns extending nine months prior to the fiscal year end and three months after the fiscal year end. (ex. return of the year 2012/13 was calculated by aggregating the returns of april 2012 to march 2013). the independent variable of this study is eva. as the study used easton and harris (1991) formal valuation model both eva and change in eva (δeva) need to be calculated for the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 245 study. stewart (1991) calculated eva by deducting a cost of operating capital from net operating profit after tax (nopatcost of capital). obtaining nopat figures of sri lankan companies is much difficult since it is not published. pandey in his book financial management 9th edition has stated that eva is defined as net earnings (pat) in excess of the charges (cost) for shareholders’ invested capital (equity). further fraker (2006) and bandara et al (2008) have used pat instead of nopat in calculating eva. therefore in this study the eva of each company was calculated by deducting the cost of equity from the profit after tax (pat). this figure represents the eva contribution only for the equity shareholders. the equation used to calculate eva could be stated as follows. eva= pat – (ke*te) where; eva : economic value added pat : profit after tax ke : cost of equity te : total equity the capital assets pricing model (capm) of sharpe (1964) was implemented to calculate cost of equity (ke). accordingly the cost of equity was calculated by using the following equation. ke = rf+ βi (rmt rf) where, ke : cost of equity rf : risk free rate iβ : beta coefficient rmt : market rate of return three hundred and sixty five days treasury bill rate was considered as the risk free rate. the beta coefficients for each company for each year were estimated by using 36 monthly returns employing regression technique. the slope of the regression line of following equation was considered as stock’s beta coefficient. where, itr : the periodic return for the firm j in time t itmtiiit err ++= βα asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 246 iα : the constant term iβ : the estimated beta (systematic risk) for the firm for the year mtr : the periodic return for the market index ite : the random error term whose expected value is zero the periodic return of the market index (rmt) was calculated using the all share price index (aspi) data. the formula used to calculate the market return can be shown as follows. 100×         − = 0p 0ptp mtr where, rmt : market return in the month t pt : all share price index of end of the month t p0 : all share price index of beginning of the month t change in economic value added (∆eva) the ∆eva indicates the annual growth or decline in net earnings in excess of cost of capital. the ∆eva was calculated in this study as the quotient of the difference between the two consecutive observations (evat evat-1) dividing by the previous time period observation (evat-1). accordingly the following formula was used to calculate the ∆eva. ∆eva = ( evat evat-1) / evat-1 3.5 data analysis techniques this study used correlation coefficient analysis and regression analysis techniques to analyze the collected data in order to achieve the research objective. as the panel data analysis endows regression analysis with both a spatial and temporal dimension, this study used panel data regression analysis technique. the appropriate panel data regression model for the collected data was selected by performing three tests, fisher f test, lagrange multiplier (lm) test and hausman specification test. the f test recommends the best panel model out of pooled data regression model and fixed effect model while the lm test recommends the best model out of pooled regression model and random effect model. the hausman specification test compares the fixed effect model and the random effect model. further the researcher used easton and harris (1991) formal valuation model in this study. according to that model the following regression model was developed and tested using panel data approach in this study. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 247 rit= at0 + a1evait/pit-1+ a2∆evait/pit-1 + eit where; rit = the annual compounded returns for firm i time t. evait = economic value added of firm i time t δevait = change in economic value added of firm i time t pit-1 = the market value per share of firm i at the first trading day of the ninth month prior to fiscal year end this regression equation was tested for multi-colinearity using variance inflation factor (vif) analysis. further the researcher conducted harristzavalis unit root test and breitung’s unit root test in order to test whether the data set of this study consists of unit roots. 4. results and discussion this study was conducted to investigate whether the eva is a significant performance measure in terms of explaining stock returns in sri lanka. the person correlation coefficient analysis was used to identify the relationship between eva and stock return in sri lanka. the results of the correlation analysis are shown below. table 1. pearson correlation coefficient variable return eva δeva return 1 eva 0.0317 1 δeva 0.0324 0.1674*** 1 n.b: the correlations between each pair of variables were measured at 10 percent, 5 percent and 1 percent significant levels. the resulted correlation coefficient values that are significant at the 1 percent level have been marked with *** , significant at 5 percent level have been marked with ** and significant at 10 percent level are marked with *. the results of the pearson correlation coefficient analysis presented in table 1 above clearly shows that both eva and δeva have positive correlation with stock return but the value is very low (week positive correlation). however this relationship is not statistically significant as the p values of both eva and δeva are greater than 0.1 level. even though the relationship between eva and stock return identified through correlation coefficient analysis was not significant, the researcher further analyzed this using panel data regression approach. the most suitable panel data regression model for the current data set was fixed effect regression model. hence the researcher tested fixed effect regression model and the results obtained were depicted below. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 248 table 2. fixed effect regression model of eva and stock return this table shows the result of the panel data regression analysis conducted to test the significance of eva in explaining stock return. further to check the existence of multi-colinearity among variables, the variance inflation factor (vif) analysis was conducted and the relevant vif values have been presented in the same table. variable coefficient robust standard error pvalue vif constant 37.4498 .2823596 0.000 eva 1.63e-07 1.77e-07 0.357 1.03 ∆eva 8.65e-07 4.90e-07 0.080 1.03 sigma u 28. 022576 sigma e 92.183593 rho 0.0846 r2 0.0017 vif > 10 indicates presence of multi-collinearity. rit = 37.4498 +1.63e-07 eva + 8.65e-07∆eva the table 2 presents the results of the estimated fixed effect regression model which was regressed on the stock returns (dependent variable) with the eva and δeva to test the hypothesis that there is a significant positive relationship between eva and stock returns in sri lanka. as per the results presented in the table the researcher failed to reject the null hypothesis in favour of the alternative hypothesis. hence it was failed to prove that the eva is a significant performance measures in explaining the cross section of stock returns in sri lanka. the results revealed that the model could explain only a 0.17 percent return variation. the intra-class correlation known as rho is 8.5 percent which is the variance due to the differences across companies and the total variance due to cross sections is (sigma u) 28.02 percent. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 249 5. conclusion this study examined the relationship between eva and stock return in sri lanka taking data from 113 public listed companies in cse. the results of the study revealed that there is no significant positive relationship between eva and stock return in sri lanka. both the eva and change in eva shows a weakly positive relationship in the pearson correlation coefficient analysis where the relationship was not statistically significant as the p value was greater than 0.1 level for both eva and δeva. the panel data regression analysis too evidenced that there is no statistically significant positive relationship between the independent and dependent variable as the results revealed that only 0.17 percent return variation could be explained by eva. accordingly, in sri lankan context the eva is not a suitable performance measure to be used in explaining stock returns in the companies whose stocks are traded in the cse. hence the researcher recommends the market participants to use any other technique/(s) in making the respective decisions in sri lankan context. references appleby, c. 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(2004).australian evidence concerning the information content of economic value-added. australian journal of management, 29(2), 201-223. https://doi.org/10.1177/031289620402900204 microsoft word 12152-42657-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 190 the impact of effective corporate boards and audit committees on attracting foreign ownership in listed companies in the gulf cooperation council mohammed gubran mohammed saad al-shamahi college of business tunku puteri intan safinaz school of accountancy (tissa) universiti utara malaysia, 06010 sintok, kedah, malaysia e-mail: gubran@outlook.com kamarul bahrain abdul manaf senior lecturer, college of business tunku puteri intan safinaz school of accountancy (tissa) universiti utara malaysia, 06010 sintok, kedah, malaysia e-mail: kama1183@uum.edu.my ali saleh al-arussi senior lecturer, college of business tunku puteri intan safinaz school of accountancy (tissa) universiti utara malaysia, 06010 sintok, kedah, malaysia e-mail: asahmed@uum.edu.my received: oct.2, 2017 accepted: nov. 16, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.12152 url: https://doi.org/10.5296/ajfa.v9i2.12152 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 191 abstract this study empirically examines the impact of effectiveness of both corporate boards and audit committee on foreign ownership in selected non-financial listed companies of the stock markets in gulf cooperation council (gcc) countries. the study was built on fixed effect model and conducted over the period of 2012-2015 for 143 non-financial listed companies on the gcc stock markets. our results explain that foreign ownership is positively related to the effectiveness of both the boards of directors and the audit committees. the implication of this study may help beneficiaries in making better policy decisions and provide guidance for corporate managers on the needs of foreign investors. keywords: effectiveness of corporate boards, effectiveness of audit committee, foreign ownership, panel data analysis; fixed effect jel classification:g34, f21 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 192 1. introduction foreign ownership is defined as the percentage of shareholding of non-resident foreign investors and foreign portfolio equity investors (bokpin, isshaq&nyarko, 2015; mangena&tauringana, 2007;waqas, hashmi &nazir, 2015).participation of foreign investors in domestic financial markets has increased over the last few years in the developing countries (ramaswamy&li, 2001). foreign capital inflow has become more significant in developing countries. prior studies have stated that foreign investors play an important role in emerging markets. first, foreign investor participation promotes development of emerging markets by increasing the supply of capital (bekaert, harvey &lundblad 2003; mangena&tauringana, 2007;ramaswamy& li, 2001), thus ensuring liquidity and efficiency of these emerging markets (bekaertet al. 2003). second, opening the market to foreign investors may increase the value of local companies, thereby reducing their cost of equity capital (bekaertet al. 2003;mangena&tauringana, 2007). third, foreign investors improve the inflow of foreign exchange, which is often greatly needed in developing countries to finance imports and other foreign payments (mangena&tauringana, 2007). miletkov, poulsen and wintoki (2014) andbushman and smith (2003) pointed out that an effective corporate governance structure reduces foreign investors’ risks and increases their confidence and willingness to invest in particular listed companies. also, it helps to ensure that foreign investors receive reliable information about the performance of the company and that the value of their investment is not expropriated by managers and controlling shareholders. ajinkya, bhojrajand sengupta (2005) indicated that effective corporate governance can constrain corporate managers and/or controlling shareholders from expropriating other investors by ensuring an environment of greater transparency through better monitoring; thus foreign investors will be likely to be more dependent on an effective corporate governance structure. this study is motivated by the fact that most of the previous studies on foreign ownership have been conducted in developed countries with low ownership concentration (e.g.,aggarwal, klapper, &wysocki, 2005; bowman & min, 2012; dahlquist&robertsson, 2001; jiang & kim, 2004; kang, 1997; miletkov et al., 2014; min & bowman, 2015). their results indicate that foreign investors are more attracted to large firms with high book-to-market ratio, low leverage and high independence of the board of directors as well as the audit committee. however, the above results might notbe generalizable to developing countries, where the ownership structure is more concentrated. therefore, our study focuseson developing countries, specifically thegulf cooperation council (gcc) countries,namely saudi arabia, bahrain, oman, the united arab emirates (uae) and qatar. the gcc’s developing countries have high concentrated ownership, where family owners control around 70% ofthe business (gulf family business, mckinsey & company, 2015). other unique features in gcc countries are high level of government intervention, low legal protection, poor information, high insider trading, politically unstable markets, low financial reporting quality and high political connections (kern, 2012). gcc countries have not asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 193 adequately attracted foreign portfolio investment. the foreign investors’ investment activity in the gcc countries remains low, as investors’ share in the stock market from outside the gcc is low. for example, in 2015 the average foreign ownership in saudi arabia is around 4.58% and in dubai, it is around 6.75% (gulfbase, 2015). many previous studies have examined the board of directors and audit committee characteristics individually on foreign ownershipsuch as bokpin, isshaq&nyarko, (2015); bowman & min, (2012);mangena&tauringana, (2007); miletkov et al., (2014) and min & bowman, (2015) however, foreign investors take into consideration the effectiveness of corporate governance practices as a bundle in their investment decisions (agrawal &knoeber, 1996). therefore, this study is motivated by agrawal and knoeber (1996) and cai, qian, and liu (2009) who arguedthat using an individual measurement for governance mechanism might not reflect the effectiveness of the governance structure comparedto using a composite measurement of the governance mechanism.basedon the fact that internal governance mechanismscomplement each other, where the effectiveness of a particular mechanism may depend on the effectiveness of others (rediker& seth, 1995; davis &useem, 2002). therefore this study contributes to the literature by examining the effectiveness of boththe corporate boards and audit committee using a composite measurementas a bundle on attracting foreign ownership. thus, the aim of this study is to examine whether the effectiveness of both the board of directors and audit committee is associated with foreign ownership in listed companies in the gcc stock markets. more specifically, this study focuses on the four main internal monitoring characteristics of the board of directors as well as audit committee, namely, independence, size, frequency of meetings and financial expertise, which effectively capture the board of directors and audit committee as monitoring devices. the components of these characteristics are constructed as a score to reflect the effectiveness of the board of directors and the audit committee. these characteristics complement each other, for example, independent directors without financial expertise might not understand accounting numbers (agrawal & chadha, 2005; and mustafa & ben youssef, 2010), and less frequent meetings and inappropriate size of the board may make it difficult to monitor management and enhance the quality of financial reporting. in other words, the absence or failure of one of the board’s monitoring characteristics can lead to the weakness or failure of others, which in turn, can weaken and hinder the performance of the board of directors as an internal monitoring device.thus, this study intends to achieve the following objective:to examine the impact of the effectiveness of both the board of directors and audit committee on attracting foreign ownership. this paper is organised as follows: section two summaries previous studies. section three describes the data used and methodology. section four presents the results and analysis, while the fifth section concludes the study. 2. literature reviewand hypothesis development since foreign investors take into consideration the quality of financial reporting in their investment’ decision.this study focus on investigate the effectiveness of the board of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 194 directors and audit committeethat have a significant role in financial reporting quality (mangena&tauringana, 2007; nawafly& al-arussi, 2016). several studies have examined the effectiveness of the board of directors and audit committee (kalbers&fogarty, 1993; garcia-sanchez, 2010; mcmullen &raghunandan, 1996). alzoubi(2012) andjohl, satirenjit, subramaniam and cooper (2013) contended that theboard of directors is the main factor that affects financial reporting quality.it has been contended that effective corporate governance may increase the confidence of foreign investor through the quality of financial reporting as the information sources to the foreign investors. goh(2009) contended that board size, board independence and frequency of board meetings are the main factors that reflect the effectiveness of the board. in addition, chobpichien, haron and ibrahim (2008) and johl et al.(2013) claimed that board size, independence, financial expertise and frequency of board meetings are the key elements that reflect board quality and that encourage managers to report more information to external stakeholders. other studies, such aszaman, hudaib andhaniffa (2011)who investigated the relationship between audit committee effectiveness and earnings quality, have argued that the effectiveness of the audit committee enhances financial reporting quality and provide high quality financial accounting information to investors and other users through annual reporting. according to salleh andhaat (2014), the primary objective of the audit committee is to achieve the board’s legal responsibilities in light of the credibility and objectivity of the financial report.the effectiveness of the audit committee refers to the number of members of the committee who have the qualifications, power and resources to safeguard the interests of foreign investors by ensuring correct financial reporting, internal controls and risk management via effective overseeing of activities (salleh&haat, 2014). in the context of a previous study on foreign ownership, bokpin and isshaq (2009) and bokpinet al. (2015) studied the effect of transparency and corporate governance on foreign share ownership, and found that decisions of foreign investors are based on corporate governance and disclosure norms of listed firms. it has also been revealed that foreign investors steer clear of investment in companies that lack a corporate governance structure and which have ineffective disclosure practices since disclosure and transparency are important for foreign investors (mangena&tauringana, 2007; al-arussi, selamat&hanefah, 2009). additionally, kim, eppler-kim, kim, and byun (2010) examined the influence of weak corporate governance on equity invested by foreign investors and found that foreign equity ownership has a negative effect on a firm’s ownership concentration. however, it impacts positively on the efforts taken by the company to improve corporate governance. meanwhile,haldarand nageswara (2012) investigated the association between foreign portfolio investment and corporate governance in india. the study used 500 industrial firms as a sample. the findings reveal that foreign ownership in the country is greatly influenced by the financial characteristics and factors of corporate governance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 195 similarly, aggarwal et al. (2005) revealed that foreign investors have a greater tendency to opt for firms having a robust corporate governance mechanism as their money requires protection from mismanaged companies. in this case, shareholders are able to control the confiscation of assets. also, block shareholders influence the company’s value and the personal benefits obtained from it. this type of companies face high costs in raising external funds. furthermore, klapper and love (2004) revealed that ineffective corporate governance changes the choice of foreign investors to foreign direct investment (fdi) as opposed to indirect portfolio investment as fdi has better protection. along a similar line of contention, dahlquistet al. (2003) studied foreign ownership and the characteristics of the company in the context of sweden’s protected market. they showed the significant presence of foreign investors in major firms having good corporate governance and having large cash assets. they also noted that the size of the company is determined by its liquidity size. ammer, holland, smith, and warnock (2012),leuz, lins, and warnock (2010) and miletkov et al. (2014) revealed that the investment of the us in a foreign company multiplies when the companies are cross-listed on the usexchange, although following the correction of selection bias related to the size of companies, financially transparent companies and liquidity of companies attract foreign investment as they are expected to be cross-listed more. previous studies on foreign ownership such as bowman & min, (2012), mangena&tauringana (2007),miletkovet al.(2014) andmin & bowman(2015) examined the relationship of foreign ownership and corporate governance mechanisms, the results indicate that foreign investors are more attracted to high independence of the board of directors as well as the audit committee. based on the above discussion, the following hypothesises formulated as follow: h1: there is a significantly positive relationship between the board of directors’ effectiveness and foreign ownership. h2: there is a significantly positive relationship between audit committee’ effectiveness and foreign ownership. 3. data and methodology 3.1 data description the study utilizes secondary data collected from the annual reports of non-financial listed companies inthe gcc stock markets. the sample comprises only non-financial listed companies that have foreign ownership for the period of 2012 to 2015.the total number of selected companies is 143 which presented 572 observations (table 1 shows the sample size of the study). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 196 table 1. sample size of selected non-financial companies with foreign ownership country saudi arabia oman qatar bahrain uae total selected nonfinancial companies with foreign ownership. 40 56 20 12 15 143 the data of the board of directors` effectiveness, audit committee` effectiveness, foreign ownership, firm size and leverage are collected from the annual reports. while the data of the economic variables collected from world bank database. political risk variable data is obtained from the political risk services (prs) group’s database. stata software package is used. 3.2 model specification this study uses panel data analysis (fixed effect) to examine the effect of both the board of directors and audit committee on the foreign ownership. this study includes firm size and leverage, exchange rate risks, inflation risks, economic growth which measured by gdp and political risks as control variables. the regression model is as follow: forownersit=α0 + β1bdscoreit + β2acscoreit + β3fmsizeit + β4levit + β5prit + β6errit + β7irit + β8gdpit +εit. where, following the literature, the former variables are defined and measured as follow: forowners foreign ownership, measured by the percentage of shares held by foreign investors in the listed non-financial company at the end of financial year. bdscore board of directors` effectiveness (score), and measured by the sum of four components (financial expertise, size, independence and frequency of meetings) ranges between 0 and 4 with 0 indicating lowest effectiveness and 4 highest effectiveness. where, board financial expertise = a value of “1” is given if at least one of the board members is a financial expertise. or alternatively a value of “1” is given if the percentage of financial experts more than the median value and “0” otherwise. board size = a value of “1” is given if the number of members in the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 197 board is larger than the median value and “0” otherwise board independence = a value of “1” is given if all board member are independent. or alternatively a value of “1” is given if the percentage of independent members in the board is larger than the median value and “0” otherwise frequency of meetings of board = a value of “1” is given if the number of board meetings is larger than the median value and “0” otherwise acscore audit committee` effectiveness (score), and measured by the sum of four components (financial expertise, size, independence and frequency of meetings) ranges between 0 and 4 with 0 indicating lowest effectiveness and 4 highest effectiveness. where, financial expertise of audit committee = a value of “1” is given if at least one of the audit committee members is a financial expertise. or alternatively a value of “1” is given if the percentage of financial experts more than the median value and “0” otherwise. audit committee size = a value of “1” is given if the number of members in the audit committee is larger than the median value and “0” otherwise audit committee independence = a value of “1” is given if all audit committee members are independent. or alternatively a value of “1” is given if the percentage of independent members in the audit committee is larger than the median value and “0” otherwise frequency of meetings of audit committee = a value of “1” is given if the number of audit committee meetings is larger than the median value and “0” otherwise fmsize firm size, measured by using the natural logarithm of the total assets. lev firm leverage, measured by dividing total liabilities by the total assets. pr political risks, measured by international countries risks guide (icrg). it is scored by assigning risk points to a pre-set group of factors. political risks rating range from a high of 100 (least risk) to a low of 0 (highest risk) guide (icrg) rate for each gcc countries. err exchange rate risk, measured by using the yearly percentage of change of nominal exchange rate of currencies of gcc countries to the us dollar. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 198 ir inflation risk, measured by using yearly percentage of change in the consumer price index (cpi) per each gcc countries. gdp economic growth, measured by using yearly gross domestic product (gdp) growth rate of each gcc countries. 4. results and discussion 4.1 descriptive statistics a summary of descriptive statistics of foreign ownership in gcc countries is presented in table 2. the descriptive statistics of foreign ownership model involves all the main independent variables. the results of the foreign ownership during the study period. table 2 indicates that the mean proportion of shares held by the foreign investors is 0.11 percent with a minimum holding of zero and a maximum holding of 0.59 percent.the zero minimum value for the foreign ownership indicates that there are companies that did not have shares held by foreign investors in 2012, while in 2013, 2014 and 2015, they had shares owned by foreign investors. table 2. descriptive statistics for continuous variables variables observations mean std. dev. min max foreownership 572 0.11 0.14 0 0.59 bdscore 572 1.76 1.23 0 4 acscore 572 1.58 1.23 0 4 logfirmsize 572 12.83 2.76 6.95 18.40 lev 572 23.39 20.49 0 86.9 pr 572 81.94 4.30 72 89 err 572 0.0000186 0.0000793 -0.0001453 0.0002085 ir 572 -13.91 56.02 -168.65 114.38 gdp 572 4.62 1.89 2.54 9.33 table 2summarises the effectiveness of the board (board score) with an average of 1.76 with a minimum score of 0 and maximum score of 4, which indicates that some boardsare more effective than others. table 2 also shows that the average score for the effectiveness of the audit committee is 1.58 with a minimum score of 0 and maximum score of 4, which indicates that the audit committee score is more effective some companies than others. 4.2. correlations matrix and multicollinearity in table 3, the pearson correlation results reveal several significant relationships between independent and control variables, results in table 3 show low coefficient correlation, where all values of correlation are below than 0.70.tabachnick and fidell (1983) emphasis the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 199 existence of multicollinearity problem if the correlation between variables is more than 0.9 percent. since the highest values are less than 0.9 percent, indicating un-existence of multicollinearity. table 3. correlations matrix of study variables 1 2 3 4 5 6 7 8 9 1 foreshare 1 2 bdscore .590** 1 3 acscore .520** .653** 1 4 logfirmsize -0.01 .246** .154** 1 5 lev .175** .233** .204** .161** 1 6 pr .217** .192** .164** -.100* .164** 1 7 err -0.06 -0.01 0.017 .125** -0.044 -.271** 1 8 ir -.107* 0.015 -0.034 .347** -0.001 0.009 0.025 1 9 gdp .091* -0.03 0.03 -.285** 0.056 .216** -.529** -.204** 1 **. correlation is significant at the 0.01 level (2-tailed). *. correlation is significant at the 0.05 level (2-tailed). myers (1990) suggested that even when the correlations between the independent variables are not very high, some degree of multicollinearity can still exist. this study examines the extent to which multicollinearity presents a problem in the estimation of the relationship between our dependent and independent variables by computing the variance inflation factor (vif) for each independent variable. the vifs should not exceed the critical value of 10 figure level (myers, 1990). table 4 shows the mean vifs in our model do not exceed 1.43. table 4. standard tests on vif results variables collinearity statistics vif 1/vif bdscore 1.87 0.534446 acscore 1.78 0.563239 logfsize 1.34 0.746162 gdp 1.55 0.646073 err 1.46 0.684420 pr 1.18 0.850589 ir 1.18 0.846486 lev 1.11 0.904524 mean vif 1.43 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 200 4.3 discussion of results the analysis of the fixed effect model is conducted based on the hausman test statistics, where the probability of the test statistics (0.066) is statistically significantat 10% level, which implies that the fixed effect model isan appropriate to conduct the regression analysis. table 5 shows that the foreign ownership (dependent variable) of the underlying model is fit and statically significant at the 5% level, where the calculated f-value = 16.80 is higher than its critical value of 1.95.the adjusted r2 indicates that the totalvariation of the foreign ownership over the study period is explained within its explanatory variables by about 41%. table 5. results of the model variables coefficient t-statistics p-values _cons -0.339*** -2.99 0.003 bdscore 0.00970*** 5.49 0.000 acscore 0.00703*** 4.44 0.000 logfmsize 0.0230*** 3.39 0.001 lev -0.00104*** -6.61 0.000 pr 0.00184** 2.17 0.031 err -22.36 -1.46 0.145 ir -.000029 -1.35 0.176 gdp 0.0000263 -0.04 0.966 observations 572 r-squared 0.242 adjusted r squared 0.41 number of id 143 prob> f 0.0000 hausmantest (prob>chi2) 0.0661 *** p<0.01, ** p<0.05, * p<0.1 table 5 shows that the coefficient of board of directors’ effectiveness is strong and positively related to foreign ownership at the 1% significance level. therefore, foreign investors are attracted to companies with a strong board of directors. this result supports the argument of the agency theory which considers the board as a significant monitoring mechanism of the management and for protectingforeign investorsfrom managers (jensen &meckling, 1976). also, this result supports the argument of famaandjensen (1983) that boards assist in enhancing financial reporting via overseeing management, to ensure foreign investors to be protected from exploitation by management. this finding is consistent with previous studies, such as johl et al. (2013), chobpichienet al.(2008) and ward,brown and rodriguez(2009) which state that the board effectiveness can optimallymitigate agency cost and safeguard the interests of investors. as for audit committee effectiveness,table 5 shows that audit committee effectiveness is positivelyrelated to foreign ownership, with the coefficient at the 1% significance level. this asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 201 result indicates that a strong audit committee attracts more foreign investors to the company.this result supports the agency theory on audit committee effectiveness in protecting investors. this result is consistent with sallehandhaat (2014) who described the effectiveness of the audit committee as the power and resources that qualified members have to safeguard the interests of investors by ensuring correct financial reporting, establishing smooth information flow among them and ensuring transparent and authentic reporting for foreign investors. other studies, like rouf (2011) and kyereboah-coleman (2008)have described the audit committee as the most dependable mechanism used to protect the interests of the foreign investors. 5. concluding remarks the aim of this study is to examine the relationship between foreign ownership and effectiveness of board of directors and effectiveness of audit committee in gcc countries, asin term of the firm level. our empirical study uses a panel data set of 143 non-financial listed firms in gcc countries during the period from 2012 to 2015. we find a positive relationship between effectiveness of the corporate board and audit committee with foreign ownership in gcc countries with high ownership concentration and low legal protection. these results indicate that the effectiveness of the board and audit committee is important determinants of foreign ownership level in the gcc countries. it suggests that foreign ownership is higher in firms with an effective corporate board as well as audit committee. our findings show that increasing the effectiveness of the board of directors and audit committee is an effective mechanism for attracting foreign investors.it has important implications for corporate decision-makers, especially for those countries with lower levels of investor protection. given this, it is suggested that foreign investors avoid investing in companies in developing countries due to weak corporate governance structures. the results of this study suggest that foreign investors have a preference for companies which have an effective corporate board as well as audit committee and companies in which their investments are more likely to be protected. in view of the efforts to improve corporate governance in developing countries, our results are likely to have policy implications. for developing countries, such as gcc countries, fostering an environment with a more effective governance mechanism could have positive effects on foreign investors’ participation in listed companies. thus, policy makers should introduce policies that can motivate more investors to the region. policy makers have to reformulate the regulations that can protect and enhance the confidence of foreign investors. the results provide an important indication that foreign ownership needs to be more investigated for a deep future study with different factors. future researchers could extend this study to other countries in the middle east region and indeed to other countries where data on foreign ownership is available. references aggarwal, r., klapper, l., & wysocki, p. d. 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(2011). corporate governance quality, audit fees and non‐audit services fees.journal of business finance & accounting, 38(1‐2), 165-197. https://doi.org/10.1111/j.1468-5957.2010.02224.x microsoft word 13892-50685-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 192 corporate social responsibility and firm performance of licensed commercial banks in sri lanka balagobei, s*and anandasayanan, s senior lecturers, department of financial management, university of jaffna, sri lanka e-mail: saseelab@univ.jfn.ac.lk received: nov. 12, 2018 accepted: dec. 26, 2018 published: december 30, 2018 doi:10.5296/ajfa.v10i2.13892 url: https://doi.org/10.5296/ajfa.v10i2.13892 abstract corporate social responsibility (csr) is a business approach that contributes to sustainable development by delivering economic, social and environmental benefits for all stakeholders. this concept has emerged over the past thirty years to occupy a significant role in certain aspects of the organizational theory. the purpose of this study is to examine the impact of csr on firm performance from a developing country’s environment. this study considered only 12 licensed commercial banks as sample and obtained secondary data from the financial statements of the licensed commercial banks in sri lanka for the period of 2012-2016. consequently, the quantitative data were employed in the panel data regression model using e-views software to scientifically analyse the data to identify the significant relationship between these two variables. the control variable is firm size, to be consistent with the previous studies in the literature review. the finding shows that there is no significant impact of social, economic and environmental variables on firm performance. further the results reveal that there is a significant positive association between csr and firm performance (roa) whereas firm size has a negative association with firm performance (tobin’s q).the study illustrates and provides some insights and builds on the literature in the area of csr in a developing country’s environment. keywords: corporate social responsibility, firm performance, firm size asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 193 1. background of the study corporate social responsibility (csr) is a concept which has become leading in business reporting and companies integrate social and environmental concerns in their business operations and stakeholders on a voluntary basis. every organization has a policy concerning csr activities and produces a report annually describing its activities and recognizing corporate activities. the other hand csr is the relationship between global corporations, government of countries and individual citizens. more locally definition is concerned with the relationship between a corporation and the local society in which it resides or operates. another definition is concerned with the relationship between a corporation and its stakeholders. in modern concept of csr states that the business enterprises is in their usual process of business decision making should pay due attention to the social interest of the people in the community. a company is not only an economic entity but a social and political entry also. most of the decisions taken by the companies not only affect the stakeholders but also the stakeholders namely creditors, debtors, employees, and the society at large in one way or the other. corporate social responsibility (csr), a concept that has been around for well over 30 years, has become prominent again recently. it overlaps with other such concepts as corporate citizenship, sustainable business, environmental responsibility, the triple bottom line, social and environmental accountability, business ethics and corporate accountability. it is highly contextual not only in terms of its corporate environment but also in terms of its national environment. moreover, csr is an essentially contested concept. thus any definitions will necessarily be challenged by those who wish to contest the reach and application of any version of csr. sri lanka is developing economy, here corporate social responsibility (csr) play an important role in organizations. in sri lankan industry one can easily notice that a paradigm shift from corporate philanthropist to being socially responsible. the importance of csr is increasing in sri lankan corporate scenario because organization have realize that ultimate goal is not profit making beside this trust building is viable and assert able with society able with societal relationship. now a day, company has become more transparent in the balance sheet. they are displaying public reporting in their accounting. companies are incorporating their corporate social responsibility initiative in their annual report. csr accompanies commitment to integrating social and environmental considerations into business operation in a sustainable manner in order to balance the interests and welfare of stakeholders. research within the scope of csr generally explore how the application of such activities within the company, with a view disclosure in the annual report. today, management of banks has found the need to provide for the environment in which they operate and hence need to evaluate the corporate social responsibility engaged in by them on their performance. therefore this research was based on the evaluation of the impact of corporate social responsibility on firm performance of banks in sri lanka. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 194 2. statement of the problem managers of banks are often faced with the challenge of determining how socially responsible their banks are, particularly with the increased competition in the banking industry in sri lanka. therefore, promoters of csr have argued that organizations should integrate economic, social and environmental concerns into their business strategies, their management tools and their activities, going beyond compliance and investing more on human, social and environmental capital. however, the findings from prior studies which from developed economies have shown that there are mixed findings on the influence that csr has on business success measured in terms of performance. the other hand most of the company measure only corporate financial performance but it is not enough to decide success of the business. in sri lankan economy social responsibility level is very lower. by researching about the problems findings should be answered these questions. what are the csr activities that banks appliance? what is relationship between corporate social responsibility and firm performance? finally is there any impact on firm performance by appliance corporate social responsibility for a bank? corporate social responsibility (csr) is the most popular term devised to describe the phenomenon of business responsibility to society. this study considers how it affects to the firm performance.  to what extent corporate social responsibility impacts on firm performance? 3. objective of the study the objective of this study is to examine the impact of corporate social responsibility on firm performance of licensed commercial banks in sri lanka during the period of 2012 to 2016. 4. literature review babalola (2012) examines the effect to csr on firms’ profitability in nigeria. in this study, secondary data was collected from ten profitable firms randomly selected on the nigeria stock exchange. using regression analysis, the study found a negative relationship between firms' csr performance measure with profit after tax and investment in csr. erhemjamts and venkateswaran (2013)carry out a study to determine the relationship between csr, firm policies and performance in us. the study used a sample of 3,268 companies using kld data. using regression analysis, they found a positive relationship between csr and firm s investment policies, organizational strategy and performance. ngwakwe and collin (2009) carry out a study to determine the relationship between environmental responsibility and firm performance in nigeria. they used a sample of 60 manufacturing companies. using regression analysis, he found that sustainable practices of the ‘responsible’ firms are significantly related with firm performance. based on the literacy review, the following hypothesis is developed. odhiambo and patrick (2006) carry out a study on csr as a strategic tool for stakeholder management in large scale enterprises in kenya. in this study, a sample of 103 large scale enterprises was drawn using systematic stratified sampling method. a standard questionnaire asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 195 was used to collect data and descriptive statistics used to analyze the data. the study found that csr is perceived to have a huge positive effect on the publicity of the organization. siegel and mcwilliams (2001) reveal conclude that there is an "ideal" level of csr, which managers can determine via cost-benefit analysis, and that there is a neutral relationship between csr and financial performance. feng, jagjit , and saini (2015) find an improvement in firm performance with increases in both non-executive and executive compensation. further, workforce-oriented csr positively moderates the association between non-executive compensation and firm performance, and negatively moderates the association between executive compensation and firm performance. yanni and yongrok (2014) investigate the mediating effect of organizational trust on the relationship between perceived corporate social responsibility (csr) practices and firm performance. a total of 674 questionnaires were sent randomly to chinese firms to obtain a total of 168 reliable responses. a confirmatory factor analysis was conducted for a validity test, and structural equation modelling was employed to test the mediating effect of organizational trust. 5. methodology the study obtained secondary data from the annual reports and financial statements of the commercial banks for the period of 2012-2016. these reports were used to derive the total assets and net income figures in order to calculate the return on assets (roa).the financial statements were used for the year ended 31st december. there are several suggested methods to select sample. the research clearly mentioned what was the research population and how to select the research sample. according tongechu (2014), population was defined as a set of events, people, services, and elements, group of households or things that were being investigated. in this study, the population consisted of all 26 licensed commercial banks operating in as per the cse supervision report. the period of study is from 2012 to 2016. this study has selected top 12 licensed commercial banks. (national development bank plc, hatton national bank plc, dfcc bank plc, commercial bank, nation trust bank, sampath bank plc, seylan bank plc, people’s bank, bank of ceylon, union bank of colombo plc, pan asia banking corporation plc and amana bank ). but the research did not consider all the banks as they did not have five years annual report. therefore the research considered only 12 licensed commercial banks in the sri lanka. 5.1 conceptualisation this conceptual model represents the relationship between corporate social responsibility and firm performance asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 196 independent variable dependent variables figure 1. conceptual model 5.2 operationalization operationalization represents measurements of corporate social responsibility variables and firm performance. table 1. measurements of concepts and variables concept indicators measurement corporate social responsibility social responsibility global reporting initiatives (gri) no of observation total no of observation environmental responsibility economic responsibility firm performance roa net income / total assets tobin’s q total market value of company total assets (or book) value control variable firm size log of total assets 6. empirical analysis correlation coefficient measures the degree and direction of the relationship between corporate social responsibility and firm performance. corporate social responsibility  social responsibility  economic responsibility  environmental responsibility control variable firm size firm performance  roa  tobin’s q asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 197 table 2. correlation matrix correlations csr firm size roa tobin’s q csr pearson correlation sig. (2-tailed) 1 firm size pearson correlation sig. (2-tailed) -0.275* 0.032 1 roa pearson correlation sig. (2-tailed) 0.249* 0.050 -0.175 0.180 1 tobin’s q pearson correlation sig. (2-tailed) 0.016 0.897 -0.390* 0.002 0.338* 0.008 1 source: research survey data according to the survey finding pvalue between corporate social responsibility (csr) and return on assets (roa) is 0.05 (p = 0.05) and value of correlation coefficient is 0.249* which indicates significant positive relationship between corporate social responsibility and firm performance (roa). according to the survey finding pvalue between corporate social responsibility (csr) and tobin’s q is more than 0.05 (p=0. 897>0.05) and value of correlation coefficient is 0.016 that indicates no significant relationship between corporate social responsibility and tobin’s q. the value of correlation between firm size and firm performance (tobin’s q) is -0.390* which is significant at 0.05 levels. therefore there is a significant relationship between firm size and firm performance (tobin’s q). regressions analysis has been used to measure the impact of independent variable (total csr) on dependent variables (tobin’s q and roa). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 198 table 3. regression coefficients for roa coefficient std. error t-statistic prob. constant csr firm size 1.763306 0.801782 -0.083637 1.041943 0.488541 0.096148 1.692325 1.641176 -0.869879 0.0960 0.1063 0 .3880 r-squared 0.074481 adjusted r-squared 0.042007 s.e. of regression 0.858503 sum squared resid 42.01056 log likelihood -74.44360 f-statistic 2.293536 prob (f-statistic) 0.010149 mean dependent var 1.318917 s.d. dependent var 0.877123 akaike info criterion 2.581453 schwarz criterion 2.686171 hannan-quinn criter. 2.622414 durbin-watson stat 1.415911 source: research survey data the r2 is 0.0744 which means that 7.44 % of the total variation in return on asset is explained by variation in corporate social responsibility activity. it is also indicating that corporate social responsibility is important in achieving adequate return on asset of the licensed commercial banks. standard error associates with estimating roa is 0.488541 %.thus 0.488541 % means that the expected error for a roa prediction is off by 0.488541 %. further, this model reveals that the coefficient for csr and roa is not significant at 0.05 levels which indicate this variable has no significant impact on roa. table 4. regression coefficients for tobin’s q variable coefficient std. error t-statistic prob. constant csr firm size 7.683066 -0.780303 -0.652769 2.139512 1.003163 0.197430 3.591036 -0.777842 -3.306340 0.0007 0.4399 0.0016 r-squared 0.161166 adjusted r-squared 0.131733 s.e. of regression 1.762839 sum squared resid 177.1332 log likelihood -117.6130 f-statistic 5.475714 prob(f-statistic) 0.006680 mean dependent var 0.877521 s.d. dependent var 1.891846 akaike info criterion 4.020434 schwarz criterion 4.125152 hannan-quinn criter. 4.061395 durbin-watson stat 0.581303 source: research survey data according to the table 04, the r2 is 0.161166 which means that 16.12% of the total variation asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 199 in tobin’s q is explained by variation in corporate social responsibility activity. it is also indicating that corporate social responsibility has no significance on tobin’s q of the licensed commercial banks. standard error associates with estimating tobin’s q is 1.00316%.thus 1.00316% means that the expected error for a tobin’s q prediction is off by 1.00316%. adjusted r squared is 0.1317. based on the p value and coefficient csr has no significant impact on tobin’s q. 7. conclusion the relationship between a firm's csr and firm performance has been getting the attention of both academics and practitioners. a clear evidence of a relationship or lack of it is an important issue for management. the focus of this paper is to investigate the impact of corporate social responsibility on firm performance. the approach focuses on the analysis of annual reports/websites of banks during the period of 2012-2016 for any socially responsible activities. this study uses three different csr disclosure measures such as social, economic and political csr disclosures. the finding shows that there is no significant impact of csr variables on firm performance. further the results reveal that there is a significant positive association between csr and firm performance (roa) whereas firm size has a negative association with firm performance (tobin’s q). the study proffers the following for further research: some limitations of this research should be investigated in the future research. the data required for this study is sourced from annual reports. future research could include other means of reporting to look into the extent of csr disclosure and its relationship with financial performance. the sample size is assumed to be small and it limits the generalizability of the findings to sri lanka. therefore, it could be taken to the next level by widening the number of firms included in the study. references babalola, y. a. (2012). the impact of corporate social responsibility on firms’ profitability in nigeria. european journal of economics, finance and administrative sciences, 45(1),3950. branco, m., & rodrigues. (2006). corporate social responsibility and resource-based. journal of business ethic, 111-132. https://doi.org/10.1007/s10551-006-9071-z erhemjamts, o., li, q., & venkateswaran, a. (2013). corporate social responsibility and its impact on firms investment policy, organizational structure, and performance. journal of business ethics, 118(2), 395-412. https://doi.org/10.1007/s10551-012-1594-x feng, m., jagjit , s., & saini. (2015). monetary compensation,workforce-oriented corporate social responsibility,and firm performance. american journal of business, 30, 196-215. https://doi.org/10.1108/ajb-10-2014-0057 ngwakwe, & collins, c. (2009). environmental responsibility and firm performance: evidence from nigeria. international journalof humanities and social sciences, 3(2),97-103. odhiambo, & patrick, w. (2006). corporate social responsibility as a strategic tool for stakeholder management in large scale enterprises in kenya. school of business. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 200 siegel, d., & mcwilliams, a. (2001). corporate social responsibility a theory of the firm perspective. academy of management review, 26, 26(1),117-127. https://doi.org/10.5465/amr.2001.4011987 yanni, y., & yongrok, c. (2014). corporate social responsibility and firm performance through the mediating effect of organizational trust in chinese firms. chinese management studies, 8, 577-592. https://doi.org/10.1108/cms-10-2013-0196 microsoft word 13719-50290-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 151 relationship between corporate capital structure and stocks liquidity: empirical evidence in vietnam vu thi thuy van (corresponding author) school of banking & finance, national economics university, ha noi, viet nam e-mail: thuyvan@neu.edu.vn tran thi thoa school of banking & finance, national economics university, ha noi, viet nam e-mail: thoa97at@gmail.com ngo thanh xuan school of banking & finance, national economics university, ha noi, viet nam e-mail: xuantn@neu.edu.vn nguyen nhat linh school of banking & finance, national economics university, ha noi, viet nam e-mail: nhatlinhkss.nhtc@neu.edu.vn received: sep. 29, 2018 accepted: nov. 26, 2018 published: december 1, 2018 doi:10.5296/ajfa.v10i2.13719 url: https://doi.org/10.5296/ajfa.v10i2.13719 abstract the paper examines the impact of capital structure on the liquidity of listed shares on the ho chi minh city stock exchange, which includes 1078 observations during the period of 2011 – 2017. in addition to the capital structure, the study also looked at the impact of controlled variables including profitability (ros), corporate value (tobin’s q) and size of the business (size) on the liquidity of listed shares. the results show that the capital structure has asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 152 inherently inverse relationship, while the controlled variables in the model have a positive relationship with stocks’ liquidity. keywords: capital structure, liquidity, corporate value, stock market, financial leverage asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 153 1. introduction for a business, liquidity is the top priority, because it is the status, prestige, the power of a business. the stock's liquidity is good when the stock is easy to trade on the market, attracting investors to invest in to find profitable investment opportunities, helping the business mobilize large capitals. conversely, if the stock of a business is less liquid, the business will suffer negative impact on the performance, resulting in the sale of investment projects, assets, capital mobilization with high fees and the worst scenario is bankruptcy. over the past ten years, the financial market in vietnam has grown exponentially but also contains many inherent risks depending on the fluctuation of the macro economy and the enterprises themselves. on the stock market, the risk of stock liquidity is increasing with more complex trends. one of the fundamental reasons is that financial management in many businesses is not respected. facing the opportunities and challenges of the economic reform process, the efficient use of resources for development, including capital resources, needs to be paid more attention by businesses. many empirical studies in the world and vietnam have examined the relationship between capital structure and liquidity of stocks. however, past researches have not yet clarified the effect of capital structure on stock liquidity but mainly focused on studying the effect of stock liquidity on capital structure decision. based on the above reasons, the authors decided to select the topic "relationship between corporate capital structure and stock liquidity: empirical evidence in vietnam". 2. theoretical background 2.1 some theories concerning the corporate capital structure and stock liquidity 2.1.1 theories of capital structure trade-offs theory of capital structure: the theory of modern capitalism derives from modigliani and miller (1958). the main hypothesis of the study is that the value of a company is independent from its capital structure. in 1963, they changed their theory by adding tax elements to their original research. with the presence of corporate income tax, m&m claims that the use of debt will increase the value of a business. however, businesses cannot fully finance their business with debt. although, benefiting from the tax shield, debt financing generates expenses, especially cost of financial exhaustion (including bankruptcy costs and financial exhaustion but not bankruptcy). as the result, businesses are always looking to optimize the total value of the business based on the equilibrium principle to determine how much debt financing and how much equity capital to allocate in their capital structure. the theory of capital structure swap balances the advantages of debt and financial exhaustion. agency cost theory: the agency cost theory is further developed in the study of jensen & meckling (1976) and jensen (1986). this theory is derived from the conflict of interest between the board of directors and the shareholders. agency cost is the cost incurred by the owner of the firm when there is a separation between ownership and management rights. in a asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 154 business, the distinction between ownership and management is essential. however, this delimitation will create many complex issues related to the interests of the parties. shareholders always want to maximize the value of their business and the value of their equity. on the other hand, managers tend to invest in projects that increase the size of the business. this type of decision is solely based on their judgement and contains many risk factors, however, does not increase shareholders’ interest. jenshen and meckling argue that there are two types of contradictory conflicts: the conflict between shareholders and business managers and the conflict between shareholders and creditors. this basic contradiction has created an agency cost. the agency cost usually reduced the benefit of using the debt as financial support. the agency cost theory presents that an optimal capital structure can be achieved by balancing the agency cost with the benefit of using debt. classification theory: classification theory developed by researcher myers and majluf(1984). this theory explains the company's funding decisions based on asymmetric information. the basic concept of asymmetric information proposed a prioritized financing order, in which profits should be kept to reinvest into the business first (retained earnings), followed by debt issuance and eventually capital issuance or new shares. the issuance of new equity is usually the last resort when the company has exhausted its ability to borrow. this theory helps explain why companies with high profitability tend to have lower borrowing ratios than others because they have more internal capital to finance themselves; whereas low-profit firmstend to issue debt because they do not have enough internal capital for their investment projects. debt issuance is topped in the ranking order of external funding. 2.1.2 the theory of stock liquidity the liquidity of a stock has many different definitions but can be understood simply by the quicklinessof buying or reselling a stock without losing its value. there are many different concepts raised by researchers and professional investors. robert f. stambaugh (2002) introduced the concept of stock liquidity as follows: "stock liquidity is a very broad and unclear concept, but generally, it reflects the ability to trade a large volume of stock quickly at a low cost with little price fluctuation." wasfi a. al salamat (2016) argues that it is difficult to give an explanation of stock liquidity and suggests the following: "it (stock liquidity) is the ability of investors to buy or sell a large amount of stock at ease and without significant loss.” stock liquidity has not only one but also many different characteristics. the liquidity of the stock is based on the following four fundamental characteristics: • “transaction time: is the execution of an immediate transaction at a common price. timeout between two transactions and the number of transactions in a time unit are measure of the transaction time. • tensions: the ability to buy or sell a certain amount of stock at an equal price at the same time. expenses related to the transaction or the cost of waiting express the tightness. tensile measures are the different types of price differences. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 155 • depth: the ability to buy or sell a certain amount of stock without affecting the listed price. listed price is the ask or bid price placed in the order book. a sign of weak liquidity is resulted from the negative impact of the market on investors when trading. the depth of the market can be measured by the order index, transaction volume or cash flow index. • elasticity: the ability to buy or sell a certain amount of stock with little effect on price. when the depth of market is only concerned with the number of transactions at the best bid or ask price, the elasticity property assumes the elasticity of supply and demand. the degree of elasticity of liquidity is described by the income of the day”. 2.2 some concepts 2.2.1 the concept of capital structure the capital structure of an enterprise is defined as the combination of debt and equity in the total long-term capital that an enterprise can mobilize to finance its investment projects. the term financial leverage implies the capital structure of an enterprise. financial leverage is used to assess the extent to which a business finances its operations by borrowing. within the scope of the study, the authors used the debt-to-asset ratio and the debt-to-equity ratio as variables representing the financial leverage. 2.2.2 measure the stock liquidity liquidity is a broad definition with many different dimensions that cannot be covered by a single metric. in this study, the authors use two different measures, including a liquidity metric and an inadequate measure of liquidity, to increase the validity of the study. these measures are widely used in the studies of scholars around the world. the computation of these two measures is as follows: • method of measurement using stock turnover (turnover) = (1) this method merely performs a business measurement of trading volume over a one-year period compared to the number of shares outstanding at the end of the previous year in order to reflect the liquidity of listed shares on the market more precisely, because the number of outstanding shares in circulation can change over time. therefore, an individual investor is most likely to be interested in this method of measurement. • the method of measuring the frequency of the zero-yielding day (zeros) this low liquidity measurement was developed by lesmond, ogden and trzcinka (1999), which is calculated as follows: = (2) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 156 if the company has a high transaction cost, it will be a negative influence on stock trading, creating a barrier to the investors making their transactions and forcing them to exploit their own information. as the result, more shares with less liquidity will be traded on days with 0 return. investors in the market are unpredictable. the number of investors fluctuate frequently and directly affect the efficiency of business operations. therefore, strategic managers need to update information on this issue in order to have appropriate business strategies and to effectively deal with problems that may incur. 3. research overview 3.1 research overview on liquidity measures liquidity is an abstract concept, with many different definitions by researchers and professional investors. in the simplest sense, liquidity is the easy level of trading a certain stock. previous research focused on developing liquidity measures from developed to emerging markets. there are a number of measures taken to choose how to measure the liquidity of a stock from a variety of perspectives and different liquidity concepts. typically, amihud (2002) measured liquidity by price sensitivity, lesmond et al. (1999) measured liquidity based on the frequency of the zero-yielding day, or roll (1984) measured liquidity based on ask or bid price. liquidity is a broad definition with many different aspects that only one measure cannot cover the whole. domestic writings of authors such as le dat chi and hoang thi phuong thao (2015) used six liquidity metrics as the relative price difference, stock turnover, sensitivity measure of price, the frequency of the zero-yielding day, the implied market spread, and the depth of the market to reinforce the research on "the impact of the global financial crisis on the liquidity of vietnamese securities". 3.2 results of empirical research on the relationship between capital structure and stock liquidity there are a lot of studies on the relationship between capital structure and liquidity of stocks. the first is a study of the interplay of stock liquidity and capital structure of firms listed on the nyse in 1988-1998 by frieder and martell (2006). hypothetical test results show that high leverage increases liquidity, which is consistent with the idea that debt managers must make better investment decisions (jensen, 1986), thereby reducing agency costs between managers and investors, and increasing the liquidity of the stock (kyle, 1985). on the other hand, the results also show that any decline in stock liquidity increases financial leverage. udomsirikul and fortune (2011) conducted a study on the relationship between capital structure and stock liquidity on 707 companies in thailand in the period of 2002-2008. the authors use three liquidity measures including method by amihud (2002), modified turnover, and adjustable liquidity ratios, which represents the liquidity of the stock and the debt-to-asset ratio represents the capital structure. thailand is a less complex capital market than the united states with predominant bank loans and more centralized corporate ownership. in spite of these differences, the author's study gives the result of the negative correlation between stock liquidity and financial leverage. lesmond, o`connor and senbet asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 157 (2008) studied capital structure and stock liquidity with 226 non-financial companies from 1980-2006. data sets are collected from financial reports and the dow jones index. using three liquidity measures, one estimates the price effect based on the hasbrouck (2007) model, lesmond et al. (1999), and the purchase price difference (representing the cost of instantaneous), the authors found that increased financial leverage was associated with reducing stock liquidity and decreased financial leverage related to increasing stock liquidity. rasa norvaišienė and jurgita stankevičienė (2014) reviewed the impact of the company specific factors on stock liquidity on the baltic stock market between 2005 and 2012. factors of the company included in the study are such as the business size, roa, financial leverage (measured by debt to equity), profit or loss ratio, current solvency. the study showed that the higher the equity of estonia's companies, the higher the liquidity affected by the increase in financial leverage. stock liquidity of latvian companies during 2005-2012 is affected only by the size of the companies. the liquidity of the lithuanian companies’ shares during the research period was positively influenced by the size of the companies and the return on their assets. however, financial leverage has a negative impact on stock liquidity. wasfi a. al salamat (2016) studied the effects of factors in the macro-economy and the company's unique factors on stock liquidity empirical evidence from jordan showed that stock liquidity is positively influenced by financial leverage, earnings per share (eps), interest rates, gross domestic product (gdp), and size; whereas it is negatively influenced by market price-to-book ratio and return-on-asset (roa). in vietnam, the study of dang thi phuong (2012) with the theme of "liquidity of stocks and capital structure of listed companies on ho chi minh city stock exchange" with the data of 60 companies listed on the ho chi minh stock exchange between 2006-2011.correlation coefficient analysis and multiple linear regression models were used to test the hypothesis. the results of the study also showed the opposite relationship between financial leverage representing corporate capital structure and stock liquidity. in addition, the study found five factors (among the six factors outside the liquidity factor studied) that have an impact on capital structure including growth opportunities, firm size, depreciation rates(having positive relationship with financial leverage), the rate of return and stock market price (having negative relationship with financial leverage). the group of authors vo xuan vinh, tran thi yen duyen (2015) also studied the above topic but with a broader scope when conducting research on the stock market of vietnam from 2006 to 2012. with the pooled ols regression analysis, the results showed that the liquidity of the stock is positively related to the company's capital structure. 4. modeling and research methodology 4.1 research hypothesis capital structure: capital structure (financial leverage) is an important factor affecting the liquidity of stocks. theoretical and empirical studies by udomsirikul et al. (2011), lesmond et al. (2008), rasanorvaišienė and jurgitastankevičienė (2014), dang thi phuong (2012), vo xuan vinh, tran thi yen duyen (2015)showed that the capital structure is inversely related to stock liquidity. however, according to the study by frieder and martell (2006), wasfi a. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 158 al salamat (2016), there is positive relationship between capital structure and stock liquidity. the proposed research hypothesis is as follows: h1: financial leverage is inversely related and statistically significant to stock liquidity. business scale: for investors, they are more likely to be interested in large-scale businesses, where information is more transparent, clear to the public so that they can capture accurate information and have rapid access to information streams to make appropriate investment decisions. as the result, more trading activities will occur to help create more market liquidity. in addition, shares of large-scale enterprises can be traded easier, faster and without significant devaluation compared to stocks of small and medium enterprises. the results of these studies are consistent with the above-mentioned theoretical basis, showing that the size of the business is closely related to stock liquidity (rasanorvaišienė and jurgitastankevičienė, 2014; wasfi a. al salamat, 2016; sedeaq nassar, 2016). based on these studies, we have the following hypothesize: h2: the size of the business has positive and significant impact on stock liquidity corporate profitability: examining the effect of profitability on liquidity of stock, studies by hansen, s., & sungsuk, k. (2013), rasa norvaišienė and jurgita stankevičienė (2014), sedeaq nassar (2016) showed a positive relationship between stock liquidity and corporate value. this can be explained by the fact that if a business has good business results and high profitability, then stocks with high returns will attract investors to exploit profit opportunities and thus increase the liquidity of the stock. the proposed research hypothesis is as follows: h3: the profitability of the business has positive and significant impact on stock liquidity corporate value:a good business or high corporate value is usually traded at a better price (allayannis & weston, 2001). moreover, the high value enterprise will attract investment. the study by trang nguyen, duong huu nhan, harminder singh (2016) also makes the same conclusion. therefore, corporate value is also considered as an important factor influencing the liquidity of stocks. the proposed research hypothesis is as follows: h4: the corporate value has positive and significant impact on stock liquidity 4.2 model and research data based on a review of the impact of capital structure on stock liquidity and research hypotheses, the regression model proposed in the study to test the hypotheses is as follows: model 1: toit = β0 + β1doait + β2sizeit + β3ros it + β4tobin’q it + εit (3) model 2: zerosit = β0 + β1doait + β2sizeit + β3ros it + β4tobin’q it + εit (4) calculation and expecting signs of variables are presented in table 1. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 159 table 1. calculation and expecting sign of variables no variables types of variables variables code calculating method expecting signs 1 stock liquidity dependent to quarter’s sales/total quarter shares outstanding on average 2 dependent zeros numbers of trading days with 0 return in year t/total number of trading days in year t 3 financial leverage independent doa debt/total assets (-) 4 business size controlled size ln (total assets) (+) 5 profitability controlled ros earnings after tax/revenue (+) 6 corporate value controlled tobin’s q tobin’s q = (total market value of equity + net debts)/total book value of assets (+) source: authors’ establishment the study looked at factors affecting dividend policy collected from listed companies on the ho chi minh city stock market for seven years from 2011 to 2017 with 1078 observations. estimation of regression model based on tabular data. research methods used in the model include fem (fixed-effect estimation model) and rem (random-effect estimation model). the final result will be used after the defect recovery process of the selected model. 5. research results 5.1 statistics describe the data table 2 shows descriptive statistics results of the data used in the model. in particular, the highest level of financial leverage of listed companies was 97.68% and the lowest value was 0.06%. ros is the variable with the highest variance compared to other variables. the results also showed that the average profitability (over revenue) of the company was 1.96%. the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 160 variables representing financial leverage have the greatest value of around 0.7, while the smallest value is the to variable, which is 0, and the zeros variable, which is 0.043. table 2. statistics describing the variables in the model variables mean std. min max ros 0.019 2.190 -7.519 2.059 tobin’s q 1.074 0.573 0.232 8.504 sizedt 13.742 1.427 9.123 18.320 doa 0.494 0.204 0.006 0.976 zeros 0.256 0.119 0.043 0.756 source: author’s computation using r software in addition, the results show that the correlation among the variables is relatively low (table 3). the purpose of examining the close correlation between independent variables and dependent variables is to eliminate factors that may lead to multi-collinearity before running the regression model. the correlation coefficient between the independent variables in the model is less than 0.8, so it is less likely that multi-collinearity will occur. the variance inflation factor (vif) will be used to test the multidimensional phenomenon between variables. table 3. correlation matrix between variables in the model ros tobin’sq sizedt doa zeros turnover ros 1.0000 tobin’s q 0.0424 1.0000 sizedt 0.0802 0.2498 1.0000 doa 0.0259 -0.1117 0.3463 1.0000 zeros 0.0388 -0.0686 -0.282 0.0303 1.0000 turnover 0.0121 0.1007 0.1227 -0.0258 -0.4163 1.0000 source: author’s computation using r software asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 161 5.2 model selection 5.2.1 the model with the dependent variable is zeros for selecting the right model, the authors used the hausman test to choose between the fixed-effect estimation model (fem) and the random-effect estimation model (rem). the hausman test results show that prob> chi2 = 0.0452 means that p-value <α = 5%, so it is sufficient to reject the h0 hypothesis. therefore, the fem is more appropriate than the rem model. table 4. the regression results with zeros as dependent variable fem rem gls doa 0.1144*** 0.0962*** 0.1144*** ros 0.0022* 0.0024* 0.0022*** tobinq -0.0241*** -0.0127* -0.0241*** size -0.0264*** -0.0271*** -0.0264*** _cons 0.5952 n 1078 1078 1078 r-sq 0.0433 0.0565 hausman test chisq = 9.7344 p-value = 0.0452 breusch-pagan lm test chisq = 17478 p-value = 0.0000 breusch-godfrey/wooldridge test chisq = 155.06 p-value = 0.0000 breusch-pagan test bp =31.199 p-value = 0.0000 t statistics in brackets * p<0.1, ** p<0.05, *** p<0.01 source: author’s computation using r software however, before analyzing in detail the factors that affect zeros, the authors use the tests of variance change, multi-collinearity, autocorrelation and makes the necessary adjustment to correct restrictions of the model. multi-collinear test: to detect the multi-collinearity in the model, the author uses the variance inflation factor (vif). as a result, the vif of the variables are less than 2, indicating that there are no multi-collinearity. doa ros tobin’sq size vif 1.08 1.018 1.029 1.12 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 162 the study used the wooldridge test to test autocorrelation in regression models and the breusch-paga method to test variance change. based on the results in table 4 the coefficient p-value <α = 0.05. so assuming h0 is rejected. the results of the model test showed that the p-values obtained were 0.000 <α (5%), which implies that h0 is not affected by thevariance change/autocorrelation phenomenon. the model is rejected with a 5% significance level. after the regression and validation, selecting the appropriate model as fem, the authors overcome the detected defects of the model by using generalized least squares (gls). the results are presented in table 4. thus, the study results showed that all four independent variables were statistically significant at 1% significance level, in which, financial leverage and profitability have the positive relationship with low liquidity (zeros), while the size and value of the business has the opposite relationship. 5.2.2 models with dependent variables are turnover for the turnover dependent variable (table 5), the hausman test results show that p-value = 0.0000 <α = 5%, thus sufficient basis for the fixed-effect estimation (fem). through the test run method, the fe model is the best model chosen. the model also applies the same test as above: multi-collinear testing (the vif coefficients are less than 2, indicating no existence of multi-collinearity) as folows: doa ros tobin’sq size vif 1.13 1.01 1.07 1.19 the variance change and the self-correlation tests showed that the p-values obtained were 0.000 <α (5%), which implies that h0 is not affected by variance change. models were rejected with a 5% significance level. therefore, the authors correct the defect of the regression model by gls regression. the results of the study (table 5) showa negative relationship between the financial leverage and the liquidity of the stock, while other variables have a positive relationship with stock liquidity. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 163 table 5. the regression results with turnover as dependent variable fem rem gls doa -0.0807*** -0.0325** -0.0807*** ros 0.0013*** 0.0011 0.0013*** tobinq 0.0347*** 0.0142*** 0.0347*** size 0.0262*** 0.0083*** 0.0262*** _cons -0.0777 n 1078 1078 1078 r-sq 0.1067 0.0391 hausman test chisq = 611.65 p-value = 0.0000 breusch-pagan lm test chisq = 17610 p-value = 0.0000 breusch-godfrey/ wooldridge test chisq =136.66 p-value = 0.0000 breusch-pagan test bp = 46.718 p-value =0.0000 t statistics in brackets * p<0.1, ** p<0.05, *** p<0.01 source: author’s computation using r software 5.3 discussion of the research results from the two models of research that have been tested, the authors elaborate some discussions: • capital structure factor (represented by financial leverage doa): doa has positive relationship with stock liquidity and negative relationship with low liquidity. this finding is consistent with conclusions by udomsirikul et al. (2011), lesmond et al. (2008). • profitability: ros has positive relationship with stock liquidity and low liquidity. this result shows that the effect of ros on liquidity of stock is unclear. profitability on one hand increases the stock's liquidity, but on the other hand may increase the proportion of low-yielding days. • corporate value factor (tobin’s q): the value of an enterprise is negatively correlated with low liquidity and positively correlated with liquidity. this is also the result of allayannis & weston (2001). • size: the size of the business has a negative relationship with low liquidity and positive relationship with liquidity. this result is consistent with study by wasfi a. al salamat (2016) and sedeaq nassar (2016). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 164 6. conclusion the study examined the impact of capital structure on the liquidity of stocks listed on the ho chi minh stock exchange using controlled variables including size, corporate value and profitability. the results show that the capital structure has negative impact on the liquidity of stocks, while the profitability, size and corporate value have a positive relationship with stock liquidity. from the results of the study, the authors propose some of the following recommendations: firstly, the capital structure has negative impact on the liquidity of the stock, which implies that the increased debt ratio will reduce liquidity and increase numbers of low-yielding transactions. therefore, businesses need to pay attention to the use of financial leverage, focusing on the source of equity capital. secondly, profitability, although has a positive relationship with liquidity, also has the same relationship with the low liquidity. for vietnam's stock market, this is a phenomenon that can be explained by the fact that investors sometimes make decisions not based entirely on the profitability of the business. investment decisions can be based on non-financial information on the market. thirdly, the research results show that the higher the size and value of the business, the greater the liquidity of the stock and the lower non-profitable transactions. therefore, for investors, those are two indicators that can be considered when making decisions to select priority stocks with high liquidity in the market. references amihud, y, (2002). illiquidity and stock returns: cross-section and time-series. journal of financial markets, 5(1), 31-56. https://doi.org/10.1016/s1386-4181(01)00024-6 albert s. kyle (1985). continuous auctions and insider trading. econometrica, 53(6), 1315-1335. https://doi.org/10.2307/1913210 allayannis, g., & weston, j. p. 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(1984). a simple implicit measure of the effective bid-ask spread in an efficient market. the journal of finance, 39(4), 1127-1139. https://doi.org/10.1111/j.1540-6261.1984.tb03897.x sedeaq nassar (2016). investigate the factors affecting share liquidity: evidence from istanbul stock exchange (ise). research journal of finance and accounting, 7(6), 71-77. trang nguyen, huu nhan duong, harminder singh (2016). stock market liquidity and firm value: an empirical examination of the australian market. international review of finance, 16(4), 639-646. http://dx.doi.org/10.1111/irfi.12082 udomsirikul p., seksak j. & pomsil j. (2010). liquidity and capital structure: the case of thailand. journal of multinational financial management, 21(2), 106-117. http://dx.doi.org/10.1016/j.mulfin.2010.12.008 asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 2 ajfa.macrothink.org 166 võ xuân vinh, trần thị yến duyên (2015). thanh khoản cổ phiếu và cấu trúc vốn dn: nghiên cứu thực nghiệm trên thị trường chứng khoán việt nam. tạp chínghiên cứu kinh tế, số 443-t4/2015, 33-42. wasfi a. al salamat (2016). macroeconomics, firm-specific factors and stock liquidity: an empirical evidence from jordan. international journal of financial research, 7(5), 110-123. http://dx.doi.org/10.5430/ijfr.v7n5p110 microsoft word 18932-article text-writer2-new d as receive doi:10.5 abstra ever si modigl among dividen this stu korean possible hypothe fixed-e stock ex chosen subsequ in the r establis impact keywo leverag jel clas determi ssociate pro ed: oct. 5, 2 5296/ajfa.v ct ince public iani (1961) g the many u nd policy an udy aims to stock exch e causes of esis that ar effect regres xchange ov to test the uent impact research are sh a relation on the same rds: divide ge, return o ssification: inants o fessor, fina sp jain sc 2021 a 13i2.18932 cation of t ), dividend unanswered nd whether i o investigate hange (krx f dividend p re used to r ssion model er a period e relationsh t on the sam ea of dividen nship betwe e on south k end payout on equity f49, f65, h of divid lis dr. a ance and as chool of glo e-mail: a ccepted: no url: ht the seminal policy con d questions, it can be str e the factors x). the stud payout poli represent th l is applied of 4 years s hip between me. the stud nd policy w een factors korean firm policy, sou h54, g32, g 107 dend po sted fir arindam ban ssistant dea obal manag arin_006@y ov. 17, 2021 https://doi.or l works of ntinues to b doubt rema ructured eith s of dividen dy involves icy. the stu he primary on a sample spanning fro n determin dy expects t with a stron that determ ms. uth korean g35 asian olicy o rms nerjee n (global m ement, dub yahoo.com 1 publ rg/10.5296/ f john lin be a signific ains on the s her in a dep nd payout p 5 distinct v udy include theories o e of 30 com om 2014 to nants of div to potentiall g notion to mine divide stock exch n journal of f f south mba and m bai campus lished: dece ajfa.v13i2.1 ntner (1956 cantly deba specific reas pendent or in policy on fir variables tha es developm f corporate mpanies liste 2017. the vidend pay ly increase improve pr end policy hange, peck finance & ac issn 19 2021, vol. 1 ajfa.macro h korea mgb program ember 1, 20 18932 6) and mil ated researc asons that de ndependent rms listed o at are consi ment of 5 r e dividend p ed on south specific mo yout policy domain kno rediction as and its sub king order ccounting 946-052x 13, no. 2 think.org/ an ms) 021 ller and ch topic. etermine t manner. on south dered as research payouts. h korean odel was and its owledge s well as bsequent theory, 1. intro (baker shareho compan earning manage pattern that sha decision multiple black ( like a p contrast to divid what fa 2. liter owing empiric on firm geograp determi has bee to estab theory, determi immedi compan 2013). typicall towards evidenc perform 2.1 cou researc dividen changes dividen its posi various depende (2016) oduction and powel olders. furth ny which are gs that is dis ement follow of cash dis areholders’ ns. despite e debates a (1976) postu puzzle, with ts his earlie dends? 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(201 dends if gd al positive and negativ adusei (2016 stment deci th rate and disbursemen audi regist ous dividen 2013). stud arnings mar rly, when i growth, p panies sugge ors impactin multi-natio fication, firm ome of the ar (2017). s that profitab and audit s impacting ties. where den. larger have bett finance & ac issn 19 2021, vol. 1 ajfa.macro f dividends a minants of d s risk. acco clearly lin ed with h g stock mark as profitabil capital mark m as an indi e of shares, acted by tran arket-to-boo dividend pa firm’s mark on is determ positive con ection betw 5). evidenc dp per capi associatio ve associati 6). evidenc ision, organ fix lower d nt strategy. tered non-f nd per shar dies specifi rgin, tax ef it comes to profit marg ests factors ng dividend onal and d ms specific major fact study condu bility, the sq t kind are g a swedish eas profitabi r firms, extr ter dividen ccounting 946-052x 13, no. 2 think.org/ amongst dividend ording to nked to historical ket such lity, size ket, it is icator of werner nsaction ok ratios. ayout of ket value mined by nnection ween the ces from ita is not on with ion with ces from nizations dividend kumar financial re of the c to the ffect and o service gin and such as d policy domestic hazard, tors that ucted on quare of critical h firm’s ility and ra liquid nd bills. ringbor across mature and bett the non pay-out liquidity a positi the tur retained (2017). of divid organiz (2019). stocks o the volu that jor profitab relation subsequ relation for divi in pakis a study showed organiz profitab of the f year’s indexed amongs risk, fre ratio an return-o and mar 3. meth this stu from fi reuters applied 4. hypo rg, (2016). sectors but and more p ter investm n-financial t of non-fin y. addition ve associati rkish mark d earnings a evidences dend policy zation is the studies ove owned by f ume of divi rdanian firm bility, age nship betwe uent impact nship betwe idend pay-o stan. y done on l d that divid zation grow bility. the d firm and ow dividends, d non-publi st malaysia ee cash flow nd thus a p on-assets, e rket-to-book hodology udy uses sec inancial rep s. the date u for the stud othesis and studies on t primarily profitable fi ment opportu firms liste nancial firm nally, return ion to divid et establish and level o from select y in develop most signi er a sample firm’s senio dend payme m’s decisio and size, en current r t on divide een market-t out ratio are listed priva dend payou wth, prior y dividend pa wnership str and profita ic commerc an firms ad w and mark positive cor earnings per k value (ay condary dat ports that a used is for dy is multip d models n indian co relate to e irms paying unities payin d on the n ms depend on equity, c dend disbur hed that fa of debt as th t uae comp ped markets ficant facto of jordania r officials o ent and its s ons in payi malkawi ratio, debt-t end payout to-book fee e profitabilit te commerc ut ratio has year’s divid yments wer ucture. hen ability were cial banks vocates tha ket-to-book rrelation be r share, retu yman, 2015) ta sources fo are publishe 4 years’ pe ple regressio 110 ompanies su existence o g more divid ng less divi nairobi sec upon prof current earn rsements. m actors such he primary panies show s are not rel or in the div an compani or directors subsequenc ing dividen (2009). r to-equity ra ratio and e and opera ty, debt equ cial banks l a positive dends and re not simp nce, levera e the key in banglad at growth o k value hav etween divi urn-on-equi ). for all furthe ed in the r eriod spanni on analysis. asian uggest that f increased dends in co dends. das curities ex fitability, g nings and fi musiega et.a as profitab factors of ws that seve levant to the idend disbu es pointed o and state p ce disbursem nd are mos rehman (2 atio, profitab at the same ating cash f uity ratio an listed on dh e and signi a negative ly influence ge, liquidity determinan desh. hosa opportunitie ve positive idend payo ity, free cas er empirical respective c ing from 20 n journal of f dividend p d free cash ntrast to fir et.al. (2015 change rev growth, cur rms ‘growth l (2013). st bility, firm dividend pa eral of the k e uae com ursement of out that a ce possession s ment. the st stly influen 2012) estab bility and co e time esta flow per sha nd market to haka stock ficant relat e relation w ed by the si y, company ts of divid in (2016). es, size, pro relation wit out ratios an sh flow, ma research. t company w 014 to 2017 finance & ac issn 19 2021, vol. 1 ajfa.macro payout ratio flow, with rms with m 5). a study veals that d rrent earnin h activities tudies cond m size, net ayout. fred known deter mpanies. siz f uae firms ertain perce significantly tudy further nced by the blished a orporate tax ablished a n are. the va o book valu k exchange tion with li with levera ize of the fi y growth, pr dend payou studies co ofitability, b th dividend nd factors market capita the data is g websites as 7. the meth ccounting 946-052x 13, no. 2 think.org/ o differs h larger, ore debt done on dividend ngs, and institute ducted in income, dynandy. rminants ze of the s, mehta entage of y impact r reveals e firm’s positive x and its negative ast bases ue ratios limited iquidity, age and irm, risk receding t of the onducted business d payout such as alization gathered well as hodology the prim five in leverag and whe 4.1 hyp ha1: k importa towards increase (1986) cash fl subsequ relation policy. ha2: ac to finan means finance to sugg more of evidenc availabl ha3: st thomas policy. lamont ratio. b positive terms o ha4: a leverag faccio existenc dividen with an measure ha5: th been ev malkaw dividen mary aim o dependent e, firm size ether any re pothesis wa kanwal & k ant factors s the fact th ed dividend argued that ows potent uent empiri nship betwe ccording to nce its new followed by is consider est that hig f their prof ce, the pec le investme tudies by li s (1998) po mcmanus, t (1998) ev based on the e relationsh f net profit a firm’s div e, crutchle & lang (2 ce of levera nd payout ra n assumptio ed in terms he establish videnced by wi (2008), a nd policy. je of the paper factors we e. these fac elationship e as written b kapoor (200 affecting d hat firms wit ds as compa t as evidenc tially pays cal evidenc een compan myers and w investmen y available red as first gh-growth fi fits as comp cking order ent opportun itzenberger oints towar , gwilym & vidence a p ese empiric hip between after tax to vidend pol y & hanse 2002) al m age ratio as atio. consid on of a relat of total liab hment of a p y several r and manos ( ensen, solb is to find th ere chosen ctors were te existed betw based on st 08), ahmed dividend po th more acc ared to firms ced by the a more divi ces this stu nies’ liquidit d majluf’s, 1 nt opportuni external so priority foll irms typical pared to fol r hypothesi nities and di & ramasw rds a positi & thomas ositive corr cal evidence n dividend total equity icy is nega n (1989). j malkawi (2 statistically ering these tionship bet bilities to to positive rela researchers. (2001) estab erg and zor 111 he determin namely li ested to che ween them. tudy questi d & javid ( licy. resea cessibility to s with insuf agency theo idends. bas udy postulat ty, measure 1994 peckin ities using ources if ne lowed by e lly require h llowing hig is points to ividend pay wamy (1979 ive correlat (2004) fur relation bet es this spec policy and y. atively imp jensen et al 2007). als y significan empirical e tween divid otal equity. ationship b . fama and blished a po rn, (1992), asian nants of divi iquidity, in eck their rel ons as follo (2009) state arch conduc owards cash fficient cash ory of cash sed on the tes the first ed in terms ng order hyp internal sou eeded. amo equity finan heavy inves h payout po owards a n yout ratio. 9, 1982), baj tion betwee rther reinfo tween stock cific study h the firms pacted by i l., (1992), a so, studies nt but negat evidences th dend policy etween divi d french (2 ositive relat fama and f n journal of f idend policy nvestments, lation to div ows ed that liqu cted by ho h has a grea h. additiona flow of firm se above r t hypothesis of current pothesis firm urce of fina ong the ext ce, this theo stments and olicy. based negative rel ajaj & vijhs en stock ret orced this f k returns an hypothesize return on e its existing agrawal & by al kuw ively assoc his study dev y and firm’s idend policy 2002), al k tionship bet french (200 finance & ac issn 19 2021, vol. 1 ajfa.macro y. for this r return on vidend payo uidity is on o (2003) po ater potentia al studies by ms that hav researches s stating a ratio and d ms generall ance as a p ternal sourc ory further d thus tend t d on this em lationship b s (1990), m turns and d finding. stu nd dividend es an existen equity meas level of f jayaraman uwari (2009 ciated with n velops a hy s financial l y and firm kuwari (20 tween firm 01) found th ccounting 946-052x 13, no. 2 think.org/ research, equity, out ratio e of the oints out al to pay y jensen e higher and the positive dividend ly intend preferred ces, debt goes on to retain mpirical between organ & dividend udies by d payout nce of a sured in financial n (1994), 9) found negative ypothesis leverage size has 009), al size and hat large firms d contras negativ dividen relation logarith div = α where div = dividen α= inter 1. liq 2. inv 3. ro 4. le 5. siz εi= erro 5. find 5.1 emp in the f exchang study hy 5.2 des table 1 div sho in divid highest roe h closely distribute a sting studie e relationsh nd. based on nship betwe hm of total a αi + b1liq : dividend p nds. measure rcept q= current v= market t oe= return o ev = leverag ze= natural or term. dings pirical stud following s ge was take ypothesis. scriptive sta 1 presents th ows that av dends as a standard de has obtained to its mean higher am es by amid hip between n these abov een the firm assets. + b2inv+ payout ratio ed by dividi ratio (curre to book rati on equity (n ge (total liab l logarithm dy ection of th en run throu atistic he descripti 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ajfa.macro s than smal id (2008) firms payin othesizes a in terms of arnings paid e. ity) n the korea study and ve alysis. the m 999) of its e ables, lev mean (1.021 ata are bunc ccounting 946-052x 13, no. 2 think.org/ ll firms. found a ng lesser positive f natural d out as an stock erify the mean of earnings has the 1). the ched up    d ra li in r le s table 1 va r s table 2 table 2 dividend  p atio  iq  nv  roe  everage  ize of the fi multip table 3 value of . ariable  m div  0. liq  2. inv  0. roe  0. lev  1. size  12 2 presents th 2. div pa rat payout  1  0.0 ‐0. 0.0 0.0 irm  ‐0. le regressi anova     regressio residual  total  3 presents th f the rsqu mean  med .345  0.2 160  1.6 059  0.0 .064  0.0 .021  0.7 2.729  12.4 he pairwise vidend  ayout  tio  c r   014  1 .028  ‐0 007  0 015  ‐0 .018  ‐0 ions df  n  5  194  199  he regressio uared and ad dian  std. d 06  1 16  1 03  0 63  0 37  1 472  1 correlation current  atio  1  0.133  0.128  0.348  0.072  ss  1.87286424 793.180908 795.05377 on results o djusted r-sq 113 deviation  1.999  1.435  0.201  0.096  1.533  1.226  coefficient inventor ratio      1  0.080  ‐0.001  ‐0.182  ms  45  0.3745 88  4.0885 3    of the study quared are 0 asian variance  3.995  2.058  0.040  0.009  2.352  1.503  of all the v ry  roe       1  ‐0.53 0.07 f  573  0.091 561      y. the resul 0.002 and -0 n journal of f minimum ‐10.420  0.505  0.000  ‐0.717  0.107  10.624  ariables use e  lever         38  1  75  0.047 sign 615  0.99 lts in table 0.023 respec finance & ac issn 19 2021, vol. 1 ajfa.macro m  maximu 17.39 9.072 1.188 0.425 18.45 16.41 ed in the stu rage  size           7  1  nificance f  93479807      e 3 indicate ctively. ccounting 946-052x 13, no. 2 think.org/ um  5  2  8  5  4  1  udy e of the firm that the m     inte liq  inv  roe leve size firm table 3 ercept  e  erage  e of the  m  the res relation 6. conc the obj south k not dep firm siz the infe findings duration policy b referen agrawa test of http://dx ahmed 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(1994). t w theory. m e.409015020 (2008). d rachi stock 09). dynami k exchange omics, 29, 1 114 p‐value  0.627  0.825  0.661  0.737  0.680  0.722  ression stat  square  rror  ons  inv, roe mine the fact by the resu vestment op ere listed on mited and th future, more search may ndustry. the dividen managerial 06 dynamics a k exchange. ics and dete e non-finan 110–125. asian lower 95% ‐2.352  ‐0.189  ‐1.783  ‐2.954  ‐0.184  ‐0.281  tistics  0.049  0.002  ‐0.023  2.022  200  e, lev an tors that inf ults, the divi pportunity, n the south here are po e sample c y be done co nd policies and decis nd determ . mpra pa erminants o cial listed n journal of f %  uppe 95%  3.893 0.237 1.133 4.171 0.282 0.195 d size hav fluence the idend decisi return on eq korea stoc ossible chan companies s onsidering of all-equi sion econom inants of d aper no. 37 of dividend firms. inter finance & ac issn 19 2021, vol. 1 ajfa.macro er  lower 9 3  ‐2.352  7  ‐0.189  3  ‐1.783  1  ‐2.954  2  ‐0.184  5  ‐0.281  ave an insig dividend p ions of the quity, lever ck exchange nces for ad spanning in factors of d ity firms: a mics, 15, 1 dividend p 7342, unive policy in p rnational r ccounting 946-052x 13, no. 2 think.org/ 95.0%  up 95 3.8 0.2 1.1 4.1 0.2 0.1 gnificant policy of firm do rage and e, hence dditional ncreased dividend a direct 139-148. olicy in ersity of pakistan: research pper  .0%  893  237  133  171  282  195  akhtar, an i https://d al-deeh econom https://d al-hasa share p https://d al-kuw the cas al-malk applica 44-70. h al-malk from jo 178-195 al-malk an app alzoma from sa amidu, journal awad, journal baker, nyse f black, https://d crutchl owners 36-46. h dai, j http://lu , shumi. (2 internationa doi.org/10.1 hani, talla. mic doi.org/10.1 an, m. a., a price: an e doi.org/10.9 wari, d. (20 se of gcc c kawi, h. a ation of the http://dx.do kawi, h. a ordanian p 5. kawi, husa plication of aia, t.s. & audi arabia , m., & ab l of risk fin b. 2015. d l of busines h. and pow firms. finan f. (1976) doi.org/10.3 ley, c. e., ship, corpo http://dx.do j. ringbo up.lub.lu.se/ 017). divid al study 1111/acfi.12 (2003). de and 1108/10264 asaduzzama evaluative s 9790/5933-0 009). determ countries. g a. n. (2007 e tobit mo oi.org/10.110 a. n. (2008 anel data. am-aldin. ( the tobit m al-khadhi a. internatio bor, j. (200 nance, 7(2), determinants ss and mana well, g. (20 ncial practi . the div 3905/jpm.19 & hansen, orate levera oi.org/10.230 rg, f. (2 /student-pap dend policie . a 2135 eterminants administ 116200300 an, m., & k study. iosr 0140611 minants of global econ 7). determi del. journa 08/1026411 ). factors i internation (2009). det model. journ ri, a. 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(2013). th of econom nd policy in finance jou orporate d omic and a 07 corporate al of busin of corporat nomic and a ination of d ss and socia dividend p org/10.1108/ in kuwait s 72-78. corporate 29), 1082-06 nal of por st of the a ividends. f of div n journal of f l and dome finance, the case of es, he effect of mics and fi n emerging urnal, 2(2), ividend po dministrativ dividend d ess and m te dividend administrati dividend po al science, 4 payout rat /152659406 stock exch dividend p 698. rtfolio man agency the financial m idend pol finance & ac issn 19 2021, vol. 1 ajfa.macro estic corpor 57, 3 kuwait. jo 19, f dividend p inance, 1(4 g stock exc 38-63. olicy in jord ve sciences decision: e management d policy in ive sciences olicy: the e 4(1), 181-19 tios in gha 610648580 hange. intern policy: a su nagement, eory of ma management licy in s ccounting 946-052x 13, no. 2 think.org/ rations – 319-349. ournal of 59-76. policy on ), 6–66. changes: dan: an s, 23(2), evidence t, 13(2), jordan: s, 23. evidence 92. ana. the national urvey of 2, 5-8. anagerial t, 18(4), sweden. echchab tunisia auditing faccio, corpora https://d fama, e dividen http://dx farooq, the m https://d gill, a payout https://d gordon statistic interna https://d hosain, private of econ iv (sep issa, ay researc jensen, owners 27(2), 2 jensen, owners 27(2), 2 julian b from l https://d kanwal informa 63-71. bi, abdelgh a: insights i g studies, 2 m., & la ations. doi.org/10.1 e. f., & fre nds and x.doi.org/10 , omar & j mena re doi.org/10.1 marjit & b ratios: e doi.org/10.2 n, m. j. 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(2010 the open stock price end policie c rese dend payou nge limited 321-5933, p d policy: ev ). simultan al of financ ). simultan al of financ 2016). divid ters, 17, dividend p rch journal n journal of f s of dividen l of accoun nership of mics, 65 ecking orde studies, vidend poli research, 0). determi business e. review es in aus earch, ut policy: a in banglad p-issn: 232 vidence from eous determ cial and qu eous determ cial and qu dend payout 197-210, ayout ratios of finance finance & ac issn 19 2021, vol. 1 ajfa.macro nd payout r nting, fina western e 65(3), 3 er prediction 15(1), icy: eviden 31, 163 inants of d journal, 3 of econom stralia and 9(2), a study on desh. iosr 21-5925. 7( m malaysian mination of uantitative a mination of uantitative a t policies: e issn 154 s: a study o and econo ccounting 946-052x 13, no. 2 think.org/ ratios in nce and european 365-395. ns about 1-33. nce from 37-1644. dividend 3, 8-14. mics and d japan. 91–100. n listed journal (5). ver. n firms. f insider analysis, f insider analysis, evidence 44-6123, of indian mics, 15, king’w finance kisava, policy researc kumar, from gc labhan ratio: https://d lease r impact litzenb prices https://d lintner earning manos. phd th mcman the rel and acc mehta, evidenc miller, of share morgan equity https://d murhad price. s musieg of divi kenya. nabaraj econom wara, r. 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(2012 nge (kse). j e, p. j. c. doi.org/10.1 ntx (2012 l of busines j, & adu tional journ doi.org/10.5 . revisiting nal of busin rian & eze dividend pa economic se imalathasan hotels and pective, 2(6 2). determin journal of c (1978). a 1080/10293 2). determi ss, economi usei, c (2 nal of econ 5539/ijef.v8 g the dete ness and so eabasili, vin ayout of c eries, 18, 14 n. (2013). d restaurants 6), 16-22. nants of di contempora review of 523.1978.1 inants of d ics and law 2016). divi nomics and f 8n6p63 118 erminants cial science ncent & al onsumer g 41. https://d dividend po s in sri la ividend pay ary issues in factors af 1082613 dividend po w, 1, 48-57. idend polic finance, 8( asian of dividen e, 5(8(1)), 2 lajekwu, u goods firms doi.org/10.2 olicy ratios anka. globa yout ratio: n business r ffecting the licy: the c cy decisio (6), issn 1 n journal of f nd payout 230-238. doka. (2018 s in nigeri 6458/1816 and firm pe al journal evidence fr research, 1 dividend p ase of viet on across a 916-971x e finance & ac issn 19 2021, vol. 1 ajfa.macro ratios in 8). analysi ia. annals o erformance of comme from karach 1(1), 20-27. policy of th tnam. inter african co e-issn 191 ccounting 946-052x 13, no. 2 think.org/ ghana. is of the of spiru : a case erce and hi stock he firm. national ountries. 16-9728. microsoft word 15640-56259-1-sp-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 81 cash conversion cycle and profitability evidence from jordan manar al-mohareb mba accounting, business faculty, university of jordan zip code 11710, na'ur, amman, jrdan tel: 96-27-9583-4507 e-mail: manar.moharib@yahoo.com received: august 21, 2019 accepted: nov. 4, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15640 url: https://doi.org/10.5296/ajfa.v11i2.15640 abstract this study investigates the impact of working capital management and its components on profitability as a practical aspect, and how is compatible with the theoretical aspect. besides, it examines other financial factors that may affect profitability by using a sample of jordanian manufacturing firms listed in the amman stock exchange for the period (2016-2018). theoretically, manufacturing firms that have been studied have current assets over half of their total assets. therefore, the working capital management role will be clearer on firm profitability. practically, the results indicate that there is a significant relationship between the cash conversion cycle, which is considered as a proxy of working capital management, and profitability of the manufacturing firms. this provides an opportunity to create value for shareholders by decreasing receivable accounts and inventory, enhancing the profitability of the firms and reducing the collection period and by adopting effective credit policy. keywords: cash conversion cycle, components, profitability, working capital management asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 82 1. introduction almost firms around the world seek to increase profitability to maximize shareholders wealth. thus, their managements traditionally focus on how to make typical financial decisions to ensure the financial soundness of a firm, which includes both the financial position and economic performance. working capital management is the most important aspect of the economic performance of a firm that contributes to enhancing profitability and providing directly liquidity to the firm (chary & kumar, 2011). in theory, planning and controlling current assets and liabilities are considered as responsibilities of efficient working capital management that contributes to eliminating the inability risk of the meeting short-term obligations and to avoiding excessive investment in these assets (eljelly, 2004). according to alipour (2011), the definition in the literature that best describes the effective working capital management is: "increasing cash flow speed, decreasing irrecoverable receivables and decreasing the costs to create opportunities to maximize the wealth". according to this definition, working capital management also requires making a trade-off between risk and return. it is known that the nearer the asset to the cash state the lower its riskiness and the lower its expected return. according to (trinh, 2011), short-term finance is related to patterns of cash inflows and outflows that are both unsynchronized and uncertain. short-term operating activities represent both the operating cycle (oc) and a cash conversion cycle (ccc). the oc is the interval between the order of inventory stock and the date when cash is collected from receivables. in addition, the ccc begins when the company pays cash to suppliers for the materials purchased and ends when cash is collected from customers for credit sales. alternatively, the ccc is the sum of the inventory period (ivp) and accounts receivables accounts period (rvp) subtract accounts payable period (pyp) as follows: ccc = oc pyp (1) ccc = (ivp + rvp) pyp (2) cash conversion cycle (ccc) is a performance indicator of working capital management efficiency, measuring the number of days that funds are committed to inventories and accounts receivable minus the number of days that payment to suppliers is deferred (gitman, 1974). the objective of working capital management is to maintain the optimum balance of each receivable, inventory and payable accounts that influence firm performance (filbeck & krueger, 2005). with the leaving other things constant, level of investment in current assets has a bearing on the profitability of the firm. excess of investment in working capital has a negative impact on the profitability of a firm and positive impact on the liquidity (van horne & wachowicz, 2006). when the ccc has a positive influence on company profitability due to a chain of positive asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 83 impacts of ivp and rvp with a negative impact of pyp on company profitability. the longer the ivp, the lower the cost involved in procrastinating of goods and/or service supply. in the same time, the longer the rvp, the higher credit sales earned. in addition, the lower the pyp, the higher reputation earned for borrowing opportunities. in contrast, shortening ccc could harm the company profitability. the company could face inventory shortages as reducing inventory conversion period, lose good credit customers as reducing rvp, and hamper its credit reputation as lengthening the pyp (trinh, 2011). this logic is consistent with the definition contained of working capital management. profitability, which each firm seeks to achieve it, is measured with income and expenses. income is money from the company's activities. however, some activities like borrowing money do not create income. in contrast, expenses are the cost of resources used up or consumed by the activities of the business. profitability can be defined as either accounting profits or economic profits (ross et al. 2010) as follows: • accounting profits traditionally provide a clear view of the viability of the business. although one year of losses may not harm the business, years of losses may jeopardize the viability of the business. • economic profits provide a long-term view of the business to examine whether you want to continue the business. increasing profitability is one of the most important tasks of business managers to maximize shareholders wealth. without profitability, the business will not survive in the end. therefore, measuring current and past profitability and expecting future profitability is very important (debi'e, 2011). on the other hand, many economists, researchers and managers seek to examine other financial factors, which may have influence either positively or negatively on firms' profitability. several empirical studies have either examined the relationship between working capital management and profitability as a main independent factor affecting the profitability (e.g., deloof, 2003) or have studied other financial factors that showing the impact on profitability (e.g., burja, 2011) such as: debt ratio (lev), fixed assets ratio (far), expenses revenue ratio (err) and firm size (fs) . however, few empirical studies have addressed this relationship in jordan (debi'e, 2011). this study is complementary to prior studies by showing the theoretical aspect of working capital management, examining empirical aspect about the effect of working capital management on profitability for manufacturing firms of jordan and exploring other financial factors that may have an impact upon profitability. according to shin and soenen (1998), working capital management's efficiency can have a significant effect on a company's liquidity and profitability. for the liquidity, lacking working capital can account for inefficiencies in a company operation when it is not able to pay off its due obligations and it will not be able to provide goods or services required to customers due to a lack of money. the company profitability can be jeopardized as results (tring, 2011). sometimes, the firms do not have a clear policy of managing their working capital where they focus on the liquidity more than profitability in order to meet their obligations, especially, they asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 84 concentrate on reputation earned for borrowing opportunities that may ensure financing resources as it needed. in the business environment of jordan, it may notice the lack of financial awareness and ability to build a perspective strategy due to unclear policy of managing working capital. theoretically, the variables, together with theoretical their predictions and the direction of their influence, are related to profitability. this study contributes to the literature on the relationship between the cash conversion cycle (ccc), which is a proxy of working capital management, and the firm’s profitability in jordan by determining the relationship between ccc and profitability in manufacturing firms of jordan to find out the shortcomings in this relationship. accordingly, the problem statement is: • what is the effect of ccc on profitability of jordanian manufacturing firms listed in ase during (2016-2018)? after achieving the first objective, i can move to the second one through the need to identify the effect of each component of the cash conversion cycle (ccc) on manufacturing firms according to the business environment of jordan. the problem statement is: • what is the effect of each components of ccc on profitability of jordanian manufacturing firms listed in ase during (2016-2018)? finally, this study seeks to identify the effect of other financial factors on profitability of manufacturing firms of jordan. accordingly, the problem statement is: • what is the effect of other financial factors on profitability of jordanian manufacturing firms listed in ase during (2016-2018)? the importance of this study lies in the knowledge of the relationship between working capital management and profitability for manufacturing firms of jordan and identifies the role of other financial factors influencing profitability. the manufacturing sector has been selected because, for one thing, the current assets of the manufacturing firms are over half of its total assets. therefore, the influential role of working capital management will be clearer on firm profitability. for this reason, i have excluded both service and financial sectors because working capital management does not have a large proportion of total assets that could affect profitability explicitly. i can define the research objectives through these main points as following: • to examine the effect of the cash conversion cycle (ccc) on profitability for jordanian manufacturing firms. • to examine the effect of working capital management components on profitability for jordanian manufacturing firms. • to examine the effect of other financial factors on profitability for jordanian manufacturing firms. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 85 this study is motivated by the fact working capital management is very important part of firm's annual financial statement and of significant important to investors, creditors and other users of financial statements. most prior related studies were carried in developed economies. this study shows the theoretical aspect of working capital management examines empirically the effectiveness of working capital management on profitability for manufacturing firms of jordan and finds out other financial factors that have an impact upon profitability. however, i should look at another side including the empirical studies related to the research issue to see how each match of the theoretical and empirical sides in jordanian environment. 2. literature review & previous studies paul and mitra (2018) examined the impact of working capital management on the profitability of the firms of the indian steel industry. the result of the study indicates that the impact of working capital management on the profitability of the firms of the indian steel industry has been significant. boțoc and anton (2017) examined the relationship between working capital management and firm profitability. the findings indicate that the firms should maintain the optimal working capital level that maximizes their profitability. bhatia and srivastava (2016) investigated the relationship between working capital management and firm performance in an emerging market in india. they observed a negative association between working capital management and firm profitability, indicating the need to manage working capital efficiently in order to improve profitability. nasreen et al. (2014) pointed out a significant impact between working capital management and profitability of firms in pakistan. makori, d. & jagongo (2013) indicated a negative association between profitability and number of day’s accounts receivable and cash conversion cycle. in contrast, there is a positive association between profitability and number of days of inventory and number of day’s payable. tufail (2013) investigated the impact of working capital policies on profitability. findings are that aggressiveness of working capital management policies is negatively associated with profitability. moreover, liquidity and size of the firm have positive relation profitability whereas debt to equity ratio is negatively correlated with profitability. mestrado (2013) investigated the relationship between working capital management and firm profitability for portugal. he found that there is a concave relationship between working capital management and profitability, indicating that firms have an optimal working capital level where firms should stand to maximize profitability. arshad and gondal (2013) examined the empirical impact of the relationship between working capital management and profitability of pakistan cement sector. they found that there is a significant negative relationship between working capital management on the profitability of the firms. thuvarakan (2012) examined whether the working capital components trade receivable, inventories and trade payable are affecting the gross operating income of firms listed on the london stock exchange (lse). they found that there is a negative relationship between the profitability of the firms and working capital components. however, there is no significant relationship between the working capital components receivable days, payable days, inventory days, cash conversion cycle and profitability of the firm. rehn (2012) investigated of how working capital management can add to corporate profitability and shareholders' value through the cash conversion cycle as a proxy asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 86 of working capital management and two variables of profitability in finnish and swedish corporations. he found that this is significant evidence that by effectively managing each part of working capital, a company can increase the net present value of its cash flows, thus adding to shareholder value. chary and kumar (2011) focused on the relationship between profitability and working capital management. they found that current assets with a larger proportion in total assets have shown a high degree of negative correlation and the current assets with considerable proportion in gross working capital have shown a moderate degree of correlation with the profitability confirms the theory that excess of working capital results in low profitability. alipour (2011) examined the relationship between working capital management and profitability depending on cash conversion as a measure to calculate the efficient working capital management. he found that there is a negative significant relationship between the number of day's accounts receivable and profitability, a negative significant relation between inventory turnover in days and profitability, a direct significant relationship between the number of day’s accounts payables and profitability and there is a negative significant relationship between cash conversion cycle and profitability. al-debi'e (2011) examined the relationship between profitability and working capital management measures for industrial companies listed on ase. he found that there is a significant relationship between working capital management and profitability. teruel and solano (2004) provided empirical evidence about the effects of working capital management on the profitability on the spanish firms. by using multiple regression, they demonstrated that managers can create value by reducing their firm’s number of days accounts receivable and inventories. it also improves the profitability of the company by shortening the cash conversion cycle. deloof (2003) investigated how working capital management can influence the profitability of belgium firms. he observed that there is a significant negative correlation between gross operating income and number of day's receivable accounts, inventories, and accounts payable in belgium. in order to create value for shareholders, he suggested reducing the number of day's accounts receivable and inventories to a reasonable minimum. 3. hypotheses of research through the theoretical perspective, it lies on the certainty about the presence of a relationship between the working capital management and the firm profitability with staying other variables constant. as i mentioned earlier by explaining the ccc that is the main performance criterion of effective working capital management. the ccc begins when the company pays cash to suppliers for the materials purchased and ends when cash is collected from customers for credit sales. the first hypothesis including all components of ccc as measure of working capital management is: h01: the ccc has no relationship with profitability of jordanian manufacturing firms listed in ase. since the ccc is based on three key components. where the ccc is the sum of the ivp and rvp subtract pyp. it must be hypothesized that each component has a relationship with the firm profitability (melicher & leach, 2009; huuynh & vergeer, 2011) as followed: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 87 h02: each component of ccc has no relationship with profitability of jordanian manufacturing firms listed in ase. company performance's information, primarily about its profitability is invaluable in substantiating management decisions about potential changes in economic resources that will allow the firm to achieve superior economic results that will improve the competitiveness of the firm and satisfy the interests of shareholders. several studies have addressed other financial ratios that may have an impact on profitability (burja, 2011). exclusively and not inclusively, i have used some financial ratios as factors that may have the effect or not on profitability. thus, the second hypothesis is: h03: the financial factors have no relationship with profitability of jordanian manufacturing firms listed in ase. 4. research methodology the research population that consists of jordanian manufacturing firms listed at ase during the period 2016-2018 was characterized by heterogeneity within firms. of the 63 companies, only 38 were extracted. the sample that has been employed after adjusting its extreme values is characterized by more homogeneity among firms. i have excluded both service and financial sectors because working capital management does not have a large proportion of total assets that could affect profitability explicitly. in addition, i have used the annual financial statements published on the website of ase to compute the study variables. 4.1 measurement of variables the cash conversion cycle (ccc) was propounded by hager (1976) and it was used by many researchers (thuvarakan, 2012). the correct policy of working capital management is minimizing the time between expenses for getting inventory and cash reception resulted from selling it (banomyong, 2005). the ccc is the sum of inventory period (ivp) and accounts receivables period (rvp) subtract accounts payable period (pyp) as mentioned earlier in the equation (2), where ivp = (average inventory / annual cost of goods sold) × 365 (3) rvp = (average receivables / annual sales) × 365 (4) pyp = (average payables / annual cost of goods sold) × 365 (5) for profitability, the return on assets (roa) indicator expresses the company’s ability to generate profit because of the productive use of resources and efficient management. roa is employed in many prior studies as a proxy for performance (e.g., tufail, 2013): roa = net income / average total assets (6) decision making in maximizing profitability is very much susceptible issue to all firms due to its internal and external effects on firms. several empirical studies have either examined the relationship between working capital management and profitability as a main independent asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 88 factor affecting the profitability (deloof, 2003) or examined other financial factors that showing the impact on profitability (burja, 2011) such as: debt ratio (lev), fixed assets ratio (far), expenses revenue ratio (err) and firm size (fs) as follows: lev = total debt / total assets (7) far = fixed assets / total assets (8) err = operating costs / operating income (9) fs = log of total assets (10) 4.2 the general research model the following model the must be tested the relationship between working capital management (wcm) and other financial factors related to wcm having impact upon profitability is: roa = α+ β1 (wcm) + β2 (lev) + β3( far) + β4 (err) + β5 (fs) + ε 5. analysis and results as i mentioned before, the research population that was characterized by heterogeneity within firms consists of jordanian manufacturing firms listed at ase during the period 2016-2018. of the 63 companies, only 38 were extracted. even the sample that has been employed has been adjusted by treating its extreme values through demonstrating the 1.5 iqrs to be more homogeneity among firms. table 1. descriptive analysis variables mean std. deviation roa -0.019 0.060 ivp 206.897 168.105 rvp 120.756 93.306 pyp 86.442 33.714 ccc 249.730 182.590 lev 0.412 0.332 far 0.413 0.212 err 1.157 0.905 fs 7.292 0.634 table (1) presents descriptive statistics for 38 manufacturing firms of jordan in the period of three years from 2016 to 2018, and for 114 observations. results of descriptive statistics in the table (1) indicate that the mean value of roa is 1.9 %, and the standard deviation is 6%. it means that the value of the profitability can deviate from mean to both sides by 6%. the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 89 average of inventory period (ivp) for firms is 207 days which shows that firms take on average 207 days from purchasing the inventory and converting it into sales. average of accounts receivable period (rvp) values is 121 days, which shows that firms receive their receivables from customers company through four months, which is considered a relatively long period. mean value of accounts payable period (ivp) for the firms on average is 86 days, which indicates that on average firm, pays to its creditors after 86 days. the mean value of the cash conversion cycle (ccc) is 250 days to convert the firm's inventory into cash flows from sales. for the firm size (fs)'s descriptive analysis, the mean value of log of sales is 7.29 while the standard deviation is 0.63. for the leverage (lev)'s descriptive analysis, the mean value of financial leverage is 0.41 while the standard deviation is 0.33. for the fixed assets ratio (far)'s descriptive analysis, the mean value of fixed assets ratio is 0.41 while the standard deviation is 0.21. for the operating expenses to operating income ratio (err)'s descriptive analysis, the mean value of expenses revenue ratio is 1.16 while the standard deviation is 0.91. table 2. pearson correlation variables roa ivp rvp pyp ccc lev far err fs roa 1 p-value ivp -.585** 1 p-value 0.000 rvp -.290** -0.045 1 p-value 0.002 0.638 pyp -0.073 0.039 .246** 1 p-value 0.443 0.68 0.008 ccc -.661** .839** .431** 0.03 1 p-value 0.000 0.000 0.000 0.75 lev -.342** .207* 0.152 -0.016 .259** 1 p-value 0.000 0.027 0.105 0.863 0.005 far -.227* 0.158 -0.066 -0.157 0.122 .297** 1 p-value 0.015 0.093 0.487 0.095 0.196 0.001 err -.266** 0.065 .285** .192* .218* .222* .368** 1 p-value 0.004 0.491 0.002 0.041 0.02 0.018 0.000 fs 0.173 -0.126 -.238* -0.022 -.243** -0.066 -0.117 -0.174 1 p-value 0.066 0.182 0.011 0.812 0.009 0.482 0.215 0.063 significant at 5% * and significant at 1%** asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 90 in table (2), i have assessed the nature and amount of association between the variables of the study and the profitability proxy (roa) through pearson correlation coefficients of the selected manufacturing firms. the results describe a high level of significant negative relationship between ccc, ivp, rvp and the measure of profitability (roa). the significant association between roa and ccc reveals that the profitability of most of the manufacturing firms of jordan increased with the decrease in ccc and vice versa ( p < 0.01). in details, the table describe that the coefficients of both inventory period (ivp) and accounts receivable period (rvp) were negative and statistically significant at 1% ( p < 0.01), while the coefficients of accounts payable period (pyp) was negative and insignificant at either 5% or 1% respectively for roa. here, the results suggest that the relationship between roa and account receivable period (rvp) in the majority of the manufacturing sector were adversely related to each other. this gives the impression that the shorter the inventory period (ivp) of the company, the shorter the accounts receivable period (rvp), the higher the firm profitability (roa). in contrast, there is no relationship between roa and accounts payable period (pyp). firms focus on the liquidity more than profitability in order to meet their obligations, especially, they concentrate on reputation earned for borrowing opportunities that may ensure financing resources as it needed. to assess other control variables quickly, the coefficients of both leverage (lev) and operating costs to operating income ratio (err) were negative and statistically significant at 1% ( p < 0.01). while the coefficients of fixed assets ratio (far) was negative and statistically significant at 5% for roa ( p > 0.05). in contrast, there is no relationship between firm size (fs) and profitability (roa). regression analysis is used to find the impact of independent variables on dependent variables. in this study, working capital management that represents the cash conversion cycle (ccc) and its components separately are taken as independent variables, in general, and firm profitability is considered as a dependent variable. each hypothesis is tested using regression analysis. table 3. model summary a model r r square adjusted r square std. error of the estimate 1 .704a 0.495 0.457 0.043943 a. predictors: (constant), fs, pyp, lev, ivp, err, rvp, far, ccc b. dependent variable: roa in table (3), the value of r (correlation coefficient) that measures the strength of the relationship between variables is 0.704. it means that a strong relationship exists between ccc and roa. in addition, the value of r square measures that if the change occurs in independent variables (e.g., ccc), and how much dependent variable (roa) will change. the value of r square shows that 49.5% variability in the roa can be explained by the changeability in independent asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 91 variables used for measuring working capital management but does not know which variable this change happens. table 4. anova b model sum of squares df mean square f sig. 1 regression 0.199 8 0.025 12.867 .000a residual 0.203 105 0.002 total 0.402 113 a. predictors: (constant), fs, pyp, lev, ivp, err, rvp, far, ccc b. dependent variable: roa table (4) tells about the statistical significance of the whole model used in this study for measuring the impact of ccc (independent variable) and its components on the firm’s roa (dependent variable). value of f measures that either value of r square shown in table (3) is due the chance or not and term (sig.) refers to p-value which is used to measure the statistical significance, if p-value is less than 0.05 it indicates that working capital management as a whole has statistically significant impact on roa of firms. in the table (4), the value of f is 12.867 and the value of p is 0.000, which is less than 0.05 means that ccc as a whole has significant influence the roa firms. table 5. ols regression results model model 1 model 2 model 3 model 4 coeff p coeff p coeff p coeff p ccc -0.598 0.000 ivp -0.525 0.000 rvp -0.217 0.023 pyp -0.062 0.503 lev -0.146 0.054 -0.185 0.019 -0.246 0.008 -0.277 0.003 far -0.085 0.273 -0.018 0.825 -0.126 0.197 -0.089 0.373 err -0.074 0.338 -0.174 0.031 -0.09 0.359 -0.139 0.163 fs -0.005 0.944 0.062 0.405 0.074 0.407 0.118 0.186 r .695a .657a .461a .421a r² 0.482 0.431 0.213 0.177 f 20.136 16.385 5.832 4.647 sig. .000a .000a .000a .001a model (1) tests the hypothesis that the ccc has no relationship with the profitability of manufacturing firms in jordan. the regression results indicate that the coefficient of ccc is negative with -0.598, and p-value of ccc is 0.000 (p<0.05) which means that the ccc has a significant impact on the roa of firms in jordan. in addition, the overall model is statistically asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 92 significant, as it is indicated by the f-value of 20.136 with (p<0.01). the model’s adjusted r square implies that 48.2% of the variation in the profitability of the firms can be explained by the model. thus, ho1 hypothesis is rejected and is concluded that the ccc is statistically significant at 1% significance level (p<=0.01). model (2) tests the hypothesis that the ivp, which is one of ccc components, has no relationship with the profitability of manufacturing firms in jordan. the regression results indicate that the coefficient of ivp is negative with -0.525, and p-value of ivp is 0.000 (p<0.05) which means that the ivp has a significant impact on the roa of firms in jordan. thus, ho2 hypothesis is rejected and is concluded that the ivp is statistically significant at 1% significance level (p<=0.01). model (3) tests the hypothesis that the rvp, which is one of ccc components, has no relationship with the profitability of manufacturing firms in jordan. the regression results indicate that the coefficient of rvp is negative with -0.217, and p-value of rvp is 0.023 (p<0.05) which means that the rvp has a significant impact on the roa of firms in jordan. thus, ho2 hypothesis is rejected and is concluded that the rvp is statistically significant at 1% significance level (p<=0.05). model (4) tests the hypothesis that the pyp, which is one of ccc components, has no relationship with the profitability of manufacturing firms in jordan. the regression results indicate that the coefficient of pyp is negative with -0.062, and p-value of pyp is 0.503 (p>0.05) which means that the pyp has insignificant impact on the roa of firms in jordan. thus, ho2 hypothesis is not rejected and is concluded that the pyp is statistically insignificant at 1% significance level (p>0.05). control variables' values of regression beta coefficients have the direct or indirect impact of on the roe by giving a positive or negative value. some of them have either significance or insignificance impact on roe of the firm in the manufacturing sector in jordan. p-value of lev is 0.019, 0.008, 0.003 in model 2, 3 and 4 respectively, these findings show that the leverage (lev) has a significant impact on roe of the firm, therefore the third hypothesis is rejected on the basis of these findings. moreover, p-value err is 0.031 in model 2, these findings show that the operating expenses to operating income ratio (err) has a significant impact on roe of the firm, therefore the third hypothesis is rejected on the basis of these findings. in contrast, both fixed assets ratio (far) and firm size (fs) have an insignificant impact on roe of the firm. 6. findings & conclusions: this study investigates the impact of working capital management and its components on profitability as a practical aspect, and how is compatible with the theoretical aspect. in addition, it examines other financial factors that may affect profitability by using a sample of jordanian manufacturing firms listed in the amman stock exchange for the period (2016-2018). results indicate that working capital management that represents the cash conversion cycle has a significant impact on the profitability of firms in the manufacturing sector, therefore, the first asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 93 null hypothesis was rejected and the alternative hypothesis is accepted. the second null hypothesis was rejected and the alternative hypothesis is accepted because the results provide evidence that the components of the cash conversion cycle have a significant impact on the firm’ profitability. this finding indicates that the shorter the inventory period of the company, the shorter the accounts receivable period, the higher the firm profitability. in contrast, there is no relationship between the profitability and the accounts payable period. due to the firms focus on the liquidity more than profitability in order to meet their obligations, especially, they concentrate on the reputation earned for borrowing opportunities that may ensure financing resources as it needed. finally, the third null hypothesis was rejected and the alternative hypothesis is accepted because the results provide evidence that some of the financial factors have a significant impact on the firm profitability. this study is conducted in the manufacturing sector, future studies should be done within a large sample of jordan to provide robust evidence. references aeshad, z., & gondal, m. 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(2004). effects of working capital management on sme profitability. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 95 social science research network, pp. 1-22, electronic copy available at: http://ssrn.com/abstract=894865 thuvarakan, s. (2012). impact of working capital management on profitability in uk management industry. social science research network, pp. 1-50, electronic copy available at: http://ssrn.com/abstract=2345804 tufail, s. (2013). impact of working capital management on profitability of textile sector of pakistan. 3rd international conference on business management, punjab, lahore, pp. 1-29. https://doi.org/10.2139/ssrn.1663354 van horne, j., & wachowicz, j. (2006). fundamentals of financial management. pearson education, prentic hall, twelfth edition, 752 pages microsoft word 13106-47899-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 242 the role of political risk and financial development factors on sukuk market development of gulf cooperation council (gcc) countries arafat mansoor al-raeai islamic business school, college of business university utara malaysia, 06010 sintok, kedah, malaysia zairyzainol head of islamic finance and islamic economic islamic business school, college of business universiti utara malaysia, 06010 sintok, kedah, malaysia ahmad khilmy bin abdul rahim senior lecturer, islamic business school,college of business universiti utara malaysia, 06010 sintok, kedah, malaysia received: april 7, 2018 accepted: may 17, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.13106 url: https://doi.org/10.5296/ajfa.v10i1.13106 abstract the literature related to the financial management acknowledges the significant role that political risk play to determine the financial market development. further, financial system development (banking and financial markets) competes to provide long-term financing, and this competition might be positive or negative for each other. the aim of this paper is to propose a conceptual model/framework for investigating the role of political risk and financial market on sukuk market development in gulf cooperation council (gcc). gcc economies depend heavily on oil revenues which makes them subject to oil prices fluctuations. therefore, gcc’s governments should diversify their economies by looking for sukuk as an alternative source of financing, to cover their budget deficit, when the price of oil decreases, and reduce their reliance on oil, because sukuk has advantages compared to the conventional bond particularly in terms of less information asymmetry. the prior studies have mostly focused on firms' characteristics determinants of sukuk issuances but gave a little consideration to the role of country' characteristics on sukuk market development. this paper asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 243 proposes a framework to explain the political risk and financial markets determinants of sukuk market development with a focus on the gcc countries that have the largest region in terms of the islamic financial assets. it is anticipated that the outcome will support policymakers to improve the current state of sukuk market. keywords: sukuk, political risk, financial market, gcc asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 244 1. introduction several types of research have been carried out on the determinants of the development of capital market including both equity and debt market. hence, the determinants of the stock and bond market development were the subject of major theoretical and empirical studies in both developed and developing countries from the different perspective. on the contrary, the growing importance of sukuk markets around the world has recently opened a new avenue of research into the challenges and factors which the development of sukuk market is facing. nevertheless, there is relatively a very limited amount of literature focusing on sukuk market. though, this paper has not found any study on the role of political risk and financial market variables on sukuk market development in gcc countries. sukuk market is important to contemporary islamic economies. this is because it plays the role of a mediator between lenders and borrowers. thus, sukuk market might play a key role in economic development and support the gross domestic product (gdp) of countries. this can be done through the mobilization of savings and by channelling these savings to useful and islamic law compliant investments. several businesses and policymakers are viewing at the sukuk markets as a long-term financing source. since they are a mechanism of financing for the long-term and thanks to their investment diversification, they can finance potential projects in industry infrastructure, and agriculture (tariq & dar, 2007). kusuma and silva (2014) argued that as many countries tried to establish sources of long-term financing, sukuk appears to be the most relevant way of assisting such countries, expand the pool of capital for investment’s financing and reinforce growth. thomas (2007) further claimed that there is a huge potential for sukuk whose growth is largely dependent on the gulf cooperation council’s (gcc) and asia’s strong economic base. sukuk as significant players of islamic financial market operate in an external business environment, which is an interdependence of several factors related to a society that form and determine their activities. the external business environment is comprised of political, environmental, social, macroeconomic, financial, legal, and technological factors that impact and form the financial markets and institution’s activities. sukuk issuances are determined by these external business environment determinants which externally impact the financial strategies of corporations, including debt funding decisions. several countries are completely involved in efforts aimed at developing their domestic sukuk markets, but with diverse levels of success recorded to date. shahida and sapiyi (2013) highlighted that identifying the factors that determine the issuance of sukuk be it based on internal or by external incentives are noteworthy. accordingly, kusuma and silva (2014) pointed out that the current approaches adopted for the development of the domestic sukuk market vary significantly across countries, due to country-specific circumstances. furthermore, samoui and khowaja (2016) noted that countries trying for the promotion of their sukuk markets should foster the development of their institutions of governance by fighting corruption in the political system and improving the local investment environment to create an attraction for investors to hold sukuk securities. gcc region has long been an unstable and constantly changing region, but the u.s. invasion asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 245 of iraq in 2003, the region wide upheavals that began in 2011, the yemeni civil war that began in 2013, and the massive drop in petroleum prices and revenues that accelerated in 2015 have combined to increase risk at every level. these uncertainty associated with an unstable political environment may reduce investment and the pace of economic development. while the weakening in oil prices may have an adverse impact on islamic capital markets, the indicators shows that so as to overcome the budget deficit the gcc countries may opt for sukuk in bringing their infrastructural development which is expected to provide further impetus for the expansion of the islamic capital market (ayturk, asutay&aksak, 2017).further, chau et al. (2014) investigated the influence of political uncertainty instigated by the current civil uprisings on the volatility and integration of conventional and islamic stock market indices in the mena region of the arab world. the findings show significantly rising volatility in islamic indices over the political turbulence period, while there is a little or insignificant influence of uprising on the volatility of conventional markets. the effect however has spread to other countries in the same region including the wealthy countries in the gcc who should be less affected by arab spring.therefore, the impacts of political risk on sukuk market still ambiguous. furthermore, the gcc region can be characterized as one of the largest islamic banking markets in the world, and its huge supply of savings and strong investment demand might be generally furnished through its banking system. this results in total dependence on the banking system rather than the sukuk market. therefore, whether the credit market is bank-oriented should have a bearing on sukuk. further, banks and sukuk markets compete in providing finance, and well-developed banking systems can deprive sukuks of market share.further, nagano (2010) found that issuance of the sukuk improves the stock returns of the issuers and total factor productivity, and this empirical finding recommends that preference is given to islamic bond issuance due to this exclusive benefit that standard external finance is unable to provide. thus, to uncover how this factor affects sukuk markets, the further empirical investigation becomes necessary. the tendency of recent studies is to focus on the firms’ characteristics and their impact on the choice decisions of bond or sukuk issuance in the firm's finance structure. however, the influence of political risk and financial development factors on sukuk market development has remained vague and not fully understood because of lack of the studies. this paper tries to fill the gap by offering a model that can be utilized to explain this research issue and makes an addition to the literature through explaining the relationship between political risk and financial development variables and sukuk market development in gcc countries. the paper proceeds as follows: section 2 concentrates on the "sukuk". section 3 discusses various literature related to political risk and financial market and sukuk market development. section 4 offers the expected policy implications. section 5 offers some conclusions. 2. what is sukuk? sukuk (plural of sakk) are explained as islamic bonds, literarily denote islamic type of investment certificates that are likened to conventional bonds. issuances of sukuk and islamic banking are two of the most famous and broadly accepted shariah-compliant asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 246 practices in the industry of islamic finance where islamic banks are considered as conventional bank’s counterparts and sukuk offers the shariah-compliant type of conventional bonds. sukuk, usually recognized as islamic bonds, is an investment certificate which follows islamic law. aaoifi (accounting and auditing organization for islamic financial institutions) (2010) describes sukuk as “certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services, or the assets of particular projects or special investment activity”. further, godlewski, turk-ariss and weill (2013) opined that sukuk is investment certificates that are characteristic of both bond and stock-like features that are allotted for financing trade activities or in producing tangible assets. contrarily, as compared to conventional bonds, the sukuk do not offer guaranteed returns and cash flows; there is no interest payment, as returns on sukuk are associated with the profit generation that is achieved by real transactions from an underlying real business risk (zakaria, azwan, isa, alawiyah, &abidin, 2012). this striking disparity among islamic and conventional financial tools provides a contribution to comparatively positive performance of islamic finance during and post global financial crisis 2008. sukuk (islamic bond) and conventional bonds are similar in purpose and both are used for long-term financing. as noted by ahmad and radzi (2011) and saad, haniff and ali (2016), in some respects, the sukuk is like the conventional bonds, it is a security instrument that offers an expected return’s level. though, the fundamental structure and provisions of the sukuk are dissimilar. in that a bond is a representation of the actual debt of the issuer, the sukuk is a representation of certificates of equivalent value with undivided beneficial (proportional to the investor’s participation) ownership in the underlying assets, usufruct, services or investment in certain projects or activities of special investment. contrary to this, conventional bonds can be classified as either pure debt contracts or represent financial claims on opaque projects where the underlying asset may not have a real economic value. 3. review of the related literature despite the emergence of sukuk across different markets worldwide, there are few studies on this subject. consequently, in what follows, it is worth assessing the literature on the political risk and financial determinants of conventional bond markets. 3.1 overview of gccs’ sukuk market development the development of sukuk market in gcc countries has undergone through three distinct stages. the first stage from 2001 to 2007 which coincided with the oil boom and rapid development of the global market; around 41% of the total sukuk issuances so far were within this period, and only 27% of the total sukuk issuances so far were in the second stage 2008 to 2010 which was low because of the global financial crisis. the third stage started from 2011 and continues to date. the best time was since 2001 in terms of sukuk issuance in gcc countries, as the number of issuances was 60 in 2012, which was the highest issuances obtained in gcc countries. the issuing value reached a new record, which broke the records of 2007 with a big margin. the beginning of the year 2013 was good for the gcc sukuk asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 247 market as the number of issuances was 18 within only three months. evidently, bahrain was the first issuer of sukuk and the central bank of bahrain (cbb) issued salam and ijarah sukuk are typically oversubscribed. however, the uae issues the highest number of sukuk in terms of volume, making it the leader in gcc region, while bahrain is leading in terms of number of issues in sukuk market. the concept of financial market development (both equity and debt) has many dimensions. as evident in literatures, there are three eminent indicators of stock market development, namely, market capitalization, trade ratio and turnover ratio. while the first indicator is usually used to measure the size of the stock market, the last two indicators are commonly used to measure the liquidity of the stock market.however, extant empirical underpinnings support the use of market capitalization as proxy for the development of the bond market.the notion behind this measure is that the complete market size is positively correlated with the ability to mobilize capital and diversify risk in an economy (yartey, 2008).for the above reason, the choice of the measurement of sukuk market development is based on the models for estimation and the data availability. regarding sukuk market, this study suggests adopt the direction taken by previous studies(smaoui & khawaja, 2016; said & grassa, 2013) and utilizes the total value of sukuk issuances as percentage of gdp as proxy for sukuk market development. according to thomson reuters report (2016), there has been deterioration in the percentage of gcc’s total sukuk issuance in the recent years. the gcc’s share of global sukuk issuances decreased in the recent years, where the volume of sukuk issuances in the gcc continued to fall since 2013, while the volume of bond financing increased. table 1 presents the descriptive statistics of sukuk market development (smd) across gcc countries; named saudi arabia, united arab emirates, bahrain, qatar, and kuwait; over the period 2001 to 2016. this analysis excludes the country of oman from the analysis because the capital market authority of oman started the process of sukuk issuance recently in october 2012. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 248 table 1. descriptive statistics of sukuk market development (smd) by countries over 2001-2016 country n min. max. mean standard deviation saudi arabia 16 0 .0137364 .0038345 .0039324 united arab emirates 16 0 .008851 .0016253 .0083509 bahrain 16 .027306 .1761255 .0917529 .0449971 qatar 16 0 .0540362 .0078257 .0134053 kuwait 16 0 .031756 .0036019 .0023473 all countries 80 0 .1761255 .0217281 .0410029 source of sukuk data: bloomberg database table 1 shows that united arab emirates has the lowest level of sukuk market development, which is about less than 1% with standard deviation 0.008 and varies from as low as 0 (no sukuk issuance) to a maximum of 0.89%, while bahrain has the highest level of sukuk market development, which is about 9.17% with standard deviation 0.045 and ranges from a minimum of 2.73% to a maximum of 17.6% of gdp. also, the percentage of sukuk market volume relative to gdp for kuwait and saudi arabia seems to be within the same level which is about less than 1% (0.36% and 0.38% respectively). the level of sukuk market development in qatar reported in this study is .78% and ranges from a minimum of 0 to a maximum of 5.4% of gdp. as it can be seen in table 1, the total average of gcc’s sukuk market development is very small relative to gdp, which is 2.17% with a maximum value of 17.6% in bahrain. this result is consistent with grassa and gazdar (2014), who found that the sukuk market is new and normally small capital market in the gcc countries, thus gcc’s sukuk market do not approach the level of threshold that enables them to contribute towards economic growth. based on the above discussion, it becomes imperative to conduct this study as an initial attempt to explore the factors affecting the sukuk market development in the gcc countries as these factors being overlooked by previous researchers. 3.2 political and financial variables and sukuk market it is apparent that there is a scarcity of literature associated with the sukuk markets at country level, but, in particular, there is also a lack with regard to the gcc's sukuk market. actually, the empirical literature reviewed in this paper, two studies only include the sukuk market development and analyzed the influence of foreign factors on its dynamic behavior. these asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 249 two studies conducted by smaoui and khawaja (2016) and said and grassa (2013), are very similar, which only focused on some macroeconomic and financial factors over the same period for 13 countries from different regions. hence, the further empirical investigation becomes necessary. therefore, the current literature reveals research gaps about the factors of sukuk market development in gcc countries, as shown in the figure 1. figure 1. theoretical framework 3.2.1 political risk and sukuk market development this is an important factor that has played a role in determining bond market development over the years and the majority of the researchers have determined a significant association among political risk and bond market development.majority of the results tend to be significant and negative on the market of stock and bond (kim & mei, 2001; roubini, 1991; cherif&gazdar, 2010; garcia & liu, 1999a; yartey, 2008, 2010) economics has a permanent relationship with politics. according to yartey (2010), the political risk is one of the most important risks facing investors when they decide to invest in emerging markets. political risk indicates the financial risk if a government suddenly changes its policies. economic growth is affected by political risk. this type of risk has direct consequences for the income level by ruining the productive capacity and does not support for the creation of business environment essential for any economy to flourish. the resolution of political risk can enhance confidence of the investor and boost the progress of the bond markets in emerging economies (cherif and gazdar, 2010). with political instability, the risk of a capital loss will tend to increase, chiefly due to political and economic rules governing asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 250 investments are expected to vary with political regimes and thus create volatility in macroeconomic indicators, rising the uncertainty in future net returns and, hence, lowering expected real rates of returns linked with investment projects. akkaş (2017) states that, in particular, since the arab spring, gcc countries have tried to invest in islamic finance through government investment, for example their own sovereign wealth fund, with the intention of development of their domestic economies. according to standard and poor credit analyst, events such as the worsening relationship between saudi arabia and iran playing out in bahrain, iraq, lebanon, qatar, syria, and yemen, corruption allegations against ministers and prominent business figures in saudi arabia, and the continuing trade restriction of qatar, which caused suffer rating downgrades. this rating downgrade is also forcing some gcc countries to diversify funding sources and widen their sukuk market. when political risk increases, uncertainty about the future polices of the government also tend to rise, resulting in increasing information asymmetry problems, and adverse selection and moral hazard in the financial market; this in turn leads to great swings in investment and financing decisions. nagano (2017) found that firms with a high degree of information asymmetry prefer sukuk to equity and debt issuance. firms with greater information asymmetry are more likely to issue sukuk than bonds because sukuk leads to a less efficient monitoring of shareholders and management than does bonds (klein and weill, 2016). consequently, sukuk is an appropriate investment and financing tool as it overcomes information asymmetry problems, because in the worst case there are assets which contain sukuk structures. further, roubini (1991) found that an increase in the degree of political instability appears to lead to greater budget deficits. therefore, increase in political risk lead to greater budget deficits, increased credit risk and increased expected costs of debt and equity, thereby expanding the sukuk market to finance these deficits. however, the influence of political risk on sukuk market still ambiguous and hence the further empirical investigation becomes necessary. to the authors’ knowledge, the influenceof political risk on sukuk market development not exists in the previous studies. hence, the further empirical investigation becomes necessary. for this paper, we suggest adopt the direction taken by previous studies (al-jaifi, 2016; cherif&gazdar, 2010; el-wassal, 2005; erb, harvey, &viskanta, 1996; gelos, sahay, &sandleris, 2004) and utilizes the political risk index of icrg, a composite index provided by the international country risk guide (icrg) as a measure of political risk. the icrg agency provides ratings which reflect the risk inherent in a country and are a reliable method of risk assessment. this index ranges from zero to 100 points, with 100 indicating the lowest risk and zero the highest (higher score, lowest risk). change in this index will have an influence on the sukuk market. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 251 3.2.2 financial market variables and sukuk market development 3.2.2.1 banking system size banking sector is an important participant in the economic development process.the banking system represents the largest part of the financial system in most countries, especially in developing and frontier market economies. islamic banks and conventional institutional are the main investors in sukuk because the market is sufficiently large and relatively liquid. as well, sukuk are the only liquidity tool available for islamic financial institutions in case of need of liquidity. hence, the growth of islamic financial assets will be associated with a growing need of liquidity, thus imply an increasing amount of issuance of sukuk by islamic financial institutions and also commercial banks. according to aziz (2007), and kusuma and silva (2014), another important aspect of the development of the sukuk market is the development of the other key components of the islamic financial system, the money market, banking sector. important implication of banks in the sukuk markets both as issuers and buyers. a large banking sector will help the government sell its debt and sukuk domestically. therefore, in developing the sukuk markets, the presence of both islamic and conventional banks as dealers and market makers is required. contrary to this, there is competition among banks and sukuk markets to provide finance, and a strong banking system can rob sukuk of its market share. adelegan and radzewicz-bak (2009) noted that countries with highly developed banking sectors show less dependence on bonds, resulting in a less developed bond market. adelegan and radzewicz-bak (2009), bhattacharyay (2013), nkwede, uguru and nkwegu (2016), and raghavan and sarwono (2012), the findings of all studies showed a significantly negative association among banking sector’s size and development of bond market. concerning sukuk, said and grassa (2013) found that banking size have no significant effect on the issuances of sukuk.on the contrary, smaoui et al., (2017) found sukuk and bank financing are substitutes (negative) and economies where banks play a key role in providing private credit issue less sukuk. hence, the further empirical investigation becomes necessary.following prior studies,for the proposed study this paper suggests the adoption of the total of domestic credit made available by the banking sector relative to gdp as a measure of banking system size.this ratio measures the role of financial institutions as a financial intermediary in providing long-term financing to the private sector and also used as an indicator of financial intermediary development. according to yartey (2008), private credit captures the amount of external resources channeled through the banking sector to private firms. this measure isolates credit issued to the private sector in opposition to credit issued to public institutions. 3.2.2.2 stock market capitalization one incontrovertible fact about stock and sukuk is their existence in the same markets albeit with separate regulations relating to shariah compliance. actually, the market is driven forward by investor demand. depending on the risk and return offered, the firm and investor take the decision to finance and invest in either or both sukuk and stock. when the capital asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 252 market is established, the corporation’s debt-financing level has a tendency to be lower for the reason that the broader supply of funds reduces the cost of equity. therefore, the presence of the stock market can deprive sukuk of market share. on the other hand, well-functioning stock markets reduce asymmetric information and enhance corporate governance, lowering the cost of external equity and the cost of issuing debt (demirgüç-kunt&maksimovic, 1996). nagano (2010) found that issuance of sukuk contributes to a rise in the stock returns of the issuer and total factor productivity, and these empirical finding recommends that issuance of the islamic bond is given preference due to the reason that, the unique benefit which standard external financing is unable to offer. furthermore, ibrahim and minai (2009) found that sukukissuance increases the issuers’ share price. further, godlewski et al. (2011, 2013) argued that two hypothetical positions suggest a positive reaction of stock markets to sukuk issuances. first, sukuk issuance could probably send positive signals to markets. this is likely going to help solve the confrontational selection problem cause by asymmetrical information between players inside and outside the firm. second, sukuk issuance is capable of reducing moral hazard behavior and agency costs occasioned by conflicts of interest between shareholders and managers. consequently, the sukuk market might substitute for or complement the stock market. alam et al. (2013) stated that borrowers with the lowest return expectations will have an inducement to prefer sukuk. however, smaoui et al., (2017) found strong positive significant between stock market capitalization and sukuk market development, hence it appears that stock market and sukuk market are complements rather than substitutes.stock market capitalization is measured by the total value of all listed shares in a stock market as a percentage of gdp. the size of stock market in previous studies (smaoui et al., 2017; cherif&gazdar, 2010; colombage, 2009; la porta et al., 1997; r.p. pradhan et al., 2015; roe & siegel, 2011) is used to measure the stock market development.the notion behind this measure is that the complete market size is positively correlated with the ability to mobilize capital and diversify risk in an economy (yartey, 2008). 4. policy implications the policy implications will be based on the outcome of the proposed research on the role of political risk and financial market variables on sukuk market development in gcc countries. if the empirical evidence establishes the political and financial factors influence the sukuk market development then the policy implication will be for the governments, policymakers, investors, creditors and researchers, especially concerning issues relating to sukuk market. it will be possible to make recommendations to support country's specific factors in the sukuk market that are expected to contribute to the sustainable growth of sukuk market with the findings. this proposed model will providesa well knowledge for external investors to recognize the political risk that affect sukuk market development in gcc so as to guide their investment decisions. furthermore, it will also be possible to provide recommendations regarding, which factors the management should give more weight in managing risks or minimize the negative effect and avoid unnecessary disappointments. the practice of good factors knowledge will definitely asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 253 help to promote the growth of the sukuk market. the findings of this study will help the investors and creditors to know that their interests will be protected from political risk with high investment in sukuk market rather than conventional markets, if the empirical evidence establishes that the political risk affect sukuk market differently of conventional market.the government should develop strategies for linking and integrating the banking sectors and sukuk market in order to promote sukuk market development. 5. conclusions in view of the ongoing global financial and economic crisis, low oil price and political instability, the development of sukuk markets in gcc region assume high importance for financing the region’s corporate and government sector and large demand for infrastructure. well-developed sukuk markets can provide gcc countries with alternative sources of financing and at the same time improve the region’s financial resilience by balancing the high dependence on the oil exports and banking sector. therefore, to enhance the sukuk market, there is the need for gcc countries to understand the role of political risk and financial market factors on sukuk market. this is essential to promote their sukuk markets through develop strategies for linking and integrating the banking sectors and sukuk market, and improving the local investment environment to create an attraction for investors to hold sukuk securities. the policy implications will be based on the outcome of the proposed research on the role of political risk and financial market variables on sukuk market development in gcc countries. if the empirical evidence establishes the political and financial factors influence the sukuk market development then the policy implication will be for the governments, policymakers, investors, creditors and researchers, especially concerning issues relating to sukuk market. references accounting and auditing organization for islamic financial institutions (aaoifi). 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(2017). sukuk, banking system, and financial markets: rivals or complements? economics letters, 161, 62-65. https://doi.org/10.1016/j.econlet.2017.09.014 tariq, a. a., & dar, h. (2007). risks of sukuk structures : implications for resource mobilization. thunderbird international business review, 49(2), 203-223. thomas, a. (2007). malaysia’s importance to the sukuk market. american journal of islamic finance, 1(2), 10-15. thomson reuters. (2016). thomson reuters zawya sukuk perceptions and forecast study 2016, islamic finance gateway. yartey, c. a. (2010). the institutional and macroeconomic determinants of stock market development in emerging economies. appl ied financial economics, 20(21), 1615-1625. https://doi.org/10.1080/09603107.2010.522519 zakaria, n. b., azwan, m., isa, m., alawiyah, r., & abidin, z. (2012). the construct of sukuk, rating and default risk. social and behavioral sciences, 65(icibsos), 662-667. https://doi.org/10.1016/j.sbspro.2012.11.181 microsoft word 11161-41160-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 330 do firms' characteristics make a difference of the choice of capital budgeting practices? evidence from sri lanka lingesiya kengatharan department of financial management, university of jaffna, sri lanka e-mail: lingesiya@yahoo.com received: may 2, 2017 accepted: nov. 24, 2017 published: december 24, 2017 doi:10.5296/ajfa.v9i2.11161 url: https://doi.org/10.5296/ajfa.v9i2.11161 abstract the aim of this study was to examine the differences of the choice of capital budgeting practices in terms of firms’ characteristics of sri lankan companies. the primary data were garnered from 186 financial officers using self-administered questionnaires. collected data were then analysed using independent sample ttest. the results of the study revealed that the use of simple capital budgeting practices were mostly preferred by small sized firms and mainly managed by finance professionals with non-mba educational qualifications and short tenure. sophisticated and advanced capital budgeting practices were used mostly by large firms; and were mainly managed by finance professionals with master of business administration qualification and long tenure. according to the industry differences, accounting rate of return was primarily applied by non-mba qualified financial officers and was also preferred by non-manufacturing firms. none of the other methods made any significant differences in terms of type of industry. sophisticated capital budgeting practices were determined by the size of the capital budget, advanced capital budgeting practices were determined by both the size of the capital budget and the educational qualifications of the finance professionals. in a similar vein, simple capital budgeting practices were determined by the size of the capital budget, the educational qualifications of the financial officers, and type of industry. overall, this study has made parametric contributions to the choice of capital budgeting practices in terms of firms’ characteristics of sri lankan companies. the findings of the study are useful to the investment decision makers when they are appraising investment projects. keywords: capital budgeting practices, firm characteristics, sri lankan companies asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 331 1. introduction 'capital budgeting practices are the methods and techniques used to evaluate and select an investment project’ (i.e., the decision-making role of the accounting system) (verbeeten,2006, p.108). capital budgeting is the application of the principle of profit maximisation to multi-period projects to pave the way for a firm’s growth, survival and sustainability. capital budgeting techniques are the best alternative for investment decision makers, to help them decide to invest a fixed amount today in exchange for an uncertain stream of future payoffs. capital budgeting decisions have been recognized as the most important strategic decisions for an organisation to determine how much to invest in specific assets and when to invest (verbeeten, 2006).the long-term success of a firm depends on excellent investment decisions more than any other factor (megginson, smart & lucey, 2008). the majority of firms’ investment decisions involve the acquisition of fixed assets, for example, the purchase of land, plant, equipment and buildings. firms invest hundreds of billions of dollars every year in investment projects. capital investment decisions are thus of utmost important in determining a firm’s fortunes over many years. the ways of looking at capital budgeting practices are different from country to country, from company to company and from project to project (akalu, 2003). this scenario places emphasis on seminal studies that capital budgeting practices are influenced by a ‘country effect’ (e.g., graham & harvey, 2001; hermes, smid & yao, 2007). many studies has been conducted on capital budgeting methods and practices, predominantly in: the usa (e.g., graham & harvey, 2001; ryan & ryan, 2002), the uk (e.g., arnold & hatzopoulos, 2000), australia (e.g., truong, partington & peat, 2008), china (e.g., chen, 2008), canada (e.g., bennouna, meredith & marchant, 2010), japan (e.g., shinoda, 2010), sweden (e.g., sandahl & sjogren, 2003), indonesia (e.g., leon, isa & kester, 2008), ireland (e.g., kester & robbins, 2011), south africa (e.g., maroyi & poll, 2012), new zealand (e.g., lord, shanahan & bogd, 2004), tennessee (e.g., sekwat, 1999), belgium (e.g., dardenne, 1998), romania (e.g., dragota et al., 2010), nigeria (e.g., elumilade, asaolu & ologunde, 2006), pakistan (e.g., zubairi, 2008), argentina (pereiro, 2006), italy (e.g., cescon, 1998), singapore (e.g., kester & chong,1998), bahrain (e.g., al-ajmi,al-saleh & hussain, 2011), cyprus (e.g., lazaridis, 2004), croatia (e.g., dedi & orsag, 2007), jordan (e.g., khamees, al-fayoumi & al-thuneibat, 2010),taiwan (e.g., haddad, sterk & wu,2010), nepal (e.g., poudel et al., 2009), india (e.g., singh, jain & yadav, 2012), hong kong (e.g., lam, wang & lam, 2007), kuwait (e.g., mutairi , tain & tan, 2012), libya (e.g., mohammed, 2013), ghana (e.g., tufuor & doku, 2013), poland (e.g., wnuk-pel, 2013), kenya (e.g., kitili & nganda, 2014), spain (e.g., andres, fuente & martin, 2015). comparative studies have been conducted in europe: the uk, france, germany and the netherlands (e.g., brounen, de jong & koedijk, 2004); in the asia-pacific region: malaysia, singapore and hong kong (e.g., wong, farragher & leung, 1987), australia, hong kong, indonesia, malaysia, the philippines and singapore (kester et al., 1999); between british and dutch companies (akalu, 2003), the netherlands and china (hermes et al., 2007); and in central and eastern europe (cee) including bulgaria, croatia, the czech republic, hungary, latvia, lithuania, poland, romania, the slovak republic, and slovenia (ander,mohanty & toth, 2010). all of these studies have made contributions to asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 332 extant literature by illuminating the prevailing capital budgeting practices across many countries. but studies focusing to examine the differences of the choice of capital budgeting practices in terms of firms’ characteristics are very rare. therefore this study identified the differences of the use of capital budgeting practices in terms of firms' characteristics. statement of the research problem can be posted as do firms' characteristics make a difference of the choice of capital budgeting practices? 2. capital budgeting practices capital budgeting practices help managers to select n out of n investment projects with the highest profits and an acceptable ‘risk of ruin’ (verbeeten, 2006, p.108). all capital budgeting practices can be considered into the categories of sophisticated, advanced and naive/simple based on empirical studies (e.g., haka, 1987; haka, gordon & pinches, 1985; verbeeten, 2006; wolffsen, 2012). naive practices includes payback, the adaptation of required payback and accounting rate of return, and the advanced /net present value based, including sensitivity analysis/break-even analysis, scenario analysis, the adaptation of required return/discount rate, internal rate of return, net present value, uncertainty absorption in cash flows, modified internal rate of return and profitability index. farragher, kleiman and sahu (2001) suggested that a degree of sophistication is represented by the use of discounted cash flow techniques and incorporating risk into the analysis. sophisticated capital budgeting methods generally include monte carlo simulations, game theory, real option, using certainty equivalents, decision trees, capm analysis / ß analysis, and adjusting expected values (verbeeten, 2006; wolffsen, 2012). 2.1 firm characteristics and capital budgeting practices this study considers firms’ demographic characteristics that are expected to account for the differences in their choice of capital budgeting practices across countries. although firms have many characteristics, many seminal studies set out three major characteristics viz., firm size, industry differences, and the financial officer’s educational qualification and experience in the field that have a strong influence on the choice of capital budgeting practices (e.g., ho & pike, 1992; trigeorgis, 1993; rogers, 1995; ho & pike, 1998; payne, heath & gale, 1999; bowman & moskowitz, 2001; graham & harvey, 2001; williams & seaman, 2001; farragher et al., 2001; ryan & ryan, 2002; billington, johnson & triantis,2003; brounen et al.,2004; mcgrath & nerkar, 2004; verbeeten, 2006; hermes et al.,2007; verma et al.,, 2009; bennouna et al., 2010; andres et al., 2015) the size of a firm is one of the major determinants of its capital budgeting practices (e.g., ho & pike, 1992; graham & harvey, 2001; farragher et al., 2001; brounen et al.,2004; verbeeten, 2006; mutairi et al., 2012; lakew & rao, 2014;). research supports the notion that large firms adopt more innovative capital budgeting methods, e.g. sophisticated capital budgeting practices, to a larger extent than smaller firms (e.g., rogers, 1995; williams & seaman, 2001 ), since larger firms have the capacity and resources to use sophisticated capital budgeting practices (ho & pike, 1992). payne, heath and gale (1999) and ryan and ryan (2002) documented the fact that large firms are more inclined to use more sophisticated capital budgeting practices. this is due to the fact that larger firms have larger projects and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 333 the use of sophisticated capital budgeting practices becomes less costly (payne et al., 1999; hermes et al., 2007). many studies considered firm size as size of the capital budget in order to focus the impact of firm characteristics on the choice of capital budgeting practices (e.g.,pike,1986; ryan & ryan, 2002). nonetheless, the nature of the relationship between the size of a firm and its capital budgeting practice has not been clearly established in literature relating to developing countries. thus, this leads to research question: rq1: is there any significant difference between the size of a firm’s capital budget and its use of capital budgeting practices? and thus, it can be hypothesised that: h1: simple capital budgeting practices are used when a firm’s capital budget is small. companies from different industries may vary in their use of capital budgeting practices (e.g., ho & pike, 1998). this may, for example, be due to the nature of their business activity, differences in technology, competition and human resource skill, the amount of investment in fixed assets, business risk, and so forth. for instance, widespread use of real option and game theory is more prevalent in the pharmaceutical industry (e.g., bowman & moskowitz, 2001; mcgrath & nerkar, 2004), the extraction industry (e.g., trigeorgis, 1993), the financial services industry and the high-tech industry (e.g., billington et al.,2003, verbeeten, 2006). this scholarship explores how industrial types are different in their use of capital budgeting practices, which leads to the research question: rq2: is there any significant difference the capital budgeting practices used in different industries? and thus, it can be hypothesised that: h2: non manufacturing firms use simple capital budgeting practices. hornstein (2013) found that managers and financial officers significantly influence corporate behavior and performance. in particular, the educational qualifications of financial officers have been recognized as a determinant of capital budgeting practice (graham & harvey, 2001). there is a general consensus that a financial officer with a higher level of education will have fewer problems in understanding more sophisticated capital budgeting techniques and thus they will be capable of using them. a positive relationship has been identified between the educational background of financial officers and the use of sophisticated methods (hermes et al.,2007). among the u.s. sample, a positive association was found between chief financial officers’ education and the use of sophisticated capital budgeting practices (graham & harvey, 2001) and these findings were consistent with those in the netherlands, germany and france, but not in the uk (brounen et al., 2004). there is a dearth of studies in emerging counties on the relationship between financial officers’ educational qualifications and the choice of capital budgeting practices and the results found in developed countries are not consistent with previous studies (e.g., brounen et al., 2004), leading to a research question: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 334 rq3: is there any significant difference between the educational qualification of financial officers’ and firms’ capital budgeting practices? and thus, it can be hypothesised that: h3: financial officers with higher educational qualifications use more sophisticated capital budgeting practices. besides the educational qualifications of financial officers, their experience might also determine their choice of capital budgeting practice. however, a handful of research studies have reported that the experience of financial officers will determine the use of capital budgeting methods since over time they become more familiar with more sophisticated capital budgeting methods (e.g., hermes et al., 2007; verma et al., 2009) and thus, this study raises the research question: rq4: is there any significant difference between years of experience of financial officers and their capital budgeting practices? and thus, it can be hypothesised that: h4: financial officers with a short tenure use simple capital budgeting practices. 3. methods sample 287 companies were listed on the colombo stock exchange in sri lanka as at 31.12.2013. from the 287, 186 companies responded to the survey. although the people who make capital budgeting decisions in sri lanka are named chief financial officers, chief executive officers, financial controllers, finance managers, management accountants, and financial directors, this research commonly refers to them as financial officers. the self-report questionnaire was designed and emailed to the respondents, some were directly distributed and some were posted to financial officers. data sources the relevant data for the purpose of this study were garnered from primary sources. the primary source of data collectionthe questionnaire a questionnaire was administered to collect the primary data. the questionnaire elicited information regarding the company’s demographic information (including the respondent’s qualifications, experience and type of industry) and corporate practices regarding capital budgeting, including the size of the capital budget, the capital budgeting technique and supplementary capital budgeting tools for incorporating risk. the questions measuring the capital budgeting practices were adopted from previous seminal studies (arnold & hatzopoulos, 2000; graham & harvey, 2001; brounen et al., 2004; hermes et al., 2007; verma et al., 2009). nonetheless, fundamental changes were made to the questionnaire in order to fit with the sri lankan context. the questionnaire survey was carried during the period from june to december 2013. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 335 4. data analysis following paragraphs intend to answer the research question concerning do firms’ characteristics make a difference of the choice of capital budgeting practices. firstly, descriptive analysis of survey responses is presented including educational qualification of the financial officers, experience of the financial officers, types of industry, and size of the capital budget. secondly, analysis focuses on the identification of prevailing capital budgeting practices in sri lanka. thirdly, firms’ characteristics are examined to see the differences in the choice of capital budgeting practices. descriptive analysis of the survey responses educational qualification of the financial officers classification of the educational qualification of the financial officers was grouped into: bachelor degree, mba, non-mba master’s, above master’s degree and professional qualification. above master degree qualification (e.g., mphil/phd or master degree with professional qualification) was held by 52.2% of financial officers, followed by mba qualification (29%), non-mba master’s (13.4%), bachelor degree (3.8%) and professional qualification (1.6%). further to such general classification, the educational qualification of the financial officers was regrouped into two for analytical purposes: mba-level and above and non-mba and other. the mba-level and above includes both mba and above master’s degree whereas non-mba and other includes bachelor degree, non-mba master’s and professional qualification. the classifications were in line with graham and harvey (2001) and brounen et al.(2004). experience of the financial officers experience of the financial officers was classified into four groups in terms of number of years they had been in the profession: less than 5 years, 5-9 years, 10-19 years and 20 years and more. the higher number of financial officers had 10 to 19 years’ experience (n=81), followed by 20 years’ and more experience (n=77), 5 to 9 years’ (n=21) and a small number of financial officers had less than 5 years’ experience (n=7). for analytical purposes, experience of financial officers was regrouped into two in line with graham and harvey (2001) and brounen et al.(2004): short tenure and long tenure. the short tenure includes both less than 5 years’ experience and 5-9 years’ experience whereas long tenure includes both 10-19 years’ experience and 20 and more years’ experience. types of industry types of industry were initially classified in terms of their nature (verbeeten, 2006) as shown in table 1: financial service industry, manufacturing industry, diversified holdings, health care industry, hotel industry and other non-financial industry. as can be seen in the table, 52.7% of industries are manufacturing, followed by other non-financial industry (17.7%), hotel asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 336 industry (15.6%), diversified holdings (5.9%), financial service industry (4.8%) and health care industry (3.2%). table 1. types of industry industries no. of companies (n) percentage (%) financial service industry (e.g., bank, finance and insurancefinserv) 9 4.8% manufacturing industry (e.g., beverages, food & tobacco, chemical & pharmaceutical, construction and engineering, foot ware and textile, manufacturing, power and energy motors, oil palms, plantations and trading mftg) 98 52.7% diversified holdings (divers) 11 5.9% health care industry (health) 6 3.2% hotel industry (hotel) 29 15.6% other non-financial industry (e.g., investment trust, land and property, services, stores and supplies and telecommunications (otnfin) 33 17.7% total 186 100.0% nonetheless, for analytical purposes as suggested by graham and harvey (2001) and brounen et al. (2004), they were regrouped into “manufacturing” and “non-manufacturing”. size of capital budget size of capital budget was categorised into five groups in line with verma et al. (2009): less than lkr 10 million, lkr 1-99 million, lkr 100-499 million, lkr 500 -999 million and lkr 1 billion and over. the large number of financial officers reported that size of their capital budget is between lkr 100 -499 million (39.2%), followed by lkr 10-99 million (27.4%), lkr 1 billion and over (14%), lkr 500-999 million (10.2%) and less than lkr 10 million (9.1%). for analytical purposes, sizes of capital budget were regrouped into “large” and “small” in line with graham and harvey (2001) and brounen et al.(2004). firms with capital budget greater than lkr 1 billion is considered as “large” and less than lkr 1 billion is considered as “small” capital budgeting practices there is a tendency to use multi-methods in making capital budgeting decisions (e.g., arnold & hatzopoulos, 2000). as a caveat, prevalent capital budgeting decision tools, namely capital asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 337 budgeting methods and capital budgeting tools incorporating risk in sri lanka, were subjected to principal component analysis with varimax rotation in line with many research scholars (e.g., verbeeten, 2006). the results are presented in table 2. table 2. total variance explained for the factors indicating to the capital budgeting practices factors advanced / npv based capital budgeting practices sophisticated capital budgeting practices simple/ naïve capital budgeting practices eigen value 5.822 2.108 1.365 proportion of variance explained 38.815% 14.052% 9.101% cumulative percentage explained 38.815% 52.867% 61.968% cronbach’s alpha reliability of factors 0.890 0.809 0.744 as can be seen in table 2, prevalent capital budgeting practices in sri lanka were grouped into three, in line with the literature: advanced capital budgeting practices include probability analysis, internal rate of return, scenario analysis, adjusting required return, uncertainty absorption in cash flows, sensitivity analysis and net present value; sophisticated capital budgeting practices include real option, capm/β analysis, game theory decisions and decision trees, and simple/naive capital budgeting practices include discounted payback , accounting rate of return and payback (e.g., verbeeten, 2006; wolffsen, 2012). table 3 shows use of capital budgeting practices in sri lanka. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 338 table 3. capital budgeting practices in sri lanka never rarely sometimes often always mean naive capital budgeting practices discounted payback period (dpb) 1.1% 10.8% 64.0% 24.2% 3.11 accounting rate of return (arr) 3.8% 13.4% 61.8% 19.9% 1.1% 3.01 payback period (pb) 2.2% 13.4% 34.4% 37.6% 12.4% 3.45 advanced capital budgeting practices probability analysis (pa) 1.1% 3.2% 13.4% 68.8% 13.4% 3.90 scenario analysis (sa) 1.6% 5.4% 12.4% 65.1% 15.6% 3.88 adjusting required return 2.7% 5.9% 14.0% 63.4% 14.0% 3.80 internal rate of return (irr) 6.5% 5.9% 8.6% 55.9% 23.1% 3.83 uncertainty absorption in cash flows 0.5% 1.6% 12.4% 69.9% 15.6% 3.98 sensitivity analysis (sa) 1.6% 8.1% 11.3% 52.7% 26.3% 3.94 net present value (npv) 1.6% 2.2% 12.4% 51.6% 32.3% 4.11 sophisticated capital budgeting practices real options (ro) 78.0% 15.6% 6.5% 1.28 game theory decisions (gtd) 83.9% 26.0% 2.2% 1.18 decision trees (dt) 65.6% 27.4% 7.0% 1.41 capm/β analysis 77.4% 11.8% 8.6% 2.2% 1.35 as can be seen in table 3, npv was the most preferred method of capital budgeting, 83.9% of the financial officers ‘always and often’ preferred it, yielding a mean value of 4.11. this was followed by uncertainty absorption in cash flows which was ’always and often’ preferred by 85.5% (m=3.98). sensitivity analysis was the next ‘always and often’ preferred method by 78% (m=3.94) followed by probability analysis with 82.2% (m=3.90), scenario analysis with 80.7 % (m=3.88), internal rate of return with 79% (m=3.83), adjusting required return with 77.4% (m=3.80), pb with 50% (m=3.45), dpb with 24.2% (m=3.11) and arr with 21% (m=3.01). methods such as ro, gtd, decision tree and capm/β analysis were not popular, yielding mean values of less than 2.0. firms’ characteristics and capital budgeting practices the current survey carefully considered the underlying firm characteristics in order to find out the differences in the use/choice of capital budgeting practices: size of capital budget, educational qualification of financial officers, experience of financial officers and types of industry. the mean difference statistics of independent sample t-test was employed. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 339 size of capital budgets and use of capital budgeting practices as aforesaid, size of capital budgets were grouped into “small” and “large”. the results of the independent sample t-test between size of capital budgets and use of capital budgeting practices are presented in table 4. table 4. size of capital budgets and use of capital budgeting practices capital budgeting practices size of the capital budget n df mean sd se t sig pb small 160 3.63 .867 .069 large 26 184 2.35 .629 .123 9.064 0.000 dpb small 160 3.18 .578 .046 large 26 184 2.73 .724 .142 2.977 0.000 arr small 160 3.13 .652 .052 large 26 184 2.31 .788 .155 5.754 0.000 npv small 160 3.97 .796 .063 large 26 184 4.96 .196 .038 -6.312 0.000 irr small 160 3.73 1.046 .083 large 26 184 4.50 .860 .169 -4.125 0.000 ro small 160 1.13 .357 .028 large 26 184 2.23 .765 .150 -11.947 0.000 gtd small 160 1.08 .274 .022 large 26 184 1.81 .694 .136 -9.516 0.000 sensitivity analysis small 160 3.79 .898 .071 large 26 184 4.85 .368 .072 -5.886 0.000 scenario analysis small 160 3.84 .797 .063 large 26 184 4.08 .744 .146 -1.467 0.151 decision trees small 160 1.26 .441 .035 large 26 184 2.35 .745 .146 -10.379 0.000 capm/β analysis small 160 1.16 .413 .033 large 26 184 2.58 1.027 .201 -12.467 0.000 uncertainty absorption in cash flows small 160 3.91 .570 .045 large 26 184 4.46 .761 .149 -4.383 0.000 adjusting required return small 160 3.76 .867 .069 large 26 184 4.08 .688 .135 -2.118 0.041 probability analysis small 160 3.88 .704 .056 large 26 184 4.04 .662 .130 -1.065 0.288 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 340 as can be seen in table 4, small firms more highly applied the payback method (m=3.63, se=.06) than large firms (m=2.35, se=.12). the difference was significant t (184) = 9.064, p < 0.01. a similar pattern was observed in the application of dpb and arr that small firms more highly applied dpb and arr (m=3.18, se=.04; m=3.13, se=.05) than large firms (m=2.73, se=.142; m=2.31, se=.155) and the differences were also significant t (184) = 2.877, p < 0.01 and t (184) = 5.754, p < 0.01 respectively. therefore, it is fair to say that simple capital budgeting practices pb, dpb and arr were more highly applied by small firms in comparison with large firms. as to advanced capital budgeting practices, npv and irr are more highly significantly applied by large firms (m=4.96, se=.038; m=4.50, se=.169) than small firms (m=3.97, se=.063; m=3.73, se=.083) and the significant mean differences were found t (184) = -6.312, p < 0.01, t (184) = -4.125, p < 0.01, respectively. as regard to sophisticated capital budgeting practices, ro, gtd are also highly applied by large companies (m=2.23, se=.150; m=1.81, se=.136) than small companies (m=1.13, se=.028; m=1.08, se=.022) and the significant differences were ro and gtd, respectively t (184) = -11.947, p < 0.01, t (184) = -9.516, p < 0.01. in the case of sensitivity analysis, uncertainty absorption in cash flows and adjusting required return were significantly highly applied by large firms (m=4.85, se=.072; m=4.46, se=.149, and m=4.08, se=.135) than small companies (m=3.79, se=.071; m=3.91, se=.045, and m=3.76 , se=.069) and the significant differences were found t (184) = -5.886, p < 0.01, t (184) = -4.383, p < 0.01 and t (184) = 2.118 , p < 0.041, respectively. although scenario analysis and probability analysis were highly applied by large firms, the differences were not statistically significant at p < 0.05. moreover, capm/β analysis and decision trees were also more highly applied by large companies (m=2.58, se=.201; m=2.35, se=.146) than small companies (m=1.16, se=.033; m=1.26, se=.035) and the differences were significant t (184) = -12.467, p < 0.01, t (184) = -10.379, p < 0.01. therefore, simple capital (naive) budgeting practices were significantly mostly used by small firms, nonetheless, advanced and sophisticated capital budgeting practices were significantly mostly used by large firms. consequently, hypothesis (h1) that simple capital budgeting practices are used when a firm’s capital budget is small was supported. types of industry and use of capital budgeting methods this section draws attention to the differences between types of industry and capital budgeting methods. types of industry were grouped into non-manufacturing (nmanu) and manufacturing (manu) in line with graham and harvey (2001). the results of an independent sample t-test are presented in table 5. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 341 table 5. types of industry and use of capital budgeting practices capital budgeting practices industry n df mean sd se t sig pb nmanu 88 3.49 .971 .103 manu 98 184 3.41 .929 .094 .577 .564 dpb nmanu 88 3.15 .635 .068 manu 98 184 3.08 .604 .061 .727 .468 arr nmanu 88 3.11 .718 .077 manu 98 184 2.92 .728 .073 1.839 .048 npv nmanu 88 4.18 .891 .095 manu 98 184 4.04 .745 .075 1.175 .242 irr nmanu 88 3.88 1.059 .113 manu 98 184 3.80 1.055 .107 .509 .611 ro nmanu 88 1.34 .604 .064 manu 98 184 1.23 .552 .056 1.252 .212 gtd nmanu 88 1.17 .407 .043 manu 98 184 1.19 .469 .047 -.362 .718 sensitivity analysis nmanu 88 4.00 .935 .100 manu 98 184 3.89 .907 .092 .831 .407 scenario analysis nmanu 88 3.89 .794 .085 manu 98 184 3.87 .795 .080 .163 .871 decision trees nmanu 88 1.44 .641 .068 manu 98 184 1.39 .603 .061 .608 .544 capm/β analysis nmanu 88 1.32 .670 .071 manu 98 184 1.39 .782 .079 -.648 .518 uncertainty absorption in cash flows nmanu 88 3.93 .708 .075 manu 98 184 4.03 .546 .055 -1072 .285 adjusting required return nmanu 88 3.83 .887 .095 manu 98 184 3.78 .819 .083 .432 .666 probability analysis nmanu 88 3.88 .724 .077 manu 98 184 3.93 .677 .068 .294 .603 as can be seen in table 5, only arr was statistically significant and mostly applied by non-manufacturing firms (m=3.11, se=.077) than manufacturing firms (m=2.92, se=.073) at t (184) = 1.839, p < 0.05. save for arr, all other capital budgeting practices were not statistically significant with type of industry (p > 0.05). therefore, in all cases except arr, type of industry was not significantly different on use of capital budgeting practices. the results only supported the notion that the use of arr was significantly greater in non-manufacturing firms than in manufacturing firms. therefore, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 342 hypothesis (h2) that non manufacturing firms use simple capital budgeting practices was supported that arr was mostly used by non manufacturing companies. education qualifications of financial officers and use of capital budgeting practices the educational qualifications of financial officers were grouped into mba and non-mba qualifications in line with graham and harvey (2001). an independent sample t-test was performed to see the difference between educational qualification of financial officers and the use of capital budgeting practices. the results are presented in table 6. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 343 table 6. education qualifications and use of capital budgeting practices capital budgeting practices educational qualifications n df mean sd se t sig pb non-mba 35 3.91 .781 .132 mba 151 184 3.34 .951 .077 3.332 .001 dpb non-mba 35 3.37 .598 .101 mba 151 184 3.05 .609 .050 2.828 .007 arr non-mba 35 3.37 .690 .117 mba 151 184 2.93 .713 .058 3.412 .001 npv non-mba 35 3.06 .873 .147 mba 151 184 4.35 .580 .047 -8.356 .000 irr non-mba 35 2.60 1.193 .202 mba 151 184 4.12 .783 .064 -9.275 .000 ro non-mba 35 1.09 .284 .048 mba 151 184 1.33 .619 .050 -2.287 .023 gtd non-mba 35 1.06 .236 .040 mba 151 184 1.21 .471 .038 -2.802 .006 sensitivity analysis non-mba 35 2.97 .985 .166 mba 151 184 4.17 .743 .060 -6.743 .000 scenario analysis non-mba 35 3.03 .857 .145 mba 151 184 4.07 .634 .052 -8.182 .000 decision trees non-mba 35 1.17 .382 .065 mba 151 184 1.47 .651 .053 -2.608 .010 capm/β analysis non-mba 35 1.14 .355 .060 mba 151 184 1.40 .785 .064 -2.980 .003 uncertainty absorption in cash flows non-mba 35 3.34 .765 .129 mba 151 184 4.13 .485 .040 -7.682 .000 adjusting required return non-mba 35 2.97 .985 .166 mba 151 184 3.99 .688 .056 -7.247 .000 probability analysis non-mba 35 3.26 .701 .118 mba 151 184 4.05 .609 .050 -6.769 .000 as shown in table 6, simple capital budgeting practices pb , dpb and arr were more highly applied by non-mba financial officers (m=3.91, se=.132; m=3.37, se=.101, and m=3.37, se=.117) and the differences were significant t (184) = 3.332, p < 0.01, t (184) = 2.828, p < 0.01 and t (184) = 3.412 , p < 0.01, respectively. in the case of advanced capital budgeting practices, npv and irr were highly applied by financial officers who had mba qualifications (m= 4.35, se=.047; m=4.12, se=.064) than non mba financial officers (m=3.06, se=.147; m=2.60, se= .202) and the differences were significant t (184) = -8.356, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 344 p < 0.01, t (184) = -9.275, p < 0.01, respectively. a similar pattern was observed in sophisticated capital budgeting practices. ro and gtd were also more highly applied by financial officers who had an mba (m=1.33, se=.050; m=1.21, se=.038) than non-mba financial officers (m=1.09, se=.048; m=1.06, se=.040) and the significant differences were found t (184) = -2.287, p < 0.05, t (184) = -2.802, p < 0.01, respectively. as for sensitivity analysis, scenario analysis, uncertainty absorption in cash flows, adjusting required return and probability analysis were significantly more highly applied by financial officers who had an mba (m=4.17, se=.060; m=4.07, se=.052, m=4.13, se=.040, m=3.99, se=.052 and m=4.05, se=.050) than non-mbas financial officers (m=2.97, se=.166; m =3.03, se =.145, m=3.34, se=.329, m=2.97, se=.166 and m=3.26, se =.118) at t (184) = -6.743, p < 0.01, t (184) = -8.182, p < 0.01, t (184)= -7.682, p <0.01, t (184) = -7.247 , p < 0.01 and t (184) = 6.769 , p < 0.01, respectively. moreover, capm/β analysis and decision trees were more highly applied by financial officers with mbas (m=1.40, se= .064; m=1.47, se=.053) than financial officers with non-mbas (m=1.14, se=.060; m=1.17, se=.065) and the differences were significant t (184) = -2.980, p < 0.01, t (184) = -2.608, p < 0.01, respectively. therefore, simple capital (naive) budgeting practices were significantly mostly used by financial officers with non-mba qualification, nonetheless, advanced and sophisticated capital budgeting practices were significantly mostly used by financial officers with mba qualifications. consequently, hypothesis (h3) that chief financial officers with higher educational qualifications use more sophisticated capital budgeting practices was supported. experience of financial officers and use of capital budgeting practices this section examines the difference in use of capital budgeting practice in terms of the experience of the financial officers (tenure). the tenure was grouped into “short” and “long” in line with graham and harvey (2001). table 7 shows the results of the independent sample t-test. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 345 table 7. tenure and use of capital budgeting practices capital budgeting practices tenure n df mean sd se t sig pb short 28 3.79 .630 .119 long 158 184 3.39 .982 .078 2.076 .039 dpb short 28 3.18 .548 .104 long 158 184 3.10 .630 .050 0.609 .543 arr short 28 3.14 .803 .152 long 158 184 2.99 .714 .057 1.042 .299 npv short 28 3.75 .799 .151 long 158 184 4.17 .808 .064 -2.546 .012 irr short 28 3.64 .870 .164 long 158 184 3.87 1.083 .086 -1.037 .301 ro short 28 1.11 .315 .060 long 158 184 1.32 .609 .048 -2.728 .008 gtd short 28 1.00 .000 .000 long 158 184 1.22 .470 .037 -5.755 .000 sensitivity analysis short 28 3.68 .863 .163 long 158 184 3.99 .924 .073 -1.726 .092 scenario analysis short 28 3.79 .568 .107 long 158 184 3.89 .826 .066 -0.656 .513 decision trees short 28 1.11 .315 .060 long 158 184 1.47 .645 .051 -2.897 .004 capm/β analysis short 28 1.11 .315 .060 long 158 184 1.40 .773 .062 -3.406 .001 uncertainty absorption in cash flows short 28 3.64 .731 .138 long 158 184 4.04 .590 .047 -3.194 .002 adjusting required return short 28 3.64 .911 .172 long 158 184 3.83 .839 .067 -1.069 .286 probability analysis short 28 3.79 .568 .107 long) 158 184 3.92 .719 .057 -1.137 .262 as can be seen in table 7, simple capital budgeting practices pb, dpb and arr were applied more by financial officers with short tenure (m=3.79, se=.119; m=3.18, se=.104, and m=3.14, se=.152) than financial officers with long tenure financial officers (m=3.39, se=.078; m=3.10, se=.050, and m= 2.99, se=.057), however, the difference was only significant for pb t (184) = 2.076, p < 0.05. similarly, for advanced capital budgeting practices, npv and irr were mostly more used by financial officers with long tenure (m=4.17, se=.064; m=3.87, se=.086) than financial officers with short tenure (m=3.75, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 346 se=.151; m=3.64, se=.164), nonetheless, the difference was only significant for npv (t (184) = -2.546, p < 0.05. in the case of sophisticated capital budgeting practices, ro and gtd were also mostly more applied by financial officers with long tenure (m=1.32, se=.048; m= 1.22, se=.037) than financial officers with short tenure (m=1.11, se=.060; m=1.00, se=.000) and the differences were significant t (184) = -2.728, p < 0.01, t (184) = -5.755, p < 0.01, respectively. capm/β analysis and decision trees were more highly applied by financial officers with long tenure (m=1.40, se=.062; m=1.47, se=.051) than financial officers with short tenure (m=1.11, se=.060; m=1.11, se=.060) and the differences were significant t (184) = -3.406, p < 0.01, t (184) = -2.897, p < 0.01, respectively. uncertainty absorption in cash flows was also more highly significantly applied by financial officers with long tenure (m=4.04, se=.047) than financial officers with short tenure (m=3.64, se=.138) at t (184) = -3.194, p < 0.01. notwithstanding that sensitivity analysis, scenario analysis, adjusting required return and probability analysis were mostly used by financial officers with long tenure, they were not statistically significant. therefore, in all cases, simple capital (naive) budgeting practices were mostly used by financial officers with short tenure (significantly different only for pb), nonetheless, advanced and sophisticated capital budgeting practices (npv, ro, gtd, uncertainty absorption in cash flows, decision trees and capm/β analysis) were significantly mostly used by financial officers with long tenure. consequently, hypothesis (h4) that financial officers with a short tenure use simple capital budgeting practices was supported. 5. conclusion the differences of the firms’ characteristics on the application of capital budgeting practices were examined in this study. 186 sri lankan firms were responded to the survey and structured questionnaire was used to collect the data. independent sample t test was performed to examine the differences on the choices of capital budgeting practices in terms of firms' characteristics. outcome of the study revealed that the use of the payback method was preferred by small sized firms and mainly managed by financial officers with nonmba educational qualifications and short tenure. industry differences did not make any significant difference to the use of pay back period. discounted payback period was more significantly used by small firms than large firms and managed by financial officers with non-mba educational qualifications. accounting rate of return was primarily applied by non-mba financial officers and was also preferred by non-manufacturing firms. net present value and internal rate of return were used mostly by large firms than small firms; these were mainly managed by financial officers who have qualified masters in business administration and long tenure. sophisticated capital budgeting practices, in particular real option and game theory, were significantly preferred by large companies more than by small companies and those were managed by masters in business administration qualified financial officers who had a long tenure. size of the capital budget increases the application of sophisticated and advanced capital budgeting practices. the relationship is much stronger in the case of sophisticated capital budgeting practices. a larger capital budget reduces the use of naive capital budgeting practices. therefore, financial officers use sophisticated and advanced capital budgeting practices when the size of the capital budget is large. overall, this study has asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 347 made a parametric contribution. in a nutshell, this study serves as a springboard for future research. references akalu,m.m. 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december 1, 2020 doi:10.5296/ajfa.v12i2.17679 url: https://doi.org/10.5296/ajfa.v12i2.17679 abstract blockchain will be the future of accounting education. triple entry accounting system is here, and shared ledger has been considered. from the shared ledger different parties can access transactions. as our discussion reveals that distributed ledger, smart contract and blockchain are three important elements in the triple entry accounting system. as a result, blockchain technology is helping the upgrading the process of education system. blockchain technology is a peer to peer communication that allows participants to secure the settlement of transactions, achieve the transactions and transfer of assets at low cost. with certain advantages there are disadvantages too. based on performance and acceptance, it is clear that in future the implication of blockchain technology would be developed. the concept of triple accounting has introduced the new way of accounting work replacing accounting standard formula. the blockchain technology eliminates the involvement of third party, maintain transparency and charges low transaction cost. it will save money and time of people as it is secure and due to decentralization, it is not controlled by one single entity. due to the decentralization, every user of the network can see the file. so, blockchain should the part the accounting education in future. keywords: blockchain, cryptocurrency, bitcoin, accounting, education asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 15 1. introduction on blockchain technology & education according to yang, li, wu & zhao (2017), blockchain technology is regarded as another innovative technology after cloud computing, internet of things and big data, which has received high concern by governments, financial institutions and technology enterprises. with the creation of bitcoin (a cryptocurrency), blockchain technology concept was appeared. blockchain technology is a technical scheme to maintain a huge and trusted database by means of confidence and high faith. blockchain technology is not only important for financing but also has a great ability in education. it is assumed that the blockchain technology is important to upgrade the process of the educational system. with advancement of technology and trust built into technology, blockchain can help transform higher education and provide alternative version to secure and guarantee lifelong learning. with the help of artificial intelligence and improved technology, personalised learning is improving learning outcomes for students at all level. as it is easier to keep track and store information, blockchain technology could be used to upgrade the library. blockchain technology includes learning behaviour in class, macro educational background, and micro academic project experience and many more. blockchain technology contributes to minimize academic degree fraud as blockchain distributed ledger is unable to change and is reliable. 2. about blockchain this technology allows data to be stored and exchanged on a peer-to-peer basis. blockchain data can share consulted and secured thanks to consensus-based algorithms. as it is being used in a decentralized manner, it removes the need for “trusted third parties” (cachin, 2016). blockchain is the chain of blocks where information of the transactions is being kept. however, blockchain is not fully secure, but it is being used for keeping various information to avoid fraudulent activities. the only con in the blockchain is when a block has been added to the last it is difficult to change or delete the blocks. it has been needed hackers to change the blocks. blockchain emerged from the amalgamation of two concepts. 2.1 asymmetrical cryptography it allows users who are unknown to each other to exchange encrypted information. the system is based on a public key that can be made available to all that allows encrypted data to be sent to a third party. now a third party gets access to the encrypted data to a private key. here the public key is similar to a bank account number and on the other hand, a private key that remains secret acts as the password for the same bank account number (kosba et al., 2016). 2.2 distributed it architecture this system is a series of different independent computers. that connects to a network and can communicate with each other. the blockchain network is a peer to peer distributed system. here, information is to be shared among the different users. 3. cryptocurrency according to harwick (2016), a cryptocurrency is a method of representing virtual “coins” and providing secure ownership. a cryptocurrency is a digital currency that is created and managed asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 16 through the use of advanced encryption techniques known as cryptography (barone, 2019). a cryptocurrency is a digital or virtual asset which plays a huge role as medium of exchange. with the creation of bitcoin, cryptocurrency has brought immense change from being an academic concept to virtual reality. cryptocurrency is built with cryptographic protocols through advanced techniques which make transaction secure and difficult to fake. there are various cryptocurrencies which are being popular in circulation today. few of the popular cryptocurrencies are explained below: 3.1 bitcoin it is a digital currency launched in 2009. it is the most original and widely used cryptocurrency. bitcoin is operated by decentralized authority and is not backed by any country’s government and central bank. it is a virtual currency used for trading goods and services with vendors who accepts bitcoins as payment. the value of bitcoins can fluctuate quickly just as with stocks. 3.2 bitcoin cash (bch) the hard fork of the original bitcoin, which was launched in 2017, has become one of the successful and most traded cryptocurrencies. bitcoin cash has an 8mb blocksize compared with 1mb for the original bitcoin which allows more transactions to be processed faster. it takes place as the result of misunderstandings and arguments between developers and miners. 3.3 litecoin (ltc) it was among the initial cryptocurrency followed by bitcoin which was launched in 2011. litecoin is a peer to peer cryptocurrency where creation and transfer of the coin is based on open source global payment network and is not managed by any central authority. it is also referred as “silver to bitcoin’s gold” or “bitcoin’s little brother” because litecoin is like bitcoin in many ways. it offers a faster transaction confirmation as it has a faster block generation rate. 3.4 ethereum (eth) it is a decentralized software platform which was launched in 2015. it enables distributed applications to be built and run without any downtime, fraud and interference from a third party. instead of mining for bitcoin, miners can earn ether. ether is a type of crypto token that fuels the ethereum platform. the bitcoin blockchain offers one particular application that enables online bitcoin payments whereas the ethereum blockchain focuses on operating the programming code of any decentralized application. 3.5 ripple (xrp) it is a global settlement network that offers instant and low-cost cross-border payments which was launched in 2012. it enables banks to settle international payments in real time with end to end transparency and at minimal cost. ripple’s consensus ledger is unique as it doesn’t require mining and reduces the usage of computing power and minimizes network latency. it is one of the most convincing digital currencies among financial institutions for cross-border payments. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 17 3.6 neo it is the first open source cryptocurrency which was launched in china as antshares in 2014. it is the largest cryptocurrency which aims to the development of smart contracts and assets on its platform. it targets to be the platform of choice for the new smart economy. 4. bitcoin according to swan, (2015) bitcoin is a digital currency or an online payment system in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. bitcoin is the first crypto currency invented by an unknown person satoshi nakamoto in 2009. it is a type of electronic cash. so, it doesn’t have any physical depiction. bitcoin can also be defined as a virtual monetary unit. a unit of bitcoin is divisible and can be further divided into 100 million “satoshis” which is the smallest fraction of a bit coin. a bitcoin blockchain is often referred to as the ledger of the bitcoin system because it is a data file that carries the records of all past bitcoin transactions including the creation of a new bitcoin units. bitcoin is very popular among the people. bitcoins are totally virtual coins designed to be self-content for their worth. there is no need for banks to move and store the money. bitcoins are just like physical gold coins they possess the same value and trade just as if they are nuggets of gold in the owner’s pocket. it can be used to purchase goods and services online or one might tuck them away and hope that their value increases over the years. bitcoins are always transacted or traded from one personal wallet to another, where a wallet is a personal database that is stored on a computer drive, smartphone, tablet, or somewhere in the cloud. bitcoins cannot be forged because it is very computationally intensive to create a bitcoin and hence, it is not financially worthy for the counterfeiters to manipulate the system. bitcoins are generated in the market from the bitcoin mining. it has been assumed that bitcoin is very safe to use, but it has some trust issues between the parties who are dealing with bitcoin. bitcoins can use in various fields to raise funds for a start-up of new business. there is an example of exchange currency by böhme, christin, edelman, & moore, (2015) that in spring 2012, the japan-based mt. gox exchange served over 80 percent of all bitcoin transactions. however, mt. gox collapsed in early 2014 and reported in its bankruptcy filing “losing” 754,000 of its customers’ bitcoins worth approximately $450 million at the time of closure (abrams, matthew, and tabuchi 2014). in march 2015, the seven largest exchanges were btc china, okcoin, huobi, bitfinex, lakebtc, bitstamp, and btc-e, which jointly served more than 95 percent of all bitcoin trade from october 2014 to march 2015. 5. implementation of blockchain technology in accounting and financial services industries as opined by yeoh (2017), blockchain accounting technology has been used in case of identifying the transfer of ownership of assets and to maintain a ledger of financial information. this is because transparency of financial information is essential for ensuring accounting activities. this technology helps to reduce cost of maintaining ledger and provides certainty over the history of assets. actually, blockchain has been used to allocate financial resources asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 18 effectively, which reduces the ledger maintenance cost. as mentioned by ducas & wilner (2017), the scope of accounting has been increased by blockchain. the reason is this technology helps to eliminate reconciliations and ensures the transaction history. as informed by michal, cohn & butcher (2018), blockchain technology has been used in resource planning and valuation rather than book recording. the effective planning of resource allocation increases efficiency level of accounting and financial service profession by developing cost strategy. hence, in case of developing the performance of financial service industry, blockchain technology has a significant role. as trust and transparency in accounting has been ensured by blockchain, the acceptance of this technology is increasing day by day. 6. block chain mechanism according to ducas & wilner (2017), blockchain technology helps to convert fiat to digital currency with the help of peer to peer protocol. every peer has a list of transactions and validation of a transaction can be made through consensus. as stated by michal, cohn & butcher (2018), blockchain technology enhances business process in the financial service industry. it is done by sharing data in a transparent and effective manner. the implementation of this technology has completely changed the performance of financial service industry. this is because the digital cash transaction system has been completely developed based on blockchain throughout the world. this method has been used in case of the back-office operation for improving security and transparency of work. in order to develop capital market performance and enhancing external audit process, blockchain has pivot role. the technology helps to improve performance in financial industry by enhancing the mechanism. the development in the standard of performance in financial market has increased the number of transactions. this technology is really essential in the field of audit and accounting. as the performance inside the audit process has been significantly developed by blockchain, the acceptance of the technology is also increasing. hence, the overall analysis reveals that blockchain has remarkable contribution in case of increasing value of digital assets and lowering the associated cost. 7. advantages of blockchain technology chen, xu, lu & chen (2018) opined that blockchain technology allows participants to secure the settlement of transactions, achieve the transaction and transfer of an asset at a low cost. some advantages of blockchain technology are described as follows: block represents transaction has been created a transaction is requested block is sent to every party nodes validate transactions nodes received a reward the block is added to existing transaction is completed asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 19 7.1 decentralization blockchain technology allows individual transaction to have their own authorization to implement their constraints instead of running huge data center and verifying transactions through the same network. it ensures that if any information gets leaked, only a small amount of data will be compromised not the entire network. 7.2 reliability due to the decentralized networks, the failures of a single network doesn’t affect the operation of the whole network. this ensures the high reliability of the applications built on blockchain technology as it does not have a central point of failure. 7.3 transparency one of the primary reasons blockchain is exciting to businesses is that it is an open source network. any changes in this network is publicly viewable by all parties involved creating transparency. all the transactions in this network are transparent to all the parties and are immutable i.e. they cannot be changed or deleted. 7.4 trust blockchain technology acts as a new trust holder among the users with decentralized ledger. as it is a user controlled the network and there is transparency in the whole network, users can trust that the transactions will be executed exactly as the protocol commands. 7.5 enhanced security blockchain is more secure than any other record keeping system. the information and data are stored across a network of computers instead of one single computer which makes difficult for hackers to hack the information or data. blockchain technology can help prevent fraud and unauthorized activity by protecting sensitive data and information of business and company. 7.6 lower transaction costs for most of the businesses, reducing cost is priority. blockchain technology allows peer to peer a transaction without the involvement of third party. by eliminating third party for transaction process, blockchain reduce transaction fees to the user or businesses (song, shi, xu & gill, 2016). 7.7 faster transaction settlements with the traditional paper process, trading anything is time consuming. transactions done through banks can potentially take days for final settlement. banks and other financial institutes are only open during normal business hours, five days a week. blockchain transactions can make the transaction faster as there are no intermediaries involved and is open 24 hours a day, seven days a week. 8. disadvantages of blockchain technology in spite of all the advantages discussed, the blockchain also has some disadvantages and asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 20 challenges. the disadvantages of the blockchain technology are explained below: 8.1 complexity as this is an advanced technology, non-technical people or old generation people cannot understand it easily. it has made cryptography more mainstream so without the proper understanding of the process, it is not possible to have a trustworthy service. 8.2 size of blockchain with every new transaction happening in blockchain, data are being recorded so the size of the blockchain grows every second. some famous cryptocurrencies like bitcoin blockchain and ethereum blockchain are of huge size so implementation of such blockchain is critical. blockchain ledger can grow larger in due course. size and storage remain a huge barrier for any application built on the blockchain. 8.3 costs the high cost is the big disadvantages of the blockchain. blockchain offers remarkable savings in transaction costs and time but the high initial capital cost could be the restriction (golosova & romanovs, 2018). 8.4 large energy consumption blockchain is the high energy consumption network. the consumption of energy is required to maintain a real time ledger. blockchain network requires nodes to run and nodes are giving time and energy to the network to run efficiently. the blockchain users are attempting thousands of transactions per second using extensive amount of computer power. 8.5 privacy blockchain transactions might appear private since it is not directly attached to your identity, but as they are recorded in the public ledger personal data cannot be addressed in this platform without cyber security concerns (song, shi, xu & gill, 2016). 8.6 security there is one security flaw in bitcoin and other blockchain i.e. attack of 51%. if two or more miners are working as nodes or calculating the hash of the blocks at the same time, they will get same results. the network will tell a lie and the lie will become the truth. 8.7 human error as the data in the blockchain cannot be altered or deleted, the database needs to be 100% sure and correct. most of the blockchain are accessed through private key. if the private key is lost, it is impossible to access the network. so, the data must be accurate. 9. futures of blockchain technology as opined by kokina, mancha & pachamanova (2017), on the basis of performance and acceptance, it is clear that in the future the implication of blockchain technology would be asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 21 developed. a blockchain based asset identity platform would be helpful to collect and share data for both virtual and physical assets. it is essential for gathering recording information in respect to virtual and physical assets separately. as per yeoh (2017), it has been projected that more than 20 billion iot devices would be existed by 2020. this technology would provide reliable and secure mechanism to iot devices for making transactions effectively. blockchain would help to provide unique identity to virtual assets. this is because; technology has the power to maintain virtual and physical assets separately. as mentioned by ducas & wilner (2017), international trade would be conducted through blockchain by 2030. the development of international trade would help to increase standard of living of people all over the world. hence, the technology-based performance would help to develop the international living standard. the quality of world trade would be improved, and the entire business world would depend on technology. as opined by nowiński, w., & kozma (2017), the blockchain technology would provide effective business value to the international supply chain. this is because the world trade has been conducted currently through chaotic business relationships among parties. as stated by ducas & wilner (2017), the government of various nations would adopt virtual currency within 2030 based on the implementation of blockchain technology. this is because virtual currency system helps to reduce the settlement time and ensures accuracy. hence, for enhancing financial transactions internationally, blockchain has vital role. continuing in the same vein, nowiński, w., & kozma (2017) have opined that the efficiency of the performance of the government of different nations would be developed. the reason is quick settlement can be made in case of financial transactions. according to michal, cohn & butcher (2018), government policies can be easily adopted throughout the world based on the blockchain. as a result, the international relationship among various nations would be improved. hence, the implementation of this technology would change the international scenario within few years. the technology-based performance would make the entire business world faster. as a result, the business performance would be more dynamic, and competition would be increased. 10. triple entry accounting the concept of triple entry accounting has been developed by yuji ijiri, a professor of carnegie mellon university. this concept has introduced the new way of accounting work replacing standard accounting formula (simoyama, grigg, bueno & oliveira, 2017). as stated by dai & vasarhelyi (2017), the triple entry accounting is important in case of strategic decision-making process. this is because; this accounting technique considers the outside parties in accounting entries. actually, third entry has been made in case of triple entry accounting for maintaining transparency in accounting activities. the concept of this accounting system is new in the market which considers cryptographic technology. the reason is cryptographic technology helps to maintain accounting information easily. in case of this accounting system the linkage has been made between two double entry accounting systems. the linkage is made to make it publicly available to see transactions. in case of implementing triple entry accounting system, blockchain has been considered. as mentioned by simoyama, grigg, bueno & oliveira (2017), the triple entry accounting is essential for developing the business performance effectively. this is because transparency can be clearly maintained in accounting activities and right asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 22 policies can be adopted. this accounting technique considers double entry plus cryptography and distributed ledger (blockchain) which ensures the performance of accounting activity. as opined by wang & kogan (2018), the triple entry accounting system helps to improve reliability in accounting system. this is because; flawless recording of transactions can be made. furthermore, the transparent overview of the transactions can be identified easily based on triple entry accounting policy. continuing in the same vein, dai & vasarhelyi (2017) have informed that implementation of the concept of blockchain has developed the acceptance of triple entry accounting. for accessing, updating and sharing accounts in the context of business relationship, this accounting technique has effective role. this is because; the concept of distributed ledger has been used in triple entry accounting system. as mentioned by wang & kogan (2018), the important concept which has been used in triple entry system is smart contracts. the technique helps to develop the performance of financial service industry. the reason is that the use of technology enhances the productivity in the financial service sector. the main advantage of the triple entry accounting system is here shared ledger has been considered. from the shared ledger different parties can access transactions. hence, the discussion reveals that distributed ledger, smart contract and blockchain are three important elements in the triple entry accounting system. 11. accounting standards at both international and domestic level blockchain is an accounting technology. it is concerned with transfer of ownership of assets and maintaining a ledger of accurate financial information. with the rapid growth of blockchain technology, the problem of lack of standards is also increasing. blockchain technology promotes development of international standards in the field of distributed bookkeeping technology (vidrih, 2018). as blockchain can hold currency transactions without any third party, it can hold transactions of any kind of property: shares, bonds, mortgage and others. lazanis (2015) emphasizes that blockchain eliminates the need of banks, insurance companies or any financial institutions if company voluntarily publishes its data and transactions on blockchain network. as for domestic level, blockchain technology has been increasing economic and accounting standards. government should start thinking how blockchain technology can be implemented in regard to monetary policy. according to the needs and conditions of the country, a cryptocurrency can be created that will make the transactions easy and make the accounting process convenient. if new cryptocurrency is created to act as a country’s official currency, it would be a great development for the country and its monetary policy. according to wetzel (2018), the economic struggles of developed and developing countries require a blockchain technology as it can sufficiently provide a new economic structure that would assist developing and developed countries with economic setbacks. it showcases the revolutionary potential that blockchain have in improving the standards of individuals and governments. the blockchain as a source of trust can be helpful for the accounting structure. modern accounting system is based on a double entry system. but with the implementation of blockchain technology, it can replace the method of double entry and make the transactions easier and faster. blockchain technology can help improve the accounting process and makes asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 23 the transaction secure and easier. 12. blockchain technology should be the part of accounting & finance related course blockchain is mainly use for maintaining the ledger of all transactional data of assets and the wallet balance. blockchain can be used in accounting finance related course, as it is transparent and there is low transaction cost in transferring bitcoin in the ledger and eliminate the thirdparty involvement. if a firm were to all voluntarily post of its business transactions on a blockchain, with a permanent time stamp on each transaction, the firm’s entire ledger would be instantaneously visible and anyone could aggregate the firm’s transactions into income statements and balance sheets in real-time (byström, 2016). the blockchain technology can be used in any market, as it has no master file like only one person will not get the access of the data, but every user can work with the data. so, if any one wants to change the data they must ask for the majority’s opinion. through blockchain technology, companies can move forward a step-in accounting by keeping separate records of transaction receipts, by writing directly in the joint register to enduring the accounting records by interlocking system. therefore, the data and information are cryptographically sealed and safe from the fraudulency or distortion. blockchain is very useful for financial sector as the blockchain technology is based on transparency, decentralization and immutability (tapscott, & tapscott, 2017). it helps financial institutions to create direct link with each other without involving a third party. digitization helps the data to be kept more securely and maintained high privacy. the aspects of blockchain technology for financial sector are discussed below. 12.1 transparency blockchain technology helps people by giving privacy while doing transactions but it is transparent. while people transact it keeps person’s original identity hidden by complex cryptography and dhow the public address to others. therefore, it helps people to be honest while using blockchain technology for transaction. 12.2 decentralization decentralization is used in blockchain technology to make the transactions easier. here involvement of third party is not needed. one can easily send money to the other person without going to bank. bitcoin is the great example of blockchain technology. 12.3 immutability the advantage of blockchain is, once data or information is entered in the blockchain it cannot be changed or tampered. so, it is very useful for companies to keep the financial records in the blockchain. 13. blockchain technology as a future part of accounting & business-related education as opined by mougayar (2016), blockchain technology has impact on the transaction recording, authorization and reporting process. this is because the accuracy in the transactions can be easily maintained on the basis of this technology. hence, in future it is essential to include the blockchain technology in business or accounting related education. the concept of this method asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 24 would help to identify people the importance of blockchain in accounting and business performance. as mentioned by dai & vasarhelyi (2017), in case of enhancing financial activities and taxation process blockchain technology has significant role. this is because the accuracy in the performance of financial industry has been developed by this technology. the banking sector has become faster due to the use of blockchain technology. this has developed transparency and quality of service. currently, businesses spend hefty amount of money in auditing. with the ease of access in blockchain technology, this is likely to decrease. as the blockchain gain more authority in the world of finance, the nature of accounting for cryptocurrency is subject to change. many companies and industries adopt blockchain based revenue streams. similarly, accounting based blockchain will need to adapt. as companies adopt this new technology, less auditing manpower and more experienced professionals with vast knowledge is required. the implication of this shift in accounting strategy may be confusing for modern businesses. the replacement for double entry accounting method could be possible as it allows secured and verified information to be stored and accessed by multiple parties from multiple locations. accountants and auditors working may not know about the techniques and procedure to operate them. so instead of firing them, the business owner can educate them on cryptocurrency and blockchain technology. the changes and developments in this technology should be tracked and discussed with the accountant, financial advisor and auditor of the business. they can help business to understand further implications and show the actions to be taken for increasing profit and reducing cost (welker, 2018). with proper knowledge of the blockchain technology and its implications, a business can take advantage of saving time and money in the auditing process. to receive and verify data and information easily, an instantly accessible decentralized ledger could be of great help. this technology opens up new opportunities. accountants’ and auditors’ skills will need to expand to include an understanding principle features, functions and implications of blockchain technology. but sadly, some auditors and accountants who fail to understand and adopt this technology may lose his/her career. 14. cost & benefit analysis blockchain is mainly used as an alternative for the traditional payment system. blockchain systems can be successfully executed in the market like hospitals, financial institutions, companies, economy, software engineering etc. (yli-huumo et al., 2016). the blockchain technology is maintained by a highly secured peer-to-peer network. it has a high level of resistance to accommodating data available in the blockchain. the computers that are involved in this network have the consent that the transactions are valid only before the entry of a new ledger. due to the decentralization, every user of the network can see the file. in addition, no one has the power of computation to the networks. therefore, individuals form a group to increase computational power. they thought of an alternative program of blockchain. all the functions of blockchain are based on a hash function. the hash rate is used for the calculation of measurement of the power of the network. blockchain is very easy to operate. the changes can be done only when a new block added to the chain. it is difficult to change the data in the previous block, as it has been already said that the data in the blocks cannot be changed or asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 25 deleted. therefore, the company needs to ask a hacker to delete or change the data it is costly. recently, the cryptocurrency is very popular among the people to raise capital for business. however, that does not mean that any business could put a thin layer of blockchain and flourish their business by raising capital. many businesses are now digitizing their operation and services. blockchain can be used in many businesses to reduce its cost. previously the cost of the transaction of bitcoin was free. however, after 2016 it charges a minimum of $0.20 each transaction. it can only store 80 bytes of data in a block and can process 7 transactions per second (cai & zhu, 2016). 15. limitations of the blockchain research the study is not free from the limitations. this research is totally based on secondary data. the data, that is available may lack of authenticity. the data available over the internet was depended on other companies. the data and information may be general, or for some particular company. lack of prior studies on this particular topic is also a major concern for this study. at the same time, thorough analysis has done to find and verify the results. 16. conclusion in the nutshell it can be concluded that, blockchain technology is not only important for financing but also has great ability in education. it helps in upgrading the process of education system. blockchain technology is a peer to peer communication that allows participants to secure the settlement of transactions, achieve the transactions and transfer of assets at low cost. with certain advantages there are disadvantages too. on the basis of performance and acceptance, it is clear that in future the implication of blockchain technology would be developed. the concept of triple accounting has introduced the new way of accounting work replacing accounting standard formula. this concept is important for strategic decision-making process. blockchain technology is very useful to use in accounting and financial sector, but there are many obstacles need to overcome. blockchain technology based on accounting sector is being adapted by many companies and businesses which could replace double entry accounting method. the blockchain technology eliminates the involvement of third party, maintain transparency and charges low transaction cost. it will save money and time of people as it is secure and due to decentralization, it is not controlled by one single entity. due to the decentralization, every user of the network can see the file. references barone, a. 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(2016). where is current research on blockchain technology?—a systematic review. plos one, 11(10), e0163477. https://doi.org/10.1371/journal.pone.0163477 copyrights copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/4.0/) microsoft word 11962-43970-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 219 a singaporean study on macroeconomic variables impacting stock returns boon leng mark, goh graduating honours student, coventry university singapore (psb academy) 6 raffles blvd, #03-200, singapore 039594, singapore tel: 65-9673-5026 e-mail: mark.g.goh@gmail.com ameen ali talib head of applied projects business school, singapore university of social science 461 clementi road, singapore e-mail: ameentalib@suss.edu.sg received: oct. 7, 2017 accepted: nov. 24, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11962 url: https://doi.org/10.5296/ajfa.v9i2.11962 abstract stock market returns has increasingly become a leading indicator of a country’s economic performance. this explains academia’s growing interest in determining factors affecting stock returns. a majority of recent studies on singapore’s economic performance focused centrally around policy impact or property prices, and not specifically on stock returns. this study aimed to fill this gap, by examining if, and how, historical movements in the straits times index (sti) were explained by the s$neer, monetary supply, cpi, balance of payments, crude oil prices, electricity generated, gfcf, industrial production, merchandise trade, or labour cost. by utilizing a structural vector auto regression (svar) model, approximately 48% of the sti’s variance was collectively attributable to these ten macroeconomic variables, all of which had short-term impact on the sti. looking forward, further research could be conducted examining the impact of said variables on individual sectoral stock indices, for greater insight on the dynamics of their relationships. keywords: finance, econometrics, structural vector auto regression, stock returns, singapore asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 220 1. introduction warren buffett, renowned investor in recent decades and owner of investment company berkshire hathaway, was noted to turn to an unorthodox indicator for valuing companies, i.e. comparing a country’s total stock market capitalization to that country’s gdp (reese, 2016). dubbed the “buffett indicator”, this ratio was intended to suggest that stocks in a certain country were undervalued at lower levels, and overvalued at higher levels (li, 2017; reese, 2016). as such, this indicator made headlines recently as it showed that levels for the us market was heading close to its peak right before the dot-com bubble of 2000; suggesting that a possible bearish turn in the market is approaching (li, 2017). chang and pak (2017) found this indicator to be reliable for some, not all countries, with singapore being one of the countries in which the indicator could be used to reliably compare countries’ stocks for better returns. at the same time, other than hong kong, singapore’s buffett indicator score of over 200% of gdp is the highest in comparison with its trade partners such as malaysia (130%), china (70%), indonesia (40%), the european union (45%), and the us (150%), or the global average of approximately 95%; hong kong aside (over 1,000%) (ministry of trade and industry, 2017; worldbank, 2017). however, in the spirit of thorough due diligence before investing, a single technical indicator is insufficient in coming to a conclusion on singapore’s stock returns. as such, this research aims to impart a more thorough understanding of how macroeconomic factors affect stock returns, with a focus on singapore’s climate. the main objectives of this research are: • to determine the effect of macroeconomic variables on stock returns in singapore, by using changes in the straits times index price as a basis of determining stock returns. • to determine the extent to which macroeconomic variables explain the differing stock returns in singapore. 2. literature review 2.1 macroeconomy and stock returns alam and rashid (2014) noted that stock market returns has grown to be a leading indicator of a country’s economic performance. this explains why there has been academic interest in determining factors which affect such returns, both in the long and short run. however, given that studies focus on different countries, with different economic climates, as well as differing time periods, there have been several similar findings, as well as dissimilar ones. kurniawati et al. (2016) examined the short-term impact of macroeconomic variables on overall indonesian stock returns, and indonesian sectoral index stock returns. a structural vector autoregression (svar) model was constructed to determine the relationships between the jakarta composite index (jci) and several sectoral indices, with macroeconomic variables such as exchange rate (vs usd), inflation, oil, gold, interest rates, monetary supply, fiscal deficit, government debt and trade balances. this study yielded findings that suggest oil and gold prices have a positive effect on agricultural and mining stock returns, while interest rates have a negative impact on the jci, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 221 and that exchange rates have a negative effect on the jci and all other indices except for mining. country-specific economic factors were noted to account for these findings. indonesia’s economy does include significant oil palm agricultural activity and that of gold mining; hence fluctuations in the price of such products do have a positive linear impact on stock returns. the study also suggested that interest rates’ negative impact on returns were attributable to the fact that a higher interest rate means a higher cost of debt, hence affecting a firm’s profitability and in turn lowering stock returns; thereby indirectly suggesting there being a norm for indonesian firms to have a high debt/leverage. as for the negative impact that exchange rates have on stock returns, it was explained that a depreciation of domestic currency decreases the relative price of exports from a second country’s perspective, hence increasing the volume of exports from indonesia, leading to increased profits and in turn higher stock returns for export-oriented firms (kurniawati et al., 2016). ravnik and zilic (2011) used an svar model to investigate the short-run impact of fiscal policy on croatian inflation, short-term interest rates, and economic activity. in croatia, a country that was noted to have a pro-cyclic and expansive fiscal policy, one notable finding this study made was that government expenditure shocks had a negative short-term impact on industrial production, which the study used as a proxy for economic activity. this was unexpected as the study had previously expected government expenditure to have a positive effect on industrial production (i.e. economic activity) (de arcangelis and lamartina, 2003; perotti, 2002; ravnik and zilic, 2011); in other words indirectly implying an expected increase in stock returns. kuwornu (2012) studied the impact of macroeconomic variables on stock returns in ghana. a different methodology, the johansen multivariate co-integration procedure, was used on the following variables: the consumer price index (cpi; as a proxy for inflation), crude oil prices, the exchange rate, and 91-day t-bill rates (proxy for interest rate); to determine their relationships with the ghana stock exchange all share index (i.e. stock returns). as ghana was noted to be a country in which investors perceive interest rates to be “alternative investment opportunities” (kuwornu, 2012), increases in interest rates lead to decreases in equities investments. this explained the findings of a negative short-term relationship between the two. ghana was also noted to be a net importer of oil, crude oil prices are considered a production cost to economic activities; hence a negative correlation finding with stock returns. contrary to indonesia, a net exporter (kurniawati et al., 2016), ghana is a net importer; hence explaining the positive effect exchange rate has on economic activity, and in turn, stock returns (kuwornu, 2012). alam and rashid (2014) went a step further by considering conditional heteroskedacity, by investigating the relationship that macroeconomic variables shares with the karachi stock market 100 index in pakistan. by using a garch (generalized autoregressive conditional heteroskedasity) model, it was found that the consumer price index, money supply, exchange rates and interest rates had a negative relationship with stock returns, while industrial production had a positive relationship with stock returns, and inflation had an inconsistent negative relationship with the latter. the study had noted that it was attributable to the fact that in pakistan, an export-oriented country, stocks are not popular investment choices. money supply was also found to only influence stock returns via inflation. this asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 222 study also noted that this market saw concentrated shareholdings, and with the lack of popularity in stock investments, there was little noted incentive for informational and operational efficiency, explaining its low liquidity (alam and rashid, 2014). chia and lim (2015) used an autoregressive distributed lag (ardl) bounds test to examine responses in the malaysian share price index to industrial production, inflation, monetary supply, interest rate and exchange rate. this study found that cpi had a negative relationship with stock returns, and an increase in money supply was found to increase stock returns. this was rationalized by the suggestion of portfolio theory that a greater money supply leads to a move from non-interest bearing to interest-bearing, such as stocks (chia and lim, 2015). exchange rates were also cited in this study as theoretically influencing stock prices, as the malaysian economy is export-oriented. 2.2 singapore’s economy and stock returns ali et al. (2014) examined the impact of monetary and fiscal policies’ shocks to housing prices in singapore, via svar modelling. this same approach was used to determine the effects of the same policies, along with other macroeconomic factors including gold prices, oil prices, exchange rates and government expenditure on stock returns. this study found that stock returns had a positive reaction to oil prices and government expenditure (proxy for fiscal policy), and negative to exchange rates and gold prices, but none to housing prices. gold and oil prices were also found to have negative impacts on exchange rates. singapore is a net exporter overall, with nearly 70% of its exports being merchandise (with the rest being services), and neither of which is in gold (ministry of trade and industry, 2017). as such, it would be unsurprising that exchange rates and gold prices negatively impact stock returns, and that gold and oil prices negatively impact the exchange rate (ali et al., 2014). however, given that singapore’s oil & gas sector remains a significant part of the local economy, it accounted for the positive relationship between oil prices and stock returns in singapore. however, there are several other notable macroeconomic factors relevant to singapore that warrant discussion as well. firstly, given that singapore is more abundant in labour than in natural resources (e.g. oil, gold etc.), the cost of labour would in fact be relevant in playing a part to influence stock returns locally; especially so since it forms up to over 40% of business costs in singapore (ministry of trade and industry, 2017). in fact, given that unit labour cost rose faster than labour productivity gains (ministry of trade and industry, 2017), this rise in labour cost should have a negative impact on stock returns. secondly, close to if not all reviewed studies used the usd as their benchmark for exchange rates. there was however no mention of whether this benchmark was justified by the us being the base country’s most significant trade partner. in singapore’s context, the us is the 4th largest merchandise trade partner, but does not make the top 5 export destinations in 2016 (ministry of trade and industry, 2017). as such, a benchmark purely against the usd may not be a reliable indicator of the strength of singapore’s currency. one possible measure would be the singapore-dollar nominal effective exchange rate (s$neer), which benchmarks the sgd against a basket of currencies; weightage of which takes into asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 223 consideration the base country’s trade partnerships (international monetary fund, 2006). as with the above-mentioned studies, as singapore is a net exporter, it is hypothesized that exchange rates (i.e. s$neer) has a negative impact on stock returns. while still on the topic of trade, given the importance of manufacturing and import/exports to singapore’s economy, both total industrial production and total merchandise trade shall also be taken into consideration for this research; with the hypotheses that both have positive impacts on stock returns. at the same time, arora and lieskovsky (2014) investigated the idea of using measures of electricity usage as an indicator of economic activity. this study found that in the us, electricity usage was a strong indicator of activity in the economy. total retail electricity sales would not only cover manufacturing, but also services and other activities in general, whether supported by or as a product of economic activity (arora and lieskovsky, 2014). as such, we hypothesize that in singapore, total electricity generated (the proxy of the equivalent), has a positive impact on stock returns. next, studies such as alam and rashid (2014) and kuwornu (2012) took into consideration cpi as a proxy for inflation. the cpi fell by 0.5% in 2016; in spite of increasing overall prices of recreation, healthcare, food and education, the decline was attributed to decreases in transport, accommodation and utilities prices (ministry of trade and industry, 2017). as with both previously-discussed studies, should inflation decrease, stock returns would hypothetically increase. as also seen in the above studies, the government plays a significant role in boosting the economy, via fiscal and monetary policies. as such, monetary supply shall also be taken into consideration. in line with the findings of kurniawati et al. (2016) and chia and lim (2015), it is hypothesized that singapore’s monetary supply has a positive impact on stock returns. even though their results showed otherwise, ravnik and zilic (2011) hypothesized that croatian government expenditure would have a positive effect on industrial production (i.e. economic activity), and in turn be positive on domestic stock returns. ali et al. (2014), however, yielded results in singapore context for this same hypothesis. with the balance of payments as a proxy for government expenditure, this same hypothesis shall be undertaken. lastly, gross fixed capital formation (gfcf) is also recognized as a key performance indicator of singapore’s economy (ministry of trade and industry, 2017). gfcf measures the overall changes in fixed assets for the different sectors in a country; being understood to have a positive relationship with economic strength (ministry of trade and industry, 2017). as such, it shall be hypothesized that gfcf has a positive impact on stock returns. 2.3 the structural vector autoregression (‘svar’) model 2.3.1 var models with a growing popularity in recent decades, a vector autoregression (var) model is a time-series analysis tool which has several similar characteristics to large-scale simultaneous equation models, is in fact a systems regression model (brooks, 2014; gottschalk, 2001; luetkepohl, 2011). in other words, it analyses several variables at once, and determines the relationships between them, even if more than one of these variables are dependent variables asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 224 (brooks, 2014; gottschalk, 2001; luetkepohl, 2011). 2.3.2 benefits of var modelling firstly, all variables are considered to be endogenous in a var model. this means that exogeneity of any variables need not be defined; hence shortening the model construction process (brooks, 2014). secondly, as var models capture the values of variables which are attributed to both its lags and white noise terms (as do univariate ar models), these models are able to offer more information on causation, while being able to handle data with higher frequency (brooks, 2014; luetkepohl, 2011). 2.3.3 drawbacks & limitations of var firstly, the appropriate lag lengths must be determined in order to construct the var model, or the interactions between the variables will not be interpreted reliably by the model (brooks, 2014). secondly, all the variables must satisfy the stationarity condition in order for their coefficients to be statistically significant for hypothesis testing (brooks, 2014). also according to brooks (2014), stationarity can be induced via differencing the values, but this would reduce the amount of insight the model could provide with regards to long-run relationships between the variables. thirdly, given that vars do not rely heavily on the theoretical information behind potential relationships between the variables, var coefficient estimate values do not have one consistent method of interpretation; hence making var models nearly impossible to interpret, especially in their reduced-form (brooks, 2014; gottschalk, 2001). on the other hand, by running the appropriate lag length test, variable stationarity tests and implementing contemporaneous structural restrictions to the var model (i.e. structural var / svar), the downsides to using a var model are reduced. 3. research hypotheses 1. s$neer has a negative impact on sti 2. monetary supply has a positive impact on sti 3. cpi has a negative impact on sti 4. balance of payments has a positive impact on sti 5. crude oil prices has a positive impact on sti 6. electricity generated has a positive impact on sti 7. gross fixed capital formation has a positive impact on sti 8. total industrial production has a positive impact on sti 9. total merchandise trade has a positive impact on sti 10. unit of labour cost has a negative impact on sti asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 225 4. research methodology 4.1 data description to investigate these hypotheses, the following quarterly data was gathered: variable unit remarks source s$neer index base jan 1999 = 100; average week ending figures department of statistics, singapore monetary supply sgd m1+m2+m3 in million dollars department of statistics, singapore consumer price index index base year 2014 = 100 department of statistics, singapore balance of payments sgd bpm6 format; overall balance in million dollars department of statistics, singapore crude oil price usd/barrel worldbank electricity generated gigawatt hours dec 2016 figure was estimated department of statistics, singapore gross fixed capital formation sgd 2010 market prices in million dollars department of statistics, singapore total industrial production index base year 2015 = 100 department of statistics, singapore total merchandise trade sgd 2012 prices in thousand dollars department of statistics, singapore unit of labour cost index base year 2010 = 100 department of statistics, singapore ftse straits times index sgd bloomberg 4.1.1 electricity generated as the data for dec 2016 was unavailable at the time of information retrieval, the figure was estimated to be 4,210 gigawatt hours by taking into consideration the existing, as well as seasonal, trends from jan 2010-dec 2016. 4.1.2 differing base years & market prices it was noted that the data had differing base years for indices and market prices. however, as illustrated by luetkepohl (2011), given that the svar model measures reactions to structural shocks, the input data for analysis shall be the differences of these data points, e.g. the first value for crude oil prices shall be derived by subtracting the price in march 2010 from the price in june 2010. differencing the values and using first difference values would also induce stationarity, which would not be an issue since long-run relationships will not be examined in this research (brooks, 2014; gottschalk, 2001). 4.2 methodology all statistical analyses were done via eviews 9. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 226 4.2.1 pre-estimation the following pre-estimation tests were carried out, and for the following purposes: the unit root test, which determines the stationarity of variables. the lag order selection criteria, which determines the optimal lag for the var model, via schwarz information criterion. the var stability test, which shall determine if the range of modulus values generated based on the var model’s equation for the sti shall allow the var model to be in a stable state. 4.2.2 svar an ab-model svar model was constructed to validate the hypotheses. more specifically, an ab-model approach shall be utilized to structure the svar. amisano and giannini (1996) describe and document evidence that it is required for a var model to be considered in its reduced form, in which the variables’ instantaneous relations are not only unexplained, but also unapparent when uninterpreted. the reduced form of the model is also required in order to utilize the appropriate choleski factor for variance decomposition at the later stage of this analysis (amisano and giannini, 1996). as such, the reduced-form var model is expressed as the following: yt = a1 yt-1 + . . . + ap yt-p + b xt + εt (1) within this model comprising of k endogenous variables, yt is a k vector of endogenous variables, p refers to the order of the variables in the var model, xt is a vector of exogenous variables, and εt is a possibly-contemporaneously correlated vector of structural disturbances that are uncorrelated with their own lagged values, as they are uncorrelated with those of the right-hand side variables. a and b refer to matrices of coefficients to be estimated. 4.2.3 contemporaneous restrictions working with the assumption that structural innovations within this model are orthogonal, structural restrictions of contemporaneous nature are applied to the var model. without applying these restrictions, it is impossible to draw conclusions from the reduced-form var (gottschalk, 2001). the expression of the svar model, with the restrictions applied, are as follows: a et = b ut (2) the notation et refers to a (k * 1) matrix of the reduced-form residuals, while ut is a (k * 1) matrix of unobserved structural innovations. a and b are (k * k) invertible matrices, where a is the identity matrix, and b is a diagonal matrix. these matrices are imposed on by a set of k(k+1)/2 non-linear restrictions, leaving 2k2-k(k+1)/2 free elements. although kurniawati et al. (2016) utilized a c-model svar with long-run restrictions to examine the effects of macroeconomic variables on stock returns, an ab-model was selected asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 227 in spite of the c-model’s benefits. the c-model is structured such that the endogenous variables have no relationships specified; rather, the impact of set orthonormal disturbances are explicitly specified in the c matrix instead (amisano and giannini, 1996; gottschalk, 2001). however, the premise of the construction of a c matrix as a square matrix has a limitation, in that it is assumed that the number of equations in the matrix is equal to the number of orthonormal disturbances, in spite of having a lack of theoretical reason to assume so (other than as a convenient assumption). the implications in doing so are that there is the assumption that a majority of, if not all, the causes for orthonormal shocks to the model are accounted for; hence potentially skewing the model’s results and not being aware of this bias even with hindsight. on the other hand, an ab-model functions such that the nature of its restrictions imposed on the svar model allows this model to explicitly determine links between the endogenous variables, while also providing insight into the effect that orthonormal random shocks have on the variables (amisano and giannini, 1996; gottschalk, 2001). in addition, given that only quarterly data spanning 17 years was obtained, imposing short-run restrictions was a more conservative option. 5. results and discussion 5.1 pre-estimation test using the augmented dickey-fuller (adf) test for unit roots, the variables were tested for unit roots to determine stationarity: variable t-statistic (5% level) stationary d(s$neer) -1.945823 yes d(ms) -1.946348 yes d(cpi) -1.945903 yes d(bal_p) -1.945903 yes d(oil) -1.945903 yes d(elec_gen) -1.946447 yes d(gfcf) -1.945823 yes d(ind_prod) -1.945823 yes d(mer_t) -1.945823 yes d(ulc) -1.946447 yes d(sti) -1.945823 yes as all the variables were found to be stationary, next is to determine the lag level for the model. this was selected using the schwarz information criterion (sic): asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 228 sample: 2000q1 2016q4 included observations: 63 lag logl lr fpe aic sc hq 0 -4521.692 na 8.62e+48 143.8950 144.2692* 144.0422 1 -4326.805 315.5309 8.70e+47 141.5494 146.0398 143.3155 2 -4146.609 228.8210 1.86e+47 139.6701 148.2767 143.0551 3 -3978.067 155.1658 1.14e+47 138.1608 150.8836 143.1648 4 -3713.071 151.4261* 1.57e+46* 133.5895* 150.4285 140.2124* * indicates lag order selected by the criterion lr: sequential modified lr test statistic (each test at 5% level) fpe: final prediction error aic: akaike information criterion sc: schwarz information criterion hq: hannan-quinn information criterion as observed from the lag order selection criteria above, the schwarz information criterion indicates that this model has an optimal lag of 0. roots of characteristic polynomial endogenous variables: d(s$neer) d(ms) d(cpi)... exogenous variables: c lag specification: 1 1 date: 06/06/17 time: 17:34 root modulus -0.053806 0.665473i 0.667644 -0.053806 + 0.665473i 0.667644 0.620409 0.620409 -0.575150 0.575150 -0.475721 0.282990i 0.553528 -0.475721 + 0.282990i 0.553528 0.154369 0.453371i 0.478931 0.154369 + 0.453371i 0.478931 -0.301318 0.102374i 0.318234 -0.301318 + 0.102374i 0.318234 0.218617 0.218617 no root lies outside the unit circle. var satisfies the stability condition. as observed in the above var stability test, the equation var model for sti generated a range of modulus values that indicated this var model is in a stable state. as such, restriction matrices a and b were imposed on the var model, and the svar model was constructed. 5.2 impulse responses impulse responses using cholesky (d.o.f. adjusted) was examined to determine the impact of the variables on the sti: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 229 5.2.1 impact of s$neer on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(s$neer) sti was found to respond negatively short-term to s$neer, with a drop to -55% over 2 periods before values recover to 0%. 5.2.2 impact of monetary supply on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(ms) monetary supply was found to have a minor short-term positive effect on the sti, as sti levels rose up to 59% over 2 periods before recovering to 0%. 5.2.3 impact of cpi on sti cpi was found to have a short-term negative impact on sti, as sti levels dropped to -52% levels over 2 periods before recovering to 0%. -100 0 100 200 2 4 6 8 10 response of d(sti) to d(cpi) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 230 5.2.4 impact of balance of payments on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(bal_p) balance of payments was found to positively impact the sti in the short run, with sti levels overall rising to as high as 39% within 3 periods before eventual correction back to 0%. 5.2.5 impact of crude oil prices on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(oil) crude oil price was found to have a short-term positive impact the sti, with sti levels initially rising to a high of 67% initially, before dropping to a low of -32% in the 4th period, and eventually recovering to 0%. 5.2.6 impact of electricity generated on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(elec_gen) electricity generated was found to have a short-term negative impact on the sti, given that asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 231 sti levels dropped to -44% over 2 periods before recovering to 0%. 5.2.7 impact of gross fixed capital formation on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(gfcf) gfcf was found to have a positive short-term impact on the sti, with sti levels rising to 9% over 3 periods before recovering to 0%. 5.2.8 impact of total industrial production on sti -100 0 100 200 2 4 6 8 10 responseofd(sti)tod(ind_prod) industrial production was found to have a positive short-term effect on the sti; the levels of which rose to 26% over 2 periods before eventual adjustments back to 0%. 5.2.9 impact of total merchandise trade on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(mer_t) merchandise trade was found to have a positive impact on the sti in the short-run, with sti asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 232 levels initially spiking to 25% before eventual correction back to 0%. 5.2.10 impact of unit of labour cost on sti -100 0 100 200 2 4 6 8 10 response of d(sti) to d(ulc) the cost of labour was found to have a short-term positive impact on the sti, with sti levels rising to 7% over 2 periods before correction back to 0%. 5.3 variance decomposition a cholesky decomposition was also carried out to determine the impact of the variables on one another. the measure of variance accountability was rounded off to the nearest percentage point: variable/ due to s$nee r ms cpi bal_p oil elect gfcf ind_prod mer_t ulc sti s$neer na 1% 8% 8% 3% 1% 3% 2% 2% 0% 1% ms 11% na 3% 6% 5% 4% 2% 1% 4% 3% 1% cpi 10% 10% na 0% 4% 3% 1% 1% 1% 6% 0% bal_p 2% 2% 1% na 1% 4% 1% 1% 0% 1% 4% oil 12% 3% 6% 2% na 1% 2% 1% 1% 1% 0% elect 9% 8% 3% 2% 4% na 1% 7% 1% 8% 4% gfcf 7% 3% 1% 22% 1% 2% na 0% 3% 4% 2% ind_pro d 2% 2% 3% 10% 21% 7% 1% na 4% 2% 1% mer_t 5% 2% 5% 12% 7% 2% 2% 6% na 2% 2% ulc 6% 10% 5% 5% 8% 20% 3% 3% 2% na 3% sti 9% 10% 9% 4% 9% 3% 0% 2% 2% 0% na 5.4 discussion 5.4.1 hypothesis 1: s$neer has a negative impact on sti sti was found to respond negatively short-term to s$neer, and it was found that approximately 9% of variance observed in the sti was attributable to the s$neer. this means the strength of singapore’s exchange rate, relative to its key trade partners, has a negative impact on its domestic stock returns; accounting for about 9% of these returns. this asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 233 finding was in line with expectations. as previously discussed, although domestic currency appreciation implies a lower cost of importing goods, net exporting countries such as singapore face an increasing demand in exports when the domestic currency depreciates, and vice-versa. 5.4.2 hypothesis 2: monetary supply has a positive impact on sti monetary supply was found to have a minor short-term positive effect on the sti, and it was found that approximately 10% of variance observed in the sti was attributable to monetary supply. this means monetary supply in singapore has a positive impact on its stock returns; accounting for about 10% of these returns. this finding was in line with expectations. previous discussions on portfolio theory, where an increase in money supply leads to an increase in interest-bearing assets including stocks, and vice-versa; as mentioned by chia and lim (2015). 5.4.3 hypothesis 3: cpi has a negative impact on sti cpi was found to have a short-term negative impact on sti, and it was found that approximately 9% of variance observed in the sti was attributable to the cpi. this means inflation was found to have a negative impact on stock returns in singapore; accounting for about 9% of these returns. this finding was in line with expectations; as discussed earlier with regards to findings in alam and rashid (2014), as well as chia and lim (2015). 5.4.4 hypothesis 4: balance of payments has a positive impact on sti balance of payments was found to positively impact the sti in the short run, and it was found that approximately 4% of variance observed in the sti was attributable to balance of payments. this means government expenditure in singapore has a positive impact on its domestic stock returns; accounting for about 4% of these returns. this finding was in line with expectations. the significance of this positive impact was highlighted in the findings that government expenditure explains approximately 10% of industrial production behaviour and 12% of merchandise trade behaviour, as well as about 8% of the s$neer changes. 5.4.5 hypothesis 5: crude oil prices has a positive impact on sti crude oil price was found to have a short-term positive impact the sti, and it was found that approximately 9% of variance observed in the sti was attributable to crude oil prices. this means crude oil prices have a positive impact on singapore’s stock returns; accounting for about 9% of these returns. this finding was in line with expectations. as previously discussed, singapore’s oil & gas sector is significant to the local economy, and hence the significant and positive relationship (ministry of trade and industry, 2017). 5.4.6 hypothesis 6: electricity generated has a positive impact on sti electricity generated was found to have a short-term negative impact on the sti, and it was found that approximately 3% of variance observed in the sti was attributable to electricity generated. this means electricity generated in singapore was found to negatively impact stock returns; accounting for about 3% of these returns. this finding was not in line with asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 234 expectations. it was, however, noted that utilities costs to singapore firms form anywhere from 3% to 29% of total costs (ministry of trade and industry, 2017). given so, electricity consumption in singapore could possibly be in fact strictly a cost variable, not a positive indicator of economic activity; hence explaining the negative relationship. another possibility was the ongoing concern which was noted earlier, that there was the possibility that estimating the dec 2016 figure skewed the data. however, estimation was only relevant to one of the 68 observations, which took into account the latest ongoing and seasonal trends. as such, likelihood of skewedness was kept to a minimal. 5.4.7 hypothesis 7: gross fixed capital formation has a positive impact on sti gfcf was found to have a positive short-term impact on the sti, and it was found that almost 0% of variance observed in the sti was attributable to the gfcf. this means the same drivers that lead to increases in fixed assets in singapore also positively impacts stock returns. this finding was in line with expectations. however, it was also found that gfcf does not explain changes in stock returns. this could be possibly be explained acquisitions of fixed assets are for future benefits, for example business expansion, which in turn leads to a better present value valuation of a firm’s stocks, and hence influencing stock returns. 5.4.8 hypothesis 8: total industrial production has a positive impact on sti industrial production was found to have a positive short-term effect on the sti, and it was found that about 2% of variance observed in the sti was attributable to industrial production. this means industrial production positively drives stock returns in singapore; accounting for about 2% of such returns. this finding was in line with expectations, validating industrial production as a reliable indicator of economic strength (ministry of trade and industry, 2017). 5.4.9 hypothesis 9: total merchandise trade has a positive impact on sti merchandise trade was found to have a positive impact on the sti in the short-run, and it was found that approximately 2% of variance observed in the sti was attributable to merchandise trade. this means merchandise trade positively influences stock returns in singapore; accounting for about 2% of these returns. this finding was in line with expectations, validating industrial production as a reliable indicator of economic strength (ministry of trade and industry, 2017). 5.4.10 hypothesis 10: unit of labour cost has a negative impact on sti the cost of labour was found to have a short-term positive impact on the sti, and it was found that nearly 0% of variance observed in the sti was attributable to the unit of labour cost. this means the same driver of rising labour costs also impacts stock returns in singapore in the same direction. this finding was not in line with expectations. one explanation for this discovered positive relationship is that as a net exporter, a significant proportion of the money used to pay for labour costs in singapore comes from the foreign trade partners. as such, the higher the unit of labour cost, the greater the amount of money in circulation in singapore (i.e. m1 of monetary supply), which has a positive impact on asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 235 stock returns in singapore. this also possibly explains why labour costs do not directly explain changes in stock returns; as the impact it has is indirect via monetary supply. this also possibly explains the manner in which labour costs explain about 3% of the changes in monetary supply. 5. limitations and further research this research did not take into consideration the impact that the selected macroeconomic variables had on individual sectoral stock indices; with reference to the methodology employed by kurniawati et al. (2016), and in doing so, that study was able to utilize their svar model to obtain a more informed insight into how macroeconomic variables impacted the different sectoral indices, which in turn impacted the overall jakarta composite index. having employed an svar model, this research’s methodology utilized certain assumptions with regards to the structural restrictions being placed on the unobserved structural innovations in the svar model (i.e. ut). the b matrix applied to ut was a square (k * k) matrix; riding on the assumption that the number of equations in the matrix is equal to the number of orthonormal disturbances (amisano and giannini, 1996; gottschalk, 2001). as such, there is the possibility that not all orthonormal disturbances this model faced were explained. further research could be done to account for more of these shocks to the model. in addition, when using the straits times index as a measure for stock returns, not the entire singaporean stock market was taken into account. the sti measures only the top 30 stocks in the market, and these individual stocks could have been replaced over time; hence making it an unreliable measure of stock returns in singapore overall (ftse russell, 2017). the alternative, however, would have been to use the ftse-allshare, which takes into weighted account approximately 86% of the entire domestic stock market (ftse russell, 2017). however, the allshare would have also taken into account shares that have little to no movement in spite of changes in the macroeconomic environment; resulting in skewed data. further research can be carried out looking into which index would be more a more reliable measure for the purposes of research in areas such as this. to add to this point with hindsight, future research could possibly entail acquiring and analysing the prices of the individual stocks or sector, as opposed to indices, for a higher likelihood of more reliable data. acknowledgements as with most if not all research, the availability of finite resources was the most significant constraint, especially the most valuable of all resources, time. dr ameen’s guidance, encouragement and faith has allowed for the overcoming of such constraints in order to produce this piece of work; thanks to him are in order. references alam, z., & rashid, k. 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(2016). buffett’s best measure of valuation is flashing danger for stocks. available: http://www.cnbc.com/2016/11/28/buffetts-best-measure-of-valuation-is-flashing-danger-for-st ocks.html (june 7, 2017) worldbank. (2017). world development indicators: market capitalization of listed domestic companies (% of gdp). available: http://data.worldbank.org/indicator/cm.mkt.lcap.gd.zs?end=2015&locations=eu-1w-s g-cn-my-id-us&start=2015&view=bar&year_high_desc=true (june 7, 2017) copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 58 the link between profitability and financial leverage, evidence from a small island economy lakshana ramnoher university of mauritius keshav seetah university of mauritius received: march 1, 2020 accepted: may 2, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.16770 url: https://doi.org/10.5296/ajfa.v12i1.16770 abstract the objective of this paper was to investigate the link between profitability and financial leverage in mauritius, a small island developing economy. for the purpose of this study data was collected from a sample of 34 companies listed on the stock exchange of mauritius (sem) for period 2007 to 2017. the pecking order theory, the modigliani and miller theory, the tradeoff theory and the agency theory were used to examine the association between profitability and financial leverage in mauritius. the findings of this research reveal a positive link between profitability and financial leverage of mauritian listed companies. this positive relationship is consistent with the modigliani and miller theory, the trade-off theory and the agency theory. this research also reveals a negative link between firm size and profitability. this study also shows that there are no significant relationships between liquidity and profitability and between growth opportunities and profitability of mauritian listed firms. keywords: profitability, financial leverage, modigliani and miller theory, trade-off theory, agency theory asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 59 1. introduction profitability has always been the ultimate aim of all firms and is widely used in assessing their financial performance. the pursuit for profitability has now become an extensive prerequisite for organizations’ long-term sustainability. as a matter of fact, no firms or businesses sustain in the market for a long period of time without generating enough profits. researchers have provided valuable insights in the field of profitability and the possible drivers behind variations in profitability. financial leverage is contemplated to be one of the central drivers of profitability. financial leverage is defined as a composition of debt that an entity uses for investment purposes. elucidating the role that financial leverage plays on profitability of organizations is not a research that was born recently, but stays among the extant research worldwide. the question as to whether financial leverage contributes towards the profitability of firms, has grabbed the attention of numerous researchers such as modigliani and miller (1958), myers (1984), jensen and meckling (1986), rajan and zingales (1995), abor (2005), rehman (2013), eckbo and kisser (2018) and many others. past studies have produced an eclectic mix of results on the link between profitability and financial leverage. in perusing how financial leverage is connected to profitability of firms, a positive association between profitability and financial leverage was supported by yoon and jang (2005), akhtar et al (2012) and eckbo and kisser (2018) amongst others. furthermore studies such as kester (1986), rajan and zingales (1995), and pradhan and khadka (2017) amongst others documented a negative influence of financial leverage on profitability. nonetheless no significant association between financial leverage and profitability was documented by kebewar (2012) and yegon (2014). it is observed that there is no unanimity in the empirical strand of literature with regards to the link between profitability and financial leverage. despite enormous studies investigated the influence of financial leverage on profitability, yet a majority of them concentrated in the economically industrialized countries. scant studies on this area were carried out in developing countries. in addition very few studies have been conducted in this field in small island economies such as mauritius, which is an emerging economy in the african markets. given the dissimilarity in the previous studies and the very limited works in developing economies and small island economies, it is important to investigate the relationship between financial leverage and profitability in mauritius which is an emerging small island economy. this study contributes to the existing literature in developing economies and small island economies in the field of financial leverage and profitability. this paper is as follows. section 2 contains the review of literature, the methodology is explained in section 3, the findings and discussion is in section 4 and section 5 concludes and provides relevant recommendations. 2. literature review 2.1 theoretical review the pecking order theory, the modigliani and miller theory, the trade-off theory and the agency asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 60 theory are commonly used theories in the literature to explain the relationship between financial leverage and profitability of firms. these theories are explained in more detail in this section of the paper. 2.1.1 pecking order theory the pecking order theory (pot) forecasts that there exists an inverse association between profitability and financial leverage. this theory advocates that firms must have recourse to different types of financing according to a specific order. a firm must first use its internal financing through retained earnings, followed by external financing through debt and the last option would be external funding through equity (myers & majluf, 1984). according to myers and majluf (1984), the pecking order of funding firms is grounded on the concept of asymmetric information. this implies that management is better informed about the company’s risks, value and opportunities than investors or shareholders. due to this information asymmetry, no adverse selection problem is observed with retained earnings while equity has higher adverse selection problem as compared to debt. thus, when external funding is used, firms have a stronger preference for debt rather than equity because of higher cost of equity. myers (1984) claims that because of the existence of information asymmetry and adverse selection, this compels profit-making firms to make use of their retained earnings over external financing. the inverse relationship between profitability and leverage can be explained as a result of the fact that profitable firms have higher retained earnings. thus, this reserve will be used when it comes to financing projects of the firm. the latter will be less willing to take debt since they are unlikely to be faced with financing constraints. 2.1.2 modigliani and miller theory as explained by modigliani and miller (1958) in its theory of irrelevance of the capital structure, in a tax-free environment, irrespective of whether a firm is financed by debt or not, its market value remains unaffected. modigliani and miller (1958) draws the attention that a firm’s market value is computed by the risks involved with the underlying assets of a firm as well as the income generated by that firm. also, whether a firm is highly geared or low geared, this has no influence on the weighted average cost of capital (wacc) of that firm. the higher the debt used by a company, the more risky it appears to be, therefore investors will demand for more return. however, as described by alifani and nugroho (2013), the expected return that is paid to investors on the level of equity is compensated by the cheaper cost of debt of the firm. so, in this case, the firm’s value remains unchanged regardless if that firm is highly geared or not in a tax free economy. however, the modigliani and miller (1958) theorem is grounded on certain assumptions such that it operates in frictionless markets and that transaction costs and taxes are not present. modigliani and miller (1963) revised its theorem and included the effect of corporate taxes. according to modigliani and miller (1963), a positive link exists between leverage and a firm’s value. to be able to increase the value of a firm, the latter should take more debt so as to gain asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 61 advantage from the tax-shield effect. this refers to a situation whereby interest is deducted when paying for taxes and hence the amount to be paid in tax is reduced. we can therefore say that a highly geared company pays a lower proportion of tax than a firm which is low geared. in the presence of tax, firms are able to take advantage of the tax shield effect in the case of rising debt proportion. consequently the wacc will decrease whilst firm’s value will rise. in other words, the level of income generated by the firm will grow hence illustrating the positive association between profitability and leverage. this situation occurs up to the optimal capital structure. however, when a firm is too highly geared, this can negatively impact the firm’s value. such a situation will prevail when the firm operates at a point which is beyond its optimal capital structure. this is because after the optimal debt to equity ratio, the costs of financial distress are greater than the cheap cost of issuing debt and consequently wacc starts to increase leading to lower firm value (modigliani & miller, 1963). 2.1.3 trade-off theory the trade-off theory (tot) advocates that a company is faced with the choice of how much debt finance to use and the extent of equity finance to use such that the costs and benefits of each source of finance offset each other. brealey & myers (2003) argued that as a result of a firm’s debt-equity decision, financial managers believe that between the costs of financial distress and interest tax shields, there exists a trade-off. in other words, the tax shield benefits are offset by financial distress costs and agency costs of that firm. under the static trade-off theory, shyam-sunder and myers (1999) stated that there is an assumption that firms will try to balance the costs of financial distress against the interest tax shields’ marginal present values. this optimal level is achieved when the marginal value of the benefits, as a result of issuing debt, completely offsets the rise in present value of the costs related with the issue of more debt. at this optimal debt ratio, the firm’s value is maximized, consequently the firm maximizes profit. the static tot hence depicts financial leverage and profitability to be positively related. niu (2008) suggested that the more profitable a firm is, the higher its target debt ratio is. 2.1.4 agency theory the agency theory portrays that financial leverage is positively associated with profitability. the theory emphasizes on the conflict of interest which may arise between the owners of a company, that is the shareholders, and management. this conflict of interest may crop up when management act in their own personal interests first rather than acting in the best interests of the shareholders. jensen and meckling (1986) stated that the problem is to find ways to prevent managers to engage in inefficient and non-profitable investments. jensen (1986) and stulz (1990) share the same idea that high leverage diminishes the amount of free cash flow available to managers, thereby reducing the need to invest in incompetent firms or other loss-making firms in which management may have personal interests. another remarkable effect is the threat of bankruptcy. due to this threat, managers are forced asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 62 to run businesses profitably. also, given that creditors have the legal right to sue a firm if it fails to honor their claims, managers are urged to run the firm in a profitable manner and avoid wastage of the business resources so as not to lose their jobs. therefore, using debt positively impacts on the level of profitability. 2.2 empirical review existing studies have revealed mixed results on the association between financial leverage and profitability of firms. some studies have documented positive relationship between financial leverage and profitability, some studies have revealed negative association between these two variables and some studies have also documented no significant link between these two variables. research on the association between financial leverage and profitability has mostly focused on developed countries. nonetheless little research has so far been conducted in this field in developing countries and in particular in small island economies. yoon and jang (2005) revealed a positive link between financial leverage and profitability in us. akhtar et al. (2012) revealed a positive link between profitability and financial leverage in pakistan. since the trade-off theory predicts that in rebalancing capital structure between debt and equity that highly profitable firms move towards a highly geared ratio, eckbo and kisser (2018) attempted to use new tests in scrutinizing about the relationship between debt and profitability. they suggested that the cross-sectional correlation of profitability and leverage is significantly positive when rebalancings of capital structure is financed internally. existing studies have also documented negative relationships between profitability and financial leverage. out of an observation carried out in american and japanese manufacturing firms, kester (1986) revealed the existence of an inverse association between profitability and debt ratios. in the same vein rajan and zingales (1995) found a negative link between profitability and leverage in the major industrialized countries namely the g-7 countries. abor (2005) found a negative relationship between profitability and long-term debt ratio in the context of ghana. goddard, tavakoli and wilson (2005) conducted an analysis in the firms of manufacturing and service sector from countries like belgium, italy and the uk and their research revealed a negative association between profitability and financial leverage. in addition kebewar (2013) found a negative relationship between profitability and financial leverage in the french trade sector. pradhan and khadka (2017) found a negative association between profitability and long-term debt ratio in nepal. existing research have also documented no significant associations between profitability and financial leverage. kebewar (2012) revealed no significant link between profitability and financial leverage in france. in addition yegon (2014) documented a non-significant association between profitability and financial leverage in kenya. 2.3 hypothesis development in spite of all the evidences provided with regards to the theories of capital structure, barclay and smith (1999) discuss that no such model exists which decisively test the validity of the contradicting theories. theories explaining the link between profitability and financial leverage asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 63 are found to be in conflicts given the fact that not all theories conform to each other and hence do not predicate a single conclusion based on the relationship between profitability and debt. whilst the modigliani and miller (1963) theory, the trade-off theory and the agency theory validate a positive association, the pecking order theory predicts an inverse relationship between financial leverage and profitability. as a matter of fact, taking into account the theoretical framework and past studies carried out, literature is still unclear on the relationship between profitability and financial leverage. out of all the assorted views revealed by the theories of capital structure in connection with the relationship between profitability and financial leverage, the majority of the existing theories predominantly ascertain a positive relationship. moreover most empirical studies in developed countries showed debt is negatively related to profitability whereas in developing countries, most of the studies concluded a positive association. since mauritius is an economically developing country, therefore the relevant hypothesis is that there is a positive link between profitability and financial leverage of mauritian listed companies. 3. methodology 3.1 model specification theories such as pecking order theory, modigliani-miller theorem, trade-off theory and the agency theory have been used to examine the relationship between financial leverage and profitability of mauritian listed firms. the period of study is 2007 to 2017. data was collected from a sample of 34 firms listed on the stock exchange of mauritius (sem). an unbalanced panel data was mounted because of a few missing data and also because a few firms started operations after 2007. the total number of firm year observations for the period of study is 312. the following regression model has been used to investigate the association between financial leverage and profitability. this model has been adapted from rajan and zingales (1995), yoon and jang (2005), akhtar et al. (2012), kebewar (2012) and pradhan and khadka (2017) amongst others. 𝑅𝑂𝐴𝑡 = 𝛽0 + 𝛽1 𝐿𝐸𝑉𝑡 + 𝛽2 𝐹𝑆𝐼𝑍𝐸𝑡 + 𝛽3 𝐿𝐼𝑄𝑡 + 𝛽4 𝐺𝑂𝑡 + 𝜀𝑡 model 1 where; roat = return on assets of a firm at time t. it is the ratio of profit for the year to total assets of a firm. levt = financial leverage of a firm at time t. it is measured as the ratio of total long-term debt to total assets of a firm. fsizet = size of a firm at time t and it is the log of total assets of a firm. liqt = liquidity of a firm at time t and it is measured as the ratio of current assets to current liabilities of a firm. got = growth opportunities of a firm at time t and it refers to annual percentage change in asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 64 total assets of a firm. in the first instance pooled cross-sectional ols has been conducted. the main problem with pooled cross-sectional ols is that it discards the characteristics of heterogeneity and uniqueness of data sets. for this reason hausman test has been conducted to determine the use of either the fixed effect or the random effect model. 3.2 description of variables profitability measure is the dependent variable employed in the model since the study focuses on the link between profitability and financial leverage. this study has assessed whether taking debt contributes to the profitability of firms. generating profits remain the ultimate objective of all firms and without profitability, this will lead to the closure of firms as in the long run, no business will survive. profitability is referred to be a measurement of efficiency. it is associated with whether a firm is able to earn a return on an investment based on its resources. hence, the financial metrics that has been used as a proxy for profitability is return on assets (roa). as per kangarlouei et al. (2012), out of all the financial ratios that exist to evaluate financial performance of a firm, roa is among the most widely used financial ratios. financial leverage is an independent variable in the regression model used to examine the link between financial leverage and profitability. the more debt a company takes, the more it will have to pay in terms of interest expense. hence the firm will be paying fewer corporate taxes due to the benefits accompanied with the tax shield effect. the reduction in tax payments will enable firms in increasing their firm value (modigliani & miller, 1963). according to jensen (1986) and stulz (1990) high leverage diminishes the amount of free cash flow available to managers, thereby reducing the need to invest in incompetent firms or other loss-making firms in which management may have personal interests. therefore, using debt positively influence the level of profitability. however it is also possible that the more profitable a firm is, the lower the firm is geared. this is because firms having high profitability levels are likely to have higher retained earnings and they are more likely to use this reserve instead of debt to finance projects of the firm (myers, 2001). control variables firm size, firm liquidity and growth opportunities of a firm have been used as control variables for the purpose of this study. according to pandey (2004), firm size is referred to be the total amount of assets that a firm possesses. it is found that larger organizations tend to be highly levered since they have an advantage over smaller firms in terms of lower borrowing costs. in addition, larger firms are less prone to bankruptcy given the fact that they are more diversified, have better technology, have higher market power and have less asymmetric information costs than small-sized firms. thus, as stated by rajan and zingales (1995) and voulgaris and lemonakis (2014), all this can lead to a positive influence on the profitability of firms. it therefore follows that firm size is expected to be positively associated with profitability of a firm. however shepherd (1972) and schneider (1991) argued that there is a negative association between firm size and profitability. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 65 according to saluja and kumar (2012), there exist a trade-off between liquidity and profitability. higher liquidity is likely to negatively affect profitability. hence an inverse association between liquidity and profitability is expected. growth opportunity encompasses an investment or project that is likely to lead to a significant growth of a firm and a rise in the level of profits for a firm. a positive relationship is expected between growth opportunities and profitability of a firm. 4. findings and discussion 4.1 findings to begin with, descriptive statistics have been conducted for the sample of firms which are illustrated in the following table. table 1: descriptive statistics roa leverage size liquidity growth mean 0.208666 0.634860 6.687800 2.638147 3.726708 maximum 55.34390 190.7986 8.538083 90.83583 1141.506 minimum -0.220918 0.000000 4.339730 0.071249 -0.998860 skewness 18.50143 18.51754 -0.235114 8.006934 17.57825 kurtosis 343.5364 343.9340 3.401753 82.28251 309.9977 table 1 demonstrates that on average mauritian listed firms’ roa is 20.86%. furthermore, the average value for financial leverage is 63.48% which indicates that listed firms in mauritius are highly geared since they have a leverage ratio greater than 50% on average. additionally, these firms are less likely to encounter liquidity issues given that on average the liquidity ratio is 2.64:1. these firms also experienced an average growth rate of 3.73% over the period 2007 to 2017. in the first instance, pooled cross-sectional ols has been used to process the regression model and its results are shown in table 2. the total number of firm year observations is 312. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 66 table 2. results of pooled cross-sectional ols variable coefficient std. error t-statistic probability intercept 0.344370 0.039965 8.616773 0.0000 leverage 0.289328 0.000402 720.2182 0.0000 size -0.048557 0.005892 -8.241427 0.0000 liquidity 0.000677 0.000572 1.185304 0.2368 growth -2.74e-05 6.61e-05 -0.414881 0.6785 adjusted r-squared 0.999423 f-statistic 134680.8*** ***denotes significance at 1% the core problem with pooled cross-sectional ols is that it discards the characteristics of heterogeneity and uniqueness of data sets. it does not take into account differences that may eventually exist among the sample of 34 listed firms. as such the fixed effect and the random effect models are preferred. the hausman test has been conducted to determine whether the fixed effect or the random effect should be used. the results of the hausman test indicated that the fixed effect is appropriate at 10% significance level. this is because the p-value of the hausman test was 0.0000 which is lower than 10%. the following table illustrates the results of the fixed effect. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 67 table 3. results of fixed effect variable coefficient std. error t-statistic probability intercept 0.490005 0.200002 2.449997 0.0149 leverage 0.289240 0.000583 496.2207 0.0000 size -0.070100 0.029778 -2.354076 0.0193 liquidity 0.000134 0.000552 0.243441 0.8078 growth 1.07e-05 5.19e-05 0.206912 0.8362 adjusted r-squared 0.999683 f-statistic 26491.27*** ***denotes significance at 1% table 3 demonstrates that at 10% significance level, financial leverage and firm size have a significant relationship with roa given that their respective p-values are 0.0000 and 0.0193 which are below 10%. given the positive coefficient of 0.289240 for financial leverage, the latter has a significant and positive link with roa. conversely, firm size has a negative coefficient of 0.070100 which indicates that firm size has a significant and negative relationship with roa. however, the findings of the study also show that liquidity and growth opportunities have probability values of 0.8078 and 0.8362 respectively. since their p-values exceed 10%, it is concluded that there is no significant relationship between roa and liquidity and between roa and growth opportunities of a mauritian listed firm. 4.2 discussion following the fixed effect model results from table 3, there is a significant positive relationship between profitability and leverage of mauritian listed firms. this shows that the higher the level of financial leverage of a mauritian listed firm, the higher is its profitability level. the findings of this study uphold the empirical works of yoon and jang (2005), akhtar et al. (2012) and eckbo and kisser (2018) amongst others. however, this result is not consistent with the studies of kester (1986), rajan and zingales (1995), abor (2005) and pradhan and khadka (2017) amongst others who documented a negative association between financial leverage and profitability. the result of this study is also not consistent with kebewar (2012) and yegon (2014) who documented a non-significant association between financial leverage and profitability. the results of this can be explained through the trade-off theory. based on the trade off theory it may be inferred that companies listed on sem actually benefit from the tax shield advantage asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 68 when paying corporation taxes. listed companies on sem may have achieved or may be moving towards the optimal debt ratio because at such a point there is maximization of firm’s value. given the value of a firm is computed as the level of earnings generated by the firm, hence at the optimal debt ratio, the firm is the most profitable. companies in mauritius, as a result of taking increasingly higher debts, bear the consequences of higher interest costs and also benefits from interest tax shields. this means that the more highly geared firms are, the more interests are paid. as a result mauritian listed firms may benefit more from interest tax shields such that profits increase. this may explain the positive link between profitability and financial leverage of mauritian listed firms. jensen and meckling (1986) have also shed light upon the explanation behind the positive association between profitability and debt through the agency theory. if viewed in the context of mauritius, companies listed on sem encounter the agency problem. this is known to be challenges faced between the principal and the agents. owners of these listed companies, who are the ordinary shareholders (principal) appoint managers or board of directors (agents) to take decisions on their behalf and equally for the efficient and effective running of the firm. however, the issue that arises is that the agents may instead act in their self-interests. when companies take more debt, the latter may find themselves trapped in a situation of elevated risk of bankruptcy. with the fear that managers may lose their jobs if their firms go bankrupt, managers are compelled to run companies profitably so as to be successful in meeting the firms’ obligations and in particular their debt obligation. hence in light with the agency theory, it can be deduced that the more debt a mauritian listed firm takes, the more profitable it is likely to be. this positive relationship between profitability and financial leverage in the mauritian context is thus explained by the agency theory. the explanation of the positive link between financial leverage and profitability can as well be clarified using the modigliani and miller (1963) theory. given that mauritian companies can benefit from interest tax shield effect resulting from issuing more debts, this will impact on the wacc of the listed firms. the wacc will start to drop thereby leading to the value of the firm to increase. firms’ value will grow and subsequently raising profitability levels only when the companies opt to operate at a point before or at the optimal capital structure. the result of this study is consistent with the trade off theory, agency theory and modiglianimiller (1963) theory but not with the pecking order theory. according to the pecking order theory, there is an order through which companies will normally have their organizations financed; first and foremost, through internal financing, that is retained earnings and afterwards through external funding. the pecking order theory advocates that the more profit-generating firms are, the less likely they will issue debt. this is because they will use their retained earnings first. mauritian listed firms may not have followed the pecking order theory. profitable mauritian listed firms having high retained earnings may have chosen not to diminish all of their internal funds and therefore took debt to fund massive projects and corporate activities instead. in addition less profitable mauritian listed firms may not be able to seek debt finance to finance their project from banks. the findings of the study reveal that profitability and firm size are significantly and negatively asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 69 associated. the findings of this study corroborate with shepherd (1972) and schneider (1991) who argued that the bigger the companies are, the lower the level of profitability is. however, the findings of this research are not consistent with those of rajan and zingales (1995) and voulgaris and lemonakis (2014) who found a positive link between firm size and profitability. the results of this research reveal no significant association between liquidity and profitability of mauritian listed firms. this research also reveals no significant association between growth and profitability of a mauritian listed firm. 5. conclusion and recommendations the objective of this study is to examine the relationship between financial leverage and profitability of mauritian listed companies. data was collected from a sample of 34 mauritian listed firms for the period 2007 to 2017 with a total of 312 firm year observations. the findings of this research reveal a significant positive link between profitability and financial leverage of mauritian listed companies. this positive relationship corroborates with the modigliani & miller (1963) theory, the trade-off theory and the agency theory. this therefore demonstrates that mauritian listed companies actually take advantage of the tax-shield from taking more debt leading to lower wacc and higher profitability and firm value. moreover managers are bound to run companies profitably so as to avoid losing their jobs if their firms go bankrupt due to non-settlement of debt obligation. this is another reason for the positive link between profitability and financial leverage. based on the results of this study, financial leverage contributes positively towards profitability of mauritian listed firms. hence firms are encouraged to increase their financial leverage. however firms must not go beyond the optimal capital structure because they will start experiencing costs of financial distress. it is advisable for firms to increase their financial leverage up to their optimal capital structure level. companies can issue attractive debentures to its investors to raise debt finance. another way of boosting the level of debt in listed companies is through the central bank of mauritius (bank of mauritius). if the bank of mauritius lowers the repo rate, then commercial banks may subsequently reduce their lending rate thereby encouraging listed firms to take additional debt. given that financial leverage positively influence profitability, the relevant regulatory body in mauritius can encourage companies to increase their financial leverage up to their optimal capital structure. this study contributes to existing literature in developing economies and small island economies on the association between financial leverage and profitability. the limitation of this study is that it focuses on listed mauritian firms only and the period of study is limited to 2007 to 2017. future research can concentrate on both listed and non-listed firms. also, future research can investigate a larger period of study by considering the influence of other drivers of profitability such as corporate governance and corporate social responsibility. references abor, j. 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(1990). managerial discretion and optimal financing policies. journal of financial economics, 26(1), 3-27. https://doi.org/10.1016/0304-405x(90)90011-n voulgaris, f. and lemonakis, c. (2014). competitiveness and profitability: the case of chemicals, pharmaceuticals and plastics. the journal of economic asymmetries, 11, 46-57. https://doi.org/10.1016/j.jeca.2014.04.003 yegon, c., cheruiyot, j., sang, j. and cheruiyot, p. (2014). the effects of capital structure on firm‟ s profitability: evidence from kenya‟ s banking sector. research journal of finance and accounting, 5(9). yoon, e. and jang, s. (2005). the effect of financial leverage on profitability and risk of restaurant firms. the journal of hospitality financial management, 13(1), 35-47. https://doi.org/10.1080/10913211.2005.10653798 https://doi.org/10.1111/j.1540-6261.1984.tb03646.x https://doi.org/10.1111/j.1540-6261.1995.tb05184.x https://doi.org/10.1016/s0304-405x(98)00051-8 https://doi.org/10.1016/0304-405x(90)90011-n https://doi.org/10.1016/j.jeca.2014.04.003 https://doi.org/10.1080/10913211.2005.10653798 microsoft word 11778-43273-1-rv-1-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 71 firm performance and corporate disclosure level of listed companies in nigeria kennedy prince modugu, phd assistant professor college of financial and administrative sciences ama international university, bahrain received: july 21, 2017 accepted: sep. 20, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11778 url: https://doi.org/10.5296/ajfa.v9i2.11778 abstract the study investigates the relationship between firm performance (proxied by profitability and liquidity) and corporate disclosure in nigerian listed firms. the data used in the study were obtained from the annual reports of 60 companies listed on the nigerian stock exchange from the various sectors of the country’s economy. the study covers the post international financial reporting standards (ifrss) adoption period of three years (2012 – 2014). corporate disclosure (dependent variable) was disaggregated into mandatory, voluntary and total disclosure. the data were analysed using both descriptive statistics and the ordinary least squares (ols) regression. findings from the descriptive statistics reveal that, contrary to prior findings, there is a steady improvement in mandatory disclosure by nigerian companies since the country’s adoption of ifrss. however, voluntary disclosure still remains relatively low. the regression results show no significant relationship between profitability and the three components of corporate disclosure. but liquidity shows a significant positive relationship with mandatory and total disclosure. the combined effect of profitability and liquidity shows no significant relationship with any of the components of corporate disclosure. the findings suggest that improved performance of companies does not necessarily induce them to disclosure more information as widely reported by previous researchers. these findings notwithstanding, the decision to disclose sufficiently and timely must be accorded priority attention by companies, considering the critical role of adequate and timely information disclosure in the global marketplace. keywords: firm performance, corporate disclosure, profitability, liquidity, ifrs asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 72 introduction annual reports and accounts of corporate organisations are the vehicles for communicating useful economic information about the operations of companies to diverse users. these users include shareholders, management, employees, suppliers, creditors, financial analysts, labour unions, stockbrokers, regulators, government agencies and the public. these users rely on published financial and non-financial reports of corporate organisations to make informed decisions. it therefore connotes that the quality of decisions made by users depends largely on the quality and quantity of available information. the last two decades witnessed large-scale corporate scandals, majority of which are attributable to either non-disclosure or under-disclosure of actual operations of corporate establishments. in the us for example, the enron debacle raised a retinue of questions on the transparency of corporate disclosure. in the wake of this debacle, a plethora of reforms were promulgated by the us government to strengthen corporate governance practices in general and corporate disclosure in particular. whereas developed economies have made efforts to improve the quality of corporate disclosure through the establishment of virile institutions saddled with the responsibility of corporate reporting transparency, most developing countries still lag behind in this drive. if the former with stronger institutions and technological advancement still record incidences of poor disclosures, it suggests that the latter with weak institutions and emerging business environment may be worse. for example, nigeria has been reputed for low-quality financial reporting occasioned by poor accounting system and weak corporate governance institutions (okike, adegbite, nakpodia, & adegbite, 2015). over time, financial reports in nigeria have been found to be deficient (wallace, 1988; adeyemi, 2006; nweke, 2009) in that they lack vital information that will enable stakeholders to make informed decisions. it is therefore imperative to further investigate the compliance level of nigerian companies with the corporate disclosure requirements in nigeria following the adoption of the international financial reporting standards (ifrs). this is with a view to understanding the nigerian financial reporting environment and identify the information needs of the diverse users in orders to adequately provide them with the appropriate mix of accounting information. despite the collective efforts of the international accounting standards board (iasb) and the global financial community to improve the quality of corporate reporting which led to the introduction of ifrs and its subsequent adoption by a significant number of companies, the abuse of corporate reporting remains unabated across the globe (okunbor, 2016). recent evidence of the prevalence of serious accounting and reporting fraud include bes 2014 scandal in which the giant portuguese bank made a loss of €3.6bn leading to the revocation of its operating license on account of serious misrepresentation and deliberate concealment of the bank’s information by the directors. also the ceo of toshiba, a japanese company, hisao tanaka resigned alongside other seven senior officers in 2015, after an independent inquiry revealed that the ceo had been aware that the company had inflated its profits by $1.2 billion for several years. the findings are expected to lead to the restatement of earnings and the imposition of heavy fines on japan's worst accounting scandal since 2011, when olympus corporation admitted to using takeovers to hide $1.7 billion in losses (ando, 2015). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 73 in 2016 weatherford international plc, a us oil services company was fined $140m by the us securities and exchange commission (sec) for fraudulently raising its earnings by over $900m through of income tax accounting fraud. the company perpetrated this act through its former vice president of tax james hudgins and former tax manager darryl kitay. the duo fraudulently reduced the company’s year-end income tax provisions by $100m to $154 for four years. sec in its administrative order against weatherford and its officers asserts thus: “between 2007 and 2012, weatherford, a large multinational provider of oil and natural gas equipment and services, issued false financial statements that inflated its earnings by over $900million in violation of u.s. generally accepted accounting principles (gaap).weatherford issued materially false and misleading statements about its net income, earnings per share (“eps”), effective tax rate (“etr”), and other key financial information. weatherford did not have sufficient internal accounting controls to identify and properly account for its accounting of income taxes throughout the relevant period” (sec, 2016, p.2) sec said that the adjustments allowed reported effective tax rate (etr) and earnings results to better align with weatherford’s analysts’ expectations and weatherford’s previously-announced projected results. in addition to the $140 million civil penalty fine; hudgins and kitay agreed to pay $334,067 and $30,000 fine respectively. also accused by sec was weatherford’s external auditors, ernst & young (ey) between 2001 and 2013 for failing to comply with public companies accounts oversight board (pcaob). sec accused ey of a significant audit failure, for ignoring red flags as weatherford accumulated a phantom $461 million income tax receivable between 2007 and 2010 by overstating net income and understating its effective tax rate, a financial irregularity that ey failed to report. for this professional negligence, ey was fined $11.8m. against this background, this study investigates the relationship between firm performance variables and corporate disclosure level of nigerian companies with a view to prescribe avenues for raising the bar of transparency in corporate reporting in nigeria. 2. literature review 2.1 corporate disclosure defined the concept of corporate disclosure seems amorphous. attempts at conceptualizing and measuring it have not yielded a universal approach for researchers (modugu & eboigbe, 2017). for instance, abu-nassar (1993) contends that a singular definition of disclosure is practically unattainable. this, according to him, is tasking being that the objects being measured are people’s needs, perception, and attitudes which are qualitative rather than quantitative. cooke and wallace (1989) assert that disclosure is an abstract concept that cannot be measured directly. it does not possess inherent characteristics by which one can determine its intensity or quality like the capacity of a car. one of the earliest definitions of disclosure is given by kohler (1957) (as cited in abdulrahman, 1998). he describes disclosure as a clear showing of the fact or conditions on asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 74 the balance sheet or other financial statements, in the footnote thereto, or in the audit report. also, choi (1973) defines disclosure as “the publication of any economic datum relating to a business enterprise, quantitative or otherwise, which facilitates the making of economic decisions” (p. 123). according to him, economic data consist of information which prunes the uncertainty that is characteristic of the outcome of future economic events, and that improved disclosure is a function of increased quantity and quality of economic data available to investors through financial statements. gibbins, richardson and waterhouse (1990) define disclosure as “any deliberate release of financial information, whether numerical or qualitative, required or voluntary, via formal or informal channels” (p.122). parker (1992) defines disclosure as the reporting of financial and non-financial information to users of accounting reports, especially to investors, which can be made according to legislation or accounting standards or can be voluntary. cooke (1992) “states that disclosure comprises mandatory and voluntary items of information provided in the financial statements, notes to the accounts, management's analysis of operations for the current and forthcoming year and any supplementary information” (p.231). abdulrahman (1998), in reviewing the preceding definitions of disclosure posits that corporate disclosure is a wide-ranging term which goes beyond the annual reports. he, therefore, narrowed it down to suit his study. according to him, disclosure is the publication of any type of information through the corporate annual reports, which are necessary, relevant and material to the various user groups in making their judgements and decisions about a company. lee (2012) (as cited in hajian & rostami, 2014) believes that disclosure refers to an accurate and timely release of information about the business strategy, financial performance and corporate governance to the general public by a company. according to al-zarouni (2008), “the definition of corporate disclosure varies and the concept itself covers a wide area. it goes beyond the corporate annual reports to cover information outside the financial statements, such as, discussion of competition, economic statistics and analysis of company”(p.45). owusu-ansah (1998a) and wallace and naser (1995) see disclosure as a communication of economic information, whether financial or non-financial, quantitative or otherwise concerning a company's financial position and performance. disclosure results in a combination of mandatory and voluntary items that constantly interact with each other. mandatory disclosure is a company's obligation to disclose a minimum amount of information in corporate reports (owusu-ansah, 1998a; wallace &naser, 1995), whereas voluntary disclosure is a provision of additional information when mandatory disclosure is unable to provide a true state of a company's value and managers' performance. voluntary disclosure is the release of additional information about a firm in excess of the statutorily required disclosure. more recently, solomon (2013) describes disclosure as a whole array of different forms of information produced by companies such as, the annual report and all forms of voluntary corporate communications. okike et al (2015) observe that the annual report and accounts of a company act as the channel of communication from the directors to shareholders and are important for corporate governance because these reports provide the means by which the directors are made accountable to the shareholders. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 75 the existing definitions of disclosure are a testament to the broadness of the concept, as prior researchers have advanced definitions suitable for the scope of their respective studies. for over four decades of research into corporate disclosure, the concept was bereft of any known theory until healy and palepu (2001) as well as omran and el-galfy (2014) proposed a list of theories for disclosure. this lack of general theory, according to abdulrahman (1998), was due to the abstract nature of disclosure which may mean several things to several people. this is why different researchers view the concept from different perspectives. the common perspectives include disclosure adequacy (buzby, 1974; al-zarouni, 2008) and disclosure quality (singhvi & desai, 1971; moore & buzby, 1972). in this study, disclosure is viewed as the fair presentation of an entity’s financial or non-financial information whether mandatory or voluntary which is included in annual reports and is useful to stakeholders’ decision making. fundamentally, for the information to be useful, it must be relevant and faithfully represents that which it purports to represent. in addition, the information is enhanced if it is comparable, verifiable, timely and understandable. 2.2 relationship between firm performance and corporate disclosure according to lang and lundholm (1993), performance-related variables represent information to which management may have preferential access and which varies from time to time. these variables are profitability and liquidity. firms may release information to signal good performance (benston, 1980). also, management may want to assure shareholders of the firm’s profitability to justify management’s compensation (singhvi & desai, 1971). lang and lundholm (1993) argue that if performance serves as a proxy for information asymmetry between investors and managers, then disclosure may be related to the variability of a firm’s performance. this means that disclosures increase when perceived management and investor information asymmetry is high. 2.2.1 profitability theoretically, management tends to disclose more information when the firm is performing well than when it is performing poorly (wallace et al. 1994). also, in the presence of disclosure costs, firms disclose more information as their performance exceeds a certain threshold. based on the signalling theory, researchers argue that a firm with a higher profitability is inclined to disclose more information in its annual report to signal its superior performance to the market (cooke, 1989; wallace, et al. 1994; wallace &naser 1995; and archambault & archambault, 2003). on the other hand, firms may voluntarily disclose information in order to justify their unexpected poor performance and to reduce the likelihood of a substantial negative stock price response in the event that a particular piece of information becomes a mandatory disclosure item (skinner, 1995). empirical evidence on the direction of relationship between firm performance and disclosure is mixed and inconclusive. while some studies (wallace et al. 1994; naser, 1998; naser et al. 2002) report that firms tend to disclose more information when they are experiencing favourable earnings results, others (wallace &naser 1995) reported a negative and significant asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 76 association between the two variables (wallace et al. 1994; naser et al. 2002, umoren, 2009). interestingly, some studies provide evidence that firms are more likely to disclose more information when they have bad news than for good news (belkaoui & kahl, 1978; and healy & palepu, 2001). most prior studies use return on equity and return on sales/profit margin as a measure of profitability (wallace et al., 1994; wallace and naser, 1995; camfferman & cooke, 2002; alsaeed, 2006). 2.2.2 liquidity companies with high liquidity levels are more likely to disclose more information to show their superior performance to investors, regulatory authorities, and lenders, that they can fulfill their short term obligations and continue in operational existence (shehata, dahawy & ismail, 2014). however, companies with low liquidity levels may also disclose more information to avoid shareholders’ claims, and to prove that management is aware of the company’s problems (wallace et al., 1994; wallace & naser, 1995; alsaeed, 2006). the majority of prior studies mentioned above use current ratio as a proxy for liquidity.a firm's liquidity has also been reported to be associated with its corporate disclosure level. regulatory bodies, as well as investors and lenders, are more concerned about the going-concern status of firms (wallace &naser, 1995; naser et al. 2002). in view of this, firms that are able to meet their short-term financial obligations without recourse to the liquidation of their active non-current assets may desire to make this known through disclosure in their annual reports (owusu-ansah, 1998b; naser & al-khatib, 2000). a firm's liquidity position can be measured by the ratio of the firm's current assets to current liabilities. some argue that quick (acid-test) ratio; current assets less inventory to current liabilities, is a more stringent measure of corporate liquidity. however, empirical investigations have shown inconclusive results. for example, while belkaoui and kahl (1978) show that financially strong firms are more likely to disclose more information than their financially weak counterparts, wallace et al. (1994), wallace and naser (1995), naser and al-khatib (2002), and naser, et al. (2002) find that liquidity is significantly and negatively associated with disclosure level. other studies, however, find no such association (e.g., owusu-ansah 1998b; alsaeed, 2005). 3. theoretical framework this study is underpinned by the positive accounting theory (pat). prior to the mid-1960s, accounting research was mainly normative, seeking to prescribe ‘what should be' or ‘what ought to be' in relation to accounting measurement and financial reporting. normative accounting research failed to provide an empirical explanation to accounting practice (omran & el-galfy, 2014). this led to the development of positive accounting research to combat this limitation. pat came into existence in the 1960s from the work of fama on the efficient market hypothesis. it was later popularized by gordan (1964) who posits that senior management was likely to manipulate the information in the financial statements in their own favour by selecting accounting procedures that maximize their own utility (umoren, 2009). according to watts and zimmerman (1990), early studies that applied pat are ball and brown (1968) and beaver (1968). pat is an accounting theory which seeks to explain and asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 77 predict how choices of accounting standards, methods, and information disclosure formats are made (watts & zimmerman, 1990). it is based on the assumptions that preparers act opportunistically in making accounting choices, contracting how costing between an entity and its stakeholders influence the choice of accounting practices and that there is an explicit set of accounting choices to select from (kiyanga, 2014). watts and zimmerman (1986) highlight key hypotheses of pat to include: the bonus plan hypothesis, debt/equity hypothesis and size hypothesis. the bonus plan hypothesis states that managers of entities with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period, other things being equal. the debt/equity hypothesis posits that the larger the debt/equity ratio, the more likely the entity’s manager is to select accounting procedures that shift earnings from future periods to the current period, other things being equal. the size hypothesis states the larger the entity the more likely managers are to choose accounting procedures that defer reported earnings from the current to future periods, other things being equal. kiyanga (2014) observes that so far, evidence from tests of the theory’s hypotheses is consistent with the hypotheses, implying that the theory does explain and predict the choice of accounting practices. however, sternberg (1997) argues that the theory has several shortcomings. in the first place, it does not clarify whether the incentives for making accounting choices are economic, or efficient or social in nature. secondly, the theory does not explain all accounting practices, as much remain unexplained. thirdly, the implication of the theory that accounting choices are influenced by transactional costs only is not correct as there are other factors that influence the accounting choices made. for example, the nature of the entity, professional requirements, and industry practice may influence the choice of accounting practices (gouws & cronje, 2008; belkaoui, 2004). lastly, the theory just focuses on the supply side of disclosure.the decision-making usefulness of the information disclosed does not feature as a factor influencing the choice. however, these shortcomings do not render the theory completely invalid. pat has a direct bearing on the research topic. in this study, corporate disclosure presents an excellent opportunity to apply pat. this is premised on the fact that since managers (agents) have better access to companies’ information, they can make credible and reliable communication to the market to optimise the value of the firm. through financial reporting, managers communicate to the users of financial reports, information that is useful in making choices among alternative uses of scarce resources. on the contrary, the managers may fail to make proper disclosure of useful information to the users due to their opportunistic tendencies. such practices will not be in the best interests of shareholders (principal). consequently, this may result in higher cost of capital and lower value of shareholders' investments. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 78 4. methodology 4.1 research design, sample and data this study adopted the longitudinal research design. this is because it is useful in the studying of the current state of a unit or a group of items over a period of time. the content analysis approach which involves the construction of disclosure checklist from a list of annual report items was used. a disclosure index was developed from the checklist and used for the study. historically, cerf (1961) is the first researcher who conducted an empirical study using a disclosure index. he developed an index consisting of 31 items, each of which was scored on a scale of 1 to 4 on the basis of interviews with financial analysts. cerf's approach, with extensions and modifications, has been used widely in many other studies (for example, wallace, 1988; lang & lundholm, 1993; alsaeed, 2006; umoren, 2009; al-zarouni, 2008; qu, 2011; ibrahim, 2014) to examine the adequacy of corporate financial disclosure in different countries. considering a given list of items, the value of the index for a particular company is obtained by dividing the number of information items disclosed by that company by the total number of information disclosure items that might be disclosed. the total population consists of the 189 listed companies on the nigerian stock exchange at 31st december 2014 (factbook, 2014). in estimating the sample size, the yamane (1967) formula was used. the formula is chosen because of its simplicity and is considered as the most popular sampling design technique (israel, 2013). in addition, the population is finite, making it amenable to the formula. this formula is given as: where: n = sample size n= population e = error limit (0.05 on the basis of 95% confidence level) therefore, n = 189 / [1 + 189 (0.052) n = 189 / 1+189(0.0025) n= 189/1.4725 n = 128 based on the above sample of 128 firms, the simple random sampling technique was then adopted in selecting 60 firms from a stratified sample of thirty industries trading on the nse between 1st january 2012 and 31st december 2014. this was to ensure that the relevant sectors have equal chances of being represented. the choice of 2012 to 2014 was informed by the fact that going by the roadmap for the adoption of ifrs by nigerian asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 79 companies which began on january 1, 2012 and ended on january 1, 2014, all public listed entities are expected to have fully complied by the year ended 2014. 3.6 model specification and variable measurement tdiscit= ∂0 + ∂1 profit it + ∂2 liq it + µit (1) where: tdisc = total corporate disclosure profit = profitability liq = liquidity µ= the stochastic error term, i = number of sampled firms (1, 2,…n), t= time period of the sample companies. the a priori expectations are: ƞ1> 0; implying that the higher the profit, the higher the disclosure level, ƞ2> 0; implying that the higher the liq, the higher the disclosure level, the model was adapted from previous empirical studies (cerf, 1961; wallace, 1987; umoren, 2008; al-zarouni, 2008; ibrahim, 2014) on corporate disclosure with some modifications. table 3.1. operationalisation of variables s/n variables codes measurement a priori sign 1 total disclosure index tdisc summation of both mandatory and voluntary disclosure indexes 2 profitability profit profit before interest and taxes divided total sales + 3 liquidity liq current asset divided by current liabilities + source: researcher’s compilation, 2016 5. empirical results the study utilizes both descriptive statistics and the pooled ordinary least squares (ols) estimation. the use ols is a simple way to examine the sensitivity of the results to alternative specifications (beaver, 1998) and allows for greater flexibility in modelling differences in sample specific behaviour (greene, 2007). the results are presented and analyzed below: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 80 5.1 descriptive statistics source: researcher’s compilation (2016) figure 5.1. average disclosure index figure 5.1 above shows the average disclosure index for the distribution in the ifrs period covered in the study. as observed, for 2012, the average mandatory disclosure index was 0.692 and then increased to 0.7036 in 2013 and to 0.7431 in 2014. the above average index score suggest that most companies in the distribution did not fair to poorly in implementation of ifrs for 2012 reporting year. for voluntary disclosures (vdisc), the average indexes for 2012 was 0.445, while 2013 and 2014 had the same index of 0.4533. the results suggest that the pattern of voluntary disclosure in annual reports is still quite low arguably so because it is voluntary. there may also be a tendency for this category of disclosures to be largely repetitive over time. for total disclosures (tdisc), the average index for 2012, 2013 and 2014 are 0.6679, 0.6791, and 0.7193 respectively. the result shows some level of improvement in total disclosures emanating basically from improvements in mandatory disclosures. this may suggest that most companies have improved their disclosures subsequently after initial 2012 reporting year. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 81 table 5.1. regression results variables mdisc vdisc tdisc mdisc vdisc tdisc c 64.0631 {1.5343} (0.000) 4.3816 {0.3981} (0.000) 68.4817 {1.6259} (0.000) 64.4207 {1.4281} (0.000) 4.4449 {0.3974} (0.000) 68.9055 {1.5147} (0.000) profit -0.0732 {0.0505} (0.1492) 0.0089 {0.0137} (0.5185) -0.0626 {0.0530} (0.2391) liq 0.6022* {0.1561} (0.000) -0.0039 {0.0089} (0.6631) 0.5898* {0.1548} (0.000) fp-index 0.6665 {0.5487} (0.2261) -0.0064 {0.0247} (0.7964) 0.6828 {0.5444} (0.2114) ar(1) 0.6880 {0.111} (0.000) 0.8543 {0.0472} (0.000) 0.7005 {0.1077} (0.000) 0.6767 {0.0966} (0.000) 0.8543 {0.0589} (0.000) 0.6862 {0.0949} (0.000) r2 0.475 0.7310 0.4875 0.4585 0.7272 0.4733 adj r2 0.466 0.7264 0.4787 0.4523 0.7241 0.4673 f-stat 52.8071 158.555 55.4833 74.0893 233.29 78.640 p(f-stat) 0.000 0.000 0.00 0.000 0.000 0.000 d.w 2.2 1.9 2.2 2.2 1.9 2.2 s.e regression 6.087 0.7945 6.2738 6.1652 0.7241 6.336 means of dependent var. 64.413 4.502 68.916 64.4606 4.511 68.9719 source: researcher’s computation (2016) * sig at 5% { } standard errors, ( ) p-values where: profit= profitability liq= liquidity fp-index = firm performance index derived using factor scores table 5.1 above shows the regression results of the effect of firm performance on corporate disclosure. as can be observed, three firm performance variables (profit, liq and fp-factor score) were regressed on mandatory disclosure, voluntary disclosure and total disclosure. we first regressed the firm performance variables and then a firm performance index derived using factor scores. for mandatory disclosure (mdisc), the model properties reveal that the coefficient of determination (r2) and adjr2 are 0.475 and 0.466 respectively. these values asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 82 suggest that the model explains only about 47.5% of systematic variations in mandatory disclosures with an adjusted value of 44.7% after controlling for degrees of freedom. the f-stat (52.807) and p-value (0.00) indicate the acceptance of the hypothesis of a significant linear relationship between the variables (dependent and independent) at 5% level of significancewhile the d.w statistic of 2.2 indicates that a serial correlation presence in the residuals is unlikely. the effect of profit is negative (-0.0732) though not significant at 5% level (p=0.1492). the effect of liq is positive (0.6022) and significant at 5% level (p=0.000). for voluntary disclosure (vdisc), the model properties reveal that the coefficient of determination (r2) and adjr2 are 0.7310 and 0.726 respectively. these values suggest that the model explains only about 73.1% of systematic variations in mandatory disclosures with an adjusted value of 72.6% after controlling for degrees of freedom. the f-values confirm that the hypothesis of a significant linear relationship between the variables (dependent and independent) cannot be rejected at 5% level while the d.w statistic of 1.9 indicates that a serial correlation presence in the residuals of the model is unlikely. the effect of profit is positive (0.0089) though not significant at 5 % level (p=0.5185). the effect of liq is negative (-0.0039) though not also significant at 5% level (p=0.6631). for total disclosure (tdisc), the model properties reveal that the coefficient of determination (r2) and adjr2 are 0.4875 and 0.4785 respectively. these values suggest that the model explains only about 48.7% of systematic variations in mandatory disclosures with an adjusted value of 47.8% after controlling for degrees of freedom. the f-values confirm that the hypothesis of a significant linear relationship between the variables (dependent and independent) cannot be rejected at 5% level while the d.w statistic of 2.2 indicates that a serial correlation presence in the residuals of the model is unlikely. the effect of profit is negative (-0.0626) though not significant at 5 % level (p=0.2391). the effect of liq is positive (0.5898) and significant at 5 % level (p=0.000). using the firm performance index, the model properties for mdisc; r2 = 0.459, adjr2 =0.452, f-stat=74.089 and d.w = 2.2. the effect of fp-index is positive (0.6665) though not significant at 5 % level (p=0.2261). for vdisc, the model properties are; r2 = 0.727, adjr2 = 0.724, f-stat=233.29 and d.w = 1.9.the effect of fp-index is negative (-0.0064) though not significant at 5 % level (p=0.7964). for tdisc, the model properties are; r2 = 0.4733, adj r2 =0.4673, f-stat= 78.640 and d.w=2.2.the effect of fp-index score is positive (0.6828) though not also significant at 5 % level (p=0.2114). 6. conclusion and recommendations prior studies have examined the relationship between firm performance and corporate disclosure. results of these studies have been mixed regarding the direction and significance of the association between firm performance and corporate disclosure levels. in this study, we moved a step further to examine not only the individual relationships, but the combined effect of profitability and liquidity (represented by the factor score of both variables) on the extent of corporate disclosure in annual reports of listed companies in nigeria. furthermore, we disaggregated corporate disclosure into three components. they include mandatory disclosure, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 83 voluntary disclosure and total disclosure. this was to allow for the determination of the association between firm performance variables and individual corporate disclosure variant. the results showed that the relationship between profitability and the three disclosure components of mandatory, voluntary and total disclosure is not significant. however, a significant positive relationship was observed between liquidity and the duo of mandatory and total disclosure; but not significant with voluntary disclosure. the combined effect of profitability and liquidity showed no significant relationship with the three components of disclosure total disclosure. the findings suggest that improved performance of companies does not necessarily induce them to disclosure more information as widely reported by previous researchers. these findings notwithstanding, the decision to disclose sufficiently and timely must be accorded priority attention by companies considering the critical role of such information in the global marketplace. based on the findings, we recommend that the financial reporting council of nigeria and other regulatory agencies should intensify efforts towards enforcement of companies’ compliance with the requirement of ifrss and other relevant statutory provisions. in addition, future empirical studies in this area should expand the number of years to include more recent years. this could be used to assess the trends of disclosure in order to confirm if there had been any improvement over time. future researchers should attempt to increase the firm performance variables beyond those examined in this study. references abdulrahman, a. 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(1967). statistics: an introductory analysis. new york: harper and row. microsoft word 13029-47671-1-sp-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 226 public sector auditing and corruption: a literature review ebrahim ahmed assakaf accounting department, college of administrative sciences, taiz university, yemen e-mail: assakaf@gmail.com rose shamsiah samsudin tissa, universiti utara malaysia, malaysia. e-mail: shamsiah@uum.edu.my zaleha othman oyagsb, universiti utara malaysia, malaysia. e-mail: zaleha@uum.edu.my received: jan. 17, 2018 accepted: may 4, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.13029 url: https://doi.org/10.5296/ajfa.v10i1.13029 abstract the notion that auditing could reduce corruption has received considerable attention in both business and academia. the purpose of the current study is to explore the latest trends and gaps in the literature that investigate the link between corruption and public sector auditing. it is based on reviews of the academic literature and draws general conclusions on the status of the latest findings. the previous literature on corruption focused on economic and political perspectives. although evidence suggests that public sector auditing helps to combat corruption, there is still a huge gap in the knowledge of this area, especially concerning the functional role of public sector auditing in corruption detection and deterrence in developing countries. moreover, there is a scarcity of literature that explains in depth how audit types conducted by the supreme audit institution (sai) may contribute to a reduction in corruption, and which types of audit are more effective. there is also minimal in-depth sharing on the challenges that public sector auditing faces in detecting and preventing corruption. keywords: corruption effects, corruption, public sector auditing, sai asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 227 introduction the increasing attention of the media over the last two decades to corruption suggests that developing countries in particular are at a fragile stage. the corruption perception index (cpi) has shown that developing countries are in need of effective mechanisms to combat corruption. in fact, more than 66% of the nations experience the ill effects of corruption, including a large proportion of the g20 countries (enste & heldman, 2017). it is important to note that corruption is not a new social phenomenon; indeed, it is as old as government itself (klitgaard, 1988; othman, shafie, & zakimi, 2014). the united nations recognizes corruption as a major global issue, listing fighting corruption as one of its seventeen sustainability development goals. it is necessary because of the devastating effects of corruption, which pose challenges to a country’s development, distorting public expenditure and markets, reducing economic growth, undermining the rule of law and democracy, and eroding the quality of life (enste & heldman, 2017; united nations, 2004). according to the world bank (1997), its roots lie deep in political and bureaucratic institutions, and its effect on development varies according to the national situation. while the negative effects of corruption can also be found in developed nations, they are felt most severely in developing countries (enste & heldman, 2017; rady, 2016; united nations, 2004), and there is much concern over how to solve the menace of this epidemic in developing countries (othman et al., 2014). in recent decades, a number of large institutional actors have become actively involved in fighting corruption (everett, neu, & rahaman, 2007); these trends can be seen through the international convention against corruption, which came into force on 31 october 2003 (transparency international, 2005; united nations, 2004). as early as 1953, international interests in fighting corruption and improving accountability in the public sector led to the establishment of an important institution, the international organization of supreme audit institutions (intosai). this body has 190 full members and operates as a parent organization that sees to the affairs of the government audit community. over many decades, the institution has provided a sound framework for government auditing, ensuring that knowledge is shared, auditing exercised and professional capacities improved. development among the membership of supreme audit institutions (sais) in their respective countries is promoted (intosai, 2015). the literature indicates that good public sector auditing has a significant impact on domestic levels of corruption (gustavson & sundström, 2016), as it is a cornerstone and an essential element in fighting corruption in the public sector, the people also expect the auditors to play an efficient role in reducing, if not eradicating, corruption (khan, 2006; otalor & eiya, 2013). this expectation arises from the assumption that the audited information is reasonably accurate, complete and unbiased. auditing represents a crucial component of accountability as it legitimizes the information on which financial and formal accountability relies (power, 1997). hence, the audit profession helps organizations in the public sector to achieve accountability and integrity, improve operations, and instill confidence among citizens. one of the public sector auditor’s roles is to function as a body overseeing the conduct of public asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 228 sector entities, especially with regard to public funds, serving to prevent and detect public corruption (goodson, mory, & lapointe, 2012). for this, the population expects auditors to play an essential role in fighting corruption in the public sector. significantly, there is little literature studying the effect of public sector auditing on corruption (gustavson & sundström, 2016). in addition, many of these limited studies do not explain why corruption is still increasing in some developing countries that have sais, which are supposed to be responsible for auditing the public sector. few have explored the challenges and obstacles faced by public sector auditing in fighting corruption, or the contribution of each type of public sector auditing. this paper is based on the analysis of three areas of literature: scientific or academic literature on corruption; scientific or academic literature on public sector auditing; and literature linking public sector auditing and corruption. this method of analysis method will identify the gaps in the literature and suggest future research questions (everett et al., 2007; guthrie, petty, & johanson, 2001). defining corruption corruption, although long in existence (klitgaard, 1988; othman et al., 2014), has become a global issue, spreading across borders and resulting in poverty through its social, economic and political presence (enste & heldman, 2017; otalor & eiya, 2013). it has become an epidemic, damaging to society in addition to undermining the rule of law and democracy, distorting markets, and reducing the quality of life (united nations, 2004). there is an inverse relationship between corruption and growth and development (atuilik, 2013; lambsdorff, 2005; mauro, 1998; papaconstantinou, tsagkanos, & siriopoulos, 2013; rady, 2016; tanzi, 1998). corruption also contributes to reducing domestic and foreign investment, due to the higher costs of entry and the uncertainties of operating in a corrupt environment (ahmadi & homauni, 2011; mauro, 1998; myint, 2000). jetter, agudelo and hassan (2015) found that although democracy in richer countries may lead to a decrease in corruption, in poor countries it leads to increased corruption, as a result of differences in income levels. corruption also leads to a lower level of public trust in democratic government institutions, as well as posing a threat to the legitimacy of government (nwabuzor, 2005), resulting in political destabilization (lambsdorff, 2005). gounev, dzhekova and bezlov (2012) suggested that a high level of corruption leads to the poor quality of bureaucratic systems, encouraging the spread of nepotism and bribery in the provision of public services. employment in public service institutions might itself be based on nepotism or bribery, without regard to the efficiency and capacity or qualifications of the individual being employed. alarmingly, corruption may also distort government budgets with respect to revenue generation and expenditure. for instance, it affects the collection of customs duties, taxes, dues and fees for public utilities such as electricity and water supply (myint, 2000). corruption lingers and can be deceptive, for example in purchasing weapons of an excessive amount under the pretext of safeguarding national security (myint, 2000; shleifer & vishny, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 229 1993). investment in public infrastructure, needing extra funding, may be sidelined, resulting in poorer quality output (everett et al., 2007; tanzi & davoodi, 1998). spending on infrastructure is often preferred by officials to avoid spending on health or education projects, as they assume that there is less opportunity for embezzlement in projects for rural development, textbooks, payment of teachers’ salaries, training and development and preventive healthcare (ahmadi & homauni, 2011; myint, 2000; shleifer & vishny, 1993). public sector auditing and corruption it has already been established that auditing is an essential element in combatting corruption (khan, 2006; otalor & eiya, 2013). khan (2006) claimed that auditing has an important role in fighting corruption in the public sector, and that auditors and the audit profession in general are significant elements in reducing fraud and corruption (borge, 1999; everett et al., 2007). this is also consistent with the assumption that higher quality auditing in the public sector seems to have a pronounced effect on reducing national corruption (dipietro, 2011). ionescu (2014) similarly argues that government should design auditing as a proficient scheme that can be used for checks and balances and for detecting fraud; such schemes should help government auditors to detect corrupt practices and so avoid serious potential economic deficiencies. the role of public sector auditing is represented by sais through the objectives of the international standards of supreme audit institutions (issais). issai’s fundamental principles of public-sector auditing indicate that audits in the public sector stem from the same objectives, although specific objectives and output may differ depending on the type of audit that is being carried out. however, all public sector auditing has four common principles. first, public sector auditing provides all the potential users with objective, independent and reliable information based on sufficient and appropriate evidence relating to public entities. secondly, it encourages accountability and transparency, promoting continuous improvement and sustained confidence in the appropriate use of public funds and assets and the performance of public administration. thirdly, it reinforces the effectiveness of those bodies within the constitutional arrangement. finally, it creates incentives for change by providing knowledge, comprehensive analysis and well-founded recommendations for improvement (issai 100, 2013). according to goodson et al. (2012), auditing is a fundamental element of efficient government as it supports the governance roles of insight, foresight and oversight, to which they added detection and prevention. since the success of the public sector is measured primarily through its capacity to successfully deliver services to the people and execute its programmes in an equitable manner, it is essential for the activities of public sector audit to be directed at evaluating the level of compliance with financial programmes and to equally measure the efficiency, effectiveness and economy of those activities. it is essential for the auditors to protect the core values of the public sector, which serve all citizens. much of the literature indicates that auditing has an important role in fighting corruption in the public sector (borge, 1999; khan, 2006), and especially that higher quality auditing in the public sector has a pronounced effect on reducing national corruption (dipietro, 2011). tara, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 230 gherai, droj and matica (2016) found that sais increase the efficiency of government entities and reduce the perceived level of corruption. in another study, gherai, tara and matica, (2016) concluded that when sais extend their work, this leads to a decrease in corruption. ionescu (2014) argued that through proficient auditing in the scheme of checks and balances and fraud detection, government auditors should detect corrupt bureaucracies. liu and lin (2012) used panel data in their analysis to find the amount of abnormality uncovered in government records by auditing, and established that it is positively and directly associated with the corruption level. this implies that the more cases of corruption in the bodies of government, the greater the likelihood that abnormality would continue to be detected by local audit agencies. these findings indicate that audit in the public sector has an essential role in detecting corruption there. otalor and eiya (2013) also state that audit in the public sector is one of the mechanisms for fighting corruption and that it plays an effective role in reducing, if not eliminating, corruption. auditors should therefore be at the forefront of the fight against both domestic and international corruption (everett et al., 2007; kassem & higson, 2016). albrecht et al. (2012) suggest that opportunities to perpetrate fraud should be eliminated and this suggestion can be adopted as a preventive measure of corruption in the public sector. such opportunities can be eliminated through the institution of sound internal controls; reduction of collusion between members of the public and civil servants; and clearly informing vendors and other contractors about the government’s policies concerning fraud. employees are to be monitored through hotlines (whistle-blowing systems) for anonymous tips, and made to establish an expectation of penalty. khan (2006) indicates that implementation of a performance audit can also help to reduce corruption by creating a deterrent to such acts. performance audits can thus be a special and powerful instrument to help prevent corruption (otalor & eiya, 2013). khan (2006) argues that although auditors can point out where opportunities for corruption exist, they cannot play a role in detecting corruption because its perpetrators normally conceal any trace in the official records. albrecht et al. (2012) state that in detecting fraud, auditors must help in identifying indicators or symptoms of fraud (otherwise known as red flags) and investigate such indicators in order to find out whether those symptoms originate from actual fraud or were caused by other factors. however, it is unfortunate that several fraud symptoms often go unnoticed, while those that are identified are not always pursued vigorously. it is important to state that many frauds would have been detected earlier if their symptoms were investigated earlier. these fraud indicators or red flags can be in the form of accounting anomalies, internal control weaknesses, analytical anomalies, extravagant lifestyle, unusual behaviour, and tips and complaints (albrecht et al., 2012). finally, khan (2006) stated that the sai is one of the most important institutions that can help in reducing corruption in the public sector. for this purpose, the sai itself needs to be credible and well-resourced. for that, he recommends eight actions for strengthening the sai so that it can play its role in the fight against corruption effectively: promoting the independence of the sai, strengthening the powers of the sai, introducing participatory asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 231 auditing, implementation of audit recommendations, reviewing of procedures and training of auditors, establishing and adhering to code of ethics, boosting the performance of the sai, and cooperation and coordination with other parties. discussion a review of the literature shows that the majority of the studies describe the relationship between corruption and the economy. some found that corruption hinders or dampens economic growth and national development (ahmadi & homauni, 2011; al-sadig, 2009; assakaf, shamsiah, & othman, 2018; ata & arvas, 2011; atuilik, 2013; borlea, achim, & miron, 2017; enste & heldman, 2017; ksenia, 2008; lambsdorff, 1998; maiyaki, 2010; mauro, 1998; nwabuzor, 2005; rady, 2016; tanzi, 1998), as well as affecting domestic and foreign investment (ahmadi & homauni, 2011; amundsen, 1999; atuilik, 2013; enste & heldman, 2017; lambsdorff, 2005; mauro, 1998; myint, 2000; tanzi, 1998). it may also distort the composition of the government’s spending (atuilik, 2013; lambsdorff, 2005; myint, 2000) and reduce the tax revenues (friedman, johnson, kaufmann, & zoido-lobaton, 2000; johnson, kaufmann, & zoido-lobaton, 1998; tanzi & davoodi, 1998). an increase in the rate of corruption also has a negative influence on political system and trust in government (anderson & tverdova, 2003; assiotis & sylwester, 2014; bowler & karp, 2004; chang & chu, 2006; kumlin & esaiasson, 2012; solé-ollé & sorribas-navarro, 2014) and democracy (amundsen, 1999; baber, 1983; jetter et al., 2015). such influences may result in political instability (assiotis & sylwester, 2014; nwabuzor, 2005; treisman, 2000). some solutions as to how corruption may be minimized were discussed. ionescu (2016), for example, examined the association between information and communications technology (ict) and e-government and corruption. utilizing data from a survey of the top 20 countries according to the un’s 2012 e-government readiness index, ionescu’s findings are indicative of the impact of ict-related e-government as an anti-corruption policy. kim, kim and lee (2009) similarly found that e-government anti-corruption systems have a positive impact on the reduction of corruption. murphy (2004) explained that corruption exists where there is ample opportunity for it to take place. hence, anti-corruption entities must take a multi-pronged approach that aims to reduce the opportunities and incentives for corruption, while increasing the expected cost of corrupt behaviour. shleifer and vishny (1993) were of the opinion that political and economic competition can reduce the degree of corruption and its negative influences. olken (2009) concluded that ordinary people currently lack the power to identify corruption and to monitor local officials effectively without any form of external assistance. this shows that transparency is essential as it helps to increase the capacity of citizens to detect and recognize corruption at any level. numerous studies have been conducted on the public sector auditing out of corruption cases (baber, 1983; dana, 2011; dragija, vašiček, & hladika, 2011; dwiputrianti, 2011; everett, 2001; gendron, cooper, & townley, 2001; gendron, cooper, & townley, 2007; goe & singh, 2012; hay & cordery, 2018; ma, 2007; neu, 2006; saito & mcintosh, 2010; santiso, 2007; schelker, 2012; schelker & eichenberger, 2010; waring & morgan, 2007; yoshimi, asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 232 2003; zhao, 2005). for example, zhao (2005, cited by liu & lin, 2012) proposed a relatively complete framework of the characteristics that divide the factors related to the quality of government audit into three categories: technical factors (professional competence, auditor size and audit hours), independence factors (audit fee, auditor reputation and the organizational design of audit institutions) and administrative factors (determining the nature of irregularities, making the right decisions and checking on rectification results). in empirical studies, researchers often use only one aspect of these characteristics as a proxy measurement of government audit quality. for example, saito and mcintosh (2010) employed time spent in auditing as a direct measure of auditing effort. ma (2007, cited by liu & lin, 2012) on the other hand reported that educational background, experience and professional competence are significantly related to the financial efficiency of government auditing. baber (1983) used cross-sectional data from state governments and revealed positive correlations between state audit budgets and measures of political competition. these results are consistent with the argument that public officials’ incentives to provide auditing arise from contracts between the officials and their supporting interests. in a similar vein, gendron et al. (2001) argued that the office of auditing in canada increased its power to persuade politicians and public servants about the merits of its specific understanding of what accountability should be. however, as an office becomes more powerful, it also becomes more vulnerable to complaints about lack of independence from the executives. santiso (2007) assessed the links between external auditing and fiscal governance to explain the role and performance of government external audit agencies in the governance of the budget and the oversight of public finances; he found a correlation between the credibility of audit agencies and the quality of governance. also established was the fact that accountability gaps in public finances originate in wider dysfunctions in the systems of fiscal control. schelker and eichenberger (2010) argued that such auditors improve transparency and provide essential information on the impact of policy proposals on common pool resources, which leads to less wasteful spending. they also found that auditors who could evaluate and criticize policy proposals ex ante to policy decisions, significantly reduced the general tax burden and public expenditure. finally, hay and cordery (2018) used a historical review to explain the value of financial statement auditing in the public sector. they concluded that the public sector auditing functions are consistent with explanations of agency theory and management control. in the public sector auditing literature, there are studies relating auditing to corruption (ahlenius, 2000; atuilik, 2013; blume & voigt, 2011; borge, 1999; dipietro, 2011; dye, 2007; dye & stapenhurst, 1998; everett et al., 2007; fan, 2012; ferraz & finan, 2008; ferraz & finan, 2011; flint, 2005; gherai et al., 2016; gustavson & sundström, 2016; ionescu, 2014; kassem & higson, 2016; kayrak, 2008; khan, 2006; labuschagne & els, 2006; liu & lin, 2012; melo, pereira, & figueiredo, 2009; morehead, 2007; neu, everett, & rahaman, 2013a; neu, everett, & rahaman, 2015; neu, everett, rahaman, & martinez, 2013b; olken, 2007; otalor & eiya, 2013; othman, aris, mardziyah, zainan, & amin, 2015; suzuki, 2004; tara et al., 2016; tunley, button, shepherd, & blackbourn, 2017; vanasco, 1998). several asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 233 studies have investigated empirically the importance of public sector auditing in fighting corruption. for example, gherai et al., (2016) used a statistical method to examine relations between the existence and the activity of the supreme audit institutions and the control of corruption. their results indicate that the more extensive the work of the sais, the more it contributes to reducing corruption and positively associated with a better quality of life. that study did not explain the mechanisms that are used by sai to detect and prevent corruption or how sais reducing public sector corruption. othman et al., (2015) used structured questionnaires to examine the techniques of fraud and corruption detection and prevention in the public sector in malaysia. the findings of that study indicated that the operational audits, implementation of whistle-blowing system, enhanced audit committees, staff rotation improved internal controls,, fraud hotlines and forensic accountants are among the most effective fraud detection and prevention techniques employed in the public sector. othman et al., (2015) did not separate between the mechanisms that are used in detection and the mechanisms that are used in the prevention, also, they did not explain in-depth the state and how that mechanisms were conducted or revealed the challenges that face every mechanism. similarly, gustavson and sundström (2016) investigated the impact of auditing conducted in the public sector by sais on the level of corruption. their findings suggest that good auditing conducted by sais has a positive effect on levels of corruption in the public sector. they also found several factors that have a positive impact in reducing corruption in the public sector, including the independent of sais from the government, the professionality of sais through acquiring staff with the appropriate skills and education, and sais communicating the audit results to the public. dipietro (2011) used cross-sectional research across different countries to prove that better auditing reduces corruption; in other words, higher quality auditing seems to have a pronounced effect on reducing national corruption. liu and lin (2012), on the other hand, focused on rectification, indicating that after an audit rectification is even more important than the fraud detection process itself. they argued that the discovery of irregularities without subsequent disposal cannot make government auditing a powerful accountability regime. rectification, which according to them includes “asking for responsibility”, is effective in reducing corruption. both schelker and eichenberger (2010) and blume and voigt (2011) indicated that government auditing can improve the transparency of public policies and also reduce wasteful spending. earlier, olken (2007) conducted a field experiment on the monitoring effect of government auditing in indonesia, documenting that when the probability of village road projects was audited by government it increased from 4% to 100%, while corruption (over-spending) on these projects decreased by 8%. similarly, ferraz and finan (2008, 2011) found that government auditing reports can reveal corrupt activities, which then affect political election results. several studies have also documented theoretically the importance of public sector auditing in fighting corruption. for instance, ionescu (2014) found that exposure of misconduct while auditing government accounts is not enough for audit institutions to moderate corruption in government establishments. by sanctioning breaches and correcting mistakes, wrongdoers in government settings can be discouraged from corrupt practices in government settings. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 234 therefore, it was argued that the rate of corruption can be minimized successfully where such rectifications are undertaken, with the focus on efficiency. otalor and eiya (2013) further suggested that audit can be an instrument to prevent corruption, by indicating those areas where the opportunity for corruption exists. they also affirmed that the performance audit is a powerful instrument that can be used to prevent corruption. murphy (2004) found that anti-corruption strategies in the public sector must be aimed at reducing or discouraging the incentives and opportunities for corruption, at the same time increasing its associated cost, and helping to change the expectations of the public. conclusion and recommendations it is clear that corruption and its determinants and motivation are discussed separately in many studies. however, most of the literature on corruption focused on the effects and consequences on an economic basis (e.g. ata & arvas, 2011; ksenia, 2008; lambsdorff, 2005; nwabuzor, 2005). in general, studies on how to fight corruption seldom pay specific attention to the role of auditing. the literature on public sector auditing primarily focuses on the independence, standards, professionalism and auditing input of government auditing agencies and how these factors affect the reputation and efficiency of government departments (e.g., baber, 1983; raman & wilson, 1994; saito & mcintosh, 2010; schelker, 2012). only a few studies touched on the relationship between public sector auditing and corruption ( e.g., blume & voigt, 2011; liu & lin, 2012; neu et al., 2013a; neu et al., 2015; neu et al., 2013b). it was also found that most of the empirical studies on corruption were conducted in developed countries (e.g., neu et al., 2013a ; neu et al., 2013b), rather than in developing countries that have to deal with real problems of corruption. moreover, most of these studies are non-empirical (e.g., dye & stapenhurst, 1998; dye, 2007; 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(2005). an analytical framework for government audit quality characteristics in china. auditing research, 4, 65-68. microsoft word 11003-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 210 the integration between strategic cost management techniques to improve the performance of iraqi manufacturing companies khalis al-naser (corresponding author) college of administration & economic university of mosul, iraq tel: 60-1-8286-5404 e-mail: alnaser7171@yahoo.com rapiah mohamed tunku puteriintan safinaz school of accountancy universiti utara malaysia, 06010 sintok, kedah, malaysia tel: 60-1-2425 7275 e-mail: rapiah@uum.edu.my received: jan. 22, 2017 accepted: march 14, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.11003 url: https://doi.org/10.5296/ajfa.v9i1.11003 abstract the performance of manufacturing industry in iraq has been declining over the last few decades. worst still, many companies in the manufacturing sector in iraq are yet to adopt balanced scorecard (bsc) to improve their performance despite its potency ensure to achieve competitive advantage and better performance. this study examines the integration between total quality management (tqm) and bsc four perspectives in iraqi manufacturing industry. data were collected by means of structured questionnaire survey using simple random sampling and a partial least squares (pls) algorithm and bootstrap techniques were used to test the hypothesis of the paper. the result revealed that tqm had a significant positive effect on bsc through the measurement of customer perspective, financial perspective, innovation and learning perspective, and internal business process perspective. the finding implies that iraqi manufacturing industries can attain the performance of their companies in the different perspective of bsc by proper implementation of tqm technique. keywords: strategic cost management techniques, bsc, tqm, iraq asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 211 1. introduction while there were no noteworthy changes in managerial accounting practice from the 1930s to 1980s (johnson and kaplan, 1987), the most recent two decades have seen a restored enthusiasm to push the boondocks of information here. "the old accounting framework, which reveals to us the cost of material and labor, is not appropriate. indeed, even in assembling, maybe three-fourth of the value included gets from learning". the accentuation has been to incorporate non-financial measures in the assessment and performance measurement models and to discover control systems for the new economy ventures and how to make them more receptive to the worldwide and temporary open doors. striking cases of these developments around there incorporate, balanced scorecard, activity-based costing, activity-based management, total quality management, agile manufacturing, just in time inventory and theory of constraints (gunasekaran, 2005). therefore, this paper was set to examine the integration between strategic cost management techniques (tqm and bsc) in iraq’s manufacturing industry with the sole aim of improving firm performance which has become one of the essential concerns for the managers of all organizations (acer & acer, 2014; pimentel & major, 2014). several organizations worldwide continuously work to improve their performance through various techniques. the ability of the top management to set appropriate firm activities and strategies will determine the strength of the organization in maintaining its performance in the long term (lynch & cross, 1992; neely, mills, platts, gregory, & richards, 1994). in the context of manufacturing industry in iraq, despite its contribution to the country’s gdp (central bank of iraq annual report (cbiar), 2013), the performance of manufacturing industry has been declining over the last few decades (harash, al-tamimi & al-timimi, 2014; saleh, 2015). the sector has been under pressure and challenges since 1990 (hafedh, akoum, zbib & ahmed, 2007). previous studies and annual reports have shown that the performance of manufacturing sector is weak as compared with other sectors, such as banking and other service sectors (bureihi, 2011; cbiar, 2013). previous management accounting research criticized the idea of relying only on traditional performance measures that are financial in nature and stresses the importance of using a combination of performance measures. the reason behind this is that the combination of financial and non-financial measures is considered as more effective in evaluating performance (atkinson et al, 1997; chenhall & langfield-smith, 2007; hoque, mia, & alam, 2001; kaplan & norton, 1992, 1993; pimentel & major, 2014). the trend of using non-financial measures is increasing in order to integrate it with accounting performance measures that are only financial. thus, this is amongst the key factors for the development of pms (elijido-ten, 2010). one of the famous pms models is the bsc (pimentel & major, 2014). this model was originated by kaplan and norton in 1992. bsc is considered as the most important technique in the area of strategic cost management (gunasekaran, 2005; malleret, 2015) that provides information for strategic decision-making. besides that, it includes three non-financial aspects like customers, learning and growth, and internal operations of businesses (kaplan & norton, 2001). many authors mentioned the importance of the bsc as an important source to improve firm performance (kaplan& norton, 1992; sandström & toivanen, 2002). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 212 therefore, the important of bsc to the modern business, matching with yet another important technique of strategic cost management: tqm may address the peculiar problem of manufacturing industry of iraq as many companies in the manufacturing sector in iraq are still to come to terms with decision about adoption of bsc to improve their performance (al-naser, 2010; suror, 2014) despite its potency to improve firm performance that ensures sustainable competitive edge (mohamed, abdul rahman & abdul aziz, 2010). again, the literature is yet to have sufficiently established a relationship between tqm and bsc performance measures. a number of the determined the effect of tqm and organizational performance (mehralian et al., 2017; peljhan, d., & marc, 2016; shafiq lasrado & hafeez, 2017; sweis, ahmad, dweik, alawneh & hammad, 2016). others used bsc to mediate between tqm and organizational performance sholihin & laksmi, 2009). also, there is no specific study has examined the effect and relationship of tqm and bsc performance measures as set in this paper. in view of the above, the rest part of this study is structured as follows: the next section discusses literature review, and research framework, followed by the methodology section, then result and conclusion. 2. literature review and hypotheses development 2.1 total quality management (tqm) tqm, part of strategic cost management techniques (hertati & sumantri, 2016; hertati, 2015; ayedh & houssem eddine, 2015; ibrahim, sukeri & rashid, 2014). long profitability of the business and firm performance can be enhanced by the adoption of tqm in the organization (wilkinson, marchington, goodman & ackers, 1992). this is in conformity with the attention gained by tqm in its effect on firm performance these last few years. it is argued that implementing tqm helps in achieving improvement in the quality of the product, and it assists in cost reduction as well, which ultimately results in customer satisfaction and enhanced financial gains (walton, 1986). similarly, prajogo and brown (2004) have also highlighted that implementation of tqm practices has enhanced quality performance of australian organizations. the researchers compared organizations that have implemented tqm with those that have not implemented tqm formally. initially, it was observed that tqm practices improved performance a lot but later on it was observed that tqm practices do not have a significant impact on all the quality assurances since it only improves management of procedures and strategic planning. the final part of the study totally negates the relationship by arguing that implementation of tqm does not improve the complete relationship between implementation of tqm practices and performance of organizations. regardless of the variations in the results in different time periods, the researchers argued that implementation of tqm has a certain benefit. in short, the study revealed that implementation of tqm always has significant predictive capacity over quality firm performance. thus, it would be right to say that it is critical for the organizations to implement tqm as a set of practices as compared to only implementing tqm as the formal program for enhancing performance. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 213 again, despite the contradictory arguments of some researchers, there are certain researchers that argue that tqm helps in improvement of firm performance. errikson and hansson (2003) argued that tqm helps to improve the financial performance of swedish organizations. the researchers have compared the swedish recipients of the quality award with branch indices for the identification of competitors. initially, it was observed that implementation of tqm has no impact on financial performance but later on it was seen that implementation of tqm has a positive impact on the firm performance. the researchers observed the change in sales, change in a number of employees, and profit margins on sales. they found that companies that have implemented tqm successfully have experienced significant improvement in the firm performance as compared to their competitors. 2.2 balanced scorecard (bsc) preceding bsc, shank (1989) proposes the mixing of three subjects: value chain analysis, strategic positioning analysis and cost driver analysis from the strategic administration writing to end up distinctly a structure called "scm" since methodology and vision are of importance to every one of the partners in the association, then kaplan and norton (1992) built up another performance measurement framework called bsc which mulls over the need of client, interior business and advancement and learning points of view close by a financial viewpoint, and characterizing future introduction. in the contemporary, the bsc is regarded among the top most developments in the field of management accounting. in fact, several researchers and academicians have empirically recognized the need and importance of bsc towards enhancing the performance of an organization (norreklit, norreklit, mitchell, & bjomenak, 2012; hoque, 2014). the importance of bsc implications can be judged by the arguments given in favour of bsc by towers perrin consulting organizational (hoque & james, 2000; hoque et al. 2001; widener, 2006). indeed, generally, it is accepted that companies that implement formal pms that are balanced in terms of financial and non-financial indicators will stand ahead of their competitors (kartalis, velentzas & broni, 2013). bsc by its name shows the balanced considerations that are given to long-term as well as short-term financial and non-financial objectives of the organization. bsc cover four different perspectives including; the perspective of innovation and learning, the perspective of business, the perspective of the customer, and last but not the least the financial perspective (kaplan & norton, 1992). these perspectives are used as the holistic performance measures that are helping the organization to stay on course. given the importance of bsc, there is a dire need of intense research in the field. despite its dire need and importance, limited empirical support is available in the field, thereby indicating an on-going research in this perspective. 2.3 total quality management and balanced scorecard the purpose of linking bsc and tqm is to harmonize vision, strategy, operation, and employees. organizations implementing tqm for the achievement of strategic goals should incorporate measures of bsc to determine appropriate multidimensional indicators that are financial and non-financial. by doing so, organization motivates the employees through reward systems that are tailored according to the necessary outcomes. organizations also asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 214 encourage and reward those who provide feedback that assists the organizations to improve (hoque, 2003). feedback is the basis for the success of any organization. feedback empowers employees to achieve continuous improvement through which success is achieved which is the core element of tqm (sunhilde, 2009). this study linked bsc and tqm for identification of opportunities. in the current literature, this linkage has not yet been explored especially in the arab region. as mentioned above that bsc is more inclined towards financial concerns and tqm is more inclined towards systems. however, tqm practices do not ignore the importance of financial solvency. considering the importance of integration between tqm and bsc more and more organizations are adopting tqm and bsc integrated control systems (lin & johnson, 2004). vora (2002) supported the argument and suggested that tqm strategies are in line with bsc. based on the abovementioned discussion the relationship has been hypothesized as follows: h1: there is a relationship between tqm and financial perspective of bsc h2: there is a relationship between tqm and customer perspective of bsc h3: there is a relationship between tqm and internal business process perspective of bsc h4: there is a relationship between tqm and innovation and learning perspective of bsc 2.4 research framework based on the literature reviewed and the subsequent development of hypothesis, figure 1 presents the pictorial positions of the research framework. balanced scorecard figure 1. research framework as shown in figure 1, the research framework has total quality management as the only independent variable and corresponding dependent variable is balance scorecard with four dimensions. hypotheses were developed between the tqm and the four dimensions of bsc (financial perspective, customer perspective, internal business process perspective, and innovation and learning perspective). total quality management financial perspective customer perspective internal business process perspective innovation and learning perspective asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 215 3. methodology this research adopts a cross-sectional field survey technique. using structured questionnaire, data was collected at one time through probability sampling for the best liners and un-bias estimate for generalizations. 3.1 sampling and data simple random sampling technique was used in this paper and data was collected using a questionnaire that was distributed to 604 manufacturing companies in iraq i.e twice the actual sample size (302, based on krejcie and morgan (1970) guideline) of the study to avoid low response rate as guided by hair, wolfinbarger & ortinail (2008). the main sampling targets were top managers of the manufacturing firm. the survey provided us with 303 completed questionnaires constituting a response rate of 50.2%, which provided an adequate sample for analyses. 3.2 variable and measurement for measuring the construct tqm, this paper basically adopts the instrument used by chenhall (1997). it includes 7 items largely based on tqm dimensions. accordingly, the instrument will help to enquire tqm dimensions. the top management asked to rate the degree of each question based on its implementation in their organization’s by using a five-point likert scale. for the bsc on the other hand, the variable was measured using an instrument that was developed by kaplan & norton (1996). the instrument contains 21 items for the four perspectives of bsc: 4 are financial items and 17 non-financial items from three different perspectives of customer, internal business process, and learning and growth perspective. the respondents were asked to indicate the extent to which each item is used in assessing performance, using a five-point likert scale. 4. results partial least square structural equation model (pls sem) was used in this paper utilising smart pls 3.0 software (ringle, wender & becker, 2015) in analysing both measurement and structural models. the measurement model was determined by running pls algorism while the structural model was determined through bootstrapping method (hair et al., 2014). 4.1 respondent descriptive analysis shows that majority of the respondents were males with total percent 76.4% of the sample while 23.6% of respondents were females. the results indicate that the industrial sector in iraq employs more males than females due to the nature of society. in terms of age, sample subjects’ age ranged from 20 to above 60 years. 36.2% of the sample age between 41 and 50 years, 28.2% of the sample age between 31 and 40 years, %20.6 of the sample age between 51 and 60, 13.3% of the sample age is between 21 and 30 years and only 1.7% of the sample age is above 60. in terms of position, the majority of respondents (59.1%) are account managers, 28.2% of respondents are managers, 7.6% are audit managers, and 3.7% are assistant managers. this is an indication that members of the top management are utilised for the survey. in terms of industry, the majority (78%) of respondent firms are asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 216 from four industries: % 21.6 are textile and wearing apparel firms; % 19.9 are food and beverage firms; % 13 are non-metallic mineral firms; % 12 are chemical products firms ; % 11.3 are wood and wood products firms. the other 22% of firms are from paper and paper products with 6 %, electrical and electronic with 5.6%, iron and steel with % 4.3, plastic products with % 4 and machinery products with %. this is an indication that the survey covers divers companies with different line of activities. 4.2 measurement model convergent and discriminant validity was used in evaluating the measurement model of the paper. all the construct of this paper has achieved the required loading above 0.7, composite reliability above 0.7 and ave above 0.5 (hair et al., 2014). however, two items cp1 and cp6 from the construct customer perspective are deleted from further analysis due to the low loading (see figure 2 and table 1). figure 2. measurement model the discriminant validity analysis result is shown in table 2. the square roots of ave for all the constructs are on the diagonal line signifying a higher square root of ave. all the square roots of ave for the constructs are greater than the off-diagonal correlation coefficients in the corresponding rows and columns. in addition, this indicates that each and every variable shares more variance with its items than with other constructs, and, thus supports discriminant validity (hair et al., 2010). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 217 table 1. reliability and validity of construct variable indicator s loading cronbach’s alpha composite reliability ave bsc: customer perspective cp2 cp3 cp4 cp5 cp7 0.782 0.871 0.793 0.784 0.714 0.853 0.892 0.625 bsc: financial perspective f1 f2 f3 f4 0.858 0.913 0.891 0.817 0.895 0.926 0.758 bsc: innovation and learning perspective ilp1 ilp2 ilp3 ilp4 ilp5 0.825 0.865 0.733 0.804 0.798 0.872 0.902 0.650 bsc: internal business process perspective ip1 ip2 ip3 ip4 ip5 0.816 0.807 0.821 0.889 0.835 0.891 0.919 0.696 total quality management tqm1 tqm2 tqm3 tqm4 tqm5 tqm6 tqm7 0.862 0.870 0.884 0.864 0.751 0.824 0.838 0.932 0.945 0.710 table 2. discriminant validity variable bsc cp bsc fp bsc ilp bsc ip tqm bsc: customer perspective 0.790 bsc: financial perspective 0.436 0.871 bsc: innovation and learning perspective 0.350 0.447 0.806 bsc: internal business process perspective 0.432 0.449 0.328 0.834 total quality management 0.280 0.319 0.224 0.311 0.843 4.3 structural model the structural model was assessed by evaluating the beta value and the corresponding t-values through the bootstrapping procedure with 500 resample. therefore, the bootstrapping asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 218 result from the smart pls reveals that path coefficient from tqm -> cp is statistically significant with a beta (β) value of 0.280, t-value of 5.245 and a p-value of 0.000 significant at the p<0.01. the result also shows significance on the effect of tqm on fp the result shows beta (β) value of 0.319, t-value of 6.296 and a p-value of 0.000, significance at p<0.01. for the effect of tqm on il the result shows beta (β) value of 0.224, t-value of 4.678 and a p-value of 0.000, significance at p<0.01 and finally the result also shows significant effect of tqm on ip with beta value of 0.311 and t-value 5.534. (see figure 3 and table 3). figure 3. structural model table 3. result of the structural model analysis relationship beta standard dev. t statistics p values tqm -> cp 0.280 0.053 5.245 0.000 tqm -> fp 0.319 0.051 6.296 0.000 tqm -> il 0.224 0.048 4.678 0.000 tqm -> ip 0.311 0.056 5.534 0.000 4.4 discussion of findings this paper empirically assessed a structural model of the integration between tqm and bsc in the manufacturing industry of iraq. the perceptions of management of the manufacturing companies were used in the analysis and the findings show a positive significant relationship between tqm and all the perspective of bsc (customer, financial, innovation and learning, and internal business process). the implication of this finding is that the management of iraqi manufacturing companies are with vies that tqm can best be a matched to bsc for better performance. by extension, the finding of this paper implies that for the companies to compete favorable in the industry it need to integrate the technique of tqm with dimensions of bsc. this finding is consistent with previous studies (mehralian et al., 2017; sholihin & laksmi, 2009). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 219 5. conclusion this paper was set to examine the integration between tqm and bsc based on its four perspectives. the result shows a significant link between tqm and the perspective of bsc (customer, financial, innovation and learning, and internal business process). therefore, this paper concludes that tqm is a good technique of strategic cost and management account that have a direct positive link with the organizational performance from the customer perspective, financial perspective, innovation and learning perspective, and internal business process perspective of bsc. this implies that iraqi manufacturing industries can attain the performance of their companies in the different perspective of bsc by proper implementation of tqm technique. acknowledgements the author would like to thank ministry of higher education & scientific research of iraq and my supervisor dr. rapiah mohamed for her guidelines and efforts. a special thanks also to the anonymous reviewers and the journal editor. references acar, a. z., & acar, p. 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(1992). total quality management and employee involvement. human resource management journal, 2(4), 1-20. https://doi.org/10.1111/j.1748-8583.1992.tb00263.x microsoft word 13259-48467-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 428 factors affecting undergraduate students’ intention to become a chartered accountant in bangladesh mohsina akter (corresponding author) assistant professor department of accounting and information systems, jahangirnagar university, savar, dhaka-1342, bangladesh e-mail: nipddu124@gmail.com, mohsina@juniv.edu muhammad muhiuddin siraj research associate, redbrick, mirpur, block i, dhaka-1236, bangladesh e-mail: muhiuddinsiraj@gmail.com received: april 7, 2018 accepted: may 17, 2018 published: june 29, 2018 doi:10.5296/ajfa.v10i1.13259 url: https://doi.org/10.5296/ajfa.v10i1.13259 abstract purpose-the objective of this paper is to examine the factors affecting bangladeshi students’ intention to be a chartered accountant. this paper specifically addresses factors like students’ gender, previous major at undergraduate level, cgpa, public vs private university status and family income. design/methodology/approach the study was conducted using a questionnaire survey with a sample of 271 students from five different public and private universities in bangladesh. the test was applied to examine the relationship between these factors and students’ aspiration for a chartered accountant. findingsthe findings of the study show that out of five variables three variables, previous major, public vs private university status and family income, have significant relationship with students’ intention to pursue ca professional qualification. on the contrary, gender and cgpa of the students are considered as insignificant factors. originality/value-this research is the first study in bangladesh which identifies several asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 429 influencing factors for students’ choice to become a chartered accountant. the findings have implications for professional bodies in bangladesh and other policy makers in their effort to develop strategies to motivate students to be a chartered accountant. keywords: professional qualification, chartered accountant, bangladesh, perception, undergraduate. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 430 1. introduction professional accountants play a significant role in deriving the economic growth of a country through ensuring accountability of the financial positions of the organizations and covering financial and strategic aspects of business. chartered accountancy has emerged as a specialized field of accounting and is the most worthwhile job not only in bangladesh but also all over the world. the institute of chartered accountants of bangladesh (icab) is the national professional accountancy body in bangladesh which has the sole responsibility to regulate the accounting profession and matters concerned therewith in the country. based on icab report (2017), there are total 1,674 members of the institute who has been practicing within or outside the country and a total of 4,321 article students as on june 2017 among which 1,305 students registered during the year 2016-2017. though the number of article students over the period of 1994 to 2017 has been increased but the country is quite far off the required numbers of chartered accountants. the number of registered cas of bangladesh (1,674 members) is quite low compare to country’s demand and other south asian countries. according to world bank report on the observance of standards and codes (2015), over the last five years, in bangladesh, the overall entry into the ca profession remained equivalent to 10 percent of current members instead of several improvements in the curriculum training and examination. the reason for bangladesh being so far behind the required number of accountants remains a questionable mark for all. the objective of this study is to investigate factors that influence bangladeshi student’s choice towards pursuing ca professional qualification. based on prior literatures those conducted mainly in abroad (jaaffar et al., 2017; sugahara et al., 2006; 2009; nga and mun, 2013) this study addresses the following factors: students’ gender, cgpa, previous major, public or private university status and family related factors such as income of family members. data are collected both from students of public and private universities through questionnaires and initially collected data are divided into two groups students who intend to be a ca and those who do not and finally these two groups are analyzed based on above mentioned factors. although prior studies on investigating factors that influence students’ intention to become a qualified chartered accountant was found in other countries such as australia (jackling and calero, 2006), malaysia (jaaffar et al., 2017), canada (felton et al., 1994) and japan (sugahara et al., 2006; 2009) but unfortunately no study has undertaken in the context of bangladesh. our current study is expected to fill this gap and contribute significantly to the existing literatures. furthermore, the results and interpretations of the study will inform the accounting educators, professional bodies and policy makers about influencing factors as well as reasons behind low percentage of enrollment for ca professional degree and finally will direct them to develop strategies to address these issues. the remainder of this paper is organized as follows: section 2 reviews prior study relevant to this study and addresses hypotheses. the research methodology including sample, data collection method and data analysis techniques are explained in section 3. section 4 describes the results of the analysis and finally, the paper concludes with possible recommendations for asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 431 future research. 2. literature review several overseas studies have been undertaken to investigate factors affecting students’ career choice in accounting (demagalhaes et al., 2011; uyar and kuzay, 2011; dibabe et al., 2015; ahmed et al. 1997, odia and ogiedu, 2013) and perceptions of accounting students towards accounting profession (byrne and willis, 2005; samsuri et al., 2016). the factors identified in these studies include personal factors like interest of the students, gender, difficulty of accounting courses, stress; job related factors such as job availability, compensation, social status and career advancement and other factors such as long study duration, influence of peer and parental groups. though several studies have been undertaken outside bangladesh none has been conducted from the perspective of the students of bangladesh. a study by tabassum and rahman (2014) examined factors influencing career choice of bangladeshi business students and found the individual, psychosocial, structural, meso, socioeconomic, organizational, familial and societal, relational, economic and educational as influential factors. there is a research gap in examining factors those have impact on bangladeshi students’ choice to be a ca. to fill up this gap, this study has considered five factors which are outlined below: 1. gender: chartered accountancy education in bangladesh is still dominated by male professionals, with very few females qualified as professional accountant. according to icab annual report (2017), up to july 2017, there are total 1,538 male members in the country compare to 105 female members. previous studies found an association between gender diversity and the students’ perceptions about accounting study. a study by byrne and willis (2005) on irish students found that female’s point of view for accounting is more specific, accurate and compliance driven compare to males. nelson and vendrzyk (1996) in the usa showed that there is a more favorable attitude towards accounting to female students than male students. according to sugahara et al. (2009) several factors influencing japanese accounting school students' career intention to become a certified public accountant where gender has insignificant relation with students’ intention of becoming a cpa. to address this, our current study has developed the following hypothesis in null form: 1. a student’s gender has no significant relationship with their choice to become a ca in bangladesh. 2. previous major: previous studies have examined possible association between career choice in the accounting profession and previous learning experiences. among them, (chen et al., 2005) found that students’ decision to major in accounting has strong relation with their overall experiences and satisfaction in the primary accounting courses. the same is supported by jones and wright (2011) where students’ major in high school level had significant effect on their decision to take major in later and (byrne et al., 2012) found that the educational and occupational ambitions of the students are decided during their final school year. on the contrary, ahmed et al.(1997) investigation on tertiary students in new zealand showed that the accounting exposure in secondary school had no significant influence in the course of student’s career path. our current study does not investigate the exposure of students at the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 432 secondary level rather their exposure at the undergraduate level before taking a professional degree are focused. sugahara et al. (2009) investigated the same association for students of japan and found that students specialized in subjects other than accounting were significantly reluctant to become a cpa. based on all these our current study has developed following hypothesis2. students’ previous major at the undergraduate level has no significant relation to the choice of ca professional education. 3. public vs private universities: every year a large number of students are graduated from public and private universities in bangladesh. according to ugc report (2016), there are 42 public and 95 private universities in bangladesh own the bulk of higher studies students. due to limited seats in few public universities, there are a large number of potential students who do not have the opportunity to enroll (hossain and siddique, 2012). according to world bank accounting and auditing rosc (2015), the majority of the students who enrolled and passed ca exam come from a renowned public university in bangladesh. so, this study examines the association between public and private universities students with their intention for ca professional degree. the related hypothesis is3. students from public and private universities in bangladesh have no significant effect in their choice to become a ca. 4. cgpa: the world bank report on the observance of standards and codes (rosc, 2015) for bangladesh showed that the accounting profession is challenged to attract sufficient high-quality graduates, many of whom opt for a career in other sectors. it also reported that there is a lack of interest of meritorious business graduates in bangladesh in entering professional accounting education because of the availability of other lucrative government jobs and low passing rate prevailing for a long article ship period in achieving ca degree. our current study investigates whether students’ cgpa at undergraduate level has any impact on their choice to be a ca. in this regard, the surveyed students cgpa is collected up to the semester they were continuing. the following hypothesis is considered: 4. the cgpa of the students at the undergraduate level has no significant relation to students’ intention to be a chartered accountant. 5. family income: previous study identified several social factors like parent influence (law, 2010), friends and teachers’ influences (myburgh, 2005) and social status (germanou et al., 2009) of the students in their choice of career. the finding of tan and laswad (2006); law (2010); byrne et al. (2012) and uyar and kuzay (2011) provided that students’ career choice is not only affected by their own interest but also by their family. conversely, the paolillo and estes (1982) showed that family does not have any significant impact on choosing accounting as a career. world bank accounting and auditing rosc (2015) for bangladesh identified that the high potential students are more interested to enter jobs after completing graduation to support families instead of taking further long term article ship training in practicing firms where the students are paid very low. in relation to this the following hypothesis is also established: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 433 5. income of the family has no significant relation to the choice of ca professional degree. 3. methodology 3.1 data collection: the data for this study has been collected via a survey based on questionnaire distributed to undergraduate students of business schools of bangladesh. the sample of this study chosen first based on stratified sampling method that is sample is classified into two groups’ public and private universities of bangladesh. then the questionnaire is distributed to students pursuing major in business which include accounting, finance, marketing and management. the survey was conducted on total 271 business students from 5 universities in bangladesh. a total of 300 questionnaires were distributed to students who are mostly pursuing their bba degree. after extracting incomplete questionnaires, we are able to analyze 271 responses. among these 159 students surveyed from two public universities and 112 students’ response is received from three private universities in bangladesh. the close ended questionnaire includes several questions like name of universities, students’ previous major, cgpa, gender, family income, year of study, and most importantly students’ intention to pursue ca professional degree. 3.2 data analysis: to analyze the data, five factors i.e. gender, cgpa, previous major, public and private university status and family income of professional education have been considered and five hypotheses have been developed to find out the relation of these factors with student’s intention to pursue ca professional degree. finally, the chi-square test was applied to investigate the relation. 4. results table 1 provides descriptive statistics of the students surveyed from different universities. a total of 271 students surveyed from five universities, all are undergraduate students. of the total students, 58.6 percent from two selected public universities and 41.3 percent from three private universities in bangladesh. a total of 61.2 percent sample was male and 38.7 percent was female. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 434 table 1. descriptive statistics of students surveyed factors sub factors frequency percentage university public 159 58.6 private 112 41.3 gender male 166 61.2 female 105 38.7 major accounting 173 63.8 finance 49 18.08 management 26 9.59 marketing 23 8.48 several factors mentioned in the hypotheses are considered for statistical analysis. for each factor, chi square test was applied to examine the relation of those factors to students’ intention to become a ca. the results of chi square test are explained below 1. gender: to explore the relationship between students’ gender and their choice for ca professional degree test was applied. the result of test in table 2 shows that there is insignificant difference between students’ intention and the gender proportion. total 43 percent of female are interested for ca professional degree compare to 57 percent of male whereas 33 percent of female are not interested compare to 67 percent male. this scenario indicates the equal distribution of gender across two group of students though it is also observed that male students are more dominant in both groups. moreover, at 5 percent level of significance, p value is large enough not to reject null hypothesis. so, 1 is not rejected that is a student’s gender has no significant relation to the choice of ca education in bangladesh. table 2. x test for gender gender students intend to be a ca students don’t intend to be a ca value p value male (166) 85 (0.57) 81 (0.67) 2.56 0.11 female (105) 65 (0.43) 40 (0.33) 2. previous major: the previous learning experience of a student is considered as an important factor so the study focuses on business graduates majored in accounting, finance, marketing and management. to examine this relationship students are categorized into four groups based on their previous major at undergraduate level. the result in table 3 presents that there is a significant difference across the four group of students, major in accounting, marketing, finance and management/hrm. the large percentage (70 percent) of the students who had major in accounting are desired to be a ca. though a large number of samples are concentrated in accounting (183 students), among them 105 students intend to pursue ca degree while it varies for other majors. in case of major in management, 15 out of 26 students is not interested to be a ca and similarly majority of the students (18 out of 23) from marketing don’t want to pursue ca degree though it is not true for finance background students. the test depicts that the number of ca intended students are significantly larger asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 435 from accounting discipline than those form other disciplines. in this context, p value is small enough to reject null hypothesis, 2, at 0.05 significance level. table 3. x test for previous major major value p value accounting (173) finance (49) management (26) marketing (23) students intend to be a ca 105 (0.7) 29 (0.19) 11 (0.07) 5 (0.03) 14.59 0.0021 students don’t intend to be a ca 68 (0.56) 20 (0.17) 15 (0.12) 18 (0.15) 3. public vs private universities: the study categorizes students into two groups, students from public university and from private university. then it is tried to examine whether there are any potential differences between these two groups in their choice of ca professional degree. the statistical result in table 4 presents that only 17 percent students from private universities are considering to pursue ca degree unlikely it is 83 percent for public universities which indicates a significant difference across the groups. so, the hypothesis 3 is rejected. table 4. x test for public and private university status universities private (112) public (159) value p value students intend to be a ca 26 (0.17) 124 (0.83) 77.57 0.000 students don’t intend to be a ca 86 (0.71) 35 (0.29) 4. cgpa: the test was applied for this factor to explore statistical significances across different group of students. the cgpa considered here is partial cgpa of the students. for statistical test, the cgpa are categorized into four groups which are depicted in table 5. from table 5, it is observed that students’ choice for ca is insignificantly affected by their result. the proportion of students at different categories of cgpa are almost equally distributed. p value is also large enough at 0.05 level. our hypothesis 4 is not rejected. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 436 table 5. test for student’s cgpa cgpa 2-2.5 (13) 2.51-3 (25) 3.01-3.5 (131) 3.514 (63) value p value students intend to be a ca 4 (0.03) 13 (0.11) 73 (0.6) 32 (0.26) 3.0841 0.3788 students don’t intend to be a ca 9 (0.08) 12 (0.1) 58 (0.53) 31 (0.28) 5. family income: table 6 presents family income of the students into four groups. it is fascinating to observe that as the level of family income increases the number of ca intended student’s decreases. so, from test statistic it is concluded that the significant differences exist in the students’ choice for ca study across different level of family income. the hypothesis 5 is rejected at 0.05 significant level. table 6. test for family income of the students income level <15000 (32) 15001-35000 (167) 35001-55000 (39) 55000> (25) value p value students intend to be a ca 19 (0.13) 107 (0.73) 15 (0.1) 5 (0.03) 22.505 0.0000 students don’t intend to be a ca 13(0.11) 60 (0.51) 24 (0.21) 20 (0.17) 5. conclusion this study is undertaken to examine factors influencing bangladeshi students’ choice for ca professional degree. with the sample of the study comprising students from public and private universities in bangladesh the findings show that 53.5 percent of the students desire to be enrolled for ca. further analysis shows that out of five hypotheses in null form three hypotheses are rejected indicating the significant relation with students’ aspiration for ca professional education. one variable gender does not have any significant relation which is also supported by other study (sugahara et al., 2009; edwards and quinter, 2011) and the same is true for students’ cgpa. the result of this study reveals that students who have major in accounting and from public universities are more interested to become a ca compare to other non-accounting group and private universities. students’ choice also varies for different group of family income. these outcomes may suggest professional body in bangladesh for strategies to increase students’ enrollment for ca education and therefore contribute to minimize the shortage of required chartered accountants in bangladesh. one possible strategy may be to aware the benefits of becoming ca to other business graduates specially the students of private universities in bangladesh. the number of chartered accountants in bangladesh is far below compare to other south asian countries like india, nepal, sri lanka. though the number has been increased over the period still it is beyond the market demand. this research may help the policy makers to understand the reason of this predicament and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 437 assist in taking strategies. this study does have limitations. firstly, the sample of the study is restricted to undergraduate business students though university study is not the only pathway into the ca profession. in some instances, students may enroll for ca professional qualifications without first obtaining an undergraduate degree though the percentage of this group is low. secondly, the study has considered only six variables there may have other intrinsic and extrinsic factors which needs further investigation. another limitation is that it examines the intention of students who are midway of their graduation. the attitude of the students may change and may be affected by other factors after completing graduation. the present study may be extended further to investigate the intention of students after completing graduation. 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(2003). factors explaining the choice of a finance major: the role of students' characteristics, personality and perceptions of the profession. accounting education, 12(3), 261-281. https://doi.org/10.1080/0963928032000088831 microsoft word 9632-35350-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 31 location, industry competition and profitability esmail tavakolnia (corresponding author) faculty of economics & administrative science, mazandaran university, babolsar, iran islamic azad university, lahijan branch, department of accounting, lahijan, iran tel: 98-911-4701706 e-mail: esmail.tavakolnia@gmail.com seyed vali mostafavi makrani department of accounting, payam noor university, behshahr, iran received: june 19, 2016 accepted: july 22, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.9632 url: http://dx.doi.org/10.5296/ajfa.v8i2.9632 abstract the construction of one or more plants in optimum sites and in the best possible situation, not only improves materials circulation and customer services, but also puts the company in a desirable situation. decisions associated with the selection and acquisition of features of a center’s site selection can have a great impact on the ability to gain and maintain competitive advantages. this study tests the impact of distance from population centers on the profitability for the first time. the sample which has been used in the food products industry, includes 21 firms listed in tehran stock exchange during 2009 to 2014, and panel data regression methods were used to process and test the hypotheses. the results showed that product market competition enhances the negative impact of corporate distance from tehran and big cities on the basic earnings power (earnings before tax). however, the relative power of the firm in a competitive environment weakens the negative impact of corporate distance from tehran and big cities on the basic earnings power (earnings before tax). keywords: corporate location, distance from population centers, industry competition, profitability, tehran stock exchange. jel: m41, r30 asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 32 1. introduction studying about the establishment of companies in various places has long been considered by economists and geographers. indeed, how do enterprises decide upon installations and their productive activities in a special place? finding an answer to this question can be of particular importance for investors in economic activities as well as policy makers in an area. on the one hand, investors are trying to find a place to maximize their earnings, and on the other hand, policy makers are trying to attract the activities with the greatest impact on the economic growth and regional development to their regions (sabaqh karimi, 2001). the construction of one or more industrial unit in optimum sites and in the best possible situation, not only improves materials circulation and customer services, but also puts the plant in a desirable situation. decisions associated with the selection and learning features of a center’s location can have a great impact on the ability to gain and maintain competitive advantages (mazzarol and choo, 2003). however, existing theories (weber’s model and hotelling’s model), have considered distance from population centers to reduce company’s profitability, and industry competition is expected to increase this impact (losch’s model). the impact of the plant site and its distance from or nearness to population centers on company’s profitability is an issue that has not been investigated in researches so far. therefore, this study investigates and tests this issue at the level of food industry companies listed in tehran stock exchange, and at the same time, examines the effects of industry competition on this relationship. it is worth mentioning that food industry, as one of the most profitable industries in tehran stock exchange in recent years, has been highly dependent on population centers for food consumption and thus, testing location models that emphasize on the center of raw materials supply and the produced materials consumption, can cover the perspective of produced materials consumption in this industry well. 2. theoretical background basically, the purpose of selecting a specific site for production is to maximize company’s earnings. hence, the best site is where that will maximize company’s earnings. scholars have distinguished between exclusive and competitive markets about the impact of site on profitability. in exclusive markets, the company can compensate the increased cost resulting from distance from population centers through increasing the price of goods and services, and thus, has no effect on its profitability. but in competitive markets, increasing prices is not simply possible, and therefore, distance from population centers cannot reduce firm profitability. of course, the issue is not that simple and some models are designed and developed, that will be mentioned later. 2.1. weber’s model weber (1909), established the foundation of modern location theories. one of his basic assumptions was that firms determine their location based on cost minimization. when the firm has minimized its transportation costs, it will be able to maximize its earnings (the difference between revenue and cost of raw materials and transportation). it should be noted asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 33 that the firm's revenues and raw materials cost are the same in different places, and only transportation costs of raw materials and products to the market matters. in this regard, the firm selects a location for production that minimizes transportation costs. where to establish the firm depends on the resultant of tensile forces related to raw materials location and market. on the one hand, in case of lower transportation costs of raw materials, the firm will tend to be established in the market location, and on the other hand, in case of lower transportation costs of the products, the firm will be attracted towards raw materials location. in each case, firm nature and the type of its products have a widespread impact on firm’s location (see sabagh kermani, 2001; mirkatooli and manafi azar, 2009; weber, 1990; reid, 1966; hannik, 1999). 2.2. hotelling model this model, indicates the role of location in determining the firm's market share. assume that there is a market which is as a straight line, like figure 1, and demand distribution is uniform along it, and consumers are at specific intervals from each other. in mode a of figure 2, the seller is located on one side of the market and has all the market under his control and acts exactly exclusively. in mode b, the second seller enters the market and affects the market covered by the first seller, and the first seller's market is reduced to the extent of point m to the location of the first seller. in this case, the first seller will suffer loss due to losing a large part of its market and thus, attempts to change its place so as to possess a greater share of the market, and his only way is to move to the left side of the second seller. likewise, the second seller must also change his location, and this will continue to the extent that neither of them cannot gain anything and even suffers loss because of moving and taking a share from the market (see sabagh kermani, 2001; mirkatooli and manafi azar, 2009; hotteling, 1929; hannik, 1999; sanjo, 2007). figure 1. the impact of increased competition on enterprises’ markets 2.3. losch’s model according to sabagh kermani (2001), the impact of distance in the sphere of influence of the monopolist firm’s market constitutes the basis of losch’s model. assume that the location of the first firm is point b in figure 2. to make it easy, assume that the area is geographically and continentally homogeneous and transportation costs, population dispersion, etc. are the same. in this case, the demand for the firm's product at point b will be more than everywhere, asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 34 since this point is the only point at which goods are cheaper than anywhere else (because consumers do not pay for goods transportation costs). the farther we get from the firm, the more the cost of goods purchased for the customers, due to the distance, will be. eventually, at a distance such as k (or k΄) final cost units added to the price of goods are too high that there will be no demand for that product. the distance at which the goods are sold is called goods range, and the maximum distance at which the goods can be sold is called goods outer range. in figure 2, goods outer range is the distance from b to k. any sales that are outside this distance are additional earnings it gains. this additional earnings is in fact the monopolist’s rente which it gains in the absence of competitors. this economic rente that is given to the monopolist can be a function of its prices for customers at different distances. if this price is increased more than usual, the demand will be likely to reach to a lesser extent that is needed for survival. therefore, unreasonable prices will shrink the size of the firm’s market (see sabagh kermani, 2001; losch, 1954; hannik, 1999). figure 2. market’s maximum and minimum with two different perspectives 2.4. company’s profitability the concept of earnings is basically an accounting concept and much of the efforts of accountants is focused on its measurement. earnings is among the greatest indicators of measuring a business unit activities and potential economic decision-makers (rahnama roodposhti and salehi, 2010). various studies have addressed the issue of profitability and identifying the factors affecting it. company’s life (rietveld and schipper, 1995), corporate governance (bernotas, 2005), company’s growth (lin and rowe, 2006), company’s size (cinca et al, 2005), advertisement costs (esther, 2006), research and development costs (verbeek and debackere, 2006), type of industry (acquaah and chi, 2007), staffs’ satisfaction (yee et al, 2008), quality management (pignanelli and csillag, 2008), the level of staff’s training and experience (chiliya and roberts-lombard, 2012), working capital management (ukaegbu, 2014), human capital reporting (ghadiri moghaddam et al, 2013), capital structure (rahimian et al, 2013), economic indices (ahmad poor and ebrahim poor, 2012), growth (khajavi et al, 2014), etc., are among effective factors on profitability that have been investigated in international studies. but in this study the effect of location on company's profitability is investigated for the first time. 3. empirical background ejngton (2000), conducted a survey in the united states and concluded that market demand asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 35 elasticity for goods, market scope, how to price goods, and in short, the extent of selling goods in the market, have significant effects on corporate earnings. wang and hong (2016) founded that companies that offer their products via the internet and takeaways to the customer have increasing profitability. sridhar and wan (2010) stated that capitals have not been attractive locations for brazilian, hindi, and chinese companies, especially if they were large. also, the relationship between access to raw materials and company’s location in brazil, china, and india have been negative. john et al (2011) examined the relation of company’s location and dividends policy. in fact, the impact of geographical location on agency costs and dividends policy was examined. their results showed that isolated companies divide more earnings, which is the result of high agency costs. arena and dewally (2012) investigated the relationship of company’s geographical location and the amount of debt. the results showed that companies located in rural areas face more financing problems compared to companies located in urban areas and attract smaller banks with less credibility. in addition, these companies are trying to reduce their information flaws through more reliance on banking relationships. cook and wilson (2013) concluded that countries’ tax laws are not the only determinants of the company's location and countries can influence this factor by signing free trade contracts. although dispersed studies on companies’ locations have been conducted around the world, but it has not been welcomed in iran, and of course, profitability is a popular subject that has attracted much attention (e.g. see ahmad poor and ebrahim poor, 2012; haghighat and mortazavi, 2014; khajavi et al, 2014; tavakolnia and mostafavi makrani, 2016). 4. hypotheses given the above mentioned materials, the following hypotheses have been developed: h1: product market competition moderates the impact of company’s distance from population centers on profitability. h2: company’s relative power in a competitive environment moderates the impact of company’s distance from population centers on profitability. 5. methodology 5.1. population and sample the population of the study includes all firms listed in tehran stock exchange in food & beverage industry, except sugar industry, during the years 2010 to 2014. due to the limited number of observations, sampling is not done and the whole population (including 21 companies) will be examined. it is worth mentioning that the required data will be extracted from companies’ financial statements and rah avard novin software. 5.2. variables and models the following regression models are used in this study to test the developed hypotheses: asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 36 profitabilityi,t = β0 + β1 distancei,t + β2 hhij,t + β3 distance*hhij,t + β4 sizei,t + β5 cii,t + ԑi,t profitabilityi,t = β0 + β1 distancei,t + β2 hhij,t + β3 distance i,t*hhij,t + β4 sizei,t + β5 distance i,t*sizei,t + β6 distance i,t*hhij,t*sizei,t + β7 cii,t + ԑi,t where: profitability = the ratio of net profit to assets (return on assets roa), and the ratio of earnings before tax to total assets (basic earnings power bep) are used to measure it. distance = company’s distance from population centers, which is calculated in two ways: distance1 = distance (based on kilometers) of the plant of the company’s products to tehran, and is calculated by using the natural values logarithm; and distance2 = distance (based on kilometers) of the plant of company’s products to the nearest big city, and is calculated by using the natural logarithm. for example, if a plant is located in rasht, its distance is considered zero. hhi = herfindahl-hirschman index as a criterion for concentration at industry level, which is calculated as follows (datta et al, 2013): hhijt = ∑nj i=1 (salesjit / ∑nj i=1 salesjit)2 where: hhijt= is hhi of industry j at time t; salesjit= indicates sales of company i in industry j at time t; higher values of herfindahl-hirschman index indicate greater concentration and less market competition. size = company’s size, which is the logarithm of the company's assets. ci = is investment in fixed assets, which is the ratio of fixed assets to total assets. in order to investigate the effect of distance from population centers on profitability (hypothesis 1), the variable of distance is used. the variable of distance*hhi is used to investigate the effect of product market competition on the relationship of distance from population centers and profitability (second hypothesis), and the variable of distance*hhi*size indicates the impact of company’s relative power in the competitive environment on profitability. it should be noted that zoltan and audretsch (1987) argued that larger companies have more innovation and can potentially play a greater role in the market. thus, the product of size and industry concentration (competition) can show that, overall, to what extent the company is able to show its power. higher values of the product indicate more relative power of the company. meanwhile, to prevent the problem of autocorrelation, the method of mean-centering has been used. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 37 6. findings the data from 21 sample companies during the years 2010 to 2014 were extracted from available databases and transferred to excel software. after necessary calculations for the independent, dependent, and control variables, necessary information for the required statistical test were saves in appropriate files and processed in eviews9 software. it is noteworthy that to assure the reliability of the variables, im, pesaran, and shin’s test was used, and to eliminate the effects of possible variance heterogeneity, estimated generalized least squares method (egsl) was used. descriptive statistics and reliability of the results of testing variables reliability are shown in table 1. it is worth mentioning that because the definition of management optimism variable was dummy (zero and one), it was excluded from descriptive statistics table. table 1. descriptive statistics im, pesaran & shin sig. s.d. min max median mean variables 0.000 0.091-0.133 0.383 0.071 0.087 roa 0.000 0.11 -0.133 0.477 0.095 0.11 bep 0.000 2.0831.098 7.311 5.529 4.816 distance1 0.000 1.7640.693 6.865 2.302 3.113 distance2 0.000 0.0240.144 0.207 0.15 0.164 hhi 0.000 1.26210.10316.12213.209 13.093size 0.000 0.1810.035 0.824 0.244 0.296 ci given table 1, the mean and median values of the variables are close to each other, and also, outlier data that have a negative effect on the analysis quality have been removed. also, the significance level of im, pesaran, and shin for all the variables was less than 0.05. therefore, all the variables are reliable within the period under study. using the firs criterion of distance (distance from tehran) as well as the ratio of net profit to total assets, the results of testing the hypotheses are presented in table 2. the results of table 2 show that distance from tehran has no significant effect on the company’s profitability. hence, the impact of industry competition and the company’s relative power in the competitive environment cannot be discussed (rejecting the first and second hypotheses). however, the variable of company’s size has a direct significant impact on the dependent variable, and the variable of investment in fixed assets has a significant inverse effect on the dependent variable. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 38 table 2. hypotheses testing (by using distance 1 and roa) variable coef. sig. coef. sig. β0 0.274 0.014 -0.356 0.03 distance1 -0.037 0.064 0.037 0.08 hhi -1.018 0.072 -1.36 0.006 distance1*hhi 0.23 0.056 0.768 0.087 size 0.057 0.000 0.05 0.000 distance1*size _ _ -0.007 0.23 distance1*hhi*size _ _ -0.032 0.317 ci -0.113 0.000 -0.075 0.000 f statistics = 11.866 f statistics = 16.778 f sig. = 0.000 f sig. = 0.000 r-square = 0.346 r-square = 0.48 adjusted r-square = 0.308 adjusted r-square = 0.434 durbin-watson = 1.89 durbin-watson = 2.008 chaw test sig. = 0.000 chaw test sig. = 0.000 hauseman test sig. = 0.001 hauseman test sig. = 0.009 fixed assets model and egsl method using the firs criterion of distance (distance from tehran) and the ratio of earnings before tax to total assets for profitability (basic earnings power), the results of testing the hypotheses are presented in table 3. according to the presented results in table 3, distance from tehran has a significant inverse impact on earnings before tax, industry concentration (and increasing herfindahl-hirschman index) has an inverse significant impact on earnings before tax (the direct impact of industry competition on earnings before tax) and also mitigates the inverse impact of distance from tehran on earnings before tax. in other words, product market competition enhances the negative effect of distance from tehran on the basic earnings (earnings before tax) (the impact of the first hypothesis). however, given the direct impact of distance from tehran* herfindahl-hirschman index*company’s size on the dependent variable, it can be claimed that the company’s relative power in a competitive environment, mitigates the negative effect of distance from tehran on the basic earnings (earnings before tax) (the effect of the second hypothesis). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 39 table 3. hypotheses testing (by using distance 1 and bep) variable coef. sig. coef. sig. β0 0.415 0.003 0.567 0.012 distance1 -0.056 0.025 -0.07 0.000 hhi -1.603 0.033 -1.727 0.01 distance1*hhi 0.34 0.021 0.944 0.019 size 0.018 0.000 0.071 0.000 distance1*size _ _ -0.01 0.155 distance1*hhi*size _ _ 0.098 0.009 ci -0.134 0.000 -0.079 0.001 f statistics = 13.938 f statistics = 16.669 f sig. = 0.000 f sig. = 0.000 r-square = 0.348 r-square = 0.395 adjusted r-square = 0.31 adjusted r-square = 0.351 durbin-watson = 1.822 durbin-watson = 1.937 chaw test sig. = 0.000 chaw test sig. = 0.000 hauseman test sig. = 0.000 hauseman test sig. = 0.000 fixed assets model and egsl method using the second criterion of distance (distance from tehran) as well as the ratio of net profit to total assets (return on assets) for profitability, the results of testing the hypotheses are presented in table 4. the results of table 4 indicate that distance from big cities does not have a significant impact on company’s profitability; thus, the impact of industry competition and the company’s relative power in a competitive environment cannot be discussed (rejecting the first and second hypotheses). however, the variable of company’s size has a direct and significant impact on the dependent variable, and the variable of investment in fixed assets has a significant effect on the dependent variable. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 40 table 4. hypotheses testing (by using distance 2 and roa) variable coef. sig. coef. sig. β0 0.234 0.000 0.231 0.004 distance2 -0.068 0.066 -0.069 0.07 hhi -0.639 0.175 -0.629 0.168 distance2*hhi 0.176 0.07 0.221 0.243 size 0.018 0.007 0.016 0.005 distance2*size _ _ -0.019 0.211 distance2*hhi*size _ _ -0.022 0.18 ci -0.102 0.000 -0.097 0.000 f statistics = 15.869 f statistics = 16.669 f sig. = 0.000 f sig. = 0.000 r-square = 0.383 r-square = 0.395 adjusted r-square = 0.347 adjusted r-square = 0.351 durbin-watson =1.928 durbin-watson = 1.937 chaw test sig. = 0.000 chaw test sig. = 0.000 hauseman test sig. = 0.000 hauseman test sig. = 0.000 fixed assets model and egsl method using the second criterion of distance (distance from tehran) and the ratio of earnings before tax to total assets for profitability (basic earnings power), the results of testing the hypotheses are presented in table 5. according to the results in table 5, distance from big cities has an inverse significant effect on earnings before taxes and increased industry concentration (herfindahl-hirschman index), while having a significant impact on earnings before tax (direct impact of earnings before tax on industry competition), mitigates the inverse impact of distance from big cities on earnings before tax. in other words, product market competition, enhances the negative impact of distance from big cities on basic earnings power (earnings before tax) (the impact of the first hypothesis). however, given the direct impact of distance from big cities* herfindahl-hirschman index*company’s size on the dependent variable, it can be claimed that the company’s relative power in a competitive environment, mitigates the negative effect of distance from big cities on the basic earnings power (earnings before tax) (the effect of the second hypothesis). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 41 table 5. hypotheses testing (by using distance 2 and bep) variable coef. sig. coef. sig. β0 0.346 0.001 0.336 0.000 distance2 -0.069 0.021 -0.093 0.008 hhi -1.049 0.004 -1.205 0.027 distance2*hhi 0.283 0.017 0.274 0.007 size 0.022 0.000 0.024 0.000 distance2*size _ _ -0.019 0.208 distance2*hhi*size _ _ -0.145 0.002 ci -0.123 0.000 -0.111 0.000 f statistics = 15.824 f statistics = 18.143 f sig. = 0.000 f sig. = 0.000 r-square = 0.504 r-square = 0.507 adjusted r-square = 0.469 adjusted r-square = 0.457 durbin-watson = 1.876 durbin-watson = 1.875 chaw test sig. = 0.000 chaw test sig. = 0.000 hauseman test sig. = 0.000 hauseman test sig. = 0.000 fixed assets model and egsl method 7. conclusion business, trade, and economic activity are objective and functional manifestations of business enterprises’ activities and measures that reveal financial concepts and financial assumptions and theories. objectives related to these indicators and components will be revealed in the form of earnings, wealth, value, and efficiency. earnings are the interest from the differences of sales (revenues) and expenses which makes sense with a short-term look. the concept of earnings is basically an accounting concept and much of the efforts of accountants is focused on its measurement. earnings are among the greatest indicators of measuring a business unit activities and potential economic decision-makers activities. from a practical perspective, accounting earnings is defined as the difference between realized revenues from the period’s transactions and the relevant expired cost of goods sold (rahnama roodposhti and salehi, 2010). for the first time, this study linked this pure accounting concept to a geographical-economic concept called distance from population centers. to explain how the relationship exists, the existing literature in regional economic texts was significantly used. having noted weber’s model (1909), hotteling’s model (1929), and losch’s model (1954), and presenting two hypotheses, some models were explained, which included some direct and some moderating impacts. the results of testing the hypotheses showed that distance from tehran and big cities has an inverse significant on earnings before tax (basic earnings power) and increased industry concentration (herfindahl-hirschman index) has an inverse significant impact on earnings before tax (the direct impact of industry competition on earnings before tax), and also mitigates the inverse impact of distance from tehran and big cities on earnings before tax. in other words, product market competition enhances the negative impact of company’s distance from tehran and big cities on basic earnings power (earnings before tax) asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 42 (the effect of the first hypothesis). meanwhile, company’s relative power in a competitive environment mitigates the negative effect of company’s distance from tehran and big cities on basic earnings power (earnings before tax) (the effect of the second hypothesis). thus, regardless of tax benefits of the location of establishing the plant, less distance from tehran and big cities could help to improve the company’s profitability in food industry, and reducing industry competition and increasing company’s relative power in the industry mitigates the effects of distance from population centers on profitability. however, a significant difference in terms of net profit (earnings after tax) was not observed. therefore, it is clear that rules relating to tax exemptions have played a significant role in this regard. for example, according to the note number 3 of article 138 of tax exemption law, factories which are located within the watershed of tehran and do not have less than fifty staffs, in case of moving their facilities outside the radius of one hundred twenty kilometers from the center of tehran, and based on the regulations established by the ministry of economic and financial affairs and the relevant ministry in each case, will be exempted from paying taxes on income resulting from related industrial activities, up to ten years from the date of operating in the new location. also, plants located in one hundred twenty radius of tehran and control zones of big cities (mashhad, tabriz, arak, isfehan, shiraz, and ahvaz) and have entirely transferred their facilities to approved industrial towns, will receive half of tax exemption time of this note starting from the operating date in the new location. given the companies, factories, and population fragmentation policies from tehran and big cities (regarding subsequent pollution), it is suggested that optimal solutions be provided to resolve the reducing effect of distance from tehran and big cities on profitability. also, although increasing companies and factories in tehran and big cities is not desirable in terms of political and macro-economic policies, but according to the results of the study, being located in tehran or big cities can be recommended as one of the ways of increasing profitability for companies operating in food industries listed in tehran stock exchange. investors in listed firms in tehran stock exchange are also recommended to take into account, when investigating in food industry that being located in big cities can increase earnings before tax and at the same time, will not significantly affect net profit figure. unless the company's management has considered appropriate approaches for tax management, and in other words, has minimized the effects of income tax on earnings before tax, which will bring net profit and earnings before tax closer to each other (which can, for example, be considered as a way of identifying these companies). also, taking into account the company’s relative power in the industry and also the competition that exists in food industry, can have a great contribution to more efficient evaluation of the relationship of distance from population centers and the company’s profitability. in addition, it is recommended to the interested researchers to conduct more comprehensive and more accurate studies and retest results of this study, and also identify and argue the effect of location on other accounting variables. references acquaah, m, & chi, t. 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(1987). innovation, market structure, and firm size. the review of economics and statistics, 69(4), 567-574. microsoft word 11636-42809-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 270 the price discovery mechanism between sovereign bond and sovereign cds market: studies in selected countries ngan bich nguyen banking faculty, banking academy, vietnam tel: 84-91-381-6047 e-mail: ngannb@hvnh.edu.vn received: august 3, 2017 accepted: sep. 8, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.11636 url: https://doi.org/10.5296/ajfa.v9i2.11636 abstract this paper employs the multivariate var model to examine the mechanic work of price discovery process between sovereign cds market and the associated sovereign bond market in contexts of five european and asian countries, including vietnam, korea, portugal, italy and france from the beginning of 2008 to the end of april, 2017. the study accentuates on three aspects: the short-term interaction nexus between the sovereign cds and the associated-sovereign bond market, the long-term co-movement between them and the discovery of which market plays the leading role in the pricing process. the results evidence the short-run and long-run relationship for the two markets. particularly, the empirical test results support for the predominant role of the sovereign cds market in the price discovery process in the bulk of sample entities. this might suggests for the governments to use cds prices as the future indicator for predicting the volatility of debt markets. keywords: asset price, asset pricing, bond interest rates, equities, equity premium jel classification: g120 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 271 1. introduction in this paper, the relationship between the sovereign credit default swap (cds) premia and bond spreads is examined in the contexts of five european and asian countries. the finding is that the prices of the two instruments interact each other in both short-run long-run but in the different ways, owing to the difference in credit risk and liquidity risk. in detailed, the tests with empirical data indicate that the leading role in the pricing process is a tribute of either sovereign cds market or sovereign bond market depends on countries. comparing the testing results of different sovereigns, the cds market tends to move ahead the other in case of more-bonds issuers, in other words, riskier countries. to begin with, the mechanics for the pricing interaction between sovereign cds market and bond market should be ascertained. hull, j. (2004) defines cds as a contract ensuring a buyer from the risk of default. the buyer of the cds contract has the right to sell and the seller of the cds is obliged to buy the underlying bonds for their face values when a credit event occurs. the most empirical advantage of cds instrument is a method to convert the risky underlying bonds to risk-free bonds at the benefit of the buyer, or in other words, cds contracts can be considered as a hedging tool against positions in bonds. in a typical cds contract, the seller receives the periodical premium, often said is annual payment, in return for bearing the default risk from the issuer (the sovereign). the premium is set based on the notional amount of the issue for a long-term period. in cases of credit events, the settlement of a cds transaction can be done in either two following methods: • the comparatively less popular method is “physical settlement” (aima research, 2011). by doing this, the cds buyer delivers the sovereign bonds to the cds seller. the seller then pays out the notional amount of the bonds delivered to the buyer. consequently, the seller of the credit-default protection owns those bonds, whose values have been slumped due to sovereign default, whilst refunds the full of face values to the buyer of the protection. • the second method is “cash settlement” (ibid). in this method, no underlying bonds are exchanged among parties. the cds seller transfers the cds buyer the amount of cash equivalent to the face value minus the residual values of the bonds. from the above snap shot on how the sovereign cds market works, it is suggested that a sovereign bond’s credit risk and liquidity risk influent its yield and then a change in the associated bond spread is a key factor in determining the premium in the cds contract. however, the objective of the paper is to investigate more deeply whether the two prices move together in practice as theories state and if they do, which one leads the other. on that basis, the cause for the current high sovereign borrowing cost can be detected. for these purposes, the two key questions below should be made clear: • do the two market co-move in the short-run and long-run? • which market is dominant in the price discovery dynamics? asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 272 2. literature review 2.1. studies on the role of sovereign cds and bond market in the price discovery process 2.1.1. existing results on the role of each market in the price discovery process the paper appears to be likely similar to the research taken by calice, g., chen, j. and williams, j. (2007). they detect that whether cds or debt market plays the determined role in the mechanics depends on the contexts of different countries. however the ebullient tendency appeared in the current financial crisis is that the cds market went prior in most cases. similarly, longstaff, f. et al (2005) and zhu, h. (2006) dedicate the forward movement of cds market over bond market in the price discovery by focusing on effects of liquidity risk. based on this approach, this paper considers a bunch of factors of liquidity risk and credit risk influent relationship between the two markets. however, we are not going to approach the aims of the paper by analysing in deep the effects of liquidity risk and credit risk to the short-term and long-term cointegration between sovereign cds and bond market. therefore these risks are not used as parameters in the regression equations. a proportion of the foundation of this paper is the research of calice, g. (2012). calice casts his analysis on the cointegration of the two markets in both short-run and long-run. moreover, he also concludes that the contribution of cds market in the price discovery process is non-uniform across different countries. according to him, cds market leads in high-yield countries whilst bond market dominates in comparatively low-yield countries. calice’s detection is approximately the same as the study of fontana, a. and scheicher, m. (2011), who supply the evidence on the superior price discovery of cds market in abnormal sovereign borrowers (high-yield countries). however, fontana and scheicher claim the cds market to exacerbate the ongoing financial crisis and swipe its contribution, with that calice’s study gives no conclusion. ammer, j. and cai, f. (2011) develop the findings of those above by criticizing that the more liquid market tends to lead regardless which country is studied. they still reach to the similar conclusion that cds market often plays leading role over bond market. to address these findings, ammer and cai use the vecm estimation with variables are the dynamic changes in 5-year cds premia and bond spreads over time, which uses the cross-section data of seven sovereign entities. other papers also find the evidence of the cds leading in the price discovery, such as blanco, r. et al (2005), hull, j. et al (2004). notably, the research’s results should be in the trend of dominant role for the cds market over its counter part as stated in researches of baba, n. and inada, m. (2009); bowe, m., klimavicienne, a. and taylor, a. (2009). nonetheless, the crisis period may moderate or drive this primary movement, during which the pricing relationship has not been investigated in the above papers. therefore this paper is going to take this financial turmoil period as the major concern in order to answer if the sovereign cds market’s supremacy is fuelled by the crisis or that is owing to the development of cds segment recent years. furthermore, the results for price discovery process for sovereigns have not been clear in previous studies. it can be seen in the research of baba and inada that they give the evidences for merely japanese banks or bowe, m. et al go to their conlusions by looking at corporate cdss in asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 273 eight emerging countries. thereby this paper will hopefully improve the recent findings on pricing process of sovereign credit instruments. the research tends to contrast the findings of jacoby, g. et al (2009) who state that there is no common component in the pricing process between the two markets and there is only the evidence about the link between equity market and cds market. in the same idea with jacoby, g. et al, levy, a. (2009) argues in his study that there is no persistent pattern of one market leads the other. analogously, coudert, v. and gex, m. (2010) explicates that sovereign cds market is relatively small in comparison to debt market, thereby cds spread can not drive the borrowing costs, specially in relative low yield contries like developed ones. in the aima research note (2011), granger causality tests on cds market and bond market give the result that the former is relatively cheaper than the later, which suggests that cds market is hardly considered as the cause of high bond yields in sluggish countries. additionally, their tests show the two markets are equally to lead or to lag the other. the paper, in one hand, is in the same idea with this work in term of the unreplacable role of sovereign cds markets though on the other hand casts the doubt on if cds market forces the bond market’ spreads to bound or not. regarding the role of each market during the recent crisis, anderson, r. (2010) advocates the cds market has been transferring the credit risk to bond market. augustin, p. and tedongap, r. (2011) neutrally state that either catastrophic cds market or bond market could engage the negative effect on the financial stability. stulz, r. (2010); andenmatten, s. and brill, f. (2010) opposingly conclude the smaller role of cds market in the financial sovereign crisis compared to bond market due to its relatively small market size. the paper, in the other way round, is to demonstrate the assertions of those above to be appropriate depend on case of low-yield or high-yield sovereigns. 2.1.2. existing methodology used to investigate the role of each market the paper has a great deal in common with the paper of calice, g. et al (2007) in term of ultilising the vector autoregression (var) model to acquire the relationship between the lag-values of cds premia and bond spreads for selected countries. in their paper, the sample of nine european countries is considered and the 5 and 10-year instruments are used as benchmarks.to capture the dynamic price spill-over effect between sovereign cds market and bond market, the sovereign bond credit spread and liquidity spreads, sovereign cds credit and liquidity spreads are included in the var equations as follows: • bondcreditspread(t) = μ1(t) + β11(t) bondcreditspread(t-1) + β12(t) cdscreditspread(t-1) + β13(t) bondliquidityspread(t-1) + β14(t) cdsliquidityspread(t-1) + u1(t) • cdscreditspread(t) = μ2(t) + β21(t) bondcreditspread(t-1) + β22(t) cdscreditspread(t-1) + β23(t) bondliquidityspread(t-1) + β24(t) cdsliquidityspread(t-1) + u2(t) • bondliquidtyspread(t) = μ3(t) + β31(t) bondcreditspread(t-1) + β32(t) cdscreditspread(t-1) + β33(t) bondliquidityspread(t-1) + β34(t) cdsliquidityspread(t-1) + u3(t) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 274 • cdsliquidityspread(t) = μ4(t) + β41(t) bondcreditspread(t-1) + β42(t) cdscreditspread(t-1) + β43(t) bondliquidityspread(t-1) + β44(t) cdsliquidityspread(t-1) + u4(t) where: μ (t): intercept u(t): error term β(t): coefficient even applying the similar var models, a somewhat distinctiveness about regression equations used in this paper and those above is that we are not going to explain any typical risk factor creates the leading role for one market over the other. infact, the paper accentuates on the prices themselves rather than their pricing structures. thus, based on the foundation above, “bondcreditspread” and “bondliquidityspread” variables, “cdscreditspread” and “cdsliquidityspread” variables are merged into “price” variable, which is “cds premium” or cdsprem for cds market and “bond spread” or byspread in case of bond market. this study is in the contrastive line with results found by jacoby, g. et al (2009) in term of price discovery process. besides, the methodologies employed in their study and this paper are aslo different. jacoby and his colleagues use monthly cross-section data in var model to examine liquidity shocks across the two markets: liqcds(t)=αcds + ∑ , liqcds(t-i)+∑ , liqbond(t-i)+ , liqbond(t)=αbond + ∑ , liqcds(t-i)+∑ , liqbond(t-i)+ , where: liqcds, liqbond: cds market and bond market liquidity shocks α: intercept β: coefficent p: lag-length ε: error term the magnitude of the coefficients is generally small indicates that there is no immediate spill-over of liquidity shocks from the bond market to cds market and vice versa. in the other words, the prices in one market can not affect the prices in the other. however, the paper is contrastly handling with daily time-series data rather than monthly cross-section data and as stated above, the regression equations are not investigating any individual risk affecting the prices but considering the entire prices themselves. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 275 2.2. studies on the short-term and long-term relationship between sovereign cds and bond market the long-term cointegration between the two assets’ prices in most cases of european entities and some selected asian entities are documented in researches of palladini, g. and portes, r. (2011), de wit, j. (2006), norden, l. and weber, m. (2004), zhu, h. (2006), for which the paper likewise hope to get. this is likely to be acute that the possible cointegrated relationship across many other markets is neglected in those studies and the general trends may be introduced bias in their results. as the more extensions on the market size, the stronger the findings are, thus this paper would extend the existing researches firstly in term of market size and then criticise for the short-run pricing rather than only the long-run dynamic linkage. the research aims at proving the cointegration of the two markets in both short-run and long-run in normal economic conditions as in line with theories. yet if this cointegrated relationship was weakened during financial turmoils such as in period from 2008 to 2016 or not, the answer should aslo be made clear in this paper. the foundation for the research on this price deviation comes from the study of alexopoulou, l. et al (2009), who provide evidences on the decoupling movements of the bond market and cds market due to the financial turbulence in 2007. first, they scruitinize at credit risk structure of the two assets, which includes: firm-specific factor, external economic factors and liquidity-related factors, by applying the merton’s structural debt valuation model as below. δcdsi,t=α1 + β11fivi,t + β12fsri,t + β13bondt + β14ivt + β15srt + β16trt + β17eci,t-1 + ε1t δcsi,t =α2 + β21fivi,t + β22fsri,t + β23bondt + β24ivt + β25srt + β26trt + β27eci,t-1 + εt where: α: intercept β: coefficent ε: error term cdsi,t: cds premium for firm i’s bond at time t csi,t: firm i’s bond spread at time t fiv: firm-specific implied volatility fsr: firm-specific weekly stock returns bondt: yield offered on the 10-year benchmark bonds at time t iv: implied volatility sr: weekly stock return otr: difference between on-the-run and off-the-run yields on us government bonds ec: lagged error from the regression equation: cdsi,t=α+βcsi,t+εi,t asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 276 the test is run on 5-year cdss and the underlying bonds of 29 large european financial and non-financial firms from 2004 to 2008. after running the test, they get the values of and . in the next step, the gonzalo and granger ratio is calculated from the equation below: gg= if gg>=1, it can be concluded that cds market tends to lead bond market. their study for the second-half of 2007 shows the reverse results compared to the whole period of 2004-2007. specifically, the gg ratio dropped from 1 to 0.83 for financial firms and from 1 to 0.66 for non-financial firms. this results assert the strengthening leading role of cds market in the price discovery process in time of financial distress compared to normal economic postures, or in the other words, the two prices are more deviated from each other. 2.3. existing literature on methodologies used for the price discovery the adoption of non-linear models in this paper to estimate the link between sovereign cds market and bond market is inspired by results of delatte, a., gex, m. and villavicencio, a. (2010). these scholars in their study run tests on daily panel data cross 11 european countries over 2008-2010. first, delatte, a. et al use the linearity model to test the null hypothesis of there is a linear nexus between the two markets as follow: cdsit= ci+αibondit+εit where i: country t: time dimension ci: constant term, which represents the factors defferentiate the bond spreads and cds premia like transactional costs. αi: country-specific intercept εit: vector of errors cdsit and bondit:cds premia and bond spread with the same maturity the results reject the null hypothesis, thus the authors continue the transition models:vecm, fully modified-ols and pooled mean group estimation and find the leading role of cds market. the paramount benefit of non-linear tests is allowing each market’s adjustment speed to transform according to different variables. another substantial advantage of those tests is allowing the paper to contribute to recent price discovery results with relaxing the restictive assumptions of linear approach. thispaper has a great deal in common with the paper of calice, g. et al (2011) in term of ultilising the non-linear method, which is the vector autoregression (var) model, to acquire the relationship between the lag-values of cds premia and bond spreads for selected asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 277 european countries. in the other research, calice, g. (2012) addresses the relationship between sovereign cds and bond market by using modern time-series techniques: johansen’s cointegration tests, granger test and vecm, which are going to be duplicated in this reseach . these tests are going to be adopted as they can be considerred as proxies for price discovery. the chronology of the methodologies for testing the price discovery process as suggested is followed (ibid). the granger causality tests will be ultilised as the starting point to provide the short-run linkage between the two assets’ prices. next to is the johansen cointegration tests in purpose to give the pattern of one market precedes the other in the long-run. inspite of that, both the johansen and granger tests only give evidence on the short-run and long-run comovement but not the tandem relationship. for this reason, given that the sovereign cds premia and bond spreads are cointegrated in the former tests, the vecm framework is used further to measure the speed of narrowing the price discrepancies from the two market short-run tendency. for all the tests, the study will be differentiated to existing literature using this scaling for price discovery in term of lag-length selection. for example, the granger tests in andenmatten, s. and brill, f. (2010) rely on 4-day lags for portugal, 3-day lags for italy and 2-day lags for the rest of sovereign markets. 3. data description 3.1. data collection to approach the purposes of this paper, the comparison of prices on sovereign cds markets and bond markets will be implemented, then it is important that the cds premia and bond spreads are comparable. moreover, there are two impediments should be overcome: to have sufficient data on liquid cdss and to obtain the whole range of the underlying bonds’ spreads. reasonably, the paper is limited to five selected countries, they are: portugal, italy, france, korea and vietnam. for the sovereigns, the cds market was rather small and lack of liquidity before 2008 and the concerns about the sovereign debt turbulence precisely raised after the collapse of lehmon brothers in 2008. another limitation is the awkwardness to access the entire historical transaction data on sovereign cds market. by comparing the data collection of different organizations, period from 2008 owns the most sufficient daily numbers. therefore, the author starts the study from january 1st, 2008 to april 31th , 2017, which means the 3040 daily data is seized. the paper is also limitted to the 10-year sovereign bond and cds as at which maturity the sovereign cds are most-traded. moreover, due to the heterogeneity in the cds and debt markets across sovereigns in the paper’s sample, there is no assumption about the homogeneity of pricing dynamics. on that basis, the examining of the price discovery processes are conducted for each country separately during the same time period. due to the tests consist of the examining the long-term cointegration between the two markets, daily data appears to be the firmest compared to monthly or weekly frequencies. on that basis, the daily data of the two markets is collected. the data for cds market is collected from datastream and adb website(asianbondsonline.adb.org). for bond market, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 278 daily yields are collected from the wall-street journal (http://europe.wsj.com) in combination with datastream source, vietnam investment review (vir.com.vn) and adb website (asianbondsonline.adb.org). 3.2. unit root tests and stationary data in this section, the author is examining the auto-correlation of individual cds premium and bond spread data by dickey-fuller test because this is the prerequisite for applying further regression models. all the data must be first-order cointegrated or stationary, means i(1), as in the way paradigms forecast to enable the robustness of the granger causality, johansen cointegration and vecm tests. otherwise, if data is low-order cointegrated, means i(0), it should be removed. the dickey-fuller test has the null hypothesis of the non-stationarity of series data. the testing results are summarized in tables below. table 1. unit root tests results for sovereign bond markets augmented dickey-fuller t-statistic test critical value 1% level test critical value 5% level test critical value 10% level france -14.4029 -3.43591 -2.86388 -2.56807 italy -18.1510 -3.43592 -2.86389 -2.56807 portugal -17.2506 -3.43595 -2.8639 -2.56808 vietnam -15.9898 -3.43592 -2.86389 -2.56807 korea -18.6781 -3.43592 -2.86389 -2.56807 table 2. unit root tests results for sovereign cds markets augmented dickey-fuller t-statistic test critical value 1% level test critical value 5% level test critical value 10% level france -14.7458 -3.43592 -2.86389 -2.56807 italy -16.5687 -3.43592 -2.86389 -2.56807 portugal -14.7118 -2.56701 -1.9411 -1.61651 vietnam -16.7428 -2.56701 -1.9411 -1.61651 korea -18.9511 -2.56702 -1.9411 -1.61651 the tables above summarize the unit root tests without a trend for the sovereign cds premia and bond spreads in each market. it can be seen from the results that all the augmented dickey-fuller t-statistic values are smaller than test critical values of 1%, 5% and 10% level. the corresponding conclusion is that the null hypothesis is rejected and this signifies there is the stationarity in the prices for each sovereign. these results also suggest asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 279 the two markets to price market risks equally in the long-run. additionally, the results pledge for market forces to abolish any arbitrage opportunities exist between the two markets for the long-term. 4. findings 4.1. linkage in the short-run the table below reports the granger causality test results for period from 2008 to april 31th 2017. table 3. granger causality test results for 2008-2017 country h0: byspread does not cause cdsprem h0: cdsprem does not cause byspread f-statistic probability f-statistic probability france 4.16225 0.01581 8.80671 0.00016 italy 0.92644 0.42728 20.6825 4.80e-13 portugal 3.53291 0.00712 26.2571 7.80e-21 vietnam 1.68741 0.18546 31.7823 3.70e-14 korea 0.48963 0.61298 3.19471 0.04135 at the significance level of 5%, if the probability is greater than 5%, the null hypothesis can not be rejected, otherwise, the other hypothesis should be accepted. overall, there is a clear evidence in four out of ten countries that there is stronger granger causality from cdsprem to byspread and both the two markets play roles in the price discovery process. the explaination for each sovereign is following: • in the cases of france and portugal: the probablilities are always smaller than 5%, then the null hypotheses are rejected, which means the byspread granger causes the cdsprem and vice versa or there is a bidirectional granger causality existing. • in the cases of italy, vietnam and korea: the probability for the test (ia) is greater than 5%, thereby the null hypothesis can not be debated. in other words, the byspread does not granger cause the cdsprem. nevertheless, for the test (ib), the probability is smaller than 5%, thus the cdsprem does granger cause the byspread. on that basis, only the cds market contributes to the dynamic price discovery process in the short-run. 4.2. linkage in the long-run in this section, the long-run equilibrium relationship between the cds market and bond market for sovereigns will be discussed after the shortrun cointegration between them is detected above. the results of johansen cointegration tests are summarised in the table below: asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 280 table 4. trace test and max-eigenvalues test results countr y number of cointegrat ed vectors trace statistic 5% critical value max-eigenvalu es statistic 5% critical value france none 10.0604 1 15.4947 1 acce pt 16.56307 14.2646 0 rejec t at most 1 3.49740 2 3.84146 6 acce pt 3.497402 3.84146 6 acce pt italy none 18.0394 1 15.4947 1 rejec t 17.51655 14.2646 0 rejec t at most 1 0.52286 8 3.84146 6 acce pt 0.522868 3.84146 6 acce pt portug al none 29.6278 8 15.4947 1 rejec t 29.56393 14.2646 0 rejec t at most 1 0.06395 6 3.84146 6 acce pt 0.063956 3.84146 6 acce pt vietna m none 14.4925 8 15.4947 1 acce pt 14.37778 14.2646 0 rejec t at most 1 0.11479 8 3.84146 6 acce pt 0.114798 3.84146 6 acce pt korea none 18.6236 5 15.4947 1 rejec t 13.96209 14.2646 0 acce pt at most 1 4.66155 2 3.84146 6 rejec t 4.661552 3.84146 6 rejec t generally, the long-term cointegration exists in cases of all five countries. to pass the trace and max-eigenvalues test to demonstrate the long-term equilibrium relationship between the two markets, either the trace statistic or max-eigenvalues statistic should be smaller than its 5% critical value. the results interpretation and cointegration equation for each country is followed. • france in trace test, for both catalog “none” and “at most 1”, the trace statistic numbers are less than the critical values of 5% level or the null hypotheses can not be rejected. thus this test does not prove the cointegration nexus between the two markets for long-term. in contrast, the results from max-eigenvalues test disclose one cointegration vector existing between asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 281 cdsprem and byspread variables. this also unveils the long-term interrelation between the two markets adjusted to the cointegrating equation following: cdsprem = 0.179793-0.255055 byspread (0.37668) • italy it can be seen from both the trace test and max-eigenvalues test results that in the “none” catalog, the statistical values are larger than the corresponding critical values at 5% level. thereby, these tests fail to accept the null hypotheses. moreover, for the “at most 1” catalog, the both tests dedicate together the smaller critical values than the 5% critical values, which represents the existence of a cointegration equation between cdsprem and byspread. it is the following equation: cdsprem = -0.208774 – 1.19633 byspread (0.11727) • portugal the results from both trace test and max-eigenvalues test support for the other hypotheses rather than the null hypotheses at 5% level of significance. furthermore, the results show the negative cointegrated relationship between sovereign cds premia and bond spreads, which is: cdsprem = -0.139821 – 1.255424 byspread (0.04165) • vietnam the trace test can not reject the null hypothesis owing to smaller value of the trace critical value compared to the 5% critical value. yet the max-eigenvalues test casts the support for the long-run co-movement between the two sovereign markets by rejecting the null hypothesis at the “none” catalog and accepting the null hypothesis at the “at most 1” catalog. the cointegration relationship is expressed in the equation below: cdsprem = -0.093835 – 1.261284 byspread (0.12936) • korea the tests for the korean markets give results of two cointegrating vectors for trace test, whereas no cointegration vector for max-eigenvalues test. overall, the combination of the two tests evidences on the positive co-movement of the two markets in the long-term as in the equation below: cdsprem = 0.445897 + 0.656949 byspread (0.19689) asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 282 4.3. price discovery after evaluating the long-run relation between thefive sample sovereign cds and bond markets, it is now turned to analyzing which market plays the leading role in the price discovery process for the cases of countries where the cointegrating relationship exists. this also means the examining is procedured for all five countries. the lead-lag relationship is estimated by vector-error correction model (vecm) and granger and gonzalo ratio (gg ratio) would be employed to measure the relative contribution of cds premium and bond spread to the price discovery process. in addition to that, contributions of cds market and bond market denoting by α1, α2 in that order are going to be showed as well as their standard errors expressed in brackets. table 3 reports the vecm results applied for 10-year sovereign cds premia and bond spreads of five countries for the period from 1st january 2008 to 31th april 2017. the ratio (gg ratio) gives conclusion about which market moves ahead. if gg ratio is larger than 0.5, then the cds market leads the bond market and reversely. table 5. vector error correction model estimations country contribution of byspread contribution of cdsprem gg ratio (std. error) p-value (std. error) p-value france 0.012110 (0.005426) 0.0258 -0.00481 (0.00299) 0.1077 0.71572 italy 0.042893 (0.011026) 0.0001 -0.00049 (0.00578) 0.9331 0.98871 portugal 0.062809 (0.018567) 0.0007 0.03074 (0.01000) 0.0022 1.95856 vietnam 0.061539 (0.014297) 0.0000 0.00711 (0.00618) 0.2500 1.13063 korea 0.028087 (0.008160) 0.0006 -0.0176 (0.00749) 0.0189 0.61477 the null hypothesis for the vecm test is that a coefficient (alpha) is not significant, or in other words, there is no long-run causality running from the independent variables to the dependent variable in the corresponding cointegrated equation. in case a p-value is larger than 5%, then the null hypothesis is accepted and vice versa. the results of which market plays the leading role by the rejection or acceptance to the null hypothesis should be in line with results from comparing gg ratios with 0.5. table 3 gives evidences on the significant positive values of ( − ) in all nine sovereign markets, then the gg ratios approach are credible. the fact that the two markets represent different roles in the price discovery process depends on the cases of different countries as explained in details as follow: • france it is inevitable that the sovereign cds market drives over the bond market in the long-run cointegration pricing process as the gg ratio is 0.71572, which is larger than 0.5. moreover, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 283 the coefficient of the cds market, , is unsignificant at 5% significance level, which means the null hypothesis is accepted or there is no long-term causality running from bond spreads to cds premia. • italy the similar conclusion as the case of france is hold for italy. the gg measurements are 0.98871 and 1.16609 respectively, which are far over 0.5. additionally, the p-values for the coefficients of cds market both give clue that the null hypotheses can not be rejected. therefore, in circumstances of italy, the sovereign cds markets play the more active role than its counterpart in the price discovery process. • portugal it can be seen that the two alphas are far less than 5%, thereby this dedicates the two coefficients , are statistically significant. this is also equivalent to state that the both markets contribute to the price discovery. however, the gg ratio is 1.95856 larger than 0.5. hence, the sovereign cds market is still considerably more dominant than the sovereign bond market. • vietnam the p-value for in the case of vietnamese markets does favour the null hypothesis that the bond spreads, which are independent variables, do not cause the cds premia, which are dependent variables. this is also consistent with the gg ratio smaller than 0.5, that shows the cds market tends to be more leading in the price discovery. • korea the roles of sovereign cds and sovereign bond market in korea have a great deal in common with those in portugal. the p-values for the two alphas are both less than 0.5 then the null hypotheses fail to negative the long-run causality from each market to the other. the empirical test results unveil that there is causality from the cds premia to the bond spreads and vice versa, then the sovereign cds market practically plays the same part as the sovereign bond market does. eventhough, the larger value of gg ratio compared to 0.5 gives the claim that the sovereign cds market is slightly dominant over the other in the long-term pricing discovery. in summary, there is a robust one-way linkage from the sovereign cds market to the sovereign bond market in four out of five countries. in details, by empirical tests, the faster price adjustment speed tributes to the sovereign cds market for all five countries. thereby in five sample sovereigns, the trend of leading movement of the cds market over the bond market is predominated. among group of entities where the cds markets are more dynamic, a common feature might be realized that these countries have relatively higher averege yield than those in group of sovereign bond markets taking the favour. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 284 5. recomendations the findings above hightlight the short-run interlinkage between the two markets in cases of france and portugal and the one-way affect from the cds prices to the bond prices in cases of italy, korea and vietnam. moreover, the papergives evidences on the long-termco-integration linkage between sovereign cds premia and bond spreads in all of five selected countries.the additional detection is the price leadership role of the sovereign cds market over its associated bond market in cases of four out of five countries and this is reinforced following the financial turbulence. this evidence also suggests that the country-specific factors influence considerably the sovereign credit risks. based on the domination of the sovereign cds market in the price discovery, sovereign cds premia can be used as the signal for market regulation. for instance, a slump or soar in the cds premia should give the advance signal for a decline or growth of the bond yields in the same maturity. this is considerably meaningful in context of developing entities such as vietnam because the average interest rate of the financial market, which can be delegated by bond yield, acting as the major indicator. besides, it is likely to be acute that though a credit derivatives market is newer and smaller but is a better source of information on predicting the prices than larger and longer-established market like bond market. the results of this research can be stated to be robust as they are in the same ideas with the bulk of previous researches about the leading role of sovereign cds market over sovereign bond market such as the studies of coudert, v. and gex, m. (2010); delis, m. and mylondinis, n. (2011). moreover, it could be possible to distinguish the paper’s findings and the conclusion of zhu, h. (2006) and houweling, p. et al (2001). zhu, h. advocates that in the long-run, the cds premium and bond spread change in the same direction but in the short-run, the relationship is not identical. with the similar conclusion, houweling, p. et al further claim that the equilibrium between bond spreads and cds spreads is not established and these spreads always change over time. this study is not in-deep in learning about the deviation of the two markets from the long-term equilibrium, then more researches need being done. this is because the regresstion equations do not take into account the macroeconomic factors like stock market indice, exchange rates or shocks and the market players involving are not considerred. in the concern about the economic policies different among the sovereigns, a specific policy on credit derivative instruments, such as issuance policy or taxation policy, might distort the cointegration between the two markets. however in the scope of this research, the author does not bring them into consideration, thereby it should be commanded more tests if these aspects might affect the price discovery mechanism./. references alexopoulou, l., andersson, m., & georgescu, o. 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(2006). an emperical comparison of credit spreads between the bond market and credit default swap market. journal of finance, 60, 2213-2253. https://doi.org/10.1111/j.1540-6261.2005.00797.x microsoft word 14627-52967-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 169 emerging technologies and the accounting profession: trends and topics for practitioners to consider sean stein smith assistant professor, lehman college city university of new york (cuny) received: april 8, 2019 accepted: may 7, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14627 url: https://doi.org/10.5296/ajfa.v11i1.14627 abstract emerging technology and technology tools such as blockchain, artificial intelligence, robotic process automation, and automation at large continue to drive change and disruption throughout the broader financial services landscape. while numerous articles, webcasts, and books have been put together analyzing these different topics and the implications they might have on different areas of the professional landscape, this article proposes a different approach. instead of focusing on definitions, terminology, or assessing potential impacts at a higher level or through a broad scope of possible applications, this research examines certain specific trends and aspects of these technologies and the impacts they will generate on the profession. definitions and work terminology will, of course, be a part of this research, but that does not form the core of this piece. rather, and written with both a practitioner and academic audience in mind, certain emerging topics such and applications built on top of blockchain technology, as well as implementation issues connected to other emerging issues, are the core of this piece. keywords: blockchain, cryptocurrencies, accounting, strategic, stablecoins asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 170 1. introduction approaching the area of emerging technologies in such a definitive, and somewhat narrow lens may appear to some as artificially narrow or limiting, but that is an incomplete view. simply put, numerous research, studies, and papers examine the potential of emerging technology to have sweeping changes at different phases of the financial services landscape, and in order to add substantially to this existing literature base, this research examines other area. be they next step applications such as stablecoins, the assemblage of proposed best practices, or the compilation of questions and considerations to take into account when implementing said technology tools, this research is meant to be further developed, refined, and utilized over time. in other words, the underlying goal of this research and analysis embedded therein is not to simply outline broader guidance or policy, but to analyze specific iterations of advanced technologies and provide specific proposed solutions to address pain points along the way. that said, prior to reviewing these situations and applications, it appears appropriate to first establish working definitions for the purposes of this paper and further discussion. this research and analysis contained within this article were developed and written with both an academic and practitioner audience in mind. drilling down, and taking into account that the blockchain ecosystem continues to evolve rapidly, the purpose of this research is to provide readers and users with appropriate working definitions and terminology to conduct further analyses and research. 2. working definitions not meant to be all inclusive nor uniquely authoritative in nature, the definitions included below should be used as a framework and starting point for further conversation, analysis, and research in this space. 2.1 blockchain for the purposes of this research blockchain can be thought of as a decentralized and distributed database for the sharing of information between network members. this information is shared and updated on a nearly continuous basis, and is done so utilizing various forms of encryption. to date, these encryption protocols have proved extremely resistant to hacking attempts, and has generated substantial innovation throughout the business landscape (lewis, mcpartland, and ranjan, 2017). 2.2 cryptocurrencies cryptocurrencies represent perhaps the most well known and commonly used application to run on blockchain technologies, but are not equivalent in nature. in other words, in order to cryptocurrencies to function, they must utilize an underlying blockchain platform. cryptocurrencies are, in theory, digital assets that can be used as currency alternatives but are not backed or supported by a centralized institution such as a national government or central bank (sontakke & ghaisas, 2017). 2.3 artificial intelligence artificial intelligence, or ai, represents a computer program or suite of programs that are able to either augment or replace human oversight and engagement within either an aspect of a asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 171 process or an entire business process. 2.4 robotic process automation robotic process, or rpa, can be summarized as the implementation of certain software programs or tools to help with the automation of business processes within an organization. additionally, it is also perceived or viewed as a stepping stone to a full artificial intelligence implementation program. 3. emerging topics of consideration by any objective measure there has been much written and discussed about the implementation and integration of technology throughout the financial services landscape recently. as this integration continues, as it appears it will virtually without interruption, it is logical to conclude that the issues, opportunities, and obstacles that must be addressed will also change and evolve as well (borthick & pennington, 2017). this section of research breaks down and analyzes both what these specific applications and iteration of technology are, as well as examining some key considerations and questions that need to be addressed by practitioners and additional research moving forward. the first, and possibly most relevant to the profession in terms of reporting, taxation, and compliance for the financial purposes is the growing interest and investment in an asset class called stablecoins. developed and refined from digitally native cryptocurrencies, these coins and the asset class they represent pose a unique set of questions for practitioners. 3.1 stablecoins a relatively recent entrant and development in the cryptocurrency landscape, a stablecoin to summarize concisely is a cryptocurrency that seeks to either reduce or eliminate altogether the price volatility and uncertainty associated with traditional or first generation cryptocurrencies such as bitcoin. this may seem like a minor change since many investors treat cryptocurrencies as an investment rather than a currency, but in order to facilitate a more mainstream adoption of cryptocurrency assets for both investing and commercial purposes, price volatility must be reduced. additionally, from strictly an accounting perspective it becomes easier to record, report, and communicate what is occurring with certain types of assets (including stablecoins) if the prices are not fluctuating as wildly as they had in the past (wieczner, 2018). interest and investment in this space is clearly indicated by both the launching of the first u.s. based institutional platform to invest in cryptocurrencies by fidelity in late 2018, and the granting of a banking custodial license to the cryptocurrency exchange coinbase, also in 2018. such developments and announcements only represent the proverbial tip of the iceberg in terms of financial and institutional interest in this space, and also reinforces the statement that these are not simply academic concerns, but market driven realities. that aside, there are a few key considerations and questions that practitioners must be able to ask and address prior to offering advisory services in this fast moving space, and a few of these items are included below first, what is the underlying stabilizer for this stablecoin, or state a different way, what asset is acting as the volatility reducing agent for the stablecoin in question. whether the underlying stabilizer is a fiat currency, a physical commodity, or a different stablecoin will have an effect asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 172 on how these items are reported and classified (meyer, 2018). drilling down specifically, one item that should be taken into account is how stablecoins are classified versus native cryptocurrencies such as bitcoin or ether. these cryptocurrencies have, based on the white papers and publications that are available for public consumption, tended to be learning toward accounting categorization as intangible assets versus other types of accounting classification. such consideration and classification may make sense when viewed through how traditional cryptocurrencies have been categorized by regulatory bodies such as the sec and cftc, but is an incomplete view of how stablecoins operate and interact with the broader cryptocurrency ecosystem. if a stablecoin is underpinned by a fiat currency, for example, then it might make sense to treat it and classify it as a currency itself, rather than as an investment or property as is currently the case with cryptocurrencies. this may seem like a minor classification or accounting change in the grand scheme of the financial ecosystem, but can have large ripple effects as to how these stablecoins are used in the financial systems as well as how they are classified, reported, and analyzed by different end users. increased standardization will also help enable the anti-money laundering aspects of different cryptocurrencies shift from pilot phases to enterprise ready applications (lai, 2018). such differentiation is perhaps most clearly demonstrated by the increased institutional interest and investment into the cryptocurrency space, including using stablecoins as collateral for fiat based financial instruments. this next step utilization in the financial space is interesting from an academic sense, but also has implications for how stablecoins should be classified. if, for example, stablecoins are used in lieu or as the underpinning for a fiat based financial instrument, then these items should be treated as currencies, with the liquidity and lack of tax implications associated therein? a second key consideration, on top of the what the stabilizing or underlying asset itself actually is, is how the stability if achieved, and whether or not the stablecoin itself is pegged directly to the underlying asset, or is merely associated with it in some other manner. if a stablecoin is linked directly to a commodity or fiat current, and has a claim on those underlying assets, then it again seems logical to conclude that appropriate accounting treatment would be equivalent to the treatment of the underlying asset itself. if, however, there is no direct claim or connection the underlying asset, or the stablecoin holders do not have a legal claim to the underlying asset in the case of a business reversal or downturn, classification as a commodity may seem more appropriate and logical. this is not just an academic issue, with nations like venezuela, complete with the political and economic instability, launching nationally backed coins and tokens; the rights of token holders and coin holders represents a viable economic business issue. building on this point, and connecting directly to the next topic of analysis and examination is just how stablecoins can be audited, or how should assurance services should be delivered as related to these coins. third, and particularly important in the case of stablecoins, which are connected to an underlying asset and done so for a specific purpose to reduce volatility and uncertainty connected to these cryptocurrencies, are the audit and assurance standards that are being built out around the broader cryptocurrency ecosystem. even if accounting and financial professionals are not expected to be coders and understand the detailed programming languages asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 173 that drive the individual blockchain platforms, practitioners are going be expected to understand the fundamentals of how different tools and platforms work. dovetailing and building off of this need and expectation of clients to have audit and report ready documentation, this leads to the next emerging topic of interest that is of focus in this research. 3.2 audit and assurance of cryptoassets as of this research there does not appear to be authoritative in nature or issued by an accreditation body such as the fasb or iasb, but there does appear to be an evolving set of standards and information connected to the field of audit, assurance, and reporting around different cryptoassets. the only guidance available in the united states as of this research is the 2014 memo issued by the irs that classifies all cryptocurrencies as property for tax and reporting purposes. this uncertainty has led to large amount of debate, analysis, and conversation around the future of how these certain assets and items will be reported, but also creates an opportunity for practitioners willing to analyze and examine the issues pertinent to the broader cryptoasset space (barnes, 2018). clearly there will be differentiated points of analysis and consideration depending on the specific asset, but there are several points that tend to straddle different cryptoaset classes. these points of analysis are not meant to determine authoritative accounting classification or reporting guidelines, but to rather pose questions related to how certain cryptoassets and items should be treated and reported. first, is there a third party way to authorize and verify the custody and valuation of these different assets? for traditional and distributed cryptocurrencies the current methodology for obtaining certification of value, via comparison to current market prices, is akin to that of intangible assets, but that is not a perfect solution given the volatility that has traditional been associated with prices of these different asset. exchange traded products seek to address some of these issues or concerns, but remain primarily in the introductory stages of market implementation (crea, shea, steingarten & cohen, 2018). adding to the difficulty in using an intangible classification to govern the reporting and documentation of cryptocurrencies going forward are the differences in price depending on what exchange is sourced as the basis for price comparison. even after the trading environment has matured during 2018, price differentials still exist between different exchanges and these different prices do not tend to reconcile over time. a second consideration that is increasingly important as stablecoins become increasingly integrated is how is the custody of different cryptoassets are verified. particularly with stablecoins, should valuation be determined based on the underlying asset itself, or be a combination of the underlying asset itself plus any market value that has been allocated to the stablecoin running on top of that stabilizer? a large part of the audit conversation and process revolves around a few key factors: existence, valuation, and confirmation of counter party balances, and it seems that the refinement of blockchain standards may mirror the effect of xbrl on audit and attestation information (amin, eshleman & feng, 2018). as the cryptoasset environment continues to evolve and proliferate, there are several additional considerations and factors that should be evaluated as a part of the broader assurance dialogue. examining how these different components of different audit processes will be influenced by the emergence of these technology forces represents an important step toward developing assurance, attest, and other reporting asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 174 frameworks and standards in this space. not meant to be authoritative nor all inclusive in nature these considerations should rather be thought of as a starting point to continue the dialogue and analysis of how audit, assurance, and attest can be integrated into this emerging field and areas. second, is there a method or vector by which the custody of certain cryptoassets can be verified? this mean seem like a rather obvious question or statement but in the face of the anonymity that accompanies many of the most dominant cryptocurrencies this is not an idle question. in fact, the proliferation and rise of so-called privacy coins whose sole characteristic and trait is the privacy that it imbues the end user with, will only amplify the importance of this question. for clients and institutions that bank with larger and more established institutions such as coinbase the obtaining of custody information may become simpler as a result of regulatory shifts and developments focused on those more established players. ironically, and perhaps harkening back to one of the initial tenants and ideals of the cryptocurrency space, decentralized exchanges and platforms are becoming increasingly common as both individuals and institutions seek to truly leverage the decentralized promise of many of these cryptoassets in not only ownership but trading as well. regardless of the specific structure of the platform or data stream, practitioners need to have access to some sort of information linking ownership of cryptoassets to a public wallet, and a methodology to connect that public wallet or even public address connected to that wallet to an identifiable institution or individual. third, and perhaps more forward looking than simply focusing on auditing and attesting to the valuation of different cryptoassets is the role that practitioners can play in the development and implementation of control based solutions around smart contracts and other more advanced applications (raphael, 2017). a smart contract, distilling the concept down to a fundamental level, represents a series of computer codes and language that can automatically execute certain pieces of or an entire transaction associated with a business process. this development and application does appear to hold substantial promise for the profession, but also raises several pertinent issues with regards to control, assurance, and attestation. in the case of a smart contract, for example, it is critically important that both the practitioners involved as well as the end users receiving data via the smart contract have confidence in the surrounding processes. for example, a smart contract may indeed automate parts of a process, but what are the controls in place over which institutions or individuals have control over the data as is it input into the system. 3.3 differentiation between ai and rpa in addition to blockchain implications and applications that have continued to permeate throughout the broader accounting and finance landscape, it also seems important to recognize the fact that other technology trends are having a potentially disruptive impact on the financial services landscape (cianni & steckler, 2017). automation, artificial intelligence, and robotic process automation are often categorized, labeled, and discussed as if these processes and programs are so similar as to be classified and treated as the same. that said, and linking back to the working definitions established at the beginning of this research, rpa and ai while related are not the same on either a technical or implementation basis. expanding on these initial working definitions, it appears logical to further differentiate and analyze just how these technology tools and processes are indeed distinct and separable. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 175 robotic process automation, although a relatively new entry into the marketplace in terms of the terminology and conversation, has existed in various forms for decades. contrasted versus the emerging fields of artificial intelligence and machine learning, robotic process automation has indeed been adopted by numerous market participants whose track records that are measurable in decades. no matter which specific organization is referenced or included in the analysis or examination of rpa, the underlying fundamentals are similar, but differentiated from the potentially more paradigm shifting artificial intelligence. while not meant to be all inclusive nor exhaustive, the following characteristics form the foundation from further examination by both practitioner and academic researchers. first, rpa is a technology system and protocol that can be implemented at a range of organizations without having to disrupt or upend current enterprise resource planning systems. this may seem like a technical detail more interesting to a computer science conversation, but it can have substantial effects on the pace with which different technologies and process can actually be adopted and implemented. the ability to install and run rpa based programs in the background means that practitioners and organizations means that organizations can begin to realize the benefits of this increased automation in a nearly instantaneous manner. said benefits may very well expand beyond accounting and finance processes, and encompass a much wider range of processes than initially anticipated. drilling down, some of the following processes may be candidates for rpa implementation. human resource and onboarding packages may indeed be customized depending on the organization and the individual employee being brought into the organization, but that surface level analysis, although temping, is incomplete in nature. many of the processes and procedures; employee training, the explanation of benefits, issuance of access codes and other information, and the integration of prior retirement information into the organization structure are surprisingly similar for every employee. even more basic tasks such as request for documentation and the processing of said documentation are similar, if not identical from employee to employee no matter what role, area of the organization, or geographic location are specified. inventory and re-ordering processes and packages are also relatively standardized at all but the smallest of organizations, with a threshold set and established that in turn triggers a reordering of certain goods. while large swaths of inventory management are indeed automated or otherwise augmented by technology much of actual stocking, verification, and reordering of physical good still involves several manual steps and human oversight. utilizing an rpa based program to assess current levels of inventory, placing orders to replenish the stock of goods at the organization, and keep counterparties aware of what is occurring is a relatively logical place to implement an automation based solution. billing and cross referencing the receipt of payments to the appropriate accounts at an organization also seem to be a logical place to increase the automation of processes. prior to drilling into specific examples or applications connected to the payment process itself, the overarching importance of increasing the efficiency associated with these processes seems a logical place to begin. in a digitally based environment, the idea and concept of float in a traditional sense, has become less important as paper checks and payment processes are less asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 176 common. that said, while external or paper based float may have been reduced in nature, it is interesting that the concept of internal float still appear to be an issue facing many organizations. not an abstract concept to understand, the idea of internal float as it relates to payments and the applying of payments against outstanding balances can improve the bottom line performance of the organization. at larger organizations, even reducing the amount of time spent manually reconciling payments by a number of hours can result in millions in cost savings and other efficiencies. legal matters, such as the review and approval of contracts, also seem to be prime candidates for augmentation or automation via a rpa based program, linking back to the earlier conversation around human resources or benefits stating that many of these contracts and agreements are similar, if not identical in nature. establishing set processes and protocols for the drafting, review, and resolution of certain contractual matters will in addition to reducing frustration and the time spent resolving these issues allow the organization the ability more effectively deploy internal resources. as much promise and potential that automation holds, however, it does appear worthy to point that rpa programming is now the equivalent to artificial intelligence. artificial intelligence may initially conjure or bring to mind certain images and ideas that have been put forth by the media and other entertainment venues, but a working definition of ai can be put forward as the following. at the core of the idea and concept, artificial intelligence simply represents a program or suite of programs that can render obsolete or irrelevant the need for human oversight or involvement in a certain process (sundhararajan, 2018). while automation is certainly prevalent in the marketplace to date, true adoption and implementation of ai by organizations requires several iterative steps that must be completed prior to true ai implementation. first, organizations must have selected the specific type of artificial intelligence that is the most appropriate option for the organization. there are numerous types and classes of artificial intelligence, but there do seem to be three categories that are most applicable to the financial services profession; computational, spatial, and linguistic. subsequent to the identification of the most appropriate class and type of artificial intelligence, a series of steps should be completed in order to leverage and unlock the true value proposition of artificial intelligence for an organization. from an accounting and financial professional perspective some of the logical applications of artificial intelligence are connected to fraud detection, continuous reporting, and the identification of patterns from the underlying data (tysiac, 2017). that said it does seem reasonable to state that, at the current state of development and implementation in the marketplace, many organizations are more well positioned to implement an rpa based program than a true artificial intelligence based solution. as of this research, a primary role and responsibility for financial professionals seems to be closely linked to education and information. distilling these developments and trends, there are certain frequently asked questions and considerations that should form the basis of a conversation, both between different classes of practitioners as well as between practitioners and clients. 3.4 frequently asked questions and considerations asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 177 clearly every organization is different and will necessitate a range of considerations to fully implement and on-board different emerging technologies, but there do appear to several consistent and broad based considerations that should be a part of the accounting and financial services conversation. viewed from a practitioner perspective this should be used as a framework from which more substantive conversations can be derived. beginning with blockchain and cryptocurrencies, some of the items that might be discussed are as follows: 1. what type of blockchain solution if applicable to the organization? this presupposes that blockchain is an appropriate technology choice for an organization, but after that initial assessment is complete a next step is to determine what type of blockchain model is the best fit at the current time. public blockchains, private blockchains, and consortium blockchains have different attributes and characteristics; one of these choices may be a better option than others. an additional consideration that should be taken into account are the relationships with customers, i.e. is it legally possible for the organization to share information between different network members. also, when implementing blockchain based solutions, an important point to be aware of and take into account is which entities will control the code, especially if external consultants are utilized in the development and implementation. a. a public blockchain may represent the completely decentralized and distributed model that blockchain supporters most often support, but does not seem to be most appropriate model for enterprise implementation. whether it is linked to the proof of work model often connected to a public blockchain model, or the association of a public blockchain with cryptocurrencies like bitcoin, organizations might not want to build an enterprise program on this type of blockchain. b. private blockchains are more efficient and consume less energy than public blockchains, but are closer to a centralized and traditional database than a true blockchain base solution. specifically, if other organizations are seeking to leverage some of the benefits of blockchain by sharing and distributing the information, a private blockchain may not be appropriate. in other words, if organizations have to trust the storage and security of information to potential competitors, or even cooperating firms, this raises additional issues of governance and data security. c. consortium blockchains are, in essence, a hybrid type of blockchain platform that might seem to be best applicable for broader enterprise adoption as of this research. an analogy that can be used for educational or explanatory purposes is that a consortium blockchain model is a platform that can be used by a number organizations to share data and information with joint ownership of the underlying processes. although the joint custody of information generates efficiency benefits, it also raises considerations that have to analyzed as they pertain cybersecurity and governance. 2. cybersecurity and governance issues are also key items that should be considered when implementing either blockchain or automation (be it ai or rpa) based solution or process within an organization. cybersecurity policies and practices based on simply possessing up to date anti-virus software or enforcing password protocols are insufficient given the rapid pace of change in the business environment at large. practitioners across different industry lines will asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 178 have to both keep pace with the underlying technology itself as well as the implications of these technologies on current processes. a. a substantial consideration and factor that should be taken into account, especially as emerging technologies are onboarded and implemented throughout the marketplace, is whether or not the controls in place at the organization are sufficient enough to deal with the acceleration of data processing and reporting. particularly as new technologies are developed and implemented it is entirely possible for existing controls to either end up bypassed or otherwise ignored as a result of these implementations. maintaining the integrity and strength of these different controls and platforms is both a core responsibility of accounting professionals as well as a fiduciary responsibility for all professionals. 3. once the blockchain platform has been decided upon, what are the processes and policies in place to ensure the organizations and individuals are both well qualified to work on the various stages of blockchain projects. if, for example, external consultants were employed to help develop and engineer a new product or service, there are well established policies and processes in place to help safeguard the information covered and discussed between internal and external consultants. blockchain is, at the core of the idea, simply a computer system and program and the controls in place must be able to control both who has control over the underlying code itself, and which individuals maintain control over the information once it has been implemented. a. a conversation surrounding the maintenance and ongoing controls linked to both blockchain itself, and the apis that migrate data stored on the blockchain to existing technology systems must be weaved into the broader control process itself. b. are the individuals and firms brought in to consult with the development of the blockchain itself properly insured and covered for potential errors of omissions that do occur. c. this broader debate surrounding the access and levels of insurance linked both the client organization and external consultants brought in to assist with specific projects are carries through to a more comprehensive conversation around the internal controls over these emerging technologies. 4. internal control considerations as they are connected to emerging technology issues would seem to pose an apparent contradiction for practitioners (drew, 2018). on one hand the increased speed and security with which transactions can be processed and stored appears to decrease the need for manual controls or reviews of information. the efficiency gains and benefits associated with this increased speed of transactional processing are relatively clear in nature, but also raise the possibility of internal controls being subverted or overwritten via the implementation of new technology. a. specifically, the implementation and adoption of new technologies that help to accelerate the data processing and reporting tools could actually amplify underlying issues and errors that otherwise might have been addressed via manual controls. b. taking this into account, and realizing that every organization is different, and that different processes are going to be governed by a variety of forces, this also seems a logical space to raise the issue and importance of documentation. properly documenting and testing asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 179 the documentation of processes to ensure that current processes are indeed appropriate is an important first step in the developing. building on this initial documentation, however, it also seems responsibility to develop frameworks and tests to maintain the integrity of controls as technology becomes more integrated. 5. is it possible to integrate and map the data and information stored on a blockchain platform with current information technology systems? even with existing technology systems there are often issues with the mapping, transmission, and exporting of information between different modules of the same system. since the majority of blockchain platforms are based on technology that, although robust in its own right, is still immature and an emerging technology platform, it is important for organizations to identify the appropriate controls and policies to safeguard information. several considerations that appear to still be open times include, but are not limited to the following: a. is the data stored on a blockchain that is private and hosted by an organizing firm, does that mean that the other blockchain members will have to request access to that information? b. rather, if the group of organizations have constructed a consortium blockchain model, are the controls and access restrictions equivalent between these different organizations. since consortium or sector specific models and platforms seem be more and more popular among different industry groups this is not an abstract issue or concern. 4. additional considerations based on the analysis included both in this research and other research projects it should be clear that the accounting and broader financial services landscape continues to change and evolve. including or producing an all inclusive listing of potential future service offerings is beyond the scope of this, or any other single research piece. that said, there do appear to be several roles and services that financial services are uniquely well positioned to fill as the technological integration and intersection of accounting and financial services continues to increase. maintaining a focus on the applications of blockchain and automation tools including both artificial intelligence and robotic process automation the following appear to represent roles and duties financial practitioners will be well versed to fill and occupy moving forward (jun & vasarhelyi, 2017). first, even as technology becomes increasingly integrated into different roles and organizations, the core responsibilities and competencies of accounting professionals will not change entirely, but will evolve to keep pace with changing expectations. one logical extension and development as a result of these changes is the continued importance of internal controls, especially those pertaining to data governance and other processes. building controls, maintaining controls, and explaining different and new controls to members of the organizations will continue to remain important for practitioners. this might seem contradictory as technology assumes more of the computational components of different processes, but controls and maintaining adequate controls are actually more important as automation becomes more important. reinforcing and developing expertise in control development, testing, and monitoring processes represents a potential new service line and revenue opportunity. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 180 second, the concept of an audit and other attestation engagements will invariably change and evolve over time as the technology tools and platforms utilized by both organizations and accounting professionals continue to change and become more sophisticated (alarcon & ng, 2018). continuous auditing and attestation are not as abstract or radical an idea as many initially appear; organizations are already experimenting with such tools to improve the quality and transparency of information. expanding this perspective, and taking into account the increased interest in sustainability and other more comprehensive forms of reporting, it seems logical to conclude that this more continuous type of reporting will become more mainstream. especially as organizations, management teams employed therein, and the stakeholders of said firms become increasingly accustomed to continuous reporting, financial professionals will have to keep pace. third, the role that practitioners will fill moving forward will be influenced by dual forces that are, in essence, of equal of importance in both united states and international markets. put simply, clients and other internal partners and stakeholders are going to have to balance the expectations including hype and excitement associated with emerging technologies with reality of where technologies actually intersect with current needs. clearly every organization is different and will have unique needs associated with different emerging technologies, but practitioners will need to posses the following traits. in addition to the technical expertise necessary to understand the tools themselves, the ability to communicate and articulate the implications of these tools will also become more important as clients have needs and expectations. while the underlying aspects and considerations for practitioners and organizations will vary depending on the individual firm, the increasing integration of technology also will develop considerations that are not yet identifiable at this point. analyzing these potential trends and directions for both accounting practitioners and management teams is something connected to this research as well as future directions. 5.future considerations & directions this research, like any research connected to an emerging technology such as those documented and analyzed within this paper, is an attempted analysis of emerging technologies and tactics, but should rather form the basis for additional considerations and research. roles and responsibilities connected to financial practitioners will evolve and change as technology continues to become increasingly integrated within the broader marketplace. whether the specific technology in question is connected to blockchain options, cryptocurrencies, stablecoins, or automaton trends in general, the overarching trends are similar. first, practitioners employed both within public practice and private industry will be involved in fewer compliance and manual tasks. such tasks and processes do not generally add value either to the practitioners involved nor the client organization so this automation and tasks elimination appears to be a positive trend. second, and across the financial services spectrum, the need and demand for practitioners to act in an advisory manner is becoming increasingly clear. whether it is connected to explaining and analyzing emerging technology trends themselves, or simply serving as a level setting reality check against unrealistic expectations, the shift toward strategic advisor appears to be well underway. finally, the need and responsibility for practitioners to engage in continuous learning and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 181 education does not appear represent a fad, but rather a fundamental change in how professional interact with the broader business environment. continuing education requirements are already a component of the professional environment, but the pace with which various technologies are changing points to a necessary shift. on top of changing the manner with which practitioners must educate themselves, the need for continuous learning and education also opens a new line of advisory services for forward looking practitioners. on balance, it seems that from the available literature that while the profession itself is in the midst of a change with regards to some core roles and responsibilities, that said changes both eliminate some current roles while simultaneously creating new roles and potential opportunities. at the core of this research was the desire to be applicable for both practitioners and academics, with concepts as well as market based and derived applications of these new tools. moving forward, the need for dialogue, analysis, and further examination of both these technology trends and associated implications is relatively clear. the reality that technology is becoming more integrated into financial services is not, in and of itself, aground breaking concept of idea. rather, and by focusing on a few specific applications and trends related to emerging technology topics, accounting practitioners and researchers can apply and expand on this analysis and findings therein moving forward. written with both a research and practitioner audience in mind, this research forms the foundation for discussion, experimentation, and further refinement both currently and in the 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(2018). pwc is backing a usd stablecoin cryptocurrency in challenge to tether. fortune.com. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 352 institutional reforms and development of corporate governance and banking system in china ratnam vijayakumaran (corresponding author)* department of financial management faculty of management studies and commerce university of jaffna, sri lanka sunitha vijayakumaran department of management studies the open university of sri lanka, sri lanka received: july 3, 2017 accepted: nov. 2, 2017 published: december 1, 2017 doi:10.5296/ajfa.v9i2.12382 url: https://doi.org/10.5296/ajfa.v9i2.12382 abstract the aim of this paper is to review china‟s institutional reforms and consequent development of chinese corporate governance system and financial system. as part of the wider economic reform initiated since the late 1970s, the chinese government has adopted various measures aimed at reforming state owned enterprises (soes). these mainly include managerial autonomy, a management responsibility system, corporatization and partial privatization of former soes. in addition, the chinese government took various steps to enhance the efficiency of the banking sector. the analysis shows that china‟s efforts to improve the corporate sector through its own unique gradual and piecemeal approach has been successful in terms of introducing a formal governance structure for the corporate sector, liberalizing its financial sector, improving governance of state owned banks, and most importantly, developing the private sector as the back bone of the economy. keywords: china, economic reform, corporate governance, ownership structure, banking system, private sector jel classification: d02, d73, g18, g21, g30, g38, h11, o16, p27, p31 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 353 1. introduction it is generally accepted that china‟s economic success is the result of its economic reform initiated in 1978, which is gradually transforming the central-command economic system into a market-based economy. in the initial stage of the transition, the government paid little attention to providing institutional infrastructures that were necessary for the capital market to function properly (note 1). although the transition necessitated the establishment of an almost entirely new set of institutions, china‟s political system inhibited the development of legal institutions and the evolution of local governmental authorities. nevertheless, its desire to integrate globally has resulted in the gradual development of legal institutions, the decentralization of political institutions, the liberalization of the financial system, development of financial markets and the widespread growth of the private sector. unlike most former centrally planned economies, china has adopted a gradual and piecemeal approach instead of the overnight privatization of soes. as part of the wider economic reform, in the 1980s, the chinese government adopted various measures aimed at reforming state owned enterprises (soes). these measures included increasing managers‟ decision making autonomy, introducing financial incentives, and bringing in performance contracts between the government and soes, which were mainly aimed at giving more latitude to soe management in managing their firms and at aligning the goals of soe management with those of the government (naughton, 1995; shirley and xu, 2001; su 2005). these reforms measures were successful to a certain extent by reducing the role of governmental intervention in the management of soes and by improving their productivity (groves, hong, mcmillan, and naughton, 1994; li, 1997). nonetheless, the rights and responsibilities of soe stakeholders and management were still ill-defined. furthermore, as the reform efforts implemented thus far had not resulted in sufficient improvements in soe performance, the government could not finance all soes itself (aivazian, ge, and qiu, 2005; jiang, yue, and zhao, 2009). therefore, it sought to corporatize and partially privatize former soes while retaining its status as the controlling shareholder (walter and howie, 2003). the latter two measures of soe reforms mainly hinge on the western-style modern corporate system, which is essentially characterized by the separation of ownership and control. this suggests that modern chinese firms are inevitably subject to the issues of incentive incompatibility and information asymmetry, which often arise between managers and owners. lin, fang, and li (1998) suggest that as a consequence of this, china‟s soes may face agency problems, such as moral hazard and managerial slacks and discretion. therefore, giving appropriate incentives to the management becomes critical in firms in order to mitigate heightened agency problem and to motivate managers to pursue profit maximization objectives (chow, 1997; xu, zhu, and li, 2005). furthermore, the chinese government traditionally wanted to retain some control in the companies, in part through partial retained ownership. this led to further conflicts between politicians/controlling shareholders and firms (shleifer and vishny, 1994; young, peng, ahlstrom, bruton, and jiang, 2008). furthermore, government ownership and control weaken the effectiveness of other governance mechanisms aimed at providing incentives for asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 354 managers (kato and long, 2006a,b and 2011; tian and estrin, 2007). despite these problems, the chinese government has taken several steps to improve the corporate governance of firms as well as banks in recent years. in sections 2 and 3, we discuss the important institutional developments, namely corporate governance system and banking system, respectively, that are underpinning the growth of the corporate sector in china. section 4 discusses present state of the private sector in china and section 5 concludes. 2. corporate governance system in china in this section, we discuss the evolution of corporate governance of chinese listed corporations, with particular emphasis on ownership structure and board structure. 2.1. evolution of corporations and financial markets the history of modern corporations in china is very short compared to other developing countries. starting from 1984, stock companies have appeared in china, but formal trading did not start until the early 1990s. beijing tianquao co, ltd which was established in 1984 became the first joint stock corporation in china. in the same year, shangai feilo acoustics co., ltd was the first chinese corporation that publicly offered shares to the market (csrc, 2006). the establishment of the two stock markets in shanghai in 1990 and in shenzhen in 1991 with the objective of promoting the reform of soes was one of the most significant economic reforms in china. the government has thereby been successful in encouraging enterprises, especially soes to raise funds by issuing stocks and corporate bonds (chi and young, 2007). moreover, the government has been seeking to improve the operating performance, and the corporate governance of soes through continuous economic and share-ownership reforms. consequently, chinese capital markets have seen a rapid development in terms of the number of listed companies, trading volume, and total market capitalization. by early 2004, china‟s stock markets emerged as the eighth largest emerging market in the world with about 1300 listed firms and a market capitalization of over $550 billion (chen, 2005). as can been seen in table 1, total number of listed companies has been increasing continuously every year since 2000 and at the end of 2010, a total of 2063 companies were listed on the two chinese stock exchanges. the total market capitalization of these companies was 26.54 trillion rmb. the combined market capitalization of these two stock exchanges in 2010 accounted for about 66.69 % of china‟s gdp (csrc, 2010). at the end of 2013, a total of 2489 companies were listed on the two chinese stock exchanges. now china is the world‟s second largest stock market after the us in terms of combined market capitalization. yet, the number of privately-owned listed companies was negligible until 1998, but boomed thereafter. the chinese stock markets exhibit some prominent characteristics when compared to mature financial markets (gordon and li, 1999). for example, the state or government plays a dual role as an owner of firms (dominance owners) and regulatory agency. while dividend income in china is subject to graduated tax rates based on the length of time the shares have been held, capital gains are generally taxed at the corporate income rate. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 355 table 1. important features of chinese stock markets year no. of listed companies no. of foreign-invested companies (b-shares) no. of overseas listed companies total outstanding shares (100 mn shares) total market capitalization (100 million yuan) total turnover (100 million yuan) 2000 1088 114 52 3792 48091 60827 2001 1160 112 60 5218 43522 38305 2002 1224 111 75 5875 38329 27990 2003 1287 111 93 6428 42458 32115 2004 1377 110 111 7149 37056 42334 2005 1381 109 122 7630 32430 31663 2006 1434 109 143 14926 89404 90487 2007 1550 109 148 22417 327141 460556 2008 1625 109 153 24523 121366 267113 2009 1718 108 159 26163 243939 535987 2010 2063 108 165 33184 265423 545634 2011 2342 108 171 36096 214758 421650 2012 2494 107 179 38395 230358 314667 2013 2489 106 185 40569 239077 468729 sources: annual reports of csrc furthermore, china‟s securities market is open to foreign investors. while international investors were for the first time allowed to invest in china‟s b share market in 1992, after ten years, foreign institutions have been allowed to invest directly into china‟s a share market via the qualified foreign institutional investor (qfii) scheme (note 2). as can been seen in table 2, with the opening of chinese economy for foreign investors, there has been a steady growth in number of qfiis (from 27 to 106) and approved investment quotas in usd billion (from 24 usd billion to 19.72 usd billion). we can also observe that the total assets held by the qfiis have steadily increased from 2004 to 2010 except in 2008. furthermore, among qfiis commercial banks accounted for about 29% in 2007 and 20 % in 2010 (note 3). furthermore, since 2001, eligible foreign companies can offer and list shares in china‟s markets. a further significant development was that since 2002 foreign companies are also allowed to take over chinese listed companies. international investors‟ participation has helped to promote chinese capital markets. at the same time, it has brought into the capital market long-term funds, which are helpful for the growth of chinese corporations, as well as advanced investment philosophies and good expertise (csrc, 2006). asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 356 table 2. qualified foreign institutional investors (qfii) in china 2004-2010 year qfii licensed foreign institutions approved investment quotas in usd billion total qfii assets securities held by qfii percentage of securities to total assets 2004 27 3.7 24 16.2 66.6% 2005 34 5.6 39 34.7 90% 2006 44 7.3 196 137 70% 2007 52 9.995 258.8 175.5 61.4% 2008 76 13.405 178.78 104.78 58.6% 2009 94 16.67 289.9 237 81.8% 2010 106 19.72 297.1 265.8 89.5% source: csrc annual reports 2004-2010 2.2. the company law and the chinese securities regulations commission the institutional framework for corporate governance in china mainly draws from both the 1994 company law of the people‟s republic of china and the chinese securities regulations commission (csrc). the 1994 company law improved property rights by establishing the firm as a legal entity that owns assets. furthermore, the company law facilitated the restructuring of traditional large and medium sized soes as legal entities, and the establishment of a modern corporate system by standardizing the organization and the behavior of the companies. it defines the functions and responsibilities of shareholders, board of directors, and board of supervisors. in 2006, a fundamental review of chinese company law was enacted, creating two types of limited companies: the limited liability companies (llc private companies) and the joint stock company (jsc public companies). this brought the legal context much in line with the company law of other countries. the enterprise bankruptcy law was introduced only in november 1988 for an initial trial period. in april 1991, the civil procedural law, which established the bankruptcy procedure for companies, was enacted. yet, due to that fact that most of the firms were owned by the government or government agents which have social and political objectives such as maintaining employment, the number of bankruptcies was very low compared to international standards (cao, 1998). a new corporate bankruptcy law was enacted in 2007, which applied to soes, foreign investment enterprises, and domestic companies. yet, tomasic and zhang (2012) note that china‟s bankruptcy judges are extremely cautious in the implementation of the new law‟s reorganization provisions due to the political considerations. the establishment of the two stock exchanges was an important milestone toward the development and implementation of the rule of law and in securing property rights for private enterprises. yet, in the early 1990s, local leaders retained a significant influence over the listing process and the enforcement of secondary market regulation, but in the late 1990s, the china security regulatory commission (csrc) was able to consolidate its influence. the stock market regained the confidence of public investors and has enjoyed rapid expansion since then. csrc is responsible for monitoring stock exchange activities and its main asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 357 objective is to protect investors. from time to time, the csrc, along with other authorities, has issued supplemental regulations, administrative rules, guidelines and codes (e.g. the provisional regulations on public offering and trading, and the measures on the administration of futures exchanges). in 2001, the china security regulatory commission (csrc) formulated some basic norms of corporate governance, aiming at protecting minority shareholders from controlling shareholders‟ expropriation. the guideline also discourages the combination of the positions of chairperson of the board of directors and general manager (ceo duality). in 2002, a code of corporate governance for listed companies was formulated for the first time by the csrc. this prescribed basic principles for the protection of investors‟ rights, as well as basic rules and standards for directors, supervisors, and senior management. the code was intended to be the major measuring standard for the evaluation of listed companies‟ corporate governance structure. 2.3. ownership structure until 2005, chinese corporations could issue non-tradable and tradable shares. thus, the equity structure of most listed companies was segmented, being characterized by the co-existing of exchange-tradable shares held mainly by public investors, and largely stated-owned nontradable shares, which could only be transferred through negotiation among designated parties. this structure stemmed mainly from a lack of consensus among policy-makers on the corporate shareholding structure in the early years, a lack of clarity over the role and functions of the securities market, and a lack of awareness of how to manage state assets through capital markets. chinese corporations typically issue non-tradable shares to soes, and other state owned legal persons and tradable shares to public investors. chinese listed firms have traditionally issued four types of tradable shares; each with its own unique characteristics. china‟s mainland companies issue a-share and b-share in shanghai and shenzhen. a-shares are denominated in local currency (rmb) mainly for the domestic investors. b-shares which are traded in u.s. dollars are mainly for overseas investors. mainland companies issue h-share in hong kong, and n-shares (american depository receipts adrs) in the us. before the 2005 reform, only one third of total shares issued by the companies were tradable. the rest were non-tradable, which significantly affected the liquidity of the china‟s stock markets. 2.3.1. the 2005 split share structure reform in 2005, the csrc launched trial reforms of non-tradable shares (referred to hereafter as the reform), with the objective of releasing the market from the historical hangover that afflicted it, and better protecting the investors. following the positive results of the trial, a full-scale reform campaign was soon carried out among listed companies. specifically, the non-tradable shares were floated through the open markets. the reform aimed to gradually eliminate the difference between the two types of shares and to balance the interest between the two categories of shareholders in a market-oriented way. in order to make government-owned shares legally tradable, state shareholders were required to compensate tradable shareholders through a share conversion process. this was achieved through fair negotiations between holders of non-tradable shares and tradable shares. the compensation was decided at asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 358 shareholders‟ meetings, without any government intervention. the reform effectively diluted the government-owned share portion, attenuating government-related agency costs. as of december 31, 2007, 1,298 listed companies, which represented 98% of the total listed companies subject to the reforms, had either initiated or completed the process of non-tradable share reform. additionally, all new ipos taking place since mid-2006 no longer have non-tradable shares. the non-tradable share reform successfully resolved problems such as the dual-pricing of shares of the same listed company. it restored the pricing functions of the capital market, greatly improved market efficiency and paved the way for further improvements in the corporate governance and development of the capital market. table 3 reports the evolution of the ownership structure, board structure of chinese listed firms over the period 2003-2010. we observe a persistent decrease in state ownership and legal person ownership throughout the sample period. in particular, state ownership which accounted on average for one third of total shares decreased from 35.9% in 2003 to 8.3% in 2010. we can observe similar trend for legal person ownership which decreased from 21.9% in 2003 to 0.086% in 2010. in contrast, shares owned by top management increased from 0.4% in 2003 to 0.8% in 2010. table 3. evolution of the ownership structure and board structure year 2003 2004 2005 2006 2007 2008 2009 2010 state ownership 0.359 0.344 0.333 0.284 0.248 0.210 0.114 0.083 legal person ownership 0.219 0.224 0.215 0.186 0.156 0.129 0.094 0.086 managerial ownership 0.004 0.011 0.013 0.019 0.030 0.036 0.048 0.080 foreign ownership 0.044 0.041 0.042 0.042 0.043 0.038 0.029 0.035 board size 9.814 9.658 9.580 9.405 9.343 9.203 9.089 9.027 proportion of independent directors 0.327 0.342 0.347 0.351 0.356 0.357 0.359 0.360 source: the china stock market accounting database (csmar) another important outcome related to the 2005 reform is that listed companies have been allowed to incentivize their managers with shares and stock options. in january 2006, the csrc issued “the administrative rules of equity compensation of listed companies”, which allow the companies that have successfully completed their split-share-reforms to adopt equity based compensation plans for their managers. according to these measures, equity incentives include restricted stocks and stock option plans. this also provided a strong incentive for the top managers of listed companies to complete the reform at the earliest possible in order to participate in the new incentive scheme. it is expected that in addition to increasing the income standards of the management, granting them stocks or equity options helps align their interest with those of the shareholders and with the long-term development of the enterprise (note 4). yet, state ownership and control in former soes hinders the use of modern governance mechanisms such as managerial ownership (conyon and he, 2011; kato and long, 2011; r.vijayakumaran, 2014; dixon, guariglia and vijayakumaran, 2015; s.vijayakumaran, 2016). however, after three decades of reform, managerial ownership has emerged as one of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 359 the important governance mechanisms at least in non-state/private chinese listed firms (conyon and he, 2011; walder, 2011; r.vijayakumaran, 2014; dixon, guariglia and vijayakumaran, 2015; s.vijayakumaran, 2016). for example, dixon et al. (2015) show that share ownership by managers in private chinese firms increases their incentive to involve in risk taking activities such as international expansion. similarly, r. vijayakumaran (2014) provides evidence that managerial ownership works as an effective governance mechanism only for private firms to mitigate asymmetric information problem and thus mitigate financial constraints faced by them and, similarly, to provide managers with incentive to align their interests with those of shareholders and reduce agency costs in their firms. in a similar vein, s. vijayakumaran (2016) finds that managerial ownership provides managers with incentive to use more debt capital in the capital structure of their firms. 2.4. board of directors in accordance with company law, chinese firms operate under a two-tier board structure, with a board of directors (management board) and a board of supervisors (with employees and others like the german model). the board of directors is responsible for the strategic operations of the firm. one of the important legal rights of shareholders is the right to elect the board of directors, which have certain rights and duties in regard to the incumbent management. in the united states, the boards of directors, which rely heavily on directors from outside a firm, have enormous power in appropriating and dismissing top executives and in determining their compensation. in japan, creditor financial institutions, which are often large shareholders as well, often dispatch directors to monitor managerial decision makings. china‟s commercial law also identifies the board of directors as the top level decision-making body of a company. directors are appointed at general shareholders‟ meetings. in practice, however, the authority and prestige of china‟s boards were comparatively low relative to those in other countries. this is because the majority of listed firms were controlled by the state and thus almost 90% of the board members of these firms were government officials who lacked the necessary knowledge or experience (su, 2005). in 2002, the csrc issued guidelines for introducing independent directors in the boards of listed companies. in particular, each listed company was required to have at least two independent directors, and by june 2003 at least one-third of the board had to be made up by independent directors (including at least one professional in accounting). independent directors could be nominated by the board of directors, the board of supervisors, or any shareholder holding 5 percent of the shares. according to the guidelines, the independent directors were expected to play a better monitoring role than non-executive directors, being more “independent”. they were not allowed to “hold posts in the company other than the position of director” and were asked to “maintain no relations with the listed company and its major shareholders that might prevent them from making objective judgment independently.” independent directors were required to provide independent opinions on substantial decisions, such as the nomination, appointment or removal of directors, the appointment or removal of senior managers, the compensation of directors and senior managers, substantial asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 360 connected transactions (with a value higher than rmb3 million or 5% of latest audited net asset value), and other issues deemed substantial. as can be seen in table 3, we observe a slight decrease in the number of board of directors listed firms over the period 2003-2010 with the number of board of directors declined from 9.814 in 2003 to 9.027 in 2010. by contrast, we observe a steady increase in the proportion of independent directors of companies which increased from 0.327% in 2003 to 0.36% in 2010. yet, in practice, many independent directors in china are, however, appointed by controlling shareholders and their independence from the management is not certain (clarke, 2003; su, 2005). 2.5. board of supervisors the main functions of the supervisors are to oversee finances, ensure diligent actions of the directors and senior management, and report any impropriety, abuse of discretionary power, or action that affects the firm. the company law does not specify the proportion of representatives of shareholders or employees on the board of supervisors, except that at least a third should be worker representatives. moreover, whilst the supervisory board in the german model sits between the shareholders and the management board and can appoint board of directors, in the chinese model, the supervisory board does not have the power to hire and fire directors. consequently, the supervisory power of chinese supervisory boards is relatively soft and seeks to act through influence. commentators point out that chinese supervisory boards are often ineffective, and have little influence on firms‟ activities, since their members have low education and professional experience and their meetings are not well attended (dahya, karbhari, xiao, yang, 2003; tong, 2003; tricker, 2009). 2.6. comparisons of the chinese corporate governance system with that of developed countries there is divergence of corporate governance systems around the world. in the developed world, one of the most prominent distinctions has been made between the anglo-american market based corporate governance model (also known as principal-agent model or shareholder model) which characterizes the us and uk, and the network based models (stakeholder), which operates in germany and japan (ahmadjian and robbins, 2005). the main features of the former are diffuse ownership, a separation of ownership and control, and external market-based financing and discipline, while the latter features concentrated ownership, insider control, and coordinated networks of firms and financial institutions. more specifically, the government is not very involved in the corporate governance system in the us. by contrast, banks and workers play a crucial role in germany‟s governance system. they provide a substantial amount of loans to corporations, own their shares, and intervene in their corporate governance through the appointment of directors or the general monitoring of their performance. additionally, in china, state ownership uniquely provides another corporate governance model with its traditional ideology of employees being masters of the enterprises. in particular, many listed companies in china are still heavily influenced by the government, asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 361 which controls them directly through share ownership, or indirectly by allocating capital to them at favorable rates through state-owned banks. thus, to some extent, the chinese government supplements the market-based economy. 3. china’s banking system and bond market unlike in developed countries, in china alternative governance mechanisms, such as reputation and personal relationship (also known as quanxi (note 5) in china) play crucial role in the financing of firms, especially in the development of entrepreneurial firms. as allen, qian, and qian (2005) discuss, out of three sectors in china, namely, state sector (soes), listed sector and unlisted private sector, the former two sectors use the formal financing channels, such as bank financing and equity and bond markets for financing investment, while a large number of private firms with arguably poor applicable legal and financial sectors use the quanxi system to finance the investment activities which contribute to the most of the growth of china‟s economy. yet, recent studies suggest that following the liberalization of china‟s financial system and the improvement in the corporate governance of the banking sector, chinese banks play an important role in monitoring corporate activities and improving the efficiency of corporations. in this study, since our focus is on the listed firms it is important to have an insight about the chinese banking system, and recent reforms so as to clearly understand their implications for the firms‟ corporate governance and financing of investment. before 1978, china‟s financial system was a mono-bank system with only one bank-the people‟s bank of china (pboc), which played both the role of central bank and commercial bank. beginning in the late 1970s, there was a structural but gradual change in the banking sector. in 1978, in line with economic reforms, the pboc was split into four state-owned banks(known as the big four),with a multi-layered system that separates central banking functions and commercial lending. these were: the pboc which has become china‟s central bank; the bank of china (boc) which specialized in transactions related to foreign trade and investment; the people‟s construction bank of china (pcbc) which specialized in transactions related to fixed investment; and the agriculture bank of china (abc) which specialized in all banking business in rural area. additionally, in 1984, the industrial and commercial bank of china (icbc) was established to take over all commercial transactions (deposit-taking and lending business) of the pboc. icb quickly became china‟s largest bank accounting for half of all bank lending and it is still the leading bank in china (cull and xu, 2003). since 1984, the chinese banking system has been undergoing a series of further reforms, with the objective of making the big four as real enterprises. since 1985, these banks have been permitted to engage in business outside of their designated economic sector. furthermore, in 1994, three wholly state-owned policy banks were established to take over the policy lending functions from the four state owned banks (note 6). from that point onwards, the big four were known as commercial banks and were expected to operate in accordance with market principles. the state-owned commercial banks have also been subject to reform in terms of managerial and mechanistic aspects. for example, the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 362 importance of risk management has been reinforced and their managers are held responsible for their lending decisions. other subsequent developments made during the 1990s, include the transformation of urban credit cooperatives into commercial banks, permitting non-state commercial banks, and introducing standard accounting and prudential norms. furthermore, because of the large volume of policy loans and weak internal controls, by the late 1990s, the accumulated large non-performing loans (npls) of the big four state owned commercial banks and their insolvency had become important issue for the government. in 1998, the government therefore injected rmb 27 billion of capital into the four state-owned banks and transferred the npls to four newly established asset management companies. to enhance the efficiency of the banking sector by increasing competition among banks, in 1986, the chinese government began to establish new banks, known as joint-equity banks and city banks (note 7). by the end of 2004, five of the 11 domestic joint-equity banks were publicly listed on china‟s stock exchanges. however, because the largest shareholders in most of joint-equity banks are usually soes, they are indirectly controlled by the government (note 8). until 2004, the big four were soes solely owned by the chinese government. yet, in 2005, the government started to privatize these banks through the recruitment of strategic investors (by providing minority foreign ownership stakes) and by listing them on the stock exchange. the china banking regulatory commission (cbrc) and the central huijin investment company were set up in 2002 in order to provide closer scrutiny and better monitoring of banking activities, and to facilitate restructuring, reform, and initial public offerings of state-owned banks, respectively another important aspect of the chinese banking system is the entry of foreign banks which predominantly takes place through setting up branches directly. prior to 1993, foreign banks were only allowed to establish branches in certain cities to conduct foreign-currency business with foreign firms and citizens. from 1993 onwards, however, the government started lifting restrictions on foreign bank lending and allowed foreign banks in china to conduct both foreignand local-currency business with foreign firms and citizens, and to conduct foreign-currency business with domestic firms. there were 190 foreign bank branches in china in 2001 (lin, 2011). following its accession to the world trade organization (wto) in december 2001, china has further opened up its banking sector to foreign banks in full scale in the following five-year period. foreign banks in 13 cities were allowed to conduct local-currency business with domestic firms from 2003 onwards. large foreign banks were allowed to acquire significant stake and become strategic partners of major state-owned banks (note 9). by 2006, there were over 300 foreign bank branches in china. despite many policy and regulatory changes have been initiated from early part of the 1980, empirical researches carried out in the first half of the 2000s such as by bandt and li (2003) and cull and xu (2003) show that the chinese banking system discriminates against private firms and private enterprises are generally significantly less likely to obtain loans and receive smaller loans and are subject to higher loan standards. bandt and li (2003) further argue that asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 363 the chinese government‟s majority ownership of banks inevitably lead to less efficient resource allocation and specially capital allocation is biased in favor of soes. since bank managers benefit only marginally from higher bank profitability, they prefer to lend to state-related firms because they enjoy the perks of their relationships with local government officials, who, for example, can use their political power to help arrange a job for a bank manager‟s relative, or facilitate their entry into the chinese communist party. yet, more recent research argues that participation of foreign capital and management in state banks, listing of state banks and many other city commercial banks on stock exchanges from mid-2000, has exerted external market pressure on banks to follow commercial judgment and prudence in their lending practices (jia, 2009 and lin, 2011) (note 10). qin (2007) argues that china‟s accession to wto has made its foreign trade and investment regime much more liberalized and less opaque than a decade ago, specially by institutionalizing the process of china's domestic reform externally through the force of wto obligations. consistent with these developments, firth et al. (2009) provide evidence that chinese banks provide loans to financially healthier and better-governed firms. ayyagari, demirguc-kunt, and maksimovic (2008) suggest that unlike financing from alternative channels, financing from china‟s formal financial system (e.g., bank financing) is associated with faster firm growth. generally, recent studies based on china‟s financial system conclude that chinese banks exercise commercial judgment and prudence in their lending and are becoming more efficient in allocating credit to private firms. thus, chinese banks‟ traditional lending bias in favor of state-owned enterprises is less likely to prevail. in china, the corporate bonds market lags behind the development of the equity market. although bonds were first issued in 1986, the corporate bond market has only begun to expand after 2000, when new rules governing issuance were implemented. local firms, besides the giant soes, are also encouraged to issue corporate bonds and market forces increasingly determine the spread on bonds. yet, china‟s bond market is still very small compared to its huge banking scoter. 4. growth of the chinese private sector one of the most significant changes in china‟s economy brought about by the market-oriented reforms is the emergence of a significant private sector. consequently, the country has gradually shifted away from the complete reliance on state-owned and collective enterprises, towards a mixed economy. private enterprises now play a major role in promoting exports, growth, innovation, and employment in china. the development of the private sector was considered as an important element of the unique chinese „„dual-track” approach to economic reform. in addition to officially recognizing private enterprises in 1988, in the 1990s, government policies began to encourage the transformation of soes and collectives firms into private enterprises (hasan, wachtel, and zhou, 2009). the government has also granted approval for banks to lend to private businesses, thus promoting the growth of numerous smalland medium-sized firms. further, the chinese private sector was formally accepted as an integral part of the economy in 1999 by an amendment to the constitution. as in the western countries, the private sector is considered as the major engine of china‟s rapid asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 364 growth (allen et al., 2005). in 2004, the national congress approved a constitutional amendment to protect private property rights, granting “private property” an equal legal status to “public property”. firth et al. (2009), based on data from the national bureau of statistics, note that the private sector accounted for roughly 50% of gnp in 2005, and was expected to rise to at least 75% by 2010. as for the listed companies, during the last decade there have been significant changes in ownership structure. in particular, walder (2011) reports that the private control of listed corporations in china increased from 6.5% in 1999 to 35% in 2007. similarly, vijayakumaran (2014) observes that the proportion of private controlled listed firms has increased from 26.76% in 2005 to around 40% in 2010. by contrast, the proportion of state-controlled firms has declined from 70.32% to 56.73% over the same time period. as discussed in conyon and he (2012), this trend can be explained by the growing number of firms coming to the exchange as private controlled firms, and by the 2005 split share reform, which converted previously non tradable state and legal person shares to tradable shares. this clearly shows that with the deepening of china‟s market reforms, private controlled firms are becoming more and more common in china. these changes suggest that reforms are making rapid progress and are in line with what would be expected in a market-based economy. 5. conclusion the above analysis shows that china‟s efforts to improve the corporate sector through its own unique gradual and piecemeal approach has been successful in terms of introducing a formal governance structure for the corporate sector, liberalizing its financial sector, improving governance of state owned banks, and most importantly, developing the private sector as the back bone of the economy. furthermore, there have been significant improvements in the political and legal environment. as discussed in hasan et al. 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(2005). politician control, agency problems and ownership reform: evidence from china. economics of transition, 13(1), 1-24. https://doi.org/10.1017/cbo9780511664335 https://doi.org/10.1177/0951692890002004001 https://doi.org/10.1093/jleo/17.1.168 https://doi.org/10.2307/2118354 https://doi.org/10.1016/j.chieco.2004.09.003 https://doi.org/10.1111/j.1468-0351.2007.00292.x https://doi.org/10.1111/j.1467-6486.2007.00752.x http://etheses.dur.ac.uk/10965/ asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 2 ajfa.macrothink.org 368 notes note 1. hereby, we denote with institutions those formal constraints such as rules, laws, and regulations, as well as informal constrains such as norms of behavior, conventions, self-imposed codes of conduct, and enforcement mechanisms, which structure human interaction to reduce uncertainty and provide incentives (north, 1990, 1994). without institutions, markets neither develop nor function properly. note 2. this was a program that permitted, on a selective basis, certain licensed global institutional investors to participate in china‟s mainland stock exchanges by buying and selling yuan-denominated “a” shares. foreign access to these shares is limited by specified quotas that determine the amount of money that the licensed foreign investors are permitted to invest in china's capital markets. note 3. other main qfiis include investment management firms, brokers (securities companies) and investment banks, insurance companies.. note 4. although these changes were gradual and evolutionary compared with those experienced in other transition countries, walder (2011, p. 23) refers to this as a chinese version of “managerial revolution”. it should be noted, however, that the rise in managerial ownership has been slower in china compared to market economies (walder, 2011; 2011; conyon and he, 2012). note 5. guanxi (literally means relationship or connection) “(in china) the system of social networks and influential relationships which facilitate business and other dealings” (online oxford dictionary). note 6. these are the state development bank, the agricultural development bank of china, and the export and import bank of china. note 7. the first joint-equity bank was the bank of communication. note 8. the china minsheng bank was the only joint-equity private bank wholly owned by private shareholders in china. note 9. for example, the hongkong and shanghai banking corporation (hsbc) acquired a 19.9% stake of the bank of communication. the bank of america and the royal bank of scotland have become strategic partners of the china construction bank and the bank of china, respectively note 10. we can observe similar development in the behaviour of auditors in china, for example, chen et al. (2010) who investigate the relation between client importance and audit quality, suggest that auditors in china are more likely to compromise audit quality for economically important clients when the institutions for investor protection are weak. however, with the institutional improvements in china, auditors become more concerned about litigation risks and regulatory sanctions instead of their economic incentives. *this paper was written while dr. r. vijayakumaran was a uk commonwealth doctoral scholar at durham university business school, uk and dr. s. vijayakumaran was a doctoral scholar at durham university business school. microsoft word 12658-43894-1-sm-writer3-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 308 determinants of corporate environmental and social disclosures in china: a comparative study within high-profile industries junru zhang school of business and law edith cowan university australia hadrian geri djajadikerta school of business and law edith cowan university australia terri trireksani school of business and governance murdoch university australia received: feb. 12, 2018 accepted: june 4, 2018 published: june 4, 2018 doi:10.5296/ajfa.v10i1.12658 url: https://doi.org/10.5296/ajfa.v10i1.12658 abstract this study examines the extent of environmental and social disclosures in annual reports made by chinese mining, utility and chemical industries. it also investigates the key drivers of the companies’ environmental and social disclosures (cesd), thereby determining the motivations of the sample organisations towards corporate environmental and social responsibility. the study adopted dichotomous index to measure the extent of cesd among the three industries in their annual reports. additionally, ordinary least square was adopted to examine the determinants of cesd. by drawing on legitimacy theory, the results depict positive associations between the extent of cesd and firm size, profitability, and firm age. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 309 engagement from industry association showed strong significance in environmental disclosure, whereas leverage was significant in social disclosures. government ownership was found insignificant in the analysis. the study contributes with direct evidence to the extent of environmental disclosure and social disclosure made by three high-profile industries based on g3. the results showed that overall there is no significant difference between the extents of cesd of the three industries, indicating that high-profile industries behave similarly in terms of the content of information in disclosure. this study has also practical implications particularly for the regulatory body and the industry association when developing regulations and guidelines on environmental and social reports. keywords: cesd, csr, high-profile industry, legitimacy theory, china asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 310 1. introduction china’s economy has grown rapidly, at a rate of about 10% per annum in the past 30 years (china state statistical bureau, 2006), yet the severe impacts of this expansion on the social and natural environment have received insufficient attention. up until now, chinese firms’ pursuit of profitability in sensitive industries (i.e. industries that are more likely to do environmental damage) has increasingly caused severe environmental and social problems. mining, utility and chemical industries were specified and highlighted to be highly sensitive by the china state statistical bureau and the china electricity council (china state statistical bureau, 2006; “china electricity information”, n.d.). because of the industrial operation processes, in these industries a substantial deleterious environmental impact has been caused in china, where water pollution was highlighted to be one of the most intractable issues (chen, 2010). chen (2010) stated that the seven water systems are in emergency, and protection of the yellow river urgently needs "green gdp" responsibility. poor food product quality, poor production safety facilities, and major health and occupational accident incidents were also revealed by the news media, and identified by researchers as the consequences of the organisations’ pursuit of profit maximisation (chu, 2007; guo, 2005; niu, 2009). in this context, organisations, having the most active role in the market economy, cannot confine their attention to economic goals only, but must focus on a more extended qualitative approach and pay attention to their environmental and social responsibility through internal and external reporting (guthrie & farneti, 2008). according to the definition, environmental and social responsibility reporting assists society to evaluate how well an organisation is performing with respect organisation’s economic and social responsibilities (lewiset al., 1995). however, in china, there are limited legislative accounting standards and legislative requirements for reporting corporate environmental and social information. although a subset of listed firms reporting social responsibility by mandatory requirement (chen et al., 2018), vast majority firms are in the absence of mandatory environmental and social reporting requirements. in 2006 and 2008, the shenzhen and shanghai stock exchange (szse and sse) issued the ‘listed corporate social responsibility (csr) guidelines’, which have been formulated in accordance with the company law and securities law. this subsequently sets mandatory requirement for reporting csr information to the firms in sse 100 index, sse corporate governance firms, and firms listed in foreign markets. while these guidelines instruct and require listed companies to actively fulfil regular assessment of their social and environmental responsibilities, their guidelines are typically generally do not provide specific indication as to what to disclose. on the other hand, public awareness and concerns over environmental and social issues have been highlighted by the media, leading to an urgent need for additional corporate environmental and social disclosures. although more firms are making corporate social and environmental disclosures, the level of disclosure is still inadequate (guo, 2005; liuet al., 2010), especially in aspects of comprehensiveness and consistency, thus hindering appropriate analysis (chu, 2007). in this context, social and environmental disclosures have generated considerably significant issues in the business community and growing awareness asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 311 of these disclosures have encouraged researchers to examine the disclosure information and its determinants (chu, 2007; dai & dong, 2010; guan & yu, 2009; kong, 1996; peng, 2009). given this background, this study examines the extent of environmental and social disclosures in 2010annual reports made by chinese mining, utility and chemical industries. it will also investigate the key drivers of the companies’ environmental and social disclosures and compare the results between each sensitive industry, thereby determining the motivations of the sample organisations towards corporate environmental and social responsibility. the study contributes with direct evidence to the extent of environmental disclosure and social disclosure made by three high-profile industries based on gri(g3). the results showed that overall there is no significant difference between the extent of corporate environmental and social disclosures (cesd) among the sample, indicating that high-profile industries behave similarly in terms of the content of information in disclosure. the result confirms the finding from prior literature one the treatment of sensitive industries as one group (clarkson et al., 2008; ong et al., 2016). in addition, the study also contributes to methodology for cesd measures, where environmental disclosure and social disclosure were measured independently. the analysis showed some difference among the drivers for the measures, even though both dimensions are considered as part of corporate sustainability development. the study indicates that government-ownership is not a strong factor promoting environmental disclosure and social disclosure, and high-profile companies were driven mostly by firm size, years become listed and profitability, which is consistent with the literature (khan et al., 2013; li & zhang, 2010; ghazali, 2007). it is also interesting that the study found engagement from industry unions and associations are strong influence on environmental disclosures but to a much lesser extent to social disclosures. overall, the three industries showed similar determinants of cesd, indicating that their behaviours did not differ significantly. 2. literature review and hypotheses development 2.1. csed regulatory background corporate social and environmental disclosing systems are influenced by both national and local regulations and standards. the disclosing system started with the 1972 united nations conference on the human environmental in stockholm, which later led china’s first national environmental protection conference (lin, 2008). environmental protection offices were then established in 1974 and it pronounced the first the prc’s environmental regulation. the chinese corporate environmental and social reporting and provisions, which are subjected to the constitution of the people’s republic of china (prc), consist of laws, provisions, regulations, ministerial and local regulations based on the environmental protection act of the prc (guo, 2005). lin (2008) found that there are implicit corporate social responsibility (csr) disclosure obligations in the annual report under the current regulations – the regulation on the contents and formats of the annual report (the annual reporting regulation)” (lin, 2008). the 2006 company law requires listed companies to consider environmental and social responsibilities in business operations. the code corporate governance for listed companies in china was also promulgated in asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 312 2002, and it addresses that a listed company shall consider in the perspectives of the interest of banks, other creditors, employees, consumers, supplies, communities and other stakeholders. a number of sections and items from the code require companies to disclosure relevant information regarding stakeholders, such as article 28, 30 and section 8, which require directors to disclose in the manner of the interests of stakeholder concerning companies' sustainability issues, and for those companies that do not disclose, appropriate explanations for not disclosing are required to be given. it seems that under the current chinese regulations, listed companies are required to undertake corporate social responsibility and consider the extent of their social and environmental performance in business operations. however, these regulations do not give specific list of guidelines on what to disclose and how to put it into practice. therefore, the current regulations are not adequate. although these articles require a range of information that directors should disclose, there are no specific indicators and sectors from the laws regarding environmental and social information. this suggests that corporate social and environmental disclosure (cesd) benefits stakeholders to a great extent but disclosures are not essentially mandatory. it concludes that corporate environmental and social reporting still remains voluntary for vast majority firms in the chinese disclosure system. 2.2. corporate responsibility guidelines in 2006, one of the two central regions stock exchange markets in china, shenzhen security exchange (szse) issued the shenzhen stock exchange guidelines on corporate social responsibility (csr) to acknowledge listed companies implementing social and environmental responsibility based on the laws, standards, regulations and rules (wang et al., 2010). according to the szse guidelines, the publication is “based on the company law and the securities law with purposes of achieving scientific development, building harmonious society, advancing toward economic and social sustainable development, and promoting corporate social responsibility” (shenzhen stock exchange corporate social disclosure guideline, n.d.). although the szse guidelines were announced by the stock exchange market, applying them was under the supervision of the government. the basic framework of theszse guidelines is referred to as the gri, which contain 8 chapters and 38 items that encourage the listed companies to commit to social accountability and promote sustainable economic and social development. since the szse guidelines on csr were issued, the listed companies in the shenzhen stock exchange have started to declare their csr disclosure, and the guidelines are recognized as a standard measurement from many shareholders (yuan, 2007). existing studies suggest that the szse guidelines play an important role in improving the quality and quantity of corporate social disclosure. chen (2010) explains that no companies were disclosing separate environmental and social reports or including csr in an ordinary annual report before the szse guidelines became published. yet in 2007, 20 listed companies issued their stand-alone reports and have referenced szse as their preferred guidelines. the guidelines issued from shenzhen stock exchange markets are voluntary initiatives and companies are not obliged to follow them. however, the standards have played an important role in guiding and monitoring the listed companies. yin and yu (2009) investigated the present status of the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 313 level of corporate social and environmental responsibility in all chinese listed firms. they concluded that in the 2008 financial year, 32.5% of the listed companies applied the szse guidelines for their social and environmental reporting (yin & yu, 2009). the significance of the szse guidelines can be observed over the past years; however, they are not a suitable guideline for research purposes. the szse guidelines were influenced by the chinese government to a significant extent; however, they are not mandatory and still remain as an advocacy and suggestive reminders. several researchers have pointed out that the szse guidelines do not provide the details of corporate environmental and social practices (cheng & tan, 2008; nie, 2009; peng, 2009). for example, article 35 explains that “companies should establish the social responsibility mechanism as required by these instructions and work out social responsibility reports on a regular basis based on their review and evaluation of the status quo”; and article 33 indicates that “companies shall accept the supervision and inspection of the competent authorities and pay due regard to the public comments and media reports on themselves” (shenzhen stock exchange corporate social disclosure guideline, n.d.). these items encourage companies to disclose; however, there is no specific information in these guidelines. 2.3. empirical studies in corporate social responsibility disclosures there has been increasingly large number of studies on corporate social responsibility (csr) since early 2000, when developed nations started to promote csr. two main streams of research have been developed. the first stream includes studies on developing the measures and the instruments of corporate social responsibility, involving mainly the scale of csr based on stakeholders’ perception or from institutional demand (lu & abeysekera, 2017; chow & chen, 2012; zhang et al., 2014; ong et al., 2016). another stream focuses on the drivers of csr, including testing the relevance of csr with firm performance (zhu & zhang, 2015; chen et al., 2018), corporate governance (jo & harjoto, 2012; flammer et al., 2017; hubbard et al., 2017; harjoto & jo, 2011), or ownership structures (khan et al., 2013; li & zhang 2010; ghazali, 2007). to define corporate environmental and social disclosures in the chinese context, lu & abeysekra (2015) developed a stakeholder-driven social and environmental index, which is examined among stakeholders, including shareholders, managers, creditors, regulators, hr managers, company employees, customers, suppliers, local community and media. the study indicated considerable difference in the perception of the stakeholders to corporate social responsibility based on the gri criteria, in which stakeholder-oriented concept, such as labour and workplace treatment was perceived much importantly. chow & chen (2012) found similar results that corporate managers are more likely to be driven by issues with high level of legitimation. in their study, environmental constructs were highly perceived due to the government engagement in environmental issue and companies’ strategic choice of environmental sustainability. both studies highlighted the importance of environmental and social constructs when investigation csr. later in 2016, ong et al. (2016) extended the concept of hard disclosure and soft disclosure based on clarkson et al. (2008). the study emphases the importance of including sustainability hard disclosure when developing a scale asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 314 in content analysis for cesd. hard sustainability disclosure refers to environmental performance indicator that is disclosed at the expense of the reporting firm, thereby hard to be mimetic by its peer firms (clarkson et al., 2008). ong et al. (2016) extend the concept from environmental aspect to other sustainability aspects, including governance, credibility, economic and social, and confirmed the values and the credibility of the hard sustainability disclosure items from gri. prior literature confirms the scale on environmental and social items when measure cesd, as well as involving gri in the valuation. this showed clear indication for measuring cesd for studies focusing on the drivers, particularly the chinese studies which are not very much reviewed in the existing literature. an empirical study conducted by yang (2009) adopted 208 small to medium firms in analysis using questionnaire. the questions reflected the firm’s intensity of social responsibility towards employees and the public, in which the questions were grouped into firm specific factors and external factors, such as competitiveness of the market and the legal environment. the hypothesised variables were directly influenced by the questionnaire results. however, the external factors were not significant predictors of corporate social responsibility reporting. yang (2009) found that the competitiveness of the market and the legal environmental condition were not perceived to influence corporate social responsibility disclosure at all. in contrast, the degree of social disclosures was strongly related to internal factors such as export intensity, innovation capability, management level, liquidity and financing capability. luo and wu (2010) and lianget al. (2011) used a similar approach to yang (2009), where performance related factors were considered. each variable was selected based on a number of prior research studies. luo and wu (2010) tested 336 sample companies listed on the shenzhen and shanghai stock exchange by analysing their 2006 annual reports. factor analysis was used to construct a measure of csd based on firms’ ability to perform, growth, size and leverage factors. the authors considered that the influential factors behind csd cannot be observed directly, but indirect associations can be found by analysing indirect indicators. in this case, a factor analysis was applied to reflect a high level of objectivity in the overall analysis. the authors found that csd is predominantly related with corporate profitability and growth ability. return on equity (roe), return on asset (roa) and earnings per share (eps) were the key variables explaining csd, as well as asset and sales growth. firms are more likely to disclose, with higher intensity, in profitable companies. while firm size, growth capacity, core competencies and solvency also show a positive association with csd; no significance was obtained. in contrast, liang et al. (2011) found that financial performance, company growth, asset quality and risk control were not influential to corporate social responsibility disclosure. they evaluated the quality of social responsibility from corporate standalone sustainability reports between 2005 and 2008 in 25 companies in banking industries. contrary to luo and wu (2010), they adopted an unweighted index. the global reporting initiative (g3) was used to identify disclosure items and indicators of the intensity of csd. subsequently, the voluntary social disclosures were considered under4 categories: social, customers, employees and stakeholders. the authors found that listed companies with large firm size had stronger levels asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 315 of social responsibility. disclosure quality also improves with the number of times a firm disclosed. they also found that stakeholders only pay little attention to csd; the only relevant indicators were whether a company is listed. in other words, listed banks are often strictly required by the exchange markets to disclose social information. li (2006)examined the relationship between the level of a firms’ social and environmental performance and the value of the sample 521 firms in year 2005, excluding financial companies listed in shenzhen and shanghai stock exchange market. the annual reports of each of the companies were collected to ascertain the level of cesd information. li measured the categories of cesd by referring to the chinese corporate governance guidelines, such as responsibility to the environment, employees, local community, consumers and stakeholders. tobin’s q value was used to measure the value of a firm. li (2006) demonstrated that firm size (total assets), industry type and leverage were significant to the level of disclosure, but a negative correlation was found between the firm value and the level of cesd. with companies issuing st shares, profitability was found to be significantly negative to cesd activities. yuan (2007) also examined the correlation between cesd and firm value, however, cesd was found to be positively related with firms with a higher value are more likely to provide better cesd quality. yuan (2007) analysed the influential factors of disclosing firms’ social and environmental responsibilities based on annual reports. the author used a set of relevant indicators and terms from the gri, the kinder, lydenberg and domini (kld) 400 social index and the dow jones sustainability index. in this study, hypothesized variables were selected in aspects of firm specific factors, performance and governance. a multi-theoretical framework which were combined with stakeholder theory, information asymmetry theory, substitution theory and signal transfer theory, were adopted. the research compared 2005 annual reports, interim reports and quarterly reports for 291 listed companies in shenzhen and shanghai stock exchange, adopting the szse guideline. it was found that large firms better performed in roe were significant to the level of cesd. for those companies which disclosed social and environmental information with higher intensity, a significant association to the heavy pollution industries (manufacturing, mining and oil and gas companies) were also concluded. liuet al. (2009) used the same methodology as yuan (2007) where tobin’s q value was used to evaluate the value of a firm, and they tested the cesd in relation to firms’ value. the authors also adopted stakeholder theory and ascertained performance and firm specific factors. the items were selected from the shanghai exchange corporate social and environmental disclosure guidelines. liu et al. (2009) found that large firms would be much more likely to disclose social information, and the intensity of disclosed social information had no influence to firm’s value. the study comprised of a sample of 115 companies’ annual reports for 2007 excluding firms from the financial and insurance industries listed in shanghai exchange. chu (2007) investigated the relationship between the implementation of firms’ social responsibility and market performance in terms of ‘contribution’ expenses. annual reports for asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 316 2003, 2004, and 2005 were extracted from a sample of 123 industrial companies listed on shanghai stock exchange. the population for this study was 156. market performance was measured in 2004, 2005 and 2006 from china stock information database. stakeholder theory and efficient capital market theory were adopted for selecting the variables. the author adopted the ‘contribution rate’ analysis in this study, where firms’ expense on tax, dividends, employee wages, environmental protection, legal right and total contribution to the society were taken into account to measure the intensity of social responsibility. however, the author demonstrates that only the amount of total contribution to society has a significant positive relationship to firms’ market performance. no association was found either from dividend expense or legal right. therefore, the amount a firm spent on a series of social activities could not be fully explained to be significantly associated with cesd, which is not relevant to the firm value either. existing studies indicate that performance indicators(e.g. roa and roe) were the key drivers that influence both csd and cesd. firms within heavy polluting industries, including mining, manufacturing, oil and gas, and water and utility sectors, were shown to disclose more information (luo & wu, 2010; yuan, 2007; li et al., 2009; nie, 2009, dai & dong, 2010, liu et al., 2009; peng, 2009; song & zu, 2009). the large number of social and environmental criteria used to score cesd may at least partly explain these inconsistent results. these criteria included szse corporate social disclosure guidelines, sse social and environmental disclosure guidelines, chinese corporate governance guidelines, kld400 social index and gri. peng (2009), nie (2009) and liang et al. (2011) aimed to develop an appropriate frame in order to guide the companies to disclose social information to an acceptable level. on the other hand, li(2006), yuan (2007) and liu et al. (2009) used the tobin’s q value to determine firm value, and nie (2009), chu (2010) and dai and dong (2010) adopted the ‘contribution’ perspective, where the amount spent on each indicator disclosed in cesd was considered. furthermore, studies of environmental and social disclosures that applied an unweighted index method were not shown to be using solely the gri index. this review of the literature highlights the increasing concerns from the stakeholders to csd, and the close association between corporate characteristics and voluntary social and environmental disclosures. however, these existing chinese studies have only been mainly based on stakeholder theory, and the results are inconsistent with various methods to measure the extent of cesd. hence, there is a gap for adopting the legitimacy theory in order to determining the motivations of cesd. in addition, the extent of cesd was not measured by the dichotomous index under the g3 initiatives, neither was the gri considered to be used solely. this study is designed to overcome the shortcomings from the previous studies in china. an unweighted index will be used under the g3 guidelines. as chen (2010) stated, the chinese corporations receive significant pressure from the government, which may be the reason that firms reporting social information to ‘rescue’ their legitimacy. thus, the hypotheses development and variables are considered from the legitimacy theory approach. in addition, the sample of the study includes the sensitive industries, which are mining, utility and chemical companies. the extent of csed is measured independent from two asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 317 perspectives: corporate environmental disclosure and social disclosure. 2.4. legitimacy theory from an organisational view, legitimacy is an operational resource that an organisation extracts from its society or cultural environment in order to pursue the goals. legitimacy is a generalised perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs and definitions” (suchman, 1995, p. 574). suchman (1995) states that legitimacy is an operation resource that organizations extract from their cultural environments and that they employ in pursuit of their goals. deegan (2002) defined that organisations continually seek to ensure that their activities are perceived by outside parties as ‘legitimate’. they are social creations where “firms are recognised by performing various social actions” (deegan, 2002, p. 292). under this definition, the willingness of societal acceptance of organisations’ continuing operation largely influences companies’ social citizenship. within the legitimacy theory, ‘legitimacy’ is considered as a fundamental resource on which an organisation is dependent for survival (o’donovan, 2002). there are certain actions and events can increase legitimacy whereas some decrease it. organisations having low legitimacy will have potentially negative consequences “which eventually lead to the forfeiture of their right to operate” (tilling, 2004, p.4). however, the amount of legitimacy is often very subjective. hybels (1995) argued that good models in the legitimacy theory must examine the relevant stakeholders. this is to ensure that how important the stakeholders influence the flow of business resources. critical organisational stakeholders were identified by hybels (1995), such as the state, the public, the financial community and the media. the importance of each stakeholder is different across nations due to cultural differences. therefore, under this approach, the organisations are assumed to be influenced by their continuing operations, as well as the society where they operate. an important reason the legitimacy theory is suitable is that, in china, an inseparable relationship between the state and its firms generates important social roles for the state-owned firms. this enables chinese companies, particularly the state-owned companies, to have a tradition of taking social and environmental responsibilities (li &wang, 1996). this legacy of the ‘iron rice bowl’ concept regarding lifetime employment and welfare persists (song & zu, 2010), although a lesser degree can be observed in modern china. in addition, the managers in the state sector maybe often appointed by the communist party, subsequently, decisions made by the state-owned firms maybe amended by the party leader. as a result, the management level of the appointed firms would always be the communist party members. therefore, “they would naturally share their ideology with the state in favour of the communist tradition” (song & zu, 2010, p.106). also, the mining, utility and chemical industries are the most sensitive industries, which are often exposed and concerned by the mass media and the public (wang et al., 2010). according to o’donovan (2002), repair legitimacy has been often related to crisis management. this suggests that companies in sensitive industries are more likely to be more “reactive, usually to an unforeseen and immediate environmental crisis” (o’donovan, 2002, p. 344). in addition, to maintaining or gaining legitimacy, managements are required to “keep current” and be “proactive” with their asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 318 social responsibility as the public requires over time (o’donovan, 2002). in other words, cesd through annual reports can be explained as one of the effective communication tactics to implement legitimisation strategies (lindblom, 1994). therefore, the legitimacy theory predicts that companies issuing social and environmental disclosure will obtain, retain or repair legitimacy effectively. 2.5. government ownership (gown) state-owned firms receive close attention by the government and the public because these firms’ operations and activities are often exposed and directly linked with the society and the media due to their perceived market power position and ownership structure (li & zhang, 2010). to avoid unfavourable news and influences, the management is more likely to disclose voluntary environmental and social information. existing literature (li & zhang, 2010) found positive association between government ownership and the extent of social and environmental disclosure that sample companies reported. further, kato & long (2006) indicated the structure of the government-ownership possess a strong connection with the pay towards social responsibility. similarly, findings were confirmed by situ et al. (2015), in which government engagement into ownership play vital role influencing the extent of environmental disclosure. although the majority of the studies has considered the relationship between government-ownership and the extent of cesd, there is limited evidence to show the drivers within high-profiles industries linked with the extent of disclosure. therefore, this study measures government ownership by a dummy variable to ‘1’ if a firm has government-ownership, otherwise ‘0’. h1a: the extent of voluntary environmental disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to government ownership. h1b: the extent of voluntary social disclosures in the annual reports of chinese listed utility companies is positively related to government ownership. 2.6. management role (mngr) more responsible managers are often assumed to provide better voluntary environmental and social disclosure. according to o’donovan (2002), managerial intentions of using legitimisation strategies can vary among industries. in sensitive industries, companies are subjected to greater public exposure, thus management might elect maintain, gain or repair legitimacy through public disclosures (hu, 2009). from the legitimacy theory perspective, these three strategies are in a sequence that reflects increasing difficulty for management and higher levels of required proactive involvement particularly in annual reporting (deegan, 2009). this response is facilitated by the level of internal control that a high management role provides. however, management may adopt accounting policies that suit their personal benefit (yuan, 2007). in this situation, rather than electing legitimacy, they may pursue short-term benefit, neglecting the enterprises’ long-term sustainable benefit such as environment protection and employee welfare (yuan, 2007). according to other studies, management role is measured by the proportion of independent directors over the total number of directors (yuan, 2007; nie, 2009). this study assumes that the higher the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 319 management role, the more likely a company would issue environmental and social disclosure (see li, 2006; yuan, 2007). therefore, the following hypothesis is tested to determine the relationship between management role and the level of voluntary environmental and social disclosures. management role rate is measured by the ratio between the number of independent directors and the total number of directors. h2a: the extent of voluntary environmental disclosures in the annual reports of chinese listed mining, utility and chemical companies is positively related to management role. h2b: the extent of voluntary social disclosures in the annual reports of chinese listed mining, utility and chemical companies is positively related to management role. 2.7. member of industrial association (mia) due to the nature of social and environment sensitive work, there are a number of industrial associations established by the government for supervising and monitoring purposes. these companies are therefore more likely to face media exposure and political pressure from the government because they are directly monitored by the state. under the legitimacy theory, those companies will be more likely to lose legitimacy which threatens their ‘survivals’ to a significant extent (deegan, 2002). previous studies have indicated that in china, the presence of being a member of a local industrial association would have a considerable impact to companies’ behaviour implementing their social contract to the society where they operate (li, 2006). to measure the association between the samples with industrial association, a dummy variable of ‘1’ is used if a company is a member, other ‘0’. h3a: the extent of voluntary environmental disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to membership of an industrial association. h3b: the extent of voluntary social disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to membership of an industrial association. 2.8. profitability (prof) the relationship between profitability and the level of environmental and social disclosure has been thoroughly discussed in existing literature (liu et al., 2009; yuan, 2007; peng, 2009), where firms with higher financial performance are more likely to have a more advanced social disclosure. legitimacy theory posits that companies are bound to an unwritten social contract within the society where they operate. failure to comply with their legitimacy will threaten companies’ performances and ‘survival’ (deegan, 2002). in addition, nie (2009) noted that positive news may facilitate investors’ decision-making processes, and encourage them to build trust upon management. in return, this will reflect from management’s compensation because a substantial increase in profit is shown to the shareholders, and so managers are more likely to disclose voluntary social information. hence, it is not only in response to the ‘resource’ by the society where companies operate, higher profitable companies will be more likely to disclose voluntary environmental and social information. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 320 return on assets (roa) is used as a proxy to measure profitability. h4a: the extent of voluntary environmental disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to profitability. h4b: the extent of voluntary social disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to profitability. 2.9. operating leverage (lev) there are a number of ways that companies may adapt in order to comply with social expectations and maintain or obtain legitimacy. dowling and pfeffer (1975) indicated that an organisation may consider altering the definition of social legitimacy through communication. therefore, disclosing social and environmental information matches the organisation’s practice, output and value. however, companies may have different capital structure, which creates conflicts to management to disclose or not. leverage ratio represents a company’s ability to meet financial obligations, and can capture the importance of creditors as stakeholders in a firm’s wealth (ma & zhao, 2009). as creditors and financial institutions may share potential liabilities, they may demand information in order to meet their debt obligations. potentially, there can be conflicts between disclosing social information and incentives of management. this is because from the shareholders’ perspective, disclosure of social and environmental information may be perceived as a confession of guilt, so that they are reluctant to issue social disclosure in order to maintain their own value (ma & zhao, 2009). according to christopher and filipovic (2008) and ma and zhao (2009) the higher the leverage, the more the company is likely to disclose social information. this also implies that if creditors are concerned with social responsibility activities, the company will be more likely to disclose environmental and social information. leverage in this study is measured by debt to equity for operating leverage ratio. h5a: the extent of voluntary environmental disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to operating leverage. h5b: the extent of voluntary social disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to operating leverage. 2.10. company age (age) under the legitimacy theory, organisations’ societal existence depends on the acceptance of the society where they operate. as the organisations can be influenced by, and have influences to the society, legitimacy is assumed as an important resource determining their survival (deegan, 2002). older companies with longer societal existence may have taken relatively more legitimacy. according to yang (2009), these companies usually have longer performance experience and histories, and are mature. subsequently, organisations’ reputation and involvement of social responsibility may become ingrained (kong, 1996). as a company operates longer, there will be more communication needed to the outside community. this provides companies with wide social networks, affecting their public images (yang, 2009). in sensitive industries, the public and the media can be quickly alerted if a mature company asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 321 reduces the extent of social activities. consequently, it will result in company regulations and political pressure from the outside to encourage disclosing social responsibility and practices (yuan, 2007). as voluntary social disclosure is a way that management can actively overcome this pressure from the public, the longer a company has been listed on the stock exchange, the more likely the company would disclose social information. other studies have found positive significant relations between company age and the extent of voluntary social disclosure (roberts, 1992; yang, 2009). company age in this study, therefore, is measured by the number of years a company has become listed. h6a: the extent of voluntary environmental disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to company age. h6b: the extent of voluntary social disclosure in the annual reports of chinese listed mining, utility and chemical companies is positively related to company age. 2.11. firm size (size) large firms in sensitive industries are deemed to be more subjected to public exposure, and often they would face more legitimate issues than smaller firms (watts & zimmerman, 1978). as a result, large firms can be easily subjected to “public expectation of social performance, government-imposed taxation and other regulations, as well as more media attention and exposure” (hu, 2009, p. 53). hence, larger firms are more likely to use certain accounting policies in order to enhance their legitimacy. in addition, under the legitimacy theory, large companies would be expected to comply with their ‘social contact’. one effective way that they can present this, is by reporting environmental and social information through annual reports. following the legitimacy theory, larger firms would have more incentive to disclose voluntary environmental and social information to manage their social contract and legitimacy. h7a: the extent of voluntary environmental and social disclosure in the annual reports of chinese listed mining companies is positively related to firm size. h7b: the extent of voluntary environmental and social disclosure in the annual reports of chinese listed utility companies is positively related to firm size. h7c: the extent of voluntary environmental and social disclosure in the annual reports of chinese listed chemical companies is positively related to firm size. in previous research, firm size has been mostly measured by total assets when legitimacy isof concerned (dai & dong, 2010; hu, 2009). to be consistent, this study uses total assets to represent firm size. 3. methods a sample of large high-profile listed companies in china were selected for hypothesis testing, which include the mining, utility and chemical industries. the listed chinese companies started to report social responsibility to difference context due to the controls from regulatory bodies, as such companies by mandatory requirement were excluded from the samples. the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 322 total sample firms adopted in this study, thus, includes 47 mining firms, 73 utility firms and 73 chemical firms. in order to testify social and environmental disclosures in report, annual reports in 2010 were collected to examine the extent and the determinants of corporate social and environmental disclosures. in this study, the entire population in the listed mining and utility industries were employed, which were 50 and 75 respective. additionally, a sample of 83 chemical companies was also selected for comparison of the legitimacy within the high-profile industries. to examine the extent of corporate social and environmental disclosures, a dichotomous index (unweighted index) will be used in this study to score the sample companies against each of the gri indicators. alternative indices were previously used by researchers, such as the number of words or weighted index. however, this study is concerned with the extent of the corporate environmental and social disclosures as opposed to the company’s importance on disclosed items. one advantage for using unweighted index is that it decreases and avoids the items being treated unequally, and minimises the risk of subjectivity created when measuring the actual quantity of environmental and social disclosure. for content analysis, a score of one for each indicator provided, and a score of zero for indicators not reported. the gri environmental or social indicators were added independently to provide total scores for the extent of each environmental or social disclosure by the selected companies. to testify the determinants of the extent of disclosures, ordinary least square multi-regressions model is used to identify the contribution to the significance of each added independent variable and determining the key influential characterises. prior to using the regression model, it is required to test the assumptions in order to ascertain they are true, for example normality and multicollinearity. a regression model is considered to provide better robust results because it examines the combined influence of all variables to explain their relations to corporate environmental disclosure and social disclosure, and how each variable influence disclosure (coakeset al., 2010). according to hairet al.(1995), multi-regression model evaluates the predictive power of explanatory variable objectively while improving the prediction of dependent variable. thus, it demonstrates statistical significance to how each independent variable affects the extent of corporate environmental and social disclosure. another reason for choosing this method is that the majority of independent variables are either ratio or continuous variables, whereas the dependent variables are additive and non-continuous (mendenhallet al., 1988).the models tested are shown as follows: model 1 cesd = + + + + + + + + (1) model 2 cesd = + + + + + + + + (2) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 323 4. results 4.1. level of environmental and social reporting the descriptive statistics that show the number of gri disclosures and percentage of companies disclosing in china are presented in table 1. within the 193 sample annual reports were viewed in total, it is notable that many companies have disclosed only general and positive information. a few companies reported information specifically related to corporate environmental information. mining companies have achieved an average of 2.68 disclosures per company, but utility and chemical companies experienced a substantial decrease of 9.7% and 32% (2.42 and 1.82 disclosures per company). this result shows that the extent of environmental disclosure in the sample company is not generally high. the figure shows also that there are 30 disclosing items listed in the g3 and only less than 10% are being reported by these companies. interestingly, there are equal amount of disclosing and non-disclosing companies in utility and chemical industries. mining companies present the highest number of disclosing companies, with only 3 non-disclosing companies. in utility and chemical companies, the percentage in the number of disclosing companies drops by 16.27%. the results from descriptive statistical overall shows that the extent of environmental disclosure is considerably similar for the three industries. note that the ranges of initiatives reported are kept constant from 1 to 10 in mining industry and 1 to 11 in utility and chemical industries. this suggests that there are some companies which choose to enhance their environmental reporting by following the gri and achieved comparatively high scores of 10 and 11, although only 30 percent of the g3 disclosing items were reported. this again reflects the overall chinese voluntary environmental disclosing level is typically low. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 324 table 1. descriptive statistics for environmental disclosures mining industry utilityindustry chemical industry mean 2.68 2.42 1.82 standarddeviation 2.406 2.345 1.888 range 0-10 0-11 0-11 non-disclosingcompanies 3 13 13 disclosing companies 44 60 60 non-disclosingcompanies in % 6.4% 21.67% 21.67% disclosing companiesin % 93.6% 78.33% 78.33% total number ofcompanies 47 73 73 for social disclosures, companies from all three industries participated to some extent of social disclosure, which means there was at least one item disclosed by the sample companies. due to the entire sample companies have disclosed information included in these items, the disclosing rate remains high comparing with environmental disclosure. as table 2 presents, utility industry has the highest mean value, where averages of 5.55 social gri indicators were obtained from companies’ annual reports. this is followed by the mining industry, then chemical industry, in which 5.49 and 4.96 disclosures were shown in annual reports. these results show that the extent of social disclosure in the sample companies across industries is similar but remain typically low. this is because there are 40 disclosing items listed in the g3 social indicators and only on an average of 5.49 were disclosed in mining industry, 5.55 were disclosed in utility industry and 4.96 were disclosed in chemical industry. in addition, the range for social disclosures for all industries has a minimum of 4 and a maximum of 15 for mining industry, 14 for utility industry and 9 for chemical industry; however, the mean values are not much more than the minimum of their range. therefore, the social reporting performances from sample industries are not high, and they remain approximately the same across industries. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 325 table 2. descriptive statistics for social disclosures mining industry utilityindustry chemical industry mean 5.49 5.55 4.96 standard deviation 1.921 2.028 1.086 range 4-15 4-14 4-9 non-disclosing companies 0 0 0 disclosing companies 47 73 73 non-disclosing companies in % 0% 0% 0% disclosing companies in % 100% 100% 100% total number of companies 47 73 73 4.2. the drivers of environmental disclosure the results from multiple regressions showed the models are statistically significant to mining, utility and chemical industries. table 3 presents the standardised beta comparison across industries with the associated p values. interestingly, member of industrial association, company listing age and company size were found to be statistically significant among all industries. the independent variable, member of industrial association, influences utility industry the most with beta of 0.490, following by chemical industry and mining industry with beta of 0.420 and 0.305 respectively. company listing age and company size were also found to be significant, influencing the mining industry the most with betas of 0.156 and 0.461, followed by utility industry and chemical industry with betas 0.141, 0.270 and 0.139, 0.255. company profitability was found to be a key determinant in both mining and chemical industries, and it correlates mining industry with beta of 0.421, whereas the beta for chemical industry is 0.171. although it does not show a significant p value for utility industry, the significance level approaches the moderate level. moreover, leverage ratio is only found to be significant in utility industry, and the remaining variables (i.e. government ownership and management role) did not show any significant results. in summary, there is not much difference that the independent variables influence across industries. it is interesting that government ownership and the independent director ratio were not shown to be significant in any of the sample industries; however, the overall results show that the three industries share a lot in common and they do have the same trend in predicting the extent of environmental disclosures by using the same independent variables. this indicates that it might be possible to have the three industries included in one single model instead of asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 326 three different models. table 3. results of multiple regressions (environmental disclosure) variable hypothesis expected sign mining utility chemical gown h1 + 0.110 0.124 0.058 mia h3 + 0.305** 0.490*** 0.420*** age h6 + 0.156** 0.141** 0.139* size h7 + 0.461*** 0.270** 0.255** prof h4 + 0.421*** 0.157* 0.477*** lev h5 + 0.129 0.450*** 0.176* mngr h2 + 0.128* 0.159* 0.125 r2 0.364 0.322 0.327 note: nmining=47, nutility=73, nchemical=73; r-square significant tests are based on f values; *p<0.1; **p<0.05;***p<0.01, two-tailed coefficient test 4.3. the drivers of social disclosure the models of social disclosure also showed statistical significance among mining, utility and chemical industries. table 4 shows that the sample industries share much in common based on the legitimacy theory and they are found to be considerably similar. size is found to be significant in both the mining industry and utility industry, and the extent of prof’s influences is similar; they have betas of 0.565 and 0.503 respectively. although it was found to be insignificant in chemical industry, the p value of size approached the moderate significance level with a beta of 0.315. variable size was found to be significant in all sample industries. it is most significant that the chemical companies had a beta of 0.504. size influences to a lesser extent than in the other two industries, where the betas are 0.495 and 0.413. in addition, mngr of the chemical industry similarly has the highest value of beta; this was shown to be statistically significant. the mining industry and utility industry, had betas of 0.423 and 0.393. for variable lev, mining and utility industries had moderate significance levels, and it influences mining industry with beta of 0.437. utility was influenced the most with a beta value of 0.447. since this variable was transformed back to lev, it is no longer significant to chemical industry. age was only found to be significant in chemical industry, and the remaining sample industries sampled were found to have largely insignificant levels, approaching moderate significance level at best. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 327 interestingly, gown and mia were found to be insignificant in all three industries; however, the p values approach moderate significance level and their signs meet the expected signs directions. the overall comparison indicates that the empirical evidence shows most of the hypothesised variables are able to explain the extent of social disclosure in chinese mining, utility, and chemical companies. there are four independent variables, size, prof, lev and mngr, which the sample companies have in common, indicate whether they influence and determine the extent of social disclosure. moreover, gown and mia were found to be insignificant in all industries while approaching moderate significance level. therefore, the results reveal that overall, the three industries were determined by the same variables, and that it may be possible to have the three industries included in one model instead of three. table 4. results of multiple regressions (social disclosure) variable hypothesis expected sign mining utility chemical gown h1 + 0.312* 0.189* 0.149* mia h3 + 0.395* 0.285* 0.126 age h6 + 0.388* 0.155 0.317** lnsize h7 + 0.495** 0.413** 0.504*** recprof h4 + 0.465*** 0.503*** 0.315* lev h5 + 0.437* 0.447** 0.299** mngr h2 + 0.423** 0.393** 0.513*** r2 0.381 0.329 0.392 note: nmining=47, nutility=73, nchemical=73; r-square significant tests are based on f values; *p<0.1; **p<0.05;***p<0.01, two-tailed coefficient test 5. discussion and findings the results from this study indicate that certain variables from the legitimacy theory are able to explain the extent of voluntary environmental disclosures in chinese mining, utility and chemical companies' annual reports, whilst other variables are less able to.in terms of the results for environmental disclosures, this study shows the applicability and predictive power of the legitimacy theory by having more than half of the predicting variables being statistically significant. first, companies that are more profitable (in terms of roa), disclose significantly more than the others that are less profitable. although this hypothesis shows a moderate significance in electricity companies, it is still statistically significant. this corresponds with the legitimacy theory that suggests older, larger and profitable companies asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 328 face more media exposure, which can threaten their survivals. in the circumstance, they obtain social acceptance or reputation for being the societal citizen through environmental disclosures. it indicates that while these companies are able to remain profitable, they are also capable of implementing corporate environmental responsibility. moreover, companies that have become a member of industrial associations established by the government disclose significantly more environmental information in their annual reports than the other ones across the three sample industries. due to the natural environmental sensitive business activities, chinese industrial associations have set policies for companies to implement environmental responsibilities in accordance with the national sustainability plans. companies that do not disclose the required amount of information are more likely to experience legitimacy loss through industrial media exposure. as explained by the legitimacy theory, a considerable impact to companies’ social contract can influence their survival significantly (o’donovan, 2002); therefore, companies are willing to disclose more information. in addition, the results show that these associations have played extraordinarily well in terms of supervising and monitoring. according to the 10th five-year plan, the chinese government announced to reduce pollution emissions by 10% but it did not meet the target by the end. the objective to reduce emissions by another 10% has been set in the 11thfive-year plan (valid from 2006 to 2010), and 14.29% for the 12th five year plan. these plans have been incorporated by the industrial associations in order to improving the current status of corporate environmental performance in china. however, plans are not mandatory regulations and rules, and having the plans cannot increase the overall environmental disclosure after all. another reason could be the five years sustainable plan, where information regarding companies’ use of material, energy consumption and general performance on environment is encouraged in annual reports. nonetheless, disclosure is on a voluntary basis; some companies choose to follow the advice while some do not. in addition, as suggested by the legitimacy theory, environment-sensitive industries are more likely to face legitimacy issues and directors in those companies are more likely to disclose relevant information in order to promote or rescue companies’ social acceptance. this could be the reason that mining companies disclose more information than the other two industries. the china electricity council has indicated that the chinese mining industry has become increasingly concerned nationally about its environmental performances. it is ranked as the top environmentally concerned industry by chinese industrial association, and is also sensitive to the public's concern about its matter. by looking at the results from mining industry, multivariate analysis shows that membership of industrial association and profitability are highly correlated and therefore are able to explain the extent of environmental reporting. hypotheses three and four are accepted. company listing age and company size were found to be moderately significant, whereas government ownership, leverage and the ratio of independent directors were found to be insignificant. in chinese utility industry, the extent of environmental disclosures can be determined by variables member of industrial association, company listing age and leverage ratio according to the multivariate results. therefore, hypotheses three, five and seven are accepted, the other four variables, government ownership, company size, profitability and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 329 management role are less significant. company size is found to be moderately significant, whereas leverage ratio and the number of independent directors were less significant, approaching moderate significance level. government ownership is found not to be significant. for chemical industry, hypotheses three and four are accepted and the remaining five hypotheses, government ownership, company age, company size, leverage and management role are rejected. company listing age and company size were found to be moderate significant. leverage ratio is less moderate significant, whereas government ownership and number of independent directors are not significant. the overall results show that there are four common variables that are positively significant in all industries: member of industrial association, company age, company size and profitability, which is consistent with the existing literature (see chen et al., 2018; oh et al., 2011; kang, 2013; cai et al., 2011; gomez-mejia et al., 2003). the variable management role approaches moderate significance in mining and utility industry, with operating leverage approaching moderate significance in the chemical industry, and significant correlation can be observed in utility industry. the remaining variables (government ownership, leverage and management role) were found to be insignificant in all industries. 6. concluding remarks the study provides evidence to the drivers of environmental and social disclosures made by mining, utility and chemical companies in china. the results indicate that the mia was found to have a strong significant relation to the extent of environmental disclosures, which is consistent with prior literature (song & zu, 2009). the inference is that the local industrial associations in china, such as chinese mining federation, chinese electricity council and chinese chemical industrial association, played important roles, encouraging corporate boards and managements to voluntarily disclose environmental information; however, the descriptive statistics provide evidence that there were only 2.68 indicators per mining company, 2.42 indicators per utility company and 1.82 per chemical company. this suggests that the disclosure manner for the sample companies can be influenced effectively by industrial associations if they are the members, but the encouragement for disclosing a wide range with detailed information regarding environmental information was not sufficient. the implication is that the industrial association, more likely the government, will need to consider the prescription of the gri as a reference when preparing environmental disclosures, and make it into the relevant guidelines. the significance across the three industries showed that the industrial associations in china have the identical amount of influence across industries.however, mia has limited influences on the social aspect, and the encouragement for corporate management is not effective; hence, it is clear that disclosures of social performances appears to be not very much required and instructed by the government and its agencies alike. in addition, profitability and leverage were shown significance in mining and chemical industries, with weaker significant relationships in utility firms. company sizeand company age were found to have moderate significant relationship across industries. these variables, again, demonstrate that the sample industries have the similardrivers in terms of corporate asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 330 financial features. this suggests that corporate with financial features in common tend to disclosure the same amount of environmental information in quantity. the implication is that economic features and activities that add value to companies are important factors that motivate corporate managements to disclose environmental information voluntarily. this further implicates that it is important for the government to link financial incentives with environmental information reporting, such as having subsidiaries for corporate pollution control. this will motivate the managements voluntarily disclose environmental information. interestingly, government ownership was found insignificant in the sample industries. this suggests that the management of chinese listed mining, utility and chemical companies were not motivated by the companies being stated-owned. as china develops, there has been increasing emergence of private sectors ownership in the last few decades, and whether a company is state-owned is no longer a strong motivation for the management to voluntarily disclose environmental information (chen et al., 2018; taylor & shan, 2007). in order to increase the extent of environmental disclosure in china, the government need to have a set of detailed and adequate environmental reporting guidelines with precise instructions as a part of mandatory requirement.company age was also found to have weak significant relationship across industries. older companies operate longer and would need more communication to the outside community; however, the results suggest that the influences of their wide social networks and public images do not motivate much the managements to disclosure social information. the implication is that the corporate managements are not concerned with the social public image based on their company age. this study extended the current research on social and environmental disclosure to the context of china. the findings on environmental and social disclosure analysis can contribute to the development and policy making among high-profile companies. the chinese officials have been implementing environmental and social responsibility controls after 2008; however, it has been highlighted by prior studies that ambiguity and uncertainty within the regulations and guidelines has led companies’ report difficult to compare among other firms (lu & abeysekera, 2017). the findings of this study indicate that environmental sensitive firms (mining, utility and chemical) disclose considerably similar information, and it shows insights in revising the existing and future governmental regulations and guidelines to treat the three subsets as one group. additional research can be taken to relating to seek for improving the quality of disclosures, especially through controlling external assurance process, which is currently at infant level in the chinese context. in addition, this study also makes methodological contribution to environmental disclosure and social disclosure measures, in which the two dimensions were treated independently. the findings indicate that environment disclosure and social disclosure are driven differently, even though the majority of the significant variables are similar. overall, these are two dimensions under corporate sustainability and they shall be treated as one group when investigating corporate sustainability development. however, the study must consider several limitations. first, due to the changing and complex nature of the business environment, there can be inherent difficulties and restrictions to capture corporate environmental and social responsibility in a single period observation. hence, the results do not show the trend of asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 331 development of corporate environmental and social disclosure over several years. future studies can apply a longitudinal method, whereby companies’ annual reports from a number of years can be selected. annual reports are not the only source that companies disclose environmental and social information with. companies that have disclosed through stand-alone reports, web-site disclosure or media announcement may have less or none environmental or social information in annual reports. also, there is a limitation for using dummy variables as proxies for ‘government ownership’ and ‘management role’ in the multiple regression models. dummy variable is effective and useful for testing categorical factors and their relationships between predictors and responsible variables. however, using dummy variable is a non-parametric approach which does not assume form for functional relationship (cohen, 1991). therefore, regressions included dummies often lose functional form of relationship and the slop of the regressions are most like to be influenced. nonetheless, dummy variables are most commonly used by researchers in multiple regressions because the extent that they influence the slope is negligible. finally, this study focuses solely on the quantitative approach and hence a dichotomous index was employed to identify the extent of companies’ environmental and social disclosures. the limitation of this method is that all items are being treated as equally important. future research can overcome this by analysing both quantitative and qualitative approaches. for example, weighted index measures can be used to examine the level of importance of each gri item of disclosure. in conclusion, this study extends and contributes to the existing studies on corporate environmental and social disclosures in china by providing 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(2015). evaluating practices and drivers of corporate social responsibility: the chinese context. journal of cleaner production, 100, 315-324. https://doi.org/10.1016/j.jclepro.2015.03.053 microsoft word 11073-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 310 a model for bank performance measurement integrating multivariate factor structure with multi-criteria promethee methodology mihir dash head of department, department of quantitative methods school of business, alliance university chikkahagade cross, anekal, bangalore, india-562106 tel: 91-99-518 2465 e-mail: mihirda@rediffmail.com received: april 16, 2017 accepted: may 24, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.11073 url: https://doi.org/10.5296/ajfa.v9i1.11073 abstract the global financial crisis and the subsequent euro-zone crises have resulted in widespread failure of banking systems worldwide. the indian banking system, which was initially hailed to be unaffected by the crises, was affected indirectly, mainly on account of growing trade and financial integration with the global economy. although indian banks were not pushed to the point of insolvency, bank performance benchmarking and evaluation have become important in the dynamic banking environment in india in order to ensure sustained profitability and avoid undue risks. the camels model is one of the most widely-used frameworks for bank performance evaluation (sahajwala and van der bergh, 2000). the camels methodology provides a broader view of bank performance than single ratios such as return on equity, particularly as it takes account of both profitability and risk factors in representing bank performance. several studies have proposed multi-criteria decision models for bank performance measurement (doumpos and zopounidis, 2011). the objective of the present study is to integrate multivariate and multi-criteria decision models in bank performance measurement. the study uses the factor structure of the camels model to derive weights for the different criteria in the promethee methodology. the resulting promethee scores are used to rank banks under different dimensions, and to compare the performance of public sector and private sector banks in india. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 311 keywords: bank performance measurement, camels model, factor structure, promethee methodology jel classification: g20 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 312 introduction bank performance evaluation has gained greatly in importance in recent years. the global financial crisis and the subsequent euro-zone crises have resulted in widespread failure of banking systems worldwide. the collapse of some of the most prominent banks in the world, including the lehman brothers and washington mutual bank, along with several near-failures which had to be bailed out of crisis by the u.s. government, highlighted the inadequacy of bank evaluation systems in detecting/predicting bank insolvency. the indian banking system, which was initially hailed to be unaffected by the crises, was affected indirectly, mainly on account of growing trade and financial integration with the global economy. though indian banks were not pushed to the point of insolvency, bank performance benchmarking and evaluation have become important in the dynamic banking environment in india in order to ensure sustained profitability and avoid undue risks. there are several systems used for bank performance evaluation. the camels model is one of the most widely-used frameworks for bank performance evaluation (sahajwala and van der bergh, 2000). originally, the camel framework was used by regulators in the u.s. to determine when to conduct on-site examination of a bank; it is still used by regulators to evaluate bank performance. the five camel parameters, viz. capital adequacy, asset quality, management soundness, earnings and profitability, and liquidity, are critical for the survival of banks inadequacy in any parameter would result in increased likelihood of bank failure. the sixth parameter, sensitivity to market risk, was added to these former parameters in order to make this method more comprehensive. the present study attempts to integrate two approaches in bank performance measurement: multivariate methods and multi-criteria decision models. the multivariate approach examines the dimensionality of the camels system. the multi-criteria decision modeling approach focuses on ranking the banks according to the dimensions inherent in the camels system. further, the factor structure of the camels model is used to derive weights for the different criteria in the multi-criteria decision model. the resulting scores are used to rank banks under different dimensions, and compare the performance of public sector and private sector banks in india. literature review there is extensive literature addressing banking performance evaluation. the camels framework in particular is a widely-used methodology for bank performance assessment, using particular financial ratios to reflect different aspects of a bank’s performance (sahajwala and van der bergh, 2000). barr et al (2002) found that the camel ratings were consistent with the efficiency scores obtained through data envelopment analysis. beaver (1966, 1968) and altman (1968) initiated the use of financial ratios for bankruptcy prediction. maishanu (2004) extended altman’s z-score model for banks, suggesting eight financial ratios to assess the financial health of a bank. mous (2005) applied decision tree models and multiple discriminant models for bankruptcy prediction in banks, using profitability, liquidity, leverage, and turnover ratios, and suggested that the decision tree asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 313 approach performed better than the discriminant model approach. dash and das (2013) compared the performance of public sector banks with private/foreign banks under the camels framework. they found that private/foreign banks fared better than public sector banks on most of the camels factors in the study period, and that the two contributing factors for the better performance of private/foreign banks were management soundness and earnings and profitability. njoku (2011) studied the factor structure of camel in order to develop an anatomic model of bank performance, using factor weights. the anatomy framework modelled a bank’s financial situation in seven structural parameters, including market presence, macro-economic condition, deposit mobilisation, prudence, earnings quality, market power and capital confidence. njoku and inanga (2012) applied the anatomic model in interpreting critical issues commonly reported in the 2008-2009 global banking crises. several studies have applied factor analysis to develop rating methods for life insurance service providers. hsiao (2006, 2008) developed the camel-s model based on fourteen financial variables and reported its consistency with dea efficiency scores. yakob et al (2012) applied factor analysis to a set of twenty-three financial ratios to develop a camel model for rating life insurance service providers. klomp and de haan (2011) applied dynamic factor analysis with a set of twenty-five financial variables under the camels framework in order to construct measures for bank risk. popovska (2014) applied factor analysis to the six camels dimensions in order to develop a measure for bank stability. maliszewski (2009) and bhattacharyay (2011) had also proposed such a measure. several multi-criteria decision methods have been applied widely in banking performance measurement. some of the most commonly-applied techniques include data envelopment analysis (dea), analytic hierarchy process (ahp), technique for order preference by similarity to ideal solution (topsis), elimination et choix traduisant la realité (electre), visekriterijumska optimizacija i kompromisno resenje (vikor), and preference ranking organization method for enrichment of evaluation (promethee). some of the literature closely linked with the present study is reviewed in the following. several studies have applied dea models to measure bank efficiency (parkan & liu, 1999; halkos & salamouris, 2004; kao & liu, 2004; avkiran, 2010; fallah et al, 2011; dash and charles, 2012; minh et al, 2013; doumpos and zopounidis, 2013; dash and vegesna, 2014). hunjak and jakovcevic (2001) proposed a methodology for bank performance measurement based on multi-criteria ahp, enabling the consideration of both quantitative factors (viz. financial ratios) and qualitative factors (internal and external) in the evaluation process. they applied their model in the context of croatian banks. seçme et al (2009) proposed a fuzzy ahp model for the banking system using both financial and non-financial performance criteria. stankeviciene and mencaite (2012) used the ahp model to evaluate the performance of lithuanian commercial banks. they used a system of indicators and assigned each indicator a different weight reflecting its significance based on the needs and priorities of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 314 both internal and external evaluators. cetin & cetin (2010) used multi-criteria vikor to rate turkish banks according to their overall financial performance. rezaei and gheibdoust (2014) used vikor to rank banks based on capital adequacy, asset quality, liquidity, structure of capital expenditures and profitability. several studies have used the promethee methodology for measuring bank performance (mareschal & brans, 1991; mareschal & mertens, 1992; babic et al, 1999; kosmidou & zopounidis, 2008; doumpos & zopounidis, 2011; ginevičius and podviezko, 2013). bayyurt (2013) compared the performance of the foreign and domestic deposit banks in turkey using several mcdm methods, viz. dea, topsis, and electre iii, using the mann-whitney u-test and the independent samples t-test. the results of the study showed that foreign-owned banks performed better than domestic banks, as foreign banks could find cheaper international funds, and domestic banks had more employees than foreign banks for similar banking functions, resulting in lower employee productivity. önder and hepşen (2013) proposed a performance evaluation model for turkish banks using time series forecasting methods and multi-criteria ahp and topsis methodology. they applied the model under ten performance categories as prescribed by the bank association of turkey: capital ratios, balance sheet ratios, assets quality, liquidity, profitability, income-expenditure structure, share in sector, share in group, branch ratios, and activity ratios. several other methods have also been applied, including disaggregation techniques (zopounidis et al, 1995; spathis et al, 2002), co-plot method (raveh, 2000), grey relational analysis (ho, 2006), classification techniques (ioannidis et al, 2010), balanced scorecard approach (wua et al, 2009), copras (ginevičius and podviezko, 2013), and several others. rosenzweig et al (2013) used a goal programming model for business strategies of commercial banks. the criteria for the model were profitability, security/risk and liquidity. the indicators were aggregated into a score which reduced all the relevant information about bank operations into an index using which the banks can be compared and ranked. thus, several studies have used factor analysis to develop composite measures of bank performance and risk, particularly in the context of the camels model, and several studies have employed multi-criteria decision models in bank performance measurement. the present study examines the factor structure of the camels model in bank performance in india. data and methodology the objective of the present study is to integrate multivariate and multi-criteria decision models in bank performance measurement. the study uses the factor structure of the camels model to derive weights for the different criteria in the promethee methodology. the resulting promethee scores are used to rank banks under different dimensions, and compare the performance of public sector and private sector banks in india. the variables used in the analysis pertain to the financial ratios corresponding to the camels parameters. these are discussed in the following (refer dash and das, 2013). capital adequacy represents the capacity of a bank in terms of sufficient capital to absorb unexpected losses. it is required in order to maintain depositors’ confidence and to prevent asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 315 the bank from going insolvent. in the current study, it is measured with the help of three ratios: the debtequity ratio, the coverage ratio, and the capital adequacy ratio. asset quality represents the nature of loans and advances the bank has made to generate interest income. highly-rated companies generally tend to be given lower interest rate terms than lower-rated, doubtful companies. thus asset quality reflects the type of debtors of the bank. the ratio used to capture this parameter in this study is net npa to total advances ratio. management soundness is the parameter used to evaluate management quality, assigning premium to better-managed banks and discounting poorly-managed banks. it involves analysis of efficiency of management in generating business (top-line) and in maximizing profits (bottom-line). in this study, it is measured through four ratios, viz. total investments to total assets ratio, total advances to total deposits ratio, business per employee, and profit per employee. earnings performance emphasises on how a bank earns its profits. this in turn explains the sustainability and growth in earnings in the future. in this study, it is measured via three ratios, namely return on net worth, interest spread to total assets ratio, and profit after tax to total assets. liquidity position is of prime importance in the banking business. in the study, it is measured using two ratios: government securities to total investment and government securities to total assets. sensitivity to market risk considers the ability of a bank to identify, measure, monitor, and control market risk. in the study, it is measured by beta, i.e. the systematic risk of the bank’s stock returns. the data for the study pertained to a sample of thirty-five banks operating in india, of which nineteen were public sector banks, and sixteen were private sector banks, listed in table 1 below. the research period for the study was 2007-2011. the data for the study consists of financial ratios based on the camels framework described above, obtained from the capitaline database1. 1 www.capitaline.com asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 316 table 1. list of sample banks public sector banks private sector banks 1 allahabad bank 1 axis bank 2 andhra bank 2 yes bank 3 bank of baroda 3 standard chartered 4 bank of india 4 south indian bank 5 canara bank 5 kotak mahindra 6 corporation bank 6 hdfc bank 7 central bank of india 7 federal bank 8 dena bank 8 dhanalaxmi bank 9 indian overseas bank 9 development credit bank 10 indian bank 10 karnataka bank 11 oriental bank of commerce 11 j &k bank 12 punjab national bank 12 ing vysya 13 state bank of india 13 bank of rajasthan 14 idbi bank 14 citi bank 15 syndicate bank 15 tamilnad mercantile bank 16 uco bank 16 icici bank 17 union bank of india 18 united bank 19 vijaya bank the camels variables, averaged across the five-year period, were taken for the factor analysis, and the subsequent factor weights were used in conjunction with a multi-criteria procedure, promethee ii (doumpos and zopounidis, 2011). following the promethee methodology, the partial preference indices were computed using the linear function , = 0 ≤ 0 ≤ − ≤ 1 − > , where the preference threshold pk was taken to be equal to one standard deviation of the underlying variable. the partial evaluation scores were computed as ( ) = ∑ ( , ) and ( ) = ∑ ( , ) , with ( ) = ( ) − ( ), and the final promethee score was computed as φ( ) = ∑ ( ). the promethee scores computed as above were used to identify the good performers and the bad performers. consistency of the promethee scores was analysed using spearman rank correlation. also, the promethee scores were used to compare the performance of public sector and private sector banks using the non-parametric mann-whitney u-test. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 317 findings the descriptive statistics of the camels parameters is presented in table 2 below. table 2. descriptive statistics of camels parameters public sector private sector mean std dev mean std dev debt/equity ratio 18.8253 3.3498 13.4292 3.4603 coverage ratio 4.262% 1.240% 7.312% 2.150% capital adequacy ratio 12.232% 0.857% 13.615% 2.303% net npa/total advances 0.921% 0.436% 0.938% 0.516% total investment/total assets 27.217% 2.186% 29.392% 4.123% total advances/total deposits 72.007% 8.334% 72.948% 11.279% business per employee 8.1363 3.3084 7.4585 3.0529 profit per employee 0.0507 0.0188 0.0703 0.0615 return on net worth 19.474% 3.954% 14.800% 5.052% interest spread/total assets 0.372% 0.081% 0.578% 0.315% pat/total assets 0.858% 0.254% 1.005% 0.550% govt sec/total investment 1.195% 0.108% 0.754% 0.092% govt sec/total asset 0.324% 0.026% 0.218% 0.025% beta 1.1637 0.2266 0.8538 0.5905 the average car was well above the basel ii required level of 9%, and within the basel iii required level of 11%-13.5%2. asset quality was generally stable across the research period, with the net npa ratio controlled to below 1%, significantly lower than its 2004 levels (about 7%). there was also a marked improvement in management soundness, especially in business per employee and profit per employee. however, earnings performance was relatively stable, especially profit after tax to total assets at around 1%, with some improvement in return on net worth and interest spread in 2011. there was a decrease in liquidity, with respect to government securities to both total investments and total assets. sensitivity to market risk was also generally stable, with the average beta at around 1. the results of the factor analysis are presented in table 3 below. 2 http://en.wikipedia.org/wiki/basel_ii asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 318 table 3. factor analysis: rotated component matrix components f1 f2 f3 f4 f5 debt/equity ratio 0.686 coverage ratio 0.688 capital adequacy ratio 0.768 net npa/total advances 0.738 total investment/total assets 0.876 total advances/total deposits 0.846 business per employee 0.899 profit per employee 0.888 return on net worth 0.930 interest spread/total assets 0.560 pat/total assets 0.626 govt sec/total investment 0.957 govt sec/total asset 0.941 beta 0.734 %age of variance explained 26.03% 16.88% 15.22% 14.61% 13.73% extraction method: principal component analysis. rotation method: varimax with kaiser normalization. k.m.o. measure of sampling adequacy: 0.652 bartlett’s test of sphericity: chi-sq = 544.99, p = 0.000** total variance explained: 86.46% the k.m.o. measure of sampling adequacy was moderate, and bartlett’s test was statistically significant, suggesting multi-collinearity of the variables. the results of the factor analysis identified five underlying factors, together explaining 86.46% of the overall variation in the variables. the first factor (f1) loaded highly on four variables, viz. total investments to total assets, total advances to total deposits, business per employee, and profit per employee. thus, this factor captures the management soundness dimension, and explains the maximum percentage of the overall variation in the variables. the second factor (f2) loaded highly on government securities to total investments and government securities to total assets. thus, this factor reflects the liquidity dimension. the third factor (f3) loaded highly on the coverage ratio, the car, and the interest spread to total assets ratio. the first two variables relate to capital adequacy, while the third relates to earnings performance. this suggests that the capital adequacy of banks should also be measured in light of the interest spread to total assets ratio, as they are closely correlated. the fourth factor (f4) combined three critical ratios. they were the debt-equity ratio, the net npa to total advances ratio, and beta. the debt-equity ratio reflects capital adequacy, the net npa ratio indicates asset quality of banks, and beta represents sensitivity to market risk. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 319 thus, although these variables represent different parameters of the camels framework, yet they are closely correlated. in fact, they all measure different types of risk; the debt-equity ratio measures financial risk, net npa ratio measures exposure to credit risk, and beta measures systematic risk. thus, the fourth factor may be interpreted as the risk factor. lastly, the fifth factor (f5) loaded highly on return on net worth and pat to total assets ratio. thus, this factor reflects the earnings performance dimension. based on the identified factors and their corresponding factor coefficients, the following weights were derived (insignificant coefficients were dropped). management soundness total investment/total assets 0.2496 total advances/total deposits 0.2411 business per employee 0.2562 profit per employee 0.2531 liquidity govt sec/total investment 0.5042 govt sec/total asset 0.4958 capital adequacy coverage ratio 0.3413 capital adequacy ratio 0.3810 interest spread/total assets 0.2778 risk debt/equity ratio 0.3179 net npa/total advances 0.3420 beta 0.3401 earnings performance return on net worth 0.5977 pat/total assets 0.4023 the final promethee scores for these dimensions are presented in tables 4-8 in the appendix. the top five and bottom five performers for each dimension and for each criterion within each dimension is highlighted in green and red, respectively. the sample banks exhibited mixed performance along the management soundness dimension. overall, the best performing banks were: idbi bank, yes bank, axis bank, citi bank, and icici bank, while the worst performing banks were: dhanalaxmi bank, central bank of india, united bank, bank of rajasthan, and development credit bank. the overall promethee scores for management soundness were significantly correlated with the promethee scores for profit per employee (ρ = 0.913), followed by business per employee (ρ = 0.655), and total advances/total deposits (ρ = 0.546), and were not significantly correlated with the promethee score for total investment/total assets (ρ = 0.013). total investment/total assets was significantly negatively correlated with business asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 320 per employee (ρ = -0.493) and total advances/total deposits (ρ = -0.480), with most banks having reverse ranks in the latter and the former, except for kotak mahindra bank. of course, profit per employee and business per employee were significantly correlated (ρ = 0.760), and total advances/total deposits was significantly correlated with both (ρ = 0.503 and ρ = 0.448, respectively). the sample banks exhibited much more consistency along the liquidity dimension. overall, the best performing banks were: allahabad bank, oriental bank of commerce, bank of india, idbi bank, and andhra bank, while the worst performing banks were: axis bank, yes bank, tamilnad mercentile bank, j & k bank, and icici bank. the overall promethee scores for liquidity were significantly correlated with the promethee scores for government securities/total investments (ρ = 0.957) and government securities/total assets (ρ = 0.953), which in turn were significantly correlated (ρ = 0.853). the sample banks also exhibited consistency along the capital adequacy dimension. overall, the best performing banks were: kotak mahindra bank, tamilnad mercentile bank, federal bank, hdfc bank, and yes bank, while the worst performing banks were: central bank of india, bank of rajasthan, united commercial bank, dena bank, and syndicate bank. the overall promethee scores for capital adequacy were significantly correlated with the promethee scores for coverage ratio (ρ = 0.910), capital adequacy ratio (ρ = 0.840), and with interest spread/total assets (ρ = 0.814). further, coverage ratio was significantly correlated with interest spread/total assets (ρ = 0.693) and capital adequacy ratio (ρ = 0.658), and interest spread/total assets was significantly correlated with capital adequacy ratio (ρ = 0.577). the sample banks also exhibited mixed performance along the risk dimension. overall, the best performing banks were: tamilnad mercentile bank, hdfc bank, citi bank, indian bank, and standard chartered bank, while the worst performing banks were: united commercial bank, dena bank, central bank of india, syndicate bank, and state bank of india. the overall promethee scores for risk were significantly correlated with the promethee scores for beta (ρ = 0.769), debt/equity ratio (ρ = 0.700), and net npa/total advances (ρ = 0.667). further, beta was significantly correlated with net npa/total advances (ρ = 0.346) and debt/equity ratio (ρ = 0.333), but net npa/total advances was not significantly correlated with debt/equity ratio (ρ = 0.172). the sample banks exhibited consistency along the earnings performance dimension. overall, the best performing banks were: standard chartered bank, indian bank, punjab national bank, union bank of india, and canara bank, while the worst performing banks were: development credit bank, united bank, dhanalakshmi bank, ing vysya bank, and bank of rajasthan. the overall promethee scores for earnings performance were significantly correlated with the promethee scores for return on net worth (ρ = 0.907) and pat/total assets (ρ = 0.611), which in turn were significantly correlated (ρ = 0.292). further, there were significant correlations between the promethee scores of some of the dimensions. the promethee score for risk was significantly negatively correlated with those of management soundness (ρ = -0.557), capital adequacy (ρ = -0.792), and earnings asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 321 performance (ρ = -0.319), and significantly positively correlated with that of liquidity (ρ = 0.330); in turn, the promethee score of management soundness was significantly positively correlated with those of capital adequacy (ρ = 0.656) and earnings performance (ρ = 0.376); and the promethee score of capital adequacy was significantly negatively correlated with that of liquidity (ρ = -0.454). the results of the mann-whitney tests comparing public sector and private sector banks are presented in table 9 below. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 322 table 9. mann-whitney tests comparing promethee scores in public sector and private sector banks mean rank z stat p-value total investment/total assets public sector 13.9211 -2.5666 0.0103 private sector 22.8438 total advances/total deposits public sector 18.3421 -0.2153 0.8296 private sector 17.5938 business per employee public sector 19.7632 -1.1095 0.2672 private sector 15.9063 profit per employee public sector 17.4737 -0.3326 0.7395 private sector 18.6250 management soundness public sector 16.2895 -1.0763 0.2818 private sector 20.0313 govt sec/total investment public sector 25.1316 -4.4875 0.0000 private sector 9.5313 govt sec/total assets public sector 24.5526 -4.1232 0.0000 private sector 10.2188 liquidity public sector 24.8684 -4.3219 0.0000 private sector 9.8438 coverage ratio public sector 12.2895 -3.5933 0.0003 private sector 24.7813 capital adequacy ratio public sector 14.0263 -2.5004 0.0124 private sector 22.7188 interest spread/total assets public sector 14.0263 -2.5004 0.0124 private sector 22.7188 capital adequacy public sector 12.7632 -3.2952 0.0010 private sector 24.2188 debt/equity ratio public sector 23.5526 -3.4939 0.0005 private sector 11.4063 net npa/total advances public sector 18.5789 -0.3643 0.7156 private sector 17.3125 beta public sector 20.4211 -1.5247 0.1273 private sector 15.1250 risk public sector 22.2895 -2.6991 0.0070 private sector 12.9063 return on net worth public sector 21.9737 -2.5004 0.0124 private sector 13.2813 pat/total assets public sector 14.8158 -2.0036 0.0451 private sector 21.7813 earnings performance public sector 19.9211 -1.2088 0.2267 private sector 15.7188 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 323 there was found to be no significant difference between public sector banks and private sector banks with respect to management soundness, and in particular with respect to total advances/total deposits, business per employee, and profit per employee; however, there was found to be significant difference between public sector banks and private sector banks with respect to total investments/total assets, with private sector banks performing significantly better than public sector banks in this regard. there was found to be significant difference between public sector banks and private sector banks with respect to liquidity, and in particular with respect to government securities/total investments and government securities/total assets, with public sector banks performing significantly better than their private sector counterparts. there was found to be significant difference between public sector banks and private sector banks with respect to capital adequacy, and in particular with respect to coverage ratio, capital adequacy ratio, and interest spread/total assets, with private sector banks performing significantly better than their public sector counterparts. there was found to be significant difference between public sector banks and private sector banks with respect to risk, and in particular with respect to debt/equity ratio, with private sector banks performing significantly better than public sector banks; however, there was no significant difference between public sector banks and private sector banks with respect to net npa/total advances and beta. there was found to be no significant difference between public sector banks and private sector banks with respect to earnings performance; however, there was found to be significant difference between public sector banks and private sector banks with respect to return on net worth, with public sector banks performing significantly better than private sector banks, and with respect to pat/total assets, with private sector banks performing significantly better than public sector banks. discussion the results of the study raise questions relating to the direct applicability of multi-criteria decision models in bank performance measurement. the factor structure underlying the camels ratios consisted of four distinct dimensions of bank performance which were analogous to the camels components, viz. management soundness, liquidity, capital adequacy, and earnings performance, as well as a distinct dimension, risk, comprising debt/equity ratio, net npa/total assets, and beta, which represent the financial/insolvency risk, credit risk, and market risk aspects, respectively, of banking risk. however, the promethee scores within these dimensions were not very consistent, particularly within the management soundness and risk dimensions. the ranking of banks along the dimensions also varied considerably. the comparison of the promethee scores of public sector and private sector banks along the dimensions was in accordance with the descriptive statistics. the results of the mann-whitney tests indicated that private sector banks performed better than public sector banks in terms of capital adequacy and risk, while public sector banks performed better asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 324 than private sector banks in terms of liquidity, while there was no significant difference between public sector and private sector banks in terms of management soundness and earnings performance. in fact, paradoxically, public sector banks performed significantly better than private sector banks with respect to return on net worth, while private sector banks performed significantly better than public sector banks with respect to pat/total assets. there were several limitations inherent in the current study. the study only considers a sample of thirty-five banks, over a period of only five years (2007-11), which in particular was adversely affected by the global financial crisis. thus, the results of the study may be specific to the period considered, and may not be generalisable. also, the current approach considers only some performance parameters, and fails to consider some qualitative aspects of banking performance, such as management performance and staff efficiency. further, the study did not analyse the sensitivity of the promethee scores to the preference thresholds and the parameter weights. also, the study has used factor analysis, which determines weights in order to maximize the variance explained, but which may not reflect the importance of the variables in banking performance. there is vast scope for further research in the area of bank performance and risk measurement, particularly due to the dynamic nature of the current banking environment. there are several other multi-criteria models that can be used to analyse banking performance to provide alternative perspectives to regulators and policy makers, for example, electre methodology may be used to identify banks that may be in distress, vikor methodology may be used to identify critical trade-offs in banking performance, and ahp methodology may be used to incorporate qualitative aspects of banking performance. references altman, i. e. 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(1995). multiattribute evaluation of greek banking performance. applied stochastic models and data analysis, 11(1), 97-107. https://doi.org/10.1002/asm.3150110110 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 328 table 4. promethee scores for management soundness total investment/total assets total advances/total deposits business per employee profit per employee ϕ+ ϕϕ ϕ+ ϕϕ ϕ+ ϕϕ ϕ+ ϕϕ φ allahabad bank 0.4602 0.2199 0.2403 0.1414 0.2955 -0.1541 0.2799 0.2679 0.0120 0.2071 0.2401 -0.0330 0.0176 andhra bank 0.0754 0.6570 -0.5816 0.2846 0.1891 0.0955 0.3820 0.2321 0.1499 0.2776 0.1908 0.0868 -0.0618 axis bank 0.7443 0.0726 0.6718 0.1659 0.2684 -0.1025 0.8103 0.0571 0.7532 0.8458 0.0681 0.7776 0.5328 bank of baroda 0.0294 0.9156 -0.8862 0.2644 0.1972 0.0672 0.5535 0.1697 0.3838 0.3691 0.1641 0.2050 -0.0548 bank of india 0.0411 0.8077 -0.7666 0.3659 0.1694 0.1965 0.4812 0.1943 0.2869 0.1858 0.2587 -0.0729 -0.0889 bank of rajasthan 0.9276 0.0057 0.9219 0.0000 0.9998 -0.9998 0.0294 0.6062 -0.5769 0.0180 0.7327 -0.7147 -0.3396 canara bank 0.1292 0.4939 -0.3646 0.2445 0.2093 0.0351 0.4356 0.2110 0.2246 0.2776 0.1908 0.0868 -0.0031 central bank of india 0.2300 0.3710 -0.1411 0.0643 0.4820 -0.4177 0.0630 0.5068 -0.4438 0.0366 0.5958 -0.5592 -0.3912 citi bank 0.0417 0.8039 -0.7622 0.8865 0.0616 0.8249 0.9375 0.0294 0.9080 0.9706 0.0294 0.9412 0.4794 corporation bank 0.3749 0.2758 0.0991 0.1671 0.2673 -0.1002 0.7696 0.0780 0.6915 0.6319 0.1081 0.5238 0.3103 dena bank 0.1814 0.4175 -0.2360 0.1006 0.3711 -0.2705 0.2519 0.2818 -0.0298 0.1166 0.3442 -0.2276 -0.1894 development credit bank 0.6510 0.1174 0.5337 0.1396 0.2981 -0.1585 0.0038 0.7105 -0.7067 0.0000 0.9614 -0.9614 -0.3293 dhanlaxmi bank 0.1084 0.5573 -0.4489 0.0433 0.5940 -0.5507 0.0101 0.6779 -0.6678 0.0220 0.6867 -0.6648 -0.5841 federal bank 0.4958 0.2001 0.2957 0.2840 0.1893 0.0946 0.2696 0.2725 -0.0029 0.2776 0.1908 0.0868 0.1179 hdfc bank 0.6605 0.1130 0.5475 0.1989 0.2415 -0.0427 0.0615 0.5102 -0.4487 0.2523 0.2055 0.0469 0.0233 icici bank 0.1276 0.4976 -0.3700 0.8724 0.0725 0.7998 0.7301 0.0982 0.6320 0.7232 0.0868 0.6364 0.4234 idbi bank 0.2158 0.0000 0.2158 0.9893 0.0000 0.9893 1.0000 0.0000 1.0000 0.7232 0.0000 0.7232 0.7316 indian bank 0.6039 0.1419 0.4620 0.0975 0.3778 -0.2802 0.1253 0.3964 -0.2711 0.3691 0.1641 0.2050 0.0302 ing vysya bank 0.2984 0.3223 -0.0239 0.3622 0.1701 0.1921 0.0841 0.4665 -0.3824 0.0740 0.4481 -0.3741 -0.1523 indian overseas bank 0.2585 0.3488 -0.0903 0.3203 0.1796 0.1407 0.1945 0.3171 -0.1226 0.1166 0.3442 -0.2276 -0.0776 j &k bank 0.6250 0.1299 0.4951 0.0336 0.6708 -0.6372 0.1475 0.3644 -0.2169 0.2776 0.1908 0.0868 -0.0637 karnataka bank 0.9562 0.0000 0.9562 0.0292 0.7197 -0.6904 0.1458 0.3667 -0.2209 0.1166 0.3442 -0.2276 -0.0419 kotak mahindra 0.8448 0.0314 0.8134 0.9706 0.0187 0.9519 0.0003 0.7467 -0.7465 0.1858 0.2587 -0.0729 0.2229 oriental bank of commerce 0.1723 0.4280 -0.2557 0.1462 0.2895 -0.1433 0.7947 0.0637 0.7310 0.4304 0.1508 0.2796 0.1597 punjab national bank 0.1256 0.5032 -0.3776 0.3690 0.1690 0.2000 0.1777 0.3319 -0.1542 0.2523 0.2055 0.0469 -0.0737 south indian bank 0.2122 0.3852 -0.1730 0.0854 0.4080 -0.3226 0.1905 0.3201 -0.1296 0.1166 0.3442 -0.2276 -0.2118 standard chartered 0.0000 1.0000 -1.0000 0.8933 0.0588 0.8345 0.7316 0.0975 0.6340 1.0000 0.0000 1.0000 0.3671 state bank of india 0.1444 0.4654 -0.3210 0.6532 0.1390 0.5143 0.0496 0.5427 -0.4931 0.0926 0.3947 -0.3021 -0.1589 syndicate bank 0.0595 0.7169 -0.6574 0.2689 0.1951 0.0738 0.1922 0.3188 -0.1266 0.0740 0.4481 -0.3741 -0.2734 tamilnad mercentile bank 0.8131 0.0426 0.7705 0.0823 0.4175 -0.3353 0.0051 0.7012 -0.6960 0.1858 0.2587 -0.0729 -0.0852 uco bank 0.2167 0.3812 -0.1645 0.1355 0.3047 -0.1693 0.2784 0.2685 0.0099 0.0433 0.5652 -0.5220 -0.2114 union bank of india 0.1487 0.4587 -0.3100 0.2655 0.1966 0.0689 0.2822 0.2671 0.0151 0.2776 0.1908 0.0868 -0.0350 united bank 0.7623 0.0631 0.6992 0.0297 0.7130 -0.6833 0.0000 0.7527 -0.7527 0.0260 0.6572 -0.6312 -0.3428 vijiya bank 0.4664 0.2165 0.2499 0.0579 0.5102 -0.4523 0.2362 0.2914 -0.0552 0.0926 0.3947 -0.3021 -0.1373 yes bank 0.5264 0.1857 0.3407 0.5787 0.1474 0.4313 0.8558 0.0434 0.8123 0.8941 0.0588 0.8352 0.6085 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 329 table 5. promethee scores for liquidity govt sec/total investment govt sec/total assets ϕ+ ϕϕ ϕ+ ϕϕ φ allahabad bank 0.6316 0.0258 0.6057 0.8057 0.0000 0.8057 0.7049 andhra bank 0.6946 0.0074 0.6872 0.5894 0.0371 0.5523 0.6203 axis bank 0.0000 0.8242 -0.8242 0.0142 0.7516 -0.7374 -0.7812 bank of baroda 0.6550 0.0143 0.6407 0.4770 0.3005 0.1765 0.4105 bank of india 0.7953 0.0000 0.7953 0.5635 0.0727 0.4908 0.6443 bank of rajasthan 0.0158 0.7178 -0.7020 0.1479 0.5561 -0.4083 -0.5564 canara bank 0.5909 0.0619 0.5290 0.5556 0.0862 0.4693 0.4994 central bank of india 0.6029 0.0456 0.5573 0.6295 0.0140 0.6154 0.5861 citi bank 0.3124 0.4764 -0.1640 0.0953 0.5994 -0.5040 -0.3326 corporation bank 0.6000 0.0485 0.5515 0.6558 0.0097 0.6461 0.5984 dena bank 0.5973 0.0519 0.5454 0.5932 0.0328 0.5604 0.5528 development credit bank 0.0867 0.6117 -0.5250 0.1591 0.5496 -0.3905 -0.4583 dhanlaxmi bank 0.2247 0.5192 -0.2945 0.1071 0.5872 -0.4801 -0.3865 federal bank 0.0625 0.6392 -0.5767 0.0801 0.6184 -0.5383 -0.5577 hdfc bank 0.0985 0.6018 -0.5032 0.1714 0.5444 -0.3729 -0.4386 icici bank 0.0609 0.6415 -0.5806 0.0159 0.7408 -0.7250 -0.6522 idbi bank 0.6520 0.0000 0.6520 0.6085 0.0000 0.6085 0.6304 indian bank 0.4917 0.2664 0.2253 0.5991 0.0274 0.5716 0.3970 ing vysya bank 0.1475 0.5677 -0.4203 0.1207 0.5752 -0.4545 -0.4372 indian overseas bank 0.5874 0.0684 0.5189 0.6142 0.0187 0.5954 0.5569 j &k bank 0.0140 0.7223 -0.7084 0.0276 0.7055 -0.6778 -0.6932 karnataka bank 0.0149 0.7197 -0.7048 0.1634 0.5474 -0.3840 -0.5458 kotak mahindra 0.1773 0.5479 -0.3705 0.4010 0.4313 -0.0304 -0.2019 oriental bank of commerce 0.6734 0.0103 0.6631 0.6396 0.0119 0.6277 0.6456 punjab national bank 0.6481 0.0168 0.6313 0.6076 0.0216 0.5860 0.6088 south indian bank 0.0889 0.6094 -0.5205 0.0483 0.6608 -0.6125 -0.5661 standard chartered 0.2241 0.5195 -0.2954 0.0000 0.9253 -0.9253 -0.6077 state bank of india 0.4439 0.3516 0.0922 0.4043 0.4279 -0.0235 0.0349 syndicate bank 0.4152 0.3990 0.0162 0.2753 0.5106 -0.2353 -0.1085 tamilnad mercentile bank 0.0038 0.7742 -0.7704 0.0467 0.6635 -0.6168 -0.6943 uco bank 0.6118 0.0385 0.5733 0.5995 0.0271 0.5723 0.5728 union bank of india 0.5398 0.1674 0.3724 0.5104 0.1889 0.3214 0.3471 united bank 0.3725 0.4400 -0.0675 0.5240 0.1546 0.3694 0.1491 vijiya bank 0.4550 0.3319 0.1232 0.5038 0.2085 0.2954 0.2086 yes bank 0.0083 0.7449 -0.7366 0.0155 0.7423 -0.7268 -0.7317 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 330 table 6. promethee scores for capital adequacy coverage ratio car interest spread/total assets ϕ+ ϕϕ ϕ+ ϕϕ ϕ+ ϕϕ φ allahabad bank 0.1788 0.4429 -0.2641 0.3434 0.2156 0.1278 0.1866 0.2799 -0.0934 -0.0674 andhra bank 0.3162 0.2950 0.0212 0.2211 0.2862 -0.0650 0.3966 0.2109 0.1857 0.0340 axis bank 0.6048 0.1621 0.4427 0.5370 0.1455 0.3915 0.9107 0.0280 0.8826 0.5454 bank of baroda 0.3375 0.2800 0.0576 0.2993 0.2377 0.0616 0.2449 0.2510 -0.0061 0.0414 bank of india 0.1202 0.5225 -0.4024 0.1690 0.3363 -0.1673 0.3302 0.2273 0.1029 -0.1725 bank of rajasthan 0.0304 0.7308 -0.7004 0.0019 0.7780 -0.7761 0.0038 0.6674 -0.6635 -0.7190 canara bank 0.1234 0.5184 -0.3951 0.6732 0.1304 0.5428 0.0425 0.4376 -0.3951 -0.0378 central bank of india 0.0031 0.8909 -0.8878 0.0000 0.8100 -0.8100 0.0195 0.5102 -0.4907 -0.7479 citi bank 0.8402 0.0653 0.7749 0.0157 0.6820 -0.6663 0.9000 0.0331 0.8669 0.2514 corporation bank 0.3486 0.2733 0.0753 0.4704 0.1599 0.3105 0.0467 0.4292 -0.3825 0.0377 dena bank 0.0514 0.6643 -0.6129 0.0122 0.6973 -0.6851 0.1381 0.3144 -0.1763 -0.5191 development credit bank 0.5699 0.1718 0.3981 0.4533 0.1656 0.2877 0.0819 0.3771 -0.2953 0.1634 dhanlaxmi bank 0.2277 0.3776 -0.1500 0.0387 0.6015 -0.5628 0.1865 0.2800 -0.0934 -0.2915 federal bank 0.8828 0.0238 0.8590 0.9571 0.0002 0.9569 0.6720 0.1576 0.5144 0.8006 hdfc bank 0.7941 0.0924 0.7016 0.8236 0.1055 0.7181 0.9001 0.0329 0.8672 0.7539 icici bank 0.5075 0.1953 0.3121 0.0788 0.4938 -0.4150 0.0156 0.5319 -0.5163 -0.1950 idbi bank 0.1161 0.0000 0.1161 0.1212 0.0000 0.1212 0.1408 0.3122 -0.1715 0.0381 indian bank 0.4517 0.2214 0.2302 0.3960 0.1891 0.2070 0.6134 0.1682 0.4452 0.2811 ing vysya bank 0.2757 0.3279 -0.0522 0.1354 0.3789 -0.2436 0.0321 0.4613 -0.4292 -0.2298 indian overseas bank 0.1011 0.5574 -0.4563 0.4138 0.1812 0.2326 0.0714 0.3911 -0.3198 -0.1559 j &k bank 0.5184 0.1900 0.3284 0.5482 0.1438 0.4044 0.2545 0.2477 0.0068 0.2680 karnataka bank 0.5189 0.1898 0.3291 0.1897 0.3127 -0.1230 0.0000 0.7528 -0.7528 -0.1437 kotak mahindra 0.9593 0.0000 0.9593 0.9574 0.0000 0.9574 0.9986 0.0000 0.9986 0.9695 oriental bank of commerce 0.3750 0.2590 0.1161 0.1166 0.4077 -0.2911 0.1293 0.3226 -0.1932 -0.1250 punjab national bank 0.2651 0.3378 -0.0727 0.2479 0.2673 -0.0194 0.4710 0.1948 0.2762 0.0445 south indian bank 0.3124 0.2978 0.0146 0.4866 0.1556 0.3310 0.2221 0.2612 -0.0392 0.1202 standard chartered 0.8769 0.0288 0.8481 0.2095 0.2951 -0.0856 0.5858 0.1730 0.4128 0.3715 state bank of india 0.2296 0.3753 -0.1457 0.1917 0.3107 -0.1191 0.0496 0.4243 -0.3748 -0.1992 syndicate bank 0.0340 0.7139 -0.6799 0.0393 0.5997 -0.5605 0.1131 0.3400 -0.2269 -0.5086 tamilnad mercentile bank 0.9073 0.0115 0.8957 0.9283 0.0319 0.8964 0.8088 0.1298 0.6790 0.8358 uco bank 0.0000 0.9205 -0.9205 0.0082 0.7215 -0.7134 0.0316 0.4626 -0.4309 -0.7056 union bank of india 0.1132 0.5335 -0.4204 0.2598 0.2597 0.0001 0.2484 0.2497 -0.0013 -0.1438 united bank 0.0354 0.7089 -0.6735 0.0859 0.4759 -0.3901 0.0279 0.4751 -0.4472 -0.5027 vijiya bank 0.0461 0.6776 -0.6315 0.1208 0.3996 -0.2788 0.0158 0.5303 -0.5145 -0.4646 yes bank 0.6631 0.1493 0.5138 0.8996 0.0754 0.8242 0.8617 0.0860 0.7758 0.7048 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 331 table 7. promethee scores for risk debt/equity ratio net npa/total advances beta ϕ+ ϕϕ ϕ+ ϕϕ ϕ+ ϕϕ φ allahabad bank 0.3280 0.2673 0.0607 0.2509 0.3843 -0.1334 0.4005 0.1408 0.2597 0.0620 andhra bank 0.4194 0.1894 0.2300 0.0068 0.8541 -0.8473 0.2671 0.2826 -0.0156 -0.2219 axis bank 0.1997 0.4965 -0.2968 0.0569 0.7037 -0.6467 0.6509 0.0227 0.6282 -0.1018 bank of baroda 0.3653 0.2243 0.1410 0.0428 0.7237 -0.6809 0.1847 0.4673 -0.2826 -0.2841 bank of india 0.5929 0.1051 0.4878 0.2642 0.3691 -0.1048 0.3802 0.1576 0.2225 0.1949 bank of rajasthan 0.6186 0.0982 0.5203 0.2142 0.4425 -0.2283 0.0000 0.9115 -0.9115 -0.2227 canara bank 0.3686 0.2213 0.1474 0.3940 0.2419 0.1521 0.2971 0.2415 0.0556 0.1178 central bank of india 0.9026 0.0350 0.8676 0.5213 0.1830 0.3382 0.4396 0.1096 0.3300 0.5037 citi bank 0.0224 0.8368 -0.8144 0.4046 0.2359 0.1688 0.0000 0.9115 -0.9115 -0.5112 corporation bank 0.3862 0.2093 0.1770 0.0310 0.7562 -0.7252 0.1306 0.7519 -0.6213 -0.4031 dena bank 0.7843 0.0649 0.7194 0.6577 0.1331 0.5246 0.6626 0.0201 0.6425 0.6266 development credit bank 0.0863 0.7202 -0.6340 0.9793 0.0000 0.9793 0.7844 0.0026 0.7818 0.3993 dhanlaxmi bank 0.5542 0.1187 0.4354 0.3365 0.2880 0.0485 0.4948 0.0772 0.4176 0.2970 federal bank 0.0402 0.8003 -0.7601 0.0413 0.7262 -0.6849 0.2528 0.3047 -0.0519 -0.4935 hdfc bank 0.0814 0.7267 -0.6454 0.0401 0.7290 -0.6889 0.1821 0.4796 -0.2975 -0.5420 icici bank 0.2120 0.4761 -0.2641 0.8213 0.0564 0.7650 0.7208 0.0104 0.7104 0.4193 idbi bank 0.3685 0.0000 0.3685 0.4634 0.0000 0.4634 0.5194 0.0668 0.4526 0.4296 indian bank 0.1331 0.6484 -0.5153 0.0189 0.7991 -0.7802 0.1990 0.4204 -0.2214 -0.5059 ing vysya bank 0.3142 0.2925 0.0217 0.3097 0.3183 -0.0086 0.1475 0.6353 -0.4879 -0.1620 indian overseas bank 0.5481 0.1218 0.4263 0.6087 0.1518 0.4569 0.2281 0.3503 -0.1222 0.2502 j &k bank 0.1902 0.5149 -0.3247 0.2537 0.3807 -0.1271 0.1168 0.8506 -0.7338 -0.3962 karnataka bank 0.1704 0.5556 -0.3852 0.5935 0.1574 0.4361 0.3315 0.2030 0.1285 0.0704 kotak mahindra 0.0000 0.8969 -0.8969 0.8824 0.0208 0.8616 0.3224 0.2123 0.1101 0.0470 oriental bank of commerce 0.2329 0.4411 -0.2081 0.2433 0.3956 -0.1523 0.2893 0.2515 0.0379 -0.1054 punjab national bank 0.3209 0.2792 0.0416 0.1282 0.5899 -0.4617 0.1912 0.4437 -0.2526 -0.2306 south indian bank 0.3375 0.2541 0.0834 0.1453 0.5594 -0.4141 0.1494 0.6254 -0.4760 -0.2770 standard chartered 0.0011 0.8894 -0.8883 0.4797 0.1997 0.2800 0.0000 0.9115 -0.9115 -0.4966 state bank of india 0.3394 0.2519 0.0875 0.8742 0.0238 0.8504 0.4396 0.1096 0.3300 0.4309 syndicate bank 0.9406 0.0179 0.9227 0.3223 0.3032 0.0191 0.5815 0.0441 0.5374 0.4826 tamilnad mercentile bank 0.0078 0.8694 -0.8616 0.3711 0.2565 0.1147 0.0000 0.9115 -0.9115 -0.5447 uco bank 0.9856 0.0000 0.9856 0.8618 0.0302 0.8316 0.8231 0.0000 0.8231 0.8776 union bank of india 0.4983 0.1474 0.3509 0.1839 0.4931 -0.3091 0.2398 0.3270 -0.0871 -0.0238 united bank 0.5610 0.1158 0.4451 0.7835 0.0770 0.7065 0.2126 0.3858 -0.1732 0.3242 vijiya bank 0.6964 0.0819 0.6145 0.3711 0.2565 0.1147 0.4948 0.0772 0.4176 0.3766 yes bank 0.1610 0.5792 -0.4182 0.0000 0.9105 -0.9105 0.6163 0.0324 0.5839 -0.2457 asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 332 table 8. promethee scores for earnings performance return on net worth pat/total assets ϕ+ ϕϕ ϕ+ ϕϕ φ allahabad bank 0.5930 0.0826 0.5104 0.3515 0.2074 0.1441 0.3631 andhra bank 0.5495 0.1151 0.4344 0.4393 0.1473 0.2920 0.3771 axis bank 0.4503 0.2177 0.2325 0.5446 0.0902 0.4544 0.3218 bank of baroda 0.3779 0.2970 0.0809 0.3125 0.2473 0.0652 0.0746 bank of india 0.6319 0.0599 0.5720 0.2782 0.2872 -0.0090 0.3383 bank of rajasthan 0.1024 0.5979 -0.4956 0.0294 0.8033 -0.7739 -0.6075 canara bank 0.6943 0.0329 0.6615 0.3514 0.2075 0.1439 0.4532 central bank of india 0.4440 0.2248 0.2192 0.0394 0.7462 -0.7068 -0.1534 citi bank 0.3156 0.3643 -0.0487 0.7650 0.0451 0.7199 0.2605 corporation bank 0.4571 0.2109 0.2462 0.3889 0.1817 0.2071 0.2305 dena bank 0.6653 0.0448 0.6205 0.2174 0.3822 -0.1648 0.3045 development credit bank 0.0000 1.0000 -1.0000 0.0000 1.0000 -1.0000 -1.0000 dhanlaxmi bank 0.0319 0.7548 -0.7229 0.0448 0.7233 -0.6785 -0.7051 federal bank 0.1002 0.6013 -0.5011 0.5159 0.1011 0.4148 -0.1326 hdfc bank 0.3210 0.3579 -0.0369 0.6797 0.0609 0.6188 0.2269 icici bank 0.0820 0.6377 -0.5558 0.2638 0.3064 -0.0425 -0.3493 idbi bank 0.0392 0.0000 0.0392 0.0511 0.0000 0.0511 0.0440 indian bank 0.8395 0.0000 0.8395 0.8397 0.0330 0.8067 0.8263 ing vysya bank 0.0323 0.7535 -0.7213 0.0890 0.6177 -0.5287 -0.6438 indian overseas bank 0.6106 0.0714 0.5391 0.2875 0.2760 0.0115 0.3269 j &k bank 0.2959 0.3899 -0.0940 0.4708 0.1263 0.3445 0.0824 karnataka bank 0.1160 0.5808 -0.4648 0.3101 0.2500 0.0601 -0.2536 kotak mahindra 0.0311 0.7593 -0.7282 0.5266 0.0965 0.4301 -0.2622 oriental bank of commerce 0.1089 0.5891 -0.4802 0.1496 0.5078 -0.3582 -0.4311 punjab national bank 0.7171 0.0259 0.6912 0.5035 0.1072 0.3962 0.5725 south indian bank 0.2421 0.4509 -0.2088 0.2497 0.3283 -0.0786 -0.1564 standard chartered 0.8383 0.0001 0.8382 1.0000 0.0000 1.0000 0.9033 state bank of india 0.1835 0.5057 -0.3222 0.2217 0.3751 -0.1534 -0.2543 syndicate bank 0.5567 0.1086 0.4481 0.1284 0.5446 -0.4162 0.1004 tamilnad mercentile bank 0.1586 0.5306 -0.3720 0.8766 0.0294 0.8472 0.1185 uco bank 0.5528 0.1119 0.4409 0.0450 0.7225 -0.6775 -0.0091 union bank of india 0.7964 0.0078 0.7886 0.3420 0.2161 0.1259 0.5220 united bank 0.0294 0.7804 -0.7510 0.0298 0.7989 -0.7691 -0.7583 vijiya bank 0.2667 0.4260 -0.1593 0.0900 0.6156 -0.5256 -0.3067 yes bank 0.4335 0.2372 0.1962 0.5465 0.0896 0.4569 0.3011 microsoft word 15149-54665-1-sm-writer2-new-final2 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 1 are islamic banks really more solvent than conventional banks in a financial stable period? achraf haddad (corresponding author) doctor in financial and accounting methods. researcher at a laboratory of finance, governance, and accounting university of sfax, tunisia. e-mail: achraf.haddad2015@gmail.com anis el ammari associate professor of accounting and finance department head of accounting and finance, university of monastir, tunisia e-mail: ammari_anis1@yahoo.fr abdelfettah bouri professor of finance at the faculty of economics and management of sfax director of finance, governance, and accounting laboratory, university of sfax, tunisia e-mail: bouriabdelf@gmail.com received: august 5, 2019 accepted: sep 22, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15149 url: https://doi.org/10.5296/ajfa.v11i2.15149 abstract: the knowledge value produced by this research was established in particular by the methodological challenges of the comparative study. based on a process of bibliographic research, available conditional observation and necessary statistical tests, we innovated an equiprobable comparison between the solvencies of conventional and islamic banks over the period (2010-2018). our study is not only a matter of dealing generically with the financial solvency question of conventional and islamic banks but also, we analyzed the inherent implications and difficulties that may alter the results and influence the establishment of an operative evaluation of financial institutions. two samples were taken from two reference populations. the core populations are all existing conventional and islamic banks in the selected countries. the choice of banks is limited to countries whose banking systems asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 2 incorporate both islamic and conventional banks regardless of the proportion of each system in the country's banking market. subsequently, each list bank was reduced based on qualitative and quantitative filtering criteria. therefore, each conventional bank has its closest islamic equivalence in terms of capital and size taken from the same country. this restriction reduced the sample size to 63 banks each. the selected banks are all large and listed in different stock exchanges around the world. in conclusion, we found that conventional banks are more solvent than islamic banks during a financial stable period. keywords: conventional banks, islamic banks, solvency, comparative study, financial stable period. jel classification: f33, g20, g21, g24, g30. abbreviations’ meaning: cb: conventional bank; cbs: conventional banks ib: islamic bank; ibs: islamic banks asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 3 1. introduction performance is a topic of debate, it remains the primary goal of any business without exception (gilbert and charpentier, 2004). numerous studies have focused on the performance of banks because of the impressive development and the pace increasingly accelerated of economic growth, marked by a succession of financial crises. interest in the performance of ibs is growing due to unexpected financial developments. redesigning this type of institution as a panoply of the global monetary system leads to the intensification of a typical differential competition between two banking models in an increasingly hostile financial world always seeking the maximization of performance and wealth. the assessment of bank performance is very important for all stakeholders: depositors, bank managers, investors, and regulators. in the financial market, the banks’ performance provides a signal to the owners of capital, depositors, and investors to operate or withdraw their funds from the bank. similarly, the assessment provides a signal to islamic and conventional bank managers to improve their deposit and loan services or both to improve their financing capabilities. regulators are also interested in knowing the degree of compliance as well as the horizon of its regulations. systemic risk could in turn trigger a solvency crisis for banks in such a country ended by the destruction of the banking system at the international level in the broad sense. from here, the world of monetary exchange has given attention to the need to control the banks’ solvency. however, previous studies of bank performance are diverse, but they are far from satisfactory (yeh, 1996; dirrar, 1996; samad, 1999; ariff and khalid, 2000; samad and hassan, 2000; roslyand bakar, 2003; webb, 2003; lacewell, 2003; halkos and salamouris, 2004; samad, 2004b; yudistira, 2004; hussein, 2004; alkassium, 2005; majid et al., 2005; tarawneh, 2006; kader et al., 2007; fadzlan, 2007; bader et al., 2007; toumi, et al., 2008; siddiqui, 2008; moin, 2008; ben khediri et al., 2008; olson and zoubi, 2008; shamsher et al., 2008; cihak and hesse, 2010; safiullah, 2010; hasan and dridi, 2010; hussein and charif, 2011; ika and abdullah, 2011; jaffar and manarvi, 2011; omar and muhammad, 2012; johnes et al., 2012; beck et al., 2013; eljelly and elobeed, 2013; fayed, 2013; rozzani and rahman, 2013b; moin, 2013; najjar, 2013; al-kayed et al., 2014; hunjra and bashir, 2014; zarrouk, 2014; cengiz et al., 2014; youssef and samir, 2015; jaffar, 2016; tlemsani and al-suwaidi, 2016; tabash et al., 2017). although solvency is a parameter of performance, from the comparison of bank solvency indicators, we have found that primary research has suffered from organizational and technical limitations to fill in the application and analysis required. based on the correspondence of the same performance measures and the same scenarios in the context of classical or islamic banks, two conclusions have been drawn from the literature. on the one hand, ibs are more solvent if the sample tested is large. moreover, the samples were taken from the countries in which both conventional and islamic banks exist simultaneously. on the other hand, if the sample tested is average, cbs are found to be more solvent than their islamic counterparts. however, some researchers have found that in countries where the market share of ibs is greater than that of cbs, solvency and stability are still volatile. specifically, cbs tend to be more solvent, but less stable. nevertheless, this does not preclude a third stream of researchers finding that ibs could not be dominant in a banking market if they operated in parallel with a conventional banking framework (sarker, 1999a). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 4 to distinguish between conventional and islamic banks in terms of financial performance, various indices have been provided by financial management theories to measure the performance of banks. since we have chosen the accounting approach, solvency has been used very often in the literature as a key indicator for measuring changes in financial performance. among the founders using financial ratios to explain these bank performance indicators, we quote (david and elyas, 1994; sabi, 1996; metwally, 1997; karim and ali, 1989; samad, 1999; samad and hassan, 2000; rosly and bakar, 2003; kader and al-maghaireh, 2007; olson and zoubi, 2008; moin, 2008; parashar and venkatesh, 2010; hasan and dridi, 2010; jaffar and manarvi, 2011; iqbal, 2012; osama et al., 2013; beck et al., 2013; wasiuzzaman and gunasegavan, 2013; fayed, 2013; cengiz et al., 2014). the existence of two banking models in the financial market does not protect the solvency of one part to the solvency of other parts. on the other hand, the literature revealed that the two categories went bankrupt in one context or another if not, the weakness of the solvency of any banks’ type varies from one context to another. the period of the subprime crisis forms a temporal space for reevaluating the conclusions of previous research focused on comparative studies between the solvencies of classical and islamic banks. moreover, the deterioration and variability of solvency, the appearance of financial crises randomly and sudden bankruptcy in one type of bank or another with different proportions explain the choice of our period of study. the subprime financial crisis is, therefore, a good opportunity to test and distinguish the divergence between the two banking models. this crisis has forced developed countries to invent classical and islamic financial models, alternative arrangements have become necessary, able to save each model apart from everything depends on its particularities. although in most cases previous studies results on the comparison between the solvency of islamic and conventional banks are mixed or contradictory, through our study, we sought to answer definitively the following question: what is the type of banks, really, the most solvent in this comparative framework? this information makes it easier for economic agents and decision-makers to detect the best choices of financial backers in the event of savings and financing when investing in a world of financial competitiveness. besides, our results will help policymakers set better solvency targets and enable bank managers to allocate capital more effectively, publish clear financial information and communicate a conclusive and definitive answer. our study provided an overview of the fragility, vulnerability, and instability of conventional and islamic banking systems, and makes a comparison between the two models. this research work makes it possible to achieve the following objective: establish a radical paradigm of choice between the banking solvencies that allows us to review its degree of validity and develop more precise, decisive and well-argued conclusions. moreover, as the first contribution to the financial literature, our study answered explicitly to the proposed gap. the second contribution of this article concerns the conditional methodological approach in the choice of the banks’ observations and by respecting a severe procedure of application of the statistical tests. our third contribution is to make a comparison between 16 heterogeneous countries covered three continents in a stable economic context. the fourth contribution, this paper brings a potentially powerful empirical demonstration and a validation of our hypothesis. restriction of size has required the elimination of small banks that are generally unlisted, this asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 5 combination systematically reduces the effect of the categorical homogeneity, the size, the extent of differences, and the particularities of banks’ structures on the solvency of each sample. in addition, we distinguished between the two types of banks based on a very specific parameter of financial performance rarely taken alone in previous studies, also, we used a single measure of solvency. the remainder of the paper is structured as follows. section 2 presents the concept of solvency in banks and literature review based on contradictory previous conclusions. section 3 describes the methodology and data. section 4 discusses the empirical results and gives the implications of the findings. section 5 concludes the study. 2. theoretical approach of bank solvency and development of hypothesis for a long time, the previous studies dealing with the ibs’ solvency are manifested in the simple research form on the management of financial instruments. it is important to note that these measures were inspired by other studies on cbs (ariff and khalid, 2000; samad and hassan, 2000). previous studies have perpetually used proportional and approximate measures to assess cbs’ solvency. subsequently, researchers adapted the same measures to estimate ibs’ solvency. the studies for which they have compared the solvency of classical and islamic banks are divided into two streams. the first current has considered that the joint existence of ibs along with cbs can let the former operate with their full levels of solvency. the decline in the solvency is not only due to the mechanical and systemic inadequacies of ibs, but also to the competition imposed by the conventional banking market; the toxic and restrained financial operations of the conventional banking system, and the contradictions between the particular dimensions of the two banking segments that hinder the smooth functioning of ibs. this does not mean that the success and survival of ibs is conditioned by the existence of a monopoly banking market. ibs can operate with minimal security effectiveness which guarantees its durability even in a conventional banking framework due to its operating system based on the mode of sharing profits and losses. besides, management of ibs and selection of sectors or areas of activity is done judiciously. however, the second current has considered the lower solvency of ibs as the origin of the systemic inefficiency of the cbs. moreover, ibs’ solvency compared to their conventional counterparts varies from one region to another depending on whether it is an islamic country or not. this view was justified by the difference between the prudential rules of the transactions applied in the two banking segments. in fact, the risk level taken by the lender by granting credit via mushraka or mudaraba is higher than the risk level generated by the techniques involved in commercial-type financing (khan, 2012; thomi, 2014). the choice of such a ratio depends on the importance of the obtained results (modell, 2004; vakkuri and meklin, 2006), the inclusiveness, the complementarity and the precision of this ratio. this ensures the logic of interpretation and is a good means of analysis and an effective method of management (weick, 1995; de-kool, 2004). however, research in the literature has shown that the simultaneous highlighting of multiple solvency ratios has revealed contradictory or non-conclusive conclusions. table 1 illustrates some comparative and recent studies between the solvency of classical and islamic banks already published in the literature. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 6 table 1. methods of solvency evaluation in previous studies. researcher(s) context period measurement results of research samad and hassan (2000) malaysia (19841997) fra method + anova method bank islam malaysia berhad is relatively less risky and more solvent than those of cbs. toumi et al. (2008) 18 countries (20042008) fra method ibs have a debt to equity ratio, debt to assets ratio and a long-term debt ratio lower than those of cbs. ibs have less leverage compared to the leverage effects recorded in cbs. mobeen et al. (2011) uae (20062008) fra method ibs are more solvent in the long run. hanif et al. (2012) pakistan (20032007) banco-meter model ib is more solvent (less risky) than the list of cbs. sehrish et al. (2012) pakistan (20072011) fra method ibs are less risky and more solvent than their conventional counterparts. this indicates that the two groups of banks do not belong to the same risk class. onakoya and onakoya (2013) united kingdom (20072011) fra method ibs are less exposed to solvency risk, while cbs rely more on additional external sources of finance. fayed (2013) egypt (20082010) banco-metre model both cbs and ibs are considered insolvent, but ibs have shown superior insolvency. zarrouk (2014) 10 mena countries (20052010) fra method the findings further pointed out that ibs in nongcc countries were less risky and more solvent during and after the period of the financial crisis than those in the gcc countries. ola and suzanna (2015) uae (20082014) fra method cbs are, on average, more solvent and less risky compared to their islamic counterparts (kader et al., 2007). mousa (2015) bahrain (20102013) fra method and dea method analysis of financial ratios did not sign definitive conclusions about the solvency capacity of cbs. banks periodically solvent in a year or rather the banks which recorded a single significant ratio were not solvent in other years in terms of periods and type of ratios. maysa and rasha (2015) jordan (20092013) fra method ibs are found to be statistically more solvent than their conventional counterparts. this indicates that ibs are less risky, which reflects their financial strength to pay their debtors. bilal and amin (2015) pakistan (20072012) fra method ibs had less solvency risk than their conventional counterparts throughout the study period. (kader et al., 2007) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 7 elgadi (2016) sudan (20052013) regression method management quality of ibs is insufficient to predict and avoid the risk associated with leverage. tlemsani and al-suwaidi (2016) uae (20072008) fra and a crosssectional analysis in terms of solvency risk mitigation, ibs outperformed cbs. referring to previous comparative studies of bank solvency through the use of multiple ratios, we have noticed that the conclusions are almost always mixed. they are sometimes similar, but they are also sometimes contradictory from one study to another. in both scenarios, the advanced results are inconclusive due to the lack of convincing confirmations and lack of generalization. since the use of various ratios or the solvency measures are not efficient enough to obtain unique results, we have developed a new approach in our work. it consists of testing its approach is to test a single measure of efficiency in order to have convincing final answers. few studies have focused on the degree of ibs’ solvency, despite that this issue has been widely explored against cbs. the subprime crisis has not only cast doubt on the smooth functioning of cbs, but it has also triggered attention to demonstrate the solvency horizon of the ibs. to assess banks’ solvency and the degree of exposure to credit risk, several methods of analysis are available to researchers. although our choice was pre-established on the ratio method, we used the usual measure. solvency ratios are primarily related to financial leverage. leverage represents the extent to which a bank relies on debt financing rather than equity (osama et al., 2013). indeed, solvency also measures the degree of repayment of the credits granted and the financial risk that the bank has faced. (tandelilin et al., 2007) concluded that loan to deposits ratio has a significant effect on performance at a 1% confidence level. a bank is solvent when the total value of its assets exceeds its liabilities. in the general sense, a high level of this ratio can lead to a high probability of bankruptcy (norhidayah et al., 2011). the measures on which most analyses of a banks’ solvency are based rely heavily on the financing of debt rather than equities. on the one hand, these ratios determine the likelihood that a bank will not meet the demand for credit and the possibility that it will be able to continue to meet its long-term debt obligations (osama et al., 2013). on the other hand, the ratios measure the bank's ability to not pay its debts to its lenders. the higher the debts of a bank, the more it will become unable to fulfill its contractual obligations. in other words, high leverage translates into rising debt levels, which can lead to financial distress and increase the likelihood of bankruptcy. in the case of cbs, the loans to deposits rapport represents the depositors' contribution to cover loans granted by banks to their borrowers. banks with low solvency ratios are considered to have excess liquidity. besides, they are characterized by potentially low levels of risk, which means they are less profitable than cbs with high solvency ratios. however, a high solvency ratio indicates that the bank has taken a considerable financial stress (risk) following the granting of excessive loans to these depositors, up to the approval of loans with high exposure to losses and losses at low collection rates granted to doubtful or insolvent customers. in contrast, in the case of ibs, the situation is different, since they are prohibited from granting loans and earning interest. loans include project financing. banks finance only projects that asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 8 produce additional value. several previous studies have confirmed the resilience of ibs during the subprime crisis more than their conventional counterparts. they justified the enormous capacity of financing the engagements by the quality of investment portfolios carried out by ibs. the reversals on these investments allow ibs to reduce their debts and improve in part their solvency levels. solvency ratios provide a picture of a bank's ability to generate cash flow and meet its long-term financial obligations. in other words, if the amount of total banking assets is greater than the amount of all types of debt (its own funds), then the bank is considered solvent. deposits are a major responsibility and a contractual alliance commitment for all banks’ types, be they islamic or conventional. in ibs, this rapport signifies the ability of ibs to cover their claims for customer loans through deposits collected, while respecting the restrictions of islamic sharia. a low ratio of depositors provides a significant proportion of loans to banks, which leads to a lack of liquidity. this makes it easier for banks to meet their commitments on time. on the contrary, a high ratio means that the bank is in financial difficulty because of insufficient liquid assets to meet their unexpected fund requirements. as previous studies dealing with the topic of a convergent or recurrent conflict, the comparative results revealed in some cases the priority of islamic banking because they are less risky and more solvent (samad, 2004b; kader et al., 2007; moin, 2008; hanif et al., 2012). however, other studies confirmed that cbs are more solvent and generated less risks, whereas, ibs were found to be riskier (hasan and dridi, 2010; fayed, 2013). hence our hypothesis is the following: hypothesis: ibs are more solvent than cbs in a financial stable period. to overcome the theoretical confusion of this subject and to answer the problem posed in the literature review, in the next section, we proceed to empirically demonstrate the evolutionary aspects of the solvency of islamic and classical banks from a comparative perspective. in what follows, we try to answer and interpret empirically the test which aims to provide answers to the question previously asked: are the ibs really financially more solvent and more solid than cbs or is the opposite assertion right? 3. methodological framework: presentation of the data and comparison between banks solvencies according to the literature review on this topic, we tested the empirical validity of the hypothesis already proposed and to qualify the interdependence, which may exist, between the solvency of cbs and that of ibs. several studies have confirmed the advantage of ibs because they can withstand international financial crises and economic collapses (jouini and pastre, 2009; siddiqui, 2009; masmoudi and belabed, 2010). indeed, other comparative studies have demonstrated the stability of the islamic financial system and its continued ability to ensure sustainable improvement of the solvency of ibs even after the occurrence of the crisis. however, a third current has proved that the assumption of financial strength / fragility of islamic and conventional banks has been destroyed during difficult periods of financial crisis / stability. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 9 to continue our approach, we began our empirical study after having discussed the main empirical results elaborated on the topic of the financial stability of the banks. this section is structured as follows: we develop the related methodological choices in the first section and we discuss our empirical evidence in section 2 after analyzing the comparative results of the solvency values of ibs and cbs. in this section, we highlight the best operational approach of comparing solvencies’ ratios of conventional and islamic banks. we adopted the financial ratios analysis method which is the most practical method applied after an adaptation procedure and a convergent methodological demonstration. this choice is explained by several reasons. first, all performance indicators are measured by non-confirmatory ratios (teker, et al., 2011; rashid and khaleequzzaman, 2015). secondly, because the solvency specific data of conventional and islamic banks are not easily collected from their annual reports, the reduction of our samples’ size is necessary since the requested information on solvency is not always disclosed. finally, given the available banking information, we conducted a conditional study, in which the selection of observations constitutes a methodological contribution of high-quality results and a basic limit to the data collection process. the preliminary observations taken into account necessarily affected the hypotheses put forward, so that the observation that does not comply with the rules of the game has been eliminated in the order of the following hypotheses until the two final samples are obtained. our contribution is to compare a single solvency ratio. first, we explained the procedure for selecting two bank samples definitively selected after applying the database collecting method. in the second step, we defined the two measures of variables. afterward, we have exploited the preferable method to interpret the results found. 3.1. description of the samples studied 3.1.1. constitution of the samples both samples tested were taken from two base populations. the first population constituted by 1788 conventional financial institutions, while the second population composed of 467 islamic financial institutions. these populations covered three continents: europe, asia, and africa. sixteen countries are involved in our work: egypt, bangladesh, indonesia, pakistan, malaysia, turkey, united kingdom, bahrain, jordan, kuwait, oman, qatar, saudi arabia, united arab emirates, south africa, and sri lanka. however, after the exclusion of all financial institutions operating with specific regulations, we tested samples include only purely conventional or islamic banks. besides, given the difficulties in collecting financial information, we excluded banks for which we detected missing observations, variables or data. moreover, we also dismissed multi-type mutated banks (ib with conventional windows and cb with islamic windows). these three conditions led us to eliminate 337 conventional financial institutions and 231 islamic financial institutions. subsequently, the number of remaining banks of each type of bank was reduced based on qualitative and quantitative filtering criteria (equality of samples, type of activity, similarity of country’s origin, bank width). therefore, each cb has its closest islamic equivalence, taken from the same country in terms of capital and size. this restriction reduced our samples’ size asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 10 to 63 banks each. finally, after several eliminations and deletion steps, we obtained two pairs of equal samples (n1= n2). 3.1.2. data collection the data was collected from the datastream database. to better understand the dissimilarities between the two groups of banks and to improve the clarity of the results, the choice of the observations relates essentially to individual data, even if the bank belongs to a group of banks. nevertheless, the accuracy of the results required following a data filtering procedure so that observations containing some missing data were eliminated. for this reason, we have been careful to remove financial institutions that do not qualify as banks. furthermore, we have also excepted the banks belonging to the same sample whose types are heterogeneous in order to obtain a sample of cbs which is almost similar to its islamic counterpart and vice versa. similarity includes also equality between cbs and ibs samples’ size. moreover, the number of ibs chose from each country is equal to the number of cbs in the same country. while, as revealed in table 2, the affinity means that in each country, the conventional or the islamic bank (cob1, inb2 or unb3) of the first sample must have its counterpart of the second sample located at the same country with a probability of 94.7%~(95%). after filtering, each sample has a total of 63 banks and 567 observations collected during the period (2010-2018). the following table summarizes of the process followed, as well as the different stages of the observation selection process. table 2. samples filtering process of classical and islamic banks. gait number of cbs number of ibs populations of initial financial institutions 1788 467 exclusion of non-bank financial institutions and banks whose data are not published, available or have missing data as well as nonconventional or islamic banks. 1451 236 exclusion of additional banks at the limit of choice of similar banks and converge. 274 168 final sample 63 63 bank type cob inb unb cob inb unb number of banks 41 15 7 36 19 8 proportion of total sample 65.08% 23.81% 11.11% 57.14% 30.16% 12.70% similarity rate 92.06% 93.65% 98.41% 92.06% 93.65% 98.41% difference rate 7.94% 6.35% 1.59% 7.94% 6.35% 1.59% 3.2. measurement of the variables to be compared since the findings in the literature are inconclusive due to the heavy use of financial ratios, we 1 cob : commercial type 2 inb : investment type 3 unb : universal type asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 11 symbolized the solvency by a single ratio. our ratios choice is justified by two main reasons. on the one hand, in practice, a deep contention arises. the large cbs listed adopt accounting rules established by international standard setters (iasb)4 and (fasb)5. the prohibition of using of interests means that some conventional accounting practices may not be applicable in islamic financial institutions. therefore, not all measures are valid for performing a comparative study between banking systems. in this case, the choice of a single ratio to assess the solvency situation provides conclusive results that better reflect the bank's reality, whatever its type. on the other hand, the two models differ in terms of the asset valuation method, the drafting of financing contracts, the recognition and treatment of income (ahmed, 2002; haniffa and hudaib, 2002). therefore, the financial ratios of the two models are not calculated in the same way and the informational content of its measures will not be treated and interpreted identically. to remedy these problems, (a.a.o.i.f.i.)6 has issued custom-tailored accounting and auditing standards in coordination with other specific agencies for use by listed and unlisted ibs. this does not mean that existing conventional accounting measures and concepts will all be ignored or adopted. but, concepts inconsistent with sharia rules have been rejected or modified, while concepts converging with sharia principles have been incorporated into the norms (a.a.o.i.f.i.) (lewis and algaoud, 2001). although each country has its own accounting framework that is more/less different from other countries, this is the theoretical proof that avoids the lack of clarity related to differences in the application of accounting standards. before the determination of the financial ratios, the account must be taken of the constitutional and functional differences between cbs and ibs. practically, the functions of ibs resemble those of cbs. islamic scholars have compared the discrepancies to develop similar products to those of cbs, allowing them to replace interest rate payments and update fees (beck et al., 2013; ada and dalkilic, 2014). for example, waseem (2008) argued that financing costs are almost the same in ibs and cbs. his argument was that interest rates take into account administrative costs, the sharing of profits and record ancillary costs. in particular, (turen, 1996) has assimilated methods for calculating financial ratios of the two types of banks. he suggested that the ib activity depends on the combined effect of three laws governing the degree of the gap between the two banking models. first, the deposits holders at the level of cbs are replaced by the shareholders of ibs. second, interest paid to depositors is converted by shared profits or losses. third, loans to cbs’ customers are converted into equity investments in ibs. compliance with these three principles indicates that most financial ratios in the two categories of banks are defined in the same way. however, the net income of an ib includes the conventional net income before taxes, plus zakat, which has been supplemented by the income tax. moreover, interest expenses are replaced by commission income and expenses. indeed, the loans and advances granted by the cbs are essentially equivalent to the investments according to the technique of mudaraba, murabaha, and moucharaka. as a result, all researchers tend to evaluate the major sections of the financial statements of two banks’ 4iasb: international accounting standards board. 5fasb: financial accounting standards board. 6a.a.o.i.f.i.: accounting and auditing organization for islamic financial institutions. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 12 types. they find that the main elements are almost similar. to measure bank solvency, we have separated this notion by a single indicator. the table 3 summarizes all the information needed to qualify this variable. table 3. clarification, description, and symbolization of banks’ solvency. cbs rating ibs rating measurement previous studies stc sti total loans / total deposits tandelilin et al. (2007) olson and zoubi (2008) bougatef (2011) norhidayah et al. (2011) onakoya and onakoya (2013) ola and suzanna (2015) 3.3. operative method of interpreting the comparison results between solvencies of islamic and conventional banks the review of the literature assessed the resistance of conventional or islamic banking institutions to financial shocks, allowed us to draw two conclusions. in previous studies, researchers have in most cases applied a deterministic or demonstrative approach, but they have never tested the exploratory approach. besides, they conducted either single-sector impact studies encompassing only cbs, only ibs or exceptionally case studies, the objective being to demonstrate the effect of financial crises or other banks characteristics on a solvency parameter, or comparative studies between two or more models to make a simple comparison to determine the type of impact between the two groups. at first sight, they justified the bankruptcy of cbs independently of their competitors in the banking market and without performing causal linear reasoning. researchers in the previous studies have shown that cbs have been hit hard because of the rapid decline in the value of their assets. some institutions went bankrupt while other institutions were saved because of public bailouts. furthermore, the islamic banking institutions, in all cases, even if they had been impacted, they had lowered their financial performances and they were not widely affected. to answer the previously asked questions, it is interesting to choose the constructivist analysis approach. this approach would be a key factor and a necessary tool for successful recognition and legitimization of research. moreover, the proposed approach is the most appropriate for assessing knowledge and suggesting new thinking. constructivism has been defined by perret and seville (2003) as "an approach to knowledge in terms of ethical validity, that is, based on criteria and methods that can be discussed". our study aims to reveal empirically the most solvent banking model during a period of economic stability, after a comparative analysis between two heterogeneous samples of islamic and classical banks. the choice of an empirical process has a direct effect on the trends in the synthesis results and the interpretations’ quality, which was why we had established a specific and original method of samples’ composition. the evaluation technique of associated bank solvency frequently used in comparative studies between ibs and cbs is the "financial ratio analysis method" (o’connor, 1973; chen and shimerda, 1981; ross, 1991; hempel and simonson, 1998; iqbal, 2001; rosly and bakar, 2003; asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 13 haron, 2004; samad, 2004b; olson and zoubi, 2008). our contribution consists in adopting a single parameter to express the bank solvency, st. after presenting our samples and our test subjects variables, this section is devoted to the analysis of the empirical results of the two samples. the statistical interpretation began with the verification of the distributions’ normality. then, we tested averages comparison. however, the application of such a parametric test relies on autonomous conditions before its adoption. moreover, the implementation of the comparison test between the averages of two or more samples requires the satisfaction of certain approved conditions. the choice varies according to the case depending on the close link with the type of sample (independent or matched sample), the type of variables (qualitative or quantitative) and if the variables to be tested are quantitative, it is necessary to make sure of the normality of distributions. in this case, before testing the hypotheses, we first checked the normality of the variables of each sample. finally, in the light of empirical results, we decided on the most solvent group of banks. since the two samples are independent, the comparison cannot be made without testing the equality between the two groups. in other words, whether the two samples come from the same reference population or belong to two distinct populations. we need to know in advance whether the average of the normally distributed solvency of cbs is higher (or lower) than the average solvency of ibs under the same law. 3.3.1. test of normality this test allows us to know if there is a significant difference between the two types of banks and determine the meaning of the correlation if it exists. first, we verified the distributions’ normality of the variables explained by the skewness and kurtosis test or by another test of normality. then we went on to analyze the results of the comparison tests between the means through the student test and variance comparison test or the mann-whitney test, if necessary. it all depends on the outputs of the statistical tests cited, which means that the variables follow the normal law or not and the rigorous approach to compare two independent samples. the selection of one test instead of another is determined by two conditions: -variables distributions’ normality of the two samples or the non-satisfaction of the simultaneous normality condition of the variables to be compared; -variances’ equality of similar variables to test two by two (homoscedasticity). figure 1 illustrated the choosing process of the appropriate test according to the data collected and the results of the statistical tests obtained: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 14 figure 1. method of choosing the appropriate comparison test to the results of the normality test for all the variables that follow the normal law, before applying the student test, the procedure of this test imposes the verification of the variances’ equality. it means that the estimation of the difference between the average solvency measurements through the student test depends on the validity of the hypothesis of equality between solvency variances. if this assumption is not verified, we apply another substitute test. in case some variables do not satisfy the normality condition, the parametric tests are not applicable. to solve this problem, we can call, as the case may be, either the mann-whitney test or the cochran test. in practice, normality scanning is mandatory if the samples’ size is less than 30 observations. this restriction is not essential when the sample exceeds 30 observations, the minimum size sufficient to ensure the quasi-normality of the sampling distributions. however, the size of our cbs’ sample, as well as that of ibs, are equal to 63 banks. notwithstanding our selection, to ensure the quality of the results and the reliability of interpretations we worked on 567 observations and we verified the normality of distributions, the assurance variables normality maintains the choice of the appropriate tests. furthermore, there is a package of normal-fit tests, among which we have chosen the skewness and kurtosis test. our approach consists in testing two sets of variables that explain the bank’s solvency. one set of variables symbolizes the ibs, and the other represents the cbs. the results of the hypothesis test showed that the normality proposition when the probability associated with the kurtosis coefficient is less than or equal to 5%. table 4 revealed that the pvalue of the cbs’ solvency is less than 5% (0.0000). otherwise, the normality test allows to state, with a certainty of 95%, the non-normality of the data distribution. normality test: skewness and kurtosis test jarque-bera test yes no equality of variances: fisher test mann-whitney test no yes yes no kolmogorov -smirnov test comparison test between means: student test cochran test asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 15 table 4. detection normality of the solvency relative to the cbs’ sample. bank type cbs / number of observations = 567 measurement skewness pr (sk) kurtosis pr (kur) prob > χ2 p-value normality stc 12.461725≠0 0.0000 26.07863≠3 0.0000 0.0000 no similarly, table 5 revealed that the skewness and kurtosis test specific to the ibs’ solvency generated a p-value (0.0057) less than 5%. therefore, we rejected the null hypothesis, which indicates that the solvency of ibs does not follow the normal law. table 5. detection normality of the solvency relative to the ibs’ sample. bank type ibs / number of observations = 567 measurement skewness pr (sk) kurtosis pr (kur) prob > χ2 p-value normality sti 6.624401≠0 0.0000 38.423971≠3 0.0000 0.0057 no 3.3.2. analysis of the non-parametric test: results for comparability of two-samples’ solvencies (mann-whitney test). although almost all statistical tests assume the normality of the random variables studied, this condition is not always confirmed. for variables that do not follow normality law, we can apply the mann-whitney test (u-test). from two independent populations, this non-parametric test devoted to the comparison between two samples. the mann-whitney test replaces the student test but never relies on the constraints of the frequency distribution parameters or the condition of the mean and variance estimate. when the distributions are not normal, the mann-whitney test is appropriate and effective because this test is widely applicable independently of the samples’ size, even if they are not subject to the normality requirement. if the solvency ratio does not validate the normality test for one of two samples, this leads us to ignore the application of the student test even if the normality hypothesis is accepted for the same variable in the other sample. therefore, the distribution of st isn't normal for both types of banks. in this case, the application of the mannwhitney test will then be automatic. according to table 6, we have detected the existence of a considerable difference between the pair of bank solvency parameters. also, we noticed that the p-value (0.0062) of st is less than 5%. for this reason, we rejected h0. so, there is a significant difference between the cbs’ solvency and that of ibs over the period (2010-2018). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 16 table 6. mann-whitney and kolmogorov-smirnov test for the detection of differences between the solvency of conventional and islamic banks. measurement kolmogorovsmirnov p-value mann-whitney ncb = 567 nib=567 p-value comparison test between averages stc and sti 0.4816 0.026 <5% 2.391 0.0062<5% h0 rejected 4. interpretation of the comparative results between conventional and islamic banks’ solvencies a bank is solvent when the total value of its assets exceeds its responsibilities. if the bank has lost its capacity of solvency, it may face financial difficulties both internally and externally. the solvency ratio used in our study is "loan deposits". the ratio of total credits to deposits measures the risk of insolvency thanks to the large amount of credits granted by the classic or islamic bank in relation to its main sources of financing of its credits. this ratio represents a measure of the bank's ability to finance its non-liquid assets (loans) through stable funding availability (deposits). this report allows banks to assess their ability to manage cash in order to summarize their operational solvency. besides, the lower the ratio, the more the bank is classified as a solvent bank (jasim, 1994) and the more it assures its favorable monetary equilibrium position and vice versa. a high value of this ratio indicates the presence of a potential source of insolvency which originates either from the excessive granting of credits or from the drop-in customer deposits. the harmony between deposits and loans has clearly shown that there is a significant difference between the average solvency of ibs and that of cbs. in our case, table 8 showed that the solvency values are marked by a divergence between averages. the average solvency generated by ibs (19.745) is much higher than the solvency generated by cbs (3.168). the mannwhitney test suggests a risk of rejection of the very low null hypothesis (0.0062<5%). indeed, the comparison test reported the existence of a significant difference between the two average solvencies. by deduction, table 7 indicates the presence of a significant effect (0.728 ± 5%). ibs are less solvent and are much more sensitive to the risk of credit distribution compared to their traditional competitors (hasan and dridi, 2010) and (fayed, 2013). this consequence is justified by a largely volatile oscillation (standard deviation = 36.57) comparing to the variation and sensitivity of solvency risk in cbs (standard deviation = 9.37). while the change in the solvency risk is due to a drop-in the level of deposits or a growth in distributed loans, it does not seriously affect performance as ibs are still trying to find the financial equilibrium across the future cash-flows. but the solvency variation signals rather the possibility of the continuity and the operational, financial and systematic durability, which assures their vitalities and guarantees their operations. the huge amount of loans allocated by ibs continuously reflects the high demand for islamic products. this act allows explaining that the rise in the risk of solvency is a normal consequence after the crisis of lack of confidence in cbs from (20072008). a very high level of liquidity reduces the potential for investment. this implies meeting a threshold of liquid assets from which the bank must invest to maintain its solvency and meet its short-term obligations (tanimulislam and ashrafuzzaman, 2015). although the probability asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 17 of comparing bank solvency is lower among ibs, it confirms that cbs are more solvent. also, cbs have a quality of control conscious of their risk of solvency; they take account of deposits and short-term financing systematically insofar as they will be used for the creation of credits. therefore, we have reversed the fourth hypothesis. this is consistent with the findings of the survey conducted by hussain and al-ajmi (2012) who found that the risk levels faced by ibs were significantly higher than those experienced by cbs. table 7. comparison between the solvencies’ ratios of classical and islamic banks. measurement hypothesis test of comparison between the ratios of the solvency decision stc and sti p(stc>sti) = 0.728  0.05 h accepted h rejected presence of significant difference the advantage of the superior cbs’ solvency, compared to that of ibs, is explained by two reasons. on the one hand, after the crisis of 2007, cbs have met a credit account application that has minimized the volume of credit default. moreover, they have kept the same asset position. on the other hand, in a reset-off period, the stability of the solvency level of the cbs is not the result of a positive evolution of the level of deposits, but it reflects a drying up of liquidity. the lack of liquidity is due to a weakness of customer deposits and the reception of additional capital made available to banks. as a result, the situation reflects the drop-in funds collected by natural persons in the case of commercial banks or received from companies in the case of investment banks. however, islamic banking activity is mainly based on three main contracts allowing the bank to raise funds, deposit contracts (qard al hasan), savings contracts whose remuneration depends on the result achieved, the contracts of moucharaka and moudharaba that feed the bank with investment resources. the average liquidity relative to ibs is positive (0.682) during the study period, which means that on average, ibs do not have deposit difficulties as long as the solvency risk is not accompanied by a decrease in liquidity. for this reason, they provided greater confidence for depositors and creditors to save and invest in islamic investments. the number of overwhelming credits granted by ibs to its customers led us to question the degree of control of credit risks. therefore, referring to table 9, although they did not collect 78.91% of deposits from cbs, ibs distributed more than 80.81% of the loans of its funds with a density higher than its competitors (95.46% 93.22%) while exceeding the constraint of size and seniority. these results show that ibs relied less on other non-deposit funds since the ratio (loans / deposits) is higher than that of cbs. thus, ibs had more reserves for loan losses and less nonperforming loans. while cbs have made relatively unproductive large loans and are less stable, they have 1.267 of the total deposits of ibs and they have granted 1.237 of the total amounts of loans distributed, but they have reached a rate of less than ibs (93.22% <95.46%). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 18 table 8. descriptive statistics of the solvency of classical and islamic banks. measurement obs mean std. dev min max stc 567 3.16807 9.3705871 -22.31306 28.6492 sti 567 19.74538 36.571922 -134.01564 173.5064 table 9. relative solvency of classical and islamic banks. bank type/measurement total loans total deposits total solvency cbs 22138659m$ 23748029.6 m$ 0.9322=93.22% ibs 17892101.28 m$ 18741491.34m$ 0.9546=95.46% ratio of relativity 1.237 0.8081 1.267 0.7891 three reasons explain the rationality of our results. first, the customer base of cbs is much narrower than the customer base of ibs in that the two types of banks coexist simultaneously in the highlighted countries, whereas the cbs are older in the modern financial market. secondly, the customer base of cbs is older, more loyal, more organized and more developed. moreover, in our study areas, ibs have succeeded in amplifying their customer bases and attracting the confidence of new depositors. with increasing demands for deposit account openings and increased credit applications, it is reasonable that a high crediting rate increases the risk of solvency, especially in islamic institutions. there are several differences in the mobilization of deposits and the use of funds between islamic and classical banks. first and foremost, the reason for the increase in ibs lending is in terms of the facilities and the remarkable advantages that come with the process of obtaining credit. secondly, the excessive demand for loans then causes less problems of balance between customer deposits and the risk of credit distribution. the growth of credit and insolvency risk in ibs is a systematic mechanism. as it depends on the profitability of the investments financed by the ibs, the level of the credit risk also depends on the projects’ durations, their performances and their returns on funds. the risk of liquidity breach is still low. money collected on the various forms of accounts will be invested in the markets for goods and services, raw materials, leasing or real estate funds. therefore, solvency depends on the profitability of investments, correlated in turn with the level of risk borne. in addition, the size of lending in the asset mix of ibs is marked by the solvency ratio. the volume of loans has shown that sharia-compliant products are very attractive to the segment of the population that requires financial services consistent with their religious beliefs. ibs offered a wide range of islamic financial products and services ranging from deposits, savings, investment, direct financing products, real estate financing to working capital financing, etc. they invested their funds mainly under murabaha, moucharaka, bai-muajjal, rental purchase and qard al hasan, ijara and various islamic lease-back programs. it is reasonable to assume that the inherent risks of the murabaha, ijara, mushraka or mudaraba financing technique are different from those involved in trade receivables, leasing, participation, and other portfolio activities or option leases. the prudential rules applied to these transactions are mechanically different (sarker, 1999b). based on this observation, we justified the allocation of decisive asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 19 reserves explaining the protective policy, simultaneously to maximize the distribution of credits. alternatively, ibs can operate at high risk because they maintain the necessary emergency reserves for late recoveries, non-recoverable debts, bad debts, and high-resistance recoveries. however, for a smaller number of loans distributed, cbs need to maintain more reserves on loan losses since they have more non-performing assets. furthermore, they relied mainly on fee income, commissions, late penalties, interest, and premiums, so they bore more costs and more loan provisions than ibs. the high number of non-performing loans (unproductive loans) indicates that cbs were riskier in their financial operations and also took more provisions when the proportion of bad debts increased. this causes losses on loans larger than those borne by its competitors. to compete in local and global deposit markets and become more profitable and more solvent in terms of commitments, ibs must design and innovate acceptable and innovative islamic instruments in financial markets. in addition, they should find investment opportunities that can raise funds and offer competitive rates of return with low levels of risk (hassan and bashir, 2003). 5. conclusion the choice between the classical and islamic banking model by referring to the banks’ solvency parameter is not a random act, but rather the purpose of a complete rational analysis. by conducting a bank solvency analysis in a well-focused single-ratio paradigm, we have constructed a new approach that allows for precise clarification reflecting the actual state of financial condition of classical or islamic banks. the results already found in our study indicate that cbs are more solvent than their islamic counterparts. however, ibs are very viable in themselves. in solvency management, cbs took solvency into account, although the valuation showed some shortcomings. on the contrary, ibs have given the privilege to liquidity at the expense of solvency, they are characterized by a systemic capacity to absorb shocks by smoothing their returns on assets (hassoune, 2002). islamic finance attracts muslim and non-muslim customers because of its ethical foundation. islam teaches that money must be channeled to the real economy and the production of real goods and services away from speculation. the islamic finance system could create a more stable global financial market (khan, 1989). pls financing is not popular enough with ib’s customers around the world (ascarya and yumanita, 2006; ascarya, 2010). this reflects the lack of knowledge of islamic financial products and its benefits to the holders of capital. in the absence of uniform operating analysis, and standard norms for the distribution of loans, the application of particular standard organization norms for pls systems, consists in attracting a certain category of customers and depositors, who are ready to accept only moral benefits (religious or behavioral) and not tangible returns (interest). subsequently, ibs will launch their offers. pls is not suitable for short-term financing. the islamic banking sector suffers from a shortage of specialists in sharia law, control, accounting, and islamic financial auditing. indeed, like cbs, ibs can smooth their liquidity, either by extending the distribution of dividends to subsequent years or by retaining annual profits to transfer them to shareholders’ accounts. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 20 references ada, a.a., & dalkilic, n. 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(2014). the impact of the international financial crisis on the performance of islamic banks in mena countries. contemporary studies in economic and financial analysis, emerald group publishing limited, 95, 45-69. https://doi.org/10.1108/s15693759(2014)0000095011 microsoft word 15234-54894-3-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 169 impacts of unusual market activity announcement on stock return: evidence from the ace market in malaysia dylan siong-yain chen faculty of economics & business, universiti malaysia sarawak, jalan datuk mohammad musa, 94300 kota samarahan, sarawak, malaysia e-mail: siongyain49@hotmail.com venus khim-sen liew faculty of economics & business, universiti malaysia sarawak, jalan datuk mohammad musa, 94300 kota samarahan, sarawak, malaysia e-mail: ksliew@unimas.my received: august 7, 2019 accepted: dec. 19, 2019 published: december 19, 2019 doi:10.5296/ajfa.v11i2.15234 url: https://doi.org/10.5296/ajfa.v11i2.15234 abstract this study examines the effect of unusual market activity (uma) announcement on stock return in malaysian market with a sample of 62 companies listed on the ace market at bursa malaysia for the period of 2007-2015. this study employs event study methodology to show that there were few days in which the average abnormal return (aar) and cumulative average abnormal return (caar) are statistically significant. in addition, this study also further investigates the abnormal return (ar) and cumulative abnormal return (car) for individual companies. it was found that majority of the stocks returns fell significantly 30 days after the uma announcement. the magnitude of the fall in returns ranges from 4% to 234%. hence, it is not advisable for investors to buy stock after uma announcement. keywords: unusual market activity; ace market; stock return; bursa malaysia asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 170 1. introduction the announcements of unusual market activities (uma) by bursa malaysia are increasing over the years. uma signals a high probability that the stocks announced are being manipulated. hence, uma announcement brings a similar definition and acts as a proxy for market manipulation. huang, chen and cheng (n.d) asserted that manipulation can be happened in a many ways, from insiders taking actions that stimulus stock price to the proclamation of incorrect news or rumours in the internet. stock manipulation of false news was spread out, causing investors to sell or buy based on inaccurate information. the manipulators then traded in the opposite direction to gain profit. now, with the advancement of internet creation, false news could spread faster and wider using internet message board and other social media. the efficiency of internet with faster and wider spread of false news hence brings a larger effect to the investors (leinweber & madhavan, 2001). the possibility that the markets can be manipulated is an imperative issue for both the efficiency of the market and the regulation of trading. particularly securities in many asian stock markets are thinly traded and thus they are more vulnerable to manipulation. this is because legal enforcement is weak, manipulation is still rampant in many emerging markets (huang, chen & cheng, n.d). manipulation of stock is illegal and it is impermissible under the regulations of the securities and exchange commission (sec) to protect investors. on the other aspect, there is debatable that market misconduct such as price manipulation can be utilised to gain profit. arbitrageurs may quickly take advantage of any mispricing if the market is efficient, moving prices into equilibrium conditions. however, very limited researches have been discussed on the announcement of unusual market activity, although numerous researches had been carried out on the wealth effect from corporate announcement. hence, this study is motivated by the importance of market efficiency on unusual market activity and scarce literature available in this particular issue in malaysia. to the best of the authors’ knowledge, no empirical study on uma announcement has been detected in malaysia. it is unknown as of whether there is any profitable finding opportunity for investors after uma announcement. therefore, it is interesting to find out the impact of uma announcement to the underlying stock return in malaysia. notably, out of the 225 umas announced from 2007 to 2015, 64 happened in the ace market. ace market involves smaller capital stocks, which increases chances of manipulation (hanafi, 2010). besides, zhao (2014) stated that “pump-and-dump” scheme where the stock price, trading volume and price volatility surges significantly, often happen for small-cap stocks because of its low selling and buying interest and short sale constraints. as such, samples from ace market are analysed in this study. results are believed to be beneficial to researchers, investors and market regulators. 2. literature review studies on the impact of uma on stock return are relatively rare compared to corporate announcement studies. two studies on uma are worth mentioning. firstly, hanafi (2010) investigated price and trading behaviour of stocks involved in the announcement of unusual market activity in indonesia market. it is found that abnormal returns and trading activities asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 171 increase on the days leading to positive unusual market activity announcement. conversely, abnormal returns and trading activities decrease on the days leading to negative unusual market activity announcement. besides, it is also told that trading characteristic of unusual market activity stocks are varying from those of matched stocks but alike to those of abnormal-returnmatched stocks. the second study of uma announcement study was conducted by yanuarti & mulyono (2012). they examined the effect of unusual moving activity announcement on stock return and trading volume in indonesia stock exchange. they noted that stock returns are different before and after the uma announcement. stock return is greater before uma than after uma. moreover, in their finding, trading volume activity is not statistically affected by uma announcement. it is the same before and after the announcement. other than uma announcement, huang et al. (n.d) conducted a research on stock manipulation and its effect on market quality in taiwan. they documented abnormal return of the manipulated stocks are more than 70 percent, which is very high in the developed markets but similar to emerging market circumstances. subsequently, they inferred stock manipulation create market inefficiency which lead to both abnormally high trading volume and volatility, worsen the market depth, and thus impact on market quality. khwaja & mian (2005) explored price manipulation on the pakistan stock market. they found that brokers could earn annual rates of return in between 50-90% higher than outside investors. furthermore, they found convincing evidence for a specific trade-based ‘‘pump and dump’’ price manipulation scheme. colluding brokers trade among themselves when prices are low to artificially raise prices and attract positive-feedback traders. then they exit once prices have risen and leave the latter to suffer the following price fall. on the other hand, rhode & strumpf (2007) conducted a study on manipulating political stock markets. they pointed out that prices are initially moved by the speculative attack, but these changes were undone quickly and prices returned close to previous levels. they also found little evidence that political stock markets could be analytically manipulated beyond short time periods. azzam & karlquist (2008) examined the market reactions to announcements of allegations of corporate misconduct on swedish market. they made a conclusion that firms being sued for violation experienced a significant negative wealth loss of 1.39% followed with the announcement of the illegality. moreover, kaltchev (2009) studied the impact of securities litigation to stock returns in the u.s. market. it is observed that stock react significantly negative to litigation but not overwhelming. nevertheless, positive reaction to lawsuits can be observed sometimes but negative reaction is twice as common as positive reaction to lawsuits. recently, gerace et al. (2014) analysed stock market manipulation on the hong kong stock exchange. they claimed that manipulation has negative impact on market efficiency measures such as the bid-ask spread and volatility due to information asymmetry. 3. data and methodology this study uses data collected from several sources which includes the stock price and the uma announcement date for each company. the initial searches of companies are from july 2007 to january 2015 through the bursa malaysia. over this sample period, a total of 64 umas asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 172 from ace market were announced. the umas are mainly due to unusual sharp change in price and sharp increase in trading volume. nevertheless, this study only consists of 62 unusual market activity announcements from ace market whereas 2 announcements have been excluded due to insufficient data during the period of study. stock price daily data are obtained from yahoo finance website while information of uma announcements are collected from bursa malaysia. according to huang et al. (n.d) and perry & fontnouvelle (2005), the prices are all adjusted to account for dividends and other splits. the market model adopted in this study assumes a linear relationship between the return of any stocks to the return on the market portfolio, which is mathematically expressed as equation (1): 𝑅 = 𝛼 + 𝛽 𝑅 + 𝜇 (1) where, 𝑅 = the expected return on stock i stock on any given day t; 𝛼 = the constant term; 𝛽 = the sensitivity of company i stock to the market returns 𝑅 ; 𝛼 and 𝛽 are also known as market model parameters or regression parameters. 𝑅 = the market’s rate of return during a given period t, whereby the klci has been employed as the market index; and 𝜇 = the random error term. in order to calculate the actual returns of each stock, the following formula is computed: 𝑅 = ( ) (2) where, 𝑅 = the actual returns on company i stock on any given day t; 𝑃 = the closing price of stock i on any given day t; 𝑃 = the closing price of stock i on previous day t-1. in the same manner, the market returns are calculated using the following formula: 𝑅 = (3) where, 𝑅 = the market returns on any given day t; 𝐾𝐿𝐶𝐼 = the klci index value on any given day t; 𝐾𝐿𝐶𝐼 = the klci index value of the previous day t-1. the market model of expected stock return is written as follows: 𝐸(𝑅 ) = 𝛼 + 𝛽 (𝑅 ) (4) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 173 the actual returns are compared with the market model expected returns in order to examine if uma announcement induces any abnormal returns for each stock on each day in the event period. the coefficient 𝛼 is the intercept and 𝛽 is the slope of the market model, respectively, which are estimated over 90 days prior to the event window. the event period consists of 61 days around the uma announcement date (t=-30 to +30). next, abnormal returns (ar) are calculated on each of the 61 days for each stock by using the following formula: 𝐴𝑅 = 𝑅 − 𝐸(𝑅 ) or 𝐴𝑅 = 𝑅 − [𝛼 + 𝛽 (𝑅 )] (5) where, 𝐴𝑅 = the abnormal return on company i stock on any given day t; 𝑅 = the actual returns on company i stock on any given day t; 𝛼 , 𝛽 = ordinary least square estimations over the estimation window, the abnormal return is the difference between the actual and the expected return. the 𝐴𝑅 can be analyzed separately for each security, but this may not be very informative as “a lot of stock price movements are caused by information unrelated to the event under study” (jong, 2007). the data used for estimation had to be sufficiently separated in time from the event in question so that the parameters are not affected by event-period abnormal stock return. therefore, the average abnormal returns over the sample companies for each of the 61 days must be considered using the following formula: 𝐴𝐴𝑅 = ∑ 𝐴𝑅 , 𝑡 = −30, … … , +30 (6) where, 𝐴𝐴𝑅 = the average abnormal returns on a given day and n is the number of announcement made by the sample companies which is 62 companies. to determine the statistical significance of the 𝐴𝐴𝑅 , most studies often take this into account by summing all the 𝐴𝑅 over the time period of interest to find the cumulative abnormal returns (car). the car is a better indicator of the total impact of information release (bodie et al., 2009). the average of car is known as the cumulative average abnormal return (𝐶𝐴𝐴𝑅 ) and is considered over the sample companies, n, at each trading day. 𝐶𝐴𝐴𝑅 is calculated using the following equation (7): 𝐶𝐴𝐴𝑅 = ∑ 𝐴𝐴𝑅 (7) where, 𝑡 and 𝑡 represent researchers’ specified time windows to investigate the cumulative effect of uma announcements on stock returns. subsequently, the 𝐴𝐴𝑅 and 𝐶𝐴𝐴𝑅 have to be tested on their statistical significance. the simple t-test for 𝐴𝐴𝑅 is the ratio of 𝐴𝐴𝑅 to its estimated standard deviation, 𝜎(𝐴𝐴𝑅 ). the standard deviation has to be estimated from the time series of 𝐴𝐴𝑅 in the parameter estimation period to ensure its stability and reliability. following patell (1976), a lot of researches applied e a standardized abnormal return (saar) where each abnormal security return is normalized by its estimation period standard deviation as follows: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 174 𝑆𝐴𝐴𝑅 = ( ) (8) the standard deviation 𝜎(𝐴𝐴𝑅 ) of each average abnormal return is further explained as: 𝜎(𝐴𝐴𝑅 ) = ∑ 𝐴𝐴𝑅 (9) where, 𝑡 is the number of days in the estimation period. thus, the day 0 of the standardized t-test is 𝜎 = √ ∑ 𝑆𝐴𝐴𝑅 (10) for the 𝐶𝐴𝐴𝑅 shown in equation (7), the test statistic is simply: 𝑡(𝐶𝐴𝐴𝑅) = ( , ) ( , ) (11) where, 𝜎(𝑡 , 𝑡 ) = 𝑙𝜎(𝐴𝐴𝑅 ) (12) the estimation of standard deviation for 𝐶𝐴𝐴𝑅 is applied in many studies (khotari & warner, 2006; rao, 1997; shaheen, 2006; voon et al., 2008). l is the horizon length of the event period which can be calculated from 𝑡 − 𝑡 + 1. in this study, the l is 61 trading days. it must also be noted that, in the estimation of 𝜎(𝐴𝐴𝑅 ), the degree of freedom, n-1, is taken into account to eliminate the bias of taking deviations from the sample arithmetic average, 𝐴𝐴𝑅 , instead of the unknown, true expected value, e(𝐴𝐴𝑅 ) (bodie et al., 2009). once the critical value has been determined at 5% level of significance, if t is less than the critical value, the null hypothesis of no negative abnormal return is rejected, and vice versa. a common practice in the event study is to employed event window that consists of 60 days surrounding the warrants listing day, which is 30 days before (t = -30) and 30 days after (t = +30), whereby (t = 0) is the uma announced date. the t refers to the number of days. this is to fully capture the effects of the event of interest (liew & puah, 2011). however, a wider event window allows for the effects of absorption by the market of more complex disclosures (dumay & tull, 2007). as such, a lot of researches denoted that the longer the estimation period, the more stable the slope 𝛽 , or beta (ray, 2010). hence, a maximum of 151 daily return observations, starting at day -120 and ending at day +30, is collected for this study (see figure 1). the earliest 90 observations are then used to estimate the regression parameters 𝛼 and slope 𝛽 for each individual security in order to eliminate bias for the impact of the event. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 175 figure 1. event study window 4. empirical results and discussion this study attempts to contribute to the stock market study by investigating the effect of unusual market activity on malaysia ace stock market before, during and after announcement. the results are presented and discussed below. 4.1 event study of effect of uma announcement on stock return figure 2 portrays a graph of aars on the y-axis against the trading day on the x-axis. the 0 on x-axis indicates the unusual market activity announcement date. the observed aar ranged between 7% and -5% over the event window. aar on the day-30 is about -2.2% and it fluctuates in the range of -2.2% and 3%. then it started to climb and reached about 3.5% on day-2, 5% on day-1 and eventually reached the peak of 7% on day 0, which is the announcement day. this indicates that insider trading might occur during these 3 days before the announcement. however, aar began to drop drastically to -2% on day1 and fell to the lowest -5% on day2 after the announcement being made by bursa malaysia. nevertheless, arr recovered at day3 but it wandered around 0% and negative 3%. this result brings the meaning of unusual price movement contain information rather than market manipulation (hanafi, 2010). besides, jiang, mahoney & mei (2005) implied that in this case, stock pools carry confirmation such as insider trading rather than pure or noisy price manipulation. figure 2. graph of aar against trading day -6.0000 -4.0000 -2.0000 0.0000 2.0000 4.0000 6.0000 8.0000 -30 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30 aa r (% ) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 176 figure 3 shows the graph of caars on y-axis against the trading day on the x-axis. a price run-up was evident as early as day -29, increasing slowly from -2% and reach 0% of caar at day -21. then it continued to climb moderately from 0% to 2.5% until day -15 and thereafter it moved in a higher speed from 2.5% to 14% throughout day -15 to day -4. next, caar eventually boosted sharply around day -3. during the four days leading to announcement from day -3 to day 0, caar increased by approximately 30%. in addition, the graph shows that caars are firstly decreased progressively from day 1 to day 3 after the announcement date at t = 0. then, it decreased in a slower manner and touched 0% at day 18 and continued dropping at negative zone at day 19 to day 30. table 1 shows the aars and caars with their respective t-values. figure 3. graph of caar against trading day table 1 shows that 9 days are found to have negative aar and 21 days to have positive aar within the pre-announcement period. nonetheless, there was only 1 day with positive aar and the remaining 29 days were having negative arr in the post-announcement period with the exclusion of event day. in addition, the event day displays a positive aar. besides, out of these 61 days, only 3 days (day -30, -2, -1) before the announcement and 7 days (day 2, 4, 5, 7, 8, 11, 20) after the announcement are discovered to be statistically significant in the confidence level of 95%. since there are only few days are discovered to be statically significant, the t-statistic of cumulative average abnormal returns (caars) should be considered. thus, looking at table 1, 9 days were found continuously generating negative continuously caars in the preannouncement period, which are day -30 to day -22. moreover, 40 days of continuous positive caar were revealed from day -21 in the pre-announcement period to day 18 in the postannouncement period, which this includes the announcement day too. subsequently, 12 days of negative caar were displayed from day 19 to day 30 in the post-announcement period. throughout these 61 days, 5 days (day -30, -29, -3, -2, -1) were found to be statistical -20.0000 -15.0000 -10.0000 -5.0000 0.0000 5.0000 10.0000 15.0000 20.0000 25.0000 30.0000 35.0000 -30 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30 ca ar (% ) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 177 significant before the announcement and 2 days (day 1 and day 2) are found to be statistical significant in the confidence level of 95% after the announcement. additionally, on the announcement day, i.e., day 0, caar was also found to be statistically significant. in addition, caars from day -3 to day 2 were all significant. table 1. aars and caars with their respective t-values days aar t value for aar caar t value for caar -30 -2.1706 -2.0013* -2.1706 -2.0013* -29 -0.7028 -0.8216 -2.8734 -2.3289* -28 0.2390 0.2598 -2.6344 -1.8033 -27 0.8236 0.7225 -1.8109 -1.1379 -26 -0.1557 -0.1324 -1.9665 -1.0477 -25 0.6140 0.5887 -1.3526 -0.6973 -24 0.4364 0.4806 -0.9162 -0.4097 -23 -0.3161 -0.3677 -1.2323 -0.4977 -22 0.8212 0.7665 -0.4111 -0.1387 -21 0.5905 0.3794 0.1794 0.0538 -20 1.8544 1.0953 2.0338 0.5295 -19 -0.0772 -0.0738 1.9566 0.4975 -18 0.6292 0.6442 2.5859 0.6126 -17 -0.2850 -0.3555 2.3008 0.5245 -16 -0.0881 -0.0985 2.2127 0.5198 -15 0.2041 0.2447 2.4168 0.5356 -14 3.0228 1.1008 5.4397 1.0015 -13 0.6804 0.6125 6.1201 1.0385 -12 1.1858 1.1115 7.3058 1.2116 -11 1.0885 1.2273 8.3943 1.3686 -10 1.8224 1.1391 10.2167 1.5267 -9 -0.7262 -0.6675 9.4905 1.3928 -8 1.2820 1.0149 10.7725 1.5208 -7 -0.7079 -0.8175 10.0646 1.4210 -6 0.3775 0.4260 10.4421 1.5203 -5 0.8112 0.5415 11.2533 1.5773 -4 1.0417 0.8287 12.2950 1.7286 -3 1.9542 1.6129 14.2491 1.9785* -2 3.4954 2.6240* 17.7445 2.4256* -1 5.0971 2.1021* 22.8416 2.7418* asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 178 table 1. aars and caars with their respective t-values (continued) days aar t value for aar caar t value for caar 0 6.9667 1.5680 29.8083 2.8752* 1 -2.0857 -1.0303 27.7226 2.5480* 2 -5.3606 -3.8877* 22.3620 2.0298* 3 0.0612 0.0462 22.4233 1.9796 4 -2.3369 -2.1367* 20.0864 1.7479 5 -2.1760 -2.1399* 17.9103 1.5624 6 -0.9734 -0.7066 16.9369 1.5103 7 -2.2922 -2.2580* 14.6448 1.2870 8 -2.0161 -1.5224 12.6287 1.1034 9 -0.5973 -0.3410 12.0313 1.0701 10 -3.2170 -2.5147* 8.8143 0.7770 11 -2.2326 -2.1859* 6.5817 0.5683 12 -1.6610 -1.8095 4.9207 0.4267 13 -0.0606 -0.0567 4.8601 0.4137 14 -1.2577 -1.3986 3.6024 0.3039 15 -1.1397 -1.3039 2.4627 0.2091 16 -0.3982 -0.3549 2.0644 0.1737 17 -0.4226 -0.5203 1.6418 0.1356 18 -1.3351 -0.8100 0.3067 0.0248 19 -0.9253 -1.0958 -0.6186 -0.0496 20 -2.6798 -2.4806* -3.2983 -0.2601 21 -2.2776 -1.5869 -5.5760 -0.4310 22 -1.2149 -1.6057 -6.7909 -0.5186 23 -0.1371 -0.1111 -6.9280 -0.5275 24 -1.7970 -1.7505 -8.7250 -0.6506 25 -1.1388 -1.4755 -9.8637 -0.7387 26 -0.3104 -0.4057 -10.1741 -0.7534 27 -0.4072 -0.4507 -10.5814 -0.7757 28 -1.1823 -1.2109 -11.7636 -0.8560 29 -0.2431 -0.2754 -12.0068 -0.8708 30 -1.7509 -1.8226 -13.7577 -0.9849 note: asterisks (*) denote significant at 5% level. 4.2 analysis for individual company with unusual increasing volume and/or price given that only 10 days and 8 days were found statistically significant in aar and caar respectively, this study further explores the analysis abnormal return (ar) and cumulative abnormal return (car) of each company. firstly, the announcements of those companies with unusual increasing volume and/or price are separated with the announcement of those companies with unusual decreasing volume and/or price. it is found that there are 52 companies with unusual increasing volume and/or price and 10 companies with unusual asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 179 decreasing volume and/or price. table 2. stock details for companies with a lower car at day 30 after announcement of unusual increasing volume and/or price car no. stock quote stock name sector day 0 (%) day 30 (%) difference (%) 1 0133 sanichi ind-prod -13.06 -39.41 -26.35 2 0104 genetec technology -238.62 -472.86 -234.23 3 0122 aim trad/serv 33.80 -67.96 -101.76 4 0122 aim trad/serv -132.58 -197.71 -65.13 5 0140 utopia trad/serv -78.17 -90.93 -12.76 6 0024 jag ind-prod 18.78 -52.07 -70.85 7 0111 k1 technology 71.33 43.91 -27.42 8 0034 ingenco technology 45.39 -116.63 -162.02 9 0036 kgroup technology 141.44 53.14 -88.30 10 0045 gnb technology 64.69 -56.70 -121.39 11 0109 flonic ind-prod 17.45 -81.34 -98.79 12 0133 sanichi ind-prod 127.66 78.83 -48.83 13 0140 utopia trad/serv 55.41 4.59 -50.82 14 0055 sersol ind-prod 105.59 93.17 -12.42 15 0060 tms technology 122.09 22.07 -100.02 16 0060 tms technology 114.01 66.52 -47.49 17 0074 gocean technology 155.12 133.91 -21.21 18 0022 ocpo technology 92.27 59.11 -33.17 19 0116 focus technology 65.88 1.23 -64.65 20 0034 ingenco technology -10.35 -84.77 -74.42 21 0001 scomnet ind-prod 138.17 34.55 -103.61 22 0020 netx technology 164.83 87.46 -77.37 23 0022 cybert technology 57.10 16.00 -41.10 24 0034 ingenco technology 53.27 -16.10 -69.37 25 0034 ingenco technology 120.54 -14.83 -135.37 26 0133 sanichi ind-prod 22.70 -65.42 -88.11 27 0036 kgroup technology 101.90 -10.09 -111.99 28 0106 rexit technology 65.25 -9.47 -74.72 29 0152 dgb technology 59.10 6.57 -52.53 30 0024 jag ind-prod 48.08 36.25 -11.83 31 0119 appasia technology 136.57 90.48 -46.09 32 0034 ingenco technology 1.46 -7.05 -8.51 33 0140 utopia trad/serv -3.66 -46.63 -42.96 34 0162 ijacobs ind-prod 38.65 -1.15 -39.80 35 0081 ideal trad/serv 54.47 10.44 -44.04 36 0064 efficient trad/serv 40.07 21.28 -18.79 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 180 table 2. stock details for companies with a lower car at day 30 after announcement of unusual increasing volume and/or price (continued) car no. stock quote stock name sector day 0 (%) day 30 (%) difference (%) 37 0113 mmsv technology 25.24 21.24 -3.99 38 0086 ygl technology 4.14 -64.04 -68.18 39 0026 novamsc technology 18.61 -19.45 -38.07 40 0050 systech technology 74.23 55.11 -19.11 41 0023 ifcamsc technology -12.34 -50.60 -38.26 42 0050 systech technology 12.82 -29.31 -42.13 out of 52 companies with unusual increasing volume and/or price, it is detected that 42 companies generate a lower car at day 30 after announcement. this is consistent with the previous analysis for uma in whole. stock name, stock quote, sector and the difference of car between day 0 and day 30 are shown in table 2. nevertheless, out of these 42 companies, only one company, which is green ocean corporation berhad (gocean, 0074) was found to have replied to qma query. in the reply, the company said its subsidiary ace edible oil industries sdn bhd was in the advance stage of negotiation to supply the whole quality cooking oil production to a conglomerate. apart from ace edible oil industries' ongoing negotiation, green ocean was not aware of any other development that could contribute to the uma after making due enquire with its directors and major shareholders. table 3. stock details for companies with a higher car at day 30 after announcement of unusual increasing volume and/or price car no. stock quote stock name sector day 0 (%) day 30 (%) difference (%) 1 0133 sanichi ind-prod 65.42 134.59 69.18 2 0020 netx technology 59.92 177.52 117.60 3 0165 xox trad/serv 90.61 97.16 6.55 4 0060 tms technology -46.46 -24.16 22.30 5 0103 mnc technology 63.59 104.68 41.09 6 0093 solutn technology 95.77 97.41 1.64 7 0055 sersol ind-prod 53.32 125.78 72.46 8 0034 ingenco technology 6.74 12.67 5.93 9 0080 raya trad/serv 72.23 85.58 13.35 10 0023 ifcamsc technology 73.92 94.53 20.61 on the other hand, 10 out of 52 companies were detected to generate a higher car at day 30 after announcement with unusual increasing volume and/or price. it was found that there are 10 individual stocks had generated higher return at day 30 after announcement. thus, it is not asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 181 necessarily that stocks return will just drop dramatically after uma announcement. however, none of these companies reply to the uma query. as such, it is unknown as of why the car kept increasing after announcement. stock name, stock quote, stock sector and the difference of car between day 0 and day 30 are shown in table 3. 4.3 analysis for individual company with unusual decreasing volume and/or price after investigated companies with unusual increasing volume and/or price, this study also further investigates for those companies under uma queries of unusual drop in price and/or volume. there were 10 companies with unusual decreasing price and/or volume. out of these 10 companies with unusual drop in price and/or volume, it was detected that 7 companies generated a lower car at day 30 after announcement. this is consistent with the previous analysis for uma in whole. stock name, stock quote, sector and the difference of car between day 0 and day 30 are shown in table 4. out of these seven stocks, no company had reply to the uma query. table 4. stock details for companies with a lower car at day 30 after announcement of unusual drop in price and/or volume car no. stock quote stock name sector day 0 (%) day 30 (%) difference (%) 1 0086 ygl technology -209.74 -323.53 -113.78 2 0095 xinghe consumer -53.09 -92.40 -39.31 3 0034 ingenco technology -44.83 -111.79 -66.96 4 0022 cybert technology -134.52 -262.67 -128.15 5 0055 sersol ind-prod -93.44 -126.28 -32.83 6 0072 at ind-prod -12.51 -67.86 -55.36 7 0120 vis technology -42.25 -124.32 -82.06 additionally, 3 out of 10 companies were detected to generate a higher car at day 30 after announcement with unusual drop in price and/or volume. all these 3 stocks had not reply to the uma query. however, their car was better at day 30 after the announcement. therefore, it shows to investors that they do not necessary have to be panic and turn out selling their stocks immediately after the announcement of uma. stock name, stock quote, stock sector and the difference of car between day 0 and day 30 are shown in table 5. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 182 table 5. stock details for companies with a higher car at day 30 after announcement of unusual drop in price and/or volume car no. stock quote stock name sector day 0 (%) day 30 (%) difference (%) 7 0103 mnc technology -30.10 -14.85 15.25 8 0150 asiabio trad/serv 6.04 16.60 10.56 10 0103 mnc technology -51.85 6.98 58.83 4.4 average abnormal return and cumulative average abnormal return table 6 shows the average abnormal return (aar) and cumulative average abnormal return (caar) for the significant days. throughout the 61 days of event period, a total of 10 days were discovered to be statistically significant for the aars. 3 days (day -30, -2, -1) before the announcement and 7 days (day 2, 4, 5, 7, 8, 11, 20) after the announcement were discovered to be statistically significant in the confidence level of 95%. during the pre-announcement, day 30 was found to have negative aar while day -2 and day -1 were found to have positive aars. in addition, all the 7 days in the post-announcement revealed negative aars. furthermore, caars were found to be statistically significant for a total of 8 days. out of these 8 days, 5 days had statistically significant caars before the announcement (day -30, -29, -3, -2, -1) and 2 days had statistically significant caars after the announcement (day 1 and 2). additionally, on the announcement day, i.e., day 0, caar was also found to be statistically significant. in addition, caars from day -3 to day 2 were all significant. moreover, only day -30 and day -29 were discovered to have negative caars while the rest of the days (day -3 to day 2) were having positive caars. the results are consistent with hanifi (2010) and yanuarti and mulyono (2013). in their studies, stock returns for indonesia market are affected by uma announcement. table 6. aars and caars with their respective t-values days aar t value for aar days caar t value for caar -30 -2.1706 -2.0013* -30 -2.1706 -2.0013* -2 3.4954 2.6240* -29 -2.8734 -2.3289* -1 5.0971 2.1021* -3 14.2491 1.9785* 2 -5.3606 -3.8877* -2 17.7445 2.4256* 4 -2.3369 -2.1367* -1 22.8416 2.7418* 5 -2.1760 -2.1399* 0 29.8083 2.8752* 7 -2.2922 -2.2580* 1 27.7226 2.5480* 10 -3.2170 -2.5147* 2 22.3620 2.0298* 11 -2.2326 -2.1859* 20 -2.6798 -2.4806* note: asterisks (*) denote significant at 5% level. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 183 besides, this study also further investigates on individual company. it was found that there are 52 companies with unusual increasing volume and/or price and 10 companies with unusual decreasing volume and/or price. out of 52 companies with unusual increasing volume and/or price, it was detected that 42 companies generate a lower car 30 days after announcement. this is consistent with the general analysis for uma. nevertheless, out of these 42 companies, only one company, which is green ocean corporation berhad (gocean, 0074) was found to reply to qma query. however, the car at the day 30 was still ended with 21% lower than announcement day. in addition, 10 out of 52 companies were detected to generate a higher car at day 30. moreover, out of 10 companies with unusual drop in price and/or volume, it was detected that 7 companies were generating a lower car at day 30 after announcement. additionally, 3 out of 10 companies were detected to generate a higher car at day 30 after announcement with unusual drop in price and/or volume. 5. conclusion uma signals a high probability that the stocks announced are being manipulated. it is logic to think that price manipulation can be utilised to gain profit. arbitrageurs may quickly take advantage of any mispricing if the market is efficient, moving prices into equilibrium conditions. to the best of the authors’ knowledge, no empirical study on uma announcement has been detected in malaysia. it is unknown as of whether there is any profitable finding opportunity for investors after uma announcement. over the sample period of 2007 to 2015, a total of 64 uma happened in the ace market, which involves smaller capital stocks, and therefore increases chances of manipulation. this study only consists of 62 unusual market activity announcements from ace market whereas 2 announcements have been excluded due to insufficient data during the period of study. this study found significant impacts of uma on stock returns. policy makers and regulators such as bursa malaysia and security commission should continue to pay attention to uma as these two institutions play crucial role in solving and preventing the rising issues of uma, in order to protect investors’ wealth. furthermore, investors and shareholders must be aware of the reply to query from the announcement of uma. investors and shareholders shall not be intimidated by uma announcement and sell the shares they hold immediately. it is not necessarily that share price will drop immediately after the announcement. some of them actually rise instead of fall. however, investors must take note that majority of the stock returns falls substantially eventually at the end of 30 days after the uma announcement. hence, it is not advisable for investors to buy stock after uma announcement. moreover, management team of the companies involved in of unusual market activity should also be aware and take concern on the announcement. a satisfying answer from the management team will reflect the responsibility of the company towards unexpected incident and subsequently increase the confidence level of the investors. in return, the share price would not be falling or falling less because the panics of the investors have been pacified. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 184 acknowledgement the authors would like to thanks the editor and reviewers on their comments that enhance the quality of our research work and the presentation of this version. disclaimer the views in this article are from the authors and do not reflect their institutions' opinions. the findings in this article obtained from the sample data at hand during our study period, are to be observed with caution as it may not be valid for other sample periods. you should be aware of the risks that are associated with uma trading, and kindly seek advice from an independent financial advisor before you perform any transactions. neither the authors, their institutions, nor the journal is held responsible for any transaction loss, if any, that you may have derived upon the findings of this article. references azzam, m., & karlquist, j. 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(2014). trade-based manipulation or speculative bubble: a case study. international business & economics research, 13(4). https://doi.org/10.19030/iber.v13i4.8693 microsoft word 12492-45849-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 1 influence of corporate transparency disclosures on financial performance of listed companies in east africa boniface muriithi wanjau (corresponding author) department of accounting, finance and economics, school of business jomo kenyatta university of agriculture and technology e-mail: bmwanjau@gmail.com willy mwangi muturi department of accounting, finance and economics, school of business jomo kenyatta university of agriculture and technology patrick ngumi department of accounting, finance and economics, school of business jomo kenyatta university of agriculture and technology received: jan. 17, 2018 accepted: feb. 21, 2018 published: june 1, 2018 doi:10.5296/ajfa.v10i1.12492 url: https://doi.org/10.5296/ajfa.v10i1.12492 abstract with the decline in the financial performance of listed companies in east africa and the rising trend of corporate failure in both global and local perspective. stakeholders are increasingly becoming more concerned of the financial performance of their firms. this study aimed to find out whether corporate transparency disclosure can be used to address the decline in financial performance and corporate failures. therefore, the current study sought to examine the influence of corporate transparency disclosure on financial performance among companies listed in east africa. specifically, the study sought to examine the influence of asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 2 financial transparency, risk transparency, social transparency and governance transparency on financial performance of companies listed in east africa. the study adopted both descriptive and correlation design. purposive sampling was used to select the 65 listed companies in nairobi securities exchange in kenya, 16 companies quoted in uganda securities exchange, 7 companies which are quoted in rwanda securities exchange as well as 24 companies listed in daresalaam securities exchange from 2006 to 2015. secondary data was collected through the use of document check index retrieved from annual audited financial statements. regression diagnostic and panel data diagnostic tests were carried out. results of the study revealed that there was a positive and significant relationship between financial, governance, risk, social transparency and financial performance of listed companies in east africa. keywords: financial transparency, social transparency, risk transparency, governance transparency and financial performance asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 3 1. introduction transparency and disclosure are essential components of a robust corporate governance framework as they provide the base for informed decision making by shareholders, stakeholders and potential investors in relation to capital allocation, corporate transactions and financial performance monitoring. the importance of transparency has been widely recognized by both academics and market regulators, resulting in numerous rules and regulations being introduced over time to ensure timely and reliable disclosure of financial information, creating standards to which companies must adhere. today, transparency is taking on a new meaning of more comprehensive and proactive disclosures instead of the release of corporate governance details or policies in a reactive fashion. the new concept of transparency putting more responsibilities in corporation not only let the truth be available to the public but imposes to disclose it to every stakeholder and different stakeholder groups (fung, 2014). scholars of corporate governance give different definitions as legal systems, rules and historical development of different countries are also varied. corporate governance is defined as the system by which business corporations are directed and controlled (cadbury, 1992). ruin (2001) defines corporate governance as a collective group of people united as one body with power and authority to direct, control and rule an organization. in this definition, group of people may mean all stakeholders of company. craig (2005) stated that corporate governance is defined and practiced in different ways globally depending upon the relative power of owners, managers and provider of capital. it entails the procedures, customs, laws and policies that affect the way corporations are directed, administered or controlled. an important objective of corporate governance is to ensure accountability and transparency for those who are involved in the policy implementation of organizations through mechanisms that will reduce principal agent conflict. corporate governance is the system by which companies are directed and controlled. it specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. it also provides the structure through which company objectives are set and monitoring performance attained (oecd, 1999). the importance of transparency has been widely recognized by both academics and market regulators, resulting in numerous rules and regulations being introduced over time to ensure timely and reliable disclosure of financial information and creating standards to which companies must adhere. transparency is taking on a new meaning of more comprehensive and proactive disclosures instead of the release of corporate governance details or policies in a reactive fashion. the new concept of transparency is putting more responsibilities on the corporation not only let the truth be available to the public but imposes to disclose it to every stakeholder and different stakeholder groups (fung, 2014). however, past studies on corporate governance and financial performance of listed firms have revealed scandals, collapse and frauds in major corporations like enron, tyco, worldcom and bank of credit and commerce international in the uk and us which has led asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 4 to a lot of worldwide interest in issues of corporate governance. in east africa listed firms questions have been raised on the governance since listed firms have been characterized with increased cases of corruption, mismanagement and government bailouts or subsidization on the failing enterprises like the kenya airways, mumias sugar company in kenya, uchumi company limited in kenya, stanbic bank in uganda and tanzania had corruption related cases, just to name a few which has been in the media for all wrong reasons. this can be attributed to lack of transparency and inadequate disclosure of company results. huge efforts to revive the falling companies to profitability have focused on financial restructuring. however, managers and practitioners still lack adequate guidance for attaining optimal financing decisions (kibet, tenei & mutwol, 2011) as cited in ayako (2012). this situation has led to loss of investors’ wealth and confidence in the stock market. corporate transparency has not been addressed leading to re-collapse of companies like uchumi, mumias sugar, kenya airways, eveready and national bank in kenya. state reports reveal that low financial performances of listed companies is a major hindrance of the realization of vision 2030 leading to lower economic development and loss of jobs in kenya and east africa. the current study sought to examine the influence of corporate transparency on financial performance of listed companies in east africa. specifically, the study sought to: i. to examine the influence of financial transparency on financial performance in companies listed in east africa. ii. to establish the influence of risk transparency on financial performance in companies listed in east africa. iii. to establish the influence of governance transparency on financial performance in companies listed in east africa. iv. to find out the influence of social transparency on financial performance among companies listed in east africa. the hypotheses of the study were: i. ho: financial transparency has no significant influence on financial performance among companies listed in east africa securities exchanges. ii. ho: risk transparency has no significant influence on financial performance among companies listed in east africa securities exchanges. iii. ho: governance transparency has no significant influence on financial performance among companies listed in east africa securities exchanges. iv. ho: social transparency has no significant influence on financial performance among companies listed in east africa securities exchanges. 2. literature review the genesis of corporate governance can be hinged on the agency theory which posits there asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 5 exist a relationship between the agents and principles (jensen & meckling, 1976). currently there is principle agent relationship between the management of listed companies and shareholders who are the main contributors of capital. mainly the study seeks to explain the relationship between corporate transparency disclosure and financial performance among companies listed in east africa securities exchange. there are chances of information asymmetry between the shareholders and the choice of management who will be involved in the management of companies. a wise choice ought to be made as such to minimize the agency costs and save on monitoring costs which will trigger positive financial performance. according to jensen and meckling (1976) there a positive and significant relationship between ownership control and agency conflicts since there are high chances of management pursuing their own self-interests at the expense of the shareholders. more so the attitude of management triggers the capital structure choice and if they are risk averse they may maintain lower gearing levels while risk seekers increases the financial risk. william, ginter and shewchuk (2006) argued that the primary purpose for studies on agency theory is to minimize the chances of information asymmetry. similar studies such as conyon and schwalbach (2000) revealed positive relationship between corporate governance and elimination of agency costs. this precipitates the need for better corporate governance practices as such to eliminate the possibilities of information asymmetry. in this study both shareholders and management have a relationship and those delegated with the day to day management of listed companies. the management should share the information which is important for decision making more so publicly shared information ought to be timely and accurate and reduce conflicts associated with investors’ confidence. any good corporate governance system requires financial transparency as fundamental objectives of financial reporting. making the management accountable of their action is an element of a good system with high level of disclosure. tarus and omandi (2013) conducted a study to examine business case for corporate transparency from kenyan market. they hypothesized financial transparency to have a positive and significant effect on firm performance. financial transparency was assessed using corporate disclosure index while firm performance was measured using the return on asset (roa). regression analysis supported the hypothesis of positive relationship though the correlation analysis showed this relationship to be weak. a similar study by ozbay (2009) was conducted to examine the relationship between corporate financial transparency and company performance in the istanbul stock exchange (ise) in turkey. secondary data for a total of 27 companies were sampled from annual reports for a period of 11years. these companies were selected since they were thought to be the largest and the most liquid companies in ise. company performance was assessed using market to book value (mtbv), price to cash flow (ptcf), price earnings ratio (pe) and market adjusted stock returns (masr). financial transparency was cross-checked with 36 attributes referring to accounting policies and standards, audit fees and efficiency indicators. panel data analysis was applied and result of the finding showed that there was inverse relationship between mtbv, ptcf, masr and financial transparency confirming aksu and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 6 kosedag (2006) findings. however, pe ratio showed a direct relationship with financial transparency. iatridis (2008) examined accounting disclosure and financial attributes in the uk market. among the key accounting attributes is risk exposure disclosure. firms ought to disclosure for assurance that they are still in line with the accounting regulation. iatridis also argues that for a firm to raise capital in the debt markets an extensive risk disclosure is necessary since it improves companies’ image as well as communicating to stakeholders how best manager are in managing risks. linsmeier, thornton, venkatachalam & welker (2002) in a study of the impact of risk disclosure on trading volume sensitivity to interest and exchange rate observed that stock prices and risk transparency have got a positive correlation. this can probably be explained due to shareholders being aware of the inherent risks and therefore coming up with mitigating mechanisms. according to stakeholder theory, companies with high degree risk should disclose the most amount of risk related information and explain the cause in an effort to reassure stakeholder that managers are prepared to address these risks (abraham & cox, 2007). bhat, hope and kang (2006) investigated whether governance transparency affect forecasting accuracy by analyst. a sample of non-us firm cross-listed in the new york stock exchange as american depositary receipts was used covering period of 10 years. governance transparency was found to be positively related to the accuracy of earning forecasts by analysts. also, it’s worth noting that governance transparency serves to explain forecasts when the financial transparency is low. stiglbauer (2010) investigated the transparency and disclosure of corporate governance in determining germany companies’ success. 100 germany firms listed in the prime standard segment were sampled. secondary data from compliance statement, annual report, compensation report, shareholder meetings, code of conduct and companies’ websites were used. firm performance was assessed using market to book value of equity and total shareholder return. governance transparency and disclosure was indicated by disclosure index prepared as per the germany regulation. it was established that there exists a significant positive relationship between corporate governance transparency and disclosure with firm performance using content analysis. molenkamp (2005) in a survey by kpmg discussed the social transparency benefits. it was seen that innovation, customized to help the stakeholders and enhanced corporate relationship made firm to enjoy long term benefits. a firm that engage in corporate social responsibility and discloses the same in their reports they are deemed to raise the esteem of the firms. such firms are found to have a competitive advantage over other firms as they are considered to be social, friendly and thus the firms will able to meet their long term and short-term goals. tsoutsoura (2004) studied the impact of corporate social responsibility disclosure and financial performance of s&p 500 firms for a period of five years. financial performance was measured using accounting variables for profitability that is return on assets (roa), return on asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 7 equity (roe) and return on sales (ros) and social transparency was cross checked with the prepared list of corporate social indices. by applying regression for panel data, results indicated positive and significant relationships, confirming the view that social responsibility can be associated with a series of bottom line benefits. the choice of the regression analysis was inappropriate for a time series data and in this case panel data should have been analysed by time series or path analysis. 3. methodology 3.1 research design in the current study both descriptive and correlation research designs were applied. kothari (2011) argued that through descriptive survey design the research seeks to describe the situation as it is. they were appropriate for the current study since the researcher seeks to describe the level of corporate transparency among companies listed in east africa. correlation design is used to explain the causal relationship between the dependent and independent variables (oso & onen, 2009; mugenda & mugenda, 2009; kothari, 2011). 3.2 sample size in the current study purposive sampling was used select companies which have been quoted for last 10 years in the east african stock exchanges among 51 companies which have been quoted in nairobi securities exchange, 16 companies quoted in uganda securities exchange, 7 companies which has been quoted in rwanda securities exchange and 24 companies listed in daresaalam securities exchange between 2006 to 2015. in total 80 listed companies were considered yielding 70% of the target population. 3.3 data collection the study used secondary data drawn from financial report of listed firms. to collect data, the researcher will use the nairobi securities exchange hand books and website, uganda securities exchange website, daresalaam stock exchange and rwanda stock exchange website and companies’ annual reports accessed through their offices. where the researcher will not access the required information in the stated medium personally visited the specific company office. therefore, the main data collection instrument for the secondary data was document disclosure check index on the specific study variables. scoring approach was used on all the items as provided in the transparency index from which an overall score was calculated, if a company has provided the information it gets one (1) otherwise it will be awarded zero (0). level of disclosure for every item will be calculated as: level of disclosure = actual items disclosed total possible items in the index 3.4 data processing and analysis the regression model used in the analysis will be as follows: asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 8 yit = β0 + β1x1it + β2x2it + β3x3it + β4x4it + ѐ it (1) where; yit represent financial performance x1it represent financial transparency for firm i in period t x2it represent risk transparency for firm i in period t x3it represent governance transparency for firm i in period t x4it represent social transparency for firm i in period t 4. findings and discussions 4.2 descriptive statistics as shown in table 4.1 the average return on asset was 9.9% with a minimum loss of 70% and maximum profit of 58%. further the distribution was skewed to the right since the skewness coefficient was 0.196, the data was not normally distributed because the p value for jarque berra was less than 0.05. although, there were fluctuations on the return on investment as accounted for by standard deviation of 0.127, the ventures were generally profitable and they gave returns to investors. concerning the level of financial transparency it averaged at 78%, with a minimum of 1% and maximum of 100%. a scrutiny in the normality of depicted that the financial transparency was not normally distributed since the p value for jarque berra test was less than 0.05. the data was skewed to the negative tail of the normal distribution. on average listed companies in east africa voluntarily disclosed 52% of the risk related information with the highest companies elaborated on their risk exposure to the tune of 98%. thirdly, the average level of governance transparency was 66.4%, with a minimum of 2% and a maximum of 98%. the average disclosure of social transparency was 32% with a minimum of 3% and a maximum of 100%. social transparency was skewed to the right. table 4.1. descriptive statistics fp ft rt gt st mean 0.099 0.776 0.520 0.664 0.319 median 0.060 0.820 0.550 0.730 0.260 maximum 0.580 1.000 0.980 0.970 1.000 minimum -0.700 0.010 0.040 0.020 0.030 std. dev. 0.127 0.191 0.184 0.201 0.228 skewness 0.196 -2.336 -0.782 -1.113 1.759 kurtosis 8.066 8.829 2.887 3.791 5.060 jarque-bera 785.264 1697.326 74.702 169.653 505.670 probability 0.000 0.000 0.000 0.000 0.000 *fp-financial performance, ft-financial transparency, rt-risk transparency, gt –governance transparency, stsocial transparency asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 9 4.3 diagnostic tests 4.3.1 multicollinearity there was no multicollinearity since none of the correlation coefficient in absolute form was greater than 0.8, therefore there was no multicollinearity (baltagi, 2005). according to el-dereny and rashwan (2011) vif indicate how variance in the variables is inflated by multicollinearity. hair, ringle, and sarstedt (2013) also states that a vif larger than five indicate poor estimates. table 4.2. multicollinearity collinearity statistics tolerance vif financial transparency 0.57 1.77 risk transparency 0.59 1.70 governance transparency 0.78 1.29 social transparency 0.90 1.12 4.3.2 serial autocorrelation serial autocorrelation test was not significant and it signified absence of first order autocorrelation. consistent with the early study of ntim et al., (2012), serial correlation was found not to pose problem. 4.3.3 heteroskedasticity further heteroscedasticity test was done by use breusch-pagan-godfrey (chi) test. according to baltagi (2005) a good regression model should not have heteroscedasticity. results in the study tested the null hypotheses that there was no heteroscedasticity for model, the test result yielded a chi-square value of 2.483 and p value > 0.05 in this case p values was greater than 0.05 and not significant thus we did not reject the null hypotheses and concluded that heteroscedasticity was not present. table 4.3. serial autocorrelation and heteroskedasticity heteroskedasticity test χ2-value p-value 2.483 0.065 serial correlation f-value p-value 2.408 0.056 4.3.4 stationarity tests as shown in table 4.4, the null hypotheses that all panels had unit roots for all variables were rejected at 5% level of significance since the p values were less than 5%. this therefore implied that all variables were stationary and robust regression models would be fitted without lags (at levels). asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 10 table 4.4. stationarity tests method statistic prob.** fp levin, lin & chu t* -37.253 0.000 im, pesaran and shin w-stat -11.147 0.000 adf fisher chi-square 273.374 0.000 pp fisher chi-square 307.054 0.000 ft levin, lin & chu t* -14.264 0.000 im, pesaran and shin w-stat -7.330 0.000 adf fisher chi-square 312.907 0.000 pp fisher chi-square 323.357 0.000 rt levin, lin & chu t* -4.413 0.000 im, pesaran and shin w-stat -4.282 0.000 adf fisher chi-square 227.853 0.000 pp fisher chi-square 168.060 0.002 gt levin, lin & chu t* -15.389 0.000 im, pesaran and shin w-stat -8.070 0.000 adf fisher chi-square 321.287 0.000 pp fisher chi-square 334.643 0.000 st levin, lin & chu t* -14.148 0.000 im, pesaran and shin w-stat -7.927 0.000 adf fisher chi-square 329.803 0.000 pp fisher chi-square 363.908 0.000 4.3.5 hausman specifications as shown in table 4.5 for models with and without moderations, the null was rejected at 5% level of significance since the p values were less than 0.05. this implies that the most preferred models were fixed effects and this was in agreement with (baltagi, 2005) who recommended it. table 4.5. hausman specifications test summary chi-sq. statistic chi-sq. d.f. prob. 69.891 4 0.00 variable fixed random var (diff.) prob. ft 0.170 0.167 0.000 0.5428 rt -0.008 -0.011 0.000 0.3205 gt 0.080 0.085 0.000 0.1668 st 0.245 0.286 0.000 0.00 4.4 regression analysis results in table 4.3 shows the full model of the study as conceptualized in the conceptual framework. as shown, the findings indicate an r squared of 0.763, which indicates that 76.3% of the variation in financial performance can be explained jointly by financial transparency, risk transparency, governance transparency and social transparency while the asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 11 remaining percentage can be accounted by other factors. an f-statistic of 27.657 with a p value of 0.000, indicate a joint significant contribution of the study variables. there was a positive and significant relationship between financial transparency and financial performance (β=0.170, p value <0.05). this implies that while holding risk transparency, governance transparency and social transparency constant a unit change in financial transparency increases financial performance by 0.170 units. in line with this finding, francis, huang, khurana and pereira (2009) also established that financial transparency give the markets more considerations and that more information with regard to agency relationship tends to lower the agency cost which consequently translate to better firm performance. secondly, there was a positive and non-significant relationship between risk transparency and financial performance (β=0.008, p value <0.05). in tandem with cebenoyan and strahan (2004) the positive relationship could be as result of the articulation of the future risk profiles to affect the state of the capital structure thus developing the cost of capital. as per tarus and omandi (2013) when a firm encompasses way of diversifying the risk exposed, it actually tell more about the quality of the management which is later translated to more confidence being created to the investors. thirdly, there was a positive and significant relationship between governance transparency and financial performance (β=0.08, p value <0.05). this implies that holding financial transparency, risk transparency and social transparency constant a unit change in governance transparency increases financial performance by 0.08 units. as argued by donaldson (2003) disclosure on governance encourages corporate accountability which further builds business reputation and images on the faces of the interested parties and groups. finally, there was a positive and significant relationship between social transparency and financial performance (β=0.245, p value <0.05). this implies that while holding financial transparency, risk transparency and governance transparency constant a unit change in social transparency increases financial performance by 0.245 units. the presumed insignificant relationship was confirmed to be actually false. as for the molenkamp (2005) disclosure on social responsibility communicates the benefits received by stakeholders hence this disclosure tends to increase the connection between the firm and stakeholder. this further corroborates with stakeholder theory which avers that an attention to stakeholders will make a firm more successful than those that are not oriented to the need of the stakeholders. financial performance = -0.160 + 0.17*financial transparency + 0.008*risk transparency +0.08*governance transparency +0.245*social transparency (2) asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 12 table 4.6. regression model of influence for corporate transparency on financial performance of listed companies in east africa variable coefficient std. error t-statistic prob. c -0.160 0.013 -12.641 0.000 financial transparency 0.170 0.019 9.108 0.000 risk transparency 0.008 0.018 0.455 0.649 governance transparency 0.080 0.015 5.223 0.000 social transparency 0.245 0.014 17.706 0.000 r-squared 0.763 mean dependent variable 0.099 adjusted r-squared 0.735 s.d. dependent variable 0.127 s.e. of regression 0.065 akaike info criterion -2.517 sum squared residuals 2.792 schwarz criterion -2.033 log likelihood 995.813 hannan-quinn criterion. -2.330 f-statistic 27.657 durbin-watson stat 1.650 prob (f-statistic) 0.000 5. summary and conclusion based on the study findings it is imperative to conclude that corporate transparency has effect on financial performance of listed companies in east africa. results of the study revealed that there was almost 80% of financial transparency, it can be implied that listed companies in east africa are more willing to disclosure information to members of the public as such to mitigate agency conflicts and minimize the asymmetric information levels. since there was a positive and significant relationship this implies as performance was increasing the level of transparency also increased within the period under investigation, it can therefore be concluded that an increased level of transparency enhanced financial performance and efficiency. generally it’s prudent for listed companies to disclose as much information as possible so as to minimize the level of information asymmetry and consequently stimulate financial performance. secondly, risk transparency mirrored the existing literature by having positive and significant relationship with financial performance. it can be concluded that risk transparency gives a yardstick against which future outlook of a specific organization can be evaluated and a clear strategy can developed in order to protect investor’s interest. indeed, a clear road map on future risk profile will provide a good credit evaluation tool and will impact the future capital composition within listed and non-listed companies. therefore, it is imperative for the management to disclose risk exposure information as such to boost investor confidence and minimize issues related to low levels of information disclosure. thirdly, governance transparency had positive and significant relationship with financial performance. these findings were in conformity with theoretical stipulations since coherent governance principles should harmonize expectations of all stakeholders more so management and shareholders. through this increased level of information sharing shareholders value is anticipated to increase because investors have a yardstick against which to monitor the management. indeed, through this listed companies accountability and asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 13 reputation are enhanced to rhyme with interest of both current and potential investors as well as debt providers. because of enhanced level of governance there will be reduction in agency conflicts, boost of investor confidence and consequently enhanced financial performance. further, there was a positive and significant relationship between social transparency and financial performance of listed companies in east africa. therefore, it can be concluded that those firms which are consistently involved in corporate social responsibilities benefits from engaging stakeholders in other issues beyond normal lines of their business. indeed, social activities increases company’s reputation through social capital development and ultimately fosters financial performance. thus, it can be concluded that engagement in social activities enhances stakeholders bonding and ultimately enhances performance. the kenya vision 2030 anticipates full access of capital for all investment needs; this can be achieved if many companies are listed. to achieve full benefits upon listing there is need for listed companies to share information freely to current and potential investors. this can only be achieved if companies adhere to provisions as stipulated by international financial reporting standards. the ability of listed companies to provide information freely will boost investor confidence and consequently attract both local and international investors. to the east african securities exchanges as they endeavor to formation of a regional capital market there is need to foster on the need for listed companies to be as transparent as possible this will boost capital flight to local markets and ultimately promote investment culture and foster economic development. since all the four facets of corporate transparency had positive significant relationship there is need for more clear guidelines to be customized to enhance the level of transparency in every sector in which companies are listed. it will be paramount for the incumbent management of all listed companies to evaluate their levels of transparency and in areas where they are void they increase as such to minimize agency conflict. to the east african community secretariat it is recommended that they lobby aggressively for regulatory and technological advancement which would enhance cross border listing and trading to be enacted and adopted by all east africa community (eac) members swiftly. moreover, the measures should be in tandem in enhancing corporate transparency and this will ultimately strengthen the growth of east africa securities exchanges through coherent and streamlined networking platforms. 6.1 suggestions for further studies since the current study drew respondents from east africa for a period of ten years there is need for a similar study to be carried out in africa, europe, america or asia. this will necessitate comparison of the study findings and minimize possibilities of generalizing the current findings. secondly, there is need to carry out a study for each independent country securities market and considered other facets of corporate transparency disclosures beyond risk, social, financial and governance. asian journal of finance & accounting issn 1946-052x 2018, vol. 10, no. 1 ajfa.macrothink.org 14 references abraham, s & cox, p. 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(2006). structuring deals and governance after the ipo: entrepreneurs and venture capitalists in high tech start-ups. business horizons, 4(9), 303-311. https://doi.org/10.1016/j.bushor.2005.11.001 microsoft word 14805-53579-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 291 the impact of managerial entrenchment indicators on cash holding adjustments: stock exchange firms zahra hashemi oskouei department of accounting, east tehran branch, islamic azad university tehran, iran tel: 98-912-381-6127 e-mail: zahra.oskouei@gmail.com zeynab aminifard (corresponding author) department of accounting, east tehran branch, islamic azad university tehran, iran tel: 98-912-359-7243 e-mail: aminifard.zeynab@gmail.com received: april 8, 2019 accepted: june 12, 2019 published: june 12, 2019 doi:10.5296/ajfa.v11i1.14805 url: https://doi.org/10.5296/ajfa.v11i1.14805 abstract this paper investigates the relationship between the managerial entrenchment and cash holding adjustments for a sample of 140 firms listed in the tehran stock exchange (tse) during 2011 to 2016. to measure the managerial entrenchment, four indicators of manager's duality, management reward, dividends, and over-investment risk were employed. a multiple linear regression model was used in order to test the hypotheses of the research. the results indicate that when management rewards were used to measure the managerial entrenchment, there is a significant positive relationship between the management rewards and cash holding adjustments. also, there is a significant positive relationship between the overinvestment risk and cash holding adjustments. cash holding speed was found to have a significant positive effect on the relationship between dividend (managerial entrenchment) and cash holding adjustments. these results suggest a significant positive relationship between the managerial entrenchment and cash holding adjustments. keywords: cash holdings, cash holdings speed, managerial entrenchment, over-investment risk, management reward asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 292 1. introduction the main advantage of cash holding is to increase the capability of a firm based on valuable investment opportunities, and to prevent costly external financing (jiang & lie, 2016). focusing on the various dimensions of cash, dittmar & smith (2007) demonstrated that cash and near cash comprise 13% of the total american firms’ assets in average. also, habib et al. (2017) indicates the presence of 6% cash in the total assets of uk firms. since all firms with unbalanced cash face many problems, it is important to investigate the amount of cash holding deviation and how rapidly their cash moves towards its own target level (titman & wessels, 1988). one of the early studies on cash holdings was performed by kim et al. (1998) focusing on the firms' investment decisions in cash assets when the cost of external financing is high. they believed that optimal cash amount is determined by balancing of low return of cash assets and the profit obtained by minimizing the needs to external financing (bates et al., 2009). the early studies of cash holdings investigated only the factors that influence cash holdings and the effect of firms' special features and their environment on cash holdings. these studies rarely considered that how quickly firms move their own cash towards the optimal level. the research by opler et al. (1999) is one of the first studies carried out about partial adjustment. the study of ozkan & ozkan (2004) about determining the level of cash holdings in uk firms estimated the optimal holdings level using a dynamic trade-off model. their study could indirectly attract attentions towards cash adjustment speed (al-dhamari & ismail, 2014). it is essential to study managerial entrenchment and cash holding adjustments because of three reasons including: (1) more studies are needed for various firms and countries; (2) for firms encountering unbalanced cash, it is important to investigate the amount of cash holding deviation, and to study how quickly the cash moves towards its own target level; and (3) understanding the factors that play a role in cash holding adjustments not only keeps the investors’ profits but also causes the growth and development of the firm. finally, it increases profitability and provides shareholders’ satisfaction in terms of excess cash holding policies in the firm. very few studies have been carried out about the factors influencing cash holding adjustments in iranian firms. the present study aims to investigate the relationship between the managerial entrenchment and cash holding adjustments for 140 iranian firms from the tehran stock exchange (listed from 2011 to 2016). this research aims to address the main question as whether managerial entrenchment can result in cash holding adjustments for this sample of firms through analyzing the data and observations of firm-year (140 firms in 6 years). 2. theoretical bases and hypotheses firms usually maintain considerable amounts of cash in their balance sheets because of capital market failures such as asymmetric information, problems of representation, transaction costs and financing costs (locorotondo et al., 2014). although cash holding is taken into account as an important asset for a firm in their balance sheet, maintaining this asset excessively indicates inefficiency of resources allocation, and it involves some costs for the firm (subramaniam et al., 2011). these costs may involve the cost of capital opportunity, external financing costs and representative costs in relation to supervision. bates et al. (2009) and ferreira & vilela (2004) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 293 studied the ratio of cash to all assets of the european monetary union firms and concluded that these firms maintained 15% of the total assets in the form of cash or near cash. also, bates et al. (2009) reported that the average ratio of cash to the assets of the us industrial firms increased by 129% from 1998 to 2004. at last, managers must decide whether the cash should be distributed among shareholders, it should be allocated to internal expenditures or it should be maintained. they should always evaluate the benefits and losses of their decision. one of the most important factors of high cash holdings is asymmetric information and its problems (supbramanian et al., 2011). francis et al. (2004, 2005) and ozkan & ozkan (2004) reported that firms are motivated to maintain high cash assets because of increasing asymmetric information. in other words, asymmetric information results in increasing the capital cost, and providing the costs from financial markets is not beneficial for firms. hence, firms prefer to maintain more cash assets so that they can provide their required cash from internal resources when necessary. this theory is based on the hypothesis that those working inside a firm are more aware than shareholders. if internal resources of a firm are not sufficient for financing of optimal investment programs, and asymmetric information becomes an obstacle, then the managers may be forced to ignore profitable projects. in this case, cash becomes very valuable. the opportunity to issue the shares without losing the market value is provided when there is no asymmetric information or very less asymmetry. therefore, managers prefer cash holdings so that they can provide financing from inside the firm in the first step (ferreira & vilela, 2004). in the present research, it is predicted that adjustment speed reflects three main factors including: (1) deviation value of the objective ratio; (2) value of cash adjustments; and (3) manager’s tendency in cash adjustments. the deviation value of the objective ratio includes the costs of financial crisis and over investment. when this optimal ratio is low, managers quickly try to compensate cash shortage (jiang & lie, 2016). in addition, it is anticipated that financial risks and operational risks affect adjustment speed. in contrast, there are some competitive hypotheses investigating the interest of managers in cash adjustment speech. opler et al. (1999) believe that managers tend to maintain excess cash because they do not want to take any risk, and they prefer to follow their own objectives. this issue prevents from using the cash timely or paying cash reservoirs to maximize the cash when there is no external pressure. therefore, we should follow high cash adjustments among the firms. on the other hand, jensen (1986) believes that managers are interested in inefficient cash investment because even the projects with negative net present value have some profit for them, thus these managers may prefer excess investment. according to richardson (2006), entrenchment is analyzed from two perspectives. the first one is the managerial entrenchment related to all behaviors resulting in keeping the job, increasing decision-making freedom and maintaining personal profits. the second one is the shareholder entrenchment. this kind of entrenchment is considered either as a demolition tool when high costs are enforced for the firm and the firm investments are inefficient; or as a desirable tool when the firm survival is possible, and it is related to the firm growth. jensen (1986) infers that when there are excessive cash resources, managers would behave in an optimistic manner and they would probably invest in projects with negative net present value to receive more rewards. this can result in losing the firm resources. harford et al. (2008) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 294 argues that large and well-known firms try to control their own cash reserves because they believe that these excessive resources can unwantedly attract the attention of individuals. lee & lee (2009) investigated negative effects of cash holdings on firm's value. a linear regression model was used to test the research hypotheses. they concluded that the negative effects of excess cash and the manager violations to the firm values could be controlled and adjusted by a strong board of directors. jani et al. (2004) studied the relationship between conservatism and cash holdings in american firms during 2005-2009 using linear regression methods. they concluded that accounting conservatism had relation with efficient use of cash holdings. this shows that accounting conservatism can be considered as a replacement for external supervision in firms, and it can reduce representative conflict costs between the managers and shareholders. gul & tsui (2012), in a study on american firms during 2006-2010, investigated the effects of firms’ credit rating on cash holdings. they found out that the firms with reduced credit ranking, in comparison to the firms without any changes of credit ranking, took actions to increase 3% of cash holdings in relation to the total non-cash assets. locorotondo et al. (2014) investigated the business group companies and cash holding level in belgian firms (those accepted in belgian stock exchange during 2010-2012). they showed that cash holding level was lower in the firms that were the member of commercial and business groups in comparison to independent firms. jiang & lie (2016) investigated the relationship between cash holding adjustments and managerial entrenchment in chinese firms during 2008-2014. they used a linear regression model and ozkan & ozkan’s method to test the hypotheses. they reported that the firms covered 31% of the gap between the ratio of real cash to target cash (the ratio of target cash) each year. generally, cash ratio adjustment occurs quickly when the ratio of real cash is greater than the ratio of target cash. the reason may be that reduction in cash is cheaper than increase in cash. when the firms become more impervious against takeover threats, they considerably decrease their cash adjustments in high cash ratios. evidence shows that managers who seek benefits do not tend to distribute surplus cash; and they tend to hold cash in high levels except in cases when the firms are under external pressures. 2.1. research hypotheses the first main hypothesis studied in the present paper is: managerial entrenchment has a significant effect on cash holding adjustments. the second main hypothesis is: the speed of cash holdings has a significant effect on the relationship between managerial entrenchment and cash holding adjustments. the sub-hypotheses include: the first sub-hypothesis: the manager's duality (managerial entrenchment) has a significant effect on cash holding adjustments. the second sub-hypothesis: the management reward (managerial entrenchment) has a significant effect on cash holding adjustments. the third sub hypothesis: dividend per share (managerial entrenchment) has a significant effect on cash holding adjustments. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 295 the fourth sub-hypothesis: over-investment risk (managerial entrenchment) has a significant effect on cash holding adjustments. the fifth sub-hypothesis: the speed of cash holdings has a significant effect on the relationship between the manager duality (managerial entrenchment) and cash holding adjustments. the sixth sub-hypothesis: the speed of cash holdings has a significant effect on the relationship between the management reward (managerial entrenchment) and cash holding adjustments. the seventh sub-hypothesis: the speed of cash holdings has a significant effect on the relationship between dividend per share (managerial entrenchment) and cash holding adjustments. the eighth sub-hypothesis: the speed of cash holdings has a significant effect on the relationship between over investment risk (managerial entrenchment) and cash holding adjustments. 3. methodology 3.1. data description for this study, a sample of firms accepted in the tehran stock exchange (tse) during 20112016 was analyzed. the following criteria were employed to screen and select the firms for investigation: (1) the acceptance date for the firm to be listed in the stock must be before 2011 and until the end of 2016; (2) the required information and data must be available, and dividends have been done continuously; and (3) the end of fiscal year is end of march, and during the period of investigation, fiscal year has not changed. these criteria resulted in 140 firms to be selected for the study over the period of 2011-2016. totally, 840 observations (firmyear) needed to be tested. the data and audited information of these firms were collated and investigated by the panel data multiple regression. the data were extracted from rahavard novin software (iran’s stock exchange databases), and were combined with their financial statements. eviews software was employed to analyze the data and information. 3.2. data analysis and research variables in this study, the model of jiang & lie (2016) was used to test the research hypotheses. to test the first hypothesis, the relationship between managerial entrenchment and cash holding adjustments is investigated; and to test the second hypothesis, the intervening effect of cash holdings speed on the relationship between managerial entrenchment and cash holdings adjustments is studied for the selected firms. to do this, models (1) and (2) were used for the first and second hypotheses, respectively: cashit-cashit-1= λ(cashit *-cashit-1)+β1(cashit *-cashit-1)×entrenchmentit+ β2(cashit *-cashit-1) × control variableit+εit model (1) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 296 cashit-cashit-1= λ(cashit *-cashit-1)+β1(cashit *-cashit-1)×highcashit× entrenchmentit + β2(cashit *-cashit-1)× control variableit+εit model (2) where the operational definition of variables is as follows: dependent variable and the method of computation cash holding adjustment: the model of ozkan & ozkan (2004) was used to compute cash holding adjustments: cashit-cashit-1= λ(cashit *-cashit-1)+εit model (3) cashit is the ratio of real cash to book value of assets in year t. cashit * is the target cash in year t that is equal to moving average of cash during past five years to the book value of assets in year t. cashit *-cashit-1 is the deviation from the target level of cash in year t. 𝜆 is the adjustment coefficient indicating the speed towards the target level. highcashit is a dummy variable. it is equal to 1 if cashit is larger than cashit *; otherwise, it is equal to zero. independent variable and the method of computation in this research, managerial entrenchment (entrenchmentit) was an independent variable. to measure the managerial entrenchment, four indicators of manager's duality, management reward, dividends, and overinvestment risk were employed. 1) manager's duality (dualityit) is measured as a dummy variable. if the manager is simultaneously both managing director and manager, then it is equal to 1; otherwise, it is equal to zero. 2) management reward (rewardit) is equal to natural logarithm of 1 and the managers reward in firm i in year t. 3) dummy variable of dividends: (dummy_divit): if firm i divides the profit in year t, it receives 1; otherwise, it receives zero. 4) over-investment risk (over-investment_riskit): in order to compute excess-investment risk, model (4) was used. for this purpose, investment efficiency should be obtained using model (4). invit= β0+ β1qit-1+ εit model (4) investmentit+1 is the amount of investment in capital assets in year t (equals the capital costs in year t). qit-1 is equal to qtobin ratio in year t: the ratio of market value of total assets (the market value of assets is equal to the capital market value plus the book value of debts) / book value of assets in firm i in year t. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 297 εit: absolute value with high regression error shows investment efficiency. generally, the smaller the absolute value of errors, the higher investment efficiency and vice versa. then, firms should be divided into two classes including over-investment and under investment. for this purpose, the median of absolute value with high regression value should be computed. the firms located above the second quarter (median) are categorized as over-investment firms, and others as under-investment. at last, we used one dummy variable. a dummy variable is a variable receiving the value of one or zero. the firms with over investment receive one, and others receive zero. moderator variable in this research, the speed of cash holdings (highcashit) is a moderator variable. to measure this variable, we used one dummy variable which is equal to 1 if cashit is larger than cashit *; otherwise, zero. control variables and the method of computation 1. the size of firm (sizeit): the variable of the firm size is equal to the natural logarithm of total assets value of firm i in year t. 2. (qtobinit) is equal to the ratio of market value of total assets (the market value of assets is equal to the capital market value plus the book value of debts) / book value of assets in firm i in year t. 3. operational cash flow risk (cfvit): it is the standard deviation of operational cash flow related to the past five years of firm i in year t. 4. net working capital (nwcit) is equal to the ratio of working capital (that is equal to current assets minus current debts) divided by the total assets in year t. 5. financial leverage (levit): the index of financial leverage of firm i in year t is equal to the ratio of debts to assets. 6. the age of firm (ageit): the variable of firm's age is equal to the age of firm since its establishment. 4. results and discussion descriptive statistics for the research variables are presented in table 1 indicating descriptive parameters for each variable separately. these parameters are commonly related to central indices such as minimum value, maximum value, mean, median as well as dispersion indices such as standard deviation. the most important central index is the mean value which shows the balance point and center of distribution gravity, and it is a suitable index to show data centrality. the mean and median cash holding level were 0.053 and 0.032, respectively with minimum and maximum values of 0.0006 and 0.515, respectively. this indicates that the cash amount and short-term investment of the firms is about 5% of their assets. the mean cash holding level in the previous year is about 0.054 which shows that the amount of cash holding has reduced in comparison to the previous year. also, standard deviation of cash holding level in the previous year is about 0.067, which has increased about 0.002 in comparison to the standard deviation of cash holding in the current year (0.065). it shows that asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 298 the liquidity risk has increased. also, the mean and median optimal cash holdings are respectively 0.056 and 0.041 with minimum and maximum values of 0.002 and 0.427, respectively. by comparing the mean cash holdings in the current year (0.053), and the mean target cash holdings (0.056), it can be said that the studied firms had a distance with their target cash holdings. the mean and median values of manager's duality were 0.078 and 0.000, respectively with minimum and maximum values of 0 and 1, respectively. this shows that in about 8% of the studied firms, the general manager was the chief executive officer (ceo) too, and this low percentage is related to the stock exchange suggesting to firms not to have the same general manager and ceo. also, the mean (standard deviation) logarithm of manager reward is 2.450 (3.340). this shows that the logarithm of auditing fee is 2.450. the high standard deviation of 3.340 shows large variations in auditing fees among the auditing companies. dummy variable mean dividends was found as 0.963, and its median is 1. this shows that 96% of the studied firms pay cash profit (paying cash profit and its statement during cash flow). the reason of cash profit payment is the necessity of stock exchange to pay dividends. the mean and median over-investment risk were 0.500 and 0.500, respectively. this shows than over half of the studied firms had over-investments. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 299 table 1. descriptive statistics of research variables. maximum minimum standard deviation median mean variable 0.515 0.0006 0.065 0.032 0.053 cash holding level (cashit) 0.515 0.0006 0.067 0.033 0.054 cash holding level of previous year (cashit-1) 0.427 0.002 0.052 0.041 0.056 optimal cash holding level (cashit *) 0.180 -0.331 0.047 0.004 0.001 deviation of optimal cash holding level (cashit *-cashit-1) 1 0 0.0486 0 0.384 cash holding speed (high cashit) 1 0 0.269 0 0.078 manager's duality (dualityit) 11.288 0 3.340 0 2.450 logarithm of managers reward (rewardit) 1 0 0.186 1 0.963 dummy variable of dividends (dummy_divit) 1 0 0.510 0.500 0.500 over-investment risk (over_investment_ riskit) 19.106 10.504 1.351 13.776 13.932 the size of firm (sizeit) 2.721 0.868 0.494 1.288 1.437 qtobin criterion (qtobinit) 0.513 -0.184 0.124 0.096 0.110 operating cash flow to asset (cfoit) 0.358 0.016 0.061 0.079 0.095 operating cash flow variations (cfvit) 0.436 -0.354 0.203 0.095 0.077 the ratio of working capital to asset (nwcit) 1.102 0.204 0.207 0.662 0.667 financial leverage (levit) 65 11 12.677 40 37.916 the age of firm (ageit) multi-linear regression was used to test the hypotheses in this study. in order to be sure of interpreting regression relations, the hypotheses of a regression were used. the first condition of using this regression is that the error distribution must involve normal distribution with a mean of zero. for this purpose, the kolmogorov smirnov test was used. the results of this test showed that the data distribution was normal. watson-durbin statistics was used to investigate the lack of autocorrelation function between the independent variables. the value of this statistics is variable between 0-4. if there is not any correlation between successive residual, then the statistics value should be near 2. if the statistics value is near zero, then it shows a asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 300 positive correlation between the residual, and if it is near 4, then it shows a negative correlation between the successive residual. generally, if watson-durbin statistics is between 1.5 and 2.5, then the hypothesis including lack of correlation between the model errors can be accepted. variance inflation factor (vif) was used to investigate the linear relation between the independent variables. when the variance inflation factor increases, it results in increasing coefficient variances, and it makes regression unsuitable for prediction. the practical experiments demonstrate that if vif is larger than 5, then there is a probable warning, and if it is larger than 10, then it reminds a serious wearing. this shows that regression coefficients related to multiple linear relations are weakly estimated. when dispersion is near zero, then the higher multi linear correlation exists, and inflation of regression of the standard deviation occurs. table 2. test results of hausman & f limer hausman test results chav test results test result significa nce level statisti cs signifi cance level statisti cs model polling methodfixed effects 0.000 26.307 crosssection random effects 0.000 1.986 crosssection fixed effects research model (1) panel methodfixed effects 0.000 22.424 crosssection random effects 0.000 1.737 crosssection fixed effects research model (2) in order to select the model of data analysis, data can be considered as series, cross-sectional or panel. since the data of this research was panel, then it should be specified that whether they were panel or pooling. for this purpose, the chav test was used, as given in table 2. the panel method is used for observations where test probability is higher than 5%, while polling method is used to estimate the model for observations where test probability is less than 5%. the polling method can be performed by using two models of “fixed effects” and “random effects”. in order to determine which model can be used, hausman test was used. the model of fixed effects was used for observations where test probability is than less 5%, and the model of random was used for observations where test probability is more than 5%. as it was observed, with regard to the obtained level and the significance level accepted as 5%, the results indicate that polling model was used for both models 1 and 2 by considering fixed effects. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 301 table 3. test results of statistical analysis for the first to fourth sub-hypotheses cashit-cashit-1= λ(cashit *-cashit-1) + β1(cashit *-cashit-1) × entrenchmentit + β2(cashit *cashit-1) × control variableit + εit dependent variable: cash holding adjustments vif significance level t-statistics standard error coefficient variable 0.000 7.999 0.001 0.008 fixed value 1.004 0.026 -2.216 0.0001 -0.0004 )1-itcash-* itλ(cash 1.266 0.676 -0.417 0.109 -0.045 ) × 1-itcash-* it(cash itduality 1.797 0.008 2.629 0.009 0.023 ) × 1-itcash-* it(cash itreward 3.029 0.629 0.483 0.136 0.065 ) × 1-itcash-* it(cash itdummy_div 1.344 0.001 3.309 0.250 0.830 ) × 1-itcash-* it(cash itover_investment_risk 1.070 0.000 -11.384 0.001 -0.22 ) × 1-itcash-* it(cash itsize 5.387 0.106 1.615 0.048 0.078 ) × 1-itcash-* it(cash itqtobin 1.052 0.695 -0.390 0.099 -0.039 it)×cfv1-itcash-* it(cash 3.092 0.533 0.623 0.170 0.106 it)×nwc1-itcash-* it(cash 1.229 0.027 2.214 0.140 0.311 it)×lev1-itcash-* it(cash 9.969 0.615 0.502 0.002 0.001 it)×age1-itcash-* it(cash 30.250 f statistics 0.277 r2-adjusted coefficient 0.000 significance level 2.093 durbin-watson statistics asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 302 table 4. test results of statistical analysis for the fifth to eighth sub-hypotheses cashit-cashit-1= λ(cashit *-cashit-1) + β1(cashit *-cashit-1) × entrenchmentit + β2(cashit *cashit-1) × control variableit + εit dependent variable: cash holding adjustments vif significance level t-statistics standard error coefficient variable 0.000 7.486 0.001 0.007 fixed value 1.004 0.052 -1.941 0.0001 -0.0003 )1-itcash-* itλ(cash 1.474 0.649 0.455 0.192 0.087 ) × 1-itcash-* it(cash it× dualityit highcash 1.686 0.622 -0.492 0.018 -0.009 ) × 1-itcash-* it(cash it× rewardit highcash 3.544 0.000 7.960 0.060 0.484 ) × 1-itcash-* it(cash × it highcash itdummy_div 1.328 0.000 5.880 0.586 0.449 ) × 1-itcash-* it(cash -× overit highcash itinvestment_risk 1.137 0.000 -11.221 0.002 -0.023 ) × 1-itcash-* it(cash it× sizeit highcash 4.437 0.041 2.040 0.047 0.097 ) × 1-itcash-* it(cash it× qtobinit highcash 1.051 0.760 -0.305 0.097 -0.029 ) × 1-itcash-* it(cash itcfv× it highcash 2.592 0.078 1.763 0.158 0.278 ) × 1-itcash-* it(cash it× nwcit highcash 60305 0.000 3.999 0.120 0.482 ) × 1-itcash-* it(cash it× levit highcash 8.085 0.107 1.610 0.001 0.003 ) × 1-itcash-* it(cash it× ageit highcash 29.517 f statistics 0.240 r2-adjusted coefficient 0.000 significance level 2.099 durbin-watson statistics 4.1. the first main hypothesis in this study, managerial entrenchment was an independent variable. to measure managerial entrenchment, four indices including manager's duality, management reward, cash profit and over-investment risk were used. hence, we investigate the first main hypothesis through four sub-hypotheses as follows. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 303 the first sub-hypothesis: in table 3, the coefficient of manager's duality [(cashit *-cashit1)×( dualityit)] is -0.045 and t-statistics is equal to -0.417. according to the significance level (0.676), there is no significant relationship between the dependent and independent variables. in other words, the manager's duality did not affect cash holding adjustments. therefore, the first sub-hypothesis can be rejected. it is noted that the results of the first subhypothesis for the studied firms in this work did not match with the results reported by jiang & lie (2016). the main reason is that the manager's duality was low in these firms. the second sub-hypothesis: the coefficient of management reward [(cashit *-cashit1)×(rewardit)] was found as 0.023 and t-statistics was equal to 2.629 (significant in the level of 0.008), as presented in table 3. since it is less than the prediction error (1%), the significance of the independent variable is confirmed in the significance level of 99%. management reward, as one of the elements of managerial entrenchment, was found to have a positive and significant effect on cash holding adjustments in the studied firms. therefore, the second sub-hypothesis is confirmed. this finding is in agreement with the results of jiang & lie (2016). the most important reason could be the opportunistic motivation of managers to increase their own reward by increasing cash holdings. the third sub-hypothesis: the coefficient of dividend payment [(cashit *-cashit1)×(dummy_divit)] was calculated as 0.065, and t-statistics was equal to 0.483. based on the significance level obtained as 0.629, no significant relationship was found between the dependent and independent variables. this indicated that the dividend payment did not affect cash holding adjustments in the studied firms. it can be argued that the reason is because of the requirement forced by the stock exchange that firms are obliged to pay dividends from their cash profit. the firms normally predict the amount of cash profit annually, and the probability of cash holding adjustments to pay dividends is low. the third sub-hypothesis is rejected. the fourth sub-hypothesis: the coefficient of over-investment risk [(cashit *-cashit1)×(over_investment_riskit)] is 0.830, and t-statistics is equal to 3.309, with a significance level of 0.001, as given in table 3. the significance of the independent variable was confirmed. in fact, with increasing over-investment risks, the amount of cash holding adjustments increased. this could be because of the opportunistic motivation of managers for overinvestment to increase their rewards. therefore, the first hypothesis is confirmed in the fourth sub-hypothesis. based on the results obtained for the first main hypothesis in this study, it is suggested that decision makers pay special attention to managerial entrenchment in relation to cash holding adjustments. managers and investors are also recommended to pay attention to managerial entrenchment when they decide about the amount of cash holding adjustments for firms, or when they decide about buying or selling the share of a firm. 4.2. the second main hypothesis the second main hypothesis was studied through the following four sub-hypotheses (fifth to eighth). as mentioned previously, four indices including the manager's duality, management asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 304 reward, cash profit and over-investment risk were used in this research to measure managerial entrenchment. the fifth sub-hypothesis: the coefficient of the cash holding adjustments variable in the relationship between the managerial entrenchment (manager duality) and cash holding adjustments [(cashit *-cashit-1)×(highcashit× dualityit)] was found as 0.067, and t-statistics was 0.455, as presented in table 4. based on the significance level of 0.649, the moderator variable has no significant direct effect on the correlation between the dependent and independent variables. in fact, cash holding adjustments did not influence the relationship between the manager's duality and cash holding adjustments. therefore, the fifth hypothesis is rejected. the main reason is that manager duality is low in the tehran stock exchange. the results of the fifth sub-hypothesis do not match with the results reported by jiang & lie (2016). the sixth sub-hypothesis: the coefficient of cash holding adjustment variable on the relationship between management entrenchment (management rewards and cash holding adjustments [(cashit *-cashit-1)×(highcashit× rewardit)] was -0.009, and t-statistics was equal to 0.492 (significance level of 0.622). the moderator variable has no significant direct effect on the correlation between the dependent and independent variables. cash holding speed did not affect the relationship between the managers' reward and cash holding adjustments in the studied firms. this was also in agreement with the findings of jiang & lie (2016). the seventh sub-hypothesis: the coefficient of cash holding adjustments variable on the relationship between management entrenchment dividends, and cash holding adjustments [(cashit *-cashit-1)×highcashit×(dummy_divit)] was obtained as 0.484 (t-statistics 0.960), as given in table 4. the results confirmed that cash holding speed can affect the relationship between the dividend and cash holding adjustments. the reason may be the necessity of the stock exchange for the firms to pay dividends. usually, firms predict this annually, hence, their cash holding speed is higher and they have higher cash holding adjustments. the seventh subhypothesis is confirmed. the eighth sub-hypothesis: the coefficient of cash holding adjustment variable on the relationship between the management entrenchment (over-investment risk) and cash holding adjustments [(cashit *-cashit-1)×(highcashit× over-investment_riskit)] was 0.449, and tstatistics was 5.880. the significance of the independent variable was confirmed with a confidence level of 99%. in fact, cash holding speed affected the relationship between the overinvestment risk and cash holding adjustments for the studied firms. the reason could be the opportunistic motivation of the firms’ managers for over-investment to increase their rewards. the eighth sub-hypothesis is confirmed and this finding agrees with the evidence reported by jiang & lie (2016). according to the results found for the second main hypothesis in this work, it is suggested that decision makers pay attention to cash holding speed on the relationship between the effect of managerial entrenchment on cash holding adjustments. managers and investors are also suggested to pay attention to the effect of cash holding adjustments speed on the relationship between managerial entrenchment and cash holding adjustments when they decide about the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 305 amount of cash holding adjustments or when they decide about buying or selling shares of a firm. 5. conclusions this study investigated the relationship between the managerial entrenchment and cash holding adjustments for a sample of 140 firms listed in the tehran stock exchange (tse) during 2011 to 2016. for managerial entrenchment, four measures of manager's duality, management reward, dividends, and over-investment risk were employed. the concluding remarks are summarized as follows. there is a significant positive relationship between the management rewards and cash holding adjustments. also, there is a significant positive relationship between the over-investment risk and cash holding adjustments. cash holding speed was found to have a significant positive effect on the relationship between the dividends and cash holding adjustments. the research findings showed that when managerial entrenchment was used by the over-investment risk, the cash holding speed had a significant positive effect on the relationship between the 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(1988). the determinants of capital structure choice. journal of finance, 43(1), 1-19. https://doi.org/10.2307/2328319 microsoft word 18959-writer2-new receive doi:10.5 abstra this pa europea 2020 pe regressi lever that val keywo the v ed: sep. 7, 2 5296/ajfa.v ct aper propose an listed co eriod. follo ion model rage, size ue is positiv rds: value, variabl of eu a univ phd univ univ 2022 ac 14i2.18959 es an analy ompanies su owing the p with roe e, cfta, d vely affecte financial p les that uropean an assistant pr versity of c e-mai a d and resear versity of c e-mail: a phd stud versity of c e-mail cepted: nov url: ht ysis of the f urveyed thro prevailing li e, as depen data as exp ed by all exp erformance 37 t influe n listed anna paola m rofessor in c cassino and il: a.michel anna maria rch fellow cassino and annamariaca elisa cafo dent in corp cassino and : elisa.cafol v. 20, 2022 https://doi.or factors that ough amad iterature, fo ndent varia planatory va planatory va e, listed com asian ence va d comp micheli, corporate f southern l i@unicas.it calce, in corporat southern l alce@unica folla, porate finan southern l lla@unicas. publi rg/10.5296/ most influe deus bureau or our study able explica ariables. th ariables exc mpanies, ene n journal of f alue: an panies inance azio, italy t te finance azio, italy as.it nce azio, italy it shed: decem ajfa.v14i2.1 ence the cor u van dijk's y we adopt ative of va he result of o cept the siz ergy sector finance & ac issn 19 2022, vol. 1 ajfa.macro n analy mber 1, 202 18959 rporate valu s database the multipl alue, and l our model i ze variable. ccounting 946-052x 14, no. 2 think.org/ ysis 22 ue of 64 over the le linear liquid, ndicates 1. intro the issu to be ac evidenc stakeho custome improve return d goals th foundat new va awarene measuri as their must be this con value c econom the ob corpora liquidity existing of refle shareho propose section finally, 1.1 lite numero influenc signific grinyer belongi capital decentr correlat empiric zealand influenc feeny ( austral oduction ue of the ult chieved has ce shows t olders contr ers aim to ement of th due to their hat the ente tion for its s alue, the go ess among ing and ens r target the e oriented, ntext the an reation, bec mic resource bjective of ate value in y, leverage g literature o ection for olders. this es those con 2 explains section 4 pr erature revie ous studies ce firm valu cant contribu r and mck ing to the u intensity, alization w tion in term cal investiga d manufactu ced by mark (2002) show ian tax off timate goal long been t that enterpr ribute to b o obtain se heir working participatio erprise's abi success. so al of the sy scholars a suring the vi research o a concept b nalysis of ec come releva es and the this study n the energ , size, cft on the subje various sta s article is ntributions c the survey resents the ew have attemp ue in differe utions from kiernan (19 uk electricit sales gr were the va ms of corp ation dwell uring sector ket power a ws that, on fice (ato) t of the enter the focus of rise it gen business ac ervices on g condition on in venture ility to crea , if the surv ystem will and practiti iability and f the value born startin conomic an ant. perform efficiency is to prop y sector in ta and da ect for our c akeholders, organized i considered y methodolo conclusions pted to iden ent industrie m the 1990s t 991) conduc ty sector. m owth, disc ariables tha porate profi l on the det r in the peri and product n a sample tax return d 38 rprise and th f numerous nerates valu ctivity with the most ns and wage e capital. it ate new val vival of the be the crea ioners who d durability o e and its ge ng from 198 nd financial mance summ of operatio pose an inv n europe. s ata. the r country. the , especially into several as the most ogy and dat s of this stud ntify the eco es. we will to the prese cted their r multiple regr ciplined m at exhibited fitability. be terminants iod 1986-19 tion efficien consisting data, calcula asian he existence studies in t ue for all i h different assistive t es, and shar is by conce lue is declin enterprise i ation of val o see profit of the enter eneration, to 80s and then performanc marizes the onal, investm vestigation pecifically, reason for t erefore, this y creditors, l sections a t significant ta set, secti dy. onomic and l pause in th ent. research on ression analy management d a positiv ennenbroek of profitab 987. the re ncy. throug of 180,738 ated as aver n journal of f e of a multi the field of its stakehol and often erms, work reholders ai erting these ned since it is linked to lue. hence t as incapa prise system o which all n spreading ce and of th e result of t ment and f of the fact the variab this study l s analysis ca investors, as follows: t in the liter ion 3 presen financial va his section t n a sample ysis showed t of work e and stati k and harri ility of ind esults show gh a simple 8 tax subje raged for the finance & ac issn 19 2022, vol. 1 ajfa.macro iplicity of su corporate f lders. the conflicting kers press im to maxim mutually d t will have its ability t the birth o able of exp m. so, scho l business a g internation heir contrib the manage financing ac ctors that in bles conside lies in the an be used managem section 1.1 rature on the nts the resu ariables tha to analyse t e of 45 com d that mark rking capit istically sig is (1995), dustries in t that profita regression ects from c e period 19 ccounting 946-052x 14, no. 2 think.org/ ub-goals finance. various g goals: for the mize the divergent laid the to create of a new plaining, lars find activities nally. in bution to ement of ctivities. nfluence ered are: lack of as cause ment and 1 briefly e theme, ults, and t mainly the most mpanies et share, tal and gnificant in their the new ability is analysis complete 94/1995 1996/ profitab goddar service were. t sector th a negati keith g size, ag asimak determi profitab negativ nunes service with hig liargov industri perform industri authors assumin and ma leverag signific bhayan industry bombay profitab interest stierwa 1995-20 from th than by firm siz instance ito and contribu 1989-20 /1997, the bility. rd et al. (200 sectors in b the research han in the s ive relation g. (1998), a ge and locati kopoulos e inants of fir bility of gre ely by lever et al. (2009 industry. t gher growth vas p. and s ial firms as mance. thei ies and list , in the 3 pa ng that leve anagement e e, exports, cantly relate ni (2010) id y. the autho y stock e bility is infl rate, and in ald (2010) 005 to iden he estimatio y sectoral eff ze contribu e, productiv d fukao (20 utes to the 002. the s variables 05) studied belgium, fr h found that service secto ship betwee applying an ion on 38 sm t al. (200 rm profitabi eek firms w rage and cu 9) identified the research h, lower lev kandalis k. s possible, ir analysis w ted on the anel regress erage, liquid efficiency c size, loca ed to firm pe dentified wh or applies a exchange fo fluenced to nflation. uses a pan ntify the det n results th ffects. in the ute mainly vity and pro 010) questi profitabilit study show size and c what the de rance, italy t there was or between en size, debt econometri mall manufa 09) analyse lity for the p was positivel urrent assets d which va h shows tha el of debt an . (2010), in recognize was conduc athens sto sion models dity, capitali can influenc ation, and erformance. hich variab a regression or the per a greater e nel consisti terminants o hat profitabi e second ins to the expl ductivity pe ion how th ty of japan ws that the 39 capital inten eterminants y and the un a stronger p market sha t ratio and p ic methodol facturing firm e the firm period 1995 ly affected b . ariables infl at the most and lower le an attempt financial a cted on a sa ock exchan s, uses ros ization ratio ce firm perf manageria . bles influenc n analysis o riod 2001-2 extent by li ing of 961 of firm pro ility is deter stance, it is lanation of ersistence h he location nese multin e profitabil asian nsity have s of profitab nited kingd positive rela re and profi profitability logy, invest ms in the ta m-specific a 5-2003. the by size, sale uence the p profitable c vel of fixed to provide and non-fin ample of 10 nge for the s, roe, and o, investmen formance. t al competen ce the prof n a sample 2008. the iquidity, fir 1 large au ofitability. in rmined mor noted that d f profitabili have a positi of procure ational ove lity of jap n journal of f a positive bility in the dom, for the ationship in itability and y. tigated what ayside regio and greek e research re es growth a profitability companies a d assets. as complete ancial facto 02 compani e period 19 d roa as d nt, age, size the research nce ratio a fitability of of 28 comp empirical rm age, ope ustralian firm n the first i re by firm-l dependence ty heteroge ive effect on ement, sales erseas affilia panese affil finance & ac issn 19 2022, vol. 1 ajfa.macro e relationsh manufactur e period 19 n the manuf d, on the oth at was the im on. economyesults show and investm y of the por are the larg e a picture o ors related ies belongin 997-2004. t dependent va e, location, h results sh are positiv f the indian panies liste results sho erating prof rms for the instance, it level charac e on profits eneity. in t n firm profi s and mana ates for the liates is po ccounting 946-052x 14, no. 2 think.org/ hip with ring and 93-2001 facturing her hand, mpact of -specific w that the ment, and rtuguese ger ones, of greek to firm ng to 15 the two ariables, exports, how that ely and n cement d on the ow that fit ratio, e period is noted cteristics lags and he third itability. agement e period ositively associat contribu burja ( compan regressi impact efficien malik ( pakistan signific signific the age charum sample the pro with siz and log almaja insuran insuran the res is posit contrast variable mistry belongi showed return ratio, a al-jafar industri method of 6 ind total as statistic working the wo perform the peri ted with the ute to highe (2011) stud nies belongi ion analysis on the dep ncy. (2011) analy n for the p cantly and p cantly but n of the comp mathi (2012 consisting ofitability e ze and liquid garithm of eq li a. y. et ce compan ce compani ults of the r tively affec t to the ag e. (2012) ana ing to the in d that profit on capital and long te ri m.k. an ial compani dology invol dependent v ssets, lever cally signifi g capital an ork of m. mance of the iod 2009-20 e local sourc er profitabili dies the f ing to the ch s, with prof pendent vari ysed the de period 2005 positively c negatively co pany. ), addressin of 23 comp expressed b dity, signifi quity capita al. (2012) nies in term ies registere research sho cted by lev ge variable alyses the e ndian autom tability larg employed erm debt to nd al samm ies listed on lves the use variables, n rage and w cant relatio nd a negative ahmad an e pakistani e 016. the re cing relation ity in china factors influ hemical ind fitability exp iable are in eterminants 5-2009. the correlated w orrelated w ng his inves panies for f by roa is cantly and n al, and unco aimed to i ms of fina ed with the ow that the verage, liqu which has effects of v motive indus gely depend d ratio, net o equity rat man h. (2 n the musc e of roa a namely, ave working ca onship betw e relationsh d n. malik energy secto esearch obje 40 nship, and b a. uencing th dustry durin pressed by nventory eff of profitab e profitabil with the size with leverage stigation to fiscal years found to b negatively c orrelated wit investigate ancial perfo amman st performanc uidity, size, s no influe various facto stry for the ds on the va t income to tio. 015) condu cat securitie and profit m erage tax ra apital. the ween profitab hip with ave k (2017) fo or; on a sam ective focus asian both local p he business ng 1999-200 roa, show ficiency, de bility of 35 ity express e and capit e and loss r o the indian s 2008-2009 e: significa correlated w th underwri the variabl ormance. t tock exchan ce of the com , and mana nce and co ors on the period 199 ariables: op o total deb ucted their es market f margin as de ate, size, gro research r bility, firm erage tax rat ocuses on mple consist ses on the i n journal of f purchasing a s performa 09. results o w that the fa bt level, lev listed insur ed by roa al volumes ratio, and, f n insurance 9, 2009-201 antly and po with leverag ting risk. les that mo the target p nge for the mpanies, as agerial com orrelation w profitability 98-2012. th perating ra bts ratio, i research o for the perio ependent va owth, ratio results sho size, growt te and levera the determ ting of 29 li impact of m finance & ac issn 19 2022, vol. 1 ajfa.macro and sales ex ance of ro of models b actors with everage, and rance comp a was foun s of the com finally, unre industry, s 10, and 201 ositively co ge, premium ost affect jo population period 200 s measured b mpetence in with the de y of 48 com he regressio atio, curren inventory t on a sampl od 2006-20 ariables and of fixed ca ow a posit th, fixed as age. minants of f isted compa macroecono ccounting 946-052x 14, no. 2 think.org/ xpansion omanian based on positive d capital panies of nd to be mpanies, elated to studies a 10-2011. orrelated m growth, ordanian has 25 02-2007. by roa, ndex, in ependent mpanies n model nt ratio, turnover le of 17 013. the d the use apital to tive and sets and financial anies for mic and compan research while it growth, rate. t. scha private 2000-20 improve positive effect o renewab to have an impa 1.2 hyp based o any rel shareho hypoth hypoth variable 2. meth the em extracte specific bosnia lithuan moldov switzer activiti category into the -d35.1 d35.1 d35.1 d35.1 d35.1 d35.2 d35.2 ny-specific d h results sho t is negativ , liquidity a abek (2020) and public 017. from ed their fin ely affected on performa ble sources lower roe act on roa potheses on previous lationships older, and a hesis 1: ther hesis 2: the es. hod mpirical anal ed using a cally, data and herz nia, luxem va, united rland, turk ies in the e y d (35) e e sub-catego electric p .1 produc .2 transm .3 distribu .4 trade o 2 manufac 2.1 manufa determinant ow that ro ely affected and gdp, w ), in his stu sustainable the author' nancial perfo d by compa ance in con has a nega e but roa a but not ro literature r between r set of varia re is no rela ere is relat lysis is base amadeus bu from states zegovina, b mbourg, mo kingdom, key, ukrain european co electricity, g ories: power gener ction of elec mission of el ution of ele of electricity ture of gas; acture of ga ts on financ oa is positiv d by leverag while it is n dy, identifie e energy pr s work, it c ormance co any size, so ntrast to wi ative impact is not affec oe. review, we f roe, a ke ables. ationship bet ionship bet ed on europ ureau van s in the eu bulgaria, f ontenegro, czech re ne. accordi ommunity, gas, steam a ration, trans ctricity lectricity ectricity y ; distributio as 41 cial perform vely affected ge and age negatively a es variables roducers fro can be seen ompared to olar power ind power t on financi cted by lega formed the ey indicator tween value tween the d pean listed c dijk's data urope 28 a finland, fra netherland epublic, ro ing to the or nace c and air cond smission an on of gaseou asian mance as me d by growth . roe is po affected by s describing om 16 emer n that: rene fossil fuel p generation generation, ial performa al status, and following h r and drive e and the in dependent companies, abase with area were c ance, germ ds, north m omania, ru statistical code, the e ditioning su nd distributi us fuels thro n journal of f asured by r h, size, risk, ositively aff risk, tangi g the financ rging mark ewable ener producers, has a stati the share ance, public d, finally, th hypotheses i er of the dependent v variable an belonging t reference considered: many, gree macedonia, ussia, serbi classifica energy secto pply, which ion ough mains finance & ac issn 19 2022, vol. 1 ajfa.macro roa and ro , liquidity, a ffected by le ibility and i cial perform kets over the rgy produce roe and r istically sig of electrici c companie he level of in order to value crea variables. nd the inde to the energ to the yea austria, b ece, ireland , norway, ia, spain, s ation of ec or, is placed h, in turn, is ccounting 946-052x 14, no. 2 think.org/ oe. the and gdp, everage, inflation mance of e period ers have roa are gnificant ity from s appear debt has evaluate tion for ependent gy sector, ar 2020. belgium, d, italy, poland, sweden, conomic d within s divided d35.2 d35.2 d35.3 d35.3 for the transmi focused initially compan model w and fina the inve al. (201 shareho overall explana 2019). equity: roe = the ind liquid levera size=l cfta= data= to test the prev bhayan and n. method of two depende maximu the line between 2.2 distribu 2.3 trade o 3 steam an 3.0 steam a e purpose ission and d as mentio y consist of nies with un were define ancial perfo estor to con 11) in their olders and e financial e atory or pre the depend net inco dependent v d= curre rage= tot log total a cash flo deprecia for the exi vailing liter ni 2010, bur malik 201 dology turns or more ex ent or resp um predictiv ear combin n the indepe ution of gas of gas throu nd air condi and air cond of this inv distribution oned above f 149 europ navailable d ed. roe as ormance. m sider in the r work me emphasize i efficiency a edictor varia dent variab ome/share variables, we ent asset/ tal debt/t asset, ow/total iation & a istence of re rature (grin rja 2011, m 7, t. schab s out to be a xplanatory ponse varia ve ability fr nation. how endent varia seous fuels ugh mains itioning supp ditioning su vestigation, n was cons on the en ean listed c data were e the depend monteiro (20 shareholde ntion that its importan and perform ables (mari ble, was cal eholders ere calculate /current total ass asset, amortiza elationship nyer and mc mistry 2012, bek 2020), an extension or predicti able. a we from the mo wever, said ables. 42 through ma pply upply sub-catego sidered. giv nergy secto companies. excluded. t dent variabl 006), states ers perspecti roe is a nce for man mance. liqu ia elisabete lculated as s equity ed as: t liabiliti set, tion/tota between de ckiernan 19 al-jafari m we use th n of simple ive variable eight is as odel on the predictive asian ains ory d35.1 ven the su or, the refer for the con the variable e, widely u that roe i ive. also a key indica nagers and o uid, leverag e neves, ca the ratio o ies, al asset. ependent an 991, liargo m.k. and al e multiple e linear regr es to under signed to set of expla ability is l n journal of f electric ubject matte rence popu nstruction o es to be use sed as a me is the most rouri et al. ( ator in the owners as it ge, size, cf arla henriqu of net incom nd independ ovas p. and l samman h linear regre ression, whe stand how each predic anatory var limited if t finance & ac issn 19 2022, vol. 1 ajfa.macro power gen er of the r ulation turns of the sampl ed in the st easure of ec important r (2010) and value crea t reflects th fta and d ues and joã me to share dent variab skandalis k h. 2015, m. ession mod ereby we m they influe ctor to ob riables belon there is cor ccounting 946-052x 14, no. 2 think.org/ neration, research, s out to le, those tatistical conomic ratio for visali et ation for he firm’s data as ão vilas, eholders' le, as in k. 2010, . ahmad del. this make use ence the tain the nging to rrelation the mo variable where: ‐  0,  1,… ‐ x1, x2 ,… ‐ ɛ rando based o roe= β the nu variable whereas variable 3. resu for the europea through which t therefo roe = 311.82* table 1 regress r multi r squar adjuste standar n. obse odel, which es, can be w …,  p unknow …, xp the valu om variable  on model (1 β0+β1 liqu ull hypothes es: s the altern e and the in ults year 2020, an listed co h the least turn out to b β0 = ore, the estim = -3.66 + *data . regression sion statistic iple red ed r squared rd error ervations relates the written as: wn constant q ues taken by with expecte ), the regre uid+β2 lev sis is that native hypo dependent v the sample mpanies. squares me be respectiv -3.66, β1= 0 mated multi 0.94*liqu n statistics cs d dependent quantities ca  the explana ed value equ ssion functi verage+β there is no h0 = β1 othesis is th variables: h1 = e, after elim ethod, the v ely: 0.94, β2= 13 iple regress uid + 13.2 43 or response y= ꞵ0 + ꞵ1 alled regress atory or pred ual to zero an ion represen β3 size+β4 o relationsh 1 + β2 = …= he existence = at least ꞵp minating una values of the 3.25, β3= 0. ion model i 25*levera asian e variable y 1x1 + ꞵ2x2 + ion coefficie dictor variabl nd variance σ nted by the cfta+β5 d hip betwee = ꞵp = 0, e of relatio p ≠ 0. available va e regression 34, β4 = 254 is: age + 0. n journal of f y to p expla …+ ꞵpxp + nts;  es x1 , x2 , ... σ2    called err present stud data+ε. n value an onship betw lues, turns o n coefficien 4.73, β5= -3 34*size + finance & ac issn 19 2022, vol. 1 ajfa.macro anatory or p ɛ ., xp ;  ror or varian dy is as foll nd the inde ween the de out to cons nts were cal 311.82 + 254.73*c 0.93 0.87 0.86 5.76 64 ccounting 946-052x 14, no. 2 think.org/ predictor (1) nce.  ows: ependent ependent ist of 64 lculated, cfta – the val of the v percent that als the sam propose table 2 regress residua total to unde lower v table 3    intercept  liquid    leverage  size    cfta    data    furtherm there is it can b variable that the is not l and da linearly 4. discu this pa the stu dijk's a lue of r squ variance in of the vari o takes into mple size, it ed model. . analysis o sion al erstand the value of 0.05 . regression coefficients  ‐3.66  0.94    13.25  0.34  254.73  ‐311.82  more, as ca sufficient e be said tha e is linearly e variable si linearly rela ata present y related to r ussion aper aimed t udy covered amadeus d uared is 0.8 n the depen iance in ro o account th can be said of variance gdl 5 58 63 significanc 5 for the 95 n analysis r standard error  3.96  0.43  3.85  0.68  13.73  35.68  an be seen evidence to at the mode y related to y ize, is the o ated to ro t a significa roe. to test the f d the univer database, ov 7, so this m ndent variab oe. looking he number d that 86 per 12,68 1,92 14,60 e of the mo percent con results stat t  s ‐0.92  2.18  3.44  0.50  18.55  ‐8.74  more than reject the n el is statist y. specifica only one wi e. on the ance value factors that se of europ ver the 202 44 means that th ble. the pr g at the adj of explana rcent of the sq 86.33 2 23.59 09.92 odel we also nfidence lev significance valu 0.3 0.0 0.00 0.6 0.00 0.00 one ꞵp coe null hypothe tically signi ally, by ana ith a value contrary, th less than 0 influence fi pean listed c 20 period. i asian he five vari redictors, ta justed r sq atory variab variance in mq 2,537.27 33.17 o look at the vel. e  lower 95%  6  ‐11.59  3  0.08  0  5.55  2  ‐1.02  0  227.24  0  ‐383.25  efficient is d esis in favou ificant beca alysing the s greater than he variables .05 and con firm value in companies, in construct n journal of f iables expla aken as a s quared value les included n roe can b f 76.50 e f statistic, upper 95%  4.27  1.81  20.95  1.70  282.22  ‐240.39  different fro ur of the alt ause at leas significance n 0.05. ther s liquid,l nsequently t n the energ surveyed th ting the sam finance & ac issn 19 2022, vol. 1 ajfa.macro ain about fo set, account e, that is, th d in the mo be explaine signifi , which has lower 95%  ‐11.59  0.08  5.55  ‐1.02  227.24  ‐383.25  om zero, th ternative hy st one inde e values we refore, this leverag they turn o gy sector in through bur mple, we e ccounting 946-052x 14, no. 2 think.org/ our-fifths t for 87 he index odel and ed by the ficance f 0.00 s a much upper 95%  4.27  1.81  20.95  1.70  282.22  ‐240.39  herefore, ypothesis. ependent e can see variable ge,cfta out to be europe. reau van excluded values n observa conside explana liquid contribu the ana develop as the in referen almaja perform of mana asimak wide w finance arouri, creatio and acc accoun bennen profitab 27(11), bhayan analysis burja, apulens https://d charum empiric feeny s tax enti workin goddar europea financi not availabl ations. bas ered the dep atory var d,levera utes to the alysis is use pment of thi nclusion of nces li a. y., a mance of jo agement re kopoulos, i. weterminant e, 11, 930–9 mohamed on under ias counting jo nting, pragu nbroek n. bility in ne 1093-1101 ni, s. j. (201 s. south asi c. (2011). sis doi.org/10.2 mathi, b. (2 cal study. pr s. (2000). d ities. the u ng paper no rd, j., tava an manufa ial econom le for the re ed on the pendent var riables. r age,cfta existing lit eful for vari is analysis m additional v alamro s. a ordanian ins esearch, 4(2 ., samitas, ts of firm 939. https:// d el hedi; s/ifrs: ev ournal, issn ue, 5(3-4), 8 and harris ew zeal an . https://doi 10). determ ian journal factors in series 29302/oecon 2012). on roceedings determinan university o o.1/00, melb akoli, m., acturing an ics, 15(18), ference yea e literature riable, while roe ap and data erature give ous stakeho may involv variables in a. and al-s surance co 2), 266-289. a. and pa profitabilit /doi.org/10. lévy, aldo idence of d n 1805-484 4-112. https s r. i. d. nd manufac i.org/10.108 minants of p of manage nfluencing o nomica.201 the determ of the worl nts of profit of melbour bourne. & wilson, d services: 1269-1282 45 ar. this disc review, th e, liquid, ppears to ratio and ne en the scar olders becau ve extending n the model. soub y. z. ompanies li . https://doi. apadogonas, ty: greek e 1108/03074 o; nguyen, discordance 46, universi s://doi.org/1 (1995). a cturing indu 80/0003684 profitability ement, 17(4) the compa oeconomic 11.13.2.3 minants of p ld congress tability: an rne. melbou j. o. s. : evidence 2. https://doi asian crimination he variable ,leverag o be p egatively by city of sim use it offers g the study (2012). fa isted at am .org/10.529 , t. 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(2 on muscat org/10.5539 nants of in academic r rla henriqu ompanies: 1-019-0050 minants of es, 7(1), 20 ck guide to o, z. m., & data approac 060902720 inants of pro melbourne oi.org/10.2 he financia renewable ne.2020.06. 46 ). the deter british jo 1.tb00012.x ants of the s: does lo world 9.01236.x wth and pro neurial be 948 actor affecti ment resear of factors f pakistan. 2015). dete securities m 9/res.v7n11p nsurance c research int ues e joão evidence 04-1 profitability 0-23. o financial & sequeira, ch. the ser 0188 ofitability: a institute w 139/ssrn.16 al performa energ 067 asian rminants of journal of profitabilit ocalization economy, ofitability in ehavior & ing firms fin rch an inter affecting balochistan rminants of market. ca p303 companies ternational, o vilas. (2 from portu y in indian ratios. the t. n. (200 rvice indust an analysis working pa 632749 ance of sus gy 160 n journal of f f corporate managem ty of japan of procur 33(12 n small ent & researc nancial perf rnational jo the financi n review j f profitabili nadian cen profitability 1(3), 315-3 2019). fina ugal. oper n automotiv citizen, m 9). profitab tries journa s of large au apers serie stainable po 0 (2020 finance & ac issn 19 2022, vol. 1 ajfa.macro profitabilit ment, 2(1), nese manuf rement, sa 2), 163 trepreneuria ch, 4(1), formance t ournal. ial perform journal, (xx ity: eviden nter of scie y: an ana 321. ancial perfo rational re ve industry. moneyweb b bility in por al, 29(5), 6 ustralian fir es. working ower produ 0) 140 ccounting 946-052x 14, no. 2 think.org/ ty in the 17-32. facturing ales and 39-1671. al firms. 18-27. the case mance of xxvii), nce from ence and alysis of ormance esearch. . tecnia business rtuguese 693-707. rms. the g paper ucers in 08e1419. visali, global b append financi roe liquid lever size cfta data s., roxburg banking – in dix a ial indicator id rage gh, c., daru n search of rs used de uvala, t., d f a sustainab net inc curren t c epreciat 47 dietz, m., l ble model, m ncome/sha nt asset/ total deb log to cash flo tion & am asian lund, s., & mckinsey & areholde /current bt/total a otal asset w/total a mortizatio n journal of f marrs, a. ( & company ers equit liabilitie asset t asset on/total finance & ac issn 19 2022, vol. 1 ajfa.macro (2011). the y, vol. 1 ty es asset ccounting 946-052x 14, no. 2 think.org/ e state of microsoft word 14678-53152-3-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 241 ajfa.macrothink.org assessment of the adoption and implementation of ifrs for small and medium scale entities (smes). “a study of selected smes ga east of ghana” john kwaku mensah mawutor dean, school of graduate studies (sogs) university of professional studies, accra ghana p.o. box lg 149, legon tel: 23-32-4328-7242 e-mail: john.mensah@upsamail.edu.gh / kwaku2mensah@gmail.com siaw wlliams university of professional studies, accra (upsa), ghana mensah anita oduwaa university of professional studies, accra (upsa), ghana received: april 17, 2019 accepted: june 5, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14678 url: https://doi.org/10.5296/ajfa.v11i1.14678 abstract the ifrs for smes is an important element for attaining competitive advantage, attracting investors and gaining access to financial assistance in today’s world of competitive business irrespective of their size. the study assessed the adoption and implementation challenges of ifrs for smes among smes in ga east (madina). to assess the adoption and implementation benefits and challenges, a qualitative research and conceptual and theoretical framework was developed. these guided the design of the data collection instrument to suit the research. the study collected primary data by conducting interviews on 20 respondents. purposive sampling techniques were used to select the firms. data collected as transcribed and coded into the nvivo software. the study revealed that, about 60% of small and medium entities in madina do not have knowledge about the ifrs for smes. the study further revealed that meeting regulatory asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 242 ajfa.macrothink.org requirements and avoiding noncompliance cost were some of the factors that necessitated firms with little knowledge on the standard to adopt it. keywords: ifrs, smes, ga est, ghana, adoption, implementation, regulatory, noncompliance asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 243 ajfa.macrothink.org 1. introduction in recent times, the rate at which economies and businesses engage in international trade has significantly increased. for this reason, investors, financiers, business partners and decision makers who are comfortable with the international standard, s may not find financial statements prepared in accordance to the local generally accepted accounting principle (gaap) useful (gyasi, 2010). titilayo, folashade and ifeoma (2014), stated in their study that, highly accepted measuring stick dialect of accounting should be used by small and medium sized entities (smes) in conveying their accounting results to their stakeholders and the intention was to make likeness in every business view point as globalization is on the rise. this practice will make smes’ financial statement reliable and simple to understand. according to the international accounting standards board (iasb) (2009), small and medium-sized entities are the principal groups of entities (public or local) with about 95 % composition on the international market. therefore, their contribution towards economic growth, exportation and revenue generation (taxation), and unemployment reduction, cannot be over emphasized particularly in developing countries (amoako g. , 2013). despite their contributions and size on the market, study shows that about 60% of smes become unsuccessful within their first five years in business and this was very alarming (boachie-mensah & marfo-yiadom, 2005). some of the reasons were the lack of requisite skills needed to, ability to ensure and sustain growth, leverage on technological advancement and the efficient use of human resources in order to sharpen its competitive advantage with the major reason being the ability to secure and mobilize finances (williams, haka, bettner, & carcello, 2008). as an emerging country, ghana needs high-quality financial information to access international financing resources (alp & ustundag, 2009). there was therefore the need for smes in ghana to discontinue with local standards for reporting purposes with reason being that, most national standards do not give a satisfactory level of comparability (wyk & rossouw, 2009). as a result of the synchronization of accounting practices, the adoption of international financial reporting standards (ifrs) has increased significantly and this has led to many nations adopting it. however, the full ifrs publicized by the iasb, has been found to be irrelevant due to the disclosure requirements which are too extensive for smes (titilayo, folashade & ifeoma, 2014). these necessitated the iasb to issue the ifrs for smes in july 2009. according to albu and albu (2012), addressing the need for international comparability in terms of financial reporting by smes was the main intention of the iasb for the introduction of ifrs for smes. this research was therefore motivated and carried out to analyze the adoption and implementation of ifrs for smes in madina. the main objective of the study was to analyze the adoption and implementation of ifrs for smes in greater accra east (ga east). 2. literature review according to pricewater house coopers (2009), the term small and medium-sized entities (smes) have different meanings in various territories. many authors argued that the concept of sme is too broad and abstract; therefore, it differs from country to country as well as entities to entities. however, ward (2018) mentioned that, what exactly an sme or small to medium asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 244 ajfa.macrothink.org entity is, depends on who is doing the defining. depending on the country, the size of the entity can be classified based on its number of employees, annual sales, assets, or any combination of these (world bank, 2017). it may also differ across industries. hence, there is no specific definition of smes due to the changing rates of improvement. in the european commission attempt to define smes, they gave three distinctive classifications of smes. the biggest classification was the medium-sized enterprises which comprises entities that employ less than 250 staffs with a yearly revenue of less than or equal to 50 million euros and an annual statement of financial position total of less than or equal to 43 million euros. in continuation, they defined small enterprises as enterprises which engage less than 50 employees and their annual gross revenue or statement of financial position aggregate does not go beyond 10 million euros. lastly, micro-enterprises were referred to as enterprises which employ less than 10 employees and whose yearly revenue or statement of financial position aggregate does not go beyond 2 million euros. they however maintained that, the employee headcount threshold is obligatory; nevertheless it is not compulsory to meet both revenue and statement of financial position thresholds simultaneously (mandilas, nikolaidis, & stavros, 2015). iasb (2009), also defined small and medium-sized entities as entities that do not have public accountability and issue general purpose financial statements to its users. the iasb (2009), further mentioned examples of these external users to include owners who are not involved in managing the business, existing and potential creditors, and credit rating agencies (o’dell, 2008). according to iasb (2009), “an entity has public accountability if its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets) or it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses (most banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks would meet this second criterion)”. for the purpose of this study, the institutional theory (it) was reviewed. according scot (2004), the institutional theory is a broadly accepted theory that highlights cogent isomorphism and legality. institutional theory ponders on the procedures by which structures, methods, customs and practices produce persuasive procedures for social conduct by centering on the robust and deeper aspects of social structure. different components of institutional theory expound how these fundamentals are formed, adopted and adapted over time. institutional theory has been noted to be a treasured tool in identifying the drivers of ifrs for smes adoption. institutions are defined as social structures that have become resilient and robust (scott r. , 1995). institutions can also be said to constitute regulative fundamentals, resources and other related activities that provide stability and meaning to life (scott r. , 1995). nevertheless, there exists no precise and generally accepted meaning of an “institution” in the institutional viewpoint. it is fascinating to note that, a supporting reason for the increasing resemblance in organizational systems and practices across the world is that, institutional isomorphic pressures asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 245 ajfa.macrothink.org have been the drivers pushing organizations with increasingly comparable characteristics to adopt policies that reflect their social position. the three forms of isomorphism contained by the new institutional theory were recognized by dimaggio and powell (1991). the first form is coercive isomorphism which emanated from political influence and the problem of legality, the second type recognized is mimetic which results from replies to principles that face uncertainty then the last which is normative is allied to professionalism. a critical examination of these forms of institutional pressures following the adoption of ifrs for smes in african countries offers great opportunities to clarify the institutional conditions that drive the policy adoption decisions. an extensive discussion and the context within which each form of institutional pressures involved in policy resolution is provided. coercive isomorphism rooted from political influence in addition to legality problems. following this reason, the existence or nonexistence of institutions that can inspire economic players to adapt to international accounting standards could be one of the key prime movers of international accounting standards acceptance (judge, li, & pinsker, 2010). this form of isomorphism might instigate from all circles of the environment in which an organization operates, be it structural or political. it assumes the form of a stringent or easy-going pressure put forth on an institution by other bigger institutions upon which they are governed or the social setting within which an organization function. this refers to the manipulation of incentives by powerful factors to encourage others to implement policy changes (simmons, hamann, harenski, xiaoping, & barsalou, 2008). the securities and exchange commission regulates institutions whose shares are openly traded under the securities industry law (1993) and securities and exchange commission regulations (2003) while the ghana stock exchange regulates listed entities under the stock exchange act (1971) and the listing regulations (worldbank, 2004). unlike the coercive which emanates from political influence and legitimacy. imitations have been prevented by the powerful force of uncertainty. effective as well as authentic organizations are imitated by other comparable organizations in their field of operation. therefore successful international businesses that originate from overseas locations are to be expected to toe the line of ifrs and local players possibly will duplicate these successful international businesses (el‐gazzar, sawn, finn, p, & jacob, 1999). also the inflow of foreign direct investment (fdi) has been a major factor influencing the international standards that are of quality within a country (guler, guillen, & macpherson, 2002)country. guler, guillen and macpherson (2002) articulated that, the inflow of foreign direct investment (fdi) has paved way for more economic cohesiveness and has therefore empowered local executives and residents to follow what they regarded as worthwhile of being a participant of the comprehensive marketplace. the world bank noted that there were serious discrepancies with respect to compliance to the generally accepted accounting principles (gaap) of ghana. that is, the institute of chartered accountants of ghana (icag) has not updated any national standards since they were originally adapted from international standards (estandardsforum, 2009). the aforementioned also recognized that the ghana national accounting standards contained twenty eight (28) standards and withdrawn from the standards was its international equivalents of certain ghana national accounting standards, while ten active international asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 246 ajfa.macrothink.org standards were not reflecting in the ghana national accounting standards as at the time of the 2004 report of the world bank. also, standard number forty-one (41) of the international accounting standards significant to agriculture was noticed to have been excluded from the ghana national accounting standards. due to the above-mentioned gaps coupled with others generated uncertainty in the accounting profession. international financial reporting standards (ifrs) adoption turns out to be of utmost importance in identifying a remedy for these gaps. normative isomorphism was the last application of isomorphism within institutional theory and this is ascribed to professionalization. the role of professionals in the formulation and advisory aspects of policy across all fields is very critical. while professionals strive to adhere to strict codes of ethics and professional practice guidance, they turn to form a social group who exchange ideas relating to their professional domain. dimaggio and powell (1991) argue that, shared principles that result in following the line of accomplishment and thought within institutional setting emerge from this form. guler, guillen and macpherson (2002) predict that, the degree of professional technical knowledge of a nation has a positive relationship with its ability to adapt to standards that are of good quality and internationally recognized which were facilitated by professional standards. therefore, a nation ‘s attainment of education may spark normative pressures birthed by professionalism. 2.1 empirical literature amoako, (2013) conducted a quantitative study which employed a sample size of 210 smes in the kumasi metropolis and obtained data through questionnaires. the findings of the study established that the owners who are mostly the managers believes that if they prepare financial statements, the real worth of their businesses would be exposed which they perceived as harmful to the image of their firms. he also found out in his study that most smes in ghana that prepare financial statements only do so for tax purposes and not because they wish to. in addition (ialin & irfan, 2010); (ezejiofor, ezenyirimba, & olise, 2014) are also of the opinion that the main reasons smes prepare financial statements was pressure from regulatory authorities. they conducted a quantitative study where 250 questionnaires were distributed to smes to obtain data. maseko & manyani, (2011) also conducted a quantitative research where structured questionnaires were used to extract primary data from the respondents. their study focused on accounting records keeping practices and found out in their study that, majority of smes do not keep complete accounting records because of lack of accounting knowledge and inefficient use of accounting information in managing financial performance. they mentioned again in the study that, smes concern of keeping incomplete accounting records in developed and developing economies has been in existence not now but for a longer time and has therefore been drawn towards the attention of researchers, professional accounting bodies, professional accountants, economists, investors, policy makers and financial institutions. the report on the observance of standards and codes (rosc, 2004) also revealed that ghana has weak institutional capacity as well as regulatory framework, weak compliance and enforcement of standards and rules leading to poor accounting by companies operating in the country. the report further argued that most institutions that claim to be preparing financial asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 247 ajfa.macrothink.org statements were either having incomplete records or their standards of reporting were poor irrespective of the standard they were using. hence, most smes in the country do not keep proper record of their transactions. scott and des (2012) concluded in their study that, the volume of accounting practices in smes depends on several operating environmental factors that include size of the business, business age and industrial grouping. they further argue that most owners and managers of smes engage public accountants to prepare required information and that they search for additional information, but only to a limited extent. 3. methodology with a sample size of twenty (20) from smes based in the ga east of the greater accra region of ghana, a qualitative research approach was adopted to describe the target population in an accurate way. survey method which a type of is (abata, 2015) descriptive method was employed where the participants were asked to answer questions through interviews. non probability sampling technique was employed since the selection of the smes was based on the researcher’s judgment thus, not all smes have equal chances to be selected. this helped to ascertain accurate information to draw conclusions for decision making. purposive sampling method was employed by the researchers as used by (sithole, 2015) in a similar research. purposive sampling technique was employed by the researchers because; smes that best suits their study who were willing and able to answer their questions in order to meet the objective of the study were selected. primary and secondary data was used in this study through a structured interview employed to solicit information from respondents. the interview questions had three major chapters. the first part covered the demographic profile of the respondents followed by the profile of the business entity. the next chapter focused on the questions that the researchers sought to ascertain from the respondents, their knowledge of the introduction of ifrs for smes followed by the extent of their adoption and implementation of the standard. finally, respondents were provided a space to list both perceived and actual benefits as well as challenges that are associated to the adoption and implementation of the ifrs for smes. to analyze data collected, the content analysis (thematic) technique was employed to comprehend the total themes that arises in qualitative data. using techniques like colorful coding specific themes and ideas helps analyze recorded data to find the most common responses. the study employed the content analyses in drawing conclusions since our data collection techniques are such as interview data and open-ended surveys. for the analysis, the nvivo software was used in the processing of the raw data as used in similar qualitative research by betul (2004) where nvivo was used to analyze the data and outlines the methodology that was adopted in their study. all necessary analysis was made from the output of the nvivo. 2.2 analysis and discussion of findings description of the results asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 248 ajfa.macrothink.org table 1. genders of respondents sex frequency cumulative frequency percentage (%) male 14 14 70 female 6 20 30 total 20 20 100 source: survey data, 2019. from the table, the representative of the firms who we interviewed as our respondents had males representing 70% of the sample size while 30% were females. although, there is a gender imbalance in our respondents the responses from all these respondents gives the actual happenings of every firm. this presupposes that males are more inclined in the implementation of the standard as compared to females. table 2. legal status of respondent firms number of firms percentage adopted the ifrs for smes percentage privately owned companies 6 30% 6 30% partnerships 5 25% 2 10% soleproprietorship 9 45% source: survey data, 2019. from the above table, twenty (20) respondents were interviewed out of which six (6) were registered privately owned companies and all these firms had adopted and implemented the standard taking between 6 months to 2 years in their implementation processes. five (5) out of the twenty (20) were partnership firms with only two (2) implementing the standard. none of the nine (9) respondents who were operating sole proprietorship business had any basic knowledge in the standard with just a handful declaring hearing the name a few times but had no knowledge of what it meant. from the table, the eight (8) firms that had adopted the standard were bigger in terms of size and structures and were well established, with a few having branches. this supports the claim by aboagye-okyere & agbeibor (2012) who in their study noted that, the standard to a significant extent is biased towards firms that are well structured. this poses a question as to whether the size and structure of these smes were considered by the iasb when designing the standard. discussion of results the awareness level of and the key motivators for the adoption, of the ifrs for smes. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 249 ajfa.macrothink.org the ifrs for smes, was initially introduced in july 2009, and finally adopted by ghana in 2012 by the institute of chartered accountants ghana. it is however surprising that, 60% of the total firms interviewed in madina, said they had no knowledge of the said standard. “our business is not aware of any thing called ifrs for smes; can you tell us about it? ifrsforsmesr6. we don’t have any idea on what the standard is although we have heard of it ifrsforsmesr11. these responses show that, firms have no knowledge of the fact that a standard has been adopted on their behalf which is expected to solve their challenges as firms. this challenge was also identified by arhin, perprem, & hulede (2017) in their study into challenges of adopting and implementing ifrs for smes in kumasi who argued that, most smes have no idea of the ifrs for smes and added that regulatory bodies should devise means to create awareness on the said standard. “i am not aware of any standard like ifrs for smes. i do not make any good sales apart from orders from partners to supply and so we using this standard will only be a burden” ifrsforsmesr1. owners of sole proprietorship business chorused similar response that, they did not know anything regarding the standard being referred to, by the researchers. to the few who did not keep proper records, the standard will only put unnecessary responsibilities on them of which they are not prepared for. “the business is small and cannot adopt any standard; we are used to our normal way just for tax purposes”. upon providing a few insights into the standard to these entities, the researchers realized that these firms have little or no interest in whatever the standard had for them and as such were not prepared to learn anything about the said standard. there is a great need to commence an awareness campaign to educate smes about the need to adopt this standard. kilic & ataman (2016) in a similar study also revealed that 50% of their total respondents had moderate knowledge while 30% had little or no knowledge about the standard. one can infer that, an awareness campaign is generally needed in all the countries that have adopted the standard. the benefits to be derived from the successful implementation of the ifrs for smes the introduction of the ifrs for smes by the iasb had with it good reasons to improve the financial reporting framework of firms specifically smes. according to zegal, yosra, & sondra, (2011) the adoption of the standard can advance the quality of a firms financial reporting. the standard from its inception promised, among other things, easy understandability, comparability and the like. despite the numerous challenges stated by the respondents, a few of them spoke of certain benefits they enjoyed in the implementation of the standard. “since we always had our financial statements prepared in our own way without any specific format but only ensured that we capture all our expenses as well as our revenues, we always found it difficult to get access to credit but upon adopting the standard, it has helped us gain financial assistance from banks through the preparation of a good financial statement” ifrsforsmesr5. two respondents believed that, there is a positive relationship between quality financial statement and access to credit and therefore the successful implementation of asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 250 ajfa.macrothink.org the ifrs for smes should also help other firms in the quest to secure financial assistance. this supports the argument by (rudzani & charles, 2016) that firms get easy access to loans when they can present financial statements that are acceptable by banks for their assessment before granting loans. “i had some business partners who wanted to invest in my business but they were not comfortable with how i prepare my financial statement but when i started using this standard, i have had three business partners investing in my business and in my view i think there might other future benefits which i am yet to enjoy with the passage of time ifrsforsmesr20. this tells that investor confidence in firms’ financial statement is paramount when it comes to choosing a company for investment. this supports the argument by the iasb 2009 that, if capital providers do not understand or have confidence in the financial information they receive, an sme’s access to, and cost of capital will suffer. “now that we can clearly identify our capital expenses from the revenue types, we now get a true reflection of our profit for the period end. the business is now able to clearly assess its financial performance for the period and make the necessary decisions. this will also help us to state the correct tax amount for every period easily” ifrsforsmesr13. quiet an appreciable number of smes asserted that they had no benefit locally from the implementation of the standard. “we are not getting any benefit from the use of the standard so if it comes to benefits what we can lay hand on is the knowledge that we are complying with regulatory requirement and avoiding any penalty from noncompliance”. “although we are using the standard, we have not had anything to do with international credit facilities or any international investment from and a foreign investor but we have had benefits within the country” ifrsforsmesr17 “although we have international investors, it was not as a result of the ifrs for smes adoption that they invested in this company. this is because we had them as investors because they are relatives and they also invested into the company before we adopted and implemented the standard ifrsforsmesr3. none of the responses showed that, any firm has had any international benefit. these raises the question as to whether smes in madina and by extension the country ghana has had more benefits than challenges from the adoption and implementation of the ifrs for smes. a similar study conducted at kumasi one of the largest cities in the country also showed that the level of adoption of the standard is quite abysmal probably because smes in the country has gained very little of any benefits from the introduction of the standard. aboagye-okyere & agbeibor, (2012) also discovered in their study that, 70% of the issues that the standard was established to solve, were found to be irrelevant to smes which also explains why smes are not benefiting greatly from the standard. the challenges encountered by firms in the implementation of the ifrs for smes challenges have become a part of every human endeavor and draws a line between human imaginations and reality in the world. responses from our respondents have sparked several issues regarding the implementation of the new standard, ifrs for smes. however, countries that decided to and have adopted the standard were expected to enjoy maximum benefits with asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 251 ajfa.macrothink.org very little room for challenges. most of these countries were driven by high motivating indicators to adopt the standard and therefore expected to experience the impact of these motivating factors on the life of their businesses. it is in this regard that, marcellan (2009) said that, global recognition, attraction of talented finance people and the easiness in implementing the full ifrs when required were the reasons that necessitated the release of the ifrs for smes. in the same vein, different authors have argued that, the supplementary benefits to a firm implementing the standard, will include qualification to government tenders and bank loans. based on this assumption, one would expect these smes in madina to attract more business or sales and to find it easier to obtain bank loans, however, responses from ifrsforsmesr9 10, 16, 20 do not support this assumption as they emphatically stated that the adoption of the standard has not added any significant benefit to the firm during and after its implementation with difference in paper works being the only change. to these firms, the level of business activities, such as sales, purchases, ability to secure credit facilities, external investment and the like have seen little or no improvement and this view was also held by rudzani & charles (2016) that most smes who have adopted the popular standard, could not clearly identify any improvement that the standard has provided to their businesses. in the view of ifrsforsmesr18“our accounting staff were not highly skilled in the standard to support the entity in the implementation processes at the initial stage and i believe is due to the fact that the format we have been using which makes the preparation easy, is far different from that of the ifrs for smes and more so, the standard is quiet difficult”. out of the users of the standard in the preparation of their financial statement, ifrsforsmesr14, ifrsforsmesr20, in support of the opinion above also believed that, there are some prerequisite skills needed by smes such as knowledge and ability to interpret and apply all sections of the standard successfully. to these firms, their staff do not possess such skills hence implementation of the standard had been a challenge. this challenge was equally realized from a similar study conducted by (rudzani & charles, 2016) in their quest to find the challenges that smes in south africa encounter when implementing the ifrs for smes. complexity of the ifrs for smes is a reason why the respondents under this study argued that they lacked the necessary skills needed to implement the standard. samugh and devi (2015) also stated in their findings that, the low patronage of the standard by smes is due to its complex nature and the low level of technical knowledge among smes. rudzani and charles (2016) agreed with this challenge and proposed in their study that the ifrs for smes should be reviewed to reduce its level of complexity “we have only one accountant who is a fresh graduate and can only assist the firm in bookkeeping and other accounting related activities but has very little knowledge of the said standard and therefore we were exposed to huge cost to start the implementation”. ifrsforsmesr13. “the accountant of the firm does not have the requisite skills to implement the standard and as such we had to outsource our accounting function before we could implement the standard” ifrsforsmesr20. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 252 ajfa.macrothink.org smes that are not properly organized in general, may incur more cost in operating certain departments fully hence resort to part-time employees and as well as outsourcing most of their functions and this is a reason why they lack professionally qualified staff who are fully employed such similar tasks. “we did not want to replace our accountant, but we eventually have to train him through seminars, cost to hire a tutor to professionally groom the accountant as well as other ifrs tutorials materials” ifrsforsmesr12. “when our accountants acquire professional qualifications, their demands becomes too high for a small private company like ours and we cannot continue paying them high salaries simply to keep them”. cost has become a key challenge in the implementation of the standard. 75% of our respondents who had adopted the standard all had cost as a similar challenge. it is no surprise that, the researchers have not yet come across studies on challenges of the implementation of the ifrs for smes that did not discover cost as one of the pressing challenges of smes in the countries that have adopted the standard. similar studies conducted by, (rudzani & charles, 2016) and arhin all attested to the fact that cost has been a major challenge when a firm decides to adopt and implement the standard. “we were made to adopt the standard because it has been made compulsory for all smes when registering the business.” ifrsforsmesr13. some of the respondents also expressed concerns of how the standard was imposed on them. to them, they had to implement the standard against their will. this is as a result of the decision by icag to adopt the internationally acclaimed standard for use by all smes in ghana. this observation is however supported by a similar study conducted by rudzani and charles (2016) in south africa that, an appreciable number of its respondents believed they adopted the standard against their will. this raises the question whether the standard should be made optional rather than its current compulsory form? the roles of regulatory bodies in the successful adoption and implementation of the ifrs for smes. a parliamentary act established the icag to regulate the accountancy profession in ghana. they are also the accounting standards setter for the country. it is expected that since they adopted the standard to replace the ghanaian accounting standards, they will have measures put in place to ensure that smes in the country are in better positions to adopt and implement the standard successfully. however, when smes were asked of their knowledge of any role of regulatory bodies in ensuring that smes successfully implement the standard as well as provide continuous support to smes as and when old standards are reviewed and new standards are introduced, they stated that, they had no such support from any regulatory body. “i have not been aware of any role of regulatory bodies to help my business or other businesses to operate the ifrs for smes” respondent 18 “i have not been assisted by any regulatory body on how to implement the standard” respondent 12. this supports the argument by arhin, perprem, & hulede (2017) that regulatory and professional bodies do not support smes to implement ifrs for smes successfully”. however, some of these smes have some expectations that they expect regulatory bodies to organize seminars, training sessions. they also expected that asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 253 ajfa.macrothink.org regulatory bodies will set up team of professional who will be engaged with the smes to know the challenges they face and assisted them to devise ways to solve their challenges. 4. conclusion and recommendations overall, the outcomes of these study give an indication that, the ifrs for smes currently is not known by smes in the country. this means that, the solutions professed by the standard to smes cannot be obtained by smes. access to local credit facilities was the main benefit that the adoption of the ifrs for smes has added to businesses in madina. the findings that, the standard brought no international benefit support the argument that, the iasb’s objective of allowing smes to access international competitive funds through the implementation of the ifrs for smes is a distant objective. the respondents who are challenged by the high cost of implementation and lack of competent staff to use the ifrs for smes support the common assumption that there is a shortage of well qualified accountants and other financial management expertise in the country, with the few available charging exorbitant fees. the study also revealed that smes expert regulatory bodies to establish policies that will assist smes in the implementation process of the standard although currently there is no such effort. limitations of the study it is important to note that, this study was exploratory in nature and thus subject to several limitations which can be addressed in future research. the first limitation relates to the small number of interviews that might affect the generalization of the findings. the sample was selected from only smes in madina and thus cannot be generalized to all smes in the country. the second restraint of this study relates to the definition of the sme itself. while it is generally accepted that the number of employees could be used as an alternate measure for firm size, expanding the definition to encompass the sales or revenue of the firms may produce different results. recommendation for further studies the ifrs for smes is a broader scope of accounting which cannot be dealt with in its entirety in this study alone. further studies should be conducted on:  the relevance of the ifrs for smes to micro entities who form part of the smes.  the suitability of the standard from the perspective of other stakeholders in sme financial reporting such as bankers and tax authorities.  the usefulness and challenges of the recognition and measurement principles, disclosures and accounting policy options of the standard.  studies focusing on entities on the larger end of the iasb’s sme definition could also consider whether the ifrs for smes would reduce the in-formativeness of the financial statements of these entities or fail to provide guidance on certain pertinent issues. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 254 ajfa.macrothink.org references abata, m. 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(2011). an analysis of mandatoryadoption of ias/ifrs on earnings management. international accounting , auditing and taxation, 61-72. https://doi.org/10.1016/j.intaccaudtax.2011.06.001 microsoft word 10968-40452-1-rv-writer2-new asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 245 accrual accounting in public sectors: possible contextual and application gaps for future research agenda rozaidy mahadi universiti malaysia sabah siti nabiha abdul khalid universiti sains malaysia rasid mail universiti malayia sabah raman noordin universiti malaysia sabah received: march 21, 2017 accepted: april 11, 2017 published: june 1, 2017 doi:10.5296/ajfa.v9i1.10968 url: https://doi.org/10.5296/ajfa.v9i1.10968 abstract this paper analyses the possible contextual and application gaps derived from the utilisation of van helden and northcott’s (2010) method of study for classifying themes in published public sector’s accrual accounting papers according to their research objectives. as a result, our theme categorisation refers to the following research objectives: a) proposing new financial/management accounting techniques/approaches for public sector accrual accounting systems (e.g. accrual output-based budgeting, performance management and costing); b) examining the effectiveness of accrual accounting techniques/approaches; c) identifying the conditions for the successful/failure of the implementation of accrual accounting techniques/approaches; and d) knowledge-building in understanding, explaining and critiquing the adoption and use of accrual accounting techniques/approaches, both theoretically and practically. through the process of populating and establishing the themes asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 246 (based on research objectives), we were able to identify which areas of study have received less attention and which areas have room for further exploration. keywords: public sector accounting, accrual accounting, future research asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 247 1. introduction within the world of public sector accounting, a distinct movement, the new public management (npm) paradigm (hood, 1995), has had a profound effect on accounting practices. the npm is a model of reform that favours quantification and results and in which accounting has a central role. one of the by-products of this movement is accrual-based accounting systems, which arguably provide better efficiency and transparency tools with regard to enhancing financial management and controls. many governments have adopted these accounting systems (pallot, 1998). chile was the first state to introduce accrual accounting for the public sector in the early 70s, followed by new zealand in 1990. unlike other countries, new zealand changed its systems comprehensively. however, other countries such as the usa and australia switched to accrual accounting in 1997, but only in central governmental administration, with changes in local administration being implemented several years later. by the turn of the year 2000, new zealand had become one of the countries with the most extensive set of accrual accounting disclosures (ellwood & newberry, 2007). subsequently, other countries gradually followed suit, especially oecd countries and those that had a similar motive, to reform the financial management systems in the public sector. whilst the adoption of accrual accounting was embraced by the various levels of public sector organisations under the umbrella of npm, research pertaining to accrual accounting in the public sector increased and enriched the body of knowledge in public sector accounting literature. among the popular themes in this area of research are: 1)proposing new financial/management accounting techniques/approaches into public sector accrual accounting systems (e.g. accrual output-based budgeting, performance management and costing); 2) the effectiveness of accrual accounting techniques and approaches; 3) identifying the conditions for the successful implementation of accrual accounting technique/approaches; and 4) knowledge-building in terms of understanding, explaining and critiquing the adoption and use of accrual accounting techniques/approaches, both theoretically and practically. those strong research-practice nexus offer important benefits to researchers, since the acknowledgement of their academic pursuits is enhanced by investigating relevant issues that contribute to the solution of practical problems and/or serve the interest of research stakeholders. these stakeholders are governments, policy-makers, accounting practitioners and business managers. the appropriate identification of plausible research gaps and/or outcomes benefits research and academic communities, and therefore forms the focus of this paper. the remainder of the paper is structured as follows. first, we draw on van helden and northcott’s (2010) method for classifying themes in published public sector accrual accounting papers according to their research objectives. the selection of academic journals and the classification procedure adopted are also explained. next, we elaborate on key issues from identified themes extracted from the reviewed papers. finally, we discuss the findings and reflect on their implications for future research gaps in the development of accrual accounting research in the public sector. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 248 2. research method: classifying themes in this study, van helden and northcott’s (2010) method of study will be employed to classify the relevant and accurate themes in published public sector accrual accounting research articles. to identify and classify the relevant themes, van helden and northcott (2010) started the process by looking at the research objectives underlying public sector management accounting research (psmar) articles in the period from 1990 to 2005 in five prominent journals after that, they examined the extent to which the reviewed papers highlighted the practical implications of their research. consequently, the main focus of their findings was on the aspects of practical relevance in the research aims and content, and the communication of practice-relevant findings. from these two main focus areas, they developed and categorised four main themes out of the 128 papers that they examined. even though this study has adapted van helden and northcott’s four themes, there is a slight difference between our study and that of van helden and northcott (2010), and this needs to be addressed. first, there is a difference in research focus; van helden and northcott’s study focused on the area of public management accounting research. therefore, when generating the themes they reviewed articles covering a broad range of management accounting research realms in the public sector, including accrual accounting based research papers. consequently, a total of 128 papers were reviewed to plot the themes. meanwhile, our study focus is limited to research papers related to the area of accrual accounting in public sectors. thus, our reviewed papers numbered only 50 articles, which are primarily accrual accounting based research papers. however, this difference does not critically impair the adaption of van helden and northcott’s thematic system since their study substantively covers a majority of accrual accounting based research papers. as a result, our themes categorisation refers to the following research objectives: a. proposing new financial/management accounting techniques/approaches for public sector accrual accounting systems (e.g. accrual output based budgeting, performance management and costing); b. examining the effectiveness of accrual accounting techniques/approaches; c. identifying the conditions for the successful/failure implementation of accrual accounting technique/approaches; d. knowledge-building in understanding, explaining and critiquing the adoption and use of accrual accounting techniques/approaches, both theoretically and practically. to arrive at the above-mentioned objectives, we followed van helden and northcott’s (2010) method for selecting journal articles for the reviewing process. the selection of the journals was based on papers published in high-quality international accounting journals with an interest in accrual accounting in the public sector. our review included a total of 50 papers published in the 1992-2012 volumes of accounting, auditing & accountability journal (aaaj); accounting, organizations & society (aos); british accounting review (bar); asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 249 critical perspectives on accounting (cpa); european accounting review (ear); financial accountability and management (fam); management accounting research (mar); and accounting history. the process continued with an examination of the extent to which the reviewed papers highlighted the practical/theoretical implications of their research (see appendix 1). consequently, the first part of the examination process started with identifying the research’s aims and content, while the second part of the process concerned the communication of their theoretical contribution and suggestions for future research. in addition, in order to classify the theme criteria and identify the research gaps, we developed categorisation schemes around these two focus areas. moreover, as shown in appendix 1, the analysis revealed that the majority of the reviewed papers have a combination of two or more research objectives. for example, adhikari and mellemvil (2011) in their paper ‘the rise and fall of accrual: a case of nepalese central government’, combined two research objectives: one as a main focus (d), and one complimentary research objective (b). another example is christianes’ (2001) study, which has a combination of more than two research objectives: research objective (d) as a backbone of the study, complimented by two other research objectives (a) and (b). based on our analysis, the majority of the articles were constructed around or incorporated two main themes (research objectives d & b). this trend shows that most scholars are interested in the explanation and examination of the implementation of accrual accounting in the public sector. with that fundamental component in mind, through the process of populating and establishing the themes (based on the research objectives), we were able to identify which areas of studies have received less attention and which areas have room for further exploration. for example, the studies that have concentrated on research objective c have often neglected the advantage of conducting comparative studies between various governmental agencies. as a result, we know only a little about the impact of variations in governmental structures (e.g. organisational structure, legislation frameworks and financial procedures) when the financial reforms take place at different levels of governmental agencies (i.e. between the federal and state level). the detail will be further explained in the next section. we adhered to the gap identification process suggested by the reviewed authors. finally, from the reviewed articles we have identified three research gaps that hopefully can be addressed as a focus for future research: a. more research on accrual accounting development research in developing countries’ public sectors. b. the importance of cross-sectional or comparative studies. c. exploration of historical studies of accrual accounting and financial management practices in varied public sector contexts. 3. research themes in accrual accounting in the public sector 3.1 analysis of research objectives a & b npm has become a popular research paradigm in public sector accounting. the migration of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 250 accounting systems from conventional cash to an accrual basis has driven the introduction of new accounting techniques that meet the changing needs and opportunities. in the case of accrual accounting in the public sector, new financial/management accounting techniques (e.g. for output-based budgeting, financial accounting standards or performance measurement) have been proposed as tools to improve the functioning of the public sector’s financial management. changes in the public sector’s accounting systems offer new ground for scholars to explore new techniques and approaches with the target of enriching the application of accrual accounting techniques in the public sector. as a result, the study of the development of new accounting techniques and approaches in public sector accounting has become one of the main research objectives among scholars in this field. for instance, luder (2000) examined systems of national accounts (sna) and the european systems of accounts (esa) in order to identify the weaknesses of the current emu-procedures for determining governments’ financial conditions and suggesting solutions. luder suggested that emu members should design an appropriate definition for government’s debt and deficit ratios to secure reliable measurement when comparing cross-country (european) governments’ financial conditions. luder’s (2000) paper provides an example of research objective a, which was uncommon in our review. this was commented on by van helden (2005) when he explained why few researchers have taken this subject as their main research theme, ‘the authors in public sector accounting mainly stick to their academic background and seem to take a rather distant stand from practice’. moreover, accrual accounting itself is not an alien or totally new practice since it has been widely practised in private sectors and commonly studied by scholars. in addition, the application of accrual accounting techniques or approaches in the public sector was largely adapted and adopted from the accrual accounting systems practised in the private sector. thus, research in this area offers limited room for new discoveries and consequently attracts less attention from scholars. despite that, the introduction of new policies or systems in government sectors is commonly welcomed with debates, the aim of which is to predict the expected prospects and negative effects on government performances in the future. the same treatment was applied when the accrual accounting systems were introduced as a new accounting system, replacing the old cash basis systems. the introduction received a mixed acceptance among public sector accounting scholars. since the functioning of conventional accounting (cash basis) had been criticised for several decades, accrual accounting techniques/approaches were argued to be a means of elevating governments’ poor financial management, as well as an effective mechanism for supervising public sector financial practices. thus, in order to examine these proposed results, many scholars have embarked on research studies to evaluate the effectiveness of this new accounting practice with regard to public sector financial performances. hence, this research focus has been identified as a research objective b in our study, and based on our analysis, this is the second most popular subject of research among public sector accounting scholars. an example of this type of research objective is as follows. mellet and howard (1997) sought to examine the consequences of adopting a more business-like approach (npm agenda) as asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 251 part of the reform of the national health systems (nhs) in wales, following the early 1990’s reforms of the u.k.’s healthcare systems. their research emphasised the role of the accounting process, using the experience of nhs trust hospitals in wales to illustrate the impact of the changes on hospital performance, especially in financial terms. meller and howard (1997) highlighted several constraints faced by public sector organisations when applying private sector practices to their financial systems, such as a vague conceptual framework for recognising profit/surplus between cash accounting and accrual accounting, which impairs the nhs’s financial accountability representation. another example is newberry and pallot’s (2005) study, which undertakes an interrogation of the new zealand government’s financial systems. it examines new zealand’s financial legislation and assesses the implications for democracy of the form of parliamentary control over the use of taxpayers’ funds. the study raised an issue regarding the auditor general’s controller function, which has been impaired by the changes and financial reforms of 1988/89. the authors also argued that accrual-based financial reporting creates wonderful opportunities for hiding problems, as the collapses of enron and parmalat have shown. other papers dealing with this type (b) research objective are commonly explored in new zealand’s, australia’s and the u.k’s public sector organisations (e.g. christianes and wielmaker, 2003; marti, 2006; hoque, 2001). however, there are several areas of studies connected with research objective b that have received less attention from scholars, and further investigation should be carried out to address the gaps in these areas of studies. studies that focus on research objective b, which is examining the effectiveness of accrual accounting practices, mostly concentrate on developed countries, and less research is focused on developing countries (for exceptions, see adhikari & mellemvik,2011; harun & eggleton, 2012). in recent years, many developing countries have declared various npm reforms, although these efforts are still underrepresented with regard to research publications (graham, 2009). more studies are needed in this context since the experiences of developing nations are bound to be different from highly developed governments with rich administrative traditions, such as hong kong. in general, the migration to accrual accounting in developed countries follows the same movement in developing countries. however, financial reforms in developing countries were driven by the requirement to abide by the rules commanded by their financial creditors or donors, such as the international monetary fund (imf), the world bank and the asian development bank (adhikari & mellemvik, 2011). in this case, new zealand in particular has been regarded as highly successful in its accrual accounting implementation, and has frequently became a proposed template to be copied by international creditors with regard to their borrowers (bale & dale, 1998). exemplary to this situation is the study conducted by harun et al. (2012) which shows that the institutionalisation of accrual accounting ideas and practices in indonesia was extensively issued and disseminated by international organisations and donors. similar situations also occurred in nepal (adhikari & mellemvik, 2011), where the changes towards accrual accounting were motivated by international donors. despite the increasing appeal of accrual asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 252 accounting and its wide ranging implications for the role and functioning of public sector accounting systems, there has been comparatively little study of its application and impacts in developing countries. the scarcity of literature on this subject in developing countries is due to the fact that the development of accrual accounting in these countries is still in its infant stage, compared to developed countries which have reached their peak maturity level. thus, research into this concern is also still in its infancy stage, and we consequently know relatively little about the issues related to accrual accounting practices in developing countries (jones & kettl, 2003). moreover, lack of research in this context provides greater opportunity to explore and examine the implementation process of accrual accounting at a national level in developing countries. for example, the malaysian government reportedly aims to implement comprehensive accrual accounting systems at all federal level ministries by 2016 and the effort will be extended to state government in the following year (pasukan pelaksanaan perakaunan akruan, 2015). the same initiative has been followed by brazil (2013), nigeria (2016) and according to pwc (2015), 29 developing countries will be expected to adopt accrual accounting systems at a federal level by 2018. this is good evidence of attempts to broaden the remit of public sector accounting research in order to consider a wider range of organisations (broadbent and guthrie, 2007; guthrie, 1998), even though, as noted earlier, scholars are still attracted to studies at a local administration level. the opportunity to study diverse locations and undertake comparisons, especially among developing countries, should be grasped as it provides the basis for contrast and comparison, which facilitate our learning and allow both the transfer of good practices and the prevention of mistakes being repeated. in addition, it is worth mentioning a few other areas of research that can be considered contextually relevant, since this kind of study is familiar in developed countries but practically new in developing countries. firstly, there is the accountability and auditing issue; it is significantly relevant but less attention has been given to this area of study. based on our review, most of the studies related to the subject of public accounting reforms in developing countries have concentrated on the readiness, standard setting and evaluation of the development of accrual accounting systems. the adoption of accrual accounting systems has altered the public sector’s legal and administration framework and subsequently affected its governing and auditing systems (english, 2003a). thus, accountability and auditing issues in the context of developing countries are undoubtedly significant and merit further investigation. secondly, studying government policy and execution plans (i.e. the implementation of accrual accounting systems) and comparing them with the outcomes is empirically important. it enables us to compare and contrast the planning and outcomes, therefore the findings generated from this process will help to prevent counterproductive results and also determine effective mechanisms to enhance organisational strategies. the third area of study in this context that requires more attention is in the area of management control systems, especially in accounting information systems (ais). changes in accounting information systems commonly occur when governments change their asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 253 accounting practices (luder, 1994; harun et al., 2012). thus, it is crucial to investigate the new accounting information systems that have been put in place. however, this area of study has also received less attention; as argued by yamamoto (2009), there are few studies about how control systems work and why they have persisted in the public sector. as goddard (2010) has emphasised, we need to know much more about how accounting and financial management reforms work in developing countries, where issues of auditing and governance may play different roles than in developed nations. 3.2 analysis of research objectives c & d research d types can be directed at explaining, understanding and critiquing the motivations behind (and/or outcomes of) the adoption and use of accrual accounting techniques/approaches. such studies tend to reconfirm or object to the analysis advocated by prominent authors, such as guthrie (1998), pallot (1999), mellet (1997) and pollitt (2002). most research in this area has tried to be more critical in its analysis of the adoption of accrual accounting techniques/approaches in various organisational contexts, and to not bluntly favour the idealistic conceptions of accrual accounting practices put forward by npm advocators such as politicians and the imf. the critical examination of how and why accrual accounting techniques/approaches are used in public sector contexts and the outcomes (intended and unintended) of their use, therefore presents a fourth agenda for research that builds knowledge to inform future research practice/theoretical developments. studies directed at understanding the use of accrual accounting techniques/approaches (research objective d) are mainstream in our review. the theoretically oriented studies mostly discuss how technical accounting is applied, including the organisational and contextual factors that influence their applications (see, for example, newberry and pallot, 2005; barton, 2004; pallot, 2001). in general, most studies that fall under this category are mainly reflective in nature – that is, they tend to critically examine the development and application of accrual accounting techniques/approaches by indirectly defined theoretical explanation (see, for example, potters, 2002; garseth, 2011; brorstrom, 1998). below are two examples of research objective d type of studies. potters’ (2002) study discusses how technical accounting is used to understand financial accounting reforms in public sector organisations. potters explores the forces at work in shaping the recent innovation in australian public sector financial accounting reforms. he pins the research findings to douglas’s institutional thinking in understanding the connection between the preparation of a conventional accounting report and the improvement in the accountability and performance of diverse public sector entities. douglas’s theory suggested that institutions are primarily denoted by their role in shaping the thinking of associated individuals. the theory also postulates that societies and cultures develop legitimised social groupings such as families, or legitimised social processes such as games or ceremonies. douglas refers to these legitimised groups or processes as an “institution”. the study found that the commercial accounting framework has been influential in shaping the nature of content of recent accounting reforms in the australian public sectors. bogt’s (2008) study examines accounting change from an institutional point of view. the asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 254 study focuses on the various possible reasons for their introduction, change process and the effect of the changes on the dutch public sector. to encapsulate the explanations, bogt uses burns and scapen’s (2000) framework for accounting change. bogt’s (2008) research indicates that economic issues, such as budgetary pressures, played a role in the introduction of various accounting changes. further, several changes were introduced because they were a ‘success’ elsewhere, in order to look ‘modern’, because they were expected by certain stakeholders, or because they have mandated. the underpinning theory indicates that accounting change in the dutch public sector, driven by the organisational culture, which is closely related to the internal institutions, might be an important effect of management accounting changes and those changes will gradually become routines and institutions. hence, bogt’s (2008) study showcased how a certain theory was chosen to examine the development and use of accrual accounting techniques/approaches in public sector organisations. finally, the fourth research objective (research objective c) relates to identifying the conditions of the success/failure of accrual accounting techniques and approaches. the reviewed articles reveal that the successful criteria for introducing new accounting techniques/approaches in public sectors depend not only on the organisation’s ability to identify appropriate techniques, but also on behavioural issues, such as a good match between various controls, organisational cultures, and attention paid to the recruitment and training of employees (e.g. nepworth, 2003; robinson, 1998; lye et al., 2005). based on the analysis, classifying the conditions that support successful implementation is a common research objective among scholars. furthermore, research objective c was commonly chosen as a complimentary focus by scholars and seldom stood as the main focus of their study. research objective c is mostly complimented either with research objectives b or d. for instance, when the scholar tries to build a theoretical explanation and understanding of the adoption of accrual accounting techniques/approaches (research objective d) in particular organisations, the study starts with identifying the conditions or factors that explainthe phenomena studied. for example, christianes’ (2002) study examines the process of change in the new south wales government’s early adoption of accrual-based financial reporting (research objective d). in his study, christianes revisited an analytic framework that is a proposed variant of luder’s (1994) contingency model, and presented five hypotheses (see christianes, 2002) for testing the revised model. christianes argued that individual factors should be incorporated in explanations of public sector accounting change. the study also acknowledged the existence of other factors in explaining the process of accounting change in the new south wales government. the study unveiled poor management control systems, inadequate accounting skills and poor asset records as the factors that paved the way for the hypotheses to expound the theoretical construction. thus, this illustration shows that the identification of factors/conditions (research objective c) is habitually designed as a complimentary focus in the process of discussing the main focus of the study (in this example, research objective d). whilst many theoretical and practical explanations have been constructed at various contextual domains in studies associated with accrual accounting practices in the public sector, fewer studies have selected cross-sectional or comparative methods as the base of asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 255 their study, and most studies frequently choose national, state, local and governmental agencies as their contextual bases. cross-sectional and comparative study between different levels of governmental agencies is crucial because each level of government has a different set of political and administration systems. for instance, in the u.k., the formation of three different states (wales, england and northern ireland) has separated the power between state government, local government, and central government. therefore, transnational or cross-sectional studies are valuable in order to understand the interplay of issues between various levels of administration. thus, to comprehend this issue, more comparative studies that employ various contextual bases need to be undertaken. even looking at this crucial point, comparative studies between various levels of government entities, such as studies comparing the accounting systems and practices of federal, state or local governments (the three levels of administration domains) were extremely rare or even non-existent (christianes, 2001). the majority of those who study this context mainly focus on a single selected administration domain. for example, some focus on central government level (see garseth, 2011; lye etal., 2005; newberry & pallot, 2005; likierman, 2000; ahikari & mellemvik, 2011); others on local government level (e.g. hoque & moll, 2001; bogt, 2008; brorstrom, 1998; harun et al., 2012; christianes, 2001; yamamoto, 1999); or on governmental entities (e.g. mellet & williams, 1996; klumpes, 2001; scott et al., 2003; mir & rahaman, 2007; mellet & williams, 1997; hodges & mellet, 2003; christianes & wielemaker, 2003); or state government level (e.g. jagalla & weber, 2011; christianes, 2002). only a few studies have performed cross-sectional/comparative studies in this context, such as luder et al., (2009). they examined and compared the implementation of accrual accounting in local government between several countries (u.k., usa, new zealand and australia for central government, and france, italy and germany for local government). also, connolly & hyndman (2006) evaluated resource accounting in northern ireland and made a comparison between the federal level and state level in order to ascertain the principal benefits and drawbacks experienced when implementing resource accounting. another rare example is marti (2006), who conducted a comparative case study on three pioneer countries (the u.k., sweden and new zealand) in order to analyse the accounting treatment of problematic elements of financial statements when introducing accrual budgeting and accounting. it is important to know what is happening in individual countries, but that does not mean that studies conducted in only one country and/or entity are of little value. hence, we need to pay more intention to the commonalities and the contrasts across single administration domains. understanding how the ideas and instruments of accounting and financial management travel internationally, as well as the channels and conduits through which they travel, is crucial in the era of diminishing cross-border barriers (humprey & miller, 2011). moreover, accrual accounting is still in the process of being operationalised for public services in some countries and it seems to face much greater challenges, with the result that its insertion into local or national settings creates many tensions and points of friction (lapsley et al., 2009). this suggests that we need to know much more about how and under what circumstances asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 256 accrual accounting as calculating instruments can be assembled and put to work in different levels of the administration context. furthermore, there is one more area of study that is significant for future research – historically based research or accounting historical analyses (humprey & miller, 2011; van helden 2005). based on our analysis, there is little historically based research in public sector accounting. there are a few exceptions, such as klumpses (2001), who examines the financial accountability implications arising from the adoption of accrual-based budgeting by australian’s pension fund managers from 1888 to 1996, and scott et al. (2003), who conducted a study to trace the use of cash and accrual accounting in the financial reports of two public hospitals in new south wales between 1857 and 1975. however, conducting this kind of research is not a matter of adhering to esoteric or antiquarian concerns, as the ‘new’ accounting history has so strongly demonstrated (hoper et al., 1991). it is more a matter of pursuing the understanding of the conditions of transformation in ways of governing economic and social life that have been taking place over the past two decades and more, and which are in the process of being transformed further (humprey & miller, 2011). as pollit (2008) has suggested, we need to attend to the importance of reinstating and understanding the past, as well as the present, of all those processes and institutions that have shaped what we know today as the public sector. the relevance of historical studies of such changes is that they can help us understand how and where the solutions currently being proffered emerged, and in the process can drive away much of their apparent self-evidence and diminish their taken-for-grantedness (humprey & miller, 2011). this is not a matter of expecting historical analyses to tell us to what to do in any specific contexts, but is rather the fact that historical studies of accounting and financial management practices in varied public sector and public service contexts can assist us with locating them within the broader shift in the management of the economic and social relations within which they are embedded (humprey & miller, 2011). 4. conclusion following van helden and northcott’s (2010) method of study for classifying themes, this study analyses published public sector’s accrual accounting papers according to van helden and northcott’s (2010) research objectives, aiming to highlight the possible contextual and applications gaps that can be derived. the findings reveal that research objective (d) was the most popular subject among the researchers, followed by research objective (b). research objective (c) is usually chosen as a complimentary focus, along with the two previous research objectives being mentioned earlier. on the other hand, most of the papers are less directed towards research objective (a). although the analysis of publications shows a vibrant research community in psa using a broad set of methodologies and topics, there are still some major issues of concern. future research may focus on accrual accounting development research in the public sectors of developing countries, as well as conducting cross-sectional or comparative studies between different levels of governmental agencies to provide valuable understanding of the interplay of issues between various levels of administration. finally, future research may also explore the historical studies of accrual asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 257 accounting and financial management practices in varied public sector contexts. acknowledgement the authors acknowledge the financial support of the universiti malaysia sabah’s sbk fund (0197-ss-2015/the implementation of accrual accounting system among public sector: comparative study between federal level and sabah’s state level). references helden, g. j. v. and northcott, d. (2010). examining the practical relevance of public sector management accounting research. financial accountability & management, 26(2), 213-241. https://doi.org/10.1111/j.1468-0408.2010.00499.x helden, g. j. v. (2005). researching public sector transformation: the role of management accounting. financial accountability & management, 21(1), 99-134. https://doi.org/10.1111/j.0267-4424.2005.00211.x hood, c. (1995). the ‘new public management’ in the 1980s: variations on a theme. accounting, organizations & society, 20(2/3), 93-109. https://doi.org/10.1016/0361-3682(93)e0001-w pasukan pelaksanaan perakaunan akruan (2015). buletin fokus akruan isu no.5 jan – mac 2015. jabatan akauntan negara malaysia. retrieved from: http://www2.anm.gov.my/publishingimages/sitepages/default/fokus%20akruan%20is u%205%202015.pdf pricewaterhousecoopers [pwc] (2015). towards a new era in government accounting and reporting. pwc. retrieved from: https://www.pwc.com/my/en/assets/publications/towards-new-era-in-govt-accounting-reporti ng.pdf appendix papers included in this review and their classifications classification criteria (included in bracket after each paper): criterion research objective: a. proposing new financial/management accounting techniques/approaches into public sector’s accrual accounting systems (e.g. accrual output based budgeting, performance management and costing); b. examining the effectiveness of existing accrual accounting techniques/approaches; c. identifying the conditions for the successful/failure implementation of accrual accounting technique/approaches; d. knowledge-building in understanding, explaining and critiquing of the adoption and use of accrual accounting techniques/approaches both in theoretically and practically. asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 258 table 1. classification of paper according to research objective authors and title a b c d adhikari, p. and mellemvik, f. (2011), ‘the rise and fall of accruals: a case of nepalese central government’ √ x arnaboldi, m and lapsley, i. (2009), ‘on the implementation of accrual accounting: a study of conflict and ambiguity’ √ x barton, a.d. (2004), ‘how to profit from defense: a study in the misapplication of business accounting to the public sector in australia’ x √ bogt, h.j. ter, (2008), ‘management accounting change and new public management in local government: a reassessment of ambitions and results –an institutionalist approach to accounting change in the dutch public sector’ √ x brignall, s. and modell, s. (2000), ‘an institutional perspective on performance measurement and management in the ‘new public sector’’ √ broadbent, j., jacobs, k., & laughlin, r. (1999), ‘comparing schools in the uk and new zealand: individualizing and socializing accountabilities and some implications for management control’ x √ broadbent, j., jacobs, k., & laughlin, r (2001), ‘organisational resistance strategies to unwanted accounting and finance changes: the case of general medical practices in the u.k’ √ x broadbent, j. and laughlin r. (2002), ‘accounting choices: technical and political trade-offs and the u.k’s private finance initiative’ x √ broadbent, j. and r. laughlin (2003), ‘the role of pfi in the uk’s government modernization agenda’ x √ brorstrom, b. (1998), ‘accrual accounting, politics and politicians’ √ x connolly, c. and hyndman, n. (2006), ‘the actual implementation of accruals accounting caveats from a case within the uk public sector’ x √ christianes, j. and rommel, j. (2008), ‘accrual accounting reforms: only for businesslike (parts of) governments’ √ x christianes, j. and wielemaker, e. d. (2003), ‘financial accounting reform in flemish universities: an empirical study of the implementation’ x √ christianes, m. (2002), ‘accrual accounting in the public sector: the case of new south wales government’ √ x christianes, j. (2001), ‘converging new public management reforms and diverging accounting practices in flemish local governments’ √ √ x doolin, b. (1999), ‘casemic management in a new zealand hospital: rationalization and resistance’ √ x edwards, p., ezzamel m., mclean c. and robson k. (2000), ‘budgeting and strategy in schools: the elusive link’ x √ english, l. (2003), ‘emasculating public accountability in the name of competition: transformation of state audit in victoria’ √ √ x english, l.m. and guthrie j. (2003), ‘driving privately financed projects in australia: what makes the thick’ √ x asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 259 ellwood, s. and newberry s. (2007), ‘public sector accrual accounting: institutionalizing neo-liberal principals’ √ x garseth, l. (2011), ‘accrual accounting representations in the public sector – a case of antopoiesis’ x guthrie, j. (1998), ‘application of accrual accounting in the australian public sector: rhetoric or reality’ √ √ x harun, h., peursem, k. v. and eggleton i. (2012), ‘institutionalization of accrual accounting in the indonesian public sector’ √ x hepworth, n. (2003), ‘preconditions for successful implementation of accrual accounting in central government’ x hodges, r. and mellett, h. (2003), ‘reporting public sector financial result’ x √ hoque, z. and moll, j. (2001), ‘public sector reforms implications for accounting, accountability and performance of state-owned entities –australia perspective’ x √ humphrey, c. and miller, p. (2012), ‘rethinking impact and redefining responsibility: the parameters and coordinates of accounting and public management reforms’ √ x jagalla, t., becker, s.d. and weber, j. (2011), ‘a taxonomy of the perceived benefits of accrual accounting and budgeting: evidence from german states’ x √ jones, l. r. and kettl, d.f. (2003), ‘assessing public management reform in an international context’ √ x klumpes, p. (2001), ‘generalization accountability of public sector management – a case study of the state authorities superannuation board of new south wales’ x √ √ lande, e. (2005, may 26th& 27th). ‘accrual accounting in the public sector: between institutional competitiveness and search for legitimacy’ √ x lapsley, i. (2001), ‘accounting, modernity and health care policy’ √ x lapsley, i. and oldfield r. (2001), ‘transforming the public sector: management consultants as agents of change’ √ x lapsley, i. and e. wright (2004), ‘the diffusion of management accounting innovations in the public sector’ √ x lapsley, i., mussari, r. and paulsson, g. (2009), ‘on the adoption of accrual accounting in the public sector: a self-evident and problematic reform’ √ x √ likierman, a. (2000), ‘changes to managerial decision-taking in u.k. central government’ x luder, k. (2000), ‘national accounting, governmental accounting and cross-country comparisons of government financial condition’ x √ √ lye, j., perera, h. and rahman, a. (2005), ‘the evolution of accruals based crown (government) financial statements in new zealand’ √ x marti, c. (2006), ‘accrual budgeting: accounting treatment of key public sector items and implications for fiscal policy’ x √ mellett, h. (1997), ‘the role of resource accounting in the u.k government’s x √ asian journal of finance & accounting issn 1946-052x 2017, vol. 9, no. 1 ajfa.macrothink.org 260 quest for ‘better accounting’’ mellet, h. and williams, j. (1996), ‘accountability and the accounting regime in the public sector: some message from the nhs’ x √ √ mir, m.z., and rahaman, a.s. (2007), ‘accounting and public sector reforms –a study of a continuously evolving governmental agency in australia’ x newberry, s. and pallot, j. (2005), ‘a wolf in sheep’s clothing? wider consequences of the financial management system of the new zealand central government’ x √ pallot, j. (2001), ‘a decade in review: new zealand’s experience with resource accounting and budgeting’ x √ √ pallot, j. (1999), ‘beyond npm: developing strategic capacity’ x √ potters, b. (2002), ‘financial accounting reforms in the australian public sector: an episode in institutional thinking’ √ x robinson, m. 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(1999), ‘accounting system reform in japanese local governments’ √ √ x note: ‘x’ symbol: indicates the main focus of research ‘√’ symbol: indicates cross-sectional research objective copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 14353-52125-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 96 ajfa.macrothink.org the effect of re-engineering of administrative processes in achieving the competitive advantage of sustainable in five-star hotels in jordan field study prof. suleiman mustafa el-dalahmeh faculty of economics and admirative sciences accounting department jerash university e-mail: dr.el-dalahmeh97@live.com received: jan. 9, 2019 accepted: march 26, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14353 url: https://doi.org/10.5296/ajfa.v11i1.14353 abstract the main aim of the research was to identify the effect of re-engineering of administration processes in achieving the competitive advantage of sustainable in five star hotels in jordan. to achieve the objective of this study, a questionnaire distributed on 120 persons in five star hotels in jordan. 90 returned with a rate of 75%. the results of the study showed that there is a significant statistical effect at the level of significance of α ≤ 0.05 for the re engineering of administrative processes in achieving sustainable competitive advantage in five star hotels in jordan in the following dimensions: *leadership * ability to analyze * advanced design * organizational communication * continuous improvement strategic planning. the total score of the mean of the study instrument was 4.43 and with a standard deviation of 0.35 and 88.6% at a very high degree. the results of the statistical analysis revealed the realization of the sample of the study in the investigated hotels, the extent of the effect of re-engineering the administrative processes in all its dimensions in achieving the competitive advantage. based on the results of hypotheses tested, the six null hypotheses of the study were rejected. in the light of the findings, the researcher recommended that: 1the need to convince the management of hotels and hotel staff the importance of the application of re-engineering of administrative processes to achieve competitive advantage sustainable asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 97 ajfa.macrothink.org 2utilizing the potential of graduates of new universities from the faculties of economics, administrative sciences and information technology. keywords: re-engineering, administration processes, five stars hotels, competitive advantage of sustainable. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 98 ajfa.macrothink.org 1. introduction the re-engineering of administrative processes is one of the important administrative directions that lead to the process of change in economic establishments so that the establishment starts work again to reduce the cost of the service or product without affecting the quality. the business environment is currently facing a competitive situation, with the openness of the world, the strength of competition, the opening of markets and the technological development that have led economic organization to keep pace with these changes in order to maintain their continuity. this study came here to examine the impact of re-engineering of administrative processes in achieving of sustainable competitive advantage in five-star hotels in the jordan. hotel services are based on many factors and components to produce the tourist able product (accommodation and food) and use many of workers. therefore, hotel services are complex and go through many stages. 2. the problem of the study the problem of the study represented in: the effect of re-engineering of administrative processes in achieving the competitive advantage of sustainability in five-star hotels in jordan? in the light of this problem, a series of sub-questions arise as follows: 1is there an effect of leadership in achieving the competitive advantage of sustainable in fivestar hotels in jordan? 2is there an effect of the ability to analyze on achieving the competitive advantage of sustainable in five-star hotels in jordan? 3is there an effect of redesign in achieving the competitive advantage of sustainable in fivestar hotels in jordan? 4is there an effect of organizational communication in achieving the competitive advantage of sustainable in five-star hotels in jordan? 5is there an effect of continuous improvement in achieving the competitive advantage of sustainable in five-star hotels in jordan? 6is there an effect of strategic planning impact in achieving competitive advantage of sustainable in five-star hotels in jordan? 3. objectives of the study the main objective of the study is: 1. to know the impact of re-engineering of administrative processes on achieving sustainable competitive advantage in five star hotels in jordan. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 99 ajfa.macrothink.org the importance of the study: this study derives its importance from its focus on the importance of the components that constitute the competitive advantage of the jordanian national economy and its representation in human capital. hypotheses of the study ho1: there is no statistically significant effect at level α ≤ 0.05 for re-engineering of administrative processes in achieving competitive advantage sustainable in five-star hotels in jordan the following hypotheses are derived from the main hypothesis: ho1.1: there is no statistically significant at level α ≤ 0.05 for leadership in achieving competitive advantage sustainable in five-star hotels in jordan ho1.2: there is no statistically significant effect at level α ≤ 0.05 for the ability to analyze in achieving competitive advantage sustainable in five-star hotels in jordan ho1.3: there is no statistically significant effect at level α ≤ 0.05 for redesign in achieving competitive advantage sustainable in five-star hotels in jordan ho1.4: 9there is no statistically significant effect at level α ≤ 0.05 for organizational communication in achieving competitive advantage sustainable in five-star hotels in jordan ho1.5: there is no statistically significant effect at level α ≤ 0.05 for continuous improvement in achieving competitive advantage sustainable in five-star hotels in jordan ho1.6: there is no statistically significant effect at level α ≤ 0.05 for strategic planning in achieving competitive advantage sustainable in five-star hotels in jordan 4. determinants of study 1 the scarcity of the arabic and english studies in the subject of the study. 2 weak cooperation of some hotels management with the researcher in conducting personal interviews with employees. 5. limitations of the study the study was limited to five-star hotels located in the jordanian capital (amman). 6.1 reengineering of administrative processes in achieving sustainable of competitive advantage the concepts presented by the researchers on the re-engineering of administrative processes have been varied due to the continuous and rapid modernization processes faced by business organizations throughout the world. accordingly, the reengineering of administrative processes can be considered as an integrated concept consisting of the following conventional concepts: 1re (re) a prefix means a new (baalbaki,2012) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 100 ajfa.macrothink.org 2engineering. means a set of methods and mechanisms for the application of mathematical and scientific rules to achieve practical results such as design, construction, efficiency and this will lead to re-engineering (hasan,1997). 3administrative process. these are activities and functions such as operations, human resources, finance, administrative activity for senior management, research and development, public relations (shamma, 2001). hammer & champy, (1993) view of process engineering is fundamentally rethinking, and radical redesign of key processes organized to achieve tremendous improvement results in modern gauges (service, quality, cost, and speed of performance). process reengineering is defined as the overall transformation of work, restricted to all business processes, techniques, management systems, organizational structure and organizational values, with a view to achieving leapfrogging in the quality of performance of all businesses in the organization (jalalie et al 2013) 6.2 motives of process reengineering: there are many motives from which the organizations start to re-establish operations (yassin 2016) 1-customers: focusing on customers by identifying their needs, fulfilling their desires and designing work according to what suits him. 2change: a rule that should be adopted by all organizations aiming at reengineering their operations because they adopt change as a key input to develop the capabilities of enterprises 3competition: this is to change the method and tools of work and results by enabling employees to carry out their tasks. 6.3 objectives of process reengineering: the goals of process reengineering are summarized as follows (ziglaris, 2000) 1. customer focus, 2. speed of implementation, 3. process compilation, 4. flexibility 5. quality, 6. innovation, 7. product improvement (increase efficiency and effectiveness) 6.4 the importance of the re-engineering of administrative processes: (roberts 1994) the re-engineering of administrative processes derives its importance from the rapid change in the methods and mechanisms required by enterprises as a result of the engineering process engineering tool, the huge technological developments and the intense global competition. therefore, the enterprises need administrative processes capable of dealing with changes which will result in improvements in service and productivity, resulting in improved output quality to meet the needs and needs of customers (roberts 1994). the importance of re-engineering management processes is thus efficient and effective the importance of process reengineering lies in the method of rapid and substantial improvement in performance. the improvement includes reducing the stages, stopping and cost of operations. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 101 ajfa.macrothink.org increasing their return as well as setting acceptable competitive prices (hammer & champy 1993) 1a method of rapid and substantial improvement in the performance aspects. the improvement includes saving the stages, stopping and cost of operations and increasing their return or added value in addition to setting competitive prices (al-refai,2006). 2tool to deal with three types of organizations. 6.5 benefits of re-engineering processes: there are several important trends that are taking place in today's business environment and are related to the re-engineering process. 1the re-engineering of administrative processes is the first starting point and is taken into account by the executive director to maximize the benefit to the organization 2competition and the ability to make a profit 3working through the functional departments, including markets and customers on the other hand through 6.6 factors for successful administrative processes re-engineering according to (lampathaki f.et al 2013): 1leadership, 2-ability to analyze, 3redesign, 4organizational communication 5continuous improvement, 6strategic planning. 6.7 obstacles to the application of re-engineering of administrative processes: venaik (2015) listed a set of obstacles to the application of re-engineering administrative processes are: problems related to communication and lack of supported communication systems neglecting organizational culture of the organization resulting in organizational resistance of workers problems related to not adopting a -culture of change or management poor training and education systems lack understanding of the management of the organization of the concept of re-engineering operations and commitment economy to the financial, material and human resources required for implementation. 6.8 sustainable competitive advantage many researchers have presented diverse definitions of sustainable competitive advantage according to their views. (harvey 1981) recognized the competitive advantage as a source that enhances the organization's position in the market by making profits by distinguishing it from its rivals in the areas of cost and excellence (dickson 1992) as the new features obtained by the business organization, making it in a position of continuous progress in the relations with its competitors. he pointed out (daft 2010) that the ability of the organization to increase its market share by keeping the low cost compared to competitors and the researcher believes that the competitive advantage is sustainable ability of the enterprise excellence and uniqueness from other facilities by tapping the optimum internal capabilities and investment opportunities asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 102 ajfa.macrothink.org and transform the challenges and threats from the external environment into opportunities in order to provide products and high quality services to current and prospective customers. 6.8 the importance of sustainable competitive advantage the competitive advantage is a positive indicator of the company's tendency to occupy a strong position in the market by acquiring a greater market share of competitors and increasing sales and profits (qaryuti 2014). the importance of competitive advantage in (evan,1993) 1-provide important support contributes to the success of business. 2characterized by permanence and difficulty to imitate competitors 3-provide orientation and motivation for the whole enterprise. 4-provide a basis for future improvements. 5determined depending on the needs and desires of customers. 6availability of harmony between fao and opportunities in the environment. 6.9 dimensions of sustainable competitive advantage: in order to achieve the research objectives, the researcher will adopt the basic dimensions of the competitive advantage of sustainable: creative culture: works to provide an encouraging work environment and help creativity information technology: information technology consists of two physical and mental components: computer equipment, automatic control and communication, while the mental side represents software, artificial intelligence, and software engineering. core competencies: the organizational skills and knowledge without which the organization does not exist that make the organization work better than any other organization and thus make it unique (ajaj, shibli, 2015) quality of service: quality is one of the best standards and the most important to judge organizations in general and service organizations in particular 5loyalty: organizational loyalty is an asset of the organization and its preservation is key to success in the organization (assaf,2015). 7. methodology of the study in order to achieve the objectives of the study, the researcher relied on the analytical descriptive approach for achieving data and information about the opinions and attitudes of the people whether it is written survey (questionnaire) or orally, and it is suitable for the purposes of the study which seeks to know the effect of independent variables on the dependent variable . asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 103 ajfa.macrothink.org population of study the study community consists of all directors, assistant managers and heads of financial and administrative departments in the five-star hotels in jordan of the total 14. (hotels in amman, 2017). 7.1 sample of the study the questionnaire was distributed to a simple random sample consistent of (120) managers, assistant managers and heads of financial and administrative departments in the five-star hotels in jordan, because their experience and knowledge of re-engineering processes, the number of questionnaires retrieved and valid for the statistical analysis was 90 (75%) of the number of questionnaires distributed statistically acceptable ratio 7.2 tests and analysis of results first, the stability of the study: to ascertain the stability of the study instrument, the stability coefficient was extracted in the cronbach alpha method and the total stability of the field of study was (0.78) which is excellent in this type of studies second, the study tool was authenticated: 1. the apparent honesty of the study tool: in order to verify the validity of the study tool, the researcher presented it to 6 arbitrators from the faculty members of the accounting departments in the jordanian universities, and after their opinion and observations, the paragraphs of the questionnaire were amended. 2. exploratory constructional honesty of the instrument of measurement: the researcher will use exploratory analysis to test the independent variable scale (re-engineering of administrative processes) and measure the dependent variable to determine the dimensions covered by the scale and to identify the paragraphs that do not correlate with the scale structure and which should be excluded from the scale a) the scale of the re-engineering of the administrative processes: to verify the adequacy of the sample and the existence of correlation between variables, the kaiser-meyer-olkin measure was used. the statistical value of this scale ranges between 0-1 and the value of (1) the correlation model is reliable, and the global analysis will be more credible. as shown in table 1, the bartlett test indicates that there is a moral asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 104 ajfa.macrothink.org table 1. kmo and bartlett testing for reengineering of administrative processes 0.725 kaiser – meyerolkin measure bartlett's test of sphericity 366.526 approx. chi-square 13 df 0.000 sig the results show that the value of kmo is 0.725, which is greater than 0.05, which is a large value. the results of bartlett's test (366.526) are significant and based on these results, the correlation matrix is not a single matrix. between vertebrae which are significant b the measure of competitive advantage: in the same way has been tested this measure, which includes 5 dimensions, namely, creative culture, information technology, material impotence, quality, loyalty, the researcher will use exploratory analysis as shown in table 2 table 2. kmo and bartlett testing for reengineering of administrative processes 0.840 kaiser – meyerolkin measure bartlett's test of sphericity 255.60 approx. chi-square 8 df 0.000 sig table 2 shows that the kmo (0.840) is larger than 0.05 and is significant for correlation between variables. the bartlett's score of 255.60 indicates a significant correlation between the two paragraphs. statistical methods used: to analyze the study data, the researcher used the statistical package for social studies (spsss) using the following descriptive and analytical treatments: the arithmetical averages, standard deviations and percentages to find the stability coefficient of the study tool used the researcher kronbach alpha test the linear correlation problem use the kaiser-meyer-olkin measure and bartlett's test of sphericity asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 105 ajfa.macrothink.org 7.3 testing hypotheses the main hypothesis: ho1: there is no statistically significant significance at α ≤ 0.05 for reengineering processes in achieving sustainable competitive advantage in five-star hotels in jordan. using the linear logarithmic model and for the purpose of achieving this can be addressed as follows: ho1.1 there is no statistically significant effect at the significance level of α ≤ 0.05 for leadership in achieving sustainable competitive advantage in five star hotels in jordan table 3. the results of the regression analysis of the impact of leadership in achieving sustainable competitive advantage independent variable dependent variable α alpha β beta r2 f sign (0.05) hypothesis result leadership sustainable of competitive advantage 2.43 0.506 %18 17.52 rejected the value of the table f at a level of significance (0.05) = 3.00 the data in table 3 show that the value of beta = 0.506 indicates that the change in leadership leads to an increase in the achievement of sustainable competitive advantage and therefore rejects the null hypothesis ho1.1 and accepts the alternative hypothesis which states "there is a statistically significant effect at the α ≤ 0.05 level to lead the sustainable competitive advantage of five-star hotels in jordan" . ho1.2: there is no statistically significant effect at significance level of α ≤ 0.05for the ability to analyze in achieving sustainable competitive advantage in five-star hotels in jordan table 4. the results of the regression analysis of the impact of the ability to analyze in achieving sustainable competitive advantage independent variable dependent variable α alpha β beta r2 f sign (0.05) hypothesis result leadership sustainable of competitive advantage 1.696 0.523 %22 24.22 rejected f value of the table at the level of significance (0.05) and the degree of freedom (80.1) = 3.00 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 106 ajfa.macrothink.org table 4 shows that there is a significant effect on the ability to analyze in achieving sustainable competitive advantage. the calculated value of f (24.022) is greater than the tabular value at the level of significance 0.05 and below 80.1 degrees of freedom. r 2 interprets 22% the value of beta 0.523 indicates that the change in the ability to analyze by one unit leads to an increase in the achievement of sustainable competitive advantage by 0.523 and therefore reject the null hypothesis ho1.2 and accept the alternative hypothesis which states that "there is a statistically significant effect at the level of significance α ≤ 0.05 for the ability to analyze the probe sustainable competitive advantage in five star hotels in jordan " ho1.3: there is no statistically significant significance at α ≤ 0.05 for redesigning sustainable competitiveness in five-star hotels in jordan table 5. the results of the regression analysis of the effect of redesign in achieving sustainable competitive advantage independent variable dependent variable α alpha β beta r2 f sign (0.05) hypothesis result leadership sustainable of competitive advantage 1.062 0.721 %45 67.892 rejected f value of the table at the level of significance (0.05) and the degree of freedom (80.1) = 3.00 table 5 shows that redesign has a significant effect on achieving sustainable competitive advantage. the calculated value of f is 67,892, which is greater than the tabular value at the level of 1.80 and r2 interprets 45% of the contribution to achieve competitive advantage. the value of beta 0.721 refers to that the change in redesign results in an increase in the competitive advantage by 0.721 and therefore rejects the null hypothesis ho1.3 and accepts the alternative hypothesis that "there is a statistically significant effect at the α ≤ 0.05 level of redesign in achieving sustainable competitive advantage 5 star hotels jordan " ho1.4: there is no statistically significant effect at significance level of α ≤ 0.05 for organizational communication in achieving sustainable competitive advantage in five star hotels in jordan asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 107 ajfa.macrothink.org table 6. the results of the regression analysis of the impact of organizational communication on achieving sustainable competitive advantage independent variable dependent variable α alpha β beta r2 f sign (0.05) hypothesis result leadership sustainable of competitive advantage 1.280 0.672 %68 173.62 rejected f value of the table at the level of significance (0.05) and the degree of freedom (80.1) = 3.00 table 6 shows that there is a significant effect of organizational communication on the achievement of sustainable competitive advantage. in addition, the value of calculated f is 173.62, which is greater than the significance level of 0.05 and the degree of freedom is 1.80. the value of r2 explains 68% of the contribution to achieving competitive advantage a beta value of 0.672 indicates that the change in organizational communication by one unit leads to increased achievement of the competitive advantage of 0.672 and therefore rejects the null hypothesis ho1.4 and accepts the alternative hypothesis that "there is a statistically significant effect at the α ≤ 0.05 achieving competitive advantage sustainable in five-star hotels in jordan ho1.5: there is no significant statistical effect at the level of significance of α ≤ 0.05 for continues improvement in sustainable competitive advantage in five star hotels in jordan table 7. the results of the regression analysis of the impact of continuous improvement in achieving sustainable competitive advantage independent variable dependent variable α alpha β beta r2 f sign (0.05) hypothesis result leadership sustainable of competitive advantage 1.281 0.646 %43 36.382 rejected f value of the table at the level of significance (0.05) and the degree of freedom (80.1) = 3.00 table 7 shows that there is an impact of continuous improvement in the achievement of sustainable competitive advantage. the calculated value of f is 36.382, which is greater than the tabular value at the level of significance 0.05 and below the freedom level of 1.80 and r2 explained 43% of the contribution to achieving the competitive advantage and the value of beta is 0.646 the result indicates that the change in continuous improvement by one unit increases the competitive advantage by 0.646 and rejects the null hypothesis ho1.5 and accepts the alternative hypothesis that "there is a statistically significant effect at the α ≤ 0.05 level for asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 108 ajfa.macrothink.org continuous improvement in feature achievement sustainable competitiveness in five star hotels in jordan " table 8. the results of the regression analysis of the impact of strategic planning on achieving sustainable competitive advantage independent variable dependent variable α alpha β beta r2 f sign (0.05) hypothesis result leadership sustainable of competitive advantage 1.455 0.554 %60 118.466 rejected f value of the table at the level of significance (0.05) and the degree of freedom (80.1) = 3.00 table 8 shows that strategic planning has an impact on achieving competitive advantage. the calculated value of f is 118.466, which is greater than the tabular value at the significance level 0.05 and r2 explains 60% of the amount of competitive contribution. the value of beta 0.554 indicates that the change in strategic planning by one unit leads to an increase in achieving the competitive advantage by 0.554 and rejects the null hypothesis ho1.6 and accepts the alternative hypothesis that "there is a significant statistical effect at the level of α ≤ 0.05 for strategic planning in achieving sustainable competitive advantage in five star hotels in jordan 8. results and recommendations 8.1 results the results of the study showed that there is a significant statistical effect at the level of significance of α ≤ 0.05 for the re engineering of administrative processes in achieving sustainable competitive advantage in five star hotels in jordan in the following dimensions: *leadership * ability to analyze * advanced design * organizational communication * continuous improvement strategic planning. the total score of the mean of the study instrument was 4.43 and with a standard deviation of 0.35 and 88.6% at a very high degree. the results of the statistical analysis revealed the realization of the sample of the study in the investigated hotels, the extent of the effect of re-engineering the administrative processes in all its dimensions in achieving the competitive advantage. there is harmony and consensus in the views and responses of the sample of the study to adopt the reengineering of administrative processes to achieve its goal and objectives with the highest degree of efficiency and effectiveness. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 109 ajfa.macrothink.org 8.2 recommendations 1the need to convince the management of hotels and hotel staff the importance of the application of re-engineering of administrative processes to achieve competitive advantage sustainable 2utilizing the potential of 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(2000). business process re-engineering, a report produced for the ecfuded project. innoregio project microsoft word 17685-writer2-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 28 the impact of coronavirus (covid-19) on new york stock exchange issam tlemsani (corresponding author) the center of international business policy london, united kingdom e-mail: i.tlemsani@tcib.org.uk maram alghamdi e-mail: maramhamdang@gmail.com samar balhareth e-mail: summer_hamad@hotmail.com fatimah alsaleh e-mail: f.f.s_98@hotmail.com munira alomair e-mail: muniraao33@gmail.com munirah alqutaim e-mail: munirahalqutaim@gmail.com received: august 1, 2020 accepted: sep. 27, 2020 published: december 1, 2020 doi:10.5296/ajfa.v12i2.17685 url: https://doi.org/10.5296/ajfa.v12i2.17685 abstract the value of any stock market could change for several diverse reasons such as financial, economic and health. the value of the new york stock exchange market has reduced drastically in the first quarter of 2020 and expected to reduce further in the upcoming months, according to many economists (ayittey et al., 2020; white, 2017). it will face a huge blow this year due to the appearance of the unexpected new virus (covid-19). the new york stock exchange has fallen sharply for the first time in 23 years, causing a significant crash in consumer sentiment indexes, thereafter, decreasing the overall global stock market value (financial buzz, 2020). such instances are rarely encountered, making investors to feel insecure and unsafe to make significant decisions about their investments. together with these asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 29 uncertainties and fears, many industries were badly affected and many other industries benefited from this global health crisis (ayittey et al., 2020). through this research paper, an exploration of the effects of covid-19 on new york stock exchange market are done with support from expert opinions. keywords: coronavirus, epidemic, new york stock exchange, consumer sentiments. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 30 1. introduction the stock market around the world differs. there are several factors that can either positively or negatively impact the value of stock markets, such factors are financial, economic or health (tlemsani and matthews, 2010). in rare cases, health factors have an impact on the stock markets; however, covid-19 (coronavirus) has proved different on the new york exchange market (nyse). coronavirus appeared in china in the last quarter of 2019 and has negatively impacted the health of millions of chinese, leading to an increased number of hospitalized patients and deaths as well (larry, 2020). however, the virus did not only create a pandemic, but being contagious, it spreads so fast, causing a world epidemic where numerous cases of hospitalizations and deaths have been reported in many countries and cities around the globe, including new york city (times, 2020). while coexisting in china, coronavirus has negatively impacted china’s economy and its stock exchange market. however, coronavirus has not only affected china but also the stock exchange market and the economy of other countries and cities as well. this paper is an attempt to describe some aspects that impacted the nyse by the unexpected pandemic. it presents the uncertainties and behaviors of the market’s participants and their impact on the overall market operation and value. the main aim of this research paper is to investigate the impact of coronavirus on the nyse by using the consumer sentiment index as a reference. it presents facts by data collection and analysis through primary and secondary online resources. the objective of the paper is to explain the importance of how the stock exchange market can be detrimentally impacted by health factor. hence, it provides the reader with new perspective on the falling of a stock exchange market. the scope of this research paper is confined to the impact on the stock exchange market in new york city. however, since the research is conducted in the kingdom of saudi arabia, there is limitation of gathering primary facts and data collection. the research methodology is highly restricted to the data collection and analysis from trusted secondary resources through the internet. both primary and secondary data analysis are included in this research paper. primary data are managed to be included in this paper since a large number of nyse’s investors live in the kingdom of saudi arabia. 2. research literature review the virus began in china at the end of 2019 and has continued to increase dramatically, causing several damages in many forms, including health and economic damages, which in turn has affected consumer sentiments and financial markets. according to analysts and capital economists, this virus will cost the world more than $15 trillion if appropriate measures are not taken as soon as possible. ayittey et al. (2020) discussed such opinions and demonstrated how the impact would be massive on financial markets; however, this research paper mainly focuses on the impact of this virus on consumer sentiment and therefore on nyse. in response to the disclosure of capital economist’s opinion, this global event has become an essential economic crisis that has affected the interruption of trade and supply chains, leading asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 31 to a sharp drop in asset prices. so far, 2020 first quarter just passed, making traders to confront the financial crisis with little information and a high level of uncertainty. with the emergence of this financial crisis, there are industries that have been negatively affected due to the lockdown, suspension of trade and low prices of financial assets, for example, the aviation and tourism industries. on the contrary, there are industries that have not been affected and somehow increased their growth, for example, the pharmaceutical industries. what investors are now facing is like what happened in 2008, when the economic recession affected their investment decisions and their awareness of risks level, thus, making investors in need of financial planners’ interventions to elevate the situation and makeup for it (kim and hanna, 2016). such instances in 2020 impacted the assets prices in nyse, the way the market operates and therefore the overall market value. follow-up to the outbreak, there are many journal articles, newspapers, scientific research and financial analysis issued by many individuals and institutions from various countries. stock platforms including nyse have become the dominant source of knowledge on the financial impact of the virus on industries in all fields by seeing the company's share price percentages. this approach leads to better knowledge in the financial field and economic growth, as it gives accurate details of the drop and rise of prices, which increases the accuracy of the corporate value assessment. recent works are escalating and taking a further stage with the escalation of the crisis and argues about taking new approaches for a better and broader understanding of the global crisis between the virus, financial markets and the global economy. 3. research methodology the paper’s focal point is the impact made by coronavirus on consumer sentiment and therefore on the nyse in a dependency. to obtain a better view on these effects, qualitative and quantitative research techniques through primary and secondary approaches were used. the primary data were collected by distributing questionnaire to get a better insight from consumer’s perspective in terms of what is happening now with regards to the global epidemic and how they feel about it. thereafter, these perceptions were supported with the qualitative data using reliable sources of newspapers, websites and journal articles. at first, the questionnaire was distributed to individuals within the research’s geographical area, within the kingdom of saudi arabia, from february to june 2020, and ended up with 362 responses in total. the questionnaire had four main questions: how individuals’ investment behaviors are impacted by the disease, what they think about it, their beliefs towards the situation and whether they have the willingness to buy stocks from nyse at this time of uncertainty. these questions are to be used to analyze the topic at hand and thereafter support it by other expert opinions. the second method which best suit the paper was through secondary data analysis. the secondary data were collected from various online sources including google scholars and electronic newspapers like the new york times and financial times. all the data that were obtained and reviewed were between 2017 and beginning of 2020, which makes the paper to have an insight from previous instances and narrow it down to the data of today. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 32 3.1 data collection this research paper is based on a global economic crisis, making the authors build their argument on published opinions from financial analysts, newspapers, scientific papers, expert opinions and many reliable sources from all over the world. in addition to that, the paper showed the need for a mixed model approach and primary data intervention through distribution of questionnaires as was discussed earlier. the data of the questionnaire were collected using google docs account and ultimately showed the responses in pie charts with corresponding percentages. furthermore, the data of the secondary sources were collected online, making the study to get access to information in an effective time frame. 4. data analysis according to the new york times website publication on the impacts of coronavirus on the usa on march 12, 2020, the new york exchange recorded a huge drop in its closing prices by 9.5%, which has never happened since 1987 (phillips, 2020). however, president trump’s speech the following day contained information assuring people about the availability of coronavirus tests across the country. as a result, the stock prices increased sharply during and after his speech. according to the world economic forum publication on march 23, 2020, the market recorded a four-time breakage during march, which could be seen as a huge effect since it has not occurred again after the market crash in 1987. the breakage indicates that prices dropped by 7% from the closing prices. the graphs in figures 1 and 2 illustrate the four breakages during march (funakoshi and hartman, 2020). the market had circuit breakdown, with hopes to stabilize the continual decrease in prices; its purpose is to provide investors time-off to calm down before making further decisions which in this case are negatively affecting the market. however, the market is still at level 1 of the circuit breakdown, which lasts for 15 min as it continues to only drop by 7%. figure 1. the breakage on march 9 and 12 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 33 figure 2. the breakage on march 16 and 18 according to the fortune website on march 22, 2020, the nyse announced closing its physical floors on march 23, 2020. this was the first since the opening of the nyse in 1871. this could lead to a huge impact on the performance of the market as it serves an important role in finding breakers and dealers, as well as trading securities. "the trading floor is an important part of not only our business but the overall financial marketplace," said john tuttle, nyse vice chairman and chief commercial officer (sherman, 2020). according to the nyse’s website, there is a great decrease in stock prices since the beginning of the coronavirus crisis (figure 3). asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 34 figure 3. decrease in stock prices on march 24, 2020 the sentiment approach states that stock prices change depending on investor’s sentiment, as such, they must be sure of the positive returns of their investment before they could decide. relatively, with covid-19, many investors have low sentiments regarding investing as the virus has globally spread causing damages in the supply chain. according to the study findings, president trump’s speech on march 12 clarified the impact degree of investor’s sentiments regarding investing, which in return affected the prices in the market index. as investors were to some extent, assured of the possible resolution of the current situation, their sentiment became positive leading to the increase in the prices after the speech. in addition, as the nyse trading floors were closed, consequently, it reduced the consumer sentiments as fear of uncertain returns or situations of the economy spread among investors. together with uncertainties, consumers and investors faced a significant blow. the new york stock exchange has fallen sharply for the first time in 23 years and thereafter stopped trading for 15 min long (financial buzz, 2020). as a result, investors were anxious and distrustful about their financial situation, thereafter, crashing their confidence level. in addition, investors encountered a strong hit in accordance with the sharp fall of consumer’s sentiments as they started to worry about their investment decisions as well (kim and hanna, 2016). based on the results of the survey, 82.2% of the respondents are hesitant to buy any stock from nyse, indicating that the uncertainty of the stock market in the current state is caused by the consumer’s sentiments in which investors are in continuous doubts. however, in another question that focused on customers’ investment behavior after covid-19, 79.2% of the participants are unwilling to invest presently. this is due to their uncertainty which occurred in a similar situation in the 2008 financial crisis; as such, investor’s uncertainty is expected to take time to resolve, of course, with the help of government incentives to help boost stock asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 35 prices, causing higher returns to attract investors. also, the refusal of participation in any investment even after the resolution of pandemic is due to the decrease in the overall economic levels as many investors have lost their employment contract. 5. findings based on the data collection regarding the companies’ stock market return and standard deviation from 2019 to 2020, it is clear that covid-19 has negatively impacted the new york stock market. the data collected included major companies in different industries. as per the data, before covid-19, the average return was increasing when standard deviation (sd) was increasing. in the stock market, standard deviation refers to the risk, and the concept of stock is high risk equals high return. however, after covid-19, the average returns did not increase proportionally with the sd, whereas it was decreased and reached below 0%, and hence, investors were losing their money. the reduction in the average return has decreased customers’ sentiment and attraction to the nyse, and hence many stopped buying from the stock market. these impacts have resulted in nyse shares’ prices fall, thus, almost all industries were affected to some extent depending on the services or goods provided by these sectors. therefore, companies like walmart, johnson & johnson and dettol were not majorly impacted as their average return did not reach below zero. the reason is that customers are still in need of these health care products, especially with the covid-19 issue. thus, despite the whole situation, these companies still generate revenues due to their importance. hence, to some extent, it matches their risks which reduces investors’ uncertainty about these shares. in contrast others like ford and walt disney companies were majorly impacted as people might not need these services presently. before covid-19 stock company name average return variance sd health care national health investors -0.01% 8.90e-05 0.94% johnson & johnson 0.16% 0.00021 1.45% reckitt benckiser (dettol) 0.07% 0.000139 1.18% consumer services nike 0.15% 9.38e-05 0.97% the walt disney company 0.39% 0.000241 1.55% walmart inc 0.03% 5.52e-05 0.74% technology twilio inc -0.14% 0.000627 2.50% shopify inc 0.42% 0.000876 2.96% oracle corporation -0.01% 0.000105 1.02% automobile toyota motor corporation 0.09% 4.20e-05 0.65% ferrari 0.28% 2.62e-04 1.62% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 36 ford motor company 0.10% 0.000294 1.72% transportation canadian pacific railway limited 0.27% 0.000116 1.08% china eastern airlines corporation 0.22% 0.000454 2.13% united parcel service inc 0.11% 0.000153 1.24% after covid-19 stock company name average return variance sd health care national health investors -0.73% 0.004893 6.99% johnson & johnson 0.02% 0.000758 2.75% reckitt benckiser (dettol) 0.00% 0.000699 2.65% consumer services nike -0.30% 0.001557 3.95% the walt disney company -0.48% 0.0014 3.74% walmart inc 0.05% 0.000719 2.68% technology twilio inc -0.25% 0.001675 4.09% shopify inc 0.17% 0.002585 5.08% oracle corporation -0.03% 0.001949 4.41% automobile toyota motor corporation -0.28% 0.000685 2.62% ferrari 0.05% 0.0005 2.30% ford motor company -0.78% 0.00178 4.22% transportation canadian pacific railway limited -0.23% 0.002069 4.55% china eastern airlines corporation -0.81% 0.001392 3.73% united parcel service inc -0.27% 0.000869 2.95% figure 4. a summary of the stock market average return and standard deviation of different companies before and after corona on the new york stock market. 6. recommendation investors are increasingly becoming hesitant to purchase stocks because of the fears and uncertainties associated with this pandemic. unfortunately, stock markets cannot make any improvements until this pandemic is contained. therefore, to reduce the impact of this pandemic on the stock market and other economic sectors, there is need for all sectors, stakeholders, citizens and organizations to come together and collaborate in containing this pandemic. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 37 investors also need to protect their investments by considering the following options. first, investors can always check their asset allocation during this period to ensure that it aligns with their risk tolerance and adequate for the time horizon or age group. secondly, investors might also consider diversifying their investing strategies by focusing on different areas of markets. for instance, they might consider sectors that are not seriously affected by the pandemic (for example, walmart, johnson & johnson and dettol). thirdly, investors can consider rebalancing their portfolios to ensure that the equity allocation aligns with their goals, and their portfolio is balanced. furthermore, coronavirus has brought unexpected disruptions to investors’ financial goals and plans. therefore, investors need to consider meeting with financial experts who can provide them with valuable advice during this stressful period. this is because such situations can adversely affect their capacity to make right and sound financial decisions. 7. conclusion to the best of the authors’ knowledge, the impact of health factors on the performance of stock exchange markets is rarely studied. however, the coronavirus pandemic has significantly affected almost all stock exchange markets across the globe, including the nyse. according to the findings of this research, the reporting of a coronavirus outbreak in the us resulted in a significant drop in closing prices by 9.5% in the nyse, a drop that has never been reported since 1987. the coronavirus pandemic has also led to a huge decrease in stock prices. it has increased fears and uncertainties among consumers and investors, hence, making more people reluctant to buy any stock from nyse. this is further worsened by the fact that many investors have lost their job. with the increasing number of covid-19 cases reported every day, these fears have continued to increase since investors do not know when this pandemic will end. almost all industries are negatively affected, except a few such as walmart because of increased online shopping to reduce the infection rates 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(2010). the roots of the financial crisis, special issue of the international journal of islamic and middle eastern finance & management, 3(4), 334-350. https://doi.org/10.1108/17538391011093270 microsoft word 18933-article text-writer2-new-final cor sma receive doi:10.5 ronaviru all and m michae oman ed: nov. 12 5296/ajfa.v us (cov medium ig colleg el and cecili departm colleg e-m gben n college o departme e-mail: mid d , 2021 a 14i1.18933 vid-19) m-scale m gbinedion u departm ge of busin -mail: josiah yemis ia ibru univ ment of acc ge of busine mail: bosunf nga ekunday f managem ent of admin : gbenga.eku f ddle east c department e-mail: f accepted: j url: ht 1 ) impac e enterp mary josiah university, o ment of acc ness and ma ah .mary@iu i bosun – f versity agba counting, ba ess and man fakunleyem yo (corresp ment and tec nistrative an kundayo@om festus odhig college, sult of managem festus@me jan. 17, 202 https://doi.or asian ct on w prises ( h okada, nige counting anagement s 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(li 9; bonn, demic on s on the none of agement d smes adediran, agement ed out a study is ement of nigerian y. working ver, the cal zone cal zone cal zone zone of apital of al zones 2. liter 2.1 cov disease on the emanate more s challeng conditio has cau investm constrai finance to limit typicall than lar them w through 2.2 con no matt required will bec workin be sold is the s expecte name im finance compon day-to-d short-te 2.3 sma small a unquote group, i owner f study, machin employ rature revi vid-19 es that are c average 5-6 e and subse severe imp ges/ailment ons under th used a simu ment specif ints, isolatio , smes typi ted liability ly have sma rge firms. s while policy h the crisis ( ncept of wor ter the amou d for produc come a wast ng capital re by a compa ame as net ed to be rea mplies it is production nents being day manufa erm finance all and med and mediu ed, ownersh it provides finance, ov small and ery and equ yees, respect iew aused by vi 6 days after equently co pact on th ts. small b he covidultaneous an fically, sma on or conta ically have l companies all inventorie ourcing fro uncertainty (marrion & rking capit unt spent on ction are no te. this is w fers to the i any, it can b currents as lized within continually n, to inves g stock, de acturing and that is curr dium -scale um-scale e hip of the and contrib erdraft fina medium-s uipment not tively. iruses, if con r infection, ould degene e older pe usinesses a 19 pandemi nd massive all and me inment of w lower cash r . also, they es. in the sa om new supp y, rapid chan mohan, 20 tal n equipment t efficiently why this topi items that ar e defined as ssets. it repr n the year’s y in use, be t in invent ebtors, cred d or trading ent liabilitie enterprises enterprises business is butes to all ance, bank l cale enterp t more than 5 ntacted by h tiredness a erate if not eople and around the ic. the shut shock to s edium-scale workers lim reserves and y experience ame vein, sh ppliers or ab nges in polic 20) t, plant and y managed, t ic is so cruc re required s the excess resents the s trading. it eing turned tory and to ditors and activities o es, or by me s (smes) have three s restricted sectors of loan trade c prises are n 500,000 n asian human bein and dry cou nipped in t people th world are tdown of lar supply and e enterprise mit productio d go out of b e supply ch hortages can bsorbing pri cies pose di machinery, the entire am cial and its n for the day of current a amount tha is not a pe over many o provide c cash. thes f a business ediumand characteri to a few in the econom credit and s defined as naira to 2 m n journal of f ngs , general ugh and diff he bud , su hat have u facing cha rge parts of demand fo es (smes) on. conside business mu hain disrupti n affect sme ce increase ifficulties fo buildings e mount comm needs to be a -to-day prod assets over c at is investe rmanent inv y times in a credit for c se assets a s. they can long-term f stics: firms ndividuals, my .the sou so on for th s those wi million naira finance & ac issn 19 2022, vol. 1 ajfa.macro lly develop fficulty in b uch diseases underlying allenging ec the world e or consumpt ) faces pro ering their a uch faster co ions becaus es faster an es is challen or smes na etc if the ing mitted to the appreciated duction of g current liab ed in assets vestment bu a year. it is customers i are needed be funded e finance. s are likely typically a urces of fina he purposes ith investm a and 50 to ccounting 946-052x 14, no. 1 think.org/ to fever reathing s have a medical conomic economy tion and oduction access to ompared se smes nd harder nging for avigating gredients e project as such. goods to ilities. it that are ut as the used to its main for the either by y to be a family ance are s of this ments in 100 paid 2.4 em zhan (2 has land regions abolaji of smal question compris which account resourc were a indepen mobiliz between nigeria of sme sme o ishola, lockdow using a probabi factors majority covid found t versus n effect o is a co lockdow whereas implica palliativ medium enesi a and me research question which w their bu include mpirical rev 2020) exami ded a heavy . i, yekinni an ll and mediu ns were rais sed one tho one thousa ted for 97% ce mobiliza analyzed us ndent t test zation and i n resource a. furthermo e owners w owners in so oladipo an wn measure an electroni ility model influencing y of the e d-19 pandem that the co non-agricul on low sales ntrary resu wn increase s total lock ations of ou ve measures m scale ent and ibrahim edium busin h technique nnaire on 10 were selecte usinesses. f s: loss of c view ined the effe y blow on c nd adeyem um-scale en sed. the stu ousand, four and, three h % response ation questi sing descri . the resul innovative c mobilizatio ore, there w while no sig outh-west, n nd oluseyi es on the is ic data coll to estimate g coping s entrepreneu mics throug ovid-19 pa ture). for in s among the ult in the co es the likeli kdown has a ur study is s) which ca terprise in n m (2021) inv ness enterp e using dat 0 selected s ed purposiv findings fro competent fect of covid chinese sm i (2019), ex nterprises (s udy adopted r hundred an hundred an e rate. data ionnaire (r = iptive stati lts showed culture in s on and inn was signific nificant dif nigeria. (2015) ex sues related lection appr the effect o strategies u urs have be h the partia andemic's e nstance, par e enterprise ontext of th ihood of sw a negative in s the need an help to c nigeria. vestigated th prises in ab ta collection smes with vely to elici m the analy staff resulti 6 d-19 in chin mes with hu xamined res smes) own d the descri and seventee nd eighty-tw a were col = 0.85) and istics, pear that sme south-west, novative cu ant differen fference exi xamines the d to small a roach, this of the pand using a mu een affecte al and total l effect differ rtial lockdow es especially he food an witching ap nfluence on to address cushion the he impact o buja-fct, n n method t 100 respond it insights in ysis indicat ting from re asian na’s smes, uge differen ource mobi ners in south iptive surve en (1417) s wo (1382) lected usin innovative rson produ owners pos , nigeria. s ulture of sm nce in the s sted in the e effect of and medium study analy demic on th ultivariate p ed (both se lockdown a rs by sector wn measure y for the no nd agricultu pproaches o n the coping s social pro effect on th of covid 19 nigeria. the through the dents in mu nto the effe ted that the eduction in n journal of f the result sh ntial effects lization and h-west, nig y research d sme owners responded ng two instr culture sc uct momen ssessed high significant r me owner core on res score on in covid-19 m scale en yzes the da e entrepren probit mode everely and and moveme r of the eco es had an in on-agricultu ure sector. i of business g strategies otection ap he pandemi on the per e study ado e administr unicipal are ct of covi covid-19 n staff salar finance & ac issn 19 2022, vol. 1 ajfa.macro hows that c s across sec d innovative geria. five r design. the s / manager appropriate truments; th cale (r = 0.6 nt correlati h level of r relationship rs’ in sout source mob nnovative cu 9 related ca nterprise in ata using th neurs and m el. we fou d slightly) ent restricti onomy (agr ncreasing lik ural sector b in addition (coping str s. one of th pproaches ( ic on the sm rformance o opted a qua ration of str ea council i id-19 pand 9 pandemic ry, low rev ccounting 946-052x 14, no. 1 think.org/ covid-19 ctors and e culture research e sample rs out of ely, this hese are 68). data ion and resource p existed th-west, ilization ulture of ases and nigeria. he linear model the und that by the ons. we riculture kelihood but there n, partial rategies) he policy (such as mall and of small antitative ructured in abuja demic on ’s effect venue or income reduce inability effect o introduc reduced were no work. adedira working nigeria period analyze of endo of day’ also imp 3. meth survey morgan survey w the geo academ 3.1 pop the pop geo-pol 3.2 sam krejcie size. he s= where: x2 = the level(3. s = the n = the p = pop d = deg generation the prevale y to pay sa on the perf ce a well m d interest ra ot mentione an, josiah, b g capital m an firms. th of 2009. d ed using the ogeneity, de s accounts proves the f hodology y research d n sampling t was guided political zo mic integrity pulation pulation of litical zone mple size an e and morg ence the sam x2np d2(n e table valu .841) sample size e population pulation pro gree of accu n, lack of p ence of the alaries, repa formance of monitored a ates, relax l ed in this stu bosun-faku management he data for data was co e multiple re emonstrate t receivable firm’s profi design was technique w by the fact, one. the qu and plausib f the study of nigeria ( nd techniqu gan 1970 sam mple size is p(1-p) n-1) + x2p(1 e of chi-squ e n size oportion (ass uracy (expre patronage, a pandemic. ay loans and f smes. m and structur loans and d udy. it is the unle and imu t on the pro r the study ollected from egression an that manage and invento tability. employed was used to , that they h uestionnaire bility, result consists of (abolaji; ye es mpling tech represented 1-p) uare for 1 de sumed to be essed as a pr 7 and lack of the smes d rent. they most respon red palliativ defer tax pa erefore nece muzeze (2012 ofitability o were colle m secondar nalysis. the ers can crea ories. equa during the obtain the s have large cl es were subj ting in all ca f 26,744 reg ekinni & ad hnique was d as; egree of fre e 0.50) roportion= asian f sincerity o s are often y establishe dents sugge ve scheme, ayments. th essary to co 2), empirica of a sample ected from ry sources e results wh ate value by lly, shorten e course of sample size lusters of sm bjected to et ases being u gistered sm deyemi 201 adopted in edom at the 0.05) n journal of f on the part faced with ed that covi ested that g poverty all here are rel onsider them ally investig e of small 30 smes c (financial s hich are rob y reducing t ning the cas the study, . the choic mall and me thical and b usable. mes located 9) order to de e desired co finance & ac issn 19 2022, vol. 1 ajfa.macro t of govern problems id has a sig government leviation pr lated variab m in future r gates the im and mediu covering th statement) a bust to the p their firm’s sh conversio while, krej ce of the des edium enterp biosafety ch d within sou etermine the onfidence ccounting 946-052x 14, no. 1 think.org/ nment to such as: gnificant t should rograms, bles that research mpact of um-sized he single and was presence number on cycle jcie and scriptive prises in hecks for uth west e sample s= = 2568 67.817 the sam 3.3 sou primar a well-s question subjecte (spss ) 3.4 met one -w working method depende 3.841 x 2 (0.052 x 2 80.926 775 mple size is urces of data ry source of structured, q nnaire was ed to reliabi ) version 23 thod of data way anova g capital va d is adopted ent variable 226744 x 0. 26743) + 3. = 378.6 378 smes a f data gather questionnai administere ility and val 3. a analysis a (multivari ariables und because we es. 5 x 0.5 841 x 0.5 x to be used ring was em ire was used ed by the co lidity tests w iate test) w der the stud e have only 8 x 0.5 in the south mployed dur d to gather ohort of rese with the aid was used to dy (invento one indepen asian h-west geop ring the cou responses f earchers and d of statistic test for the ry, receivab ndent variab n journal of f political zon urse of the st from variou d all collate cal package e effect of c bles, payabl ble to be reg finance & ac issn 19 2022, vol. 1 ajfa.macro ne in nigeri tudy. conse us responde ed informati for social s covid 19 o les and cas gressed aga ccounting 946-052x 14, no. 1 think.org/ a. equently, nts. the ion were sciences n smes sh). this inst four 3.5 dat table 1 s/ 1 2 3 4 table 1 in busin in busin and 66( the gen respecti 264(71. shows t represen have bs qualific ta analysis . descriptiv /n varia no o below 5 – 1 10ye total gend male fema total mari singl marr divo total educ wac ond bsc. msc. other total above show ness shows ness below (7.8%) respo nder of the r ively. also, .4%) were m that 19(5.1% nting 122(3 sc./ hnd w cations that ve statistics able f years in b w 5years 0years ars and abo l der: e ale l ital status: le ried rced l cational qu ce d/ nce /hnd . rs l ws the dem that a vast 5years, whi ondents app respondents , their mar married, wh %) possess 33.0) have o while 30(8.1 were not sp business: ve ualification mographic p majority of ile 248(67% peared to ha representin ital status s hile 26(7%) wace/ ss ond/nce, 1%) are hol pecified in th 9 frequen 56 248 66 370 205 165 370 80 264 26 370 n: 19 122 174 30 25 370 resentation f the respon %) turned ou ave been in ng 205(55.4 shows that ) are also d sce ,while , an overw lders of ms he question asian ncy of the resp ndents repre ut to be in b business fo 4%) and 165 80(21.6%) divorced. th e a staggeri whelming m sc qualificat nnaire. n journal of f perce 15.1 67.0 7.8 100 55.4 44.6 100 21.6 71.4 7.0 100 5.1 33.0 47.0 8.1 6.8 100 pondents. th esenting 56 business bet r 10years an (44.6%) we ) appear to heir educati ng amount ajority repr tions. and 2 finance & ac issn 19 2022, vol. 1 ajfa.macro entages he number 6(15.1%) ha tween 5 to nd above. ere male and have been ional qualif of the part resenting 17 25(6.8%) ha ccounting 946-052x 14, no. 1 think.org/ of years ave been 10 years d female n single, fications ticipants 74(47%) ave other table 2 author using th the vari assume a. questio the tab table 3 s/n c invet 1 is du invet 2 re of du invet 3 th pa 1nve t4 m co un ca pa 1nve t5 l du th source: table 3 that “is opted f undecid . reliability r’s computa he rule of g iables. the d that the d on analysis bles below s . does covi covid-19 on inv suing of ma uring the pand eduction in p f delay in sup uring the pand here was sto andemic. majority of ome to wo nprecedente aused by andemic. ow product uring the p he incessant : field surv above show ssuing of m for strongly ded and als y statistic te relia cr ation, 2021 geory and m result for th egree to wh hows the pe id 19 have a 9 pandem ventory aterials was demic. roduction bec pplies of mat demic ck out durin staff could ork, due to ed disrup the covid tion was evi andemic du t lockdown. vey, 2021 ws that mos aterials wa y agree an so stuck to est for varia ability stat ronbach's alpha .985 . mallery (20 he variable hich an instr ercentage di any significa mic y sa (1) rigid 199 (53.8 cause erials 197 (53.2 ng the 196 (53.0 d not o the ption d 19 197 (53.2 ident ue to 201 (54.3 st of the resp as rigid dur nd agree re o disagree 10 ables tistics cronbach alpha bas on standardiz items 03), table 2 shows an e rument yield distribution o ant effect on a (2) 8%) 163 (44.1% 2%) 162 (44.1% 0%) 162 (43.8% 2%) 160 43.2% %) 165 (44.6% pondents sh ring the pan espectively, respectivel asian h's sed zed n of it .986 2 above whi excellent res ds is consist of smes by n inventory n (3) %) 3 (0.8%) %) 3 (0.8%) %) 4 (1.1%) %) 6 (1.6%) %) 2 (0.5%) how a level ndemic” 53 , while 0.8 ly , and 0 n journal of f tems 30 ich shows th sult of 0.98 tent. y working c of sme’s i d (4) 3 (0.8%) 6 (1.6%) 4 (1.1%) 6 (1.6%) 2 (0.5%) of agreeme .8% (199) 8 %( 3) w .5 %( 2) s finance & ac issn 19 2022, vol. 1 ajfa.macro he reliabilit 85.based on capital param in nigeria? sd (5) m 2 (0.5%) 4 2 (0.5%) 4 4 (1.1%) 4 1 (0.3%) 4 0 (0%) 4 ent on the st and 44.1 % were unequ strongly di ccounting 946-052x 14, no. 1 think.org/ ty test of n this we meters mean st 4.4973 0.6 5 4.4757 0.6 4 4.4649 0.6 4.4757 0.6 1 4.5270 0.5 8 tatement %( 163) uivocally sagreed. td 6170 6549 6828 6424 5415 53.2 % “reduc 0.8 %( 43.8 %( during t stateme caused agreed incessa table 4 geopoli c o rec1 w de di en tim rec2 w cr de rec3 d to in rec4 w ou rec5 d w in source: table 4 that “w to pay 42.4 %( were in disagree “we can amount disagree stateme 54.9%(2 %( 197) and tion in prod 3) were u ( 162)indica the pandem ent “majori by covid 19 to the fifth nt lockdown 4. does cov itical zone o covid-19 on receiv we cannot g ebtors by iscount so th ncouraged t me we can mana redit cease ebtors longe debt collect o reduce nvestment in we cannot g ur debtors during the p was incomp ncomes : field surv above show we cannot ge back on ( 157) held n favour o ed. 54.1 %( n manage th t of particip e. also, 53. ent “in the a 203) and 43 d 43.8 %( 1 duction beca undecided a ated strongl mic” 53.2%( ity of staff 9” respectiv h statement n”. vid 19 have of nigeria pandem vables get back to giving hat they wil to pay back age the deb ed by giv er time tion enable the cost n debtors give promo pandemic th lete receipt vey, 2021 ws that mos et back to ou time”. an d to a stand of undecide ( 200) and 4 he debt by c pants repres .8 %( 199) a aspect of de 3.0%(159) 162) opined ause of delay and 2.1% ( ly agreed an (197) and 4 could not vely while t “low prod e any signif mic sa (1) our out ll be k on 199 (53.8% t by ving 200 (54.1% s us of 199 (53.8% o to 203 (54.9% here t of 201 (54.3% st of the resp ur debtors b upper lim point of str ed and disa 42.2 %( 156 credit cease senting 0.8 and 42.4 % ebt collectio indicated st 11 d strongly a y in supplie (8) disagre nd agreed to 43.2%(160) come to wo 54.3% (20 duction was ficant effec a (2) %) 157 (42.4%) %) 156 (42.2%) %) 157 (42.4%) %) 159 (43.0%) %) 156 (42.2%) pondents sh by giving ou mit of parti trongly agre agreed resp 6) strongly a ed by giving %( 3) affirm ( 157) indic on we can r trongly agr asian agree and a es of materia ed concurr o the third s strongly ag ork due to 01) and 44. s evident du t on receiv n (3) d ( 3 (0.8%) ( 3 (0.8%) 9 ( 4 (1.1%) 9 ( 2 (0.5%) 6 ( 2 (0.5%) ( how a level ut discount s icipants rep ee and agre pectively, 3 agreed and a g debtors lo med undeci cated strong reduce the ee and agre n journal of f agree to the als during th ently. also statement “t greed and a the unprec 6%(165) st uring the pa vables of sm d (4) sd (5) 10 (2.7%) 1 (0.3 9 (2.4%) 2 (0.5 9 (2.4%) 1 (0.3 6 (1.6%) 0 (0% 10 (2.7%) 1 (0.3 of agreeme so that they presenting e respective 3.0%(11) o agreed to th onger time” ided and 3.0 gly agree an cost of inve ee to the fou finance & ac issn 19 2022, vol. 1 ajfa.macro e second st he pandemic o, 53 %( 1 there was s agreed to th cedented dis trongly agr andemic du mes in sou d mean 3%) 4.4676 5%) 4.4676 3%) 4.4703 %) 4.5108 3%) 4.4757 ent on the st will be enc 53.8% (19 ely, while 0 of participan he second st ” while a m 0% (11) als nd agree to t estment in d ourth statem ccounting 946-052x 14, no. 1 think.org/ tatement c” while 96) and stock out he fourth sruption reed and ue to the uth west std 0.67897 0.69084 0.67107 0.59913 0.67531 tatement ouraged 99) and 0.8 %(3) nts also tatement miniature so chose the third debtors” ment “we cannot g for stro received table 5 geopoli pay1 i pay2 o t m l pay3 o d m d pay4 w c c pay5 o r a p source: table 5 that “c strongly (3) by 54.1 % creditor 3.0 %( and 40. us disco reached pay our (201) a compan give promo ongly agree d completely 5. does cov itical zone o covid -19 on pay creditors are issue material our creditors that we can money within limits. our credito discount in money to be due date. we are not a creditors on cash is not rea our company reduce staff adverse conse pandemic. : field surv above show creditors are y agree and indicating u ( 200) and r gave prom 11) were u 3 %( 149) d ount in orde d a consensu r creditors and 40.3%( ny was plan to our debt and agree t ly”. vid 19 hav of nigeria 9 pandemic ayables e not ready s. gave promo pay them th n available tim ors gave order for th paid within t able to pay o time becau adily available was planning f due to t equences of t vey, 2021 ws that mos e not ready d agree respe undecided 40.5 %( 1 mo so that w undecided an declared stro er for their m us on stron on time bec (149) opini ning to redu tors” respec to the fifth e any signi c sa (1) to 201 (54.3%) so eir me 200 (54.1%) us eir the 201 (54.3%) our use e 203 (54.9%) to the the 201 (54.3% st of the resp to give us m ectively, wh and disagre 50) strongl we can pay t nd 2.5% (9) ongly agree money to be ngly agree a cause cash onated stro uce staff du 12 ctively whil statement “ ificant effe a (2) 149 (40.3%) 150 (40.5%) 149 (40.3%) 151 (40.8%) 149 40.3%) pondents sh materials” 5 hile a minut eed respect ly agreed a then their m ) firmly dis e and agree e paid as and and agree to is not read ongly agree e to the adv asian le 54.3% (20 “during the ect on paya n (3) d (4) 11 (3.0%) 3 (0.8 11 (3.0%) 5 (1.4 11 (3.0%) 4 (1.1 10 (2.7%) 2 (0.5 12 (3.2%) 3 (0.8 how a level 54.3% (201 te segment tively, and and agreed money within sagreed resp to the third d when due o the fourth dily availab e and agree verse conseq n journal of f 01) and 42.2 e pandemic ables of sm sd (5) %) 6 (1.6%) %) 4 (1.1%) %) 5 (1.4%) %) 4 1.1%) %) 5 (1.4%) of agreeme ) and 40.3 opted for 3. 1.6 %( 6) to the seco n stipulated pectively . a statement “ ” 54.9%(20 h statement ble” respect e to the fif quences of t finance & ac issn 19 2022, vol. 1 ajfa.macro 2%(156) ac the incomes mes in sou mean 4.448665 4.4514 4.4514 4.4784 4.4541 ent on the st %( 149) o .0 %( 11) an strongly di ond stateme d time limits also, 54.3 “our credito 03) and 40.8 “we are no tively while fth stateme the pandem ccounting 946-052x 14, no. 1 think.org/ ccounted s are not uth west std 0.742668 0.72062 0.73182 0.6338 0.72456 tatement opted for nd 0.8% sagreed. ent “our s” while %( 201) ors gave 8%(151) ot able to e 54.3% nt “our mic”. table 6 geopoli cov cas cas1 the durin busin cas2 the work cas3 staff to se cas4 we drou of ba cas5 cash redu pand source: table 6 that “th survive stuck to indicate strongly workers undecid third st 44.1%( insuffic particip the fifth pandem 6. does co itical zone o vid19 p sh residual amo ng the pandem nesses to surv cash is no lon kers their wag f may be laid o ervices. can solve th ught through a ank loans h flow operati uced during demic. : field surv above show the residual ”. a vast m o strongly ag ed disagree y agree and s their wag ded. also, 5 tatement “s 160) strong ient cash th pants repres h statement mic”. ovid 19 ha of nigeria pandemic ount of mone mic is not enou vive. nger enough t ges off due to disru e problem of availing the su ons have dras the period o vey, 2021 ws that mos amount of ajority of p gree and ag to the que d agree to ges” unfort 54.1 %( 20 staff may gly agreed a hrough ava enting 54.9 t “cash flo ave any sig on sa (1) ey left ugh for 201 (54.3 to pay 203 (54.9 uption 201 (54.1 f cash upport 201 (54.3 tically of the 203 (54.9 st of the resp money left participants gree respecti stion posed the second tunately a 0) and 43.8 be laid off and agreed ailing the su % (203) an w operation 13 gnificant ef a (2) 3%) 162 (43.8% 9%) 165 (44.6% 1%) 162 (43.8% 3%) 163 (44.1% 9%) 165 (44.6% pondents sh during the p representin ively, while d to them. 5 d statement very small 8 %( 162) s ff due to d to the fourt upport of b nd 44.6%(16 ns have dra asian ffect on ca n (3) d %) 3 (0.8%) %) 2 (0.5%) %) 3 (0.8%) %) 3 (0.8%) 2 %) 2 (0.5%) how a level pandemic i ng 54.3% (2 e 0.8 %( 3) w 54.9 %( 20 t “the cash segment, specified st disruption i th statemen ank loans” 65) stipulat astically red n journal of f ash of sm d (4) sd (5) 3 (0.8%) 1 (0.3% 0 (0%) 0 (0% 5 (1.4%) 1 (0% 2 (0.5%) 0 (0.3% 0 (0%) 0 (0% of agreeme s not enoug 201) and 43 were undec 3) and 44.6 h is no lon representing rongly agre n services” nt “we can s . a conces ed strongly duced durin finance & ac issn 19 2022, vol. 1 ajfa.macro mes in sou mean %) 4.5108 %) 4.5432 %) 4.5054 %) 4.5162 %) 0.5432 ent on the st gh for busin 3.8 %( 162 cided, and 1 6 %( 165) a nger enough ng 0.5 %( ee and agre ” 54.3%(20 solve the pro ssionary am y agree and ng the perio ccounting 946-052x 14, no. 1 think.org/ th west std 0.59002 0.50955 0.59009 0.57595 0.50955 tatement nesses to 2) firmly .1 %( 4) affirmed h to pay 2) were ee to the 01) and oblem of mount of agree to od of the table 7 covd19 covd19 covd19 covd19 covd19 source: table 7 stateme particip agreed r 43.5 % “covidand 1.8 53.5 % “covidreported world e 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ctivities, mpanies continue mpanies f looking . at could advance into pa adversa from m the ove paramet studies exante p referen adedira working nigeria https://s akinsul bukki, enterpri nigeria. https://d cennim https://e chen, j small https://d chow, econom 11(6), 4 cook, s in https://d druker, hiatt, s surviva https://d ishola, an auto retriev https://l e broad insi aramount co arial effect, most other stu erdependen ters on sm should also position in o nces an, a. s., j g capital m a. resea scialert.net/ lire, 0. (201 a., ogunti ises (smes . annual j doi.org/10.2 mo. d. emedicine.m j. (2006). d busines doi.org/10.1 c.k.w. & my in transit 489-505. htt s. (1999). c rural doi.org/10.1 , p.f. (2009) s. r. & we l amid poli doi.org/10.1 w.o., olad oregressive ed lahoreschoo ights for fur onsideration our studies udies. nce of a sing me’s could s o deliberate order to min josiah, m., management arch jou fulltext/?do 4). financi mehin, y. & s) owners’ journal of 29114/ajtuv (2020). medscape.co developmen ss and 1108/14626 fung, m.k tion: implic tps://doi.org creating wea chin 1111/j.1759). innovatio esley, d.s. itical and c 1002/smj.21 dipo, o. d. distributed olofeconomi rther resear n, in order examined a gle key info suggest that on reducing nimize the e bosun-fak on the pro urnal of oi=rjbm.201 al managem & adeyemi resources f technica v.vol3.iss1. coronaviru om/article nt of chine d ente 000610665 k.y. (1996). cations for s g/10.1016/s alth and we a, i -5436.1999 on and entre (2014). cl civil violenc 113 & oluseyi d lag appro ics.edu.pk/b 19 rch. first, d r to achieve a single ind ormant to ex t the results g the effect o effects of co kunle y.f. & ofitability o f busin 12.61.69 ment. lagos i, m. (2019 mobilizatio al univers 109 rus disea ese small an erprise 854 firm dyna small busine 0883-9026 elfare – entr ids 9.mp300040 epreneurship lear and pre ce. strategi , a. (2015) oach. the l businessjou asian diverse subs e impactful dustry, which xamine the p s could be s of such bias onsistency a & imuzeze, of small and ess man s. el-toda v 9). a study on and inno sity of v ase. retr nd medium developme amics and in ess policy. j (96)00019repreneursh bulletin, 008.x p, new yor esent dange ic managem ). smes and lahore jou urnals/v3iss n journal of f ectors shou l generaliza h happens t potency of t subject to m s by conside artifacts. o. e. (201 d medium s nagement, ventured pre of small a ovative cult varna, bul ieved on m-sized ente ent, 13 ndustrializa journal of b -5 ip and the d 30 k: harper c er: planning ment journa d economic rnal of bu ue2/01%20 finance & ac issn 19 2022, vol. 1 ajfa.macro uld have bee ations. due to be quite d the working method bias ering the exp 12). the im scale enterp 6(2), ess. and medium ture in sou lgaria, 3(1) n 3/4/202 erprises. jou 3(2), 1 ation in the business ve developmen 0(4), collins. g and new al, 35(5), 7 growth in usiness, 3(2 0oyeniran% ccounting 946-052x 14, no. 1 think.org/ en taken e to the different g capital s. future post and mpact of prises in 61-69 m scale uth-west, , 1-10. 20 on urnal of 140-147. chinese enturing, ntal state 60-70. venture 773-785. nigeria: ), 1–16. from %20et%2 0al.pdf krejcie educatio https://d li, j. & overvie 13(2), 2 lopez-c for tour marion covid file:///c olicies% morris, instrum omoley zhang ( http://w , r.v. & onal and m doi.org/10.1 & matlay, h ew and rese 248 – 262. h cordova, e rism service , j. & moha 1 c:/users/dr% %20 s. 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(1970 nt. educati 644700300 chinese en da", journa i.org/10.110 a slowdown ank policy r ). a variety retrieve 20josiah%2 ng the impa h and spain kout strateg pact on chin missions htm 20 0). determi ion and ps 0308 ntrepreneurs al of small 08/1462600 n of china's research w of policies ed 0mary/des act of cor n. via cente gic financia na small and ml. asian ining samp sychologica ship and sm l business 0061066595 s economy working pap to support m on ktop/covid/ rona virus er for globa al managem d medium-si n journal of f le size for al measurem mall busines and enterp 3 and its imp er wps914 micro and sm 3/4/2 /%20a%20v on global al developm ment fifth ed ze business finance & ac issn 19 2022, vol. 1 ajfa.macro r research ment 30, 6 ss developm prise devel pact on the 46. mall busine 2020 variety%20 smes: a ment. dition, cleo s. retrieved ccounting 946-052x 14, no. 1 think.org/ activies 607-610. ment: an lopment, demand ess hit by on 0of%20p a survey consult. on from microsoft word 14348-52106-2-sm-writer2-new.docx asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 63 volatility spillover effect of international crude oil futures and china-russia stock market: a multivariate bekk-garch model based on wavelet multiresolution analysis maoguo wu (corresponding author) maoguo wu, shu-uts silc business school, shanghai university, shanghai, china daimin lu shu-uts silc business school, shanghai university, shanghai, china received: feb. 15, 2019 accepted: may 17, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14348 url: https://doi.org/10.5296/ajfa.v11i1.14348 abstract the increasingly prominent strategic position of crude oil determines its high impact on macro-economy. the value of crude oil is reflected in the price of crude oil futures. stock market is the barometer of macro economy. to what extent does international crude oil futures price affect stock market? china and russia are the biggest importer and exporter of crude oil, respectively. crude oil is of strategic value to both countries. this study empirically investigates the volatility spillover effect of international crude oil futures and china-russia stock market from april 24th, 2015 to april 20th, 2018, based on the data of international crude oil futures prices, china-russia stock market composite index, and industry stock index. the empirical results show that there is a short-term relationship between china-russia stock market composite index and international crude oil futures price. the international crude oil futures price has a greater explanatory power to russian rts index, but a smaller explanatory power to shanghai composite index. all industry stock indices are cointegrated with international crude oil futures prices. except for china industry and russia energy, the adjustment coefficient of international crude oil futures price on stock index volatility of other industries is insignificant. this study mainly studies the relationship between international crude oil futures price and the comprehensive stock index and industry stock index of china and russia, and compares the impact of international crude oil futures price on the stock market of the largest importer and the largest exporter of crude oil to explore the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 64 linkage between crude oil futures price and stock market, and puts forward policy implications based on the empirical results. keywords: volatility spillover effect, international crude oil futures, china-russia stock market, multivariate bekk-garch model, wavelet multiresolution analysis asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 65 1. 1. introduction crude oil has always occupied an unshakable position in industry, and its derivatives cover many industries. due to its poor extraction and refining technology, china imports large quantities of crude oil from abroad, and jumps to the top of the world’s crude oil consumption in 2017. china’s crude oil dependence is expected to exceed 60% by 2020. thus, the fluctuation of international crude oil prices will have an important impact on china’s economy. russia is currently the world’s largest oil reserve country, and the fluctuation of international crude oil prices has a significant impact on its economy. since the two crude oil crises in the early 1970s and early 1980s, the economic status and financial attributes of crude oil have become increasingly prominent. in order to avoid the risk caused by the fluctuation of crude oil price, the crude oil futures market came into being. the fluctuation of crude oil futures price is inseparable from the corresponding spot price fluctuation. the stock market, which is called the “barometer” of macro-economy, directly reflects the trend of a country’s economy. therefore, the price of crude oil futures reflecting spot price affects the stock market, revealing the economic situation to a certain extent. at present, existing literature on the impact of international crude oil futures prices on composite index and industry index is extremely limited. in view of this, this study investigates the volatility spillover effect of international crude oil futures price and china-russia composite stock index and industry stock index, and investigates the linkage between crude oil and stock market by comparing the impact of international crude oil futures price on the stock markets of the largest importer and the largest exporter of crude oil. in previous literature, when discussing the correlation between international crude oil futures and stock market, a single model is often used, but the difference of data is neglected. in this study, according to the characteristics of variable groups in the test, different empirical models are used for analysis. specifically, this study chooses the international crude oil futures price as the explanatory variable, and the stock market composite index and industry index of china and russia as the explained variable, and establishes the corresponding variable group. it is found that all the time series are non-stationary, so two schemes are put forward in this study: (1) making first-order difference to the original data, establishing var model and garch model, then processing the international crude oil futures price with wavelet multiresolution, establishing bekk-garch model, and judging whether there exists volatility spillover effect according to wald test results; (2) making cointegration test to the original data. on the basis of granger causality test results, the variable groups are divided and vecm and ecm models are established, respectively. this study explores the relationship between the international crude oil futures and the stock markets of china and russia through the above-mentioned research methods, and further strengthens the research on the influencing factors of the market, so as to help macroeconomic policymakers better understand the effectiveness of china’s financial market and the role of market regulators, and to provide reference for the development of follow-up financial market and formulate more reasonable policies. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 66 2. related literature most of the existing literature on the linkage between international crude oil futures and stock market is based on stock pricing model. in the stock pricing model, the stock price at each time point corresponds to the discount value of future cash flow. early theoretical studies have shown that there is a close relationship between crude oil price and macro-economy. crude oil futures price is the embodiment of crude oil price, and stock market is the barometer of macro-economy. there may be a corresponding relationship between crude oil futures price and stock market. huang, masulis and stoll (1996) proposed that changes in international crude oil futures prices would have an impact on discount rates and future cash flows of companies. crude oil price shocks mainly affect inflation and interest rates through influencing the government’s monetary policy. when the government is facing the impact of crude oil prices, because crude oil prices affect the production and operation costs of a considerable number of companies, in order to stabilize the economy and investor sentiment, the government usually adjusts the interest rate and inflation rate accordingly. hooker, leblanc and chin (2004) argued that the impact of international crude oil futures prices on inflation is asymmetric. this may be because the government cannot regulate the currency as frequently as the fluctuation of international crude oil futures prices, so the impact of international crude oil futures prices on inflation is band-wise. in addition, changes in crude oil prices will also have an impact on the nation’s macroeconomic situation, industry development and companies’ own operating conditions. fried and schultze (1975) argue that rising crude oil prices would lead to lower global demand and economic recession. hamilton (1983) constructed a six-variable system similar to the real macro-economy and found that the rise of international crude oil prices would indeed lead to economic recession. the most obvious industry impacted by the rising crude oil price would be the crude oil extraction and processing industry. in addition, most companies use crude oil more or less as fuel (raw materials), and the fluctuation of crude oil price undoubtedly affect the operating conditions of companies, and then affect the cash flow of companies. early studies on the linkage between international crude oil futures prices and stock markets did not find significant results. the multi-factor model used by chen, roll and ross (1986) is a model for early research on the impact of international crude oil futures prices on stock markets. since then, hamao (1990), ferson and havey (1994) have extended the model, but no significant impact of international crude oil futures prices on the stock market has been found in the us and japanese stock markets. however, most subsequent studies have come to the conclusion that international crude oil futures prices impact the stock market. jones and kaul (1996) found that the impact of international crude oil futures prices on canadian and american stock markets is significant. qi and zhu (2011) and zhang and wang (2013) found that the fluctuation of international crude oil futures prices had a strong and lasting influence on the stock markets of the united kingdom and the united states, but had a small impact on the stock markets of china and india. zhuge and hao (2009) found that there was a long-term asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 67 cointegration relationship between the volatility of china’s stock market and the volatility of international crude oil futures prices between 2002 and 2008, which was consistent with the results obtained by zhang (2013) using data from 2006 to 2010. zhu (2015) established an asymmetric bekk model and wald test. it was found that there was a two-way volatility spillover effect between international crude oil futures and stock markets. despite a great deal of literature, there are relatively few studies on the impact of international crude oil futures prices on various industry indices of the stock market. sadorsky (2001) found that the stock returns of oil companies are positively correlated with oil prices, while the stock returns of natural gas companies are negatively correlated with them. lao (2008) used the method of multivariate equation regression and concluded that the international crude oil futures price has a significant positive impact on the first-class industry index (including financial, industrial and other categories of index). however, by establishing ged-garch (1,1)-m model, jin and jin (2010) found that international crude oil futures prices had significant negative effects on automobile, construction, finance and other industries, but had significant positive effects on the crude oil industry and the gas industry. dai (2014) used arma-egarch-m model to analyze the data from 2009 to 2013 and found that the rise of international crude oil futures prices have a positive impact on the mining industry, but a negative impact on the chemical industry. most of the previous literature assumed that there was a stable linear relationship between macro-economy and international crude oil futures prices. it was not until mork (1989) found that the impact of crude oil price shocks on macro-economy was non-linear and asymmetric that this assumption was overturned. in addition, some previous literature chose the composite index as the explained variable, but did not consider the possible correlation between the industry index and the international crude oil futures price. when studying the impact of the international crude oil futures price on the industrial stock index, most literature utilized a single model to analyze all the data, without considering the differences between the data, and the results are prone to bias. at the same time, many studies only analyze the linkage between international crude oil futures prices and a country’s stock market. therefore, in the empirical research, (1) this study makes first-order difference processing of the original data, establishes var model and garch model, and then makes wavelet multiresolution processing of the international crude oil futures price, and establishes bekk-garch model; (2) this study not only investigates the stock market composite index of china (the largest crude oil importer) and russia (the largest crude oil exporter), but also considers the industry index of china and russia; (3) in the study of the impact of crude oil futures prices on the stock industry index, this study does not use a single model to analyze, but first divides the data into groups of variables with different characteristics, and then uses different models to analyze different groups of variables. 3. channels of crude oil influencing stock market on the one hand, this study focuses on the macroeconomic impact on the stock market, i.e., how the discount rate changes when the crude oil price fluctuates; on the other hand, it focuses on the impact of specific industries on the stock market, i.e., how the future cash flow asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 68 of companies changes when the crude oil price fluctuates. 3.1 the impact of crude oil futures prices on the stock market as a whole crude oil price fluctuation affects the stock market through trading currency. since the birth of crude oil futures contracts, crude oil derived financial attributes. demand and supply are no longer the only factors that influence the price of crude oil. capital injection has gradually made crude oil out of the control of oil-producing countries. at present, international crude oil futures are mainly valued and settled in us dollar, sterling pound, and other currencies. monetary policies and corresponding exchange rates of various countries affect crude oil trading through interaction. in addition, the fluctuation of crude oil price also affects the stock market by influencing macro-economy. when the price of crude oil rises, the consumption level of net importing countries tends to decreases, the purchasing power of money decreases, and the inflationary pressure increases. the situation of net exporting countries is the opposite. as the number of net importers of crude oil is greater than that of net exporters of crude oil, when crude oil prices rise, the global economy generally shows a downward trend. at this time, inflationary pressure is high, investors will consider the expected discount rate when calculating stock prices, and naturally think that the future inflation rate will be higher than previously estimated, and then change the discount rate. because the stock price is lower than the present value, the yield will also be lower. at the same time, crude oil futures and stock market are both high-risk and high-yield financial markets. there may be a competitive relationship between them. when the government increases the funds used to maintain the price stability of crude oil futures, the funds available for investing in the stock market will naturally decrease, and the reduction of funds will lead to the decline of the stock market and the reduction of the yield. 3.2 impact of crude oil futures prices on related industries referring to china’s classification standards of national economic industries, this study selects five industries closely related to crude oil to analyze the impact of crude oil prices on specific industries. 1) in the mining industry, the price of crude oil has risen, which is good news for crude oil and coal miners, but bad news for other resource miners. therefore, the impact of crude oil on the extraction industry depends on the tripartite game between crude oil, coal and other resources; 2) in the manufacturing industry, crude oil is used as raw material or fuel, and the rise of crude oil price will have a negative effect; 3) in the electricity, heat, gas and water production and supply industry, rise of crude oil price leads to increase in supply cost and decrease in corporate profits; 4) in the construction industry, asphalt and other raw materials in engineering consumes a large amount of industrial lubricant. industrial lubricant is extracted from crude oil, so if the price of crude oil rises then the future cash flow of companies will decrease. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 69 5) the transportation, storage, and postal industry is more sensitive to crude oil prices than most industries, such as road, rail, and air transport. crude oil is a direct or indirect fuel, and the rising price of crude oil will lead to an increase in operating costs, thus reducing the overall profit of the transport industry. 4. empirical analysis this study focuses on the linkage between international crude oil futures price and china-russia stock market, specifically the impact of international crude oil futures price on the composite stock index of the stock market and the industry stock index. this study chooses the daily frequency data from april 24th, 2015 to april 20th, 2018. specific variables are: 1) international crude oil futures price: the crude oil futures of china and russia are linked to brent crude oil futures price, which is one of the three major international crude oil futures prices. therefore, they are regarded as international crude oil futures price. the data are gathered from wind database. 2) composite stock index: shanghai stock index (sha) and russia rts index (rts) are selected as the stock market indices of china and russia, respectively. the data are collected from bloomberg database. 3) industry stock index: for china’s stock market, referring to the industry division standard of the national bureau of statistics, in the industry index of the china stock index limited company, co-founded by shanghai stock exchange and shenzhen stock exchange, this study selects zcp, zzfz, zzgy, zzjz, zzjt, zny, zzny, zfz, and zrl data from wind database; for the russian stock market, this study selects the industry index corresponding to the chinese stock market, respectively, i.e., russia car parts (rcp), russia textile (rfz), russia industry (rgy), russia construction (rjz), russia transportation (rys), russia energy (rny), russia fuel (rrl). the data are gathered from bloomberg database. jarque-bera tests on the 17 variables show that all the variables exhibit the characteristics of “sharp peak and thick tail”, which does not comply with the normal distribution and has a wide range of fluctuations. stationarity tests find that the 17 variables have unit roots at the 1% significance level, i.e., they are non-stationary time series. in view of this, this study proposes two schemes for further research: 1. first-order difference of the original data; 2. cointegration test of the original data. 4.1 first-order difference after making first-order difference for the original data, the 17 variables selected reject the null hypothesis that there is a unit root at the 1% significance level, i.e., all variables become stationary series. the results of granger causality test show that there is a two-way granger causality between brent crude oil futures price and russia industry; brent crude oil futures price is the granger cause of zzny, zzrl, rcp, and rny; brent crude oil futures price is also the granger cause of russia textile (rfz) and russia fuel (rrl). there is no granger asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 70 causality between brent crude oil futures price and the other nine variables. for brent crude oil futures price with two-way granger causality and rts index, var regression is used to judge the relationship between them. aic, fpe and hq information criteria show that the optimal lag period of var model is two lags. the results of var regression are shown in table 1. table 1.var results dbrent drts drgy dbrent(-1) -0.037323 (0.04548) [0.82060] -0.055881 (0.69359) [-0.08057] 0.039866 (0.06696) [0.59539] dbrent(-2) -0.000506 (0.04554) [-0.01111] -0.275300 (0.69449) [-0.39640] -0.183224 (0.06705) [-2.73283] drts (-1) -0.002704 (0.00319) [-0.84773] -0.015363 (0.04864) [-3.31588] -0.001126 (0.00470) [-0.23989] drts (-2) -0.002807 (0.00318) [-0.88212] -0.012482 (0.04853) [-2.25721] -0.005343 (0.00468) [1.14055] drgy(-1) 0.089737 (0.02975) [3.01601] 2.145214 (0.45373) [4.72793] 0.219919 (0.04380) [5.02068] drgy(-2) -0.026533 (0.03018) [-0.87920] -0.948154 (0.46021) [-2.06026] -0.086517 (0.04443) [-1.94736] c 0.029198 (0.03792) 0.284026 (0.57822) 0.074043 (0.05582) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 71 [0.77006] [0.49121] [1.32645] r2 0.020318 0.044186 0.061708 var test results show that: 1. the first and second lag orders of brent crude oil futures price have significant negative effects on itself; 2. the first and second lag orders of rts index have negative effects on itself, among which the first lag order has greater and more significant effects; 3. the first lag order of russia industry has positive effects on itself, while the second lag order has negative effects on itself. the influence of the second lag order is greater and more significant; 4. the influence of the first and second lag order of rts index on brent crude oil futures price is equal, while the coefficient of the second lag order is more significant; 5. the first and second lag order of russia industry has greater influence on rts index, and the effect is opposite. before impulse response, this study first detects the stability of var by ar root graph. the stability test diagram and impulse response diagram are shown in figure 1. figure 1. ar root graph and impulse response graph the impulse response results show that the impact of rts index on brent crude oil futures price has two lags; the impact of brent crude oil futures price on rts index has no lag, and has immediate impact and lasts about four periods; in the long run, both rts index and brent crude oil futures price are stable, and the impact effect is basically unchanged. based on the established var model, the variance decomposition of rts index and crude oil futures price is carried out. before variance decomposition, cholesky orthogonalization is used to eliminate the serial correlation and autocorrelation among residuals. the results of variance decomposition are shown in table 2. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 72 table 2.variance decomposition results dbrent drts period s.e. dbrent drts period s.e. dbrent drts 1 0.984979 100.0000 0.000000 1 15.16729 27.71142 72.28858 2 0.986134 99.99845 0.001547 2 15.20552 27.79667 72.20333 3 0.987249 99.81215 0.187845 3 15.22351 27.85850 72.14150 4 0.987266 99.80984 0.190164 4 15.22392 27.85987 72.14013 5 0.987268 99.80968 0.190320 5 15.22396 27.85994 72.14006 6 0.987268 99.80967 0.190329 6 15.22397 27.85994 72.14006 7 0.987268 99.80967 0.190329 7 15.22397 27.85994 72.14006 8 0.987268 99.80967 0.190329 8 15.22397 27.85994 72.14006 9 0.987268 99.80967 0.190329 9 15.22397 27.85994 72.14006 10 0.987268 99.80967 0.190329 10 15.22397 27.85994 72.14006 the results of variance decomposition show that the initial rts index has a low explanatory power to brent crude oil futures price fluctuation, but it increases slowly with the increase of futures, and remains unchanged from the fourth to 0.19%. to be specific, the influence of rts index on brent crude oil futures price fluctuation has a lagging effect, and the explanatory power is low. brent crude oil futures price has a strong explanation for itself. the contribution of brent crude oil futures price to rts index is medium. the first explanation is 27.71%, but the growth is very slow. by the fifth period, brent crude oil futures price stagnates to 27.86%. therefore, brent crude oil futures price has no lagging effect on rts index, and its impact is instantaneous. at the same time, it also shows that brent crude oil futures price has stronger self-development and strengthening ability. the results of variance decomposition are consistent with those of impulse response. in this study, breusch-godfrey serial correlation lm test is used to test serial correlation. the results show that serial correlation exists in the variable groups dsha & dbrent, dzzcp & dbrent, dzzfz & dbrent, dzjz & dbrent, and dzzjt & dbrent. in order to eliminate serial correlation, the arma model is introduced. the results are shown in table 3. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 73 at this time, serial correlation of each equation has been eliminated. table 3. serial correlation test results variable group serial correlation elimination method t-value p-value dsha & dbrent ar(1), ar(2), ma(1) 1.474066 0.2292 dzzcp & dbrent ar(1), ar(2), ma(1), ma(2) 1.195445 0.3028 dzzfz & dbrent ar(2), ar(3) 3.636489 0.2650 dzzjz & dbrent ar(1) 4.018771 0.1811 dzzjt & dbrent ar(1), ar(3), ma(1), ma(3) 3.215683 0.4032 in view of the fact that the regression equation constructed in this study contains only one explanatory variable, this study tests the arch effect of the regression equation. the results show that the arch effect exists in all variables except the futures prices of china textile and brent crude oil. for the group of variables without arch effect, i.e., the futures prices of china textile and brent crude oil, ols regression is performed directly. wald test shows that there is no significant relationship between them. for the variables with arch effect, garch model is used to further analyze: if they do not show serial correlation in lm test, the first-order autoregression of the explained variables is added to the equation. the re-test results of arch effect show that after the establishment of garch model, the arch effect of each variable group has been eliminated. in order to further study the volatility spillover effect between brent crude oil futures price and stock index of china and russia, this study chooses bekk-garch model, which is expressed as follows: , (1) in which is the stock price index, is the crude oil futures price, is the conditional covariance matrix, a and b are the parameter matrices of order 2*2, a reflects the arch effect of volatility, b reflects the garch effect of volatility, and c is the upper triangular matrix of order 2*2. the conditional covariance matrix can be expanded as follows: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 74 (2) in which denotes the conditional variance of stock price index at time t, denotes the conditional variance of crude oil futures price at time t, and denotes the conditional covariance of stock price index and crude oil futures price. the bekk-garch model is used for the above variable groups. some parameters of the model are selected as table 4. table 4. test results of bekk-garch model explained variable insignificant coefficients in the model a(1,2) and b(1,2) comparison of b(1,1) with b(2,2) dsha m(1,2) both significant > drts m(1,2) both significant < dzzcp m(1,2) both significant > dzzgy null both significant < dzzjt m(1,2) both significant < asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 75 dzzjz m(1,2) both significant < dzzny m(1,2) both significant < dzzrl m(1,2) both significant < drcp m(1,2) both significant < drfz m(1,2) both significant > drjz m(1,2) both significant > drny m(1,2) both significant < drrl m(1,2) both significant < drys m(1,2) both significant < table 4 shows that in the beek-garch model, except for the m(1,2) coefficients of the futures prices of china industry and brent crude oil, the other coefficients are significant, which confirms the applicability of the model. the coefficients of a(1,2) and b(1,2) are significant, which indicates that the price of brent crude oil futures has volatility spillover effect with china, russian composite stock index, and industry stock index. comparing b(1,1) with b(2,2), it can be found that in the combination of shanghai stock index, china auto parts, russia textile, russia construction, and brent crude oil futures prices, b(1)>b(2,2), which indicates that the stock index reacts to shocks faster and has shorter cycle than brent crude oil futures prices. in other portfolios, b(1,1)<b(2,2), indicating that the volatility of stock index is greater than that of brent crude oil futures price, and the response period to information shocks is longer. wavelet transformation and multiresolution processing can transform the time and frequency of time series, and study the morphology of a subspace sequence satisfying multiresolution conditions in different subspaces. in this study, discrete wavelet transform (dwt) is used to stratify and process the original data, and dyadic orthogonal wavelet multiresolution analysis asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 76 method is used to decompose the original data into short, medium and long-term data. among them, the time scale of short-term data (high frequency signal) is days and days (close to work week), the medium-term time scale is days and days (week to month), and the long-term time scale is days (month). the granger causality tests of brent crude oil futures price in short, medium and long periods, original data, composite index of china and russia stock markets and industry index show that only rts index and brent crude oil futures price, rts index and brent crude oil futures price in short term, and sha index and brent crude oil futures price have two-way granger causality. the regression results of beek-garch model are shown in figure 2, figure 3, and figure 4. -.001 .000 .001 .002 .003 .004 .005 .006 .007 100 200 300 400 500 600 var_y1 var_y2 cov_y1y2 -.0005 .0000 .0005 .0010 .0015 .0020 .0025 .0030 100 200 300 400 500 600 var_y1 var_y2 cov_y1y2 figure 2. rts and brent figure 3 rts and brent short -.0005 .0000 .0005 .0010 .0015 .0020 .0025 .0030 100 200 300 400 500 600 var_y1 var_y2 cov_y1y2 figure 4. sha and brent wald test is conducted on rts index and brent crude oil futures price, and sha index and brent crude oil futures price, to determine the direction of volatility spillover effect. the results are shown in table 5. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 77 table 5. wald test results there is no two-way volatility spillover effect between brent crude oil futures price and rts index there is no one-way volatility spillover effect between rts index and brent crude oil futures price there is no one-way volatility spillover effect between brent crude oil futures price and rts index f-value p-value f-value p-value f-value p-value s 749.0268 0.0000 282146.2 0.000 941138.14 0.0000 2526.654 0.0000 1761374 0.0000 34865.67 0.0000 7973.026 0.0000 1848848 0.0000 296475.1 0.0000 0.2450 0.9128 0.3120 0.7319 7.42e-009 0.9999 there is no two-way volatility spillover effect between brent crude oil futures price and shanghai composite index there is no one-way volatility spillover effect between shanghai composite index and brent crude oil futures price there is no one-way volatility spillover effect between brent crude oil futures price and shanghai composite index f-value p-value f-value p-value f-value p-value s 6551.491 0.0000 401.2298 0.000 973683.0 0.0000 1.026588 0.3268 2.568956 0.4456 1.50792 0.556 6 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 78 0.8561 0.5029 0.6122 0.6250 0.2567 0.773 6 0.2380 0.9356 0.4569 0.7259 8.602e-011 0.9999 the results show that there is a two-way volatility spillover effect between the original sequence of brent crude oil futures price and the data at and levels and rts index, while there is no two-way volatility spillover effect between the other levels of brent crude oil futures price and rts index; only the original series of brent crude oil futures price and shanghai composite index have two-way volatility spillover effect. the conditional covariance diagram of brent crude oil futures price and rts index (figure 2) shows that the trend of covariance curve is very similar to that of brent crude oil futures price and rts index, indicating that the volatility spillover effect between them is very strong, especially in the short term when the volatility spillover effect is more obvious; the volatility spillover effect of brent crude oil futures price and shanghai composite index is not very obvious. although there is a certain relationship between them, the volatility spillover effect of brent crude oil futures price on shanghai composite index is less than that on rts index. the correlation coefficient between brent crude oil futures price and rts index and shanghai composite index is basically positive, suggesting that the fluctuation of international crude oil futures price may increase the fluctuation of china and russia stock market. 4.2 cointegration in order to prevent the loss of long-term relationship between data caused by first-order difference, this study uses cointegration method to explore whether there is a long-term relationship between variables. this study uses e-g two-step method for cointegration test and regression. the results show that the coefficients of shanghai stock index, china textile, and brent crude oil futures prices are significant and positive, except that the coefficients between shanghai stock index and brent crude oil futures prices are not significant. it can be seen that in the long run, the stock index has a positive correlation with the international crude oil futures prices. the granger causality test on the long-term cointegration variable group shows that there is a granger two-way causality between rts index, shanghai composite index, and brent crude oil futures price, while brent crude oil futures price is the granger cause of energy and fuel in china stock exchange, the textile industry in china stock exchange, russia industry, russia construction, russia energy and russia transportation are the granger cause of the origin brent crude oil futures prices. the vecm models of brent crude oil futures price and rts index, brent crude oil futures price and shanghai composite index, are established, respectively. the impulse response (figure 5) and variance decomposition results show that the international crude oil futures asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 79 price has considerable explanatory power to the volatility of rts index and most industry indices, but less explanatory power to the volatility of shanghai composite index. the volatility of china industry, china transportation, and china textile can be explained by crude oil futures price, but the volatility of china vehicle parts and china transportation can be explained by crude oil futures price more strongly, which indicates that crude oil futures price has a strong impact on the vehicle parts industry and the transportation industry. on the contrary, the composite index of china’s stock market and the industry index have less explanatory power to the fluctuation of international crude oil futures price. -0.4 0.0 0.4 0.8 1.2 1 2 3 4 5 6 7 8 9 10 response of brent to brent -0.4 0.0 0.4 0.8 1.2 1 2 3 4 5 6 7 8 9 10 response of brent to rts -0.4 0.0 0.4 0.8 1.2 1 2 3 4 5 6 7 8 9 10 response of brent to shanghai -0.4 0.0 0.4 0.8 1.2 1 2 3 4 5 6 7 8 9 10 response of brent to speurony -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of rts to brent -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of rts to rts -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of rts to shanghai -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of rts to speurony -20 0 20 40 60 80 1 2 3 4 5 6 7 8 9 10 response of shanghai to brent -20 0 20 40 60 80 1 2 3 4 5 6 7 8 9 10 response of shanghai to rts -20 0 20 40 60 80 1 2 3 4 5 6 7 8 9 10 response of shanghai to shanghai -20 0 20 40 60 80 1 2 3 4 5 6 7 8 9 10 response of shanghai to speurony -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of speurony to brent -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of speurony to rts -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of speurony to shanghai -5 0 5 10 15 1 2 3 4 5 6 7 8 9 10 response of speurony to speurony response to cholesky one s.d. innovations ?2 s.e. figure 5. impulse response graph after checking the long-term relationship among variables, in order to study the adjustment speed of variables when they deviate from the long-term trend, this study constructs an error correction model (ecm) through the first-order linear autoregressive distribution lag model. an ecm model based on cointegration theory is established for the variables without granger’s two-way causality by e-g two-step method. in the ecm model, all error correction coefficients are negative, indicating that the stock market has the function of reverse correction. the results of each variable group are similar, and the absolute values of error correction coefficients are small, which means that if the current fluctuation deviates from the long-term equilibrium, the reverse adjustment of error correction term is limited, i.e., the adjustment range of the error of crude oil futures price to the current explained variable fluctuation is small, and the influence is small. the results of parameter test show that the adjustment coefficients of crude oil futures price to other industry index fluctuations are not significant except china industry and russia energy, which indicates that there is a long-term asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 80 correlation between china industry and russia energy industry and international crude oil futures price. 5. conclusions and policy implications based on the data from april 24th, 2015 to april 20th, 2018, according to the characteristics of the data in the preliminary test, this study chooses different models to investigate the volatility spillover effect between international crude oil futures and china-russia stock markets, and explores the relationship between crude oil and stock markets by comparing the impact of international crude oil futures prices on china-russia stock markets. the results show that russia composite stock index is more affected by international crude oil futures prices, and the effectiveness of russian stock market is more obvious. rts index and shanghai stock exchange index are cointegrated with international crude oil futures prices. the results of variance decomposition show that the volatility of international crude oil futures price has greater explanatory power to the volatility of rts index. empirical results show that the composite index and industry index of chinese stock market are less sensitive to information, reaction speed, and digestion cycle than russian stock market. in the short run, the rise of international crude oil futures prices will aggravate the volatility of shanghai stock index, china industrial index and russia energy index, but the impact on other crude oil-related industries in china and russia is not obvious; in the long run, all indices are cointegrated with international crude oil futures prices. therefore, stabilizing international crude oil futures prices has a positive effect on stabilizing stock prices. based on the above conclusions, this study puts forward the following policy implications: since most of the factors affecting crude oil supply and demand are not controlled, the government needs to improve the financial supervision system to effectively control malicious speculation or malicious long (short) speculation, so as to stabilize the international crude oil price at an appropriate level. in addition, because chinese stock market is a weak efficient market (or even near an ineffective market), information is controlled by a few people, most ordinary investors find it difficult to obtain effective information through normal channels, and it is common that a large amount of funds manipulate the stock price. therefore, the relevant regulatory bodies of china’s stock market should strengthen the monitoring of the flow of large 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(2004). do high oil prices presage inflation? the evidence from g-5 countries. santa cruz center for international economics working paper, 39(2), 38-48. https://doi.org/10.2139/ssrn.509262 mork, k. a. (1989). oil and the macroeconomy when prices go up and down: an extension of hamilton’s results. journal of political economics, 97(3), 740-744. https://doi.org/10.1086/261625 qi, q., & zhu, h. (2011). econometrics study of relationship between international oil market and stock markets of china and usa (in chinese). financial theory and practice, 2011(7), 82-87. sadorsky, p. (2001). risk factors in stock returns of canadian oil and gas companies. energy economics, 23(1), 17-28. https://doi.org/10.1016/s0140-9883(00)00072-4 zhang, h. (2013). a comparative study of the impact of crude oil price fluctuations on stock prices: perspective of different industries and periods (in chinese). zhejiang university of technology. zhang, x., & wang, j. (2013). international comparison of the impact of crude oil price on stock market (in chinese). price theory and practice, 2013(1), 75-76. zhu, c. (2015). spillover effects among spot market, exchange rate market, and stock market with crude oil futures(in chinese). ocean university of china. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 82 zhuge, s., & hao, x. (2009). oil price shocks at home and abroad and chinese stock market (in chinese). china price, 2009(6), 41-44. microsoft word 14157-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 272 ajfa.macrothink.org determinants of systemic risk of banks in india mihir dash school of business, alliance university received: jan. 2, 2019 accepted: june 5, 2019 published: june 5, 2019 doi:10.5296/ajfa.v11i1.14157 url: https://doi.org/10.5296/ajfa.v11i1.14157 abstract this study examines the determinants of systemic risk for banks in india. the independent variables considered for the study include the sector, bank size, return on assets, beta, leverage, capital adequacy, non-performing assets, price to book value, deposits, loans & advances, investments, net interest income, and non-interest income. a mixed panel regression model was applied, with bank fixed effects and year random effects. the results of the study indicate that public sector banks have a much higher level of systemic impact than private sector banks. further, the determinants of systemic impact are different for public sector and private sector banks. the systemic impact of public sector banks was positively related with size and negatively related with price to book value ratio and investments to total assets ratio, while the systemic impact of private sector banks was negatively related with return on assets and positively related with beta and net interest income to total funds ratio. keywords: systemic risk, determinants, public sector banks, private sector banks. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 273 ajfa.macrothink.org introduction systemic risk represents the impact that the failure of a bank or financial institution would have on the entire financial system and/or economy, through its network of interlinked financial intermediaries. the failure of an institution leads to financial stress on institutions that have lent money to it, which in turn may lead to failure of some of these institutions. this leads to a kind of domino or ripple effect, and spreads across the entire financial system. the recent experience of the global financial crisis of 2008-09 and the subsequent euro-zone crises of 2010-11 has demonstrated the importance of measuring the level of systemic risk associated with different financial institutions and understanding the factors contributing to systemic risk. the collapse of some of the most prominent banks in the world, including the lehman brothers and washington mutual bank, along with several near-failures which had to be bailed out of crisis by the u.s. government, highlighted the significance of understanding, measuring, and monitoring systemic risk. several economists have suggested that undercapitalisation of large financial institutions can result in financial instability, particularly when the entire financial system is undercapitalised. this is leads to the concept of “too big to fail” (tbtf), i.e. that large financial institutions are so systemically important that they cannot be allowed to fail. a similar concept is that of “too interconnected to fail” (tictf), i.e. that financial institutions that are highly inter-connected with other institutions are very systemically important and so cannot be allowed to fail. a question that several authors have posed is: which financial institutions should be bailed out in the event of a solvency/liquidity crisis (e.g. acharya et al, 2012)? this logically requires identifying which institutions are critical to stability of the financial system, i.e. “systemically important.” according to the basel committee on banking supervision (bcbs), the concept of systemic importance should be measured in terms of the potential impact of the failure of a bank on the global financial system and wider economy, rather than just the risk that a failure can occur (moore and zhou, 2014). there are many theories suggesting that large and complex banks contribute to systemic risk. a possible root for the systemic importance of large, inter-connected banks is moral hazard; as regulators are reluctant to close or unwind large and complex banks, this leads banks to take on excessive risks in the expectation of government bailouts (e.g., farhi and tirole, 2012). another possibility is that of agency effects, i.e. that poor governance of large and complex banks can lead to bank managers engaging in non-traditional risky activities (for example, trading) and tend to be financed more through short-term debt, making them more vulnerable to liquidity shocks and market failures (e.g. laeven and levine, 2007; boot and ratnovski, 2012). the indian banking system, which was initially hailed to be unaffected by the crises, was affected indirectly, mainly on account of growing trade and financial integration with the global economy. though indian banks were not pushed to the point of insolvency, monitoring of systemic risk has become important in the dynamic banking environment in india in order to avoid potential system failure. this study examines the determinants of systemic risk for indian asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 274 ajfa.macrothink.org banks. the indian banking industry has two important segments, public sector banks and private sector banks. public sector banks are owned and controlled by the government, and are subjected to political interference and constraints. many studies have argued that private sector banks outperform public sector banks due to professional, efficient management, and better customer focus and service, particularly in terms of management soundness and earnings and profitability (dash and das, 2013; dash et al, 2015). in view of this, the determinants of systemic risk would be expected to differ between public sector and private sector banks. literature review measurement of systemic risk there are many definitions of systemic risk and systemic importance advocated in the literature, and many more approaches proposed for their measurement. adrian and brunnermeier (2008) was one of the first authors to suggest a measure for systemic risk, viz. the conditional value-at-risk (covar), which focuses on the tail distribiution. they were able to identify the contribution of each bank to systemic risk using this measure. acharya et al (2010a, 2010b) proposed the concept of systemic expected shortfall (ses), i.e. the amount by which a bank is undercapitalised in a systemic event in which the entire financial system is undercapitalised, to measure systemic risk. acharya and steffan (2012) extended the framework by introducing the concepts of marginal expected shortfall (mes), which measures the performance of a bank when the market return as a whole experiences its worst 5% trading days within a year, and the bank’s market leverage ratio (lvg), the market value of assets divided by the market value of equity. brownlees and engle (2012, 2017) and acharya et al (2012) suggested the srisk index, which estimates the expected capital shortage of a bank during on a substantial market meltdown, as a measure for systemic risk. hautsch et al (2013, 2015) used a parsimonius econometric approach to measure systemic risk, the realised systemic risk beta, viz. the total effect of a bank’s var on the var of the entire financial system, taking into account the bank’s network relationships. suh et al (2013) proposed a method for estimating systemic risk using credit default swaps. their method had the added advantage of being able to measure systemic risk contributions in both directions, i.e. the overall effect of systemic risk on individual credit risks and vice versa. karimalis and nomikos (2014) proposed a methodology for estimating the covar, i.e. the value-at-risk of the financial system conditional on the failure of a financial institution based on copula functions, and extended this approach to estimate other conditional risk measures such as conditional expected shortfall (coes). moore and zhou (2014) proposed the expected system loss (esl), viz. the expected loss to the financial system as a whole given that a particular bank fails, which they estimated using multivariate extreme value theory, as a measure of systemic importance of the bank. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 275 ajfa.macrothink.org hattori et al (2014) pointed out that systemic risk measures are essentially a form of scenario analysis, as they analyse the impact of certain types of assumed trigger events on the financial system, based on past patterns of failure; however, this may not be an indicator for robustness against future, unprecedented modes of failure. also, they argued that most market-based estimates of systemic risk may overestimate the importance of short-term changes. they suggested combining different systemic risk measures together with macro-stress testing scenarios, providing a wider range of potential sources of failure. van oordt and zhou (2015) analysed bank systemic risk into two dimensions, the level of bank tail risk and the linkage between the level of bank tail risk and severe financial shocks to the system. determinants of systemic risk several studies have analysed the determinants of systemic risk and systemic importance of banks. stolbov (2012) examined macro-determinants of systemic risk for some major economies. he found that gross government debt to gdp, state fragility index, eu membership, and world gross gdp share are key determinants of systemic risk for the sovereign cds prices, while stock market total value traded to gdp, state fragility index, and financial openness index are the key determinants of systemic risk in the stock market. moore and zhou (2014) found that size and non-traditional banking activities were the significant determinants of systemic importance of us banks in the period 2000-10; in particular, they found that banks above a certain size have equal systemic importance. bostandzic et al (2014) found that banks with higher levels of tier 1 capital had lower exposure and contribution to global systemic risk. further, they found that bank size and interconnectedness are positively related to global financial fragility. they also found that deposit insurance schemes that require banks and depositors to bear more financial risk are associated with greater vulnerability and contribution to a crisis of the financial sector. van oordt and zhou (2015) found that banks with higher non-performing loan ratios and lower profitability ratios tended to have higher tail risk, while larger banks, with higher trading revenue, and higher non-interest income tend to have higher systemic risk. laeven et al (2016) found that systemic risk increases with bank size and is inversely related with bank capital; in particular, low capital in large banks is the key driver of systemic risk. further, they found that market-based activities and country characteristics have moderating effect on these relationships. anghelache and oanea (2016) found that financial leverage, size, risk, and market to book value had a significant impact on systemic risk contribution of romanian commercial banks. methodology the objective of the study is to analyse the determinants of systemic risk for banks in india. due to the wide differences in performance between public sector and private sector banks, the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 276 ajfa.macrothink.org determinants of systemic risk would be expected to differ between public sector and private sector banks. the study was conducted using sample of thirty-one indian banks, including twenty-one public sector banks, and ten private sector banks. the list of sample banks is given in the table below. public sector banks private sector banks allahabad bank axis bank ltd andhra bank federal bank ltd bank of baroda hdfc bank ltd bank of india icici bank ltd bank of maharashtra indusind bank ltd canara bank jammu & kashmir bank ltd central bank of india karnataka bank ltd corportaion bank karur vysya bank ltd dena bank kotak mahindra bank ltd idbi bank ltd yes bank ltd indian overseas bank punjab & sind bank punjab national bank state bank of bikaner & jaipur state bank of india state bank of mysore state bank of travancore syndicate bank united commercial bank union bank of india vijaya bank the data pertaining to bank characteristics was collected from the capitaline database1. the srisk estimates were collected from nyu stern’s v-lab database2. the study period was 2007-16. the dependent variable considered for the study is the measure of systemic risk proposed by brownlees and engle (2012), srisk. this index measures the expected capital shortage faced by a bank during a period of system distress when the market declines substantially. it is estimated as 𝑆𝑅𝐼𝑆𝐾 , = 𝑘𝐷 , − (1 − 𝑘)𝑊 , (1 − 𝐿𝑅𝑀𝐸𝑆 , | 𝐶 | ), where k is the minimum fraction of capital (as a ratio of total assets) each bank needs to hold, di,t and wi,t are the book value of its debt (total liabilities) and the market value of its equity, 1 www.capitaline.com 2 https://vlab.stern.nyu.edu/analysis/risk.worldfin-mr.gmes asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 277 ajfa.macrothink.org respectively, and the long-run marginal expected shortfall lrmes is defined as the tail expectation of the firm’s equity return conditional on a market decline 𝐿𝑅𝑀𝐸𝑆 , | = −𝐸 𝑅 , | 𝑅 , | < 𝐶 . note that srisk can take negative values. a bank with negative srisk represents a wellcapitalised bank with large enough capital buffers to easily absorb systemic shocks. the total systemic risk in the financial system is measured by aggregating the positive srisk contributions of different financial institutions. the independent variables considered for the study ae discussed in the following. the most common determinant for systemic risk is that of bank size, and the commonly-used proxy for size is the logarithm of the bank’s total assets (see for example, laeven et al, 2014). the systemic risk of a bank would be expected to increase with bank size. this reflects the “too big to fail” hypothesis, that the failure of a large bank would have too a great impact on the entire financial system, so that government should intervene to prevent such a failure. another common determinant is capital adequacy (laeven et al, 2014). the measure for capital adequacy used for the study is the capital adequacy ratio. it is expected that higher levels of capital adequacy would be associated with a lower systemic impact. non-performing loans is an important determinant (van oordt and zhou, 2015), and would be expected to play a role in increasing systemic risk particularly for public sector banks. the measure considered in the study is the net non-performing loans to net advances. two other important determinants are beta and leverage (anghelache and oanea, 2016). these have also been included in the present study. both would be expected to be positively related with systemic impact. bank profitability may also be related with systemic impact. in the present study, it is measured by the return on assets of the bank. non-interest income has been found to be a significant determinant of systemic impact in several studies (moore and zhou, 2013; van oordt and zhou, 2015), positively related with systemic impact. this was measured in the present study using the non-interest income to total funds ratio. along with this, the net interest income to total funds ratio is also considered. laeven et al (2014) have also considered deposits to total assets and loans & advances to total assets in their analysis. these have also been included in the present study, along with investments to total assets. bostandzic et al (2014) have also considered the valuation ratios as potential determinants of systemic impact. the price to book value ratio has been considered in the present study. the study used a mixed panel regression model for explaining systemic risk, formulated as follows: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 278 ajfa.macrothink.org 𝑆𝑅𝐼𝑆𝐾 , = 𝑎 + ∑ 𝑏 (1 + 𝑆)𝑥 , + ∑ 𝑐 𝐷 + ∑ 𝑑 𝐷 + 𝜖 , , where the dependent variable on the lhs is the srisk of the ith bank at time point t, xi,t are the independent variables for the ith bank at time point t, s represents a dummy variable for public sector banks (s = 1) against private sector banks (s = 0), the di represent the individual bank dummies, in order to capture the bank fixed effect, and the dt represent the year dummies, in order to capture the year random effect. findings the descriptive statistics for the variables are presented in table 1 below. table 1. descriptive statistics of srisk and its determinants private sector public sector mean st. dev. min max mean st. dev. min max srisk ($ m) -2841.41 5079.93 -25319 3100 1940.70 2120.98 -122 14521 ln(total assets) 13.63 1.11 11.62 15.80 14.32 0.86 12.50 16.93 return on assets 1.39 0.40 0.34 2.02 0.72 0.51 -1.25 2.50 beta 0.84 0.27 0.24 1.57 0.80 0.22 0.22 1.41 leverage 8.50 6.05 1.89 27.68 29.31 15.92 7.83 103.85 capital adequacy ratio 14.78 2.33 11.03 22.46 11.92 1.05 9.44 15.00 net non-performing assets to net advances 0.83 0.81 0.00 4.31 1.99 1.77 0.15 11.89 price to book value ratio 2.47 1.79 0.46 9.58 0.87 0.42 0.26 2.70 deposits to total assets 0.76 0.11 0.52 0.90 0.84 0.05 0.42 0.91 loans & advances to total assets 0.58 0.04 0.47 0.68 0.62 0.03 0.51 0.70 investments to total assets 0.30 0.04 0.20 0.43 0.26 0.03 0.16 0.34 net interest income to total funds 3.15 0.86 1.07 5.62 2.46 0.52 0.59 3.66 non-interest income to total funds 1.61 0.52 0.52 2.63 0.97 0.27 0.45 1.83 the private sector banks had a negative average srisk and a negatively-skewed distribution of srisk, while the public sector banks had a positive average srisk and a positively-skewed distribution of srisk. private sector banks also had higher return on assets, capital adequacy, price to book value ratios, net interest income to total funds, and non-interest income to total funds than public sector banks, while public sector banks had higher leverage and net nonperforming assets to net advances than private sector banks. there was not much of a difference between public and private sector banks in terms of size, beta, deposits to total assets, loans & advances to total assets, and investments to total assets. the results of the panel regression are presented in tables 2 and 3 below. table 2 presents the summary of statistical tests for groups and covariates, while table 3 presents the parameter estimates and significance. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 279 ajfa.macrothink.org table 2. tests of between-subjects effects dependent variable: srisk ($ m) model i model ii source f stat p-value f stat p-value intercept 7.078 0.008 16.165 0.000 bank 8.586 0.000 15.359 0.000 year 4.310 0.000 5.710 0.000 ln(total assets) 9.330 0.003 11.150 0.001 sector * ln(total assets) 28.447 0.000 78.262 0.000 return on assets 14.857 0.000 25.459 0.000 sector * return on assets 13.317 0.000 15.552 0.000 beta 34.197 0.000 46.760 0.000 sector * beta 21.806 0.000 33.223 0.000 leverage 1.954 0.163 1.941 0.165 sector * leverage 4.057 0.045 4.391 0.037 capital adequacy ratio 0.591 0.443 sector * capital adequacy ratio 0.820 0.366 net non-performing assets to net advances 0.000 0.993 sector * net non-performing assets to net advances 1.084 0.299 price to book value ratio 14.025 0.000 17.062 0.000 sector * price to book value ratio 11.546 0.001 15.256 0.000 deposits to total assets 0.892 0.346 2.323 0.129 sector * deposits to total assets 5.737 0.017 5.098 0.025 loans & advances to total assets 3.574 0.060 sector * loans & advances to total assets 1.233 0.268 investments to total assets 3.091 0.080 sector * investments to total assets 0.082 0.775 net interest income to total funds 8.432 0.004 6.576 0.011 sector * net interest income to total funds 9.893 0.002 6.955 0.009 non-interest income to total funds 0.913 0.340 sector * non-interest income to total funds 0.978 0.324 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 280 ajfa.macrothink.org table 3. parameter estimates dependent variable: srisk ($ m) parameter coeff t stat p-value coeff t stat p-value intercept 4397.226 0.257 0.797 -10578.643 -0.852 0.395 allahabad bank -76113.340 -4.481 0.000 -70040.480 -6.933 0.000 andhra bank -74703.558 -4.447 0.000 -68478.262 -6.895 0.000 axis bank ltd -3637.858 -2.230 0.027 -3469.793 -2.294 0.023 bank of baroda -79996.195 -4.608 0.000 -73454.769 -6.868 0.000 bank of india -78701.873 -4.537 0.000 -72351.973 -6.820 0.000 bank of maharashtra -73313.242 -4.409 0.000 -67396.971 -6.906 0.000 canara bank -78607.887 -4.521 0.000 -72674.861 -6.863 0.000 central bank of india -76482.713 -4.487 0.000 -70938.551 -6.917 0.000 corporation bank -75233.326 -4.459 0.000 -69225.172 -6.928 0.000 dena bank -73311.008 -4.425 0.000 -66986.663 -6.895 0.000 federal bank ltd 1974.807 1.447 0.149 1783.790 1.481 0.140 hdfc bank ltd -14842.406 -7.445 0.000 -13858.932 -7.273 0.000 icici bank ltd -9110.329 -3.916 0.000 -8845.393 -4.288 0.000 idbi bank ltd -76973.519 -4.515 0.000 -71788.620 -7.102 0.000 indian overseas bank -76908.534 -4.523 0.000 -70738.764 -6.956 0.000 indusind bank ltd -456.462 -0.469 0.639 -31.621 -0.037 0.971 jammu & kashmir bank ltd/the 4129.962 2.244 0.026 5258.616 3.245 0.001 karnataka bank ltd/the 3002.203 2.006 0.046 3046.984 2.278 0.024 karur vysya bank ltd/the 6283.394 3.750 0.000 5914.837 4.157 0.000 kotak mahindra bank ltd -6245.489 -4.194 0.000 -6393.232 -4.480 0.000 punjab & sind bank -71849.270 -4.363 0.000 -65983.535 -6.852 0.000 punjab national bank -79229.726 -4.530 0.000 -73249.639 -6.838 0.000 state bank of bikaner & jaipur -72529.804 -4.385 0.000 -65696.653 -6.836 0.000 state bank of india -78764.352 -4.310 0.000 -72869.284 -6.336 0.000 state bank of mysore -71165.576 -4.319 0.000 -64565.665 -6.790 0.000 state bank of travancore -72212.815 -4.357 0.000 -66164.736 -6.863 0.000 syndicate bank -76269.478 -4.495 0.000 -70422.623 -6.922 0.000 united commercial bank -75788.491 -4.486 0.000 -70006.842 -6.934 0.000 union bank of india -77423.677 -4.495 0.000 -71365.530 -6.860 0.000 vijaya bank -74417.073 -4.475 0.000 -68716.606 -7.024 0.000 yes bank ltd 0a 0a [year=2007] 6722.166 4.062 0.000 7065.554 4.861 0.000 [year=2008] 6388.592 4.283 0.000 6702.933 5.156 0.000 [year=2009] 5575.231 4.254 0.000 5793.970 5.238 0.000 [year=2010] 4680.356 4.150 0.000 4689.801 4.862 0.000 [year=2011] 4913.351 4.730 0.000 4849.746 5.649 0.000 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 281 ajfa.macrothink.org [year=2012] 4049.743 4.963 0.000 3671.839 5.644 0.000 [year=2013] 2428.967 3.468 0.001 1952.050 3.460 0.001 [year=2014] 1573.958 2.660 0.008 1002.343 2.099 0.037 [year=2015] 566.039 1.070 0.286 412.203 0.874 0.383 [year=2016] 0a 0a ln(total assets) 5066.337 4.252 0.000 5462.618 5.254 0.000 [sector=0] * ln(total assets) -4332.851 -5.334 0.000 -5020.016 -8.847 0.000 [sector=1] * ln(total assets) 0a 0a return on assets -131.243 -0.242 0.809 -683.160 -1.723 0.086 [sector=0] * return on assets -3871.904 -3.649 0.000 -2838.175 -3.944 0.000 [sector=1] * return on assets 0a 0a beta 2302.747 2.292 0.023 2342.717 2.377 0.018 [sector=0] * beta 6221.938 4.670 0.000 7214.696 5.764 0.000 [sector=1] * beta 0a 0a leverage -17.468 -1.138 0.256 -19.551 -1.294 0.197 [sector=0] * leverage 131.409 2.014 0.045 129.460 2.096 0.037 [sector=1] * leverage 0a 0a capital adequacy ratio 10.027 0.070 0.944 [sector=0] * capital adequacy ratio -165.643 -0.905 0.366 [sector=1] * capital adequacy ratio 0a net non-performing assets to net advances 256.942 1.512 0.132 [sector=0] * net non-performing assets to net advances -509.354 -1.041 0.299 [sector=1] * net non-performing assets to net advances 0a price to book value ratio -2492.467 -3.717 0.000 -2732.728 -4.170 0.000 [sector=0] * price to book value ratio 2353.533 3.398 0.001 2657.621 3.906 0.000 [sector=1] * price to book value ratio 0a 0a deposits to total assets 5194.245 1.046 0.297 2474.266 .540 0.589 [sector=0] * deposits to total assets -17527.892 -2.395 0.017 -15445.471 -2.258 0.025 [sector=1] * deposits to total assets 0a 0a loans & advances to total assets -6438.208 -0.856 0.393 [sector=0] * loans & advances to total assets -16477.730 -1.110 0.268 [sector=1] * loans & advances to total assets 0a investments to total assets -15264.478 -1.902 0.058 [sector=0] * investments to total assets 3935.368 0.286 0.775 [sector=1] * investments to total assets 0a asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 282 ajfa.macrothink.org net interest income to total funds 1.879 0.004 0.997 27.788 0.057 0.954 [sector=0] * net interest income to total funds 2338.908 3.145 0.002 1827.424 2.637 0.009 [sector=1] * net interest income to total funds 0a 0a non-interest income to total funds 1199.327 1.346 0.180 [sector=0] * non-interest income to total funds -1161.044 -0.989 0.324 [sector=1] * non-interest income to total funds 0a a. this parameter is set to zero because it is redundant. there were several significant factors in the model. the bank fixed effects were found to be significant, indicating that there were significant differences in systemic impact between the banks. in particular, the banks with highest systemic impact were karur vysaya bank, jammu and kashmir bank, and karnataka bank (all of which are private sector banks), while the banks with least systemic impact were bank of baroda, punjab national bank, and state bank of india (all of which are public sector banks). the year random effects were also found to be significant, indicating significant differences in systemic impact over time. of course, systemic impact was highest in the crisis period of 2007-09, and there was found to be a significant decrease in systemic impact in 2015-16 as compared with previous years. this could be the result of tightening of capital regulations with the implementation of the basel iii norms from 2013. bank size was found to be significant and positively related with systemic impact; however, for private sector banks, the relationship was not significant. return on assets was found to be not significant; however, for private sector banks, return on assets was significant and negatively related with systemic impact. beta was found to be significant and positively related with systemic impact, and was more influential for private sector banks than for public sector banks. leverage was found to be not significant; however, for private sector banks, leverage was significant and positively related with systemic impact. price to book value ratio was found to be significant and negatively related with systemic impact; however, for private sector banks, the relationship was not significant. deposits to total assets was found to be not significant; however, for private sector banks, deposits to total assets was significant and negatively related with systemic impact. net interest income to total funds was found to be not significant; however, for private sector banks, net interest income to total funds was significant and positively related with systemic impact. finally, capital adequacy ratio, net non-performing assets to net advances, loans & advances to total assets, investments to total assets, and non-interest income to total funds were found to be not significant. the results of the panel regression for public sector banks are presented in tables 4 and 5 below. table 4 presents the summary of statistical tests for groups and covariates, while table 5 presents the parameter estimates and significance. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 283 ajfa.macrothink.org table 4. tests of between-subjects effects (public sector banks) dependent variable: srisk ($ m) source f stat p-value intercept 9.594 0.002 bank 4.349 0.000 year 2.749 0.005 ln(total assets) 12.073 0.001 return on assets 0.423 0.517 beta 2.679 0.104 leverage 2.274 0.134 capital adequacy ratio 0.002 0.965 net non-performing assets to net advances 0.000 0.985 price to book value ratio 30.831 0.000 deposits to total assets 1.376 0.243 loans & advances to total assets 0.283 0.595 investments to total assets 4.275 0.040 net interest income to total funds 0.578 0.448 non-interest income to total funds 1.328 0.251 table 5. parameter estimates (public sector banks) dependent variable: srisk ($ m) parameter coeff t stat p-value intercept -71514.348 -3.165 0.002 allahabad bank -1636.940 -1.490 0.138 andhra bank -498.757 -0.662 0.509 bank of baroda -5312.641 -2.351 0.020 bank of india -3961.561 -1.796 0.075 bank of maharashtra 885.432 1.439 0.152 canara bank -3998.239 -1.922 0.056 central bank of india -1851.295 -1.293 0.198 corporation bank -789.810 -0.917 0.361 dena bank 1155.592 1.930 0.055 idbi bank ltd -2325.580 -1.312 0.191 indian overseas bank -2119.980 -1.557 0.122 punjab & sind bank 2290.483 2.409 0.017 punjab national bank -4745.687 -1.930 0.055 state bank of bikaner & jaipur 1528.728 1.893 0.060 state bank of india -4157.103 -0.987 0.325 state bank of mysore 3082.076 3.305 0.001 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 284 ajfa.macrothink.org state bank of travancore 1802.566 2.713 0.007 syndicate bank -2135.242 -1.753 0.082 united commercial bank -1231.812 -1.160 0.248 union bank of india -2984.208 -1.779 0.077 vijaya bank 0a [year=2007] 5795.819 2.747 0.007 [year=2008] 5619.692 2.895 0.004 [year=2009] 3876.008 2.379 0.019 [year=2010] 3913.768 2.838 0.005 [year=2011] 3228.041 2.742 0.007 [year=2012] 2342.197 2.710 0.007 [year=2013] 1449.163 2.124 0.035 [year=2014] 326.312 0.604 0.547 [year=2015] -415.003 -0.830 0.408 [year=2016] 0a ln(total assets) 5198.187 3.475 0.001 return on assets -250.612 -0.650 0.517 beta 1290.967 1.637 0.104 leverage -16.780 -1.508 0.134 capital adequacy ratio -4.500 -0.044 0.965 net non-performing assets to net advances -2.493 -0.019 0.985 price to book value ratio -2920.455 -5.553 0.000 deposits to total assets 4212.420 1.173 0.243 loans & advances to total assets -2880.443 -0.532 0.595 investments to total assets -11938.625 -2.068 0.040 net interest income to total funds 322.384 0.760 0.448 non-interest income to total funds 747.846 1.153 0.251 a. this parameter is set to zero because it is redundant. for the public sector banks, the bank fixed effects were again found to be significant, indicating that there were significant differences in systemic impact between the banks. in particular, the banks with highest systemic impact were state bank of mysore, punjab & sind bank, and state bank of travancore, while the banks with least systemic impact were bank of baroda, punjab national bank, and state bank of india. the year random effects were also found to be significant, again indicating a significant decrease in systemic impact in 2015-16 as compared with previous years. further, for the public sector banks, bank size was found to be significant and positively related with systemic impact, while price to book value ratio and investments to total assets ratio were found to be significant and negatively related with systemic impact. the other variables were not significantly related with systemic impact. the results of the panel regression for private sector banks are presented in tables 4 and 5 below. table 4 presents the summary of statistical tests for groups and covariates, while table 5 presents the parameter estimates and significance. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 285 ajfa.macrothink.org table 6. tests of between-subjects effects (private sector banks) dependent variable: srisk ($ m) source f stat p-value intercept 0.024 0.877 bank 10.667 0.000 year 2.884 0.006 ln(total assets) 1.661 0.202 return on assets 8.509 0.005 beta 18.668 0.000 leverage 0.020 0.888 capital adequacy ratio 0.146 0.704 net non-performing assets to net advances 0.411 0.524 price to book value ratio 0.000 0.994 deposits to total assets 1.134 0.291 loans & advances to total assets 0.024 0.877 investments to total assets 10.667 0.000 net interest income to total funds 2.884 0.006 non-interest income to total funds 1.661 0.202 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 286 ajfa.macrothink.org table 7. parameter estimates (private sector banks) dependent variable: srisk ($ m) parameter coeff t stat p-value intercept -7473.603 -0.273 0.785 axis bank ltd -5928.249 -2.223 0.030 federal bank ltd 2719.082 1.295 0.200 hdfc bank ltd -17370.329 -5.311 0.000 icici bank ltd -12577.122 -3.244 0.002 indusind bank ltd -895.387 -0.555 0.581 jammu & kashmir bank ltd/the 5842.883 1.985 0.051 karnataka bank ltd/the 4870.375 2.077 0.042 karur vysya bank ltd/the 8118.748 3.035 0.003 kotak mahindra bank ltd -6581.768 -2.924 0.005 yes bank ltd 0a [year=2007] 8448.572 2.765 0.007 [year=2008] 7777.578 2.960 0.004 [year=2009] 9369.069 3.805 0.000 [year=2010] 6195.154 2.901 0.005 [year=2011] 7651.405 3.710 0.000 [year=2012] 7039.089 4.045 0.000 [year=2013] 3936.757 2.454 0.017 [year=2014] 3357.982 2.443 0.017 [year=2015] 1173.581 1.014 0.314 [year=2016] 0a ln(total assets) 1813.567 1.289 0.202 return on assets -3963.675 -2.917 0.005 beta 9623.341 4.321 0.000 leverage -16.043 -0.142 0.888 capital adequacy ratio -68.630 -0.382 0.704 net non-performing assets to net advances 457.091 0.641 0.524 price to book value ratio -2.145 -0.007 0.994 deposits to total assets -8651.957 -1.065 0.291 loans & advances to total assets -31624.452 -1.568 0.122 investments to total assets -24602.327 -1.280 0.205 net interest income to total funds 1980.436 2.270 0.027 non-interest income to total funds 596.284 0.460 0.647 a. this parameter is set to zero because it is redundant. for the private sector banks, the bank fixed effects were again found to be significant, indicating that there were significant differences in systemic impact between the banks. in particular, the banks with highest systemic impact were karur vysaya bank, jammu and kashmir bank, and karnataka bank, while the banks with least systemic impact were hdfc asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 287 ajfa.macrothink.org bank, icici bank, and kotak mahindra bank. the year random effects were also found to be significant, again indicating a significant decrease in systemic impact in 2015-16 as compared with previous years. further, for the private sector banks, return on assets was found to be significant and negatively related with systemic impact, while beta and net interest income to total funds ratio were found to be significant and positively related with systemic impact. the other variables were not significantly related with systemic impact. discussion the results of the study have identified some banks with relatively high systemic impact, viz. karur vysaya bank, jammu and kashmir bank, and karnataka bank. these banks must be monitored more carefully, and perhaps may be required to hold more capital or liquid assets to avert crisis. the results of the study also suggest that systemic risk of indian banks has been declining significantly from 2013. this is perhaps the result of higher capital controls by the rbi with the phased implementation of basel iii norms in india. the results of the study indicate that public sector banks have a much higher level of systemic impact than private sector banks. further, the determinants of systemic impact are different for public sector and private sector banks. the systemic impact of public sector banks was positively related with size and negatively related with price to book value ratio and investments to total assets ratio, while the systemic impact of private sector banks was negatively related with return on assets and positively related with beta and net interest income to total funds ratio. the presence of a size effect for systemic impact in the case of public sector banks suggests that consolidation for public sector banks may increase instability of the financial system. this is not the case for private sector banks, so that private sector bank mergers may be beneficial for systemic risk. this would, however, need to be studied in greater detail. several of the findings are similar to those in the literature. bank size was found to be significant and positively related with systemic impact for public sector banks, as suggested by several authors (moore and zhou, 2014; laeven et al, 2016). return on assets was found to be significant and negatively related with systemic impact for private sector banks, which is related to the findings of van oordt and zhou (2015). beta was found to be significant and positively related with systemic impact, which is related to the findings of anghelache and oanea (2016). leverage was found to be significant and positively related with systemic impact for private sector banks, as suggested by anghelache and oanea (2016). price to book value ratio was found to be significant and negatively related with systemic impact for public sector banks, as suggested by anghelache and oanea (2016). some findings have not been discussed previously in the literature. for example, deposits to total assets was found to be significant and negatively related with systemic impact for private sector banks; on the other hand, loans & advances to total assets and investments to total assets were not significant. also, net interest income to total funds was found to be significant and positively related with systemic impact for private sector banks. on the other hand, some of the findings are contrary to the literature; asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 288 ajfa.macrothink.org for example, non-interest income to total funds were found to be not significant, contrary to the finding of moore and zhou (2014). finally, two important variables, capital adequacy ratio and net non-performing assets to net advances, were found to be not significant, contrary to the findings of laeven et al (2016) and van oordt and zhou (2014), respectively. the results of the study suggest that capital adequacy does not have much of an effect on systemic impact, which is contrary to economic logic. this would have to be investigated further to understand the interlinkage between capital adequacy, leverage, liquidity, and other relevant variables. in particular, this would have important policy implications for the regulation of bank capital and leverage. there are some limitations inherent in the study. the sample considered for the study was relatively small, and consisted of the relatively larger indian banks. also, the global financial crisis and euro-zone crises had taken place during the study period, possibly contaminating the results. further, there could be some multicollinearity between the variables, since many of the measures considered are related. for example, capital adequacy has improved in recent years, so that the significance of capital adequacy could have been affected by the year random effect. the results of the study thus need to be tested for robustness. references acharya, v.v., brownlees, c., engle, r., farazmand, f., & richardson, m. (2010). measuring systemic risk. in regulating wall street: the dodd-frank act and the new architecture of global finance, edited by acharya, v.v., cooley, t., richardson, m., and walter, i., john wiley & sons. https://doi.org/10.1002/9781118258231 acharya, v.v., engle, r.f., & richardson, m. (2012). capital shortfall: a new approach to ranking and regulating systemic risks. presented at the american economic association meeting held at chicago, illinois, usa on jan 7, 2012. https://doi.org/10.1257/aer.102.3.59 acharya, v.v., pedersen, l., philippon, t., & richardson, m. (2010). measuring systemic risk. nyu stern working paper. https://doi.org/10.26509/frbc-wp-201002 acharya, v.v., & steffen, s. (2012). analyzing systemic risk of the european banking sector. nyu stern working paper. in handbook on systemic risk, edt. j.-pfouque and j. langsam. cambridge university press adrian, t., & brunnermeier, m.k. (2008). covar. federal reserve bank of new york staff report no. 348. https://doi.org/10.2139/ssrn.1269446 anghelache, g.-v., & oanea, d.-c. (2016). romanian commercial banks’ systemic risk and its determinants: a covar approach. international journal of academic research in accounting, finance and management sciences, 6(3), 96-109. https://doi.org/10.6007/ijarafms/v6-i3/2175 boot, a.w.a., & ratnovski, l. (2012). banking and trading. international monetary fund working paper no. 12/238. https://doi.org/10.5089/9781475511215.001 bostandzic, d., pelster, m., & weiss, g.n.f. (2014). systemic risk, bank capital, and deposit asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 289 ajfa.macrothink.org insurance around the world. ssrn working paper no. 2438693. https://doi.org/10.2139/ssrn.2438693 brownlees, c.t., & engle, r.f. (2012). volatility, correlation and tails for systemic risk measurement. nyu stern working paper. https://doi.org/10.2139/ssrn.1611229 brownlees, c.t., & engle, r.f. (2017). srisk: a conditional capital shortfall model for systemic risk. european systemic risk board working paper. https://doi.org/10.1093/rfs/hhw060 dash, m., & das, a. (2013). performance appraisal of indian banks using camels rating. iup journal of bank management, 12(2), 31-42. dash, m., kumari, g., & anand, s. (2015). comparison of public and private sector banking performance using camels framework. management todayan international journal of management studies, 5(3), 107-112. https://doi.org/10.11127/gmt.2015.09.02 farhi, e., & tirole, j. (2012). collective moral hazard, maturity mismatch and systemic bailouts. american economic review, 12(1), 60-93. https://doi.org/10.1257/aer.102.1.60 hattori, a., kikuchi, k., niwa, f., & uchida, y. (2014). a survey of systemic risk measures: methodology and application to the japanese market. imes discussion paper series, no. 2014-e-3. hautsch, n., schaumburg, j., & schienle, m. (2013). forecasting systemic impact in financial networks. syrto working paper series, paper no. 16/2013. https://doi.org/10.2139/ssrn.2315827 hautsch, n., schaumburg, j., & schienle, m. (2015). financial network systemic risk contributions. review of finance, 19(2), 685-738. https://doi.org/10.1093/rof/rfu010 hendricks, d., kambhu, j., & mosser, p. (2006). systemic risk and the financial system: background paper. nas-frbny conference on new directions in understanding systemic risk held at federal reserve bank of new york on may 18, 2006. karimalis, e.n., & nomikos, n. (2014). measuring systemic risk in the european banking sector: a copula covar approach. cass business school working paper. laeven, l., & levine, r. (2007). is there a diversification discount in financial conglomerates?” journal of financial economics, 85, 331-367. https://doi.org/10.1016/j.jfineco.2005.06.001 laeven, l., ratnovski, l., & tong, h. (2016). bank size, capital, and systemic risk: some international evidence. journal of banking and finance, 69(1), s25-s34. https://doi.org/10.1016/j.jbankfin.2015.06.022 moore, k., & zhou, c. (2014). the determinants of systemic importance. systemic risk centre, london school of economics, discussion paper no. 19. stolbov, m. (2017). assessing systemic risk and its determinants for advanced and major emerging economies: the case of δcovar. international economics and economic policy, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 290 ajfa.macrothink.org 14(1), 119-142. https://doi.org/10.1007/s10368-015-0330-2 suh, s., jang, i., & ahn, m. (2013). a simple method for measuring systemic risk using credit default swap market data. journal of economic development, 38(4), 75-100. van oordt, m.r.c., & zhou, c. (2015). systemic risk and bank business models. de nederlandsche bank working papers, paper no. 442. https://doi.org/10.2139/ssrn.2509314 microsoft word 9129-33376-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 152 modelling and estimation of volatility using arch/garch models in jordan’s stock market dana al-najjar dept. of finance and banking, applied science university po box 166, amman postal code 11931, jordan tel: 962-777-476-164 e-mail: dr.danaalnajjar@gmail.com received: march 1, 2016 accepted: april 30, 2016 published: june 1, 2016 doi:10.5296/ajfa.v8i1.9129 url: http://dx.doi.org/10.5296/ajfa.v8i1.9129 abstract financials have been concerned constantly with factors that have impact on both taking and assessing various financial decisions in firms. hence modelling volatility in financial markets is one of the factors that have direct role and effect on pricing, risk and portfolio management. therefore, this study aims to examine the volatility characteristics on jordan’s capital market that include; clustering volatility, leptokurtosis, and leverage effect. this objective can be accomplished by selecting symmetric and asymmetric models from garch family models. this study applies; arch, garch, and egarch to investigate the behavior of stock return volatility for amman stock exchange (ase) covering the period from jan. 1 2005 through dec.31 2014. the main findings suggest that the symmetric arch /garch models can capture characteristics of ase, and provide more evidence for both volatility clustering and leptokurtic, whereas egarch output reveals no support for the existence of leverage effect in the stock returns at amman stock exchange. keywords:times series, garch models, modelling volatility, leverage effect, emerging markets, jordan. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 153 1. introduction financial markets are considered to have a keen role in economic conditions for countries worldwide. in this regard one of the major aspects of the financial markets is to model and estimate financial market volatility caused by its importance as an indicator for the dynamic fluctuations in stock prices (raja and selvam, 2011). thus volatility is considered to be a measure of uncertainty for changes in asset prices, and it was used earlier by markowitz (1952) as a measure of risk. during the last three decades there were continuous need to find out accurate measurement of volatility due to its vital role in pricing assets, risk and portfolio management (goudarzi, 2011; ezzat, 2012; gokbulut and pekkaya, 2014). consequently, modelling volatility will improve the usefulness of stock prices as an appropriate signal for intrinsic value of securities; thereby better modelling gives us better prediction that in the end will provide practitioners and academics with more accurate pricing models for financial assets. that all in return will make it easier for different interested parties such as investors, managers, and policy makers to take various financial decisions such as raising capital, and investment decisions in financial markets (emenike, 2010). moreover, early studies by mandelbrot (1963), fama (1965), and black (1976), side by side with the recent numerous studies such as poterba and summer (1986), tse (1991), mcmillan et.al (2000), najand (2002), lee(2009), emenike (2010), and ezzat(2012); all have documented evidence showing that financial time series does exhibit both volatility clustering and leptokurtosis. regarding the occurrence of volatility clustering it is when large changes in stock prices are followed by large changes in price of both signs, and vice versa, i.e. the small price changes are followed by periods of small changes in prices. on the other hand, the case of non-normal distribution of financial return which tends to be fat tailed is called leptokurtosis. furthermore, studies such as kosapattarapim et.al (2011), rousan and al khouri (2005), liu and huang (2010), freedi et.al (2012), and gokbulut and pekkaya (2014); observed new insights encountered in time series studies that is leverage effect (asymmetric) that was first detected by black (1976). it occurs when stock return tends to have a negative correlation with changes in volatility, i.e. volatility is expected to rise in response to bad news and fall in response to good news. in accordance to the aforementioned, all those characteristics accompanied with financial time series especially the part related to the estimation of volatility drives us away from linear models into searching for more appropriate statistical models. thus, a study by engle (1982) proposed to model time varying conditional variance through applying auto regressive conditional heteroscedasticity process (arch), which is expected to capture mainly the dynamic behavior of conditional variance using lagged disturbance. in the same vein, study by bollerselev (1986) suggested one step forward to overcome the problem related to the arch model regarding the number of parameters, by applying generalized auto regressive conditional heteroscedasticity (garch) model; in this way asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 154 instead of having infinite parameters using arch models, we can reduce the number into only two parameters in garch model. accordingly, both arch and garch models that were proposed by engle (1982) and bollerslev (1986) respectively, can capture simultaneously volatility clustering and leptokurtosis. so in return they have been widely employed in financial markets analysis studies. but on the other hand, they both fail to capture the leverage effect. hence, nelson (1991) proposed one of the extended arch models by using exponential generalized auto regressive conditional heteroscedasticity well known as (egarch) model, in order to track the asymmetric shocks of the conditional variance (gokcan, 2000; su, 2010; abd al aal, 2011; ezzat, 2012; freedi et. al, 2012). in regards to this study it aims to contribute to the available literature in that it adds new updated daily return gathered from one of the emerging economies which is jordan; to investigate the behavior of stock return volatility for amman stock exchange general index (asei) during the period from 2005-2014 which covers the period of both recent financial crisis that affected all economies worldwide, also arab spring revolutions in the middle east region. in addition this paper adopts garch model to capture the nature of volatility and employs exponential garch (egarch) for capturing asymmetry in volatility clustering and the leverage effect in jordan’s capital market for the period of 20052014. the remainder of this paper is organized as follows; section 2 literature review, section 3 methodology, section 4 analytical analysis and empirical results, and section 5 concluding remarks. 2. literature review the main early highlight studies to mention volatility clustering. leptokurtosis, and leverage effect of stock return in financial market was provided by the following three studies of; mandelbrot (1963), fama (1965), and black (1976). measuring and estimating the stock prices volatility is an important concept in finance in general, and in investment decisions in specific, due to its dynamic behavior. that led researchers to propose multiple mathematical and statistical models to capture volatility of stock return in financial markets worldwide. the pioneering studies in this field are referred to engle (1982), and bollerslev (1986) who proposed the use of both arch and garch models respectively. this section will provide brief review for the main empirical findings provided by researchers from both developed and emerging markets. many researchers found that conventional time series models that operates under the main assumption of constant variance was not actually accurate in estimating stock return movements. thus, engle (1982) study proposed the use of arch models that allows the conditional variance to change over time as a function of past errors leaving the unconditional variance constant. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 155 applying the arch model shade light on some limitations regarding this model, hence to overcome them bollerslev (1986) proposed a modified form through generalized arch (garch) to allow a longer memory and a more flexible lag structure. not only does garch shares with the arch model in the main assumption regarding conditional variance is specified as a linear function of past sample variance, but also it allows lagged conditional variances to enter in the model too. more extended forms of the arch model were provided by many researchers such as; engle et al. (1987) in which they introduced the garch –m, that allows the conditional variance to be determinant of the mean. in addition their empirical findings supports that risk premium are not time invariant; rather they vary systematically. moreover, to break the rigidness of the garch specifications, nelson (1991) contributed a new model through exponential garch (egarch) which supported that variance of return was affected differently by positive and negative excess returns. also the empirical findings support the negative correlation between both excess returns and stock market variance. furthermore, depending on the previously mentioned garch-m model, glosten et al. (1993) study modified the model by proposing gjr garch, in which their model is based on the fact that there is asymmetric response of volatility depending on the positive and negative shocks. since then successive studies came out with new proposed members to the garch models family to overcome drawbacks of each model, such as for example studies by; ding et. al (1993) proposed asymmetric power garch (apgarch), then zokoian (1994) applied threshold garch (tgarch), in the study of caporin and mcaleer (2006) their employed models were dynamic asymmetric (dagarch), conditional auto regressive range (carr), and quadratic garch (qgarch) model, and so on with more models to be applied and tested by different researchers worldwide. concerning the effectiveness of the arch/garch, many empirical findings such as hsieh (1989), taylor (1994), bekaert and harvey (1997), aggarwal et. al (1999), brook and burke (2003), frimpong and oteng (2006), and olowe (2009); found similar conclusion that is; the best model to describe the data and measure the volatility is the garch (1,1). also, they all confirm the ability of asymmetric garch models in capturing asymmetry in stock return volatility. regarding the studies of gokan (2000), awartani and corradi (2005), yalami and sevil (2008), miron and tudor (2010), and su (2010); their methodologies depended on comparing between various asymmetric models proposed previously such as tgarch, pgarch, egarch, and garch-m; their main findings supported that asymmetric garch models plays a vital role in volatility prediction for daily stock return in different countries, also they found that egarch model exhibit more fitness accuracy in estimation of volatility in comparison to other types in the asymmetric garch family models. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 156 recently, there is a growing empirical researches in which their methodologies depends on applying arch/ garch models on emerging stock markets to estimate and predict volatility such as; the studies of aydin (2002), akgül and sayyan (2005) and gokbulut and pekkaya (2014) in turkey, rashid and ahmad (2008) in pakistan, goudarzi and ramanarayanan (2011) in india. their main findings were the occurrence of non-normality, volatility clusters, negative skewness, leptokurtosis for data gathered from emerging economies; in addition, the best fit model for the data is garch (1, 1). also, gokbulut and pekkaya (2014) supported that the cgarch and tgarch appear to be superior in modelling volatility. consequently, many researchers in emerging countries are interested in applying and comparing between various arch/garch family models on selected data gathered from emerging economies, so at the end each empirical study may figure out the best fit models in their countries such as; floros (2008), and emenike (2010) in nigeria su (2010) in china, angabini and wasiuzzaman (2011) in malaysia, abd el aal (2011), and ezzat (2012) in egypt, and freedi et al. (2012) in saudi arabia. they all applied one or more from these models; garch, egarch, and gjr garch, and their main findings shows that egarch and gjr garch are the best models for measuring volatility, detecting clustering effect, leptokurtosis, also the leverage effect. although there are many studies around the world that tested the arch/garch family models in their capital markets, few studies were found in jordan concerning this issue. rousan and al khouri (2005) study investigated the volatility for amman stock exchange (ase) for the period during (1992-2004), depending on daily observations for the general index of the exchange; and their results support that arch/garch models can provide good approximation for capturing the characteristics of ase. in addition the study applied multiple asymmetric models to track the leverage effect and found that the exchange is symmetric; hence, good and bad news has the same magnitude. for rimony and nader (2012) study, it measured the volatility and the effect of macroeconomics on it by applying arch/garch, and their findings were that the arch was found statistically significant. on the other hand, garch was found statistically insignificant during the period (1991-2010). consequently, our study will aim to update the data that were used in previous studies regarding measuring volatility and testing leverage effect for amman stock exchange index (asei100). also, the period of the study will cover important events that affected the economic conditions regionally and worldwide such as recent financial crisis. such kind of events is expected to stimulate the importance of estimating and forecasting stock market volatility so that it will ease taking various economic and investment decisions in firms. 3. methodology the estimation of both risk and return has been considered to be one of the main concerns of financial experts, academics and policy makers especially measuring risk. thus, financials compete to find satisfactory mathematical models to estimate volatility that is an indicator of risk. during the last three decades lots of studies adopted modeling conditional volatility to asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 157 capture fluctuations of return in financial markets in particular especially in developed countries. the pioneer study in this field is credited to the study of engle (1982) who offered modeling conditional volatility by using autoregressive conditional heteroscedasticity (arch) process; which is in simple words a function of lagged squared residuals, and the general form of the model is: = + ∑ (1) where α0 is mean, αi is conditional volatility and εt-i is white noise representing residuals of time series. however, to overcome the weaknesses that were found while applying arch models, especially the one related to the inability to exhibit volatility clustering. another proposal was introduced by bollerslev (1986) study to modify the version of arch models, which is symmetric generalized autoregressive conditional heteroscedasticity (garch) model; that synchronized both lagged squared residuals and lagged variances. in this way garch model is allowed to be dependent on both recent variance of itself side by side with past shocks, so at the end it will provide us with volatility clustering. in general the garch (p, q) model is presented in the following formula: = + ∑ + ∑ (2) where i=0,1,2,3,… p, conditional volatility, , , are non-negative constants with + < 1 it should be near to unity for an accurate model, εt-j is residuals and it is lagged conditional volatility. and the last part of the formula is the main difference in applying both arch and garch models. hence, αj and εt-j 2 are arch components and βj and are garch components. in addition, both arch and garch models depend on a major assumption that is; all of the shock effects on volatility have a symmetric distribution. however, the empirical results of studies applying arch/garch model in different countries found that this assumption does not hold true for many stock markets in the world due to the special characteristics for each market. hence, even though garch model did capture many important issues connected to the financial time series, but on the other hand failed to detect other volatility properties for example leverage effect and heavy tailedness too. thus, modified models were presented by multiple researchers depending on nonlinear distribution so that it can take advantage from the well-known fact which states that; negative shocks have stronger effect on increasing volatility materially in comparison to the effect of positive shocks on volatility in the same magnitude. that all in return led to build asymmetric garch models that can capture the extent of availability for asymmetric distribution, parameter restrictions and leverage effect of stock return. the issue of asymmetric condition was firstly proposed by black (1976), then across time there have been many empirical studies that provided supporting evidence for black proposal such as exponential garch (egarch) by nelson (1991), gjr garch by glosten et al. (1993), threshold garch by zakoian (1994), and many other models were added to garch models family to estimate volatility more efficiently. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 158 in accordance to the aforementioned, this study adopts in particular employing egarch model due to the ability of this model to show greater impact of volatility by large shocks, also this will be side by side with the classical models of arch/garch as well, to test and measure both asymmetric and symmetric distribution respectively and to find out the main characteristics of stock return at amman stock exchange general index (asei100). the formula of egarch can be expressed as following: ( ) = + ( ) + − 2 − (3) regarding the egarch formula it is easy to figure out its added advantages, in that; firstly, the parameters are guaranteed to be positive since the model uses the log of the variances. and secondly, no restrictions on the parameters included in the formula which are , β , γ. moreover, to make sure that the stationery assumption still holds β must be positive and less than 1, in addition, the value of gamma (γ) is the indicator of leverage effect (asymmetric) and must be both negative and significant. consequently, to accomplish the objective of this study our methodology depends mainly on applying the most widely used nonlinear models for specifying volatility; which are arch/garch models to stylized facts about volatility of stock return in amman stock exchange (ase). also to investigate different properties in jordan’s capital market regarding the availability of volatility clustering, long memory, leptokurtosis, and finally leverage effect through egarch model. therefore, the first stage in the analysis process is to investigate the presence of arch effect in the data by generating regression residuals through applying least square method. afterwards, next step is to test the availability of volatility clustering by using garch. after making sure of the arch/garch effect existence there will be a necessity to run different statistical analysis to give a clearer image of the relation between volatility and stock return such as jarquebera test and augmented dickey-fuller test (adf) and many other test that will be discussed in details in the next section. the final step is to run egarch model to test leverage effect. 4. analytical analysis and empirical results 4.1 data this study employ’s data including; 2469daily closing observations of amman stock exchange general index (asei100) for the period from jan. 1. 2005 till dec. 31. 2014. the asei100 stock return is calculated through: rt= log (pt/pt-1) (4) by using primarily visual inspection of the plot sketching for daily series of asei100 during the period of the study, it proves to be satisfactory. in other words, the return fluctuates asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 159 around mean value that is close to zero. also the observations show consistent fluctuations that are considered to be high for certain periods and low for others. 4.2 empirical results table 1 reports the statistical description for daily observations of amman stock exchange general index (asei) during the period of 2005-2014 that contains; mean, median, max, min, skewness, kurtosis and jarque and bera results. table 1. descriptive statistics statistical indicators amount statistical indicators amount mean -4.76e-05 kurtosis 6.686370 median 7.86e-05 jarque-bera 1440.862 std. dev. 0.004284 probability 0.000000 maximum 0.020350 sum -0.117410 minimum -0.019654 sum sq. dev. 0.045302 skewness -0.322735 observations 2469 the average daily observations of asei is -4.67e-5, which indicates that there were losses across the period of the study, also the standard deviation is .004. there is a substantial gap between the max (.020) and min (-.019) which gives support to the high variability of price changes. in a normally distributed series skewness must be 0 and kurtosis is around 3, regarding our results the skewness is -.322 negatively skewed which implies that the distribution has a long left tail and a deviation from normality. in addition, the asei returns are leptokurtic caused by large kurtosis statistics of 6.68 that exceeds normal value of 3 indicating that the return is fat tailed. regarding jarque and bera test for normality, it is consistent with the outcome provided by both statistics of kurtosis and skewness, since the jb test is significant at 1% level, that means to reject null and accept the hypothesis which states that; returns are not normally distributed. consequently, all the pre mentioned statistical analysis gives more support to the suitability of applying arch/garch model for our data gathered from amman stock exchange, since the selected observations can be described as leptokurtic, fat tailed and not normally distributed. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 160 figure1. log return distribution moreover, by visual inspection for asei returns during 2005-2014 represented by figure 1, it can be observed that volatility changes over time tends to cluster financial return, which is an indicator for long memory too. in other words large changes tend to be followed by large changes and vice versa the small changes are followed by small changes as well. table 2. augmented dickey-fuller test t-statistic prob.* augmented dickey-fuller test statistic -33.98253 0.0000 test critical values: 1% level -3.432807 5% level -2.862511 10% level -2.567332 *mackinnon (1996) one-sided p-values. table 2 represents the augmented dickey fuller (adf) test to examine the unit roots in return series. the main result based on this test is that; adf is statistically significant at 1% level. this indicates to reject null hypothesis and accept that the returns are stationery; hence, it is mean reverting. that all confirms the non-existence of autocorrelation. however, since the series are stationery, the next step is to determine the best fitting mean equation through applying auto regressive moving average (arma) to choose the best process in modelling the conditional mean, and it can expressed as following: -.02 -.01 .00 .01 .02 .03 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 log price asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 161 = + + (5) table 3. arch/garch model output dependent variable: market return volatility method: ml – arch included observations: 2468 garch = c(3) + c(4)*resid(-1)^2 + c(5)*garch(-1) variable coefficient std. error z-statistic prob. α0 2.77e-05 5.30e-05 0.522034 0.6016 α1 0.149274 0.019509 7.651440 0.0000 variance equation c 1.80e-07 2.35e-08 7.632834 0.0000 α1 0.117966 0.009882 11.93752 0.0000 β 0.871524 0.008743 99.67907 0.0000 r-squared 0.041913 mean dependent var. -5.13e-05 adjusted r-squared 0.041524 s.d. dependent var. 0.004281 s.e. of regression 0.004191 akaike info criterion -8.649857 sum squared residual 0.043321 schwarz criterion -8.638084 log likelihood 10678.92 hannan-quinn criterion. -8.645580 durbin-watson stat 1.839387 after building the arma model for estimating mean, the volatility will be modeled using both arch/garch model. according to table 3 the arch model is significant at 1% level, implying to reject null hypothesis and accept that there is an arch effect in the return of asei, also it indicates that there is a direct effect between news that enters the market and the level of volatility in the ase. the appropriate model is arch (1). as the return exhibits an arch effect, it is followed by applying garch model that is sufficient to cope with the changing variance. the study applies the garch (1, 1) consistent with many previous studies such as franses and van dijk (1996), gokcan (2000). however, the parameters of garch model for asei returns is positively significant at 1% level, which implies to reject null hypothesis and accept the existence of volatility clustering in return series. in other words volatility from the previous periods has a power of explaining the current volatility condition. thus, the sum of coefficients α and β in garch model is a measure of the persistence in the volatility shocks, if the result is close to unity (i.e. one) then asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 162 the more persistent is the stock to conditional variance. however, it appears from the analytical output that the (α + β) is around (0.99) which means that the asei return series have both attributes; volatility clustering and persistent. hence, all previously mentioned tests indicate that the variance equation is well characterized and specified. table 4. egarch model output dependent variable: market return volatility method: ml – arch included observations: 2468 log(garch) = c(3) + c(4)*abs(resid(-1)/@sqrt(garch(-1))) + c(5) *resid(-1)/@sqrt(garch(-1)) + c(6)*log(garch(-1)) variable coefficient std. error z-statistic prob. α0 2.10e-05 4.98e-05 0.421103 0.6737 α1 0.144455 0.019069 7.575441 0.0000 variance equation c -0.463614 0.046386 -9.994775 0.0000 α1 0.243625 0.016511 14.75535 0.0000 β -0.016854 0.009284 -1.815490 0.0694 γ 0.975853 0.003336 292.4830 0.0000 r-squared 0.041296 mean dependent var. -5.13e-05 adjusted r-squared 0.040907 s.d. dependent var. 0.004281 s.e. of regression 0.004193 akaike info criterion -8.650504 sum squared residual 0.043349 schwarz criterion -8.636376 log likelihood 10680.72 hannan-quinn criterion -8.645371 durbin-watson stat. 1.830550 in order to capture the availability of asymmetric behavior and the existence of leverage effect in the financial return of asei, the study applies egarch model in order to detect the leverage effect (asymmetric). it is expected that the sign of gamma (γ) in egarch model must be negative and significant. table 4 represents egarch output. all estimated parameters are statistically significant at 1% level except for β at 10% level of significance. regarding the gamma parameter which is the indicator for asymmetric volatility, it is positive and significant at 1% level; this result implies that shocks including good and bad news that may impact amman stock exchange will affect volatility for a quite time in the future, and it is not expected to be forgotten with a short period of time, this result is consistent with the empirical findings of cohary and rad (1994), and rousan and al khouri (2005). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 1 ajfa.macrothink.org 163 5. main conclusions measuring and modelling volatility is vital in determining cost of capital for financial securities, also in assessing leverage and investment decisions that will affect the firm performance and its continuity especially in emerging economies where essential number of investors is described to be risk averters. thus, this study attempts to model the volatility of stock market return in jordan’s capital market. to achieve this goal the empirical analysis depends on running both arch/ garch models, so that to investigate the major volatility characteristics accompanied with amman stock exchange general index (asei) through the period from january 1. 2005 to december 31. 2014; which includes volatility clustering. leptokurtic distribution, and leverage effect. to capture the symmetry effect in amman stock exchange data, both arch and garch (1, 1) model is employed. the primary empirical findings of the stock return data is far from normality, whereas it showed existence of conditional heteroscedasticity; in other words volatility clustering. moreover, the statistical output reveals evidence for leptokurtosis, long memory, skewed to left (fat tailed), and persistence of volatility. all these results are consistent with many previous studies such as; cohary and rad (1994), rousan and al khouri (2005), emenike (2010), goudarzi (2011), ezzat (2012) and so on. in regards to detecting the asymmetric effect in the data, the study applied egarch (1, 1) model, so that it can investigate if there is a various effect of good and bad news on the future volatility in amman stock exchange (ase). therefore the expected outcome for the existence of asymmetric effect in the data is related to having negative significant gamma (γ), and since the results in our study is positively significant this indicates that; there is no support to the existence of leverage effect in amman stock exchange. thus, the stock return is considered to be volatile. hence, whether the shocks are positive (good news) or negative (bad news) of the same magnitude, they will have the same impact on the future volatility. this part of the results in particular is consistent with few studies such as cohary and rad (1994), and rousan and al khouri (2005). in addition, the unavailability of leverage effect at ase can be due to many reasons such as; jordan is an emerging country with limited resources that were affected by successive hard political and economic circumstances on both levels regionally and internationally, that all in return affected the economic conditions in jordan in general, and capital market in specific; such as iraq war in 2003, financial crisis of 2007-2011, and arab spring revolutions, that all have had its material impact directly and indirectly on stock market (amman stock exchange). overall results of this study provide more evidence for both volatility clustering and leptokurtic, whereas no support for the existence of leverage effect in the stock returns at amman stock exchange. references abd el aal m.a. 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(1994). threshold heteroscedasticity models. journal of economic dynamics and control, 18(5), 931–955. http://dx.doi.org/10.1016/0165-1889 (94)90039-6 microsoft word 18952-article text-writer2-new for scho receive doi:10.5 abstra the aim 2009 to analysis compan (roe); ratios e price-ea the res designa returns. keywo funda recastin ool of busin ed: june 7, 2 5296/ajfa.v ct m of this pa o 2016 for a s utilizes e ny’s operati liquidity r earnings pe arnings ratio sults from ate insignifi . rds: stock amenta ng stoc ind ness econom e2022 ac 14i2.18952 aper will be all 30 comp ight indicat ions i.e pro atios (curre er share (e o (p/e). our model cant relatio market, ma al analy k retur dustrial msc. mics and m -mail: stefan ccepted: july url: ht e achieved panies listed tors aiming ofitability ra ent ratio); eps), divid indicate th onship betw arket indice 1 ysis and rns: ev l averag . stefan tan management n.tanevski@ y 27, 2022 https://doi.or through an d on the do g to provid atios: 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analysis potentia the sho stock p (muham 1.1. lite the firs was not such as 1936). among fundam investor abarban oduction ock market back to the ating that th ars later the e need to c representing ng in the in ance for th nies. today important s ns, 2000). a d (shoven a g for the fl in multiple mark when it cally with ng, the lates he crash in ng in the s dge or hav al losses as er the facto n making s s, especially gh technical o not posse s (menkho al for growt rt run. how prices of mmad and a erature revi st applicatio t until 1936 : assets, liab today, m which is mentals are n rs can achi nell and bu has been a 1400s in a he price wo first stock e create what g 12 compa ndustrial se he u.s eco y, the 30 bl sector of th although o and clemen ow of fund e sectors. fu t comes to p the recent st liquidity n march 20 stock marke ing no und we have se ors involved should not y in the con analysis is ess the abil ff, 1997). th and prosp wever, the m the specif ali, 2018, p. iew on of fund 6 when gra bilities, exp many researc the ‘pione not always r eve abnorm ushee (1996 around for c amsterdam ould eventua exchange w is today kn anies which ector, as at onomy. late lue-chip co he econom often labele ns, 2000), ds from inve urthermore performance developme injections 20, the dji et exposes derstanding een many tim d in stock be done wi nstantly shi often secon lity to prod fundament pect in the main concep fic securitie .84). amental an aham and d penses, earn chers have eer work’ reflected in mal returns ) found that 2 centuries, in m, netherlan ally rise, en was founded known as th h were liste the time m er on in th ompanies w my except u ed as a fla djia is of estors and g today, mos e-reporting ents in the have enabl ia has reco one to a g of it. poor mes in the p price move ithout incor ifting stock nd to fundam duce their o tals are exc long-run an pt of both es are un nalysis in te dodd analy nings and m studied the of ou and prices conc as well as t the approa asian n fact, the nds, where nabling them d. in 1896 c he dow jon ed on the n manufacturin he ‘roaring with large c utilities and awed indexe f great imp granting the t mutual fu . e economy, ed many to overed in l great risk i investment past, and m ements and rporating an market. bo mental, and own expect cellent in g nd find grea is the same dervalued erms of pre yzed the fun management e financial d penman cluding that predict futu ach of ou an n journal of f first idea o merchants m to gener charles dow nes industri new york s ng compani ’ 20s it wa apitalization d transporta es due to i portance to em access to nds and eco , the stock o bet in the less than a if done wit t decisions any new inv d returns. g ny fundame oth analyse d it is mainly tations base guiding inv atly underva e “buy the s and sell w edicting stoc ndamentals expertise ( signals and (1989) wh t through fu ure earning nd penman finance & ac issn 19 2022, vol. 1 ajfa.macro of the stock would buy rate profits. w and edwa ial average stock excha ies were of as upgrade n represent ation (shov its price-w the u.s ec o companie onomists us k market h e stock mar year. none thout any p often lead vestors ofte generally sp ental and t es go hand ly used by in ed on fund vestors to d alued comp securities w when over ck returns h of share v (graham an d drawn inf ho discover undamental gs. contrary (1989) with ccounting 946-052x 14, no. 2 think.org/ k market y goods almost rd jones e (djia) ange, all f a great d to 30 t almost ven and weighting conomy, es which se it as a has been rket and etheless, previous to great en fail to peaking, echnical in hand, nvestors damental discover panies in when the rvalued” however valuation nd dodd, ferences, red that analysis y to this, hholds a signific to why appropr doubled among muham models stock r fundam exchan returns. dwiyan evidenc earning likewis market as well (dps) a dividen per sha profits, iwaisak stock re fama a predicti research valuatio sense disappo btm ra conclud howeve signals insignif muham stock re equity accordin estimati cant number they are g riate financ d their retu which is a mmad and a concluded returns in mental analy nge conclud . nto and hat ce from the gs per shar se, ebrahim and found l as a direc and stock r nds and earn are are the company d ko (2010) c eturn on the and french ive ability w hed the re on of “btm that value ointments ar atio predict ding the asso er, not all f and stock ficant effect mmad and a eturns in pa (d/e) rati ng to the f ing future s r of explana good signals ial signals. urns in a ca high p/e ra ali (2018) u that some pakistan. c ysis drawin ding a posi tta (2012) in indonesian re (eps) is mi and chad a direct rel ct and signi returns. add nings and th most powe dividends a conclude th e u.s marke (1992) con when it com elationship m ratio has stocks w re larger on ts how the ociation bet findings sho returns. na t on the sto ali (2018) akistan, add o, has a n findings of tock returns atory variab s in predict moreover, alendar yea atio. to fur used five f of the varia contrary to ng evidence itive yet in nvestigated n stock exc s positively degani (201 ationship b ificant relat ditionally, t he behavior erful indica affect prices hat (p/e) rat et relative to ncluded that mes to assess between an ability will have n average th market reac tween book ow a signifi amely, curr ock prices i found nega ditionally, d negative rel ahsan (20 s. 3 bles, stating ting future reinganum ar, finding t rther inspect fundamental ables have o this, iqb e from non nsignificant the effects change for t y related to 1) studied t between ear tionship bet twaijry (20 r of stock re ator in expl s of shares atio exerts q o the japane t book-to-m sing stock r book-to-ma to predict more earn han those o cts to an ea k-to-market icant and p rent ratio ( in indonesi ative relatio dwiyanto a lationship 012), return asian g that some earnings, h m (1988) re that all sha t the predic l signals an significant bal et. al n-financial relationshi of compan the period o stock pric the compan rnings per s tween curre 06), who te eturns concl laining stoc 15 times a quite strong ese stock ma market ratio returns. add arket ratio earnings di nings disap f growth st arnings disa t ratio and r ositive relat (cr) and r a. dwiyant onship betw and hatta (2 with stock n on equity n journal of f do not have owever the esearched 2 are 9 comm ctive power nd through and positiv (2018) per firms on th ip between nies' fundam of 2002 20 es on the i nies listed o share (eps) ent period ested the re luded that c ck returns a as much. m ger influenc arket. is among ditionally, d , earnings isappointme ppointments ocks. they appointmen returns. tionship bet return on a to and hatta ween curre 2012) also prices in y has a sig finance & ac issn 19 2022, vol. 1 ajfa.macro ve any sound ey do not o 222 compan mon charact r of financia multiple st ve relationsh rformed fhe pakistan signals an mental facto 006 conclud indonesian on the irania ) and stock dividend p elationship b changes in d and relativ moreover, a ce when pr the indicato donelly (20 expectatio ents, at leas ts and tha y also show nt” (p.26), th tween the f assets (roa ta (2012). l ent ratio (c found that indonesia. gnificant im ccounting 946-052x 14, no. 2 think.org/ dness as offer any nies that teristics, al ratios, tatistical hip with -score ni stock nd stock ors using ding that market. an stock returns, er share between dividend e to the ono and redicting ors with 14) who ons and st in the at these that the herefore financial a) have likewise cr) and debt to lastly, mpact on 1.2. hyp based o any rela hypoth roe) a hypoth ratio) a hypoth btm an 2. meth this pa the sec period o we con financia were di operatio the lat perform (correla as men account perform fundam append by reim econom basic re sr = β β8*d/e sr,i,t = sr sto to incre price + β0 (in potheses on our litera ationships b hesis 1: th and stock ret hesis 2: th and leverage hesis 3: th nd dps) an hod aper aims at condary dat of 2009 2 ntinue to wo al statement iscussed in onal aspects tter will be ming a desc ation and mu ntioned prev ting inform mance of a mental analy dix we list a mer (2009, p metric mod egression eq β0 + β1*cr e + ɛ, where =[(p,i,t – pi,t ock return, ease/decreas dividends) ntercept), the ature review between stoc here is no s turns here is no s e ratio (deb ere is no si nd stock retu t exploring a used in th 2016. howe ork and ana ts will be e the previou s of a comp e achieved criptive sta ultiple regre viously, “fu ation, such a company” yst consider and define t p.75, p.289, del quation: y = β0 + β r + β2*ro e, t-1)+div1/ p the depend se in stock ) divided by e stock retu w we have f ck returns a significant ignificant r bt to equity) ignificant r urns the predict he paper is d ever, since t alyze the co extracted an us section. t pany: profit by calcula atistical ana ession) of th undamental as financia ” (tanevsk rs signals w the ratios w , p.338, p.38 β1x1 + ɛ, w oa + β3*ro pi,t-1]x100% ent variable k value (en y the beginn urn when all 4 formed the and a set of relationship relationship ) and stock relationship tive power drawn from the dow r ompanies li nd analyzed the goal o tability, liqu ating all of alysis (cent he data usin l analysis i al signals w ki, 2021). which may which will b 88, p.389) which can be oe + β4*d %, e in this mo nding period ning period l given vari asian following h variables. p between between li returns between m of fundame m the 30 com evises its c isted in 200 d via the eig f the signal uidity, solve f the ratios ral tendenc ng spss sof is a process which in retu given this y slightly d be used in th e rewritten dps + β5* odel defined d stock pri stock price iables are eq n journal of f hypotheses i profitability iquidity me market-based ental analys mpanies list omponents 09. moreov ght fundame ls is to eval ency and m s listed bel cy) and cor ftware. s in which urn provide s, a possib ifferentiate. his paper as as follows: btm + β6 d as the perc ice begin e qual to 0 w finance & ac issn 19 2022, vol. 1 ajfa.macro in order to y ratios (r easured in ( d ratios (ep sis in stock ted on djia from time ver, data fro ental signal luate the fo market perfo low as wel rrelational an investor e data relate bility exists . therefore s stated in t 6*eps + β7 centage cha nning perio which in thi ccounting 946-052x 14, no. 2 think.org/ evaluate roa and (current ps, p/e, returns. a for the to time, om their ls which our main ormance. ll as by analysis r studies ed to the s that a e, in the the book 7*p/e + ange due od stock is model would h any equ β1 (b1 ɛ ‘sta equation we estim cr cu roe btm p/e pr p0 ini 3. resu 3.1 des explana table 1 as evid note tha 0 is pr represen the med measure or 0.28 enjoys that it h the stan between on aver respecti have no pra uity on their 1 or beta 1), andard erro n mate the ec urrent ratio return on eq book to ma rice to earni itial stock p ults scriptive sta atory variab . descriptiv dent from t at the due to resent, ergo ntation of th dian which e of the sho above the a favorable has solid op ndard deviat n 0.58 and rage, compa ively. with actical/econo r books. , the change or’, other fa conometric m quity arket ings price atistics bles ve statistics table 1, the o the inclus o it can gre he liquidity h is not aff ort-term liqu minimum a e short-term perations sin tion of 0.76 2,1 (one sta anies were the most e omic meani e in the inde actors omit model with average sh ion of finan eatly influe y of financia fected by e uidity. the acceptable c m liquidity w nce elevated 6 indicates t andard devi able to gen efficient uti 5 ing, as a co ependent va tted and th ordinary le roa r dps di eps e d/e de p1 end hort term liq ncial entitie ence the av al institution extreme val results indi current ratio with a curre d liquidity i that 68% of iation away nerate 7.6% ilization of asian mpany cann ariable, for a herefore not east squares return on ass ividend per arnings per ebt to equity ding stock p quidity is 1, es in our sam verage and ns. therefo lues and it icate that th o of 1. on t ent ratio of is an indica f the observ y from the m % return, on assets bein n journal of f not have no a unit chang t explained by pooling sets share share y price 34, howeve mple minim is not by re we have provides a he median cu the other ha 3,49, and h tor of such. ved current mean). rega assets and ng 24%, ye finance & ac issn 19 2022, vol. 1 ajfa.macro o turnover, a ge in the var d by the re g cross sectio er it is impo mum current any means e decided to a more tran urrent ratio and, cisco hence it can . last but n ratios are c arding prof 24.41% on et ranging t ccounting 946-052x 14, no. 2 think.org/ assets or riable gression ons. ortant to t ratio of s a true o include nsparent o is 1,28, systems n be said not least, clustered fitability, n equity, to -11%. roe on thus it s be a mo only 25 in light in a co brought may int in the c in p/e r in the d a high multiple multiple contrar which i compan share, i earning was $1, earning compan 3.2 cor the cor availabl correlat of 0.05 insignif demons earning returns n the other should be n ore reliable 5% of our ob of the data ontinuous s t about a ne terpret the u case of the m ratio as evid dataset) of standard d e in the ra es in conjun rily, book t implies that nies trading in both case gs per share ,36 while th gs per shar nies during t rrelation ma rrelation ma le literature tion with the 5. on the ficant corre strates a sig gs ratio, lea s decrease a hand has e noted that as indicator. a bservations published i share repurc egative stoc unfavorable market base dent per the 808.78 and deviation of ange of -69 nction with to market d t on averag at 7 times es substanti and dividen he average re can be the period o atrix atrix (see ta e, see: (mu e dependent other hand elation with gnificant ye ading to a c and vice ver even higher s in the case as for the l had a debt in the yearly chase progr ckholder's e indebtedne d explanato e maximum 663.45 resp f 84.01 whi .33 and 98 other metri does not ex ge companie its book va ial range of nd per shar earnings p manipulate of 2009-201 ble 2) indic uhammad a t variable st d, return o h stock retu et negative conclusion rsa. 6 r variation w e of current level of inde to equity ra y reports it ram which equity (see m ess present i ory variable and minim pectively, w ich suggest 8.69, conseq ics when jus xhibit such es are tradin alue. as for f values wa re respective er share wa ed by shar 16, and ergo ates that cur and ali (20 tock return, on assets, urns. thenc correlation that as pri asian with values t ratio, the m ebtedness, f atio lower th must be no h considerab mcdonald’s in many of o es, extremely mum values with an aver ts that 68% quently it i stifying the a high devi ng below th r the earnin s noted, -6. ely, where t as $3.92, ho re buyback o potentially rrent ratio (f 018), exhib where sign return on ce, the only n with the d ice to earni n journal of f ranging fro median retu from table han or equa ted that man bly decreas s annual r our observa y high rang (i.e. lowest rage p/e mu % of the co is best that financial he iation from heir value, ngs per shar .41 to 15,06 the average owever we s which w y inflated. findings are bits negativ nificance is d n equity ex y variable dependent v ings ratio i finance & ac issn 19 2022, vol. 1 ajfa.macro om -41% to urn on equit 1, it is evid al to 0.975, h any compan sed their eq report 2016) ations. ge in values t and highes ultiple of 14 ompanies ha t investors ealth of com m its mean o with only 1 re and divid 6 and 0 to e dividend p must consi was ongoin e consistent ve yet insig defined as a xhibit posi in this mo variable is increases th ccounting 946-052x 14, no. 2 think.org/ o 242%, ty would dent that however, ies were quity or ), which is noted st values 4.68 and ad a pe use p/e mpanies. of 0.475 1 out 30 dend per 5.50 for per share ider that g many with the gnificant at a level tive yet odel that price to he stock table 2 4. testi multipl homosc aforeme or valid 240 obs (see sch in regar and exp scatterp axis few . correlatio ing assump le regressio cedasticity, entioned the d. given thi servations, hmidt. et. al rds to the li planatory va plot). as ev w observatio on matrix ptions on require multicolli e assumptio is we have which is ab l, 2014). inearity assu ariables mus vident from ons are abo figu es that ce nearity an ons are viola decided to bove the mi umption, gi st exist. the our scatter ove the uppe 7 ure 1. scatte ertain assum nd autocor ated, interpr include 30 inimum req iven that a l e results fro rplot, no lin er limit (i.e asian erplot mptions su rrelation a retation and 0 observatio quirement a linear relati om the scatt near relation ., +3). to ev n journal of f uch as no are tested. d inference m ons per para s per the fi onship betw ter plot are s nship exists valuate whe finance & ac issn 19 2022, vol. 1 ajfa.macro ormality, l if any may not be ameter or a indings in l ween the de shown in (f , likewise o ether the de ccounting 946-052x 14, no. 2 think.org/ linearity, of the reliable a total of iterature ependent figure 1, on the y eviations are base as data line of b <1 is th testing i the thi results i varianc behavio literatur concern in (tabl present, that the perform general explana is evide to concl ed on realis with large d best fit, redu he maximum indicates th ird importan in figure 2, ce inflation or of an ind re suggests n)” (landau f le 3 regres , a maximu e model is med a pearso rule of th atory variab ent between lude that mu stically expl deviations c ucing our m m acceptabl hat no value nt assumpti , indicate th factor (v dependent v s that “vif u and everit figure 2. tes sion output um value of free from m on’s correla humb for a bles. as evid n dividend p ulticollinea lainable valu can signific model’s valid le value, an s greater tha ion is the o hat the assum vif) is appl variable by fs above 10 t, 2004, p.1 sting the no t and collin 2.47 and a multicolline ation in orde maximum dent from (t per share an rity is not p 8 ues or error cantly impai dity. per sta nd anything an 0.635 are one of mul mption of m lied which interacting 0 or tolera 16). ormal distrib nearity stati minimum v earity. aside er to further m correlation table 2, pea nd earnings present in ou asian rs we proce ir the statist atistics solu g above may e observed ltivariate no multivariate measures t g with anoth ances below bution of the istics) low v value of 1.4 e from the prove no ex n coefficien arson’s corr s per share. ur model. n journal of f ed to test fo tical analysi utions (2019 y prevent pr in our mode ormality, in normality is the level o her indepen w 0.1 are s e error term values for m 44 for our m variance in xistence of nt of 0.8 is relation), a c from the l finance & ac issn 19 2022, vol. 1 ajfa.macro or cook’s d is and thus 9), cook’s d roper analy el, thus we n all variab s met. in ou of influence ndent variab seen as a c ms. multicolline model, we a nflation fa multicollin s allowed b correlation latter, it is su ccounting 946-052x 14, no. 2 think.org/ distance, shift the distance ysis. our can. les. the ur model e on the ble. the cause of arity are ascertain ctor, we earity. a between of 0.662 ufficient table 3 in addit of corre tested w durbinwhere v assump scattere 5. regr results given t = 2.639 associat explain . regression tion to mult elation betw with the du -watson sta values close ption of hom ed across the f ression out related to o the data in t 9, p<0,05) ted with sto ed by our m n output an ticollinearit ween errors urbin-watson atistic of 1, e to 2 sugg moscedastic e regression figure 3. sc tput our statistica table 4, we and ascerta ock returns. model, whic d collineari ty, we must . for the p n statistic. t 770. durbin est less aut city. from f n line. henc catterplot fo al sample ca have suffic ain that at the r2 ind ch is expec 9 ity statistics t verify for proposed mo the results n-watson p tocorrelation figure 3 it ce, the assum or the homo an be found cient eviden least one o dicates that cted given t asian s autocorrela odel, the au from (tabl produces a n is present is evident mption is fu scedasticity d in table 3 ce to reject of the inclu 8,4% of th that macroe n journal of f ation, which utocorrelatio le 4, model statistic in t. and final that the va ulfilled. y assumption and table 4 the null hyp uded explan e variability economic, b finance & ac issn 19 2022, vol. 1 ajfa.macro h refers to t on assumpt l summary) the range o lly, we chec ariables are on 4. pothesis, (f anatory vari y in stock re behavioral, ccounting 946-052x 14, no. 2 think.org/ the level tion was ) show a of 0 4, cked the equally f (8.231) iables is eturns is political factors table 4 furtherm clearly accord p.10) on a perce return 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vidend pay noted a per o earnings r anged. return on icance, we ssociation b gests no st and stock r ali, 2018; d istically sig ct h2 and s uidity expre on the oth per share, correlation b gs and rese d chadegani o accept h3 ccounting 946-052x 14, no. 2 think.org/ cs, p.10) tatistics, ratio) by hermore, ital with oints for ge point ine with y after a ffects on valuation returns, turns by youts on rcentage atio saw n assets, have no between tatistical returns. dwiyanto gnificant state that essed in er hand, book to between earch of i, 2011), 3. 5.1 rob in addi importa period o for our differen in quick to our f our init remaine liquidity and ro changes the sec exclude given n model. model, change one (pri stock re variable 6. conc this pap share re an eligi industri regardin (roa) equity) book ra we stud both fin aforeme paper is we con liquidity coheren (2018). bustness test ition to the ant to demon of analysis. r first robust nt short-term k ratio (qr findings no tial regressi ed unchange y and profit oce both s s were prese cond robust e the effects no vif facto further we we can conf is that relat ice to earni eturns chan es no notabl clusion per aims to eturns by m ible sample ial average ng multiple and return ) and marke atio (p/b), p dy the relati nancial and entioned fin s of further nclude that th y ratio retu nce with pre furtherm ting initial mod nstrate the r tness test w m liquidity a r), while pro collinearity ion model, ed (8.3%). r tability varia showed insi ent as. tness test an s of the fin or greater th e proceeded firm that giv tive to our i ings) ratio is ge for a do le changes w assess whe means of fun e with 240 through the e areas of a on equity ( et-based rati price-earning ions betwee d non-financ nancial ratio use to finan here is an in urn on asse evious resea more, unlike del which robustness o we have perf and profitab ofitability w y is present even thoug regarding t ables did no ignificance nalyzed the nancial crisi han 2,5, we d with regre ven (f = 2.2 initial mode s significant llar change were presen ther historic damental an observation e utilization a company’s roe); liqui ios earnings gs ratio (p/e en stock retu cial sectors os used in t ncial analyst nsignificant ts, current arch done by previous r 11 we tested i of the mode formed a mu bility measu with return in the mod gh it is sign the regressi ot seem imp (sig > 5% e period fro is of 2008. concluded ession testin 286, p<0.05 el where 3 v t. yet p/e st e in p/e wh nt. hence, w cal financia nalysis of th ns based on n of eight ind s operations idity ratios s per share e). urns and a s and thus e this model ts, and rese association ratio and s y dwiyanto research (m asian in the prev l by replacin ultiple regre ure where sh on capital e del. the mod nificant ove on coefficie prove the mo %), as for th om 2010 to we first te that multico ng. as for t ), with an r variables ex till exhibits ich is quite we can confi al informatio he dow jon n 30 compa 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(2013) nancial com financial a average: the nt, 3(3), umption. jo 7.12.006 statistics so analyses/ass ccounting 946-052x 14, no. 2 think.org/ journal rediction 295-329 edition. pman & ournal of 307-318. from: annual-r nd stock e (kse). ). does mpanies analysts e impact 9-18. ournal of olutions, from sumptio append financi current ra return on a debt to equ earnings p return on e price-earn book to ma dividend p dix a ial indicator atio assets uity per share equity ings (p/e) r arket ratio er share (dp rs used ratio (btm) ps) 𝑊𝑒𝑖𝑔ℎ𝑡𝑒 𝑊𝑒𝑖𝑔ℎ𝑡𝑒 14 𝑇𝑜 𝑁𝑒𝑡 𝐼𝑛𝑐 𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑀 𝑇𝑜𝑡𝑎 𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 asian 𝐶𝑢𝑟𝑟𝑒𝑛 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿 𝑁𝑒𝑡 𝐼𝑛 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖 𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒ℎ𝑜 𝑐𝑜𝑚𝑒 𝑃𝑟𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑒 𝑃𝑟𝑒 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇 𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 n journal of f 𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑛𝑐𝑜𝑚𝑒 𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑜𝑙𝑑𝑒𝑟 𝑠𝐸𝑞𝑢 𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣 𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆 𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙 𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆 finance & ac issn 19 2022, vol. 1 ajfa.macro 𝑠 𝑢𝑖𝑡𝑦 𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠 𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑟 𝑠𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑒 𝑙𝑖𝑡𝑖𝑒𝑠 𝑛 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠 ccounting 946-052x 14, no. 2 think.org/ 𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 microsoft word 14679-53155-1-sm-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 259 ajfa.macrothink.org investment and growth amidst widening government debt: “the ghanaian story” john kwaku mensah mawutor dean, school of graduate studies (sogs) university of professional studies, accra, ghana p.o. box lg 149, legon tel: 23-32-4328-7242 e-mail: john.mensah@upsamail.edu.gh / kwaku2mensah@gmail.com eric boachie yiadom university of professional studies, accra, ghana richard fosu amankwa university of professional studies, accra, ghana received: april 17, 2019 accepted: june 5, 2019 published: june 5, 2019 doi:10.5296/ajfa.v11i1.14679 url: https://doi.org/10.5296/ajfa.v11i1.14679 abstract the study revisits the debt-growth nexus and broadens the argument to examine the unique effect of government debt on investment in ghana. data from world development indicators on the ghanaian economy were sampled from 1990 to 2015. the empirical results from the multiple linear regression (mlr) suggest an inverse relationship between government debt and economic growth in ghana. in addition, a percentage increase in government debt reduces investment by 0.65%; implying that government debt harms investment due to fungibility of debt and accompanying debt repayment responsibilities. policy ramifications resulting from the study are that the ghanaian government should restructure public debt management to eliminate debt fungibility and reduce debt to gdp ratio as well. keywords: investment, growth, government debt, ghana, debt fungibility asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 260 ajfa.macrothink.org 1. introduction the constant returns to scale condition of the solow-swan neoclassical growth theory advances that doubling the rival inputs leads to doubling output; inferring that a large inflow of resources (for example capital) is a necessary condition to achieve growth. this generalization has resulted in ideological differences among various economists on the effect of increasing capital flows on macroeconomic indicators. whereas extant empirical studies (eberhardt & presbitero, 2015; gui-diby, 2014; sulaiman & azeez, 2012; sedik & sun, 2012; mody & murshid, 2011; aizenman & spiegel, 2006; sachs et al., 2004) support this assertion; other evidences especially from sub-saharan africa (ssa) suggest contrasting results in the absence of some mitigating factors (mensah, bokpin, & boachie-yiadom, 2018; agbloyor, gyeke-darko, kuipo, & abor, 2016; zouhaier & fatma, 2014; panizza & presbitero, 2014; dipeitro & anoruo, 2012; presbitero, 2008). the seminal work of solow (1956) on ‘contributory to theory of economic growth’ also confirm that countrywide growth rate is determined by the savings rate, incremental output-capital ratio, depreciation and population growth. he explains that the rate of growth depends on the rate of investment in these growth factors. unfortunately, ghana’s growth challenges epitomize scanty investment in these factors. sachs et al. (2004) and collier and dollar (2002) confirmed an earlier assertion by chenery and strout (1966) that developing countries do not have the needed resources to spur investment in the growth factors that could subsequently propel expansion in output. particularly, sachs et al. (2004) associate developing countries growth challenges to low capital threshold, savings trap and demographic trap. the lack of resources according to chenery & strout (1966) creates a “two gap” model. the “two gap” is identified to be the savings gap and the import gap. the savings gap is the gap between the level of domestic savings needed for investment and the required level of investment for a targeted growth rate. the import gap on the other hand, is the differences between foreign exchange earnings and import required to achieve a certain level of output and at any moment in time, one gap is binding, and government debt fills that gap (easterly, 2003). beside the worsening budget deficit experiencing by the ghanaian economy, the world bank (2015) is of the opinion that the country needs at least us$1.5 billion each year for the next 10 years in order to address its infrastructural challenges. recently, another report pecked ghana’s annual housing infrastructure deficit cost at us$90 billion (essabra-mensah, 2018). obviously, these funds can scarcely be raised through domestic taxes. successive governments’ attempt to solicit for more funds to invest in the development agenda of ghana is pushing the country into a timing debt crisis. lately, there is evidence of large borrowing by the ghanaian government. ghana’s public debt as a percentage of gdp which fell from 112% in 2000 to 26% in 2006 due to debt cancelation is on the rise again with a current ratio of 72% (world bank, 2017). these large borrowings are intended to cushion the country’s consistent budget deficit. for over 25 years the government’s gross fixed capital formation requirement has stood at 22% of gdp whereas domestic savings is lagging at 15% leading to the economy running an average annual budget deficit of 7% of gdp (world bank, 2017). it is clear that government borrowing is necessary for the government in order to meet budgetary promises. debt is not entirely bad as some studies have painted it (dipeitro & anoruo, 2012; easterly, 2003; collier & dollar, 2002) but asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 261 ajfa.macrothink.org it depends on how the debt is used. if government debt goes into the right investment, it could pay for itself and trigger growth. however, poor debt management and debt fungibility is a greater concern in ghana that deprives the economy from reaping the dividends associated with debt. if debt is not properly managed it correlates negatively with investment and eventually retards growth. this is because the domestic portion of government debt has the tendency of crowding out private investment. in a private sector driven economy like ghana, if business activities in private sector slows down it affects the entire economy. there is extant literature that has examined the debt-growth nexus. unfortunately, most of these studies focus narrowly on external debt impact on economic growth, neglecting the fact that domestic debt may negatively influence investment and growth. also, large segment of the literature offers generalized cross-country analysis which makes it difficult to identify the country specific context. this study solves these problems by examining the effect of total government debt on economic and investment in ghana. 2. literature review the solow growth model offers explanation to the dynamics in growth economics. in this model, increasing the quantity of inputs (say capital) lead to increase in national output. solow explored the behavior of the economy as it steadily grows through time. in particular, he looked at the relationship between the labor force growth, capital growth and technological growth and examined whether the growth process has any inherent tendencies to slow down. the model focuses on four variables: aggregate output(y), capital (k), labour (l), and technology (a). at any time, the economy has some amount of capital, labour and technology, and these are combined to produce output. two features of the production function should be noted. first, time does not enter the production function directly, but only through k, l, and a. that is, output changes over time only if the inputs into production change. in particularly, the amount of output obtained from given quantities of capital and labour rises over time, there will be a technological progress only if the amount of knowledge (technology) increases. second, a and l enter multiplicatively. al is referred to as effective labour and technological progress that enters into this function is known as labour-augmenting or harrod-neutral. this way of specifying how a enters, together with other assumptions of the model, will imply that the ratio of capital to output (k/y) eventually settles down. in practice, capital-output ratios do not show any clear upward or downward trend over extended periods. in addition, building the model so that harrod-neutral ratio is eventually constant makes the analysis much simpler. for convenience it is assume that the product of a and l is constant throughout. the neoclassical solow growth model form the basis for many countries’ sourcing for large capital resources to spur growth. the model proposes ‘common sense’ phenomenon; thus, a country’s level of input determines its level of output. therefore, a country seeking to increase output should focus on enlarging it input resources. the three input (technology, capital and labor) within the model can simply be reduced to capital. this is because funds are needed to acquire technology. labor which seem to be independent of capital is not entirely free, because the dividend on human capital can be fully utilized if labor has been properly trained. this training in the form of education require funds. reducing the solow model to capital implies that the other input factors need capital investment to function properly and hence a country that lacks capital asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 262 ajfa.macrothink.org investment would see a dwindling growth. in ghana and africa at large, such capital requirement for growth investment can hardly be obtained through domestic taxes. borrowing therefore becomes the gateway to sourcing capital to fund the desire growth. the two main components of government borrowing are external and domestic debt. external debt constitutes debts owed to nonresident individuals, firms and governments. domestic debt on the other are borrowings from the residents of a country through the issue of treasury bills, bonds and direct market borrowing from banks and other institutions. each of the two components has it unique feature. whereas domestic debt could destabilize local investments and push lending rate and inflation upwards; external debt suffers from exchange rate volatility. as beaugrand, mlachila, and loko (2002) had noted, domestic debt tends to have a crowdingout effect on private investment and thus penalize economic growth. in addition, the government’s recourse to domestic financing reduces the supply of loanable funds. in countries where interest rates are relatively flexible, the upward pressure on real interest rates leads to a decline in private investment (christensen, 2004). due to these adverse effects, if debt is not properly managed it may worsen the economic fundamentals of the host nation (mensah, bokpin, & boachie-yiadom, 2018). various empirical studies have suggested the existence of unmitigated direct positive or negative effects of government debts on investment and economic growth. others also maintain the presence of contingency effect; implying that the influence of government debts on growth is through some other factors. more also, there is a methodological disconnection in the empirical literature. whereas some researchers argue that the debt growth nexus is best captured by non-linear models; others, however, continue to assume a linear relation between external debts and growth. dipeitro and anoruo (2012, p. 416) examine the impact of government size and public debt on real economic growth, for a panel of 175 countries around the world. their hausman test which favors a fixed-effect panel regression shows that both the size of government and the extent of government indebtedness have negative effects on real economic growth. and for that matter “a 1 percentage increase in the size of government on the average reduces real economic growth by approximately 10 percent”. panizza and presbitero (2014) use the instrumental variable estimation approach to study whether public debt has a causal effect on economic growth in a sample of 17 oecd countries. after controlling for national gross savings (as a share of gdp); population growth; average number of years of secondary education; trade openness; inflation; age dependency ratio; banking crisis dummy; and the ratio of liquid liabilities to gdp they report negative effect of public debt on economic growth. moreover, the empirical investigation of agbloyor et al. (2016) on a related subject fail to reject the panizza & presbitero (2014) findings that government debts have a negative impact on economic growth. similarly, zouhaier and fatma (2014 p. 445) using arellano-bond dynamic panel data estimator explore the effect of debt on economic growth of 19 developing countries over the period 1990-2011. they employ data from world bank’s wdi database and regress different measures of government debts and other exogenous variables (investment, trade openness and inflation) on growth rate of real gdp per capita. they buttress the earlier negative claims of government debts’ impact on growth; adding that if the government debt to gross national asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 263 ajfa.macrothink.org income (gni) increased by 10%, growth decreases by 0.27 percentage points. they further report a negative coefficient results after interacting external debt and investment. this supports their assertion that “external debt penalizes economic growth by blocking the main channels and growth engines such as investment”. in addition, doğan and bilgil (2014) use the markovregime switching model in a study which focuses on government debt growth dynamics of turkey for the period of 1974 to 2009 and summit that external borrowing has negative impact on growth both in regime at zero and regime at one. eberhardt and presbitero (2015) examine the long run relationship between public debt and growth in a large panel of 118 developing, emerging and advanced economies for the period of 1960-2012. their standard linear regression models results reiterate existing empirical conclusion that there is a negative relationship between public debt and long-run growth across countries. other studies have documented that government debt has positive effect on economic growth. zaman and arslan (2014) use a time series data over 39-year period to determine the role of government debt on economic growth in pakistan economy. arguing that the capital structure of the pakistan economy is largely financed by government debt. they employ the ols model and regressed three regresses (external debt stock, gross capital formation and gross domestic product) on pakistan’s gdp. their main finding is that gross capital formation (investment) and external debt stock has significant positive effect on pakistan gdp. another study that purports positive relationship between external debt and growth is a paper by hassan and mamman (2013). their findings were not different from zaman and arslan (2014). mishra, das and pradhan (2009) asserts that government debts encourage growth financing opportunities and it supports investment finance, imports and consumption so that a country can reach its development goals and economic growth. abbas and christensen (2007) also conclude that optimal government debt improves economic outcomes. 3. empirical method and strategy the study is quantitatively designed. data on the ghanaian economy over the 1990-2015 periods were sourced form world development indicator (2017). the study is bounded with this time period because ghana received considerable debt relief over these periods. the study estimates the relationship using the multiple linear regressions. two (2) econometric equations are estimated in order to help answer two important questions: i. does government debt affect investment in ghana? ii.what is the effect of government debt on ghana’s economic growth? equation (1) below answers research question one. 𝐼𝑁𝑉 = 𝛽 + 𝛽 𝐷𝐸𝐵𝑇 + 𝛽 𝑃𝑂𝑃 + 𝛽 𝑇𝑅𝐴𝐷𝐸 + 𝛽 𝑆𝐴𝑉 + 𝛽 𝐿𝑅𝐴𝑇𝐸 + 𝛽 𝐺𝑂𝑉𝑇𝑆𝐼𝑍𝐸 + 𝑣 (1) where; t denotes time, 𝐼𝑁𝑉 represents investment which is ghana’s gross capital formation, 𝐷𝐸𝐵𝑇 is total debt stock to gdp, 𝑇𝑅𝐴𝐷𝐸 is a measure of total international trade as a percentage of gdp, 𝑃𝑂𝑃 is the growth rate of population, 𝐺𝑂𝑉𝑇𝑆𝐼𝑍𝐸 denotes general government final asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 264 ajfa.macrothink.org consumption expenditure to gdp ratio, 𝑆𝐴𝑉 is the savings growth rate to gdp ratio, 𝐿𝑅𝐴𝑇𝐸 represents lending interest rate which is a proxy of ghana’s macroeconomic indicator and 𝑣 is the error term. the betas ( 𝛽 ) are the coefficients of the independent variables after estimation. on the other equation (2) as specified below answers research question two. 𝐺𝐷𝑃 = 𝛽 𝐷𝐸𝐵𝑇 + 𝛽 𝑃𝑂𝑃 + 𝛽 𝑇𝑅𝐴𝐷𝐸 + 𝛽 𝑆𝐴𝑉 + 𝛽 𝐿𝑅𝐴𝑇𝐸 + 𝛽 𝐺𝑂𝑉𝑇𝑆𝐼𝑍𝐸 + 𝑣 (2) where: 𝐺𝐷𝑃 denotes gdp per capita and other descriptions of the variables are same as in equation (1) above. 4. empirical results and discussion 4.1 descriptive statistics the descriptive statistics in table 1 shows that the average gdp per capita of ghana is us$757.20 over the 26 observations indicating low income country. however, a critical look at world bank’s (2017) wdi data shows that the ghana’s gross national income (gni) has steadily risen into a low-middle income country over the periods. from 1990 to 2015 ghana’s average growth rate has been pecked at 3% per annum. this is an indication that the country is making giant strikes towards economic freedom in the sub-region. table 1 also shows that investment (invest), measured as percentage of gross capital formation to gdp recorded 22.6% and 30.2% as mean and maximum respectively. the results show low capital investment to the generation of the growth in the country. it is no surprise that ghana government continuously source for debt to boost investment. the debt levels in ghana is relatively high with a mean of 56.5% of gdp. the high debt levels do not give opportunity to the government to plan with future taxes. this is because debt make claims on these taxes and therefore the economy needs to rely on further borrowing to survive. this leads to revolving debt cycle as advanced by mensah, bokpin and boachie-yiadom (2018). the descriptive statistics also show that government machinery capture by govsize needs at least 12.9% of gdp to run the economy. government size is also another form of investment which may have adverse impact on capital investment. in the case of ghana government size is relatively low. another important variable in the study is the savings. it could be seen from table 1 that ghana’s economy has low savings as a percentage to gpd within the 1990-2015 periods. the low savings infer that the needed growth cannot be financed with local funds and hence borrowing becomes inevitable. the macroeconomic proxy – lending rate (lrate) is quite high with a mean of 21.5%. this is expected in cases where government actively participate in borrowing from local financial market like the ghana. government participation creates demand for local loans, leading to interest rate surging upwards. the 1990-2015 periods were also characterized with high population growth rate and unfavorable balance of trade. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 265 ajfa.macrothink.org table 1. descriptive statistics variable obs mean std. dev. min max gdppc 26 757.2 512.2 264.7 1827.1 invest 26 22.6 4.3 12.7 30.9 debt 26 56.5 21.7 26.2 112.0 govtsize 26 12.9 3.4 9.3 20.9 sav 26 15.8 4.2 6.9 22.9 l.rate 26 21.5 2.9 17.0 28.2 popg 26 2.5 0.2 2.3 2.8 trade 26 -5.7 3.9 -13.7 1.7 4.2 correlation matrix the correlation matrix reveals a significant negative correlation of about 58% between gdp per capita and debt, it implies that the more the ghanaian economy grows the less it should borrow and vice versa. the association confirms empirical findings that debt is relevant at a certain level of growth but when debt exceed a certain threshold it retards growth (mensah, bokpin, & boachie-yiadom, 2018; eberhardt & presbitero, 2015; doğan & bilgili, 2014; panizza & presbitero, 2014). again, the matrix suggests a positive relationship of about 39% between government size and economic growth. the intuition behind this relationship could be that government’s spending on goods and services stimulates private sector investment leading to increased economic activities in the country. as expected, there is a strong positive correlation of about 43% between investment and per capita gdp; following that increase in investment leads to economic growth. generally, the pairwise correlation matrix indicates that the presence of multicollinearity is improbable within the dataset. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 266 ajfa.macrothink.org table 2. correlation matrix sav gdppc invest popg trade govtsize debt l.rate sav 1.0000 gdppc -0.2320 1.0000 invest 0.1401 0.4360 1.0000 popg 0.0573 -0.1137 -0.5094 1.0000 trade 0.3204 0.1502 0.7192 -0.6399 1.0000 govtsize -0.3523 -0.3859 0.6062 -0.2704 0.2362 1.0000 debt 0.5119 -0.5818 -0.2530 -0.1550 0.0477 -0.4162 1.0000 l.rate 0.0905 0.2492 0.3058 -0.2519 0.5449 -0.0611 -0.3751 1.0000 4.3 effect of government debt on investment table 3 shows the multiple linear regression results for the effect of government debt on investment in ghana. the dataset reveals the presence of significant negative debt-investment nexus. thus, on the average a us$1 increase in debt would cause investment to reduce by 0.65% holding all other factors constant. this is serious for an economy that largely depends on debt. there are several factors that account for this situation. ordinarily, government borrows to invest, or payoff matured debts and future taxes are used to settle other future maturing debts. consequently, present borrowings reduce future investment since future taxes are already committed to debt repayment. if present debts are not wisely invested in projects with positive net present value, there would be little funds to invest in the future unless further debt is sourced. there are evidences of poor public investment management in ghana (international monetary fund, 2015), therefore, the abuse of government debt is inevitable. in addition, government borrows to meet other obligations other than capital investment. for example, government may borrow to meet social intervention needs. these debts still need to be repaid from domestic taxes leading to reduction in public investment. savings was found to be significant at conventional levels. this does not follow ‘common sense’ because one cannot spend and save at the same time. however, when time lag is introduced into the discussion, it makes econometric sense that previous savings determines current investment. therefore, the higher the previous savings, the greater the current investment and vice versa; hence the positive relationship between savings and investment. trade and government size were found to be significant in the model. there is no debate on the fact that trade improves investment and low government size releases funds for capital investment. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 267 ajfa.macrothink.org population growth rate and lending rate could enter the model at conventional levels, indicating that the two variables do account for the variations in the investment as far as the equation one is concerned. post estimation check using the r-squared and the f-statistics confirm the appropriateness of the model to achieving the research objective. table 3. mlr results: effect of government debt on investment (equation 1) investment coef debt -0.6521 (0.303)** sav 0.2865 (0.1314)** pop -5.9382 (4.5933) trade 0.1100 (0.0446)** govtsize 0.4994 (0.202)** lrate -0.2950 (0.292) cons 30.1342 (16.2597)** observation 26 r2 0.7898 f-stat prob>f 11.90 0.000 * p<0.1; ** p<0.05; *** p<0.01 4.4 effect of government debt on economic growth model two examined government’s debt impacts on economic growth. although debt maintain the expected negative sign, it however, failed to enter the model at the traditional significance levels. it means that debt is irrelevant in explaining economic growth dynamics in ghana. this finding is not unique to the current study (megersa, 2015; panizza & presbitero, 2014). if government debts are not placed in strategic investment, it would not yield the intended results and in cases deteriorate economic growth. it is therefore important that government debts are utilize efficiently to bring growth in the country. from table 4, trade, savings and government size are relevant in explaining the variations ghana’s economic growth. again, the post estimation check using the r-squared and the f-statistics confirm that this model is appropriate asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 268 ajfa.macrothink.org for achieving the research objective. table 4. mlr results: effect of government debt on economic growth (equation 2) gdp per capita coefficient debt -0.6127 (0.2149) sav 0.0772 (0.0989)** pop -3.2777 (1.8080) trade 0.0014 (0.0256)** govtsize 0.0592 (0.1905)** int -0.0792 (0.2067) cons 14.0991 (6.7997)** observation 26 r2 0.4076 f-stat prob>f 2.45 0.0629 * p<0.1; ** p<0.05; *** p<0.01 5. conclusion the study has shown that government debt and investment run in opposite direction. this is contrary to policy makers promises of borrowing for investment purposes. the negative effect is associated with poor public investment management. the ghanaian government has debt fungibility problem which deprives the economy from reaping benefits associated with debt. it has also been established that debt is irrelevant in telling ghana’s economic growth story. therefore, overreliance on debt retards investment and weakens economic growth. it is important that government maintains active public investment management division backed by statutory instrument to specifically oversee the efficient utilization of government debt. in addition, low savings and government size in the country immensely underpins borrowing. it is important governments maintain low government size to save funds to invest in the productive sectors of the economy. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 269 ajfa.macrothink.org references abbas, s. a., & christensen, m. j. 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(2015). the africa infrastructure diagnostic report. washington dc: world bank . world bank. (2017). world development indicators. washington dc: world bank. zaman, r., & arslan, m. (2014). the role of external debt on economic growth: evidence from pakistan economy. journal of economics and sustainable development, 24. zouhaier, h., & fatma, m. (2014). debt and economic growth. international journal of economics and financial issues, 4(2), 440-448. microsoft word 16887-59685-1-sm (3)-writer3-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 86 factors hindering class attendance: views of university accounting students lillian wally-dima senior lecturer, faculty of business, university of botswana e-mail: dimalb@ub.ac.bw christian john mbekomize (corresponding author) senior lecturer, faculty of business, university of botswana e-mail: mbekomizecj@ub.ac.bw alicia nametsegang, lecturer, faculty of business, university of botswana e-mail: nametsegang@ub.ac.bw received: march 1, 2020 accepted: may 7, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.16887 url: https://doi.org/10.5296/ajfa.v12i1.16887 abstract this paper examines the factors that hinder university accounting students from attending classes. a survey instrument comprising of factors that impede class attendance was administered to the second, third and fourth year students doing accounting courses. descriptive statistics were computed and independent sample t-tests were performed to measure the variance in views among students from different years of study. the results suggest that studying for other tests, uploading of lecture materials to ict platforms, failure to do the necessary reading in advance, working on the project which is due on the same day with a class, lack of proper time management and failure to properly allocate time to school activities are among the key factors responsible for absenteeism. other hindrances to class attendance include having many lectures to attend in a day, transport problems to school, lack of personal motivation and time lag between classes. in addition, the results reveal that majority of respondents assess their class attendance to be satisfactory; and there is no evidence to indicate that course type, gender and accommodation status are among the causes of differences in class asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 87 attendance. these results have implications to students, lecturers, tertiary institutions and sponsors who can devise means to mitigate class absenteeism. keywords: accounting courses, class attendance, academic performance, year of study, university students asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 88 introduction class attendance at institutions of higher learning has been a topic for debate for a long time. it is reported that students at tertiary institutions do not attend classes on a regular basis. various prior studies document a wide range of absenteeism rates. romer (1993) reported the class non-attendance rate of 40% and friedman, rodriguez and mccomb (2001) documented that in some cases 25% or more students miss classes on a given day. robert (2007) estimated that class non-attendance rates could reach to about 50% of students in some academic disciplines. thatcher, fridjhon and cockcroft (2007) recorded a class absenteeism rate ranging from 35% to 60%. these studies show that class non-attendance has been the problem that many tertiary institutions have been grappling with since many instructors associate class attendance with academic success while their students seem to be skeptical about that view (credé, roch, & kieszczynka, 2010). the university of botswana where the current study is conducted is not an exception when it comes to absenteeism. the university wide study by tidimane et al (2014) which investigated the failure rates and their causes at the university of botswana identified class and tutorial attendance to be among the most important risk factors associated with failing a course. the university of botswana is the largest university in a country with enrollment of about 14,000 students in 2019/2020. teaching and learning at the university of botswana is predominantly face to face lecturing augmented by ict platforms accommodating course materials which students can access anytime. contact tutorials, group discussions and seminars are also conducted to support face to face teaching. class attendance at higher education institutions in botswana, of which the university of botswana is part, is primarily non-mandatory. the approach has been to avoid infantilizing students and allowing them to make their own decisions whether to attend classes or not (lukusa, kaur, kumari, & iyer, 2015). however, it appears this “academic freedom of attendance” might have caused students to skip classes on account of various reasons. at the university of botswana class attendance is encouraged but absenteeism is not punished. a decline in the number of students attending classes is a concern of higher learning institutions because non-class attendance is considered to be a significant contributor to poor academic performance. numerous prior studies have confirmed a strong link between class attendance and academic achievement. studies by romer (1993) and paisey and paisey (2004) reported positive relationship between class attendance and academic performance. chung (2004) documented that students who attend classes and/or tutorial on a regular basis are more likely to perform better academically than those who skip classes. leblanc (2005) found that class attendance significantly impacts tests scores for students from different sections and institutions. ajiboye and tella (2006) also reported a significant relationship between class attendance and academic performance among social studies students at the university of botswana. chen and lin (2008) noted that class non-attendance is a problem that affects academic performance. credé, roch and kieszczynka (2010) also established a strong relationship between attendance and class grades at state university of new york. nyatanga and mukorera (2017) and papageorgiou (2019) reported a positive and significant relationship between lecture attendance and academic performance in south african universities. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 89 despite a myriad of studies supporting a strong link between class attendance and achievement, some studies argue academic performance cannot be pinned only on class attendance. chung (2004) observes that some students attend classes regularly but do not achieve good results while others skip classes and succeed. clair (1999) also opine that the association between class attendance and academic achievement should not be overemphasized since academic success is influenced by other factors such as students’ feeling of being in control of learning environment. caviglia-harris (2004) investigated the relationship between class attendance and academic achievement using microenomics principles students in the usa and did not find attendance rates to be significant indicators of exam grades. although a good numbers of studies have been carried out worldwide to investigate the causes of classes’ absenteeism among the undergraduates, very few researches have been conducted in botswana to examine this phenomenon. this paper literature search revealed only two published studies conducted in botswana about class attendance namely, ajiboye and tella (2006) at the university of botswana and lukusa, et al. (2015) at botho university. the former focused on the impact of class attendance on academic achievement and established a significant association between the two while the latter examined the causes of absenteeism and truancy and identified delayed students allowances and time-tabling issues to be among the major causes of poor class attendance. this shows that there is still a knowledge gap regarding the factors causing high class absenteeism in higher learning institutions in botswana and measures to combat it from students’ perspective. the current study attempts to bridge this gap by seeking students’ views regarding factors hindering class attendance and their opinions on which interventions can be implemented to reduce it, if not to eliminate it. the findings of this study are expected to be beneficial to learners whose future livelihood, to larger extent, depends on their success at tertiary level. the results of this study will also be useful to higher education institutions, lecturers, parents, the government and professional accounting bodies all who are interested in the good performance of accounting students. a strong academic achievement of accounting students is crucial in botswana since highfliers are expected to mitigate the prevailing acute shortage of citizen qualified chartered accountants in the country (motsamai, 2018; human resource development council, 2016). the subsequent sections review extant literature on the subject matter, highlight the methods employed to collect and analyze the data, describe and discuss the findings and present the conclusions and recommendations of the study. literature review problem of class non-attendance various studies have attempted to assess the rate of class absenteeism. robert (2007) estimated that class non-attendance rates could reach to about 50% in some academic disciplines. the study by romer (1993) reported the class non-attendance rate of 40% in a biology course. marburger (2001) examined the relationship between absenteeism and student’ examination grades using principles of microenomics students and reports non-attendance rate of 18.5% in the course. friedman, rodriguez, and mccomb (2001) in the united states reported the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 90 absenteeism rate of 25%. in the work of thatcher, fridjhon and cockcroft (2007) in south africa the investigation of second year psychology class exhibited an average absenteeism rate of between 35% and 60%. despite the persistence of class absenteeism in many tertiary institutions globally some studies which have sought the views of students regarding the benefits of class attendance have indicate that most students prefer face to face learning as they find it beneficial in many ways such as enhancing their understanding of the course materials (fung & carr, 2000; schmulian & coetzee, 2011) and getting information about course procedures and tests cues (friedman, rodriguez, & mccomb, 2001). effects of class non-attendance numerous researchers have suggested that there is a positive correlation between class attendance and academic performance. the study by white (1992) found that students who miss class usually get lower grades. devados and folts (1996), rodgers (2001) and marburger (2001) concluded that class attendance is positively linked to academic performance. paisey and paisey (2004) who studied accounting students in scotland reported that lecture attendance correlated positively with academic performance. leblanc (2005) carried out a study which examined the relationship between class attendance and average scores using the data from 4 institutions involving different courses over a period of 14 years and reported that class attendance significantly impacts tests scores for students from different sections and institutions. according to ajiboye and tella (2006) class attendance had a significant relationship with academic performance among social studies students at the university of botswana. a similar study a few years later by clark et al. (2011) using geography student at lancaster university in the united kingdom also came to the same conclusion that lecture attendance is positively related to academic performance. the study by nyatanga and mukorera (2017) in south africa also confirmed a positive and statistically significant relationship between lecture attendance and academic performance among the first and second year students doing microeconomics and macroeconomics modules. papageorgiou (2019) examined the first year accounting students in south africa and documented a strong association between lecture attendance and academic performance. chen and lin (2008) also reported that lecture attendance affects students’ performance and they further reported that students who attended lectures were more likely to improve in their examination performance. according to sleigh and ritzer as cited by schmulian and coetzee (2011) students who do not attend lectures lose the benefit of learning from the questions asked by fellow students during class time and the explanation that the lecturer would have given. they further stated that students who skip classes also lose the opportunity to generate their own notes as an additional source of information beside the textbook. the work by lukkarinena, koivukangasa and seppäläa (2016) in finland revealed that a small cohort of students would succeed in exams without attending but for majority of students participation in teaching events is a significant explainer of academic achievement. factors influencing class attendance various factors are said to affect class attendance. devadoss and foltz (1996) and paisey and paisey (2004) reported that classes which were scheduled between 10am and 3pm had better asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 91 attendance than those scheduled early or late in the day. kotttasz (2005) reported that inconvenient lecture time is one of the reasons given by students for missing classes. massingham and herrington (2006) also found that time of class can affect class attendance. lukusa et al. (2015) also reported that time tabling issues were among the significant contributors to class absenteeism. other factors that are thought to influence class attendance include engagement in part-time employment (mcinnis & hartley, 2002; massingham & herrington, 2006; woodfield, jessop & mcmillan, 2006). paisey and paisey (2004) noted that in the accounting area, the most cited reason for non-attendance in classes was students’ participation in part-time jobs. westrick, helms, mcdonough and breland (2009) found that students’ illness is a major factor that contributes to non-attendance of classes. research carried out by nasrulla and khan (2015) found that the way in which students manage their time can have an effect on their academic performance and could also affect their daily routine and activities and personal achievements. van walbeek (2004) reported that gender also affects class attendance. on the contrary, oldfield, rodwell, curry and marks (2017), lukusa et al (2015) and kelly (2012) did not find gender to be a major restraining factor to class attendance. morgan (2001) in a study carried out at bradford university in the united kingdom stated that the most common reasons given by students for not attending classes were that students were out the previous night, having early classes and having backlogs of work to catch up on. longhurst (1999), paisey and paisey (2004), and westrick, et al (2009) also reported that engaging in various forms of social activities which can result in oversleeping affect class attendance. lack of interest in the subject was reported by participants in a study done by paisey and paisey (2004) in scotland and schmulian and coetzee (2011) in south africa. both studies found that there was a positive relationship between class attendance and academic performance in accounting. earlier research such that of devados and foltz (1996) and friedman et al. (2001) reported that lack of respect for the lecturer could also affect class attendance in a negative way. if students have little or no respect for the lecturer they might choose not to come to class which is conducted by that lecturer. schwartz (1997) investigated the influence that the internet has on student’s performance. his findings were that the use of internet has led to a decrease in class attendance in some courses. schwartz concluded that students who use the internet to access lecture information without attending classes were missing valuable interactive lecturer information. similarly, gomisporqueras, meinecke and rodrigues-neto (2011) documented that the use of technologies which allow online access to class materials reduces class attendance. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 92 interventions to improve class attendance as stated above the extant literature indicate that class attendance is influenced by a wide range of factors and therefore so are the interventions that are suggested to enhance class attendance. in the words of clair (1999 p.179) “the classroom environment that engage students, emphasizes the importance of students’ contribution, and have content directly related to knowledge assessed will undoubtedly provide encouragement to students to attend regularly”. similarly, moores, birdi and higson (2019) reiterated the need of making the lectures interesting and interactive with a view of encouraging attendance. in the same vein, effectiveness of teachers and using real world settings in class (fjortoft, 2005) and offering interesting course content (van schalkwyk, menkveld and ruiters, 2010) are said to incentivize students to attend classes. leblanc (2005) opined that attentiveness and immediacy of the lecture should be able to draw students to classes. gump (2005) proposed that students should be given credit and bonus points for attending class. early work done by white (1992) suggested rewarding attendance in order to enhance class attendance. ssemugenyi, mubaraka, and nandacha (2013) advocated for extensive testing of material presented in class, administration of quizzes during class session and assigning more homework to foster class attendance. counselling students on health issues and financial management matters were suggested by lukusa et al (2015) as measures that can help to resolve some of the factors contributing to non-attendance. methodology the target population for this study was students taking second, third and fourth level accounting courses of the 4 year bachelor of accountancy degree programme in the second semester at the university of botswana. three courses were randomly picked to provide the sample of the study. these were introduction to cost accounting (acc201) at the second level, principles of auditing (acc309) at the third level and financial reporting (acc410) at the fourth level. the registered number of students in these courses amounted to 841 but only 424 were targeted since only one group out of four groups of an average of 150 students taking acc201 was targeted. it should be noted that the selected courses comprised students coming from other programmes than bachelor of accountancy. survey design was employed to collect the views of students using a self-administered questionnaire containing both closed and open ended questions. the questionnaire was in three sections. the first section collected the demographic characteristics of participants. the second section contained 32 statements about the factors that can hinder students from attending classes. some of these items were adopted from studies by jameel and hamdan (2015) and lang, joyce, conaty and kelly (2008) but were modified to fit the current study environment. the responses to this set of statements were in 5-point likert scale with “strongly agree” on the high end and “strongly disagree” on the low end. the third section comprised two open-ended questions one of which asked students to suggest other factors that can hinder their class attendance while the other solicited students’ views about how class attendance can be improved. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 93 convenience sampling was used to select the respondents to the study as the questionnaires were administered during lecture time in classes after obtaining permission from lecturers responsible for targeted courses. level 3 and 4 courses were offered by two researchers of this study. permission was sought from one of the four lecturers co-teaching acc201 to administer the questionnaire during class time. the purpose of the study was explained to students participating in the study and they were given 15 minutes to complete the questionnaire. descriptive statistics were computed and test of reliability to measure the internal consistency within the 32 items using cronbach’s alpha were performed. in addition, independent samples t-tests were performed to measure how significant the differences in means between the responses of second years and third years, between third years and fourth years and between second years and fourth years were. data analysis and discussion. demographic characteristics out of 424 targeted students only 279 returned the questionnaires and all of them were found usable. table 1 shows the demographic characteristics of the respondents with two-thirds of them being females and majority of them (95%) being within 19 to 25 years of age group. although only three courses were studied the students in these courses came from more than three programmes namely, bachelor of accountancy (36%), bachelor of arts (social sciences) (15%), bachelor of finance (14%), bachelor of science (computing and finance) (16%) and bachelor of business administration (20%). of the three courses studied principles of auditing accounted for 47% of respondents while financial reporting and introduction to cost accounting each contributed 28% and 25% respectively. majority of respondents (76%) were not accommodated in the university halls of residence and only a handful of them (24%) resided in campus. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 94 table 1. demographic characteristics of respondents number percentage gender male 95 34.1 female 184 65.9 total 279 100.0 age group under 19 years 3 1.1 19 to 25 years 264 95.0 26 to 30 years 8 2.9 above 35 years 3 1.1 total 278 100 programme bacc 99 35.5 bass 42 15.1 bfin 39 14.0 bsc 44 15.8 other 55 19.7 total 279 100.0 course type acc201 69 24.7 acc309 131 47.0 acc410 79 28.3 total 279 100.0 accommodation status boarding 66 23.7 off campus 213 76.3 total 279 100.0 class attendance and academic performance students were asked to self-assess their class attendance in general and their cumulative academic achievement from the beginning of their academic journey at the university until the last assessed semester. table 2 reflects the students’ class attendance and academic performance measured in cumulative grade point average out of 5. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 95 table 2. class attendance and academic performance number percentage class attendance 0% to 25% 10 3.6 26% to 50% 36 12.9 51% to 75% 82 29.5 above 75% 150 54.0 total 278 100.0 performance-cgpa below 2.00 9 3.3 2.00 to 2.99 71 26.1 3.00 to 3.99 137 50.4 4.00 to 4.69 48 17.6 4.70 to 5.00 7 2.6 total 272 100 just above 50% of respondents assessed their class attendance to be above 75% and about 30% of them considered their class attendance to be between 51% and 75%. around 13% of respondents put their class attendance between 26% and 50% while 4% of them perceived their class attendance to be equal or below 25%. class attendance and demographic characteristics the cross tabulation analysis of class attendance per course as reflected in table 3 revealed that 93% of students in second year course, and around 80% of students in both third and fourth year courses put their estimated class attendance above 50%. however, while there was no single second year course student who estimated his/her class attendance to be below 25%, just above 5% of students in the third year course and 4% of the fourth year course assessed their class attendance to be below 25%. it is worth noting that the third year course, principles of auditing is essentially a non-mathematical course, while the second and fourth year courses, introduction to cost accounting and financial reporting have a huge mathematical component. it has been argued that absenteeism is normally lower in courses with significant mathematical component (romer, 1993; schmulian & coetzee, 2011). it is therefore more likely that the non-mathematical nature of acc309 contributed to the higher rate of self-estimated nonclass attendance. other factors being held constant, these results tell us that students in second year have higher class attendance rate than their counterparts in third and fourth years. this is contrary to jordaan (2009) who observed based on the evidence from prior studies that generally older students behave more responsibly towards lecture attendance. in addition, the earlier work by chenneville and jordan (2008) is also inconsistent with our results as they did not find a significant difference in attendance between lower and upper classes. in this study the gender factor does not appear to be the cause of differences in class attendance rate since 84% of females and 82% of males estimated their class attendance to be above 50. this is consistent with findings of oldfield, rodwell, curry and marks (2017) in the united asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 96 kingdom; lukusa et al. (2015) in botswana; kelly (2012) in ireland; chenneville and jordan (2008) and friedman, rodriguez, and mccomb (2001) in the united states who also did not find association between gender and attendance. credé, roch, & kieszczynka (2010) in the united states noted that gender affected attendance in a small way. table 3. class attendance per course, gender, accommodation status and cumulative gpa 0% to 25% 26% to 50% 51% to 75% above 75% total course acc201 0.0% 7.2% 21.7% 71.0% 100.0% acc309 5.4% 15.4% 30.0% 49.2% 100.0% acc410 3.8% 13.9% 35.4% 46.8% 100.0% gender male 3.2% 14.7% 24.2% 57.9% 100.0% female 3.8% 12.0% 32.2% 51.9% 100.0% accommodation status boarding 4.5% 12.1% 33.3% 50.0% 100.0% off campus 3.3% 13.2% 28.3% 55.2% 100.0% cumulative gpa below 2.00 11.1% 11.1% 66.7% 11.1% 100.0% 2.00 to 2.99 2.9% 11.4% 35.7% 50.0% 100.0% 3.00 to 3.99 2.2% 11.7% 31.4% 54.7% 100.0% 4.00 to 4.69 6.3% 20.8% 12.5% 60.4% 100.0% 4.70 to 5.00 14.3% 0.0% 0.0% 85.7% 100.0% moreover, according to students who responded to this study’s questionnaire accommodation status does not appear to be the reason for differences in class attendance patterns. an equal percentage (83%) of boarding and of off-campus students estimated their class attendance to be above 50%. this is contrary to our expectation as we anticipated off campus students to have relatively poorer class attendance than the students staying on campus since the former could be facing more inhibiting challenges than the latter. according to respondents cumulative gpa appears to have an effect on class attendance. from table 3 it is clear that the percentage of respondents who estimated their class attendance to be above 75% increased with the rise in cumulative gpa. while only 11% of students with cumulative gpa of below 2 assessed their attendance to be above 75% most of the students with cumulative gpa of between 4.7 and 5 (85%) estimated their class attendance to be above 75%. this may imply that consistent failing may lead to disgruntlement and discouragement while good academic performance may spark students to put more effort into their school work. these results support the findings of numerous prior studies which reported positive association between lecture attendance and academic performance (paisey & paisey, 2004; clark et al., 2011; leblanc, 2005; nyatanga and mukorera, 2017; papageorgiou, 2019). asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 97 factors influencing class attendance regarding the internal consistency among the 32 question items measuring the causes of failure to attend classes, the reliability test revealed the cronbach’s alpha coefficient of 0.86. this is an indication of strong internal consistency among the items affecting class attendance since the coefficient was above the lower limit of recommended score of 0.70 (tavakol & dennick, 2011). table 4 shows the items statistics arranged in the descending order of mean scores starting with item which received the highest. studying for other tests emerged as the strongest reason why students would fail to attend other classes (mean =3.79). this is consistent with gump (2005) who reported that 66% of his respondents indicated that studying for another exam or working on another assignment was the reason for absenteeism. that means students would forgo classes in order to prepare for tests. this calls for the proper scheduling of continuous assessment items on part of the learning institution and academic staff during the semester. lack of proper synchronization of tests and classes is more likely to disadvantage students as they may end up missing the valuable cues for the next tests for the class they missed. the second strongest reason for missing classes was the uploading of lecture materials to ict platforms (blackboard or moodle) (mean =3.57). this means that if students knew that the entire course material will be uploaded to e-learning platforms they would not be motivated to attend classes. this is the conundrum that the learning institutions in general and lecturers in particular face as they strive to balance the support for the use of technology to facilitate independent study and encouraging face to face contact to enhance interactive learning through classroom questions and discussions. gomis-porqueras, meinecke and rodrigues-neto (2011) call for extensive assessment of the net effect of use of technology on students’ learning. the third strongest factor to hinder class attendance according to sampled students is the failure to do the necessary reading in advance of the topic which is going to be discussed in the next class (mean =3.09). this finding is in contrast with gump (2005) who found that only 8% of respondents agreed that unpreparedness for the class would prevent them from attending. at the same time the finding supports the argument by gump (2005) that accepting attendance without preparedness would mean encouraging passive instead of active learning and it should only work where attending without preparation does not interfere with learning. but one would argue that failure to attend a class where the material which one has not read would be discussed puts a student in a lose-lose situation. the student fails to take advantage of discussions which will be held in class on the topic he/she has not prepared on. on the fourth place was the working on the assignment/project which is due on the day (mean= 3.07). this finding also corroborates the results of gump (2005) where 66% of respondents agreed that working on another assignment would interfere with their class attendance. this could be the result of genuine overload or students failing to properly schedule their work. lack of proper time management on part of students came fifth on the list of factors which would hinder appropriate class attendance (mean = 3.06). failure to properly allocate time to school activities and having many lectures to attend in a day came sixth on the list of factors hampering class attendance each scoring a mean of 3.05. transport problems to come to school asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 98 were also among the top ten reasons why a student would fail to come to class (mean= 3.03).this finding is in agreement with observation by davis, hodgson and macaulay (2012) that travelling time to school was one of the major factors discouraging class attendance at monash university in australia. this would mostly affect students who stay outside campus, who are in the majority at the university of botswana. lack of personal motivation (mean = 3.01) was also mentioned as one of the ten serious reasons why a student would not come to class. several factors could be contributing to lack of personal motivation to come to class. braak (2015) asserts that motivation can be both external and internal factor. according to the work by braak (2015) 80% of hospitality students indicated that they attend class to listen and be exposed to theory while 20% of them were motivated to attend classes by other numerous factors. the length of time between lectures was also identified to be among the ten most serious reasons why a student would miss a class (mean = 2.99). according to respondents, if a student has to wait for a long time before going to another lesson it would be a good reason for missing the next class. this is consistent with findings of davis, hodgson and macaulay (2012) and kelly (2012) who reported that large gaps between classes or few classes in a day negatively affect class attendance. in big institutions such as university of botswana where the time table is centrally prepared and more often than not there are several courses to be allocated to limited class rooms long spacing between classes may seem unavoidable. therefore this could be an area where new entrants into the university may need to be sensitized on to prepare them psychologically to face such challenges of tertiary education. in contrast to conclusion of davis, hodgson and macaulay (2012) that timetable clashes were the major factors influencing attendance, in this study timetabling clashes were the least factor to hamper attendance with mean score of 1.87. this could be, perhaps, at the university of botswana lecture clashes rarely take place and once identified and cannot be resolved the affected student is usually advised to deregister from the other course especially if that alternative is not going to affect the graduating date. the respondents of this study, surprisingly disagreed with the statement suggesting that the desire to emulate others who do not attend class (mean = 1.91) would be the factor to deter them from attending class due. although prior studies like that one by westrick, et al. (2009) reported that students’ illness would hinder class attendance, in the current study being genuinely sick (mean = 2.74) did not feature among the top ten causes of absenteeism. overall, the average mean score of 2.62 as reflected in table 4 indicates that students were not agreeable to most factors suggested to be hindrances to their class attendance. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 99 table 4. ranked factors hindering class attendance. variables mean std dev. i. i am studying for other test 3.79 1.057 ii. contents of lecture include all information in blackboard or moodle 3.57 1.378 iii. i have not done the necessary reading in advance on the topic of the course 3.09 1.069 iv. i am working on assignment/project that is due on the same day 3.07 1.327 v. lack of proper time management on my part. 3.06 1.206 vi. failure to allocate time properly on my part 3.05 1.254 vii. too many lectures to attend in a day 3.05 1.292 viii. transport problems to come to school (eg lack of tax/combi fare, traffic jam, motor vehicle breakdown) 3.03 1.54 ix. lack of personal motivation 3.01 1.237 x. i have to wait for too long to go to the next class 2.99 1.318 xi. lack of interactive activities 2.84 1.262 xii. the way the course is delivered does not appeal to my way of learning. 2.83 1.318 xiii. just being lazy (could not be bothered) 2.80 1.287 xiv. genuinely sick 2.74 1.334 xv. unexciting/uninspiring lecturer 2.72 1.317 xvi. large class size in terms of number of students 2.66 1.16 xvii. i can succeed in the course without going to lectures/tutorials 2.65 1.222 xviii. distraction from other things such as movies and games 2.64 1.193 xix. family commitment, e.g. taking care of a sick relative, attending bereavement 2.59 1.304 xx. instruction material of low quality 2.43 1.146 xxi. class room not conducive 2.33 1.155 xxii. being involved in part-time jobs 2.24 1.257 xxiii. i am unhappy with the lecturer(s) 2.23 1.273 xxiv. class attendance is not the best use of my time 2.17 1.034 xxv. being involved in extra curricula activities e.g member of soccer team. 2.14 1.137 xxvi. i am doing a course at the level lower than i am supposed to be 2.11 1.035 xxvii. i am unhappy with the course(s) 2.10 1.107 xxviii. time of the class too early in the morning 2.05 1.227 xxix. i am unhappy with classmates 1.96 1.001 xxx. preferring following what is trending in social media rather than attending classes 1.96 1.017 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 100 xxxi. peer pressuredesire to be like others who do not attend 1.91 1.071 xxxii. clashing with another course 1.87 1.049 average 2.62 1.21 comparison of means of second and third years’ students table 5 shows the comparison of mean codes of the views of level 200 and level 300 courses on 32 factors that may hamper class attendance. statistically significant differences in means of the views of students taking introduction to cost accounting in the second year and those doing principles of auditing in the third year were observed in 10 out of 32 items at 5% significance level. on the statement that a student can be successful in the course without going to lectures or tutorials, second year students had a mean of 2.43 while their counter parts in the third year had a mean of 2.82 with mean difference of -0.390 and p value of 0.036. regarding whether being unhappy with a course can be the reason for not attending class, third year students had a mean of 2.3 while their counter parts in the second year had a mean code of 1.83. the means difference was -0.488 and p value was 0.004. this means that third year students are more likely to miss the class because they are not amused with course. put in other words, students taking principles of auditing are more likely not to come to class due to their hostile attitude towards the course than students taking introduction to cost accounting. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 101 table 5. acc201 (n=69) vs. acc309 (n=131) students’ opinion about causes of poor class attendance acc201 acc309 md t-test for equality of means variables mean std dev. mean std dev. t sig. i. i can succeed in the course without going to lectures/tutorials 2.43 1.206 2.82 1.256 -.390 -2.114 0.036 ii. i am unhappy with the course(s) 1.81 1.061 2.3 1.172 -.488 -2.889 0.004 iii. i am unhappy with the lecturer(s) 1.80 1.106 2.30 1.287 -.501 -2.741 0.007 iv. i have to wait for too long to go to the next class 2.35 1.082 3.28 1.377 -.935 -5.270 0.000 v. i am working on assignment/project that is due on the same day 2.64 1.372 3.15 1.344 -.515 -2.557 0.011 vi. i am studying for other test 3.59 1.142 3.96 0.956 -.368 -2.286 0.024 vii. too many lectures to attend in a day 2.80 1.170 3.35 1.347 -.554 -2.889 0.004 viii. the way the course is delivered does not appeal to my way of learning. 2.04 1.035 3.08 1.351 -1.033 -6.017 0.000 ix. preferring following what is trending in social media rather than attending classes 2.12 1.182 1.76 0.921 .360 2.203 0.030 x. unexciting/uninspiring lecturer 2.25 1.265 2.73 1.277 -.479 -2.528 0.012 being unhappy with the lecturer was another factor where level 200 (means = 1.80) and level 300 students (mean =2.30) had a significant difference in their views (p = 0.007). this means that level 300 students are more likely to miss lectures than the level 200 students on the grounds of being unhappy with the lecturer. the mean difference on this factor was -0.501. the significant differences in mean scores (p = 0.000) between level 200 students and level 300 students was also identified on the statement about waiting for too long before getting into another class. the second year students reflected a mean code of 2.38 while the third year students reflected mean score of 3.28 resulting in a mean difference of -0.935. this implies that asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 102 the third year students are less resilient in relation to the duration they have to wait to catch the next class. a significant difference in views (p = 0.011) was also produced on the statement that working on an assignment which is due on the same day as the lecture would inhibit a student from going to class. second year students had a mean code of 2.64 whilst their counterparts in the third year had a mean score of 3.15 with a mean difference of -0.515. this implies that third year students were more agreeable to the statement than the second year. in addition, studying for another test was one of the factors that produced a significant difference in means (p = 0.024) between the second year (mean = 3.59) and third year students (mean = 3.96). again the third years were more agreeable to the statement than the second years. moreover, too many lectures to attend in a day produced a statistically significant difference (p = 0.004) in means of views of two cohorts. the second year students had a lower mean of 2.80 while their third year counterparts reflected a mean code of 3.35 with a mean difference of -0.554. furthermore, the statement that the way the course is delivered does not appeal to student’s way of learning yielded a significant difference in means (p = 0.000) among the second and third year students. the mean codes for second year and third year students on this factor were 2.04 and 3.08 respectively with the largest mean difference of -1.033. both second and third year students disagreed with the statement that they would prefer to follow what is trending in social media to attending classes. however, there was a statistically significant difference (p = 0.030) in their views with second year students reflecting a mean score of 2.12 and third year students producing a lesser mean score of 1.76. another factor on which statistically significant difference in views (p = 0.012) between second and third year students was produced was the unexciting/uninspiring lecturer. on this factor second years had a mean code of 2.25 while the third years had a mean score of 2.73 implying that both groups disagreed with the statement that a boring lecturer would prevent them from attending class. to sum up, table 5 shows that 9 out of 10 factors in which the second and third years displayed significant differences in mean scores, third year students had a relatively higher mean scores than the second year students as exhibited by negative mean differences and t-values. these factors are: succeeding in a course without going to class, being unhappy with the course, being unhappy with lecturer(s) and waiting for too long before going to the next class. other factors are working on other assignment, studying for tests, too many lectures in a day, the way the course is delivered not appealing to student’s style of learning and unexciting lecturer. second years’ mean scores where higher than the third years’ on only one statement suggesting that students would miss class on account of following up what is trending in social media. the average mean scores of each of the two cohorts are 2.47 for second years against 2.63 for third years. this implies that in general the mean scores of third year students were relatively higher than those of second year counterparts; meaning that the third year students were more agreeable with factors suggested as hindrances to attendance than the second year students. in fact, mean codes of the third years were superior to the second years in 20 items out of 32. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 103 comparison of means of second and fourth years’ students table 6 shows the results of the t-test on views of the second year and fourth year students regarding the factors that hinder class attendance. statistically significant differences in views of two groups were observed in only 9 items out of 32 at 5% significance level. both second year’s respondents doing introduction to cost accounting and fourth year respondents taking financial reporting agreed that uploading lecture contents to ict platforms hinder them from attending classes. there was a statistically significant difference in views of second year students (mean = 3.78) and of fourth year students (mean = 3.16) with a mean difference of 0.618 and p value of 0.04. there were also significantly divergent views (p =0.000) regarding whether being unhappy with a lecture(s) would prevent the students from attending classes. second year students reflected a mean of 1.80 while their counterparts in the fourth year produced a mean score of 2.51 implying that the latter is more likely to skip classes if they are not happy with lecturer(s). waiting for too long to go to class was also the source of significant differences in views (p =0.000) between the second year (mean = 2.35) and fourth year students (mean = 3.08). this factor seems to affect the fourth year students more than the second years. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 104 table 6. acc201 (n= 69) vs. acc410 (n=79) students’ opinion about causes of poor class attendance acc201 acc410 md t-test for equality of means variables mean std dev. mean std dev. t sig. i. contents of lecture include all information in blackboard or moodle 3.78 1.247 3.16 1.344 .618 2.886 .004 ii. i am unhappy with the lecturer(s) 1.80 1.106 2.51 1.309 -.709 -3.572 .000 iii. i have to wait for too long to go to the next class 2.35 1.082 3.08 1.217 -.728 -3.822 .000 iv. i am working on assignment/project that is due on the same day 2.64 1.372 3.32 1.172 -.679 -3.247 .001 v. large class size in terms of number of students 2.93 1.264 2.42 1.008 .510 2.687 .008 vi. genuinely sick 2.49 1.313 3.28 1.290 -.786 -3.665 .000 vii. the way the course is delivered does not appeal to my way of learning. 2.04 1.035 3.13 1.213 -1.083 -5.861 .000 viii. instruction material of low quality 2.22 1.162 2.84 1.148 -.618 -3.249 .001 ix. unexciting/uninspiring lecturer 2.25 1.265 3.15 1.312 -.906 -4.260 .000 statistically significant difference in means (p = 0.001) was also witnessed with the statement about working on other assignment/project that is due on the same day. the fourth year students were more agreeable to the statement (means = 3.32) than the second year students (mean = 2.64) with a mean difference of -0.679. this could be due to the fact that as students move to the higher academic levels their workload intensifies. large class size in terms of number of students also yielded a significant differences in views (p = 0.008) of second years and fourth year students. the second years registered a mean code of 2.93 whilst the fourth years registered mean scores of 2.42 with a mean difference of 0.510. interestingly being genuinely sick also yielded a significant difference in means between second year students (mean = 2.49) and fourth year students (mean=3.28) with mean difference of -0.786. these asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 105 results were opposite to what was expected since under normal circumstances every student should be expected to miss a class on account of being genuinely sick. the significant differences in views (p = 0.000) were also detected in relation to the statement that the way the course is delivered is not in sync with student’ way of learning. fourth years were more agreeable to the statement (mean = 3.13) than second years (mean= 2.04) with mean difference of -1.083. instructional material being of low quality was also the source of statistically differences in views (p=0.001) between second years (mean = 2.22) and fourth years (mean = 2.84). second year students’ views were statistically significant from those of fourth year (p = 0.000) regarding the factor of uninspiring lecturer. fourth years respondents (mean = 3.15) were more agreeable to the factor being a hindrance to class attendance than the second year students (mean = 2.25). in summary table 6 shows that that in 7 items out of 9 fourth year students doing financial reporting reflected relatively higher mean scores than the second year students doing introduction to cost accounting as shown by negative mean differences and t-values. fourth years were more agreeable than the second years that being unhappy with lecturer(s), long waiting time before getting to another class, working on an assignment due on the same day of the lecture, large class size, ill-health, unpleasant delivery of the course, poor instructional material and unexciting lecturer would hinder them from going to class. the average of mean scores of each of the two groups are 2.47 for second years against 2.70 for fourth years implying that in general the mean scores of fourth year students were relatively higher than those of second year. mean scores of the fourth years were superior to the second years in 26 items out of 32. comparison of means of third and fourth years’ students table 7 reflects the comparison of views of third year students doing principles of auditing and fourth year students taking financial reporting. statistically significant differences in views between third year and fourth year students about the factors that can prevent students from attending class were detected in 9 items out of 32 items at 5% significance level. significant different views (p = 0.011) were expressed about the item regarding uploading lecture contents to ict platforms. third year students had a mean score of 3.68 whilst the fourth year students had 3.16 with a mean difference of 0.515. this tells us that putting all lecture information to ict platforms would affect more the class attendance of students taking principles of auditing than those doing financial reporting. having many lectures to attend in a day was also a factor that reflected significant different means (p = 0.001) between third year student (mean =3.35) and fourth year students (mean = 2.73) with mean difference of 0.617. again we see here that class attendance of students taking principles of auditing will be more affected by number of classes to attend in a day than their counterparts doing financial reporting. being genuinely sick also produced statistically significant different means (p = 0.000) between third year students (mean = 2.56) and fourth year student (mean = 3.28) with mean differences of -0.744. the reason why this factor is producing significantly different views is not clear. who would push himself or herself to come to class if genuinely sick? preferring to follow what is trending in social media rather than attending class also created asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 106 significant different views (p = 0.003) between students in third year (mean = 1.76) and those in fourth years (mean = 2.15) implying that third year students disagreed more with the statement than the fourth years. table 7. acc309 (n=131) vs. acc410 (n=79) students’ opinion about causes of poor class attendance acc309 acc410 md t-test for equality of means variables mean std dev. mean std dev. t sig. i. contents of lecture include all information in blackboard or moodle 3.68 1.437 3.16 1.344 .515 2.576 .011 ii. too many lectures to attend in a day 3.35 1.347 2.73 1.206 .617 3.342 .001 iii. genuinely sick 2.56 1.290 3.28 1.290 -.714 -3.884 .000 iv. preferring following what is trending in social media rather than attending classes 1.76 0.921 2.15 0.962 -.396 -2.970 .003 v. being involved in extra curricula activities e.g member of soccer team. 2.02 1.126 2.37 1.146 -.344 -2.131 .034 vi. peer pressuredesire to be like others who do not attend 1.73 0.959 2.19 1.188 -.457 -2.896 .004 vii. instruction material of low quality 2.28 1.083 2.84 1.148 -.553 -3.503 .001 viii. unexciting/uninspiring lecturer 2.73 1.277 3.15 1.312 -.427 -2.322 .021 ix. family commitment, e.g. taking care of a sick relative, attending bereavement 2.46 1.291 2.85 1.262 -.390 -2.140 .034 in addition, being involved in extra curricula activities also produced statistically significant different views (p = 0.034) from two groups of students. third year students had a mean score of 2.02 while fourth year students had a mean code of 2.37 with a small mean difference of 0.344. again the third year students perceived their class attendance being less affected by engaging in extracurricular activities than their counterparts in fourth year. significant difference in views (p = 0.034) between third year students (mean = 1.73) and fourth year (mean = 2.19) were also observed in relation to missing classes on the grounds of imitating asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 107 others who do not attend classes. although both groups negated the statement that suggested that they would miss a class in order to please those who usually don’t attend classes, the third year students were less aggregable to the statement than the fourth year students. furthermore, low quality of instructional material as factor capable of causing class nonattendance produced a significant difference in mean scores (p = 0.001) between students doing principles of auditing (mean= 2.28) and their colleagues doing financial reporting (mean = 2.84) with a mean difference of -0.553. however, both classes disagreed with the notion that poor instructional material would prevent them from coming to class. unexciting lecturer was also the cause of significant difference in means (p = 0.021) between third years and fourth years whereby the former registered a mean score of 2.73 while the latter recorded a mean score of 3.15 with a mean difference of -0.427. a significant difference in views (p = 0.034) was also observed on the item about family commitment with third years showing a mean score of 2.46 and fourth years registering a mean code of 2.85. to cup up, table 7 show that in 7 items out of 9 in which significant differences were spotted mean scores of fourth year students were relatively higher than those of their counterparts in the third year as indicated by negative mean differences and t-values. this means that fourth year students were more agreeable than the third year students that being genuinely sick, following what is trending in social media, involvement in extracurricular activities, desire to imitate those who do not come to class, poor quality of instructional material, unexciting lecturer and family commitment would prevent them from attending classes. the average means scores of 2.63 for the third years as opposed to 2.70 of fourth years indicate that in general the mean scores of the latter were relatively higher in most of the items than the former. in actual fact fourth years’ mean scores were higher in 20 items out of 32 items. overall, the comparison of the mean scores of different years of study revealed that the higher class had relatively superior mean scores than the immediate lower class. this implies that the higher the students move in their programme the more excuses they would have for missing classes. while on one hand the reason for this finding could be associated with increased workload at the higher level, on the other hand it could be that students in higher classes get more familiar with the programme and college environment and become less serious with their studies. other factors that affect class attendance students were asked to suggest other factors contributing to poor attendance than those mentioned in the close ended questions. classes scheduled late hours in the day was mentioned by students as the main reason for not coming to class followed by what was termed boring lecturer or non-motivating lecturer. prior studies, for example, paisey and paisey (2004), kotttasz (2005) and massingham and herrington (2006) mentioned late lecture time to be the major contributor to absenteeism. in addition, harsh weather and lack of funds to cover transport to and from school and food were also cited as factors hindering class attendance. findings about insufficient funds for school requirements is consistent with findings of lukusa et al. (2015) who reported that late allowances was among the top three factors contributing to absenteeism at botho university. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 108 regarding the question of how class attendance can be improved, respondents suggested the exciting and interactive classes as the prominent means to attract students to class. this supports the recommendations of moores, birdi and higson (2019, p374) who assert that “academics wishing to encourage attendance should therefore seek to make their lectures interesting and interactive and try to create enjoyable social occasions”. the other suggested approach to improve class attendance was moving classes to morning or mid-day hours from afternoon hours. these results collaborate the findings of paisey and paisey (2004) who documented that classes which are scheduled between 10 am and 3pm had better attendance than those scheduled early or late in the day. moreover, participants were of the view that a combination of keeping attendance register and awarding marks for attendance would motivate students to attend classes. these suggestions imply making attendance mandatory and awarding it. compulsory attendance in botswana could be against the prevailing silent practice of allowing students to become adults by making their own class attendance choices. some prior studies discourage mandatory attendance policies. hyde and flournoy (1986) reject mandatory class attendance because of the evidence that some students with poor attendance manage to attain outstanding academic achievement. clair (1999) is against compulsory class attendance on the grounds that class attendance is more influenced by personal motivational beliefs and class context and therefore cohesive class attendance may deny students’ control and make them feel bad about their decision to enroll with the higher education institution. frisbie, diamond and ory (1979) and clair (1999) refute the notion of awarding marks for attendance on the grounds that marks should only be a reflection of each student’s competence in the course. conclusion and recommendation this study used the responses of self-administered survey from second, third and fourth year students of selected business core courses of bachelor of accountancy degrees at the university of botswana to assess their self-estimated class attendance and their views on the factors that would influence class non-attendance. in general students perceived themselves to have a satisfactory class attendance as 54% of them assessed their normal class attendance to be above 75% and almost 84% perceived their class attendance to be over 50%. gender, type of course and accommodation status did not appear to be major sources of discrepancies in respondents’ average class attendance. however, academic performance appeared to be a stimulus for class attendance. despite strong consistence among the items, only 9 items out of 32 had mean scores of above 3 out of 5. in essence, students indicated that studying for other test, uploading course material to ict platform, having not read in advance the topic(s) to be discussed in the class, being busy on other assignments and lack of proper time management would impede their class attendance. in addition, failure to allocate time properly, too many lectures/tutorials on the same day, transport problem and lack of personal motivation are among the 9 critical factors that would hamper class attendance in business programmes at the university of botswana. moreover, this study revealed that on average students included in the sample negated most of the factors as being hindrances to their class attendance as indicated by average mean score asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 109 ranging between 2.47 to 2.70. in addition, the findings of this study suggest that the higher the year of study the more agreeable the students were to the factors affecting class attendance. these results call for serious reflection by the three stakeholders on how to resolve the issues surrounding at least the top ten causes of class non-attendance. the university should find ways of sensitizing students about the importance of class attendance if they have to attain full benefits of their university enrollment. academic staff should devise means of attracting students to classes. for example, for courses which have tests as components of their continuous assessment earmarking a week in which all tests could be administered would address the problem of missing classes due to tests. awarding marks for class attendance can also entice students to come to class. students need to develop a habit of having a continuous preparation for tests not to wait until the few days remaining to write to start reading. having a good timetable which one can strictly adhere to will go a long way to address the issues of missing a class because of other tests or working on other assignments. limitation of the study only students that were in class when the questionnaire was being administered answered the questionnaire. therefore the views of those that were absent and are probably the ones that do not attend classes on a regular basis were not captured. the views of the latter group are important in addressing the issue of class absenteeism. administering the questionnaire in class might have caused the respondents to complete the questionnaire referring to the particular course they were attending at that time when completing the questionnaire instead of looking at their class attendance in general as it relates to other courses. also the negative effect of self-assessment questionnaire as highlighted by moores, birdi and higson (2019) and demetriou, ozer and essau (2015) whereby respondents tend not to tell the whole truth might have constrained this study. the results of this study are limited to only students taking accounting courses at the exclusion of non-accounting students who might have different reasons from the targeted group. the views of students from other universities where also not examined. also the study did not try to seek the opinion of instructors whose views could have reinforced or negated the views given by the students. despite these limitations the study yielded important knowledge which is useful in addressing the class non-attendance by all interested stakeholders. future research numerous factors are responsible for class absenteeism and therefore various studies may be done from different perspectives to understand the whole phenomenon. the study that compares the views about factors explaining class non-attendance from different learning institutions using both students and academic staff is highly recommended. results of such a study have a high likelihood of attracting the attention of more stakeholders interested in enhancing learners’ performance and 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(2006). gender differences in undergraduate attendance rates. studies in higher education, 31(1), 1-22. https://doi.org/10.1080/03075070500340127 microsoft word 10095-37142-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 95 the influence of directors’ and officers’ insurance on managerial myopic behavior guang-zheng chen department of accounting, feng chia university no.100, wenhwa road, seatwen, taichung 40724, taiwan, r.o.c. e-mail: gzchen0120@gmail.com received: oct. 1, 2016 accepted: oct. 20, 2016 published: december 1, 2016 doi:10.5296/ajfa.v8i2.10095 url: http://dx.doi.org/10.5296/ajfa.v8i2.10095 abstract literature on the effect of directors’ and officers’ insurance (d&o insurance) on managers’ decision-making supports the contention that d&o insurance encourages managers to engage in opportunistic behaviors that benefit themselves at the expense of shareholders. managerial myopia is an essential agency issue. the literature suggests that myopic managers have incentives to reduce r&d spending to boost current earnings in order to increase their private benefits. this study examines whether d&o insurance induces myopic r&d cuts. using a sample of taiwanese listed firms, the results show that firms with higher levels of d&o insurance coverage are more likely to cut r&d expenditures to avoid earnings declines. this study provide insight into how the incentives arising from d&o insurance play an essential role in determining managerial myopic behavior. keywords: corporate governance, d&o insurance, r&d, managerial myopia, agency theory asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 96 1. introduction directors’ and officers’ insurance (d&o insurance) alleviates the financial liability of officers and directors stemming from lawsuits filed against them while working for the company. however, empirical studies provide evidence that d&o insurance is likely to motivate managers to engage in opportunistic behavior (chalmers et al., 2002; chung and wynn, 2008; lin et al., 2011). managerial myopia is an agency problem that occurs when managers sacrifice long-term value creation projects (e.g., r&d) for the purpose of meeting short-term goals (porter, 1992). research (graham et al., 2005; roychowdhury, 2006; osma and young, 2009) also suggests that managers opportunistically reduce r&d spending to boost current earnings for private benefits. therefore, i examine whether d&o insurance provide managers with incentives to behave myopically by cutting r&d spending. d&o insurance policy typically provides an essential shield for directors and officers against personal legal liabilities stemming from their business decisions. nevertheless, d&o insurance can induce moral hazard problems, thus reducing the incentive of managers to act in the best interest of stakeholders (baker and griffith, 2010; lin et al., 2011, 2013). empirical studies of managerial myopic behavior have focused primarily on r&d expenditure. the evidence is consistent with managers myopically reducing r&d investment to meet short-term earnings goals (baber et al., 1991; dechow and sloan, 1991; bange and de bondt, 1998; bens et al., 2002; roychowdhury, 2006; cohen and zarowin, 2010). such managerial myopia occurs because r&d investments are immediately expensed under current accounting rules, yet may pay off in the long-term rather than in the short term (fama and jensen, 1983; baysinger et al., 1991). research indicates that two circumstances are required for myopic investment behavior (stein, 1988, 1989; bushee, 1998). first, managers should place greater emphasis on the current market value of their firm. second, capital markets should misprice current earnings without fully considering their underlying economics, or managers should believe that they do. since d&o insurance leads managers to act in their own interest rather than the firm’s interest, well-protected managers may have incentives to engage in myopic r&d investment behavior. r&d activities have a long-term relationship with highly uncertain, unpredictable future cash flows, as well as a high risk of failure (holmstrom, 1989). since d&o insurance induces managers to take action in pursuit of personal goals, they may be reluctant to engage in r&d activities and more likely to reduce the amount of r&d investment to achieve current-period earnings performance. research (fuller and jensen, 2002; rappaport, 2005) also provides evidence that capital markets can incorrectly price current earnings, and investors and managers have a mutually reinforcing obsession with short-term performance, with earnings as the most widely accepted metric.1 since d&o insurance induces managers to pursue opportunistic behavior and damage firm value, well-protected managers may be inclined to reduce r&d expenditures in order to report strong earnings, which in turn, drives up the firm’s stock price in the shortrun and increases their compensation. i therefore expect that d&o insurance coverage is associated with myopic r&d investment behavior. 1 it is also consistent with stein’s (1988, 1989) observation that the capital market is myopic and will induce managers to behave myopically. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 97 based on a sample of taiwanese listed firms over the period 2008-2012, i find that, consistent with my prediction, firms with higher d&o insurance coverage are more likely to cut r&d expenditures when faced with potential earnings declines. this finding suggests that d&o insurance induces managers to make corporate decisions which advance their own interests. the results are robust to several sensitivity checks. this study contributes to the literature in several ways. first, research has investigated the effect of d&o insurance on the outcome of mergers and acquisitions (m&as) (lin et al., 2011) and financial reporting quality (chung and wynn, 2008; chung et a., 2013; kim, 2015). this study adds to the literature on d&o insurance by showing that moral hazards related to d&o insurance can affect myopic r&d cuts. second, this study contributes to the literature on managerial myopia. a large number of studies document that managers are inclined to sacrifice long-term value creation to achieve short-term earnings targets. these studies suggest that managers tend to reduce r&d expenditures in response to concerns about earnings declines or losses (baber et al., 1991), short managerial horizons (dechow and sloan, 1991), catering to the short-term needs of transient institutional investors (bushee, 1998), and the need to raise capital (cohen and zarowin, 2010). this study extends this line of research by provide evidence that d&o insurance coverage appears to be an important determinant of managerial myopia. finally, this study adds to the stream of real earnings management literature since myopic r&d reduction is a type of real activities manipulation. the reminder of this paper is organized as follows. section 2 reviews relevant literature and develop the hypothesis. section 3 outlines the research design. section 4 details the sample selection and presents the empirical findings. section 5 concludes. 2. literature review and hypothesis development 2.1 research on d&o insurance d&o insurance is designed to protect directors and officers from liability stemming from actions connected to their corporate position. d&o insurance covers situations in which the director or officer commits fraudulent or illegal activities unintentionally, but does not violate his/her duty to the shareholders and the firm. the insurance policy typically does not cover the total liability, and management should bear part of the cost personally. the items generally covered contain judgments or settlements in actions alleging negligence. the policy does not cover liability including willful misconduct, self-dealing, bad faith, knowing violation of security laws, personal profit, or dishonesty. holderness (1990) and o’sullivan (1997) argue that d&o insurance acts as a monitor mechanism for directors and officers because the d&o insurer entirely scrutinizes the insured, and coverage limits and deductibles exist. in addition, kalelkar and nwaeze (2015) suggest that abnormally higher d&o insurance coverage can more fully insulate managers against legal penalties stemming from exercising their corporate decision-making authority. therefore, higher abnormal coverage induces mangers to take actions that will maximize shareholder value. however, a considerable body of research suggests that d&o insurance alleviates the expected litigation risk of managers, thus introducing severe agency problems asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 98 and managerial opportunism. for instance, zou et al. (2008) indicate that d&o insurance could be opportunistically purchased to protect corporate insiders (managers or controlling shareholders) against potential lawsuit costs stemming from the expropriation of outside shareholders. chalmers et al. (2002) document a negative association between the amount of d&o insurance purchased at the time of the ipo (initial public offering) and three-year post-ipo stock returns. their finding suggests that managers are prone to purchase d&o insurance when they are aware of overvalued ipo stocks (and thus the litigation risks caused by subsequent price decreases). in addition, several studies document a significantly positive association between d&o coverage limits and the likelihood that firms restate earnings (lin et al., 2013; kim, 2015). similarly, d&o insurance coverage limits have also been shown to be negatively associated with earnings quality (chung et al., 2013) and earnings conservatism (chung and wynn, 2008). moreover, higher d&o coverage is pertinent to firms that have lower abnormal-period returns during mergers and acquisitions (lin et al., 2011), higher costs of debt and equity capital (lin et al., 2013; chen et al., 2016), and higher audit fees (chung et al., 2015). 2.2 research on managerial myopia myopia refers to underinvestment in long-term value creating activities for the purpose of meeting short-term goals (porter, 1992). research provides evidence of managerial myopia, mainly with respect to r&d expenditures. for instance, baber et al. (1991) demonstrate that when spending on r&d may reduce the ability of managers to report positive income or an increase in income, they decrease r&d expenditures to report stronger earnings. dechow and sloan (1991) show that ceos will reduce r&d expenditures to increase short-term earnings in the final years of their tenure. bens et al. (2002) find that managers cut r&d expenditure to fund share repurchase programs in order to mitigate earnings per share dilution due to stock option exercise. in addition, graham et al. (2005) survey and interview over 400 senior executives and report that 80% would cut r&d as well as other discretionary expenditures to meet earnings benchmarks. roychowdhury (2006) provides evidence consistent with the contention that managers manipulate real activities, such as r&d, to avoid reporting annual losses. osma and young (2009) also document that the pressure to report positive levels and changes of earnings in a large sample of r&d-active uk firms results in contemporaneous cuts in r&d spending. more recently, chen et al. (2015) report evidence that firms with severance pay or fixed employment agreements for managers can reduce their myopic behavior of cutting r&d expenditures to boost short term performance in order to increase their job security. as mentioned above, such managerial myopia can be attributed to the current accounting rules forcing firms to expense r&d in the period incurred. namely, the increase of r&d expenditures has a negative effect on short-term accounting earnings and stock performance, while benefits from the expenditures occur in the future.2 in the presence of such negative effects, firms have incentives to reduce r&d expenditures to boost current earnings, which results in conflicts of interest between managers and outside shareholders. 2.3 d&o insurance and managerial myopia 2 the literature indicates that r&d projects are typically risky, unpredictable, long-term oriented, multi-stage, labor intensive and idiosyncratic (e.g., holmstrom, 1989; baysinger et al., 1991; kothari et al., 2002). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 99 myopic managerial behavior typically occur under two circumstances (stein, 1988, 1989; bushee, 1998). first, managers should place greater emphasis on current market value relative to future market value. they are reluctant to wait until the temporary mispricing (if any) based on short-term earnings performance is corrected and thus reluctant to adopt a long-term perspective. second, capital markets should misprice firms’ current-period earnings without regard to their underlying economics, or managers must believe that they do. since d&o insurance results in a host of moral hazard issues and reduces managers’ incentives to act in the best interest of shareholders (baker and griffith, 2010; lin et al., 2011), well-protected managers may have incentives to cut r&d to increase short-term earnings rather than engage in long-term value creation. first, r&d investments are long-term, risky, and expensive projects. since d&o insurance induces managers to act opportunistically, they may focus on short-term earnings performance and thus underinvest in r&d. second, capital markets can incorrectly price current earnings if investors are short-term oriented (ellis, 2004) or misinterpret the persistence of earnings components (sloan, 1996). research suggests that investors and managers have a mutually reinforcing obsession with short-term performance, and such short-term focus motivates managers to actively participate in the earnings game (fuller and jensen, 2002; rappaport, 2005).3 as well-protected managers are inclined to make decisions that primarily generate private benefits for themselves rather than for shareholders, they may underinvest in r&d to increase current earnings. this boosts their firms’ stock price and maximizes their compensation. consequently, d&o insurance leads managers to act in their own interest at the expense of shareholders, and well-protected managers may be reluctant to pursue risky r&d activities and inclined to cut r&d to achieve near-term earnings performance. this leads to the following hypothesis: hypothesis 1: ceteris paribus, firms with higher d&o insurance coverage are more likely to cut r&d to manage earnings. 3. research design to capture managerial myopic behaviors, i follow bushee (1998) and partition sample firms into three groups: a small earnings decrease (sd) group, a large earnings decrease (ld) group, and an earnings increase (in) group. the sd group includes firm-years which have a decrease in the pre-tax, pre-r&d earnings from the previous year to the current year and in which the decrease is less than the previous year’s r&d. baber et al. (1991) and bushee (1998) suggest that within this group, myopic managers can potentially avoid an earnings decrease by cutting the current year r&d. the ld group includes firm-years in which there is a decrease in the pre-tax, pre-r&d earnings from the previous year to the current year and in which the decrease is greater than the previous year’s r&d. the in group includes firm-years which have an increase in the pre-tax, pre-r&d earnings from the previous year to the current year. for ld and in groups, cutting r&d is not helpful or necessary to achieve short-term earnings increase (chen et al., 2015). 3 even when the capital markets are efficient, managerial myopic behavior can result so long as managers believe that markets can be fooled (stein, 1989), which they do (graham et al., 2005). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 100 i run the following logit regression to test the effect of d&o insurance coverage on r&d cuts. 0 1 2 3 4 5 6 7 8 9 10 11 12 prob( 1) ( ln ) t t t t t t t t t t t t n m t cut f dolimit pcrd cird cgdp toq csales ccap mv lev fcf dist insown year ind α β β β β β β β β β β β β β β ε = = + + + + + + + + + + + + + + + (1) where cut is a dummy variable equal to 1 if r&d decreases relative to the previous year, 0 otherwise. dolimit is d&o coverage limit scaled by market value of equity. pcrd is the difference in the natural logarithm of r&d between the previous year and the year before. cird is the difference in industry r&d intensity (r&d expenditures scaled by total sales) between the current year and the previous year, where the industry is defined using the two-digit taiwan economic journal (tej) code. cgdp is the difference in the natural logarithm of gdp between the current year and the previous year. toq is the sum of market value of common equity and book value of debt, divided by the book value of total assets. csales is the difference in the natural logarithm of sales between the current year and the previous year. ccap is the difference in the logarithm of capital expenditures between the current year and the previous year. lnmv is the natural logarithm of market value of equity. lev is total debts divided by total assets. fcf is operating cash flows minus capital expenditures, scaled by total assets. dist is the change in pre-tax, pre-r&d earnings divided by previous year’s r&d. insown is the percentage of shares held by institutional investors. in equation (1), the primary variable of interest is the coefficient on dolimit. if well-protected managers are prone to cut r&d expenditures to manage earnings upwards, i would expect a positive and significant coefficient on dolimit in the small earnings decrease (sd) group. by contrast, i expect that the coefficients on dolimit would not be significant for the large earnings decrease (ld) and earnings increase (in) groups. following bushee (1998), i include several control variables that influence r&d investments and the likelihood of cutting r&d. first, i control for a firm’s r&d investment opportunity set by using following proxies: (1) last year’s change in r&d (pcrd) that captures the trend in r&d investments; (2) the change in industry r&d intensity (cird) that captures the r&d investment opportunity in the industry; (3) the change in gdp (cgdp) that captures the economy level of investment opportunity; and (4) tobin’s q (toq), change in sales (csales), and change in capital expenditures (ccap) that capture the firm’s growth opportunities. each of the above variables is expected to be negatively related to the likelihood of an r&d cut. second, firm size (size) is controlled for because smaller firms are more likely to suffer cash flow shortages that lead them to cut r&d. third, leverage (lev) is included in the model to capture the firm’s incentives to increase earnings to reduce debt contracting costs. fourth, free cash flows (fcf) is included to control for fund availability because firms have higher incentives to cut r&d when facing a serious cash shortage. fifth, distance to earnings goal (dist) is controlled for because larger distance increases the likelihood of an r&d cut to meet earnings goals. fifth, institutional ownership (insown) captures the monitoring by institutional investors and firms are less likely to engage in asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 101 earnings management through r&d reduction. lastly, i include year dummies (year) and industry dummies (ind) in the regression to control year and industry fixed effects. 4. data sample and empirical results 4.1 sample the initial sample includes nonfinancial firms listed in the taiwan stock exchange (tse) over the period 2008-2012.4 the data concerning d&o insurance coverage, ownership structure, financial statement and stock price are obtained from taiwan economics journal (tej) database.5 table 1 outlines the sample selection. i start with an initial sample of 7,143 firm-years for the empirical analysis. i delete 969 firm-years due to the lack of d&o insurance data. i drop 2,730 firm-years with missing or insignificant r&d expenditures (r&d expenditures less than 1% of sales). i exclude another 136 firm-years because they do not have sufficient data to calculate the regression variable. the final sample consists of 3,308 firm-year observations; 684 for sd group, 1,067 for ld group, and 1,557 for in group. table 1. sample selection firm-years non-financial firms listed on the taiwan stock exchange from 2008 to 2012 7,143 less: firms with missing d&o insurance data 969 firms with missing r&d data in the current year 72 firms with missing or insignificant r&d in the previous year 2,658 firms without necessary data to calculate regression variables 136 final sample 3,308 small earnings decrease (sd) group 684 large earnings decrease (ld) group 1,067 earnings increase (in) group 1,557 the sd group comprises firm-years for which –rdexpt-1 < (ebtrdt-ebtrdt-1) < 0. the ld group comprises firm-years for which (ebtrdt-ebtrdt-1) < -rdexpt-1. the in group comprises firm-years for which (ebtrdt-ebtrdt-1) > 0. rdexp = r&d expenditures. ebtrd = pre-tax, pre-r&d earnings. 4.2 descriptive statistics table 2 presents descriptive statistics for the sample (panel a) and the results of univariate tests that statistically assess the comparisons between sd group, ld group, and in group (panel b). to avoid the effect of outliers, all continuous variables are winsorized at the 1% and 99% tails. in panel a, it is about 47% of the sample firm-years cut r&d expenditures. overall, the average (median) d&o coverage limit (coverage_limit) is $170.989 million ($87.374 million), and the mean (median) d&o coverage limit (dolimit) accounts for 6.9% (2.0%) of market value of equity. in panel b, for almost all of the variables, the mean for the sd group lies between those of the ld and in groups, consistent with previous research (bushee, 1998) that is concerned with the performance ranking of this three groups. in addition, the means difference of cut and dolimit between sd group and in group are statistically significant at the 1% and 5% levels. this suggests that firms in sd group with 4 i start with the year 2008 because it is the first year with public disclosure of d&o insurance coverage. 5 the data for gdp is retrieved from national statistics, r.o.c. (taiwan) website. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 102 higher likelihood of cutting r&d and higher d&o coverage. however, there is no significant difference between sd group and ld group in cut and dolimit. table 2. descriptive statistics panel a: full sample mean standard deviation q1 median q3 cut 0.468 0.499 0.000 0.000 1.000 coverage_limit 170.989 362.660 0.000 87.374 194.985 dolimit 0.069 0.140 0.000 0.020 0.072 pcrd 0.056 0.288 -0.093 0.045 0.189 cird 0.000 0.002 0.000 0.001 0.001 cgdp 0.019 0.038 -0.014 0.014 0.026 toq 1.426 0.767 0.916 1.202 1.687 csales -0.015 0.303 -0.167 -0.009 0.142 ccap -0.078 1.214 -0.760 -0.080 0.585 lnmv 14.841 1.405 13.861 14.713 15.695 lev 0.323 0.156 0.201 0.309 0.423 fcf 0.037 0.100 -0.014 0.037 0.094 dist 0.018 5.033 -1.614 -0.121 1.272 insown 0.329 0.207 0.163 0.296 0.468 panel b: separately for the small earnings decrease (sd), large earnings decrease (ld), and earnings increase (in) groups mean differences in means sd group (n = 684) ld group (n = 1,067) in group (n = 1,557) sd versus ld sd versus in cut 0.518 0.540 0.397 -0.022 0.121*** dolimit 0.073 0.078 0.061 -0.004 0.013** pcrd 0.095 0.065 0.033 0.030** 0.062*** cird 0.001 0.001 0.000 -0.000*** 0.001*** cgdp 0.015 0.009 0.028 0.007*** -0.013*** toq 1.416 1.160 1.613 0.256*** -0.198*** csales -0.055 -0.166 0.107 0.111*** -0.162*** ccap -0.160 -0.180 0.027 0.020 -0.187*** lnmv 14.753 14.628 15.025 0.125* -0.273*** lev 0.296 0.329 0.331 -0.032*** -0.035*** fcf 0.041 0.026 0.042 0.015*** -0.001 dist -0.451 -4.292 3.177 3.841*** -3.628*** insown 0.325 0.317 0.338 0.008 -0.012 the sd group comprises firm-years for which –rdexpt-1 < (ebtrdt-ebtrdt-1) < 0. the ld group comprises firm-years for which (ebtrdt-ebtrdt-1) < -rdexpt-1. the in group comprises firm-years for which (ebtrdt-ebtrdt-1) > 0. rdexp = r&d expenditures. ebtrd = pre-tax, pre-r&d earnings. variable definitions: cut = 1 if r&d decreases relative to the previous year, and 0 otherwise; dolimit = d&o coverage limit scaled by market value of equity; coverage_limit is the d&o insurance coverage limit measured in million dollars. pcrd = the difference in the natural logarithm of r&d between the previous year and the year before; cird = the difference in industry r&d intensity (r&d expenditures scaled by total sales) between the current year and the previous year, where the industry is defined using the two-digit taiwan economic journal (tej) code; cgdp = the difference in the natural logarithm of gdp between the current year and the previous year; toq = the sum of market value of common equity and book value of debt, divided by the book value of total assets; csales = the difference in the natural logarithm of sales between the current year and the previous year; ccap = the difference in the logarithm of capital expenditures between the current year and the previous year; lnmv = the natural logarithm of market value of equity; lev = total debts divided by total assets; fcf = operating cash flows minus capital expenditures, scaled by total assets; dist = the change in pre-tax, pre-r&d earnings divided by previous year’s r&d; insown = the percentage of shares held by institutional investors. *, **, and *** indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed tests). asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 103 4.3 empirical results table 3 presents logit regression results, first for sd group (model 1) and then for ld group (model 2) and in group (model 3). as shown in model 1, the coefficient on dolimit is positive and significant at the 5% level, consistent with the hypothesis that firms with higher d&o coverage are more likely to cut r&d to avoid earnings decreases. in addition, the marginal effect for dolimit in model 1, 0.308, when multiplied by the interquartile range of 0.091, suggests that moving from the first to the third quartile of dolimit increases the probability of cutting r&d by approximately 3%. among control variables, cird and ccap are significantly associated with the likelihood of cutting r&d in predicted directions. on the other hand, cgdp and dis are positively and negatively associated with cut, respectively, which is inconsistent with my predictions. in models 2 and 3, the coefficients on dolimit are not significant at conventional levels. consistent with my prediction, managers’ incentives to cut r&d to avoid earnings decrease is low or non-existent in the ld and in groups, and thus d&o coverage is not expected to affect the likelihood of cutting r&d. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 104 table 3. d&o coverage and the likelihood of cutting r&d predicted signs dependent variable: cut model 1 model 2 model 3 sd group ld group in group coefficient (z-statistic) marginal effect coefficient (z-statistic) marginal effect coefficient (z-statistic) marginal effect dolimit + 2.315** (2.43) 0.308 0.141 (0.29) 0.008 0.202 (0.40) 0.014 pcrd – -0.544 (-1.51) -0.137 -0.485** (-2.08) -0.121 -0.891*** (-3.67) -0.227 cird – -214.058** (-2.35) -36.881 -59.675 (-0.79) -7.516 -16.985 (-0.37) -21.940 cgdp – 14.451** (2.34) -1.182 5.735 (1.11) 0.305 10.241* (1.78) -1.894 toq – -0.234 (-1.53) -0.035 -0.246 (-1.60) -0.038 -0.339*** (-3.29) -0.039 csales – -0.830 (-1.43) -0.314 -1.873*** (-6.14) -0.485 -1.189*** (-4.70) -0.333 ccap – -0.201** (-2.46) -0.053 -0.097* (-1.73) -0.030 -0.232*** (-4.49) -0.055 lnmv – -0.079 (-0.86) -0.010 -0.079 (-1.24) -0.013 -0.252*** (-4.30) -0.048 lev + 0.289 (0.43) 0.063 0.889** (2.06) 0.196 -0.056 (-0.13) 0.017 fcf – 1.065 (1.03) -0.008 -0.774 (-1.01) -0.260 -2.061*** (-2.76) -0.570 dist + -0.687** (-2.23) -0.140 -0.001 (-0.05) 0.000 0.006 (0.41) 0.003 insown + -0.419 (-0.85) -0.140 -0.224 (-0.60) -0.020 -0.121 (-0.36) -0.079 intercept 15.584*** (11.00) 0.986 (0.88) 5.412*** (4.25) year / industry dummy variables included included included pseudo r2 0.108 0.084 0.155 n 684 1,067 1,557 the sd group comprises firm-years for which –rdexpt-1 < (ebtrdt-ebtrdt-1) < 0. the ld group comprises firm-years for which (ebtrdt-ebtrdt-1) < -rdexpt-1. the in group comprises firm-years for which (ebtrdt-ebtrdt-1) > 0. rdexp = r&d expenditures. ebtrd = pre-tax, pre-r&d earnings. variable definitions: cut = 1 if r&d decreases relative to the previous year, and 0 otherwise; dolimit = d&o coverage limit scaled by market value of equity; pcrd = the difference in the natural logarithm of r&d between the previous year and the year before; cird = the difference in industry r&d intensity (r&d expenditures scaled by total sales) between the current year and the previous year, where the industry is defined using the two-digit taiwan economic journal (tej) code; cgdp = the difference in the natural logarithm of gdp between the current year and the previous year; toq = the sum of market value of common equity and book value of debt, divided by the book value of total assets; csales = the difference in the natural logarithm of sales between the current year and the previous year; ccap = the difference in the logarithm of capital expenditures between the current year and the previous year; lnmv = the natural logarithm of market value of equity; lev = total debts divided by total assets; fcf = operating cash flows minus capital expenditures, scaled by total assets; dist = the change in pre-tax, pre-r&d earnings divided by previous year’s r&d; insown = the percentage of shares held by institutional investors. *, **, and *** indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed tests). the z-statistics in parentheses are based on standard errors adjusted for clustering at the firm level. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 105 4.4 robustness checks 4.4.1 endogeneity to address the endogeneity issue for managerial myopic behaviors and d&o insurance purchase decision, i use a two-stage estimation technique developed by heckman (1979). in the first stage, i estimate a probit model to obtain the inverse mills ratio (imr) by using variables that previous studies (e.g., core, 1997, o’sullivan, 2002, chung and whynn, 2008) have found to affect d&o purchase decision. in the second stage, i include imr in equation (1) as an additional control variable to correct for potential endogeneity bias. the first-stage probit model is specified as follows. 0 1 2 3 4 5 6 7 8 9 10 prob( 1) ( ln ) t t t t t t t t t t t n m t purchase f mv lev mtb ceoown outown acqu dive cross hite excash year ind γ γ γ γ γ γ γ γ γ γ γ γ γ ε = = + + + + + + + + + + + + + (2) where purchase is a dummy variable equal to 1 if the firm carries d&o insurance coverage, 0 otherwise. mtb is market-to-book ratio. ceoown is the percentage of shares held by ceo. outown is the percentage of shares held by outside blockholders. acqu is a dummy equal to 1 if the book value of total assets at the fiscal year-end increases by more than 25% from the beginning of the fiscal year, 0 otherwise. dive is a dummy equal to 1 if the book value of total assets at the fiscal year-end decreases by more than 25% from the beginning of the fiscal year, 0 otherwise. cross is a dummy variable equal to 1 if the firm is cross-listed in a foreign stock exchange, 0 otherwise. excash is the residual from the regression of cash on determinants of cash holdings.6 other variables are defined as before. the results of this analysis are shown in table 4. the coefficient on dolimit remains significant with expected positive sign, whereas the coefficient on imr is not significant at conventional levels. this suggests that the main results unlikely to be driven by the potential endogeneity problem associated with d&o purchase decision. 6 following chung and wynn (2008), cash holdings is defined as the sum of cash, cash equivalents, and short-term investments. the determinants of cash holdings include firm size, market-to-book ratio, leverage ratio, cash flow (defined as earnings before depreciation and amortization, less interest, taxes, and common dividends), net working capital (excluding cash), percentage of independent directors on the board, outside blockholder ownership, engagement in divestures, cross-listing status, and membership in high-tech industry, where cash holdings, cash flow, and net working capital are all scaled by lagged total assets. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 106 table 4. endogeneity dependent variable: cut sd group predicted signs coefficient z-statistic dolimit + 2.439** 2.53 pcrd – -0.537 -1.47 cird – -205.769** -2.25 cgdp – 17.337** 2.52 toq – -0.223 -1.47 csales – -0.894 -1.50 ccap – -0.190** -2.30 lnmv – -0.009 -0.07 lev + 0.328 0.49 fcf – 1.087 1.05 dist + -0.666** -2.16 insown + -0.386 -0.78 imr 0.895 1.10 intercept 13.323*** 5.05 year / industry dummy variables included pseudo r2 0.108 n 682 the sd group comprises firm-years for which –rdexpt-1 < (ebtrdt-ebtrdt-1) < 0. rdexp = r&d expenditures. ebtrd = pre-tax, pre-r&d earnings. variable definitions: cut = 1 if r&d decreases relative to the previous year, and 0 otherwise; dolimit = d&o coverage limit scaled by market value of equity; pcrd = the difference in the natural logarithm of r&d between the previous year and the year before; cird = the difference in industry r&d intensity (r&d expenditures scaled by total sales) between the current year and the previous year, where the industry is defined using the two-digit taiwan economic journal (tej) code; cgdp = the difference in the natural logarithm of gdp between the current year and the previous year; toq = the sum of market value of common equity and book value of debt, divided by the book value of total assets; csales = the difference in the natural logarithm of sales between the current year and the previous year; ccap = the difference in the logarithm of capital expenditures between the current year and the previous year; lnmv = the natural logarithm of market value of equity; lev = total debts divided by total assets; fcf = operating cash flows minus capital expenditures, scaled by total assets; dist = the change in pre-tax, pre-r&d earnings divided by previous year’s r&d; insown = the percentage of shares held by institutional investors. imr = the inverse mills ratio obtained from equation (2). *, **, and *** indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed tests). the z-statistics are based on standard errors adjusted for clustering at the firm level. 4.4.2 alternative measure of d&o coverage this paper adopts the raw d&o coverage levels (coverage limits deflated by market value of equity) as the independent variable of interest in the primary test. to provide more direct and compelling evidence on whether abnormally high d&o coverage increases the likelihood of cutting r&d, i replace the raw coverage variable by an estimated abnormal d&o coverage, abdolimit, which is defined as the residual from the regression of coverage limits on its determinants7. as shown in table 5, the coefficient on abdolimit is still positive and significant. this suggests that the results based on abnormal d&o coverage as the dependent 7 following wynn (2008) and chung et al. (2013), the determinants of d&o insurance coverage limits include firm size, leverage ratio, cash holdings, volatility of stock returns (measured as the natural logarithm of annualized variance of daily return over the current fiscal year), percentage of independent directors on the board, outside blockholder ownership, cross-listed status, and membership in high-tech industry. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 107 variable are very similar to those reported in the paper using d&o coverage levels. table 5. abnormal d&o coverage dependent variable: cut sd group predicted signs coefficient z-statistic abdolimit + 2.225** 2.33 pcrd – -0.540 -1.50 cird – -211.079** -2.35 cgdp – 13.707** 2.23 toq – -0.219 -1.44 csales – -0.836 -1.44 ccap – -0.201** -2.46 lnmv – -0.148* -1.66 lev + 0.442 0.66 fcf – 0.985 0.96 dist + -0.680** -2.21 insown + -0.363 -0.74 intercept 16.861*** 12.32 year / industry dummy variables included pseudo r2 0.106 n 684 the sd group comprises firm-years for which –rdexpt-1 < (ebtrdt-ebtrdt-1) < 0. rdexp = r&d expenditures. ebtrd = pre-tax, pre-r&d earnings. variable definitions: cut = 1 if r&d decreases relative to the previous year, and 0 otherwise; abdolimit = the residual from the regression of dolimit on the economic determinants of d&o coverage; dolimit = d&o coverage limit scaled by market value of equity; pcrd = the difference in the natural logarithm of r&d between the previous year and the year before; cird = the difference in industry r&d intensity (r&d expenditures scaled by total sales) between the current year and the previous year, where the industry is defined using the two-digit taiwan economic journal (tej) code; cgdp = the difference in the natural logarithm of gdp between the current year and the previous year; toq = the sum of market value of common equity and book value of debt, divided by the book value of total assets; csales = the difference in the natural logarithm of sales between the current year and the previous year; ccap = the difference in the logarithm of capital expenditures between the current year and the previous year; lnmv = the natural logarithm of market value of equity; lev = total debts divided by total assets; fcf = operating cash flows minus capital expenditures, scaled by total assets; dist = the change in pre-tax, pre-r&d earnings divided by previous year’s r&d; insown = the percentage of shares held by institutional investors. *, **, and *** indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed tests). the z-statistics are based on standard errors adjusted for clustering at the firm level. 4.4.3 alternative measure of myopic r&d cutting behavior in addition to using the previous year’s r&d expenditures as a benchmark, i also adopt the normal level of r&d expenditures using the model developed by roychowdhury (2006). to estimate the model, i run the following cross-sectional regression for each industry (defined by two-digit tej codes) and year. 1 0 1 2 1 1 1 1t t t t t t rdexp sales asset asset asset θ θ θ ε− − − − = + + + (3) where rdexp is r&d expenditures, asset is total assets, and sales is total sales. consistent with roychowdhury (2006), i require at least 15 observations for each asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 108 industry-year grouping. the abnormal level of r&d expenditures is measured as the estimated residual from equation (3). i then create a dummy variable, negabrd, which equals 1 if firms with negative abnormal r&d expenditures, 0 otherwise. i further exclude firms that issue seasoned equity offerings as they are inclined to seek external financing due to existing r&d projects. hence, the exclusion of such firms may produce a cleaner sample that exhibits incentives to manage earnings towards performance targets and thus increases the power of the tests. in table 6, the regression with negabrd as the dependent variable shows that the coefficient on dolimit is positive and significant (marginally significant). therefore, the results are robust to alternative measures of managerial myopia. table 6. abnormal r&d expenditure dependent variable: negabrd sd group predicted signs coefficient z-statistic dolimit + -1.704* -1.79 pcrd – -1.604*** -3.33 cird – 14.029 0.12 cgdp – 24.693*** 2.98 toq – -0.774*** -3.54 csales – 1.212** 2.09 ccap – -0.187** -2.01 lnmv – -0.363*** -3.40 lev + 2.107*** 2.87 fcf – -0.469 -0.38 dist + -1.184*** -3.31 insown + 1.394** 2.40 intercept -12.075 -0.02 year / industry dummy variables included pseudo r2 0.174 n 598 the sd group comprises firm-years for which –rdexpt-1 < (ebtrdt-ebtrdt-1) < 0. rdexp = r&d expenditures. ebtrd = pre-tax, pre-r&d earnings. variable definitions: negabrd = 1 if firms with negative abnormal r&d expenditures, and 0 otherwise, where abnormal r&d expenditures is calculated using the method of roychowdhury (2006); dolimit = d&o coverage limit scaled by market value of equity; pcrd = the difference in the natural logarithm of r&d between the previous year and the year before; cird = the difference in industry r&d intensity (r&d expenditures scaled by total sales) between the current year and the previous year, where the industry is defined using the two-digit taiwan economic journal (tej) code; cgdp = the difference in the natural logarithm of gdp between the current year and the previous year; toq = the sum of market value of common equity and book value of debt, divided by the book value of total assets; csales = the difference in the natural logarithm of sales between the current year and the previous year; ccap = the difference in the logarithm of capital expenditures between the current year and the previous year; lnmv = the natural logarithm of market value of equity; lev = total debts divided by total assets; fcf = operating cash flows minus capital expenditures, scaled by total assets; dist = the change in pre-tax, pre-r&d earnings divided by previous year’s r&d; insown = the percentage of shares held by institutional investors. imr = the inverse mills ratio obtained from equation (2). *, **, and *** indicate significance at the 10%, 5%, and 1% levels, respectively (two-tailed tests). the z-statistics are based on standard errors adjusted for clustering at the firm level. 5. conclusion in this paper, i examine whether d&o insurance coverage results in managerial myopia. asian journal of finance & accounting issn 1946-052x 2016, vol. 8, no. 2 ajfa.macrothink.org 109 managers have incentives to boost short term performance to achieve targets for compensation and other contract reasons. d&o insurance could cause moral hazard problems and provide managers with incentives to take actions that attain their personal goals. i thus argue that d&o insurance increases managers’ incentives to cut r&d expenditures to achieve earnings targets. using a sample of 3,308 firm-years from taiwanese listed firms over the period 2008-2012 that have d&o insurance information and material r&d expenditures (i.e., greater than 1% of sales). i partition the sample into three groups. the small earnings decrease group comprises firms with declines in pre-tax, pre-r&d earnings less than the amount of previous year’s r&d expenditures. in these firms, managers have incentives to cut r&d to avoid earnings declines. therefore, d&o insurance coverage is predicted to increase the likelihood of cutting r&d for this group. for firms that have a large decrease or an increase in the pre-tax, pre-r&d earnings, managers do not have incentives to reduce r&d to avoid earnings decreases because it is not feasible or necessary to do so. they are treated as control groups. consistent with my prediction, i find that firms with higher d&o insurance coverage tend to have a significantly higher incidence of cutting r&d in the small earnings decrease group. also as expected, the impact of d&o insurance coverage is not significant for the control groups. the results are robust to controlling for endogeneity bias by using a heckman self-selection model and to alternative measures of d&o insurance coverage and myopic r&d cuts. at the practical level, this study has important implications for regulators and accounting standard-setters in their attempts to protect outside investors in the market place. regulators may need to oversee the amounts of d&o insurance coverage purchased by firms and require them to strengthen corporate governance effectiveness. acknowledgement i gratefully acknowledge the financial support provided by the research grant from ministry of science and technology of taiwan r.o.c. 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(2008). controlling-minority shareholder incentive conflicts and directors’ and officers’ liability insurance: evidence from china. journal of banking & finance, 32(12), 2636-2645. http://dx.doi.org/10.1016/j.jbankfin.2008.05.015 microsoft word 18939-article text-66560-writer2-new receive doi:10.5 abstra this re internal likert s the ua indepen auditor client’s study's auditors the rese continu keywo audit pr t d t ed: march 1 5296/ajfa.v ct esearch inv l controls, a scale-based ae. multipl ndent variab education internal co findings w s and firms earch may a uing educati rds: audit rocedures pe the de dr. n dept. of bus po box 2 tel: 39-0351, 2022 a 14i1.18939 vestigates th and audit p questionna e regressio ble was inv are signific ontrols and will assist re in allocatin aid accounti on offering quality, aud erformed etermin nidhal al sh iness and m 24127, via -205-2250 accepted: a url: ht he impact procedures p ire was dist n analysis vestigated. t cantly and d audit proc ecruiters in ng human ca ing institute s. ditor experi 21 nants of hanti (corre management caniana 2, e-mail: n april 7, 2022 https://doi.or of auditor performed tributed to a was adopte the results positively cedures are n identifying apital to the es and audit ience, audit asian f audit esponding au t, university bergamo (b nidhal.alsha 2 publ rg/10.5296/ r experienc on audit qu auditors wit ed to analy demonstrat associated e not assoc g the appro eir large and t firms in d tor educatio n journal of f quality uthor) y of bergam bg), italy anti@unibg. lished: june ajfa.v14i1.1 e, auditor uality in th th financial yze data sin te that audi with audit ciated with opriate crite d sensitive c eveloping a on, internal finance & ac issn 19 2022, vol. 1 ajfa.macro y mo .it e 1, 2022 18939 education, he uae. an audit exper nce more th itor experie t quality, w audit qual eria for hiri clients. add and improvi l control of ccounting 946-052x 14, no. 1 think.org/ client’s n online rience in han one ence and while the lity. the ing new ditionally, ing their f clients, 1. intro accord fraud. w potentia examin explain (ashfor order to gain mo fraud ri fraud, signific professi the best events c by clien ketchan auditin entruste europea inflows annual transact perform regardin applied through perform steward steward interest enhance (donald efforts r & wilk authors jeanjean (1981) client's assuran 1 internat oduction ing to surve when applie al loss of ners, 2010). ed as an a rth & anan o avoid such ore trust fro isk factors t such as cantly relate ionals to pr t outcome, t could be co nts. hence nd, & morr ng traditiona ed with pu an court of s and outflo financial sta tions, as we med to provi ng a comp to steward h fraud pr mance to sh d's and princ dship theory s, given th e the qualit dson, schoo represented kins, 2021). s have wid n, & suca, has defined accounting nce that the tional auditing ey responde ed to the es more than today's bu abuse of po nd, 2003). a h threats. t om third pa that serve a increased ed party tra ractice their they do not mplex and , standards is, 2004). ally refers ublic power f auditors ( ows, classif atements; 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(2 n ineffectiv over 14,000 over, the ease in mate he research ’s internal c to equip pa during the has been sh gned to the suca, 2014 crease his ty. ew, there is due to the for becomi öm, 2018). t positively as negatively a s hasis on int ors are requ l reporting u auditing sta while streng haviour, it ng on the wu, 2015). ss is a signi r omission. d to perform (hogan & f detecting ol questionn n internal c find that eff improves nformation 2017) conc ve internal c 0 auditor in adoption o erial missta hypothesiz ontrol is po 27 articipants w audit proc hown to be e employee 4). similarl or her eff s a shady c e fact that e ing an acco therefore, t ssociated w associated w ternal contr quired to rep under the sa andard 2201 gthening in may also purpose fo . ficant facto internal co m addition wilkins, 2 fraud and naires and controls are ffective inte the quality technology cluded in a controls and nternal cont of required atements (le zes that: ositively ass asian with the kno cess and m e positively is related t ly, it has b fort (che, l correlation each country ountant (al the research with audit qu with audit qu rols is one o port on the arbanes-ox 1 article 3 nternal cont result in a or which th or affecting ontrol defici al procedur 2008). acco determining flowcharts; e tested fo ernal contro y of financ y with the previous s d fraud detec trol opinion d internal c ennox & w ociated with n journal of f owledge and may have a associated to it (locke een stated langli, & between ed y has its ow len & woo h hypothesiz uality in the uality in the of the mech effectivene xley act sec (public co trols may an increase he internal inherent ris encies resul res to mitig ording to s g the sourc in other w or effectiven ols have a p cial reportin internal c study that ction. this c ns, of which control aud wu, 2022). b h audit qual finance & ac issn 19 2022, vol. 1 ajfa.macro d skills nece a direct im d with perfo e & latham that increa svanström ducation an wn teaching odland, 201 zes the follo uae. e uae. hanisms the ess of a co ction 404 (s ompany acc aid in pre e in dishon controls ar sk, which is lt in increas gate audit r sare et al. ce of missta words, the a eness. addi positive im ng. this h control fram there is a conclusion h 1,488 are dits resulte based on th lity in the u ccounting 946-052x 14, no. 1 think.org/ essary to mpact on ormance, m, 2002; sing the , 2018), nd audit g system 0; anis, owing: ey use to mpany's sarbanes counting eventing nest and re being the risk sed audit risk and (2013), atements ability to itionally, mpact on has been mework. positive is based deemed ed in a he above uae. 2.4 aud financi the au particul during t the tech auditors oversig nor to u fischer professi use of t furtherm the big same vo hours in are pro more pe two pot one of lyubim higher q the diff the sam own. co h5: 3. meth when e from a design i the rese from a investig where: aq = a internal the dat survey w dit procedur ial auditing udit plannin larly their d this stage, w hniques, pr s' responsib ght board, 2 under-audit, (1996) p ion increase technology more, blok four) is su olume of au n a less pro ompted to l ertinent sch tential strat f which is mov et al. 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p correlation udit quality d by the dely adopte issues whe ve effects in breakdown s s cussion and analyz art. table 2 sample aud udit quality, the auditin arabic, 2020 erienced, a eptions of a fact that m han 12 years rking with tion. coefficient and fast rul n equal to d moderate p < 0.01) is matrix. sim (0.79; p < 0 main effe ed as a n group siz n an unbiase zes finding 2 contains ditors indic followed b ng sector in 0). furtherm and 66% audit experi most respond s of audit ex h auditors interpretati es for deter or greater t , and less strongly an milarly, aud 0.01), where 30 ects of trea method f zes are equa ed manner ( gs based on descriptive cate that a by auditor e n the uae more, over 6 agree that ience and p dents held xperience ( who lacke ion varies s rmining the than 0.65 is than that i nd positivel ditor educat eas client in asian atments an for overco al; and faci (creswell, 2 f n descriptiv e data and audit experi education ( e is not ve 68% of resp t their au preference f a professio table 1), im d audit ex significantly ir strength s considered s considere ly correlated tion is stron nternal cont n journal of f nd their in oming mu litating the 2003). frequency 52 52 104 21 21 21 41 104 ve statistic relationship ience (ex: mean = 4.1 ery active i pondents ag uditors are for auditor onal auditin mplying that xperience o y across sci (akoglu, 20 d a strong ed weak. a d with audit ngly and po trols (0.58; finance & ac issn 19 2022, vol. 1 ajfa.macro nteractions. ulticollineari estimation 5 5 10 2 2 2 3 10 cs and mul ps for each mean = 16). these in recruiti gree that the highly ed education c ng title and at they were or had rec ientific disc 018). thus, coefficient, as a result, it quality, ac ositively as p < 0.01) a ccounting 946-052x 14, no. 1 think.org/ it was ity and of both % 50.00% 50.00% 00.00% 20.19% 20.19% 20.19% 39.42% 00.00% tivariate h of the 4.18) is findings ing new eir firm's ducated. could be d had an e already ceived a ciplines, , for this 0.30 to auditor ccording sociated and audit procedu it appea table 2 descrip minimu maximu mean standar median cronba correla ex ed ic ap aq a in acc table 3 multiple the “r for the p conside (also kn variable variable table 3 model 1 a predic furtherm regressi conside p.001; t ures (0.59; p ars as thoug . descripti ptive statisti um um rd deviation n ch’s alphaa ation matrix ordance wit 3 summariz e regression r” column d predictive q ered to be a nown as th es explain es account f 3. model su ctors: (cons more, the ion model f ered statistic the regressio p < 0.01) ar gh only h1 a ive statistic ics 4 n 0 4 a 0 x 0 0 0 0 th malcolm es the resu n model ass denotes the quality of th an acceptab he coefficien the depend for 73% of t ummary r .85a stant), ap, e f-ratio in fits the data cally signif on model fi re only mod and h2 are s s and correl ex 2 5 4.18 0.68 4.25 0.83 1 0.79 0.56 0.54 0.80 m (2003), a c lts of multi sumptions w correlation he dependen le level of nt of determ dent variab the variance ed, ic, ex the anov a well. as t ficant in pre its the data w 31 derately ass supported. lation matri ed 1 5 4.16 0.75 4.25 0.84 1 0.50 0.49 0.79 cronbach’s iple regress was examine n coefficient nt variable: prediction. mination), w ble. the va e in audit qu r2 .73 va table ( the table in edicting the well. asian ociated with ix 3 0 3 0 0 0 alpha of 0. sion analyse ed in light o t's value. r in this case the “r2” which show alue of 0.7 uality. adj (table 4) in dicates, the e dependen n journal of f h audit qual ic 1 5 3.68 0.96 3.75 0.88 1 0.79 0.58 80 is accept es. complia of chatterje can be tho , audit quali column den ws how muc 73 indicates justed r2 .72 ndicates w e independe nt variable, finance & ac issn 19 2022, vol. 1 ajfa.macro lity. at first ap 1 5 3.76 0.93 4.00 0.83 1 0.59 table. ance with c ee and hadi ought of as ity. a value enotes the r ch the inde s that inde std. e .4 whether the ent variables f (4, 99) = ccounting 946-052x 14, no. 1 think.org/ t glance, aq 1 5 4.10 0.82 4.25 0.81 1 common i (2012). a proxy e of.85 is r2 value ependent ependent error 44 overall s can be = 64.02, table 4 model 1 a. depe b. predi table 5 variable coeffici from ze table 5 model 1 c a a. depe the reg (<0.001 quality. educatio the sig educatio bröchel prior re (clikem hypothe investig and pro actively level of result is and rub 4. anovaa regress residua total endent varia ictors: (con 5, on the o e. this test ients equal ero (zero). t . coefficien constant ex ed ic ap endent vari gression re 1) and audi h3 is not on and audi gnificance l on to impr ler et al.'s ( esearch has man, schwa esis. it is re gated in this ofessional c y recruit qu f these two s contrary t bino and vi sum sion al able: aq nstant), ap, other hand, t determine 0 (zero). i the “t” and ntsa standardiz coefficien b s e -.25 .46 .42 .04 .14 able: aq sults suppo itor educati supported b it quality. level of th rove and en (2004) find s establishe artz, & lath easonable to s study, inc certification ualified audi variables ar to previous itolla (2014 of squares 48.96 18.16 67.12 ed, ic, ex , determine es whether if p.05, the “sig.” colum zed nts stan coe std. rror b .279 .111 .096 .077 .079 ort h1 and ion (<.001) because the he second h nhance aud ding that a m d a negativ han, 2001; o argue that cluding adv n will have itors. h4 an re much hig studies con ). however 32 df 4 99 100 x es the stati the popul e coefficien umns contain ndardized efficients beta .384 .384 .047 .158 h2 becau ) are positi ere is no ev hypothesis dit quality. more know ve correlati anis, 2017 t the defini vanced educ little effec nd h5 were gher than th nducted, for r, one could asian mean s 12.2 .19 istical signi ation's uns nts are stati n the t-value t -.907 4.165 4.365 .522 1.779 se they ind ively and s idence of a demonstrat notably, th wledgeable a ion between 7), this stud tion of edu cation, conti ct on their e supported he accepted r instance, b argue that b n journal of f square 24 9 ificance of tandardized stically sig e and corres sig. 95 l b .367 <.001 <.001 .603 .078 dicate that trongly ass a negative a tes the criti his finding auditor perf n education dy does no ucation prov inuing prof opinion, as d as the stat one (p < 0 by hogan a business in finance & ac issn 19 2022, vol. 1 ajfa.macro f 64.02 f each inde d (or stand gnificantly d sponding p5.0% confid interval fo lower bound u b -.806 .242 .229 -.113 -.016 auditor exp sociated wi association b tical import is consiste forms better n and audit ot support t vided to the fessional ed s many aud tistical sign 0.05). howe and wilkins the uae is ccounting 946-052x 14, no. 1 think.org/ sig. <.001b ependent dardized) different -value. dence r b upper bound .301 .683 .612 .193 .296 perience ith audit between tance of ent with r. while t quality the third e sample ducation, dit firms nificance ever, this s (2008) s distinct from th from th also be the fin quality & woo howeve experien factors limitatio distribu with ca the find context exampl which a 5. discu the pri underst (“uae” stateme tate, & several audit q examin steward examin indicate associat steward relation audit qu studies the firs findings sare, et the res audit qu (libby support correlat hat of busin hose of thei distinct. dings of the in relation odland, 2010 er, this is nce, and au (client's i ons create uted electron aution. a su dings. it w s for compa e, to addres affect audit ussion mary data p anding of ”). because ents frequen & xu, 2015 years after quality may ed the effec dship theory ing the fact e that aud ted with au dship theory nships. mor uality and p have exam st time they s allow for t al., 2013; a sults, in part uality, whic & frederic ted by the tion betwee ness in othe ir clients in e five hypot to internal 0) and resta the first s udit procedu internal con opportunit nically, and urvey of a l would also arison; or t ss the limita quality. presented in audit quali e audit quali ntly rely on 5), ignoring r providing y not be q ct of interna y provided tors that inf dit experien dit quality, y, this study re precisely personal ch mined these p y have been r the refinem anis, 2017) ticular, indic ch supports ck, 1990; g findings n audit edu er countries other coun theses contr and externa atements (i study to ex ures) on au ntrol). alth ties for fu d the sample arger sampl be valuabl o conduct a ations of the n this paper ity in audit ity cannot b the reputat g other fact training an quantifiable al and extern the theoret fluence aud nce and au consistent w adds to the y, it increas aracteristics personal ch n examined ment of pri . cate a robus s the first h gul, wu, & of this res cation and a 33 . as a resu ntries, so th ribute to the al factors. s irani, tate, xamine the udit quality hough this uture resear e size was le of uaele to under a qualitative e quantitativ r makes a si t firms wo be directly o tion of an a tors such a nd encoura (allen & nal factors o tical framew dit quality in uditor educ with previo e audit litera ses awarene s such as ex haracteristic d in conjun ior audit qu st positive r hypothesis & yang, 20 search, wh audit qualit asian ult, their int he audit pro e existing b some resear & xu, 201 e impact of in the uae research rch. given small, the -based audit rtake resea e study usin ve data by d ignificant an orking withi observed, p audit firm to s auditor e aging audito woodland, on audit qua work for thi n the united cation are ous research ature, specif ess surround xperience a s as factors nction with uality studie relationship and is cons 013). simila ich demon ty. on the o n journal of f ernal contro ocedures to body of kno rch examine 5) as audit f internal e in conjun has some that the findings sh tors would arch in othe ng face-to-f drilling dee nd original in the unit reparers and o determine ducation an ors to study , 2010). a ality. is study, ac d arab emi significant h. additiona fically regar ding the re and educatio s affecting a other fact es (allen & between au sistent with arly, the sec nstrate a st ther hand, t finance & ac issn 19 2022, vol. 1 ajfa.macro ols may be be perform owledge abo es audit fee t quality ind factors (ed nction with limitations questionna hould be int aid in gene er countryface intervi eper into the contributio ted arab e nd users of f e the qualit nd experien y, improvem as such, thi cting as a po irates. the tly and po ally, by utili rding audito elationship b on. althoug audit quality tors. moreo & woodland udit experie h previous r cond hypot trong and the third hy ccounting 946-052x 14, no. 1 think.org/ distinct med may out audit es (allen dicators. ducation, external s, these aire was terpreted eralizing -specific ews, for e factors on to our emirates financial y (irani, nce. for ments in is study ortal for findings ositively izing the or–client between gh a few y, this is over, the d, 2010; 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ed to trx h gap for the ng capital. t ty and signi blue-chip c he enca receiva moniruzzam andidate, pu dato' dr. ess school, u dr. a mics and ma cepted: june url: ht the econom business (b and 99% of smes). the ge and blue 60 days, 90 ack of work the corpora hange (trx the study p f trx. it a it has explo . the acad e study. her the study a ificance for orporate ma 35 ashmen able ex man (corres utra busines mohd padz universiti p annuar md n anagement, e 6, 2023 https://doi.or my remains b2b) transa f them are i ey supply th e-chip corpo 0 days and s rking capita ate buyers. x) to releas presents the assesses th ored marke demic resea re, around 5 addresses th r the researc anufacturers asian nt of tra xchange sponding au ss school, m zil hashim putra malay nassir , xiamen un publish rg/10.5296/ in the form actions amo in the categ he raw mate orate manu so on for the al that rem the study e the fund e concept an e applicatio et space, rea arch on tr 51% cmsm his working ch. s, cmsmes n journal of f ade rec e in ba uthor) malaysia ysia, malays niversity m hed: june 6, ajfa.v15i1.1 m of trade r ong the firm gories of cot rials, semi-f facturers. c e payment. ains tied in provides a into cash fr nd modus o on of trx adiness, fin rx in bang mes close th capital pro s, trx finance & ac issn 19 2023, vol. 1 ajfa.macro ceivabl anglade sia malaysia, ma 2023 18968 receivables ms. there ar ttage, micro finished go cmsmes g during this n trade rec financing rom the inv operandi of x in the co ntech indus gladesh is r heir busines oblem throu ccounting 946-052x 15, no. 1 think.org/ les esh alaysia that are re 7.818 o, small, ods, and generally s period, eivables solution vestment trx. it ntext of stry, and rare that s for the gh trx 1. intro a large trade re econom (firm); firm or practica firm kn (mnc) there a firms ar (87.52% (10.99% (0.07%) small, a remaini in othe working through indirect 1.1. pro the cm blue ch financia money services instantly lead tim paymen into a f the pay trade re new wo buyer(s such as dues of oduction e amount of eceivables mic activitie or firm to f business to ally, these e nown at na . are 7.818 m re smes an %) are cotta %) are smal ) are large and medium ing 1% larg er words, th g in the stat h few (1%) l tly on the su oblem state msmes do hip firms. t al institutio invested in s to their cu y. they pay me is called nt remains u financial pro yment. thei eceivables. t ork orders f s) whose exi s wages and f raw materi f money in are generat s are execu firm. in the o business (b economic a ational level million firm nd their co age enterpri l enterprise enterprises m enterprise ge firms are he total bu te. a large p large firms upplies from ment not possess they do no ns. howeve n their bus ustomers. so y after a per d the credit unpaid that oblem for c ir investmen they suffer from the ne isting bill is d salaries, e ials purchas the econom ted from th uted between e paper, the b2b). the s activities ma l or even a ms in bangl ontribution t ses, 0.104 m es, 0.007 mi (bbs, 201 s (cmsme directly or usiness activ portion of t owned priv m the small s the financ t carry the er, they hav iness. as p ome of thes riod of 15 d t period. d gives the b cmsmes. t nt remains r from the s ew buyers s not paid y electricity a ed, etc. 36 my remains he economi n individua focus is on size of the f ay take pla at internatio ladesh econ to gdp is million are illion (0.09% 3). so, the es) constitut indirectly d vities in th the business vately and p firms labele cial stateme collateral ve an equit part of the se customers days, 30 day during this p birth of the they canno locked in t shortfall of as well as yet. they ca and gas bill asian s in the for ic activities al to individ n the econo firms range ace between onal level l nomy. gros around 22% micro ente %) are med firms in the te 99% of al dependent o he economy s activities i publicly and ed as cmsm nt as so hap to get the ty in their c ir business s, mostly th ys, 60 days, period, the trade receiv t take the sh the hands o working ca from the e annot pay th ls, office re n journal of f m of trade s undertaken ual; individ mic activiti from small n a firm at c like a mult ssly, over 9 %. specific rprises (1.3 dium enterpr e categories ll the firms on cmsme y are depen in the econo d they are de mes. ppens in th loan from b capital. it is , they supp he corporate 90 days, or small supp vables for c hock of the of their buy apital. they xisting buy heir regular ent, rentals finance & ac issn 19 2023, vol. 1 ajfa.macro receivables n on credit dual to orga ies between l level to lar cottage lev tinational c 98 percent cally, 6.843 33%), 0.859 rises, 0.005 s of cottage in the coun es for their s ndent on th omy are car ependent dir he case of la banks or n s their hard ply (sell) g e clients, do r the like on pliers’ (cm cmsmes. i e waiting pe yers in the cannot add yers, even f operating e of long-ter ccounting 946-052x 15, no. 1 think.org/ s. these t. these anization n firm to rge level. el and a company of these million 9 million 5 million e, micro, ntry. the supplies. he firms rried out rectly or arge and non-bank d earned goods or o not pay nes. this msmes’) it results eriod for form of dress the from the expenses rm loan, 1.2. res 1.2.1 g the bro receivab 1.2.2 sp to attai i. to fin ii. to as ii. to ex 1.3. sig the sig i. macro finance firms in tied in respecti would i 2041, v ii. micr the sig 99% of of all bu industri shortag 51% of 2008 to cmsm this lea 1.4. sco the stu capital of trx banglad techno search obje general obje oad objectiv bles for cm pecific obje in the overa nd the conce ssess the glo xamine the gnificance of gnificance of o perspectiv e (or capita nvolved in t receivables ive firm), th increase fur vision 2071 ro perspectiv gnificance fr f firms in th usiness acti ial units suf e. accordin f smes clos o 2012 in mes acutely ads to findin ope of the st udy focuses needs of cm x. it looks in desh. it exa ology) in the ectives ective ve of the stu msmes thro ectives all objective ept of trx obal practic application f the study f the study i ve al) is a majo the econom s could be he economy rther, the pe , delta plan ve rom micro l e economy ivities and p ffer from m ng to the su sed due to t the develo face the ca ng a solutio study s on provid msmes. it nto the glob amines the e e country. it udy is to find ough a trade e, the study . ce of trx. n of trx in is described or factor fo my run the b liquidated t y would get erspective p n: vision 21 level relates are in the c provide two any folds o urvey of me the lack of c oping econo apital shorta n for worki ing an alter covers wor bal scenario existing rela t observes th 37 d a liquidity e receivable addresses th bangladesh d from macr or economic business acti timely (just accelerated plans of the 100, etc. wo s to the firm category of o out of ever of problem i edium indu capital, part omies (un age for runn ing capital f rnative mod rking on pr of trx. it ated market he prepared asian y solution fo exchange ( he followin h ro and micr c growth of ivities for th t after the d further, th governmen ould get mom ms involved. cmsmes. ry three job in which the ustry develo ticularly wo nctad, 20 ning the bu for cmsme de of finan roviding the assesses th t for trx i dness of the n journal of f or working (trx) in ba g specific o o perspectiv f a country. he country. discharge o he productiv nt such as v mentum fur it refers to they gener s in the priv e most dom opment ass orking capit 001). in ba siness (the es. cing for me e concept an he potential in terms of country for finance & ac issn 19 2023, vol. 1 ajfa.macro capital tied angladesh. objectives: ves: different k if their inv of the work vity of the e vision 2031 rther. o cmsmes. rate more th vate sector. minant one i sociation (m tal, in the p angladesh, e daily star meeting the w nd modus-o or space of fintech (f r trx. ccounting 946-052x 15, no. 1 think.org/ d in trade kinds of vestment k by the economy , vision . almost han 90% these s capital midas), period of 50% of r, 2019). working operandi f trx in financial 1.5. con figure financin concept countrie the app and/or a 2. liter literatu with the study. 2.1 und the obj firms. b theories (ii) pec trade-o black a miller ( under l motives paying repair, b assets ( address trx to their pr making theory. the pec fund. t fund (b nceptual fr figu sou 1 depicts th ng through t of trx (c es has been plication of adaptation o rature revi ure review i e underpinn derpinning t jective of t broadly, the s of the stud cking order off theory and myron s (1958). liquidity pre s: (i) transa utility bills buying hou (stephenson s the regular o purchase r roduction c g profit. in cking order the financin bhama, jain con prac app ramework ure 1. res urce: the he overall f trx is ju ct) has be n stated. thi trx (at) of financing iew is divided in ning theorie theories the propose e study fall dy include ( r theory by by myers scholes (19 eference the action motiv s, etc.; (ii) p uses, etc.; (i n, 1950; jh r operationa aw material costs to ma this way, t r theory sta ng through & yadav, 2 ncept of trx ctice of trx plication of t search fram e author framework o ustified with en develope irdly, a thirs ) in the con g through tr nto two part es. secondly ed mode of ls under the i) liquidity y g. dona (1984); (iv 973), and (v eory, keyne ve to meet precautiona ii) speculat hingan, 200 al expenses ls at the fav aximize the the financin ates that ma discounting 2015). x (ct) x (pt) trx (at) 38 mework of the study h the expla ed. second st for trx ntext of ba rx (ft) in ts. firstly, i y, it presen f financing e area of w y preference aldson, s. c v) black-sc v) m-m the es mention daily needs ary motive tive motive 04). the ob of the enter vorable price eir profit. t ng with tr anagers of t g invoices w asian y. the stud anation of ly, the prac has been ex angladesh. a bangladesh t provides t nts the previ is to fund w orking capi e theory by c. myers, a choles opti eory by fran that people s such as b to face any to obtain c bjective of rprises. the es (when th trx provid rx goes thr the firms pr with trx is finan n journal of f dy is qualita ct, pt, an ctice of trx xplored with all these le h. he brief rele ious researc working ca ital finance. y john mayn and n. s. m ion pricing nco modigl need mone uying groce y unforeseen capital gain financing t ey also avai he prices go des a venue rough the l refer to use s the use of ncing through finance & ac issn 19 2023, vol. 1 ajfa.macro ative in natu nd at. fir x (pt) in d h the assess ead to the a evance of th ches relevan apital for su . the under nard keyne majluf (201 model by liani and m ey for three eries, payin n costs suc through tra through tr il financing down) to m e for inves liquidity pre e internal so f internal so h trx ccounting 946-052x 15, no. 1 think.org/ ure. the stly, the different sment of adoption he study nt to the upplying rpinning s (1930); 15); (iii) fischer erton h. e distinct ng rents, h as car ading on rx is to through minimize stors for eference ource of ource of the trad debt at & lotfa the wor expense the firm market expandi the bl influenc relevan the dis strength period o the mvalue. i called e do not receivab create e enhance value of 2.2 pre the pre touches factorin trade re al. (201 receivab where t there i busines that can of finan emerged transfor through through fintech represen de-off theor which the m aliei, 2019) rk orders o es such as o ms sometim rate for s ing market lack-schole cing the pri ce with the counting pe h of the deb of the invoi -m theory i it states tha earnings bef create exte bles) to get extra risk f e the earnin f the firm. b vious studie evious resea s the off-bal ng, supply c eceivable ex 17) is prob bles. they trade receiva is a gap be ss models as nnot match ncing with d. ketterer rmative dev h discountin h trade recei h is the s ntatives of ry strives fo marginal be . under fina or paying t office rent, r mes avail fin securing lo share, etc. es model; t ice of deriv e financing ercentages, btor to who ce, kind of indicates th at the value fore interest ernal debt t liquidity. for the firm ng power o briefly this es arches on tr lance sheet chain finan xchange is s ably is the worked on ables (invoi etween the s well as tec always the h trade rec r (2017) st velopments ng trade rece ivable excha short form companies or an optimu nefit and co ancing with the urgent rental of loa nancing wit ong-term bu though it w vatives such through tr fees, intere om the invo goods (not at debt in th e of a firm t and taxes burden for the balanc m. the opp of and mark way, the m rx include financing m cing (or rev scarce (van first evide how the pr ices) are tra convention chnologies. requiremen eivable exc tates that that have gi eivables wit ange has a c of financ that provid 39 um level of ost of debt f h trx, the operating b an, etc. with th trx eve usiness gai was develo h as forward rx. the fin st, etc. are i oice has be te 1) or serv the capital s depends o (ebit). th r the firm. ce sheet re portunity of ket share fo m-m theory i e the studies mechanisms verse factor nnoni, 2020 ence in the rice of an in aded. nal ways o business m nts of conve change (tr current con iven the bir th the help o connotation cial techn de financial asian f capital stru financing ar firms trade business ex h the fees an en with hig ins such a oped to ex ds, futures, nancial instr influenced b een drawn, vices provid structure of n the capita he financing the firm mains the f getting m or the firm. influences f s conducted s or alternat ring), etc. t ; ozili, 201 area of fin nvoice is de of financing models have entional fina rx), fintec ntext of fi rth of this k of an excha n with (i) fin nology. it services w n journal of f ucture comp re equal to e -off the ben xpenses or nd interest to gher fees an as retaining xplore the options, an rument in t by factors su brand of th ed, etc. f a firm doe alization of g through di uses its cu same. as a oney quick it leads to financing w on fintech tive mode o the quantit 8). the wo nancing thr etermined in g and the e become co ancing. as a ch, digital f inance is m ind of finan ange. it indic ntech and ( refers to with applicat finance & ac issn 19 2023, vol. 1 ajfa.macro posed of eq each other ( nefit of disc paying the o be paid. i nd interest t g good cu underlined nd swaps; it trx is the uch as the f he debtor, m es not impa f its earning discounting urrent asset a result it d kly with tr o increasing with trx. h, digital fin of financing ty of resear ork of dorfl rough tradin n the online emergence omplex incr a result, new finance, et moving thr ncing: the fi cates that fi (ii) digital f the compa tion of mod ccounting 946-052x 15, no. 1 think.org/ quity and (haddad charging regular n reality, than the stomers, factors t has the invoice. financial maturity ct on its g power invoices ts (trade does not rx may g market nance. it g such as rches on eitner et ng trade e market of new easingly w modes tc. have rough a inancing inancing finance. anies or dern and innovat fintech automat 2017a). dorfleit fintech each seg other and fac source: fintech coopera without days, w tive technol hs usually t ted product . tner et al. (2 h industry in gments. th fintechs a ctoring. this : dorfl hs in credit ation with b t recourse ( weeks, month logies. thes try to attrac ts and servi 2017a) has nto major fo e segments s shown in s is why, a b figure eitner et al. and factor bank(s), fin (note 2). l hs via mobi se financial ct the custo ces than the shown the d four segmen are (i) finan figure 2. t brief of cred e 2. segm , (2017a) ring works w ntechs prov oans are so ile phone. h 40 services ar mers with m e ones that divisions of nts in accord ncing, (ii) a this study is dit and facto ments of the with a sing vide credit f ometimes g here, fintec asian re internet b more user-f are currentl f fintech in dance with t asset manag s mostly rela oring is give e fintech in le partner b facilities to iven for a s chs provide n journal of f based and ap friendly, eff ly available ndustry. the the business gement, (iii) ated to the s en here. ndustry bank or a nu the individu short-time p innovative finance & ac issn 19 2023, vol. 1 ajfa.macro pplication o fficient, tran e (dorfleitn ey have div s models ap ) payments, sub-segmen umber of b uals and bu period such e factoring s ccounting 946-052x 15, no. 1 think.org/ oriented. nsparent, er et al., vided the pplied in and (iv) nt, credit banks. in usinesses h as few solutions such as compan transpar 2017a). digital electron exchang etc. (go finance innovat micro-f has wid infrastru have be zhang e immens increase 2015. t 2015. f baeck e technol organiz financin large fi financin through gomber in the a through receivab line) fac vannon cash in facilitat take fin a buyer or produ klapper factorin (finance s selling cla nies under c rent, innov . finance re nic product ge systems, omber, 201 e institute ( tion for inte finance, pay dened the c ucture is no een easily ac et al. (2016) se in terms ed substanti the volume from the glo et al. (2014 ogy based zations. aca ng has expa rms get mo ng such as h trade recei r et al., (20 area of fact h digitized bles or trad ctoring and ni (2020) st advance, ju tes the supp nancing to p r (debtor) cr ucer. r (2006) an ng in wh ers/investor aims online credit and f ative, fast, epresents th ts and serv home bank 7; banks, 2 (2015) desc egrating dist yment soluti overage of ot efficient. ccessible he ) and dorfl of volume ially in rece of this mark obal perspec 4), ketterer financing h ademics are anded the ac ore access t bank loans ivable excha 17) mention toring, crow format. t ding on invo a hybrid ve ates that tra ust after the ply chain fin pay their sup reated for th nd dorfleitn hich the i rs). if at the e, offering f factoring au and efficie he digitaliz vices in the king, home 2001). it als ribes digita tributed digi ions, peer-t banking se payment sy ere due to di eitner et al. and growt ent years. in ket was £97 ctive, the m (2017), and has improv e consistent ccess of the to firms. in s and overd ange (trx) n that nowwdfunding, the underli oices is akin ersion of fac ading of co e delivery of nancing (or ppliers’ bills he delivery ner et al. (2 invoices a beginning 41 factoring so utomate the ent in disch zation of th e financial trading serv so includes al finance ital banking to-peer lend ervices in th ystems such igital financ (2017b) sta th. the mar n the uk, t 7 million in market is also d dorfleitne ved the acc in the opin e firms and i addition to draft facilit ) can enhan -a-days vari supply cha ined transa n to factorin ctoring. ommercial i f goods, ins r reverse fac s. this is a (selling) of 2017b) stat are assigne of the servi asian olutions wi ir business harging thei he financia sector suc vices, autom all mobile start-ups as g, mobile so ding and cro he less deve h as the con ce (gomber ate that the rket for onl this market 2013 while o growing in er et al. (20 cess to fina nion that th individuals o traditional ties, the liq nce the work ious kinds o ain financin action, i.e., ng. it is an e invoices pro stead of wai ctoring) und kind of sell f goods or s te that this ed to a ice (factorin n journal of f thout minim processes t ir services al industry. ch as credi mated teller and app se s “companie olutions and owd-funding eloped econ ncept of “p r, 2017; rizz practice of line based i has tripled e the same w ncreasingly 017b) state t ance for bo is kind of a to the finan l factoring quidation pr king capital of platforms ng to offer the disinv evolution of ovides an o iting for a c der which t ling a loan m ervices on c financing h single or ng service) finance & ac issn 19 2023, vol. 1 ajfa.macro mum requir to be cost e (dorfleitne . it covers it cards, el r machines ( ervices. the es that are d delivery p ng”. digital nomies whe prepaid” and zzo, 2014). f digital fina invoice trad d between 2 was £325 m y. that innova oth individu alternative m nce. both sm and other f rogram of base of cm s have been financing nvestment o f the traditio opportunity credit period the large co made on the credit by a has similar multiple all the invo ccounting 946-052x 15, no. 1 think.org/ rements. ffective, er et al., all the lectronic (atms), e digital creating latforms, finance ere bank d credits ancing is ding has 013 and million in ative and uals and mode of mall and forms of invoices msmes. n formed services of trade onal (off to avail d. it also orporates e part of supplier rity with factors oices are assigne howeve also be which t factorin trx is the bene tinn an receivab crowdf resourc investor particip chatnan receivab instituti received financin for bidd ozil (20 and pro exchang product financin finance for poor 3. rese the me seconda venues screene banglad in differ the ex platform and pre as well on the banglad d to a sing er, this fixe discounted the bill is d ng client). o s open to m eficiary, i.e nd chemla ble exchan funding is a es to achie rs can part pate under t ni (2018) f ble exchan ional) for p d at the ma ng works as ding a price 017) finds t omoting ec ge increase tion of good ng, poverty providers a r entreprene earch meth eta-analysis ary sources (46) have ed. few of desh bank; rent countri xisting form ms or invoi evious resea as the globa e other ha desh-based gle factor, in ed policy w d with mult drawn), and on the othe many finance . the cmsm (2019) and nge is akin a financing eve a comm ticipate un trx to prov finds that u ge, an invo purchasing aturity date s like as a s and the div that there is conomic gr s the volum ds and serv y reduction, and users), eurs, etc. hodology procedure and they a been referr the importa bangladesh ies; sme fo m of trx ice platform arch works h al status of and, the d contexts ha nvoices are with a single tiple factors d the client er hand, un ers/investor mes. d belleflam to crowdfu g in which mon goal: g der crowdf vide capital under the m oice is offe at a disco e [the due d stock excha vidend is pa a relation b rowth of th me of financ vices in the , cost of fi governmen has been us are both qu red), i.e., jo ant data sou h economic oundation, b in differen ms or invoic have been u trx. data from ave been use 42 discounted e factor is s with the c (the suppli nder financi rs that lead mme et al. ( fuding in w many contr generally pr funding; si to a firm. mechanism ered openly ount price a date of pay ange where aid based on between fin he state. a cial transac economy. i inance for nt revenue, g sed in the st uantitative a ournals, web urces (beyo c review; le bangladesh nt countrie ce trading p used to find world b ed to find th asian d with a sin amendable. consent fro ier or the b ing through to lowering (2013) state which multi ributors cal roviding ca milarly ma of discount y to all kin and the ful yment of th a share is o n the face va nancing thro arranging f tions in the it also addr intermediat governance tudy. the d and qualitat bsites, perio ond journal eading trade h; relevant w s is mostly platforms. t d the concep bank, multi he applicatio n journal of f ngle factor sometime m the debt beneficiary h discountin g financial e that finan ple investo lled backer pital for a any finance ting an inv nd of inves ll amount ( he invoice]. offered open alue of the s ough trade re finance wit e economy t resses the is tion (on th of business data used in tive in natu odicals, boo papers) inc e receivable websites; etc y known a the data fro pt and modu ilateral age on of trx finance & ac issn 19 2023, vol. 1 ajfa.macro (financer/in es, the invo tor (the con of finance, ng with the cost on the ncing throug ors can par rs provide f firm. so, a ers (investo voice throug stors (indiv (of the inv in this sen nly to the in share. eceivable ex th trade re that acceler ssues like in he part of b s, access to n the study a ure. more th oks, etc. ha clude worl e platforms w c. as trade re om these p us operandi encies, an in banglade ccounting 946-052x 15, no. 1 think.org/ nvestor). ices can ncern on , i.e. the help of e part of gh trade rticipate. financial as many ors) can gh trade idual or voice) is nse, this nvestors xchange ceivable rates the nclusive both the o finance are from han 100 ave been ld bank; working ceivable latforms of trx d other esh. 4. find based o 4.1 con trx is cmsm the obj the one invoice been us in a brie trading  a trading  on invoice maximu  th the exc  th certain  wh exchan a comp (i) buye (ii) cm by due (iii) bu cmsm (iv) re bidding (v) vari (vi) cm auction dings and d on the objec ncept of trx s deemed t mes to post t jective of th s available s are legitim sed before to ef way, as p g explained supplying g exchange nce approve e. the mon um amoun e due proc change, wh e firm (su percentag hen the end nge makes t prehensive f er corporate msme deliv date. uyer corpora me, posts the ceivables o g and financ ious bids su msme eval closes at th discussion ctives of the x: how doe o bring bu their receiva he bidding m to them con mate, have o obtain fin per step by s d, 2021): firm appli . ed, a client netary valu t. cess of the here multip upplying fi e of the inv d debtor (th the remain functional d e sends purc ers the good ate accepts e accepted b of cmsme ciers submit ubmitted by uates the o he expiry of e study, the es trx wor uyers, suppl ables, buyer model is to nventionally been appro ancing from tep procedu ies online t bank acco ue of the i exchange le investor rm) receiv voice value he buyer) p ing balanc definition of chase order ds or servic the goods bill on the t e from buye their online financiers b ptions and f specified p 43 findings are rk? liers, and f rs to approv enable cm y. a due fra oved accord m another le ure, the mod to become ount is set invoice ma verifies th rs buy slice ves funds i e (say, 90% pays its in e available f trx is as to cmsme ces as per th or services trade receiv er corporate e bids to the become ava accepts a b period. asian e as follows financers to ve invoices, msmes to ac aud-checkin dingly by th ender (wass dus operand e an appro up and th ay vary fro he invoice. es of the in in its acco %) within 2 voice into e to the firm follows (re e. he requirem s and based vables exch e become a e trx. ailable to th bid. if it do n journal of f s: ogether in o , and financ ccess funds ng mechani he buyer an s, 2019). i of trx is ved memb e supplyin om a minim once veri voice. ount as an 24-48 hours the client m, minus th eserve bank ments along d on instruc hange (trx available to he cmsme. oes not exer finance & ac issn 19 2023, vol. 1 ajfa.macro one place a cers to bid o s at lower ra ism ensures nd have not as follows ber of the ng firm can mum amou ified, it is advance s. bank acco heir fees. k of india, 2 with bill to ction receiv x). o the financ . rcise its opt ccounting 946-052x 15, no. 1 think.org/ allowing on them. ates than that the already (invoice invoice n sell an unt to a sold on up to a unt, the 2014): o be paid ved from ciers for tion, the (vii) wh all conc bill thro (viii) pa cmsm (ix) on based function same is source: 4.2 glo many c neighbo incorpo (klappe platform adoptin enterpr incorpo countrie usa back to exchang liquidx hen cmsm cerned part ough the tr ayment is m me about the due date, b on the pra nal definitio given in fi : the a obal practic countries h oring countr orated by m er, 2005; kl ms) in indi ng this mo rises) mark orated this f es is given b o more tha ge started t x) was laun me accepts t ies viz, cm rx. made by the e same to tr buyer corpor actices of on of trx igure 3. fi author (202 ce of trx have adopte ry, india, ha mexican dev lapper, 200 ia. united a del of fina ket. unite financing lo below: an a decade the journey nched as a the bid of a msme, buy e financier t rx. rate directly different in x has been p igure 3. 1) with the ed and/or a as incorpora velopment b 6). there ar arab emira ancing to ed kingdom ong before. e, the trade y. in the u an alternativ 44 financier, a yer corporat to cmsme y pays to the nvoice trad provided ab modus ope aid of tre adapted thi ated this fin bank – the s are three (03 ates (uae) cater their m (uk), u a brief on e receivable usa, in 200 ve to facto asian an online in te and finan e and intima e financier. ding platfor bove and a erandi of tr eds platform is financing nancing in 2 state-owned 3) such kind ), a global msmes united stat n the practic e finance m 07, the rec oring, anoth n journal of f ntimation is ncier about ation is give rms in diff graphical rx m, india (20 g modality. 2015. india f d nacional f d of exchan trade hub, (micro, sm tes of am ce of this fi market thro ceivable ex her mode o finance & ac issn 19 2023, vol. 1 ajfa.macro sent by the the discou en by finan fferent coun presentation 017) . for instan followed th financiera ( nges (also kn , is on the mall, and m merica (usa financing ac ough the or xchange (no of trade re ccounting 946-052x 15, no. 1 think.org/ trx to unting of ncier and ntries, a n of the nce, the he model (nafin) nown as way of medium a) have cross the rganized ow it is ceivable finance the foc sources in 2011 of finan finance uk in uk, receivab 2017, it is the w ii. anot 2012 t receivab iii. still by form sme cl sloveni the firs is locat exchan after de attracte invested in nove by may and reac withou france, receivab india in india ltd (rx m1 xch on de receiva . it was bas cus of liqu s of finance 1, another tr ncing invoi the receiva in 2010, bles with bi t expanded world’s large ther trade re o provide bles. l another br mer morgan lients in the ia st organized ted in ljub nge was con eveloping a d the attent d 150.000 e ember, 2015 y 2016, the ched a total ut uk, there spain, sw ble trading a, there are xil), (ii) t hange). cember 1, able exchan sed in new uidx was on from banks rade receiva ices of sup ables of both market inv idding in th its portfolio est invoice eceivable ex cash supp ritish trade n stanley an ir book or p d exchange bljana, the nceived by tw a pilot tradin tion of busi eur of seed 5 (conda, 2 e invoice e l of 3.25 mi e are many weden, etc market in n three such treds ltd 2016; res nge of india york. it w n small firm s, nbfis, an able exchang pplying firm h the small voice starte he auction m o remarkab trading plat xchange gia port to the receivable nd hsbc e portfolio and for trading capital ci wo entrepre ng platform iness angels d equity to k 021). exchange ha llion eur o trade receiv . in europ non-uk eur markets or (known as serve bank a limited (rx 45 was a subsid ms since th nd other for ge player n ms by acqu suppliers an ed business mode as like ly with incr tform. ant in uk n e small su exchange p executives. d in 2017 th b2b receiv ity of slov eneurs name m and testing s peter rib kick-start th ad over 190 of receivabl vable excha pe. statist rope over th platforms n s invoicema k of india, rxil) as ind asian diary of the he large one r their suppl amed nyse uiring a sha nd large cor of financi e as the con reasing tren named platf uppliers aga player name as of 2016 hey secured vables is inv venia. the ed marko r g it with pro arič and jan he project. i 0 registered les traded on anges in dif ta (2021) p he years 201 namely (i) r art), and (iii the centra dia’s first rec n journal of f e new orle es (firms) h y chain (ch e euronext s are in liqui rporate supp ng through nventional s nd as of tod form black ainst their ed aztec ex 6, they repo place in the voice excha idea of es rant and to ospective cl nez klobča invoice exc d clients – e n the platfo fferent coun presents a 13-2018 as s receivables i) mynd so al bank of ceivable exc finance & ac issn 19 2023, vol. 1 ajfa.macro eans exchan have the alt hatnani, 201 started the b uidx. they pliers. h discountin stock excha day. market k started bus outstandin xchange wa orted havin e list of for ange in slo stablishing omi šefman lients, the c ar who in la change wen exchange m orm (conda, ntries such robust gro shown in ta s exchange olutions (kn f india, au change. rx ccounting 946-052x 15, no. 1 think.org/ nge, inc. ternative 18). business used to ng trade ange. by invoice siness in ng trade as set up ng 6,000 rbes. venia. it invoice in 2011. company ate 2014 t on live members, , 2021). as italy, owth of able 1. of india nown as uthorized xil is table 1 source: promote instituti india l include icic se another limited invoice 2019). the thi solution technol the gov exchang ministry 02, 201 2013 w availabl get the supplier in respo econom india h develop cadena united in unite dhabi c year 2013 2014 2015 2016 2017 2018 . value : statis ed by sma ion of prom limited, the state bank ecurities lim r trade rece d (a joint emart was g ird trade re ns, a global ogy, and co vernment of ge platform y) vide its 8 has mand with a turnov le audited f emselves re rs (rao & g onse to the my registered has develop pment bank as productiv arab emir ed arab em commercial e of invoice sta (2021) an all industri moting and e premier s k of india (s mited (sam eivable exc venture be given on ju eceivable e l service pro onsulting. it f india has t m. their m notification dated all com ver of more financial sta egistered on gupta, 2021 e above step d a bullish t ped this m k – the sta vas (rbi, 20 rates mirates (ua l bank (ad value 1.2 8.8 89.5 278.7 604.3 803 e trading in nd author’s es develop financing m stock excha sbi), icici mie, 2017). change of i tween axi une 29, 201 exchange o ovider in fin was launch taken steps ministry of n (msme n mpanies (la than rs. 50 atements an n the tred ; chatnani, ps of indian trend as dep arket with ate-owned n 014). e), a global dcb) are wo e 7 46 n europe (ex s calculatio pment bank msmes in ange in in bank, yes india is inv s bank an 7 and it w f india is nance and a hed on 7th a further to e f micro, sm notification arge corpora 00 crore (r nd all centr ds platform 2018). n governme picted in ta the help o nacional fi l trade hub, orking toget asian xcept) uk: on (2021) k of india n india, and dia. other s bank, sbi voicemart. i nd mjunctio ent on live m1 xchang accounting, april 2017 ( expedite the mall and m n) bearing s ates) registe rupees five ral public s m to ensur ent, the trad able 2. of the mod inanciera (n abu dhabi ther to launc comp 132.8 n journal of f 2013 to 201 (sidbi), d national s joint inves i capital m it is promo on services) on july 5, ge. it is p human reso (m1 exchan e operation o medium en s.o. 5621(e ered under t hundred c sector ente re cash liq de receivab del incorpo nafin) w i’s financial ch a trade re pound gro 83% finance & ac issn 19 2023, vol. 1 ajfa.macro 18 in milli the apex f stock exch stors behin markets limi oted by a. s). the lice , 2017 (nar promoted by ources, info nge, 2021). of trade rec enterprises e) dated no the compan crore) as per erprises (cp quidity for bles market orated by m which oper l free zone a eceivable ex owth rate ccounting 946-052x 15, no. 1 think.org/ ion usd financial hange of d rxil ited, and treds ense for rayanan, y mynd ormation eivables (msme ovember nies act, r the last pses) to msme in their mexican rates the and abu xchange table 2 particul disburse number (trade r discoun number banks/n participa number buyers ( number vendors source: note: market. receiva for the have th legitima launder authorit 4.3 app banglad maintai econom econom literacy poverty (covid banglad 2030 (w capital graduat howeve 2021). cagr 2. perfor lars ement amou r of invoices receivables) nted r of nbfis ated r of corporat (debtors) r of msmes s (suppliers) : naray 1 cro they are r ables excha msmes at e deliberate acy of the in ring activitie ties of hong plication of desh is bec ined an imp my has grow mic growth. y, and per c y since 199 d-19). desh is the world econ income, hu tion to be u er, due to in 2019, th of 11.32% rmance of t march 2018 unt 315 2,532 14 te 47 201 yanan (2019 ore = 10 mil replicating ange. the u a lower co e plan and m nvoices (tra es, double f g kong and trx in the coming a n pressive trac wn at nearly poverty dro apita food 92 (note 3) 39th larges nomic foru uman assets upper-midd corona pan he economy over last 10 trade recei m1x h 31, mar 2019 2,614 34,04 24 200 1285 9); author’s llion india’s m1 uae govern ost than the mechanism ade receivab financing o d singapore context of b new model ck record o y 6% per ye opped by ne intake. mor ). all these t economy um, october s index, eco le income c ndemic, thi y registered 0 years since 47 ivable exch xchange rch 31, 9 gr 4 730 44 1,2 71% 326 5 539 s calculatio xchange. t nment inten same of th for the frau bles). they of the invoic to set their bangladesh l for devel on growth a ear, and hum early a third re than 15 e are the c in the worl r, 2019). it onomic vuln country by s transition d growth at e 2010 as sh asian hanges in in in rowth m 2 0% 4 245% 1 % 1 6% 3 9% 3 on this market nds to do it he sources a ud checking also have se ces. they a trade receiv h lopment (b and develop man develop d, coupled w million ban ondition ex ld. it will be t has fulfille nerability in 2024 (wo n time has 10.41% on hown in fig n journal of f ndia n crore inr i march 31, 018 15 4,304 0 2 10 will be nam to pave th available co to ensure th et procedure are working vable excha bird, 2021). pment. in th pment went with increas ngladeshis h xcluding the e the 24th l ed all three ndex) and i orld bank, 1 been exten n year over gure 4. finance & ac issn 19 2023, vol. 1 ajfa.macro rs (indian r invoicemart march 31, 2019 2,712 1,83,088 24 259 1802 med as ua he access to onventionall he genuinen es to protec g with the m ange (wass, . the coun he past dec t hand-in-ha sed life exp have move e pandemic largest econ e requireme is now on t 15 october nded till 20 r year basis ccounting 946-052x 15, no. 1 think.org/ rupees) t growth 553% 1,180% 140% 709% 481% ae trade finance ly. they ness and ct money monetary 2019). ntry has cade, the and with ectancy, d out of c period nomy by ents (per track for r, 2019). 26 (jha, s having source: note: to mee gdp gr public a inclusiv to sus urbaniz impacts strength financia urban m powerh digits o the ind namely the eco generat the priv most do associa capital, banglad daily s under t prospec and (iv) 4.3.1 pr the ma of this c : autho data o 2021] et its target rowth at aro and private ve through c stain accele zation proce s. at the s hen revenu al-sector an managemen house, with n a sustaine dustries in cottage, m nomy and d e more than vate sector. ominant is c ation (mida in the peri desh, 50% o star, 2019). the above co ct of trx, ) identificat rospect of t arket of trx credit transa 0.00 100.00 200.00 300.00 400.00 g d p in u s d b il li on f or’s calcula of 2020 no ]. however, of becomin ound 9% pe investment creation of p erated and ess more ef same time ue mobiliza d external t nt; and ada its labor-in ed basis. bangladesh icro, small, driving forc n 90% of al these ind capital short as), 51% o iod of 2008 of cmsme ondition of (ii) readine tion of the s trx x depends actions is de 115.28 128.68 2010 2011 figure 4. ation using t yet publis statista.com ng the 24th er year base will need t productive d inclusive ffectively, a bangladesh ation; tack rade reform apting to cl ntensive ma h are made and mediu ce of solvin ll business dustrial uni tage. accor of smes clo 8 to 2012 i es acutely fa the econom ss for trx takeholders on b2b (bu epicted here 8 133.36 149 2012 20 48 banglade world ban shed on the m (2021) m h largest eco d on accele to increase a employmen growth, b as well as p h will need kle energy ms; improvin limate chan anufactured e up of ma um enterpris ng the unem activities an its suffer fro rding to the osed due to in the deve ace the capi my, the appl x, (iii) exist s. usiness to b e with few i 9.99 172.89 013 2014 yea asian sh economy k data (202 same sourc mentions gd onomy by 2 erated expor as well. gro nt opportuni bangladesh prepare for d to maint and infra ng labor ski nge. bangla d and servic ainly of sm ses that are mployment nd provide om many fo survey of m o the lack o eloping eco tal shortage lication of t ing market usiness) tra instances: (i 195.08 221.42 2015 2016 ar n journal of f y 20). ce [accesse dp in 2020 a 2030 it will rt and remit owth will al ities in the d h will nee adaptation tain macroe structure d ills, econom adesh can ce exports mall manufa considered problem of two out of olds of prob medium ind of capital, p nomies (un e for running trx may b scenario in ansactions o i) governme 2 249.72 274 2017 20 finance & ac issn 19 2023, vol. 1 ajfa.macro ed 20 febru as $338.39 b l require in ttance grow lso need to domestic ec ed to man n to climate economic s deficits; de mic governan become an growing at acturing com as the back f the countr every three blems in w dustry deve articularly w nctad, 2 ng the busine be justified u n terms of f on credit. th ent procurem 4.04 302.57 018 2019 ccounting 946-052x 15, no. 1 think.org/ uary billion. creasing wth. both be more conomy. age the e change stability; eepening nce, and n export t double mpanies kbone of ry. they e jobs in which the lopment working 001). in ess (the under (i) fintech, he space ment, (ii) purchas exchang i. gove the tot 2020 (n cash. it so on. i form. ii. purc banglad sectors agricult maintai income in recei 2018 2 iii. pur the pri carries remains from ve 60, 90, total pu (dse) shown i table 3 fiscal y 2014-15 2015-16 2016-17 2017-18 2018-19 source: note: the sce compan listed c se of state-o ge(s), (iv) g ernment pr al amount o note 4). (w remained i in other wo chase of so desh econo (such as ture; constru ining nation . these pur vable form. 2019. chase of th ivate sector a large am s in the form ery short tim 120, 180 d urchase in 2 from the to in dse web . good year 5 6 7 8 9 : bangl 1 cro bangl enario is s nies are 598 ompanies, owned ente gdp scenar rocurement of procurem world bank, n receivabl ords, in the e oes omic review industry; p uction; serv nal produc rchases mos . table 3 d he listed co r carries alm mount of bu m of trade r me period su days, and so 2020 (note op 20 best bsite (dse, ds and servi amo 1270 1140 1266 1549 1615 ladesh econ ore = 10 mi ladesh bank such that th 8 (note 6) the volume rprises’ (so rio. t ment of ban , 2020). mo e (invoice) economy, a w (2020) sta power, gas vices) condu ctivity, valu stly take pla depicts a pu ompanies most 85% o usiness activ receivables uch as seven o on (klapp 5) of top fi performing 2021). ces purchas ount 014.54 077.15 643.24 985.90 553.65 nomic revie llion; 1usd k, the centr here are su (including e becomes a 49 oes), (iii) p ngladesh go ostly, this a form for a a large amou ates that sta and wate uct a signif ue addition ace on credi urchase reco of the deve vities on cr in the econ n (07) days per, 2005). five (05) list g companie sed by the n compo 6.20% ew 2020, m d = bdt 84 ral bank of uch 20 top 20 top one a gigantic o asian purchase of overnment s amount of p time such a unt of mon ate-owned e r; transpor ficant amou n, employm it that also k ord of soes lopment ac redit. that nomy. the or 15 days for instanc ted compan s is given non-financi ound growt ministry of f 4.80 as on 1 bangladesh performin es). if we c one that rem n journal of f f listed com stood aroun procuremen as 30 days, 6 ey remained enterprises ( t and com nt of purch ment genera keep a large s over the y tivities of t is, a large ages of the to long-term ce, an appr nies in dhak in table 4 ial soes th rate finance 18 february h g compani consider the mains tied i finance & ac issn 19 2023, vol. 1 ajfa.macro mpanies in th nd $25.00 b nt was not 60 days, 90 d tied in re (soes) in d mmunication hases every ation and e amount o years 2014 the country amount of ese receivab m period su roximate am ka stock ex based on in cror y, 2021; sou es and tota e purchase in receivab ccounting 946-052x 15, no. 1 think.org/ he stock billion in made in 0 days or ceivable different n; trade; year for revenue f money 2015 to y. it also f money bles vary uch as 30, mount of xchange the data re bdt urce: al listed of total le form. the tim can rele table 4 s/l no. 1 2 3 4 5 total source: * ** based o market iv. gdp beyond purchas are not activitie depicted table 5 27 cror 2011-20 mllion) period, million) analogy me cost or ec ease this fun 4. total name of the bangladesh company ltd british am bangladesh c beximco phar robi axiata l summit powe : dhak data o the c from on governm space for t p scenario d the transac se; a large a t listed in t es on credit d in table 5 5 shows that re (270 mi 012 to 2019 to maximu the averag ) to maximu y for a mark conomic va nd remainin purchase s company export imp d. merican toba company limite rmaceuticals lt ltd. (q3)* er ltd. a stock exc of q1 were calculation the sales rev ment procur trx is depic ctions unde amount of b the exchang can be gras 5. t per day ec illion) to m 9-2020 in di um bdt 74 ge daily ec um bdt 89 ket of trx. lue of this c ng in inactiv size of five q1 purc (in bdt million) port 6,207.45 cco ed 17,193.5 td. 6,579.63 18,370.5 11,701.1 60,052.3 change [acc not availab was based venue to ge rement, so cted in figu er governme b2b transac ges or own sped throug conomic ac maximum b ifferent sect 17 crore (74 conomic ac 92 crore (89 50 colossus am ve form. it g dse-listed chase** t ) q1 (in 5 62 58 17 3 65 55 18 5 11 37 6,0 cessed 2 feb ble. on the sal et the purcha oes’ purcha ure 5. ent procure ctions also t ned by the gh per day g ctivities in t bdt 1459 tors totaling 4170 millio ctivities sto 920 million) asian mount of mo glimpses the d companie 1 purchase n bdt crore) 0.745 19.358 7.963 37.055 70.115 005.24 bruary, 202 les turnover ase volume ase, and lis ment, soe take place o governmen gdp activiti he economy crore (145 g from mini on) as depict od from m ) as shown n journal of f oney is a sig e space for t es annual purchase (i bdt millio 24,829.81 68,774.34 26,318.53 73,482.20 46,804.60 240,209.48 21] r. there wa . ted compan s’ purchase on credit am nt. the vol ies in the ec y ranged fro 590 million imum bdt ted in figur minimum b in figure 7 finance & ac issn 19 2023, vol. 1 ajfa.macro gnificant. t the market o in on) annu purch (in b 2482. 6877. 2631. 7348. 4680. 24,02 as a 5% de nies’ purch e, listed com mong the fi lume of su conomy (no rom minimu n) over yea t 2274 crore re 6. over t bdt 50 cro . all these m ccounting 946-052x 15, no. 1 think.org/ the trx of trx. ual hase bdt crore) .981 .434 .853 .22 .46 20.95 eduction hase; the mpanies’ rms that uch b2b ote 7) as um bdt ars from e (22740 the same ore (500 make an source: note: table 5 sector 1. agricul 2. fishing 3.mining 4.manufac 5.electrici 6. constru 7.wholesa 8.hotel an 9.transpo communi 10.financ 11.real e 12.public 13. educa 14.health 15.comm source: note: t 2,120, (gov : the a 1usd 5. daily lture and forest g and quarrying cturing ity, gas and wa uction ale and retail t nd restaurants ort, stora ication cial intermediati state, renting a administration ation and social wo munity, social an : bangl (i) ca numb 1usd supplying (selling f trade receiva ,000,000,000. vernment proc figu author’s ca d = bdt 84 y business a try ater supply trade age & ions and n orks nd personal ladesh econ alculated by ber of days i d = bdt 84 g firms firms) ables of bdt 00 remain un curement in 20 ure 5. sc lculation (2 4.80 as on 1 activities in 2011 2012 2012 2013 386 413 88 103 46 54 466 548 39 46 190 229 382 429 27 31 313 345 101 117 191 219 93 105 70 79 56 66 326 386 nomic revie y dividing an in a year. (ii 4.80 as on 1 npaid 020) tra trade 1,6 (49 51 cenario of t 2021) using 8 february, n the econom 2 3 2013 2014 455 118 59 620 51 252 479 36 373 135 253 124 91 75 435 ew 2020, nnual gdp i) * means p 8 february, ade receivable outstandi e receivables 15,536,500,00 state owned asian trade receiv g respective , 2021; sour my at current 2014 2015 2015 2016 490 529 132 147 66 79 707 820 55 66 301 351 535 595 41 47 417 470 155 177 295 344 141 185 105 129 84 97 490 540 ministry of by 360 day provisional( , 2021; sour tr 143,645, (598 l es remain ing of bdt 00.00 firms) n journal of f vable e data sour rce: bangla market pri 5 6 2016 2017 571 166 95 950 73 406 678 54 520 203 401 218 158 108 595 f finance s considere (iii) 1 crore rce: bangla rade receivab 266,648,000.0 listed compa finance & ac issn 19 2023, vol. 1 ajfa.macro rces cited. adesh bank ices, in cror 2017 2018 2018 2019 632 689 186 206 108 122 1123 1337 81 89 472 546 777 896 61 70 568 628 233 262 462 529 251 275 179 203 122 144 657 725 ed as financi e = 10 millio adesh bank conglom (buying bles of bdt 00 remain un anies’ purchas ccounting 946-052x 15, no. 1 think.org/ re bdt 89 20192020* 737 229 131 7 1459 95 623 1001 79 691 281 590 311 227 163 800 ial on; merates firms) npaid se) source: figur source: note: 4.3.2 re the rea regulato to trx i. techn the fun informa indicate the gov into “d implem of (i) m 200 400 600 800 c ro re s in b d t 1 a t c ur re nt m ar ke t p ri ce s in b d t c ro re fig : the a re 7. ave : autho 2020, (i) af manu wrt storag rentin work (ii) 1u eadiness for adiness refe ory issues f x is as follow nology base nction of fi ation and c es the status vernment of digital ban mented in thi making peop 2774 0 00 00 00 00 2011-2012 545 0 200 400 600 800 1000 af gure 6. t author’s ca erage daily or’s calcula , ministry o f: agricultu ufacturing; e : wholesale ge & comm ng; pa: pub ks; csp: com usd = bdt r trx ers to the p for trx. th ws: ed prepared inancing th communicat s of ict of t f the countr gladesh” b is motto an ple skilled i 3170 2012-2013 2 153 85 8 f mq m total daily lculation us business a ation (2021) f finance ure and fore egws: ele e and retail munication; blic admini mmunity, s t 84.80 as o reparedness he present s dness hrough trx tion techno the country ry is pro-ic y 2021. a d many are in ict, (ii) 3556 40 013-2014 2014 892 66 37 m egws c 52 economic a sing data of activities in ) using dat estry; f: fis ectricity, ga l trade; hr fi: financi istration; e: social and p on 18 febru s of the cou status of tec x is mostly ology (ict) (note 8). ct. the visio a lot of pro e in the proc ensuring c 014 4576 4-2015 2015-20 financial 74 641 50 c wrt hr secto asian activities (i f banglades the econom ta from ban hing; mq: m s and water r: hotel and ial intermed education; ersonal. uary, 2021; s untry in ter chnology an y dependent ). so, the te on of the go ojects and cess to build connectivity 6 5196 016 2016-2017 year 0 481 185 r tsc fi ors n journal of f in crore bd sh economic my: 2011-20 ngladesh eco mining and r supply; c restaurant diations; re ; hsw: hea source: ban rms of (i) te nd regulator t on techno echnology b overnment i programs h d the nation y for people 5912 2017-2018 2 365 189 rer pa finance & ac issn 19 2023, vol. 1 ajfa.macro dt) c review (2 012 to 2019 onomic rev d quarrying : constructi ts, tsc: tra er: real es alth and soc ngladesh ba echnology, ry issues in ology, speci based prepa is to turn th have alread n on the fou e at every c 6721 7 2018-2019 201 138 102 egws hsw ccounting 946-052x 15, no. 1 think.org/ 2020). 9-2020 view ; m: ion; ansport, tate, cial ank and (ii) relation ially the aredness he nation dy been ur pillars orner of 7417 9-2020 550 csp the cou digitiza for bui some o (bangla 2021; u banglad hi-tech the cou employ establis departm citizens, control of ict d banglad by the mileston projects (tier-iv innovat island m block c learnin security ii. regu the re regulato seems t a) laws policies some o amendm agency hi-tech 2018; b b) laws in the co untry, (iii) m ation, (iv) pr lding a digi of the mega adesh econo unctad, 2 desh hi-tec park/softwa untry. bhp yment, build shing depa ment of ict w , promote kn ller of certif division to se desh compu parliament ne activitie s completed v certified); tion design maheshkhal chain, inter ng, 3-d pri y agency (d ulatory issue gulatory is ory issues a to be akin to s, acts, rul s have been of them in ment in 200 y rules 202 h park auth bcc act 19 s, acts, rul ountry nam making pub roviding req italized cou a and notab omic revie 2019; uk a ch park (bh are technolo p was crea ding an inve artment of was created in nowledge-bas ifying autho ecure e-comm uter counc t to promot s to establis d by bcc i ; smart cla n entrepren li (note 9); rnet of thin inting, etc.) dsa); a2i p es based pr ssues inclu are divided o stock exch les, policies n formulated nclude: inf 09 and 2013 20; digital hority 2010 90; etc. (ic les, policies ed dhaka s blic service quired servi untry to adop ble ict pro ew, 2020; ic aid, n.d.): hp): bangla ogy parks, t ated to pro estment-frien f informatio n 2013 unde sed economy orities (cca merce, e-tran il (bcc): bc te ict infr sh an ecosy include: tie assrooms in neurship ac center for ngs (iot), b ); banglade program; et reparedness de related under two hange] (van s related to d in the coun formation a 3); nationa security a 0 (with ame ct division, s related to stock excha 53 es available ices to the it pt and/or ad ojects comp ct division adesh hi-tec training and omote it/it ndly econom on and co er ict divisio y and good g a): the cca nsaction, and cc was cre rastructure ystem based er –iii nat educationa cademy (id excellence big data, d esh nationa tc. (banglad laws, acts heads: (1) nnoni, 2020 o ict: di untry in diffe and comm al ict polic act 2018; o endment in , the peopl o stock exc ange (dse) asian e at the doo t-industries dapt an incl pleted by th n, the peop ch park aut d incubation tes based my. ommunicatio on to deliver overnance in a was establis d e-governanc eated under of the cou d ict infras ional data al institution dea); “con e on fourth data analy al digital a desh compu s, rules, re ict, and (2 0). ifferent ict ferent times munication y 2009, 20 one stop se 2014) act e’s republi hange: the established n journal of f orstep of th s. lusive finan he governm ple’s repub thority was n centers at hi-teck ind on technol e-services a n the country shed in 2011 ce in the cou the act no untry. it ha tructure. so center; na ns; 5g-based nnected ba industry re ytics, machi architecture uter counci egulations, 2) stock exc t related law to make the technology 15 and 201 ervice law 2014; one ic of bangla ere are two b d in 1954 an finance & ac issn 19 2023, vol. 1 ajfa.macro he citizens nce based ec ment are as blic of ban created to e t different p dustry, tech logy (doic at the doorste y. as an attach untry. o ix of 1990 as complete ome of the s ational data d wi-fi 6 n angladesh”; evolution (r ine learnin e (bnda); il [bcc], 20 policies, e change [sin ws, acts, ru e country d y act 200 18; digital w 2018; ban e stop serv adesh; 2021 big stock ex nd chittagon ccounting 946-052x 15, no. 1 think.org/ through conomy, follows gladesh, establish places in h based ct): the eps of the hed office 0 passed ed many strategic a center network; digital robotic, ng, deep digital 021). etc. the nce trx ules, and digitized. 06 (with security ngladesh ice law 1). xchanges ng stock exchan for func acts, ru limited of finan  new formula facilitat  lis receivab the sam regard, exchan  new be creat  reg represe commi  the based o trading 4.3.3 ex trx h innovat mfs op bank of mfs re unbank banglad (p2b), (g2p) remittan to offer bank, 2 nge (cse) e ctioning of ules, and po to only the nce; 2021): w rules sim ated for a te the establ sting regul bles and pa me are paya there is a nge ltd.” “t w regulatio ted for the s gulations f entative to ission (stock e trading of on automat such as “dh xisting mar has an akin tive fintech perates unde f banglades efers to br ed populat desh bank business to payment s nce coming r mfss (uk 2021). stablished i these stock olicies to es ese) are her milar to ex trade recei lishment of lations to b ayables resp ables on the already a r the public i ons like “se settlement o for trade be create k dealer, st f trade recei ted trading haka stock rket scenari n to finte h is depend er a bank-le h. banglade ranchless b tion groups allows cas o person (b services do g through ba k aid, 201 n 1995. the k exchanges tablish and re (banglad xisting “th ivables base a commod be created ectively (i.e e part of bu regulation ssue rules” ettlement of of trade re receivable d as made tock broker ivables will g of trade exchange a io in terms ech (gombe dent on mob ed structure esh bank in banking or s at reason sh in, cash b2p), person mestically. anking chan 7) out of w 54 ere are man and their h d operate tr desh securit he securitie ed seconda dity exchang for the su e., receivab uying firms named “li ” may also b f stock exc eceivables e s dealer, e for stock r and autho l be conduc receivable automated of fintech er et al., 2 bile financi e under the g ntroduced m mobile ba nable rates h out, perso n to gover however, nnel is perm which 19 ha asian ny laws, act help may be rx. in this ties and ex es and exc ary market, ge in the co upplying fir les are on t s) will be tr isting regu be taken int hange tran exchange tr trade rec k market l orized repre cted electron s to be cre trading re 2017). in b ial services guidance of mfs in 2011 anking serv (medici, 2 on to perso rnment (p2g local disb mitted. the ave launche n journal of f s, rules, pol e taken to fo regard, few change com change rul i.e. trx. untry. rms and bu he part of s raded in the ulations of o considera nsactions re ransactions. ceivables b like “secur esentative) nically. the ated as wa egulations 1 bangladesh (mfs) (m f banglades 1. vices offere 2021). und on (p2p), p g) and gov bursement central bank ed their ope finance & ac issn 19 2023, vol. 1 ajfa.macro licies in the formulate ne w propositio mmission, m les 1987” this may uying firms supplying fi e exchange f the dhak ation in this egulations 1 . broker, au rities & e regulations erefore a re as created f 999”. h, the appr medici, 2021 sh bank, the ed to bank der mfs p person to b vernment to of inward nk granted 2 eration (ban ccounting 946-052x 15, no. 1 think.org/ country ew laws, ons (not ministry may be y further s whose irms and . in this a stock regard. 1998” to uthorized xchange s 2000”. gulation for stock roach of 1). here, e central ked and program, business o person foreign 28 banks ngladesh source: note: mfs ha seven y (bangla phenom based o the mf mfs ex though compon out, me bank sh februar 4.3.4 id stakeho achieve conside with mo will be consult (mahmu stakeho trx ar (iv) exte : the a bps: numb not: dat: in cro as grown si years, the adesh bank menal growt on the data a s market st xits as show h the numbe nent has sho erchant paym hows the mf ry, 2021) pr dentification olders refer ement of th eration (fre ore success bearing the ting with th ud, 2020; olders as pr re categorize ernal, and ( 6 0 -1 1 -6b p s g r o w t h r a t e i n % figu author’s ca number of ber of regi : number o : number o ore bdt. ignificantly mfs mark k, 2021). an th in mfs, available at tands as dep wn in table er of banks p own remark ment, etc. f fs data on m roduct wise n of the stak r to any g he objective eman, 2008 and less co e ultimate co he related m rahman, 2 rimary and ed under th v) global an 11 13 10 9 a g december, 20 ure 8. g lculation us f banks prov stered clien of total tr f daily ave over the pa ket in bang nd after the cards, and t the respect picted in fig 6. providing m able growth intech mar monthly bas performanc keholders group or i es of an o 8). it is gen onflict when onsequences materials, the 2019; solaim secondary e headings nd/or intern 43 32 15 18 25 r c 17 decembe 55 growth rate sing data of viding (mf nts in lac, ransaction; erage trans ast few year gladesh has e outbreak o other alter tive webpag gure 8. as o mfss show h. based on rket shows g sis. as per t ce is shown individual organization nerally argu n they are l s of the dec e study find man, 2005) suggested of: (i) gove national. 32 24 78 26 -7 -7a c n items in mf er, 2018 dec asian e (in %) of m f banglades fs) services ac: numb ttt: tota saction: ad rs (uk aid s become t of covidrnative paym ge of bangla of 28 febru s the negati the product growth as d the data ava n in table 8. who can a n and their ued that bett led by the s cisions (voi ds a possibl ). followin by freema rnment, (ii) 2326 128 2732 o t t t t fs cember, 2019 n journal of f mfs sh bank (20 s; ag: num er of activ al transacti dt: average d, 2017; me the largest 19, the cou ment metho adesh bank ary, 2021; t ive growth, t category su epicted in t ailable, the l . (banglade affect or i forces sho ter decision stakeholders nov & bous le list of sta ng the broa an (2008), t ) non-govern 20 2627 8 39 32 t d a t december, 2020 finance & ac issn 19 2023, vol. 1 ajfa.macro 021) mber of age ve accounts ion in bdt e daily tran edici, 2021) one in th untry has w ods (rashid k, the growth the market s but the oth such as cash table 7. the latest’ (janu esh bank, 20 is affected ould be tak ns are imple s, i.e. by tho squet, 2010 akeholders f ad classific the stakeho rnment, (iii) 19 12 2732 39 a d t 0 ccounting 946-052x 15, no. 1 think.org/ nts; rc: s in lac; t crore; nsaction . within e world witnessed d, 2021). h rate of status of her every h in, cash e central uary and 021). by the ken into emented ose who 0). for trx ation of olders of internal, table 6 source: note: table 7 produc inward cash in cash o p2p tra salary d utility b mercha govern others source: i. gover the bod ministry (bb), b chittag investm authori power o particu number number number number number total tr number average 6. mfs : bangl (i) 1 l (ii) ac (ii) *a 7. produ cts remittance n transactio ut transacti ansaction disburseme bill paymen ant payment nment paym : the a rnment stak dies under g y of financ bangladesh ong stock e ment corp ity (bida) of the state ( ulars r of banks c r of agents r of registe r of active a r of total t ransaction i r of daily a e daily tran (fintech) p ladesh bank lac = 0.10 m ctual numbe account in w uct wise gr e on ion ent (b2p) nt (p2b) t ment author’s ca keholders government ce (mof), m security e exchange (c poration of , central d (ppp) [(pol currently p ered clients accounts in transaction in taka (in c average tra nsaction (in position in t k (2021) million and er of days in which trans rowth of mf dec. 2017 -43% 20% 20% 31% 73% 2% 0% 0% 3% alculation us t stakeholde ministry of exchange co cse), bang f banglad depository litical gover providing th s in lac n lac* crore bdt) nsaction n crore bdt 56 the market d 1 crore = n month ha saction mad fs (2016 – . 7 dec 201 % 128 % 2% % 12% % 15% % 51% 54% 227 413 38% sing data of ers include j commerce ommission gladesh ins esh (icb) of banglad rnment], et he services ) t) asian 10 million] s been used de in last 3 ( 2020) c. 18 de 20 81% -51 19 % 10 % 94 % 64 % 10 7% 41 3% -90 % 45 f banglades jatiya sang e (moc), c (bsec), d stitute of d ), banglade desh limite c. amount 15 1,054,781 1,023.69 342.27 279,663,3 55,059.27 9,987,976 1,966.40 n journal of f d for average three) mon ec. 19 d 20 1% 33 % 19 % 15 % 72 % 10 % 16 % 25 0% -3 % 10 sh bank (20 sad (js) [n entral bank dhaka stock developmen esh investm ed (cdbl) a -3 1 11 25 24 337 23 7 25 6 22 24 finance & ac issn 19 2023, vol. 1 ajfa.macro e calculatio nths. dec. 020 a 35% 3 9% 1 5% 1 2% 5 08% 7 67% 5 58% 1 37% 7 06% 4 021) national par k, banglade k exchange nt studies ( ment deve ), political aagr (201 3% 1% 5% 4% 3% 5% 2% 4% ccounting 946-052x 15, no. 1 think.org/ ons. aagr 380% 15% 14% 53% 74% 58% 131% 72% 48% liament], sh bank e (dse), (bids), lopment party in 6 – 2020) table 8 produc inward cash in cash o p2p tra salary d utility b mercha govern others source: ii. nonthe bod country dialogu initiativ investo iii. inter the int registra sme fo stock d industry banglad publicly regulat associa iv. exte the ex banglad banks ( v. glob the glo bank (a and oth the abo 8. latest cts remittance n transactio ut transacti ansaction disburseme bill paymen ant payment nment paym : bangl -governmen dies under y (ppo), t ue (cpd), ve leading ors, and the rnal stakeh ternal stak ar of joint oundation; dealers; stoc y, dhaka (m desh cham y listed co tory author ation (blfc ernal stakeh xternal stak desh bank, (bab), cre bal and/or in obal and/or adb), inte her. ove stakeho t product w e on ion ent (b2p) nt (p2b) t ment ladesh bank nt stakehold non-govern transparen policy r g developm e other. olders keholders in stock com smes in th ck brokers; mcci); dha mbers of co ompanies ( rity of bang ca); etc. holders keholders i , non-bank dit rating a nternational internation ernational m olders to be wise perform janu 188.7 17,2 15,80 17,45 2,189 803. 1,924 132.2 1,53 k (2021) ders nment stake ncy interna research in ment (buil nclude liste mpanies and e country; f merchant aka chambe ommerce a (baplc); i gladesh (id include me k financial agencies, a stakeholde nal stakehol monetary fu taken into c 57 mance of m uary, 2021 74 12.22 07.87 59.33 9.63 12 4.70 28 8.82 eholders inc ational ba nstitute (pr ld), foreig ed compan firms (rjs firms involv bankers; m er of comm and industr insurance c dra); ban edia (both l institution audit firms, ers lders includ und (imf), consideratio asian mfs (2016 – clude politic angladesh ri), policy gn investor ies in dse scf); large ved in tradin metropolitan merce and in ry (fbcci) companies; ngladesh le print and ns (nbfis) , and the oth de world ba , united na on duly. the n journal of f 2020) februa 179.29 16,042.8 15,235.3 16,744.5 2,190.82 765.81 1,873.88 568.24 1,458.46 cal parties i (tib), c y exchang rs, non-resi e, cse; lis e buying com ng and manu n chamber ndustry (dc ); banglade insurance asing and f digital), b ), banglade her. ank (wb), a ations deve ey need to b finance & ac issn 19 2023, vol. 1 ajfa.macro in cror ary, 2021 89 33 55 2 8 6 in oppositio center for ge (pe), b ident bang sted compa mpanies (d nufacturing b of comme cci); feder esh associa developm finance com banks listed esh associa asian deve elopment p be mapped ccounting 946-052x 15, no. 1 think.org/ re bdt on in the policy business gladeshi anies in debtors); business; erce and ration of ation of ment and mpanies d under ation of lopment program, in terms of their program visualiz decision on the 5. conc the stu through wherein urgent practice function the stu increasi nation: pandem the stu remains owned transact place in day eco to maxi place on the stu assessed conditio with the the stu (financ financia instance transact over the the stu formula in bang finance r power, su m (chinyio zing the po n. it allows decision. clusion udy presents h trade rece n the suppl and regular es of leadin nal definitio udy finds ingly adopt by 2024 mic, this tran udy finds b s in trade r enterprises tions, etc. t n the econom onomic activ imum bdt n credit that udy has ass d in terms o on of ict in e help of the udy finds th cial techno al services e, the annu tion, numbe e period 201 udy gives a ate the strate gladesh, th , particularl upport, influ o & olom osition of a the extent o . it also sho s an alterna eivable (tr ying firms r business e ng invoice t on of trx. that many ting and/or it will be nsition time bangladesh receivable s’ (soes’) the study f my. for inst vities in the t 892 crore t justifies th sessed the of ict prep n the countr e existing la hat a robust logy). in b (mfs). th ual average er of daily 16 – 2020. tentative lis egies to man here is no e ly for cottag uence, inter olaiye, 201 all stakehol of the influe ws how the ative mode rx). trx can discou expenses. t trading plat countries adapting t an upper-m has been ex as potentia form in th purchase, l finds that ev tance, over economy t (8920 milli he adoption readiness o paration and ry is suppor aws, acts, ru t ready mar bangladesh, he mfs ma e growth ra average tra st of the sta nage them w exchange li ge, micro, s 58 rest, and att 10). the s lders in ter ence and th ey are conne of financin is propose unt their inv trx is a hy tforms in d including trx. bangl middle inco xtended till al for trx he economy listed comp very day a the years fr took place fr ion). a sign and/or adap of the coun d regulatory rtive to trx ules, policie arket is exis the fintec arket is exp ates of mf ansaction, a akeholders r which may ike trx. i small, and m asian titude in re stakeholder ms of their he depth of t ected with th g by the en d to work voices for ybrid versio different cou developing ladesh is on ome countr 2026. . it finds th y against go panies’ pur large volu rom 2011-2 from minimu nificant amo ptation of t ntry to ado y issues. th x. the regu es related to sting in the ch industry panding inc fs were 25 nd average related to t be continue it may pro medium ent n journal of f elation to im mapping r influence the interest he decision ncashment o as like as immediate on of facto untries, the g and deve n the way t ry. howeve hat a large overnment rchase, non me of busin 012 to 2019 um bdt 50 ount of thes trx in the c opt and/or a he study fin ulatory issue ict and st country in works in t creasingly i 5%, 22%, daily trans rx that can ed as a furth vide an alt terprises (c finance & ac issn 19 2023, vol. 1 ajfa.macro mplement th is the pro e and intere of the stake n. of trade rec a stock ex cash to me oring. based e study has eloped nati to be a dev er, due to volume of procuremen n-listed firm iness activit 9-2020, ave 0 crore (500 se transactio country. adapt trx nds that the es can be ad tock exchan n terms of the form of in the coun and 24% f saction resp n be mappe her study on ternative so cmsmes) o ccounting 946-052x 15, no. 1 think.org/ he trx ocess of est on a eholders eivables xchange eet their d on the given a ions are veloping corona f money nt, state ms’ b2b ties take erage per 0 million) ons take x. it has existing ddressed nges. fintech f mobile ntry. for for total pectively ed out to n trx. ource of of which more th financin the stu a soluti trx as mandat register the stu the fiel of mon points: consum opportu banglad of every bdt 28 receivab implem vision 2 notes note 1 discoun note 2. or the o discoun note 3. pandem note 4. 2021; 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(2 rading platfo 6-971x es. environm 2010.03.007 ange replica ement system pushing bo ntre for al finance & ac issn 19 2023, vol. 1 ajfa.macro nd stability strategic n rporates on ners llp, s h. the daily ge for finan new techn powering-p thor] tal works raisal of its jstor. saction-valu sh: prospe 2019). ban forms. inter e-issn 191 mental mode 7 ates india’s m. oundaries: t lternative f ccounting 946-052x 15, no. 1 think.org/ y. borsa nvestor’s n trade olicitors y star. ncing of nologies. poor-ne growth (2021). ue-invoi ects and ngladesh national 16-9728. elling & s treds the2015 finance. microsoft word 18664-new asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 22 the impact of the covid-19 epidemic on saudi stock market performance using a regression model and granger causality test-empirical analysis dr. kavita panjwani & dr. mohammad arif riaz finance and banking department college of business administration jazan university, jazan kingdom of saudi arabia (k.s.a) received: april 5, 2021 accepted: june 1, 2021 published: june 1, 2021 doi:10.5296/ajfa.v13i1.18664 url: https://doi.org/10.5296/ajfa.v13i1.18664 abstract the objective of the study to investigates the impact of covid-19 epidemic on saudi stock market performance by using regression model and pairwise granger causality tests. the time series data has been taken for this study from 01 march 2020 to 6 dec 2020. coronavirus has been measured in terms of cumulative new corona cases per million, new corona deaths per million, total corona cases per million and total corona deaths per million, whereas stock market return is evaluated in terms of stock market index. the study’s finding reveal that saudi stock market significance affected by covid-19. the study also depicts that unidirectional and bidirectional relationship between corona-virus cases and saudi stock market with the help of granger causality test. we also highlight the main the preventive policies taken by governments related to covid-19 have affected the stock market. key words: corona-virus, market return, stock market index, time series, unidirectional. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 23 introduction an unexpected outbreak of covid-19 spread globally towards the end of year 2019. wuhan, a chines city center, has been designed as the primary covid-19 event for december 2019. since early january 2020, an epidemic has been spreading silently to different regions of china because of a mass of migration during the new years of china and the wuhan geographical area, as a major transport hub. the initial three out-of-wuhan cases were reported on 19 january. on 23 january, at 10:00 am in wuhan, the ship and large-distance passenger traffic were suspended. as a further safety precaution, each exit and flight train were cancelled. in order to prevent pesticides from being made more popular, the chinese government continues to pursue other welfare initiative, for example travel ban, curfews and end of school. the world health organization issued the first worldwide warning for epidemic on 30 january 2020 (who2020a). the total overall confirmed cases around the worldwide proclaimed a pandemic on 11 march 2020. (who2020b). flare-up focus has gradually been shifting from china to europe and america. the global pandemic was confirmed by the world health organization (who) covid-19 on 11 march 2020. consequently, it is a significant reminder for all nations since it presents additionally a genuine danger to general wellbeing and by and large economy on both public and global level. coronavirus' monetary impacts are not just extensive but rather decidedly destructive as much as they caused perpetual business sectors conclusion, long haul work misfortunes in the midst of this pandemic, and so on the flow coronavirus has widegoing and critical stun waves on monetary market that is comprised of obligation, commodity (crude oil and gold) and securities exchanges. the economic disruption caused by the pandemic has dramatic effects on stock markets, particular stock, defense, and material (such as crude oil and gold) markets, making prediction a far more difficult task during the pandemic. significant events in march 2020 included a suspected russia–saudi arabia oil cost war as a result of the failure to negotiate an opec+ settlement, resulting in oil prices falling and a stock market crashes. many economic implications of the coronavirus pandemic, which is part of the coronavirus recession, is financial market consequences. stock return or securities exchange forecast is a significant exploration subject that has pulled in re-searchers' consideration for a long time. stock market around the world hit badly with this pandemic and many big companies struggling to survive in the covid19 times. it’s turned out to be a lot harder job for analyst to foresee the market movement effectively. prediction is an actual act of indicating that something will happen in the future with lot of confidence that can influence the market sentiments by having limited access to the information. covid-19's pandemic affected world financial markets. continuous changes to economic growth predictions, as well as rising risk aversion, have led in extreme volatility in the stock market and other risky asset markets, accompanied by severe uncertainty about future pandemic development. by the end of february 2020, financial markets reached the risk-aversion stage, with market volatility considerably enhanced. stock markets began to fall rapidly, with sales dropping by about 30 percent of their market value in weeks, faster than during the 2008 global financial crisis. overall, stock markets reacted unfavourably due to pandemic but recovered marginally by announcing the rescue scheme (rahman, et al. 2021). consequently, the financial market's reaction to the covid-19 epidemic is noteworthy. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 24 stock market returns prediction is one of the most testing position because of numerous components that associated with the market prediction for example interest, politics, and economic growth that make the stock market volatile and difficult to predict precisely. principle aims to anticipate the future market movement of the financial markets will prompt more benefit investor can make. firstly, the importance of study to investigates the effect of epidemic on saudi stock market performance by using regression model and pairwise granger causality tests. by using regression model. secondly, pairwise granger causality tests also depict unidirectional and bidirectional relationship between corona-virus and saudi stock market. thirdly, the remaining paper is organized such as data collection, model and technique can be found in the next section. in the following, the empirical results are described and analysed. the final section of the report includes conclusion and policy prevention. literature review the coronavirus (covid-19) is a global epidemic with unclear origins, a scarcity of targeted treatments, and limited therapeutic competence. every country is responding to the pandemic, which is wreaking havoc on the global economy and financial markets (aslam et al., 2020). as a result, studying the economic effects of the pandemic is a hot topic that has recently piqued the interest of researchers (liu et al., 2020). the stock market has the potential to be an extremely powerful economic tool. it provides a unique perspective on a company's and the economy's future prospects. this is because the value of a corporation is generated by all future cash flows, which are now reduced to take time and uncertainty into consideration (wagner, 2020). the literature on coronavirus’s effects on the worldwide stock market is fast growing. while the stock market's behavior during the epidemic may appear arbitrary, irrational, or even insane at first glance, a closer look indicates that they did not act haphazardly (capelle blancard & desroziers, 2020). during covid-19, stock market swings reflected emotions rather than substance (cox et al., 2020). several analyses have linked the covid-19 epidemic to an unprecedented economic and financial disaster. global financial market risks have surged as a consequence of the covid-19 outbreak (zhang et al., 2020). the majority of empirical investigations revealed that the expansion of the coronavirus outbreak harmed stock market indices. (cao et al., 2020; ashraf, 2020; alber, 2020; rahman et al., 2021; ahmar & del val, 2020; anh & gan, 2020; eleftheriou & patsoulis, 2020; shujan et al., 2020; camba & camba jr, 2020). olatunji, al-ahmadi, elshafei and fallatah (2013) suggested that methodology is based on historical information from long-term stock markets. they employed inventory closing price as a variable for input devices. the optimal value is found via experimental simulation based on data from the day before the closing prices are estimated on the following day. the coefficient includes the r2, root mean squared error and average absolute defect (mad) and the mape to quantify efficiencies in the proposed artificial neutral network (ann) saudi stock price forecast (mape).the analysis conclude that the proposed ann model forecasts a very low rmse (1.8174), an extremely low mad of 18.2835, an extremely low mape (1.6476) and a strong correlation factor of up to 99.9% of the sample to the test next day, suggesting that the model reliably predicts and mimics the market trend in its predictions. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 25 v kranthi and sai reddy (2018) establish a machine learning (ml) approach to prediction in their research. the system, which is derived from available stock data, gathers information and applies the knowledge gained to make predictions. in their analysis, they use vector machine support (svm) and radial base function (rbf) for bond prediction. their research concludes that numerical results suggest a high degree of efficiency in effective stock market forecasting. vijha, chandolab, tikkiwalb, and kumarc (2019) explained using random forest methods and artificial neural network for predicting a closing cost of five businesses in different industries the following day. for the modeling of new variables, financial data such as open, high, low, inventory closed prices are used. normal strategic metrics like the rmse and mape are used to evaluate the models. they conclude that, in order to improve the precision of the forecast price value, new variables were generated by combining existing variables. ann is used to forecast the stock's following day closing price, while rf is utilized for a comparative study. an identical rmse, mape, and mbe values research clearly reveals that ann delivers better stock price forecasting compared to rf. chaouachi, m., & slim, c. (2020). described using a cointegration methodology for autoregressive distributed lag (ardl), this research finds out the pandemic result on the saudi stock market. more particularly, this research shows the relation between the tadawul all shares index (tasi) natural logarithm trading volume and the covid-19 natural logarithm validated in both short and long-term cases. cointegration boundary test is performed on daily basis series. the causality test is used to determine variable relationships. our findings show that pandemic has a long-term adverse influence on financial market. the causality test reveals the unidirectional relationship. the robustness test seems conclusive. he.d., d.j., yu, s.j. (2020). this article discusses the immediate effect on the financial markets and the covid-19 disaster. empirical research depicts that the effect of coronavirus on share price of afflicted nations is negative, albeit short-term, through ordinary t-testing and chisquare test such as mann–whitney testing. on the other hand, it doesn't seem in these countries to have a greater effect than the global average on financial markets. according to the findings, coronavirus is influencing the economic effect of the pandemic on other countries' financial markets. the findings also serve as a basis to track global stock market trends and boost the global economy. alam, m. n., alam, m. s., & chavali, k. (2020). this paper examined the lock-down effect of coronavirus on the indian stock market was specified. this study assessed the influence of lockout on the indian stock market and if the market reaction before and after covid-19 would be the same. research approach is used for the market model event. a sample of 31 bombay stock exchange-listed companies was chosen at random (bse). the occasion was a formal lockdown announcement. the results show that the average lockdown predicted by abnormal returns and investors was a highly positive market response during the current lockdown period; however, investors panicked before to the lockdown and generated a negative aar. the study shows that the current lock-down period is ar, showing that until the situation in india improves, the lock-down has a favourable impact on stock market performance. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 26 lorenzo1, olivas (2020) studied the history of stock markets as well as their impacts and the current effect of covid-19 outbreaks and pandemics occurring before stock markets. they propose to employ a provided model with case-based reasoning (cbr): the 2008 crisis runs parallel to the cbr crisis by 2020, predicting how long the stock markets would need to recover. they conclude that current forecasting approaches are adequate when the trend is followed, but insufficient when a trend-breaking event occurs. sayed, o. a., & eledum, h. (2021). the purpose of this research is to examine the effects of covid-19 on the saudi stock market. between 15 march 2020 and 10 august 2020, the daily shutdown prices index (tasi) of the tadawul all share index and the number of cases infected with covid-19 were used. the research is conducted using vector self-regressive (var), impulse response (irf) and autoregressive heterogonic conditions (arch) models. the results of the correlation matrix and the impulse response function (irf) demonstrate a reactive effect from the financial markets in the epidemic on the growth. the results of the arch model show the detrimental influence on ksa stock market returns of the covid-19 epidemic. furthermore, the study suggested that the covid-19 outbreak had a strong initial market reaction. hypothesis h1: there is significant association between coronavirus total cases with saudi arabia’s stock market return. h2: there is significant association between coronavirus total death cases with saudi arabia’s stock market return. h3: there is significant association between coronavirus new cases with saudi arabia’s stock market return. h4: there is significant association between coronavirus new death cases with saudi arabia’s stock market return. model, data collection, methodology, empirical findings model: to analysis the impact of epidemic on saudi stock market performance. we are applying least square regression model. stock market return= α+β coronavirus total cases+¥ coronavirus total deaths cases+ 𝜆coronavirus new cases +𝛾 coronavirus new deaths cases. coronavirus has been quantified in terms of cumulative new corona cases per million, new corona deaths per million, total corona cases per million, and total corona deaths per million, whereas stock market return has been quantified in terms of stock market index in this model. data collection to investigates the impact of covid-19 epidemic on saudi stock market performance time series data related to stock market was obtained from the https://www.investing.com/indices website, and daily data on covid-19 was obtained from the https://ourworldindata.org official asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 27 website of the ministry of health of the kingdom of saudi arabia, which included all independent variables for the period beginning from 1 march 2020 to 6 dec 2020. table 1. descriptive analysis stock market returns new corona cases per million new corona death per million total corona cases per million total corona death per million mean 7542.080 5685.600 73.84313 498253.9 5511.309 median 7427.335 7097.150 69.74800 284341.4 2306.439 maximum 8747.090 10303.74 171.3510 1603093. 20594.46 minimum 5959.690 0.000000 0.000000 0.000000 0.000000 std. dev. 735.8140 4081.255 62.89728 519387.1 6351.617 skewness -0.127376 -0.303278 0.144277 0.654302 0.892457 kurtosis 1.958026 1.374039 1.422034 1.989485 2.422245 jarque-bera 9.108975 23.84230 20.37148 21.64087 27.86444 probability 0.010520 0.000007 0.000038 0.000020 0.000001 sum 1432995. 1080264. 14030.19 94668240 1047149. sum sq. dev. 1.02e+08 3.15e+09 747696.7 5.10e+13 7.62e+09 observations 190 190 190 190 190 source: author’s calculation using eviews 12. result analysis of table 1 demonstrates mean, median, minimum and maximum values, standard deviation, skewness, kurtosis, jarque-bera, and number of observations. mean means average value which is highest in case of coronavirus total cases per million. median means the middle value; maximum and minimum values are extreme value. standard deviation is the most significant measurement for dispersion or spread over a series which is highest in total corona cases per million. skewness measure negative values in case of share market return and new corona cases per million means long tail on the left and when there is a positive value for new corona deaths per million, total corona cases per million, and total corona deaths per million, it indicates that there is a long tail on the right. kurtosis results below 3 implies a flat (platykurtic) distribution in relation to normal distribution. jerque-bera can be used to test for normal distribution. as p-value (probability) which is p<.05, the null hypothesis is rejected in favor of the alternative hypothesis. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 28 table 2. summary of regression model dependent variable: stock market returns method: least squares number of observations: 190 variable coefficient std. error t-statistic prob. new cases per million 0.231299 0.059738 3.871911 0.0001 new death per million -39.4579 13.74961 -2.869747 0.0046 total cases per million 0.010856 0.003356 3.23435 0.0014 total death per million -0.537727 0.176072 -3.054012 0.0026 c 6695.207 34.10451 196.3144 0 r-squared 0.891949 mean dependent var 7542.08 adjusted rsquared 0.889612 s.d. dependent var 735.814 s.e. of regression 244.4715 akaike info criterion 13.86204 sum squared resid 11056767 schwarz criterion 13.94749 log likelihood -1311.894 hannan-quinn criter. 13.89665 f-statistic 381.7872 durbin-watson stat 0.216087 prob(f-statistic) 0 source: author’s calculation using eviews12. table.2 the summary of regression model demonstrates that r square (coefficient of determination) depicts that 89% of the dependent variable from independent variables that may be expected. adjusted r-square, on the other hand, has a value of.889612, which is less than and quite near to r square 0.891949. in comparison to predictors, the number of observations is fairly large. the standard error of regression (244.4715) measures estimated variance of the residuals. probability (f-statistic) which is p<.05, we reject the null hypothesis in favour of alternative. on the basis of p value, we can say that there is significant association between corona total cases, corona total death cases, corona new cases and corona new death cases and stock market return of saudi arabia. serial correlation measured by durbinweston stat (.0216087), if the value is smaller than 2, there is evidence of positive serial correlation, according to the rule of thumb. akaike info criterion is the lowest value as compare to schwarz asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 29 criterion and hannanquinn criter. so, we can say that it is the best least square regression model to adopt in this study. table 3. result of pairwise granger causality tests lags: 2 null hypothesis: obs fstatistic prob. new cases per million does not granger cause share market return. 188 7.21460 0.0010 share market return does not granger cause new cases per million 1.42307 0.2436 new death per million does not granger cause share market return 188 7.79741 0.0006 share market return does not granger cause new death per million 1.22949 0.2948 total cases per million does not granger cause share market return 188 4.72253 0.0100 share market return does not granger cause total cases per million 6.19920 0.0025 total death per million does not granger cause share market return 188 3.61279 0.0289 share market return does not granger cause total death per million 7.85532 0.0005 source: author’s calculation using eviews12. table: 3 analysis of pairwise granger causality tests: new cases per million granger cause share market return since p value is less than 0.05 but share market return does not granger cause new cases per million so there is unidirectional relationship. new death per million granger cause share market return since p value is less than 0.05 but share market return does not granger cause new death per million so there is a unidirectional relationship. total cases per million does not granger cause share market return and share market return does not granger cause total cases per million both cases p value is less than 0.05 represent that there is bidirectional relationship. total death per million does not granger cause share market return and share market return does not granger cause total death per million both cases p value is less than 0.05 represent that there is bidirectional relationship. conclusion and preventive policies: the covid-19 affected almost all stock market around the world. saudi stock market also affected with covid-19 pandemic. the study found that the saudi arabian market responded quickly to the covid pandemic, but that, according to the stage of the epidemic, the response was different with time. the saud government has aided in mitigating the effects of the covid-19 epidemic on the saudi stock market by providing a speedy response time and a large stimulus package. government covid-19 preventive rules, in particular shutdown measures, have affected the stock markets, which in many financial institutions have disturbed decision-making, making fast reactions and trading impossible. due asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 30 to a lack of electronic infrastructure, certain financial institutions may be forced to close and traders may be unable to transact. of course, their significance would reduce at least partially if a substantial proportion of commerce were automated and the economy technologically evolved; consequently, potential impacts could be greater in emerging markets than in established countries. it is important mentioning that even if company premises are not completely shut down, soft rules can indirectly affect financial markets (zaremba et al., 2021). in addition, covid-19 policies can affect the stock market through policy reactions to changes in the future economic environment, and deteriorating economic conditions can lead to changes in corporate cash flow estimates and higher risk premiums, making investors less likely to do so by allocating their money to risky assets such as equities. behavioural and psychological issues may affect investors. this means investors hesitate to investigate their holdings when there is adverse news about government constraints. individuals with several successive loss episodes become more averse to loss. according to this school of thought, stock market trading activity falls (zaremba et al., 2021). saudi arabia succeeds in minimizing transmission by restricting access to its holy sites at an early stage. non-saudi expatriates account for roughly 30.82 percent of saudi arabia's total population. despite the fact that the main risk of illness transmission to asymptomatic evacuees remains, stringent action is being taken based on an assessment of the situation. the saudi government's expertise in prevention strategies could help other countries deal with covid-19 and similar pandemics. this article examines the impact of coronavirus on saudi stock market performance by using regression model and pairwise granger causality tests. results indicate that covid-19 significant associated with saudi stock market 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ident erformance nts the meth the study w now, have b majority of ing standar joint proje included a l the iasb of lease-rela effective as ovisions of (off balanc model oblig for short-ra ess firms re ds to more asian ng egyptian 76 of 2018) hat the less ding. law nu edes law nu ng number 1 oring. uthority fra ates that fin ght to posse ments in acc ontract stat e lessee. th oduction ac ng act (law nancial leas and use the ength of the tifying thos . this study hodology. th wraps up wit been delibe f leases onrds board ect was t leasing proj delivered a ated liabiliti s of year 2 ias 17 l ce sheet) an ges the less ange leases cord all of t e transparen n journal of f n accountin was to incr sor firms ap umber 176 y umber 95 ye 1446 year 2 a issued th nancial lea ess and use ordance wit ting that th he intension tivities for w 176 of 20 sing activity e leased ass e country ec se factors t y reviews re he study pre th the concl erating on th -balance she fasb and the drafting ject for both an exposure ies and asse 2019 to rep eases oblig nd a finance see to iden and inexpe the leases an nt, accurate finance & ac issn 19 2022, vol. 1 ajfa.macro ng standard rease the nu pply the acc year 2018 r ear 1995 re 2003 related he financial asing is a fi a leased as th the provi he lessor t n is to use th a certain pe 018), states y. the lesse set in accord conomy. th that might elated literat esents the st lusion. the best me eet for less d the inter g of a dis h the lessor e draft sugg ets. finally, place inter gated the le e lease (on ntify majori ensive asse and in the sa te and com ccounting 946-052x 14, no. 2 think.org/ eas 49 umber of counting regulates elated to d to rules leasing inancing sset to a isions of transfers he leased eriod for that the ee is the dance to hus, it is have an ture then tatistical thod for ees. the rnational scussion r and the gesting a in 2016, rnational essee to balance ity lease ets). the ame way mparable informa expecte the fol benefit that, co matter t has a vi states th the sha busines to help between agent an the shar of maki parties d studies the eco supplier their co how hig the com nasser air ara quarter and rela gross pr assets fr there is debt rat maali ( compan qatar a capitali standard in the li and deb öztürk turkey lease st ation. after ed. llowing star the shareho ome the sele that justify ital part in th hat a purpos areholders ( ss firms, esp explain co n sharehold nd principa reholders an ing the most drive the sta prove firm onomy of s rs and cust ounterparts, ghly influen mpany the m & alrashed abia after ap ended marc ated ratios w rofit, revenu from operati an increase tio and debt 2018), anal nies (emirat airways) f ization app d will cons iabilities an bt to equity & serçem and the inf tandard. ou r examining rts with a p olders. thes ected observ the concep he determin se of financ (watts & z pecially for l ommon age ders and ma l. therefore nd the mana t of persona andard sette m size and fi scale concep tomers, gen and retainin ntial big com more reliable dy (2022) ex pplying ifr ch 31, 2019 with those o ues, current ions. results in return on t to equity ra lyze the resu tes airlines financial re proach is us iderably inf nd assets of y ratios. meli (2016) fluence of t utcomes sho g firm cash presentation se theories a vations and pts. the pos nation of stan ial reporting zimmerman, large size fir ency theory anagers, as e, it is clear agement of b al benefits (w ers to presen irm growth pt confirms nerating and ng better pri mpanies are e its public i xplore the ou rs 16. the 9. the study of the quart assets, curr s also show a n equity, curr atio. ult of imple , royal jor eports as w sed. the fin fluence the these comp take a clos the variatio ow operating 18 h flow, no n of a coupl are the agen d findings of sitive acco ndards (wa g is to force , 1978). ac rms, to appl y problems well as, the that the acc business fir watts & zim nt new stan opportuniti s that big co d withstand rices than th e over smal information utcomes of study inves y compares a ter ended se rent liabiliti a fall in net rrent ratio, a ementing th rdanian, air well as bas ndings show middle ea panies with a se look at on in the rel g leases inc asian change to le of theori ncy theory f previous l unting theo tts & zimm e manageme ccordingly, ly new and i associated e diverse ap counting sta rms especial mmerman, dards, speci ies as signi ompanies ar ding strateg he competiti ll companie n. f the financia stigates fina and changes eptember 30 es, net incom change of, and return on he new lease r arabia, tu sic financia w applicatio ast aviation a significan the balance lated ratios creases liabi n journal of f the value es to make and econom literature re ory propose merman, 197 ent to opera it is extrem improved ac d with the pproaches t andard sette lly large siz 1978). in tu ifically for l ficant deter re capable o ic expansio ve level. th es. this imp al performa ancial statem s financial s 0, 2018. re me, cash, to eps, total l n assets wh e standard o urkish airlin al ratios. c on of the if business. t nt impact on e sheet of t after the ad ilities and a finance & ac issn 19 2022, vol. 1 ajfa.macro of the com manageme mies of scal elated to the es that mana 78). this the ate for the be mely impor ccounting st conflict of towards risk ers are press ze ones with urn, these be leasing ifr rminants of of negotiati on, competi his theory d plies that th ance of the e ments for th statements e esults show otal equity, a liabilities, a hereas, a dec on six majo nes, oman constructive frs 16 new there is an n the debt to the lessee doption of assets with ccounting 946-052x 14, no. 2 think.org/ mpany is ent act to le. after e subject agement eory also enefit of rtant for tandards interest k by the sured by h the aim enefiting rs 16. f leasing. ing with ing with describes e bigger egyptian he fourth elements a rise in and total and cash. crease in or airline air, and e lease w lease increase o assets firms in the new a rise in the debt de fari new lea industry operatin the toro results affects f park & account 2001-20 adoptio register well as joubert ratios o from pu 2015-20 near fut influenc there is zamora of adop reveal th coverag exampl consiste park & debt an korea. during corpora amount credit r listed c choose magli e and the results liabilitie t/asset ratio ia olivo et. ase standard y because t ng lease. th onto, sydne infer abno firm value. & na (2017) ting. the k 013 equival on of operati red firms. th profiting fro et. al. (201 of main firm ublic financ 016. in add ture compan ce return on no compan a-ramírez & pting the if hat total ass ge ratio wil e retail, pro ent results r na (2018) nd credit ra the study c 2001-2013 ate credit ra t than firms ratings beca ompanies, t operating le et. al. (2018 e financial l indicate th es and leas o and a fall i . al. (2022) d affected fi there is he he study inv ey, and lon ormal return ) inspects h korean firms lent to 7,023 ing leases. p hus, private om off-bala 17) examine ms in the avi cial reports dition, the st ny financia n assets ro ny heading t & moralesrs 16 on th sets and liab ll decrease ofessional s related to pr ) inspects th atings for 6 collects num . outcomes atings. but, s that emplo ause of the there is no eases over c ) analyses th everage of hat in the ba e assets. in in the retur under take irm value. eavy use of m vestigated d ndon stock ns variation how the firm s record eith 3 firm-year private firm e firms favor ance sheet fi es the poten iation and te of firms r tudy exami l distress. o oa and debt to a differen díaz (2018 he financia bilities, as w except for services, m rofitability. he influence 6133 listed merical data s prove lea , enterprise oy capital l listing statu difference capital lease he effect of different in alance sheet n the income 19 rn on asset e an event s this study movable as data from th exchanges n. this ind m listing po ther a capita r observation ms have a hig r using oper inancing, in ntial impact elecommun registered o ines the alt outcomes re t to equity nt z score ra 8) perform a al statement well as, lever r those indu media and h e of operati and non-lis a from fina ase choice d es that impl leases. resu us of the b due to leas es experienc f applying (i nstitutions li t, there is a e statement asian roa ratio. study to ide y focuses on sets that re e financial for year 20 dicates that osition affec al or an ope ns. finding gher ratio of rating leases n contrast to t that the if nication segm n the austr tman z scor eveal inclus d/e ratios. ange. an empirica s of quoted rage ratios w ustries with hotels. the ing lease an sted local f ancial statem does not ha lement ope ults also co business firm se selection ce a drop in ifrs 16) le isted in the decrease in t, there is a n journal of f entify if the n the evalua equires the reports of 1 016 and yea the adoptio cts the firm' erating lease s show priv f operating l s to escape r publicly reg frs has on ments. the ralian stock re results fo sion of addi altman z al analysis to d spanish co will increase h increased results of t nd capital le firms that r ments for a ave conside rating lease nvey there m. as for th . however, n their cost o eases, on th italian bus n equity, and an increase finance & ac issn 19 2022, vol. 1 ajfa.macro e applicatio ation of the use of ren 1002 firms l ar 2019 sep on of the i 's adoption e during th vate firms se leases than rising debt l gistered bus n the basic f study acqui k exchange or the predi itional lease score resul o identify th ompanies. f e. however, d lease volu the study fo ease on the recognize l period of 1 erable influ es spend a is no diffe the cost of unlisted fir of debt. he firm perfo siness envir d a rise in f in earnings ccounting 946-052x 14, no. 2 think.org/ on of the e mining ntal and listed on parately. ifrs 16 of lease e period elect the publicly levels as sinesses. financial ires data e during iction of ed items ts imply he effect findings , interest ume, for ound no e cost of eases in 13 years uence on smaller rence in debt for rms that ormance ronment. financial s before interest susanti lease ac financi an airlin level of of asset cash f (roe) i singh ( americ operatin relation debt. biondi account measure impact recogni sliwosk 2016–0 of the sheet fin knubley project the rele also out propose the bala bunea-b draw a stateme chatfie usa. r amount gibson reported credit r signific t tax depre et. al. (202 ccounting st ial accounti ne company f profitabilit ts drop. how flow from o increase. (2013) exa can restaura ng leases ar n between le et. al. (20 ting. the s ement and of lease a ition and inc ki (2017) p 02. the stu ese rules nancing. y (2010) d and its addi ease of the a tlines the p ed changes d ance sheet li bontaş (20 attention to ents. ld et. al. (20 results indic ted to 51% o (2021) pro d financial risk, resourc cant change ciation and 21) made a tandard ifr ing standar y in indones ty represent wever, the operations amines the ant and retai re completel easing and d 011) discuss study comm reassessme accounting come measu provides a g udy also pr prohibits distinctly cla ition to the i august 201 proposed app described re iabilities an 17) from r the effect 017) analyz cate that ho of their asse oved that b data and fi ce efficienc es. firms w amortizatio case-study rs 16 corres rds board o sia that heav ed by return liquidity rat cfo and t relationship il firms dur ly measured debt. this m ses the situ ments on t ent at fair v elements o urement. general disc rovides a m s lessees arifies the j iasb and fa 10 exposure proach to le equire by th nd assets. romania dis ts of the n zes the off-b ospitality co ets in 2015. by applying financial per cy, liquidity with operatin 20 on ebitda to determin sponding to on the financ vily utilizes n on assets ( tio represen the profitab p between ring the per d. results sh means that $ uation of the the definiti values, clas on accountin cussion on more focuse from u justification fasb joint p e draft sugg essor and le he new lease cusses the new accou balance shee ompanies do g ifrs 16 l rformance y, and finan ng leases d asian a and financ ne the influe psak 73 l cial stateme lease finan (roa), solv nted by inte bility repres the lease a riod 2006 – how that th $1.00 of lea e proposed ion of a l ssification o ng ratios, im the new le ed discussio using leas ns behind t project agen gesting a "ri essee accou e standard e contrast bet nting mode et leases by o extensive leases, ther metrics tha ncial leverag demonstrate n journal of f ce costs. ence of the a leases issue ents and key ncing. the re vency, and e erest covera sented by th and debt in 2008. both ere is a sign asing displac exposure d ease, accou of lease ac mpact of le ease accoun on for how es to ob the proposi nda in july 2 ight-of-use" unting. find enforce the a tween ias el on a co y the hospita ly use oper re are mea at measure ge. the stu ed more vo finance & ac issn 19 2022, vol. 1 ajfa.macro adoption of ed by the ind y financial r esults show efficiency in rage ratio i he return on n a sample h capital lea nificant and ced nearly draft towar unting for ccounting el ease accoun nting rules w implem obtain offition of the 2006 that res " model. th dings prove acknowledg 17 and ifr ompany’s f ality industr rating leases asurable cha firms’ prof udy results r olatility in f ccounting 946-052x 14, no. 2 think.org/ f the new donesian ratios of w that the n the use icr and n equity of 233 ases and d inverse $0.50 of rds lease lessors, lements, nting on in asu mentation f-balance e leasing sulted in his study that the gment of rs 16 to financial ry in the s, which anges in fitability, revealed financial perform tóth (2 on liste the appl secinar the fina made co the stu usa, c oman, aviation heavily ifrs 1 the fina conside this stu after th factorin ebit/o perform asset tu total de 1.3 hyp it is ev nationa on hand h1 there applicat and fac h0 there the app leasing 2. meth this stu country sectiona control and tim mance. asse 018) discus d hungaria lication of i ro et. al. (20 ancial statem onfirm the a udies presen canada, eng and qatar. n, mining, depend on 6 (leases) ancial perfo eration if the udy evaluat he applicatio ng act (law operating pr mance repres urn over, ret bt/total asse pothesis vident that lly and inte d proposes t e is a signifi tion of both ctoring act e is no sign plication of g and factor hod udy uses pa y and firm al of firms for heterog me series me t efficiency sses the app an entities. a ifrs 16 ma 020) investig ments of it adoption of nted above gland, austr . studies ar telecommu n leasing. significantl ormance rati e company i tes the impa on of eas w 176 of 2 rofit or lo sents (total turn on cap ets) the studie ernationally the followin icant impact h the ifrs 1 (law 176 o nificant impa both the if ring act (la anel data a effects. pa during sev geneity in a ethods (balt y and profita lication of i according t ay have sign gates the re talian small f ifrs 16 ha took place ralia, spain, re available unication, m the studies y impact th ios. howev is a lessor or act of some 49, equival 2018). the ss, and fin debt/total e pital employ s made co are rare. ac ng hypothes t of firm spe 16 equivalen of 2018). act of firm frs 16 equ aw 176 of 2 approach to anel (longitu veral period addition to t agi, 2008). 21 ability decre ifrs16 (le to the resul nificant effe epresentatio l and mediu as a substan in differen , korea, ind e related to media, retai s above una he balance s ver, results h r a lessee, in e firm speci lent of the firm specif nancial lea equity, earni yed roce, oncerning th ccording to sis: ecific factor nt of the ea specific fac uivalent of 2018). accommod udinal) dat ds (baltagi time invaria asian ease. financ eases), effec ts of the stu ect on the le n of change um enterpri ntial effect o nt business e donesia, hun o different il, hotel, an animously sheet assets have to be in n addition to fic factors o ifrs 16, a fic factors a ased fixed ings per sha current rat he account the results rs on lessor as 49 and t ctors on less the eas 4 date inconsi a is poolin , 2013). pa ant variable n journal of f cial leverage ctive as of 2 udy, expecta ase market. e in the acco ises. resu on the balan environmen ngary, emir business s nd restaura agree that t s and the lia nterpreted c o, the differe on lessor fin and the fin are (sales, f assets). th are eps, retu io, return o ing treatme of the abov financial pe he egyptian sor financia 49 and the istencies in ng of observ anel data a es not proba finance & ac issn 19 2022, vol. 1 ajfa.macro e increased 2019, and its ations are h . ounting of l ults of a cas nce sheet. nts in italy, rates, egypt sectors such ant sectors the adoptio abilities, as carefully tak ent business nancial perfo nancial leas financial lia he lessor f urn on equi on assets ro ents for th ve studies, th erformance n financial al performan egyptian f n unnoticed rvations on approach is able cross s ccounting 946-052x 14, no. 2 think.org/ . s impact high that leases in se study turkey, t, jordan, h as the that all n of the well as, king into s sectors. formance sing and abilities, financial ty roe, oa, and e lessor he study after the leasing nce after financial distinct a cross able to sectional the stu applicat factorin reports fra. t the dep firm spe assets], ebit/c current assets], liability current the stu accomp yit: depe αoi: fixe βit xit: in eit: rand the stu poo fix com ran com the pur effect m after ap the ind or loss, y2 retur capital equity. it is wo udy uses dat tion of the ng act (law of 10 non-f the sample o pendent var ecific facto return on a apital empl ratio [curr return on y/equity]. t liabilities], udy used th panied by th endent varia ed term for s ndependent dom error udy follows oled model xed effect m mparison of ndom effec mparison of rpose was t model best pplication of dependent v x4 financia rn on equity employed r orth noting t a for 5 year eas 49 c w 176 of 201 financial in of the study riable is the ors. the dep assets roa oyed (net as rent assets/c equity ro the indepen ebit/ oper he pooled m he panel dat able, accom sample i t variable an five steps: , model, f pooled m ct model, f random e to specify w indicates th f eas 49 an variables rep al leased fix y roe, y3 r roce, y6 that the f-t rs during the correspondin 18). the stu nstitutions li y is equivale firm financ pendent vari [= net incom ssets = total current liab oe [= net ndent variab rating profit model, the a approach. mpanied by u nd slope odel and fix effects mod which of th he effect of t nd financia present x1 sa xed assets. t return on as current rati test compar 22 e period 20 ng to the i udy evaluate isted in the ent to 50 firm cial perform iable is rep me/total ass l assets – cu bilities], tot income/eq bles are sal t or loss, fin fixed effec . the found unit i, over xed effect m del and fixe he pooled m the indepen al leasing an ales, x2 fina the depend ssets roa, io, y7 total res the pool asian 16-2020 tha ifrs 16 an es public nu egyptian f m year obse mance. the in resented by sets], return urrent liabili tal debt/tota quity], and les, financia nancial leas ct model, a ation is: period t model, ed effect m model, fixe ndent variab nd factorin ancial liabil dent variable y4 earning l debt/total led model a n journal of f at signifies b nd the fina umerical dat financial re ervations. ndependent y: asset turn on capital e ities)], earni al assets [t total debt/ al liabilities ed fixed ass and the ran yit = αoi + β odel using t ed effect m bles on the d g act (law lities, x3 eb es represent gs per share assets, and and the fixe finance & ac issn 19 2022, vol. 1 ajfa.macro before and ancial leas ta from the f egulatory a t variables a n over [= sa employed r nings per sha total liabilit t/total equit s [total liab sets ndom effec βit xit + eit the hausma model, and r dependent v w 176 of 201 bit/operatin t y1 asset tu e eps, y5 r d y8 total d ed effect m ccounting 946-052x 14, no. 2 think.org/ after the sing and financial authority are some ales/total roce [= are eps, ties/total ty [total bilities – ct model (1) an test random variables 18). ng profit urn over, eturn on debt/total model. if the resu one: wh two: w three: w four: w five: w six: wh seven: eight: w 3. resu the fol and ind table 1 independe constant x1 x2 x3 x4 p-v f-test & h the stu f-test: t check is hausma ults show th hen the dep when the dep when the de when the dep when the dep hen the depe when the de when the de ults llowing is a dependent va . dependen ent variables f value r2 hausman te udy compare to distinguis s significan an test: to d he pooled m pendent vari pendent vari ependent va pendent var pendent vari endent varia ependent va ependent var a presentatio ariables. nt variable y s po coeffic 0.2473 0.0002 -0.0000 -0.0724 -0.0000 st es the three sh between nt (f = 2.898 distinguish b model is the iable is y1 a iable is y2 a ariable is y3 riable is y4 a iable is y5 a able is y6 an ariable is y7 riable is y8 on of the st y1 oled model cient p-va 352 0.0 277 0.0 087 0.0 486 0.1 001 0.9 5.906 0.000 0.383 f 2.898 models usin the pooled 8, p < 0.05), between the 23 best, then s and the inde and the inde 3 and the ind and the inde and the inde nd the indep 7 and the ind and the ind tatistical re fix alue coef 000 0.29 000 0.00 002 -0.0 01 -0.1 940 -0.0 f-test ng two tests model and , inferring th e random e asian stop. otherw ependent var ependent va dependent v ependent va ependent va pendent var dependent v dependent v esults for th xed effects m fficient p95866 0 00445 0 00079 0 84046 0 00023 0 4.640 0.000 0.675 p-value 0.014 χ2 7.404 s: the fixed ef hat the fixe effect model n journal of f wise, go to s riables are x ariables are x variables are ariables are ariables are x iables are x variables are ariables are he evaluatio model r -value c 0.000 0 0.000 0 0.014 0.035 0.105 hausman ffects mode d effects mo l and fixed finance & ac issn 19 2022, vol. 1 ajfa.macro step four. x1, x2, x3, a x1, x2, x3, e x1, x2, x3 x1, x2, x3, x1, x2, x3, x1, x2, x3, a e x1, x2, x3 e x1, x2, x3, on of the de random effe coefficient 0.250913 0.000338 0.000085 0.089837 0.000012 7.14 0.00 0.42 n test p-val 0.11 el. the resul odel is pref effects mo ccounting 946-052x 14, no. 2 think.org/ and x4 and x4 , and x4 and x4 and x4 and x4 3, and x4 , and x4 ependent ects model p-value 0.000 0.000 0.001 0.085 0.345 48 00 29 lue 6 lt of this ferred. del. the result o model i based o the res the ov determi of the v accord a signif insignif the coe x1 by e coeffici the x2 b table 2 independe constant x1 x2 x3 x4 p-v f-test & h the stu f-test: t check is hausma the res model i of this chec is better. on the previ ults of this verall regres ination (r2) variance in t ing to the e ficance on y ficant effect efficient of x egp 1 y1 i ient of x2 h by egp 1 y . dependen ent variables f value r2 hausman te udy compare to distinguis s significan an test: to d ult of this c is better. k is non-sig ious e.g. tab model are a ssion mode ) is 0.429, i the depende .g. table 1 r y1. howeve t on y1. x1 has a dir increases, o has an indire 1 decreases nt variable y s po coeffic 0.252 0.000 0.000 -0.055 -0.000 0 st 4 es the three sh between nt (f = 4.713 distinguish b check is non gnificant (χ ble 1 results as follows: el is signifi .e. the indep ent variable results, only er, x3 (0.08 rect effect a overall, by ect effect an , on average y2 oled model cient p-va 2716 0.0 0334 0.2 0146 0.2 5916 0.7 0110 0.0 1.345 0.270 0.124071 f 4.713639 models usin the pooled 3639, p < 0. between the n-significant 24 χ2 = 7.404, s, the appro cant (f = pendent var (y1). y x1 (0.000 851) and x4 and is equal 0.000338, nd is equal e, by 8.57e fix alue coef 0970 0.5 2678 -0.0 2097 3.7 7634 -0.0 0772 -3.8 5630 0960 f-test ng two tests model and .05), indicat e fixed effe t (χ2 = 2.41 asian p > 0.05), opriate mode 7.148, p < riables (x1, 0) and x2 (0 (0.3451) h to 0.00033 supposing to -8.57e-0 -05, assumi xed effects m fficient p522356 0 000399 0 74e-05 0 064813 0 86e-05 0 4.0 0.0 0.644344 p-value 0.0007 χ2 2.4 s: the fixed ef ting that the ects model a 1391, p > 0 n journal of f indicating el is the ran 0.05), and x2, x3 and 0.0012) hav have p > 0.0 8. so, for ev the x2, x3, 05. thus, fo ing the x1, x model r -value c 0.0679 0.3183 0.7456 0.8375 0.4744 041495 000854 4 hausman 411391 ffects mode e fixed effec and the rand .05), indicat finance & ac issn 19 2022, vol. 1 ajfa.macro the random ndom effects d the coeffi d x4) explain ve p < 0.05 05 that indi very increa , x4 are fix or every inc x3, x4 are fi random effe coefficient 0.385204 -7.49e-05 0.000103 -0.019758 -6.66e-05 n test p-val 0.660 el. the resul cts model is dom effects ating random ccounting 946-052x 14, no. 2 think.org/ m effects s model. icient of n 42.9% assumes cates an se in the xed. the crease in fixed. ects model p-value 0.0929 0.8165 0.3111 0.9372 0.1916 0.898846 0.474257 0.086437 lue 06 lt of this s better. s model. m effects accord is non-s p-value x4 (0.19 based o the res the ov coeffici table 3 independe constant x1 x2 x3 x4 p-v f-test & h the stu f-test: signific hausma this che better. accord f-statist equal to x1 (0.77 based o the res ing to e.g. t significant. e of the f te 916) individ on the previ ults of this verall regres ient of deter . dependen ent variables f value r2 hausman te udy compare compare b cant (f = 24 an test: dist eck is noning to e.g. tics (p = 0. o 0.140872 737), x2 (0. on the previ ults of this table 2 abo the r-squ est for each dually. ious e.g. tab model are a ssion mode rmination (r nt variable y s po coeffic 4.748 -0.008 -0.004 17.34 0.000 0 st 24 es the three between po 4.663458, p inguishes b significant table 3 ab .271434) p subsequent 3436), x3 ( ious e.g. tab model are a ove, f-statis uare equals independen ble 2 results as follows: l is signific r2) equal 8. y3 oled model cient p-va 8137 0.3 8819 0.3 4910 0.2 4003 0.0 0219 0.9 2.851 0.039 0.256834 f 44.663458 models usin ooled mode p < 0.05), in etween rand (χ2 = 4.756 bove that re > 0.05. so t to 14%. th 0.1753), x4 ble 3 results as follows: 25 stics (p = 0.4 0.086437 c nt variable a s, the appro cant (f = 0 .6%. fix alue coef 3634 9.5 3896 0.0 2204 0.0 0105 -2.7 9228 0.0 1150 9090 f-test ng two tests el and fixe ndicating th dom effects 6123, p > 0 epresent the o, the whole he p-value 4 (0.3294) in s, the appro asian 474257) p > correspondin are x1 (0.81 opriate mode 0.898846, p xed effects m fficient p507359 0 001121 0 000774 0 712163 0 000305 0 22 0.0 0.991987 p-value 0 χ2 4.7 s: ed effects m at fixed effe s model and 0.05), indica e outcomes e model is of f test of ndividually. opriate mode n journal of f > 0.05. thu ng to 8.6%. 165), x2 (0. el is the ran p > 0.05) no model r -value c 0.0000 0.6533 0.2842 0.1528 0.3716 8.5579 000000 0.0000 hausman 756123 model. res ects model i d fixed effec ating rando of the rand non-signific f each indep el is the ran finance & ac issn 19 2022, vol. 1 ajfa.macro us, the whol . the result 3111), x3 ( ndom effects non-significa random effe coefficient 11.89553 0.000708 0.000674 -2.527432 0.000330 n test p-val 0.313 sult of this is better. cts model. r om effects m dom effects cant. the r pendent vari ndom effects ccounting 946-052x 14, no. 2 think.org/ le model ts of the 0.9372), s model. ant. the ects model p-value 0.0290 0.7737 0.3436 0.1753 0.3294 1.352764 0.271434 0.140872 lue 32 s test is result of model is s model, r-square iable are s model. the ov coeffici table 4 independe constant x1 x2 x3 x4 p-v f-test & h the stu f-test: signific hausma outcom is better based o the res 5.92339 variable accord x1 (p > (p < 0. 0.04243 assumin -4.63ethe x1, verall regres ient of deter . dependen ent variables f value r2 hausman te udy compare to distingu cance (f = 5 an test: to mes show no r. on previous sults of this 96, p < 0.05 es (x1, x2, x ing to the e 0.05) and x 05) show s 39. in turn, ng the x1, x -06. so, whe x2, x3 are f ssion mode rmination (r nt variable y s po coeffic 0.015 1.30e -2.24e 0.040 -4.64e 0 st 8 es the three uish amon 5.923396, p distinguish on-significa s e.g. table s model are 5), and coe x3 and x4) e .g. table 4 r x2 (p > 0.05 significance when x3 in x2, x4 are fi en x4 increa fixed. l is signific r2) equal 14 y4 oled model cient p-va 5436 0.0 e-05 0.3 e-06 0.7 0054 0.0 e-07 0.8 5.507 0.001 0.366992 f 8.689996 models usin ng pooled < 0.05), ind h between ance (χ2 = 8 e 4 results, e as follow fficient of d explain 38.4 results, x1 ( 5) imply non e on y4. th creases by e ixed. the co ases by egp 26 cant (f = 1 4%. fix alue coef 0490 0.0 3963 3.8 7042 5.0 0001 0.0 8813 -6.2 7711 1344 f-test ng two tests model and dicating tha random e 8.980611, p the appropr ws: the ove determinati 4% of the va (0.0542), x2 nsignifican he x3 coeffi egp 1 there oefficient o p 1 y4 decre asian 1.352764, p xed effects m fficient p004025 0 82e-05 0 07e-06 0 045844 0 26e-06 0 10 0.0 0.828773 p-value 0 χ2 8.9 s: d fixed eff at fixed effec effects mod > 0.05), ind riate model erall regress on (r2) is 0 ariance in th 2 (0.6415), x nce on y4. h ficient has a e is an overa of x4 has an eases -on av n journal of f p > 0.05) no model r -value c 0.7285 0.0269 0.2953 0.0015 0.0086 .79738 000000 0.0000 hausman 980611 ffects mode cts model is del and fix dicating ran l is the rand sion model 0.384053, i he dependen x3 (0.0001) however, x a direct effe all increase n indirect ef verageby 4 finance & ac issn 19 2022, vol. 1 ajfa.macro non-significa random effe coefficient 0.011615 2.54e-05 1.93e-06 0.042439 -4.63e-06 n test p-val 0.061 el. results s better. xed effects ndom effect dom effects is significa i.e. the inde nt variable ), x4 (0.030 x3 (p < 0.05 fect and is in y4 by 0. ffect and is 4.63e-06, a ccounting 946-052x 14, no. 2 think.org/ ant. the ects model p-value 0.1820 0.0542 0.6415 0.0001 0.0307 5.923396 0.000832 0.384053 lue 16 are of model. ts model s model. ant (f = ependent (y4). 7) ) and x4 equal to 042439, equal to ssuming table 5 independe constant x1 x2 x3 x4 p-v f-test & h accord result o model i the res 4.72480 and x4) accord signific indepen (p >0.0 effect a decreas and is e increase . dependen ent variables f value r2 hausman te ing to e.g. t of this chec is better. in sults of this 03, p < 0.05 ) independen ing to e.g. cant. the re ndent variab 05) and x4 and is equal ses by 0.000 equal to 0.0 e in y5 by 0 nt variable y s po coeffic 0.573 -0.000 0.000 0.421 -0.000 0 st 1 table 4 f-te ck is non-si relation to p s model are 5), and the c nt variables table 5 the esults x1 (0. bles x1 (p (p >0.05) h l to -0.0007 0754, assum 000302. thi 0.000302, as y5 oled model cient p-va 3330 0.0 0754 0.0 0302 0.0 1389 0.0 0124 0.0 4.724 0.003 0.332152 f 1.028045 est: to distin gnificant (f previous ou e as follow coefficient o s explain 33 e f-statistics .0375), x2 ( <0.05) and have non-si 754. this m ming x2, x3, is explains t ssuming x1, 27 fix alue coef 0022 0.3 0375 -0.0 0314 0.0 0597 0.3 0904 -0.0 4803 3411 f-test nguish betw f = 1.02804 utcomes, the ws: the ove of determin 3.2% of the s (p=0.0034 (0.0314), x3 d x2 (p <0 ignificance means for e , x4 are fixe that whenev , x3, x4 are asian xed effects m fficient p394811 0 000770 0 000526 0 357579 0 000124 0 2.1 0.0 0.493690 p-value 0.4419 χ2 7.0 een pooled 45, p > 0.0 e appropriat erall regress ation (r2) i variance in 411) so p<0 3 (0.0597), 0.05) have on y5. t every increa ed. the coe ver x2 incre fixed. n journal of f model r -value c 0.3799 0.2332 0.0076 0.4835 0.1585 175165 040106 0 hausman 038992 model and 05), indicati te model is t sion model s 0.332152, the depend 0.05. thus, x4 (0.0904 significance the x1 coef ase in the x efficient of x eases egp finance & ac issn 19 2022, vol. 1 ajfa.macro random effe coefficient 0.573330 -0.000754 0.000302 0.421389 -0.000124 0.3321 n test p-val 0.133 fixed effect ing that the the pooled m is significa , i.e. the (x1 dent variable the entire m 4) individua e on y5, w fficient has x1 by egp1 x2 has dire 1 there is a ccounting 946-052x 14, no. 2 think.org/ ects model p-value 0.0022 0.0370 0.0309 0.0589 0.0893 4.724803 0.003411 152 lue 38 ts model, e pooled model. ant (f = 1, x2, x3 e (y5). model is ally. the while x3 indirect 1 the y5 ect effect a general table 6 independe constant x1 x2 x3 x4 p-v f-test & h the stu f-test: signific hausma prove n better. based o the coe and x4) accord individu non-sig direct e is an inc . dependen ent variables f value r2 hausman te udy compare to distingu cance (f = 4 an test: to d non-signific on previous efficient of ) explain 14 ing to the ually. the x gnificance o effect and is crease in y6 nt variable y s po coeffic 0.027 3.69e -5.12e 0.023 -1.90e 0 st 4 es the three uishes betw 48.975328, p differentiate cance (χ2 = e.g. table 6 determinat 4.2% of the v e.g. table x1 (p > 0.05 on y6, while s equal to 0. 6 with an ov y6 oled model cient p-va 7153 0.1 e-06 0.9 e-06 0.7 3770 0.3 e-06 0.8 0.253 0.905 0.026008 f 48.975328 models usin ween pooled p < 0.05), in between ra 0.650879, 6 results, th ion (r2) is variance in 6 results, x 5), x2 (p > e x3 (p < 0. .037615. th verall value 28 fix alue coef 1926 0.0 9287 1.7 7477 -5.8 3557 0.0 8209 -2.5 3670 5625 f-test ng two tests d model an ndicating th andom effec p > 0.05), he appropria 0.142459, the depend x1 (0.4703) 0.05), and .05) has a s his shows th of 0.03761 asian xed effects m fficient p007561 0 73e-05 0 88e-07 0 038812 0 54e-06 0 34 0.0 0.939874 p-value 0 χ2 0.6 s: nd fixed ef hat fixed eff cts model an indicating ate model is i.e. the inde dent variable ), x2 (0.842 x4 (p > 0.0 ignificance hat whenev 5, assuming n journal of f model r -value c 0.6133 0.4183 0.9243 0.0285 0.3828 .87092 000000 4 0.0000 hausman 650879 ffects mode fects model nd fixed effe that random the fixed ef ependent va e (y6). 21), x3 (0.0 05) independ on y6. the er x3 increa g x1, x2, x4 finance & ac issn 19 2022, vol. 1 ajfa.macro random effe coefficient 0.021593 1.50e-05 -1.21e-06 0.037615 -2.40e-06 0.1424 n test p-val 0.957 el. results is better. fects model. m effects m ffect model ariables (x1 0277), x4 ( dent variab e x3 coeffic ases by egp 4 are fixed. ccounting 946-052x 14, no. 2 think.org/ ects model p-value 0.4099 0.4703 0.8421 0.0277 0.4029 1.578192 0.199908 459 lue 72 display . results model is l. 1, x2, x3 (0.4029) les have cient has p1 there table 7 independe constant x1 x2 x3 x4 p-v f-test & h accord reveal n the res 5.23299 and x4) accord overall individu y7, whi the x1 increase coeffici egp1 y . dependen ent variables f value r2 hausman te ing to e.g. t non-signific sults of this 93, p < 0.05 ) independen ing to e.g. t significanc ually. the x ile x3 (p > 0 coefficien es egp1 y ient of x2 h y7 increases nt variable y s po coeffic 0.776 -0.000 0.000 -0.041 2.37e 0 st table 7 f-te cance (f = 1 s model are 5), and the c nt variables table 4 the ce. results x1 (p <0.05 0.05) and x4 nt has indire 7 will decr has direct ef s by 0.00012 y7 oled model cient p-va 6028 0.0 0271 0.0 0127 0.0 1746 0.4 e-05 0.1 5.232 0.001 0.355189 f 1.537 est: to comp 1.537970, p e as follow coefficient o s explain 35 f-statistics present x1 5) and x2 (p 4 (p > 0.05) ect effect a rease by ab ffect and is 27, assumin 29 fix alue coef 0000 0.8 0026 -9.2 0003 0.0 4272 -0.1 1722 1.0 2993 1855 f-test 7970 pare pooled > 0.05), ind ws: the over of determin 5.5% of the s (p = 0.001 1 (0.0026), p <0.05) ind have non-s and is equa bout 0.0002 equal to 0. ng x1, x3, x4 asian xed effects m fficient p840974 0 25e-05 0 000122 0 183745 06e-05 0 2.8 0.0 0.563521 p-value 0 χ2 4.0 model and t dicating tha rall regress ation (r2) i variance in 855) is less x2 (0.000 dependent v significant o al to -0.000 271, assumi .000127. a 4 are fixed. n journal of f model r -value c 0.0000 0.5230 0.0062 0.1180 0.5902 880056 008701 0.1816 hausman 092307 the fixed ef at the pooled ion model s 0.355189, the depend s than 0.05. 03), x3 (0.4 variables ha on y7. 0271. cons ing x2, x3, ccordingly, finance & ac issn 19 2022, vol. 1 ajfa.macro random effe coefficient 0.787391 -0.000234 0.000121 -0.058816 2.05e-05 0.3284 n test p-val 0.393 ffects model d model is b is significa , i.e. the (x1 dent variable therefore, 4272), x4 ( ave signific sequently, w x4 are fix when x2 in ccounting 946-052x 14, no. 2 think.org/ ects model p-value 0.0000 0.0126 0.0006 0.3370 0.2298 4.646938 0.003749 477 lue 37 l, results better. ant (f = 1, x2, x3 e (y7). there is (0.1722) cance on when x1 xed. the ncreases table 8 independe constant x1 x2 x3 x4 p-v f-test & h accord outcom better. accord of this p >0.05 indepen accord non-sig the e.g individu signific on y8. increase . dependen ent variables f value r2 hausman te ing to e.g. t mes are noning to previ model are 5), and the ndent variab ing to tab gnificance. g. table 8 ually. cons cance on y8, the x4 co es by egp1 nt variable: y s po coeffic 10.36 0.009 0.005 -5.268 -0.003 0 st table 8 f-te -significant ious e.g. tab e as follow coefficient bles explain ble 8 the 8 results pr sistent with , while x1 ( oefficient ha y8 decreas y8 oled model cient p-va 6703 0.0 9486 0.3 5865 0.1 8782 0.3 3982 0.0 1.734 0.162 0.154417 f 2.009 est: to distin (f = 2.009 ble 8 outcom ws: the ove of determin n 15.4% of th f-statistics resent x1 h the resul p > 0.05), x as indirect ses by 0.003 30 fix alue coef 0348 23 3233 -0.0 1171 -1.3 3760 -6.3 0457 -0.0 4847 2479 f-test 9915 nguish betw 9915, p > 0 mes, the po erall regres nation (r2) he variance s (p=0.162 (0.3233), x lt, the inde x2 (p > 0.05 effect and 3982, assum asian xed effects m fficient p.92257 0 021265 0 34e-05 0 348233 0 001231 0 2.0 0.0 0.479246 p-value 0 χ2 4.8 een pooled 0.05), indica ooled model ssion mode is 0.15441 e in the depe 2479) exce x2 (0.1171 ependent v 5), and x3(p is equal to ming x1, x2, n journal of f model r -value c 0.0350 0.1789 0.9976 0.6097 0.5606 052958 052555 6 0.0748 hausman 882239 model and ating that th l is the appr el is signifi 7, i.e. the ( endent varia eds 0.05 ), x3 (0.3 ariables x4 > 0.05) hav o -0.003982 x3 are fixe finance & ac issn 19 2022, vol. 1 ajfa.macro random effe coefficient 11.62339 0.003275 0.005130 -4.291338 -0.003244 0.1064 n test p-val 0.299 fixed effect he pooled m ropriate. th icant (f=1. (x1, x2, x3 able (y8). suggesting 760), x4 ( 4 (p <0.05 ve non-sign 2. hence, w ed. ccounting 946-052x 14, no. 2 think.org/ ects model p-value 0.0608 0.7537 0.1617 0.5642 0.0891 1.131637 0.356199 441 lue 96 ts model, model is e results 734847, and x4) overall (0.0457) ) has a nificance when x4 table 9 dep from th a signif ifrs 16 176 of 2 (y1 asse asset tu (y4 eps equity). 4. discu during the valu the num represen of the f million the top vehicles june 20 . summary pendent var y1 y2 y3 y4 y5 y6 y7 y8 he evaluatio ficant impac 6 equivalen 2018). thus et turn over urn over, y5 s, y6 curren . ussion the period f ue of the fin mber of th nting an inc financial lea egyptian p p three fina s, and heav 021, the rea y riable i x n results e.g ct on financ nt of the eas s, the h1is c r, y5 roce roce, y7 t nt ratio) x4 ( from april nancial leas he financia crease of 95 asing contra pounds respe ancial lease y equipmen al estate and independen variable 1, x2, x3, x g. table 9, th cial perform s 49 and the confirmed. e, y7 total d total debt/to (financial le to june 202 sing contrac l leasing c 5.4%. from acts increas ectively rep e contracts nt for april d land secto 31 nt x4 r r r r r the study gen mance of th e egyptian f results als debt/total as otal assets) x ased fixed a 20 and 2021 cts. from a contracts in april to ju ed from 92 presenting a sectors are to june 202 or acquired asian model random effe random effe random effe random effe pool random effe pool pool nerally conf he lessor aft financial l so specifical ssets) x2 (fin x3 (ebit/op assets) impa 1, there was april to june ncreased fr une 2020 an 92.5 million n increase o e the real e 21 and apr the largest n journal of f d ect is x x ect ect ect is x3 x is x1 ect is is x is x firms firm s ter the appl easing and f lly identifie nancial liab perating pro acts (y4 eps an increase e 2020 and rom 482 to d april to j n egyptian of 106.4%. estate and l il to june 2 share of the finance & ac issn 19 2022, vol. 1 ajfa.macro description s effected b 1(direct) an x2(indirect) no impact no impact s effected b 3(direct) an x4(indirect) s effected b (indirect) a x2(direct) s effected b x3(direct) s effected b x1(indirect) x2(direct) s effected b x4(indirect) specific fact lication of b factoring a es x1 (sales) bilities) imp ofit or loss) s, y8 total d e in the num april to ju o 942 resp june 2021 th pounds to land, transp 2020. from e value of f ccounting 946-052x 14, no. 2 think.org/ n y nd ) y nd ) y and y y ), y ) ors have both the act (law impacts pacts (y1 impacts debt/total mber and une 2021 pectively he value 19180.3 portation april to financial leasing the tota about 7 from a pounds transpor of the to about 7 april to pounds the tot million are in fi 17.33% 2,936.8 financi financi first six corples the peri third pla accord financi percent of june while it with a compan there w represen egyptia the tot 2021. f compar likely d a repor increase during existed contract contracts w al value of c 7,395.6 mill april to june representin rt vehicles otal value o 87.7 million o june 202 representin tal market s egyptian p first place ef % of total m egyptian ial leasing w ial leasing c x months o ss leasing iod. in seco ace was ef ing to the ial regulat age of shar 2021. efg t lent only 1 share of 16 ny in third p was an over nting an an an pounds in al financial financial l red to 58.9 b due to the re rt issued by e in the num 2017-2021. in 2017. t ts from 1,7 worth to ab contracts. fr lion egyptia e 2021, the ng 4.57% o sector acqu of contracts. n egyptian 20, the hea ng 3.90% of shares of fin pounds. the fg hermes market share pounds rep with 2,036. companies of 2021. th egypt (co ond place w g hermes f non-bank ory author res that reac g hermes f .1 billion p 6.8%, follow place with a rall increas nnual recor n 2020. l leasing co easing con billion egyp ecovery from y the egypt mber of com . there wer this report 59 to 3,516 bout 15,776 rom april t an pounds r transport ve of the total uired about . from apri pounds rep avy equipm f the total va nancial leas e top three s financial s es. in secon presenting 1 6 egyptian provided lo his represen orpless) wit was bm fin financial so financial a rity, efg ched 21.8% financial so ounds in m wed by cor a share of 11 e in the ma rd of 10.7 ontracts reac ntracts amo ptian pound m the conse tian financi mpanies ope re 46 comp also expla 6 by the end 32 .7 million e to june 202 representin ehicles sect l value of c 557.7 mill il to june 20 presenting 4 ment sector alue of cont sing compa financial le solutions w nd place, c 15.76% of pounds rep oans worth nted an ann th a share o nancial lea olutions wit activities m hermes fi % of the fina olutions lent may. after th rpless leasi 1.9%. arket month billion eg ched an am ounted to 7 ds in 2020. t equences of ial regulato erating in th anies by th ained that t d of the yea asian egyptian po 0, the real e g 79.59% o tor acquired contracts. f ion egyptia 021, the hea .11% of the acquired a tracts. nies for ap easing com with 3,228.2 corpless lea total marke presenting 1 35.6 billion nual increas of 16.6% of sing compa th a share o monthly rep inancial so ancial leasin t 2.2 billion hat came bm ing egypt hly lending gyptian pou mount of 10. 79.8 billion this represe the covid ory author he financial he end of 20 there was a ar 2021. thi n journal of f ounds repre estate and la of the total d about 877. from april an pounds r avy equipm e total value about 362.0 pril to june panies for a egyptian p asing egy et shares. i 0.93%. n egyptian se of 39%. f the value any with a f 10.7%. ports issued olutions acq ng market in n pounds to m financial t (corpless) rate in jun unds, compa .1 billion e n egyptian ents an incre d 19 pandem ity revealed leasing dur 021, while an increase is is in addi finance & ac issn 19 2022, vol. 1 ajfa.macro esenting 82 and sector a value of co .3 million e to june 20 representing ment sector a e of contract 0 million e 2021 was april to ju pounds repr ypt (corple in third pla pounds du in first pl of contract share of 15 d by the e quired the n egypt by customers l leasing c ) financial ne 2021 by ared to 4.3 egyptian pou n pounds in ease of 35.5 mic. d that there ring the last only 27 com e in the num ition to the ccounting 946-052x 14, no. 2 think.org/ .25% of acquired ontracts. egyptian 020, the g 6.00% acquired ts. from egyptian 18632.3 ne 2021 esenting ss) with ace, bm uring the ace was s during 5.1%. in egyptian highest the end in june, company leasing 151.3% 3 billion unds for n 2021, 5% most e was an t 5 years mpanies mber of increase in the v billion record o 21.045 sector th 2.185 b amount egyptia 5. conc this stu firms li second egyptia firms ad financia number of some the fina the disc signific equival 2018). t asset tu turn ove eps, y6 equity). authori during 5 by usin decision couple adoptin act (la ifrs 16 176 of compar egyptia above i from fin lessee in value of the egyptian po of 66.741 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identify ent of eas of studies o y. accordin noticeable ch o identify the eas 49 (20 aluation res tors actually both the i ng act (law (sales) imp s) impacts ( or loss) imp , y8 total d nancial re ir names fo ble to mak rm perform plies to the asing and f ssor firms a factoring a firms for the eas 49 mitations d s can evalu rchers can e ccounting 946-052x 14, no. 2 think.org/ hing 79.8 e highest hile only tomobile hile only contracts 3 billion 10 lessor change. 49 and on lessor ng to the hange in e impact 019) and sults and y have a ifrs 16 w 176 of pacts (y1 (y1 asset pacts (y4 debt/total gulatory r lessors ke better mance. a e lessors actoring adopting act (law a better 9 and the iscussed uate data examine acknow the dat regulat univers the pape disclos no pote referen asimak wide d finance baltagi, https://d baltagi, https://d biondi, t. j. (20 americ fasc). bunea-b approac chatfie new lea 101-111 de fari adoptio academ 116-143 de ma account gibson, analysi joubert leases a journal wledgemen ta used in th tory author sity, on the er. sure statem ential confli nces kopoulos, i. determinants e, 35(11), 9 , b. h. (201 doi.org/10.1 , b. h. (20 doi.org/10.1 y., bloomf 011). a per can accoun accounting bontaş, c. ch. revista e ld, h. k., c ase account 1. https://do ia olivo, r. on of ifrs mic scientif 3. artino, g. ( ting, 27(2), , y. s. (20 is of its imp , m., garvi aasb 16 l of new bus nt his paper is rity fra. w statistical a ment ict of intere ., samitas, s of firm 30-939. http 13). panel d 1016/b978008). foreca 1002/for.104 field, r. j., rspective on nting asso g horizons, a. (2017). economia c chatfield, r ting standar oi.org/10.10 l., ricciar s 16 for c fic research 2011). con 355-365. h 021). the n pacts on key ie, l., & pa (ifrs 16) siness ideas available a we appreciat analysis mad st was repor a. and pap profitability ps://doi.org/ ata forecast 0-444-6273 asting with 47 glover, j. c n the joint ia ciation's fi 25(4), 861 lease acc contempora r. e., & poo rds?. the jo 80/1091321 rdi, r., sale companies h journal f nsiderations https://doi.or new lease y financial arle, g. (201 with the i s and trends 34 and can be a te the work de. all error rted by the padogonas, y: greek e /10.1108/03 ting. handb 31-5.00018panel data c., jamal, k asb/fasb inancial a -871. https: counting un ană, 2(2), 7 on, p. (2017 ournal of h 11.2017.139 es, g. a. w with inten for engine s on the su rg/10.1016/j accounting performan 17). implica inclusion o s, 15(2), 1-1 asian accessed dir of dr. saye s are our own authors. t. 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(20 of mobile hnology, an ease accoun 1.08.007 ds (topic 8 e new acco g leases in finance & ac issn 19 2022, vol. 1 ajfa.macro egyptian f d bahrawy, ors worked eq ecific and e data. man asting, 2, 9 ng, 27(2), 1 man, s. h., & counting fo committee h-50048 s 17-a com dustry ready managemen 022). impac assets. a nd sciences nting. adva 842): an em ounting stan the balanc ccounting 946-052x 14, no. 2 think.org/ financial helwan qually on economy nagerial 95-1024. 153-173. & wilks, r leases: e (aaa mparative y for the t, 25(2), ts of the merican s, 85(1), ances in mpirical ndard for ce sheet. knubley finance maali, b an emp innovat magli, perform https://d nasser, perform https://d öztürk, of finan and eco park, y from s https://d park, y evidenc https://d secinar ifrs 16 smes. h singh, a and re https://d susanti implem confere https://d tóth, á new ifr watts, r account zamora spanish https://d y, r. (2010 e, 28(5), 32 b. 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(2016). im ratios: a ca rnal, 7(4), 1 e effects of h mada in aijb.12848 e effect of l s in 7090154 annaci, d., & ents: empir 65/1537-150 substitute o al of hos 4801142550 & dewi, s. p ancial ratio ship and bu .k.210507.0 the capitali ounting in h j. l. (1978 ting review, ales-díaz, j. tudies of v36i2.2536 35 o lease acco 10.1108/146 g the new if dustry in the m. (2018). ernational the effec ـــوث مجلة ح .1219 mpact of new ase study on 143. https:// f listing statu internationa lease acco korea. & chmet, f rical eviden 06/2020.01. or complem spitality & 01 p. (2021, m os: evidence usiness ma 045 ization imp hungary. hu 8). towards , 112-134. (2018). eff of applie asian ounting. jou 6357810110 frs 16 "le e middle ea the effect business t of ifrs اليـــــة البحـ w standard n an airline /doi.org/10.2 us on a firm al journal ounting on c social f. (2020). r nce the impa 001 ment to debt? & tourism may). the im e from indo nagement ( pact of off-b ungarian sta a positive ffects of ifr ed econ n journal of f urnal of prop 069936 eases" on fin ast. organiz ts on finan research 16 applica ـــــة المال جاري ifrs 16 l company i 20409/berj.2 m's lease acc of busine credit ratin sciences, relevance in act of the f ? evidence research, mpact of if onesia. in n (icebm 20 balance she atistical rev theory of th rs 16 on key nomics, 3 finance & ac issn 19 2022, vol. 1 ajfa.macro operty inves inancial stat zational stud ncial levera h, 11(8), ation on f 1)23 ,والتجا leases on st in turkey. b 201642234 counting: e ess, 19(1), ng and cost 7(9), n the applic financial m from the re , 37(2), 1 frs 16 (ps ninth inter 020) (pp. 29 eet items un view, 1(1), 9 he determin y financial 36(2), 3 ccounting 946-052x 14, no. 2 think.org/ tment & tements: dies and age and 76-89. financial 1), 1-23. tatement business 4 evidence 77-92. t of debt: 154. cation of method in estaurant 155-183. sak 73) national 95-303). nder the 91-108. nation of ratios of 385-406. copyri copyrig the jour this is commo ights ght for this rnal. an open-a ons attribut article is re access articl tion license etained by t le distribute (http://crea 36 the author(s ed under th ativecommo asian s), with firs he terms an ons.org/licen n journal of f st publicatio nd conditio nses/by/4.0/ finance & ac issn 19 2022, vol. 1 ajfa.macro on rights gr ons of the c /) ccounting 946-052x 14, no. 2 think.org/ ranted to creative microsoft word 15215-54850-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 42 explaining value vs. growth fallacy: an empirical study for indian market dr. vibhuti vasishth assistant professor department of commerce, kamala nehru college, university of delhi prof. sanjay sehgal professor department of financial studies, university of delhi received: august 5, 2019 accepted: sep 19, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15215 url: https://doi.org/10.5296/ajfa.v11i2.15215 abstract prior research describes value and growth characteristics on the same continuum. we attempt to test this for the indian market. similar to past studies, our results confirm the presence of value premium. but unlike previous literature, superior profits in growth strategy are also observed. this leads us to believe that value and growth are different dimensions. value premium may be explained by investor overreaction. whereas, growth premium arises due to future growth potential of high growth stocks. negative correlation is observed between value and growth premiums which can be used by investors for achieving time diversification. we find that higher profits can be achieved by combining value and growth. the returns on univariate value or growth strategies are explained by either capital asset pricing model or fama-french three factor model. the returns on bivariate strategies based on both value and growth remain unexplained even by fama-french five factor model. the study contributes to existing literature in the following ways: 1. it highlights the role of both value and growth attributes in portfolio construction. 2. time diversification is important for achieving higher risk adjusted return. the findings shall be pertinent for portfolio managers, market regulators and the academic community. keywords: asset pricing, value strategy, growth strategy, investor overreaction, time diversification asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 43 1. introduction security markets across the world have confirmed the existence of value anomaly. it has been observed in various markets that stocks with low market price-to-book value (p/b) ratio or low market price-to-earnings ratio (p/e) have outperformed stocks with higher p/b and p/e ratio. past literature documents various reasons in support of this evidence. basu (1977) documents that low p/e stocks outperform high p/e stocks. this proves semi-strong form of inefficiency in markets where publicly available p/e does not reflect the entire information. stattman (1980) confirmed the existence of value effect with book-to-market (b/m) ratio. he concludes that stocks with high b/m ratios outperform stocks with lower b/m ratio. [1] basu (1983) further evaluates if value effect is dependent on firm size. his results conclude the existence of this effect even after controlling for differences in firm size. outperformance of growth stocks (low b/m) by value stocks (high b/m) is also confirmed by rosenberg, reid and lanstein (1985); and chan, hamao and lakonishok (1991). according to chan and chen 1991, small firms are distressed and this explains the difference between returns offered by small and large firms. lakonishok, shleifer and vishny (1994) report the existence of value premium and explain the reason behind value stocks performing better than growth/glamour stocks. they conclude that value strategies are more profitable not because of the inherent risk, but due to under reaction associated with distressed firms. fama and french (1995) confirm the association of high book equity-to-market equity stocks with poor earnings, making them distressed stocks. on the other hand, higher profitability is associated with low book equity-to-market equity stocks. fama and french (1998) prove the existence of value premium in various markets (including emerging markets) by sorting securities on the basis of book-to-market equity, earnings-to-price, cash flow-to-price and dividend-to-price ratio. chan, karceski and lakonishok (2000) report there is a high chance of high p/e stocks earning lesser returns in future. they use behavioural arguments to support their results. chan and lakonishok (2004) revisit value vs growth investing styles and find greater support for value investing in small-cap stocks, though value premium also exists in large-cap stocks. they conclude that investors over react to growth stocks, whereas market price of value stocks is much below their fundamental value. thus, long-term profits can be earned by staying patiently invested in value stocks. houge and loughran (2006) do not find value stocks earning higher returns than growth stocks for their sample indices and large-cap firms. they also report value and growth mutual funds earning similar returns across all sizes. sehgal and tripathi (2007) find value effect in indian stock markets by using book-to-market equity, earnings-to-price, cash flow-to-price and dividend-to-price ratio. schatzberg and vora (2009) confirm profitability of peg investment strategy. marx (2013) analyses trading strategies created on the basis of profitability (measured using gross profit-to-assets ratio) and book-to-market ratio. better returns are found amongst profitable firms in spite of higher p/b ratios. according to him it is beneficial to combine profitability and value strategies. value effect is confirmed by sehgal and balakrihsnan (2013), where value is defined using p/e, p/b and psg (past sales growth). sehgal and pandey (2014) find that in indian market low priceto-book, price-to-equity and price-to-sales ratio stocks outperform stocks with high price-toasian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 44 book, price-to-equity and price-to-sales ratios. subramanaiam, sharma and sehgal (2017) confirm value effect using p/b ratio for the indian stock market. past literature labels stocks with lower price-to-book and price-to-equity ratios as value stocks and securities with higher value ratios as glamour or growth stocks. value effect is defined as stocks with low p/b and p/e ratios outperforming securities with higher p/b and p/e ratios. this could be due to undervaluation of relatively distressed value stocks. on the other hand, investors who believe in growth investing strategy, assume that high growth stocks continue to have higher growth potential which leads to outperforming low growth stocks. damodaran (2012) defines growth investors as those who invest in companies based on market valuation of their growth potential. he demonstrates that over long term, value investing outperforms growth investing. but there are certain periods when growth investing proves to be better. till now value and growth have been identified on the same continuum. in this study we attempt to test this and analyse if we are mixing up two different dimensions. we examine the profitability of value and growth strategy in the indian market. if both strategies prove to be profitable, then value and growth may possibly be different dimensions. we attempt to explore this, and evaluate the profitability earned by combining these two strategies. combination of value and growth would result in enhanced profits, if these two phenomenon are countercyclical in nature. this could be due to preference of different strategies in different market states. market upturns are usually sentiment-driven. high investor sentiments lead to overreaction to good as well as bad information. this leads to overvaluation of growth stocks. at the same time, overreaction to bad information leads to undervaluation of relatively distressed value stocks. (see veronesi (1999)). thus, it may be profitable for investors to buy low p/b and p/e stocks and aim at earning long-term profits in upswings. on the other hand, investors resort to fundamentals in pessimistic situations. thus in market downturns the focus shifts from value strategies to growth strategies, where more emphasis is on realising benefits from future growth potential. specifically, this paper attempts to answer the following questions for the indian stock market: 1. is value strategy profitable? 2. is growth strategy profitable? 3. is trading strategy based on growth and value based investing more profitable than above mentioned strategies? 4. do standard risk models such as capital asset pricing model (capm) and fama-french (f-f) three factor model (1993) explain returns of these sample strategies? 5. can additional risk factors given by fama-french five factor model (2015) explain cross section of returns for portfolios created using information on value or/and growth? the paper is divided into 5 sections including the current one. data used and its sources are given in section 2. the next section describes estimation procedure and methodology used. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 45 empirical results and analysis are discussed in section 4. summary and concluding observations are given in the last section. 2. data this study uses data for nse 500 companies from december 2001 to 2017. data for month end stock prices is used which is adjusted for stock dividends, rights issues and stock splits. for further analysis, they are converted into percentage returns. to evaluate value anomaly, data for price-to-book ratio and price-to-earnings ratio is taken at the end of december each year. for evaluating growth anomaly, data for net sales and earnings before interest, taxes, depreciation and amortisation (ebitda) is used. this is further converted into growth rate. for each year’s estimate of growth rate, average of past 5 years’ growth rate is computed using 3 measures. estimations are made using simple average, compound annual growth rate and weighted average (where highest weightage is given to the most recent value). month end value of nifty 500 is taken which is further converted into returns to represent market performance. 91-day treasury bill yields are used as the risk free proxy. further, data for market capitalisation, return on assets and total assets is taken at the end of december each year to construct factors used in asset pricing models. data source: prowess database, reserve bank of india’s website. 3. methodology this section describes methodology used to construct univariate strategies (based on price-tobook ratio, price-to-earnings ratio and growth rates) and bivariate strategies (created by combining information in value and growth). we use 12-12 trading strategy with formation and holding period of 12 months each. to assess value effect, p/b and p/e ratios are used. past growth rate in net sales and earnings before interest, taxes, depreciation and amortization (ebitda) are considered for growth rate formation. for the first formation period, value ratios as on december 2006 are taken and average growth rate estimation is made using net sales and ebitda values from december 2001 to december 2006 [2]. annual growth rate for 5 years prior to portfolio formation is estimated, which is further used to compute average growth rate using 3 construction methods; namely simple average growth rate, weighted average growth rate and compound annual growth rate. annual growth is computed by subtracting net sales (ebitda) in year ‘t-1’ from net sales (ebitda) in year ‘t’, which is divided by net sales (ebitda) in year ‘t-1’. this creates 5 annual growth estimates from december 2001 to december 2006, which are labelled as g1, g2, g3, g4 and g5 respectively. simple average of these growth rates is calculated using arithmetic mean formula. weighted average growth rate is calculated by giving maximum weightage to latest year’s growth rate and least weightage is given to the earliest annual growth rate. the following asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 46 formula describes calculation of weighted average: 5 ∑ (wi) (gi) i=1 5 where, wi = i/ ∑ (i) i=1 compound annual growth rate is estimated using geometric mean formula. the construction methodology used is suggested by sehgal and balakrishnan (2013). the process of estimating value and growth is repeated each year for successive formation periods. to estimate profitability of value strategies, stocks are sorted into 10 equally-weighted portfolios on the basis of p/b and p/e ratios at the end of december each year (t). their returns for the next 12 months (january to december of year t+1) are observed. portfolio pe1(pb1) consists of stocks with lowest p/e(p/b) ratio and stocks with the highest p/e(p/b) ratio are a part of portfolio pe10(pb10). similarly, to evaluate profitability of growth strategies, past 5 years’ average growth rate in net sales and earnings is taken as the ranking criterion. on the basis of growth rate at the end of december each year (t) we sort securities into 10 equally-weighted portfolios. portfolios with low growth rate in past net sales (earnings) are labelled as ns1sa (e1sa), ns1wa (e1wa), ns1cagr(e1cagr) where sub-scripts sa, wa and cagr represent simple average, weighted average and compound annual growth rate method of computing average growth rate. similarly, portfolios with high past sales (earnings) growth are labelled as ns10 sa (e10sa), ns10wa(e10wa), ns10cagr(e10cagr). subscripts have the same meaning as described earlier. returns of these portfolios are observed for the next 12 months (january to december of year t+1). the process is repeated each year and portfolios are rebalanced annually based on new information in value and growth, thereby creating a return series from january 2007 to december 2017. for value strategies, we obtain maximum return differential in p/e sorted portfolios (i.e. pe1pe10) and in growth strategies, best results are observed in ebtida simple average growth based portfolios (i.e. e10sa e1sa) amongst all univariate growth sample strategies. henceforth, these two strategies are used for all further analysis. using these investment styles, bivariate strategies are employed to analyse profitability of combined information contained in growth and value. three types of bivariate sorted strategiesindependent, conditional i and conditional ii are used. in independent sorted strategy, securities are first ranked on the basis of p/e ratios into 3 portfolios with pe1 consisting of lowest 33-1/3 percent stocks and pe3 comprising of highest 33-1/3 percent stocks. then securities are independently sorted on the basis of average earnings growth into 3 portfolios with e1 and e3 having lowest and highest 33-1/3 percent stocks asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 47 respectively. stocks in the portfolio pe1e3 and pe3e1 are defined as low value-high growth stocks and high value-low growth stocks respectively. further two types of conditional sorted strategies; namely value-growth and growth-value are used. they are labelled as conditional i and conditional ii respectively. in value-growth strategy, securities are sorted in ascending order into 3 portfolios on the basis of pe ratio. within these groups, stocks are further sorted into 3 portfolios on the basis of past growth rate in earnings. in the conditional ii strategy, the process is reversed. stocks are first sorted on the basis of earnings growth, then on the basis of p/e ratio. in all the above mentioned strategies, intersections of value based and growth based portfolios are created to form 9 portfolios on the basis of p/e and earnings growth (namely pe1e1, pe1e2, pe1e3, pe2e1, pe2e2, pe2e3, pe3e1, pe3e2, pe3e3. estimation procedures similar to univariate strategies are followed. portfolios are constructed at the end of each year by observing past information in value and growth. returns of these portfolios are observed for the next year and they are rebalanced annually to reflect new information. for all univariate and bivariate sorted portfolios, returns of long-short (zero cost) strategies are estimated which involves going long in portfolio with low value or/and high growth; and short in high value or/and low growth portfolio. next an attempt is made to see if standard risk models explain cross section of returns of our univariate and bivariate sorted portfolios. for this purpose, three asset pricing models namely capital asset pricing model (capm), fama-french 3 factor model (1993), and fama-french 5 factor model (2015) are used. we do further analysis only on corner portfolios as they have direct implications for developing long-short strategies. since some months of our data period are impacted by global financial crisis, we add a dummy variable to account for the structural break between crisis and tranquil periods. markets are known to be affected by the financial crisis from august 2007-october 2009 (see trichet, 2010; angelini et al, 2011; sehgal et al, 2016). the dummy variable takes value of ‘0’ during crisis period and ‘1’ during tranquil periods. following equation shows the excess return version of market model which is used to operationalise capm: rpt– rft = ap + bp (rmt – rft) + + dp (dt)+ ept (1) where, rpt – rft is the excess return on portfolios at time “t”; i.e; return on portfolio at time “t” minus risk free return at time “t”. rmt – rft is the excess return on market factor asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 48 dt is the dummy variable to account for global financial crisis. it takes value of ‘0’ and ‘1’ during crisis and normal periods respectively. ap is the intercept, which is the measure of abnormal profits. bp is the slope coefficient which shows the sensitivity of portfolio returns to market returns dp represents responsiveness to dummy variable ept is the error term for capm to hold true, portfolio returns must be fully explained by market returns. a significantly positive or negative intercept implies that portfolios are earning abnormal returns which are not explained by capm. in this case, fama-french 3 factor model is used which is described in the following equation: rpt– rft = ap + bp (rmt – rft) + sp (rsmb) + lp (rlmh) + dp (dt)+ ept (2) where, smb and lmh are mimicking portfolios for size factor and value factor respectively. sp and lp are sensitivity coefficients. other variables have the same description as in equation (1). construction methodology adopted by us is different from fama-french 3 factor model estimated in fama-french 1996 in two ways. 2*2 size-value partition is used instead of 2*3 size-value partition due to problems of multicollinearity. [3]. instead of hml factor, we construct lmh factor. this reverses the interpretation of value factor. we divide the sample stocks into two groups on the basis of their market capitalization. stocks are categorized into small (s) if their market capitalization is less than the median value and remaining as big (b). in the same manner, they are classified as low (l) or high (h) on the basis of price-to-book ratio. using intersection of two size and two p/b groups, four portfolios (s-l, s-h, b-l and b-h) are formed. for each holding period, difference between average return of small stocks and big stocks gives the smb factor. lmh factor is constructed as the difference between average return of low and high p/b stocks. the fundamental reasoning behind using these factors is the superior performance of small stocks over big stocks due to higher risk associated with small stocks. better performance of low p/b stocks vis-à-vis high p/b stocks is associated with their undervaluation of low p/b securities. if portfolio returns remain unexplained by fama-french three factor model, we investigate the role of profitability and investment rate as proposed by fama-french (2015). for constructing profitability factor, each year stocks are divided into 10 portfolios on the basis of return on assets (roa). stocks with highest and lowest roa are labelled as robust and weak respectively. average asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 49 returns of robust and weak portfolios across all holding periods are considered for constructing the profitability factor; labelled as rmw (robust minus weak factor). this factor is based on the rationale of stocks with higher past profitability outperforming stocks with lower past profits. investment rate is added to the explanatory model by constructing amc factor (aggressive minus constructive). investment rate for all stocks is computed each year by looking at the difference between total assets at the end of year ‘t’ and total assets at the end of year ‘t-1’. this is divided by total assets at the end of year ‘t-1’. stocks are divided into 10 portfolios each year on the basis of investment rate and are labelled as aggressive and conservative with higher and lower investment rate respectively. contrary to previous studies on asset growth anomaly, we find that firms with higher investment rate are performing better in future vis-àvis conservative firms. though asset growth anomaly is well documented in previous research, some recent studies support our findings. possible explanations are provided by fu (2014) and kumar and li (2016). the following equation describes the 5 factor model used: rpt– rft = ap + bp(rmt – rft) + sp(rsmb) + lp(rlmh) + rp(rrmw) + ip(ramc)+ dp (dt)+ ept (3) where, smb, lmh, rmw and amc are mimicking portfolios for size, value, profitability and investment rate factors respectively. sp, lp, rp and ip are sensitivity coefficients. other variables have the same description as in equation (1). all multi-factor models used are adjusted for multi-collinearity. appropriate corrections are made in case correlation between any two factors is more than 0.3. an insignificant alpha from 5 factor model implies abnormal performance observed in case of 3 factor f-f model was only due to missing risk factors. on the other hand, there would be a stronger support for strategy design and arbitrage, if the alpha values are significantly positive in case of 5 factor model. 4. empirical results 4.1 unadjusted returns of univariate portfolios this sub-section reports unadjusted returns for our univariate sample strategies. (see table 1). value based strategies give results consistent with past studies. stocks with low p/e and p/b ratios outperform securities with high p/e and p/b ratios. portfolio pe1 and pb1 provide mean monthly return of 1.95% and 1.69% respectively. on the other hand, portfolio pe10 and pb10 give an average return of 0.56% p.m. and 0.78% p.m. respectively. thus, investors realise a mean monthly return differential of 1.38% and 0.91% from p/e based asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 50 and p/b based value investing strategy respectively. annual return of 16.56% and 10.92% can be earned by a zero-cost arbitrage strategy which involves going long in low p/e(p/b) stocks and short in high p/e(p/b) stocks. for all growth based strategies, higher returns are observed for portfolios with higher past growth rate vis-à-vis portfolios with lower past growth rate. portfolio ns10sa, ns10wa and ns10cagr provide an average monthly return of 1.48%, 1.43% and 1.60% respectively. in contrast, portfolios ns1 sa, ns1wa and ns1cagr earn 1.18%, 1.13% and 1.35% respectively p.m. this gives an average monthly return premium of 0.30%, 0.29% and 0.25% for the above mentioned strategies, when investors go short in low growth stocks and long in high growth stocks. high earnings growth portfolios e10 sa, e10wa and e10cagr earn 1.55% p.m., 1.64% p.m. and 1.41% p.m. respectively. on the other hand, low earnings growth stocks in portfolios e1sa, e1wa and e1cagr give mean monthly return of 0.84%, 1.04% and 0.92% respectively. zero cost portfolios with long position in high growth stocks and short position in low growth stocks provide a return differential of 0.72% p.m., 0.60% p.m. and 0.49% p.m. respectively. we observe that low p/e(p/b) stocks are outperforming high (p/e)/(p/b) stocks. at the same time, stocks with higher past growth rates are also giving better returns than low growth stocks. this leads us to investigate if value and growth are on a separate continuum. amongst the various value and growth based investing styles used for checking robustness of our results, we observe that maximum return differentials are provided by zero cost pe based strategy (i.e. pe1-pe10) and earnings’ average growth based strategy (i.e. e10sa e1sa). henceforth, all analysis is done on these two criteria. further, we analyse the growth rates of p/e based sample portfolios. low p/e stocks have lower past growth rate vis-à-vis high p/e stocks. thus, they are classified as relatively distressed securities. but, future growth rate of low p/e stocks is higher as compared to future growth of high p/e stocks. reversal in their growth rates explains the value effect. investors may have undervalued low pe stocks due to the relative distress associated with them, but they are not so bad if we look at their future growth. this leads to an increase in their value as market realises their potential. at the same time, investors believe high p/e stocks to be much better than they actually are. this is shown by the bend in their future growth rates. on the other hand, stocks with higher past growth continue to have higher growth rate in future vis-à-vis low growth portfolios. so, significant profits can be realised by growth based investing style, which is based on future growth potential. this explains profitability of value as-well-as growth based investing in the indian market. on further analysis, we find negative correlation of -0.214 between return premiums of value and growth based strategies, which suggests a countercyclical relation between them. (see figure 1). this can be explained using behavioural reaction of investors in different market situations. when business conditions are robust and markets are in upswing, investors tend to overreact asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 51 to good as well as to bad information. this sentiment driven market leads to overvaluation of high growth stocks. at the same time, overreaction to bad news leads to undervaluation of relatively distressed low p/e and low p/b stocks. thus, significant profits can be earned by staying invested in value stocks. on the other hand, in pessimistic situations when markets are in a downturn, investor sentiment dries out and investors resort back to fundamentals. previous over valuation of growth stocks is corrected in this phase, and market players tend to invest in securities with high past growth with the belief that this growth rate will continue in future. so, a combined value and growth strategy can diversify risk and give enhanced profits as compared to univariate value based or growth based investing styles. this is further evaluated in the subsequent sub-section. 4.2 unadjusted returns of bivariate portfolios to evaluate profitability of combined information, we create three types of bivariate portfolios, namely; independent, conditional i (value-growth) and conditional ii (growth-value). all these strategies perform better than our univariate sorted portfolios. (see table 2) for independently sorted strategy, 2.43% and 0.82% mean monthly return is earned by low p/e-high growth group and high p/e-low growth group respectively. in conditional i (value-growth) strategy; when growth based portfolios are constructed within value based groups, stocks with low p/e-high growth and high p/e-low growth provide an average monthly return of 2.37% and 0.78% respectively. with reverse conditional sorting process; i.e. constructing value based portfolios within growth based groups, we observe that 2.39% p.m. and 0.83% p.m. is earned by low p/e-high growth portfolio and high p/e-low growth portfolio respectively. maximum mean monthly return differential of 1.61% is provided by zero-cost independently sorted strategy, which is followed by conditional i and conditional ii strategy, which give a return differential of 1.59% and 1.56% respectively. thus, instead of focusing on value vs growth investing style, investors in the indian markets should focus on value and growth investing style. enhanced performance of bivariate strategies is confirmed with higher sharpe’s ratio vis-à-vis univariate strategies. we report sharpe ratios for portfolios on the winner side. portfolio pe1 and e10sa have sharpe ratio of 0.196 and 0.150 respectively. for bivariate low value-high growth portfolios, sharpe ratio rises to 0.251, 0.242 and 0.244 for independent, conditional i and conditional ii strategy respectively. this increase is observed because of lower volatility of bivariate strategies due to the benefit of time-diversification. 4.3 risk adjusted returns based on factor model(s) after the estimation of unadjusted returns, risk adjusted returns are observed using capm framework. we regress excess returns on all univariate and bivariate strategies on market return. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 52 results are reported in table 3. for univariate strategies, market risk factor absorbs returns of both earnings growth based portfolios and high p/e portfolio amongst value strategies. for all bivariate strategies, capm explains returns of portfolios with lower earnings growth and higher p/e ratio. however, portfolios return of high growth-low value stocks in all groups remain unexplained at this stage. using fama-french 3 factor model (1993), excess returns of unexplained portfolios are regressed on market, size and value factors. these results are reported in table 4. this model captures return of univariate low value portfolio that was unexplained at the previous stage. return of all bivariate sorted high growth-low value portfolios remain unexplained. these are further regressed on two additional factors suggested by fama-french (2015); i.e. profitability factor and investment rate factor. (see table 5). we find that fama-french 5 factor model is also unable to absorb excess returns of these portfolios. our results suggest significant profits can be earned by going long in portfolios with high earnings growth and low value. these portfolios may be sorted independently or conditionally. since standard risk models are unable to explain results of these portfolios, there may be behavioural reasons to explain their superior performance, which may be an issue for examination in subsequent research. 5. summary and concluding observations this study attempts to evaluate profitability of value and growth investing styles. past literature defines low p/e(p/b) stocks as value stocks. growth stocks are defined as securities with higher past growth rate in net sales and earnings. value stocks are found to have lower growth rates, and till now value and growth strategies have been identified on the same continuum. we attempt to verify this and evaluate if we are mixing up two different dimensions. for this we use data of nse 500 companies from december 2001 to 2017. since, this time period was partly affected by global financial crisis, we make appropriate adjustments using dummy variables to account for the structural break between crisis and tranquil periods. to evaluate profitability of value based strategy, we sort stocks on the basis of p/e and p/b ratios. portfolios with low p/e(p/b) ratios outperform stocks with higher value ratios. this can be explained with distress exhibited by low value stocks at the time of portfolio formation. these stocks have lower growth rates in net sales and earnings prior to formation of portfolios. however, this trend reverses in future years after framing portfolios. value premium is borne out of investor overreaction to bad information associated with relatively distressed value stocks, which leads to their undervaluation. for growth based strategy, we estimate average growth rates in net sales and ebitda. average of past 5 years’ annual growth prior to portfolio formation is calculated using simple average, weighted average and compound annual growth rate. using all the above mentioned criterion, growth based investing proves to be profitable as asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 53 securities with higher growth rates outperform low growth stocks. this strategy is profitable due to future growth potential of high growth stocks. stocks with higher past growth rate continue to have higher growth rates post portfolio formation as compared to low growth stocks. superior performance of low p/e (p/b) stocks and high growth stocks at the same time, leads us to investigate if value and growth are on a separate continuum. amongst univariate value and growth strategies, maximum return differential is provided by price-to-earnings based and simple average earnings growth based strategy respectively. so we use these two investing styles for further analysis. negative correlation is found between return premiums of value strategy and growth strategy, thereby leading to profitable bivariate strategies that use combined information contained in value ratios and growth rates. this can be due to different behaviour exhibited by investors in market upswings and downswings. when business conditions are robust and markets are rising, investors tend to overreact to good as well as to bad information. this sentiment driven market leads to overvaluation of high growth stocks. at the same time, overreaction to bad news leads to undervaluation of relatively distressed low p/e and low p/b stocks. thus, significant profits can be earned by staying invested in value stocks. on the other hand, in pessimistic situations when markets are in a downturn, investor sentiment dries out and investors resort back to fundamentals. previous over valuation of growth stocks is corrected in this phase, and market players tend to invest in securities with high past growth with the belief that this growth rate will continue in future. negative correlation helps investors achieve the benefit of time diversification, as it is possible to beat the market on both ends by investing in bivariate strategies. so investors should focus on value and growth strategy instead of value vs growth strategy. to evaluate profitability of combined information, we use independent sorted and two conditionally sorted bivariate strategies (growth within value and value within growth). for all three styles, low value-high growth stocks outperform high value-low growth stocks. all of them provide higher returns vis-à-vis univariate value strategy and growth strategy. maximum return is provided by independently sorted portfolio. profitability of combined strategies is also confirmed by higher sharpe ratios exhibited by bivariate sorted portfolios visà-vis univariate sorted portfolios. further, an analysis of risk adjusted returns shows that profits of univariate earnings growth based portfolios, and high value portfolio is captured by capital asset pricing model. famafrench 3 factor model absorbs returns earned by low value stocks. thus, return earned by univariate growth and value investing style is merely a compensation for risk, which is explained by standard risk models. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 54 however, profits associated with combination of growth and value can be successfully exploited by investors in the indian market. returns on independently and conditionally sorted low value-high growth portfolios remain unexplained by standard risk models. even famafrench 5 factor model is unable to capture these profits. the study is useful for various stakeholders and has strong implications for portfolio managers, market regulators and academic community. till now value and growth characteristics have been identified on the same continuum. we explode this myth and conclude that these are two separate dimensions. low p/e and p/b stocks are relatively distressed, and investor overreaction may be leading to a profitable value strategy. whereas, growth strategies are profitable due to future growth potential of stocks with higher past growth. these investing styles are found to be countercyclical in nature and time diversification benefits can be achieved by combining the two, as reflected by risk adjusted returns provided by bivariate strategies which are not even explained by multifactor asset pricing models. these alpha generating strategies can be profitably exploited by global portfolio managers who focused only on value or growth trading style till now. they should consider both dimensions for appropriate portfolio design. countercyclical anomalies can pose higher challenges than standalone anomalies for market regulators. the study highlights the problem of information inefficiency in indian securities market. market regulators and policy makers should address this problem by employing more efforts to strengthen the corporate governance norms and expanding the investor base by stronger financial inclusion policies. the study contributes to academic literature as value and growth have been identified as separate dimensions for strategy design. this work can be extended to other countries. table 1. unadjusted returns of value sorted and growth sorted portfolios (univariate analysis) panel a: value sorted portfolios price-to-earnings based portfolios portfolios pe1 pe10 pe1-pe10 mean 0.0195 0.0056 0.0138 t-value 2.2521 0.6517 4.2216 price-to-book based portfolios portfolios pb1 pb10 pb1-pb10 mean 0.0169 0.0078 0.0091 t-value 1.7506 1.2321 1.4912 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 55 panel b: growth sorted portfolios net sales simple average growth based portfolios portfolios ns1sa ns10sa ns10sa-ns1sa mean 0.0118 0.0148 0.0030 t-value 1.4235 1.6818 1.0864 net sales weighted average growth based portfolios portfolios ns1wa ns10wa ns10wa-ns1wa mean 0.0113 0.0143 0.0029 t-value 1.3869 1.6369 0.9905 net sales compound annual growth based portfolios portfolios ns1cagr ns10cagr ns10cagrns1cagr mean 0.0135 0.0160 0.0025 t-value 1.6213 1.8261 0.7894 earnings simple average growth based portfolios portfolios e1sa e10sa e10sa-e1sa mean 0.0084 0.0155 0.0072 t-value 1.0188 1.7258 2.4406 earnings weighted average growth based portfolios portfolios e1wa e10wa e10wa-e1wa mean 0.0104 0.0164 0.0060 t-value 1.2376 1.8676 1.9209 earnings compound annual growth based portfolios portfolios e1cagr e10cagr e10cagr-e1cagr mean 0.0092 0.0141 0.0049 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 56 t-value 1.0412 1.6228 1.6765 the above table shows mean excess returns for value and growth sorted univariate portfolios. all returns are tested for significance at 5% level on two tailed basis. figure 1. correlation between value and growth based strategy the above figure represents correlation between return premiums of price-to-earnings based value strategy and earnings simple average growth based strategy. note: mean correlation between return premiums of price-to-earnings based strategy and simple average earnings growth based strategy = -0.214 table 2. unadjusted returns of bivariate value and growth based portfolios panel a: bivariate growth and value based portfolios (independent sorted) portfolios pe1e3 pe3e1 pe1e3-pe3e1 mean 0.0243 0.0082 0.0161 t-value 2.8805 1.1029 4.8003 panel b: bivariate growth and value based portfolios (conditional i sorted) portfolios pe1e3 pe3e1 pe1e3-pe3e1 mean 0.0237 0.0078 0.0159 t-value 2.7813 1.0534 4.7689 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 20 07 年 1月 1日 20 07 年 7月 1日 20 08 年 1月 1日 20 08 年 7月 1日 20 09 年 1月 1日 20 09 年 7月 1日 20 10 年 1月 1日 20 10 年 7月 1日 20 11 年 1月 1日 20 11 年 7月 1日 20 12 年 1月 1日 20 12 年 7月 1日 20 13 年 1月 1日 20 13 年 7月 1日 20 14 年 1月 1日 20 14 年 7月 1日 20 15 年 1月 1日 20 15 年 7月 1日 20 16 年 1月 1日 20 16 年 7月 1日 20 17 年 1月 1日 20 17 年 7月 1日 re tu rn p re m iu m s of v al ue a nd g ro w th ba se d st ra te gi es time period pe1-pe10 e10(sa)-e1(sa) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 57 panel c: bivariate growth and value based portfolios (conditional ii sorted) portfolios e3pe1 e1pe3 e3pe1-e1pe3 mean 0.0239 0.0083 0.0156 t-value 2.8069 1.1516 4.6698 the above table shows mean excess returns for value and growth based bivariate portfolios. three types of bivariate sorted strategiesindependent, conditional i and conditional ii are used. in independent sorted strategy, securities are first ranked on the basis of p/e ratios into 3 equally weighted portfolios. then securities are independently sorted on the basis of earnings growth into 3 equally weighted portfolios. in conditional i (value-growth) strategy, securities are sorted in ascending order into 3 equally weighted portfolios on the basis of p/e ratios. within these groups, stocks are further sorted into 3 equally weighted portfolios on the basis of earnings growth. in the conditional ii (growth-value) strategy, the process is reversed. stocks are first sorted on the basis of earnings growth, then on the basis of p/e ratio. all returns are tested for significance at 5% level on two tailed basis. table 3: capital asset pricing model based results panel a: univariate sorted portfolios price-to-earnings based portfolios portfolios pe1 pe10 a 0.0208 -0.0053 t-value 2.6289 -0.9139 b 1.2713 1.3345 t-value 25.1149 35.9718 d -0.0091 0.0061 t-value -1.0236 0.9303 adjusted r-squared 0.8277 0.9080 earnings growth based portfolios asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 58 portfolios e1 e10 a 0.0057 0.0081 t-value 0.7739 1.2799 b 1.2162 1.3812 t-value 26.0631 34.2566 d -0.0036 0.0014 t-value -0.4426 0.1964 adjusted rsquared 0.8379 0.8994 panel b: bivariate sorted portfolios bivariate growth and value based portfolios (independent sorted) portfolios pe3e1 pe1e3 a -0.0041 0.0211 t-value -0.6866 2.9947 b 1.1146 1.2626 t-value 29.3876 28.0596 d 0.0089 -0.0033 t-value 1.3438 -0.4192 adjusted r-squared 0.8684 0.8571 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 59 bivariate growth and value based portfolios (conditional i sorted) portfolios pe3e1 pe1e3 a -0.0017 0.0206 t-value -0.2891 2.8542 b 1.1106 1.2759 t-value 29.8852 27.7003 d 0.0054 -0.0034 t-value 0.8331 -0.4238 adjusted r-squared 0.8719 0.8538 bivariate growth and value based portfolios (conditional ii sorted) portfolios e1pe3 e3pe1 a -9e-05 0.0213 t-value -0.0155 2.9463 b 1.0825 1.2699 t-value 29.2361 27.4818 d 0.0043 -0.0042 t-value 0.6557 -0.5108 adjusted r-squared 0.8669 0.8519 the above table reports capital asset pricing model based results for best performing portfolios (price-earnings based and simple average earnings growth based) as these are used further for bivariate formation. we regress excess portfolio returns on returns of market factor using capm specification. alpha (a) measures extra normal return. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 60 table 4. fama-french three factor model based results portfolios pe1 pe1e3 (independent sorted) pe1e3 (conditional i sorted) e3pe1 (conditional ii sorted) a 0.0099 0.0139 0.0131 0.0144 t-value 1.6907 2.7048 2.4952 2.6985 b 1.2211 1.2150 1.2271 1.2213 t-value 33.7753 38.5212 38.1123 37.3398 s 0.9863 0.9398 0.9630 0.9613 t-value 10.5485 11.5218 11.5657 11.3654 l 0.9437 0.6575 0.6827 0.6399 t-value 6.7635 5.4010 5.4943 5.0692 d -0.0082 -0.0065 -0.0065 -0.0079 t-value -1.2219 -1.1005 -1.0855 -1.2983 adjusted rsquared 0.9136 0.9309 0.9298 0.9271 the above table reports fama-french three factor model based results. we regress excess portfolio returns on returns of market factor and factor mimicking portfolios that proxy for size and value. alpha (a) measures extra normal return. we report results of only those portfolios that have unexplained returns by capital asset pricing model. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 61 table 5. fama-french five factor model based results portfolios pe1e3 (independent sorted) pe1e3 (conditional i sorted) e3pe1 (conditional ii sorted) a 0.0149 0.0142 0.0150 t-value 2.8467 2.6701 2.7696 b 1.2168 1.2294 1.2223 t-value 39.0004 38.5378 37.6704 s 0.9033 0.9314 0.9205 t-value 10.6396 10.7288 10.4255 l 0.6374 0.6623 0.6212 t-value 5.3080 5.3942 4.9748 r -0.1084 -0.1065 -0.1054 t-value -2.4957 -2.3959 -2.3320 i -0.0018 0.0103 -0.0169 t-value -0.0274 0.1506 -0.2455 d -0.0072 -0.0076 -0.0081 t-value -1.1700 -1.2075 -1.2761 adjusted rsquared 0.9332 0.9318 0.9289 the above table reports fama-french five factor model based results. we regress excess portfolio returns on returns of market factor and factor mimicking portfolios that proxy for size, value, profitability and investment rate. alpha (a) measures extra normal return. we report results of only those portfolios that have unexplained returns by fama-french three factor model. notes [1] some studies use book-to-market and earnings-to-price ratios instead of price-to-book and price-to-earnings ratios used by us. therefore, interpretation of our results is reversed. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 62 [2] forward trading in the indian securities market was banned from july 2001. thus, we have taken data after this period to maintain uniformity in prices throughout the time series. since we are working on calendar years, we have taken data from december 2001. 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(1999). stock market overreaction to bad news in good times: a rational expectations equilibrium model. review of financial studies, 12(5), 975-1007. https://doi.org/10.1093/rfs/12.5.975 microsoft word 15645-56209-1-sm(1)-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 186 the impact of bank's asset and liability structure on their profitability regardless of monetary policy and size: a panel analysis osama wagdi (corresponding author) financial institutions department, faculty of management modern university for technology and information, cairo, egypt e-mails: osamawagdi_ta@yahoo.com amira hasaneen accounting department, faculty of management, modern university for technology and information, cairo, egypt walid abouzeid business administration department international academy for engineering and media science iaems 6th of october city, egypt received: october 20, 2019 accepted: dec. 20, 2019 published: december 20, 2019 doi:10.5296/ajfa.v11i2.15645 url: https://doi.org/10.5296/ajfa.v11i2.15645 abstract the study examines the impact of bank's asset and liability structure on their profitability without monetary policy and size; the study utilizes panel data with cross section analysis on data of 10 unit banks according to the annual balance sheet & performance. the populations of the study are bank units listed on egyptian exchange (egx), the study’s data collection covered the duration from 2008 till 2016. eventually, the study ascertained that there is an impact of the bank's asset and liability structure on their profitability according to "return on asset" and "return on equity"; however, the interprets of bank's asset and liability structure asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 187 for "return on equity" more that to "return on asset". therefore, the banking units should work to maintain the optimal rate of the structure of the bank's assets and liabilities; this may be a potential research scope in banks. keywords: banking structure; banking profitability; egypt, panel analysis jel codes: g2; m2; m4 introduction two traditional roles that banks perform in the economy are to create liquidity and transform risk (bhattacharya & thakor, 1993; berger & bouwman, 2009). financial innovation over the last few decades has spurred value creation in the forms of risk sharing and risk management in the banking sector. allen and santomero (1997) and scholtens and van wensveen (2003) argue that these changes have increasingly shifted banks away from their traditional activities. instead, they suggest that banks are making increasing use of the financial markets to transfer, transform, and redistribute risk. liquidity plays an enormous role in financial crises. in the classic model of diamond and dybvig (1983), the illiquidity of bank assets coupled with the liquidity promised through bank liabilities leaves banks vulnerable to runs and financial crises. during the 2007 to 2009 financial crisis, the u.s. government provided several trillion dollars of reserves to the financial sector to forestall and ameliorate a liquidity crisis. the study finds that the bank's characteristics of the structure has been affected by these developments in the business environment, through the introduction of non-conventional financial instruments, which leads banks to become vulnerable to more risks in the light of targeting to maximize the return on assets.so; the performance of banking units is influenced by both liquidity levels as well as the ability to provide loans in addition to taking advantage of investment opportunities; all that is the bank's characteristics of the structure. literature review the unit banks play an important role in allocating countries ' economic resources by channeling depositors ' funds continuously to investors ' funds (ongore and kusa, 2013). the banks are able to provide all essential facilities for personal and corporate deposit and loan customers and provide credit, liquidity under the nation’s payments systems (handley schachler et al., 2007). furthermore, the banks are also the player to convey the central bank's active monetary policy, sharing their obligation to stabilize the economy and finance system. (siddiqui and shoaib, 2011). on the other side; the impact of the interest rate structure on net interest income dominate for bank unit. also its effect is stronger on bank's profit (borio et al 2017) according to monetary policy; there are several studies that have addressed the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 188 relationship between bank profitability and monetary policy (demertzis and wolff, 2016; borio et. al.m 2017; altavilla et al., 2018). kashyap and stein (2000) found a relationship between monetary policy changes and loan growth; according to the standard monetary transmission mechanisms prediction (see mishkin, 1995). den haan et al. (2007) showed that commercial lending increases while real estate loans decrease sharply after monetary policy tightening. many studies were conducted to determine the profitability in general and, in particular, the determinants of banks ' profitability. nevertheless, many of the studies in developed markets are carried out, emerging markets. (ayanda et al., 2013) according to ayanda et al. (2013) the term profitability refers to the ability of the business organization to maintain its profit year after year. profitability of a bank according to podder (2012) is the efficiency of a bank at generating earnings. profitability apart from ensuring the sustainability of the companies it has also wider implications of the economy as a whole. according to ayanda et al. (2013) generally profitability of organizations contributes to the economic development of the nation by way of providing additional employment and tax revenue to government. ayanda et al. (2013) further state that profitability contribute the income of the investors by having a higher dividend and thereby improve the standard of living of the people. on the other hand, however in relation to the banks poor profitability can lead to banking failure and crisis which have dire negative repercussions on the economic growth (ongore and kusa, 2013) and the wellbeing of the people. the soundness of the banking sector is highly important to the whole economy. (sufian and chong, 2008). in agreement katrodia (2012) posited that they are closely related. in contrast, the soundness of a bank depends largely on its financial performance, which shows a bank's strength and weakness (makkar and singh, 2013). one of the groups for bank's kpis are evaluated by the profitability. banks ultimately rely on their survival on their profitability. this is because the banks have to generate the revenue needed to offset the operating costs incurred (ongore and kusa, 2013). in fact, investors profit from their savings, which also encourages additional investment in units of bank (ongore and kusa, 2013). ultimately, banks continue to operate because they expect profit; therefore, the most rational decision to leave once that expectation is proven unattainable (ayanda et al., 2013). ongore and kusa (2013) asserted that gain is the commercial banks ' ultimate goal and that therefore, all the policies and activities planned and executed aim to achieve this essential purpose. however, ongore and kusa (2013) explained that this does not mean that commercial banks have no other aims. in reality it also has social and economic additional priorities. profitability determinants in the units of bank; kumbirai and webb (2010) at south african; a significant change in trend is noticed at the onset of the global financial crisis in 2007, reaching asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 189 its peak during 2008-2009. this resulted in falling profitability, low liquidity and deteriorating credit quality in the banking sector. still within africa, ayanda et al. (2013) results revealed in nigeria that contrary to views of some authors, bank size and cost efficiency did not significantly determine bank profitability. however, credit risk and capital adequacy have significant drivers which affected bank profitability both in the long run and short run respectively. but, while liquidity affected bank profitability in the short run, labor efficiency only affected bank profitability in the long run. in kenya , according to ongore and kusa (2013). the results highlighted that bank specific factors significantly affect the performance of commercial banks; except for liquidity variable. on the other hand, the overall impact of macroeconomic variables was not definitive; as for the islamic bank; bashir (2003) found high capital-to asset and loan-to-asset ratios lead to higher profitability. in addition, there is evidence that indicate that foreign-owned banks are likely to be profitable. on the other hand; haron (2004) found that internal factors like liquidity, gross investment, islamic securities fund and profit-sharing ratio ratios between the lender and the borrower are highly related to the rate of total income earned. external factors such as interest rates, market share and bank size are similarly affected. certain determinants like the funds invested in the current accounts, the share of income between banks and depositors and the supply of liquidity also play an important role in affecting the profitability of islamic banks. in india; makkar and singh (2013) the results revealed significant difference in the capital adequacy, asset quality and earning capacity of public and private sector banks. in contrast, they found no significant difference in the management, liquidity position and sensitivity to market risk of the two different banking groups. in addition to several studies that used the method of case study analysis of the profitability of banks: almazari (2012) ; alkhatib and harsheh (2012); alalaya and al khattab (2015); dehghan and shamsi (2015); ramlan and adnan (2016); dewi et. al. (2016); abbas et. al. (2019); setiawan et. al., (2019). according to generally, financial performance is measured by properly establishing the association between the items of the balance sheet and profit and loss account (makkar and singh, 2013). the process of establishing relevant association is referred as financial analysis which involves calculating of financial ratios, thus it also called ratio analysis. there are several ratios that can be computed in assessing profitability. according to ongore and kusa (2013) return on assets (roa) is one of the major ratios that indicates the profitability of a bank. it measures the ability of the bank management to generate income by utilizing company assets at their disposal (davydenko, 2011; ongore and kusa, 2013). in other words, the ratio indicates how much net income is generated on each unit of assets thus the higher the roa, the more the profitable the bank (kumbirai and webb, 2010; davydenko, 2011). the ratio shows how asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 190 efficiently the resources of the company are used to generate the income (ongore and kusa, 2013). the problem of roa is that it excludes off-balance sheet items of the bank creating a positive bias in evaluating bank performance (davydenko, 2011). another related ratio is called return on equity (roe) which measures how much profit a company earned compared to the total amount of shareholder equity invested or found on the balance sheet. it is the rate of return to shareholders or the percentage return on each unit of equity invested in the bank (kumbirai and webb, 2010). a business that has a high return on equity is more likely to be one that is capable of generating cash internally (ongore and kusa, 2013). kalluci (2011) it is better to look at both roa and roe, citing that even though they differ from each other and express different aspects, they both remain two main indicators of management efficiency towards generating income from the money invested by the shareholders and the total investments made in assets, as well. however, of the two, extant literature favors of roa to roe (davydenko, 2011). one of the stated reasons is that roe does not provide an indication for the bank’s financing through borrowing, whereas roa does (kalluci, 2011), thus roe gives limited insight about the bank profitability and performance (alkhatib and harsheh, 2012). the study therefore employs roa as the proxy of internal profitability. both roa and roe uses the accounting book values however they can be adjusted to take into account the market values through the calculation of earnings yield found by earnings per share divided by the share price. according to sangoi (2011) earnings yield is an important indicator of future profitability of the company per the assessment of the market. a high earnings yield indicates that the market is assuming a lower future growth in profits and a low ey indicates expectation by the market for high profit growth for an extended period of time. the study employs earnings yield as the proxy for external profitability. in relation to the determinants of profitability ayanda et al. (2013) categorized them into two namely; endogenous (internal) and exogenous (external) factors. according to ayanda et al. (2013) the key drivers of profitability that may be affected by the management decisions of the bank relate to internal factors. external factors, on the other hand, are beyond the control of a bank management which represents phenomena outside the bank's power. nevertheless, it is understood that the management must predict changes in the outside world and seek to position the organization to use the planned developments. the internal factors are the subject of this analysis ongore and kusa (2013) the internal factors include equity, deposit liability, loan portfolio size and composition, interest rate policy, efficiency of work and information technology system, risk level, quality management, bank size, ownership and so on. alkhatib and harsheh (2012) recognized also that some principal factors to improve asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 191 financial performance for financial institutions include the bank’s size, its assets management, leverage ratio, operational efficiency ratio, its portfolio composition, and credit risk. the main motivation behind this study is to examine the relationship between banks profitability and bank's characteristics of structure. an additional and interconnected motivation is to test whether shifting bank loan portfolios, as suggested by den haan, sumner, and yamashiro (2007), may help to explain some of the relationship between loan growth and changes in characteristics of structure without economic policy and effect of bank size. the analysis contributes to and extends the broad monetary literature by examining banks grouped by different types of profitability measurements to see if they behave differently under the same monetary policy in regard to their loan growth and the loan portfolio mix between real estate and commercial loans. to the best of my knowledge, such an analysis of a bank's loan portfolio mix; these estimations help to extend and fill in the gaps in the related literature conducted by den haan et al. (2007) and black and rosen (2007), which raised questions regarding how changes in monetary policy can cause banks to shift their loan portfolios. in contrast, the traditional monetary literature focuses on bank capital, deposits, and interest rates as important determinates of loan growth, with little attention given to the role of bank profitability. examples of such traditional studies include those by kashyap and stein (2000) and kishan and opiela (2000, 2006). hence; this study analyzes the impact of changes in bank's characteristics of the structure and the levels of deposit employment on the profitability of banks, which assists these institutions to achieve the highest profitability possible through risk-return trade off without monetary policy and effect of bank size. study problem there are many studies to indicate the impact of monetary policies on the profitability of banks, this fact now and not tested, now we are observing the impact of the characteristics of the structure of the bank on its profitability without the impact of monetary policy (interest rate / legal reserve rate); therefore the study addresses the following question: how does the bank's characteristics of its structure impacts on their profitability regardless of monetary policy and size? asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 192 study layout the general framework of the study can be viewed in the following figure; according to the this figure, economic policies affect the structure of bank assets and liabilities through monetary and fiscal policies. monetary policy is more influential in the banking sector compared to fiscal policy, which is reflected in five sets of indicators of the bank's asset and liability structure: "liquid assets to deposits ratio", "investments to deposits ratio", "loans to total assets ratio", "liquid assets to total assets ratio" and "financial investments to total assets ratio"-. this is reflected in the profitability indicators of banks such as "return on assets" and "return on equity" figure 1. study layout bank size monetary policies fiscal policy s tr uc tu re o f th e b an k' s as se ts a nd li ab ili tie s liquid assets to deposits ratio investments to deposits ratio loans to total assets ratio liquid assets to total assets ratio financial investments to total assets banking profitability roa, roe regulatory restrictions asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 193 study hypotheses according to study problem and their layout; the researcher can formulate the study hypothesis as follows: there is an impact of the bank's asset and liability structure on their profitability therefore, sub-hypotheses can be examined as follows (h1) there is an impact of the bank's asset and liability structure on their profitability according to "return on assets". (h2) there is an impact of the bank's asset and liability structure on their profitability according to "return on equity ". study methodology the study utilizes panel data with cross section analysis on data of 10 unit bank according to annual balance sheet and performance; the data covered the time period 2008-2016 society and sample the study sampled banks that are listed on egyptian exchange (egx) as they were palpable to the measurement profitability. there were eleven banks operating in egypt; table 1 listed the egyptian banks in the sample of the applied study. table 1. the egyptian banks in the sample of the applied study listing date reuters listed securities no. 29/11/1980 saib.ca societe arabe internationale de banque (saib) 1 13/09/1983 hdbk.ca housing & development bank 2 17/11/1983 egbe.ca egyptian gulf bank 3 12/09/1994 nbke.ca national bank of kuwaitegyptnbk 4 02/02/1995 comi.ca commercial international bank (egypt) 5 05/11/1995 unbe.ca union national bank egypt " unb-e 6 14/12/1995 expa.ca export development bank of egypt (edbe) 7 19/06/1996 adib.ca abu dhabi islamic bankegypt 8 03/07/1996 qnba.ca qatar national bank alahly 9 03/07/1996 cieb.ca credit agricole egypt 10 source: the egyptian exchange variables of study data extracted from financial reporting in the study for dependent and independent variables. the following table illustrates different variables that will be used in the analysis. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 194 table 2. variables of study no. variables description 1 y1 return on assets 2 y2 return on equity 3 x1 liquid assets to deposits ratio 4 x2 investments to deposits ratio 5 x3 loans to total assets ratio 6 x4 liquid assets to total assets ratio 7 x5 financial investments to total assets ratio data description at individual bank units the participation of bank units in egyptian exchange is relatively a modest one, the following bank's characteristics of the structure and the profit of bank for 10 units in the study sample. a. societe arabe internationale de banque (saib) the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 2. the bank's structure and profitability indicators for source: authors calculations based on data extracted from financial reports of banking units. according to the previous figure, the study finds that the highest rate of return on assets is (1.45%) in 2010, but the highest rate of return on equity is (14.39%) in 2016. b. housing & development bank the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 100.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 195 figure 3. the bank's structure and profitability indicators for housing & development bank source: authors calculations based on data extracted from financial reports of banking units. according to the previous figure, the study observes that the highest rate of return on assets is (2.30%) in 2009, but the highest rate of return on equity is (22.53%) in 2009. c. egyptian gulf bank the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 4. the bank's structure and profitability indicators for egyptian gulf bank source: authors calculations based on data extracted from financial reports of banking units. 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 196 according to the previous figure, the study observes that the highest rate of return on assets is (2.44) in 2011, but the highest rate of return on equity is (23.42) in 2015. d. national bank of kuwaitegyptnbk the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 5. the bank's structure and profitability indicators for national bank of kuwait source: authors calculations based on data extracted from financial reports of banking units. according to the previous figure, the study observes that the highest rate of return on assets is (2.76%) in 2008, but the highest rate of return on equity is (24.83%) in 2011. e. commercial international bank (egypt) the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 6. the bank's structure and profitability indicators for commercial international bank (egypt) source: authors calculations based on data extracted from financial reports of banking units. 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 197 according to the previous figure, the study finds that the highest rate of return on assets is (2.68%) in 2011, but the highest rate of return on equity is (32.97%) in 2008 f. union national bank egypt " unb-e the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 7. the bank's structure and profitability indicators for source: authors calculations based on data extracted from financial reports of banking units. according to the previous figure, the study finds that the highest rate of return on assets is (1.5) in 2008, but the highest rate of return on equity is (9.04) in 2008. g. export development bank of egypt (edbe) the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 8. the bank's structure and profitability indicators for export development bank of egypt source: authors calculations based on data extracted from financial reports of banking units. 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 198 according to the previous figure, the study finds that the highest rate of return on assets is (2%) in 2008, but the highest rate of return on equity is (17.37%) in 2008. h. abu dhabi islamic bankegypt the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 9. the bank's structure and profitability indicators for source: authors calculations based on data extracted from financial reports of banking units. according to the previous figure, the study finds that the highest rate of return on assets is (1.93) in 2008, but the highest rate of return on equity is (17.35% 2008) in i. qatar national bank alahly the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 10. the bank's structure and profitability indicators for source: authors calculations based on data extracted from financial reports of banking units 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 199 according to the previous figure, the study finds that the highest rate of return on assets is (2.65%) in 2016, but the highest rate of return on equity is (22.45%) in 2009 j. credit agricole egypt the following figure illustrates the historical evolution of the bank's structure and profitability indicators during the period from 2008 to 2016 figure 11. the bank's structure and profitability indicators for source: authors calculations based on data extracted from financial reports of banking units. according to the previous figure, the study finds that the highest rate of return on assets is (3.24%) in 2015, but the highest rate of return on equity is (29.55%) in 2015. 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 200820092010201120122013201420152016 x1 x2 x3 x4 x5 y1 y2 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 200 examining the impact of the bank's asset and liability structure on banking profitability a. roa table 3. examining h1 model 2: wls, using 90 observations included 10 cross-sectional units dependent variable: y1 weights based on per-unit error variances coefficient std. error t-ratio p-value constant −0.117071 0.0719871 −1.626 0.1076 x1 0.0327687 0.0268574 1.220 0.2258 x2 −0.0350306 0.0208117 −1.683 0.0960 * x3 0.144622 0.0716657 2.018 0.0468 ** x4 0.0882186 0.0683934 1.290 0.2006 x5 0.167670 0.0861432 1.946 0.0549 * statistics based on the weighted data: sum squared residual 89.62471 s.e. of regression 1.032938 r-squared 0.116962 adjusted r-squared 0.064400 f(5, 84) 2.225225 p-value(f) 0.059188 log-likelihood −127.5164 akaike criterion 267.0329 schwarz criterion 282.0317 hannan-quinn 273.0813 statistics based on the original data: mean dependent variable 0.016667 s.d. dependent variable 0.007495 sum squared residual 0.004399 s.e. of regression 0.007237 source: gnu regression, econometrics and time-series library output. the previous statistical results show that there impact of the bank's asset and liability structure on banking profitability according to roa, and loans to total assets ratio; liquid assets to total assets ratio and financial investments to total assets ratio is significant at 0.1; 0.05 and 0.06 levels. according to adjusted r-squared; it interprets (6.44%) of a banking profitability according to roa. therefore, the study ascertained that there is an impact of the bank's asset and liability structure on their profitability according to "return on assets". asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 201 b. roe table 3. examining h2 model 4: wls, using 90 observations included 10 cross-sectional units dependent variable: y2 weights based on per-unit error variances coefficient std. error t-ratio p-value constant −1.49291 0.585038 −2.552 0.0125 ** x1 0.0745095 0.231523 0.3218 0.7484 x2 −0.360735 0.179255 −2.012 0.0474 ** x3 1.71765 0.581691 2.953 0.0041 *** x4 1.52448 0.540484 2.821 0.0060 *** x5 2.03829 0.722426 2.821 0.0060 *** statistics based on the weighted data: sum squared residual 89.64545 s.e. of regression 1.033057 r-squared 0.183525 adjusted r-squared 0.134925 f(5, 84) 3.776259 p-value(f) 0.003917 log-likelihood −127.5268 akaike criterion 267.0537 schwarz criterion 282.0525 hannan-quinn 273.1021 statistics based on the original data: mean dependent variable 0.153222 s.d. dependent variable 0.068200 sum squared residual 0.352671 s.e. of regression 0.064796 source: gnu regression, econometrics and time-series library output. the previous statistical results indicate that the impact of the bank's asset and liability structure on banking profitability according to roe, and investments to deposits ratio; loans to total assets ratio; liquid assets to total assets ratio and financial investments to total assets ratio is significant at 0.05; 0.01; 0.01 and 0.01 levels. according to adjusted r-squared; it interprets (13.49%) of a banking profitability according to roe. hence, the study found that there is an impact of the bank's asset and liability structure on their profitability according to "return on equity ". discussion and conclusions the study confirmed that there is an impact of the bank's asset and liability structure on their profitability according to "return on asset" and "return on equity"; but the interprets of bank's asset and liability structure for "return on equity" are more that to "return on asset". through inferential analysis, the study substantiated that both investments to deposits ratio; loans to total assets ratio; liquid assets to total assets ratio and financial investments to total assets ratio has impact on bank's profitability according to " return on equity ", these are significant at 0.05; 0.01; 0.01 and 0.01 levels. in addition to loans to total assets ratio; liquid asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 202 assets to total assets ratio and financial investments to total assets ratio has an impact on bank's profitability according to "return on asset"; these are significant at 0.1; 0.05 and 0.06 levels. through the above, the study reveals that the characteristics of the structure of assets and liabilities of the bank act as intermediate variables to convey the impact of economic policies; especially monetary policies (see: hancock, 1985; aharony et al., 1986; udeh, 2015; alalaya and al khattab, 2015; alessandri and nelson, 2015; djalilov and piesse, 2016; borio et al., 2017; altavilla et. al., 2018) ; and the impact of the size of the bank on profitability at different levels (aladwan, 2015; menicucci and paolucci, 2015), in addition to the impact of development of regulatory restrictions from the central bank (tran et al., 2016; helmy and wagdi, 2019). 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(2015). impact of monetary policy instruments on profitability of commercial banks in nigeria: zenith bank experience. research journal of finance and accounting, 6(10). microsoft word 15328-55162-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 66 corporate governance, performance and efficiency: case of the tunisian listed firms wided khiari dept. of finance, university of tunis 41 avenue de la liberté, bouchoucha, bardo 2000, tunis, tunisia tel: 21-69-858-6639 e-mail: khiariwided@yahoo.fr received: august 5, 2019 accepted: oct. 28, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15328 url: https://doi.org/10.5296/ajfa.v11i2.15328 abstract the purpose of this article is to develop a synthetic index to evaluate the firms' practices with regard to corporate governance and this based on the stochastic frontier methodology, and stalled on the level of performance achieved by tunisian listed firms. the sample used makes it possible to determine the effect of the corporate governance characteristics on performance as well as the effect of the firm-specific features on the level of efficiency. the profile study of calculated efficiency indices shows that tunisian firms in general and, especially, those belonging to the financial sector (represented mainly by banks) suffer from a problem of governance. keywords: corporate governance, efficiency, index, performance, governance mechanisms, stochastic frontier, tunisian listed companies… jel classification: g34, c01, c13 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 67 1. introduction many striking examples of scandals such as enron and worldcom in the united states, marconi in the united kingdom and others around the world were caused or worsened by weak governance; this attracted the attention of the financial community as to the accuracy of the simple use of the firm’s profitability or growth prospectuses in the evaluation of the firm. several studies have shaped measures of corporate governance, and studied the impact of these measures on the performance of firms (gompers et al. 2003; bebchuk et al. 2004; core et al. 2006; gillan, hartzell and starks, 2003; samontaray 2010; varshney et al. (2012), zitouni, 2016 and kaur and vij, 2018). the corporate governance measure of gompers et al. (2003) is a governance index (g-index) composed of 24 distinct corporate governance provisions developed by the investors of the investor responsibility research center (irrc). according to bebchuk et al. (2004) some of these provisions may be more interesting than others and some of them may be correlated. therefore, they built an index composed of six provisions. however, the majority of these studies face certain conceptual limitations. indeed, the indices considered assume that governance is a linear function of the chosen mechanisms and that they are equal-weighted, which is not the case. in fact, morck et al. (1988) have shown that performance is a nonlinear function of managerial ownership. in addition, some research has focused on a particular aspect of governance in the development of governance measures such as the independence of the board (hermalin and weisbach (1998, 2003)), the ownership of directors (bhagat, carey and elson (1999)) and duality (brickley, coles and jarrell (1997)). furthermore, some authors have attempted to synthesize governance practices based on a very specific sample, such as black (2001) in russia; black et al. (2006) in korea (in the context of emerging countries) and gompers et al. (2003), core et al. (2006), and gillan, hartzell and starks (2003) in the american context. hence, what motivates us to embark on this path of research lies first and foremost in the originality of the theme that breaks with the classic framework of the relationship between governance and performance. then, there is a challenge to try to identify the scanty character of previous research in this field, including the small number of governance mechanisms studied. finally, the existence of a theoretical controversy over quite a large number of points leads us to attempt an empirical analysis likely to better perceive the various approaches. thus, in this work, we try to contribute to the literature that deals with the relationship between corporate governance and performance by taking into account the interaction between the various mechanisms of governance as well as the criticisms addressed to the level of quantification of governance score using an efficiency score-based approach, the stochastic frontier approach, in order to calculate indices reflecting the (in) efficiency of governance. in addition, the choice of tunisian companies is in itself is a contribution as there is not yet an existing governance measures for listed tunisian companies (khiari and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 68 lajmi, 2018). 2. corporate governance and efficiency: a literature review the concept of efficiency emphasizes the quality of the organization and strategic decisions in the markets. it measures not only the financial performance but also the productive performance. this approach to efficiency focuses attention on the quality of internal management and the quality of strategic choices. it can be considered as measuring managerial efficiency. it is also a useful tool for benchmarking, since the determination of the boundary makes it possible to identify efficient firms that have "best practices" and can therefore serve as a reference for others. the article by leibenstein (1966) is certainly one of the classic works which, in conceptualizing the notion of x-efficiency, spoke primarily with the language of corporate governance. theories on corporate governance based on efficiency paradigm use a specific model of value creation (bouaicha, 2015) which allows organization to achieve its objective and reach its survival. thus, corporate governance characteristics allow firms to improve their efficiency by creating maximum value. within this framework, zelenyuk and zheka (2006) tried to empirically study the efficiency of firms in an explicit way in the context of corporate governance. they show the existence of a positive relationship between the quality of the corporate governance of the firm and its level of relative efficiency. according to them, this result provides empirical support to liebenstein's idea that the major source of efficiency is the motivation at each level of management / ownership. this also supports the idea of stulz (1998) which says that the establishment and strengthening of corporate governance principles should significantly improve individual businesses and the entire economy, at least because of the efficiency of the resources used. it also result in a negative relationship between the shares held by the state and the efficiency level of the firm, which converges with previous studies (brown and earle, 2000, andreeva, 2003, and melnychenko, 2002). in the same context, el mir and khanchel (2004) tried to identify efficient governance that is apprehended by the ownership structure and the effectiveness of the control exercised by the board of directors. based on a sample of 331 us listed firms, for the period 1994-2001, they synthesized governance practices by an index calculated using a non-parametric method, the data wrapping method, which takes into account the nature of the relationship (linear or not, endogenous or exogenous) between the inputs (the control system) and the outputs (the performance). the results they have achieved show that the majority of companies are moderately efficient. also, khiari et al. (2007) attempted to investigate the association between performance and the specific characteristics of a sample of american companies. and in order to achieve that asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 69 they used a governance efficiency index, calculated using the stochastic frontier method. the purpose of using a latent class structure that is not observable in the sample specification is to establish several levels of efficiency for firms according to their intrinsic characteristics. this structure allowed discerning two groups of companies. the results obtained show that the probability of being in the best performing group is even more important than the stock market return, the size of the company, and a high roe, whereas a high level of debt seems to increase the chance of being in the lowest performing group. the calculation of the governance indices also shows a significant increase in the index of (in) efficiency over the years. this increase occurred between 1999 and 2001 and could be explained by the very dramatic falls of large american companies. 3. research methodology the objective of this work is to develop a synthetic index that evaluates the firms’ practices with regard to the corporate governance. the creation of the model takes, as a starting point, a basic idea that there is a real willingness on the part of firms to comply with international standards of governance and to combine, therefore, the best practices in governance in order to achieve a high level of performance. the chosen approach is econometric and is based on the stochastic efficiency frontier method. the proposed governance index is presented as an efficiency score that reflects, for each firm, the distance that separates it from an efficiency frontier expressing "best practices" in terms of corporate governance. this method makes it possible to determine the possible ways to access "best practices" for n decision-making units (companies), by varying the inputs (the governance variables) or by varying the outputs (the performance apprehended by tobin's q) or by combining these two ways. however, the theoretical and empirical literature shows a tendency towards the decomposition of the indices of governance into sub-indices. given that the governance mechanisms we use are internal and related solely to the features of the board of directors and the ownership structure, we will create two sub-indices reflecting respectively the efficiency of the board of directors and the efficiency of the ownership structure. the same principle is applied: for each index, it is a question of how to regress the variables related to performance, and how to draw an index of efficiency which translates, for each firm, the distance separating it from applying the best practices on the board of directors and the ownership structure. 3.1. sample and variables presentation the study covers 46 tunisian companies listed on the tunis stock exchange and over a period of 15 years from 1996 to 2010, which means 690 observations. all data was collected from the annual reports present on the following sites: www.bvmt.com.tn, and www.tustesx.com.tn. most of the companies in the sample belong to the financial sector (52.19%) while the rest are industrial companies (26.08%) or services (21.73%). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 70 governance is captured by a number of ownership structure and board variables (as shown in table 1). whereas the performance is apprehended by the logarithm of tobin's q, this latter is measured by the ratio between market capitalization and total assets. table 1. definition and measurement of governance variables variables definitions and measures board of directors bosize board size = number of directors on the board outdir percentage of outsider external directors on the board = number of outside directors / total number of directors on the board dual a dummy variable that takes the value 1 if the manager is a member of the board and 0 otherwise. dirmand directors' term of office: number of years as a member of the board of directors manmand manager's mandate: number of directors' mandates. ceoturn ceo turover: a dummy variable that takes the value 1 if the ceo has been replaced and 0 otherwise ownership structure famown percentage held by families owncon the percentage of capital held by the majority shareholders (greater than 5%) statown the percentage of capital held by the state instown the percentage held by institutional investors dirown the percentage held by the directors manown managerial ownership: the percentage held by the manager audit committee audit a dummy variable that takes the value 1 if there is an audit committee and 0 otherwise. big4 a dummy variable that takes the value 1 if the audit firm is big4 and 0 otherwise. 3.2. econometric model also known as the "compound error model", the stochastic frontier approach breaks down the error term of the studied function into two parts. the first represents random effects and measurement errors and the second represents the degree of inefficiency. the stochastic frontier approach is characterized by taking into account a single output (production, cost, profit) and multiple inputs, and it is also known especially by the hypothesis of the existence of special relations that connect the output to the inputs. the goal is to derive a measure of performance, called "efficiency". the model of the stochastic frontier can be written as follows:   ftftft ,t,xfy  with ftftft uv  and )],m(n[u 2 uftft  and ),0(nv 2 vft  asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 71 f(.) is the theoretical function of production or cost, yft is the output of the firm f at the date t, xft is the level of the input j and β is the vector of the parameters to be estimated. in our case, yft is the level of the company's performance f at the date t measured by the logarithm of the tobin’q. xft is the vector of the explanatory variables associating respectively the characteristics of the board of directors and the structure of ownership of the company f during the year t; the vft are the random error terms which are independently and identically distributed and uncorrelated with the regression coefficients. vft mainly captures measurement errors and shocks with a white noise character. uft are non-negative random variables associated with the (in) efficiency of the firm. in the second part of the model, the term (in) efficiency is an explicit function of the k explanatory variables, zk,ft, is associated with the specific characteristics of the firms present in our study. in our case, the specific characteristics of the selected firms are presented in table 2. table 2. definitions and measurements of control variables variables measures period the period between the ipo date of the company and the date of the study. sector the business sector to which the company belongs. this variable is set to 1 if the business belongs to the financial sector and 0 otherwise age age of the company roe it is the ratio "return on equity", it measures the ratio between the net profit and the equity of the company indebt the level of indebtedness of the company measured by the logarithm of total debts size it is the size of the firm measured by the logarithm of total assets uft are independently but not identically distributed: ),z(nu m 1k 2 uft,kk0ft    the stochastic frontier model is often specified in log, the (in) efficiency term can be interpreted as the deviation from the observed performance and the estimated performance. the firm's performance frontier is: ftft '* ft vxy  our focus is on measuring the efficiency or inefficiency of the firm. thus, the efficiency of the firm i at the date t is )uexp()yexp(/)yexp( ftft * ft  with ftftft ' ft uvxy  . it is often more convincing to analyze inefficiency, 1-exp(-uft). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 72 the most common assumption in the literature is that uft follow a semi-normal distribution (absolute value of a normal distribution (0, u 2)). vft  [n (0, v 2)] uft = uit or uit  [n (0, u 2)]. in order to estimate the different parameters of the model, we write the likelihood function in the following way:                                                f 1f f 1f f 1f 2 f ' f 2 f ' f 2 f ' f f ' f 2 f ' f f 1f f 1f f ' f f 1f f 2 f 2 )1(2 1 ])1(1[)1(2 1 ])1(1[)1( 1ln 2 1 lnf)1ln( 2 1 )1ln()1t 2 1 ))ln()2(ln(t 2 1 ),,,(lln where 2 = u 2 + v 2,  = u 2/2, uft = exp (-(t – t)), and ft = uft vft = ln cft ’xft. the estimated maximum likelihood of this function generates the estimate of all parameters of the frontier function as well as 2,  and . in this model, the effect of firm inefficiency f at time t, uft, is defined as the product of the exponential function of time, exp (-(t – t)), involving an unknown parameter, , which informs about the efficiency feature and the non-negative random variable uft. if  is positive then -(t – t) = (t – t) is positive for t inferior to t and consequently exp (-(t – t)) > 1 which means that the (in)efficiency decreases with time. if  is negative then -(t – t) < 0 and consequently the (in)efficiency evolves over time. a value of  = 0 indicates that the deviations around the frontier are entirely due to white noise, while a value equal to unity indicates that all deviations are due to (in) efficiency. knowing that  =u 2 / u 2 + v 2 is between 0 and 1. once the likelihood function is estimated, the residual term can be derived by substituting the vector of the estimated parameters  of the cost function. battese and coelli (1992) show that efficiency is given by:                  2* f 2 ft * fft* f * f * fft * f * f fft 2 1 exp / / uexpeeffx with 2 uf ' f 2 v 2 uf ' f* f    2 uf ' f 2 v 2 u 2 v* f 2    an efficiency value x equal to unity indicates the efficiency of the firm. thus, the closer you get to the unit, the more the company in question is efficient. however, a value close to zero indicates low governance efficiency. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 73 4. empirical results 4.1. estimation of the efficiency frontier related to the characteristics of the board of directors the results of the estimation based on the maximum likelihood method related to the board characteristics and control variables are presented in the following table: table 3. results of the estimation of the efficiency frontier related to the characteristics of the board of directors variables estimations std. err. prob 2 -0.1423 0.0201 0.0000  -3.6795 0.9238 0.0007 constante -1.9987 0.7128 0.0057 outdir -0.2045 0.1032 0.0943 bosize -0.2546 0.2673 0.4768 audit -0.2537 0.1137 0.0176 big4 0.3112 0.0764 0.0076 dual -0.0653 0.1121 0.4963 dirmand -0.1132 0.0327 0.2765 manmand 0.0187 0.0099 0.0000 ceoturn -0.4178 0.0895 0.0000  0.4256 0.1620 0.0000 roa 0.7467 0.3701 0.0005 size 0.1798 0.0263 0.0000 indebt -0.5457 0.1467 0.0006 industrial 0.5231 0.3762 0.0520 service 0.6342 0.2991 0.0310 results show a negative but insignificant effect of the size of the board and the combination of the functions of chairman of the board and chief executive officer on the performance. regarding the presence of outsiders in the board, the table above shows a negative and significant relationship between this variable and performance. this result can be explained by the fact that a board of directors dominated by external members can harm shareholders' interests because they place too much emphasis on their supervisory role rather than on their role as advisers. similarly, the results show a negative and significant effect of manager turnover on performance. this implies that the change of the manager is likely to lower the performance. indeed, several authors show that the more the leader is rooted, the more he will tend to increase the value of the company since he is concerned and affected by any trouble that may harm the interests of the company, so he would be motivated to favor the company's long-term performance, which supports the convergence of interest argument. in addition, the company could benefit from the knowledge and experience of executives who have spent several years in their department. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 74 however, we note a positive effect on the performance when the external audit is a member to one of the large firms as well as the number of mandates of the manager. this result finds its explanation in the rooting thesis. this can be associated with the fact that the longer the period the audit is in the company, the more it become experienced and knowledgeable of the specificities of the company, which facilitates decision-making and will have a positive effect on performance. on the other hand, the auditor is, because of his expertise, a trusted provider. he ensures the statutory audit of the accounts in the interest of the shareholders. throughout his mission, he assesses the internal control procedures and rules, as well as the degree of compliance of the financial statements prepared with the generally recognized accounting principles. his role aims to reduce the asymmetry of information due to the opportunistic behavior of managers. thus, strengthening the quality of the audit allows at best the reduction of asymmetric information. owners as well as managers have an interest in adopting an audit deemed more efficient. it allows the shareholders to value their investment by better controlling the wealth of the firm and the managers to report the quality of their management. 4.2. estimation of the efficiency frontier related to the ownership structure variables the results of the maximum likelihood estimation for the ownership structure are presented in the following table: table 4. results of the estimation of the efficiency frontier related to the ownership structure variables variables estimations std. err. prob 2 0.1978 0.0147 0.0000  -3.0098 0.9879 0.0004 constante -2.7865 0.3234 0.0000 owncon -0.0960 0.1755 0.5298 statown -1.3426 0.5678 0.0125 instown -0.1332 0.3122 0.0085 admown 1.3725 0.4761 0.0022 famiown 0.0184 0.2067 0.7398 manown -1.8964 1.7956 0.8561  0.0174 0.0039 0.0000 roa 0.8722 0.3351 0.0001 size 0.1736 0.0365 0.0000 indebt -0.7360 0.1728 0.0100 industrial 0.5427 0.1735 0.0216 service 0.6013 0.3421 0.0235 according to these results, the company's performance reacts negatively to the increase in the concentration of the ownership since the coefficient obtained is negative but not significant, implying neutrality in the concentration / performance relationship. institutional ownership results show a negative and significant relationship between this variable and performance. indeed, various studies have examined the impact of institutional asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 75 investor presence on performance, and have led to the fact that the presence of institutional investors can lead to an improvement in performance. this result was explained by the fact that institutional investors are best able to encourage managers to increase the development of new products through commitment to research and development expenses. also, the training of large institutional investors could nevertheless strengthen corporate governance, because they have both the will and the ability to monitor the performance of a company and a significant power to take action in this regard. if institutional investors influence managers' decisions in order to maximize the return on their investments, the value of the business, agency costs decrease and performance improves. with respect to state-owned property, the results we have achieved indicate that the lower the state's ownership interests in the property, the lower the performance. this result shows that the presence of the state is likely to affect performance. regarding the managerial ownership, we note a positive and significant effect of this variable on performance. in fact, according to some authors, the proportion of capital held by the directors appears to be a determining factor in the firm's performance. this result can be explained by the fact that the percentage of capital held by the directors is supposed to favorably influence the control of the directors by encouraging the members of the board to defend their interests more harshly. as a result, the greater the share of capital held by directors, the less bad management is allowed. 4.3. the influence of the firm-specific characteristics on efficiency the model used has the advantage of determining the effect of firm-specific characteristics on the level of efficiency. this work will enable us to establish a link between the governance related to the ownership structure, the board of directors and some observable characteristics specific to the firms as this relation was discussed in many research works related to the relation between firms characteristics and performance (arora and bhandari, 2017), notably the size, the level of indebtedness, the return on the assets (roa) and the business sector. the results obtained show a globally significant impact of all the control variables used on the level of efficiency of the ownership structure and the board of directors. this shows that firm-specific characteristics are important determinants of the efficiency of the governance mechanisms of tunisian listed companies. the results in tables 3 and 4 show a similarity in the relationship between a firm-specific characteristics and efficiency indices. we note a positive effect of the size, the affiliation to the sector of industry and service and the asset profitability on the level of efficiency of the firms in the sample. this indicates that the governance system is efficient in large companies. indeed, they have the means and the capacity to invest in more efficient and sophisticated governance systems. they are also motivated to do so because they want to maintain their competitive position and reputation on the stock market. these results are consistent with those of black et al. (2006) who affirm the existence of a positive relationship between governance and the size of the firm. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 76 however, we note a negative effect of indebtedness on efficiency. in other words, inefficiency arises both from a failure in the ownership structure and at the level of the board structure. this result shows that the most indebted companies suffer from an inefficient governance system. further, these results show that in the financial sector (represented mainly by the banks), the governance system is inefficient, which reflects the reality of tunisian companies in this sector. indeed, the specificity of the sector strongly influences the governance system of companies in this field. this sector is more complex as it includes several partners with divergent interests. it is characterized by external mechanisms with controversial effects and a discipline exerted by ineffective or limited markets. 4.4. characteristics of efficiency indices the goal of this section is to study the profile of calculated efficiency indices. figure 1. classification of companies by means of the averages of efficiency indices this figure shows the distribution of tunisian listed companies based on average indices reflecting the efficiency of corporate governance. the results obtained show that the majority of tunisian listed companies are relatively characterized by a poor efficiency in terms of governance practices related to the ownership structure and the board of directors. indeed, this theme is not yet very developed in tunisia, and tunisian companies do not have a code of good governance practices that they are supposed to follow and apply the recommendations. it was only in 2008 that tunisia put in place a code expressing best practices in governance. however, the rules in this report are a bit general and their bo rd _i nd ex ownership_index asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 77 application is not forced. nevertheless, only five companies are, on average, efficient in terms of governance (sotrapil, sfbt, siame, air liquide and spdit sicaf), which corresponds to 10.87% of the companies in the sample. indeed, we notice that in class 3 (poor efficiency) the majority of companies belong to the financial sector. similarly, class 1 (good efficiency) shows that the majority of companies with good governance practices are non-financial enterprises, which shows that tunisian firms in general and particularly those in the financial sector (represented mainly by the banks) suffer from a problem of governance. indeed, banks are more opaque than other firms, (furfine, 2001). in other words, they present problems of transparency towards all the constituents of their internal and external environments. they are characterized by distinct and accentuated agency problems compared to other firms, which are generated mainly by the information asymmetry existing between all the players in the banking sector (llewellyn, 2001). this information asymmetry affects the relations between the directors and the members of the bank's board. it also affects the relations between these "interns" and the shareholders. 5. conclusion this work aims to develop a synthetic index of corporate governance practices, based on the stochastic frontier method, which is determined by the level of performance achieved by different firms. in addition, the adopted model has the advantage of evaluating the quality of the governance practices of each firm, and offering benchmarking tools since the determination of the frontier makes it possible to identify the efficient firms that have the ‘best practices’, and can therefore serve as a reference for others. it also enables businesses to identify ways to access "best practices", which are a guarantee of better performance. on the other hand, the model makes it possible to determine the effect of corporate governance characteristics on performance as well as the effect of firm-specific characteristics on efficiency indices. the results obtained show a globally significant impact of firm-specific characteristics on the level of efficiency of the ownership structure and the board of directors. this shows that firm-specific characteristics are important determinants of the efficiency of the governance mechanisms of tunisian listed companies. moreover, the results obtained show that in the financial sector (represented mainly by banks), the governance system is inefficient, which absolutely reflects the reality of tunisian companies in this sector. nonetheless, it is important to mention that there are some caveats that should be considered. the sample used that covers only the pre-revolution period of the 14th of january 2011 makes our results less precise and cannot be generalized to the actual situation of the tunisian firms. in fact, after the revolution of january 14, 2011, tunisians have lived a period of insecurity through its struggle with terrorism and strikes which deepened instability and delayed economic recovery. tunisia's economic difficulties become even more important with the debt crisis of its main economic partner, namely the european union. moreover, the former regime and its allies engaged in conspicuous and predatory corruption that undermined asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 78 investment and entrepreneurial incentives and sowed indignation over the lack of free and fair competition in the market place. for instance, poor governance of the banking sector has led to deep dysfunctions which made the banking system inefficient, highly vulnerable, characterized by low profitability, and especially unable to optimally allocate resources toward the productive activities resulting in weak economic performance and insufficient jobs creation. we think that a comparison pre 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(2006). index approach of corporate governance. journal of business studies quarterly, 7(3), 97-109. microsoft word 18977-writer2-new m receive doi:10.5 abstra as the (ifr) h measur financ unive unive 2acco unive am ed: march 1 5296/ajfa.v ct world econ as evolved i ring qu cial re faculty ersiti malay n faculty ersiti malay ounting res 40 azma ersiti teknol mc college 1, 2024 a 16i1.18977 nomy under into an imp ualitativ eporting math of business ysia sabah, nelson laju of business ysia sabah, search instit 0450, shah a mohd no an hashim i logi malays me e sabah, 884 accepted: a url: ht rgoes a rapi ortant platfo 1 ve char g: evid thew kevin s, economic 88400, kot uni (correspo s, economic 88400, kot & tute (ari), u alam, selan oor azli bin internationa sia, 81310, j elissa della 400 kota k april 16, 202 https://doi.or id digital tr form for the asian racteris ence fr bosi cs and acco ta kinabalu, onding autho cs and acco ta kinabalu, universiti t ngor, malay n ali khan al business s johor bahru joy kinabalu, sa 24 pub rg/10.5296/ ansformatio disseminati n journal of f tics of rom ma ountancy, , sabah, ma or) ountancy , sabah, ma teknologi m ysia school u, johor, ma abah, malay blished: jun ajfa.v16i1.1 on, internet ion of inform finance & ac issn 19 2024, vol. 1 ajfa.macro interne alaysia alaysia alaysia mara alaysia ysia ne 1, 2024 18977 financial r mation to in ccounting 946-052x 16, no. 1 think.org/ et eporting nvestors. it has al the abse varying ifr's qu adoptin scoring and enh concep standar select t bursa m extracte listed in financia absence designin compan measuri characte bodies informa keywo characte lso been a f ence of stric g across liste ualitative ch ng 34 constr scale anch hance the q ptual frame rds board ( the compan malaysia's ed from cor n the main al reporting e of strict i ng their if ny's reputat ing mecha eristics of i to impleme ation's usefu rds: corpo eristics focal topic o ct laws gove ed compani haracteristic ructed index ored from " qualitative c ework for (masb) in nies from 11 main mark rporate web n market of framework ifr regulat r disclosur ion. this r anism that ifr. it ackn ent account ulness in the orate inter of discussio erning ifr ies. this stu cs for comp x items bas "very poor" characteristi financial n 2018. non 1 relevant i et. annual bsites for 20 f bursa ma k, notably ti tions, mana re in a way esearch enr can gauge nowledges t ting reforms e industrial rnet repor 2 on among pr practices, r udy aims to panies listed ed on prior (1) to "exc ics of ifr, reporting" n-probabilit industries, reports an 018. finding alaysia have imeliness, w agers may y that serve riches the b e the exte the importa s and the b revolution rting, inte asian ractitioners esulting in d o assess the d on bursa r literature a cellence" (5 which is a " issued by ty purposiv consisting o d corporate gs suggest t e yet to ful which requir also be fre es their per body of lite ent of acco ance of coll best ifr go n era. 4.0. ernet finan n journal of f and researc disclosures extent of c malaysia. t and the use ) to measur also in line y the mala ve sampling of 160 liste e governanc that most co lly comply res urgent im ee to act op rsonal inter erature on i ordance wi lective effor overnance p ncial repo finance & ac issn 19 2024, vol. 1 ajfa.macro chers, mainl of financia compliance this study i of a 5-poin re the funda with the " aysian acc g was empl ed compani ce statemen orporations with the m mprovemen opportunistic rests as wel ifr and de ith the qu orts from re practices to orting, qu ccounting 946-052x 16, no. 1 think.org/ ly due to l reports with the involves nt likert amentals "revised counting loyed to ies from nts were that are masb’s nt. in the cally by ll as the elivers a ualitative gulatory harness ualitative 1. intro the glo technol artificia advance financia delibera deficien practice obtainin 2014; s that are al. (201 the disc in an e address of nonreportin for user entities entities frequen 2016 by their inv that ifr howeve decision can ev characte measuri indirect manage are incl disclosu crucial mbobo argue t reporti financia measure technol publish oduction obal busine ogical brea al intelligen ement of te al reporting ation of eco ncy of rigo e of ifr c ng the infor sia et al., 20 e affecting t 18) collabor closure of if effort to attr ses ifr disc -financial in ng, accordin rs of financ for their in are not pr ntly. this is y kamallua vestor relat r’s framewo er, the dif n-making is valuate the eristics of ing mechan t proxies, ement, etc. c luded as pa ure in the c for investm & ekpo, 2 that the ind ing standar al data mor ement tool ogical com ed on corpo ess landsca akthroughs, nce (ai), an chnology a g (ifr) for onomic deci orous proce could negat rmation nec 018). simil the quality o ratively con fr in order ract more i closure. on nformation ng to the stu ial reports, nvestment p roactive en s evident in arifin demon tions conten orks are stil fficulty of s further ex e usefulnes financial r nisms have such as consequent art of the cr corporate re ment decisi 2016; efimo dex-based m rds (ifrs) re than non ls used to mponents, w orate websit ape has see including t nd data anal lso affected key stakeho sion-makin dures as w tively impa cessary for m arly, an ext of ifr (ifr ntend that m r only to dis investors. t another not due to the udy by efim especially p portfolio pu ough to up n malaysian nstrates that nt on their w ll voluntary assessing acerbated b ss of info reporting. been widel financial r tly, only qua riteria for a eports), wh ion-making ova & rozh measuring regulations n-financial i gauge if which are al tes. the arg 3 en substant the internet lytics (tibe d the conten olders, part ng (serban, 2 well as spec act ifr qua making an tensive amo rq). for ins management sclose posit this is due te, different lack of acc mova and ro prospective urposes. an pdate their n corporate t most mala websites. th in nature. the conte by the scarc ormation, w multiple p ly used to ratios, fina alitative cha assessment hile the crit g, are given hnova, 2018 tools do n s on the ba information frq are in lso vital in guments hig asian tial changes of things erius & hirt nt and comm icularly sha 2017; schal cific accoun ality (ifrq informed ec ount of liter stance, bott t now has b tive news w to the unre t reporting e counting sta ozhnova (20 e investors, other crucia corporate i practices, i aysian listed his can be e ent of info city of a reli which cor previous stu assess ifrq ancial state aracteristics (e.g., the e teria of info n less atten 8). in a sim not comply asis that the n. the study nadequate enhancing hlighted ab n journal of f s in the 21 (iot), bloc th, 2019). t munication areholders, ller et al., 2 nting standa q), preventi conomic de rature point ti et al. (201 broad discre while omittin egulated po entities prov andards for 018). this h to make co al issue is t information n which a d companie explained b ormation u iable measu responds t udies show q. these m ement resta s that can be existence of ormation us ntion (kelto milar vein, h y with inter ese tools em y also demo in consider the quality ove imply t finance & ac issn 19 2024, vol. 1 ajfa.macro 1st century ckchain tech the emerge strategy of in dealing w 2019). howe ards govern ing investo ecision (bot ts to certain 14) and ke etion to ma ng negative olicy that ex vide differen r corporate has made it omparisons b that some r n on their w study cond es sluggishly by virtue of used for ec urement dev to the qu w that inde mechanisms atements, e e measured f specific d sefulness, w on & yang hanafi et al rnational f mphasise a monstrates th ring the v y of corpor the need to ccounting 946-052x 16, no. 1 think.org/ y due to hnology, ence and internet with the ever, the ning the ors from tti et al., n factors liwon et anipulate e reports xplicitly nt levels internet difficult between eporting websites ducted in y update f the fact conomic vice that ualitative ex-based include earnings directly etails or which is g, 2008; l. (2009) financial assessing hat most value of rate data evaluate ifrq th to main et al., 2 qualitat obtaine (2017). informa is also complia concep standar study co the rem delibera and se section limitatio 2. liter the int in the d (1999) perform online t (lymer broaden shareho mokoal compan financia keliwon despite reliabili rohnov that the the digi and you to misre note, be manage audited horoughly i ntain market 2017; mas tive charact d from the this will e ation in ann being evalu ance with ptual framew rds board (m ontributes to maining se ates on the l ction 4 exp n 6 reveals ons. rature revi ernet has be digital busin define ifr mance of bus tool analys r et al., 199 ned to inclu olders and leli-mokote ny informa al and busi n et al., 201 e ifr's exte ity are inten va, 2018; si e integrity o ital era. for ung (2016) epresent inf ecause ifr ement can e when, in in order to t efficiency sb, 2018). teristics ele prior studie enable the o nual reports uated in ac regard to work for fi masb) acr o the body o ction of th literature re plains the this study's iew ecome prev ness environ r as the use sinesses. in sis and mul 99; lizzcha ude the notio potential i eli, 2012). c ation to in iness report 18; kaur & ensive use nsifying, wh ia et al., 20 of ifr has b r example, , the poor g formation f r relies heav easily misle fact, they accommoda y (braam & hence, the ements thro es of braam operationali and investo cordance w the qualita nancial rep oss 160 list of literature his study is eview and a results. me s conclusion valent as a m nment, wher e of interne nternet-based ltimedia co arly et al., on of "comp investors in companies g nterested st ting (garca singh, 2019 in the 21s hich require 018). simila been jeopar according t governance for personal vily on hyp ead investor have not 4 ate the need van beest e objective ough an ad m and beest ization of th or relations with the rese ative charac porting" pub ted compani e with its fin s organised analysis of l eanwhile, s n and futur means of co re it has exp et technolog d communi onvey the i 2013). nev plete disclo n making t globally are takeholders a sánchez 9). st century, es actions to arly, a strea rdized by th to studies b of ifr fram l interest at perlinks to rs into belie (amin & asian ds of invest , 2013; mb of this res dopt and a t (2013), ne he qualitati materials pu earch objec cteristics in blished in 2 ies in bursa ndings. into the f literature. s section 5 e re research, ommunicatio panded its i gy to disse cations and dea of fina vertheless, osure" of ma the best ec e increasing , notably et al., 201 concerns re o address the am of past l he emergen by kelton a meworks ha the expens connect to eving that th mohamed, n journal of f tors for info obo & ekpo earch is to adapt metho el (2016), an ive characte ublished on ctives to asc ncorporated 2018 by ma a malaysia's following st ection 3 exp elaborates o while sect on in recent ifr functio minate fina technologi ancial repor the concep aterial infor conomic ju ly using ifr shareholder 1; valentin egarding its em (almilia literature ha nce of advan and yang (2 s given spa se of shareh other sourc he financial 2016; fish finance & ac issn 19 2024, vol. 1 ajfa.macro ormation us o, 2016; al o establish odology, p and al-dmo eristics in if n company w certain the d in "the alaysian acc s main mark tructure: se plains the m on the disc tion 7 prov t years, par ons. ashbau ancial data ical features rting dissem pt of ifr h rmation to f udgement ( r for dissem rs, via we netti & rea s transparen a, 2015; efi as also docu nced techno 2008) and s ace for mana holders. on ces of infor l reports ha her naylor ccounting 946-052x 16, no. 1 think.org/ efulness l-dmour a set of primarily our et al. fr. the websites level of revised counting ket. this ection 2 methods, cussions, vides the ticularly ugh et al. and the s such as mination has been facilitate ojah & minating eb-based a, 2013; ncy and imova & umented ology in sherman agement another rmation, ave been , 2016). meanw major th framew allowin rozhno based o how m disclosu its volu perform unautho confide that all negativ mechan conside which alebrah concept somewh have us exampl 2005; a years. table 1 resea kelto (2008 hana while, other hreats to if works, which ng them to m ova, 2018). on the prece much inform ure varies a untary natu mance for orized acces ential data o the articul e conseque nism that c ered necessa may lead hem, 2018). t, character hat complex sed various e, checklist ali et al., 20 . measurem archers on and yang 8) afi et al empirical s fr's trustwo h have prov manipulate eding occur mation to re across firms ure. this f investmen ss from wit on the comp lated issues nces for the can reliably ary. nevert to conflict . most of th ristics, and x and subjec measuring ts, disclosur 011). table ment tools f method g disclosu index l. develop of an i tudies asser orthiness. th vided an ave data and di rrence, keliw eveal and p s globally, p further com nt purposes thin or outs pany’s webs s can have e users of f y assess th heless, the ting results he past rese dimension ctive. henc g mechanism re indexes, a e 1 shows so for internet sco ure dis inde con form cor gov stat pment index web 5 rt that cybe his mainly enue for intr isrupt opera won et al. ( publish on particularly mplicates in s (efimov side the co sites. based an advers financial rep he quality virtuosity o (ali et a earchers col ns of ifr e, past liter ms to deter and qualitat ome of the financial r opes closure ex– ntent, mat and rporate vernance tement bsite asian erattacks hav points to th ruders to ac ations (cum (2018) argu corporate on non-fin nvestors' ab a & roz mpany prov d on these a e effect on ports. henc of informa of assessing al., 2011; e llectively co are broad, ature review rmine the q tive measur measureme reporting q contributi measurem improves content, and co governanc statement. developm the latest n journal of f ve been con he flexibility ccess confid mming et al. ue that mana websites. c ancial infor bility to co hnova, 20 vides the sp arguments, i n ifrq, wh e, establish ation incorp g ifrq is r efimova & ontend that and asses w shows tha quality of if rement instr ent tools wi quality on in ment l format orporate ce o th sp th ra q fi n (u in 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(ias mohamed, 2 r studies w he study w zkowska, 20 med, 2016). n undertaken in-depth inf hers and us he interview began. sco ure vol disc cir indi com bited in tab rect proxies o assess ifr ments predo h this meth and yang e the details al in making sment inde harm investo d an impor et al. (200 at are more in line wi s 1). it also 2016) have were bound was confined 014) and in the analy n by ahmed formation d ers of the d wees may 9 opes luntary closure of r on ian-listed mpanies ble 1, show s (e.g., ratio rq (almilia ominantly u hod cannot (2008) ex s in the fina g better eco ex-based in ors and bus rtant substa 09) also a financial d ith the pro notes that o examined by several d to financ ncomplete q ysis above d et al. 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(2 ancial info ation publis eristics used nalysis also explained b -skerbinjek (2017) arti pliance with ework for f ubstances o itative char tive attribut l studies hav critical to m the best ec vides both & van bee uring the qu l the assess financial att nces stock m vity (wbcs arch adopts refers to in (2016), te e they can e time inform sen as the s ernational tr d service sec oyment gen dustry 4.0 s loy emergin 2020). this ng business e financial preciated by prompted r d conceptu n market, b onstructed in 2017). the ormation d shed on co d in this stu highlights y several sc , 2018). t culate the h the appro financial re of financial racteristics tes such as ve found th maintaining conomic dec h historical est, 2013; m ualitative ch sed items u tributes (ma market pric sd and pw s the critica formation o echnologica enhance the ation to inv subject of th rade and inv ctors, which neration (w strategy as ng technolo study also es prepare reports pr y domestic a researchers al framewo bursa mala n the studie dimensions derived fro rporate web udy. 10 the impor cholars (e.g the studies importance oved accoun eporting," w reporting such as re s verifiabilit hat evaluatin the usefuln cisions but and forw mbobo & e haracteristic under the f asb, 2018) ces (arvidss wc, 2018). al dimension on investor r al attributes e corporate d vestors. his study b vestment. it h have been world bank, s part of it ogy to boost investigate statutory fi roduced are and global m to look at th ork for fina aysia. this es by braam s measured om annual bsites. tab asian rtance of a ., alali and by braam e of evalua nting frame which was are applied elevance an ty, understa ng the quali ness of infor also helps ard-looking ekpo, 2016; 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(200 ss communi bank www.world business aterhouseco nancial tps://docs.w 8). toward ication, 45( malaysia dbank.org/en s counc oopers (pw informat wbcsd.org/20 d a taxonom (3), 232-264 a (publi n/country/m il for wc) (publis tion th 018/10/wb 22 my of corpo 4. https://do ished m malaysia/ove sustainab shed octob he in csd_enha asian orate report oi.org/10.117 march, 2 erview le deve ber 2018). nvestor ancing_cred n journal of f ing strategi 77/0021943 2019). r lopment enhancing perspectiv dibility_rep finance & ac issn 19 2024, vol. 1 ajfa.macro ies. the jo 3608317520 retrieved (wbcsd) the credib ve. r port.pdf ccounting 946-052x 16, no. 1 think.org/ urnal of 0 from ) and bility of retrieved microsoft word 15469-55633-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 120 determinants of successful agri futures contracts in india dr. tarunika jain agrawal (corresponding author) dept. of financial studies, university of delhi benito juarez marg, new delhi -110068, india tel: +91-987-108-7407 e-mail: tarunika.jain@gmail.com prof sanjay sehgal dept. of financial studies, university of delhi benito juarez marg, new delhi -110068, india tel: +91-989-119-9840 e-mail: sanjayfin15@gmail.com mr rahul agrawal deputy general manager, ifci ltd. ifci limited ifci tower, 61 nehru place, new delhi-110 019, india received: august 5, 2019 accepted: oct. 21, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15469 url: https://doi.org/10.5296/ajfa.v11i2.15469 abstract the study empirically examines the factors which impact the success of the agri commodity futures contracts. daily data from july 2012 to july 2017 is used for 22 commodities traded on the three national commodity derivatives exchanges and analyzed in a panel data analysis framework. the results of the study suggest that higher volatility in the spot and futures market, competition in terms of multiple exchange listing, the age of the futures contract, lot size and tick size increase the success potential of the agri futures contract. the international listing, the imposition of commodity transaction tax, a higher number of levels in the value chain and greater geographical coverage in the spot market reduces the liquidity for the contract. thus, the study identifies important market characteristics and elements of contract design that have implications for the success of agri commodities futures contract in india. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 121 keywords: agriculture, futures market, panel data analysis, successful factors, commodity transaction tax jel classification: g10, g13, q02, q18 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 122 1. introduction agriculture sector plays a crucial role in a developing economy like india as the industry contributes almost 16% of gross domestic product (gdp) and 49% of employment (economic survey 2017-18). the sector is also pivotal as india ranks second in the agricultural production, accounting for about 7.68% of total global agricultural output (ibef report 2018). india dominates the spices market regarding production, consumption, and export. agriculture activity is inherently risky owing to the inelastic demand and supply and overdependence on monsoon. several problems exist in the market for the agri commodities – lack of technology, transportation and warehousing facilities, market infrastructure and weak farm-to-market linkages, leading to high price volatility in the market. the vested interest of the middlemen in the markets, inhibiting the knowledge sharing initiatives aggravates the problem. the distress in the agriculture sector has widespread ramifications rising inflation, unrest among the farmers, and dissatisfaction in the political and social sections. inefficient price risk management is considered to be one of the key factors why farmers are not able to get out of the vicious circle of poverty. (unctad, 2019) the market for agriculture goods can be classified into two segments– spot and derivatives market. the spot market for the agriculture commodities comprises broadly of the mandis, agricultural produce market committee (apmc), traders (arhatiyas). as per the data provided by the economic survey 2014-15, principal regulated markets based on geography (the apmcs) are 2477 and submarket yards governed by these apmc’s are 4843. apmc act requires the first-time auction of agri commodities only through the apmc licensed commission agents. apmc levies some charges for providing and facilitating the trade in the spot market from all the players (the market fee from buyers, licensing fees from the functionaries, and commission fees by the agents) in addition to the mandi tax and goods and service tax (gst). all of this put together distorts the prices in the spot market and cascades into higher rates of commodities and thus creates inflationary pressures in the economy. in 2016, the electronically traded national agricultural market (e-nam) was inaugurated with its primary objective to create a more organized, transparent and informationally efficient agri spot market. one of the key legislations relating to agriculture is the essential commodities act, 1955. under this act, primary agriculture goods like rice, wheat, pulses, oilseeds and commercial crop like jute and copra are procured by the government at the minimum support prices (msp). in india, the government allowed trading in commodity futures nationwide in 2003 on multi commodity exchange of india (mcx), national commodity and derivatives exchange (ncdex) and national multi commodity exchange of india (nmce). presently, ncdex dominates agricultural commodities derivative market. (sebi annual report, 2015-16). in 2013, a commodities transaction tax (ctt) of 0.01% on exchange-traded commodity derivatives was imposed, with the exemption to agri derivatives. often market participants, regulators, and academicians debate on the role of the commodity derivative market in the indian context. there has been a contention that the trading in agri commodities have resulted in an increase in the price volatility and led to inflation (nath and lingareddy, 2008, ahmad and sehgal, 2015). internationally it is observed that the commodity asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 123 derivative market plays a beneficial role by helping in better price discovery, risk management and information transmission in the market (purcell and koontz, 2003, du, 2004). though consent is given by the political sections for active commodity futures markets development. still, the commodity futures market remains highly unpredictable, owing to frequent bans on futures trading of essential commodities. for instance, government imposed a phase-wise ban beginning from january 2007 when red gram (tur) and black gram (urad) were initially banned, followed by a ban on wheat and rice in february 2007 and on chickpeas (channa), soybean oil, potato, and rubber in may 2008. forward markets commission suspended futures trading in guar seed, pepper, and potato in 2012, 2013, and 2014 respectively. such a policy was justified by citing futures trading as a source of inflationary pressure on spot prices. in 2015, the forward contracts regulation act (fcra) was repealed, and forward market commission (fmc) was merged with the securities and exchange board of india (sebi). sebi classifies agri commodities into various categories, as mentioned in its notification of september 27, 2016, which is followed by the exchanges too. however, for ctt imposition, the segmentation is done differently into two categories primary and processed agri commodities. though the agri commodities have been kept outside the purview of ctt, the imposition on agro-processed commodities has created an anomaly. several studies (sahoo and kumar (2008), sehgal & ahmad (2013), ray and malik (2014), kumar et al. (2017), sehgal and agrawal (2019)) have confirmed a negative impact of ctt on the liquidity in the commodity market. it is well established that developing and introducing new derivative contracts is a costly and time-consuming process (pennings and leuthold, 2001). given this important consideration, in january 2017, sebi, in its effort to ascertain the suitability of commodities for derivatives trading, laid down criteria for identifying such commodities/ products. it defines five broad parameters, namely commodity fundamentals, ease of doing business, trade factors, risk management and benchmark potential. weights and commodity specific subscores are to be assigned by the exchanges and submitted to sebi when seeking permission to trade. higher the score better are the prospects of a commodity in futures trade. however, this is not the first time that an attempt has been made to identify commodities where trading in futures contracts can be more appropriate. in the indian context, several committees (dantwala committee (1956 and 1967), khusro committee (1980), kabra committee (1994), habibullah committee (2003) and abhijit sen committee (2008)) have studied the commodity derivative market and made a comment on whether it fulfils its objective of enhancing price discovery and risk hedging for the participants or not. these studies also observed its impact on the prices and made recommendations to strengthen the regulatory framework, improve related infrastructure and emphasized on the spot and futures market integration. notably, khusro committee (1980) and kabra committee (1994) deliberate on characteristics which make derivative trading in the futures for commodity successful. these reports highlighted those commodities which are homogenous, non-perishable, likely to be standardized and have an abundant and uncertain supply and demand to be more suitable for the futures trading. interestingly, in the absence of empirical analysis, the recommended list of commodities by different studies was in contradiction with each other as in the case of rice, cotton, spices, etc. as a cumulative effect of the above-mentioned developments in the indian agri commodity asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 124 market – frequent suspensions in futures trading, steep special and additional margin requirement, and the imposition of ctt have hurt the market sentiment and hampered the liquidity in the market. it has added distress to the agricultural sector, which suffers from several weaknesses. improvement in the agriculture sector can take place only when the institutions in both spot and derivative markets are strengthened (thomas, 2003). presence of favourable market sentiment and investor confidence is essential for the agri commodity derivative market to perform its functions of price discovery and risk management effectively and efficiently. the motivation of the present study lies in the substantial economic costs associated with the failure of the futures contract. not only launching new contracts is an expensive exercise but it also damages the market institutional infrastructure and investors’ sentiment. a limited number of the contracts puts the agri commodity derivative market in the vicious circle of low liquidity, which questions the viability and growth prospects of the exchanges and results in dwindling tax revenue collection of the government (sahoo and kumar, 2008; sehgal and agrawal 2019). the inability of the derivatives market to function efficiently results in negligible innovation and thus there is a constant debate regarding its relevance in the political sections, which leads to frequent interventions and adverse public policy towards the agri derivatives market. in this context, it is pertinent to empirically identify and examine the factors which have a substantial impact on the success of the agri commodity futures contracts. furthermore, it would be beneficial to pay attention to elements which are significant to strengthen them to make the contract trading successful. such analysis provides a strong foundation based on which financial regulator can revisit and reassess the criteria adopted for evaluating the suitability of commodities for derivative trading. as discussed in the next section, literature examining the determinants of success for the indian agri commodities is virtually absent. given the importance attached to the agricultural sector in the indian economy, there is an urgent need for revisiting the agri commodity market for taking necessary policy measures. specifically, the study aims to identify essential characteristics which distinguish between successful and relatively less successful trading contracts in indian agri futures market. the proposed criterion is based on an empirical analysis which can guide the policymakers, regulators, exchanges and market participants for the choice of agri commodities which should be permitted and encouraged in the commodity derivative market and which ones to be withdrawn and suspended. the findings of the study suggest that increased volatility in the spot market increases the likelihood of success for an agri futures contract. furthermore, increased futures price volatility and increased competition among the exchanges regarding multiple contracts with the same underlying commodity has a positive influence on the trading volume of the futures contract, increasing its success potential. on the other hand, contracts on the underlying commodities which are traded globally on different exchanges are less likely to succeed in the indian market as there are multiple reference points providing efficient price discovery mechanism thus reducing the liquidity for the contract. the imposition of ctt has a negative impact on contract success. the levels in the value chain and the number of mandis for a commodity exhibit a negative relation with the futures trading volume. the findings highlight that as the age of the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 125 contract increases, the contract is more successful. furthermore, tick size, a contract design specification is positively related to contract success. in light of the results of the study, sebi could re-examine its criteria for incorporating additional factors and reduce the weight of some in its standards. the paper is organized as follows. the second section presents the literature review. in section 3, the data and variable construction are discussed. section 4 presents the methodology and empirical results. the last section contains the conclusion and policy suggestions for agri market development. 2. literature review in the literature, two main aspects have been studied when analyzing the determinants of successful contracts – definition of success and factors contributing to contract success. the prior work reviewed encompasses studies offering explanations for why a few traded contracts achieve the liquidity, requisite for success and some experience low liquidity and failure in general and some studies specifically in the context of agricultural commodities (bialkowski and jakubowski, 2012; till, 2014; webb, 2015; garcia et al., 2015). it helps us to identify broad characteristics essential to the success of the contract and specifically examine them in the context of agricultural commodities in india. not all future contracts that are launched succeed i.e. they are characterized by low volume reflecting less interest from the market participants (sandor 1973, silber 1981, carlton 1984, black, 1986, kolb 1991, thompson and kunda 2000, pennings and leuthold 2001, brorsen & fofana 2001). previous studies suggest alternative measures of success. some studies measure success based on the length of the time that the contract has been trading for (silber, 1981) and others based on the levels of trading volumes associated with the contract. sandor (1973) takes the annual trading volume of 1000 contracts as a cut off for identifying successful contract. some studies also examine daily trading volumes like dew (1981) and carlton (1984) 10,000 contracts and 1,000 contracts on a daily basis respectively. holder et al. (1999) took 10000 contracts as the monthly trading volume for identifying a successful contract. gorham and kundu (2012) categorize contracts into highly successful, successful, moderately successful and failure by the 5th year trading volume. a broad consensus is established from the previous studies in favour of trading volume over different periods as a measure of success. prior literature (for examples; see baer and saxon (1949), gray (1966), powers (1967), black (1986), brown et al. (1991), tashjian (1995), harris (1998), karagozoglu and martell (1999), longin (1999), brorsen and fofana (2001), pennings and garcia (2001), pennings and leuthold (2001), meulenberg and pennings (2002), bollen et al. (2003) and pennings and egelkraut (2003)) also highlights that commodities differ in characteristics which influence their potential to be successful in the futures trading. few of the earlier studies, gray (1966) summaries the following factors resulting in future contracts to fail. 1. legal aspect – many government policy interventions; 2. loss of economic basis – the need for hedging; 3. contract neutrality – towards favoring either the buyer or seller; 4. disposition of large firms to use market power to boycott the futures market; 5. futures markets failing to attract speculators, agents who provide liquidity; and 6. different expiration months and seasonality of production. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 126 hyeronymus (1977) reinforce these considerations in his study. black (1986) focuses on commodity-specific characteristics like homogeneity, storability, spot market size, considerable variations in prices for identifying successful contracts (contracts with high trading interest). corkish et al. (1997) conclude that the volume and volatility of the spot market are essential conditions for a future contract to be successful. cornell (1981) indicates the variability in the spot market prices to be the most significant factor. thompson et al. (1996) attribute the demise of the corn syrup future to a highly concentrated market and poor contract specifications, less homogenous product; small sized spot market and the inability of the contract to attract sufficient participants in the futures market. williams et al. (1998) make an interesting observation about the positive influence of futures trading on the china zhengzhou commodity exchange on the spot market practices, like the adoption of better-quality standards. sanders and pennings (1999) suggest the role of poor contract design and high transactions cost involved in the failure of minneapolis grain exchange's white shrimp futures contracts. they also underline the role played by the presence of an efficient alternative risk hedging mechanism. brorsen and fofana (2001) assessed the factors specifically for the agricultural commodities and highlighted the significant role played by the spot/ cash market characteristics like the number of levels in the value chain, buyer concentration and an active cash market in the contract success. bollman et al. (2003) observe that diammonium phosphate futures contract at chicago board of trade (cbot) failed because of a weak association between the spot and futures prices, making the futures contract to be an inefficient tool for price risk management. siqueira, da silva, and aguiar (2008) recommend the introduction of milk futures contracts in brazil by analyzing various aspects specific to commodity and markets. they highlight the role of high volatility and competition in the spot market, the absence of traditional risk management mechanism and no cross-hedge possibility in their explanation. tavares (2008) found high transaction costs, poor knowledge of futures among farmers and highly concentrated market, the presence of forwards contracts, which was adequately fulfilling the need for hedging, to be the factors causing the intercontinental exchange (ice) futures contract on orange juice to fail. hosseini-yekani et al. (2009) find saffron, pistachio, and rice to be fit for the launch of an agri futures contract by analyzing factors including basis risk in the futures trading, size, and volatility of the cash market, homogeneity and the level of exports to total supply. hung et al. (2011) examined ten contracts from six exchanges in east asia from january 2001 to february 2007 and concluded spot market volatility, smaller contract size and existence of cross-hedging product to have a beneficial impact on the contract’s successfulness. quintino and david (2013) examine the relationship between the hydrous ethanol spot and futures to assess its feasibility on the são paulo stock exchange. they study factors like the cross-hedging possibilities, competition, spot market volatility and correlations between the possible substitutes for the period may 2010 to april 2012. the findings point out the role of highly concentrated nature of the sector in impairing contract liquidity, in spite of all others requirements for being successful were met. till (2014) illustrates three essential elements that determine success by discussing various case studies. it shows that a contract can be successful only if there is a need felt for hedging commercially, the market can attract speculators for trading and the favourable role of public policy. webb (2015) underlines the significant asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 127 influence of cash market volatility, fulfilling hedging requirement, participation by hedgers and speculators, the presence of related contracts, liquidity, the timing of the launch, trading costs and contract specifications on the contact success. roche (2016) examines various factors influencing the success of the red chilli contract of pakistan mercantile exchange launched on september 2015 and highlight the role of price volatility and liquidity in the market for the continued success of the contract. bekkerman and tejeda (2017) attempt to find out the reason for the futures contract success by analyzing the data for 21 agricultural products listed on the north american futures exchange throughout january 2007 and september 2012. the study concludes that the activeness of the spot and cross hedge futures market, variability in the spot market, the degree of homogeneity, level of vertical integration and market power concentration significantly explain futures market’s success. sittisawad & sukcharoensin (2018) conclude size, volatility and liquidity in the cash segment and tick size, contract size and option-type in the futures market segment to contribute to financial derivative’s success in the context of six select asian exchanges using a panel regression method. białkowski & koeman (2018) underpin the presence of an efficient spot market for a contract to be successful when analyzing dairy futures contract for the period of 2012 to 2015 in the us and new zealand market. these studies have been conducted for the international commodity markets. nevertheless, the factors influencing the success potential of the commodities in the derivatives market needs to be explored further, as suggested by bhardwaj, gorton, and rouwenhorst (2015). in the indian context, prior empirical work mainly focuses on the destabilization effects and information linkages between the spot and futures market. (thomas and karande (2001), sahi & raizada (2006), iyer and pillai (2010), shihabudheen and padhi (2010), kumar and shollapur (2015), seth & sidhu (2018), gupta et al. (2018)). in a recent study, gulati et al. (2017) propose criteria based on principal component analysis for ten commodities over the period 2010 – 2013 to identify factors influencing the success of the future contract in the indian context. the study points out those commodities which are not sensitive from the perspective of food security, have price variation, and a large share in the global trade and huge surplus are more suitable for future trading as they are less prone to government interventions. however, this study presents the necessary but not sufficient conditions for the contract to be successful. for instance, the success of the futures contract may also depend on market characteristics and contract specification as shown by prior international work. the present study is an endeavour to address this gap by identifying essential characteristics which distinguish between successful and non-successful trading contracts and recommend criteria based on empirical analysis for the choice of agri commodities which should be permitted and encouraged in the commodity derivative market. 3. data and variable description because of data availability constraints, we use daily data for about five years (july 2012 to july 2017) for 22 commodities traded on the three national commodity derivatives exchange – mcx, ncdex, and nmce. in case the commodity is traded at multiple exchanges, contract with the higher trading volume has been selected, in particular, crude palm oil. futures contract asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 128 on commodities like black pepper, castor seed and rbd palmolien on mcx, chana, 29 mm cotton, castor seed, degummed soy oil, mustard seed oil cake, and pepper on ncdex were introduced in the year 2017 only and thus were not included in the analysis. data for guar seed, shankar kapas on ncdex, copra and sacking on nmce was not available and therefore excluded. the sample commodities represent the significant categories of the indian agricultural market cereals and pulses, oil and oil seeds, spices and others. however, the data can be said to suffer from survival bias. (haugen and baker (1996). following prior work (see black, 1986; brorsen and fofana, 2001 and hung et al., 2011), we use the natural log of trading volume (of near month future contract) as a measure of success. based on the literature review, we identify and discuss the following characteristics in detail under two broad categories – spot market and futures market characteristics. the spot market characteristics help determine the viability, and the future market factors offer to augment understanding of the elements for the sustained success of the futures contract. 3.1 spot market characteristics 3.1.1 spot market size (cms) – the size of the spot market indicates the trading interest in terms of the possible number of participants for the derivatives market. ideally, greater the spot market size, higher the success of the futures contract. the physical market size is the natural log of annual production (in tons). exhibit a summarizes the data sources for different commodities, taken from multiple sources. exhibit a. the data sources for different commodities commodity source wheat, barley, cottonseed oilcake, crude palm oil, refined soy oil united states department of agriculture (usda) foreign agricultural service cotton, rapeseed, soybean, v 797 kapas reserve bank of india (rbi) maize (kharif, rabi), castor seed directorate of economics and statistics, department of agriculture, govt. of india mentha oil council of scientific and industrial research central institute of medicinal and aromatic plants (csircimap) sugar agricoop sugar report 2017, department of agriculture cooperation & farmers welfare, govt. of india isabgul seed psyllium seed report 2016 (https://www.premcemgums.com/psy llium-seed-2016-crop-report/) 3.1.2 spot market activeness (sma) the primary data required for calculating spot market activeness is spot prices. the data is retrieved from the respective exchanges where the contract asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 129 on the commodity is listed and the gaps were filled with the help of agriwatch. following bekkerman and tejeda (2017) we calculate spot market activeness. the first difference of the weekly prices is used (as daily price data commonly doesn’t exhibit substantial change) and a 26-period lagged value is generated. over the rolling window of 26 weeks, we record the mean number of times when there was no difference in the price. a 95% confidence interval is calculated, and the mean values are tested for their significance. the market is categorized as a highly active market if the mean number of times the weekly price levels are significantly different from zero. a dummy variable takes a value 1 for a highly active market and vice versa. 3.1.3 spot market volatility (spv) – we calculate spot market volatility in terms of the annualized standard deviation of daily spot price log returns. it is a prerequisite for the success of the futures contract as higher the price volatility; more significant is the need for hedging it and thus more participation in the future market. 3.1.4 level of vertical integration (vi) – this variable captures the length of the value chain. previous studies (see brorsen and fofana, 2001; bekkerman and tejeda, 2017) suggest that more extensive the value chain is, higher the number of participants involved in derivatives trading of such commodity. more points of the transaction in the value chain because of low vertical integration results in higher likelihood of futures markets. we take the information about the value chain from the product note for particular commodities on the exchange on which it is traded. 3.1.5 geographical coverage (gc) – according to sebi, higher geographic coverage would attract a higher number of participants to the derivatives. on the contrary, having access to a higher number of mandis increases the bargaining power of farmer vis-à-vis intermediaries helping them get a better price for their produce. to empirically verify its significance in the indian context a dummy variable is included, which takes a value of 1 for high geographical coverage and 0 otherwise to avoid the noise in data, due to large variation in the number of mandis ranging from 1 mandi to about 400 mandis for different commodities. to assess the degree of geographical coverage, we record the average number of mandis over the five years and calculate the median number of mandis across all commodities. if the number of mandis for a commodity is lower than the median, it is categorized as a low geographical coverage and vice versa. 3.1.6 the degree of homogeneity (homo) – the success of the futures contract is inhibited by a considerable quality difference among the commodities, leading to the market being segmented and reduced resultant participation in the futures market. this variable is measured by the number of variants in which the commodity is traded in the spot market. we obtain the data from the agmark website. 3.1.7 covered in the essential commodities act (ec) – it is theorized that commodities which have too many restrictions are less favourable for derivatives markets and additionally if the traditional risk mitigation tools work efficiently then the futures contract is likely to fail (siqueira et al.2008). in the indian context, the government regulates essential commodities through various measures like price control or buying the commodities directly from farmers at a fixed price, reducing price fluctuations and hampering the futures contract success potential. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 130 we create a dummy variable which takes a value of 1 if the commodity is covered under the essential commodities act and 0 otherwise. the data for the same is sourced from des, ministry of agri. 3.2 future market characteristics we obtain the data related to future prices, volume and open interest of near month future contract from bloomberg. 3.2.1 hedging effectiveness (he) – following corkish et al. (1997), we estimate the hedging effectiveness by the coefficient of determination of the regression equation: rst = a + b*rft + et where the spot (futures) return rst (rft) are defined as logarithmic price changes. the more successful contracts should provide more effective risk reduction 3.2.2 futures price volatility (fpv) volatility is the annualized standard deviation of daily futures price returns (assuming 250 trading days). higher volatility in the futures market leads to higher participation of speculators, and thus a positive impact is expected. 3.2.3 commodity transaction tax (ctt) we use 0, 1 dummy to study the effect of ctt imposition, where it is equal to 1 if ctt is imposed and 0 otherwise. ctt imposition increases the cost of trading of contracts resulting in lesser chances of it becoming successful (webb, 2015, sehgal & agrawal, 2019). 3.2.4 competition (comp) – we create a dummy variable taking a value of 1 when a similar contract exists on another indian exchange (mcx, ncdex, and nmce) and 0 otherwise. competing contracts may divert trading from the existing market (black (1986) and brorsen and fofana (2001). alternatively, some studies point to that competition may have a positive impact too through more revenue generation (tashjian and weissman (1995); corkish et al. (1997); hung et al. 2011)) and spread trading (webb, 2015) 3.2.5 internationally listed (int) – theoretically, corkish et al. (1997); siqueira, da silva, and aguiar (2008); hung et al. (2011), the international listing (listed on an exchange outside of india) could be a conducive factor for derivatives trading by creating multiple reference points, incorporating the influence of global factors. conversely, it is also postulated that in the presence of a cross hedge, a new derivatives contract would find it difficult to succeed in the face of competition. if the commodity is internationally listed, then there is increased competition from other exchanges. we collect information about the contract listing from the websites of major international exchanges for agricultural goods, namely ice, cbot, new york mercantile exchange (nymex), tokyo commodity exchange (tocom), chicago mercantile exchange (cme), and bursa malaysia. we define a dummy variable equal to 1 when a commodity is traded on international exchange and 0 otherwise. 3.2.6 contract specifications – one of the critical aspects emphasized for the success of the contract is the contract design (see gray 1966, pennings and meulenberg, 1997, black 1986, pennings and leuthold, 2001). contract design is relevant as it should appeal to both hedgers and speculators. the absence of speculators, as suppliers of liquidity, will have an adverse impact on market development. tick size, lot size and the age of the contract have an asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 131 undeniable role in determining the contract success. the information related to contract specifications like launch date, lot size and tick size is obtained from the respective exchanges in their product notes for the commodities.  age of the contract silber (1981) and kolb (1991) have provided evidence of the same indicating only about one-third of the new contracts sustain on the exchange. thus, old contracts are expected to be more successful. we calculate the age of each contract by the number of days it has been traded since its launch date.  size of the contract – the literature suggests the optimal contract size as one which can attract small participants as well as minimize transaction costs (see hull, 2000; purcell and koontz, 2003). smaller contracts draw interest from a higher number of players because the related risks are relatively lesser. on the other hand, a small contract suffers from the issue of greater administrative expense, which can be offset if there are higher volumes in the derivatives market. (siqueira, da silva, and aguiar (2008); hung et al. (2011), webb 2015). we measure the contract size by estimating the amount of money required to trade one lot of the commodity contract (future price * lot size).  tick size – tick size is the minimum price movement in the contract. theory suggests that a decrease in the tick size results in an increase in the market liquidity (see brown et al. (1991), chordia and subrahmanyam (1995), ahn et al. (1996), frino (1997) and kurov and zabotina (2005), improvement in the price discovery and informational efficiency (see kurov 2008). some studies have also concluded that a decrease in the tick size results in improved liquidity for highly liquid stocks and the opposite holds for the less liquid stocks (harris (1994), niemeyer & sandås (1994); ahn et al. (1996); grossman et al. (1997), goldstein & kavajecz (2000). in the present study, we measure tick size in rupee terms for all contracts (lot size* tick size) table 1 presents a list of commodities and a summary of the factors where dummy variables are used in the study table 1. list of commodities and summary of research variables used s. no. commoditi es categor y exchan ge from which data is taken launch date lot size tick size presenc e of cross hedge listing on an internati onal exchang e ctt impositi on industry vertical integrat ion msp applica ble 1 barley cereals and pulses ncde x 29 nov 2006 10 mt 0.5 no yes no low yes 2 cardamom spices mcx 11 feb 2006 1 quintal 0.1 yes no no high no 3 castor seed oil and oilseed nmce 02 may 2012 10 mt 1 no no no low no asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 132 s 4 cotton fibres mcx 01 oct 2011 25 bales 10 no yes no high yes 5 cottonseed oil cake oil and oilseed s ncde x 22 july 2009 10 mt 1 no no no low no 6 crude palm oil oil and oilseed s mcx 04 sep 2004 10 mt 0.1 yes yes yes low no 7 coriander spices ncde x 11 aug 2008 10 mt 1 yes no no high no 8 guar gum others ncde x 27 july 2004 5 mt 1 no no yes low no 9 isabgulsee d others nmce 05 mar 2006 10.125 mt (135 bags of 75 kgs) 0.1 no no no low no 10 jeera spices ncde x 03 feb 2005 3 mt 5 no no no high no 11 maize (kharif) cereals and pulses ncde x 24 june 2013 10 mt 1 no yes no low yes 12 maize (rabi) industrial grade cereals and pulses ncde x 19 may 2010 10 mt 1 no yes no low yes 13 mentha oil others mcx 21 april 2005 360 kg 2 drums 0.1 no no yes high no 14 rape/must ard seed oil and oilseed s ncde x 21 dec 2004 10 mt 1 yes yes no high yes 15 raw jute fibres nmce 07 june 2004 10 mt 0.1 no no no high yes 16 refined soy oil oil and oilseed s ncde x 04 dec 2008 10 mt 0.05 yes yes yes low yes 17 rubber fibres nmce 15 mar 2003 1 mt 10 no yes yes high no 18 soybean oil and oilseed s ncde x 15 jan 2004 10 mt 1 no yes no low yes 19 sugar m others ncde 27 july 10 mt 1 no yes yes high yes asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 133 x 2004 20 turmeric spices ncde x 27 july 2004 5 mt 2 no no no high no 21 v‐797 kapas fibers ncde x 07 aug 2006 1 lot (200 maunds of 20 kg each) 0.5 no no no low no 22 wheat cereals and pulses ncde x 02 july 2004 10 mt 1 no yes no low yes 4. methodology and results in the analysis, we measure returns as the log difference in price for each of the commodities (both in the futures and spot market). as shown in table 2, the results of the augmented dickey–fuller (adf) test indicate the return series in both markets to be stationary. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 134 table 2. adf results for the test of stationarity for the return series in the spot and the futures market (h0: unit root vs. ha: no unit root) spot market return futures market return commodity t-statistic prob.* t-statistic prob.* barley -34.34 0.00 -36.99 0.00 cardamom -28.88 0.00 -32.52 0.00 castor seed -30.33 0.00 -21.37 0.00 cotton -26.44 0.00 -35.60 0.00 cottonseed oil cake -20.09 0.00 -35.56 0.00 crude palm oil -34.23 0.00 -23.45 0.00 coriander -34.69 0.00 -36.81 0.00 guar gum -33.58 0.00 -28.61 0.00 isabgul seed -23.73 0.00 -18.73 0.00 jeera -31.64 0.00 -35.37 0.00 maize (kharif) -27.14 0.00 -16.44 0.00 maize (rabi) -32.63 0.00 -31.28 0.00 mentha oil -37.40 0.00 -36.58 0.00 rape/mustard seed -84.22 0.00 -35.09 0.00 raw jute -24.18 0.00 -26.11 0.00 refined soy oil -24.73 0.00 -35.30 0.00 rubber -24.64 0.00 -14.47 0.00 soybean -33.91 0.00 -33.73 0.00 sugar m -34.55 0.00 -24.53 0.00 turmeric -3.45 0.02 -35.77 0.00 v797 kapas -11.52 0.00 -35.07 0.00 wheat -34.24 0.00 -39.76 0.00 notes: number of minimum lags have been chosen according to minimizing of schwarz information criterion (sic). table 3 presents mean values of trading volume in the futures market and spot market capitalization for sample commodities along with the return and volatility for the spot and future market. as shown in table 3 column 2, soybean, followed by refined soy oil and crude palm oil are the top three traded commodities, when looking at the traded volume in the futures market. cotton records the lowest trading volume in the future market, in spite of the highest spot market capitalization (column 5). column 3 indicates that the mean return in the futures market is close to zero for most of the sample commodities, with the highest for raw jute and lowest for castor seed. barley, jeera, turmeric, and rubber show positive future market return when at the same time the spot returns are negative. the converse holds for castor seed, isabgul seed, maize kharif, and v 797 kapas. as shown in column 6, isabgul seed shows the highest return in the spot market. additionally, guar gum has the least spot market return and the highest spot market volatility. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 135 cotton has the least spot market volatility, as observed in column 7. furthermore, in the case of jeera, menthe oil, soybean, turmeric, dhaniya, guar gum, the spot market volatility is higher than the future market volatility. the future market volatility is highest for raw jute and lowest for sugar (see column 4) table 3. mean values for the research variables for the commodities mean values futures market spot market commodities trading volume (in no. of lots) mean return standard deviation cap (in rs) mean return standard deviation 1 2 3 4 5 6 7 barley 2154 0.00% 1.53% 2462.67 -0.01% 0.87% cardamom 1677 -0.02% 2.83% 17.19 -0.03% 1.12% castor seed 3894 -0.75% 99.16% 6656.71 0.04% 1.42% cotton 1331 0.01% 1.05% 617931.61 0.01% 0.69% cottonseed oil cake 30671 0.01% 1.94% 7401.18 0.02% 1.18% crude palm oil 40731 -0.01% 1.10% 103.06 -0.01% 1.12% coriander 11832 0.01% 2.39% 3642.58 0.00% 2.69% guar gum 5640 -0.14% 2.48% 14008.20 -0.13% 4.22% isabgulseed 8778 -0.16% 107.30% 1024.83 0.10% 0.78% jeera 4605 0.02% 1.46% 6554.39 -0.02% 1.51% maize (kharif) 3480 -0.04% 1.20% 23701.33 0.01% 1.33% maize (rabi) 3605 0.01% 1.38% 8824.52 0.03% 1.17% mentha oil 2835 -0.03% 1.63% 33.12 -0.03% 1.69% rape/mustard seed 33134 -0.01% 1.24% 30404.96 0.00% 0.94% raw jute 3708 0.49% 109.24% 9319.79 0.03% 0.76% refined soy oil 49029 -0.01% 1.03% 10353.44 -0.02% 0.87% rubber 14096 0.21% 81.90% 170050.24 -0.04% 0.86% soybean 54367 -0.01% 1.41% 39521.37 -0.03% 1.85% sugar m 14439 -0.02% 0.77% 77632.12 -0.02% 1.01% turmeric 12681 0.03% 2.06% 6709.55 -0.03% 2.16% v797 kapas 5394 -0.01% 1.39% 29167.79 0.01% 0.88% wheat 6927 0.02% 1.16% 152599.12 0.03% 0.95% the trading volume is measured in the average annual number of lots traded, mean return in the futures (spot) market is the average of annual return in the futures (spot) market in percentage; mean standard deviation is the annualized measure of volatility in percentage; cap, spot market capitalization is measured by the annual spot market volumes (in million asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 136 tonnes) multiplied with the yearly average price in the spot market. to conclude about the significance of the various determining factor of contract success, we use panel data analysis for the total sample period from 2012 to 2017. hausman test recommends random effects model. 𝑌 , = 𝛼 + 𝛽 (𝑆𝑃𝑉) + 𝛽 (𝐶𝑀𝑆) + 𝛽 (𝑆𝑀𝐴) + 𝛽 (vi) + 𝛽 (𝐺𝐶) + 𝛽 (𝐻𝑂𝑀𝑂) + 𝛽 (𝐸𝐶) + 𝛽 (𝐹𝑃𝑉) + 𝛽 (𝐻𝐸) + 𝛽 (𝐶𝑂𝑀𝑃) + 𝛽 (𝐼𝑁𝑇) + 𝛽 (𝐴𝐺𝐸) + 𝛽 (𝑆𝐼𝑍𝐸) + 𝛽 (𝑇𝐼𝐶𝐾) + 𝛽 (𝐶𝑇𝑇) + 𝜇 , where, represents the natural log of trading volume as a measure of success, following black (1986), brorsen and fofana (2001) and hung et al. (2011) that a continuous variable does not discard relevant information. a list of factors as mentioned in the previous section has been incorporated as explanatory variables for contract success. the results presented in table 4 point out that spot market volatility has a positive impact on contract success. the result is consistent with the past studies (see black, 1986; corkish et al., 1997; siqueira, da silva, and aguiar, 2008; hung et al., 2011; till 2014; webb, 2015), which have stated this as the most crucial condition for the contract to be successful. a volatile spot market results in the commercial need for hedging to reduce the price risk and thus it is more likely that the contract will be successful. a highly vertically integrated value chain has an adverse effect. this result is in contrast to the expectation based on prior studies (brorsen and fofana 2001) as more the number of participants greater should be the demand in the futures market. the probable reason for this could be the presence of inbuilt risk mitigating mechanisms at each level of value chain making futures markets less attractive. there is also a possibility that the risk at each level is even less relative to the cost of trading involved and thus there is little incentive for the players to participate in the futures market, exhibiting a negative relation to the successfulness of the contract. results concerning geographical coverage are contrary to the belief that greater geographic coverage would lead to a higher number of participants in the derivatives market. it is likely that there is a better price discovery mechanism when there are a number of mandis and thus reducing the need for hedging through a futures contract. in the indian context, a large number of variants in the spot market, poor warehousing, and grading facilities could be the reasons for this outcome. perhaps, with the vast geographical coverage, there is a wide disparity in the goods produced making it unviable for the commodity to be traded on the exchange. for the continual success of the futures contract, it is crucial that there is considerable volatility in the futures market, attracting a large number of speculators and thus have a positive impact on the likelihood of the contract to be successful. several studies in the past have also highlighted the vital role of speculators in providing liquidity in the market (pennings and leuthold, 2001; pennings and meulenberg, 1997). gray (1966) and hyeronymus (1977) thompson et al. (1996) brorsen and fofana 2001; till 2014, webb 2015). the outcomes of the study underline that the commodities on which ctt is levied have been adversely affected. the imposition of ctt has led to an increase in the transaction costs and as suggested by sanders and pennings (1999), tavares (2008); webb (2015) such a rise in the trading costs inhibit the potential of the futures contract to be successful. the coefficient of comp is significantly positive, consistent with the findings of asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 137 tashjian and weissman (1995), corkish et al. (1997), hung et al. 2011. these studies argue that the presence of contracts which are related works in favour of the success potential of the contract as it gives the opportunity to spread trading. thus commodities which are traded on multiple indian exchanges are more likely to succeed in the indian commodity derivative market. another takeaway from the analysis is that as the age of the contract increases, the contract is more successful, thus implying frequent banning of the trading in the derivative market has a detrimental effect on the contract success, as also highlighted by gulati et al. (2017). contracts on the underlying commodities which are traded globally on different exchanges are less likely to succeed in the indian market, owing to increased competition faced from the international exchanges regarding lower transaction costs and efficient price discovery and risk hedging mechanism. the tick size has a significant positive effect on the contract success as higher tick size appears to provide greater compensation to the providers of the liquidity in the market and thus results in higher volume. this result is consistent with the studies (see (harris (1994), niemeyer & sandås (1994); ahn et al. (1996); grossman et al. (1997), goldstein & kavajecz (2000), aitken and comerton-forde (2005) which suggest that for contracts where the liquidity is low, decline in the tick size results in a negative impact on the trading volume. table 4. estimated coefficients from panel data estimations, years 20122017. factors coefficient pvalue spv 1.415 0.06* cms -0.012 0.595 sma -0.189 0.467 vi -0.488 0.033** gc -0.007 0.057* homo 0.097 0.232 ec 1.392 0.152 fpv 0.030 0.091* he 0.286 0.582 comp 1.737 0.016** int -1.935 0.087* age 0.001 0.005*** size 0.000 0.661 tick 0.032 0*** ctt -0.268 0.048** constant 0.480 0.752 notes: the coefficient estimates and t-statistics (in parentheses) reported in the table are obtained from equation 1: 𝑌 , = 𝛼 + 𝛽 (𝑆𝑃𝑉) + 𝛽 (𝐶𝑀𝑆) + 𝛽 (𝑆𝑀𝐴) + 𝛽 (vi) + 𝛽 (𝐺𝐶) + 𝛽 (𝐻𝑂𝑀𝑂) + 𝛽 (𝐸𝐶) + 𝛽 (𝐹𝑃𝑉) + 𝛽 (𝐻𝐸) + 𝛽 (𝐶𝑂𝑀𝑃) + 𝛽 (𝐼𝑁𝑇) + 𝛽 (𝐴𝐺𝐸) + 𝛽 (𝑆𝐼𝑍𝐸) + 𝛽 (𝑇𝐼𝐶𝐾) + 𝛽 (𝐶𝑇𝑇) + 𝜇 , where 𝑌 , represents the measure of contract success (natural log of trading volume) as the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 138 dependent variable. variables capturing for the spot market characteristics are spv, spot market volatility; cms, spot market size; sma, dummy variable for spot market activeness; vi, level of vertical integration; homo, degree of homogeneity; gc, degree of geographical coverage; ec, dummy variable for commodity procured at msp under the essential commodities act; the characteristics for the future market are fpv, futures market volatility; comp, dummy variable for competition; int, dummy variable for commodities listed internationally; ctt, dummy variable for ctt imposition; age, number of days of contract life; size, contract size; tick, measures tick size in rupee terms; he, hedging effectiveness, measured as the coefficient of determination; if the commodity is produced at msp under the essential commodities act, or if the ctt is imposed, or is listed on any other indian or international exchange, the dummy variable takes a value 1 or 0 otherwise. the analysis of the findings confirms some of the parameters and measures used by sebi in its criteria and suggest a few more factors which have a significant impact on contract success. a comparison between the factors considered in the sebi criteria with the set of factors analyzed in the model in the present study offers vital insights. spot market size and degree of homogeneity, considered under the commodity fundamentals by sebi don’t empirically have a significant impact on the contract success, questioning the emphasis attached with the commodity fundamentals. the study does not include the durability/ storability aspect of the commodity as all the commodities considered under the analysis do not differ much in this aspect. looking at the trade factors, the findings of the study are in contrast to sebi expectations about commodities with internationally linked prices being more successful (measured as international listing). however, commodities with a long value chain and broad geographical coverage (reflected by the number of mandis) do not necessarily lead to the contract being successful, as postulated by sebi. on the contrary, they might inhibit the contract success, owing to insignificant price risk at each level or inbuilt risk mitigating mechanism present in the spot market. sebi considers msp in its criteria but ignores the impact of ctt on contract success. the effect of ctt imposition has been included in our analysis and the results highlight a significant adverse influence. the outcome of the study is in line with sebi’s assumption that higher spot market volatility enhances the contract success potential. furthermore, it is recommended that sebi could look into additional factors under the risk management parameter highlighted by the results like the complementarities existing with the presence of a related contract on multiple exchanges. it may also be relevant for sebi to include the level of potential volatility in the futures market as a factor when evaluating the commodities to be traded in the indian agri derivative market as it shows a positive relationship with the contract success. the contract design specifications lot size, tick size, etc. are ignored in the sebi’s criteria. the results indicate that tick size is a significant factor influencing contract success. sebi could also strengthen its standards by including the age of the contract when examining the commodities where futures trading should continue to take place, as older the contract, higher the likelihood of success. in sum, our empirical study highlights that success of the contract is significantly positively asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 139 related to volatility in the spot and future market, existence of duplicate contracts on indian exchanges, tick size and the age of the contract and considerably negatively associated with level of vertical integration and geographical coverage, ctt imposition and international listing of commodities. 5. summary, and conclusion; policy implications issues related to the indian agricultural sector have been deliberated extensively, in the academic and political spheres. the role of the agri commodity derivative market has been questioned continuously and often blamed for increased volatility and speculation in the agri commodity, especially in the context of the farmer’s distress. this has led to excessive policy interventions and adverse public opinion for the agri commodity derivative market. inadequate understanding of the dynamics and structure of the indian agri market has hampered its growth and development irrespective of the boost given by the government in 2003 by permitting national level exchanges to set up derivatives trading and expanding the list of agri commodities which can be traded. it has been well established that for the agriculture sector to develop, the institutional and regulatory framework for the spot and derivative market needs to be strengthened. in the light of the grave economic consequences of the failure of the contract, the emphasis has been given on the factors which contribute to making the contracts successful, ensuring enough market participation, and generating liquidity in the market. given the indian context, it is pertinent to identify, understand and evaluate the determinants which make the agri futures contracts successful. in the existent study, an effort has been made to empirically analyze the factors influencing the contract prospects of being successful and create an objective, data-driven framework to evaluate their significance. it is relevant for the exchanges, regulators, and policymakers to take appropriate steps in complementarity to develop the agri futures market and ensuring the benefits of the commodity derivative are translated to the real economy regarding better price risk management, price discovery and information transmission. specifically, the results of the study would facilitate to identify commodities which when introduced would be more likely to succeed. the review of prior work helps to identify a wide array of characteristics related to the spot and future market which influence the success potential of the commodity in the future contract trading. these factors are examined for 22 commodities from july 2012july 2017. the empirical analysis reveals several interesting findings. one of the necessary factors to be considered for ensuring contract success is the presence of spot market volatility. a long value chain and high geographical coverage for a product may limit the futures contract success. need for commodity market infrastructure, including the availability of warehousing, transport and grading facilities is warranted. the continued success of the contract depends on the futures price volatility, which should be substantial enough to attract speculators in the market. the findings of the study point toward that frequent bans/suspensions hurt the market sentiment, create a lot of uncertainty and thus hamper the success prospects of the contract. a long-lived contract has greater success potential than the newly launched contract. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 140 additionally, the imposition of ctt has increased the trading costs, making it expensive to trade and causing a shift of the trading volumes to the international platforms wherever possible. this is validated by a negative impact of international listing on the likelihood of contract success. it is vital for the policymakers to encourage the market participants by providing incentives to trade in the indian agri derivative market. tick size, a contract design specification, has a positive and significant coefficient. the indian agri derivative market suffers from low liquidity, and higher tick size provides greater compensation to the providers of the liquidity in the market, which is crucial for the market to develop. the coefficient of comp is significantly positive, indicating that in the indian context, probably trading in a set of related contracts is more profitable and thus the presence of contracts (with same underlying commodities) on different exchanges results in higher trading volumes. the study outcomes are relevant for all the stakeholders in the indian agri commodity derivative market as it augments the understanding of factors having an impact on the success potential of the contract. the findings suggest that resources should not be wasted in permitting commodities, where there is negligible volatility in the spot market. efforts should be directed towards creating a conducive environment for the contract to be successful instead of suspending contracts frequently. a system of commodity surveillance both at the level of exchange and regulator should be put in place for regular reviewing and monitoring of the significant factors. a continuous reassessment of the changing fundamentals of the commodities would enable them to take corrective measures well in time. it is also vital for the government to reconsider the levy of ctt on the agro-processed goods in light of the detrimental impact it has on the success potential of the contract. it is essential for the exchange that the contract is effectively designed in a manner to attract both hedgers and speculators. individually, the impact of tick size on the liquidity should be evaluated before making any modifications. additionally, exchanges should take active steps for investor education to encourage higher participation in the agri commodity derivative market. proactive measures should be taken to develop the derivatives market for spices, where india dominates the global market and is the only platform for derivative trading. the study provides an empirical basis to the criteria adopted by sebi and attempts to quantify the variables considered, which would help in undertaking necessary reform, giving clarity for permitting and retaining commodities to trade, ensuring more involvement in futures trading (hedgers and speculators), strengthening the regulatory policy framework with minimal interventions in future. in india, as of now, only a few commodities are traded in the agri derivative market. further research should assess the viability of remaining commodities (especially which are permitted) for potentially being traded on the indian exchanges. it will also be of interest to evaluate the relevant which determine the success of the agri options contract in the indian context. the future studies should even attempt to analyze the perceptions and opinions of various stakeholders of the indian agri commodity market to have more profound insights about the issues of indian agri commodity derivatives market besides relying solely on secondary data. the present work makes a 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(1998). the emergence of a futures market: mungbeans on the china zhengzhou commodity exchange. journal of futures markets: futures, options, and other derivative products, 18(4), 427-448. copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 17362-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 1 operational risks and equity returns: dynamic and static panel data analyses theophilus anaekenwa aguguom ph.d. department of accounting and finance augustine university, ilara epelagos state, nigeria tel: 23-481-2222-1167 e-mail: theophilus.aguguom@augustineuniversity.edu.ng received: july 17, 2020 accepted: oct. 13, 2020 published: december 1, 2020 doi:10.5296/ajfa.v12i2.17362 url: https://doi.org/10.5296/ajfa.v12i2.17362 abstract this study investigated the effect of operational risk on equity returns of deposit money banks (dmbs), using a population consisted of 19 listed deposit money banks in the nigeria stock exchange. 15 dmbs were purposively selected for a period of 15 years 2005 to 2019. descriptive and inferential statistics were explored for the data analysis which was sourced from the published financial statements of the banks, using dynamic and static panel data. diagnostics tests were carried out since the application of the hausman test provided the criteria for choosing between random effect models and fixed effect models. breusch and pagan lagrangian multiplier test was employed to confirm the hausman test results in order to decide between random effects and pooled ols. correlation matrix for multicollinearity test and cross-sectional dependent test were equally carried out for the study. three models were estimated, based on the three proxies of the dependent variable. the study found that operational risk had a statistically positive significant effect on return on equity (roe), while operational risk equally exhibited statistically positive significant effect on roa. when the controlling variable of fsize was introduced, the study exhibited stronger effects which demonstrates that operational risk had a statistically positive effect on roe, while operational risk with fsize had a statistically positive effect on roa. the study recommends that dmbs managers should carefully carry out due diligence on loan applicants, to ascertain performance trend and creditworthiness of potential and prospective borrowers before advancing loans in order to reduce huge profiles of credit risk exposures. keywords: credit risk, equity returns, liquidity risk, operational risk, return on assets. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 2 1. introduction managerial incompetence, and unhealthy punitive distortions of financial surveillance are influencing huge gaps in robust equity returns in deposit money banks in nigeria. creation of artificial debts, huge nonperforming loans, weak due-diligence practices, and inadequate professional proficiencies are the hallmarks behind non-sustainable equity returns in the nigerian banks (adesina, olufuwobi & ayinde, 2018; ogbuagu, ubi & effiom, 2014). financial institutions have become more technological reliant on their operations, making operational risk management correspondingly less prioritized, as the banks now rely on new technologies that depend on non-reliable, and epileptic power supplies (azejiofor, adigwe & john-akamelu, 2015; olalere & wan, 2018). porous internal control systems and unidentified inherent risks shrink equity returns expectations (aguguom, 2020; aguayo & slusarczyk, 2020; el-ansary, 2019). basel iii identified some basic concerns in risk cases such as physical capital (pc). pc incorporates damage to tangible assets, operational and service disruptions, system malfunctions, execution, delivery problems and managerial ability concerns. basically, the main concern here is technological failures in relation to the banks' computer systems. another identified basic concern in operational risk is in the area of human capital error which refers to intentional human error and irrational behavior of employees. this type of error includes employment practices mismatch, health and safety employee’s hazards and internal fraud. these human capital errors which are prevalent in financial institutions tend to are compounding operation risks characteristic (buckova & reuse, 2011; kariuki & peddy, 2017; chaikovskyi & kovlchuk, 2019). gary (2016) documented that the evidence from the various financial crisis in the financial institutions have shown that the guidelines operated at prior years were insufficient to protect the banking and other financial institutions from failure. it was observed that an extreme debt profile, inadequate equity funding, and illiquidity challenges were some of the deficiencies that deepened the severity of the financial crisis. in an effort to alleviate effects and reduce the frequency of financial crisis and/or avoid them, basel iii regulatory reform became introduced (gelter, 2009, gary, 2016). the basel ii and basel iii agreements have a far-reaching influence on shareholders wealth maximization and equity returns, as a change in the equity requirements has an effect on the equity returns performance measures of the bank managers (institute of company secretaries of india, 2016). as expected, higher equity capital influences higher dividend payment and increases earnings per share. basically, basel iii is a major post-crisis response to the problem of supervising banks, following high profile financial crisis. basel iii represents a substantial change on the basel ii regulatory guidelines, with the objective of having a strong regulatory framework that will ensure strong and adequate equity capital base for the institutions (bank international settlement, 2013; sharfman, 2013). consequently, the intension of a new basel iii is to take care of the lapses that basel ii could not address, and as a result, institute more vibrant and sufficient regulations that will ensure adequate shareholders’ equity capital and excellently handle unforeseen and contingencies. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 3 2. literature review 2.1 operational risk operational risk is crucial and has become of increasing concern to bank regulations and the regulations of other financial institutions. the operational risk which arise from mistakes, incompetence, criminal acts, qualitative and quantitative unavailability of employees, failure of technical systems, and dangers resulting from external factors such as external fraud, violence, physical threats or natural disasters as well as legal risk can be countered (nabweteme, 2015). one way financial institutions can, effectively, ameliorate operational risks is to invest a substantial amount of funds in the creation of a vigorous and viable framework. also, this involves collaborations from all banks because the highest threats to banks are coming from external events that are not controllable. thus, a single bank effort will not be sufficient to mitigate operational risks. as a result, the joint actions of all participants in the market are required for effective operational risk management. one of the possible solutions could be the exchange of risk events data between banks within the same system and putting in place a protocol for blacklisting clients. however, this is a problem because banks are reluctant to share data or in house information (knežević, 2013; maixe-altes, 2019). contrastingly, one strange phenomenon of operations risk is that it may not be evident in the reported figures on banks. however, its negative effects on banks' performance may develop suddenly and might also be of huge catastrophic dimensions. recently nigerian banks posted an improvement in their financial performance but a fitch 2018 report pointed out an existing risk surrounding most nigerian banks' performance and even survival. also, higher us dollars were used to offset rising impairment charges. in addition, large earnings were non-recurring. the moody report of 2018 also showed similar reports but expressed that there is an increasing rise in loan risk and worsening asset quality (aguguom & olaoye, 2018; isoh, amnang & nchang, 2020). 2.2 equity returns equity returns are the whole essence of equity capital investment as aligned to shareholders' wealth maximization model (swm). shareholders wealth maximization, contextually, implies the principles that advocate corporate objective or that the main objective of companies is to maximize equity holders' wealth and ensure that all management decisions be tailored towards achieving this objective. by implication, other objectives of the entity should be jettisoned and groups interest be exploited for this singular purpose (fox & lorsch, 2012). critics had advanced that shareholders' wealth or equity holders’ returns-maximization model do exist theoretically and dogmatically, rather they are underlying economic agenda of the managers. incidentally, managers are persuaded and highly motivated to carry out decisions to maximize equity returns for many reasons. these reasons include firstly, to protect and retain their managerial positions; and secondly, to target higher bonuses which results from higher earnings, and thirdly, for their individual interests as managers. to achieve expected equity returns, the managers take decisions that will yield quick returns, engage in discretionary and earning management through privileged information, information asymmetry, insider dealings, manipulating stock prices, and bonus incentives. equity returns on an asset is the most asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 4 widely-used measure of performances, and this assists banks and other financial institutions in assessing their ability to satisfy equity capital holders’ expectations (ican, 2014). 2.3 credit risk against the backdrop of the recent events, credit risk is considered one of the single source of risk for most financial institutions and in particular deposit money banks in nigeria and other developing economies (aguguom & olaoye, 2019; gadzo, kportorgbi & gatsi, 2019). it has been a significant factor in many bank failures and unceremonious collapses, near-collapses and financial system crisis (jones & will, 2013). credit risk management is essentially expedient for financial institutions managers because it determines several important features of loans such as interest rate, maturity and collateral. as credit risks get potentially riskier, projects such as loans and advances require a more in-depth analysis and evaluation before they are approved. apparently, if credit risk is inadequate, default rates would be higher and push financial institutions into insolvency. this is with particular reference to situations where the markets are competitive and the margins are low, especially, among banks in emerging economies. 2.4 insolvency risk as operational risk is devastating and capable of destabilizing an institution. thus, one of the protections against operational risk is to mitigate against insolvency risk and reduce failures in financials’ institutions capital (pracoyo & imani, 2018; nurlida, 2017). adequate equity capital is capable of absorbing unanticipated loses if there is enough margin to inspire confidence and enable the financial situations to continue as a going entity (aguguom & salawu, 2018). adequate capital of a financial institution, ultimately, offers protections for uninsured depositors, bondholders, and creditors, in the event of insolvency and liquidation. 2.5 empirical review mostafa, mahmoud, jalal and elahe (2016) conducted a study to determine the relationship between financial risk and profitability of the banks listed in the tehran stock exchange. the study advanced three hypotheses and sought to determine the relationship between financial risk proxied with return on equity, return on assets, and return on capital. the study collected data from 8 sampled private banks of karafarin, eghtesad novin, parsian, pasargad, saman, sarmayeh,shahr and the sina for a period of 5 years (2000-2015). the study found that there was a significant negative relationship between financial risk and profitability of the banks listed on the tehran stock exchange. in a study, muhammad and abdul (2017) examined the factors affecting risk and performance in the banking institution and identified key factors influencing risk in bank operation in malaysia. the performance of ocbc bank from the year 2011 to 2015 showed unfavorable performance of liquidity and operational risk. the study, among others, found that banks were not effective in terms of converting their asset into cash in order to make debt settlements. also, the banks did not efficiently manage their expenses and, expectedly, it negatively impacted the banks' profit performance. return on assets was one of the indicators used in measuring the profitability for the study and it was found to be negatively related and unsatisfactory. the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 5 operating ratio also showed that the bank was inefficient in its operation and as a result, incurred more expenses. the findings suggested some implications. firstly, considering that the credit risk in ocbc bank remained high, there is a need to monitor risk management, especially, in areas of the variables that had a significant impact on bank credit risk. secondly, corporate governance in the bank also impacted the performance of the bank. olabamiji and michael (2018) examined the influence of credit management practices on the financial performance of nigerian banks with specific reference to first bank plc. data was collected using a purposive sampling technique from thirty (30) respondents as a sample size used to collect data from the respondents. both descriptive and inferential statistics were used to analyze data, such as frequency, percentage, weighted mean score, and multiple regression. the result revealed that credit management practices have a significant positive influence on the financial performance of first bank. the study concluded that client appraisal, credit risk control, and collection policy are major predictors of the financial performance of the first bank. subsequently, the study recommended that the management of other banks should learn from the first bank by enhancing their client appraisal techniques, credit risk control, and adopting a more stringent policy to improve their financial performance. ahmad (2018) carried out a study to examine the impact of risk management practices on the profitability of jordanian deposit money banks, using a sample of 13 jordanian deposit money banks during the period (2010-2015). data regarding variables were collected from the annual financial statements of the sample study. return on assets represented the profitability of banks, while risk management practices consisted of liquidity, operational, credit and market risks. the study used two ratios to symbolize each type of risk. the ordinary least square method (fixed effect and random effect) was used to test the hypothesis. the study revealed that risk management practices as a whole, explains a significant part of the variation in banks' profitability. the results also showed that only financial risk management practices significantly affected the profitability, while liquidity, credit and market risks have an insignificant effect. the implications of the results indicated that jordanian deposit money banks (jcb) have successfully managed liquidity, credit, operating income and market risks during the study period, but at the same time failed to manage financial risk represented in overheads imad (2017) conducted a study to analyze the impact between credit risk and the profitability of five banks on the palestine exchange. the study used data collected from the financial statements of five out of the six listed banks on the palestine exchange for a period of 6 years from 2010 to 2015. in order to ensure that the data does not suffer from multicollinearity, the study tested for variance inflation factor (vif) in addition to the tolerance test, and the test was satisfactory. profitability was measured by using a return on equity and return on assets while credit risk was measured by net charge-offs to total loans and advances, non-performing loans to total loans and advances, and pre-provision profit to total loans and advances. other variables such as bank size, leverage, and net income growth were included to account for their effects. the study found a weak but positive relationship between credit risk, as measured by non-performing loans to total loans and advances, and profitability as measured by return on assets. the study also found that bank size was positively related to profitability. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 6 table 4.1. measure of variables variables abbrev measurement source dependent variables (equity returns) return on equity roe net profit after tax shareholder’s equity aguguom & salawu (2018) return on assets roa npbit total assets biswas (2016) independent variables (operational risk) credit risk cr bad & doubtful loan provisions total loans gadzo et al. (2019) insolvency risk insor total loans total assets jilkoya & stranska (2017) liquidity risk lqr short term security total deposit olalere et al. (2018) controlling variable firm size frmsiz log of total assets (absolute fig) gadzo et al., (2019 source: researcher’ compilation (2020). 3. methodology this study investigated the effect of operational risk on equity returns of deposit money banks, using a population which consisted of 19 listed deposit money banks in the nigeria stock exchange. 15 deposit money banks were purposively selected for a period of 15 years 2005 and 2019. descriptive and inferential statistics were explored for the data analysis sourced from the published financial statements of the banks. the application of the hausman test provided the criteria for choosing between random effect models and fixed effect model. breusch and pagan lagrangian multiplier test was employed to confirm the hausman test’s result in order to decide between random effects and pooled ols. three models were estimated based on the three proxies of the dependent variable. the first equation is the one which considers the return on equity (roe) and returns on assets (roa) as the performance indicator of equity returns, while credit risk, liquidity risk (lqr), and insolvency risk (insr) are controlling variable of firm size (fsize). research hypotheses h01: operational risk has no significant effect on equity returns (roe) of deposit money banks h02: operational risk with control variable of firm size has no significant effect on equity returns (roe) of deposit money banks in nigeria. h03: operational risk has no significant effect on return on assets (roa) of deposit money banks in nigeria. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 7 h04: operational risk with control variable of firm size has no significant effect on return on assets (roa) of deposit money banks in nigeria functional relationship yit = β0 +βxzit y= dependent variable: equity returns x = independent variable: operational risk z = controlling variable: firm size model specification lognroeit =β0 +β1∆logroeit + β2logcrit + β3loginsrit + β4loglqrit + ɛit model 1 logroeit =β0 +β1∆lognpmrit + β2logcrit + β3loginsrit + β4loglqrit + β5fsizeit + β5∆fsizeit + ɛit model 2 roait =β0 +β1crit + β2loginsrit + β3lqrit + ɛit model 3 roait =β0 +β1crit + β2loginsrit + β3lqrit + β4fsizeit + ɛit model 4 where: roe = return on equity; roa = return on assets; cr = credit ratio; insr = liquidity risk; lqr 4.1 descriptive analysis this section describes the variables used in this study. the variables are presented in three (3) different subsections. subsections (1) and (2) focus on the description of dependent and independent variables, respectively, in terms of the number of observations, mean, median, maximum, minimum, and standard deviation. in addition, subsection (3) focuses on the description of the associations that exist among the selected variables. 4.1.1 summary statistics indicators (dependent variables) this subsection focuses on the description of the variables that are considered as dependent variables in the subsequent analysis. the dependent variables are returned on equity (roe), and return on assets (roa), and they are used as indicators or proxies for measuring equity returns of the selected listed dmbs in nigeria. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 8 table 4.1. summary statistics indicators (dependent variables) roe roa observations 225 225 mean 602.1182 0.5403 median 506.4328 0.0237 maximum 4780.6030 30.5852 minimum -131.5863 -0.1021 std. dev. 610.7984 3.4302 source: author’s computation (2020). return on equity from the result in table 4.1, the average value of roe is 0.8111 while the median value is 0.8787, suggesting that the selected listed dmbs’ average roe during the period of this the study was 81.1%. this means that the listed dmbs were able to make 81% profit from their shareholders investment. the slight difference between the average and median values suggests that the performance ratio of the selected dmbs is not quite different from one bank to another. the maximum value of roe of the selected bands is approximately 2 million and in percentage, it implies that some of the selected dmbs recorded more than 100%, specifically 202% within the period of the study, and the level of deviation between the selected banks is approximately 31% during the period. return on assets it can be seen from the table that the average percentage of roa is 54%. while the maximum and the minimum distributions of the series (roa) are 30.6 million and -0.1 million, respectively, the standard deviation between the value of roa among the listed dmbs are 3.4 million. by implications, the level of equity returns of the selected banks differs from one another, and the extent of operational risk management among these banks vary as well. 4.1.2 summary statistics indicators (independent variables) operational risk is the independent variable in this study. the summary statistics of the various proxies used for operational risk management of the selected deposit money banks are presented in table 4.2. the independent variables are credit risk (cr), insolvency risk (insr), and liquidity risk (lqr), while firm size (fsize) was used as a controlled variable. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 9 table 4.2. summary statistics indicators (independent variables) cr insr lqr fsize observations 225 225 225 225 mean 0.761993 1.630116 1.911175 7.351349 median 0.753594 1.632801 1.841115 6.711791 maximum 1.519670 4.633305 4.004754 9.671570 minimum 0.129087 0.744469 -0.398530 3.694956 std. dev. 0.193659 0.434723 0.486193 1.451314 source: author’s computation (2020). credit risk in table 4.2, it can be seen that the computed average credit risk ratio for the selected dmbs in the nigerian stock exchange during the years under study stood at 0.761993, its median is 0.754, and the maximum is 1.519 while the minimum distribution is 0.129. this distribution shows that the mean and mid amount of cr of the banks are closely related and the amount of deviation of cr among the banks is 19.4%. the indication from the above is that the average and mid amount of cr are 76.26% and 75.4% respectively. this implies that the level of the credit risk of the selected dmbs is high and that there is a need for prudent financial management to diminish overall operational risk of the banks. insolvency risk in table 4.2, the average insr recorded by the selected banks within the study period 1.63. this means that the extent of the average annual insolvency risk is over 100% (163%) at the aggregate level for the selected banks. the minimum and maximum value of insr is 0.744 and 4.633 representing 74.4% and 463.3%. the median value of the distributed is 163.3%, while the level of the standard deviation of insr among the selected banks is approximately liquidity risk from the above table, the maximum value of lqr is 4.005 (400.5%) while the minimum value is -0.398) (-40%). the median value of the distribution is 1.841 (181.4%) and overall average distribution of 1.911 (191.1%). these figures depict that there was a decline of about 40%. the banks are therefore expected to constantly decrease sources of inefficiencies in their risk management. firm size this is used as the control variable in this study. the distribution of this series is summarized in the table above. it is indicated that within the period of the study, the selected banks have recorded an average of 7.4% increase in total assets. since the firm size is obtained as a logarithmic transformation of the total assets of the listed firms, it is expressed in percentage. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 10 therefore, the maximum level of increase in firm size is 9.7% while the minimum is 3.7%. the level of deviation between firms’ size of the listed banks is 1.5%, hence, the selected banks have closely related firm sizes. this is further varied as the percentage of maximum firm size and the median firm size is close to each other and the banks are relatively large as the standard deviations of the cross-sections of firm size only 1.5%. 4.1.3 correlation matrix and interpretations this subsection focuses on the results of the correlation analysis that depicts the degree of associations among the selected variables in this study. the correlation result relates to the level of associations of the proxies of equity returns and measures of operational risk. this correlation analysis helps identify those time series variables that either has negative or positive association with each other, and the extent of their relationship in order to further, determine whether the correlation can cause multicollinearity problem in the subsequent empirical analysis. table 4.3. correlation matrix and interpretations var roe (1) roa (2) cr (3) insr (4) lqr (5) fsize (6) roe 1.000 roa -0.024 1.000 cr -0.029 0.291 1.000 insr -0.021 0.707 -0.023 1.000 lqr -0.029 -0.027 -0.030 -0.023 1.000 fsize 0.144 -0.241 -0.238 -0.147 0.082 1.000 source: author’s computation (2020). the result in column (1) to (3) of table 4.3 shows that the associations among the dependent and independent variables absolutely take values between 0.020 and 0.144. it is pertinent to mention here that not any of these correlation coefficients suggest a multicollinearity problem. multicollinearity problem occurs only when there are high correlations among independent variables. specifically, in column (1) of the table; all the correlation coefficients with the exception of firm size (fsize) are negatives indicating that increasing risk exposures of the dmbs will lead to less equity returns. while the positive correlation coefficient of 0.144(14.4%) between firm size and return on equity (roe) potentially shows that as firm size increase, the level of marginal profit will increase, some measures of risk, especially credit risk (cr) and liquidity risk (lqr) show the same magnitude of association with roe, asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 11 implying that cr and lqr would likely have a similar negative effect on the level of equity returns of the selected listed banks. in all, it is evidenced by the correlation coefficients in the table that there are predominantly negative relationships between measures of operational risks and equity returns measures. 4.2 inferential statistics table 4.4. regression result of the effect of operational risk on equity returns variable panel regression result random effect model without control variable (model 1) panel regression result fixed effect model with control variable (model 2) dependent variable = lognpmr coeff. robust std. error. t-stat. p-value coeff. robust std. error. t-stat. p-value. c 1.672* 0.235 7.114 0.000 1.897* 0.405 4.678 0.000 ∆(logroe) 0.402* 0.064 6.270 0.000 0.383* 0.059 6.462 0.000 logcr -0.007* 0.001 -4.770 0.000 -0.008* 0.002 -4.989 0.000 loginsr -0.036 0.055 -0.665 0.508 -0.129** 0.057 -2.249 0.027 loglqr -0.152** 0.065 -2.345 0.021 -0.175** 0.065 -2.703 0.008 fsize 0.010 0.041 0.248 0.805 ∆(fsize) -0.063 0.041 -1.564 0.121 adj. r2 = 0.535; f-stat = 9.955 (0.000) adj. r2 = 0.435; f-stat = 6.645 (0.000) hausman test 2.239 (0.692) 32.521 (0.000) bp lm test 80.690 (0.000) 52.700 (0.201) pcd test -1.597 (0.110) 2.984 (0.003) source: author’s computation (2020). note: * and ** represent 1% and 5% level of statistical significance. 4.2.1. hausman tests and breusch and pagan lm test as in table 4.4 in model 1, the hausman test result without the control variable is not significant (p-values > 0.05). this suggests the acceptance of the null hypothesis and that the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 12 random effects estimator is appropriate in investigating the effect of operational risk on the financial performance of the listed dmbs in nigeria. however, the breusch and pagan lm test employed to confirm the results of hausman tests further strengthened the decision to use the random effect model as its estimated value is statistically significant. by this, the null hypothesis underlying the bp lm test is rejected and that the pooled ols cannot be used. therefore, the random effect model is considered as the most appropriate and used for the analyses of the model in panel 1 without the control variable. for the model with the control variable in a panel in model 4 of table 4.4, the hausman test result is statistically significant with p-values < 0.05. this implies the rejection of the null hypothesis and the suggestion is that the fixed effect model is the best. on the contrary, however, the breusch and pagan lm test (b-p lm) result is not statistically significant and this implies that pooled ols should be used. the comparison of the f-test and the adjusted coefficient of the determination (adj. r2) the pooled and fixed-effect model, however, suggests that the fixed effect model is the best. therefore, the fixed effect model is reported for the effect of operational risk on equity returns (roe) of the selected dmbs with firm size as the control variable in panel 2. 4.2.3 cross-sectional dependence test in this study, pesaran cd test statistic results in table 4.4 are meant to check whether the estimated models have cross sectional dependence or not when return on equity (roe) is regressed on credit risk (cr), insolvency risk (insr), and liquidity risk (lqr), as well as firm size (fsize). from the table above, the pcd test value in the model without the control is statistically insignificant, and it strongly suggests the acceptance of the null hypothesis of no cross-sectional dependence in the model. the pcd test for the model with control variable shows that there is a cross-sectional dependency of the units examined because the test is statistically significant. the implication is that the selected listed dmbs are in the same sector, hence there is an unobserved common factor among the non-stationary panels of the selected banks. following the post-estimation tests’ results carried out, the results of the random and fixed effects model with and without the control variable, are analyzed and discussed. model one logroeit =β0 +β1∆logroeit + β2logcrit + β3loginsrit + β4loglqrit + ɛit – model 1 roeit = 1.672 + 0402roeit 0.007crit – 0.036insrit +0.152lqrit +eit model 1 using dynamic model: in column (1) of table 4.4, the significant value of f-statistics [9.955; p-value = 0.000] shows that the selected random effect model is statistically significant. that is, the combined effect of cr, insr, and lqr on roe is statistically significant at 5% level of statistical significance. the adjusted coefficient of the multiple determinations (adj.r2 = 0.535) further confirmed the usefulness of the model. the adjusted r-square value of 0.535 indicates that the explanatory variables jointly account for about 54% of the variation in return on equity asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 13 of the selected listed banks. this evidence, therefore, indicate that operational risk has a significant effect on equity returns of dmbs in nigeria. focusing on the coefficient of individual parameters (independent variables), the dynamic coefficient of the dependent variable which is the change in the logarithmic value of return on equity ∆(logroe) is statistically significant at 5% and it shows if change if roe of the selected banks increase by 1%, it will cause the current value of roe to increase by 0.4%. also, if all things being equal, the result indicated that a 1% increase in the coefficient of the log value of credit risk (cr) will lead to a 0.01% decrease in roe. it is also found from the result in panel 1 of table 4.4 that a 1% increase in liquidity risk of the banks will lead to about a 0.2% decrease in equity returns of the banks. the result for the coefficient of insolvency risk is not significant although it shows that an increase of 1% in insolvency risk will potentially decrease equity returns of the banks by 0.04%. overall, two of these proxies of operational risk validate the point that operational risk has significant negative impacts on equity returns of dmbs in nigeria. model two logroeit =β0 +β1∆logroeit + β2logcrit + β3loginsrit + β4loglqrit + β5fsizeit + β5∆fsizeit + ɛit ………………………………………………………………model 4 roeit = 1.897 + 0.383logroeit – 0.008logcrit +0.129loginsrit + 0.175loglqrit +0.010fsizeit – 0.063∆fsizeit ………………………………model 4 in column (1) of table 4.4, the significant value of f-statistics [6.645; p-value = 0.000] indicates that the selected results in the fixed effect model are statistically significant and that the joint effects of the regressors (independent variables) which are cr, insr and opir on roe is statistically significant at 5%. it is further supported by the adjusted value of the coefficient of the determination of the model (adj.r2 = 0.435). this indicates that the proxies of operational risk jointly accounted for about 44% of variation in the dependent variable-return on equity (roe) of the selected listed banks. by implication, operational risk has a significant effect on equity returns of dmbs in nigeria. in terms of individual significance of the explanatory variables, the result indicates that the dynamic coefficient of the dependent variable, which is the change in the logarithmic value of roe, is statistically significant at 5% with the implication that a 1% increase in equity returns of the banks will trigger current value of profit margin to increase by 0.4%. in other words, a positive change in profit margin of dmbs in nigeria increases the equity returns of the banks. on the part of credit risk (cr), the result demonstrates that a 1% increase in cr of the banks will lead to about 0.01% decline in net profit margin of the selected listed deposit money banks in nigeria. the control variable, which is firm size (fsize), established an insignificant impact on equity returns of the selected banks. in fact, the value of firm size and the coefficient of its change (dynamics), indicated insignificant effects on the roe of the firms. since the joint impact measures of the model with the firm size are significant, it implies that firm size can potentially increase the level of equity returns of the banks. this is confirmed from the positive coefficient asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 14 of the variables. for instance, a 1% increase in fsize will potentially increase the roe of the banks by about 0.01%. also, a 1% change in firm size will potentially lead to a decrease of about 0.06% in roe of the banks. discussion of findings (models 1 & 2) the findings from the regression result in table 4.4 reveal that negative relationships exist between credit risks (cr), insolvency risk (insr), liquidity risk (lqr), and return on equity (roe) in panel 1. in the same fashion, cr, insr, and lqr portrayed negative impacts on net profit margin of the banks in the fixed-effect model with control variable in panel 4. this result is consistent with the findings of lyambiko (2015) who established that cr and insr as indicators of operational risk had negative effects on the financial performance of deposit money banks in tanzania. also, the findings of this study is consistent with muriithi and muigai (2017) on quantitative analysis of operational risk and equity returns of kenyan deposit money banks using cost income ratio, indicated that cost income is negatively influenced bank equity returns both in the long run and short run. like the findings of negative impacts of operational risks on banks’ performance in nigeria in this study, olalere and wan (2018) obtained similar findings in their study. they empirically found that effects of credit risk on equity returns of deposit money banks in nigeria were evidently negative and significant. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 15 table 4.6. regression result of the effect of operational risk on return on assets variable panel regression result random effect model without control variable (model 3) panel regression result fixed effect model with control variable (model 4) dependent variable = roa coeff. robust stderr t-stat. p-value coeff. robust stderr. t-stat. p-value. c -839.907* 88.661 -9.473 0.000 290.296 280.920 1.033 0.304 cr 0.099* 0.021 4.762 0.000 0.042*** 0.024 1.804 0.074 loginsr 536.688* 52.300 10.262 0.000 524.610* 53.722 9.765 0.000 lqr -0.0000013 0.000 -0.005 0.996 -0.00023 0.00023 -0.986 0.327 fsize -148.914* 34.535 -4.312 0.000 adj. r2 = 0.520 f-stat = 10.187 (0.000) adj. r2 = 0.581 f-stat = 13.678 (0.000) hausman test 4.697 (0.195) 18.924 (0.000) bp lm test 174.844 (0.000) 168.334 (0.000) pcd test 2.805 (0.005) 2.677 (0.007) source: author’s computation (2020). note: *, **, and *** represent 1%, 5%, and 10% level of significance. 4.2.4 hausman tests and breusch and pagan lm test results in table 4.6 reveal that the estimated coefficient of the hausman test shows insignificant with the p-value of 0.195. this suggests the acceptance of random effect model in panel 1 without the control variable for investigating the effect of operational risk on the financial performance of the listed dmbs in nigeria in terms of return on assets (roas). to be able to choose between random effect model and pooled ols, however, the result for the b-p lm test confirms that the best model is random effect as its p-value was significant (p-value < 0.05). therefore, the random effect model is used for the analyses of the model in panel 1 without the control variable. for the model with the control variable of firm size in panel 6 of table 4.6, the hausman test result is statistically significant (p-values < 0.05). this requires that the null hypothesis is rejected and that the fixed effect model is the best. the b-p lm test reveals that pooled ols asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 16 cannot be used as the p-value < 0.05 is statistically significant. therefore, the fixed effect model is the best and is reported for the effect of operational risk on equity returns (roe) of the selected dmbs with firm size as the control variable in panel 2. 4.2.5 cross-sectional dependence test evidence for the existence of cross-sectional dependence is checked with the use of pcd test statistics for the model with and without control variable. the result in panel 3 and 6 show that there is a presence of cross-sectional dependence of the estimates for the selected banks. by implication, the sampled banks may have common heterogeneous factors that determine their financial performances and risk management. based on these diagnostics or post-estimation tests’ results, the results of the random and fixed effects model with and without the control, variable are analyzed and discussed and the models reinstated as: model three roait =β0 +β1crit + β2loginsrit + β3lqrit + ɛit ………………………..……model 3 roait = -839.907 + 0.099crit + 536.688lognsrit + 0.003lqrit + ɛit……………model 3 in column (1) of table 4.6 above, the overall joint test of significant, f-statistics [f-stat = 10.187; p-value = 0.000] shows that the selected random effect model is statistically significant, and it implies that the measures of operational risk (cr, insr, and lqr) had a statistically significant combined effect on roa of the selected listed banks at a 5% level of significance. the adjusted r-square which is the coefficient of the determination of the model shows that the independent variables jointly determine variation in roa for about 52%. that is, other variable that is not included as part of the independent variable account for about 48% of total variations in return on assets (roa) of dmbs. in all, the included measures of operational risk of the banks are statistically significant in determining the extent of roa of the banks. since the estimated model in table 4.6 is a semi-log model, that is a linear-log model, evidence from the estimates of the independent variables reveals that a unit increase in credit risk (cr) will lead to 0.099 unit increase in roa of the banks. similarly, if insolvency risks (insr) increase by 1%, it will cause about 5.37 unit (i.e. 536.688/100) change in the average value of roa for the selected dmbs in nigeria. the coefficient for the value of liquidity risk is insignificant; however, it reveals that a unit increase in liquidity risk will decrease roa of the banks by 0.0000013 units. it is only credit risk (cr) and insolvency risk (insr) that showed a positive impact on roa. the overall indication from the analysis above, therefore, shows that operational risk has significant positive effects on equity returns of dmbs in nigeria. model four roait =β0 +β1crit + β2loginsrit + β3lqrit + β4fsizeit + ɛit model 4 roait = 290.296 + 0.042crit + 524.610lognsrit – 0.013lqrit 148.914fsizeit model 4 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 17 results in panel 4 in table 4.6 implies that the joint f-statistic that measures the overall significant of the explanatory variables is 13.678 with p-value = 0.000 and it implies that the indicators of operational risk with firm size as the control variable are jointly significant in predicting return on assets (roa) of the banks. the adjusted r-square (adjr2 = 0.581) indicates that all the independent variables including the control, significantly accounted for overall 58.1% variation in roa of the selected dmbs in nigeria. with reference to individual performances of the regressors, the results in table 4.6 with the control exhume that at a 10% level of statistical significance, a unit increase in cr will lead to 0.042 units increase in roa of the selected banks. for insolvency risk, a 1% increase in the level of insolvency of the banks will cause 5.23 units to rise in the average value of roa of the banks. again, the coefficient for liquidity risk is not significant, but it potentially shows that if a unit changes in lqr could cause roa to decrease by 0.00023 units. the control variable, firm size (fsize) proves to be statistically significant as a determinant of the financial performance of the selected dmbs in nigeria. in this case, the result indicates that a unit increase in firm size will decrease roa of the banks by 149 units, approximately. this result suggests that increase in firm size, which is measured as a logarithmic transformed value of total assets without a significant corresponding rise in gross earnings, will decrease the roa of the banks. therefore an augmented model of operational risk impact on banks equity returns with firm size as a control variable is significantly robust. discussion of findings (model 3 & 4) the findings from the regression result in table 4.6 reveal that negative relationships exist between credit risks (cr) and return on equity (roe) of the banks, and liquidity risk (lqr) and roe in panel 3. in the same fashion, cr, insr and lqr portrayed negative impacts on net profit margin of the banks in the fixed effect model with a control variable in panel 6. this result is consistent with the findings of sempabwa and kariuk (2017) who found in their study on rwandan enterprise risk management practices and financial performance of deposit money banks with simple regression analyses, that credit risk management had a positive influence on the financial performance of rwandan’s deposit money banks. also, arnet, gregory and maurice (2016) who studied the effect of risk management practices on the financial performance of dmbs in kenya although a positive statistically significant relationship between risk management practices and financial performance of dmbs in kenya was established. the result found which was found in this study for hypothesis three corroborates with the findings of other authors such as nurlida (2017) who conducted a study on operational risks in malaysia. by employing credit risk ratio, liquidity ratio, operational risk ratio, and performance indicators of return on asset ratio, return on equity ratio, net interest margin as was used for a period of 5 years (2011-2015), this author found that risk management positively affected performance of dmbs in malaysia. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 18 5. conclusion, recommendations and contribution to knowledge 5.1 conclusion this study examined the effect of operational risk on equity returns, applying dynamic and static panel data analysis. the study formulated and tested four models of the effect of operational risk on net profit margin for model 1, and the effect of operational risk on return on assets for model 2. the control variable of firm size was introduced to each of the models for models 3 and 4. the aim was to determine the reaction of the models. the results revealed that operational risk had a statistically positive significant effect on return on equity in model 1, while operational risk exerted positive statistical effect also on return on assets. the control variable on each of the models revealed operational risk with firm size exhibited statistical positive significance on each of the return on equity and return on assets. conclusively, the study affirms that equity returns were statistically affected by operational risk in nigeria. 5.2 recommendations and contribution to knowledge the study recommends that dmbs managers should carefully carry out due diligence on loan applicants, to ascertain performance trend and creditworthiness of potential and prospective borrowers before advancing loans in order to reduce huge profiles of credit risk exposures. operational competence and recruitment procedure are critical for dbms towards the reduction of operational risks. optimal utilization of banks resources is imperative if adequate returns must be ensured. directors should be more diligent and implement effective monitoring roles in line with the corporate governance best practices. while vast literature does exist in the area of operational risk, however, only a considerably limited work has attempted to study the effects of operational risk on equity return exploring dynamic and static panel analysis in the nigerian emerging literature. in addressing this gap, this study has investigated the effects of operational risk on equity literature. it might be possible to expand this study to include more years of data and also extend the analysis to include more banks in further studies. references aguayo, f. z., & slusarczyk, b. 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(2018). analysis of the effect of capital, credit risk, and liquidity risk on profitability in banks. jurnal ilmu manajemen & ekonomika, 10(2), 44-50 https://doi.org/10.35384/jime.v10i2.80 sharfman, b. (2013). shareholder wealth maximization and its implementation under corporate law. florida law reviews, 4th june 2013. https://doi.org/10.2139/ssrn.2129376 sempabwa, e., & kariuki, p. (2017). enterprise risk management practices and financial performance of deposit money banks in rwanda. european journal of business and social sciences, 6(6), 112 127 microsoft word 18589-65440-1-sm-new asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 35 a vector autoregressive market model for it sector stocks in india mihir dash school of business, alliance university india rita s. department of statistics, periyar university india received: march 10, 2021 accepted: june 1, 2021 published: june 1, 2021 doi:10.5296/ajfa.v13i1.18589 url: https://doi.org/10.5296/ajfa.v13i1.18589 abstract this study proposes a vector autoregressive form for the market model and tests its significance against the market model for information technology (it) sector stocks in the indian stock market. the analysis was performed for a sample of nineteen it sector stocks listed on the national stock exchange of india, of which nine stocks were large-cap, six were mid-cap, and four were small-cap. the study period considered was jan. 1, 2018 – dec. 31, 2018. the key contribution of the study was the finding that the vector autoregressive model is a better model of stock returns than the market model for it sector stocks. thus, it sector stocks seem to react more to market movements from the previous day than on the day itself. the implication for asset pricing modelling is that systematic risk may be further decomposed into a component corresponding to sensitivity to market movements on the day and a component corresponding to sensitivity to market movements on the previous day. the asset pricing model would be extended to include market risk premia for both of these components of systemic risk. keywords: market model, vector autoregressive model, it sector, asset pricing modelling, systematic risk. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 36 introduction the market model (also called the single-index model) is a framework which represents the inter-relationship between all stocks through the market portfolio (sharpe, 1963). it asserts that stock returns are linearly related with market returns, specifically, 𝑟 = 𝛼 + 𝛽𝑟 , where α is the expected return of the stock when market return is zero, and β is the sensitivity of stock returns to changes in market returns. the model also yields a decomposition of the total risk/volatility of stock returns into a systematic component (related with market risk) and an unsystematic component (risk that is specific to the stock). subsequently, the parameter β plays a pivotal role in the capital asset pricing model (capm), which relates the expected returns of the stock with its systematic risk. the market model is very widely used in financial research, for evaluating and comparing stock/portfolio performance, for estimating systematic risk and cost of capital in capital budgeting, for computing abnormal returns in event studies (e.g. brown and warner, 1980), and for testing asset pricing models (fama and macbeth, 1973; gibbons, 1988). several studies have identified certain econometric limitations with the market model, particularly heteroskedasticity. mcdonald and lee (1988) proposed a generalised functional form for the market model using box-cox transformations in order to stabilise variance and reduce heteroskedasticity. coutts et al (1997) found significant parameter instability in the market model, which they suggested was affected considerably by non-firm-specific events. mills (1995) suggested that the market model should be estimated only after examining cointegration and/or short-run dynamics of the relationship between the stock price and the market index. fama and ross (1976) proposed the arbitrage pricing theory, which generalised the capm to include multiple macro-economic factors in the market model. french (1996) extended the capm by including the size and book-to-market effects. carhart (1997) suggested a further extension of the fama-french three-factor model including the momentum factor. another direction along which the capm was extended was that of autocorrelation. jegadeesh and titman (1993) explained medium-term autocorrelation in stock returns using the momentum effect. chan (1993) suggested that cross-autocorrelations in stock returns may be explained through nonsynchronous trading and that, further, cross-autocorrelation coefficients of stock returns are significantly higher under large market movements than under small market movements. soufian (2001) suggested that, before analysing factor models, it is essential to identify the process that generating the stock returns and macro-economic series and that vector autoregressive models may be used for this purpose. dash (2014, 2017) has used vector autoregressive models to test for granger causality between stock returns and market returns. the present study proposes a vector autoregressive form for the market model and tests its significance against the market model for information technology (it) sector stocks in the indian stock market. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 37 data & methodology the objective of the study is to examine vector autoregressive extensions of the market model for it sector stocks in the indian stock market. the sample stocks considered for the study are listed in table 1 below. the study period considered was jan. 1, 2018 – dec. 31, 2018. the data was collected from the national stock exchange of india (www.nseindia.com) . the nse index nifty 50 was considered as a proxy for the market portfolio. the risk-free rate was taken to be 6.33% p.a. based on average mibor for the study period. table 1. sample stocks considered for the study large-cap mid-cap tata consultancy services persistent systems infosys technologies firstsource solutions wipro technologies cyient hcl technologies hexaware technologies tech mahindra sonata software larsen & tourbo infotech zenstar technologies mindtree mphasis small-cap oracle financials services software eclerx services niit technologies nucleus software exports mastek the daily returns of the sample stocks and of the nifty 50 index were computed as the percentage change in daily closing prices, adjusting for dividends and stock splits/bonus share issues, if any. the kwiatkowski-phillips-schmidt-shin (kpss) test was used to test the stationarity of the series. the market model was estimated for each of the sample stocks using the regression model: 𝑟 = 𝛼 + 𝛽𝑟 , + 𝜀 as an alternative, the study proposes a vector autoregressive market model of the form: 𝑟 = 𝛼 + 𝜑 𝑟 + ⋯ + 𝜑 𝑟 + 𝛽𝑟 , + 𝛽 𝑟 , + ⋯ + 𝛽 𝑟 , + 𝜀 where the lag structures p and q are determined by minimising the akaike information criterion (aic). the significance of the vector autoregressive model over the market model is tested using the nested f-test. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 38 analysis & findings the descriptive statistics of the sample stock returns are presented in tables 2a, 2b, and 2c below. table 2a. descriptive statistics of daily returns – large cap stocks tcs infosys tech wipro tech hcl tech tech mahindra l & t infotech mindtree mphasis oracle fin serv mean 0.17% 0.14% 0.07% 0.08% 0.18% 0.19% 0.20% 0.13% -0.02% std dev 1.63% 1.48% 1.40% 1.77% 1.94% 2.50% 2.62% 2.33% 1.64% sharpe 0.0898 0.0738 0.0302 0.0317 0.0795 0.0669 0.0673 0.0465 -0.0288 skewness 0.2911 -0.1829 -0.0830 -0.7078 0.0314 0.6378 -0.8777 0.3736 0.1638 max. 6.41% 4.21% 5.24% 4.93% 8.23% 11.32% 9.18% 9.12% 5.42% min. -5.57% -4.66% -4.15% -7.77% -7.26% -7.68% -18.36% -6.17% -5.25% table 2b. descriptive statistics of daily returns – mid cap stocks persistent systems firstsource cyient hexaware sonata software zenstar tech mean -0.03% 0.12% 0.02% -0.02% 0.13% 0.13% std dev 2.38% 2.87% 2.21% 2.76% 3.03% 2.66% sharpe -0.0217 0.0316 -0.0008 -0.0149 0.0351 0.0394 skewness -1.5976 0.3610 0.5866 -1.0781 0.6683 0.5791 max. 6.36% 11.42% 11.67% 12.89% 14.57% 12.74% min. -16.64% -7.98% -6.70% -15.65% -10.90% -8.99% table 2c. descriptive statistics of daily returns – small cap stocks eclerx niit tech nucleus s/w exp mastek mean -0.10% 0.23% -0.14% 0.07% std dev 1.87% 2.80% 2.61% 3.00% sharpe -0.0677 0.0721 -0.0629 0.0162 skewness 0.9943 -0.0943 0.7791 0.6979 max. 9.85% 9.50% 13.12% 15.18% min. -5.17% -12.22% -6.87% 10.32% the performance of the sample it sector stocks varied considerably, with mean daily returns ranging between -0.14% and 0.23%, and the volatility of daily returns ranging between 1.40% and 3.03%. in terms of risk-adjusted excess returns (i.e. sharpe ratio), several stocks outperformed the nifty 50 index, which had a sharpe ratio of 0.0626, particularly among the large-cap it stocks. the best-performing stock was tcs, with a sharpe ratio of 0.0898. some of the sample stock returns were considerably negatively skewed, particularly hcl technologies, mindtree, persistent systems, and hexaware, while eclerx was considerably asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 39 positively skewed. some very extreme negative daily returns and some very extreme positive daily returns were observed for several sample stocks: mindtree (-18.36%), persistent systems (-16.64%), niit technologies (-12.22%), mastek (+15.18% and -10.32%), sonata software (+14.57% and -10.90%), hexaware (+12.89% and -15.65%), nucleus software exports (+13.12%), zenstar technologies (+12.74%), cyient (+11.67%), firstsource (+11.42%), and l&t infotech (+11.32%). the results of the kpss tests for stationarity of the returns of the sample stocks are presented in table 3 below. table 3. results of the kpss test for stationarity kpss stat p-value nifty 50 0.0542 > 0.1000 tcs 0.1124 > 0.1000 infosys tech 0.0956 > 0.1000 wipro tech 0.1405 ≈ 0.0630 hcl tech 0.1322 ≈ 0.0780 tech mahindra 0.1213 ≈ 0.0970 l & t tech 0.1027 > 0.1000 mphasis 0.0667 > 0.1000 mindtree 0.0222 > 0.1000 oracle financials services software 0.1276 ≈ 0.0860 persistent systems 0.1180 > 0.1000 firstsource 0.0943 > 0.1000 cyient 0.1175 > 0.1000 hexaware 0.1245 ≈ 0.0920 sonata software 0.0844 > 0.1000 zenstar tech 0.0590 > 0.1000 eclerx 0.1441 ≈ 0.0570 niit tech 0.1100 > 0.1000 nucleus software exports 0.1144 > 0.1000 mastek 0.1322 ≈ 0.0780 all of the sample stock daily returns and nifty 50 daily returns were found to be stationary at 5% level of significance. the results of the market model regressions are summarised in table 4 below. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 40 table 4. results of market model regressions alpha beta r2 p-value tcs 0.17% 0.2155 1.07% 0.1062 infosys tech 0.13% 0.1857 0.97% 0.1247 wipro tech 0.07% 0.0211 0.01% 0.8537 hcl tech 0.08% 0.0387 0.03% 0.7889 tech mahindra 0.17% 0.2488 1.01% 0.1168 l & t tech 0.19% 0.1620 0.26% 0.4284 mphasis 0.13% 0.1855 0.39% 0.3316 mindtree 0.19% 0.3313 0.99% 0.1212 oracle financials services software -0.02% 0.1109 0.28% 0.4073 persistent systems -0.04% 0.3765 1.53% 0.0529 firstsource 0.12% -0.0919 0.06% 0.6956 cyient 0.03% -0.0995 0.12% 0.5827 hexaware -0.01% -0.0783 0.05% 0.7292 sonata software 0.13% 0.2215 0.33% 0.3721 zenstar tech 0.12% 0.3525 1.08% 0.1044 eclerx -0.10% -0.0331 0.02% 0.8290 niit tech 0.24% -0.3358 0.88% 0.1428 nucleus software exports -0.14% 0.1263 0.14% 0.5552 mastek 0.07% 0.2339 0.37% 0.3415 it was found that none of the market model regressions were statistically significant at 5% level of significance, with the highest r2 at 1.53%. further, the beta estimates were found to be relatively low and statistically insignificant. thus, the market model was not adequate in explaining stock returns for it sector stocks. the results of the vector autoregressive model regressions are summarised in table 5 below. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 41 table 5. results of vector autoregressive model regressions alpha phi1 betam betam(-i) r2 p-value tcs 0.16% -0.0540 0.2066 0.4363** 5.52% 0.0034 infosys tech 0.12% -0.0400 0.1664 0.6353** 8.83% 0.0001 wipro tech 0.06% 0.0414 0.0186 0.3111** 3.24% 0.0328 hcl tech 0.06% -0.0482 0.0165 0.5252** 5.62% 0.0030 tech mahindra 0.16% -0.0331 0.2163 0.5852** 6.44% 0.0002 l & t tech 0.16% -0.0023 0.1387 0.9145** 8.47% 0.0001 mphasis 0.12% -0.0201 0.1711 0.3856** 2.06% 0.0448 mindtree 0.17% 0.0073 0.3050 0.8405** 7.35% 0.0004 oracle financials services software -0.04% -0.1288* 0.0898 0.5304** 7.96% 0.0002 persistent systems -0.06% -0.0180 0.3541* 0.6599** 6.15% 0.0016 firstsource 0.08% 0.0718 -0.1252 1.1600** 10.47% 0.0000 cyient 0.01% -0.0077 -0.1271 0.6051** 4.73% 0.0086 hexaware -0.03% -0.0371 -0.0913 0.7862** 5.16% 0.0052 sonata software 0.06% 0.1228* 0.1521 1.3842** 15.07% 0.0000 zenstar tech 0.08% 0.1038* 0.3265 0.7718** 7.82% 0.0002 eclerx -0.12% -0.0072 -0.0596 0.5064** 4.52% 0.0111 niit tech 0.19% 0.0593 -0.3556 1.1867** 11.80% 0.0000 nucleus software exports -0.17% 0.0708 0.0829 1.1300** 12.26% 0.0000 mastek 0.05% -0.0013 0.1891 1.1989** 10.08% 0.0000 the optimal lag structure minimising the aic was found to be p = q = 1 for all of the vector autoregressive models. it was found that all of the vector autoregressive model regressions were statistically significant at 5% level of significance, with r2 in the range of 2.06% to 15.07%. further, the beta estimates for one-day lagged nifty 50 returns were all found to be statistically significant at 1% level of significance. thus, the vector autoregressive model was adequate in explaining stock returns for it sector stocks. the results of the nested f-tests are summarised in table 6 below. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 42 table 6. results of nested f-tests f stat p-value tcs 5.6520 0.0040 infosys tech 10.3455 0.0000 wipro tech 4.0058 0.0194 hcl tech 7.1074 0.0010 tech mahindra 6.9645 0.0011 l & t tech 10.7637 0.0000 mphasis 3.1396 0.0451 mindtree 8.2375 0.0003 oracle financials services software 10.0130 0.0001 persistent systems 5.9073 0.0031 firstsource 13.9529 0.0000 cyient 5.8067 0.0034 hexaware 6.4656 0.0018 sonata software 20.8266 0.0000 zenstar tech 8.7741 0.0002 eclerx 5.6556 0.0040 niit tech 14.8571 0.0000 nucleus software exports 16.5762 0.0000 mastek 12.9582 0.0000 it was found that the vector autoregressive model was significant over the market model for all sample stocks at 5% level of significance. discussion the results of the study suggest that the vector autoregressive model is a better model of stock returns than the market model. specifically, as the one-day lagged nifty 50 returns were found to be statistically significant at 1% level of significance, it sector stocks seem to react more to market movements from the previous day than on the day itself. this could be due to the relative isolation of it stocks from domestic economic shocks, as their customer base is primarily the american and european markets. the implication for asset pricing modelling is that systematic risk may be further decomposed into a component corresponding to sensitivity to market movements on the day and a component corresponding to sensitivity to market movements on the previous day. the asset pricing model would be extended to include market risk premia for both of these components of systemic risk. this would need to be formalised theoretically and tested empirically in other sectors. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 43 there are some limitations inherent in the study. the sample size for the study was relatively small, only nineteen stocks in the it sector, and the research period was very short, only one year. thus, the results of the study may not be generalisable. additionally, the data of the sample stocks may contain many outliers, as there were several stocks with very extreme positive and negative daily returns, which may have affected the significance of the market model regressions. there is also the possibility of multicollinearity, as there may be significant autocorrelation in index returns, and heteroskedasticity. the latter may require a garch model approach. also, the highest r2 attained using the vector autoregressive model was a little above 15%, suggesting that there is scope to include other factors to improve the explanatory power. in particular, for the it sector, exchange rates would be expected to play a major role. further, other indices may be more appropriate than the nifty 50 index; for example the niftyit index or even the s&p 500 index. other macroeconomic variables may also play an important role. these should be investigated in future studies. references brown, s.j., & warner, j.b. (1980). measuring security price performance. journal of financial economics, 8, 205-258. https://doi.org/10.1016/0304-405x(80)90002-1 carhart, m. (1997). on persistence in mutual fund performance. journal of finance, 52(1), 57-82. https://doi.org/10.1111/j.1540-6261.1997.tb03808.x chan, k. (1993). imperfect information and cross-autocorrelation among stock prices. journal of finance, 48(4), 1211-1230. https://doi.org/10.1111/j.1540-6261.1993.tb04752.x coutts, j.a., roberts, j., & mills, t.c. (1997). parameter stability in the market model: tests and time varying parameter estimation with uk data. journal of the royal statistical society: series d (the statistician), 46(1), 57-70. https://doi.org/10.1111/1467-9884.00059 dash, m. (2014). granger causality and the capital asset pricing model. journal of applied management and investments, 3(2), 68-73. dash, m. (2017). a study of granger causality in the capm. i-manager’s journal on management, 11(4), 61-68. https://doi.org/10.26634/jmgt.11.4.13452 fama, e.f., & french, k.r. (1996). multifactor explanations of asset pricing anomalies. journal of finance, 51(1), 55-84. https://doi.org/10.1111/j.1540-6261.1996.tb05202.x fama, e.f., & macbeth, j. d. (1973). risk, return, and equilibrium: empirical tests. journal of political economy, 81(3), 607-636. https://doi.org/10.1086/260061 gibbons, m. r. (1988). multivariate tests of financial models: a new approach. journal of financial economics, 10(1), 3-27. https://doi.org/10.1016/0304-405x(82)90028-9 jegadeesh, n., & titman, s. (1993). returns on buying winners and selling losers: implications for market efficiency. journal of finance, 48(1), 64-91. https://doi.org/10.1111/j.15406261.1993.tb04702.x asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 44 mcdonald, b., & lee, c.-f. (1988). an analysis of nonlinearities, heteroskedasticity and functional form in the market model. journal of business and economic statistics, 6, 505-509. https://doi.org/10.1080/07350015.1988.10509699 mills, t.c. (1995). the econometrics of the ‘market model’: cointegration, error correction and exogeneity. international journal of finance economics, 1(4), 275-286. ross, s. a. (1976). the arbitrage theory of capital asset pricing. journal of economic theory, 13(3), 341-360. https://doi.org/10.1016/0022-0531(76)90046-6 sharpe, w. f. (1963). a simplified model for portfolio analysis. management science, 9(2), 277-293. https://doi.org/10.1287/mnsc.9.2.277 soufian, n. (2001). empirical content of capital asset pricing model (capm) and arbitrage pricing theory (apt) across time. manchester metropolitan university business school working paper series, wps010. microsoft word 18970-new asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 65 a study on the effect of portfolio allocation on mutual funds mihir dash (research scholar of department of statistics, periyar university) & interim associate dean school of applied mathematics, alliance university bangalore, india 562106 rita samikannu head of department, department of statistics, periyar university salem, india – 636011 received: may. 8, 2023 accepted: june 10, 2023 published: june 10, 2023 doi:10.5296/ajfa.v15i1.18970 url: https://doi.org/10.5296/ajfa.v15i1.18970 abstract there are hundreds of mutual funds in the market, each offering different returns. the investors always look at funds which give high returns and have low risk. thus while making a portfolio the asset management company should make investment allocations where returns are definite and to give justified returns for every rupee the investors pay, considering the different risks. the objective of the study was to find the short-term effects of portfolio allocation on the performance of mutual funds. the data for the study was consisted of the portfolio allocations and the performance statistics of one hundred and fifty-nine open-ended mutual funds, of which fifty were diversified debt/ income funds and one hundred and nine were diversified equity funds. these funds were further classified into different mutual fund schemes. each of the mutual funds had a different portfolio and investments were made in different instruments like bonds, certificates of deposit, commercial papers, etc. (in case of debt) and in different sectors like technology, chemicals, services, etc. (in case of equity). the findings from the study indicate that, for debt funds, allocation in bonds and government securities tend to impact the performance of the fund, while for equity funds, allocation in asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 66 engineering, energy, and service sector stocks tend to impact the performance of the fund. keywords: asset management company, portfolio allocations, returns, performance, debt funds, equity funds asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 67 introduction there are hundreds of mutual funds in the market, each offering different returns. the investors always look at funds which give high returns and have low risk. thus while making a portfolio allocation the asset management company (amc) should make investment allocations where returns are definite, giving justified returns for every rupee the investors pay, considering the different risks. on the other hand, there are lots of sectors and instruments in which the pool of money collected can be invested. the main aim of the amc is to make a portfolio allocation that gives maximum returns to the investors. the problem of asset allocation for mutual funds is a long-standing field of interest for researchers. it can be traced back to the beginning of portfolio theory itself. in particular, markowitz (1987) discussed some of the early models and approaches in portfolio construction. sharpe (1994) studied the effect of asset allocation and management style on mutual fund performance. he proposed an asset class model for the management of mutual fund investments. ibbotson and kaplan (1998) examined the effect of asset allocation on returns for balanced funds and pension funds. they found that that about 90% of the variability of returns of a typical fund across time was explained by policy; about 40% of the variation of returns across funds was explained by policy; and that on average, about 100% of the return level was explained by policy return. kadiyala (2004) studied the effect of investment in mutual funds on stock market returns. she found that stock market returns are related to contemporaneous flows into mutual funds that invest in risky stocks and bonds, but are unrelated to flows into funds that invest in safer stocks and bonds; in particular, this means that asset allocations of funds have an impact on market returns. data & methodology the present study examines the short-term effects of portfolio allocation on performance for open-ended mutual funds. the study was conducted with a random sample consisting of one hundred and fifty-nine different open-ended mutual funds, of which one hundred and nine diversified equity funds were used to study the allocation of funds in different sectors and fifty diversified debt/ income funds were used to study the allocation in different instruments. the sample of diversified debt/ income funds were classified as debt: ultrashort-term funds (24%), debt short term funds (2%), debt: floating-rate short-term funds (6%), debt: medium-term funds (26%), gilt: short-term funds (6%), gilt: medium-term funds (18%), and hybrid funds (18%). the sample of diversified equity funds were classified as equity: diversified funds (70.6%), equity: index funds (13.8%) and equity: tax planning funds (15.6%). the data for the study consisted of the portfolio allocations and the performance measures of the sample funds. the data was collected from the websites valueresearchonline.com and amfiindia.com. asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 68 the primary objective of the study was to analyze the short-term effects of the portfolio allocation on the performance of funds. in the case of diversified debt/ income funds, this involved analyzing the effect of differences in allocation of different debt/ income funds in different instruments on the differences in performance. on the other hand, in the case of diversified equity funds, this involved analyzing the effect of differences in allocation in different sectors on the difference in performance. stepwise multiple regression analysis was used in both situations to identify statistically significant effects. analysis & interpretation diversified debt/ income funds the overall allocation of the sample diversified debt/ income funds is shown in table 1: table 1: overall allocation of debt/ income funds in different instruments descriptive statistics 33.8808% 15.5846% 13.1120% 9.6396% 7.4802% 6.0148% 5.7076% 4.4026% 1.9400% 1.1908% 1.0470% bonds govt. securities others cash, call & others comm pap debt cert of deposit tresury bills reverse repo term deposits cp/cd mean it was found that bonds had the highest allocation (33.88%), followed by government securities (15.58%) and others (13.11%). amongst the least preferred instruments were reverse repos, term deposits and cp/cd’s. the descriptive statistics of the performance measures for the sample diversified debt/ income funds is shown in table 2: table 2. descriptive statistics of performance measures of debt/ income funds descriptive statistics .3004 .73436 4.660 22.948 .5582 1.16057 4.530 21.655 .2994 .33645 1.543 1.526 .3120 .32071 .941 -.447 .4505 .57141 1.015 .423 .6491 1.17430 2.029 4.413 mean returns standard deviation of returns beta r2 sharpe ratio treynor ratio mean std. skewnes kurtosis the allocation in each type of debt/ income fund in the sample is shown in table 3: asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 69 table 3. allocation in different instruments for different debt/ income funds report mean 26.4950% 40.6300% 52.2433% 53.0246% .0000% .0000% 54.3800% 33.8808% .0000% .0000% 6.2500% .8662% .0000% .0000% 2.4822% 1.0470% 19.9767% 26.4500% .0000% 1.4777% .0000% .0000% .0000% 5.7076% 20.0908% 22.6700% 14.3500% 4.2292% .0000% .0000% 1.3578% 7.4802% 5.9075% .0000% 2.3567% 4.1877% 27.4700% 23.034% 6.6511% 9.6396% 2.9025% .0000% 15.8600% 7.3231% .0000% .0000% 13.6811% 6.0148% .0000% .0000% .0000% 16.5738% 12.5100% 58.072% .3989% 15.5846% 2.5800% .0000% .0000% .0000% .0000% 3.1756% .0000% 1.1908% 2.6892% .0000% .0000% .4154% 14.8500% 15.323% .0000% 4.4026% .0000% .0000% .0000% 2.9192% 19.6833% .0000% .0000% 1.9400% 19.3583% 10.2500% 8.9400% 8.9831% 25.4867% .3944% 21.0489% 13.1120% bonds cp/cd cert of deposit comm pap cash, call & others debt govt. securities term deposits tresury bills reverse repo others debt: ultrashortterm debt: short-term debt: floating-rate short-term debt: medium term gilt: short-term gilt: mediumterm hybrid total category it was found that the debt: ultrashort-term funds allocated primarily in bonds (26.50%), commercial papers (20.09%), certificates of deposit (19.98%), and others (19.36%). debt short term funds showed a similar pattern, with bonds having the highest allocation (40.63%), followed by certificates of deposit (26.45%), commercial papers (22.67%), and others (10.25%). in the case of debt floating-rate short-term funds, bonds had the highest allocation (52.24%), followed by debt (with 15.86%), commercial papers (14.35%), and others (8.94%). debt: medium term funds had highest allocation in bonds (53.02%), followed by government securities (16.57%) and others (8.98%). in contrast, gilt short term funds had highest allocation in cash, call, and others (27.47%) and others (25.48%), followed by reverse repos (19.68%), t-bills (14.85%), and government securities (12.51%). gilt medium term funds allocated heavily in government securities (58.07%), followed by cash, call, and others (23.03%) and treasury bills (15.32%). finally, hybrid funds allocated highest in bonds (54.38%), followed by others (21.04%) and debt (13.68%). the descriptive statistics of the performance measures for each type of debt/ income fund are shown in tables 4, and the anova tests for differences in performance between different types of debt/ income funds are shown in table 5: asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 70 table 4. descriptive statistics of performance measures for each type of debt/ income fund report .0967 .1600 1.5333 .2585 .0900 .1322 .4756 .01303 . 2.49127 .36113 .01000 .16679 .89847 .0292 .0900 2.2933 .4469 .0733 .6711 .9467 .04814 . 3.95485 .25094 .00577 .31102 1.50889 .0492 .2100 .5733 .3408 .3867 .5200 .2422 .04660 . .45938 .23333 .11240 .46425 .38745 .0742 .0300 .3567 .5762 .0667 .5022 .1556 .09199 . .29006 .27467 .04041 .36148 .23093 1.0556 .8889 1.2104 .1959 .1310 .0006 .2660 .46782 . .70824 .45745 .12542 .19331 .13776 1.0576 .3810 1.5881 .2865 .0322 -.1281 1.3276 1.47770 . 2.49420 .79861 .03470 .30577 .83324 mean std. deviation mean std. deviation mean std. deviation mean std. deviation mean std. deviation mean std. deviation mean returns standard deviation of returnsbeta r2 sharpe ratio treynor ratio debt: ultrashortterm debt: short-term debt: floating-rate short-term debt: medium term gilt: short-term gilt: mediumterm hybrid category table 5. anova tests for differences in performance between different types of debt/ income funds anova table 5.765 6 .961 2.000 .087 20.660 43 .480 26.425 49 14.949 6 2.491 2.099 .073 51.051 43 1.187 66.000 49 1.497 6 .250 2.649 .028 4.050 43 .094 5.547 49 2.398 6 .400 6.505 .000 2.642 43 .061 5.040 49 9.595 6 1.599 10.738 .000 6.404 43 .149 15.999 49 17.150 6 2.858 2.438 .041 50.420 43 1.173 67.570 49 (combined)between groups within groups total (combined)between groups within groups total (combined)between groups within groups total (combined)between groups within groups total (combined)between groups within groups total (combined)between groups within groups total mean returns * category standard deviation of returns * category beta * category r2 * category sharpe ratio * category treynor ratio * category sum of squares df mean square f sig. it was found that there is no statistically significant difference in mean returns and standard deviation of returns between different types of debt/ income funds. among the sample funds, the debt floating rate short term funds had the highest mean returns, but with a lot of variation. on the other hand, there were statistically significant differences in all of the other performance measures between different types of debt/ income funds. among the sample funds, the debt floating rate short term funds had the highest mean beta, followed by the gilt: medium-term funds, while the debt: ultrashort-term funds had the lowest mean beta; the debt medium term funds had the highest mean r2, followed by the gilt: medium-term funds, while the debt: ultrashort-term funds had the lowest mean r2; finally, the debt floating rate short asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 71 term funds had the highest mean sharpe and treynor ratios, followed by the debt: ultrashort-term funds, while the gilt: medium-term funds had the lowest mean sharpe and treynor ratios. the correlation of the allocations of the debt/ income funds in the different instruments is shown in table 6: table 6. correlation of the allocations of the debt/ income funds in different instruments correlations 1 -.024 -.202 -.158 -.312* .195 -.439** -.226 -.391** -.113 -.148 .435 .079 .136 .014 .088 .001 .057 .003 .218 .152 50 50 50 50 50 50 50 50 50 50 50 -.024 1 -.105 -.099 .035 .213 -.155 -.058 -.087 -.049 .143 .435 .235 .246 .404 .068 .141 .343 .274 .369 .161 50 50 50 50 50 50 50 50 50 50 50 -.202 -.105 1 -.008 -.215 -.124 -.261* .200 -.044 -.085 .320* .079 .235 .479 .067 .195 .034 .082 .381 .277 .012 50 50 50 50 50 50 50 50 50 50 50 -.158 -.099 -.008 1 -.101 -.133 -.244* -.098 -.146 -.081 -.061 .136 .246 .479 .243 .178 .044 .249 .156 .287 .338 50 50 50 50 50 50 50 50 50 50 50 -.312* .035 -.215 -.101 1 -.242* .180 -.134 .048 -.111 -.267* .014 .404 .067 .243 .045 .105 .176 .370 .221 .030 50 50 50 50 50 50 50 50 50 50 50 .195 .213 -.124 -.133 -.242* 1 -.257* -.129 -.191 -.107 .053 .088 .068 .195 .178 .045 .036 .187 .092 .230 .359 50 50 50 50 50 50 50 50 50 50 50 -.439** -.155 -.261* -.244* .180 -.257* 1 .127 .136 .099 -.421** .001 .141 .034 .044 .105 .036 .190 .174 .246 .001 50 50 50 50 50 50 50 50 50 50 50 -.226 -.058 .200 -.098 -.134 -.129 .127 1 .173 -.048 -.002 .057 .343 .082 .249 .176 .187 .190 .115 .371 .494 50 50 50 50 50 50 50 50 50 50 50 -.391** -.087 -.044 -.146 .048 -.191 .136 .173 1 -.071 .030 .003 .274 .381 .156 .370 .092 .174 .115 .312 .419 50 50 50 50 50 50 50 50 50 50 50 -.113 -.049 -.085 -.081 -.111 -.107 .099 -.048 -.071 1 -.117 .218 .369 .277 .287 .221 .230 .246 .371 .312 .209 50 50 50 50 50 50 50 50 50 50 50 -.148 .143 .320* -.061 -.267* .053 -.421** -.002 .030 -.117 1 .152 .161 .012 .338 .030 .359 .001 .494 .419 .209 50 50 50 50 50 50 50 50 50 50 50 pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n bonds cp/cd cert of deposit comm pap cash, call & others debt govt. securities term deposits tresury bills reverse repo others bonds cp/cd cert of deposit comm pap cash, call & others debt govt. securities term deposits tresury bills reverse repo others correlation is significant at the 0.05 level (1-tailed).*. correlation is significant at the 0.01 level (1-tailed).**. correlation analysis of the allocations in the different instruments has yielded the following results:  allocation in bonds was not positively correlated to allocation in any of the securities, and was negatively correlated to allocation in cash, call, and others, government securities, and treasury bills.  allocation in cp/cd was uncorrelated with allocation in the other security.  allocation in certificates of deposit was positively correlated to allocation in others, and negatively correlated to allocation in the government securities  allocation in commercial papers was not positively correlated to allocation in any of the securities, and was negatively correlated to allocation in government securities. asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 72  allocation in cash, call, and others was not positively correlated to allocation in any of the securities, and was negatively correlated to allocation in the bonds, debt, and others.  allocation in debt was not positively correlated to allocation in any of the securities, and was negatively correlated to allocation in cash, call, and others and government securities.  allocation in government securities was not positively correlated to allocation in any of the securities, and was negatively correlated to allocation in bonds, certificates of deposit, commercial papers, debt, and others.  allocation in term deposits was uncorrelated with the allocation in any other security.  allocation in treasury bills was not positively correlated to allocation in any of the securities, and was negatively correlated to allocation in bonds.  allocation in reverse repos was uncorrelated with allocation in any other security.  allocation in others was positively correlated to allocation in certificates of deposit, and was negatively correlated to allocation in cash, call, and others and in government securities. regression analysis was performed to analyze the effect of allocation in different instruments on the performance of debt/ income funds. the results of stepwise multiple regression of mean returns of debt/ income funds on the portfolio allocation in different instruments is shown in table 7: table 7. stepwise multiple regression of mean returns on portfolio allocation in different instruments coefficientsa .036 .153 .236 .814 .008 .003 .311 2.267 .028 (constant) bonds model 1 b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: mean returnsa. it was found that variation in mean returns of debt/ income funds was explained by variation in allocation in only one instrument, viz. bonds, that the allocation in this instrument explained 9.7% of the variation in mean returns of the debt mutual funds, and that this effect was statistically significant. the results of stepwise multiple regression of standard deviation of returns of debt/ income funds on portfolio allocation in different instruments showed that variation in standard deviation of returns of debt/ income funds was not affected by allocation in any of the instruments. asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 73 the results of stepwise multiple regression of beta of debt/ income funds on the portfolio allocation in different instruments is shown in table 8: table 8. stepwise multiple regression of beta on portfolio allocation in different instruments coefficientsa .209 .052 4.054 .000 .006 .002 .424 3.246 .002 (constant) govt. securities model 1 b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: betaa. it was found that variation in beta of debt/ income funds was explained by variation in allocation in only one instrument, viz. government securities, that the allocation in this instrument explained 18% of the variation in beta of the debt/ income funds, and that this effect was statistically significant. the results of stepwise multiple regression of r2 of debt/ income funds on the portfolio allocation in different instruments is shown in table 9: table 9. stepwise multiple regression of r2 on portfolio allocation in different instruments coefficientsa .215 .048 4.510 .000 .006 .002 .477 3.762 .000 (constant) govt. securities model 1 b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: r2a. it was found that variation in r2 of debt/ income funds was explained by variation in allocation in only one instrument, viz. government securities, that the allocation in this instrument explained 22.8% of the variation in r2 of the debt/ income funds, and that this effect was statistically significant. the results of stepwise multiple regression of the sharpe ratio of debt/ income funds on the portfolio allocation in different instruments is shown in table 10: table 10. stepwise multiple regression of the sharpe ratio on portfolio allocation in different instruments coefficientsa .583 .090 6.482 .000 -.009 .003 -.369 -2.748 .008 (constant) govt. securities model 1 b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: sharpe ratioa. asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 74 it was found that variation in the sharpe ratio of debt/ income funds was explained by variation in allocation in only one instrument, viz. government securities, that the allocation in this instrument explained 13.6% of the variation in the sharpe ratio of the debt/ income funds, and that this effect was statistically significant. the results of stepwise multiple regression of the treynor ratio of debt/ income funds on the portfolio allocation in different instruments is shown in table 11: table 11. stepwise multiple regression of the treynor ratio on portfolio allocation in different instruments coefficientsa .327 .207 1.583 .120 .025 .010 .330 2.420 .019 -.156 .279 -.560 .578 .028 .010 .377 2.879 .006 .013 .005 .321 2.452 .018 (constant) others (constant) others bonds model 1 2 b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: treynor ratioa. it was found that variation in treynor of debt/ income funds was explained by variation in allocation in only two instruments, viz. others and bonds. together, allocation in these two instruments explained 21% of the variation in the treynor ratio of the debt/ income funds, and this effect was statistically significant. of the allocations in the two instruments, allocation in others had the greater impact on the treynor ratio than allocation in bonds had. diversified equity funds the overall allocation of the sample diversified equity funds is shown in table 12: table 12. overall allocation of equity funds in different sectors descriptive statistics 32.0731% 17.7861% 10.2243% 9.8389% 8.2821% 5.2116% 3.9085% 3.8983% 2.2239% 2.1537% 1.9894% 1.9103% .4999% others technology fin services energy engineering diversified services metals consu non dur health care construction automobile chemicals mean it was found that others had the highest allocation (32.07%), followed by technology (17.79%) and financial services (10.22%). amongst the least preferred sectors were construction, asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 75 automobile, and chemicals. the descriptive statistics of the performance measures for the sample diversified equity funds is shown in table 13: table 13. descriptive statistics of performance measures of equity funds descriptive statistics 3.4580 .73472 -1.094 7.769 5.7580 1.10827 -2.950 14.705 .9396 .58738 9.548 97.341 .7598 .16722 -.860 1.659 mean returns std dev of ret beta r2 statistic statistic statistic statistic mean std. skewnes kurtosis the allocation in each type of equity fund in the sample is shown in table 14: table 14. allocation in different sectors for different equity funds report mean 8.7543% 3.8033% 10.0953% 8.2821% 2.2921% .0000% 1.8665% 1.9103% 8.3540% 19.3540% 8.1688% 9.8389% .6219% .0000% .3882% .4999% 2.1240% .0000% 3.1347% 1.9894% 6.1670% 2.4740% 3.2994% 5.2116% 2.4527% .0000% 2.6994% 2.1537% 16.7930% 24.7440% 16.1447% 17.7861% 8.9595% 19.7433% 7.5541% 10.2243% 1.9922% 3.0187% 2.5724% 2.2239% 3.9439% 2.5767% 4.8576% 3.8983% 4.9114% .0673% 2.7553% 3.9085% 32.6339% 24.2187% 36.4635% 32.0731% engineering automobile energy chemicals construction diversified health care technology fin services consu non dur metals services others equity: diversified equity: index equity: tax-planning total category amongst the equity: diversified funds, others had the highest allocation (32.63%), followed by technology (16.79%), financial services (8.95%), and engineering (8.75%). in the case of equity: index funds, technology had the highest allocation (24.74%), followed by others (24.21%), financial services (19.74%), and energy (19.35%). finally, in the case of equity: tax planning funds, others had the highest allocation (36.46%), followed by technology (16.14%) and engineering (10.09%). the descriptive statistics of the performance measures for each type of equity fund are shown in table 15, and the anova tests for differences in performance between different types of debt/ income funds are shown in table 16: asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 76 table 15. descriptive statistics of performance measures for each type of equity fund report 3.4764 5.6803 .9508 .7400 .80126 1.22193 .69799 .15960 77 77 77 77 3.1700 5.6573 .9400 .9560 .32894 .88905 .06908 .07908 15 15 15 15 3.6288 6.1988 .8888 .6765 .62378 .51169 .08455 .13005 17 17 17 17 mean std. deviation n mean std. deviation n mean std. deviation n category equity: diversified equity: index equity: tax-planning mean returns std dev of ret beta r2 table 16. anova tests for differences in performance between different types of equity funds anova table 1.766 2 .883 1.656 .196 56.534 106 .533 58.300 108 3.920 2 1.960 1.614 .204 128.731 106 1.214 132.652 108 .053 2 .027 .076 .927 37.208 106 .351 37.262 108 .726 2 .363 16.764 .000 2.294 106 .022 3.020 108 (combined)between groups within groups total (combined)between groups within groups total (combined)between groups within groups total (combined)between groups within groups total mean returns * category std dev of ret * category beta * category r2 * category sum of squares df mean square f sig. it was found that there is no statistically significant difference in mean returns, standard deviation of returns, and beta between different types of equity funds. among the sample funds, the equity: tax planning funds had the highest mean returns, but with highest variation and lowest beta. on the other hand, there were statistically significant differences in r2 between different types of equity funds. among the sample funds, the equity: index funds had the highest mean r2, followed by the equity: diversified funds, while the equity: tax planning funds had the lowest mean r2. the correlation of the allocations of the equity funds in the different sectors is shown in table 17: asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 77 table 17. correlation of the allocations of the equity funds in different sectors correlations 1 .328** -.340** -.121 .217* -.060 .087 -.194* -.236** .053 -.096 -.205* -.049 .000 .000 .105 .012 .269 .183 .022 .007 .291 .160 .016 .308 109 109 109 109 109 109 109 109 109 109 109 109 109 .328** 1 -.341** -.039 .078 .144 .031 -.317** -.192* .006 -.163* -.120 .142 .000 .000 .344 .210 .068 .373 .000 .023 .474 .046 .107 .070 109 109 109 109 109 109 109 109 109 109 109 109 109 -.340** -.341** 1 -.205* -.348** -.169* -.255** .454** .198* -.093 -.004 -.326** -.349** .000 .000 .016 .000 .039 .004 .000 .019 .168 .483 .000 .000 109 109 109 109 109 109 109 109 109 109 109 109 109 -.121 -.039 -.205* 1 -.101 -.105 .206* -.159* -.079 -.033 .211* .112 .114 .105 .344 .016 .149 .139 .016 .050 .206 .365 .014 .124 .119 109 109 109 109 109 109 109 109 109 109 109 109 109 .217* .078 -.348** -.101 1 .017 -.047 -.262** -.260** -.194* .126 .166* .108 .012 .210 .000 .149 .429 .314 .003 .003 .022 .096 .042 .132 109 109 109 109 109 109 109 109 109 109 109 109 109 -.060 .144 -.169* -.105 .017 1 -.080 -.160* -.076 -.153 -.141 -.009 -.004 .269 .068 .039 .139 .429 .203 .049 .217 .056 .071 .464 .485 109 109 109 109 109 109 109 109 109 109 109 109 109 .087 .031 -.255** .206* -.047 -.080 1 .033 -.299** .289** -.157 -.067 -.045 .183 .373 .004 .016 .314 .203 .367 .001 .001 .051 .245 .321 109 109 109 109 109 109 109 109 109 109 109 109 109 -.194* -.317** .454** -.159* -.262** -.160* .033 1 .095 .039 -.311** -.189* -.545** .022 .000 .000 .050 .003 .049 .367 .162 .343 .001 .025 .000 109 109 109 109 109 109 109 109 109 109 109 109 109 -.236** -.192* .198* -.079 -.260** -.076 -.299** .095 1 -.149 -.106 -.066 -.465** .007 .023 .019 .206 .003 .217 .001 .162 .061 .135 .246 .000 109 109 109 109 109 109 109 109 109 109 109 109 109 .053 .006 -.093 -.033 -.194* -.153 .289** .039 -.149 1 -.192* -.061 -.100 .291 .474 .168 .365 .022 .056 .001 .343 .061 .023 .265 .150 109 109 109 109 109 109 109 109 109 109 109 109 109 -.096 -.163* -.004 .211* .126 -.141 -.157 -.311** -.106 -.192* 1 .184* .027 .160 .046 .483 .014 .096 .071 .051 .001 .135 .023 .028 .389 109 109 109 109 109 109 109 109 109 109 109 109 109 -.205* -.120 -.326** .112 .166* -.009 -.067 -.189* -.066 -.061 .184* 1 .017 .016 .107 .000 .124 .042 .464 .245 .025 .246 .265 .028 .432 109 109 109 109 109 109 109 109 109 109 109 109 109 -.049 .142 -.349** .114 .108 -.004 -.045 -.545** -.465** -.100 .027 .017 1 .308 .070 .000 .119 .132 .485 .321 .000 .000 .150 .389 .432 109 109 109 109 109 109 109 109 109 109 109 109 109 pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n pearson correlation sig. (1-tailed) n engineering automobile energy chemicals construction diversified health care technology fin services consu non dur metals services others engineering automobile energy chemicals construction diversified health care technology fin services consu non dur metals services others correlation is significant at the 0.01 level (1-tailed).**. correlation is significant at the 0.05 level (1-tailed).*. correlation analysis of the allocations to the different sectors has yielded the following results:  allocation in the engineering sector was positively correlated with allocation in the automobiles and construction sectors, and negatively correlated with allocation in the energy, technology, financial services and services sectors.  allocation in the automobile sector was positively correlated with allocation in the engineering sector, and negatively correlated with allocation in the energy, technology, and financial services sectors.  allocation in the energy sector was positively correlated with allocation in the technology and financial services sectors, and negatively correlated with allocation in the engineering, automobile, chemical, construction, diversified, health-care, and services sectors.  allocation in the health-care sector was positively correlated with allocation in the metals sector, and negatively correlated with allocation in the energy and technology sectors.  allocation in the construction sector was positively correlated with allocation in the engineering and services sectors, and negatively correlated with allocation in the energy, technology, financial services, and consumer non-durables sectors. asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 78  allocation in the diversified sector was negatively correlated with allocation in the energy and technology sectors.  allocation in the health-care sector was positively correlated with allocation in the chemical and consumer non-durables sectors, and negatively correlated with allocation in the energy and financial services sectors.  allocation in the technology sector was positively correlated with allocation in the energy sector, and negatively correlated with allocation in the automobile, chemical, construction, metals, services, and diversified sectors.  allocation in the financial services sector was positively correlated with allocation in the energy sector, and negatively correlated with allocation in the engineering, automobile, construction, and health-care sectors.  allocation in the consumer non-durables sector was positively correlated with allocation in the health-care sector, and negatively correlated with allocation in the construction and metals sectors.  allocation in the metals sector was positively correlated with allocation in the chemicals and services sectors, and negatively correlated with allocation in the automobiles, technology, and consumer non-durables sectors.  allocation in the services sector was positively correlated with allocation in the construction and metals sectors, and negatively correlated with allocation in the engineering, energy, and technology sectors. regression analysis was performed to analyze the effect of allocation in different instruments on the performance of equity funds. the results of stepwise multiple regression of mean returns of equity funds on the portfolio allocation in different sectors is shown in table 18: table 18. stepwise multiple regression of mean returns on portfolio allocation in different sectors coefficientsa,b .021 .007 .298 2.764 .013 .094 .031 .313 2.985 .008 .193 .050 .414 3.864 .001 .184 .062 .283 2.963 .009 others engineering energy services model b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: mean returnsa. linear regression through the originb. it was found that variation in mean returns of equity funds was explained by variation in allocation in four sectors, viz. others, engineering, energy and services sectors. together, asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 79 allocation in these four sectors explained 88% of the variation in mean returns of the equity funds, and this effect was statistically significant. of the allocations in the three sectors, allocation in financial services had the greatest impact on mean returns. the results of stepwise multiple regression of standard deviation of returns of equity funds on the portfolio allocation in different sectors is shown in table 19: table 19. stepwise multiple regression of mean returns on portfolio allocation in different sectors coefficientsa,b .030 .007 .276 4.211 .001 .135 .032 .288 4.179 .001 .308 .056 .304 5.539 .000 .242 .046 .332 5.316 .000 .166 .058 .171 2.878 .011 .378 .135 .145 2.801 .013 others engineering services energy automobile chemicals model b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: std dev of reta. linear regression through the originb. it was found that variation in standard deviation of returns of equity funds was explained by variation in allocation in six sectors, viz. others, engineering, services, energy, automobiles and chemicals. together, allocation in these six sectors explained 96.6% of the variation in standard deviation of returns of the equity funds, and this effect was statistically significant. of the allocations in the six sectors, allocation in energy and services had the greatest impact on standard deviation of returns. the results of stepwise multiple regression of beta of equity funds on the portfolio allocation in different sectors is shown in table 20: table 20. stepwise multiple regression of beta on portfolio allocation in different sectors coefficientsa,b .009 .001 .495 8.994 .000 .027 .007 .185 3.964 .001 .021 .005 .200 3.841 .002 .052 .008 .303 6.443 .000 .059 .020 .139 2.901 .011 .029 .008 .182 3.707 .002 others consu non dur fin services construction chemicals automobile model b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: betaa. linear regression through the originb. it was found that variation in beta of equity funds was explained by variation in allocation in six sectors, viz. others, consumer non-durables, financial services, construction, chemicals and automobiles. together, allocation in these six sectors explained 97.3% of the variation in asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 80 beta of the equity mutual funds, and this effect was statistically significant. of the allocations in the six sectors, allocation in others had the greatest impact on beta. the results of stepwise multiple regression of r2 of equity funds on the portfolio allocation in different sectors is shown in table 21: table 21. stepwise multiple regression of r2 on portfolio allocation in different sectors coefficientsa,b .009 .001 .612 8.424 .000 .008 .004 .195 2.162 .045 .012 .005 .199 2.401 .028 .015 .007 .178 2.160 .045 others technology engineering fin services model b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: r2a. linear regression through the originb. it was found that variation in r2 of equity funds was explained by variation in allocation in four sectors, viz. financial services, technology, others and engineering. together, allocation in these four sectors explained 93.7% of the variation in r2 of the equity funds, and this effect was statistically significant. of the allocations in the four sectors, allocation in others had the greatest impact on r2. the results of stepwise multiple regression of the sharpe ratio of equity funds on the portfolio allocation in different sectors is shown in table 22: table 22. stepwise multiple regression of the sharpe ratio on portfolio allocation in different sectors coefficientsa,b .004 .001 .414 5.528 .000 .014 .002 .427 6.973 .000 .026 .005 .348 5.569 .000 -.052 .015 -.199 -3.414 .004 .017 .006 .182 2.925 .010 others technology metals chemicals diversified model b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: sharpea. linear regression through the originb. it was found that variation in sharpe ratio of equity funds was explained by variation in allocation in five sectors, viz. others, technology, metals, chemicals, diversified and health-care. together, allocation in these five sectors explained 95.3% of the variation in sharpe ratio of the equity funds, and this effect was statistically significant. of the allocations in the five sectors, allocation in technology had the greatest impact on the sharpe ratio. asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 81 the results of stepwise multiple regression of the treynor ratio of debt/ income funds on the portfolio allocation in different sectors is shown in table 23: table 23. stepwise multiple regression of the treynor ratio on portfolio allocation in different sectors coefficientsa,b .000 .000 .234 2.096 .051 .001 .000 .456 4.908 .000 .002 .000 .399 4.201 .001 .001 .001 .213 2.268 .037 others technology metals diversified model b std. error unstandardized coefficients beta standardized coefficients t sig. dependent variable: treynora. linear regression through the originb. it was found that variation in treynor ratio of equity funds was explained by variation in allocation in four sectors, viz. others, technology, metals and diversified. together, allocation in these four sectors explained 8.84% of the variation in treynor ratio of the equity funds, and this effect was statistically significant. of the allocations in the four sectors, allocation in technology had the greatest impact on treynor ratio. discussion the findings from the study indicate that, for diversified debt/ income funds, allocation in bonds and government securities impact the performance of the fund, while for diversified equity funds, allocation in engineering, energy, and service sector stocks tend to impact the performance of the fund. the study suffers from a few mild limitations. firstly, the study considers a sample of one hundred and fifty-nine mutual funds only. though this is a reasonably-sized sample, a larger sample would have yielded more statistically significant results. further, the high level of variation observed in the sample indicates that the sampling method used may be inadequate – i.e. stratified sampling may have been more appropriate in this situation. it may be possible that, along with the classification of funds used in the study, other moderating factors would be required to stratify the funds. though the results of the study are statistically significant, there is scope for further research in order firstly to identify such factors, and secondly to take these factors into consideration in examining the effect of portfolio allocation on performance of mutual funds. a further limitation of the study is the limited period (one month) which it encompasses. in order to generalize the results, a similar methodology would have to be applied to monthly data for different months. this would have to be undertaken in subsequent studies. it would perhaps be expected that the results of the analysis for diversified debt/ income funds would be relatively unchanged, while the results of the analysis for diversified equity funds would vary, depending on the performance of the sectors; of course, sectors which have been asian journal of finance & accounting issn 1946-052x 2023, vol. 15, no. 1 ajfa.macrothink.org/ 82 performing consistently well would be expected to have a significant effect throughout. references ibbotson, r.g. and kaplan, p.d. (1998). does asset allocation policy explain 40%, 90%, or 100% of performance?. yale working paper series kadiyala, p. (2004). asset allocation decision of mutual fund investors. financial services review, academy of financial services markowitz, h.m. (1987). mean-variance analyses in portfolio choice and capital markets. oxford: basil blackwell, inc. sharpe, w.f. (1988). determining a fund's effective asset mix. investment management review sharpe, w.f. (1994). asset allocation: management style and performance measurement. journal of portfolio management, institutional investor, inc. microsoft word 16850-59952-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 115 bearing of tax audit on tax compliance and revenue generation in ekiti state dada, raphael adekola school of business, university of aberdeen, uk e-mail: r.dada.18@abdn.ac.uk, aderalph@gmail.com taiwo, isaac babatope school of management, universiti sains malaysia e-mail: taiwoib@student.usm.my received: march 1, 2020 accepted: may 12, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.16850 url: https://doi.org/10.5296/ajfa.v12i1.16850 abstract the paper examined the impact of tax audit on revenue generation in ekiti state. the data used for this study was gathered using structured questionnaire administered to 312 staff of the ekiti state internal revenue service. a regression analysis technique was adopted, and the result revealed that certain per cent of the revenue generated in ekiti state could be explained by the tax audit; it was also discovered that auditing access, auditing officials, an effective tax audit, non-compliance, audit fieldwork, tax audit control, and corruption affect the revenue generation by 1.188, 0.319, 0.596, 0.148, 0.157, 0.125 and 0.002 respectively; the probability value 0.00, 0.01, 0.00, 0.022 and 0.00 ˂ 0.05 showed that auditing access, auditing officials, effective tax audit and incentive were statistically significant at 5 per cent level; the probability of f-statistic value 0.000 ˂ 0.05 revealed that the model was appropriate for determining the impact of tax audit on revenue generation in ekiti state. thus, the study concluded that tax audit should be embraced as it maximizes the collection of revenue which enables the government to address developmental projects that will benefit its citizenry and also helps in strengthening the businesses of the taxpayer. keywords: taxation, tax audit, compliance, tax evasion, tax avoidance, back duty. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 116 introduction there is no gainsaying all over the world that governments at all levels undertake huge public expenditure on behalf of the citizenry for the provision of basic amenities and other social services. in meeting with the constitutional responsibilities, governments thus require a substantial amount of funds which are to be generated across different sources. among different sources from which governments can generate its revenue/fund are taxes, with the primary purpose of raising revenue to finance government expenditure (mu'azu 2012). kanbiro (2018a) described tax revenue as a powerful tool in the hands of government both in developed and developing countries to generate funds/revenues to finance the public expenditure and to stabilize the national economy, and it may also be used to influence expenditure patterns, to redistribute income and wealth among the citizen and also to reflect other social and political objectives. the nigerian government (federal, state & local) like many other countries are saddled with the responsibility for tax administration, revenue collection and allocation for the developmental program across the tiers of government in the country (ojonta, 2011). therefore, this constitutional responsibility reposed in the government at various levels to makes tax a compulsory levy imposed on the salaries, income, profit or wealth of an individual, family, community, partnership, corporate or non-corporate bodies, etc. for the purpose of generating adequate funds to finance public expenditures. as described in the literature, taxation is the inherent power of the government, exercised through the legislation, to impose financial burdens (tax and levy) upon their subjects within its jurisdiction to raise revenues to carry out the government functions (modugu & anyaduba, 2014; engida & baisa, 2014). therefore, it is become imperative to note that any individual or establishment that falls within the above income groups, is obliged by the law of the federal republic of nigeria (lfn) and the law of the respective state’s to pay tax, this can be voluntarily or otherwise (mu'azu 2012). while the amount of revenue government is expected to generate from taxes for its program depends largely on the effective administration of tax law and willingness of the taxpayers to adhere to the relevant tax laws of the land (kanbiro, 2018b). it is on this process that the issues of returns and self-assessment arose. every individual or organization liable under the relevant tax law of the country is required to file the returns of their income(s) and other relevant information/matters to the relevant tax authority having the power to assess him or her to tax for the relevant year of assessment, and this is subject to the satisfaction of the returns by the tax authority (olaoye & ekundayo, 2019; oyebanji, 2006). however, it is expedient for the relevant tax authority to review and verify self-assessed tax filed by individual taxpayers by way of an audit and, or investigation (kpng, 2017), this exercise was put in place like control to reduced non-compliance (ojo, 2016; olaoye & ekundayo, 2019). thus, if this professional examination was not in place as control over the taxpayer; it will be difficult for the government to actualize its aims and objectives. meanwhile, opoku (2015) defines a tax audit as an investigation conducted into the financial record of the taxpayer by revenue service officials to verify the compliance of the taxpayer. in the same manner kpmg (2017) describe tax audit as a review of tax payer's records which covers the disclosure of all significant accounting practices employed in the course of preparing the financial report which includes; statement of financial position, statement of profit or loss account and other related accounts and schedules asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 117 which form part of financial reports to ascertain compliance with the relevant tax law. also, further information is required for the computation of assessable income as well as to ensure that tax provision is complied with. adeniran, alade, and oshode, (2013) described that tax audit as a financial audit which involves the gathering and processing of taxpayers information to determining the level of their compliance with tax laws of the territory. kircher (2008) in its definition says, tax audit as "an examination of the tax report of an individual or organizations by the relevant tax authorities to ascertain their compliance with applicable tax laws and regulations of the state". he further said that a tax audit is a review where the internal revenue service set to confirm that the self-returns filed by the taxpayer is appropriate, adequate and correct. meanwhile, frank (2010) concludes that designing an effective tax audit policy can have an influence on production/revenue generation decisions of the firms and government, respectively. the increase in the government running cost coupled with government willingness to meet infrastructures deficit and socials needs of the citizenry has left various governments with no option other than to formulate strategies that will improve their revenue base (oladele, uduma & aderemi, 2013). over the years, nigerian had experienced economical unruliness and political instability. the national economy became totally cripple due to over-dependence on the oil revenues, which eventually resulted in the serious decline in crude oil price in the world market. this led the country into a recession as a result of this, taxation is now regarded as a critical and best alternatives source of revenues to augment whatever individual state received from central government purse to finance their project as a result of dwindling in the distributable revenues accrued to the federation accounts (afuberoh & okoye, 2014; sokenu, 2016). for the state governments to meet up with their constitutional functions, there is a need to generate adequate and more revenue from internal sources, this has, therefore, become a matter of urgency and imperatively importance. this need highlights the enthusiasm on the part of state governments and even the federal government agent to look for both the old and new sources of revenue or to become more aggressive and innovative in the manner at which the revenue has been collected from existing sources (afuberoh & okoye, 2014; dada, adebayo & ogunmakin, 2017). achieving this target will allow the government to broaden the scope of tax coverage and sustained the continual compliance by the taxpayer through effective legislation, e.g. tax audit and investigation (kpmg, 2017). mu'azu (2012) agreed that tax audit reduces the problems of tax evasion while onoja and iwarere (2015) revealed that, tax audit had significantly impacted revenue generation in federal inland revenue service. the extent of the impact of the tax audit on tax compliance and revenue generation is not well understood and probably not been felt across the state of the federation due to the scare/few kinds of literature addressing the impact on the state government most especially ekiti state to the best of the authors' knowledge. therefore, examining the tax audit impact on tax compliance and revenue generation in ekiti state and the factors that influence tax compliance are the primary purpose of this study. therefore, the paper is organized in five parts. in addition to the introduction, other parts of the paper include the conceptual framework which comprised revenue and tax audit concept, empirical review, research methodology and discussion, and the last section is conclusion and recommendation. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 118 literature review conceptual framework author’s model (2020) tax revenue: the term revenue generation all over the world of which nigeria is not exempted is derived from tax and non-tax sources. dada et al. (2017) stated that revenue is a general term that encompasses all monetary receipts accrued both from the tax and non-taxes sources such as fees, fines, sales of government properties, grants and contributions, etc., as these constitute the live wire of any government. meanwhile, opoku (2015) defined tax as the compulsory levying on the public by the government through the relevant tax authorities having tax jurisdiction to exercise power to collect taxes, to defray the cost of their activities. olatunji, olaleye, and adesina (2001) define tax is a system of imposing a compulsory levy on all incomes, goods, services, and properties of individuals, partnerships, trustees, executors and companies by the government. tax is a certain percentage of money that you must pay to the government according to your income, property, goods which are used to cater for public services/demand and perform other social responsibilities, which there is no direct return to the taxpayers for obliged other than the general benefit (tilahun 2018). therefore, taxation is a compulsory level or transfer of resources from the private sector to the public sector or and tax revenue tax compliance tax audit back duty audit field audit desk audit asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 119 levied based on the criterion and without reference to specific benefits received to execute the nation's economic and social objectives (dada et al., 2017; olaoye & ekundayo, 2019). taxation primarily aimed at generating revenue for the government to cater to national or state expenditure as the case may be (mu'azual 2012). while non-taxes are the revenue accrued to the government treasury other than tax and which is supported by the law of the federation. ojo (2009) had shown the reasons why people have to pay tax to enable the government to discharge its constitutional functions. the rationale for imposing taxes in a market economy such as nigeria may not be far from the government responsibilities which include the followings as stated by ariwodola (2001), dinku and alamirew (2018), olatunji, et al. (2001): redistribution of income and wealth; promotion of social and economic welfare; economic stability and growth; provision of public goods and services, pure public goods are the one that displays the following characteristics: displays zero marginal cost, that is, no extra cost is incurred in supplying the good to more than one person, individuals cannot be excluded from consuming the good, even if they have no desire for it, all members of society must consume it at the same amount; it cannot be rejected. for example, law and order, peace and security, good access road, pipe born water, etc. therefore, the ability of the government to fulfil these constitutional functions depend heavily on the willingness and readiness of the citizen to respond to this civic right/duty. tax compliance: tax compliance can be explained as any strategy put in place to prevent tax evasion and avoidance. according to kircher (2008) tax compliance is the ability of a tax liable body (individuals or corporate bodies) to submit accurate, comprehensive and satisfactory tax returns in conformity with tax laws and provisions of the state to the relevant tax authority within their jurisdiction for tax assessment without been coerce. palil and mustapha (2011) also describe tax compliance as taxpayers' ability and willingness to comply with relevant tax laws provision which is determined by ethics, culture, legal environment and other situational factors at a particular time and place. similarly, tax compliance is also defined by tax authorities as to the ability and willingness of taxpayers to cooperate or comply with tax laws by declaring their true, correct and total income for the year and pay the correct/right amount of tax on time to the relevant authority (irs, 2009; ato, 2009; irbm, 2009; oladipupo & obazee, 2016; olaoye & ekundayo, 2019). government effort increases the tax compliance among the tax liable bodies, introduced a self-assessment approach. self-assessment was introduced effect from the 1996 year of assessment to encourage voluntary declaration of incomes and compliance, to reduce tax evasion and enable taxpayers to make returns within the stipulated time limit. it is the most convenient method to ensure prompt payment of tax, as it enables the taxpayer to compute their tax and capital allowances liability and remitted same to the government purse within the time frame (olaoye, 2008; olatunji et al., 2001; verboon & van dijke, 2014). despite the government effort through the relevant tax authority's to encourage tax compliance among the taxpayers, non-compliance still persist which is "the failure of the tax liable bodies either intentionally or non-intentionally, deliberate or not deliberate (avoidance or evasion) to meet their tax obligations to the relevant tax agent (jaidi, noordin & kassim, 2013; kinsey, 1985). non-compliance does happen when taxpayers' cleverly capitalized on tax law loopholes to reduce their tax burden, and other factors could be carelessness, such as forgetting to pay their tax, tax calculating error and even more critical asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 120 factor is the taxpayer illiteracy and information asymmetric about tax law. on the other hand, tax fraud or a crime is a type of non-compliance willfully done by the taxpayers against the tax law (jaidi, noordin & kassim, 2013; kpmg, 2017). in other to reduced and at the same time fight the menace of non-compliance, government at a different level and in various state introduce the concept of a tax audit to enforced compliance. tax audit: auditing is an independent examination and expression of opinion on the financial statement of an enterprise by an external auditor in accordance with his terms of engagement and compliance with statutory regulation and professional requirements (oladipupu, 2005), while on the other hand, taxation as been described by some authors, is the inherent power of the state, exercised through the legislature, to impose financial burdens upon tax liable citizen within its jurisdiction for raising revenues to carry out the constitutional duties of government (modugu & anyaduba, 2014; palil & mustapha, 2011; ojo, 2016). however, this constitutional duty has been frustrated by tax evasion and tax avoidance, and in other to combat this ugly phenomenon, government at a various level most especially in nigeria have introduced a tax audit into their tax system (modugu & anyaduba,2014; olaoye, ayeni & alaran-ajewole, 2017). according to oecd (2006), a tax audit is described as an examination of the record to satisfy whether a taxpayer has correctly disclosed and reported their tax liability and fulfilled other obligations. in another view, adeniran et al. (2013), opined that tax audit just like financial audit involves the review of taxpayer financial records in other to determine the level of compliance with tax laws of the territory. for a successful audit, the auditor must organize his work in such a way that the assignment is accomplished economically and efficiently without additional cost. corroborating this olaoye and ekundayo (2019) define tax audit as "an examination of an organization or individual's tax report by the relevant tax authorities to ascertain compliance with applicable tax laws and regulations of the state". he further stated that tax audit is an exercise of internal revenue service officer to confirm the correctness and accuracy of the figure put up on your tax return (mukhtar, kerosi and ondabu, 2015). tax audit is best carried out either as desk audit, field audit or back duty audit. desk (or office) audit: this is the type of tax audit, where the whole activity of the audit exercise takes place within the premises and confines of the office of the tax officials. in this situation, the tax office may request the taxpayers to provide or forward some additional documents as a matter of statutory to his office to enable him to clear some grey area in the self-assessment returns submitted with the revenue officer. in this type of audit, revenue officer does not mandate nor required to the notified taxpayer of the ongoing exercise. he gets to know this when the letter(s) are written to him requested that certain documents be forwarded or should appear to give explanations on a certain issue. the essence of the exercise is to ensure some level of compliance with tax laws, rules and regulations as well as carry out administrative checks or task on returns submitted (nuon, 2015; adediran et al., 2013). field audit: a field audit is elaborate and comprehensive than a desk audit. it is usually carried out outside the tax authority's office in the taxpayer's office premises. the essence of carrying it out in the taxpayer's premises is to enable the tax auditor's carry out the examination of necessary documents and also obtain appropriate information directly from the officials of the business (ojo, 2016; olaoye & ekundayo, 2019). this takes more time, and more basic asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 121 documents are always required. some documentation can also be taken down to the office for detailed verification while some may not. the scope or depth of this exercise largely depends on the outcome of the desk audit task carried out by the tax auditor as well as the risk factors of the audit exercise. special attention will be paid to those items likely to have high tax yield potentials. the tax audit is normally carried out as a result of the back duty audit exercise (badara, 2012; ojonta & iwarere, 2015). back duty audit: according to olaoye (2008), olatunji, et al. (2001) and ariwodola (2000). back duty audit may be instituted against the taxpayers when the following case(s) occurs: failure to fully disclose or include all income(s) or earnings in the return files or submitted to the revenue office; the doubtful claim of capital allowance in respect of current or previous year; conspicuous reduction in the reported profit in the returns files in the tax office or where the tax charged is less than what it ought to be. the charging of back duty audit on a taxpayer can either be a routine or random, which may be as a result of the above reason. it is an exercise required of the relevant tax authority to ensure that the exact amount due to the government is duly collected. causes of tax evasion and tax avoidance in nigeria tax evasion according to ifere and eko (2014), jarunee (2010), uadiale, fagbemi and ogunleye (2010) is a deliberate, willful practice or an outright dishonest action, whereby the taxpayer reduced his tax liability through the use of illegal means. while tax avoidance refers to the arrangement through which a person acting within the letter of the law reduces his true tax liability, infringing in the process both the spirit and intention of the law (fatoki, 2014). kay (1980) said that tax avoidance takes place when the facts of the transaction are admitted, arranged or presented in a way that the resulting tax treatment will differ from the intended by the relevant legislation. thus, while tax avoidance is within the ambit of the law and legal, tax evasion is illegal and is a criminal offence punishable under the law (oladele et al., 2013; arowomole and oluwakayode 2006). tax evasion is accomplished by a willful practise and deliberate act of omission or commission which amounted to criminal acts under the tax laws of a nation, and these acts include failure to pay tax, e.g. withholding tax, value-added tax etc. failure to submit returns, the omission of items from returns, claiming relief (in personal income tax; for example, unborn children, non-existed dependant), understating income, documenting fictitious transactions, overstating expenses, failure to answer queries (farayola, 1987; ojo, 2016; olaoye & ekundayo, 2019). according to uadialeet et al. (2010), kastlunger, kirchler, mittone, and pitters (2009), other causes of non-compliance are corruption in a public institution, inadequate awareness and tax education, misappropriation of taxes received, lack of adequate enforcement for default, ignorance of the tax authority, the proliferation of taxes, inequitable distribution of income, loopholes in the tax laws, absence of 'quid pro quo,' i.e. value given in return (by the government) for taxes paid, high level of illiteracy, information asymmetric, lack of proper record-keeping and high tax rates. kpmg (2017), in other to put strategies in place to resolve tax dispute between the tax authority and the liable taxpayers, to maintain a strong mechanism to deal with tax avoidance and evasion techniques which are available to various organizations, asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 122 but are susceptible to tax abuse and to bring defaulter taxpayers to the net of tax authorities tax audit was introduced. objectives of tax audit according to mukhtar, kerosi and ondabu (2015); noun, (2015); erard (1994) cited in mu'azu (2012) the objectives of tax audit excercise are to enable the tax auditors to determine whether or not: adequate accounting books and records exist for determining the taxable profits or loss of the taxpayer and consequently review the tax payable; the tax computations submitted to the tax authority by the respective taxpayer agreed with the underlying records; all applicable tax legislations have been observed and complied with; there is a provision of an avenue to educate taxpayers on various provisions of the tax law; discourage tax evasion; detect and correct accounting or arithmetical errors in tax returns; provide feedback to the decisions maker on various provisions of the law and recommend possible changes; identify cases involving tax fraud and recommend them for proper investigation; forestall taxable persons' failure to render tax returns; prevent taxable persons' from rendering incomplete or inaccurate returns; encourage voluntary compliance among the tax payer which is one of the strong reasons in support of the self-assessment scheme. tax audit officer and taxpayer responsibilities the following are the responsibilities of both tax official and taxpayer as stated in the beyene, deresse and mathewos (2019), biber (2010), modugo and anyaduba (2014), oecd (2006) olaoye and ekundayo (2019). responsibilities of audit officer a tax auditor is expected to carry out the tax audit exercise in the following manner: be professional and courteous; knowledgeable and be fair in administering tax laws; be honest and trustworthy; cooperative and be a willingness to give advice and guidance to the taxpayer at all time; ensure that the exercise is carried out as expected with minimum disruption to the taxpayer business or activities; request for documents, records and books of accounts and any other pieces of information that are relevant to the audit assignment only; ensure that the rights and interest of taxpayers, tax agents and documents are safeguarded responsibilities of taxpayer according to modugo and anyaduba (2014), oecd (2006), taxpayers are expected to be courteous, fair and honest, they must ready to provide reasonable facilities, information and assistance during an audit assignment. this includes giving access to tax audit officers to the business premises, providing information and making available relevant documents and records required for the purpose of the exercise. promptly respond to all queries. if the questions raised are ambiguous, he must seek clarification from the tax audit official without delay. also, the taxpayer may also be a query on personal matters such as personal expenses, savings, bank accounts, assets, etc. taxpayers can request that their tax agents be present during an interview in order to facilitate the audit process. the taxpayer is not expected to suspend or stop business activities during the audit assignment. therefore, giving full cooperation and asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 123 support to make sure that the assignment does not unnecessarily prolonged or linger and ensure that any disruption to the business is kept at a minimum. furthermore, taxpayers are not allowed under any law to transact business with the audit officer while the exercise lasts other than on normal terms. taxpayers should avoid making payment to audit officers. any tax payment arising out of an audit adjustment must be payable directly to the official revenues bank account at the designated bank or any collection branch of the internal revenue service. empirical review mu'azu (2012) studied the effect of tax audit on tax compliance in nigeria a case of bauchi state board of internal revenue, employed primary source to obtained data from the staff of bauchi state board of internal revenue and used the simple percentage to analyze the data, and the finding revealed that tax audit reduces tax avoidance and tax evasion, that taxpayers do not usually cooperate with tax audit officers during the exercise. adediran, alade, and oshode (2013) examined the impact of tax audit and investigations on revenue generation in nigeria, obtained data through structure questionnaire from the respondent, tested the hypotheses with pearson correlation coefficient using spss output data, the study concluded that tax audit and investigations could increase the government revenue base and can also stamp out the incidents of tax evasion in the country. he recommended that tax audit and investigations should be carried out often and must be thorough in accomplishing its task of increasing the government revenue base and stamping out tax evasion in the country. in the same manner, ibrahim, yusuf, and bello (2014) investigated the contribution of tax audit and the resultants investigation to the sustainable development of the nigerian economy and concluded that the practising accountants should follow the fundamental principles of professional ethics while rendering consultancy services since they often act for taxpayers in their dealings with the relevant tax authority. kennedy and john (2014) investigated the impact of tax audit on tax compliance in nigeria and concluded that the probability of being audited, perception on government spending, penalties and enforcement, the joint effect of tax audit and penalties tend to influence tax compliance in nigeria significantly. wuyah, aku and ahmad (2018) study the impact of tax audit and investigation on value added tax generation in kaduna state used percentages and graphs and pearson correlation coefficient (spss) to analyze the data collected through the use of a questionnaire. the result of the findings revealed that tax audit and investigations have the potential to increase valueadded and reduce vat evasion. while dickson (2014) evaluate the impact of tax reform on federal revenue generation in nigeria concluded that tax reform by improving the tax system and reducing tax burden enhances the ability of the government to generate more revenue. afuberoh and okoye (2014), examined the effect of taxation on revenue generation in nigeria and recommends among others that well-equipped database (wedb) on all taxpayers should be created by the federal, state and local governments for the purpose of identifying all possible sources of income of taxpayers for tax purpose however the tax collection processes must be free from corruption. meanwhile, onoja and iwarere (2015) examined the effects of asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 124 tax audit on revenue generation: federal inland revenue service abuja; generated data through a questionnaire administered to the respondent while they employed analysis of variance (anova) to analyse the data, the findings revealed that tax audit has significant impacts on revenue generation by federal inland revenue service while tax audit has a positive effect with the revenue generation by federal inland revenue service. oladipupo and obazee (2016) in their study investigated the impacts of taxpayers' knowledge and penalties on tax compliance of a small and medium enterprise in nigeria, they employed the use of survey research design, the data gathered through the administered questionnaire were analyzed using the ols regression method, and the results of the finding revealed that tax knowledge had a significant positive impact on tax compliance while tax penalty had an inconsequential impact on tax compliance. thus, the study concluded that tax knowledge has a tendency to promote tax compliance among the taxpayer than the tax penalty. methodology the population of the study is three hundred and twelve (312) from ekiti state internal revenue service (sirs) in their staff disposition list as of 2016. the data source for this study was generated through the primary sources with the use of questionnaires administered to the staff of the ekiti state internal revenue service (sirs) while secondary sources were obtained from the review of several publications that are relevant to the study. two hundred and sixty-five (265) questionnaires were properly filled and returned. the questionnaires were then analyzed using anova. the analysis of the results is presented below. interpretation model summary model r r square adjusted r square standard error of the estimate 1 .794a .630 .618 1.09993 the table shows that the correlation coefficient (r) was 0.749. it implies a positive correlation or relationship between independent variables and dependent variables. the r-square, which shows the overall explanatory power of the model, reveals that independent variables explain about 63% of the systematic variation of the dependent variable while the remaining 37% was due to other variables outside the regression model. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 125 anova model sum of squares df mean square f sig. 1 regression 527.318 8 65.915 54.482 .000b residual 309.723 256 1.210 total 837.042 264 the table above shows the overall significance of the test, which is reported as follows; f (8, 248) 54.482, p<0.05. the degree of freedom of the regression is 8; also, the degree of freedom of the residual is 256, f calculated is 54.482 and significant value or p-value is 0.000. this reveals that there is a significant effect of independent variables on the dependent variable. coefficients model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 16.603 1.477 11.243 .000 auditi_inf_acces 1.188 .136 .455 8.751 .000 inadeq_tax_officio .319 .094 .204 3.374 .001 effect_tax_audit -.596 .108 -.281 -5.517 .000 non_compliance .148 .111 .062 1.335 .183 audit_field_work .157 .068 .103 2.297 .022 tax_audit_control .125 .095 .057 1.312 .191 corruption .002 .079 .002 .027 .979 incentive .389 .075 .250 5.149 .000 a. dependent variable: revenue generation the regression above is a multiple regression, the model of the equation is stated as; asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 126 y=16.6+1.188aud_acc+0.319ind_off-0.596eff_aud+ 0.148non_com+0.157aud_work+ 0.125tax_con+ 0.389cor the result presented above shows the effect of independent variables on the dependent variable. the explanatory variables include auditing access, auditing officials, effective tax audit, noncompliance, audit fieldwork, tax audit control, and corruption, while the explained variable is revenue generation. the signs of the coefficients of these variables, the positive signs depict a positive relationship between the variables while the negative sign depicts the otherwise. the constant (16.603) represents the value that revenue generation will assume if all the variables are zero. it was also discovered that 1% increase in auditing access, auditing officials, effective tax audit, non-compliance, audit fieldwork and, tax audit control and corruption other things being equal, will increase revenue generation by 1.188, 0.319, 0.596, 0.148, 0.157, 0.125 and 0.002 respectively and vice-versa. the p-value checks the significant level of the variables, and the analysis revealed that auditing access, auditing officials, effective tax audit and incentive were significantly correlated to revenue generation with a p-value of 0.00, 0.01, 0.00, 0.022 and 0.00 respectively. on the other hand, non-compliance, tax audit control, and corruption were not significantly correlated to revenue generation with a p-value of 0.183, 0.191 and 0.070, respectively. discussion, conclusion, and recommendation discussion the study revealed that tax audit was significantly correlated to revenue generation in ekiti state. this implies that tax audit ensures proper filing of appropriate and accurate returns and computation in taxpayer's records; tax audit reduced tax evasion and tax avoidance and ensures compliance with tax laws, rules, and regulations by the taxpayers. the study revealed that tax audit has a positive relationship with the revenue generation in ekiti state. this means that 1% increase in tax audit (increase in auditing access, auditing officials, effective tax audit, noncompliance, audit fieldwork and, tax audit control and corruption) other things being equal, will increase revenue generation by 1.188, 0.319, 0.596, 0.148, 0.157, 0.125 and 0.002 respectively and vice-versa. this was in consonant with onoja and iwarere (2015); olaoye and ekundayo (2019) who concluded that tax audit has significant effects on revenue generation by federal inland revenue service and tax audit has a positive relationship with the revenue generation by federal inland revenue service. conclusion the study objective is to investigate the effect of the tax audit on the revenue generation in ekiti state. the study went further to access the relationship between the tax audit and revenue generation in the state. the study concluded that tax audit should be embraced as it maximizes the collection of revenue which enables the government to address developmental projects that will benefit its citizenry and also helps in strengthening the activities of the taxpayer. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 127 recommendation the study recommended that the government should focus more on tax audit now that the oil revenue accrued to the federation account is dwindle as a result of global drop in crude oil prices; sufficient mechanism should be in place to check and monitor the staff of the tax audit department to minimize the level of corruption and enhance the effectiveness of the tax audit; government should give autonomy to tax audit department to enable them to carry out their responsibility effectively as specified in established law/edict; states should ensure that the officer conducting the tax audit are tax professional; tax audit staff should have full knowledge of modern audit tools like computer aided audit tools (caats) to enhance performance and maximum tax revenue generation; tax audit should be carried out on a routine basis to ensure that taxpayers file the correct returns and that actual revenue collected was remitted to the government coffer. references adediran s. a., alade s. o., & oshode a. a. 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(2014). a self-interest analysis of justice and compliance: how distributive justice moderates the effect of outcome favorability. journal of economic psychology, 28, 704-727. https://doi.org/10.1016/j.joep.2007.09.004 microsoft word 14455-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 111 ajfa.macrothink.org bank failure: a new approach to prediction and supervision calvin w. h. cheong (corresponding author) faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malayis tel: 60-82-260-996 e-mail: ccheong@swinburne.edu.my sockalingam ramasamy department of accounting, banking & finance, school of business, monash university malaysia jalan lagoon selatan, 47500 selangor, malaysia tel: 60-3-5514-4931 e-mail: r.sockalingam@monash.edu received: jan. 9, 2019 accepted: april 8, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14455 url: https://doi.org/10.5296/ajfa.v11i1.14455 abstract bank failures are costly to customers and the wider market. prevention is always better than cure but in light of recent economic downturns, it has become increasingly difficult for regulators to allocate more resources towards in-depth monitoring of banking practices. in this paper, we construct a tool that is able to predict bank failures ahead of time with reasonable accuracy. through a logistic regression on a matched sample of 536 failed and non-failed us banks, we determine the financial indicators that most accurately predicts bank failure. from the regression, we construct a bank health index that assesses a bank’s propensity to failure. in-sample and out-of-sample tests show that our model is about 90% accurate two years prior to failure, and 95% accurate the year before failure. the accuracy and efficiency of the model and index provides a more efficient and effective tool for assessing a bank’s propensity to failure besides requiring far less resources. with these methods, regulators will be able to take preventive measures at least one year before failure, saving the economy millions if not billions in the process. keywords: bank failure, financial crisis, failure prediction, commercial banks, early warning system asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 112 ajfa.macrothink.org 1. introduction are current risk management and monitoring devices adequate to avoid bank failures in light of increasing globalisation, market integration, and the use of innovative (and sometimes questionable) financial innovations used by banks and other financial institutions? despite the well-meaning objectives of the basel capital accord – now in its third iteration – many banks the world over have failed as a result of a number of financial crises such as the asian financial crisis of 1997 (afc) and the global financial crisis of 2007 (gfc). governments and central banks around the world resorted to billion-dollar liquidity injections and bailouts to avoid a severe tightening of credit and losses to customer deposits in their respective economies. wary of bank failures, regulators have responded by introducing a multitude of risk management tools and benchmark financial indicators to ensure that banks remain adequately capitalised to absorb losses arising from credit, operational, and market risks. but as the large number of bank failures resulting from the recent crises shows, our ability to predict bank failure is severely lacking. if we are able to understand the factors related to bank failure, we could develop predictive methods to distinguish between sound and troubled banks (thomas, 1991). with sufficient accuracy, these predictive methods will enable regulators to detect problems much allowing for remedial action to mitigate the risk of bank failure. a number of works in predicting bank failure have been conducted (see beaver, 1996; altman 1968; agarwal and taffler, 2008; andersen, 2008; atiya, 2001; balcaen and ooghe, 2005; bell and pain, 2000; bongini, laeven and majnoni, 2002; and brossard, ducrozef and roche, 2007 for example) but despite the tremendous methodological developments in bank failure prediction models, bank failures persist; a strong indication of the inadequacy of existing models. thus exists a need for a rethink and redesign of bank health evaluation using a new set of indicators, and subsequently, a unified device or tool that can be continuously used to monitor the soundness of individual banks. in this study, we derive these key bank health indicators from 536 recent examples of bank failures resulting from the gfc in the u.s. by observing the changes to camel (capital, asset, management, earnings and liquidity) framework indicators in the 4 years leading up to the bank’s failure. by estimating a logit model on a year by year basis, we find that the indicators that can best distinguish between healthy and unhealthy banks are tier 1 capital ratio, impaired loans to equity, rate of loan growth, return on average assets, net interest margin, net loans to total assets, loans to deposits ratio, and impaired loans to gross loans. in-sample tests show that our model has a reasonably high chance of correctly predicting bank failure in the year of failure (89.86%) and the preceding year (81.30%). out-of-sample tests validate our findings; showing a perfect accuracy of predicting bank failure in the year of failure (100%) and nearperfect accuracy in the preceding year (95.38%), with minimal type i and ii errors. on the basis of these indicators, we then construct a “bank health index” to develop a more efficient method of assessing the soundness of a bank relative to other banks as well as the entire banking system. we used a sample of 20 domestic and foreign banks operating in malaysia for this purpose as malaysia’s banking regulatory system has been regarded as one of the best in the world. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 113 ajfa.macrothink.org our findings contribute to extant literature in a few ways. first, our model’s accuracy in correctly predicting bank failure surpasses the predictive power of other failure-prediction models in the literature, with minimal error. second, the simplicity of our variables and methods used in deriving the model makes ours more efficient and practicable for regulators and market observers alike. finally, the “bank health index” provides a quick and easy way for regulators to identify potentially unhealthy banks and take immediate remedial action at least one year before failure. the rest of this paper is structured as follows. section 2 provides a review of relevant literature. section 3 presents the theoretical framework and methodology used in this study. we present our findings and discussion in section 4. section 5 concludes. 2. literature review central to the existence of the modern economy is the role banks play as the primary intermediary for the distribution of funds. it is thus in the best interests of the regulators to avoid the possibility of a bank failure. but despite the regulators’ best efforts, bank failures still occur. and when they do, the repercussions are far-reaching. in order to detect and prevent bank failure, we must first identify the aspects of bank operations and fund flows that are critical to the survival of the bank. the following discussion on relevant indicators is based on the camel framework prescribed by central bankers and the international monetary fund (gersl and hermanek, 2006). the first is its highly leveraged nature of business that is reliant on loans, advances and shortterm investments, as assets that stem from liabilities held by the bank (e.g. deposits). the creation of assets from liabilities is simply a redistribution of wealth and is a system that has worked for centuries. however, an economic downturn may cause a rise in loan defaults, or falling asset values. banks in response would have to make higher loan loss provisions and be prepared to write-off bad loans as collateral values are insufficient to cover bad loans; a prime indicator of insolvency (kunt and detragiache, 1998), and poor asset quality (gonzalezhermosillo et al., 1996). periods of economic growth meanwhile would see the growth of the banking system outpacing that of the country and even inflation. the exuberance may result in questionable lending practices and poor asset quality, creating potential loan repayment and recovery problems in the future (bell and pain, 2000; jimenez and saurina, 2006; berg and hexeberg, 1994; logan, 2003). studies (e.g. foos et al., 2010; andersen, 2010) have shown that aggressive lending during growth periods often lead to defaults two to four years after, resulting in a cooling and declining period of banking growth that may even amount to negative growth. even if steps to ensure the quality of their loans and assets were taken, defaults inadvertently occur, hence the need for loan loss reserves to act as a buffer against writing down the bank’s capital (anglomkiew et al., 2008; floro, 2010). during severe market downturns, loan loss reserves are insufficient; capital erosion becomes inevitable until loan losses significantly outweigh available capital resulting in insolvency and subsequently, failure. common indicators of bank capital adequacy are the core capital ratio and the risk-weighted capital ratio, prescribed by the basel ii (and iii) capital accords. these ratios are a good measure to determine the strength of a bank as adjustments for credit risk arising from off-balance sheet asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 114 ajfa.macrothink.org items have been considered in these ratios (estrella, 2000). thus, a greater amount of capital improves a bank’s chance of survival (andersen, 2008). another key aspect for bank survivability is liquidity. bank liabilities, primarily stemming from customer deposits, are generally short term in nature vis-à-vis its assets that are longer term, thereby creating liquidity mismatch. as depositors have a right to withdraw funds without notice, banks must maintain sufficient liquidity at all times. but when revenue generated from loans and other assets fall short of liquidity demands, or when banks fail to convert liquid assets into cash on time, the liquidity shortage might result in a bank run (lanine, 2005; reed and gill, 1989). close observation of the loan-to-deposit ratio and the net-loans-to-assets ratio may provide indication of the bank’s level of liquidity. bank profitability is reflected in the net interest margin (nim). however, as nim is dependent on the rate of interest charged on loans as well as the interest cost of sourcing loanable funds for distribution, high nims may be indicative of excessive risk taking and imprudent lending practices (evans et al., 2000). during the afc and gfc, banks dependent on short-term money market funds saw market interest rates rising to their detriment, reducing nims from two fronts: higher cost of funds, and greater loan defaults due to higher repayments. extraordinarily high nims are possibly indicative of potential failure as banks hold a large portfolio of high-yield risky, as well as interest-bearing assets (ross et al., 2007). high nims may also precede failure much earlier and fall significantly immediately before failure due to higher loan loss provisions (despagne, 2010). regardless, inclusion of nims into a failure-prediction model should provide additional explanatory power. the literature is replete with off-balance sheet items (obs) and short-term wholesale funding and its association with bank failures. greater amounts of these assets are associated with a greater probability of failure. similarly, studies (e.g. deyoung and toma, 2012; allen and jagtiani, 2000; clark et al., 2007) have shown that reliance on volatile non-traditional income sources (i.e. non-interest income) such as insurance income, fees, commissions and other noninterest bearing income are associated with higher probabilities of bank distress. failed banks are expected to have been more aggressive in their business diversification strategies and to have sought out the opportunities arising from scope deregulation. banks have also diversified their sources of funding into non-traditional sources such as short-term money market funds. given the volatile nature of these funding sources, over-reliance on such funds could place the bank in a risky liquidity position. observation of the ratio of wholesale short-term liabilities to liquid assets (wst) is thus warranted. but even with hawkish monitoring over these indicators, bank failures can and do occur as a result of inefficient bank management exemplified through poor operations, management, monitoring of loans and sub-optimal use of resources. often observed through return on average assets (roaa), management efficiency can be translated as the profits generated through efficient usage of assets. operational efficiency on the other hand, can be observed through the cost to income ratio (cir); an indication of how well the bank has kept growth of revenues ahead of rising expenses (rahman, 2004). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 115 ajfa.macrothink.org 3. theoretical framework and methodology 3.1 explanatory variables based on the literature review in section 2, the variables observed in this study, their definitions and their expected impact on the propensity of bank failure is summarised in table 1 below. table 1. definition of variables variable variable abbreviation expected sign capitalization total capital ratio (tier 1 + tier 2 capital / risk-weighted assets) totcap (-) core capital ratio (tier 1 capital / risk-weighted assets) tiercap (-) asset quality/credit risk impaired loans / gross loans impl (+) loan loss reserves llr (+) impaired loans / total equity impe (+) loan loss reserves / impaired loans llimp (+) / (-) loan growth (year-on-year) loangrowth (+) asset growth rate (year-on-year) agr (+) earnings or profitability net income / average equity roae (-) net interest margin (nim): (net interest income – net interest expense / total earning assets) nim (-) / (+) liquidity net loans / total assets netloans (+) loans to deposit ratio loandep (+) liquid funds (cash and short-term assets) / total assets liq (-) reliance on fee income non-interest fee income / total income interest (+) relience on off-balance sheet items off-balance sheet items / total assets obs (+) reliance on short-term wholesale funds volatile wholesale short-term liabilties / liquid assets wst (+) management quality / efficiency return on average assets roaa (-) cost to income ratio cir (+) we obtained a sample of 536 u.s. banks between the years 2004 to 2010, with an equal number of failed and non-failed banks, matched by total assets, from the bankscope database. because the u.s. saw a large number of bank failures during the gfc, it provides an ideal setting to the predictive power of our model. malaysia alongside many other countries around asia on the other hand, was relatively unscathed. even during the afc, malaysia being one of the worsthit did not see any bank failures due to rescue packages and bank mergers and acquisitions. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 116 ajfa.macrothink.org because our purpose is to study the predictability of bank failure a priori, we collected data on the variables listed in table 1 for the years before the bank failed. we denote the year of failure as year0, and the preceding years as year-1, year-2, year-3, and year-4; observing changes to the variables over the years for any significant changes or trends. identifying the variables with considerable explanatory power is simply a matter of determining the statistically significant differences in the mean values between the failed and non-failed sample (vilen, 2010). 3.2 empirical model we use a logistic regression model to identify the financial ratios that can most effectively discriminate between failed and non-failed banks in the most reliable (frydman et al, 1985; marais et al, 1984; ohlson, 1980; casey and bartczak, 1985; zavgren, 1985; glezakos et al, 2010) manner. the model specification is: i k i ii xy    1 0  (1), where yi is a binary variable with a value of “1” for a failed bank and “0” for a non-failed bank, while xi is a vector of the explanatory variables that have been determined to possibly have the strongest explanatory power in predicting bank failure. if the probability of bank i failing is pyp i ˆ)1(  and the probability of bank i not failing is pyp i ˆ1)0(  , then         k i i k i ii x x e e p 1 0 1 0 1 ˆ   (2). logit models are sensitive to extreme multicollinearity (balcaen and ooghe, 2005) and thus, espahbodi (1991) advocates the use of more than one measure in studying bank health to avoid issues related to multicollinearity. as we seek to construct a model as an early warning system, we estimate the regression for the year of failure as well as for each of the four years preceding failure. to test the reliability and external validity of our method, we re-estimate the logit model using a hold out sample (jones, 1987). 3.3 constructing the bank health index to construct the “bank health index”, we first define the value ranges of the statistically significant variables from the logit estimates by computing 95% confidence intervals around the mean values of each variable for the failed and non-failed sample. we only compute value ranges for year-1 and year-2 as the predictive power of variables diminish beyond two years preceding failure (espahbodi, 1991). this confidence level for the variables is constructed base on the following expression. upper bound = �̅� + 1.96 ∗ √ ; lower bound = �̅� − 1.96 ∗ √ (3) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 117 ajfa.macrothink.org the computed value ranges will be further classified into a risk continuum ranging from critical to excellent depending on the correlation of the significant variable ratios to failure. the value ranges computed above need to be interpreted with respect to each of the ratios. for example, for variables negatively related to bank failure such as capitalization ratios, a higher ratio indicates better health. hence, a ratio falling below the “failed” range will be categorised as “critical” while a ratio value above the “non-failed” range is categorised as “excellent”. for variables positively related to bank failure such as impaired loans to total equity (impe), a ratio above the “failed” range would be categorised as “critical” while a ratio below the “non-failed” range is categorised as “excellent”. we then convert the value ranges into scores (0 to 10). to ensure an even spread, the median value of each variable is given a score of 5. for variables that are negatively related to failure, any value that falls above the median obtained a score higher than 5 and the rest obtained scores lower than 5. with x as the variable value and m as the median value for the variable, the score is calculated as follows: if x < m then the score for the bank = 5 ∗ 5 ; and if x > m then the score for the bank = 5 + ∗ 5 . for example, if totcap had a maximum of 25%, a minimum of 0% and a median of 13%, the score for the bank is = 5∗ 5. if x < 13 or if x > 13 then the score for the respective bank is = 5+ ∗ 5 . thus, a bank with a totcap ratio below the median would receive a score below 5 while a bank with a ratio above the median would receive a score higher than 5. hence, the higher the totcap ratio, the higher the score a bank achieves. the scores for the variables which have a positive correlation with bank failures is calculated as follows; if x < m, then the score for the bank = 5+ ∗ 5 ; and if x > m, then the score for the bank = 5∗ 5 . that is to say, the lower the ratio, the better the bank’s health. hence, a bank with a lower x would receive a higher score than a bank with a higher x. the calculation of scores for the variable loangrowth, poses a problem as too high or too low a ratio would point to failure. the score for loangrowth is thus calculated as follows: if x < m, then the score for the bank = 10 ∗ 10 ; and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 118 ajfa.macrothink.org if x > m, then the score for the bank = 10 ∗ 10 . here, the median value gets a score of 10. any value further away from the median in either direction would result in a lower score. with the scores computed, we then construct a micro-soundness index for each bank as well as a macro-soundness index for the entire banking industry. the soundness index will consist of the five main aspects of bank health prescribed by the camel framework i.e. capitalisation, asset quality, management efficiency, earnings and liquidity. the micro-soundness index is constructed by summing the component scores for each health aspects of the bank. where a health component is represented by more than one variable (e.g. asset quality), the component score is calculated by taking an average of the scores. with a maximum score of 10 for each significant variable, the maximum total health score will be 50. this score will then be converted into a scale ranging from 0 to 100. in this instance, the maximum score of 50 would be defined as 100 on the health scale, which will be the soundness index for individual banks. the macro-soundness index is constructed by taking the summation of individual bank health scores, weighted by the ratio of total assets of the bank and the total assets of the banking industry. the weighted average health score would be on a continuum of 0 to 100, with 0 representing poor health and 100 excellent health. 4. analysis and findings 4.1 descriptive statistics to determine the independent variables that have the greatest explanatory power to predict bank failure, we first determined whether there are statistical significant differences in the mean values of the two samples (vilen, 2010) on a year-by-year basis, beginning in year-4 until year0, by observing changes to the financial ratios over the years for the failed and non-failed banks. we then conduct a student t-test at the 1% level of significance (note 1). we present these in tables 2 – 7 below. since not all variables were statistically significant in all the five years, we omit those that: (1) did not show a statistically significant difference in any of the years; (2) showed significant difference only in the year of failure; and (3) showed significant difference in just one of the years. the variables employed in this study were strictly required to show a statistically significant difference between the two data samples (failed and non-failed banks) (note 2). for brevity purposes, we only discuss the variables that from the t-test, has sufficient power to predict bank failure. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 119 ajfa.macrothink.org table 2. descriptive statistics and t-test for capital adequacy capital adequacy non-failed banks failed banks t-stat mean std. dev. % change mean std. dev. % change tiercap0 16.126 11.604 -3.19% 5.800 4.129 44.58% 13.69*** tiercap-1 16.658 16.824 2.77% 10.465 3.189 29.59% 5.91*** tiercap-2 16.208 11.375 -6.75% 14.863 15.841 6.00% 1.12 tiercap-3 17.381 13.748 -1.90% 14.022 18.080 26.04% 2.41**** tiercap-4 17.717 15.642 18.958 39.822 0.47 totcap0 17.291 11.519 -2.61% 7.023 4.317 40.11% 13.64 *** totcap-1 17.755 16.711 2.75% 11.726 3.150 26.61% 5.79 *** totcap-2 17.279 11.280 -6.48% 15.978 15.786 5.31% 1.09 totcap-3 18.475 13.655 -1.81% 15.172 18.002 24.42% 2.39*** totcap-4 18.817 15.535 20.074 39.668 0.48 the table presents the descriptive statistics, percentage change in mean values and t-statistics for the capital adequacy variables from year-4 to year0. tiercap is the core capital ratio and totcap is the total capital ratio. full variable definitions are in table 1. ***, **, and * indicate significance at the 1%, 5%, and 10% level respectively. table 2 presents the descriptive statistics, the percentage change in mean values and t-statistics for the capital adequacy variables in this study from year-4 to year0. from table 2, we can see that tiercap and totalcap for non-failed banks remained relatively constant even until year0. failed banks in contrast exhibited falling tiercap and totalcap values from year to year; falling below the minimum of 8% in the year of failure. these changes seemingly support the proposition that failed banks are poorly capitalised i.e. they have a much smaller buffer against potential losses arising from credit or economic risk. we also recorded statistically significant differences between the mean tiercap and totcap values of failed and non-failed banks, allowing both to be reasonable indicators of bank health. table 3 presents the descriptive statistics, percentage change in mean values and t-statistics for the asset quality variables in this study from year-4 to year0. impaired loans for non-failed banks have risen steadily over the years (up to 21 times of total equity in year0). impe for failed banks on the other hand, rose exponentially up to 227 times in year0. t-tests also reveal a statistically significant difference in impe values between both samples – an indicator of their suitability in distinguishing bank failure. similar trends were observed for impaired assets to gross loans (impl). failed banks recorded tremendous growth in this regard, leading up to year0; suggestive of the variable’s power in explaining bank failure. the trend observed for loangrowth is consistent with our earlier discussion. failed banks were lending aggressively in the years prior to failure, finally leading to negative growth in the year of failure as a result of loan defaults. while a similar trend is observed for non-failed banks, the rate of change was more subdued. asset growth rate (agr) displayed a similar trend and statistical significance over the years. the t-statistics support the proposition that high loan growths as well as asset growth in preceding years are indicators of failure. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 120 ajfa.macrothink.org table 3. descriptive statistics and t-test for asset quality asset quality non-failed banks failed banks t-stat mean std. dev. % change mean std. dev. % change impe0 21.251 35.105 60.48% 227.144 214.575 320.69% 15.47*** impe-1 13.242 22.221 91.46% 53.993 68.580 297.95% 9.24 *** impe-2 6.916 13.124 78.62% 13.568 19.428 148.21% 4.64 *** impe-3 3.872 5.896 22.12% 5.466 7.990 21.28% 2.62 *** impe-4 3.171 4.656 4.507 7.179 2.552 *** impl0 2.861 4.065 68.01% 13.898 8.887 162.14% 18.46 *** impl-1 1.703 2.174 74.86% 5.302 5.514 229.70% 9.93 *** impl-2 0.974 1.748 66.90% 1.608 2.217 135.13% 3.67 *** impl-3 0.583 0.838 18.52% 0.684 0.964 20.99% 1.29 ** impl-4 0.492 0.707 0.565 0.927 1.02 * loangrowth0 3.834 19.646 -64.29% -6.112 23.072 -136.34% 5.36 *** loangrowth-1 10.734 25.111 -40.30% 16.821 63.718 -49.08% 1.45 ** loangrowth-2 17.981 51.372 -8.68% 33.033 71.026 -1.49% 2.81 *** loangrowth-3 19.690 66.928 45.00% 33.533 50.839 -27.76% 2.69 *** loangrowth-4 13.580 21.365 46.420 101.342 5.18 *** llr0 1.676 0.826 17.25% 3.572 2.245 7782.00% 12.96 *** llr-1 1.429 0.653 12.44% 2.009 1.358 4742.00% 6.28 *** llr-2 1.271 0.512 0.57% 1.363 0.647 1130.00% 1.81 ** llr-3 1.264 0.499 -2.20% 1.224 0.374 -124.00% 1.03 llr-4 1.292 0.514 1.240 0.403 1.32 ** llimp0 0.296 1.139 -42.46% 0.042 0.080 -90.45% 3.63 *** llimp-1 0.515 1.589 -29.10% 0.444 2.832 -23.53% 0.36 llimp-2 0.726 2.116 -17.91% 0.580 1.660 -77.64% 0.89 llimp-3 0.885 3.124 -53.28% 2.594 14.178 16.29% 1.92 *** llimp-4 1.894 4.671 2.231 7.104 0.65 agr0 6.457 13.847 -45.11% -1.465 18.665 -109.71% 5.57 *** agr-1 11.762 23.277 -8.48% 15.088 41.322 -35.65% 1.15 * agr-2 12.852 32.472 -23.23% 23.445 34.852 -27.73% 3.63 *** agr-3 16.740 61.890 26.91% 32.439 49.044 -2.86% 3.25 *** agr-4 13.190 28.513 45.118 45.118 9.77 *** the table presents the descriptive statistics, percentage change in mean values and t-statistics for the asset quality variables from year-4 to year0. impe is the ratio of impaired loans to total equity, impl is the ratio of impaired loans to gross loans, loangrowth is the bank’s year-on-year growth in loans, llr is the loan loss reserves, llimp is the ratio of loan loss reserves to impaired loans, and agr is the bank’s year-on-year asset growth rate. full variable definitions are in table 1. ***, **, and * indicate significance at the 1%, 5%, and 10% level respectively. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 121 ajfa.macrothink.org table 4. descriptive statistics and t-test for management efficiency management efficiency non-failed banks failed banks t-stat mean std. dev. % change mean std. dev. % change cir0 76.530 36.966 0.81% 147.782 96.926 66.46% 11.22 *** cir-1 75.916 28.791 2.47% 88.779 46.882 19.76% 3.82 *** cir-2 74.089 27.039 2.18% 74.131 38.475 -4.25% 0.01 cir-3 72.509 29.078 3.08% 77.422 60.374 0.91% 1.19 cir-4 70.342 24.524 76.721 70.988 1.38 ** roaa0 0.449 1.235 -11.84% -4.119 3.347 623.34% 20.92 *** roaa-1 0.509 1.942 -43.20% -0.569 2.009 -205.16% 6.31 *** roaa-2 0.896 1.983 -10.95% 0.542 1.507 -32.80% 2.32 *** roaa-3 1.006 1.946 -0.74% 0.806 1.608 -6.75% 1.29 ** roaa-4 1.013 1.696 0.864 1.731 1.01 the table presents the descriptive statistics, percentage change in mean values and t-statistics for the management efficiency variables from year-4 to year0. cir is the cost to income ratio and roaa is the return on average assets. full variable definitions are in table 1. ***, **, and * indicate significance at the 1%, 5%, and 10% level respectively. table 4 presents the descriptive statistics, percentage change in mean values and t-statistics for the management efficiency variables in this study from year-4 to year0. the cost to income ratio (cir) for failed banks rose drastically in the years leading to failure, doubling from about 77 to 147 in just 5 years, as compared to the cir for non-failed banks which rose albeit at a much slower pace. in contrast, return on average assets (roaa) for both failed and non-failed banks over 5 years. however, non-failed banks recorded negative roaas in year-1 and year0. statistically significant t-statistics for cir and roaa is indicative of their suitability in predicting management efficiency and subsequently, bank failure. table 5 presents the descriptive statistics, percentage change in mean values and t-statistics for the liquidity variables in this study from year-4 to year0. we can see that net loans to total assets (netloans) for non-failed banks to remain relatively unchanged as opposed to failed banks who failed banks which recorded about a 7% fall in netloans in year0. the loan to deposit ratio (loandep) for both failed and non-failed banks meanwhile fell in year-1 and year0, with failed banks recording a much greater fall than non-failed banks. t-statistics for both variables suggest that both are good indicators of potential bank failure. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 122 ajfa.macrothink.org table 5. descriptive statistics and t-test for liquidity liquidity non-failed banks failed banks t-stat mean std. dev. % change mean std. dev. % change netloans0 62.766 14.411 -2.62% 70.718 10.400 -6.84% 7.31 *** netloans-1 64.453 15.845 -1.83% 75.908 10.014 1.49% 9.99 *** netloans-2 65.657 15.816 2.42% 74.792 13.205 -2.07% 7.24 *** netloans-3 64.103 16.283 1.57% 76.371 11.761 4.72% 9.98 *** netloans-4 63.111 16.585 72.927 16.021 6.96 *** liq0 0.009 0.008 12.50% 0.010 0.007 42.86% 1.59 ** liq-1 0.008 0.008 14.30% 0.007 0.005 0.00% 2.77 *** liq-2 0.007 0.007 -12.50% 0.007 0.009 -12.50% 0.14 liq-3 0.008 0.008 0.00% 0.008 0.009 -11.11% 0.28 liq-4 0.008 0.008 0.009 0.013 0.95 loandep0 79.510 23.250 -7.67% 84.500 14.780 -11.33% 2.97 *** loandep-1 86.120 49.100 -0.31% 95.300 18.050 -3.57% 2.87 *** loandep-2 86.380 44.190 4.82% 98.830 28.670 5.19% 3.86 *** loandep-3 82.410 25.380 3.30% 93.950 18.340 2.44% 6.02 *** loandep-4 79.780 22.470 91.710 21.760 6.23 *** the table presents the descriptive statistics, percentage change in mean values and t-statistics for the liquidity variables from year-4 to year0. netloans is the ratio of net loans to total assets, liq is the ratio of liquid funds to total assets, and loandep is loans to deposits ratio. full variable definitions are in table 1. ***, **, and * indicate significance at the 1%, 5%, and 10% level respectively. table 6 presents the descriptive statistics, percentage change in mean values and t-statistics for the earnings and net interest income variables in this study from year-4 to year0. net income to average equity (roae) stands out in particular. we can see that in the years leading up to year0, both failed and non-failed banks recorded falling roaes. however, non-failed banks were able to maintain a positive roae. failed banks in contrast, recorded a fall of more than 1,000% from year-1 to year0. though not to this extent, a similar trend can be observed for net interest margins (nim) for both samples; indicating that holding high-risk, high-yield assets initially increases the nim of banks but when the bank faces financial distress, increasing funding costs and high levels of defaults deteriorate nim. (despagne, 2010). the magnitude of change observed for both variables is suggestive of their explanatory power. outside the camel framework, other financial items may provide indication as to the health of the bank. non-interest income have often been perceived as riskier (allen & jagtiani, 2000; clark et al, 2007; deyoung & torna, 2012) but may also be seen as a diversification of business, if carefully executed (gamra and plihon, 2011). our non-failed bank sample seem to fall into the latter category, recording much higher levels of non-interest income as compared to failed banks. it is possible that a well-diversified mix of interest and non-interest sources of income lowers insolvency risks whilst improving profitability (sanya and wolfe, 2010). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 123 ajfa.macrothink.org table 6. descriptive statistics and t-test for earnings & net interest income earnings & net interest income non-failed banks failed banks t-stat mean std. dev. % change mean std. dev. % change roae0 3.527 13.422 -23.99% -76.054 89.775 1017.24% 14.33 *** roae-1 4.640 13.078 -40.27% -6.807 23.196 -164.05% 7.02 *** roae-2 7.768 8.124 -20.63% 10.628 10.593 58.30% 3.49 *** roae-3 9.787 7.686 -8.26% 6.714 12.306 -41.34% 3.46 *** roae-4 10.668 8.223 11.445 9.656 1.01 nim0 3.951 1.048 2.28% 2.976 1.183 -20.31% 10.08 *** nim-1 3.863 1.055 -2.33% 3.734 1.107 -13.54% 1.37 ** nim-2 3.955 1.055 -3.18% 4.319 1.157 -4.07% 3.80 *** nim-3 4.085 1.375 0.22% 4.503 1.212 2.24% 3.73 *** nim-4 4.076 1.229 4.404 1.241 3.07 *** interest0 14.922 35.863 -11.22% 9.828 80.088 -17.66% 0.94 * interest-1 16.808 17.201 -0.54% 11.936 25.600 -1.42% 2.58 *** interest-2 16.898 12.844 -4.51% 12.108 9.855 -9.04% 4.84 *** interest-3 17.696 12.435 0.28% 13.311 10.652 -6.02% 4.38 *** interest-4 17.647 13.688 14.164 11.035 3.24 *** the table presents the descriptive statistics, percentage change in mean values and t-statistics for the earnings and net interest income variables from year-4 to year0. roae is ratio of net income to average equity, nim is ratio of net interest margin to total earning assets, and interest is the ratio of non-interest fee income to total income. full variable definitions are in table 1. ***, **, and * indicate significance at the 1%, 5%, and 10% level respectively. table 7 presents the descriptive statistics, percentage change in mean values and t-statistics for the off-balance sheet items and short-term wholesale funds variables in this study from year4 to year0. off-balance sheet items (obs) have similarly been perceived as risky as their true nature is often not made publicly known. our sample shows both failed and non-failed banks to hold an almost equal amount of obs. although t-tests show statistically significant differences between the two in the earlier years, the magnitude seems to have fallen leading up to year0. a similar trend can be observed for the banks’ reliance on short-term wholesale funding (wst). although wst mean values suggest failed banks rely heavily on wst, t-tests do not indicate a statistically significant difference between the two samples. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 124 ajfa.macrothink.org table 7. descriptive statistics and t-test for off-balance sheet items & short-term wholesale funds off-balance sheet items & short-term wholesale funds non-failed banks failed banks t-stat mean std. dev. % change mean std. dev. % change obs0 0.015 0.035 22.71% 0.011 0.023 -16.87% 1.55 ** obs-1 0.012 0.011 5.63% 0.013 0.009 -23.25% 1.15 * obs-2 0.012 0.008 -3.80% 0.017 0.019 -18.68% 4.45 *** obs-3 0.012 0.008 -0.32% 0.021 0.042 13.75% 3.52 *** obs-4 0.012 0.008 0.019 0.011 7.86 *** wst0 50.960 111.527 -45.07% 61.991 137.521 -39.03% 1.02 * wst-1 92.770 169.877 -12.97% 101.671 169.800 -5.56% 0.61 wst-2 106.595 171.197 39.52% 107.657 182.345 6.11% 0.07 wst-3 76.399 133.777 -7.24% 101.461 174.821 -5.69% 1.86 ** wst-4 82.360 139.420 107.581 176.327 1.83 ** the table presents the descriptive statistics, percentage change in mean values and t-statistics for the off-balance sheet items and short-term wholesale funds variables from year-4 to year0. obs is ratio of off-balance sheet items to total assets and wst is the ratio of volatile wholesale short-term liabilities to liquid assets. full variable definitions are in table 1. ***, **, and * indicate significance at the 1%, 5%, and 10% level respectively. 4.2 logistic regression estimation the discussion of the descriptive statistics above provides early insight into which variables can discriminate between failed and non-failed banks. to identify the variables that can provide early warning signals of bank distress in advance, we perform a cross-sectional logistic regression for each of the 5 years preceding bank failure. although our t-tests identified a number of financial ratios that may have strong explanatory power in predicting bank failure, we only use one measure for every aspect of bank health (espahbodi, 1991) since logit models are sensitive towards multicollinearity (balcaen and ooghe, 2005). the regression estimates are presented in table 8 below. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 125 ajfa.macrothink.org table 8. logistic regression estimation explanatory variables year0 year-1 year-2 year-3 year-4 totcap -0.222*** -0.172*** 0.012 -0.095*** -0.009 (0.081) (0.042) (0.013) (0.031) (0.022) impe 0.016*** 0.024*** 0.023*** 0.016 0.046** (0.004) (0.006) (0.008) (0.016) (0.019) llr -0.117 0.245 0.216 0.384 0.138 (0.159) (0.174) (0.209) (0.276) (0.254) loangrowth 0.15 0.013*** 0.007*** 0.003 0.025*** (0.011) (0.005) (0.002) (0.002) (0.005) roaa -0.661*** -0.239** -0.311** -0.192 -0.033 (0.124) (0.116) (0.157) (0.198) (0.178) cir 0.005 -0.001 -0.006 0.004 0.004 (0.004) (0.004) (0.005) (0.006) (0.004) nim -0.108 0.032 0.445*** 0.424*** 0.287** (0.196) (0.121) (0.120) (0.127) (0.127) netloans 0.029 0.054*** 0.046*** 0.060*** 0.040*** (0.018) (0.011) (0.009) (0.011) (0.010) constant -1.526 -2.902** -5.359*** -5.631*** -5.170*** log likelihood 187.847 503.16 607.308 541.216 518.826 nagelkerke r square 0.837 0.446 0.24 0.315 0.297 prob. > χ2 0.000 0.000 0.000 0.000 0.000 variable definitions are in table 1. robust standard errors are in parentheses. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% level respectively. from table 8, we can see that in the years where the coefficient estimates were significant, the coefficient signs are as argued earlier. totcap and roaa were negative i.e. higher levels of capitalization and greater management efficiency mitigates the probability of failure. netloans, loangrowth and impe meanwhile were positive as expected. interestingly, nim estimates suggest that higher levels of nim in the earlier years is indicative of risky behaviour which eventually leads to failure i.e. positive coefficient sign from year-4 to year-1 and subsequently, negative in year0. llr and cir however, did not show any statistically significant power in predicting bank failure. we re-estimated the logit model twice to avoid multicollinearity, each time using a different proxy to represent a particular aspect of bank health. in model 1, we replaced netloans with loandep to represent liquidity while in model 2, we used impl as a proxy for asset quality instead of impe. the estimates of model 1 and 2 are consistent with those presented in table 8, with both loandep and impl showing a statistically significant positive relationship to bank failure (note 3). from our regression estimates, we can conclude that eight financial ratios are significant predictors of bank failures: totcap, impe, loangrowth, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 126 ajfa.macrothink.org roaa, nim, netloans, loandep; and impl. the classification accuracy of the model for the year of failure and the four years preceding it are illustrated in the table 9 below. table 9. classification accuracy panel a: in-sample year0 year-1 year-2 year-3 year-4 overall classification accuracy 91.82% 71.81% 72.41% 73.40% 73.20% correct classification of failed banks 89.86% 81.30% 73.73% 76.92% 66.36% correct classification of non-failed banks 93.46% 78.29% 71.09% 70.12% 79.18% type i error 10.14% 18.70% 26.27% 23.08% 33.64% type ii error 6.54% 21.71% 28.91% 29.88% 20.82% panel b: out-of-sample year0 year-1 year-2 year-3 year-4 overall accuracy 96.15% 87.69% 76.15% 81.54% 72.31% correct classification of failed banks 100% 95.38% 89.23% 96.92% 84.62% correct classification of non-failed banks 92.31% 80.00% 63.08% 66.15% 60.00% type i error 0% 4.62% 10.77% 3.02% 15.38% type ii error 7.69% 20% 36.92% 33.85% 40.00% in-sample tests (panel a, table 9) show that the model displays fairly reasonable predictive power considering past studies have suggested that failure-prediction models are only reliable up until two years before failure (altman, 2000; espahbodi, 1991; meyer & pifer, 1970). overall, our model is about 70% accurate, increasing to 91.82% in year0. our model also seems to be more accurate in predicting failure even up to as far as year-1. it is however expected that accuracy of correct classification will fall the further away it is from year0. we have also managed to keep type i errors i.e. the probability of incorrectly classifying a failed bank as non-failed, lower than type ii errors i.e. the probability of incorrectly classifying non-failed banks as failed, in the years preceding failure. as misclassification costs arising from type i error are greater (barr and siems, 1997; fidrmuc and sub; 2011), relatively lower type i errors in our model suggests greater predictive power. although the model has high in-sample accuracy, we conduct further tests to evaluate its reliability and validity in classifying out of sample data (jones, 1987). the out-of-sample predictive accuracy was tested using a sample of u.s. commercial banks from 2011. the hold out sample consists of 65 failed banks in year 2011, matched by a sample of 65 non-failed banks according to asset size in the same year. the results presented in panel b, table 9 show that our model has a high overall rate of accuracy even up to year-1 with minimal type i error. accuracy of correctly classifying a failed bank is near perfect in year-1 and perfect in year0. type i errors were well below type ii errors and are also much lower than what was observed in the in-sample test. the accuracy of our model is greater than that of glezakos et al. (2010) i.e. ours is able to predict failure at a higher degree asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 127 ajfa.macrothink.org of accuracy (100% 85%) as compared to theirs (60% 55%). we must note however that the accuracy of our model in correctly classifying healthy banks is similar to theirs. 4.3 the soundness of malaysian banks having identified the financial variables that are able to effectively distinguish between healthy and unhealthy banks, we then construct ‘value ranges’ to assess the soundness of malaysian commercial banks by computing 95% confidence intervals around the mean values of each variable for both the failed and non-failed sample banks. since the predictive power of the variables diminish beyond two years prior to failure, we only computed value ranges for year1 and year-2, although a few variables were only significant for just one year. the value ranges are presented in table 10 below. table 10. value ranges of bank distress indicators non-failed (%) failed (%) lower boundary upper boundary lower boundary upper boundary totcap-1 15.73 19.78 11.35 12.11 totcap-2 n/s n/s netloans-1 62.53 66.73 74.70 77.11 netloans-2 63.73 67.58 73.17 76.41 loangrowth-1 n/s n/s loangrowht-2 11.67 24.29 24.33 41.74 roaa-1 0.2739 0.7437 -0.81 -0.33 roaa-2 n/s n/s nim-1 n/s n/s nim-2 3.83 4.08 4.18 4.46 impe-1 10.55 15.93 45.74 62.24 impe-2 5.32 8.52 11.22 15.91 loandep-1 80.15 92.08 93.13 97.47 loandep-2 80.99 91.78 95.36 102.29 impl-1 1.74 2.52 4.62 5.94 impl-2 1.13 1.63 1.33 1.87 note: n/s indicates non-statistically significant coefficient estimate we then categorise the value ranges in table 10 into five distinct tranches, colour-coded for ease of presentation: (1) critical i.e. recorded ratio is worse than failed banks (in red); (2) unsound i.e. ratio is within failed banks’ range (in pink); (3) moderate i.e. ratio is between failed and non-failed range (in yellow); (4) sound i.e. ratio is within non-failed range (in light green); and (5) excellent i.e. ratio is better than non-failed banks (in dark green). interpretation of the value ranges is variable-specific. for variables negatively related to the likelihood of failure, higher ratios indicate better health. ratios falling below the ‘failed’ range will thus be considered ‘critical’ while ratios above ‘non-failed’ are considered ‘excellent’. for variables asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 128 ajfa.macrothink.org positively related to bank failure, ratios above the ‘failed’ range are considered ‘critical’ while ratios below ‘non-failed’ are considered ‘excellent’. interpreting loangrowth however, requires more discretion as too low a value may indicate inability in generating profits while too high a value may indicate poor lending practices. we assessed the soundness of 20 domestic and foreign commercial banks in malaysia as of 2011 based on our colour-coded categories above. the results of the assessment are presented in table 11 below. table 11. malaysian commercial bank soundness assessment bank c ap it al t o t c a p a ss et q u al it y l o a n g r o w t h a ss et q u al it y im pe a ss et q u al it y im pl m an ag em en t r o a a e ar n in gs n im l iq u id it y l o a n d e p l iq u id it y n e t l o a n s affin ambank alliance bangkok bank of america bank of nova scotia bank of tokyo mitsubishi cimb citibank deutsche hong leong hsbc jp morgan chase maybank ocbc public bank rhb royal bank of scotland standard chartered united overseas bank the soundness of malaysian commercial banks is assessed on 8 categories formed on the basis of the value ranges in table 10. each category is divided into 5 tranches: critical (in red); unsound (in pink); moderate (in yellow); sound (in light green); and excellent (in dark green). the bank soundness assessment in table 11 shows that for the most part, malaysian commercial banks seem to be reasonably sound. a few problem areas exist however, especially in terms of capitalisation and asset quality. we can see that banks such as ambank, alliance, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 129 ajfa.macrothink.org bank of america, bank of tokyo and citibank have very low or even negative loan growth rates (-12.63%; 4.92%; -36.86%; 6.51% and 4.29% respectively), while united overseas bank recorded exceptionally high loan growth rates (35.4%). other aspects of asset quality seem to be acceptable with the exception of royal bank of scotland which recorded a high amount of impl (11.65%). earnings wise, bank of america recorded high levels of nim (8.18%) while citibank was just the opposite (4.26%). with regards to liquidity, we can see that both ambank and bangkok bank recorded high levels of loandep (96.79 and 97.82 respectively) while the bank of nova scotia is seemingly facing liquidity problems with high levels of loandep and netloans (>200%). the above assessment shows that 35% (7 out of 20 banks) of the commercial banks in malaysia have asset quality issues, 20% (4 banks) have problem liquidity issues and 10% (2 banks) have problems with earnings. 4.4 constructing the bank soundness index although the construction of a soundness assessment framework for banks has provided us some insight to the bank’s health, there is still a need for assessments from a wider perspective that allows for inter-bank comparisons to be made. we thus construct a ‘bank health index’ that gives regulators and interested parties a birds-eye view of the soundness of the overall banking industry in the country. the bank health index is computed on a score ranging from 0 to 10 for each component capital; asset quality; management efficiency; earnings; and liquidity – its summation an overall “health score” for the individual bank. with each bank’s health score, an industry score can be computed, allowing for comparisons against the overall banking system to be made. the health scores for each bank are presented in table 12 below. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 130 ajfa.macrothink.org table 12. bank health index scores ownership capialization management efficiency asset quality earnings liquidity total score health score total assets weighted score 1 bank of tokyomitsubishi f 9.25 8.06 8.54 7.57 10 43.42 86.85 2919 0.46 2 jp morgan chase f 10 7.06 7.19 6.61 10 40.86 81.73 2366 0.35 3 royal bank of scotland f 6.07 6.19 5.46 9.56 10 37.29 74.57 1434 0.2 4 hsbc f 5.25 8.26 6.27 7.06 10 36.84 73.68 25094 3.37 5 standard chartered f 5.23 7.82 6.9 7.5 8.69 36.13 72.26 15531 2.05 6 deutsche bank f 5.63 5.22 8.23 6.95 10 36.03 72.06 3727 0.49 7 cimb l 6.61 7.58 5.92 6.16 9.05 35.33 70.65 73783 9.51 8 public bank l 6.21 8.38 7.86 6.23 6.19 34.86 69.71 78505 9.98 9 hong leong l 5.44 6.83 5.61 6.98 10 34.85 69.71 49471 6.29 10 bangkok bank f 9.93 5.5 6.88 7.07 4.87 34.25 68.5 852 0.11 11 alliance bank l 6.48 7.59 4.36 6.24 9.55 34.22 68.43 12898 1.61 12 ocbc f 6.23 7.65 5.28 6.76 7.08 32.99 65.98 20271 2.44 13 citibank f 5.97 9 4.89 3.03 10 32.88 65.76 13991 1.68 14 bank of nova scotia f 8.59 8.77 6.71 6.68 2.08 32.82 65.65 1560 0.19 15 bank of america f 10 6.51 6.22 0 10 32.73 65.46 491 0.06 16 rhb l 6.33 7.46 5.26 6.12 7.24 32.42 64.83 45006 5.32 17 affin l 4.66 6.76 5.84 6.28 8.78 32.32 64.64 15501 1.83 18 maybank l 6.02 7.61 4.72 6.52 7.01 31.87 63.75 136388 15.86 19 united overseas bank f 5.9 7.81 3.87 6.39 6.3 30.27 60.53 21648 2.39 20 ambank l 5.62 7.61 2.12 5.78 4.52 25.65 51.3 26896 2.52 industry component score 6.77 7.38 5.91 6.27 8.07 industry health score 66.69 note: f denotes foreign bank; l denotes domestic bank. health score is each bank’s total score indexed to100. weighted score is the health score multiplied by the bank’s total assets divided by the total assets in the entire banking industry. industry health score is the summation of the weighted health scores for each bank. scores of 100 indicate excellent health, 0 otherwise. table 12 presents the health scores for the 20 foreign and domestic commercial banks in asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 131 ajfa.macrothink.org malaysia for the year 2011. we can see that the top 3 banks in malaysia in terms of health are bank of tokyo-mitsubishi, jp morgan chase and the royal bank of scotland while the bottom 3 are maybank, united overseas bank and ambank. we can also see that on average, banks in malaysia are in a sound position in terms of liquidity and management efficiency but still have a long way to go in terms of capitalisation, asset quality and earnings. eight banks had a perfect liquidity score while three had liquidity scores below 5. in terms of management efficiency, only seven banks scored below the industry average although all 20 banks scored above 5 – an acceptable level but could still be further improved. only 2 banks had a perfect capitalisation score while only one bank scored below 5. although most banks had capitalisation scores above 5, some caution must be noted as only five banks recorded scores that were significantly greater than 5. the other 14 banks only managed scores no greater than 6.7. with regards to earnings, only two banks scored below 5. the other 18 banks recorded earnings scores that were comparable to one another and the industry average with the exception of the royal bank of scotland which scored the highest (9.56). the asset quality of commercial banks in malaysia warrants the most attention. ten banks recorded asset quality scores below the industry average while five banks scored below 5, placing them in the critical category. as a whole, it is reasonable to say that the malaysian banking industry is in a state of moderate health, with a health score of 66.69 – a c or c+ at best. as a result, precautionary measures should be put in place to address these concerns, the first being the asset quality of malaysian banks since 55.61% of the total loans in the banking sector are driven by household borrowings (bnm, 2011) where 26% of it is for residential mortgages. banks are essentially exposing themselves to high level of concentration risk in sectors that might not be as stable as once thought. the drop in property prices as a result of the afc and the crash in the property and mortgage market as a result of the sub-prime crisis are two prime examples of the dangers inherent in the property sector. 5. conclusion over the last decade, we have witnessed major financial institutions collapse due to poor lending practices. given their importance in the economy, bank failures send shockwaves across the country and the region as well – something that economies recovering from the recession can scarcely afford. burdened with the task of steering the economy into recovery, regulators find it difficult to dedicate more resources into overseeing bank practices. consequently, regulators need a bank health framework that makes their oversight task simpler, yet effective. our model meets this purpose with a much higher degree of accuracy as compared to others. we also develop a bank health index that allows for time-progressive monitoring of bank health, as opposed to the conventional point-in-time assessments. progressive monitoring provides regulators with timely information allowing them to take precautionary measures in advance whenever any bank breaches a pre-determined lower threshold. the bank health index also serves observers, investors and potential clients by providing information on the bank’s soundness vis-à-vis other banks, allowing them to make a more informed when choosing their bank, besides keeping banks in check. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 132 ajfa.macrothink.org acknowledgement this paper is in memory of our mentor and friend associate professor balachandher krishnan guru, who unfortunately passed away before this paper could be published. without his drive and guidance, this paper would have never seen the light of day. notes note 1. in the t-test, the hypothesis is stated as follows: h0: the difference between the two group means is zero, h1: the difference between the two group means is significantly different from zero. note 2. in this study, the failure-prediction model is not to predict failure per se, but to identify which variables have the power to predict failure in advance. it is thus necessary that the variables in the model here do show a statistically significant difference between the two samples. in previous studies of bank failure prediction, this had not been a strict requirement (espahbodi, 1991). note 3. due to space constraints, we did not report these figures here. they are however, available from us upon request. references agarwal, v., & taffler, r. 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(1984). methodological issues related to the estimation of financial distress prediction models. journal of accounting research, 22 (1984), 59-82, https://doi.org/10.2307/2490859 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 16968-60314-1-sm (1)-writer2-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 131 a reexamination of firm’s r&d expenditure behavior hsin-jung hsieh department of international business, kainan university no. 1 kainan rd., luzhu, taoyuan 33857, taiwan e-mail: hjh@mail.knu.edu.tw yen-chih liu (corresponding author) department of accounting, kainan university no. 1 kainan rd., luzhu, taoyuan 33857, taiwan e-mail: ycliu@mail.knu.edu.tw received: march 1, 2020 accepted: may 18, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.16968 url: https://doi.org/10.5296/ajfa.v12i1.16968 abstract knowledge acts as a crucial element in economic activities. for knowledge-intensive business, r&d activities maintain market competitiveness and create new firm value. r&d expenditure indeed brings forth potential growth opportunities for firm value although the growth may take a long time to achieve. apart from that, it usually accompanies problems of agency costs and asymmetric information in daily firm operations, which, in turn, may offset the certainty of a firm’s increasing value. this study examines the decision-making on optimal r&d expenditure for listed firms in taiwan. from january 1986 to december 2013, the data of all the listed firms excluding financial, insurance, and securities firms have been analyzed. in addition, to further explore the differences in decision-making among different macroeconomic conditions, industrial attributes and firms’ characteristics, we divide all samples into subsamples to reexamine. the empirical findings indicate that firms may weigh the cost and benefit of r&d expenditure in its decision, but the driving factor lies in firm’s return on assets (roa), potential growth opportunity, and capital structure. keywords: firm value, agency problem, asymmetric information research, and development (r&d) expenditure jel classification: g32, g34, o32 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 132 1. introduction people generally agree that r&d innovation activities hold a key position—that of maintaining market competitiveness and creating new firm value in knowledge-intensive enterprises. r&d expenditure can indeed bring about potential growth opportunities for firm value; however, cultivating the advantages of r&d innovation requires long-term cooperation. therefore, how firms weigh the benefits and costs to make the most appropriate decision of r&d expenditure is an important issue. according to statistics from the indicators of science and technology of the republic of china, issued by the ministry of science and technology, the proportion of taiwan's r&d expenditure to gdp has increased year by year since the time it exceeded 2% in 2001 and has increased to more than 3.1% since 2012. therefore, the trend at home and abroad and the promoted national policies all advocate that r&d should be the main source of power for industrial upgrading and approve that the absolute amount of r&d expenditure plays a direct extra role in global industry competition. with respect to the research on r&d expenditure and firm value, scholars found that the increase in r&d expenditure has a positive impact on firm share price, verifying that r&d activities do help to create future earnings and cash flows and increase firm value(hirschey and weygandt, 1985; bublitz and ettredge, 1989; chan, martin, and kensinger, 1990; kothari and zimmerman,1995). however, morris, teisberg, and kolbe (1991) proposed two risks threatening the future growth opportunities and real cash income in the r&d plan. if the plan failed, the huge expenditure would cause great losses to firm surplus. for example, jensen (1993) found that most r&d plans that had been conducted failed to earn profits as expected, but investors' high expectations of profitability from r&d activities may cause firm stock price to be overvalued. however, in the accounting statements, when the expended annual r&d expenditure (included in the income statement under the subject of the profit and loss account) fails to consider the economic added value brought about by r&d activities, it may lead to underestimated firm value in the accounting surplus. hall (1993) and porter (1993) also proposed that because the benefits of r&d plans take a long time to generate investment returns, investors taking reference from the distorted accounting statements may overlook future firm value. such shortsighted capital markets may also trigger agency problems between managers and shareholders. empirical studies found that managers have a strong incentive to reduce the current r&d or other long-term expenditures to improve the firm's short-term performance; however, this will be inevitably inconsistent with the goals of shareholders who pursue long-term interests of the firm, resulting in related agency costs( baber, fairfiled, and haggard, 1991; dechow and sloan, 1991; murphy and zimmerman, 1993). the r&d expenditure and information asymmetry between managers and shareholders can also not be ignored. aboody and lev (2000) found that insiders in firms with strong r&d capability earn more profits than those in firms that do not conduct r&d activities, indicating that the problem of r&d expenditure and information asymmetry between managers and shareholders does exist. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 133 therefore, there is still no specific or effective method available in practice or academic research as to whether firms should always maintain a certain amount of money each year as an innovative r&d budget or maintain a certain ratio according to different characteristics and differences of the firms. to effectively control and allocate r&d resources, it is the most important research purpose of this study to find an effective measurement indicator system that can be used in taiwan. the rest of this paper is organized as follows. section 2 presents a review of the literature on the benefits of firm value brought about by r&d expenditure, the cost of agency problem, and that of information asymmetry, while section 3 provides our research design and empirical models. section 4 presents the empirical results of this work, and section 5 then gives the conclusions. 2. literature reviews according to standard no. 2 issued by the financial accounting standards board, research is planned search or critical investigation that is aimed at discovering new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about significant improvement to an existing product or process. development is the transaction of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process, whether intended for sale or use. nason (1981) defined research and development (r&d) as a planned new knowledge activity that systematically develops and improves existing technologies and products and converts the results or new knowledge into new products and processes. the main purpose of this study is to explore how firms balance growth benefits and information asymmetry and agency problems brought about r&d expenditure, to obtain the optimal level of r&d expenditure. therefore, the relevant literature review is based on the impact of r&d expenditure on the firm, and the following aspects are analysed according to r&d expenditure and firm value, information asymmetry, and agency problems. 2.1 r&d expenditure and firm value in recent years, many scholars have discussed the impact of firm r&d plans on firm value (measured by firm stock price return). hirschey and weygandt (1985) explored the impact of r&d expenditure and advertising costs on firm stock price. the results indicated that r&d expenditure and advertising costs have significant positive impacts on firm book value and book-to-market ratio. in addition, these inputs can increase firm market value as firm durable goods. however, the period of benefits created by advertising costs is shorter and that created by r&d expenditure is longer. bublitz and ettredge (1986) further used the cumulative abnormal return to analyze the impact of non-expected r&d and advertising costs on stock return, and they referred to the lipe’s (1986) model for discussion. the results show that r&d activities can indeed exert a positive impact on firm value and that firm investment in r&d activities should be reasonably evaluated by the market and in the same manner as general investment projects. chan et al. (1990) examined the impact of the announcement of r&d expenditure on firm stock price. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 134 they adopted the sample period from 1979 to 1985 to distinguish between two subsamples: high-tech and low-tech. they found that the stock price does have significant excess return after the announcement of r&d expenditure but that the market gives positive evaluation on the announcements made by high-tech firms. on the contrary, for firms with a lower degree of technology, the market gives significantly negative market returns, indicating that r&d expenditure can still receive positive evaluation from the capital market although it would reduce annual surplus and that industrial category has a decisive influence on the information effect of r&d expenditure. kothari and zimmerman (1995) also examined the relationship between r&d expenditure and firm share price. the results also pointed out that a firm’s increased r&d expenditure brings about positive returns to the firm's share price, and therefore, r&d activities indeed helps to create future earnings and cash flow and further increase firm value. sougiannis (1994) found that r&d investment has a significant positive deferral effect on firm stock price and earnings. on average, a 1-dollar increase in r&d expenditure leads to a 2dollar increase in profit over a 7-year period and an increase in stock value over a 5-year period. lev and sougiannis (1996) found that r&d expenditure not only contributes positively to firm current stock returns but also to firm future stock returns, i.e., r&d expenditure has deferred benefit to surplus. deeds (2000) indicated that the intensity of r&d is significantly positively correlated with market added value. from the perspective of firm business performance, bourgeois (1981), singh (1986), and chakrarthy (1986) advocated that better business performance results in more resources in excess of what is required for the “normal” efficient operation of a firm and that these excess resources encourage firms to more actively interact with or compete against the environment. this means that better performance give a firm more resources to try to develop innovative products. morbey and reithner (1990) identified that r&d expenditure brings about net growth in firm future operating income. dugal and morbey (1995) also found that in the recession period where the economic environment faces a decline in the gross growth rate of real national production, a firm’s sales would not decline if its r&d expenditure exceeded 3% of its sales volume, and the r&d density is significantly positively correlated with corporate profits. in taiwan, lin’s (2001) empirical research pointed out that the domestic capital market does have a positive evaluation of firm r&d expenditure and that firm r&d expenditure could contribute about 0.089 to 1.144 yuan for its current share price returns; hsu (2002) pointed out that for electronic firms listed on the domestic market, there was a significantly positive relationship between the first and second phases of r&d density and shareholder returns. a 1% increase in r&d density leads to a 1.995% increase in current shareholder returns. therefore, firm investment in r&d activities seems to focus more on the short-term. jhao (2002) analysed the relationship between firm r&d expenditure and stock price returns after the r&d expenditure is capitalized. the results show that after capitalization, the book value of r&d assets has positive explanatory power on stock price. after dividing the sample, there are significantly positive differences between firms with higher r&d concentration and those with lower r&d concentration in terms of long-term shareholder returns. however, as for asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 135 advertising expenses with the same nature as r&d expenditure, after being capitalized, they are not positively evaluated by the stock market. therefore, it is more appropriate to recognize the current advertising expenses. from the perspective of firm business performance, the empirical research by huang (1999) found that the r&d expenditure of the domestic electronics industry has a significantly negative relationship with the current revenue growth rate and that the next year's revenue growth rate has a significantly positive deferral effect; in addition, as for the relationship between r&d expenditure and firm return on assets, there is a significantly negative correlation between r&d expenditure and the current asset return rate, and there is a significantly positive deferral effect on the asset return rate in the lagged period of the previous 5 years. however, in terms of the correlation between r&d expenditure and post-tax net return, the result shows a significantly negative correlation in the current period and a significantly positive deferral effect in the lagged period of the previous 5 years. both ou (1998) and yang (2002) found that r&d activities have significantly positive effects on firm operating performance and operating gross margins, respectively, in the current and the next year. lin (2002) explored the contribution of taiwan's listed information and electronics industry to firm value and found that r&d expenditure is significantly negatively correlated with business performance in the current year and significantly positively correlated with business performance in the next year and that there is a significantly negative deferral effect on the business performance after 4 years’ lagged period. firms with high r&d expenditure obviously have better business performance than those with low r&d expenditure, particularly in the fourth and fifth year after r&d investment. 2.2 r&d expenditure and information asymmetry aboody and lev (2000) studied firm insider gains and believed that the information asymmetry caused by r&d expenditure is triggered by a firm's own investment strategy. the reason for the degree of information asymmetry caused by r&d expenditure being much greater than that caused by other tangible assets lies in the uniqueness of r&d activities. therefore, investors cannot infer firm r&d performance by the performance of other firms' r&d activities. another reason is that the accounting measure used in r&d expenditure is different from that used in general tangible assets. as r&d expenditure is categorized as expenses according to the current regulations, accounting statements cannot provide useful information on account of the confidentiality of information on r&d expenditures. the research results show that insiders of firms with higher r&d density earn more profits than do those of firms with lower r&d density. in addition, as most r&d projects are firm internal confidential plans and as there is no market for r&d project trading, the current market has not effectively estimated or evaluated r&d projects. referring to the characteristics of intangible assets, with the accounting system not yet having capitalized r&d expenditure, firms categorize current r&d expenditures as current expenses. such an accounting system seriously underestimates firm assets. chan, lakonishok, and sougiannis (2001) found that because the accounting system cannot estimate the value of asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 136 intangible assets, investors with knowledge of the accounting statements may make invalid judgments on firm stock price and future growth opportunities. it can be seen that when firms engage in r&d activities, there will likely be information asymmetry between insiders and investors, explaining why many scholars explore the relationship between r&d expenditure and information asymmetry. alam and walton (1995) divided the sample into two categories: high r&d density and low r&d density. the event study method was used to analyse the stock price effect of the two subsamples after the announcement of new bond issuance. the results show that the information asymmetry caused by r&d expenditure leads to significantly positive abnormal returns when a firm declares bond issuance. that is to say, firms with high r&d density and low r&d density have significant differences in returns after the announcement. boone and raman (2001) used the amount of r&d expenditure as the substitute variable for information asymmetry to verify the relationship between information asymmetry and firm stock liquidity. glosten and milgrom (1985) mentioned that the market lose confidence in firms with serious problems of information asymmetry. therefore, market makers suffer losses when dealing with information owners, and they increase the bid-ask spread in the market to obtain compensation from the traders who lack information. however, such increased bid-ask spreads make firms with the problem of information asymmetry left with lower stock liquidity. the empirical results of boone and raman (2001) are also in line with glosten and milgrom’s (1985) inference, which confirms that firms that invest heavily in r&d activities do have relatively poor liquidity. in summary, the information asymmetry generated by firms with higher r&d expenditure is significantly different from that generated by those with lower r&d expenditure, in terms of performance on the capital market (stock performance). in taiwan research on the relationship between r&d expenditure and information asymmetry are rare. the empirical research by liu (2001) found that the r&d expenditure of domestic listed firms tends to defer the financial benefits that should be obtained by the firm and that it will take 2–5 years for the benefits to show significant effects. the results show that the higher the r&d expenditure, the more obvious it is that r&d expenditure efficiency is behind the current period. lee (2003) explored patent rights, the intangible asset closely related to r&d expenditure, to discuss whether the insiders of taiwan-listed firms have more information than outsiders through their positions. the results show that the insiders of firms with patent rights have higher stock returns than those of patent-free firms, revealing that intangible assets do generate information asymmetry between insiders and outside investors, which, in turn, affects firm stock returns. 2.3 r&d expenditure and agency problem morris et al. (1991) proposed that firm r&d plans face two types of risks: uncertain future growth space and uncertain future cash income. the findings of their study also highlight the difficulty of decision-making of r&d expenditure within an enterprise. even if firm assessment of the investment in r&d activities is of great help to its future economic benefits, there are hidden risks behind the r&d plan. if the plan fails, the huge expenses in the plan would cause great loss to the firm's surplus. such loss would be a dilemma to be faced by firm asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 137 managers and shareholders. for example, jensen (1993) found that most r&d plans failed to benefit as expected. but investors' high expectations of profit brought about by the r&d activities may result in overestimated stock price. in addition, when a firm invests in r&d funds, it can increase firm value. however, in the accounting statements, when the expensed annual r&d expenditure (included in the income statement under the subject of the profit and loss account) fails to consider the economic added value brought about by r&d activities, it may lead to underestimated firm value in the accounting surplus. hall (1993) proposed that as it takes a relatively long period of time for the benefits of an r&d plan to create returns, firms expect to recover about 20%~30% of the annual profit from r&d activities, and that there are significant differences among different industries. porter (1993) also found similar results. nevertheless, kothari, laguerre, and leone (2002) found that r&d expenditure has three times the impact on the firm future earnings variable than do general fixed assets. chan et al. (2001) further found that the r&d density has a considerable correlation with the variation in firm stock returns. therefore, when investors face the current distorted accounting statements as a reference for investment decisions, along with the unclear impact of the r&d activities on firm future performance, it may prompt the capital market to ignore the firm’s future firm value and become short-sighted. such a short-sighted capital market can lead to agency problems between managers and shareholders. the results of baber et al. (1991) indicated that when a firm's r&d expenditure affects the positive or negative value of a firm's current earnings or switches the firm's revenue from increase to decline, the firm's managers significantly reduce the firm's r&d expenditure, to maintain a relatively high level of surplus. the empirical research also found that as firm performance affects the retention of the firm's manager position, the manager has a strong motivation to conceal poor firm performance to ensure their position (dechow and sloan,1991; murphy and zimmerman, 1993). however, reducing the current r&d expenditure or other long-term expenditures to improve the firm's short-term performance is a commonly used method. still the move is bound to be inconsistent with those shareholders whose goal is to pursue the firm's long-term interests, resulting in agency costs between the shareholders and the manager. on the other hand, previous scholars have found that when firms invest in r&d activities, managers are given an opportunity to transfer wealth to shareholders. when a firm invests or spends money in r&d activities, there is a large demand for capital. jensen and meckling (1976) and galai and masulis (1976) found that when investment causes a firm to raise external debts, it will increase the firm’s agency cost. since investment activities such as r&d are risky, the increased risk of a firm helps to lift shareholder value when the debts are repaid within a limited period of time. however, when compared with the creditor, the shareholders must bear the risk of wealth transfer, and therefore emerges the phenomenon of redistribution of wealth. thus, the creditor requires higher interest rates or they add more restrictions to hedge against the risk, and the increased need of capital brought about by the r&d expenditure will also result in an increase in agency costs between shareholders and creditors. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 138 3. research method 3.1 sample and data source in the previous literature on r&d expenditure, the difficulty of obtaining data meant that the one-year cross-sectional data of specific industries were mostly taken as the object of research. to obtain a more in-depth and comprehensive understanding of the r&d activities in various industries and eras, this study takes all the firms listed on the taiwan stock market from 1986 to 2013 as research objects. in addition, because of different industrial characteristics, relevant industries such as financial, insurance, and securities are excluded, and special stocks and beneficiary certificates are also deducted. the final sample totaled 29026 observations. this study is aimed at the annual data. the information on firm rate of return is taken from the stock price database in the taiwan economic journal (tej), and the relevant financial information is derived from the financial database of listed firms in the general industry of the tej. 3.2 variable definitions according to the literature review of fong, tseng, chung, and shen (2000), the factors that affect the r&d expenditure of enterprises at home and abroad can be roughly divided into two categories: industrial and environmental characteristics and enterprise characteristics. however, the main purpose of this study is to explore how firms balance the growth benefits brought about by r&d expenditure on one side and the information asymmetry and agency problems also brought about by r&d expenditure on the other side, to obtain the optimal level of r&d expenditure. we use the method of ordinary least square (ols) (note 1) of pooled crosssectional data to estimate multiple regression analysis and list the definitions and operations of the variables in the model as follows: titititititititi finlroaopplnretsizefcfrdrate ,,6,5,4,3,2,10,   (1) 3.2.1 dependent variable rdrate: research and development ratio. because the absolute amount of r&d expenditure does not eliminate the effect of firm size and because it is prone to heteroscedasticity (hoskisson and hitt, 1988), we adopt the methods of hambrick and mcmillan (1985) and baysinger and hoskisson (1989) and use the ratio of r&d expenditure as a measure to eliminate scale effects and to reduce the possibility of heteroscedasticity. %100 sales net eexpenditur d&  r rdrate (2) 3.2.2 explanatory variables fcf: free cash flow, a substitute variable for equity agency costs (jensen, 1986). it equals operating profit before depreciation interest expense income tax expense cash dividend. size: firm size, a substitute variable for information asymmetry (hasbrouck, 1991). because of the small number of shares in circulation, the internal shareholding ratio in small firms is asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 139 relatively high. there are relatively more incentives for insiders to conceal the hidden key information in pursuit of private gains, leading to more serious information asymmetry. this study uses firm market value as a variable to measure firm size. lnret: this measures firm value. this study uses the stock price return rate as a reference indicator for firms to make the optimal r&d expenditure decision. it takes the adjusted stock price return rate from the taiwan economic journal, and natural logarithm (ln), in response to the concept of using continuously compounded interest to calculate returns, to preserve the additive nature of time series. opp: this means a firm's future investment growth opportunities. because a firm's future investment opportunities are critical to its investment decisions, firm current market to book ratio is taken as the substitute variable for investment opportunity （myers, 1977）. assets total of value book equities total of value market + equities total of value bookassets total of value book  b mopp (3) 3.2.3 control variables roa: this measures firm performance. as return on assets (roa) is an effective indicator that is used to measure firm business performance (lant, milliken, and batra, 1992；trevino and daniels, 1994, 1996), roa is adopted in this study as a reference indicator for firms to make optimal r&d expenditure decisions. (4) finl: this means debt ratio. this study adopts the debt ratio measured by previous related research (hitt et.al,1991 ) as the control variable. %100 equity sr'shareholde total sliabilitie total finl (5) 4. results of empirical analysis the purpose of this study is to observe the decision-making behaviour of listed firms in r&d expenditure. because of the difficulties in making the decisions of r&d expenditure, firms need to make a trade-off between firm future competitive potential and current surplus, as well as the possible subsequent agency problem and information asymmetry. thus, the data collected in this study includes all the listed firms from 1986 to 2013 as the sample group, and industries such as financial, insurance, and securities are excluded to avoid bias. in addition, in accordance with fong et al. (2000), who discovered the impact of industry, environment, and corporate characteristics on firm r&d expenditure, this study explores different overall economic conditions (including monitoring indicator, leading indicator, real gdp growth, and different eras) and industrial characteristics (including listed firms and electronic and nonelectronic stocks), in the hope that we can use the subsamples to explore the differences in %100 assets total tax and interest beforeincome net roa asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 140 decision-making on r&d expenditure under different contexts. the empirical results at various stages are shown as follows. 4.1 entire sample first, the basic descriptive statistics of each variable and the results of the spearman's rho correlation coefficient matrix used for the preliminary observation of the degree and direction of the correlation between the variables are disclosed in tables 1 and 2, respectively. table 3 shows the empirical results of the decision-making on r&d expenditure using the entire sample. in the spearman’s rho correlation coefficient matrix in table 2, although the spearman’s rho correlation coefficients of most variables are significantly different than 0, the results of the collinearity statistics in table 3 show no significant collinearity problems for the variables in the model. the main empirical results in table 3 indicate that the free cash flow (fcf) used to measure agency problems is not statistically significant but that it indeed shows a negative coefficient of -0.10, which means that firms with more fcf may have more agency problems, which do have a negative impact on rdrate. in addition, we try to verify information asymmetry through firm size (size). just as the past literature found that the smaller the firm size the more serious the information asymmetry, we also found no significantly positive relationship between size and rdrate, which also shows that although the statistical relationship is not significant, larger firm size reduces information asymmetry problems and further improves r&d expenditure. table 1. descriptive statistics min. value max. value average standard deviation rdrate .0000 157018.7500 20.227874 1.3414731e3 fcf -421877648 401185110 315215.06 9271846.870 size 31 2735469 15549.60 70514.353 lnret -290 339 3.05 54.931 opp .00 2.44 .3935 .18862 roa -8.81 1.10 .0562 .13664 finl -992.73 913.33 1.3958 9.81474 note 1: rdrate: r&d expenditure ratio; fcf: free cash flow; size: firm size lnret: ln (return on share price); opp: future investment growth opportunity; roa: return on assets; finl: debt-to-equity ratio. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 141 table 2. spearman’s rho correlation matrix rdrate fcf size lnret opp roa finl rdrate 1.000 -.012 -.039** -.029** -.261** .010 -.287** fcf -.012 1.000 .299** .019* -.153* .245*** -.176** size -.039** .299** 1.000 .242** -.025** .370** -.026** lnret -.029** .019* .242** 1.000 -.043** .300** -.045** opp .010 .245** .370** .300** 1.000.271** -.180** roa -.261** -.153** -.025** -.043** -.271 1.000** .999** finl -.287** -.176** -.026** -.045** .999** -.180** 1.000 note 1: rdrate: r&d expenditure ratio; fcf: free cash flow; size: firm size; lnret: ln (return on share price); opp: future investment growth opportunity; roa: return on assets; finl: debt-to-equity ratio. note 2: ** represents the statistical significance level of two-paired test of 1%. note 3: * represents the statistical significance level of two-paired test of 5%. table 3. research and development expenditure decision model for the entire sample model standardized coefficients sig. collinearity statistics tolerance vif (constant) .000 fcf -.010 .321 .593 1.686 size .006 .511 .593 1.685 lnret .006 .413 .933 1.072 opp -.134*** .000 .840 1.191 roa -.096*** .000 .886 1.129 finl .020** .014 .871 1.147 note 1: the study adopts the method of ordinary least square (ols) of pooled cross-sectional data to estimate the multiple regression analysis. titititititititi finlroaopplnretsizefcfrdrate ,,6,5,4,3,2,10,   note 2: rdrate: r&d expenditure ratio; fcf: free cash flow; size: firm size;nret: ln (return on share price); opp: future investment growth opportunity;roa: return on assets; finl: debt-to-equity ratio note 3: *** represents the statistical significance level of two-paired test of 1% note 4: ** represents the statistical significance level of two-paired test of 5% although the results of all the samples in this study find that the impact of agency problems and information asymmetry on company r&d investment is not statistically significant and that the direction of the regression coefficient is the same as that expected by us. in addition, in terms of other explanatory variables, the impact of lnret on rdrate is positive, 0.006. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 142 although it does not reach the statistically significant level, it can be inferred that the decisionmaking of firm r&d expenditure is indeed influenced by investors’ positive affirmation of firm value. in addition, firm investment growth opportunity (opp) also has a significant negative relationship with rdrate, with an estimated coefficient of -0.134. although this result differs from that in which firms make more optimistic and positive r&d investment under expectant future growth opportunities, it reveals that firms are willing to be more cautious regarding innovative r&d challenges in the anticipation of an optimistic future. in terms of control variables, there is a significantly negative coefficient of -0.096 between firm roa and rdrate, which is in line with our expectations. it indicates that r&d expenditure must be recognized as current expense in the accounting system, thus affecting the current surplus and reducing the level of asset returns. in terms of the control variable finl, a significant coefficient +0.020 indicates that firm r&d expenditure indeed affects its capital structure. 4.2 re-examination of r&d expenditure decisions under different overall environments to determine whether the differences in the overall environment exert different impacts on firm r&d expenditure decisions, we further re-observed the entire sample on the basis of different monitoring indicators and different eras. the data in table 4 show the changes in firm decision-making behaviour on r&d expenditure under different monitoring indicators. in what is case with the entire sample, both roa and opp have a significant negative relationship with rdrate regardless of the overall annual economic situation. this once again illustrates the dilution effect of r&d expenditure on earnings and the cautious r&d expenditure decision made by firms in the presence of a high potential for future growth. however, interestingly, finl shows a statistically insignificant positive relationship when the monitoring indicator shows a green light and a yellow and red light. unlike the previous findings from the entire sample, it seems that firm capital structure does not significantly affect firm r&d decisionmaking in a relatively optimistic economy. however, when the indicator shows that the economy falls into recession, which is denoted by a blue light or a yellow and blue light, firm r&d decision-making is affected by firm capital structure. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 143 table 4. r&d expenditure behavior of firms in different overall environments and eras with different levels of r&d intensity model standardized coefficients monitoring indicator (light signal) period blue (sluggis h) yellowblue (transition al) green (stable) yellowred (transition al) 1986~20 00 2001~20 11 2012~20 13 (consta nt) fcf -.004 -.019 -.009 -.013 -.072*** -.006 -.017 size .004 .004 .008 .015 .111*** .005 .008 lnret .022 .049* .005 -.014 -.043** .002 .003 opp -.143** * -.211*** -.126** * -.163*** -.135*** -.152*** -.153*** roa -.100** * -.093*** -.101** * -.138*** .025 -.126*** -.053*** finl .033** .074** .017 .016 .004 .023** .046** note 1: the study adopts the method of ordinary least square (ols) of pooled cross-sectional data to estimate the multiple regression analysis. titititititititi finlroaopplnretsizefcfrdrate ,,6,5,4,3,2,10,   note 2: rdrate: r&d expenditure ratio; fcf: free cash flow; size: firm size; lnret: ln (return on share price); opp: future investment growth opportunity; roa: return on assets; finl: debt-to-equity ratio. note 3: to avoid subjectively distinguishing different subsamples of the overall economic situations, this study takes the monitoring indicators of each year as the indicator for overall economic situations. the monitoring indicator is the sum of the indicator scores of nine economic activities published monthly by the council for economic planning and development, executive yuan, namely monetary aggregate m1b; direct and indirect finance; taiex average closing price; industrial production index; non-agricultural employment; customs export value; imports of machineries & electrical equipment; tier manufacturing composite indicator/index of producer’s shipment for manufacturing; and sales of trade and food services. the highest score for the monitoring indicator is 45, and the lowest is 9. the comprehensive scores obtained are used to distinguish the corresponding monitoring indicators for them to be used as a reference for future monitoring. the scores and meaning of each monitoring indicator are shown as follows: if the comprehensive indicator score falls between 9 and 16, it shows a blue light, meaning that the economy is in a downturn; a score between 17 and 22 shows a yellow-blue light, meaning that the economy is getting rid of a downturn; a score between 23 and 31 shows a green light, meaning that the economy is stable; a score between 32 and 37 shows a yellow-red light, meaning that the economy is growing steadily; asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 144 and a score between 38 and 45 shows a red light, meaning that the economy is booming. there was no indicator flashing a red light in the samples during the 28-year study period. note 4: according to the statistics from the indicators of science and technology of the republic of china issued by the ministry of science and technology, the proportion of taiwan's overall r&d expenditure to gdp has increased year by year ever since it exceeded 2% in 2001, and it has increased to more than 3.1% since 2012. thus, this study has divided the entire sample period into three parts, which are the low r&d era before 2000, the leap forward r&d era from 2001 to 2011, and the high r&d era after 2012. note 5: *** represents the statistical significance level of two-paired test of 1%. note 6: ** represents the statistical significance level of two-paired test of 5%. note 7: * represents the statistical significance level of two-paired test of 10%. in addition, as the proportion of taiwan's overall r&d expenditure in gdp has exceeded 2% and increased gradually since 2001 and has exceeded 3.1% since 2012, this study has divided the entire sample period into three parts, which are the low r&d era before 2000; the leap forward r&d era from 2001 to 2011; and the high r&d era after 2012. the right-hand side half of table 4 shows the results under different eras with different r&d intensities. the r&d expenditure decisions after 2000 show the same result as that shown by the entire sample; however, before the low r&d era preceding 2000 firms made very cautious decisions on r&d expenditures. fcf, size, and lnret are all key factors that significantly affect firm behaviour, indicating that in the early days, of low r&d density, agency problems and information asymmetry significantly affected firm r&d expenditure decisions. we believe that a smaller agency problem (less fcf) leads to less asymmetric information (larger size), as well as the lowest return on stock price, all of which prompt a firm to conduct more active r&d actions. 4.3 re-examination of r&d expenditure decisions under different industrial characteristics in addition to the overall environmental factor affecting firm decision-making, this study carries out discussions by further dividing the samples into two subsamples, which are listed firms and otc firms, and into two other subsamples, which are electronic stocks and nonelectronic stocks. the results in table 5 indicate that in what is different from the entire sample and listed firms, otc firms have smaller agency problems and larger firm size, which can encourage them to have more active r&d expenditure activities. as for the subsamples of electronic stocks and non-electronic stocks, different returns on stock price lead to different directions of decision-making. for general industry firms with non-electronic stocks, r&d expenditure decisions are all significantly subject to positive feedback from investors. however, as for firms with electronic stocks, r&d expenditure plays a more important role in the electronics industry because of fierce competition in the industry. thus, when the stock price returns are low, firms are motivated to conduct more r&d expenditure. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 145 table 5. r&d expenditure behavior of firms in different market categories and industries model standardized coefficients market level industry level twse gtme electronics non electronics (constant) fcf -.014 -.031** -.027 -.011 size .018 .060*** .021 .002 lnret -.002 .006 -.031** .021** opp -.128*** -.160*** -.286*** -.133*** roa -.066*** -.123*** -.194*** -.109*** finl .017* .028* .073*** .016* note 1: the study adopts the method of ordinary least square (ols) of pooled cross-sectional data to estimate the multiple regression analysis. titititititititi finlroaopplnretsizefcfrdrate ,,6,5,4,3,2,10,   note 2: rdrate: r&d expenditure ratio; fcf: free cash flow; size: firm size; lnret: ln (return on share price); opp: future investment growth opportunity; roa: return on assets; finl: debt-to-equity ratio. note 3: *** represents the statistical significance level of two-paired test of 1%. note 4: ** represents the statistical significance level of two-paired test of 5%. note 5: * represents the statistical significance level of two-paired test of 10%. 5. conclusions and suggestions this study examines the decision-making on optimal r&d expenditure for listed firms in taiwan during the period1986 to 2013.the results of the empirical analysis are summarized as follows: a significant negative correlation between the rate of return on assets and the ratio of r&d expenditure can be observed in both the entire sample group and different subsample groups. this again demonstrates the problem that the loss of book value and negative dilution might appear in current surplus if r&d expenditure is recognized in the accounting system as expenses. this may cause firms to be affected by pressure from the current target surplus level when making r&d expenditure decisions, resulting in the failure to grasp the innovation opportunities in time. therefore, in addition to the disclosure of intangible assets such as patents in the notes to the financial statements, the development of a set of appropriate accounting methods proposed by many research institutes to capitalize intangible assets such as r&d investment is worthy of further improvement by relevant units. the significantly negative relationship with future investment growth opportunities indicates that firms are optimistic regarding future investment growth opportunities but hold a more cautious attitude asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 146 and that investors show positive support for firm investment in r&d activities. these results further motivate firm management to invest in innovative activities with more confidence and incentives. this is because firms need the recognition and support of shareholders before making active progress in r&d innovation. thus, when making r&d expenditure decisions, firms should cautiously assess future growth opportunities so as to seize the opportunity to help raise their future competitiveness and firm value. although the agency problems and the information asymmetry possibly brought up by r&d expenditure, is not statistically significant in the empirical results of the entire sample, the empirical results show that these negative effects may indeed make firms pay a higher price while pursuing firm value increase. acknowledgments: the authors thank crimson interactive pvt. ltd. 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(2000). a research on insider trading performance (unpublished master's thesis). national cheng kung university, taiwan. microsoft word 18929-article text-writer2-new e pe receive doi:10.5 abstra this st perform time se selected employ and pea play sig particul opennes financia macroe effect o erforma dr enugu enugu dep enugu ed: july 5, 2 5296/ajfa.v ct tudy empiri mance in ni eries second d firms. th yed were de arson correl gnificant ro larly, the r ss have a al position conomic va of macr ance of r. ifeyinwa u state univ eu state univ partment of u state univ e 2021 a 13i2.18929 ically inves igeria health dary data e he ex-post f escriptive st lation analy les in the fi result show negative e of health ariables, the roecono f health n elizabeth n versity of s mail: judeth anthon versity of s al f accountan versity of s e-mail: denn ccepted: no url: ht stigated the hcare sector extracted fr facto resear tatistics, ful ysis. findin financial pos wed that ex ffect while hcare manu e 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2.2.1 th in 1936 publish rates fa demand driven b primary are thre openness re s that restric trade polic tion include arket comp ulation of fa on assets (r ng to onye g a compan turn on ass in mac e i i e t . concept : author’s c eoretical fr he keynesia 6, john may ed, kicking all as the m d curve. the by money d y determina ee motives f efers to a ct or encou cy consider e trade obsta petitiveness actors, techn roa) is a m ekwelu, nna ny's annual i sets (roa) ndependent v croeconomic exchange ra interest rate inflation rat external deb trade openn tual framew conceptualiz ramework an theory of ynard keyn off the key money supp e model ass demand. ac nts of intere for holding m country's e urage cross-b rations that acles, impor . trade op nological dif measure of a adi, and iyi ncome by it measures variable c variable ate e te bt ness work of the r p zation f interest rat nes' "genera ynesian revo ply expands sumes a con ccording to est rates (o money: tran 57 economy's border trad t countries rt-export, in penness en ffusion, and a company's idiobi (2018 ts total asse how well a relationship profitability ate al theory o olution. acc s, ceteris p nstant mone o keynes, th osadume, 20 nsaction, pre asian outward or de are measu make to nfrastructure ncourages e d knowledg s profitabili 8). roa is ets. a company' depen pr roa (r p between m y f employm cording to t paribus, res ey supply, h he supply a 018). accord ecautionary n journal of f r inward di ured by trad facilitate o e, technolog effective re e spillovers ty in relatio calculated 's assets ar ndent variab rofitability return on ass macroecono ment, interes the keynesi ulting in a ence the int nd demand ding to key y, and specu finance & ac issn 19 2021, vol. 1 ajfa.macro irection. ec de opennes outward or gy, scale eco esource all s (wang, 20 on to its tota as a percen re used to g ble set) omic variabl st, and mon ians' model, a negatively terest rate is d for money ynes' analys ulative motiv ccounting 946-052x 13, no. 2 think.org/ conomic ss. some inward onomies, location, 016). al assets, ntage by generate les and ney" was , interest y sloppy s mostly y are the sis, there ves. 2.2.2 pu the pu asserts change name fr fluctuat country purchas always between theory a local an which h 2.2.3 th two wo (1984). imply e inefficie theory, financin theory s sources from ba econom 2.2.4 fi the fis inflation high inf of mone costs, re equal-ri arbitrag until a s change the sam 2.2.5 co this the to the product country urchasing p urchasing po that the ch in their ex rom the the tions. acco y's currency sing power. buy a simi n countries applies in th nd internati has an impa he pecking orks that co (1984). its expectations encies in th have finan ng to extern stated that i s are opaque anking inst mic situation isher’s effec sher effect n from two flation, con ey has decl educing pro isk investm ge process, state of equ in inflation me. omparative eory was fir theory, le tivity increa y to open u power parity ower parity hange in re xchange rate ory that it f ording to c y is convert according lar basket o are represe his study be ional busin act on the co order theo ontributed to belief was s, and that m he company ncial optimi nal financing in less deve e, forcing th itutions for n. ct theory of theory of i perspective nsumers wit lined, result ofit margins ments in var which enta uilibrium is n rates due t advantage rst proposed eads to gr ase, or impr up to the o y theory y (ppp) the lative price e. the infla focuses on p coakley, f ted to forei g to coakley of goods in ented by var ecause the c ess, necess ompany's fin ory o pecking o based on d managers w y due to in ization con g, and debt eloped coun hem to rely r external fu f inflation inflation, in es: aggregat th fixed inc ting in fewe s. pandey w rious count ails a contin achieved. t to the fisher e trade theo d by ricard rowth gain roved resou outside wor 58 eory is a m e levels of ationary the price level c flood, fuer ign currenc y, flood, fu n a foreign c riations in n chosen heal itating the nancial perf order theory donaldson's would make nformation a ncerns. as financing o ntries with y on interna funding nee ntroduced b te demand a omes have er demand f went on to ex tries should nuous transf the nomina r effect if th ory do in 1958. ns through urce allocat rld helps it asian method for d two curren ory of exch change as th rtes, and t y in absolu uertes, and country. ch national pric lthcare man use of bot formance. y are myers (1960) arg e financial d asymmetry. a result, a over stock fi less develop ally generate eds, thereby y pandey ( and cost of less purcha for goods. i xplain that i d yield equ fer of funds al interest ra he real rates openness a specializa tion. accord t to realloc n journal of f determining ncies over t hange rate m he key driv taylor (200 ute terms, i taylor, hom hanges in no ces based on nufacturing c h local and (1984) and gument that decisions in businesse company w inancing wi ped financi ed funds as y contributin (2009), look production asing power nflation als if capital ma al returns. s from one ates will adj s of return i at the count ation, innov ding to the cate scarce finance & ac issn 19 2021, vol. 1 ajfa.macro g exchange time influen movements ver of excha 05), when it will have me currency nominal pric n relative p company do d foreign c d myers and financing p n order to e es, accordin will prefer ill be favour ial systems, s well as bo ng to the c ks at the ef n. during pe r because th so raises pro arkets were this is du country to just perfectl in two coun try level, ac vation inve theory, all resources ccounting 946-052x 13, no. 2 think.org/ rates. it nces the gets its ange rate a home e similar y should ce levels ppp. the oes both urrency, d majluf practices liminate ng to the internal red. the finance orrowing country's ffects of eriods of he value oduction perfect, e to the another ly to the ntries are ccording estment, owing a to more product theory, likely to as a r organiz 2.3 emp ubesie econom data. th least s accord had the that nig attracts using m between listed m exchang size, lev odior ( conditio models impact investm bernard manufa squares capital exchang consum ifuero profitab interest profitab domesti to the st the inte on retur on equi tive sectors higher fact o be negativ result, the zation, is use pirical revi (2016) lo my's financia he data was squares (ol ing to ols expected b geria's econ foreign inv multiple lin n macroeco manufacturin ge rates had verage, and (2013) look ons. for 37 (ols). th on manufa ment had a b d and aden acturing sec s (ols) app spending a ge rate has mption of ele and chijuk bility in nig rate (intr bility, and ic product ( tudies (roe erest rate an rn on equity ty (roe), b s, resulting or productiv ve, implying pecking o ed in this stu iews oked at th al depth. fr s examined ls), which s regression beneficial ef nomy has a vestment. near regressi onomic con ng enterpris d no effect o liquidity w ked into the 7 years, the he research acturing pro big impact. nuga (2016 ctor perform proach. th all show u a direct and ectric power ka (2014) geria using a r), and infl the analyt (gdp) and e). return o nd inflation r y (roe), wh but inflation in increase vity leads to g a j curve r rder theory udy. he effect o rom 1985 t d using the h included n studies, fl ffect on the lengthy his ion, egbuni ditions, cor ses in niger on roa, in were also imp e impact of e data was h revealed t oductivity, ) investigat mance in ni e exchange unilateral re d considerab r has an ind examined annual data ation (infr ical tool w return on e on equity (r rate; the gro hereas the in n was not sig 59 ed total pro o longer gro reaction. y, which e of foreign through 20 multiple re the unit ro luctuations depth of th story of fail ike and ok rporate char ria. the find nflation and portant fact f nigerian examined that in nig but manuf ted the asso igeria from e rate, elect elationships ble impact o direct and si the impact from 1990 r) on return was pooled equity (roe roe) was f oss domesti nterest rate gnificant at asian oductivity. f owth gains, emphasizes exchange 15, the stud gression an oot test of in foreign he nigerian ing to achie kerekeoti (20 racteristics, dings reveal gdp grow tors. industrial p using ordi geria, broad facturing se ociation be m 1981 to 2 tric power c s, according on manufac gnificant im t of macro to 2013. th n on equity d ordinary e) have a p found to hav ic product h has a signif all levels o n journal of f furthermore but the inte financial o fluctuations dy used sec nalytical app time series exchange in financial in eve a stable 018) explor and financ ed that whi th rates did production o inary least d money su ector loans tween econ 009 using t consumptio g to the d turing produ mpact. oeconomic he variables y (roe), w least squa ositive rela ve a negativ has a signifi ficant negat of significan finance & ac issn 19 2021, vol. 1 ajfa.macro e, accordin ermediate im optimization s on the n condary tim proach of o s data stati n nigeria h ndustry. thi e exchange red the rela cial perform ile interest r d. furthermo on macroec squares re upply has m and foreig nomic chan the ordinar on, and gov data. in eff duction, whe variables o s studied we which is a pr are method ationship, ac ve relationsh icant positiv tive effect o nce. ccounting 946-052x 13, no. 2 think.org/ g to the mpact is n in an nigerian me series ordinary ionarity. have not is means rate that ationship mance of rates and ore, firm conomic gression minimal gn direct nges and ry least vernment fect, the ereas the on bank ere gdp, roxy for d. gross ccording hip with ve effect on return from 2 factors compan accordin leverag variable industry multipl analyze from 20 signific impact profitab inyiama financia discove stock p insignif 2-step c procedu negligib profits p samilog perform study fo ratio, ea link w relation signific from 2 relation exchang and retu return o to the f impact banks' r hand, h long ru evidenc negativ 2005 to 201 that influe nies. return ng to the e and com es have a si y businesses le regressio e the factors 008 to 2016 cant impact on profitab bility of nig a and ozou al performa ered that ear prices, net ficantly rela cointegratio ures. they ble relation per share to glu, oztop, mance on the ound that r arnings per ith the pri nship betwe cant and pos 2006 to 20 nship betwe ge rate, and urn on equi on assets an findings. ba on banks' r return on eq have a nega un, whereas ce suggests e impact in 5, ali and enced the n on assets study (roa mpany size. ignificant im s. on techniqu s that influen 6. according on profitab bility, and op gerian listed uli (2014) s ance metrics rnings per s asset valu ated to the f on, engle an also disco nship with o exchange r , and kahr e istanbul s roa has a s r share (eps ice-to-book een (roe) sitive relatio 015, combe een three m d inflation) ity) in togo nd return on ank capital t eturn on as quity. real ative and st s inflation that real g the long ru bilal (2018 financial p s is favorab a). it also furthermo mpact on th ues were ut nced the pro g to the find bility (roe perating exp d agricultura studied the s in the nig share has a ue per sh foreign exch nd granger overed that all of the rate and exc raman (201 tock exchan strong and n s), and divi k ratio (pb and (roe onship with ey and to main macro and bankin o using the p equity are to assets rat sets, whilst gdp grow tatistically s has no suc gdp growth un. 60 8) used mul performance bly related has a neg ore, the re he financial tilized by l ofitability o dings, liqui e), whereas pense effici al companie connection gerian beer short-term n hare, and p hange rate i r's error co t the excha variables, change vari 17) investi nge from 20 negative rel idend yield b). further e) (eps). roe. gbenou (20 oeconomic ng sector pr pool mean unconnecte tio and ban bank capita wth and the significant ch impact. h, real effec asian ltiple regres e of jordan to liquidit gative relati gression fi performanc lasisi, dik of listed agr dity and sal s leverage h iency has a es. s between t r industry b negative an price-earnin in the short orrection m ange rate h with unidir ations rate t gated the 006 to 2015 lationship w d (dy), how rmore, ther finally, ep 017) exami indicators rofitability group esti ed to macro nk size, on t al to assets real effectiv impact on in terms o ctive excha n journal of f ssion analys nian manuf ty, profitab ionship wit ndings dem ce of jordan ki, and ok icultural en les growth h has a negat negligible the foreign between 200 nd insignific ngs ratio a run, using model, and c has a long rectional ca to net asset drivers of . (bist). t with the pric wever roa re is a str ps, pb, an ined the sh (gdp grow (measured b mator. in th economic v he other ha ratio has a ve exchang banks' retu of a bank's nge rate, an finance & ac issn 19 2021, vol. 1 ajfa.macro sis to look facturing in bility, and r th the varia monstrated nian manuf kpanachi (2 nterprises in have a posi tive and sig negative im exchange 00 and 201 cant effect, are positiv granger ca correlation g-run negat ausality con value per sh business f the panel re ce-to-earnin a had no sig rong and n nd dy all hortand l wth, real e by return o he short run variables, ac and, have a negative im ge rate, on t urn on asset s return on nd inflation ccounting 946-052x 13, no. 2 think.org/ into the ndustrial revenue, ables of that all facturing 2018) to n nigeria itive and gnificant mpact on rate and 3. they whereas ely and ausality, analysis tive and nnecting hare. financial gression ngs (pe) gnificant negative have a long-run effective on assets n, banks' ccording positive mpact on he other ts in the n equity, n have a kanwal profitab pooled inflation indicato ratios w positive found to once mo the rate small im ugwu ( nigeria squares out usin showed profitab in nige bank pr bulletin over a t dickey, rate, rea profitab return o rate has deposit between using t okoye manufa exogeno cointegr disequil in nige varianc opennes dewi, profitab and the l and nade bility of pa ordinary l n rate, real ors such as r was investi e relationsh o have a mi ore. all thre e of inflatio mpact on co (2017) look an manufact s-based mu ng the adf d that chan bility of nig eria, ogunbi rofitability. ns and year thirteen-yea , and the fu al interest ra bility of ni on assets at s a negative banks at th n interest ra the engle an and clemen acturing cap ous variabl ration test librium, and eria. further es in manu ss have no m soei, and bility (2019) e results rev eem (2013) akistan's pub least squar l gross dom return on as gated in th hip with ro inor positiv ee profitabi on. the mac ommercial b ked at the turing firms ultivariate re f unit root nges in ex gerian manu iyi and ihej the data w rly reports, ar period, fr uller unit ro ate, and sav igerian depo the 5% lev e and signifi he 8% leve ate factors a nd granger nt (2015) ev pacity utiliz les were s t. accordin d shocks ar rmore, exr ufacturing c meaningful surjoko ex ). the data vealed that t ) looked a blic limited re (pols) mestic prod ssets (roa) hree separat oa, roe, a e impact on ility metrics croeconomi bank earning impact of s (1986 to 2 egression m and johan xchange rat ufacturing fi irika (2014) was acquired as well as rom 1999 to oot test wer vings deposi osit money vel of signif ficant relatio el of signifi and nigerian r, johansen valuated the zation in n hown to b ng to ec re the prima r, int, and capacity uti impact in n xplored the was evalua the roa ra 61 at the impa d commerci method, th duct (gdp) ), return on te models. and em, ac n roa but a s, on the oth ic character gs in genera exchange 2016). the method. how nsen cointeg tes had a irms. ) looked int d from the c s world ba o 2012. mu re used to e it rate all ha y banks, acc ficance. the onship with icance. the n deposit m cointegrati e impact of nigeria from be co-integ cm, the m ary rate of v d tot all ilization, w nigeria. impact of ated using m atio is influ asian act of mac ial banks fr he effect of ), and real n equity (ro the real i ccording to a minor neg her hand, ha ristics chose al. rate fluctua researchers wever, erro gration test statisticall to how inter central ban ank global ultivariate re examine the ave negative cording to e study also h the return study, on money bank on test, and f finance and m 1975 to grated using model resp variances in contribute s whereas ifr f macroecon multiple regr enced by al n journal of f roeconomic rom 2001 t f three majo interest ra oe), and equ interest rate the statisti gative impa ave a negati en have bee ations on th s employed oneous estim s. the outc y significa rest rates ef nk of nigeri financial d egression an e data. the e and signif the finding o revealed th n on equity the other h ks' net inter d error corr d macroeco o 2012. th g the gran ponds slow n industrial significantly r, external nomic cond ression met ll independ finance & ac issn 19 2021, vol. 1 ajfa.macro c variables to 2011. u or external ate on prof uity multipl e has a sub ics. real g act on roe ive associat en found to the perform d an ordinar mations we comes of th ant impact ffect deposi ia (cbn) st developmen nalysis, aug e maximum ficant effect gs, as meas hat the real of nigerian hand, found rest margin. rection mec onomic vari he endogeno nger and j wly to sh capacity ut y but negat reserve, an ditions on thods and th dent variable ccounting 946-052x 13, no. 2 think.org/ on the sing the factors: fitability lier (em) bstantial gdp was and em ion with o have a mance of ry least ere ruled he study on the t money tatistical nt data, gmented lending ts on the sured by l interest n money no link . chanism, ables on ous and johansen hort-term tilization tively to nd trade a firm's he t-test, es. only the leve while in from 1 dynami a co-in associat short ru on stock current product kabeer, influenc exchang kse de sufian perform a total fixed an findings naser a macroe banks f the imp profitab and the accordin hassan investig employ nationa relation client d from 1 assets o acquire rates is bhattar the perf using r profitab el of gdp nflation, une 1980 to 20 ic interactio ntegration te tion betwee un, past mon k prices. fu stock valu t is a leading , iqbal, naj ce of macro ge rate, and ependent va (2011) loo mance of the of 251 bank nd random s, inflation h and abdolla conomic va from 2008 t pact of inte bility of twe e profitabil ng to the fin (2016) use gate the imp yed seconda al bureau nship with c deposits in n 1995 to 201 of multinat d from seco followed by ai (2018) in formance o regression bility is prim has a subst employmen 16, ditimi, on between est and an en macroec ney supply urthermore, ues. accord g indicator jaf, and naj oeconomic f d foreign di ariable, but o oked how e korean ba k year recor effect regr has a positi ah (2015) in ariables, on to 2012. th ernal and e enty-six (26 lity of pak ndings. ed the ordin pact of inte ary data fr of statistic commercial nigerian com 10, akabom tional firms ondary sour y an increas nvestigated f nepalese models, an marily influ tantial impa nt, and the e , sunday, e macroecono error corre conomic fun and interes the recent ding to the that increas jaf (2016) e factors on c irect investm only a sligh bank-speci anking syste rds from 11 ression tech ve relations nvestigated t n the profita ey used pan external fac 6) pakistani kistani dep nary least erest rates o om the ce cs between bank depo mmercial ba m-ita (2012 s in nigeri rces, and th se in net ass at the impa commercia nd the fin uenced by co 62 act on com exchange rat emma-eber omic funda ection meth ndamentals st rate value stock mark data, the n ses stock pri employed o capital mark ment all ha ht negative i ific and m em before to 1 commercia hniques bet ship with ba the impact o ability of tw nel data ana ctors, as w deposit m posit mone square (ol on commer entral bank n 2000 and osits, meanin anks, accord 2) examined ia using re he findings sets. act of bankal banks fro ndings reve ost per loan asian mpany profit te have no r re, and on amentals and hod. the f and stock es were fou ket return h natural loga ices in the l ordinary le ket performa ad a consid mpact on th macroeconom o and follow al banks we tween 1993 anks' return of internal a wenty-six ( alysis with 1 well as mac money bank ey banks h ls) and mu rcial bank d k of nigeri d 2013. in ng that inte ding to the f d the impac egression an demonstrat -specific and om 2011 to ealed that n asset, that n journal of f tability, acc rate. nyedikachi d stock pric findings rev prices in n nd to have as had a sig arithm of re ong and sho ast square ance in pak erable nega he kse inde mic variabl wing the as ere used and 3 and 2003 on assets. and externa (26) pakista 130 observa roeconomic s from 2008 have a po ultiple regre deposits in n ia statistica nterest rates erest rates ar findings. ct of intere nalysis. th ted that an d macroeco 2016. the in nepal, t macroecon finance & ac issn 19 2021, vol. 1 ajfa.macro cording to a (2018) stud ces in niger vealed a lo nigeria, bu a substanti gnificant im real gross d ort run. (ols) to s kistan. infla ative impac ependent va les influen sian financi d tested usin . according al factors, as ani deposit ations to inv c variables, 8 to 2012. i ositive relat ession techn nigeria. th al bulletin s have a n are not to bl est rates on he informat increase in onomic vari data was a commerci nomic varia ccounting 946-052x 13, no. 2 think.org/ a t-test, died the ria using ong-term ut in the al effect mpact on domestic tudy the tion, the ct on the ariable. nced the al crisis. ng panel g to the s well as t money vestigate , on the inflation tionship, niques to he study and the negative lame for n the net ion was n interest ables on analyzed al asset ables are not sign perform musah, profitab signific owusuinvestig spread findings are also enyioko perform showed of retu the au and zab develop are stat aided e total fac falaye, investig manufa manufa betwee granger followi impact exchang well as that ca relation (mfdi) over a bamise nigeria model ( the joha depreci causal r nificant, an mance. anokye, bility in g cant relation -antwi, ba gate interest has a posit s, but the re o linked. o (2012) in mance in n d that intere urn on asset ugmented d bairu (2012 pment from tionary, and economic gr ctor product eseyin, ot gated at th acturing sec acturing sec en 1990 and r causality ing that, th on nigeria' ge rate has a causal an apacity util nship with ), exchange a 25-year ele, niyi-oy a's manufac (ecm) mec ansen co-in ation of the relationship nd that there and gakpe ghana (201 nship betwee anerjee, and t rate spread tive impact elationship nvestigated nigeria usin est rate strat ts (roa). dickey-fulle 2) to invest 1970 to 20 d gdp cau rowth by in tivity. ekunri, asa he impact ctor, using ctor foreign d 2014, it to test, joha he study's f 's manufact a negative nd long-rela lization (cu sector per rates, and i period, ad yebanji, and turing secto chanism, as ntegration t e naira has a p with the e is no evi etor investig 8). regres en interest r d antwi (20 ds and profi on comme is statistica d the impac ng regressi tegies benef er technique igate the ef 010. accord uses inflatio ncreasing p amu, ogunla of exchan g exchange n direct in ook occurre ansen co-in findings rev uring sector e and signif ationship re ur) and i rformance, imports (im debanjo, o d damilola or performa s well as bas test, were a a negative s performanc 63 dence that gated the ssion resea rate spread 017) emplo fitability of ercial bank ally negligib ct of intere on and err fited banks' e and the gr ffect of infl ding to the f on rather th productivity ade, egbide nge rates e rates, inf nvestments, ed. analytic ntegration t vealed that r. in more c ficant relati elationship. inflation ra whereas m mp) have a n oluwasegun (2019) exam ance. the sic diagnost applied by th significant r ce of the n asian external fo impact of arch found and bank pr oyed ordina commercia profitabilit ble. bank pr est rate po ror correcti ' overall per ranger caus flation on n findings, al han inflation y and outpu e, rasak, m on the pe flation rate and impor cal tools inc test, and e the naira's concrete ter ionship with furthermo ates (inf) manufacturin negative sig , adegbola mined at th granger ca tic techniqu he research relationship nigerian ma n journal of f orces have a interest rat a positive rofitability i ary least sq l banks in g ty in ghana rofitability a licy on de ion techniq rformance, sality test w nigerian eco l of the var n driving g ut, as well a moyinoluwa, erformance es, capacity rts as inde cluded the a error corre s depreciati rms, it was h the sector re, empirica have a p ng foreign gnificant rela a, festus, he impact of ausality and ues like the ers. the fin , a long-run anufacturing finance & ac issn 19 2021, vol. 1 ajfa.macro an impact te spread o e and stat in ghana. quare regre ghana. inte a, accordin and interest eposit mone ques. the especially were used by onomic grow riables in th gdp. inflat as the evol , and eluye e of the n y utilizatio ependent v adf unit r ection mec ion has a n discovered r's perform al evidence positive sig direct inv ationship. peter, ben f exchange nd error co unit root t ndings revea n relationshi g sector. ex ccounting 946-052x 13, no. 2 think.org/ on bank on bank tistically ssion to erest rate g to the t margin ey bank findings in terms y umaru wth and he model ion also ution of la (2019) nigerian n rates, ariables. root test, chanism. negative that the ance, as e reveals gnificant vestment n-caleb, rates on orrection test and aled that ip, and a xchange rates, im substan agubat financia 2014. a were us had a p selected impact the mea tams-a rate der directio to see output, correcti short-ru rate ha unidirec using th william perform investig used de the exc exchang from 19 (exch ordinar (exch expendi fluctuat industri connect related. segun multipl includin and the rate and has a p mports (im ntial relation a and odu al performa an ex post sed to analy positive effe d enterprise on manufa antime, non alasia, olok regulation o on of causat if there wa the johanse ing process un disequilib as no sign ctional caus he pairs gran ms (2018) mance in n gate into the escriptive an change rate ge rate trans 981 to 2016 h) fluctuatio ry least sq h), manufact iture variab tions in the ies. mgdp ted to exc investigated le econome ng the augm e chow brea d industrial ositive and p), and ma nship with th ubuasi (201 ance of nig facto study yze the data fect on the es (roe). cturing ente e of these ra koyo, okoy on manufac tion between as a long-ru en and juse was also us brium scena nificant po sal impact o nger causali looked at nigeria. th e impact of nd ordinary has a subst sactions, as 6, orji, ogb ons on the n quare (ols) turing gdp bles, privat exch hav p and gov ch, import d the impac etric metho mented dic akpoint test output in n significant nufacturing he performa 8) examine erian busin y approach a. the findi return on according erprises' re amification e, and ejem cturing outp n the variab un relation elius norma sed to calcu ario (ecm) ositive effe of exchange ity test. the impac he study's m f exchange least square tantial impa the study s buabor, and nigerian man ) estimate t p (mgdp), te sector c e a major im vernment c s, and fdi ct of the e dologies w ckey-fuller t. although nigeria, the t effect on i 64 g foreign di ance of the n ed the effe nesses. the and a varie ings reveale assets (ro to the fin eturn on as ns were nota meyovwi (2 put perform bles was de ship betwe alized cointe ulate the mo ). the study ect on ma e rate on m ct of excha major purp rate variati e methodol act on retur hows. okeke (20 nufacturing technique w foreign dir credit, and mpact on th capital exp i, while cre xchange ra were used o unit root te there is no box jenkin industrial ou asian rect investm nigerian m ect of exch study was ety of regre ed that exch oa) and re ndings, inter ssets and re able. 018) invest mance in nig etermined us en the exch egration tec odel's veloci y found that anufacturin manufacturin ange rate pose was t ions on ret ogies and sp rn on invest 18) examine g sector usin was used to ect investm import va e performan enditure (g edit to the ate on nige on time-ser est, the box o long-run r ns o.l.s re utput. furth n journal of f ment (mfd anufacturin ange rate f carried out ession analy hange rates eturn on eq rest rates h eturn on eq tigated the i geria from sing the gra hange rate hnique was ty (speed) o , in the long g industry ng producti fluctuations to use emp turn on inve panned the ment, as mo ed the impa ng annual tim investigate ment (fdi), lue. the f nce of nige gcexp) w private sec erian indust ies data fro x jenkins o relationship sults reveal hermore, the finance & ac issn 19 2021, vol. 1 ajfa.macro di) show a n ng sector. fluctuations between 2 ysis method s and inflati quity (roe have a detr quity in nig impact of ex 1980 to 20 anger causa and manuf s applied. t of adjustme g run, the e y productio ion was est s on a co pirical rese vestment. th years 2012 ost banks en act of excha me series d e the excha governmen findings sh eria's manuf were all fa ctor was ad trial output om 1986 t o.l.s metho p between e l that excha he chow bre ccounting 946-052x 13, no. 2 think.org/ negative s on the 005 and dologies ion rates e) of the rimental geria. in xchange 016. the ality test. facturing the error nt to the xchange on. the ablished mpany's earch to he study to 2016. ngage in ange rate data. the nge rate nt capital ow that facturing avorably dversely (2018). to 2016, odology, xchange ange rate eakpoint test sug and ind 3. meth 3.1 res the stu depende seconda well as numeri publish 3.2 mod the mo linear techniqu maintai the mo where regressi explicit 𝑌 where; y is the represen model. 𝑅 ggests that a dustrial outp hodology earch desig udy is a "a ent variable ary data we annual rep ical data w ed and unpu del specific odel for thi regression ue. the ch ining the pro odel did not y is the d ion model,𝜎 tly, the mod 𝑌 = 𝛽o + 𝛽 e estimator nting the in such that, 𝑅𝑂𝐴 = 𝛽o roat = excht = intrt infrt extdt opnt = 𝛽o = a fundamen put happened gn after-the-fac e. as a resu ere taken fr ports and fin was gathere ublished sou cation s study foll n model (c oice of lea operty of th undermine dependent 𝜎 is the va del is specif 𝛽1x1ij + 𝛽2 for return ndependent + 𝛽1exch = return o = exchang = inte = infl = exte = trade o = constan ntal shift in d from the s ct" study o ult, the stud rom the ce nancial stat ed from jo urces. lows the wo clrm), and st squares t he best unbia the assump (or respon ariances and fied thus: 2x2ij + 𝛽3x n on assets variables un ht + 𝛽2int on assets at ge rate at tim erest rate at ation rate a ernal debt a openness at nt 65 the pattern start of the f of the impa dy was con entral bank tements of ournal artic ork of oko d particular technique i ased linear ption that: 𝑌 nse) variabl d covariance x3ij + 𝛽4x4ij while x1, nder invest trt + 𝛽3inf t time t, (de ime t, (indep t time t, (ind at time t, (in at time t, (in time t, (ind asian n and direct fourth repub act of the nducted afte of nigeria the selected cles, newsp oye and cle ly, the ordi is to minim estimator. 𝑌 ~ 𝑁 𝜃, 𝜎 le; 𝜃 is the es of the ran + 𝛽5x5ij + x2, x3, x4, igation,𝛽 frt + 𝛽4ex ependent va pendent var dependent v ndependent independent dependent va n journal of f ion of nige blic in 1999 independen er the fact. a (cbn) sta d firms, for papers, tex ement (2015 inary least mize the erro e constant o ndom term. + … + 𝛽kxk , and x5 are are coeffic xtdt + 𝛽5o riable). riable). variable). variable). t variable). ariable). finance & ac issn 19 2021, vol. 1 ajfa.macro eria's excha 9. nt variables annual tim atistical bul r the study xtbooks, an 5). it is a c squares re ror sum of (3.1) or intercep kij + 𝜇ij e random v cients of 𝑋 opnt + 𝜇ij ccounting 946-052x 13, no. 2 think.org/ ange rate s on the me series lletin, as periods. nd other classical gression squares, pt of the (3.2) variables in the (3.3) 𝛽1, 𝛽2, 𝛽 3.3 des return profit fr indicati to its to exchan in time, trade the glob opennes interes borrowi of as a interest extern country includin develop inflatio spectrum percent 3.4 met descrip data. t examin answer decisio reject t reject. 3.4.1 d to sum skewne follows 𝜇t = 𝛽3,𝛽4and 𝛽 scription of n on assets rom its tota ing how suc otal assets, u nge rate (e , or the valu openness bal market. ss in this stu st rate (in ing money return paid rate is state al debt (e y. it can be ng the inte pment bank on rate (i m of good ages. thods of da ptive statisti the descrip ation, wher variable. on rule the null hyp iagnostic t mmarize the ess and kurt s: = random 𝛽5are the reg f model vari s (roa): t l assets. it s ccessfully it usually repre excr): th ue of one na (opn): th . the sum udy. nt): this is from a lend d to the pro ed as a perc extd): thi provided b ernational k (adb), as nfl): th ds and serv ta analysis ics and ordi ptive statisti reas the regr pothesis (h ests e level of sy tosis statisti m error assoc gression coe iables this is an a shows how utilizes its esented as a is is the exc ation's curre his metric a of imports s the cost o der that is re ovider who entage. is is money y foreign c monetary s well as for his is a pe vices in a inary least s ics provide ression anal o) if the p-v ymmetry an ics were us 66 ciated with efficients of accounting-b lucrative a assets. it is a percentage change rate ency in term assesses a c and export of doing bu eferred to a provided th y that has b commercial fund (imf reign govern ersistent rise country ov squares reg e an empir lysis analyz value is les nd tail thic sed. the sk asian the model. f the respect based meas company is the ratio of e. between tw ms of anothe country's in ts over gd usiness with as the oppor he financial been borrow banks, inte f), the w nments. e in the ge ver a one-y ression ana rical descri zes the expla ss than or e ckness of th kewness and n journal of f tive indepen sure of a co s in compan f a company wo currencie r nation's cu ternational p was used h money. it rtunity cost. l resources. wed from a ernational fi orld bank, eneral price year period lysis were u ption of th anatory vari qual to 0.05 he data seri d kurtosis o finance & ac issn 19 2021, vol. 1 ajfa.macro ndent variab ompany's a ny to its tota y's annual n es at a certa urrency. competitiv d to calcula t is the exp it can also in most ca source out inancial ins , and the e level of d. it's meas used to ana he variable riable's effec 5, otherwise ies distribut of x are de ccounting 946-052x 13, no. 2 think.org/ bles. ability to al assets, net profit ain point eness in ate trade pense of be seen ases, the tside the titutions african a broad sured in alyze the es under ct on the e do not tion, the efined as s(x) = also, s k(x) = the k(x where observa the am in a no kurtosis tails tha distribu leptoku platyku jarque a jb = with 2statistic 4. data table 4 manufa table 4 year g 2008 14 2009 14 2010 13 2011 12 2012 12 2013 11 2014 6. 2015 2. 2016 8. 2017 2018 1. 2. 𝐸 (x) ~ n 0 𝐸 x) ~ n 0, x stands ations,𝜎 an mount k(x) ormal rando s is conside an a norma ution is mor urtic. in con urtic. and bera (1 degrees of c is less than a presentati 4.1 present acturing firm 4.1 annual d gsk 4.22 4.09 3.42 2.79 2.96 1.14 .60 .79 .44 .84 .05 which im 0, which im for obser nd 𝜎 stan 3 is known om variabl ered to have al distributi re likely to ntrast, a dis 987) integr which freedom. in n the signifi ion and an ts the annu ms for the pe data of roa neimet -17.02 -15.76 -4.53 3.69 -2.07 4.52 -8.21 -15.26 2.42 -18.04 5.21 mplies that𝑆 mplies that𝐾 rvations fo nds for the v n as the exc e, excess k e heavy tail ion. this in contain ex stribution w rated the two h is asympto n this test, o icance level nalysis ual time d eriod under a from 2008 th ma 3.5 3.7 2.8 3.1 0.9 -1.2 0.7 0.8 -0.4 4.0 7.5 67 𝐾 or the peri variance of x cess kurtosis kurtosis is ls, indicatin ndicates tha xtreme value with negativ o previous t otically dist one rejects l. data of ret r review. 8-2018 ay & bak 54 77 83 16 94 26 78 83 48 01 58 asian ∑ 𝑋 ∑ 𝑋 iod, 𝜇 is x from the s since k(x) nil. a dist ng it puts m at a random es. this typ ve excess k tests to arriv ributed as a ho of norm turn on a ker ph -3 -5 -1 2. 26 -8 3. 25 -9 0. 3.2 n journal of f �̂� . �̂� . the mean mean. ) = 3 for a n tribution wi more emphas m sample d pe of distrib kurtosis has ve at the fol a chi-square mality if the ssets (roa harma-d 9.11 0.17 8.89 98 6.63 .88 56 5.65 .41 56 27 finance & ac issn 19 2021, vol. 1 ajfa.macro of series normal distr ith positive sis on the s drawn from bution is kn s short tail llowing con ed random e p-value o a) of the deko f 6 5 5 3 1 1 4 4 0 6 2 ccounting 946-052x 13, no. 2 think.org/ of the ribution. e excess support's m such a nown as s and is nclusion: variable f the jb selected fidson 6.01 5.97 5.90 3.31 1.92 1.27 4.01 4.52 0.75 6.08 2.08 source comput table 4 years 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 source 4.2 dat data an show d shows t table 4 mean median maximum minimum std. dev skewnes kurtosis jarque-b probabili sum sum sq. observat source the beh diagnos : author’s c tational form 4.2 annual int (%) 15.14 18.99 17.59 16.02 16.79 16.72 16.55 16.85 16.87 17.58 16.90 : cbn stati ta analysis nalysis inclu descriptive s the results o 4.3 descript 0. 2. m 26 m -5 . 12 s -1. 7. bera 78 ity dev 0. 39 86 tions : author’s havior of th stic test res computation mula: roa ized time se ) ex istical bulle udes descri statistics, fi of inferentia ive statistic roa 709091 .980000 6.63000 0.17000 2.68462 .641389 .829927 8.15688 .000000 9.00000 688.576 55 eviews 10 he data seri sults. intere n from the a a = return eries data of xcr (n1/us 118.5669 148.8802 150.2980 153.8616 157.4994 157.3112 158.5526 193.2792 253.4923 305.7901 306.0753 etin 2019 iptive, diagn gure 1 show al (especially cs excr 191.2370 157.4994 306.0753 118.5669 63.60727 0.931756 2.308927 9.052671 0.010820 10518.03 218477.8 55 output ies over per est and inf 68 annual acco n on asset = f the selecte sd) op 0.4 0.3 0.3 0.4 0.3 0.3 0.2 0.2 0.1 0.2 0.2 nostic, and ws the resu y regression int 16.9090 16.8500 18.9900 15.1400 0.93035 0.38686 3.72671 2.58218 0.27497 930.000 46.7404 55 riod is indi flation rate asian ounts & fina = ed macroeco pn 408114 318094 369431 416519 347295 308411 263907 211602 180472 218034 231072 inferential ults of the d n) analysis. inf 09 11.88 0 12.10 00 16.50 00 8.000 57 2.574 67 0.249 1 2.282 88 1.750 70 0 5 0.416 653.5 357.7 55 icated in tab s were stab n journal of f ancial statem 100 onomic vari extd (n 523 590 689 896 1,026 1,387 1,631 2,111 3,478 5,787 5,901 statistics. t diagnostic t fl ex 182 218 0000 138 0000 590 0000 523 4022 192 9533 1.1 2589 2.6 0249 11. 6810 000 818 0.0 120 2.00 5 ble 4.3 by t ble (low st finance & ac issn 19 2021, vol. 1 ajfa.macro ments of the 0 iables (2008 n’b) .25 0.44 9.84 6.85 6.90 7.33 1.52 1.53 8.92 7.51 1.20 tables 4.3 test, and ta xtd 84.117 0 87.330 0 01.200 0 3.2500 0 23.310 0 03207 0 663006 1 .41669 4 003318 0126.4 0e+08 0 1 0 55 the descrip tandard dev ccounting 946-052x 13, no. 2 think.org/ e firms 8-2018) infl (%) 11.6 12.4 13.3 10.9 12.2 8.5 8.0 9.5 15.7 16.5 12.1 and 4.4 ables 4.5 opn 0.297541 0.308411 0.416519 0.180472 0.079073 0.088330 1.654913 4.217737 0.121375 16.36475 0.337639 55 tive and viation), c d s i b ( c t p whereas infl, e the data control, infl, e the pr exchan (0.05), over the 0.05) on table 4 macroe covariance date: 03/20/ sample: 200 included ob balances sam (listwise mi correlation t-statistic probability lnroa lnexc lnint lninf s the roa, extd, and a series ex , however, t excr, and robability v nge rate (e indicating t e time perio n the other h 4.4 empiric conomic va analysis: o /20 time: 0 08 2018 bservations: mple ssing value a cr t fl excr, ex opn were xcr, int, i the kurtosi opn. value of th excr), and that the ser od under con hand, follow al result of ariables in n ordinary 00:02 41 deletion) lnroa 1.000000 ---- ---- 0.276160 1.794401 0.0805 0.011457 0.071556 0.9433 0.063883 0.399768 xtd, and o clustered o nfl, extd s statistics r he jarque-b d external ries of roa nsideration. ws a normal f the relatio nigeria lnexcr 1.000000 -------- 0.307192 2.015888 0.0507 0.496821 3.575085 69 opn series w on the left ta d, and opn reveal a po bera (jb) s debt (ext a, excr, a . the series l distributio onship betw r lnin 2 1.0000 8 -7 - 1 0.3430 5 2.2808 asian were volatile ail of the no n were clus sitive exces statistics fo td) was le and extd of int, in on. ween return nt lni 000 -- -- 059 1.00 820 n journal of f e. the data ormal distrib stered on th ss kurtosis i or return o ss than the were not n nfl, and op n on assets infl ln 00000 ---- finance & ac issn 19 2021, vol. 1 ajfa.macro series exc bution curv he right tail in a series o on assets e significan normally dis pn (with p-v and some nextd ccounting 946-052x 13, no. 2 think.org/ cr, int, ve, while . within of roa, (roa), nce level stributed values > selected lnopn lnext lnopn source: the pe between manufa exchang (lnex the corr exchang opennes multico least s the expl table 4 variable depend method sample periods cross-s total p panel m cointeg coeffic long-ru l td n : author’s e earson corre n trade op acturing firm ge rate (ln xtd) to ret relation res ge rate, ext ss (lnop ollinearity p squares (fm lanatory var 4.5 coint es on return dent variab d: panel ful e (adjusted) s included: sections inc panel (balan method: poo grating equa cient covaria un covarian variable lnexcr lnint lninfl 0.6915 0.311203 2.045010 0.0476 0.275732 1.791388 0.0810 eviews 10.0 elation test penness (l ms in nig nexcr), int turn on ass ult, a high ternal debt n) and e problem. h mols) pane riables on th tegrating r n on assets le: lnroa lly modified : 2009 2018 10 luded: 4 ced) observ oled estimat ation determ ance compu nce estimate 0.0010 0.965444 23.13492 0.0000 -0.795373 -8.194907 0.0000 0 result t result as lnopn) a eria. mean terest rate ( set (lnroa coefficient (lnextd) external de hence, the r el cointegra he response regression r (roa) of t a d least squ 8 vations: 34 tion ministic: c uted using d es (bartlett k coefficien -2.84003 -0.252066 1.285022 70 0 0.02 4 0.1665 2 1.0550 0 0.29 3 -0.3335 7 -2.2092 0 0.03 shown in and return nwhile, ther (lnint), in a) of the se t was shown ) and excha ebt (lnex researcher ating regres e variable. t result of the healthc uares (fmo default meth kernel, new nt s 1 6 2 asian 281 577 0.30 015 1.99 979 0 505 -0.21 219 -1.35 331 0 table 4.4 s n on asse re were ne nflation rate elected firm n between ange rate (l xtd), whi employed ssion techni the result is effects of are manufa ls) hod wey-west fi std. error 1.169481 0.917652 0.421165 n journal of f ---- 03733 1 90869 .0535 12503 -0 58097 -9 .1822 shows a po et (lnroa egative rela e (lninfl) ms over the trade openn lnexcr) ich is an the fully m que to asce s as shown i the selecte cturing firm xed bandwi t-stat -2.322 -0.280 3.296 finance & ac issn 19 2021, vol. 1 ajfa.macro .000000 ---- ---- .840188 .675486 0.0000 ositive rela a) of he ationships b ), and exter period. als ness (lnop and betwe indication modified o ertain the ef in table 4.5 ed macroec ms idth) tistic 2044 0324 6603 ccounting 946-052x 13, no. 2 think.org/ 1.000000 ---- ---- ationship ealthcare between rnal debt so, from pn) and en trade n of a ordinary ffects of below. conomic prob. 0.0173 0.7811 0.0125 l r-squa adjuste s.e. of long-ru source: from th result a on asse externa the exp (r2) wa in retu macroe 4.3 test hypoth ho1: ex firms in decisio hypoth result; regardi assets o rate dec hypothe hypoth ho2: healthc decisio hypoth result; as show and ass return lnextd lnopn ared ed r-square f regression un variance : author’s e he fully m s presented ets of the h l debt and t planatory po as 0.739 ind urn on ass conomic va t of hypothe heses one xchange ra n nigeria. on criteria heses if p-va p-value = 0 ing table 4. of healthca creases the esis is there heses two interest rat care manufa on criteria heses if p-va p-value = 0 wn in table ociated prob on assets of ed e eviews 10.0 modified ord in table 4.5 healthcare m trade openn ower of the dicating that sets (roa) ariables in n eses ate does not a: accept alue<0.05 0.0173; 0.01 5, the exch are manufac return on fore rejecte te does no acturing firm a: accept alue<0.05 0.7811; 0.78 e 4.5, intere bability val f healthcare -0.089132 -0.170522 0.739452 0.693386 0.378859 0.025884 0 output dinary leas 5 above, onl manufacturin ness have a model as e t the model of the sel nigeria. t have a sign null hyp 173 < 0.05 ange rate h cturing firm assets of ed. ot have a s ms in nigeri null hyp 811>0.05 st rate with lue of 0.781 e manufactu 71 2 2 2 mean d 6 s.d. dep 9 sum squ 4 st squares ly inflation ng firms in negative ef estimated by l is a good o lected firm nificant effe potheses i as a negativ ms in nigeri a healthcar significant ia. potheses i h a coefficie 11>0.05 has uring firms asian 0.350888 0.221083 dependent va pendent var uared resid (fmols) p rate exerts nigeria. th ffect on the y the coeffic one as abou ms are attrib fect on roa f p-value> ve and sign ia. a unit i re manufac effect on f p-value> ent value of s a negative in nigeria. n journal of f -0.251 -0.731 ar r panel coint a positive i he exchange return of a cient of mul ut 73.9% of butable to a of healthc >0.05 other ificant effec ncrease in cturing firm return on >0.05 other f -0.25, t-st and insigni particularly finance & ac issn 19 2021, vol. 1 ajfa.macro 1045 1809 tegrating re influence on e rate, inter assets of th ltiple determ f the total va fluctuations care manuf erwise reje ct on the re the naira ex m by 2.81. t assets (r erwise reje tatistics valu ificant effec y, a unit inc ccounting 946-052x 13, no. 2 think.org/ 0.7943 0.4598 2.039433 0.708121 5.412510 gression n return rest rate, he firms. mination ariations s in the facturing ct null eturn on xchange the null roa) of ct null ue -0.28 ct on the crease in interest null hyp hypoth ho3: in healthca decisio hypoth result: inflation probabi rate has unit inc hypoth ho4: e healthca decisio p-value result: externa probabi assets o conclud manufa of healt hypoth ho5: tr healthca decisio p-value result: the em probabi negativ increase manufa rate decrea pothesis as hesis three nflation rat are manufac on criteria heses if p-va : p-value = n rate wit ility value o s a significa crease in inf heses four external deb are manufac on rule: ac e<0.05 : p-value = al debt wit ility value of healthca de that exte acturing firm thcare manu heses five rade openn are manufac on rule: ac e<0.05. : p-value = mpirical res ility of 0.45 ely and ins e in the l acturing firm ases the ret stated in hy es does not cturing firm a: accept alue<0.05 0.0125; 0.0 th a coeffi of 0.0125<0 ant effect o flation rate i bt does not cturing firm ccept null h 0.7943; 0.7 th a coeffi of 0.7943> are manufac ernal debt do ms in niger ufacturing fi ness does no cturing firm ccept null h 0.4598; 0.4 sult with a 598>0.05 sh ignificantly evel of tra m by o.17, w turn on ass ypothesis tw t have a sig ms in nigeri null hyp 125<0.05 icient value 0.05, we re on roa of increases ro t have a sig ms in nigeri hypotheses 943>0.05 icient value >0.05 has a cturing firm oes not hav ia, a unit in firm by 0.09 ot have a si ms in nigeri hypotheses 598>0.05 coefficient hows that re y influenced ade openne we accept th 72 set of a hea wo is therefo gnificant ef a. potheses i e of 1.29, eject the nu healthcare oa by 1.29 gnificant ef a. if p-value> e of -0.09 a negative a ms in nige ve a signific ncrease in e 9. ignificant e a. if p-value> t value of eturn on as d by the vol ess decreas he null hyp asian althcare ma ore upheld. ffect on the f p-value> t-statistics ull hypothes manufactu 9. ffect on the >0.05 otherw , t-statistic and insignif eria, we ac ant effect o external deb effect on th >0.05 otherw -0.17, t-sta ssets of hea lume of tra se the ret 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healthca findings utilizati 5. sum 5.1 sum evidenc i) the healthca ii) the healthca ot have a sig n nigeria. cussion of r he first obj al performa on the retu and cleme y and togb o similar co ge rate has n oan rates acturing com mic situatio eoti (2018) ka (2014), a m (2013)'s es ditimi et udy discove a by measu care manuf s of naser ah (2015). kabeer et findings (20 urth hypoth a stifles the and cleme ss was foun are manufa s that trade ion. mary of fi mmary of fi ce from this e exchange are manufac e interest ra are manufac gnificant ef results ective, it w ance of nig urn on asse ent's (2015) benou (201 onclusions. i no substanti are detrim mpanies, a ons and ea ). it also ba and okoye a findings, w t al's (2018) ered that a h uring the e facturing fir and abdol this result al (2016), 019). esis was tes growth of h ent's findin nd to be ne cturing firm e openness ndings, co indings s research w e rate has a cturing firm ate has a ne cturing firm ffect with r was ascertai gerian health ets of the se , kabeer et 7), bernard it contradic ial impact o mental to th according t arlier resear acks up fin and clemen which were ) findings, a high inflatio effect of th rms in nig llah (2015) t disagrees combey an sted, and it healthcare m ngs (2015). egatively co ms. this fin has a nega onclusion an work showed a significan ms in nigeri egative and ms in nigeri 73 return on a ined that a hcare manu elected nig t al's (2016 d and aden cts dewi, so on firm roa the financia to objective rch, such ndings of if nt (2014). ( e based on among other on rate favo he inflation geria. this ), egbunike kanwal a nd togbeno was discov manufacturi . as a resu onnected wi nding is con ative and m nd recomm d that: nt negative a. insignifica a. asian assets (roa high excha ufacturing f gerian firms 6), and egb nuga (2016 oei, and sur a. al perform e two. thi as akabom fuero and c (2015). thi a study co rs. ors the grow n rate on t result, how e and okere nd nadeem ou (2017), vered that a ing firms. t ult of the ith the finan nsistent with minor impa mendations effect on ant effect on n journal of f a) of healthc ange rate is firms. it has s. this findi unike and o 6), and ugw rjoko's (201 ance of n is is consi m-ita (2012 chijuka (20 s result disa onducted in wth of the the financi wever, is c ekeoti (201 m (2013), i and dewi, a high level this result w study's fift ncial perfor h okoye an act on manu s the financi n the financ finance & ac issn 19 2021, vol. 1 ajfa.macro care manuf s detrimenta s a strong n ing is in wo okerekeoti' wu (2016) 19) findings nigerian he istent with 2), egbuni 014), ogunb agrees kan n pakistan. industrial s ial perform consistent w 15), and na ifuero and soei, and of external was consist fth objectiv rmance of n nd clement's ufacturing ial perform cial perform ccounting 946-052x 13, no. 2 think.org/ facturing al to the negative ork with 's study. have all that the ealthcare current ike, and biyi and nwal and . it also sector in mance of with the aser and chijuka surjoko l debt in ent with ve, trade nigerian s (2015) capacity mance of mance of iii) the healthca iv) ext healthca v) tra healthca 5.2 con having macroe panel m macroe manufa 5.3 rec based o i) the controll ii) ban healthc iii) eff growth iv) the borrowi manufa v) the healthc referen adeban bamise manufa techno agubat financia tobacco akabom busines e inflation are manufac ternal debt are manufac ade opennes are manufac nclusion explored th conomic va multiple re conomic in acturing firm commendati on this resea e exchange ling the exc nk lending care manufa forts to main of manufac e federal g ing from f acturing firm e volume o care manufa nces njo, j. f., ele, r., niy acturing sec logy, 10(2), a, s. n. & al performa o sector. int m-ita, a. (2 sses in nige rate has a cturing firm has a nega cturing firm ss has a ne cturing firm he nexus be ariables in n egression a ndices play ms in nigeri ions arch discove e rate shou change rate i rate should acturing com ntain single cturing firm government foreign cou ms’ perform of trade op acturing firm oluwasegu yi-oyebanji, ctor in nig , 1568-1583 & odubuasi ance of nig ternational j 2012). impa ria. researc a significan ms in nigeri ative and in ms in nigeri gative and ms in nigeri etween key nigeria wit analysis tec y significan ia. ery, the foll uld be mon in nigeria s d be regula mpanies in n e-digit inflat ms and the ov t of niger untries and mance in nig penness sho ms in nigeri un, e,. ade , m., & da geria, inter 3. i, a. c. (2 geria manuf journal of c act analysis ch journal o 74 nt positive a. nsignificant a. insignifican a. y financial p th the help chniques, th nt roles in lowing reco nitored whi should be es ated and se nigeria. tion should verall grow ria should d internatio geria. ould be mi ia. egbola, o., amilola, e. rnational jo 2018). effec facturing fi commerce s of interes of finance asian effect on t effect on nt effect on performance of fully m he big les n the finan ommendatio ile econom stablished. et to a rate be intensifi th of the ni work tow onal bodies inimized to , festus, a (2019). im journal of m ct of excha irms: evide and manag st rate on th and accoun n journal of f the financi the financ n the financ e indicators modified ord son from ncial positi ons were ma ic policy m e favourable ied since it igerian econ ards reduci s since it enhance t a., peter, o mpact of exc mechanical ange rate f ence from f gement rese he net asse nting, 3(7). finance & ac issn 19 2021, vol. 1 ajfa.macro ial perform cial perform cial perform s and some dinary least this study tion of he ade: measures a e to the gr is favourab nomy. ing their l negatively the product o., ben-ca change rate l engineer fluctuations food, bever earch, 4(4), ets of multi ccounting 946-052x 13, no. 2 think.org/ mance of mance of mance of selected squares is that ealthcare aimed at rowth of ble to the level of affects tivity of aleb, e., e on the ing and s on the rage and 56-61. inational bernard manufa bhattar perform 35-53. combey environ 9(2). htt darfor stocks. dewi, v firm’s p stock ex ditimi, between egbunik andfina journal enyioko nigeria falaye, moyino in nige 1568-15 gikomb perform econom hassan, america social s ifuero, profitab and fin ijirshar, econom 6(1), 2d, o. a., & acturing sec ai, b. p. mance of ne y, a. & to nment: emp tps://doi.org j & agyapy journal of b v. i., soei, profitability xchange. ac a. sunda n macroeco ke, c. f. & ancial perfor l of account o, n. 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(2016 www.scienc ms, h. t. tions on th ement and e olokoyo, f egulation o nment agric 016). the geria. euro 7). foreign ational journ airu, a. a. ( y. internatio 6).vertical cedirect.com (2018). a he performa economic r f. o., okoy on manufact culture and b effect of v opean journ exchange ra nal of huma (2012). effe onal. specializat m/topics/eco an empirica ance of sel research, 2( 78 ye, l. u., & turing secto biotechnolo variations i nal of acco ate dynamic anities and ect of inflati tion and onomics-e al investiga ected listed (3), 1-10. asian & ejemeyo or performa ogy, 3(3), 0 in foreign ounting, au cs and man social scie ion on the g enlarging ation of th d firms in n journal of f ovwi, j. o. ance in nig 994-1001. exchange o diting and ufacturing f ence inventi growth and the size he impact nigeria. jo finance & ac issn 19 2021, vol. 1 ajfa.macro (2018). im geria. inter on financia finance re firms’ perfo ion, 6(9), 09 developmen of the ec of exchan ournal of b ccounting 946-052x 13, no. 2 think.org/ mpact of national al depth: esearch, ormance 9-14. nt of the conomy. nge rate business microsoft word 18930-article-writer2-new receive doi:10.5 abstra this pa the stu 2009. w account the res will ten the bad study is conserv the ma compan keywo impac ed: july 5, 2 5296/ajfa.v ct aper analyze udy is cond we used the ting conserv sults showe nd to be mo . the effect s important. vatism and f ain limitatio nies. rds: accou ct of th higher in 79 route d tel: 216-58 2021 a 13i2.18930 es the financ ducted on a e basu mod vatism pre-c d that comp ore aggressi t of the finan . it contribu financial cri on of the p unting conse he finan con ri r commerc nternational de la plage 4 835-0993 ccepted: no url: ht cial crisis e sample of el (1997) to crisis (2005 panies duri ive by repor ncial crisis utes to the u isis. present stud ervatism, fi 39 ncial cr nservat im el houci ial studies l finance g 4011 hamm e-mail: ri ov. 17, 2021 https://doi.or effect on fre 120 french o test the ef 5-2007) and ing the crisi rting the go is still an im understandin dy is that i inancial cris asian risis on tism ine of sousse, t group tunis mam sousse imelhoucine 1 publ rg/10.5296/ ench compa h firms, ob ffect of the during the is period ar ood news an mportant top ng of the re it limited t sis, french c n journal of f n accou tunisia ia etunisie e@yahoo.fr lished: dece ajfa.v13i2.1 anies accoun bserved from financial cr crisis (2008 re not cons nd delaying pic to study. lationship b o the effec companies finance & ac issn 19 2021, vol. 1 ajfa.macro unting e r ember 1, 20 18930 nting conse m the year risis on the 8-2009). ervative. m g the recogn y. in that reg between acc cts in frens ccounting 946-052x 13, no. 2 think.org/ 021 ervatism. 2005 to level of managers nition of gard, this counting sh listed introdu this ar conserv problem countrie majority conserv this wo little di conserv 120 ind 400 obs section sample, 1. liter the effe eu and on the conserv (2008-2 balakri compan less con followin other w compan that we had a h lower d suggest informa filip an earning signific crisis pe iatridis results portuga portuga uction rticle focus vatism in th matic, in the es. in fran y of article vatism. ork has, the scussed in vatism. the dex over fiv servations. t n1 reviews t , and sectio rature rev fect of finan d in particul e other han vatism and 2009). shnan and ny's investm nservative ng the onse words, the nies with ag ere financial higher infor declines in ts that acc ation friction nd raffourn gs managem cant decreas eriod. this t and dimitr manipulatio al, ireland, al, italy, an ses on the he french e context o ce, few stu s have stud refore, the a france, abo study is est ve years fro the remaind the relevan on 3 present view ncial crisis st lar, in franc nd, some earnings m al. (2016) s ment during financial re et of the cr investment ggressive fi lly constrai rmation asy debt-raisin counting c ns. nier (2012) ment behav se in income trend was c ras (2013) on, and the italy, gree d greece te e effect of context. in of central a udies contri died the effe ambition to out the effe timated on a om 2005-20 der of this p nt literature. s the results tudy (2008ce, is still lim studies ha management study the ef the financia eporting ex risis than fi t was more inancial rep ned is face mmetry. th ng activity conservatism examine th ior of euro e smoothing confirmed in study how e relevance ek, and spa end to be m 40 f the finan ndeed, desp and eastern ibute to the fect of the 1 o provide ad ect of the fi a sample of 009 to 600 o paper is org . section 2 s. the final -2009) on th mited since ave analyze in the eur ffect of acc al crisis (20 xperienced irms with m e sensitive porting. thi ed with mor hey also fin than in st m reduces he impact o opean-listed g and an im n most of th the econom e of the fin anish that a more involv asian ncial crisis pite the wea n europe co e understand 1997 asian dditional lig nancial cris f 120 french observation anized as fo discusses t section con he level of a e there is no ed the ass ropean cont counting con 007-2008). t a sharper d more conse to a nega is relationsh re significan nd that mor tock marke underinve of the finan d firms. th mprovement he 16 countr mic crisis i nancial figu are audited ved in earn n journal of f on the le alth of stud ountries, inc ding of this financial cr ht on a curr sis (2008-20 h companie ns. the fina ollows: the research ncludes. accounting c o research d ociation be text during nservatism they find th decline in i rvative fina ative credit hip is stron nt external re conservat t performan estment in cial crisis ( hey noticed t of accruals ries studied. s affecting ures of the by a big4 nings manag finance & ac issn 19 2021, vol. 1 ajfa.macro evel of acc dies related cluding dev s theme. t crisis on acc rent topic, s 009) on acc es listed on al example h methodol conservatis done in this etween acc the financi on the leve hat compan investment ancial repor market sh nger for com financing n tive firms r ance. the e the prese (2008-2009 d that there s quality du . the possibi e listed com 4. they fou gement to ccounting 946-052x 13, no. 2 think.org/ counting d to our veloping hus, the counting still very counting the sbf includes ogy and m in the context. counting ial crisis el of the nies with activity rting. in hock for mpanies needs or recorded evidence ence of ) on the e was a uring the ilities of mpanies: und that improve their pr evidenc similar conserv positive stock p relation perform kousen financia low tax the fina the fin manage over the that the news. m in an at more ac the man at the account he used stock re compan returns. non-fin stronger conserv risk for many e to ident watts (2 he con litigatio the ma characte characte compos profit m rofitability ce of manipu ly, in the c vative accou e relationsh performance nship and mance durin nidis and al al crisis imp x sustainabil ancial crisis. nancial cris ers. wargan e period 199 e pessimism most invest ttempt to de ccurate info nager will ch same time, ting conserv d to detect co eturns as a nies, they fo . they us ancial com r. subsequ vatism is an agency pro empirical stu tify the main 2003a) deb nsiders alter on, taxation, ajority of eristics and eristics incl sition of the management and liquid ulation resu context of unting affe hip and an e e during th a financial g this perio l. (2013), t pacted the q lity. the res . sis is a fac negara and v 96-2001 on m of investo ors respond eal with the ormation tha hoose a mo , using con vatism on s onservatism proxy for t found that t ed substitu mpanies in th uently, this n effective g oblems, and udies have a n advantage ates the imp rnative expl , and accoun articles fin d companie lude primar e board, pub t, the size o dity during ults than spa the 2008 f cts shareho economicall his period. lly signific d. taking a sa quality of rep sults show t ctor that in vionita (20 n the levels o ors is domin d to bad new ese adverse an they wou re aggressiv nditional co shareholder m is the c-sc the value of here is a p utes for c he sample, s finding governance that shareh attempted to es of conser plications o lanations fo nting regula nd that the es' econom rily: high t blic and pri f the compa 41 the 2008 ain. financial cr older value ly importan they foun ant relation ample of e ported earn that the ave nfluences th 10) examin of accounti nated, and a ws by furth e reactions, uld typicall ve conserva onservatism, r value duri core of kha f the firm. b ositive asso conservatism and variou provides p mechanism holders bene o quantify t rvatism. of accountin or accountin ation. e conservat mic context technology ivate compa any, and bes asian financial c risis, franc . they fou nt relationsh nd that the nship betw eu compan nings of liste erage of earn he extent o ne the effect ng conserva all good new her reducing managers h ly (francis atism during , wu and a ng the 2007 an and watt by choosin ociation bet m, differen us statistica proof posit m to mitigat efit from pru the extent o ng conserva ng conserva tism of pro t. accordin firms vers anies, the si sides, the m n journal of f crisis, whil is and al. und that the hip between ere is a m ween conser nies, examin ed companie nings qualit of conserva ts of the as atism in ind ws has been g companies have an inc and al., 201 g the financi al.(2013) stu 7 financial s (2009), wh g a sample tween cons nt start dat al methods, tive theory te the inform udent accou f accountin tism on acc atism: contr ofits varies ng to ryan us low tech ize of an au most studied finance & ac issn 19 2021, vol. 1 ajfa.macro le ireland h (2013) test ere is a sig n conservat meaningful rvatism an ned how th es in countr ty improved atism pract sian financi donesia. th n covered w s' access to entive to re 13). in such ial crisis. tudied the e crisis. the who used cum of 5500 a ervatism an ates of the making th y accounti rmation and unting. ng conservat counting reg racting, sha s according n (2006), b hnology fir uditor, the e d economic ccounting 946-052x 13, no. 2 think.org/ has less ted how gnificant tism and positive nd stock he 2008 ries with d during ticed by ial crisis ey show with bad o capital. ecognize h a case, effect of method mulative american nd stock e crisis, his result ng that d control tism and gulators. reholder g to the business rms, the extent of contexts are fisca howeve conserv khuran expansi when th recordin jenkins contract empiric and the account financia passage increase neverth conserv and al to sum cycle o 2007-20 based o level o compar anticipa the cris europea mechan vichitsa in east they as positive tend to as a re period. decreas al quarters a er, few pre vatism or the na and al. ( ionary perio he economy ng of bad ne s and al. (2 tions from cal results. f e risk of li ting (watts al crisis mo e in fundin ed demand heless, man vatism foun l. (2009). mmarize, the on accountin 008 global f on the theo of condition red to peri ate that the sis period. a an bank-ori nisms of the arawong an asian coun sume that c e informatio be more ag esult, the le we can the ses in times and countri evious stud e effect of t (2006) fou ods and arg y is expand ews during 2009) demo the year 19 first, securi itigation is s 2003b). s otivates the ng sources for more co ny studies th nd evidence ere is mixed ng conserv financial cri oretical argu nal conserv ods of exp risk of litig as a result, iented com e undevelop nd al. (2010 ntries is low companies on to invest ggressive in vel of cons en state the of financial es. ies are exp the economi und that fir gue that the ding. as a r the expansi onstrated th 980-2003. t ities litigatio one of the second, the e submissio from intern onservative hat have stu against the d evidence o vatism and isis on cons uments and vatism mus pansion for gation is hig , they will n mpanies in e ed capital m 0) and gul a wer during th facing the tors to redu reporting g servatism ha e following l crisis. 42 ploring the ic crisis on rms presen e penalty fo result, comp ion of the ec hat conserva they provid on generally e essential e threat of on of conse nal to exter accounting udied the im e findings of previous an apparen servatism. d empirical st be lowe r companie gher. as a r not be esse eastern and market. and al. (2 he crisis tha financial cr uce the neg good news a as decrease hypothesis asian impact of conservatis nt less con or reporting panies have conomy. atism is ind ded several y occurs in factors in increased ervative acc rnal during information mpact of th of khurana research on nt lack of r evidence p er during p es in centr result, regul ential factor d central e 002) report an during re risis are un gative impac and delayin ed from the s: the lev n journal of f the busine m. nditional co bad news e more ince deed highe critical exp a period of the deman regulatory counting nu the recess n. he 1997 as a and al. ( n the impac research on presented, w periods of ral and ea latory revie rs of conser european co t that accou egular econo nder pressur ct of the cri g the recog pre-crisis p el of accou finance & ac issn 19 2021, vol. 1 ajfa.macro ess cycle o onservatism is more sig entives to d er during ec planations f f economic nd for cons review dur umbers. th sion must r sian crisis o (2006) and ct of the co n the effect we assume economic astern euro ew increase rvatism for ountries du unting conse omic period re to pass o risis. manag gnition of ba period to th unting conse ccounting 946-052x 13, no. 2 think.org/ on profit m during gnificant delay the conomic for these decline, servative ring the hird, the result in on profit jenkins mpany's s of the that the decline ope. we s during eastern e to the ervatism ds. thus, on more gers will ad news. he crisis ervatism 2. meth 2.1. sam the sam stock ex covered to stud two sub describe table 1 compan -compa -compa -financ final sa 3.2 mod we use account model ( basu (1 gains an returns. we will the coe returns) benefits the coe positive so that hodology mple and d mple is com xchange ind d by this stu dy the level b-samples a es the samp . descriptio nies listed anies belon anies with u cial stateme ample deling regr ed the basu ting conser (1997) is ca 1997) consid nd bad as l . the basu m l integrate th efficient α2 ) and the su s to bad new efficient of e stock mar the increas ata collecti mposed by i dex through udy from the of account a pre-crisis ple. on of the sa on sbf 12 nging to the unavailable ents of non ression u model (1 rvatism pre alled the di ders accoun osses is cap model (199 he size and xit/ measures t um of coeff ws (negative f determinat rket returns se in the va ion ndustrial an hout an inve e thomson ing conserv period (200 ample 20 (year 2 e financial e data n-consolidat 997) to tes -crisis (200 ifferential ti nting conser ptured by th 7) applied i debt variab /pit-1=α0+α1 he rapidity fficients α2 e returns). tion (r2) is as well as alue of this 43 nd commerc estigation f financial d vatism in tim 05-2007) an 2005-2009) sector ted groups st the effec 05-2007) a imelines of rvatism as t he linear re is as follows bles in our m 1dit+α2rit+ of the recog and α3 me s measured between in coefficient asian cial compan from 2005 t database. mes of crisi nd during th number compag 120 18 18 4 80 ct of the fin nd during f earning co he asymme egression of s: model. +α3dit*rit+α gnition of b easures the by the asso ncomes, and implies tha n journal of f nies belongi to 2009. we is, we divid he crisis (20 r of nies nancial cris the crisis oncerning b tric treatme f accounting α4size+α5 benefits to g rapidity of ociation bet d adverse st at the assoc finance & ac issn 19 2021, vol. 1 ajfa.macro ing to the s e collected ded our sam 008-2009). number o observatio 600 90 90 20 400 sis on the (2008-2009 bad and goo ent of good g earnings o 5debt+εit good news ( f the recogn tween earni tock market ciation betw ccounting 946-052x 13, no. 2 think.org/ sbf 120 the data mple into table 1 of ons level of 9). basu od news. news as on stock (1) (positive nition of ings and t returns ween the profit a postulat either b we wil during t r2. 3.3 var 3.3.1 our dep ratio div price at regressi the divi earning make up 3.3.2 t the ind good an before studies to give year’s r (differe we hav fiscal ye pit: the pit-1: the easton, applicat adopted 3.3.3. t and the stock tes that to m bad news or l apply the the crisis (2 riables mea the depend pendent var vided by th t the beginn ion of good ision of the gs per share p its capital xit : t pit-1 : t xit/pit-1 he independ dependent v nd bad new fiscal year use the fisc the market return preve nt from ben ve opted to c ear-end unt share price e share pric harris, an tion of divi d for the dis the dichoto k market re measure the good news e basu mod 2008-2009) asurements dent variab riable, denot he price giv ning of the d quality an accounting e (eps) the l. eps is a r the earnings the price pe : earnings p dent variab variable is t ws. basu ( r-end to thr cal year. the t time to in ents the yie nefits) on th calculate pe il the third m i three mon e i nine mon d ohlson ( idends for sregard of di omous varia eturn will th e level of a . del (1997) f to compare ble: earning ted by xit/p en by the re period. ac nd the contr variables b e ratio of a ratio that com s per share f er share at th per share ble: stock r the stock re 1997) uses ree months e performan ntegrate info ld from bei he market. erformance f month after rit= (pit nths after fis nths before 1992) and d the adjustm ividends co able : good 44 hen be more accounting c for the two e the coeffic gs per share pit-1 in the re eport of the ccording to rol of the he by the price company's mpanies lis for firm i in he beginnin to price rati returns eturns. basu annual sto s after fisc nce measure formation in ing distorte for the perio r fiscal year -pit-1)/pit-1 scal year-en fiscal yeardumontier ment of retu oncerning th or bad new asian e significan conservatism sub-sampl cient α3 and to price rat egressions, i e accounting christie (1 eteroscedas at the begin net income sted under if n fiscal year ng of the fis io. u (1997) us ock returns al year-end e, three mon nto contemp d by the int od beginnin -end, using with: nd. -end. and labell urns does n he calculatio ws n journal of f nt. in this co m, we mus es pre-crisi even comp io is the earnin g result per 1987) and k ticity of the nning of the e to the num frs must p t. cal year. ses equity r measured d. however nths after fi porary prof troduction o ng from the the followi le (1998) ha not affect th on of stock m finance & ac issn 19 2021, vol. 1 ajfa.macro ontext, basu st compare is (2005-20 pare their re ngs per sha r share on th kothari (19 e residues i e period. mber of sha present. returns to r from nine r, most sub iscal year-en fits. the us of new info ninth mont ing formula ave shown he result. w market retu ccounting 946-052x 13, no. 2 think.org/ u (1997) r2 with 007) and spective are (eps) he share 992), the is due to ares that epresent months bsequent nd, aims e of the ormation h before : that the we have urns. dit wor stock m basu (1 asset lo gains t value of 3.3.4. s the tota total nu richard we opte during this mea 3.3.5. in there a level of exampl by the keep th (2008), 3. ana 3.1. des table 2 returns per sha such as rth 1 if the market return 1997) revea sses, and po that show in f net assets. size al market c umber of em dson (1997) ed for mark our study, w asure becau ndebtedness are multiple f debt by the e, black, se ratio of to he total rate we measur lysis and d scriptive st 2 presents t of subsamp are/price and the sodan, stock mark n is positive als that neg ositive stock ncreases in . apitalization mployees pr . ket capitaliza we used the use of the di s measures o e ratio of to ellers, and m otal non-cur e of financi re the level o discussion o atistics the descrip ple: pre-cris d share retu barac, and ket return is e (good new gative stock k returns ref the value o n, that of th resent the va ation as a m e neperian ifferences n of debt in th otal listed an manly (199 rrent financ al debts by of debt by t of results tive statisti sis (2005-20 urn variable vurko stud 45 s negative ( ws). k market re flect net ass of net asset he assets, th arious meas measure of th logarithm o noted due to he literature nd unlisted 8) measure cial debt/eq y total liabil the total de ics of the r 007) and du es show tren dy, 2013). asian (indicating eturns over set gains. ts, whereas, he turnover, sures of com he size of th of market ca the heterog e. daley and debt or non the level o quity. also, lities and e ebt / total a ratio earnin uring the cri nds similar n journal of f bad news) a period ge , losses sho the accoun mpany size he firm. apitalization geneity of th d vigeland ( n-current de f indebtedn brown, iza quity. like assets ratio. ngs per sha isis (2008-2 to those of finance & ac issn 19 2021, vol. 1 ajfa.macro and worth enerally ref ow decrease nting result, cited by bu n to better l he sample. (1983) mea ebt/total ass ness of the c an and loh e lafond an are/price an 2009). the e f previous ccounting 946-052x 13, no. 2 think.org/ 0 if the flect net es in the and the ujak and linearize asure the sets. for company h (1992) nd watts nd share earnings research table 2 we find was hig give sig crisis. t found in per shar the crisi . descriptiv variable xit/pit-1 dit rit dit*rit size debt variable xit/pit-1 dit rit dit*rit size debt d that the m gher during gnificantly l these result n the count re/ price an is period (2 ve statistics median 0.0626 0.0097 0 0.0085 0.2428 median 0.0496 0.0050 0 0.0081 0.2368 median earn g the crisis p lower avera ts are consis tries of cen nd share retu 008-2009). for subsam pre-c n mean 6 0.0777 0.3437 7 0.0095 -0.0059 0.0084 0.2864 during th n mean 6 0.0469 0.475 0 0.0049 -0.0182 0.0081 0.2758 nings per sh period. bes ge values du stent with th ntral and ea urns before 46 mples « fina crisis (2005standard 0.0 0.0 0.0 0.0 0.2 he crisis (2 standard 0.0 0.0 0.0 0.0 0.2 hare / shar sides, the e during the cr those of sod astern euro e the financi asian ancial crisis -2007) deviation 635 265 122 013 168 008-2009) deviation 0311 483 248 014 004 e returns r arnings per risis than in dan, barac a ope, that the ial crisis (2 n journal of f s » minimum 0 -0.0784 -0.0784 0.0055 0.0027 minimum 0 -0.0925 -0.0925 0.0047 0.0015 atio before r share/price the period and vurko e median of 005-2007) finance & ac issn 19 2021, vol. 1 ajfa.macro m maximu 0.5047 0.1344 0 0.011 0.690 m maxim 0.169 5 0.14 5 0 0.01 0.153 the financi e and share before the f (2013) whi f the ratio e were highe ccounting 946-052x 13, no. 2 think.org/ um 7 4 8 8 mum 95 13 17 35 ial crisis e returns financial ch were earnings er during besides of the o to see a deviatio finally, during t 3.2. bito find have us variable variable table 3 confirm does no table 3 we find dit*rit the sha with the the rec s, we note th order of 0.0 a decrease on of share r , we find th the financia -varied ana d out if there sed the corr es studied. t e coefficien 3 shows tha m the correla ot exist in ou . correlatio d that the d (-0.6974) are returns e size (-0.14 cognition o dit rit ditrit size debt hat the stand 635. during in the stan returns duri hat the aver al crisis than alysis e is a probl elation matr there is no nts are less th at all the co ation betwe ur model. on matrix dit is correla at the signif is positively 438) at the s f bad news dit 1 -0.7808*** (0.0000) 0.6974*** (0.0000) 0.0718*** (0.1520) -0.0592 (0.2373) dard deviati g the crisis ndard deviat ing the crisi rage size of n before the lem of mult rix, which m problem wi han 80per c orrelation c een the varia ated negativ ficance leve y correlated significance s relative to rit * * ) 0.7116 (0.00 * -0.1438 (0.003 0.027 (0.582 47 ion of earni period, it i tion. on th is period wa f companies e crisis. ti-collineari must affirm ith multicol cent (kenne coefficients ables. it me vely and sig el of 1 per c d with the d e level of 1 p o the recog dit 1 6 *** 000) 8*** 39) 0.0 (0.7 76 22) -0.0 (0.9 asian ings per sha s of the ord he other han as higher th s and the le ity between m a multi-co llinearity if edy, 1985). are less th eans that the gnificantly w cent. dit*rit (0.71 per cent. gnition of g t rit 1 0172 7314) 0035 9436) n journal of f are before th der of 0.031 nd, it show an before th evel of inde the explan llinearity be all depende an 0.8, and e problem o with the rit 116) and ne good news g size 1 -0.0371 (0.4599) finance & ac issn 19 2021, vol. 1 ajfa.macro he financial 11, which al ws that the s he crisis. ebtedness de natory variab etween som ent and inde d therefore, of multi-col (-0.7808), egatively co generated b debt 1 ccounting 946-052x 13, no. 2 think.org/ crisis is llows us standard ecreased bles, we me of the ependent we can linearity with the orrelated by stock market negativ finally, (-0.037 for our allows u study, th the abse 3.3. mu the reg (2005-2 the coe will exa during t sample accord α3 (dit* cent. d statistic initially cent thr negativ the cris and sign tend to which compan reduce t we no crisis (account on the the sam the sam during report t conserv from th returns (di ely correlat , the size o 1). r analysis t us to detect he average ence of mul ulti-varied a gression resu 2007) and d efficient α3 amine the l the crisis an pre-crisis a ing to table *rit) are sta during the c cally signific y, the coef reshold befo e returns is, that the nificant at t be more ag means that nies under the negative ote that the -0.8086< -0 ting conserv other hand. mple pre-cris mple during the crisis p the bad new vative durin he conclusio it*rit) is po ted with the of the comp to be more t the problem vif of the lti-collinear analysis ults of the t during the cr 3 relative to evel of acc nd also com and during th e 4, we obs atistically si crisis perio cant at the 5 fficient of i fore the fina « bad news coefficient the threshol gressive in t companies pressure to e impact of coefficient 0.6946). the vatism durin . the coeffic sis (r2=0.1 the crisis ( period (2008 ws of the g the period ons from co ositively cor indebtedne pany is corr in-depth, w m of multivariables is ity between two sub-sam risis (2008-2 o dit*rit me ounting con mpare the a he crisis. serve that be ignificant a d, we note 5 per cent th nteraction d ancial crisis s » than pos α3 (dit*rit d of 5 per c reporting g s are not co o transmit m the crisis. α3 (dit*rit ese latest re ng the perio cient of dete 742) is high r2=0.1575 8-2009) mo losses. bas d of financia oefficient α3 48 rrelated wit ess (-0.0035 related neg we used th colinearity s less than 5 n the explan mples in the 2009). easures the nservatism adjusted r2 efore the fin at the respec e that the c hreshold. dit*rit (α3) s, which im sitive return t), lower co cent. it mean good news a onservative more positi t) is lower d esults confir od of financ ermination r her than the ). french c ore than bef sed on this al crisis than 3 and the co asian th the size 5). atively with e vif (var between th 5. thus, we natory variab e panel are p practice of of the coef of the basu nancial cris ctive thresh coefficients ) is negative mplies that th ns « good n mpared to b ns that com and delaying e during thi ive informa during the f rm, in the fr ial crisis is r2 of the e r2 of the ompanies in fore the fin s coefficien n before the oefficient of n journal of f of the com h the comp riance infla e explanato can confirm bles of our m presented in f accounting fficient α3 ( u model (1 is the coeff holds of 1 p α1 (dit) an e and signif he gains are ews ». also before the c mpanies duri g recognitio s period. t ation to inv financial cri rench conte lower than basu mode basu mode ntegrate the nancial crisi nt, french c e crisis. f determinat finance & ac issn 19 2021, vol. 1 ajfa.macro mpany (0.01 pany's indeb ation factor ory variable m the hypot model. n table 4: p g conservati (dit*rit) bef 997) applie ficients α2 ( per cent and nd α3 (dit* ficant at the re more sen o, we notice crisis, it is n ing the crisi on of bad ne this may be vestors in o isis than be ext, that the before the c el (1997) ap el (1997) ap eir economi is and they companies tion r2, we ccounting 946-052x 13, no. 2 think.org/ 172) and btedness r) which s. in our thesis of pre-crisis ism. we fore and ed to the (rit) and d 10 per *rit) are e 10 per nsitive to e during negative is period ews. e due to order to efore the level of crisis. pplied to pplied to ic losses quickly are less e can say that the crisis pe the siz other h financia table 4 v c d r d si d n r v c d r d si d n r e hypothesi eriod is con ze and debt hand, the siz al crisis. 4. the impac variable constant dit rit dit*rit ize debt n r2 variable constant dit rit dit*rit ize debt n r2 s assuming nfirmed. variables h ze variable ct of the fin g that the le have no sig is positive nancial cris pre-crisis c 0. -0 0. -0 -8 -0 24 0. model d c 0. -0 -0 -0 4. -0 16 0. 49 evel of acco gnificant im e and signif sis on accou model (200 coefficient .0692*** 0.0021 .5295*** 0.6946* 8.4094 0.0302 40 .1742 during the coefficient .0413*** 0.0189** 0.0479 0.8086** .7721*** 0.0084 60 .1575 asian ounting con mpact during ficant at th unting cons 05-2007) e crisis (2 n journal of f nservatism g the pre-cr he 1 per cen servatism: b probability 0.000 0.827 0.007 0.090 0.801 0.519 008-2009) probability 0.000 0.037 0.780 0.018 0.005 0.573 finance & ac issn 19 2021, vol. 1 ajfa.macro decreases d risis period. nt level du basu model y y ccounting 946-052x 13, no. 2 think.org/ during a . on the uring the l (1997) 4. con empiric conserv explore period effects 120 fr account during reportin referen balakri corpora accoun basu. s journal https://d black. e an inte busines https://d brown. abacus bujaki. accoun https://w holar&c christie accoun daley. l of acco econom dumon the https://d easton. most o econom clusion cal evidenc vatism of fin e the impact of financial in french l rench firms ting conser the crisis p ng the good nces shnan.k., w ate investm nting, 43(5-6 s. (1997). t l of doi.org/10.1 e.l., seller ernational s ss fi doi.org/10.1 p., izan. h , 28(1), 36m.l., rich nting re www.proqu cbl=31366 e. a.a. (1 nting and ec l., vigelan ounting met mics, 5(3), 1 ntier. p., lab europea doi.org/10.1 p.d., harr f security mics, 15(2-3 e concernin nancial stat t of mandat l crisis. th listed comp s during 2 rvatism dur period are n news and d watts.r. an ment during 6), 513–542 the conser acco 1016/s0165 rs. k.f. and study of co inance 1111/1468-5 h.y., loh. a 57. https:/ hardson. a. esearch. uest.com/op 987). on c conomics, 9 d. r. (1983 thods: the 195-211. htt belle. r. (20 an ac 1080/09638 ris. t. s. oh retums: the 3), 119-142. ng the role tements rep ory ifrs ad e main lim panies. inde 2005-2009. ring the fin not conserva delaying the nd zuo. l. ( the global 2. https://doi rvatism prin ounting -4101(97)0 manly. t. ountries al and 5957.00238 a.l. (1992). //doi.org/10 j. (1997). a journal enview/2c2 cross-sectio 9(3), 231-25 ). the effec case of acc tps://doi.org 010). accou ccounting 189833643 hlson. j. a. e case of l https://doi. 50 played by porting has doption on mitation of t eed, we used we find nancial cris ative. mana e recognitio (2016). th l financial i.org/10.111 nciple and t and 00014-1 s. (1998). e llowing non accoun 8 fixed asse .1111/j.146 a citation t of ac 20eea8ed6c6 onal analys 8. https://do cts of debt c counting fo g/10.1016/0 unting earn review 9 (1992). ag long-term i .org/10.101 asian internationa proven inco accounting the present d the basu evidence o sis. the re agers will t n of the bad e effect of crisis. jou 11/jbfa.1220 the asymm econom earnings m ncurrent a nting, et revaluati 67-6281.199 trail review ccounting 69966ccfe5 sis in acco oi.org/10.10 covenants an or r&d co 165-4101(8 nings and fir w, 7(2 ggregate ac intervals. t 6/0165-410 n journal of f al accountin onclusive. t conservatis study is th model (199 of a signifi sults show end to be m d. f accountin rnal of bus 06 metric time mics, management sset revalu 25(9-10), ons and ma 92.tb00268.x w of the us literatur 6b8cae2c37 ounting res 016/0165-41 nd political sts. journa 83)90012-5 rm valuatio 2), counting ea the journal 01(92)90015 finance & ac issn 19 2021, vol. 1 ajfa.macro ng standard this paper sm in franc hat it limite 97) on a sa ficant reduc wed that com more aggre ng conserva siness fina eliness of e 24(1), using asse uation. jou 128 anagerial ln x ses of firm re, 16, 7/1?pq-orig search. jou 101(87)900 costs on th al of accou on: the fren arnings can l of accou 5-t ccounting 946-052x 13, no. 2 think.org/ ds in the seeks to ce in the d to the ample of ction of mpanies ssive by atism on ance and earnings. 3-37. et sales: urnal of 87-1317. ncentives. m size in 1-27. gsite=gsc urnal of 007-3 e choice unting & nch case. 163-83. n explain nting & filip. a manage 455-478 francis shareho https://d gul. f. and a https://d iatridis. five eu accoun jenkins across 1041-10 khan. measur https://d khuran incentiv missour kothari respons https://d kousen crisis o https://d lafond review, ryan. g 15(4), 5 sodan. central https://d vichit §crisis a., raffourn ement: the 8. https://do . b., hasa olders: evid doi.org/10.2 , srinidhi. b audit fees doi.org/10.2 . g., dimitr uropean cou nting, 29(1), s. s., kane. the busin 058. https: m., & wa re of accou doi.org/10.1 na. i.k., ma ves and tim ri-columbia i. s.p. (199 se coeffici doi.org/10.1 nidis. d.v., on earning doi.org/10.1 d. r., & wa , 83(2), 447 g. (2006). 511-525. htt s., barac. z and easter doi.org/10.1 tsarawong. on conserv nier. b. (20 e european oi.org/10.10 an. i., & w dence from 2308/acch-5 b., shieh. t s: eviden 2139/ssrn.31 ras. a.i. (20 untries. adv 154-160. h d., & vel ness cycle. ://doi.org/10 atts. r.l. ( unting cons 1016/j.jacce artin. x., p mely recog a. http://aaah 92). informa ients. jour 1016/0165-4 ladas. a.c gs quality. 1016/j.irfa.2 atts. r. (200 7-478. http:/ identify tps://doi.org z.a., & vu rn europe 1080/13316 t.. eng. l vatism and 014). the im evidence. 016/j.intacc. wu. q. (20 m the finan 50431 t. (2002). t nce from 15062 013). fin vances in a https://doi.or lury. u. (20 journal 0.1111/j.146 (2009). est servatism. j eco.2009.08 pereira. r., gnition of hq.org/am2 ation in pric rnal of a 4101(92)90 c., & nega internatio 2013.03.004 8). the i //dx.doi.org/ ing conditi g/10.1080/0 uko. t. 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ar ng of hc (s cations of a w, 1993; rio een the ou ose the mos ost of hc ets to be exp hc in organi ships betwe remains the firm theor which pres dge should tems such a capabilitie ile (karthike were hc q asian so that it sh to measure depicted in ent truths m resource at the hra, pted by key ) has prop accounting measureme part) in or as research d the evt w d as the para the premise ating to hc outside the tion) existin uch, they el rgyres & l schepker, o asset specifi ordan & w tside hiring st efficient in the hr plored. mor izations. a een hc cost goal of hr ry supposes tha be nurtured as outsourc s are hetero eyan, bhaga ualities suc n journal of f hould functi ement-comm the model, make it func accounting , as a strateg y constituen posed that g should be ents to dec rganizations hers to pose were used a asol. that hiring c deployme firm in wh ng ones in w lect to empl liebeskind, oh, martyno icity, as a fo illiamson, 1 g (ac) and combination ra branch re specifica accordingly ts and hum ra practice. at those rare d and reposi ed technolo ogeneously at, & kanna h as value, finance & ac issn 19 2021, vol. 1 ajfa.macro ion in organ munication economics ction pragm g (hra), a gic decision nts in organi for acc considered cision mod s. these un the right q as key inform g and trainin ent. therefo hich case h which case loy hc in t 1999). tc ov & poppo form of asse 1985). rior nd internal on. asset sp of account ally, the ac y, this theor man capital e competen itioned from ogy are intr y distributed an, 2012). rareness, n ccounting 946-052x 13, no. 2 think.org/ nizations decision s did not matically. as a hc n model, izations. to be a as a set dels (the derlying questions mants of ng costs ore, they hiring or training the most cet has o, 2014) et–based rdan and training ecificity ting and and lc ry would earning ncies and m within roduced. d among barney not being imitable source through valuabl advanta compet of any f obtaine disclosu and hig conclud compan that dro middle manage the firm kaplan facilitat accord disciplin 2.1.1.3 third, i its pote dual qu the the among training general the firm firm-sp benefits accord is impe compet be adop total h actual h applied tandem 2.1.1.4 the ev e, and imm of competit h business p e, rare, ini age to the fi ence and pr firm (porter d, maintain ure of hc in gh value of ded that hc ny and that t ove its comp stages of de ers would ac m’s compet and nort ting firms ingly, this ne in organ the human is the hct, ential future ualities of sp eory describ employees g and retent skills that c m and which ecific skill s linked wit ingly, hc w erative that encies that pted in orga human capit human cap to typify t with the m the econom vt presume mobility. ray tive advanta processes a imitable, a irm. porter rofits. hc w r & stern, 2 ned, and se nvestments. f hc, as we c possessing the compan petitive adv evelopment ccount for t titive edge on (1992). to repositio theory wo izations. n capital th which is fo e economic pecialized c bed hc in t (chaudhry ion (flamho could easily h were harde s were com th such skill with firm-sp kiss firm drove their nizations; th tal cost (th pital revenu the basis up matching pos mic value t s that all em y, barney, a age only if nd that tho and non-sub (1985) opin which posse 001). chen egregated th . lepak and ell as low g high uniqu ny continued vantage. hc t and replac the quantita by especia accountin on their ke uld be fun heory ounded on th benefits to core compe terms of inv y & roomi oltz, 1999). y be transfer er to apply mpensated ls, interim e pecific skill ms employed r profitabilit he hra as hcc) in org ue (ahcr) pon which o stulate. theory mployees in 123 and muhan f they were ose business bstitutable nes that hc essed these n and lin (2 these catego d snell (199 uniqueness ueness and d to invest i c costs in th cement cost ative value o ally focusin ng for hc ey hc in ndamental i he premise be derived etencies and vestments m i, 2010). in . becker (19 rred to orga in another f for at leas employee m ls would op d robust pa ty. thus, th a strategic d ganizations ) to be deriv organization n firms bear asian nna (2004) p used to do s processes resources c with rare attributes w 004) stipula ories of hc 9) distingui and low-v high value in these asse his regard in s at the fina of their hc ng on learn c in organ the most p in promotin that firms a d from it. h d non-transf made in tra nvestments i 993) promo anizations o firm. he ori st a portion mobility wou pt to stay, an ay schemes his theory w decisions to , to be matc ved from it. ns can accu value since n journal of f propose tha something and activit were sourc skills was t would be the ate that the w c would e ished betwe value hc in were nurtur ets as posse ncluded: le al stages of in hra to ning and gr izations wo profitable s ng the ado acquire suff hc in this th ferability (c ining and k in hc were oted that hc or firm-spec iginated tha n of the in uld accrue a nd hence ret s aimed at would affirm ool would p ched with h the theory urately fore e they are ca finance & ac issn 19 2021, vol. 1 ajfa.macro at resources g, or were e ties that use ces of com the roots of e ultimate a way a firm equal its qu een high uni n a quadran red from w essing the ra earning cos developme effectively growth prop ould be u strategic fu option of th ficient hc b heory posse chen & lin knowledge b e acquired c could gro cific skills u at if employ ncreased ec a monetary tention ach retaining th m the notion promote the hcep as we would ther ecast their h apable of re ccounting 946-052x 13, no. 2 think.org/ s were a xploited ed these mpetitive f a firm's attention formed, uantified iqueness nt. they ithin the are skills sts at the ent. firm manage posed in seful in unctions. he hra based on esses the n, 2004). building through w either unique to ees with conomic penalty. ieved. it heir hc n that: to acc of ell as the refore be hcep in endering future s inescap instrum value o derived (flamho addition butt (2 particul or othe interven view th current manage 2.1.2 th the fou acc th enuncia finance impacts in acc 2.1.2.1 basic a pragma measuri 1973; a (asob informa & auer activity in acc matthew broad p guide th found th how the definitio account or blind self-exp their re services to o pable conclu mental sense of hc has d from each oltz, 1999). n within the 2013), hra lar organiza er functiona ning factor hat hc is th dispensati erial decisio he torch ur key econ heories of ation origina disciplines s on organiz c was the me the basic a acc theory atic proposi ing, and co aicpa, 19 at) as th ation to per rbach, 1974 y for certain c was the m w (1996) p principles th he developm hat the theo ey were der ons uphold tants, name dly prepare planatory an elation to organization usion that e as their cr been define h employee . thus in th e firm for th a took cogn ation and at al structure for competi he foremost on. investm ons which au nomic theor basic, norm ate. the ac s provide us zations (cas easurement accounting y has been itions expl ommunicati 970). it wa he process mit informe 4). aaa (1 kinds of de measuremen proposed tha hat provide a ment of new ory consists ived, and it what rom ly, to read t d, and to in nd free from each other ns. foster ( firms’ only riterion of j ed as the p e for the p he evt, the he entire per nizance of t whatever es. human itive advant t investmen ments in h ugment firm retical foun mative, and cc theories seful analyt scio & boud of the econ theory identified aining and ng econom as highlight of identif ed judgmen 973) furthe ecision mod nt of the ec at basic ac a general fr w practices s of basic as included th meo and mc the record, t nterpret, rea m mysteries and intrin 124 (2001) has a y choice wa judgment, a present valu period they e efficiency riod of wor the efforts level of eng capital a tage in orga nt in organiz hc would m market va ndations wer d positivity s promote t tical concep dreau, 2011 nomic perfo as a cohes d guiding t mic informat ted in the fying, mea nts and deci er identified dels. accord conomic pe cc theory w rame of refe s and proce ssumptions, he reporting ckinney (20 the hierogly arrange, an s of bookkee nsic results asian argued that as to accep as their theo ue of the fu y were exp y of hc in rk was the o s employed gagement, i accounting anizations. t zations, and be accoun alue. re the basis y view; de he hra di pts for mea ). ijiri (197 ormance of t sive set of the accoun tion to user statement asuring, an isions by us d basic ac ding to kab erformance was the log erence to ev edures. wol , definitions g of acc an 008) propos yphics of ac nd produce eping, the n s. accordin n journal of f evidence r pt economic ory of valu future servic pected to re the quest f overriding f by all tho including d presuppose this theory d especially ted for in s upon whic esignated as scipline. t suring hc p 5) suggeste the accounte conceptual ntant's actio rs of financ of basic a nd commun sers of the i c theory a bir (2005), th of the acco gical reason ery account lk, dodd, an s, principles nd financial sed to be th ccounts, wh in a simple narrative of ngly, basic finance & ac issn 19 2021, vol. 1 ajfa.macro rationally le c efficiency ue. the in ces expecte remain in t for econom factor. acco ose that wo directors, m es that hc would prom y kiss firm hra to p ch the fund s the torch the econom programs a ed that the k ed. l, hypotheti ons in iden cial reports accounting nicating ec information as the meas he underlyi ounted. per ning in the tant to evalu and rozyck s, and conce information he key activ hether unmi e but distin f facts as the acc theo ccounting 946-052x 13, no. 2 think.org/ ed to the y in the ndividual ed to be the firm mic value ording to ork in a anagers, c is the mote the ms of the promote damental h in the mics and and their key issue cal, and ntifying, s (aaa, theory conomic n (sadan urement ing issue rara and form of uate and i (2008) epts and n. these vities of stakably nct form, ey were, ory was acknow econom make in quantita decision guiding thcc a 2.1.2.2 the nor acc p normati (kabir, firms fo started (1953) account account argued discussi an indu classify this wa in some presum on the d of econ hugely howeve sinha, there w informa measure theory p with the as a sy professi appears indeed, investig theoreti applied enhance wledged in t mic results i nformed de ative value ns. the the g the contem and ahcr the norma rmative ac rocedures, ive acc th 2005), and or improved with some considered ting practic ting practic that the g ions were o uctive study y work as b as a reasona e assumptio ed the obje deductive ap nomic value supplement er, the norm 2008). al was a lack of ation needs ement prop progressive e possible u ystem of k ional acc s to have pa normative gation empl ical framew to underpi e firm value this inquiry in their fina ecisions. h of hc as eory would mporary acc in their org ative accou cc theory s and the co heory notio d measurem d decisions goal assum d normative ce and then e. ijiri (197 goal assum often stated y of the exi being induc able proposa ons and go ctivity postu pproach. no s, and paths ts both the b mative theor lthough wit f agreement s of users osals (kabi ely defined uses of that knowledge; world. nev aved the w e research loyed the n works are d in the found e. y as a meas ancial repor ra, as a u the most f d therefore countant’s w ganizations. unting theor seeks to pre ontents of f on presuppo ment was ab . ijiri (1975 mptions and e theory a n rationalize 75) distingu mptions in based on on isting system ctive or ded al as the exi al propositi ulate when onetheless, s on clear pr basic and po ry was critic th emphasis t among the s, and the ir 2005). ra itself as a knowledge and this vertheless, th ay for the s was not k normative p erived to p dation of h 125 surement an rts to enable unique bran fundamenta be applied work of ide ry escribe som financial rep oses measu bout determ 5) viewed t d then deduc as inductiv ed and just uished betw normative ne's convict m. kabir (2 ductive onl isting practi ions that d assumption the normat rocedures a ositive theo cized as bei s on recogn e theorists o ese differen amirez and set of know e, was never created a hey added t success of killed off perspective promote the hca in org asian nd quantifi e managers nch of acc al investme d as the ba entifying, m me basis of ports (watt urement an mining the q the normativ ced acc p e and argu tified the m ween inducti models or tions and pr 2005) conte ly, as some ice promote deduced its ns were emp tive acc th and processe retical fram ing prescrip nition and n the basic nces led t jeanjean (2 wledge whi rtheless det distance be that the suc the positivi by the ris as the basi e hra disc anizations f n journal of f cation tool and other c, aspires nt in organ sis of the measuring, a acc meas ts & zimm d recogniti quantitative ve theory a procedures. ued that it major eleme iveness and r goals ad references ra ended that i e works uti ed in ijiri (1 existence. ployed, as t heory is a m es as envisa meworks. tive (miller measureme assumption to different 2009) sugge ich, while r ached from etween the cess of the ity theory; a e of positi s upon whi ipline. th for improve finance & ac issn 19 2021, vol. 1 ajfa.macro of firms’ v key constit to account nizations fo hra disci and commu surement, p merman, 198 ion issues e value of a as deductive however, l t examined ents of the d deductiven dvocated in rather than b it was infea ilized both 975) had its furthermor this analysis measurement aged in hra r & bahnso ent issues i ns and hypo nt recogniti ested that no remaining i m those uses e theorists normative t and conclu ive researc ich advance he theory w ed decision ccounting 946-052x 13, no. 2 think.org/ valuable tuents to for the or better ipline in unicating articular 86). the in acc assets in e, which littleton d extant existing ness and n policy based on asible to models. s origins re, acc s hinged t system a, and it n, 2010; in acc, thesized ion and ormative in touch s to exist and the theorists ded that ch. this ed acc would be ns which 2.1.2.3 the pat explain paradig to expla and exp stipulat practice view of explicit theory o 1992). t inculcat the beh and hu politico determi 2001). tradition measure frames complex were co can be epitomi the int counter measure organiz measure disciplin account akintoy strategi econom the hca 2.1.3 th in figur structur capital capital the positiv at is a measu the interco gms in organ ain and pre planatory o ed that the e rather than f theory in tly champio on economi thus pat a te: first, the havioral app uman beh o-contractua inants of ac the pos nal acc re ement and and dealt w x business omplementa the produ ize its work terconnecte rparts has em e the quant zations. ste ement and nes such ting discipli ye, 2012; t c decision mists' counte a practice. he hra str re 2.1, the h re and which (ic), hum (ind.c), as vity accoun urement-qu onnectednes nizations. a dict acc p of the acc positivity n improve th science. in oned a met ic-based exp accomplishe e impact of proach whi havior (blo al perspectiv cc policy c sitivity fram esearch was recognition with the rap environmen ary in this e ct of good kability and edness of t manated th titative valu en, welch, quantificati as econom ine in the e theeke, 200 tool in o erparts. in t ructure hra has em h include: h man compet s well as so nting theory uantification ss between according to practices. pa c practice ( view was b hem, and w their first a thodology t planations a ed more tha acc inform ch analyses oomfield, ve, which e choices mad mework, al s normative n paramete pidly chang nt, and how enunciation. d acc theo how it fits w the three a e hra as a ue of hc a and mcc ion of hc w mics and sc arly 1960s 05; herman organization this inquiry, manated sev human cap tence acco ocial capita 126 y n-procedura the acc p o sinha (200 at is a scie (chambers, based on th was a scienti article on p that would and predicti an mere eco mation on f s the relatio libby, & examines th de by prepa lthough cri e (sinha, 2 ers in acc ging modern w they are a . imke (200 ories. thee with other k acc theor a unique br as the forem cormack (2 was underst cientific m of the last nson, 1986), ns. this fo , the interco ven disciplin pital (hc), a ounting (hc al (soc.c). asian al approach t practice and 08), the prim entific, emp 1993). wa he intention ific theory s positivism, w focus emp ions of acc nomic mea financial ma onships bet & nelson, he organizat arers of acc iticized as 008), ration c promoted n economic accounted. a 01) has sugg eke (2005) known and a retical fram ranch of ac most factor 011) have tandable wi management century (ch , when acco ollowed an onnectednes nes identifie accounting coa), struc these were n journal of f that seeks to d the socialmary object pirical, econ atts and zi n to explain since it was watts and z pirical resea c practice ( surement an arkets (koth tween acco 2002); a tional, econ ounts (field not being nale was be by the ba c behaviora accordingly gested that g proposes t accepted the meworks an cc whose s r of compet suggested th the roots t. hra wa houhan & n ountants em n earlier re ss of the th ed in this de for people ctural capit e typified as finance & ac issn 19 2021, vol. 1 ajfa.macro o communi -political-ec tive of the p nomic-based immermann n and predi consistent zimmerman arch in acc (boland & nd quantific hari, 2001); ounting info and, third, nomic, and ds, lys, & v scientific eyond the e asic and no al relationsh y, the three good acc that a theo eories. nd their ec solitary them etitive advan that the fo s of acc in as exposed naghshband mbraced it a evelation b heories unde epiction as t e (afp), inte tal (sc), in s synonymo ccounting 946-052x 13, no. 2 think.org/ cate and conomic pat was d theory n (1986) ict acc with the n (1986) counting gordon, cation to second, ormation , the political vincent, because essential ormative hips in a theories practice ry must conomic me is to ntage in focus on n source d as an di, 2015; as a hc by their erpinned the hra ellectual ndividual ous with hra pr hra th disciplin 2.1.3.1 most h key them case stu tool in research measure (flamho expose. corpora footbal kenyan implem abandon empiric strategi compet three e quantita support manage compet this ex focused market ractice (the heory in org ne ought to human cap hra researc matic areas udies on hr organizatio h on controv ement and/ oltz, narasi . various em ation, touch ll clubs, wm n medium mented acc ned the pr cal works w c hc decis ence develo empirical w ative versus t of quantita ers and sha itiveness. xpose has d d on hc fi value: as de eeke, 2005) ganizations be pragmat pital ch work ha s to include: ra implem ons concern versies in h /or quantif imhan, & b mpirical wo he ross & c m data, ska and large c for hc ractice alto which focu sions such a opment, and works on h s soft qualit ative measu areholders distinguishe inancial me epicted belo ; and this ve for improv tically defin s focused o : (i) the ana mentation in ning other t hra; (v) bo fication of bullen, 2004 rks were ca co., the me andia group e organizat with positi gether. mo used on hr as selection d human ca hra contro tative measu urement of h of organiza ed between easures in t ow: 127 eracity may ved firm ma ned for ease on hca (r alysis of too organizatio tools such ottlenecks an hc in th 4). these arried out es etro bank, th p and bhara tions, amo ive bottomoreover, fla ra as aidi n, tenure, p apital retur oversies to urement of hc in organ ations, espe n financial the financi asian y have hinde arket value. e of implem roslender, 2 ols of hca ons; (iii) hr as the bala nd impedim e financial were descri specially in he usa nav at heavy ele ong others. -line result amholtz, et ing manage performance rn on inves o include th f hc, and jo nizations as ecially thos and non-fin al reports o n journal of f ered the imp it is imper mentation. 009), and h in organizat ra as a hc anced score ments to hr statements ibed as mod companies vy, dow ch ectrical –in most of s. however t al. 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(2011) reativity, pertise it adoption finance, ource of stinguish nted for orks, ic 2.1.3.3 murthy austral while p human howeve on its segmen younger produce compet hc than promoti market 2.1.3.4 accord consiste publicly structur systems describe organiz physica in this notwith scrutiny enhance 2.1.3.5 flamho for ind organiz synergy flamho an emp was the 2.1.3.6 social defined on a fi spanish human com y and guthri ian financia promoting th resource er, hc, as e original int nt employee r counterpa e superior encies? do n others? b ing the adop value. structural c ing to sve ed of man y present th re which co s; and (ii) ed as a c zations as str al, operation investigatio hstanding th y focused on e firm mark individual c oltz (2005:7 dividual cap zation as a w y of the hum oltz (1999), loyee. how e impetus on social capi capital wa d by doming irm’s reputa h companie mpetence a ie (2012) in al firms. ho hat: terms s costing and exemplified tent, hcoa e groups. f arts? does g products some insti ased on the ption of the capital eiby (1997: agers from heir intangi omprised pa the extern omponent rategic orga nal, markets on as the i he foregoin n financial ket value. capital 8, 79), ackn pital (ind.c whole or 'hu man organi promoted i wever, organ n this enunc ital as synonym guez (2011) ation, and es which fo accounting ntroduced th owever, the such as hum d acc, we in this inqu a may bette for example gender play or provide itutions of h theoretical e practice in 73), sc w m sweden w ible assets. atents, conc nal structure of ic. ho ans which d s, and hc. s intervening ng, sc has acc for h nowledged c) and ther uman capit ization as a ind.c as the nizations foc ciation. mous with ) as the prac cited a 20 found that: 129 he concept authors refe man asset ere applied uiry, has wid er be appli e: are olde y a role in c e superior higher learn l intent of h n organizatio was originat who used they desc epts, model e which nu owever, it drove the fun sc, therefo factor for been exem hc adoption that most h refore negle tal of the th a whole: as e present va cus on acc relational c ctice of soc 003 survey a major r asian of hcoa w ferred to the acc, hum interchang der tenets th ied to stud er employee competence services ning inculca hca, these d ons for bett ted by ‘the nonfinancia cribed sc t ls, compute urtured ext incorporate nctioning o ore, affirmed competitiv mplified as n in organiz hra works ected what hird kind' or distinct fro alue of futu c for their t capital in t cial behavio by pricew reason for n journal of f when they s originators man resourc geably to m han hcoa. dy divergen es more co appraisal? 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(2011). c an resource 234 ganizationa r. san franc e accountin ource cos 694 07). consol list for inte ), 349-357. 86). positiv (2008). ac h ed.) sage p asian coordination 0149206313 critique. th conflicting e costing & al wealth: cisco, ca. ng transmi sting & lidated crit erviews and https://doi.o ve accounti counting th publications n journal of f n and adap 491289 he icfai un conceptua & accountin managing ssion: shift accounting teria for re d focus gr org/10.1093 ng theory. heory: con s inc. califo finance & ac issn 19 2021, vol. 1 ajfa.macro ptation. jou university jo alization of ng, 15(4), 2 g and me ting from f ng, 9(1), eporting qu roups. inter 3/intqhc/mz englewood nceptual iss ornia. ccounting 946-052x 13, no. 2 think.org/ urnal of ournal of f human 299-312. easuring ailure to 40-59. ualitative rnational zm042 d cliffs. ues in a microsoft word 15740-56439-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 110 how stablecoin implementation can lead to increased accounting clarity and standardization dr. sean stein smith assistant professor city university of new york lehman college american institute for economic research received: october 21, 2019 accepted: nov. 13, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15740 url: https://doi.org/10.5296/ajfa.v11i2.15740 abstract stablecoins represent the current iteration of cryptoasset development and implementation but remain an area in which further development and research is necessary to improve the reporting and accounting codification conversation. although the various iterations of stablecoins do purport to address some of the significant problems and issues preventing wide adoption and implementation of cryptocurrencies there is also some debate around the future of these cryptoassets. accounting and reporting guidelines for cryptoassets overall, including stablecoins, remain fragmented due to regulatory misunderstanding as well regulatory scrutiny over proposed stablecoin projects. what this research does is present both an analysis of stablecoins as well as put forth a number of suggestions as to how stablecoins can help drive the accounting classification dialogue forward. written with both a practitioner and academic audience in mind this research can be used to pursue further implementation and research projects moving forward. keywords: stablecoins, cryptoassets, accounting, financial reporting, codification asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 111 1. introduction stablecoins continue to generate conversation and analysis both in the blockchain and broader financial services marketplace, but there does seem to still be a level of uncertainty and confusion related to just what these assets represent. depending on the specific stablecoin in question there do appear to be several appropriate or relevant definitions that are applicable and important to further the professional conversation. taking these definitions into account, however, merely is the first step in the process of understanding and analyzing just what these types of cryptoassets mean for the blockchain and cryptoasset space at large. bitcoin and more traditionally decentralized cryptocurrencies may have led to the conversation and adoption of blockchain technology, but institutional interest and investment continues to increase. specifically as incumbent financial institutions continue to invest both financial and human capital into the development and implementation of blockchain platforms, it seems logical to predict that stablecoins will fill an important role moving forward. such increased adoption and utilization may ultimately also lead to increased clarity with regards to accounting taxonomy, but prior to a broader analysis it seems logical to revisit just what the core characteristics of stablecoins represent. 2. stablecoin analysis the development of stablecoins has been characterized by some market actors as an inevitable result and implication of how traditionally decentralized and distributed cryptocurrencies interact with the broader economic landscape (kharif, 2019). specifically the price volatility commonly associated with bitcoin and other cryptocurrencies seems to have played a prominent role in the rise of stablecoins for both individual and institutional utilization. stablecoins as an asset class attempt to resolve and address this price volatility that undermines many institutional projects. while this position certainly has merit and should be considered as a part of any stablecoin analysis it is also worth taking into account the accounting and financial reporting implications of cryptocurrencies. price volatility did play a role in the rise of stablecoins, but the continued uncertainty and ambiguity with regards to accounting classification and reporting also represents a factor that should be included as a part of any comprehensive analysis (r.f, b.h., & t.r., 2019). cryptocurrencies in the united states are not classified as currency, despite the currency labeling, and are instead classified as property for tax purposes. compounding this ambiguity is the fact that different market regulators, including both the sec and cftc, have issued guidance and comments on how these various cryptoassets should be treated and classified (thursfield, 2019). such ambiguity means that, despite the numerous comments and opinions, the appropriate classification and reporting of cryptocurrencies remains uncertain. organizations, including those in the financial services field, and those operating in other industry verticals, require certainty to make longer term decisions and investments. in this context, and keeping in mind the uncertainty that continues to exist in the cryptoasset space, defining core characteristics of stablecoins is a logical next step. first and perhaps most obviously is the fact that stablecoins purport to have lower levels of volatility than other types of decentralized cryptocurrencies. said stabilization can be achieved in any number of ways, but there do seem to be several areas leading the space forward as asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 112 stablecoins continue to develop and mature in response to institutional interest. these categories are not meant to be all-inclusive nor exhaustive, but rather should form the basis for comprehensive conversation moving forward. said categories of stablecoins include, but are not limited to, the following: 1. stabilized by fiat currencies. perhaps the most popular and simple to understand in the context of traditional financial instruments, stablecoins that are stabilized by connecting these cryptoassets to a fiat currency also appear to be the most popular iteration. while it is true that the majority of fiat linked stablecoins are connected to the us dollar the potential for other fiat linked stablecoins continues to increase. interestingly enough, and while the libra project – spearheaded by facebook but including an array of other organizations – has obtained massive amounts of coverage, this concept may not be as unique as initially thought. a. the sdr, launched by the imf several decades ago, has many of the same characteristics of libra (waller, 2019). the sdr, like libra, is backed and supported by a basket of currencies in a certain ratio, and can used to settle international transactions. it remains to be seen what ultimately happens with the libra initiative, but the similarities between the sdr and libra are both worth mentioning and intriguing. 2. stabilized by commodities. if a particular government or institution does not have a significant appetite for creating a cryptoasset or cryptocurrency supported or pegged by a fiat currency, developing a cryptoasset supported by a commodity appears to represent a legitimate alternative. gold possibly represents the most obvious and initial choice of commodity to choose for stabilization initiatives, but there are other options that may be as useful depending on the content in question. oil, other commodities, or a blend of external commodities may serve as a useful alternative, but such a structure raises the following question. a. if a stablecoin is supported or backed by a commodity, what exactly does that entail for the users of this cryptoasset? for example, if an investor wishes to exchange or redeem a stablecoin backed by gold, what does that investor receive? an investor may assume that a stablecoin supported by gold will be redeemable for gold itself, but that may not be the case. instead the investor may only be eligible to receive a gold etf or other type of derivative instrument, which in addition to representing a surprise may also undermine some of the usefulness of investing in such a stablecoin. 3. stablecoins backed or supported by a basket of fiat currencies. returning to libra for illustrative purposes, the development and implementation of stablecoins backed and supported by an array of cryptocurrencies seems to be gaining steam going forward. reasons for this may be a combination of purely financial as well as political in nature, but the message is the same; reducing exposure and affiliation to any one single fiat currency does appear to make sense in a global economic landscape characterized by political uncertainty and increasing competition on an economic basis. although these basket backed cryptoassets may indeed reduce the exposure of cryptoasset holders to any one specific currency, this scenario also raises an array of questions. a. as an example, if an investor has converted $100 usd into an equivalent amount of stablecoins but at some point in the future wants to redeem these stablecoins for fiat, how does asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 113 that process actually function? expanded upon below, the questions of redemption and redeemability remain open items for many stablecoin issuers there is also a subset of stablecoins that are stabilized by other cryptocurrencies, with the most high-profile example of such an arrangement represented by the dai stablecoin handled by makerdao. in addition to the stabilization that is a byproduct of the cryptoasset structure, a cryptoasset such as this also has perhaps the strongest connection to the concept of decentralized cryptocurrencies. while technically complex to execute and scale, such a scenario does hold potential as the broader blockchain and cryptoasset ecosystem continues to develop and mature. as of this research there does not appear to be broad institutional support for such a stabilized cryptoasset, but it remains interesting to see where such an arrangement or structure fits into the wider conversation moving forward. 4. exchange and redeemability redeeming or exchanging specific cryptoassets, including stablecoins, for either the underlying asset supporting the cryptoasset in question remains an issue that needs to be addressed by issuers and practitioners seeking to facilitate increased mainstream adoption of these cryptoassets (lee, 2018). while various stablecoins will be underpinned or supported by different assets or categories of assets, the redemption process and considerations do appear to be consistent across the range of stablecoin assets. seemingly an academic or theoretical question, the process by which individual or institutional investors can both enter into, and exit, investments into cryptoassets is a consideration that is worthy of future analysis. more to the point, and linking back to the core point of this research, if an asset or purported medium or exchange is not redeemable or is not redeemable in a liquid manner, the argument for classifying and treating these assets as currency equivalents is weakened. focusing on the current regulations and guidance, including the late 2019 release of additional information from the irs, the debate and analysis around how cryptoassets can be construed as a legitimate currency equivalent appears to hinge on how liquid and free flowing stablecoins become. 4.1 the current equivalent question cryptocurrencies, ranging from traditional decentralized options such as bitcoin to centralized and stabilized options including libra, were initially developed and marketed as technologically superior alternatives to fiat currencies. that said, in order to truly replace fiat options that currently exist it is required, somewhat obviously, that these cryptoassets be classified as treated as currency equivalents. as of this research the current treatment of these assets remains varied, with the united states classifying these items as property. what this truly means is that every time a cryptoasset – regardless of whether it is stabilized by an external asset or not – generates a taxable event and item every time it changes hands (browning & davison, 2019). whether or not a cryptocurrency is used to pay for goods and services, received in exchange for goods and services provided, or paid to employees in lieu of wages, there are additional reporting and compliance considerations that must be taken into account. in addition to these reporting items there is also the reality that income taxes will be owed on the change in fair market value of cryptocurrencies, illustrated by the following scenario.  option 1 – a u.s. consumer uses usd to purchase a pizza for $15, and pays $15 for this food product. sales tax in this jurisdiction are not applied to food, so that is not a consideration. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 114  option 2 – a u.s. consumer uses a cryptoasset to purchase a pizza that is still priced in $15 usd. assuming that the merchant accepts cryptocurrency as a valid payment option (which is not guaranteed), there are several other complicating factors that need to be taken into account. most notably are the tax reporting and payment aspects of using cryptocurrencies to purchase goods or services under the current regulatory structure. if that individual had purchased that cryptocurrency for $5,000 and used it to pay for pizza when the fair market value was at $7,500 would owe taxes on the $2,500 increase in value. no matter what specific asset underpins or supports the stablecoin itself there does appear to be a connection between the redeemability and liquidity of a specific cryptoasset and the ability of proponents to argue for treatment as a currency equivalent (parashar & rasiwata, 2019). stated another way, in order for cryptoassets – including stablecoins – to gain broader adoption and utilization by consumers as legitimate currency options it seems reasonable for consumers to expect that these items can be redeemed or transformed into fiat options with relative ease. this is where a stablecoin can attempt to bridge the gap between decentralized and distributed cryptocurrencies and the current fiat options that exist in the marketplace. while no stablecoin as of this research have been able to successfully change the classification as property to one of a currency equivalent, there does appear to be a case to made that this would be possible. at this point in time this remains a theoretical conversation and analysis, but the continued and increasing investment into this space by some of the largest financial institutions in the world it is not unreasonable to expect this conversation to move the forefront in the near term. 4.1.1 headwinds given the pace of development and refinement of the stablecoin subset of the cryptoasset space it might seem unusual that no single stablecoin has managed to successfully push the conversation forward. upon closer examination, however, there are several pain points and open items that need to be resolved prior to the ability of any product or organization to close the loops on these items (robertson, 2019). stablecoins do, in theory, represent the next stage of the tools underpinning financial transactions so it is not entirely unreasonable to expect these cryptoassets to come under some level of scrutiny. acknowledging this reality, however, is just one aspect of the stablecoin analysis, and is compounded by the fact that many stablecoin options appear to be trying to enact an alternative financial system to rival established financial markets. the scrutiny and backlash that the libra initiative and association has generated since its initial launch is indicative of this structural headwind that continues to present challenges to other stablecoins oriented and designed to either augment or entirely replace existing financial infrastructure and systems. viewed strictly through a technical or crypto-related lens it might seem unusual to see such robust and publish criticism, but that only represents a partial view that misses the bigger point. taking a step back and viewing this analysis and evolution from the perspective of financial policy makes and legislators the rise of stablecoins and decentralized financial systems creates a potential systemic risk to the current financial order. these risks are routinely cited by lawmakers in any number of countries as a core issue and problem connected to stablecoin development (cox, 2019). taking a look at libra this concern and feedback does seem to have some validity to it; the structure of the libra association and authorized resellers does seem to mirror the current version of the u.s. federal reserve system. libra reserves are going to be asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 115 held and managed by a governing body, and the only methods by which libra cryptoassets can be converted or exchanged for fiat currencies is via a designated list of wholesale institutions. such a setup seems to closely track and mirror the current setup and structure of the federal reserve (located in washington d.c.), and the regional fed banks located in the districts throughout the country. governments across the global have any number of responsibilities, duties, and obligations, but arguably the most sacrosanct is the right of a government to control and manage the currency used within its sovereign borders. much of the discourse and debate that routinely takes place in the european union is directly linked to the fact that the nations that have adopted the euro have – in effect – given up financial control over their economies. framed in that context is becomes readily apparent why regulators and lawmakers have appeared so reticent to embrace the rise of private sector stablecoins. if these cryptoassets do launch and function even partially as advertised it could potentially undermine the financial strength and sovereignty of the nation in question. these concerns are compounded by the fact that the layers of financial compliance and regulation have been developed, implemented, and tweaked based on the assumption that only financial institutions will be involved in the conversation and debate (berson & berson, 2019). technology institutions, or organizations wholly constructed to deal with cryptoassets, facebook and paxos come to mind as respective examples, simply do not have the background or expertise to contend with these thickets of compliance inherent to the financial services space. proponents of stablecoins argue that this differentiation represents a strength of the idea; financial institutions have become too inflexible, and in some cases too big to fail; fresh ideas are required to reinvigorate the financial sector (marsh, 2019). what these arguments fail to take into account, however, is that while the financial services sector continues to be augmented by technology, the financial sector plays a critical role in the global economy. financial services, and the markets at large, play an important role in allocating capital, pairing investors and content producers, and allows companies to achieve the scale necessary to compete and thrive in a global economy. privatizing such a critical component of governmental authority and enforcement, rather obviously, does not appear to be a course of action many of those in governmental positions are interested in seeing come to fruition. such resistance aside it is increasingly apparent that private or consortia based alternatives to currency and fiat capital are emerging as priorities at a number of different locations on a global basis. in order to such proposals to succeed, however, there are a number of components and factors that will have to be incorporated into any cryptoasset truly seeking to supplant crypto. 5. proposed stablecoin requirements in order for this conversation to move from a theoretical or abstract item to one that is tangible and realistic to expect from market actors there appear to be several components that will be required. this listing and factor list should not be considered to be an all-inclusive listing, nor one that is exhaustive in nature, but items that should from the basis for a robust and comprehensive ongoing conversation. said factors include the following: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 116 1. assets that can be documented and reported to external stakeholders on a consistent and continuous basis. most notably highlighted by the sage that unfolded in 2019 that eventually looped in tether, bitfinex, and crypto capital corp, the importance of being able to verify and attest to reserves cannot be overstated. by the very nature of the cryptoasset itself, stablecoins imply a stabilization factor derived from association with an underlying asset. confidence in said stabilization, however, is at least partially dependent on external verification regardless of the asset in question. 2. proof that the stabilization actually functions as advertised. stating that a particular coin or token is stabilized or is redeemable or otherwise connected to an underlying asset is one matter; actually having it work in the marketplace is a different matter entirely. financial instruments that may include hedges, futures, forwards, or simply a commitment to buy or burn (destroy) tokens to maintain a certain level or parity of ratio of value need to be published and documented. in addition to documenting these tools it should also be expected that the financial costs associated with said tools are disclosed and reported in a transparent manner. 3. custody and custodial services are provided in a manner that is both secure and does not violate the decentralized and distributed nature of blockchain and cryptoasset technologies. constructing such custodial services continues to be an area of interest and investment for institutional players, but there is one underlying consideration that remains a variable across current offerings. how does an asset holder, be they individual or institutional in nature, verify and prove the custody and provenance of a specific cryptoasset? in the case of bitcoin the ultimate proof of ownership is also the way in which an unethical actor could redirect said funds; private keys. stablecoins may have different ownership structures, but establishing how these can be held in a custodial fashion is imperative. 4. a corollary to the first necessary component is the fact that in order for any asset, stablecoin or otherwise, to be effectively used as a medium or exchange, is that these assets have a verifiable external value of this asset. in essence what this mean is that in order for the proposed stablecoin to have any lasting value in the marketplace it must be able to be used for an intended purpose. while it is unlikely that a newly issued stablecoin will have a deep and liquid marketplace that does not mean that the valuation conversation should not occur, or should only happen periodically. much like traditional assets have different levels of value depending on how liquid and transparent the marketplace is, the valuation prospect for stablecoins will need to evolve and transition over time. 5. functionality must be understood and communicated to the proposed stakeholder groups, including financial actors as well as consumer groups. as highlighted by the multiple 2019 hearings convened by the u.s. congress it is also important to ensure that information and data is communicated to regulators and various oversight bodies that are going to be involved in the regulatory and legal conversation. ensuring that information is produced and communicated to the different regulators and stakeholder groups are going to obviously occupy a large amount of initial time and energy for management professionals, but this is one that cannot be overstated. being in compliance with the different legal and other regulatory compliance mechanisms is something that must be completed. financial markets and financial services do tend to have large amounts of compliance for the simple reason that financial services have a asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 117 large impact on the economy. compliance by its nature can restrict growth and innovation, but also serves an opportunity to safeguard the financial assets and rights of the users. 6. accounting considerations and clarifications mentioned above one of the largest open items and considerations that still remains unaddressed in the current marketplace is the lack of accounting standards and codification in the broader cryptoasset landscape. until these issues are resolved in one way or another, but ideally in a manner that does not burden users and financial actors with undue compliance requirements such as those that currently exist with the treatment and classification as tax property, adoption does seem posed to accelerate (bruno & gift, 2019). accounting, reporting, and taxation requirements still do occupy large amounts of professional time in financial services circles, and that is because of the importance of having financial and accounting information that is useable to external parties. at the core of the idea as it connects to accounting and financial markets is the importance of accounting information to be consistent, clear, and comparable to other asset classes and information. accounting information systems as they connect to cryptoassets and financial information must be able to produce clear, concise, and comparable information. as it connects to the reporting of cryptoasset information it is also important to recognize the fact that a core component of how data is communicated is, in turn, based on the functionality and use cases connected to different financial markets and information. while certain cryptoassets and other cryptocurrency information may be labeled and thought of as currency alternatives they do not function nor are they currently treated as such under current market guidelines and information. many of the current tools including the broader cryptoasset class are, although labeled as currency, are not treated as such from a financial reporting or taxation point of view. this paradox poses a substantial headwind to broader adoption and implementation. stablecoins, especially ones that are created and organized to operate legitimately as currency alternatives, may provide a realistic option to assist with making the case for an accounting classification. depending on the use case or application of these stablecoins, such clarification might also highlight the applicable and usability of stablecoins for other purposes such as charitable giving (searing & macleod, 2019). linking back to the to the necessary components for a stablecoin to operate as advertised there are a few statements or points that should be communicated in order for this conversation and position to make sense. first and foremost the stablecoin must actually operate as advertised and be stabilized, regardless of what specific asset in question is used as the stabilizing agent. the peg itself, nor the asset used to stabilize the coin, is as important as the fact that the pegging or stabilizing functionality performs correctly. if a cryptoasset is meant to be developed and ultimately utilized as a legitimate currency alternative it must be able to be exchanged, redeemed, or otherwise linked to the asset in question. one of the largest arguments against the adoption and utilization of cryptoassets for the purchasing of goods and services is the price volatility so commonly associated with bitcoin and other cryptocurrencies. this very price volatility and action is also a leading reason as to why cryptocurrency products such as etfs have faced such severe headwinds toward adoption and acceptance. addressing this issue and doing so on a consistent basis is a critical structural aspect that must be solved. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 118 a second argument that could be made for reporting and classifying specific stablecoins as different classes of assets is to determine how these assets are to be used, or what the use case for the specific asset tends to be. different organizations will hold and use certain types of cryptocurrencies and cryptoassets for different uses so it does tend to make sense that different types of stablecoins will be developed as a result. this trend is already beginning to emerge represented by the development and implementation of utility and security token classifications. without delving into unnecessary technical details, the difference between the utility and security tokens can be distilled into the following. utility tokens, in essence, operate as an equivalent to coupons or other types of native tokens that grant the token holders access to the goods and services of the organization. security tokens, contrastingly, operate as close equivalents to equity securities in so much as they tend to be traded externally, have external value, and often are linked to the profits and management rights of the organization. different classes of stablecoins, including some of which might indeed remain classified as intangible assets may not be as radical an idea or concept as it might initially appear. assets are classified, including cash, inventory, and prepaid equipment, already presented and classified dependent both linked to how the assets are used at the business itself. stablecoins and different versions of stablecoins could just as easily grow and be differentiated as the ecosystem matures. they need not all be classified as currencies, and may very well be judged and classified by how they function in addition to whether the stabilization functions as advertised. 7. forward directions ultimately the case for stablecoins to lead the conversation forward is based on a number of factors and the flexibility that the cryptoasset model creates. coins and cryptoassets can be created stabilized by any number of external assets, or even other cryptocurrencies themselves, and this inherent complexity also can simplify the debate moving forward. stablecoins address, simultaneously, two of the biggest problems that have continued to plague the broader cryptoasset ecosystem; price volatility and uncertainty with regards to business use. stablecoins or asset backed coins – whichever label ultimately succeeds – by the very nature of being stabilized cam assist in addressing the price volatility that continues to prevent broader consumer and commercial adoption. building on this ability to address the price volatility linked to many cryptocurrencies also assists in developing and refining the specific use cases for these assets, including the accounting classification and codification of cryptoassets at large. whatever the outcome of these conversations are, it will remain an intriguing and important are for both practitioners and academics to continue examining for the foreseeable future. references berson, d., & berson, s. 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(2019). facebook open to currency-pegged stablecoins for libra: reuters. bloomberg.com, n.pag. copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 18707-article text-65842-writer2-new dire receive doi:10.5 abstra diversit effectiv differen firm. h and firm diversit generat concept ctor’s a tunku p tunku pute scho ed: july 5, 2 5296/ajfa.v ct ty of board veness. it c nt values, k however, ea m performa ty, research ions carry i t, age diver age di puteri intan eri intan sa ool of econo 4 2021 a 13i2.18707 members h an be post knowledge a arlier studie ance. this hers must ca its own com sity should iversity pe mazrah ma safinaz sch 06010 s e-mail ayo afinaz schoo 06010 sin e-mail: a saidat omics and m 43300 serda e-mail: sai 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e on corpo e long-term s. furtherm oard structu ointments, i ’s approval. attention, no because th e effectiven ; horvath & an be viewed ng the direc viduals whic . diversity o by having uitful discus fs that a hom ersity, they has now ex oint that the & rindova, recognize e top public & kakabad ates and th n journal of f on in the ea in many c tter’ corpor s sarbanes mphasis on ectors which rbanes oxle advisory and the company ce (2017) re e (9) years just their n the compa stulated by h tegic directi orate gover success of more, as th ure, most m internal con . therefore, ot only by r he perceptio ness of the b & spirollar d as having ctors (peche ch can cont of board me several dif ssions and mogenous g can bring xpanded to board shou 2001; abdu the benefit c listed com dse, 2019). m he european finance & ac issn 19 2021, vol. 1 ajfa.macro arly 21st cen countries in rate govern oxley ac board of d h is consist ey act (20 d compensa ny or any sub equires inde only, amon oversight any’s opera hambrick & ions and im rnance (201 a company he highest main decisi ntrols and s , in recent y researchers on is that b board and t ri, 2012; ga g a mix of ed ersky, 2016 tribute and embers can fferent pers exchange o group of ind g in several other stake uld be comp ullah & ku ts of diver mpanies to meanwhile n union ha ccounting 946-052x 13, no. 2 think.org/ ntury can ncluding nance by t, 2002; irectors’ ent with 002) has atory fee bsidiary. ependent ng other role to ations, in & mason mproving 17) also y and the internal ions are strategic ears, the but also board of thus, the avrea & ducation 6). each enhance improve pectives of ideas dividuals l inputs. eholders prised of u ismail, sity, for improve , several ave now required laksma policy o shrader effect it age is have co tradition people generat by the b the s&p compan half of director study in 2007 re and the average malays executiv & marim average recent s by a pr (2020) represen (based o into the showed only 5 boards a the max previou limited perform gavrea studies, concept corpora d corporatio ana & lee, of 30-percen r (2003), div t has on firm recognized ommonly cla nalists, baby of the same ion) and un board gove p 500 in 20 nies with an the s&p 50 rs in their 50 n malaysia evealed that mean is alm e age of be ia consisted ve directors muthu (201 e age of boa study titled rivate invest had found ntation. the on market c eir gender an d that 95 per per cent of are becomin ximum age usly, the ma d empirical mance (see & stegerea , especially tual framew ate entity. a ons to disc 2015). in m nt women o versity may m’s perform d as one dis assified ind y boom, ge e age gener ique (as com ernance res 017 had fou n average ag 00 boards h 0s, 60s and by abdulla the minimu most 58. it etween 50 t d of middle s or ex-gove 6) of 60 list ard member ‘detailed a tment firm that malay e study had capitalizatio nd age diver r cent of dire f directors a ng ‘older’. r e limit for aximum age studies ha for exampl an, 2012) an y those con work of the as noted by close their b malaysia, the on the board y be a highly mance is less stinct charac dividuals acc eneration-x ration have mpared to ot search llc und little di ge of all bo have three d 70s. simil ah & ku ism um average has also be to 59 years e to retire-a ernment off ted compan rs is 59; wh analysis on rhl ventu ysia’s corpo d assessed 8 n on bursa rsity, educat ectors are ag are aged be recently, th directorship of director ave been c le abdullah nd the eviden nducted in m e relationsh carter, sim 92 board diver e prime min d by 2016. y visible eff s clear. cteristic am cording to d x, generatio been postu ther generat c based in th ispersion in oards was 6 decades repr lar scenario mail (2013) age of the b een found th s old. the aged group ficers, comm nies between hile the low malaysia’s tures based orate board 873 director malaysia) i tion, career, ged 40-plus elow 40. cu he new mala p and has rs is seventy conducted o h & ku ism nce has been malaysia. t hip between mkins & sim asian rsity practic nister has a however, a fort to demo mong individ different age on-y and ge ulated to ha tions) chara he u.s on th n the averag 62.4. within resented on o can also be ) of 100 top board is 49, hat almost 7 study also members w monly politi n the years 2 west is 49 an top 100 c in malaysi drooms lack rships from in 2020, whe , and other r (with most umulatively aysian com set the mi y (70) under on the effe mail, 2013; n mixed, wh this paper n age diver mpson (2003 n journal of f ces conside nnounced o as noted by onstrate disc duals. rese e generation eneration-z ave common acteristics. in he boards o ge of directo n individual n their board e found in m p listed com , while the m 75 percent o observed th who have pr icians. a lat 2009 to 2013 nd the highe ompanies b a, cited fro k diversity malaysia’s ereby exam related expe aged in the , this signa mpanies act nimum age r the compa ct of direc ; horvath & hich suggest is proposin rsity and th 3): finance & ac issn 19 2021, vol. 1 ajfa.macro ering this ( on 27th june erhardt, w crimination, earchers in ns (cohorts) z. at the sam n (among th n a study co of companie ors in the s l boards, m ds, most com malaysia. a mpanies for maximum a of the board hat most bo reviously se ter study by 3 had found est is 71. in board comp om the born in gender s largest com minations we eriences. th eir 50s and 6 als to users 2016 has ab e of eighte anies act, 1 ctor's age a & spirollar ts the need f ing a more he perform ccounting 946-052x 13, no. 2 think.org/ harjoto, e 2011, a werbel & , and the the past ) such as me time, he same onducted es within s&p 500 ore than mmonly an earlier the year age is 68 d has an oards in erved as y hassan d that the n a more position’ neo post and age mpanies ere made he results 60s), and that our bolished en (18). 965. and firm ri, 2012; for more refined mance of “….give the rela theoreti furtherm relevant otherwi more ef differen (creary inconsis director limited firm pe (2013) within m more st and dom contrary 2. liter 2.1 firm previou governa affect f 1992; h leadersh butler, reid, 2 gourlay there a that the decision mitigati lorsch, part of t be cons secure c a small accord associat (1992) happeni en the emph ationship b ical and emp more, as hi t in the bu ise, it is jus ffective, bo nt voices, in y, mcdonn stencies in rs, while the studies hav erformance and hassan malaysian tudies are to minance of y to develop rature revi m performa us studies c ance mecha firm perform hermalin an hip structur 1985; wei 2003; shuke y and seato are mixed re e size of the n making in ing the effo , 1992), but the managem structive for critical reso l board of ing to jen tion and co believed th ing among m hasis being p between bo mpirical inve ighlighted b usiness env st a ‘tokenis oards need ntegrates co nell, ghai measuring e basic conc ve also been especially i n & marim corporation o be conduc f family-ow ped countrie iew ance conducted o anisms. am mance are b nd weisbac re, independ sbach, 1988 eri and sha n, 2004; na esults regar e board doe n a compan ort problem when they ment proces r some com ources and re f directors nsen (1993) ommunicati hat small siz members of placed on b ard diversi estigation” ( by abdullah vironment i sm’ or a sim to have a m ontrasting in & scrug age divers cept of diver n conducted in malaysia muthu (2016 ns, distinct cted in mal wned firms es which ha on firm pe mong the co board size ch, 2000; z dent non-ex 8), firm siz aari, 2012; achum, 2004 rding board es matter as ny (monks a and in beco grow too bi ss (hermali mpanies as t educe envir improves f ), smaller ion, co-ope ze of board f boards. 93 board divers ity and sha (p. 35). ah & ku ism if it helps mple ‘comp more egalit nsights, and ggs, 2019). sity, whereb rsity looks a d to examin a, the excep 6). with th from those laysia. high are among ave disperse erformance ommon fact (see for ex emzem and xecutive ch ze (see for e abor, 200 4; santalo a size and pe s it affects and minow oming more ig, boards b in and weis they provid ronmental u firms’ perf groups of eration and d may prev asian sity as part o areholder v mail (2013) in enhanci pliance’. in tarian cultur d welcomes . earlier s by it has b at the inclus ne the effect ption are th he unique o of develop h ownership g the chara ed ownershi have alway tors identifi xample jens d kacem, 2 hairman (se example eh 07) and div and becerra erformance the extent o w, 1995). sm e effective become mor bach, 2000) de diversity uncertainties formance (z boards are coordinatio ent free-rid n journal of f of good corp value creat ), board div ng the boa order to m re, which i conversatio studies hav been based sion as well t of director ose by abd wnership s ped countrie p concentrat acteristics o p (thillaina ys related ied in previ sen, 1993; l 014), non-e e for exam hikioya, 200 versification a, 2008). . empirical of monitorin mall boards (jensen, 19 re symbolic ). however, that would s. there is s zemzem an e assumed on while, l ding and cha finance & ac issn 19 2021, vol. 1 ajfa.macro rporate gove tion deserv versity can ard’s effect make diverse is one that ons about d ave suffere on average l. in addition r's’ age dive dullah & ku structure tha es, it is hop tion, cross h of malaysia athan, 1999 it to the c ious literatu lipton and executive d mple baysin 09; bernad n (see for e l evidence i ng, controll are said to 993; and lip c rather than , bigger boa d help comp strong evide and kacem, to produc lipton and hallenges of ccounting 946-052x 13, no. 2 think.org/ ernance, ves both only be tiveness; e boards elevates diversity ed from e age of n to this, ersity on u ismail at exists ped that holdings an firms ). orporate ures that lorsch, directors, nger and dette and example ndicates ling and o help in pton and n being a ards may panies to ence that , 2014). e easier lorsch, f interest non-ex expecte the dire on the b proport effect o director xiao-la associat evidenc non-exe known compan relation shareho non-exe financia executiv (haniff presump not sele legitima hence, perform evidenc studies perform perform study fo with sep single p (abdull past res perform organiz non-exe executiv organiz role in c ehikioy perform bernade xecutive dire ed to bring in ectors (abdu board, prior ion of non-e on the firm rs on the c an (2006) r ted with the ce suggestin ecutive dire as bursa nies’ board nships with olding and c ecutive dire al reporting ve director fa and huda ption that in ected based ate busines they do not m the role ef ce on the rel provided mance. in m mance of m ound that fir parate board person led to lah, 2004). search has a mance of co zations perfo ecutive dom ve chairma zation by ke controlling ya (2009) mance since ette and re ectors are c ndependenc ullah, 2004) studies doc executive di m performan company bo revealed tha e probabilit ng the adv ctors on boa malaysia) ds that we the presenc ceo dualit ectors had le g timeliness rs in malay ib, 2006; ra n most deve d on their ex s activities t function as ffectively. lationship b evidence o malaysia, m malaysian fi rms that had d leadership o financial r also figured orporations form better minated chai an can act eeping basic managemen had found e it can gen eid (2003) w commonly ce into the b ). despite th cumented m irectors and nce for kor oard. simil at a larger ty of distres vantages an ards. a stud main boar ere domina ce of large ty. meanwh ed to better s (abdullah ysia had no ahman and m loping coun xpertise and and for co s monitors d between ceo of a positiv many studie irms (rahm d duality ro p (rahman a eports being out the influ . for insta financially irman as co a vital pa c points. ou nt compared that firm nerate more which found 94 known as board and ad he advantag mixed results d firm perfor rean listed ar finding proportion ss. several nd disadvan dy by abdul rd listed co ated by no shareholde hile, other s auditing sy h, 2006). ot influence mohamed a ntries, includ d experienc ontacts and due to the la o duality an ve relations es show th man and ha oles were no and haniffa g issued mu uence of no ance, baysin with outsi ompared to art in crea utside indep d to inside c size has revenue an d that a tra asian ‘non-emplo dd to the div es of having s pertaining rmance. cho firms as a was also f of non-exe studies in m ntages of h llah (2002) ompanies s on-executive ers, while n studies foun ystems (sall however, o ed the perf ali, 2006). t ding malay ce, but more d contracts ack of exper nd firm perf ship betwee hat duality aniffa, 2005 ot performin a, 2005). in uch later than on-executive nger and b ders who a insiders (ex ating variou pendent chai chairman (w a significa nd high lev de-off exist n journal of f oyees’ or ou versity of sk g more nonto the relati oi et al. (200 result of h found in ch ecutive dire malaysia pr having a h involving th showed tha e independ negatively r nd that a hi leh et al., 20 other studie formance o the argume sia, indepen e often for (haniffa a tise and kno formance ar en duality roles have 5; abdullah ng as well a addition, fir n those with e and indepe butler (198 are placed a xecutives) d us strategic irman is ass weisbach, 1 nt positive verage. this ts between finance & ac issn 19 2021, vol. 1 ajfa.macro utside direc kills and exp -executive d ionship betw 07) found a having inde hina, zong ectors is ne resent contr high percen he klse (c at malaysia dents had related to d igher percen 005), and im es found th of malaysia ent was base ndent directo political re and hudaib owledge req re also mixe of roles a no impact h, 2006). as their coun rms domina h separation endent chai 85), conclud as independ dominated, c decisions sumed to ac 1988). e relationsh s is consiste the firm’s ccounting 946-052x 13, no. 2 think.org/ ctors are pertise of directors ween the positive ependent jun and egatively radictory ntage of currently an listed positive irectors’ ntage of mproved hat non an firms ed on the ors were asons to , 2006). quired to ed. some and firm t on the another nterparts ated by a n of roles rman on ded that dent and for non s in the ct a vital hip with ent with size and perform firm. in higher p large fi improve relation monitor evidenc among firms ha burgers product that firm the pres 2.2 boa under t japan a the ma respons structur other no only res matters organiz earlier perspec function 1976; f minima actions the firm director making director their ov indepen director early 20 for exa govern things. mance that i ndirectly it potential of irms can ut ed firm perf nship betwee ring ability ce also indi them (gour ave operatio s (1989) co ts or service ms in devel sence of the ard of direc the two-tier and netherla anagement sible in mo re as practic on-executiv sponsible to relating to zation. literatures ctives. this n to the ma fama, 1980 al involvem and decisio m’s resourc rs are respo g decisions t rs under the versight role ndent from t rs relates to 000s have fo ample, the s nance (2002) is, increase is said that f communic tilize their formance. a en board siz pursue high icate that di rlay and se ons in more ontend that es in genera oping coun e commodity ctors as cor r board stru ands requir board perf onitoring th ced in count ve directors o communic strategy, pe on the b theory view anagers to m 0; fama & ment in the ons. on the o ces for their onsible to m that may ha e agency the es. based on the managem o this theory ocused on e sarbanes ox ), both focu (decrease) t larger firm cation confl resources e a study by a ze and lever her leverage iversified st eaton, 2004; than one in diversificati ating the rev ntries would y sectors. rporate gov ucture such e the board forms the e he managem tries such as sit on the cate to stake erformance, board of di ws the resp mitigate the jensen, 19 corporate e other hand, r own bene monitor and ave a negati eory focuse n the theory ment, comp y. furtherm nhancing th xley act (20 us on definin 95 in firm size m size has b licts. as rep efficiently abor (2007) rage. the stu e to raise the trategy cou ; nachum, 2 ndustry (san ion may im venues. nac d be better o vernance m as the ones d of supervi executive fu ment board s malaysia same board eholders, bu , planning, directors mo ponsibility o e agency co 983). the th entity, they managers h efits at the d control th ive impact s on the ind y, the board pany, and sh more, many he independ 002) in the u ng and appo asian e reduces (r better sourc ported by s and minim ) reported ev udy argued e value of th uld be used 2004). dive ntalo and be mprove firm chum (2004 off by adopt mechanism s practiced i isor to appo unctions, w d. meanwh and many o d. therefore ut they are a resources a ostly discu of the direc ost within a heory is be y have limit have the opp expense of he managers on the shar dependence d is suggeste hareholders. reforms on dence of the u.s and the ointing indep n journal of f raises) the p e of ideas a shukeri and ize downsi vidence in s that large b he firm. to enhance ersified stra ecerra, 2008 m performan 4) on the oth ting diversif in countries oint the boa while the su hile, under other countr e, the board also respons and standard uss accordin ctors is to p an entity (je cause share ted informa portunity an f sharehold s from takin reholders. t of the direc ed to includ . the concep n corporate board (and malaysian pendent dire finance & ac issn 19 2021, vol. 1 ajfa.macro performanc and knowle d shaari (20 ide risk, lea support of a boards with e firm perfo ategy is iden 8). kim, hw nce through ther hand ad fied strateg s such as g ard of mana upervisory b the unitary ries, execut d of director sible in deal ds of condu ing to the provide mo ensen & m eholders ha ation on ma nd motivatio ders. theref ng any acti the effectiv ctors in per de directors ept of non-ex e governanc its sub-com code on c ectors, amo ccounting 946-052x 13, no. 2 think.org/ ce of the edge but 012) that ading to positive superior ormance, ntified if wang and various dvocates y due to germany, agement. board is y board ives and rs is not ing with ct of the agency onitoring meckling, ave very anagers’ on to use fore, the ions and eness of rforming who are xecutive ce in the mmittee). orporate ng other in contr work di of share self-actu internal commit steward combin meanw legitima pfeffer focusin for man transact therefo bring a 2.3 boa board d director represen people. appreci backgro as a var are obse (cogniti 2003). d and per engen ( related t and dis heterog represen refers to board d creativi furtherm homoge allows increase rast, the stew iligently (do eholders, in ualization ( l personnel tment to th dship theory nation of ind while, the res acy, advice & salancik g on broade naging exte tion costs a ore, based o difference t ard’s divers diversity ha rs with diff ntation (ba however, ated based ounds and e riety in com ervable (dem ive) such as demograph rceptions th (2013) class to informati parity has b geneous thu ntation of n o having a v diversity ha ity and inn more, dive enous board the board t es firm’s ab wardship th onaldson & n order to ac (davis et a has more in he success y), it can b dependent a source depen and couns k, 1978). th er aspects o ernal depend associated w on the theory to the comp sity as been defi fferent char asaglio, 201 as highligh d on skills xperiences mposition of mographic) s knowledge hics charact hat will infl sifies divers ion and dec been relate us, the boa not only sha variety of m as been arg novation an erse membe d (arfken et to provide bility to reco heory views & davis, 199 chieve highe al., 1997). t ntimate kno of the firm be conclud nd executiv ndence theo el to the fir he theory lo of directors’ dencies, red with environ y, the direct pany. ined in seve racteristics. 12), whereb hted by ba each indi in their life. f the board ) such as ge e, values, pe eristics are fluence the sity into var ision makin d to statusard should areholders b members on gued to en nd creates ers might a t al., 2004). a wide ran ognize the n 96 managers a 94). the man er personal therefore, b wledge of t m. based o ded that bo ve directors. ory views di rms (hillma ooks beyond responsibi ducing envi nmental inte tors should eral ways, b the basic by the boar asaglio (201 dividual pos . kang, che of directors ender, age, r erception an claimed to decision-m riety, separa ng, separatio -related pro reflect tha but also oth the board (v nhance the effective also ask qu . as claime nge of know need of the s asian as good stew nagers are a outcomes o board of di the organiza on these tw ards should . irectors as r an et al., 20 d the monit lity. the bo ironmental erdependenc be appointe but in gener concept o rd should b 12), the ben ssesses thr eng & gray s. two gene race and eth nd personalit be associat making proc ation and dis on has been ocesses. the at society. her stakeho van der wa understand problem-so uestions th d by harjot wledge and stakeholder n journal of f wards who a argued to ac of achievem irectors com ational oper wo theories d be consis esource pro 000; hilma toring roles oard is view uncertainty cy (pfeffer ed among in ral it can be of diversity be represent nefits of di rough diffe (2007) defi eral classifi hnicity and ty (erhardt, ted with cog ess, and th sparity, whe related to so e fact that t a diverse olders. simp alt & ingley ding of the olving (car hat would n to, laksman d skills and s. finance & ac issn 19 2021, vol. 1 ajfa.macro are trustwo ct in the best ment, affilia mprising m rations and a s (i.e., agen sted of a b oviders that an & dalzie of the dire wed as a me y, and redu & salancik ndividuals w e defined as can be re nted by a m iversity nee erent career ined board d ications of d the non-ob , werbel & gnitive base hus quality. ere variety h ocial catego the society board allo ply, board d y, 2003). in e market, in rter et al., not be que na & lee (2 d at the sam ccounting 946-052x 13, no. 2 think.org/ rthy and t interest ation and mostly of a deeper ncy and balanced supplies el, 2003; ectors by chanism cing the k, 1978). who can s having elated to mixed of ed to be r paths, diversity diversity servable shrader, es, value dijk & has been orization itself is ows for diversity general, ncreases , 2003). eried by 2015), it me time, 2.4 age age has areas ha on the l related innovat concept generat were bo expecte were le hence, career w careers 2017). taught t may be one-oneye-to-e meanw baby-b which t signific optimis for thei meyer, they are persona (kane,2 (dankle gen-xe fits the gen-xe complex profess this ma technol come as their pr their car is a nor generat e and gener s been recog ave classifie lines dividin to unique tions of its t. people bo tion" becau orn during t ed to have a ed to be har they consid with one co than those o besides tha to respect au e less tech -one interpe eye (kane, 2 while, those oomers got they were cant events stic, followin ir hard-wor 2015). the e also respo al gratificati 2017). how efsen & me ers (those bo m well du ers are the x generation ionally, this ay be becau ogy busines s no surpris redecessors reers and m rmal, accept ions (i.e., b rations gnized as on ed individu ng one gene characteri time-period orn before m se children the most dev a tough life d-working, der work as mpany. in o of the young at, being ra uthority, and hnologically ersonal skil 2017). e born in their names born (dan that affect ng the indep rk, idealism ey are more onsible for ion, which wever, boom eyer, 2015). orn in mide to their first gener n and some s generation use they hav sses and the e that gen-x (jennings, maybe even m ted method aby boomer ne distinct c uals based o eration to th stics which d. psycholo mid-1940s a 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politi y and loyal roup is mor less likely to ey expect th c environme team-player generation more accust mid-1960s a ed mark in t 015). the b y grew up i n. like tradi peace in t en to change ” (a.k.a gen sense of ent tivated and are known f ant nature ( omfortably en-xers as s n authority corporate do ge, establish heir work an ct to have m lefsen & me nt for gen-x different co n journal of f dividuals. r er, no conse each gener unique ev ween genera alist, also kn n and not he r nation’s hi ical uncerta (danklefse re likely to h o change jo he same loya ent, the sile rs. even tho s, but they tomed to d are known the birth rat boomer gen n a time wh itionalists, b the workpla e than the p neration-y) titlement in show long for being en (danklefsen with techn elf-indulgen and to be sk ownsizing, hed compani nd careers v multiple em eyer, 2015), xers (jennin ommunicati finance & ac issn 19 2021, vol. 1 ajfa.macro researchers ensus (as ye ration has a vents, settin ations is no nown as 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ecision-mak nes, 1995; m capital prov alth which c role of boar nce roles. t e involved i y role can en e decisions ver the dec firm perfo formal and d g-term persp ion-y can als . unlike the williams, 20 p in a time t attributabl e ability to ). in other lly collabor aracteristics rting in the m this genera te their obvi ns and are ac a global bus nd hypoth rd diversity dependence nder the ag s of the firm etween the e (pfeffer 19 because it pr er, 2001). m e contracts w eman 1983, ded as one king process mitchell et a viders to th can be achi rd of directo he board is in the strate nhance the p s are under isions. upp ormance is 98 direct. they pective that so be called e baby-boom 013). this g e when the le to the fac o access inf words, the rative, talen well-suited mid-90s to ation tend to ious techno ccustomed t siness envir hesis develo and firm pe e and stakeh gency theory m. under the firm and th 973; pfeffer rovides a lin meanwhile, with variou 1984; dona of the man s (clarkson, al., 1997), h he firm, sh ieved throu ors under th not only re egic decisio performance the respon per echelon s affected b asian y rely heavil t their senior d “generatio mers, this g eneration w e largest nu ct that this g formation a ey are mult nted and op d to the new the early ’0 o be indepen ology profici o engaging ronment. opment erformance holder theor y in reducin e resource d he external r & salanci nk with the e the stakeho us social co aldson & pr ny stakehold , 1995; don hence the bo areholders ugh better f he unitary s sponsible to on-making e of the com nsibility of n theory by by the top n journal of f ly on e-mai r colleagues on me” beca generation is which is also umber of h generation g almost anyw i-taskers w pen-minded w economy. 00s) are pois ndent, as a r iency, genwith friends can be exp ries. as age ng the infor dependence resources t ik, 1978) an external env older theory nstituents a reston, 1995 ders whom aldson & pr oard works h expect thei 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expecte ther hand, d iefs; and th n. therefor board’s discu ng. vroom while risk formance (h members are improve pr more inclin an be related might be bias ustomers an s generation furthermore hment to m gs on the eff esämaa, k erage age an s&p 500 in onship betwe ange in 2010 aysia, abdu ard and ro f et. al (201 st, hassan d with roe o be insignif measuring r example h ysian studie ullah & ku less than 60 ment is con ty argument asian cisions and alth. formance c argued tha e-aged mem whilst young ed to bring directors of t herefore, ha re, board wit ussion and & pahl (19 k taking is e hassan & m e more wil rospects. h ned to adop d to the pos sed towards nd others hav n. having th e, younger m anagement fect of direct klaesson, h nd its effect ndex compa een age and 0, gavrea e ullah & ku i oa, but is 13) found a & marimut e and tobin ficant with r age diversi horvath & s by abdul ismail (201 0 years, and nsidered to b ts which foc n journal of f actions of t can be relat at older 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(2004 l o doi.org/10.1 , d. & barb of corporate doi.org/10.2 sky, a. (20 e board doi.org/10.1 aa, o; klae mance: the c , j. (1973). zation envi doi.org/10.2 , j. & sala ence perspe o, j. & bece mance lin doi.org/10.1 es oxley ac i, s. w., sh mance? evid 20-127. http nathan, r. ( s, mechanis ate governa ach, m. s. (1 -460. https: ms, r. (2013 nials loo www.psych eration. mohd iskand evidence 17576/pengu minow, n. 4). geograp of 1111/j.1467 ber, b. m. e acquisitio 2307/26671 016). divers performanc 1515/stcb-2 esson, j. & case of gnos size, comp ironment l 2307/23916 ancik, g. r ective. new rra, m. (200 nkage. th 1111/j.1540 ct. (2002). r hin, o. w. & dence from ps://doi.org/ (1999). cor sms, agent ance. 1988). outsi ://doi.org/10 3). is gen y ok dim. hologytoday dar, t. & rah from m urusan-200 . (1995). co phic and ind manageme -6486.2004 (2001). cha ons in the 1 26 sity in boa ce. studia 016-0009 & haahti, sjö region in position and linkage. a 68 r. 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(2000). lo sigmod 1145/34200 21, april 1 nations. n journal of f ategic impli zed ranking atures of u y built-in b uggest the f ation. prosp o the exten rankings, a f the various , their assig ccommodate l for diver ablished col ver time, th pplied to pri for admini ngs/united-s e as a ities-qs-rank review of l nitive co & martens 5.10069v1. of: identify internation 09.335388 5). nice: arxiv.org/ finance & ac issn 19 2024, vol. 1 ajfa.macro lications are gs. for exam us mba pr biases or con following. pective user nt that apply college cou s variables o gned weight e changes i rsity and in llege rankin he method p rior, earlier v istrators loo states/2024, kaggle kings-2025/ local outlie computing, s, d. 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(2022). ternational doi.org/10.1 2021). deve y asses ncl, r. w. college ra in 9336-9 anations an d knowl 00831-6 reputation 009/08/19/r niversity ra own, a. l. in asia-p 1-16-2327-1 unified ap o, h. wall an a d-approachasian 2019). a fi center on handle/1082 (2022). m ccess.202 on doctor journal of july 9). a ional journ 7/s12008-02 a data ana journal 1007/s12008 eloping a m ssment (2014, may ankings: wh higher d how to fi ledge di without eputation-w anking gam . goodwin pacific. sin 1_91-1 pproach to in lach, r. fe associates. -to-interpret n journal of f irst try at r education a 22/1060569 odel-agnos 22.3177783 rs, mechan f economic a data anal nal on inter 22-00966-2 alytics appro on interac 8-022-0096 method for reports, y 18). mod hat would it educat nd them: lit iscovery, rigor. without-rigo mes in east , & a. gr gapore: sp nterpreting rgus, s. vi retr ting-modelfinance & ac issn 19 2024, vol. 1 ajfa.macro roi: rankin and the wo 9/college_r stic counte nics, and c c literature lytics appro ractive des oach for un ctive desig 66-2 evaluating 3(1), deling chan t really take tion, 7 terature rev 38, 277 retrieved or asia: trigg reen, inter pringer, sin model pred ishwanathan rieved -predictions ccounting 946-052x 16, no. 2 think.org/ ng 4,500 orkforce. from roi.pdf? erfactual omputer e, 44(1), oach for sign and niversity gn and g global 1-19. nge and e to be in 761-769. view and 70-2824. d from gers and national ngapore. dictions. n, & r. from s.pdf mcgrat interpre http://a molnar nagy, m persona 274-300 ponton, private doi:http ribeiro predicti confere associa rodrigu in ran doi:http rybinsk an ana doi:http salimip canadi https://p thadde ranking https://w wachte openin techno waters, admiss zhang, potentia journal th, r., cos etable cre rxiv.org/abs , c. 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( vention. int ://doi.org/10 024). finan ies in the /10.5296/jse ngh, s., & ny classifi nowledge d omputing m ozkul, a. s illustrative /10.1080/25 wodecki, a. 00 univers /10.1080/08 (2023). co nference ticscholar.o 22, february columbia.ed elstadt, b., k box: aut 41-854. ikkulainen, agazine, 35( j., lv, c., behavior pa zation, 26, 7 ., sweeney lication p 45. retrieve ble machine (2024). inte ternational 0.1007/s405 ncial return united s e.v14i1.215 guestrin, c ier. procee discovery a machinery. s., & mark e case of 573234x.20 (2022, mar sities in go 8841241.202 unterfactua on a rg/3c3c/2b7 y). an inves du/~thaddeu & russell tomated de r. (2014). (1), 64-75. , lin, y., & atterns in o 723-741. do 13 y, p., kami predictions ed from http e learning. erpretable d journal of 593-023-00 n on inves states. jou 67 c. (n.d.). w edings of t and data m ks, b. a. (20 state ran 019.1605312 rch 13). are oogle tren 22.2049952 al explanat artificial 75ea9b6b04 estigation of retrieve us/ranking/ l, c. 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( online learn oi:https://do asian iab, f., sh with c p://arxiv.org dropout pre f artificial i 331-8 stment: an urnal of s why should the 22nd a mining, kdd 019). expla nkings. jou 2 e university nds and the 2 ions for r intellige 4127e56d2f f the facts b ed investigatio 8). counter d the gdpr machine l (2022, nove ning based o i.org/10.100 n journal of f hen, z., & counterfactu g/abs/1811.0 ediction: to intelligence analysis o studies in i trust yo acm sigk d san fran aining the im urnal of b ranking and e qs ranki rankings. p ence. r fd80a7e191 behind col on.html rfactual exp r. harvard learning su ember 5). v on counterf 07/s12650-0 finance & ac issn 19 2024, vol. 1 ajfa.macro lecue, f. ual expla 05245 owards xa e in educat of the topeducation, ou?: explain kdd inter ncisco. new mpact of pr business an d popularity king in 201 proceedings retrieved 175104.pdf lumbia’s u. planations journal of upport for g visual anal factual expl 022-00899ccounting 946-052x 16, no. 2 think.org/ (2018). anations. ai-based tion, 34, -ranked , 14(1). ning the national w york: redictors nalytics. y related? 12-2020. s of the from f s. news from without f law & graduate lytics of lanation. -8 microsoft word 18704-65828-3-sm-writer2-new-final asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 1 performance of shanghai composite index and sector indices in the beginning of novel coronavirus pandemic venus khim-sen liew (corresponding author) faculty of economics and business, universiti malaysia sarawak e-mail: ksliew@unimas.my chin-hong puah faculty of economics and business, universiti malaysia sarawak e-mail: chpuah@unimas.my received: april 5, 2021 accepted: june 1, 2021 published: june 1, 2021 doi:10.5296/ajfa.v13i1.18664 url: https://doi.org/10.5296/ajfa.v13i1.18664 abstract this paper aims to quantify the effect of the deadly novel coronavirus (covid-19) pandemic outbreak on chinese stock market performance. shanghai stock exchange composite index and its component sector indices are examined in this study. the pandemic is represented by a lockdown dummy, new covid-19 cases and a dummy for 3 february 2020. first, descriptive analysis is performed on these indices to compare their performances before and during the lockdown period. next, regression analysis with exponential generalized autoregressive conditional heteroscedasticity specification is estimated to quantify the pandemic effect on the chinese stock market. this paper finds that health care, information technology and telecommunication services sectors were relatively more pandemic-resistant, while other sectors were more severely hurt by the pandemic outbreak. the extent to which each sector was affected by pandemic and sentiments in other financial and commodity markets were reported in details in this paper. the findings of this paper are resourceful for investors to avoid huge loss amid pandemic outburst and the china securities regulatory commission in handling future pandemic occurrence to cool down excessive market sentiments. keywords: novel coronavirus, covid-19, sars-cov-2, pandemic, chinese stock market, exponential generalized autoregressive conditional heteroscedasticity jel classification: g14, g15 asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 2 introduction the novel coronavirus (covid-19) pandemic was first detected in wuhan, central china in december 2019 (wuhan municipal health commission, 2019) (note 1). this human transmitted disease spread at a rapid rate to other parts of china, and then to other parts of the world (note 2) (note 3). as of 28 april 2020, there were total of 2,883,603 confirmed cases, while the death toll had reached 198,842 cases (6.9%) (world health organization, 2020). to halt the outbreak, china swiftly imposed the unprecedented lockdown in wuhan city, the epicenter of covid-19, and nearby cities (so-called wuhan lockdown), starting from 23 january 2020. by mid-february, some 200 other cities around the nation had implemented similar social distancing measures, control of movement, closed management and ban on travels (note 4). disregarding the sudden spike on 12 february 2020 (due to diagnostic changes), it took 2 weeks after the lockdown imposition for the daily new covid-19 confirmed cases and deaths to exhibit declining trends, see figure 1. while china was able to curtail the outbreak of covid-19 by containment, its production and economy were badly affected. businesses and factories in china were essentially scaled down if not totally shutdown in the lockdown period. subsequently, the country’s industrial profit plunged by 38.3% in the first two months of the year 2020. meanwhile, some 5 million employees lost their jobs in the same period, with urban unemployment surged to 6.2% in february 2020, up from 5.2% in december 2019. moreover, barometers of economic growth such as retail sales of consumer goods and investment spending (on infrastructure, property, machinery and equipment) fell 29.5 and 24.5% respectively (bermingham. and wang, 2020; chen, 2020; national bureau of statistics of china, 2020; roper, 2020). as china’s economy sank to all-time low in the first two months of the year, international monetary fund remarked on 20 march 2020 that “china’s slowdown in the first quarter of 2020 will be significant and will leave a deep mark for the year” (berger et al., 2020). in fact, china economy shrank 6.8% in the first quarter compared with the year before (vaswani, 2020). asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 3 0 20,000 40,000 60,000 80,000 100,000 6 13 20 27 3 10 17 24 2 9 16 23 30 6 13 jan 2020 feb 2020 mar 2020 apr 2020 total new confirmed cases 0 1,000 2,000 3,000 4,000 6 13 20 27 3 10 17 24 2 9 16 23 30 6 13 jan 2020 feb 2020 mar 2020 apr 2020 total deaths -4,000 0 4,000 8,000 12,000 16,000 6 13 20 27 3 10 17 24 2 9 16 23 30 6 13 jan 2020 feb 2020 mar 2020 apr 2020 daily new confirmed cases diagnostic change -40 0 40 80 120 160 6 13 20 27 3 10 17 24 2 9 16 23 30 6 13 jan 2020 feb 2020 mar 2020 apr 2020 daily deaths source: worldometer (2020). note: shaded region denotes wuhan lockdown period (23 january 2020 to 8 april 2020). figure 1. covid-19 confirmed cases and deaths (31 december 2019 to 15 april 2020) from the perspective of stock exchange, another barometer of economic growth (note 5), chinese stock markets had tumbled following the news of covid-19 outbreak (avalos and zakraišek, 2020; oxford analytica, 2020). in this respect, the shanghai and shenzhen composite indices recorded the biggest single-day loss (2.75% and 3.25% respectively) in almost 9 months on 23 january 2020 (chinanews.com, 2020a) (note 6). on the next trading day (3 february, 2020), these two indices further suffered a gap down of 8% in the opening session. they eventually closed with a loss of 7.72% for shanghai and 8.45% for shenzhen composite indices, with the single day biggest loss in 12 months (chinanews.com, 2020b). the current empirical study attempts to provide a comprehensive measure on the effect of the deadly covid-19 outbreak on chinese stock market performance, with reference to shanghai composite index and its component sectors indices. the rest of this paper is structured as followed. the brief literature overview section points out the urgency of conducting the current research. the empirical data and descriptive analysis section describes the data sources and variables involved in this study. besides, descriptive analysis is performed for data exploration. the regression model section explains the ordinary least squares regression model with the egarch (1,1) specification employed in this study. the regression results section presents the estimated results and interpretation of results. the last section on conclusion and policy recommendation summarizes the key findings, suggests policy implications and concludes this paper. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 4 brief literature overview in the recent decade, there has been a considerable surge in chinese stock market research in conjunction to the intensifying china’s influential roles on various aspects of the world including the stock exchanges. majority of these studies focused on the efficiency (see among others, chong et al., 2012; han et al., 2019, liu et al., 2020 and references therein) or relationship analysis between chinese stock market with international stock markets (zhang and li, 2014; he et al., 2015; hung, 2019), commodity markets or/and macroeconomic aspects (ahmed and huo, 2020; zhuang et al., 2015, jebran, 2019, wei et al., 2019; wen et al. 2019; yousaf and hassan, 2019; zhao et al., 2020 and references therein). remarkably, effect of financial crises on chinese stock market was also commonly examined in the past (jebran, 2019; han et al., 2019; hung, 2019; lin and tsai, 2019; yousaf and hassan 2019, and wei et al., 2019), while studies on natural disasters were rare. two contributions in this aspect are worth-mentioning. specifically, li et al. (2015) examine 60 natural disaster announcements over the period 2003-2013 and find that they produced significant negative stock returns in china. earlier on, chong et al. (2010) report significant positive abnormal returns for pharmaceutical stocks in china, while tourism stocks were significantly affected by the severe acute respiratory syndrome (sars) caused by coronavirus (note 7). these two studies adopted the event study approach. the current study attempts to estimate the nature, magnitude and significance of effect of covid-19 pandemic on chinese stock market with regression analysis that controls for the plausible financial and commodity markets spillover effects (note 8) (note 8). empirical data and descriptive analysis the data set spanning from 2 september 2019 to 27 march 2020 are considered in this study. to estimate the effect of covid-19 pandemic on the chinese stock market, shanghai stock exchange composite index (sse) and its component sector indices are employed. they are from the sectors of energy (en), materials (mt), industrials (ind), consumer discretionary (cd), consumer staples (cs), health care (hc), financials (fn), information technology (int), telecommunication services (ts), and utilities (ul) (note 9). covid-19 pandemic is represented by a lockdown dummy (ld), the daily new confirmed cases in china (cncc) and the first trading day after the chinese new year holidays (d1). ld assumes a value of 1 for observations ranging from 23 january 2020 to 27 march 2020, and zero otherwise. other financial market variables specifically the new york stock exchange composite index (nyse), the remninbi per us dollar exchange rate (er), and commodity markets represented by spot gold price (gp) and crude oil wti spot us dollar price (op) are included for control purpose. daily financial and commodity variables are obtained from investing.com. daily new confirmed cases in china is obtained from worldometer. these time series are plotted in figure 2. financial and commodities variables figure 2 depicts that, for the first weeks upon the first official covid-19 outbreak report to the world health organization (who), the markets in china (sse) and us (nyse) did not asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 5 respond negatively. in the meantime, the china exchange rate and the spot gold price were continuing their value appreciation trend, while the crude oil was extending its declining trend. after the wuhan lockdown imposition, the chinese and us stock markets did not only behave differently in the process but they eventually ended up with significant different performances. sse and nyse stood at 14,102.04 and 2,976.53 respectively on the wuhan lockdown day. as of 27 march 2020, they remained 8,777.38 and 2,660.17. this is equivalent to a considerable loss of 60.66% for nyse in the us and 11.89% for sse in china within 41 trading days. figure 3 shows that there was an increasing trend starting from november 2019 in majority of the sectors in shanghai stock exchange, and so the composite index, probably due seasonal effects (note 10). this trend was extended into the middle of january 2020 or later, although who was officially informed of the of the new virus on 31 december 2019. for the composite index, it reached its peak at 3,115.57 (h1) on 13 january 2020, and from there on it slipped to 2,746.61(l1) on 3 february 2020. sector indices performance sector-wise, both consumer discretionary and staples sector indices reached their peaks (h1) at 2,548.69 and 11,128.32 respectively on 13 january 2020. besides, information technology as well as telecommunication services and health care sector indices further climbed to h1 at 4, 611.15 (22 january); 3,442.73 (22 january) and 6,967.30 (21 january) correspondingly, before the trend reversed. in this conjunction, it is evident from figure 2 that, the reversal trend ended with a big dip for all sectors on 3 february 2020 (note11). in fact, on this first trading day after the extended chinese new year celebrations, the composite index plunged by 7.72% amid the fear of the covid-19 pandemic rapid outbreak when millions of workforces were commuting to work. meanwhile, all sectors were extensively down without exception, see table 1 which highlights of percentage returns of sse stock indices in the first three months of the year 2020. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 6 2,600 2,700 2,800 2,900 3,000 3,100 3,200 m9 m10 m11 m12 m1 m2 m3 2019 2020 shanghai stock exchange com posite index 8,000 9,000 10,000 11,000 12,000 13,000 14,000 15,000 m9 m10 m11 m12 m1 m2 m3 2019 2020 new york stock exchange com pos ite index 6.8 6.9 7.0 7.1 7.2 m9 m10 m11 m12 m1 m2 m3 2019 2020 renminbi per us dollar exchange rate 1,450 1,500 1,550 1,600 1,650 1,700 m9 m10 m11 m12 m1 m2 m3 2019 2020 spot gold us dollar price 20 30 40 50 60 70 m9 m10 m11 m12 m1 m2 m3 2019 2020 crude oil wti spot us dollar price notes: dotted vertical line denotes 31 december 2019 when who first received covid-19 official report. shaded region denotes wuhan lockdown period. figure 2. time series plots of financial and commodities variables after the deep market correction on 3 february 2020, sending the indices to their new lows (at l1) in 12 months, all these indices exhibited technical rebound with different strengths (figure 2). in general, this round of rebound ended on 5 march (h2), and then they started to decline again until 23 march (l2), with the exception of information technology and telecommunication sectors. as we can observe in column 4 of table 1, the energy and financials sectors set for the comparatively weakest rebound (note12) before their indices continued with another fall to find their lower lows (l2 < l1) at 1,019.20 and 4,614.08 respectively on 23 march 2020 (note 13). asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 7 as for information technology, telecommunication sectors and consumer staples, they exhibited the strongest strength in rebound to succeed their higher highs (h2 > h1) (see figure 2) of 5,578, 3,803 and 11,229.08 on 24 february, 25 february and 5 march respectively (note 14). remarkably, they managed to pose higher lows (l2 > l1), in the following round of price falling action, indicating a better future prospect than other sectors. the index of health care (h2 at 6 february) sector also managed to find their higher highs (compared h1) but like the majority of other sectors, it ended up with lower lows (l2 < l1). indices which rebounded for only lower highs (h2 < h1) and ended up eventually with lower lows (l2 < l1) were materials, industrials, energy, consumer discretionary and financials. table 1 (column 3) shows that the daily performances of these sectors on the 3 february, from the most wounded to the least hurt were: telecommunication services (-9.99%), information technology (-9.72%), industrials (-9.03%), consumer discretionary (-8.91%), materials (8.64%), energy (-8.44%), utilities (-7.68%), financials (-7.28%), consumer staples (-6.85%) and health care (-3.22%). indeed, this scenario was the extension of the market fears which drove all the indices far to the south on 23 january 2020, when wuhan city was locked down (note 15). the daily performances of these sectors on wuhan lockdown day, in the same manner were: telecommunication services (-4.79%), materials (-3.57%), consumer staples (3.53%), consumer discretionary (-3.28%), information technology (-3.07%), industrials (2.96%), energy (-2.78%), financials (-2.73%), utilities (-7.68%) and health care (-2.08%) (see column 2, table 1). table 1 also reveals that the indices of consumer discretionary (-19.45%), materials (-16.44%) and information technology (-15.32%) performed the worst in terms of periodic returns from 5 march to 23 march 2020. on the other hand, telecommunication services (-5.69%) and utilities (-7.86%) sectors experienced the smallest loss over the same period. table 1. highlights of percentage returns of sse stock indices in the early 2020 daily periodic index 23 jan 3 feb 3 feb to 5 mar 5 mar to 23 mar shanghai stock exchange composite -2.75 -7.72 11.84 -13.40 energy sector -2.78 -8.44 6.47 -12.53 materials sector -3.57 -8.64 14.14 -16.44 industrials sector -2.96 -9.03 15.45 -13.74 consumer discretionary sector -3.28 -8.91 13.44 -19.45 consumer staples sector -3.53 -6.95 15.88 -11.36 health care sector -2.08 -3.22 10.97 -11.33 financials sector -2.73 -7.28 8.13 -14.85 information technology sector -3.07 -9.72 23.42 -15.32 telecommunication services sector -4.79 -9.99 20.92 -5.69 utilities sector -2.04 -7.68 8.68 -7.86 note: china stock market was closed from 24 january to 2 february 2020 for chinese new year holidays. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 8 2,600 2,700 2,800 2,900 3,000 3,100 3,200 sep oct nov dec jan feb mar 2019 2020 composite l1 h1 h2 l2 1,000 1,100 1,200 1,300 1,400 sep oct nov dec jan feb mar 2019 2020 energy h1 h2 l1 l2 1,600 1,700 1,800 1,900 2,000 2,100 sep oct nov dec jan feb mar 2019 2020 materials h1 h2 l1 l2 1,800 1,900 2,000 2,100 2,200 sep oct nov dec jan feb mar 2019 2020 industrials h1 h2 l1 l2 1,800 2,000 2,200 2,400 2,600 sep oc t nov dec jan feb mar 2019 2020 consumer discretionary h1 h2 l1 l2 9,600 10,000 10,400 10,800 11,200 11,600 sep oct nov dec jan feb mar 2019 2020 consumer staples h1 h2 l1 l2 6,000 6,200 6,400 6,600 6,800 7,000 7,200 7,400 sep oct nov dec jan feb mar 2019 2020 health care h1 h2 l1 l2 4,600 4,800 5,000 5,200 5,400 5,600 5,800 sep oct nov dec jan feb mar 2019 2020 financials h1 h2 l1 l2 3,200 3,600 4,000 4,400 4,800 5,200 5,600 sep oct nov dec jan feb mar 2019 2020 information technology h1 h2 l1 l2 2,800 3,000 3,200 3,400 3,600 3,800 4,000 sep oct nov dec jan feb mar 2019 2020 telecommunicat ion services h1 h2 l1 l2 1,600 1,700 1,800 1,900 2,000 2,100 sep oct nov dec jan feb mar 2019 2020 utilit ies h1 h2 l1 l2 note: shaded region indicates wuhan lockdown period (23 january 2020 to 27 march 2020). dotted vertical line denotes 31 december 2019 when who first received covid-19 official report. h1 denotes the index’s peak (high) pre-wuhan lockdown, while h2 refers to the next peak occurred on 5 march 2020 for majority of the indices. conversely, l1 refers to the index’s first bottom (low) (occurred on 3 february 2020), whereas l2 denotes the second bottom occurred on 23 march 2020 in most cases. technically, if an index exhibits h2 > h1, one can say that it has a higher high. similarly, h2 < h1 means lower high, l2<l1 means lower low, and l2 > l1 means higher low. figure 3. time series plots of shanghai stock exchange composite and sector indices table 2 summarizes the descriptive statistics of sse composite and sector indices before and during lockdown, after controlling for equal window length for the sub-samples. indices that consistently have lower maximum, average, minimum prices during the lockdown period compared to pre-lockdown period are shanghai stock exchange composite index (sse), energy (en) materials (mt), industrials (ind), consumer discretionary (cd), financials (fn), and utilities (ul). moreover, all their returns were turning from positive pre-lockdown to negative during lockdown, with the exception of utilities sector index which was already in the negative pre-lockdown. this means the price performance of these sectors was very much affected by the lockdown as a result of covid-19 outbreak. in sharp contrast, health care (hc), information technology (int), telecommunication services (ts) sectors were able to record higher maximum, average and minimum prices during the lockdown period. in fact, health care is the only sector that was able to maintain its positive return amid the lockdown, while information technology (-4.06%) and telecommunication services (-0.98%) sectors suffered relatively milder losses in indices returns in the lockdown period. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 9 having analyze the indices price behavior and return performance before and during the lockdown to prevent covid-19 outbreak, another key finding can be derived from table 2. specifically, the standard deviation of all indices were larger during lockdown in relation to pre-lock period, with the exception of industrial sector. this is probably because investors’ reaction was more sensitive to covid-19 news such that the overall chinese stock market was relative more volatile during lockdown. table 2. descriptive statistics of sse indices before and during lockdown regression model this study adopts regression model to quantify the effect on covid-19 pandemic on the chinese stock market. the following regression model is estimated: 𝐼𝑁𝐷𝐸𝑋 = 𝜃 + 𝜃 𝐿𝐷 + 𝜃 𝐶𝑁𝐶𝐶 + 𝜃 𝐷1 + 𝜃 𝐸𝑅 + 𝜃 𝑁𝑌𝑆𝐸 + 𝜃 𝐺𝑂𝐿𝐷 + 𝜃 𝑂𝐼𝐿 + 𝜀 , 𝜀 ~ n(0, 𝜎 ), (1) 𝑙𝑜𝑔𝜎 = 𝜙 + 𝜙 |𝜀̂ 𝜎⁄ | − 2 𝜋⁄ + 𝜙 (𝜀̂ 𝜎⁄ ) + 𝜙 𝑙𝑜𝑔𝜎 , (2) where index denotes the composite or sector index to be tested, including shanghai stock exchange composite index (sse), energy (en) materials (mt), industrials (ind), consumer discretionary (cd), consumer staples (cs), health care (hc), financials (fn), information technology (int), telecommunication services (ts), and utilities (ul) sector indices. in addition, er, nyse, gold and oil represent the exchange rate of china in terms of renminbi per us dollar, new york stock exchange composite index of us, spot gold us dollar price and crude oil wti us dollar price, accordingly. subscript t for refers to daily observation, asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 10 and 𝜃 for 𝑖 = 0, 1, … ,7 are the parameters to be estimated. the model residuals series is denoted by 𝜀 and 𝜎 is the heteroscedastic variance of 𝜀 . in the meantime, 𝜙 for 𝑖 = 0, 1, … ,3 are the parameters to be estimated in the variance equation. notably, as this study estimates the effect of the covid-19 outbreak, three proxies are included. ld is the dummy variable for lockdown as a result of covid-19 outbreak. ld assumes a value of one for dates (inclusively) ranging from 23 january 2020 to 27 march 2020, and zero otherwise. cncc stands for daily new confirmed covid-19 cases in china. a dummy variable (d1) is included to estimate the effect of the incident of drastic plunged in the chinese stock market on the first trading day after the prolonged chinese new year holidays, amid the fears of rapid spread covid-19 (note 16). d1 takes a value of one for the day 3 february 2020 and zero for all other dates. it is expected that the chinese stock market is adversely affected by the lockdown, and so the coefficient of ld (𝜃 ) should be negative, for lower index price during the lockdown period. on the other hand, cncc signals the condition of the coronavirus outbreak with higher (lower) value means more (less) confirmed covid-19 cases in china. a rational investor would take less cases as favorable news of improving condition and more cases as deteriorating condition. thus, 𝜃 < 0 is expected. on the other hand, 𝜃 should be negative to confirm with the observations of market plunged. importantly, the magnitude of 𝜃 , 𝜃 and 𝜃 will reveal the extent of the covid-19 effect on the chinese stock market. equation (1) is estimated with exponential general autoregressive conditional heteroscedasticity egarch (1, 1) specification as shown in equation (2) to model the residuals. in this respect, egarch (1, 1) is commonly used to model and predict the financial time series that exhibit time-varying volatility (note 17) (note 18). remarkably, 𝜙 and 𝜙 are of particular interest. 𝜙 is the asymmetry parameter. if 𝜙 ≠ 1, then positive and negative shocks/news, 𝜀 , will have asymmetric effect on the price volatility on the next day. if 𝜙 = 0, there is no asymmetrical behavior detected. 𝜙 is the persistence parameter. the larger (smaller) the 𝜙 , the longer (shorter) it takes for the shocks/news to decay. in this respect, following olbrys and majewska (2017), this study measures the persistence by calculating the half-life, which is the time taken for 𝜀 to be reduced to one–half of their original size. specifically, half-life = ln(0.5)/ln(|𝜙 |). (3) in addition, for the conditional volatility process as represented in equation (2) to be stationary, the condition for |𝜙 | < 1 must be met. otherwise the process is explosive and the index is unpredictable. regression results the estimated regression models over the sample period spanning from 2 september 2019 to 27 march 2020 are reported in table 3 (note 19), while the half-life and diagnostic results are given in table 4. first and foremost, it is evident from table 3 that the lockdown imposition to circumvent covid-19 outbreak had exerted a significant impact on the shanghai stock asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 11 exchange, as the estimated 𝜃 coefficient is significant at 5% statistical level for the over market composite index and all its component sectors. second, different sectors received different covid-19 effect in terms of lockdown, depending on their nature of business. specifically, negative effect is observed in the shanghai stock exchange overall market as well as the energy, materials, industrials, consumer discretionary, consumer staples, financials and utilities sectors. in contrast, positive effect is revealed in the health care, information technology and telecommunication services sectors in specific. these sectors had benefited from their important contributions to the fight against covid-19. third, estimated coefficient for the lockdown to was -67.99 points for shanghai stock exchange composite index as dependent variable. it reveals, overall, that the composite index had slumped by an average of 67.99 points significantly (as noted in the first point) in response to the lockdown, compared to the its average value before lockdown, holding other variables constant. similarly, on average, the indices of the energy, materials, industrials, consumer discretionary, consumer staples, financials and utilities sectors were down by 129.80, 52.88, 60.35, 64.02, 693.23, 272.62, 148.83 points respectively during the lockdown. conversely, the indices for the health care, information technology and telecommunication services sectors were up by 237.46, 654.92 and 159.81 corresponding. fourth, the estimated coefficient 𝜃 for daily new confirmed covid-19 cases in china (cncc) is essentially negligible in size and it was insignificant at all for all sectors, except for financials sector ( 𝜃 = −0.01, 𝑚𝑠𝑣 < 0.05) . it reveals, in general, that the market was insignificantly affected by the new developments of covid-19 cases. fifth, the estimated sign of coefficient 𝜃 is negative in all sectors. moreover, the effect is significant for all sectors, excluding the energy and financials sectors. this indicates that the fears of covid-19 outbreak did not only persisted but it had mounted over this long holidays with no share trading activities. subsequently, the whole chinese stock market reacted negatively when the market resumed trading on 3 february 2020. sixth, exchange rate had significant and negative effect on shanghai stock exchange composite index (-301.66 points), materials (-612.02), industrials (-53.43), consumer discretionary (-345.26), consumer staples (-391.20), financials (-945.88), information technology (-1196.89) and telecommunication services (-1046.23). it suggests that lower (higher) indices are associated to appreciation (depreciation) of renminbi with respect to the us dollar (note 20). in other words, depreciation of renminbi is favorable for the growth of these sectors in china. conversely, the results indicate that appreciation of renminbi is favorable for the energy and utilities sectors. seventh, the us stock market as the world’s leading stock market on the chinese stock market is minute if not totally negligible as the magnitude is less than one point in all sectors. eighth, the chinese stock market is significant and positively related to the spot gold market. the coefficient is significant and positive for all indices with no exception. ninth, the chinese stock market is significant and positively affected by the crude oil market, with the exception of consumer staples (negative effect) and health care (insignificant effect). asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 12 tenth, the estimated 𝜙 is insignificantly different from zero in all sectors, implying the absence of asymmetrical reactions on favorable or unfavorable news in the chinese stock market. last but not least, the estimated 𝜙 are all less than one in magnitude, implying the conditional volatility process is stationary and the index is predictable. moreover, the half-life values calculated from estimated 𝜙 suggest fast market digestion of shocks as it took the chinese stock market less than 3 trading days for shocks to be reduced to one-half its original size. table 3. estimated regression results asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 13 table 4. half-life and diagnostic results conclusion and policy implications the current empirical study attempts to provide a comprehensive measure on the effect of the deadly covid-19 outbreak on chinese stock market performance, with reference to shanghai composite index and its component sectors indices. the data set spanning from 2 september 2019 to 27 march 2020 are considered in this study. shanghai stock exchange composite index and its component sector indices (energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services, and utilities are examined. covid-19 is represented by a lockdown dummy (ld), the daily new confirmed cases in china (cncc) and a proxy for the first trading day after the chinese new year holidays. financial market variables specifically the new york stock exchange composite index (nyse) and exchange rate (er), and commodity markets represented by spot gold price (gp) and crude oil wti spot us dollar price (op) are included for control purpose. few key findings could be drawn from the numerical analysis over the chinese stock markets data. first, when the market resume trading after a prolonged chinese new year celebrations, the composite index unreservedly plunged by 7.72% amid the extended fear of the covid-19 rapid outbreak. with no exception, all sectors were extensively down and the daily performances of these sectors on the 3 february 2020, from the most wounded to the least were: telecommunication services (-9.99%), information technology (-9.72%), industrials (-9.03%), consumer discretionary (-8.91%), materials (-8.64%), energy (-8.44%), utilities (-7.68%), financials (-7.28%), consumer staples (-6.85%) and health care (-3.22%). in fact, on 23 january 2020, when wuhan city was locked down, there was already one round of market considerable drop. the daily performances of these sectors in the same manner were: telecommunication services (-4.79%), materials (-3.57%), consumer staples (-3.53%), consumer discretionary (3.28%), information technology (-3.07%), industrials (-2.96%), energy (-2.78%), financials (2.73%), utilities (-7.68%) and health care (-2.08%). second, after the deep market correction on 3 february 2020, sending the indices to their new lows in 12 months, all these indices exhibited technical rebound with different strengths. in general, the energy and financials sectors set for the comparatively weakest rebound, while information technology, telecommunication sectors and consumer staples exhibited the strongest strength in rebound (table 1). these findings suggest investors who hold shares should close their trades to avoid asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 14 huge loss, as soon as quality information on negative shocks are received. besides, short-term investors could buy low whenever there is a substantially dip in the market and close the trade within 5 to 10 trading days upon technical rebound for sizable profits. on the other perspective, the china securities regulatory commission should immediately prohibit short-selling for considerate period in handling future events of pandemic outbreak and other crisis. this could avoid market over-reaction and to reduce market volatility. third, sub-sample analysis for the composite and sector indices before and during lockdown, with equal window length reveals that all the indices returns of materials, industrials, consumer discretionary and financials sectors dropped from positive to negative after the lockdown as a result of covid-19 outbreak. contradictory, health care is the only sector that was able to maintain its positive return amid the lockdown, while information technology and telecommunication services sectors suffered mild losses in indices returns in the lockdown period. fourth, the standard deviation of all indices were larger during lockdown in relation to pre-lockdown period, with the exception of industrial sector, implying the chinese stock market as a whole turned relatively more volatile during lockdown (table 2). in this respect, risk adverse investors are advised to stay away from the market amid pandemic outbreak or crisis in the future. first, different sectors received significant but different covid-19 effect in terms of lockdown, depending on their nature of business. specifically, overall, shanghai stock exchange composite index slumped by an average of 67.99 points significantly in response to the lockdown. in the meantime, the indices of the energy, materials, industrials, consumer discretionary, consumer staples, financials and utilities sectors were down by 129.80, 52.88, 60.35, 64.02, 693.23, 272.62, 148.83 points respectively during the lockdown. conversely, the indices for the health care, information technology and telecommunication services sectors were up by 237.46, 654.92 and 159.81 corresponding. this reveals that health care, information technology telecommunication services sectors are potential avenues for profit-seeking in the time of pandemic outbreak. second, the fears of covid-19 outbreak had mounted over the prolonged chinese new year holidays with no share trading activities. subsequently, the all indices in the chinese stock market was negative and significant when the market resumed trading on 3 february 2020, confirming the significance of the findings from descriptive analysis. on the other hand, the estimated results suggest that the chinese stock market was insignificantly affected by the new developments of covid-19 cases, probably the effect was overshadowed by the other two covid-19 proxies. third, it is found that depreciation of renminbi is favorable for the growth of materials, industrials, consumer discretionary, consumer staples, financials, information technology and telecommunication services sectors in china. conversely, appreciation of renminbi is favorable for the energy and utilities sector, probably due to the oil importing nature of china. as such, the chinese government should maintain a fair renminbi in order to promote its economic growth by expanding its exports on consumer and industrial products as well as information technology and telecommunication services. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 15 fourth, the chinese stock market is significant and positively related to the spot gold market and crude oil market in general. thus, these two commodity markets are not suitable avenue for investment diversification. however, investors could detect the sentiments in these commodity markets for plausible trading signals for the chinese stock market. fifth, this study finds no asymmetrical reactions on favorable and unfavorable shocks in the chinese stock market. nevertheless, these shocks were digested quickly as it took the chinese stock market less than 3 trading days for shocks to be reduced to one-half its original size. this suggests that the covid-19 effect on the chinese stock market in general and the various sectors in the country specifically is not persistent and hence these sectors will recover very soon upon removal of lockdown and when the pandemic is over. acknowledgment both authors are grateful to universiti malaysia sarawak (unimas) for supporting this research in terms of funding and other aspects. notes note 1. on 31 december 2019, world health organization (who) china country office was officially informed of the new virus with a total of 27 cases detected. note 2. on 30 january 2020, who declared the outbreak an international emergency. on 11 february 2020, who assigned it the name of sars-cov2 for severe acute respiratory syndrome coronavirus 2, and covid-19 for coronavirus disease discovered in 2019. note 3. the total number of confirmed cases in china were 27; 11,791; 79,824 and 81,584 for 31 december 2019, 31 january 2020, 29 february 2020 and 31 march 2020 respectively. on 11 january 2020, china reported the first and only death case (in china, and also the world) due to covid-19 for that day. by the end of january, february and march 2020, total confirmed deaths were 259; 2,890 and 3,312 correspondingly. note 4. the lockdown was finally lifted on 25 march 2020, after 8 weeks of imposition for areas except wuhan, while lockdown in wuhan was lifted in 8 april (the state council republic of china, 2020a; hubei novel coronavirus prevention and control center, 2020; wikipedia, 2020). note 5. for the role of exchange market in fostering economic growth, see for instance world federation of exchanges (2017). note 6. the last trading day before chinese new year holidays (24 to 31 january 2020). the holidays were prolonged to 2 february 2020 to contain covid-19 outbreak (moon et al., 2020; the state council republic of china, 2020b). hence, the stock markets in china was closed from 24 january to 2 february 2020. note 7. sars first emerged in the human population near guangdong, china in november 2002. sars is alternatively known as sars-cov. see abdelhedi and boujelbène-abbes (2020). note 9. see, china securities index co., ltd. (n.d.) for a list of sse component sectors. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 1 ajfa.macrothink.org/ 16 note 10. see, among others, yuan and gupta (2014), casalin (2018), chia and teng (2018) and wagner et al. (2019) for significant positive holidays, new year and chinese new year effects in china market. meanwhile, better trade outlook as the us-china tariffs tension diminished may had also contributed (li, 2020). note11. all these indices found their first lows (l1) on the same day. note12. these indices registered a rise of 6.47% and 8.13% corresponding, from 3 february until the end of this rebound on 5 march (h2), see column 4, table 1. note 13. equivalent to a drop of -12.53% (energy) and -14.85% (financials) from 5 march to 23 march. utilities sector ranked the third in terms of weakness in strength of renouncing (8.68%) but it only dropped to a low (l2) of 1,678 on 19 march, which was 2 points higher than its previous low (l1) of 1,676. note 14. a rise of 38.4% (information technology) and 28.9% (telecommunication), counting from l1 on 3 february 2020. note 15. it was coincidently the last trading day before the chinese new year holidays. see note 6. note 16. another purpose for the inclusion of d1 is to normalized the model’s residuals. note 17. see nelson (1991) for more information on egarch model. see lin (2018), for instance, for the application of garch family models in sse composite index. lin (2018) reports that egarch (1,1) model outperforms the other garch models in both in-sample fitting and out-of-sample forecast performances for this index. note 18. in fact, the residuals of equation (1) estimated by the ordinary least squares (ols) regression principle exhibit arch effect. moreover, they do not pass the serial correlation test (results are omitted here to conserve space). note 19. except for the dummy variables, all variables included in equation (1) are stationary in their level by the augmented dickey-fuller unit root test. these variables are found to be cointegrated various indices based on the phillips-ouliaris residual-based tests for cointegration. both sets of results are omitted here to conserve space. note 20. for instance, a one renminbi appreciation in the chinese currency with respect to us dollar can be associated to and a drop of 301.66 point in the composite index. references abdelhedi, m. & boujelbène-abbes, m. 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( ons for lis age public pacific stoc m walk hypo udy builds o have exam n stock pric volatility ( and white 2 ance of law es evidence s and invest , this study r 2017. the ic events (s n 2009 and ternal event risis). this nously dete l shocks ide erstand how investment for the first ped by nara series. naray stimulation sts develop n and popp unit root tes ore, our pap ng a new an st of the p dology. sec s. ntives boos pacific stoc market in f ax-free for r (b) tax exem sting relate listing; (e) k exchange othesis of sto on the scanty mined stock ces and ma mala and r 2009), corp w for stock m on random tors. uses latest e major ben such as poli return to d ts (such as study uses ermine the b entified abo w future sho strategies a time in con ayan and p yan and pop study. the ped by lee p (2010). t st has a bett per offers ro nd relatively aper is stru ction 3 disc sted investo ck exchange iji through residents, re mptions on ed cost; (d and increa e (spse) 20 ock prices u y empirical k price clus acroeconom reddy 2007 orate gover market dev m walk hyp monthly st nefit of usin itical coup i democratic r global fina s a battery break dates ove. such in cks are like and develop ntext of fiji popp (2010) pp (2013) h ey investiga e and stra the main fi ter size and obust eviden y robust uni uctured as cusses the 81 or confiden e (spse) 2 a range of t eduction of gains arisin d) commen ased investo 016, 2014). using month literature th stering (na mic activitie 7), factors i rnance initi velopment ( pothesis for tock price d ng the lates in decembe rule followi ancial crisi of unit roo and examin nformation i ely to impac pment polici ’s stock ma ) that allow have demon ated small s azicich (20 inding of th high power nce on the it root test. follows. se results, wh asian nce and fac 016). the g tax incentiv corporate t ng from res ncement of or awarenes in light of t hly data. hat exists on arayan an s (puah an influencing atives (red (sharma a r fiji and h data over the st data is ou er 2006, 20 ing general s 2007/200 ot tests allo ne if it is as is important ct fiji’s sto ies. arket, this pa ws for multi nstrated the sample size 003), lumsd heir study w r and identif unit root pr ection 2 di hile section n journal of f cilitated gr government es and mea tax rate of 1 structure du f national ss (governm these reform n fiji’s stoc nd smyth 2 d jayarama listing on t ddy and sha and nguyen has importa e large perio ur sample p 0 percent de elections i 8 and 2007 owing for s ssociated wi t for investo ock market a aper uses a iple structu key advanta e and power daine and was that n fies break d roperties of iscusses the n 4 provid finance & ac issn 19 2021, vol. 1 ajfa.macro rowth of th t has been t asures includ 10% for com ue to listing listing fo nment of fij ms, we exam ck market. p 2013), rela an 2007) an the stock ex arma 2011) n 2011). th ant implicat iod january period cover evaluation o in septembe 7-2008 wor structural b ith any dom ors and gov and aid in d novel unit ural breaks age of this u r properties papell (19 narayan and dates more c f the stock p e data sour des the con ccounting 946-052x 13, no. 2 think.org/ he stock trying to ding: (a) mpanies g; (c) tax orum to iji 2014, mine the previous ationship nd stock xchange and the his paper tions for 2000 to rs major of fijian er 2014) rld food reaks to mestic or vernment devising root test in stock unit root s of unit 97) and d popp’s correctly. prices in rces and ncluding 2. data this stu internat analysis dickey test (ph well-kn for stru hypothe followi properly unit roo zivot an root tes root tes identify unit ro next th employ zivot-a to mod the test prices i trend st we det (absolut below i noise. i differen the rem mean s where (1992) a a and meth udy uses m tional mon s by invest fuller (ad hillips and p nown in the uctural brea esis. ing a semin y allow for ot hypothes nd andrew st of naraya sts identifie ying the imp oot test with he unit root yed to verify andrews uni del a. thus, allows for s an integra tationary wi  ty 0 termine the te value of including ∆𝑦 in equation nce operator maining var hift occurri 1tdu an and set the odology monthly dat netary fund tigating the df) test (di perron 1988 applied tim aks and thu nal paper b r structural sis. in light s (1992) tha an and popp es structural pact of inter h a single str test with a y the order o it root test m we employ a change in ated process ith a structu   t ty 1  break date the t-statisti 𝑦 to cor (1), 𝑦 den r, t ~ iid riables are d ing at time nd tdt t  ‘trimming r ta on stock d’s internati e order of ickey and f 8). this stud me series lite us might lea y perron (1 breaks can of this, the at allows fo p (2010) tha l break date rnal and ext ructural bre a single stru of integratio minimizes t y model c v n both slope s without a s ural break in  tdut 1 e by identif ic for π) is m rrect for ser notes log of d (0, σ2), t = defined as f e tb, while tb if t  region’ to: [ 82 k prices fro ional finan integration fuller 1981 dy does not erature. how ad us to in 1989), it ha n bias the un e present st or a single s at accounts es which ca ternal shock eak uctural brea on. sen (20 the loss of p version of t e and interc structural b n the trend fu    k j tdt1 fying the va maximised. erial correla f stock pric 1…. n. follows: du e tdt is th ;tb otherw [0.15, 0.85] asian om january ncial statist of stock p , 1979) and t provide de wever, these ncorrectly c as been wid nit root test tudy employ structural br for two stru an informat ks on the ser k developed 03) showe power and i the unit roo cept and has reak agains function that     jtj y 1  alue of tb we estima ation, and e ces and t is tu is an in he correspo wise 0. we . n journal of f y 2000 – o tics. we be price series d phillip-pe etails of the e unit root t conclude on dely recogn t towards n ys unit root reak and ne uctural brea tive for app ries. d by zivoted that mod s relatively t test. the m s the null hy t the alterna t occurs at u t for which te the follow nsure that e s the time t ndicator dum onding trend e follow zi finance & ac issn 19 2021, vol. 1 ajfa.macro october 20 egin our em using aug erron (pp) u ese tests as tests do not n the rando nized that fa non-rejectio t test devel ewly develo aks. both th plied econo -andrews ( del c versio y superior co model c ve ypothesis th ative stock p unknown tim the adf twing equati error term trend. ∆ is mmy variab ding shift v ivot and a ccounting 946-052x 13, no. 2 think.org/ 17 from mpirical gmented unit root they are account om walk ailure to n of the oped by ped unit hese unit mists in 1992) is on of the ompared ersion of hat stock prices is me. (1) -statistic ion as (1) is white the first ble for a variable, andrews unit ro we nex by estim level, w narayan has a b alternat papell ( model model 2 the bre procedu popp 20 stock p hypothe 3. resu unit ro table 1 it can b probabi are not trend. t hypothe express unit hy become stock pr i(1) var oot test with xt use naray mating equa while mode n and popp etter size, h tive unit ro (1997). 1 2 t m2 t yy    1 1 *  eak dates i ure. howev 010) and br prices and t esis of 𝜌 ults and dis oot test res presents a be seen that ility values) significant thus, in b esis is easil sed in the fir ypothesis is es stationary rice is best riable. h multiple st yan and pop ations (2-3) el 2 allows p (2013) sho high power oot tests de tdu' t   1,1* **   in the stock ver, sequent reaks are no the unit roo 1. the t-sta scussion sults withou adf and pp in the level ). a similar t. it is wort oth cases, ly rejected rst differenc rejected. t y after first characteriz tructural br pp (2010) un . we consid for two br owed that u and is able eveloped by t m1 t d yy    1 1   t b du' tdt  1,22 1 ' 1 * )(   k prices ca ial procedu ot much dif ot null hypo atistic of ̂ t structural p unit root te ls, the adf observation th noting th the unit ro at 1 percen ce. in both c the stock differencing zed as a non 83 reaks unit root test der two cas reaks in the unit root test e to identify y lee and t ddu t    21,1 11 ' *   t bt dt' td   ,11 ' 2,1 * )(   an be deter ure is less c fferent. in m othesis of is denoted l breaks est results f f test statisti n can be ma hat the resu oot hypoth nt significa cases, the te price serie g. the res n-stationary asian t that allows ses. model e level and t developed y break date d strazicich k j t b du tdt      1 1,2 1 ' 1 ' )( t dt 21 ,2 * )  rmined usin computation model 1 an 𝜌 1 are d by ̂t . for stock pri ics is not si ade regardin ults are not hesis is not ance level w est-statistics s contains sults from b y series. in n journal of f s for multip 1 allows fo the slope. d by naraya es more cor h (2003) an jtj bt ey td    ' 2,1 (   k j jtt'     1 1,2  ng grid sea nally deman d model 2, tested aga ices for fiji gnificant (a ng the pp te sensitive to rejected. when the st s are highly a unit root both unit roo other word finance & ac issn 19 2021, vol. 1 ajfa.macro ple structura or two break in a recen an and popp rrectly comp nd lumsda t t e ,2) tjtj ey   arch and se nding (nara , 𝑦 denote ainst the alt i. for the a as indicated est-statistics o inclusion however, tock price y significant t in the lev ot tests indic ds, stock pri ccounting 946-052x 13, no. 2 think.org/ al breaks ks in the nt study, p (2010) pared to aine and (2) (3) equential ayan and es log of ternative adf test, by high s, which of time the unit series is t and the vels but cate that ice is an table 1 unit ro since th be misl single b and inte date an rejected howeve test-stat absolute table 2   varia in spi δ in s *** in table 3 variab in spi δ in s in spi δ in s . unit root       variab   in spit    variab   δ in sp the re indica eview oot test res he adf and leading. to break using ercept. we nd optimal d in level a er, when th tistics of -15 e terms) at 2. unit root able  it  spit  ndicates statistic . unit root ble  it  spit  it  spit  t test resul le  0 (0 le  pit  ‐13. 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(2001) dence from nting, 28(1-2 m, fazal j efficiency ardo jose, & uity market , 11(4), 255 cs. the critical -5.181).the cri test was implem e 2014:08 a winning the therefore, t ral breaks b in table 3 ected for st er 2011. th owing for m was to exam january 20 oot tests wi is best desc s stock mar suggests th the result al ock prices a evaluation more import predicted fr paper is tha walk hypo new guinea udies can al fiji. . efficient m m the colom 2), 249-261 seyyed, & of the gulf & benjamin ts: evidence 5-258. 85 values for mod itical values w mented in gaus and 2014:12 majority o the stock pr by employi indicate tha tock prices hus, the unit multiple stru mine the ran 000 to octo ith and with cribed as a n rket is likely hat weak-fo lso indicate are unlikely and politic tantly, the f rom historic at it has focu othesis/effic a (png)) in lso investig markets hyp mbo stock . sulaiman stock mark n miranda t e from chi asian del 1: 1 % (-5.2 was extracted fr s 15.0. 2 and is per f the votes. rices is an i( ing narayan at regardles in levels. t root result uctural break ndom walk ober 2017. w hout structu non-stationa y to increas orm efficien es that shock y return to it al shock su finding sugg cal stock pri used on fiji cient marke n the pacific gate how st pothesis an exchange– a alsakran kets. financ tabak. 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(1 ation. the hien-chiang hypothesis rld economy ., & m. c. ral breaks. r dat bue. (2 n 7(3), 1-8. aine, r. l., of econom rajni, & ma my. internati rajni, & mi symbol? a j, gary ch e random w nomics, 43-6 & kuo-sh wan's stock & olivier d from varian k, & yangr from emerg 1016/s0378 a., & way ime series 66), 427-431 & wayne a a unit root. i. 2014. ec ddress. s uhammad t sting the w markets. in 1997). the e pakistan d g, jun-de l : evidence my, 22(1), 49 strazicich. review of e 2007). the & d. h. pa ics and stat ahendra re ional resea ichael whit australian a hen, and li walk model 63. hiuan ting. market. app darné. (200 nce ratio tes ru wu. (20 ging market 8-4266(01)0 yne a. fu s with a 1. doi: 10.23 a. fuller. (1 econometr conomic suva , fiji is tahir sulem weak form o nternational random w developmen lee, & chi from a pan 9-58. https:/ (2003). m conomics a taiwan sto apell. (1997) tistics, 79(2 eddy. (2007 arch journa te. (2009). t accounting 86 in zheng. l and techn . (2000). a pplied finan 09). the ran sts. econom 003). rando ts. journal 00252-7. uller. (1979 unit root 307/228634 1981). like rica, 49(4), and fisc slands. man, syed z of efficient l research j walk mode nt review, 2 i-chuan le nel stationa //doi.org/10 minimum la and statistic ock market ). multiple 2), 212-218. ). measurin al of financ the south p review, 19 asian (2007). th nical tradin a variance r ncial econo ndom walk mic systems, om walk v of banking 9). distribu t. journal 48. elihood rati 1057-1072 cal updat zulfiqar ali t market hy journal of f el in the p 221-240. ee. (2010). ary test with .1016/j.japw agrange mul cs, 85(4), 10 does follow trend break ng stock ma ce and econ pacific stoc 9(1), 54-63. n journal of f he chinese g rules. qu ratio test of omics, 10(5) hypothesis , 33(2), 117 ersus break g & financ ution of th of the am io statistics . te : suppl i shah, & r ypothesis: e finance and pakistani e stock price h structural wor.2009.04 ltiplier unit 082-1089. w a random ks and the un arket volatil omics, 8(5) ck exchang finance & ac issn 19 2021, vol. 1 ajfa.macro stock mar uarterly jou f the rando ), 525-532. s for chine 7-126. king trend ce, 27(4), 5 the estimat merican st for autore lement t rana shahid empirical e d economic equity mark es and the breaks. jap 4.002. t root test w m walk. ec unit-root hyp lity in an em ), 53-71. ge: is it a m ccounting 946-052x 13, no. 2 think.org/ rket: an urnal of om walk se stock in stock 575-592. tors for tatistical gressive to the d imdad evidence s (58). ket: an efficient pan and with two onomics pothesis. merging market or narayan and slop narayan tests. narayan thresho https://d narayan evidenc simulat narayan g7 stoc financi https://d narayan price c https://d ngene, revisite and fin phillips biometr puah, c a south 229-244 reddy, crossroa ryaly, weak-f exchan sen, am process sharma develop sharma bombay and fin n, p. k., & pe at unkno n, p. k., & applied ec n, paresh ld autoregre doi.org/10.1 n , paresh ce from pan tion, 77(4), n, paresh k ck prices ev ial ma doi.org/10.1 n, paresh k clustering o doi.org/10.1 geoffrey, d: new evid nance in em s, peter cb, rika, 75(2), chin-hon h pacific isl 4. krishna, ads: lesson venkata r form marke nge index (b mit. (2003) s. journal of a, parmendr pment? the a, rakesh k y stock exc nance, 7(2), s. popp. ( own time. jo & s. popp. ( onomics, 45 kumar. (20 essive mod 1016/j.matc kumar. (20 nel unit roo 369-373. ht kumar, & r vidence from arkets, 1016/j.intfin kumar, & r on fiji's s 1016/j.asiec kenneth a dence on m merging mar , & pierre p 335-346. ng, & tk ja and econom & umesh ns for fiji. rajasekhar, et efficienc bse) sensex ). on unit-r f business & ra, & duc-t e case of fi kumar, & r change and 141-162. 2010). a n ournal of ap (2013). size 5(6), 721-72 006). the el. mathem om.2005.11 008). do sh ot tests with ttps://doi.or russell smy m multiple institution n.2005.10.0 russell sm stock mark co.2013.07.0 a tah, & a multiple struc rket econom perron. (198 ayaraman. ( my. internat sharma. 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diver io. ing to the c io’s beta mu curity marke s that a por t on its vola t on its total apm is an “ nvestors wi s equation of the asset price for th s the same ed price is he observed nt rate” for nt rate with en the asset pm predict nd expected t pricing m a theoretic ws can be es nto account ate of return mposes an a component rough the re unsystemati mponent of g to capm aking speci holds a port sification, t capm, the ultiplied by ( et line, as e rtfolio’s exc atility; that risk. “asset pricin ll bid its cu (2). once t can be dis he asset. in as its val higher than d price is be the observ the capm is overvalu s the equilib d return of a model (cap cally approp stimated) of t the asset’s n. sset’s risk i t of the tota egression of (1) tr ic risk, is t f an asset’s , the marke fic risk. th tfolio, each the investor expected re the expecte (2) )(re  equation (2) cess expecte is, a portfo ng model” urrent price the expected scounted to theory, ther ue calculat n the valuat elow the ca ved price gi rate. if the ued (and und brium price any asset. i 42 pm; sharpe priate requi f an asset, g s systematic into systema al risk of th f asset retur mr  . the risk wh return wh etplace com his is becau individual r’s net exp eturn of a p ed excess re ([ rer mf  ) is also call ed return ov olio’s exces because, gi up or down d return is o their prese refore, an a ted using th tion, then t apm valuat iven a parti e discount ra dervalued f e of an asset in practice, asian , 1964; tre ired rate of given the as c risk, the e atic and spe he asset tha rns rt on ma tmt  . hich is uniq hich is unco mpensates in use specific asset in that posure is ju portfolio eq turn of the m )(].) rrf  led, is the e ver the risk s return dep iven a beta n, adjusting calculated ent value u sset is corre he capm the asset is ion). altern icular valua ate in the m for a too hig t, assuming , this assum n journal of f eynor, 1961 f return (an set’s system expected re ecific risk. t at is explain arket returns que to an i orrelated w nvestors for risk can b t portfolio e ust the syst quals the ris market port . essential con k-free rate d pends upon and an exp g the expect using cap using this ra ectly priced derived di overvalued natively, one ation model model is low gh discount g that all inv mption is un finance & ac issn 19 2022, vol. 1 ajfa.macro 1; lintner, nd thus the matic risk. t eturn of the the system ned by mar s rmt, viz. individual with general r taking sy e diversifie entails spec tematic risk sk-free rate tfolio, i.e. nclusion of depends on n its system pected retur ted return s pm, the futu ate to estab d when its o iscount rate d (and unde e can “solve l and comp wer than the rate). acco vestors agre nreasonable ccounting 946-052x 14, no. 1 think.org/ 1965) is price if to do so, market, matic risk ket risk. asset. it l market stematic ed away. ific risk, k of the plus the f capm. its beta matic risk rn for an so that it ure cash blish the observed e. if the ervalued e for the pare that e capm ordingly, ee on the e, so the capm the ca distribu equity a or six s normal an adeq distribu the inve adequat may off since b of one. case (by mutual should (includi is unob portfoli to false unobser arbitrag general modele where s similar risk. th f1, … f the reg sensitiv portfoli portfoli where t the mo sensitiv is largely o apm has sev uted random and other m standard de distribution quate measu uted returns, estors’ prefe tely explain fer higher re beta reflects stock mark y definition fund) there in theory ing works o bservable an io. unfortun e inferences rvability of ge pricing izes the ca d as a linea sensitivity to ly to the ca his is captu fk, viz. gression (1 vities β1, … io returns to io is linearly the λ1, … λk odel in equ vities, yieldi of theoretica veral limita m variables. markets are n eviations fr n assumptio urement of , but for ge ferences mo n the variati eturns than sensitivity ket indices n) have a be efore expec include all of art, real e nd people u nately, it has s as to the the true ma theory (a apm. apt ar function o o changes in apm, the a ured through (1 1a), known βk, which, o changes i y related to (2 k represent uation (2a) ing estimate al value. ations. firstl however, not normally rom the me on would ex risk. this m eneral return ore adequate on in stock the model w to market r are frequen ta of one. a cts perform l types of estate, huma usually subs s been show validity of arket portfol apt; ross, t holds tha of various m n each facto apt decom h the regres 1a) tr   as the fir , similarly t in the risk f its factor se 2a) )(re  risk premia is estimate es for the ris 43 ly, it assume it is freque y distribute ean) occur xpect. it als might be ju n distributio ely. also, in returns. em would predi risk, the ma ntly used as an investor mance in lin assets that an capital...) stitute a sto wn that this f the capm lio, the cap , 1976) is at the expe macro-econo or is represe mposes 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ajfa.macro e (jointly) n rved that re ften more th frequently t ariance of re mption of n es will likely does not ap that low bet efinition, ha market and portfolio (s he market p e as an inv h a market p for the true ocuous and aid that du rically testa asset pric ancial asset ical market fic beta coe ematic and a set of risk e portfolio’ e sensitivity xpected retu sk factors f turns on th ccounting 946-052x 14, no. 1 think.org/ normally eturns in han three than the eturns is normally y reflect ppear to ta stocks as a beta d in that uch as a portfolio vestment portfolio e market can lead e to the able. ing that can be indices, fficient. specific k factors ’s factor y of the urn of a f1, … fk. he factor the ap its facto correctl implied the ap is misp under tr as descr “arbitra line wit consists sells th correctl asset th syntheti exposur long the positive has a ne firm spe the ap an expl can be single-f market. sensitiv structur profitab althoug utility f “consum as with security itself re to chan nature. signific by an i default be used monthly pt asserts th or sensitivit ly the asse d by model. pt describes riced, accor rue arbitrag ribed below age in expec th the retur s of trading he asset wh ly priced, o hat is relativ ic asset a re to each o e asset and e expected r et-zero expo ecific risk). pt differs fr lanatory (as considered factor mode the apt c vity of the ral changes bility. on th gh similar to function, an mers” of the h the capm y returns on eveal the ide ge over tim chen, rol cant in expla industrial p premium in d in place y) and often hat equation ties. the m et price shou if the price s the mecha rding to the ge, the inves w, the inves ctations” rns expected g in two as hich is relat or sells an a vely underp portfolio c of the macr d short the p return (the osure to any the arbitra rom the ca s opposed to a “special el of the as can be seen underlying s in the ass he other han o those in th nd from the e assets). m, the facto n the factor entity of its me and betw ll and ross aining secu production i n corporate of macro-e n with signi n (2a) can be model-derive uld equal th diverges, a anism wher e apt mod stor locks-in tor locks-in i.e. that arb d by the m sets, with a tively overp asset that is priced. a co onsisting o oeconomic portfolio (or difference b y macroecon ageur is thus apm in that o statistical case” of the sset price, n as a “supp asset to e set’s expect nd, the cap he apt, ari resulting m or-specific b r in questio priced fact ween econom s (1986) id urity returns index; and bonds. in p economic f ificant estim 44 e used to fin ed rate of re he expected arbitrage sho reby arbitra del, back in n a guarant n a positive bitrage by in model portfo at least one priced and s correctly orrectly pric of other corr factors as t r vice versa between ass nomic facto s in a positi t it is less re l) model of e apt in th where beta ply side” mo economic fa ted return, pm is consi ise from a m market equili betas are fo on. unlike t tors the nu mies. as a r dentified th s: surprises surprises in practice, ind factors, wh mation error asian nd the expec eturn will th end of peri ould bring i ge by inves nto line with teed payoff, expected p nvestors wi olio theory. e being mis uses the p priced and ced asset in rectly price the mispric a), he has c set return an or and is the on to make estrictive in f asset retur hat the secu a is expose odel, since actors. thu or in the dered a “de maximizati ibrium (inv ound via a the capm umber and n result, this i he followin in inflation n investor dices or spo ich are rep rs. market n journal of f cted return hen be used iod price dis it back into stors will br h its expect whereas un payoff. the ill bring ass in the apt spriced. the proceeds to uses the p n this contex d assets w ed asset. w created a po nd portfolio erefore risk a risk-free n its assump rns. in some urities mark d to chang its beta coe s, factor sh case of sto emand side” on problem estors are c linear regre , the apt, nature of the ssue is esse g macro-ec ; surprises confidence ot or futures ported at lo indices are finance & ac issn 19 2022, vol. 1 ajfa.macro of a portfol d to price t scounted at line. ring an asse ted price. n nder apt a apt thus set prices b t context, a e arbitrageu buy one w proceeds to xt may be i which has th when the inv osition whic o return) an free (other profit. ptions. it all e ways, the ket line repr ges in value efficients re hocks woul ocks, in th ” model. its m of each in considered t ession of h however, d hese factors entially emp conomic fa in gdp as due to cha s market pri ow frequen sometimes ccounting 946-052x 14, no. 1 think.org/ lio given the asset t the rate et which note that arbitrage assumes ack into arbitrage ur either which is buy the in fact a he same vestor is ch has a nd which than for lows for e capm resents a e of the flect the ld cause e firm’s s results, nvestor’s to be the historical does not is likely pirical in actors as indicted anges in ces may ncy (e.g. derived by mean rates; th prices; macroe literat there i does no suggest expecte such as studies (1986), a major whether offering model r samples sufficie ability t relation check o implica assets. generat idiosyn the sens malkam evidenc the pric finnish ordinary problem betas fo pooled efficien soufian london sub-sam experien procedu ns of factor he differenc gold or conomic va ture review s abundant ot explain th ting that one ed returns. a s firm size have exam antoniou, g r issue in th r it adequat g economic requires mo s. and the nt to assess to price ass ns between outside the ation of the antoniou, ing process cratic return se that they mäki (1990 ce does not ce of the be h stock mar y least squa m by estima orecasted on data showe ncy of the m n (2001) in n stock ex mples of tim nced differ ure analysis r analysis. m ce in long-t other pre ariables. w empirical e he cross-sec e or more ad a number o and bookmined the im garret and p he empirical ely prices th insight into ore evidenc erefore, to s the empir ets outside returns and e sample st apt is the garrett an s for two su ns to be cor carry the sa 0) examine support the eta risk is si rket. malka ares beta es ating firm-s n the basis o ed that the p market index nvestigated xchange, in me periods o rent econom s of fama a more direct erm and sh ecious met evidence ind ctional expe dditional fa of studies h -to-market-v mpact of the priestly (19 l analysis o he assets, is o the determ ce on how determine rical conten of the samp d economic tudied. con e equality o nd priestley ub-samples rrelated acro ame prices o ed the ca e capm in ignificantly amäki show stimates wh pecific beta of these esti price of con x cannot be r the validity order to e on the basis mic condit and mcbeth 45 t “indices” t hort term in tal prices; dicating tha ected returns actors may b have examin value, as in macro-eco 998), and po of any asset s that it mus minants of se different fa the econo nt of apt. t ple used for factors ma nnor and k of the price y (1998) e of assets. oss assets, t of risk in bo apm using that it sugg y negative fo wed explicitl hich are spu as using ka imated betas nditional ris rejected, su y of capm explain pri that during tions (1980 h (1973) to asian that might b nterest rates; currency/ at the sourc s, such as f be required ned the imp n fama and onomic facto oon and tay pricing mo st be robust ecurity retu factors expl omic factor the validity r estimation ay be spurio korajczyk ( es of risk ac xamined th using the e they found t oth samples time-vary gests that m for a thin eu ly that this urious, and r alman filter s in a crosssk is positiv upporting th m and apt cing across g each subse 0-1997). so o test the pr n journal of f be used are: ; a diversifi /exchange e of risk in fama and fr to character pact of firm d french ( ors, as in c ylor (1992). del, apart fr enough wh rns. fama ( ain pricing s, influenci y of apt a n. fama (19 ous requirin (1992) argu cross differ he uniquen estimation m that three fa s. ying-parame market risk i uropean sto phenomen reduced the techniques -sectional an ve and that e capm. t for securi s time, tak et of sample oufian appl roposition t finance & ac issn 19 2022, vol. 1 ajfa.macro : short term fied stock in rates, and ntroduced in rench (1995 rize the beh m-specific v 1992), whi chen, roll a from the que hilst simulta (1991) argue assets in d ing pricing also depend 991) argued ng for a rob ued that a rent sub-sam ness of the method tha actors are u eter model is not priced ock market, non is due e errors-in-v s and emplo nalysis. an t the mean-v rities traded king three d es the uk e lied the tw that at any ccounting 946-052x 14, no. 1 think.org/ m interest ndex; oil d other n capm 5, 1996), havior of variables ile other and ross estion of aneously ed that a different g is not ds on its that the bustness testable mples of returns at allows unique in s. prior d or that e.g. the to static variables oyed the alysis of variance d on the different economy wo-stage point in time the returns. soufian relation process cross-co of the r pricing and ca statistic and est unexpec for the univaria then sec davidso investor candida davidso returns, (1988) thirty s regresse “consen priced, davidso factors internat dash (2 found t returns signific sample explain thus, th few use analyse process been an the pre ere is a line . n used tim nship betwe s that gen orrelation fu elation betw are sensitiv apm, it is es cally, it is p timating a cted innova input serie ate arima condly filter on (2002) rs and corp ate. as fam on examine , following calculated f stocks that ed the facto nsus” risk fa and at the on followed are extracte tional capm 2017) analy that there w for 93.33% cant causalit stocks con ing individu hough seve e time series es used for ses that gene nalyzed in th esent study ear and pos me series te en stock re erating the unction betw ween the inp ve to the wa ssential to u possible to o vector auto ations in the es; market a model to e ring the inp argued tha porations f ma and fr ed whether the work factor loadi comprise th or loadings a actor: at the ten percen d a similar ed from the m beta is a ysed grang was signific % of the s ty of stock nsidered, in ual stock re eral studies s techniques capm an erate the se he literature examines g sitive relatio echniques f eturns and m e series. i ween the inp put and resp ay that the u use an appro obtain the t o-regressive e economic portfolios each series put series wi at, to the e for decision rench (199 the capm of born an ings on six he dow jo against the c e five percen nt level an a r methodol e returns dat consensus m ger causality cant bi-direc sample stoc returns with ndicating th turns, it in i address the s. as soufia nd apt tes eries. in part e. granger cau 46 onship betw for the pre macro-econ if an inpu nput and resp ponse series unexpected opriate met time series e model in factor. sou and the m sufficient to ith this mod extent that n making p 7) asserted m-β is a goo nd moser ( factors (usi ones industr correspondi nt significan additional f logy, using ta using fac measure of y in the co ctional cau cks conside h market re hat though itself it does e empirical an (2001) h sts to be m ticular, gra usality in th asian ween capm e-whitening omic series ut series is ponse series s. since the components thod to gene of unexpec n an attemp ufian perform acroeconom o reduce th del to get the asset prici purposes, th d, “the cho od proxy fo 1988) and ing principa rial index i ing β's. the nce level th factor is pri an endoge ctor analysi up to four r ntext of the usality betw ered in thei eturns in eit market ret s not explai testing of t has pointed meaningful, anger causal he context n journal of f m’s β coeffi process. b s, it is essen s auto-corr s gives a mi estimated r s are genera erate the un ted movem pt to use it med the pre mic series, e residuals e white nois ing models he capm oice of mo or the “true” wei (1988) al compone in the perio ey found evi hey report th iced (born enous apt s, and foun return gener e capm fo ween stock r ir study, w ther directio urns is a n n stock retu the capm out, in orde it is essent lity on secu of the apt finance & ac issn 19 2022, vol. 1 ajfa.macro icient and e before test ntial to iden related, the isleading in risk premia ated to test t nanticipated ments by ide ts residuals e-whitening by firstly f to white no se residual s s are emplo is the mos odel is imp ” factors th ). born and ent analysis) od 1962-19 idence that hat three fac and moser t model wh nd evidence rating factor for nse sto returns and while there on for 6.67% necessary f urns. and the ap er for the re ntial to iden urity returns t for indian ccounting 946-052x 14, no. 1 think.org/ expected ting the ntify the e direct ndication a in asset the apt d factors. entifying s as the g process fitting a oise, and series. oyed by st likely portant.” hat drive d moser ) for the 982, and β 　is a ctors are r, 1988). here the that the rs. ocks. he d market was no % of the factor in pt, very gression ntify the s has not n stocks. the val from ch used in euro/ and cru data & the pre indian m consiste mutual over th mutual canara the dat values w corresp beginni “percen differen comput the obj of mutu granger order to mutual models (a) the where returns weekly (b) the r lidity of the hanges in m the study i /inr excha ude oil price & methodol esent study mutual fund ed of the w fund schem he period of fund schem bank mutu ta was coll were collec onding to ing-of-the-w ntage differ nces and lag tation in the jective of th ual fund sch r (1969), th o assess the fund schem : e unrestricte 0 ty are the of the mu average va restricted m apt in par market return include mar ange rates, i es. logy investigate d schemes weekly aver mes, and the f ninety-on mes were sel ual fund, f ected from cted, and th tuesday, week or end rence” base gs were com e study cons he study wa hemes and d he followin effect of th me, the gr ed model:  e first orde tual fund s alues/varianc model:  rticular wou ns to chang rket returns interest rate es granger c and differen rages and v weekly ave ne weeks, fr lected by co franklin te different o he weekly a wednesday d-of-the-we ed on the mputed, as d sisted of ten s to investig different m ng modified e macroeco ranger caus p i t bay 1 0 0    er forward scheme, and ces of the ex p i t bay 1 0 0    47 uld imply th ges in securi (calculated es (mumba causality be nt macroec variances of erages and v from oct. 2 onvenience empleton m official web averages an ay, and th ek effects. weekly av desired belo n-week lagg gate causali macroeconom d linear gr onomic vari sality tests k j ti yb 1 0 1 0     differences d j ty are th xplanatory jj iti yb 0 00     asian hat there sho ity returns. d from the b ai inter-ban etween the onomic var f nav retu variances of 2006 throug sampling fr mutual fund sites. wher nd variances hursday on the weekly erages, fro ow. the opt ed first orde ity between mic variable ranger caus able j0 on th involve the j it p i j i yb j 0     in the wee he first ord macroecono j t p i j i yb j 1 1     n journal of f ould be som the macroe bse-sense k offer rat daily return riables. the urns of a sa f the macro gh to june from three m d, and relia rever applic s were com nly, in ord y returns w m which f timal lag str er differenc the daily re es. for this ality tests w he nav retu e estimation t1 , ekly nav der forward omic variab t2 finance & ac issn 19 2022, vol. 1 ajfa.macro me form of c economic v ex), usd/i tes), inflatio ns and vola e data for th ample of se oeconomic v 2008. the mutual fund ance mutua cable, daily mputed using der to avo were compu first order ructure used ces of each v eturns and v purpose, fo were emplo urns/varianc n of the fo returns/vari d difference bles. ccounting 946-052x 14, no. 1 think.org/ causality variables inr and on rates, atility of he study eventeen variables sample d houses: al fund. y closing g values oid any uted as a forward d for the variable. volatility ollowing oyed. in ce of the ollowing iance of s in the (i.e. exc the coe orders p to test t the mut if the e changes returns analys causal the res the sam it was scheme the sam 23.53% crude o further, influenc fund variable sensitiv banking found to of reli changes tax sav sense sensitiv of the s causal the res returns it was cluding the efficients a, p0 and pj are the significa tual fund sch estimated la s in the ma of the mutu is & interp ity on retur sults of the mple mutual found that es; from cru mple scheme % of the sam il prices had , it was fou ced by the growth pla es. the retu ve to all of t g fund g o be sensiti ance grow s in crude o ver scheme ex. the retu ve to change ample schem ity on varia sults of the g of the samp found that particular m , bi 0, and bi j e the optima ance of the heme, the u agged coeffi acroeconom ual fund sch pretation rns granger ca fund schem there was de oil price es; from in mple scheme d the greate und that the macroecon an was foun urns of relia the macroec growth plan ive to all th wth fund oil prices, m e were foun urns of rel es in crude o mes were n ance of retu granger cau ple mutual f there was macroecono i j are the pa al lags chos effect of th usual f-stati sse f  icient bi j0 is mic variable heme. ausality test mes are show significant s to 35.29% nr/usd to es; and from est influence e returns of nomic varia nd to be high ance nri e conomic va n. the retur he macroeco growth pl mibor, and nd to be sen iance tax s oil prices an not sensitive urns usality tests fund scheme significant 48 omic variabl arameters to en by akaik he macroeco istic as belo  ur urr mse df ssee (  s statisticall e j0 causes ts for the m wn in table t causality % of the sam 17.65% of m sensex e on the retu f 35.29% o ables consid hly sensitiv quity fund ariables, but rns of frank onomic vari lan bonu d inr/eur nsitive to c saver (els nd inr/eu e to any of th s for the ma es are show t causality asian le j0). o be estimat ke’s (1969) onomic var ow is employ urr dff ) . ly significan changes in macroeconom 1. from inflat mple scheme the sample x to 23.53% urns of mutu of the samp dered. the ve to change growth p t to a lesser klin india b iables excep s option w ro. the retu hanges in i s) fund g ro. the re he macroec acroeconom wn in table 1 from inflat n journal of f ted in the r information iable j0 on t yed: nt, then it c n the nav mic variable ion to 23.5 es; from mi schemes; f of the sam ual fund sch le schemes returns of es in all of t plan were al r extent than bluechip fu pt for inr/e were found urns of can inflation, cr growth plan turns of the onomic var mic variables 1. ion to 17.6 finance & ac issn 19 2022, vol. 1 ajfa.macro regressions, n criterion. the nav re can be infer returns/vari es on the re 53% of the ibor to 23 from isd/e mple scheme hemes. s were sign f reliance b the macroec lso found to n those of r und grow euro. the to be sens nara rebeco rude oil pri n were foun e remaining riables cons s on the var 65% of the ccounting 946-052x 14, no. 1 think.org/ and the in order eturns of rred that iance of eturns of e sample 3.53% of euro to es. thus, ificantly banking conomic o be very reliance wth were e returns sitive to o equity ces, and nd to be 64.71% sidered. riance of e sample scheme the sam 11.76% sense further, signific of cana macroe bonus o to a les franklin prices, debt pl the va changes relianc plan returns macroe overal it was f bonu bluechi the retu of the m discuss in recen prices a fund re scheme the mac they do minima causes potentia the res affect th would e and, on affectin es; from cru mple scheme % of the sam ex had the g , it was fou cantly influe ara robeco conomic va option was sser extent n india blu mibor, an lan growt ariance of r s in mibor ce media & growth pla of the rem conomic va l results found that th us option, ip fund – g urns and var macroecono sion nt times the and other un turns, chan e. the nav cro econom o so, the fu al. thus the the change al loss can b sults of thes he returns a enable fund n the other ng their inv de oil price es; from in mple scheme greatest infl und that th enced by th expo sch ariables. th s also found than that o uechip fund nd sensex th option w returns of c r. the vari entertainm an were fo maining 52.9 ariables con he returns a reliance t growth wer riance of ret mic variabl ere is high v nfavorable c nges in the s of many m mic variables und manage e granger c es in the re be minimize se causality and volatili d managers r hand, wo vestments, s to 17.65% nr/usd to es; and from uence on th e variance e macroeco heme was f he variance o d to be very of canara r d growth x. the vari was found to canara rob ances of ret ment fund und to be 94% of the nsidered. and varianc tax saver re significan turns of 35.2 les consider volatility in changes in specific var utual fund s s. by knowi er can take causality m eturns. by ed and retur y tests has i ty of partic to manage ould enable so that th 49 % of the sam 17.65% of m sensex he variance of returns onomic vari found to be of returns o y sensitive to robeco ex h was found iance of retu o be sensiti beco cigo turns of re growth pl sensitive to e sample sc e of returns (elss) fu ntly affecte 29% of the red. the market the market. riables caus schemes ha ing which f necessary model can a identifying rns can be m identified th cular mutua the risk pro e investors hey can tak asian mple scheme the sample to 35.29% of returns o of 47.06% iables consi e highly sen of reliance o all of the xpo schem d to be sen urns of rel ive to chang o scheme w liance tax lan, and fra o changes i chemes wer s of relianc und grow d by the m sample sch t due to incr . though al se intense c ve dropped factors affec precaution ct as impor g and moni maximized. he specific al fund sche ofiles of the to underst ke more in n journal of f es; from mi schemes; f of the sam of mutual fu of the sam dered. the nsitive to ch growth fu macroecon me. the vari nsitive to ch liance regu ges in inflat was found saver (els anklin india in sensex re not sens ce growth f wth plan, a acroeconom emes were n rease in infl ll these vari change in re due to unfa ct a scheme s so that th rtant tool in itoring the macroecono emes, which eir portfolio tand the sp nformed inv finance & ac issn 19 2022, vol. 1 ajfa.macro ibor to 23 from isd/e mple scheme und schemes mple schem variance of hanges in a und growt nomic variab iance of re hanges in c ular savings tion and in to be sens ss) fund a index fun x. the vari sitive to any fund grow and frankli mic variable not sensitiv flation and c iables affect eturns of a avorable ch e and to wha he damage n finding o causes of omic factor h, on the on os more effe pecific risk vestment d ccounting 946-052x 14, no. 1 think.org/ 3.53% of euro to es. thus, s. mes were f returns ll of the th plan bles, but eturns of crude oil s fund nr/usd. sitive to growth, nd bse iance of y of the wth plan in india es. also, ve to any crude oil t mutual specific anges in at extent done is out what returns, rs which ne hand, ectively; k factors decisions pertaini there w collecte weeks o were no results not sen macroe and var referen antonio pervasiv empiric born, j journal chen, n busines connor models school dash, m manage davidso explain 26(1), 1 fama, https://d fama, returns https://d fama, e 51(5), 1 fama, e politica malkam a thin s ing to mutua were severa ed from dif only, due to ot exhaustiv show that t nsitive to an conomic va riance of ret nces ou, a., gar ve risk fact cal finance j.a., and m l of financi n-f, roll, r ss, 59, 383-4 r, g., and k s of asset r of econom m. (2017). ement, 11(4 on, s., faff ned by a si 17-32. https e. (1991) doi.org/10.1 e., and fr s. doi.org/10.1 e., and fren 147-158. htt e.f., and m al economy, mäki, m. (19 stock mark al funds. al limitation fferent offic availability ve; some va the returns a ny of the m ariables sho turns. rrett, i., an tors and the e, 5(3), 221moser, j.t. ( ial services r. and ross 403. https:// korajczyk, returns. lse mics. a study o 4), 61-68. ht f, r., and m ingle or mu ://doi.org/1 . efficient 1111/j.1540rench, k.r. journal 1111/j.1540nch, k.r. ( tps://doi.org mcbeth, j.d. , 81, 607-63 990). in the ket. bank of ns inherent i cial website y of data. ariables we and varianc macroecono ould also be nd priestely, e empirical -240. https:/ (1990). ban research, 4 , r. (1986) /doi.org/10. r.a. (199 e financial on granger tps://doi.org mitchell, h. ulti-factor s 0.1080/108 capital m -6261.1991 (1995). s of -6261.1995 1996). the g/10.1111/j. (1973). ris 36. https://d defense of f finland wo 50 in the study e. secondly also, the m ere excluded ce of return omic variab e considere y, r. (1998) l content of //doi.org/10 nk equity r 4(3), 223-24 . economic .1086/29634 92). the ar l markets g r causality g/10.26634/ . (2002). a structure? s 00379.2002 markets: ii .tb04636.x size and bo f .tb05169.x capm wa 1540-6261. sk, return a doi.org/10.1 f the capm working pape asian y. firstly, th y, the resear macroeconom d due to in s of 35.29% bles conside d to explain ). macroeco f the arbitra 0.1016/s092 returns and 41. https://d c forces and 44 rbitrage pri group discu in the ca /jmgt.11.4.1 are returns studies in e 2.12106323 i. journal ook-to-mark finance, anted, dead 1996.tb052 nd equilibr 086/260061 m: evidence ers. n journal of f he data was rch period w mic variable nadequacy o % of the sam ered. this s n mutual fu onomic var age pricing 27-5398(97) changes in doi.org/10.1 d the stock m icing theor ussion pape apm. i-man 13452 in the inter econometric of financ ket factors 50, d or alive. j 233.x ium: empiri 1 using tim finance & ac issn 19 2022, vol. 1 ajfa.macro entirely sec was for nin es used in th of data. in mple schem suggests th und scheme riables as c theory. jo )00019-4 n the discou 1007/bf003 markets. jo ry and mu er no. 149, nager's jou ernational e ics and eco ce, 5, 157 s in earnin 1 journal of f ical test. jo me-varying b ccounting 946-052x 14, no. 1 think.org/ condary, nety-one he study fact, the mes were hat other e returns common urnal of unt rate. 365424 ournal of ultifactor london urnal on economy onomics, 75-1617. ngs and 131-155. finance, ournal of betas on poon, s of https://d ross, s 13(3), 3 ross, s balling soufian pricing working wei, j. 43(4), 8 table 1 mutual canara saver sch canara r canara r canara equities s canara scheme canara r canara r scheme reliance fund-gro reliance sector fu s., and tayl business doi.org/10.1 s., (1976). t 341-360. htt s., (1977). r ger. n, n. (2001) theory (a g paper ser (1988). an 881-892. htt 1. granger c fund schem robeco equ heme robeco income robeco cigo s robeco e scheme robeco gil robeco expo robeco infras owth plan diversified und-growth lor, s.j. (19 fina 1111/j.1468the arbitrag tps://doi.org return, risk ). empirical apt) acros ries, wps01 n asset pric tps://doi.org causality te mes i uity tax e scheme scheme emerging lt pgs scheme structure banking power 91). macro ance -5957.1991 ge theory of g/10.1016/0 k and arbit content of ss time. m 10 cing theory g/10.1111/j. ests for mac inflation 4.7393 0.0246 2.4280 0.1243 1.3131 0.3701 0.6915 0.7196 0.6915 0.7196 0.2967 0.9645 2.7058 0.0982 17.5927 0.0005 1.2225 51 oeconomic f and a .tb00229.x of capital a 0022-0531(7 trage. risk f capital as manchester m y unifying t 1540-6261. croeconomi crude price 4.9543 0.0218 1.9407 0.1944 0.6839 0.7249 0.5164 0.8427 0.0514 1.0000 0.4479 0.8874 2.6237 0.1051 21.971 0.0002 2.3401 asian factors and accounting sset pricing 76)90046-6 and return sset pricing metropolita the capm 1988.tb026 ic variables oil es mib 3 1.9 8 0.1 7 1.1 4 0.4 9 0.7 9 0.6 4 0.7 7 0.6 4 0.8 0 0.5 9 0.3 4 0.9 7 2.8 1 0.0 4 15.7 2 0.0 1 1.4 n journal of f the uk sto g, 18( g. journal of n in finance model (ca an universit and apt. j 610.x on the retu bor inr usd 236 2.09 976 0.16 475 1.18 431 0.42 292 0.38 931 0.92 825 1.54 565 0.28 882 1.33 873 0.36 424 0.47 452 0.86 582 3.51 868 0.05 7508 16.5 5 007 0.00 984 1.74 finance & ac issn 19 2022, vol. 1 ajfa.macro ock market. (5), 6 of economic e, cambridg apm) and a ity business journal of f turns of the r/ d inr/ euro 903 3.5822 686 0.0507 803 2.4938 275 0.1174 828 0.6042 251 0.7815 445 1.1641 895 0.4351 05 1.3421 632 0.3588 763 0.1417 693 0.9976 55 3.0850 531 0.0728 522 19.2605 006 0.0003 463 1.7005 ccounting 946-052x 14, no. 1 think.org/ journal 619-636. c theory, dge, ma: arbitrage s school finance, e sample sens ex 3.7419 0.0455 2.8677 0.0862 0.9311 0.5608 0.6613 0.7409 0.7357 0.6886 0.6131 0.7752 1.4432 0.3220 5 20.301 7 0.0003 1.1786 franklin fund-gro reliance fund-gro reliance fund-gro reliance fund-de option reliance plan-bon reliance entertain plan franklin bse plan franklin dividend table 2 sample canara r scheme canara r canara r canara r scheme india b owth tax saver owth plan nri owth plan regular ebt plan growth fund nus option media nment fund india index n growth plan fmcg f . granger c mutual fun robeco equity robeco income robeco cigo s robeco emerg bluechip (elss) equity savings n-growth d-growth & d-growth fund n fund ausality tes nd schemes y tax saver e scheme scheme ging equities 0.4083 6.1427 0.0120 3.1183 0.0709 6.9921 0.0082 0.0927 0.9996 3.3365 0.0604 1.7741 0.2290 1.4091 0.3339 1.2576 0.3930 ts for macro inflation 0.3267 0.9523 0.2600 0.9768 1.4989 0.3036 0.7012 52 0.1342 9.7506 0.0030 4.3409 0.0310 6.5665 0.0099 1.5775 0.2797 4.3332 0.0312 1.8189 0.2190 1.2291 0.4054 1.1241 0.4546 oeconomic n crude price 0.242 0.981 0.346 0.943 3.123 0.070 1.183 asian 2 0.3 6 6.1 0 0.0 9 2.8 0 0.0 5 4.8 9 0.0 5 0.4 7 0.9 2 3.6 2 0.0 9 1.5 0 0.2 1 0.5 4 0.8 1 1.0 6 0.4 variables on e oil es mi 25 0.3 17 0.9 68 0.2 32 0.9 35 7.8 07 0.0 36 1.2 n journal of f 038 0.23 239 6.45 121 0.01 004 3.114 909 0.07 733 6.01 228 0.01 081 1.31 111 0.37 195 3.28 494 0.06 614 1.71 845 0.24 072 1.77 490 0.22 456 1.01 953 0.51 n the varian ibor inr usd 3200 0.422 9552 0.902 2094 0.18 9891 0.99 8565 1.64 0058 0.26 2637 0.96 finance & ac issn 19 2022, vol. 1 ajfa.macro 54 0.2466 545 2.7645 04 0.0936 47 5.1817 711 0.0193 78 6.0872 27 0.0123 01 0.6778 713 0.7293 829 4.9135 628 0.0223 11 1.9150 439 0.1993 780 0.6678 281 0.7364 04 1.0983 47 0.4676 nce of return r/ d inr/ euro 228 0.3901 025 0.9211 38 0.2725 933 0.9730 474 2.3218 603 0.1364 697 1.6649 ccounting 946-052x 14, no. 1 think.org/ 0.4283 6.2746 0.0113 2.9805 0.0789 5.1170 0.0200 1.0617 0.4866 2.9372 0.0816 1.7313 0.2390 1.0540 0.4907 1.2679 0.3887 ns of the sens ex 3.3395 0.0602 0.1823 0.9935 2.4939 0.1174 2.3853 canara r canara r canara scheme reliance plan reliance fund-gro franklin fund-gro reliance fund-gro reliance plan reliance fund-de option reliance plan-bon reliance fund-gro franklin plan gr franklin robeco gilt pg robeco expo robeco in banking fu diversified p owth india owth tax save owth plan nri equity fu regular ebt pl growth fu nus option media & en owth plan india index f rowth plan fmcg fund gs scheme scheme nfrastructure und-growth ower sector bluechip er (elss) und-growth savings lan-growth und-growth ntertainment fund bse dividend 0.7127 0.6524 0.7473 36.9978 0.0000 0.3531 0.9402 0.3707 0.9314 0.7709 0.6643 2.2005 0.1522 1.6398 0.2623 0.3739 0.9297 4.8952 0.0225 12.9000 0.0013 1.2061 0.4156 1.0489 0.4935 0.1722 0.9948 53 0.426 0.962 0.542 29.15 0.000 0.614 0.774 0.385 0.923 0.998 0.521 4.580 0.026 2.887 0.084 0.329 0.951 1.899 0.202 12.26 0.001 1.873 0.207 1.498 0.303 0.164 0.995 asian 60 0.3 23 0.5 23 0.8 19 21 01 0.0 46 0.3 42 0.9 58 0. 34 0.9 83 0.8 15 0.6 09 3.8 69 0.0 70 1.7 49 0.2 91 0.3 12 0.9 95 1.7 23 0.2 48 7.4 15 0.0 30 0.8 76 0.6 85 1.2 38 0.3 48 0.2 56 0.9 n journal of f 3904 0.53 5152 0.64 8436 0.74 .2693 33.3 5 0002 0.00 3961 0.41 9178 0.90 1781 0.40 9941 0.912 8439 0.632 6156 0.76 8785 1.754 0415 0.23 7719 0.90 2295 0.574 3729 0.44 9303 0.89 7883 3.99 2257 0.03 4732 5.77 0068 0.014 8656 0.99 6016 0.522 2616 2.27 3913 0.14 2422 0.19 9818 0.99 finance & ac issn 19 2022, vol. 1 ajfa.macro 79 0.2557 491 0.3079 496 0.9602 61 42.5728 001 0.0000 77 0.3580 055 0.9378 060 0.1899 22 0.9924 27 0.3986 613 0.9165 44 0.9903 35 0.5260 081 1.2838 749 0.3820 410 0.4542 916 0.8834 916 3.0896 86 0.0725 736 5.3781 43 0.0174 970 1.2024 222 0.4173 788 0.9953 418 0.5232 955 0.2199 916 0.9870 ccounting 946-052x 14, no. 1 think.org/ 0.1290 1.0562 0.4896 37.088 6 0.0000 1.9913 0.1851 0.4230 0.9024 1.5643 0.2836 94.087 9 0.0000 4.8563 0.0230 1.8096 0.2210 3.1104 0.0714 21.737 0 0.0002 21.737 0 0.0002 449.70 40 0.0000 0.4608 0.8792 microsoft word 15958-57211-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 151 the effect of adopting activity – based costing (abc) on maximizing profitability in jordanian private health care sector prof suleiman mustafa el-dalahmeh jerash university – business college received: march 1, 2020 accepted: april 1, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.15958 url: https://doi.org/10.5296/ajfa.v12i1.15958 abstract the aim of this study is to assess the effect of adopting activity based costing (abc) on maximizing profitability in jordanian private health care sector. stating the role of (abc) system in maximizing profitability in jordanian private hospitals, showing the availability of infrastructure and capabilities of needed to adopt and apply the (abc) in jordanian private hospitals to achieve the study objectives, the researcher distributed (110) of the employees in jordanian private hospitals, to identifying the obstacles that facing jordanian private hospitals in adopting and applying (abc) system. to achieve the study objectives, a questionnaire was designed and distributed to survey sample of 110 respondents who worked in jordanian private hospitals as accountants, financial managers and internal editors. (90) questionnaires were returned and the response rate of which was (81.8%). after using the statistical analysis program "statistical package for social studies" (spss). the study concluded that adopting and applying (abc) system in jordanian private hospitals play very important role in reducing cost in a way that maximizing profitability the results also, reveal that the infrastructure and capabilities needed to apply the (abc) system are available in the jordanian private hospitals in a medium degree. in addition, the results of the study showed there are a set of obstacles that facing the adoption and application (abc) system in jordanian private hospitals related to management, salaries and difficulty in allocating treatment costs to direct and indirect costs. the study recommended attracted qualified and trained persons who can apply (abc) system and connivance the management of jordanian private hospitals of the visibility of apply (abc) system. keywords: activity-based costing, health care sector, jordanian private hospitals, indirect costs, cost drivers, maximizing profitability asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 152 introduction the health services sector in the hashemite kingdom of jordan has witnessed rapid development over the past years, and increased the ability of jordanian private hospitals, to compete in neighboring countries. the number of jordanian private hospitals (70) hospitals, which is more the 60% of number of hospitals in jordan, and employs more than 35000 employees, mostly, high income professionals, and the volume of investment in jordanian private hospitals more than fourth billion dinars therefore, jordanian private is one of the pillars of the jordan economy. due to the lack of capacity to calculate the cost of heath services due to the multiplicity of health services the researcher believes that it is necessary to high light on jordanian private hospitals to adopting the activity – based costing (abc) because of accuracy (el-dalahmeh 2019). problem of the study the problem of the study is represented in the following questions: 1dose the activity – based costing system enable jordanian private hospitals to reduce health services costs in a way that maximizing profitability? 2do jordanian private hospitals have infrastructure and capabilities needed to adopt and apply the activitybased costing system? 3are jordanian private hospitals facing obstacles in adopting and applying the activity – based costing system? importance of the study this study derives its importance from the important of adopting and applying the activity based costing system in jordanian private healthcare sector, which is the use of modern system in the allocation of treatment costs in jordanian private hospitals. activity basedcosting system (abc) considering enormous technical development witnesses in the industrial sector in the world in general. this system has proven its ability to reduce indirect industrial costs in the industrial sector and to its accuracy of information, which helps management to make rational decisions in pricing services and this is what prompted the researcher to conduct this study in jordanian private healthcare sector. objectives of the study the main objectives of the study are represented in the following: 1stating the role of activity – based costing system in maximizing profitability in jordanian private hospitals. 2showing the availability of infrastructure and capabilities needed to adopt and apply the activity – based costing system in jordanian private hospitals. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 153 3identifying the obstacles that facing jordanian private hospitals in adopting and applying activity – based costing. hypotheses of the study based on the question of the study's problem the following hypotheses are formulated: ho1: the application of abc system does not enable private hospitals in jordan to reduce the cost of health services in away that maximizes profitability. ho2: the infrastructure and capability needed to apply the activity – based costing system are not available in the jordanian private hospitals. ho3: there are no obstacle that facing the jordanian private hospitals in the applying of activity based costing system. theoretical framework a cost – based system of activities emerged in 1949 when (goetz) defended the principle of the system, and pointed out, that each indirect cost complex should be homogeneous and that each complex could change with the change of certain process, indicating the casual relation ship between cost complex and activities (dury, 2002). in the late 1985s and early 1990s, the activity – based costing system (abc) attracted the attention of researcher and academics due to overcoming the problems arising from the use of traditional costing systems. the (abc) was implemented in a large number of factories and companies, and the system of (abc) proved its ability to reduce costs (cooper & kaplan 1991, pp 130 -135). activity – based costing system (abc) was defined by (horngren,et al 2005) as the system which works on assembling the manufacturing overhead costs for each drivers on products (horngren 2005: 131 ). also, defined by (el-dalahmeh, 2019) activity – based system costing as managerial accounting method that allocate indirect overhead costs to activities and the assigns them to objects. benefits of activity – based system (abc) 1in planning: activity – based costing system benefit the administration in the planning, where activity – based system enables the study of each activity performed by the enterprise independently and bread winner can divide activity into aactivity add value to the product and these kind of activities must be taken care of and developed. b -activities do not add value to the product, and this disposed of or reduced to a minimum. 2in controlling: activity – based costing system play an active role in controlling cost elements, where the practice control, over the level of activities rather than the final product level, as in traditional cost system, enabling to measure cost of production and analyze profitability. 3in decision making: activity – based costing system assist administration in making pricing decisions because company will be in a competitive position, because the costs of its product and services are precisely defined. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 154 criticism of activity – based costing system: 1activity – based costing system is a process of loading traditional costing systems that rely on loading and allocating indirect industrial costs on a cause – and – effect relationship with more details in the activity code. 2the efficiency of using (abc) depends on the proper selection of cost drivers, and this is not easy, and it is necessary to determine the best cost drivers of the activity and study the behavior effects. 3the application of (abc) requires high costs and considerable effort, so some services organizations are reluctant to use it. literature review al hanini (2018) study the impact of adopting activity – based costing (abc) on decreasing cost and maximizing profitability in industrial companies listed in amman stock exchange. the study revealed that adopting and implementing (abc) play a good role in reducing costs and maximizing profitability. the results also reveal that some it industrial companies have the infrastructure to adopt and implement the (abc) system to a medium degree, while other companies lack any of these components. al-bader (2017). attempted to clarify the impact of applying activity – based costing system in confectionary companies. the study concluded that the most cost effective systems to enhance profitability were the (abc). yousef, z, & odeh (2014) study " the importance of the system of activity based costing (abc) in the decision making ". their study demonstrated that the application of (abc) helps gather the manufacturing overhead costs of the enterprise at cost points to be distributed later on good and services. bin moussa's (2013) study " the impact of activity – based costing on decreasing cost and enhancing the performance " aimed at identifying the role of the (abc) system in cost management, its applicability of required data due to the short coming of traditional systems the study demonstrated that the use of the (abc) system leads to more accurate calculation of the cost of treatment services. krishan (2006) study the application (abc) system at higher learning institution. the study concluded the (abc) system establishes accurate basis for determining the real cost of the student and not necessary for (abc) system implementation, provides cost accounting staff to determine which activities do not add value, and thus exclude them without affecting the final output. martin, melissa (2005) conducted a study entitled the association between (abc) system adoption and the performance of hospitals. the study revealed that the benefit of applying the (abc) system differ from one hospital to another. in profit oriented hospitals, the applying of (abc) system increased profitability, helped increase occupancy rate and thus was increased asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 155 by the hospital patients, as the (abc) system contributed to increased control over operational costs and there was no impact on increasing profitability in nonprofit hospitals. grandlich, chery,(2004) study the use of cost accounting activities in surgical operations conducted this study in a hospital in milwaukee in the united states of america the researcher has found that the application of a cost system based on activities in health hospitals works on 1 enable hospitals to determine their costs accurately 2empowerment hospitals can develop appropriate pricing mechanisms for their service to patients. 3. give detailed information about the costs of activities within the hospital, which enables them to compare the results of work with competitors. ittner & et al (2002) the study was conducted in united states of america and aimed to examining the extent of association between the activity basedcosting and the manufacturing performance. the study found that the reason for wide spread of. (abc) system mandated to the basis of activities, was due to high quality levels, and decrease in industrial costs, as the study found that the use of (abc) system is not related to return on investment. cooper & kaplan (1998) study entitled " cost -cutting activity ". this study aimed to find out whether the application of the (abc) system will head to a reduction in costs. the study concluded that the application of (abc) system will reduce costs by excluding activities that do not add value to the product unit, and retaining the activities that add value to the product unit, and retaining the activities that add value to the product. this leads decrease costs. research methodology data collection sources were both primary and secondary. the primary sources represent the questionnaire tool that was designed according to likert scale, from 1-5. while the secondary resources of the study data constituted books, periodicals related to the subject of the study. population of the study: population of the study consists of (70) jordanian private hospitals (www.phajordan.org) sample of the study: the study was conducted on a random sample of (110) employees in the field of accounting and financial managers, accountants, internal (auditor), (90) questionnaires were returned and the response rate of which was (81.8%) of the population. statistical analysis of data: in order to analysis the data, the researcher used the statistical package for social studies (spss): reliability: the alpha – cronbach was used to measure the internal stability of the resolution paragraphs and internal consistency between respondent answers. the coefficient of stability (α = 72.8% ) which is excellent compared to the acceptable rate of 60%. the normal distribution test. (kolmogorov – smirnov). the research conducting the statistical analysis shows that the data were distributed naturally. the mean ( z ) for the three hypotheses of the study was grater than ( 0.05 ). as shown in table 1. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 156 one – sample kolmogorov – smirnov test hypotheses h1 h2 h3 kolmogorov – smirnov z 1.052 1.352 1.578 hypotheses testing: the hypotheses of the study were tested as follows: 1one sample t – test at significant level of 5% according to the role of decision which provides for acceptance of the hypothesis if the calculated t is less than t tabular, and reject it if it is greater. 2descriptive analysis: which includes frequencies, the mean and standard deviation to accept or reject the hypothesis paragraph. table 2. arithmetic averages and standard deviations of the role of abc cost system in maximizing profitability. jordanian hospitals from the point of view of the study sample no items mean s.t percentage % level of importance 1 the application of (abc) system reduces the time and effort required to carry out the activities and thus reduce cost. 4.68 0.56 93.6% very high 2 abc system helps control and reduce early or reduce costs 4.25 0.62 85% very high 3 the jordanian health services sector is witnessing intense competition among private hospitals 4.20 0.70 84% very high 4 abc system helps in determining the prices of health service better and more accurately 4.18 0.76 83.6% very high 5 the indirect costs of health services are an important of the cost of health services provided to the patient 4.02 0.85 80.4% very high 6 guided by the casual relationship between the indirect costs of health services and the activities that caused the leads to the excluding activities that do not add value or benefit to the patient. 3.88 1.12 77.6% high 7 the role of abc system in maximizing profitability 4.21 0.38 84.2% very high total average 4.20 0.79 84.% very high asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 157 table 3. hypothesis (1) testing result calculated t t tabular sig allowed error result mean s.d 2.199 1.645 0.32 0.05 rejected 4.20 0.79 table 3 shows that the calculated t is greater than t. tabular and this means that the application of abc system enables private hospitals in jordan to reduce the costs of health services in away that maximizing profitability. therefore, the researcher rejects the null hypothesis and accept the alternative hypothesis according to the role of decision arithmetic averages and standard s deviation to provide the abc system possibilities in measuring the cost of health services. table 4. the availability of infrastructure and capabilities needed to adopt and apply (abc) system in jordanian hospitals no items mean s.t percentage % level of importance 1 the corresponding work mechanism in the jordanian private hospitals is imposed by the administration, but it is possible to develop method to calculate the cost of health service accurately 3.46 0.63 69.2% medium 2 determine the price of health service provided to patients by adding a margin (markup) to the cost of service provided to patient 3.44 0.78 68.8% medium 3 the jordanian private hospitals have a department specialized in determining the cost of health services that provided to patient 3.31 0.67 66.2% medium 4 the health services provided to patients in private jordanian hospitals to re engineering from time to time in order to get rid of services that do not benefit patients. 3.60 6.70 67% medium 5 the extent to which infrastructure and the potential to adopt and apply the abc system the jordanian private hospitals are available 3.25 0.58 65% medium total average 3.412 0.59 62% medium asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 158 table 5. hypothesis 2 result calculated t t tabular sig allowed error result mean s.d 2.032 1.645 0.042 0.05 rejected 3.412 0.59 table 5 shows that calculated (t) is greater than (t, tabular). therefore, the researcher rejects the null hypothesis according to the role of the decision and accept the alternative hypothesis: the infrastructure and capabilities needed to apply the (abc) system are available in the jordanian private hospitals. table 6. arithmetic averages and standard deviations to the obstacles of applying abc system in jordanian private hospitals no items mean s.t percentage % level of importance 1 the hospital administration is not convinced of the feasibility of abc system in jordanian private hospitals. 4.05 1.26 81% very high 2 the average level of salaries of financial state prevents abc system from being applied due to the time and investment it needs 3.66 0.91 73.2% high 3 the application of abc system in jordanian private hospitals costly, and less effective than the cost of its implementation 3.76 0.95 75.2% high 4 cost management personal are not eligible to apply (abc) system in jordanian private hospitals 3.82 1.04 76.4% high 5 the cost centers in jordanian private hospitals are not defined by the appropriate application for abc system 3.44 1.15 68.8% moderate 6 the difficulty of dividing the cost of the patients health services directly and indirectly 2.56 1.10 51.2% little 7 the pricing of health services in jordanian private hospitals depends more on supply and demand factors and competition on the cost of service. 3.77 1.06 75.4% high total average 3.58 0.65 71.6% high from the table 6 above the overall average of all paragraphs is ( 3.58 ) and is greater than the average of the study tool ( 3 ), it is also, noted from table 6 that there are is agreement in the sample of the study on the obstacle of applying ( abc) system in jordanian private hospitals. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 159 based on this, the null hypothesis was rejected and accepts the alternative hypothesis. table 7. hypothesis 3 result calculated t t tabular sig allowed error result mean s.d 2.664 1.645 0.004 0.05 rejected 3.58 0.65 therefore, it rejects the third null hypothesis and accepts the alternative hypothesis that there are obstacles to the application of (abc) system in jordanian private hospitals. results and discussion the study results indicate that the adoption of activity – based costing system in jordanian private healthcare contributes to reducing costs by concentrating on value added activities and excluding activities that have no added value. (abc) system also reduces the costs because its assists in reducing time and efforts. therefore, it helps increase profitability through the system. the adopting and applying activity based – cost in jordanian private hospitals leads to improve the performance of staff and efficiency of hospital services. also the efficiency of administration in planning and assist the administration in making pricing decisions, which leads to achieve a competitive position because the costs of its services are precisely defined. the results of statistical analysis of data indicates that the role of (abc) system in maximizing profitability in jordanian private hospitals is very high. in general, there is agreement in the opinions of the study sample on importance of the role of (abc) system in maximizing profitability, where the total average of all paragraphs in table ( 2) ( 4.20), standard deviation (0.79) and the level of importance very high, percentage ( 84% ) also, the infrastructure and capabilities needed for the adopting and applying the (abc) system in jordanian private hospitals are available to a medium extent. finally, the results of the statistical analysis showed that there are obstacles facing the applying of activity – based costing system in jordanian private hospitals related to management, salaries and difficulty allocating treatment cost to direct and indirect cost. recommendations in the light of the findings, the researcher recommends the following: 1attract qualified and trained persons who can apply activities – based costing. 2connivance the management of jordanian private hospitals of the feasibility of applying activity base-costing system. 3conducting other studies on the services sector in particular due to the high percentage of indirect costs. references albader. (2017). the impact of activity based – costing in enhancing the profitability of jordanian food manufacturing companies. unpublished master thesis, middle east university, amman, jordan. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 160 alhanini eman. (2018). the impact of adopting activity based costing (abc) on decreasing cost and maximizing profitability in industrial companies listed. amman stock exchange. academy of accounting and financial studies journal, 22(5), 1-8. bin mousa, i.a.d (2013). the impact of activity based costing on decreasing cost and enhancing the performance. unpublished master thesis, liaside university. algeria. cooper robin, kaplan. s. robert. (1991). the design of cost management system: text and reading, new jersey, prentice, tt all, 130-135. cooper, & kaplan, r. (1998). cost cutting activity economist, 348, 57-67. dargham, mm (2007) the availability of the main fundamentals to implementing abc on industrial companies in gaza, islamic university for humanities, 15(2), 679 -725. dury, colin. (2002). management and cost accounting, 5th ed, thomson learning, 340. el-dalahmeh suleiman. (2019). managerial accounting and edition. alwarag – pub, amman – jordan pp (261-280). graudich, chery. (2004). using activity – based accounting in surger: aorn journal, 9(l), 189192. https://doi.org/10.1016/s0001-2092(06)61152-6 horengren, c, t, sundem, g. l., & stration, w. o. (2005). introduction management accounting, (thirteenth edition). wpper saddle river-new jersey, prentice-hall. horngren, c.t, sundew, g 1. & stratton, w. o. (2005). introduction to management accounting. (thirteenth, edition) upper saddle river, new jersey, prentice hall. https://moh.gov.jo https://ssrn.com https://www.phajordan.org ittner, g, lanen, w, & larcker, d. (2002). the association between activity – based costing and manufacturing performance. journal of accounting research, 40(3), june, 111-130. https://doi.org/10.1111/1475-679x.00068 krishnan, & balagan (2006). an application of (abc) system in higher learning institution: a local case study. contemporary management research, 2(2), 75-90. https://doi.org/10.7903/cmr.652 martin, melissa. (2005). the association between (abc) system adoption and hospital performance "phd". candidate unpublished university of southern california 3660 troas dale park wag, los angels ca 90089 – 0441.usa. private hospital, association. (2019). kingdom of jordan. microsoft word 13929-50799-3-sm-new-final asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 148 corporate governance in banks and its impact on credit and liquidity risks: case of tunisian banks nesrine djebali (corresponding author) university of jendouba, faculty of law economics and management of jendouba, tunisia tel: 216-22-961-769e-mail: djbeli.nesrine@gmail.com khemais zaghdoudi university of jendouba, faculty of law economics and management of jendouba, tunisia tel: 216-98-553-863 e-mail: k.zaghdoudi@yahoo.fr received: nov.18, 2018 accepted: dec. 2, 2019 published: december 2, 2019 doi:10.5296/ajfa.v11i2.13929 url: https://doi.org/10.5296/ajfa.v11i2.13929 abstract given the crucial role played by banks in a developing country like tunisia, it is important to maintain their stability. the purpose of this article is twofold. first, it studies the effect of banking governance on credit risk. second, it tests the relationship between bank governance mechanisms and liquidity risk. in this article, we have combined literature regarding two areas of governance, first, ownership structure and board characteristics, and second, their impact on banking risks. to achieve this goal, we used a sample of 10 tunisian banks observed during the period 1998-2015. the econometric approach used in this study is based on both the fixed and random effects models of panel data analysis. our results show that credit risk and liquidity risk are directly related to bank governance mechanisms. these findings enable bank managers to better understand the factors influencing bank risk and serve as a basis for regulations to strengthen bank governance. keywords: board of directors, institutional ownership, credit risk, liquidity risk, stability, tunisian banks. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 149 1. introduction liquidity and credit risks are positively related and jointly contribute to bank volatility. in a recent study, based on a sample of 49 banks in the mena region from 2006 to 2013, ghenimi a. et al. (2017) examined the main sources of bank fragility. their analysis is based on the relationship between credit risk and liquidity risk and their impact on bank stability. in a note from the basel committee on banking supervision (2016), good corporate governance for banking organizations increases the effectiveness of risk management, thereby increasing the financial strength of these entities. in order to assess the progress made by the banking sector in the area of risk governance, the financial stability board (fsb) published a thematic analysis on governance in february 2013. such analysis encourages financial institutions and national authorities to take steps to improve risk governance. in general, banks deliberately take the financial risk to generate revenue and serve their customers, resulting in asymmetric information. however, good internal governance of banks is essential, forcing boards to focus more on risk assessment, management and mitigation. hence our problem is presented as follows: what is the impact of the governance mechanisms of characteristics of the board of directors and ownership structure on the risks of tunisian banks, which continue to occupy a leading position in the financing of the economy? we have chosen a developing country such as tunisia for several reasons. first, given the crucial role played by banks in tunisia's economy, it is important to maintain their stability. the stability of the banking system essentially leads to political stability and therefore to economic and financial stability. second, since the 2011 revolution, the underlying economic situation in tunisia has worsened. the economic and political uncertainties resulting from recent unrest and regime changes have led the major rating agencies to degrade tunisian sovereign ratings in early 2011. however, banks were the first victims of the post-revolutionary period, as the tunisian banking sector suffered an economic downturn involving "crisis of liquidity, fall of investments, increase of doubtful debts, weak recovery1 ..." third, despite the return of bank shares four years after the revolution, the sector has not yet emerged from the crisis. liquidity is still under pressure, competition is raging and becoming more aggressive and private investment has not yet resumed. at this stage, understanding the risk behavior of banks is essential from the point of view of financial stability. at this stage, the contribution of our article to literature is twofold. on the one hand, to our knowledge, few studies have examined the cumulative impact of banking governance, particularly board characteristics and ownership structure, on the main banking risks of tunisian banks. on the other hand, given that the tunisian banking sector is exposed to certain disruptions related to various environmental, economic and political changes, risk management measures become a necessity to strengthen the role of banks in the economy and system restructuring. hence, we provide bankers with tools to more effectively manage bank stability through the monitoring of credit and liquidity risks. 1 as a result of these events, the central bank of tunisia (bct) immediately launched a plea for tighter banking regulation, but the tunisian banking system continues to suffer from structural problems and long-standing assets. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 150 the next section (2) will give a brief literature review. an overview of tunisian bank system intermediation is presented in section 3. empirical methodology is explained in section 4. a discussion of the major findings is presented in section 5, while section 6 concludes. 2. corporate governance and bank attitude towards credit and liquidity risk literature review of the ownership structure and board characteristics are at the heart of this article, where our banking governance mechanisms are presented in two categories as follows: 2.1 characteristics of the board of directors 2.1.1 board size and bank risks the size of the board is an indicator of the number of board members. a very small board may have difficulty resisting management and dealing with the different risks of the banking sector. a very large board may also be unable to effectively oppose management. this suggests that board effectiveness in promoting shareholder interests may be related to board size in a nonlinear fashion. this measure has been used in previous work, such as simpson and gleason (1999), sumner and webb (2005) and pathan (2009), where they examined the link between board size and bank risks. since studies on the relationship between board size and bank risks have yielded contradictory results, we present two parts: first, jensen (1993) postulates that a reasonably sized board would be more effective because it allows for better coordination, faster decisions and reduced agency costs. using a sample of 27 egyptian banks covering the period 2006-2011, abobakr and elgiziry (2017) studied the influence of board characteristics on risk-taking by banks. empirical results indicate that the size of the board has a significant positive effect on risk taking by banks. adams and mehran (2005) found that banks with larger boards are more exposed to bank risks. manthos et al (2009) supported this finding when they explored the relationship between board size and liquidity risk for a sample of 127 banks from 10 countries for a period from 2000 to 2006. their research showed that banks with large boards of directors invest more of their portfolios in risky activities and increase their liquidity risk. on the other hand, the work of andres and vallelado (2008) and pathan (2009) have shown the contrary by demonstrating that a small number of directors on the board accelerate decision-making and facilitate control. second, crespi et al. (2004), states that a large board of directors would be an organizational response to the company's environmental requirements by allowing the representation of different stakeholders. faleye and krishnan (2017) analyzed the effects of banking governance on risk taking. empirical results indicate that banks with more efficient boards are less likely to lend to riskier borrowers. faced with riskier borrowers, banks can practice credit rationing to avoid credit risk. dannon p.h. (2009) studied the impact of a little board on the reduction of banking risks. he demonstrated the presence of a negative relationship between a small board of directors and banking risk, so that a large board of directors could better control the risk of investment projects through a diversified structure and better expertise. based on the analysis of the literature we assume that a very small board may have difficulty resisting management, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 151 dealing with various risks for the banking sector, decision-making and control within banks. to better understand the impact of the size of the board on banking risks, we propose the following hypothesis: h1. a large size of the board increases bank credit and liquidity risks. 2.2.2 duality and bank risks for jensen (1993), the dual role of chairman of the board and chief executive officer is also likely to influence the level of risk-taking by the board of directors. this theory has been confirmed by the works of dannon (2009). he noted that this dual has led to risky credit and investment decisions. thus, in the case of duality, officer may have a higher authority than the board of directors, which leads to high exposure to different banking risks. in addition, pathan s. (2009) examined the ceo's ability to control board decision for 212 major us banks. their main conclusions have shown that the duality of the two functions (ceo-chairman) affects bank risk. this study of the tunisian context reminds us of the note published in (2012) by the governor of the central bank2. therefore, based on the rules of good governance of tunisian companies, it is recommended to separate the two functions to ensure a good decision. while some studies confirm that the combination of ceo functions has a positive impact on banking risk (core et al. 1999, st onge et al. 2001), others do not establish meaningful relationships (conyon et al. peck 1998, cordeiro and veliyath 2003). in our study, we believe that for the oversight function to be effective, it is recommended that the director general not hold the position of chair. on the basis of the literature review, we will establish the following hypothesis: h2. the duality of the two functions of ceo and chairman of the board of directors increases the risks of bank credit and liquidity. 2.2.3 board independence and bank risks the previous literature review has focused on the relationship between bank risk and the independence of the board of directors as a means of control to ensure greater effectiveness of risk management. an independent member of the board of directors is a board member free from any conflict of interest, independent in the protection of investors and the improvement of the quality of control exercised by the board. this person helps guide the bank's strategic policies and make them more effective in managing bank risks. several studies have examined the effects of the presence of independent directors on the bank's board of directors. agency theory suggests that independent directors play an important role in monitoring the performance of managers. jensen (1993) and pathan (2009) suggest that a significant percentage of "external" independent directors have a positive influence on the reduction of different banking risks. at this point, we distinguish two different flows: 2such a note aims to establish a sound and prudent system and to ensure better management of banks. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 152 at first, dahya et al. (2008) and lin et al (2010) agree that the presence of independent directors on the board maximizes the wealth of shareholders and investors through their skills and experience in managing different risks. francesco vallascas et al. (2017) examined the impact of the board's independence on the risk taking of large banks following the global crisis of 2007-2009 for a sample of 262 large banks. using zscore and roa as two measures of risk, their main results showed that greater independence of the board of directors led to more conservative risk taking in banking. this is due to the fact that the independent board favors the increase of banking capitalization and the risk reduction of banking portfolios after the global crisis. in response to this argument, dionne and triki (2004) stated that independent directors are not in a position to control director functions. their strong presence on the board of directors has no impact on bank activities and does not cover risks. at this stage, we formulate the following hypothesis: h3. an independent board of directors reduces bank risk. 2.2 ownership structure 2.3.1 state ownership and bank risk state administrators play a key role in managing credit risk and liquidity (choi and hasan 2005 and gulamhussen and guerreiro 2009). according to konishi and yasuda (2004), the presence of the state has a positive influence on bank credit risk. according to agency theory, stateowned banks would suffer less disciplinary effect from the financial market. this would encourage their leaders to follow their own interests, increase their profitability and reduce the level of risk for their institutions. on the other hand, for la porta et al. (2002), state participation in commercial banks is a common fact and a clear consideration of their inefficiency as they are increasingly exposed to risks. some studies have focused on the governance of banks in emerging countries. these studies point out that for banks where the state or public institutions hold a significant portion of their capital, their results are positive, representing their efficiency and performance. lang and so (2002) argue that banks characterized by the presence of the state are under increased pressure from their environment and more intense disciplinary effect from the financial market. as a result, state involvement in strategic economic sectors such as banks is needed to accelerate growth and performance. on the basis of the literature review, we formulate the following hypothesis: h4. a high percentage of directors representing the state reduces the level of credit risk and increases liquidity risks. 2.3.2 foreign director ownership and bank risks the presence of foreign investors reinforces surveillance activities and encourages the bank's management to adopt more effective strategic and operational practices. in fact, banks with a high participation of foreign directors have better access to capital markets, greater ability to asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 153 diversify risks and better opportunities to offer some of their services to foreign clients that are difficult to access at local banks. on the contrary, in the tunisian context, for a sample of 8 tunisian commercial banks, chenini. h and jarboui. a (2016) proved that a high percentage of foreign administrators reveal a negative impact on performance. based on the review of the literature we formulate the following hypothesis: h5. a high percentage of foreign directors negatively affect banking risks. 2.3.3 institutional investor-ownership and bank risks david h et al. (2012), used a sample of financial companies from 30 countries that were at the center of the economic crisis, to show that institutional ownership defined as "percentage of shares held by institutional investors who have or represent 5 % of capital", experienced better stock returns during the crisis period and took more risks before the crisis, which resulted in greater shareholder losses over the same period. vincent aebi et al. (2012) studied whether risk management is linked to corporate governance mechanisms. the results show that the percentage of shares of a bank belonging to major shareholders holding 5%or more, affects performance and banking risk. in the same context, pathan, s. (2009) applied the zscore technique to a sample of 212 large us financial firms for a period from 1997-2004. this technique showed that a lower percentage of institutional investors are positively associated with bank risk taking as banking associates. h6. a high percentage of institutional investors holding 5% or more of capital reduce banking risks. 3. an overview of the tunisian bank system the banking system has seen a reduction in available liquidity in recent years due to factors such as a large current account deficit of about 9% of gdp in 2014. in order to remedy this problem and consolidate this segment, the authorities launched in 2014 an audit of the three main public institutions. in 2015, the three state-owned tunisian banks "stb, bna and bh" represented 38% of total assets. their future seems vital for the system. in 2015, in order to carry out a radical restructuring for the benefit of the public banks reforms were introduced. the objective of such a restructuring is to make the latter more competitive and put them in a better position to finance the economy. specifically, in july 2015, the government decided to restructure these three state-owned banks3. in tunisia, bank loans to the economy in december 2016 amounted to 65.1 billion dinars data from the central bank of tunisia. this rose from tnd59.4 billion a year earlier, a 9.6% increase. bank loans from two years earlier had been tnd56 billion, marking an increase of 16.3% over that period. government bank credit had further increased to 8.5 billion dinars in november 2016, against 7.2 billion dinars at the end of 2015, with total loans equal to tnd 6,818m at the end of 2015 and tnd7,286m at the end of 2016. 3 by recapitalizing stb and bh banks with respective amounts of tnd756m and tnd110m. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 154 graph1 shows an average annual evolution in the two main banking risks over the period 19982015. these are credit risk (rcdr) and liquidity risk (liqr). credit risk (rcdr) has been almost stable over the period 1998-2015. this risk was approximately 52.11% in 1998 and reached 69.30% in 2015. during this period, the level of credit risk was approximately 75%. regarding the liquidity risk of tunisian banks, it can be interpreted in three phases. from 2000 to 2005, the level of liquidity risk was around 100%. this means that deposits were almost equal to the amount of credits. tunisian banks have tried to cover the credits granted by the deposits collected. the second phase covers the period 2007-2009. during this period, the level of liquidity risk increased. this increase does not explain the increase in credits granted. on the contrary, this reflects the low level of deposits received by banks. the international financial crisis of 2008 was followed by a decline in the level of depositor confidence in banking institutions. for this reason, they preferred to withdraw and/or keep their capital outside banks. however, in the third phase, which covers the period 2010-2015, the descriptive statistics indicate a stable level of liquidity risk around 100%. it can be considered that the credits granted4 were covered by the deposits collected5. graph1. average annual evolution of risk indicators for tunisian banks during the period 19982015 source: graph developed by the authors from the annual reports of banks. 4. empirical analysis in this part of our study, we will begin by presenting the data and the methodology. second, we will specify the econometric model used. the definition and measurement of variables are also provided in this step. thirdly, we will interpret a possible econometric and economic association between banking governance and banking risks, namely liquidity risk and credit risk. 4 the total credits of the 10 banks in our sample changed from tnd43, 412,765m in 2015 to tnd40, 249,688m in 2016. for more details see appendix1 "evolution of deposits and credits of customers" 5 the total deposits of the 10 banks in our sample increased from tnd42, 542,865m in 2015 to tnd46, 367,969mmtd in 2016. for more details see appendix1 "evolution of deposits and credits of customers" 0.00 50.00 100.00 150.00 200.00 250.00 199819992000200120022003200420052006200720082009201020112012201320142015 rliq (%) rcrdt (%) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 155 4.1 data and methodology an important step in our empirical study is to review the literature and identify the causalityrelated governance variables identified for credit risk and liquidity risk. to do this, we will analyze two sets of data. the first set concerns components of banking governance mechanisms while the second set concerns the evolution of banking risks estimated by the control variables of our model. we will use a sample of 10 tunisian banks covering the period 19982015.although this tunisian banking system covers more than 29 banks, we only consider these 10 banks for our study for several reasons. first, these banks are the best-tuned empirical studies for the tunisian banking system. therefore, we can ask for a comparison of the results. second, these 10 banks are the most dynamic of the tunisian economy. thus, they monopolize the largest market share in terms of total assets (about 70% of all assets), total loans, total deposits and 88% of total gdp. third, we assume that governance mechanisms are different from other banks in terms of size, ownership, and banking strategies. the data for the governance variables are collected from the annual reports of the various banks, while the performance measures are collected from the financial statements of our sample. 4.2 model and variable definitions in this study, we will present a model to estimate the impact of internal banking governance mechanisms on the various risks to which banks are exposed. we have therefore developed a model that allows us to understand the complexity of the impacts of governance mechanisms and to avoid the problem of endogeneity between the governance variables and the credit and liquidity risk within each bank. indeed, we have noted that large banks communicate more about their governance than smaller banks and often take proportionately more risks. for this reason, we will include the size of the bank as a control variable in our model. to empirically validate the association between governance risks and banking risks, two econometric models will be used in this study. the first will test relationship governance and credit risk while the second will examine the impact of governance mechanisms on liquidity. recall that these models were inspired by previous studies with adjustments applicable to the tunisian context. it should also be noted that following the unavailability of some data for the tunisian case, the variables were replaced by others. as an example, we cite the works of cheneni and jarboui (2016), himaj.s (2014) and aebi et al. (2012), vallascas et al (2017) and rose (2016). they are presented in the following form: rcdr i,t=β0+ β1bdsizei,t+ β2duali,t +β3 ind i,t + β4 statei,t + β5 exti,t+ β6 inst i,t + β7 cap i,t+ β8 sizei,t+ β9 liqr i,t+ £ i,t (eq1) liqr i,t=β0+ β1bdsizei,t+ β2duali,t +β3 ind i,t + β4 statei,t + β5 ext i,t+ β6 inst i,t + β7 cap i,t+ β8 sizei,t+ β9 rcdr + £ i,t (eq2) the definition and measurement of the variables used in both models are presented in the following table: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 156 table1. definitions and measures of variables variables definitions measurement sources dependent variables rcdr credit risk total loans/ total assets iannotta et al. (2007), chiorazzo et al. (2008), and ghenmia. et al. (2017) liqr liquidity risk total loans /total deposit hakimia. et al. (2017), zaghdoudik. and hakimia. (2017), and ghenmia. et al. (2017). bank specifics size bank size ln (total assets) anginer et al. (2014), hakimia. et al. (2017) cap capital total equity/total assets pathan (2009), hakimia. et al. (2017) bank governance mechanisms bdsize board size total number of directors on the board. switzer (2013) and caspar rose (2016) dual duality binary variable that takes 1 when the executive director is also chairman of the board and 0 otherwise. simpson and gleason (1999), pathan (2009) and cheninih. and jarbouia. (2016) ind board independence number of independent directors / total number of directors on the board. pathan (2009) and cheninih. and jarbouia. (2016) state state ownership number of directors representing the state / total number of directors on the board. guerreiro (2009) and cheninih. and jarbouia. (2016) ext foreign director ownership number of foreign directors / total number of directors on the board. choi and hasan (2005), gulamhussen and guerreirol. (2009) and cheninih. and jarbouia. (2016) inst institutional investor ownership percentage of investors holding 5% or more of the capital. baysinger et al.(1991), hugan et al. (2011), and aebi et al. (2012) source: table made by authors based on the literature review. 5. results and discussion before interpreting the empirical results, we will give an overview of all the variables used in this study. the descriptive statistics presented in table2 give information on each variable, such asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 157 as the mean value of the standard deviation and the maximum and minimum values. table2 below provides information on the average evolution, the dispersion with respect to the mean (standard deviation), the maximum and the minimum of each variable. this table provides readers with more information about our sample. table 2. descriptive statistics variable obs mean std. dev. min max rcdr 180 0.747 0.130 0.030 0.965 liqr 180 1.179 0.366 0.551 2.597 bdsize 180 11.039 1.511 5.000 14.000 dual 180 0.594 0.492 0.000 1.000 ind (note 4) 180 1.452 4.658 0.000 18.180 state 180 0.149 0.195 0.000 0.545 ext 180 0.226 0.244 0.000 0.777 inst 180 0.369 0.204 0.000 0.875 cap 180 0.089 0.031 0.011 0.175 size 180 14.877 0.620 13.742 16.169 source: author's calculations based on data from the banks' annual reports. for dependent variables, the average value of credit risk is approximately 74.7%, with a standard deviation of 13%, a minimum value of 30% and a maximum value of 96.5%. for the evolution of bank liquidity risk, the average is 117.9% with a standard deviation of 36.6%, with maximum and minimum values of 55.1% and 25.97%. this means that for liquidity risk, total credit is more than double the total deposit. however, we note that, with respect to liquidity risk, there is a significant gap between the maximum and minimum variables. this means that in our sample of tunisian banks for the period 1998-2015, some are stable banks, and others are unstable. most notable for this descriptive statistic is that the size of the bank for tunisian banks is stable and uniform. there are no strong differences between mean, maximum and minimum values. hence, we note that the average size of tunisian banks in our sample is 14.877 in total assets, ranging from 13.742 to 16.169. unlike lending activity, which is considered in many studies as a proxy for credit risk, value is on average 0.089. regarding banking governance mechanisms, the size of the board of directors is on average 11.039. the minimum and maximum values are approximately 5 and 14 members respectively. for the presence of independent directors, the average value is about 1.452% with a maximum of 18.18%. such a value indicates that the presence of independent investors is low in tunisian banks. this low rate indicates the importance of the dependent directors for the boards of directors of tunisian banks. the duality is a binary variable, with classical values recorded as 0 for the minimum value and 1 as the maximum value. regarding the presence of directors representing the state on the board, the value is an average of 14.9%. the minimum value is equal to 0%with 54.4% as the maximum value. similarly, for the percentage of foreign directors on the board, the average is 22.6% with 77.7% as the maximum. finally, institutional investors on the board of directors average 36.9%. such an average indicates their strong presence on the board, which shows that institutional investors hold significant shares in bank asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 158 capital. after having an idea of the variables used in the econometric model, the correlation matrix is presented in the table3 below indicating the nature and level of correlation between the variables. table 3. correlation matrix of banking governance variables rcdr bdsize dual ind state ext inst cap size liqr rcdr 1.0000 bdsize -0.1756 1.0000 dual -0.1489 -0.0838 1.0000 ind 0.1682 0.1568 -0.0913 1.0000 state -0.1379 0.1888 0.3292 0.0850 1.0000 ext 0.1228 -0.2265 -0.2890 -0.1787 -0.6254 1.0000 inst 0.1789 -0.1353 -0.4082 -0.1147 -0.6996 0.0801 1.0000 cap 0.1149 -0.1679 -0.0309 0.0682 -0.0885 -0.1481 -0.0621 1.0000 size 0.2565 0.1045 -0.2815 0.1232 -0.0086 -0.0719 0.0385 -0.2735 1.0000 liqr 0.1288 -0.0713 0.1329 0.1008 0.1312 -0.0657 -0.1057 0.2881 -0.2242 1.0000 source: author's calculations based on data from the banks' annual reports. from table3 above, we can observe that there is no high correlation between the variables. it appears that the level of correlation between all the variables is very low. the highest correlation did not exceed a level of 33%. it is registered between the two variables of state and dual. this low level of correlation confirms the absence of a multicollinearity problem in this study. 5.1 bank governance and credit risk the results relating to the impact of governance mechanisms on bank credit risk are presented in table4. regarding the impact of governance variables on credit risk, it should be noted that these variable are introduced gradually for two reasons. the first one is to avoid multicolinearity problems between dummy variables. the second is to detect the partial impact of each variable of governance. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 159 table 4. estimation results, governance and credit risk (rcdr: dependent variable) m1(re) m2 (re) m3 (re) m4 (re) m 5 (re) m 6 (re) rcdr coef, coef, coef, coef, coef, coef, cap 0.482 0.414 0.469 0.661 0.625 0.617 1.50 1.30 1.48 2.070** 1.900* 1.920* size 0.087 0.079 0.082 0.082 0.087 0.082 6.480*** 5.670*** 6.000*** 6.090*** 6.410*** 5.800*** liqr 0.047 0.048 0.044 0.044 0.044 0.048 2.110** 2.170** 1.970** 2.020** 1.940* 2.040** bdsize -0.005 -0.88 dual -0.045 -2.430** ind 0.004 2.160** state -0.264 -2.900*** ext 0.066 1.44 inst 0.085 1.51 _cons -0.594 -0.489 -0.57 -0.539 -0.676 -0.611 -2.610*** -2.200** -2.650** -2.530** -3.130*** 2.760*** hausman 1.32 1.62 3.50 1.39 4.133 1.79 prob chi2 0.857 0.804 0.477 0.847 0.459 0.795 fisher _ _ _ _ _ _ prob chi2 _ _ _ _ _ _ wald 45.84 52.43 50.27 55.38 44.81 40.17 prob chi2 0.000 0.000 0.000 0.000 0.000 0.000 obs 180 180 180 180 180 180 *, ** and *** indicate the significance level of 10%, 5% and 1% respectively source: author's calculations based on data from the banks' annual reports. the results show that the capital adequacy ratio increases credit risk. it is clear that a better capitalized bank remains more stable and profitable. in this study, a high capital ratio leads to an increase in credit risk. this result can be explained as follows. highly capitalized banks may engage in speculative and risky behavior. a sufficiently capitalized bank seeks to reinvest this capital to be more profitable. the search for this profitability may encourage banks to sometimes be more flexible in terms of credit distribution. this flexibility is based on the distribution of loans without requiring sufficient guarantees or, in some cases, the financing of asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 160 risky projects, generally with high rates of return, but with a low probability of success. the size of the bank is positively and significantly correlated with credit risk. the big banks are difficult to control and manage. as a result, credit decisions can be stifled. big banks are constrained by a problem of asymmetric information as a result of their large number of customers. this can have a negative influence on decision-making and increases the credit risk. there is a second argument explaining this positive association between size and credit risk. in general, the big banks are heavily involved in financing well-defined industries such as tourism or agriculture. however, these sectors depend on economic and political stability (tourism) as well as climatic conditions (agriculture). take the case of the three public banks in tunisia that have heavily financed the tourism sector. after the tunisian revolution of 2011, there was a fall in this sector because of the flight of tourists to other more stable and secure countries. tourism companies were unable to meet their commitments and banks have been exposed to credit risk. as a result, our results are divergent from the work of saunders et al. (1990), chen et al. (1998), cebenoyan et al. (1999) and legginson (2005). when it comes to liquidity risk, it has a positive and significant correlation with credit risk. this association seems to also be reciprocal. in other words, an increase in credit risk leads to an increase in liquidity risk. a bank with liquidity deficits may be the result of capital losses and interest. our results are consistent with those of douglas et al. (2005), gorton and metrick (2010) and he and xiong (2012). in addition to traditional variables that may affect credit and liquidity risk, the banking literature has shown the importance of governance mechanisms. the main empirical results show that the sign of the coefficient attached to the duality variable is statistically significant and negative. in the banks in our sample, the more the duality increases, the lower the credit risk. we note that the combination of control and enforcement powers in tunisian banks ensures better management of credit risk. our results are consistent with the work of malette et al. (1995) and bebchuk and fried (2006), where when the executive director combines both functions at the same time, he has more power to control board decisions to serve his own interests and those of shareholders. as a result, we can say that the duality of the two functions ceo and chairman of the board" reduces the level of credit risk. h2 is rejected. in addition, we note that for our sample, the presence of independent directors on the board is weak, while increased independence can in theory improve management control and oversight. this can be explained by the fact that independent directors are less familiar with the bank with respect to the board of non-independent directors. our results are contradictory to those of caspar rose (2016) who found that banks with more independent directors limited their exposure to risk. our results were confirmed and followed by structural changes for tunisian banks from the year 2016. these changes included the addition of independent directors to the boards of directors. they were extended to all banks under “article 47” of the new banking law6 . at this stage, we conclude that the weak presence of independent directors in our tunisian banks positively influences the level of credit risk. therefore, h3 is rejected. 6 according to law no. 2016-48 of 11 july 2016, relating to banks and financial institutions, "the board of directors or the supervisory board of a bank or financial institution must include at least two independent members of the shareholders and a member representing the smaller shareholders within the meaning of the laws and regulations relating to the financial market, as regards institutions listed on the tunis stock exchange ". asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 161 in the same context, we note that the percentage of directors representing the state significantly reduces the credit risk at the 1% level. in accordance with the work of choi and hasan (2005) and gulamhussen and guerreiro (2009), state administrators play a role of guarantor in the management of credit risk. they reduce the level of risk to which their institutions are exposed. in our study, according to the negative sign of the coefficient attached to the presence of directors representing the state, it can be concluded that state participation preserves the interests of tunisian banks not only as shareholders, but also as regulators. therefore, h4 is accepted. 5.2 bank governance and liquidity risk table5 presents the results of estimates of the impact of governance mechanisms on liquidity risk. our governance variables are introduced gradually into the econometric model in order to detect the partial impact of each governance mechanism on the liquidity risk of banks. table5.estimation results: governance and liquidity risk (dependent variable liqr) m1(re) m2 (re) m3 (re) m4 (re) m 5 (re) m 6 (re) liqr coef, coef, coef, coef, coef, coef, cap 2.933 2.682 2.619 2.688 4.084 3.938 3.020*** 3.020*** 2.840*** 3.070*** 3.660*** 3.600*** size -0.129 -0.102 -0.13 -0.122 -0.132 -0.151 -2.720*** -2.160** -2.810*** -2.740*** -2.600*** -2.980*** rcdr 0.478 0.462 0.422 0.506 0.492 0.522 2.070*** 2.210** 1.930** 2.440** 1.900* 2.030** bdsize -0.001 -0.040 dual 0.086 1.570 ind 0.006 1.130 state 0.328 2.480** ext 0.353 2.100** inst 0.574 2.290** _cons 2.486 2.056 2.556 2.332 2.327 2.467 3.460*** 2.890*** 3.740*** 3.520*** 3.220*** 3.450*** hausman 2.01 7.83 5.35 4.76 16.32 15.99 prob chi2 0.733 0.098 0.235 0.313 0.002 0.003 fisher _ _ _ _ 7.50 7.74 prob chi2 _ _ _ _ 0.000 0.000 wald 25.51 28.52 26.98 32.75 _ _ prob chi2 0.000 0.000 0.000 0.000 _ _ obs 180 180 180 180 180 180 *, ** and *** indicate the significance level of 10%, 5% and 1% respectively source: author's calculations based on data from the banks' annual reports. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 162 table5 presents the results of the estimates of the impact of governance mechanisms on liquidity risk. the capital adequacy ratio is positively correlated with liquidity risk. in other words, any increase in this ratio increases liquidity risk. this result seems surprising, as the most capitalized banks are less exposed to liquidity risk. having sufficient capital is a very positive signal sent to the market about the solvency of the bank and its very low credit risk. this reduces the bank's risk of bankruptcy. a highly capitalized bank versus a weakly capitalized bank does not need to borrow to finance a certain level of assets. the use of its selffinanced capital to finance a project indicates to the market that the bank is very confident in its projects. these results are in contradiction with the work of olivier j. (2010), liu et al. (2010), ben naceur et al. (2010), garcíah. et al. (2009), and pasiourasf. and kosmidouk. (2007).the size of the bank has a negative and significant effect at the 1% level for liquidity risk. any increase in size is associated with a reduction in liquidity risk. the larger the size, the more the bank must manage its risks. this size may result from an aggressive growth strategy, which does not necessarily lead to an improvement in the bank's performance. smaller banks can better withstand difficult economic conditions. our results are consistent with the work of stiroh et al. (2006), barros et al. (2007) and de.jonghe (2010). when it comes to credit risk, it seems to have a positive and significant impact on liquidity risk. this result is expected given the reciprocal relationship between credit risk and liquidity risk. credit risk often leads to a loss of capital and interest. an increase in this risk increases liquidity risk. banks specializing in customer loans are more exposed to liquidity risk. when banks have a comparative advantage in providing credit to certain industries, financial integration may encourage banks to specialize in lending. greater concentration of loans does not necessarily increase risk, as a well-functioning interbank market provides the necessary diversification. our results corroborate the work of doriana c. (2013) and kim (2011). finally, table5 shows that the presence of the state, the presence of institutional investors and the percentage of foreign directors significantly increase liquidity risk. the percentage of institutional investors has a positive and significant impact on liquidity risk at the 5% level. in our sample we noted that the percentage of institutional investors is approximately 36.9%. this can be confirmed by the work of pathan s. (2009) who suggests that a lower percentage of institutional investors is positively associated with banking risk taking as banking associates. a second explanation can be presented, from where, based on agency theory, risk-taking behavior is influenced by conflicts between managers and shareholders. for their part, managers are reluctant to take risks to protect their position and personal benefits, while shareholders with a diversified portfolio are encouraged to increase bank risk. in this study, we conclude that the percentage of institutional investors can positively affects the liquidity risk of banks. as a result, h5 is rejected. regarding the impact of state ownership on bank risk taking in the case of liquidity risk, we find from table5 the coefficient of the state variable is significantly positive for our model. our results have been confirmed by the works of srairi(2013), berger and udell(2005), iannotta, nocera and sironi(2007).they found a positive and significant association between state participation in banking property and risk. this can be explained by the fact that state-owned banks have higher proportions of non-performing loans than other banks. we confirm that the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 163 presence of state participants on the board increases the risk of bank liquidity. at this stage, h4 is accepted. from our results, it appears that the percentage of foreign directors positively affects the liquidity risk of tunisian banks. the results indicate that there is a positive and statistically significant relationship between foreign participation and bank liquidity. in the tunisian context, this supports the idea that foreign directors do not know the economic nature of the country. they also bring new perspectives to the local banking business, thus reducing their dependence on traditional sectors of activity as they seek other sources of activity that are riskier. in our study, we conclude that the percentage of foreign directors positively affects the liquidity risk of banks. in the context of our study, this can be explained by the fact that foreign administrators are generally unaware of the tunisian economic reality and may have difficulties in implementing and applying their governance concepts to the specific case of tunisian commercial banks. thus, h6 is rejected. 6. conclusion and policy recommendations given the crucial role played by banks in a developing country like tunisia, it is important to maintain their stability. based on our experience in this area, we have provided a model to study the impact of board and shareholding structure characteristics on bank risk from a sample of 10 tunisians banks covering the period (1998-2015).we first analyzed the impact of banking governance on credit risk. our main econometric results have shown that duality and state ownership reduce credit risk, while the ownership of independent directors is associated with an increase in credit risk. in a second step, by analyzing the impact of governance mechanisms on liquidity risk, we found that the ownership of institutional investors, state ownership and the ownership of foreign directors positively impacted liquidity risk of banks. from our results, it appears that tunisian banks are not required to seek banking stability unless specific laws or regulations require it. interestingly, such targets, banks can lead to risks leading to financial contagion. in this context, a legal change should be evaluated. for example, the board should be equipped with new skills. we have been informed that these directors have accumulated successful experience in the banking system which should help to consolidate the banking stability. in addition, tunisian banks are invited to reduce the presence of foreign investors as a result of their positive impact on risks. similarly, the authorities are urged to radically restructure tunisian banks to make them competitive and put them in a better position to finance the economy. according to our results, it is recommended to improve the measurement methodology of corporate governance, as most banks do not communicate indicators on their governance practices. as a result, financial regulators should focus on banks with weaker corporate governance and evaluate policy measures to improve them. by doing this, banks would be healthier and more sustainable over time.these results could be of great importance to decision makers. however, banks and national authorities need more work to establish effective risk governance frameworks. on the one hand, banks need to strengthen their supervisory powers. the results of our study have certain limitations. first, we have selected the 10 most dynamic banks and those most involved in the financing of the economy. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 164 our sample seems too limited for 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(2017). the determinants of liquidity risk: evidence from tunisian banks. journal of applied finance and banking, 7(2,5), 71-81. appendix appendix1. evolution of deposits and credit of tunisian banks per mtdn deposits evolution credits evolution rang denomination abbreviation 2016 2015 var 2016 2015 var 1 amen bank ab 5,116,107 5,142,391 -0.5% 5,890,736 5,971,463 -1.4% 2 arab tunisian bank atb 4,082,786 3,876,934 5.3% 3,665,425 3,331,679 10.0% 3 attijari bank attijari 5,460,301 4,870,850 12.1% 4,482,854 3,836,075 16.9% 4 international arab bank of tunisia biat 9,078,141 8,092,342 12.2% 7,679,218 6,583,294 16.6% 5 bank of tunisia bt 3,153,153 2,847,254 10.7% 3,655,442 3,412,300 7.1% 6 banking union for trade and industry ubci 2,248,441 1,958,564 14.8% 2,561,769 2,381,519 7.6% 7 international union of banks uib 3,661,507 3,402,263 7.6% 4,126,831 3,725,437 10.8% 8 housing bank bh 5,260,709 4,696,798 12.0% 6,264,672 5,342,413 17.3% 9 national agricultural bank bna 6,946,257 6,247,322 11.2% 7,286,380 6,818,824 6.9% 10 tunisian bank company stb 5443,353 5,285,081 3.0% 5,588,166 5,341,440 4.6% total 46,367,969 42,542,865 8.6% 40,249,688 43,412,765 9.6% source: data extracted from the ranking of tunisian banks for the year 2014 and 2015 by the tse. microsoft word 14645-53048-1-sm(1)-writer2-new.doc asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 202 empirical evidence of the causative association between spot, futures and options market: an ardl model approach vaishali jain assistant professor symbiosis institute of management studies symbiosis international (deemed university), india rahul dhaigude (corresponding author) assistant professor symbiosis institute of management studies symbiosis international (deemed university), india rajiv divekar director symbiosis institute of management studies symbiosis international (deemed university), india received: april 10, 2019 accepted: may 28, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14645 url: https://doi.org/10.5296/ajfa.v11i1.14645 abstract purpose: the purpose of this paper is to explore and provide evidence about the nature of short run causal relationship as well as the speed with which prices adjust towards achieving the long run equilibrium between cash and fao markets in india as represented by national stock exchange. the study uses individual stocks for studying the underlying relationship. design/methodology: the paper makes use of the auto regressive distributed lag model to study the causal relationship between spot, futures and options markets. the study makes use of the 15-minute interval trades data for the purpose of analysis. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 203 findings: the ardl model shows a long run association between spot, futures & options (both call & put) prices but we do not have sufficient statistical evidence to conclude the short run causal association between the variable except for call and put options. practical implications: the results indicate that derivative markets are not leading the spot market but spot market contributes towards price discovery in the fao markets. potential investors can take their positions and design their portfolio in the cash and fao segments using the insights provided by this piece of work. originality/value: this paper is an original piece of work towards evidencing the causative association between spot, futures and options markets using individual securities. matters pertaining to price discovery process in indian financial markets are issues of interest for financial thinkers, traders, investors and financial analysts. keywords: futures and options markets, autoregressive distributed lag (ardl) model, nse nifty, stock market, derivatives asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 204 1. introduction “price discovery is the process through which asset markets reach equilibrium price levels. increased information efficiency of a market allows for faster price discovery. this process in the stock market is aided by the presence of derivative markets, which allow for information to flow through another channel. futures are one of the most commonly traded derivatives which support the spot markets in discovering the equilibrium price. as futures have inherent leverage and can be easily shorted, these markets tend to have higher liquidity than the underlying cash markets. higher liquidity implies greater participation by various groups of investors and traders and hence faster information absorption. the addition of options market further improves the liquidity in the derivatives market which allows it to play a greater role in the price discovery process. research in the area of price discovery and information sharing amongst futures and cash markets is important from two main standpoints. firstly, it has implications for market efficiency. presence of arbitrage opportunities indicates an inefficient market. secondly, the fundamental reason behind the introduction of derivatives markets is to increase liquidity and price discovery in the underlying cash markets through the trading linkages between these markets. this hypothesis assumes the importance of futures markets in absorbing and disseminating information to the cash market.” (jain & biswal, 2012) 2. overview of empirical literature some empirical studies in the past tried to analyze whether the spot prices are determined by the futures price. they found conflicting evidence and gave some questionable understandings. by applying the unidirectional econometrical technique, few papers found the lead of futures markets over the spot markets. it implies that the stock market has a mellow positive prescient capacity on returns of futures contracts. kawaller et al. (1987) used the tsls regression and evidenced that spot prices were led by s&p 500 futures prices to the extent of 20 minutes to 45 minutes and that the futures prices were influenced by the spot prices by 1 minute. finnerty and park (1987) found that evidence of association between the price changes in index futures and spot but they did not provide any evidence for a causative relationship. stoll and whaley (1990) applied time series analysis on the futures returns of the s&p 500 index and major market index (mmi) to inquire about their connection with stock index returns. they envisaged that mmi index futures returns and s&p 500 index futures returns had a lead over stock index returns by more than 5 minutes. however, they also found that futures returns were led by spot returns during the early periods of futures trading. nonetheless, they neglected to manage the issue of short and long run equipoise relationships in view of arbitrage exercises. in another study ghosh (1993), observed that the s&p 500 index prices were led by futures prices and the commodity research bureau (crb) futures index prices were led by spot prices. tse (1995) estimated the leading and lagging relationship between futures and spot index prices of the nikkei stock average (nsa). in his study, he used ecm on daily observations and found a long-run relationship between the two series. shyy et al. (1996) explored the lead–lag association between the cash index and continuous assisted quotation (cac) index futures. applying the ecm on one-minute trading price they found that the cash index was led by the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 205 cac futures. however, it was also found that when the mid-quote points of bid–ask prices were used the cac cash index led the futures. gee and karim (2005) analyzed the same lead– lag relationship in a study on the malaysian markets using daily data of futures contracts over spot and index. the process of price discovery in the hang seng index market was investigated by so and tse (2004) using the common-factor models of hasbrouck (1995) and gonzalo and granger (1995) and the m-garch model. using the 1-minute interval data from the hang seng index futures, hang seng index and the tracker fund (etf) it was observed that the movements of these markets were interconnected. fleming et al. (1996) investigated the us markets for the price discovery process in the spot and fao markets in the presence of trading costs. they envisaged that the lead lag association between these markets was significantly influenced by the structure of trading costs. jong & donders (1998) tested the lead lag association between the spot, options and futures contracts at the amsterdam exchange index and envisaged that the options market yields were led by the futures markets yields by 10 minutes. gwilym & buckle (2001) tested the lead-lag linkage among the spot index of financial times stock exchange 100 and its related fao contracts, and found that both the futures and put options markets were led by the call options markets. kang, lee, & lee (2006) used the returns of the korea composite stock price index spot, futures & options market to test the temporal associations and found the options market to be steering and trailing the futures market by 5 minutes only. nam, oh, kim, & kim (2006) studied financial markets in korea to investigate the relationship among the korea composite stock price index spot, the index futures and options markets. the cross-sectional analysis as well as the time series analysis indicated a symmetric lead–lag association between the options and the futures markets with an exclusion for out of the money option contracts. debasish & mishra, (2008) tested the lead-lag linkage between the nse nifty index and its associated fao contracts. they found a robust linkage between options and futures market where futures markets were led by the call options markets and put options markets were led by futures markets. maniar (2011) studied the outcome of the existence of arbitrageurs on the contemporaneous relationship between the spot index, options & futures market and established that futures markets led the options markets by ten minutes. ryu (2015) analyzed the informational content of futures and options transaction in kospi 200 index. they applied simple regression and studied the price influence of derivative trades over sequential time intervals. they concluded that not only the price discovery was greater in futures markets but they also led the options markets. (lee, kang, & ryu, 2015) examined intraday data for kospi200 futures and options markets. they found a common deviation in the futures and options markets and the pattern of deviation was flat on the basis of intraday trades. they also envisaged that there was a strong linkage between the two markets with reference to dynamics of asset prices and trading volume. (huang, wang, & wang, 2016), in their study on s&p 500 index options using the generalized spectrum method, found the statistical evidence of the options markets being inefficient. (sim, ryu, & yang, 2016) tested the monotonicity characteristics of the options prices using the options trades on kospi 200 index and found that the options prices violated these properties and the increase/decrease in the prices of call and put options was concurrent. (ryu & yang, 2017) examined kospi200 futures and options markets to examine the mechanism through which prices of index futures and options contracts asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 206 correct themselves to eliminate price disagreements. they found a strong association between index derivatives and stated that though both markets adjust to price disagreements but options markets were more likely to follow futures markets. (yang, choi, & ryu, 2017) analyzed the monotonicity properties of options prices and found that they did not correlate with spot prices, rather the change in call and put options prices often takes place concurrently. apart from these, there are some studies that are conducted on low-frequency data on the measures of volume, returns and volatility and have reported a bidirectional relationship. to name a few are, in 1992 malliaris & urrutia (malliaris & urrutia, 1992), in 2001 bhanupant (bhanupant, 2001) and chen et al. (chen et al, 2001), in 2003 mestel et al. (mestel et al., 2003), in 2008 floros (floros, 2008) and mahajan & singh (mahajan & singh, 2008), in 2009 kumar et al. (kumar et al., 2009) and in 2013 brüggemann et al. (brüggemann et al., 2013) and gurgul & syrek (gurgul & syrek, 2013). similarly, granger et al. (1964) examined the association among the trading volume and prices and could not find proof of a linkage between the two. there are many studies conducted to find the causality for low frequency data but very few studies talk about the high frequency data, which is a phenomenon for intraday trade. this research paper tries to fill this literature gap especially regarding indian stock market. 3. data and methodology 3.1 data description the study uses 15-minute interval intraday data on prices of spot and near month futures and options contracts, sourced from bloomberg, for the period of january 2017 to december 2017. for options contracts, contracts with highest strike price were selected. s, f, c and p represent the logarithmic value of prices in spot, futures, call and put options market respectively. 3.2 cointegration this paper makes use of the ardl bounds testing methodology which was developed by pesaran et al (pesaran, shin, & smith, 2001) to test the long run equilibrium association between spot, options and futures markets. ardl model provides a common dynamic measurement for approximating the long run and short run interactions between variables. this model makes use of the lagged values of dependent variables and lagged as well as concurrent values of the explanatory variables. with the help of these values, short run causality can be estimated directly while long run association can be estimated indirectly. ardl model comprises of estimating the following unrestricted ecm: ∆𝑆 = 𝑎 + 𝑏 ∆𝑆 + 𝑐 ∆𝐹 + 𝑑 ∆𝐶 + 𝑒 ∆𝑃 +∝ 𝑆 +∝ 𝐹 +∝ 𝐶 +∝ 𝑃 + 𝜖 (1) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 207 ∆𝐹 = 𝑎 + 𝑏 ∆𝐹 + 𝑐 ∆𝑆 + 𝑑 ∆𝐶 + 𝑒 ∆𝑃 + 𝛽 𝐹 + 𝛽 𝑆 + 𝛽 𝐶 + 𝛽 𝑃 + 𝜀 (2) ∆𝐶 = 𝑎 + 𝑏 ∆𝐶 + 𝑐 ∆𝑆 + 𝑑 ∆𝐹 + 𝑒 ∆𝑃 + 𝛾 𝐶 + 𝛾 𝑆 + 𝛾 𝐹 + 𝛾 𝑃 + 𝜀 (3) ∆𝑃 = 𝑎 + 𝑏 ∆𝑃 + 𝑐 ∆𝑆 + 𝑑 ∆𝐹 + 𝑒 ∆𝐶 + 𝛿 𝑃 + 𝛿 𝑆 + 𝛿 𝐹 + 𝛿 𝐶 + 𝜀 (4) the advantage with using ardl model is that it can be used regardless of the order of integration of underlying variables i.e. whether the variables are i(0), i(1) or fractionally integrated, doesn’t affects the methodology. f-test is used to study the cointegrating association among the variables. the null hypothesis of no cointegration among the variables in eq. (1) is h0:∝ =∝ =∝ = ∝ = 0, against h1: ∝ ≠∝ ≠∝ ≠∝ ≠ 0, which is denoted as fs(s/f,c,p). similarly, for eq. (2), h0: 𝛽 = 𝛽 = 𝛽 = 𝛽 = 0, against h1:𝛽 ≠ 𝛽 ≠ 𝛽 ≠ 𝛽 ≠ 0 which is denoted as ff(f/s,c,p) and so on for eq. (3) and (4). pesaran et al (pesaran, shin, & smith, 2001) have proposed two sets of critical f values (upper bound and lower bound) for large samples, where one set supposes that all the variable are i (0) and the other set supposes all the variables to be i (1). if the calculated f values lie above the higher bound, we can reject the null hypothesis of no cointegration and conclude that the variables are cointegrated implying a long run equilibrium relation. if the calculated f values lie below the lower bound, we cannot reject the null hypothesis and conclude that the variables are not cointegrated. no inferences can be drawn if the f value lies between the upper and lower bounds. 3.3 granger causality engle and granger (engle & granger, 1987) stated that if two series are i(1) individually and are cointegrated, there would exist a contributory association at least in one direction, which can be detected using the vector error correction model. causal association between a given set of variables can very conveniently detected using the granger causality test. a variable ‘x’ is said to granger cause variable ‘y’ if the prediction error of ‘y’ reduces by using preceding values of ‘x’ and ‘y’. for the purpose of this study, granger causality can be tested with the following equations: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 208 ∆𝑆 = 𝜑 + 𝜑 ∆𝑆 + 𝜑 ∆𝐹 + 𝜑 ∆𝐶 + 𝜑 ∆𝑃 + 𝜑 𝜀 + 𝑢 (5) ∆𝐹 = 𝜑 + 𝜑 ∆𝐹 + 𝜑 ∆𝑆 + 𝜑 ∆𝐶 + 𝜑 ∆𝑃 + 𝜑 𝜀 + 𝑢 (6) ∆𝐶 = 𝜑 + 𝜑 ∆𝐶 + 𝜑 ∆𝑆 + 𝜑 ∆𝐹 + 𝜑 ∆𝑃 + 𝜑 𝜀 + 𝑢 (7) ∆𝑃 = 𝜑 + 𝜑 ∆𝑃 + 𝜑 ∆𝑆 + 𝜑 ∆𝐹 + 𝜑 ∆𝐶 + 𝜑 𝜀 + 𝑢 (8) where φ’s are the parameters to be estimated, ut’s are the error terms and 𝜀 is the error correction term (ect). significance of short run causality is shown by the f-statistics on the lagged independent variables of error correction model. similarly, significance of long run causality is shown by the t-statistics on the coefficients of lagged ect. lag length is selected using the aic and/or sic. also the models are tested for serial correlation using the breusch-godfrey serial correlation lm test and for stability using the recursive estimates of cusum test. all the models were free from serial correlation and were found to be stable at 5 percent level of significance. 4. empirical results the results of bounds testing are presented in table 1. results indicate that cointegration is not present when spot prices are the dependent variable because fs (s/f, c, p) is lower than the lower bound critical value at 5 percent level. however, when futures, call and put options prices are dependent variables ff (f/s, c, p), fc(c/s, f, p) and fp(p/s, f, c) are higher than the upper bound critical value at 5 percent level. therefore, we can say that there is a long run relationship when they are treated as a dependent variable. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 209 table 1. results of bounds testing f-statistics f-value fs(s/f, c, p) 1.383215 (0.2370) ff(f/s, c, p) 423.2759 (0.0000) fc(c/s, f, p) 31.99496 (0.0000) fp(p/s, f, c) 30.30069 (0.0000) f-critical at 5% level i(0) 3.23 i(1) 4.35 the results of granger causality test are presented in table 2. results indicate that when spot prices are dependent variable, there is no short run causality found i.e. futures, call and put options are not granger causing spot prices. also the error correction term is not significant. when futures price is dependent variable, though we have a long run association coupled with a negative and significant error correction term, there is no short run causality among the variables implying spot, call and put options prices are not granger causing futures prices. the error correction term shows that the system achieves its equilibrium at a speed of 99.27 percent. when call options price is the dependent variable, there is a short run causality with put options prices but not with spot and futures prices i.e. put options prices do granger cause call options prices in short run but the same is not true for spot and futures prices. also we have a significant negative error correction term implying the speed of adjustment towards achieving equilibrium in long run is 25.91 percent. when put options price is the dependent variable, though we have a long run relationship with a negative and significant error correction term, there is no short run causality among the variables implying spot, futures and call options prices are not granger causing put options prices. the error correction term shows that the system achieves its long run equilibrium at a speed of 19.5 percent. table 2. results of granger causality test dependent variable δs δf δc δp ectt-1 δs 0.066753 (0.9354) 1.07122 (0.3427) 1.733595 ( 0.1767) -0.001470 (0.8554) δf 0.009469 (0.9906) 0.273945 ( 0.7604) 0.187493 (0.8290) -0.992741 (0.0000) δc 1.493275 (0.0923) 0.969910 (0.4872) 1.698347 (0.0399) -0.259197 (0.0000) δp 0.851604 (0.5967) 0.541120 (0.8891) 1.473722 ( 0.1260) -0.195083 (0.0000) 5. conclusion contrary to previous studies, this study establishes a long run association between spot, futures & options (both call & put) prices but we do not have sufficient statistical evidence to conclude the short run causal association between the variable except for call and put options. this implies that in long run, prices of futures and options together as well as individually, fail to asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 210 influence the prices in spot market i.e. they do not aid the price discovery process in spot markets. on the contrary, prices in spot and options market, collectively as well as individually, affect the prices in futures market. similarly, prices in spot and futures market, collectively as well as individually, affect the prices in options market. in short, we can say that while spot prices aid the price discovery process in both futures and options markets, 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(2004). price discovery and volatility spillovers in index futures markets: some evidence from mexico. journal of banking & finance, 28(12), 30373054. https://doi.org/10.1016/j.jbankfin.2004.05.001 copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 18949-article text-66560-writer2-new-final t receive doi:10.5 ca to allow achieve impact (2005… a positiv keywo the imp ed: march 1 5296/ajfa.v apital and li w a bank to e the financi of capital ….2020). by ve effect on rds: capita pact of faculty of 1, 2022 a 14i1.18946 iquidity are o cover any ial requirem on bank li y applying a n bank liqui al, bank, liqu capita t ben mous do economic s univ accepted: m url: ht ab two import y losses wi ments of ban iquidity. w a method of dity. uidity, pane 54 al on ba tunisia ssa moham octor in fina sciences and versity of m may 30, 202 https://doi.or bstract rtant variabl ith its own nk activity. we used a s f panel stati el static, fix asian ank liq a med aymen ance d manageme manar 22 pub rg/10.5296/ les in banki n funds. als the aim of sample of c (fixed eff ed effects n journal of f quidity: ent of tunis blished: jun ajfa.v14i1.1 ing industry so liquidity f this article 11 banks in fects) we fou finance & ac issn 19 2022, vol. 1 ajfa.macr : case o s ne 1, 2022 18946 y. capital is y is fundam e is to determ in tunisia b und that cap ccounting 946-052x 14, no. 1 rothink.org/ of s needed mental to mine the between pital has 1. intro the term can be can me liquidity repay b it has e prices. bank ca capital turn into losses a cover an the obj method sectionw 2. liter a-bank diamon cash so losses. l withdra compan liquidit due wit explain bank. traditio fund fo adequat deposito when bo b-bank first, ca from it liquidat bank fro oduction m “liquidity bought or s et its sched y refers to t orrowers w extended wi moreover, an quickly s is supposed o losses. th and to build ny losses w jectif of our dology of 3 we will mak rature revie k liquidity nd; rajan (2 o that banks liquidity ca aws from d nies or gove ty is the ab thout incurr ed that the onally, bank or different te liquidity ors’ deman orrowers dr k capital apital is the s assets. se ting all the om insolven y” has two sold quickly duled paym the latter me when due, m ithout payin because ba spillover to o d to protect his is where and mainta with its own r article is t 3 sections. ke the empi ew 2001) defin s can meet an also be d depositors o ernment. ility of the ring accept e viability o ks basically t groups wi in order t nd or withdr raw on com e accounting econd, it is assets at th ncy: the poi related but y in size wi ments or dem eaning but a eet deposit ng inordinat anks provid other banks a bank from we get to th ain confide funds. to analyse th the first s rical study. ed bank liq their oblig defined as th or requests bank to fun able losses of commerc y function a ithin the so to efficientl rawals, settl mitted cred g residual th s what is o heir accoun int at which 55 t distinct me ithout movi mands for f also depend withdrawal ately in fund de funding s. m all sorts o the two prin ence in a ba he impact o section is we finish b quidity as th gations on t he cash ava for borrow nd asset gro (bis (2008 cial banks as financia ociety. the ly perform ling wholes dit facilities hat remains owed to the nting value. h its liabilitie asian eanings in f ing the pric funds witho ds on the fo ls, and satis ding market to each oth of uninsured ncipal func ank. capital of capital on devoted to by conclusi he degree of time withou ailable with wers when g owth and m 8)). indeed, depends on l intermedi erefore, ban their daily sale commit (fsc, 20 after subtra e banks’ ow third, it is es exceed th n journal of f finance. an ce. an instit out incurring rmer. a ban fy draws on ts or selling her, liquidit d and unsecu ctions of cap is needed t n bank liqui literature on of resear f ease of con ut incurring the banks t granting cre meet its obli , the basel n the liquid aries and c nks are exp y obligation tments and 0). acting a ban wners—its s s the buffer he value of finance & ac issn 19 2022, vol. 1 ajfa.macr n asset is liq tution is liq ng high cost nk is liquid n lines of cr g assets at ty problems ured risks a pital – to ab to allow a b idity. we w review. in rch. nverting as g any unex to meet requ edit to indi igations as t committee dity position collecting p pected to m ns such as provision o nk’s fixed li shareholder r that separ assets. ccounting 946-052x 14, no. 1 rothink.org/ quid if it quid if it ts. bank if it can redit that fire-sale s at one apt to bsorb ank to will use a second sets into ceptable uests for ividuals, they fall e (2009) n of the points of maintain meeting of funds iabilities rs—after rates the more c (rime(2 capital b the as interest section asa bu agents; more ca risk of d c-the using u between relation hovarth issue is requirem gmm p they sh majority distingu and liqu strength basel i (2009)) they are ilyas an by usin various using g between danism for the banks h besides china. from ti perform capital tend 2001)). ban buffer as sig sset portio t-earning lo of a bank's uffer; capita the deposit apital; it is default; and relationshi us data; b n capital a nship for the h and al (20 s interesting ments such panel estim how that ca y of banks a uin and al ( uidity for eu hen their re iii accords ). their resu e exposed to nd sarwar ( ng data set classificati generalized n the desire man (2018) e period (20 has dramatic s xie (2016 this issue i ighten capi med regress ds to absorb nks raise ca gned by lea on of a b oans (e.g., m capital incl al will help t insusrance easier for a d be able to ip between berger and and liquidit e small bank 012) examin g because of h those in b mation frame apital negat are small. (2013) inve uropean and egulatory ca or when th ults show sm o higher illi 2018) explo of the ban ions of the b d least squa d variables explored th 001…2017) cally increas 6) investiga is interestin ital require sion analys b adverse apital when aven and le bank's cap mortgages, ludes loan-l p to protect e agency, fro a bank to ab go on. capital and bouwman ty creation ks. ned the rela f the potent basel 3. th ework on ex tively grang estigated the d us public apital buffer hey create mall banks d quidity. ored the imp nks of paki banks (overa ares (gls) for large ba he impact of ). the findi sed over tim ated the rel ng because o ements whi sis in simu 56 shocks and the portfol evine (2002 ital includ letters of cr loss reserve t debtholde om the cons bsorb losses d bank liqu (2009) fou n for the l ationship be tial impact hey perform xhausitive d ger causes e relationsh cly banks. o r when they more liqui do actuallay mpact of ban stan from ( all; small; m model; th anks and ne f bank capit ings indica me and it is lationship b of the poten ile propose ultaneous asian d thus redu lio risk goe 2). des cash, g redit, and in s and any d ers; includin sequences o s when hit b uidity und that th large banks etween capit on liquidity med grange data of czec liquidity cr ip between on the whol y face high idity as me y strengthen nk capital on (2004…201 medium; lar he results sh egative for s tal on bank ate that the primarily d between liq ntial impact ed by new equation m n journal of f uces the lik s up in ord government nter-bank lo debt it owes. ng small de of financial by an adver here is a po s; while th tal and liqu y creation f er causality ch banks; fr reation in th bank regul le;they fin er illiquidit easured by n the solven n liquidity c 13). the an rge). how the po small and m liquidity o liquidity c riven by lar quidity creat t on credit w capital ru model on t finance & ac issn 19 2022, vol. 1 ajfa.macr kelihood of der to keep t securitie oans). the li . epositors a distress. by rse stock; a ositive rela here is a n uidity creati from tighten y test in a d from (2000… his industry latory capita nd that bank ty as define berger; bo ncy standar creation in p nalysis is b ositive rela medium bank of 21 turkis creation of rge banks. ation and ca weakness p ules in ch the panel ccounting 946-052x 14, no. 1 rothink.org/ f failure up their es, and iabilities and their y having void the ationship negative on. this n capital dynamic …2010). y; where al buffer ks do not ed in the ouwman ds when pakistan based on ationship ks. sh banks turkish apital in problems hina. he data of chineas that sta creation higher the ban capital t in addi through le (20 vitenam contribu findings creation creation kayan banking between absorpt 3. emp 3.1 met we wil stb, b we mak the tem data wh data hav of degr improvi 3.2 spe we esti (1) +b8. cf b0= con b1, b2… sebanks; wh ate owned c n and capita capital tend nks, which tends to dec ition; gorto h another eff 018)investig mese banki uted a stron s alos indic n. in additi n and bank c and al (202 g liquidity n regulator ion hypothe pirical study thodology ll use a sam bna,uib; u ke a method mporal and hich offers ve also the ree of freed ing hence re ecification o imated the ala i,t = b +b7ceai,t fci,t +b9.t nstant ……b11: pa hich mainly commercial al. ds to mitiga hampers t crease liquid on, winton ffect “the cro gated the i ng between ng growth cate that of on the find capital in v 21) examin creation in ry capital a esis. y mple of 11 b ubci)includ dology of pa individual d great poten advantage dom and red esults estim of model following m b0+b1 roa t tdepositi,t + arameters to y includes 2 l banks do ate the finan the credibil dity creation (2017) sho owding out interrelation n (2007…2 in liquidity ff balance s dings indica vietnam. ned the effe n emerging and bank l banks (attij ded in finan anel static ( dimension o ntial analys of increasin duce the pro mates. (zagh model: ai,t +b2 ro +b10 tpib o be estimat 57 28 commerc not have s ncial fragili lity of its c n. ow that a h of deposits nip between 2015). the y cration in sheet activit ate a negati ect of regul asian eco iquidity cre jari bank; a ncial market (estimation of our samp is by track ng the samp oblem of co hdoudi and h oei,t +b3 n bi,t +b11 ti ted asian cial banks f significant r ity and enha commitmen higher capi s ”. n liquidity findings sh n vietname ties only pl ive 2 way atory capita onomies. w eation, whi amen bank; t of tunisia by fixed eff ple allows u ing individu ple size, thi ollinearity b hakimi (20 nimi,t +b4 s infi,t +ei,t n journal of f from (2004 relationship ances the b nts to depo ital ratio ca creation an how that la e between ( layed a sma relationship al and own we find a p ile inconsis atb; bia a for the p fects). us to use the ual behavio s leads to in between exp 17)). sizei,t +b5 t finance & ac issn 19 2022, vol. 1 ajfa.macr …2014). h p between l bargaining p osits. thus an reduce l nd bank ca arge banks (2007…201 all role in l p between l nership struc positive ass stent with at; bt; bt period (2005 e approach or over tim ncrease the xplanatory v tlai,t +b6 ccounting 946-052x 14, no. 1 rothink.org/ he found liquidity power of s higher liquidity apital in mainly 15). the liquidity liquidity cture on sociation the risk tei; bh, 5..2020). of panel me. panel number variables 6 capit i= bank ei,t = e table 1 variab ala roa roe nim size cap cea cfc tdeposi tpib tinf we will h 1: ba h2: ba k ; t= time error term .specificatio ble it l estimate th ank capital ank capital on of variab he following l have a sig don’t have bles name liquid ass return on return on net intere bank size capital operating financial part of de economic rate of in g hypothesi nificant eff e a significa 58 sets n assets n equity est margin e g costs credits eposits c growth nflation is: fect on ban ant effect o asian nk liquidity n bank liqu n journal of f measure liquid asset net income net income net intere equity logarithm o total capita operating c financial credits total depos gdp growt growth of i uidity finance & ac issn 19 2022, vol. 1 ajfa.macr ets / total asse e / total asset e / total equit est income of total asset al / total asse costs / total a expenses sits / total ass th inflation ccounting 946-052x 14, no. 1 rothink.org/ ets s ty / total ts ets assets / total sets table 2 variab ala tla roa roe nim size cap cea cfc t depo tpib tinf ala (m standard of total term of also t standard roa (m deviatio besides standard of total very dif size (m cap (m 2. descriptiv ble ob 176 176 176 176 176 176 176 176 176 sit 176 176 176 mean = 0.0 d deviation l deposits. t f part of cred la (mean d deviation mean = 0.0 on is low. t s roe (mea d deviation assets. the fferent betw mean =15.3 mean =0.105 ve statistics bservations 6 6 6 6 6 6 6 6 6 6 6 6 0285). the is not high the standar dits to depo = 0.775). n is not high 012). net in there is no b an = 0.111). is not high e standard d ween the ban 35). the mo 51). the equ s mean 0.0285 0.775 0.012 0.111 0.026 15.35 0.1051 0.032 0.038 0.7657 0.022 0.061 liquid asse h. cd (mean rd deviation sits. total loans h. there is ncome repre big differenc . the net inc h. also nim deviation b nks of samp st of banks uity represe 59 stan devi 0.02 0.11 0.00 0.06 0.01 0.92 0.06 0.02 0.01 0.11 0.03 0.01 ets represen n = 1.193). n is high. t s represent no big diff esent on av ce between come repre m (mean =0 between ban ple. are medium ent on avera asian ndard iation 225 142 094 631 132 2 632 26 153 181 361 167 nt on averag total cred there is big t on averag ference betw verage 1.2% banks in te sent on ave .026). net i nks is low. m size. age 10.51% n journal of f minimum 0.0028 0.12 0.000881 0.0029 0.0083 12.52 0.0086 0.000237 0.01849 0.099 -0.1051 0.0340 ge 2.85% o its represen g difference ge 77.5% o ween banks % of total as rm of roa rage 11.1% interest mar the net int of total ass finance & ac issn 19 2022, vol. 1 ajfa.macr m maxi 0.104 0.981 0.097 0.297 0.163 18.29 0.48 0.35 0.168 0.956 0.064 0.085 of total ass nt on averag e between b of total asse s in term of ssets. the s a. % of total equ rgin represe terest margi ets. ccounting 946-052x 14, no. 1 rothink.org/ imum 426 7 75 76 91 9 9 6 4 43 ets. the ge 1.193 banks in ets. the f credits. standard uity.the ent 2.6% in is not cea (m standard cfc (m standard tdepos t pib tunisia tinf (m table 3 ala cd tla roa roe nim size cap cea cfc tdepos tpib tinf mean = 0.0 d deviation mean =0.038 d deviation it (mean =0 (mean = 0 a. there is n mean =0.06 .multicolin ala 1.000 0.0730 -0.0844 -0.1684 -0.2150 0.0158 0.0973 -0.0775 0.2036 -0.0378 sit -0.2385 0.0604 -0.1198 032). the o is low. the 8). the fina is low. the 0.7657). tot 0.022). the negative eco 61). the ave nearity test cd 1.000 4 -0.1949 4 0.1631 0 -0.1616 0.0833 -0.2745 5 0.6962 0.0159 8 -0.0258 5 -0.5547 0.0589 8 -0.0893 operating co ere is no big ancial expen ere is no big tal deposits average eco onomic grow erage inflati tla 1.000 0.1191 -0.1176 0.2478 0.1577 0.1346 -0.0661 -0.0117 0.0531 -0.1125 0.3496 60 osts represe g difference nses repres g difference represent onomic grow wth in 2022 ion is 6.1% roa 1.000 0.3921 0.1073 0.0857 0.2912 -0.0267 -0.0076 0.0169 0.0679 -0.0374 asian ent on aver of cea be ent on aver of cfc bet t on average wth is 2.2% because of in the perio roe 1.000 0.0834 0.3635 -0.1852 0.075 -0.047 0.3814 -0.0117 0.2111 n journal of f age 3.2% o tween bank rage 3.8% o tween bank e 76.57% of % in the peri f negative ef od (2005…2 nim 1.000 0.255 0.0615 -0.0641 -0.1476 -0.0711 -0.0250 0.043 finance & ac issn 19 2022, vol. 1 ajfa.macr of total ass ks of sample of total cred ks of sample f total assets iod (2005… ffect of cov 2020) in tun size 1.000 -0.3575 0.1237 0.1384 0.4336 -0.2505 0.4291 ccounting 946-052x 14, no. 1 rothink.org/ ets. the e. dits. the e s. …2020)in vid19. nisia cap 1.000 -0.0076 -0.0227 -0.6191 0.0123 -0.1064 table 4 cea cfc tdepos tpib tinf all the table. v var t de cap tin size roe tpi roa tla cfc cea nim varianc multiple equal to that sin high vi variable vif inf 4.suite of co ce 1.0 0.3 sit -0. -0. 0.1 coefficients vif riable eposit p nf e e ib a a c a m ce inflation e regression o the ratio o ngle indepen if indicates es in the mo ferior to 5. rrelation be ea 000 3142 .1459 .1394 1031 s are inferio factor (vi n variables. of the overa ndent varia s that the as odel. there is no etween varia cfc 1.000 -0.1598 -0.2233 0.1271 or to 0.80. t vif 2.20 2.13 1.90 1.67 1.56 1.53 1.43 1.31 1.27 1.17 1.12 f) is a me mathemati all model va able. this r ssociated ind o problem 61 ables tde 1.00 -0.0 0.16 there is no p asure of th ically, the ariance to th ratio is calc dependent v of multicol asian eposit 00 303 602 problem of m he amount o vif for a he variance culated for variable is h linearity. n journal of f tpib 1.000 -0.5512 multicoline 1/vif 0.4542 0.4689 0.5260 0.5992 0.6422 0.6519 0.6720 0.762 0.788 0.825 0.8902 of multicoll regression of a model each indep highly colli finance & ac issn 19 2022, vol. 1 ajfa.macr tinf 1.000 earity linearity in model var l that includ pendent var inear with t ccounting 946-052x 14, no. 1 rothink.org/ f a set of riable is des only iable. a he other hausm in pane choose preferre essentia regresso in your random table 5 ala roa roe nim size cap cea cfc tdepos tla tpib tinf constan there i decreas liquidity contrary there i decreas liquidity relation the inc man test el data ana between fix ed model is ally, the tes ors in the m r case prob m effect. 5. results of sit nt is a negativ se by 0.149 y. this resu y to result f is a negativ se by 0.028 y. this resu nship betwee crease of net alysis (the a xed effects m random eff sts look to model. the n chi2 = 0.0 f estimation coeff -0.149 -0.028 0.024 0.005 0.023 0.065 -1.087 -0.025 -0.003 0.013 -0.202 -0.013 ve relations 9%). the in ult if similar found by al ve relations 8%). the i ult is contr en nim and t interest ma analysis of model or a r fects; the a see if there null hypothe 75(it is sup n of model ( ficient 9 8 214 182 35 7 5 305 3 26 3 ship betwe ncrease of r to result fo homaidi an ship betwee increase of ary to resu d ala (if n argin has a 62 data over t random effe alternate hyp e is a corre esis is that t perior to 5% 1) z -1.0 -1.2 0.27 2.14 2.56 1.45 -1.2 -1.3 -2.2 0.36 -2.1 -0.4 en ala et return on found by mo nd al (2019 en ala an f return on ult found by nim increas positive im asian time), the h fects model. pothesis is t lation betw there is no c %). there fo 6 0 7 4 6 5 0 5 2** 6 1** 6 t roa (if assets ha orina; qarri ), gjorgi an nd roe (if equity has y agawal (2 se by 1%, a mpact on ban n journal of f hausman te the null hy that the mo ween the uni correlation b or we use e z< 0.2 0.2 0.7 0.0 0.0 0.1 0.2 0.1 0.0 0.7 0.0 0.6 roa incre s a negativ i (2021);alq nd goran (2 f roe incr s a negativ 2019).also ala will in nk liquidity. finance & ac issn 19 2022, vol. 1 ajfa.macr est can help ypothesis is odel is fixed ique errors between the estimation o <p 291 228 785 032 0547 148 229 176 0228 718 035 648 ease by 1% ve impact o qudah (20 2019). rease by 1% ve impact o there is a ncrease by 0 . ccounting 946-052x 14, no. 1 rothink.org/ p you to s that the d effects. and the e two. of model %. ala on bank 020) but %, ala on bank positive 0.024%). there i increase relation and al ( there i ala in this res contrary vodova there i ala w liquidity there i ala w bank liq deposits negativ (2020) there i ala w impact also th increase liquidity (2008) there i decreas result is qudah( conclu bank ca worth o cash, go inter-ba debt it o the bank ability o holding is a positive e by 0.005 nship is stati (2019); mas s a positive ncrease by 0 sult is simil y to result f a (2011) fou is a positive will increase y. is a negativ will decrease quidity. bes s increase b e impact on is a negativ will decrease on bank liq here is a pos e by 0.013 y. this res is a negativ se by 0.2026 s similar to (2020). usion apital is the of the bank o overnment s ank loans). t owes. a ban k would liq of a bank to gs in curren e relationsh 2%). the i istically sig shamba (202 e relationshi 0.023%). th lar to found found by xi und that ban e relationsh e by 0.065% ve relationsh e by 1.087% sides there i by 1%; liqu n bank liqu ve relationsh e by 0.0030 quidity. sitive relatio 3%). the in sult is simi ve relations 6%). the in result foun difference b or its equity securities, a the liabiliti nk's capital quidate its as meet its fin ncy or on hip between increase of nificant at 1 22) ip between he increase o d by (gjorg ie (2016); g nk capital ha hip between %). the incr hip between %).the incr is a negative uidity will d idity. this hip between 05%). the i onship betw ncrease of lar to resul hip betwee ncrease of in d by bista a between a b y value to in and interesties section o can be thou ssets. on th nancial oblig account at 63 n size and a f size has a 1%. this re capital and of capital h gi and goran gorton and w as a positive n cea and rease of ope n cfc and rease of fin e relationsh decrease by result is sim n tla and increase of ween ala a economic lt found by en ala an nflation has and basnet bank's assets nvestors. th -earning loa of a bank's c ught of as th he other hand gations as th the federa asian ala (if si a positive e esult is simi d bank liquid as a positiv n (2019)). a winton (20 e impact on bank liquid erating costs d bank liqui nancial expe hip between y 0.025%). t milar to res d bank liqui total loans and tpib ( growth ha y (fola (20 d tinf (if a negative (2020) but s and its liab he asset port ans (e.g., m capital inclu he margin to d bank liqui hey come du al reserve n journal of f ze increase effect on b lar to result dity (if capi e effect on b al homaidi 17).singh a n bank liquid dity (if cea s has a posi idity (if cf enses has a deposits an the increas ult found b dity (if tl by total as if tpib inc s a positiv 015)); bund f tinf incr impact on b contrary to bilities, and ion of a ban mortgages, le udes loan-lo o which cred idity is very ue. it can com or other c finance & ac issn 19 2022, vol. 1 ajfa.macr e by 1%, a ank liquidi t found by h ital increase bank liquid i and al (20 and sharma dity. ea increase itive effect fc increase a negative e nd bank liqu se of deposi by bista and la increase ssets has a n crease by 1% ve impact o da and des rease by 1% bank liquidi o result foun it represent nk's capital etters of cre oss reserves ditors are co y important me from dir central bank ccounting 946-052x 14, no. 1 rothink.org/ ala will ity. this homaidi e by 1% dity. 019), but a (2016); by 1%; on bank by 1%, effect on uidity (if its has a d basnet by 1%; negative %; ala on bank squilbert %: ala ity. this nd by al ts the net includes edit, and and any overed if to the rect cash k. more frequen basicall short te if their maturity volume neverth more th assets w providin in this a of 11 b signific referen -al ho liquidity finance -al qu jordani -berger studies, -bista.r econom -bunda regime. danism of turk diamon fragility disting from p154.ht gorton journal ntly, it come ly states hig rm maturiti maturity is y. for short es can be sol heless, a ba han just this will also m ng an additi article we st banks throu cantimpact o nces omaidi e; m y of indian e, 7(1) p 1-2 udah.a.m.( an commer r.a.n,& c 22(9), 3779 r.b,&p.ba mics and ma a.i,&desqu internation man.g.o. (2 kish banks.j nd.d.w,& y: a theory guin.i, c.ro us ttps://doi.org n.g.,&a.w l of money; es from acqu ghly creditw ies. short enou t term, very ld without m ank’s liquid s reserve of matter. as o ional source tudied the i ugh the pe on bank liqu m.i tabas listed com 20 (2020). ma cial banks.j .h.s bouw 9-3837. asnet.(2020) anagement s uilbet.j.b. ( nal econom 2018).a fin journal of b r.g. raja y of bankin oulet,&a.t and e g/10.1016/j winton.(2017 credit and uiring secur worthy secu ugh the bank safe securit moving pric ity conditio cash and hi of them m e of funds. ( mpact of ca eriod (2005 uidity. h; n.h fa mmercial ban croconomic journal of a wman.(2009 ).determina studies, 1(6) (2008). th mic journal, nancial analy usiness rese an. (2001). ng. journa tarazi. (201 european .jbankfin.20 7). liquidit d banking, 4 64 rities that ca urities, com k may simp ties favor to ces too muc on, particula ighly liquid may mature (tutorialpoin apital on ba .2020). we arhan; f.a nks: a pane c and bank asian finan 9). bank liq ants of b ), p390-398 he bank liqu 22(3), p36 ysis of the l earch –turk . liquidity al of politica 13). bank r publicly 013.04.027 ty provisio 49(1), 633. asian an be sold q mprising of ply wait for o trade in liq h and with arly in a cr d securities. before the nts.com) nk liquidity e found tha a.almqtari. el data appr k specific v nce; econom quidity crea bank liqui 8. uidity smil 1-386. liquidity cre k, 10(3),p1risk, liqu al economy, regulatory c traded n; bank ca n journal of f quickly with governmen them to ret quid market low transac isis, will be the maturi cash crun y in tunisia at capital h (2019). th roach. coge variables an mics and bu ation.the r idity in e across 2 eation and t -14 uidity creat 109(2), p28 capital and d banks apital and t finance & ac issn 19 2022, vol. 1 ajfa.macr h minimal lo nt bills, whi turn the prin ts, stating th ction costs. e affected b rity of its les nch passes, . we used a has a posit he determin gent econom nd the liqu usiness, 7(12 review of f nepal.qua 008 exchan the capital h tion, and f 87-327. liquidity: e s. the macroec ccounting 946-052x 14, no. 1 rothink.org/ oss. this ich have nciple at hat large by much ss liquid thereby a sample tive and nants of mics and uidity of 2), financial ntitative nge rate holdings financial evidence ssrn; conomy. hovart evidenc https://d ilyas.h disaggr econom le.tu. vietnam https://d masham of centr morina kosovo rime.b journal singh.a factors vodova journal zaghdo banks.j th.r, j.seid ce.working doi.org/10.2 h, & s.sarw egated ana mics, p171-1 (2018).th mese doi.org/10.1 mba.t. (20 ral banking a.m, a.qa o.european j b. (2001). c l of banking a,&a.k.sh affecting liq a.p.k. (201 l of mathem oudi.k; a.h journal of a dler,l.weil paper 2139/ssrn.2 war. (2018) alysis of b 190. he interrela ban 1108/mf-09 022). liquid g theory and arri (2021 journal of s capital requi g and financ harma. (201 quidity of in 11).liquidity matical mod hakimi (20 applied fina ll. (2012). b series 178383 ). relations banking ind ationship b nking.manag 9-2017-033 dity dynami d practice, 1 ). factors sustainable irements an ce, 25(4), p7 16). an emp ndian banks y of cezch c dels and met 017). the de ance and ba 65 bank capita s numb ship betwee dustry of between li gerial 7 ic of banks 1(1), p179-2 that affe developme nd bank beh 789-805. pirical anal s. future bu commercial thod in appl eterminants anking, 7(2) asian l and liquid ber 149 en bank cap pakistan. p quidity cre fi in emergin 206. ect liquidity nt, 10(1), 22 havior: empi ysis of mac usiness jour l banks and lied science of liquidity ), p1-5 n journal of f dity creation 97; se pital and liq pakistan jo eation and nance;june ng market e y of com 29-238. irical eviden croeconomic rnal, 2(1), d its determi es, 5(6),p106 y risk: evide finance & ac issn 19 2022, vol. 1 ajfa.macr n: grange c eptember; quidity crea journal of d bank cap , economies. mmercial ba nce for swi c and bank inants.inter 63-1067. dence from t ccounting 946-052x 14, no. 1 rothink.org/ causality 232. ation: a applied pital in 218. journal anks in itzerland. specific national tunisian microsoft word 18926-66534-1-sm-writer2-new-final orga receive doi:10.5 abstra having surviva are not for diss played account review suggest study u raman' result, f the fou practice reportin skills on keywo accou anizatio faculty faculty ed: july 5, 2 5296/ajfa.v ct substantial l of religio only repres seminating a significan tability issu of literatu ting plausib utilised van 's (2017) ta four main t ur themes a es; 2) eval ng disclosur n rnpos’ a rds: accou untabilit ons: pos of econom jalan u e r of econom jalan u 2021 a 13i2.18945 l accountab ous-based n senting the r ethical ma nt role in so ues involvin ure that ex ble contextu n helden a xonomical hemes have are 1) exam luating the res practice accountabili untability, r ty stud ssible c z mics, busines ums, 8840 e-mail: zuba rozaidy ma mics, busines ums, 8840 e-mai ccepted: se url: ht bility standa non-profit o religion’s id assage and ociety, many ng rnpos. xamined rn ual and app and nortco methods in e been iden mining the rnpos’ i es among r ity practices eligious no 23 dies in r context zubaidah mo ss and acco 00, kota kin aidah.mohd ahadi (corre ss and acco 00, kota kin il: zaidy@u ep. 26, 2021 https://doi.or ards and pr organisatio deals but at good value y studies ha . hence, th rnpos’ acc plication ga ott’s (2010) n categorisin ntified from outcomes o internal con rnpos; and s. on-profit or asian religiou tual and ohd ali ountancy, u nabalu saba dali69@gma esponding a ountancy, u nabalu saba ums.edu.my publi rg/10.5296/ ractices is ons (rnpos t the same ti es in the c ave highligh his study ai countability aps for futu and roza ng accounta m 60 selected of corporat ntrol practi d 4) explorin rganisation, n journal of f us non d appli universiti m ah, malaysia ail.com author) universiti m ah, malaysia y ished: dece ajfa.v13i2.1 a vital prac s). this is b ime, there a ommunity. hted the ne ims to prov practices ure research aidy, siti n ability studi d high-impa e integrity ices; 3) id ng the influ transparen finance & ac issn 19 2021, vol. 1 ajfa.macro n-profit cation g malaysia sab a malaysia sab a ember 1, 20 18945 ctice to en because the are also resp since the eed to explo vide a taxo and subse h. in so doi nabiha, ras ies in rnpo act journal and accoun dentifying f uence of lea ncy, taxono ccounting 946-052x 13, no. 2 think.org/ gaps bah bah 21 sure the rnpos ponsible rnpos ore more onomical equently, ing, this sid, and os. as a articles. ntability financial adership my 1. intro in gene individu disclose 1996; r associat humani can be (haniffa while b of trust implem by havi prepare over t governa become particul al., 201 play a importa since th financia rnpos despite there ar (saat et financia explore rnpos in comb to prov constru plausibl the tax and ro journals rnpos practice reportin skills to oduction eral, accou ual or orga e the results roberts and ted with h ity (yasmin viewed as fa and huda buddhist an t, aspiration mentation of ing adequat e financial re the past d ance practic e an increa larly, when 19; roslan e significant ant and at th he main ob al growth, t s are left to b e the rnpo re many rn t al., 2013). al accounta e various co s, and subse batting acco vide fresh cting taxon le research xonomy con ozaidy et al s articles w s were ident es; 2) eval ng disclosur owards rnp untability is anisation to s in a transp d scapens, aving good n et al., 201 s a broader aib, 2011) t nd hindu so n, and loyal f the accoun te financial eports. decades, in ces, sound asingly im it involves et al., 2017 t role in so he same tim bjective of a thus, there be explored os’ status a npos that e as a result, ability pract ontextual an equently, it ountability i avenues nomical rese gaps for fut nstruction fo l., 2017 tax were analys tified: 1) ex luating the res practice pos’ accoun s defined a be accoun parency man 1985). in d stewardsh 14). for exa r concept c that is desig cieties show lty (jayasin ntability mo managemen ncorporating financial m portant ele s religious7; atan et a ociety, thei me contribu a non-profit are many f d. s a public engaged wit , more dema tices in ma nd practica will provid issues from of accoun earch theme ture study. for this stud xonomical m sed and as xamining th rnpos’ i es among r ntability pra 24 as the inter ntable for th nner (paiva addition, th hip and ad ample, from consisting o gned for a wed the mai nghe and so odel in man nt practices g accounta management ement in p -based non al., 2017; ja ir contribut uting to the t organisati facets of pe frontier in th mismana and from th anaging the al contexts de better un m reoccurring ntability pe es from rela dy was base methods of a result, f he outcomes internal con rnpos, and actices. the asian rnal and e heir activiti a & carvalh he concept dhering to c m the islam of vicegere allah and its in mechanis oobaroyen, naging chur s, such as h bility prac t, adhere to projecting v n-profit org ayasinghe & tions to th country’s s ion is neith erspectives fighting an agement of f he public for eir funds. t of account nderstanding g in the futu erspectives ated journa ed on van h f themes ca four themes s of corpora ntrol practi d 4) explorin e rest of the n journal of f xternal dut ies, accept ho, 2018; ed of account common no mic perspect ency, trust, s subjects (b sms of accou 2009). for rches is com having accou ctices (i.e., o high ethic virtuous im ganizations & soobaroy e public w social-econo er profit-m of account nd champion funds and f r rnpos to thus, there ability pers g and solut ure. therefo involving l articles, a helden and ategorisation s of accoun ate integrity ices; 3) id ng the influ paper is str finance & ac issn 19 2021, vol. 1 ajfa.macro ty that dict responsibil dwards and tability is n norms and tive, accoun and respo (basri et al. untability is r the christ mmonly ref unting pers integratin cal standard mages and (rnpos) ( yen, 2009). welfares are nomic devel making nor r tability prac ning human fraudulent a o incorporat e is an urg spectives in tions for au fore, this stu g rnpos and then sug northcott’s n. in so do ntability stu y and accoun dentifying f uence of lea ructured as ccounting 946-052x 13, no. 2 think.org/ tates an lity, and d hulme, normally rules of ntability nsibility ., 2016). s consist tian, the ferred to sonals to ng good ds) have values, (fang et rnpos e highly lopment. reaching ctices of n rights, activities te decent gency to nvolving uthorities udy aims through ggesting s (2010) oing, 60 udies in ntability financial adership follows. it start explana follow conclud identifie 2. rese to iden perspec commo account of them al.'s (20 the firs that stu of the jo account and 68 journals auditin perspec accoun account a. b. c. d. 3. the m the jou revealed the det 3.1 the theme rnpos over the jayasin category organis s with a d ation of the with an e ding remark ed themes. earch meth ntify the n ctives, sever on or popu tability prac mes are infal 017) taxono st step in c died accoun ournal artic ting, and ma percent of s, ranging f ng & accou ctive on a nting histo tability stud examining evaluating identifying exploring t main them urnals were d that most tails of each eme a: exam a refers to s. studies th e past decad ghe and so y mainly v ational cultu discussion e selection elaboration ks on the od: classif new segmen ral steps are ular themes ctices in rn llible, this s mical meth categorising ntability pra cles was lim anagement j the articles from busine untability j accounting orians journ dies in rnp the outcom the rnpos financial re the influenc mes in acco grouped ba of the articl h theme will mining the o a study that hat employe des (see, ali oobaroyen, ventured on ures, and (ii on the me of academi of key iss future rese fying them nts of stud e needed, it s of study npos. to en tudy follow ods of them g the theme actices in re mited to artic journals. a s were publ ess, manage journal (aa (cpa); a nal. hence os: mes of corpo s’ internal co eporting dis ce of leaders ountability ased on the les are focu l be discuss outcomes of t focused on d theme a a i et al., 2020 2009 and i n these thr ii) whistleb 25 ethodologic ic journals sues from earch’s sugg mes dy and/or n t includes i (i.e., topic nsure the pr ws van held mes categori s begins by eligious-bas cles that we s a result, 6 lished in top ement, and aaj); briti accounting e, the foll orate integri ontrol pract sclosures pr ship skills to studies in e similarity used on them ed in the ne f corporate n the outcom are mostly b 0; atan et al irvine, 2005 ree main a lowing pers asian cal process and the cla the identif gestion dra new areas identify, ana cs/subject/is rocess of id den and nor isation. y identifyin ed non-prof ere publishe 60 relevant j p-tier (high accounting ish accoun g, organiz owing are ity and acco tices. ractices amo owards rnp rnpos of their res me a, then fo ext subsectio e integrity a mes of corpo based on fra ., 2017; ars 5). based o areas of top spectives. n journal of f of the stu assification fied theme awn from t of research alyse, and c ssues/subjec dentification rthcott’s (20 ng the relev fit organisat ed in high-im ournals arti h impact/ind journals, su nting revie ations and the four ountability p ong rnpos pos’ accoun earch objec followed by ons. and account orate integri aud cases inv shad et al., 2 on the analy pics: (i) et finance & ac issn 19 2021, vol. 1 ajfa.macro udy, includ n procedure es and end the analysis h in accoun categorise t cts) connec n and catego 010) and ro vant journal tions. the s mpact inter icles were r dexes) inter uch as acc ew (bar); d society themes re practices. s. ntability pra ctives. the theme b, c tability pra ity practice volving the 2015; given ysis, studies thical cultu ccounting 946-052x 13, no. 2 think.org/ ding the s. then, ed with s of the ntability the most cting to orisation ozaidy et l articles selection rnational eviewed rnational ounting, critical (aos); egarding actices. analysis c, and d. actices s among rnpos ns, 2012, s in this ures, (ii) studies individu in prom and org jayasin individu and altr activitie mind. m account aimed t general relation for org organis that org in corpo maintai 2019; a revealed better o whistle and acc urgency public c fraudule which c and pot discusse detectin impacts 3.2 the rnpos with po ramli, emanate ventura ngos’ abuse s also acc 2016; c in ethical ual’s religio moting proso ganisational ghe and s ual level, fo ruistic attitu es irrespecti meanwhile, tability prac to strengthe , the previou nship betwee ganisational ational cult ganisational orate practic in a good org atan et al., 2 d that organ organisation eblowing pe countability y for rnpo confidence. ent behavio consequentl tential stake ed the char ng inherent s on the org eme b: eval s are never oor internal 2017; atan ed from ch a and danie fraudulent candals inv cused of em cornell et al culture (i) osity ideal s ocial behavi l level (see, soobaroyen, or instance, j udes motiv ive of religi at organisa ctices imple en the temp us study ind en accounta cultures (i tures toward culture is h ces, which i ganisationa 2017; sense nisation wit nal performa erspectives y practices a s to adopt w having sou ours detectio ly increased eholders (a racteristics fraudulenc anization’s luating the r shy from f control sys n et al., 201 hristian-bas l, 2010; bu cases is no volving cath mbezzlement l., 2013; bu ) dispensed uch as dona our or volun , chuto et a 2009; irv jamal et. al. vate muslim ious backgr ational leve ementation ple’s righte dicates that ability and c ii), a study d rnpos’ c highly influe is often prac al image or s es-ozyurt, 2 th the same ance, as wel (iii) are the among rnp whistleblowi und whistleb on, and at t d the rnpo ali et al., 20 of whistleb e behaviour survival. rnpo’s inte fraudulent c tems (zaino 17). context sed organisa udde, 2008; ot a strange holic church t of funds a dde, 2008; b 26 d empirical ating, volun ntary action al., 2020; s vine, 2005; (2019) stud m members round with el, jayasingh is perceive eous and pr the ethical c corporate in in this cat corporate in enced by the cticed by th strong work 2015; given e values and ll as a benef e third com pos. studie ing practice blowing pra the same ti s’ chances o 020). for in blowing tha rs and help ernal contr cases, espec on et al., 20 tually, most ations (see, and elson e e phenomen hes, and on and illegal le bowrin, 20 asian l supports nteering, an n at both inst septianto et grimalda dy revealed in islamic peace and h he and soob ed by peop rudent imag culture is th ntegrity (ata tegory main ntegrity prac e rnpos’ e he rnpos w k ethic (see, ns, 2012). f d beliefs wi ficial trait in mmon topic es in this c es to enhanc actices will me projecti of acquiring stance, a stu at should be ing the rn rol practices cially amon 014; arshad t of the stu , tanui et a et al., 2007) non, since th n top of that easing of ch 04). n journal of f to back up d helping o titutional lev al., 2020; and sacco that islamic c ngos to harmony as baroyen (20 le as being ge to the re he most impo an et al., 200 nly discusse ctices. more ffort in prov with the und slatten et al for example ll motivate n attracting of study in ontext main e their integ provide a d ing a positi g more dona udy from a e implemen npos to min s ng small an d et al., 2015 dies in this al. 2016; c ). coverage here are ma , some of th hurch’s prop finance & ac issn 19 2021, vol. 1 ajfa.macro p the prem others are be velsi.e., in jamal et al oni, 2005). c beliefs and involve in s the focal p 009) found g ceremonia eligious soc ortant featu 07). ed the influ eover, studi viding trans derlying obje l., 2020; fan e, atan et al employees new volunt corporate i nly focused grity and to diagnostic si ive integrity ations from arshad et al nted by rn nimize the n nd medium 5; kamarud s category a cornell et a on christia any cases o hose church perties (tan ccounting 946-052x 13, no. 2 think.org/ mise that eneficial ndividual, l., 2019; at the d values, n charity points in that the al rituals ciety. in ure in the uence of ies show sparency ective to ng et al., l. (2017) to have teers. integrity d on the increase ignal for y image, existing l. (2015) npos in negative rnpos ddin and are often al. 2013; an-based of sexual hes were nui et al., in addit ramli, al., 200 importa measure 2017; a practice scarce ( studies 3.3 the recentl motivat lack of a and goo stakeho al., 202 studies reportin al., 201 howeve stringen informa informa inconsis (saping adminis examin disclosu suggest among al., 201 3.4 the practic the fou rnpos studies bartune glimpse location phipps tion, other 2017; tanu 07 discusse ance of m ement syste arvidson an es in other (said et al. are needed eme c: iden ly, more res ted by nume accountabil od governan olders are sta 20; paiva an in this cat ng disclosur 6; paiva an er, previous nt reporting ation by th ation (rosla stent standa gi et al., 20 strative info ed disclosu ures among t that more rnpos (sa 4; radzi an eme d: exp es urth theme s’ accountab among rn ek, 1984). h e on the emb n, size, cultu et al., 2010 studies in t ui et al., 201 d the adva measuring ems in the o nd lyon, 20 main religi , 2013; lig in this cont tifying fina searchers ha erous report lity practice nce models arting to que nd carvalho tegory also res in entici d carvalho, s literature r g requirem e rnpos s an et al., 2 ards and gui 020, roslan ormation ra ure practice g rnpos ha studies are apingi et al., nd noor, 201 ploring the i is a study f bility practic npos (see p hence, stud bedded mot ure, and org ; geer et al. this categor 16; cornell antages of h rnpos’ p organisation 014). howe ions (such ghtbody, 20 text (kamar ancial repo ave ventured ted fraudule s, such as ef have tarnis estion the r o, 2018; ro elaborate ing more fin , 2018; ram revealed tha ents. this since they 2017; arsha delines in p n et al., 201 ather than fi s in variou ave been n needed, es , 2020; rosl 12). influence of focused on ces. study in phipps et a dies on lead tivations and anisational ., 2016; ars 27 ry, such as et al, 2013 having effe performance ns (gresako ever, studies as islam, b 000; elson ruddin and r orting disclo d into this c ent cases inv ffective fina shed the rn rnpos’ abil oslan et al., the advant nancial supp mli et al., 20 at rnpos ar unfavourab are less pr ad et al., 2 preparing fin 17). as a r inancial ach us organizat neglected (y specially in lan et al., 20 of leadersh the explora n the area is al., 2010; m dership in r d challenge and institut shad et al., 2 asian daff and p ; saat et al. ective intern es through ova, 2020; m s that exam buddhism, et al., 2007 ramli, 2017 osure pract category of s volving rnp ancial proce npos’ repu ity in manag 2017; zain tage of hav ports from r 018; yasmin re often bein ble rule af ressured to 013). this nancial repo result, rnp hievements. tions, studie yasmin et a examining 017; yasmin ip skills to ation of the the least fav mcmurray e rnpos give s faced by t ional structu 2018). n journal of f parker, 2020 , 2013; bud nal controls implemen moura et al mined rnpo hinduism, 7; bowrin, 7; sani et al tices among study. this pos. studie edures, prop utation and c ging their re non et al., 2 ving a high rnpos’ sta n and haniff ng imposed ffects the q provide tra situation h orts for non-p pos are ofte . although es on financ al., 2014). t financial re n and hanif owards rnp effects of l vourite them et al., 2009 es a context the rnpos, ures (ortizfinance & ac issn 19 2021, vol. 1 ajfa.macro 0; kamarud dde, 2008; s practices nting perfo l., 2018; san os’ internal etc.) are re 2004). thu l., 2017). g rnpos new trend h s have revea per auditing consequent esources (sa 2014). besid h level of f akeholders ( ffa, 2015). d or subjecte quality of r ransparent f happens bec -profit organ en disclosin many studi ncial guideli thus, some reporting gu ffa, 2015; ya pos’ accoun leadership s me in accou 9; lightbody tual and the , depending -gomez et a ccounting 946-052x 13, no. 2 think.org/ ddin and elson et and the ormance ni et al., l control elatively us, more has been aled that systems, ly, more apingi et des that, financial (basri et ed to less reported financial cause of nisations ng more ies have ines and authors uidelines yasmin et ntability skills on ntability y, 2000; eoretical on their al., 2020; the serv the em since le 2016; s influenc account qualitie member mcmur lack of heavily caused 4. conc our tax religiou lack of and hin occur in (2016) there is posed a perform context types of moreov develop because requirem rnpos exampl inconsis al., 202 besides organis valuabl organis rnpos financia (arshad vice of their mbeddedness eader plays a sharip et al ced an org tability pra es of good rs to achiev rray et al., 2 studies in t relies on p a lack of de clusion rem xonomical us-based ng studies don ndu. more s n christianexpressed t an uptrend an extreme m their due provides a f religions. ver, despite ped countrie e many de ments and s to be follo e, in malay stency in fin 0; zainon a s that, for t ations (i.e., e understa ations. mo s are crucia al managem d et al., 201 r teams, (ii) s of leaders a central rol ., 2019). fo ganisation’s actices in th leadership ve organisat 010; arshad this categor erception m emands from marks analysis sh gos is main ne from the studies in ot -based ngo the need to in fraudule concern am diligent in greater opp e the incre es, there has eveloping c low legal f owed (paiva ysia, studie nancial disc and wah, 20 he future, c religious, a anding of re studies al to ensure ment can b 3). the mission s’ moral va le in promot or example, accountab he organisa such as co tional objec d et al., 201 ry might be models rathe m academic hows that m nly derived f perspective ther religion os but also conduct mo nt cases inv mong musl managing d portunity to asing studi s been little countries ha framework a and carva es showed a closure requ 014; arshad comparative and non-rel the interpl concerning e more inf e scrutinise 28 n, and (iii) a alues positiv ting accoun , atan et al bility throug ations. mor ommunicati ctives (moh 8; ortiz-go e due to the er than emp c readers for most of the from christ e of other m ns are need occurred in ore empiric volving islam lims toward donations a explore rn ies on acc study on th ave been uniformity alho 2018; r a low comp uirements fo d et al., 2013 e case stud ligious-base lay issues the imple formation a ed by both asian act with just vely affects ntability valu l. (2017), fo gh the role reover, oth ion skill ca d sharip et omez et al., 2 e nature of t ploying emp r more studi e literature tian-based in major religion ded because n other relig al research mic-based n ds the abili accountably npos’ accou ountability he rnpos in associated for good g ramli et al. pliance lev for rnpos ( 3). ies between ed ngos) a between mentation about the tr h parties, th n journal of f ice (ortiz-g organisatio ues to its me ound that le es of leade er studies apabilities i al., 2019; a 2020; yaghi the study o pirical case s ies to be don on accoun nstitutions, w ns including accountabi gions. for i on islamicnon-profit o ity of islam . thus, mo untability pr practices n developin with less governance , 2018; bas el of transp (sapingi et n different t are highly n various ty of accounta ransparency he authoriti finance & ac issn 19 2021, vol. 1 ajfa.macro gomez et al onal accoun embers (ge eadership in ers in enco examined in motivati arshad et a i, 2008). he of this categ studies met ne in this ca ntability stu while there g islam, bu ility issues n instance, sa -based ngo organisation mic-based n ore research practices in d among rn ng countries stringent s practices f sri et al., 20 parency du al., 2020; y types of no needed to p ypes of no ability prac y and effici ies, and the ccounting 946-052x 13, no. 2 think.org/ ., 2020). ntability, eer et al., ndirectly ouraging external ng their l., 2018; ence, the gory that thod that ategory. udies in is still a uddhism, not only ani et al. os since s, which ngos to h in this different npos in s. this is statutory for their 16). for e to the yusop et on-profit rovide a on-profit ctices in iency in e public acknow the aut malays integrity also lik and par referen ali, z., non-pro and goo arshad, fight a finance arshad, and dis 209-217 arvidso compli nonprof bartune the ex https://d basri, h religiou interna bowrin accoun https://d budde, christia chuto, socio-e science cornell on inter investig edward wledgment thors ackno ia under t y assessme ke to extend rticipation in nces abdul-kad ofit founda od governa , r., razali against fra e, 28, 114-1 , r., abu b sclosure pra 7. https://do on, m., and iance, resis ofit organiza ek, j. m. 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(20 titutions in inon s., at udy on the d alaysian non ights ght for this rnal. an open-a ons attribut ahmud r., 020). source kuala selan tan r. & w determinan n-profit org article is re access articl tion license sabli n. a es of fundin ngor. wah y. b. nts of inform ganizations. etained by t le distribute (http://crea 38 awang n. ng for priva 2014. an e mation disc . the author(s ed under th ativecommo asian f. a. & ate tahfiz empirical closure of s), with firs he terms an ons.org/licen n journal of f / st publicatio nd conditio nses/by/4.0/ finance & ac issn 19 2021, vol. 1 ajfa.macro / on rights gr ons of the c /) ccounting 946-052x 13, no. 2 think.org/ ranted to creative microsoft word 14202-51609-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 41 ajfa.macrothink.org volatility estimation using symmetric and asymmetric models in oil exporting emerging markets dr latha sreeram professor, dept of finance gnvs institute of management, india tel: 91-98-3360-9896 e-mail: lathamurthy9500@gmail.com received: jan. 9, 2019 accepted: feb. 24, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14202 url: https://doi.org/10.5296/ajfa.v11i1.14202 abstract the study empirically investigates the volatility pattern of thirteen emerging economies which are predominantly oil exporting countries. it is based on the time series data which consists of monthly closing price data of their index for a ten-year period from 01 january 2008 to 31 december 2017. emerging markets are considered as investment destinations due to the presence of risk premium which has made the stock markets of these countries more volatile. added to this is that these countries underwent crisis due to the sharp decline in crude oil prices as they were primarily dependent on oil exports. hence it is a significant to study the volatility behavior of these countries. the study has been done by employing both symmetric and asymmetric models of generalized autoregressive conditional heteroscedastic. as per akaike information criterion (aic), log likelihood and schwarz information criterion (sic) the study provides evidence that garch (1,1) and tgarch(1,1) estimations are found to be the most appropriate model that fits symmetric and asymmetric volatility respectively for all the thirteen countries. there was evidence of volatility clustering and leptokurtic in all the countries considered in the study. while egarch model revealed no support of existence of leverage on the stock returns, tgarch supported existence of leverage in case of four countries. the tests for asymmetries in volatility indicate the size effect of the news, reaffirmed through the results of sign bias tests and news impact curves, which indicate that the size effect is stronger for bad news than the good news for countries which supported existence of leverage. keywords: volatility modeling, emerging markets, garch, leverage, heterosedascity, asymmetry, nic curves jel classification codes: c5, c22, c53, g1, g10, g15 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 42 ajfa.macrothink.org 1. introduction some of the most accepted univariate conditional volatility models are the generalized autoregressive conditional heteroscedasticity (garch), glosten, jagannathan and runkle (gjr), threshold garch model (tgarch) and exponential garch (egarch) model. these models estimate and forecast volatility and also indicate asymmetry, which implies that they capture different effects on conditional volatility of positive and negative effects of equal magnitude. they indicate the presence of leverage which is the negative correlation between the shocks to returns and subsequent shocks to volatility. stock market volatility is a well-researched topic as per the evidence of the empirical literatures; this paper investigates the possibility to explore new information on volatility pattern using the extended garch models. the data taken is from the monthly closing data of thirteen emerging markets chosen on the basis of their listing as emerging economies and are primarily oil exporting countries. hence the data analyzed is from the year 2007 to 2016 considering a total period of ten years to estimate the volatility of the countries considered for this study. global crude oil prices have witnessed a steady decline by 103% from 2012 to 2016 leading to a remarkable revenue deficit in many crude oil exporting nations. the substantial supply of crude oil by the oil producing countries during the period continued to pressure markets. the volatility in crude oil prices has had an extensive impact on the economy as well as the stock market of oil exporting countries; specially emerging economies. this study seeks to find the volatility in the stock markets of these oil exporting, emerging economies during that phase. 1. review of literature and development of hypothesis in the past decades, economists have captured the transformation in financial data. fitting an estimated model for volatility has been the intent for researchers viz. french, schwert and stambaugh (1987), bollerslev (1987), engle (2002). much of the research on modeling the volatility shares the asymmetries found in stock market returns. engle and ng (1993) substantiated the quadraticgarch model with evidence. brailsford and fagg (1996) confirmed that gjr-garch was most suitable; heynen and kat (1994) established that egarch has a finer extrapolative ability. even though the literature does not prove any one individual asymmetry model as being evidently better, awartani and corradi (2005) argue that they by and large do better than non-asymmetric models in financial market prediction. however, mcmillan, speight and apgwilym (2000) established that garch, moving average and exponential smoothing models provided better daily volatility forecasts and specifically egarch does not essentially surpass simple garch model. brooks (2007) examined a set of markets using the asymmetric power arch model. he established that in the developed markets, non-normal conditional error distribution fit the data accurately and in case of emerging markets where estimation problems arise a conditional ‘t’ distribution fits better. further the degree of volatility asymmetry differs across markets, with the middle eastern and african markets having very different volatility asymmetry characteristics compared to latin american markets. raza et al. (2015) applied a number of garch family models for the valuation and foreseeing the volatility of kse100 index stock returns. the results indicated that the best-fitted volatility model was garch(1,1) with asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 43 ajfa.macrothink.org students t-distribution and best prediction volatility model is garch (1,1) with ged, and the next fit volatility forecasting model is egarch (1,1) with ged. su (2010) empirical study found that the egarch model fits the sample data better than garch in modeling the volatility of chinese stock returns. tuyen (2011) investigated whether the stock return volatility vary over time in vietnamese stock market and found that the standard garch model was well fit. floros (2008) examined the use of garch –type models for modeling volatility in egypt (cma general index) and israel (tase 100 index). his results proved that the daily returns can be characterized by the garch models. abd el aal (2011) examined egyptian stock market return volatility and he found that egarch is the best fit model. some of the research which applied arch/garch models on emerging stock markets to estimate and predict volatility found the occurrence of non-normality, volatility clusters, negative skewness, leptokurtosis such as the studies of aydin (2002), akgul and sayyan (2005) and gokbulut and pekkkaya (2014), rashid and ahmad (2008) & goudarzi and ramnarayanan (2011). gokbulut and pekkaya (2014) maintained that the cgarch and tgarch were finer in modeling volatility. floros (2008) and emenike (2010) in nigeria, su (2010) in china, angabini and wasiuzzaman (2011) in malaysia, abd el aal (2011) and ezzat (2012) in egypt and freedi et al. (2012) in saudi arabia applied tgarch, egarch, and gjr garch models in their study and their findings indicated that egarch and gjr-garch are the best models for measuring volatility, detecting clustering effect, leptokurtosis and the leverage effect. this study forms the first hypothesis as: h0:asymmetric information impacts more on the volatility of emerging markets and an asymmetric model fits the return series well historical examination of financial time series data has revealed that volatility is not constant over time (mandelbrot, 1963). it has been found that great returns are frequently followed by further large returns and vice-a-versa termed as volatility clustering (mandelbrot, 1963; schwert and seguin, 1990). the swing in volatility over time is due to the supposed market and unique risks not being constant, leading to risk at different periods. (brooks, 2014). further on, asset returns have leptokurtic unconditional distributions (mandelbrot 1963, fama 1963, fama 1965), which is related to the time varying volatility (corhay and rad, 1994) and are characterized by volatility clustering (mandelbrot 1963, fama 1965). schwart (1989), proved that financial time series reveals high and low volatility episodes at any time, entailing that volatility in current time will lead to the probability of volatility many periods in future. skewness can be associated to the fact that stock prices are liable to cluster; large (small) changes are followed by large (small) changes (bollerslev 1987, lo 2000). the next hypothesis in this study is: h0:the monthly return data of the index are not normally distributed and that the series of residuals will exhibit conditional heteroscedasticity (arch effects) shin (2005) studied the relationship between risk and return for numerous emerging markets and found a significant association between volatility and returns in emerging capital markets by following non-parametric conditional variance modeling. de santis and imrohoroglu (1997) examined stock returns and volatility in emerging markets and proved the presence of asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 44 ajfa.macrothink.org clustering, predictability and persistence in conditional volatility, but exhibit it at a higher level than mature markets. bekaert and harvey (1995) suggested that emerging markets are found to offer superior return than those of mature markets but is associated, nevertheless, with high volatility and high serial correlation. lee c.f, chen g.m and rui o.m (2001) studied the financial data of stock returns and volatility in four of china’s stock markets and found evidence of time-varying volatility and showed volatility is highly persistent and expected. balaban .e, bayar .a and fatt .r (2003) examined financial data from 14 countries and found arch-type models provide the best fitted model. ogum .g, beer .f and nouyrigat .g (2005) investigated the market volatility using nigeria and kenya stock return series and found that the egarch model was the best fit and showed that asymmetric volatility found in the u.s. and other developed markets was also present in the nigerian stock market (nsm), but kenya demonstrated significant and positive asymmetric volatility. based on the above literature the final hypothesis of this study is: h0: stock markets in the emerging economies are volatile and persistent the arch and garch literature in emerging markets which are also primarily oil exporting countries is very scarce. hence an attempt is made in this study to explore the volatility pattern of the stock market in emerging economies which are primarily oil exporting countries using both symmetric and asymmetric models. this study also investigates the presence of leverage effect in the daily return series using egarch and tgarch model. 2. methodology 3.1 data and samples monthly close level data for analysis was extracted for selected emerging economies from january 2008 to december 2017.the data collected were transformed into continuously compounded return as follows: 𝑟 =in (𝑃 /𝑃 )*100 (1) 𝑟 = logarithmic index return, in = natural logarithm, 𝑃 =current closing price, 𝑃 =previous closing price. the indices considered are shown in table no i, for the period covering january 1st, 2008 to december 31, 2017. after filtering the return series with ar (1) models, the study fitted the garch (1,1), tgarch (1,1), egarch(1,1), and gjr-garch(1,1) models with standardized student ‘t’ model. three methods are used to compare the models. the first one uses the log likelihood, akaike information criterion (aic) (akaike, 1974) and the schwartz information criterion (sic) (schwarz, 1978) to select the best model. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 45 ajfa.macrothink.org table i. name of the exchange country name of exchange index year of establishment no of listed companies south africa johannesburg stock exchange jse 8th november 1887 388 south korea korean exchange krx 27th january 2005 2030 saudi arabia tadawul tasi 19th march,2007 171 peru the lima stock exchange bvl 31st december,1860 283 hungary budapest stock exchange bse 18th january,1864 58 iran tehran stock exchange tse february 4, 1967 339 brazil brasil bolsa balcão s.a.(b3) bovespa august 23, 1890 368 poland warsaw stock exchange wse april 12, 1991 64 philippines philippine stock exchange pse august 8, 1927 344 vietnam ho chi minh city stock exchange hose/hsx july,2000 396 columbia colombia stock exchange bvc november 23, 1928 89 russia moscow exchange moex 19 december 2011 219 egypt egyptian exchange egx march,1883 202 3.2 stationarity test the financial time series data is deemed stationary, when it’s mean, variance and autocovariance at different lags are same and so time independent. for a stationary series, shocks to the data die away steadily. if the impact of the shocks to the system persists for a longer period, the system will be explosive. any research on non-stationary data leads to spurious regression. the study used philips-peron unit root test on the data for determination of stationarity. the test involves fitting the regression as: 𝑌 =α+𝑃𝑌 +𝑒 (2) 3.3 testing for arch effects the indices were tested by using box and jenkins (1976) methodology and ljung-box (1978) to determine the number of autoregressive (ar), moving average (ma) and arma terms. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 46 ajfa.macrothink.org 3.3.1 box and jenkins (1976) methodology box-jenkins (1976) methodology involves three steps: 1. detection of ar/ma/ arma and arima order by correlogram and partial correlogram (lags 1 to 30). 2. assessment of the parameters (co-efficient) of the ar/ma/arma and arima model. 3. diagnostic checking of the selected ar/ma/arma/arima model. ac at k lags(𝜌 ) = cov 𝑢 , 𝑢 / √𝑉𝐴𝑅𝑈 x √𝑉𝐴𝑅𝑈 (3) pac at lag1= ac at lag 1= (𝜌 -𝜌 ) (4) pac at lag 2(𝜌 )= (𝜌 ) / (1-𝜌 ) (5) the study then used the acs and pacs by plotting them graphically to obtain the correlogram. this enabled in the determination of ar/ma/arma model. for using box-jenkins’s methodology, to accurately determine the ar/ma/arma terms, ols regression is run on yt with yt-i and ut-1. the significance of regression coefficients of lagged term the values of akaike’s information criteria (aic) and schwarz’s bayesian information criteria (sbic) are used. aic value= [ in (∑ 𝑢 )] +2k (6) sbic value= t[in(∑ 𝑢 )] + k in(t) (7) k = no. of parameters to be estimated t = total no. of observations ln = natural logarithm 3.3.2 ljung-box (1978) test the test of significance for the values of (ac) and (pac) are computed by using the qstatistics proved by ljung-box (1978), which is as follows: 𝑄 = t(t+2)∑ 𝜌 / m-1˜𝑥 (8) qm = ljung-box q statistics t = no. of observations i = no. of lags varies from 1, 2, ……., m. 𝜌 =sample ac at lag m 𝑋 = chi-square distribution ‘m’ degrees of freedom asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 47 ajfa.macrothink.org the test is used to check the soundness of autoregressive conditional heteroscedasticity (arch) in the residuals. the return series demonstrate the presence or absence of arch effect heteroscedasticity, which is a precondition for applying the garch models to the return series. hence the next step would be volatility modeling using garch models. 3.4 heteroscedasticity test heteroscedasticity is the unequal variance (𝜎 ) in the error term (𝑢 ) obtained from the regression of yt with yt-i under ols method. if coefficient of yt-1 is statistically significant, it signifies the presence of autocorrelation in the return series between yt and yt-1. hence before applying the garch methodology, the study examined the residuals to check the presence of heteroscedasticity. to this end, lagrange multiplier (lm) test for arch has been used, against the null hypothesis of no arch effects. the statistic has a chi-square distribution with ‘q’ degrees of freedom. if the lm statistic is larger than the critical value, then there is evidence of presence of arch effects. 3.5 lagrange multiplier test the lm is a test for arch in the residuals. the arch-lm test statistic is calculated from a supplementary test regression. the test procedure is executed by first finding the residuals 𝜀 from the ols regression of the conditional mean equation which might be a an autoregressive process, moving average process or a combination of ar and ma process (arma) (suliman 2012). in this study, an arma (1,1) model for the conditional mean in the return series is used as a supplementary regression. the conditional mean equation is: 𝑅 = ∅ 𝑅 +𝜀 +∅ 𝜀 (9) the objective is to obtain the residuals from the regression in order to test the null hypothesis that there is no arch up to order ‘q’ in the residuals. to test the null hypothesis a regression is run as follows: 𝜀 = 𝛼 +𝛼 𝜀 +𝛼 𝜀 +.....+𝛼 +𝑉 (10) the null hypothesis that all ‘q’ lags of the squared residuals have coefficient values that is not significantly different from zero. if the value of the test statistic is larger than the critical values from the 𝜒 distribution, then the null hypothesis would be rejected. 3.6 student-t distribution assumption this was employed to report for fat tails that are common in financial series. the arch models are estimated by applying the maximum likelihood approach given a distributional assumption. the contribution to the likelihood for observation ‘t’ for the student–t distribution is as follows: 𝑖 = log( ( ) ( )^ ( )^ log𝜎 log(1+ ^ ( ) (11) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 48 ajfa.macrothink.org where r (.) is a gamma function and v>2 is a shape parameter which controls the tail behavior. thus when v→ 𝜑 , the distribution converges to gaussian. 3.7 mean reversion mean reversion implies that the present information has no influence on the long run forecast of the volatility. persistence dynamics in volatility is generally captured in the garch coefficients of the garch model. in the stationery garch model, the volatility mean reverts to its long run level, at a rate given by the sum of arch and garch coefficients which is usually closer to 1. the magnitude of the mean reverting rate 𝛼 +𝛽 controls the speed of the mean reversion. 3.8 volatility measurement techniques 3.8.1 symmetric models most of the studies endeavored on modeling volatility found that garch (1,1) is the best to capture the symmetric effects and for the leverage effects egarch model have been found to be appropriate by previous studies. the present study uses garch (1,1), egarch and tgarch to capture symmetric as well as asymmetric effects of the return series and to choose the most appropriate model in volatility estimation. to model leverage effects characteristics of the data the egarch and tgarch models were used. according to brook and burke (2003) lag order (1,1) is satisfactory to capture all the volatility clustering in the returns data. the garch model (bollerslev, 1986), which allows the conditional variance to be dependent upon the previous own lags conform to the conditional variance equation in the simplest form as: mean equation: 𝑟 =µ+𝑒 and variance equation:𝜎 = 𝜔+𝛼𝜀 +𝛽𝜀 where 𝜔>0, 𝛼 ,𝛽 ≥0,𝑟 is the return of the asset at time t, 𝜇 is the average return and 𝜀 is the residual return.the conditional variance equation postulates that the volatility in the current period is not only related to the squared error term in the previous term but also on its conditional variance in the previous time period. 3.8.2 asymmetric measurement egarch model the key shortcoming of the symmetric garch is that the conditional variance is not capable of reacting asymmetrically to abrupt changes in the stock returns as only the squared residuals 𝜀 enter the equation and the signs of the residuals or the shocks have no effect. egarch and tgarch are two of the asymmetric models used in this study to check the association between asymmetric volatility and the returns. a stylized fact of financial volatility is that negative shocks tend to have a larger impact on volatility than the positive shocks. the extended garch models calculate conditional variance in the incidence of asymmetric shocks and persistence of the shocks to the market. egarch is one of the extensions of the garch model which captures the asymmetric effect of news and the volatility. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 49 ajfa.macrothink.org 𝜎 = 𝛼 +𝛼 ∪ +𝛼 ∪ +……..𝛼 ∪ ……….arch (q) (12) α0 = is the measure of long term constant volatility i.e. unconditional variance estimation. α1….αq are the coefficients of the residuals/ error terms α 1 = is the measure of persistence 𝜎 = 𝛼 + 𝛼 ∪ +𝛽𝜎 …………………………garch (1,1) (13) α0, α1 and β1 are the coefficients of the regression α0 unconditional variance estimation α1+ β1 represents persistence equation given by nelson (1991) for egarch (1,1) in𝜎 = 𝜔+𝛽 in (𝜎 )+𝛼 [(| |)]-𝛾 (14) the above equation gives the log of the conditional variance. the co-efficient 𝛾 is the asymmetry term and the presence of leverage effects can also be tested by the hypothesis that 𝛾 <0. threshold garch model-tgarch the conditional variance for threshold garch (zakoiian, 1994) is given by the following generalized specification: 𝜎 =𝜔 + 𝛼 𝜀 +𝛾𝑑 𝜀 +𝛽𝜎 (15) the 𝛾coefficient captures the asymmetry in the return series if its value is positive. all the other variables in the equation other than the error term are the parameters of the conditional variance equation that will be estimated. in tgarch model, the impact of good news(𝜀 >0 ) and bad news (𝜀 <0) on the conditional variance is different. when 𝛾 is positive there is leverage effect and when it is not equal to 0 it is asymmetric. tgarch presumes that the impact of the squared error term of the conditional standard deviation is dissimilar when the error term is positive or negative. as a result, it establishes a sign that takes the value of 0 when the conditional standard deviation is positive and 1 when negative. the leverage term usually occurs when the unconditional returns are skewed, ensuing in positive (negative) 𝛾 approximation when the returns are negatively skewed on average.at times the magnitude or the size of the shock will also impact the response to volatility to shocks is symmetric or not. to investigate this negative sign bias has to be conducted and is present if 𝑏 is statistically significant in the following regression: 𝑍 , =𝑏 +𝑏 𝐷 , 𝜀 , +v (16) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 50 ajfa.macrothink.org the positive sign bias is said to be present if 𝑏 is statistically significant in the regression given below 𝑍 , =𝑏 +𝑏 (1 − 𝐷 , )𝜀 , +v (17) 3. estimation results 4.1 descriptive statistics table ii presents the descriptive statistics of the emerging economies which is the continuously compounded monthly returns series over the period under the study. the data is negatively skewed for saudi arabia, south korea, south africa, philippines, russia and colombia indicating that in these countries there is high probability of earnings return which is greater than the mean returns and the distribution of the variables has a long left tail. further it implies that the distribution is negatively skewed to the normal distribution. the volatility is very high in emerging markets such as iran, saudi arabia, vietnam and russia as measured by the standard deviation. this result of high volatility in emerging markets is consistent with harvey (1995). the data is normally distributed when the results of the analysis for skewness are zero and kurtosis is three. the descriptive statistics (table ii) of the return data over the period of study were derived by using r software. the normality test of the descriptive statistics was found by using an asymptotic jarque-bera (1981) test statistic which is: jb statistics= t( + ( ) ) (18) t = no. of observations s = skewness coefficient k = kurtosis coefficient jb test of normality is the test of the joint null hypothesis if s & k are 0 and 3, correspondingly. the kurtosis is greater than 3 in case of south korea, iran, colombia, philippines, peru and hungary; implying that the return series is fat tailed. this is further confirmed by the jb statistics which is significant at 1% level. the hypothesis of monthly return series being not normally distributed is accepted. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 51 ajfa.macrothink.org table ii. descriptive name of the country mean median standard deviation skew j-b brazil 0.0093 0.008 6.5 0.5735 -0.1834 poland 0.007 0.0064 5.6 0.0033 -0.3088 peru 0.01544 0.0089 4.7 3.4712 0.3032 hungary 0.011 0.011 6.6 2.025 -0.4334 iran 0.00013 0.0012 8.2 142.5 11.8798 s. africa 0.0109 0.0111 4.35 -0.1586 0.7085 s. korea 0.0069 0.0073 5.11 -0.4549 3.3637 s.arabia 0.057 0.0124 7.91 -0.4098 0.6957 philippines 0.0118 0.0185 5.5 -0.6096 2.4861 vietnam 0.0107 0.0034 9.4 1.9801 0.5504 colombia 0.0052 0.0101 4.01 -0.7616 2.1783 russia 0.0123 0.01219 8.9 -0.1891 1.5475 egypt 0.0199 0.0219 0.01019 0.2222 1.5000 4.2 stationarity tests table iii shows the presence of unit root in the series tested using pp tests. the results indicate that it has produced higher negative value than its critical value at 1%, 5% and 10% level and significant at 1% level. hence we reject null hypothesis and accept that the returns are stationery for the entire study period and is mean reverting. table iii. pp -unit root test and arch-lm test of residual vietnam iran peru poland hungary south africa philipp ines south korea saudi arabia colombia egypt brazil russia pptest tstat -8.8328 12.523 -11.69 -11.703 -10.491 -13.216 -11.897 -11.362 -10.548 -10.734 -8.84 -13.582 -11.027 prob 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 arch-lm test 28.364 0.051 20.989 28.268 12.645 25.653 17.584 51.135 26.731 18.078 23.82 19.63 39.544 prob(1) 0.012 1 0.002 0.001 0.024 0 0.04 0 0 0 0.03 0.01 0 4.3 l-jung box tests and testing for arch effects after the first step of obtaining the residuals 𝜀 , from the arma process arch lm test was applied to test for the presence of arch effect in the residuals by regressing the squared residuals on a constant and 5 lags. the output in table iii shows that there are arch effects in the return series for all the countries. thus the variance of the errors is non-constant for the period under the study. the series being stationery, the study proceeds with the determination of the best fitting mean equation by applying arma (auto regressive moving average) to asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 52 ajfa.macrothink.org choose the best process in modeling the conditional mean. table iv depicts appropriate arma models, fitted by using boxjenkins methodology, for all the indices considered. fitted arma models generally follow moving average pattern apart from russia, egypt, poland and hungary where autoregressive pattern are found along with the moving average pattern. but saudi arabia return series follows a pure ar pattern. from the results it is found that most of the emerging economies have longer moving average pattern thus leading to persistent shocks in the market over a period of time. table iv. fitted autoregressive moving average model russia egypt colombi a vietnam philippi nes saudi arabia south korea iran south africa poland hungary peru brazil ar(1) ar(1) ma(1) ma(1) ma(1) ar(1) ma(1) ma(1) ma(1) ar(1) ar(1) ar(1) ma(1) ma(1) ma(1) ma(2) ma(2) ma(13) ma(4) ma(8) ma(1) ma(2) ma(1) ma(6) ma(2) ma(2) ma(6) ma(6) ma(16) ma(6) ma(11) ma(2) ma(9) ma(8) ma(9) ma(11) 4.4 garch(1,1) in this study we estimate conditional volatility using student’s t distribution proposed by bollerslev (1987) with ʋ greater than 2 degress of freedom. garch (1,1) is applied on the selected emerging markets. the result of garch (1,1) is shown in table v which disclose that parameter of garch is statistically significant. the coefficients constant (ω), arch term α and garch term β are significant at 1% level. in the conditional variance equation, the estimated β coefficient is to the highest degree greater than α coefficient which implies that the market has a memory longer than one period and the volatility is more responsive to its lagged values than its new surprises in the market values. sampled parameters 𝛼, 𝛽 are significant for all the markets other than hungary as 𝜌<0.01 which signifies that the first lagged squared returns and the trailing variance significantly explains the conditional variance. the results confirms that the coefficient of the arch effects (𝛼 )) is statistically significant for all the countries except for hungary, brazil, egypt and philippines. this shows that the news from volatility of the previous period has an explanatory power on current volatility. the summation of parameters α and β establish the volatility in the return series and indicates that is persistent in case of all the countries. the sum of the coefficients is unity or closer to it indicating that the shock will persevere to many future periods. when the sum of the coefficients for market returns is closer to 1, the process of mean reversion gets slower (engle 2001). the slowest mean reversion process is sighted in brazil, egypt, saudi arabia, south korea, poland and iran. hungary has the highest mean reversion process as the sum of coefficient is the least. with respect to garch (1,1) model it has been found that volatility is highly persistent for all the countries (sum of alpha and beta closer to unity) meaning a current shock persists indefinitely in conditioning the future variance. hence large changes in the returns have a propensity to be followed by large changes and mild changes likely to be asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 53 ajfa.macrothink.org followed by mild changes. it implies that in these countries stock returns volatility happens in clusters and is predictable. the study applies garch (1,1) consistent with many previous studies (gokcan 2000). the parameters of garch model for the return series for all the countries is significant at 1% level, implying to reject the null hypothesis and accept the existence of volatility clustering in the return series. that is, volatility from the previous periods has the power of explaining the current volatility condition. similarly the coefficient of the lagged conditional variance (𝛽 ) is significantly different from zero indicating volatility clustering in the sample selected. thus the return series for all the emerging economies have both the attributesvolatility clustering and are persistent. hence all the tests indicate that variance equation is well characterized and specified. further the arch-lm test is used to check arch effect residuals and from the results it is inferred that ρ>0.05. this proves that the variance equation is well specified for the market. table v. estimated result of s garch (1,1) model mean egypt brazil colom bia saudi arabia south korea south africa hungary philip pines russia vietnam peru poland iran µ(constant) 0.020 0.010 0.01 0.01 0.003 0.01 0.01 0.01 0.01 0.01 0.02 0.01 0.00 ɯ(constant) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 α(arch effects) 0.00 0.00 0.25 0.21 0.09 0.30 0.09 0.08 0.44 0.20 0.18 0.10 1.00 b(garch effects) 1.00 1.00 0.69 0.79 0.90 0.63 0.76 0.87 0.51 0.75 0.77 0.87 0.00 α±β 1.00 1.00 0.94 1.00 0.99 0.93 0.85 0.95 0.95 0.95 0.95 0.97 1.00 log likelihood 139.15 203.62 298.50 191.07 255.27 281.41 203.40 239.50 191.22 174.92 166.93 233.46 427.49 akaike information criterion -1.71 -2.55 -3.77 -2.39 -3.21 -3.55 -2.58 -2.98 -2.39 -2.17 -2.07 -2.93 -5.43 schwarz information -1.72 -2.55 -3.78 -2.39 -3.22 -3.43 -2.58 -2.99 -2.39 -2.18 -2.08 -2.93 -5.44 arch-lm test stat 0.631 1.004 3.50 1.84 0.51 0.91 2.35 3.42 0.62 0.09 3.50 1.94 0.02 prob.chi square(1) 0.84 0.73 0.22 0.75 0.47 0.75 0.39 0.23 0.84 0.76 0.22 0.48 0.99 4.5 egarch (1,1) in order to capture the availability of asymmetric behavior and the existence of leverage effect in the return series, the study applied egarch and tgarch model. table.vi represents the egarch output. the gamma parameter which is the indicator of asymmetric volatility is positive and significant at 1% level for peru, south africa, iran and colombia. this implies that shocks including both good and bad news will affect volatility for a long time in future and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 54 ajfa.macrothink.org it is not expected to be forgotten within a short period of time. further since the leverage coefficient being positive and significant, effect of previous period positive news is greater than effect of bad news of same magnitude. the table also shows that arch (𝛼) and garch coefficient (β) are equal to one in case of vietnam and saudi arabia and nearly to unity in case of other countries indicating that conditional variance is not explosive. further coefficient gamma has specified the asymmetric effect as it is positive for all the countries in the study. the asymmetric term in egarch is not negative and significant for any of the countries in the study suggesting that there is no leverage effects in the returns during the study period. this leads to the conclusion that previous period positive and negative shocks do not have a different impact on the conditional variance. iran, south africa and egypt markets are impacted due to recent information while south korea, vietnam and saudi arabia by old news or information. iran has the highest leverage coefficient indicating that its stock market has been impacted by volatility due to negative information. findings show that sign-bias statistics are significant for the asymmetric models in case of russia, saudi arabia and vietnam. the two size bias test statistic is highly significant with positive size bias test statistic having higher value. this proves that size effect of news, is stronger for good news than bad news. finally, arch lm test statistics discloses that the null hypothesis of no arch effects is accepted. table vi. estimated result of e garch (1,1) model mean egypt brazil saudi arabia south korea south africa philippines russia vietnam peru iran µ(constant) 0.02 0.01 0.13 0.01 0.01 0.01 0.00 0.01 0.01 0.00 ɯ(constant) -1.00 -0.85 -0.18 -0.15 -0.95 -0.66 -0.69 -0.17 -0.49 -8.15 α(arch effects) -0.15 -0.05 -0.04 0.0 -0.21 -0.05 -0.04 -0.05 -0.11 -0.45 b(garch effects) 0.78 0.84 0.96 0.98 0.86 0.88 0.87 0.97 0.90 -0.005 gamma 0.11 0.18 0.40 0.20 0.46 0.13 0.56 0.46 0.43 1.84 shape 5.62 0.99 29.12 4.62 0.99 8.59 62.31 4.97 11.40 2.1 log likelihood 141.75 204.13 188.47 259.45 281.717 239.99 190.50 176.81 166.55 502.43 akaike information criterion -1.75 -2.55 -2.35 -3.27 -3.55 -3.01 -2.3 -2.20 -2.07 -6.40 schwarz information criterion -1.75 -2.56 -2.36 -3.27 -3.56 -3.02 -2.3 -2.21 -2.07 -6.40 arch-lm test stat 1.64 2.42 0.18 0.56 2.69 3.18 0.65 0.63 1.14 0.01 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 55 ajfa.macrothink.org prob 0.55 0.38 0.96 0.45 0.33 0.26 0.83 0.42 0.69 0.99 4.6 tgarch (1,1) an alternate model to test for asymmetric volatility is tgarch shown in table vii. it has been found that coefficient of leverage effect is positive and significant at 1% level for peru, south africa, iran, colombia which implies that bad news or negative shocks have greater effect on conditional variance than positive shocks or good news. in other words, negative shock stimulates a larger raise in volatility greater than the positive shocks. it also implies that in these countries the distribution of the variance is skewed to the left and there are higher chances of negative returns. the positive asymmetric coefficient points out to the leverage effects in the above mentioned countries. the coefficient gamma in the model also established the asymmetric effect as it is positive for all the countries considered in the study and hence the hypothesis of asymmetry is accepted. table vii. estimated result of t garch (1, 1) model 4.7 news impact curves (nic) nic curves below presents the impact of news on volatility in the best fitted asymmetric models. the news impact curves indicate that bad news have more impact on volatility than good news mean egypt brazil colom bia saudi arabia south korea south africa hungary philip pines russia vietnam peru poland iran µ(constant) 0.02 0.01 0.00 0.01 0.00 0.01 0.01 0.01 0.01 0.00 0.00 0.00 0.01 ɯ(constant) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1(arch effects) 0.00 0.00 0.00 0.23 0.06 0.16 0.00 0.00 0.36 0.29 0.00 0.03 0.24 β1(garch effects) 1.00 1.00 0.74 0.79 0.93 0.61 0.83 0.77 0.48 0.76 0.80 0.80 0.92 gamma -0.007 -0.04 0.39 -0.06 0.00 0.32 0.12 0.15 0.11 -0.15 0.29 0.17 0.05 shape 1.28 1.93 2.45 2.00 1.07 3.89 1.35 1.61 1.96 1.24 1.44 1.72 2 log likelihood 143.223 204.67 303.62 191.224 262.76 286.77 209.01 239.83 190.38 180.12 172.97 235.31 538.91 akaike information criterion -1.74 -2.54 -3.81 -2.36 -3.28 -3.59 -2.62 -2.99 -2.35 -2.22 -2.12 -2.93 -6.87 schwarz information criterion -1.75 -2.54 -3.81 -2.37 -3.29 -3.60 -2.63 -2.99 -2.35 -2.22 -2.13 -2.93 -6.87 arch-lm 0.70 0.74 3.114 0.52 0.63 1.56 2.72 3.38 0.65 0.155 0.56 1.41 0.02 p-value 0.82 0.80 0.27 0.87 0.42 0.57 0.32 0.23 0.83 0.69 0.96 0.61 0.99 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 56 ajfa.macrothink.org in peru, iran, south africa, colombia and egypt. this is validated in the findings presented in figure i. the graphs indicate that responsiveness of future volatility in stock returns vis-a-vis the current period news (shocks) and are determined from the residuals of the models. the positive slope of the nic of the symmetric models measures the level of confidence in the market. the upward trend of the nic on the positive side of the shocks depicts increasing confidence in the stock markets of russia, saudi arabia and vietnam. this is an indication of a well fitted model and is similar to research findings of (ai,2011), (eric 2008) and hojatallah (2011). a positive return shock does not seem to have much impact on conditional volatility. in other words, when the stock market experiences a sharp decline, the large negative return shock leads to high volatility. when the market re-bounds the large positive returns does not seem to reduce the volatility immediately. thus high volatility could not be reduced quickly with large positive return shocks and there is high persistence as per the results of the study. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 57 ajfa.macrothink.org poland s.korea russia egypt asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 58 ajfa.macrothink.org s.arabia columbia peru brazil asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 59 ajfa.macrothink.org 4. conclusion assessment of leverage and investment decisions in firms in emerging economies is significant as numbers of investors are risk averse. this study attempts to model the volatility of stock market return in 14 selected opec countries which are termed as emerging economies by testing both the symmetric and asymmetric models. the monthly closing prices for ten years were extracted and modeled using three different garch models after verifying the unit root test and arch effects. the study further conducted empirical analysis on arch and garch models to investigate volatility characteristics through the period jan 2008 to dec 2017, to determine volatility clustering, leptokurtic distribution and leverage effect. to capture the symmetry effect in the stock markets, both the arch and garch (1,1) model is employed. the primary empirical findings of the stock return data is far from normality and showed existence of conditional heteroscedacity or volatility clustering. further the study found evidence of leptokurtosis, long memory, fat tailed and persistence of volatility. all these are consistent with previous research. garch (1,1) results indicate persistence for all the countries studied which signifies that the current shock persists indefinitely in conditioning the future variance. with respect to detecting the asymmetric effect in the data, egarch (1,1) and tgarch (1,1) were applied, in order to investigate the various effects of good and bad news on the future volatility of the selected data. in egarch model, none of the countries indicated negative and significant gamma and there was absence of support of leverage effects. thus the stock return is considered volatile. the gamma coefficient indicated that iran had the maximum impact on volatility due to negative information. the study also verifies whether incorporating asymmetric response of volatility to positive and negative shocks changes the conclusions obtained from the symmetric garch models. in order to corroborate the best fitted model from the models applied, akaike information vietnam philliphines asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 60 ajfa.macrothink.org criterion (aic), log likelihood, and shwarz information criterion(sic) were used. findings indicate that tgarch model was found out to be the best fitted model for all the emerging economies considered in the study based on the highest log likelihood with least aic and sic criterion. as per the tgarch output, the asymmetric effect was captured and leverage effects were found in peru, iran, south africa and colombia, implying that negative shocks stimulates a higher raise in volatility than the positive shocks. tests for asymmetries in volatility indicate a size effect of news, which is stronger for bad news than good news in case of countries where leverage was captured by use of sign-bias tests. the main intention of using nic curves was to look for incidence of leverage effects, influencing volatility by previous good or bad news. the return series were used to compute news impact curves (nic), which pointed out the inadequacy of using garch in the presence of asymmetric volatility effects, which treats all volatility equally. the nic for the asymmetric models indicate that bad news have more impact on volatility than good news in peru, iran, south africa, colombia and egypt. iran has had a turbulent period since 2010 with successive negative events of high inflation, monetary / credit policy measures taken by the government to combat it and finally the sanctions imposed by european union and the usa leading to depreciation of currency and thus adversely impacting the stock market. in case of south africa, the markets witnessed volatility since 2013 when 60% of the domestic flows were routed to offshore funds and was followed by political rout when they had three finance ministers in a week which distressed the investors’ confidence. though, colombian stock market has at all times traded at a premium to its worldwide emerging market peers, the relative prices of colombia to global emerging markets have always been extremely volatile. during the period of global financial crisis in 2008 colombian market traded at 35% discount to gem moving to 70% premium two months later. such large swings echo the reliance of index on small number of companies and relative thin trading liquidity. the upward trend of the nic on the positive side of the shocks depicts the increasing confidence in the stock markets of russia, saudi arabia and vietnam. saudi arabia has seen uptrend in its stock market performance since 2014 when it opened it up for foreign investors. 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(2014). the p/e ratio and profitability. journal of business & economics research, 12, 67-76. microsoft word 16782-59740-1-sm (1)-writer2-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 39 neoclassical asset pricing tests in sri lanka: a structural empirical review n. s. nanayakkara (corresponding author) department of finance, faculty of management studies and commerce university of sri jayewardenepura, sri lanka e-mail: neelangie@sjp.ac.lk p. d. nimal department of finance, faculty of management studies and commerce university of sri jayewardenepura, sri lanka e-mail: pdnimal@sjp.ac.lk y. k. weerakoon department of finance, faculty of management studies and commerce university of sri jayewardenepura, sri lanka e-mail: weerakon@sjp.ac.lk received: april 1, 2020 accepted: sep. 30, 2020 published: december 1, 2020 doi:10.5296/ajfa.v12i2.16782 url: https://doi.org/10.5296/ajfa.v12i2.16782 abstract neoclassical asset pricing models try to explain cross sectional variation in stock returns. this study critically reviews the findings of empirical investigations on neoclassical asset pricing models in the colombo stock exchange (cse), sri lanka. the study uses the structural empirical review (ser) methodology to capture a holistic view of empirical investigations carried out in the cse from the year 1997 to 2017. the pioneering capital asset pricing model (capm) (sharpe, 1964; lintner, 1965: black, 1972) (slb) states that market betas of stocks are sufficient to explain the cross sectional variation of stock returns. alternatively there are multifactor models (ross, 1976; chen, 1986; asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 40 fama and french, 1993, 2015; cahart, 1997) that state stock returns are driven by multiple risk factors. similar to other markets the findings on the slb model are not consistent in the cse. the fama and french (1993) and the cahart (1997) models are supported in the cse which is consistent with other markets, but the explanatory powers of them are substantially low in the sri lankan context. contrasting the findings of a significant impact of macroeconomic factors on stock returns in developed markets, the impact of them in the cse are temporary. the overall findings of the applicability of neoclassical asset pricing models in the cse are inconsistent and inconclusive and the study identifies two reasons that may have contributed to such results. firstly, it recognises that the inherent limitations of neoclassical asset pricing models may have affected the findings in the cse. secondly, it supports the argument that neoclassical models, as they are may not be applicable in emerging or frontier markets, thus they may need to be augmented with characteristics of such markets to make them more applicable. keywords: neoclassical, asset pricing, returns, factor models, frontier market jel classification: g12, g 15, g23 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 41 1. introduction neoclassical asset pricing models try to explain cross sectional variation of stock returns. the pioneering capital asset pricing model (capm) (sharpe, 1964; lintner, 1965; black, 1972) (slb) relates the stock return to a measure of its systematic risk, beta. according to the slb model the expected returns of securities are a positive linear function of their market betas; and market betas suffice to describe the cross section of expected returns. early studies support the linear relationship between average return and beta (black, jensen & scholes, 1972; fama & macbeth, 1973). subsequent empirical studies found anomalies to the slb model that were not captured by beta alone (basu, 1983; banz, 1981; stattman, 1980; bhandari, 1988). as campbell (2000) reflects, the empirical anomalies and puzzles stimulates the development of new models in asset pricing, hence the inconclusive evidence on the slb model led to the development of extensions to the slb model (mayers, 1972; merton, 1973; breeden, 1979) and other theoretical models such as arbitrage pricing theory (apt) (ross, 1976) for the variation of returns. on the other hand, atheoretical factor models were developed to fit the anomalous empirical evidence to the slb model (fama and french, 1993; 2015; cahart, 1997). though there is no consensus on a specific asset pricing model, neoclassical models are widely used in empirical research around the world. there are studies that review neoclassical asset pricing tests in markets around the world. dimson and mussavian (1999) analyse the development of asset pricing theories, and highlight the fact that asset pricing literature is a coherent body of theory rather than a disjointed collection of publications. campbell (2000) focuses on the interplay between theory and empirical work on the development of asset pricing literature for a period of twenty years. celik (2012) provides a comprehensive review of asset pricing models and historical stream of empirical research from the year 1974 to 2005. he states, factors that affect asset pricing vary through time yet the theoretical framework is still useful to incorporate the changing factors into pricing models. the empirical reviews in asset pricing literature are centred on developed markets where neoclassical theories and empirical models were originated. though these theories and models are later adopted in emerging and frontier markets it is hard to find studies that use systematic reviews that provide a holistic view of asset pricing tests in such markets. according to berger et al. (2011) frontier markets have low integration with the world market and thereby offer significant diversification benefits to international investors. therefore reviews of this nature will provide an insight to the frontier markets and shed light to the inquiry, whether asset pricing models that are originated in developed markets are applicable to emerging and frontier markets. the colombo stock exchange (cse) in sri lanka is a frontier market established in 1985. it has around us$ 20 billion market capitalisation with about 300 listed companies as of december 2017. even though cse is a contrastingly smaller market, tests of neoclassical asset pricing models are carried out in sri lanka similar to other emerging and frontier markets (samarakoon, 1997; nimal, 1997: anuradha, 2008; nanayakkara, 2008; randeniya & wijerathna, 2012; kongahawatte & nimal, 2015; abeysekara & nimal, 2017). therefore, the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 42 purpose of this study is to review the existing empirical asset pricing literature in the cse to identify the extent to which neoclassical asset pricing tests can capture the cross sectional variation of stock returns in the market. the study provides a comprehensive systematic literature review of empirical findings on neoclassical asset pricing tests, during the period from 1997 to 2017 in sri lanka. the study uses the structured empirical review (ser) methodology similar to celik (2012) and jesson and lacey (2006). the study is significant in sri lankan context since it covers twenty years of empirical investigations on asset pricing tests in cse. in the global context it will provide an insight to a frontier market and will be a pivotal point for the consideration of alternative approaches in asset pricing tests in such markets. the remainder of this paper is structured as follows: section 2, the literature review which includes a brief theoretical development and empirical findings of the neoclassical asset pricing models. section 3 describes the structured empirical review (ser) methodology which is adopted in this study. section 3.2 shows the classification and number of local studies selected for this review. section 4 elaborates the findings of sri lankan studies with an overview of sri lankan investigations. section 5 discusses the sri lankan findings in relation to the findings of other markets. section 6 concludes the study with future direction for research. 2. literature review neoclassical asset pricing models are built upon the assumptions that; investors are rational, markets are highly efficient and investors exploit potential arbitrage opportunities (dimson & mussavian, 1999). markowitz (1952) portfolio theory and tobin (1958) separation theorem led to the development of pioneering capital asset pricing model (capm) (sharpe, 1964; lintner, 1965; black, 1972) (slb). according to the slb model; if all investors are single period mean variance optimisers, then the market portfolio is mean-variance efficient, which implies a positive beta return relationship between all assets and the market portfolio and market betas suffice to describe the cross section of stock returns (fama & french, 1992). mayers (1972) extends the one period two parameter slb model to include non-marketable asset, human capital. the model assumes holding of specific marketable asset by an investor is partly determined by the relationship between returns on the assets and the payoffs on the specific non-marketable asset held by the investor (fama & schwert, 1977). merton (1973) develops an intertemporal capm (icapm) with the assumption that time flows continuously rather than discretely. breeden (1979) derives the consumption capm (ccapm) where, the single beta model in multi good, continuous time with uncertain consumption goods’ prices and investment opportunities. fabozzi and francis (1978) test stability of beta over bull and bear markets, and finds that beta corresponding to bear market may be more appropriate measure of portfolio risk than the conventional single beta. similarly pettengill, sundaram and mathur (1995) test the conditional relationship between beta and return; it supports that there is a positive (negative) relationship between beta and stock returns during the periods of up (down) markets. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 43 ross (1976) develops the arbitrage pricing theory (apt) as an alternative theoretical explanation for variation of stock returns. apt points out that the slb conclusion can also be reached; using an asymptotic no-arbitrage argument with the assumption that market portfolio is the only source of common, undiversifiable risk. therefore, if there are several common factors that generate undiversifiable risk, then a multifactor model holds (campbell, 2000). chen et al. (1986) try to identify the specific macroeconomic variables to test the effect of economic forces within an apt (ross, 1976) framework. the study selects the economic state factors which are expected to systematically influence the asset risk and finds that, though these macroeconomic variables are not exhaustive, the selected variables appear to outperform other potential pricing factors. early work by black, jensen and scholes (1972); fama and macbeth (1973) were supportive to the slb model, but subsequent studies find empirical contradictions to the slb model. banz (1981) reports the size effect, where small stocks have higher average excess returns which cannot be explained by the slb model. stattaman (1980); rosenberg, reid and lanstein (1984) find that average return on stocks are positively related to the ratio of firm’s book value of common equity (be), to its market value (me). bhandari (1988) reports a positive relation between leverage and average return. basu (1983) shows the earnings-price ratio (e/p) help explain the cross section of returns and ball (1978) argues that e/p is a catch-all proxy for unnamed factors in expected returns. in 1993 based on the general pattern in stock returns jegadeesh and titman provide evidence on the momentum anomaly, where stocks with high/low returns over the past three to twelve months tend to outperform/underperform in the next three to twelve months. anomalous evidence to the slb model led to the development of atheoritical multifactor models, where factors were chosen to fit the empirical evidence rather than its adherence to the theory. fama and french (1992) use multifactor models and find that size, be/me absorb the apparent roles of leverage and e/p in average returns. consistent with the findings, fama and french (1993) introduce the three factor model (ff3fm) which includes the factors; the return on a broad market index, the excess return on a portfolio of small stocks over a portfolio of large stocks and the excess return on a portfolio of high be/me stocks over a portfolio of low be/me stocks. cahart (1997) augments ff3fm with momentum factor (jegadeesh & titman, 1993), to develop the cahart four factor model (c4fm). in 2015, fama and french relate profitability (novy marx, 2013) and investment (titman, wei, & xie, 2004) factors to average returns and introduce the fama and french five factor model (ff5fm) by augmenting profitability and investment factors to the existing ff3fm. according to dempsey (2013) the trend of adding factors to better explain observed price behaviours has continued to dominate asset pricing theory. the above asset pricing tests commonly use either cross sectional regression approach of fama and macbeth (1973) or the time series regression approach which centres on the grs test of gibbons, ross and shanken (grs) (1989). according to fama (2015) time series and cross sectional regression approaches to test asset pricing models are not competitors but complements. therefore, tests in asset pricing include both time series and cross sectional analysis. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 44 mehrling (2007) refers the slb model as the revolutionary idea that runs through finance theory. the neoclassical asset pricing models have been continually and extensively tested in developed markets and they have been reviewed for their applicability and consistency. similarly these models are tested in emerging and frontier markets, yet it is rare to find reviews that provide a holistic view of applicability and consistency of these models in the smaller markets. therefore this study reviews twenty years of empirical investigations in neoclassical asset pricing models in the cse to find whether these models provide similar results to that of developed markets. 3. methodology and data 3.1 structural empirical review (ser) the study uses structural empirical review (ser) methodology to systematically review existing neoclassical asset pricing investigations in sri lanka. ser is specifically designed and developed to analyse research papers’ evidence and interpreting results in a robust framework (celik, 2012). according to jesson and lacey (2006) a systematic review is considered a quasiexperiment which derives results from data already described in published literature. it is a comprehensive and if possible a complete review of published articles selected to address a specific question. ser develops explicit statement of selection criteria to the studies that are to be reviewed (kahn, kunz, kleijnen, & antes, 2003). this study uses ser for a comprehensive analysis of empirical evidence on neoclassical asset pricing tests in the cse. the study uses three search methods to identify and gather the relevant empirical investigations. the first search method was based on two selection/elimination criteria, which were developed on the evolution of neoclassical asset pricing models. the initial selection criterion was to search literature in the web based on key terms of asset pricing. the terms used with the word sri lanka were: asset pricing, capm, beta, anomalies, size, be/me, momentum, macroeconomic variables, apt, ff3fm, c4fm and ff5fm. they were used in different sets coupled with the word sri lanka. thereafter, the study uses an elimination criterion that the relevant study should consider the cse as a whole, and further that the investigation should be carried out during the period, 1997 to 2017. the search considers sri lankan and international journal articles and proceedings in academic conferences. a second search method was developed based on the articles retrieved through the first method. the reference lists of the studies were explored to find studies which may not have been found in the first search. a third search method was to investigate research gate, social science research network (ssrn), and google scholar profiles of authors of the articles retrieved up to this stage, to find any studies that may not have been identified yet. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 45 3.2 data initially the search collected 44 articles based on the key words identified through asset pricing literature. however, the applications of elimination criteria resulted 23 articles which are compared, contrasted, and critically reviewed in this study. the database of studies was coded based on the asset pricing model used in the study. if a study has investigated more than one model it was coded under each asset pricing model. table 1 depicts the relevant code, the asset pricing model, the originators and number of studies reviewed in this study. table 1. a structural empirical review (ser): application of neoclassical asset pricing models in sri lanka. code the model originators number of studies ca 00 capital asset pricing model (capm) sharpe (1964); lintner (1965); black (1972) 13 ap 00 arbitrage pricing theory (apt) ross (1976) 01 cc 00 capm conditional on market condition pettengill et al. (1995) 02 tf 00 fama and french three factor model (ff3fm) fama & french (1993) 07 mo -00 momentum jegadeesh & titman (1993) 02 cf 00 cahart four factor model (c4fm) cahart (1997) 02 ff 00 fama and french five factor model(ff5fm) fama & french (2015) 00 ma -00 macroeconomic variables/ asset pricing (chen et al., 1986) 04 source: author 4. findings 4.1 overview of sri lankan studies the study includes empirical investigations of neoclassical asset pricing models in the cse for a period of twenty years from 1997 to 2017. the empirical tests of asset pricing in sri lanka demonstrate that they have evolved consistently with the developments in the neoclassical literature. according to the table 1 most of the studies during the twenty-year period from 1997 to 2017 test the slb model and some studies use extensions to slb model conditional to market conditions. there are studies that test atheoretical factor models such as ff3fm, c4fm in different time intervals in the cse. however, the test of ff5fm is harder to find in the sri lankan market. there are studies that consider the momentum anomaly and tests of macroeconomic variables based on apt (1976) and chen et al. (1986) framework. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 46 the table 2 shows empirical investigations in the cse that test the relationship between beta and cross section of stock returns during the period from 1997 to 2017. these studies are extended to include tests of anomalous evidence to the slb model in the cse such as; be/me, size, e/p, leverage and liquidity. the column 1 of table 2 shows the reference of the study, column 2 depicts the time period of the study while column 3 depicts the test employed. when the earlier studies are considered, the time periods of the tests are shorter while later studies have included fifteen years or more data. these studies have employed both fama and macbeth (1973) and grs test of gibbons, ross and shanken (grs) (1989) to test the models. 4.2 findings of sri lankan studies confirming existing asset pricing literature, sri lankan literature finds that beta as a measure of systematic risk is not consistent in explaining cross sectional variation of stock returns in the cse. initial studies by samarakoon (1997) and nimal (1997) test the slb model together with anomalous evidence to the slb in the cse. these studies confirm existing literature on beta return relations while providing inconsistent findings on anomalies to the slb model. furthermore, the more recent studies of slb confirm that beta cannot be used to explain cross sectional variation of returns in the cse (thilakarathne & jayasinghe, 2014). rathnasekara (2017) finds that there is no statistically significant evidence to constitute the slb model and raises the joint hypothesis problem where the market inefficiency may have affected the results. therefore, it is apparent during the period of this review that beta is rejected and evidences on anomalies are inconclusive in sri lanka. fama (1998) argues that asset pricing anomalies can be made marginal or disappear by exposing them to different models or statistical approaches. based on a similar argument sri lankan studies try to defend the slb model with extensions to the model and employing different statistical approaches. as depicted in the table 2, anuradha (2008) investigates the conditional relations in the sri lankan market. the study finds that there is a significant positive (negative) relationship between beta and return in up (down) markets for both individual and portfolio of stocks. it concludes that beta cannot be rejected since it shows a significant relationship subject to the condition of the market. nimal and fernando (2013) defends the same argument in the continued use of beta as a measure of systematic risk in cse. further to find a better applicability of the slb model in the cse, fernando and nimal (2009) apply two pass ols regression for a simulated artificial market. the study finds that two pass ols regression approach has merely less than ten percent possibility of detecting slb even when it exists in the market. since power of fama and macbeth (1973) test is very low the study suggests that existing empirical evidence on slb using two pass ols in the cse should be interpreted with caution. the study suggests more powerful tests like gibbons, ross, and shanken (grs) (1989) in making judgments on the slb model in sri lanka. in neoclassical literature the empirical evidence against the slb model led to the development of new theoretical arguments (ross, 1976; chen et al., 1986) in the form of factor models to explain stock returns. the table 3 depicts the evidence on factor models in asset pricing employed in the sri lankan market. gunasekarage et al. (2004) find that the shocks to economic variables explain only a minority of the forecast variance error of the market index asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 47 of sri lanka and that the affects did not persist in the long run. menike et al. (2015) find that stock prices in sri lanka are sensitive to both firm level variables and changes in macroeconomic fundamentals. furthermore, kongahawatte and nimal (2015) table 2. the relationship between explanatory factors and stock returns in sri lanka 19972017 the table depicts tests of asset pricing in the sri lankan market from 1997 to 2017. the first column is the reference of the empirical investigation and the second is the period of the study. the methodology applied is in the third column. then the relationship of beta, be/me, size, e/p, leverage and liquidity are depicted. when a specific variable is not tested in the relevant investigation it is marked (-). study whether systematic risk factors; size and be/me anomalies can be subsumed through macro-economic factors in the cse. the study finds that size and be/me become insignificant with the inclusion of macro factors and that the effect of macroeconomic variables are temporary in sri lanka unlike studies such as chen (1986). atheoritical asset pricing models argue that anomalies in asset pricing can be described through parsimonious multifactor models, where the factors are chosen to fit the empirical evidence (campbell, 2000). table 3 shows the findings of atheoritical factor models; ff3fm (1993), c4fm (1997) and ff5fm (2015) that are empirically tested in the sri lankan market. nanayakkara (2008) tests ff3fm (1993) and establishes that market, size and be/me factors collectively capture much of the variation of stock returns in the cse than the single factor, beta. senevirathna and nimal (2009) test the economic rationale behind the ff3fm through the characteristics of size and be/me factors similar to the argument built by fama and french (1995). it finds mixed evidence for the three factors when explaining company earnings and it does not find any reliable link between common risk factors in earnings and stock returns. the most crucial finding of the study is that; though the three factors capture much of the variation in returns, it is the market factor that captures most of the variation. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 48 dayaratne (2010) compares capm and ff3fm in predicting stock returns during the market crisis and non-crisis periods, and concludes that three factor model is a better model in capturing the variations in return during both crisis and non-crisis periods. randeniya and wijerathna (2012) compare capm and ff3fm to find whether these risk factors can capture the different characteristics of the market before and after the war in sri lanka. they find that small capitalisation, high be/me stocks tend to outperform the market, and their study suggests ff3fm is better than capm during the period, but the explanatory power of the model is low compared to the findings of developed markets. in 1993 jegadeesh and titman find evidence of momentum where stocks that perform the best (worst) over a three to twelve months period tend to continue to perform well (poorly) over subsequent three to twelve months and that the momentum strategies are consitently profitable. pathirawasam and weerakoon (2008) examine the profitability of momentum strategy in the sri lankan context, and find that the most successful momentum strategy in cse is selecting stocks based on their returns over the past twelve months and then holding them for next nine months. anuradha and nimal (2013) test momentum effect immediately and with one month lag using return for the period of twenty years with overlapping holding periods. similar to previous findings the study concludes that stocks selected based on past twelve months return and holding them for the next six months is most profitable in cse. these profits in the cse initiate the momentum arguments in the sri lankan market whether; it is a result of market inefficiency (campbell, 2000; jegadeesh & titman, 1999), it is a product of data mining or it arise because of inherent biases in the way that investors interpret information (barberis et al., 1998; daniel et al., 1998). asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 49 table 3. tests of multifactor asset pricing models in sri lanka 1997-2017 the table depicts tests of multifactor asset pricing models in the sri lankan market during the period 1997 to 2017. the first column is the reference of the empirical investigation. second column depicts the nature of the investigation and the third column shows the time period considered. the fourth column depicts the multifactor models/s investigated in respective studies. with the evidence of momentum (jegadeesh & titman, 1993) anomaly, cahart four factor model (c4fm) (1997) extends the ff3fm (1993) by adding momentum as a risk factor of return. the c4fm model finds that there is a common pattern of returns in many regions including asia pacific. riyath and nimal (2014) test the c4fm (1997) for a period of seventeen years in sri lanka. it is a comprehensive study that tests capm, ff3fm, c4fm, and reward beta model using both fama and macbeth (1973) and grs (1989) for non-financial firms in sri lanka. the study shows an insignificant positive market factor, a be/me premium and a significant momentum factor. the size effect is weak which adds to the evidence that there is no persistent pattern related to size and return in cse. abeysekara and nimal (2016, 2017) is a similar inclusive study of asset pricing models in sri lanka that covers a period of fourteen years, and it considers all firms and non-financial firms in the cse. the study rejects capm based on grs f-statistic and finds that there is a considerable drop in grs values for the ff3fm and c4fm respectively. thus both studies confirm that the capm does not hold in the cse, ff3fm and c4fm has the ability to explain cross sectional variation of stock returns in the cse, while c4fm perform marginally well than the ff3fm. 5. discussion neoclassical asset pricing literature is a coherent body of theory rather than a disjointed collection of publications (dimson & mussavian, 1999). sri lankan asset pricing literature has aligned with the evolution of neoclassical theory by initiating with the pioneering slb model, and empirically investigating the milestone developments in neoclassical asset pricing tests in asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 50 the cse. ryan et al. (2002) state neoclassical asset pricing has reached a very high degree of sophistication but there are many new questions and unresolved problems in the existing literature, including issues relating to its fundamental assumptions. this review of two decades of neoclassical asset pricing tests in sri lanka confirms the findings in other markets. it provides evidence that the rational slb model is not supported and that the single factor beta alone cannot capture the variation of cross section of stock returns in the cse. these inconsistencies provide the basis for the investigations of a conditional relationship between beta and return, and sri lankan literature finds that beta explains stock returns based on the condition of the market (anuradha, 2008; nimal & fernando, 2013). however it is hard to find the tests of dynamic versions of the slb model (mayers, 1972; merton, 1973; breeden, 1979) in the cse which relaxes the assumption of a single period mode. neoclassical asset pricing literature debate many reasons for the inapplicability of the slb model in asset markets. a main argument by campbell (2000), states that anomalies provide genuine evidence against the slb model but not against the broader concept in which there are multiple risk fators that may explain stock returns. we find evidence for mulitfactor explanation of stock returns through factor models (ross, 1976; chen at al, 1986; fama and french, 1993,1996) in the cse. while early studies were not supportive to the factor models, the recent studies provide evidence of multiple risk factors in the cse. however, one should be cautious when interpreting results of multifactor models in cse since the explanatory power of the models are not as strong as the findings in developed markets. harvey (1995) studying emerging markets develops a debate that, asset pricing models as specified are unable to explain the cross section of expected returns, because the equities exposure to commonly used risk factors are different in these markets. alles and murray (2009) argue that investors in emerging and frontier markets should be concerned about both systematic and unsystematic risk than beta alone. therefore, cse tests can be further developed by augmenting existing neoclassical models with unique characteristics identified in the frontier markets. models such as liquidity adjusted capm (lcapm) (acharya & pederesen, 2005); three moment capm (kraus and litzenberger, 1976) may perform better in the cse. another argument in neoclassical literature is where roll (1977) takes the extreme position that slb is actually untestable, because any negative results might be due to errors in the proxy used as the market. shanken (1987) has shown that empirical results can only be reconciled with the capm if the correlation of the proxy with the true market is quite high. therefore, it highlights the inquiry whether the index in the cse correlates to the true market in sri lanka. furthermore, behavioural finance builds the contrary debate that investors are not always rational. behavioural researchers (shefrin, 2009; statman, 1999;black, 1986; delong et al., 1990) argue that investors form beliefs based on psychological biases and heuristics thus security prices reflect both a rational and an irrational components. the lack of support for neoclassical asset pricing tests in sri lanka may be caused by the behavioural component in asset prices. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 51 6. conclusion neoclassical asset pricing models try to explain cross sectional variation of stock returns in asset markets, and the original model assumes that market betas can capture the total systematic variation of returns. later empirical investigations uncovered anomalies to slb model which led to development of augmented asset pricing theories and models. although there are inconsistent and inconclusive evidence of neoclassical asset pricing models, it remains a strong body of knowledge that is applicable until the present (dimson & mussavian, 1999). in this background, this study critically reviews two decades of neoclassical asset pricing tests in the frontier market sri lanka. to select the relevant literature in the colombo stock exchange (cse) the study employs structural empirical review (ser) methodology, which is a quasi-experiment that derives a conclusion from the data already published. it develops a clear selection and elimination criteria to identify relevant studies to be reviewed. based on the criteria this study specifically compare, contrast, and critically review 23 empirical investigations on neoclassical asset pricing tests in the cse, for a period of twenty years from the year 1997 to 2017. confirming the existing findings the slb model is not supported in the sri lankan market, while a conditional relationship between beta and returns are established. the findings of the multifactor asset pricing models are not consistent with other markets. the review finds a temporary effect of macroeconomic variables on stock returns in sri lanka. though the atheoritical ff3fm was not initially supported, the longer period studies support the model. these studies suggest it is the market factor that includes multiple sources of risk, which captures much of the variation in the cse. the recent studies conclude c4fm provides a better explanation than the slb and the ff3fm, but the explanatory powers of these models are quiet low compared to the findings in developed markets. next, the review discusses the debates set forth for the inconsistencies and inconclusive evidence of neoclassical asset pricing tests, specifically in frontier markets such as cse. campbell (2000) argues that in asset pricing the concept of multiple risk factors prevail over a single factor asset pricing model. harvey (1995) debates that neoclassical model as specified lack support in emerging markets, because the assets’ exposure to risk factors is different. alles and murray (2009) highlight the unique characteristics of the emerging and frontier markets that set them apart from developed markets. the viability of using the cse as a reflection of the true market of sri lanka is discussed with shanken (1987) critique. finally the bahavioural argument inquires whether investors in the sri lankan market are rational. the findings of this review supports the argument that neoclassical models should be augmented with characteristics of emerging and frontier markets to make them more applicable to sri lanka while being aware of the inherent limitations of neoclassical asset pricing models which may have affected the findings. references abeysekera, a. p., & nimal, p. d. 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(1958). estimation of relationships for limited dependent variables. econometrica, 26, 24-36. https://doi.org/10.2307/1907382 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 194 determinants of capital adequacy ratio of commercial banks in nepal bishnu prasad bhattarai, phd academic director / business unit head, excel business college pokhara university affiliated, new baneshwor, kathmandu & faculty member patan multiple campus, tribhuvan university, patan dhoka, lalitpur, nepal e-mail: drbhattarai2019@gmail.com / bishnu.bhattarai@excelcollege.edu.np / bishnu.bhattarai@pmc.tu.edu.np received: march 1, 2020 accepted: may 2, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.17521 url: https://doi.org/10.5296/ajfa.v12i1.17521 abstract the study attempts to determine the capital adequacy ratio of commercial banks in nepal. this study is based on the secondary balance panel data. the data were collected from the 11 commercial banks for the period of 2013/14 to 2017/18 leading to 55 observations. the convenience sampling technique has been used to selection of sample of the study. the study period has been made for fresh data in the analysis. the descriptive, correlational and casual comparative research design has been used for data analysis. the study assumes that the capital adequacy ratio of commercial banks depends on bank specific variable: credit risk, asset quality, management quality, return on assets, liquidity, size of bank and macroeconomics variables gross domestic products growth rate and consumer price index i.e. inflation rate. the three different model like pooled ols, fixed effects model and random effects model have been used for data analysis. the results of the study revealed that the liquidity has positive and statistically significant effects on capital adequacy ratio. size of bank and inflation rate have negatively and statistically significant results. the others variables profitability, asset quality, credit risk, management quality and growth of gross domestic products does not effect to capital adequacy ratio. the study concluded that liquidity, size of bank and inflation have major determinants of capital adequacy ratio in nepal. keywords: commercial bank, capital adequacy ratio, credit risk, asset quality, management quality, return on assets, liquidity, size of bank, gross domestic products growth rate, inflation rate asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 195 1. introduction capital adequacy rules are safety valve for regulators and banks' clients/shareholders to reduce expected risks faced by commercial banks especially for cross border transactions as these rules are applied compulsory by all banks internationally. applying these rules will achieve rational management and governance (el-ansary & hafez; 2015). capital adequacy ratio (car) is an important indicator of bank safety sustainability. banks that can guarantee car means the bank has the power to resist the financial crisis, protecting the bank itself and funds from depositors (usman, lestari & puspa; 2019) car is one of the major indicators of the stability of the commercial banks. pertinent to its pervasive importance, over the years, the regulators and policymakers focused on the maintenance of the particular level of capital ratio (cr) to minimize the solvency and liquidation risk. it is an important measure of “safety and soundness” for banks and depository institutions because it serves as a buffer or cushion for absorbing losses. it is one of the major benchmarks for financial institutions the world over, especially with the introduction and adoption of the various basel accords. due to a poor capital standard some depository institutions (dis) failed recently. therefore, stakeholders such as regulators, managers, researchers, etc. are concerned to fix a precise level of long-term sources of fund in their capital structure. dis are highly levered firm because major portion of their capital structure consists of debt collected from deposits. one of essential requirements for banks and financial institutions is adequate and sufficient capital and every banks and financial organizations must keep balance between capital and available risk in its assets in order to guarantee its stability. thus it has become one of the most important criteria for depository institutions. car is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process. it is an acknowledged economic fact that banks cannot underestimate the role of capital adequacy since adequacy of capital in banks directly influences the amount of funds available for loans disbursement which invariably affects their risk appetite, efficiency and stability. in nepalese context, nepal rastra bank (nrb) issued some considerations for commercial banks in order to create healthy banking system and have ability to compete with worldwide should be preparing minimum capital adequacy ratio that meets with the international standards. capital adequacy ratio means amount of capital to ensure that banks can handle risk exposures. implementing the minimum capital adequacy ratio must be adjusted to risk profile for absorb the potential losses on risk exposure as well as to fulfilling the minimum capital requirement. the basel iii norms stipulated a capital to risk weighted assets of 8%. however, as per nrb norms, nepal scheduled commercial banks are required to maintain a car of 11%. hence, the survival of banks is vested with the maintenance of sufficient capital and it serves as buffer in the event of liquidity crunch. in this regards, the main research question of this study as follows: what are the determinants of capital adequacy ratio of commercial banks in nepal? asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 196 although, review of literature in nepalese context very limited research have been found. these study were: shrestha, raut, yadhav and thapaliya (2014), poudel and khanal (2015), aryal (2016) and adhikari (2017). in the changing situations this study has fulfill the new knowledge gap and recent literature in this phenomena. the purpose of this study is to determine the capital adequacy ratio of commercial banks in nepal. the remainder of the study organized as follows: section two describes the literature review. section three explain the research methodology, section four focuses on empirical results and final section draws the summary and conclusion of the study. 2. literature review the study were conducted in many countries in around world to determine capital adequacy ratio of commercial banks or others financial institutions. the some valuable literature has been reviewed as follows. shrieves and dahl (1992) have investigated the relationship between changes in risk and capital in a large sample of banks. a positive association between changes in risk and capital is found. the fact that this finding holds in banks with capital ratios in excess of regulatory minimum levels supports the conclusion that, for most banks, bank owners’ and/or managers’ private incentives work to limit total risk exposure. results for banks which were undercapitalized by regulatory standards indicate that regulation was at least partially effective during the period covered. overall, the findings support a conclusion that changes in bank capital over the period studied have been ‘risk-based’. białas and sole (2010) have studied on the capital adequacy ratio (car) determinants of a bank‘s core capital to the assets and off-balance liabilities weighted by the risk. the core capital of the bank is supposed to absorb the potential losses due to the risk of the banking activities. it has been specified that the value of this coefficient cannot be lower than 8%. throughout the years the way of calculating the ratio has been changing, which is the subject of this study. in this study, the situation of polish and ukrainian banking sector has also been analyzed from the point of view of the coefficient in question. yuanjuan & shishun (2012) have analyzed the prime crisis detonated fully exposed the risks of high leverage ratio of financial institutions operating, on the analysis of the effectiveness of capital adequacy is even more important. at that time, china's banking capital adequacy ratio is not entirely from external capital markets and bank performance improvement, and also the supervision of the superior pressure. the regression analysis on the 2005-2010 combined data of the 14 listed banks, china's listed banks' capital adequacy supervision must have the effect of has been shown. continue to enhance the effectiveness of the capital adequacy ratio regulation. al-tamimi and obeidat (2013) have identified the most important factors that determine the capital adequacy of commercial banks of jordan in amman stock exchange for the period from 2000 2008 using multiple linear regression analysis and the correlation coefficient (pearson correlation). the study shows that there is a statistically significant positive correlation between the degree of capital adequacy in commercial banks and the following asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 197 independent factors: liquidity risk, and the rate of return on assets. in another hand, there is an inverse relationship with statistical significance between the degree of capital adequacy of commercial banks and factors independent of the following: the rate of return on equity and interest rate risk. there is an inverse relationship is not statistically significant between the degree of capital adequacy in commercial banks and factors independent of the following: capital risk, credit risk, and the rate of force-revenue. as shown by the results of the study that the independent variables combined with a relatively high effect on the dependent variable and the changes that occur within, as the percentage of the interpretation of the independent variables of the dependent variable reached approximately 61 percent. abusharba, triyuwono, ismail, and rahman (2013) have analyzed the determinants of the capital adequacy ratio in the indonesian islamic banking industry. secondary data were obtained from islamic banks annual reports and islamic banking statistics that derived from bank indonesia covering the period of 2009 to 2011. multiple linear regression analysis and pair-wise correlation matrix are used to explain the effect of explanatory variables; profitability (roa), assets earning quality (npf), deposits structure (dep), liquidity (fdr) and operational efficiency (oeoi) on a proxy variable which is the capital adequacy ratio (car). the study found that profitability and liquidity are positively related to the capital adequacy requirements. meanwhile, uncollectable funds measured by nonperforming financing (npf) is significant but negatively related to the capital adequacy ratio. on the other hand, depositor's funds and operational efficiency have no significant effect on capital adequacy of indonesian islamic banks. moreover, this study revealed that all selected islamic commercial banks in indonesia are committed over than 8 percent the minimum of capital requirements during the period of financial global crises. finally, it was found that indonesian islamic banks have an excessive fund to meet their obligations and protect the owners of capital. bateni, vakilifard and asghari (2014) have focused on influential factors (precisely seven financial factors) over capital adequacy in iranian private banks for the period 2006–2012. the results obtained indicate negative relationship between bank size and capital adequacy ratio of banks and positive relationship between loan asset ratio (lar), return on equity (roe), and return on asset (roa), equity ratio (eqr), and capital adequacy ratio. rar and dar do not have any impact on capital adequacy ratio. polat and al-khalaf (2014) have presented an empirical evidence to explain some bank internal factors that influence the capital adequacy ratio (car) of listed banks in the kingdom of saudi arabia (ksa). they have used the data covering from 2008 to 2012 for the saudi arabian banks that are listed in saudi arabian stock market, tadawul. by using a panel data and modelling through fixed effect, robust estimation and generalized least square (gls) and feasible gls, they found that except non-performing loans, other variables have significant effect on car. depending on the model type the results vary. fixed effect, robust estimation and least squared dummy regression (lsdr) results shows that loans to assets ratio has negatively significant while leverage and the size of the banks have positively significant in determining car. in gls estimation they found that in addition to earlier model results, loan to deposit ratio has negatively significant and the return on assets has positively significant on asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 198 car. the analysis of the study also shows that there are significant bank specific effects in panel data structure while no time effect is found. aktas, acikalin, bakin and celik (2015) have evaluated the impact of bank-dimensional and environmental factors on bank’s capital adequacy ratio in south eastern european (see) region. size, profitability (roa), leverage, liquidity, net interest margin (nim), and risk are used as bank-dimensional explanatory variables in a feasible gls regression model. on the other hand, economic growth rate, inflation, real interest rate, eurozone stock market volatility index, deposit insurance coverage, and governance indicator are added to the original model to control for environmental factors. annual data from 71 commercial banks belong to 10 different countries in see region for the period of 2007 – 2012 is used. this region mainly consists of the “transition economies” which are still experiencing the difficulties of turning into efficient market economies with high economic potentials. the results of our study show that among the bank dimensional explanatory variables size, roa, leverage, liquidity, net interest margin and risk have statistically significant effects in determining car for the banks in the region. among the environmental factors, economic growth rate, eurozone stock market volatility index, deposit insurance coverage, and governance have statistically significant effects in determining car for the banks in the see region. irawan, and anggono (2015) have examined the determinants of capital adequacy ratio of bank buku 3 and bank buku 4 in indonesia. determinants and its effect toward capital adequacy ratio of indonesian banks are covered by the study. data were gathered from monthly financial statement of indonesian banks during 2005—2014. regression analysis was used in this study to analyze the relationships between independent variables; bank size (asset), deposits, credits, nonperforming loan, liquidity coverage ratio (lcr), profitability (roa and roe), and net interest margin (nim) and a dependent variable which is capital adequacy ratio (car). the results of this study were assets, nonperforming loan, and roa have positive effect toward the capital adequacy ratio, while roe, nim, credit, and deposit have negative effect toward the dependent variable. on the other hand, liquidity coverage ratio not has any significant effect toward the capital adequacy ratio. alajmi and alqasem (2015) have identified the effects of seven internal factors of five conventional kuwaiti banks on capital adequacy ratio (car). the five factors are: loans to assets, loans to deposits, nonperforming loans to total loans, return on assets, return on equity, dividend payout and total liability to total assets. the study covers the period from 2005 to 2013. the study shows that under fixed effect model, variables diviedend, lar, ldr, npllr, and roe do not have any impact on capital adequacy ratio. however, size has a significant and negative relationship with capital adequacy ratio. also, roa shows a significant and negative relationship with capital adequacy ratio. under random effect model, results indicate that car is adversely affected by bank’s size (total liability to assets), and roa has a significant and negative relationship with capital adequacy ratio. however, loan to deposit ratio (ldr) showed a significant and positive relationship with capital adequacy ratio. on the other hand, dividend payout, loans to assets, non-performing loans to total loans and return on equity do not have significant effect on car under random effect model. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 199 asma and khadidja (2015) have investigated the determinants of malaysia islamic banks capital adequacy ratio and its effects on financial positions of banks covered by the study. data were obtained from banks' annual reports; other proxies were collected from bank scope database for the period 2006 2011. capital adequacy ratio is the ratio which determines the bank's capacity to meet the time liabilities and other risks such as credit risk, operational risk etc. in the simplest formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other lenders. banking regulators in most countries define and monitor car to protect depositors, thereby maintaining confidence in the banking system. panel data methodology was used in this study and analyzes relationships between independent variables; bank size (size), operational efficiency (opr), liquidity risk (lqr), profitability (roa and roe), credit risk (cr) and a dependent variable which was capital adequacy ratio (car). the results of the paper indicate that credit risk (cr) and return on equity have a negative effect on car, while return on assets positively influence car. on the other hand operating efficiency (opr), liquidity risk (lr) and bank size (sb) do not appear to have any significant effect on car. el-ansary & hafez (2015) have examined explanatory victors that influence capital adequacy ratio (car) in the egyptian commercial banks. the study covers 36 banks during the period from 2004-2013. they have examined the relationship between car as dependent variable and the following independent variables: earning assets ratio, profitability, and liquidity, loan loss provision as measure of credit risk, net interest margin growth, size, loans assets ratio and deposits assets ratio. furthermore, they investigate determinants of car before and after the 20072008 international financial crises. results vary according to the period understudy. for the whole period 2003 to 2013 results show that liquidity, size and management quality are the most significant variables. before the period 2008 results show that asset quality, size and profitability are the most significant variables. after the period 2009 results show that asset quality, size, liquidity, management quality and credit risk are the most significant variable that explain the variance of egyptian banks' car. paudel and khanal (2015) have explored that the capital adequacy ratio is a significant measure to evaluate efficiency and stability which affects the likelihood of insolvency for those institutions. nepalese banks are applying basel framework in order to maintaining a precise level capital standard. but, nepalese cooperatives such as saving and credit cooperatives, multipurpose cooperatives, etc. are not regulated by the central bank, and thus, are not subjected to follow the basel. in this regard, the study have evaluated the determinants of the capital adequacy ratio of nepalese cooperative societies through descriptive, correlation, and regression analysis using an unbalance panel data of 126 co-operatives from 2009 to 2013. the core determinants of capital adequacy ratio for the nepalese cooperatives are credit to deposit ratio, net interest margin and types of cooperative in positive direction, whereas assets utilization ratio, size and return on equity in negative direction. though, the big sized cooperatives have poor strategic capital, the resulted mean and standard deviation suggest cooperatives’ capital adequacy ratio is higher but inconsistent than commercial banks. mili, sahut, trimeche and teulon (2016) have examined the factors influencing the capital adequacy ratio (car) of foreign banks. they have tested whether the car of subsidiaries and asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 200 branches in developed and developing countries depends on the same factors. they have used data from 310 subsidiaries and 265 branches to test the impact of the parent banks’ fundamentals on subsidiaries’ and branches’ capital ratios. they also study how the economic condition and regulatory environment in a bank’s home country determine foreign banks’ car. our results provide strong evidence that the car of subsidiaries and branches operating in developing and developed countries do not depend on the same set of explanatory factors. they also find that the regulatory framework of a parent bank’s home country affects the capitalization of its foreign subsidiaries in the host countries. the study show that specific variables of the parent bank have a stronger effect for foreign banks highly related to the interbank market. olarewaju and akande (2016) have examined the determinants of capital adequacy in nigerian quoted deposit money banks for the years 2005-2014. the study employs both descriptive and fixed effect panel regression. the descriptive analysis shows that the mean and median values are within the minimum values and the standard deviation shows the expected growth rate deviation for each of the identified determinants of capital adequacy. from the analysis of panel data using cross-sectional specific fixed effect estimations, it is discovered that a direct relationship exists among eta, roa and siz while an inverse linear relationship that exists among roa, cr, dep and liq are statistically significant in determining the level of capital adequacy among the deposit money banks in nigeria. the study recommends the need for all these affected banks to gear up and invest more on the significant factors that can lead to improvements in their capital adequacy in order to achieve viability, sustainability and stability in the long run. masood and ansari (2016) have analyzed the bank specific factors which had an impact on the determination of capital adequacy ratio (car). the impact of roa (return on assets), roe (return on equity), lat (loan to asset ratio), llr (loan loss reserves), npl (nonperforming loans), dar (deposit asset ratio), ear (equity asset ratio) and ownership concentration with a level of more than 10%, 25% and 50% was analyzed by using fixed effect method and the validity was tested by hausman test. the results proved that random effect model is better suited in this case. the data of 14 pakistani commercial banks which were included in the kse (karachi stock exchange) 100 index was gathered for the period 2008 2014. the results revealed that the lat and ownership concentration of more 50% had a significant but a negative impact on the car. the ear, dar, llr had a significant and positive impact the determination of car, whereas the size of the bank, roa, roe and npl had no impact on car. kasmadi, lambey and tumiwa (2017) have explained banks are expected to perform their activities effectively and efficiently in order to reach financial goals. a healthy standard for banks in indonesia is determined by central bank (bank indonesia), which is above 8% for the indication of capital adequacy ratio. this research analyses the relationship between capital adequacy ratio and its determinants between mandiri and mandiri syariah bank. this research examines the simultaneous and partial influences between capital adequacy ratio and the variables of return on equity, net interest margin, loan/financing to deposit ratio, and bank size by using time series regression and using the quarterly period of 2009-2016. the results reveal asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 201 that the independent variables simultaneously affect capital adequacy ratio for both banks, and by partially, the results confirm that return on equity and bank size significantly affect capital adequacy ratio. with this research, companies are encouraged to figure out the root problems on how to manage a stable financial statement that may lay on some of the variables that are discussed in this study. thoa and anh (2017) have analyzed the vietnamese banks in the period 2011-2015 and shows how the capital adequacy ratio (car) is influenced by selected factors, namely: asset of the bank size, loans in total assets loa, leverage lev, net interest margin nim, loans lost reserve llr, cash and precious metals in total assets liq. the result revealed that nim and liq have significant effect on car. on the other hand, size and lev do not appear to have significant effect on car. variables nim, liq have positive effect on car, while variables llr and loa are negatively related with car. hewaidy and alyousef (2018) have investigated the impact of bank-specific and macroeconomic factors on bank’s capital adequacy ratio (car). size, profitability (roa & roe), asset quality (aq), management quality (mq), liquidity (liq), net interest margin (nim), and bank type are used as bank-specific factors. gross domestic product (gdp) and inflation are used as macroeconomic factors. annual data for all kuwaiti listed banks is used for the period from 2009 to 2016. the findings indicate that in terms of bank characteristics, only bank size, aq, mq and bank liq have significant impact on car. the findings suggests that car tends to be more affected by how efficient bank resources are utilized than by any other bank characteristic or macroeconomic variable. hadjixenophontos and christodoulou-volos (2018) have analyzed the determinants of capital adequacy of cypriot banks mainly during the period of financial crisis using multiple linear regression. specifically, the study focuses on certain features of banks (risk, liquidity, return etc.) to determine whether they affect the volatility of capital adequacy. the study provides supportive evidence that there is a negative statistically significant relationship regarding bank size and risk and a positive regarding the level of provisions and percentage of net interest margin. the factors affecting the capital adequacy ratio in cyprus are the increases in credit risk and nonperforming loans, excessive leverage, increased requirements by regulatory authorities for the implementation and fulfillment of the basel iii rules by 2019, the negative environment and lack of trust, intensive competition among banks, the small size of banks in comparison with the interbank market, low yield and target for long-term growth, poor corporate governance and the problem of information asymmetry. moreover, in the case of cyprus, the additional capital is a strategic hedge to secure access to deposits and money markets and “buffer” as insurance in case of unforeseen events in the future due to the previous negative experience. alali (2019) has investigated the influence of capital adequacy on financial stability indexes in commercial banks in jordan (return on invested capital roic, profitability rate pr), follows the descriptive analytic approach in order to analyze the results. the population of the study consists of all commercial banks in jordan, a sample selected from these population (13) commercial banks in jordan. the results of the study showed most of jordanian banks, asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 202 committed to capital adequacy ratio defined in the international (basel ii), this ratio largest percentage of decided by the base iii committee, and there is statistically significance influence of capital adequacy ratio on financial stability indexes (profit rate) and (return on invested capital ratio) in jordanian banks. linh et al. (2019) have studied by using the data of 26 vietnamese join-stock commercial banks. the result analysis through the panel tobit model, the research found that the net interest margin (nim), bank size, gdp growth, interest rate and exchange rate have the inverse relationship with car while the leverage and deposits positively correlated to car. usman, lestari and puspa (2019) have determined the factors that affect the car. the sample used in this study was the banking industry listed on the indonesia stock exchange (idx) from 2007 until 2018. independent variables were bank size, leverage, loan loss reserves, net interest margin, loan assets ratio, and liquidity. the dependent variable was car. the number of samples is 27 conventional banks by using purposive sampling. by using panel data regression analysis by estimating ordinary general least squares (gls) method. the results of this study indicate that bank size, leverage, loan loss reserve, net interest margin, and loan asset ratio has an effect on car significantly while liquidity has no effect on car. the results of this study are expected to be used as a reference for bank managers and investors in looking at the factors that affect the car in the banking industry. 3. research methodology this study is based on the secondary balance panel data. the data were collected from the 11 commercial banks for the period of 2013/14 to 2017/18 leading to 55 observations. the annual report of respective commercial banks collected through the web site for banks specific variables and economic survey which is collected through the web page of ministry of finance were main source of data. the convenience sampling technique has been used to selection of sample of the study. the study period has been made for fresh data in the analysis. the descriptive, correlational and casual comparative research design has been used for data analysis. the selected banks for study are nabil bank, nic asia bank, machhapuchchhre bank, sanima bank, megha bank, everest bank, himalayan banks, nepal sbi bank, standard chartered bank, prime bank and citizen bank. 3.1 the model the study assumes that the capital adequacy ratio of commercial banks depends on bank specific variable: credit risk, asset quality, management quality, return on assets, liquidity, size of bank and macroeconomics variables gross domestic products growth rate and consumer price index i.e. inflation rate. hence, the model takes the following form: carit = β0 + β 1crit + β 2aqit + β 3mqit + β 4roait + β 5liqit + β 6sizeit + β 7gdpit + β 8infit + eit where, β0 = constant term asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 203 β1 to β8 = coefficient of variables carit = capital adequacy ratio of ith bank in year t crit = credit risk ratio of ith bank in year t aqit = assets quality of ith bank in year t mqit = management quality of ith bank in year t roait= return on assets of ith bank in year t liqit= liquidity of ith bank in year t sizeit= bank size of ith bank in year t gdp = gdp growth rate in year t inf= inflation rate in year t eit = error term 3.2 variables and hypothesis the study has been selected capital adequacy as dependent variable. the study also have been taken bank specific variables: profitability, credit risk, management quality, liquidity, size of bank, and asset quality and macroeconomics variable: gross domestic product growth rate and inflation rate as independent variables. the explanations about the measurement and hypothesis of the study have been described as follows. 3.2.1 dependent variable capital adequacy ratio (car) capital is important in banking and financial institutions. one of the essential requirements for banks and financial institutions is adequate and sufficient capital and every banks and financial organizations must keep balance between capital and available risk in its assets in order to guarantee its stability (bateni et al.; 2014). capital adequacy ratio is a measure of the amount of bank’s capital measured as bank’s capital expressed as a percentage of bank’s total assets adjusted by loan loss provision and risk-free assets. 3.2.2 independent variable bank specific variable credit risk (cr) the non-performing loan to total loan ratio has proxy of credit risk in this study. the credit risk has positive and significant effects on capital adequacy ratio. the results of the studies related to the findings were abusharba et al. (2013) and hadjixenophontos and christodoulou-volos (2018). the result against to this line were asma and khadidja (2015), mohanty and mahakud (2019), and usman, lestari and puspa (2019). this study has expected also negative relation with capital adequacy ratio. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 204 h1: credit risk has negative significantly effect on capital adequacy ratio. assets quality (aq) asset quality refers to an evaluation of the credit risk associated with any particular asset, measured as loans loss provision to total assets. the study of el-ansary and hafez (2015) have found that assets quality have positive and significant with capital adequacy ratio. the studies have found negative and significant were: blose (2001), thoa and anh (2017) and usman, lestari and puspa (2019). in this study also expected negative relationship with capital adequacy ratio. h2: assets quality (loan loss provision on total asset ratio) has negative significantly effects on capital adequacy ratio. management quality (mq) the total loans to total deposit as measured for management quality proxy. it has ability to generate business and maintain profit. the management quality have found positive and significant result with capital adequacy ratio. the study have been supported in the same line were: aspal and nazneen (2014), aktas et al. (2015), thoa and anh (2017) and alajmi and alqasem (2015). the previous study of polat and al-khalaf (2014) has found that negative and statistically significant with capital adequacy ratio. similarly, the study has expected positive relation with capital adequacy ratio. h3: management quality (ratio of total loan to total deposit) has positive significantly effect on capital adequacy ratio. profitability (roa) the net profit after tax to total assets has been measurement of return on asset (roa). which is also called profitability. the return on assets indicates the ability of bank management to generate profit by utilizing the available assets of bank. there is significant and positive result found between the profitability (roa) and capital adequacy ratio. the previous studies have found in the same line were: polat and al-khalaf (2014), asma and khadidja (2015) and adhikari (2017). in this study expected that there positive relationship with capital adequacy ratio. h4: the profitability (roa) has positive significantly effects on capital adequacy ratio. liquidity (liq) liquidity refers to the ability of a bank to respond to short-term obligations, measured as net loans to total assets. the priori studies have found positive and significant with capital adequacy ratio were: abusharba, et al. (2013) and bateni et al., (2014). the past studies liquidity has found negative and significant were: buyuksalvarci and adioglu (2011), dreca (2013), nuviyanti and anggono (2014), polat and al-khalaf (2014), thoa and anh (2017), and mohanty and mahakud (2019). the study expected hypothesis is as follows. h5: the liquidity (loans asset ratio) has negative significantly effect on capital adequacy ratio. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 205 size of bank (size) the natural logarithm of total assets is measure to size of bank. there is significant and positive result found between the size of bank and capital adequacy ratio. the previous studies have found in the same line were: polat and al-khalaf (2014), mekonnen (2015); el-ansary and hafez (2015), mekonnen (2015), and mohanty and mahakud (2019). similarly, the studies have found in against were: al-sabbagh (2004), bateni et al., (2014), alajmi and alqasem (2015); hewaidy and alyousef (2018), hadjixenophontos and christodoulou-volos (2018), linh et al. (2019), and usman, lestari and puspa (2019). based on the priori studies capital adequacy has a negative influence with bank size, so that large banks have lower capital adequacy ratios, and more profitable banks have more capital adequacy high. therefore, the present study has been formulated hypothesis as follows. h6: the size of bank has negative significantly effect on capital adequacy ratio. macroeconomic variables gross domestic product growth rate (gdp) gross domestic product growth rate (gdp) is a measure of economic growth. gdp is the annual rate of change in the total output of all economic activities of a country in nepal. the gdp has found positive and statistically significant result s of schaeck and čihák (2007) and mili et al. (2014), aktas, et al., (2015) and ben moussa (2018) in different countries. the gdp has found native and statistically negative in the study of linh et al. (2019). in this regards, the present study has expected negative relationship with capital adequacy ratio. h7: gdp has negative significantly effects on capital adequacy ratio. inflation rate (inf) consumer price index, is a proxy for inflation rate which represents the macroeconomic conditions. the study of schaeck and čihák (2007), ogere et al. (2013), aktas, et al., (2015) and ben moussa (2018) have found a positive association between inflation and capital adequacy ratio. the previous studied have found negative and significant relation with capital adequacy ratio were: williams (2011), ochei (2013) and aktas, acikalin, bakin, and celik (2015). the present study has also expected negative relationship with capital adequacy ratio. h8: inflation rate has negative significantly effects on capital adequacy ratio. 3.3 summary of variables the selected study variable variables, measurements, nation, source and hypothesis (expected sign) have been presented in the table1. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 206 table 1. summary of variables, measurements, nation, source of findings and expected sign variables measurement notation source of findings exp.sign capital adequacy ratio capital / risk – weighted assets 0r (tier1 capital +tier 2 capital) to total risk weighted assets car buyuksalvarci and adioglu (2011), dreca (2013), nuviyanti and anggono (2014), polat and al-khalaf (2014), thoa and anh (2017), mohanty and mahakud (2019), and usman, lestari and puspa (2019) n/a credit risk non-performing loan to total loan cr (+) abusharba et. al. (2013), hadjixenophontos and christodoulou-volos (2018) (-) asma and khadidja (2015), mohanty and mahakud (2019), usman, lestari and puspa (2019) assets quality loan loss provision to total loan aq (+) el-ansary and hafez (2015) (-) blose (2001), thoa and anh (2017) and usman, lestari and puspa (2019) management quality total loan to total deposit mq (+) aspal and nazneen (2014), aktas et al. (2015), thoa and anh (2017), and alajmi and alqasem (2015) (-) polat and al-khalaf (2014) + profitability net profit after tax to total assets roa (+) polat and al-khalaf (2014), asma and khadidja (2015)adhikari (2017) + liquidity total loan to total asset liq (+) abusharba, et al. (2013) and bateni et al., (2014) (-) buyuksalvarci and adioglu (2011), dreca (2013), nuviyanti and anggono (2014), polat and al-khalaf (2014), thoa and anh (2017), and mohanty and mahakud (2019) size of bank natural logarithm of total assets size (+) polat and al-khalaf (2014), mekonnen (2015); el-ansary and hafez(2015), mekonnen (2015), and mohanty and mahakud (2019), (-) al-sabbagh (2004), bateni et al., (2014)., alajmi and alqasem (2015); hewaidy and alyousef (2018), hadjixenophontos and christodoulou-volos (2018), linh et al. (2019), and usman, lestari and puspa (2019) economic growth gross domestic products growth rate gdp (+) schaeck and čihák (2007) and mili et al. (2014), aktas, et al., (2015) and ben moussa (2018), (-) linh et al. (2019) consumer price index annual average consumer price index inf (+) schaeck and čihák (2007), ogere et al. (2013) aktas, et al., (2015) and ben moussa (2018), (-) williams (2011), ochei (2013) and aktas, acikalin, bakin, and celik (2015) source: survey of literature (2020) asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 207 4. results and discussion 4.1 descriptive statistics table 2 shows the summary statistics for study variables. the average capital adequacy ratio is 13.6percent. it shows that average capital adequacy ratio is beyond the limit of nrb. the maximum and minimum nonperforming loan ratio are 0.10 percent and 3.40 percent respectively. the standard deviation 0.833 percent which shows that low variation of credit risk. the average credit risk is 0.894 percent which less than 1 percent. it represented that nepalese sample commercial banks has nonperforming loan less than percent. table 2. summary statistics, using the observations 1:1 11:5 variable min max mean s.d. car 10.6 23.0 13.6 2.36 cr(npl/tl) 0.0100 3.40 0.894 0.833 aq(llp/tl) 0.00667 2.64 0.581 0.562 mq(tl/td) 48.9 90.5 79.4 9.61 roa 0.970 2.89 1.81 0.398 liq(tl/ta) 42.6 533. 75.7 63.2 size(lnta) 22.4 25.9 24.9 0.580 gdp 0.400 7.40 4.60 2.51 inf 4.48 9.90 7.32 1.98 the average asset quality represent ratio the loan loss provision by total loan is 0.581 percent. it indicates that nepalese commercial banks have provision on total loan have not big issues. the average return on assets is 1.81 percent. the total asset of commercial have return in average 1.81 percent. the minimum and maximum gdp growth rate are 0.40 percent and 7.40 percent. the minimum gdp growth rate was 2015/16 at that time nepalese economy has suffered from earthquake. due to the covid -19 pandemic world economy will face the problem as earthquake. the average inflation rate is 7.32 percent. it shows that consumer price index has increased by 7.32 percent. 4.2 correlation analysis the pearson correlation coefficients of study variables have been presented in table 3. the capital adequacy ratio is dependent variable. the independent bank specific variable are credit risk, asset quality, management quality, return on assets liquidity and size of bank and macroeconomic variables are gross domestic products growth rate and inflation rate. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 208 table 3. pearson correlation coefficient of study variables correlation coefficients, using the observations 1:1 11:5 (5% critical value (two-tailed) = 0.2656 for n = 55 car cr(npl/tl) aq(llp/tl) mq(tl/td) roa liq(tl/ta) size(lnta) gdp inf variables 1.0000 -0.2577 -0.2231 -0.0857 0.1823 0.5351 -0.0219 0.3315 0.4398 car 1.0000 0.7124 0.0681 0.0275 -0.1055 -0.2468 0.0302 0.1948 crnpltl 1.0000 -0.0075 0.3192 -0.1389 -0.2941 0.0360 0.2037 aqllptl 1.0000 0.2893 -0.0729 -0.1751 0.0826 0.1553 mqtltd 1.0000 0.2453 0.2779 0.0792 0.0798 roa 1.0000 0.0342 0.0906 0.1157 liqtlta 1.0000 0.0566 0.3606 lnta 1.0000 0.7379 gdp 1.0000 inf the table 3 shows the relation of dependent and independent variables. the relation between capital adequacy ratio and credit risk, asset quality, management quality, size and inflation rate have negative. whereas, the relation between capital adequacy ratio and profitability (return on assets), liquidity, and gross domestic products growth rate have positive. 4.3 regression analysis as per model test diagnostics from gretl statistical software for pooled ols or fixed effects model suitable for this study has been done. then, the result reveals that joint significance of differing group means: f(10, 36) = 3.48343 with p-value 0.00274725 the p-vale is 0.00274725<0.05. the assumption of model selection is: a low p-value counts against the null hypothesis that the pooled ols model is adequate, in favor of the fixed effects alternative. hence, the as p-value less than 0.05, the fixed effect model is appropriate for this case. again, the model test for the pooled ols or random effect model appropriate for this study has been test. then, the result shows that breusch-pagan test statistic: lm = 3.50017with pvalue = prob(chi-square(1) > 3.50017) = 0.0613625. the p-vale 0.0613625 is greater than 0.05. the assumption of hypothesis test is: a low p-value counts against the null hypothesis that the pooled ols model is adequate, in favor of the random effects alternative. hence, the p-value is greater than 0.05, the pooled ols is suitable in this case. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 209 table 4. regression results of determinants of capital adequacy ratio model 1: pooled ols, using 55 observations variables coefficient std. error t-ratio p-value vif constant 52.9958 14.4722 3.662 0.0006*** cr(npl/tl) −0.451491 0.452642 −0.9975 0.3238 2.486 aq(llp/tl) −0.0467778 0.693644 −0.06744 0.9465 2.655 mq(tl/td) −0.0386466 0.0280702 −1.377 0.1752 1.272 roa 0.432214 0.744346 0.5807 0.5643 1.533 liq(tl/ta) 0.0165215 0.00395380 4.179 0.0001*** 1.094 size(lnta) −1.31335 0.508406 −2.583 0.0130** 1.524 gdp −0.0837411 0.156297 −0.5358 0.5947 2.683 inf −0.662252 0.218182 −3.035 0.0039*** 3.274 r-squared = 0.528917 adjusted r-squared = 0.446989 test for different group intercepts : test statistic: f(10, 36) = 3.48343 p-value = p(f(10, 36) > 3.48343) = 0.00274725<0.05 durbin-watson = 1.099494 model 2: fixed effects, using 55 observations coefficient std. error t-ratio p-value constant 20.5851 14.9288 1.379 0.1764 cr(npl/tl) −0.510662 0.730723 −0.6988 0.4891 aq(llp/tl) 0.696559 0.870140 0.8005 0.4287 mq(tl/td) 0.0853605 0.0525413 1.625 0.1130 roa −0.296984 0.974650 −0.3047 0.7623 liq(tl/ta) 0.0128240 0.00360295 3.559 0.0011*** size(lnta) −0.440132 0.550544 −0.7995 0.4293 gdp 0.0146814 0.139311 0.1054 0.9167 inf −0.448347 0.194758 −2.302 0.0272** lsdv r-squared = 0.760582 within r-squared = 0.581996 lsdv f(18, 36) = 6.353594 p-value(f) = 0.00000134<0.05 durbin-watson = 1.462053 model 3: random effects (gls), using 55 observations coefficient std. error z p-value constant 47.6715 14.4045 3.309 0.0009*** cr(npl/tl) −0.508522 0.465715 −1.092 0.2749 aq(llp/tl) 0.0789790 0.707937 0.1116 0.9112 mq(tl/td) −0.0306310 0.0286947 −1.067 0.2858 roa 0.454224 0.740372 0.6135 0.5395 liq(tl/ta) 0.0160952 0.00383045 4.202 <0.0001*** size(lnta) −1.14188 0.507847 −2.248 0.0245** gdp −0.0631796 0.151005 −0.4184 0.6757 inf −0.622759 0.211413 −2.946 0.0032*** breusch-pagan test : hausman test : asymptotic test statistic: chi-square(1) = 3.50017 asymptotic test statistic: chi-square(6) = 34.272 p-value = 0.0613625>0.05 p-value = 0.00000596<0.05 durbin-watson = 2.080926 similarly, the selection process has been done for model test between random effect and fixed effect model. the result of hausman test statistic: h = 34.272 with p-value = prob(chiasian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 210 square(6) > 34.272) = 0.00000596the assumption of hypothesis test is: a low p-value counts against the null hypothesis that the random effects model is consistent, in favor of the fixed effects model. the p-vale is lower than 0.05 shows that among tested models the fixed effects model is appropriate in this case. thus, the study has been explained pooled ols and random effects model in this study as model diagnostics tested. the table 4 presented the analysis of regression results among credit risk, assets quality, management quality, profitability, liquidity, size of bank, growth rate of gross domestic products and inflation rate towards the capital adequacy ratio on different three like pooled ols, fixed effects model, and random effects model. the liquidity has positive and statistically significant effects on capital adequacy ratio. it shows that liquidity and capital adequacy have moving toward the same direction. the results consistent with the study of abusharba, et al. (2013) and bateni et al., (2014). the results of the study contrary with the study of buyuksalvarci and adioglu (2011), dreca (2013), nuviyanti and anggono (2014), polat and al-khalaf (2014), thoa and anh (2017), and mohanty and mahakud (2019). the results of the study has as per priori hypothesis. size of bank has negatively and statistically significant result. it shows that large bank have low capital adequacy ratio. the result supported by priori studies were: al-sabbagh (2004), bateni et al., (2014), alajmi and alqasem (2015); hewaidy and alyousef (2018), hadjixenophontos and christodoulou-volos (2018), linh et al. (2019), and usman, lestari and puspa (2019). the result of the study has inconsistent with the previous studies were: polat and al-khalaf (2014), mekonnen (2015); el-ansary and hafez (2015), mekonnen (2015), and mohanty and mahakud (2019). inflation rate has negatively associated with capital adequacy ratio. the result has as per priori hypothesis. when inflation rate has decreases the capital adequacy ratio increases. it shows the inflation rate effect on the capital adequacy ratio adversely. the study result in the similar line were: williams (2011), ochei (2013) and aktas, acikalin, bakin, and celik (2015). the study results inconsistent with the studies were: schaeck and čihák (2007), ogere et al. (2013) aktas, et al., (2015) and ben moussa (2018). the profitability and asset quality have positive but insignificant with capital adequacy ratio. they have positive effect on capital adequacy but statistically insignificant. the credit risk, management quality and growth of gross domestic products have negative and insignificant with capital adequacy ratio. it shows that profitability, asset quality, credit risk, management quality and growth of gross domestic products does not have role to determine capital adequacy ratio. 5. summary and conclusion the study attempts to determining the capital adequacy ratio of commercial banks in nepal. this study is based on the secondary balance panel data. the data were collected from the 11 commercial banks for the period of 2013/14 to 2017/18 leading to 55 observations. the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 211 convenience sampling technique has been used to selection of sample of the study. the study period has been made for fresh data in the analysis. the descriptive, correlational and casual comparative research design has been used for data analysis. the study assumes that the capital adequacy ratio of commercial banks depends on bank specific variable: credit risk, asset quality, management quality, return on assets, liquidity, size of bank and macroeconomics variables gross domestic products growth rate and consumer price index i.e. inflation rate. the three different model like pooled ols, fixed effects model and random effects model have been used for data analysis. the results of the study revealed that the liquidity has positive and statistically significant effects on capital adequacy ratio. size of bank and inflation rate have negatively and statistically significant results. the others variables profitability, asset quality, credit risk, management quality and growth of gross domestic products does not affect capital adequacy ratio. the study concluded that liquidity, size of bank and inflation have major determinants of capital adequacy ratio in nepal. references abba, g.o, okwa, e, soje, b., aikpitanyi, l.n. 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(2014). determinants of capital adequacy ratio (car) in 19 commercial banks (case study: period 2008 2013). journal of business and management, 3(7), 752-765. olarewaju, o.m. & akande, j.o. (2016). an empirical analysis of capital adequacy determinants in nigerian banking sector. international journal of economics and finance, 8(12), 132-142. https://doi.org/10.5539/ijef.v8n12p132 paudel, g.p. & khanal, s. (2015). determinants of capital adequacy ratio (car) in nepalese cooperative societies. https://doi.org/10.2139/ssrn.2647541 https://doi.org/10.14254/2071-789x.2010/3-2/5 https://doi.org/10.22495/cocv13i1c10p4 https://doi.org/10.1016/j.ribaf.2016.02.002 https://doi.org/10.1177/0972150919837082 https://doi.org/10.5539/ijef.v8n12p132 https://doi.org/10.2139/ssrn.2647541 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 213 polat, a. and al-khalaf, h. 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(2012). effectiveness of china's commercial banks' capital adequacy ratio regulation: a case study of the listed banks. interdisciplinary journal of contemporary research in business, 4(1), 58-68. https://doi.org/10.1016/0378-4266(92)90024-t https://doi.org/10.1016/0378-4266(92)90024-t https://doi.org/10.25073/2588-1108/vnueab.4070 https://doi.org/10.26905/jkdp.v23i3.2981 microsoft word 17014-60438-1-sm (1)-writer2-new-final asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 161 capital structure and bank performance: empirical evidence from bangladesh md. ibrahim molla assistant professor department of finance and banking, university of barishal barishal-8200, bangladesh e-mail: mmibrahimfnb@gmail.com received: may 11, 2020 accepted: june 11, 2020 published: june 11, 2020 doi:10.5296/ajfa.v12i1.17014 url: https://doi.org/10.5296/ajfa.v12i1.17014 abstract the paper empirically investigates the relationship between capital structure and the performance of listed banks in bangladesh using panel data over the period of five years from 2014-2018. to estimate the association between leverage level and bank performance the panel corrected standard error (pcse) model is used in this study and the findings indicate that long term debt has a positive influence on the performance of banks which is measured in terms of roa and roe. this implies that long term debts are associated with the higher performance of banks listed in bangladesh. the regression results also reveal that the capital structure component of total debt has no statistically significant impact on roa, roe and eps but it has a significant positive impact on the performance of banks measured by price earning ratio. furthermore, this analysis finds no relationship of long term debt and total debt with the eps. these findings lead to conclude that capital structure has a weak to no influence on the performance of listed banks in bangladesh. this paper is the first research attempt that investigates the impact of capital structure on the performance of all banks listed on the dhaka stock exchange in bangladesh. keywords: capital structure, leverage, pcse, banks, bangladesh. jel classification: g 21, g 32 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 162 1. introduction one of the main goals of a financial manager is to maximize the market value of the firm. the market value of the firm can be maximized by sound financing decisions where the financial manager uses the combination of debt and equity. a proper mixture of debt and equity would minimize the cost of capital and maximize the firm performance which in turn enhances the market value of the firm. the ratio of debt and equity and its relationship with firm performance has been the subject of a long line of investigation. this debate first started after the introduction of capital structure irrelevance theory propounded by modigliani and miller (1958), in which they claim that capital structure has no effect on the market value of the firm in an efficient market condition. mm negates the presence of optimal capital structure as the firm’s market value is independent of its financing choices and concludes firms financing choices does not influence the performance of the firm. opposing the mm structure, kraus and litzenberger (1973) propose that if the net tax benefits of debt financing equilibriums leverage related costs while keeping the company’s assets and investment decisions constant, then the optimal capital structure can be found. he also believes a positive association between firms’ leverage ratios and their performance which is later confirmed by (chakraborty, 2010). although several theories have been propounded to explain the capital structure of companies, and many of them suggest that the firm should optimize its capital structure but there is no consensus on how to achieve an optimal debt to equity ratio. for example, based on the perception that managers would not generally act to the greatest advantage of the investors, jensen and meckling (1976) concludes that an optimal capital structure is one that reduces the agency costs and by reducing the agency cost relating to managers and shareholders, debt can positively affect the firm’s worth. whereas, myers and majluf (1984) claim a negative relationship between capital structure and firm performance since more profitable firms opt to utilize internal financing over debt. the impact of corporation's capital structure on its financial achievement is still debated because some studies report positive relationship, for instance, ghosh and jain (2000); hadlock and james (2002) while others document a negative association of debt with financial performance such as (fama and french, 1998; simerly and li, 2000). the conflicting findings in the influence of debt ratio on firm’s profitability motivate the researcher to carry out the study about the link between capital structure and firm’s financial achievement focusing on the banks operating in bangladesh. the commercial banks listed in the dhaka stock exchange (dse) have been chosen as a sample in this study for the following reasons. first, the financial market of bangladesh is predominantly based on banks. the capital market of bangladesh is undeveloped and less efficient so the economy remains reliant on bank financing to finance the large infrastructural development projects. the nature of large volatility with recurrent periods of boom and bust of stock markets in bangladesh leads banks to play dominant roles in providing credit to non financial sectors, facilitating the central bank in executing the monetary policy, and in providing stability to the economy as a whole. so for the stability of the economy and accelerating the economic growth rate, the survivals of the banks are indispensable. the survival depends on the bank’s performance and the performance of banks may be affected by the proper mixture of debt and equity as the inaccurate mixture of debt and equity can badly affect the performance and the value of the banks. the second reason for selecting the banking industry lies in the fact that the intense regulations, complex nature, asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 163 and level of risk differentiate the capital structure of financial institutions such as banks from that of non-financial firms. thirdly, as per the corporate governance guidelines of the bangladesh securities and exchange commission (bsec), the separation of ownership and control of management is essential for the firms. this separation of ownership and control may result in mangers to accomplish their personal gains at the cost of the shareholders’ interest or otherwise failing to maximize firm value. the choice of the capital structure may be one of the instruments that can help to reduce the agency cost of equity and increases firm value by constraining or encouraging managers to act more in favor of the shareholders. the objective of this article is to examine the influence of capital structure on the performance of banks listed in the dhaka stock exchange (dse) over a period of five years from 2014 to 2018. the variables are selected based on the financial theories, previous empirical studies and the availability of data, including long-term debts on assets (ltd), total debts on assets (td), growth opportunity of the banks, firm size, economic growth rate, and inflation as independent variables, while return on assets (roa), return on equity (roe), earnings per share (eps) and price-earnings (p/e) ratio have been chosen as performance indicators. this study uses both the accounting and market-based measurements of firm performance. accounting based measurements focus on the past financial performance of the firms, while market-based performance measurement focuses on the market expectation about the future growth of the firms (demsetz and villalonga, 2001). this work is expected to make a number of contributions to the existing literature. first, it adds to the scarce empirical evidence on the topic of capital structure in bangladesh’s perspective. the majority of the prior studies on the effect of capital structure have been conducted in the context of developed economies and markets; there still exists a dearth of researches on this issue in the context of an emerging market like bangladesh. a limited amount of study relating to this issue has been carried out using the data of bangladeshi firms and in most cases; the researchers used the data of non-financial companies. a very few existing studies has been used the data of banks listed in the dhaka stock exchange (dse). thus, the author considers it appropriate to examine how the capital structure of banks affects their performance. this is the first study where all banks listed in dse are considered in the sample to investigate the effect of capital structure on the performance of banks, therefore expected to provide an overall scenario of the listed banking industry. second, this analysis makes use of panel data methodology, which is more powerful in controlling for unobservable heterogeneity, a factor that is overlooked by the majority of prior studies. finally, the use of the setting of the banking industry of a developing country like bangladesh will facilitate the comparison with the context of other emerging economies. the remainder of the paper is structured as follows. section 2 discusses some empirical evidence regarding capital structure related literature and develops the various hypotheses for testing. data, research methodology and econometric model are presented in section 3. section 4 provides empirical results. finally, section 5 will indicate the conclusions that can be derived from the empirical findings. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 164 2. literature review capital structure is considered as one of the powerful tools that could influence the firm’s performance. but there involves the risk of bankruptcy to use the excess amount of debt in the firm’s capital structure. if the bankruptcy cost exceeds the benefits of using debt in the form of tax deduction then firms may experience a lower amount of return. recognizing the importance of capital structure, numerous studies concentrated on the impact of capital structure choices on firm's profitability as a measure of financial performance. most of the empirical shreds of evidence suggest more or less influence on the firm’s performance. however, the sign of the relationship is still inconclusive. getahun (2016), using panel data of nine ethiopian insurance companies over the period of 10 years, claims that the leverage has a negative impact on the performance which is measured by roa. similar results are reported by ebaid (2009) who measures leverage in terms of std and td for the non-financial egyptian listed companies for the period of 19997-2005, rouf (2015) for the 106 manufacturing companies listed in dhaka stock exchange (dse) from 2008 to 2011, nenu et al. (2018) for romanian companies listed on the bucharest stock exchange, das and swain (2018) for the manufacturing companies in india, zeitun and tian (2007) for the jordanian companies during 1989-2003. mursalim et al. (2017) investigated the leverage behavior of 94 indonesian firms, 153 malaysian firms, and 74 thailand firms for the period of 2008-2012 and their result reflects the capital structure of firms is negatively related to the sampled firm performance measured by economic value added (eva), this finding is consistent with nakhaei and jafari (2015) for the companies listed on tse. similarly, manawaduge et al. (2011) employ three leverage indicators such as total debt to total asset, total debt to equity ratio and short term total debt to total asset ratios to detect the impact of capital structure on the srilankan’s firm performance represented by roa and tobin’s q. utilizing panel data fixed estimation regression model authors observe a negative association between these variables. in another study, mwangi et al. (2014) apply feasible generalised least square (fgls) regression to analyze the data of nairobian non-financial firms and document a significant negative effect of financial leverage on roa and roe which is also affirmed by siddik et al. (2017) by using panel data of 22 bangladeshi banks for the period of 2005-2014. cole et al. (2015) use long-term liabilities to total assets ratio to detect the impact of debt on the performance of 30 u.s. firms in the industrial, healthcare, and energy sectors over 10 years of 2004 to 2013. utilizing regression analysis the authors conclude that capital structure has a negative impact on return on assets and operating return in all three sectors whereas, the relationship between the capital structure and profit margin is not the same for all the sectors used in their study. they also claim no relationship between capital structures and stock prices in all three sectors. recently, the paper of khodavandloo et al. (2017) focuses on the trading and services sector of the bursa malaysia points out a strong negative impact of capital structure on firms’ performance. their study also reveals that the degree of association is stronger during the global financial crisis began in 2007 and ended in 2009 than pre and postfinancial crisis. in contrast with the above findings, some empirical findings demonstrate the positive association between capital structure and firm performance. musah and gakpetor (2017) asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 165 examine the relationship between capital structure and the profitability of nbfis in ghana taking a sample of 42 non-bank financial institutions over a period of 7 years from 2008-2014. their results conclude that debt ratio which is a proxy of capital structure (dr) is positively associated with roa of nbfis in ghana, which is partly relevant to the study of saputra et al. (2015) who focus on the effect of capital structure on firm performance of the financial sector in the indonesia stock exchange from 2009 to 2013 and using panel data analysis they come up with the findings that capital structure has a positive effect on banking and insurance sectors. likewise, goyal (2013) attempts to find the impact of capital structure on profitability of public sector banks in india listed on the national stock exchange from 2008 to 2012. utilizing regression analysis he confirms a positive effect of short term debt on public sector bank’s profitability as measured by roe, roa, which is related with the findings of amin and jamil (2015), aramvalarthan et al. (2018). a part of such results is in line with abor (2005) who reveals that short term debt to total assets and total debt to total assets have a positive impact on roe for the firms of ghana stock exchange. the author also claims a negative association between long term debt to total assets and roe. however, the impact of capital structure components on each profitable measurement is not often identical. mehar (2018) reports that long term debt ratio is negatively related to roa and eps, while short term and total debt ratios have a positive link with roa and eps by investigating 25 public and private banks listed on pakistan stock exchange for the period of five years from 2011 to 2017 which is partly consistent with the findings of vuong et al. (2017) who examine the effect of capital structure on the financial performance of the uk firms by using data of 739 very large and large companies listed on london stock exchange over the period of 10 years and their results depict long term liabilities has a negative relation with the firms financial performance measured by roa and roe but both short and long term liabilities affect tobins’ q positively. their study also reveals leverage has no impact on eps. these results are opposing to githire and muturi (2015) who report equity and long term debt have a positive effect on financial performance, while short term debt has a negative effect on the financial performance of nairobi firms by utilizing multiple regression analysis on the data of the firms listed on the nairobi securities exchange from the year 2008-2013. the paper of salim and yadav (2012) focuses on the sample of 237 malaysian listed companies on the bursa malaysia stock exchange during 19952011 reports that short term debt (std), long term debt (ltd), total debt (td) have a negative influence on the accounting-based measurement such as return on asset (roa), return on equity( roe) and earning per share (eps) whereas short term debt (std) and long term debt (ltd) have a positive effect on the market based-measurement such as tobin’s q. likewise, a positive association has been re-counted between the growth and performance of all sectors. regarding the effect of the financial crisis, olaniyi et al. (2015) reveal the debt-equity ratio has a negative relation with roe before and after the global crisis but positive relation has been found with roa in the post-crisis period. however, other variables that have been employed in this study have been found an insignificant relation with roa. in addition to this, al-taani (2013) come up with the conclusion that capital structure is not a major determinant of firm performance by testing the relationship between capital structure and performance of 45 manufacturing companies listed on the amman stock exchange over a period of five (5) years from 2005-2009. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 166 to sum up, it is clear from the above published empirical evidence that the effect of capital structure on firm’s performance is inconclusive. the ambiguous results can be explained in a number of ways. first, the studies are conducted in different countries and different time periods are used in the studies by the researchers. the second reason may be due to the different analytical models are employed by the various researchers. thirdly, the corporate internal policies regarding the financing and legal system of the countries differentiate the capital structure of firms in different countries. in addition to this, there may be some unobserved factors that can influence the firm’s performance. the previous empirical findings regarding the influence of leverage on firms financial performance is not beyond questionable. thus it creates an avenue for the academicians, researchers, and regulators to analyze the impact of capital structure on the performance of banks operating in bangladesh. moreover, there are a few studies analyzing the impact of capital structure on the financial performance of all banks listed on the dhaka stock exchange. an effort has been made by siddik et al. (2017) to examine the impact of capital structure on the performance of banks in bangladesh but their sample size was not large to go for a comprehensive analysis. therefore, an endeavor has been taken to fill the void of the literature with a systematic analysis using the data of all the banks listed in dse and this analysis expects to provide the comprehensive scenario of capital structure practices by the banks operating in bangladesh. 3. methodology 3.1 data to examine the impact of capital structure on the financial performance of banks listed in dhaka stock exchange ltd., this study uses 5-year period data from 2014 to 2018 whereby the firm-level data are sourced from the audited financial statements of the companies and the macroeconomic variables data are from the world bank database. there are 30 banks listed on dhaka stock exchange ltd. as of 30 june 2019. the study uses balanced panel in this analysis. 3.2 measurement of the variables 3.2.1 dependent variables the dependent variables of this study are the financial performance of banks. both the accounting and market based performance measurements have been employed in this study to explore whether the independent variables explained the performance measures (accounting and market) at the same level or not. accounting based performance measurements reflect the banks past performance and market based performance measurements indicate the expectations of the investor’s future earnings of the banks. to measure the financial performance of bank four proxy variables have been employed in this study as a dependent variable such as return on assets (roa), return on equity (roe), earning per share (eps) and price earnings (p/e) ratio. roa, roe and eps are accounting-based measurements calculated from firms' financial statements, while p/e ratio is used to measure the market performance of the banks. roa and roe have been used by different empirical studies as a measure of financial performance (such as amin and jamil, 2015; akintoye, 2008; salim and yadav, 2012; akintoye, 2008, vuong et asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 167 al., 2017), eps by (salim and yadav, 2012; mehar, 2018; vuong et al., 2017) and p/e ratio has been used by zeitun and tian (2007). their measurements are shown in table-1. table 1. name and definition of dependent variables 3.2.2 independent variables this study uses six independent variables comprising of four firm-specific factors such as long term debt ratio, total debt ratio, firm size, growth opportunities and two macroeconomic variables namely economic growth rate and inflation. firm-specific factors such as firm size, growth opportunities and macroeconomic variables are used as controlled variables in this paper as it is expected that they may have an influence on the performance of banks. the size of a bank determines the level of economies of scale enjoyed by a bank. the bank size may influence its profitability as large banks have a greater capacity for dealing with adverse market fluctuations than the smaller ones (ramaswamy, 2001; frank and goyal, 2003). thus this study controls the variances in the firm's operating environment by introducing the size variable in the model. it is expected that highly growing banks have a chance to contribute positively to the performance ratio, as highly growing banks can generate higher profit from the investment. economic growth rate and inflation rate have been employed in this research to measure the effect of the macroeconomic environment on the performance of the banks operating in bangladesh. in the boom period, people will have idle money and they will purchase various products and savings schemes offered by the banks as well as the firms will undertake large profitable projects and vice-versa. this study uses log of gdp to measure the economic growth rate and it is expected that there is a positive association between the economic growth rate and bank’s performance. on the other hand, during the inflationary period, the deposit holders will withdraw their money from the banks to meet up their daily expenses and when the inflation rises the people will have a fewer amount of savings. moreover, banks have to offer highinterest rate on the deposits to collect money from the market and they will charge a higher interest rate on their credit. the cost of capital is higher during the inflationary period; as a result, the demand for the loan will be lower. by considering the above-mentioned consequences inflation rate has been applied in this research to see the impact on the performance ratios of banks. the number of independent variables and their measurements are summarized in the following table. sl. no. name of the variables variables indicator measurement (proxy) 1 return on assets roa net income (before tax) /total asset 2 return on equity roe net income (before tax) /total equity 3 earning per share eps net income / no. of shares outstanding 4 price-earnings ratio p/e ratio market price per share / earning per share asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 168 table 2. name of independent variables and their definition sl. no. name of the variables variables indicator measurement (proxy) 1 long-term debt to total asset ltd total long term debt / total assets 2 total debt to total asset td total debt / total assets 3 growth opportunity gr (assets of year1assets of year0) / assets of year0 4 firm’s size size natural logarithm of total assets 5 economic growth rate egr natural logarithm of gdp 6 inflation rate inf the annual inflation rate 3.3 model specification on the basis of the variables as mentioned earlier, we have designed the following multiple regression models to test the relationship between the firm’s capital structure and its financial performance. roa it = α0 +β1ltdit+β2tdit+β3szit+β4grit+β5egrit+β6infit+ εit (1) roe it = α0 + β1ltdit+β2tdit +β3szit+β4grit+β5egrit+β6infit+ εit (2) eps it = α0 + β1ltdit+β2tdit +β3szit+β4grit+β5egrit+β6infit+ εit (3) p/e ratio it = α0 + β1ltdit+β2tdit +β3szit+β4grit+β5egrit+β6infit+ εit (4) where, α0 represents constant. β1 and β2 indicate the regression coefficient for the leverage variables, namely ltd and td respectively; β3 and β4 represent the regression coefficient for the firm-specific variables, namely sz and gr respectively and β5 and β6 represent the regression coefficient for the macro-variables, namely egr and inf respectively. ε represents the error term, i refers to the individual banks and t refers to the time period. in this research endeavor, the panel data approach has been employed to determine the effect of capital structure on the bank’s financial performance. various tests were carried out to check if the panel data fulfilled the cardinal requirements of classical linear regression analysis include unit root test, multicollinearity test, heteroscedasticity test and autocorrelation test. these tests suggest heteroscedasticity and autocorrelation are present in the data. to overcome these problems, prais-winsten panels corrected standard error (pcse) estimate has been applied in this study to investigate the association of capital structure and bank performance as it automatically corrects the problems of first-order autocorrelation and heteroscedasticity and offers the best estimates for the variables. pcse has become the popular methods and widely used by the researchers as it preserves the weighting of observations for autocorrelation, but uses a sandwich estimator to incorporate cross-sectional dependence when calculating standard errors. feasible generalized least squares (fgls) is an alternative method to pcse that can solve the above mentioned problems but it is not the best choice in this case since the present study has a "large n and small t" panel dataset. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 169 4. empirical findings 4.1 descriptive statistics this analysis examined the effect of capital structure on the financial performance of banking companies using a balanced panel of 30 banks over the period of five years from 2014-2018. table 3 depicts the summary of descriptive statistics of the capital structure and banks financial performance measures along with the control variables. table 3. descriptive statistics among the accounting based performance measures roa has the lowest average mean (.841) and roe has the highest mean value (11.046) percent which means that sampled banks earned a return of .841 percent of total assets and 11.046 percent of total equity respectively. the standard deviation, which reflects the variability involved in, is .783 for roa and 5.037 for roe respectively. the market performance measurement of p/e ratio has the mean value of (15.63), the highest one among the performance measurement used in this study, which indicates that investors are willing to pay a high share price today as they are expecting higher growth opportunities in the banking companies of bangladesh, with the highest value of 566.02 and lowest value of -20.73 in conjunction with variability, measured by standard deviation, of 60.649. for the independent variables used in this study, the average td ratio is 8.268, and the ltd ratio is 3.244 with a standard deviation of 32.035 and 15.099 for td and ltd respectively which suggest that the sampled banks in this study use short term debt more than the long term debt. for other variables applied in this analysis, such as size, egr and inf have a low level of standard deviation whereas gr (assets) reports a substantial amount of variation from the mean value (22.982). 4.2 correlation pairwise correlation analysis was conducted to test the association between capital structure and the performance of banks listed in the dhaka stock exchange. the test results are presented in table 4. variable obs. mean std. dev. min max roa 150 .841 .783 -4.25 2.36 roe 150 11.046 5.037 -4.44 22.16 eps 150 2.733 2.516 -4.56 21 pe ratio 150 15.63 60.649 -20.73 566.02 td 150 8.268 32.035 .091 290.005 ltd 150 3.244 15.199 .001 88.831 size 150 5.175 .608 3.068 6.53 gr assets 150 2.198 22.982 -1 280.618 egr 150 6.972 .621 6.06 7.86 inf 150 5.986 .56 5.51 6.99 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 170 table 4. matrix of correlations variables roa roe eps pe ratio td ltd size gr assets egr inf roa 1.000 roe 0.778 1.000 eps 0.389 0.561 1.000 pe ratio -0.091 -0.244 -0.116 1.000 td 0.008 -0.049 -0.033 -0.022 1.000 ltd 0.057 0.060 -0.006 -0.033 0.503 1.000 size 0.262 0.210 0.146 0.085 -0.725 -0.613 1.000 gr assets -0.010 0.031 0.004 -0.017 0.207 0.459 -0.261 1.000 egr -0.172 -0.064 0.009 0.123 0.047 0.007 0.127 0.120 1.000 inf 0.135 0.044 0.011 -0.085 -0.042 -0.002 -0.106 -0.065 -0.899 1.000 as can be observed from table 4, total debt has a negative association with almost all the bank’s performance measurement variables, except for roa. however, the coefficients are not high between total debt and all other bank performance variables, around more or less than zero. long term debt has a positive relation between roa and roe but negative with eps and pe ratio. in general, the analysis does not reveal a high correlation between any of the dependent and independent variables. thus, it can be concluded that the multicollinearity problem does not exist in this analysis, which usually requires correlations between the independent variables of the order of 0.80 or more. 4.3 regression results to examine the relationship between the capital structure and bank performance multiple regression analysis were conducted in this study. the results of the tests of models 1 to 4 are shown in table 5 below. table-5. regression results model1 model2 model3 model4 iv roa roe eps pe ratio ltd 0.016*** 0.091*** 0.011 -0.054 (0.005) (0.017) (0.012) (0.090) td 0.005 0.007 -0.004 0.078** (0.004) (0.025) (0.005) (0.037) size 0.784*** 3.362*** 0.430 5.298 (0.223) (1.092) (0.466) (6.820) gr assets 0.000 0.005 0.001 -0.037 (0.001) (0.003) (0.001) (0.033) egr -0.465*** -1.616* 0.415 17.898 (0.117) (0.825) (0.314) (15.987) inf -0.199* -0.880 0.414 15.636 (0.113) (0.819) (0.291) (15.081) asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 171 the results derived from the regression analysis reveal that the capital structure component of long term debt seems slightly have a positive effect on the performance of the banks measured by roa and roe, while there is no impact on the eps and price earning ratio. the result is consistent with (coleman, 2007; githire and muturi, 2015 and berger and bonaccora di patti, 2006) who indicate that the firm’s performance is positively associated with capital structure. this result could be explained by the fact that the higher amount of long term debt components presents in the bank’s financial statement indicates the acquisition of a large amount of funds by the bank in the form of either debt or fixed deposits. the banks can then convert this fund into the long term loan and give funds to the borrowers at a higher rate of interest which could enhance the profitability of the banks operating in bangladesh. besides this, the bank can use the debt to resolve the liquidity crisis and can use this money to pay back the depositors money on the demands of the depositors which enhance the confidence of the bank’s customers that ultimately have an impact on the performance of the banks. also, banks with higher long term debt can enjoy the tax benefits and can go for undertaking long term profitable investments that can influence the performance of the banks. coleman (2007) explains that long-term debts exert less pressure on the management for repayment and giving management enough time to organize their operations towards the enhancement of profitability. however, this finding is in contrast with (zeitun and tian, 2007; siddik et al., 2017; amin and jamil, 2015; getahun, 2016; cole et al., 2015; mehar, 2018) who posit that long term debt has significant negative explanatory power in influencing firm’s performance measured by roa. again, the result of a positive association of long term debt with roe is not in line with (abor 2005; voung et al., 2017) who reveal a negative association between long term debt ratio and roe. the result also depicts that total debt has a positive influence on roa and roe and negative influence on eps but the relationship of total debt with all accounting-based performance measurements is not found statistically significant, which is pertinent with musah and gakpetor, 2017; saputra, et al., 2015; mehar, 2018). this finding is not in line with ebaid (2009) who reports an increase in total debt is associated with a decrease in roa. he also suggests that it may happen due to the firm’s policy of using a considerable amount of short term debt in its capital structure choices. on the other hand, there is a significant and positive association of total debt with the market-based performance measure of price earning ratio. furthermore, the results also show that neither total debt nor long term debt has any significant relationship with the bank’s performance measured by eps. this finding is relevant to vuong et al. (2017) who documents that leverage has no effect on eps. again the firm-specific and macroeconomic variables also have no significant influence on the accounting-based performance measurement of eps. the size of the banks also brings benefits for the banks by showing a positive relationship between the size and roa and roe which is supported by the findings of voung et al. (2017). however, size does not have any impact on the eps and pe ratio of the banks. besides that, relating to cons. 1.131 9.852 -4.861 -232.100 (1.574) (10.972) (3.778) (182.623) obs. 150 150 150 150 r-squared 0.279 0.227 0.080 0.005 standard errors are in parenthesis *** p<0.01, ** p<0.05, * p<0.1 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 172 the coefficient of growth variable, the changes in total assets has an insignificant impact on the financial performance of bangladeshis banks. so, in general, it can be concluded that the bank’s growth and profitability are independent. among the macroeconomic variables, the economic growth rate has a positive association with eps and pe ratio but none of them is statistically significant. however, the financial performance measured by roa and roe is being negatively influenced by the economic growth rate. finally, this paper finds that inflation is not significantly associated with the performance of measures used in this study except roa which shows a negative effect of inflation on roa. 5. summary and conclusion bangladesh is one of the fastest-growing economies in the world. it has been denominated as the new asian tiger and considered one of the next eleven economies n-11. as a bank dominant financial system, banks can play a pivotal role to achieve the two ambitious goals of 2021 and 2041 fixed by the bangladesh government in which bangladesh wishes to become an upper middle income and a developed country respectively. this study has empirically observed the impact of capital structure choices on the performance of listed banks in bangladesh as one of the emerging economies. three accounting-based measurement of firm performance such as roa, roe, and eps and one market-based measurement of firm performance (p/e ratio) have been employed in this study. empirical findings indicate that long term debt has a positive effect on the performance of banks which is measured in terms of roa and roe. this implies that long term debts are associated with the higher performance of banks listed in bangladesh. one of the reasons might be the banks with long term debt can undertake long term profitable projects which can magnify the profitability. on the other hand, the regression results point to the fact that the capital structure component of total debt has no statistically significant impact on the performance of banks measured by roa, roe, and eps but it has a significant positive impact on the performance of banks measured by price earning ratio. however, this paper further suggests no nexus of earning per share (eps) with any of the capital structure components used in this study. these findings suggest concluding that capital structure has a weak to no influence on the performance of banks in bangladesh. these findings have significant implications for bank management and policymaker to develop their optimal capital structure policy and it will facilitate to comparison the scenario of the listed banking industry in bangladesh with the context to the other emerging economies. the findings of this study would have been more plausible if we could apply a large panel data for this analysis but accessibility and availability of data was a major challenging job. recognizing the limitations it can be said that this study could serve as a framework for further studies in this field and it opens up the avenue for the banks management to rethink the use of optimal capital structure policy to enhance the profitability of the banks. it would be quite interesting for further research to look into the impact of capital structure on bank’s performance incorporating short term debt, total debt to equity as explanatory variables and tobins’ q as an explained variable. likewise, further study can be directed to investigate the combined influence of both ownership structure and capital structure on the bank’s performance since a large number of shares of bangladeshi banks are held by family firms. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 173 references abor, j. 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(2007). capital structure and corporate performance: evidence from jordan. australasian accounting business and finance journal, 1(4), 40-61. https://doi.org/10.14453/aabfj.v1i4.3 microsoft word 14168-51531-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 141 application of credit risk management model in chinese banks chen haojie (corresponding author) school of economics & management, xiamen university malaysia campus jalan sunsuria, bandar sunsuria, 43900 selangor d.e., malaysia tel: 60-1-0899-1663 e-mail: chj6869@icloud.com ng sin huei school of economics & management, xiamen university malaysia campus jalan sunsuria, bandar sunsuria, 43900 selangor d.e., malaysia tel: 60-3-8705-5037 e-mail: shng@xmu.edu.my lew shian loong school of economics & management, xiamen university malaysia campus jalan sunsuria, bandar sunsuria, 43900 selangor d.e., malaysia tel: 60-3-8705-5126 e-mail: shianloong.lew@xmu.edu.my received: nov. 29, 2018 accepted: jan. 24, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14168 url: https://doi.org/10.5296/ajfa.v11i1.14168 abstract the main objective of this paper is to perform empirical analysis and research on the kmv and zeta models, discussing whether banks in china could adopt both models in their credit risk management practices. in order to measure credit risk, the kmv model focuses on “expected default probability” (edp) that is calculated using black-scholes option pricing formula. on the other hand, the zeta model focuses on determining the probability of a company going bankrupt two years prior to the event. previous research on risk management has shown that the primary risk the banks generally face is credit risk as an increasingly greater number of banks suffer losses because of credit issues. this paper therefore aims to add to the existing literature a strong case for the relevance of both the kmv and zeta models to be considered in the topic of banks’ credit risk management. keywords: kmv model, zeta model, expected default probability (edp), credit risk assessment asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 142 1. introduction 1.1 background since the 1990s the global economic, political and technological landscapes have experienced a wide range of dramatic transformations, which have subsequently fueled an exponential growth in credit risk. and with the inception of a floating exchange rate regime, financial markets throughout the world have since witnessed an ongoing process of deregulation. while greater financial liquidity worldwide is creating opportunities for new capital sources to thrive, the increasing complexity of credit risk is posing a host of challenges. in china, due to the current financial system in place, credit risk has inevitably become the main factor of financial risk—which is also influenced by:  indirect financing that dominates the financial structure,  precarious relationship between banks and enterprises,  vague business distinction between bank policy and commerce,  inadequate financial management,  weak sense of risk,  lack of effective internal mechanisms and risk prevention measures, and  information asymmetry between borrowers and lenders, which could potentially lead to moral hazard. on the evidence of the above, the financial risk situation in china reflects the more obvious characteristics of the traditional form of financial risk—as opposed to what is usually seen in other developed countries. the credit risk faced by the commercial banks in china is largely affected by bad credit assets, tendency towards concentration of credit risk and insufficient credit risk management. so, measuring credit risk has become imperative to banks. the credit risk exposure featured in the new basel accord mainly involves five essential aspects, namely corporate risk, bank risk, retail risk, sovereign risk and equity risk— fully affirming the important role of irb in risk management and capital regulation. the new basel accord proposes an irb method for calculating credit risk, where the data analysis time period required for parameter estimation is long, and the source and content requirements are very high. using the pd (probability of default ), lgd (loss given default, which is amount of money a bank or other financial institution losses when a borrower defaults on a loan ), ead (exposure at default, which is the total value a bank is exposed to when a loan defaults ) and m (maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be reviewed.), we could ascertain the risk weight of different asset situations and then determine the risk assets. as the credit risk management model gradually develops from being qualitative to being quantitative, both the kmv model and the zeta model will be used to discuss the feasibility of applying a credit risk management model in china. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 143 2. literature review 2.1 literature review there are a number of research papers that revolve around credit risk management models, but for the purposes of our study, we shall focus our attention on those that discuss the kmv model and the zeta model. generally, the most common credit default model is the kmv model whereas the most accurate bankrupt probability model is the zeta model. some scholars in china have researched the adaptability of kmv model in china. zhang lin and zhang jialin (2000) as well as wang qiong and chen jinxian (2002) presented a theoretical comparison between the kmv model and the other models—pointing out that the kmv model might be more appropriate for the credit risk assessment of a public company. xue feng, lu wei, zhao heng jie and liu jiyun (2003) used the data of china's stock market to determine the relationship function between the 𝜎 and 𝜎 in the actual equity market as they performed an empirical analysis based on a particular stock. qiao zhuo et al (2003) discussed the basic characteristics of the kmv model without any empirical evidence. on the other hand, yi danhui and wu jianmin (2004) calculated and compared the distance to default and default probability. with 30 companies in china randomly selected from the shenzhen and shanghai stock markets, the researchers verified the feasibility of measuring the listed company’s credit risk by using distance to default. according to peter crosbie (2003) the credit risk model can be summarized as follows. credit risk can be divided into two components: single risk and portfolio risk. while single risk consists of pd, lgd and migration risk (migration risk is a change in value caused by a deviation of the actual probability of a future default by an obligor from the expected probability of future default, adversely affecting the present value of the contract with the obligor today), portfolio risk comprises risk exposure and default correlations. in order to determine a company’s credit risk default probability, we must calculate the company’s value of assets, asset risk and leverage. as for the three-step method to calculate the expected default frequency of the kmv model, we must first estimate the market value of the company’s assets and then calculate the volatility of those assets. and after we calculate the distance to default based on the volatility of the company’s assets, we must eventually convert the distance to default to the expected default frequency using empirical distribution. as pointed out by peter crosbie (2003) the measurement of edf is an effective tool in managing the credit process of institutions and continuous monitoring is the only way for detecting deterioration in credit quality. because the edf value is a real probability, it is widely used by institutions to measure credit risk. michel crouhy, dan galai and robert mark (2000) performed a comprehensive analysis on the current credit risk models—comparing the creditmetrics, kmv, creditrisk+ and creditprotfolioview models. creditmetrics is a credit migration approach proposed by jp morgan that accounts for the change of the company’s credit quality within a time period. meanwhile, the option pricing method or structural approach is initiated by kmv based on the asset value model originally proposed by merton. kmv is then used to further develop the option pricing theory. as the endogenous default process in the model is compatible with the capital structure of the company, the company will suffer default when the asset value of the company is below a certain level. on the other hand, creditrisk+ is an actuarial approach asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 144 proposed by credit suisse financial products (csfp) to calculate default probability. focusing on default probability using joint conditional distribution, this approach assumes that individual bonds and loans follow an exogenous poisson process. as for the last model, credit portfolio view—proposed by mckinsey—is a time model using discrete time periods. unlike the other models, credi tportfolio view uses macroscopic variables—such as unemployment rate, government expenditure and gdp growth—that play a vital role in the credit cycle of the economy. according to michel crouhy, dan galai and robert mark (2000) both the credit portfolio view and kmv methods are based on the same empirical observation, with their default risk and migration probability changing over time. while the kmv method adopts microeconomic factors by using the market value of assets to measure the pd of the debtor, the credit portfolio view method links the pd to the probability of mitigation by using macroeconomic factors. but we still need to calibrate default data for every country and corresponding industries. and the ad-hoc procedure in adjusting the mitigation matrix is another obvious limitation. being more practical than the simple bayesian model though, the proposed models should perform better because the revision of transition probability depends on the accumulation of internal professional knowledge of the bank's credit department and the internal credit quality assessment of a bank's given credit portfolio. the kmv method is related to the credit portfolio view method since the company's market value is mostly dependent on the economic situation. therefore, the transition matrices produced by the kmv and credit portfolio view methods are comparable. edward i. altman and anthony saunders (1998) summarized the development of credit risk models in the last two decades. first, the researchers discussed the evolution of individual loans and portfolio of the loans credit risk measurement put forward by the journal of banking & finance and other well-known publications. subsequently, the researchers presented a new mortality risk framework that could be used to measure the risk and return of loans and bonds. offering us some hope for analyzing the risk-return structure of portfolio of debt instruments exposed to credit risk, the framework basically uses a variant z-score model—called 𝑍 − 𝑆𝑐𝑜𝑟𝑒 model—to determine unexpected losses (the unexpected loss is the average total loss over and above the mean loss. it is calculated as a standard deviation from the mean at a certain confidence level. it is also referred to as credit var.) and to assign a bond rating that is equivalent to the portfolio which each loan or bond may enter. as these scores and rating equivalents can consistently estimate expected losses, we should have a specific procedure for estimating unexpected losses if we have access to the standard deviation around the expected losses. edward i. altman and anthony saunders (1998) also discussed the portfolio risk. the unexpected loss measure of 𝑈𝐴𝐿 in the portfolio includes the correlation between the expected loss during the sample measurement period and the unexpected loss of personal assets. so, by comparing the bond rating equivalents, we can compute the expected value of the unexpected loss by using the standard deviation of the expected loss. it has also been highlighted that in order to gain the experience and confidence in applying this fixed income portfolio technology, we must spend more time in studying additional samples. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 145 stephen kealhofer and matthew kurbat (2002) discussed the use of merton's method to predict default based on debt ratings and accounting variables. adding moody's rating and accounting variables into merton's method can significantly improve the viability of default prediction. it is important to note that both the moody's ratings and the accounting variables contain default prediction information that is beyond the predictive information presented in merton's method. however, it is still possible to show all default predictive information of moody’s ratings and accounting variables in the kmv expected default frequencies. with less incorrect default identification that is observed in other models, the expected default frequencies of kmv are more uniform. it is also worth noting that merton's approach generally performs better than moody's credit rating or other accounting ratios in forecasting default conditions—due to the stronger connection that merton’s approach has with accounting variables. to predict future share price, merton's method uses historical share price information that includes information ratios such as return on asset and returns on equity. it has also been pointed out that the merton’s approach is unfair, due to the various judgements made about non-defaulting companies. every method faces the possibility of generating too many false rejections, but this is hardly surprising since ratings and accounting ratios cannot be fully projected in the share price. there are just too many factors affecting the share price. 3. research methodology 3.1 kmv model overview the original intention of kmv corporation in creating the kmv model was to estimate the default probability of kmv company’s borrowers. the kmv model has two stages. the first stage of the kmv model is to test the precision of the model by comparing the predicted results with the actual results. it has been observed that in most cases the kmv model can truly reflect the size of credit risk, thanks to a high sensitivity to credit risk. the second stage of kmv model is to verify the validity of the model—a subject that many famous scholars have studied before. the pricing basis of the kmv model is modern option pricing theory, which has been a major innovation in the measurement of credit default. the kmv model has several advantages. besides fully utilizing the information available in the capital market, the kmv model can be used to quantitatively analyze the credit risk of listed companies. since the data used by the kmv model is derived from stock price information of listed companies rather than internal data that is generated within the company itself, the company's current credit situation can be accurately projected. in addition, the kmv model is based on a number of previous theories— such as corporate finance theory and option pricing theory—so there is a theoretical basis to support its viability. the kmv model is more suitable for credit quality evaluation of listed companies because listed companies are more transparent about their data whereas the data of non-listed companies is less accessible. when we apply the kmv model to non-listed companies, we need to adjust the parameters of the model. and because the expected default probability is the result of comparative analysis, the accuracy of the model may be somewhat compromised. most importantly, the kmv model assumes that the value of company assets conforms to the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 146 characteristics of lognormal distribution, but the value of company assets generally exhibits non-normal statistical characteristics in reality. in short, the kmv model offers certain practical significance in calculating the probability of default. 3.2 zeta model overview derived from quantitative and qualitative methods, the scoring model is a statistical method which uses a large amount of historical data to determine parameters and predict variables of default probability. lda (linear discriminant analysis: it is a generalization of fisher’s linear discriminant, a method used in statistics, pattern recognition and machine learning to find a linear combination of features that characterizes or separates two or more classes of objects or events. ) is one of the most commonly used statistical methods in developing scoring models. generally, due to the choice of exogenous variables, default composition and default definition, usage of the lda-based model is reduced. an lda produces a scoring function, which is a linear function of variables. these variables are chosen based on their estimated contribution to the likelihood of default, the large number of qualitative characteristics and the accounting ratios. each accounting ratio could have a big or small impact on the overall score, as determined by altman’s z-score. although there are many ways to calculate z-score, the most commonly used method is the least squares method. proposed by edward i. altman, an assistant professor of finance at new york university in 1968, z-score is a quantitative analysis method used to determine the condition of the balance sheet. the lower the z-score, the greater the probability for the company to face a financial problem in the future under normal circumstances. lda divides the companies into two groups: performing or solvent companies and defaulting or insolvent companies. one of the challenges of such classification is whether or not we can predict which companies will be solvent and which companies will be insolvent before default. although the approach is flawed as both solvent and insolvent companies may have similar scores, the z cut-off point is used to distinguish the two groups. altman’s z-score is also used to estimate the possibility of financial distress, which is denoted by a weighted average of five financial ratios. as sharp decline in the company's share price is mostly caused by balance sheet issues, financial statements have a strong influence on shareholders' judgement of the company. the importance of financial ratios is therefore selfevident. altman’ s initial research was based on financial data from manufacturing companies. focusing on 66 companies where half had applied for bankruptcy, altman calculated various financial indicators for those 66 companies, obtained their corresponding weights through discrete methods and selected the most important weights to build the relevant model. to validate the model, altman calculated the z-score for groups of bankrupt and non-bankrupt but sick companies, i.e. st companies. altman’s goal was to ascertain how well the model could distinguish between sick companies and those that had gone bankrupt. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 147 it was observed that altman's model predicted with a 72% accuracy a company’s bankruptcy two years in advance. in the next 31 years of testing though, it was discovered that the accuracy of the model in predicting bankruptcy one year in advance had eventually increased to 80%– 90%. using the z-score to rank a group of european companies in 2009, graham secker—a morgan stanley strategy analyst—found that companies with weaker balance sheets underperformed in most cases as those with a z score of less than 1 usually underperformed by more than 4%. if the company is not listed, the market value of the company cannot be obtained directly. the zeta model therefore has different forms for listed companies and non-listed companies. when the company is listed, the z-score is calculated as follows: 𝑍 = 1.2𝑋 + 1.4𝑋 + 3.3𝑋 + 0.6𝑋 + 1.0𝑋 where z: the overall index of the z-score model 𝑋 : working capital / total assets this suggests the company may experience shrinking liquidity when the company’s liquid assets double. 𝑋 : retained earnings / total assets this ratio measures profitability, which reflects the company's age and earning power. 𝑋 : earnings before interest and tax / total assets this ratio shows the efficiency of the company in generating earnings under the same asset size. 𝑋 : market value of equity / book value of total liabilities this ratio provides a quick test of how much the company’s assets can fall before the company becomes technically insolvent, i.e. when its liabilities exceed its assets. 𝑋 : sales / total assets this ratio represents asset turnover, which measures how effectively the company uses its assets to generates sales. a great deal of factual research has shown that investors must do some serious due diligence before considering whether to invest in a company with an altman z-score of close to or less than 3. companies can be classified according to their z-score as follows:  when the company’s z-score is more than 2.99, based on the financial figures only, the company is placed in the “safe” zone.  when the company's z-score ranges from 1.80 to 2.99, based on the financial figures only, the company is placed in the “grey” zone. the company may or may not go bankrupt in the next two years. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 148  when the company's z-score is less than 1.80, based on the financial figures only, the company is placed in the “distress” zone. there is a high probability that the company will face distress in the next two years. when the company is not listed, the z-score is calculated as follows: 𝑍 = 0.717𝑋 + 0.847𝑋 + 3.107𝑋 + 0.42𝑋 + 0.998𝑋 where z: the overall index of the z-score model for private manufacturing companies 𝑋 : working capital / total assets this suggests the company may experience shrinking liquidity when the company’s liquid assets double. 𝑋 : retained earnings / total assets this ratio measures profitability that reflects the company's age and earning power. 𝑋 : earnings before interest and tax / total assets this ratio shows the efficiency of the company in generating earnings under the same asset size. 𝑋 : book value of equity / total liabilities this formula uses the book value of equity, not the market value of equity. 𝑋 : sales / total assets this ratio represents asset turnover, which measures how effectively the company uses its assets to generates sales. non-listed companies can be classified according to their z-score as follows:  when the company’s z-score is more than 2.9, based on the financial figures only, the company is placed in the “safe” zone.  when the company's z-score ranges from 1.23 to 2.9, based on the financial figures only, the company is placed in the “grey” zone. the company may or may not go bankrupt in the next two years.  when the company's z-score is less than 1.23, based on the financial figures only, the company is placed in the “distress” zone. there is a high probability that the company will face distress in the next two years. asset turnover changes according to the industry the company is in. since the above formula is mainly used for companies in the manufacturing industry, we need to consider the following altman models that provide corresponding formulas for non-manufacturing companies. for non-manufacturing companies, the z-score is calculated as follows: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 149 𝑍 = 6.56𝑋 + 3.26𝑋 + 6.72𝑋 + 1.05𝑋 where z: the overall index of the z-score model for private manufacturing companies 𝑋 : working capital / total assets this suggests the company may experience shrinking liquidity when the company’s liquid assets double. 𝑋 : retained earnings / total assets this ratio measures profitability that reflects the company's age and earning power. 𝑋 : earnings before interest and tax / total assets this ratio shows the efficiency of the company in generating earnings under the same asset size. 𝑋 : book value of equity / total liabilities this formula uses the book value of equity, not the market value of equity. non-manufacturing companies can be classified according to their z-score as follows:  when the company’s z-score is more than 2.6, based on the financial figures only, the company is placed in the “safe” zone.  when the company's z-score ranges from 1.1 to 2.6, based on the financial figures only, the company is placed in the “grey” zone. the company may or may not go bankrupt in the next two years.  when the company's z-score is less than 1.1, based on the financial figures only, the company is placed in the “distress” zone. there is a high probability that the company will face distress in the next two years. 3.3 data acquisition since information on the bad credit records of listed companies is not disclosed publicly, we must use other means to ascertain the default probability of these companies. one way of computing the default probability is to calculate the stock yield using information on the stock price of the listed companies and then determine the default distance. 30 listed companies have been randomly selected from china’s shanghai and shenzhen stock markets. the financial data of these companies from 1 january 2017 to 31 december 2017 is shown in table 1. there are 10 listed companies with good performance, 10 listed companies with mediocre performance and 10 listed companies with poor performance. through the following analysis, the feasibility of the kmv and zeta models in reality can be ascertained. according to the empirical analysis of a large number of default events, it has been highlighted by the kmv model that: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 150  when the long-term debt value is less than 1.5 times the short-term debt value, the most frequent default critical point is located near the company's short-term debt value plus 0.5 times the long-term debt value, but  when the long-term debt value is more than 1.5 times the short-term debt value, the most frequent default critical point is located near the company's 0.7 times total of short-term debt value and long-term debt value. there are some basic assumptions in this paper.  the default distance formula that defines the company's market value is larger than its debt value in a year, assuming that the growth rate of the company's asset value is zero.  the stock price of a company is consistent with logarithmic normal distribution and the stock price volatility is derived from stock price logarithmically.  the annual volatility of equity is computed using the stock closing price of the 252 trading days in 2017.  the annual risk-free interest rate is fixed. the standard one-year maturity yield of china’s treasury bond in 2017 and 𝑟 = 2.7484% are used.  equity is a call option on the firm value with a strike price that is equal to the face value of debt. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 151 table 1. 30 listed companies from shanghai and shenzhen stock markets blue-chip companies (note 1) ordinary companies (note 2) code industry code industry 600519 wine & beverage 600000 banking 002302 metal & nonmetal 000905 transportation 300176 machinery & equipment & instrument 600549 metal & nonmetal 002307 construction business 603377 transportation 002081 decoration 600479 pharmaceuticals 600808 metal & nonmetal 002403 metal & nonmetal 000709 metal & nonmetal 600826 business brokerage & agency 601919 marine traffic 300220 electronics 601899 nonferrous metal mining 300104 information dissemination service 600340 real estate development 600363 electronics st companies (note 3) st companies code industry code industry 600860 machinery & equipment & instrument 600608 metal & nonmetal 002490 machinery & equipment & instrument 600403 coal mining 000526 real estate development 601005 metal & nonmetal 600696 real estate development 000932 metal & nonmetal 000595 machinery & equipment & instrument 000982 textile & clothing &fur note 1. blue-ship companies: they are the mature companies in the stock market that represent the stalwarts of industry-safe, stable, profitable, and long-lasting companies that represent relatively safe, low volatility investments. note 2. ordinary companies: the companies with mediocre performance. note 3. st companies: st stand for special treatment. under regulation of shenzhen stock exchange and shanghai stock exchange, in the event of financial issues or other abnormal conditions of listed companies that make investors unable to judge the future of the companies and may endanger the interest of investors, the stock exchange shall take special treatment on these stocks. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 152 4. calculation and results 4.1 the calculation and results equity value volatility (𝜎 ) in this paper, the volatility of equity value is derived from historical stock price data. assuming that the stock price of listed companies conforms with logarithmic normal distribution, the volatility of equity value is expressed as: 𝛿 = 𝑙𝑛 𝑆 𝑆 𝜎 = ∑ 𝛿 − ( ) ∑ where 𝑆 , 𝑆 : the stock closing price on day 𝑖 and 𝑖 − 1 𝑛: the trading day, where 252 days have been selected as the benchmark 𝛿 : the log return at time 𝑖 𝜎 : the annual volatility of equity value the results, including the volatility of equity value computed using microsoft excel, are shown in table 2. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 153 table 2. average return and annual equity volatility of selected companies blue-chip stock common stock code average return* annual equity volatility code average return* annual equity volatility 600519 0.3010% 0.2026 600000 -0.1063% 0.2302 002302 0.3453% 0.6604 000905 0.0059% 0.4636 300176 0.5908% 0.5288 600549 0.0639% 0.4549 002307 0.1180% 0.6060 603377 0.0006% 0.2424 002081 0.1805% 0.2988 600479 -0.0466% 0.2272 600808 0.1512% 0.3902 002403 -0.0738% 0.2005 000709 0.0650% 0.4288 600826 -0.3042% 0.3112 601919 0.1023% 0.3495 300220 -0.1605% 0.4474 601899 0.1284% 0.2531 300104 -0.3490% 0.7298 600340 0.1124% 0.3755 600363 -0.1158% 0.3480 st stock st stock code average return (note 1) annual equity volatility code average return* annual equity volatility 600860 -0.2184% 0.3106 600608 -0.2975% 0.3795 002490 -0.2840% 0.3850 600403 -0.0819% 0.1850 000526 -0.0336% 0.2347 601005 -0.0653% 0.1994 600696 -0.2577% 0.3426 000932 0.1206% 0.4118 000595 -0.2903% 0.4744 000982 -0.3955% 0.3613 note 1. average return: it means daily average return. dpt (default point is the level of the market value of a company’s assets, below which the firm would fail to make scheduled debt payments. the default point is firm specific and is a function of the firm’s liability structure.) according to the 2017 annual report of the selected listed companies, dpt can be derived from year-end short-term liabilities and long-term liabilities. existing companies use a variety of debt instruments (with different maturities, coupons and so forth) so there is no unique dpt. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 154 “purely empirical” rule of thumb (de servigny/ renault [2004] and kmv [2002]) where std is short term debt and ltd is long term debt: de𝑓𝑎𝑢𝑙𝑡 𝑃𝑜𝑖𝑛𝑡 = 𝑆𝑇𝐷 + 0.5𝐿𝑇𝐷 𝑖𝑓 𝐿𝑇𝐷/𝑆𝑇𝐷 < 1.5 𝑆𝑇𝐷 + 0.7 − 0.3𝑆𝑇𝐷 𝐿𝑇𝐷 ∗ 𝐿𝑇𝐷 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒 the results are shown in table 3. table 3. dpt of selected companies blue-chip stock code short-term debt (million) long-term debt (million) dpt (million) 600519 38,574.92 15.57 38,582.70 002302 9,489.41 2,023.70 10,501.26 300176 1,349.78 191.77 1,445.67 002307 10,844.23 5,439.59 13,564.02 002081 16,022.89 411.32 16,228.55 600808 28,093.36 10,324.06 33,255.39 000709 113,240.57 29,248.25 127,864.70 601919 43,491.99 45,987.43 66,485.71 601899 28,793.59 22,878.83 40,233.01 600340 228,063.69 76,768.47 266,447.92 common stock code short-term debt (million) long-term debt (million) dpt (million) 000905 2,974.20 1,578.95 3,763.68 600549 8,200.72 1,902.12 9,151.78 603377 709.74 256.82 838.15 600479 934.39 111.33 990.05 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 155 002403 1,530.95 562.85 1,812.38 600826 958.60 332.15 1,124.68 300220 99.56 1.31 100.21 300104 14,494.25 4,069.89 16,529.19 600363 1,682.18 66.09 1,715.23 st stock code short-term debt (million) long-term debt (million) dpt (million) 002490 3,531.93 759.54 3,911.70 000526 3,501.99 17.64 3,510.81 600696 501.90 16.58 510.19 000595 883.89 225.15 996.47 600608 121.21 4.75 123.59 600403 8,595.46 846.06 9,018.49 601005 4,810.95 3,397.55 6,509.72 000932 47,920.36 12,428.63 54,134.67 000982 8,469.57 1,773.63 9,356.39 asset value volatility (𝜎 ) the kmv model assumes that when the asset value of a company is less than the value of its liabilities, the company will default. we can get the market value and volatility of assets through the black-scholes-merton (bsm) options pricing method. the model also assumes that the company's capital structure contains only equity and short-term debt, which are recognized as cash or cash equivalents. long-term debt is considered permanent and can be converted into preferred stock. having made the above basic assumptions, we can use recursion based on the following formula to find out the asset value volatility: 𝐸 = 𝑉 ∗ 𝑁(𝑑 ) − 𝐷 ∗ 𝑒 ( ) ∗ 𝑁(𝑑 ) 𝑑 = 𝑙𝑛 ∗ ( ) 𝜎 ∗ √𝑇 − 𝑡 + 1 2 𝜎 ∗ √𝑇 − 𝑡 𝑑 = 𝑑 − 𝜎 ∗ √𝑇 − 𝑡 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 156 𝑁(𝑑) = 1 √2𝜋 𝑒 𝑑 the relationship between volatility of the underlying asset value (𝜎 ) and the volatility of the equity market value (𝜎 ) is as follows: 𝜎 = 𝑁(𝑑 ) ∗ 𝑉 𝐸 ∗ 𝜎 𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 = 1 − 𝑁(𝑑 ) = 𝑁(−𝑑 ) where v: market value of the asset d: face value of the company’s zero-coupon debt maturing at t (only liability) 𝜎 : the standard deviation of the assets value 𝜎 : the standard deviation of the equity value 𝑟: the risk-free interest rate 𝑁(𝑑): cumulative normal distribution function evaluated at d 𝑇 − 𝑡: the time interval (maturity) using microsoft excel, the equations are solved via the iterative method. the asset value volatility has been calculated and the results are shown in table 4. table 4. default probability of selected companies blue-chip stock code market value assets (million) asset volatility 𝑑 𝑑 default probability 600519 914,768.11 0.1941 16.5527 16.3586 1.888e-60 002302 32,617.70 0.4478 2.8161 2.3683 0.0089344 300176 15,402.80 0.4792 5.2347 4.7556 9.894e-07 002307 19,913.22 0.1932 2.2260 2.0328 0.0210386 002081 56,724.04 0.2133 6.1026 5.8893 1.939e-09 600808 65,059.21 0.1908 3.7574 3.5667 0.0001808 000709 169,277.27 0.1049 2.9891 2.8842 0.0019622 601919 135,649.89 0.1782 4.2445 4.0663 2.388e-05 601899 50,804.34 0.0527 4.9771 4.9244 4.231e-07 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 157 600340 359,203.70 0.0970 3.4128 3.3158 0.0004569 common stock code market value assets (million) asset volatility 𝑑 𝑑 default probability 600000 5,258,054.19 0.0162 6.2116 6.1955 2.906e-10 000905 9,360.42 0.2772 3.5249 3.2478 0.0005816 600549 37,121.61 0.3427 4.3370 3.9943 3.244e-05 603377 17,629.75 0.2309 13.4270 13.1961 4.618e-40 600479 5,879.61 0.1890 9.6679 9.4790 1.284e-21 002403 6,145.85 0.1414 8.9007 8.7593 9.824e-19 600826 6,664.54 0.2587 7.1146 6.8560 3.542e-12 300220 2,639.11 0.4305 7.8778 7.4473 4.762e-14 300104 77,687.31 0.5745 3.0287 2.4542 0.0070603 600363 7,285.30 0.2661 5.6716 5.4055 3.231e-08 st stock code market value assets (million) asset volatility 𝑑 𝑑 default probability 600860 3,725.82 0.2416 6.465176 6.223527 2.431e-10 002490 7,829.14 0.1926 3.841322 3.648702 0.0001318 000526 7,039.24 0.1176 6.206955 6.089336 5.669e-10 600696 2,505.90 0.2728 6.071256 5.798442 3.347e-09 000595 4,978.31 0.3794 4.50202 4.122615 1.873e-05 600608 2,728.17 0.3624 8.796849 8.434495 1.663e-17 600403 20,207.49 0.1025 8.194313 8.091863 2.938e-16 601005 25,684.72 0.1488 9.481618 9.332787 5.156e-21 000932 78,591.60 0.1281 3.187562 3.059412 0.0011089 000982 15,674.04 0.1456 3.80494 3.659331 0.0001264 recovery rate (𝜌 ), expected loss given default (lgd) according to merton´s model, at the default point of the face value of the debt, the distance to default can be calculated using the volatility of the company’s assets. when the computed "distance to default" is high, the company is less likely to default. since the asset value asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 158 volatility has already been computed, the aim here is to calculate the distance to default in order to determine the probability of default. the following formula is used: 𝐷𝑖𝑠𝑡𝑎𝑛𝑐𝑒𝐷𝑒𝑓𝑎𝑢𝑙𝑡(𝐷𝐷) = 𝑉 − 𝐷𝑃𝑇 𝜎 𝑉 where 𝑉 : the market value of the company’s assets 𝜎 : the standard deviation of the asset value the merton model for lgd assumes that the company’s value is lognormal distributed with a constant volatility and the company only has one liability, which is zero-coupon debt issue. the formula is as follows: 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝐺𝑖𝑣𝑒𝑛 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 (𝑅𝐺𝐷 ) = 𝑉 ∗ 𝑁(−𝑑 )/𝑁(−𝑑 ) recovery rate (𝜌 ) = 𝑅𝐺𝐷 /𝐷 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐿𝑜𝑠𝑠 𝐺𝑖𝑣𝑒𝑛 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 (𝐿𝐺𝐷 ) = 𝑒 ∗ 𝐷 − 𝑅𝐺𝐷 where 𝑉 : the market value of the company’s assets at time t 𝐷: the face value of the company’s zero-coupon debt maturing at t (only liability) 𝑟: the expected return on the value of the company, which uses risk-free interest rates using microsoft excel, the recovery rate, recovery given default and expected loss given default are computed. the results are shown in table 5. table 5. distance to default and expected loss given default of selected companies blue-chip stock code distance to default recovery given default (million) recovery rate expected loss given default (million) 600519 4.9358 37,099.84 96.1567% 37,536.74 002302 1.5141 8,872.21 84.4871% 10,216.57 300176 1.8911 1,286.08 88.9608% 1,406.48 002307 1.6501 12,311.94 90.7691% 13,196.30 002081 3.3470 15,263.45 94.0531% 15,788.60 600808 2.5626 30,891.31 92.8911% 32,353.85 000709 2.3322 120,700.76 94.3973% 124,398.32 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 159 601919 2.8609 62,211.96 93.5719% 64,683.30 601899 3.9503 38,756.33 96.3297% 39,142.30 600340 2.6633 252,787.43 94.8731% 259,224.59 common stock code distance to default recovery given default (million) recovery rate expected loss given default (million) 600000 4.3444 4,744,171.22 97.0474% 4,755,985.17 000905 2.1573 3,408.85 90.5725% 3,661.64 600549 2.1984 8,262.13 90.2789% 8,903.68 603377 4.1250 801.56 95.6342% 815.43 600479 4.4011 944.77 95.4266% 963.21 002403 4.9864 1,735.90 95.7804% 1,763.24 600826 3.2137 1,055.87 93.8818% 1,094.19 300220 2.2349 92.33 92.1360% 97.50 300104 1.3702 13,512.09 81.7468% 16,081.09 600363 2.8733 1,594.77 92.9770% 1,668.73 st stock code distance to default recovery given default (million) recovery rate expected loss given default (million) 600860 3.2200 775.52 93.8114% 804.27 002490 2.5977 3,635.02 92.9270% 3,805.65 000526 4.2617 3,353.92 95.5313% 3,415.63 600696 2.9192 475.15 93.1316% 496.36 000595 2.1081 894.55 89.7720% 969.45 600608 2.6347 115.41 93.3809% 120.24 600403 5.4046 8,667.37 96.1066% 8,774.00 601005 5.0161 6,235.95 95.7944% 6,333.24 000932 2.4283 50,845.72 93.9245% 52,667.10 000982 2.7681 8,791.66 93.9643% 9,102.74 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 160 4.2 zeta model empirical analysis the companies we choose are listed companies, so the z-score is calculated as follows: 𝑍 = 1.2𝑋 + 1.4𝑋 + 3.3𝑋 + 0.6𝑋 + 1.0𝑋 we use this formula to calculate the results, which are shown in table 6. table 6. zeta value of selected companies blue-chip companies code t1 t2 t3 t4 t5 zeta 600519 0.5473 0.6554 0.2893 32.4543 0.4536 22.4552 002302 0.3020 0.1224 0.0113 1.9210 0.8187 2.5422 300176 0.0740 0.2570 0.2456 9.0539 1.1087 7.8001 002307 0.0386 0.0222 0.0065 0.3899 0.5024 0.8350 002081 0.2895 0.3077 0.0829 2.4641 0.7450 3.2750 600808 -0.0557 0.1073 0.0783 0.7075 1.0144 1.7804 000709 -0.3208 0.0626 0.0163 0.2906 0.5731 0.5040 601919 -0.0304 -0.1180 0.0372 0.7730 0.6792 1.0641 601899 -0.0013 0.2409 0.0563 0.2046 1.0586 1.7027 600340 0.3204 0.0577 0.0343 0.3043 0.1587 0.9196 ordinary companies code t1 t2 t3 t4 t5 zeta 600000 -0.0092 0.0349 0.0115 0.0648 0.0275 0.1418 000905 -0.0666 0.2626 0.0289 1.2292 1.6965 2.8172 600549 0.0818 0.1282 0.0641 2.7685 0.7527 2.9028 603377 0.0848 0.1782 0.1043 17.3725 0.3713 11.4903 600479 0.4548 0.2660 0.0902 4.6758 0.9683 4.9895 002403 0.1849 0.1414 0.0418 2.0697 0.7085 2.5082 600826 0.3751 0.3929 0.0766 4.2920 0.6934 4.5214 300220 0.2985 0.0910 -0.1467 25.1713 0.5266 15.6310 300104 -0.3677 -0.6672 -0.9727 3.2944 0.3965 -2.2120 600363 0.1573 0.2709 0.0554 3.1860 0.7050 3.3673 st companies asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 161 code t1 t2 t3 t4 t5 zeta 600860 0.1126 -0.2712 0.0016 3.2187 0.6252 2.3170 002490 -0.1457 0.0342 0.0073 0.9128 0.4765 0.9214 000526 -0.5585 -0.0239 0.0220 1.0025 0.7842 0.7547 600696 0.1339 -0.1299 0.0239 3.8492 0.2153 2.5827 000595 0.0128 -0.2673 -0.0090 3.5903 0.2319 1.9975 600608 0.3596 -3.7899 0.2883 20.6771 2.4788 10.9623 600403 -0.1046 0.2574 0.0269 1.1851 0.4157 1.4503 601005 -0.0021 -0.4586 -0.2710 2.3360 0.5292 0.3920 000932 -0.2410 0.0038 0.0715 0.4053 1.0230 1.2181 000982 -0.2457 -0.1577 -0.0013 0.6168 0.2301 0.0803 5. discussion 5.1 discussion in order to determine the applicability of the kmv and zeta models in china, the default probability of listed companies should be compared with the credit rating that credit rating agencies have issued them. credit rating is an evaluation of the borrower’s creditworthiness performed by credit rating agencies. since china’s economic system is now a market economy, credit rating is more important than ever. to investors credit rating is a good indicator of the company’s ability to fulfil its financial obligations, so the credit ratings given by these credit rating agencies have a strong influence on investors’ decision of whether to invest or not. good credit ratings could therefore help china attract greater foreign direct investment. in china, there are five main credit rating agencies licensed by the government, which are respectively dagong global credit rating, china cheng xin international credit rating, china lianhe credit rating, golden credit rating international, and shanghai brilliance credit rating & investors service. according to the credit rating and certification centre of the people’s republic of china department of commerce research institute, the credit ratings of the selected listed companies can be divided into several categories. the companies’ creditworthiness is mainly assessed according to the company's financial data and financial indicators, which include the company's operating turnover changes, financial debt sales ratio, financial debt degree, physical asset turnover, efficiency of investment assets, efficiency of intangible assets, current account benefit cost ratio, anomaly coefficient, residual force coefficient of payment, cost system and various asset coefficients. the corresponding credit rating is then ascertained using a proper weighting ratio. the comparison between the default probability, z-score and credit rating of the 30 selected listed companies is shown in table 9. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 162 table 9. comparison between default probability, z-score and credit rating blue-chip companies ordinary companies code default probability z-score credit rating code default probability z-score credit rating 600519 1.888e-60 22.4552 bbb 600000 2.9056e-10 0.1418 bbb 002302 0.0089344 2.5422 bbb 000905 0.00058159 2.8172 a 300176 9.894e-07 7.8001 bbb 600549 3.2441e-05 2.9028 a 002307 0.0210386 0.8350 ccc 603377 4.6181e-40 11.4903 bb 002081 1.939e-09 3.2750 bb 600479 1.2839e-21 4.9895 aa 600808 0.0001808 1.7804 bb 002403 9.8236e-19 2.5082 aa 000709 0.0019622 0.5040 ccc 600826 3.5418e-12 4.5214 a 601919 2.388e-05 1.0641 bb 300220 4.762e-14 15.6310 bb 601899 4.231e-07 1.7027 bbb 300104 0.00706027 -2.2120 cc 600340 0.0004569 0.9196 ccc 600363 3.2305e-08 3.3673 a st companies st companies code default probability z-score credit rating code default probability z-score credit rating 600860 2.431e-10 2.3170 ccc 600608 1.6632e-17 10.9623 c 002490 0.0001318 0.9214 d 600403 2.938e-16 1.4503 cc 000526 5.669e-10 0.7547 d 601005 5.1561e-21 0.3920 d 600696 3.347e-09 2.5827 d 000932 0.00110886 1.2181 bb 000595 1.873e-05 1.9975 c 000982 0.00012644 0.0803 b asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 163 5.2 advantages and disadvantages it is self-evident that kmv is of great importance to contemporary credit risk research. the kmv model is a default probability prediction model based on the modern option pricing theory, which is an important innovation of traditional credit risk measurement. the kmv model can take into account information in the capital market as well as quantification and analysis of credit risk for all listed companies. since the data required by the model comes from the stock market, market information is fully utilized—leading to a better reflection of the current credit standing of listed companies. in addition, the kmv model is based on contemporary corporate finance theory and option pricing theory, so there is a strong theoretical foundation to rely on. the kmv model has become the most important credit risk rating model in the world thanks to the strong theoretical basis and low hypothetical condition. application of the kmv model can improve the validity of credit risk analysis of commercial banks in china, offering a useful reference to credit risk managers. however, every model is flawed; the kmv model is no exception. first of all, the scope of application of the kmv model has certain limitations. generally, the kmv model is more practical for listed companies than non-listed companies. since information on listed companies is more accessible, the market value of listed companies is easier to determine. on the other hand, information on non-listed companies is not publicly disclosed. as accounting indicators are pivotal to the kmv model, it is therefore a challenge to use the model for nonlisted companies. so, we need to make some adjustments to the important variables of the kmv model when we are dealing with non-listed companies. and the expected default probability of the companies is obtained through comparative analysis, which may reduce the accuracy of calculation to a certain extent. the kmv model also assumes that the asset value of a company is subordinated to lognormal distribution, but in actual fact the asset value of a company does not necessarily conform to this characteristic. the kmv model cannot measure portfolio risk too due to the complexity and uncertainty of the market. consequently, we cannot get the actual default correlation between two different companies. but the combination of copula function theory and kmv model may help us overcome this problem for now. in short, with the gradual development and perfection of china's securities market, it will be a feasible choice for banks to use stock market data to evaluate the credit standing of listed companies. 6. conclusion and recommendations 6.1 conclusion the main purposes of this paper are as follows:  by using the share price and financial reporting information of these listed companies, we compute the distance to default and credit default probability based on the kmv model. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 164  by using financial statements of these listed companies, we compute the z-score based on the zeta model to determine the probability of the company going bankrupt within the next two years.  by comparing the default probability of the kmv model and the z-score of the zeta model with the credit rating of these listed companies, we ascertain whether application of credit risk management model in china’s banks is feasible. having met the above objectives of the paper, the following conclusion can be made. bluechip companies generally have a relatively larger z-score and a relatively smaller default probability. the z-score of st companies is generally less than 1.80. for companies with a high z-score value, the default probability of the kmv model is relatively lower in general and their credit rating is generally better, i.e. class a and b. in general, for companies with a low z-score value, the default probability of the kmv model is relatively larger in general and their credit rating is generally poorer. but in class c and d, a few companies’ default probability under kmv model is very low and their z-score is very high, i.e. 600608 and 600696. this situation may be due to insufficient sample size and list companies’ wrong financial statements though they have been audited. it is obvious that credit rating is affected by many factors, which include the credit default risk of the subject of evaluation, the ability and willingness of the economic entity to fulfil the debt and other financial obligations on time in accordance with the contract, and the technical and professional experience of the third-party credit rating agency. the process of issuing credit ratings involves a complex and structured risk assessment of credit products. the increasing complexity of investment products has only made the relationship between rating and product risk more important than ever. but the consequences of default on these complex products may be minimal since the risk of default can be dispersed. so, the default probability derived from the kmv model and the zeta model cannot completely correspond to the entity’s credit rating as these indicators are only some reference bases to help investors make an informed decision. 6.2 recommendations in the previous study, we found that the company's credit rating, z-score and default probability do not correspond one by one. we can try to amend the specific subjects of the financial statements. by modifying these figures, we can get effective financial results. if there are opportunities in the future, i will re-analysis credit risk and consider more comprehensive factors. it is self-evident that the measurement of credit risk is of great importance to banks. the risk management team of banks should establish the right model where benefit is balanced against risk. banks have the responsibility to do the following actions to minimize the size of credit risk:  establish appropriate risk control models that are based on the actual situation, and quantitatively and qualitatively analyze its credit risk. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 165  promote the reliability of data sources in order to provide a reasonable basis for the evaluation of enterprises’ credit risk.  maintain the independence of internal control to enhance impartiality of the evaluation results.  train employees regularly to strengthen their ability to review credit and to promote their awareness of the adequacy and necessity of the credit process. references altman, e. i., zhang, l., & yen, j. 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(2000). comments on ‘equity market value and its importance for credit analysis: facts and fiction’,” kmv corporation. appendices the solution procedure of multivariate equation for blue-chip companies. the solution procedure of multivariate equation for ordinary companies. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 167 the solution procedure of multivariate equation for st companies. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 168 microsoft word 13976-50945-2-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 1 the complementary effects of islam and csr: some empirical evidence calvin w. h. cheong (corresponding author) faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malaysia tel: 60-82-260-996 e-mail: ccheong@swinburne.edu.my nurul ilma salleh faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malaysia tel: 60-82-260-985 e-mail: nisalleh@swinburne.edu.my fung chorng yuan faculty of business, design and arts, swinburne university of technology sarawak jalan simpang tiga, 93350 kuching, malaysia tel: 60-82-260-680 e-mail: cfung@swinburne.edu.my received: nov. 29, 2018 accepted: jan. 7, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.13976 url: https://doi.org/10.5296/ajfa.v11i1.13976 abstract this paper empirically investigates what has been claimed in the literature; that there are no significant differences between the islamic and western schools of business ethics. a proxy for the western school is corporate social responsibility (csr) while in the islamic school, a reasonable approximation would be shariah-compliance (sc). but because financial performance is not the main priority in csr and sc, this study examines the effects csr and sc has on firm resilience and firm risk. the regression estimates using an emerging market sample show that both csr and sc improves firm resilience besides reducing firm risk in the following year. the findings empirically validate the claims made in the literature; that business ethics, islamic or otherwise, are similar in substance and form. by empirically asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 2 examining this claim, this study paves the way for a convergence of values and practices besides fostering greater unity between cultures. keywords: corporate social responsibility, ethics, islamic finance, shariah-compliance, firm risk, firm resilience asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 3 1. introduction the wedge driven between muslim and non-muslim communities as a result of recent changes in global geopolitics in the northern hemisphere have led to animosity, social segregation, and even violence between cultures. central to this demarcation is a lack of understanding among non-muslims towards islam, its philosophy and practice. despite what many opponents of the religion would like to believe, islam’s fundamental underpinnings share remarkable similarities to those of conventional ethical thought and philosophy. a prominent manifestation of western business ethics is corporate social responsibility (csr). ideologically both islam and csr agree that accountability and responsibility toward society and the environment at large is, or at least, should be what every company should strive for. while the reasons may vary – for csr, it is the ethically right thing to do; for islam, man is the vicegerent and steward of allah and all creation – both are in essence, two sides of the same coin (williams and zinkin, 2010). incidentally, there is no islamic equivalent to csr within its scriptures as it is implied that a muslim business owner will embody these principles in managing the enterprise. in a modern context, we can say that the practice of islamic business principles is personified by the shariah-compliant (sc) company. although similar in principle, in practice csr and sc differ on three fronts: (1) corporate governance, social, and environmental performance; (2) prohibited industries and; (3) financial performance requirements. as such, this paper aims to empirically investigate the similarities and differences between csr and sc companies, and the effects these two seemingly substitutable principles may have on the companies that choose to practice them. instead of the often undertaken comparison of financial performance, this paper examines how csr or sc affects the resilience and risk levels of companies in the subsequent year. resilience is the difference in the magnitude of change observed in a particular variable relative to its maximum observed change throughout the sample period, a measure borrowed from the field of ecological economics (rose, 2004). in this study, the variables are sales revenue, cost of goods sold, operating expenses, and share prices. firm risk meanwhile is both total risk and idiosyncratic risk (bouslah et al., 2013). total risk is the annualized standard deviation from daily stock returns over the preceding year while idiosyncratic risk the standard deviation of the residuals from carhart’s (1997) four-factor model using the previous year’s daily excess returns. using a sample of 2,125 companies across 14 countries (note 1) from 2007 to 2014, the ordinary least squares (ols) estimates show an inverse relationship between the company’s socially responsible / shariah-compliance status and the four indicators of resilience as well as risk. specifically, by being socially responsible or shariah-compliant, the sample companies experience greater resilience in terms of their sales, cost, operating expenses and share prices besides lower total and idiosyncratic risk in the following year. the relationship persists even after controlling for a number of firm-level attributes that are known to have an impact on the relationship. we also include the performance of the sample companies’ respective asset markets as well as the overall market as a moderating variable in the model. the results show that market performance does have a slight moderating effect but not enough to alter the direction of the relationship. as a robustness test, we examine the effects a asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 4 change in the company’s socially responsible / shariah-compliant status has on its resilience and risk. the results show that losing its status adversely affects its resilience and risk while achieving or maintaining its status improves resilience and risk in the following year. given these results, it is reasonable to say that both csr and sc are merely two sides to the same coin as there was no observable differences in their effects on a company’s resilience and risk. the contributions of this paper are as follows. first, this paper is to the best of our knowledge, the first paper that empirically substantiates the claims of various studies on the similarities between conventional and islamic business ethics and philosophy. second, this paper addresses the need for a cross-cultural perspective on the effects of csr and shariah-compliance. although robust, prior studies on csr leaves a gap that needs to be filled as they were often based on u.s. or european data. similarly, studies on shariah-compliance are largely focused on muslim majority countries with limited data availability. finally, by drawing parallels between csr and shariah-compliance, this study provides the much needed understanding and compromise between the faith and beliefs of muslims and non-muslims alike. the rest of this paper is as follows. section 2 provides the review of relevant literature, highlighting the similarities between csr and shariah-compliance. section 3 describes the methodology used in this study. the results and a brief discussion is presented in section 4. section 5 concludes. 2. literature review 2.1 shariah-compliance the concept of corporate social responsibility (csr) and its underlying philosophy has been well documented in the literature and thus needs no reintroduction. islamic philosophy, especially with regards to business practices, on the other hand, has not enjoyed the same exposure. rather, since the turn of the century, islam has incessantly been placed in a negative light by various media outlets (shadid and van koningsveld, 2002, 2005; drees and van koningsveld, 2008), contributing to the worsening animosity between muslims and non-muslims. things have taken a turn for the worse given recent changes to global geopolitics such as the brexit referendum and the new u.s. presidential administration. but despite these adverse circumstances, the fundamental precepts of islamic finance have continued to gain widespread acceptance among financial markets especially in christian-majority nations, with the introduction of shariah-compliant financial products and the establishment of shariah equity indices in the u.s. (e.g. the dow jones islamic market index), the u.k. (e.g. the ftse shariah equity index), or europe (e.g. the stoxx europe islamic index). the islamic stock indices offer greater liquidity into the markets whilst providing more opportunities for companies to raise capital. the catch is these companies have to be shariah-compliant. shariah-compliance on the surface is simply a culmination of two criteria: (1) qualitative: is the business involved in prohibited industries, and (2) quantitative: are its finances meeting the permissible thresholds? prohibited, or haram industries are normally alcohol, pork, conventional financial services such as banking and insurance, entertainment such as hotels, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 5 casinos, cinemas, and pornography; tobacco; and weapons and defense industries. the quantitative criteria meanwhile generally observe the company’s level of interest income, debt, and receivables, following the islamic prohibition of riba (i.e. interest) and gharar (i.e. risk). if a company meets both the qualitative and quantitative criteria, it is deemed to be shariah-compliant. some commentators have argued that while these criteria comply with islamic principles, it is not a complete reflection of islamic business ethics. in the following sections, we explore a few key islamic business principles whilst drawing parallels between islamic business ethics and csr. 2.2 islamic business ethics islamic philosophy is deeply rooted in the principles of stewardship and brotherhood. mankind was placed on earth to act as vicegerents of allah and being bestowed with intelligence, is expected to safeguard the environment by using natural resources that have been gifted in a non-exploitative manner. also, as all beings are equal in the eyes of god, all human beings are deemed to be in a brotherhood and have a duty to show compassion and help one another in times of need. a responsible or ethical business in islam is founded upon these principles, complemented by the practices of prophet muhammad s.a.w. who himself, was a tradesman. even in the quran, it is explicitly stated that “… god has permitted trade” (sura al-baqarah, 275) but not all forms of trade are permitted. the prohibition on certain industries stems from the principle of protecting health and life. products and services that may threaten this principle such as alcohol, gambling, and weapons are thus prohibited or haram. other industries that may potentially degrade ethics and morals through the promotion of obscenities or violence such as entertainment is also prohibited. gambling, in particular, is prohibited as it represents gains without any serious, productive effort. a well-known prohibition in islam is that of interest or riba. because islam encourages and rewards hard work, interest is seen as a convenient manner to create profit without having to put in any work. it is feared that this would lead to wealthy capital-owners exploiting the poor and needy, widening the inequality between the groups, and tearing down the moral, social and economic well-being of society (al-qaradawi, 1985). instead, islam encourages the risk/profit-sharing system, where all parties are jointly responsible for the success or failure of a venture in order to avoid any one party exploiting the other. gharar (i.e. speculation or excessive risk-taking) is also a prohibited practice as it exploits the ignorance of the poor and less-informed, causing them to pay a higher price. because islam prizes an egalitarian society, information asymmetry is strongly discouraged. as such, business owners are often encouraged to conduct their affairs at “arm’s length” where all information about the transaction and the underlying asset is known to all parties to the transaction. transactions dependent on a leap of faith is thus forbidden. the responsibilities of the individual, the corporation and the state are clearly defined and deeply rooted in the quran and hadith. prophet muhammad, in his final sermon (which is commonly taken to exemplify islamic social responsibility and justice), said: “verily, you asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 6 will meet your lord, and he will ask you about your actions. you will neither commit injustice nor will you be wronged. no muslim is allowed from his brother’s property except what he gives away with a good heart; so do not wrong each other. the most honourable of you with allah is that believer who has morality” (haykal, 1976: 486-7). his final sermon also serves as a reminder that acting immorally when the rest of society is acting, in the same way, is not excusable; and that every individual is responsible for and bears the consequences of their actions. 2.3 islam and csr while a legally binding code of corporate social responsibility does not exist, many attempts have been made in establishing a concise guide as to what constitutes corporate social responsibility and sustainability. most notable of all is the un global compact, first outlined at the world economic forum of 1999. the un global compact aims to foster greater cooperation among companies, un agencies, labour organizations, and civil society towards establishing and nurturing universal principles of responsible business, and to act as a catalyst for initiatives that support the un in social and environmental development. like all csr guides, the un global compact is not a legal document but instead, relies on public accountability, transparency and a sense of enlightened self-interest in pursuing the principles within. the compact consists of ten principles in the areas of human rights, labour, the environment, and anti-corruption. these principles are summarized in table 1 below. table 1. the ten principles of the un global compact human rights principle 1 to support and respect the protection of internationally human rights principle 2 to refuse in participation in or condoning human rights abuses labour principle 3 to uphold freedom of association and recognition of the right to collective bargaining principle 4 to eliminate all forms of forced and compulsory labour principle 5 to abolish child labour principle 6 to eliminate discrimination in employment and occupation environment principle 7 to support a precautionary approach to environmental challenges principle 8 to undertake initiatives to promote greater environmental responsibility principle 9 to encourage the development and diffusion of environmentally friendly technologies anti-corruption principle 10 to work against corruption in all its forms, including extortion and bribery source: https://www.unglobalcompact.org/what-is-gc/mission/principles, viewed 19 april 2017 these principles are the ten principles of the un global compact are derived from the universal declaration of human rights, the international labour organization’s declaration on fundamental principles and rights at work, the rio declaration on environment and development, and the united nations convention against corruption. these international conventions and declarations have been widely read and applied in various contexts around asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 7 the world. but what is not immediately apparent to many is the fundamental philosophies of these international declarations have existed in islam for centuries. to illustrate my point, we highlight a few of them in the following paragraphs. first, as mankind are merely stewards of allah, islam recognizes that no one has the absolute right to rule, that governance should be through consultation (chapra, 2000). that is to say, no individual should hold authority over another individual’s personal autonomy and freedom of choice and movement. the prophet himself was responsible for the freedom of a large number of slaves over throughout his lifetime. the prophet also stated that he is opposed to those “… who sold a free person and devoured his price” (bukhari, 3, p. 258). islam also recognizes the right to equal treatment of all mankind as “… we created you from a single (pair) of male and female and made you into nations and tribes that ye may know each other” (quran, 49, p. 13). islam also respects the individual freedom of religion and belief – “to you be your way and to me mine” (quran, 109, p. 6) – and that there will be no compulsion to religion. instead, islam respects and honours those that are righteous. the prophet made this clear in his last sermon: “no arab has superiority over any non-arab and no non-arab has any superiority over an arab; no dark person has superiority over a white person and no white person has any superiority over a dark person. the criterion of honour in the sight of allah is righteousness and honest living’’ (the prophet’s last sermon). a lesser known aspect of equal treatment in islam is that women’s rights are equal to men. there are many instances within the quran where this is evident (for example quran, 4; 7; 3). superiority in islam is only on the basis of virtue and righteousness (quran, 49, p. 13). it is only in modern times that these teachings and virtues have been misinterpreted due to inherent cultural biases (undp, 2002). with regards to social and economic well-being, islam recognizes the importance of a basic standard of living through the establishment of zakat or obligatory charity. zakat contributions are made by muslims who are better off to provide a minimum social safety net for their less fortunate brothers and sisters in islam. beyond zakat, muslims are strongly encouraged to engage in charitable giving since “… in their wealth, there is a due share for the needy and deprived” (quran, 51, p. 19). besides helping the impoverished, muslims are also required to aid the personal development of his fellow muslim, to guide them to the right path when they have strayed, and to stand up against any form of oppression (hadith muslim, book 3, no. 6246). the teachings within the quran and hadith are explicit on the need for muslims to protect and preserve the natural environment. because mankind is simply the vicegerent of allah, he serves as a steward of the natural environment and is responsible for its protection (quran, 6, p. 165). as mankind is ultimately answerable to allah, he faces punishment if he does not perform his duties to preserve and protect nature that rightfully belongs to allah (quran, 4, p. 126). it has been widely cited that the prophet had established natural reserves to protect wildlife and preserve natural resources. as a result, scholars have through the principle of qiyas, extrapolated this example set by the prophet to mean environmental protection legislation (beekun and badawi, 2005). despite its stance on environmental preservation, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 8 islam also recognizes the human need to use natural resources for daily life and economic work but cautions against wastage and encourages moderation (quran, 7, p. 31). finally, islam adopts a strict stance against corruption and promotes ethical business conduct (al-qaradawi, 1985). additionally, given the strict prohibition on gharar, islam strongly encourages transparency in business dealings; that all business transactions are written contracts with all relevant information made clear to all contracting parties at the point of agreement. as such, the principle of caveat emptor prevalent in modern society is forbidden. trustworthiness and honesty in the transaction especially with regards to the quality and standards of the underlying traded commodities are also explicitly stated in the quran (6; 17; 83). the fundamental philosophy of csr is based on similar, if not the same, principles. companies are expected to be mindful of the environment they operate in, proactively engage in projects that promote social development and protect the rights of its workers and consumers whilst owing a responsibility to its shareholders to earn a profit. according to csr principles, these initiatives are the responsibility of the managers, not the owners (i.e. shareholders). islam, on the other hand, makes no distinction between the owner (or manager) and the firm: the firm is deemed to be a part of the owner (or manager) and is as such, expected to fulfill the same responsibilities borne by the owner. the principles of environmental stewardship, caring for the community or brotherhood, and avoidance of questionable business practices are but a few of the many similarities shared between the fundamental principles of csr or corporate sustainability and the islamic notion of an ethical and responsible business. in practice, however, differences between these concepts are more apparent. arguably, the practice of csr or corporate sustainability arises from corporate altruism. but it may also stem from the need to appease the public and to maintain legitimacy. ethical and responsible business practices, on the other hand, is a religious obligation for all shariah-compliant businesses. as a result, in the pursuit of csr, companies have to still place emphasis on financial gains. similarly, islam encourages trade (quran, sura al-baqarah, 275) and the pursuit of financial gain, so long as it has been obtained through ethical and responsible practices. as the preceding discussion suggests, islam and csr are profoundly similar in principle. the key difference lies in its practice. csr manifests itself in the form of companies that actively pursue csr objectives. islamic business principles, on the other hand, are not quite that easy to place. the closest approximation is the shariah-compliant company as it meets most of the islamic business principles discussed earlier: prohibition on haram industries; prohibition on risk and excessive risk-taking, the provision of zakat; respect and protection of human and labour rights; protection and preservation of the natural environment; and abstinence from corrupt practices. with this in mind, we make comparisons between csr and shariah-compliance in the following section. 2.4 csr and shariah-compliance: contrary or complementary? in theory, both of these concepts are noble aspirations that companies should ideally strive for. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 9 however, the true meaning of csr and shariah-compliance seems to have been lost in practice. many companies, despite grand, benevolent gestures of social and environmental responsibility, have failed to uphold the essence of csr. a good example of this would be royal dutch shell who in early 2015 caused a massive oil spill in nigeria (bbc, 2015) that polluted the waterways resulting in irreparable damage to the local environment besides disrupting the livelihood of the natives for many years to come. this is in spite of their thorough csr strategic plan communicated to the masses in their media relations. the hypocrisy is not limited to csr companies alone. the principles of islamic economics and finance, as well as the concept of shariah-compliance, have also been subjects of substantive criticism. critics contend that the ‘islamic’ terminology used in practice and in literature are merely different in form rather than substance from their conventional counterparts (see khan, 2010; el gamal, 2006; kuran, 2004; zaman, 2002; nomani; 2006). given such harsh criticism, why do companies still insist on being socially responsible or shariah-compliant? the literature abounds with arguments for the ‘business case’ of these hotly debated concepts. we briefly summarize these arguments in the following paragraphs. davidson and worrell (1988) and davidson, worrell, and lee (1994) examined a firm’s stock return response to corporate illegalities and found that stock markets react negatively when a firm was embroiled in bribery, tax evasion, and violation of government contracts. the authors also found the magnitude of negative reaction to being greater for repeat offenders. balabanis, phillips, and lyall (1998) meanwhile found firm’s that performed well in the previous year were more likely to partake in philanthropic activities in the next year. stanwick and stanwick (1998) likewise found a strong correlation between profitability and a firm’s likelihood of being socially responsible. mcwilliams and siegel (2000) meanwhile argued that r&d and advertising expenditure contributed towards a firm’s level of csr. public disclosure of csr activities has also been found to affect share price returns (murray, power, and gray, 2006) and cost of equity capital (dhaliwal, li, tsang and yang, 2011). following stakeholder theory, better csr performance lowers firm risk through reduced financial and operating risks (mcguire et al., 1988.) as well as social and environmental risks (feldman et al., 1997; sharfman and fernando, 2008). csr engagements may also reduce information asymmetries as it may be perceived as a signal of greater management quality (mcguire et al., 1988; waddock and graves, 1997). strategic investment in csr initiatives such as environmental relations and product innovation suggests to stakeholders that their expectations are taken seriously by the firm, thereby contributing to lower firm risks (surroca et al., 2010.). similarly, durand et al. (2013) found societal values to exert significant pressure on “sin” firms resulting in lower fund manager interest, poorer analyst coverage, lower share prices, and a higher likelihood of being shunned by equity markets which contribute to greater risk. shariah-compliant companies, on the other hand, have not attracted so much interest due to a lack of data. we briefly review a few here. in a study on the pecuniary costs of an investor’s compliance with shariah, hakim and rashidian (2004) observed treynor ratios, risk-return tradeoffs, and correlations to the dow jones islamic index. their findings showed that shariah restrictions did not expose investors to risks greater than what the investors would asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 10 have had if they had invested in a broad market index. in a comparative study between islamic and conventional mutual funds, elfakhani, hassan and sidani (2005) likewise found that the performance of both funds do not differ enough to warrant investors making a choice between the two based solely on returns. albaity and ahmad (2008) arrived at similar conclusions in their comparative study between the kuala lumpur shariah and composite index. in fact, their tests results suggest that the movement of the shariah index may actually be predicted by the composite index. using firm-level data in the malaysian plantations industry, dali, mudasir and abdul hamid (2008) similarly found no statistically significant difference in the performance of shariah and non-shariah compliant companies. in what is arguably one of the most mathematically rigorous studies on shariah-compliance, derigs and marzban (2009) constructed an optimized equity portfolio based on shariah precepts. their shariah-compliant optimized portfolio performed significantly better than other normally available shariah-compliant portfolios besides performing as well as its conventional counterparts within the same asset universe. alam and rajjaque (2010) meanwhile, found shariah-compliant equity returns to be more resilient during periods of market turmoil but underperform their conventional counterparts when the market is bullish. hoepner, rammal, and rezec (2011) similarly found islamic equity funds based in muslim-majority countries to outperform international equity indices. those based in christian-majority nations or in countries where islamic finance has yet to gain widespread acceptance underperformed their benchmarks. perhaps the best empirical evidence that suggests shariah-compliance and csr are not that different comes from abdelsalam et al. (2013) who found no statistically significant difference in the efficiency and performance of shariah-compliant and socially responsible investment funds. given the fundamental similarities between csr and shariah-compliance, it is reasonable to assume that the effect/s of csr performance on various firm performance measures can also be observed in shariah-compliant firms. in fact, the effects on shariah-compliant companies may be more profound for a number of reasons. ideally, the firm is expected to exhibit a conscience towards the natural environment besides imparting a greater sense of benevolence upon the community. these expectations naturally stem from a growing social conscience towards the environment and community, pressuring companies to reflect this conscience or risk losing its corporate legitimacy. in this regard, shariah-compliant companies are placed under greater scrutiny due to their religious foundations. not only do they have to meet environmental and social expectations but religious expectations as well. following this argument, it is possible that shariah-compliant companies are more sensitive to changes in market expectations and will experience greater variability in firm performance i.e. they are less resilient as compared to good csr performance companies during periods of economic distress. the hypothesis to be tested is thus: hypothesis 1: shariah-compliant companies are less resilient than good csr performance companies during periods of economic distress, ceteris paribus. islamic businesses ideally should not be involved with gharar or risk. but at the same time, islam accepts that riskless business ventures do not exist. rather, islamic businesses are encouraged to avoid investing in risky projects or taking on excessive risks as far as it is asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 11 reasonable for the wellbeing of the business. additionally, the islamic prohibition of “sin” industries such as alcohol, tobacco, gambling, firearms, and other haram industries should technically lower a shariah-compliant company’s level of firm risk (durand et al., 2013.). the prohibition on industry involvement may, however, be a double-edged sword as it increases the company’s concentration risk and reduces its ability to diversify its operations into other more profitable industries. attig et al. (2013) argue that firms can reduce their perceived risk of financial distress by signaling their availability and efficient allocation of the firm’s internal resources through their csr initiatives. firms that actively pursue csr objectives are more likely to disclose their csr activities (dhaliwal et al., 2011.) and are consequently more transparent, thereby reducing informational asymmetries between the firm and investors, thus mitigating firm risk. in contrast, there is a need for shariah-compliant companies to improve the disclosure of their activities especially those that fall under the direct purview of shariah-compliance screening criteria. furthermore, shariah-compliant equity or debt issues: (1) in principle, have not been treated in the same manner as conventional instruments for accounting purposes and; (2) generally do not hold the same level of transparency as their conventional counterparts due to pricing mechanisms that are based upon an underlying commodity that is not fully disclosed (pricewaterhousecoopers, 2010). the absence of a reliable and independent assessment of these risks makes it difficult for market participants to evaluate the company’s level of risk. given the additional restrictions imposed upon shariah-compliant companies and the lack of voluntary disclosure on their operations and investments, shariah-compliant companies are likely to exhibit greater levels of firm risk as compared to good csr performance companies. the hypothesis to be tested is thus: hypothesis 2: shariah-compliant companies are riskier than good csr performance companies, ceteris paribus. 3. methodology 3.1 defining a socially responsible and shariah-compliant company most firm-level studies on csr utilize data from msci esg stats (formerly known as kld research analytics inc.). however, msci only provides csr information for us companies. in this paper, we use csr information provided by robecosam, a zurich-based investment company. every year robecosam surveys thousands of companies around the world in their corporate sustainability assessment (csa) exercise. the csa comprises a series of questions that evaluate companies on their performance in three broad categories: economic, environmental, and social. the scores compiled from the csa forms the opinion of the dow jones to include or drop companies from its sustainability index. because the csa scores are proprietary, robecosam publishes the annual sustainability yearbook wherein it lists the companies that are in the top 15% of their respective industries csr-wise. for the purpose of this paper, a socially responsible company (sr) is defined as a company that has been listed in the sustainability yearbook for the given year. because the sustainability yearbook is normally published during the fourth quarter of each year, some questions may arise as to the exact timing of the information. as the information in the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 12 yearbook takes some time to be compiled, it is assumed that the contents of the yearbook reflect the company’s csr efforts as at january of the year the yearbook was published. the different interpretations of islamic principles derived from the various islamic sects makes defining shariah-compliance a trickier affair. generally, for a company to be deemed shariah-compliant, it must meet both qualitative and quantitative criteria. for consistency, a shariah-compliant company is defined as a company that has met the dow jones islamic market index (djimi) shariah-compliance criteria, regarded among commentators as the most conservative (khatkatay and nisar, 2006; 2007; derigs and marzban, 2008) yet inclusive (derigs and marzban, 2009). the djimi’s shariah supervisory board’s qualitative criteria establishes the following broad categories of industries considered haram: alcohol, pork, conventional financial services such as banking and insurance, entertainment such as hotels, casinos, cinemas and pornography, tobacco; and weapons and defense industries. the quantitative criteria meanwhile are the company’s level of debt, level of interest earnings, and level of receivables. level of debt is defined as the company’s total debt divided by its trailing 24-month average market capitalization; level of interest earnings is the sum of company’s cash and interest-bearing securities divided by its trailing 24-month average market capitalization, and level of receivables is the company’s total accounts receivables divided by its trailing 24-month average market capitalization. the maximum acceptable threshold for these three measures as prescribed by the djimi is 33 percent. if the company does not belong to a haram industry, and meets the 33 percent threshold, it is thus recognized as a shariah-compliant company (sc). 3.2 dependent variable 3.2.1 firm resilience to borrow a term from the ecological economics literature, resilience is defined as the inherent and adaptive responses to external shocks that firms undertake to avoid potential losses, with emphasis on the ingenuity and resourcefulness applied during and after the event (rose, 2004). following this definition, firm resilience can be measured across a number of indicators that are most susceptible to market-wide phenomenon. in this paper, firm resilience, fr, is measured using an adaptation of rose (2004), defined as: = %∆ %∆%∆ (1) where %δdqmax is the maximum percentage change in the observed indicator and %δdq is the percent change in the observed indicator, on a monthly basis. a lower fr value indicates greater resilience. the indicators observed in this study are the company’s sales revenue, cost of goods sold, operating expenses, and share price. the intuition behind the choice of indicators is simple. a company’s sales revenue and cost of goods sold is to a great extent, dependent on its ability to inspire and attract customers, and to build strong relationships with its suppliers. prior studies (e.g. kotha, rajgopal and rindova, 2001; lev, petrovits, and radhakrishnan, 2010) have established that csr has a profound positive impact on a firm’s relationships with its customers and suppliers. operating expenses is included as one of the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 13 indicators of resilience as a reflection of managerial efficiency since active engagement in csr activities is a sign of efficient allocation of resources (attig et al., 2013). share price is the final resilience indicator as it reflects the market’s sentiments towards the company and its activities. companies in controversial industries exhibit greater share price volatility while socially responsible companies have lowered firm risk (durand et al., 2013; jo and na, 2012). 3.2.2 firm risk following bouslah et al. (2013), total risk is measured by the annualized standard deviation from daily stock returns over the preceding year. idiosyncratic risk is measured as the standard deviation of the residuals from carhart’s (1997) four-factor model using the previous year’s daily excess returns. carhart’s four-factor model is as follows: rit – rft = αi + βim (rmt – rft) + βissmbt + βihhmlt + βiuumdt + εit (2) where rit is the return of firm i for day t. rft is the risk-free rate (based on 1-month t-bill rate). (rmt – rft) is the excess return of the market portfolio (the local stock market index) for day t. smbt is the difference between the returns on portfolios of “small” and “big” capitalization stocks for day t. hmlt is the difference between the returns on portfolios of “high” and “low” book-to-market stocks for day t. umdt is the difference between the returns on portfolios of high and low prior return stocks. εit is the stochastic error term, assumed to be iid normal with mean zero and constant variance . for each firm-year observation, we use daily excess returns over the previous year to estimate idiosyncratic risk using time series regressions. this process is repeated for each year throughout the sample period to obtain a time-varying idiosyncratic risk. 3.3 control variables following theoretical arguments and empirical evidence presented in prior studies (see for example, fama and french 1992; 1993; brennan et al., 1998; gebhardt et al., 2001; chordia et al., 2001; botosan and plumlee, 2005; and bouslah et al., 2013) the firm-specific control vaiables included in this study are firm size, book-to-market (b/m) ratio, net leverage, expected return, stock liquidity, liquidity risk, return-on-assets, investment-to-asset ratio, expected growth in earnings, default risk and investor base. firm size is the logarithm of the market value of common equity at the most recent fiscal year end prior to the measurement date of the risk measures used to account for the highly skewed nature of this variable. book-to-market (b/m) ratio is measured as the ratio of the book to market value of common equity as of the most recent fiscal year end. following bates et al., (2009) this study also includes net leverage, measured as the ratio of long-term debt minus cash and marketable securities to the market value of common equity using values for the most recent fiscal year end. the study uses annualized return from the previous year’s daily stock returns to proxy for expected return. the level of stock liquidity is measured by the average daily share turnover, while liquidity risk is the coefficient of variation of the average daily share turnover. share turnover is defined as daily shares traded divided by daily shares outstanding. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 14 this study also uses the standard deviation of the return on assets (roa) over the previous 5 years to control for cash flow risk. investment-to-asset ratio is computed as the sum of capital expenditures, research and development expenditures and advertising expenses, divided by total assets. this study uses the mean annualized 5-year earnings growth rate estimated as the implicit growth in forecasted earnings from year 1 to year 2 to proxy for expected growth in earnings. default risk is measured using altman’s (1993) z score. a higher value of the z score indicates a lower likelihood of default. following merton’s (1987) argument, this study also includes the investor base, measured as the number of common ordinary shareholders divided by common shares outstanding. the descriptive statistics of these variables for both the socially responsible and shariah-compliant companies are presented in table 2 below. table 2. descriptive statistics of dependent and control variables, 2007 – 2014 all companies socially responsible only shariah-compliant only n = 17,000 n = 1,552 n = 5,712 mean std. dev. kurtosis skew mean std. dev. kurtosis skew mean std. dev. kurtosis skew fr-s 0.413 0.437 1.681 1.29 0.253 0.022 3.069 -0.122 0.542 0.753 5.694 1.541 fr-c 0.646 0.691 0.999 0.018 0.406 0.360 0.186 0.520 0.554 0.722 0.819 0.487 fr-e 0.284 0.893 0.130 0.160 0.532 0.413 0.919 0.873 0.593 0.271 0.710 0.708 fr-p 0.331 0.298 0.769 0.225 0.580 0.430 0.641 0.078 0.434 0.568 0.881 0.043 tr 1.274 4.711 5.873 7.51 0.475 0.774 1.142 3.161 0.442 3.383 5.062 6.932 ir 3.645 2.182 8.492 9.21 0.002 0.006 9.524 0.453 0.002 0.012 3.488 5.223 size 3.832 2.489 0.092 0.713 4.502 2.593 -0.036 0.938 4.217 2.788 -0.501 0.372 bm 1.869 8.471 1.144 1.15 2.031 17.972 2.123 1.433 2.746 1.421 5.564 7.413 lev 0.575 2.249 4.314 5.94 0.592 0.996 5.714 6.251 0.266 1.805 4.464 6.322 er 1.231 2.041 1.671 3.78 0.188 1.409 9.914 8.994 1.858 3.413 6.237 2.383 liq 0.004 0.007 4.522 1.47 0.003 0.003 2.412 3.802 0.004 0.006 1.689 9.817 liqr 0.719 0.573 1.033 7.679 0.622 0.611 1.581 1.152 0.753 0.535 6.433 5.672 sroa 0.043 0.081 6.022 1.57 0.036 0.052 4.983 5.682 0.056 0.106 6.444 1.696 ia 2.276 6.842 4.351 5.85 0.442 1.941 1.125 9.677 4.087 8.162 8.356 2.754 eg 3.544 9.694 3.563 5.82 0.222 0.961 1.457 1.072 5.352 1.063 4.174 1.833 z 9.567 1.381 1.954 4.21 8.998 6.036 2.563 1.571 3.633 1.374 1.175 3.312 invb 0.437 9.492 1.431 1.15 0.256 0.517 2.958 4.788 0.389 1.718 2.061 1.351 note: fr-s = firm resilience-sales; fr-c = firm resilience–cost of goods sold; fr-e = firm-resilience – operating expenses; fr-p = firm resilience – share price; tr = total risk; ir = idiosyncratic risk; size = firm size; bm = book-to-market ratio; lev = net leverage; er = expected return; liq = stock liquidity; liqr = liquidity risk; sroa = standard deviation of return on assets; ia = investment-to-asset ratio; eg = expected growth in earnings; z = default risk; invb = investor base. a cursory glance at table 2 would suggest that both sr and sc companies are not that much different from one another, especially in the dependent variables. all four firm resilience indicators for both sr and sc companies have mean values that are quite close to each other. the same can also be said of the mean values of total and idiosyncratic risk for both sr and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 15 sc companies. to validate these observations, we conduct a simple paired sample t-test to determine whether the mean difference between each of the dependent variables for sr and sc companies is zero. because the sc sample is larger, 1,552 observations are randomly selected from the 5,712 to be tested. the t-test suggests that there is no statistically significant difference in the mean values of the dependent variables between sr and sc companies (note 2). 3.4 econometric model although the t-test suggests that there is no statistically significant difference between sr and sc companies, it does not illustrate the effects sr or sc has on a company’s level of resilience and risk. in this regard, we estimate the following model: , = + , + , + ∑ , , + , (3) where yi,t+1 is the four resilience indicators, total risk, and idiosyncratic risk for company i at time t + 1, srit is a binary variable that represents company i’s listing in the sustainability yearbook at time t¸ scit is a binary variable that represents company i’s shariah-compliant status, cvs,i,t is a vector of independent control variables, and eit is the error term. the explanatory variables are lagged one period to avoid issues of endogeneity. to reduce the interference from noise due to outliers, all variables used in this study except for the dummy variables, are winsorized at the 1% level (oikonomou et al., 2012). because this study employs firm-year observations, outliers and missing values may lead to spurious results, especially in the derivation of the adjusted r2 (baltagi, 2005). as such, missing values are accounted for through linear interpolation. 4. findings & discussion 4.1 firm resilience from table 3, we can see that both sr and sc has the same effect on firm resilience. the negative sign implies that being socially responsible or shariah-compliant results in greater firm resilience. model (1) illustrates this simple yet statistically significant relationship. in model (2), we can see that the relationship persists even after controlling for firm-level attributes that may have an impact on the relationship observed. in model (3), the performance of the dow jones sustainability index (djsi) and dow jones islamic market index (djimi) is a proxy for the overall performance of the “sustainable” i.e. “socially responsible” and shariah-compliant asset markets respectively. the interaction term srxdjsi and scxdjimi tests the impact of both asset markets on sr and sc companies respectively. as we can see, the djsi moderates the effects on a firm’s resilience in operating expenses, but has little to no impact on the other indicators of resilience. the djimi on the other hand, moderates the effects on a firm’s resilience in costs and operating expenses but has little impact on sales and share prices. we also include the variable mkt to control for the effects overall market performance may have on the relationship. the estimates suggest that market performance has little influence on the resilience of sr and sc companies. the estimates in table 3 provide some confirmation to the earlier t-test which suggested that asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 16 there is no difference in the effects of sr and sc on firm resilience. the respective asset markets’ performance on the other hand, seems to have some impact on a sr and sc company’s level of resilience. the effect is particularly pronounced for sc companies. in terms of cost and operating expenses, the djimi has a much stronger moderating impact on sc companies’ resilience than the djsi has on sr companies. ideally, sc companies should avoid doing business with non-halal companies, reducing their available choices of suppliers thus leaving them exposed to greater cost and expense variations. it is however, reasonable to say that the act of being socially responsible or shariah-compliant creates greater resilience within companies due to (1) with regards to sales and share price: a greater level of trust from the public (dhaliwal et al., 2011) and (2) with regards to costs and expenses: a greater level of managerial efficiency and discipline (attig et al., 2013). table 3. regression of social responsibility and shariah-compliance on firm resilience dependent: firm resilience sales revenue (1) (2) (3) sr -0.55*** (-2.78) -0.32*** (-2.45) -0.27*** (-2.33) sc -0.46*** (-2.63) -0.27*** (-2.27) -0.28*** (-2.41) srxdjsi -0.11* (-1.61) scxdjimi -0.15* (-1.64) mkt 0.33* (1.68) cv no yes yes r2 0.2143 0.2513 0.2832 dependent: firm resilience cost of goods sold (1) (2) (3) sr -0.75** (-1.89) -0.55** (-1.83) -0.43*** (-2.21) sc -0.56*** (-2.15) -0.59*** (-2.01) -0.51** (-1.91) srxdjsi -0.28 (-1.07) scxdjimi -0.75** (-1.85) mkt 0.87 (0.98) cv no yes yes r2 0.1983 0.2206 0.2442 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 17 table 3 continued dependent: firm resilience operating expenses (1) (2) (3) sr -0.89*** (-2.34) -0.65** (-1.92) -0.85** (-1.93) sc -0.76*** (-3.01) -0.71*** (-2.22) -0.67** (-1.91) srxdjsi -0.55** (-1.89) scxdjimi -0.72*** (-1.99) mkt -0.11 (-0.78) cv no yes yes r2 0.2296 0.2199 0.2071 dependent: firm resilience share price (1) (2) (3) sr -0.91*** (-3.11) -0.86*** (-2.88) -0.77*** (-3.22) sc -0.87*** (-2.97) -0.85*** (-2.57) -0.71*** (-2.76) srxdjsi 0.22* (1.65) scxdjimi 0.15* (1.75) mkt 0.07* (1.77) cv no yes yes r2 0.3104 0.3085 0.2581 this table reports the estimates of coefficients of equation 3. the dependent variables are the four firm resilience indicators. sr is a binary variable that is 1 if the company is listed in the sustainability yearbook in the observation year; sc is a binary variable that is 1 if the company is shariah-compliant in the observation year; srxdjsi is an interaction term between sr and the excess returns on the dow jones sustainability index; scxdjimi is an interaction term between sc and the dow jones islamic market index; mkt is the excess return on the main stock exchange of the country; and cv are the firm-level control variables (see section 3.3). all variables have been winsorized at the bottom and top 1% levels. robust t-statistics are in parentheses. ***, **, and * indicate statistical significance at the 1, 5 and 10% levels. 4.2 firm risk from table 4, we can see that both sr and sc has the same effect on total risk and idiosyncratic risk. the negative sign implies that being socially responsible or shariah-compliant lowers firm risk. the coefficient estimates in model (1) illustrates the statistically significant negative relationship. even with the inclusion of firm-level attributes that have been known to have an impact on firm risk, the negative effect sr and sc has on risk remains statistically significant. in model (3) we can see that the performance of the djsi and djimi has a slight moderating effect on the negative relationship between sr and sc on total and idiosyncratic risk. the overall performance of the market meanwhile has a statistically significant positive effect on total risk and idiosyncratic risk. the coefficient estimates in table 4 provide further confirmation to the findings of the t-test i.e. there does not seem to be a difference in the effects sr and sc has on firm risk. however, we can see that the djsi and djimi’s performance has a greater moderating effect on total and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 18 idiosyncratic risk as compared to its effects on firm resilience. due to the closer relations between companies and the smaller asset universe in the djsi and djimi, it would not be unusual for the performance of the respective asset markets to have influence over the level of risk exhibited by sr and sc companies. also, given the manner in which both total and idiosyncratic risk is derived, it is unsurprising that overall market performance has a positive impact on both measures. however, it does not detract from the fact that sr and sc reduces firm risk. table 4. regression of social responsibility and shariah-compliance on total and idiosyncratic risk dependent: total risk (1) (2) (3) sr -1.33*** (-2.01) -1.01** (-1.91) -1.12*** (-3.22) sc -1.45*** (-2.15) -1.44*** (-2.07) -1.51*** (-2.85) srxdjsi -0.84** (-1.82) scxdjimi -0.66** (-1.90) mkt 0.51** (1.78) cv no yes yes r2 0.2265 0.2315 0.2441 dependent: idiosyncratic risk (1) (2) (3) sr -0.033*** (-4.11) -0.027*** (-3.18) -0.031** (-1.91) sc -0.041*** (-2.98) -0.036*** (-2.97) -0.049** (-1.89) srxdjsi -0.015* (-1.75) scxdjimi -0.021* (-1.72) mkt 0.006* (1.61) cv no yes yes r2 0.2117 0.2209 0.2002 this table reports the estimates of coefficients of equation 3. the dependent variables are total risk and idiosyncratic risk. sr is a binary variable that is 1 if the company is listed in the sustainability yearbook in the observation year; sc is a binary variable that is 1 if the company is shariah-compliant in the observation year; srxdjsi is an interaction term between sr and the excess returns on the dow jones sustainability index; scxdjimi is an interaction term between sc and the dow jones islamic market index; mkt is the excess return on the main stock exchange of the country; and cv are the firm-level control variables (see section 3.3). all variables have been winsorized at the bottom and top 1% levels. robust t-statistics are in parentheses. ***, **, and * indicate statistical significance at the 1, 5 and 10% levels. understandably, some questions may arise as to the validity of the findings above given the sample period used in this study (2007 – 2014) during which the global financial crisis (gfc) took place. to address this concern, we re-estimate model (3) in tables 3 and 4 using a crisisand recovery-period sample. the crisis-period sample is from 2007 to 2010 while the recovery-period sample is from 2011 to 2014. the estimates are in table 5 below. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 19 table 5. regression of social responsibility and shariah-compliance on firm resilience and risk, crisis and recovery period crisis fr-s fr-c fr-e fr-p tr ir sr -0.74*** -0.66*** -0.74*** -0.72** -1.01*** -0.036*** (-2.94) (-3.01) (-2.54) (-1.89) (-2.33) (-2.44) sc -0.55*** -0.77*** -0.70*** -0.68*** -1.51*** -0.085** (-2.22) (-1.99) (-2.48) (-2.39) (-3.11) (-2.72) srxdjsi -0.78* -0.66 -0.81** -0.71* -0.91 -0.021* (-1.71) (-0.91) (-1.89) (-1.77) (-0.87) (-1.81) scxdjimi -0.23* -0.55** -0.71*** -0.44* -0.48** -0.025* (-1.72) (-1.92) (-2.08) (-1.75) (-1.89) (-1.69) mkt -0.33 -0.45 -0.65 -0.69 2.21*** 0.207*** (-0.76) (-0.65) (-0.81) (-0.95) (3.41) (2.83) cv yes yes yes yes yes yes r2 0.2451 0.2401 0.2631 0.2491 0.1311 0.1446 recovery fr-s fr-c fr-e fr-p tr ir sr -0.34*** -0.35*** -0.31** -0.25*** -1.12** -0.046** (-3.10) (-2.55) (-1.83) (-2.47) (-1.79) (-1.90) sc -0.37*** -0.47*** -0.40*** -0.36** -1.07** -0.073*** (-3.82) (-2.71) (-1.98) (-1.88) (-1.85) (-3.25) srxdjsi -0.82 -0.51 0.49 -0.82 1.49* 0.068* (-0.43) (-0.39) (0.41) (-0.71) (1.68) (1.71) scxdjimi -0.81* -0.69 -0.55 -0.37* -1.33* 0.081 (-0.61) (-0.74) (-0.33) (-0.41) (-1.65) (1.05) mkt 1.04* 0.98 0.88** 1.15* 1.45** 0.741* (1.69) (0.99) (1.88) (1.71) (1.91) (1.88) cv yes yes yes yes yes yes r2 0.2027 0.2513 0.1984 0.2701 0.1563 0.1433 this table reports the estimates of coefficients of equation 3. the dependent variables are firm resilience – sales revenue (fr-s); cost of goods sold (fr-c); operating expenses (fr-e); share price (fr-p); total risk (tr) and idiosyncratic risk (ir). sr is a binary variable that is 1 if the company is listed in the sustainability yearbook in the observation year; sc is a binary variable that is 1 if the company is shariah-compliant in the observation year; srxdjsi is an interaction term between sr and the excess returns on the dow jones sustainability index; scxdjimi is an interaction term between sc and the dow jones islamic market index; mkt is the excess return on the main stock exchange of the country; and cv are the firm-level control variables (see section 3.3). all variables have been winsorized at the bottom and top 1% levels. robust t-statistics are in parentheses. ***, **, and * indicate statistical significance at the 1, 5 and 10% levels. the crisis period is 2007 to 2010; recovery is 2011 to 2014. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 20 we can see that during the crisis period (table 5, top panel) the performance of sr and sc companies held steady despite the turmoil in the markets. the negative relationship observed in the earlier findings is evident even with volatile market conditions. the performance of the djsi and djimi however, had little to no effect on the relationship. overall market performance likewise, did not have any influence on the resilience of sr and sc companies. the coefficient estimates during the crisis period also shows that both sr and sc companies were less risky than their counterparts, judging by the negative signs. we can also see that there is a noticeable difference in the magnitude of the effect between sr and sc on total and idiosyncratic risk. in the recovery period (table 5, bottom panel), we can see that the signs of the coefficient estimates have remained the same; that being socially responsible or shariah-compliant results in greater firm resilience besides lowering firm risk. there is however, a noticeable difference in the magnitude of the relationship between the crisis and recovery period for both sr and sc. during the crisis period, the effects of sr and sc on firm resilience was greater as compared to during the recovery period, judging by the larger negative values observed. the same cannot be said about the effects of sr and sc on risk. it seems that sc companies are on the whole, less risky than others during periods of market uncertainty. when markets began to recover, the coefficient estimates suggest that sr companies were less risky. however, the estimates in both periods show that sc companies on the whole, have lower idiosyncratic risk. 4.3 robustness tests as the csa is conducted yearly, the constituents of the sustainability yearbook do not remain the same from year to year. as a company’s csr performance differs every year, there is the possibility that its performance may dip in one year and soar in the next. even if it had maintained its performance, another company may have outperformed it. to derive additional inferences, we examine the effects listing, delisting, or maintaining one’s position in the sustainability yearbook has on firm resilience and risk in the following year. the sample companies are categorized according to their socially responsible status at year t. the model is specified as follows: , = + + + + + + ∑ , , + , (4), where listt is a dichotomous variable that is 1 if the company was listed in the sustainability yearbook at year t; contt is a dichotomous variable that is 1 if the company was listed in the yearbook for at least two consecutive years; and delistt is a dichotomous variable that is 1 if the company was dropped from the yearbook. definitions of the remaining variables are the same as equation 3. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 21 table 6. regression of change in socially responsible status on firm resilience and risk fr-s fr-c fr-e fr-p tr ir list -0.81*** -0.71*** -0.77*** -0.85*** -1.71*** -0.075*** (-2.44) (-2.71) (-2.85) (-2.21) (-2.48) (-2.33) maintain -0.65*** -0.53*** -0.62*** -0.79*** -1.52** -0.055** (-3.01) (-2.61) (-2.35) (-2.11) (-1.90) (-1.85) delist 0.11** -0.21* 0.25*** 0.31** 0.67** 0.042* (1.85) (-1.65) (2.01) (1.89) (1.92) (1.70) djsi -0.32 -0.65 -0.36 0.41* -1.22* 0.021* (-0.76) (-0.61) (-0.53) (1.71) (-1.79) (1.68) mkt 0.65 0.43 0.25 0.78* 0.99* 0.051* (0.81) (0.76) (0.61) (1.65) (1.77) (1.81) cv yes yes yes yes yes yes r2 0.2581 0.2375 0.1961 0.2103 0.1638 0.1748 this table reports the estimates of coefficients of equation 4. the dependent variables are firm resilience – sales revenue (fr-s); cost of goods sold (fr-c); operating expenses (fr-e); share price (fr-p); total risk (tr) and idiosyncratic risk (ir). djsi is the excess returns on the dow jones sustainability index; mkt is the excess return on the main stock exchange of the country; and cv are the firm-level control variables (see section 3.3). all variables have been winsorized at the bottom and top 1% levels. robust t-statistics are in parentheses. ***, **, and * indicate statistical significance at the 1, 5 and 10% levels. in table 6, we can see a distinct difference in the effects a company’s status in the sustainability yearbook has on firm resilience and risk. companies that were listed in the yearbook either for the first time or were re-listed following a delisting experienced greater firm resilience and lower firm risk in the year after listing. the same effect can also be observed for companies that maintained their positions in the yearbook. we can however see that newly listed or relisted companies recorded greater firm resilience and lower firm risk as compared to companies that were continuously listed. in contrast, companies that were delisted from the yearbook saw lower firm resilience and greater firm risk in the following year. re-estimating equation 4 using the sc sample yields the coefficient estimates in table 7. companies that were newly listed or re-listed as shariah-compliant exhibited greater firm resilience and lower risk in the following year. companies that were continuously shariah-compliant for at least two years (i.e. “maintain”) exhibited similar traits but as was seen in table 6, those that were newly listed or re-listed displayed a much stronger effect that those that maintained their status. on the other hand, those that were delisted saw lower firm resilience and greater risk in the following year. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 22 table 7. regression of change in shariah-compliant status on firm resilience and risk fr-s fr-c fr-e fr-p tr ir list -1.04*** -0.98*** -0.85*** -0.45*** -1.21*** -0.078*** (-2.94) (-3.22) (-2.58) (-2.32) (-3.63) (-2.88) maintain -0.87*** -0.76** -0.68*** -0.51** -1.05** -0.077*** (-3.45) (-1.93) (-3.05) (-1.89) (-1.81) (-2.71) delist 1.13** 0.88** 0.76** 0.58*** 1.31*** 0.078* (1.89) (1.81) (1.76) (3.11) (2.71) (1.58) djimi 0.83* 0.78 0.90 0.65* 0.85* 0.072* (1.65) (0.99) (1.13) (1.66) (1.70) (1.67) mkt 0.91 0.78 0.44 0.65** 1.33* 0.044 (0.11) (1.16) (1.02) (1.81) (1.71) (0.88) cv yes yes yes yes yes yes r2 0.2015 0.2120 0.2089 0.2101 0.1788 0.1811 this table reports the estimates of coefficients of equation 4. the dependent variables are firm resilience – sales revenue (fr-s); cost of goods sold (fr-c); operating expenses (fr-e); share price (fr-p); total risk (tr) and idiosyncratic risk (ir). djimi is the excess returns on the dow jones islamic market index; mkt is the excess return on the main stock exchange of the country; and cv are the firm-level control variables (see section 3.3). all variables have been winsorized at the bottom and top 1% levels. robust t-statistics are in parentheses. ***, **, and * indicate statistical significance at the 1, 5 and 10% levels. from the observations in tables 6 and 7, it would seem that the company’s status as socially responsible or shariah-compliant has an observable impact on its resilience and levels of risk. but far from being a simple direct relationship between status and resilience/risk, it would have been the result of the company’s (in)actions towards acquiring said status that would also have had an impact on its resilience and risk. for example, companies that seek to be shariah-compliant are restricted to only a few industries that do not incite controversy. as they attract less negative attention, their reputation and credibility in eyes of their various stakeholders are better protected, providing greater stability whilst possibly attracting goodwill in the process the restrictions on the amount of risky instruments it may hold such as debt or interest-earning assets meanwhile, lessens the impact of negative market-level shocks on the company thereby lowering firm risk. socially responsible companies go through a similar process. the social responsibility initiatives they undertake culminate in the awarding of the socially responsible status. prior studies on csr agree that although the impact each initiative (economic, social, environmental) has on the company is widely divergent (see for example bird et al., 2011; muhammad et al., 2013), csr results in greater stability and lower risks. what the findings above imply is the argument that there is an ‘islamization’ of cultures especially in the west is unfounded, given the profound similarities between the principles and practices of islamic and western ethical philosophy. the attack on halal industries have likewise, been unfair because as the findings above show, there is no observable difference in asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org 23 the impact shariah-compliance or social responsibility has on companies. as the literature has suggested, many parallels can be drawn between islamic principles and the western ‘ideals’ of ethics and morality. the new wave of socio-politics that have driven a divide between muslims and non-muslims are merely fought on ideological grounds. as far as businesses go, this study shows that the alleged ‘concerns’ raised by political opportunists and other members of the public playing devil’s advocate are merely tools to gain political leverage and have no basis in fact. rather than simply being a study on ideological differences, the findings of this study also paves the way for better cooperation and integration in the practice of social responsibility and shariah-compliance. currently, the greatest obstacle faced by regulators with regards to shariah-compliance assessment is the lack of consensus on the criteria used (derigs and marzban, 2008). institutions such as robeco sam meanwhile have successfully created and implemented an objective and consistent method of assessing a company’s corporate social responsibility performance. by providing evidence that the effects of shariah-compliance or social responsibility on companies are similar, regulators can begin to draft more objective and consistent methods of assessing shariah-compliance that can be practiced universally. although shariah-compliance is a binary condition, this study also provides an opportunity for future research to develop a performance scorecard for shariah-compliance much like what robecosam has done with its annual csa. an adaptation of the csa, the scorecard would highlight aspects of the company that has been compliant as well as areas that need improvement which would then be published in the form of an annual report. dissemination of such information fosters a greater understanding of islamic teachings and lends credibility to the arguments made proponents of shariah-compliance, leading to the cessation of unfair attacks on halal industries. 5. conclusion despite what is reported, islamic ethics shares many parallels with those that many western civilizations have come to accept. although this is not the first time these parallels have been drawn, this study is the first to test these claims empirically. a common yardstick for business ethics and morality in recent years has been a company’s commitment to social and environmental responsibility. while there is as yet no islamic equivalent, shariah-compliance is a reasonable approximation since its qualifying criteria are based on the principles set within the quran and prescribed by the sunnah. by comparing the effects practice of these two seemingly different ethical schools of thought, this study provides the empirical evidence to show that where business ethics, islamic or otherwise is concerned, they are both 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(2002). interest free islamic banking: ideals and reality. international journal of finance, 14, 2428–2442. copyright disclaimer copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/3.0/). microsoft word 17092-60677-1-sm (1)-writer2-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 178 the role of gold prices and interest rate in stock index: insights from vietnam by using the autoregressive distributed lag approach le thi minh huong (corresponding author) school of economics, huazhong university of science and technology department of economics, danang university of architecture luoyu road 1037, wuhan, hubei, china tel: 86-131-6462-3203 e-mail: huongltm@dau.edu.vn phan minh trung school of economics, huazhong university of science and technology school of hospitality & tourism, hue university, vietnam luoyu road 1037, wuhan, hubei, china tel: 86-156-2327-1931 e-mail: minhtrung_233@yahoo.com received: march 1, 2020 accepted: may 7, 2020 published: june 16, 2020 doi:10.5296/ajfa.v12i1.17092 url: https://doi.org/10.5296/ajfa.v12i1.17092 abstract this study aimed to determine the impact of domestic gold prices, interest rates in the stock market index (vni) in vietnam for the period of january 2009 to december 2018. this study employed the autoregressive distributed lag (ardl) to check the association of independent variable gold prices and the interest rate on the dependent variable stock market index. the results show a close correlation together in the long-run. the vietnam stock index is adversely affected by fluctuations in the credit market in the short-run. we observed that domestic gold prices and interest rates have one-way causal relations to the stock price index. similarly, interest rates were causal for gold prices and still not yet had any particular direction. the adjustment in the short-run moves the long-run equilibrium, although the change is quite slow. keywords: autoregressive distributed lag, domestic gold price, interest rate, vni stock index asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 179 1. introduction the capital flow in the financial market will shift from a place with a high percentage of return to an area with a lower return rate according to the general principle such as currency, gold, or securities. the efficient market hypothesis proposes that not one person can get the better of the stock market. it means that investors capture all new information through the market (fama, 1970). we consider the efficient-market hypothesis when it is simultaneously effective in all three aspects, including distribution, operations, and information. vietnam's economy is now considered an emerging economy due to the characteristics of the socialist-oriented market economy. after 20 years of service in vietnam, the scale of the stock market has increased in volume, but the range is still quite small. the price fluctuation of the different investment channels has an evident influence. this impact comes from many factors of including the most recent critical factors such as interest rate and price fluctuations. the interest rate has a significant role in the control of the monetary market. it can affect the whole economy, especially the operation of commercial banks and the decision of investors on the stock market. since ancient times, people considered gold with investment role and risk prevention. recently in asia, vietnam has the highest period of inflation. therefore, vietnamese people like to buy gold for hoarding as an anti-inflation tool because the domestic currency has depreciated a lot, and gold is the safest haven. to manage the local gold market, saigon jewelry company limited (sjc) gold brand became an only gold brand and under the management of the state. the impact on the domestic gold activities and psychology of investors in the sjc gold market also significantly affected the stock market. so far, many empirical researchers have examined the connection between financial components and the stock index. in particular, factors include consumption price index, money supply m2, economic growth rate, etc. (mukherjee & naka, 1995); (cong, wei, jiao, & fan, 2008); (chang & su, 2010); (yang, kim, kim, & ryu, 2018); (wei, qin, li, zhu, & wei, 2019); (kaur & singh, 2019). however, the study only focuses on the gold prices at the domestic level and interest rate on the stock market, i.e. (chang & su, 2010); (kumar & narayan, 2010); (trung & vinh, 2011); (vinh, 2014); (luu, pham, & pham, 2016). therefore, due to its important role in exploring the plan about the interaction of the interest rate, gold price, and vn index in the emerging economy of vietnam. the objective of this study is to determine the role of domestic gold prices, interest rates in the stock market index (vni) in vietnam. we limit the scope from january 2009 to december 2018 (after the global economic crisis) by using the autoregressive distributed lag (ardl) approach as used in recent studies (chittedi, 2012); (gokmenoglu, 2015); (arfaoui, 2016); (khai, sang, thi, & nguyet, 2017); (tursoy & faisal, 2017); (le, 2018). this approach of ardl is significant because recent studies prove that it is quite a suitable model for analyzing the relationship between economic factors. the further study consists of a short review of the literature and the relationship of variables on a theoretical basis. the following section includes sample data and estimation; the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 180 methodology discusses implemented methods along with a demonstration of experimental results from the model. in the final one, we conclude this study with significant policy implications. 2. literature review 2.1 relationship between the gold price and stock index stocks and gold are two alternative investment channels, or simultaneously gold and securities, to seek profitable opportunities. in this aspect, when the stock price rises, investors will have many opportunities to profit on the stock market, decreasing investment in gold. however, we should note two things from the above comments. (i) never securities and gold are entirely substitutes for each other. this implies that even if stock prices are attractive, there are some investors who only often investment in gold; (ii) like stocks, gold is a vital investment channel in the financial market. the bustle in this investment activity will create excitement for them to invest in other activities. in southeast asia, countries with emerging economies include vietnam, thailand, indonesia, malaysia, philippine, and india reported by the (mishra, das, and mishra, 2010) research, which demonstrates that in vietnamese and philippine stock markets, gold and securities are interchangeable assets. meanwhile, it is just an additional investment channel for the stock market of some developing countries, such as thailand, malaysia, and indonesia. the study has investigated the role of gold by using granger causality from january 1991 to december 2009. india's gold and securities prices had correlated positively and had short-run relationships along with a coherent long-run co-correlation. in contrast to the above study, in the us stock market, between 1991 and 2001, with four gold price indexes and six stock indexes, (smith, 2001) presented the small and negative correlation in the short-run. between variables in the long-run, there is no cointegration, along with the granger causality test illustrates that gold prices and stock indexes have no direct relationship. when studying at the vietnam stock market, (vinh, 2014) evaluated us stock index s & p 500, domestic gold price, exchange rate, and the crude oil price from the global financial crisis. research has shown that gold prices are co-integration in long-run relationships only after the crisis period. (nguyen, bhatti, komorníková, and komorník, 2016) reported on the role of risk prevention on the stock market and stated that people often use gold as a top priority asset after studying for 12 years from 1999 to 2010. they confirm that gold is a safe storage asset for stock markets in singapore, thailand, england, and the us, except for japan, indonesia, and the philippines. the authors used a mixed-copulas method to study the role of the gold market, affecting the stock market, thereby assessing the market's risk level. (hood and malik, 2013) used the garch model from the year of 1995 to the year 2010 on the american stock market and shows that gold is an excellent safety prevention tool and acts as a shelter. in the united states stock exchange that the study considers, the writer stressed that in the period of extremely low or extremely high volatility, the gold price did not fluctuate in the opposite direction to the stock price. also, with the aim of research on the role of gold in the stock market, analysis by asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 181 (gürgün and ünalmıs, 2014) investigated the demand for developing and emerging economies. the results presented that gold still has a real meaning in shelter and investment in most countries, even during the world economic crisis period. 2.2 relationship between the interest rate and stock index interest rates often have the opposite effect with some economic factors, especially on stock indexes. for example, a rise in interest rates will attract a flow of money into the banking system or invest in government bonds because of increasing profitability, making cash flow into the stock market low, and vice versa. besides, when the lending rate increases, it will limit the cash flow into the stock market because the investment cost will increase, and the expected profit will increase. another possibility is the rising interest rates might also affect the cost of the capital used by businesses, reducing the predicted cash flow in the future of companies, which will affect the price of securities. a study (mukherjee and naka, 1995) showed that government bond rates affected the nominal risk-free rate. then, it also affects the discount rate and the stock market. another study has shown that when interest rates rise or fall in a particular direction, cash flow into the stock market will increase or decrease (brown k. & c., 2000). cointegration testing using the ardl model and vecm technique is by (akbar, rauf, and chaudhry, 2019) to study the pakistan stock market from 1992 to 2012. the model consists of 7 independent variables: tax, inflation, money supply, exchange rate, total domestic savings, the gross domestic product, and nominal interest rates. specifically, interest rates have positive effects in the current month but have adverse effects on the next month in pakistan's stock market. with panel data, the research described the long-run negative impact of interest rates on stock markets in 7 selected countries in africa sarahan from 1990 to 2003 (balogun, dahalan, & hassan, 2016). the long-run relationship studied in turkey from 1998 to 2012 by the johansen cointegration test (toraman, 2014). however, in some other studies, there is no mutual relationship of interest rate with the stock market, or not statistically significant when conducting regression model analysis. the author analyzed the association of eight macroeconomic factors with the islam stocks in pakistan (hanif & bhatti, 2019). industrial production and the stock market have a positive correlation. the result is similar to the money supply factor. at the same time, the gold price also has a negligible effect on the domestic stock index during the research period from july 2011 to october 2016. another study also concluded the same results (cooper & lee chuin howe maysamihamzah, 2004) in the arab market, it is generally not by a normal distribution, so the ardl model research method is implemented at jordanian by (mohamed & ahmed, 2014). in this model, the authors used annual data of 218 companies from 1976 to 2016, using six essential macroeconomic factors. the result of this study showed that the market is statistically insignificant when considering the short-run and long-run relationship with the stock index. vietnam as an emerging economy, one of the studies developed by (hussainey and khanh ngoc, 2009), provided evidence of factors such as domestic manufacturing, money market, and stock index have a close relationship. in particular, the author stressed the foundation of us economic components that significantly impacted the vietnam stock index. however, from 2001 to 2008, between interest rates and the stock market, the author didn't find short-run and long-run relationships. with current studies, we still do not have a clear answer about interest asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 182 rates versus the stock index. acquiring past results and continuing to apply to the vietnam stock market by finding the gap left by previous studies, this study is an effort to overcome. 3. data and methodology 3.1 data before conducting the analysis, we determined some descriptions of the variables of the gold price, interest rate, and stock index. study in vietnam for ten years with monthly data of time series 120 observations from january 2009 to december 2018. table 1. explain the variables used in the ardl model variables unit symbol concept domestic gold price million vnd / tael sjc sjc is a national gold brand at vietnam, data collected is the close price on the last trading day every month at the sjc jewelry company stock price index point vni vni is the most popular index in vietnam; data collected is the close price on the last trading day every month at vietnam stock market interest rate % ir ir is the refinancing rate; data collected the central bank in vietnam. monthly data was used because of the high consistency between the number of variables when applying the analytical model and further to make sure the update and timeliness of time series data. the daily data of variables do not have a uniform number of trading days in a year, nor does it coincide with the trading day of the sjc jewelry company, the central bank, and the vietnam stock market. variables changed in natural logarithms before being used to make the data smoother, decrease the high dispersion, or having some variable with extraordinary observations. this study used logarithmic data from the sjc gold price, vni stock index, and interest rate helps facilitate the identification and analysis of data. 3.2 research methodology the study uses a quantitative method with a model approach to the ardl model with the monthly time series. the research order is done in turn as follows: first, adf and pp test methods define the stationary of the time series. tests include constants that do not tend at i (0) and i (1) of variables. to determine the stationary level of variables, ensure that there are no stationary variables at the second difference when applying the ardl regression model. step two, we will define the ardl model with the suggestion by (pesaran & shinb, 1996). according to (pesaran, 1997). ardl model has many advantages compared to other cointegration methods for many reasons. when the number of observations is small, the ardl asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 183 model is a significant approach to verify cointegration. meanwhile, johansen's co-bonding technique requires a large number of samples to achieve reliability. the ardl method does not estimate the system of equations when looking for long-run relationships; in this case, it only gives a single comparison. besides, regression variables can tolerate different optimization lag, as well as when the data does not guarantee the properties of the stationary, with time-series i(1) or i(0), the application of ardl is most suitable for empirical research. through aic, sc, hqic test standards, we will find the optimal ardl model. ardl model (p0, p1, p2) has the form; lvnit = α + ∑ 𝛼 𝐿𝑉𝑁𝐼 + ∑ 𝛼 𝐿𝑆𝐽𝐶 + ∑ 𝛼 𝐿𝐼𝑅 + ε1t (1) where: lvni, lsjc, and lir are by natural logarithms of vni, sjc, and ir, p0, p1, p2 are the optimal lag selected, α: is the constant of the model. αi0, αj1, αk2, are coefficients with a defined time lag. ε1t is a free error of the equation (1). step three, bound tests is determined based on f-statistics coefficients to detect the cointegration of variables, that also means that, consider the long-run relationship of research variables. ∆lvnit =β+∑ 𝛽 ∆𝐿𝑉𝑁𝐼 + ∑ 𝛽 ∆𝐿𝑆𝐽𝐶 + ∑ 𝛽 ∆𝐿𝐼𝑅 + 𝛾 𝐿𝑉𝑁𝐼 + 𝛾 𝐿𝑆𝐽𝐶 + 𝛾 𝐿𝐼𝑅 + ε2t (2) where: ∆: this is the first difference between the variables. β is the constant of the model. βi0, βj1, βk2, are coefficients with defined time lags. ε2 is a free error of the equation (2). the model has no co-integration if; γ_1 = γ_2 = γ_3 = 0 ardl model is essential for the development of the vector autoregressive model (var) and the least-squares regression model (ols). therefore, after determining the cointegration of variables, the study will conduct regression to determine the long-run relationship in the original data with the selected dependent variable. step four; via granger causality, we conduct to check the short-run relationship. besides, the speed of the adjustments will measure by the error correction model. this will explain shortrun shock will affect long-run values. ∆lvnit = µ + ∑ µ ∆𝐿𝑉𝑁𝐼 + ∑ µ ∆𝐿𝑆𝐽𝐶 + ∑ µ ∆𝐿𝐼𝑅 + 𝛿ecmt-1 + ε3t (3) where: µ: is the constant of the model. µi0, µj1, µk2, are coefficients with defined time lags. ε3t is a free error of the equation (3). the ecm error correction part is the residual of the model longrun regression results of ardl that has done it before. δ is the coefficient of ecm. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 184 finally, we apply breusch godfery langrage multiplier (lm) test and white's test to investigate the certainty of ardl, the model, undergoes diagnostic tests, including serial correlation and the heteroscedasticity of the residual model. the graphs with cusum and cusumsq simulate the stability of the ardl estimation model. 4. results 4.1 verify the stationary the requirement when analyzing time series is that the strings must be stationary. the test of stationary by the unit test from 2 different methods, but all showed quite similar results. table 2. verify the stationary by unit root test note: ***, ** symbol * corresponds to 1%, 5%, 10% meaning table 2 indicates the stationary of time series data by the unit root test approach; at there, lvni and lir are stationary at the first difference, and lsjc alone is stationary at level 0. according to (pesaran & shinb, 1996), (mehrara & musai, 2011), the variables are not the same as the level i(1) or i(0), then the ardl procedure is most suitable for empirical research. 4.2 the optimal lag of the ardl model the model selection comes from optimal lag applying by the ardl model. in that case, the model selects itself according to standards of aic, sc, and hannan-quinn information (hq). the results are consistent with the most standards determined the optimal lag. the chosen optimal model is the ardl (1, 0, 2) model. this result shows that the vni index will fluctuate its price from the previous month. besides, it will be influenced by the current gold price variable and the interest rate variable in the last two months. variable standard: adf standard: pp conclusion i(0) i(1) i(0) i(1) lvni -1.570009 -10.00975*** -1.663736 -10.07165*** i(1) lsjc -3.318524** -3.066182** -3.764007*** -9.883701*** i(0) lir -2.421778 -5.746777*** -1.532341 -9.839243*** i(1) asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 185 figure 1. chart of ardl model selection the ardl model represented as follows: table 3. ardl model (1, 0, 2) variable coefficient std. error t-statistic prob.* lvni(-1) 0.933047 0.026647 35.01527 0.0000*** lsjc -0.023876 0.040501 -0.589528 0.5567 lir -0.180622 0.084209 -2.144924 0.0341** lir(-1) -0.112404 0.124996 -0.899258 0.3704 lir(-2) 0.229113 0.087781 2.610053 0.0103** c 0.813177 0.322225 2.523628 0.0130** note: ***, ** symbol * corresponds to 1%, 5%, 10% meaning 4.3 verification of cointegration with bound test test the bound of the ardl method with results as follows: table 4. verification of cointegration with bound analysis f-bounds test null hypothesis: no levels relationship results cusum test f-statistic value significant i(0) i(1) dependent variable asymptotic: n=1000 lvni 5.329543 10% 3.17 4.14 cointegration stable lsjc 7.775785 5% 3.79 4.85 co-integration not stable lir 2.907628 2.5% 4.41 5.52 no cointegration not stable 1% 5.15 6.36 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 186 table 5. ardl model (1, 0, 2) when considering co-integration relationships dependent variable: d(lvni) variable coefficient std. error t-statistic prob. d(lvni(-1)) 0.082720 0.093967 0.880312 0.3806 d(lsjc) 0.088235 0.175457 0.502886 0.6161 d(lir) -0.205555 0.091000 -2.258837 0.0259** d(lir(-1)) -0.225874 0.092788 -2.434287 0.0166** d(lir(-2)) 0.089727 0.099259 0.903974 0.3680 lvni(-1) -0.067289 0.028072 -2.397001 0.0182** lsjc(-1) 0.002833 0.044742 0.063309 0.9496 lir(-1) -0.073825 0.035526 -2.078082 0.0401** c 0.554003 0.366969 1.509674 0.1340 note: ***, ** symbol * corresponds to 1%, 5%, 10% meaning test hypotheses:  hypothesis h0: γ_1 = γ_2 = γ_3 = 0: no co-integration relationship exists between variables;  hypothesis h1: γ_1 ≠ 0, γ_2 ≠ 0, γ_3 ≠ 0: exists the co-integration relationship between the variables. the results of the bound test with the statistical valuef is higher than the upper bound limit value (i (1)) corresponding to the 1%, 2.5%, 5%, 10% significance level. that means, the coefficients are all different from 0. so we can reject the null hypothesis, or accept hypothesis h1. then there exists a cointegration relationship between the variables. in this case, we can say that a long-run relationship between variables in the model. the result of table 4 in the cointegration test illustrates that when we chose the vni stock price index or the sjc gold price index as the dependent variables. at that time, models have cointegration, meaning that a long-run relationship between vni and sjc with the other two variables existed. however, when using the cusum test to check the stability of the model, the study showed that selecting vni as the dependent variable is more optimal. also, results with the gold price make the dependent variable insignificant. this confirms that the choice of the model with the vni stock index variable as a dependent variable is perfectly reasonable to carry out further tests. 4.4 the long-run relationship between variables the results from table 6 tell us the dependence of stock index on the sjc gold price and interest rate. specifically, when we see other factors unchanged, if the price of gold rose 1%, the vni stock price will increase by 0.82%. we can explain easily on the market in vietnam; investors still consider gold as a reserve, a type of asset people use in many commercial transactions and real estate investment. therefore, when the economic growth rate increases, the stock market is active, people have the psychology of storing gold. then, the demand of people for gold to rise, the sjc price will fluctuate in the same way with the vni index. the interest rate has asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 187 a negative impact and statistically significant. this indicates when other factors remain unchanged, vni will decrease by 0.88% if the interest rate increases by 1%. table 6. long-run relationship between variables variable coefficient std. error t-statistic prob. lsjc 0.827755 0.107554 7.696141 0.0000 lir -0.886040 0.078865 -11.23493 0.0000 c -0.536467 1.053714 -0.509120 0.6116 note: ***, ** symbol * corresponds to 1%, 5%, 10% meaning 4.5 short-run relationship and error correction model after defining the long-run relationship of sjc gold price, interest rate, and the vni stock index (this is a temporary relationship at the time of the study), we continue to consider the short-run relationship of ardl model. the vni and the fluctuation of interest rates in the previous period of 1 month affected itself instability, not by the sjc gold price. because of cointegration, the ardl model is used to determine, considering the residual correction when t-1 lags into the model. the residual variable is defined based on the regression model of a long-run variable table 7. error correction model variable coefficient std. error t-statistic prob. c 0.813177 0.199117 4.083908 0.0001 d(lir) -0.180622 0.082507 -2.189181 0.0307 d(lir(-1)) -0.229113 0.084211 -2.720722 0.0076 ecm(-1)* -0.066953 0.016597 -4.034122 0.0001 note: ***, ** symbol * corresponds to 1%, 5%, 10% meaning the results from table 7 show in the short-run the relationship of the factors affecting the stock index as follows: ecm (-1) = -0.066953 indicates that the price fluctuation of the vni stock index is about 0.066953. this is the difference in the short-run and long-run. the sign of the ecm coefficient is negative and statistically significant at 1%. the above result implies a cointegration relationship between variables, as observed earlier, according to previous studies (engle & granger, 1987). this proves that shocks, or short-run fluctuations, will affect stock prices and take about 15 months for short-run corrections to achieve long-run equilibrium, a slow correction. 4.6 granger causality relationship between variables once again, we test the interplay of variables in the short-run model. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 188 table 8. granger causality test ho: f-statistic prob. conclusion obs lsjc does not granger cause lvni 2.47535 0.0887* reject ho 118 lvni does not granger cause lsjc 0.44565 0.6415 accept ho lir does not granger cause lvni 10.4626 7.e-05*** reject ho lvni does not granger cause lir 1.16173 0.3167 accept ho lir does not granger cause lsjc 5.55787 0.0050*** reject ho lsjc does not granger cause lir 1.17313 0.3131 accept ho note: ***, ** symbol * corresponds to 1%, 5%, 10% meaning table 8 shows the causal relationship of the variables, the sjc gold price the vni stock index has a positive causal effect. however, the impact is quite weak, with a 10% significance level. in particular, the inspection reveals that the strong impact of the interest rate on vni with the meaning 1% level. the sjc gold price is affected by interest rate at the 1% level. 4.7 diagnostic test carrying out diagnostics for ecm is to simulate the stability of the model and to approve the effectiveness of using the ardl approach. the results from figure 2 and figure 3 illustrate that the selected model has quite good stability. figure 2. diagnostic test for the stability of the model asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 189 figure 3: diagnostic test for the stability of the model after adjustment table 9. diagnostic tests from model breusch-godfrey serial correlation lm test: result conclusion f-statistic 1.407241 prob. f(2,110) 0.2492 accept ho no serial correlation obs*r-squared 2.943851 prob. chisquare(2) 0.2295 h0: that there is no serial correlation h1: there is a serial correlation heteroscedasticity test: white f-statistic 1.418738 prob. f(20,97) 0.1322 accept ho no heteroscedasticity obs*r-squared 26.70571 prob. chisquare(20) 0.1437 scaled explained ss 20.34172 prob. chisquare(20) 0.4367 h0: there is no heteroscedasticity (constant variance) h1: there is heteroscedasticity although in 2017, 2018, lines fluctuate from the 5% significance level, but not much. after using the adjustment model in squared form, the oscillation line has shown quite well. table 9 means that the correlation test of the serial and the heteroscedasticity also satisfy the requirements. the appropriateness of the model is 5% significant. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 190 5. conclusion the study has shown that the data series is stationary at the level i (0) or the first difference i (1), which means no time series of data is stationary at the second difference. this is perfectly suitable for conducting the ardl model in the analysis. the bound test has shown the longrun relationship between variables. the sjc gold price has the same direction in the long-run and has no short-run impact on the vni stock index. the results are contrary to some previous studies (do, mcaleer, and sriboonchitta, 2009). in real life, the gold market in vietnam still looses, not strictly managed. vietnam chose the sjc gold as the national gold brand since 2012, as well as no gold trading floor, and the sjc gold price is strongly affected by the crude gold price in the world. the interest rate variable has a negative impact both in the short and long-run on the vni stock index. the variability of the stock price index has an inverse correlation with the variation of interest rates in the previous month. this result is also exact while testing by short-run causality granger. this is consistent with past research results (balogun et al., 2016) in sahara african countries. the error correction model has obtained results consistent with the theoretical basis in the adjustment of equilibrium. specifically, the results also indicate that the expected adjustment rate of the vni stock price index converges to long-run equilibrium is very slow, about one year (i.e., adjust 6.6953%/month to reach the balanced state in the long-run). some of the study's findings have also filled a gap of previous studies considering the selection of data series of 10 years after the global economic crisis up to now, supplementing the research in the vietnam stock market with the data series before 2009 (hussainey & khanh ngoc, 2009). this study considers the gold price as an independent variable, along with the collection of the sjc domestic gold prices instead of the world gold price according to research by (vinh, 2014) which is more practical when assessing the vietnam market. a comprehensive look at the impact aspects of variables to find the right model in the analysis using the ardl model approach makes research more objective. to expand for further study on the relationship of gold prices, interest rates, and stock indexes, we need to add some other factors to the model, such as investor psychology, exchange rate, world gold price, economic development speed, etc. further, the analysis can also use different approaches to enrich the study, such as the var model, the garch model, and so on. acknowledgments i would like to express my sincere gratitude to the danang university of architecture science and technology research department. this university provides time and funds for me to study better in my studies. at the same time, i would like to thank the instructors and colleagues at huazhong university of science and technology. they have helped me to have good ideas for me to complete this article. references akbar, m. i., rauf, a., & chaudhry, a. f. 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(2018). macroeconomic shocks and stock market returns the case of korea. applied economics, 50(7), 757–773. https://doi.org/10.1080/00036846.2017.1340574 copyrights copyright for this article is retained by the author(s), with first publication rights granted to the journal. this is an open-access article distributed under the terms and conditions of the creative commons attribution license (http://creativecommons.org/licenses/by/4.0/) microsoft word 14866-53743-1-sm(1)-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 307 ajfa.macrothink.org does nifty index inclusion (still) convey information? a comprehensive empirical examination in the indian stock market dr srikanth parthasarathy associate professor rajalakshmi school of business, chennai-600124 tel: 98-8480-6248 email: psrikanth2011@gmail.com received: jan. 9, 2019 accepted: feb. 24, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14866 url: https://doi.org/10.5296/ajfa.v11i1.14866 abstract the objective of this study is to conduct a comprehensive empirical examination of the s&p cnx nifty index additions, for the complete period (2000 2018), first sub period (2000-2009) and second sub period (2010-2018), using both the price and non-price effects and the explanations surrounding them in the indian stock market. this event methodology is used with three abnormal return computational methods, around the announcement and inclusion dates of index addition, in order to improve the robustness and reliability of the results. the results show that the nifty index additions are associated with significant permanent abnormal returns in the complete, first and second period. however, the index effect has diminished in the second period. the information related explanations dominate in the complete and first period. the second period finds support for the downward sloping demand curve hypothesis. i extend the existing literature to a hitherto unexplored new sample period (2010-2018) in order to examine the price and non-price effects around nifty index additions. keywords: india, financial markets, index inclusions, nifty index, demand curves asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 308 ajfa.macrothink.org 1. introduction the index inclusion effects have fascinated researchers and the price effects are well documented since 1986 in developed economies and since 2000 in the emerging economies. the earlier research focused mainly on the price effects, however, the recent research have additionally considered the non-price attributes like liquidity, information and other attributes. the index inclusion effect is interesting, as apparently the index inclusion is an information free event because the decision to include stocks into index is made using publicly available information. if information content is not the primary explanation, it provides a perfect setting to examine whether stocks have horizontal demand curves. this has important implications as one of the key assumptions in finance theory is the horizontal demand curve in which investors can buy and sell stocks without affecting the price. the two pillars of modern finance, the modigliani miller theorem (mm) (modigliani and miller, 1958) and the capital asset pricing models (capm) (sharpe, 1964) predict horizontal demand curves for stocks. the home leverage explanation of mm and efficient market hypothesis (emh), the foundation stone of capm, assume horizontal demand curves for stocks. if stocks have long term downward sloping demand curve (dsdc hypothesis), the added stocks face increased demand and buying pressure which cannot be satisfied without a shift in the demand curve, as stocks are not perfect substitutes. then the price effects following index additions should be permanent as evidenced by shleifer (1986), lynch and mendenhall (1987) and wurgler and zhuravskya (2002). the short run downward sloping curve implies that the price effects are due to the short term demand of the index funds tracking the index. the stock prices will revert back to its original level once the index funds complete their portfolio rebalancing to track the index (price pressure hypothesis, pph). the evidence by harris and gurel (1986) and vespro (2006) is consistent with this hypothesis. the price effects following index additions, however, are also consistent with horizontal demand curves, if the price effects are due to increase in expected cash flow or due to reduction in the discount rate. the increase in expected cash flow can happen if index additions convey positive information about the prospects of the firm (certification hypothesis, jain (1987) and dhillon and johnson (1991)). next, investor awareness or greater interest in the stocks added to an index could be the reason for increase in expected cash flow if companies are forced to become more efficient due to increased monitoring by investors and analysts (denis et al. (2003) and chen et al. (2004). the decrease in discount rate can happen if liquidity improves post index addition. increased interest in index stocks may cause more efficient information production leading to reduced information asymmetry and consequently improved liquidity (amihud and mendelson (1986), chen et al. (2003) and hradzil et al. (2007)). emh asserts that all information, both public and private, is reflected in the stock prices quickly. the implication is that active portfolio management is useless, as it will be impossible to use the information to make consistent economic gains. the ascendancy of this paradigm caused a shift from the active to passive investment strategies like the index funds. consequently, this could lead to buying and selling pressure during index revisions leading to asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 309 ajfa.macrothink.org significant price effects. further, emh asserts that all public information will be quickly and correctly incorporated in the stock prices. hence, the index addition announcements, made with public available information, should not have any impact on the prices. even if we assume information content in index additions, the information should be quickly reflected in the prices. therefore, this empirical examination also has implications for the market efficiency in the indian stock market. these studies on index inclusion, providing clarity on the price and non-price effects, have important implications for both the investors, investment managers and corporate finance managers alike. further, the managers of companies can prioritise their choices and decision-making depending on its impact and importance. this study examines the price and trading volume changes in the nifty index constituents using a sample of 50 index additions for the complete period between april 2000 and march 2018. also, the full sample is further divided into sub periods namely, march 2000 to december 2009 and january 2010 to march 2018 in order to examine the price and trading volume changes in the sub periods and delineate the various explanations surrounding index additions in the subperiods. the objective of this study is to conduct a comprehensive empirical examination of the s&p cnx nifty index additions from 2000 to 2018 focusing on both the price and non-price effects and the explanations surrounding them. the article proceeds as follows, the next section reviews the literature so far and develops the hypothesis. the third section details the data and methodology. the fourth section reports and discusses the results of the comprehensive empirical investigation. the fifth section concludes. 2. literature review the prior research has evidenced significant price and non-price effects on the announcement day (ad) and the effective date of inclusion (ed). the explanations for those effects can be divided into two broad categories namely, information related theories and the demand related theories, based on the assumption of information content. shliefer (1986) and harris and gurel (1986) are the two pioneering studies which contributed to the basic research design, methodology and empirical techniques to analyse index addition and are used by the researchers till date. shleifer (1986) analysed s&p 500 additions for the 1976-1983 period and evidenced a permanent increase of 3% on the announcement day which persisted till at least 20 days after inclusion. shleifer (1986) found support for the dsdc hypothesis which was later supported by the lynch and mendenhall (1997) and wurgler and zhuravskaya (2002). harris and gurel (1986) examined the s&p 500 additions for the 1976-1983 period, evidenced a price increase to the tune of 3.13% post addition and documented a systematic reversal in support of price pressure hypothesis. elliot et al. (2006) analysing the s&p 500 additions and mase (2002) studying ftse 100 inclusions also found evidence in support of price pressure hypothesis. in the recent studies on the index revisions, hacibedel & bommel (2007), daya et al. (2012) and kamal (2014) found support for the information based theories. while vespro (2006), asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 310 ajfa.macrothink.org miller & ward (2015) and wang et al. (2015) found support for the price pressure hypothesis, cai and houge (2008) and fernandes and mergulhao (2016) found support for the dsdc hypothesis. a few studies in the developed markets have evidenced declining index effects in the recent period, soe and dash (2008), kamal (2014). the studies focusing on nifty index additions in the indian market is quite limited. the studies could be classified into two categories based on whether they evidence permanent effects or not. the studies evidencing lack of permanent effects are rahman and rajib (2014) analysed the price and volume effects of companies included and excluded for the nifty index during the 2008-2010 period, found evidence for short term effects for both the announcement day and inclusion day providing support to pph. kumar (2003) evidenced results similar to rahman and rajib (2014) findings. however, parthasarathy, s. (2010), examined the nifty index addition between 1999 and 2010, and evidenced permanent abnormal returns to the tune of 4.90%. but the evidence for permanent abnormal volume was limited. this study found support for information related explanations. chakrabarti et al (2005) studied additions to msci india standard index during the 1998-2000 period and evidenced permanent abnormal returns post announcement to the tune of 4.17 % and found support for the information based theories. the literature review brings out three important points; the empirical methodologies and varying explanation in such studies, the importance and continuing interest in index revision effects across the world and the conflicting evidence with regard to the price effects in the indian nifty additions. though the sample was more or less similar, as all the indian studies have predominantly studied the 1999-2009 period, the conflicting evidence and the varying explanations might be due to the choice of the methodology and the market index. this study intends to resolve this debate by conducting a comprehensive examination of the price and non-price effects in the 2000 -2009 period. this study also makes an important contribution by extending the literature to the hitherto unexplored recent period till 2018. to my best knowledge, no other study has examined the nifty index additions in the recent 2000 2018 period. this study is very important in india for many reasons. the indian equity market, one of the fastest growing economies in the world, will be the fifth largest in the world by the end of 2018, in terms of both traded value and market capitalization. this study also addresses the lack of comprehensive single country studies in the emerging markets similar to miller &ward (2015) and wang et al. (2015). the effects of unique regulatory environment, level of informational efficiency and liquidity can be understood by these studies. though, the price pressure hypothesis (predominantly due to the demand from index funds tracking the nifty index) predicts temporary abnormal price and volume effects, both around ad and ed, the ed makes more sense as index funds will know the exact weights of the added stocks in the nifty index around ed rather than ad. but if investors believe dsdc, imperfect substitutes and permanent abnormal returns, it makes sense for them to act at ad. similarly, if investors perceive index addition as indicators of future improved performance or becoming more efficient in incorporating information into prices, then the abnormal price asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 311 ajfa.macrothink.org effects should occur around ad. in this study, the complete period (2000 -2018) is divided into two sub periodsi; 2000 -2009 and 2010 -2018. if the nifty index additions price effects are due to increase in expected cash flow due to certification or investor awareness. this study predicts an increase in the shareholding of retail investors and institutions (other than mutual funds), post addition. if the index addition increases liquidity, thereby reducing the discount rate, this study predicts an association between liquidity and the permanent abnormal returns around ads for the complete period and the first sub period. the securities exchange board of india (sebi), since 2000, had initiated steps2 to improve investor protection, disclosure norms and corporate governance, which has also contributed to the growth of both cash and mutual fund segment, especially from 2009 to 2018. consequently, information asymmetry might be reduced, well before the stock becomes eligible for nifty index addition, especially in the later period. therefore, this study predicts that the dsdc hypothesis might be the dominant explanation for the permanent abnormal returns around ads in the second period. 3. data and methods 3.1 nifty information the national stock exchange (nse) is the largest stock exchange in india and was ranked tenth in the world in terms of domestic market capitalization in 20173. a total of 1938 companies are listed in the nse with an annual turnover of approximately us$ 1033 billion in 2017-2018 and market capitalisation of approximately us$ 2350 billion as on march 20184.aum in indian mutual fund industry increased fivefold from rs 4173 billion between march 2009 and march 2018. the growth in equity category in the same period was nearly seven times. further, midcap mutual funds have also grown exponentially in the same period. the nifty 50 index (nifty) is the flagship index of the nse tracking the portfolio of fifty large, liquid, blue chip companies and capturing approximately 63% of its equity market capitalization as on march, 2017.the nifty is owned and managed by nse indices ltd. the nifty index constituents are selected on the basis of market capitalisation, liquidity and industry representation. the index is normally reviewed twice a year with a notice period of six weeks. the stocks are normally removed due to corporate actions like restructuring or when the free float market capitalisation of the companies eligible for inclusion is at least 1.5 times the free float market capitalisation of the smallest constituent in the index. 3.2 sample selection the sample period begins on april 2000 and ends on march 2018 to coincide with the start of index funds in india and chosen market index. the daily data from the nse official website is used to calculate the return and volume of the added stocks and the market index. the data is adjusted for corporate actions like stock dividend and stock splits. during this sample period, 71 companies were added5 to the nifty index and from this original sample of added stocks, a ‘clean sample’ is constructed. as in chen et al (2003), wurgler and zhuvarskya (2002) and hradzil (2007), only clean additions that did not result from spin-off, mergers & asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 312 ajfa.macrothink.org acquisitions and name changes are considered reducing the sample to 60. in two cases, the added stocks are excluded, as they did not have at least three clear days between the announcement date and inclusion date reducing the sample to 58. apart from this, eight post-ipo stocks having less than one year trading history are also excluded to construct the ‘clean’ additions sample of 50 added stocks to avoid confounding effects. nse normally makes the announcement four weeks before the actual inclusion day. the number of days between announcement and inclusion varies between 7 and 33 with a mean of approx 25 days. appendix 1 lists the included companies with announcement and inclusion dates. 3.3 methodology this study uses an event study methodology of ‘brown and warner’ with two event dates for each sample; the announcement date of addition (ad) and effective date of addition (ed). as nse normally announces the nifty index revisions after trading hours, the following day or ad+1 is the actual announcement day. the appropriate choice for market index is the cnx 500 index (a 500 stock portfolio),as it captures approximately 90% of nse’s equity market capitalization. this provides independence between the market portfolio and the index under examination as in chakrabarti (2008). the choice of period of study (starting from 2000) is also due to the choice of cnx 500 as the market index and the daily data for this index is available only from june 1999. 3.3.1 cumulative abnormal returns in order to examine the index addition effect, this cumulative abnormal return (car) is calculated around the two event dates namely, ad and ed. according to kothari and warmer (2007), the difficulty of dealing with statistical and econometric inferences in event study methodology might weaken the robustness and reliability of the results. consequently, many alternative models of computing abnormal returns have been used in the extant literature. this study uses three abnormal return computational methods in this study. the first method of computing the abnormal return is subtracting the cnx 500 index return from the stock return. the car is then the aggregated abnormal return(ar)over the estimation period as the car represents the buy and hold return which makes sense to the investors. the daily return is the log return using closing price at time t and time t-1. mcar abnormal return arit = ritrmt, (1) where rit is the stock return and rmt is the cnx 500 index return on day ‘t’. the second model for calculating abnormal return in this study is the widely used ols market model where the expected return is calculated as  ,][ miii rere   (2) where, i and i are the model parameters and mr is the cnx 500 return and the estimation window starts 130 days before and ends 10 days (approximately 120 trading days) before the index addition ad. the abnormal return is, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 313 ajfa.macrothink.org ocarabnormal return  ,ˆˆ mtiiitit rrar   (3) the abnormal return calculated by the ols market model6has two key methodological problems in the context of index revision studies. lynch and mendenhall(1987) point out that abnormal return might be biased downwards, as stocks added to the index are likely to have performed well just prior to the addition and using the daily data to estimate the model parameters may produce upwardly biased alpha estimates especially when aggregated over time. the second methodological problem is the possible shift in beta, post addition. also, jain (1987) shows that stocks perform better in the pre-addition period and estimation of pre event alphas and betas might vitiate the abnormal return estimates. in order to overcome this bias, the market model for ‘high’ alpha7 stocks in this study is again estimated using returns from 370 to 251 days prior to announcement day (approximately 120 trading days) in the spirit of lynch and mendenhall (1987)8. thirdly, abnormal return is computed as the stock return minus the ‘control sample’ return (ccar) as in hradzil (2009). the stocks which are likely candidates for inclusion in the nifty index based on market capitalization are candidates for control sample in this study. normally, eligible stocks from another index, namely nifty junior index9 is added to the nifty index and the deleted stocks usually get included in the nifty junior index. the top three stocks other than the added stocks will be the control sample since they had been considered for addition to nifty index but are not included and will be the ideal candidates for the control sample. the ratio of control (eligible) stocks to added stocks is three to one. 3.3.2 abnormal volume the abnormal volume is calculated in the spirit of harris and gurel (1986) volume ratio (vr) = (vit / vmt) ÷ (vi / vm) (4) where vitandvmt are the trading volumes of the stock and the total nse respectively, and viandvm are the average trading volumes of the stock and total nse for the period ad-70 through ad-10. the daily vr is averaged across the various event windows and the volume ratio10should have a value of ‘one’ under null hypothesis. in any event window, the volume ratio (vr) should be significantly greater than one. 3.3.3 liquidity ratio the liquidity measure employed in this study is the ratio of daily rupee volume of the stock to the absolute stock return as in amihud (2002)11. this can be interpreted as the daily price response to one rupee of trading value and essentially capturing the price impact. liquidity ratio (lr) =volit/ │rit│÷ voli/│ ri│ (5) where rit is the daily stock return and volit is the daily rupee volume. ‘voli/│ ri│’is the average liquidity of the stock for the period ad-70 through ad-10.the liquidity ratio is averaged across the various event windows and if, in any event window, the average liquidity ratio is significantly greater than one, then it is said to be abnormal for that event window. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 314 ajfa.macrothink.org amihud (2002) has discussed the advantages of this measure and disadvantages of measures like rupee volume and turnover. lastly, prior researches have indicated that the methodological issue surrounding studies focusing on single event change like index addition could be exposed to biases in standard errors associated with date clustered event studies. this impact of the bias will be minimal for this study as on an average less than two stocks were added in the biannual revisions so far. also, there are 30 unique ads for the 50nifty additions over the 18 year period. 4. results and discussion: this section documents the nifty index addition premia around the announcement date (ad+1) and the effective inclusion day (ed). in order to analyse the abnormal returns and disentangle the various explanations surrounding the price changes, this study focuses on the following event windows in the spirit of lynch and mendenhall (1987): anticipation window (ad-10 to ad); announcement day (ad+1); run up window (ad+2 to ed-2); ed window (ed-1 to ed); release window (ed+1 to ed+3); long term window (ad+1 to ad+40 or ad40) and long term window (ad+1 to ad+60 or ad60). the car is considered permanent in this study, if it is permanent for at least 40 days from adin order to avoid the noise added by other events and news. 4.1 complete period 2000-2018 table 1 reports the mean, median and the fraction of added stocks with positive car for all the chosen event windows for the clean sample for the nifty index additions for the ‘complete’ period.for the complete period 20002018, table 1 reports a significant ad+1 abnormal return of 1.49% that persists not only for 40 days ( 3.50%, p-value < 0.1)but also for 60 days (4.19%, p-value < 0.05) from ad+1. the evidenced significant announcement day abnormal return is robust to alternate measures of abnormal return computational methods. consistent with the findings of chakrabarti et al. (2005) and hacibedel & bommel (2007), this study evidenced smaller index addition effect in india compared to the developed markets. the evidenced ad+1 return of 1.49% is comparatively smaller than that of the developed markets. also, the ad+1 abnormal return, for the added firms, is significantly larger than for the chosen control firms. the next important result, from table 1, is the abnormal return around the actual inclusion day return or effective day (ed). the added firms experience a statistically significant ed window mcar of 1.67% for the complete period. table 1 reports a partial price reversal to the tune of -1.5% suggesting more tests to examine the price pressure around ed. table 2 and table 3 present the abnormal volume (vr) results around ad and ed respectively. even though, the mean vr is greater than one for most of the days around ad and the event windows for the complete period, the median along with the fraction of stocks with vr > 1 suggest that the high volume outliers have skewed the results. the vr is significant only if the statistical significance suggested by the parametric t-test is confirmed by the non-parametric wilcoxon signed rank test. it is seen that the mean vr is not significantly greater than one at any reasonable level of significance for any event window asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 315 ajfa.macrothink.org ed and pressure release window for the complete period. the significant price effects without accompanying volume increase in the nifty index addition are different from those other studies in the developed markets beneish and whaley (1996),hegde and mcdermott (1988), chen et al. (2003) and hradzil (2009). 4.2 sub period results table 1 reports a significant ad+1 window12 abnormal return of 2.32% that persists not only for 40 days (5.06%, p-value < 0.05) but also for 60 days (6.28%, p-value < 0.05) from ad+1 for the first period. this result contradicts earlier studies in the indian stock market which have evidenced temporary abnormal returns, that too around ed only. the ocar and the adjusted ocar results for ad40 & ad60 permanent abnormal return for first period clearly show the dampening effect of high alpha stocks. these results suggest that the choice of market model for abnormal returns, choice of market index and the estimation period close to ad might be the reasons for the lack of permanent abnormal returns evidenced by earlier studies on nifty index additions for the same period. for the second period, table 1 reports a ad+1 abnormal return of 1.24% that persists not only for 40 days (2.18%) but also for 60 days (2.43%) from ad+1.though, the index effect appears to be declining in the recent period similar to some studies in the developed markets, the ad40 and ad60 permanent ccars in the second period are statistically significant at 2.57% and 3.64% respectively. the complete period and the sub period results are robust to alternate abnormal return calculations. overall, the results evidence significant permanent abnormal returns following index additions for the first period and second period. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 316 ajfa.macrothink.org table 1. long window statistics for the daily abnormal returns using multiple calculation methodology for the clean sample added to nifty index during the complete period, april 2000 march 2018, sub period 1 (2000 2009) and sub period 2 (2010-2018). windows complete period n = 50 i period n= 23 ii period n = 27 car in % mcar ccar ocar mcar ccar ocar mcar ccar ocar anticipation window mean -0.70% -1.21% -0.74% -0.90% -1.14% -0.94% -0.51% -1.26% 0.57% ad-10; ad median -0.30% -1.14% -0.05% -0.40% -1.76% -0.58% 0.10% -0.90% 0.02% car > 0 48% 40% 48% 43% 48 43% 52% 43% 52% ad window ad+1 mean 1.49%** 1.94%** 1.25%** 2.32%** 3.32%** 1.96%** 1.24%** 1.19%** 1.32%** median 2.30% 2.13% 2.15% 2.67% 2.81% 3.33% 1.53 1.76% 1.25 car > 0 66% 66% 62% 78% 74% 70% 78% 63% 81% run up window mean 2.30%* 2.69%* 2.83%** 3.66%* 3.41% 4.37%* 1.21% 2.10% 1.52% ad+2;ed-2 median 3.40% 1.43% 1.58% 5.12% 5.23% 2.79% 1.90% 0.90% 0.61% car > 0 62% 54% 58% 74% 61% 65% 52% 52% 52% ed window mean 1.67%** 1.63%** 1.42%** 1.81%** 1.72%* 1.22%** 1.56%** 1.55%** 1.6%** ed-1; ed median 1.57% 1.34% 1.12% 2.10% 1.30% 1.10% 1.24% 1.34% 1.25% car > 0 70% 76% 68% 70% 70% 61% 70% 81% 74% pressure release mean -1.50%** -2.02%** -1.61%** -2.03%* -3.03%** -2.49% -0.78% -1.11% -0.85% ed+1;ed+3 median -1.49% -1.04% -1.16% -2.22% -2.82% -2.17% -0.93% -1.10% -0.91% car > 0 32% 24% 28% 26% 17% 22% 37% 30% 33% permanent ad 40 mean 3.50%* 3.32%* 3.96%* 5.06%** 3.53% 5.62%* 2.18% 3.06%* 2.57%* ad+1; ad+40 median 3.10% 1.62% 4.72% 3.98% 1.02% 8.09% 2.12% 4.19% 3.20% car > 0 60% 56% 60% 65% 54% 61% 56% 56% 59% permanent ad 60 mean 4.19%** 4.23%* 4.49% 6.28%** 5.09%* 5.51% 2.43% 3.41%* 3.64%* ad+1; ad+60 median 4.12% 2.94% 2.73% 5.19% 2.24% 5.27% 3.86% 5.31% 2.54% car > 0 60% 58% 60% 65% 54% 65% 56% 63% 59% this table reports the long window statistics for the daily abnormal return for the clean sample for the complete period (2000-2018), first period (2000 2009) and second period (2010 2018). using the standard event methodology, the market adjusted (mcar): ‘adjusted’ market model adjusted (ocar); control sample adjusted (ccar), buy and hold, cars using daily returns from the nse, india official website (equation 1,2 and 3). the market return is represented by the cnx 500 index return. the control sample are the other firms which satisfy all the addition criteria, however were not added. ad-10:ad car represents car from ad-10 to ad. permanent ad 40 indicates car from ad+1 to ad+40.the mean and median car are reported. car>0 represents the fraction of stocks for which the car is positive. values are returns in percentages and **, * represents significance (t -test) at 5% level and 10% level respectively. the complete period unadjusted ad40 & ad60 ocar are 2.86% and 2.85% respectively. the first period unadjusted ad40 & ad60 ocar are 4.39% and 3.73% respectively. the second period unadjusted ad40 & ad60 ocar are 1.57% and 2.10% respectively. this table reports asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 317 ajfa.macrothink.org the long window statistics for the daily abnormal return for the clean sample for the complete period (2000-2018), first period (2000 2009) and second period (2010 2018). using the standard event methodology, the market adjusted (mcar): ‘adjusted’ market model adjusted (ocar); control sample adjusted (ccar), buy and hold, cars using daily returns from the nse, india official website (equation 1,2 and 3). the market return is represented by the cnx 500 index return. the control sample are the other firms which satisfy all the addition criteria, however were not added. ad-10:ad car represents car from ad-10 to ad. permanent ad 40 indicates car from ad+1 to ad+40.the mean and median car are reported. car>0 represents the fraction of stocks for which the car is positive. values are returns in percentages and **, * represents significance (t -test) at 5% level and 10% level respectively. the complete period unadjusted ad40 & ad60 ocar are 2.86% and 2.85% respectively. the first period unadjusted ad40 & ad60 ocar are 4.39% and 3.73% respectively. the second period unadjusted ad40 & ad60 ocar are 1.57% and 2.10% respectively. table 2. daily abnormal volume (vr) for the nifty index additions during the 2000-2018 period day t / event window mean vr on day t / event window media n vr > 1 mean vr on day t / event window media n vr > 1 mean vr on day t / event window media n vr > 1 full period (2000-2018) i period (2000-2009) ii period (2010-2018) ad-2 1.07 0.78 40% 1.04 0.58 30% 1.10 0.91 48% ad-1 1.05 0.71 36% 1.03 0.73 39% 1.07 0.69 33% ad 1.15 0.93 46% 1.18 0.75 39% 1.13* 1.01 52% ad+1 1.41 0.97 46% 1.51 0.92 35% 1.33** 1.13 56% ad+2 1.23 0.93 46% 1.39 0.93 43% 1.09 0.94 48% ad+3 1.15 0.86 40% 1.37 0.85 39% 0.97 0.93 41% ad+4 1.20 0.82 40% 1.44 0.84 35% 0.99 0.81 44% ad+5 1.17 0.77 36% 1.44 0.87 43% 0.94 0.74 30% anticipation window 1.07 0.86 36% 1.13 0.80 35% 1.02 0.94 37% ad window ad+1 1.41 0.97 46% 1.51 0.92 35% 1.33** 1.13 56% run up window 1.23 0.98 48% 1.46 0.96 48% 1.04 0.99 48% ed window 2.30** 1.86 86% 2.42** 1.61 78% 2.21** 2.07 93% ed1ed3 1.35* 1.01 52% 1.65* 1.10 57% 1.10 0.99 48% ed+6 to ed+15 1.43 0.92 44% 1.78 0.93 43% 1.14 0.91 44% the samples are described in sec 3.2. the volume ratio (vr) calculation is explained in sec 3.3.2. . the vr is significant only if the statistical significance suggested by the parametric t-test is confirmed by the non-parametric wilcoxon signed rank test. **, * represents significance (t -test) at 5% level and 10% level respectively. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 318 ajfa.macrothink.org table 3. mean car from ed+1 to day t and the mean ar on day t for the 38 stocks added to nifty index between 1999-2018 and for which ed abnormal return is greater than zero. day t mean ar on day t median ar > 0 mean mcar from ed+1 to the day t mean ar on day t median % of stocks ar > 0 mean mcar from ed+1 to the day t mean ar on day t median ar > 0 mean mcar from ed+1 to the day t full period mcar n = 38 i period mcar n = 17 ii period mcar n = 21 ed-3 0.59% -0.13% 47% 1.37% 1.11% 59% -0.04% -0.48% 38% ed-2 -0.05% -0.20% 45% -0.25% -1.37% 41% 0.11% -0.09% 48% ed-1 1.28%* 1.54% 71% 1.31%* 2.09% 65% 1.25%* 1.52% 76% ed 1.48%* 1.11% 79% 2.15%* 1.27% 82% 0.94%* 1.09% 76% ed+1 -0.61% -0.58% 42% -0.61% -1.22% -0.64% 35% -1.22% -0.12% -0.51% 48% -0.12% ed+2 -0.46% -0.64% 34% -1.07% -0.46% -0.52% 41% -1.68% -0.46% -0.69% 29% -0.58% ed+3 -0.34% 0.02% 53% -1.41%* -0.47% -0.28% 47% -2.15%* -0.24% 0.20% 57% -0.82% ed+4 0.41% 0.01% 50% -1.00% 0.29% -0.92% 41% -1.86% 0.51% 0.18% 57% -0.30% ed+5 0.18% -0.56% 45% -0.82% 0.47% -0.27% 47% -1.40% -0.05% -0.85% 43% -0.35% ed+6 -0.08% -0.37% 39% -0.89% 0.25% -0.41% 35% -1.15% -0.34% -0.33% 43% -0.69% ed+7 0.41% 0.25% 63% -0.49% 0.64% 0.35% 65% -0.51% 0.23% 0.24% 62% -0.47% ed+8 0.67% 0.13% 55% 0.19% 0.86% 0.68% 59% 0.35% 0.52% 0.07% 52% 0.06% ed+9 0.77% 0.07% 50% 0.96% 1.42% -0.06% 47% 1.77% 0.25% 0.19% 52% 0.30% ed+10 -0.48% -0.27% 42% 0.47% -1.53% -1.77% 35% 0.24% 0.37% -0.03% 48% 0.67% this table reports the mean car from ed+1 to day t and the mean ar on day t for the 38 stocks added to nifty index for the full period (2000-2018), first period (2000 2009) and second period (2010 2018) and for which ed abnormal return is greater than zero. ar> 0 represents the fraction of stocks for which the ar is positive. values are returns in percentages. * represents significance (t -test) at 5% level respectively. the ii period ed+1 to ed+3 car is significant at 10% level. table 2 and table 3 present the abnormal volume (vr) results around ad and ed respectively for both the sub periods. the mean vr is not significantly greater than one at any reasonable level of significance for any event window except for the ed and pressure release window for the first sub period. however, the ad+1 vr is significant for the second period. overall, there is no evidence of significant permanent abnormal volume for the complete period, first sub period and second sub period. the significant price effects without accompanying volume increase in the nifty index addition are different from those of other studies in the developed markets beneish and whaley (1996), hegde and mcdermott (1988), chen et al. (2003) and hradzil (2009). 4.3 nifty index reconstitutions in the context of prior research this study examines the prior explanations in the literature in the context of the nifty index reconstitutions. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 319 ajfa.macrothink.org 4.3.1 tests for dsdc hypothesis the evidence of abnormal volume effects so far, is not consistent with the dsdc hypothesis in the complete period and first sub period. according to beneish & whaley (1986), price and volume increase around ad is evidence of short term investors front running the index funds indicating the possibility of downward sloping demand curves. the evidence of abnormal returns and abnormal volume in second sub period is so far consistent with the previous findings for dsdc hypothesis shliefer (1986) contends that a significant positive slope in the cross sectional regression between abnormal ad return and volume is consistent with dsdc hypothesis. in order to complete the dsdc analysis and to delineate which variables explain the index addition premia, this study uses shliefer (1986) cross sectional regression on various intervals around ad namely, ad+1; ad+1 to ad+2; ad+1 to ad+3. table 513, panel a reports only the ad+1 to ad+2 results14. ad2 window car = α + ψ * ad2 abvoli + εit (6) where, ad2 window car is the ad+1 to ad+2car, ad2abvol is the mean (ad+1 and ad+2) vr. the results show that the slope estimate was negative for the complete period and first period and positive at 10% level of significance for second period. further, shliefer (1986) asserts that due to standard errors, the slope coefficient may be biased towards zero and suggested introducing usual volume usvol independently in the regression. a significantly positive abnormal volume coefficient and significantly negative usual volume slope coefficient is consistent with dsdc hypothesis. ad2 window car = α + ψ * ad2 abvoli + µ * usvoli + εit (7) where, usvol is usual volume and is the mean vr from ad-10 to ad-515. the results, reported in table 4 panel a, show that the sign of the coefficients are of the expected sign for both the abvol and usvol in the complete period and the two sub periods. however, though the slope coefficient of usvol is negative and statistically significant at 10% level in the complete period, the slope coefficient of abvol is not significant at any level of significance suggesting weak support for dsdc hypothesis. the first period regression result coefficients are of expected sign but not statistically significant. in the second period, the coefficient of abvol is positive and significant at 5% level. the slope coefficient of usvol is negative and significant at 5% level. the volume results along with these results are consistent with downward sloping curves in the second period. however, the results of the complete period and first period are not consistent with the dsdc hypothesis. 4.3.2 tests for price pressure hypothesis the price pressure hypothesis also posits a downward sloping demand curve, albeit only in the short run. also, the inclusion or effective day abnormal return is expected to be positive due to indexing. hence, i have included only the stocks with positive ed window car as asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 320 ajfa.macrothink.org this more appropriate as the price pressure hypothesis postulates complete reversion once the excess demand is satisfied. table 3 presents the mean daily return around ed along with the car from ed+1 to day t till ed+10. the ed window car for the complete period is 2.72% with a maximum cumulative reversal in ed+3 of -1.41%. the ed window car for the first period and sub period 2 are 3.46% and 2.61% respectively. the maximum cumulative reversals happen ated+3 in both the sub periods at -2.15 and -0.82% respectively. the price reversal appears partial and does not support the price pressure hypothesis. if the price reversal is only due to short term price pressure, then the magnitude of reversal should be inversely proportional to ed window car. i regress the pressure release window ed+1 to ed+3 car with the ed window car similar to elliot et al. (2006) pressure release window car = α0 + α1 ed window car + εit (8) if the cross sectional variation in the pressure release window is correlated with the initial ed window price shock, then the slope coefficient should be closer to negative one. table 4, panel c reports the results of the regression and though the slope coefficients are negative, they are neither significant not closer to negative one for the complete period, first period and second period. therefore, it seems reasonable to conclude that the evidence in support of price pressure hypothesis is limited at best. 4.3.3 test for investor awareness and certification the assessment of investor awareness and certification is difficult in the absence of direct measures. as in chen et al. (2003), i rely on proxies like percentage in shareholding16 of mutual funds and non-mutual funds. the percentage of shareholding by mutual funds and others before announcement of the index addition is compared with the percentage of shareholding after the effective date of addition. the percentage of shareholding data before ad is obtained from the quarter immediately preceding the ad. the percentage of shareholding data after the effective date is obtained is obtained six months after the effective date similar to chen et al. (2003). the mean % change in mutual funds (mf) holding and the mean % change in non mfs holding before and after the nifty index additions are reported in table 5 panel d. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 321 ajfa.macrothink.org table 4. univariate and regression results nifty index additions panel a: dsdc hypothesis dependent variable ad2 abnormal return complete period n = 50 i period n = 23 ii period n = 27 reg 1 reg2 reg 1 reg2 reg 1 reg2 c 0.016 0.025** 0.028* 0.031* -0.011 0.008 prob (0.12) (0.04) (0.08) (0.09) (0.39) (0.55) ad abvol -0.003 0.003 -0.009 -0.006 0.016* 0.024** prob (0.58) (0.49) (0.26) (0.57) (0.09) (0.01) usvol -0.018* -0.008 -0.030** prob (0.09) (0.64) (0.02) r sq 0.02 0.064 0.059 0.069 0.11 0.303 panel b: liquidity hypothesis dependent variable ad40 abnormal return complete period n = 50 i period n = 23 ii period n = 27 c 0.001 -0.019 0.018 -0.026 -0.018 -0.011 prob (0.98) (0.63) (0.80) (0.68) (0.77) (0.12) ad40 abvol 0.027 0.01 0.022 -0.007 0.035 0.046 prob (0.38) (0.72) (0.56) (0.85) (0.51) (0.15) ad40 abliq 0.023** 0.041** -0.012 prob (0.03) (0.02) (0.34) r sq 0.021 0.11 0.016 0.273 0.018 0.055 panel c: price pressure hypothesis dependent variable ed release window complete period n = 38 i period n = 18 ii period n = 20 c -0.007 -0.018 -0.001 prob (0.39) (0.28) (0.87) ed window -0.257 -0.097 -0.314 (0.26) (0.81) (0.28) r sq 0.035 0.004 0.06 panel d: investor awareness and certification hypothesis complete period n= 50 i period n= 23 ii period n= 27 mean % change in mfs holding mean -0.12% -0.53%* 0.22% median 0.04% -0.44% 0.20% % change >0 51.00% 41% 59.00% mean % change in non mfs holding mean 0.32%* 0.89%* -0.16% median 0.17% 0.88% -0.11% % change >0 61% 73% 31% asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 322 ajfa.macrothink.org the panel a relates the abnormal returns around ad with the abnormal volume and usual volume for the complete period and first period and second period. the specified equations are ad2 window car = α + ψ * ad2 abvol + εit ad2 window car = α + ψ * ad2 abvol + µ * usvol + εit . the dependent variable is ad+1 to ad+2 car . abnormal volume isthe average vr for ad+1 and ad+2 . the usual volume is the mean vr from ad-10 to ad-5. the statistic and associated p-values are given. **, * represents significance (t -test) at 5% level and 10% level respectively. the panel b relates the abnormal return with abnormal volume and abnormal liquidity for the complete period and first period and second period. the specified equation is ad40 car = α0 +α1abvoli + α2abliqi + εit car ad+1 to ad+40(ad40) is the dependent variable. ad40 abvol is the average vr from ad+1 to ad+40. the abliq is the average lr from ad+1 to ad+40. the statistic and associated p-values are given. **, * represents significance (t -test) at 5% level and 10% level respectively. the panel c relates the ed release window car with the ed window car for added stocks with positive ed abnormal return. the specified equation is pressure release window car = α0 + α1 ed window car + εit. ed release window car is ed+1 to ed+3 car. ed window car is ed-1 to ed car. the statistic and associated p-values are reported. **, * represents significance (t -test) at 5% level and 10% level respectively. panel d compares the percentage of shareholding around the nifty index additions. the percentage of share holding data before ad is obtained from the quarter immediately preceding the ad. the percentage of share holding data after the effective date is obtained is obtained six months after the effective date. **, * represents significance (t -test) at 5% level and 10% level respectively. the non-mfs holding includes banks, insurance companies, retail investors and non-resident indians. table 4 panel d reports the paired changes where the change for each form is calculated before calculating the mean and median as in chen et al. (2003). the mean percentage change in non-mf shareholding increases by a statistically significant 0.32%; increases by a statistically significant 0.89% in the first period; and reduces by 0.16% in the second period. the change in the percentage of non-mf holding is large and statistically significant for the complete period and the first period. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 323 ajfa.macrothink.org when the index funds buys large amount of stock following index additions, pressure is exerted on the non-mfs in general and non-institutional investors in particular in the direction of reduction in the shareholding in the absence of opposite forces like certification or investor awareness chen et al. (2003). even though, index funds have grown compared to the first period, the substantial increase in percentage change in non-mf shareholding supports the investor awareness and certification hypothesis in the complete period and the first period. the mean percentage change in mf shareholding falls by 0.12% in the complete period; falls by a statistically significant 0.53% in the first period and increases by 0.22% in the second period. the increase in the percentage of mf shareholding and decrease in the percentage of non-mf shareholding17in the second period also corroborate earlier evidence suggesting that the dsdc hypothesis might explain the price effects in that sub period. 4.3.4 tests for liquidity hypothesis chen et al (2003) contend that liquidity can improve without information production provided there is an increase in the trading volume. the reason being the increase in trading volume normally lowers the cost of trading by reducing the inventory cost of market makers. on the other hand, indexing could also reduce liquidity. the results in table 2 suggest that there is no significant abnormal volume in any chosen event windows, except ed window for both the complete period and first period. also, there is a significant volume increase around ad, only for the second period. consequently, if there is an increased interest for the added stocks, liquidity increase could be due to increased information production by analysts and others. this study specifies a regression model with the permanent window car as the dependent variable and the regressors are proxies for liquidity (liquidity ratio) and volume (volume ratio). the model is similar in spirit to beneish and gardner (1995) and gregoriou et al. (2006). ad40 car = α0 +α1abvoli + α2abliqi + εit (9) where, ad40 car is the mcar from ad+1 to ad+40, abvol is the mean vr and abliq is the mean lr for the same period. table 4, panel b presents the results of the cross sectional regression. the variable abvol, though positive, is not significant for the complete period, first period and second period. the variable abliq is positive and statistically significant for the complete period and first sub period. similar results were evidenced with ad60 as the dependent variable. these results corroborate the earlier finding that information related effects might explain the permanent abnormal return in the complete period and first period. the variable abliq is negative and not significant in the second sub period suggesting that the information related effects might not explain the permanent abnormal return in second sub period. the results for the first period is similar to that of hacibedel & von bommel (2007) that index changes in emerging markets are not information free events. however, the second period results are similar to that of the mature markets. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 324 ajfa.macrothink.org the evidence suggesting downward sloping demand curve as the explanation for the permanent abnormal returns in the second period is not consistent with efficient market hypothesis (emh) in the indian stock market which relies on arbitrage and price takers in competitive market. further, the basic assumption in finance theory, that the price of the stock is determined only by the information about future cash flows and appropriate discount rate, is not consistent with the downward sloping curve. also, the slow multi day adjustment to index addition announcement is not consistent with market efficiency in the indian stock market. 5. conclusion this paper documents the price and non-price effects of the additions to nifty index during 2000-2018. the stocks added to nifty index experience a significant permanent increase in abnormal return subsequent to announcement and inclusion similar to the effect seen in the developed markets. but the evidence of permanent abnormal volume is limited, unlike the developed markets, as abnormal volume is evidenced only around announcement date and inclusion date. there is clear evidence that the nifty index addition during the 2000 -2018 is associated with permanent abnormal return in the complete and the sub periods. the statistically and economically significant permanent abnormal returns in the complete period and first period contradict some of the earlier studies on nifty index addition which evidenced temporary abnormal returns around the actual inclusion day. among the four different views in the extant literature information effect, liquidity effect, downward sloping curve and price pressure view, the evidence appears to favour the information effect as the primary explanation for the permanent abnormal return for the complete period and the first period. this study documents a decrease in the percentage of mutual fund shareholding and a significant increase in the percentage of non-mutual fund shareholding (which includes retail investors).this along with increased liquidity, without abnormal volume, may be attributable to the increase in investor awareness, greater market scrutiny and certification. this study also extends the previous empirical literature on nifty index additions to the recent (2010 -2018) period as it reflects the current economic environment. the results show that index addition effect, though significant, has diminished in the second sub period. the downward sloping demand curve appears to be the dominant explanation for the evidenced significant permanent abnormal return in the second period. the evidence in favour of the price pressure hypothesis, relevant around the actual inclusion date, is limited. the findings in the paper are not consistent with the efficient market hypothesis. the evidence, of downward sloping demand curves for stocks in the indian stock market, is important to investors and portfolio managers with exposure to the market as there is potential for profitable trading strategies. this result is also important to the regulators as they can evaluate their initiative towards investor protection, disclosure and corporate governance. the study has focused only on additions to the index and did not consider deletions from the index. also the behavioural biases or corporate governance issues as the asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 325 ajfa.macrothink.org possible explanations for the index revision effects were not part of the study. these could be avenues for future research. notes note 1. as the sample size is small, three periods are not possible. however, i changed the sub period to 2000 -2010 and 20112018 and evidenced similar sub period results. note 2. https://www.sebi.gov.in/media/speeches/mar-2004/a-historical-perspective-of-the-securitiesmarket-reforms_2882.html. https://www.nseindia.com/education/content/prs_publications.htm the index funds including etf were 10 in number in 2003. it increased to 32 in 2011 and 67 in 2017. note 3. according to world federation of exchanges (wfe) note 4. source-nse website, www.nseindia.com note 5. i did not study deletions from nifty index as the focus of this study is nifty index additions only. it is also difficult to get reasonable sized ‘clean’ sample as comparatively more deletions happen due to mergers, acquisitions and financial distress. note 6. the indian studies evidencing lack of permanent abnormal returns have all used ols market model with estimation period very similar to this study note 7. nine added stocks with alphas greater than 0.2% were part of the adjusted sample. note 8. lynch and mendenhall (1987) used returns from 872 to 673 days prior to ad. this period was not used in this study lest the sample size become even smaller due to lack of data. note 9. nifty junior index is now called ‘nifty next 50 index’ is next only to nifty index in terms of market capitalization and liquidity in the indian stock market. note 10. volume in this study is the number of shares traded. the stock volume is standarised using the total nse market volume. the calculation of volume ratio takes into account the capitalization changes note 11. amihud (2002) employed the illiquidity measure, whereas this study uses the reciprocal ie. liquidity measure note 12. the rationale behind the choice of ad window (ad+1 to ad+3) for the sub period i is the fraction of stocks for which car >0 is more than 50% for ad+1, ad+2 and ad+3 (neither ad nor ad+4 satisfied the above criterion for sub period i). note 13. all the regression results reported in this study are based on mcar. however, this study evidenced similar results using ccar and ocar. note 14. ad+1 and ad+1 to ad+3 results are similar to the reported ad+1 to ad+2 results. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 326 ajfa.macrothink.org note 15. i also used mean vr of ad-10 to ad-4, ad-10 to ad-3 and evidenced similar results. note 16. chen et al. and other studies analyse the number of shareholders and the number of trades. these data are not available in the nse indian official website for the complete period. the number of shareholders data and number of trades data are available only from 2007 and 2011 respectively. the total mutual fund data is used in this study due to non-availability of required index data. note 17. when the mean percentage change in retail shareholding alone was considered, it was found to be negative and significant -0.32% for sub period 2 and a positive 0.15% for sub period 1 corroborating the earlier evidence. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 327 ajfa.macrothink.org references amihud, y. 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(2002). does arbitrage flatten demand curve for stocks? journal of business, 75, 583-608. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 330 ajfa.macrothink.org appendix-1 ad stock symbol ed trading days 24-apr-00 hcl-insys 24-may-00 19 24-apr-00 zeetele 24-may-00 19 20-jul-00 digitaleqp 1-sep-00 28 26-apr-00 dabur 5-oct-00 8 6-dec-01 sunpharma 17-jan-02 26 6-dec-01 wipro 17-jan-02 26 15-apr-02 vsnl 31-may-02 31 16-sep-02 sci 10-oct-02 15 16-sep-02 bpcl 28-oct-02 26 16-sep-02 hcltech 28-oct-02 26 13-mar-03 gail 2-may-03 30 13-mar-03 natalum 2-may-03 30 16-jun-03 sail 4-aug-03 33 16-jan-04 bhartiairtel 1-mar-04 27 26-mar-04 ongc 12-apr-04 8 12-may-06 siemens 27-jun-06 31 20-feb-07 ster 4-apr-07 28 10-aug-07 ntpc 24-sep-07 28 11-sep-07 unitech 5-oct-07 15 10-feb-09 axisbank 27-mar-09 28 19-may-09 jindalstel 17-jun-09 19 4-sep-09 jpassociat 22-oct-09 28 4-sep-09 idfc 22-oct-09 28 24-feb-10 kotakbank 8-apr-10 26 19-aug-10 sesagoa 1-oct-10 29 19-aug-10 drreddy 1-oct-10 28 19-aug-10 bajajauto 1-oct-10 28 14-mar-12 asianpaints 27-apr-12 28 14-mar-12 bankbar 27-apr-12 28 16-aug-12 lupin 28-sep-12 28 16-aug-12 ultratech. 28-sep-12 28 13-feb-13 indusind 1-apr-13 29 13-feb-13 nmdc 1-apr-13 29 27-feb-14 techm 28-mar-14 19 27-feb-14 mcdowell-n 28-mar-14 19 21-aug-14 zeel 19-sep-14 18 20-feb-15 idea 27-mar-15 23 20-feb-15 yesbank 27-mar-15 23 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 331 ajfa.macrothink.org 29-apr-15 boschltd 29-may-15 18 12-aug-15 adaniport 28-sep-15 29 22-feb-16 auropharma 1-apr-16 24 22-feb-16 infratel 1-apr-16 24 22-feb-16 eichermot 1-apr-16 24 16-feb-17 indbulhsg 31-mar-17 27 16-feb-17 ioc 31-mar-17 27 28-aug-17 bajfinance 29-sep-17 22 28-aug-17 hpcl 29-sep-17 22 28-aug-17 upl 29-sep-17 22 21-feb-18 bajfinsv 2-apr-18 27 21-feb-18 titan 2-apr-18 27 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 1 capital adequacy and systemic risk of banks in india mihir dash head of department, quantitative methods & economics school of business, alliance university chikkahagade cross, anekal, bangalore, india-562106 tel: 91-99-518-2465 e-mail: mihirda@rediffmail.com received: march 1, 2020 accepted: april 1, 2020 published: june 1, 2020 doi:10.5296/ajfa.v12i1.16698 url: https://doi.org/10.5296/ajfa.v12i1.16698 abstract this study examines the role of capital adequacy in systemic risk for banks in india. the moderator variables considered for the study include bank size, non-performing assets, leverage, deposits, loans & advances, and investments. a fixed-effects panel regression model was applied, with bank fixed effects and year fixed effects. the study contributes to the literature by proposing the concept of minimum level of capital adequacy for neutral systemic risk, which is the level of capital adequacy for which the systemic risk is non-positive. the results of the study indicate that bank size, non-performing assets, leverage, and loans & advances have a significant impact on the minimum capital adequacy for neutral systemic risk. further, the results of the study suggest that the role of capital adequacy in systemic impact was different for public sector and private sector banks. the study suggests that, instead of setting a fixed capital adequacy level for all banks, the model can be used to set capital adequacy targets for individual banks with estimates or projections of the bank’s characteristics. this can be used in conjunction with the basel iii framework in order to rationalise capital adequacy targets. keywords: systemic risk, capital adequacy, neutral systemic risk, public sector banks, private sector banks. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 2 introduction systemic risk is defined as the impact that the failure of a bank or financial institution would have on the entire financial system and/or economy, through its network of interlinked financial intermediaries. the failure of an institution leads to financial stress on institutions that have lent money to it, which in turn may lead to failure of some of these institutions. this leads to a kind of domino or ripple effect, and spreads across the entire financial system. the recent experience of the global financial crisis of 2008-09 and the subsequent euro-zone crises of 2010-11 has demonstrated the importance of measuring the level of systemic risk associated with different financial institutions and understanding the factors contributing to systemic risk. the collapse of some of the most prominent banks in the world, including the lehman brothers and washington mutual bank, along with several near-failures which had to be bailed out of crisis by the u.s. government, highlighted the significance of understanding, measuring, and monitoring systemic risk. many theories suggest that large and complex banks contribute to systemic risk. a possible source of the systemic importance of large, inter-connected banks is moral hazard; as regulators are reluctant to close or unwind large and complex banks, this leads banks to take on excessive risks in the expectation of government bailouts (e.g. farhi and tirole, 2012). another source is that of agency effects, i.e. poor governance of large and complex banks may lead to bank managers engaging in non-traditional risky activities (e.g. trading) and tend to be financed more through short-term debt, making them more vulnerable to liquidity shocks and market failures (e.g. laeven and levine, 2007; boot and ratnovski, 2012). capital adequacy has been recognised by the basel committee of the bank for international settlements as an effective tool for controlling credit risk. the underlying principle was that prudential policies can control the risk exposure of the financial industry by ensuring that individual banks are managed properly. regulation of capital adequacy was expected to decrease the probability of a bank failing and decrease the bank’s losses given default (diamond and rajan, 2010). the basel iii norms form a comprehensive set of reform measures, to strengthen the regulation, supervision and risk management of the banking sector. they aim to improve the banking sector's ability to absorb shocks arising from financial and economic stress, to improve risk management and governance, and to strengthen banks' transparency and disclosures. they operate at the micro-prudential level, to help raise the resilience of individual banks in periods of stress, and at the macro-prudential level, to counter systemic risks in the banking sector as well as the pro-cyclical amplification of these risks over time. the basel iii norms (post-2015) include capital requirements, including a minimum common equity tier i ratio of 4.5%, a minimum tier i capital ratio of 6%, a mandatory “capital conservation buffer” of 2.5%, and a “discretionary counter-cyclic buffer” of 2.5% during periods of high credit growth; minimum leverage ratio of 3%; and a liquidity coverage ratio in excess of 100%. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 3 the indian banking system, which was initially hailed to be unaffected by the crises, was affected indirectly, mainly on account of growing trade and financial integration with the global economy. though indian banks were not pushed to the point of insolvency, monitoring of systemic risk has become important in the dynamic banking environment in india in order to avoid potential system failure. this study examines the role of capital adequacy in controlling systemic risk for indian banks. the indian banking industry has two important segments, public sector banks and private sector banks. public sector banks are owned and controlled by the government, and are subjected to political interference and constraints. many studies have argued that private sector banks outperform public sector banks due to professional, efficient management, and better customer focus and service, particularly in terms of management soundness and earnings and profitability (dash and das, 2013; dash et al, 2015). in view of this, the role of capital adequacy in controlling systemic risk would be expected to differ between public sector and private sector banks. literature review there are many definitions of systemic risk advocated in the literature, and many more approaches proposed for their measurement. adrian and brunnermeier (2008) was one of the first studies to suggest a measure for systemic risk, viz. the conditional value-at-risk (covar), which focuses on the tail distribution. they were able to identify the contribution of each bank to systemic risk using this measure. acharya et al (2010a, 2010b) proposed the concept of systemic expected shortfall (ses), i.e. the amount by which a bank is undercapitalised in a systemic event in which the entire financial system is undercapitalised, to measure systemic risk. acharya and steffan (2012) extended the framework by introducing the concepts of marginal expected shortfall (mes), which measures the performance of a bank when the market return as a whole experiences its worst 5% trading days within a year, and the bank’s market leverage ratio, the market value of assets divided by the market value of equity. brownlees and engle (2012, 2017) and acharya et al (2012) suggested the srisk index, which estimates the expected capital shortage of a bank during on a substantial market meltdown, as a measure for systemic risk. moore and zhou (2014) proposed the expected system loss (esl), viz. the expected loss to the financial system as a whole given that a particular bank fails, which they estimated using multivariate extreme value theory, as a measure of systemic importance of the bank. hattori et al (2014) pointed out that systemic risk measures are essentially a form of scenario analysis, as they analyse the impact of certain types of assumed trigger events on the financial system, based on past patterns of failure; however, this may not be an indicator for robustness against future, unprecedented modes of failure. also, they argued that most market-based estimates of systemic risk may overestimate the importance of short-term changes. they suggested combining different systemic risk measures together with macro-stress testing scenarios, providing a wider range of potential sources of failure. van oordt and zhou (2015) analysed bank systemic risk into two dimensions, the level of bank tail risk and the linkage between the level of bank tail risk and severe financial shocks to the system. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 4 several studies have analysed the determinants of systemic risk and systemic importance of banks. moore and zhou (2014) found that size and non-traditional banking activities were the significant determinants of systemic importance of us banks in the period 2000-10; in particular, they found that banks above a certain size have equal systemic importance. bostandzic et al (2014) found that banks with higher levels of tier 1 capital had lower exposure and contribution to global systemic risk. further, they found that bank size and interconnectedness are positively related to global financial fragility. they also found that deposit insurance schemes that require banks and depositors to bear more financial risk are associated with greater vulnerability and contribution to a crisis of the financial sector. van oordt and zhou (2015) found that banks with higher non-performing loan ratios and lower profitability ratios tended to have higher tail risk, while larger banks, with higher trading revenue, and higher non-interest income tend to have higher systemic risk. laeven et al (2016) found that systemic risk increases with bank size and is inversely related with bank capital; in particular, low capital in large banks is the key driver of systemic risk. further, they found that market-based activities and country characteristics have moderating effect on these relationships. anghelache and oanea (2016) found that financial leverage, size, risk, and market to book value had a significant impact on systemic risk contribution of romanian commercial banks. some studies have examined the impact of bank capital on systemic risk. dhumale (2000) suggested that controlling individual banks’ capital adequacy can decrease their impact on the fragility of the banking system, i.e. systemic risk. de jonghe (2010) found that a bank’s exposure to systemic risk is reduced by higher capital. miles et al (2012) suggested that higher capital reduces the probability of banking crises. jarrow (2012) argued that the basis of the basel iii capital adequacy rules, viz. value-at-risk (var), leverage ratios, and stress testing, provide an incentive to increase the probability of catastrophic bank failure, thus increasing systemic risk. he further argued that the 2007-09 crisis was an unintended consequence of the basel ii var capital adequacy rules. he proposed that these capital adequacy rules be replaced by one based on a risk measure related to the conditional expected loss given insolvency. de haan and klomp (2015) found that capital regulations increased the “capital and asset risk” of banks operating in emerging and developing countries, with a stronger relation in case of low capitalized or riskier banks. the role of capital adequacy in systemic risk is ambiguous from the literature. higher capital adequacy is expected to decrease a bank’s systemic impact, however, it may also increase bank risk-taking. following jarrow (2012), the study proposes neutral systemic risk as a criterion for capital adequacy. methodology the objective of the study is to analyse the role of capital adequacy in systemic risk for banks in india. due to the wide differences in performance between public sector and private sector banks, the determinants of systemic risk would be expected to differ between public sector and private sector banks. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 5 the study was conducted using sample of thirty-two indian banks, including twenty-one public sector banks, and ten private sector banks. the list of sample banks is given in the table below. public sector banks private sector banks allahabad bank axis bank ltd andhra bank federal bank ltd bank of baroda hdfc bank ltd bank of india icici bank ltd bank of maharashtra indusind bank ltd canara bank jammu & kashmir bank ltd central bank of india karnataka bank ltd corporation bank karur vysya bank ltd dena bank kotak mahindra bank ltd idbi bank ltd yes bank ltd indian bank indian overseas bank punjab & sind bank punjab national bank state bank of bikaner & jaipur state bank of india state bank of mysore state bank of travancore syndicate bank united commercial bank union bank of india vijaya bank the data pertaining to bank characteristics was collected from the capitaline database (www.capitaline.com). the srisk estimates were collected from nyu stern’s v-lab database (https://vlab.stern.nyu.edu/analysis/risk.worldfin-mr.gmes). the study period was 2007-16. the dependent variable considered for the study is the measure of systemic risk proposed by brownlees and engle (2012), srisk. this index measures the expected capital shortage faced by a bank during a period of system distress when the market declines substantially. it is estimated as , where k is the minimum fraction of capital (as a ratio of total assets) each bank needs to hold, di,t and wi,t are the book value of its debt (total liabilities) and the market value of its equity, respectively, and the long-run marginal expected shortfall lrmes is defined as the tail expectation of the firm’s equity return conditional on a market decline http://www.capitaline.com/ https://vlab.stern.nyu.edu/analysis/risk.worldfin-mr.gmes asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 6 . note that srisk can take negative values. a bank with negative srisk represents a well-capitalised bank with large enough capital buffers to easily absorb systemic shocks. the total systemic risk in the financial system is measured by aggregating the positive srisk contributions of different financial institutions. the study focuses on the role of capital adequacy in systemic risk (laeven et al, 2014). the measure for capital adequacy used for the study is the capital adequacy ratio. it is expected that higher levels of capital adequacy would be associated with a lower systemic risk. other moderating variables considered for the study are discussed in the following. the most common determinant for systemic risk is that of bank size, and the commonly-used proxy for size is the logarithm of the bank’s total assets (see for example, laeven et al, 2014). the systemic risk of a bank would be expected to increase with bank size. this reflects the “too big to fail” hypothesis, that the failure of a large bank would have too a great impact on the entire financial system, so that government should intervene to prevent such a failure. consequently, the capital requirement for large banks would be expected to be larger than for small banks. non-performing loans is an important determinant of systemic risk (van oordt and zhou, 2015), and would be expected to play a role in increasing systemic risk particularly for public sector banks. the measure considered in the study is the net non-performing loans to net advances. a bank with a larger proportion of non-performing assets would be expected to have higher systemic risk than a bank with a smaller proportion of non-performing assets, and would thus be expected to have a larger capital requirement. another important determinant of systemic risk is leverage (anghelache and oanea, 2016). this has also been included in the present study. this would be expected to be positively related with systemic risk. laeven et al (2014) have also considered deposits to total assets and loans & advances to total assets in their analysis. these have also been included in the present study, along with investments to total assets. the study used a fixed effects panel regression model for explaining systemic risk, formulated as follows: , where the dependent variable on the lhs is the srisk of the ith bank at time point t, xij,t are the independent variables for the ith bank at time point t, the di represent the individual bank dummies, in order to capture the bank fixed effect, and the dt represent the year dummies, in order to capture the year fixed effect. if the model is re-expressed as asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 7 , with and , the condition for neutral systemic risk is given by this condition gives a simple way to set capital adequacy requirements for banks. it can be used in conjunction with other approaches suggested by basel iii for setting minimal capital adequacy requirements of banks. the model was developed in stages. the first step was to consider capital adequacy ratio on its own as the independent variable in a simple linear regression model (model ia) and a panel regression model with bank and year fixed effects (model ic). this is expected to yield an overall minimum level of capital adequacy, without considering other bank characteristics. the second step was to consider capital adequacy ratio and ln(total assets) in a multiple linear regression, without interaction (model iia) and with interaction (model iib), as well as in a panel regression model with bank and year fixed effects, without interaction (model iic) and with interaction (model iid). this is expected to yield a minimum level of capital adequacy, taking bank size into account. the next steps involved capital adequacy ratio and ln(total assets) taken with different sets of moderator variables: net non-performing assets to net advances (models iiia iiid), leverage (models iva ivd), deposits to total assets, loans & advances to total assets, and investments to total assets (models va vd). each of these models were expected to yield minimum levels of capital adequacy, taking bank size and the different bank characteristics into account. the final step was to consider capital adequacy ratio along with all of the variables discussed above, in a multiple linear regression with interactions (model vib) and in a panel regression with bank and year fixed effects and with interactions (model vid). the final model was selected by removing insignificant variables from the above models. findings the descriptive statistics for the variables are presented in table 1 below. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 8 table 1. descriptive statistics of srisk and its determinants private sector public sector mean st. dev. min max mean st. dev. min max srisk ($ m) -2841.41 5079.93 -25319 3100 1940.70 2120.98 -122 14521 capital adequacy ratio 14.78 2.33 11.03 22.46 11.92 1.05 9.44 15.00 ln(total assets) 13.63 1.11 11.62 15.80 14.32 0.86 12.50 16.93 net non-performing assets to net advances 0.83 0.81 0.00 4.31 1.99 1.77 0.15 11.89 leverage 8.50 6.05 1.89 27.68 29.31 15.92 7.83 103.85 deposits to total assets 0.76 0.11 0.52 0.90 0.84 0.05 0.42 0.91 loans & advances to total assets 0.58 0.04 0.47 0.68 0.62 0.03 0.51 0.70 investments to total assets 0.30 0.04 0.20 0.43 0.26 0.03 0.16 0.34 the private sector banks had a negative average srisk and a negatively-skewed distribution of srisk, while the public sector banks had a positive average srisk and a positively-skewed distribution of srisk. private sector banks also had higher capital adequacy than public sector banks, while public sector banks had higher leverage and net non-performing assets to net advances than private sector banks. there was not much of a difference between public and private sector banks in terms of size, deposits to total assets, loans & advances to total assets, and investments to total assets. the relationship between capital adequacy and srisk for private sector and public sector banks is presented in figure 1 below. figure 1. capital adequacy and srisk for private sector and public sector banks the results of model i are presented in table 2 below. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 9 table 2. model i srisk on capital adequacy ratio overall private sector banks public sector banks model ia model ic model ia model ic model ia model ic [intercept] 13275.42** 4654.75* 8380.96** 1540.91 1503.84 1646.56 capital adequacy ratio -1001.85** -357.57** -761.01** -319.84 34.39 -8.24 between-subjects effects 106.16** 12.66** 0.06 capital adequacy ratio 9.94** 2.52 0.01 bank fixed effects 13.03** 13.01** 18.14** year fixed effects 2.71** 5.33** 9.23** r2 26.20% 72.50% 12.10% 0.00% 73.00% min car 13.25% 13.02% 11.01% the results of model i indicate a significant negative impact of capital adequacy on systemic risk, overall as well as for private sector banks; however, the relationship was not significant for public sector banks. the results of model ia yielded an estimate of 13.25% as the minimum level of capital adequacy ratio for neutral systemic risk. similarly, model ib yielded an estimate of 13.02% as the minimum level of capital adequacy ratio for neutral systemic risk for the base level; estimates for other banks can be obtained by the bank dummy variable coefficient to the constant term. for example, taking the worst case (viz. state bank of india), the estimate for the minimum level of capital adequacy ratio for neutral systemic risk becomes 34.19%. for private sector banks, the results of model ia yielded an estimate of 11.01% for the minimum level of capital adequacy ratio for neutral systemic risk. for public sector banks, the estimates for the minimum level of capital adequacy ratio for neutral systemic risk were unreliable, as the regression results were not significant. the results of model ii for all banks are presented in table 3a below. table 3a. model ii srisk on capital adequacy ratio and ln(ta), all banks model iia model iib model iic model iid [intercept] 6830.32* -143591.93** 60573.81** -49424.36* capital adequacy ratio -990.98** 10471.27** -305.24** 7421.68** ln(total assets) 447.13* 11159.18** -4110.37 3719.10* ln(total assets)* capital adequacy ratio -816.81** -552.14** between-subjects effects 56.32** 85.80** capital adequacy ratio 7.57** 44.31** ln(total assets) 16.58** 6.50* ln(total assets)* capital adequacy ratio 48.43** bank fixed effects 13.61** 10.24** year fixed effects 4.36** 4.49** r2 27.40% 46.40% 71.40% 78.20% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 10 the results of model iia indicate a significant negative impact of capital adequacy on systemic risk and a significant positive impact of size on systemic risk. the estimates for the minimum level of capital adequacy ratio for neutral systemic risk vary from 12.13% to 14.53% (the worst case again being state bank of india). the results of model iib indicate, further, a significant negative interaction effect of capital adequacy and size on systemic risk. the estimates for the minimum level of capital adequacy ratio for neutral systemic risk vary from 13.50% to 14.21%. the results of model iic were similar to the results of model ic, as size was not significant in the model; for example, the estimate for the minimum level of capital adequacy ratio for neutral systemic risk for state bank of india from this model was 38.14%. the results of model iid were similar to the results of model iib; for example, for state bank of india, the estimate for the minimum level of capital adequacy ratio for neutral systemic risk from this model was 16.50%. the results of model ii for private sector banks and public sector banks are presented in table 3b and table 3c below. table 3b. model ii srisk on capital adequacy ratio and ln(ta), private sector banks model iia model iib model iic model iid [intercept] 38683.99** -47939.06 27879.14 -61707.43 capital adequacy ratio -295.42 5364.62* -298.22 7324.23** ln(total assets) -2726.98** 3818.11 -1911.80 4817.38 ln(total assets)* capital adequacy ratio -426.17* -563.37** between-subjects effects 34.50** 25.87** capital adequacy ratio 2.19 10.18** ln(total assets) 1.34 3.58 ln(total assets)* capital adequacy ratio 11.10** bank fixed effects 6.98** 8.21** year fixed effects 2.08* 2.11* r2 43.10% 46.30% 73.20% 76.80% table 3c. model ii srisk on capital adequacy ratio and ln(ta), public sector banks model iia model iib model iic model iid [intercept] -25090.26** 18530.08 -35941.42 -6877.863 capital adequacy ratio -37.82 -3680.10* -3.68 -2332.747 ln(total assets) 1919.78** -1101.19 2641.15* 630.548 ln(total assets)* capital adequacy ratio 252.18* 160.863 between-subjects effects 158.70** 109.32** capital adequacy ratio 0.00 1.75 ln(total assets) 4.07* 0.10 ln(total assets)* capital adequacy ratio 1.75 bank fixed effects 2.75** 2.63** year fixed effects 2.52* 2.45* r2 60.90% 61.80% 73.60% 73.90% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 11 for private sector banks, the results of model iia indicate a significant negative impact of size on systemic risk, while for public sector banks, the results of model iia and model iic indicate a significant positive impact of size on systemic risk. for private sector banks, the results of model iia, iib, and iid yielded estimates of 15.56%, 9.03%, and 11.05%, respectively, for the minimum level of capital adequacy ratio for neutral systemic risk. for public sector banks, the estimates for the minimum level of capital adequacy ratio for neutral systemic risk were unreliable, as the regression results were not significant. the results of model iii for all banks are presented in table 4a below. table 4a. model iii srisk on capital adequacy ratio, ln(ta), and net non-performing assets to net advances, all banks model iiia model iiib model iiic model iiid [intercept] 7438.62* -149863.09** 24722.79 -70612.28** capital adequacy ratio -900.72** 10989.84** -197.11 6344.60** ln(total assets) 283.80 11929.56** -1812.12 5420.74** net non-performing assets to net advances 330.60* -4395.67** 846.41** -2521.54** ln(total assets)* capital adequacy ratio -881.65** -493.72** net non-performing assets to net advances* capital adequacy ratio 387.89** 278.79** between-subjects effects 40.11** 63.87** capital adequacy ratio 3.51 32.57** ln(total assets) 3.18 14.95** net non-performing assets to net advances 37.69** 16.66** ln(total assets)* capital adequacy ratio 37.88** net non-performing assets to net advances* capital adequacy ratio 26.41** bank fixed effects 14.29** 10.55** year fixed effects 6.12** 5.71** r2 28.80% 52.00% 77.40% 81.50% the results of model iiia indicate a significant negative impact of capital adequacy on systemic risk and a significant positive impact of non-performing assets on systemic risk. the results of models iiib and iiid further indicate a significant negative interaction effect between capital adequacy and size and a significant positive interaction effect between capital adequacy and non-performing assets, with estimates for the minimum level of capital adequacy ratio for neutral systemic risk as 17.96%, 15.08%, and 12.54%, respectively. the results of model iii for private sector banks and public sector banks are presented in table 4b and table 4c below. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 12 table 4b. model iii srisk on capital adequacy ratio, ln(ta), and net non-performing assets to net advances, private sector banks model iiia model iiib model iiic model iiid [intercept] 37755.22** -55268.35 1644.24 -82966.52* capital adequacy ratio -270.91 5802.10* -249.13 6841.34** ln(total assets) -2730.85** 4406.02 -177.42 6275.13* net non-performing assets to net advances 739.64 -753.81 1728.22** 65.45 ln(total assets)* capital adequacy ratio -465.17* -530.18** net non-performing assets to net advances* capital adequacy ratio 112.67 113.57 between-subjects effects 24.05** 16.44** capital adequacy ratio 1.69 9.73** ln(total assets) 0.01 6.33* net non-performing assets to net advances 9.29** 0.00 ln(total assets)* capital adequacy ratio 10.76** net non-performing assets to net advances* capital adequacy ratio 0.43 bank fixed effects 7.88** 8.81** year fixed effects 3.07** 2.87** r2 44.50% 48.30% 76.20% 79.50% table 4c. model iii srisk on capital adequacy ratio, ln(ta), and net non-performing assets to net advances, public sector banks model iiia model iiib model iiic model iiid [intercept] -25072.15** 11578.40 -38101.44* -13098.77 capital adequacy ratio -30.13 -3059.73 7.13 -1874.74 ln(total assets) 1910.33** -527.62 2756.45* 1130.37 net non-performing assets to net advances 12.84 -860.95 71.95 -831.02 ln(total assets)* capital adequacy ratio 200.78 117.97 net non-performing assets to net advances* capital adequacy ratio 79.36 86.36 between-subjects effects 105.32** 66.27** capital adequacy ratio 0.01 1.08 ln(total assets) 4.34* 0.31 net non-performing assets to net advances 0.42 2.02 ln(total assets)* capital adequacy ratio 0.87 net non-performing assets to net advances* capital adequacy ratio 2.56 bank fixed effects 2.75** 2.49** year fixed effects 2.33* 2.22* r2 60.90% 62.20% 73.70% 74.40% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 13 for private sector banks, the results of model iiia indicate a significant negative impact of size on systemic risk, and the results of model iiib and model iiid indicate a significant negative interaction effect between capital adequacy and size; for public sector banks, the results of model iiia and model iiic indicate a significant positive impact of size on systemic risk. for private sector banks, the results of model iiib and iiid yielded estimates of 14.11% and 30.60%, respectively, for the minimum level of capital adequacy ratio for neutral systemic risk. for public sector banks, the estimates for the minimum level of capital adequacy ratio for neutral systemic risk were unreliable, as the regression results were not significant. the results of model iv for all banks are presented in table 5a below. table 5a. model iv srisk on capital adequacy ratio, ln(ta), and leverage, all banks model iva model ivb model ivc model ivd [intercept] 4497.84 -142039.97** 13803.82** -49522.38* capital adequacy ratio -814.93** 10189.67** -234.75* 7153.18** ln(total assets) 389.37* 11398.55** -3901.96** 3953.06** leverage 39.06** -623.40** 42.15** -188.45* ln(total assets)* capital adequacy ratio -829.16** -550.88** leverage * capital adequacy ratio 55.38** 18.55** between-subjects effects 40.88** 78.15** capital adequacy ratio 4.35* 40.78** ln(total assets) 15.22** 7.35** leverage 7.42** 5.94* ln(total assets)* capital adequacy ratio 46.77** leverage* capital adequacy ratio 7.64** bank fixed effects 13.56** 7.58** year fixed effects 3.24** 3.38** r2 29.20% 57.00% 74.80% 79.00% the results of model iva indicate a significant negative impact of capital adequacy on systemic risk and significant positive impacts of size and leverage on systemic risk. the results of models ivb and ivd further indicate a significant negative interaction effect between capital adequacy and size and a significant positive interaction effect between capital adequacy and leverage. models iva and ivb yielded estimates of 18.59% and 7.24% for the minimum level of capital adequacy ratio for neutral systemic risk. models ivc and ivd did not yield consistent estimates for the minimum level of capital adequacy ratio for neutral systemic risk, despite all coefficients being significant. the results of model iv for private sector banks and public sector banks are presented in table 5b and table 5c below. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 14 table 5b. model iv srisk on capital adequacy ratio, ln(ta), and leverage, private sector banks model iva model ivb model ivc model ivd [intercept] 29434.94** -31952.56 24843.68 -65278.32 capital adequacy ratio -106.05 3743.93 -286.55 7389.00** ln(total assets) -2393.00** 3023.15 -1744.07 4986.53 leverage 222.10** -1126.05* 70.50 139.38 ln(total assets)* capital adequacy ratio -345.29* -563.52** leverage * capital adequacy ratio 100.21** -7.49 between-subjects effects 28.11** 22.20** capital adequacy ratio 1.98 9.02** ln(total assets) 1.08 3.43 leverage 0.40 0.06 ln(total assets)* capital adequacy ratio 10.36** leverage* capital adequacy ratio 0.03 bank fixed effects 5.92** 5.53** year fixed effects 1.74 1.78 r2 48.40% 55.80% 73.3% 76.8% table 5c. model iv srisk on capital adequacy ratio, ln(ta), and leverage, public sector banks model iva model ivb model ivc model ivd [intercept] -26033.41** 27937.06 -33929.90 883.25 capital adequacy ratio 16.13 -4522.74** 20.51 -2872.88 ln(total assets) 1921.82** -1598.61 2458.35 183.68 leverage 9.24 -101.86 8.84 -57.03 ln(total assets)* capital adequacy ratio 298.74* 188.03 leverage * capital adequacy ratio 9.65 5.76 between-subjects effects 107.11** 67.61** capital adequacy ratio 0.04 2.40 ln(total assets) 3.44 0.01 leverage 0.79 0.62 ln(total assets)* capital adequacy ratio 2.28 leverage* capital adequacy ratio 0.86 bank fixed effects 2.76** 2.53* year fixed effects 1.60 1.39 r2 61.30% 62.70% 73.80% 74.20% for private sector banks, the results of model iva indicate a significant negative impact of size on systemic risk and a significant positive impact of leverage on systemic risk, and the results of model ivb and model ivd indicate a significant negative interaction effect between capital adequacy and size and a significant positive interaction effect between capital asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 15 adequacy and leverage; for public sector banks, the results of model iva indicate a significant positive impact of size on systemic risk, and the results of model ivb indicate a significant positive interaction effect of capital adequacy and size. for private sector banks, the results of model ivb and ivd yielded estimates of 11.77% and 11.48%, respectively, for the minimum level of capital adequacy ratio for neutral systemic risk. for public sector banks, the estimates for the minimum level of capital adequacy ratio for neutral systemic risk were unreliable, as the regression results were not significant. the results of model v for all banks are presented in table 6a below. table 6a. model v srisk on capital adequacy ratio, ln(ta), deposits to total assets, loans & advances to total assets, and investments to total assets, all banks model va model vb model vc model vd [intercept] -2811.29 -170408.19** 74250.33** -57142.74 capital adequacy ratio -820.33** 12824.40** -319.21** 9122.53** ln(total assets) 628.58** 10390.25** -3882.81** 2415.33 deposits to total assets ratio 8041.09** -24988.86 -1697.73 -22936.79 loans & advances to total assets ratio -3304.98 94967.26 -24203.98** 71704.85 investments to total assets ratio 1336.50 -4708.11 -7386.49 -212.08 ln(total assets)* capital adequacy ratio -751.56** -448.39** deposits to total assets ratio* capital adequacy ratio 2342.03* 1796.19 loans & advances to total assets ratio* capital adequacy ratio -8275.05* -7231.44* investments to total assets ratio* capital adequacy ratio -97.86 -797.74 between-subjects effects 24.22** 32.30** capital adequacy ratio 7.83** 8.56** ln(total assets) 15.12** 2.44 deposits to total assets ratio 0.14 2.45 loans & advances to total assets ratio 8.17** 2.94 investments to total assets ratio 0.69 0.00 ln(total assets)* capital adequacy ratio 28.03** deposits to total assets ratio* capital adequacy ratio 3.28 loans & advances to total assets ratio* capital adequacy ratio 4.96* investments to total assets ratio* capital adequacy ratio 0.06 bank fixed effects 14.03** 10.44** year fixed effects 4.65** 4.58** r2 29.10% 50.00% 75.40% 80.00% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 16 the results of model va indicate a significant negative impact of capital adequacy on systemic risk and significant positive impacts of size and deposits on systemic risk. the results of models vb and vd further indicate a significant negative interaction effect between capital adequacy and size and between capital adequacy and loans & advances and a significant positive interaction effect between capital adequacy and deposits. models va and vb yielded estimates of 16.30% and 13.08% for the minimum level of capital adequacy ratio for neutral systemic risk. models vc and vd did not yield consistent estimates for the minimum level of capital adequacy ratio for neutral systemic risk. the results of model v for private sector banks and public sector banks are presented in table 6b and table 6c below. table 6b. model v srisk on capital adequacy ratio, ln(ta), deposits to total assets, loans & advances to total assets, and investments to total assets, private sector banks model va model vb model vc model vd [intercept] 39228.81** -273741.84* 68640.04* -53112.548 capital adequacy ratio -408.32 21228.20** -393.71 8909.727 ln(total assets) -2520.29** 6749.04* -1684.00 5199.344 deposits to total assets ratio -611.57 4171.26 -12983.36 -2799.656 loans & advances to total assets ratio -11192.19 257637.59* -46803.45 -9161.005 investments to total assets ratio 17785.85 118236.25 -20072.81 -18248.088 ln(total assets)* capital adequacy ratio -609.11** -577.082** deposits to total assets ratio* capital adequacy ratio -236.96 -314.495 loans & advances to total assets ratio* capital adequacy ratio -19072.48* -2325.883 investments to total assets ratio* capital adequacy ratio -7581.38 345.259 between-subjects effects 18.31** 12.35** capital adequacy ratio 3.51 1.43 ln(total assets) 1.06 2.99 deposits to total assets ratio 2.00 0.01 loans & advances to total assets ratio 3.41 0.01 investments to total assets ratio 0.69 0.03 ln(total assets)* capital adequacy ratio 9.71** deposits to total assets ratio* capital adequacy ratio 0.03 loans & advances to total assets ratio* capital adequacy ratio 0.09 investments to total assets ratio* capital adequacy ratio 0.00 bank fixed effects 7.49** 7.02** year fixed effects 1.55 1.40 r2 48.10% 57.00% 75.90% 79.70% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 17 table 6c. model v srisk on capital adequacy ratio, ln(ta), deposits to total assets, loans & advances to total assets, and investments to total assets, public sector banks model va model vb model vc model vd [intercept] -20408.50** 105413.74* -30580.96 19630.69 capital adequacy ratio -56.76 -10461.04* 6.50 -4437.12 ln(total assets) 1839.23** -2578.02 2299.99 736.93 deposits to total assets ratio -2686.37 3768.73 4625.73 20712.95 loans & advances to total assets ratio -169.69 -69549.73 -1832.27 -51138.40 investments to total assets ratio -3601.90 -96962.84 -12744.77* -52980.36 ln(total assets)* capital adequacy ratio 368.89** 148.15 deposits to total assets ratio* capital adequacy ratio -587.70 -1331.64 loans & advances to total assets ratio* capital adequacy ratio 5728.65 4086.51 investments to total assets ratio* capital adequacy ratio 7716.07 3373.75 between-subjects effects 64.20** 37.66** capital adequacy ratio 0.00 0.88 ln(total assets) 3.03 0.11 deposits to total assets ratio 1.81 0.76 loans & advances to total assets ratio 0.11 1.26 investments to total assets ratio 4.28* 0.98 ln(total assets)* capital adequacy ratio 1.10 deposits to total assets ratio* capital adequacy ratio 0.57 loans & advances to total assets ratio* capital adequacy ratio 1.19 investments to total assets ratio* capital adequacy ratio 0.58 bank fixed effects 2.85** 2.46** year fixed effects 3.00** 2.93** r2 61.50% 63.20% 74.60% 75.00% for private sector banks, the results of model va indicate a significant negative impact of size on systemic risk, and the results of model vb and model vd indicate a significant negative interaction effect between capital adequacy and size and a significant negative interaction effect between capital adequacy and loans & advances; for public sector banks, the results of model va indicate a significant positive impact of size on systemic risk, the results of model vb indicate a significant positive interaction effect of capital adequacy and size, and the results of model vc indicate a significant negative impact of investments on systemic risk. for private sector banks, the results of model ivb yielded an estimate of 12.80% for the minimum level of capital adequacy ratio for neutral systemic risk; other models did not yield consistent estimates of the minimum level of capital adequacy ratio for neutral asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 18 systemic risk, as the coefficients were not significant. for public sector banks, the estimates for the minimum level of capital adequacy ratio for neutral systemic risk were unreliable, as the regression results were not significant. the results of model vi for all banks are presented in table 7a below. table 7a. model vi – final model, all banks model vib model vib stepwise model vid model vid modified [intercept] -162071.31** -190206.01** -89333.10** -84769.64** capital adequacy ratio 12087.64** 14405.14** 8286.33** 7954.14** ln(total assets) 10934.11** 11453.04** 4846.45** 4862.68** net non-performing assets to net advances -2746.07** -2274.20** -2279.23** -2768.90** leverage -582.25** -651.30** -138.53 deposits to total assets ratio -4331.72 loans & advances to total assets ratio 71261.29 86726.95** 48179.58* 36888.55* investments to total assets ratio -33302.55 ln(total assets)* capital adequacy ratio -793.77** -836.54** -447.45** -449.58** net non-performing assets to net advances* capital adequacy ratio 252.77** 209.52** 248.61** 290.63** leverage* capital adequacy ratio 50.79** 56.94** 11.64 deposits to total assets ratio* capital adequacy ratio 565.86 loans & advances to total assets ratio* capital adequacy ratio -6404.31 -7500.38** -4654.49** -3811.32* investments to total assets ratio* capital adequacy ratio 2512.35 between-subjects effects 36.33** 52.50** capital adequacy ratio 40.56** 38.27** ln(total assets) 12.02** 12.24** net non-performing assets to net advances 11.20** 20.31** leverage 2.91 deposits to total assets ratio loans & advances to total assets ratio 4.43* 3.82* investments to total assets ratio ln(total assets)* capital adequacy ratio 30.58** 30.97** net non-performing assets to net advances* capital adequacy ratio 17.24** 29.40** leverage* capital adequacy ratio 2.71 deposits to total assets ratio* capital adequacy ratio loans & advances to total assets ratio* capital adequacy ratio 7.65** 5.59* investments to total assets ratio* capital adequacy ratio bank fixed effects 8.38** 11.31** year fixed effects 4.05** 4.89** r2 62.20% 61.90% 82.60% 82.40% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 19 the results of model vib indicate that size and loans & advances have a significant negative interaction effect with capital adequacy and non-performing assets and leverage have a significant positive interaction effect with capital adequacy on systemic risk. the results of model vid further indicate a significant negative interaction effect between capital adequacy and size and between capital adequacy and loans & advances and a significant positive interaction effect between capital adequacy and non-performing assets, controlling for bank and year fixed effects. the models yielded estimates of 9.51% and 9.88% for the minimum level of capital adequacy ratio for neutral systemic risk. the results of model vi for private sector banks and public sector banks are presented in table 7b and table 7c below. table 7b. model vi – final model, private sector banks model vib model vib stepwise model vid model vid modified [intercept] -170927.10 -136776.66** -71403.32 -80739.40* capital adequacy ratio 13104.40 11682.61** 8282.17** 8316.11** ln(total assets) 5485.69 4509.35* 6275.84* 6377.49* net non-performing assets to net advances -170.73 -1469.17** 2750.50 -12.71 leverage -1954.25** -136776.66** -235.82 deposits to total assets ratio 33170.57 loans & advances to total assets ratio 140162.55 155323.50** -18082.58 -4568.86** investments to total assets ratio 36124.03 ln(total assets)* capital adequacy ratio -503.13* -442.13** -581.84** -565.36 net non-performing assets to net advances* capital adequacy ratio 56.73 67.17* -52.14 106.15 leverage* capital adequacy ratio 157.98 119.58** 0.86 deposits to total assets ratio* capital adequacy ratio -2681.87 loans & advances to total assets ratio* capital adequacy ratio -9725.97 -12080.19** -1185.32 -1772.74 investments to total assets ratio* capital adequacy ratio -1297.56 between-subjects effects 12.59** 18.85** capital adequacy ratio 7.57** 7.88** ln(total assets) 6.44* 6.98* net non-performing assets to net advances 0.93 0.00 leverage 0.19 deposits to total assets ratio loans & advances to total assets ratio 0.09 0.01 investments to total assets ratio ln(total assets)* capital adequacy ratio 13.22** 12.96** net non-performing assets to net advances* 0.07 0.40 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 20 capital adequacy ratio leverage* capital adequacy ratio 0.00 deposits to total assets ratio* capital adequacy ratio loans & advances to total assets ratio* capital adequacy ratio 0.10 0.22 investments to total assets ratio* capital adequacy ratio bank fixed effects 5.33** 7.99** year fixed effects 2.15* 1.85* r2 67.20% 65.10% 82.20% 81.40% for the private sector banks, the results of model vib indicate that size and loans & advances have a significant negative interaction effect with capital adequacy and non-performing assets and leverage have a significant positive interaction effect with capital adequacy on systemic risk. the results of model vid further indicate a significant negative interaction effect between capital adequacy and size, controlling for bank and year fixed effects. the models yielded estimates of 12.49% and 11.63% for the minimum level of capital adequacy ratio for neutral systemic risk. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 21 table 7c. model vi – final model, public sector banks model vib model vib stepwise model vid [intercept] 105544.65* -177072.01** -25444.38 capital adequacy ratio -10396.01* 12777.39** -1049.90 ln(total assets) -2906.25 12030.28** 688.33 net non-performing assets to net advances -90.50 leverage -80.13 -785.11** -64.77 deposits to total assets ratio 3238.94 37324.15** 22583.00 loans & advances to total assets ratio -61511.10 investments to total assets ratio -89877.30 ln(total assets)* capital adequacy ratio 397.72** -876.18** 154.56 net non-performing assets to net advances* capital adequacy ratio 6.57 leverage* capital adequacy ratio 8.04 68.67** 6.36 deposits to total assets ratio* capital adequacy ratio -586.75 -2795.57** -1598.92 loans & advances to total assets ratio* capital adequacy ratio 4936.99 investments to total assets ratio* capital adequacy ratio 7055.82 between-subjects effects 26.74** 58.59** capital adequacy ratio 0.16 ln(total assets) 0.11 net non-performing assets to net advances leverage 0.76 deposits to total assets ratio 0.89 loans & advances to total assets ratio investments to total assets ratio ln(total assets)* capital adequacy ratio 1.39 net non-performing assets to net advances* capital adequacy ratio leverage* capital adequacy ratio 0.89 deposits to total assets ratio* capital adequacy ratio 0.80 loans & advances to total assets ratio* capital adequacy ratio investments to total assets ratio* capital adequacy ratio bank fixed effects 2.44** year fixed effects 1.42 r2 64.30% 58.30% 74.30% asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 22 for the public sector banks, the results of model vib indicate that size and deposits have a significant negative interaction effect with capital adequacy and leverage has a significant positive interaction effect with capital adequacy on systemic risk. the results of model vid further indicate no significant variables, controlling for bank and year fixed effects. the models yielded estimates of 8.29% and 9.96% for the minimum level of capital adequacy ratio for neutral systemic risk. discussion the study contributes to the literature by proposing the concept of minimum level of capital adequacy for neutral systemic risk, which is the level of capital adequacy for which the systemic risk is non-positive. this arises from the negative relationship between systemic risk and capital adequacy, as discussed in the methodology. the results of the study indicate that capital adequacy has a significant negative impact on systemic risk. further, many of the variables considered were significant moderators of the relationship between capital adequacy and systemic risk. bank size was found to have a significant positive impact on systemic risk and a significant negative interaction effect with capital adequacy, so that the minimum capital adequacy for neutral systemic risk was found to increase with bank size. net non-performing assets to net advances was found to have a significant positive impact on systemic risk and a significant positive interaction effect with capital adequacy, so that the minimum capital adequacy for neutral systemic risk was found to increase with non-performing assets. leverage was found to have a significant positive impact on systemic risk and a significant positive interaction effect with capital adequacy, so that the minimum capital adequacy for neutral systemic risk was found to increase with leverage. deposits to total assets was found to have a significant positive impact on systemic risk and a significant positive interaction effect with capital adequacy, so that the minimum capital adequacy for neutral systemic risk was found to increase with deposits. loans & advances to total assets was found to have a significant negative impact on systemic risk, but it had a significant negative interaction effect with capital adequacy, so that the minimum capital adequacy for neutral systemic risk was found to decrease with loans & advances. investments to total assets was not found to have a significant impact on systemic risk and consequently on the minimum capital adequacy for neutral systemic risk. in the final model, bank size, non-performing assets, leverage, and loans & advances were found to have a significant impact on the minimum capital adequacy for neutral systemic risk. there were significant fixed effects in the final panel regression model. the bank fixed effects were found to be significant, indicating that there were significant differences in systemic impact between the banks. in particular, the banks with highest systemic impact were state bank of india, bank of baroda, and canara bank (all of which are public sector banks), while the banks with least systemic impact were hdfc bank, kotak mahindra bank, and icici bank (all of which are private sector banks). the year fixed effects were also found to be significant, indicating significant differences in systemic impact over time. of course, systemic impact was high in the crisis period of 2008-09, and there was found to be a significant increase in systemic impact in 2012-14 as compared with previous years. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 ajfa.macrothink.org/ 23 for private sector banks, bank size, non-performing assets, leverage, and loans & advances were found to have a significant impact on the minimum capital adequacy for neutral systemic risk; however, controlling for bank and year fixed effects, only bank size and loans & advances were found to have significant impact on the minimum capital adequacy for neutral systemic risk; bank size was found to increase the minimum capital adequacy for neutral systemic risk, while loans & advances was found to decrease the minimum capital adequacy for neutral systemic risk. for the private sector banks, the bank fixed effects were again found to be significant, indicating that there were significant differences in systemic risk between the banks. the year fixed effects were also found to be significant, indicating a significant decrease in systemic risk in 2015-16 as compared with previous years. for public sector banks, bank size, leverage, and deposits were found to have a significant impact on the minimum capital adequacy for neutral systemic risk; however, controlling for bank and year fixed effects, neither capital adequacy nor any of the moderating variables was found to be significant. for the public sector banks, the bank fixed effects were found to be significant, indicating that there were significant differences in systemic risk between the banks. the year fixed effects were found to be not significant. the results of the study give a wide range of estimates for the minimum capital adequacy for neutral systemic risk, varying from 7.24% to 18.59%; and for private sector banks, the estimates varied from 9.03% to 30.60%. however, instead of setting a fixed capital adequacy level for all banks, the model can be used to set capital adequacy targets for individual banks with estimates or projections of the bank’s characteristics. this can be used in conjunction with the basel iii framework in order to rationalise capital adequacy targets. in particular, the results of the study have identified some banks with relatively high systemic impact, viz. state bank of india, bank of baroda, and canara bank. these banks must be monitored more carefully, and perhaps may be required to hold more capital or liquid assets to avert crisis. several of the findings are similar to those in the literature. capital adequacy was found to be significant and negatively related with systemic risk, as found by laeven et al (2016). bank size was found to be significant and positively related with systemic risk, as suggested by several authors (moore and zhou, 2014; laeven et al, 2016). non-performing assets was found to have a significant positive impact on systemic risk, as suggested by van oordt and zhou (2015). leverage was found to be significant and positively related with systemic risk, as suggested by anghelache and oanea (2016). there are some limitations inherent in the study. the sample considered for the study was relatively small, and consisted of the relatively larger indian banks. also, the global financial crisis and euro-zone crises had taken place during the study period, possibly contaminating the results. further, there could be some multicollinearity between the variables, since many of the measures considered are related. for example, capital adequacy has improved in recent years, so that the significance of capital adequacy could have been affected by the year fixed effect. the results of the study thus need to be tested for robustness. there is great scope for extending the study by including other possible determinants of systemic risk. also, as most of the variables were found to be insignificant in the models for public sector banks, the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 1 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(2015). systemic risk and bank business models. de nederlandsche bank working papers, paper no. 442. https://doi.org/10.2139/ssrn.2509314 https://doi.org/10.11127/gmt.2015.09.02 https://doi.org/10.1016/j.jfi.2009.04.001 https://doi.org/10.1111/0022-1082.00296 https://doi.org/10.1257/aer.102.1.60 https://doi.org/10.2139/ssrn.2084200 https://doi.org/10.1016/j.jfineco.2005.06.001 https://doi.org/10.1016/j.jbankfin.2015.06.022 https://doi.org/10.1111/j.1468-0297.2012.02521.x https://doi.org/10.2139/ssrn.2509314 microsoft word 15276-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 209 accounting education and labor market needs mr. meshari alhussain umm al-qura university, college of business administration e-mail: mahussain@uqu.edu.sa received: august 5, 2019 accepted: sep 22, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15276 url: https://doi.org/10.5296/ajfa.v11i2.15276 abstract the study aimed at identifying the appropriateness of educational outputs in the saudi public universities for the labor market from the point of view of graduates from the specialization of accounting and finance by investigating the following axes (motivation in specialization identification, teaching staff in universities, the appropriateness of the study plan for the labor market, and the extent of knowledge of professional tests) and its impact on the quality of educational outputs. the study adopted the inductive method trough reviewing the previous studies regarding the research subject. on the field study, the study used the questionnaire as the study tool. on the statistical side, the following statistical analyzes were conducted (frequencies, percentages, arithmetic means and standard deviations), as well as pearson correlation coefficients to determine the relationships between the variables of the study. the study population consisted of all graduates from the accounting and finance departments of the saudi public universities working in the public sector or the private sector or self-employed " entrepreneurial". the field study was carried out in 2018 and the number of participants was (125) graduates from saudi public universities and (80%) of the participants were under the age of (30) years. this is an excellent percentage as the study focused more on graduates. the study concluded the approval of the sample on each of the following: (the specialization identification was their personal desire, the teaching staff at the university is characterized by knowledge and eruditeness, the quality of study plans in universities and their knowledge of the study plan and its requirements, quality of educational outputs). it also concluded that the most prominent obstacles for graduates in the professional tests was the high financial fees of professional tests. in addition to there was no relationship between the specialization identification and the quality of educational outputs, while there was a relationship between (the efficiency of the teaching staff, the study plan, and the professional tests) and the quality of the educational outputs. keywords: university accounting education, educational outputs. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 210 1. research’s introduction and methodological framework 1.1 introduction the continuous evolution in all different fields requires us to keep up with these changes and seek towards the best. the financial and accounting field is one of the most important pillars in any sector, whether in the public or private sectors. regarding the previous financial events, we have the best attestation of the importance of this field and the great impact caused by any weakness in the financial and accounting sector for examples at the international level what happened at enron in the united states of america in 2001, as for the local level in saudi arabia, the best example is what happened to mobily in 2014 as the company made a proof of income before gaining it among other violations and errors that led to share price collapse in the company as the share collapsed in september from 92sr to less than 45sr in december of the same year. the educational authorities at all different levels provides education, guidance, and training for students, but this has led to the arrival of students to the required level of skill to meet the requirements of the labor market and there is no doubt that this matter varies from one student to another and from one educational entity to another. the student has the responsibility to strive for developing and educating himself and to try to gain experience in the field he wishes. universities have no responsibility for qualifying students for the labor market because universities are the center of studies, researches and experiments rather than a product line for the labor market. in addition, the requirements of the labor market vary from one company to another as industrial companies have their requirements in financial majors that differ from the requirements of a financial service company or financial management in a public sector or a brokerage company. the gulf countries, including saudi arabia, are witnessing economic growth and a steady increase in the size and number of public and private facilities. the interest in the development of technology, information systems, and modern management methods undoubtedly need a special type of cadres required by these facilities in terms of scientific and personal qualifications. therefore, gulf academic institutions should not be isolated from global trends in the development of accounting education (boudy, 1998). 1.2 study problem the study problem can be summarized in the following question: are the outputs of accounting education in saudi public universities satisfying the needs of the saudi labor market? by focusing on the following axes (specialization identification, teaching staff, study plan, professional tests, educational outputs). 1.3 study objectives the study aimed at identifying the appropriateness level of educational outputs in the saudi public universities for the labor market, from the point of view of graduates in the field of accounting and financing and employees in the public and private sector or in a personal work through investigating the following axes which are : (motivation in specialization identification, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 211 teaching staff in universities, the appropriateness of the study plan for the labor market, and the extent of knowledge of professional tests) and their impact on educational outputs. 1.4 study importance the changing world requires us to reconsider what accounting education means in order to prepare individuals for the period of digital imbalance, thus future accountants must be flexible and adaptable. in order to achieve this, their educational needs must be comprehensive, integrated, innovative and diverse (mcguigan; ken, 2016). the university accounting education faces a lot of criticism due to the widening gap between the university accounting education and the desired qualification requirements for practicing accounting profession (alwabel; juma’ah, 1997, a). accounting services have become more extensive and specialized, and are no longer limited to the understanding, interpretation and application of accounting standards, but increased the need for innovation and development to confront the change in the demand for accounting services in a world characterized by international competition according to the report of the "bedford committee" established by the american accounting association in 1986 (al-wabel; juma’ah, 1997, a). (khalil, 2005) emphasized the existence of a real problem represented in the low efficiency and effectiveness of inputs, methods, and outputs of accounting education in arab universities, in addition to the scarcity of accounting studies interested in assessing the reality and future of accounting education. one of the main reasons for paying attention to the development of accounting education programs is the change in the role of the accountant within the facility. as, the traditional tasks performed by the accountant from bookkeeping and reporting are automatically implemented depending on the programming, which led to the assignment of accountants in roles with analytical and diagnostic aspects, as the accountant produces information based mainly on the outputs of financial information systems programmed on the computer (boudy, 1998). the study plans in the accounting programs in the saudi universities are different, not only in the overall structure of the program, but also in the quantity and type of accounting knowledge provided to the student and this is what was referred to by the study of (al-wabel; juma’ah, 1997, b) which concluded that the difference in knowledge is accompanied by varying methods of teaching and the used means due to the following: 1. the diversity schools to which faculty members belong in saudi universities. 2. the absence of a clear and specific teaching plan for each course in some universities and leaving the determination of the content of the course and the method of teaching to the professor of the subject. 3. lack of familiarity of some faculty members with the necessary knowledge in the field of computers limiting their use of computers in the curriculum and the lack of computers in some universities. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 212 4. the diversity of courses taught by faculty member per class reducing the chance of creativity in teaching methods. 5. the old courses and references used in some universities in a way that does not meet the requirements of the modern qualification of the graduates of accounting compared to what is taught in other universities. 6. lack of coordination between accounting departments in saudi universities whether in the field of curriculum identification or in the development of methods and means of teaching. (al-asmari, 2018) pointed out that the importance of university accounting education is reflected in its role in the economic development of countries, so the graduate of the accounting specialization must be qualified to help him perform his job in a positive and effective manner. 1.5 previous studies (al-wabel; juma’ah, 1997, b) the study aimed at analyzing and evaluating the status of accounting programs in saudi universities and he proposed the framework of accounting education in the kingdom of saudi arabia. in order to achieve this objective, the study presented the elements of the necessary vocational qualification for practicing the profession of accounting through the recommendations of scientific and professional councils and related studies. the study explained that an accountant in service must have a combination of general knowledge as well as accounting knowledge and business areas with the need of acquiring many skills in communication, information systems, decision making, leadership, and professional conduct. the study included a framework for the development of accounting education in saudi universities. this strategic framework emphasized the need to clearly define the message of the accounting department clearly which is achieving excellence in finding, discovering, transferring and applying accounting knowledge and skills through achieving excellence in research and accounting education and contributing to excellence in accounting application. (khalil, 2005) the study aimed at assessing the current situation in the inputs and outputs of accounting education. in order to achieve this, the researcher extrapolated and analyzed the related previous studies, and the design of both survey lists distributed to members of the faculty in jordanian universities and the other list to students. the study conclude that there was a positive relationship between (teaching competencies, accounting curriculum, infrastructure of the teaching process) and the quality of education. it has also been shown that there was weakness in keeping pace with the competencies, curriculums, and infrastructure of knowledge developments. (boudy, 1998) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 213 the study aimed at highlighting the programs of academic education and training in accounting field with a focus on undergraduate programs and how to promote those programs. the study concluded that the accounting and training programs are witnessing developments aimed at increasing the effectiveness of these programs to prepare cadres capable of dealing with the work environment. one of the most important challenges facing accountants is to understand the role that accounting systems play in modern information systems, and to acquire the required personal, technical and analytical skills and abilities. also, dealing with the modern technology and programs required by the accountant is essential. (hassan, 2018) the study aimed at identifying the compatibility of accounting education with the requirements of the labor market from the point of view of accountants and employers in institutions and local non-governmental associations (ngos) in the gaza strip. the questionnaire was used to test the hypotheses of the study. the number of valid questionnaires for the analysis was (220) in addition to (15) interviews with officials of ngos. the study concluded that the accounting education of knowledge, experience, skills, and courses is capable of meeting the requirements of the labor market. the "field" training has helped the graduates to enhance their expertise. also, the accounting curriculum needs more communication with computer science to be heavily supported by the market in operations. the methods used in teaching need to be updated to better suit the scientific and professional requirements of the labor market. however, universities have helped graduates develop their administrative, supervisory, and decisionmaking skills. (al-zamili, n.d.) the study aimed at examining the subject of accounting education and showing its role in developing the professional skills of graduates of the accounting department, namely intellectual, technical, practical skills, personal skills, communication skills, organizational skills and business management through a survey of the views of faculty members and graduates of the accounting department at the university of qadisiyah in iraq. the study concluded that accounting education helps to develop technical and practical skills but other skills, namely, mastering information technology and risk taking couldn’t be developed by accounting education according to the sample. in addition, the study concluded that accounting education helps to develop the personal skills of graduates of the accounting department, namely self-learning, self-management, organization of work, respect for time, selection and prioritization within limited resources, introduction of ethical values, and professional attitudes in decision making, while adaptive skills in the business environment, accounting education does not help to develop them. 1.6 study hypotheses the study consisted of independent variables and a dependent variable. the independent variables consisted of the following axes (specialization identification, teaching staff, study plan, professional tests, educational outputs), while the dependent variable is (the quality of educational outputs). the independent variable and the dependent variable are defined, as (alasian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 214 assaf, 2012) stated that the independent variable is the used factor or reason to determine its effect on the outcome. while the dependent variable meant that: the result of which the effect of the independent variable is measured. (murad, 2011) explains that the independent variables are the researcher's interest in studying their effect on other dependent variables as the independent variables are called experimental variables or processors. while the dependent variables are affected by an experimental or independent variable. therefore, the hypotheses can be formulated as follow: 1. there is a relationship between specialization identification and the quality of educational outputs. 2. there is a relationship between the efficiency of teaching staff and the quality of educational outputs. 3. there is a relationship between the study plan and the quality of educational outputs. 4. there is a relationship between the professional tests and the quality of educational outputs. 1.7 study community the study targeted graduate students from the saudi universities in the field of accounting and finance, full-time students (internal student) and didn’t target part-time students (external student). it also targeted all the following degrees (bachelor, master, phd). the study also targeted working graduate students whether in the public or the private sector, or personal business and trade and it didn’t target the unemployed. the study community can be summarized in the following points:  graduates from public universities in accounting and finance.  full-time learners (internal student)  working people. 1.8 study methodology the study followed the inductive approach in the theoretical aspect by reviewing the previous studies related to the subject of the research. on the field side, the study used the questionnaire as a research tool. the five-point likert scale was used, and the questionnaire is usually used as a research tool when the required information is the private respondent's view or personal opinion in a particular case (al-assaf, 2012). the questionnaire can be defined as "an appropriate tool for obtaining information, data, and facts related to a given reality." (obeidat et al., 2007, 104). the study community consisted of all graduates from the accounting and financial departments of the saudi public universities working in the public sector or the private sector or self-employed " entrepreneurial". asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 215 2. theoretical framework 2.1 accounting education (its important, objectives, and elements) the universities seek in developing their educational programs to meet the needs of the labor market and also to work on the qualification of accounting outputs that have the compatible skills and experiences with the labor market. the association between education and professional practice is important for the progress of the accounting profession. therefore, educational institutions will be required to meet the needs of the labor market with the highest efficiency and effectiveness (hassan, 2018). accounting is defined as an art that relies on the use of the self-capacity of accountants to judge the economic and financial events facing accounting work (qitnani, aweys, n.d). while accounting education can be defined as an organized process carried out by the responsible bodies including universities in the forefront and this process provides the learner with the basic knowledge and the necessary scientific and practical capabilities that enable him to practice the profession of accounting (bouazaria; londar, 2017). due to the importance of training and experience in changing the behavior of accountants and developing their skills and professional competence through increasing knowledge and skills development and bridging the gap between the requirements of the labor market and the capabilities and abilities of accountants, which is advocated by most professional organizations in most countries of the world that the applicant who wants to obtain a legal accounting certificate must complete training requirements and experience (saleh, 2017). the importance of good and effective accounting education can be summarized as follows (bouazaria; londar, 2017): 1. contribution to the preparation and rehabilitation of accounting frameworks through providing them with different accounting knowledge. 2. providing accounting frames in various economic units with the most important developments that accompany the profession. 3. assistance in meeting the requirements of economic development and meet the needs of the work environment. 4. assistance in identifying the needs of economic units of programs and training courses and solving the problems faced by these units. 5. good accounting education contributes to the development of the accounting profession through the development of programs according to modern developments. in addition, (saleh, 2017) emphasized that accounting education occupies a prominent importance compared to other specialization. this importance stems from the role played by the accounting profession in the development of accounting practices in society. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 216 the development of accounting education is of great interest because it contributes to the development of the accounting profession. in addition, the development of accounting education increases the efficiency of graduates of the accounting departments, enabling them to meet the demands of the labor market. this led the international federation of accountants to issue international standards on accounting education and contribute to the development of its outputs in line with the requirements of the accounting profession (bouazaria; londar, 2017). (al-zamili, n.d.) emphasized that there are two approaches to accounting education, namely the traditional approach and the modern approach. the modern approach is the best because it has the ability to prepare accounting outputs that are able to take in the scientific and analytical models and enable them to be familiar with the requirements of practicing the profession. university institutions play an important role in preparing qualified accounting competencies through what they should do to focus on acquiring the learner's abilities and professional skills, and moving from the traditional approach in education to the skills transfer approach. in other words, the skills developed during the different educational stages can benefit the person who gains it from entering the labor market (saleh, 2017). however, although the primary objective of the academic institutions is to prepare students scientifically and practically, they can contribute to the training due to the availability of qualified competencies in these institutions. but institutions are not expected to expand into specialized training areas associated with specific types of work given the nature of these institutions (boudy, 1998). the importance of accounting education is clearly demonstrated by the continuing need for accounting work within any community, therefore, it is necessary to create accounting cadres with the necessary skills to carry out the required tasks in the correct and appropriate manner (al-zamili, n.d.). the goals of accounting education can be summarized in the following points (bouazaria; londar, 2017):  increasing the efficiency and effectiveness of the outputs of accounting education.  ensuring the optimal use of accounting education resources.  developing accounting curricula and developing the accounting profession.  providing cadres for the labor market.  focusing on accounting education is to be committed to the ethics and professional behaviors to which the profession must adhere. however, the elements of accounting education are as follows (qitnani, aweys, n.d, 7): 1. inputs: persons who can be prepared to practice accounting work (in all its forms and types). 2. operations: the means of education that can be used to provide accounting skills. 3. outputs: qualified persons who are capable of practicing accounting (academic or professional) to achieve the goal of the accounting education system in general. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 217 4. reverse feedback (control): through monitoring, evaluating and developing the above elements and trying to correct any deviations that occur in any of them. 2.2 saudi vision 2030 the vision of the kingdom of saudi arabia (2030) (note 1) has included continuing investment in education and training, enhancing efforts to align the outputs of the educational system with the needs of the labor market through the launch of the national employment portal, establishing professional councils to identify the needs of each development sector, expanding vocational training, and increasing opportunities for scholarships on areas that serve the national economy, as well as focusing on innovation, advanced technologies and entrepreneurship. the vision has included seeking to develop education, guide students towards appropriate career options, and become at least five of the top (200) international universities by 2030. this will be achieved through the development of advanced educational curricula focusing on personal skills, talent development, teacher qualification, monitoring the level of progress in this aspect, publishing the results of indicators that measure the level of education outputs annually, working with specialists to ensure that higher education outputs are aligned with labor market requirements, establishing partnerships with those who provide training opportunities for graduates locally and internationally, establishing human resource platforms in different sectors to enhance training and rehabilitation opportunities, enabling the private sector to invest in education, and eliminating all obstacles to the private sector's great role in development. 3. practical framework 3.1 sample description: personal characteristics of the study sample the sample included (125) graduates from saudi public universities. the characteristics of the sample can be characterized as follows: part 1: demographic characteristics: 1. gender table 1. distribution of the sample according to gender gender frequency percent % female 77 61.6 male 48 38.4 total 125 100.0 table 1 shows the distribution of the sample according to gender. the female sample was (61.6%), while males (38.4%) of the total sample. 2. age asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 218 table 2. distribution of the sample according to age age frequency percent % less than 30 years 99 79.2 from 30 to less than 40 20 16.0 from 40 to less than 50 5 4.0 50 years and above 1 0.8 total 125 100.0 the sample of the study was distributed according to age as shown in table (2). the vast majority of the sample was represented by the age group (less than 30 years) by (79.2%), followed by the age group (from 30 to less than 40 years) by (16%). the age group (from 40 to less than 50 years) was (4%), until the lowest age group regarding age (50 years and above) was represented by one individual only by (0.8%) of the sample. thus, the majority of the sample was from the younger age groups and it is the best in the current situation of the current accounting education outputs. 3. graduation date table 3. distribution of the sample according to graduation date graduation date frequency percent % less than one year 51 40.8 from one year to less than 3 years 33 26.4 from 3 years to less than 5 years 14 11.2 5 years and above 27 21.6 total 125 100.0 the results indicated that the date of graduation of the sample of (less than one year) came in the first rank by (40.8%) of the total frequencies, followed by the date of graduation (from one year to less than 3 years) by (26.4%), followed by those who graduated from 5 years and above by (21.6%), until the lowest rate of the graduation date group (from 3 years to less than 5 years) achieved (11.2%) as shown in table (3). thus, the data indicated that the sample is represented by graduates, which is the best for the study, as they understand the best vision of the outputs of education in the current situation and their relationship is better with the practical reality in the field of work in the current period. 4. universities asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 219 table 4. distribution of the sample according to universities university frequency percent % imam university 24 19.2 king saud university 12 9.6 umm al-qura university 9 7.2 princess nourah university 8 6.4 taibah university 7 5.6 king abdulaziz university 6 4.8 majmaah university 4 3.2 najran university 3 2.4 university of ha’il 3 2.4 university of tabuk 3 2.4 qassim university 3 2.4 taif university 3 2.4 al-baha university 1 0.8 didn’t mention any university 39 31.2 total 125 100.0 a variety samples of saudi universities participated in the study as shown in table (4) as the highest universities participated in the study was from imam university by (19.2%), followed by king saud university by (9.6%), and then umm al-qura university by (7.2%), followed by princess nourah university by (6.4%), while the lowest universities represented in the sample was al-baha university represented by one unit, while (31.2%) of the sample did not mention the university name. thus, the sample distributed in a good manner on the large saudi universities, which indicates the efficiency of measuring the outputs of education well and its relationship to reality and the requirements of the labor market. 5. scientific degrees: table 5. distribution of the sample according to scientific degrees scientific degree frequency percent % ba 110 88.0 m.a. 13 10.4 ph.d. 2 1.6 total 125 100.0 the results showed that the sample was distributed according to the scientific degree, where the vast majority reached (88%) of the sample for the category of education with a bachelor's degree, followed by the category of education obtained by the master sample by (13%) of the sample, until the lowest percentage of the sample representation of phd degree was (1.6%) of the total sample. therefore, the sample is considered a good representation of the degrees as shown in table (5). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 220 6. employer table 6. distribution of the sample according to employer scientific degree frequency percent % public sector 30 24.0 private sector 7 56.8 personal work or business 24 19.2 total 125 100.0 the results showed that the sample was distributed according to the employer, where work in the private sector came in the highest percentage by (56.8%), followed by the government sector by (24%), until the lowest percentage of the sample of whom working in personal work or business came in (19.2%) of the total sample as shown in table (6). thus, it is possible to say that the sample is represented by the three sectors of labor in proportion to the needs of the work as they have the best vision towards the outputs of education in the labor market. 3.2 validity and reliability tests:  validity of the tool: the validity test of the tool was carried out by calculating the internal validity of the questionnaire axes between each item and the axis to which it belongs. the results were as shown in the following table: table 7. the correlation coefficients between each item and the total score of the axis to which it belongs item correlation coefficient item correlation coefficient item correlation coefficient 1 0.55** 12 0.49 ** 23 0.46** 2 0.48** 13 0.33** 24 0.68** 3 0.67** 14 0.59** 25 0.64** 4 0.59** 15 0.52** 26 0.65** 5 0.68** 16 0.46** 27 0.68** 6 0.74** 17 0.36** 28 0.43** 7 0.80** 18 0.55** 29 0.79** 8 0.79** 19 0.62** 30 0.75** 9 0.73** 20 0.48** 31 0.79** 10 0.76** 21 0.52** 32 0.77** 11 0.68** 22 0.30** 33 0.55** ** significant at 0.01 table (7) showed the results of the validity test of the tool. all the correlation coefficients were positive and statistically significant at the mean of 0.01, and ranged from (0.30 to 0.80) indicating the validity of the items of these axes. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 221 correlation was calculated between the axes and the total score of the questionnaire and the results were as follows: table 8. correlation coefficients between the axes and the total score of the questionnaire axis correlation coefficient the first axis: specialization identification 0.60** the second axis: teaching staff 0.72** the third axis: study plan 0.66** the fourth axis: professional tests 0.63** the fifth axis: educational outputs 0.85** table (8) shows the results of the correlation coefficients indicating a statistical correlation between the axes and the total score of the questionnaire and they ranged from (0.60 to 0.85).  reliability the reliability test was performed by calculating the reliability of the internal consistency using cronbach’s alpha reliability coefficient for the questionnaire axes. the results were as follows: table 9. cronbach’s alpha for the reliability of the questionnaire axes and the total score axis item cronbach’s alpha coefficients the first axis: specialization identification 5 0.69 the second axis: teaching staff 6 0.85 the third axis: study plan 6 0.69 the fourth axis: professional tests 6 0.68 the fifth axis: educational outputs 10 0.86 total degree of the questionnaire 33 0.83 table (9) indicates the cronbach’s alpha reliability coefficients of the axes indicating that the availability of the reliability degree that ranges between acceptable to high (0.68-0.86), and the general reliability of the questionnaire was (0.83) indicating a high degree of the questionnaire reliability. 3.3 statistical analysis several statistical analyzes were carried out including:  frequencies, percentages, arithmetic means and standard deviations of respondents' responses to each paragraph.  pearson correlation coefficients to determine the relationships between the study variables. the arithmetic means have been classified according to the following table: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 222 table 10. classification of arithmetic means categories category arithmetic mean strongly agree 4.24-5.00 agree 3.43-4.23 somewhat agree 2.62-3.42 disagree 1.81-2.61 strongly disagree 1.80-1.00 3.4 results the calculation of frequencies, percentages, arithmetic means and standard deviations of the questionnaire axes was performed. the results were as follows: table 11. frequencies, percentages, arithmetic means, standard deviations, and the ranks of the items of the specialization identification axis. item frequency/ percent approval degree am sd rank review strongly agree agree somewhat agree disagree strongly disagree the first axis: specialization identification 1 f 61 44 13 4 3 4.25 0.939 1 strongly agree % 48.8 35.2 10.4 3.2 2.4 2 f 2 2 7 36 78 1.51 0.809 5 strongly disagree % 1.6 1.6 5.6 28.8 62.4 3 f 4 11 29 37 44 2.15 1.100 3 disagree % 3.2 8.8 23.2 29.6 35.2 4 f 12 23 25 27 38 2.55 1.347 2 disagree % 9.6 18.4 20 21.6 30.4 5 f 8 11 20 31 55 2.09 1.238 4 disagree % 6.4 8.8 16 24.8 44 general mean of the axis 2.51 1.087 disagree table (11) refers to the results in the general mean of the specialization identification axis which indicated that the graduates disagree with most of these paragraphs. the most important choices agreed by (48.8%) of the sample were the fact that they choose their specialization with a personal desire, while the rest of the paragraphs were reviewed “disagree” and they were (3) paragraphs and one paragraph was in the category of “strongly disagree”. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 223 table 12. frequencies, percentages, arithmetic means, standard deviations, and the ranks of the items of the teaching staff axis. item frequency/ percent approval degree am sd rank review strongly agree agree somewhat agree disagree strongly disagree the second axis: teaching staff 1 f 18 51 34 18 4 3.49 1.013 2 agree % 14.4 40.8 27.2 14.4 3.2 2 f 21 48 36 14 6 3.51 1.052 1 agree % 16.8 38.4 28.8 11.2 4.8 3 f 15 44 41 18 7 3.34 1.047 4 somewhat agree % 12 35.2 32.8 14.4 5.6 4 f 12 33 38 33 9 3.05 1.099 5 somewhat agree % 9.6 26.4 30.4 26.4 7.2 5 f 7 37 36 30 15 2.93 1.116 6 somewhat agree % 5.6 29.6 28.8 24 12 6 f 28 36 33 19 9 3.44 1.201 3 agree % 22.4 28.8 26.4 15.2 7.2 general mean of the axis 3.29 1.088 somewhat agree the general mean of the axis indicated that the graduates somewhat agreed to the reality of the teaching staff in the saudi universities as shown in table (12). three paragraphs were in the “agree” category, respectively. the teaching staff at the university is characterized by knowledge and eruditeness with a mean of (3.51), followed by “the teaching staff is characterized by cooperation with students” with a mean of (3.49), then “i can communicate with the faculty member when i need easily” with a mean of (3.44) and the three paragraphs were in the “somewhat agree” category and the item of “the teaching staff is able to benefit from modern technology” was the last one with a mean of (2.93). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 224 table 13. frequencies, percentages, arithmetic means, standard deviations, and the ranks of the items of the study plan axis. item frequency/ percent approval degree am sd rank review strongly agree agree somewhat agree disagree strongly disagree the third axis: study plan 1 f 42 55 15 12 1 4.00 0.959 1 agree % 33.6 44 12 9.6 0.8 2 f 29 40 27 24 5 3.51 1.16 4 agree % 23.2 32 21.6 19.2 4 3 f 17 50 26 26 6 3.37 1.10 5 somewhat agree % 13.6 40 20.8 20.8 4.8 4 f 27 55 25 13 5 3.69 1.05 3 agree % 21.6 44 20 10.4 4 5 f 18 29 22 27 29 2.84 1.39 6 somewhat agree % 14.4 23.2 17.6 21.6 23.2 6 f 49 23 29 16 8 3.71 1.28 2 agree % 39.2 18.4 23.2 12.8 6.4 general mean of the axis 3.52 1.16 agree the degree of the general mean of the axis indicated the graduates agree to the quality of the study plan in saudi universities as shown in table (13). the graduates agreed that they agreed on four paragraphs, the most important of which was "i have familiar with the study plan and its requirements" with a mean of (4.00), followed by "the hours allocated for practical training are few and insufficient "and that they were somewhat agree to three paragraphs, the least of which was" practical training during the study enabled me to understand the work environment "with an average of (2.84). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 225 table 14. frequencies, percentages, arithmetic means, standard deviations, and the ranks of the items of the professional tests axis. item frequency/ percent approval degree am sd rank review strongly agree agree somewhat agree disagree strongly disagree the fourth axis: professional tests 1 f 19 45 15 29 17 3.16 1.316 5 somewhat agree % 15.2 36 12 23.2 13.6 2 f 24 44 25 20 12 3.38 1.236 4 somewhat agree % 19.2 35.2 20 16 9.6 3 f 18 35 13 35 24 2.90 1.382 6 somewhat agree % 14.4 28 10.4 28 19.2 4 f 61 34 22 5 3 4.16 1.011 1 agree % 48.8 27.2 17.6 4 2.4 5 f 35 35 26 17 12 3.51 1.293 2 agree % 28 28 20.8 13.6 9.6 6 f 29 35 34 18 9 3.46 1.202 3 agree % 23.2 28 27.2 14.4 7.2 general mean of the axis 3.43 1.240 agree the degree of the general mean of the axis indicated the graduates approval to professional tests as shown in table (14). three paragraphs were in the "agree" category, the most important of which was the "the obstacle in the professional tests is the high financial fees" with a mean of (4.16) and three paragraphs were in the "somewhat agree" category, and the lowest was "i registered in some professional tests" with a mean of (2.90). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 226 table 15. frequencies, percentages, arithmetic means, standard deviations, and the ranks of the items of the educational outputs axis. item frequency/ percent approval degree am sd rank review strongly agree agree somewhat agree disagree strongly disagree the fifth axis: educational outputs 1 f 25 53 28 12 7 3.62 1.083 4 agree % 20 42.4 22.4 9.6 5.6 2 f 13 41 37 25 9 3.19 1.098 9 somewhat agree % 10.4 32.8 26.6 20 7.2 3 f 20 64 23 11 7 3.63 1.036 3 agree % 16 51.2 18.4 8.8 5.6 4 f 18 53 29 21 4 3.48 1.036 5 agree % 14.4 42.4 23.2 16.8 3.2 5 f 28 31 25 19 22 3.19 1.407 10 somewhat agree % 22.4 24.8 20 15.2 17.6 6 f 23 43 23 29 7 3.37 1.188 7 somewhat agree % 18.4 34.4 18.4 23.2 5.6 7 f 22 41 28 24 10 3.33 1.203 8 somewhat agree % 17.6 32.8 22.4 19.2 8 8 f 29 54 20 13 9 3.65 1.159 2 agree % 23.2 43.2 16 10.4 7.2 9 f 34 35 22 21 13 3.45 1.329 6 agree % 27.2 28 17.6 16.8 10.4 10 f 30 37 28 14 6 3.65 1.109 1 agree % 24 37.6 22.4 11.2 4.8 general mean of the axis 3.46 1.165 agree the degree of the general mean of the axis indicated the sample members' approval to the items of the educational outputs as shown in table (15). the course included six paragraphs, their mean was in the "agree" category, the most important of which was "university education contributed to the development of my personal abilities" with a mean of (3.65), and four paragraphs were in the "somewhat agree" category and the lowest was "i am currently working in the field of specialization" with a mean of (3.19). in order to determine which axes were approved by the sample, the arithmetic means of the axes were ranked and the results were as follows: asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 227 table 16. rank of the axes according to arithmetic means axis arithmetic mean rank the first axis: specialization identification 2.51 5 the second axis: teaching staff 3.29 4 the third axis: study plan 3.52 1 the fourth axis: professional tests 3.43 3 the fifth axis: educational outputs 3.46 2 the results in table (16) indicate that the most agreeable axes was the study plan with a mean of (3.52), followed by the educational outputs with a mean of (3.46), then the professional tests with a mean of (3.43), the teaching staff axis in the fourth rank with a mean of (3.29), and the specialization identification in the last rank with a mean of (2.51). 3.5 study hypnoses test the first hypothesis: there is a relationship between specialization identification and the quality of educational outputs. table 17. axis correlation coefficient significant relationship between specialization identification and the quality of educational outputs -0.04 not significant the correlation between the specialization identification and the quality of educational outputs indicated that there was no significant relationship at (0.05) level as shown in table (17). thus, according to the results of the study, there was no relationship between the specialization identification and the quality of educational outputs. the second hypothesis: there is a relationship between the efficiency of teaching staff and the quality of educational outputs. table .18. axis correlation coefficient significant relationship between the efficiency of teaching staff and the quality of educational outputs 0.52 significant the results of the relations indicated that there was a significant correlation between the efficiency of the teaching staff and the quality of the educational outputs at a level of (0.01). the correlation coefficient between them was (0.52) as shown in table (18) and this is logical because the efficiency of the teaching staff has an impact on the educational outputs of the university. thus, the second hypothesis is that there was a relationship between the efficiency of teaching staff and the quality of educational outputs. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 228 the third hypothesis: there is a relationship between the study plan and the quality of educational outputs. table 19. axis correlation coefficient significant relationship between the study plan and the quality of educational outputs. 0.41 significant the results indicated that there was a significant correlation between the study plan and the quality of the educational outputs at a significant level of (0.01) with correlation coefficient (0.41) as shown in table (19) and this is logical because the study plan is part of the educational outputs. thus, the third hypothesis is that there was a relationship between the study plan and the quality of the educational outputs. the fourth hypothesis: there is a relationship between the professional tests and the quality of educational outputs. table 20. axis correlation coefficient significant relationship between the professional tests and the quality of educational outputs. 0.39 significant as shown in table (20), there was a significant relationship between the professional tests and the quality of the educational outputs at a significant level of (0.01) and the correlation coefficient was (0.39). this can be explained by the fact that professional tests are an indicator of the quality of outputs. they vary from one student to another and thus the relationship is average because the competency of the graduate does not necessarily have to match the quality of the outputs. thus, the fourth hypothesis is accepted, namely there was a relationship between the professional tests and the quality of the educational outputs. 4. results and recommendations the study concluded the following:  the approval of the sample was (48.8%) on the fact that they chose their specialization with their own desire and without external pressure and this is an excellent indicator. the choice of the student to specialize with his own conviction and desire is often reflected on the level of study and the results achieved.  the approval of the sample on what is distinguished by the teaching stuff of knowledge and eruditeness, cooperation with students, the possibility of communication between the student and the faculty member when needed easily, while the item of "benefit from modern technology" was the lowest item as the sample was somewhat agree on this item, this may be due to from my personal view (lack of modern technology in some universities, lack of periodic asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 229 maintenance of modern equipment and appliances in universities, difficulty in accessing modern equipment, lack of modern equipment and lack of financial support).  the approval of the sample on the quality of study plans in saudi universities and their knowledge of the study plan and its requirements, while the lowest items approved was the item "understanding the working environment during practical application", this may be due to the reservation of some training information and restricting access of students during the application of information and data in order to preserve the clients' privacy. this can be solved by obtaining a pledge from the student to preserve the information and data and not to disclose it or use it, or to view part of the information and data of the company, which does not entail damage to the company.  the most prominent obstacles of the graduates in the professional tests are the high fees for the professional tests as this was the highest approval items from the point of view of the sample of the study, which led to the lack of registration of some in the professional tests as the item of registration in the professional tests was the lowest approval items in the category " somewhat agree", and this may be due to the high financial costs of the professional tests as confirmed by the study sample. therefore, the professional bodies should review the prices of tests, courses, and books issued by them, and the development of prices commensurate with the financial ability of students. in this regard, we find, for example, the saudi organization of certified public accountants has provided scholarships and courses for students which is an excellent initiative, and has reduced the prices of training packages, so the professional accounting and financial entities should take into account the financial ability of students.  the approval of sample members on the quality of educational outputs and the item " university education contributed to the development of my personal abilities" as the highest items approved by the sample, while the item "work in the field of specialization" was the least approved items in the category "somewhat agree".  there was no relationship between the specialization identification and the quality of educational outputs and this may be due to the possibility of changing the specialization of the student during the university study.  there was a relationship between (the efficiency of the teaching staff, the study plan, the professional tests) and the quality of the educational outputs. recommendations  universities bear a limited part in the responsibility of providing qualified cadres to meet the requirements of the labor market because of the continuous change in the requirements of the labor market. for example, what a brokerage company is looking for from graduates of accounting and financial specializations is different from what is looked for by an industrial company. thus, the rehabilitation of graduates is an integrative role carried out by several parties, part of which is the educational bodies, the other part is borne by the employer, and part falls on the student so there must be joint cooperation between all parties. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 230  self-development of graduates, the search for integration in the capital market, and the acquisition of experience are required, but the problem lies in the reluctance of some companies to bear the costs of training or rehabilitation of the student, in addition to their fear of leaving the company after being rehabilitated and developed, and this can be solved by obliging the student to serve the company for a similar period for the duration of his training or compensate the company for the costs of training and rehabilitation if he wanted to leave the company.  reconsidering the financial costs of the professional tests. the results of the study showed that the sample of the study faced financial difficulties in preparing or conducting professional tests due to the high fees. therefore, we recommend the review the financial costs of the tests, training packages and fees imposed on the professional tests and make them accessible to new graduates.  conducting futures studies about the level of modern technology in universities from the point of view of the members of the teaching staff, the level of accounting education between the public sector and the private sector, and the output of accounting education in the private sector. notes note 1. the vision of the kingdom of saudi arabia (2030). link: https://www.vision2030.gov.sa/sites/default/files/report/saudi_vision2030_ar_2017.pdf. references al-asmari, hajar. 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(1998). التعليم والتدريب المحاسبي. (education and accounting training). journal of accounting. saudi. fifth edition. no. 19. 34-39. hassan, mahmoud. (2018). مدى توافق التعليم المحاسبي مع متطلبات سوق العمل "دراسة ميدانية: على المؤسسات the compatibility of accounting education with the) والجمعيات األهلية المحلية في قطاع غزة". requirements of the labor market "field study: on the institutions and local ngos in the gaza strip". master thesis. islamic university of gaza. khalil, atta allah. (2005). اسة تحليلية في الجامعات األردنية. دور إدارة المعرفة في تطوير التعليم المحاسبي در (the role of knowledge management in the development of accounting education: an analytical study in jordanian universities). journal of trade and finance. commerce college. tanta university. egypt. issue 2. pp. 221-266. mcguigan, nicholas; kern, thomas. (2016). creactive accounting education: visioning future-oriented accounting programs through a reflective unlearning of current practice. journal of university teaching & learning practice, 13(2). murad, salah. (2011). األساليب اإلحصائية في العلوم النفسية والتربوية واالجتماعية. (statistical methods in psychological, educational and social sciences). the anglo egyptian library. cairo. obeidat, zaokan; abdul haq, kayed; adas, abdulrahman. (2007). دواته البحث العلمي مفهومه وأ scientific research, its concept, tools and methods. 10th edition. dar el fikr for) وأسالي publishing & distribution. qitnani, khalid; aweys, khalid. (n.d). مدى مالئمة مناهج التعليم المحاسبي في الجامعات العمانية لمتطلبات the appropriateness of accounting curricula in omani)سوق العمل في ظل تداعيات االزمة المالية. universities to the requirements of the labor market in light of the repercussions of the financial crisis). unpublished research. saleh, abdullah. (2017). أهمية تطوير التعليم المحاسبي في ضوء مستجدات معايير اإلبالغ المالي الدولية ودورها في تحرير الخدمات المحاسبية في الدول العربية. (the importance of the development of accounting education in the light of the latest international financial reporting standards and its role in the liberalization of accounting services in the arab countries. phd thesis. faculty of economic and commercial sciences and management sciences. hassiba benbouali university of chlef. algeria. appendix (1) dear mr./mrs. (allah bless him/her) may the peace, mercy and blessings of allah be upon you, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 232 this questionnaire aims at identifying the appropriateness of educational outputs in the saudi universities for the labor market from the point of view of graduates in the financial field, employees in the public sector, private sector, or personal business. the questionnaire consisted of two parts: the first part includes the personal and functional characteristics, the second part includes the study axes, which are 5 axes, 33 paragraphs (the first axis is 5 paragraphs, the second is 6 paragraphs, the third and the fourth are six paragraphs each, and the last is 10 paragraphs). we hope to answer all the items of the questionnaire, and we assure you that all the information required is for the purposes of scientific research only, we appreciate your participation, your views, and your cooperation in this, may allah grant you and us all the success. thank you for your cooperation, the researcher part 1: personal and functional characteristics: 1. gender male ( ) female ( ) 2. age less than 30 years ( ) from 30 to less than 40 ( ) from 40 to less than 50 ( ) 50 years and above ( ) 3. graduation date less than one year ( ) from one year to less than 3 years ( ) from 3 years to less than 5 years ( ) 5 years and above ( ) 4. university name -------------------------- 5. scientific degree bachelor ( ) master ( ) ph.d. ( ) 6. job public sector ( ) private sector ( ) personal work or business ( ) part 2: the study axes sr. items strongly agree agree somewhat agree disagree strongly disagree the first axis: specialization identification 1 i chose this specialization with my personal desire 2 i chose this specialization under family pressure 3 i chose this specialization because asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 233 of pressure from the community 4 my academic grade is my reason for this specialization identification 5 i chose this specialization because of a friend or colleague the second axis: teaching staff 6 the teaching staff in the department cooperate with the students 7 the teaching staff is erudite and knowledgeable 8 the teaching staff deliver the information in a good way 9 the teaching staff is characterized by keeping up with changes and developments in specialization 10 the teaching staff is able to benefit from modern technology 11 i can communicate with a faculty member when needed easily the third axis: study plan 12 i have knowledge of the study plan and its requirements 13 the study plan consists of a large number of hours in general subjects 14 the study plan consists of a large asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 234 number of hours in the subjects of specialization 15 the study plan consists of a large number of hours required for graduation 16 practical training during the study enabled me to understand the work environment 17 the number of hours allocated for practical training is few and insufficient the fourth axis: professional tests 18 i have knowledge of the professional tests and options available when i graduate 19 i have a clear direction in the area in which i want to work 20 i registered in some professional tests 21 the obstacle in professional testing is high financial fees 22 the obstacle in professional tests is english 23 the obstacle in professional testing is the availability of scientific sources the fifth axis: educational outputs 24 i benefited from what i studies in my field asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 235 25 i applied what i learned in my field 26 i have benefited from what has been studied in personal life 27 i applied what i learned in my personal life 28 i am currently working in the field of specialization 29 university education contributed to the development of my technical abilities 30 university education has contributed to my analytical abilities 31 university education has contributed to my scientific development 32 university education has contributed to the development of my research capacity 33 university education has contributed to my personal abilities development microsoft word 14630-52976-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 220 how do indian firms cope with a crisis? earnings management characteristics of cnx nifty 100 companies amit mittal indian institute of management, lucknow india ajay kumar garg indian institute of management, lucknow india received: april 8, 2019 accepted: may 30, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14839 url: https://doi.org/10.5296/ajfa.v11i1.14839 abstract an analysis of indian cnx nifty 100 companies uncovers the perils of opportunistic earnings management as crises affect balance sheets in fy2007 and fy2012, recession years around the global financial crisis. only a small portion of the companies engage in sophisticated earnings management commensurate with performance. operating accruals of the firm are synonymous with its working capital investment. these accruals measure working capital dependencies in financing growth and should instantiate on ppe investments. the modified jones model is measured for the sample of cnx 100 companies including banks and a did approach used to compare data before and after a crisis year. indian firms show only a 2% level of accruals, but more than 30% firm years show significantly higher accruals in growth years. the study proves indications of performance measurement hypothesis yet primarily only opportunistic accruals with negative correlation between post crisis and pre-crisis accruals and accruals increasing in the post crisis year. accruals are significantly incident on sales in the pre-crisis years. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 221 the presence of negative accruals may show effects of high growth and slack corporate governance. banking firms respond with a more sophisticated earnings management strategy. discretionary loan loss provisions significantly increase with increase in cash profits. these operating accruals of the firm are synonymous with its working capital investment. keywords: discretionary accruals, earnings management, gfc, global financial crisis, financial reporting, corporate governance, india, nse 100, negative accruals jel: m41, m49 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 222 1. introduction india is one of the deepest financial markets and an attractive destination for venture capital and private equity (groh et al., 2018). this study features the behavior of the 100 largest and most liquid nse 100 firms from india, analyzed in the modified jones model used by dechow, sloan and sweeney (1995), hereinafter referred to as dss95. we also include banks in our analysis for earnings management. across two recessions in 2007 and 2012 recovering firms show striking changes in earnings management behavior revealing opportunistic behavior of firms caught in all its glory using a simple did design while banks show up as sophisticated users of accrual-based earnings management during the same period. financial reporting continues to become sophisticated and is consistently harmonized internationally. there is evidence, however, that firms worldwide continue to engage in accruals-based earnings management and real activity earnings management. this also corresponds to a general reluctance on part of managers to report bad news and to report in line with or beating expectations from their own guidance and analysts’ forecasts. accruals are a significant indicator of earnings quality along with persistence, smoothness, timeliness, loss avoidance and frequently used for verification in the literature with events of earnings restatement and enforcement actions by sec(usa), sebi(india) or other regulators (dechow, ge and schrand, 2010). evidence of counteracting business cycle impact on the firm is linked with both real and accrualbased earnings management. however, reporting enforcement of real measures that include one-off expenses may be unreliable and we rely on accrual-based earnings measures of earnings management. recent analyses link earnings management propensity of firms with market returns (li and hwang, 2019, dayanandan and sra, 2018). earnings management literature relies heavily on the jones (1991) model. different variations in methodology have been focused around maintaining and improving the power of the test and a recognition of the limitations of the test while its continuing effectiveness in isolating discretionary accruals. we use a sample of the 100 largest and most liquid indian firms listed on the nse, represented in the nifty 100 index. as of march 2018, the index represented nearly four fifths of the indian market capitalization. operating accruals of the firm are synonymous with its working capital investment. both industry-based models and the generalized models have been applied to the problem of isolating non-discretionary and discretionary accruals. competing earnings management theories can be variously applied and extended to therefore, forecast companies’ idiosyncratic and market wide responses to information flow and macroeconomic factors to its version of the truth in providing earnings guidance, reacting to good and bad news and creating cookie jar reserves for the future. agency theory (jensen and meckling, 1976) explains partly the managers’ increasing requirements for a discretion in reporting earnings and smoothing earnings irrespective of industry. the study investigates earnings management strategies of the 100 largest banks and nonfinancial companies from india and compares their reactions to financial crises to separate how asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 223 many firms are displaying sophisticated corporate governance and following performance measurement hypothesis of earnings management in a larger emerging market like india with deeper financial markets and a robust regulatory environment. emerging markets have a higher average economic growth and growth imperatives are expected to influence firms’ earnings management strategies. follow on research can show the impact of national accounting guidelines, ifrs, guidance and forecast revisions and pre-ipo or pre-merger valuation motivations on the earnings management strategy of the firm and relate to its expectation management of stock returns. goel (2018) tests for mne vs domestic difference in earnings management using reputation; ming (2003) and elleuch and taktak(2015) use earnings management to trace the process of effectivising corporate governance and regulation in an emerging economy; while safdar and yan (2016) and attia, lassoud & attia (2016) recover significant managerial outcomes employing earnings management models. 1.1 earnings management in banks banks have been found to exercise a similar discretion in providing and renewing loan loss reserves to create a managerial control option in reported earnings. while current research ignores banks in earnings management analysis, we collate earnings management analyses by banks and present a consolidated finding comparing the entire nse 100 sample. current research also finds the role for afs securities following on realized gains from securities which we also attempt as a proxy for indian banks in the nifty 50 and junior 50 indices. fair value accounting is still not likely to show up in indian banks’ reported data though some data on outstanding derivatives’ positions is available and securitization is also expected to add more power to manage growth financing to banking balance sheets. gombola, ho and huang (2016) have also linked the recent literature in leverage and liquidity to earnings and capital management. othman and mersni (2014) provide an informative analysis using loan loss provisions (llps) in middle eastern banks while ozili (2018) links discretionary llps to macroeconomic progress and investor protection. 1.2 dealing with crises cyclical recessions and non-cyclical crisis events such as the global financial crisis of 2007 generate a similar response from firms within the means available to managers to tweak their financial reporting and minimize the impact of the crises on the firm’s stakeholders and future investing and financing activities. we use crisis years of 2007 and 2012 to measure and report the earnings management activities of indian non-financial firms and banks and review the results considering existing evidence and for the benefit of follow on research in the area. the analysis and the literature recognizes that quarterly earnings announcements facilitate the smoother management of earnings management strategies but as it relies on a large sample, it expects sufficient power in the tests to ignore other announcement effects in a consideration of annual earnings announcement windows. flores et al. (2018) and persakis and iatridis (2015) review the relationship between crises and earnings management. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 224 final earnings announcements of the year are likely to be more definitive regarding the company’s overall earnings management intentions and avoid seasonal fluctuations. as indian firms follow an april – march fiscal year, we also follow their march fiscal announcements. we also expect in general that changes in accounting guidelines over the years would have reduced overall opportunities for earnings management. however, the corresponding likely increase of intangible assets during the period would correspond to some increasing opportunity for earnings management as well as is visible in table 2. the analysis precludes the final introduction of ifrs as a mandatory requirement for indian firms though internationally focused and corporate governance aware firms invest in ifrs based financial reporting. we also rely on a consensus that informativeness of financial reporting has not decreased in the period of 2002-2015 which data we employ in the analysis. seminal research in the area includes a discussion on informativeness in beaver, correia and mcnichols (2009); discussion on earnings quality by dechow, ge and schrand (2010) and the discussion by mcnichols and stubbens (2008) on the role of earnings management in relation to investment activity envisaged by the firm. this study contributes to the literature in establishing a benchmark level of earnings management in emerging markets which at 2% verifies with other multi country studies in the area. we find there are no significant differences based in industries however given that growth-oriented firms are creating more earnings management, the influence of innovationbased strategies can be explained in industrials and healthcare (see table 2) apart from the significant effect of corporate governance on earnings management. the study is based on 100 largest listed enterprises in india under the companies act (2013) and the relevant banking acts for listed banks. sophisticated earnings management is proved by a negative correlation in larger corporates and the pro cyclical ramp up of discretionary llps in banks the study importantly proves the opportunistic reliance of large, well-managed and established firms on sales. earnings management is related to sales with a large coefficient that significantly changes signs in the crisis years. this reflects poorly on corporate governance standards in large emerging markets and reflects on the requirement of investment outstripping available capital as managers increase profit reporting using all available cash into working capital investments making ppe investments a second-best priority. earnings management is lower in larger companies with recognition in corporate governance. india is an investor friendly, well-regulated destination with deep financial markets (groh et al., 2018). the study tries to close the gap in the higher earnings management given in the sample given the better standards of corporate governance visible based on compliance with international reporting standards and the recent outward m&a seen in such large emerging markets and compares earnings management strategies of banks in the sample(listed banks in the nifty 100 in india). we find banks to be sophisticate users of earnings management, increasing llps during profitable years supported by express regulation from the rbi (central bank). jooste (2013) employs a survey to confirm the ethical issues surrounding discretionary earnings management while li, park and bao (2014) comment on trustworthiness of financial reporting in emerging market economies. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 225 the following section updates the literature review on the subject. the document proceeds to explain the data and apply did measurement with the earnings management model to isolate the behavior of discretionary accruals in the designated crises years. in the end we discuss the conclusions from our data and the implications for the subject. 2. literature review earnings management has been tested empirically across international accounting regimes. it is seen to be lower in common law countries because of better investor protection (leuz, nanda and wysocki, 2003). real earnings management becomes more possible with lower discretionary expenses. however, li (2019) confirms that real and accrual-based earnings management are complementary. attia, lassoued and attia (2016); ahmed (2015); safdar and yan (2016); and dayanandan and sra (2018) comment on the accrual-based earnings management in emerging markets and their earnings quality, informativeness and value relevance in a growth environment. asia and other higher growth countries are found to lie in an independent cluster with both civil and common law characteristics with significant accrual-based earnings management (ibid.). these dimensions in earnings management advantage from corporate finance literature of laporta et al (2002) relating corporate governance, monitoring and investor protection and legal frameworks in host countries. accruals are frequently used for verification in the literature with events of earnings restatement and enforcement actions by sec (usa), sebi (india) or other regulators. (dechow, ge and schrand, 2010) bonus contracts necessitate earnings management in line with agency implications. evidence of counteracting business cycle impact on the firm motivates it. the extent of earnings management using accruals may depend on the extent of ownership control in the company. beating forecasts (earnings surprise), a frequent phenomenon in india, however, is not seen as a motivating factor for increasing institutional ownership, as in sen (2009). dechow et al. (2012) continue their 1995 seminal review of earnings management models in an effort to create a more robust test to detect earnings management by assuming the eventual reversal of discretionary accruals in the very next year. while the presence of a large sample in our case allows us to avoid making such assumptions, we expect the reversal of accruals to force ill prepared firms into a reactive crisis of earnings in their post crisis reports in fy 2007 and fy 2012. we rely on the original modified jones models and then separate the discretionary accruals for the firms. the jones (1991) model introduced a linear relation between total accruals and changes in sales and property, plant and equipment. the effect of account receivables from credit sales is subsequently accounted for in the modified jones model by dss95 and remains the bedrock of earnings management literature. this model replaced the total accruals approach and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 226 industry model approaches as succinctly explained in dss95. the detailed model is presented in section 4.3. while non-discretionary accruals relate to the operating characteristics of the business, discretionary accruals reverse out in a few years. corrections to the modified jones models in the literature by dechow et al. (2011) incorporating reversals in the very next year and by use of matched firms by kothari, leone and wasley (2005) are found to be exceedingly complex without additional benefits of power or reliability. other mechanisms to separate accruals also frequently underperform the modified jones model and thus the same as typified in equations (1) and (2) is primarily used on the sample here to separate discretionary accruals. the reversal of discretionary accruals in fact improves the statistical validity of the test and improves its power over a larger sample. the model remains robust and the most effective in discerning the role of accruals after controlling for long term growth and the return on assets. the growth variation is realized because of dependence of growth on the working capital investment outlays. the success of the modified jones model however argues that the model may be biased against growth companies seen as reporting higher discretionary accruals (mcnichols, 2000). this study separates the discretionary accruals for the firms as per the model. using discretionary accruals thus available, the literature goes on to implement market model event studies based in ross’ apt in defond and jimbalvo(1994) and estimate the influence of independent components of non-discretionary accruals after controlling for expected growth as in mcnichols(2000). however, the attempt at specifying specific accruals tests has failed repeatedly in the literature. additionally, even the use of annual year end data as in our study has to contend with clustered announcements at the end of the year and it is difficult to assume a parametric relation even after specifying different bases to tackle event contamination and it is virtually impossible to isolate the effects of specific accruals except for that may be argued in theory. for example, changes in receivables are specific to the credit policy (easy or discriminatory or other generous) adopted by each firm and even price changes of the product may show up in higher sales and higher discretionary accruals. kothari, mizik and roychowdhury (2015) process the available models for discretionary accruals and real activity manipulation to affect the causality in valuation of pre-seo companies’ (ipo) valuation. similarly, the use of this earnings management analysis will be useful in discovering valuation issues prior to a firm planning higher inorganic investments i.e. large public and private mergers and acquisitions (mao and renneboog, 2015). however, issues of valuation are more affected by real activity manipulation, namely by influencing consistent opportunistic reduction of intangible expenses and sga expenses prior to ipo. investors’ trust is more affected by accrual-based earnings management (hewitt, hodge and pratt, 2015). discretion available to managers allows us to account for the basu asymmetric timeliness coefficient (ball, kothari and nikolaev, 2013) or the negative coefficient to bad news in asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 227 earnings that allows for slower digestion of negative earnings impact news that ties in with accounting conservatism. dechow et al. (2012) reinforces a negative correlation in discretionary accruals time series as they are expected to be reversed. richardson et al. (2005) describe earnings persistence as a criterion for discerning whether accruals are reliable or not. this implies that firms may be marked as unreliable after having used opportunistic accruals to trump up earnings as reversals ensue. on the other hand, this increases the tendency of firms to engage in downward earnings management as they understate earnings in good times and that allows them to smooth earnings during crises. we analyze our sample to affirm if specific firms can be seen to be implementing downward earnings management or if they are engaging primarily in opportunistic accruals management. earnings management motivations are frequently explained in agency theory. this includes earnings forecasts and earnings surprises, differentiating positive and negative surprises and the management propensity to influence bonuses and manage bad news slowly as measured in the basu asymmetry coefficient (ball, kothari and nikolaev, 2013). earnings management will depend on institutional ownership (ghosh, 2011), the presence of international investors, accounting conservatism, impairment and loss events, and analyst forecasts or management guidance. dechow et al. (2011) and others use the list of sec enforcement actions to identify a sample of firms engaging in accruals misstatements and try to predict characteristics of misstating firms using f-statistics to get rid of chances of type i errors in the model. li (2019), hsieh et al. (2018) and lewellen and resutek (2019) again emphasize for our paper the importance of accrual-based earnings management in unravelling corporate governance because of the low persistence of accruals and their direct linkages with managerial incentives and managerial background while ozili (2018) and dayanandan and sra (2018) confirm effective procyclical governance using accrual based earnings management and their obvious value relevance. working capital investments as mentioned earlier, the formulation for accruals in equation (2) in section 4.3 refers the working capital investment of the firm. as such, this formulation is likely to be highly skewed in growth times as firms rely on working capital investments to increase the ppe investments of the firm. this is additionally evidenced strongly in our sample of indian firms. banking firms oosterbosch (2000) presents a comprehensive literature review of earnings management practices in banking firms and tests findings of earnings management thru loan loss provisions after the introduction of ifrs in small and large banks. banks valuation and reporting models specify regulatory effects and a reliability of operating profit measures. we therefore rely on banks’ specific accrual measures from the literature in loan loss provisions, and trading gains. in a regulator motivated study, meisel (2013) applies an industry specific model to banks and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 228 compares for valuation effects in banking firms planning mergers and merger defense. ahmed, takeda and thomas (1999) find no expected earnings management effect in banks and explains the negative correlation of loan loss provisions to future earnings and stock returns allowing banks to focus on loan loss provisions (countercyclical and not pro-cyclical as expected in earnings management) for capital management. event studies earnings management motivations and information flows relationships are also a frequently tested subject in the literature. these models rely on event study based parametric and nonparametric tests to establish relationship between derivatives pricing, analyst coverage and the accruals anomaly to investigate relationships with accruals. meeting expectations on a regular basis may for example, improve abnormal returns in calibrated event studies. also, for companies forced to produce a negative earnings surprise, there may be a motivation to manage earnings downward and create cookie jar reserves for future periods. this has been explored by dechow et al. (2011, 2012) for firms reporting zero or negative earnings, showing up as a very asymmetric distribution around 0 earnings. firms positively manipulating earnings also end up over investing in the period with higher discretionary accruals. earnings management was also definitively changed for cross listed firms after the introduction of sox in the us in 2002. also, audit firms are seen to increase their fee around increasing earnings management. mncs in india (ghosh, 2011) are seen to employ international auditors with lower monitoring resulting in higher discretionary accruals. earnings management will thus depend on institutional ownership, the presence of international investors, accounting conservatism, impairment and loss events, and analyst forecasts or management guidance. more importantly it has significant linkages in the corporate governance literature and a significant indicator of the corporate governance score of the candidate firms. we complete the literature review as we began with another application of discretionary accruals in the earnings management literature with barth et al. (2014) that attempt a market model based earnings transparency measure, where they find in favor of a lower cost of capital reward for firms that can prove earnings transparency. the new ifrs mandate in the meanwhile is expected to homogenize financial reporting completely after its launch in 2019 and may necessitate a reevaluation of any firm specific measures and traditional earnings management (barth et al., 2012). however, oosterbosch(2000) confirms that sophisticated earnings management users in large banks continue to prefer earnings management to retain investor trust. 3. hypotheses we propose and evaluate the following hypotheses for indian firms employing accruals-based earnings management hypothesis 1: crisis events will expose firms’ specific earnings management strategies. proactive strategies (performance measurement) can be compared with reactive earnings management (opportunistic accruals). asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 229 if there is proactive earnings management, there may be no change in the firms’ em strategies. it is reasonable to expect that the reversal of accruals to force ill prepared firms into a reactive crisis of earnings in their post crisis reports in fy 2007 and fy 2012. the low persistence of accruals (lewellen and resutek, 2019) link accrual-based earnings management directly to managerial incentives (ahmed, 2015) as higher earnings management expose manipulation. also, as li (2019) discovers, accrual and real based earnings management are complementary to each other. hypothesis 2: indian firms will reflect earnings management strategies more suited to growth firms. crisis response will be heightened in indian firms because of the pressures of growth. hsieh et al. (2018) finds in an emerging market sample that the firms’ executive leadership defines its earnings management levels effectively moderated by the presence of founders. emerging markets in asia therefore balance between curbing earnings manipulation because of the educational backgrounds of top management whilst managing the trade off with entrenchment hypothesis hypothesis 3: both banking firms and non-financial firms will exhibit complementary earnings management strategies. banking firms will respond with more sophisticated earnings management as adverse credit decisions lead the onset of a crisis. in the presence of basic data on loan loss provisions and trading gains on securities the analysis shows the presence of earnings management in the financial firms (tested in only banking firms) as being more sophisticated than that in the sample of nonfinancial firms. elleuch and taktak (2015) decode earnings management in banks as regulations change while ozili (2018) and othman and mersni (2014) trace the macroeconomic cycles and efficient and effective earnings management by banks using discretionary llps. hypothesis 4: indian firms primarily engage in performance measurement using discretionary accruals if they have the requisite size. as tested in guay, kothari and watts (1996) henceforth gkw, the discretionary accrual amounts and their relationship to earnings can be used to tie in the firms’ use of discretionary accruals as performance measurement vis a vis opportunistic accruals management hypothesis. this will be shown by the presence of a negative correlation in the discretionary accruals in the pre-crisis and post crisis years. however, this might be significant evidence of opportunistic accruals management if the direction of the accruals is higher in the post crises year. earnings management in emerging markets with robust markets and investor protection regimes is significantly affected by growth and management skills (hsieh et al. 2018) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 230 4. experimental design 4.1 sample selection the nifty 100 index constituents form the sample of firms in the study. the popular nifty 50 and nifty junior 50 indices together account for the nifty 100 firms. these firms are spread across 12 sectors and as for march 2015 account for 78% of the free float of the national stock exchange in india. after excluding other financial firms, we end up with 76 firms and 12 banks and calculate the accrual measures based on the modified jones model weighted by total assets at the beginning of year to take care of endogeneity and minimize size effects in the pooled regression. for each firm we get financial statement data from the bloomberg database for the period 2001-2015. some firms need to be excluded for non -availability of key financial statement data such as m&m (receivables) and bharat forge (total assets). as firm years are separated later based on crises events in 2001, 2006 and 2011, we use financial data as available only when completely available for both pre and post crisis years. other firm years are collated together to compute the ols coefficients in (1). we neglect the small impact of taxes in the calculation of total accruals in the data. apart from the effect being small in size, most tax aligned manipulation of earnings is likely to be included in real activity earnings management and we concern ourselves with accruals based earnings management. we also appreciate our limitation of this study in that in the style of bartov (2003) we would prefer using 10-q and equivalent indian disclosures to closely track earnings management. however, it is also true that earning management is intuitive to the firms’ management and usually advantages from earnings seasonality and priorities. thus, an experiment design with quarterly statements may not be ideal for earnings management analysis. 4.2 data the 76 non-financial firms yield a total of 692 eligible firm years. as 2001 is usually the first available year in the bloomberg data files, we are unable to use the crisis year in 2001 in the specification. the scaling requires last year’s total assets to form the variables. this is because the development of the accrual model realizes the previous years’ closing balance sheet value (total assets) as the best company datum to weight accruals and revenue and property plant and equipment data assigned in equation (2). we calculate weighted data for total accruals and the two independent variables for the 692 firm years using the values of revenues, receivables, current assets, current liabilities, cash and equivalent, short term debt, total assets (t-1 year) as well as pp&e, directly available from bloomberg or within reasonable permutations from available fields without restating earnings or applying further approximations. this meant sometimes computing the value of total assets for all years based on net current assets + total non-current assets. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 231 the sample of 692 firm years has corresponding 109 crisis observation pairs, which are tested for difference in discretionary accruals using paired t tests. the crises reactions can be separately analyzed for 2012(2011) and 2007(2006) with 64 and 45 pairs respectively. interestingly at least 191 firm years show negative total accruals even when a -10% ta level is used, signifying a heavy reliance of large growth companies in the index. these growth companies habitually rely on current liability accruals and significant ppe investments even though the amount of intangibles is increasing that may also be invested in corporate governance. in our sample of banks, the available data set of 131 firm years, we collate different ols data on loan loss provisions scaled by total loans, non-performing loans (also scaled by total loans) (which we drop for intractability), income before taxes and loss provisions scaled by total assets (ibitt )as well as trading gains scaled by the ibit. this data correspondingly has 20 crisis observations, (20 pre crises year and 20 post crises years). the fiscal year returns for the nifty 100 members are taken corresponding to available financial statement data. where such correspondence is not available, we are left with 668 eligible firm years for the decomposition models of fiscal year returns. descriptive statistics of the data series in each case from the estimation of discretionary accruals, to impact of crises years on discretionary accruals and non-discretionary accruals estimates are presented with the results from each stage of the design. 4.3 methodology the modified jones model in dss95 is implemented as under: tat = 1(1/at-1) + 1(revt rect) /a t-1 +2(ppet) /at-1 (1) tat = (cat – clt – casht + stdebtt – deptnt)/assett-1 (2) firm years are collated together to compute the ols coefficients in (1). the non-discretionary accruals are directly estimated in the above form as the total estimable accruals and the ols regression across firm years yields errors as discretionary accruals. the discretionary accruals separated from the modified jones (1991) formulation as error can thus be estimated. the small impact of taxes in the calculation of total accruals in the data is neglected. the study follows annual march fiscal announcements. informativeness of financial reporting has not decreased in the period of 2001-2015 which data we employ in the analysis. estimation of discretionary accruals have been assessed for power and relevance variously by dechow et al. (2011); kothari, leone and wasley (2005) and kothari, mizik and roychowdhury (2015). while non-discretionary accruals relate to the operating characteristics of the business, discretionary accruals reverse out after a few years. corrections to the modified jones models in the literature by dechow et al. (2011) incorporating reversals in the very next asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 232 year and by use of matched firms by kothari, leone and wasley (2005) were found to be exceedingly complex without additional benefits of power or reliability. as already discussed in the literature, other mechanisms to separate accruals also frequently underperform the modified jones model and thus the same as typified in equations (1) and (2) is primarily used on the sample here to separate discretionary accruals. the reversal of discretionary accruals in fact improves the statistical validity of the test and improves its power over a larger sample. for the crises pairs, a dummy variable partt is employed. the results of the regression using the dummy variable partt in a single regression misspecifies the results and we end up with increasing non-discretionary accruals in the crisis year. as many as 32 firm years out of 64 represent firms increasing their total accruals during the crises year. when a separate regression is run for prior and post years models to capture different non-discretionary accrual and estimate back the da from them as error, we find the increased accruals showing as expected in the padded discretionary accruals. this difference is tested using a paired t test of these firm years. the discretionary accruals estimated in the overall model are written back into the data and estimated accruals from the ols regression used for non-discretionary accruals. these nondiscretionary accruals and discretionary accruals are currently used to estimate their impact on fiscal year earnings in the style of gkw (1996). these discretionary accruals can be utilized for computing any impact on returns in follow on research using the discretionary accruals reported in this analysis as tested in the literature, the discretionary accrual amounts and their relationship to earnings can be used to tie in the firms’ use of discretionary accruals as performance measurement vis a vis opportunistic accruals management hypothesis. as per performance measurement hypothesis, we analyze our sample to affirm if specific firms can be seen to be implementing downward earnings management as per the performance measurement hypothesis or if they are engaging primarily in opportunistic accruals management. the presence of cookie jar reserves can be cogently tested in subsamples of large firms and also in industry wise measures as industry firms may likely follow similar management mantras. the sample for banks is run for earnings management on cash profits before accruals and loan loss provisions. loan loss provisions represent by far the most important discretionary accrual on bank balance sheets ad are used directly. thus the study operates on scaled llpt as a ratio of overall loans measured in a regression with two ivs, scaled trading gains (scaled by ebit), tradt and the cash profit scaled by total assets of the firm of the same year), ibitt. we also use bloomberg data for npls and trading gains as well as tier i capital ratios to measure the extent of use of discretionary accruals. on the non-financial sample we run a test of correlations between non-discretionary accruals and discretionary accruals. a negative correlation specifies an under reaction to the economic shock in the performance measurement hypothesis and conforms to the opportunistic accruals management hypothesis for firms that are forcing earnings upward. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 233 all ols regressions are run using robust standard errors in stata. 5. results 5.1 preliminary observations of the non-financial sample a simple analysis of the pre-crisis accruals shows a lack of earnings management savvy in indian public corporations as they prefer to depend on next year’s growing sales instead of creating any distance between them and a crisis with a large negative dependence on the increasing sales (-24.7%). firms also show more negative dependence on ppe investments that continues with highly significant coefficients in both pre crisis (-6.8%) and post crisis years (8.0%). however, in the post crisis years it becomes more discernible that negative accruals are related to higher capital expenditure and hence growth. this is primarily because the crisis year forces managements to invest a more significant proportion of their total accruals in discretionary cookie jar reserves. however the sales coefficient is not found to be significant in either regression. the situation is more a reflection of corporate governance practices and the larger availability of cash in each of the firm’s balance sheets balancing larger supplier liabilities. 5.2 results from the non-financial sample we present the results of the ols regressions in table 1. the da measurements are included in the results of the pooled regression using robust standard errors. the f statistic of the test is 12 and the ppe variable is significant at greater than 99% level with an r2 from the sales growth and ppe variables of 3.38% the relation for estimating back nda and separating da is thus nda = 0.004074 -.013541 * sales -.077697 * ppet (3) the post crises relation shows a better significance of sales and a positive coefficient on the same, with significantly higher discretionary accruals ta (post) = -.005196 + .040315 * sales .073017 * ppet (4) ta (pre) = .083543 0.249178 * sales .095347 * ppet (5) separated pre crisis years show perfect dependence with sales (t=4.47) and almost 0 discretionary accruals. for the pooled results the perfect correlation with ppe is restored in the post crisis years as the firms get caught for bleeding all the cash in booking higher sales at the top of the pre-crisis boom. discretionary accruals rise by 29% of assets in the year following as firms show opportunistic accruals to claw earnings at level using accruals-based earnings management apart from any real activity-based earnings management not measured here. paired t-test statistic is 9.15. additional confirmation of negative correlation between non-discretionary and discretionary accruals at -10% shows a presence of performance measurement accruals. however, negative asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 234 accruals between pre and post crisis data with increase in post crisis accruals show preponderance of opportunistic accruals management in the post crisis year. thus, we show that crisis expose the presence of performance measurement in indian firms’, yet there is evidence of continuing opportunistic accruals management. the effects of growth are unable to mask the firms’ choice of earnings management. as we see below, banking firms however respond more proactively, and accruals reduce in the post crisis years. table 1. descriptive statistics for the accrual data for the cnx nifty 100 from fy2002fy2015. all data is presented as the ratio of previous year's assets to normalise the data. only non-financial firms are included in this part in table 2 we try and see if there is an industry wise difference visible in the computed discretionary accruals and further research is merited. accounting guidelines may have changed over the years resulting in reduced overall opportunities for earnings management. however, the corresponding likely increase of intangible assets during the period would correspond to some increasing opportunity for earnings management. the dominant effect of the latter is visible in table 2 where increased r&d expenditure for industrials and healthcare that can be inferred from the objects of these industries shows up in significantly high positive discretionary accruals for similar ppe levels. information technology firms, consumer discretionary firms, consumer staples firms and energy firms show consistently minimal discretionary accruals from the focus on operational efficiencies in the business. nondiscretionary accruals are more or less consistent around industry groups at 0.037 0.042 other than the higher nde in the nine telecom and utility firms. industry level analysis is left for follow on research with a larger data set. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 235 table 2. accrual data for the cnx nifty 100 from fy2002-fy2015 sorted by industry groups. all data is presented as the ratio of previous year's assets to normalise the data. only non-financial firms are included in this part. 5.3 results from the financial sample the sample of financial firms yields significant relationships in ols regressions with each independent variable at the 95% level. the results are presented in table 3. the llp increase with ebit by a coefficient of 8.1% and decrease with reported trading gains by 0.11%, both significant at >99.99% level. in the combined regression using partt in the regression as dummy with trading gains and ebit, the constant term remains significant as expected. the ebit term is significant (t=2.92) but the trading gains terms with the negative coefficient is not significant (t-=1.15). the dummy variable for crisis is not found to be significant. we do not attach significance to the combined regression because of paucity of data. however, for the post crisis sample we are unable to retrieve any significant relationships in the chosen variables. there is a decrease in the llp in both crisis years at a confidence level under 90%. however, in the pre-crisis sample again, we note that the accruals, llpt are significantly related to each of the chosen ivs, trading gains and the profit. banking firms are also better practitioners of earnings management given better tools of earnings management for them. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 236 table 3. descriptive statistics for the banking firms in cnx nifty 100 from fy2005-fy2015. each of the selected variables are normalised using their effective counterpart in assets. with 12 banking firms there are only 40 crisis observations in the period standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1 qreg: quantile regression models 1-3 are linear regressions adj r2 is not reported in post crisis models/qreg llp relations are significant for regressions of pre crisis paired observations(20) as well, and the t-test testing for significant different between precrisis and post crisis is not significant with t=-1.21 6. conclusions the paper shows the strong impact of earnings management in managing crisis year financial reporting. the ability of firms to grow a base of discretionary accruals in the growth environment lies in the ability of firms to disconnect working capital investments as represented by the accruals here in from investments for sales. this also stresses firm balance sheets in later years as these discretionary accruals reverse themselves. 7. possible implications indian firms might benefit from adopting transparent corporate governance measures that restrict a management’s ability to use accruals opportunistically and focus on effecting investor trust. this might reflect in a more widespread adoption of downward earnings management. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 ajfa.macrothink.org/ 237 as challenges from the global financial crisis translate to more channeled flows of foreign direct investment, india stands to benefit from harmonized financial reporting and investors would support businesses that adopt a proactive performance based earnings management strategy investors would respond negatively to further volatility in earnings when faced by a crisis and this may erode investor trust and confidence. references ahmed, s. 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people luate the cesee stem, i.e., d by the oecd number adults a financia digital t facilitie services howeve because busines not a c between usually countrie bank an indeed, lower th and ne improve source: needles advance connect graph – particul per hea usd 10 respecti (oecd 20 r of comme and the sha al services technologie es. as the o s has fallen er, the num e of m&a ss models, t omplete su n the interm areas that es, but also nd branch d the share o han in 2017 ew zealand ed significa figure 1. f elaboration ss to say, t ed economi tion betwee – show a hi larly true fo d of usd 1 0,000), braz ively) and t 0 10000 20000 30000 40000 50000 60000 70000 80000 90000 100000 0 g d p pe r-h ea d (u sd ) 022), financ ercial bank are of adult may be rel es significan oecd has sa considerab mber of ban operations thanks to th ubstitute for mediary and are isolated in advanced density refl of adults ho 7, when it w d (in 2011 antly, to 41% financial inc ns on world the higher t ies, financia en these two igh level o or china (no 10,500), ru zil (with 84 thailand (94 pk 0% cial inclusi branches a ts with a b lated to a h ntly reduce aid, the imp ly over time nks and br s or bankru he massive r physical b d the custom d or too far d economie lects the de olding bank was 9%) to 1 the lowest % by 2017, t clusion and d bank data the gdp p al inclusion o variables, f financial ote 5) (with ssia (note 6 4% and usd 4% and usd eg 20% fin 4 on is usual and automa bank accoun higher num e the import portance of e, thereby r ranches is g uptcies, as utilisation o bank branch mer more d away from es (note 4). egree of fin k accounts 100% in ma t percentag though data d gdp per h a (gfid), ei per head, th n is closed t , many cou inclusion b h high finan 6) (with 89% d 7,000, re d 7,500, res et mx ph 40% n. inst. acco asian lly monitor ted teller m nt. neverth mber of atm tance of ge physical lo educing the gradually f well as th of technolo hes, this tre ifficult in p m cities. thi nancial inclu ranged from any norther e was 1% a from 2021 head (2021 a iu and cent he greater t o 100%. ne untries – as but a still-m cial inclusio % inclusion spectively), spectively). co ecid md pe 60% ount (%) n journal of f red through machines (a eless, while ms and com eographical cations for e usefulness falling in d he adoption gy. conside end can ma places not w is is true no usion only t m 5.8% in rn european in turkme 1 was not av and 2020, % tral banks. the financia evertheless, indicated in modest gdp on at 87%, b n but gdp p , serbia (89 ba brbgc hu in il kz p ro ru sa zatr ua 80% finance & ac issn 19 2023, vol. 1 ajfa.macro h indicators atms) per e greater a mmercial b proximity providing f s of this mea developed c n of more ering techn ake the rela well served ot only in e to a certain south suda n countries, enistan, wh vailable). % and usd) al inclusion , if we cons in the ellips p per head. but a still-lo per head low 9% and usd auat be g ca clcn hr cz dk fi fr de gr hk ie l it jp kr my nl nz no pl pt rs sg sk si a es se ch tw th gb us 100% ccounting 946-052x 15, no. 1 think.org/ s on the 100,000 ccess to ranches, to these financial asure. countries efficient nology is ationship enough, merging n extent. an (even canada hich had ) n. in the sider the se in the this is ow gdp wer than d 6,800, looking signal th (conver head gr account services busines similar high lev individu correlat represen of adult in the c extreme loan/gd account in addit role pla (bank-o low. cle for, as but also furtherm relative financia subjects side of china, m on by th account african (15.4% income g at the co hat finance rging to hig rowth. how t diffusion s (to pay ta ss reasons (n ly, a high n vel of finan uals with h ted to the d ntative exam ts (21% in 2 czech repu ely widespr dp ratio w t. tion, in dev ayed by ban oriented) the early, there financial in o from cultu more, in m es, friends al flows. sim s), which is the coin, ad more than 8 he world ba ts from othe n countries t in 2021) (e level classi ntribution o may be sup h-income c wever, a hig can be stro axes, to rec note 7). number of l ncial inclusi high creditw degree of fin mple: thoug 2011, but da ublic, which read (95% as low (41 veloped cou nks in the b e ratio is hig is no balan nclusion der ural and soc many countri and other milarly, sha s spreading ddressing m 88% of adul ank offer in er intermed that accoun eib 2022), ifications, th of finance t pportive for ountries). t gher financi ongly supp ceive the p loans grante ion (note 8 worthiness. nancial dept gh lending to ata in 2021 h has a low in 2021, % in 2021 ntries the lo broader fina gh, while in cing share, rives not on ial factors. ies, unconv entities (of adow bankin rapidly in many superv lts (from 80 nsight on inc diaries. it is nts from int in line with hese accoun 5 to gdp gro r gdp grow thus, financ ial inclusio ported – im ension, to p ed in a cou 8). lending . in fact, t th, as meas o the privat was not av w loan/gdp rising from , 44% in 2 oan/gdp ra ancial interm n market-ori a sort of “m nly from bu ventional int ften religiou ng (i.e., ban large coun visory and f 0% in 2017) clusion amo interesting termediaries h data on m nts were con asian owth, the d wth, presumi cial inclusio n can also mposed actu pay bills), untry does n could be co the use of ured by the te sector is a vailable) hel p ratio (53% m 81% in 2017), but atio has diff mediation p iented coun magic” num usiness mot termediaries us) account nking activi ntries such a financial sta ) had an acc ong both fin to note tha s other than mobile mon ncentrated i n journal of f distribution ing a further on has antic be explain ually – in o not only fo not necessar oncentrated financial a e loan/gdp about 200% ld a bank ac % in 2021), 2017). in 97.5% of a ferent value process; in e ntries (e.g., t mber that all tivations an s and social t for a sign ity carried o as china, r ability issue count in 202 nancial instit at it is only n banks play ney accounts in low-incom finance & ac issn 19 2023, vol. 1 ajfa.macro of countrie r improvem cipated the g ned by the f order to use or strictly f rily translat d on busines accounts is ratio. vietn % of gdp, on ccount. con bank acco slovenia adults held es dependin european c the us), the countries m nd economi l networks gnificant po out by nonrepresents th es. neverth 21. data ela itution accou in the subay a signific s. accordin me countrie ccounting 946-052x 15, no. 1 think.org/ es might ment of it gdp per fact that e public financial te into a sses and s poorly nam is a nly 31% nversely, ounts are too, the d a bank g on the countries e ratio is must aim c needs, of close ortion of -banking he other heless, in aborated unts and -saharan cant role ng to the es. fi note.em sas=s latin a databas financi service some p or othe services of acces the ma availabi account signific account high ac instituti religiou to achi their us equival one-fift form or inactive but wa populat lower (7 igure 2. fin mu=euro outh asia; america & c se 2021. ial inclusion does not n people can h er barriers s due to the ss is attribut ain barrier p ility of suf t in develo cant portion ts held by o count fees ( ions, are pr us reasons d ieve financi se must be ent to using th of accou r otherwise e account (n as especially tion had an 7.5%). ancial instit area; eca mna*=mi caribbean; w n and acce necessarily have access (regulatory ese sorts of table to a la preventing h fficient fund oping coun of people a other family (note 9). “p resent but do not appea ial inclusion e continuou g it. not al unt holders e – in the p note 10). t y high for inactive ac 0 20 40 60 80 100 e tution accou a*=europe iddle east & wld=wor ss to financ mean an in to financial or otherw issues is co ack of dema households ds (relevant ntries; no and corpora y members psychologic are not wid ar to be very n, the produ us and on a ll people w reported no past 12 mo the share h many eco ccount in 2 eap emu ec 6 unts and acc & centra & north af rld. * exclu cial service ndividual o l services bu wise). thus, onsidered ex and for finan and busine t for more data are a ates were als or because cal” reasons despread (a y relevant (9 ucts/service a long-term who have an ot making onths and th holding an i onomies in 2021, while ca lac mna fin inst. oth asian counts by re al asia; e frica; ssa* uding high in es are not s or corporati ut abstain fr anyone w xcluded. th ncial service esses from a than 60% available on so unbanked e they chose s, such as a accounting 9.9%). es offered m m basis. op n account a any deposit herefore ha inactive acc south as the averag a sas ssa hers n journal of f egion (%, ag eap*=east =sub-sahar ncome. sou synonymou ion doesn’t rom their us who does no here is no ex es (voluntar accessing ac of adults w n high-inco d either bec e not to par lack of con for approx must meet c pening a ba ctively use ts or withd ad what can count varied ia. in this ge across th wld finance & ac issn 19 2023, vol. 1 ajfa.macro ge 15+, 202 asia & ran africa; urce: global us. failure t t have acce se due to hi ot access f xclusion wh ry exclusion ccounts is a without a f ome count cause they r rticipate bec nfidence in f ximately 24 customer ne ank accoun it. globall drawals – in n be consid d across eco area, 22% he world wa ccounting 946-052x 15, no. 1 think.org/ 21) pacific; lac*= l findex to use a ess to it. igh costs financial hen lack n). a lack of financial ries). a relied on cause of financial %), and eeds and nt is not y, about n digital dered an onomies % of the as much fig note. l umc=u lmy=l databas 3. facto several strongly and tho financia financia supply b govern changin and the especia where f avoid fi public impress the mai 2019, f with us internat moreov especia 16). th introduc the wo hazard i gure 3. fina lic=low in upper midd low & mid se 2021. ors promot l studies, to y contribute ose in finan al resources al inclusion by banks an nments play ng legal reg e internet) lly for busi financial ac inancial inst incentives, sive growth in global rec for the first sd 7.6 bill tional financ ver, technol lly by cuttin his concerns ction of bio rld bank – in the credit ancial instit ncome ($1,0 dle income ddle income ting growin o which ref es to econom ncial defici s even if m n that are li nd other ope y a key role gulations, as (note 13) inesses and ccounts hav tability and of course, h in financia cipient of fi time, sublion (cgap cial inclusio logy repres ng costs an s not only m ometric iden – substantial t market. 0 20 40 60 80 100 ution accou 085 or less ($4,256 t e; mic=mid ng financial ference is m mic growth it, and at t modest. th nked to bo erators, whe e in promot s well as by . credit bu d financial ve ample d a run on de , play a re al inclusion inancial inc -saharan a p 2021) in on projects. sents a fun d making a mobile banki ntification (e lly reduces hi lmy 7 unts and acc s); lmc=lo to $13,205) ddle incom l inclusion made (note h, favouring the same t here are dif oth demand ether financ ting growin y improving ureaux and institutions diffusion, ad eposits (not elevant role (+12p.p. in clusion fund africa receiv active com ndamental d access to fin king and mo e.g., throug the distort lic lmc fin inst. oth asian counts by in ower-middle ); hi=high me; wld=w 11), have the match ime suppor fferent fact from hous cial or not (n ng financial g infrastruc d guarantee (note 14) dequate dep te 15). e. sub-saha n 2021 in co ding in the p ved more fu mmitments, r driver supp nancial serv obile payme gh fingerprin tion of info mic umc hers n journal of f ncome (%, a e income ($ income ($ world. sour found that between the rting the u ors promot eholds and note 12). inclusion b cture (e.g., t registers a . on the ot posit protec aran africa omparison t past decade. unding than representing orting finan vices more c nts, but also nts), which rmation, as wld finance & ac issn 19 2023, vol. 1 ajfa.macro age 15+, 202 $1,086 to $13,205 or rce: global financial in he sectors in use of all a ting the gr businesses by introduc telephone n are very e ther hand, ction is req a – which to 2017) – h . more prec n any other g about 30% ncial devel cost-effectiv o more rece – as highlig s well as th ccounting 946-052x 15, no. 1 think.org/ 21) $4,255); r more); l findex nclusion n surplus available owth of s, and to cing and networks ffective, in cases quired to showed has been cisely, in r region, % of all lopment, ve (note ently the ghted by he moral the ado globe. i been fo almost phone w internet instituti for such figure r source: the mi highest used a region, or the i instituti another compet particul of the sy followi inclusio (quality (low-in illness services option of ne it is worth ound betwee 86% of the were quite t to make ion account h purposes. e 4. use of a receive mon global fin iddle east & mobile pho mobile to a particularly internet to m ion account r factor tha ition betwe lar attention ystem (such ing the spre on is also fi y educatio come earne or disabilit s available. ew technolo noting that en the sprea population widespread payments, t) in 2021. h a mobile ph ney using a ndex databa & north afr one coverag access a fin y albania an make paym . at significa en financial n to avoidin h as excessi ead of techn inancial edu n). financ ers, the unem ty), but this 0 20 40 60 80 100 e ogies in fin in regard t ad of mobil n (% aged 1 d (almost 4 buy things however, a hone or the i financial in se 2021 rica (exclud ge (88.3% o nancial inst nd bosnia s ments, buy th antly affects l operators ( ng any sprea ive credit (n nology, one ucation, wh ial exclusi mployed, sin s also depe eap emu ec use a mob 8 nancial area to mobile te le phone us 5+) owned 40% of the s, or to se a large part internet to m nstitution ac ding high-in of the popul titution acco shows stillhings or to s the sprea (note 17). i ading of con note 18). e important hich is inclu ion still a ngle parents ends on the ca lac mna b ph don't asian s is followi echnology, se and mobi a mobile p population end or rece of the pop make payme ccount (regi ncome) regi ation owns ount. amon low rates of send or rec ad of financ in this regar nditions tha factor that uded in goa ffects som s or people eir degree o a sa ssa use a mob ph n journal of f ing differen a clear corr ile banking. phone and p n used a mo eive money ulation had ents, buy th onal areas, on is one o a mobile ph ng cesee f citizens us ceive mone cial service rd, central a at could jeop can suppor al no. 4 of me people who are un of knowledg wld finance & ac issn 19 2023, vol. 1 ajfa.macro nt routes aro relation has . across the payments by mobile phon y using a f d not used a hings, or to s %, age 15+ f the areas hone) but o countries, t sing mobile ey using a f es is the de authorities m pardise the rt growing f the un’s 1 more than nable to wor dge of the f ccounting 946-052x 15, no. 1 think.org/ ound the s not yet e world, y mobile e or the financial a mobile send or +) with the nly 15.6% the see e phones financial egree of must pay stability financial 7 sdgs n others rk due to financial figure rec source: 3.1 ope open b the inte third-pa banks a and mo revised been th uk, eu taken de open b econom fintechs these d consum promise serve th needs (n financi consum differen support open b lenders, used as where a data. o e 5. use of a ceive mone global fin en banking s banking (no erfaces that arty service and non-ban ore countrie payment s he main cata urope and t etermined s banking cou mies. by bre s and other data to dev mers. for em e to foster i he underser note 20). ial inclusion mer credit, nt nature op ts financial i banking cou , although i s a complem an applicant open bankin a mobile ph ey using a fi ndex databa supports fin ote 19) refer link a bank es access to nk financial es are work services di alyst for ope the nordic steps to defi uld have a r eaking open r innovators velop new p merging an innovation rved and un n refers no insurance, perate, not j inclusion. uld play a s it will need ment or a c t’s problem ng technolo 0 20 40 60 80 100 c hone or the i inancial inst se 2021 nancial incl rs to the us k's database o consumer institutions king on reg irective (ps en banking. region, cou ine legislatio relevant im n the data si s to access products an nd developi and lower nbanked an ot only to p pensions, e just banks, significant r to “comple counterweig m go further ogy is som z hu pl sk s use a mob 9 internet to m titution acco lusion se of open a with an out banking, t s, providing gulating ope sd2) regula . while the untries such on that will mpact on the los of tradit customer d nd services ing econom costs in wa nd offer pro payments, b etc.). in th it is impor role in the ement” cred ght, either w back in his metimes tho si al bh hr r b ph don't asian make payme ount (cese apis – appl tside progra transaction g they have en banking ation entere open banki h as canada l drive open e financial tional banks data, includ s that are b mies (emd ays that wil oducts and but to all f he context rtant to con affordabili dit bureau d where bure story than c ought of si ro rs md ru use a mob ph n journal of f ents, buy th ee countries lication pro am or applic and other f the custom . in the eu ed into forc ing market a, brazil an n banking. services ind s, open ban ding transac better suite des), open l make it m services be financial se in which i sider open ty assessme ata. open b au data is m an be seen imply as a ua eg finance & ac issn 19 2023, vol. 1 ajfa.macro hings, or to s s, %, age 15 ogram interf cation – tha financial da mer’s consen uropean un ce in 2018 leaders are nd mexico dustry in a nking regim ction data, ed to the n banking ho more econom etter suited ervices (mo intermediari banking be ents carried banking data missing or from open a way to ex ccounting 946-052x 15, no. 1 think.org/ send or 5+) faces, or at enable ata from nt. more nion, the and has still the have all dvanced es allow and use needs of olds the mical to to their ortgages, ies of a ecause it d out by a can be thin, or banking xchange financia 1 acc countrie financia exclude open ba services profiles history rejected banking compan history financia 2 imp fraud, a instead anomal 3 pro means (iamtn protecti 4. the d accord 22), 76% 2017, 6 update. noneth countrie high-inc was ste over th econom al data, but cess to the es are eith al products ed when the anking can a s such as s. it could al may not b d. it is pos g, which in nies can qui should fun al products. proved sub as highlight be shared ous account oof of owne being bette n 2021). a ion, which s degree of fi ing to the m % of adults 62% in 2014 eless, the d es and emer come and d eper. overa he past dec mies have se it can also s e mainstream her complet because th ey don’t hav allow comp mortgages lso be usefu be visible to ssible to ga turn increa ickly and ea ndamentally -prime app ted by centr instantly an ts can be id ership and er able to at the sam should be sa financial inc most recent s worldwide 4 and 51% data concer rging countr developing e all, account cade, rising een different support fina m. very of tely exclud hey do not ve enough fi panies to agg and insura ul when peo o new comp ather more ases the cha asily gain a y increase roval rates ral authoriti nd verified dentified mo identity. gi prove who me time, o afeguarded clusion imp release of t e had one o in 2011, hi rning acces ries. althou economies, ownership g from 42% t rates of gr 10 ancial inclus ften, differe ded or syst meet stan financial his gregate data ance) and t ople move to mpanies, wh e meaningfu ances of ins a more detai the numbe . furthermo ies. using o in real tim ore easily. iving more o they are open banki by central a proved furt the world b or more acco ghlighting s varied co ugh account the average in developi % in 2011 rowth over t asian sion in three ent segment tematically dard risk p story on trad a (from curr therefore to o another co ich leaves ul and deta stitutions ap iled underst er of peopl ore, a pape open bankin me, directly people acc (overcomin ng require authorities ( ther in 202 bank’s new ounts (note a further im onsiderably, t ownership e rate of gro ing econom to 71% in the past dec n journal of f e key ways: ts of the p pushed to profile crite ditional data rent account o better un ountry, mea the custom ailed inform pproving pe tanding of s e who can er-based pro ng, informat from the b cess to fina ng the docu s strong d (note 21). 1 global fin e 23) in 202 mprovement , especially increased, owth in dev ies has grow n 2021. h ade. finance & ac issn 19 2023, vol. 1 ajfa.macro : population i owards suberia. people abases. in th nts to other f nderstand c aning their f mer at risk o mation usin eople. the someone's f n access tra ocess can f tion on inco bank. fraud ancial servi umentation data and co ndex databas 21, up from t since the p y among de on average veloping eco wn by almo however, in ccounting 946-052x 15, no. 1 think.org/ in many -optimal e can be his case, financial customer financial of being ng open fact that financial aditional facilitate ome can dulent or ces also barrier) onsumer se (note m 69% in previous eveloped , in both onomies ost 30p.p. ndividual note: h asia; m source: among remaine 2017) t average to 79% 84%), p context diffusio it is inte in the s and soc of each in the e sas (7 mena and sig respecti hi=high inc mena=mid global fin g the cese ed very hig to 99.1% in e of 98.5%) , or +20p.p probably du , which led on of bank a eresting to n sub-saharan cial habits/s area shows eca region 78% vs. 51% countries a gnificantly ively). figu figure 6. a ome, eca= ddle east & ndex databa ee countrie gh (note 24 n slovenia ( . the increa p.), in mold ue to both t to security accounts am note that th n africa reg tandard of l s an accoun n (90% vs. 6 %) and bra and nigeria lower than ure 7. adult 0 20 40 60 80 100 0.0 20.0 40.0 60.0 80.0 100.0 c adults with a =europe & & north afr se 2021. es, the imp 4). data var (where the ases from 20 dova (from 4 their low st concerns a mong adults he range wit gion, where living, the r nt diffusion 68%), china azil in latin in the ssa n the avera ts with an ac hi eca ea 2011 cz hu pl sk 20 11 an account central as rica; ssa= provement ried from 44 percentage 017 to 2021 44% to 64% tarting poin and precauti rose from 7 thin regions e countries a range is nar higher than a among ea n america ( a area show age for th ccount (ce ap sa men 2014 201 si al bh h 014 2017 asian (by region, sia; eap=e sub-sahara has been s 4% in alba e of adults w 1 were very %, also +20 nts and the ionary savin 71% in 2017 s is particula are more si rrower. in m n the averag ap countrie (84% vs. 59 w an accoun e area (27 see countr na ssa la 7 2021 hr ro rs ru 2021 n journal of f % age 15+) ast asia & an africa; l significant b ania (increa was higher significant 0p.p.) and u difficult so ng. furtherm 7 to 89% in arly wide in milar both most areas, t ge. this is th es (89% vs. 9%). in con t diffusion 7% vs. 40% ries, % age world u ua md finance & ac issn 19 2023, vol. 1 ajfa.macro ) pacific; sa la=latin a but dispers asing by 4p than the eu in bosnia ( ukraine (+2 ocial and ec more, in se n 2021. n south asi in terms of the biggest he case with . 66%), indi ntrast, egyp that is very %; 45% v 15+) ccounting 946-052x 15, no. 1 think.org/ a=south america. sion has .p. from uro area (from 59% 21p.p. to conomic rbia, the ia, while f income country h russia ia in the pt in the y modest s. 54%, source: the use greater from 94 (71%), account source: the en requeste 2021 (3 countrie saudi a furtherm just sev china a million, source: global fin e of a bank the banking 4% in 2017 but had im t at a bank, world ban nvironment ed, are also 35% in 20 es. all high arabia to 98 more, it is ven econom and india cl , respective world ban ndex databa account is, g penetratio 7 and 88% mproved from a microfina figure 8. nk data (gfi and lower o important 017) in low h-income co % or more relevant to mies. meanw laim large s ly) because figure 9. f nk data (gfi se 2021. of course, on. in high in 2011); m 63% in 2 ance institut financial in id). r bank fees t. on avera w-income co ountries ben in 23 count note that 5 while, despit shares of th e of their siz financial in id). 12 strictly rela -income cou in develop 2017. the v tion or anoth nclusion (di s, as well age, the sha ountries to nefit from a tries out of 4 54% of the te having re he global un zes. nclusion (dis asian ated to incom untries, 96% ping countri vast majori her type of istribution, b as bank p are of banke 96% (93.7 ample acco 42). unbanked – elatively hig nbanked pop stribution, b n journal of f me: the high % of adults ies, the per ty of accou regulated fi by region) proximity a ed adults v 7% in 201 unt distribu – 740 millio gh rates of a pulation (13 by income) finance & ac issn 19 2023, vol. 1 ajfa.macro gher the inco had an acco rcentage wa unt owners inancial inst and the do varied from 7) in high ution (from on people – account ow 30 million ccounting 946-052x 15, no. 1 think.org/ ome, the ount (up as lower have an titution. cuments 39% in h-income 74% in – live in wnership, and 230 women achievin challeng norms t nearest a prom develop are also neverth include seventy women 4p.p. in howeve among and in t and 6p. 4p.p.) a 31% of fell to 5 finally, negativ this res between and 10. source: as far a the tota female n face parti ng women ges, such as that restrict bank, and u mising mech ping countri o often not e heless, acco d in sdg n y-eight perc (65% in 2 n 2021 (a ga er, the gend women inc the eca reg p., respectiv and in the m f women had 5% of wome , it is intere e, highlight sult is surpr n the media 9% in the e f global fin as cesee c al distributi distribution icular barri ’s financia s laws that p t their mob unequal lev hanism to e ies far less entitled to h ount owners no. 5 of the cent of men 2017; 59% i ap of 7p.p. w der gap chan creased in a gion (from vely). the g mena coun d a bank ac en and 15% sting to not ting a highe rising if we an earnings european un figure 10. w ndex databa countries ar ion, with th n was high 0.0 20.0 40.0 60.0 80.0 100.0 iers to acc al inclusion prohibit fem bility and a vels of educ expand fina comfortabl ave control ship among e un’s 17 s had an acco in 2014). t was observe nges varied all areas, ma 62% to 75% gap shrank ntries (from count, comp % of men (lo te that the g r diffusion e consider th of men an nion (27 cou women with se 2021. e concerned he only ex her than ave hi eca e 2011 13 essing and n challengin male accoun ability to tr cation and e ancial servi le and fami l over their f women has sdgs, gend ount in 202 therefore, th ed in 2014) d strongly am ainly in la %), but in th particularly 17p.p. to 1 mpared to 45 ong 2022). gender gap of accounts that the gen nd women – untries) in 2 h an accoun d, the distrib xceptions be erage, even eap sa men 2014 201 asian d using fina ng. these nt ownershi avel what m conomic as ces to wom iliar with sm finances. s continued er equality 1 (72% in 2 he gender g (note 25). mong regio atin america hese areas t y in the sou 13p.p.). in a 5% of men. in high-inco s among wo nder wage g – was still 2020. nt (% age 15 bution amon eing alban n if only ve na ssa la 7 2021 n journal of f ancial syste barriers in ip or asset in may be lon ssets. digita men, but w martphones d to grow an shrank sig 2017; 66% i gap fell from ns (wef 20 a (from 51% the gender g uth asia reg asia (not in in afghanis ome countri omen than am gap – define 11.7% in th 5+) by regio ng females ia, russia ery modestl world finance & ac issn 19 2023, vol. 1 ajfa.macro ems, which nclude mac inheritance, ng distance al technolog women are than men. nd the gend gnificantly in 2014) vs. m 7p.p. in 022). the d % to 69% i gap persiste gion (from 1 ncluding ind stan, the pro ries became among men ed as the di he oecd c on was very si and serbia ly. furtherm ccounting 946-052x 15, no. 1 think.org/ h makes cro-level cultural es to the gy offers often in women er gap – in 2021. . 74% of 2017 to diffusion in 2021) ed (7p.p. 11p.p. to dia) only oportion slightly in 2021. ifference countries imilar to a, where more, in these co +14p.p. varied f in both europe source: conseq account and slig 2021. source: the gro but no s in some (as in th past dec in bosn and 202 ountries, the . in russia from 46% i moldova ( countries. figur global fin quently, the t diffusion) ghtly in ukr global fin owth or dec single set o e economie he cee cou cade missed nia and her 21, but over ere was a s between 20 in albania t (from 45% re 11. wom ndex databa gender gap decreased raine (from fig ndex databa cline of the f circumsta s, the gende untries). ot d the opport rzegovina i r the same p 0.0 20.0 40.0 60.0 80.0 100.0 c -05 00 05 10 15 20 ignificant in 017 and 202 to 98% in s to 63%) an en with an a se 2021. p (defined in many co 4p.p. to 6p. gure 12. ge se 2021. gender gap ances drives er gap has n ther econom tunity for gr n particular period the ge cz hu pl sk 20 hi eca e 2011 14 ncrease in w 21). the pe slovenia. a nd ukraine account (% as the diffe ountries, bu .p.). russia, ender gap (p p has differ s gender equ narrowed as mies that sa reater progr r, account o ender gap m si al bh h 014 2017 eap sa men 2014 20 asian women’s ac ercentage o strong incr e (from 61% age 15+, c erence betw t surprising , serbia and p.p., by regi rent pattern uity in relat s overall acc aw growth i ress because ownership g more than do hr ro rs ru 2021 na ssa la 017 2021 n journal of f ccounts (+2 f women w rease also o % to 81%) cesee coun ween the m gly increase d albania ha on) s, dependin tion to acco count owne in account o e of a lack o grew by 20 oubled from u ua md world finance & ac issn 19 2023, vol. 1 ajfa.macro 20p.p. in se who had an occurred for among the ntries) male and the ed further in ad no gende ng on the ec ount growth ership has in ownership of inclusive 0p.p. betwe m 8p.p. to 18 ccounting 946-052x 15, no. 1 think.org/ rbia and account r women eastern e female n bosnia er gap in conomy, overall. ncreased over the growth. en 2017 8p.p. source: young educate 15-24) high-inc (about particul risen dr (note 2 countrie they are over the source: among (aged b but also probabl accoun ukraine global fin people wer ed and with in the world come count 60% in 202 larly in ec ramatically 7). young es, showing e often not eir future, e fi global fin g cesee co between 15o in the eas ly linked to nt ownershi e, for examp figure ndex databa re less likel people livi d had an ac tries (93% 21 and less a and lati (from 50% people acco g there is gr considered tc. gure 14. ac ndex databa ountries, it -24) accoun stern europe the growth p also cont ple, accoun -5.0 0.0 5.0 10.0 15.0 20.0 c 00 20 40 60 80 100 e 13. gender se 2021. ly to have b ing in rural ccount in 20 in 2021, 82 s than 50% in america, in 2017 to ount for a l reat potentia d “good clie ccounts, you se 2021. is very int nts in the c e countries, in mobile p tinues to be nt ownership cz hu pl sk hi eca ea 2011 15 r gap (p.p., bank accou areas. in pa 021 (56% in 2% in 2017 in 2017) ( , the percen 73% in the large portio al for finan ents”, becau ung adults ( teresting to cee countri , particularl phone owne e low amon p rates amo si al bh h 2017 202 ap sa men 2014 201 asian cesee cou nts, along w articular, on n 2017), but 7 and 2014) (note 26). i ntage of yo former and on of the po ncial service use of their (by region, % o note the j ies (now we ly in ukrain ership. ng less edu ng more ed r ro rs ru 1 na ssa la 7 2021 n journal of f untries) with the un nly 66% of t the share w ) than in de in some reg oung adults d from 39% opulation in es growth, d lack of col % ages 15-2 ump shown ell over 90% ne (from 54 ucated adult ducated adul ua md world finance & ac issn 19 2023, vol. 1 ajfa.macro nemployed, young adul was much h eveloping c gions in the with accou to 66% in t n many dev despite the llateral, unc 24) n by young % in all co 4% to 91%) ts. in roma lts are almo ccounting 946-052x 15, no. 1 think.org/ the less lts (aged higher in countries e world, unts has the latter) veloping fact that certainty g adults’ untries), . this is ania and ost twice those of more ed source: as far a use of m account the othe particul zimbab source: the gl showed had a m countrie as far a age, but is no ge f less educa ducated cou figure global fin as mobile m mobile mon t. among th er half repor larly widesp bwe (about 5 global fin lobal findex d a low num mobile mon es, data are as the gende t it remains ender gap i 0 5 10 15 20 25 30 35 ec ated adults. unterparts to e 15. accou ndex databa money is co ney in 2021; his group, n rted also ha pread in ke 50% in each figure ndex databa x survey fi mber of mob ney account) not availab er gap for fi s small for m n mobile m 0 20 40 60 80 100 cz a eap in bosnia, o have an ac unts, young a se 2021. oncerned, su 33% of adu nearly half r aving a finan enya, where h). e 16. mobile se 2021. irst collecte bile money ) and globa ble or aggreg inancial inst men and wo money accou z hu pl sk 20 sa 20 16 less educat ccount. adults (ces ub-saharan ults (21% in reported hav ncial institu e 69% of ad e money acc ed data on accounts in ally (2%) (n gates canno titution acc omen who unt ownersh si al bh hr 014 2017 mena 14 2017 asian ted adults a see countri n africa rem n 2017) in t ving only a ution accoun dults have o count (% ag mobile mo n both sub-s note 28). u ot be calcula ounts is con only have m hip as adult r ro rs ru 2021 ssa 2021 n journal of f are 32p.p. le ies, % ages mained the g the region h mobile mo nt. mobile m one, as well ge 15+) oney accoun saharan afr unfortunatel ated because ncerned, it i mobile mon ts age. twe ua md la finance & ac issn 19 2023, vol. 1 ajfa.macro ess likely th 15-24) global leade had a mobile oney accoun money acco ll as in uga nts in 2014 frica (12% o ly, in other e of missing increases as ney account enty-five pe world ccounting 946-052x 15, no. 1 think.org/ han their er in the e money nt, while ounts are anda and 4, which of adults cesee g data. s women ts. there ercent of young w mobile technol carrying literacy 5. the u globall survey d instituti most ga the mo without was the not hav cost wa at a fin too exp 2017) t account many a were to in perc account in 2017 fig note: re women hav money acco logy can cr g out transa y to engage w unbanked: ly, 24% of data helps i ion. respon ave two. ost common t an account e case in 20 ve enough m as another i ancial instit pensive was than in othe t because a as well: on oo far away centages ran t ownership 7) reported l gure 17. unb espondents 0.0 eca eap sa mena ssa la ve only a m ounts remai reate barrier actions, and with digital the reason adults were inform our u ndents could nly cited ba t at a financ 017). amon money. mportant ba tution (28% much high er areas. g family mem average, 28 (20% in 20 nging from p. almost 2 lacking the d banked (rea could offer 50 lack of trust insufficient fu too far away religious reas mobile mone ins insignifi rs for older d for those financial se ns why e unbanked understandi d offer mor arrier was l cial instituti ng the regio arrier, one w % in 2017). er in latin globally, a s mber alread 8% of adult 017). in la m 32% to 7% of adul documentat sons, develo ac more than 0.0 1 unds y sons 17 ey account icant as adu r consumers who may l ervices. d in 2021 ( ing of why a re than one lack of suff ion said tha ons, in the m which was c we note th america an similar sha dy had one ( ts without a a, ssa, sa 36%. docu lts without a tion needed oping count ccount, 202 one reason 00.0 asian and 27% o ults age. s, who may lack the fam (31% in 20 adults did n e reason, an ficient fund at they had t mena coun cited by 38% hat the share nd the carib re, 27%, sa (25% in 20 an account and eap, a umentation an account d to open on tries, % wit 21) source: glo 150.0 lack of doc too expensi someone e n journal of f of men do; y prefer trad miliarity, co 17). the 20 not have acc nd in the gl ds. nearly tw too little mo ntries 81% % of adults e reporting bbean (61% aid that the 17). distanc said that fi dults cited requiremen at a financi e. thout a finan obal findex 200.0 umentation ve lse in the famil finance & ac issn 19 2023, vol. 1 ajfa.macro the gender ditional met onfidence o 021 global counts at a f lobal finde wo-thirds o oney to use of respond without an that accoun %, as was the ey did not ce was a ba inancial ins distance as nts also ha ial institutio ncial institu x database 2 250.0 ly ccounting 946-052x 15, no. 1 think.org/ gap for thods of or digital l findex financial ex report of adults e one (as dents did account nts were e case in have an arrier for titutions a factor ampered on (20% ution 2021. distrust (note 2 barrier than 30 cited re mena muslim among about 5 adults w were co (note 3 highest another serbia a cited “l cited th only in as far a are ava account percent figure note: * data as 6. use o the glo instrum t in the fina 29). global (16% in 20 0%). only 1 eligious con countries ( m population g the cese 50% of adul who didn’t h onsidered to 30) (and the among ce r relevant r and croatia lack of trus he same barr ukraine an as the mobi ailable only t because th age as for b 18. unbank data not av of 2017 are of financial obal findex ments (paym 0.0 hu al bh hr ro rs md ru ua ancial syste ly, 24% of 017), partic 10% of adu cerns as a r (12%), and n (for examp ee countrie lts. in any c have an acc oo expensiv erefore high see countr reason was a (52% of a st”. it is ver rier in russi nd moldova ile accounts for the “d hey didn't h bank accoun ked (reasons vailable for e not availa l services – x provides f ments, credit 50.0 lack of trust insufficient f too far awa religious rea em featured f adults with cularly in th ults without eason. this substantial ple, morocc s, the most case, the dis ount in cro ve by about h prices) m ries, who co that someo adults) and ry surprisin ia, where ba (32%). s are concer eveloping c have enoug nts. s, cesee c cz, pl, sk able source: – digital pay further data t and debit c 100 funds ay asons 18 d as a great hout an acc he eca and t an accoun s factor was lly higher in co at 19% a t relevant b spersion wa oatia to 74% 46-48% of may explain onsidered ac ne else in t bosnia (47 ng that more anks are mo rned, reason country” ca gh money to countries *, 2021) k, si. respo global fin yments a on the use cards). acc 0.0 asian er barrier in count at a d in latin a nt at a finan slightly hig n some eco and iraq at 2 barrier was as very high % in albania adults. in r the high pe ccounts “too the family h 7%). in ukr e than one ostly state-o ns for not ha ategory, wh o use a mob % without ondents cou ndex databas e of account ording to th 150.0 lack of doc too expens someone e n journal of f n some reg financial in america co ncial institu gher than th onomies wit 24%). insufficien h: this varie a. in the ee russia, the l ercentage o o expensive had an acco raine, 54% o in three un owned. dist aving a mob ere 60% of bile money a financial i uld offer mo se 2021. ts and on so he 2021 glo 200.0 cumentation sive else in the fam finance & ac issn 19 2023, vol. 1 ajfa.macro gions than i nstitution ci ountries (bo ution (6% i he global av th a predom nt money, c ed between countries, a limited com of adults (48 e”. ount, particu of unbanke nbanked adu tance was im bile money f adults had y account, a institution a ore than one ome main f obal findex 250.0 mily ccounting 946-052x 15, no. 1 think.org/ n others ited this oth more in 2017) verage in minantly cited by 40% of accounts mpetition 8%), the ularly in ed adults ults also mportant account d not an a similar account, e reason. financial x survey, 64% of at least of acco account using m account 12 mon remittan transfer through source: in high 2014, w econom recent y growth develop increase digital p globall in the fo govern unempl f adults – or one digital ount owners t owners) re mobile mon t or who rep nths. they nces, receiv rs or a pub h a mobile m figur global fin h-income ec when such d mies, the sh years and r in the us ping econom ed to 80% payments am ly, 28% of a form of pub nment trans loyment ben r 84% of ac payment in s) reported eported doi ey, a debit ported using y also inclu ving payme lic sector p money accou re 19. made ndex databa conomies, t data were fi are of adul rose by 13p se of digita mies; the sh in 2021, up mong accou adults receiv lic sector w sfer payme nefits or pay 0 20 40 60 80 100 ccount owne n the past y doing so; ng so. thes or credit ca g the intern ude those ents for agr pension dire unt in the p e or received se 2021. the use of d rst collected lts making p.p. betwee al payment hare of acco p from 69% unt owners ( ved at least wages, a pub nts include yments for e hi eca ea 19 ers – aroun year. in high in develop se percenta ard, or a m net to pay bi who repor ricultural pr ectly from ast 12 mont d digital pay digital paym d as part of or receivin en 2017 an ts outpaced ount owner % in 2017. e (12pp). one payme blic sector p e any kind educational ap sa men 2017 202 asian d the world h-income ec ping econom ges include mobile phon ills or to bu rted paying roducts, or or into a fi ths. yments (reg ments has b f the global ng digital pa nd 2021, fro d the grow rs making o egypt has d ent from the pension or g d of social or medical na ssa lac 1 n journal of f d reported m conomies, 9 mies, 57% e all respond e to make a uy somethin g bills, sen receiving w inancial ins gions, % age been virtua l findex sur ayments ha om 44% to wth in acco or receiving double-digit e governmen government l benefits s expenses (n world finance & ac issn 19 2023, vol. 1 ajfa.macro making or re 95% of adul of adults ( dents who r a payment ng online in nding or re wages, gov stitution acc e 15+) ally univers rvey. in dev as grown ra o 57%. ind ount owner g a digital p t gaps in th ent, whether t transfer pa such as su note 31). ccounting 946-052x 15, no. 1 think.org/ eceiving lts (98% (80% of reported from an the past eceiving vernment count or sal since veloping apidly in deed, the rship in payment he use of r it came ayments. ubsidies, source: except paymen almost a many d than go may be frequen and so russia source: internat policy o 33% of elsewhe where 5 presenc are stro adults in figure 20. global fin in low-inc nts received all adults re developing c overnment tr that wage p nt, and they less likely sent or rece fi global fin tional remit objectives r f adults sen ere in the 53% of adu ce of “other” ngly increa n russia sen made or re ndex databa come count d them into eceiving a p countries, in ransfers and payments ar y are harder to be serve eived remitt igure 21. re ndex databa ttances play related to fin nt or receive country. r ults sent o ” intermedi asing in this nt or receiv 00 20 40 60 80 100 0 10 20 30 40 50 e ceived digit se 2021. tries, most an account, public sector ncluding ru d pension p re recurrent to digitise d by financ ances. emittances ( se 2021 y an essen nancial incl ed a domes emittances r received aries (remit segment, w ved remittan hi mi 20 ca eap 20 tal payment adults rec , and in both r wage had ussia, a hig payments w t, whereas g when issue cial instituti (sent or rece ntial role in lusion (ard stic remittan are particu such paym ttance servi with positive nces. li lm 014 2017 sa men received s asian ts (income c eiving gov h developin this paid in gher share o was paid into government ed to peopl ions. furthe eived, %, ag n supporting dic et al. 202 nce to or fr ularly impo ments (note ce provider e effects on mi lrmi 2021 na ssa sent n journal of f categories, % vernment tra ng and highnto an accou of governme o an accoun transfer pay le living in ermore, abo ge 15+, 202 g economic 22). in deve rom a relati ortant in su e 32), in lin rs) and mob costs (note umi lac finance & ac issn 19 2023, vol. 1 ajfa.macro % age 15+) ransfers or -income eco unt. furtherm ent wage p nt. one exp yments may more remo out half of a 21) c developm eloping eco ive or frien ub-saharan ne with the bile account e 33). abou ccounting 946-052x 15, no. 1 think.org/ ) pension onomies more, in ayments planation y be less ote areas adults in ment and onomies, nd living africa, e higher s, which ut half of among in mold figure 2 note: re 7. paym to fully conveni such as paymen a remar and dev among in 2017 regions debit c 2017), b latin a areas of account bank tel it is wo used on g cesee co dova (15.2% 22. remitta emittance in ment (credi y benefit f ient ways. p s debit or c nts from acc rkable diffe veloping co g high-incom 7) than in e . card use wa both in hig america and f sa and ss t or to with llers in bran orth noting t ne was still h ountries, rem %), albania ances (sent o nflows as % it and debit from having people may credit cards, counts witho erence can b ountries. a me countrie eap (24%) as much mo gh-income c d more than sa). people hdraw mon nches. that the gap high in the w 0 10 20 30 40 cz mittance inf and bosnia or received, % of gdp so t) cards g an accou access and , provide ac out having t be noted in t cross the w s, the use of ) and latin ore widespr countries (7 n 23% in me e can use d ey through between ad world (20p. z hu pl sk a received 21 flows were a (9.4% and , cesee co 2021) ource: glob unt, people d use their a ccount own to withdraw the use of c world, 20.6 f credit card n america ( read (35% 74%) and em ena count debit cards e automated dults who h .p.), especia al bh hr ro d sent asian particularly 10.5%, resp ountries, %, bal findex d need to b ccounts in d ners with a w cash. credit and d 6% used a ds was muc (23%), with across the merging co ries, but on either to ma d teller mac had a debit o ally in eap o rs md ru % gdp rhs n journal of f y high as a p pectively) in age 15+, an database 202 be able to different wa convenient ebit cards in credit card ch higher (5 h data not world in 2 ountries (37 nly about 10 ake direct p chines (atm or a credit c countries (3 0 5 10 15 20 ua finance & ac issn 19 2023, vol. 1 ajfa.macro percentage in 2021. nd in % of t 21. use it in s ays. paymen t means of n both high d (15.5% in 0.5% in 202 available f 2021, from 7% in eap, 0% in the ot payments fro ms) rather t card and adu 30p.p.). ccounting 946-052x 15, no. 1 think.org/ of gdp the gdp, safe and nt cards, f making h-income n 2017). 21, 49% for other 29% in 35% in ther two om their than via ults who f source: in cese (albani the use in the c in the o respecti between countrie moldov the use were in improvi cards w slightly furtherm which i compar debit ca financia at branc figure 23. c global fin ee countrie ia and bosn e of debit ca cee countri other countr ively). debi n 2017 and es. in ee, va and ukra e of credit c n slovenia ing slightly was also rele y in almost a more, we a is very hig rison to ce ards, which al institution ches, which credit and d ndex databa es, the use o nia) and mol ards was mu ies (80% vs ries, debit a it card use i 2021, and a the use of aine in 2021 cards was m (38%), cro y from the p evant (rising all countries also see a g h in see ( ee countries are a usefu ns. neverth h is typical o 0 20 40 60 80 100 h debit card (u se 2021. of electronic ldova. uch higher t . 20%, respe and credit ca increased st also in bosn f debit card vs. 2017, a much lower oatia (28%) previous sur g to 27%, fr s, particular gap between (16p.p., on s (5p.p.). t ul (almost in eless, this c of aged or le ic eap ecs cr. card 22 used and ow c payments than the use ectively, in ard use rem trongly in th nia (+13p.p ds increased and by 13p. in all the co and the c rvey conduc from 19% in rly in poland n use and o average) a this result w ndispensabl could be exp ess educated s sa mena d deb. car asian wned, by reg was quite l e of credit ca 2021). mained muc he czech re p.) and rom d strongly p. in russia ountries cov zech repub cted in 2017 n 2017). th d (+6p.p.), o ownership and ee (ex was surpris le) way to u plained by t d people. a ssa lac w d owns n journal of f gion, % age low, especia ards in all c h lower (ab epublic, hu mania (+16p. as well, by a. vered. the h blic (24%) 7. in ukrain e use of cre or remained among ces -russia) (1 ing, especia use current the direct us 0 20 40 60 80 100 wld finance & ac issn 19 2023, vol. 1 ajfa.macro e 15+, 2021 ally in the s countries, es bout 37% an ungary and s .p.) among y almost 2 highest perc in 2021, w ne, the use o edit cards in d stable. see countr 15p.p.) coun ally with re accounts h se of bank a ccounting 946-052x 15, no. 1 think.org/ ) see area specially nd 16%, slovakia the see 20p.p. in centages with data of credit ncreased ries, one ntries in egard to eld with accounts figu notes: for alba 8. savin global adults in 76% of (48%), during essentia user bas people about tw past 12 who re develop among high-inc this wa countrie in deve semi-fo reported formally in the s only 3.6 of the lo uzbekis (down f ure 24. cred owns refer ania, moldo ngs showed findex data n the world f adults; in d which is su the pandem ally with sa se. saved mone wo-thirds o months, at eported sav ping econom g savers, th come econo as the first t es. eloping coun ormally, by d saving in y. ssa countri 6% of adult owest data stan at 3% a from 30.6% dit and debit rs to owning ova and egy d a slight in a also show d had saved developing urprising con mic. this avers who a ey in differ of people w t a bank or ving forma mies. he share sa omies, and time formal ntries, a co using a sav this manne ies 10% of a ts (from 6.2 points in th and zimbab % in 2017), t 0 20 40 60 80 100 c t card (used g a debit or ypt source: ncrease wed how and some mone countries 4 nsidering th slight incre already held ent ways. g ho saved an other type lly average aving form more than h l savings w ommon alter vings club o er, including adults repor % in 2017) he entire sam bwe and par therefore ma z hu po sk s cr. card 23 d and owned r a credit ca global find d why peop ey in the pa 42%), only a he strong de ease therefo d an accoun globally, in ny money — of financia ed 58% in mally (note half in deve was the most rnative to s or a person g the 4% of rted saving ) reported ha mple (close raguay at 4 ainly with o si al bh hr r d deb. ca asian d, cesee c ard. data on dex databas le saved an ast 12 month a slight incr eposit increa fore suggest nt and ther 2021 29% — reported al institution n high-inco e 34) was eloping econ t common m saving at a outside the f adults wh using a mo aving saved to pakistan %), but 21% other interm o rs md ru u rd owns n journal of f ountries, % n credit car se 2021. d borrowed hs (in highrease in com ase registere ts an incre efore not a (27% in 20 d having sav n. among a ome econom more than nomies. it i mode of sa financial in family. in o saved sem obile money d formally in n and iraq a % of adults mediaries (16 0 20 40 60 80 100 ua finance & ac issn 19 2023, vol. 1 ajfa.macro % age 15+, 2 rd are not a d. in 2021 4 -income eco mparison w red across th ease in ava an expansio 017) of adul ved formall all adults, th mies and n three-qua is worth not aving in dev nstitution is 2021, 9% o mi-formally y account. in n the past y at 2%, leba saved some 6%). ccounting 946-052x 15, no. 1 think.org/ 2021) available 48.8% of onomies, ith 2017 he world ailability n of the lts — or ly in the he share 25% in arters in ting that veloping s to save of adults y but not n egypt, year, one anon and e money as far a saved i develop fig source: among money, method instituti in the c countrie figur source: “other ukraine of mone of trust ukraine as the main in the past ping countri gure 25. sav global fin g cesee co mostly (60 ds and 40% ion. savings czech repu es (in croat re 26. saved global fin methods” w e (25% vs. ey (not eno in financia e (-2p.p.) an reasons for 12 month ies (44% an ved any mo ndex databa ountries, in 0%) “at a f saved form s at a finan ublic (+14p tia these eve d any money ndex databa were more r 10% at a fi ugh to have al institution nd moldova 0 20 40 60 80 h 0 20 40 60 80 100 c o r saving wer hs for old nd 16% in 20 oney and sav se 2021. slovakia a financial ins mally. in hu cial institut .p.), among en decreased y and saved se 2021 relevant in inancial ins e an accoun ns (note 35) a (-1p.p.). hi eca e others z hu pl sk s thers at a 24 re concerne age, 53% 017, respec ved at a fina and the cze stitution”, w ungary 27% tion strength g the cee c d by 10p.p. d at a financ 15+) moldova (4 stitution) for nt), but also ). savings a eap sa at a fin. inst. si al bh hr r fin. inst. a asian ed, 26% of a in high-inc tively). ancial institu ech republi while in slo % used other hened betw countries, b in favour o cial institutio 44% vs. 8% r many reas because of at a financia lac ssa mob.mon. ro rs md ru u t a formal fin n journal of f adults globa come econo ution (regio ic, 80% of ovenia 25% r methods a een 2017 an but at a low of other inte on (cesee % at a financ sons: first, b f low interes al institution world -15 -10 -5 0 5 10 15 20 ua n. inst. finance & ac issn 19 2023, vol. 1 ajfa.macro ally reported omies and on, % age 1 adults save % saved usin and 32% a f nd 2022, es wer rate in t ermediaries) e countries, cial instituti because of st rates and n decreased ccounting 946-052x 15, no. 1 think.org/ d having 19% in 5+) ed some ng other financial specially the see ). % age ion) and the lack the lack d both in 9. borr globall 12 mon formal develop in high almost of a cre family a (2%), b source: in the c last yea particul (33%) i adults w countrie instituti source: rowing incr ly, in 2021 5 nths, includi or non-for ping econom -income eco 90% 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countrie reported ukraine substan source: in high cesee coun ar, in line w larly in slo in the see who borrow es, particul ion in 2021) figure 29. world ban es in total bo ing a highe es, in bosn ing countrie from a fin es, particul d a decrease e). the sim ntial shift to figure 30. world ban -income co ntries, almo with the wor ovenia (42% area, and in wed from f larly in mo ), showing t savings % c nk data (gfi orrowing in er number o ia and serb es, in nomi nancial inst larly croati e in the “sa multaneous other interm savings % c nk data (gfi untries, the -20 -10 0 10 20 30 cz -15 -10 -5 0 5 10 15 20 cz ost 50% of a rld average. %) and slov n ua (34%) family or fr oldova (32% there is room changes fro id). n the 2017-2 of borrower bia in the se nal terms. i titution in ia, where t aved any mo decrease o mediaries. changes fro id) majority o z hu pl sk at a f z hu pl sk total 26 adults, on a many peop vakia (34% ). neverthel friends rema % from a m for bank om 2017 to 2 2021 period rs, especial ee countrie in contrast, the past y this fell by oney” categ of formal b om 2017 to 2 of those able si al bh hr formal fin. inst. si al bh hr from a form asian average, had ple borrowe %), among t less, in man ained highe family vs. lending gro 2022 (pp, c d were posit ly in slova es, and in r , the percen year decreas y 5p.p.), in gory (three borrowing 2022 (pp, c e to come u r ro rs md total r ro rs md mal fin. inst. n journal of f d borrowed ed from a fi the cee co ny countries er, especiall only 13% owth. cee/see/ee ive in many akia and slo russia and u ntage of adu sed in a fe line with countries, n and saving cee/see/ee up with eme ru ua ru ua finance & ac issn 19 2023, vol. 1 ajfa.macro some mone financial ins ountries, in s, the perce ly in see % from a f e countries) y cesee co ovenia in t ukraine am dults who b few countri the countr namely cro gs may hig e countries) ergency fun ccounting 946-052x 15, no. 1 think.org/ ey in the stitution, croatia ntage of and ee financial ) ountries, the cee mong the orrowed es (four ries that oatia and hlight a ) nds cited savings was the countrie and earn emergen fi source: in the c 6% in b in cee countrie sources respecti percent all three to reach figur source: s as their ma e main sou es, the two nings from ncy money. igure 31. m global fin case of finan both cee an e countries, es. in contra s of emerge ively) in 2 ages (about e areas (ce h new custo re 32. main global fin 0 hic eca eap sa mena ssa lac wld famil 0 cz hu pl sk si al bh hr ro rs md ru ua ain source ( urce of fun most comm work – nea . main source ndex databa ncial need, b nd see cou the main so ast, in the o ency funds 2021, accor t 20% vs. 1 ee 7%, see omers. source of e ndex databa 10 20 y or friends 20 (49.5% of a nds in men mon source arly 60% of of emergen se 2021 banks were untries). ource of fun ther cesee remained rding to the 3%). bank e 5.5% and emergency f se 2021 0 30 bank other 40 27 all adults), w ena countr es of such fu f 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the mo improve hand, th other, th and cor in many is now concent digital between suggest volume have an as far occurre the sus 2015 co now to extensiv can be differen notes note 1. iif — (global househo 2021 g adults a note 2. hungar croatia note 3. encomp account that fall non-ban compan ‘financi usion ost importa ed further b he impact o here were n rporates and y countries, w at the le trated in a f payments n ownershi ting there is es of transac n account bu as banking ed in many c stainable d ould realisti improve f ve use of fi reached ma nt developm various int follow the l findex), olds and en global finde aged 15 and the expres ry, poland, , romania a the defin passes all t ts — includ l under pru nk financia nies, or equ ial institutio ant data ana by 2021, bo of the econo numerous m d this soften , for examp evel of maj few asian co strengthene ip and util s a need to ctions, only ut still prefe g is concern countries hi evelopment ically be re financial ed inancial acc ainly with a ment models ternational topic. our which the nterprises in ex was com d above. ssion “cese slovakia a and serbia ( ition of for types of fin ding banks, udential regu al institution uity holdin on’ refers to alysed in t th despite a omic crisis measures ad ned the impa ple, the cee ajor high-in ountries. ed in all r lisation of further ince the number er to use cas ned, the sim ghlighted a t goal relat ached by 2 ducation an counts. nev a more even s which are institutions analysis is world ban n 123 count mpiled using ee countrie and sloven (see area); rmal financ nancial ins credit union ulation by a ns, such as ngs, such a o a formal fi 28 this note sh and also bec led to a fal dopted by c act. e area, finan ncome coun regions, esp credit and entivise use r of accoun sh. multaneous a substantial ted to financ 030, but ow nd digital li vertheless, t n income d spreading in — in parti s based on nk processe tries in 202 g nationally es” refers to nia (cee ar moldova, r cial instituti stitutions th ns, microfin a governme s pension f as stock. a inancial ins asian howed first cause of the ll in income central auth ncial inclus ntries. mos pecially in d debit car . the globa nts. it is wor decrease in l shift to oth cial inclusio wnership is iteracy to e the ample d distribution, n the world icular, the w the global ed based o 21, during t y representa o the followi rea); alban russia and ion used by hat offer de nance instit ent body. th funds, retir as used thr titution. it c n journal of f , that finan e covid-19 e and consu horities to s ion has bec st of the u the eap. rds remain al findex d rth noting th n borrowin her financial on included not utilisat encourage m diffusion of in all coun . world bank l financial on a survey he covid ative survey ing countrie nia, bosnia ukraine (ee y the globa eposit, cheq tutions and he definitio rement acco oughout th can be usefu finance & ac issn 19 2023, vol. 1 ajfa.macro ncial inclus 9 crisis. on umption, bu support hou come very h unbanked however, ned large in does not cap hat custome ng and savi l intermedia d in the un tion. it is ne more effect f financial in ntries and in k, oecd, im inclusion d y carried o d-19 pandem ys of about es: czech r a and herze e area). al findex d quing and post offices on does not ounts or in he report, t ul to remem ccounting 946-052x 15, no. 1 think.org/ sion had n the one ut on the useholds high and are still the gap n 2021, pture the ers often ngs that aries. agenda ecessary tive and nclusion n all the mf and, database out with mic. the 125,000 republic, egovina, database savings s — and t include nsurance he term mber that financia banks ( banks (i depositfinancia microcr e-mone note 4. out of decreas compar of inha france annual experts solution note 5. have su financia in chin note 6. have be underpo presenc smes a of russ note 7. academ distribu insuran been in it is sup note 8. bank as conside (such a signific equal to lowest f note 9. findex note 10 al service pr (licenced fo i.e., postal b -taking inst al cooperati redit targeti ey that is not . it has bee 8,000 (com sed by 8%; s rison with th abitants per and spain report 20 predict a ns. (wind 20 super app ucceeded in al services b na (mybank since 2018 een involve opulated an ce. the ban a key policy sia, 2021). . the relatio mia. the topi ution, but al ce, etc.) off cluded amo pportive of g an alterna ssets/gdp r ered that len as egypt), cant part, to o 25.8% (2 financial inc barriers re survey. 0. it is not p roviders are or taking d banks); fina titutions (w ive); micro ing low-inc t a bank). en the case muni) bank since 2012, he other ma branch ros (about 2,10 21, p.160. rising dem 023). s have been establishin beyond pay k, aibank an 8, some maj ed in bank nd hard-tonk of russia y area and a onship betw ic is comple lso the othe ffered by ba ong the 2030 growth and ative measu ratio, but th nding repres however, o such an e 2021), ta/ clusion rate mained ver possible to a e divided in eposits from ancial coope which collec credit instit come custom in italy, fo k branches the decline ain europea se to more 00) and that while digit mand for fa n especially g a large an yments. furt nd webank jor credit in of russia i -reach area a still consi a strategic g ween financ ex, of cours er financial anks and oth 0 agenda fo equality. ure of the d his data is n sents the gre the other extent that w gdp excee es (26% in 2 ry similar to ascertain wh 29 nto the follo m the gene eratives (go ct savings, tutions (wh mers); and or instance, are not pr e has been 3 an countries than 2,500 t of german tal channel face-to-face y popular i nd highly en thermore, p k) (world ba nstitutions w initiatives t as, as well iders a grea goal of russ ce and econ se, and requ l products a her financia for sustainab degree of fi not as easil eater part o items of t while the l eded 120% 2021). o those hig hether acco asian owing institu eral public overned by “ but do not hich do not non-bank e where in m resent. in 2 34%. based s (referring 0, an interm ny (more th s will conti customer n china, w ngaged cust prominent e ank, april 2 with a wide to enhance as to dev ater financia sian financi nomic grow ires to cons and service al intermed ble develop inancial dep ly available f ta in mos ta, firstly loan to the . furthermo ghlighted in unts with n n journal of f utional cate subject to “one membe t fit the def take depos e-money is more than 3 2021 the nu on the lates to 2020), th mediate valu han 3,400). inue to play interaction where alipay tomer base xamples of 2020). e network of financial in velop ‘simp al inclusion al market d wth has been ider not onl s (asset ma diaries. fina pment goal pth is repre e. in this re st countries portfolio s private sec ore, egypt 2017, in th no deposits a finance & ac issn 19 2023, vol. 1 ajfa.macro egories: com supervision er one vote” finition of sits but do ssuers (an i ,000 munic umber of b st data avail the average ue between see bank y an essent ns and new ay and wec and expand f virtual ban f regional c nclusion in plified’ for for consum developmen n deeply pr ly financial anagement, ancial inclu ls precisely esented by t espect, it sh s. in some c securities, ctor/gdp ra shows one he previous and no with ccounting 946-052x 15, no. 1 think.org/ mmercial n); other ”); other bank or provide ssuer of cipalities branches lable for number n that of of italy, tial role, w hybrid chat pay ding into nks exist coverage remote, rmats of mers and nt. 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(202 . lenders s bankingexpo -consumer-d ing in afric nce in africa caleta, th ments, annua argentin 400205453/1 gional econ obal financ -8-40021-9 2018). mob of academ ries, 84(5), & yang, yu mf, wp 5089/97984 igital bridg and windin rg/10.1787/ s. staschen. 020. . financial 5089/97815 11). pais, f y 2011. https & dyna h 022, isbn/i bal gender g major trends 20). commi say open b duty, o.com/news duty/. ca: financing a: navigatin he digital al report. na, cou 1934-7685. nomic outlo cial stability 67-2. bile financia ic literature september. yuanchen. ( p/22/108, 00210655.0 e for asia's ng road to 2 af4b630d-e (2020). op inclusion: isbn/is 13585154.0 financial in s://doi.org/1 heng. (2022 issn:97984 gap report for europea ittee on pay 33 banking wil s/lenders-sa g transform ng the finan transforma untry r ook, europe y report, n al services, e. the elec https://doi. (2022). fin jun. 001 gender gap 2030. (2022 en pen bankin can it mee ssn: 006 nclusion and 10.1002/jid. 2). fintech: 400208645/ t, july 2022 an retail ban yments and asian ll ‘complem 2 ay-open-ban mation amid ncial landsca ation, prom eport n e, october. i avigating th financial in tronic jour .org/10.100 ntech fema isbn/issn p, the bank 2). measurin ng: how to d et multiple d developm 1698 financial /1018-5941 2. isbn-13: nks in 2023 d market in n journal of f ment’ credit nking-will-c uncertainty ape in turbu mise of a no.22/92, isbn 97984 he high-infl nclusion, an rnal of infor 2/isd2.1204 ale employ n:97984002 ker, septemb ng distance design for f macroecon 97815135 ment, journ inclusion o 978-2-9406 , the bank nfrastructure finance & ac issn 19 2023, vol. 1 ajfa.macro bureau dat complement y. ulent times. new dynam march 400220586. flation envir nd develop rmation sys 44 yment and 210655/101 ber. 2022 to the sdg financial in nomic goals 585154/261 nal of inter or exclusio 631-36-0 ker, january es, group p ccounting 946-052x 15, no. 1 think.org/ ta under august. t-credit mic for 2022. . ronment, ment: a stems in gender 18-5941. g targets, nclusion, s?, imf, 17-6750. national n? imf, 2023. payment aspects world https://d of financia bank doi.org/10.1 al inclusion i k, th 1596/978-1 in the fintec he g -4648-1897 34 ch era, bis, global 7-4 asian , april 2020 findex n journal of f 0. isbn 978 datab finance & ac issn 19 2023, vol. 1 ajfa.macro 8-92-9259-3 base. ccounting 946-052x 15, no. 1 think.org/ 345-2 (2021). microsoft word 18753-66021-1-rv-writer2-new-final asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 1 firm performance and market behavior during first wave of covid-19 in egypt: panel data analysis may elewa assistant professor accounting, school of business administration ahram canadian university – giza egypt shwikar nagy assistant professor of accounting, faculty of economics and management october 6th university giza, egypt received: may 5, 2021 accepted: july 13, 2021 published: december 1, 2021 doi:10.5296/ajfa.v13i2.18846 url: https://doi.org/10.5296/ajfa.v13i2.18846 abstract the purpose of this paper is to identify the impact of market capital mc and net profit np on stock price sp and trade volume (tv) in the developing egyptian business context. this study collects data from 29 non-financial organizations registered on the egx 30 during the 6 month, 1/1/2020 to 30/6/2020, lockdown in egypt due to the first wave of covid-19. data for the monthly confirmed cases and death cases of covid-19 are collected for the 6 months of the study and compared to the monthly records of closing prices and trade volume in egyptian pounds egp. the study population represents 174 firm year observations. the firms studied operate in cash, have annual financial reports during the period 1/1 to 31/12, obtain complete financial data, and have not been eliminated all throughout the study. in this work the pooled model, the fixed effects model, and the random effects model are used. spss is applied to achieve the required statistical analysis. the study is a panel data analysis. outcomes demonstrate existing substantial effects between market capital mc and stock price sp during the first wave of covid-19. however, no significant effect is evident of the market capital mc and net profit np with the trade volume tv during the first wave of this pandemic. this literature is advantageous for external and internal stakeholders and regulatory bodies. the study is a modest contribution that may help boost the business processes to reach better financial performance in times of unexpected catastrophes. keywords: market capital, net profit, stock price, trade volume, covid-19, egypt asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 2 introduction an increasing public and media awareness has come to being of the efforts made by corporations in the egyptian culture. (abdelshahid, 2003) discusses that the egyptian stock exchange is ready for the age of globalization. the stock market is an instrument that offers investors the opportunities to trade with an assortment of financial assets and collect a return on them. even though stock prices are unclear of the upcoming worth of the firms, the general belief remains that information is revealed in the alteration of existing stock prices. investors consider the behavior of the stock market when making investment decisions. egypt is found in the middle east which is considered a politically disturbed and unsound area. regardless of these circumstances, egypt has showed continuous and swift economic progress in parallel to other developing economies (elsayed and hoque, 2010; and dahawy and samaha, 2010). according to (samaha and dahawy, 2010), egypt is greatly progressing in economic reform, refining investment environment and drawing local, regional and foreign direct investments. furthermore, egypt is going through a privatization plan to several of its public organizations. egypt is a growing country that is moving to being a market economy. however, the covid-19 virus has transported great social anguish and detrimental economic disruption (oecd, 2020). never the less, in the latest forecast from the imf`s world economic outlook, egypt is expected to be the only country in the mena region to witness positive economic growth in 2020, estimated at 1.95%. thus, the egyptian model is considered as an inspiring model to be followed in the mena region. estimates from the egyptian center for economic studies indicate that the effects of covid-19 on the egyptian economy are likely to continue till june 2021 due to declining travel and tourism, lower domestic consumption, capital outflows, and reduced remittances. weaker global trade is also expected to reduce egypt`s exports and earnings from the suez canal. foreign direct investment is also expected to decrease and only gradually increase to the pre-crisis levels by june 2021. (dahawy, 2009) finds that the qualities of financial statement disclosure from firms registered in the egyptian stock exchange are influenced by the exceedingly secretive egyptian culture. we confirm this argument through the data collected for the 6 months of 1/1/2020 to 30/6/2020 lock down period in egypt for 29 non-financial institutions listed in the egx 30. the public data issued by the ministry of health and population of egypt show that from january 2020 till june 2020 monthly confirmed cases of covid-19 recorded were january 0 cases, february 2 cases, march 710 cases, april 5537 cases, may 24985 cases, june 68311 cases. the monthly death cases from covid-19 recorded were january 0 cases, february 0 cases, march 46 cases, april 392 cases, may 959 cases, june 2953 cases. according to the public data issued on mubashr misr the monthly recorded closing prices were in egyptian pounds egp january 13918.84, february 13008.94, march 9593.94, april 10554.04, may 10220.14, and june 10764.59. the monthly recorded trade volume were in egyptian pounds egp january 1433193887, february 1891092410, march 3643681016, april 4185316058, may 2059843502, and june 232406248. after carefully observing these numbers we notice; a sharp monthly increase in the covid-19 confirmed cases, a sharp monthly increase in the covid19 death cases, a plunge in the monthly recorded closing prices, and an increase from january asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 3 1433193887 to april 4185316058 where the trade volume reached its peak and then there was a sharp decrease from may 2059843502 and june 232406248 in the trade volume. this study is limited to the egx 30 non-financial institutions only. this study analyzes the relationship that exists among the market capital mc, net profit np, stock price sp, and trade volume tv. this study does not go in depth as to whether or not covid-19 confirmed cases and death cases actually have a direct relation with market capital mc, net profit np, stock price sp, and trade volume tv. till now egypt has gone through two waves of the covid-19 and the third wave is on the way. this study makes its evaluation during the first wave only. it focuses on the lockdown period. to our knowledge, no previous study has been made using these variables under this condition in the egyptian business environment. in addition, related literature seems to be rare. this study tries to reduce this research gap. the aim is to search for those variables that represent firm performance that will increase the stock price and trade volume in the egyptian non-financial publicly listed firms during this pandemic. the rest of this paper continues along these lines; the second part presents the literature review and hypotheses development, the third part explains the research methodology, and the fourth part reveals the conclusion and proposes future studies. literature review and hypotheses development here, is a presentation of some of the work of other researchers and their observations and their findings relating to the subject matter. there are various concepts that have emerged that try to clarify why organizations come to being and the rationale for the variances in their establishment and performance. some of these are the economies of scale theory, agency theory, shareholder theory, and stewardship theory. the economy of scale theory explains how large firm size is of greater influence over small firm size. (padron et. al., 2005) agrees with the idea that the firm profitability and firm size and are associated in line with the economies of scale theory. this perspective approves that largesize firms have the ability to: compete with their counterparts, negotiate with suppliers and customers, create and sustain strategic expansion, keep higher prices than the competitive level. (schmitt and yu, 2001) demonstrates that a rise in the range of economies of scale promotes the size of intra-industry trade and the share of trade in total production. according to (eisenhardt, 1989) agency theory defines the link between two groups, the agentmanager and the principal. this study also points out that the principal-manager connection defines any type of relationship where work is passed on from a principal to a manager, irrespective of actual position. both (davis et al., 1997 and eisenhardt, 1989) imply that the agency theory proposes that managers will select devious selfish conduct instead of conduct meant for making the most of the principal’s interest. (davis et. al., 1997; eisenhardt, 1989; jensen and meckling, 1976; ross, 1973) confirm the agency theory postulates agents will act speculatively because they are selfish. consequently, the principal endorses tools to reduce losses to their own convenience. (kultys, 2016) suggest the agency theory postulates selfishness and the quest of one’s own benefits. (teixeira, 2017) infers that the agency theory asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 4 addresses potential conflicts between shareholders and managers. (mahoney, 2012) suggests that considering shareholders as the only criteria is a weak description of the actual relationships among a firm’s various stakeholders. stakeholder theory begins with the assumption that values are necessarily and explicitly a part of doing business. it asks managers to articulate the shared sense of the value they create, and what brings its core stakeholders together. it also pushes managers to be clear about how they want to do business, specifically what kinds of relationships they want and need to create with their stakeholders to deliver on their purpose. (freeman et. al., 2010) support stakeholder theory as a means of facilitating understanding of the complexities of today’s business challenges as the problem of understanding how value is created and traded, the problem of connecting ethics and capitalism, and the problem of helping managers think about management. establishing good relations with primary stakeholders can lead to higher financial returns. fair and balanced stakeholder’s outlook ends up with long term shareholders maximization significance (elena, 2007; gioia, 1999; sternberg, 1994; cooper, 1996; kaplan and norton, 1992). (rampling, 2012) argues that there is much benefit and correlation by reordering executive focus and remuneration incentives away from the agency theory model to a managerial model of stakeholder theory. (hernandez, 2008 and zahra et. al., 2008) indicate that the stewardship theory relates managers to stewards with behavior that is built on a fundamental aspiration to work for the firm thus indeed supporting the principal’s interests. (davis et. al., 1997; and donaldson and davis, 1991) point out that the stewardship theory relates to the work bond concerning two individuals, the principal (owner) and the steward (manager). the studies examine this bond from a social and a physical viewpoint. (zahra et. al., 2009 and davis et. al., 1997) argue that the stewardship theory proposes that managers will act in a pro-social manner intended for the benefit of the owner hence the organization. in the steward-principle relationship, the steward places the interests of the principal before selfish benefits (davis et. al., 2010; zahra et. al., 2009; corbetta and salvato, 2004; davis et. al., 1997). according to (davis et. al., 1997) the principal generates an organizational structure where stewardship behaviors can mature. thus, a stewardship arrangement considered supportive and collectivistic, causing rewards for the organization. (madison et. al., 2016) argues that agency and stewardship theories are opposite theories. however, they deal with the identical phenomena of the individual-level activities and firmlevel governance tools that forecast organizational consequences. (davis et. al., 1997) explains that stewardship theory is like the agency theory because it describes the relationship between the principal and the steward-manager from an authoritative and a social outlook. both the stewardship and the agency theories propose opposing suppositions and expectations for firm performance (cruz et. al., 2010; chrisman et. al., 2007; wasserman, 2006; and tosi et. al., 2003). stewardship theory may be opposing or corresponding to the agency theory depending on the status quo. (zaigham et. al., 2019) test the influence of stock price behavior on firm investment and the counter impact of variations in investment expenditures on stock price behavior. the study uses the random effects model on the data collected from manufacturing firms registered on the asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 5 shanghai stock exchange and the shenzhen stock exchange china throughout 2002 2016. the sample covers 398 firms. findings show the influence of stock price on investment expenditures is way more than that of investment expenditures on stock price. in addition, there is a statistically significant negative association between stock price and investment expenditures. (hanuman and shrimal, 2014) examines literature in line with the relationship between firm financial performance and its market capitalization and leading to the conclusion that other studies have established a positive relationship. (handayani, 2018) determine the effect of market value, profitability, solvency, activity and liquidity to the stock price of 23 institutions in consumer goods manufacturing sectors registered on the indonesia stock exchange indonesia during 2014-2016. the independent variables are debt to equity ratio (der), price earnings ratio (per), total assets turnover (tato), current ratio (cr), return on equity (roe), and return on assets (roa). the dependent variable is stock price. the findings concluded that roe and tato affect the stock prices of companies manufacturing consumer goods, while the variables per, der, cr, and roa do not affect the stock prices of companies manufacturing consumer goods. (puspitaningtyas, 2017) determines if financial performance is actually reflected in stock prices. financial performance is measured using liquidity, profitability, growth, and market valuation. the population of this study is a non-banking company registered in the indonesia stock exchange indonesia and incorporated in lq45 index during 20112016. multiple linear regression analysis is used. findings showed that only market valuation variables significantly influence stock prices, while, liquidity, profitability, and growth have no effect on stock prices. (asmirantho and somantri, 2017) determine the effect of liquidity, solvency, activity, profitability and stock price with debt to equity ratio (der), return on equity (roe), total assets turnover (tato), earnings per share (eps), and current ratio (cr) for the pharmaceutical entities registered in indonesia stock exchange indonesia during 2012-2016. inferential statistics and regression analysis of panel data is used. the results show eps has partial significant effect on stock price, while cr, roe, der, and tato have no significant effect on stock price. (chessar, 2015) analyze the relation between market capitalization and stock price volatility in the nairobi securities exchange kenya throughout 2010-2014. the statistical regression analysis is used. a descriptive survey design using quantitative data from secondary sources was applied. findings show the most significant factor that affected the stock market volatility of the listed firms was market capitalization followed by liquidity. (chashmi and fadaee, 2016) investigates the impact of the financial performance represented by (earnings per share eps, return on equity roe, and return on assets roa) and growth opportunities on success or failure of 115 registered companies in the tehran stock exchange iran during 2006-2012. measures of financial performance and growth opportunities are the independent variables and success or failure are the dependent variables. pearson correlation coefficient and multiple regressions were used. the findings showed a significant relationship asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 6 between eps and roa with success or failure, but there is no significant relationship between roe and success or failure, and there is no significant relationship between growth opportunities and success or failure. (nassirzadeh et. al., 2015) evaluate the effectiveness of liquidity ratios, profitability ratios, efficiency ratios, debt ratios, and stock market ratios on trade volume of 67 institutions registered in the tehran stock exchange iran for the duration of 2010-2014. hierarchical multiple regression and a general regression were used. the outcomes specify that performance and liquidity ratios are considerably associated to trade volume and the most significant is the working capital. (shawer and al-ajlouni, 2018) explore the relationship between the profitability measured by return on investment roi, return on equity roe and net profit np and stock market prices of the petrochemical industry firms in saudi arabia during the period 2008-2015. multiple regression analysis is employed. the study confirms that the stock prices of petrochemical companies registered in the saudi stock market does not reflect its profit performance. (odularu, 2009) analyses the impact of companies’ shares on their performance, using one of the largest confectionary companies in nigeria as a case study. the study analyses the correlation concerning the sales of shares and the progression of the company. ordinary least square (ols) analytical technique is used. the company’s annual data for 20 years is evaluated. findings indicate profit after tax, dividends, and turnovers have positive and statistically robust implication on the fluctuations in the company’s operations and the value of its market capitalization. (elewa, 2016) examines the relationship between the independent variable firm performance proxied by (return on equity roe, property plant and equipment turnover ppet, return on assets roa, equity ratio er, earnings per share eps, non-discretionary accruals nda) and the dependent variable trade volume. the sample of the study consists of 62 nonfinancial institutions from the egx100 listed on the egyptian stock exchange egypt in 2007-2014, which is equivalent to 496 firm year observations. multiple regression analysis was used. findings indicate that no relation was supported between any of the variables that represent the firm performance (earnings per share eps, return on assets roa, property plant and equipment turnover ppet, return on equity roe, equity ratio er, non-discretionary accruals nda) and the trade volume. this is a signal that maybe the relationship is limited to none between (roa, eps, roe, ppet, er, nda) and the trade volume despite, stock prices and trade volumes go hand in hand in reality when evaluating firm performance. (dahawy and samaha, 2012) state that in spite of the difficulty of getting hold of annual reports by the general public and the lack of reliance on information, greater number of users perceive these reports to be the most essential resources of firm information. egyptian users depend more on annual report information than on advice from stock holders and friends or on tips and rumors. (chandrapala, 2011) examines the relationship between trade volume and stock returns. the sample of the study consists of 266 stocks traded at the colombo stock exchange (cse) sri asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 7 lanka during 2000-2008. this study follows the conventional methodology used by jagadeesh and titman (jagadeesh and titman, 1993). findings revealed that stock returns are positively related to the change in past trade volume. (el-ansary and atuea, 2012) examines the relationship between trade volume and stock return. the study sample consists of 26 out of 30 companies listed in egx 30 index egypt. the study covers the period from 1/7/2001 to 21/3/2010.the data consists of daily numbers of traded stocks, numbers of outstanding stocks, daily numbers of transactions and the corresponding daily closing price for each stock. the pearson correlation coefficient, the general autoregressive conditional hetroskedasticity garch (1,1) model, and the granger causality test were applied. findings show a simultaneous relationship between trade volume and stock return. (girard and omran, 2009) tests the relations of volume and volatility. the sample consists of returns of 79 listed institutions at the cairo and alexandria stock exchange (case) egypt during january 1998 to may 2005. the general autoregressive conditional hetroskedasticity garch (1,1) model is used. some results are evident. first, information direction and size have an unimportant effect on conditional volatility so the existence of imaginary bubbles and noise trading is assumed. second, volatility persistence decreases when volume is broken down even more into its unexpected and expected components. last but not least, projected information shocks have a negative influence on the volatility of return that suggests information distribution and trade efficiency have developed. this in-turn reinsures foreign investors and boosts the reform momentum. (joher, et. al., 2005) examines the volatility characteristics of kuala lumpur stock exchanges malaysia by considering mixing variable (volume) as innovation. this study presents a comprehensive analysis of the distributional and time series properties of returns. the garch (1, 1) model is used. findings indicate that current volatility can be clarified by past volatility that is likely to continue over time. the return volatility is best explained by a garch (1, 1) specification. this study considers volume as an additional explanatory variable contained by the garch (1, 1) model to examine if it can actually capture garch (1, 1) effects. results show that the persistence in volatility rests in the return series even when volume is incorporated in the model as an explanatory variable. this finding holds for simultaneous volume when it is comprised in the variance equation. (habib, 2011) investigates the joint dynamics of stock returns and trade volume in the egyptian securities exchange (ese) egypt during the period 1998-2005. findings establish several regularities about the role of trade volume in predicting the volatility of return. first, the lagged stock trade volume has an insignificant role to play in forecasting the future return volatility. second, there is no relation between volume and first autocorrelation of stock return. third, the granger causality tests indicate a bidirectional causal relation between volume and volatility. specifically, any change in return volatility leads to a change in trade volume and vice versa. however no such inference can be made about the causal relation between return and volume. (farag, 2011) examines the link concerning stock returns and trade volume of small and medium-sized enterprises in the nile stock exchange egypt. data consists of daily stock price asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 8 and trade volume for 12 firms. the investigation covers the period from the first day of trade 03 june 2010 to 01 june 2011. the findings suggest that the stock returns are influenced by the trade volume and vice versa. (abdelzaher, 2019) evaluates the consequences of the egyptian revolution on the stock performance in the egyptian stock market throughout 2010–2012 by evaluating its influence on closing price, market return fluctuation, and trade volume. these variables are examined before and after the egyptian revolution that happened on january 25th. the co-integrating equation model, the descriptive statistics group unit root test, the arch model, and the garch (1, 1) model, are applied. the sample contains 30 institutions registered on the egx30 index egypt. the independent variable is the egyptian revolution that happened on january 25th. the dependent variables are the trade volume, the fluctuation of returns, and the closing prices. findings indicate; the egyptian revolution had a significant negative impact on the closing prices, while it had a significant positive impact on the return fluctuation. the revolution had no significant impact on the trade volume. however, the trade volume decreased before, during, and after the january 25th egyptian revolution. (sun, 2003) discusses how volume and price move together and how unusual volume can be a predictive measure of future price changes. (gul, 2009) investigates the link regarding volume and price changes of individual stocks on a given day. an empirical analysis is made to evaluate the link concerning performance of the stock exchange index and trade volume. data for 92 successive days are gathered from june 18, 2007 to october 31, 2007. this data is gathered from the karachi stock exchange pakistan website. the data is form the kse 100 index and of the measures of volume. descriptive statistics are used. findings indicate that; a similar relationship exists, a significantly positive correlation exists, and the price-volume relationship occurs. (alber, 2020) states that the covid-19 spread is not considered "an event", as it does not have proper dated information content for use to determine the event window in terms of event study methodology. in addition, the spread of this virus is still going on from the first wave to the second wave and now on the third wave with rapid transformation, making it difficult to identify the event period. so, (alber, 2020) pursues to examine the effects of covid-19 outbreak on the european stock markets. the study measures the covid-19 spread in terms of cumulative cases, new cases, cumulative deaths and new deaths, while abnormal return of stock market is measured according to the market model. (alber, 2020) examines the stock markets of france, italy, germany, belgium, spain, uk, and netherlands, on an everyday basis throughout the febreuary15, 2020 to may 24, 2020. a vigorous check has been conducted on 273 stocks during the study period of (100 days). findings prove that stock markets have reacted negatively to the covid-19 spread during the first and second period. findings don’t support any negative effects during the third and fourth periods. starting from the fifth period, stock markets seem to be influenced negatively by “relative cumulative covid-19 deaths” (rccd). according to results of investigations made on the country effect, the stock markets of germany, netherlands and uk have been affected by the covid-19 spread during the second period. however, these results for belgium, france, italy and spain, have been asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 9 supported during the fourth period. the above literature review portrays some of the different studies made on different business environments of different countries (china, indonesia, kenya, iran, nigeria, saudi arabia, sri lanka, france, belgium, italy, germany, spain, uk, and netherlands) to identify different variables that have an impact on the firm stock price and trade volume. this study then focuses on trying to identify variables that might have a positive significant impact on the firm stock price and trade volume in the egyptian business environment during the first wave of covid19. thus, from the above literature review, the following question arises: qdo market capital mc and net profit np have an effect on firm's stock price sp and trade volume tv in the egyptian business environment during the first wave of covid-19? from here, we develop the following hypotheses: h1: market capital has a significant impact on stock price and trade volume during the first wave of covid-19. h2: net profit has a significant impact on stock price and trade volume during the first wave of covid-19. research methodology this study examines the link concerning the market capital mc, net profit np, stock price sp and trade volume tv of the non-financial institutions listed in the egx30 during the first wave of covid-19. the public data issued by the ministry of health and population of egypt show that from january 2020 till june 2020 monthly confirmed covid-19 cases recorded were january 0 cases, february 2 cases, march 710 cases, april 5537 cases, may 24985 cases, june 68311 cases. the monthly death cases from covid-19 recorded were january 0 cases, february 0 cases, march 46 cases, april 392 cases, may 959 cases, june 2953 cases. according to the public data issued on mubashr misr the monthly recorded closing prices were in egyptian pounds egp january 13918.84, february 13008.94, march 9593.94, april 10554.04, may 10220.14, and june 10764.59. the monthly recorded trade volume tv were in egyptian pounds egp january 1433193887, february 1891092410, march 3643681016, april 4185316058, may 2059843502, and june 232406248. there was an increase from january 1433193887 to april 4185316058 where the trade volume tv reached its peak. there was a sharp decrease from may 2059843502 and june 232406248. these numbers imply; a sharp monthly increase in the covid-19 confirmed cases, a sharp monthly increase in the covid19 death cases, a plunge in the monthly recorded closing prices, and an increase from january 1433193887 to april 4185316058 where the trade volume tv reached its peak and then there was a sharp decrease from may 2059843502 and june 232406248 in the trade volume tv. further investigation is needed to identify the reasons behind the increase of trade volume during the first wave of covid-19 according to the recorded data. it is worth noting that mubashr misr is a website that covers financial and stock markets & provides latest prices & values for local and global exchanges in addition to company initial asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 10 public offering ipo, which is the process by which a private company can go public by sale of its stocks to the general public. the data for the study is collected for the period from 1/1/2020 to 30/6/2020 that represents the period of quarantine in egypt as indicated from the egyptian presidential rulings. the data collected are for 28 non-financial institutions listed in the egx30 during 6 months equivalent to 168 firm year observations. these institutions operate in cash, have not been eliminated from the index throughout the study, have complete data, use the egyptian pounds egp to record in their financial statements, financial period starts 1/1 and ends 31/12. these 28 institutions are (porto group, dice, gb auto, egyptian chemicals-kema, pioneers holding, ezz steel, citadel capital, elswedy electric, palm hills development, eastern company, t m g holding, heliopolis housing, telecom egypt, cairo for investment, juhayna food industries, sidi kerir petrochemicals, orascom investment, six of october development, medinet nasr housing, cleopatra hospital, egyptian financial group-hermes, orascom development, emaar misr for development, orascom construction plc, ci capital holding, alexandria mineral oils, ibnsina pharma, egyptian for tourism oriental weavers) the market capital mc and the net profit np are the independent variables, while the stock price sp and trade volume tv are the dependent variables. empirical results and findings the study applied the pooled regression, the fixed effect, and the random effect techniques with the panel data analysis based on the following equation: yit = αoi + βit xit + eit yit: the dependent variable, attributed to i units, over the period t αoi: represent the fixed term for the sample i βit xit: independent variable and its slope eit: random error the subsequent three models were employed to analyze the available panel data: 1pooled model 2fixed effects model 3random effects model to indicate which model most suitably signifies the influence of the independent variables (mc and np) on the dependent variable stock price (sp) or trade volume (tv), the following five steps were applied: 1the pooled model 2the fixed effect model asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 11 3the results of the pooled model and the fixed effect model were compared using the ftest 4the random effect model 5the results of the random effects model and the fixed effect model were compared using the hausman test to verify the appropriate model for use. the analysis was made by using the five steps twice: first: when the dependent variable is represented by the stock price (sp) and the independent variables are represented by the mc and np. second: when the dependent variable is represented by the trade volume (tv) and the independent variables are represented by the mc and np. table 1. results of the pooled model of market capital and net profit jointly on stock price. variable coefficient prob. mc 0.422764 0.0001 np 1.685900 0.0483 adjusted r-squared 0.447415 f-statistic 73.06131 prob(f-statistic) 0.000000 source: spss output program according to table 1 presented above the f-test is used to evaluate the significance of the model, or the significance of the independent variables market capital mc and net profit np jointly (p=0.000000). if the p-value of f-statistics is less than 0.05, the model is significant. if the p-value of f-statistics is higher than 0.05, the model is considered insignificant. according to the results of the pooled model, market capital mc and net profit np (p < 0.05) where the p-value for f-statistics (0.000000) is less than 0.05. this implies the whole model is significant. the adjusted r-square has a value of 44.7%, which means that the independent variables are only able to explain less than or almost half of the changes in the stock price sp. the t-test is utilized to test the significance of each independent variable market capital mc (p=0.0001) and net profit np (p=0.0483) individually. if the p-value of t-test is less than 0.05, then the independent variable has a significant effect on the stock price sp. if the p-value of ttest is higher than 0.05, then the independent variable has an insignificant effect on the stock price sp. according to the results, both the independent variables market capital mc (p<0.05) and net profit np (p<0.05) have a significant effect on stock prices sp. the coefficient of market capital mc is 0.42 that means for every increase in the market capital mc by 1 billion dollars, the stock price sp increase -on averageby $0.42, assuming the net profits are fixed. in addition, the coefficient of net profit np is 1.69 that means that for each increase in the net profits by 1 billion dollars, the stock price sp increase -on averageby $1.69, asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 12 assuming the market capital is fixed. table 2.fixed effect model of market capital and net profit on stock price source: spss output program according to table 2 presented above the f-test is used to evaluate the significance of the model, or the significance of all independent variables market capital mc and net profit np jointly (0.000000). if the p-value of f-statistics is less than 0.05, the model is significant. if it is higher than 0.05, the model is considered insignificant. according to the results of the fixed effect model, market capital mc and net profit np (p < 0.05) where the p-value for f-statistics (0.000000) is less than 0.05. results imply the whole model is significant. the adjusted r-square is 97.4%, which means that the independent variables are able to explain the changes in the stock price sp almost completely. the t-test is conducted to test the significance of each independent variable market capital mc (0.0000) and net profit np (0.7551) individually. if the p-value of t-test is less than 0.05, then the independent variable has a significant effect on the stock price sp. if the p-value of t-test is higher than 0.05, then the independent variable has an insignificant effect on the stock price sp. according to the results, it is inferred that only market capital mc (0.0000) where (p < 0.05) has a significant effect on stock prices sp, and net profit np (0.7551) where (p > 0.05) has an insignificant effect on stock prices sp. the coefficient of market capital mc is 0.77 which means that for each increase in the market capital by 1 billion dollars, the stock price sp increase -on averageby $0.77, assuming the net profits are fixed. table 3. ftest of market capital and net profit on stock price source: spss output program to test the significance of the fixed effects, and to determine whether to choose the pooled model or the fixed effects model, the redundant fixed effects test was conducted. both models were estimated first, and then the redundant fixed effects likelihood ratio is performed. redundant fixed effects test hypothesizes that the fixed effects are redundant and insignificant. variable coefficient prob. mc 0.772085 0.0000 np 0.120755 0.7551 adjusted r-squared 0.974834 prob (f-statistic) 0.000000 effects test prob. cross-section chi-square 0.0000 prob(f-statistic) 0.0000 asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 13 according to table 3 to examine the significance of these fixed effects, fstatistic = (0.000000) and chi-square statistic = (0.0000) are conducted. if the p-value of f-statistic or p-value of chisquare statistic is less than 0.05, the fixed effects are significant. if it is higher than 0.05, the fixed effects are insignificant and redundant. according to the results, the p-value of fstatistic = (0.000000) and chi-square statistic = (0.000000) where the fstatistic p < 0.05, and chi-square statistic p < 0.05 which strongly reject the hypothesis of redundant fixed effects test. in other words, the results indicate that the fixed effects are statistically significant. so, the fixed effect model results are used. table 4. random effects model of market capital and net profit on stock price variable coefficient prob. mc 0.734591 0.0000 np 0.027956 0.9376 adjusted r-squared 0.474172 prob(f-statistic) 0.000000 source: spss output program according to table 4 above the f-test is used to evaluate the significance of the model, or the significance of all independent variables market capital mc and net profit np jointly (0.000000). if the p-value of f-statistics is less than 0.05, the model is significant. if it is higher than 0.05, the model is considered insignificant. according to the results of the random effects model, it is inferred f-statistics p < 0.05, which means that the whole model is significant. the adjusted r-square has a value of 0.474172 that is equivalent to 47.4%, which means that the independent variables are only able to explain less than or almost half of the changes in the stock price sp. the t-test is conducted to test the significance of each independent variable market capital mc (0.0000) and net profit np (0.9376) individually. if the p-value of t-test is less than 0.05, then the independent variable has a significant effect on the stock price sp. if the p-value of t-test is higher than 0.05, then the independent variable has an insignificant effect on the stock price sp. according to the results, only mc (0.0000) has p < 0.05 that infers to a significant effect on stock prices. the coefficient of market capital mc is of 0.73, which means that for each increase in the market capital by 1 billion dollars, the stock price sp increase -on averageby $0.73, assuming the net profits are fixed. table 5. hausman test of market capital and net profit on stock price variable random mc 0.734591 np 0.027956 chi-sq. statistic prob. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 14 3.238073 0.1981 source: spss output program the study analysis can be performed by using the fixed effects regression model or random effects regression model. according to table 5 above the hausman test is conducted through the measurement and the evaluation of the chi-square statistic (p = 0.1981) to choose the most appropriate regression model. if the p-value of chi-square statistic is higher than 0.05, the hypothesis is accepted and the random effects model is used. if p-value is less than 0.05, the hypothesis is rejected and the random effects model is not used. instead, the fixed effects model will be used. based on the results of hausman test, the chi-square statistic (p=0.1981) where (p>0.05), which means that the random effects model is used. after applying the above five steps when the dependent variable is represented by the stock price sp and the independent variables are represented by the market capital mc and net profit np, findings suggest that the random effects model most appropriately represent the impact of the independent variables (market capital mc and net profit np) on the dependent variable stock price sp where only mc has a significant effect on stock prices with a coefficient of 0.73. this means that for each increase in the market capital by 1 billion dollars, the stock price sp increase -on averageby $0.73, assuming the net profits are fixed. table 6. pooled model of market capital and net profit on trade volume variable prob. mc 0.5315 np 0.6211 adjusted r-squared 0.018267 prob(f-statistic) 0.073039 source: spss output program according to table 6 above, the f-test is used to evaluate the significance of the model, or the significance of the independent variables market capital mc and net profit np jointly (0.073039). if the p-value of f-statistics is less than 0.05, the model is considered significant. if the p-value of f-statistics is higher than 0.05, the model is considered insignificant. according to the results of the pooled model, market capital mc and net profit np (0.073039) shows that (p > 0.05) where the p-value for f-statistics (0.073039) is higher than 0.05. results imply the whole model is insignificant. the adjusted r-square has a very low value (1.8%), which means that the independent variables are almost completely not able to explain the changes in the trade volume tv. the t-test is also conducted to test the significance of each independent variable market capital mc (0.5315) and net profit np (0.6211) individually. if the p-value of t-test is less than 0.05, asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 15 then the independent variable has a significant effect on the trade volume tv. if the p-value of t-test is higher than 0.05, then the independent variable has an insignificant effect on the trade volume tv. according to the results, the p-value of both the independent variables market capital mc (0.5315) and net profit np (0.6211) are higher than 0.05 (p > 0.05). results infer that both the independent variables market capital mc (p = 0.5315) and net profit np (p = 0.6211) have an insignificant effect on trade volume. table 7. fixed effect model of market capital and net profit on trade volume variable prob. mc 0.2109 np 0.9127 adjusted r-squared 0.702170 prob(f-statistic) 0.000000 source: spss output program according to table 7 above, the f-test is used to evaluate the significance of the model, or the significance of the independent variables of capital market mc and net profit np jointly (p = 0.000000). if the p-value of f-statistics is less than 0.05, the model is significant. if the p-value of f-statistics is higher than 0.05, the model is insignificant. according to the results of the fixed effect model, market capital mc and net profit np (p < 0.05) where the p-value for fstatistics (0.000000) is less than 0.05. results imply the whole model is significant. the adjusted r-square is (0.702170) equivalent to 70.2% which means that the independent variables are able to explain more than two-third the changes in the trade volume tv. the t-test is conducted to test the significance of each independent variable of market capital mc (p = 0.2109) and net profit np (p = 0.9127) individually. if the p-value of the t-test is less than 0.05, then the independent variable has a significant effect on the trade volume tv. if the p-value of the t-test is higher than 0.05, then the independent variable has an insignificant effect on the trade volume tv. according to the results, mc (p = 0.2109) shows (p > 0.05) and np (p = 0.9127) shows (p > 0.05). results infer that each of the independent variable market capital mc and the independent variable net profit np are individually insignificant. asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 16 table 8. f-test on market capital and net profit on trade volume effects test prob. cross-section chi-square 0.0000 prob(f-statistic) 0.073039 source: spss output program to test the significance of the fixed effects, and to determine whether to choose the pooled model or the fixed effects model, the redundant fixed effects test was conducted. both models are first estimated, and then the redundant fixed effects likelihood ratio is applied. the redundant fixed effects test hypothesizes that the fixed effects are redundant and insignificant. to examine the significance of these fixed effects, fstatistic and chi-square statistic are conducted. if the p-value of f-statistic or chi-square statistic is less than 0.05, the fixed effects are significant. if the p-value of f-statistic or chi-square statistic is higher than (0.05), the fixed effects are insignificant and redundant. according to table 8 above, results show the p-value of f-statistic is (0.073039) and the p-value of chi-square statistic is (0.0000). according to the results, fstatistic (0.073039) and chi-square statistic (0.0000) it is clear that (p < 0.05), which strongly reject the hypothesis of redundant fixed effects test. in other words, the results indicate that the fixed effects are statistically significant. so, the fixed effect model results are used. table 9. random effects model of market capital and net profit on trade volume variable prob. mc 0.1958 np 0.9329 adjusted r-squared 0.001419 prob(f-statistic) 0.326487 source: spss output program in table 9 above, the f-test is used to evaluate the significance of the model (p=0.326487), or the significance of all independent variables market capital mc and net profit np jointly (p=0.326487). if the p-value of f-statistics is less than 0.05, the model is significant. if the pvalue of f-statistics is higher than 0.05, the model is insignificant. according to the results of the random effects model it can be found that the (p=0.326487) for the f-statistics is higher than 0.05. results suggest that the whole model is insignificant. the adjusted r-square is (0.001419), which means that the independent variables are not able to explain the changes in the trade volume tv completely. the t-test is also conducted to test the significance of each independent variable of market capital mc (p=0.1958) and net profit np (p=0.9329) individually. if the p-value of the t-test is less than 0.05, then the independent variable has a significant effect on the trade volume tv. if the p-value of the t-test is higher than 0.05, then the independent variable has an insignificant asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 17 effect on the trade volume tv. according to the results, the market capital mc (p=0.1958) shows (p>0.05) and the net profit np (p=0.9329) shows (p>0.05). results conclude both the independent variables are insignificant. table 10. hausman test of market capital and net profit on trade volume test summary prob. cross-section random 0.8218 cross-section random effects test comparisons: variable random mc -0.001681 np 0.000763 source: spss output program to choose between the two regressions models fixed effects or random effects, the hausman test is conducted. hausman test hypothesizes that the random effects model is preferred. it uses chi-square statistic to examine this hypothesis. if the p-value of chi-square statistic is higher than 0.05, the hypothesis is accepted, so the random effects model is used. if p-value is less than 0.05, the random effects model is not used. instead, the fixed effects model will be used. based on the results of hausman test in table 10 above, the p-value of chi-square statistic is found to be (0.8218), that is (p > 0.05), which means that the random effects model is preferred. the dependent variable, represented by the trade volume tv and the independent variables, represented by the market capital mc and net profit np have gone through the above five steps. findings assume the random effects model most appropriately represent the impact of the independent variables market capital mc (-0.001681) and net profit np (0.000763) on the dependent variable trade volume tv where the effects of both independent variables on trade volume are insignificant. conclusion and future studies this study seeks to detect the influence of the market capital mc and the net profit np on the stock price sp and trade volume tv in the developing egyptian business setting during the lockdown in egypt due to the first wave of covid-19. the study uses the pooled model, the fixed effects model, and the random effects model. findings suggest only the market capital mc has a significant effect on stock prices sp and both independent variables market capital mc and the net profit np have an insignificant effect on trade volume tv. consequently, we make some suggestions to help enhance the results of related future studies. even though stock prices, in the egyptian stock market, are unclear of the upcoming worth of the firms, the general belief remains that information is revealed in the alteration of existing stock prices. also, investors consider the behavior of the stock market when making investment decisions. we suggest that tools other than the stock price and trade volume to be used by the investors for more accurate decision making. we suggest further investigation to be asian journal of finance & accounting issn 1946-052x 2021, vol. 13, no. 2 ajfa.macrothink.org/ 18 undertaken to find the reasons behind the increase of trade volume during the first wave of covid-19 according to the recorded data. the egyptian regulatory environment is weak; therefore financial reporting quality is inclined to be determined by manager's incentives instead of the strength of the country's financial reporting standards. we suggest that the information that reaches the users is of accuracy, simplicity, transparence, and is issued on a timely basis. this study is limited to the egx 30 non-financial institutions only. this study does not go in depth as to whether or not covid-19 confirmed cases and death cases actually have a direct relation with market capital mc, net profit np, stock price sp, and trade volume tv. till now egypt has gone through two waves of the covid-19 and the third wave is on the way. this study makes its evaluation during the first wave during the lockdown period only because there are a lot of lessons learned from this period that can be used to better face any future confrontations with this or any other catastrophe in the egyptian business environment. thus, further studies can be made taking into consideration listed financial institutions (banks and insurance companies) instead of the listed nonfinancial institutions. investigations can be made during the second and third wave of covid-19. future studies can also be made using other tools as dependent variables other than the stock price and trade volume. finally, we suggest further studies to be made to find possible ways to strengthen the egyptian regulatory bodies to be more prepared to aiding the egyptian business environment to better handle unexpected catastrophes. acknowledgement we appreciate the invaluable work of mr. mohamed m. youssef, on the statistical analysis which substantially improved the article. the data used in this paper is available and can be accessed from mubasher misr website and the egyptian center for economic studies. references abdelrhim, elsayed, mohamed & farouh. 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(2019). causal relation between stock market performance and firm investment in china: mediating role of information asymmetry. sage open, 9(4), 2158244019885146. https://doi.org/10.1177/2158244019885146 microsoft word 15235-54896-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 96 tracking errors of exchange traded funds in bursa malaysia alfred ing-soon ku rhb investment bank berhad 102, pusat pedada, jalan pedada, 96000 sibu, sarawak, malaysia tel: 60-84-329214 e-mail: alfredku85@gmail.com venus khim-sen liew (corresponding author) faculty of economics and business, universiti malaysia sarawak jalan datuk mohammad musa, 94300 kota samarahan, sarawak tel: 60-82-584291 e-mail: ksliew@unimas.my chin-hong puah faculty of economics and business, universiti malaysia sarawak jalan datuk mohammad musa, 94300 kota samarahan, sarawak tel: 60-82-584294 e-mail: chpuah@unimas.my received: august 7, 2019 accepted: nov 7, 2019 published: december 1, 2019 doi:10.5296/ajfa.v11i2.15235 url: https://doi.org/10.5296/ajfa.v11i2.15235 abstract this study measures the tracking errors of exchange traded funds (etfs) listed in bursa malaysia. five measures of tracking errors are estimated in this study for the seven etfs involved. overall, the best etf is metfapa with the least tracking error. the ranking of the remainder etfs, in the ascending order of tracking error is myetfid, metfsid, myetfdj, cimc50, fbmklci-ea and cimba40 (highest tracking error). the findings in this study is expected to provide clue for passive institutional and retail investors on their selection of etfs to mimic the portfolio of the desired underlying assets. moreover, it is anticipated that these findings will motivate the improvement in the tracking ability of the existing etfs, solicit more follow up studies to encourage the development of new etfs and increase the participation of investors. keywords: exchanged traded fund, bursa malaysia, passive managment, tracking error asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 97 1. introduction exchange traded fund (etf) is invented to replicate performance of underlying index in the stocks, bonds, commodities or foreign currencies markets. etfs are pooled-investment funds that allow investors to own the undelying assets. as they are traded directly on stock exchange, their prices fluctuate throughout the trading day due to buying and selling activities like stocks. the world’s first etf, toronto index participation units (tips), was listed in canada in 1990, less than 3 decades ago (note 1). despite the relative shorter history of existence compared to their underlying financial assets, etfs are accepted by worldwide institutional and retail investors, as they provide the cheaptest way to massively diversify their investments. etfs enjoy strong growth in terms of numbers of etfs and asset under management (aum). as of august 2017, etfs hold approximately us$4.38 trillion of assets globally (note 2). according to a survey conducted by pricewaterhouse cooper (2015), 75% of the participants around the globe are confident that etfs assets will grow to us$ 5 trillion by 2020. etfs performance are substantially less researched compared to investments performance on stocks, bonds and commodities. elton, gruber, comer and li (2002) were among the first to provide an analysis of the spider etf, which tracks the standard & poor’s 500 index. they found that, on average, the spider traded at a discount of 0.18% to its nav and 1.8% below low cost index fund. this was mainly due to the management fees and holding dividend in the non-interest bearing account (note 3). in a seperate endavour, gastineau (2004) investigated the operating efficiency of the funds. gastineau (2004) claimed that etfs underperformed relative to their benchmarks and mutual funds, which are actively-managed pooled investment products widely known to investors. he argued that the underperformance is due to the reluctance of etfs managers to timely adjust the index if underlying benchmark makes any changes. since etfs are invented to track the underlying index, it is logic to evaluate their tracking errors. tracking error is defined as difference between the return of etf and its underlying benchmark. engle and sarkar (2006) did a comprehensive analysis on tracking error of etfs listed in the u.s. they included a larger number of both domestic and international etfs in the us. they found that domestic etf only showed small deviations that typically last for a few minutes only. contradictory, international etf showed persistent higher premium or discount to compared the net asset values of the underlying assets (navs). the relatively high tracking errors of international etfs was also observed by jares and javin (2004). both of them opined that larger tracking errors were attributed to timing mismatch between the pricing of etfs and navs that arose due to time different of trading hours. milonas and rompotis (2006) found an average tracking error of 1.02% among 36 swiss etfs. shin and soydemir (2010) estimated tracking errors from 26 etfs covering 20 ishares morgan stanley capital international (msci) country funds and 6 ishares broad u.s. equity market funds. they documented persistent tracking errors that range from 0.001% to 0.014% on daily basis. they further showed that the tracking errors were due to expenses, dividends and exchange rates. blitz and huij (2011) pointed out that global emerging market (gem) etf posed larger tracking error due to the larger dispersion of stock return. bassie (2012) reported that tracking errors of etfs listed in europe were relatively small and stable over time. qiao (2013) reported asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 98 that etfs in the us provide excess return against underlying benchmark but do not outperform relative mutual funds based on historical data from 2011 until 2013. heino and kromlid (2014) showed tracking errors of 0.57% for u.s. etfs. dinglestad (2015) documented that the etfs listed in london stock exchange (lse) had small tracking errors and they were decreasing over time. as for asia pacific, gallagher and segara (2006) reported that etfs traded on the australian stock exchange produced the same return as their underlying benchmark before costs. lin, chan and hsu (2005) revealed that among all taiwan listed etfs, taiwan top 50 tracker fund (ttt) which tracks taiwan 50 index, was price efficient. it almost produces identical return to taiwan index. however, lin and chou (2006) reported that tracking errors of ttt more often occurred during the companies’ dividend payment period. in a seperate endeavor, chu (2011) documented that tracking errors of hong kong etfs are as high as those in the u.s. and australia. prasanna (2012) did a thorough analysis on growth and performance of etf in india and found that cnx 50 generated excess return of 3% per annum. li (2013) analyzed 6 etfs listed on hong kong and china which are all tracking shanghai shenzen csi 300 index and reported that etfs in emerging market, especially in china showed underperformance in return as compared to the respective indices. the current study attempts to measure the tracking errors of etfs traded in bursa malaysia. 2. etfs in malaysia the first etf was listed on bursa malaysia in 2005. it is the abf malaysia index fund, which is a bond fund that track markit iboxx abf malaysia bond index. the first equity etf, which is the ftse bursa malaysia klci, came in two years later. as of today, the numbers of etfs increased to eight after a more than a decade of development. etfs listed on bursa malaysia are summarized in table 1. development of etfs in malaysia have been sluggish. this could attribute to low product awareness among investors and thin trading volume. there are three etfs providers in malaysia. aminvestment is the pioneer in malaysia etf industry. aminvestment launched malaysia first and the only bond fund, abf malaysia bond index fund and ftse bursa malaysia klci , which tracks against kuala lumpur composite index. i-vcap managment is the most active provider, with four funds launched and total asset under management (aum) amounting to rm343 million. i-vcap management, a wholly subsidiary of value cap sdn bhd, is islamic etf provider of malaysia. cimbprincipal asset management launched two regional funds in 2010 worth aum rm15 million in total. i-vcap management launched malaysia first islamic etf, myetf dow jones islamic market malaysia titan 25. islamic etf is etf that track benchmark index that comprise of securities which are shariah compliant. i-vcap management continue its effort in pioneering in islamic etfs with conitnuous launching new funds in recent years. myetf msci malaysia islamic dividend, myetf msci south east asia islamic dividend and myetf thomson reutuers asia pacific ex-japan islamic agribusiness are among islamic etfs that are listed on bursa malaysia. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 99 trading volume of malaysia etfs on exchange have been thin since inception. however, continuous education effort on etfs by bursa malaysia had resulted in 66% growth in the trading volume with 28.9 million units being traded in 2015 as compared to 17.4 million in previous year. thus, investors education is crucial in order to increase their participation. table 1. etfs listed on bursa malaysia listing year fund provider etf code symbol underlying index 2005 aminvestment abf malaysia bond index fund 0800ea abfmy1 markit iboxx abf malaysia bond index 2007 aminvestment ftse bursa malaysia klci 0820ea fbmklciea ftse bursa malaysia klci index 2008 i-vcap management myetf dow jones islamic market titan 25 0821ea myetfdj dow jones islamic market malaysia titans 25 index 2010 cimb-principal asset management cimb ftse asean 40 malaysia 0822ea cimba40 ftse asean 40 index 2010 cimb-principal asset management cimb ftse china 50 index 0823ea cimbc50 ftse china 50 index 2014 i-vcap management myetf msci malayisa islamic dividend 0824ea myetfid msci malaysia imi islamic high dividend yield 10/40 2015 i-vcap management my etf msci sea islamic dividend 0825ea metfsid msci sea imi islamic high dividend yield 10/40 2015 i-vcap management my etf thomson reuters asia acific ex-japan islamic agribusiness 0826ea metfapa thomson reuters islamic asia pacific ex-japan agribusiness index source: bursa malaysia (2017) 3. data and methodology weekly closing prices of etfs and the underlying indices covering the period from june 2007 to may 2016 were employed in this study. the data set was gathered from nextview and asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 100 bloomberg terminal. the etfs examined are all equity etfs: metfapa (0826ea), metfsid (0825ea), myetfid (0824ea), cimbc50 (0823ea), cimba40 (0822ea), myetfedj (0821ea) and fmbklci-ea (0820ea) (note 4). the plots of these weekly etfs price movement together with their underlying indices are given in the appendix. from the figures, apparently these etfs traced closely their underlying indices over the sample period. the weekly return of the etf is calculated as: 𝐹𝑅 , = , , , x 100 , (1) where, 𝐹𝑅 , = return of the etf 𝑖 at time t; 𝑃𝑟𝑖𝑐𝑒 , = price of etf 𝑖 at time t; and 𝑃𝑟𝑖𝑐𝑒 , = price of etf 𝑖 at time t-1. meanwhile, weekly return of the underlying index is obtained using the same principle: 𝐼𝑅 , = , , , x 100, (2) where, 𝐼𝑅 , = return of the underlying index 𝑖 at time t; 𝐼𝑛𝑑𝑒𝑥 , = price of the underlying index 𝑖 at time t;; and 𝐼𝑛𝑑𝑒𝑥 , = price of the underlying index 𝑖 at time t-1. tracking error refers to the difference between the return of etfs and return of indices. the following widely adopted calculations of tracking errors (𝑇𝐸 , 𝑇𝐸 and 𝑇𝐸 ) are employed in this study (see dingelstad, 2015): 𝑇𝐸 = 𝐹𝑅 , 𝐼𝑅 , ; (3) 𝑇𝐸 = ∑ | , , | ; and (4) 𝑇𝐸 = ∑ (𝑒 − ē ) , (5) where, 𝑒 = 𝐹𝑅 , 𝐼𝑅 , = difference in return of etf 𝑖 and its underlying index at time t; ē = sample mean difference; and n = numbers of observation. te1 refer to the simple difference between the returns of the etf and its underlying index. positive (negative) te1 indicates that the etf has better (worse) return than the underlying index. meanwhile, te2 is the mean absolute deviation between the returns of etf and its underlying index. te3 refers to standard deviation of te1. in general, the lower the tracking error, the better the tracking ability. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 101 apart from calculated tracking errors, regression analysis technique is adopted to estimate the tracking ability of etfs. in this analysis, the ordinary least squares (ols) model 𝐹𝑅 = 𝛼 + 𝛽 𝐼𝑅 + 𝜀 is first estimated to obtain intercept or alpha coefficient ( 𝛼 ), slope or beta (𝛽 ) coefficient and the coefficient of determination (𝑅 ). a positive (negative) sign of alpha indicates outperformance or excess profit (underperformance or excess loss) of the etf against the underlying benchmark. theoretically, it would be unlikely to get a positive figure for alpha because etf is meant to replicate the benchmark index only. nonetheless, according to bassie (2012), etfs may outperform its underlying benchmark when investors are confidence with underlying benchmark and thus willing to buy the etf on premium. the beta coefficient represents rate of change of etfs when the benchmark index changes by one percent. etf that adopts perfect replication strategy towards its underlying index will have a beta of one. as such, the closer the beta to one, the better is the tracking performance. 𝑅 indicates how much of the variation in the etf return is explained by variation in the return of the underlying index. it is another indicator for the tracking ability of an etf (aroskar et al., 2012). in this case, the higher the 𝑅 , the better is the tracking ability. 4. empirical results table 2 below shows the tracking errors of etfs listed in bursa malaysia against their underlying indices. the calculated te1 values range from -9.7018% (cimba40) to 9.8214% (myetfdj). overall, the average te1 values range from the lowest tracking error of 0.0092% (fbmklci-ea) to the higher tracking error of 0.1091% (cimbc50). from another perspective, since te1 is essentially the returns difference, it implies that, all etfs outperformed their underlying indices in terms of simple weekly returns over the sample period of study. table 2. calculated tracking errors etf sample period n te1 te2 te3 min max mean metfapa 4/12/2015 27/5/2016 25 -2.2850 1.9101 0.0122 0.6788 0.8868 metfsid 5/8/2015 27/5/2016 53 -3.5577 2.0685 0.0664 0.8864 1.1361 myetfid 21/3/2014 27/5/2016 114 -3.0665 2.6797 0.0335 0.8139 1.1084 cimbc50 9/7/2010 27/5/2016 307 -5.5311 9.5543 0.1091 1.1340 1.5395 cimba40 9/7/2010 27/5/2016 307 -9.7018 7.2361 0.0663 1.4300 1.9695 myetfdj 31/1/2008 27/5/2016 429 -6.2909 9.8214 0.0292 0.9850 1.5236 fbmklciea 20/7/2007 27/5/2016 461 -5.8218 4.6890 0.0092 1.1215 1.4640 note: te1 refers to the simple return difference between etfs and underlying indices; te2 refers to the mean absolute difference between etf and underlying index; te3 refers to standard deviation of te1. n, min, max represent sample size, minimum and maximum respectively. as for te2 which measures the average absolute mean return difference, metfapa had the lowest tracking error (0.6788%), whereas cimba40 had the highest tracking error (1.4300%). consistently, metfapa and cimba40 had the lowest (0.8868%) and the highest (1.9695%) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 102 tracking error respectively by the te3. noting that te3 is actually the standard deviation of the simple mean return difference, it means the simple mean return difference is the least (most) volatile in metfapa (cimba40). the weekly returns of etfs and indices are further analyzed using regression analysis. the estimated results are summarised in table 3. it is evident from table 3 that all estimated α’s are positive, with the exception of metfapa. it means these six etfs had excess returns. among the six etfs that had positive α, metfsid had the smallest α of 0.0124, while cimbc50 had the highest α of 0.0745. in another words, excess returns are detected for these 6 etfs with magnitude ranging from 0.0124% to 0.0745% per week. however, none of these excess returns are statistically siginificant. results obtained from nonparametric test, namely the wilcoxon signed ranks test, confirmed that there was no significant excess return in all cases, see table 4. this is evident since the null hypothesis of equal means in the returns of the etf and its underlying index could not be rejected at conventional significance level. as for the slope coeeficients, it is reported in table 3 that the estimated β’s range from 0.3611 (cimba40) to 0.8771 (metfapa). they are all statistically difference from zero at conventional significance level. furthermore, they are also statistically different from one with the exception of metfapa. since the estimated β for metfapa is indifferent from one, it implies that this etf traced the underlying thomson reuters islamic asia pacific ex-japan agribusiness index perfectly well. other etfs that traced their underlying indices excellently well are myetfid (0.8281), metfsid (0.7809), cimbc50 (0.7719) and myetfdj (0.7510). on the other hand, fbmklci-ea (0.7510) performed moderately well while cimba40 (0.3611) performed poorly in tracing ftse bursa malaysia klci index and ftse asean 40 index respectively. lastly, the r2 value of 0.7972 for cimbc50 implies that 79.72% of the variation in this etf can be explained by variation in the underlying index. meanwhile, only 26.13% of the variaiton in cimba40 could be explained by variation in its underlying index. that means 73. 87% of its variation was due to factors other than the underlying index. in the context of tracking error, the higher the r2, the better is the performance in the sense that the tracking error is lesser. thus, cimbc50 outperformed all other etfs as it has the highest r2 value, whereas the etf that performed the worst is cimba40. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 103 table 3. regression results etf α t (α=0) β t (β=0) t (β=1) r2 n metfapa -0.003 -0.016 0.8771 7.7274** -1.0828 0.7308 25 metfsid 0.0124 0.0805 0.7809 7.5300** -2.1127* 0.5314 53 myetfid 0.0407 0.396 0.8281 10.3005** -2.1382* 0.4887 114 cimbc50 0.0745 1.0473 0.7719 34.5659** 10.2144** 0.7972 307 cimba40 0.0686 0.8837 0.3611 10.3691** 18.3462** 0.2613 307 myetfdj 0.0331 0.4731 0.7510 19.9350** -6.6096** 0.4797 429 fbmklciea 0.0260 0.4137 0.6825 19.5700** 9.1040** 0.4554 461 notes: equation 𝐹𝑅 = 𝛼 + 𝛽 𝐼𝑅 + 𝜀 is estimated. α refer to intercept from regression and β refer to slope coefficient from regression. r2 refers to how close is the data fitted onto the regression line. n is the sample size. t(α=0) and t(β=0) represent the t-ratio to test whether α and β are statistically significantly difference from zero respectively. t(β=1) represent the t-ratio to test whether β is statistically significantly difference from one. * and ** represent significance at 5% and 1% level respectively. table 4. wilcoxon signed ranks test results etf z p metfapa 0.0000 1.0000 metfsid -0.7190 0.4720 myetfid -0.8120 0.4170 cimbc50 -1.2280 0.2190 cimba40 -0.6260 0.5310 myetfdj -0.2660 0.7900 fbmklci-ea -0.1430 0.8860 notes: z is the statistics of the test, and p is the p-value of z. the null hypothesis of equal means in the returns of the etf and its underlying index is tested against the alternative hypothesis of unqual means in the returns of the two series. based on the p-value, none lof the null hypothesis could be rejected at conventional significance level. table 5 summarizes the tracking errors of etfs based on different measurements. it is evident that metfapa consistently ranked number 1 in 3 out of 5 tracking error measurements. that means metfapa outperformed all other etfs from the perspectives of te2, te3 , β. meanwhile myetfid consistently ranked second in 3 out of 5 tracking error measures. as for metfsid, it consistently ranked third in 4 out of 5 measurements. on the other hand, fbmklci-ea managed to appear top in the te1 race, while cimbc50 was able to secure the first position in th r2 comparison exercise. on average, the performance of the etfs in the ascending order average tracking errors is: metfapa, myetfid, metfsid, myetfdj, cimc50, fbmklci-ea and cimba40. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 104 table 5. summary of tracking errors etf te1 te2 te3 β r2 average metfapa 2 1 1 1 2 1.4 metfsid 6 3 3 3 3 3.6 myetfid 4 2 2 2 4 2.8 cimbc50 7 5 6 4 1 4.6 cimba40 5 6 7 7 7 6.4 myetfdj 3 4 5 5 5 4.4 fbmklci-ea 1 7 4 6 6 4.8 note: rank of etf is given in this table with number 1 given to etf with the smallest tracking error while number 7 given to etf with the largest tracking error. 5. conclusion exchange traded funds (etfs) are pooled-investment funds that allow investors to own the undelying assets at the cheaptest way to massively diversify their investments. since etfs are invented to track the underlying indices, it is logic to evaluate their performances in terms of tracking errors. an etf that traced the undelying index perfectly should produce zero trackimg error. previous researches had documented significant tracking errors for etfs in u.s., europe stock as well as asia-pacifics stock markets. malaysia stock market had introduced its first etf in the year 2005, some 15 years after the listing of the world’s first etf in canada. the objective of this study is to measure the tracking errors of etfs traded in bursa malaysia. seven etfs are included in this study. it is found that all the average te1 values are positive and they range from 0.0092% (fbmklci-ea) to 0.1091% (cimbc50). as te1 is essentially measuring the difference between the returns of etf and its underlying index, we can said that, all etfs performed better than their underlying indices in terms of simple weekly return. the positive values of the estimated intercept coefficients (𝛼) from simple regression analysis confirmed the existence of excess returns. however, results from both t-test and wilcoxon signed ranks test showed no statistical evidence of significant excess returns. as such, no etfs had significantly outperformed their underlying indices. as for te2, metfapa had the lowest value (0.6788%), whereas cimba40 had the highest value (1.4300%). consistently, metfapa and cimba40 had the lowest (0.8868%) and the highest (1.9695%) te3 values. the tracking error performance of these etfs was also analysed by regressing the retuns of etf on the returns of its underlying index. the estimated slope coefficient (β) and the coefficient of determintion (r2) obtained served as two alternative measures of tracking error. all the estimated β’s are significantly smaller than one, except metfapa. it implies that metfapa replicated the underlying index perfectly. other etfs that traced their underlying indices excellently well (β close to one) are myetfid (0.8281), metfsid (0.7809), cimbc50 (0.7719) and myetfdj (0.7510). from the perspective of r2, cimbc50 outperformed all other etfs as it has the highest r2 value, whereas the cimb40 turned out to be the worst in tracking ability. taking into consideration of all measures of tracking errors, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 105 the best etf is matfapa with the least tracking error as a whole. the ranking of the remainder etfs, in the ascending order of tracking error is myetfid, metfsid, myetfdj, cimc50, fbmklci-ea and cimba40 (highest tracking error). noted that the top four etfs are managed by i-vcap management. the findings in this study is expected to provide clue for passive institutional and retail investors on their selection of etf to mimic the portfolio of the desired underlying assets. moreover, as tracking error is an indicator of a fund manager’s skills, it is anticipated that these findings will motivate in improvement in the tracking ability of existing etfs. in addition, since the trading volume of etfs in malaysia is still thin, more subsequent studies on etf are encouraged for the development of new etfs and to increase trading volume. besides, bursa malaysia and malaysian government should give promotion and tax reduction incentives respectively to etfs investors to increase their participation. acknowledgement the authors would like to thanks the editor and reviewers on thier comments that enhance the quality of our research work and the presentation of this version. disclaimer the findings in this paper obtained from the sample data at hand during our study period, are to be observed with caution as it may not be valid for other sample periods. you should be aware of the risks that are associated with etfs trading, and kindly seek advice from an independent financial advisor before you perform any transactions. neither the authors, their institutions, nor the journal is held responsible for any transaction loss, if any, that you may have derived upon the findings of this article. notes note 1. etfs are relatively new in asia. the nikkei 300 index fund, which was listed in may 1995, is the first etf in asia note 2. some 90% of the etfs are based in the united states (us) and europe, while asia pacific had just started to grow rapidly in recently years. note 3. the dividends paid by stocks must be held until the etf pays its dividend to shareholders. note 4. abf malaysia bond index fund is excluded in this study. references aroskar, r. & ogden, w. a. 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(2012). performance of exchange-traded funds in india. international journal of business management, 7(23), 122-141. https://doi.org/10.5539/ijbm.v7n23p122 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 107 appendix figure 1. plot of metfapa and thomson reuters islamic asia pacific ex-japan agribusiness index figure 2. plot of metfsid and msci sea imi islamic high dividend yield 10/40 0.86 0.88 0.90 0.92 0.94 0.96 0.98 1.00 1.02 165.00 170.00 175.00 180.00 185.00 190.00 195.00 2015/12/4 2015/12/11 2015/12/18 2015/12/25 2016/1/1 2016/1/8 2016/1/15 2016/1/22 2016/1/29 2016/2/5 2016/2/12 2016/2/19 2016/2/26 2016/3/4 2016/3/11 2016/3/18 2016/3/25 2016/4/1 2016/4/8 2016/4/15 2016/4/22 2016/4/29 2016/5/6 2016/5/13 2016/5/20 2016/5/27 index metfapa 0.75 0.80 0.85 0.90 0.95 1.00 1.05 1800.00 1900.00 2000.00 2100.00 2200.00 2300.00 2400.00 2500.00 2015/5/8 2015/5/22 2015/6/5 2015/6/19 2015/7/3 2015/7/17 2015/7/31 2015/8/14 2015/8/28 2015/9/11 2015/9/25 2015/10/9 2015/10/23 2015/11/6 2015/11/20 2015/12/4 2015/12/18 2016/1/1 2016/1/15 2016/1/29 2016/2/12 2016/2/26 2016/3/11 2016/3/25 2016/4/8 2016/4/22 2016/5/6 2016/5/20 index metfsid asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 108 figure 3. plot of myetfid and msci malaysia imi islamic high dividend yield 10/40 figure 4. plot of cimbc50 and ftse china 50 index figure 5. plot of cimba40 and ftse asean 40 index 0.85 0.90 0.95 1.00 1.05 1.10 2000.00 2050.00 2100.00 2150.00 2200.00 2250.00 2300.00 2350.00 2400.00 2450.00 2500.00 21 /3 /2 01 4 18 /4 /2 01 4 16 /5 /2 01 4 13 /6 /2 01 4 11 /7 /2 01 4 8/ 8/ 20 14 5/ 9/ 20 14 3/ 10 /2 01 4 31 /1 0/ 20 14 28 /1 1/ 20 14 26 /1 2/ 20 14 23 /1 /2 01 5 18 /2 /2 01 5 20 /3 /2 01 5 17 /4 /2 01 5 22 /5 /2 01 5 19 /6 /2 01 5 16 /7 /2 01 5 14 /8 /2 01 5 11 /9 /2 01 5 9/ 10 /2 01 5 13 /1 1/ 20 15 4/ 12 /2 01 5 15 /1 /2 01 6 12 /2 /2 01 6 11 /3 /2 01 6 8/ 4/ 20 16 6/ 5/ 20 16 23 /6 /2 01 6 index myetfid 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 0.00 5000.00 10000.00 15000.00 20000.00 25000.00 2010/7/9 2010/10/9 2011/1/9 2011/4/9 2011/7/9 2011/10/9 2012/1/9 2012/4/9 2012/7/9 2012/10/9 2013/1/9 2013/4/9 2013/7/9 2013/10/9 2014/1/9 2014/4/9 2014/7/9 2014/10/9 2015/1/9 2015/4/9 2015/7/9 2015/10/9 2016/1/9 2016/4/9 index cimbc50 0.00 0.50 1.00 1.50 2.00 0.00 2000.00 4000.00 6000.00 8000.00 10000.00 12000.00 14000.00 2010/7/9 2010/10/9 2011/1/9 2011/4/9 2011/7/9 2011/10/9 2012/1/9 2012/4/9 2012/7/9 2012/10/9 2013/1/9 2013/4/9 2013/7/9 2013/10/9 2014/1/9 2014/4/9 2014/7/9 2014/10/9 2015/1/9 2015/4/9 2015/7/9 2015/10/9 2016/1/9 2016/4/9 index cimba40 asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 2 ajfa.macrothink.org/ 109 figure 6. plot of myetfdj and dow jones islamic market malaysia titans 25 index figure 7. plot of fbmklci-ea and ftse bursa malaysia klci index 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 0.00 200.00 400.00 600.00 800.00 1000.00 1200.00 2008/1/31 2008/3/31 2008/5/31 2008/7/31 2008/9/30 2008/11/30 2009/1/31 2009/3/31 2009/5/31 2009/7/31 2009/9/30 2009/11/30 2010/1/31 2010/3/31 2010/5/31 2010/7/31 2010/9/30 2010/11/30 2011/1/31 2011/3/31 2011/5/31 2011/7/31 2011/9/30 2011/11/30 2012/1/31 2012/3/31 2012/5/31 2012/7/31 2012/9/30 2012/11/30 2013/1/31 2013/3/31 2013/5/31 2013/7/31 2013/9/30 2013/11/30 2014/1/31 2014/3/31 2014/5/31 2014/7/31 2014/9/30 2014/11/30 2015/1/31 2015/3/31 2015/5/31 2015/7/31 2015/9/30 2015/11/30 2016/1/31 2016/3/31 index myetfdj 0.00 0.50 1.00 1.50 2.00 2.50 0.00 200.00 400.00 600.00 800.00 1000.00 1200.00 1400.00 1600.00 1800.00 2000.00 20 07 /7 /2 0 20 07 /9 /2 0 20 07 /1 1/ 20 20 08 /1 /2 0 20 08 /3 /2 0 20 08 /5 /2 0 20 08 /7 /2 0 20 08 /9 /2 0 20 08 /1 1/ 20 20 09 /1 /2 0 20 09 /3 /2 0 20 09 /5 /2 0 20 09 /7 /2 0 20 09 /9 /2 0 20 09 /1 1/ 20 20 10 /1 /2 0 20 10 /3 /2 0 20 10 /5 /2 0 20 10 /7 /2 0 20 10 /9 /2 0 20 10 /1 1/ 20 20 11 /1 /2 0 20 11 /3 /2 0 20 11 /5 /2 0 20 11 /7 /2 0 20 11 /9 /2 0 20 11 /1 1/ 20 20 12 /1 /2 0 20 12 /3 /2 0 20 12 /5 /2 0 20 12 /7 /2 0 20 12 /9 /2 0 20 12 /1 1/ 20 20 13 /1 /2 0 20 13 /3 /2 0 20 13 /5 /2 0 20 13 /7 /2 0 20 13 /9 /2 0 20 13 /1 1/ 20 20 14 /1 /2 0 20 14 /3 /2 0 20 14 /5 /2 0 20 14 /7 /2 0 20 14 /9 /2 0 20 14 /1 1/ 20 20 15 /1 /2 0 20 15 /3 /2 0 20 15 /5 /2 0 20 15 /7 /2 0 20 15 /9 /2 0 20 15 /1 1/ 20 20 16 /1 /2 0 20 16 /3 /2 0 20 16 /5 /2 0 index fbmklci-ea microsoft word 17310-61417-1-sm (1)-writer2-new asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 1 operating cash flow and dividend changes as a management tool for planning and making decision associate professor faris alqadi accounting department, jarash university tel: 96-27-9639-9989 e-mail: faris.1965@hotmail.com received: june 5, 2020 accepted: july 27, 2020 published: december 1, 2020 doi:10.5296/ajfa.v12i2.17310 url: https://doi.org/10.5296/ajfa.v12i2.17310 abstract the main objective of this study was to examine whether operating cash flows have incremental information beyond operating net income in explaining dividend changes for a sample of jordanian industrial firms listed on the amman stock exchange (ase) during the period 2010-2016 arguments for operating cash flow information suggest that it is better than accrual net income in reflecting the firm performance and in measuring the firm liquidity. both performance and liquidity are viewed as significant factors influencing a firm’s dividend policy. to examine this, operating cash flow, operating net income and lagged dividends were incorporated in a regression model. the results of this model indicated that the only significant variables explaining dividend changes were operating net income and lagged dividends with positive and negative coefficients, respectively. an attempt was also made to address the problem of nonlinearity in the relationship between cash flow and dividend changes. the sample of the industrial firms were divided into two groups (high growth and low growth firms) based on market to book value ratio. the results of the two regression models provided evidence consistent with the superiority of accrual operating net income over operating cash flow in explaining dividend changes. the results of this study suggest that jordanian industrial firms base their dividend policies on accrual net income rather than on cash flows. one possible consequence of this suggestion is that cash dividends are not internally financed and as a result, this would deteriorate the liquidity and solvency position of a firm. keywords: operating cash flow, dividend changes, operating net income, amman stock exchange (ase) asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 2 introduction interest in cash flow reporting has increased in recent years. realizing the usefulness of cash flow information, regulatory bodies in most countries, including jordan, and the international accounting standards committee (iasc) require companies to prepare a statement of cash flows as part of their reporting system. several studies have attempted to compare the usefulness of cash flow information with that of accrual income. for example, dechow found that accrual income was more closely related to firm performance (as reflected in stock returns) than cash flow from operations. on the other hand, sloanfound that the levels of cash flow achieved are more likely to continue in the future, while the accrual components of income are temporary and likely to be reversed. in addition, several studies linked cash flow information with dividends. they assume that cash flows have superiority over accrual income in explaining dividend changes. two possible explanations are provided to support this superiority. first, the amount and timing of net income is subject to management discretion and manipulation, and is also based on estimates that change over time. for instance, management may overstate accrual income to increase their compensations or to satisfy debt covenants. thus, if a firm’s dividend policy is assumed to reflect the firm’s performance, cash flow components of income could be a better indicator of a firm’s performance than accrual components, and as a result, a better predictor of a firm’s dividend changes. second, compared with accrual income, cash flow is a more direct measure of liquidity. liquidity is considered an important determinant of a firm’s dividend policy. statement of the problem the main objectives of this study is to examine whether operating cash flows have incremental information beyond operating net income in explaining dividend changes. specifically, this study examines the impact of operating cash flow, given net income, on the dividend changes of a sample of 42 jordanian industrial companies listed on the amman stock exchange (ase) during the period 2010-2016. in addition, the study will attempt to address the problem of nonlinearity in the relationship between cash flows and dividend changes depends on each firm’s growth opportunities. we hypothesize that high growth firms are expected to have a lower cash flowdividend relations ship than that for low growth firms. although previous research has examined similar questions to the ones addressed by the current study, no prior study, as far as this author is aware, has investigated them in jordan. thus, the current study is expected to enhance our understanding of the importance given by the management of jordanian industrial firms to operating cash flows and operating net income in setting their dividend policies. advocates of cash flow reporting argue that basing dividends on accrual net income rather than on cash flows would result in paying cash dividends that are not internally financed. consequently, this would deteriorate both the liquidity and solvency position of a firm. the remaining part of this study is organized as follows. the following section provides a review of related literature. section 5 develops testable hypotheses concerning the relationship between operating cash flows and dividend changes. section 6 describes the asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 3 research methodology and design. section 7 presents the results of the study and section 8 summarizes the study and provides its main conclusions. 2. extant literature substantial theoretical research supports the notion that corporate dividend policy is designed to reveal information about expected levels of a firm’s future cash flows and /or earnings. however, empirical research on the association between dividend changes and cash flows has been inconclusive. lintner found that current net earnings and prior year dividends are the most important variables determining dividend changes. hagerman and huefiner, baker, and pruitt and gitman also reported similar results. hagerman and huefner, for instance, found that net income is a better determinant of dividend changes than cash flows. these studies were criticized on the ground that they defined cash flows as the net income plus depreciation which may be considered as a profitability measure rather than a liquidity measure. thus, simonsused three measures of cash flows; cash flow from operations, net current operating funds and total cash flow before dividends. each measure of cash flows was incorporated into a regression model, which also included the net income and previous year dividends. the results of the study indicated that the only significant variables explaining dividend changes were the net income and previous year dividend with positive and negative coefficients respectively. simons concluded that none of the three measures of cash flows added an incremental value to the net income and previous dividends explaining dividend changes. in another study, benartzi et al., based on an extensive empirical analysis of dividend changes, concluded that “…lintner’s model of dividends remains the best description of the dividend setting process available.” (p. 1032) in contrast, a study by lipson et al. found that dividend initiation was not followed by an increase in firm earnings. ettredge and kim extended previous research by investigating the impact of the adoption of lastin-first-out (lifo) inventory pricing method in periods of inflation on changes in cash dividends. the adoption of lifo in such periods depresses reported net income below the level that would have been reported without lifo adoption and increases cash flows through the postponement of taxes to future periods. the results of the study indicated that the changes in cash dividends in the year of adoption were positively associated with the negative net income effect rather than the positive cash flow effect of lifo adoption. a recent study by charitou and vafeas examined the impact of operating cash flows and operating net income on dividend changes. they found that the net income is significantly and positively related to dividend changes while cash flow is not. they also found that previous year dividends are significantly and negatively associated with dividend changes. however, when the sample of firms was divided into five groups based on the size of cash flows, they found that cash flow from operations was an important variable in explaining dividend changes for those firms with relatively low cash flows. they concluded that for those firms cash flow acts as a constraint on their ability to pay dividends. in another study, brook et al. attempted to answer the question whether firms use dividends to signal large future cash flow increases. they divided their sample of firms into three groups. the first included those firms which experienced permanently increased cash flows, the second asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 4 included those firms which had temporary increased cash flows, and the third included firms which experienced a continued period of flat cash flow. the results of the study indicated that the average dividend increase in the group of firms which experienced permanently increased cash flows, was higher than the average dividend increase offered by the other two groups. the study also indicated that dividend decisions are made to signal positive information about permanent future cash flow levels rather than about future income changes. the studies by charitou and vafeas and brook et al. suggest that the relative benefits of accruals versus cash flows in explaining dividend changes may be firm – specific. for instance, bernard and stober pointed out that the variation in cash flow results found by some studies might be caused by using models, which were unable to capture the specific characteristics of any particular firm or situation. they indicated that the information content of cash flows versus accruals might be firmindustry-, and /or situation – specific. the current study will take into account the industry factor by concentrating only on the industrial firms listed on the amman stock exchange. also an attempt is made to examine the impact of the firm’s growth prospects on the incremental information of cash flows. 2.1 conceptual review (define and explain all the variables used in the study) as discussed earlier in the study, two plausible explanations are provided to support the superiority of operating cash flows over accrual income in explaining dividend changes. first, the accrual income is subject to manipulation caused by the recognition, estimation and measurement criteria employed in its determination. management may manipulate the net income to boost their compensation. to the extent that this manipulation occurs, cash flow from operations provides a better measure of a firm’s performance than the accrual income. in support of this reasoning, bernstein states that, (p. 461): cash flow operations, as a measure of performance, is less subject to distortion than is the net income figure. this is so because the accrual system, which produces the income number, relies on accruals, deferrals, allocations and valuations, all of which involve higher degree of subjectivity than what enters the determination of cash flow from operations. similar reasoning was also advanced by the financial accounting standard board (fasb) as a justification for requiring firms to concentrate on cash flows information in their reporting system. second, one of the important determinants of dividends is liquidity. in this regard, profitability does not necessarily mean liquidity or the availability of cash. consequently, cash flow is considered a more direct measure of liquidity compared to the accrual income. based on the above reasoning, the following hypothesis stated in its alternative form is tested by the study: h1: operating cash flows are better than operating net income in explaining dividend changes. the relationship between cash flows and dividend policy may be affected by the firm’s investment opportunities. on the one hand, firms that have future investment opportunities asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 5 are more expected to retain their cash flows instead of paying dividends. this is so because as future investment opportunities grow, the expected return on these investment opportunities becomes higher. thus, the firm might give a priority to its investment opportunities are limited, the likelihood of paying dividends increases. consistent with this reasoning, gaver and gaver found that a firm’s dividend yield is negatively associated with its growth opportunities. based on the above, the following hypothesis stated in its alternative form is tested by the study: h2: operating cash flows are better than operating net income in explaining dividend changes for firms with low growth prospects than for firms with high growth prospects. 3. methodology and development of hypotheses 3.1. sample selection the following criteria are employed to select the sample of firms used in this study: (1) annual reports for the period 2010-2016 must be available for each firm included in the study; (2) the firm must belong to the industrial sector; (3) cash dividends are not zero for the year under examination; (4) market value of equity (market capitalization), and market value per share must be available at the calendar – year end for each firm throughout the period 1992-1998. forty-two industrial firms listed on the amman stock exchange met these criteria. the observations collected from these firms were checked for the presence of outliers, and these were subsequently removed from the analysis. the final set included 164 firm/year observations. 3.2 measurement of variables measures of the variables used by this study are similar to those employed by pervious studies. the definitions of these measures are as follows: (1) dividend changes are measured as cash dividend per share for the current year minus cash dividend per share for the past year divided (deflated) by the beginning of the year market price per share. (2) operating income is measured as a net income before extraordinary and nonoperating items for the year divided by the beginning of the year market capitalization. (3) operating cash flows are measured by adjusting operating income for non-cash expenses (e.g., depreciation) and for changes in working capital accounts related to operations with the exception to changes in cash and marketable securities divided by the beginning of the year market capitalization. (4) lagged dividends are measured by the previous year dividends deflated by a firm’s market capitalization. (5) growth prospect is measured by dividing market capitalization plus the book value of the debt by the book value of the total assets. asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 6 the use of market values as deflators is preferable because they avoid the bias inherited in historical cost measures. in addition, a firm’s dividend policy is usually driven by market performance rather than by book values. 3.3 empirical model to examine the relationship between operating cash flows and dividend changes, the researcher used multiple regression analysis. the analysis is conducted at two levels. at the first level this relationship is examined for the entire sample of firms using pooled cross sectional /time series regression during the period 2010-2016, while at the second level, the relationship is tested after dividing the sample into two groups; high growth firms versus low growth firms. building on multivariate analysis, the regression model is: adivit = b0 + b1 opcfit + b2 opniit + b3ldivit + eit where: adivit =change in dividends for firm-year i in time t, opcfit = operating cash flows for firm-year i in time t, opniit =operating net incone for firm-year i in time t, ldivit =lagged dividends for firm-year i in time t-1, eit =error term, b1 =the regression coefficients m, i=0, 1,2,3 the above regression model is used to estimate the coefficients of the variables. the purpose of this model is to test whether the variable operating cash flow contributes significantly and positively to the predictions of dividend changes given the operating net income. 4. data analysis, results/interpretation and discussion of findings 4.1. descriptive statistics table (1), panel a presents a summary of the statistics of the variables used in the study for the full sample. as seen from the table, the mean of the dividend changes variable (adiv) (normalized by market price per share) is 0.0046 with a high standard deviation indicating that there is a considerable variation in dividend changes among the 164 firm/year observations. it can also be seen that the mean of the operating cash variable exceeded that of the operating net income variable although the difference is not statistically significant at the 5% level. however, the standard deviation of the operating cash flows variable is much higher than that of the operating net income variable. this is consistent with the notion that the operating cash flow is deemed a noisier measure of performance compared with the operating income. panels b and c of table (1) present descriptive statistics of the variables of the study after the researcher had divided the sample of firms into a low growth firms and high growth firms according to market to book value ratio. as seen, the low growth firms have a lower average asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 7 operating net income and operating cash flows compared to those of the high growth firms. it can also be noted that the changes in dividends (adiv ), though negative, is higher for the low growth firms than that for the high growth firms. finally, it is worth mentioning that the mean opcf is higher than the mean opni for the high growth firms, while the mean opni is higher than the mean opcf for the low growth firms. this suggests that on average the higher operating cash flows compared to operating net income, the better the market performance of the firm as reflected by the market to book value ratio. table 1. descriptive statistics panel a: full sample (n = 164) mean st. deviation minimum maximum adiv -.0046 .0488 -.3395 .4139 opcf .0963 .3196 -2.309 1.926 opni .0732 .0963 -.3994 .4220 ldiv .0308 .0240 0 .1340 gp 1.2687 .6018 .2620 3.795 panel b: low growth firms ( n = 82) mean st. deviation minimum maximum adiv -.0054 .0648 -.3395 .4139 opcf .0581 .3740 -2.3099 1.0390 opni .0724 .1142 -.3994 .4220 ldiv .0286 .0246 0 .1340 gp .8410 .2490 .2620 1.198 panel c: high growth firms (n = 82) mean st. deviation minimum maximum adiv -.0029 .0212 -.1020 .0444 opcf .1281 .2477 -.5281 1.9263 opni .0839 .0745 -.1386 .3469 ldiv .0331 .0232 0 .1020 gp 1.7085 .5377 1.200 3.795 where: adiv : change in dividends opcf: operating cash flows opni : operating net income ldiv : lagged dividends gp : growth prospects (market to book value) 4.2. regression results 4.2.1. testing h1 asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 8 hypothesis one states that operating cash flows are better than operating net income in explaining dividend changes. this hypothesis was examined by regressing the dependent variable, dividend changes on the independent variables, operating cash flows, operating net income and lagged dividends. panel (1) of table (2), repots the results of the regression model. as can be seen, the regression model is highly significant (f = 23.432) and can explain 32% (adj. r2 = .3185) of the variation in dividend changes for the 164 firm-year observations. both operating net income and lagged dividends are statistically significant at the 1% level. while, the coefficient of the operating net income is positive, the coefficient of the lagged dividend is negative. these results are consistent with previous studies, suggesting that operating net income is an important determinant of a firm’s dividend policy. the coefficient of the operating cash flows is positive as hypothesized, though asignificant at the conventional level of 5%. the mean coefficient of the operating net income is gteater than that of the operating cash flows suggesting that the operating net tacome has incremental information beyond operating cash flows in explaining dividend changes. the above model was checked for the presence of multicollinearity among the independent variables. a correlation matrix incorporating all the variables was run (see table 3). as can be seen, the correlation coefficient between each pair of the independent variables, particularly between the opcf variable and the opni variable is low, suggesting that the results of the above regression model are not affected by multicollinearity. however, to explore the matter further, the researcher gives panel (2) of table (2) which repots the regression results after excluding the operating net income from the original model whereas panel (3) of the table reports these results after excluding the operating cash flow from the original model. as can be seen form panel (2), the regression model incorporating the operating cash flows and lagged dividends is significant and can explain an out 14% of the variation in the dividend changes. the coefficient of the operating cash was insignificant. compared with these result, the model incorporating operating income and lagged dividends can explain about 32% the variation in the dividend changes, and the variable operating net income is highly significant. table 2. cross sectional regression results using 164 firm-year observations for the period 1997-2002 panel (1) b0 (constant) b1(opcf) b2(opni) b3(ldiv) adj.r2 f .0101** .0081 .1525*** -.6915*** .3185 23.435*** (2.602) (1.095) (6.094) (-6.923) panel (2) b0 (constant) b1(opcf) b2(opni) b3(ldiv) adj.r2 f .0163*** .0022 -.5474*** .1451 13.219*** (3.913) (.793) (-5.036) panel (3) asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 9 b0 (constant) b1(opcf) b2(opni) b3(ldiv) adj.r2 f .0100** .1489*** -.7040*** .3175 34.501*** (2.591) (5.997) (-7.090) b0 – b3 : regression coefficients t – values are between parentheses *** significant at 1% ** significant at 5% table 3. correlation matrix variable adiv opcf opni ldiv adiv 1.00 (. )* opcf .080 1.00 (.170) (.) opni .298 .164 1.00 (.001) (.024) (.) ldiv -.396 .151 .217 1.00 (.000) (.035) (.011) (.) * denotes significance level. to sum up, the results of the regression analysis indicate that the operating net income and lagged dividend are significantly associated with dividend changes. in addition, operating cash flows have no incremental information content beyond the operating net income in explaining dividend changes. therefore, the null hypothesis of h1 cannot be rejected. 4.2.2. testing h2 the above results could be attributed to our assumption that the relation between cash flow and dividend changes is linear across the firms. however, this assumption may not hold for all firms. as discussed earlier in the study, the information content of cash flows versus accruals might be firm-, industry-, and /or situationspecific. while this study has taken into account the industry factor by concentrating only on the industrial firms listed on the amman stock exchange, an attempt is here made to examine the impact of the firm’s growth prospects on the incremental information of cash flows. firms with high growth prospects are more expected to retain their cash flows than those firms with low growth prospects do. to examine this, the firm/ year observations were divided into tow groups according to their growth prospects (as measured by market to book value). panel a of table (4) reports the regression results for the low growth group, while panel b of the table reports those results of the high growth group. as for the low growth group (see panel a of table 4), the model is highly significant (f = 13.752, p = .0001) and can explain about 34% of the dividend changes. similar to the results reported in table (2) above, both opni and ldiv are highly significant with positive and negative coefficients, respectively. the opcf variable is significant though at 10%. similar results are also reported for the high growth group (see panel b). both opni and ldiv are found significant at 1% with positive and negative suggest that the opni has asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 10 incremental information beyond opcf in explaining dividend changes for both the low growth group and high growth group. table 4. summary results of the regressions for the low growth firms and high growth firms panel a: low growth firms b0 (constant b1(opcf) b2(opni) b3(ldiv) adj.r2 f .0087 .0154* .1378*** -.6699*** .3437 13.572*** (1.658) (1.742) (4.671) (-4.863) panel b: high growth firms b0 (constant b1(opcf) b2(opni) b3(ldiv) adj.r2 f .0052 -.0135 .1252*** -.5904*** .4121 17.361*** (1.501) (-1.520) (4.082) (-6.488) b0 – b3 : regression coefficients t – values are between parentheses *** significant at 1% * significant at 10% 5. conclusion, recommendations the main objective of this study was to examine whether operating cash flows have incremental information beyond the operating net income in explaining dividend changes for a sample of jordanian industrial firms listed on the ase during the period 2010-2016. arguments for the operating cash flow information suggest that it is better than the accrual net income in reflecting the firm performance, and in measuring the firm liquidity. both performance and liquidity are viewed as significant factors in influencing a firm’s dividend policy. however, the results of this study do not render support to the asserted relationship between operating cash flows and dividend changes. the study found that the operating cash flows do not provide any incremental information beyond that provided by the accrual operating income. these results are consistent with those of the previous studies. previous research on the information content of cash flows versus accrual income assumes linear relations between cash flows and dividend changes. following charitou and vafeas, this study allowed nonlinearity in the relationship between cash flow and dividend changes asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 11 by using separate models for high growth firms and low growth firms. the results of the tow regression models provide evidence consistent with the superiority of the accrual operating income over the operating cash flow in explaining dividend changes. the results of this study suggest that jordanian industrial firms base their dividend polices on accrual income rather than on operating cash flows. according to lawson, paying dividends should be based on cash flows rather than accrual earnings. he stated that basing dividend policy on accrual income would result in dividend payments that are not internally financed and, in effect, this would deteriorate the liquidity and solvency position of the firm. references ali, a. (spring, 1994). the incremental information content of earnings, working capital from operations, and cash flows. journal of accounting research, 61-74. https://doi.org/10.2307/2491387 andreas charitou, & nikos vafeas. (1998). the association between operating cash flows and dividend changes: an empirical investigation. journal of business finance and accounting, 225-249. https://doi.org/10.1111/1468-5957.00185 baker, h. (autumn, 1985). survey of management views on dividend policy. financial management, 78-84. https://doi.org/10.2307/3665062 benartzi, s., & r. michaely. (july, 1997). do changes in dividends signal the future or the past?. journal of finance, 1007-1034. https://doi.org/10.1111/j.1540-6261.1997.tb02723.x bernard, v.l. and t.stober. (october, 1989). the nature and amount of information in cash flows and accruals. the accounting review, pp. 624-652. bernstein, a.l. (1993). financial statement analysis, fifth edition, homewood, il: irwin. bernstein, a.l., & j.j. wild. 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(1993). additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies. journal of accounting and economics, 16, 126-161. https://doi.org/10.1016/0165-4101(93)90007-3 gibson, c.h. (1995). financial statement analysis: using financial accounting information, sixth edition, south-western college publishing, ohio, usa. hagerman, r.l., & r.j. huefner. (spring, 1980). earnings numbers and dividend prediction. review of business and economic research, 39-48. ibid, hagerman, & huefiner. (1980). book reviews, jewish education, 48(4), 39-48. https://doi.org/10.1080/0021642800480408 ibid, lawson. (1996). the measurement of the economic performance of the us nonfinancial corporate business sector 1946–1990: an application of the shareholder value creation concept. european accounting review, 5(4), 715-741. https://doi.org/10.1080/09638189600000044 kathleen simons. (1994). the relationship between dividend changes and cash flow: an empirical analysis. journal of business finance and accounting, 577-587. https://doi.org/10.1111/j.1468-5957.1994.tb00337.x lawson, m. c. (1996). the measurement of the economic performance of the us nonfinancial corporate business sector 1946-1990: an application of the shareholder value creation concept. european accounting review, 5(4), 715-741. https://doi.org/10.1080/09638189600000044 lintner, j.v. (may, 1956). distribution of incomes of corporations among dividends, retained earnings, and taxes. american econmic review, 97-113. lipson, m., c. macquieira, & w. megginson. (autumn, 1998). dividend initiation and earnings surprises. financial management, 36-45. https://doi.org/10.2307/3666273 merton h. miller, & kevin rock. (1985). dividend policy under asymmetric information, the journal of finance, xl(4), 37-61. https://doi.org/10.1111/j.1540-6261.1985.tb02362.x pruitt, s.w., & l.j. gitman. (august, 1991). the interactions between the investment, financing, and dividend decisions of major u.s.firms. financial review, 409-430. https://doi.org/10.1111/j.1540-6288.1991.tb00388.x asian journal of finance & accounting issn 1946-052x 2020, vol. 12, no. 2 ajfa.macrothink.org/ 13 rayburn, j. (1986). the association of operating cash flow and accruals with security returns. journal of accounting research, 24, 112-133. https://doi.org/10.2307/2490732 simons, k. (june,1994). the relationship between dividend changes and cash flow: an empirical analysis. journal of business finance and accounting, 577-587. simons, k. (june,1994). the relationship between dividend changes and cash flow: an empirical analysis. journal of business finance and accounting, 577-587. sloan, r.g. (july,1996). do stock prices fully reflect information in accruals and cash flows about future earnings. the accounting review, pp.289-315. white, g. i., a. c. sondhi, & d. fried. (januray/march, 1998). the analysis and use of financial statements, second edition, john wiley & sons, inc., new york (1997). microsoft word 14242-51744-1-sm-writer2-new asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 29 ajfa.macrothink.org motivations for classification shifting a systematic review nisreen mohammed said almaleeh accounting department, faculty of commerce menofia university, egypt tel: 20-100-133-4221 e-mail: nesreen.mohamed@commerce.menofia.edu.eg received: jan. 20, 2019 accepted: feb. 19, 2019 published: june 1, 2019 doi:10.5296/ajfa.v11i1.14242 url: https://doi.org/10.5296/ajfa.v11i1.14242 abstract the purpose of the current paper is to highlight the motivations that may encourage managements of firms to shift core expenses to special items in order to inflate core or operating earnings i.e. to practice classification shifting, which would have an effect on the decisions of financial statements' users. this was done through conducting a systematic review on the available literature about classification shifting. the most obvious findings to emerge from this study is that management may engage in classification shifting for the reason that it is less costly than other earnings management methods, the firm being in current or potential state of financial distress, the desire of the management of the firm to meet or beat earnings benchmarks, the ownership structure of the firm having some characteristics that encourage management to engage in such a practice, the firm performing in a weak corporate governance environment, or due to the fact that classification shifting is tough to be detected by external monitors compared to other earnings management methods. keywords: earnings management, classification shifting, motivations, systematic review asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 30 ajfa.macrothink.org 1. introduction earnings management is increasingly recognized as a serious accounting research concern, a considerable amount of accounting literature has been published on earnings management in the last two decades. that literature has documented two main methods of earnings management, accrual management and manipulation of real activities. accruals-based earnings management is done when managers borrow earnings from future periods through the acceleration of revenues and/or deceleration of expenses with the intent to improve current earnings. (dechow and schrand, 2004; dechow et.al. 2010).while real activities manipulation include actions such as reduction in the discretionary spending on research and development ,selling, general ,and administrative expenses, price discounts to increase sales, or overproduction to reduce cost of goods sold expense (roychodhury, 2006; gunny, 2010; zang,2011) such actions can increase revenues or net income. classification shifting is the third tool to manage earnings. it was first introduced by mcvay (2006) and it is defined as the deliberate misclassification of operating expenses to special items in order to inflate core or operating earnings without affecting the bottom line net income or loss. in addition to that, classification shifting may take the form of shifting of incomeincreasing special items such as gains on sale of assets and equity income on investment against operating expenses. some businesses have used gains on sale of assets to offset operating expenses (maremont & bulkeley, 2002; mcvay, 2006; noh et. al., 2017) this is done to decrease operating expenses and/or increase core earnings (nagar & sen, 2016). the mechanism of classification shifting can be illustrated by the following figure: income statement income statement sales 200 sales 200 operating expenses 190 operating expenses 185 operating income 10 operating income 15 non-operating expenses 5 non-operating expenses 10 net income 5 net income 5 figure 1. mechanism of classification shifting source: chae& nakano, 2015 recently, research indicates that investors focus more on core earnings compared to total earnings because total earnings include non-recurring items which provide relatively little information that has less predictability about the future performance of the company (bradshaw& sloan,2002; lougee & marquardt, 2004) therefore, companies have significant incentives to misclassify core earnings. (desai& nagar,2016). numerous studies have suggested that classification shifting is prevalent in the usa and the east asian countries, managers in these countries shift expenses from recurring to the nonrecurring section in the income statement in order to inflate operating income. (fan et.al. 2010; haw et. al., 2011). other studies have provided evidence that japanese companies deliberately shift revenues and expenses to increase core earnings (shirato & nagata, 2012; chae& nakano, asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 31 ajfa.macrothink.org 2015). furthermore, classification shifting was proved to be practiced by uk firms, evidence suggested that large uk firms engage in classification shifting of core expenses to other nonrecurring items to meet analysts' forecasts. (athanasakou et.al, 2009; athanasakou et.al, 2011; zalata& roberts, 2017) so far, however, there has been little discussion about the motivations that encourage management to practice classification shifting. like other earnings management methods, classification shifting is always a means to an end, and uncovering the motives behind it is a key to explain it. this study is trying to answer the question about the factors that do encourage firms to shift core expenses to special items in order to inflate core or operating earnings, i.e. it is trying to explore the reasons, incentives, and motivations behind such practice. so, this study systematically reviews the data available about the above mentioned motivations, aiming to provide a comprehensive understanding of this practice. 2. research methodology: a systematic review a systematic review was employed in order to answer the question of this study; it was defined by denyer & tranfield (2009) as a specific methodology that locates and selects existing studies, evaluates contributions, analyses data, and reports the evidence in a way that allows reasonably clear conclusions to be reached. it is different from the traditional narrative literature review (khan et.al., 2003), the difference stems from the fact that a systematic review is considered to be a research project on its own that pursues to answer a specific research question by secondary analysis of existing studies. applying a systematic review is expected to produce sound and robust evidence that can be applied to different contexts. additionally, it can contribute to identifying knowledge gabs or findings inconsistencies that indicate a need for further future research (denyer & tranfield, 2009) the methodology of a systematic review that was adopted in this study, was applied according to the five-steps approach that was introduced by denyer & tranfield (2009), the detailed description of applying these steps is explained below: 2.1 identifying the research question the objective of the study was specified in the form of a clear, unambiguous question before beginning the review work. i.e. what are the motivations of managements to practice classification shifting? 2.2 material collection as the search for studies should be extensive, a comprehensive database analysis was performed. for this purpose, five major databases that include accounting-related journals were identified: ebsco academic search complete database, emerald e-journals premier collection, elsevier databases, jstor digital library of academic journals, and proquest dissertations and theses. 2.3 selection and evaluation the evaluation of the relevant studies followed a structural categorizing approach which asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 32 ajfa.macrothink.org allowed identification of relevant themes and interpretation of several findings. to perform a comprehensive gathering of the most relevant articles related to classification shifting, all articles that contained the term "classification shifting" in its title or keywords were included. on the other hand, book reviews, editorial notes and comments were excluded, as well as duplicates, which were certain to happen as a result of searching multiple data bases. this process resulted in the selection of all available articles related to classification shifting published up to the year 2017, which totaled 47 articles. 2.4 descriptive analysis and synthesis this analysis aimed to arrange the individual results of the selected articles into consistent parts by describing how each article complements the other in terms of identification of the underlying motives of management to practice classification shifting. the descriptive analysis and synthesis of previous studies are discussed in detail in the next section; they resulted in the identification of the motivations for classification shifting. several previous studies have attempted to explain the association between classification shifting and other research variables (for example, abernathy et.al. 2014; chae& nakano, 2015; desai& nagar, 2016). overall, these studies provide important insights into the reasons that encourage management to practice classification shifting. depending on the results of those studies, motivations for classification shifting can be summarized and classified into the following: 2.4.1 weak corporate governance strong boards of directors and audit committees play an important role in protecting shareholders' interests and providing them with credible financial statements free from manipulation (zalata & roberts, 2016). this role can be either direct, by analyzing or discussing the financial statements with management, or indirect because ceos who anticipate boards' oversight will have their manipulation incentives reduced (laux& laux, 2009). there is an unambiguous relationship between classification shifting and weak corporate governance.(narayanaswamy et.al.,2012) found that weak corporate governance and investor protection in any country may encourage managers to practice classification shifting especially because of the fact that it is less costly and tough to be detected (mcvay,2006). evidence that earnings management; in particular classification shifting is more prevalent in countries with weak corporate governance was introduced by numerous studies (for example, leuz et.al., 2003; haw et.al.,2011; behn et.al.,2013) zalata & roberts (2016) found that classification shifting is less prevalent in firms whose boards comprise of more independent directors or more directors with long tenure. moreover, it is less prevalent when audit committees are characterized by more meetings, more members with financial expertise, or more members with long tenure. collectively, these studies outline the significant role of strong boards and audit committees in mitigating manipulation method of classification shifting with the purpose of inflating core earnings. asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 33 ajfa.macrothink.org 2.4.2 ownership structure previous studies have reported that the components of the ownership structure have an impact on the tendency of firm's management to practice earnings management techniques. according to the agency theory, the separation of ownership and control encourages managers to select and apply accounting techniques that can increase their own wealth (ali et.al, 2010). (fan& wong, 2002; ding& zhang, 2007; haw et.al., 2011) found that earnings management practices are influenced by ownership concentration because large shareholders tend to maximize accounting earnings in order to gain benefits in the future. moreover, concentrated ownership creates agency conflicts between controlling owners and other investors. controlling owners are perceived to report accounting information for self-interest purposes, causing the reported earnings to lose credibility to outside investors. as for private versus state ownership, (fan& wong, 2002) found that privately owned firms prefer earnings boosting methods more than their state-owned counterparts because of the pressure to report a better-than-real financial performance to reassure the market. in the same context, (siregar& utama2008; noh, et.al, 2014) suggested that classification shifting is more likely in family businesses or firms belonging to business groups. if family firms and business groups dominate a country's business landscape, and company founders or promoters hold a lot of the firms' shares, there is a higher chance that management will shift core expenses to inflate operating income. 2.4.3 financial distress a number of researchers have reported that financially distressed firms are likely to report more special items, and are more likely to value pro-forma earnings (for example, francis et. al., 1996; lougee& marquardt, a. 2004; mcvay, 2006; johnson et.al., 2011). (hodgson & clarke, 2000) found that these firms that are characterized by high debt-to-equity ratios and higher magnitudes of special items are more likely to disclose pro-forma earnings in their press releases than other firms. as noted by (nagar& sen, 2017), managers of financially distressed firms misclassify more core expenses to income-decreasing special items; such as goodwill impairments, settlement costs, restructuring costs, and write offs. they are also more likely to cut dividends to save cash, as compared to those of healthy firms. moreover, substituting real earnings management with classification shifting was found to be more prevalent in firms which are in poor financial condition (abernathy, 2014).further, classification shifting is also more likely to be practiced by management when management's ability to engage in accruals-based earnings management is limited due to prior accruals manipulation.(fan et.al, 2010; abernathy, 2014) prior studies also found that firms in the decline stage are more likely to engage in classification shifting, they sell assets to fund operations or to repay debts, and thus are more likely to report income-increasing special items like gains on sale of assets (dickinson, 2011). these firms are more likely to have bloated balance sheets because of either prior upward accrual manipulation (barton & simko, 2002), or their inability to collect money from debtors or unintended asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 34 ajfa.macrothink.org accumulation of inventories (troy, 2003). such a constraint prevents firms from engaging in accruals-based earnings management (fan et.al, 2010), and makes it possible that firms in the decline stage prefer earnings manipulation through classification shifting (nagar & sen, 2017). the incentives of financially distressed firms to engage in core expenses classification shifting must be accompanied by the opportunity to do it. (francis et. al., 1996; mcvay, 2006; johnson et. al., 2011) agreed that these firms are likely to have more opportunities to shift core expenses to income-decreasing special items as they report more of such items. 2.4.4 low costs managers may be motivated to use classification shifting when it provides them with a lower cost method to inflate core earnings. classification shifting makes it possible to managers to avoid both accrualsbased earnings management that reverse in subsequent periods, and the forgone returns or increased costs of real business activities manipulation (athanasakou et. al, 2009) managers often have the capacity to use all of the three forms of earnings management to achieve earnings targets, making trade-off decisions among them based on the costs, constraints, and timing of each form. (abernathy et.al, 2014). when constraints are imposed on managers not to use accrual-based earnings management, or when the cost of accruals management is high, management is likely to substitute it with other manipulation methods that may have lower detection costs. (cohen& zarowin, 2010; fan et. al, 2010) 2.4.5 the desire to meet or beat earnings benchmarks a large and growing body of literature has investigated the importance of earnings benchmarks and found that firms which meet or beat earnings benchmarks earn higher stock return than other firms which fail to do so (barton & simko, 2002). mangers seem to value operating earnings to a great extent and that is the reason why they tend to manipulate these figures. (wieland et. al, 2013) due to the fact that core or pro-forma earnings are primary determinants of stock prices, they are preferred to be announced by management. this is because the exclusion of non-recurring special items by analysts, and higher persistence of operating income than non-operating income and special items. (nagar& sen, 2017) a number of previous studies reported that a primary incentive to engage in classification shifting comes from management's desire to meet or beat earnings benchmarks like zero core earnings, prior-period core earnings, and analysts' forecasts, they also may have the desire to achieve positive surprises to analysts' forecasts (for example, fan et. al, 2010; athanasakou et. al, 2011; haw et. al, 2011). managers were found to engage in classification shifting prior to seasoned equity offerings in order to influence the investment decision of potential investors. (siu& faff, 2013) some writers have attempted to link the firm management's engagement in classification shifting to meet or beat analysts' forecasts and specific characteristics of these firms. for example, (mcvay,2006) documented that managers of high growth firms are more likely to asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 35 ajfa.macrothink.org practice classification shifting than other firms because they want to meet or beat analysts' forecasts. this is due to the fact that high-growth firms suffer more negative price shocks when they fail to meet analysts' forecast. (skinner& sloan, 2002) in addition to that,( bartov et. al,2002 ) suggested that rewards (future stock returns) for meeting or beating analysts' forecasts are higher for financially distressed firms compared to financially sound ones because financially distressed firms convey their survival ability to market participants when they meet or beat earnings benchmarks. 2.4.6 undetectability by external monitors mcvay (2006) argued that internal and external monitors are less likely to have concerns about the proper classification of expenses. managers that have motivations to manage earnings may resort to classification shifting because it is less likely to be detected than accrual-based earnings management, this is due to the fact that classification shifting does not change the bottom-line net income, in addition to the fact that regulators or external auditors pay it less attention.( zalata & roberts, 2017). however, even if regulators or external auditors would pay classification shifting much attention, firms with misclassified nonrecurring items may be suffering declining performance. thus, despite being high, reported core income may still fall below either previous periods' figures, or relevant industry benchmarks (mcvay,2006), which means that the improper categorization of expenses is not obvious to monitors. it is known that high audit quality is associated with effective monitoring, which limits managers' ability to take opportunistic choices. it is established in the auditing literature that the better the audit technology, the better the detection of earnings management, the greater the penalties for them, the less are the incentives of management to manipulate the performance measures, and the larger the sensitivity to earnings components. this will make the overall perceived core earnings more revealing of production effort. (joo& chamberlain, 2016). as a result, auditors could act as a deterrent to earnings management. prior research indicated that the presence of a big n auditor has a significant positive effect on the quality of reported earnings.( knechel et. al, 2012) however, the detection of classification shifting by auditors is tough, as managers may keep the documentation too general (mcvay, 2006). as a result, auditors cannot always accurately verify the appropriateness of core expenses classification. (chae& nakano,2015). as net income does not change when operating income is manipulated due to classification shifting, auditors may pay less attention to the identification and verification of these accounts. (chae& nakano, 2015), they also may exert fewer efforts to correct these misclassifications as they have no impact on the bottom-line profits. (nelson et. al, 2002) a considerable amount of research indicated that auditors fail to curb this form of earnings management in countries with weak, inefficient legal institutions, as the willingness to report such misclassifications is primarily driven by the perceived strength of the institutional controls and legal regimes. (haw et.al, 2011; desai& nagar, 2016) asian journal of finance & accounting issn 1946-052x 2019, vol. 11, no. 1 36 ajfa.macrothink.org 3. discussion and implications the purpose of the current paper was to highlight the motivations that may encourage managements of firms to practice classification shifting. it has systematically presented the state of empirical research on classification shifting and analyzed the motives of practicing it using a qualitative approach. as the aim of this study was to demonstrate and discuss the underlying motives and incentives that encourage management to practice classification shifting, a comprehensive search was performed in five major data bases that relates to business and accounting subjects, this search resulted in identifying 47 articles discussing classification shifting that were published in english journals up to the year 2017. the most obvious findings to emerge from this study is that management may engage in classification shifting for the reason that it is less costly than other earnings management methods, the firm is in current or potential state of financial distress, management of the firm has the desire to meet or beat earnings benchmarks, the ownership structure of the firm has some characteristics that encourage management to engage in such a practice, the firm is performing in a weak corporate governance environment, or due to the fact that classification shifting is tough to be detected by external monitors. the results of this paper support the idea that , when surrounded by the suitable circumstances, managements tend to resort to classification shifting as one of less costly, paid less attention earnings management methods. as classification shifting is a relatively new method as opposed to other earnings management methods, it would be beneficial to accounting researchers to get deeper understanding about it, in order to be better able to explore its association with other variables. the above mentioned findings provide the following insights for future research: exploring whether firms' managements in certain countries engage in classification shifting or not, comparing classification shifting practices in developed versus developing countries, and statistically testing the association between classification shifting and each of the motivations highlighted in this paper. beyond these potentially interesting aspects and suggestions for future research, the findings of this systematic review can be used as a guideline for standard setters, policy makers and regulators with the purpose of controlling the practices of earnings management generally, and particularly, classification shifting. references abernathy, j. l., beyer, b., & rapley, e. t. 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(2011). evidence on the trade-off between real activities manipulation and accrualbased earnings management. the accounting review, 87(2), 675-703. https://doi.org/10.2308/accr-10196 microsoft word 18994-article-writer2-new receive doi:10.5 abstra objecti of com represe perform method examin compris 2022, o georgia equity. results firm pe assets o leads to determi conclu profitab achievin knowle compan the im ed: march 1 5296/ajfa.v ct ive: this stu mpanies in entativeness mance indica dology: the e the relati ses financia obtained fro a. the study s: the findin erformance. outperform t o improved ining firm p usions: this bility in ge ng competi dge-based e ny financial mpact o pe assistant 1, 2025 a 17i1.18994 udy investig georgia. t s of intangi ator. e research u onship betw al reports fro om the ser y excludes ngs indicate the study their peers, d profitabil performance s study prov eorgian com itive advan economies. statements of intan erforma gur phd in bu t professor caucasus e-mail: g.k accepted: ju url: ht gates the eff the focus i ible assets utilizes a pa ween intang om 845 ge rvice for ac companies e that intang reveals tha supporting t ity. compa e. vides empiri mpanies. it h ntages, parti limitations , which may 1 ngible a ance in rgen kalash usiness adm at caucasus s university kalashiani@ une 16, 202 https://doi.or ffect of intan is on how (ria), infl anel regress gible assets orgian com ccounting, from the fi gible assets at companie the hypothe any-specific ical evidenc highlights t icularly in s include inc y affect the asian assets n georg hyan ministration s school of y, georgia @gmail.com 25 pub rg/10.5296/ ngible asset intangible luence retu ion analysis s and comp mpanies, spa reporting, financial ind have a sign es with a h esis that inve c factors al ce that intan the importan emerging m complete di analysis' co n journal of f on com gia f business m blished: jun ajfa.v17i1.1 ts on the fin resources, urn on asse s with a fixe any perform nning the p and audit dustry and t nificant and higher propo estment in i lso play a ngible asset nce of intan markets tra isclosure of omprehensiv finance & ac issn 19 2025, vol. 1 ajfa.macro mpany ne 16, 2025 18994 nancial perfo , measured ets (roa) a xed-effects m mance. the period from ting superv those with n d positive im ortion of in intangible re substantial ts are key dr ngible reso ansitioning f intangible veness. ccounting 946-052x 17, no. 1 think.org/ ormance by the as a key model to e dataset 2019 to vision of negative mpact on ntangible esources role in rivers of urces in towards assets in implica for com conduci keywo ations: the mpanies to i ive to the de rds: intang study offer invest in in evelopment ible assets, s insights fo ntangible as t of these re company p 2 or corporate ssets and fo esources. performance asian e strategy an or policyma e, roa, geo n journal of f nd policy, em kers to fost orgia, emerg finance & ac issn 19 2025, vol. 1 ajfa.macro mphasizing ter an envir ging econom ccounting 946-052x 17, no. 1 think.org/ the need ronment mies introdu intangib and driv brand e sustaina nichita to intan of intan for em crucial t provide especia increasi the liter compan prior re perform wang ( intangib such as assets a therefo ria has this res financia of intan of intan with fir analysis service by focu of resea policym process framew literat the ris intangib assets, uction ble assets h ving perform equity, good able growth , 2019). glo ngible assets ngible inves merging econ to shift from es a unique lly as the ing importa rature by ex nies, providi esearch has mance, with (2014), ga bles yield su those by el and perform ore, the follo s a positive search addre al performa ngible assets ngible assets rm size as a s includes e for accoun using on an e arch on int makers. und ses, guiding works that fa ture review se of intangi ble capital especially o have increas mance in tod dwill, and in h and mainta obally, high s compared tments in fo nomies like m resource-b context to country po ance of know xamining ho ing valuable s produced studies sho amayuni (2 uperior prof ly et al. 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(2009 ex and may sted in this s mance, as me estion: do in georgia? s presentative m performan ng a panel r gian compan auditing sup ext, this stud so offers pr f intangible strategicall nt and prote ern econom asingly imp cades. intan asian mental in en assets, enco are essentia in rapidly ev locate signi counterparts cess (chariy c managem iven growth of intangible the global n. this study ce financial porate strate the effect d negligible gam (2021 ive advanta 9), suggest t y vary acro study: h1 easured by r ntangible as pecifically, eness of inta nce, measure regression w nies across pervision of dy not only c ractical ins e resources ly and enab ection of the my portant part ngibles incl n journal of f nhancing fir mpassing in al for firms volving mar ificantly mo s, underscor yawattanaru ment of inta h models. th e assets on economy y seeks to f performanc egy and pol of intangib e impacts. f ) report th ges. conver that the link oss industri intangible a roa. ssets signific the study ex angible asse ed by return with a fixed 2019-2022 f georgia. contributes t ights for g can enhanc bling policy ese assets. t of firms’ lude data, p finance & ac issn 19 2025, vol. 1 ajfa.macro rm competi ntellectual p looking to arkets (elena ore of their ring the crit ut et al., 202 angible reso he georgian firm perfo and embra fill a notabl ce among g licymaking. ble assets for instance hat investm ersely, other k between in ies and eco assets, meas icantly influ examines the ets (ria) n on assets d-effects mo 2, provided to the existi georgian fir ce decision ymakers to capital sto patents, cop ccounting 946-052x 17, no. 1 think.org/ itiveness property, achieve a-mirela revenue tical role 22). ources is n market ormance, aces the le gap in georgian . on firm e, li and ments in r studies, ntangible onomies. sured by uence the e impact the ratio (roa), odel, the d by the ing body rms and -making support ocks and pyrights, softwar have ri despite argue t transfor assets— databas product firms in are bett is visib value— platform mohanl brand e the stu strategi financia importa compon benefit intellec innovat hand, b enhanci intangib innovat globall peers. e below t invested many e proport cvetano the rol for dev for mov one. as advance in intan educatio re, audio an sen, while an increas that econo rming how —factories, m ses, r&d, a ts but also f nvesting he ter positione ble in the ri —companies ms than in p lingam et al equity, were udy highlig c success. al metrics su ance of int nents in bu from these ctual proper tions, secure builds custo ing profitab ble assets tion are key ly, high-gro european lo the global a d 4.4 times european lo ion of th ovski, kelly le of intang veloping cou ving from a s the global ement, geo ngible asset on, researc nd video ma the share se in profita mies are i companies machinery, and brand v for maintain eavily in int ed to thrive ise of tech like ama physical ass l. (2021) st found to be ghts how t a 1% incre uch as retur tangible as uilding long e assets due rty, such as e market sh omer loyal bility. these in sustaini y drivers of p wth compan ow-growth c and north as much in ow-growth heir revenu y, spillecke gible assets untries like a resourceeconomy in orgia must i ts. this shif ch and dev aterials, bra of physical ability (jan increasingly s invest an and land— value. these ning custom tellectual pr in today's h companies azon, faceb ets. ates that int e strong pre these assets ease in inta rn on assets sets not o g-term comp e to the fas patents and are, and ma lty and allo e findings u ng growth, performanc nies invest companies i american r n intangible companies ue to inta , 2022). in emerging e georgia, th -based econ ncreasingly implement f ft involves elopment ( 4 ands, and or l capital, su nice c. ebe y driven b nd create v —is being ov e intangible mer relations roperty, org hyper-comp where inta book, and tangible ass edictors of 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echnology f on-driven na gy, helps fir lity. brand and premiu al and strat ustries wher angible asse f their reven opean highnues). thes committing (chariyaw ent of intan edge-based, e, creativity cies that enc nsive ecosy hip, and in finance & ac issn 19 2025, vol. 1 ajfa.macro ares of thes uipment, ha nd westlake and this focus on p tments in s al for creat ovation eco e, and bran markets. th for nearly re in softw ectual prop in technolog th operatio mprovemen e). this ref but also as firms, in pa ature of the rms to prot equity, on t um pricing, tegic impor re knowled ets than low nues in inta -growth com se data sugg a more sig wattanarut, ngible assets , innovation y, and techn courage inv ystem that s ntellectual p ccounting 946-052x 17, no. 1 think.org/ se assets as fallen e (2020) shift is physical oftware, ting new osystems. d equity his trend all their ware and erty and gy firms. onal and t in key flects the crucial articular, e sector. ect their the other further rtance of dge and w-growth angibles, mpanies gest that gnificant hazan, s is vital n-driven nological vestment supports property protecti educati needed georgia output, must en innovat strong boostin the ro entrepre innovat enhanci technol tradema researc building shows which w these a strategi shifts t profitab compet by focu signific innovat invest compet challen accord used in future p characte and hum the path assets, intangib like tec equity, ion. ion is the c to innovate a can deve and innova nhance its tors, researc legal prote g economic ole of inn eneurship, g tion not onl ing their co ogy, pharm arks, and so ch into how g evidence a positive will give bu ssets. such es that prio to a know bility but a itiveness on using on str cant econom tion-driven more in itiveness, an nges in acco ing to lev n the produc productive b erized by hi man capital h forward emphasizin ble assets as chnology an are often o cornerstone e and adapt elop a know ative solutio legal fram chers, and ection also c developme ovation ca georgia can y fosters ne ompetitive e maceuticals, oftware deve w intangib that suppor relationship usinesses co h scientific oritize intan wledge-base also promo n the global rategic man mic growt developme their intan nd economi ounting and (2001), inta ction of goo benefits to igh risks, hi l intensity. l for investo ng their in s critical dr nd pharmac overlooked of this tra t to changin wledge-rich ons become meworks to businesses incentivizes ent. annot be o n nurture a b ew business edge in both and digital elopment. les impact rts these pol p between onfidence to evidence w ngible assets ed econom te long-ter stage. nagement an th potentia ent. the re ngible reso ic prosperity d valuation angible asse ods, the pro individuals igh uncertai lev and gu ors and ma ncreasing i ivers of inn ceuticals. t in tradition 5 ansition, as ng market d h environme primary ec protect in can secure s internatio overstated. business en s ventures b h local and services rel 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empo ng the cyc actors that c that are ex their use. in bsence of ri , "the end d the discus n economi ation, partic patents, so orks, which finance & ac issn 19 2025, vol. 1 ajfa.macro orce with th g in human l property, ionally, the ghts, ensur r intangible artnerships, &d, startup ngible asset isting comp xample, sec e assets like ance is cru empirical d mpany prof the develop designing e onomy. as enhance c osting the georgia can merging le ower compa cle of inn contribute t xpected to g ntangible as ivalry betwe of account ssion on in ies. they cularly in in oftware, an h focus on ccounting 946-052x 17, no. 1 think.org/ he skills n capital, creative country ing that e assets. , further ps, and ts thrive. anies by tors like e patents, ucial for data that fitability, pment of effective georgia orporate nation's n unlock eader in anies to novation, to or are generate ssets are een uses, ting and ntangible describe ndustries nd brand tangible assets. l capture intangib there i improve moham perform sector" value o properly intangib ohlson intangib related accurate includin more tra qureshi perform inadequ assets. t these as the bulk the con (ifrs) in the r assets, operatin balance related technica during e this tre ratios a measure appear recogni and pri reflecte and the lev and gu the value ble nature o is an ongoin e the report mmed and a mance, and , highlight f intangible y assess the bles are bec and johann ble assets i to intangib ely predicti ng qualitati ansparency i and siddi mance, fina uacy of exi they call fo ssets, partic k of a comp nservative a and genera recognition such as r ng expense e sheet unle to intangi ally feasibl early develo eatment not and measur es of profit artificially ized as asse ice-to-earnin ed in book v firm's true u also stress and risks of these asse ng debate a ting and valu al ani (202 financial p the limitatio e assets. the e economic coming mor nesson (201 in financial ble assets ing their fu ive reports for stakeho iqui 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(2007) nd stock m e investme to an unde ent with hir alue intangi ments. ver, ciftci a r&d, tend s in assigni ricing can p earnings, lea studies sugg l value. panies in hig nvestments lues these a lead to und 8) also poi as tradition rowth and i ssues, there propriately v zation, and ntangible as ion to invest l to fully gr n content an ng (2011). ike intellect y but are ina financial m e assets, resu 6) further el gibles contr disclose an ancial metr he true eco r market do also explor market return ents, investo ervaluation rschey and r ible assets and darroug d to be unde ing value to persist unti ading to an gest that th gh-innovatio in r&d an assets. this dervaluation int out that nal financia innovation e has been value intan d developin ssets would tors, allowin asp the valu nd a slower this phen tual property adequately r metrics, whi ulting in del laborate on ibutes to th nd value int rics and ma onomic val ominance. red the relat ns. they fou ors are slo of firms w richardson such as pa gh (2016) s erpriced rela o assets that il the mark eventual co he conserva 7 on sectors l nd intellectu s results in n in the ma t such treat al statemen increasing ngible assets ng new m d help prov ng them to ue of intang r reaction to nomenon is ty, brand va represented ich do not layed or mu this issue, he lack of vi tangible ass arket valua lue of thes tionship bet und that du ow to incor with strong r n (2003), wh atents, leadi showed that ative to thei do not hav ket recogniz orrection in ative accoun asian like technol ual property an understa arketplace ( tment affec nts fail to c advocacy f s. enhancin metrics that vide more make more gible assets, o them in the particularl alue, and hu d in financia fully captur uted reaction arguing tha isibility for sets leads to ations. as a se assets is tween r&d ue to the unc rporate thei r&d progr ho conclude ing to a de t firms with r earnings p ve immediat zes the inta stock prices nting treatm n journal of f ogy and pha y, but conse atement of (lev & gu ts firms' co capture the for better fr ng disclosur capture t accurate a informed d leading to e stock mar y prevalent uman capital al statement re the longns in stock p at the conse investors. t o significan a result, inv s eventually d investmen certainty an ir potential ams in the ed that inves layed respo h high intan potential, as te cash flow angible asse s. ment of inta finance & ac issn 19 2025, vol. 1 ajfa.macro armaceutica ervative acc the firm’s e u, 2016). sa ompetitiven critical in rameworks re, refining the true ec and compre decisions. an underest rket, as obse nt in sector al are key dr ts. investors -term value prices. ervative acc they claim nt informatio nvestors ofte y realized nts, a key in nd long-term into stock short term. stors system onse in stoc ngible inve s investors a w implicatio et's contrib angibles, co ccounting 946-052x 17, no. 1 think.org/ als often counting earnings ardo and ness and ntangible that can g criteria conomic ehensive timation erved by s where rivers of s tend to e created counting that the on gaps, en react through ntangible m nature k prices, . this is matically ck price stments, are often ons. this ution to ombined with inv market. that can impact li h. an financia as a fin benefic dancak compan a posit industri value p between mohanl intangib financia findings signific sardo & and fou strong d importa șerban leverag manage investm long-ter the res found t and ro custome gamayu policies study c perform mantoh financia vestor relian as such, t n help bridg of intangib nd wang (2 al performa nancial mea ial to firms’ ková et al. nies across m ive link be ies reliant o profitability n these facto lingam et ble assets s al performa s align with cantly impro & serrasque und that inte drivers of g ance of intan (2020) look ing intangib ement, tend ments, such rm success. search plo that intangib oe. the stu er trust and uni (2015) s, financial concludes th mance and fi h (2015) inv al performa nce on trad there is a gr ge the gap be le assets on 2014) exam ance of liste sure of firm ’ financial p (2022) exa multiple sec etween inta on innovati y over inta ors in firm v al. (2021) such as int ance, particu h global rese ove profitab eiro (2018) ellectual cap growth oppo ngible asset ked at the w ble assets, p d to achiev as in corp s one stu ble assets p udy highlig intellectual empirically performanc hat intangib irm value. vestigated t ance of pu ditional finan rowing nee etween inta n firm perfo ine the influ d informati ms. the stud performance amined the ctors in fra angible ass ion and int angible asse valuation focused o tellectual pr ularly return earch, demo bility. using a dyn pital and int ortunities an ts in sustain world's mo particularly ve higher fi porate cultu udy (2022) f positively im ghts how b l property, s y examined ce, and firm ble assets h the contribu ublicly limi 8 ancial metric ed for impro angible asset formance: g uence of int ion technolo dy finds tha e. effect of i ance, germa set disclosu tellectual ca et disclosur on technolo roperty and n on assets onstrating th ynamic pane tangible ass nd financial ning a comp st profitabl through str inancial per ure and bra focusing on mpact finan banks with show better the relation m value of c have a pos ution of int ited germa asian cs, leads to oved report t investmen global evide tangible ass ogy compan at r&d inv ntangible a any, and sw ure and ma apital. how res, highlig ogy firms d r&d inv (roa) and hat a 1% in el data analy sets, such as l performan petitive adva e corporatio rong corpora rformance and equity, n commerci ncial perfor stronger in profitability nship betwe companies g sitive and s tangible ass an compan n journal of f a slower re ing and val nts and inves ence sets (r&d e nies in hong vestment an assets on th witzerland. t arket valua wever, inves ghting the in thailan vestments p d return on ncrease in in ysis, analyz s brand and nce. this stu antage. ons and fou ate values a and marke were found al banks in rmance, as ntangible as y metrics. een intangib going public significant sets to valu nies. the f finance & ac issn 19 2025, vol. 1 ajfa.macro eaction in th luation fram stor underst expenditure g kong usin nd sales trai he market v the researc ation, espec stors still p complex i nd, explorin positively in equity (ro ntangible as zed europea d human cap udy emphas und that com and human r et value. in d to be cru emerging m measured b sset bases, ble assets, f c in indone effect on f ue creation findings sh ccounting 946-052x 17, no. 1 think.org/ he stock meworks tanding. e) on the ng roa ning are value of ch found cially in primarily nterplay ng how nfluence oe). the ssets can an firms pital, are sizes the mpanies resource ntangible ucial for markets, by roa such as financial esia. the financial and the ow that intangib ahmed resourc technol weaker ozkan intangib results i contrad seo and medium enhanci investm of these radonić industry intangib profitab particul protecti another global c technol by impr especia investm as bus intangib relation asset po similar and org ferdaou in drivi that inv various research impact ble assets po haji and a es improve ogy has the firm perfor n., cakan ble assets a indicate tha dictory find d kim (202 m-sized ente ing innovat ments in inta e assets for ć et al. (20 y, an innov ble asset p bility and m larly releva ion are critic r important comparative ogy firms. roving fina lly evident ments are cen sinesses be ble assets w nships often ortfolios are results acro ganizational us and rahm ing the fina vestment in innovation h and devel on a firm's ositively co anum moh es compani e potential rmance. s., & kaya and banking at intangible dings on int 20) emphasi erprises (sm tion and pro angibles sho sustainable 021) explore vation-depe portfolios, i market value ant in sector cal for com t contributio e analysis o they found ancial flexib in the tech ntral to mai ecome incre will continue n outweigh e better equ oss europea knowledge man (2019) ancial perfo intangibles n-driving a lopment (r& ability to in ontribute to f hd ghazali ies’ financi to improve acan m. (2 g profitabilit e assets impr tangible ass ized that int mes), have oductivity. t owed superi growth. ed how inta endent sect including in e compared rs where te petitive adv on comes fr n the effect d that intan bility and st hnology sec intaining ma easingly re e to grow. in the value o uipped to a an public co e were critic ) conducted ormance of plays in fos ctivities, in &d), and h nnovate and 9 firms’ profi (2018) sug al perform e profitabilit 2017) exam ty in the sh rove long-t sets and pe ntangible ass e a direct p their resea ior financia angible asse tor. the stu ntellectual d to firms w echnologica vantage. from quresh ts of intangi ngible assets trategic pos ctor, where arket leader eliant on k n the digita of physical adapt and th ompanies, w cal to drivin d an in-dept 66 banglad stering inno ntangible in human capit d compete in asian itability and ggest that b ance. inves ty and a lac ine the asso hort and lon erm bankin erformance set investm positive imp arch demon al performan ets drive fin udy found property a with lower i l advancem hi and sidd ible assets o s significan sitioning in intellectual rship. knowledge al era, where assets, com hrive. glova where intang ng market va th analysis o deshi firms ovation. the nvestments tal enhancem n the market n journal of f d productivit better invest stment in h ck of inves ociation am ng run using g performan ments, partic pact on fir strated that nce, thus un nancial perf that comp and softwar ntangible in ments and in diqui (2020) on the financ ntly enhance n competitiv property, s and techno e data, softw mpanies wit a and mraz gible assets alue and gro of the role o , emphasizi eir study ide such as b ment have t tplace. finance & ac issn 19 2025, vol. 1 ajfa.macro ty. tment in in human cap stment can r mong invest ng panel dat nce in the lo cularly in sm rm perform t firms with nderlining th formance in panies with re, reported nvestments ntellectual p ), who cond cial perform e firm perfo ve markets. software, an ology, the ware, and c th strong in zkova (2018 like human owth. of intangibl ing the cruc entified tha brand devel the most sig ccounting 946-052x 17, no. 1 think.org/ ntangible pital and result in tment in ta. their ong run. mall and mance by h greater he value n the it h robust d higher . this is property ducted a mance of ormance this is nd r&d role of customer ntangible 8) found n capital le assets cial role at among lopment, gnificant the res financia heavily organiz this su prioritiz perform ferdaou immedi long-ter experien for inno howeve disputed dragom profitab that a h when a popular financia additio found th profitab percept suscept may req potentia rizova intangib on firm adjusted estimati noise, p financia additio returns. profitab periods may un assets a sults of th al performa in intang zational kno uggests tha ze the deve m financially us and ra iately refle rm value cr nced sustain ovation and er, the asse d by coun mir (2024) bility of tec higher propo accounting i r belief, int al outcomes onally, vince hat while in bility, firms ion stems ibility to fi quire a high ally leading and saito ( ble assets ac m performan d, the pos ing the valu providing li al metrics li onally, savin . they fou bility, they of econom nderperform as collateral eir research ance and t gible asset owledge wer at, in the c elopment an y. ahman also cted in sh eation. they ned growth sustained c erted positi terparts wh examined chnology an ortion of str inefficiencie tangible ass s in certain i enz (2023) ntangible as s with high from the inancial dist her risk pre g to underpe (2021) cond cross global nce was not sitive impa ue of intern ttle addition ike cash flow na and nam und that w often face mic downtur m during pe , which affe h revealed their intang s like inte re more lik competitive nd managem highlighte hort-term fi y pointed o over time, competitive ive link be ho argue fo the role of nd healthcar ructural cap es or mana sets like in industries, e explored th ssets can im h intangibl difficulty i tress during mium to in erformance i ducted an in l markets. t as significa act of intan nally develo nal informa w miko (2021) while intang higher risk rn. this mea eriods of m ects liquidity 10 a strong, gible assets ellectual p kely to achie e landscape ment of inta ed that the inancial sta out that firm demonstrat advantage. etween inta for a negat f structural re compani pital might n agement issu ntellectual c especially w he "intangib mprove sorti e assets ar in using in g economic nvest in com in adverse e n-depth ana their findin ant as antic ngibles lar oped intang ation beyon explored th gible asset ks and tigh ans that com market stress y and borro asian positive co s. specifica property, te eve higher p e of bangl angible reso e benefits atements bu ms with a gre ting that the angible asse tive or neg capital (a ies across e negatively a ues exist. t capital may when not ma le value fac ing on fund re often pe ntangible a c downturns mpanies wit economic co lysis on the gs revealed ipated. in f rgely dimin gibles introd d what is a he role of in ts are valu hter financi mpanies wi s due to th owing powe n journal of f orrelation b ally, compa echnologica profitability ladesh’s ec ources are b of intangib ut contribu eater focus o ese assets pr ets and per gligible imp key intang europe. his affect profit this sugges y not alway anaged effec ctor" across amentals lik erceived as assets as c s. this sugg h significan onditions. e value of in that the im fact, when s nished. the duces a sig lready cont ntangible as uable in te ial constrain th significa eir inability r finance & ac issn 19 2025, vol. 1 ajfa.macro between th anies that al innovatio y and marke conomy, fir better positi ble assets ute significa on intangib rovide a fou rformance pact. for i gible asset) s research i tability, part sts that, con ys lead to ctively. global mar ke producti s riskier. t collateral an gests that in nt intangibl nternally de mpact of thes sector weigh ey conclud gnificant am tained in tra ssets in glob erms of lo ints, particu ant intangibl y to leverag ccounting 946-052x 17, no. 1 think.org/ he firms' invested on, and et share. rms that ioned to are not antly to le assets undation is often instance, ) in the ndicates ticularly ntrary to positive rkets. he vity and this risk nd their nvestors e assets, eveloped se assets hts were ded that mount of aditional bal stock ong-term ularly in le assets ge these radonić intangib financia makes i another (smes) human delayed slower gaps in after ex applied internat these s models, financia results h range o these em for ex demons particul sardo & investm signific howeve structur one no intangib has bee emergin effectiv property of firms on emer given t assets in georgia typicall markets ć et al. (2 ble assets s al performa it difficult to r significan ) in korea a capital) do d effect ofte stock marke n the literat xamining th to assess tional conte studies hav , and indust al outcomes have been l of methodol mpirical fin xample, stu strated a cle larly in high & serrasque ments in in cantly to lon er, the div res complica otable gap in ble assets o en on devel ng markets veness and v y protection s to leverag rging econo these gaps, t nfluence th a's econom ly studied, m s hold true 2021) provi such as soft nce. this v o rely on in nt study by and found th o positively en leads to et reactions ture and ne he literature the impact exts, includi ve utilized try-specific s like profi largely posi logies and ndings. udies in ad ear positive h-innovation eiro, 2018). ntangible a ng-term pro versity in e ates the task n the existin on companie loped econo s present u valuation o n or underde ge their inta omies (rado the present e financial mic and reg making it c in this con ided a focu ftware, pate olatility, com tangible ass seo and ki hat while in affect firm undervalua eed for furth e, it becom of intangib ing the usa various ap case studie itability, ma itive in term regional co dvanced ec e relationsh n sectors lik similarly, assets, incl ofitability a economic e k of general ng literature es in emerg omies with unique chal f intangible eveloped ca angible asse onić et al., 2 study aims performanc gulatory env crucial to in ntext. the s 11 used analy ents, and in mbined wit sets as a sta im (2020) f nvestments m performan ation by inv ther researc mes evident ble assets o a, canada, pproaches, es, to explo arket valuat ms of recog ontexts raise conomies s hip between ke technolog research fr luding r& and compet environmen lizing these e is the abs ging market well-establ lenges and e assets. fo apital marke ets for finan 2021; seo & to address ce of compa vironment nvestigate w study will d asian sis on the ntellectual p th challenge ble predicto focused on in intangib nce, the ben vestors in t ch that numer on compan the uk, au such as pa ore the link tion, and in gnizing the es concerns such as th n intangible gy and phar rom austral &d and in itiveness (m nts, regulato findings ac sence of res ts like geor lished finan d opportuni r example, ets in these ncial gain, a & kim, 2020 the underex anies in geo differs sign whether the determine h n journal of f it sector, property oft es in accoun or of profita small and m le assets (e nefits are no he short ter rous method y performa ustralia, ger anel data a between in nnovation c value of in s about the he usa an assets and rmaceuticals lia and turk ntellectual mohammed ory framew cross differe search explo rgia. while ncial and le ties that co the lack of regions ma as suggeste 0). xplored area orgia. as an nificantly f trends obse how investm finance & ac issn 19 2025, vol. 1 ajfa.macro , highlighti ten lead to nting and va ability medium ent specially r not immedia rm, contrib dologies ha ance across rmany, and analysis, re ntangible as capacity. w ntangibles, t generalizab nd german d firm perfo s (lev & g key has sho capital, co d & al ani works, and ent regions. oring the im much of th egal infrastr ould influe f robust inte ay hinder th ed by recent a of how in n emerging from the c erved in de ments in in ccounting 946-052x 17, no. 1 think.org/ ng how volatile aluation, terprises r&d and ate. this buting to ave been diverse turkey. gression sets and while the the wide bility of ny have ormance, gu, 2016; own that ontribute i, 2020). market mpact of he focus ructures, ence the ellectual he ability t studies ntangible market, countries eveloped ntangible assets profitab intangib compan develop researc data co the dat reporti compan analysis from th study’s the fina to 2022 perform of trend variabl the pri perform indepen indepen  the ratio how mu such as strategi outperfo depend  widely uses its impact analytic the stu relation and tim like intelle bility. this r ble assets in nies and pol pment. ch method ollection an ta for this st ing, and au nies operati s, companie he sample, results. al sample co 2, a timefra mance. this ds over time les and mod imary objec mance, with ndent variab ndent variab ria (repre o of intangib uch of a co patents, tra c focus on i form others dent variabl return on a recognized s total asset of intangibl cal approac udy employ nship betwe me-series d ectual prop research is n emerging licymakers dology nd sample tudy were dr diting supe ng in the g es in the fin as these fir omprises fin ame that cap dataset allo e. del specifica ctive of thi a specific f ble. ble esentativene ble assets to mpany’s to demarks, go ntangible re due to the c le assets (ro d measure o s to genera le assets on ch ys a panel r en ria and imensions, perty, brand essential no g markets b on how to rawn from t ervision of g georgian m nancial indu rms have d nancial data ptures a bro ows for a ro ation is study is focus on the ess of intang o total assets tal asset ba oodwill, and esources, an competitive oa): the stu f firm perfo ate earnings profitabilit regression a d firm perfo is well-su 12 d equity, ot only for a but also for better lever the electron georgia. th market. to e ustry and th distinct fina a from 845 oad spectru obust longit to assess e representa gible assets s, referred t ase is compo d brand valu nd the idea i advantages udy uses ro ormance. r , making it ty. analysis usi ormance. pa uited for th asian and human advancing t providing rage these c nic database his dataset p ensure the a hose with n ancial chara georgian co um of econo tudinal anal the impact ativeness of s): the indep o as ria. t osed of inta ue. the ria s that comp s derived fro oa as the d roa indicat t an appropr ing a fixedanel data, w his analysis n journal of f n capital c the academi practical in critical resou of the serv rovides fina accuracy an negative equ acteristics th ompanies ov omic condit ysis, enabli of intangi f intangible pendent vari this ratio pro angible asse a serves as a anies with a om these as dependent v es how effe riate metric -effects mo which combi as it allow finance & ac issn 19 2025, vol. 1 ajfa.macro contribute ic understan nsights to g urces for ec vice for acc ancial statem nd relevanc uity were e hat could s ver the peri tions and c ing the exam ible assets assets (ria iable in this ovides a me ets, includin proxy for th a higher ria ssets. variable, wh ectively a c c for evalua odel to exam ines cross-s ows for con ccounting 946-052x 17, no. 1 think.org/ to firm nding of georgian conomic ounting, ments of e of the excluded kew the iod 2019 orporate mination on firm a) as the study is easure of ng items he firm's a tend to hich is a company ating the mine the sectional ntrolling unobser the fix time-inv corpora helps re is more the fixe yit=αi + where:   characte    statistic the stat and reg perform random differen instance variable additio  the inde  standard presenc results multiv multiva collectiv multiple rved heterog xed-effects variant cha ate governan educe the ris accurate an ed-effects m + β riait + γ yit repres αi is the eristics, β is the coe size it is th εit is the err cal software tistical analy gression an ming the hau m-effects mo nces betwee e, it sugges e (ria), nec onal diagnos multicollin ependent an autocorrela d errors, en ce of these i s variate tests ariate tests w ve effect o e compariso geneity acro model is p aracteristics nce practice sk of omitte nd not drive model used γsizeit + εit ents the ro firm-spec efficient for he control v ror term, cap e and proce ysis was con nalysis. the usman test, odel in this en the estima sted that fir cessitating t stic tests we nearity was nd control v ation and he nsuring that ssues. s were condu n the depen ons. the re oss firms. particularly of each co es, industry ed variable b en by other u in this study oa for firm ific fixed ria, the in ariable, repr pturing uno edures nducted usin e decision which indi case. the h ates provide rm-specific the use of th ere carried o tested using ariables we eteroskedas the estimat cted to dete ndent varia sults are su 13 appropriate ompany tha y positioning bias, ensurin unmeasured y is specifie i at time t, effect, ac ndependent resenting co observed fac ng spss so to use a cated that th hausman te ed by the fix characteris he fixed-eff out to ensur g variance ere not exces sticity were ted coefficie ermine whet able (roa) ummarized asian e in this co at could in g, or manag ng that the o d factors. ed as follow ccounting variable, ompany siz ctors that m oftware, a wi fixed-effec he fixed-eff est assesses xed and rand stics are co fects approa e the robust inflation f ssively corr also tested ents are unb ther the ind ) and to con in table 1, n journal of f ontext beca fluence per gerial exper observed eff ws: for time-in e, ight affect r idely used to cts model w fects model s whether th dom-effects orrelated wi ch. tness of the actors (vif related. and address biased and e dependent va ntrol for ty which incl finance & ac issn 19 2025, vol. 1 ajfa.macro ause it cont rformance, rtise. this a fect of ria invariant c roa. tool for econ was confir was superi here are sig s models, an ith the inde results: fs), confirm sed by usin efficient eve ariable (ria ype i error ludes four d ccounting 946-052x 17, no. 1 think.org/ trols for such as approach on roa company nometric rmed by or to the gnificant nd in this ependent ming that ng robust en in the a) had a rs across different multiva each t indepen table 1 effect intercep indepen variable compan 1. inter all mul root) r ariate tests: est provide ndent variab . multivaria pt pilla wilk hote roy roo ndent e (x) pilla wilk hote roy roo ny pilla wilk hote roy roo rcept ltivariate te revealed tha pillai’s tra ed consiste ble, and the ate tests ai's trace ks' lambda elling’s trac y's larg ot ai's trace ks' lambda elling’s trac y's larg ot ai's trace ks' lambda elling’s trac y's larg ot ests (pillai’s at the inter ace, wilks’ l ent results company-sp value .654 .346 ce 1.890 gest 1.890 .103 .897 ce .114 gest .114 1.051 .161 ce 3.891 gest 3.517 s trace, wi rcept was h 14 lambda, h regarding pecific fact e f 2394.14 2394.14 2394.14 2394.14 144.837 144.837 144.837 144.837 3.341 4.498 5.865 10.610 ilks’ lambd highly signi asian hotelling’s t the signif tors. hypot df 46 2.000 46 2.000 46 2.000 46 2.000 7 2.000 7 2.000 7 2.000 7 2.000 1680.0 1680.0 1680.0 840.00 da, hotellin ificant acro n journal of f trace, and r ficance of hesis erro 2533 2533 2533 2533 2533 2533 2533 2533 00 5068 00 5066 00 5066 0 2534 ng’s trace, ss all mode finance & ac issn 19 2025, vol. 1 ajfa.macro roy's large the interc ror df sig 3.000 <.0 3.000 <.0 3.000 <.0 3.000 <.0 3.000 <.0 3.000 <.0 3.000 <.0 3.000 <.0 8.000 <.0 6.000 <.0 6.000 <.0 4.000 <.0 and roy’s els (p<0.00 ccounting 946-052x 17, no. 1 think.org/ est root. ept, the . part eta squa 01 .654 01 .654 01 .654 01 .654 01 .103 01 .103 01 .103 01 .103 01 .525 01 .529 01 .661 01 .779 largest 01), with tial ared large ef effect, m 2. inde the ind althoug ria ha compar 3. com the mu (p<0.00 compan (roa), univari univari (ria) o table 2 source correct intercep x compan error total correct 1. corr the cor proport effectiv ffect sizes (p meaning tha ependent v dependent v gh with a sm as a signific red to the in mpany-spe ultivariate te 01) across a ny-specific , underscori iate tests (t iate tests we on the depen . tests of be ted model pt ny ted total rected mod rrected mod ion of the v veness in pre partial eta at roa is si variable (r variable, ri maller effect cant and pos ntercept. ecific facto ests also sh all tests, wit characteris ing the impo tests of betw ere also cond ndent variab etween-subj dependen variable roa roa roa roa roa roa roa del del was hig variance in r edicting firm a squared = ignificantly ria) ia, was als t size (part sitive impac or howed that t th effect siz tics play a ortance of c ween-subjec ducted to as ble (roa). jects effects t typ sum squ 214 96. 5.8 179 51. 420 265 ghly signific roa (adju m performa 15 = 0.654). th y influenced o significan tial eta squ ct on roa, the compan zes ranging a substantia controlling f cts effects) ssess the ind the results s pe iii m of uares 4.617b 761 53 9.485 201 0.479 5.818 cant for ro usted r² = 0 ance. asian his finding d by the fixe nt across al uared = 0.1 , the overal ny-specific g from 0.525 al role in d for these fac dividual effe of these tes df m s 841 . 1 9 1 5 840 . 2534 . 3376 3375 oa (p<0.00 0.807), dem n journal of f suggests a s ed intercept l multivaria 103). this i ll effect size factor was 5 to 0.779. determining ctors in the ects of the in sts are prese mean square f .255 12 96.761 47 5.853 28 .214 10 .020 1) and expl monstrating t finance & ac issn 19 2025, vol. 1 ajfa.macro substantial in the mod ate tests (p< indicates th e is more m s highly sig this indica g firm perfo analysis. ndependent ented in tab f s 2.630 < 788.826 < 89.681 < 0.575 < lained a sub the model’s ccounting 946-052x 17, no. 1 think.org/ baseline el. <0.001), hat while moderate gnificant ates that ormance variable ble 2. sig. pa et sq <.001 .80 <.001 .65 <.001 .10 <.001 .77 bstantial s overall artial ta quared 07 54 03 78 2. inter the int effect s on roa 3. inde ria wa partial represen 4. com the com effect s compan parame table intercep table 3 depend variabl y2_adju y2_adju key fin  substan  represen the res  reflectin  tests for rcept tercept rema ize (partia a. ependent v as found to eta squar nted by ria mpany-spe mpany-spec size (partia ny-specific c eter estimat 3 presents pt. . parameter dent le par usted inte usted x ndings: the interce ntial fixed ef the ria ntativeness ults from bo the interce ng a substan the indepe r roa, sugg ained signif al eta squa variable (r o be highly red of 0.103 a, have a po ecific facto cific factor a al eta squa characterist tes the param r estimates rameter b ercept 9 5 ept is sign ffect in the m paramete of intangib oth the mul ept has a si ntial baselin endent varia gesting a po ficant in the ared = 0.65 ria) significant 3. this find ositive and s or also showed ared = 0.77 tics remain c meter estim b t 6.761 47 .853 289 ificant (p< model. r is high le assets ha tivariate an ignificant ef ne effect on able ria is ositive and s 16 e univariate 54), reinforc t for roa ding support statistically d a significa 78). this su crucial in d mates for th si 88.826 <. 9.681 <. <0.001) with hly signifi as a strong a nd univariate ffect on bo firm perfor significant strong impac asian e analysis a cing the imp (p<0.001) ts the hypot significant ant effect (p uggests tha etermining he independ g. par eta squ 001 .654 001 .103 h a large b icant (p<0 and positive e analyses in th multivar rmance (ro t in both mu ct of intangi n journal of f as well (p<0 portance of in the univ thesis that i impact on f p<0.001) on at while ria firm-level o dent variab rtial a uared 4 3 baseline eff 0.001), ind impact on ndicate that riate tests an oa). ultivariate t ible assets o finance & ac issn 19 2025, vol. 1 ajfa.macro 0.001) with f the baselin variate tests intangible a firm perform n roa, with a influence outcomes. ble (ria) ffect, reflec dicating th roa. t: and univaria tests and un on firm prof ccounting 946-052x 17, no. 1 think.org/ h a large ne effect , with a assets, as mance. h a large es roa, and the ting the hat the ate tests, nivariate fitability.  firm-sp these r intangib by roa discuss the pur ria (r by retu the hyp perform providin and pro the im the cen statistic a highe provide include enhanci the sig that int eta-squ to othe finding intellect superior in the c operatin capital as key advanta intangib firms in the compa ecific chara results provi ble assets (r a. sion rpose of th epresentati urn on asse pothesis th mance. seve ng insights ofitability. mpact of in ntral finding cally signif er proportio e competitiv intellectua ing a firm’s gnificance o tangible ass uared value er factors, i is consiste tual propert r financial o context of an ng in trans and fluctua differentia ages even ble assets ef n emerging any-specific acteristics pl ide robust e ria) has a p his study wa iveness of i ets (roa). hat intangib eral key fin into the re ntangibles g of this stu ficant positi on of intang ve advantag al property, s market pos of ria acro sets contrib e of 0.103 in it is noneth ent with p ty portfolio outcomes. n emerging sitional eco ating market ators, enabl when exte ffectively m economies. c factor is lay a key ro evidence sup positive and as to exami intangible the results ble assets ndings eme lationship b on firm p dy is that r ive effect o gible assets ges that are brand equi sitioning an oss both mu bute to firm ndicates tha heless subst rior researc os, brand va market like onomies fac t conditions ling compa ernal condit may thus be 17 highly sig ole in determ pporting the d significant ine the imp assets), on s of the ana have a si erged from between int performan ria, the rati on roa. th s tend to p difficult fo ity, goodwi nd its ability ultivariate m performa at while the tantial in i ch, which alue, and ot e georgia, t ce distinct s. in such e anies to bu tions are l a critical fa asian gnificant ac mining roa e hypothesi t effect on f pact of inta firm perfor alysis provi ignificant a m both mult tangible ass ce io of intang his supports perform bett or rivals to ill, and inno y to generate and univa ance in a m e effect size influencing has shown her intangib this result is challenges environment uild resilien less favora actor in lon n journal of f ross all tes a. s that the re firm perform angible asse rmance, spe de robust e and positiv tivariate an sets, compan ible assets t the hypoth ter, as intan replicate. t ovation, pla e profits. ariate tests meaningful of ria is m the firm’s n that comp ble resource s 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pr rformance, h could exp on equity tangible ass plete disclos it challengin clusion, thi play in th ntativeness ble resource nces tah ahmed h es in firm p 42-59. https onte, c., ba mance, and ni. https://do oor, a. 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(200 ion press. l. k., lakon d recomm important sults highlig f profitabili into their b esources pro the finding n-friendly p nificantly co s to invest and develop future re rovides valu it is limited pand on this (roe) or sets impact sure of int ng to analyz s study con he modern of intangib es in achiev haji, & naz performance ://doi.org/1 auer, p., gil finance d oi.org/10.21 21). the imp y. iranian jo 01). intangi nishok, j., & mendations implication ght the need ity and lon broader stra ovide. gs suggest t policies, inte ontribute to t in and ca pment in ge esearch uable insigh d by the use s by incorpo market va t firm succe tangible res ze the propo ntributes to economy. ble assets ou ing competi zli anum m e: empirical 0.1108/jaa lardi, a. m during crise 39/ssrn.401 pact of intan ournal of ac ibles: mana & sougiann 20 s ns for both d to prioritiz ng-term suc ategic frame that support ellectual pro o the compe apitalize on eorgia. hts into the r e of roa a orating othe aluation, co ess. one of sources in osed relation o the growi the findi utperform t itive advant mohd ghazal l evidence. ar-12-2015 m., & soriol es. baffi 18400 ngible asset ccounting, a agement, m nis, t. (2001 asian business st ze investme ccess. firms ework to fu ting the dev operty prote etitiveness o n intangible relationship as the prima er measures ould offer a f the limita companies nship comp ing underst ngs empha their peers, tage and sus li. (2018). t journal of 5-0108 lo, c. (202 carefin ts on firm p auditing & measuremen 1). the stoc n journal of f trategy and ent in intang s should fo fully leverag velopment o ection, and of firms in e assets co p between in ary performa s of firm pe more comp tions of thi ’ financial prehensively tanding of asize that reinforcing stainable gr the role of in applied ac 2). intangib working p erformance finance, 5( nt, and rep k market va finance & ac issn 19 2025, vol. 1 ajfa.macro public pol gible assets, ocus on int ge the com of intangibl enhanced a emerging m ould foster ntangible as ance metric erformance, prehensive is study is statements y and accura the role in firms with g the impor rowth. ntangible as ccounting r ble assets, papers, un e: evidence (2), 61-77. porting. br aluation of r ccounting 946-052x 17, no. 1 think.org/ licy. for , as they tegrating mpetitive le assets access to markets. broader ssets and c. future such as view of also the s, which ately. ntangible h higher rtance of ssets and esearch, industry niversità from an rookings research and https://d chariya intangib ciftci, m journal das, a perform analysi dancak market dragom healthca earth, c the key elena-m accoun https://d ferdaou an emp america glova, perform gamayu perform 202-212 haskel, econom jinsu, k interna https://d lev, b. manage li, h., & listed it developme doi.org/10.1 awattanarut bles are the m., & darr l of account a., haldar, mance: a stu is, 36(3), 63 ková, d., h value of fir mir, v. d. are firms. j c., hazan, e to faster gr mirela nich nting an doi.org/10.2 us, j., & ra pirical inve an journal j., & mra mance of eu uni, r. r. mance on fir 2. , j., & wes my. princeto k., & gee-j tional j doi.org/10.5 , & gu, f. ers. wiley. h & wang, w t firms. inte nt expen 1111/0022-1 , e., cvetan key to faste rough, m. 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(2022 ropean jour pital and pr capital, 25( elly, g., & insey & com e assets: in informat 04 the effects e listed ma 48-168. http ntangible as ies. europe f intangible l journal of italism with tps://doi.org persistence ness and accounting 2/978111927 e of intangi business re asian of fina kelly, g., mckinsey & estments an (2009). in ry. journal 2). the effe rnal of fina rofitability (3), 431-452 spillecke, d mpany. nsights from ion sys of intangib anufacturing ps://doi.org ssets and t ean business e assets, fin f scientific hout capita g/10.17323/ and market d mana and the pa 70041 ible assets o esearch, 23( n journal of f ance, 56 & spilleck & company. nd analysts' ntangible as of financia ect of intan nce, 28(6), in europea 2. d. (2022). w m literature stems, 1 le assets on g firms in g/10.1108/a their impac s review, 32 nancial poli & technolo al: the ris 1726-3247t reaction of agement, ath forward on the financ 2), 93-105. finance & ac issn 19 2025, vol. 1 ajfa.macro 6(6), 243 ke, d. (2022 earnings fo ssets and f al and qua ngible asset 721-738. an technolo why intangi review. jou 18(2), 2 n firm perfo dse, ban ajb-11-2018 ct on the f 2(4), 552-56 icies, and f ogy researc se of the in -2021-1-61f r&d inve 6(4), 1 d for invest cial perform ccounting 946-052x 17, no. 1 think.org/ 31-2456. 2). why orecasts. financial ntitative s on the ogy and ibles are urnal of 224-261. ormance: gladesh. 8-0065 financial 68. financial ch, 4(1), tangible -70 estment. 100-116. tors and mance of mantoh compan megna, econom moham and fin finance mohanl perform 342-356 ohlson, assets in ozkan, study https://d qureshi financia social s radonić financia manage sardo, perform https://d seo, m smes. j vincenz journal h, r. k. 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(2021). journal of intellectual ournal of 9 asset inves gement, 58(2 factor: sort 101-118. asian ble assets to 09-223. s and intan i.org/10.230 intangible a industrial s the impac and. journal link: recog research, 5 ectual capita a istanbu ntangible as rms. interna the impac f informatio capital, in intellectua stments and 2), 243-264 ing firms ba n journal of f o firm profi ngible capit 07/2109402 ssets on fin sector. cope ct of intang l of busines gnizing and 4(5), 823-8 al and financ l review, ssets on fina ational jour ct of intang on systems ntangible as al capital, d firm perfo . ased on inta finance & ac issn 19 2025, vol. 1 ajfa.macro fitability in tal. the re 2 nancial perfo ernican jou gible assets ss research d valuing in 846. cial perform 17(3), 1 ancial perfo rnal of busin gible assets s and tec ssets, and f 19(2), 2 ormance in angible inve ccounting 946-052x 17, no. 1 think.org/ german eview of ormance urnal of on firm h, 29(3), ntangible mance: a 190-198. ormance, ness and s on the chnology financial 291-308. korean stments. microsoft word 18987-data analysis-66700-writer2-new2 div fi receive doi:10.5 abstra the ku of its h paper e challeng analysis identifie with ot implem toward undersc renewab investm industri these m long-ter revenue conclud financia econom keywo industri ersifyin inancia depa the ed: oct. 20, 5296/ajfa.v ct uwaiti econo heavy relian explores the ges by refe s of current es the ineffi ther gulf c mentation of a more div cores the ur ble energy ment in hum ies, and im measures ai rm growth. es, enhance des by emph al future an mic landscap rds: econo ies, public-p ng inve l risks noo rtment of in public auth e 2024 a 16i2.18987 omy has be nce on oil e importanc erring to k economic d ficiencies of cooperation f reforms an versified eco rgent need t to build a man capital mplementing m to create by adopti economic hasizing tha nd improvin pe. omic divers private part estment from o k ra f. alibra nsurance an hority for ap e-mail: nf.a ccepted: de url: ht en highly s revenues, w ce of econ kuwait visi dependencie f existing div council (g d regulatory onomic bas o explore e resilient e , fostering g a robust m e an enablin ng these st stability, an at proactive ng the qualit sification, o tnerships, f 14 ts in gu oil pric kuwait ahim (corres nd banking, applied educ alibrahim@p ec. 11, 2024 https://doi.or susceptible t which chall nomic diver ion 2035 an es, sectoral versificatio gcc) coun y barriers h se, leaving i emerging in economy. r public-priv monitoring ng environm trategies, k nd align wi e diversifica ty of life fo oil price vo inancial sta asian ulf cou ce vola t sponding au college of cation and t paaet.edu.kw 4 publ rg/10.5296/ to shocks in lenges its s rsification a nd its dive performanc n strategies ntries. key ave hindere it exposed t ndustries suc recommend vate partner framework ment for entr kuwait can ith global su ation is imp or its citizen olatility, ku ability, glob n journal of f 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expired of econ for dive can bett 1.1 bac kuwait econom has bee such as achieve sensitiv foremos found to and bud also lim technol challeng diversif the dive of thes sources develop funding system. 1.2 pro fluctua stability diversif the cou recent p oduction uwait and o heir econom the global al risks and f diversifyi ose charges mic, strategi or source of mportant. it d with fluctu nomy of ku ersification ter ensure a ckground like other mic hub and en relative e s schools a ed at the ex ve to the fl st source o o have long dgetary defi mited the d logy, which ges above, fying the ec ersification e efforts in s such as th pment. neve g, and outlo blem statem ations in th y and devel fy the econo untry is very past has put other countr mic model o markets ha d through po ng on the r s toward re c and devel f export, the t is stated th uating oil pr uwait, the im of investme a sustainable r gcc cou d strength. s economic gr and hospita xpense of th luctuations of governme g-term effec 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ajfa.macro ) have trad tions in the vulnerable avoured to wards a new on oil com at depends o ent portfolio o minimise of the curr ssible oppo ding of how xports as th of the centu ctures and f been sign kuwait cons ince it rem ice of oil h balance of p the econom uring, touri in response d the nece cies geared liance on oi fication of and privat on its mana ges in the ec at to the ec de over the from oil an the oil price dgets, spend ccounting 946-052x 16, no. 2 think.org/ itionally price of to such look for w energy mes with on oil as o is even the risk ent state rtunities w kuwait he main ury there facilities ificantly iderably ains the has been payment my. it has ism and e to the ssity of towards il. some revenue te sector agement, conomic conomic years to nd hence es in the ding, and resulted worsene from fo strategi decreas 1.3 res the aim in mitig contemp econom the obj  to prospec  to recent t  to kuwait  to kuwait  to to achie 1.4 res this res  wh  ho  wh effectiv  wh 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ment divers my on oil re mic stability lemented by or diversific e effectiven lity in kuw urrent literat in the conte finance & ac issn 19 2024, vol. 1 ajfa.macro s problem is g and shiftin ources. this kuwait, beca rsification st per will ana atility on k t. enue as wel my, with a f rategies in r could contri sification in evenues? y in recent y y kuwait, a cation in k ness of inv wait? ture on the ext of the g ccounting 946-052x 16, no. 2 think.org/ s further ng away s shift is ause of a trategies alyse the kuwait’s ll as the focus on reducing ibute to n kuwait years? and how kuwait's vestment topic of gcc. as such, th purpose the eco improve kuwait econom also exp terms sustaina transitio econom can stre this res facing t 2. liter due to these co they ar diversif of the s followin implica context reader diversif 2.1 eco the cou on the e with oil develop econom from th state ho as poin imperat reliabili changes largest d concern econom and soc his research e of informi onomics of e understan ’s capacity mic stability perience sim of adequat ability. in a on to renew mies. thus, engthen the search seeks the global en rature revi the massiv ountries hav re more vu fication in o shift from h ng literature ations on ec of the gcc of the nat fication, and onomic dep untries of th export of o l revenues h pment. alqa mies are the he rent of th olding most nted out b tive to the ity pitfalls. s in externa dependence ning that, t my but also s cial stability h work is s ing more ef oil export nding of exi y to mitiga y. furthermo milar proble tely prepar a larger per wable sourc by discussi economies s to shed li nergy indus iew e oil resour ve been tran ulnerable t oil-exportin heavy depen e: investme conomic sta c and kuw ture of the d the paths t endence on he gcc inc il. this has having beco ahtani & k e epitome o he local res t of the eco y antwi‐b increased this has m al events su e for this va the literatur social and p y. seen as a c ffective poli ing countri isting and f ate the imp ore, this wo ems and ma ring for c rspective, th ces of energ ing differen of kuwait ight on the stry. rces in the g nsformed. t to fluctuatio g countries ndence on nt diversific ability from wait. throug e considera toward the c oil in gcc cluding kuw s destined th ome core fu klein, (2021 of rentier st sources to th onomic wea oateng & growth an made these uch as the ch ariable as it re underlin political poi 17 country-leve icymaking a ies. the re future inves pacts of oi ork can be u ay potentia crises and his research gy and the nt investmen and other g best strate gcc count these econo ons in the explain the a single pro cation as a m the result gh reviewing ations that creation of c countries wait have a hese nation unding for th ) and bolli tates, where he internati alth, and ver al jaberi, nd developm economies hanges in i accounts fo nes that this ints in terms asian el analysis among thos esults of th stment dive il price in useful to ot ally become investing h highlights impacts oc nt opportun gcc countr egies for ov tries especia omies have e price of e prospects oduct. this model, fluc t of diversif g those area have drive a more sust s always had ns’ economi he governin ino & galk ein the stat ional consu ry little div (2022), alt ment of the s over-depe nternationa or about 90% s kind of d s of governm n journal of f of kuwait’ se who may is research rsification p stability an her countrie a guide fo in the lon s the need ccurring wi nities and ex ries in terms vercoming t ally kuwait benefited g oil. litera and constra literature r ctuations in fication exe as, it is inte en kuwait tainable eco their econo c, social an ng budgets, kin, (2021) te’s income mers. this versification though oil e gcc cou endent and l prices of o % of the gov dependence ment’s spen finance & ac issn 19 2024, vol. 1 ajfa.macro ’s economy y have an in h could be policies, en nd fostering es of the g or further ac ng-term ec to account ithin the oi xamining h s of diversi the new ch t, the econo greatly from ature on ec aints of the review look oil prices a ercises don ended to inf toward ec onomy. omy depend nd political social serv state that th e is obtaine has resulte n into other has been untries, it very vulne oil. kuwait vernment’s is not onl nding, empl ccounting 946-052x 16, no. 2 think.org/ y for the nterest in used to nhancing g better gcc that ctions in conomic t for the il-reliant ow they fication, hallenges omies of m oil, but conomic process ks at the and their ne in the form the conomic d mostly systems vices and he gcc d solely ed to the sectors. the key has had erable to t has the revenue. ly about loyment, 2.2 imp fluctua rely on polinor especia domina comes t low oil public exacerb breakev budgets econom this sh trickle-d activitie spendin diversif econom 2.3 the soverei econom authori naifar, oversee requirem effectiv episode investm econom literatur integrat optimum diversif in term infrastru investm prices h kuwait when it pact of oil p ations in glo n oil. as st i, (2021), lly if its exp ated by oil to the globa l prices inc expenditure bated by the ven oil pric s. it also e mic growth s hows that o down effect es by the ng are sensi fied in a b my. e role of sov ign wealth mic diversifi ity (kia), w shahzad & es the inves ments of t vely reduce es as well ment portfol my depends re made al ted idea reit m strategic fication thro ms of kuwa ucture. how ments despit have not rea . thus, it b t comes to price volatil obal oil pric tated by k studies rev ports depen revenues m al oil marke clude decrea e as reveal e fact that s ces, which xamines th slowdown, r oil price vo ts at the sec constructio tive to the o bid to avoid vereign wea funds (sw ication in o which is one & hammoud stment in a the econom the risks o as on acc lios. howev on the strat loui & ham terates that c asset allo ough the sw ait, the kia wever, there te encouragi ally encoura becomes ap diversificat lity on econ ces have re khalfaoui, s veal that oi nd on oil. fo meaning tha et. literatur ase in gove led by alk some gcc means they he longer-te rising debts olatility is ctor and firm on and real oil price ch d the effec alth funds i wfs) have il-based eco e of the olde deh, (2020), a variety of my. studies of oil price count of th ver, the abil tegies of inv mida, (2021 transparenc ocation so wfs. a has vast e have been ing the mod aged the pr parent that tion of kuw 18 nomic stabi emained a p sarwar, & t il price ch or instance, at the natio re review ha ernment rev khouri & a countries, y need hig erm conseq s, and social not only a m levels. al l estate co hanges. this cts of fluctu in economi been discu onomy. the est and larg , swfs act f assets to s on swfs fluctuation he enhance lity of swf vestments a 1) and al-f cy be uphel as to affo t investmen n some crit deration of t rocess of di there is a wait’s econ asian ility persistent is tiwari, (20 hanges sign the econom on’s econom as indicated venues, bud arouri, (20 including k gher oil pri quences of l conflict. a macro lev qahtani, kle ompanies e s makes it i uating oil p ic diversific ussed in th e kuwaiti s gest swfs i as the key ensure that s have ind n through b ed investm fs in enhan and the stru fayoumi, bo d and accou ord maximu nts oversea tics in the l the risk asso versificatio need for a nomy that w n journal of f sue in econ 019) and b nificantly af my of kuwa my has bee d that other dget deficit 19). such kuwait, hav ces in orde oil price fl vel phenom ein, & khal ssential in mperative t prices on t cation e literature swf is the n existence steward of they can f dicated that balancing du ment income ncing the div cture of gov ouri, & ab untability en um contribu s in equitie literature th ociated with n of the do more comp will include finance & ac issn 19 2024, vol. 1 ajfa.macro nomies that igerna, bol ffect the e ait has been en volatile negative e ts and redu effects are ve relatively er to balan fluctuation, menon sinc lid, (2019) n the gover that the eco the stability e as impera kuwait inv e. as highlig f the oil we fund the lo at these fun uring low o e from div iversificatio vernance. b buzayed, (20 nhanced be ution to ec es, propert hat argue th h the fluctu omestic econ prehensive e not only f ccounting 946-052x 16, no. 2 think.org/ t heavily llino, & economy n greatly when it ffects of uction of e further y higher nce their such as e it has note that rnmental onomy is y of the atives to vestment ghted by ealth and ong-term nds can oil price versified on of the based on 023), an esides an conomic ies, and hat these ating oil nomy in strategy financial investm 2.4 inve analyse oil-base diversif and m develop revenue into sec kuwait includin accord initiativ indicato structur and the foreign when it (2021) diversif the liter which i kuwait are requ 2.5 cha kuwait despite several underta overwh the priv along w skill-de wang & skills w sectors there a elsayed rentier s the econ ments but the estment div es for inve ed economi fication stra matallah, (20 ped some str es through o ctors like fi , there are ng the kuw ing to man ve and their ors of the s ral constrain need for ex n direct inve t comes to point out fication in t rature also includes po , attempts to uired to enh allenges to e has severa the realizat structural, akings. for helming con vate sector a with providi eficient hum & luo (2020 which is req like techno are also poli d et al. (202 state, does n nomy. this e growth of versification estment div ic structure ategies of th 020), for w rategies as a oil exports. inance, tour various po wait vision 2 nsour, ham r risks and state of the ns such as t xploiting sec estment (fd strategic as that fdi the gcc reg indicates t olitical stab o attract fd hance the co economic d al challenge tion that it i , institutio r instance, ntrol of the k and creativi ing social w man capital 0) and küçü uired by th logy, financ itical factor 24), downi not easily a includes op f other secto n strategies ersification es and succ he gcc cou which has b a way of try some of th rism, buildin olicies targe 2035 that se mdi, majdo prospects e non-oil se the over reli ctors throug di) is anoth sset. elsaye can becom gion by pro hat fdi de ility, the ea di have had ountry’s fdi diversificati es that it en is important nal and c bugshan, kuwaiti eco ity. the pub welfare henc that weake ük (2024), t e private se ce, and man s that const ing et al. (2 adopt to cha pposition to 19 ors besides t in the gcc n are impor cess across untries inclu been noted ying to brea hese strategi ng human c eting the c eeks to esta oub & slim are discuss ectors, muc iance on th gh policy re her factor th ed, nasreen me a stron oviding cap epends on t ase of doin d some posit i attractiven ion in kuwa ncounters in t in the curr cultural fac (2021) an onomy by th blic sector c ce the depe ens the sup the educatio ector. this s nufacturing train the div 2024), and anges that m o privatisati asian the oil indus c rtant for im the region ude the work in the liter ak the traditi ies are the d capital, infr ountry’s di ablish it as mane (2020 sed below. ch more ne e public sec eforms. hat has a pl n, & tiwari ng factor t ital and tec the host cou ng business, tive and neg ness. ait n the proces rent global ctors that nd almask he public se clearly offer endence on pport to non on system fa skills mism that are key versification bacha (202 may weaken ion, labour n journal of f stry. mproving th ns. other a k done by e rature that ional metho diversificati rastructure, versification a financial 0), more de however, u eds to be d ctor, inadeq lace in dive , (2020) an towards pro hnology kn untry’s bus , and the le gative effect ss of divers economy. t have limit kati, (2022) ector has lim rs a large p it. the four n-oil indust ails to provi atch has lim y in diversif n of the eco 24) indicate n the authori market flex finance & ac issn 19 2024, vol. 1 ajfa.macro he sustainab academic w el-chaarani the countri od of remitti ion of the e and techno on of the ec and trading etails abou using the l done to red quate human ersity of inv nd bentour omoting ec now how. h siness envir egal framew ts, and mor sifying its e the literatur ited divers ), show h mited the gr pool of emp rth challeng tries. acco ide the right mited the gr fying the ec onomy. rese e that kuw ity of the st xibility and ccounting 946-052x 16, no. 2 think.org/ bility of works on i, (2019) ies have ing their economy ology. in conomy, g centre. ut theses iterature duce the n capital vestment & fund conomic however, ronment, work. in e efforts economy re raises ification how the rowth of loyment ge is the rding to t kind of rowth of onomy. earch by wait, as a tate over the cuts in subsi demand 2.6 path as high the fac another from be & bouj there is governa way of literatur develop gas. bu educatio drive fo in the f internat abdulla integrat internat organis infrastru the econ 2.7 lite despite approac ggc st socio-p diversif taking i and cul extensiv and dev prospec emergin effect o plans is process idies as all d. hways to su hlighted abo ce of the v r suggestion eing heavily elbène-abb s a need to ance and th approachin re has also pment to fo ugshan, bak on expendit or diversific final sectio tional supp ayeva & ab tion of the tional organ ational cap ucture and t nomy away erature gap e the exten ches to man tates, the fo olitical and fication atte into conside ltural facto ve studies f velopment cts of such ng and vita of internatio s still under s of diversifi these are c uccessful ec ove, literatu various cha n is to prov y dependent bes, (2023) build a co he regulator ng diversific revealed th ster innova kry, & li, ( tures are ne cation for st ns of the li port to div bdullayeva e gcc cou nisations a pacities for technologie y from oil. p nsive body naging econ ollowing lim d economic empts. man eration the ors that ma focusing on within the strategies l domains l onal trends r analysed. fication in k crucial in th conomic div re provides allenges aff vide structur t on the pub and elsayed ompetitive b y environm cation is thr hat educatio ation and de (2023) & b ecessary to tem fields. iterature, th versification (2024) and untries in t and investor r a diverse es and effici of work nomic diver mitations can characterist ny of the s unique feat ay affect d n effects of kuwaiti e for the dev like technol to transitio these gaps kuwait to av 20 he creation versification the followi ffecting ku ral changes blic sector to d, naifar, u business en ments as a w rough the c on and trai evelopment banerjee, m establish th . he focus is n strategie d alqahtani terms of e rs is neede e economy iency in ene that alread rsification i n be identif tics of kuw studies tend tures in the diversificatio swfs and economy, th velopment o logy and re on towards s need to be void overdep asian of a comp n ing suggesti uwait’s econ s that may i o develop p uddin, & wa nvironment, way of enco cultivation o ning is a c of product majumdar, & he human c placed on s. for ins & klein (2 conomic co ed to avail y. this inc ergy sources dy exists i in oil-relian fied. first, t wait that can d to apply r economic s on in kuw fdi policie he evaluati of kuwait enewable en s renewable e filled to g pendence on n journal of f etitive and ions that mi nomic dive influence th rivate secto ang, (2023), , as well as ouraging inv of human c ritical succ s in sectors & mohamme capital requ the necessi stance, a s 2021) point ooperation, l the requi ludes capit s such as in n examinin nt states wit here is little n be applied results at th systems, ma wait. second es on econo on of effic sectors and nergy is def es on kuwa get better un n oil in the finance & ac issn 19 2024, vol. 1 ajfa.macro mixed stru ight prove u ersification he economy ors. from m , it was noti s strengthen vestments. capital. a re cess factor i s other than med, 2023) p uired to sup ity of regio study by h towards en partnershi ired resour tal investm renewables ng the issu th emphasi e prior liter d to the liter he gcc le anagement d, while th omic divers ciency, grow d the prom ficient. furt ait’s divers nderstandin future. ccounting 946-052x 16, no. 2 think.org/ ucture of useful in efforts. y to shift mezghani iced that ning the another eview of in talent n oil and post that pport the onal and hajiyev, nhancing ips with rces and ments in s to shift ues and s on the rature on rature on evel, not systems here are ification wth and otion of ther, the ification ng of the 2.8 sum the exi gcc an efforts. kuwait domina indicate investm 3. rese this ch research research effectiv volatilit 3.1 res a quali studies countrie about th second existing of colle this qu already argume success design i possibil expert a 3.2 res the ind context the stu instead identify the bro sustaina explora framew mmary isting litera nd kuwait although i economy, ance and ye es that div ment on hum earch meth hapter outlin h design, a h methodolo veness in d ty. earch desig itative rese and other l es. the use he dynamic ary data al g diversifica ecting the pr ualitative ap exist on r nt by leve ses and shor is well desi lity of its o analyses. earch appro ductive appr of kuwait’ udy then ado collects da y emergent oader econ able energy atory studie works. ature on eco can help in there have challenges et again pol ersification man capital, odology nes the me approach, d ogy is chos diversificatio gn arch design literature on e of second cs of the ec llows a bro ation initiati rimary data. pproach allo research, po eraging sec rtcomings o igned to ans oil price re oach roach empl ’s economic opts this app ata from sp themes. th omic impli y could aff s is that we onomic dive n understand been some that are sti litical and e must ado and regiona ethodologica data collec en to provid on strategie n is used in n kuwait's dary data is conomy in k oad perspec ives and the . ows the ex olicy report ondary sou of diversific swer the qu esilience thr oyed in this c dependenc proach by re pecific case hrough inve ications an fect kuwait e do not ye 21 ersification ding the pr e small ach ill apparent economic li opt differen al and intern al framewo ction, data de a holistic es in the c n this study economy a s essential a kuwait and ctive on the e trends ove xploration o ts and econ urces, whic cation effort uestions of t rough synth s study is f ce on oil, a efraining fr es, policies, estigating th nd how oil t ((habu, 2 et expect to asian in oil depe ospects and hievements are structur iberalization nt strategies national coo ork adopted analysis, a c analysis o case of risk y which us and the gul as it provid d the other e impacts o er time with of relationsh nomic analy ch provide ts in kuwait the country hesizing fin fit for explo s well as th rom imposin , and literat hese theme l price vol 2023). the o find the r n journal of f endent coun d constraint towards div ral impedim n. on this b s such as s operation. d for this st and limitati of kuwait's k factors re ses seconda f cooperati des relevant gcc count of oil price hout the logi hips, theme yses. this s a rich bod t (delios, 2 ’s economic ndings from oring the sp he feasibility ng pre-exist ture on ku s, the resea latility and advantage results, only finance & ac issn 19 2024, vol. 1 ajfa.macro ntries includ ts of divers versification ments, publi basis, the l structural c tudy, includ ions. a se oil depende related to o ary data fro ion counci t historical ntries (habu e volatility gistical comp es and patte study advan dy of data 023). this r c strategies m case stud pecific and d y of diversi ting hypothe uwait’s econ arch concep d the trans of this me y new patte ccounting 946-052x 16, no. 2 think.org/ ding the ification n of the ic sector iterature changes, ding the econdary ence and oil price om case l (gcc) insights u, 2023). already plexities erns that nces the on the research and the dies and dynamic fication. eses and nomy to ptualizes sition to ethod in erns and the ind underst employ therefor facilitat applicat revenue grounds how to (sundqv 3.3 dat this stu case stu (gcc) peer-rev the inte impact uae (n attempt financia fosterin externa and fisc challeng the sel uae, th insights and adv context on one strategi diversif review the era 3.4 dat this stu qualitat collecte study is analysis ductive app and what p ys secondary re its focu tes a nuanc tion of rent es and econ s these theo o overcome vist, 2024). ta collectio udy’s data c udies and li strategies viewed artic ernational m of diversif nayar, 2024 ts at mitiga al landscap ng non-oil s l factors (su cal stability ges and pot lected case hat also pur s on kuwai vances in s -specific re side in the es. these i fication effo the paths an of oil depen ta analysis udy uses the tive method ed secondar s particular s and help proach allow particular fa y data sour us changes ced underst tier state th nomic depe ories in the e the challe n collection s iterature reg for diver cles from jo monetary fu fication initi 4). the sec ating the ec e and effec sectors are uch as oil p y. this appr tential strate studies exa rsued simila it's progress seeking div ecommendat literature on include reg orts in resou nd hurdles ndency. ematic analy d is based o ry data on o rly well su s extract m ws for flexi actors play rces such a with every tanding of heory, a per endency the e specific ca enges of at strategy reli garding kuw rsification, ournals, gov und (imf) a iatives with ondary data conomic ris ctiveness of assessed to price fluctua roach prese egies for ku amine the e ar diversific s. they are versification tions (nasri n economic gional studi urce-depend faced in fin ysis as the p on identifyi oil depende ited to them meaningful 22 ibility in th into kuwa as policy d y analysis kuwait’s e rspective on eories fram ase of kuw ttaining a ies solely o wait’s relian and speci vernment re and the wo hin other g a give a wi sks of oil d f the econo o provide a ations and g ents an evid uwait’s econ efforts of g cation initia e relevant b n. it is esse i, 2023). th c dependenc ies of the dent econom nding a sust primary data ing, analyz ence and di matic analy themes fro asian he handling ait’s econom documents, that result economic st n the socio ming structu wait and pro more resili on secondar nce on oil, ific policy eports, inter orld bank, a gcc countri ide range o dependency omies from robust und global energ dence-based nomic diver gcc countri tives to pro because thes ential to an he theoretic ce, rentier s gcc and mies. these tainable path a analysis te ing, and re iversificatio ysis as it is om various n journal of f of the dat mic diversif historical e ts from th tructure, in -political d ural vulnera ovides impo ient and di ry sources d the gulf co analyses. rnational org and case stu ies like sau of historical y, particular these sour erstanding gy trends) o d based info rsification fo ies, such as ovide the ba se cases rev nalyze these cal basis of tate theory, global rese works prov h to econom echnique. t eporting pat on efforts (s s flexible f data sourc finance & ac issn 19 2024, vol. 1 ajfa.macro ta and is ne fication. th economic d hese finding ncluding the dependencie abilities. th ortant insig iversified e drawn from ooperation the sour rganizations udies lookin udi arabia l and contem rly in kuw rces with re of the influ on economi formed view for the future s saudi ara asis for com veal the dif e cases to this study and divers earch on ec vide a frame mic develop the approac tterns or th saliya, 202 for qualitati ces such as ccounting 946-052x 16, no. 2 think.org/ eeded to he study data and gs. this eoretical es on oil he study ghts into economy m myriad council rces are such as ng at the and the mporary wait. the egard to uence of ic policy w on the e. abia and mparative fficulties provide is found ification conomic ework to pment in h of this emes of 23). this ive data s policy reports themat 1. extensiv diversif 2. which t 3. policy executin 4. kuwait of oil pr this stu depende this, pro 3.5 lim this pa the rel limiting result o structur views compre it can policym primary limit th about d relevant gulf co countrie arrange themati is in pa and a le objectiv delve in (2023). and econom tic analysis familiariz vely to id fication stra coding: th the data can identifying effectivene ng diversifi reviewing ’s unique si rice volatili udy adopts ency and as ovide basis mitations of t aper based s liance on ex g the study of which the re. seconda of the or ehensivenes capture th makers, bus y data colle he depth of diversificatio t to kuwait ooperation es, particu ements (nas ic and inher atterns in tha engthy revie vely biased n detail into this resear mic literatur is performe ation with dentify recu ategies. hese key ph n be analyze g themes: ess, potentia ication. and defin ituation, an ity. thematic an ssess the im for policy r the study olely on sec xisting liter to informa e study may ary data ma riginal aut s (nayar, 20 he current siness lead ection meth understand on (habu, 2 t’s economi council (g larly non-o sri, 2023). f rently subjec at data and ew process by interpre o kuwait’s o rch employs re. ed in severa the data: urring them hrases, conc ed. the study i al sectors ning them nd used to a nalysis to u mpact of pot recommend condary dat rature limits ation genera y not reflect ay introduc thors, cons 024). moreo sentiments ers and th hods like su ding of cont 2023). addi c structure gcc) region oil produci furthermore ctive in pos can vary be are also ne etative varia oil dependen s case studi 23 al stages: : first, the mes of oi cepts and arg identifies co for diversi mes: theme analyze how understand tential mea dations. ta, has some s the study ated before t swift polic ce biases st sequently h over, the re s and view he public a urveys or in temporary c itionally, wh and strateg n, the applic ing countr e, thematic ssibly servin etween ana eeded for th ations. how ncy and div ies and them asian case studie il dependen guments are ore themes s ification an es are refine w the curren underlying sures to div e limitation to what ha the introdu cy changes o temming fro hindering search is re wpoints of about diver nterviews. a challenges hile insight gies, given k cability of r ries or tho analysis is ng as the int lysts. metic hematic anal wever, this m versification matic analys n journal of f es and liter nce, econo e labeled, fo such as econ nd challeng ed and inte nt policies r causes of k versify the e s that limit as already b uction of th or shifts in k om the sub the study' strained in key stake rsification i a lack of fi and diversi s gained fro kuwait’s un results may ose with d a strong qu terpretation culous ident lysis, yet a methodolog strategies p sis to offer v finance & ac issn 19 2024, vol. 1 ajfa.macro rature are r omic stabil orming the nomic vuln ges encount erpreted in respond to t kuwait’s ec economy, a its scope an been produc he new pol kuwait’s ec bjective or 's objectiv the extent t eholders, in initiatives, firsthand inp ity (in my o om the find nique contex be limited different ec ualitative ap n of the data tification of process tha gy still allow presented by valuable ins ccounting 946-052x 16, no. 2 think.org/ eviewed lity and basis on nerability, tered in light of the risks conomic and from nd depth. ced thus icy as a conomic planned ity and to which ncluding without put may opinion) dings are xt in the to other conomic pproach, a of what f themes at can be ws us to y delios sights to help ku context 4. data this ch econom and ch opportu 4.1 kuw the eco revenue kuwait played revenue total go governm kuwait econom country price flu decline complic and infr oil reve source uwait decre of the glob a presentati hapter inve mic diversifi harts, illustr unities. wait’s depen onomy of k es generated have been in shaping e is far grea overnment i ment incom f is deep in mic framew y’s depende uctuations. in oil pric cates fiscal frastructure enue and n to safegua ease its dep bal energy tr ion and fin estigates k ication thro rating kuw ndency on o kuwait is h d from this n starkly dif kuwait’s fi ater than no income. for me and non-o figure 1. k n oil as ove work is near ncy on glo kuwait rem ces, because planning an developmen non-oil reve ard itself f pendence on ransition. ndings kuwait's eco ough second wait’s reven oil revenue highly depen s source. fi fferent over inancial stru on-oil incom r example, oil revenue j kuwait’s rev er 90 perce rly defined bal oil pric mains highly e this direct nd taxes the nt, which o enue is larg from the ri 24 n oil and e onomic dep dary data. k nue depend e ndent on oi ig. 1 shows r a decade, ucture. the me and in a in 2021 oil just 12%. venue comp ent of gove d by this d ces, which c y exposed t tly impacts e governme obstructs ov ge. kuwait isk of vola asian nsure longpendence o key trends dency, oil il, with alm s that oil re illustrating data revea any year oil revenue m position by ernment rev dependence. can swing to external s public spe nt to cut ba erall econo urgently n atility in o n journal of f -term stabil on oil and are illustrat price vola most 90 perc evenue and g the huge i ls a consist l was more made up app sector oi venues com the relian from good shocks, prim ending. suc ack on 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it ility oil price flu tions in oil lobal oil ex omic diver uwait gdp tween econ urn commo s have been for instance ch indicates volatility a g the econom velopment-in emic present additional g enue is a pri the consequ n journal of f chnology, k my. the goa financial po wait must a er overall f ts citizens. ctuations. f l prices ove xpenditures sification t growth ra nomic grow only leading significant e, when oil p s that oil p also impacts mic environ nitiated pro t opportunit government mary conce uences of th finance & ac issn 19 2024, vol. 1 ajfa.macro kuwait can al of these s osition but address this fiscal resili figure 2 sho er the past and kuwai to countera ate wth in kuw g to gdp t, indicating prices tumb price volati s the gover nment comp ojects. in a ties and cha t revenue a ern of policy he fluctuatio ccounting 946-052x 16, no. 2 think.org/ create a strategic also to s critical ence by ows how decade, it's gdp act such wait and growth. g that the bled, the ility can 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been w these dive ches are em and private tes innovati elopment o wait vision 2 portunities f lysis of suc n potential utions to gd strate kuwa figu omparative cant contrib es has been mies of thes of the oil se ogy are pr is especiall solar and w ence on fos region. mo l technolog t skills em t has set am quite limite ersification mployed is n e sectors, s on and dev f non-oil se 2035. for econom ccessful non lly contribu dp across k ait’s revenue ure 4. secto analysis sho butors to th n its achill e nations v ector. in ku romising, g y critical as wind energy sil fuels but oreover, giv y, the healt mpowers k mbitious go ed. the effe approaches necessary. t streamlined elops entrep ectors in ku mic diversifi n-oil industr ute to econ kuwait and e. oral gdp co so ows how to he uae and es heel. di vibrant with uwait, sector given globa s kuwait pi y investmen t also put it ven the risi thcare indus kuwait's citi 27 oals and fr ectiveness o s are implem this include d regulation preneurship uwait and he fication tries in the nomic dive d other gulf ontributions ources: und ourism, tech d qatar, w iversificatio h many othe rs like renew al sustainab ivots its eco nt could no t in front of ing demand stry has exc izens to e asian rameworks. of these div mented, and es brokering ns and inve p. this can f elp it get clo gulf region ersification. f cooperatio s in gcc c dp hnology and while the ov on strategie er sectors th wable energ bility and i onomy to al ot only help other count d for highcellent pote nable a sm n journal of f the imple versification d a reassess g closer col estment in foster a bett oser to realiz n was made figure 4 on council ountries (20 d financial ver reliance s have succ hat are mak gy, healthca innovation ign with glo p kuwait br tries in the g -quality me ntial for ex moother tra finance & ac issn 19 2024, vol. 1 ajfa.macro ementation n strategies sment of ho llaboration b infrastruct ter environm zing the asp e to identify compares (gcc) cou 023) services ha e of kuwai cessfully m king huge r are, and info trends. ren obal enviro reak away green energ edical servi xpansion. a ansition tow ccounting 946-052x 16, no. 2 think.org/ and its depends ow these between ure that ment for pirations y sectors sectoral untries to ave been it on oil made the revenue, ormation newable onmental from its gy sector ices and access to wards a diversif governm consequ withstan kuwait kuwait revenue region, product increase its inno share ro product estimati bank co investm importa has bee and gro and resp 4.5 pote the cou budgeta 5 illustr diversif fied econom ment entitie uently lead nding the vo t finance h fi finance h e share grow and it has ts and serv ed until 202 ovative prod ose further ts, retail ba ions, kfh i ontinues to ments. this ance to kuw en able to ke owing chall pond to mar ential finan untry still ary flexibili rates projec fication. my. howev es and priva d to more olatility ass house's sha igure 5. kuw ouse (kfh wing from chosen to ices. in 20 20 around 3 duct offerin in 2022, p anking, cor is predicted o expand in shows kfh wait’s balan eep up its gr enges facin rket demand ncial risks faces finan ity without m ctions of k ver, there is ate sectors i balanced a sociated with are of mark wait financ ) is a major 2017 to 20 exploit the 17 kfh m 3%. several ngs, improve pushing it c rporate fina d to stabilize n digital b h’s resilien ncing of its rowth mom ng the indus d. without div ncial risks s making sub kuwait’s fisc 28 s also a ne in these are and sustaina th the oil ma ket revenu ce house's s r player in k 023. kfh i e growth in market reven l factors are ed custome close to 35% ance and i e market re banking and nce in a fie economy aw mentum over stry is also versification such as a d bstantial pro cal sustaina asian eed for enh eas to impro able econo arkets. ue share of ma kuwait's fin s one of th n demand f nue share w e also respo er service, a %, as it co nvestment evenue share d makes m rcely comp way from o r the past fe due to its n depleted so ogress in ec ability unde n journal of f hanced coll ove growth mic develo arket reven nancial mar e largest is for sharia-c was around onsible for t and powerfu ntinued its services. a e at approxi more signifi petitive bank oil reliance. w years des continuous overeign we onomic div er scenarios finance & ac issn 19 2024, vol. 1 ajfa.macro laboration b h in these ar opment cap nue rket with its slamic bank compliant f d 30% and the bank's g ul branding ascent into according ximately 40% ficant techn nking sector the fact th spite the he ability to i ealth fund versification s with and ccounting 946-052x 16, no. 2 think.org/ between reas and pable of s market ks in the financial steadily growth – g. kfh’s o plastic to 2023 % as the nological r and its hat kfh adwinds innovate and lost n. figure without figure the pr continu prices m fiscal st health oil-depe and brin on the the co fluctuat energy. stable g from ex inspire sustaina investm econom 5. conc this pa mitigate depende budget that de econom effectiv 6. projected rojections a ues to depen makes this train that ca and educat endent econ ng budget d other hand ountry coul tions with in according growth patte xternal mar creativity, a ability. to e ment in the my (kuwait clusion and aper critica e the finan ent on oil slack and s evelopment my through f ve as the ma -100.00% 0.00% 100.00% 200.00% 300.00% 400.00% d fiscal hea also indicat nd to a larg dependency an lead to d tion. the i nomies are deficits (imf d, the divers ld improve nvestment i g to research erns and bet rkets (world and help to ensure the w se sectors economic s d recomme ally undersc ncial risks revenues, m social spend initiatives foreign dire anagement p gdp growt rate alth of kuw te that kuw ge extent on y subject to debt accumu internationa particularly f, 2020). sification ca e its econo in alternativ h, countries tter fiscal h d bank, 20 create a mo well-being are impera society, 202 endations cores the im of oil pri making it v ding cuts to such as k ect investme put in place h oil reven dependen fi projected v projected v difference ( 29 wait with vs. wait’s econ n oil revenu o volatility, ulation, or it al monetary y at risk of ase is a mo omic resilie ve sectors su s with more health as the 21). additi ore equitabl of future g ative for k 22). mportance ice volatilit vulnerable endure per kuwait vis ent (fdi) an e and the tim nue nce fisca surplus/d nancial ri value (with div value (without (%) asian . without d nomy will ues. the de which can t could requ y fund (im f economic ore sustaina ence and r uch as techn e diversified eir systems c ionally, dive ly structured generations, kuwait to h of diversify ty. kuwait' to the glob riods of low sion 2035 nd private s me at which al deficit unempl ra ks versification) diversification n journal of f diversificatio face sever ependency amount to uire signific mf) has w shocks tha ble fiscal o reduce expo nology, tour d economie can more ea ersification d economic timely refo ave a robu ying kuwa 's economy bal market w oil prices. focused on sector devel h the initiati oyment ate non-o contri g n) finance & ac issn 19 2024, vol. 1 ajfa.macro on (mirzoev re difficulti on these gl o a large am cant cuts, su warned that at can stifle outlook for osure to o rism and ren es can receiv asily absorb can genera c base for lo forms and p ust and sus ait’s investm y has beco and causin the findin n diversify lopment are ive is imple oil sector ibution to gdp ccounting 946-052x 16, no. 2 think.org/ v, 2023) ies if it lobal oil mount of uch as in heavily e growth kuwait. oil price newable ve more b shocks ate jobs, ong-term proactive stainable ments to ome too ng huge gs show ying the e only as emented. in addit to urgen more ro a holis environ additio need fo more th vulnera between instance and bud additio framew regulato shows t more d kuwait energy, the pap finance econom diversif wealth reliance reforms is ultim changin reliant o challeng 5.1 rec to nav recomm 1. expedie particip environ the econ 2. tion, if glob ntly explore obust econo stic approa nments to at onally, this p r diversifica han 90% of ability to sw n oil price v e, a sharp d dget deficits onally, cons work of kuw ory problem that the con diversified e 's pressing medical ca per also hi e house (k mic environ fication, ku fund and e on oil rev s and invest mately critica ng global e on oil reven ges. commendati vigate these mendations a policy refo ently simpli pation. this nment for en nomy. investmen bal energy d e other sect omic setting ach that st ttract private paper has a ation to secu f governme wings in glo volatility an drop in oil p s and underm sidering tha wait vision ms and slo ntribution o economies i need to e are, and info ighlights th kfh), who nment. nev uwait has s reduction o venues cou tments in ot al to immed conomic la nues and sav ions e challenge are propose form and r ify the proc s will help ntrepreneurs t in hum dynamics ar tors like tec g. the propo trengthens e investmen analyzed ku ure the coun ent revenues bal oil price nd gdp gro rices, which mined publi at kuwait n 2035, the w impleme of the gdp in terms of xpand its e ormation tec e role of k o have show vertheless, u significant f of budgetar uld bring se ther sectors. diate financ andscape. k ve its peopl es and secu ed: regulatory cesses that d p to stream ship and inn man capita 30 re evolving chnology, t osed policy investmen nt. uwait’s econ ntry’s longs for kuwa es in the ec owth and th h in the pas ic services. has launch e efficiency entation. a sector in k f tourism, t economic b chnology. key players wn resilien unless sub financial ris ry flexibili evere econo . the succe cial stability kuwait can le from bad ure a susta simplificat discourage mline burea novation, al al: there m asian toward ren tourism, and y recommen nt in youn nomic depe -term econo ait come fro conomy. fig hat kuwait's st have caus hed diversif y of these s a compariso kuwait is hi technology, base is evid in the fina nce and gro stantial pro sks, includi ity. accord omic conse ssful divers y and long-t develop a d times by re ainable eco tion: the ne the private aucratic hu ll of which must be co n journal of f newable sou d renewable ndations und ng industrie endence on omic sustain om oil, a fa gures show s economy i sed a sharp c fication tec strategies is on with oth ighly contra and financ dent, espec ancial secto owth despi ogress is m ing depletio ing to proj equences, n sification of term sustain prosperous esponding p onomic futu ew kuwait sector and urdles for a are very im oncerted ef finance & ac issn 19 2024, vol. 1 ajfa.macro urces, kuwa e energy to derline the n es and re oil and the nability and actor that p a direct cor is on the br contraction chniques un s slowed d her gcc c asting comp cial service cially in ren or, such as ite the cha made in ec on of its so jections, co necessitating f kuwait's e nability in a s future tha proactively ture, the fo governmen foreign inv a more co mportant to d fforts to in ccounting 946-052x 16, no. 2 think.org/ ait needs o build a need for gulatory e critical growth. uts high rrelation rink. for n in gdp nder the down by countries pared to s. thus, newable kuwait allenging conomic overeign ontinued g timely economy a rapidly at is less to these ollowing nt should vestment onducive diversify nvest in educatio new ind such as econom 3. and pr partners allow v 4. sustaina projects a leader 5. monitor framew flow of to achie the fin revenue and bal increase citizens kuwait towards referen al-fayo stock https://d alkhou sector: manage almask emergin https://d aloui, c risk ma https://d alqahta on and trai dustries to e s technolog my based on enhanced rivate enter ships may s various econ focus on able industr s, kuwait ca r in the regi continuou r and eval work will he f economic t eve its diver ndings of th e. the impl lanced kuw ed resilienc s. this can can chart s a prospero nces oumi, n., b market s doi.org/10.1 uri, r., & a evidence f erial financ kati, n. (202 ng m doi.org/10.1 c., & hami atter in term doi.org/10.1 ani, a., & k ining progra emerge. ku gy and ren n knowledge public-pri rprises wil support the nomic activi sustainabl ries, particu an not only on's green e us monitor luate the e elp policym trends and t rsification g his paper h ementation wait econo e and future be fraught a path tow ous future. bouri, e., & ector retu 1016/j.eneco arouri, h. (2 from the g ce, 15(1), 1 22). oil, fo markets 1080/15404 ida, h. b. ( ms of investm 1080/10242 klein, t. (2 ams that ac uwait needs ewable ene e. ivate partn ll encourag ability to de ities to supp e industrie ularly renew y reduce its energy mark ring and effectivenes makers conti the perform goals. ighlight the of the reco my that le e sustainabl t with chall ward econo & abuzayed urns and o.2023.1069 2019). the e gulf coope 00-128. http oreign excha finance 96x.2021.1 (2021). oilment horizo 694.2019.1 021). oil p 31 cculturate th s a skilled l ergy so tha nerships: c ge investm evelop infra port the grow es: kuwait wable energ dependence ket, aligning evaluation ss of diver inuously fin mances of the e need for ommendatio eans more le growth to lenges but omic divers d, b. (2023) volatility. 930 effect of div eration cou ps://doi.org ange swaps and 1990751 -stock nexu ons?. defenc 696094 price change asian he foundati abour force at it can ex collaboratio ment in no astructure an wth of over should act gy. by prior e on fossil f g with globa n: importan rsification ne-tune the e non-oil se kuwait to ons stated a towards in ogether with with certai sification a ). decompo energy versification uncil countr /10.1108/ij s and intere trade, s in an oil-r ce and peac es, uncertain n journal of f ion with th e to develop xperience a on between on-oil secto nd innovate all gdp. tively prom ritizing sola fuels but als al sustainab ntly, a rob strategies i ir approach ectors so tha reduce its above will f ternal force h a better q in foresight way from sed oil pric economics n on risk an ries. intern mf-01-201 st rates in t 58(8) rich country ce economi nty, and geo finance & ac issn 19 2024, vol. 1 ajfa.macro he needed s p growth in a shift tow public ins ors. public e, creating a mote investm ar and wind so position bility goals. bust framew is necessar hes in line w at kuwait co dependenc foster a mor es, contribu quality of lif t and comm its oil wea ce shocks an s, 126, nd return in national jou 18-0024 the gcc co ), 238 y: does geo ics, 32(4), 4 opolitical ri ccounting 946-052x 16, no. 2 think.org/ kills for n sectors wards an titutions c-private a zone to ments in d energy itself as work to ry. this with the ontinues e on oil re stable uting to fe for its mitment, alth and nd gcc 106930. banking urnal of ountries. 88-2406. political 468-488. isks: on the re https://d alqahta stock m antwi‐b examin https://d bacha, the ex 14(2), 2 banerje perform interna https://d bentour oil-expo bigerna volatilit bollino conven https://d bugsha perform bugsha empiric journal https://d el-chaa sector i markets econom https://d elsayed shocks of finan elsayed spillove esilience o doi.org/10.1 ani, a., kle markets. res boateng, o ation of div doi.org/10.1 s. 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